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FINANCIAL ACCOUNTING Tools for Business Decision Making

E IGHTH EDIT ION

CHART OF ACCOUNTS

The following is a sample chart of accounts. It does not represent a comprehensive chart of all the accounts used in this textbook but rather those accounts that are commonly used. This sample chart of accounts is for a company that generates both service revenue as well as sales revenue. It uses the perpetual approach to inventory. If a periodic system was used, the following temporary accounts would be needed to record inventory purchases: Purchases, Freight-In, Purchase Returns and Allowances, and Purchase Discounts.

Assets Cash

Accounts Receivable

Allowance for Doubtful Accounts

Interest Receivable

Inventory

Supplies

Prepaid Insurance

Prepaid Rent

Land

Equipment

Accumulated Depreciation— Equipment

Buildings

Accumulated Depreciation— Buildings

Copyrights

Goodwill

Patents

Liabilities Notes Payable

Accounts Payable

Unearned Service Revenue

Salaries and Wages Payable

Interest Payable

Dividends Payable

Income Taxes Payable

Bonds Payable

Discount on Bonds Payable

Premium on Bonds Payable

Mortgage Payable

Stockholders’ Equity Common Stock

Paid-in Capital in Excess of Par Value—Common Stock

Preferred Stock

Paid-in Capital in Excess of Par Value—Preferred Stock

Treasury Stock

Retained Earnings

Dividends

Income Summary

Revenues Service Revenue

Sales Revenue

Sales Discounts

Sales Returns and Allowances

Interest Revenue

Gain on Disposal of Plant Assets

Expenses Administrative Expenses

Amortization Expense

Bad Debt Expense

Cost of Goods Sold

Depreciation Expense

Freight-Out

Income Tax Expense

Insurance Expense

Interest Expense

Loss on Disposal of Plant Assets

Maintenance and Repairs Expense

Rent Expense

Salaries and Wages Expense

Selling Expenses

Supplies Expense

Utilities Expense

ACCOUNT CLASSIFICATION AND PRESENTATION

Account Title Classification Financial Statement Normal Balance

A Accounts Payable Current Liability Balance Sheet Credit

Accounts Receivable Current Asset Balance Sheet Debit

Accumulated Depreciation—Buildings Plant Asset—Contra Balance Sheet Credit

Accumulated Depreciation—Equipment Plant Asset—Contra Balance Sheet Credit

Administrative Expenses Operating Expense Income Statement Debit

Allowance for Doubtful Accounts Current Asset—Contra Balance Sheet Credit

Amortization Expense Operating Expense Income Statement Debit

B Bad Debt Expense Operating Expense Income Statement Debit

Bonds Payable Long-Term Liability Balance Sheet Credit

Buildings Plant Asset Balance Sheet Debit

C Cash Current Asset Balance Sheet Debit

Common Stock Stockholders’ Equity Balance Sheet Credit

Copyrights Intangible Asset Balance Sheet Debit

Cost of Goods Sold Cost of Goods Sold Income Statement Debit

D Debt Investments Current Asset/

Long-Term Investment Balance Sheet Debit

Depreciation Expense Operating Expense Income Statement Debit

Discount on Bonds Payable Long-Term Liability—Contra Balance Sheet Debit

Dividend Revenue Other Income Income Statement Credit Dividends Temporary account closed

to Retained Earnings Retained Earnings Statement

Debit

Dividends Payable Current Liability Balance Sheet Credit

E Equipment Plant Asset Balance Sheet Debit

F Freight-Out Operating Expense Income Statement Debit

G Gain on Disposal of Plant Assets Other Income Income Statement Credit

Goodwill Intangible Asset Balance Sheet Debit

I Income Summary Temporary account closed

to Retained Earnings Not Applicable (1)

Income Tax Expense Income Tax Expense Income Statement Debit

Income Taxes Payable Current Liability Balance Sheet Credit

Insurance Expense Operating Expense Income Statement Debit

Interest Expense Other Expense Income Statement Debit

Interest Payable Current Liability Balance Sheet Credit

Interest Receivable Current Asset Balance Sheet Debit

Interest Revenue Other Income Income Statement Credit

Inventory Current Asset Balance Sheet (2) Debit

Account Title Classification Financial Statement Normal Balance

L Land Plant Asset Balance Sheet Debit

Loss on Disposal of Plant Assets Other Expense Income Statement Debit

M Maintenance and Repairs Expense Operating Expense Income Statement Debit

Mortgage Payable Long-Term Liability Balance Sheet Credit

N Notes Payable Current Liability/

Long-Term Liability Balance Sheet Credit

P Patents Intangible Asset Balance Sheet Debit

Paid-in Capital in Excess of Par Value—Common Stock

Stockholders’ Equity Balance Sheet Credit

Paid-in Capital in Excess of Par Value—Preferred Stock

Stockholders’ Equity Balance Sheet Credit

Preferred Stock Stockholders’ Equity Balance Sheet Credit

Premium on Bonds Payable Long-Term Liability—Contra Balance Sheet Credit

Prepaid Insurance Current Asset Balance Sheet Debit

Prepaid Rent Current Asset Balance Sheet Debit

R Rent Expense Operating Expense Income Statement Debit Retained Earnings Stockholders’ Equity Balance Sheet and Retained

Earnings Statement Credit

S Salaries and Wages Expense Operating Expense Income Statement Debit

Salaries and Wages Payable Current Liability Balance Sheet Credit

Sales Discounts Revenue—Contra Income Statement Debit

Sales Returns and Allowances Revenue—Contra Income Statement Debit

Sales Revenue Revenue Income Statement Credit

Selling Expenses Operating Expense Income Statement Debit

Service Revenue Revenue Income Statement Credit

Stock Investments Current Asset/Long-Term Investment

Balance Sheet Debit

Supplies Current Asset Balance Sheet Debit

Supplies Expense Operating Expense Income Statement Debit

T Treasury Stock Stockholders’ Equity Balance Sheet Debit

U Unearned Service Revenue Current Liability Balance Sheet Credit

Utilities Expense Operating Expense Income Statement Debit

(1) The normal balance for Income Summary will be credit when there is a net income, debit when there is a net loss. The Income Summary account does not appear on any financial statement.

(2) If a periodic system is used, Inventory also appears on the income statement in the calculation of cost of goods sold.

FINANCIAL ACCOUNTING Tools for Business Decision Making

E IGHTH EDIT ION

Paul D. Kimmel PhD, CPA University of Wisconsin—Milwaukee

Milwaukee, Wisconsin

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

Madison, Wisconsin

Donald E. Kieso PhD, CPA Northern Illinois University

DeKalb, Illinois

Vice President and Director George Hoffman Executive Editor Michael McDonald Development Editor Ed Brislin Editorial Supervisor Terry Ann Tatro Editorial Associate Margaret Thompson Senior Content Manager Dorothy Sinclair Senior Production Editor Suzie Pfister Executive Marketing Manager Karolina Zarychta Hons Product Design Manager Allison Morris Product Designer Matt Origoni Media Specialist Elena Santa Maria Design Director Harry Nolan Cover Design Maureen Eide Interior Design Maureen Eide Senior Photo Editor Mary Ann Price Market Solutions Assistant Elizabeth Kearns Cover Credit Susanna Price/Getty Images, Inc.

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1 Introduction to Financial Statements 2 2 A Further Look at Financial Statements 44 3 The Accounting Information System 90 4 Accrual Accounting Concepts 150 5 Merchandising Operations and the

Multiple-Step Income Statement 214 6 Reporting and Analyzing Inventory 266 7 Fraud, Internal Control, and Cash 316 8 Reporting and Analyzing Receivables 374 9 Reporting and Analyzing Long-Lived Assets 422 10 Reporting and Analyzing Liabilities 478 11 Reporting and Analyzing Stockholders’

Equity 536 12 Statement of Cash Flows 590 13 Financial Analysis: The Big Picture 646

APPENDICES A Specimen Financial Statements:

Apple Inc. A-1 B Specimen Financial Statements:

Columbia Sportswear Company B-1 C Specimen Financial Statements:

VF Corporation C-1 D Specimen Financial Statements: Amazon.com, Inc. D-1 E Specimen Financial Statements: Wal-Mart Stores, Inc. E-1 F Specimen Financial Statements: Louis Vuitton F-1 G Time Value of Money G-1 H Reporting and Analyzing Investments H-1

COMPANY INDEX I-1 SUBJECT INDEX I-5

iii

Brief Contents

Dear Student,

Why This Course? Remember your biology course in high school? Did you have one of those “invisible man” models (or maybe something more high-tech than that) that gave you the opportunity to look “inside” the human body? This accounting course offers something similar. To understand a business, you have to understand the financial insides of a business organization. A financial accounting course will help you understand the essential financial components of businesses. Whether you are looking at a large multinational company like Apple or Starbucks or a single- owner software consulting business or coffee shop, knowing the fundamentals of financial accounting will help you understand what is happening. As an employee, a manager, an investor,a business owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you will make better decisions for having taken this course.

Why This Book? Hundreds of thousands of students have used this textbook. Your instructor has chosen it for you because of its trusted reputation. The authors have worked hard to keep the book fresh, timely, and accurate.

How to Succeed? We’ve asked many students and many instructors whether there is a secret for success in this course. The nearly unanimous answer turns out to be not much of a secret: “Do the homework.” This is one course where doing is learn- ing. The more time you spend on the homework assignments—using the various tools that this textbook provides—the more likely you are to learn the essential concepts, techniques, and methods of accounting. Besides the textbook itself, WileyPLUS and the book’s companion website also offer various support resources.

Good luck in this course. We hope you enjoy the experience and that you put to good use throughout a lifetime of success the knowledge you obtain in this course. We are sure you will not be disappointed.

Paul D. Kimmel Jerry J. Weygandt

Donald E. Kieso

“Whether you are looking at a large multinational company like Apple or Starbucks or a single-owner software consulting business or coffee shop, knowing the fundamentals of financial accounting will help you understand what is happening.”

From the Authors

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 journals. 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.

Paul Kimmel PAUL D. KIMMEL, PhD, CPA, received his bachelor’s degree from the University of Minnesota and his doctorate in account- ing from the University of Wisconsin. He is an Associate Professor at the University of Wisconsin—Milwaukee, and has pub- lic accounting experience with Deloitte & Touche (Minneapolis). He was the recipient of the UWM School of Business Advisory Council Teaching Award, the Reggie Taite Excellence in Teaching Award and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin. He is also a recipient of the Elijah Watts Sells Award for Honorary Distinction for his results on the CPA exam. He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting Education, Journal of Accounting Education, as well as other journals. His research interests include accounting for financial instruments and innovation in accounting education. He has published papers and given numerous talks on incorporating critical thinking into accounting education, and helped prepare a catalog of critical thinking resources for the Federated Schools of Accountancy.

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 chair- man 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 postdoctoral 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.

Author Commitment

Quickly identify areas of strength and weakness before the first exam, and use the information to build a learning path to success.

A little time with ORION goes a long way. Based on usage data, students who engage in ORION adaptive practice—just a few minutes per week—get better outcomes. In fact, students who used ORION five or more times over the course of a semester reported the following results:

Developing effective problem solving skills requires practice, relevant feedback, and insightful examples.

Solutions to practice multiple-choice questions, exercises, and problems are now available at the end of each chapter.

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Discuss how to classify and determine inventory. Merchandisers need only one inventory classifi cation, merchandise inventory, to describe the different items that make up total inventory. Manufacturers, on the other hand, usually classify inventory into three catego- ries: fi nished goods, work in process, and raw materi- als. To determine inventory quantities, manufactur- ers (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.

2 Apply inventory cost fl ow methods and discuss their fi nancial effects. The primary basis of accounting for inventories is cost. Cost includes all expenditures neces- sary to acquire goods and place them in a condition ready for sale. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost fl ow methods are specifi c identifi cation and three assumed cost fl ow methods—FIFO, LIFO, and average-cost. The cost of goods available for sale may be allocated to cost of goods sold and ending inventory by specifi c identifi cation or by a method based on an assumed cost fl ow. When prices are rising, the fi rst-in, fi rst-out (FIFO) method results in lower cost of goods sold and higher net income than the average-cost and the last-in, fi rst-out (LIFO) methods. The reverse is true when prices are fall- ing. In the balance sheet, FIFO results in an ending inven- tory that is closest to current value, whereas the inven- tory under LIFO is the farthest from current value. LIFO

lt i th l t i t (b f l t

Inventory turnover is calculated as cost of goods sold divided by average inventory. It can be converted to average days in inventory by dividing 365 days by the inventory turnover. A higher inventory turnover or lower average days in inventory suggests that management is trying to keep inventory levels low relative to its sales level. The LIFO reserve represents the difference between ending inventory using LIFO and ending inventory if FIFO were employed instead. For some companies this differ- ence can be signifi cant, and ignoring it can lead to inappro- priate conclusions when using the current ratio or inven- tory turnover.

*4 Apply inventory cost fl ow methods to perpetual inven- tory records. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. Under the average- cost method, a new average cost is computed after each purchase.

▼

c06ReportingAndAnalyzingInventory.indd Page 291 01/06/15 8:11 PM f-0161 /202/WB01539/9781118552551/ch06/text_s

SOLUTION

1. Ending inventory—as reported $650,000

1. Subtract from inventory: The goods belong to Bosnia Corporation. Sergei is merely holding them for Bosnia. (200,000)

2. Add to inventory: The goods belong to Sergei when they were shipped. 40,000

3. Subtract from inventory: Offi ce supplies should be carried in a separate account. They are not considered inventory held for resale. (15,000)

4. Add to inventory: The goods belong to Sergei until they are shipped (Jan. 1). 30,000

p p

INSTRUCTIONS

Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, saying why you did or did not make an adjustment for each item.

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SOLUTIONS 1. (d) A physical inventory is usually taken when a limited number of goods are being sold or received, and at the end

of the company’s fi scal year. Choice (a) is incorrect because a physical inventory count is usually taken when the com- pany has the least, not greatest, amount of inventory. Choices (b) and (c) are correct, but (d) is the better answer.

2. (a) Goods held on consignment should not be included because another company has title (ownership) to the goods. The other choices are incorrect because (b) goods shipped on consignment to another company and (c) goods in transit from another company shipped FOB shipping point should be included in a company’s ending inventory. Choice (d) is incorrect because (a) is not included in the physical inventory.

3. (b) The inventory held on consignment by Rogers should be included in Railway’s inventory balance at cost ($35,000). The purchased goods of $13,000 should not be included in inventory until January 3 because the goods are shipped FOB destination. Therefore, the correct amount of inventory is $215,000 ($180,000 + $35,000), not (a) $230,000, (c) $228,000, or (d) $193,000.

4. (c) Under FIFO, ending inventory will consist of 5,000 units from the Nov. 8 purchase and 4,000 units from the June 19 purchase. Therefore, ending inventory is (5,000 × $13) + (4,000 × $12) = $113,000, not (a) $99,000, (b) $108,000, or (d) $117,000.

5. (d) Under LIFO, ending inventory will consist of 8,000 units from the inventory at Jan. 1 and 1,000 units from the June 19 purchase. Therefore, ending inventory is (8,000 × $11) + (1,000 × $12) = $100,000, not (a) $113,000, (b) $108,000, or (c) $99,000.

6 (d) Under the average-cost method total cost of goods available for sale needs to be calculated in order to deter-

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S l ti t ti lti l

New PRACTICE QUESTIONS WITH SOLUTIONS include:

• BRIEF EXERCISES

• EXERCISES

• DO IT! Exercises

• PROBLEMS

All new practice questions provide

assessment, helping students see what

they understand and where they can

improve.

Algorithmic versions of the questions

allow students to revisit practice

questions until they understand a

topic completely.

Focus on the Accounting Cycle To help students master accounting cycle concepts, we added (1) new, recurring illustrations that show students the big picture of the accounting cycle, (2) new comprehensive accounting cycle exercises and problems, and (3) new accounting cycle questions in the Test Bank and .

Student 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 sum- maries, multiple-choice questions with feedback for each answer choice, practice exercises with solutions, and a prac- tice problem with a solution. Also, all learning objective modules in the textbook are followed by a DO IT! exercise with an accompanying solution.

In WileyPLUS, two brief exercises, two DO IT! exercises, two exercises, and a new problem are available for practice with each chapter. All of the new practice questions are algorithmic, providing students with multiple opportunities for advanced practice. WileyPLUS assessment now includes new narrative student feedback.

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

Updated Content and Design We scrutinized all content to find new ways to engage students and help them learn accounting concepts. A new learning objective structure helps students practice their understanding of concepts with DO IT! exercises before they move on to different topics in other learning objectives. Coupled with a new interior design, revised infographics, and the newly designed interactive chapter tutorials, the new outcomes-oriented approach motivates students and helps them make the best use of their time.

WileyPLUS Videos Over 150 videos are available in WileyPLUS. More than 80 of the videos are new to the Eighth Edition. The videos walk students through relevant homework problems and solutions, review important concepts, provide overviews of Excel skills, and explore topics in a real-world context.

Real World Context: Feature Stories and Comprehensive Problems New feature stories frame chapter topics in a real-world company example. Also, the feature stories now closely cor- relate with the Using Decision Tools problem at the end of each chapter. In WileyPLUS, real-world Insight boxes now have questions that can be assigned as homework.

More information about the Eighth Edition is available on the book’s website at www.wiley.com/college/kimmel.

viii

What’s New?

2Introduction to FinancialStatements1

Knowing the Numbers 3 LO 1: Study the forms of business organization and

the uses of accounting information. 4 Forms of Business Organization 4 Users and Uses of Financial Information 5 Ethics in Financial Reporting 7

LO 2: Explain the three principal types of business activity. 8

Financing Activities 9 Investing Activities 9 Operating Activities 9

LO 3: Describe the four financial statements and how they are prepared. 11

Income Statement 11 Retained Earnings Statement 12 Balance Sheet 13 Statement of Cash Flows 14 Interrelationships of Statements 15 Other Elements of an Annual Report 18

A Look at IFRS 42

46A Further Look at Financial Statements2

Just Fooling Around? 45 LO 1: Identity the sections of a classified

balance sheet. 46 Current Assets 46 Long-Term Investments 48 Property, Plant, and Equipment 48 Intangible Assets 48 Current Liabilities 50 Long-Term Liabilities 50 Stockholders’ Equity 50

LO 2: Use ratios to evaluate a company’s profitability, liquidity, and solvency. 51

Ratio Analysis 51 Using the Income Statement 52 Using a Classified Balance Sheet 53 Using the Statement of Cash Flows 57

LO 3: Discuss financial reporting concepts. 58 The Standard-Setting Environment 58 Qualities of Useful Information 59 Assumptions in Financial Reporting 60 Principles in Financial Reporting 61 Cost Constraint 62

A Look at IFRS 87

90The Accounting InformationSystem 3

Accidents Happen 91 LO 1: Analyze the effect of business transactions

on the basic accounting equation. 92 Accounting Transactions 92 Analyzing Transactions 93 Summary of Transactions 99

LO 2: Explain how accounts, debits, and credits are used to record business transactions. 100

Debits and Credits 101 Debit and Credit Procedures 101 Stockholders’ Equity Relationships 104 Summary of Debit/Credit Rules 105

LO 3: Indicate how a journal is used in the recording process. 106

The Recording Process 106 The Journal 106

LO 4: Explain how a ledger and posting help in the recording process. 109

The Ledger 109 Chart of Accounts 109 Posting 110 The Recording Process Illustrated 111 Summary Illustration of Journalizing and

Posting 117 LO 5: Prepare a trial balance. 119

Limitations of a Trial Balance 119 A Look at IFRS 148

46Accrual Accounting Concepts4 Keeping Track of Groupons 151 LO 1: Explain the accrual basis of accounting and

the reasons for adjusting entries. 152 The Revenue Recognition Principle 152 The Expense Recognition Principle 152 Accrual versus Cash Basis of Accounting 153 The Need for Adjusting Entries 154 Types of Adjusting Entries 155

LO 2: Prepare adjusting entries for deferrals. 156 Prepaid Expenses 156 Unearned Revenues 160

LO 3: Prepare adjusting entries for accruals. 163 Accrued Revenues 163 Accrued Expenses 164 Summary of Basic Relationships 167

Table of Contents

LO 4: Prepare an adjusted trial balance and closing entries. 170

Preparing the Adjusted Trial Balance 170 Preparing Financial Statements 171 Quality of Earnings 172 Closing the Books 175 Summary of the Accounting Cycle 177

LO *5: APPENDIX 4A: Describe the purpose and the basic form of a worksheet. 182

A Look at IFRS 212

150 Merchandising Operations and the Multiple-Step Income Statement

Buy Now, Vote Later 215 LO 1: Describe merchandising operations and

inventory systems. 216 Operating Cycles 216 Flow of Costs 217

LO 2: Record purchases under a perpetual inventory system. 219

Freight Costs 221 Purchase Returns and Allowances 221 Purchase Discounts 222 Summary of Purchasing Transactions 223

LO 3: Record sales under a perpetual inventory system. 224

Sales Returns and Allowances 225 Sales Discounts 226

LO 4: Prepare a multiple-step income statement and a comprehensive income statement. 227

Single-Step Income Statement 227 Multiple-Step Income Statement 228 Comprehensive Income Statement 231

LO 5: Determine cost of goods sold under a periodic inventory system. 233

LO 6: Compute and analyze gross profit rate and profit margin. 234

Gross Profit Rate 234 Profit Margin 235

LO *7: APPENDIX 5A: Record purchases and sales of inventory under a periodic inventory system. 239

Recording Merchandise Transactions 239 Recording Purchases of Merchandise 239 Freight Costs 240 Recording Sales of Merchandise 240 Comparison of Entries—Perpetual vs.

Periodic 241 A Look at IFRS 264

266Reporting and Analyzing Inventory6

“Where Is That Spare Bulldozer Blade?” 267 LO 1: Discuss how to classify and

determine inventory. 268 Classifying Inventory 268 Determining Inventory Quantities 269

LO 2: Apply inventory cost flow methods and discuss their financial effects. 271

Specific Identification 272 Cost Flow Assumptions 273 Financial Statement and Tax Effects of Cost Flow

Methods 277 Using Inventory Cost Flow Methods

Consistently 280 LO 3: Explain the statement presentation and

analysis of inventory. 281 Presentation 281 Lower-of-Cost-or-Market 281 Analysis 283 Analysts’ Adjustments for LIFO Reserve 284

LO *4: APPENDIX 6A: Apply inventory cost flow methods to perpetual inventory records. 287

First-In, First-Out (FIFO) 287 Last-In, First-Out (LIFO) 288 Average-Cost 289

LO *5: APPENDIX 6B: Indicate the effects of inventory errors on the financial statements. 289

Income Statement Effects 289 Balance Sheet Effects 290

A Look at IFRS 314

316Fraud, Internal Control, and Cash7

Minding the Money in Madison 317 LO 1: Define fraud and the principles of

internal control. 318 Fraud 318 The Sarbanes-Oxley Act 318 Internal Control 319 Principles of Internal Control Activities 320 Limitations of Internal Control 326

LO 2: Apply internal control principles to cash. 327

Cash Receipts Controls 328 Cash Disbursements Controls 330

LO 3: Apply the control features of a bank account. 333

Electronic Funds Transfer (EFT) System 333 Bank Statements 333 Reconciling the Bank Account 334

LO 4: Explain the reporting of cash and the basic principles of cash management. 340

Reporting Cash 340 Managing and Monitoring Cash 341 Cash Budgeting 344

LO *5: APPENDIX 7A: Explain the operation of a petty cash fund. 347

Establishing the Petty Cash Fund 347 Making Payments from Petty Cash 347 Replenishing the Petty Cash Fund 348

A Look at IFRS 371

374Reporting and Analyzing Receivables8

What’s Cooking? 375 LO 1: Explain how companies recognize

accounts receivable. 376 Types of Receivables 376 Recognizing Accounts Receivable 376

LO 2: Describe how companies value accounts receivable and record their disposition. 378

Valuing Accounts Receivable 378 Disposing of Accounts Receivable 385

LO 3: Explain how companies recognize, value, and dispose of notes receivable. 387

Determining the Maturity Date 388 Computing Interest 388 Recognizing Notes Receivable 388 Valuing Notes Receivable 389 Disposing of Notes Receivable 389

LO 4: Describe the statement presentation of receivables and the principles of receivables management. 391

Financial Statement Presentation of Receivables 391

Managing Receivables 392 Evaluating Liquidity of Receivables 394 Accelerating Cash Receipts 396

A Look at IFRS 419

422Reporting and Analyzing Long-Lived Assets9

A Tale of Two Airlines 423 LO 1: Explain the accounting for plant

asset expenditures. 424 Determining the Cost of Plant Assets 424 Expenditures During Useful Life 427 To Buy or Lease? 428

LO 2: Apply depreciation methods to plant assets. 429

Factors in Computing Depreciation 430 Depreciation Methods 430

Revising Periodic Depreciation 435 Impairments 436

LO 3: Explain how to account for the disposal of plant assets. 437

Sale of Plant Assets 437 Retirement of Plant Assets 438

LO 4: Identity the basic issues related to reporting intangible assets. 439

Accounting for Intangible Assets 440 Types of Intangible Assets 440

LO 5: Discuss how long-lived assets are reported and analyzed. 443

Presentation 443 Analysis 444

LO *6: APPENDIX 9A: Compute periodic depreciation using the declining-balance method and the units-of-activity method. 449

Declining-Balance Method 449 Units-of-Activity Method 450

A Look at IFRS 475

478Reporting and Analyzing Liabilities10

And Then There Were Two 479 LO 1: Explain how to account for current

liabilities. 480 What Is a Current Liability? 480 Notes Payable 480 Sales Taxes Payable 481 Unearned Revenues 481 Current Maturities of Long-Term Debt 482 Payroll and Payroll Taxes Payable 483

LO 2: Describe the major characteristics of bonds. 485

Types of Bonds 486 Issuing Procedures 486 Determining the Market Price of Bonds 486

LO 3: Explain how to account for bond transactions. 489

Issuing Bonds at Face Value 489 Discount or Premium on Bonds 489 Issuing Bonds at a Discount 490 Issuing Bonds at a Premium 492 Redeeming Bonds at Maturity 493 Redeeming Bonds before Maturity 493

LO 4: Discuss how liabilities are reported and analyzed. 495

Presentation 495 Analysis 496

LO *5: APPENDIX 10A: Apply the straight-line method of amortizing bond discount and bond premium. 502

Amortizing Bond Discount 502 Amortizing Bond Premium 503

LO *6: APPENDIX 10B: Apply the effective-interest method of amortizing bond discount and bond premium. 504

Amortizing Bond Discount 505 Amortizing Bond Premium 506

LO *7: APPENDIX 10C: Describe the accounting for long-term notes payable. 507

A Look at IFRS 534

536Reporting and Analyzing Stockholders’ Equity11

Oh Well, I Guess I’ll Get Rich 537 LO 1: Discuss the major characteristics of a

corporation. 538 Characteristics of a Corporation 538 Forming a Corporation 541 Stockholder Rights 541 Stock Issue Considerations 542 Corporate Capital 544

LO 2: Explain how to account for the issuance of common and preferred stock, and the purchase of treasury stock. 545

Accounting for Common Stock 545 Accounting for Preferred Stock 546 Treasury Stock 547

LO 3: Explain how to account for cash dividends and describe the effect of stock dividends and stock splits. 549

Cash Dividends 549 Dividend Preferences 552 Stock Dividends 553 Stock Splits 555

LO 4: Discuss how stockholders’ equity is reported and analyzed. 557

Retained Earnings 557 Retained Earnings Restrictions 558 Balance Sheet Presentation of Stockholders’

Equity 558 Analysis of Stockholders’ Equity 560 Debt versus Equity Decision 562

LO *5: APPENDIX 11A: Prepare entries for stock dividends. 565

A Look at IFRS 587

590Statement of Cash Flows12 Got Cash? 591 LO 1: Discuss the usefulness and format of the

statement of cash flows. 592 Usefulness of the Statement of Cash Flows 592 Classification of Cash Flows 592

Significant Noncash Activities 593 Format of the Statement of

Cash Flows 594 LO 2: Prepare a statement of cash flows using

the indirect method. 595 Indirect and Direct Methods 596 Indirect Method—Computer Services

Company 596 Step 1: Operating Activities 598 Summary of Conversion to Net Cash

Provided by Operating Activities– Indirect Method 601

Step 2: Investing and Financing Activities 603

Step 3: Net Change in Cash 604 LO 3: Use the statement of cash flows to

evaluate a company. 607 The Corporate Life Cycle 607 Free Cash Flow 609

LO *4: APPENDIX 12A: Prepare a statement of cash flows using the direct method. 611

Step 1: Operating Activities 613 Step 2: Investing and Financing Activities 617 Step 3: Net Change in Cash 618

LO *5: APPENDIX 12B: Use the T-account approach to prepare a statement of cash flows. 618

A Look at IFRS 643

646Financial Analysis: The Big Picture13

It Pays to Be Patient 647 LO 1: Apply the concept of sustainable income

and quality of earnings. 648 Sustainable Income 648 Quality of Earnings 652

LO 2: Apply horizontal analysis and vertical analysis. 654

Horizontal Analysis 655 Vertical Analysis 657

LO 3: Analyze a company’s performance using ratio analysis. 660

Price-Earnings Ratio 660 Liquidity Ratios 660 Solvency Ratios 661 Profitability Ratios 661

LO *4: APPENDIX 13A: Evaluate a company comprehensively using ratio analysis. 666

Liquidity Ratios 668 Solvency Ratios 670 Profitability Ratios 672

A Look at IFRS 699

xii

A-1Specimen Financial Statements: Apple Inc.A

B-1 Specimen Financial Statements: Columbia Sportswear Company

C-1 Specimen Financial Statements: VF Corporation

D-1 Specimen Financial Statements: Amazon.com, Inc.

E-1 Specimen Financial Statements: Wal-Mart Stores, Inc.

F-1Specimen Financial Statements: Louis VuittonF

G-1Time Value of MoneyG LO 1: Compute interest and future values. G-1

Nature of Interest G-1 Future Value of a Single Amount G-3 Future Value of an Annuity G-4

LO 2: Compute present values. G-7 Present Value Variables G-7

Present Value of a Single Amount G-7 Present Value of an Annuity G-9 Time Periods and Discounting G-11 Present Value of a Long-Term Note or Bond G-11

LO 3: Use a financial calculator to solve time value of money problems. G-13

Present Value of a Single Sum G-14 Present Value of an Annuity G-15 Useful Applications of the Financial

Calculator G-15

H-1Reporting and Analyzing InvestmentsH

LO 1: Explain how to account for debt investments. H-1

Why Corporations Invest H-1 Accounting for Debt Investments H-3

LO 2: Explain how to account for stock investments. H-4

Holdings of Less than 20% H-4 Holdings Between 20% and 50% H-5 Holdings of More than 50% H-6

LO 3: Discuss how debt and stock investments are reported in the financial statements. H-7

Categories of Securities H-7 Balance Sheet Presentation H-10 Presentation of Realized and Unrealized Gain

or Loss H-11 Statement of Cash Flows Presentation H-12

Company Index I-1 Subject Index I-5

xiii

Eighth Edition

Dennis Avola Northeastern University Thomas Bednarcik Robert Morris University Illinois Martin Blaine Columbus State Community College Bradley Blaylock Oklahoma State University Gary Bower Community College of Rhode Island Robert Braun Southeastern Louisiana University Lou Bravo North Lake College Myra Bruegger Southeastern Community College Barry Buchoff Towson University Matthew Calderisi Fairleigh Dickinson University Julia Camp Providence College Marian Canada Ivy Tech Community College at Franklin Bea Chiang The College of New Jersey Colleen Chung Miami Dade College Shifei Chung Rowan University Tony Cioffi Lorain County Community College Leslie Cohen University of Arizona Jim Coughlin Robert Morris University Patricia Crenny Villanova University Dori Danko Grand Valley State University Mingcherng Deng Baruch College Kathy Dunne Rider University Barbara Durham University of Central Florida David Emerson Salisbury University Caroline Falconetti Nassau Community College

Nancy Fan California State Polytechnic University, Pomona Magdy Farag California State Polytechnic University, Pomona Linda Flaming Monmouth University Joseph Fournier University of Rhode Island Amy Geile University of Arizona Alan Glaser Franklin & Marshall College J. D. Golub Northeastern University Rita Grant Grand Valley State University Steve Groves Ivy Tech Community College Konrad Gunderson Missouri Western State University Marcye Hampton University of Central Florida Qian Hao Wilkes University Huong Higgins Worcester Polytechnic Institute Yongtao Hong North Dakota State University Robert Hurst Franklin University Wayne Ingalls University of Maine Jennifer Joe University of Delaware James B. Johnson Community College of Philadelphia Patricia Johnson Canisius College Jordan Kanter University of Rhode Island Ann Galligan Kelley Providence College Robert Kenny The College of New Jersey Emil Koren Saint Leo University Faith Lamprey Providence College Gary Laycock Ivy Tech Community College

Charles Leflar University of Arkansas Jennifer LeSure Ivy Tech Community College Claudia Lubaski Lorain County Community College Yuanyuan Ma University of Minnesota Don McFall Hiram College Allison McLeod University of North Texas Maha Mitrelis Providence College Louella Moore Washburn University Sia Nassiripour William Paterson University Joseph Nesi Monmouth University Glenn Pate Palm Beach State College Suzy Pearse Clemson University Rachel Pernia Essex County College George Psaras Aurora University Patrick Reihing Nassau Community College John Ribezzo Community College of Rhode Island Vernon Richardson University of Arkansas Patrick Rogan Consumnes River College Juan Roman Saint Leo University John Rude Bloomsburg University Martin Rudnick William Paterson University August Saibeni Consumnes River College Barbara Sandler Queens College Barbara Scofield Washburn University Chris Severson Franklin University Suzanne Seymoure Saint Leo University

xiv

Acknowledgments Financial Accounting has benefitted 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.

Abdus Shahid The College of New Jersey Mike Shapeero Bloomsburg University Todd Shawver Bloomsburg University Eileen Shifflett James Madison University Ladd Simms Mississippi Valley State University

Doug Stives Monmouth University Karen Tower Ivy Tech Community College Daniel Tschopp Saint Leo University Mark Ulrich St. John’s University Nancy Wilburn Northern Arizona University

Wayne W. Williams Community College of Philadelphia Hannah Wong William Paterson University Kenneth Zheng University at Buffalo

Prior Editions

Thanks to the following reviewers and focus group participants of prior editions of Financial Accounting: Dawn Addington, Central New Mexico Community College; Gilda Agacer, Monmouth University; Solochidi Ahiarah, Buffalo State College; C. Richard Aldridge, Western Kentucky University; Sylvia Allen, Los Angeles Valley College; Sheila Ammons, Austin Community College; Thomas G. Amyot, College of Santa Rose; Juanita Ardavany, Los Angeles Valley College; Brian Baick, Montgomery College; Timothy Baker, California State University—Fresno; Cheryl Bartlett, Central New Mexico Community College; Benjamin Bean, Utah Valley State College.

Victoria Beard, University of North Dakota; Angela H. Bell, Jacksonville State University; Charles Bokemeier, Michigan State University; John A. Booker, Tennessee Technological University; Duane Brandon, Auburn University; Gary Braun, University of Texas—El Paso; Jerold K. Braun, Daytona State College; Robert L. Braun, Southeastern Louisiana University; Daniel Brickner, Eastern Michigan University; Evangelie Brodie, North Carolina State University; Sarah Ruth Brown, University of North Alabama; Charles Bunn, Wake Technical Community College; Thane Butt, Champlain College; Sandra Byrd, Missouri State University; James Byrne, Oregon State University.

Judy Cadle, Tarleton State University; Julia Camp, University of Massachusetts—Boston; David Carr, Austin Community College; Jack Cathey, University of North Carolina—Charlotte; Andy Chen, Northeast Illinois University; Jim Christianson, Austin Community College; Siu Chung, Los Angeles Valley College; Laura Claus, Louisiana State University; Leslie A. Cohen, University of Arizona; Teresa L. Conover, University of North Texas; Rita Kingery Cook, University of Delaware; Cheryl Corke, Genesee Community College; Sue Counte, St. Louis Community College—Meramec; Janet Courts, San Bernardino Valley College; Samantha Cox, Wake Technical Community College; Cheryl Crespi, Central Connecticut State University; Dori Danko, Grand Valley State University; Brent W. Darwin, Allan Hancock College; Helen Davis, Johnson and Wales University; Paquita Davis-Friday, Baruch College; Michael Deschamps, Mira Costa College; Cheryl Dickerson, Western Washington University; Gadis Dillon, Oakland University; George M. Dow, Valencia Community College—West; Kathy J. Dow, Salem State College; Lola Dudley, Eastern Illinois University.

Mary Emery, St. Olaf College; Martin L. Epstein, Central New Mexico Community College; Ann Escaro, McHenry County College; Larry R. Falcetto, Emporia State University; Alan Falcon, Loyola Marymount University; Scott Fargason, Louisiana State University; Janet Farler, Pima Community College; Lance Fisher, Oklahoma State University; Sheila D. Foster, The Citadel; Jessica J. Frazier, Eastern Kentucky University; Roger Gee, San Diego Mesa College; Lisa Gillespie, Loyola University—Chicago; Hubert Glover, Drexel University; Norman H. Godwin, Auburn University; David Gotlob, Indiana University—Purdue University—Fort Wayne; Lisa Gray, Seminole State College and Valencia Community College; Emmett Griner, Georgia State University; Leon J. Hanouille, Syracuse University; Hassan Hefzi, California State PolyTech University— Pomona; Kenneth M. Hiltebeitel, Villanova University; Harry Hooper, Santa Fe Community College; Judith A. Hora, University of San Diego; Carol Olson Houston, San Diego State University; Ryan Huldah, Iona College; Sam Isley, Wake Technical Community College.

Norma Jacobs, Austin Community College; Marianne L. James, California State University—Los Angeles; Stanley Jenne, University of Montana; Christopher Jones, George Washington University; Siriyama Kanthi Herath, Georgia Institute of Technology; Jane Kaplan, Drexel University; John E. Karayan, California State University—Pomona; Susan Kattelus, Eastern Michigan University; Ann Kelly, Providence College; Dawn Kelly, Texas Tech University; Robert Kenny, The College of New Jersey; Cindi Khanlarian, University of North Carolina—Greensboro; Robert Kiddoo, California State University—Northridge; Marinilka Kimbro, Gonzaga University; Robert J. Kirsch, Southern Connecticut State University; Frank Korman, Mountain View College; Jerry G. Kreuze, Western Michigan University.

John Lacey, California State University—Long Beach; Joseph Larkin, Saint Joseph’s University; Doulas Larson, Salem State College; Doug Laufer, Metropolitan State College of Denver; Keith Leeseberg, Manatee Community College; Glenda Levendowski, Arizona State University; Seth Levine, DeVry University; Lihon Liang, Syracuse University; James Lukawitz, University of Memphis; Nancy Lynch, West Virginia University; P. Merle Maddocks, University of Alabama—Huntsville; Janice Mardon, Green River Community College; Sal Marino, Westchester Community College; John Marts, University of North Carolina—Wilmington; Alan Mayer- Sommer, Georgetown University; Florence McGovern, Bergen Community College; Noel McKeon, Florida Community College at Jacksonville; Sara Melendy, Gonzaga University; Barbara Merino, University of North Texas; Paul Mihalek, Central Connecticut State University; Jeanne Miller, Cypress College; Robert Miller, California State University—Fullerton; Elizabeth Minbiole, Northwood University; Sherry Mirbod, Montgomery College; Andrew Morgret, University of Memphis; Michelle Moshier, SUNY Albany; Marguerite Muise, Santa Ana College; Kathy Munter, Pima Community College; William J. Nealon, Schenectady County Community College; James Neurath, Central Michigan University; Gale E. Newell, Western Michigan University; Garth Novack, Utah State University; Rosemary Nurre, San Mateo Community College.

xvi

Suzanne Ogilby, Sacramento State University; Sarah N. Palmer, University of North Carolina—Charlotte; Patricia Parker, Columbus State Community College; Terry Patton, Midwestern State University; Charles Pier, Appalachian State University; Ronald Pierno, Florida State University; Janice Pitera, Broome Community College; Franklin J. Plewa, Idaho State University; Meg Pollard, American River College; John Purisky, Salem State College; Donald J. Raux, Siena College; Ray Reisig, Pace University, Pleasantville; Judith Resnick, Borough of Manhattan Community College; Mary Ann Reynolds, Western Washington University; Ruthie G. Reynolds, Howard University; Carla Rich, Pensacola Junior College; Rod Ridenour, Montana State University—Bozeman; Ray Rigoli, Ramapo College of New Jersey; Larry Rittenberg, University of Wisconsin; Jeff Ritter, St. Norbert College; Cecile M. Roberti, Community College of Rhode Island; Brandi Roberts, Southeastern Louisiana University; Patricia A. Robinson, Johnson and Wales University; Nancy Rochman, University of Arizona; Lawrence Roman, Cuyahoga Community College; Marc A. Rubin, Miami University; John A. Rude, Bloomsburg University; Robert Russ, Northern Kentucky University.

Alfredo Salas, El Paso Community College; Christine Schalow, California State University—San Bernardino; Michael Schoderbek, Rutgers University; Richard Schroeder, University of North Carolina—Charlotte; Bill N. Schwartz, Stevens Institute of Technology; Jerry Searfoss, University of Utah; Cindy Seipel, New Mexico State University; Anne E. Selk, University of Wisconsin—Green Bay; William Seltz, University of Massachusetts; Suzanne Sevalstad, University of Nevada; Mary Alice Seville, Oregon State University; Donald Smillie, Southwest Missouri State University; Aileen Smith, Stephen F. Austin State University; Gerald Smith, University of Northern Iowa; Pam Smith, Northern Illinois University; Talitha Smith, Auburn University; William E. Smith, Xavier University; Will Snyder, San Diego State University; Naomi Soderstrom, University of Colorado—Boulder; Chris Solomon, Trident Technical College; Teresa A. Speck, St. Mary’s University of Minnesota; Charles Stanley, Baylor University; Vic Stanton, University of California, Berkeley; Ron Stone, California State University—Northridge; Gary Stout, California State University—Northridge; Gracelyn Stuart, Palm Beach Community College; Paul Swanson, Illinois Central College; Ellen L. Sweatt, Georgia Perimeter College.

William Talbot, Montgomery College; Diane Tanner, University of North Florida; Pamadda Tantral, Fairleigh Dickinson University; Steve Teeter, Utah Valley State College; Michael Tydlaska, Mountain View College; Michael F. van Breda, Texas Christian University; Joan Van Hise, Fairfi eld University; Richard Van Ness, Schenectady County Community College; Christopher Wallace, California State University—Sacramento; Barbara Warschawski, Schenectady County Community College; Andrea B. Weickgenannt, Northern Kentucky University; David P. Weiner, University of San Francisco; Frederick Weis, Claremont McKenna College; T. Sterling Wetzel, Oklahoma State University; Wendy Wilson, Southern Methodist University; Allan Young, DeVry University; Linda G. Wade, Tarleton State University; Stuart K. Webster, University of Wyoming; Kathryn Yarbrough, University of North Carolina—Charlotte; V. Joyce Yearley, New Mexico State University; Judith Zander, Grossmont College

Ancillary Authors, Contributors, Proofers, and Accuracy Checkers

We sincerely thank the following individuals for their hard work in preparing the content that accompanies this textbook: Ellen Bartley St. Joseph’s College LuAnn Bean Florida Institute of Technology Jack Borke University of Wisconsin—Platteville Melanie Bunting Edgewood College Sandra Cohen Columbia College—Chicago James M. Emig Villanova University Larry R. Falcetto Emporia State University Heidi Hansel Kirkwood Community College

Coby Harmon University of California, Santa Barbara DeAnna Kirchen Golden West College Laura McNally Black Hills State University Jill Mitchell Northern Virginia Community College Barb Muller Arizona State University George Psarsas Aurora University Laura Prosser Black Hills State University Alice Sineath Forsyth Technical Community College Teresa Speck Saint Mary’s University of Minnesota Mark Ulrich St. John’s University Sheila Viel University of Wisconsin—Milwaukee Dick D. Wasson Southwestern College

Andrea Weickgenannt Xavier University Melanie Yon

Advisory Board

Robert Braun Southeastern Louisiana University Rita Grant Grand Valley State University Marcye Hampton University of Central Florida Michelle Moshier State University of New York—Albany Courtney Naismith Collin College Michael Newman University of Houston Pamela Rouse Butler University Chris Solomon Trident Technical College

We appreciate the exemplary support and commitment given to us by executive editor Michael McDonald, executive marketing manager Karolina Zarychta Honsa, development editor Ed Brislin, market solutions assistant Elizabeth Kearns, development editors Terry Ann Tatro and Margaret Thompson, product design manager Allie Morris, product designer Matt Origoni, designer Maureen Eide, photo editor Mary Ann Price, and Jackie Henry at Aptara. All of these professionals provided innumerable services that helped the textbook take shape.

Finally, our thanks to George Hoffman, Tim Stookesberry, Douglas Reiner, Joe Heider, Brent Gordon, and Mark Allin for their support and leadership at Wiley. We will appreciate sug- gestions and comments from users—instructors and students alike. You can send your thoughts and ideas about the text- book to us via email at: [email protected].

Paul D. Kimmel Jerry J. Weygandt Donald E. Kieso Milwaukee, Wisconsin Madison, Wisconsin DeKalb, Illinois

xvii

How do you start a business? How do you determine whether your business is making or losing

money? How should you fi nance expansion—should you borrow, should you issue stock, should

you use your own funds? How do you convince banks to lend you money or investors to buy your

stock? Success in business requires making countless decisions, and decisions require fi nancial

information.

The purpose of this chapter is to show you what role accounting plays in providing fi nancial

information.

Introduction to Financial Statements 1

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

The Chapter Preview describes the purpose of the chapter and highlights major topics.

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CHAPTER PREVIEW

The Chapter Outline presents the chapter’s topics and subtopics, as well as practice opportunities.

LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

• Forms of business organization

• Users and uses of fi nancial information

• Ethics in fi nancial reporting

▼1 Identify the forms of business organization and the uses of accounting information.

DO IT!

1 Business Organization Forms

▼3 Describe the four fi nancial statements and how they are prepared.

• Income statement • Retained earnings statement • Balance sheet • Statement of cash fl ows • Interrelationships of statements • Other annual report elements

DO IT!

3 3a Financial Statements 3b Components of Annual

Reports

▼2 Explain the three principal types of business activity.

• Financing activities • Investing activities • Operating activities

DO IT!

2 Business Activities

Many students who take this course do not plan to be accountants. If you are in that group, you might be thinking, “If I’m not going to be an accountant, why do I need to know accounting?” Well, consider this quote from Harold Geneen, the former chairman of IT&T: “To be good at your business, you have to know the numbers—cold.” In business, accounting and fi nancial statements are the means for communicating the numbers. If you don’t know how to read fi nancial statements, you can’t really know your business.

Knowing the numbers is sometimes even a matter of corporate survival. Consider the story of Columbia Sportswear Company, headquartered in Portland, Oregon. Gert Boyle’s family fl ed Nazi Germany when she was 13 years old and then purchased a small hat company in Oregon, Columbia Hat Company. In 1971, Gert’s husband, who was then running the company, died suddenly of a heart attack. The company was in the midst of an aggressive expansion, which had taken its sales above $1 million for the fi rst time but which had also left the company fi nancially stressed. Gert took over the small, struggling company with help from her son Tim, who was then a senior at the University of Oregon. Somehow, they kept the company afl oat.

Today, Columbia has more than 4,000 employees and annual sales in excess of $1 billion. Its brands include Columbia, Mountain Hardwear, Sorel, and Montrail.

Gert still heads up the Board of Directors, and Tim is the company’s President and CEO.

Columbia doesn’t just focus on fi nancial success. The company is very committed to corporate, social, and environmental responsibility. For example, several of its factories have participated in a project to increase

health awareness of female factory workers in developing countries. Columbia was also a founding member of the Sustainable Apparel Coalition, which is a group that strives to reduce the environmental and social impact of the apparel industry. In addition, it monitors all of the independent factories that produce its products to ensure that they comply with the company’s Standards of Manufacturing Practices. These standards address issues including forced labor, child labor, harassment, wages and benefi ts, health and safety, and the environment.

Employers such as Columbia Sportswear generally assume that managers in all areas of the company are “fi nancially literate.” To help prepare you for that, in this textbook you will learn how to read and prepare fi nancial statements, and how to use basic tools to evaluate fi nancial results.

Knowing the Numbers

The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business.

FEATURE STORY

4 1 Introduction to Financial Statements

LEARNING OBJECTIVE 1 Identify the forms of business organization and the uses of accounting information.▼

-Simple to establish -Owner controlled -Tax advantages

Sole Proprietorship

-Simple to establish -Shared control -Broader skills and resources -Tax advantages

Partnership

-Easier to transfer ownership -Easier to raise funds -No personal liability

Corporation

Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You enjoy working with people, espe- cially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.

FORMS OF BUSINESS ORGANIZATION

Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation.

SOLE PROPRIETORSHIP You might choose the sole proprietorship form for your outdoor guide service. A business owned by one person is a sole proprietorship. It is simple to set up and gives you control over the business. Small owner- operated businesses such as barber shops, law offi ces, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

PARTNERSHIP Another possibility is for you to join forces with other individuals to form a partnership. A business owned by two or more persons associated as partners is a partnership. Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certifi ed public accountants), often organize as partnerships.

CORPORATION As a third alternative, you might organize as a corporation. A busi- ness organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money. There- fore, it is easier for corporations to raise funds. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole pro- prietorships or partnerships and eventually incorporate. Other factors to consider in deciding which organizational form to choose are taxes and legal liability. If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stock- holders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter. Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. These hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. Probably the most common among these hybrids types are limited liability companies (LLCs) and subchapter S corporations. These forms are discussed extensively in business law classes. The combined number of proprietorships and partnerships in the United States is more than fi ve times the number of corporations. However, the revenue

ALTERNATIVE TERMINOLOGY Stockholders are sometimes called shareholders.

Alternative Terminology notes present synonymous terms that you may come across in practice.

Business Organization and Accounting Information Uses 5

produced by corporations is eight times greater. Most of the largest businesses in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this textbook is on the corporate form of organization.

USERS AND USES OF FINANCIAL INFORMATION

The purpose of fi nancial information is to provide inputs for decision-making. Accounting is the information system that identifi es, records, and communicates the economic events of an organization to interested users. Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, fi nance directors, and company offi cers. In running a business, managers must answer many important questions, as shown in Illustration 1-1.

To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as fi nancial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized fi nancial information in the form of fi nancial statements.

Accounting Across the Organization boxes show applications of accounting information in various business functions.

Owning a Piece of the Bar

The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees and is considered one of the leading Landor’s Breakaway Brands®. One of Clif Bar & Company’s proudest moments was the creation of an employee stock ownership plan

(ESOP) in 2010. This plan gives its employees 20% ownership of the company. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its fi nances. Armed with basic accounting knowledge, employees are more aware of the fi nancial impact of their actions, which leads to better decisions.

What are the benefi ts to the company and to the employees of making the fi nancial statements available to all employees? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Clif Bar & Company

STOCK

ON STRIKEON

STRIKE

ON STRIKE

Snack chips Beverages

C O

Questions Asked by Internal Users

Is cash sufficient to pay dividends to

Microsoft stockholders?

Finance Can General Motors afford to give its employees pay

raises this year?

Human Resources Which PepsiCo product line is the most profitable? Should any

product lines be eliminated?

Management What price should Apple charge

for an iPad to maximize the company's net income?

Marketing

ILLUSTRATION 1-1 Questions that internal users ask

6 1 Introduction to Financial Statements

External Users There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1-2.

What do we do if they catch us?

BILL COLLECTOR

Yeah!

Questions Asked by External Users

Is General Electric earning satisfactory income?

Investors How does Disney compare in size and profitability with Time Warner?

Investors Will United Airlines be able

to pay its debts as they come due?

Creditors

ILLUSTRATION 1-2 Questions that external users ask

The information needs and questions of other external users vary consider- ably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws. Customers are interested in whether a company like General Motors will continue to honor product warran- ties and otherwise support its product lines. Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and benefi ts. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record profi ts at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to inves- tigate the energy traders to make sure that the profi ts were earned by legitimate and fair practices.

Spinning the Career Wheel

How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every fi eld of business. Some examples of how account- ing is used in business careers include the following. General management: Managers of Ford Motors, Massachusetts General Hospital, California State University–Fullerton, a McDonald’s franchise, and a Trek bike shop all need to understand

accounting data in order to make wise business decisions. Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and benefi ts, which accounting helps

them quantify and understand. Making a sale is meaningless unless it is a profi table sale. Finance: Do you want to be a banker for Citicorp, an invest- ment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These fi elds rely heavily on accounting knowledge to an- alyze fi nancial statements. In fact, it is diffi cult to get a good job in a fi nance function without two or three courses in accounting. Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank— is almost always involved in fi nancing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash fl ow from an industrial property justify the purchase price? What are the tax benefi ts of the purchase?

How might accounting help you? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION

Business Organization and Accounting Information Uses 7

Solving an Ethical Dilemma

#1 ALT

#2 ALT

2. Identify and analyze the principal elements in the situation. Identify the stakeholders— persons or groups who may be harmed or benefited. Ask the question: What are the responsibilities and obligations of the parties involved?

3. Identify the alternatives, and weigh the impact of each alternative on various stakeholders. Select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one right solution; these situations require you to evaluate each alternative and select the best one.

1. Recognize an ethical situation and the ethical issues involved. Use your personal ethics to identify ethical situations and issues. Some businesses and professional organizations provide written codes of ethics for guidance in some business situations.

ILLUSTRATION 1-3 Steps in analyzing ethics cases

ETHICS IN FINANCIAL REPORTING

People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t “play” the stock market if they think stock prices are rigged. At one time, the fi nancial press was full of articles about fi nancial scandals at Enron, WorldCom, HealthSouth, and AIG. As more scandals came to light, a mistrust of fi nancial reporting in general seemed to be developing. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting prac- tices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the fi nancial statements to be hon- estly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable fi nan- cial reporting. United States regulators and lawmakers were very concerned that the econ- omy would suffer if investors lost confi dence in corporate accounting because of unethical fi nancial reporting. Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now certify the accuracy of fi nancial information. In addition, penalties for fraudulent fi nancial activity are much more severe. Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate fi nancial statements and the oversight role of boards of directors. Effective fi nancial reporting depends on sound ethical behavior. To sensi- tize you to ethical situations and to give you practice at solving ethical dilem- mas, we address ethics in a number of ways in this textbook. (1) A number of the Feature Stories and other parts of the text discuss the central importance of ethical behavior to fi nancial reporting. (2) Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings. (3) Many of the People, Planet, and Profi t Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. (4) At the end of each chapter, an Ethics Case simulates a business situa tion and asks you to put yourself in the position of a decision-maker in that case. When analyzing these various ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1-3.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

ETHICS NOTE Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.

▼

8 1 Introduction to Financial Statements

Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers to the critical thinking questions are available in WileyPLUS and at www.wiley.com/college/weygandt. Additional questions are offered in WileyPLUS.

I Felt the Pressure— Would You?

“I felt the pressure.” That’s what some of the employees of the now-defunct law fi rm of Dewey & LeBoeuf LLP indicated when they helped to over- state revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former fi nance director and for- mer chief fi nancial offi cer (CFO) of the fi rm. Here are some of their comments:

• “I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”

• “I intentionally gave the auditors incorrect information in the course of the audit.”

What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their fi nancial manipulations as accounting tricks, cooking the books, and fake income.

Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014).

Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to WileyPLUS for this answer and additional questions.)

ETHICS INSIGHT Dewey & LeBoeuf LLP

Alliance/Shutterstock

SOLUTION 1. Easier to raise funds: Corporation.

2. Simple to establish: Sole proprietorship and partnership.

3. No personal legal liability: Corporation.

4. Tax advantages: Sole proprietorship and partnership.

5. Easier to transfer ownership: Corporation.

1▼ Business Organization FormsDO IT! In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated.

1. Easier to raise funds.

2. Simple to establish.

3. No personal legal liability.

4. Tax advantages.

5. Easier to transfer ownership.

Action Plan ✔ Know which organiza-

tional form best matches the business type, size, and preferences of the owner(s).

Related exercise material: BE1-1 and DO IT! 1-1.

DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.

All businesses are involved in three types of activity—fi nancing, investing, and operating. For example, Gert Boyle’s parents, the founders of Columbia Sports- wear, obtained cash through fi nancing to start and grow their business. Some of

Explain the three principal types of business activity. LEARNING OBJECTIVE 2▼

The Three Types of Business Activity 9

this fi nancing came from personal savings, and some likely came from outside sources like banks. The family then invested the cash in equipment to run the business, such as sewing equipment and delivery vehicles. Once this equipment was in place, they could begin the operating activities of making and selling clothing. The accounting information system keeps track of the results of each of the various business activities—fi nancing, investing, and operating. Let’s look at each type of business activity in more detail.

FINANCING ACTIVITIES

It takes money to make money. The two primary sources of outside funds for corporations are borrowing money (debt fi nancing) and issuing (selling) shares of stock in exchange for cash (equity fi nancing). Columbia Sportswear may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom Columbia owes money are its creditors. Amounts owed to creditors—in the form of debt and other obligations— are called liabilities. Specifi c names are given to different types of liabilities, depending on their source. Columbia may have a note payable to a bank for the money borrowed to purchase delivery trucks. Debt securities sold to investors that must be repaid at a particular date some years in the future are bonds payable. Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase. The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a pay- ment schedule (e.g., payment at the end of three months). As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may legally force the company to sell property to pay its debts. In the case of fi nancial diffi culty, creditor claims must be paid before stockholders’ claims. Stockholders, on the other hand, have no claim to corporate cash until the claims of creditors are satisfi ed. Suppose you buy a company’s stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company’s creditors are paid amounts currently due. However, many corporations make payments to stockholders on a regular basis as long as there is suffi cient cash to cover required payments to creditors. These cash payments to stockholders are called dividends.

INVESTING ACTIVITIES

Once the company has raised cash through fi nancing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. A growing company purchases many resources, such as computers, delivery trucks, furniture, and buildings. Resources owned by a business are called assets. Different types of assets are given different names. For example, Columbia Sportswear’s sewing equipment is a type of asset referred to as property, plant, and equipment. Cash is one of the more important assets owned by Columbia or any other business. If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations. Invest- ments are another example of an investing activity.

OPERATING ACTIVITIES

Once a business has the assets it needs to get started, it begins operations. Columbia Sportswear is in the business of selling outdoor clothing and footwear. It sells TurboDown jackets, Millenium snowboard pants, Sorel® snow boots,

Mountain Sportswear Mountain

Sportswear

Mountain Sportswear

Investing

Operating

Financing

BONDSTOCK

ALTERNATIVE TERMINOLOGY Property, plant, and equipment is sometimes called fi xed assets.

10 1 Introduction to Financial Statements

SOLUTION 1. Cost of renting property: Expense.

2. Truck purchased: Asset.

2▼ Business ActivitiesDO IT! Classify each item as an asset, liability, common stock, revenue, or expense.

1. Cost of renting property.

2. Truck purchased.

3. Notes payable.

4. Issuance of ownership shares.

5. Amount earned from performing service.

6. Amounts owed to suppliers.

Bugaboots™, rainwear, and anything else you might need to protect you from the elements. We call amounts earned on the sale of these products revenues. Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business. For example, Columbia records revenue when it sells a footwear product. Revenues arise from different sources and are identifi ed by various names depending on the nature of the business. For instance, Columbia’s primary source of revenue is the sale of sportswear. However, it also generates interest revenue on debt securities held as investments. Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue. The company purchases its longer-lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operat- ing activities. For example, supplies are assets used in day-to-day operations. Goods available for future sales to customers are assets called inventory. Also, if Columbia sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future. This right to receive money in the future is called an account receivable. Before Columbia can sell a single Sorel® boot, it must purchase wool, rubber, leather, metal lace loops, laces, and other materials. It then must process, wrap, and ship the fi nished product. It also incurs costs like salaries, rents, and utilities. All of these costs, referred to as expenses, are necessary to produce and sell the product. In accounting language, expenses are the cost of assets consumed or services used in the process of generating revenues. Expenses take many forms and are identifi ed by various names depending on the type of asset consumed or service used. For example, Columbia keeps track of these types of expenses: cost of goods sold (such as the cost of materials), sell- ing expenses (such as the cost of salespersons’ salaries), marketing expenses (such as the cost of advertising), administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corpo- rate offi ce), interest expense (amounts of interest paid on various debts), and income taxes (corporate taxes paid to the government). Columbia may also have liabilities arising from these expenses. For example, it may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable. Additionally, Columbia may have interest payable on the outstanding amounts owed to the bank. It may also have wages payable to its employees and sales taxes payable, property taxes payable, and income taxes payable to the government. Columbia compares the revenues of a period with the expenses of that period to determine whether it earned a profi t. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.

Action Plan ✔ Classify each item based

on its economic charac- teristics. Proper classifi ca- tion of items is critical if accounting is to provide useful information.

The Four Financial Statements 11

3. Notes payable: Liabilities.

4. Issuance of ownership shares: Common stock.

5. Amount earned from performing service: Revenue.

6. Amounts owed to suppliers: Liabilities.

Related exercise material: BE1-3, DO IT! 1-2, and E1-3.

LEARNING OBJECTIVE 3 Describe the four fi nancial statements and how they are prepared.▼

Assets, liabilities, expenses, and revenues are of interest to users of accounting information. This information is arranged in the format of four different fi nan- cial statements, which form the backbone of fi nancial accounting:

• To show how successfully your business performed during a period of time, you report its revenues and expenses in an income statement.

• To indicate how much of previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth, you present a retained earnings statement.

• To present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities), you prepare a balance sheet.

• To show where your business obtained cash during a period of time and how that cash was used, you present a statement of cash fl ows.

To introduce you to these statements, we have prepared the fi nancial state- ments for your outdoor guide service, Sierra Corporation, after your fi rst month of operations. To summarize, you offi cially started your business in Truckee, California, on October 1, 2017. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe out- door day trips, such as rafting, snowshoeing, and hiking, as well as multi-day backcountry experiences. To minimize your initial investment, at this point the company has limited outdoor equipment for customer use. Instead, your cus- tomers either bring their own equipment or rent equipment through local outfi t- ters. The fi nancial statements for Sierra’s fi rst month of business are provided in the following pages.

INCOME STATEMENT

The income statement reports a company’s revenues and expenses and result- ing net income or loss for a period of time. To indicate that its income statement reports the results of operations for a specifi c period of time, Sierra dates the income statement “For the Month Ended October 31, 2017.” The income statement lists the company’s revenues followed by its expenses. Finally, Sierra determines the net income (or net loss) by deducting expenses from revenues. Sierra Corpora- tion’s income statement is shown in Illustration 1-4 (page 12). Congratulations, you are already showing a profi t! Why are fi nancial statement users interested in net income? Investors are interested in a company’s past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company’s future performance. If investors believe that Sierra will be successful in the future and that this will result in a higher stock price, they will

International Notes highlight differences between U.S. and international accounting standards.

INTERNATIONAL NOTE The primary types of fi nancial statements required by Inter- national Financial Reporting Stan- dards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same. Neither IFRS nor GAAP is very specifi c regarding format requirements for the primary fi nancial state- ments. However, in practice, some format differences do exist in presentations commonly employed by IFRS companies as compared to GAAP companies.

Decision Tools that are useful for business decision- making are highlighted throughout the textbook. A summary of the Decision Tools, such as the one on page 21, is provided in each chapter.

DECISION TOOLS

The income statement helps users determine if the company’s operations are profi table.

12 1 Introduction to Financial Statements

buy its stock. Creditors also use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn’t think it would be repaid, it wouldn’t loan the money. There- fore, prior to making the loan the bank loan offi cer uses the income statement as a source of information to predict whether the company will be profi table enough to repay its loan. Thus, reporting a strong profi t will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing. Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (see Illustration 1-7), nor does it regard as a business expense the $500 of dividends paid (see Illustration 1-5).

RETAINED EARNINGS STATEMENT

If Sierra is profi table, at the end of each period it must decide what portion of profi ts to pay to shareholders in dividends. In theory, it could pay all of its current-

period profi ts, but few companies do this. Why? Because they want to retain part of the profi ts to allow for further expansion. High-growth companies, such as Google and Facebook, often pay no dividends. Retained earnings is the net income retained in the corporation.

The retained earnings statement shows the amounts and causes of changes in retained earnings for a specifi c time period. The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the fi rst line of the statement. Then, the com-

pany adds net income and deducts dividends to determine the retained earnings at the end of the period. If a company has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1-5 presents Sierra Corpora- tion’s retained earnings statement.

▼ HELPFUL HINT The fi nancial statement heading identifi es the company, the type of statement, and the time period covered. Sometimes, another line indicates the unit of measure, e.g., “in thousands” or “in millions.”

ETHICS NOTE When companies fi nd errors

in previously released income statements, they restate those numbers. Perhaps because of the increased scrutiny shortly

after Sarbanes-Oxley was implemented, companies fi led a

record 1,195 restatements.

▼

ILLUSTRATION 1-4 Sierra Corporation’s income statement

ILLUSTRATION 1-5 Sierra Corporation’s retained earnings statement

Retained earnings, October 1 $ 0 Add: Net income 2,860

2,860 Less: Dividends 500

Retained earnings, October 31 $2,360

SIERRA CORPORATION Retained Earnings Statement

For the Month Ended October 31, 2017

▼ HELPFUL HINT The heading of this statement identifi es the company, the type of statement, and the time period covered by the statement.

DECISION TOOLS The retained earnings statement helps users determine the com- pany’s policy toward dividends and growth.

Revenues Service revenue $10,600 Expenses Salaries and wages expense $5,200 Rent expense 900 Supplies expense 1,500 Depreciation expense 40 Interest expense 50 Insurance expense 50

Total expenses 7,740

Net income $ 2,860

SIERRA CORPORATION Income Statement

For the Month Ended October 31, 2017

The Four Financial Statements 13

By monitoring the retained earnings statement, fi nancial statement users can evaluate dividend payment practices. Some investors seek companies, such as Dow Chemical, that have a history of paying high dividends. Other investors seek companies, such as Amazon.com, that reinvest earnings to increase the company’s growth instead of paying dividends. Lenders monitor their corporate customers’ dividend payments because any money paid in dividends reduces a company’s ability to repay its debts.

BALANCE SHEET

The balance sheet reports assets and claims to assets at a specifi c point in time. Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. The owners’ claim to assets is called stockholders’ equity. Illustration 1-6 shows the relationship among the categories on the balance sheet in equation form. This equation is referred to as the basic accounting equation.

This relationship is where the name “balance sheet” comes from. Assets must bal- ance with the claims to assets.

As you can see from looking at Sierra’s balance sheet in Illustration 1-7, the balance sheet presents the company’s fi nancial position as of a specifi c date—in this case, October 31, 2017. It lists assets fi rst, followed by liabilities and stockhold- ers’ equity. Stockholders’ equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the company

ALTERNATIVE TERMINOLOGY Liabilities are also referred to as debt.

ILLUSTRATION 1-6 Basic accounting equationAssets = Liabilities + Stockholders’ Equity

▼ HELPFUL HINT The heading of a balance sheet must identify the company, the statement, and the date.

ILLUSTRATION 1-7 Sierra Corporation’s balance sheet

Assets

Cash $15,200 Accounts receivable 200 Supplies 1,000 Prepaid insurance 550 Equipment, net 4,960

Total assets $21,910

Liabilities and Stockholders’ Equity

Liabilities Notes payable $ 5,000 Accounts payable 2,500 Unearned service revenue 800 Salaries and wages payable 1,200 Interest payable 50

Total liabilities $ 9,550

Stockholders’ equity Common stock 10,000 Retained earnings 2,360

Total stockholders’ equity 12,360

Total liabilities and stockholders’ equity $21,910

SIERRA CORPORATION Balance Sheet

October 31, 2017

DECISION TOOLS

The balance sheet helps users determine if the company relies on debt or stockholders’ equity to fi nance its assets.

14 1 Introduction to Financial Statements

sells new shares of stock; retained earnings is the net income retained in the cor- poration. Sierra has common stock of $10,000 and retained earnings of $2,360, for total stockholders’ equity of $12,360. Creditors analyze a company’s balance sheet to determine the likelihood that they will be repaid. They carefully evaluate the nature of the company’s assets and liabilities. In operating the Sierra Corporation guide service, the balance sheet will be used to determine whether cash on hand is suffi cient for immedi- ate cash needs. The balance sheet will also be used to evaluate the relationship between debt and stockholders’ equity to determine whether the company has a satisfactory proportion of debt and common stock fi nancing.

STATEMENT OF CASH FLOWS

The primary purpose of a statement of cash fl ows is to provide fi nancial infor- mation about the cash receipts and cash payments of a business for a specifi c

period of time. To help investors, creditors, and others in their analysis of a company’s cash position, the statement of cash fl ows reports the cash effects of a company’s operating, investing, and fi nancing activi- ties. In addition, the statement shows the net increase or decrease in cash during the period, and the amount of cash at the end of the period.

Users are interested in the statement of cash fl ows because they want to know what is happening to a company’s most important

resource. The statement of cash fl ows provides answers to these simple but important questions:

• Where did cash come from during the period?

• How was cash used during the period?

• What was the change in the cash balance during the period?

The statement of cash fl ows for Sierra, in Illustration 1-8, shows that cash increased $15,200 during the month. This increase resulted because operating activities (services to clients) increased cash $5,700, and fi nancing activities increased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment.

Cash fl ows from operating activities Cash receipts from operating activities $11,200 Cash payments for operating activities (5,500)

Net cash provided by operating activities $ 5,700

Cash fl ows from investing activities Purchased offi ce equipment (5,000)

Net cash used by investing activities (5,000)

Cash fl ows from fi nancing activities Issuance of common stock 10,000 Issuance of note payable 5,000 Payment of dividend (500)

Net cash provided by fi nancing activities 14,500

Net increase in cash 15,200 Cash at beginning of period 0

Cash at end of period $15,200

SIERRA CORPORATION Statement of Cash Flows

For the Month Ended October 31, 2017

ILLUSTRATION 1-8 Sierra Corporation’s statement of cash fl ows

▼ HELPFUL HINT The heading of this statement identifi es the company, the type of statement, and the time period covered by the statement. Negative numbers are shown in parentheses.

DECISION TOOLS The statement of cash fl ows helps users determine if the company generates enough cash from opera- tions to fund its investing activities.

INTERRELATIONSHIPS OF STATEMENTS

Illustration 1-9 (page 16) shows the fi nancial statements of Sierra Corporation. Because the results on some fi nancial statements become inputs to other state- ments, the statements are interrelated. These interrelationships can be seen in Sierra’s fi nancial statements, as follows.

1. The retained earnings statement uses the results of the income statement. Sierra reported net income of $2,860 for the period. Net income is added to the beginning amount of retained earnings to determine ending retained earnings.

2. The balance sheet and retained earnings statement are also interrelated. Sierra reports the ending amount of $2,360 on the retained earnings statement as the retained earnings amount on the balance sheet.

3. Finally, the statement of cash fl ows relates to information on the balance sheet. The statement of cash fl ows shows how the Cash account changed dur- ing the period. It shows the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the $15,200 of cash at the end of the period. The ending amount of cash shown on the statement of cash fl ows must agree with the amount of cash on the balance sheet.

Study these interrelationships carefully. To prepare fi nancial statements, you must understand the sequence in which these amounts are determined and how each statement impacts the next.

The Four Financial Statements 15

PEOPLE, PLANET, AND PROFIT INSIGHT

Beyond Financial Statements

Should we expand our corporate reports beyond the income state- ment, retained earnings statement, balance sheet, and statement of cash fl ows? Some believe we should take into account ecological and

social performance, in addition to fi nancial results, in evaluat- ing a company. The argument is that a company’s responsibil- ity lies with anyone who is infl uenced by its actions. In other words, a company should be interested in benefi ting many different parties, instead of only maximizing stockholders’ interests.

A socially responsible business does not exploit or endan- ger any group of individuals. It follows fair trade practices, provides safe environments for workers, and bears respon- sibility for environmental damage. Granted, measurement of these factors is diffi cult. How to report this information is also controversial. But many interesting and useful efforts are underway. Throughout this textbook, we provide additional insights into how companies are attempting to meet the chal- lenge of measuring and reporting their contributions to society, as well as their fi nancial results, to stockholders.

Why might a company’s stockholders be interested in its environmental and social performance? (Go to WileyPLUS for this answer and additional questions.)

Assets

Cash $15,200 Accounts receivable 200 Advertising supplies 1,000 Prepaid insurance 550 Equipment, net 4,960

Total assets $21,910

Liabilities and Stockholders’ Equity

Liabilities Notes payable $ 5,000 Accounts payable 2,500 Unearned service revenue 800 Salaries and wages payable 1,200 Interest payable 50

Total liabilities $ 9,550

Stockholders’ equity Common stock 10,000 Retained earnings 2,360

Total stockholders’ equity 12,360

Total liabilities and stockholders’ equity $21,910

SIERRA CORPORATION Balance Sheet

October 31, 2017

Revenues Service revenue $10,600 Expenses Salaries expense $5,200 Rent expense 900 Supplies expense 1,500 Depreciation expense 40 Interest expense 50 Insurance expense 50

Total expenses 7,740

Net income $ 2,860

SIERRA CORPORATION Income Statement

For the Month Ended October 31, 2017

Cash fl ows from operating activities Cash receipts from operating activities $11,200 Cash payments for operating activities (5,500)

Net cash provided by operating activities $ 5,700

Cash fl ows from investing activities Purchased offi ce equipment (5,000)

Net cash used by investing activities (5,000)

Cash fl ows from fi nancing activities Issuance of common stock 10,000 Issued note payable 5,000 Payment of dividend (500)

Net cash provided by fi nancing activities 14,500

Net increase in cash 15,200 Cash at beginning of period 0

Cash at end of period $15,200

SIERRA CORPORATION Statement of Cash Flows

For the Month Ended October 31, 2017

Retained earnings, October 1 $ 0 Add: Net income 2,860

2,860 Less: Dividends 500

Retained earnings, October 31 $ 2,360

SIERRA CORPORATION Retained Earnings Statement

For the Month Ended October 31, 2017

ILLUSTRATION 1-9 Sierra Corporation’s fi nancial statements

▼ HELPFUL HINT Note that fi nal sums are double-underlined.

▼ HELPFUL HINT The arrows in this illustration show interrelationships of the four fi nancial statements.

▼ HELPFUL HINT Negative amounts are presented in parentheses.

SOLUTION

3a▼ Financial StatementsDO IT! CSU Corporation began operations on January 1, 2017. The following information is avail- able for CSU on December 31, 2017:

Accounts receivable 1,800 Retained earnings ? Supplies expense 200 Accounts payable 2,000 Equipment 16,000 Cash 1,400 Rent expense 9,000 Insurance expense 1,000 Dividends 600 Notes payable 5,000 Service revenue 17,000 Common stock 10,000 Supplies 4,000

Prepare an income statement, a retained earnings statement, and a balance sheet.

Action Plan ✔ Report the revenues and

expenses for a period of time in an income statement.

✔ Show the amounts and causes (net income and dividends) of changes in retained earnings during the period in the retained earnings statement.

✔ Present the assets and claims to those assets (liabilities and equity) at a specifi c point in time in the balance sheet.

Revenues Service revenue $17,000 Expenses Rent expense $9,000 Insurance expense 1,000 Supplies expense 200 Total expenses 10,200 Net income $ 6,800

CSU CORPORATION Income Statement

For the Year Ended December 31, 2017

Retained earnings, January 1 $ 0 Add: Net income 6,800 6,800 Less: Dividends 600 Retained earnings, December 31 $6,200

CSU CORPORATION Retained Earnings Statement

For the Year Ended December 31, 2017

Related exercise material: BE1-5, BE1-6, BE1-7, BE1-8, BE1-9, BE1-10, DO IT! 1-3a, E1-4, E1-5, E1-6, E1-7, E1-8, E1-9, E1-10, E1-11, and E1-14.

Assets Cash $ 1,400 Accounts receivable 1,800 Supplies 4,000 Equipment 16,000 Total assets $23,200

Liabilities and Stockholders’ Equity Liabilities Notes payable $ 5,000 Accounts payable 2,000 Total liabilities $ 7,000 Stockholders’ equity Common stock 10,000 Retained earnings 6,200 Total stockholders’ equity 16,200 Total liabilities and stockholders’ equity $23,200

CSU CORPORATION Balance Sheet

December 31, 2017

18 1 Introduction to Financial Statements

OTHER ELEMENTS OF AN ANNUAL REPORT

Publicly traded U.S. companies must provide shareholders with an annual report. The annual report always includes the fi nancial statements introduced in this chapter. The annual report also includes other important information such as a management discussion and analysis section, notes to the fi nancial state- ments, and an independent auditor’s report. No analysis of a company’s fi nancial situation and performance is complete without a review of these items.

Management Discussion and Analysis The management discussion and analysis (MD&A) section presents manage- ment’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. Management must highlight favorable or unfavorable trends and identify signifi cant events and uncertainties that affect these three factors. This discussion obviously involves a number of subjective estimates and opinions. A brief excerpt from the MD&A section of Columbia Sportswear’s annual report, which addresses its liquidity requirements, is presented in Illustration 1-10.

ILLUSTRATION 1-10 Columbia Sportswear’s management discussion and analysis

Our operations are affected by seasonal trends typical in the outdoor apparel and footwear industry and have historically resulted in higher sales and profi ts in the third and fourth calendar quarters. This pattern has resulted primarily from the timing of shipments of fall season products to wholesale customers in the third and fourth quarters and proportionally higher sales in our direct-to-consumer op- erations in the fourth quarter, combined with an expense base that is spread more evenly throughout the year. We believe that our liquidity requirements for at least the next 12 months will be adequately covered by existing cash, cash provided by operations and existing short-term borrowing arrangements.

COLUMBIA SPORTSWEAR COMPANY Management’s Discussion and Analysis of

Seasonality and Variability of Business

ILLUSTRATION 1-11 Notes to Columbia Sportswear’s fi nancial statements

We record wholesale, distributor, e-commerce and licensed product revenues when title passes and the risks and rewards of ownership have passed to the customer. Title generally passes upon shipment to, or upon receipt by, the customer depend- ing on the terms of sale with the customer. Retail store revenues are recorded at the time of sale.

COLUMBIA SPORTSWEAR COMPANY Notes to Financial Statements

Revenue Recognition

Notes to the Financial Statements Explanatory notes and supporting schedules accompany every set of fi nancial statements and are an integral part of the statements. The notes to the fi nancial statements clarify the fi nancial statements and provide additional detail. Infor- mation in the notes does not have to be quantifi able (numeric). Examples of notes are descriptions of the signifi cant accounting policies and methods used in preparing the statements, explanations of uncertainties and contingencies, and various statistics and details too voluminous to be included in the statements. The notes are essential to understanding a company’s operating performance and fi nancial position. Illustration 1-11 is an excerpt from the notes to Columbia Sportswear’s fi nan- cial statements. It describes the methods that the company uses to account for revenues.

Real World

The Four Financial Statements 19

Auditor’s Report An auditor’s report is prepared by an independent outside auditor. It states the audi- tor’s opinion as to the fairness of the presentation of the fi nancial position and results of operations and their conformance with generally accepted accounting principles. An auditor is an accounting professional who conducts an independent exami- nation of a company’s fi nancial statements. Only accountants who meet certain cri- teria and thereby attain the designation certifi ed public accountant (CPA) may perform audits. If the auditor is satisfi ed that the fi nancial statements provide a fair representation of the company’s fi nancial position and results of operations in accor- dance with generally accepted accounting principles, then the auditor expresses an unqualifi ed opinion. If the auditor expresses anything other than an unqualifi ed opinion, then readers should only use the fi nancial statements with caution. That is, without an unqualifi ed opinion, we cannot have complete confi dence that the fi nancial statements give an accurate picture of the company’s fi nancial health. For example, recently Blockbuster, Inc.’s auditor stated that its fi nancial situation raised “substantial doubt about the Company’s ability to continue as a going concern.” Illustration 1-12 is an excerpt from the auditor’s report from Columbia Sportswear’s 2014 annual report. Columbia received an unqualifi ed opinion from its auditor, Deloitte & Touche.

3b▼ Components of Annual ReportsDO IT! State whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the fi nancial statements, or the auditor’s report.

1. Descriptions of signifi cant accounting policies.

2. Unqualifi ed opinion.

3. Explanations of uncertainties and contingencies.

4. Description of ability to fund operations and expansion.

5. Description of results of operations.

6. Certifi ed public accountant (CPA).

SOLUTION 1. Descriptions of signifi cant accounting policies: Notes.

2. Unqualifi ed opinion: Auditor’s report.

3. Explanations of uncertainties and contingencies: Notes.

4. Description of ability to fund operations and expansion: MD&A.

5. Description of results of operations: MD&A.

6. Certifi ed public accountant (CPA): Auditor’s report.

Action Plan ✔ Realize that fi nancial

statements provide information about a company’s performance and fi nancial position.

✔ Be familiar with the other elements of the annual report in order to gain a fuller understanding of a company.

Related exercise material: BE1-11, DO IT! 1-3b, and E1-17.

ILLUSTRATION 1-12 Excerpt from auditor’s report on Columbia Sportswear’s fi nancial statements

In our opinion, such consolidated fi nancial statements present fairly, in all ma terial respects, the fi nancial position of Columbia Sportswear Company and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash fl ows for each of the three years in the period ended December 31, 2014, in confor- mity with accounting principles generally accepted in the United States of America. Also, in our opinion, such fi nancial statement schedules, when considered in relation to the basic consolidated fi nancial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

COLUMBIA SPORTSWEAR COMPANY Excerpt from Auditor’s Report

Real World

20 1 Introduction to Financial Statements

Using Decision Tools comprehensive exercises ask you to apply business information and the decision tools presented in the chapter. Most of these exercises are based on the companies highlighted in the Feature Story.

There is a good chance that you may have never heard of VF Corporation. There is also a very good chance that you are wearing one of VF’s products right now. VF owns North Face, Lee, Vans, Nautica, Wrangler, Timberland, and numerous other brands. VF is a direct competitor to Columbia Sportswear. Suppose that you are considering investing in shares of VF’s common stock.

INSTRUCTIONS

Answer these questions related to your decision whether to invest.

(a) What fi nancial statements should you evaluate? (b) What should these fi nancial statements tell you? (c) Do you care if the fi nancial statements have been audited? Explain. (d) Appendix B at the end of this textbook contains fi nancial statements for Columbia, and Appendix C contains those

for VF. You can make many comparisons between Columbia and VF in terms of their respective results from operations and fi nancial position. Compare their respective total assets, total revenues, and net cash provided by operating activities.

SOLUTION (a) Before you invest, you should evaluate the income statement, retained earnings statement, balance sheet, and state-

ment of cash fl ows. (b) You would probably be most interested in the income statement because it tells about past performance and thus

gives an indication of future performance. The retained earnings statement provides a record of the company’s divi- dend history. The balance sheet reveals the relationship between assets and liabilities. The statement of cash fl ows reveals where the company is getting and spending its cash. This is especially important for a company that wants to grow.

(c) You would want audited fi nancial statements. These statements indicate that a CPA (certifi ed public accountant) has examined and expressed an opinion that the statements present fairly the fi nancial position and results of operations of the company. Investors and creditors should not make decisions without studying audited fi nancial statements.

(d) Many interesting comparisons can be made between the two companies (all numbers are in thousands). Columbia is smaller, with total assets of $1,792,209 versus $9,980,140 for VF, and it has lower revenue—$2,100,590 versus $12,282,161 for VF. In addition, Columbia’s net cash provided by operating activities of $185,783 is less than VF’s $1,697,629. However, while useful, these basic measures are not enough to determine whether one company is a better investment than the other. In later chapters, you will learn tools that will allow you to compare the relative profi tability and fi nancial health of these and other companies.

USING DECISION TOOLS—VF CORPORATION

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Identify the forms of business organization and the uses of accounting information. A sole proprietorship is a business owned by one person. A partnership is a business owned by two or more people associated as partners. A corporation is a separate legal entity for which evidence of ownership is provided by shares of stock.

Internal users are managers who need accounting infor- mation to plan, organize, and run business operations. The primary external users are investors and creditors. Investors (stockholders) use accounting information to decide whether to buy, hold, or sell shares of a company’s stock. Creditors (suppliers and bankers) use accounting

▼

The Review and Practice section provides opportunities for students to review key concepts and terms as well as complete multiple-choice questions, exercises, and a comprehensive problem. Detailed solutions are also included.

Glossary Review 21

information to assess the risk of granting credit or loaning money to a business. Other groups who have an indirect interest in a business are taxing authorities, customers, labor unions, and regulatory agencies.

2 Explain the three principal types of business activity. Financing activities involve collecting the necessary funds to support the business. Investing activities involve acquir- ing the resources necessary to run the business. Operating activities involve putting the resources of the business into action to generate a profi t.

3 Describe the four fi nancial statements and how they are prepared. An income statement presents the revenues and expenses of a company for a specifi c period of time. A retained earnings statement summarizes the changes in retained earnings that have occurred for a specifi c period of time. A balance sheet reports the assets, liabilities, and stockholders’ equity of a business at a specifi c date. A state- ment of cash fl ows summarizes information concerning

the cash infl ows (receipts) and outfl ows (payments) for a specifi c period of time. Assets are resources owned by a business. Liabilities are the debts and obligations of the business. Liabilities represent claims of creditors on the assets of the business. Stockholders’ equity represents the claims of owners on the assets of the business. Stockholders’ equity is subdi- vided into two parts: common stock and retained earnings. The basic accounting equation is Assets = Liabilities + Stockholders’ Equity. Within the annual report, the management discussion and analysis provides management’s interpretation of the company’s results and fi nancial position as well as a discussion of plans for the future. Notes to the fi nan- cial statements provide additional explanation or detail to make the fi nancial statements more informative. The auditor’s report expresses an opinion as to whether the fi nancial statements present fairly the company’s results of operations and fi nancial position.

Accounting The information system that identifi es, records, and communicates the economic events of an organiza- tion to interested users. (p. 5).

Annual report A report prepared by corporate management that presents fi nancial information including fi nancial statements, a management discussion and analysis section, notes, and an independent auditor’s report. (p. 18).

Assets Resources owned by a business. (p. 9).

Auditor’s report A report prepared by an independent outside auditor stating the auditor’s opinion as to the fairness of the presentation of the fi nancial position and results of operations and their conformance with gener- ally accepted accounting principles. (p. 19).

GLOSSARY REVIEW▼

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Are the company’s opera- tions profi table?

Income statement The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time.

What is the company’s policy toward dividends and growth?

Retained earnings statement

The retained earnings statement reports how much of this year’s income the company paid out in dividends to shareholders.

A company striving for rapid growth will pay a low (or no) dividend.

Does the company rely primarily on debt or stock- holders’ equity to fi nance its assets?

Balance sheet The balance sheet reports the company’s resources and claims to those resources. There are two types of claims: liabilities and stockholders’ equity.

Compare the amount of debt versus the amount of stockholders’ equity to determine whether the company relies more on creditors or owners for its fi nancing.

Does the company gener- ate suffi cient cash from operations to fund its investing activities?

Statement of cash fl ows The statement of cash fl ows shows the amount of net cash provided or used by operating activities, investing activities, and fi nancing activities.

Compare the amount of net cash provided by operating activities with the amount of net cash used by investing activities. Any defi ciency in cash from operating activities must be made up with cash from fi nancing activities.

If the company’s revenues exceed its expenses, it will report net income; other- wise, it will report a net loss.

22 1 Introduction to Financial Statements

Balance sheet A fi nancial statement that reports the assets and claims to those assets at a specifi c point in time. (p. 13).

Basic accounting equation Assets = Liabilities + Stock- holders’ Equity. (p. 13).

Certifi ed public accountant (CPA) An individual who has met certain criteria and is thus allowed to perform audits of corporations. (p. 19).

Common stock Term used to describe the total amount paid in by stockholders for the shares they purchase. (p. 9).

Corporation A business organized as a separate legal entity owned by stockholders. (p. 4).

Dividends Payments of cash from a corporation to its stockholders. (p. 9).

Expenses The cost of assets consumed or services used in the process of generating revenues. (p. 10).

Income statement A fi nancial statement that reports a company’s revenues and expenses and resulting net income or net loss for a specifi c period of time. (p. 11).

Liabilities Amounts owed to creditors in the form of debts and other obligations. (p. 9).

Management discussion and analysis (MD&A) A section of the annual report that presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. (p. 18).

Net income The amount by which revenues exceed ex- penses. (p. 10).

Net loss The amount by which expenses exceed revenues. (p. 10).

Notes to the fi nancial statements Notes clarify informa- tion presented in the fi nancial statements and provide additional detail. (p. 18).

Partnership A business owned by two or more persons as- sociated as partners. (p. 4).

Retained earnings The amount of net income retained in the corporation. (p. 12).

Retained earnings statement A fi nancial statement that summarizes the amounts and causes of changes in re- tained earnings for a specifi c time period. (p. 12).

Revenue The increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business. (p. 10).

Sarbanes-Oxley Act (SOX) Regulations passed by Congress to reduce unethical corporate behavior. (p. 7).

Sole proprietorship A business owned by one person. (p. 4).

Statement of cash fl ows A fi nancial statement that provides fi nancial information about the cash receipts and cash payments of a business for a specifi c period of time. (p. 14).

Stockholders’ equity The owners’ claim to assets. (p. 13).

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

1. Which is not one of the three forms of business organization? (a) Sole proprietorship. (c) Partnership. (b) Creditorship. (d) Corporation.

2. Which is an advantage of corporations relative to partnerships and sole proprietorships? (a) Lower taxes. (b) Harder to transfer ownership. (c) Reduced legal liability for investors. (d) Most common form of organization.

3. Which statement about users of accounting informa- tion is incorrect? (a) Management is considered an internal user. (b) Taxing authorities are considered external users. (c) Present creditors are considered external users. (d) Regulatory authorities are considered internal users.

4. Which of the following did not result from the Sarbanes-Oxley Act? (a) Top management must now certify the accuracy

of fi nancial information. (b) Penalties for fraudulent activity increased. (c) Independence of auditors increased. (d) Tax rates on corporations increased.

5. Which is not one of the three primary business activities? (a) Financing. (c) Advertising. (b) Operating. (d) Investing.

6. Which of the following is an example of a fi nancing activity? (a) Issuing shares of common stock. (b) Selling goods on account. (c) Buying delivery equipment. (d) Buying inventory.

(LO 1)

(LO 2)

7. Net income will result during a time period when: (a) assets exceed liabilities. (b) assets exceed revenues. (c) expenses exceed revenues. (d) revenues exceed expenses.

8. The fi nancial statements for Macias Corporation contained the following information.

Accounts receivable $ 5,000 Sales revenue 75,000 Cash 15,000 Salaries and wages expense 20,000 Rent expense 10,000 What was Macias Corporation’s net income?

(a) $60,000. (c) $65,000. (b) $15,000. (d) $45,000.

9. What section of a statement of cash fl ows indicates the cash spent on new equipment during the past accounting period? (a) The investing activities section. (b) The operating activities section. (c) The fi nancing activities section. (d) The statement of cash fl ows does not give this

information. 10. Which statement presents information as of a spe-

cifi c point in time? (a) Income statement. (b) Balance sheet. (c) Statement of cash fl ows. (d) Retained earnings statement.

11. Which fi nancial statement reports assets, liabilities, and stockholders’ equity? (a) Income statement. (b) Retained earnings statement.

(LO 2)

(LO 3)

Practice Multiple-Choice Questions 23

SOLUTIONS 1. (b) Creditorship is not a form of business organization. The other choices are incorrect because (a) sole proprietorship,

2. (c) An advantage of corporations is that investors are not personally liable for debts of the business. The other choices are incorrect because (a) lower taxes, (b) harder to transfer ownership, and (d) most common form of organization are not true of corporations.

3. (d) Regulatory authorities are considered external, not internal, users. The other choices are true statements.

4. (d) The Sarbanes-Oxley Act (SOX) was created to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals, not to address tax rates. The other choices are incorrect because (a) top management must now certify the accuracy of fi nancial information, (b) penalties for fraudulent activity increased, and (c) increased independence of auditors all resulted from SOX.

5. (c) Advertising is a type of operating activity. The other choices are incorrect because (a) fi nancing, (b) operating, and (d) investing are the three primary business activities.

6. (a) Issuing shares of common stock is a fi nancing activity. The other choices are incorrect because (b) selling goods on account is an operating activity, (c) buying delivery equipment is an investing activity, and (d) buying inventory is an operating activity.

7. (d) When a company earns more revenues than expenses, it will report net income during a time period. The other choices are incorrect because (a) assets and liabilities are on the balance sheet, not the income statement; (b) assets are on the balance sheet, not the income statement; and (c) net income results when revenues exceed expenses, not when expenses exceed revenues.

8. (d) Net income = Sales revenue ($75,000) − Salaries and wages expense ($20,000) − Rent expense ($10,000) = $45,000. The other choices are therefore incorrect.

9. (a) The investing activities section of the statement of cash fl ows provides information about property, plant, and equipment accounts, not (b) the operating activities section or (c) the fi nancing activities section. Choice (d) is incor- rect as the statement of cash fl ows does provide this information.

10. (b) The balance sheet presents information as of a specifi c point in time. The other choices are incorrect because the (a) income statement, (c) statement of cash fl ows, and (d) retained earnings statement all cover a period of time.

11. (c) The balance sheet is a formal presentation of the accounting equation, such that Assets = Liabilities + Stockholders’ Equity, not the (a) income statement, (b) retained earnings statement, or (d) statement of cash fl ows.

12. (d) Stockholders’ equity represents claims of owners. The other choices are incorrect because (a) claims of credi- tors and (b) claims of employees are liabilities. Choice (c) is incorrect because the difference between revenues and expenses is net income.

13. (d) Using the accounting equation, liabilities can be computed by subtracting stockholders’ equity from assets, or $3,500 − $1,500 = $2,000, not (a) $1,500, (b) $1,000, or (c) $2,500.

14. (a) The corporation’s accounting methods are described in the notes to the fi nancial statements, not in the (b) manage- ment discussion and analysis, (c) auditor’s report, or (d) income statement.

15. (b) The element of the annual report that presents an opinion regarding the fairness of the presentation of the fi - nancial position and results of operations is the auditor’s opinion, not the (a) income statement, (c) balance sheet, or (d) comparative statements.

14. The element of a corporation’s annual report that de- scribes the corporation’s accounting methods is/are the: (a) notes to the fi nancial statements. (b) management discussion and analysis. (c) auditor’s report. (d) income statement.

15. The element of the annual report that presents an opin- ion regarding the fairness of the presentation of the fi nancial position and results of operations is/are the: (a) income statement. (b) auditor’s opinion. (c) balance sheet. (d) comparative statements.

(LO 3)

12. Stockholders’ equity represents: (a) claims of creditors. (b) claims of employees. (c) the difference between revenues and expenses. (d) claims of owners.

13. As of December 31, 2017, Rockford Corporation has assets of $3,500 and stockholders’ equity of $1,500. What are the liabilities for Rockford Corporation as of December 31, 2017? (a) $1,500. (c) $2,500. (b) $1,000. (d) $2,000.

(LO 3)

24 1 Introduction to Financial Statements

1. The following items and amounts were taken from Ricardo Inc.’s 2017 income state- ment and balance sheet.

Cash $ 84,700 Inventory $ 64,618 Retained earnings 123,192 Accounts receivable 88,419 Cost of goods sold 483,854 Sales revenue 693,485 Salaries and wages expense 125,000 Income taxes payable 6,499 Prepaid insurance 7,818 Accounts payable 49,384 Interest expense 994 Service revenue 8,998

INSTRUCTIONS

Prepare an income statement for Ricardo Inc. for the year ended December 31, 2017.

PRACTICE EXERCISES▼

Prepare an income statement.

(LO 3)

2. Cozy Bear is a private camping ground near the Mountain Home Recreation Area. It has compiled the following fi nancial information as of December 31, 2017.

Service revenue (from camping fees) $148,000 Dividends $ 9,000 Sales revenue (from general store) 35,000 Notes payable 50,000 Accounts payable 16,000 Expenses during 2017 135,000 Cash 18,500 Supplies 12,500 Equipment 129,000 Common stock 40,000 Retained earnings (1/1/2017) 15,000

INSTRUCTIONS

(a) Determine net income from Cozy Bear for 2017.

(b) Prepare a retained earnings statement and a balance sheet for Cozy Bear as of December 31, 2017.

Compute net income and prepare a balance sheet.

(LO 3)

SOLUTION

2. (a) Service revenue $148,000 Sales revenue 35,000

Total revenue 183,000 Expenses 135,000

Net income $ 48,000

SOLUTION

Revenues Sales revenue $693,485 Service revenue 8,998

Total revenues $702,483 Expenses Cost of goods sold 483,854 Salaries and wages expense 125,000 Interest expense 994

Total expenses 609,848

Net income $ 92,635

RICARDO INC. Income Statement

For the Year Ended December 31, 2017

Practice Problem 25

(b)

Jeff Andringa, a former college hockey player, quit his job and started Ice Camp, a hockey camp for kids ages 8 to 18. Eventually, he would like to open hockey camps nationwide. Jeff has asked you to help him prepare fi nancial statements at the end of his fi rst year of operations. He relates the following facts about his business activities.

In order to get the business off the ground, Jeff decided to incorporate. He sold shares of common stock to a few close friends, as well as bought some of the shares himself. He initially raised $25,000 through the sale of these shares. In addition, the company took out a $10,000 loan at a local bank.

Ice Camp purchased, for $12,000 cash, a bus for transporting kids. The company also bought hockey goals and other miscellaneous equipment with $1,500 cash. The company earned camp tuition during the year of $100,000 but had collected only $80,000 of this amount. Thus, at the end of the year, its customers still owed $20,000. The company rents time at a local rink for $50 per hour. Total rink rental costs during the year were $8,000, insurance was $10,000, salary expense was $20,000, and supplies used totaled $9,000, all of which were paid in cash. The company incurred $800 in interest expense on the bank loan, which it still owed at the end of the year.

The company paid dividends during the year of $5,000 cash. The balance in the corporate bank account at December 31, 2017, was $49,500.

Prepare fi nancial statements.

(LO 3)

PRACTICE PROBLEM▼

Retained earnings, January 1 $15,000 Add: Net income 48,000

63,000 Less: Dividends 9,000

Retained earnings, December 31 $54,000

COZY BEAR Retained Earnings Statement

For the Year Ended December 31, 2017

Assets

Cash $ 18,500 Supplies 12,500 Equipment 129,000

Total assets $160,000

Liabilities and Stockholders’ Equity

Liabilities Notes payable $50,000 Accounts payable 16,000

Total liabilities $ 66,000 Stockholders’ equity Common stock 40,000 Retained earnings 54,000

Total stockholders’ equity 94,000

Total liabilities and stockholders’ equity $160,000

COZY BEAR Balance Sheet

December 31, 2017

26 1 Introduction to Financial Statements

SOLUTION

Revenues Service revenue $100,000 Expenses Salaries and wages expense $20,000 Insurance expense 10,000 Supplies expense 9,000 Rent expense 8,000 Interest expense 800

Total expenses 47,800

Net income $ 52,200

ICE CAMP Income Statement

For the Year Ended December 31, 2017

Retained earnings, January 1, 2017 $ 0 Add: Net income 52,200

52,200 Less: Dividends 5,000

Retained earnings, December 31, 2017 $ 47,200

ICE CAMP Retained Earnings Statement

For the Year Ended December 31, 2017

Assets

Cash $ 49,500 Accounts receivable 20,000 Equipment ($12,000 + $1,500) 13,500 Total assets $ 83,000

Liabilities and Stockholders’ Equity

Liabilities Notes payable $10,000 Interest payable 800

Total liabilities $ 10,800 Stockholders’ equity Common stock 25,000 Retained earnings 47,200

Total stockholders’ equity 72,200

Total liabilities and stockholders’ equity $ 83,000

ICE CAMP Balance Sheet

December 31, 2017

INSTRUCTIONS

Using the format of the Sierra Corporation statements in this chapter, prepare an income statement, retained earnings statement, balance sheet, and statement of cash fl ows. (Hint: Prepare the statements in the order stated to take advantage of the fl ow of information from one statement to the next, as shown in Illustration 1-9 on page 16.)

1. What are the three basic forms of business orga- nizations?

2. What are the advantages to a business of being formed as a corporation? What are the disadvantages?

3. What are the advantages to a business of being formed as a partnership or sole proprietorship? What are the disadvantages?

4. “Accounting is ingrained in our society and is vital to our economic system.” Do you agree? Explain.

5. Who are the internal users of accounting data? How does accounting provide relevant data to the internal users?

6. Who are the external users of accounting data? Give examples.

7. What are the three main types of business activity? Give examples of each activity.

8. Listed here are some items found in the fi nancial statements of Finzelberg. Indicate in which fi nancial statement(s) each item would appear. (a) Service revenue. (b) Equipment. (c) Advertising expense.

(d) Accounts receivable. (e) Common stock. (f) Interest payable.

9. Why would a bank want to monitor the dividend payment practices of the corporations to which it lends money?

10. “A company’s net income appears directly on the in- come statement and the retained earnings statement, and it is included indirectly in the company’s balance sheet.” Do you agree? Explain.

11. What is the primary purpose of the statement of cash fl ows?

12. What are the three main categories of the statement of cash fl ows? Why do you think these categories were chosen?

13. What is retained earnings? What items increase the balance in retained earnings? What items decrease the balance in retained earnings?

14. What is the basic accounting equation?

15. (a) Defi ne the terms assets, liabilities, and stockholders’ equity.

(b) What items affect stockholders’ equity?

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

QUESTIONS▼

The tool icon indicates that an activity employs one of the decision tools presented in the chapter. The indicates that an activity relates to a business function beyond accounting. The pencil icon indicates that an activity requires written communication.

(b)

Cash fl ows from operating activities Cash receipts from operating activities $80,000 Cash payments for operating activities (47,000)

Net cash provided by operating activities $33,000

Cash fl ows from investing activities Purchase of equipment (13,500)

Net cash used by investing activities (13,500)

Cash fl ows from fi nancing activities Issuance of common stock 25,000 Issuance of notes payable 10,000 Dividends paid (5,000)

Net cash provided by fi nancing activities 30,000

Net increase in cash 49,500 Cash at beginning of period 0

Cash at end of period $49,500

ICE CAMP Statement of Cash Flows

For the Year Ended December 31, 2017

Questions 27

28 1 Introduction to Financial Statements

16. Which of these items are liabilities of White Glove Cleaning Service? (a) Cash. (f) Equipment. (b) Accounts payable. (g) Salaries and wages (c) Dividends. payable. (d) Accounts receivable. (h) Service revenue. (e) Supplies. (i) Rent expense.

17. How are each of the following fi nancial statements interrelated? (a) Retained earnings statement and in- come statement. (b) Retained earnings statement and balance sheet. (c) Balance sheet and statement of cash fl ows.

18. What is the purpose of the management dis- cussion and analysis section (MD&A)?

19. Why is it important for fi nancial statements to receive an unqualifi ed auditor’s opinion?

20. What types of information are presented in the notes to the fi nancial statements?

21. The accounting equation is Assets = Liabilities + Stock- holders’ Equity. Appendix A, at the end of this textbook, reproduces Apple’s fi nancial statements. Replacing words in the equation with dollar amounts, what is Apple’s accounting equation at September 27, 2014?

BE1-1 Match each of the following forms of business organization with a set of character- istics: sole proprietorship (SP), partnership (P), corporation (C). (a) _____ Shared control, tax advantages, increased skills and resources. (b) _____ Simple to set up and maintains control with owner. (c) _____ Easier to transfer ownership and raise funds, no personal liability.

BE1-2 Match each of the following types of evaluation with one of the listed users of accounting information. 1. Trying to determine whether the company complied with tax laws. 2. Trying to determine whether the company can pay its obligations. 3. Trying to determine whether an advertising proposal will be cost-effective. 4. Trying to determine whether the company’s net income will result in a stock price

increase. 5. Trying to determine whether the company should employ debt or equity financing. (a) _____ Investors in common stock. (d) _____ Chief Financial Offi cer. (b) _____ Marketing managers. (e) _____ Internal Revenue Service. (c) _____ Creditors.

BE1-3 Indicate in which part of the statement of cash fl ows each item would appear: operating activities (O), investing activities (I), or fi nancing activities (F). (a) _____ Cash received from customers. (b) _____ Cash paid to stockholders (dividends). (c) _____ Cash received from issuing new common stock. (d) _____ Cash paid to suppliers. (e) _____ Cash paid to purchase a new offi ce building.

BE1-4 Presented below are a number of transactions. Determine whether each transac- tion affects common stock (C), dividends (D), revenues (R), expenses (E), or does not affect stockholders’ equity (NSE). Provide titles for the revenues and expenses. (a) Costs incurred for advertising. (b) Cash received for services performed. (c) Costs incurred for insurance. (d) Amounts paid to employees. (e) Cash distributed to stockholders. (f) Cash received in exchange for allowing the use of the company’s building. (g) Costs incurred for utilities used. (h) Cash purchase of equipment. (i) Cash received from investors.

BE1-5 In alphabetical order below are balance sheet items for Karol Company at December 31, 2017. Prepare a balance sheet following the format of Illustration 1-7 (page 13).

Accounts payable $65,000 Accounts receivable 71,000 Cash 22,000 Common stock 18,000 Retained earnings 10,000

Describe forms of business organization.

(LO 1), K

Identify users of accounting information.

(LO 1), K

Classify items by activity.

(LO 2), K

Determine effect of transactions on stockholders’ equity.

(LO 3), C

Prepare a balance sheet.

(LO 3), AP

BRIEF EXERCISES▼

DO IT! Exercises 29

Identify each of the following organizational characteristics with the business organizational form or forms with which it is associated.

(a) Easier to transfer ownership. (d) Tax advantages. (b) Easier to raise funds. (e) No personal legal liability. (c) More owner control.

Classify each item as an asset, liability, common stock, revenue, or expense.

(a) Issuance of ownership shares. (b) Land purchased. (c) Amounts owed to suppliers. (d) Bonds payable. (e) Amount earned from selling a product. (f) Cost of advertising.

DO IT! 1-1 Identify benefi ts of business organization forms.

(LO 1), C

DO IT! 1-2 Classify fi nancial statement elements.

(LO 2), K

EXERCISES▼DO IT!

BE1-6 Eskimo Pie Corporation markets a broad range of frozen treats, including its famous Eskimo Pie ice cream bars. The following items were taken from a recent income statement and balance sheet. In each case, identify whether the item would appear on the balance sheet (BS) or income statement (IS). (a) _____ Income tax expense. (f) _____ Sales revenue. (b) _____ Inventory. (g) _____ Cost of goods sold. (c) _____ Accounts payable. (h) _____ Common stock. (d) _____ Retained earnings. (i) _____ Accounts receivable. (e) _____ Equipment. (j) _____ Interest expense.

BE1-7 Indicate which statement you would examine to fi nd each of the following items: income statement (IS), balance sheet (BS), retained earnings statement (RES), or state- ment of cash fl ows (SCF). (a) Revenue during the period. (b) Supplies on hand at the end of the year. (c) Cash received from issuing new bonds during the period. (d) Total debts outstanding at the end of the period.

BE1-8 Use the basic accounting equation to answer these questions. (a) The liabilities of Lantz Company are $90,000 and the stockholders’ equity is $230,000.

What is the amount of Lantz Company’s total assets? (b) The total assets of Salley Company are $170,000 and its stockholders’ equity is

$80,000. What is the amount of its total liabilities? (c) The total assets of Brandon Co. are $800,000 and its liabilities are equal to one-fourth

of its total assets. What is the amount of Brandon Co.’s stockholders’ equity?

BE1-9 At the beginning of the year, Morales Company had total assets of $800,000 and total liabilities of $500,000. (Treat each item independently.) (a) If total assets increased $150,000 during the year and total liabilities decreased

$80,000, what is the amount of stockholders’ equity at the end of the year? (b) During the year, total liabilities increased $100,000 and stockholders’ equity decreased

$70,000. What is the amount of total assets at the end of the year? (c) If total assets decreased $80,000 and stockholders’ equity increased $110,000 during

the year, what is the amount of total liabilities at the end of the year?

BE1-10 Indicate whether each of these items is an asset (A), a liability (L), or part of stock- holders’ equity (SE). (a) Accounts receivable. (d) Supplies. (b) Salaries and wages payable. (e) Common stock. (c) Equipment. (f) Notes payable.

BE1-11 Which is not a required part of an annual report of a publicly traded company? (a) Statement of cash fl ows. (c) Management discussion and analysis. (b) Notes to the fi nancial statements. (d) All of these are required.

Determine where items appear on fi nancial statements.

(LO 3), K

Determine proper fi nancial statement.

(LO 3), K

Use basic accounting equation.

(LO 3), AP

Use basic accounting equation.

(LO 3), AP

Identify assets, liabilities, and stockholders’ equity.

(LO 3), K

Determine required parts of annual report.

(LO 3), K

E1-1 Here is a list of words or phrases discussed in this chapter: 1. Corporation 4. Partnership 7. Accounts payable 2. Creditor 5. Stockholder 8. Auditor’s opinion 3. Accounts receivable 6. Common stock

Instructions Match each word or phrase with the best description of it. ______ (a) An expression about whether fi nancial statements conform with generally

accepted accounting principles. ______ (b) A business that raises money by issuing shares of stock. ______ (c) The portion of stockholders’ equity that results from receiving cash from

investors. ______ (d) Obligations to suppliers of goods. ______ (e) Amounts due from customers. ______ (f) A party to whom a business owes money. ______ (g) A party that invests in common stock. ______ (h) A business that is owned jointly by two or more individuals but does not issue

stock.

E1-2 All businesses are involved in three types of activities—fi nancing, investing, and operating. Listed below are the names and descriptions of companies in several different industries.

Abitibi Consolidated Inc.—manufacturer and marketer of newsprint Cal State–Northridge Stdt Union—university student union Oracle Corporation—computer software developer and retailer Sportsco Investments—owner of the Vancouver Canucks hockey club Grant Thornton LLP—professional accounting and business advisory firm Southwest Airlines—low-cost airline

Instructions (a) For each of the above companies, provide examples of (1) a fi nancing activity, (2) an

investing activity, and (3) an operating activity that the company likely engages in. (b) Which of the activities that you identifi ed in (a) are common to most businesses?

Which activities are not?

Match items with descriptions.

(LO 1, 2, 3), K

Identify business activities.

(LO 2), C

EXERCISES▼ Gray Corporation began operations on January 1, 2017. The following infor- mation is available for Gray Corporation on December 31, 2017.

Accounts payable $ 5,000 Notes payable $ 7,000 Accounts receivable 2,000 Rent expense 10,000 Advertising expense 4,000 Retained earnings ? Cash 3,100 Service revenue 25,000 Common stock 15,000 Supplies 1,900 Dividends 2,500 Supplies expense 1,700 Equipment 26,800

Prepare an income statement, a retained earnings statement, and a balance sheet for Gray Corporation.

Indicate whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the fi nancial statements, or the auditor’s report.

(a) Description of ability to pay near-term obligations. (b) Unqualifi ed opinion. (c) Details concerning liabilities, too voluminous to be included in the statements. (d) Description of favorable and unfavorable trends. (e) Certifi ed public accountant (CPA). (f) Descriptions of signifi cant accounting policies.

DO IT! 1-3aPrepare fi nancial statements.

(LO 3), AP

DO IT! 1-3bIdentify components of annual reports.

(LO 3), K

30 1 Introduction to Financial Statements

Exercises 31

E1-3 The Bonita Vista Golf & Country Club details the following accounts in its fi nancial statements.

Accounts payable _____ Accounts receivable _____ Equipment _____ Sales revenue _____ Service revenue _____ Inventory _____ Mortgage payable _____ Supplies expense _____ Rent expense _____ Salaries and wages expense _____

Instructions Classify each of the above accounts as an asset (A), liability (L), stockholders’ equity (SE), revenue (R), or expense (E) item.

E1-4 This information relates to Benser Co. for the year 2017.

Retained earnings, January 1, 2017 $67,000 Advertising expense 1,800 Dividends 6,000 Rent expense 10,400 Service revenue 58,000 Utilities expense 2,400 Salaries and wages expense 30,000

Instructions After analyzing the data, prepare an income statement and a retained earnings statement for the year ending December 31, 2017.

E1-5 Suppose the following information was taken from the 2017 fi nancial statements of pharmaceutical giant Merck and Co. (All dollar amounts are in millions.)

Retained earnings, January 1, 2017 $43,698.8 Cost of goods sold 9,018.9 Selling and administrative expenses 8,543.2 Dividends 3,597.7 Sales revenue 38,576.0 Research and development expense 5,845.0 Income tax expense 2,267.6

Instructions (a) After analyzing the data, prepare an income statement and a retained earnings state-

ment for the year ending December 31, 2017. (b) Suppose that Merck decided to reduce its research and development expense by 50%.

What would be the short-term implications? What would be the long-term implica- tions? How do you think the stock market would react?

E1-6 Presented here is information for Zheng Inc. for 2017.

Retained earnings, January 1 $130,000 Service revenue 400,000 Total expenses 175,000 Dividends 65,000

Instructions Prepare the 2017 retained earnings statement for Zheng Inc.

E1-7 Consider each of the following independent situations. (a) The retained earnings statement of Lee Corporation shows dividends of $68,000,

while net income for the year was $75,000. (b) The statement of cash fl ows for Steele Corporation shows that cash provided by oper-

ating activities was $10,000, cash used in investing activities was $110,000, and cash provided by fi nancing activities was $130,000.

Classify accounts.

(LO 2, 3), C

Prepare income statement and retained earnings statement.

(LO 3), AP

Prepare a retained earnings statement.

(LO 3), AP

Interpret fi nancial facts.

(LO 3), AP

Prepare income statement and retained earnings statement.

(LO 3), AP

32 1 Introduction to Financial Statements

Instructions Calculate the missing amounts.

E1-10 Otay Lakes Park is a private camping ground near the Mount Miguel Recreation Area. It has compiled the following fi nancial information as of December 31, 2017.

Service revenue (from camping fees) $132,000 Dividends $ 9,000 Sales revenue (from general store) 25,000 Notes payable 50,000 Accounts payable 11,000 Expenses during 2017 126,000 Cash 8,500 Supplies 5,500 Equipment 114,000 Common stock 40,000 Retained earnings (1/1/2017) 5,000

Instructions (a) Determine Otay Lakes Park’s net income for 2017. (b) Prepare a retained earnings statement and a balance sheet for Otay Lakes Park as of

December 31, 2017.

Income Statement Revenues $85,000 Cost of goods sold (c) Salaries and wages expense 10,000

Net income $ (d)

Retained Earnings Statement Beginning retained earnings $12,000 Add: Net income (e) Less: Dividends 5,000

Ending retained earnings $27,000

DONAVAN, INC. Balance Sheet

Liabilities and Stockholders’ Equity

Liabilities Accounts payable $ 5,000 Stockholders’ equity Common stock (a) Retained earnings (b)

Total liabilities and stockholders’ equity $62,000

Assets

Cash $ 7,000 Inventory 10,000 Buildings 45,000

Total assets $62,000

Instructions For each company, provide a brief discussion interpreting these fi nancial facts. For example, you might discuss the company’s fi nancial health or its apparent growth philosophy.

E1-8 The following items and amounts were taken from Lonyear Inc.’s 2017 income state- ment and balance sheet. ______ Cash $ 84,700 ______ Accounts receivable $ 88,419 ______ Retained earnings 123,192 ______ Sales revenue 584,951 ______ Cost of goods sold 438,458 ______ Notes payable 6,499 ______ Salaries and wages expense 115,131 ______ Accounts payable 49,384 ______ Prepaid insurance 7,818 ______ Service revenue 4,806 ______ Inventory 64,618 ______ Interest expense 1,882

Instructions (a) In each, case, identify on the blank line whether the item is an asset (A), liability (L),

stockholders’ equity (SE), revenue (R), or expense (E) item. (b) Prepare an income statement for Lonyear Inc. for the year ended December 31, 2017.

E1-9 Here are incomplete fi nancial statements for Donavan, Inc.

Identify fi nancial statement components and prepare income statement.

(LO 3), C

Calculate missing amounts.

(LO 3), AN

Compute net income and prepare a balance sheet.

(LO 3), AP

Exercises 33

(c) Upon seeing this income statement, Walt Jones, the campground manager, im- mediately concluded, “The general store is more trouble than it is worth—let’s get rid of it.” The marketing director isn’t so sure this is a good idea. What do you think?

E1-11 Kellogg Company is the world’s leading producer of ready-to-eat cereal and a lead- ing producer of grain-based convenience foods such as frozen waffl es and cereal bars. Suppose the following items were taken from its 2017 income statement and balance sheet. (All dollars are in millions.)

____ Retained earnings $5,481 ____ Bonds payable $ 4,835 ____ Cost of goods sold 7,184 ____ Inventory 910 ____ Selling and ____ Sales revenue 12,575

administrative expenses 3,390 ____ Accounts payable 1,077 ____ Cash 334 ____ Common stock 105 ____ Notes payable 44 ____ Income tax expense 498 ____ Interest expense 295

Instructions (a) In each case, identify whether the item is an asset (A), liability (L), stockholders’ equity

(SE), revenue (R), or expense (E). (b) Prepare an income statement for Kellogg Company for the year ended December 31,

2017.

E1-12 This information is for Williams Corporation for the year ended December 31, 2017.

Cash received from lenders $20,000 Cash received from customers 50,000 Cash paid for new equipment 28,000 Cash dividends paid 8,000 Cash paid to suppliers 16,000 Cash balance 1/1/17 12,000

Instructions (a) Prepare the 2017 statement of cash fl ows for Williams Corporation. (b) Suppose you are one of Williams’ creditors. Referring to the statement of cash fl ows,

evaluate Williams’ ability to repay its creditors.

E1-13 Suppose the following data are derived from the 2017 fi nancial statements of Southwest Airlines. (All dollars are in millions.) Southwest has a December 31 year-end.

Cash balance, January 1, 2017 $1,390 Cash paid for repayment of debt 122 Cash received from issuance of common stock 144 Cash received from issuance of long-term debt 500 Cash received from customers 9,823 Cash paid for property and equipment 1,529 Cash paid for dividends 14 Cash paid for repurchase of common stock 1,001 Cash paid for goods and services 6,978

Instructions (a) After analyzing the data, prepare a statement of cash fl ows for Southwest Airlines for

the year ended December 31, 2017. (b) Discuss whether the company’s net cash provided by operating activities was suffi -

cient to fi nance its investing activities. If it was not, how did the company fi nance its investing activities?

E1-14 Wayne Holtz is the bookkeeper for Beeson Company. Wayne has been trying to get the balance sheet of Beeson Company to balance. It fi nally balanced, but now he’s not sure it is correct.

Identify fi nancial statement components and prepare an income statement.

(LO 3), AP

Prepare a statement of cash fl ows.

(LO 3), AP

Correct an incorrectly prepared balance sheet.

(LO 3), AP

Prepare a statement of cash fl ows.

(LO 3), AP

34 1 Introduction to Financial Statements

Walco Corporation Gunther Enterprises Beginning of year Total assets $110,000 $150,000 Total liabilities 70,000 (d) Total stockholders’ equity (a) 70,000 End of year Total assets (b) 180,000 Total liabilities 120,000 55,000 Total stockholders’ equity 60,000 (e) Changes during year in retained earnings Dividends (c) 5,000 Total revenues 215,000 (f) Total expenses 165,000 80,000

Instructions Determine the missing amounts. Assume all changes in stockholders’ equity are due to changes in retained earnings.

E1-17 The annual report provides fi nancial information in a variety of formats, including the following.

Management discussion and analysis (MD&A) Financial statements Notes to the financial statements Auditor’s opinion

Classify various items in an annual report.

(LO 3), K

BEESON COMPANY Balance Sheet

December 31, 2017

Assets

Cash $18,000 Supplies 9,500 Equipment 40,000 Dividends 8,000

Total assets $75,500

Liabilities and Stockholders’ Equity

Accounts payable $16,000 Accounts receivable (12,000) Common stock 40,000 Retained earnings 31,500 Total liabilities and stockholders’ equity $75,500

Instructions Prepare a correct balance sheet.

E1-15 Suppose the following items were taken from the balance sheet of Nike, Inc. (All dollars are in millions.)

1. Cash $2,291.1 7. Inventory $2,357.0 2. Accounts receivable 2,883.9 8. Income taxes payable 86.3 3. Common stock 2,874.2 9. Equipment 1,957.7 4. Notes payable 342.9 10. Retained earnings 5,818.9 5. Buildings 3,759.9 11. Accounts payable 2,815.8 6. Mortgage payable 1,311.5

Instructions Perform each of the following. (a) Classify each of these items as an asset, liability, or stockholders’ equity, and deter-

mine the total dollar amount for each classifi cation. (b) Determine Nike’s accounting equation by calculating the value of total assets, total

liabilities, and total stockholders’ equity. (c) To what extent does Nike rely on debt versus equity fi nancing?

E1-16 The summaries of data from the balance sheet, income statement, and retained earnings statement for two corporations, Walco Corporation and Gunther Enterprises, are presented as follows for 2017.

Use fi nancial statement relationships to determine missing amounts.

(LO 3), AN

Classify items as assets, liabilities, and stockholders’ equity and prepare accounting equation.

(LO 3), AP

Problems: Set A 35

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P1-1A Presented below are fi ve independent situations.

(a) Three physics professors at MIT have formed a business to improve the speed of infor- mation transfer over the Internet for stock exchange transactions. Each has contrib- uted an equal amount of cash and knowledge to the venture. Although their approach looks promising, they are concerned about the legal liabilities that their business might confront.

(b) Bob Colt, a college student looking for summer employment, opened a bait shop in a small shed at a local marina.

(c) Alma Ortiz and Jaime Falco each owned separate shoe manufacturing businesses. They have decided to combine their businesses. They expect that within the coming year they will need signifi cant funds to expand their operations.

(d) Alice, Donna, and Sam recently graduated with marketing degrees. They have been friends since childhood. They have decided to start a consulting business focused on marketing sporting goods over the Internet.

(e) Don Rolls has developed a low-cost GPS device that can be implanted into pets so that they can be easily located when lost. He would like to build a small manufac- turing facility to make the devices and then sell them to veterinarians across the country. Don has no savings or personal assets. He wants to maintain control over the business.

Instructions In each case, explain what form of organization the business is likely to take—sole propri- etorship, partnership, or corporation. Give reasons for your choice.

P1-2A Financial decisions often place heavier emphasis on one type of fi nancial statement over the others. Consider each of the following hypothetical situations independently.

(a) The North Face is considering extending credit to a new customer. The terms of the credit would require the customer to pay within 30 days of receipt of goods.

(b) An investor is considering purchasing common stock of Amazon.com. The investor plans to hold the investment for at least 5 years.

(c) JPMorgan Chase Bank is considering extending a loan to a small company. The com- pany would be required to make interest payments at the end of each year for 5 years, and to repay the loan at the end of the fi fth year.

(d) The president of Campbell Soup is trying to determine whether the company is gener- ating enough cash to increase the amount of dividends paid to investors in this and future years, and still have enough cash to buy equipment as it is needed.

Determine forms of business organization.

(LO 1), C

Identify users and uses of fi nancial statements.

(LO 3), C

PROBLEMS: SET A▼

Instructions For each of the following, state in what area of the annual report the item would be pre- sented. If the item would probably not be found in an annual report, state “Not disclosed.” (a) The total cumulative amount received from stockholders in exchange for common

stock. (b) An independent assessment concerning whether the fi nancial statements present a

fair depiction of the company’s results and fi nancial position. (c) The interest rate that the company is being charged on all outstanding debts. (d) Total revenue from operating activities. (e) Management’s assessment of the company’s results. (f) The names and positions of all employees hired in the last year.

36 1 Introduction to Financial Statements

Instructions In each situation, state whether the decision-maker would be most likely to place primary emphasis on information provided by the income statement, balance sheet, or statement of cash fl ows. In each case provide a brief justifi cation for your choice. Choose only one fi nancial statement in each case.

P1-3A On June 1, 2017, Elite Service Co. was started with an initial investment in the com- pany of $22,100 cash. Here are the assets, liabilities, and common stock of the company at June 30, 2017, and the revenues and expenses for the month of June, its fi rst month of operations:

Cash $ 4,600 Notes payable $12,000 Accounts receivable 4,000 Accounts payable 500 Service revenue 7,500 Supplies expense 1,000 Supplies 2,400 Maintenance and repairs expense 600 Advertising expense 400 Utilities expense 300 Equipment 26,000 Salaries and wages expense 1,400 Common stock 22,100

In June, the company issued no additional stock but paid dividends of $1,400.

Instructions (a) Prepare an income statement and a retained earnings statement for the month of June

and a balance sheet at June 30, 2017. (b) Briefl y discuss whether the company’s fi rst month of operations was a success. (c) Discuss the company’s decision to distribute a dividend.

P1-4A Presented below is selected fi nancial information for Rojo Corporation for December 31, 2017.

Inventory $ 25,000 Cash paid to purchase equipment $ 12,000 Cash paid to suppliers 104,000 Equipment 40,000 Buildings 200,000 Service revenue 100,000 Common stock 50,000 Cash received from customers 132,000 Cash dividends paid 7,000 Cash received from issuing Cash at beginning of period 9,000 common stock 22,000

Instructions (a) Determine which items should be included in a statement of cash fl ows and then pre-

pare the statement for Rojo Corporation. (b) Comment on the adequacy of net cash provided by operating activities to fund the

company’s investing activities and dividend payments.

P1-5A Micado Corporation was formed on January 1, 2017. At December 31, 2017, Miko Liu, the president and sole stockholder, decided to prepare a balance sheet, which appeared as follows.

MICADO CORPORATION Balance Sheet

December 31, 2017

Assets Liabilities and Stockholders’ Equity

Cash $20,000 Accounts payable $30,000 Accounts receivable 50,000 Notes payable 15,000 Inventory 36,000 Boat loan 22,000 Boat 24,000 Stockholders’ equity 63,000

Miko willingly admits that she is not an accountant by training. She is concerned that her balance sheet might not be correct. She has provided you with the following additional information.

1. The boat actually belongs to Miko, not to Micado Corporation. However, because she thinks she might take customers out on the boat occasionally, she decided to list it as an asset of the company. To be consistent, she also listed as a liability of the corpora- tion her personal loan that she took out at the bank to buy the boat.

2. The inventory was originally purchased for $25,000, but due to a surge in demand Miko now thinks she could sell it for $36,000. She thought it would be best to record it at $36,000.

Check fi gures provide a key number to let you know you are on the right track.

(a) Net income $ 3,800 Ret. earnings $ 2,400 Tot. assets $37,000

Determine items included in a statement of cash fl ows, prepare the statement, and comment.

(LO 3), AP

(a) Net increase $31,000

Comment on proper accounting treatment and prepare a corrected balance sheet.

(LO 3), AN

Prepare an income statement, retained earnings statement, and balance sheet; discuss results.

(LO 3), AP

Expand Your Critical Thinking 37

3. Included in the accounts receivable balance is $10,000 that Miko loaned to her brother 5 years ago. Miko included this in the receivables of Micado Corporation so she wouldn’t forget that her brother owes her money.

Instructions (a) Comment on the proper accounting treatment of the three items above. (b) Provide a corrected balance sheet for Micado Corporation. (Hint: To get the balance

sheet to balance, adjust stockholders’ equity.) (b) Tot. assets $85,000

CC1 Natalie Koebel spent much of her childhood learning the art of cookie-making from her grandmother. They spent many happy hours mastering every type of cookie imagin- able and later devised new recipes that were both healthy and delicious. Now at the start of her second year in college, Natalie is investigating possibilities for starting her own business as part of the entrepreneurship program in which she is enrolled. A long-time friend insists that Natalie has to include cookies in her business plan. After a series of brainstorming sessions, Natalie settles on the idea of operating a cookie-making school. She will start on a part-time basis and offer her services in people’s homes. Now that she has started thinking about it, the possibilities seem endless. During the fall, she will con- centrate on holiday cookies. She will offer group sessions (which will probably be more en- tertainment than education) and individual lessons. Natalie also decides to include children in her target market. The fi rst diffi cult decision is coming up with the perfect name for her business. She settles on “Cookie Creations,” and then moves on to more important issues.

Instructions (a) What form of business organization—proprietorship, partnership, or corporation—do

you recommend that Natalie use for her business? Discuss the benefi ts and weak- nesses of each form that Natalie might consider.

(b) Will Natalie need accounting information? If yes, what information will she need and why? How often will she need this information?

(c) Identify specifi c asset, liability, revenue, and expense accounts that Cookie Creations will likely use to record its business transactions.

(d) Should Natalie open a separate bank account for the business? Why or why not? (e) Natalie expects she will have to use her car to drive to people’s homes and to pick up sup-

plies, but she also needs to use her car for personal reasons. She recalls from her fi rst-year accounting course something about keeping business and personal assets separate. She wonders what she should do for accounting purposes. What do you recommend?

CONTINUING PROBLEM Cookie Creations▼

The Cookie Creations problem starts in Chapter 1 and continues in every chapter. You can also fi nd this problem at the book’s companion website.

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT1-1 The fi nancial statements of Apple Inc. for 2014 are presented in Appendix A.

Instructions Refer to Apple’s fi nancial statements and answer the following questions.

(a) What were Apple’s total assets at September 27, 2014? At September 28, 2013? (b) How much cash (and cash equivalents) did Apple have on September 27, 2014? (c) What amount of accounts payable did Apple report on September 27, 2014? On

September 28, 2013? (d) What were Apple’s net sales in 2012? In 2013? In 2014? (e) What is the amount of the change in Apple’s net income from 2013 to 2014?

Financial Reporting

▼

38 1 Introduction to Financial Statements

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT1-2 Columbia Sportswear Company’s fi nancial statements are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information in these financial statements, determine the following for

each company. (1) Total liabilities at December 31, 2014. (2) Net property, plant, and equipment at December 31, 2014. (3) Net cash provided or (used) in investing activities for 2014. (4) Net income for 2014. (b) What conclusions concerning the two companies can you draw from these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT1-3 Amazon.com, Inc.’s fi nancial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information contained in these financial statements, determine the follow-

ing for each company. (1) Total assets at December 31, 2014, for Amazon and for Wal-Mart at January 31,

2015. (2) Receivables (net) at December 31, 2014, for Amazon and for Wal-Mart at January

31, 2015. (3) Net sales (product only) for the year ended in 2014 (2015 for Wal-Mart). (4) Net income for year ended in 2014 (2015 for Wal-Mart). (b) What conclusions concerning these two companies can be drawn from these data?

INTERPRETING FINANCIAL STATEMENTS

CT1-4 Xerox was not having a particularly pleasant year. The company’s stock price had already fallen in the previous year from $60 per share to $30. Just when it seemed things couldn’t get worse, Xerox’s stock fell to $4 per share. The data below were taken from the statement of cash fl ows of Xerox. (All dollars are in millions.)

Cash used in operating activities $ (663) Cash used in investing activities (644) Financing activities Dividends paid $ (587) Net cash received from issuing debt 3,498

Cash provided by fi nancing activities 2,911

Instructions Analyze the information, and then answer the following questions.

(a) If you were a creditor of Xerox, what reaction might you have to the above information? (b) If you were an investor in Xerox, what reaction might you have to the above information? (c) If you were evaluating the company as either a creditor or a stockholder, what other

information would you be interested in seeing? (d) Xerox decided to pay a cash dividend. This dividend was approximately equal to the

amount paid in the previous year. Discuss the issues that were probably considered in making this decision.

REAL-WORLD FOCUS

CT1-5 Purpose: Identify summary information about companies. This information in- cludes basic descriptions of the company’s location, activities, industry, fi nancial health, and fi nancial performance.

Address: http://biz.yahoo.com/i

Financial Analysis

▼

Financial Analysis

▼

Financial Analysis

▼

Expand Your Critical Thinking 39

Steps 1. Type in a company name, or use the index to find company name. 2. Under Financials, choose Income Statement. Perform instructions (a) and (b) below. 3. Under Company, choose Industry to identify others in this industry. Perform instruc-

tions (c)–(e) below.

Instructions Answer the following questions.

(a) What is the company’s net income? Over what period was this measured? (b) What is the company’s total sales? Over what period was this measured? (c) What is the company’s industry? (d) What are the names of four companies in this industry? (e) Choose one of the competitors. What is this competitor’s name? What is its total sales?

What is its net income?

CT1-6 The June 22, 2011, issue of the Wall Street Journal Online includes an article by Michael Rapoport entitled “Auditors Urged to Tell More.” It provides an interesting discus- sion of the possible expanding role of CPAs.

Instructions Read the article and answer the following questions.

(a) What are some of the ideas that the Public Company Accounting Oversight Board proposed for expanding the role of auditors in “passing judgment on more of what a company does and says?”

(b) How might the financial crisis influence the public’s opinion regarding the need for more information from auditors?

(c) Describe the proposed “Auditor’s Discussion and Analysis.” (d) Discuss whether you think that auditors will view these proposals positively or

negatively.

DECISION-MAKING ACROSS THE ORGANIZATION

CT1-7 Sylvia Ayala recently accepted a job in the production department at Apple. Before she starts work, she decides to review the company’s annual report to better understand its operations. The content and organization of corporate annual reports have become fairly stan- dardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional fi nancial portions of the annual report:

• Financial Highlights • Letter to the Stockholders • Management’s Discussion and Analysis • Financial Statements • Notes to the Financial Statements • Management’s Responsibility for Financial Reporting • Management’s Report on Internal Control over Financial Reporting • Report of Independent Registered Public Accounting Firm • Selected Financial Data

The offi cial SEC fi ling of the annual report is called a Form 10-K, which often omits the public relations pieces found in most standard annual reports. To access Apple’s Form 10-K, including notes to the fi nancial statements, follow these steps:

1. Go to http://investor.apple.com. 2. Select the Financial Information tab. 3. Select the 10-K annual report dated September 2014. 4. The financial portions of the annual report begin on page 21.

Instructions Use Apple’s annual report to answer the following questions.

(a) What CPA firm performed the audit of Apple’s financial statements? (b) What was the amount of Apple’s basic earnings per share in 2014?

Financial Analysis

Writing

Group Project

▼

40 1 Introduction to Financial Statements

(c) What are the company’s net sales in foreign countries in 2014? (d) What were net sales in 2012? (e) How many shares of common stock have been authorized? (f) How much cash was spent on capital expenditures in 2014? (g) Over what life does the company depreciate its buildings? (h) What was the value of inventory in 2013?

COMMUNICATION ACTIVITY

CT1-8 Marci Ling is the bookkeeper for Samco Company, Inc. Marci has been trying to get the company’s balance sheet to balance. She fi nally got it to balance, but she still isn’t sure that it is correct.

SAMCO COMPANY, INC. Balance Sheet

For the Month Ended December 31, 2017

Assets Liabilities and Stockholders’ Equity

Equipment $18,000 Common stock $12,000 Cash 9,000 Accounts receivable (6,000) Supplies 1,000 Dividends (2,000) Accounts payable (4,000) Notes payable 10,000

Total assets $24,000 Retained earnings 10,000

Total liabilities and stockholders’ equity $24,000

Instructions Explain to Marci Ling in a memo (a) the purpose of a balance sheet, and (b) why this balance sheet is incorrect and what she should do to correct it.

ETHICS CASE

CT1-9 Rules governing the investment practices of individual certifi ed public accountants prohibit them from investing in the stock of a company that their fi rm audits. The Secu- rities and Exchange Commission (SEC) became concerned that some accountants were violating this rule. In response to an SEC investigation, PricewaterhouseCoopers fi red 10 people and spent $25 million educating employees about the investment rules and install- ing an investment tracking system.

Instructions Answer the following questions.

(a) Why do you think rules exist that restrict auditors from investing in companies that are audited by their firms?

(b) Some accountants argue that they should be allowed to invest in a company’s stock as long as they themselves aren’t involved in working on the company’s audit or consult- ing. What do you think of this idea?

(c) Today, a very high percentage of publicly traded companies are audited by only four very large public accounting firms. These firms also do a high percentage of the con- sulting work that is done for publicly traded companies. How does this fact compli- cate the decision regarding whether CPAs should be allowed to invest in companies audited by their firm?

(d) Suppose you were a CPA and you had invested in IBM when IBM was not one of your firm’s clients. Two years later, after IBM’s stock price had fallen considerably, your firm won the IBM audit contract. You will be involved in working with the IBM audit. You know that your firm’s rules require that you sell your shares immediately. If you do sell immediately, you will sustain a large loss. Do you think this is fair? What would you do?

(e) Why do you think PricewaterhouseCoopers took such extreme steps in response to the SEC investigation?

Expand Your Critical Thinking 41

ALL ABOUT YOU

CT1-10 Some people are tempted to make their fi nances look worse to get fi nancial aid. Companies sometimes also manage their fi nancial numbers in order to accomplish certain goals. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. In managing earnings, companies’ actions vary from being within the range of ethical activity, to being both unethical and illegal attempts to mislead investors and creditors.

Instructions Provide responses for each of the following questions.

(a) Discuss whether you think each of the following actions (adapted from www.finaid. org/fafsa/maximize.phtml) to increase the chances of receiving financial aid is ethical.

(i) Spend down the student’s assets and income first, before spending parents’ assets and income.

(ii) Accelerate necessary expenses to reduce available cash. For example, if you need a new car, buy it before applying for financial aid.

(iii) State that a truly financially dependent child is independent. (iv) Have a parent take an unpaid leave of absence for long enough to get below the

“threshold” level of income. (b) What are some reasons why a company might want to overstate its earnings? (c) What are some reasons why a company might want to understate its earnings? (d) Under what circumstances might an otherwise ethical person decide to illegally over-

state or understate earnings?

FASB CODIFICATION ACTIVITY

CT1-11 The FASB has developed the Financial Accounting Standards Board Account- ing Standards Codifi cation (or more simply “the Codifi cation”). The FASB’s primary goal in developing the Codifi cation is to provide in one place all the authoritative literature related to a particular topic. To provide easy access to the Codifi cation, the FASB also developed the Financial Accounting Standards Board Codifi cation Research System (CRS). CRS is an online, real-time database that provides easy access to the Codifi cation. The Codifi cation and the related CRS provide a topically organized structure, subdivided into topic, subtopics, sections, and paragraphs, using a numerical index system. You may fi nd this system useful in your present and future studies, and so we have provided an opportunity to use this online system as part of the Expand Your Critical Thinking section.

Instructions Academic access to the FASB Codifi cation is available through university subscriptions, obtained from the American Accounting 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) and familiarize yourself with the resources that are accessible at the FASB Codifi cation site.

CONSIDERING PEOPLE, PLANET, AND PROFIT

CT1-12 Although Clif Bar & Company is not a public company, it does share its fi nancial information with its employees as part of its open-book management approach. Further, although it does not publicly share its fi nancial information, it does provide a different form of an annual report to external users. In this report, the company provides informa- tion regarding its sustainability efforts.

Address: www.clifbar.com/article/our-fi ve-aspirations

Instructions Access the article at the site shown above and then answer the following questions.

(a) What are the Five Aspirations? (b) Click on the “All Aspirations Annual Report” link at the bottom of the page. How does

this annual report differ from the annual report discussed in the chapter? Are there any similarities?

42 1 Introduction to Financial Statements

A Look at IFRS

Most agree that there is a need for one set of international accounting standards. Here is why:

Multinational corporations. Today’s companies view the entire world as their market. For example, Coca-Cola, Intel, and McDonald’s generate more than 50% of their sales outside the United States. Many foreign companies, such as Toyota, Nestlé, and Sony, find their largest market to be the United States.

Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann suggest that we will see even more such business combinations of companies from dif- ferent countries in the future.

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

Financial markets. Financial markets are of international significance today. Whether it is currency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments.

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

Similarities • The basic techniques for recording business transactions are the same for U.S. and

international companies. • Both international and U.S. accounting standards emphasize transparency in financial

reporting. Both sets of standards are primarily driven by meeting the needs of investors and creditors.

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

Differences • International standards are referred to as International Financial Reporting Standards

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

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

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

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

LEARNING OBJECTIVE 4 Describe the impact of international accounting standards on U.S. fi nancial reporting.▼

A Look at IFRS 43

IFRS Practice IFRS SELF-TEST QUESTIONS 1. Which of the following is not a reason why a single set of high-quality international

accounting standards would be beneficial? (a) Mergers and acquisition activity. (b) Financial markets. (c) Multinational corporations. (d) GAAP is widely considered to be a superior reporting system.

2. The Sarbanes-Oxley Act determines: (a) international tax regulations. (b) internal control standards as enforced by the IASB. (c) internal control standards of U.S. publicly traded companies. (d) U.S. tax regulations.

3. IFRS is considered to be more: (a) principles-based and less rules-based than GAAP. (b) rules-based and less principles-based than GAAP. (c) detailed than GAAP. (d) None of the above.

IFRS EXERCISES IFRS1-1 Who are the two key international players in the development of international accounting standards? Explain their role.

IFRS1-2 What is the benefit of a single set of high-quality accounting standards?

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS1-3 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Visit Louis Vuitton’s corporate website and answer the following questions from the company’s 2014 annual report.

(a) What accounting firm performed the audit of Louis Vuitton’s financial statements? (b) What is the address of the company’s corporate headquarters? (c) What is the company’s reporting currency?

Answers to IFRS Self-Test Questions 1. d 2. c 3. a

LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

• Current assets • Long-term investments • Property, plant, and equipment • Intangible assets • Current liabilities • Long-term liabilities • Stockholders’ equity

▼1 Identify the sections of a classifi ed balance sheet.

DO IT!

1a Assets Section of Classifi ed Balance Sheet

1b Balance Sheet Classifi cations

▼Discuss fi nancial reporting concepts.

• The standard-setting environment

• Qualities of useful information • Assumptions in fi nancial

reporting • Principles in fi nancial reporting • Cost constraint

DO IT!

3 Financial Accounting Concepts and Principles

▼2

Use ratios to evaluate a company’s profi tability, liquidity, and solvency.

• Ratio analysis • Using the income statement • Using a classifi ed balance

sheet • Using the statement of cash

fl ows

DO IT!

2 Ratio Analysis

If you are thinking of purchasing Best Buy stock, or any stock, how can you decide what the shares

are worth? If you manage Columbia Sportswear’s credit department, how should you determine

whether to extend credit to a new customer? If you are a fi nancial executive at Google, how do you

decide whether your company is generating adequate cash to expand operations without borrowing?

Your decision in each of these situations will be infl uenced by a variety of considerations. One of

them should be your careful analysis of a company’s fi nancial statements. The reason: Financial

statements offer relevant and reliable information, which will help you in your decision-making.

In this chapter, we take a closer look at the balance sheet and introduce some useful ways for

evaluating the information provided by the fi nancial statements. We also examine the fi nancial reporting

concepts underlying the fi nancial statements. We begin by introducing the classifi ed balance sheet.

CHAPTER PREVIEW

A Further Look at Financial Statements 2

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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Few people could have predicted how dramatically the Internet would change the investment world. One of the most interesting results is how it has changed the way ordinary people invest their savings. More and more people are striking out on their own, making their own investment decisions.

Two early pioneers in providing investment information to the masses were Tom and David Gardner, brothers who created an online investor website called The Motley Fool. The name comes from Shakespeare’s As You Like It. The fool in Shakespeare’s play was the only one who could speak unpleasant truths to kings and queens without being killed. Tom and David view themselves as 21st-century “fools,” revealing the “truths” of the stock market to the small investor, who they feel has been taken advantage of by Wall Street insiders. The Motley Fool’s online bulletin board enables investors to exchange information and insights about companies.

Critics of these bulletin boards contend that they are simply high-tech rumor mills that cause investors to bid up stock prices to unreasonable levels. For example, the stock of PairGain Technologies jumped 32% in a single day as a result of a bogus takeover rumor on an investment bulletin board. Some observers are concerned that small investors—ironically, the very

people the Gardner brothers are trying to help—will be hurt the most by misinformation and intentional scams.

To show how these bulletin boards work, suppose that you had $10,000 to invest. You were considering Best Buy Company, the largest seller of electronics equipment in the United States. You scanned the Internet investment bulletin boards and found messages posted by two different investors. Here are excerpts from actual postings:

TMPVenus: “Where are the prospects for positive movement for this company? Poor margins, poor management, astronomical P/E!”

broachman: “I believe that this is a LONG TERM winner, and presently at a good price.”

One says sell, and one says buy. Whom should you believe? If you had taken “broachman’s” advice and purchased the stock, the $10,000 you invested would have been worth over $300,000 fi ve years later. Best Buy was one of America’s best-performing stocks during that period of time.

Rather than getting swept away by rumors, investors must sort out the good information from the bad. One thing is certain—as information services such as The Motley Fool increase in number, gathering information will become even easier. Evaluating it will be the harder task.

FEATURE STORY

Just Fooling Around?

46 2 A Further Look at Financial Statements

LEARNING OBJECTIVE 1 Identify the sections of a classifi ed balance sheet.▼

In Chapter 1, you learned that a balance sheet presents a snapshot of a com- pany’s fi nancial position at a point in time. It lists individual asset, liability, and stockholders’ equity items. However, to improve users’ understanding of a company’s fi nancial position, companies often use a classifi ed balance sheet instead. A classifi ed balance sheet groups together similar assets and similar liabilities, using a number of standard classifi cations and sections. This is useful because items within a group have similar economic characteristics. A classifi ed balance sheet generally contains the standard classifi cations listed in Illustration 2-1.

These groupings help fi nancial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short- and long-term creditors on the company’s total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2 on the next page. In the sections that follow, we explain each of these groupings.

CURRENT ASSETS

Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2, Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classifi cation as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year. Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one-year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term. Common types of current assets are (1) cash, (2) investments (such as short- term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.

ILLUSTRATION 2-1 Standard balance sheet classifi cations

Assets Liabilities and Stockholders’ Equity

Current assets Current liabilities Long-term investments Long-term liabilities Property, plant, and equipment Stockholders’ equity Intangible assets

Illustration 2-3 presents the current assets of Southwest Airlines Co. in a recent year.

▼ HELPFUL HINT Recall that the accounting equation is Assets = Liabilities + Stockholders’ Equity.

ILLUSTRATION 2-2 Classifi ed balance sheet

Assets

Current assets Cash $ 6,600 Debt investments 2,000 Accounts receivable 7,000 Notes receivable 1,000 Inventory 3,000 Supplies 2,100 Prepaid insurance 400

Total current assets $22,100

Long-term investments Stock investments 5,200 Investment in real estate 2,000 7,200

Property, plant, and equipment Land 10,000 Equipment $24,000 Less: Accumulated depreciation—equipment 5,000 19,000 29,000 Intangible assets Patents 3,100 Total assets $61,400

Liabilities and Stockholders’ Equity

Current liabilities Notes payable $11,000 Accounts payable 2,100 Unearned sales revenue 900 Salaries and wages payable 1,600 Interest payable 450

Total current liabilities $16,050

Long-term liabilities Mortgage payable 10,000 Notes payable 1,300

Total long-term liabilities 11,300

Total liabilities 27,350

Stockholders’ equity Common stock 14,000 Retained earnings 20,050

Total stockholders’ equity 34,050

Total liabilities and stockholders’ equity $61,400

FRANKLIN CORPORATION Balance Sheet

October 31, 2017

ILLUSTRATION 2-3 Current assets section

Current assets Cash and cash equivalents $1,355 Short-term investments 1,797 Accounts receivable 419 Inventories 467 Prepaid expenses and other current assets 418

Total current assets $4,456

SOUTHWEST AIRLINES CO. Balance Sheet (partial)

(in millions)

Real World

48 2 A Further Look at Financial Statements

As explained later in the chapter, a company’s current assets are important in assessing its short-term debt-paying ability.

LONG-TERM INVESTMENTS

Long-term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long-term assets such as land or buildings that a company is not currently using in its operating activi- ties, and (3) long-term notes receivable. In Illustration 2-2, Franklin Corporation reported total long-term investments of $7,200 on its balance sheet. Google Inc. reported long-term investments on its balance sheet in a recent year as shown in Illustration 2-4.

ALTERNATIVE TERMINOLOGY Long-term investments are often referred to simply as investments.

PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, build- ings, equipment, delivery vehicles, and furniture. In Illustration 2-2, Franklin Corporation reported property, plant, and equipment of $29,000. Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset’s cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life. In Illustration 2-2, Franklin Corporation reported accu- mulated depreciation of $5,000. Illustration 2-5 presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.

ALTERNATIVE TERMINOLOGY Property, plant, and equipment is sometimes called fi xed assets or plant assets.

ILLUSTRATION 2-5 Property, plant, and equipment section

Property, plant, and equipment Machinery, equipment and offi ce furniture $ 322,394 Tooling 230,385 Leasehold improvements 94,763 Building and building improvements 67,707 Land 45,020 Computer equipment and software 42,073 Construction in progress 76,294

878,636 Less: Accumulated depreciation and amortization (140,142)

Total $ 738,494

TESLA MOTORS, INC. Balance Sheet (partial)

(in thousands)

Real World

ILLUSTRATION 2-4 Long-term investments section

Long-term investments Non-marketable equity investments $1,469

GOOGLE INC. Balance Sheet (partial)

(in millions)

Real World

INTANGIBLE ASSETS

Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets. One common intangible

▼ HELPFUL HINT Sometimes intangible assets are reported under a broader heading called “Other assets.”

The Classifi ed Balance Sheet 49

is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specifi ed period of time. In Illustration 2-2, Franklin Corporation reported intangible assets of $3,100. Illustration 2-6 shows the intangible assets of media and theme park giant The Walt Disney Company in a recent year.

ILLUSTRATION 2-6 Intangible assets section

Intangible assets and goodwill Character/franchise intangibles and copyrights $ 5,830 Other amortizable intangible assets 903 Accumulated amortization (1,204)

Net amortizable intangible assets 5,529 FCC licenses 667 Trademarks 1,218 Other indefi nite lived intangible assets 20

7,434 Goodwill 27,881

$35,315

THE WALT DISNEY COMPANY Balance Sheet (partial)

(in millions)

Real World

SOLUTION

1a▼ Assets Section of Classifi ed Balance SheetDO IT! Baxter Hoffman recently received the following information related to Hoffman Corpo- ration’s December 31, 2017, balance sheet.

Prepaid insurance $ 2,300 Inventory $3,400 Cash 800 Accumulated depreciation— Equipment 10,700 equipment 2,700 Accounts receivable 1,100

Prepare the assets section of Hoffman Corporation’s classifi ed balance sheet.

Assets

Current assets Cash $ 800 Accounts receivable 1,100 Inventory 3,400 Prepaid insurance 2,300

Total current assets $ 7,600 Property, plant, and equipment Equipment 10,700 Less: Accumulated depreciation—equipment 2,700 8,000

Total assets $15,600

HOFFMAN CORPORATION Balance Sheet (partial)

December 31, 2017

Action Plan ✔ Present current assets

fi rst. Current assets are cash and other resources that the company expects to convert to cash or use up within one year.

✔ Present current assets in the order in which the company expects to convert them into cash.

✔ Subtract accumulated depreciation—equipment from equipment to deter- mine net equipment.

Related exercise material: BE2-2, DO IT! 2-1a, E2-3, and E2-4.

50 2 A Further Look at Financial Statements

CURRENT LIABILITIES

In the liabilities and stockholders’ equity section of the balance sheet, the fi rst grouping is current liabilities. Current liabilities are obligations that the com- pany is to pay within the next year or operating cycle, whichever is longer. Com- mon examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable. Also included as current liabilities are current maturities of long-term obligations—payments to be made within the next year on long-term obligations. In Illustration 2-2, Franklin Corporation reported fi ve different types of current liabilities, for a total of $16,050. Illustration 2-7 shows the current liabilities section adapted from the balance sheet of Google Inc. in a recent year.

ILLUSTRATION 2-7 Current liabilities section

Current liabilities Accounts payable $ 2,012 Short-term debt 2,549 Accrued compensation and benefi ts 2,239 Accrued expenses and other current liabilities 7,297 Income taxes payable, net 240

Total current liabilities $14,337

GOOGLE INC. Balance Sheet (partial)

(in millions)

Real World

ILLUSTRATION 2-8 Long-term liabilities section

Long-term liabilities Bonds payable $1,106 Notes payable 51 Deferred income taxes and other 1,544

Total long-term liabilities $2,701

NIKE, INC. Balance Sheet (partial)

(in millions)

Real World

LONG-TERM LIABILITIES

Long-term liabilities (long-term debt) are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. Many companies report long-term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the fi nancial statements. Others list the various types of long-term liabilities. In Illus- tration 2-2, Franklin Corporation reported long-term liabilities of $11,300. Illustration 2-8 shows the long-term liabilities that Nike, Inc. reported in its balance sheet in a recent year.

STOCKHOLDERS’ EQUITY

Stockholders’ equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business. These two parts, combined, make up stockholders’ equity on the balance sheet. In Illustration 2-2, Franklin Corporation reported common stock of $14,000 and retained earnings of $20,050.

ALTERNATIVE TERMINOLOGY Common stock is sometimes called capital stock.

Analyzing the Financial Statements 51

1b▼ Balance Sheet Classifi cationsDO IT! The following fi nancial statement items were taken from the fi nancial statements of Callahan Corp.

Salaries and wages payable Equipment Service revenue Accumulated depreciation— Interest payable equipment Goodwill Depreciation expense Debt investments (short-term) Retained earnings Mortgage payable (due in 3 years) Unearned service revenue Investment in real estate

Match each of the items to its proper balance sheet classifi cation, shown below. If the item would not appear on a balance sheet, use “NA.”

Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Stockholders’ equity (SE) Intangible assets (IA)

SOLUTION CL Salaries and wages payable LTI Investment in real estate NA Service revenue PPE Equipment CL Interest payable PPE Accumulated depreciation— IA Goodwill equipment CA Debt investments (short-term) NA Depreciation expense LTL Mortgage payable SE Retained earnings (due in 3 years) CL Unearned service revenue

Action Plan ✔ Analyze whether each

fi nancial statement item is an asset, liability, or stockholders’ equity item.

✔ Determine if asset and liability items are current or long-term.

Related exercise material: BE2-1, DO IT! 2-1b, E2-1, E2-2, E2-3, E2-5, and E2-6.

LEARNING OBJECTIVE 2 Use ratios to evaluate a company’s profi tability, liquidity, and solvency.▼

In Chapter 1, we introduced the four fi nancial statements. We discussed how these statements provide information about a company’s performance and fi nan- cial position. In this chapter, we extend this discussion by showing you specifi c tools that you can use to analyze fi nancial statements in order to make a more meaningful evaluation of a company.

RATIO ANALYSIS

Ratio analysis expresses the relationship among selected items of fi nancial state- ment data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary fi nancial statements, we classify ratios as shown in Illustration 2-9 (page 52). A single ratio by itself is not very meaningful. Accordingly, in this and the following chapters, we will use various comparisons to shed light on company performance:

1. Intracompany comparisons covering two years for the same company.

2. Industry-average comparisons based on average ratios for particular industries.

3. Intercompany comparisons based on comparisons with a competitor in the same industry.

52 2 A Further Look at Financial Statements

Next, we use some ratios and comparisons to analyze the fi nancial statements of Best Buy.

USING THE INCOME STATEMENT

Best Buy generates profi ts for its stockholders by selling electronics. The income statement reveals how successful the company is at generating a profi t from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2-10 shows a simplifi ed income statement for Best Buy.

ILLUSTRATION 2-9 Financial ratio classifi cations

Liquidity Ratios

Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

Profitability Ratios

Measure the income or operating success of a company for a given period of time

Solvency Ratios

Measure the ability of the company to survive over a long period of time

Founded in 1892

TRUE GRIT Co.

Net income– =

Revenues Expenses

ILLUSTRATION 2-10 Best Buy’s income statement

2014 2013 Revenues Net sales and other revenue $42,410 $39,827

Expenses Cost of goods sold 32,720 30,528 Selling, general, and administrative expenses and other 8,760 9,471 Income tax expense 398 269

Total expenses 41,878 40,268

Net income/(loss) $ 532 $ (441)

BEST BUY CO., INC. Income Statements

For the 12 Months Ended February 1, 2014, and 11 Months Ended February 2, 2013 (in millions)

Real World

From this income statement, we can see that Best Buy’s sales and net income increased during the period. Net income increased from a $441 million loss to a positive $532 million. One extremely unusual aspect of Best Buy’s income state- ment is that the 2013 comparative column only covers 11 months. This occurred because Best Buy changed its year-end from “the Saturday nearest the end of February to the Saturday nearest the end of January.” Such a change is very uncommon and complicates efforts to compare performance across years. A much smaller competitor of Best Buy is hhgregg. hhgregg operates 228 stores in 20 states and is headquartered in Indianapolis, Indiana. It reported net income of $228,000 for the year ended March 31, 2014.

Analyzing the Financial Statements 53

To evaluate the profi tability of Best Buy, we will use ratio analysis. Profi tability ratios, such as earnings per share, measure the operating success of a company for a given period of time.

Earnings per Share Earnings per share (EPS) measures the net income earned on each share of common stock. Stockholders usually think in terms of the number of shares they own or plan to buy or sell, so stating net income earned as a per share amount provides a useful perspective for deter- mining the investment return. Advanced accounting courses present more refi ned techniques for calculating earnings per share. For now, a basic approach for calculating earnings per share is to divide earnings available to common stockholders by weighted-average common shares outstanding during the year. What is “earnings available to common stockholders”? It is an earnings amount calculated as net income less dividends paid on another type of stock, called preferred stock (Net income − Preferred dividends). By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder— that is, on a per share basis. It is very important to note that comparisons of earn- ings per share across companies are not meaningful because of the wide varia- tions in the numbers of shares of outstanding stock among companies. Illustration 2-11 shows the earnings per share calculation for Best Buy in 2014 and 2013, based on the information presented below. Recall that Best Buy’s 2013 income is based on 11 months of results. Further, to simplify our calcula- tions, we assumed that any change in the number of shares for Best Buy occurred in the middle of the year.

(in millions) 2014 2013

Net income (loss) $532 $(441) Preferred dividends –0– –0– Shares outstanding at beginning of year 338 341 Shares outstanding at end of year 347 338

USING A CLASSIFIED BALANCE SHEET

You can learn a lot about a company’s fi nancial health by also evaluating the relationship between its various assets and liabilities. Illustration 2-12 (page 54) provides a simplifi ed balance sheet for Best Buy.

Liquidity Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a sales manager at Hewlett-Packard interested in selling computers to Best Buy on credit. You would be concerned about Best Buy’s liquidity—its abil- ity to pay obligations expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities.

DECISION TOOLS

Earnings per share helps users compare a company’s performance with that of previous years.

Earnings per = Net Income – Preferred Dividends Share Weighted-Average Common Shares Outstanding

Earnings per share $532 – $0 = $1.55 –$441 – $0 = –$1.30 (347 + 338)/2 (338 + 341)/2

($ and shares in millions) 2014 2013

ILLUSTRATION 2-11 Best Buy’s earnings per share

54 2 A Further Look at Financial Statements

WORKING CAPITAL One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities:

ILLUSTRATION 2-12 Best Buy’s balance sheet

Assets February 1, 2014 February 2, 2013

Current assets Cash and cash equivalents $ 2,678 $ 1,826 Short-term investments 223 0 Receivables 1,308 2,704 Merchandise inventories 5,376 6,571 Other current assets 900 946

Total current assets 10,485 12,047

Property and equipment 7,575 8,375 Less: Accumulated depreciation 4,977 5,105

Net property and equipment 2,598 3,270

Other assets 930 1,470

Total assets $14,013 $16,787

Liabilities and Stockholders’ Equity

Current liabilities Accounts payable $ 5,122 $ 6,951 Accrued liabilities 873 1,188 Accrued income taxes 147 129 Accrued compensation payable 444 520 Other current liabilities 850 2,022

Total current liabilities 7,436 10,810

Long-term liabilities Long-term debt 976 1,109 Other long-term liabilities 1,612 1,153

Total long-term liabilities 2,588 2,262

Total liabilities 10,024 13,072

Stockholders’ equity Common stock 335 88 Retained earnings and other 3,654 3,627

Total stockholders’ equity 3,989 3,715

Total liabilities and stockholders’ equity $14,013 $16,787

BEST BUY CO., INC. Balance Sheets

(in millions)

Real World

When current assets exceed current liabilities, working capital is positive. When this occurs, there is a greater likelihood that the company will pay its liabilities. When working capital is negative, a company might not be able to pay short-term creditors, and the company might ultimately be forced into bankruptcy. Best Buy had working capital in 2014 of $3,049 million ($10,485 million − $7,436 million).

CURRENT RATIO Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio, computed as current assets divided by current liabilities. The current ratio is a more dependable indicator of liquidity than work- ing capital. Two companies with the same amount of working capital may

ILLUSTRATION 2-13 Working capital Working Capital = Current Assets − Current Liabilities

DECISION TOOLS The current ratio helps users determine if a company can meet its near-term obligations.

Analyzing the Financial Statements 55

have signifi cantly different current ratios. Illustration 2-14 shows the 2014 and 2013 current ratios for Best Buy and for hhgregg, along with the 2014 industry average.

ETHICS NOTE A company that has more current assets than current liabilities can increase the ratio of current assets to current liabilities by using cash to pay off some current liabilities. This gives the appearance of being more liquid. Do you think this move is ethical?

▼

What does the ratio actually mean? Best Buy’s 2014 current ratio of 1.41:1 means that for every dollar of current liabilities, Best Buy has $1.41 of current assets. Best Buy’s current ratio increased in 2014. When compared to the indus- try average of .88:1, Best Buy’s liquidity seems strong. It is lower than hhgregg’s but not signifi cantly so. One potential weakness of the current ratio is that it does not take into account the composition of the current assets. For example, a satisfactory cur- rent ratio does not disclose whether a portion of the current assets is tied up in slow-moving inventory. The composition of the current assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inven- tory. For example, suppose a company’s cash balance declined while its mer- chandise inventory increased substantially. If inventory increased because the company is having diffi culty selling its products, then the current ratio might not fully refl ect the reduction in the company’s liquidity.

Can a Company Be Too Liquid?

There actually is a point where a company can be too liquid—that is, it can have too much working capi- tal. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money.

By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative

excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a “ deterioration in the management of operations.” Given that managers throughout a company are interested in improving profi tability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.

Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).

What can various company managers do to ensure that working capital is managed effi ciently to maximize net income? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION REL Consultancy Group

Jorge Salcedo/iStockphoto

Solvency Now suppose that instead of being a short-term creditor, you are interested in either buying Best Buy’s stock or extending the company a long-term loan. Long- term creditors and stockholders are interested in a company’s solvency—its abil- ity to pay interest as it comes due and to repay the balance of a debt due at its

Current Ratio = Current Assets Current Liabilities

Best Buy Industry ($ in millions) hhgregg Average

$10,485 = 1.41:1 1.11:1 1.68:1 .88:1 $7,436

2014 2013 2014 2014

ILLUSTRATION 2-14 Current ratio

56 2 A Further Look at Financial Statements

maturity. Solvency ratios measure the ability of the company to survive over a long period of time.

DEBT TO ASSETS RATIO The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long-term) by total assets. It measures the percentage of total fi nancing provided by creditors rather than stockholders. Debt fi nancing is more risky than equity fi nancing because debt must be repaid at specifi c points in time, whether the company is performing well or not. Thus, the higher the percentage of debt fi nancing, the riskier the company. The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. Illus- tration 2-15 shows the debt to assets ratios for Best Buy and hhgregg, along with the industry average.

▼ HELPFUL HINT Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the lower is a company’s solvency.

The 2014 ratio of 72% means that every dollar of assets was fi nanced by 72 cents of debt. Best Buy’s ratio is less than the industry average of 88% and is signifi cantly higher than hhgregg’s ratio of 51%. The higher the ratio, the more reliant the company is on debt fi nancing. This means that Best Buy has a lower equity “buffer” available to creditors if the company becomes insolvent when compared to hhgregg. Thus, from the creditors’ point of view, a high ratio of debt to assets is undesirable. Best Buy’s solvency appears lower than hhgregg’s and higher than the average company in the industry. The adequacy of this ratio is often judged in light of the company’s earn-

ings. Generally, companies with relatively stable earnings, such as pub- lic utilities, can support higher debt to assets ratios than can cyclical companies with widely fl uctuating earnings, such as many high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.

When Debt Is Good

Debt fi nancing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:

Debt to Assets Ratio

Google 23% Nike 41% Microsoft 48% ExxonMobil 48% General Motors 74%

Discuss the difference in the debt to assets ratio of Microsoft and General Motors. (Go to WileyPLUS for this answer and additional questions.)

INVESTOR INSIGHT

ILLUSTRATION 2-15 Debt to assets ratio

Best Buy Industry ($ in millions) hhgregg Average

$10,024 = 72% 78% 51% 88% $14,013

2014 2013 2014 2014

Debt to Assets Ratio = Total Liabilities Total Assets

DECISION TOOLS The debt to assets ratio helps users determine if a company can meet its long-term obligations.

Analyzing the Financial Statements 57

USING THE STATEMENT OF CASH FLOWS

In the statement of cash fl ows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A measurement to provide additional insight regarding a company’s cash- generating ability is free cash fl ow. Free cash fl ow describes the net cash provided by operat- ing activities after adjusting for capital expenditures and dividends paid. Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 net cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash fl ow was $80,000 ($100,000 − $15,000 − $5,000). The company could use this $80,000 to purchase new assets to expand the business, pay off debts, or increase its dividend distribu- tion. In practice, analysts often calculate free cash fl ow with the for- mula shown in Illustration 2-16. (Alternative defi nitions also exist.)

DECISION TOOLS

Free cash fl ow helps users determine the amount of cash a company generated to expand operations, pay off debts, or increase dividends.

ILLUSTRATION 2-16 Free cash fl ow

We can calculate Best Buy’s 2014 free cash fl ow as shown in Illustration 2-17 (dollars in millions).

ILLUSTRATION 2-17 Best Buy’s free cash fl owNet cash provided by operating activities $1,094

Less: Expenditures on property, plant, and equipment 547 Dividends paid 233

Free cash fl ow $ 314

Best Buy generated free cash fl ow of $314 million, which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of addi- tional dividends. Long-term creditors consider a high free cash fl ow amount an indication of solvency. hhgregg’s free cash fl ow for 2014 is $60 million. Given that hhgregg is considerably smaller than Best Buy, we would expect its free cash fl ow to be much lower.

2▼ Ratio AnalysisDO IT! The following information is available for Ozone Inc.

2017 2016

Current assets $ 88,000 $ 60,800 Total assets 400,000 341,000 Current liabilities 40,000 38,000 Total liabilities 120,000 150,000 Net income 100,000 50,000 Net cash provided by operating activities 110,000 70,000 Preferred dividends 10,000 10,000 Common dividends 5,000 2,500 Expenditures on property, plant, and equipment 45,000 20,000

Shares outstanding at beginning of year 60,000 40,000 Shares outstanding at end of year 120,000 60,000

Free Cash = Net Cash Provided − Capital − Cash Flow by Operating Activities Expenditures Dividends

58 2 A Further Look at Financial Statements

(a) Compute earnings per share for 2017 and 2016 for Ozone, and comment on the change. Ozone’s primary competitor, Frost Corporation, had earnings per share of $2 in 2017. Comment on the difference in the ratios of the two companies.

(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.

Action Plan ✔ Use the formula for

earnings per share (EPS): (Net income − Preferred dividends) ÷ Weighted- average common shares outstanding.

✔ Use the formula for the current ratio: Current assets ÷ Current liabilities.

✔ Use the formula for the debt to assets ratio: Total liabilities ÷ Total assets.

✔ Use the formula for free cash fl ow: Net cash provided by operating activities − Capital expenditures − Cash dividends.

SOLUTION (a) Earnings per share

Ozone’s profi tability, as measured by the amount of income available to each share of common stock, increased by 25% [($1.00 − $0.80) ÷ $0.80] during 2017. Earnings per share should not be compared across companies because the number of shares issued by companies varies widely. Thus, we cannot conclude that Frost Corporation is more profi table than Ozone based on its higher EPS.

(b)

Current ratio

Debt to assets ratio

The company’s liquidity, as measured by the current ratio, improved from 1.60:1 to 2.20:1. Its solvency also improved, as measured by the debt to assets ratio, which de- clined from 44% to 30%.

2017: $110,000 − $45,000 − ($10,000 + $5,000) = $50,000 2016: $70,000 − $20,000 − ($10,000 + $2,500) = $37,500

The amount of cash generated by the company above its needs for dividends and capi- tal expenditures increased from $37,500 to $50,000.

2017

($100,000 − $10,000) = $1.00

(120,000 + 60,000)/2

2016

($50,000 − $10,000) = $0.80

(60,000 + 40,000)/2

2017

$88,000 = 2.20:1 $40,000

2016

$60,800 = 1.60:1 $38,000

$120,000 = 30% $400,000

$150,000 = 44% $341,000

Related exercise material: BE2-3, BE2-4, BE2-5, DO IT! 2-2, E2-7, E2-9, E2-10, and E2-11.

You have now learned about the four fi nancial statements and some basic ways to interpret those statements. In this last section, we will discuss concepts that underlie these fi nancial statements. It would be unwise to make business deci- sions based on fi nancial statements without understanding the implications of these concepts.

THE STANDARD-SETTING ENVIRONMENT

How does Best Buy decide on the type of fi nancial information to disclose? What format should it use? How should it measure assets, liabilities, revenues, and expenses? Accounting professionals at Best Buy and all other U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard- setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards.

Discuss fi nancial reporting concepts. LEARNING OBJECTIVE 3▼

Financial Reporting Concepts 59

The Securities and Exchange Commission (SEC) is the agency of the U.S. government that oversees U.S. fi nancial markets and accounting standard- setting bodies. The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States. The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States. Today, the FASB and IASB are working closely together to minimize the differences in their standards. Recently, the SEC announced that foreign companies that wish to have their shares traded on U.S stock exchanges no longer have to prepare reports that conform with GAAP, as long as their reports conform with IFRS. The SEC is currently evaluating whether the United States should eventually adopt IFRS as the required set of standards for U.S. publicly traded companies. Another relatively recent change to the fi nan- cial reporting environment was that, as a result of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) was created. Its job is to determine auditing standards and review the performance of auditing fi rms. If the United States adopts IFRS for its accounting standards, it will also have to coordinate its auditing regulations with those of other countries.

INTERNATIONAL NOTE Over 115 countries use interna- tional standards (called IFRS). For example, all companies in the European Union follow IFRS. In this textbook, we highlight any signifi cant differences using International Notes like this one, as well as a more in-depth discussion in the A Look at IFRS section at the end of each chapter.

The Korean Discount

If you think that account- ing standards don’t matter, consider recent events in South Korea. For many years, inter- national investors com- plained that the fi nancial reports of South Korean companies were in-

adequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of compa- rable companies in different countries. This difference in share price was often referred to as the “Korean discount.”

In response, Korean regulators decided that companies would have to comply with international accounting stan- dards. This change was motivated by a desire to “make the country’s businesses more transparent” in order to build in- vestor confi dence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international stan- dards or to create standards that are based on the interna- tional standards.

Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).

What is meant by the phrase “make the country’s businesses more transparent”? Why would increasing transparency spur economic growth? (Go to WileyPLUS for this answer and additional questions.)

INTERNATIONAL INSIGHT

SeongJoon Cho/Bloomberg/Getty Images, Inc.

QUALITIES OF USEFUL INFORMATION

Recently, the FASB and IASB completed the fi rst phase of a joint project in which they developed a conceptual framework to serve as the basis for future account- ing standards. The framework begins by stating that the primary objective of fi nancial reporting is to provide fi nancial information that is useful to inves- tors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 2-18 (page 60).

Enhancing Qualities In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include com- parability, verifi ability, timeliness, and understandability. In accounting,

60 2 A Further Look at Financial Statements

comparability results when different companies use the same accounting prin- ciples. Another type of comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifi able if independent observers, using the same methods, obtain similar results. As noted in Chapter 1, certifi ed public accountants (CPAs) perform audits of fi nancial statements to verify their accuracy. For accounting information to have relevance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to infl uence decisions. The SEC requires that large public companies provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.

ILLUSTRATION 2-18 Fundamental qualities of useful information

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

Relevance Accounting information has relevance if it would make a difference in a business decision. Information is considered relevant if it provides information that has predictive value, that is, helps provide accurate expecta- tions about the future, and has confi rmatory value, that is, confi rms or corrects prior expectations. Materiality is a company-specifi c aspect of relevance. An item is material when its size makes it likely to infl uence the decision of an investor or creditor.BIG SHOT

Tell me what I need

to know.

What Do These Companies Have in Common?

Another issue related to comparability is the ac- counting time period. An accounting period that is one-year long is called a fi scal year. But a fi scal year need not match the calendar year. For example, a company could end its fi scal year on April 30 rather than on December 31.

Why do companies choose the particular year-ends that they do? For example, why doesn’t every company use

December 31 as its accounting year-end? Many companies choose to end their accounting year when inventory or opera- tions are at a low point. This is advantageous because com- piling accounting information requires much time and effort by managers, so they would rather do it when they aren’t as busy operating the business. Also, inventory is easier and less costly to count when its volume is low. Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; The Walt Disney Company, September 30; and Dunkin’ Donuts, Inc., October 31. In the notes to its fi nancial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of January.

What problems might Best Buy’s year-end create for analysts? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION

ASSUMPTIONS IN FINANCIAL REPORTING

To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-19. These include assumptions about the monetary unit, economic entity, periodicity, and going concern.

Financial Reporting Concepts 61

PRINCIPLES IN FINANCIAL REPORTING

Measurement Principles GAAP generally uses one of two measurement principles, the historical cost prin- ciple or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.

HISTORICAL COST PRINCIPLE The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.

FAIR VALUE PRINCIPLE The fair value principle indicates that assets and liabili- ties should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for cer- tain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, the FASB uses two qualities that make accounting information useful for decision-making— relevance and faithful representation. In determining which measurement principle to use, the FASB weighs the factual nature of cost fi gures versus the relevance of fair value. In general, the FASB indicates that most assets must fol- low the historical cost principle because market values may not be represen- tationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.

ILLUSTRATION 2-19 Key assumptions in fi nancial reporting

Monetary Unit Assumption The monetary unit assumption requires that only those things that can be expressed in money are included in the accounting records. This means that certain important information needed by investors, creditors, and managers, such as customer satisfaction, is not reported in the fi nancial statements. This assumption relies on the monetary unit remaining relatively stable in value.

Accounting Records

– Salaries paid

$ $ $ $ $

Measure of employee satisfaction

Total number of employees

Salaries paid

Percent of international employees

Economic Entity Assumption The economic entity assumption states that every economic entity can be separately identifi ed and accounted for. In order to assess a company’s performance and fi nancial position accurately, it is important to not blur company trans- actions with personal transactions (especially those of its managers) or transactions of other companies.

Periodicity Assumption Notice that the income statement, retained earnings statement, and state- ment of cash fl ows all cover periods of one year, and the balance sheet is prepared at the end of each year. The periodicity assumption states that the life of a business can be divided into artifi cial time periods and that useful reports covering those periods can be prepared for the business.

Going Concern Assumption The going concern assumption states that the business will remain in operation for the foreseeable future. Of course, many businesses do fail, but in general it is reasonable to assume that the business will continue operating.

Ford

Chrysler

Ford

Chrysler

Start of business

End of business

2013

2015 2017 2019 2021

2023

J F

QTR 1

QTR 2

QTR 3

QTR 4

M A M J J A S O N D

Now Future

ETHICS NOTE The importance of the economic entity assumption is illustrated by scandals involving Adelphia. In this case, senior company employees entered into transactions that blurred the line between the employees’ fi nancial interests and those of the company. For example, Adelphia guaranteed over $2 billion of loans to the founding family.

▼

62 2 A Further Look at Financial Statements

Full Disclosure Principle The full disclosure principle requires that companies disclose all circum- stances and events that would make a difference to fi nancial statement users. If an important item cannot reasonably be reported directly in one of the four types of fi nancial statements, then it should be discussed in notes that accompany the statements.

COST CONSTRAINT

Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to pro- vide the information against the benefi t that fi nancial statement users will gain from having the information available.

Cost

Benefits

SOLUTION 1. Comparability 7. Historical cost principle

2. Going concern assumption 8. Consistency

3. Materiality 9. Economic entity assumption

4. Full disclosure principle 10. Faithful representation

5. Periodicity assumption 11. Monetary unit assumption

6. Relevance

3▼ Financial Accounting Concepts and PrinciplesDO IT! The following items guide the FASB when it creates accounting standards.

Relevance Periodicity assumption Faithful representation Going concern assumption Comparability Historical cost principle Consistency Full disclosure principle Monetary unit assumption Materiality Economic entity assumption

Match each item above with a description below.

1. ________ Ability to easily evaluate one company’s results relative to another’s.

2. ________ Belief that a company will continue to operate for the foreseeable future.

3. ________ The judgment concerning whether an item is large enough to matter to decision-makers.

4. ________ The reporting of all information that would make a difference to fi nancial statement users.

5. ________ The practice of preparing fi nancial statements at regular intervals.

6. ________ The quality of information that indicates the information makes a differ- ence in a decision.

7. ________ A belief that items should be reported on the balance sheet at the price that was paid to acquire the item.

8. ________ A company’s use of the same accounting principles and methods from year to year.

9. ________ Tracing accounting events to particular companies.

10. ________ The desire to minimize errors and bias in fi nancial statements.

11. ________ Reporting only those things that can be measured in dollars.

Action Plan ✔ Understand the need for

conceptual guidelines in accounting.

✔ List the characteristics of useful fi nancial information.

✔ Review the assumptions, principles, and constraint that comprise the guidelines in accounting.

Related exercise material: BE2-8, BE2-9, BE2-10, DO IT! 2-3, E2-12, and E2-13.

Using Decision Tools 63

In this chapter, we evaluated a home electronics giant, Best Buy. Tweeter Home Entertainment sold consumer electronics products from 154 stores on the East Coast under various names. It specialized in products with high-end features. Tweeter fi led for bankruptcy in June 2007 and was acquired by another company in July 2007. Financial data for Tweeter, prior to its bankruptcy, are provided below.

September 30 (amounts in millions) 2006 2005 Current assets $146.4 $158.2 Total assets 258.6 284.0 Current liabilities 107.1 119.0 Total liabilities 190.4 201.1 Total common stockholders’ equity 68.2 82.9 Net income (loss) (16.5) (74.4) Net cash provided (used) by operating activities 15.6 (26.7) Capital expenditures (net) 17.4 22.2 Dividends paid 0 0 Weighted-average shares of common stock (millions) 25.2 24.6

INSTRUCTIONS

Using the data provided, answer the following questions and discuss how these results might have provided an indication of Tweeter’s fi nancial troubles.

1. Calculate the current ratio for Tweeter for 2006 and 2005 and discuss its liquidity position. 2. Calculate the debt to assets ratio and free cash fl ow for Tweeter for 2006 and 2005 and discuss its solvency. 3. Calculate the earnings per share for Tweeter for 2006 and 2005, and discuss its change in profi tability. 4. Best Buy’s accounting year-end was February 28, 2006; Tweeter’s was September 30, 2006. How does this difference

affect your ability to compare their profi tability?

SOLUTION 1. Current ratio: 2006: $146.4 ÷ $107.1 = 1.37:1 2005: $158.2 ÷ $119.0 = 1.33:1 Tweeter’s liquidity improved slightly from 2005 to 2006, but in both years it would most likely have been considered

inadequate. In 2006, Tweeter had only $1.37 in current assets for every dollar of current liabilities. Sometimes larger com- panies, such as Best Buy, can function with lower current ratios because they have alternative sources of working capital. But a company of Tweeter’s size would normally want a higher ratio.

2. Debt to assets ratio: 2006: $190.4 ÷ $258.6 = 73.6% 2005: $201.1 ÷ $284.0 = 70.8% Tweeter’s solvency, as measured by its debt to assets ratio, declined from 2005 to 2006. Its ratio of 73.6% meant that

every dollar of assets was fi nanced by 73.6 cents of debt. For a retailer, this is extremely high reliance on debt. This low solvency suggests Tweeter’s ability to meet its debt payments was questionable.

Free cash fl ow: 2006: $15.6 − $17.4 − $0 = −$1.8 million 2005: −$26.7 − $22.2 − $0 = −$48.9 million Tweeter’s free cash fl ow was negative in both years. The company did not generate enough net cash provided by

operating activities even to cover its capital expenditures, and it was not paying a dividend. While this is not unusual for new companies in their early years, it is also not sustainable for very long. Part of the reason that its debt to assets ratio, discussed above, was so high was that it had to borrow money to make up for its defi cient free cash fl ow.

3. Loss per share: 2006: −$16.5 ÷ 25.2 = −$0.65 per share 2005: −$74.4 ÷ 24.6 = −$3.02 per share Tweeter’s loss per share declined substantially. However, this was little consolation for its shareholders, who experienced

losses in previous years as well. The company’s lack of profi tability, combined with its poor liquidity and solvency, in- creased the likelihood that it would eventually fi le for bankruptcy.

4. Tweeter’s income statement covers 7 months not covered by Best Buy’s. Suppose that the economy changed dramatically during this 7-month period, either improving or declining. This change in the economy would be refl ected in Tweeter’s income statement but would not be refl ected in Best Buy’s income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies.

USING DECISION TOOLS—TWEETER HOME ENTERTAINMENT

64 2 A Further Look at Financial Statements

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Identify the sections of a classifi ed balance sheet. In a classifi ed balance sheet, companies classify assets as current assets; long-term investments; property, plant, and equipment; and intangibles. They classify liabilities as either current or long-term. A stockholders’ equity section shows common stock and retained earnings.

2 Use ratios to evaluate a company’s profi tability, liquidity, and solvency. Ratio analysis expresses the relationship among selected items of fi nancial statement data. Profi tability ratios, such as earnings per share (EPS), measure aspects of the operating success of a company for a given period of time. Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obli- gations and to meet unexpected needs for cash. Solvency ratios, such as the debt to assets ratio, measure the abil- ity of a company to survive over a long period. Free cash fl ow indicates a company’s ability to generate net cash pro- vided by operating activities that is suffi cient to pay debts, acquire assets, and distribute dividends.

3 Discuss fi nancial reporting concepts. Generally accepted accounting principles are a set of rules and practices recog- nized as a general guide for fi nancial reporting purposes. The basic objective of fi nancial reporting is to provide information that is useful for decision-making.

To be judged useful, information should have the pri- mary characteristics of relevance and faithful representa- tion. In addition, useful information is com parable, con- sistent, verifi able, timely, and understandable. The monetary unit assumption requires that com- panies include in the accounting records only transac- tion data that can be expressed in terms of money. The economic entity assumption states that economic events can be identifi ed with a particular unit of account- ability. The periodicity assumption states that the eco- nomic life of a business can be divided into artifi cial time periods and that meaningful accounting reports can be prepared for each period. The going concern assump- tion states that the company will continue in operation long enough to carry out its existing objectives and commitments. The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The full disclosure principle requires that companies disclose circumstances and events that matter to fi nancial statement users. The cost constraint weighs the cost that companies incur to provide a type of information against its benefi t to fi nancial statement users.

▼

Classifi ed balance sheet A balance sheet that groups together similar assets and similar liabilities, using a number of standard classifi cations and sections. (p. 46).

Comparability Ability to compare the accounting infor- mation of different companies because they use the same accounting principles. (p. 60).

GLOSSARY REVIEW▼

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

How does the company’s earnings performance compare with that of previous years?

Net income available to common stockholders and weighted-average common shares outstanding

Can the company meet its near-term obligations?

Current assets and current liabilities

Higher ratio suggests favorable liquidity.

Can the company meet its long-term obligations?

Total liabilities and total assets

Lower value suggests favorable solvency.

How much cash did the company generate to expand operations, pay off debts, or distribute dividends?

Net cash provided by operating activities, cash spent on fi xed assets, and cash dividends

Signifi cant free cash fl ow indicates greater potential to fi nance new investments and pay additional dividends.

A higher measure suggests improved performance, although the number is subject to manipulation. Values should not be com- pared across companies.

Net income − Preferred dividends Weighted-average common shares

outstanding

Earnings per =share

Current ratio

= Current assets

Current liabilities

Debt to assets ratio

= Total liabilities Total assets

Free cash = fl ow

Net cash provided by operating activities

Capital expen- ditures

Cash dividends

− −

Glossary Review 65

Consistency Use of the same accounting principles and methods from year to year within a company. (p. 60).

Cost constraint Constraint that weighs the cost that com- panies will incur to provide the information against the benefi t that fi nancial statement users will gain from having the information available. (p. 62).

Current assets Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer. (p. 46).

Current liabilities Obligations that a company expects to pay within the next year or operating cycle, whichever is longer. (p. 50).

Current ratio A measure of liquidity computed as current assets divided by current liabilities. (p. 54).

Debt to assets ratio A measure of solvency calculated as total liabilities divided by total assets. It measures the percentage of total fi nancing provided by creditors. (p. 56).

Earnings per share (EPS) A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the weighted-average number of common shares outstand- ing during the year. (p. 53).

Economic entity assumption An assumption that every economic entity can be separately identifi ed and accounted for. (p. 61).

Fair value principle Assets and liabilities should be re- ported at fair value (the price received to sell an asset or settle a liability). (p. 61).

Faithful representation Information that is complete, neutral, and free from error. (p. 60).

Financial Accounting Standards Board (FASB) The pri- mary accounting standard-setting body in the United States. (p. 59).

Free cash fl ow Net cash provided by operating activities after adjusting for capital expenditures and cash divi- dends paid. (p. 57).

Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to fi nancial statement users. (p. 62).

Generally accepted accounting principles (GAAP) A set of accounting standards that have substantial authorita- tive support and which guide accounting professionals. (p. 58).

Going concern assumption The assumption that the company will continue in operation for the foreseeable future. (p. 61).

Historical cost principle An accounting principle that states that companies should record assets at their cost. (p. 61).

Intangible assets Assets that do not have physical sub- stance. (p. 48).

International Accounting Standards Board (IASB) An accounting standard-setting body that issues standards adopted by many countries outside of the United States. (p. 59).

International Financial Reporting Standards (IFRS) Accounting standards, issued by the IASB, that have been adopted by many countries outside of the United States. (p. 59).

Liquidity The ability of a company to pay obligations that are expected to become due within the next year or operating cycle. (p. 53).

Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. (p. 54).

Long-term investments Generally, (1) investments in stocks and bonds of other corporations that companies hold for more than one year; (2) long-term assets, such as land and buildings, not currently being used in the company’s operations; and (3) long-term notes receiv- able. (p. 48).

Long-term liabilities (long-term debt) Obligations that a company expects to pay after one year. (p. 50).

Materiality Whether an item is large enough to likely in- fl uence the decision of an investor or creditor. (p. 60).

Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records. (p. 61).

Operating cycle The average time required to purchase inventory, sell it on account, and then collect cash from customers—that is, go from cash to cash. (p. 46).

Periodicity assumption An assumption that the life of a business can be divided into artifi cial time periods and that useful reports covering those periods can be pre- pared for the business. (p. 61).

Profi tability ratios Measures of the operating success of a company for a given period of time. (p. 53).

Property, plant, and equipment Assets with relatively long useful lives that are currently used in operating the business. (p. 48).

Public Company Accounting Oversight Board (PCAOB) The group charged with determining auditing standards and reviewing the performance of auditing fi rms. (p. 59).

Ratio An expression of the mathematical relationship be- tween one quantity and another. (p. 51).

Ratio analysis A technique that expresses the relationship among selected items of fi nancial statement data. (p. 51).

Relevance The quality of information that indicates the information makes a difference in a decision. (p. 60).

Securities and Exchange Commission (SEC) The agency of the U.S. government that oversees U.S. fi nancial mar- kets and accounting standard-setting bodies. (p. 59).

Solvency The ability of a company to pay interest as it comes due and to repay the balance of debt due at its maturity. (p. 55).

Solvency ratios Measures of the ability of the company to survive over a long period of time. (p. 56).

Timely Information that is available to decision-makers before it loses its capacity to infl uence decisions. (p. 60).

Understandability Information presented in a clear and concise fashion so that users can interpret it and com- prehend its meaning. (p. 60).

Verifi able The quality of information that occurs when in- dependent observers, using the same methods, obtain similar results. (p. 60).

Working capital The difference between the amounts of current assets and current liabilities. (p. 54).

66 2 A Further Look at Financial Statements

1. In a classifi ed balance sheet, assets are usually classi- fi ed as: (a) current assets; long-term assets; property, plant,

and equipment; and intangible assets. (b) current assets; long-term investments; property,

plant, and equipment; and common stock. (c) current assets; long-term investments; tangible

assets; and intangible assets. (d) current assets; long-term investments; property,

plant, and equipment; and intangible assets. 2. Current assets are listed:

(a) by order of expected conversion to cash. (b) by importance. (c) by longevity. (d) alphabetically.

3. The correct order of presentation in a classifi ed bal- ance sheet for the following current assets is: (a) accounts receivable, cash, prepaid insurance,

inventory. (b) cash, inventory, accounts receivable, prepaid

insurance. (c) cash, accounts receivable, inventory, prepaid

insurance. (d) inventory, cash, accounts receivable, prepaid

insurance. 4. A company has purchased a tract of land. It expects to

build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. The land should be reported as: (a) property, plant, and equipment. (b) land expense. (c) a long-term investment. (d) an intangible asset.

5. The balance in retained earnings is not affected by: (a) net income. (b) net loss. (c) issuance of common stock. (d) dividends.

6. Which is an indicator of profi tability? (a) Current ratio. (b) Earnings per share. (c) Debt to assets ratio. (d) Free cash fl ow.

7. For 2017, Spanos Corporation reported net income $26,000, net sales $400,000, and weighted- average shares outstanding 4,000. There were pre- ferred dividends of $2,000. What was the 2017 earn- ings per share? (a) $6.00. (c) $99.50. (b) $6.50. (d) $100.00.

8. Which of these measures is an evaluation of a company’s ability to pay current liabilities? (a) Earnings per share. (b) Current ratio.

(LO 1)

(LO 2)

9. The following ratios are available for Reilly Inc. and O’Hare Inc.

Current Debt to Earnings Ratio Assets Ratio per Share

Reilly Inc. 2:1 75% $3.50 O’Hare Inc. 1.5:1 40% $2.75

Compared to O’Hare Inc., Reilly Inc. has: (a) higher liquidity, higher solvency, and higher

profi tability. (b) lower liquidity, higher solvency, and higher

profi tability. (c) higher liquidity, lower solvency, and higher

profi tability. (d) higher liquidity and lower solvency, but profi tability

cannot be compared based on information provided.

10. Companies can use free cash fl ow to: (a) pay additional dividends. (b) acquire more property, plant, and equipment. (c) pay off debts. (d) All of the above.

11. Generally accepted accounting principles are: (a) a set of standards and rules that are recognized

as a general guide for fi nancial reporting. (b) usually established by the Internal Revenue

Service. (c) the guidelines used to resolve ethical dilemmas. (d) fundamental truths that can be derived from the

laws of nature. 12. What organization issues U.S. accounting standards?

(a) Financial Accounting Standards Board. (b) International Accounting Standards Committee. (c) International Auditing Standards Committee. (d) None of the above.

13. What is the primary criterion by which accounting information can be judged? (a) Consistency. (b) Predictive value. (c) Usefulness for decision-making. (d) Comparability.

14. Neutrality is an ingredient of:

Faithful Representation Relevance (a) Yes Yes (b) No No (c) Yes No (d) No Yes

15. The characteristic of information that evaluates whether it is large enough to impact a decision. (a) Comparability. (c) Cost. (b) Materiality. (d) Consistency.

(LO 2)

(LO 3)

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

SOLUTIONS 1. (d) Assets are classifi ed as current assets; long-term investments; property, plant and equipment; and intangible

assets. The other choices are incorrect because (a) long-term assets includes long-term investments; property, plant, and equipment; and intangible assets; (b) common stock refers to the equity of the fi rm and is not an asset; and

Practice Exercises 67

1. Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fi ne food products—for the year ended April 30, 2017.

Prepaid insurance $ 168,182 Buildings $4,344,269 Land 56,007 Cash 617,687 Goodwill 4,411,521 Accounts receivable 1,161,481 Trademarks 723,243 Accumulated depreciation— Inventory 1,378,216 buildings 2,295,563

PRACTICE EXERCISES▼

Prepare assets section of a classifi ed balance sheet.

(LO 1)

(c) while tangible assets describes property, plant, and equipment, it is better to use the more common terminol- ogy of property, plant, and equipment.

2. (a) Current assets should be listed by order of expected conversion to cash (liquidity), not (b) by importance, (c) by longevity, or (d) alphabetically.

3. (c) The correct order of presentation for current assets is cash, accounts receivable, inventory, and then prepaid insurance. The other choices are therefore incorrect.

4. (c) Land or buildings that are currently not used in operations are considered to be long-term investments. The other choices are incorrect because (a) this classifi cation is for property, plant, and equipment used in operations; (b) land is never expensed; and (d) intangible assets have no physical existence and are used in the production of income.

5. (c) Issuance of common stock has no impact on retained earnings. The other choices are incorrect because (a) net income increases retained earnings, (b) net loss decreases retained earnings, and (d) dividends decrease retained earnings.

6. (b) Earnings per share is a measure of profi tability. The other choices are incorrect because (a) the current ratio is a measure of liquidity, (c) the debt to assets ratio is a measure of solvency, and (d) free cash fl ow is a measure of solvency.

7. (a) Earnings per share = Net income ($26,000) less Preferred dividends ($2,000) divided by Weighted-average shares outstanding (4,000) = $6.00/share, not (b) $6.50, (c) $99.50, or (d) $100.00.

8. (b) The current ratio measures liquidity. Higher current ratios indicate higher liquidity. The other choices are incorrect because (a) earnings per share is a measure of a fi rm’s profi tability, not its ability to pay its current liabili- ties; (c) one of these answers is incorrect; and (d) there is a correct answer.

9. (d) Reilly Inc. has higher liquidity as it has a higher current ratio, and lower solvency due to its higher debt to as- sets ratio. However, profi tability cannot be compared across companies using earnings per share because of the wide variations in the number of shares of common stock of different companies. The other choices are therefore incorrect.

10. (d) Free cash fl ow can be used to pay dividends; acquire more property, plant, and equipment; and pay off debts. Although choices (a), (b), and (c) are correct, choice (d) is the better answer.

11. (a) All U.S. companies get guidance from a set of rules and practices that have authoritative support, referred to as generally accepted accounting principles (GAAP). Standard-setting bodies, in consultation with the accounting profession and the business community, determine these accounting standards. The other choices are incorrect because GAAP is (b) not established by the Internal Revenue Service, (c) not intended to provide guidance in re- solving ethical dilemmas, or (d) created by people and can evolve over time, unlike laws of nature, such as those in physics and chemistry.

12. (a) The Financial Accounting Standards Board (FASB) is the organization that issues U.S. accounting standards, not the (b) International Accounting Standards Committee or (c) International Auditing Standards Committee. Choice (d) is wrong as there is a correct answer.

13. (c) Usefulness for decision-making is the primary criterion by which accounting information can be judged. The other choices are incorrect because (a) consistency, (b) predictive value, and (d) comparability all help to make accounting information more useful but are not the primary criterion by which accounting information is judged.

14. (c) Neutrality is an ingredient of faithful representation but not relevance. The other choices are therefore incorrect.

15. (b) Materiality evaluates whether information is large enough to impact a decision, not (a) comparability, (c) cost, or (d) consistency.

68 2 A Further Look at Financial Statements

SOLUTION

Assets

Current assets Cash $ 617,687 Accounts receivable 1,161,481 Inventory 1,378,216 Prepaid insurance 168,182

Total current assets $ 3,325,566

Property, plant, and equipment Land 56,007 Buildings $4,344,269 Less: Accumulated depr.—buildings 2,295,563 2,048,706 2,104,713

Intangible assets Goodwill 4,411,521 Trademarks 723,243 5,134,764

Total assets $10,565,043

H. J. HEINZ COMPANY Partial Balance Sheet

April 30, 2017 (in thousands)

INSTRUCTIONS

Prepare the assets section of a classifi ed balance sheet, listing the items in proper sequence and including a statement heading.

2. Suppose the following data were taken from the 2017 and 2016 fi nancial statements of American Eagle Outfi tters. (All dollars are in thousands.)

2017 2016

Current assets $1,020,834 $1,189,108 Total assets 1,867,680 1,979,558 Current liabilities 376,178 464,618 Total liabilities 527,216 562,246 Net income 400,019 387,359 Net cash provided by operating activities 464,270 749,268 Capital expenditures 250,407 225,939 Dividends paid on common stock 80,796 61,521 Weighted-average shares outstanding 216,119 222,662

INSTRUCTIONS

Perform each of the following.

(a) Calculate the current ratio for each year.

(b) Calculate earnings per share for each year.

(d) Calculate the free cash fl ow for each year.

(e) Discuss American Eagle’s solvency in 2017 versus 2016.

Compute and interpret various ratios.

(LO 2)

SOLUTION

2. 2017 2016

(a) Current ratio $1,020,834 $376,178

= 2.71:1 $1,189,108 $464,618

= 2.56:1

Practice Problem 69

2017 2016

(b) Earning per share $400,019 216,119

= $1.85 $387,359 222,662

= $1.74

$1,867,680 = 28.2% $562,246

$1,979,558 = 28.4%

(d) Free cash fl ow $464,270 − $250,407 − $749,268 − $225,939 − $80,796 = $133,067 $61,521 = $461,808

(e) Using the debt to assets ratio and free cash fl ow as measures of solvency produces negative results for American Eagle Outfi tters. Its debt to assets ratio decreased slightly from 28.4% for 2016 to 28.2% for 2017, indicating a very small increase in solvency for 2017. Its free cash fl ow decreased by 71%, indicating a signifi cant decline in solvency.

Listed here are items taken from the income statement and balance sheet of Bargain Elec- tronics, Inc. for the year ended December 31, 2017. Certain items have been combined for simplifi cation. (Amounts are given in thousands.)

Notes payable (due in 3 years) $ 50.5 Cash 141.1 Salaries and wages expense 2,933.6 Common stock 454.9 Accounts payable 922.2 Accounts receivable 723.3 Equipment, net 921.0 Cost of goods sold 9,501.4 Income taxes payable 7.2 Interest expense 1.5 Mortgage payable 451.5 Retained earnings 1,336.3 Inventory 1,636.5 Sales revenue 12,456.9 Debt investments (short-term) 382.6 Income tax expense 30.5 Goodwill 202.7 Notes payable (due in 6 months) 784.6

INSTRUCTIONS

Prepare an income statement and a classifi ed balance sheet using the items listed. Do not use any item more than once.

Prepare fi nancial statements.

(LO 1)

PRACTICE PROBLEM▼

Revenues Sales revenue $12,456.9 Expenses Cost of goods sold $9,501.4 Salaries and wages expense 2,933.6 Interest expense 1.5 Income tax expense 30.5

Total expenses 12,467.0

Net loss $ (10.1)

BARGAIN ELECTRONICS, INC. Income Statement

For the Year Ended December 31, 2017 (in thousands)

SOLUTION

70 2 A Further Look at Financial Statements

Assets

Current assets Cash $ 141.1 Debt investments 382.6 Accounts receivable 723.3 Inventory 1,636.5

Total current assets $2,883.5 Equipment, net 921.0 Goodwill 202.7

Total assets $4,007.2

Liabilities and Stockholders’ Equity

Current liabilities Notes payable $ 784.6 Accounts payable 922.2 Income taxes payable 7.2

Total current liabilities $1,714.0

Long-term liabilities Mortgage payable 451.5 Notes payable 50.5 502.0

Total liabilities 2,216.0

Stockholders’ equity Common stock 454.9 Retained earnings 1,336.3

Total stockholders’ equity 1,791.2

Total liabilities and stockholders’ equity $4,007.2

BARGAIN ELECTRONICS, INC. Balance Sheet

December 31, 2017 (in thousands)

1. What is meant by the term operating cycle?

2. Define current assets. What basis is used for or- dering individual items within the current assets section?

3. Distinguish between long-term investments and prop- erty, plant, and equipment.

4. How do current liabilities differ from long-term liabilities?

5. Identify the two parts of stockholders’ equity in a cor- poration and indicate the purpose of each.

6. (a) Geena Lowe believes that the analysis of financial state-

ments is directed at two characteristics of a company: liquidity and profitability. Is Geena correct? Explain.

(b) Are short-term creditors, long-term creditors, and stockholders primarily interested in the same characteristics of a company? Explain.

7. Name ratios useful in assessing (a) liquidity, (b) solvency, and (c) profitability.

8. Tom Dawes, the founder of Footwear Inc., needs to raise $500,000 to expand his company’s

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

QUESTIONS▼

Brief Exercises 71

operations. He has been told that raising the money through debt will increase the riskiness of his company much more than issuing stock. He doesn’t understand why this is true. Explain it to him.

9. What do these classes of ratios measure? (a) Liquidity ratios. (b) Profi tability ratios. (c) Solvency ratios.

10. Holding all other factors constant, indi- cate whether each of the following signals generally good or bad news about a company. (a) Increase in earnings per share. (b) Increase in the current ratio. (c) Increase in the debt to assets ratio. (d) Decrease in free cash fl ow.

11. Which ratio or ratios from this chapter do you think should be of greatest interest to: (a) a pension fund considering investing in a corpora-

tion’s 20-year bonds? (b) a bank contemplating a short-term loan? (c) an investor in common stock?

12. (a) What are generally accepted accounting principles (GAAP)?

(b) What body provides authoritative support for GAAP?

13. (a) What is the primary objective of financial reporting?

(b) Identify the characteristics of useful accounting in- formation.

14. Merle Hawkins, the president of Pathway Company, is pleased. Pathway substantially increased its net in- come in 2017 while keeping its unit inventory relatively the same. Jon Dietz, chief accountant, cautions Merle, however. Dietz says that since Pathway changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether Path- way is better off. Is Dietz correct? Why or why not?

15. What is the distinction between comparability and consistency?

16. Describe the constraint inherent in the presentation of accounting information.

17. Your roommate believes that accounting standards are uniform throughout the world. Is your roommate correct? Explain.

18. Wanda Roberts is president of Best Texts. She has no accounting background. Wanda cannot understand why fair value is not used as the basis for all account- ing measurement and reporting. Discuss.

19. What is the economic entity assumption? Give an example of its violation.

20. What was Apple’s largest current asset, largest current liability, and largest item under “Assets” at September 27, 2014?

BE2-1 The following are the major balance sheet classifi cations:

Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Common stock (CS) Intangible assets (IA) Retained earnings (RE)

Match each of the following accounts to its proper balance sheet classifi cation.

_____ Accounts payable _____ Income taxes payable _____ Accounts receivable _____ Investment in long-term bonds _____ Accumulated depreciation _____ Land _____ Buildings _____ Inventory _____ Cash _____ Patent _____ Goodwill _____ Supplies

BE2-2 A list of fi nancial statement items for Chin Company includes the following: ac- counts receivable $14,000, prepaid insurance $2,600, cash $10,400, supplies $3,800, and debt investments (short-term) $8,200. Prepare the current assets section of the balance sheet listing the items in the proper sequence.

BE2-3 The following information (in millions of dollars) is available for Limited Brands for a recent year: sales revenue $9,043, net income $220, preferred dividend $0, and weighted- average shares outstanding 333 million. Compute the earnings per share for Limited Brands.

BE2-4 These selected condensed data are taken from a recent balance sheet of Bob Evans Farms (in millions of dollars).

Cash $ 29.3 Accounts receivable 20.5 Inventory 28.7 Other current assets 24.0

Total current assets $102.5 Total current liabilities $201.2

Compute working capital and the current ratio.

Classify accounts on balance sheet.

(LO 1), K

Prepare the current assets section of a balance sheet.

(LO 1), AP

Compute earnings per share.

(LO 2), AP

Calculate liquidity ratios.

(LO 2), AP

BRIEF EXERCISES▼

72 2 A Further Look at Financial Statements

BE2-5 Ross Music Inc. reported the following selected information at March 31.

2017

Total current assets $262,787 Total assets 439,832 Total current liabilities 293,625 Total liabilities 376,002 Net cash provided by operating activities 62,300

Calculate (a) the current ratio, (b) the debt to assets ratio, and (c) free cash fl ow for March 31, 2017. The company paid dividends of $12,000 and spent $24,787 on capital expendi- tures.

BE2-6 Indicate whether each statement is true or false. (a) GAAP is a set of rules and practices established by accounting standard-setting bodies

to serve as a general guide for fi nancial reporting purposes. (b) Substantial authoritative support for GAAP usually comes from two standards-setting

bodies: the FASB and the IRS.

BE2-7 The accompanying chart shows the qualitative characteristics of useful accounting information. Fill in the blanks.

Calculate liquidity and solvency ratios.

(LO 2), AP

Recognize generally accepted accounting principles.

(LO 3), K

Identify characteristics of useful information.

(LO 3), K

BE2-8 Given the characteristics of useful accounting information, complete each of the following statements. (a) For information to be _____, it should have predictive and confi rmatory value. (b) _____ means that information accurately depicts what really happened. (c) _____ means using the same accounting principles and methods from year to year

within a company.

BE2-9 Here are some qualitative characteristics of useful accounting information: 1. Predictive value 3. Verifiable 2. Neutral 4. Timely

Match each qualitative characteristic to one of the following statements. ______ (a) Accounting information should help provide accurate expectations about

future events. ______ (b) Accounting information cannot be selected, prepared, or presented to favor

one set of interested users over another. ______ (c) The quality of information that occurs when independent observers, using the

same methods, obtain similar results. ______ (d) Accounting information must be available to decision-makers before it loses its

capacity to infl uence their decisions.

Identify characteristics of useful information.

(LO 3), K

Identify characteristics of useful information.

(LO 3), K

Fundamental Qualities

Relevance

(a)

(b)

(c)

Faithful Representation

(d)

Neutral

(e)

Enhancing Qualities

(f)

(g)

(h)

Understandability

Usefulness

DO IT! Exercises 73

BE2-10 The full disclosure principle dictates that: (a) fi nancial statements should disclose all assets at their cost. (b) fi nancial statements should disclose only those events that can be measured in

dollars. (c) fi nancial statements should disclose all events and circumstances that would matter

to users of fi nancial statements. (d) fi nancial statements should not be relied on unless an auditor has expressed an un-

qualifi ed opinion on them.

Defi ne full disclosure principle.

(LO 3), K

Mylar Corporation has collected the following information related to its December 31, 2017, balance sheet.

Accounts receivable $22,000 Equipment $180,000 Accumulated depreciation—equipment 50,000 Inventory 58,000 Cash 13,000 Supplies 7,000

Prepare the assets section of Mylar Corporation’s balance sheet.

The following fi nancial statement items were taken from the fi nancial state- ments of Gomez Corp.

____ Trademarks ____ Inventory ____ Notes payable (current) ____ Accumulated depreciation ____ Interest revenue ____ Land ____ Income taxes payable ____ Common stock ____ Debt investments (long-term) ____ Advertising expense ____ Unearned sales revenue ____ Mortgage payable (due in 3 years)

Match each of the fi nancial statement items to its proper balance sheet classifi cation. (See E2-1, on page 74, for a list of the balance sheet classifi cations.) If the item would not appear on a balance sheet, use “NA.”

The following information is available for Nguoi Corporation.

2017 2016

Current assets $ 54,000 $ 36,000 Total assets 240,000 205,000 Current liabilities 22,000 30,000 Total liabilities 72,000 100,000 Net income 80,000 40,000 Net cash provided by operating activities 90,000 56,000 Preferred dividends 6,000 6,000 Common dividends 3,000 1,500 Expenditures on property, plant, and equipment 27,000 12,000

Shares outstanding at beginning of year 40,000 30,000 Shares outstanding at end of year 75,000 40,000

(a) Compute earnings per share for 2017 and 2016 for Nguoi, and comment on the change. Nguoi’s primary competitor, Matisse Corporation, had earnings per share of $1 per share in 2017. Comment on the difference in the ratios of the two companies.

(b) Compute the current ratio and debt to assets ratio for each year, and comment on the changes.

The following characteristics, assumptions, principles, and constraint guide the FASB when it creates accounting standards.

DO IT! 2-1a Prepare assets section of balance sheet.

(LO 1), AP

DO IT! 2-1b Classify fi nancial statement items by balance sheet classifi cation.

(LO 1), AP

DO IT! 2-2 Compute ratios and analyze.

(LO 2), AP

DO IT! 2-3 Identify fi nancial accounting concepts and principles.

(LO 3), K

EXERCISES▼DO IT!

74 2 A Further Look at Financial Statements

Match each item above with a description below.

1. __________ Items not easily quantifi ed in dollar terms are not reported in the fi nancial statements.

2. __________ Accounting information must be complete, neutral, and free from error. 3. __________ Personal transactions are not mixed with the company’s transactions. 4. __________ The cost to provide information should be weighed against the benefi t

that users will gain from having the information available. 5. __________ A company’s use of the same accounting principles from year to year. 6. __________ Assets are recorded and reported at original purchase price. 7. __________ Accounting information should help users predict future events, and

should confi rm or correct prior expectations. 8. __________ The life of a business can be divided into artifi cial segments of time. 9. __________ The reporting of all information that would make a difference to fi nancial

statement users. 10. __________ The judgment concerning whether an item’s size makes it likely to infl u-

ence a decision-maker. 11. __________ Assumes a business will remain in operation for the foreseeable future. 12. __________ Different companies use the same accounting principles.

E2-1 The following are the major balance sheet classifi cations.

Current assets (CA) Current liabilities (CL) Long-term investments (LTI) Long-term liabilities (LTL) Property, plant, and equipment (PPE) Stockholders’ equity (SE) Intangible assets (IA)

Instructions Classify each of the following financial statement items taken from Ming Corporation’s balance sheet.

____ Accounts payable ____ Income taxes payable ____ Accounts receivable ____ Inventory ____ Accumulated depreciation— ____ Stock investments (to be sold in 7 months) equipment ____ Land (in use) ____ Buildings ____ Mortgage payable ____ Cash ____ Supplies ____ Interest payable ____ Equipment ____ Goodwill ____ Prepaid rent

E2-2 The major balance sheet classifications are listed in E2-1.

Instructions Classify each of the following financial statement items based upon the major balance sheet classifications listed in E2-1.

____ Prepaid advertising ____ Patents ____ Equipment ____ Bonds payable ____ Trademarks ____ Common stock ____ Salaries and wages payable ____ Accumulated depreciation— ____ Income taxes payable equipment ____ Retained earnings ____ Unearned sales revenue ____ Accounts receivable ____ Inventory ____ Land (held for future use)

E2-3 Suppose the following items were taken from the December 31, 2017, assets section of the Boeing Company balance sheet. (All dollars are in millions.)

Inventory $16,933 Patents $12,528 Notes receivable—due after Buildings 21,579 December 31, 2018 5,466 Cash 9,215 Notes receivable—due before Accounts receivable 5,785 December 31, 2018 368 Debt investments (short-term) 2,008 Accumulated depreciation—buildings 12,795

Classify accounts on balance sheet.

(LO 1), AP

Classify fi nancial statement items by balance sheet classifi cation.

(LO 1), AP

Classify items as current or noncurrent, and prepare assets section of balance sheet.

(LO 1), AP

EXERCISES▼

Exercises 75

Instructions Prepare the assets section of a classified balance sheet, listing the current assets in order of their liquidity.

E2-4 Suppose the following information (in thousands of dollars) is available for H. J. Heinz Company—famous for ketchup and other fine food products—for the year ended April 30, 2017.

Prepaid insurance $ 125,765 Buildings $4,033,369 Land 76,193 Cash 373,145 Goodwill 3,982,954 Accounts receivable 1,171,797 Trademarks 757,907 Accumulated depreciation— Inventory 1,237,613 buildings 2,131,260

Instructions Prepare the assets section of a classified balance sheet, listing the items in proper sequence and including a statement heading.

E2-5 These items are taken from the fi nancial statements of Longhorn Co. at December 31, 2017.

Buildings $105,800 Accounts receivable 12,600 Prepaid insurance 3,200 Cash 11,840 Equipment 82,400 Land 61,200 Insurance expense 780 Depreciation expense 5,300 Interest expense 2,600 Common stock 60,000 Retained earnings (January 1, 2017) 40,000 Accumulated depreciation—buildings 45,600 Accounts payable 9,500 Notes payable 93,600 Accumulated depreciation—equipment 18,720 Interest payable 3,600 Service revenue 14,700

Instructions Prepare a classified balance sheet. Assume that $13,600 of the note payable will be paid in 2018.

E2-6 Suppose the following items were taken from the 2017 financial statements of Texas Instruments, Inc. (All dollars are in millions.)

Common stock $2,826 Accumulated depreciation— Prepaid rent 164 equipment $3,547 Equipment 6,705 Accounts payable 1,459 Stock investments (long-term) 637 Patents 2,210 Debt investments (short-term) 1,743 Notes payable (long-term) 810 Income taxes payable 128 Retained earnings 6,896 Cash 1,182 Accounts receivable 1,823 Inventory 1,202

Instructions Prepare a classified balance sheet in good form as of December 31, 2017.

E2-7 Suppose the following information is available for Callaway Golf Company for the years 2017 and 2016. (Dollars are in thousands, except share information.)

2017 2016

Net sales $1,117,204 $1,124,591 Net income (loss) 66,176 54,587 Total assets 855,338 838,078

Prepare a classifi ed balance sheet.

(LO 1), AP

Prepare a classifi ed balance sheet.

(LO 1), AP

Compute and interpret profi tability ratio.

(LO 2), AP

Prepare assets section of a classifi ed balance sheet.

(LO 1), AP

76 2 A Further Look at Financial Statements

Share information 2017 2016

Shares outstanding at year-end 64,507,000 66,282,000 Preferred dividends –0– –0–

There were 73,139,000 shares outstanding at the end of 2015.

Instructions (a) What was the company’s earnings per share for each year? (b) Based on your fi ndings above, how did the company’s profi tability change from 2016

to 2017? (c) Suppose the company had paid dividends on preferred stock and on common stock

during the year. How would this affect your calculation in part (a)?

E2-8 These fi nancial statement items are for Fairview Corporation at year-end, July 31, 2017.

Salaries and wages payable $ 2,080 Salaries and wages expense 57,500 Supplies expense 15,600 Equipment 18,500 Accounts payable 4,100 Service revenue 66,100 Rent revenue 8,500 Notes payable (due in 2020) 1,800 Common stock 16,000 Cash 29,200 Accounts receivable 9,780 Accumulated depreciation—equipment 6,000 Dividends 4,000 Depreciation expense 4,000 Retained earnings (beginning of the year) 34,000

Instructions (a) Prepare an income statement and a retained earnings statement for the year. Fairview

Corporation did not issue any new stock during the year. (b) Prepare a classifi ed balance sheet at July 31. (c) Compute the current ratio and debt to assets ratio. (d) Suppose that you are the president of Lunar Equipment. Your sales manager has ap-

proached you with a proposal to sell $20,000 of equipment to Fairview. He would like to provide a loan to Fairview in the form of a 10%, 5-year note payable. Evaluate how this loan would change Fairview’s current ratio and debt to assets ratio, and discuss whether you would make the sale.

E2-9 Nordstrom, Inc. operates department stores in numerous states. Selected fi nancial statement data (in millions of dollars) for a recent year follow.

End of Year Beginning of Year

Cash and cash equivalents $ 72 $ 358 Receivables (net) 1,942 1,788 Merchandise inventory 900 956 Other current assets 303 259

Total current assets $3,217 $3,361

Total current liabilities $1,601 $1,635

Instructions (a) Compute working capital and the current ratio at the beginning of the year and at the

end of the year. (b) Did Nordstrom’s liquidity improve or worsen during the year? (c) Using the data in the chapter, compare Nordstrom’s liquidity with Best Buy’s (see

page 55).

E2-10 The chief fi nancial offi cer (CFO) of Myeneke Corporation requested that the ac- counting department prepare a preliminary balance sheet on December 30, 2017, so that the CFO could get an idea of how the company stood. He knows that certain debt agreements

Compute liquidity measures and discuss fi ndings.

(LO 2), AP

Compute liquidity ratios and compare results.

(LO 2), AP

Prepare fi nancial statements.

(LO 1, 2), AP

Exercises 77

with its creditors require the company to maintain a current ratio of at least 2:1. The pre- liminary balance sheet is as follows.

MYENEKE CORP. Balance Sheet

December 30, 2017

Current assets Current liabilities Cash $25,000 Accounts payable $ 20,000 Accounts receivable 30,000 Salaries and wages payable 10,000 $ 30,000

Prepaid insurance 5,000 $ 60,000 Long-term liabilities Equipment (net) 200,000 Notes payable 80,000

Total assets $260,000 Total liabilities 110,000 Stockholders’ equity Common stock 100,000 Retained earnings 50,000 150,000

Total liabilities and stockholders’ equity $260,000

Instructions (a) Calculate the current ratio and working capital based on the preliminary balance sheet. (b) Based on the results in (a), the CFO requested that $20,000 of cash be used to pay off

the balance of the Accounts Payable account on December 31, 2017. Calculate the new current ratio and working capital after the company takes these actions.

(d) Was it unethical for the CFO to take these steps?

E2-11 Suppose the following data were taken from the 2017 and 2016 fi nancial statements of American Eagle Outfi tters. (All numbers, including share data, are in thousands.)

2017 2016

Current assets $ 925,359 $1,020,834 Total assets 1,963,676 1,867,680 Current liabilities 401,763 376,178 Total liabilities 554,645 527,216 Net income 179,061 400,019 Net cash provided by operating activities 302,193 464,270 Capital expenditures 265,335 250,407 Dividends paid on common stock 82,394 80,796

Weighted-average shares outstanding 205,169 216,119

Instructions Perform each of the following. (a) Calculate the current ratio for each year. (b) Calculate earnings per share for each year. (c) Calculate the debt to assets ratio for each year. (d) Calculate the free cash fl ow for each year. (e) Discuss American Eagle’s solvency in 2017 versus 2016. (f) Discuss American Eagle’s ability to fi nance its investment activities with net cash pro-

vided by operating activities, and how any defi ciency would be met.

E2-12 Presented below are the assumptions and principles discussed in this chapter. 1. Full disclosure principle 4. Periodicity assumption 2. Going concern assumption 5. Historical cost principle 3. Monetary unit assumption 6. Economic entity assumption

Instructions Identify by number the accounting assumption or principle that is described below. Do not use a number more than once. ______ (a) Is the rationale for why plant assets are not reported at liquidation value.

(Note: Do not use the historical cost principle.)

Identify accounting assumptions and principles.

(LO 3), K

Compute and interpret solvency ratios.

(LO 2), AP

78 2 A Further Look at Financial Statements

______ (b) Indicates that personal and business recordkeeping should be separately maintained.

______ (c) Assumes that the dollar is the “measuring stick” used to report on fi nancial performance.

______ (d) Separates fi nancial information into time periods for reporting purposes. ______ (e) Measurement basis used when a reliable estimate of fair value is not available. ______ (f) Dictates that companies should disclose all circumstances and events that

make a difference to fi nancial statement users.

E2-13 Lopez Co. had three major business transactions during 2017. (a) Reported at its fair value of $260,000 merchandise inventory with a cost of $208,000. (b) The president of Lopez Co., Victor Lopez, purchased a truck for personal use and

charged it to his expense account. (c) Lopez Co. wanted to make its 2017 income look better, so it added 2 more weeks to its

income statement reporting period (a 54-week year). Previous years were 52 weeks.

Instructions In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done.

Identify the assumption or principle that has been violated.

(LO 3), C

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P2-1A Suppose the following items are taken from the 2017 balance sheet of Yahoo! Inc. (All dollars are in millions.)

Goodwill $3,927 Common stock 6,283 Equipment 1,737 Accounts payable 152 Patents 234 Stock investments (long-term) 3,247 Accounts receivable 1,061 Prepaid rent 233 Debt investments (short-term) 1,160 Retained earnings 6,108 Cash 2,292 Notes payable (long-term) 734 Unearned sales revenue 413 Accumulated depreciation—equipment 201

Instructions Prepare a classifi ed balance sheet for Yahoo! Inc. as of December 31, 2017.

P2-2A These items are taken from the fi nancial statements of Martin Corporation for 2017.

Retained earnings (beginning of year) $31,000 Utilities expense 2,000 Equipment 66,000 Accounts payable 18,300 Cash 10,100 Salaries and wages payable 3,000 Common stock 12,000 Dividends 12,000

Prepare a classifi ed balance sheet.

(LO 1), AP

Tot. current assets $4,746 Tot. assets $13,690

Prepare fi nancial statements.

(LO 1), AP

PROBLEMS: SET A▼

Problems: Set A 79

Service revenue 68,000 Prepaid insurance 3,500 Maintenance and repairs expense 1,800 Depreciation expense 3,600 Accounts receivable 11,700 Insurance expense 2,200 Salaries and wages expense 37,000 Accumulated depreciation—equipment 17,600

Instructions Prepare an income statement, a retained earnings statement, and a classifi ed balance sheet as of December 31, 2017.

P2-3A You are provided with the following information for Lazuris Enterprises, effective as of its April 30, 2017, year-end.

Accounts payable $ 834 Accounts receivable 810 Accumulated depreciation—equipment 670 Cash 1,270 Common stock 900 Cost of goods sold 1,060 Depreciation expense 335 Dividends 325 Equipment 2,420 Income tax expense 165 Income taxes payable 135 Insurance expense 210 Interest expense 400 Inventory 967 Land 3,100 Mortgage payable 3,500 Notes payable 61 Prepaid insurance 60 Retained earnings (beginning) 1,600 Salaries and wages expense 700 Salaries and wages payable 222 Sales revenue 5,100 Stock investments (short-term) 1,200

Instructions (a) Prepare an income statement and a retained earnings statement for Lazuris Enter-

prises for the year ended April 30, 2017. (b) Prepare a classifi ed balance sheet for Lazuris Enterprises as of April 30, 2017.

P2-4A Comparative fi nancial statement data for Loeb Corporation and Bowsh Corpora- tion, two competitors, appear below. All balance sheet data are as of December 31, 2017.

Loeb Corporation Bowsh Corporation

2017 2017

Net sales $1,800,000 $620,000 Cost of goods sold 1,175,000 340,000 Operating expenses 283,000 98,000 Interest expense 9,000 3,800 Income tax expense 85,000 36,000 Current assets 407,200 190,336 Plant assets (net) 532,000 139,728 Current liabilities 66,325 33,716 Long-term liabilities 108,500 40,684 Net cash provided by operating activities 138,000 36,000 Capital expenditures 90,000 20,000 Dividends paid on common stock 36,000 15,000

Weighted-average number of shares outstanding 80,000 50,000

Net income $21,400 Tot. assets $73,700

Prepare fi nancial statements.

(LO 1), AP

(a) Net income $2,230 (b) Tot. current assets $4,307 Tot. assets $9,157

Compute ratios; comment on relative profi tability, liquidity, and solvency.

(LO 2), AN

80 2 A Further Look at Financial Statements

Additional information: The net cash provided by operating activities for 2017 was $190,800. The cash used for capital expenditures was $92,000. The cash used for dividends was $31,000. The weighted-average number of shares outstanding during the year was 50,000.

Instructions (a) Compute the following values and ratios for 2017. (We provide the results from 2016

for comparative purposes.) (i) Working capital. (2016: $160,500) (ii) Current ratio. (2016: 1.65:1) (iii) Free cash fl ow. (2016: $48,700) (iv) Debt to assets ratio. (2016: 31%) (v) Earnings per share. (2016: $3.15) (b) Using your calculations from part (a), discuss changes from 2016 in liquidity, solvency,

and profi tability.

Instructions (a) Comment on the relative profi tability of the companies by computing the net income

and earnings per share for each company for 2017. (b) Comment on the relative liquidity of the companies by computing working capital and

the current ratio for each company for 2017. (c) Comment on the relative solvency of the companies by computing the debt to assets

ratio and the free cash fl ow for each company for 2017.

P2-5A The following are fi nancial statements of Ohara Company.

OHARA COMPANY Income Statement

For the Year Ended December 31, 2017

Net sales $2,218,500 Cost of goods sold 1,012,400 Selling and administrative expenses 906,000 Interest expense 78,000 Income tax expense 69,000

Net income $ 153,100

OHARA COMPANY Balance Sheet

December 31, 2017

Assets

Current assets Cash $ 60,100 Debt investments 84,000 Accounts receivable (net) 169,800 Inventory 145,000

Total current assets 458,900

Plant assets (net) 575,300

Total assets $1,034,200

Liabilities and Stockholders’ Equity

Current liabilities Accounts payable $ 160,000 Income taxes payable 35,500

Total current liabilities 195,500

Bonds payable 200,000

Total liabilities 395,500

Stockholders’ equity Common stock 350,000 Retained earnings 288,700

Total stockholders’ equity 638,700

Total liabilities and stockholders’ equity $1,034,200

Compute and interpret liquidity, solvency, and profi tability ratios.

(LO 2), AP

Problems: Set A 81

Additional information:

Net cash provided by operating activities $82,000 $56,000 Cash used for capital expenditures $45,000 $38,000 Dividends paid $20,000 $15,000 Weighted-average number of shares outstanding 33,000 30,000

Instructions Compute these values and ratios for 2016 and 2017.

(a) Earnings per share. (b) Working capital. (c) Current ratio. (d) Debt to assets ratio. (e) Free cash fl ow. (f) Based on the ratios calculated, discuss briefl y the improvement or lack thereof

in fi nancial position and operating results from 2016 to 2017 of Danke Corporation.

P2-7A Selected fi nancial data of two competitors, Target and Wal-Mart, are presented here. (All dollars are in millions.) Suppose the data were taken from the 2017 fi nancial statements of each company.

Compute ratios and compare liquidity, solvency, and profi tability for two companies.

(LO 2), AP

P2-6A Condensed balance sheet and income statement data for Danke Corporation are presented as follows.

Target Wal-Mart (1/31/17) (1/31/17)

Income Statement Data for Year

Net sales $64,948 $401,244 Cost of goods sold 44,157 306,158 Selling and administrative expenses 16,389 76,651 Interest expense 894 2,103 Other income 28 4,213 Income taxes 1,322 7,145

Net income $ 2,214 $ 13,400

DANKE CORPORATION Balance Sheets December 31

2017 2016 Assets

Cash $ 28,000 $ 20,000 Receivables (net) 70,000 62,000 Other current assets 90,000 73,000 Long-term investments 62,000 60,000 Property, plant, and equipment (net) 510,000 470,000

Total assets $760,000 $685,000

Liabilities and Stockholders’ Equity

Current liabilities $ 75,000 $ 70,000 Long-term liabilities 80,000 90,000 Common stock 330,000 300,000 Retained earnings 275,000 225,000

Total liabilities and stockholders’ equity $760,000 $685,000

DANKE CORPORATION Income Statements

For the Years Ended December 31

2017 2016

Sales revenue $750,000 $680,000 Cost of goods sold 440,000 400,000 Operating expenses (including income taxes) 240,000 220,000

Net income $ 70,000 $ 60,000

Compute and interpret liquidity, solvency, and profi tability ratios.

(LO 2), AP

82 2 A Further Look at Financial Statements

Target Wal-Mart

Balance Sheet Data (End of Year)

Current assets $17,488 $ 48,949 Noncurrent assets 26,618 114,480

Total assets $44,106 $163,429

Current liabilities $10,512 $ 55,390 Long-term liabilities 19,882 42,754 Total stockholders’ equity 13,712 65,285

Total liabilities and stockholders’ equity $44,106 $163,429

Net cash provided by operating activities $4,430 $23,147 Cash paid for capital expenditures $3,547 $11,499 Dividends declared and paid on common stock $465 $3,746

Weighted-average shares outstanding (millions) 774 3,951

Instructions For each company, compute these values and ratios.

(a) Working capital. (b) Current ratio. (c) Debt to assets ratio. (d) Free cash fl ow. (e) Earnings per share. (f) Compare the liquidity and solvency of the two companies.

P2-8A A friend of yours, Saira Ortiz, recently completed an undergraduate degree in sci- ence and has just started working with a biotechnology company. Saira tells you that the owners of the business are trying to secure new sources of fi nancing which are needed in order for the company to proceed with development of a new healthcare product. Saira said that her boss told her that the company must put together a report to present to potential investors. Saira thought that the company should include in this package the detailed scientifi c fi ndings related to the Phase I clinical trials for this product. She said, “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scientifi c fi ndings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting prin- ciples. Why do we need to look at some accounting rules? What they need to realize is that we have scientifi c results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven’t made any sales yet, but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!”

Instructions (a) What is accounting information? Explain to Saira what is meant by generally accepted

accounting principles. (b) Comment on how Saira’s suggestions for what should be reported to prospective inves-

tors conforms to the qualitative characteristics of accounting information. Do you think that the things that Saira wants to include in the information for investors will conform to fi nancial reporting guidelines?

Comment on the objectives and qualitative characteristics of fi nancial reporting.

(LO 3), E

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

Expand Your Critical Thinking 83

(Note: This is a continuation of the Cookie Creations problem from Chapter 1.)

CC2 After investigating the different forms of business organization, Natalie Koebel decides to operate her business as a corporation, Cookie Creations Inc. She then begins the process of getting her business running.

Go to the book’s companion website, www.wiley.com/college/kimmel, to see the com- pletion of this problem.

CONTINUING PROBLEM Cookie Creations▼

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT2-1 The fi nancial statements of Apple Inc. are presented in Appendix A at the end of this textbook.

Instructions Answer the following questions using the fi nancial statements and the notes to the fi nancial statements.

(a) What were Apple’s total current assets at September 27, 2014, and September 28, 2013?

(b) Are the assets included in current assets listed in the proper order? Explain. (c) How are Apple’s assets classified? (d) What were Apple’s current liabilities at September 27, 2014, and September 28, 2013?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT2-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C. Assume Columbia’s weighted-average number of shares outstanding was 227,514,000, and VF’s was 56,997,000.

Instructions (a) For each company, calculate the following values for 2014. (1) Working capital. (3) Debt to assets ratio. (2) Current ratio. (4) Free cash flow. (Hint: When calculating free cash flow, do not consider business acquisitions to be

part of capital expenditures.) (b) Based on your findings above, discuss the relative liquidity and solvency of the two

companies.

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT2-3 Amazon.com, Inc.’s fi nancial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) For each company, calculate the following values for 2014. (1) Working capital. (3) Debt to assets ratio. (2) Current ratio. (4) Free cash flow. (b) Based on your findings above, discuss the relative liquidity and solvency of the two

companies.

INTERPRETING FINANCIAL STATEMENTS

CT2-4 Suppose the following information was reported by Gap, Inc.

Financial Reporting

▼

Financial Analysis

▼

Financial Analysis

▼

Financial Analysis

▼

84 2 A Further Look at Financial Statements

2017 2016 2015 2014 2013

Total assets (millions) $7,065 $7,985 $7,564 $7,838 $8,544 Working capital $1,831 $2,533 $1,847 $1,653 $2,757 Current ratio 1.87:1 2.19:1 1.86:1 1.68:1 2.21:1 Debt to assets ratio .42:1 .39:1 .42:1 .45:1 .39:1 Earnings per share $1.89 $1.59 $1.35 $1.05 $0.94

(a) Determine the overall percentage decrease in Gap’s total assets from 2013 to 2017. What was the average decrease per year?

(b) Comment on the change in Gap’s liquidity. Does working capital or the current ratio appear to provide a better indication of Gap’s liquidity? What might explain the change in Gap’s liquidity during this period?

(c) Comment on the change in Gap’s solvency during this period. (d) Comment on the change in Gap’s profi tability during this period. How might this

affect your prediction about Gap’s future profi tability?

REAL-WORLD FOCUS

CT2-5 Purpose: Identify summary liquidity, solvency, and profi tability information about companies, and compare this information across companies in the same industry.

Address: http://biz.yahoo.com/i

Steps 1. Type in a company name, or use the index to find a company name. Choose Profile.

Choose Key Statistics. Perform instruction (a) below. 2. Go back to Profile. Click on the company’s particular industry behind the heading

“Industry.” Perform instructions (b), (c), and (d).

Instructions Answer the following questions.

(a) What is the company’s name? What was the company’s current ratio and debt to equity ratio (a variation of the debt to assets ratio)?

(b) What is the company’s industry? (c) What is the name of a competitor? What is the competitor’s current ratio and its debt

to equity ratio? (d) Based on these measures, which company is more liquid? Which company is more

solvent?

CT2-6 The Feature Story described the dramatic effect that investment bulletin boards are having on the investment world. This exercise will allow you to evaluate a bulletin board discussing a company of your choice.

Address: http://biz.yahoo.com/i

Steps 1. Type in a company name, or use the index to find a company name. 2. Choose Msgs or Message Board. (for messages). 3. Read the 10 most recent messages.

Instructions Answer the following questions.

(a) State the nature of each of these messages (e.g., offering advice, criticizing company, predicting future results, ridiculing other people who have posted messages).

(b) For those messages that expressed an opinion about the company, was evidence pro- vided to support the opinion?

(c) What effect do you think it would have on bulletin board discussions if the partici- pants provided their actual names? Do you think this would be a good policy?

CT2-7 The July 6, 2011, edition of the Wall Street Journal Online includes an article by Michael Rapoport entitled “U.S. Firms Clash Over Accounting Rules.” The article discusses why some U.S. companies favored adoption of International Financial Reporting Stan- dards (IFRS) while other companies opposed it.

Expand Your Critical Thinking 85

Instructions Read the article and answer the following questions.

(a) The articles says that the switch to IFRS tends to be favored by “larger companies, big accounting firms, and rule makers.” What reasons are given for favoring the switch?

(b) What two reasons are given by many smaller companies that oppose the switch? (c) What criticism of IFRS is raised with regard to regulated companies? (d) Explain what is meant by “condorsement.”

DECISION-MAKING ACROSS THE ORGANIZATION

CT2-8 As a fi nancial analyst in the planning department for Erin Industries, Inc., you must develop ratios from the comparative fi nancial statements. This information is to be used to convince creditors that, despite a slight decline in sales, Erin Industries, Inc. is liquid, solvent, and profi table, and that it deserves their continued support. Lenders are particularly concerned about the company’s ability to continue as a going concern. Here are the data requested and the computations developed from the fi nancial statements:

2017 2016

Current ratio 3.1 2.1 Working capital Up 22% Down 7% Free cash flow Up 25% Up 18% Debt to assets ratio 0.60 0.70 Net income Up 32% Down 8% Earnings per share $2.40 $1.15

Instructions Erin Industries, Inc. asks you to prepare brief comments stating how each of these items supports the argument that its fi nancial health is improving. The company wishes to use these comments to support presentation of data to its creditors. With the class divided into groups, prepare the comments as requested, giving the implications and the limitations of each item regarding Erin’s fi nancial well-being.

COMMUNICATION ACTIVITY

CT2-9 B. P. Palmer is the chief executive offi cer of Future Products. Palmer is an expert engineer but a novice in accounting.

Instructions Write a letter to B. P. Palmer that explains (a) the three main types of ratios; (b) examples of each, how they are calculated, and what they measure; and (c) the bases for comparison in analyzing Future Products’ fi nancial statements.

ETHICS CASE

CT2-10 At one time, Boeing closed a giant deal to acquire another manufacturer, McDonnell Douglas. Boeing paid for the acquisition by issuing shares of its own stock to the stockhold- ers of McDonnell Douglas. In order for the deal not to be revoked, the value of Boeing’s stock could not decline below a certain level for a number of months after the deal. During the fi rst half of the year, Boeing suffered signifi cant cost overruns because of ineffi ciencies in its production methods. Had these problems been disclosed in the quar- terly fi nancial statements during the fi rst and second quarters of the year, the company’s stock most likely would have plummeted, and the deal would have been revoked. Com- pany managers spent considerable time debating when the bad news should be disclosed. One public relations manager suggested that the company’s problems be revealed on the date of either Princess Diana’s or Mother Teresa’s funeral, in the hope that it would be lost among those big stories that day. Instead, the company waited until October 22 of that year to announce a $2.6 billion write-off due to cost overruns. Within one week, the com- pany’s stock price had fallen 20%, but by this time the McDonnell Douglas deal could not be reversed.

Financial Analysis

Writing

Group Project

▼

86 2 A Further Look at Financial Statements

Instructions Answer the following questions.

(a) Who are the stakeholders in this situation? (b) What are the ethical issues? (c) What assumptions or principles of accounting are relevant to this case? (d) Do you think it is ethical to try to “time” the release of a story so as to diminish its

effect? (e) What would you have done if you were the chief executive officer of Boeing? (f) Boeing’s top management maintains that it did not have an obligation to reveal its

problems during the first half of the year. What implications does this have for inves- tors and analysts who follow Boeing’s stock?

ALL ABOUT YOU

CT2-11 Every company needs to plan in order to move forward. Its top management must consider where it wants the company to be in three to fi ve years. Like a company, you need to think about where you want to be three to fi ve years from now, and you need to start taking steps now in order to get there.

Instructions Provide responses to each of the following items.

(a) Where would you like to be working in three to five years? Describe your plan for getting there by identifying between five and 10 specific steps that you need to take in order to get there.

(b) In order to get the job you want, you will need a résumé. Your résumé is the equivalent of a company’s annual report. It needs to provide relevant and reliable information about your past accomplishments so that employers can decide whether to “invest” in you. Do a search on the Internet to find a good résumé format. What are the basic elements of a résumé?

(c) A company’s annual report provides information about a company’s accomplish- ments. In order for investors to use the annual report, the information must be reliable; that is, users must have faith that the information is accurate and believ- able. How can you provide assurance that the information on your résumé is reliable?

(d) Prepare a résumé assuming that you have accomplished the five to 10 specific steps you identified in part (a). Also, provide evidence that would give assurance that the information is reliable.

FASB CODIFICATION ACTIVITY

CT2-12 If your school has a subscription to the FASB Codifi cation, go to http://aaahq. org/ascLogin.cfm to log in and prepare responses to the following.

Instructions (a) Access the glossary (“Master Glossary”) at the FASB Codification website to answer

the following. (1) What is the definition of current assets? (2) What is the definition of current liabilities? (b) A company wants to offset its accounts payable against its cash account and show a

cash amount net of accounts payable on its balance sheet. Identify the criteria (found in the FASB Codification) under which a company has the right of set off. Does the company have the right to offset accounts payable against the cash account?

CONSIDERING PEOPLE, PLANET, AND PROFIT

CT2-13 Auditors provide a type of certifi cation of corporate fi nancial statements. Certi- fi cation is used in many other aspects of business as well. For example, it plays a critical role in the sustainability movement. The February 7, 2012, issue of the New York Times contained an article by S. Amanda Caudill entitled “Better Lives in Better Coffee,” which discusses the role of certifi cation in the coffee business.

Address: http://scientistatwork.blogs.nytimes.com/2012/02/07/better-lives-in-better- coffee/

A Look at IFRS 87

Instructions Read the article and answer the following questions.

(a) The article mentions three different certification types that coffee growers can obtain from three different certification bodies. Using financial reporting as an example, what potential problems might the existence of multiple certification types present to coffee purchasers?

(b) According to the author, which certification is most common among coffee growers? What are the possible reasons for this?

(c) What social and environmental benefits are coffee certifications trying to achieve? Are there also potential financial benefits to the parties involved?

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

KEY POINTS Following are the key similarities and differences between GAAP and IFRS related to the financial statements.

Similarities • IFRS generally requires a classified statement of financial position similar to the classi-

fied balance sheet under GAAP. • IFRS follows the same guidelines as this textbook for distinguishing between current

and noncurrent assets and liabilities.

Differences • IFRS recommends but does not require the use of the title “statement of financial pos-

ition” rather than balance sheet. • The format of statement of financial position information is often presented differently

under IFRS. Although no specific format is required, many companies that follow IFRS present statement of financial position information in this order: ♦ Non-current assets ♦ Current assets ♦ Equity ♦ Non-current liabilities ♦ Current liabilities

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

• IFRS has many differences in terminology from what are shown in your textbook. For example, in the sample statement of financial position illustrated on the next page, notice in the investment category that stock is called shares.

LEARNING OBJECTIVE 4 Compare the classifi ed balance sheet format under GAAP and IFRS.▼

A Look at IFRS

88 2 A Further Look at Financial Statements

Assets Intangible assets Patents $ 3,100 Property, plant, and equipment Land $10,000 Equipment $24,000 Less: Accumulated depreciation 5,000 19,000 29,000 Long-term investments Share investments 5,200 Investment in real estate 2,000 7,200 Current assets Prepaid insurance 400 Supplies 2,100 Inventory 3,000 Notes receivable 1,000 Accounts receivable 7,000 Debt investments 2,000 Cash 6,600 22,100 Total assets $61,400

Equity and Liabilities Equity Share capital $20,050 Retained earnings 14,000 Non-current liabilities Mortgage payable $10,000 Notes payable 1,300 11,300 Current liabilities Notes payable 11,000 Accounts payable 2,100 Salaries and wages payable 1,600 Unearned service revenue 900 Interest payable 450 16,050 Total equity and liabilities $61,400

FRANKLIN CORPORATION Statement of Financial Position

October 31, 2017

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

LOOKING TO THE FUTURE The IASB and the FASB are working on a project to converge their standards related to finan- cial 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 operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the income statement and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://www.fasb.org/project/-financial_statement_presentation.shtml.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. 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.

A Look at IFRS 89

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 financial position at fair value. (b) may offset assets against liabilities and show net assets and net liabilities on their

statements of financial position, rather than the underlying detailed line items. (c) may report non-current assets before current assets on the statement of financial

position. (d) do not have any guidelines as to what should be reported on the statement of

financial position. 4. Companies that follow IFRS to prepare a statement of financial position generally use

the following order of classification: (a) current assets, current liabilities, non-current assets, non-current liabilities, equity. (b) non-current assets, non-current liabilities, current assets, current liabilities, equity. (c) non-current assets, current assets, equity, non-current liabilities, current liabilities. (d) equity, non-current assets, current assets, non-current liabilities, current liabilities.

IFRS EXERCISES IFRS2-1 In what ways does the format of a statement of financial of position under IFRS often differ from a balance sheet presented under GAAP?

IFRS2-2 What term is commonly used under IFRS in reference to the balance sheet?

IFRS2-3 The statement of financial position for Sundell Company includes the following accounts (in British pounds): Accounts Receivable £12,500, Prepaid Insurance £3,600, Cash £15,400, Supplies £5,200, and Debt Investments (short-term) £6,700. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence.

IFRS2-4 The following information is available for Lessila Bowling Alley at December 31, 2017.

Buildings $128,800 Share Capital $100,000 Accounts Receivable 14,520 Retained Earnings (beginning) 15,000 Prepaid Insurance 4,680 Accumulated Depreciation—Buildings 42,600 Cash 18,040 Accounts Payable 12,300 Equipment 62,400 Notes Payable 97,780 Land 64,000 Accumulated Depreciation—Equipment 18,720 Insurance Expense 780 Interest Payable 2,600 Depreciation Expense 7,360 Bowling Revenues 14,180 Interest Expense 2,600

Prepare a classified statement of financial position. Assume that $13,900 of the notes payable will be paid in 2018.

INTERNATIONAL COMPARATIVE ANALYSIS PROBLEM: Apple vs. Louis Vuitton IFRS2-5 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Identify five differences in the format of the statement of financial position used by Louis Vuitton compared to a company, such as Apple, that follows GAAP. (Apple’s financial statements are available in Appendix A.)

Answers to IFRS Self-Test Questions 1. d 2. b 3. c 4. c

As indicated in the Feature Story, a reliable information system is a necessity for any company. The

purpose of this chapter is to explain and illustrate the features of an accounting information system.

CHAPTER PREVIEW

The Accounting Information System 3

LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

• Accounting transactions • Analyzing transactions • Summary of transactions

▼1 Analyze the effect of business transactions on the basic accounting equation.

DO IT!

1 Transaction Analysis

▼3 Indicate how a journal is used in the recording process.

• The recording process • The journal

DO IT!

3 Journal Entries

▼4 Explain how a ledger and posting help in the recording process.

• The ledger • Chart of accounts • Posting • The recording process

illustrated • Summary illustration

DO IT!

4 Posting

▼5 Prepare a trial balance. • Limitations of a trial balance DO IT!

5 Trial Balance

▼2 Explain how accounts, debits, and credits are used to record business transactions.

• Debits and credits • Debit and credit procedures • Stockholders’ equity

relationships • Summary of debit/credit rules

DO IT!

2 Debits and Credits for Balance Sheet Accounts

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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How organized are you fi nancially? Take a short quiz. Answer yes or no to each question:

• Does your wallet contain so many cash machine receipts that you’ve been declared a walking fi re hazard?

• Do you wait until your debit card is denied before checking the status of your funds?

• Was Aaron Rodgers (the quarterback for the Green Bay Packers) playing high school football the last time you verifi ed the accuracy of your bank account?

If you think it is hard to keep track of the many transactions that make up your life, imagine how diffi cult it is for a big corporation to do so. Not only that, but now consider how important it is for a big company to have good accounting records, especially if it has control of your life savings. MF Global Holdings Ltd was such a company. As a large investment broker, it held billions of dollars of investments for clients. If you had your life savings invested at MF Global, you might be slightly displeased if you heard this from one of its representatives: “You know, I kind of remember an account for someone with a name like yours—now what did we do with that?”

Unfortunately, that is almost exactly what happened to MF Global’s clients shortly before it fi led for bankruptcy. During the days immediately following

the bankruptcy fi ling, regulators and auditors struggled to piece things together. In the words of one regulator, “Their books are a disaster . . . we’re trying to fi gure out what numbers are real numbers.” One company that considered buying an interest in MF Global walked away from the deal

because it “couldn’t get a sense of what was on the balance sheet.” That company said the information that should have been instantly available instead took days to produce.

It now appears that MF Global did not properly segregate customer accounts from company accounts. And, because of its sloppy recordkeeping, customers were not protected when the company had fi nancial troubles. Total customer losses were approximately $1 billion. As you can see, accounting matters!

Source: S. Patterson and A. Lucchetti, “Inside the Hunt for MF Global Cash,” Wall Street Journal Online (November 11, 2011).

FEATURE STORY

Accidents Happen

92 3 The Accounting Information System

LEARNING OBJECTIVE 1 Analyze the effect of business transactions on the basic accounting equation.▼

The system of collecting and processing transaction data and communicating fi nancial information to decision-makers is known as the accounting infor- mation system. Factors that shape an accounting information system include the nature of the company’s business, the types of transactions, the size of the company, the volume of data, and the information demands of management and others. Most businesses use computerized accounting systems—sometimes referred to as electronic data processing (EDP) systems. These systems handle all the steps involved in the recording process, from initial data entry to preparation of the fi nancial statements. In order to remain competitive, companies continu- ally improve their accounting systems to provide accurate and timely data for decision-making. For example, in a recent annual report, Tootsie Roll stated, “We also invested in additional processing and data storage hardware during the year. We view information technology as a key strategic tool, and are committed to deploying leading edge technology in this area.” In addition, many companies have upgraded their accounting information systems in response to the require- ments of Sarbanes-Oxley. Accounting information systems rely on a process referred to as the accounting cycle. As you can see from the graphic above, the accounting cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance. We explain each of the steps in this chapter as well as in Chapter 4. In this chapter, in order to emphasize the underlying concepts and principles, we focus on a manual accounting system. The accounting concepts and prin- ciples do not change whether a system is computerized or manual.

ACCOUNTING TRANSACTIONS

To use an accounting information system, you need to know which economic events to recognize (record). Not all events are recorded and reported in the fi nancial statements. For example, suppose General Motors hired a new employee and purchased a new computer. Are these events entered in its accounting records? The fi rst event would not be recorded, but the second event would. We call economic events that require recording in the fi nancial statements accounting transactions. An accounting transaction occurs when assets, liabilities, or stockholders’ equity items change as a result of some economic event. The purchase of a com- puter by General Motors, the payment of rent by Microsoft, and the sale of a multi-day guided trip by Sierra Corporation are examples of events that change a company’s assets, liabilities, or stockholders’ equity. Illustration 3-1 summarizes the decision process companies use to decide whether or not to record economic events.

The accounting cycle graphic above illustrates the steps companies follow each period to record transactions and eventually prepare fi nancial statements.

JOURNALIZE POST TRIAL

BALANCE

ADJUSTING ENTRIES

ADJUSTED TRIAL

BALANCE

FINANCIAL STATEMENTS

CLOSING ENTRIES

POST-CLOSING TRIAL BALANCE

JJJOJJ Analyze business

transactions

Using the Accounting Equation to Analyze Transactions 93

ANALYZING TRANSACTIONS

In Chapter 1, you learned the basic accounting equation:

TRAV EL

RENTRENT

CHIP CITY

DELL

YesNoYes

Events

Criterion

Record/ Don’t Record

Pay rentDiscuss guided trip options with potential customer

Purchase computer

Is the financial position (assets, liabilities, or stockholders’ equity) of the company changed?

ILLUSTRATION 3-1 Transaction identifi cation process

Assets = Liabilities + Stockholders’ Equity

In this chapter, you will learn how to analyze transactions in terms of their effect on assets, liabilities, and stockholders’ equity. Transaction analysis is the process of identifying the specifi c effects of economic events on the accounting equation.

The accounting equation must always balance. Each transaction has a dual (double-sided) effect on the equation. For example, if an individual asset is increased, there must be a corresponding:

• Decrease in another asset, or

• Increase in a specifi c liability, or

• Increase in stockholders’ equity.

Two or more items could be affected when an asset is increased. For exam- ple, if a company purchases a computer for $10,000 by paying $6,000 in cash and signing a note for $4,000, one asset (equipment) increases $10,000, another asset (cash) decreases $6,000, and a liability (notes payable) increases $4,000. The result is that the accounting equation remains in balance—assets increased by a net $4,000 and liabilities increased by $4,000, as shown below.

DECISION TOOLS

The accounting equation is used to determine if an accounting transac- tion has occurred.

Assets = Liabilities + Stockholders’ Equity +$10,000 +$4,000 − 6,000 $ 4,000 = $4,000

Chapter 1 presented the fi nancial statements for Sierra Corporation for its fi rst month. You should review those fi nancial statements (on page 16) at this time. To illustrate how economic events affect the accounting equation, we will examine events affecting Sierra during its fi rst month.

94 3 The Accounting Information System

In order to analyze the transactions for Sierra, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transac- tions on stockholders’ equity. Recall from the balance sheets in Chapters 1 and 2 that stockholders’ equity is comprised of two parts: common stock and retained earnings. Common stock is affected when the company issues new shares of stock in exchange for cash. Retained earnings is affected when the company recognizes revenue, incurs expenses, or pays dividends. Illustration 3-2 shows the expanded equation.

ILLUSTRATION 3-2 Expanded accounting equation

Assets Liabilities Stockholders' Equity5 1

Retained EarningsCommon Stock 1

Expenses DividendsRevenues 2 2

If you are tempted to skip ahead after you’ve read a few of the following transaction analyses, don’t do it. Each has something unique to teach, some- thing you’ll need later. (We assure you that we’ve kept them to the minimum needed!)

EVENT (1). INVESTMENT OF CASH BY STOCKHOLDERS. On October 1, cash of $10,000 is invested in the business by investors in exchange for $10,000 of com- mon stock. This event is an accounting transaction that results in an increase in both assets and stockholders’ equity.

The equation is in balance after the issuance of common stock. Keeping track of the source of each change in stockholders’ equity is essential for later account- ing activities. In particular, items recorded in the revenue and expense columns are used for the calculation of net income.

EVENT (2). NOTE ISSUED IN EXCHANGE FOR CASH. On October 1, Sierra borrowed $5,000 from Castle Bank by signing a 3-month, 12%, $5,000 note payable. This transaction results in an equal increase in assets and liabilities. The specifi c effect of this transaction and the cumulative effect of the fi rst two transactions are as follows.

Basic Analysis

The asset Cash is increased $10,000; stockholders’ equity (specifically Common Stock) is increased $10,000.

Equation Analysis

Assets = Liabilities + Stockholders’ Equity Common Cash = Stock

(1) +$10,000 +$10,000 Issued stock

Using the Accounting Equation to Analyze Transactions 95

Total assets are now $15,000, and liabilities plus stockholders’ equity also total $15,000.

EVENT (3). PURCHASE OF EQUIPMENT FOR CASH. On October 2, Sierra purchased equipment by paying $5,000 cash to Superior Equipment Sales Co. This transac- tion results in an equal increase and decrease in Sierra’s assets.

The total assets are now $15,000, and liabilities plus stockholders’ equity also total $15,000.

EVENT (4). RECEIPT OF CASH IN ADVANCE FROM CUSTOMER. On October 2, Sierra received a $1,200 cash advance from R. Knox, a client. Sierra received cash (an asset) for guide services for multi-day trips that it expects to complete in the future. Although Sierra received cash, it does not record revenue until it has performed the work. In some industries, such as the magazine and airline industries, customers are expected to prepay. These companies have a liability to the customer until they deliver the magazines or provide the fl ight. When the company eventually provides the product or service, it records the revenue. Since Sierra received cash prior to performance of the service, Sierra has a liability for the work due.

Basic Analysis

Equation Analysis

The asset Cash is increased $5,000; the liability Notes Payable is increased $5,000.

� � � � � � � � � � � � � � � � � � � � �

Assets = Liabilities + Stockholders’ Equity Notes Common Cash = Payable + Stock

$10,000 $10,000 (2) +5,000 +$5,000 $15,000 = $5,000 + $10,000

$15,000

Basic Analysis The asset Equipment is increased $5,000; the asset Cash is decreased $5,000.

Equation Analysis

Assets = Liabilities + Stockholders’ Equity Notes Common Cash + Equipment = Payable + Stock

$15,000 $5,000 $10,000 (3) −5,000 +$5,000 $10,000 + $5,000 = $5,000 + $10,000

$15,000 $15,000

Basic Analysis

The asset Cash is increased $1,200; the liability Unearned Service Revenue is increased $1,200 because the service has not been performed yet. That is, when an advance payment is received, unearned revenue (a liability) should be recorded in order to recognize the obligation that exists.

Equation Analysis

Assets = Liabilities + Stockholders’ Equity Equip- Notes Unearned Service Common Cash + ment = Payable + Revenue + Stock $10,000 $5,000 $5,000 $10,000 (4) +1,200 +$1,200 $11,200 + $5,000 = $5,000 + $1,200 + $10,000

$16,200 $16,200

96 3 The Accounting Information System

EVENT (5). SERVICES PERFORMED FOR CASH. On October 3, Sierra received $10,000 in cash (an asset) from Copa Company for guide services performed for a cor- porate event. Guide service is the principal revenue-producing activity of Sierra. Revenue increases stockholders’ equity. This transaction, then, increases both assets and stockholders’ equity.

Often companies perform services “on account.” That is, they perform services for which they are paid at a later date. Revenue, however, is recorded when services are performed. Therefore, revenues would increase when services are performed, even though cash has not been received. Instead of receiving cash, the company receives a different type of asset, an account receivable. Accounts receivable represent the right to receive payment at a later date. Suppose that Sierra had performed these services on account rather than for cash. This event would be reported using the accounting equation as:

Assets = Liabilities + Stockholders’ Equity Accounts Receivable = Revenues +$10,000 +$10,000 Service Revenue

Assets = Liabilities + Stockholders’ Equity Accounts Cash Receivable

+$10,000 −$10,000

Later, when Sierra collects the $10,000 from the customer, Accounts Receivable decreases by $10,000, and Cash increases by $10,000.

Note that in this case, revenues are not affected by the collection of cash. Instead Sierra records an exchange of one asset (Accounts Receivable) for a different asset (Cash).

EVENT (6). PAYMENT OF RENT. On October 3, Sierra paid its offi ce rent for the month of October in cash, $900. This rent payment is a transaction that results in a decrease in an asset, cash. Rent is a cost incurred by Sierra in its effort to generate revenues. It is treated as an expense because it pertains only to the current month. Expenses decrease stockholders’ equity. Sierra records the rent payment by decreasing cash and increasing expenses to maintain the balance of the accounting equation.

Basic Analysis The asset Cash is increased $10,000; the revenue Service Revenue is increased $10,000.

Assets = Liabilities + Stockholders’ Equity Equip- Notes Unearned Common Retained Earnings Cash + ment = Pay. + Serv. Rev. + Stock + Rev. – Exp. – Div.

$11,200 $5,000 $5,000 $1,200 $10,000 (5) +10,000 +$10,000

$21,200 + $5,000 = $5,000 + $1,200 + $10,000 + $10,000

$26,200 $26,200

Service Revenue

Equation Analysis

Using the Accounting Equation to Analyze Transactions 97

EVENT (7). PURCHASE OF INSURANCE POLICY FOR CASH. On October 4, Sierra paid $600 for a one-year insurance policy that will expire next year on September 30. Payments of expenses that will benefi t more than one accounting period are iden- tifi ed as assets called prepaid expenses or prepayments.

The balance in total assets did not change; one asset account decreased by the same amount that another increased.

EVENT (8). PURCHASE OF SUPPLIES ON ACCOUNT. On October 5, Sierra purchased an estimated three months of supplies on account from Aero Supply for $2,500. In this case, “on account” means that the company receives goods or services that it will pay for at a later date. This transaction increases both an asset (supplies) and a liability (accounts payable).

Basic Analysis

The expense account Rent Expense is increased $900 because the payment pertains only to the current month; the asset Cash is decreased $900.

Assets = Liabilities + Stockholders’ Equity

Equip- Notes Unearned Common Retained Earnings Cash + ment = Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.

$21,200 $5,000 $5,000 $1,200 $10,000 $10,000 (6) −900 −$900

$20,300 + $5,000 = $5,000 + $1,200 + $10,000 + $10,000 − $900

$25,300 $25,300

Rent Expense

Equation Analysis

Basic Analysis The asset Cash is decreased $600; the asset Prepaid Insurance is increased $600.

Equation Analysis

Assets = Liabilities + Stockholders’ Equity

Prepaid Equip- Notes Unearned Common Retained Earnings Cash + Insurance + ment = Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.

$20,300 $5,000 $5,000 $1,200 $10,000 $10,000 $900 (7) −600 +$600

$19,700 + $600 + $5,000 = $5,000 + $1,200 + $10,000 + $10,000 − $900

$25,300 $25,300

Basic Analysis The asset Supplies is increased $2,500; the liability Accounts Payable is increased $2,500.

Assets = Liabilities + Stockholders’ Equity

Prepd. Equip- Notes Accounts Unearned Common Retained Earnings Cash + Supplies + Insur. + ment = Pay. + Payable + Serv. Rev. + Stock + Rev. − Exp. − Div.

$19,700 $600 $5,000 $5,000 $1,200 $10,000 $10,000 $900 (8) +$2,500 +$2,500

$19,700 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $900

$27,800 $27,800

Equation Analysis

98 3 The Accounting Information System

EVENT (9). HIRING OF NEW EMPLOYEES. On October 9, Sierra hired four new employees to begin work on October 15. Each employee will receive a weekly salary of $500 for a fi ve-day work week, payable every two weeks. Employees will receive their fi rst paychecks on October 26. On the date Sierra hires the employees, there is no effect on the accounting equation because the assets, liabilities, and stockholders’ equity of the company have not changed.

Basic Analysis

An accounting transaction has not occurred. There is only an agreement that the employees will begin work on October 15. (See Event (11) for the first payment.)

EVENT (10). PAYMENT OF DIVIDEND. On October 20, Sierra paid a $500 cash dividend. Dividends are a reduction of stockholders’ equity but not an expense. Dividends are not included in the calculation of net income. Instead, a dividend is a distribution of the company’s assets to its stockholders.

Basic Analysis The Dividends account is increased $500; the asset Cash is decreased $500.

Equation Analysis

Assets = Liabilities + Stockholders’ Equity

Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings Cash + plies + Insur. + ment = Pay. + Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.

$19,700 $2,500 $600 $5,000 $5,000 $2,500 $1,200 $10,000 $10,000 $900 (10) −500 − $500

$19,200 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $900 − $500

$27,300 $27,300

EVENT (11). PAYMENT OF CASH FOR EMPLOYEE SALARIES. Employees have worked two weeks, earning $4,000 in salaries, which were paid on October 26. Salaries and Wages Expense is an expense that reduces stockholders’ equity. In this transaction, both assets and stockholders’ equity are reduced.

Basic Analysis

The asset Cash is decreased $4,000; the expense account Salaries and Wages Expense is increased $4,000.

Equation Analysis

Assets = Liabilities + Stockholders’ Equity

Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings

Cash + plies + Insur. + ment = Pay. + Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.

$19,200 $2,500 $600 $5,000 $5,000 $2,500 $1,200 $10,000 $10,000 $ 900 $500

(11) −4,000 − 4,000 Sal./Wages

$15,200 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $4,900 − $500 Expense

$23,300 $23,300

Using the Accounting Equation to Analyze Transactions 99

SUMMARY OF TRANSACTIONS

Illustration 3-3 summarizes the transactions of Sierra Corporation to show their cumulative effect on the basic accounting equation. It includes the transaction number in the fi rst column on the left. The right-most column shows the specifi c effect of any transaction that affects stockholders’ equity. Remember that Event (9) did not result in a transaction, so no entry is included for that event. The illus- tration demonstrates three important points:

1. Each transaction is analyzed in terms of its effect on assets, liabilities, and stockholders’ equity.

2. The two sides of the equation must always be equal.

3. The cause of each change in stockholders’ equity must be indicated.

INVESTOR INSIGHT

Why Accuracy Matters

While most companies record trans- actions very carefully, the reality is that mistakes still happen. For example, bank regulators fi ned Bank One Corporation (now JPMorgan Chase) $1.8 million because they felt that the unreliability of the bank’s accounting system caused it to violate regulatory requirements.

Also, in recent years Fannie Mae, the government- chartered mortgage association, announced a series of large accounting errors. These announcements caused alarm among investors, regulators, and politicians because they feared that the errors might suggest larger, undetected problems. This was important because the home-mortgage

market depends on Fannie Mae to buy hundreds of billions of dollars of mortgages each year from banks, thus enabling the banks to issue new mortgages. Finally, before a major overhaul of its accounting system, the fi nancial records of Waste Management Company were in such disarray that of the company’s 57,000 employees, 10,000 were receiving pay slips that were in error. The Sarbanes-Oxley Act was created to minimize the occurrence of errors like these by increasing every employee’s responsibility for accurate fi nancial reporting.

In order for these companies to prepare and issue fi nancial statements, their accounting equations (debits and credits) must have been in balance at year-end. How could these errors or misstatements have occurred? (Go to WileyPLUS for this answer and additional questions.)

Assets = Liabilities + Stockholders’ Equity

Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings

Cash + plies + Insur. + ment = Pay. + Pay. + Serv. Rev. + Stock + Rev. − Exp. − Div.

(1) +$10,000 = +$10,000 Issued stock (2) +5,000 +$5,000 (3) −5,000 +$5,000 (4) +1,200 +$1,200 (5) +10,000 +$10,000 Service Revenue (6) −900 −$ 900 Rent Expense (7) −600 +$600 (8) +$2,500 + $2,500 (10) −500 −$500 Dividends (11) −4,000 −4,000 Sal./Wages Expense $15,200 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $4,900 − $500

$23,300 $23,300

ILLUSTRATION 3-3 Summary of transactions

100 3 The Accounting Information System

SOLUTION 1. The company issued shares of stock to stockholders for $25,000 cash.

2. The company purchased $7,000 of equipment on account.

3. The company received $8,000 of cash in exchange for services performed.

4. The company paid $850 for this month’s rent.

1▼ Transaction AnalysisDO IT! A tabular analysis of the transactions made by Roberta Mendez & Co., a certifi ed public accounting fi rm, for the month of August is shown below. Each increase and decrease in stockholders’ equity is explained.

Assets = Liabilities + Stockholders’ Equity Accounts Common Retained Earnings Cash + Equipment = Payable + Stock + Revenue − Expenses

1. +$25,000 +$25,000 Issued stock 2. +$7,000 = +$7,000 3. +8,000 +$8,000 Service Revenue 4. −850 −$850 Rent Expense $32,150 + $7,000 = $7,000 + $25,000 + $8,000 − $850

$39,150 $39,150

Describe each transaction that occurred for the month.Action Plan ✔ Analyze the tabular

analysis to determine the nature and effect of each transaction.

✔ Keep the accounting equation in balance.

✔ Remember that a change in an asset will require a change in another asset, a liability, or in stockholders’ equity. Related exercise material: BE3-1, BE3-2, BE3-3, DO IT! 3-1, E3-1, E3-2, E3-3, and E3-4.

LEARNING OBJECTIVE 2 Explain how accounts, debits, and credits are used to record business transactions.▼

Rather than using a tabular summary like the one in Illustration 3-3 for Sierra Corporation, an accounting information system uses accounts. An account is an individual accounting record of increases and decreases in a specifi c asset, liability, stockholders’ equity, revenue, or expense item. For example, Sierra Cor- poration has separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries and Wages Expense, and so on. (Note that whenever we are referring to a specifi c account, we capitalize the name.) In its simplest form, an account consists of three parts: (1) the title of the account, (2) a left or debit side, and (3) a right or credit side. Because the align- ment of these parts of an account resembles the letter T, it is referred to as a T-account. The basic form of an account is shown in Illustration 3-4.

Title of Account

Left or debit side Right or credit side

ILLUSTRATION 3-4 Basic form of account

Accounts, Debits, and Credits 101

We use this form of account often throughout this textbook to explain basic accounting relationships.

DEBITS AND CREDITS

The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease, as is commonly thought. We use the terms debit and credit repeatedly in the recording process to describe where entries are made in accounts. For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account. When comparing the totals of the two sides, an account shows a debit bal- ance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits. Note the position of the debit side and credit side in Illustration 3-4. The procedure of recording debits and credits in an account is shown in Illustra- tion 3-5 for the transactions affecting the Cash account of Sierra Corporation. The data are taken from the Cash column of the tabular summary in Illustration 3-3.

$10,000 5,000

–5,000 1,200

10,000 –900 –600 –500

–4,000

5,000 900 600 500

4,000

10,000 5,000 1,200

10,000

(Debits)

(Debit) Balance

(Credits) Cash Cash

$15,200

15,200

Account FormTabular Summary ILLUSTRATION 3-5 Tabular summary and account form for Sierra Corporation’s Cash account

Every positive item in the tabular summary represents a receipt of cash; every negative amount represents a payment of cash. Notice that in the account form, we record the increases in cash as debits and the decreases in cash as credits. For example, the $10,000 receipt of cash (in blue) is debited to Cash, and the −$5,000 payment of cash (in red) is credited to Cash. Having increases on one side and decreases on the other reduces recording errors and helps in determining the totals of each side of the account as well as the account balance. The balance is determined by netting the two sides (subtracting one amount from the other). The account balance, a debit of $15,200, indicates that Sierra had $15,200 more increases than decreases in cash. That is, since it started with a balance of zero, it has $15,200 in its Cash account.

DEBIT AND CREDIT PROCEDURES

Each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits. The equality of debits and credits provides the basis for the double-entry accounting system. Under the double-entry system, the two-sided effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. The double-entry system also helps to ensure the accuracy of the recorded amounts and helps to detect errors such as those at MF Global as discussed in the Feature Story. If every transaction is recorded with equal debits

INTERNATIONAL NOTE Rules for accounting for specifi c events sometimes differ across countries. For example, European 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.

102 3 The Accounting Information System

and credits, then the sum of all the debits to the accounts must equal the sum of all the credits. The double-entry system for determining the equality of the accounting equation is much more effi cient than the plus/minus procedure used earlier.

Dr./Cr. Procedures for Assets and Liabilities In Illustration 3-5 for Sierra Corporation, increases in Cash—an asset—are entered on the left side, and decreases in Cash are entered on the right side. We know that both sides of the basic equation (Assets = Liabilities + Stockholders’ Equity) must be equal. It therefore follows that increases and decreases in liabili- ties have to be recorded opposite from increases and decreases in assets. Thus, increases in liabilities are entered on the right or credit side, and decreases in liabilities are entered on the left or debit side. The effects that debits and credits have on assets and liabilities are summarized in Illustration 3-6.

Debits Credits

Increase assets Decrease assets Decrease liabilities Increase liabilities

ILLUSTRATION 3-6 Debit and credit effects–assets and liabilities

Asset accounts normally show debit balances. That is, debits to a specifi c asset account should exceed credits to that account. Likewise, liability accounts normally show credit balances. That is, credits to a liability account should exceed debits to that account. The normal balances may be diagrammed as in Illustration 3-7.

Debit for increase

Assets Credit for decrease

Normal balance Normal balance

Debit for decrease

Liabilities Credit for increase Normal balance Normal balance

ILLUSTRATION 3-7 Normal balances–assets and liabilities

Knowing which is the normal balance in an account may help when you are trying to identify errors. For example, a credit balance in an asset account, such as Land, or a debit balance in a liability account, such as Salaries and Wages Pay- able, usually indicates errors in recording. Occasionally, however, an abnormal balance may be correct. The Cash account, for example, will have a credit balance when a company has overdrawn its bank balance by spending more than it has in its account. In automated accounting systems, the computer is programmed to fl ag violations of the normal balance and to print out error or exception reports. In manual systems, careful visual inspection of the accounts is required to detect normal balance problems.

Dr./Cr. Procedures for Stockholders’ Equity In Chapter 1, we indicated that stockholders’ equity is comprised of two parts: common stock and retained earnings. In the transaction events earlier in this chapter, you saw that revenues, expenses, and the payment of dividends affect retained earnings. Therefore, the subdivisions of stockholders’ equity are com- mon stock, retained earnings, dividends, revenues, and expenses.

COMMON STOCK Common stock is issued to investors in exchange for the stock- holders’ investment. The Common Stock account is increased by credits and

▼ HELPFUL HINT The normal balance is the side where increases in the account are recorded.

Accounts, Debits, and Credits 103

decreased by debits. For example, when cash is invested in the business, Cash is debited and Common Stock is credited. The effects of debits and credits on the Common Stock account are shown in Illustration 3-8.

Debits Credits

Decrease Common Stock Increase Common Stock

ILLUSTRATION 3-8 Debit and credit effects– common stock

Debits Credits

Decrease Retained Earnings Increase Retained Earnings

ILLUSTRATION 3-10 Debit and credit effects– retained earnings

The normal balance in the Common Stock account may be diagrammed as in Illustration 3-9.

Debit for decrease

Common Stock Credit for increase Normal balance Normal balance

ILLUSTRATION 3-9 Normal balance–common stock

RETAINED EARNINGS Retained earnings is net income that is retained in the busi- ness. It represents the portion of stockholders’ equity that has been accumulated through the profi table operation of the company. Retained Earnings is increased by credits (for example, by net income) and decreased by debits (for example, by a net loss), as shown in Illustration 3-10.

The normal balance for the Retained Earnings account may be diagrammed as in Illustration 3-11.

Debit for decrease

Retained Earnings Credit for increase Normal balance Normal balance

ILLUSTRATION 3-11 Normal balance–retained earnings

DIVIDENDS A dividend is a distribution by a corporation to its stockholders. The most common form of distribution is a cash dividend. Dividends result in a reduc- tion of the stockholders’ claims on retained earnings. Because dividends reduce stockholders’ equity, increases in the Dividends account are recorded with debits. As shown in Illustration 3-12, the Dividends account normally has a debit balance.

Debit for increase

Dividends Credit for decrease

Normal balance Normal balance

ILLUSTRATION 3-12 Normal balance–dividends

104 3 The Accounting Information System

REVENUES AND EXPENSES When a company recognizes revenues, stockholders’ equity is increased. Revenue accounts are increased by credits and decreased by debits. Expenses decrease stockholders’ equity. Thus, expense accounts are increased by debits and decreased by credits. The effects of debits and credits on revenues and expenses are shown in Illustration 3-13.

Debits Credits

Decrease revenue Increase revenue Increase expenses Decrease expenses

ILLUSTRATION 3-13 Debit and credit effects– revenues and expenses

Credits to revenue accounts should exceed debits; debits to expense accounts should exceed credits. Thus, revenue accounts normally show credit balances, and expense accounts normally show debit balances. The normal balances may be diagrammed as in Illustration 3-14.

Debit for increase

Expenses Credit for decrease

Debit for decrease

Revenues Credit for increase Normal balance Normal balance

Normal balance Normal balance

ILLUSTRATION 3-14 Normal balances–revenues and expenses

INVESTOR INSIGHT Chicago Cubs

Keeping Score

The Chicago Cubs baseball team has these major revenue and expense accounts: Revenues Expenses Admissions (ticket sales) Players’ salaries Concessions Administrative salaries Television and radio Travel Advertising Ballpark maintenance

Do you think that the Chicago Bears football team would be likely to have the same major revenue and expense accounts as the Cubs? (Go to WileyPLUS for this answer and additional questions.)

STOCKHOLDERS’ EQUITY RELATIONSHIPS

Companies report the subdivisions of stockholders’ equity in various places in the fi nancial statements:

• Common stock and retained earnings: in the stockholders’ equity section of the balance sheet.

• Dividends: on the retained earnings statement.

• Revenues and expenses: on the income statement.

Dividends, revenues, and expenses are eventually transferred to retained earn- ings at the end of the period. As a result, a change in any one of these three items affects stockholders’ equity. Illustration 3-15 shows the relationships of the accounts affecting stockholders’ equity.

Accounts, Debits, and Credits 105

SUMMARY OF DEBIT/CREDIT RULES

Illustration 3-16 summarizes the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the funda- mentals of the double-entry system. No matter what the transaction, total debits must equal total credits in order to keep the accounting equation in balance.

Income Statement

Revenues

Less: Expenses Net income or net loss

Retained Earnings Statement

Beginning retained earnings

Add: Net income

Less: Dividends Ending retained earnings

Balance Sheet

Assets

Liabilities

Stockholders’ equity Common stock Retained earnings

Investments by stockholders

Net income retained in the business

ILLUSTRATION 3-15 Stockholders’ equity relationships

Assets Stockholders’ Equity+Basic Equation

Expanded Basic Equation

Debit / Credit Rules

Liabilities=

= + + –

Dr. +

Assets

Cr. –

Dr. –

Liabilities

Cr. +

Dr. –

Retained Earnings

Cr. +

–

Dr. +

Dividends

Cr. –

Dr. –

Revenues

Cr. +

Dr. +

Expenses

Cr. –

Dr. –

Common Stock

Cr. +

ILLUSTRATION 3-16 Summary of debit/credit rules

2▼ Debits and Credits for Balance Sheet AccountsDO IT! Kate Browne, president of Hair It Is Inc., has just rented space in a shopping mall for the purpose of opening and operating a beauty salon. Long before opening day and before purchasing equipment, hiring assistants, and remodeling the space, Kate was strongly advised to set up a double-entry set of accounting records in which to record all of her business transactions. Identify the balance sheet accounts that Hair It Is Inc. will likely need to record the transactions necessary to establish and open for business. Also, indicate whether the normal balance of each account is a debit or a credit.

Action Plan ✔ First identify asset

accounts for each different type of asset invested in the business.

✔ Then identify liability accounts for debts incurred by the business.

106 3 The Accounting Information System

SOLUTION Hair It Is Inc. would likely need the following accounts in which to record the transactions necessary to establish and ready the beauty salon for opening day: Cash (debit balance); Equipment (debit balance); Supplies (debit balance); Accounts Payable (credit balance); Notes Payable (credit balance), if the business borrows money; and Common Stock (credit balance).

Related exercise material: BE3-4, BE3-5, DO IT! 3-2, E3-6, E3-7, and E3-8.

Action Plan (cont.) ✔ Hair It Is Inc. needs only

one stockholders’ equity account, Common Stock, when it begins the business. The other stockholders’ equity account, Retained Earnings, will be needed after the business is operating.

THE RECORDING PROCESS

Although it is possible to enter transaction information directly into the accounts, few businesses do so. Practically every business uses these basic steps in the recording process (an integral part of the accounting cycle):

1. Analyze each transaction in terms of its effect on the accounts.

2. Enter the transaction information in a journal.

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

The actual sequence of events begins with the transaction. Evidence of the transaction comes in the form of a source document, such as a sales slip, a check, a bill, or a cash register document. This evidence is analyzed to determine the effect of the transaction on specifi c accounts. The transaction is then entered in the journal. Finally, the journal entry is transferred to the designated accounts in the ledger. The sequence of events in the recording process is shown in Illustration 3-17.

ANALYZE POST TRIAL

BALANCE

ADJUSTING ENTRIES

ADJUSTED TRIAL

BALANCE

FINANCIAL STATEMENTS

CLOSING ENTRIES

POST-CLOSING TRIAL BALANCE

Journalize the transactions

Indicate how a journal is used in the recording process. LEARNING OBJECTIVE 3▼

THE JOURNAL

Transactions are initially recorded in chronological order in a journal before they are transferred to the accounts. For each transaction, the journal shows the debit and credit effects on specifi c accounts. (In a computerized system, journals are kept as fi les, and accounts are recorded in computer databases.)

ILLUSTRATION 3-17 The recording process

Superior Equipment Sales

9/26/20XX

Bill to: Sierra Corporation

Description Purchase of Equipment for $5,000

INVOICE

Date Account Titles and Explanation Debit Credit

20XX Oct. 2 Equipment Cash (Purchased Equ

GENERAL JOURNAL

2. Enter transaction

3. Transfer from journal to ledger

1. Analyze transaction

Cash Equipment

Oct. 1 10,000 Oct. 2 5,000 Oct 2. 5,000 2 5,000 Bal. 5,000

GENERAL LEDGER

Using a Journal 107

Companies may use various kinds of journals, but every company has at least the most basic form of journal, a general journal. The journal makes three signifi cant contributions to the recording process:

1. It discloses in one place the complete effect of a transaction.

2. It provides a chronological record of transactions.

3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be readily compared.

Entering transaction data in the journal is known as journalizing. To illus- trate the technique of journalizing, let’s look at the fi rst three transactions of Sierra Corporation in equation form.

On October 1, Sierra issued common stock in exchange for $10,000 cash:

Assets = Liabilities + Stockholders’ Equity Common Cash = Stock

+$10,000 +$10,000 Issued stock

Assets = Liabilities + Stockholders’ Equity Notes Cash = Payable

+$5,000 +$5,000

On October 1, Sierra borrowed $5,000 by signing a note:

On October 2, Sierra purchased equipment for $5,000:

Assets = Liabilities + Stockholders’ Equity Cash Equipment

−$5,000 +$5,000

Sierra makes separate journal entries for each transaction. A complete entry consists of (1) the date of the transaction, (2) the accounts and amounts to be debited and credited, and (3) a brief explanation of the transaction. These trans- actions are journalized in Illustration 3-18.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2017

Oct. 1 Cash 10,000 Common Stock 10,000 (Issued stock for cash)

1 Cash 5,000 Notes Payable 5,000

(Issued 3-month, 12% note payable for cash)

2 Equipment 5,000 Cash 5,000

(Purchased equipment for cash)

ILLUSTRATION 3-18 Recording transactions in journal form

ETHICS NOTE Business documents provide evidence that transactions actually occurred. International Outsourcing Services, LLC was accused of submitting fraudulent documents (store coupons) to companies such as Kraft Foods and PepsiCo for reimbursement of as much as $250 million. Use of proper business documents reduces the likelihood of fraudulent activity.

▼

108 3 The Accounting Information System

Note the following features of the journal entries.

1. The date of the transaction is entered in the Date column.

2. The account to be debited is entered fi rst at the left. The account to be credited is then entered on the next line, indented under the line above. The indentation differentiates debits from credits and decreases the possibility of switching the debit and credit amounts.

3. The amounts for the debits are recorded in the Debit (left) column, and the amounts for the credits are recorded in the Credit (right) column.

4. A brief explanation of the transaction is given.

It is important to use correct and specifi c account titles in journalizing. Erroneous account titles lead to incorrect fi nancial statements. Some fl exibility exists initially in selecting account titles. The main criterion is that each title must appropriately describe the content of the account. For example, a company could use any of these account titles for recording the cost of delivery trucks: Equipment, Delivery Equipment, Delivery Trucks, or Trucks. Once the company chooses the specifi c title to use, however, it should record under that account title all subsequent transactions involving the account.

3▼ Journal EntriesDO IT! The following events occurred during the fi rst month of business of Hair It Is Inc., Kate Browne’s beauty salon:

1. Issued common stock to shareholders in exchange for $20,000 cash.

2. Purchased $4,800 of equipment on account (to be paid in 30 days).

3. Interviewed three people for the position of stylist.

Prepare the entries to record the transactions.

ACCOUNTING ACROSS THE ORGANIZATION Microsoft

Boosting Profi ts

Microsoft originally designed the Xbox 360 to have 256 megabytes of memory. But the design department said that amount of memory wouldn’t support the best special effects. The purchasing department said that adding more memory would cost $30— which was 10% of the estimated selling price of $300. The marketing department, how- ever, “determined that adding the memory would let Microsoft reduce marketing costs and attract more game developers, boost- ing royalty revenue. It would also extend the life of the console, generating more sales.”

As a result of these changes, Xbox en- joyed great success. But, it does have com- petitors. Its newest video game console, Xbox One, is now in a battle with Sony’s

Playstation4 for market share. How to compete? First, Micro- soft bundled the critically acclaimed Titanfall with its Xbox One. By including the game most Xbox One buyers were going to purchase anyway, Microsoft was making its console more attractive. In addition, retailers are also discounting the Xbox, which should get the momentum going for increased sales. What Microsoft is doing is making sure that Xbox One is the center of the home entertainment system in the long run.

Sources: Robert A. Guth, “New Xbox Aim for Microsoft: Profi t- ability,” Wall Street Journal (May 24, 2005), p. C1; and David Thier, “Will Microsoft Give the Xbox One a $50 Price Cut? www.Forbes. com (March 26, 2014).

In what ways is this Microsoft division using accounting to assist in its effort to become more profi table? (Go to WileyPLUS for this answer and additional questions.)

The Ledger and Posting 109

SOLUTION The three activities are recorded as follows.

1. Cash 20,000 Common Stock 20,000 (Issued stock for cash)

2. Equipment 4,800 Accounts Payable 4,800 (Purchased equipment on account)

3. No entry because no transaction occurred.

Action Plan ✔ Make sure to provide a

complete and accurate representation of the transactions’ effects on the assets, liabilities, and stockholders’ equity of the business.

Related exercise material: BE3-6, BE3-9, DO IT! 3-3, E3-7, E3-9, E3-10, E3-11, and E3-12.

LEARNING OBJECTIVE 4 Explain how a ledger and posting help in the recording process.▼

THE LEDGER

The entire group of accounts maintained by a company is referred to collectively as the ledger. The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances. Companies may use various kinds of ledgers, but every company has a general ledger. A general ledger contains all the asset, liability, stockholders’ equity, rev- enue, and expense accounts, as shown in Illustration 3-19. Whenever we use the term ledger in this textbook without additional specifi cation, it will mean the general ledger.

ANALYZE JOURNALIZE TRIAL

BALANCE

ADJUSTING ENTRIES

ADJUSTED TRIAL

BALANCE

FINANCIAL STATEMENTS

CLOSING ENTRIES

POST-CLOSING TRIAL BALANCE

E BBA

Post to ledger accounts

Equipment Land

Supplies

Cash

Interest Payable Salaries and Wages

Payable Accounts Payable

Notes Payable

Salaries and Wages Expense

Service Revenue Dividends

Retained Earnings

Common Stock

Asset Accounts

Liability Accounts

Stockholders’ Equity Accounts

ILLUSTRATION 3-19 The general ledger

CHART OF ACCOUNTS

The number and type of accounts used differ for each company, depending on the size, complexity, and type of business. For example, the number of accounts depends on the amount of detail desired by management. The management of one company may want one single account for all types of utility expense. Another may keep separate expense accounts for each type of utility expenditure,

110 3 The Accounting Information System

such as gas, electricity, and water. A small corporation like Sierra Corpora- tion will not have many accounts compared with a corporate giant like Ford Motor Company. Sierra may be able to manage and report its activities in 20 to 30 accounts, whereas Ford requires thousands of accounts to keep track of its worldwide activities. Most companies list the accounts in a chart of accounts. They may create new accounts as needed during the life of the business. Illustration 3-20 shows the chart of accounts for Sierra in the order that they are typically listed (assets, liabilities, stockholders’ equity, revenues, and expenses). Accounts shown in red are used in this chapter; accounts shown in black are explained in later chapters.ILLUSTRATION 3-20

Chart of accounts for Sierra Corporation

SIERRA CORPORATION Chart of Accounts

Stockholders’ Assets Liabilities Equity Revenues Expenses

Cash Notes Payable Common Stock Service Revenue Salaries and Wages Accounts Receivable Accounts Payable Retained Earnings Expense Supplies Interest Payable Dividends Supplies Expense Prepaid Insurance Unearned Income Summary Rent Expense Equipment Service Revenue Insurance Expense Accumulated Depreciation— Salaries and Wages Interest Expense Equipment Payable Depreciation Expense

POSTING

The procedure of transferring journal entry amounts to ledger accounts is called posting. This phase of the recording process accumulates the effects of jour- nalized transactions in the individual accounts. Posting involves these steps:

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

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

A Convenient Overstatement

Sometimes a company’s invest- ment securities suffer a perma- nent decline in value below their original cost. When this occurs, the company is supposed to reduce the recorded value of the securi- ties on its balance sheet (“write them down” in common fi nancial lingo) and record a loss. It appears, however, that during the fi nancial crisis of 2008, employees at some

fi nancial institutions chose to look the other way as the value of their investments skidded. A number of Wall Street traders that worked for the investment bank Credit Suisse Group were charged with

intentionally overstating the value of securities that had suf- fered declines of approximately $2.85 billion. One reason that they may have been reluctant to record the losses is out of fear that the company’s shareholders and clients would panic if they saw the magnitude of the losses. However, personal self-interest might have been equally to blame—the bonuses of the traders were tied to the value of the investment securities.

Source: S. Pulliam, J. Eaglesham, and M. Siconolfi , “U.S. Plans Changes on Bond Fraud,” Wall Street Journal Online (February 1, 2012).

What incentives might employees have had to overstate the value of these investment securities on the company’s fi nancial statements? (Go to WileyPLUS for this answer and additional questions.)

ETHICS INSIGHT Credit Suisse Group

The Ledger and Posting 111

THE RECORDING PROCESS ILLUSTRATED

Illustrations 3-21 through 3-31 on the following pages show the basic steps in the recording process using the October transactions of Sierra Corporation. Sierra’s accounting period is a month. A basic analysis and a debit–credit analysis pre- cede the journalizing and posting of each transaction. Study these transaction analyses carefully. The purpose of transaction analysis is fi rst to identify the type of account involved and then to determine whether a debit or a credit to the account 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 to be described in later chapters.

Debit–Credit Analysis

Debits increase assets: debit Cash $10,000. Credits increase stockholders’ equity: credit Common Stock $10,000.

Journal Entry

Posting Oct. 1 10,000

Cash Common Stock

Oct. 1 Cash Common Stock (Issued stock for cash)

10,000 10,000

On October 1, stockholders invest $10,000 cash in an outdoor guide service company to be known as Sierra Corporation.

Basic Analysis

Equation Analysis

The asset Cash is increased $10,000; stockholders’ equity (specifically Common Stock) is increased $10,000.

Assets

Cash

+$10,000(1)

+Liabilities Stockholders’ Equity Common

Stock

+$10,000 Issued stock

Event 1

Oct. 1 10,000

ILLUSTRATION 3-21 Investment of cash by stockholders

Cash Flows +10,000

Cash fl ow analyses show the impact of each transaction on cash.

112 3 The Accounting Information System

Equation Analysis

On October 1, Sierra borrows cash of $5,000 by signing a 3-month, 12%, $5,000 note payable.

Basic Analysis

The asset Cash is increased $5,000; the liability Notes Payable is increased $5,000.

Debit–Credit Analysis

Debits increase assets: debit Cash $5,000. Credits increase liabilities: credit Notes Payable $5,000.

Journal Entry

Cash

Oct. 1 5,000

Notes Payable Posting

Oct. 1 Cash Notes Payable (Issued 3-month, 12% note payable for cash)

5,000 5,000

Oct. 1 10,000 1 5,000

Assets

Cash

+$5,000(2)

+Liabilities Stockholders’ Equity Notes Payable

+$5,000

Event 2

ILLUSTRATION 3-22 Issue of note payable

Cash Flows +5,000

Equation Analysis

On October 2, Sierra used $5,000 cash to purchase equipment.

Basic Analysis

Debit–Credit Analysis

Debits increase assets: debit Equipment $5,000. Credits decrease assets: credit Cash $5,000.

The asset Equipment is increased $5,000; the asset Cash is decreased $5,000.

Journal Entry

Posting Cash Equipment

Oct. 2 Equipment Cash (Purchased equipment for cash)

5,000 5,000

Oct. 1 10,000 1 5,000

Oct. 2 5,000

+$5,000

Assets

Cash +

–$5,000(3)

= +Liabilities Stockholders’

Equity

Equipment

Oct. 2 5,000

Event 3

ILLUSTRATION 3-23 Purchase of equipment

Cash Flows −5,000

The Ledger and Posting 113

Equation Analysis

On October 2, Sierra received a $1,200 cash advance from R. Knox, a client, for guide services for multi-day trips that are expected to be completed in the future.

Basic Analysis

Debit–Credit Analysis

Debits increase assets: debit Cash $1,200. Credits increase liabilities: credit Unearned Service Revenue $1,200.

Journal Entry

Posting Oct. 1 10,000 1 5,000 2 1,200

Cash Oct. 2 1,200Oct. 2 5,000

Unearned Service Revenue

Oct. 2 Cash Unearned Service Revenue (Received advance from R. Knox for future services)

1,200 1,200

Assets

Cash

+$1,200(4)

+Liabilities Stockholders’ Equity Unearned Serv. Rev.

+$1,200

Event 4 ILLUSTRATION 3-24 Receipt of cash in advance from customer

Equation Analysis

On October 3, Sierra received $10,000 in cash from Copa Company for guide services performed in October.

Basic Analysis

The asset Cash is increased $10,000; the revenue Service Revenue is increased $10,000.

Debit–Credit Analysis

Debits increase assets: debit Cash $10,000. Credits increase revenues: credit Service Revenue $10,000.

Journal Entry

Posting Oct. 3 10,000

Service RevenueCash

Oct. 2 5,000

Oct. 3 Cash Service Revenue (Received cash for services performed)

10,000 10,000

Assets

Cash

+$10,000(5)

+Liabilities Stockholders’ Equity

Revenues

+$10,000 Service Revenue

Event 5

Oct. 1 10,000 1 5,000 2 1,200 3 10,000

ILLUSTRATION 3-25 Services performed for cash

Cash Flows +1,200

Cash Flows +10,000

▼ HELPFUL HINT Many liabilities have the word “payable” in their title. But, note that Unearned Service Revenue is considered a liability even though the word payable is not used.

114 3 The Accounting Information System

Equation Analysis

Debit–Credit Analysis

Debits increase expenses: debit Rent Expense $900. Credits decrease assets: credit Cash $900.

On October 3, Sierra paid office rent for October in cash, $900.

Basic Analysis

The expense account Rent Expense is increased $900 because the payment pertains only to the current month; the asset Cash is decreased $900.

Journal Entry

Posting

Rent Expense

Oct. 3 Rent Expense Cash (Paid cash for October office rent)

900 900

Oct. 3 900Oct. 1 10,000 1 5,000 2 1,200 3 10,000

Cash

Oct. 2 5,000 3 900

Assets

Cash

–$900(6)

+Liabilities Stockholders’ Equity

Expenses

–$900 Rent Expense

Event 6 ILLUSTRATION 3-26 Payment of rent with cash

Equation Analysis

Posting Oct. 1 10,000 1 5,000 2 1,200 3 10,000

Cash

Oct. 2 5,000 3 900 4 600

Debit–Credit Analysis

Debits increase assets: debit Prepaid Insurance $600. Credits decrease assets: credit Cash $600.

On October 4, Sierra paid $600 for a 1-year insurance policy that will expire next year on September 30.

Basic Analysis

The asset Cash is decreased $600. Payments of expenses that will benefit more than one accounting period are identified as prepaid expenses or prepayments. When a payment is made, an asset account is debited in order to show the service or benefit that will be received in the future. Therefore, the asset Prepaid Insurance is increased $600.

Journal Entry

Oct. 4 600

Prepaid Insurance

Oct. 4 Prepaid Insurance Cash (Paid 1-year policy; effective date October 1)

600 600

+$600

Assets

Cash +

–$600(7)

= +Liabilities Stockholders’

Equity Prepaid

Insurance

Event 7 ILLUSTRATION 3-27 Purchase of insurance policy with cash

Cash Flows −900

Cash Flows −600

The Ledger and Posting 115

Equation Analysis

Debit–Credit Analysis

Debits increase assets: debit Supplies $2,500. Credits increase liabilities: credit Accounts Payable $2,500.

On October 5, Sierra purchased an estimated 3 months of supplies on account from Aero Supply for $2,500.

Basic Analysis

The asset Supplies is increased $2,500; the liability Accounts Payable is increased $2,500.

Journal Entry

Posting Oct. 5 2,500

Supplies

Oct. 5 2,500

Accounts Payable

Oct. 5 Supplies Accounts Payable (Purchased supplies on account from Aero Supply)

2,500 2,500

Assets

Supplies

+$2,500(8)

+Liabilities Stockholders’ Equity Accounts Payable

+$2,500

Event 8

ILLUSTRATION 3-28 Purchase of supplies on account

Cash Flows no eff ect

On October 9, Sierra hired four employees to begin work on October 15. Each employee will receive a weekly salary of $500 for a 5-day work week, payable every 2 weeks—first payment made on October 26.

Basic Analysis

An accounting transaction has not occurred. There is only an agreement that the employees will begin work on October 15. Thus, a debit–credit analysis is not needed because there is no accounting entry. (See transaction of October 26 (Event II) for first payment.)

Event 9

ILLUSTRATION 3-29 Hiring of new employees

116 3 The Accounting Information System

Equation Analysis

Posting Oct. 1 10,000

1 5,000 2 1,200 3 10,000

Cash

Oct. 2 5,000 3 900 4 600

20 500

Oct. 20 500

Dividends

Debit–Credit Analysis

Debits increase dividends: debit Dividends $500. Credits decrease assets: credit Cash $500.

On October 20, Sierra paid a $500 cash dividend to stockholders.

Basic Analysis

The Dividends account is increased $500; the asset Cash is decreased $500.

Journal Entry

Oct. 20 Dividends Cash (Declared and paid a cash dividend)

500 500

Assets

Cash

–$500(10)

+Liabilities Stockholders’ Equity

Dividends

–$500

Event 10 ILLUSTRATION 3-30 Payment of dividend

Equation Analysis

Debit–Credit Analysis

Debits increase expenses: debit Salaries and Wages Expense $4,000. Credits decrease assets: credit Cash $4,000.

On October 26, Sierra paid employee salaries of $4,000 in cash. (See October 9 event.)

Basic Analysis

The expense account Salaries and Wages Expense is increased $4,000; the asset Cash is decreased $4,000.

Journal Entry

Posting

Oct. 26 Salaries and Wages Expense Cash (Paid salaries to date)

4,000 4,000

Cash

Oct. 26 4,000

Salaries and Wages Expense

Oct. 1 10,000 1 5,000 2 1,200 3 10,000

Oct. 2 5,000 3 900 4 600

20 500 26 4,000

Assets

Cash

–$4,000(11)

= =

+Liabilities Stockholders’ Equity

Expenses

–$4,000 Salaries and Wages Expense

Event 11 ILLUSTRATION 3-31 Payment of cash for employee salaries

Cash Flows −500

Cash Flows −4,000

The Ledger and Posting 117

SUMMARY ILLUSTRATION OF JOURNALIZING AND POSTING

The journal for Sierra Corporation for the month of October is summarized in Illustration 3-32. The ledger is shown in Illustration 3-33 (on page 118) with all balances highlighted in red.

ILLUSTRATION 3-32 General journal for Sierra Corporation

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2017

Oct. 1 Cash 10,000 Common Stock 10,000 (Issued stock for cash)

1 Cash 5,000 Notes Payable 5,000 (Issued 3-month, 12% note payable for cash)

2 Equipment 5,000 Cash 5,000 (Purchased equipment for cash)

2 Cash 1,200 Unearned Service Revenue 1,200 (Received advance from R. Knox for future service)

3 Cash 10,000 Service Revenue 10,000 (Received cash for services performed)

3 Rent Expense 900 Cash 900 (Paid cash for October offi ce rent)

4 Prepaid Insurance 600 Cash 600 (Paid 1-year policy; effective date October 1)

5 Supplies 2,500 Accounts Payable 2,500 (Purchased supplies on account from Aero Supply)

20 Dividends 500 Cash 500 (Declared and paid a cash dividend)

26 Salaries and Wages Expense 4,000 Cash 4,000 (Paid salaries to date)

118 3 The Accounting Information System

SOLUTION

4▼ PostingDO IT! Selected transactions from the journal of Faital Inc. during its fi rst month of operations are presented below. Post these transactions to T-accounts.

Action Plan ✔ Journalize transactions

to keep track of fi nan- cial activities (receipts, payments, receivables, payables, etc.).

✔ To make entries useful, classify and summarize them by posting the entries to specifi c ledger accounts.

Related exercise material: BE3-10, DO IT! 3-4, and E3-14.

Date Account Titles Debit Credit

July 1 Cash 30,000 Common Stock 30,000

9 Accounts Receivable 6,000 Service Revenue 6,000

24 Cash 4,000 Accounts Receivable 4,000

Cash

July 1 30,000 24 4,000

Common Stock

July 1 30,000

Accounts Receivable

July 9 6,000 July 24 4,000

Service Revenue

July 9 6,000

ILLUSTRATION 3-33 General ledger for Sierra Corporation

Supplies

Oct. 5 2,500

Bal. 2,500

Prepaid Insurance

Oct. 4 600

Bal. 600

Equipment

Oct. 2 5,000

Bal. 5,000

Notes Payable

Oct. 1 5,000

Bal. 5,000

Accounts Payable

Oct. 5 2,500

Bal. 2,500

Common Stock

Oct. 1 10,000

Bal. 10,000

Dividends

Oct. 20 500

Bal. 500

Service Revenue

Oct. 3 10,000

Bal. 10,000

Salaries and Wages Expense

Oct. 26 4,000

Bal. 4,000

Rent Expense

Oct. 3 900

Bal. 900

GENERAL LEDGER

Cash

Oct. 1 10,000 Oct. 2 5,000 1 5,000 3 900 2 1,200 4 600 3 10,000 20 500 26 4,000

Bal. 15,200

Unearned Service Revenue

Oct. 2 1,200

Bal. 1,200

The Trial Balance 119

A trial balance lists accounts and their balances at a given time. A company usually prepares a trial balance at the end of an accounting period. The accounts are listed in the order in which they appear in the ledger. Debit balances are listed in the left column and credit balances in the right column. The totals of the two columns must be equal.

The trial balance proves the mathematical equality of debits and cred- its after posting. 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 may also uncover errors in journalizing and posting. For example, a trial balance may well have detected the error at MF Global discussed in the Feature Story. In addition, a trial balance is useful in the preparation of fi nancial statements. These are the procedures for preparing a trial balance:

1. List the account titles and their balances.

2. Total the debit column and total the credit column.

3. Verify the equality of the two columns.

Illustration 3-34 presents the trial balance prepared from the ledger of Sierra Corporation. Note that the total debits, $28,700, equal the total credits, $28,700.

LEARNING OBJECTIVE 5▼ Prepare a trial balance.

DECISION TOOLS

A trial balance proves that debits equal credits.

Debit Credit

Cash $ 15,200 Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries and Wages Expense 4,000 Rent Expense 900

$28,700 $28,700

SIERRA CORPORATION Trial Balance

October 31, 2017

ILLUSTRATION 3-34 Sierra Corporation trial balance

▼ HELPFUL HINT Note that the order of presentation in the trial balance is:

Assets Liabilities Stockholders’ equity Revenues Expenses

LIMITATIONS OF A TRIAL BALANCE

A trial balance does not prove that all transactions have been recorded or that the ledger is correct. Numerous errors may exist even though the trial balance column totals agree. For example, the trial balance may balance even when any of the following occurs: (1) a transaction is not journalized, (2) a correct journal entry is not posted, (3) a journal entry is posted twice, (4) incorrect accounts are

ETHICS NOTE An error is the result of an unintentional mistake. It is neither ethical nor unethical. An irregularity is an intentional misstatement, which is viewed as unethical.

▼

JOURNALIZEANALYZE POST ADJUSTING

ENTRIES

ADJUSTED TRIAL

BALANCE

FINANCIAL STATEMENTS

CLOSING ENTRIES

POST-CLOSING TRIAL BALANCE

ADAA E

Prepare a trial balance

120 3 The Accounting Information System

used in journalizing or posting, or (5) offsetting errors are made in recording the amount of a transaction. In other words, as long as equal debits and credits are posted, even to the wrong account or in the wrong amount, the total debits will equal the total credits. Nevertheless, despite these limitations, the trial balance is a useful screen for fi nding errors and is frequently used in practice.

KEEPING AN EYE ON CASH

The Cash account shown below reflects all of the inflows and outflows of cash that occurred during October for Sierra Corporation (see Illustrations 3-21 to 3-31). We have also provided a description of each transaction that affected the Cash account.

1. Oct. 1 Issued stock for $10,000 cash. 2. Oct. 1 Issued note payable for $5,000 cash. 3. Oct. 2 Purchased equipment for $5,000 cash. 4. Oct. 2 Received $1,200 cash in advance from customer. 5. Oct. 3 Received $10,000 cash for services performed. 6. Oct. 3 Paid $900 cash for October rent. 7. Oct. 4 Paid $600 cash for one-year insurance policy. 8. Oct. 20 Paid $500 cash dividend to stockholders. 9. Oct. 26 Paid $4,000 cash salaries.

The Cash account and the related cash transactions indicate why cash changed during October. However, to make this information useful for analysis,

it is summarized in a statement of cash flows. The statement of cash flows classifies each transaction as an operating activity, an investing activity, or a financing activity. A user of this statement can then determine the amount of net cash provided by operating activities, the amount of cash used for investing purposes, and the amount of cash provided by financing activities. Operating activities are the types of activities the company per- forms to generate profits. Sierra is an outdoor guide business, so its operating activities involve providing guide services. Activities 4, 5,

6, 7, and 9 relate to cash received or spent to directly support its guide services. Investing activities include the purchase or sale of long-lived assets used in operating the business, or the purchase or sale of investment securities (stocks and bonds of companies other than Sierra). Activity 3, the purchase of equip- ment, is an investing activity. The primary types of financing activities are borrowing money, issuing shares of stock, and paying dividends. The financing activities of Sierra are Activities 1, 2, and 8.

Cash

Oct. 1 10,000 Oct. 2 5,000 1 5,000 3 900 2 1,200 4 600 3 10,000 20 500 26 4,000

Bal. 15,200

5▼ Trial BalanceDO IT! The following accounts come from the ledger of SnowGo Corporation at December 31, 2017.

Equipment $88,000 Common Stock $20,000 Dividends 8,000 Salaries and Wages Payable 2,000 Accounts Payable 22,000 Notes Payable (due in 3 months) 19,000 Salaries and Wages Expense 42,000 Utilities Expense 3,000 Accounts Receivable 4,000 Prepaid Insurance 6,000 Service Revenue 95,000 Cash 7,000

Prepare a trial balance in good form.

Using Decision Tools 121

SOLUTION Action Plan ✔ Determine normal

balances and list accounts in the order they appear in the ledger.

✔ Accounts with debit balances appear in the left column, and those with credit balances in the right column.

✔ Total the debit and credit columns to prove equality.

Debit Credit

Cash $ 7,000 Accounts Receivable 4,000 Prepaid Insurance 6,000 Equipment 88,000 Notes Payable $ 19,000 Accounts Payable 22,000 Salaries and Wages Payable 2,000 Common Stock 20,000 Dividends 8,000 Service Revenue 95,000 Utilities Expense 3,000 Salaries and Wages Expense 42,000

$158,000 $158,000

SNOWGO CORPORATION Trial Balance

December 31, 2017

Related exercise material: BE3-11, BE3-12, DO IT! 3-5, E3-13, E3-15, E3-16, E3-17, E3-18, E3-19, E3-20, E3-21, and E3-22.

The Kansas Farmers’ Vertically Integrated Cooperative, Inc. (K-VIC) was formed by over 200 northeast Kansas farmers in the late 1980s. Its purpose is to process raw materials, primarily grain and meat products grown by K-VIC’s members, into end-user food products and then to distribute the products nationally. Profi ts not needed for expansion or investment are returned to the members annually, on a pro rata basis, according to the fair value of the grain and meat products received from each farmer. Assume that the following trial balance was prepared for K-VIC.

USING DECISION TOOLS—KANSAS FARMERS’ VERTICALLY INTEGRATED COOPERATIVE, INC.

KANSAS FARMERS’ VERTICALLY INTEGRATED COOPERATIVE, INC. Trial Balance

December 31, 2017 (in thousands)

Debit Credit Accounts Receivable $ 712,000 Accounts Payable $ 673,000 Buildings 365,000 Cash 32,000 Cost of Goods Sold 2,384,000 Notes Payable (due in 2018) 12,000 Inventory 1,291,000 Land 110,000 Mortgage Payable 873,000 Equipment 63,000 Retained Earnings 822,000 Sales Revenue 3,741,000 Salaries and Wages Payable 62,000 Salaries and Wages Expense 651,000 Maintenance and Repairs Expense 500,000 $6,108,000 $6,183,000

122 3 The Accounting Information System

Because the trial balance is not in balance, you have checked with various people responsible for entering accounting data and have discovered the following. 1. The purchase of 35 new trucks, costing $7 million and paid for with cash, was not recorded. 2. A data entry clerk accidentally deleted the account name for an account with a credit balance of $472 million,

so the amount was added to the Mortgage Payable account in the trial balance. 3. December cash sales revenue of $75 million was credited to the Sales Revenue account, but the other half of

the entry was not made. 4. $50 million of salaries expense were mistakenly charged to Maintenance and Repairs Expense.

INSTRUCTIONS

Answer these questions. (a) Which mistake(s) have caused the trial balance to be out of balance? (b) Should all of the items be corrected? Explain. (c) What is the name of the account the data entry clerk deleted? (d) Make the necessary corrections and prepare a correct trial balance with accounts listed in proper order. (e) On your trial balance, write BAL beside the accounts that go on the balance sheet and INC beside those that go on

the income statement.

SOLUTION (a) Only mistake #3 has caused the trial balance to be out of balance. (b) All of the items should be corrected. The misclassifi cation error (mistake #4) on the salaries expense would not affect

bottom-line net income, but it does affect the amounts reported in the two expense accounts. (c) There is no Common Stock account, so that must be the account that was deleted by the data entry clerk. (d) and (e)

Debit Credit Cash ($32,000 2 $7,000 1 $75,000) $ 100,000 BAL Accounts Receivable 712,000 BAL Inventory 1,291,000 BAL Land 110,000 BAL Buildings 365,000 BAL Equipment ($63,000 1 $7,000) 70,000 BAL Accounts Payable $ 673,000 BAL Salaries and Wages Payable 62,000 BAL Notes Payable (due in 2018) 12,000 BAL Mortgage Payable ($873,000 2 $472,000) 401,000 BAL Common Stock 472,000 BAL Retained Earnings 822,000 BAL Sales Revenue 3,741,000 INC Cost of Goods Sold 2,384,000 INC Salaries and Wages Expense 701,000 INC ($651,000 1 $50,000) Maintenance and Repairs Expense 450,000 INC ($500,000 2 $50,000) $6,183,000 $6,183,000

KANSAS FARMERS’ VERTICALLY INTEGRATED COOPERATIVE, INC. Trial Balance

December 31, 2017 (in thousands)

Glossary Review 123

LEARNING OBJECTIVE REVIEW

REVIEW AND PRACTICE

1 Analyze the effect of business transactions on the basic accounting equation. Each business transaction must have a dual effect on the accounting equation. For example, if an individual asset is increased, there must be a corresponding (a) decrease in another asset, or (b) increase in a specifi c liability, or (c) increase in stockholders’ equity.

2 Explain how accounts, debits, and credits are used to record business transactions. An account is an individual accounting record of increases and decreases in specifi c asset, liability, and stockholders’ equity items. The terms debit and credit are synonymous with left and right. Assets, dividends, and expenses are increased by debits and decreased by credits. Liabilities, common stock, retained earnings, and revenues are increased by credits and decreased by debits.

3 Indicate how a journal is used in the recording process. The basic steps in the recording process are (a) analyze each transaction in terms of its effect on the accounts, (b) enter the transaction information in a journal, and (c) transfer the journal information to the appropriate accounts in the ledger.

The initial accounting record of a transaction is entered in a journal before the data are entered in the accounts. A journal (a) discloses in one place the complete effect of a transaction, (b) provides a chronological record of transac- tions, and (c) prevents or locates errors because the debit and credit amounts for each entry can be readily compared.

4 Explain how a ledger and posting help in the record- ing process. The entire group of accounts maintained by a company is referred to collectively as a ledger. The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances. Posting is the procedure of transferring journal entries to the ledger accounts. This phase of the recording process accumulates the effects of journalized transactions in the individual accounts.

5 Prepare a trial balance. A trial balance is a list of accounts and their balances at a given time. The primary purpose of the trial balance is to prove the mathematical equality of debits and credits after posting. A trial balance also uncovers errors in journalizing and posting and is useful in preparing fi nancial statements.

▼

Account An individual accounting record of increases and decreases in specifi c asset, liability, stockholders’ equity, revenue, or expense items. (p. 100).

Accounting information system The system of collecting and processing transaction data and communicating fi nancial information to decision-makers. (p. 92).

Accounting transactions Events that require recording in the fi nancial statements because they affect assets, liabilities, or stockholders’ equity. (p. 92).

Chart of accounts A list of a company’s accounts. (p. 110).

Credit The right side of an account. (p. 101).

Debit The left side of an account. (p. 101).

Double-entry system A system that records the two-sided effect of each transaction in appropriate accounts. (p. 101).

General journal The most basic form of journal. (p. 107).

General ledger A ledger that contains all asset, liability, stockholders’ equity, revenue, and expense accounts. (p. 109).

Journal An accounting record in which transactions are initially recorded in chronological order. (p. 106).

Journalizing The procedure of entering transaction data in the journal. (p. 107).

Ledger The group of accounts maintained by a company. (p. 109).

Posting The procedure of transferring journal entry amounts to the ledger accounts. (p. 110).

T-account The basic form of an account. (p. 100).

Trial balance A list of accounts and their balances at a given time. (p. 119).

GLOSSARY REVIEW▼

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Has an accounting transaction occurred?

Details of the event Accounting equation

How do you determine that debits equal credits?

All account balances Trial balance List the account titles and their balances; total the debit and credit columns; verify equality.

If the event affected assets, liabilities, or stockholders’ equity, then record as a transaction.

124 3 The Accounting Information System

1. The effects on the basic accounting equation of per- forming services for cash are to: (a) increase assets and decrease stockholders’ equity. (b) increase assets and increase stockholders’ equity. (c) increase assets and increase liabilities. (d) increase liabilities and increase stockholders’

equity. 2. Genesis Company buys a $900 machine on credit.

This transaction will affect the: (a) income statement only. (b) balance sheet only. (c) income statement and retained earnings state-

ment only. (d) income statement, retained earnings statement,

and balance sheet. 3. Which of the following events is not recorded in the

accounting records? (a) Equipment is purchased on account. (b) An employee is terminated. (c) A cash investment is made into the business. (d) Company pays dividend to stockholders.

4. During 2017, Gibson Company assets decreased $50,000 and its liabilities decreased $90,000. Its stockholders’ equity therefore: (a) increased $40,000. (b) decreased $140,000. (c) decreased $40,000. (d) increased $140,000.

5. Which statement about an account is true? (a) In its simplest form, an account consists of two

parts. (b) An account is an individual accounting record of

increases and decreases in specifi c asset, liability, and stockholders’ equity items.

(c) There are separate accounts for specifi c assets and liabilities but only one account for stock- holders’ equity items.

(d) The left side of an account is the credit, or decrease, side.

6. Debits: (a) increase both assets and liabilities. (b) decrease both assets and liabilities. (c) increase assets and decrease liabilities. (d) decrease assets and increase liabilities.

7. A revenue account: (a) is increased by debits. (b) is decreased by credits. (c) has a normal balance of a debit. (d) is increased by credits.

8. Which accounts normally have debit balances? (a) Assets, expenses, and revenues. (b) Assets, expenses, and retained earnings.

(LO 1)

(LO 2)

9. Paying an account payable with cash affects the com- ponents of the accounting equation in the following way: (a) Decreases stockholders’ equity and decreases

liabilities. (b) Increases assets and decreases liabilities. (c) Decreases assets and increases stockholders’

equity. (d) Decreases assets and decreases liabilities.

10. Which is not part of the recording process? (a) Analyzing transactions. (b) Preparing an income statement. (c) Entering transactions in a journal. (d) Posting journal entries.

11. Which of these statements about a journal is false? (a) It contains only revenue and expense accounts. (b) It provides a chronological record of transactions. (c) It helps to locate errors because the debit and

credit amounts for each entry can be readily compared.

(d) It discloses in one place the complete effect of a transaction.

12. A ledger: (a) contains only asset and liability accounts. (b) should show accounts in alphabetical order. (c) is a collection of the entire group of accounts

maintained by a company. (d) provides a chronological record of transactions.

13. Posting: (a) normally occurs before journalizing. (b) transfers ledger transaction data to the journal. (c) is an optional step in the recording process. (d) transfers journal entries to ledger accounts.

14. A trial balance: (a) is a list of accounts with their balances at a given

time. (b) proves that proper account titles were used. (c) will not balance if a correct journal entry is posted

twice. (d) proves that all transactions have been recorded.

15. p

A trial balance will not balance if: (a) a correct journal entry is posted twice. (b) the purchase of supplies on account is debited to

Supplies and credited to Cash. (c) a $100 cash dividend is debited to Dividends for

$1,000 and credited to Cash for $100. (d) a $450 payment on account is debited to

Accounts Payable for $45 and credited to Cash for $45.

(LO 2)

(LO 3)

(LO 4)

(LO 5)

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

SOLUTIONS 1. (b) When services are performed for cash, assets are increased and stockholders’ equity is increased. The other choices

are therefore incorrect.

2. (b) When equipment is purchased on credit, assets are increased and liabilities are increased. These are both balance sheet accounts. The other choices are incorrect because neither the income statement nor the retained earnings state- ment is affected.

Practice Exercises 125

3. (b) Termination of an employee is not a recordable event in the accounting records. The other choices all represent events that are recorded.

4. (a) Since assets decreased by $50,000 and liabilities decreased by $90,000, stockholders’ equity has to increase by $40,000 to keep the accounting equation balanced. The other choices are therefore incorrect.

5. (b) An account is an individual accounting record of increases and decreases in specifi c asset, liability, and stockhold- ers’ equity items. The other choices are incorrect because (a) in its simplest form, an account consists of three parts: a title and debit and credit side; (c) there are specifi c accounts for different types of stockholders’ equity, such as Com- mon Stock, Retained Earnings, and Dividends; and (d) the left side of an account is the debit side.

6. (c) Debits increase assets and decrease liabilities. The other choices are therefore incorrect.

7. (d) Revenues are increased by credits. Revenues have a normal credit balance. The other choices are therefore incorrect.

8. (d) Assets, dividends, and expenses have normal debit balances. The other choices are incorrect because (a) revenues have a normal credit balance, (b) retained earnings has a normal credit balance, and (c) liabilities have a normal credit balance.

9. (d) When paying an account payable with cash, the asset cash decreases. Accounts payable, a liability, decreases as well. The other choices are therefore incorrect.

10. (b) Preparing an income statement is not part of the recording process. Choices (a) analyzing transactions, (c) entering transactions in a journal, and (d) posting transactions are all steps in the recording process.

11. (a) A journal contains entries affecting all accounts, not just revenue and expense accounts. The other choices are true statements.

12. (c) A ledger is a collection of the entire group of accounts maintained by a company. The other choices are therefore incorrect.

13. (d) Posting transfers journal entries to ledger accounts. The other choices are incorrect because posting (a) occurs after journalizing, (b) transfers the information contained in journal entries to the ledger, and (c) is a required step in the recording process. If posting is not done, the ledger accounts will not refl ect changes in the accounts resulting from transactions.

14. (a) A trial balance is a list of accounts with their balances at a given time. The other choices are incorrect because (b) it does not confi rm that proper account titles were used; (c) if a journal entry is posted twice, the trial balance will still balance; and (d) a trial balance does not prove that all transactions have been recorded.

15. (c) The entry will cause the trial balance to be out of balance. The other choices are incorrect because although these entries are incorrect, they will still allow the trial balance to balance.

1. Legal Services Inc. was incorporated on July 1, 2017. During the fi rst month of opera- tions, the following transactions occurred.

1. Stockholders invested $10,000 in cash in exchange for common stock of Legal Services Inc.

2. Paid $800 for July rent on offi ce space.

3. Purchased offi ce equipment on account $3,000.

4. Performed legal services for clients for cash $1,500.

5. Borrowed $700 cash from a bank on a note payable.

6. Performed legal services for client on account $2,000.

7. Paid monthly expenses: salaries $500, utilities $300, and advertising $100.

INSTRUCTIONS

Prepare a tabular summary of the transactions.

PRACTICE EXERCISES▼

Prepare a tabular presentation.

(LO 1)

126 3 The Accounting Information System

2. Presented below is information related to Conan Real Estate Agency.

Oct. 1 Arnold Conan begins business as a real estate agent with a cash investment of $18,000 in exchange for common stock.

2 Hires an administrative assistant. 3 Purchases offi ce equipment for $1,700, on account. 6 Sells a house and lot for B. Clinton; bills B. Clinton $4,200 for realty services

performed. 27 Pays $900 on the balance related to the transaction of October 3. 30 Pays the administrative assistant $2,800 in salary for October.

INSTRUCTIONS

Journalize the transactions. (You may omit explanations.)

Journalize transactions.

(LO 3)

SOLUTION

1. Assets 5 Liabilities 1 Stockholders’ Equity Trans- Accounts Notes Accounts Common Retained Earnings action

Cash

1 Receivable

1 Equipment 5 Payable

1 Payable

1 Stock

1 Rev. 2 Exp. 2 Div.

(1) 1$10,000 5 1$10,000 (2) 2800 2$800 (3) 1$3,000 5 1$3,000 (4) 11,500 1$1,500 (5) 1700 1$700 (6) 1$2,000 12,000 (7) 2500 2500

2300 2300 2100 2100

$10,500 1 $2,000 1 $3,000 5 $700 1 $3,000 1 $10,000 1 $3,500 2 $1,700

$15,500 $15,500 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

SOLUTION

Issued Stock Rent Expense

Service Revenue

Service Revenue Sal./Wages Exp. Utilities Expense Advertising Expense

2. GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Oct. 1 Cash 18,000 Common Stock 18,000

2 No entry required

3 Equipment 1,700 Accounts Payable 1,700

6 Accounts Receivable 4,200 Service Revenue 4,200

27 Accounts Payable 900 Cash 900

30 Salaries and Wages Expense 2,800 Cash 2,800

Practice Problem 127

Bob Sample and other student investors opened Campus Carpet Cleaning, Inc. on Septem- ber 1, 2017. During the fi rst month of operations, the following transactions occurred.

Sept. 1 Stockholders invested $20,000 cash in the business. 2 Paid $1,000 cash for store rent for the month of September. 3 Purchased industrial carpet-cleaning equipment for $25,000, paying $10,000

in cash and signing a $15,000 6-month, 12% note payable. 4 Paid $1,200 for 1-year accident insurance policy. 10 Received bill from the Daily News for advertising the opening of the cleaning

service, $200. 15 Performed services on account for $6,200. 20 Paid a $700 cash dividend to stockholders. 30 Received $5,000 from customers billed on September 15.

The chart of accounts for the company is the same as for Sierra Corporation except for the following additional account: Advertising Expense.

INSTRUCTIONS

(a) Journalize the September transactions. (b) Open ledger accounts and post the September transactions. (c) Prepare a trial balance at September 30, 2017.

PRACTICE PROBLEM▼ Journalize transactions, post, and prepare a trial balance.

(LO 3, 4, 5)

SOLUTION

(a) GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2017 Sept. 1 Cash 20,000

Common Stock 20,000 (Issued stock for cash)

2 Rent Expense 1,000 Cash 1,000 (Paid September rent)

3 Equipment 25,000 Cash 10,000 Notes Payable 15,000 (Purchased cleaning equipment for cash

and 6-month, 12% note payable)

4 Prepaid Insurance 1,200 Cash 1,200 (Paid 1-year insurance policy)

10 Advertising Expense 200 Accounts Payable 200 (Received bill from Daily News for

advertising)

15 Accounts Receivable 6,200 Service Revenue 6,200 (Services performed on account)

20 Dividends 700 Cash 700 (Declared and paid a cash dividend)

30 Cash 5,000 Accounts Receivable 5,000 (Collection of accounts receivable)

128 3 The Accounting Information System

September 30, 2017

Debit Credit

Cash $12,100 Accounts Receivable 1,200 Prepaid Insurance 1,200 Equipment 25,000 Notes Payable $15,000 Accounts Payable 200 Common Stock 20,000 Dividends 700 Service Revenue 6,200 Advertising Expense 200 Rent Expense 1,000

$41,400 $41,400

(b) GENERAL LEDGER

Prepaid Insurance

Sept. 4 1,200

Bal. 1,200

Equipment

Sept. 3 25,000

Bal. 25,000

Notes Payable

Sept. 3 15,000

Bal. 15,000

Accounts Payable

Sept. 10 200

Bal. 200

Service Revenue

Sept. 15 6,200

Bal. 6,200

Advertising Expense

Sept. 10 200

Bal. 200

Rent Expense

Sept. 2 1,000

Bal. 1,000

Cash

Sept. 1 20,000 Sept. 2 1,000 30 5,000 3 10,000 4 1,200 20 700

Bal. 12,100

Accounts Receivable

Sept. 15 6,200 Sept. 30 5,000

Bal. 1,200

Common Stock

Sept. 1 20,000

Bal. 20,000

Dividends

Sept. 20 700

Bal. 700

Questions 129

1. Describe the accounting information system.

2. Can a business enter into a transaction that affects only the left side of the basic accounting equation? If so, give an example.

3. Are the following events recorded in the accounting records? Explain your answer in each case. (a) A major stockholder of the company dies. (b) Supplies are purchased on account. (c) An employee is fi red. (d) The company pays a cash dividend to its stock-

holders.

4. Indicate how each business transaction affects the basic accounting equation. (a) Paid cash for janitorial services. (b) Purchased equipment for cash. (c) Issued common stock to investors in exchange for

cash. (d) Paid an account payable in full.

5. Why is an account referred to as a T-account?

6. The terms debit and credit mean “increase” and “decrease,” respectively. Do you agree? Explain.

7. Barry Barack, a fellow student, contends that the double-entry system means each transaction must be recorded twice. Is Barry correct? Explain.

8. Misty Reno, a beginning accounting student, believes debit balances are favorable and credit balances are unfavorable. Is Misty correct? Discuss.

9. State the rules of debit and credit as applied to (a) asset accounts, (b) liability accounts, and (c) the Common Stock account.

10. What is the normal balance for each of these accounts? (a) Accounts Receivable. (b) Cash. (c) Dividends. (d) Accounts Payable. (e) Service Revenue. (f) Salaries and Wages Expense. (g) Common Stock.

11. Indicate whether each account is an asset, a liability, or a stockholders’ equity account, and whether it would have a normal debit or credit balance. (a) Accounts Receivable. (d) Dividends. (b) Accounts Payable. (e) Supplies. (c) Equipment.

12. For the following transactions, indicate the account debited and the account credited. (a) Supplies are purchased on account. (b) Cash is received on signing a note payable. (c) Employees are paid salaries in cash.

13. For each account listed here, indicate whether it gen- erally will have debit entries only, credit entries only, or both debit and credit entries. (a) Cash. (b) Accounts Receivable. (c) Dividends. (d) Accounts Payable. (e) Salaries and Wages Expense. (f) Service Revenue.

14. What are the normal balances for the following ac- counts of Apple? (a) Accounts Receivable, (b) Accounts Payable, (c) Sales, and (d) Selling, General, and Administrative Expenses.

15. What are the basic steps in the recording process?

16. (a) When entering a transaction in the journal, should the debit or credit be written fi rst?

(b) Which should be indented, the debit or the credit?

17. (a) Should accounting transaction debits and credits be recorded directly in the ledger accounts?

(b) What are the advantages of fi rst recording transac- tions in the journal and then posting to the ledger?

18. Journalize these accounting transactions. (a) Stockholders invested $12,000 in the business in

exchange for common stock. (b) Insurance of $800 is paid for the year. (c) Supplies of $1,800 are purchased on account. (d) Cash of $7,500 is received for services rendered.

19. (a) What is a ledger? (b) Why is a chart of accounts important?

20. What is a trial balance and what are its purposes?

21. Brad Tyler is confused about how accounting informa- tion fl ows through the accounting system. He believes information fl ows in this order: (a) Debits and credits are posted to the ledger. (b) Accounting transaction occurs. (c) Information is entered in the journal. (d) Financial statements are prepared. (e) Trial balance is prepared.

Indicate to Brad the proper fl ow of the information.

22. Two students are discussing the use of a trial balance. They wonder whether the following errors, each considered separately, would prevent the trial balance from balancing. What would you tell them? (a) The bookkeeper debited Cash for $600 and cred-

ited Salaries and Wages Expense for $600 for pay- ment of wages.

(b) Cash collected on account was debited to Cash for $800, and Service Revenue was credited for $80.

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

QUESTIONS▼

130 3 The Accounting Information System

BE3-1 Presented below are three economic events. On a sheet of paper, list the letters (a), (b), and (c) with columns for assets, liabilities, and stockholders’ equity. In each column, indicate whether the event increased (+), decreased (−), or had no effect (NE) on assets, liabilities, and stockholders’ equity. (a) Purchased supplies on account. (b) Received cash for performing a service. (c) Expenses paid in cash.

BE3-2 During 2017, Manion Corp. entered into the following transactions. 1. Borrowed $60,000 by issuing bonds. 2. Paid $9,000 cash dividend to stockholders. 3. Received $13,000 cash from a previously billed customer for services performed. 4. Purchased supplies on account for $3,100.

Using the following tabular analysis, show the effect of each transaction on the accounting equation. Put explanations for changes to Stockholders’ Equity in the right-hand margin. For Retained Earnings, use separate columns for Revenues, Expenses, and Dividends if necessary. Use Illustration 3-3 (page 99) as a model.

Determine effect of transactions on basic accounting equation.

(LO 1), C

Determine effect of transactions on basic accounting equation.

(LO 1), AP

BRIEF EXERCISES▼

Assets = Liabilities + Stockholders’ Equity Accounts Accounts Bonds Common Retained Cash + Receivable + Supplies = Payable + Payable + Stock + Earnings

BE3-3 During 2017, Rostock Company entered into the following transactions. 1. Purchased equipment for $286,176 cash. 2. Issued common stock to investors for $137,590 cash. 3. Purchased inventory of $68,480 on account.

Determine effect of transactions on basic accounting equation.

(LO 1), AP

Assets = Liabilities + Stockholders’ Equity Accounts Common Retained Cash + Inventory + Equipment = Payable + Stock + Earnings

BE3-4 For each of the following accounts, indicate the effect of a debit or a credit on the account and the normal balance. (a) Accounts Payable. (d) Accounts Receivable. (b) Advertising Expense. (e) Retained Earnings. (c) Service Revenue. (f) Dividends.

BE3-5 Transactions for Jayne Company for the month of June are presented below. Identify the accounts to be debited and credited for each transaction.

June 1 Issues common stock to investors in exchange for $5,000 cash. 2 Buys equipment on account for $1,100. 3 Pays $740 to landlord for June rent. 12 Sends Wil Wheaton a bill for $700 after completing welding work.

BE3-6 Use the data in BE3-5 and journalize the transactions. (You may omit explanations.)

BE3-7 Rae Mohlee, a fellow student, is unclear about the basic steps in the recording process. Identify and briefl y explain the steps in the order in which they occur.

BE3-8 Tilton Corporation has the following transactions during August of the current year. Indicate (a) the basic analysis and (b) the debit–credit analysis illustrated on pages 111–116.

Indicate debit and credit effects.

(LO 2), K

Identify accounts to be debited and credited.

(LO 2), C

Journalize transactions.

(LO 3), AP

Identify steps in the recording process.

(LO 3), C

Indicate basic debit–credit analysis.

(LO 3), C

DO IT! Exercises 131

Aug. 1 Issues shares of common stock to investors in exchange for $10,000. 4 Pays insurance in advance for 3 months, $1,500. 16 Receives $900 from clients for services rendered. 27 Pays the secretary $620 salary.

BE3-9 Use the data in BE3-8 and journalize the transactions. (You may omit explanations.)

BE3-10 Selected transactions for Montes Company are presented below in journal form (without explanations). Post the transactions to T-accounts.

Date Account Title Debit Credit

May 5 Accounts Receivable 3,800 Service Revenue 3,800

12 Cash 1,600 Accounts Receivable 1,600

15 Cash 2,000 Service Revenue 2,000

BE3-11 From the ledger balances below, prepare a trial balance for Peete Company at June 30, 2017. All account balances are normal.

Accounts Payable $ 1,000 Service Revenue $8,600 Cash 5,400 Accounts Receivable 3,000 Common Stock 18,000 Salaries and Wages Expense 4,000 Dividends 1,200 Rent Expense 1,000 Equipment 13,000

BE3-12 An inexperienced bookkeeper prepared the following trial balance that does not balance. Prepare a correct trial balance, assuming all account balances are normal.

BIRELLIE COMPANY Trial Balance

December 31, 2017

Debit Credit

Cash $20,800 Prepaid Insurance $ 3,500 Accounts Payable 2,500 Unearned Service Revenue 1,800 Common Stock 10,000 Retained Earnings 6,600 Dividends 5,000 Service Revenue 25,600 Salaries and Wages Expense 14,600 Rent Expense 2,600

$37,200 $55,800

Journalize transactions.

(LO 3), AP

Post journal entries to T-accounts.

(LO 4), AP

Prepare a trial balance.

(LO 5), AP

Prepare a corrected trial balance.

(LO 5), AN

Transactions made by Mickelson Co. for the month of March are shown below. Prepare a tabular analysis that shows the effects of these transactions on the expanded accounting equation, similar to that shown in Illustration 3-3 (page 99).

1. The company performed $20,000 of services for customers on account. 2. The company received $20,000 in cash from customers who had been billed for ser-

vices [in transaction (1)]. 3. The company received a bill for $1,800 of advertising but will not pay it until a later date. 4. Mickelson Co. paid a cash dividend of $3,000.

DO IT! 3-1 Prepare tabular analysis.

(LO 1), AP

EXERCISES▼DO IT!

132 3 The Accounting Information System

Boyd Docker has just rented space in a strip mall. In this space, he will open a photography studio, to be called SnapShot! A friend has advised Boyd to set up a double- entry set of accounting records in which to record all of his business transactions.

Identify the balance sheet accounts that Boyd will likely need to record the transac- tions needed to open his business (a corporation). Indicate whether the normal balance of each account is a debit or credit.

Boyd Docker engaged in the following activities in establishing his photogra- phy studio, SnapShot!:

1. Opened a bank account in the name of SnapShot! and deposited $8,000 of his own money into this account in exchange for common stock.

2. Purchased photography supplies at a total cost of $950. The business paid $400 in cash, and the balance is on account.

3. Obtained estimates on the cost of photography equipment from three different manufacturers.

Prepare the journal entries to record the transactions.

Boyd Docker recorded the following transactions during the month of April.

Apr. 3 Cash 3,400 Service Revenue 3,400

16 Rent Expense 500 Cash 500

20 Salaries and Wages Expense 300 Cash 300

Post these entries to the Cash account of the general ledger to determine the ending balance in cash. The beginning balance in cash on April 1 was $1,900.

The following accounts are taken from the ledger of Chillin’ Company at December 31, 2017.

Notes Payable $20,000 Cash $6,000 Common Stock 25,000 Supplies 5,000 Equipment 76,000 Rent Expense 2,000 Dividends 8,000 Salaries and Wages Payable 3,000 Salaries and Wages Expense 38,000 Accounts Payable 9,000 Service Revenue 86,000 Accounts Receivable 8,000

Prepare a trial balance in good form.

DO IT! 3-2Identify normal balances.

(LO 2), C

DO IT! 3-3Record business activities.

(LO 3), AP

Post transactions.

(LO 4), AP

DO IT! 3-4

DO IT! 3-5Prepare a trial balance.

(LO 5), AP

E3-1 Selected transactions for Thyme Advertising Company, Inc. are listed here.

1. Issued common stock to investors in exchange for cash received from investors. 2. Paid monthly rent. 3. Received cash from customers when service was performed. 4. Billed customers for services performed. 5. Paid dividend to stockholders. 6. Incurred advertising expense on account. 7. Received cash from customers billed in (4). 8. Purchased additional equipment for cash. 9. Purchased equipment on account.

Instructions Describe the effect of each transaction on assets, liabilities, and stockholders’ equity. For example, the fi rst answer is (1) Increase in assets and increase in stockholders’ equity.

E3-2 Brady Company entered into these transactions during May 2017, its fi rst month of operations.

1. Stockholders invested $40,000 in the business in exchange for common stock of the company.

Analyze the effect of transactions.

(LO 1), C

Analyze the effect of transactions on assets, liabilities, and stockholders’ equity.

(LO 1), AP

EXERCISES▼

Exercises 133

2. Purchased computers for office use for $30,000 from Ladd on account. 3. Paid $4,000 cash for May rent on storage space. 4. Performed computer services worth $19,000 on account. 5. Performed computer services for Wharton Construction Company for $5,000 cash. 6. Paid Western States Power Co. $8,000 cash for energy usage in May. 7. Paid Ladd for the computers purchased in (2). 8. Incurred advertising expense for May of $1,300 on account. 9. Received $12,000 cash from customers for contracts billed in (4).

Instructions Using the following tabular analysis, show the effect of each transaction on the accounting equation. Put explanations for changes to Stockholders’ Equity in the right-hand margin. Use Illustration 3-3 (page 99) as a model.

Assets = Liabilities + Stockholders’ Equity

Accounts Accounts Common Retained Earnings

Cash + Receivable + Equipment = Payable + Stock + Revenues − Expenses − Dividends

E3-3 During 2017, its fi rst year of operations as a delivery service, Persimmon Corp. entered into the following transactions.

1. Issued shares of common stock to investors in exchange for $100,000 in cash. 2. Borrowed $45,000 by issuing bonds. 3. Purchased delivery trucks for $60,000 cash. 4. Received $16,000 from customers for services performed. 5. Purchased supplies for $4,700 on account. 6. Paid rent of $5,200. 7. Performed services on account for $10,000. 8. Paid salaries of $28,000. 9. Paid a dividend of $11,000 to shareholders.

Determine effect of transactions on basic accounting equation.

(LO 1), AP

Assets = Liabilities + Stockholders’ Equity

Accounts Equip- Accounts Bonds Common Retained Earnings

Cash + Receivable + Supplies + ment = Payable + Payable + Stock + Revenues − Expenses − Dividends

E3-4 A tabular analysis of the transactions made during August 2017 by Wolfe Company during its fi rst month of operations is shown below. Each increase and decrease in stock- holders’ equity is explained.

Analyze transactions and compute net income.

(LO 1), AP

Assets = Liabilities + Stockholders’ Equity

Accounts Common Retained Earnings

Cash + A/R + Supp. + Equip. = Payable + Stock + Rev. − Exp. − Div.

1. +$20,000 1$20,000 Com. Stock 2. 21,000 1$5,000 1$4,000

3. 2750 1$750

4. +4,100 1$5,400 1$9,500 Serv. Rev. 5. 21,500 21,500

6. 22,000 2$2,000 Div.

7. 2800 2$ 800 Rent Exp.

8. 1450 2450

9. 23,000 23,000 Salar. Exp.

10. 1300 2300 Util. Exp.

Instructions (a) Describe each transaction. (b) Determine how much stockholders’ equity increased for the month. (c) Compute the net income for the month.

134 3 The Accounting Information System

E3-5 The tabular analysis of transactions for Wolfe Company is presented in E3-4.

Instructions Prepare an income statement and a retained earnings statement for August and a classi- fi ed balance sheet at August 31, 2017.

E3-6 The following accounts, in alphabetical order, were selected from recent fi nancial statements of Krispy Kreme Doughnuts, Inc.

Accounts Payable Interest Income Accounts Receivable Inventories Common Stock Prepaid Expenses Depreciation Expense Property and Equipment Interest Expense Revenues

Instructions For each account, indicate (a) whether the normal balance is a debit or a credit, and (b) the fi nancial statement—balance sheet or income statement—where the account should be presented.

E3-7 Selected transactions for Front Room, an interior decorator corporation, in its fi rst month of business, are as follows.

1. Issued stock to investors for $15,000 in cash. 2. Purchased used car for $10,000 cash for use in business. 3. Purchased supplies on account for $300. 4. Billed customers $3,700 for services performed. 5. Paid $200 cash for advertising at the start of the business. 6. Received $1,100 cash from customers billed in transaction (4). 7. Paid creditor $300 cash on account. 8. Paid dividends of $400 cash to stockholders.

Instructions (a) For each transaction indicate (a) the basic type of account debited and credited (asset,

liability, stockholders’ equity); (b) the specifi c account debited and credited (Cash, Rent Expense, Service Revenue, etc.); (c) whether the specifi c account is increased or decreased; and (d) the normal balance of the specifi c account. Use the following format, in which transaction (1) is given as an example.

Prepare an income statement, retained earnings statement, and balance sheet.

(LO 2), AP

Identify normal account balance and corresponding fi nancial statement.

(LO 2), K

Identify debits, credits, and normal balances and journalize transactions.

(LO 2, 3), AP

Account Debited Account Credited

(a) (b) (c) (d) (a) (b) (c) (d) Trans- Basic Specific Normal Basic Specific Normal action Type Account Effect Balance Type Account Effect Balance

1 Asset Cash Increase Debit Stock- Common Increase Credit holders’ Stock equity

(b) Journalize the transactions. Do not provide explanations.

E3-8 This information relates to McCall Real Estate Agency.

Oct. 1 Stockholders invest $30,000 in exchange for common stock of the corporation.

2 Hires an administrative assistant at an annual salary of $36,000. 3 Buys office furniture for $3,800, on account. 6 Sells a house and lot for E. C. Roads; commissions due from Roads, $10,800

(not paid by Roads at this time). 10 Receives cash of $140 as commission for acting as rental agent renting an

apartment. 27 Pays $700 on account for the office furniture purchased on October 3. 30 Pays the administrative assistant $3,000 in salary for October.

Instructions Prepare the debit–credit analysis for each transaction, as illustrated on pages 111–116.

Analyze transactions and determine their effect on accounts.

(LO 2), C

Exercises 135

E3-9 Transaction data for McCall Real Estate Agency are presented in E3-8.

Instructions Journalize the transactions. Do not provide explanations.

E3-10 The May transactions of Chulak Corporation were as follows.

May 4 Paid $700 due for supplies previously purchased on account. 7 Performed advisory services on account for $6,800. 8 Purchased supplies for $850 on account. 9 Purchased equipment for $1,000 in cash. 17 Paid employees $530 in cash. 22 Received bill for equipment repairs of $900. 29 Paid $1,200 for 12 months of insurance policy. Coverage begins June 1.

Instructions Journalize the transactions. Do not provide explanations.

E3-11 Selected transactions for Sophie’s Dog Care are as follows during the month of March.

March 1 Paid monthly rent of $1,200. 3 Performed services for $140 on account. 5 Performed services for cash of $75. 8 Purchased equipment for $600. The company paid cash of $80 and the

balance was on account. 12 Received cash from customers billed on March 3. 14 Paid wages to employees of $525. 22 Paid utilities of $72. 24 Borrowed $1,500 from Grafton State Bank by signing a note. 27 Paid $220 to repair service for plumbing repairs. 28 Paid balance amount owed from equipment purchase on March 8. 30 Paid $1,800 for six months of insurance.

Instructions Journalize the transactions. Do not provide explanations.

E3-12 On April 1, Adventures Travel Agency, Inc. began operations. The following transac- tions were completed during the month.

1. Issued common stock for $24,000 cash. 2. Obtained a bank loan for $7,000 by issuing a note payable. 3. Paid $11,000 cash to buy equipment. 4. Paid $1,200 cash for April office rent. 5. Paid $1,450 for supplies. 6. Purchased $600 of advertising in the Daily Herald, on account. 7. Performed services for $18,000: cash of $2,000 was received from customers, and the

balance of $16,000 was billed to customers on account. 8. Paid $400 cash dividend to stockholders. 9. Paid the utility bill for the month, $2,000. 10. Paid Daily Herald the amount due in transaction (6). 11. Paid $40 of interest on the bank loan obtained in transaction (2). 12. Paid employees’ salaries, $6,400. 13. Received $12,000 cash from customers billed in transaction (7). 14. Paid income tax, $1,500.

Instructions Journalize the transactions. Do not provide explanations.

E3-13 Transaction data and journal entries for McCall Real Estate Agency are presented in E3-8 and E3-9.

Instructions (a) Post the transactions to T-accounts. (b) Prepare a trial balance at October 31, 2017.

Journalize transactions.

(LO 3), AP

Journalize a series of transactions.

(LO 3), AP

Journalize a series of transactions.

(LO 3), AP

Record journal entries.

(LO 3), AP

Post journal entries and prepare a trial balance.

(LO 4, 5), AP

136 3 The Accounting Information System

E3-14 Selected transactions for Therow Corporation during its fi rst month in business are presented below.

Sept. 1 Issued common stock in exchange for $20,000 cash received from investors. 5 Purchased equipment for $9,000, paying $3,000 in cash and the balance on

account. 8 Performed services on account for $18,000. 14 Paid salaries of $1,200. 25 Paid $4,000 cash on balance owed for equipment. 30 Paid $500 cash dividend.

Therow’s chart of accounts shows Cash, Accounts Receivable, Equipment, Accounts Pay- able, Common Stock, Dividends, Service Revenue, and Salaries and Wages Expense.

Instructions (a) Prepare a tabular analysis of the September transactions. The column headings

should be Cash + Accounts Receivable + Equipment = Accounts Payable + Common Stock + Revenues − Expenses − Dividends. For transactions affecting stockholders’ equity, provide explanations in the right margin, as shown on Illustration 3-3 on page 99.

(b) Journalize the transactions. Do not provide explanations. (c) Post the transactions to T-accounts.

E3-15 The T-accounts below summarize the ledger of Salvador’s Gardening Company, Inc. at the end of the fi rst month of operations.

Analyze transactions, prepare journal entries, and post transactions to T-accounts.

(LO 1, 3, 4), AP

Journalize transactions from T-accounts and prepare a trial balance.

(LO 3, 5), AN Cash

Apr. 1 15,000 Apr. 15 800 12 700 25 3,500 29 800 30 900

Accounts Receivable

Apr. 7 3,400 Apr. 29 800

Supplies

Apr. 4 5,200

Accounts Payable

Apr. 25 3,500 Apr. 4 5,200

Unearned Service Revenue

Apr. 30 900

Common Stock

Apr. 1 15,000

Service Revenue

Apr. 7 3,400 12 700

Salaries and Wages Expense

Apr. 15 800

Instructions (a) Prepare the journal entries (including explanations) that resulted in the amounts

posted to the accounts. Present them in the order they occurred. (b) Prepare a trial balance at April 30, 2017. (Hint: Compute ending balances of T-accounts

fi rst.)

E3-16 Selected transactions from the journal of Baylee Inc. during its fi rst month of operations are presented here.

Post journal entries and prepare a trial balance.

(LO 4, 5), AP

Date Account Titles Debit Credit

Aug. 1 Cash 8,000 Common Stock 8,000

10 Cash 1,700 Service Revenue 1,700

12 Equipment 6,200 Cash 1,200 Notes Payable 5,000

25 Accounts Receivable 3,400 Service Revenue 3,400

31 Cash 600 Accounts Receivable 600

Exercises 137

Instructions (a) Post the transactions to T-accounts. (b) Prepare a trial balance at August 31, 2017.

E3-17 Here is the ledger for Kriscoe Co. Journalize transactions from T-accounts and prepare a trial balance.

(LO 3, 5), AN Cash

Oct. 1 7,000 Oct. 4 400 10 980 12 1,500 10 8,000 15 250 20 700 30 300 25 2,000 31 500

Accounts Receivable

Oct. 6 800 Oct. 20 700 20 920

Supplies

Oct. 4 400 Oct. 31 180

Common Stock

Oct. 1 7,000 25 2,000

Dividends

Oct. 30 300

Service Revenue

Oct. 6 800 10 980 20 920

Instructions (a) Reproduce the journal entries for only the transactions that occurred on October 1,

10, and 20, and provide explanations for each. (b) Prepare a trial balance at October 31, 2017. (Hint: Compute ending balances of

T-accounts fi rst.)

E3-18 Beyers Corporation provides security services. Selected transactions for Beyers are presented below.

Oct. 1 Issued common stock in exchange for $66,000 cash from investors. 2 Hired part-time security consultant. Salary will be $2,000 per month. First

day of work will be October 15. 4 Paid 1 month of rent for building for $2,000. 7 Purchased equipment for $18,000, paying $4,000 cash and the balance on

account. 8 Paid $500 for advertising. 10 Received bill for equipment repair cost of $390. 12 Provided security services for event for $3,200 on account. 16 Purchased supplies for $410 on account. 21 Paid balance due from October 7 purchase of equipment. 24 Received and paid utility bill for $148. 27 Received payment from customer for October 12 services performed. 31 Paid employee salaries and wages of $5,100.

Instructions (a) Journalize the transactions. Do not provide explanations. (b) Post the transactions to T-accounts. (c) Prepare a trial balance at October 31, 2017. (Hint: Compute ending balances of

T-accounts fi rst.)

E3-19 The bookkeeper for Birmingham Corporation made these errors in journalizing and posting.

1. A credit posting of $400 to Accounts Receivable was omitted. 2. A debit posting of $750 for Prepaid Insurance was debited to Insurance Expense.

Journalize transactions, post transactions to T-accounts, and prepare trial balance.

(LO 3, 4, 5), AP

Analyze errors and their effects on trial balance.

(LO 5), AN

Equipment

Oct. 3 3,000

Notes Payable

Oct. 10 8,000

Accounts Payable

Oct. 12 1,500 Oct. 3 3,000

Salaries and Wages Expense

Oct. 31 500

Supplies Expense

Oct. 31 180

Rent Expense

Oct. 15 250

138 3 The Accounting Information System

3. A collection on account of $100 was journalized and posted as a debit to Cash $100 and a credit to Accounts Payable $100.

4. A credit posting of $300 to Income Taxes Payable was made twice. 5. A cash purchase of supplies for $250 was journalized and posted as a debit to Supplies

$25 and a credit to Cash $25. 6. A debit of $395 to Advertising Expense was posted as $359.

Instructions For each error, indicate (a) whether the trial balance will balance; if the trial balance will not balance, indicate (b) the amount of the difference and (c) the trial balance column that will have the larger total. Consider each error separately. Use the following form, in which error 1 is given as an example.

(a) (b) (c) Error In Balance Difference Larger Column

1 No $400 Debit

E3-20 The accounts in the ledger of Rapid Delivery Service contain the following balances on July 31, 2017.

Accounts Receivable $13,400 Prepaid Insurance $ 2,200 Accounts Payable 8,400 Service Revenue 15,500 Cash ? Dividends 700 Equipment 59,360 Common Stock 40,000 Maintenance and Salaries and Wages Expense 7,428 Repairs Expense 1,958 Salaries and Wages Payable 820 Insurance Expense 900 Retained Earnings (July 1, 2017) 5,200 Notes Payable (due 2020) 28,450

Instructions (a) Prepare a trial balance with the accounts arranged as illustrated in the chapter, and

fi ll in the missing amount for Cash. (b) Prepare an income statement, a retained earnings statement, and a classifi ed balance

sheet for the month of July 2017.

E3-21 Review the transactions listed in E3-1 for Thyme Advertising Company. Classify each transaction as either an operating activity, investing activity, or fi nancing activity, or if no cash is exchanged, as a noncash event.

E3-22 Review the transactions listed in E3-3 for Persimmon Corp. Classify each transac- tion as either an operating activity, investing activity, or fi nancing activity, or if no cash is exchanged, as a noncash event.

Prepare a trial balance and fi nancial statements.

(LO 5), AP

Classify transactions as cash-fl ow activities.

(LO 5), AP

Classify transactions as cash-fl ow activities.

(LO 5), AP

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P3-1A On April 1, Wonder Travel Agency Inc. was established. These transactions were completed during the month.

1. Stockholders invested $30,000 cash in the company in exchange for common stock. 2. Paid $900 cash for April office rent. 3. Purchased office equipment for $3,400 cash. 4. Purchased $200 of advertising in the Chicago Tribune, on account. 5. Paid $500 cash for office supplies. 6. Performed services worth $12,000. Cash of $3,000 is received from customers, and the

balance of $9,000 is billed to customers on account. 7. Paid $400 cash dividend.

Analyze transactions and compute net income.

(LO 1), AP

PROBLEMS: SET A▼

Problems: Set A 139

8. Paid Chicago Tribune amount due in transaction (4). 9. Paid employees’ salaries $1,800. 10. Received $9,000 in cash from customers billed previously in transaction (6).

Instructions (a) Prepare a tabular analysis of the transactions using these column headings: Cash,

Accounts Receivable, Supplies, Equipment, Accounts Payable, Common Stock, and Retained Earnings (with separate columns for Revenues, Expenses, and Dividends). Include margin explanations for any changes in Retained Earnings.

(b) From an analysis of the Retained Earnings columns, compute the net income or net loss for April.

P3-2A Nona Curry started her own consulting fi rm, Curry Consulting Inc., on May 1, 2017. The following transactions occurred during the month of May.

May 1 Stockholders invested $15,000 cash in the business in exchange for com- mon stock.

2 Paid $600 for offi ce rent for the month. 3 Purchased $500 of supplies on account. 5 Paid $150 to advertise in the County News. 9 Received $1,400 cash for services performed. 12 Paid $200 cash dividend. 15 Performed $4,200 of services on account. 17 Paid $2,500 for employee salaries. 20 Paid for the supplies purchased on account on May 3. 23 Received a cash payment of $1,200 for services performed on account

on May 15. 26 Borrowed $5,000 from the bank on a note payable. 29 Purchased offi ce equipment for $2,000 paying $200 in cash and the balance

on account. 30 Paid $180 for utilities.

Instructions (a) Show the effects of the previous transactions on the accounting equation using the

following format. Assume the note payable is to be repaid within the year.

(a) Cash $34,800 Total assets $38,700

Analyze transactions and prepare fi nancial statements.

(LO 1, 2), AP

(a) Cash $18,270 Total assets $23,770

Stockholders’ Assets = Liabilities + Equity

Accounts Notes Accounts Common Retained Earnings Date Cash + Receivable + Supplies + Equipment = Payable + Payable + Stock + Revenues − Expenses − Dividends

Include margin explanations for any changes in Retained Earnings. (b) Prepare an income statement for the month of May 2017. (c) Prepare a classifi ed balance sheet at May 31, 2017.

P3-3A Bindy Crawford created a corporation providing legal services, Bindy Crawford Inc., on July 1, 2017. On July 31 the balance sheet showed Cash $4,000, Accounts Re- ceivable $2,500, Supplies $500, Equipment $5,000, Accounts Payable $4,200, Common Stock $6,200, and Retained Earnings $1,600. During August, the following transactions occurred.

Aug. 1 Collected $1,100 of accounts receivable due from customers. 4 Paid $2,700 cash for accounts payable due. 9 Performed services worth $5,400, of which $3,600 is collected in cash and

the balance is due in September. 15 Purchased additional offi ce equipment for $4,000, paying $700 in cash and

the balance on account. 19 Paid salaries $1,400, rent for August $700, and advertising expenses $350. 23 Paid a cash dividend of $700. 26 Borrowed $5,000 from American Federal Bank; the money was borrowed

on a 4-month note payable. 31 Incurred utility expenses for the month on account $380.

(b) Net income $2,170

Analyze transactions and prepare an income statement, retained earnings statement, and balance sheet.

(LO 1, 2), AP

140 3 The Accounting Information System

Instructions (a) Prepare a tabular analysis of the August transactions beginning with July 31 balances.

The column heading should be Cash + Accounts Receivable + Supplies + Equipment = Notes Payable + Accounts Payable + Common Stock + Retained Earnings + Revenues − Expenses − Dividends. Include margin explanations for any changes in Retained Earnings.

(b) Prepare an income statement for August, a retained earnings statement for August, and a classifi ed balance sheet at August 31.

P3-4A Bradley’s Miniature Golf and Driving Range Inc. was opened on March 1 by Bob Dean. These selected events and transactions occurred during March.

Mar. 1 Stockholders invested $50,000 cash in the business in exchange for common stock of the corporation.

3 Purchased Snead’s Golf Land for $38,000 cash. The price consists of land $23,000, building $9,000, and equipment $6,000. (Record this in a single entry.)

5 Advertised the opening of the driving range and miniature golf course, paying advertising expenses of $1,200 cash.

6 Paid cash $2,400 for a 1-year insurance policy. 10 Purchased golf clubs and other equipment for $5,500 from Tahoe Company,

payable in 30 days. 18 Received golf fees of $1,600 in cash from customers for golf services performed. 19 Sold 100 coupon books for $25 each in cash. Each book contains 10 cou-

pons that enable the holder to play one round of miniature golf or to hit one bucket of golf balls. (Hint: The revenue should not be recognized until the customers use the coupons.)

25 Paid a $500 cash dividend. 30 Paid salaries of $800. 30 Paid Tahoe Company in full for equipment purchased on March 10. 31 Received $900 in cash from customers for golf services performed.

The company uses these accounts: Cash, Prepaid Insurance, Land, Buildings, Equipment, Accounts Payable, Unearned Service Revenue, Common Stock, Retained Earnings, Divi- dends, Service Revenue, Advertising Expense, and Salaries and Wages Expense.

Instructions Journalize the March transactions, including explanations. Bradley’s records golf fees as service revenue.

P3-5A Ayala Architects incorporated as licensed architects on April 1, 2017. During the fi rst month of the operation of the business, these events and transactions occurred:

Apr. 1 Stockholders invested $18,000 cash in exchange for common stock of the corporation.

1 Hired a secretary-receptionist at a salary of $375 per week, payable monthly.

2 Paid offi ce rent for the month $900. 3 Purchased architectural supplies on account from Burmingham Company

$1,300. 10 Completed blueprints on a carport and billed client $1,900 for services. 11 Received $700 cash advance from M. Jason to design a new home. 20 Received $2,800 cash for services completed and delivered to S. Melvin. 30 Paid secretary-receptionist for the month $1,500. 30 Paid $300 to Burmingham Company for accounts payable due.

The company uses these accounts: Cash, Accounts Receivable, Supplies, Accounts Pay- able, Unearned Service Revenue, Common Stock, Service Revenue, Salaries and Wages Expense, and Rent Expense.

Instructions (a) Journalize the transactions, including explanations. (b) Post to the ledger T-accounts. (c) Prepare a trial balance on April 30, 2017.

(a) Cash $7,150

(b) Net income $2,570 Ret. earnings $3,470

Journalize a series of transactions.

(LO 3), AP

Journalize transactions, post, and prepare a trial balance.

(LO 3, 4, 5), AP

Problems: Set A 141

P3-6A This is the trial balance of Lacey Company on September 30.

LACEY COMPANY Trial Balance

September 30, 2017

Debit Credit

Cash $19,200 Accounts Receivable 2,600 Supplies 2,100 Equipment 8,000 Accounts Payable $ 4,800 Unearned Service Revenue 1,100 Common Stock 15,000 Retained Earnings 11,000

$31,900 $31,900

The October transactions were as follows.

Oct. 5 Received $1,300 in cash from customers for accounts receivable due. 10 Billed customers for services performed $5,100. 15 Paid employee salaries $1,200. 17 Performed $600 of services in exchange for cash. 20 Paid $1,900 to creditors for accounts payable due. 29 Paid a $300 cash dividend. 31 Paid utilities $400.

Instructions (a) Prepare a general ledger using T-accounts. Enter the opening balances in the ledger

accounts as of October 1. (Hint: The October 1 beginning amounts are the Septem- ber 30 balances in the trial balance above.) Provision should be made for these addi- tional accounts: Dividends, Service Revenue, Salaries and Wages Expense, and Utilities Expense.

(b) Journalize the transactions, including explanations. (c) Post to the ledger accounts. (d) Prepare a trial balance on October 31, 2017.

P3-7A This trial balance of Washburn Co. does not balance.

WASHBURN CO. Trial Balance June 30, 2017

Debit Credit

Cash $ 3,090 Accounts Receivable $ 3,190 Supplies 800 Equipment 3,000 Accounts Payable 3,686 Unearned Service Revenue 1,200 Common Stock 9,000 Dividends 800 Service Revenue 3,480 Salaries and Wages Expense 3,600 Utilities Expense 910

$13,500 $19,256

Each of the listed accounts has 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 $780, and Accounts Receiv- able was credited for the same amount. The actual collection was for $870.

2. The purchase of a printer on account for $340 was recorded as a debit to Supplies for $340 and a credit to Accounts Payable for $340.

3. Services were performed on account for a client for $900. Accounts Receivable was debited for $90 and Service Revenue was credited for $900.

4. A debit posting to Salaries and Wages Expense of $700 was omitted.

Journalize transactions, post, and prepare a trial balance.

(LO 3, 4, 5), AP

(d) Cash $17,300 Tot. trial balance $35,700

Prepare a correct trial balance.

(LO 5), AN

142 3 The Accounting Information System

5. A payment on account for $206 was credited to Cash for $206 and credited to Accounts Payable for $260.

6. Payment of a $600 cash dividend to Washburn’s stockholders was debited to Salaries and Wages Expense for $600 and credited to Cash for $600.

Instructions Prepare the correct trial balance. (Hint: All accounts have normal balances.)

P3-8A The Triquel Theater Inc. was recently formed. It began operations in March 2017. The Triquel is unique in that it will show only triple features of sequential theme movies. On March 1, the ledger of The Triquel showed Cash $16,000, Land $38,000, Buildings (con- cession stand, projection room, ticket booth, and screen) $22,000, Equipment $16,000, Accounts Payable $12,000, and Common Stock $80,000. During the month of March, the following events and transactions occurred.

Mar. 2 Rented the fi rst three Star Wars movies (Star Wars®, The Empire Strikes Back, and The Return of the Jedi) to be shown for the fi rst three weeks of March. The fi lm rental was $10,000; $2,000 was paid in cash and $8,000 will be paid on March 10.

3 Ordered the fi rst three Star Trek movies to be shown the last 10 days of March. It will cost $500 per night.

9 Received $9,900 cash from admissions. 10 Paid balance due on Star Wars movies’ rental and $2,900 on March 1

accounts payable. 11 The Triquel Theater contracted with R. Lazlo to operate the concession

stand. Lazlo agrees to pay The Triquel 15% of gross receipts, payable monthly, for the rental of the concession stand.

12 Paid advertising expenses $500. 20 Received $8,300 cash from customers for admissions. 20 Received the Star Trek movies and paid rental fee of $5,000. 31 Paid salaries of $3,800. 31 Received statement from R. Lazlo showing gross receipts from concessions

of $10,000 and the balance due to The Triquel of $1,500 ($10,000 3 .15) for March. Lazlo paid half the balance due and will remit the remainder on April 5.

31 Received $20,000 cash from customers for admissions.

In addition to the accounts identifi ed above, the chart of accounts includes Accounts Receivable, Service Revenue, Rent Revenue, Advertising Expense, Rent Expense, and Salaries and Wages Expense.

Instructions (a) Using T-accounts, enter the beginning balances to the ledger. (b) Journalize the March transactions, including explanations. The Triquel records admis-

sion revenue as service revenue, concession revenue as sales revenue, and fi lm rental expense as rent expense.

P3-9A On July 31, 2017, the general ledger of Hills Legal Services Inc. showed the follow- ing balances: Cash $4,000, Accounts Receivable $1,500, Supplies $500, Equipment $5,000, Accounts Payable $4,100, Common Stock $3,500, and Retained Earnings $3,400. During August, the following transactions occurred.

Aug. 3 Collected $1,200 of accounts receivable due from customers. 5 Received $1,300 cash for issuing common stock to new investors. 6 Paid $2,700 cash on accounts payable. 7 Performed legal services of $6,500, of which $3,000 was collected in cash

and the remainder was due on account. 12 Purchased additional equipment for $1,200, paying $400 in cash and the

balance on account. 14 Paid salaries $3,500, rent $900, and advertising expenses $275 for the month

of August. 18 Collected the balance for the services performed on August 7. 20 Paid cash dividend of $500 to stockholders.

Tot. trial balance $16,900

Journalize transactions, post, and prepare a trial balance.

(LO 3, 4, 5), AP

(d) Cash $32,750 Tot. trial balance $128,800

Journalize transactions, post, and prepare a trial balance.

(LO 3, 4, 5), AP

Problems: Set A 143

24 Billed a client $1,000 for legal services performed. 26 Received $2,000 from Laurentian Bank; the money was borrowed on a bank

note payable that is due in 6 months. 27 Agreed to perform legal services for a client in September for $4,500. The

client will pay the amount owing after the services have been performed. 28 Received the utility bill for the month of August in the amount of $275; it is

not due until September 15. 31 Paid income tax for the month $500.

Instructions (a) Using T-accounts, enter the beginning balances to the ledger. (b) Journalize the August transactions. (c) Post the August journal entries to the ledger. (d) Prepare a trial balance on August 31, 2017.

P3-10A Pamper Me Salon Inc.’s general ledger at April 30, 2017, included the following: Cash $5,000, Supplies $500, Equipment $24,000, Accounts Payable $2,100, Notes Payable $10,000, Unearned Service Revenue (from gift certifi cates) $1,000, Common Stock $5,000, and Retained Earnings $11,400. The following events and transactions occurred during May.

May 1 Paid rent for the month of May $1,000. 4 Paid $1,100 of the account payable at April 30. 7 Issued gift certifi cates for future services for $1,500 cash. 8 Received $1,200 cash from customers for services performed. 14 Paid $1,200 in salaries to employees. 15 Received $800 in cash from customers for services performed. 15 Customers receiving services worth $700 used gift certifi cates in payment. 21 Paid the remaining accounts payable from April 30. 22 Received $1,000 in cash from customers for services performed. 22 Purchased supplies of $700 on account. All of these were used during the

month. 25 Received a bill for advertising for $500. This bill is due on June 13. 25 Received and paid a utilities bill for $400. 29 Received $1,700 in cash from customers for services performed. 29 Customers receiving services worth $600 used gift certifi cates in payment. 31 Interest of $50 was paid on the note payable. 31 Paid $1,200 in salaries to employees. 31 Paid income tax payment for the month $150.

Instructions (a) Using T-accounts, enter the beginning balances in the general ledger as of April 30,

2017. (b) Journalize the May transactions. (c) Post the May journal entries to the general ledger. (d) Prepare a trial balance on May 31, 2017.

P3-11A The bookkeeper for Roger’s Dance Studio made the following errors in journal- izing and posting. 1. A credit to Supplies of $600 was omitted. 2. A debit posting of $300 to Accounts Payable was inadvertently debited to Accounts

Receivable. 3. A purchase of supplies on account of $450 was debited to Supplies for $540 and cred-

ited to Accounts Payable for $540. 4. A credit posting of $680 to Interest Payable was posted twice. 5. A debit posting to Income Taxes Payable for $250 and a credit posting to Cash for

$250 were made twice. 6. A debit posting for $1,200 of Dividends was inadvertently posted to Salaries and Wages

Expense instead. 7. A credit to Service Revenue for $450 was inadvertently posted as a debit to Service

Revenue. 8. A credit to Accounts Receivable of $250 was credited to Accounts Payable.

Instructions For each error, indicate (a) whether the trial balance will balance, (b) the amount of the difference if the trial balance will not balance, and (c) the trial balance column that will

(d) Cash $6,225 Tot. trial balance $20,175

Journalize transactions, post, and prepare trial balance.

(LO 3, 4, 5), AP

(d) Cash $5,100 Tot. trial balance $34,800

Analyze errors and their effects on the trial balance.

(LO 5), AN

144 3 The Accounting Information System

have the larger total. Consider each error separately. Use the following form, in which error 1 is given as an example.

(a) (b) (c) Error In Balance Difference Larger Column

1 No $600 Debit

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 and 2.)

CC3 In November 2017, after having incorporated Cookie Creations Inc., Natalie begins operations. She has decided not to pursue the offer to supply cookies to Biscuits. Instead, the company will focus on offering cooking classes.

Go to the book’s companion website, www.wiley.com/college/kimmel, to see the com- pletion of this problem.

CONTINUING PROBLEM Cookie Creations▼

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT3-1 The fi nancial statements of Apple Inc. in Appendix A at the back of this textbook contain the following selected accounts, all in thousands of dollars.

Common Stock $ 23,313 Accounts Payable 30,196 Accounts Receivable 17,460 Selling, General, and Administrative Expenses 11,993 Inventories 2,111 Net Property, Plant, and Equipment 20,624 Net Sales 182,795

Instructions (a) What is the increase and decrease side for each account? What is the normal balance

for each account? (b) Identify the probable other account in the transaction and the effect on that account

when: (1) Accounts Receivable is decreased. (2) Accounts Payable is decreased. (3) Inventories is increased. (c) Identify the other account(s) that ordinarily would be involved when: (1) Interest Expense is increased. (2) Property, Plant, and Equipment is increased.

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT3-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information contained in these fi nancial statements, determine the

normal balance for:

Financial Reporting

▼

Financial Analysis

▼

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

▼ PROBLEMS: SET B AND SET C

Expand Your Critical Thinking 145

Columbia Sportswear VF

(1) Accounts Receivable (1) Inventories (2) Net Property, Plant, and Equipment (2) Income Taxes (3) Accounts Payable (3) Accrued Liabilities (4) Retained Earnings (4) Common Stock (5) Net Sales (5) Interest Expense

(b) Identify the other account ordinarily involved when: (1) Accounts Receivable is increased. (2) Notes Payable is decreased. (3) Equipment is increased. (4) Interest Revenue is increased.

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT3-3 Amazon.com, Inc.’s fi nancial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information contained in the fi nancial statements, determine the normal

balance of the listed accounts for each company.

Amazon Wal-Mart

1. Interest Expense 1. Product Revenues 2. Cash and Cash Equivalents 2. Inventories 3. Accounts Payable 3. Cost of Sales

(b) Identify the other account ordinarily involved when: (1) Accounts Receivable is increased. (2) Interest Expense is increased. (3) Salaries and Wages Payable is decreased. (4) Service Revenue is increased.

INTERPRETING FINANCIAL STATEMENTS

CT3-4 Chieftain International, Inc., is an oil and natural gas exploration and production company. A recent balance sheet reported $208 million in assets with only $4.6 million in liabilities, all of which were short-term accounts payable. During the year, Chieftain expanded its holdings of oil and gas rights, drilled 37 new wells, and invested in expensive 3-D seismic technology. The company generated $19 million cash from operating activities and paid no dividends. It had a cash balance of $102 million at the end of the year.

Instructions (a) Name at least two advantages to Chieftain from having no long-term debt. Can you

think of disadvantages? (b) What are some of the advantages to Chieftain from having this large a cash balance?

What is a disadvantage? (c) Why do you suppose Chieftain has the $4.6 million balance in accounts payable, since

it appears that it could have made all its purchases for cash?

REAL-WORLD FOCUS

CT3-5 Purpose: This activity provides information about career opportunities for CPAs.

Address: www.startheregoplaces.com/why-accounting, or go to www.wiley.com/ college/kimmel

Instructions Go the address shown above and then answer the following questions.

(a) Where do CPAs work? (b) What skills does a CPA need?

Financial Analysis

▼

Financial Analysis

▼

146 3 The Accounting Information System

(c) What is the salary range for a CPA at a large fi rm during the fi rst three years? What is the salary range for chief fi nancial offi cers and treasurers at large corporations?

CT3-6 The January 27, 2011, edition of the New York Times contains an article by Richard Sandomir entitled “N.F.L. Finances, as Seen Through Packers’ Records.” The article dis- cusses the fact that the Green Bay Packers are the only NFL team that publicly publishes its annual report.

Instructions Read the article and answer the following questions.

(a) Why are the Green Bay Packers the only professional football team to publish and distribute an annual report?

(b) Why is the football players’ labor union particularly interested in the Packers’ annual report?

(d) Even though the Packers’ revenue increased in recent years, the company’s operating profi t fell signifi cantly. How does the article explain this decline?

DECISION-MAKING ACROSS THE ORGANIZATION

CT3-7 Saira Morrow operates Dressage Riding Academy, Inc. The academy’s primary sourc- es of revenue are riding fees and lesson fees, which are provided on a cash basis. Saira also boards horses for owners, who are billed monthly for boarding fees. In a few cases, boarders pay in advance of expected use. For its revenue transactions, the academy main- tains these accounts: Cash, Accounts Receivable, Unearned Service Revenue, and Service Revenue. The academy owns 10 horses, a stable, a riding corral, riding equipment, and offi ce equipment. These assets are accounted for in the following accounts: Horses, Buildings, and Equipment. The academy employs stable helpers and an offi ce employee, who receive weekly salaries. At the end of each month, the mail usually brings bills for advertising, utilities, and veterinary service. Other expenses include feed for the horses and insurance. For its expenses, the academy maintains the following accounts: Supplies, Prepaid Insurance, Accounts Payable, Salaries and Wages Expense, Advertising Expense, Utilities Expense, Maintenance and Repairs Expense, Supplies Expense, and Insurance Expense. Saira’s sole source of personal income is dividends from the academy. Thus, the corporation declares and pays periodic dividends. To account for stockholders’ eq- uity in the business and dividends, two accounts are maintained: Common Stock and Dividends. During the fi rst month of operations, an inexperienced bookkeeper was employed. Saira asks you to review the following eight entries of the 50 entries made during the month. In each case, the explanation for the entry is correct.

May 1 Cash 15,000 Unearned Service Revenue 15,000 (Issued common stock in exchange for

$15,000 cash)

5 Cash 250 Service Revenue 250 (Received $250 cash for lesson fees)

7 Cash 500 Service Revenue 500 (Received $500 for boarding of horses

beginning June 1)

9 Supplies Expense 1,500 Cash 1,500 (Purchased estimated 5 months’ supply

of feed and hay for $1,500 on account)

Financial Analysis

Writing

Group Project

▼

Expand Your Critical Thinking 147

14 Equipment 80 Cash 800 (Purchased desk and other offi ce

equipment for $800 cash)

15 Salaries and Wages Expense 400 Cash 400 (Issued check to Saira Morrow for

personal use)

20 Cash 145 Service Revenue 154 (Received $154 cash for riding fees)

31 Maintenance and Repairs Expense 75 Accounts Receivable 75 (Received bill of $75 from carpenter

for repair services performed)

Instructions With the class divided into groups, answer the following.

(a) For each journal entry that is correct, so state. For each journal entry that is incorrect, prepare the entry that should have been made by the bookkeeper.

(b) Which of the incorrect entries would prevent the trial balance from balancing? (c) What was the correct net income for May, assuming the bookkeeper originally reported

net income of $4,500 after posting all 50 entries? (d) What was the correct cash balance at May 31, assuming the bookkeeper reported a

balance of $12,475 after posting all 50 entries?

COMMUNICATION ACTIVITY

CT3-8 Klean Sweep Company offers home cleaning service. Two recurring transactions for the company are billing customers for services performed and paying employee sala- ries. For example, on March 15 bills totaling $6,000 were sent to customers, and $2,000 was paid in salaries to employees.

Instructions Write a memorandum to your instructor that explains and illustrates the steps in the re- cording process for each of the March 15 transactions. Use the format illustrated in the textbook under the heading “The Recording Process Illustrated” (pp. 111–116).

ETHICS CASES

CT3-9 Vanessa Jones is the assistant chief accountant at IBT Company, a manufacturer of computer chips and cellular phones. The company presently has total sales of $20 million. It is the end of the fi rst quarter and Vanessa is hurriedly trying to prepare a trial balance so that quarterly fi nancial statements can be prepared and released to management and the regulatory agencies. The total credits on the trial balance exceed the debits by $1,000. In order to meet the 4 P.M. deadline, Vanessa decides to force the debits and credits into balance by adding the amount of the difference to the Equipment account. She chose Equipment because it is one of the larger account balances; percentage-wise, it will be the least misstated. Vanessa plugs the difference! She believes that the difference is quite small and will not affect anyone’s decisions. She wishes that she had another few days to fi nd the error but realizes that the fi nancial statements are already late.

Instructions (a) Who are the stakeholders in this situation? (b) What ethical issues are involved? (c) What are Vanessa’s alternatives?

CT3-10 The July 28, 2007, issue of the Wall Street Journal includes an article by Kathryn Kranhold entitled “GE’s Accounting Draws Fresh Focus on News of Improper Sales Bookings.”

Instructions Read the article and answer the following questions.

(a) What improper activity did the employees at GE engage in? (b) Why might the employees have engaged in this activity?

148 3 The Accounting Information System

(c) What were the implications for the employees who engaged in this activity? (d) What does it mean to “restate” fi nancial results? Why didn’t GE restate its results to

correct for the improperly reported locomotive sales?

ALL ABOUT YOU

CT3-11 In their annual reports to stockholders, companies must report or disclose infor- mation about all liabilities, including potential liabilities related to environmental clean-up. There are many situations in which you will be asked to provide personal fi nancial information about your assets, liabilities, revenues, and expenses. Sometimes you will face diffi cult decisions regarding what to disclose and how to disclose it.

Instructions Suppose that you are putting together a loan application to purchase a home. Based on your income and assets, you qualify for the mortgage loan, but just barely. How would you address each of the following situations in reporting your fi nancial position for the loan application? Provide responses for each of the following questions.

(a) You signed a guarantee for a bank loan that a friend took out for $20,000. If your friend doesn’t pay, you will have to pay. Your friend has made all of the payments so far, and it appears he will be able to pay in the future.

(b) You were involved in an auto accident in which you were at fault. There is the possi- bility that you may have to pay as much as $50,000 as part of a settlement. The issue will not be resolved before the bank processes your mortgage request.

(c) The company at which you work isn’t doing very well, and it has recently laid off employees. You are still employed, but it is quite possible that you will lose your job in the next few months.

A Look at IFRS

International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 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.

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

Similarities • Transaction analysis is the same under IFRS and GAAP. • Both the IASB and the FASB go beyond the basic definitions provided in the textbook

for the key elements of financial statements, that is assets, liabilities, equity, revenues, and expenses. The implications of the expanded definitions are discussed in more advanced accounting courses.

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

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

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

LEARNING OBJECTIVE 6 Compare the procedures for the recording process under GAAP and IFRS.▼

A Look at IFRS 149

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

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

IFRS PRACTICE IFRS SELF-TEST QUESTIONS 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 transactions as GAAP. (c) The chart of accounts under IFRS is different because revenues follow assets. (d) None of the above statements are correct.

2. The expanded accounting equation under IFRS is as follows: (a) Assets = Liabilities + Common Stock + Retained Earnings + Revenues −

Expenses + Dividends. (b) Assets + Liabilities = Common Stock + Retained Earnings + Revenues −

Expenses − Dividends. (c) Assets = Liabilities + Common Stock + Retained Earnings + Revenues −

Expenses − Dividends. (d) Assets = Liabilities + Common Stock + Retained Earnings − Revenues −

Expenses − Dividends. 3. A trial balance:

(a) is the same under IFRS and GAAP. (b) proves that transactions are recorded correctly. (c) proves that all transactions have been recorded. (d) will not balance if a correct journal entry is posted twice.

4. One difference between IFRS and GAAP is that: (a) GAAP uses accrual-accounting concepts and IFRS uses primarily the cash basis of

accounting. (b) IFRS uses a different posting process than GAAP. (c) IFRS uses more fair value measurements than GAAP. (d) the limitations of a trial balance are different between IFRS and GAAP.

5. The general policy for using proper currency signs (dollar, yen, pound, etc.) is the same for both IFRS and this textbook. This policy is as follows: (a) Currency signs only appear in ledgers and journal entries. (b) Currency signs are only shown in the trial balance. (c) Currency signs are shown for all compound journal entries. (d) Currency signs are shown in trial balances and financial statements.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS3-1 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Describe in which statement each of the following items is reported, and the position in the statement (e.g., current asset).

(a) Other operating income and expense. (b) Cash and cash equivalents. (c) Trade accounts payable. (d) Cost of net financial debt.

Answers to IFRS Self-Test Questions 1. b 2. c 3. a 4. c 5. d

As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of

revenues and expenses such as those at Groupon. In this chapter, we introduce you to the accrual

accounting concepts that make such adjustments possible.

CHAPTER PREVIEW

Accrual Accounting Concepts 4

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

• Revenue recognition principle • Expense recognition principle • Accrual vs. cash basis • Need for adjusting entries • Types of adjusting entries

▼1 Explain the accrual basis of accounting and the reasons for adjusting entries.

DO IT!

1 Timing Concepts

▼ ▼

Prepare adjusting entries for accruals.

Prepare an adjusted trial balance and closing entries.

• Accrued revenues • Accrued expenses • Summary of basic

relationships

• Preparing the adjusted trial balance

• Preparing fi nancial statements • Quality of earnings • Closing the books • Summary of the accounting

cycle

DO IT!

Adjusting Entries for Accruals

4a Trial Balance 4b Closing Entries

▼2

Prepare adjusting entries for deferrals. • Prepaid expenses• Unearned revenues

DO IT!

2 Adjusting Entries for Deferrals

Who doesn’t like buying things at a discount? That’s why it’s not surprising that three years after it started as a company, Groupon, Inc. was estimated to be worth $16 billion. This translates into an average increase in value of almost $15 million per day.

Now consider that Groupon had previously been estimated to be worth even more than that. What happened? Well, accounting regulators and investors began to question the way that Groupon had accounted for some of its transactions. Groupon sells coupons (“ Groupons”), so how hard can it be to account for that? It turns out that accounting for coupons is not as easy as you might think.

First, consider what happens when Groupon makes a sale. Suppose it sells a Groupon for $30 for Highrise Hamburgers. When it receives the $30 from the customer, it must turn over half of that amount ($15) to Highrise Hamburgers. So should Groupon record revenue for the full $30 or just $15? Until recently, Groupon recorded the full $30. But, in response to an SEC ruling on the issue, Groupon now records revenue of $15 instead. This caused Groupon to restate its previous fi nancial statements. This restatement reduced annual revenue by $312.9 million.

A second issue is a matter of timing. When should Groupon record this $15 revenue? Should it record the revenue when it sells the Groupon, or must it wait until

the customer uses the Groupon at Highrise Hamburgers? The accounting becomes even more complicated when you consider the company’s loyalty programs. Groupon offers free or discounted Groupons to its subscribers for doing things such as referring new customers or participating in

promotions. These Groupons are to be used for future purchases, yet the company must record the expense at the time the customer receives the Groupon.

Finally, Groupon, like all other companies, relies on many estimates in its fi nancial reporting. For example, Groupon reports that “estimates are utilized for, but not limited to, stock-based compensation, income taxes, valuation of acquired goodwill and intangible assets, customer refunds, contingent liabilities and the depreciable lives of fi xed assets.” It notes that “actual results could differ materially from those estimates.” So, next time you use a coupon, think about what that means for the company’s accountants!

FEATURE STORY

Keeping Track of Groupons

Rudy Archuleta/Redux Pictures

152 4 Accrual Accounting Concepts

LEARNING OBJECTIVE 1 Explain the accrual basis of accounting and the reasons for adjusting entries.▼

Businesses need feedback about how well they are performing during a period of time. For example, management usually wants monthly reports on fi nancial results, most large corporations are required to present quarterly and annual fi nan- cial statements to stockholders, and the Internal Revenue Service requires all busi- nesses to fi le annual tax returns. Accounting divides the economic life of a busi- ness into artifi cial time periods. As indicated in Chapter 2, this is the periodicity assumption. Accounting time periods are generally a month, a quarter, or a year. Companies often report using the calendar year (i.e., January 1 to December 31) but sometimes choose a different 12-month period (e.g., August 1 to July 31).

Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Citigroup or a new airplane purchased by Delta Air Lines will be used for many years. It would not make sense to expense the full cost of the building or the airplane at the time of pur- chase because each will be used for many subsequent periods. Instead, companies allocate the cost to the periods of use. Determining the amount of revenues and expenses to report in a given accounting period can be diffi cult. Proper reporting requires an understanding of the nature of the company’s business. Two principles are used as guidelines: the revenue recognition principle and the expense recognition principle.

THE REVENUE RECOGNITION PRINCIPLE

When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. The revenue recognition principle requires that com- panies recognize revenue in the accounting period in which the performance obligation is satisfi ed. To illustrate, assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the fi rst week of July. Under the revenue recognition principle, Conrad records revenue in June when it satisfi es its performance obligation, which is when it performs the service, not in July when it receives the cash. At June 30, Conrad would report a receivable on its balance sheet and revenue in its income statement for the service performed. The journal entries for June and July would be as follows.

June Accounts Receivable xxx Service Revenue xxx

July Cash xxx Accounts Receivable xxx

THE EXPENSE RECOGNITION PRINCIPLE

In recognizing expenses, a simple rule is followed: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. Applied to the preceding example, this means that the salary expense Conrad incurred in performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue. The critical issue in expense recogni- tion is determining when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Conrad does not pay the salary incurred on June 30 until July, it would report salaries and wages payable on its June 30 balance sheet. The practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle). It dictates that efforts (expenses) be matched with results (revenues). Illustration 4-1 shows these relationships.

▼ HELPFUL HINT An accounting time period that is one year long is called a fi scal year.

Revenue should be recog- nized in the accounting

period in which the service is performed.

Revenue Recognition

Customer requests service

Service performed

Cash received

Matching Revenues

Expenses

Advertising

Delivery

Utilities

Expense Recognition

Accrual-Basis Accounting and Adjusting Entries 153

Revenue and Expense Recognition

In accordance with generally accepted accounting principles

(GAAP).

Expense Recognition Principle

Match expenses with revenues in the period when the company makes efforts

to generate those revenues.

Periodicity Assumption

Economic life of business can be divided into

artificial time periods.

Revenue Recognition Principle

Revenue recognized in the accounting period in which the performance obligation

is satisfied.

ILLUSTRATION 4-1 GAAP relationships in revenue and expense recognition

DECISION TOOLS The revenue recognition principle and the expense recognition principle help to ensure that companies report the correct amount of revenues and expenses in a given period.

ACCRUAL VERSUS CASH BASIS OF ACCOUNTING

Accrual-basis accounting means that transactions that change a company’s fi nancial statements are recorded in the periods in which the events occur, even if cash was not exchanged. For example, using the accrual basis means that companies recognize revenues when they perform the services (the revenue recognition principle), even if cash was not received. Likewise, under the accrual basis, companies recognize expenses when incurred (the expense recognition principle), even if cash was not paid. An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue at the time they receive cash. They record an expense at the time they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading fi nancial statements. For example, it fails to record revenue for a company that has performed services but has not

INTERNATIONAL NOTE Although different accounting standards are often used by companies in other countries, the accrual basis of accounting is central to all of these standards.

Reporting Revenue Accurately

Until recently, electronics manufac- turer Apple was required to spread the revenues from iPhone sales over the two-year period following the sale of the phone. Accounting standards required this because Apple was obligated to provide software updates after the phone was sold. Since Apple had service obligations after the initial date of sale, it was forced to spread the revenue over a two-year period.

As a result, the rapid growth of iPhone sales was not fully refl ected in the revenue amounts reported in Apple’s income statement. A new accounting standard now enables Apple to report much more of its iPhone revenue at the point of sale. It was estimated that under the new rule revenues would have been about 17% higher and earnings per share almost 50% higher.

In the past, why was it argued that Apple should spread the recognition of iPhone revenue over a two-year period, rather than recording it upfront? (Go to WileyPLUS for this answer and additional questions.)

PhotoAlto/James Hardy/Getty Images, Inc.

INVESTOR INSIGHT Apple Inc.

154 4 Accrual Accounting Concepts

yet received payment. As a result, the cash basis may not refl ect revenue in the period that a performance obligation is satisfi ed. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Illustration 4-2 compares accrual-based numbers and cash-based numbers. Suppose that Fresh Colors paints a large building in 2016. In 2016, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000 but does not receive payment until 2017. On an accrual basis, Fresh Colors reports $80,000 of revenue during 2016 because that is when it performed the service. The company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2016 net income is $30,000 ($80,000 − $50,000). The $30,000 of net income reported for 2016 indicates the profi tability of Fresh Colors’ efforts during that period.

BOB’S

PIZZA

BARN

Fresh Colors

BOB’S PIZZA BARN

FRESH COLORS

( )

$ 0 0

$ 0

Revenue Expense Net loss

$80,000 0

$80,000

Revenue Expense Net income

Cash basis

$80,000 50,000

$30,000

Revenue Expense Net income

Accrual basis

Purchased paint, painted building, paid employees

2016

Received payment for work done in 2016

Activity

2017

$ 0 50,000

$ 50,000

ILLUSTRATION 4-2 Accrual-versus cash-basis accounting If Fresh Colors instead used cash-basis accounting, it would report $50,000

of expenses in 2016 and $80,000 of revenues during 2017. As shown in Illustra- tion 4-2, it would report a loss of $50,000 in 2016 and net income of $80,000 in 2017. Clearly, the cash-basis measures are misleading because the financial performance of the company would be misstated for both 2016 and 2017.

THE NEED FOR ADJUSTING ENTRIES

In order for revenues to be recorded in the period in which the performance obligations are satisfi ed and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed. Adjusting entries are necessary because the trial balance—the fi rst pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several 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 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

Accrual-Basis Accounting and Adjusting Entries 155

daily transactions. Examples are charges related to the use of buildings and equipment, 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 prepares fi nancial statements. The company analyzes each account in the trial balance to deter- mine whether it is complete and up-to-date for fi nancial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account.

TYPES OF ADJUSTING ENTRIES

Adjusting entries are classifi ed as either deferrals or accruals. As Illustration 4-3 shows, each of these classes has two subcategories.

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.

ILLUSTRATION 4-3 Categories of adjusting entries

Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Sierra Corporation from Chapter 3. It is reproduced in Illustration 4-4. Note that Retained Earnings has been added to this trial balance with a zero balance. We will explain its use later.

SIERRA CORPORATION Trial Balance

October 31, 2017

Debit Credit

Cash $15,200 Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Retained Earnings 0 Dividends 500 Service Revenue 10,000 Salaries and Wages Expense 4,000 Rent Expense 900

$28,700 $28,700

ILLUSTRATION 4-4 Trial balance

We assume that Sierra uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31.

156 4 Accrual Accounting Concepts

SOLUTION 1. f 2. e 3. c 4. b

1▼ Timing ConceptsDO IT! Below is a list of concepts in the left column, with descriptions of the concepts in the right column. There are more descriptions provided than concepts. Match the description of the concept to the concept.

1. ________ Accrual-basis accounting.

2. ________ Calendar year.

3. ________ Periodicity assumption.

4. ________ Expense recognition principle.

Action Plan ✔ Review the terms identi-

fi ed on pages 152–153. ✔ Study carefully the

revenue recognition principle, the expense recognition principle, and the periodicity assumption. Related exercise material: BE4-1, BE4-2, DO IT! 4-1, E4-1, E4-2, E4-3, and E4-5.

(a) Monthly and quarterly time periods. (b) Efforts (expenses) should be matched

with results (revenues). (c) Accountants divide the economic life of

a business into artifi cial time periods. (d) Companies record revenues when they

receive cash and record expenses when they pay out cash.

(e) An accounting time period that starts on January 1 and ends on December 31.

(f) Companies record transactions in the period in which the events occur.

LEARNING OBJECTIVE 2 Prepare adjusting entries for deferrals.▼

To defer means to postpone or delay. Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged. Companies make adjusting entries for deferred expenses to record the portion that was incurred during the period. Companies also make adjusting entries for deferred revenues to record services performed during the period. The two types of deferrals are prepaid expenses and unearned revenues.

PREPAID EXPENSES

Companies record payments of expenses that will benefi t more than one account- ing period as assets. These prepaid expenses or prepayments are expenses paid in cash before they are used or consumed. When expenses are prepaid, an asset account is increased (debited) to show the service or benefi t that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they pur- chase buildings and equipment. Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of such cost expirations until they prepare fi nancial statements. At each statement date, they make adjusting

JOURNALIZEANALYZE POST TRIAL

BALANCE

ADJUSTED TRIAL

BALANCE

FINANCIAL STATEMENTS

CLOSING ENTRIES

POST-CLOSING TRIAL BALANCEE

ADJA T

BBBABA

Journalize and post adjusting

entries: deferrals/accruals

Adjusting Entries for Deferrals 157

entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts. Prior to adjustment, assets are overstated and expenses are understated. Therefore, as shown in Illustration 4-5, an adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.

Prepaid Expenses

Asset

Credit Adjusting Entry (–)

Unadjusted Balance

Expense

Debit Adjusting Entry (+)

ILLUSTRATION 4-5 Adjusting entries for prepaid expenses

Let’s look in more detail at some specifi c types of prepaid expenses, beginning with supplies.

Supplies The purchase of supplies, such as paper and envelopes, results in an increase (a debit) to an asset account. During the accounting period, the company uses sup- plies. Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period. At the end of the accounting period, the company counts the remaining supplies. The difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies used (an expense) for that period. Recall from Chapter 3 that Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. A physical count of the inventory at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Thus, the cost of supplies used is $1,500 ($2,500 − $1,000). This use of supplies decreases an asset, Supplies. It also decreases stockholders’ equity by increasing an expense account, Supplies Expense. This is shown in Illustration 4-6.

Supplies used; record supplies expense

Supplies purchased; record asset

Oct. 31

Oct. 5

Supplies

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Equation Analysis

Oct. 5 2,500

Oct. 31 Bal. 1,000

Oct. 31 Adj. 1,500

Supplies

Oct. 31 Adj. 1,500

Oct. 31 Bal. 1,500

Supplies Expense

Debits increase expenses: debit Supplies Expense $1,500. Credits decrease assets: credit Supplies $1,500.

Oct. 31 Supplies Expense Supplies (To record supplies used)

1,500 1,500

The expense Supplies Expense is increased $1,500; the asset Supplies is decreased $1,500.

Assets Supplies

–$1,500

+Liabilities Stockholders’ Equity Supplies Expense

–$1,500

(1)

ILLUSTRATION 4-6 Adjustment for supplies

▼ HELPFUL HINT Due to their nature, adjusting entries have no effect on cash fl ows. As a result, we do not show the cash fl ow effects as we did in Chapter 3.

158 4 Accrual Accounting Concepts

After adjustment, the asset account Supplies shows a balance of $1,000, which is equal to the cost of supplies on hand at the statement date. In addition, Sup- plies Expense shows a balance of $1,500, which equals the cost of supplies used in October. If Sierra does not make the adjusting entry, October expenses will be understated and net income overstated by $1,500. Moreover, both assets and stockholders’ equity will be overstated by $1,500 on the October 31 balance sheet.

Insurance Companies purchase insurance to protect themselves from losses due to fi re, theft, and unforeseen events. Insurance must be paid in advance, often for multiple months. The cost of insurance (premiums) paid in advance is recorded as an increase (debit) in the asset account Prepaid Insurance. At the fi nancial state- ment date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period. On October 4, Sierra Corporation paid $600 for a one-year fi re insurance policy. Coverage began on October 1. Sierra recorded the payment by increas- ing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 ÷ 12) expires each month. The expi- ration of prepaid insurance decreases an asset, Prepaid Insurance. It also decreases stockholders’ equity by increasing an expense account, Insurance Expense. As shown in Illustration 4-7, the asset Prepaid Insurance shows a balance of $550, which represents the unexpired cost for the remaining 11 months of cov- erage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. If Sierra does not make this adjustment, October expenses are understated by $50 and net income is overstated by $50. More- over, both assets and stockholders’ equity will be overstated by $50 on the October 31 balance sheet.

Insurance Policy Nov $50

Dec $50

Jan $50

Feb $50

March $50

April $50

May $50

June $50

July $50

Aug $50

Sept $50

Insurance = $600/year

Oct $50

FIRE INSURANCE 1 year

insurance policy $600

Insurance expired; record insurance expense

Insurance purchased; record asset

Oct. 4

Oct. 31

Insurance

Debit–Credit Analysis

Journal Entry

Basic Analysis

Debits increase expenses: debit Insurance Expense $50. Credits decrease assets: credit Prepaid Insurance $50.

Oct. 31 Insurance Expense Prepaid Insurance (To record insurance expired)

50 50

The expense Insurance Expense is increased $50; the asset Prepaid Insurance is decreased $50.

Assets Prepaid Insurance

2$50

(2) =

+Liabilities Stockholders’ Equity Insurance Expense

2$50

Equation Analysis

Posting Prepaid Insurance Insurance Expense

Oct. 4 600

Oct. 31 Bal. 550

Oct. 31 Adj. 50 Oct. 31 Adj. 50

Oct. 31 Bal. 50

ILLUSTRATION 4-7 Adjustment for insurance

Depreciation A company typically owns a variety of assets that have long lives, such as build- ings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset. Because a building is expected to be of service for many years, it is recorded as an asset, rather than an expense, on the date it is acquired. As explained in Chapter 2, companies record such assets at cost, as required by the historical cost principle. To follow the expense recognition principle,

Adjusting Entries for Deferrals 159

companies allocate a portion of this cost as an expense during each period of the asset’s useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life.

NEED FOR ADJUSTMENT The acquisition of long-lived assets is essentially a long- term prepayment for the use of an asset. An adjusting entry for depreciation is needed to recognize the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the end of the period. One very impor- tant point to understand: Depreciation is an allocation concept, not a valua- tion 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. For Sierra Corporation, assume that depreciation on the equipment is $480 a year, or $40 per month. As shown in Illustration 4-8, rather than decrease (credit) the asset account directly, Sierra instead credits Accumulated Depreciation— Equipment. Accumulated Depreciation is called a contra asset account. Such an account is offset against an asset account on the balance sheet. Thus, the Accumu- lated Depreciation—Equipment account offsets the asset Equipment. This account keeps track of the total amount of depreciation expense taken over the life of the asset. To keep the accounting equation in balance, Sierra decreases stockholders’ equity by increasing an expense account, Depreciation Expense.

Equipment Nov $40

Dec $40

Jan $40

Feb $40

March $40

April $40

May $40

June $40

July $40

Aug $40

Sept $40

Oct $40

Depreciation = $480/year

Depreciation recognized; record depreciation expense

Equipment purchased; record asset

Oct. 2

Oct. 31

Depreciation

▼ HELPFUL HINT All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Oct. 31 Adj. 40

Oct. 31 Bal. 40

Accumulated Depreciation—Equipment Oct. 31 Adj. 40

Oct. 31 Bal. 40

Depreciation Expense

Oct. 2 5,000

Oct. 31 Bal. 5,000

Equipment

Debits increase expenses: debit Depreciation Expense $40. Credits increase contra assets: credit Accumulated Depreciation—Equipment $40.

Oct. 31 Depreciation Expense Accumulated Depreciation— Equipment (To record monthly depreciation)

40 40

The expense Depreciation Expense is increased $40; the contra asset Accumulated Depreciation—Equipment is increased $40.

Assets Accumulated

Depreciation—Equipment

2$40

+Liabilities Stockholders’ Equity

Depreciation Expense

2$40

Equation Analysis

ILLUSTRATION 4-8 Adjustment for depreciation

The balance in the Accumulated Depreciation—Equipment account will increase $40 each month, and the balance in Equipment remains $5,000.

STATEMENT PRESENTATION As noted above, Accumulated Depreciation— Equipment is a contra asset account. It is offset against Equipment on the balance sheet. The normal balance of a contra asset account is a credit. A theoretical alternative to using a contra asset account would be to decrease (credit) the asset account by the amount of depreciation each period. But using the contra account is prefer- able for a simple reason: It discloses both the original cost of the equipment and the total cost that has expired to date. Thus, in the balance sheet, Sierra deducts Accumulated Depreciation—Equipment from the related asset account, as shown in Illustration 4-9 (page 160).

160 4 Accrual Accounting Concepts

Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation. In Illustration 4-9, the book value of the equipment at the balance sheet date is $4,960. The book value and the fair value of the asset are generally two different values. As noted earlier, the purpose of depreciation is not valuation but a means of cost allocation. Depreciation expense identifi es the portion of an asset’s cost that expired dur- ing the period (in this case, in October). Without this adjusting entry, total assets, total stockholders’ equity, and net income are overstated by $40 and depreciation expense is understated by $40. Illustration 4-10 summarizes the accounting for prepaid expenses.

ALTERNATIVE TERMINOLOGY Book value is also referred to as carrying value.

UNEARNED REVENUES

Companies record cash received before services are performed by increasing (crediting) a liability account called unearned revenues. In other words, the company has a performance obligation to transfer a service to one of its cus- tomers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines such as United, American, and Delta, for instance, treat receipts from the sale of tickets as unearned revenue until the fl ight service is provided. Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepaid expense on the books of the company that has made the advance payment. For example, if iden- tical accounting periods are assumed, a landlord will have unearned rent revenue when a tenant has prepaid rent. When a company receives payment for services to be performed in a future accounting period, it increases (credits) an unearned revenue account. Unearned revenue is a liability account used to recognize the obligation that exists. The company subsequently recognizes revenues when it performs the service. Dur- ing the accounting period, it is not practical to make daily entries as the com- pany performs services. Instead, the company delays recognition of revenue until the adjustment process. The company then 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. Prior to adjustment, liabilities are typically overstated and revenues are understated. Therefore, as shown in Illustration 4-11, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a rev- enue account. Sierra Corporation received $1,200 on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Sierra credited the payment to Unearned Service Revenue. This liability account shows a balance of

$1,200

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

ILLUSTRATION 4-10 Accounting for prepaid expenses

ACCOUNTING FOR PREPAID EXPENSES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Insurance, supplies, Prepaid expenses Assets overstated. Dr. Expenses advertising, rent, originally recorded Expenses understated. Cr. Assets depreciation in asset accounts or Contra have been used. Assets

ILLUSTRATION 4-9 Balance sheet presentation of accumulated depreciation

Equipment $ 5,000 Less: Accumulated depreciation—equipment 40

$4,960

Adjusting Entries for Deferrals 161

$1,200 in the October 31 trial balance. From an evaluation of the service Sierra performed for Knox during October, the company determines that it should rec- ognize $400 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased and stockholders’ equity (Service Revenue) is increased. As shown in Illustration 4-12, the liability Unearned Service Revenue now shows a balance of $800. That amount represents the remaining guide services Sierra is obligated to perform in the future. Service Revenue shows total revenue for October of $10,400. Without this adjustment, revenues and net income are understated by $400 in the income statement. Moreover, liabilities are overstated and stockholders’ equity is understated by $400 on the October 31 balance sheet.

Unearned Revenues

Liability Revenue

Credit Adjusting Entry (+)

Debit Adjusting Entry (–)

Unadjusted Balance

ILLUSTRATION 4-11 Adjusting entries for unearned revenues

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Oct. 31 Adj. 400 Oct. 2 1,200

Oct.31 Bal. 800

Oct. 3 10,000 31 Adj. 400

Oct. 31 Bal. 10,400

Unearned Service Revenue Service Revenue

Debits decrease liabilities: debit Unearned Service Revenue $400. Credits increase revenues: credit Service Revenue $400.

Oct. 31 Unearned Service Revenue Service Revenue (To record revenue for services performed)

400 400

The liability Unearned Service Revenue is decreased $400; the revenue Service Revenue is increased $400.

Assets Unearned

Service Revenue

= +Liabilities Stockholders’ Equity

Service Revenue Equation Analysis

2$400 1$400

ILLUSTRATION 4-12 Service revenue accounts after adjustment

Illustration 4-13 summarizes the accounting for unearned revenues.

ILLUSTRATION 4-13 Accounting for unearned revenues

ACCOUNTING FOR UNEARNED REVENUES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Rent, magazine Unearned revenues Liabilities overstated. Dr. Liabilities subscriptions, recorded in liability Revenues understated. Cr. Revenues customer deposits accounts are now for future service recognized as revenue for services performed.

162 4 Accrual Accounting Concepts

Turning Gift Cards into Revenue

Those of you who are marketing majors (and even most of you who are not) know that gift cards are among the hottest marketing tools in merchandising today. Custom- ers purchase gift cards and give them to someone for later use. In a recent year, gift-card sales were expected to exceed $124 billion.

Although these programs are popular with marketing executives, they create accounting questions.

Should revenue be recorded at the time the gift card is sold, or when it is exercised? How should expired gift cards be accounted for? In a recent balance sheet, Best Buy reported unearned revenue related to gift cards of $406 million.

Source: “2014 Gift Card Sales to Top $124 Billion, But Growth Slowing,” PRNewswire (December 10, 2014).

Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24, 2016, and gives it to his wife, Mary Jones, on December 25, 2016. On January 3, 2017, Mary uses the card to purchase $100 worth of CDs. When do you think Best Buy should recognize revenue and why? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Best Buy

2▼ Adjusting Entries for DeferralsDO IT! The ledger of Hammond, Inc. on March 31, 2017, includes these selected accounts before adjusting entries are prepared.

Debit Credit

Prepaid Insurance $ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment $5,000 Unearned Service Revenue 9,200

An analysis of the accounts shows the following.

1. Insurance expires at the rate of $100 per month.

2. Supplies on hand total $800.

3. The equipment depreciates $200 a month.

4. During March, services were performed for $4,000 of the unearned service revenue reported.

Prepare the adjusting entries for the month of March.

SOLUTION 1. Insurance Expense 100 Prepaid Insurance 100 (To record insurance expired)

2. Supplies Expense ($2,800 − $800) 2,000 Supplies 2,000 (To record supplies used)

3. Depreciation Expense 200 Accumulated Depreciation—Equipment 200 (To record monthly depreciation)

4. Unearned Service Revenue 4,000 Service Revenue 4,000 (To record revenue for services performed)

Related exercise material: BE4-4, BE4-5, BE4-6, BE4-7, and DO IT! 4-2.

Action Plan ✔ Make adjusting entries at

the end of the period for revenues recognized and expenses incurred in the period.

✔ Don’t forget to make adjusting entries for deferrals. Failure to adjust for deferrals leads to overstatement of the asset or liability and understatement of the related expense or revenue.

Adjusting Entries for Accruals 163

LEARNING OBJECTIVE 3 Prepare adjusting entries for accruals.▼ The second category of adjusting entries is accruals. Prior to an accrual adjust- ment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account.

ACCRUED REVENUES

Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the pass- ing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not 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 unre- corded because only a portion of the total service has been performed and the clients won’t 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 adjust- ment, both assets and revenues are understated. As shown in Illustration 4-14, an adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.

ANALYZE JOURNALIZE TRIAL

BALANCE POST

ADJUSTED TRIAL

BALANCE

FINANCIAL STATEMENTS

CLOSING ENTRIES

POST-CLOSING TRIAL BALANCEE

AD T

BBBBA

Journalize and post adjusting

entries: deferrals/accruals

$200

My fee is $200

Cash is received; receivable is reduced

Revenue and receivable are recorded for unbilled services

Nov. 10

Accrued Revenues

Asset Revenue

Debit Adjusting Entry (+)

Credit Adjusting Entry (+)

ILLUSTRATION 4-14 Adjusting entries for accrued revenues

▼ HELPFUL HINT For accruals, there may have been no prior entry, and the accounts requiring adjustment may both have zero balances prior to adjustment.

In October, Sierra Corporation performed guide services worth $200 that were not billed to clients on or before October 31. Because these services were not billed, they were not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases stockhold- ers’ equity by increasing a revenue account, Service Revenue, as shown in Illustration 4-15 (page 164). The asset Accounts Receivable shows that clients owe Sierra $200 at the balance sheet date. The balance of $10,600 in Service Revenue represents the total revenue for services Sierra performed during the month ($10,000 + $400 + $200). Without the adjusting entry, assets and stockholders’ equity on the balance sheet and revenues and net income on the income statement are understated.

164 4 Accrual Accounting Concepts

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Oct. 31 Adj. 200

Oct. 31 Bal. 200

Accounts Receivable

Debits increase assets: debit Accounts Receivable $200. Credits increase revenues: credit Service Revenue $200.

Oct. 31 Accounts Receivable Service Revenue (To record revenue for services performed)

200 200

The asset Accounts Receivable is increased $200; the revenue Service Revenue is increased $200.

Assets = +Liabilities Stockholders’ Equity

Service Revenue

1$200

Accounts Receivable

1$200

Equation Analysis

Oct. 3 10,000 31 400 31 Adj. 200

Oct. 31 Bal. 10,600

Service Revenue

ILLUSTRATION 4-15 Adjustment for accrued revenue

On November 10, Sierra receives cash of $200 for the services performed in October and makes the following entry.

Nov. 10 Cash 200 Accounts Receivable 200 (To record cash collected on account)

The company records the collection of the receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable. Illustration 4-16 summarizes the accounting for accrued revenues.

A L SE= + +200 −200 Cash Flows +200

ACCOUNTING FOR ACCRUED REVENUES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Interest, rent, Services performed Assets understated. Dr. Assets services but not yet received Revenues understated. Cr. Revenues in cash or recorded.

ILLUSTRATION 4-16 Accounting for accrued revenues

ACCRUED EXPENSES

Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, utilities, and salaries are common examples of accrued expenses. Companies make adjustments for accrued expenses to record the obligations that exist at the balance sheet date and to recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, as shown in Illustration 4-17, an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

ETHICS NOTE A report released by Fannie

Mae’s board of directors stated that improper adjusting

entries at the mortgage-fi nance company resulted in delayed

recognition of expenses caused by interest-rate changes. The motivation for this improper

accounting apparently was the desire to meet earnings targets.

▼

Equation analyses summarize the effects of transactions on the three elements of the accounting equation, as well as the effect on cash fl ows.

Adjusting Entries for Accruals 165

Accrued Expenses

Expense Liability

Credit Adjusting Entry (+)

Debit Adjusting Entry (+)

ILLUSTRATION 4-17 Adjusting entries for accrued expenses

Let’s look in more detail at some specifi c types of accrued expenses, begin- ning with accrued interest.

Accrued Interest Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%. The amount of the interest recorded is determined by three factors: (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 Sierra, the total interest due on the $5,000 note at its maturity date three months in the future is $150 ($5,000 × 12% × 312), or $50 for one month. Illustration 4-18 shows the formula for comput- ing interest and its application to Sierra for the month of October.

Annual Time in

Face Value × Interest × Terms of = Interest

of Note

Rate One Year

$5,000 × 12% × 112 = $50

ILLUSTRATION 4-18 Formula for computing interest

▼ HELPFUL HINT In computing interest, we express the time period as a fraction of a year.

As Illustration 4-19 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.

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Equation Analysis

Oct. 31 Adj. 50

Oct. 31 Bal. 50

Oct. 31 Adj. 50

Oct. 31 Bal. 50

Interest Expense Interest Payable

Debits increase expenses: debit Interest Expense $50. Credits increase liabilities: credit Interest Payable $50.

Oct. 31 Interest Expense Interest Payable (To record interest on notes payable)

50 50

The expense Interest Expense is increased $50; the liability Interest Payable is increased $50.

Assets Interest Payable

1$50

= +Liabilities Stockholders’ Equity Interest Expense

2$50

ILLUSTRATION 4-19 Adjustment for accrued interest

166 4 Accrual Accounting Concepts

Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest the company owes at the statement date. Sierra will not pay the interest until the note comes due at the end of three months. Com- panies use the Interest Payable account, instead of crediting Notes Payable, to dis- close 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 net income and stockholders’ equity are overstated.

Accrued Salaries Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. Sierra paid salaries on October 26 for its employees’ fi rst two weeks of work; the next payment of salaries will not occur until November 9. As Illustration 4-20 shows, three working days remain in October (October 29–31).

October

Adjustment period

Start of pay period

Payday Payday

S M Tu W Th F S 1 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

ILLUSTRATION 4-20 Calendar showing Sierra Corporation’s pay periods

At October 31, the salaries for these three days represent an accrued expense and a related liability to Sierra. The employees receive total salaries of $2,000 for a fi ve-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 × 3). This accrual increases a liability, Salaries and Wages Payable. It also decreases stockholders’ equity by increasing an expense account, Salaries and Wages Expense, as shown in Illustration 4-21.

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Equation Analysis

Oct. 26 4,000 31 Adj. 1,200

Oct. 31 Bal. 5,200

Oct. 31 Adj. 1,200

Oct. 31 Bal. 1,200

Salaries and Wages Expense Salaries and Wages Payable

Debits increase expenses: debit Salaries and Wages Expense $1,200. Credits increase liabilities: credit Salaries and Wages Payable $1,200.

Oct. 31 Salaries and Wages Expense Salaries and Wages Payable (To record accrued salaries)

1,200 1,200

The expense Salaries and Wages Expense is increased $1,200; the liability Salaries and Wages Payable is increased $1,200.

Assets Salaries and Wages Payable

1$1,200

= +Liabilities Stockholders’ Equity Salaries and Wages Expense

2$1,200

ILLUSTRATION 4-21 Adjustment for accrued salaries

Adjusting Entries for Accruals 167

After this adjustment, the balance in Salaries and Wages Expense of $5,200 (13 days × $400) is the actual salary expense for October. (The employees worked 13 days in October after beginning work on October 15.) The balance in Salaries and Wages Payable of $1,200 is the amount of the liability for salaries Sierra owes as of October 31. Without the $1,200 adjustment for salaries, Sierra’s expenses are understated $1,200 and its liabilities are understated $1,200. Sierra pays salaries every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries of $4,000. The pay- ment consists of $1,200 of salaries and wages payable at October 31 plus $2,800 of salaries and wages expense for November (7 working days as shown in the November calendar × $400). Therefore, Sierra makes the following entry on November 9.

Nov. 9 Salaries and Wages Payable 1,200 Salaries and Wages Expense 2,800 Cash 4,000 (To record November 9 payroll)

This entry eliminates the liability for Salaries and Wages Payable that Sierra recorded in the October 31 adjusting entry, and it records the proper amount of Salaries and Wages Expense for the period between November 1 and November 9. Illustration 4-22 summarizes the accounting for accrued expenses.

A L SE= + −1,200 −2,800 −4,000

Cash Flows −4,000

ACCOUNTING FOR ACCRUED EXPENSES

Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry

Interest, rent, Expenses have been Expenses understated. Dr. Expenses salaries incurred but not yet paid Liabilities understated. Cr. Liabilities in cash or recorded.

ILLUSTRATION 4-22 Accounting for accrued expenses

PEOPLE, PLANET, AND PROFIT INSIGHT

Got Junk?

Do you have an old computer or two in your garage? How about an old TV that needs replacing? Many people do. Approximately 163,000 computers and televisions become obsolete each day. Yet, in a recent year, only 11% of computers were recycled. It is estimated that 75% of

all computers ever sold are sitting in storage somewhere, wait- ing to be disposed of. Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemi- cals. If you have one of these electronic gadgets, you have a responsibility, and a probable cost, for disposing of it. Compa- nies have the same problem, but their discarded materials may include lead paint, asbestos, and other toxic chemicals.

What accounting issue might this cause for companies? (Go to WileyPLUS for this answer and additional questions.)© Nathan Gleave/iStockphoto

SUMMARY OF BASIC RELATIONSHIPS

Illustration 4-23 (page 168) summarizes the four basic types of adjusting entries. Take some time to study and analyze the adjusting entries. Be sure to note that each adjusting entry affects one balance sheet account and one income statement account.

168 4 Accrual Accounting Concepts

Type of Adjustment Accounts Before Adjustment Adjusting Entry Prepaid expenses Assets overstated. Dr. Expenses Expenses understated. Cr. Assets or Contra Assets

Unearned revenues Liabilities overstated. Dr. Liabilities Revenues understated. Cr. Revenues

Accrued revenues Assets understated. Dr. Assets Revenues understated. Cr. Revenues

Accrued expenses Expenses understated. Dr. Expenses Liabilities understated. Cr. Liabilities

ILLUSTRATION 4-23 Summary of adjusting entries

Illustrations 4-24 and 4-25 show the journalizing and posting of adjusting entries for Sierra Corporation on October 31. When reviewing the general ledger in Illustration 4-25, note that for learning purposes we have highlighted the adjustments in red.

ILLUSTRATION 4-24 General journal showing adjusting entries

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2017 Adjusting Entries

Oct. 31 Supplies Expense 1,500 Supplies 1,500 (To record supplies used)

31 Insurance Expense 50 Prepaid Insurance 50 (To record insurance expired)

31 Depreciation Expense 40 Accumulated Depreciation—Equipment 40 (To record monthly depreciation)

31 Unearned Service Revenue 400 Service Revenue 400 (To record revenue for services performed)

31 Accounts Receivable 200 Service Revenue 200 (To record revenue for services performed)

31 Interest Expense 50 Interest Payable 50 (To record interest on notes payable)

31 Salaries and Wages Expense 1,200 Salaries and Wages Payable 1,200 (To record accrued salaries)

Adjusting Entries for Accruals 169

GENERAL LEDGER

Cash

Oct. 1 10,000 Oct. 2 5,000 1 5,000 3 900 2 1,200 4 600 3 10,000 20 500 26 4,000

Oct. 31 Bal. 15,200

Accounts Receivable

Oct. 31 200

Oct. 31 Bal. 200

Supplies

Oct. 5 2,500 Oct. 31 1,500

Oct. 31 Bal. 1,000

Prepaid Insurance

Oct. 4 600 Oct. 31 50

Oct. 31 Bal. 550

Equipment

Oct. 2 5,000

Oct. 31 Bal. 5,000

Accumulated Depreciation— Equipment

Oct. 31 40

Oct. 31 Bal. 40

Notes Payable

Oct. 1 5,000

Oct. 31 Bal. 5,000

Accounts Payable

Oct. 5 2,500

Oct. 31 Bal. 2,500

Interest Payable

Oct. 31 50

Oct. 31 Bal. 50

Unearned Service Revenue

Oct. 31 400 Oct. 2 1,200

Oct. 31 Bal. 800

Salaries and Wages Payable

Oct. 31 1,200

Oct. 31 Bal. 1,200

Common Stock

Oct. 1 10,000

Oct. 31 Bal. 10,000

Retained Earnings

Oct. 31 Bal. 0

Dividends

Oct. 20 500

Oct. 31 Bal. 500

Service Revenue

Oct. 3 10,000 31 400 31 200

Oct. 31 Bal. 10,600

Salaries and Wages Expense

Oct. 26 4,000 31 1,200

Oct. 31 Bal. 5,200

Supplies Expense

Oct. 31 1,500

Oct. 31 Bal. 1,500

Rent Expense

Oct. 3 900

Oct. 31 Bal. 900

Insurance Expense

Oct. 31 50

Oct. 31 Bal. 50

Interest Expense

Oct. 31 50

Oct. 31 Bal. 50

Depreciation Expense

Oct. 31 40

Oct. 31 Bal. 40

ILLUSTRATION 4-25 General ledger after adjustments

170 4 Accrual Accounting Concepts

3▼ Adjusting Entries for AccrualsDO IT! Micro Computer Services Inc. began operations on August 1, 2017. At the end of August 2017, management attempted to prepare monthly fi nancial statements. The following information relates to August.

1. At August 31, the company owed its employees $800 in salaries that will be paid on September 1.

2. On August 1, the company borrowed $30,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%.

3. Revenue for services performed but unrecorded for August totaled $1,100.

Prepare the adjusting entries needed at August 31, 2017.

SOLUTION 1. Salaries and Wages Expense 800 Salaries and Wages Payable 800 (To record accrued salaries)

2. Interest Expense 250 Interest Payable 250 (To record accrued interest: $30,000 × 10% × 112 = $250) 3. Accounts Receivable 1,100 Service Revenue 1,100 (To record revenue for services performed)

Related exercise material: BE4-8, DO IT! 4-3, E4-8, E4-9, E4-10, E4-11, E4-12, E4-13, E4-14, E4-15, E4-16, E4-17, and E4-18.

Action Plan ✔ Make adjusting entries

at the end of the period to recognize revenue for services performed and for expenses incurred.

✔ Don’t forget to make adjusting entries for accruals. Adjusting entries for accruals will increase both a balance sheet and an income statement account.

LEARNING OBJECTIVE 4 Prepare an adjusted trial balance and closing entries.▼

After a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the balances of all accounts, including those adjusted, at the end of the accounting period. 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 fi nancial statements, the adjusted trial balance is the primary basis for the preparation of fi nancial statements.

PREPARING THE ADJUSTED TRIAL BALANCE

Illustration 4-26 presents the adjusted trial balance for Sierra Corporation pre- pared from the ledger accounts in Illustration 4-25. The amounts affected by the adjusting entries are highlighted in red.

JOURNALIZEANALYZE POST TRIAL

BALANCE

ADJUSTING ENTRIES

Prepare a post-closing trial balance pp ttr

Journalize and post closing

entries

Jo p

Prepare fi nancial

statements fi

sssst

Adjusted trial

balance

The Adjusted Trial Balance and Closing Entries 171

PREPARING FINANCIAL STATEMENTS

Companies can prepare fi nancial statements directly from an adjusted trial balance. Illustrations 4-27 (page 172) and 4-28 (page 173) present the relation- ships between the data in the adjusted trial balance of Sierra Corporation and the corresponding fi nancial statements. As Illustration 4-27 shows, companies prepare the income statement from the revenue and expense accounts. Similarly, they derive the retained earnings statement from the Retained Earnings account, Dividends account, and the net income (or net loss) shown in the income state- ment. As Illustration 4-28 shows, companies then prepare the balance sheet from the asset, liability, and stockholders’ equity accounts. They obtain the amount reported for retained earnings on the balance sheet from the ending balance in the retained earnings statement.

ILLUSTRATION 4-26 Adjusted trial balanceSIERRA CORPORATION

Adjusted Trial Balance October 31, 2017

Debit Credit

Cash $ 15,200 Accounts Receivable 200 Supplies 1,000 Prepaid Insurance 550 Equipment 5,000 Accumulated Depreciation—Equipment $ 40 Notes Payable 5,000 Accounts Payable 2,500 Interest Payable 50 Unearned Service Revenue 800 Salaries and Wages Payable 1,200 Common Stock 10,000 Retained Earnings 0 Dividends 500 Service Revenue 10,600 Salaries and Wages Expense 5,200 Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40

$30,190 $30,190

172 4 Accrual Accounting Concepts

QUALITY OF EARNINGS

Companies and employees are continually under pressure to “make the numbers”—that is, to have earnings that are in line with expectations. There- fore, it is not surprising that many companies practice earnings management. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. The quality of earnings is greatly affected when a company manages earnings up or down to meet some targeted earnings number. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead fi nancial statement users. A company with questionable quality of earnings may mislead investors and creditors, who believe they are relying on rele- vant information that provides a faithful representation of the company. As a result, investors and creditors lose confi dence in fi nancial reporting, and it becomes diffi cult for our capital markets to work effi ciently. Companies manage earnings in a variety of ways. One way is through the use of one-time items to prop up earnings numbers. For example, ConAgra Foods

SIERRA CORPORATION Adjusted Trial Balance

October 31, 2017

$15,200 200

1,000 550

5,000

500

5,200 1,500

900 50 50 40

$ 40 5,000 2,500

50 800

1,200 10,000

10,600

$30,190 $30,190

Account Debit Credit

SIERRA CORPORATION 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

$5,200 1,500

900 50 50 40

$10,600

7,740

$ 2,860

SIERRA CORPORATION Retained Earnings Statement

For the Month Ended October 31, 2017

Retained earnings, October 1 Add: Net income

Less: Dividends Retained earnings, October 31

$ 0 2,860

2,860 500

$ 2,360

Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

Retained Earnings Dividends

To balance sheet

ILLUSTRATION 4-27 Preparation of the income statement and retained earnings statement from the adjusted trial balance

The Adjusted Trial Balance and Closing Entries 173

recorded a non-recurring gain from the sale of Pilgrim’s Pride stock for $186 mil- lion to help meet an earnings projection for the quarter. Another way is to infl ate revenue numbers in the short-run to the det- riment of the long-run. For example, Bristol-Myers Squibb provided sales incentives to its wholesalers to encourage them to buy products at the end of the quarter (often referred to as channel-stuffi ng). This practice allowed Bristol-Myers to meet its sales projections. The problem was that the whole- salers could not sell that amount of merchandise and ended up returning it to Bristol-Myers. The result was that Bristol-Myers had to restate its income numbers. Companies also manage earnings through improper adjusting entries. Reg- ulators investigated Xerox for accusations that it was booking too much revenue upfront on multi-year contract sales. Financial executives at Offi ce Max resigned amid accusations that the company was recognizing rebates from its vendors too early and therefore overstating revenue. Finally, WorldCom’s abuse of adjusting entries to meet its net income targets is unsurpassed. It used adjusting entries to increase net income by reclassifying liabilities as revenue and reclassifying expenses as assets. Investigations of the company’s books after it went bankrupt revealed adjusting entries of more than a billion dollars that had no supporting documentation.

SIERRA CORPORATION Adjusted Trial Balance

October 31, 2017

Cash Accounts Receivable Supplies Prepaid Insurance Equipment Accumulated Depreciation— Equipment Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries and Wages Payable Common Stock Retained Earnings Dividends Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

$15,200 200

1,000 550

5,000

500

5,200 1,500

900 50 50 40

$ 40 5,000 2,500

50 800

1,200 10,000

10,600

$30,190 $30,190

Account Debit Credit

SIERRA CORPORATION Balance Sheet

October 31, 2017

Cash Accounts receivable Supplies Prepaid insurance Equipment Less: Accumulated depreciation—equipment Total assets

$5,000

Assets

Liabilities Notes payable Accounts payable Salaries and wages payable Unearned service revenue Interest payable Total liabilities Stockholders’ equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders’ equity

$15,200 200

1,000 550

4,960 $21,910

Liabilities and Stockholders’ Equity

$ 9,550

12,360 $21,910

$ 5,000

2,500 1,200 800 50

10,000 2,360

Balance at Oct. 31 from retained earnings statement in Illustration 4-27

ILLUSTRATION 4-28 Preparation of the balance sheet from the adjusted trial balance

174 4 Accrual Accounting Concepts

4a▼ Trial BalanceDO IT! Skolnick Co. was organized on April 1, 2017. The company prepares quarterly fi nancial statements. The adjusted trial balance amounts at June 30 are shown below.

Debit Credit

Cash $ 6,700 Accumulated Depreciation—Equipment $ 850 Accounts Receivable 600 Notes Payable 5,000 Prepaid Rent 900 Accounts Payable 1,510 Supplies 1,000 Salaries and Wages Payable 400 Equipment 15,000 Interest Payable 50 Dividends 600 Unearned Rent Revenue 500 Salaries and Wages Expense 9,400 Common Stock 14,000 Rent Expense 1,500 Retained Earning 0 Depreciation Expense 850 Service Revenue 14,200 Supplies Expense 200 Rent Revenue 800 Utilities Expense 510 Interest Expense 50 $37,310 $37,310

(a) Determine the net income for the quarter April 1 to June 30.

(b) Determine the total assets and total liabilities at June 30, 2017, for Skolnick Co.

Action Plan ✔ In an adjusted trial

balance, all asset, liability, revenue, and expense accounts are properly stated.

✔ To determine the ending balance in Retained Earnings, add net income and subtract dividends.

SOLUTION (a) The net income is determined by adding revenues and subtracting expenses. The net

income is computed as follows.

Revenues Service revenue $14,200 Rent revenue 800 Total revenues $15,000

Expenses Salaries and wages expense 9,400 Rent expense 1,500 Depreciation expense 850 Utilities expense 510 Supplies expense 200 Interest expense 50 Total expenses 12,510

Net income $ 2,490

(b) Total assets and liabilities are computed as follows.

Assets Liabilities

Cash $ 6,700 Notes payable $5,000 Accounts receivable 600 Accounts payable 1,510 Supplies 1,000 Unearned rent revenue 500 Prepaid rent 900 Salaries and wages Equipment $15,000 payable 400 Less: Accumulated Interest payable 50

depreciation— equipment 850 14,150

Total assets $23,350 Total liabilities $7,460

Retained earnings, June 30 $1,890

Related exercise material: BE4-9, BE4-10, BE4-11, BE4-12, DO IT! 4-4a, E4-21, and E4-22.

The Adjusted Trial Balance and Closing Entries 175

CLOSING THE BOOKS

In previous chapters, you learned that revenue and expense accounts and the Dividends account are subdivisions of retained earnings, which is reported in the stockholders’ equity section of the balance sheet. Because revenues, expenses, and dividends relate only to a given accounting period, they are considered temporary accounts. In contrast, all balance sheet accounts are considered permanent accounts because their balances are carried forward into future accounting periods. Illustration 4-29 identifi es the accounts in each category.

ALTERNATIVE TERMINOLOGY Temporary accounts are some- times called nominal accounts, and permanent accounts are sometimes called real accounts.

PermanentTemporary

Dividends All expense accounts All revenue accounts

Stockholders’ equity accounts All liability accounts All asset accounts

ILLUSTRATION 4-29 Temporary versus permanent accounts

Preparing Closing Entries At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account—Retained Earnings— through the preparation of closing entries. Closing entries transfer net income (or net loss) and dividends to Retained Earnings, so the balance in Retained Earn- ings agrees with the retained earnings statement. For example, in the adjusted trial balance in Illustration 4-26 (page 171), Retained Earnings has a balance of zero. Prior to the closing entries, the balance in Retained Earnings is its beginning- of-the-period balance. (For Sierra Corporation, this is zero because it is the company’s fi rst month of operations.) In addition to updating Retained Earnings to its correct ending balance, clos- ing entries produce a zero balance in each temporary account. As a result, these accounts are ready to accumulate data about revenues, expenses, and divi- dends that occur in the next accounting period. Permanent accounts are not closed. When companies prepare closing entries, they could close each income statement account directly to Retained Earnings. However, to do so would result in excessive detail in the Retained Earnings account. Instead, companies close the revenue and expense accounts to another temporary account, Income Summary. The balance in Income Summary is the net income or loss for the accounting period. Income Summary is then closed, which transfers the net income or net loss from this account to Retained Earnings. Illustration 4-30 (page 176) depicts the closing process. While it still takes the average large company seven days to close, some companies such as Cisco employ technol- ogy that allows them to do a so-called “virtual close” almost instantaneously any time during the year. Besides dramatically reducing the cost of closing, the virtual close provides companies with accurate data for decision-making whenever they desire it.

176 4 Accrual Accounting Concepts

Illustration 4-31 shows the closing entries for Sierra Corporation. Illustration 4-32 (page 177) diagrams the posting process for Sierra’s closing entries.

▼ HELPFUL HINT Income Summary is a very descriptive title: Companies close total revenues to Income Summary and total expenses to Income Summary. The balance in Income Summary in this case is net income of $2,860.

Retained Earnings

Expense Accounts

Dividends

Income Summary

Revenue Accounts

ILLUSTRATION 4-30 The closing process

ILLUSTRATION 4-31 Closing entries journalized

Date Account Titles and Explanation Debit Credit

Closing Entries

2017 (1) Oct. 31 Service Revenue 10,600 Income Summary 10,600 (To close revenue account)

(2) 31 Income Summary 7,740 Salaries and Wages Expense 5,200 Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 (To close expense accounts)

(3) 31 Income Summary 2,860 Retained Earnings 2,860 (To close net income to retained earnings)

(4) 31 Retained Earnings 500 Dividends 500 (To close dividends to retained earnings)

GENERAL JOURNAL

Preparing a Post-Closing Trial Balance After a company journalizes and posts all closing entries, it prepares another trial balance, called a post-closing trial balance, from the ledger. A post-closing trial balance is a list of all permanent accounts and their balances after clos- ing entries are journalized and posted. The purpose of this trial balance is to prove the equality of the total debit balances and total credit balances 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—balance sheet— accounts.

The Adjusted Trial Balance and Closing Entries 177

SUMMARY OF THE ACCOUNTING CYCLE

Illustration 4-33 (page 178) shows the required steps in the accounting cycle. You can see that the cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance. Companies perform the steps in the cycle in sequence and repeat them in each accounting period. Steps 1–3 may occur daily during the accounting period, as explained in Chapter 3. Companies perform Steps 4–7 on a periodic basis, such as monthly, quarterly, or annually. Steps 8 and 9, closing entries and a post-closing trial balance, usually take place only at the end of a company’s annual accounting period.

▼ HELPFUL HINT Some companies reverse certain adjusting entries at the beginning of a new accounting period. The company makes a reversing entry at the beginning of the next accounting period. This entry is the exact opposite of the adjusting entry made in the previous period.

ILLUSTRATION 4-32 Posting of closing entries

4,000 1,200

Salaries and Wages Expense

5,200

(2)

900

Rent Expense

900(2)

Insurance Expense

50(2)

Depreciation Expense

40(2)

Interest Expense

50(2)

1,500

Supplies Expense

1,500(2)

500 –0– 2,860

Bal. 2,360

(3) (4)

10,600

Service Revenue

10,600

10,000 400 200

10,600

(1)

500

Dividends

500(4)

7,740 2,860

Income Summary

10,600

(1)(2) (3)

10,600

Retained Earnings

ILLUSTRATION 4-33 Required steps in the accounting cycle

1. ANALYZE BUSINESS TRANSACTIONS

9. PREPARE A POST-CLOSING TRIAL BALANCE

4. PREPARE A TRIAL BALANCE

3. POST TO THE LEDGER ACCOUNTS

6. PREPARE AN ADJUSTED TRIAL BALANCE

7. PREPARE FINANCIAL STATEMENTS

8. JOURNALIZE AND POST CLOSING ENTRIES

5. JOURNALIZE AND POST ADJUSTING ENTRIES: DEFERRALS/ACCRUALS

2. JOURNALIZE THE TRANSACTIONS

THE ACCOUNTING CYCLE

Assets = Liabilities + Stockholders’ Equity

Prepd. Equip- Notes Accounts Unearned Common Retained Earnings Cash + Supplies + Insur. + ment = Pay. + Payable + Serv. Rev. + Stock + Rev. − Exp. − Div.

$19,700 $600 $5,000 $5,000 $1,200 $10,000 $10,000 $900 (8) +$2,500 +$2,500

$19,700 + $2,500 + $600 + $5,000 = $5,000 + $2,500 + $1,200 + $10,000 + $10,000 − $900

$27,800 $27,800

Equation Analysis

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GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2017

Oct. 1 Cash 10,000 Common Stock 10,000 (Issued stock for cash)

1 Cash 5,000 Notes Payable 5,000

(Issued 3-month, 12% note payable for cash)

2 Equipment 5,000 Cash 5,000

(Purchased equipment for cash)

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Supplies

Oct. 5 2,500

Bal. 2,500

Common Stock

Oct. 1 10,000

Bal. 10,000

GENERAL LEDGER

Cash

Oct. 1 10,000 Oct. 2 5,000 1 5,000 3 900 2 1,200 4 600 3 10,000 20 500 26 4,000

Bal. 15,200

Unearned Service Revenue

Oct. 2 1,200

Bal. 1,200

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SIERRA CORPORATION Trial Balance

October 31, 2017

Debit Credit

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GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2017 Adjusting Entries

Oct. 31 Supplies Expense 1,500 Supplies 1,500 (To record supplies used)

31 Insurance Expense 50 Prepaid Insurance 50 (To record insurance expired)

31 Depreciation Expense 40 Accumulated Depreciation—Equipment 40 (To record monthly depreciation)

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GENERAL LEDGER

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Supplies

Oct. 5 2,500 Oct. 31 1,500

Oct. 31 Bal. 1,000

Prepaid Insurance

Oct. 4 600 Oct. 31 50

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Supplies Expense

Oct. 31 1,500

Oct. 31 Bal. 1,500

Rent Expense

Oct. 3 900

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SIERRA CORPORATION Adjusted Trial Balance

October 31, 2017

Debit Credit

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SIERRA CORPORATION Income Statement

For the Month Ended October 31, 2017

Revenues Service revenue

$10,600

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SIERRA CORPORATION Retained Earnings Statement

For the Month Ended October 31, 2017

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SIERRA CORPORATION Balance Sheet

October 31, 2017

Cash Accounts receivable

Assets

$15,200 200

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Date Account Titles and Explanation Debit Credit

Closing Entries

2017 (1) Oct. 31 Service Revenue 10,600 Income Summary 10,600 (To close revenue account)

(2) 31 Income Summary 7,740 Salaries and Wages Expense 5,200 Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50

GENERAL JOURNAL

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SIERRA CORPORATION Post-Closing Trial Balance

October 31, 2017

Debit Credit

Cash $15,200 Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Retained Earnings 0

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178

The Adjusted Trial Balance and Closing Entries 179

KEEPING AN EYE ON CASH

Computation of Computation Net Cash Provided by of Operating Activities Net Income

(1) Cash received in advance from customer $ 1,200 $ 0 (2) Cash received from customers for services performed 10,000 10,000 (3) Services performed for cash received previously in (1) 0 400 (4) Services performed on account 0 200 (5) Payment of rent (900) (900) (6) Purchase of insurance (600) 0 (7) Payment of employee salaries (4,000) (4,000) (8) Use of supplies 0 (1,500) (9) Use of insurance 0 (50) (10) Depreciation 0 (40) (11) Interest cost incurred, but not paid 0 (50) (12) Salaries incurred, but not paid 0 (1,200)

$ 5,700 $ 2,860

In this chapter, you learned that adjusting entries are used to adjust numbers that would otherwise be stated on a cash basis. Sierra Corporation’s income statement (Illustration 4-27, page 172) shows net income of $2,860. The statement of cash flows reports a form of cash-basis income referred to as “Net cash provided by operating activities.” For example, Illustration 1-8 (page 14), which shows a statement of cash flows, reports net cash provided by operating activities of $5,700 for Sierra. Net income and net cash provided by operating activities often differ. The difference for Sierra is $2,840 ($5,700 − $2,860). The following summary shows the causes of this difference of $2,840.

For each item included in the computation of net cash provided by operating activities, confirm that cash was either received or paid. For each item in the income statement, confirm that revenue should be recorded because a performance obligation has been satisfied (even when cash was not received) or that an expense was incurred (even when cash was not paid).

4b▼ Closing EntriesDO IT! Hancock Company has the following balances in selected accounts of its adjusted trial balance.

Accounts Payable $27,000 Dividends $15,000 Service Revenue 98,000 Retained Earnings 42,000 Rent Expense 22,000 Accounts Receivable 38,000 Salaries and Wages Expense 51,000 Supplies Expense 7,000

Prepare the closing entries at December 31.

Action Plan ✔ Close revenue and expense

accounts to Income Summary.

✔ Close Income Summary to Retained Earnings.

✔ Close Dividends to Retained Earnings.

SOLUTION Dec. 31 Service Revenue 98,000 Income Summary 98,000 (To close revenue account to Income Summary)

31 Income Summary 80,000 Salaries and Wages Expense 51,000 Rent Expense 22,000 Supplies Expense 7,000 (To close expense accounts to Income Summary)

180 4 Accrual Accounting Concepts

Dec. 31 Income Summary ($98,000 − $80,000) 18,000 Retained Earnings 18,000 (To close net income to retained earnings)

31 Retained Earnings 15,000 Dividends 15,000 (To close dividends to retained earnings)

Related exercise material: BE4-13, BE4-14, DO IT! 4-4b, E4-19, E4-20, and E4-23.

Groupon, Inc. operates online marketplaces that provide goods and services at discounted prices worldwide. Headquar- tered in Chicago, Illinois, it has over 11,843 employees. Suppose that the information shown in the trial balance below was taken from Groupon’s 2017 fi nancial records.

USING DECISION TOOLS—GROUPON, INC.

Account Dr. Cr.

Cash $1,072 Accounts Receivable 105 Other Current Assets 224 Equipment 377 Accumulated Depreciation—Equipment $ 195 Stock Investments (noncurrent) 24 Goodwill 558 Other Long-Term Assets 61 Accounts and Other Payables 932 Accrued Expenses Payable 230 Other Current Liabilities 163 Notes Payable (noncurrent) 137 Common Stock 1,687 Dividends 0 Accumulated Defi cit 849 Revenues 3,181 Cost of Goods Sold 1,643 Selling and Administrative Expenses 1,294 Marketing Expense 269 Other Expense 33 Income Tax Expense 16

$6,525 $6,525

GROUPON, INC. Adjusted Trial Balance December 31, 2017

(in millions)

INSTRUCTIONS

From the trial balance, prepare an income statement, retained earnings statement, and classifi ed balance sheet. Be sure to prepare them in that order since each statement depends on information determined in the preceding statement. (Hint: Note that because Groupon has experienced losses, it reports an Accumulated Defi cit rather than Retained Earnings. Remember that the amount of the Accumulated Defi cit reported in the trial balance represents the balance at the beginning of the year.)

181

SOLUTION

GROUPON, INC. Income Statement

For the Year Ended December 31, 2017 (in millions)

Revenues $3,181 Cost of goods sold $1,643 Selling and administrative expenses 1,294 Marketing expense 269 Other expense 33 Income tax expense 16 3,255

Net loss $ (74)

Beginning accumulated defi cit $(849) Less: Net loss 74 Less: Dividends 0

Ending accumulated defi cit $(923)

GROUPON, INC. Retained Earnings Statement

For the Year Ended December 31, 2017 (in millions)

Assets

Current assets Cash $1,072 Accounts receivable 105 Other current assets 224 Total current assets $1,401 Long-term investments Stock investments 24 Property, plant, and equipment Equipment 377 Accumulated depreciation—equipment 195 182 Intangible assets Goodwill 558 Other long-term assets 61

Total assets $2,226

Liabilities and Stockholders’ Equity

Liabilities Current liabilities Accounts and other payables $ 932 Accrued expenses payable 230 Other current liabilities 163 Total current liabilities $1,325 Long-term liabilities Notes payable 137

Total liabilities 1,462 Stockholders’ equity Common stock 1,687 Accumulated defi cit (923) Total stockholders’ equity 764

Total liabilities and stockholders’ equity $2,226

GROUPON, INC. Balance Sheet

December 31, 2017 (in millions)

182 4 Accrual Accounting Concepts

In Chapter 4, we used T-accounts and trial balances to arrive at the amounts used to prepare fi nancial statements. Accountants frequently use a device known as a worksheet to determine these amounts. A worksheet is a multiple-column form that may be used in the adjustment process and in preparing fi nancial state- ments. Accountants can prepare worksheets manually, but today most use com- puter spreadsheets. As its name suggests, the worksheet is a working tool for the accountant. A worksheet is not a permanent accounting record; it is neither a journal nor a part of the general ledger. The worksheet is merely a supplemental device used to make it easier to prepare adjusting entries and the fi nancial statements. Small companies with relatively few accounts and adjustments may not need a worksheet. In large companies with numerous accounts and many adjustments, a worksheet is almost indispensable. Illustration 4A-1 shows the basic form and procedures for preparing a worksheet. Note the headings. The worksheet starts with two columns for the Trial Balance. The next two columns record all Adjustments. Next is the Adjusted Trial Balance. The last two sets of columns correspond to the Income Statement and the Balance Sheet. All items listed in the Adjusted Trial Balance columns are included in either the Income Statement or the Balance Sheet columns.

APPENDIX 4A: Describe the purpose and the basic form of a worksheet.

LEARNING OBJECTIVE *5▼

Appendix 4A: Using a Worksheet 183

Formulas Data Review ViewPage LayoutInsert

A P18 fx

E F GB C D H J KI

Sierra Corporation.xlsSierra Corporation.xls Home

1 2 3

Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.Account Titles

Trial Balance Adjustments AdjustedTrial Balance Income

Statement Balance Sheet

SIERRA CORPORATION Worksheet

For the Month Ended October 31, 2017

Extend adjusted balances to appropriate

statement columns

Total the statement columns, compute net income

(or net loss), and complete worksheet

Enter adjustment

data

2 4

Prepare a trial balance

on the worksheet

1 Enter

adjusted balances

Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue

Salaries and Wages Expense Rent Expense Totals

Supplies Expense Insurance Expense Accum. Depreciation— Equipment Depreciation Expense Interest Expense Accounts Receivable Interest Payable Salaries and Wages Payable

Net Income Totals

15,200 2,500

600 5,000

500

4,000 900

28,700

5,000 2,500 1,200

10,000 –0–

10,000

28,700

15,200 1,000

550 5,000

500

5,200 900

1,500 50

40 50

200

5,000 2,500

800 10,000

–0–

10,600

50 1,200

1,500 50

400 200

50 1,200

(a) (b)

(d) (e)

(c)

(f) (g)

400

1,200

1,500 50

40 50

200

3,440

(d)

(g)

(a) (b)

5,200 900

1,500 50

40 50

2,860 10,600

10,600

15,200 1,000

550 5,000

500

200

22,450

5,000 2,500

800 10,000

–0–

50 1,200

2,860 22,450

30,1903,440 30,190 7,740 10,600 22,450 19,590Totals

ILLUSTRATION 4A-1 Form and procedure for a worksheet

184 4 Accrual Accounting Concepts

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Explain the accrual basis of accounting and the reasons for adjusting entries. The revenue recognition principle dictates that companies recognize revenue when a perfor- mance obligation has been satisfi ed. The expense recogni- tion principle dictates that companies recognize expenses in the period when the company makes efforts to generate those revenues. Under the cash basis, companies record events only in the periods in which the company receives or pays cash. Accrual- based accounting means that companies record, in the peri- ods in which the events occur, events that change a company’s fi nancial statements even if cash has not been exchanged. Companies make adjusting entries at the end of an accounting period. These entries ensure that companies record revenues in the period in which the performance obli- gation is satisfi ed and that companies recognize expenses in the period in which they are incurred. The major types of adjusting entries are prepaid expenses, unearned revenues, accrued revenues, and accrued expenses.

2 Prepare adjusting entries for deferrals. Deferrals are either prepaid expenses or unearned revenues. Companies make adjusting entries for deferrals at the statement date to record the portion of the deferred item that represents the expense incurred or the revenue for services performed in the current accounting period.

3 Prepare adjusting entries for accruals. Accruals are either accrued revenues or accrued expenses. Adjusting entries for accruals record revenues for services performed and expenses incurred in the current accounting period that have not been recognized through daily entries.

4 Prepare an adjusted trial balance and closing entries. An adjusted trial balance is a trial balance that shows the balances of all accounts, including those that have been adjusted, at the end of an accounting period. The purpose of an adjusted trial balance is to show the effects of all fi nan- cial events that have occurred during the accounting period. One purpose of closing entries is to transfer net income or net loss for the period to Retained Earnings. A second purpose is to “zero-out” all temporary accounts (revenue accounts, expense accounts, and Dividends) so that they start each new period with a zero balance. To accomplish this, companies “close” all temporary accounts at the end of an accounting period. They make separate entries to close revenues and expenses to Income Summary, Income Summary to Retained Earnings, and Dividends to Retained Earnings. Only temporary accounts are closed. The required steps in the accounting cycle are (a) ana- lyze business transactions, (b) journalize the transactions, (c) post to ledger accounts, (d) prepare a trial balance, (e) journalize and post adjusting entries, (f) prepare an adjusted trial balance, (g) prepare fi nancial statements, (h) journalize and post closing entries, and (i) prepare a post- closing trial balance.

*5 Describe the purpose and the basic form of a work- sheet. The worksheet is a device to make it easier to prepare adjusting entries and the fi nancial statements. Companies often prepare a worksheet using a computer spreadsheet. The sets of columns of the worksheet are, from left to right, the unadjusted trial balance, adjustments, adjusted trial balance, income statement, and balance sheet.

▼

Accrual-basis accounting Accounting basis in which com- panies record, in the periods in which the events occur, transactions that change a company’s fi nancial state- ments, even if cash was not exchanged. (p. 153).

Accrued expenses Expenses incurred but not yet paid in cash or recorded. (p. 164).

Accrued revenues Revenues for services performed but not yet received in cash or recorded. (p. 163).

GLOSSARY REVIEW▼

At what point should the company record revenue?

Need to understand the nature of the company’s business

At what point should the company record expenses?

Need to understand the nature of the company’s business

Record revenue in the period in which the performance obligation is satisfi ed.

Expenses should “follow” revenues—that is, match the effort (expense) with the result (revenue).

Recognizing expenses too early overstates current period expense; recognizing them too late understates current period expense.

Recognizing revenue too early overstates current period revenue; recogniz- ing it too late understates current period revenue.

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Practice Multiple-Choice Questions 185

Adjusted trial balance A list of accounts and their bal- ances after all adjustments have been made. (p. 170).

Adjusting entries Entries made at the end of an ac- counting period to ensure that the revenue recogni- tion and expense recognition principles are followed. (p. 154).

Book value The difference between the cost of a depre- ciable asset and its related accumulated depreciation. (p. 160).

Cash-basis accounting Accounting basis in which a com- pany records revenue only when it receives cash and an expense only when it pays cash. (p. 153).

Closing entries Entries at the end of an accounting period to transfer the balances of temporary accounts to a permanent stockholders’ equity account, Retained Earnings. (p. 175).

Contra asset account An account that is offset against an asset account on the balance sheet. (p. 159).

Depreciation The process of allocating the cost of an asset to expense over its useful life. (p. 159).

Earnings management The planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. (p. 172).

Expense recognition principle (matching principle) The principle that matches expenses with revenues in the period when the company makes efforts to generate those revenues. (p. 152).

Fiscal year An accounting period that is one year long. (p. 152, in margin).

Income Summary A temporary account used in closing revenue and expense accounts. (p. 175).

Periodicity assumption An assumption that the economic life of a business can be divided into artifi cial time periods. (p. 152).

Permanent accounts Balance sheet accounts whose bal- ances are carried forward to the next accounting period. (p. 175).

Post-closing trial balance A list of permanent accounts and their balances after a company has journalized and posted closing entries. (p. 176).

Prepaid expenses (prepayments) Expenses paid in cash before they are used or consumed. (p. 156).

Quality of earnings Indicates the level of full and trans- parent information that a company provides to users of its fi nancial statements. (p. 172).

Revenue recognition principle The principle that com- panies recognize revenue in the accounting period in which the performance obligation is satisfi ed. (p. 152).

Reversing entry An entry made at the beginning of the next accounting period; the exact opposite of the adjusting entry made in the previous period. (p. 177, in margin).

Temporary accounts Revenue, expense, and dividend ac- counts whose balances a company transfers to Retained Earnings at the end of an accounting period. (p. 175).

Unearned revenues Cash received and a liability recorded before services are performed. (p. 160).

Useful life The length of service of a productive asset. (p. 158).

*Worksheet A multiple-column form that companies may use in the adjustment process and in preparing fi nancial statements. (p. 182).

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

4. Adjusting entries are made to ensure that: (a) expenses are recognized in the period in which

they are incurred. (b) revenues are recorded in the period in which the

performance obligation is satisfi ed. (c) balance sheet and income statement accounts have

correct balances at the end of an accounting period. (d) All of the above.

5. Each of the following is a major type (or category) of adjusting entry except: (a) prepaid expenses. (c) accrued expenses. (b) accrued revenues. (d) unearned expenses.

6. The trial balance shows Supplies $1,350 and Sup- plies Expense $0. If $600 of supplies are on hand at the end of the period, the adjusting entry is: (a) Supplies 600 Supplies Expense 600 (b) Supplies 750 Supplies Expense 750 (c) Supplies Expense 750 Supplies 750 (d) Supplies Expense 600 Supplies 600

7. Adjustments for unearned revenues: (a) decrease liabilities and increase revenues. (b) increase liabilities and increase revenues.

(LO 1)

(LO 2, 3)

(LO 2)

1. What is the periodicity assumption? (a) Companies should recognize revenue in the ac-

counting period in which services are performed. (b) Companies should match expenses with revenues. (c) The economic life of a business can be divided

into artifi cial time periods. (d) The fi scal year should correspond with the calen-

dar year. 2. Which principle dictates that efforts (expenses) be

recorded with accomplishments (revenues)? (a) Expense recognition principle. (b) Historical cost principle. (c) Periodicity principle. (d) Revenue recognition principle.

3. Which one of these statements about the accrual basis of accounting is false? (a) Companies record events that change their fi nan-

cial statements in the period in which events oc- cur, even if cash was not exchanged.

(b) Companies recognize revenue in the period in which the performance obligation is satisfi ed.

(d) Companies record revenue only when they re- ceive cash and record expense only when they pay out cash.

(LO 1)

186 4 Accrual Accounting Concepts

SOLUTIONS 1. (c) The periodicity assumption states that the economic life of a business can be divided into artifi cial time periods.

The other choices are incorrect because (a) this statement describes the revenue recognition principle, (b) this state- ment describes the expense recognition principle, and (d) the periodicity assumption states that the life of a business can be divided into artifi cial time periods, not that the fi scal year and calendar year must coincide.

2. (a) The expense recognition principle dictates that efforts (expenses) be recorded with accomplishments (revenues). The other choices are incorrect because (b) the historical cost principle states that when assets are purchased, they should be recorded at cost; (c) the periodicity assumption states that the life of a business can be divided into artifi cial time periods; and (d) the revenue recognition principle states that revenue should be recorded in the period in which the performance obligation is satisfi ed.

3. (d) If companies record revenue only when they receive cash and record expense only when they pay out cash, they are using the cash basis of accounting. The other choices are true statements about accrual-basis accounting.

4. (d) Adjusting entries are made to ensure that expenses are recognized in the period in which they are incurred, that revenues are recorded in the period in which the performance obligation is satisfi ed, and that balance sheet and income statement accounts have correct balances at the end of an accounting period. Although choices (a), (b), and (c) are correct, choice (d) is the better answer.

5. (d) Unearned expenses are not a major type of adjusting entry. Choices (a) prepaid expenses, (b) accrued revenues, and (c) accrued expenses are all a major type of adjusting entry.

6. (c) The adjusting entry is to debit Supplies Expense for $750 ($1,350 − $600) and credit Supplies for $750. The other choices are therefore incorrect.

7. (a) Adjustments for unearned revenues decrease liabilities and increase revenues. The other choices are therefore incorrect.

8. (c) Adjustments for prepaid expenses decrease assets and increase expenses. The other choices are therefore incorrect.

8. Adjustments for prepaid expenses: (a) decrease assets and increase revenues. (b) decrease expenses and increase assets. (c) decrease assets and increase expenses. (d) decrease revenues and increase assets.

9. Queenan Company computes depreciation on de- livery equipment at $1,000 for the month of June. The adjusting entry to record this depreciation is as follows: (a) Depreciation Expense 1,000 Accumulated Depreciation—

Queenan Company 1,000 (b) Depreciation Expense 1,000 Equipment 1,000 (c) Depreciation Expense 1,000 Accumulated Depreciation—

Equipment 1,000 (d) Equipment Expense 1,000 Accumulated Depreciation—

Equipment 1,000 10. Adjustments for accrued revenues:

(a) increase assets and increase liabilities. (b) increase assets and increase revenues. (c) decrease assets and decrease revenues. (d) decrease liabilities and increase revenues.

11. Colleen Mooney earned a salary of $400 for the last week of September. She will be paid on October 1. The adjusting entry for Colleen’s employer at Sep- tember 30 is: (a) No entry is required. (b) Salaries and Wages Expense 400 Salaries and Wages Payable 400

(LO 2)

(LO 3)

12. Which statement is incorrect concerning the ad- justed trial balance? (a) An adjusted trial balance proves the equality of

the total debit balances and the total credit bal- ances in the ledger after all adjustments are made.

(b) The adjusted trial balance provides the primary basis for the preparation of fi nancial statements.

(d) The company prepares the adjusted trial balance af- ter it has journalized and posted the adjusting entries.

13. Which account will have a zero balance after a com- pany has journalized and posted closing entries? (a) Service Revenue. (b) Supplies. (c) Prepaid Insurance. (d) Accumulated Depreciation.

14. Which types of accounts will appear in the post- closing trial balance? (a) Permanent accounts. (b) Temporary accounts. (c) Expense accounts. (d) None of the above.

15. All of the following are required steps in the account- ing cycle except: (a) journalizing and posting closing entries. (b) preparing an adjusted trial balance. (c) preparing a post-closing trial balance. (d) prepare fi nancial statements from the unadjusted

trial balance.

(LO 4)

Practice Exercises 187

9. (c) The adjusting entry is to debit Depreciation Expense and credit Accumulation Depreciation—Equipment. The other choices are incorrect because (a) the contra asset account title includes the asset being depreciated, not the com- pany name; (b) the credit should be to the contra asset account, not the asset; and (d) the debit should be to Deprecia- tion Expense, not Equipment Expense.

10. (b) When the adjustment is made for accrued revenues, an asset account (usually Accounts Receivable) is increased and a revenue account is increased. The other choices are therefore incorrect.

11. (b) The adjusting entry should be to debit Salaries and Wages Expense $400 and credit Salaries and Wages Payable for $400. Choice (a) is incorrect because if an adjusting entry is not made, the amount of money owed (liability) that is shown on the balance sheet will be understated and the amount of salaries and wages expense will also be under- stated. Choices (c) and (d) are incorrect because adjusting entries never affect cash.

12. (c) The adjusted trial balance does list temporary accounts. The other choices are true statements about the adjusted trial balance.

13. (a) Service Revenue will have a zero balance after a company has journalized and posted closing entries. The other choices are incorrect because (b) Supplies is an asset, or permanent account, and will not be closed at the end of the year; (c) Prepaid Insurance is an asset, or permanent account, and will not be closed at the end of the year; and (d) Accumulated Depreciation is a contra asset account. Contra asset accounts are permanent accounts and are not closed at the end of the year.

14. (a) Permanent accounts are the only type of accounts that appear in the post-closing trial balance because they are not closed at the end of the accounting period. Choices (b) and (c) are temporary accounts. Choice (d) is wrong because there is a correct answer.

15. (d) Financial statements are prepared from the adjusted trial balance, not the unadjusted trial balance. The other choices are incorrect because (a) journalizing and posting closing entries, (b) preparing an adjusted trial balance, and (c) preparing a post-closing trial balance are all required steps in the accounting cycle.

1. The income statement of Bragg Co. for the month of July shows net income of $1,400 based on Service Revenue $5,500, Salaries and Wages Expense $2,300, Supplies Expense $1,200, and Utilities Expense $600. In reviewing the statement, you discover the following.

1. Insurance expired during July of $450 was omitted.

2. Supplies expense includes $300 of supplies that are still on hand at July 31.

3. Depreciation on equipment of $180 was omitted.

4. Accrued but unpaid salaries and wages at July 31 of $400 were not included.

5. Services performed but unrecorded totaled $600.

INSTRUCTIONS

Prepare a correct income statement for July 2017.

Prepare correct income statement.

(LO 2, 3)

PRACTICE EXERCISES▼

SOLUTION

Revenues Service revenue ($5,500 + $600) $6,100 Expenses Salaries and wages expense ($2,300 + $400) $2,700 Supplies expense ($1,200 − $300) 900 Utilities expense 600 Insurance expense 450 Depreciation expense 180

Total expenses 4,830

Net income $1,270

BRAGG CO. Income Statement

For the Month Ended July 31, 2017

188 4 Accrual Accounting Concepts

2. Arapaho Company ended its fi scal year on July 31, 2017. The company’s adjusted trial balance as of the end of its fi scal year is as shown below.

Journalize and post closing entries, and prepare a post- closing trial balance.

(LO 4)

Account Titles Debit Credit

Cash $ 15,940 Accounts Receivable 8,580 Equipment 16,900 Accumulated Depreciation—Equipment $ 7,500 Accounts Payable 4,420 Unearned Rent Revenue 1,600 Common Stock 20,500 Retained Earnings 25,000 Dividends 14,000 Service Revenue 64,000 Rent Revenue 5,500 Depreciation Expense 4,500 Salaries and Wages Expense 54,700 Utilities Expense 13,900

$128,520 $128,520

ARAPAHO COMPANY Adjusted Trial Balance

July 31, 2017

INSTRUCTIONS

(a) Prepare the closing entries.

(b) Post to Retained Earnings and Income Summary T-accounts.

SOLUTION

2. (a)

Date Account Titles Debit Credit

July 31 Service Revenue 64,000 Rent Revenue 5,500 Income Summary 69,500 (To close revenue accounts)

31 Income Summary 73,100 Depreciation Expense 4,500 Salaries and Wages Expense 54,700 Utilities Expense 13,900 (To close expense accounts)

31 Retained Earnings ($73,100 − $69,500) 3,600 Income Summary 3,600 (To close net loss to retained earnings)

31 Retained Earnings 14,000 Dividends 14,000 (To close dividends to retained earnings)

(b) Retained Earnings Income Summary

Bal. 25,000 69,500 3,600 73,100 14,000 3,600

Bal. 7,400 Bal. 0

GENERAL JOURNAL J15

Practice Problem 189

Debit Credit

Cash $15,940 Accounts Receivable 8,580 Equipment 16,900 Accumulated Depreciation—Equipment $ 7,500 Accounts Payable 4,420 Unearned Rent Revenue 1,600 Common Stock 20,500 Retained Earnings 7,400

$41,420 $41,420

ARAPAHO COMPANY Post-Closing Trial Balance

July 31, 2017

(c)

Terry Thomas and a group of investors incorporated the Green Thumb Lawn Care Corpo- ration on April 1. At April 30, the trial balance shows the following balances for selected accounts.

Prepaid Insurance $ 3,600 Equipment 28,000 Notes Payable 20,000 Unearned Service Revenue 4,200 Service Revenue 1,800

Analysis reveals the following additional data pertaining to these accounts.

1. Prepaid insurance is the cost of a 2-year insurance policy, effective April 1.

2. Depreciation on the equipment is $500 per month.

3. The note payable is dated April 1. It is a 6-month, 6% note.

4. Seven customers paid for the company’s 6-month lawn service package of $600 begin- ning in April. These customers received the fi rst month of services in April.

5. Lawn services performed for other customers but not billed at April 30 totaled $1,500.

INSTRUCTIONS

Prepare the adjusting entries for the month of April. Show computations.

Prepare adjusting entries from selected data.

(LO 2, 3)

PRACTICE PROBLEM▼

SOLUTION

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Adjusting Entries Apr. 30 Insurance Expense 150

Prepaid Insurance 150 (To record insurance expired: $3,600 ÷ 24 = $150 per month) 30 Depreciation Expense 500 Accumulated Depreciation—Equipment 500 (To record monthly depreciation)

30 Interest Expense 100 Interest Payable 100 (To accrue interest on notes payable: $20,000 × 6% × 112 = $100)

190 4 Accrual Accounting Concepts

1. (a) How does the periodicity assumption affect an accountant’s analysis of accounting transactions?

(b) Explain the term fi scal year.

2. Identify and state two generally accepted accounting principles that relate to adjusting the accounts.

3. Max Wilson, a lawyer, accepts a legal engage- ment in March, performs the work in April, and is paid in May. If Wilson’s law fi rm prepares monthly fi nancial statements, when should it recognize revenue from this engagement? Why?

4. In completing the engagement in Question 3, Wilson pays no costs in March, $2,500 in April, and $2,200 in May (incurred in April). How much expense should the fi rm deduct from revenues in the month when it recognizes the revenue? Why?

5. “The historical cost principle of accounting requires adjusting entries.” Do you agree? Explain.

6. Why may the fi nancial information in an unadjusted trial balance not be up-to-date and complete?

7. Distinguish between the two categories of adjusting entries, and identify the types of adjustments appli- cable to each category.

8. What types of accounts does a company debit and credit in a prepaid expense adjusting entry?

9. “Depreciation is a process of valuation that results in the reporting of the fair value of the asset.” Do you agree? Explain.

10. Explain the differences between depreciation expense and accumulated depreciation.

11. Steele Company purchased equipment for $15,000. By the current balance sheet date, the company had de- preciated $7,000. Indicate the balance sheet presenta- tion of the data.

12. What types of accounts are debited and credited in an unearned revenue adjusting entry?

13. Abe Technologies provides maintenance service for computers and offi ce equipment for companies throughout the Northeast. The sales manager is elated

because she closed a $300,000, 3-year maintenance contract on December 29, 2016, two days before the company’s year-end. “Now we will hit this year’s net income target for sure,” she crowed. The customer is required to pay $100,000 on December 29 (the day the deal was closed). Two more payments of $100,000 each are also required on December 29, 2017 and 2018. Discuss the effect that this event will have on the company’s fi nancial statements.

14. BeneMart, a large national retail chain, is nearing its fi scal year-end. It appears that the company is not going to hit its revenue and net income targets. The company’s marketing manager, Ed Mellon, suggests running a promotion selling $50 gift cards for $45. He believes that this would be very popular and would en- able the company to meet its targets for revenue and net income. What do you think of this idea?

15. Whistler Corp. performed services for a cus- tomer but has not received payment, nor has it recorded any entry related to the work. Which of the following types of accounts are involved in the adjusting entry: (a) asset, (b) liability, (c) revenue, or (d) expense? For the accounts selected, indicate whether they would be debited or credited in the entry.

16. A company fails to recognize an expense in- curred but not paid. Indicate which of the following types of accounts is debited and which is credited in the adjusting entry: (a) asset, (b) liability, (c) revenue, or (d) expense.

17. A company makes an accrued revenue adjust- ing entry for $780 and an accrued expense adjusting entry for $510. How much was net income understated or overstated prior to these entries? Explain.

18. On January 9, a company pays $6,200 for salaries, of which $1,100 was reported as Salaries and Wages Payable on December 31. Give the entry to record the payment.

19. For each of the following items before adjustment, indicate the type of adjusting entry—prepaid expense, unearned revenue, accrued revenue, and accrued expense—that is needed to correct the misstatement.

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS▼ 30 Unearned Service Revenue 700 Service Revenue 700 (To record revenue for services performed: $600 ÷ 6 = $100; $100 per month × 7 = $700) 30 Accounts Receivable 1,500 Service Revenue 1,500 (To accrue revenue for services performed)

Brief Exercises 191

If an item could result in more than one type of adjust- ing entry, indicate each of the types. (a) Assets are understated. (b) Liabilities are overstated. (c) Liabilities are understated. (d) Expenses are understated. (e) Assets are overstated. (f) Revenue is understated.

20. One-half of the adjusting entry is given below. Indicate the account title for the other half of the entry. (a) Salaries and Wages Expense is debited. (b) Depreciation Expense is debited. (c) Interest Payable is credited. (d) Supplies is credited. (e) Accounts Receivable is debited. (f) Unearned Service Revenue is debited.

21. “An adjusting entry may affect more than one balance sheet or income statement account.” Do you agree? Why or why not?

22. Which balance sheet account provides evidence that Apple records sales on an accrual basis rather than a cash basis? Explain.

23. Why is it possible to prepare fi nancial statements di- rectly from an adjusted trial balance?

24. (a) What information do accrual-basis fi nancial state-

ments provide that cash-basis statements do not? (b) What information do cash-basis fi nancial state-

ments provide that accrual-basis statements do not?

25. What is the relationship, if any, between the amount shown in the adjusted trial balance column for an ac- count and that account’s ledger balance?

26. Identify the account(s) debited and credited in each of the four closing entries, assuming the company has net income for the year.

27. Some companies employ technologies that allow them to do a so-called “virtual close.” This enables them to close their books nearly instantaneously any time during the year. What advantages does a “virtual close” provide?

28. Describe the nature of the Income Summary account, and identify the types of summary data that may be posted to this account.

29. What items are disclosed on a post-closing trial balance. What is its purpose?

30. Which of these accounts would not appear in the post- closing trial balance? Interest Payable, Equipment, Depreciation Expense, Dividends, Unearned Service Revenue, Accumulated Depreciation— Equipment, and Service Revenue.

31. Indicate, in the sequence in which they are made, the three required steps in the accounting cycle that involve journalizing.

32. Identify, in the sequence in which they are prepared, the three trial balances that are required in the ac- counting cycle.

33. Explain the terms earnings management and quality of earnings.

34. Give examples of how companies manage earnings.

*35. What is the purpose of a worksheet?

*36. What is the basic form of a worksheet?

BE4-1 Transactions that affect earnings do not necessarily affect cash. Identify the effect, if any, that each of the following transactions would have upon cash and net income. The first transaction has been completed as an example.

Net Cash Income

(a) Purchased $100 of supplies for cash. −$100 $ 0 (b) Recorded an adjusting entry to record use of $20 of the above

supplies. (c) Made sales of $1,300, all on account. (d) Received $800 from customers in payment of their accounts. (e) Purchased equipment for cash, $2,500. (f) Recorded depreciation of building for period used, $600.

BE4-2 The ledger of Melmann Company includes the following accounts. Explain why each account may require adjustment. (a) Prepaid Insurance. (c) Unearned Service Revenue. (b) Depreciation Expense. (d) Interest Payable.

BE4-3 Cortina Company accumulates the following adjustment data at December 31. Indicate (1) the type of adjustment (prepaid expense, accrued revenue, and so on) and (2) the status of the accounts before adjustment (for example, “assets understated and revenues understated”). (a) Supplies of $400 are on hand. Supplies account shows $1,600 balance. (b) Services performed but unbilled total $700. (c) Interest of $300 has accumulated on a note payable. (d) Rent collected in advance totaling $1,100 has been earned.

Identify impact of transactions on cash and net income.

(LO 1), C

Indicate why adjusting entries are needed.

(LO 1), C

Identify the major types of adjusting entries.

(LO 1), AN

BRIEF EXERCISES▼

192 4 Accrual Accounting Concepts

BE4-4 Lahey Advertising Company’s trial balance at December 31 shows Supplies $8,800 and Supplies Expense $0. On December 31, there are $1,100 of supplies on hand. Prepare the adjusting entry at December 31 and, using T-accounts, enter the balances in the accounts, post the adjusting entry, and indicate the adjusted balance in each account.

BE4-5 At the end of its first year, the trial balance of Rayburn Company shows Equipment $22,000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Depreciation for the year is estimated to be $2,750. Prepare the annual adjusting entry for depreciation at December 31, post the adjustments to T-accounts, and indicate the balance sheet presentation of the equipment at December 31.

BE4-6 On July 1, 2017, Ling Co. pays $12,400 to Marsh Insurance Co. for a 2-year insurance contract. Both companies have fiscal years ending December 31. For Ling Co., journalize and post the entry on July 1 and the annual adjusting entry on December 31.

BE4-7 Using the data in BE4-6, journalize and post the entry on July 1 and the adjusting entry on December 31 for Marsh Insurance Co. Marsh uses the accounts Unearned Service Revenue and Service Revenue.

BE4-8 The bookkeeper for Tran Company asks you to prepare the following accrual adjusting entries at December 31. Use these account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries and Wages Expense, and Salaries and Wages Payable. (a) Interest on notes payable of $300 is accrued. (b) Services performed but unbilled totals $1,700. (c) Salaries of $780 earned by employees have not been recorded.

BE4-9 The trial balance of Woods Company includes the following balance sheet accounts. Identify the accounts that might require adjustment. For each account that requires adjustment, indicate (1) the type of adjusting entry (prepaid expense, unearned revenue, accrued revenue, or accrued expense) and (2) the related account in the adjusting entry. (a) Accounts Receivable. (e) Notes Payable. (b) Prepaid Insurance. (f) Interest Payable. (c) Equipment. (g) Unearned Service Revenue. (d) Accumulated Depreciation—Equipment.

BE4-10 The adjusted trial balance of Levin Corporation at December 31, 2017, includes the following accounts: Retained Earnings $17,200, Dividends $6,000, Service Revenue $32,000, Salaries and Wages Expense $14,000, Insurance Expense $1,800, Rent Expense $3,900, Supplies Expense $1,500, and Depreciation Expense $1,000. Prepare an income statement for the year.

BE4-11 Partial adjusted trial balance data for Levin Corporation are presented in BE4-10. The balance in Retained Earnings is the balance as of January 1. Prepare a retained earn- ings statement for the year assuming net income is $10,400.

BE4-12 The following selected accounts appear in the adjusted trial balance for Deane Company. Indicate the financial statement on which each account would be reported. (a) Accumulated Depreciation. (e) Service Revenue. (b) Depreciation Expense. (f) Supplies. (c) Retained Earnings (beginning). (g) Accounts Payable. (d) Dividends.

BE4-13 Using the data in BE4-12, identify the accounts that would be included in a post- closing trial balance.

BE4-14 The income statement for the Bonita Pines Golf Club Inc. for the month ended July 31 shows Service Revenue $16,000, Salaries and Wages Expense $8,400, Maintenance and Repairs Expense $2,500, and Income Tax Expense $1,000. The statement of retained earnings shows an opening balance for Retained Earnings of $20,000 and Dividends $1,300. (a) Prepare closing journal entries. (b) What is the ending balance in Retained Earnings?

Prepare adjusting entry for supplies.

(LO 2), AP

Prepare adjusting entry for depreciation.

(LO 2), AP

Prepare adjusting entry for prepaid expense.

(LO 2), AP

Prepare adjusting entry for unearned revenue.

(LO 2), AP

Prepare adjusting entries for accruals.

(LO 3), AP

Analyze accounts in an adjusted trial balance.

(LO 4), AN

Prepare an income statement from an adjusted trial balance.

(LO 4), AP

Prepare a retained earnings statement from an adjusted trial balance.

(LO 4), AP

Identify fi nancial statement for selected accounts.

(LO 4), K

Identify post-closing trial balance accounts.

(LO 4), K Prepare and post closing entries.

(LO 4), AP

DO IT! Exercises 193

A list of concepts is provided below in the left column, with descriptions of the concepts in the right column. There are more descriptions provided than concepts. Match the description to the concept.

1. ______ Cash-basis accounting. 2. ______ Fiscal year. 3. ______ Revenue recognition principle. 4. ______ Expense recognition principle.

The ledger of Umatilla, Inc. on March 31, 2017, includes the following selected accounts before adjusting entries.

Debit Credit

Supplies 2,500 Prepaid Insurance 2,400 Equipment 30,000 Unearned Service Revenue 10,000

An analysis of the accounts shows the following.

1. Insurance expires at the rate of $300 per month. 2. Supplies on hand total $900. 3. The equipment depreciates $200 per month. 4. During March, services were performed for two-fifths of the unearned service revenue.

Prepare the adjusting entries for the month of March.

Jean Karns is the new owner of Jean’s Computer Services. At the end of July 2017, her fi rst month of ownership, Jean is trying to prepare monthly fi nancial statements. She has the following information for the month.

1. At July 31, Jean owed employees $1,100 in salaries that the company will pay in August. 2. On July 1, Jean borrowed $20,000 from a local bank on a 10-year note. The annual

interest rate is 9%. 3. Service revenue unrecorded in July totaled $1,600.

Prepare the adjusting entries needed at July 31, 2017.

Indicate in which fi nancial statement each of the following adjusted trial bal- ance accounts would be presented.

Service Revenue Accounts Receivable Notes Payable Accumulated Depreciation Common Stock Utilities Expense

DO IT! 4-1 Identify timing concepts.

(LO 1), C

DO IT! 4-2 Prepare adjusting entries for deferrals.

(LO 2), AP

DO IT! 4-3 Prepare adjusting entries for accruals.

(LO 3), AP

DO IT! 4-2DO IT! 4-4a Prepare fi nancial statements from adjusted trial balance.

(LO 4), C

EXERCISES▼DO IT!

BE4-15 The required steps in the accounting cycle are listed in random order below. List the steps in proper sequence. (a) Prepare a post-closing trial balance. (f) Journalize and post closing entries. (b) Prepare an adjusted trial balance. (g) Prepare financial statements. (c) Analyze business transactions. (h) Journalize and post adjusting entries. (d) Prepare a trial balance. (i) Post to ledger accounts. (e) Journalize the transactions.

List required steps in the accounting cycle sequence.

(LO 4), K

(a) Monthly and quarterly time periods. (b) Accountants divide the economic life of a

business into artifi cial time periods. (c) Efforts (expenses) should be matched with

accomplishments (revenues). (d) Companies record revenues when they re-

ceive cash and record expenses when they pay out cash.

(e) An accounting time period that is one year in length.

(f) An accounting time period that starts on January 1 and ends on December 31.

(g) Companies record transactions in the period in which the events occur.

(h) Recognize revenue in the accounting period in which a performance obligation is satisfi ed.

194 4 Accrual Accounting Concepts

Paloma Company shows the following balances in selected accounts of its adjusted trial balance.

Supplies $32,000 Service Revenue $108,000 Supplies Expense 6,000 Salaries and Wages Expense 40,000 Accounts Receivable 12,000 Utilities Expense 8,000 Dividends 22,000 Rent Expense 18,000 Retained Earnings 70,000

Prepare the remaining closing entries at December 31.

DO IT! 4-2DO IT! 4-4bPrepare closing entries.

(LO 4), AP

E4-1 The following independent situations require professional judgment for determining when to recognize revenue from the transactions. (a) Southwest Airlines sells you an advance-purchase airline ticket in September for your

fl ight home in December. (b) Ultimate Electronics sells you a home theater on a “no money down and full payment

in three months” promotional deal. (c) The Toronto Blue Jays sell season tickets online to games in the Skydome. Fans can

purchase the tickets at any time, although the season doesn’t offi cially begin until April. The major league baseball season runs from April through October.

(d) RBC Financial Group loans money on August 1. The loan and the interest are repay- able in full in November.

(e) In August, you order a sweater from Sears using its online catalog. The sweater arrives in September, which you charged to your Sears credit card. You receive and pay the Sears bill in October.

Instructions Identify when revenue should be recognized in each of the above situations.

E4-2 These accounting concepts were discussed in this and previous chapters. 1. Economic entity assumption. 6. Materiality. 2. Expense recognition principle. 7. Full disclosure principle. 3. Monetary unit assumption. 8. Going concern assumption. 4. Periodicity assumption. 9. Revenue recognition principle. 5. Historical cost principle. 10. Cost constraint.

Instructions Identify by number the accounting concept that describes each situation below. Do not use a number more than once. _____ (a) Is the rationale for why plant assets are not reported at liquidation value. (Do not

use the historical cost principle.) _____ (b) Indicates that personal and business recordkeeping should be separately

maintained. _____ (c) Ensures that all relevant financial information is reported. _____ (d) Assumes that the dollar is the “measuring stick” used to report on financial

performance. _____ (e) Requires that accounting standards be followed for all items of significant size. _____ (f) Separates financial information into time periods for reporting purposes. _____ (g) Requires recognition of expenses in the same period as related revenues. _____ (h) Indicates that fair value changes subsequent to purchase are not recorded in the

accounts.

E4-3 Here are some accounting reporting situations. (a) East Lake Company recognizes revenue at the end of the production cycle but before

sale. The price of the product, as well as the amount that can be sold, is not certain. (b) Hilo Company is in its fi fth year of operation and has yet to issue fi nancial statements.

(Do not use the full disclosure principle.) (c) Gomez, Inc. is carrying inventory at its original cost of $100,000. Inventory has a fair

value of $110,000.

Identify point of revenue recognition.

(LO 1), C

Identify accounting assumptions, principles, and constraint.

(LO 1), K

Identify the violated assumption, principle, or constraint.

(LO 1), C

EXERCISES▼

Exercises 195

(d) Bly Hospital Supply Corporation reports only current assets and current liabilities on its balance sheet. Equipment and bonds payable are reported as current assets and current liabilities, respectively. Liquidation of the company is unlikely.

(e) Chieu Company has inventory on hand that cost $400,000. Chieu reports inventory on its balance sheet at its current fair value of $425,000.

(f) Toxy Syles, president of Classic Music Company, bought a computer for her personal use. She paid for the computer by using company funds and debited the “Computers” account.

Instructions For each situation, list the assumption, principle, or constraint that has been violated, if any. (Some were presented in earlier chapters.) List only one answer for each situation.

E4-4 Your examination of the records of a company that follows the cash basis of account- ing tells you that the company’s reported cash-basis earnings in 2017 are $33,640. If this firm had followed accrual-basis accounting practices, it would have reported the following year-end balances.

2017 2016

Accounts receivable $3,400 $2,800 Supplies on hand 1,300 1,460 Unpaid wages owed 2,000 2,400 Other unpaid expenses 1,400 1,100

Instructions Determine the company’s net earnings on an accrual basis for 2017. Show all your calcu- lations in an orderly fashion.

E4-5 In its first year of operations, Gomes Company recognized $28,000 in service revenue, $6,000 of which was on account and still outstanding at year-end. The remaining $22,000 was received in cash from customers. The company incurred operating expenses of $15,800. Of these expenses, $12,000 were paid in cash; $3,800 was still owed on account at year-end. In addition, Gomes prepaid $2,400 for insurance coverage that would not be used until the second year of operations.

Instructions (a) Calculate the fi rst year’s net earnings under the cash basis of accounting, and calcu-

late the fi rst year’s net earnings under the accrual basis of accounting. (b) Which basis of accounting (cash or accrual) provides more useful information for

decision-makers?

E4-6 Franken Company, a ski tuning and repair shop, opened on November 1, 2016. The company carefully kept track of all its cash receipts and cash payments. The following information is available at the end of the ski season, April 30, 2017.

Cash Cash Receipts Payments

Issuance of common shares $20,000 Payment to purchase repair shop equipment $ 9,200 Payments to landlord 1,225 Newspaper advertising payment 375 Utility bill payments 970 Part-time helper’s wage payments 2,600 Income tax payment 10,000 Cash receipts from ski and snowboard repair services 32,150

Subtotals 52,150 24,370 Cash balance 27,780

Totals $52,150 $52,150

The repair shop equipment was purchased on November 1 and has an estimated useful life of 4 years. Lease payments to the landlord are made at the beginning of each month. The amount of the payments to the landlord shown above includes a one-time security deposit of $175. The part-time helper is owed $420 at April 30, 2017, for unpaid wages. At April 30, 2017, customers owe Franken Company $540 for services they have received but have not yet paid for.

Convert earnings from cash to accrual basis.

(LO 1, 2, 3), AP

Determine cash-basis and accrual-basis earnings.

(LO 1), AP

Convert earnings from cash to accrual basis; prepare accrual- based fi nancial statements.

(LO 1, 2, 3), AP

196 4 Accrual Accounting Concepts

Instructions (a) Prepare an accrual-basis income statement for the 6 months ended April 30, 2017. (b) Prepare the April 30, 2017, classifi ed balance sheet.

E4-7 BizCon, a consulting firm, has just completed its first year of operations. The com- pany’s sales growth was explosive. To encourage clients to hire its services, BizCon offered 180-day financing—meaning its largest customers do not pay for nearly 6 months. Because BizCon is a new company, its equipment suppliers insist on being paid cash on delivery. Also, it had to pay up front for 2 years of insurance. At the end of the year, BizCon owed employees for one full month of salaries, but due to a cash shortfall, it promised to pay them the first week of next year.

Instructions (a) Explain how cash and accrual accounting would differ for each of the events listed

above and describe the proper accrual accounting. (b) Assume that at the end of the year, BizCon reported a favorable net income, yet the

company’s management is concerned because the company is very short of cash. Explain how BizCon could have positive net income and yet run out of cash.

E4-8 Wang Company accumulates the following adjustment data at December 31. (a) Services performed but unbilled total $600. (b) Store supplies of $160 are on hand. The supplies account shows a $1,900 balance. (c) Utility expenses of $275 are unpaid. (d) Services performed of $490 collected in advance. (e) Salaries of $620 are unpaid. (f) Prepaid insurance totaling $400 has expired.

Instructions For each item, indicate (1) the type of adjustment (prepaid expense, unearned revenue, accrued revenue, or accrued expense) and (2) the status of the accounts before adjustment (overstated or understated).

E4-9 The ledger of Howard Rental Agency on March 31 of the current year includes the selected accounts below before adjusting entries have been prepared.

Debit Credit

Supplies $ 3,000 Prepaid Insurance 3,600 Equipment 25,000 Accumulated Depreciation—Equipment $ 8,400 Notes Payable 20,000 Unearned Rent Revenue 12,400 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 $280 per month. 2. Half of the unearned rent revenue was earned during the quarter. 3. Interest of $400 is accrued on the notes payable. 4. Supplies on hand total $850. 5. Insurance expires at the rate of $400 per month.

Instructions Prepare the adjusting entries at March 31, assuming that adjusting entries are made quar- terly. Additional accounts are Depreciation Expense, Insurance Expense, Interest Payable, and Supplies Expense.

E4-10 Al Medina, D.D.S., opened an incorporated 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, $760

of such services was completed but not yet billed to the insurance companies. 2. Utility expenses incurred but not paid prior to January 31 totaled $450. 3. Purchased dental equipment on January 1 for $80,000, paying $20,000 in cash and

signing a $60,000, 3-year note payable (interest is paid each December 31). The equipment depreciates $400 per month. Interest is $500 per month.

Identify differences between cash and accrual accounting.

(LO 1, 2, 3), C

Identify types of adjustments and accounts before adjustment.

(LO 1, 2, 3), AN

Prepare adjusting entries from selected account data.

(LO 2, 3), AP

Prepare adjusting entries.

(LO 2, 3), AP

Exercises 197

4. Purchased a 1-year malpractice insurance policy on January 1 for $24,000. 5. Purchased $1,750 of dental supplies (recorded as increase to Supplies). On January

31, determined that $550 of supplies were on hand.

Instructions Prepare the adjusting entries on January 31. Account titles are Accumulated Depreciation— Equipment, Depreciation Expense, Service Revenue, Accounts Receivable, Insurance Expense, Interest Expense, Interest Payable, Prepaid Insurance, Supplies, Supplies Expense, Utilities Expense, and Accounts Payable.

E4-11 The unadjusted trial balance for Sierra Corp. is shown in Illustration 4-4 (page 155). Instead of the adjusting entries shown in the text at October 31, assume the following adjustment data. 1. Supplies on hand at October 31 total $500. 2. Expired insurance for the month is $100. 3. Depreciation for the month is $75. 4. As of October 31, services worth $800 related to the previously recorded unearned

revenue had been performed. 5. Services performed but unbilled (and no receivable has been recorded) at October 31

are $280. 6. Interest expense accrued at October 31 is $70. 7. Accrued salaries at October 31 are $1,400.

Instructions Prepare the adjusting entries for the items above.

E4-12 The ledger of Armour Lake Lumber Supply on July 31, 2017, includes the selected accounts below before adjusting entries have been prepared.

Debit Credit

Investment in Note Receivable $ 20,000 Supplies 24,000 Prepaid Rent 3,600 Buildings 250,000 Accumulated Depreciation—Buildings $140,000 Unearned Service Revenue 11,500

An analysis of the company’s accounts shows the following. 1. The investment in the notes receivable earns interest at a rate of 6% per year. 2. Supplies on hand at the end of the month totaled $18,600. 3. The balance in Prepaid Rent represents 4 months of rent costs. 4. Employees were owed $3,100 related to unpaid salaries and wages. 5. Depreciation on buildings is $6,000 per year. 6. During the month, the company satisfied obligations worth $4,700 related to the

Unearned Services Revenue. 7. Unpaid maintenance and repairs costs were $2,300.

Instructions Prepare the adjusting entries at July 31 assuming that adjusting entries are made monthly. Use additional accounts as needed.

E4-13 The income statement of Norski Co. for the month of July shows net income of $2,000 based on Service Revenue $5,500, Salaries and Wages Expense $2,100, Supplies Expense $900, and Utilities Expense $500. In reviewing the statement, you discover the following: 1. Insurance expired during July of $350 was omitted. 2. Supplies expense includes $200 of supplies that are still on hand at July 31. 3. Depreciation on equipment of $150 was omitted. 4. Accrued but unpaid wages at July 31 of $360 were not included. 5. Services performed but unrecorded totaled $700.

Instructions Prepare a correct income statement for July 2017.

Prepare adjusting entries.

(LO 2, 3), AP

Prepare adjusting entries from selected account data.

(LO 2, 3), AP

Prepare a correct income statement.

(LO 1, 2, 3), AN

198 4 Accrual Accounting Concepts

E4-14 Selected accounts of Villa Company are shown here.Journalize basic transactions and adjusting entries.

(LO 2, 3), AN Supplies Expense

July 31 750

Salaries and Wages Payable

July 31 1,000

Salaries and Wages Expense

July 15 1,000 31 1,000

Service Revenue

July 14 3,800 31 900 31 500

Supplies

July 1 Bal. 1,100 July 31 750 10 200

Accounts Receivable

July 31 500

Unearned Service Revenue

July 31 900 July 1 Bal. 1,500 20 600

Instructions After analyzing the accounts, journalize (a) the July transactions and (b) the adjusting entries that were made on July 31. (Hint: July transactions were for cash.)

E4-15 This is a partial adjusted trial balance of Ramon Company.

RAMON COMPANY Adjusted Trial Balance

January 31, 2017

Debit Credit

Supplies $ 700 Prepaid Insurance 1,560 Salaries and Wages Payable $1,060 Unearned Service Revenue 750 Supplies Expense 950 Insurance Expense 520 Salaries and Wages Expense 1,800 Service Revenue 4,000

Instructions Answer these questions, assuming the year begins January 1. (a) If the amount in Supplies Expense is the January 31 adjusting entry and $300 of sup-

plies 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 1 year, what was the total premium and when was the policy purchased?

(d) If $1,800 was received in January for services performed in January, what was the bal- ance in Unearned Service Revenue at December 31, 2016?

E4-16 On December 31, 2017, Waters Company prepared an income statement and bal- ance sheet, but failed to take into account three adjusting entries. The balance sheet showed total assets $150,000, total liabilities $70,000, and stockholders’ equity $80,000. The incorrect income statement showed net income of $70,000. The data for the three adjusting entries were: 1. Salaries and wages amounting to $10,000 for the last 2 days in December were not

paid and not recorded. The next payroll will be in January. 2. Rent payments of $8,000 was received for two months in advance on December 1. The

entire amount was credited to Unearned Rent Revenue when paid. 3. Depreciation expense for 2017 is $9,000.

Analyze adjusted data.

(LO 1, 2, 3), AN

Determine effect of adjusting entries.

(LO 2, 3), AN

Exercises 199

Instructions Complete the following table to correct the financial statement amounts shown (indicate deductions with parentheses).

Total Stockholders’ Item Net Income Total Assets Liabilities Equity

Incorrect balances $70,000 $150,000 $70,000 $80,000 Effects of: Salaries and Wages _______ ________ _______ _______ Rent Revenue _______ ________ _______ _______ Depreciation _______ ________ _______ _______ Correct balances _______ ________ _______ _______ _______ ________ _______ _______

E4-17 Action Quest Games Inc. adjusts its accounts annually. The following information is available for the year ended December 31, 2017. 1. Purchased a 1-year insurance policy on June 1 for $1,800 cash. 2. Paid $6,500 on August 31 for 5 months’ rent in advance. 3. On September 4, received $3,600 cash in advance from a corporation to sponsor a

game each month for a total of 9 months for the most improved students at a local school.

4. Signed a contract for cleaning services starting December 1 for $1,000 per month. Paid for the first 2 months on November 30. (Hint: Use the account Prepaid Cleaning to record prepayments.)

5. On December 5, received $1,500 in advance from a gaming club. Determined that on December 31, $475 of these games had not yet been played.

Instructions (a) For each of the above transactions, prepare the journal entry to record the initial

transaction. (b) For each of the above transactions, prepare the adjusting journal entry that is required

on December 31. (Hint: Use the account Service Revenue for item 3 and Repairs and Maintenance Expense for item 4.)

(c) Post the journal entries in parts (a) and (b) to T-accounts and determine the fi nal balance in each account balance. (Note: Posting to the Cash account is not required.)

E4-18 Greenock Limited has the following information available for accruals for the year ended December 31, 2017. The company adjusts its accounts annually. 1. The December utility bill for $425 was unrecorded on December 31. Greenock paid

the bill on January 11. 2. Greenock is open 7 days a week and employees are paid a total of $3,500 every

Monday for a 7-day (Monday–Sunday) workweek. December 31 is a Thursday, so employees will have worked 4 days (Monday, December 28–Thursday, December 31) that they have not been paid for by year-end. Employees will be paid next on January 4.

3. Greenock signed a $45,000, 5% bank loan on November 1, 2016, due in 2 years. Inter- est is payable on the first day of each following month.

4. Greenock receives a fee from Pizza Shop next door for all pizzas sold to customers using Greenock’s facility. The amount owed for December is $300, which Pizza Shop will pay on January 4. (Hint: Use the Service Revenue account.)

5. Greenock rented some of its unused warehouse space to a client for $6,000 a month, payable the first day of the following month. It received the rent for the month of December on January 2.

Instructions (a) For each situation, prepare the adjusting entry required at December 31. (Round all

calculations to the nearest dollar.) (b) For each situation, prepare the journal entry to record the subsequent cash transac-

tion in 2018.

E4-19 A partial adjusted trial balance for Ramon Company is given in E4-15.

Instructions Prepare the closing entries at January 31, 2017.

Prepare and post transaction and adjusting entries for prepayments.

(LO 2, 3), AP

Prepare adjusting and subsequent entries for accruals.

(LO 2, 3), AP

Prepare closing entries.

(LO 4), AP

200 4 Accrual Accounting Concepts

E4-20 Selected year-end account balances from the adjusted trial balance as of December 31, 2017, for Tippy Corporation is provided below.

Debit Credit

Accounts Receivable $ 72,600 Dividends 26,300 Depreciation Expense 13,200 Equipment 212,800 Salaries and Wages Expense 91,100 Accounts Payable $ 53,000 Accumulated Depreciation—Equipment 114,800 Unearned Rent Revenue 22,900 Service Revenue 183,800 Rent Revenue 6,200 Rent Expense 3,600 Retained Earnings 61,800 Supplies Expense 1,400

Instructions (a) Prepare closing entries (b) Determine the post-closing balance in Retained Earnings.

E4-21 The trial balances shown below are before and after adjustment for Ryan Company at the end of its fiscal year.

RYAN COMPANY Trial Balance

August 31, 2017

Before After Adjustment Adjustment

Dr. Cr. Dr. Cr.

Cash $10,900 $10,900 Accounts Receivable 8,800 9,400 Supplies 2,500 500 Prepaid Insurance 4,000 2,500 Equipment 16,000 16,000 Accumulated Depreciation—Equipment $ 3,600 $ 4,800 Accounts Payable 5,800 5,800 Salaries and Wages Payable 0 1,100 Unearned Rent Revenue 1,800 800 Common Stock 10,000 10,000 Retained Earnings 5,500 5,500 Dividends 2,800 2,800 Service Revenue 34,000 34,600 Rent Revenue 12,100 13,100 Salaries and Wages Expense 17,000 18,100 Supplies Expense 0 2,000 Rent Expense 10,800 10,800 Insurance Expense 0 1,500 Depreciation Expense 0 1,200

$72,800 $72,800 $75,700 $75,700

Instructions Prepare the adjusting entries that were made.

E4-22 The adjusted trial balance for Ryan Company is given in E4-21.

Instructions Prepare the income and retained earnings statements for the year and the classified bal- ance sheet at August 31.

E4-23 The adjusted trial balance for Ryan Company is given in E4-21.

Instructions Prepare the closing entries for the temporary accounts at August 31.

Prepare closing entries.

(LO 4), AP

Prepare adjusting entries from analysis of trial balance.

(LO 2, 3, 4), AN

Prepare fi nancial statements from adjusted trial balance.

(LO 4), AP

Prepare closing entries.

(LO 4), AP

Problems: Set A 201

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P4-1A The following selected data are taken from the comparative fi nancial statements of Yankee Curling Club. The club prepares its fi nancial statements using the accrual basis of accounting.

September 30 2017 2016

Accounts receivable for member dues $ 15,000 $ 19,000 Unearned sales revenue 20,000 23,000 Service revenue (from member dues) 151,000 135,000

Dues are billed to members based upon their use of the club’s facilities. Unearned sales revenues arise from the sale of tickets to events, such as the Skins Game.

Instructions (Hint: You will fi nd it helpful to use T-accounts to analyze the following data. You must analyze these data sequentially, as missing information must fi rst be deduced before mov- ing on. Post your journal entries as you progress, rather than waiting until the end.)

(a) Prepare journal entries for each of the following events that took place during 2017. 1. Dues receivable from members from 2016 were all collected during 2017. 2. During 2017, goods were provided for all of the unearned sales revenue at the end

of 2016. 3. Additional tickets were sold for $44,000 cash during 2017; a portion of these were

used by the purchasers during the year. The entire balance remaining in Unearned Sales Revenue relates to the upcoming Skins Game in 2017.

4. Dues for the 2016–2017 fi scal year were billed to members. 5. Dues receivable for 2017 (i.e., those billed in item 4 above) were partially collected. (b) Determine the amount of cash received by Yankee from the above transactions during

the year ended September 30, 2017.

P4-2A Len Kumar started his own consulting fi rm, Kumar Consulting, on June 1, 2017. The trial balance at June 30 is as follows.

KUMAR CONSULTING Trial Balance June 30, 2017

Debit Credit

Cash $ 6,850 Accounts Receivable 7,000 Supplies 2,000 Prepaid Insurance 2,880 Equipment 15,000 Accounts Payable $ 4,230 Unearned Service Revenue 5,200 Common Stock 22,000 Service Revenue 8,300 Salaries and Wages Expense 4,000 Rent Expense 2,000

$39,730 $39,730

In addition to those accounts listed on the trial balance, the chart of accounts for Kumar also contains the following accounts: Accumulated Depreciation—Equipment, Salaries and Wages Payable, Depreciation Expense, Insurance Expense, Utilities Expense, and Supplies Expense.

Record transactions on accrual basis; convert revenue to cash receipts.

(LO 1, 2, 3), AP

(b) Cash received $199,000

Prepare adjusting entries, post to ledger accounts, and prepare adjusted trial balance.

(LO 2, 3, 4), AP

PROBLEMS: SET A▼

202 4 Accrual Accounting Concepts

Other data:

1. Supplies on hand at June 30 total $720. 2. A utility bill for $180 has not been recorded and will not be paid until next month. 3. The insurance policy is for a year. 4. Services were performed for $4,100 of unearned service revenue by the end of the

month. 5. Salaries of $1,250 are accrued at June 30. 6. The equipment has a 5-year life with no salvage value and is being depreciated at $250

per month for 60 months. 7. Invoices representing $3,900 of services performed during the month have not been

recorded as of June 30.

Instructions (a) Prepare the adjusting entries for the month of June. (b) Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance

as beginning account balances. (Use T-accounts.) (c) Prepare an adjusted trial balance at June 30, 2017.

P4-3A The Moto Hotel opened for business on May 1, 2017. Here is its trial balance before adjustment on May 31.

MOTO HOTEL Trial Balance May 31, 2017

Debit Credit

Cash $ 2,500 Supplies 2,600 Prepaid Insurance 1,800 Land 15,000 Buildings 70,000 Equipment 16,800 Accounts Payable $ 4,700 Unearned Rent Revenue 3,300 Mortgage Payable 36,000 Common Stock 60,000 Rent Revenue 9,000 Salaries and Wages Expense 3,000 Utilities Expense 800 Advertising Expense 500

$113,000 $113,000

Other data:

1. Insurance expires at the rate of $450 per month. 2. A count of supplies shows $1,050 of unused supplies on May 31. 3. Annual depreciation is $3,600 on the building and $3,000 on equipment. 4. The mortgage interest rate is 6%. (The mortgage was taken out on May 1.) 5. Unearned rent of $2,500 has been earned. 6. Salaries of $900 are accrued and unpaid at May 31.

Instructions (a) Journalize the adjusting entries on May 31. (b) Prepare a ledger using T-accounts. Enter the trial balance amounts and post the adjust-

ing entries. (c) Prepare an adjusted trial balance on May 31. (d) Prepare an income statement and a retained earnings statement for the month of May

and a classifi ed balance sheet at May 31. (e) Identify which accounts should be closed on May 31.

P4-4A Salt Creek Golf Inc. was organized on July 1, 2017. Quarterly fi nancial statements are prepared. The trial balance and adjusted trial balance on September 30 are shown on page 203.

(b) Service rev. $16,300

Prepare adjusting entries, adjusted trial balance, and fi nancial statements.

(LO 2, 3, 4), AP

(d) Net income $3,570

Prepare adjusting entries and fi nancial statements; identify accounts to be closed.

(LO 2, 3, 4), AP

Problems: Set A 203

SALT CREEK GOLF INC. Trial Balance

September 30, 2017

Unadjusted Adjusted

Dr. Cr. Dr. Cr.

Cash $ 6,700 $ 6,700 Accounts Receivable 400 1,000 Supplies 1,200 180 Prepaid Rent 1,800 900 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 Expense 470 470 Interest Expense 50

$35,870 $35,870 $37,470 $37,470

Instructions (a) Journalize the adjusting entries that were made. (b) Prepare an income statement and a retained earnings statement for the 3 months end-

ing September 30 and a classifi ed 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?

P4-5A A review of the ledger of Lewis Company at December 31, 2017, produces these data pertaining to the preparation of annual adjusting entries.

1. Prepaid Insurance $15,200. The company has separate insurance policies on its buildings and its motor vehicles. Policy B4564 on the building was purchased on July 1, 2016, for $9,600. The policy has a term of 3 years. Policy A2958 on the vehicles was purchased on January 1, 2017, for $7,200. This policy has a term of 18 months.

2. Unearned Rent Revenue $429,000. The company began subleasing office space in its new building on November 1. At December 31, the company had the following rental contracts that are paid in full for the entire term of the lease.

Term Number of Date (in months) Monthly Rent Leases

Nov. 1 9 $5,000 5 Dec. 1 6 $8,500 4

3. Notes Payable $40,000. This balance consists of a note for 6 months at an annual interest rate of 7%, dated October 1.

4. Salaries and Wages Payable $0. There are eight salaried employees. Salaries are paid every Friday for the current week. Five employees receive a salary of $600 each per week, and three employees earn $700 each per week. Assume December 31 is a Wednesday. Employees do not work weekends. All employees worked the last 3 days of December.

Instructions Prepare the adjusting entries at December 31, 2017.

(b) Net income $2,510 Tot. assets $23,430

Prepare adjusting entries.

(LO 2, 3), AP

2. Rent revenue $84,000

204 4 Accrual Accounting Concepts

P4-6A Roadside Travel Court was organized on July 1, 2016, by Betty Johnson. Betty is a good manager but a poor accountant. From the trial balance prepared by a part-time bookkeeper, Betty prepared the following income statement for her fourth quarter, which ended June 30, 2017.

ROADSIDE TRAVEL COURT Income Statement

For the Quarter Ended June 30, 2017

Revenues Rent revenue $212,000 Operating expenses Advertising expense $ 3,800 Salaries and wages expense 80,500 Utilities expense 900 Depreciation expense 2,700 Maintenance and repairs expense 4,300 Total operating expenses 92,200

Net income $119,800

Betty suspected that something was wrong with the statement because net income had never exceeded $30,000 in any one quarter. Knowing that you are an experienced ac- countant, she asks you to review the income statement and other data. You fi rst look at the trial balance. In addition to the account balances reported above in the income statement, the trial balance contains the following additional selected balances at June 30, 2017.

Supplies $ 8,200 Prepaid Insurance 14,400 Notes Payable 14,000

You then make inquiries and discover the following.

1. Roadside rental revenues include advanced rental payments received for summer occupancy, in the amount of $57,000.

2. There were $1,800 of supplies on hand at June 30. 3. Prepaid insurance resulted from the payment of a 1-year policy on April 1, 2017. 4. The mail in July 2017 brought the following bills: advertising for the week of June 24,

$110; repairs made June 18, $4,450; and utilities for the month of June, $215. 5. Wage expense is $300 per day. At June 30, 4 days’ wages have been incurred but not

paid. 6. The note payable is a 6% note dated May 1, 2017, and due on July 31, 2017. 7. Income tax of $13,400 for the quarter is due in July but has not yet been recorded.

Instructions (a) Prepare any adjusting journal entries required at June 30, 2017. (b) Prepare a correct income statement for the quarter ended June 30, 2017. (c) Explain to Betty the generally accepted accounting principles that she did not recog-

nize in preparing her income statement and their effect on her results.

P4-7A On November 1, 2017, the following were the account balances of Soho Equipment Repair.

Debit Credit

Cash $ 2,790 Accumulated Depreciation—Equipment $ 500 Accounts Receivable 2,910 Accounts Payable 2,300 Supplies 1,120 Unearned Service Revenue 400 Equipment 10,000 Salaries and Wages Payable 620 Common Stock 10,000 Retained Earnings 3,000

$16,820 $16,820

Prepare adjusting entries and a corrected income statement.

(LO 2, 3), AN

(b) Net income $33,285

Journalize transactions and follow through accounting cycle to preparation of fi nancial statements.

(LO 2, 3, 4), AP

Comprehensive Accounting Cycle Review 205

During November, the following summary transactions were completed.

Nov. 8 Paid $1,220 for salaries due employees, of which $600 is for November and $620 is for October salaries payable.

10 Received $1,800 cash from customers in payment of account. 12 Received $3,700 cash for services performed in November. 15 Purchased store equipment on account $3,600. 17 Purchased supplies on account $1,300. 20 Paid creditors $2,500 of accounts payable due. 22 Paid November rent $480. 25 Paid salaries $1,000. 27 Performed services on account worth $900 and billed customers. 29 Received $750 from customers for services to be performed in the future.

Adjustment data:

1. Supplies on hand are valued at $1,100. 2. Accrued salaries payable are $480. 3. Depreciation for the month is $250. 4. Services were performed to satisfy $500 of unearned service revenue.

Instructions (a) Enter the November 1 balances in the ledger accounts. (Use T-accounts.) (b) Journalize the November transactions. (c) Post to the ledger accounts. Use Service Revenue, Depreciation Expense, Supplies

Expense, Salaries and Wages Expense, and Rent Expense. (d) Prepare a trial balance at November 30. (e) Journalize and post adjusting entries. (f) Prepare an adjusted trial balance. (g) Prepare an income statement and a retained earnings statement for November and a

classifi ed balance sheet at November 30.

(f) Cash $3,840 Tot. adj. trial balance $24,680

(g) Net income $970

COMPREHENSIVE ACCOUNTING CYCLE REVIEW ACR4-1 Mike Greenberg opened Kleene Window Washing Inc. on July 1, 2017. During July, the following transactions were completed.

July 1 Issued 12,000 shares of common stock for $12,000 cash. 1 Purchased used truck for $8,000, paying $2,000 cash and the balance on

account. 3 Purchased cleaning supplies for $900 on account. 5 Paid $1,800 cash on a 1-year insurance policy effective July 1. 12 Billed customers $3,700 for cleaning services performed. 18 Paid $1,000 cash on amount owed on truck and $500 on amount owed on

cleaning supplies.

Complete all steps in accounting cycle.

(LO 2, 3, 4), AP

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 3.)

CC4 It is the end of November and Natalie has been in touch with her grandmother. Her grandmother asked Natalie how well things went in her fi rst month of business. Natalie, too, would like to know if her business has been profi table or not during November. Natalie realizes that in order to determine Cookie Creations’ income, she must fi rst make adjustments.

Go to the book’s companion website, www.wiley.com/college/kimmel, to see the completion of this problem.

CONTINUING PROBLEM Cookie Creations▼

206 4 Accrual Accounting Concepts

July 20 Paid $2,000 cash for employee salaries. 21 Collected $1,600 cash from customers billed on July 12. 25 Billed customers $2,500 for cleaning services performed. 31 Paid $290 for maintenance of the truck during month. 31 Declared and paid $600 cash dividend.

The chart of accounts for Kleene Window Washing contains the following accounts: Cash, Accounts Receivable, Supplies, Prepaid Insurance, Equipment, Accumulated Depreciation— Equipment, Accounts Payable, Salaries and Wages Payable, Common Stock, Retained Earnings, Dividends, Income Summary, Service Revenue, Maintenance and Repairs Expense, Supplies Expense, Depreciation Expense, Insurance Expense, and Salaries and Wages Expense.

Instructions (a) Journalize the July transactions. (b) Post to the ledger accounts. (Use T-accounts.) (c) Prepare a trial balance at July 31. (d) Journalize the following adjustments. (1) Services performed but unbilled and uncollected at July 31 were $1,700. (2) Depreciation on equipment for the month was $180. (3) One-twelfth of the insurance expired. (4) A count shows $320 of cleaning supplies on hand at July 31. (5) Accrued but unpaid employee salaries were $400. (e) Post adjusting entries to the T-accounts. (f) Prepare an adjusted trial balance. (g) Prepare the income statement and a retained earnings statement for July and a classi-

fi ed balance sheet at July 31. (h) Journalize and post closing entries and complete the closing process. (i) Prepare a post-closing trial balance at July 31.

ACR4-2 Lars Linken opened Lars Cleaners on March 1, 2017. During March, the follow- ing transactions were completed.

Mar. 1 Issued 10,000 shares of common stock for $15,000 cash. 1 Borrowed $6,000 cash by signing a 6-month, 6%, $6,000 note payable. Interest

will be paid the fi rst day of each subsequent month. 1 Purchased used truck for $8,000 cash. 2 Paid $1,500 cash to cover rent from March 1 through May 31. 3 Paid $2,400 cash on a 6-month insurance policy effective March 1. 6 Purchased cleaning supplies for $2,000 on account. 14 Billed customers $3,700 for cleaning services performed. 18 Paid $500 on amount owed on cleaning supplies. 20 Paid $1,750 cash for employee salaries. 21 Collected $1,600 cash from customers billed on March 14. 28 Billed customers $4,200 for cleaning services performed. 31 Paid $350 for gas and oil used in truck during month (use Maintenance and

Repairs Expense). 31 Declared and paid a $900 cash dividend.

The chart of accounts for Lars Cleaners contains the following accounts: Cash, Accounts Receivable, Supplies, Prepaid Insurance, Prepaid Rent, Equipment, Accumulated Depreciation—Equipment, Accounts Payable, Salaries and Wages Payable, Notes Payable, Interest Payable, Common Stock, Retained Earnings, Dividends, Income Summary, Service Revenue, Maintenance and Repairs Expense, Supplies Expense, Depreciation Expense, Insurance Expense, Salaries and Wages Expense, Rent Expense, and Interest Expense.

Instructions (a) Journalize the March transactions. (b) Post to the ledger accounts. (Use T-accounts.) (c) Prepare a trial balance at March 31. (d) Journalize the following adjustments. 1. Services performed but unbilled and uncollected at March 31 was $200. 2. Depreciation on equipment for the month was $250. 3. One-sixth of the insurance expired. 4. An inventory count shows $280 of cleaning supplies on hand at March 31.

(f) Cash $5,410 (g) Tot. assets $21,500

Complete all steps in accounting cycle.

(LO 2, 3, 4), AP

Comprehensive Accounting Cycle Review 207

5. Accrued but unpaid employee salaries were $1,080. 6. One month of the prepaid rent has expired. 7. One month of interest expense related to the note payable has accrued and will be

paid April 1. (Hint: Use the formula from Illustration 4-18 to compute interest.) (e) Post adjusting entries to the T-accounts. (f) Prepare an adjusted trial balance. (g) Prepare the income statement and a retained earnings statement for March and a clas-

sifi ed balance sheet at March 31. (h) Journalize and post closing entries and complete the closing process. (i) Prepare a post-closing trial balance at March 31.

ACR4-3 On August 1, 2017, the following were the account balances of B&B Repair Services.

Debit Credit

Cash $ 6,040 Accumulated Depreciation—Equipment $ 600 Accounts Receivable 2,910 Accounts Payable 2,300 Notes Receivable 4,000 Unearned Service Revenue 1,260 Supplies 1,030 Salaries and Wages Payable 1,420 Equipment 10,000 Common Stock 12,000 Retained Earnings 6,400

$23,980 $23,980

During August, the following summary transactions were completed.

Aug. 1 Paid $400 cash for advertising in local newspapers. Advertising fl yers will be included with newspapers delivered during August and September.

3 Paid August rent $380. 5 Received $1,200 cash from customers in payment of account. 10 Paid $3,120 for salaries due employees, of which $1,700 is for August and

$1,420 is for July salaries payable. 12 Received $2,800 cash for services performed in August. 15 Purchased store equipment on account $2,000. 20 Paid creditors $2,000 of accounts payable due. 22 Purchased supplies on account $800. 25 Paid $2,900 cash for employees’ salaries. 27 Billed customers $3,760 for services performed. 29 Received $780 from customers for services to be performed in the future.

Adjustment data:

1. A count shows supplies on hand of $960. 2. Accrued but unpaid employees’ salaries are $1,540. 3. Depreciation on equipment for the month is $320. 4. Services were performed to satisfy $800 of unearned service revenue. 5. One month’s worth of advertising services has been received. 6. One month of interest revenue related to the $4,000 note receivable has accrued. The

4-month note has a 6% annual interest rate. (Hint: Use the formula from Illustration 4-18 to compute interest.)

Instructions (a) Enter the August 1 balances in the ledger accounts. (Use T-accounts.) (b) Journalize the August transactions. (c) Post to the ledger accounts. B&B’s chart of accounts includes Prepaid Advertising,

Interest Receivable, Service Revenue, Interest Revenue, Advertising Expense, Depre- ciation Expense, Supplies Expense, Salaries and Wages Expense, and Rent Expense.

(d) Prepare a trial balance at August 31. (e) Journalize and post adjusting entries. (f) Prepare an adjusted trial balance. (g) Prepare an income statement and a retained earnings statement for August and a

classifi ed balance sheet at August 31. (h) Journalize and post closing entries and complete the closing process. (i) Prepare a post-closing trial balance at August 31.

(f) Tot. adj. trial balance $31,960

(g) Tot. assets $24,730

Journalize transactions and follow through accounting cycle to preparation of fi nancial statements.

(LO 2, 3, 4), AP

(f) Cash $2,020 Tot. Adj. trial

balance $32,580 (g) Net loss $530

208 4 Accrual Accounting Concepts

ACR4-4 At June 30, 2017, the end of its most recent fi scal year, Green River Computer Consultants’ post-closing trial balance was as follows:

Record and post transaction, adjusting, and closing journal entries; prepare adjusted trial balance and fi nancial statements.

(LO 2, 3, 4), AP

Debit Credit

Cash $5,230 Accounts receivable 1,200 Supplies 690 Accounts payable $ 400 Unearned service revenue 1,120 Common stock 3,600 Retained earnings 2,000

$7,120 $7,120

The company underwent a major expansion in July. New staff was hired and more fi nancing was obtained. Green River conducted the following transactions during July 2017, and adjusts its accounts monthly.

July 1 Purchased equipment, paying $4,000 cash and signing a 2-year note payable for $20,000. The equipment has a 4-year useful life. The note has a 6% interest rate which is payable on the fi rst day of each following month.

2 Issued 20,000 shares of common stock for $50,000 cash. 3 Paid $3,600 cash for a 12-month insurance policy effective July 1. 3 Paid the fi rst 2 (July and August 2017) months’ rent for an annual lease of offi ce

space for $4,000 per month. 6 Paid $3,800 for supplies. 9 Visited client offi ces and agreed on the terms of a consulting project. Green

River will bill the client, Connor Productions, on the 20th of each month for services performed.

10 Collected $1,200 cash on account from Milani Brothers. This client was billed in June when Green River performed the service.

13 Performed services for Fitzgerald Enterprises. This client paid $1,120 in ad- vance last month. All services relating to this payment are now completed.

14 Paid $400 cash for a utility bill. This related to June utilities that were accrued at the end of June.

16 Met with a new client, Thunder Bay Technologies. Received $12,000 cash in advance for future services to be performed.

18 Paid semi-monthly salaries for $11,000. 20 Performed services worth $28,000 on account and billed customers. 20 Received a bill for $2,200 for advertising services received during July. The

amount is not due until August 15. 23 Performed the fi rst phase of the project for Thunder Bay Technologies. Recog-

nized $10,000 of revenue from the cash advance received July 16. 27 Received $15,000 cash from customers billed on July 20.

Adjustment data:

1. Adjustment of prepaid insurance. 2. Adjustment of prepaid rent. 3. Supplies used, $1,250. 4. Equipment depreciation, $500 per month. 5. Accrual of interest on note payable. (Hint: Use the formula from Illustration 4-18 to

compute interest.) 6. Salaries for the second half of July, $11,000, to be paid on August 1. 7. Estimated utilities expense for July, $800 (invoice will be received in August). 8. Income tax for July, $1,200, will be paid in August.

The chart of accounts for Green River Computer Consultants contains the following accounts: Cash, Accounts Receivable, Supplies, Prepaid Insurance. Prepaid Rent, Equip- ment, Accumulated Depreciation—Equipment, Accounts Payable, Notes Payable, Interest Payable, Income Taxes Payable, Salaries and Wages Payable, Unearned Service Revenue, Common Stock, Retained Earnings, Dividends, Income Summary, Service Revenue, Sup- plies Expense, Depreciation Expense, Insurance Expense, Salaries and Wages Expense, Advertising Expense, Income Tax Expense, Interest Expense, Rent Expense, Supplies Expense, and Utilities Expense.

Expand Your Critical Thinking 209

Instructions (a) Enter the July 1 balances in the ledger accounts. (Use T-accounts.) (b) Journalize the July transactions. (c) Post to the ledger accounts. (d) Prepare a trial balance at July 31. (e) Journalize and post adjusting entries for the month ending July 31. (f) Prepare an adjusted trial balance. (g) Prepare an income statement and a retained earning statement for July and a classi-

fi ed balance sheet at July 31. (h) Journalize and post closing entries and complete the closing process. (i) Prepare a post-closing trial balance at July 31.

(g) Net income $6,770 Tot. assets $99,670

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT4-1 The fi nancial statements of Apple Inc. are presented in Appendix A at the end of this textbook.

Instructions (a) Using the consolidated income statement and balance sheet, identify items that may

result in adjusting entries for deferrals. (b) Using the consolidated income statement, identify two items that may result in adjust-

ing entries for accruals. (c) What was the amount of depreciation and amortization expense for 2014 and 2013?

(You will need to examine the notes to the financial statements or the statement of cash flows.) Where was accumulated depreciation and amortization reported?

(d) What was the cash paid for income taxes during 2014, reported at the bottom of the consolidated statement of cash flows? What was income tax expense (provision for income taxes) for 2014?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT4-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Identify two accounts on Columbia’s balance sheet that provide evidence that Colum-

bia uses accrual accounting. In each case, identify the income statement account that would be affected by the adjustment process.

(b) Identify two accounts on VF’s balance sheet that provide evidence that VF uses accrual accounting (different from the two you listed for Columbia). In each case, identify the income statement account that would be affected by the adjustment process.

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT4-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Identify two accounts on Amazon’s balance sheet that provide evidence that Amazon

uses accrual accounting. In each case, identify the income statement account that would be affected by the adjustment process.

(b) Identify two accounts on Wal-Mart’s balance sheet that provide evidence that Wal-Mart uses accrual accounting (different from the two you listed for Amazon). In each case, identify the income statement account that would be affected by the adjustment process.

INTERPRETING FINANCIAL STATEMENTS

CT4-4 Laser Recording Systems, founded in 1981, produces disks for use in the home market. The following is an excerpt from Laser Recording Systems’ fi nancial statements (all dollars in thousands).

Financial Reporting

▼

Financial Analysis

▼

Financial Analysis

▼

Financial Analysis

▼

210 4 Accrual Accounting Concepts

Instructions (a) Can you tell from the discussion whether Laser Recording Systems has prepaid its legal

expenses and is now making an adjustment to the asset account Prepaid Legal Expenses, or whether the company is handling the legal expense via an accrued expense adjustment?

(b) Identify each of the adjustments Laser Recording Systems is discussing as one of the four types of possible adjustments discussed in the chapter. How is net income ulti- mately affected by each of the adjustments?

REAL-WORLD FOCUS

CT4-5 Purpose: To learn about the functions of the Securities and Exchange Commission (SEC).

Address: www.sec.gov/about/whatwedo.shtml, or go to www.wiley.com/college/kimmel

Instructions Use the information in this site to answer the following questions.

(a) What event spurred the creation of the SEC? Why was the SEC created? (b) What are the fi ve divisions of the SEC? Briefl y describe the purpose of each. (c) What are the responsibilities of the chief accountant?

DECISION-MAKING ACROSS THE ORGANIZATION

CT4-6 Abbey Park was organized on April 1, 2016, by Trudy Crawford. Trudy is a good manager but a poor accountant. From the trial balance prepared by a part-time bookkeeper, Trudy prepared the following income statement for the quarter that ended March 31, 2017.

ABBEY PARK Income Statement

For the Quarter Ended March 31, 2017

Revenues Rent revenue $83,000 Operating expenses Advertising expense $ 4,200 Salaries and wages expense 27,600 Utilities expense 1,500 Depreciation expense 800 Maintenance and repairs expense 2,800 Total operating expenses 36,900

Net income $46,100

Trudy knew that something was wrong with the statement because net income had never exceeded $20,000 in any one quarter. Knowing that you are an experienced accountant, she asks you to review the income statement and other data.

You first look at the trial balance. In addition to the account balances reported in the income statement, the ledger contains these selected balances at March 31, 2017.

Supplies $ 4,500 Prepaid Insurance 7,200 Notes Payable 20,000

You then make inquiries and discover the following.

1. Rent revenue includes advanced rentals for summer-month occupancy, $21,000. 2. There were $600 of supplies on hand at March 31.

Financial Analysis

Writing

Group Project

▼

Accrued liabilities increased to $1,642 at January 31, from $138 at the end of the pre- vious fi scal year. Compensation and related accruals increased $195 due primarily to increases in accruals for severance, vacation, commissions, and relocation expenses. Accrued professional services increased by $137 primarily as a result of legal ex- penses related to several outstanding contractual disputes. Other expenses increased $35, of which $18 was for interest payable.

LASER RECORDING SYSTEMS Management Discussion

Expand Your Critical Thinking 211

3. Prepaid insurance resulted from the payment of a 1-year policy on January 1, 2017. 4. The mail on April 1, 2017, brought the following bills: advertising for week of March 24,

$110; repairs made March 10, $1,040; and utilities $240. 5. Wage expense totals $290 per day. At March 31, 3 days’ wages have been incurred but

not paid. 6. The note payable is a 3-month, 7% note dated January 1, 2017.

Instructions With the class divided into groups, answer the following.

(a) Prepare a correct income statement for the quarter ended March 31, 2017. (b) Explain to Trudy the generally accepted accounting principles that she did not follow

in preparing her income statement and their effect on her results.

COMMUNICATION ACTIVITY

CT4-7 On numerous occasions, proposals have surfaced to put the federal government on the accrual basis of accounting. This is no small issue because if this basis were used, it would mean that billions in unrecorded liabilities would have to be booked and the federal defi cit would increase substantially.

Instructions (a) What is the difference between accrual-basis accounting and cash-basis accounting? (b) Comment on why politicians prefer a cash-basis accounting system over an accrual-

basis system. (c) Write a letter to your senators explaining why you think the federal government

should adopt the accrual basis of accounting.

ETHICS CASE

CT4-8 Wells Company is a pesticide manufacturer. Its sales declined greatly this year due to the passage of legislation outlawing the sale of several of Wells’ chemical pesticides. During the coming year, Wells will have environmentally safe and competitive replace- ment chemicals to replace these discontinued products. Sales in the next year are expected to greatly exceed those of any prior year. Therefore, the decline in this year’s sales and profi ts appears to be a one-year aberration.

Even so, the company president believes that a large dip in the current year’s profits could cause a significant drop in the market price of Wells’ stock and make it a takeover target. To avoid this possibility, he urges Tim Allen, controller, to accrue every possible revenue and to defer as many expenses as possible in making this period’s year-end adjust- ing entries. The president says to Tim, “We need the revenues this year, and next year we can easily absorb expenses deferred from this year. We can’t let our stock price be ham- mered down!” Tim didn’t get around to recording the adjusting entries until January 17, but he dated the entries December 31 as if they were recorded then. Tim also made every effort to comply with the president’s request.

Instructions (a) Who are the stakeholders in this situation? (b) What are the ethical considerations of the president’s request and Tim’s dating the

adjusting entries December 31? (c) Can Tim accrue revenues and defer expenses and still be ethical?

ALL ABOUT YOU

CT4-9 Companies prepare balance sheets in order to know their fi nancial position at a specifi c point in time. This enables them to make a comparison to their position at previ- ous points in time and gives them a basis for planning for the future. In order to evaluate your fi nancial position, you can prepare a personal balance sheet. Assume that you have compiled the following information regarding your fi nances. (Hint: Some of the items might not be used in your personal balance sheet.)

Amount owed on student loan balance (long-term) $ 5,000 Balance in checking account 1,200 Certificate of deposit (6-month) 3,000 Annual earnings from part-time job 11,300 Automobile 7,000 Balance on automobile loan (current portion) 1,500 Balance on automobile loan (long-term portion) 4,000

212 4 Accrual Accounting Concepts

Home computer 800 Amount owed to you by younger brother 300 Balance in money market account 1,800 Annual tuition 6,400 Video and stereo equipment 1,250 Balance owed on credit card (current portion) 150 Balance owed on credit card (long-term portion) 1,650

Instructions Prepare a personal balance sheet using the format you have learned for a classifi ed balance sheet for a company. For the equity account, use M. Y. Own, Capital.

FASB CODIFICATION ACTIVITY

CT4-10 If your school has a subscription to the FASB Codifi cation, go to http://aaahq.org/ ascLogin.cfm to log in and prepare responses to the following.

Instructions Access the glossary (“Master Glossary”) to answer the following.

(a) What is the defi nition of revenue? (b) What is the defi nition of compensation?

It is often difficult for companies to determine in what time period they should report particular revenues and expenses. Both the IASB and FASB are working on a joint project to develop a common conceptual framework that will enable companies to better use the same principles to record transactions consistently over time.

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

Similarities • In this chapter, you learned accrual-basis accounting applied under GAAP. Companies

applying IFRS also use accrual-basis accounting to ensure that they record transac- tions that change a company’s financial statements in the period in which events occur.

• Similar to GAAP, cash-basis accounting is not in accordance with IFRS. • IFRS also divides the economic life of companies into artificial time periods. Under

both GAAP and IFRS, this is referred to as the periodicity assumption. • The general revenue recognition principle required by GAAP that is used in this text-

book is similar to that used under IFRS. • Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation

occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer Ahold NV.

Differences • Under IFRS, revaluation (using fair value) of items such as land and buildings is per-

mitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.

• The terminology used for revenues and gains, and expenses and losses, differs some- what between IFRS and GAAP. For example, income under IFRS includes both reve- nues, which arise during the normal course of operating activities, and gains, which arise from activities outside of the normal sales of goods and services. The term income

LEARNING OBJECTIVE 6 Compare the procedures for adjusting entries under GAAP and IFRS.▼

A Look at IFRS

A Look at IFRS 213

is not used this way under GAAP. Instead, under GAAP income refers to the net differ- ence between revenues and expenses.

• Under IFRS, expenses include both those costs incurred in the normal course of oper- ations as well as losses that are not part of normal operations. This is in contrast to GAAP, which defines each separately.

LOOKING TO THE FUTURE The IASB and FASB are completing a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. It is hoped that this approach will lead to more consistent accounting in this area. For more on this topic, see www.fasb.org/project/revenue_recognition.shtml.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. IFRS:

(a) uses accrual accounting. (b) uses cash-basis accounting. (c) allows revenue to be recognized when a customer makes an order. (d) requires that revenue not be recognized until cash is received.

2. Which of the following statements is false? (a) IFRS employs the periodicity assumption. (b) IFRS employs accrual accounting. (c) IFRS requires that revenues and costs must be capable of being measured reliably. (d) IFRS uses the cash basis of accounting.

3. As a result of the revenue recognition project by the FASB and IASB: (a) revenue recognition places more emphasis on when the performance obligation is

satisfied. (b) revenue recognition places more emphasis on when revenue is realized. (c) revenue recognition places more emphasis on when expenses are incurred. (d) revenue is no longer recorded unless cash has been received.

4. Which of the following is false? (a) Under IFRS, the term income describes both revenues and gains. (b) Under IFRS, the term expenses includes losses. (c) Under IFRS, companies do not engage in the adjusting process. (d) Under IFRS, revenue recognition fraud is a major issue.

5. Accrual-basis accounting: (a) is optional under IFRS. (b) results in companies recording transactions that change a company’s financial

statements in the period in which events occur. (c) has been eliminated as a result of the IASB/FASB joint project on revenue recognition. (d) is not consistent with the IASB conceptual framework.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS4-1 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Visit Louis Vuitton’s corporate website and answer the following questions from Louis Vuitton’s 2014 annual report.

(a) From the notes to the financial statements, how does the company determine the amount of revenue to record at the time of a sale?

(b) From the notes to the financial statements, how does the company determine the provision for product returns?

(c) Using the consolidated income statement and consolidated statement of financial position, identify items that may result in adjusting entries for deferrals.

(d) Using the consolidated income statement, identify two items that may result in adjust- ing entries for accruals.

Answers to IFRS Self-Test Questions 1. a 2. d 3. a 4. c 5. b

Merchandising is one of the largest and most infl uential industries in the United States. It is likely

that a number of you will work for a merchandiser. Therefore, understanding the fi nancial statements

of merchandising companies is important. In this chapter, you will learn the basics about reporting

merchandising transactions. In addition, you will learn how to prepare and analyze a commonly used

form of the income statement—the multiple-step income statement.

CHAPTER PREVIEW

Merchandising Operations and the Multiple-Step Income Statement

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

▼1 Describe merchandising operations and inventory systems.

• Operating cycles • Flow of costs

DO IT!

1 Merchandising Operations and Inventory Systems

▼2 Record purchases under a perpetual inventory system.

• Freight costs • Purchase returns and

allowances • Purchase discounts

DO IT!

2 Purchase Transactions

▼3 Record sales under a perpetual inventory system.

• Sales returns and allowances • Sales discounts

DO IT!

3 Sales Transactions

▼4 Prepare a multiple-step income statement and a comprehensive income statement.

• Single-step income statement • Multiple-step income

statement • Comprehensive income

statement

DO IT!

4 Multiple-Step Income Statement

5 Determine cost of goods sold under a periodic inventory system. • Cost of goods purchased • Cost of goods sold

DO IT!

5 Cost of Goods Sold— Periodic System

6 Compute and analyze gross profi t rate and profi t margin. • Gross profi t rate • Profi t margin

DO IT!

6 Gross Profi t Rate and Profi t Margin

▼ ▼

Have you ever shopped for outdoor gear at an REI (Recreational Equipment Incorporated) store? If so, you might have been surprised if a salesclerk asked if you were a member. A member? What do you mean a member? REI is a consumer cooperative, or “co-op” for short. To fi gure out what that means, consider this quote from the company’s annual report:

As a cooperative, the Company is owned by its members. Each member is entitled to one vote in the election of the Company’s Board of Directors. Since January 1, 2008, the nonrefundable, nontransferable, one-time membership fee has been $20 dollars. As of Decem- ber 31, 2010, there were approximately 10.8 million members.

Voting rights? Now that’s something you don’t get from shopping at Wal-Mart. REI members get other benefi ts as well, including sharing in the company’s profi ts through a dividend at the end of the year. The more you spend, the bigger your dividend.

Since REI is a co-op, you might wonder whether management’s incentives might be a little different. Management is still concerned about making a profi t, as it ensures the long-term viability of the company.

REI’s members also want the company to be run effi ciently, so that prices remain low. In order for its members to evaluate just how well management is

doing, REI publishes an audited annual report, just like publicly traded companies do.

How well is this business model working for REI? Well, it has consistently been rated as one of the best places to work in the United States by Fortune maga- zine. Also, REI had sustainable

business practices long before social responsibility became popular at other companies. The CEO’s Stewardship Report states “we reduced the abso- lute amount of energy we use despite opening four new stores and growing our business; we grew the amount of FSC-certifi ed paper we use to 58.4 percent of our total paper footprint—including our cash register receipt paper; we facilitated 2.2 million volunteer hours and we provided $3.7 million to more than 330 conservation and recreation nonprofits.”

So, while REI, like other retailers, closely monitors its fi nancial results, it also strives to succeed in other areas. And, with over 10 million votes at stake, REI’s management knows that it has to deliver.

FEATURE STORY

Buy Now, Vote Later

216 5 Merchandising Operations and the Multiple-Step Income Statement

LEARNING OBJECTIVE 1 Describe merchandising operations and inventory systems.▼

REI, Wal-Mart, and Amazon.com are called merchandising companies because they buy and sell merchandise rather than perform services as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers. For example, retailer Walgreens might buy goods from wholesaler McKesson; retailer Offi ce Depot might buy offi ce supplies from wholesaler United Stationers. The primary source of revenue for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses.

Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of goods. Illustration 5-1 shows the income measurement process for a merchandising company. The items in the two blue boxes are unique to a merchandising company; they are not used by a service company.

Sales Revenue

Cost of Goods Sold

Gross Profit

Operating Expenses

Net Income (Loss)

Less

Equals Less

Equals

ILLUSTRATION 5-1 Income measurement process for a merchandising company

OPERATING CYCLES

The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of inventory and its eventual sale lengthen the cycle. Illustration 5-2 contrasts the operating cycles of service and merchandising companies. Note that the added asset account for a merchandising company is the Inventory account.

FLOW OF COSTS

The fl ow of costs for a merchandising company is as follows. Beginning inven- tory plus the cost of goods purchased is the cost of goods available 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 5-3 describes these relationships. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system.

Merchandising Operations and Inventory Systems 217

Sell Inventory

Service Company

Cash

Accounts Receivable

Receive Cash Perform Services

Merchandising Company

Cash

Inventory Accounts Receivable

Receive Cash Buy Inventory

MAIL

TVTV TV

ILLUSTRATION 5-2 Operating cycles for a service company and a merchandising company

Beginning Inventory

Cost of Goods Purchased

Cost of Goods Available for Sale

Cost of Goods Sold

Ending Inventory

ILLUSTRATION 5-3 Flow of costs

Perpetual System In a perpetual inventory system, companies maintain detailed records of the cost of each inventory purchase and sale. These records continuously— perpetually— show the inventory that should be on hand for every item. For example, a Ford dealership has separate inventory records for each automobile, truck, and van on its lot and showroom fl oor. Similarly, a grocery store uses bar codes and optical scanners to keep a daily running record of every box of cereal and every jar of

▼ HELPFUL HINT Even under perpetual inventory systems, companies perform physical inventory counts. This is done as a control procedure to verify inventory levels, in order to detect theft or “shrinkage.”

218 5 Merchandising Operations and the Multiple-Step Income Statement

jelly that it buys and sells. Under a perpetual inventory system, a company deter- mines the cost of goods sold each time a sale occurs.

Periodic System In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. They determine the cost of goods sold only at the end of the accounting period—that is, periodically. At that point, the company takes a physical inventory count to determine the cost of goods on hand. To determine the cost of goods sold under a periodic inventory system, the following steps are necessary:

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

2. Add to it the cost of goods purchased.

3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period.

Illustration 5-4 graphically compares the sequence of activities and the timing of the cost of goods sold computation under the two inventory systems.

Perpetual

End of PeriodInventory Purchased

Record revenue and

compute and record cost of goods sold

Record purchase of inventory

Item Sold

End of PeriodInventory Purchased Item Sold

No entry

Periodic

Record revenue only

Compute and record cost

of goods sold

SOL D

ILLUSTRATION 5-4 Comparing perpetual and periodic inventory systems

Advantages of the Perpetual System Companies that sell merchandise with high unit values, such as automobiles, furniture, and major home appliances, have traditionally used perpetual systems. The growing use of computers and electronic scanners has enabled many more companies to install perpetual inventory systems. The perpetual inventory system is so named because the accounting records continuously—perpetually—show the quantity and cost of the inventory that should be on hand at any time. A perpetual inventory system provides better control over inventories than a periodic system. Since the inventory records show the quantities that should be on hand, the company can count the goods at any time to see whether the amount of goods actually on hand agrees with the inventory records. If shortages are uncovered, the company can investigate immediately. Although a perpetual inventory system requires additional clerical work and additional cost to main- tain inventory records, a computerized system can minimize this cost. Much of Amazon.com’s success is attributed to its sophisticated inventory system. Some businesses fi nd it either unnecessary or uneconomical to invest in a sophisticated, computerized perpetual inventory system such as Amazon’s.

Recording Purchases under a Perpetual System 219

However, many small merchandising businesses now use basic accounting soft- ware, which provides some of the essential benefi ts of a perpetual inventory system. Yet, managers of some small businesses still fi nd that they can control their mer- chandise and manage day-to-day operations using a periodic inventory system.

Because of the widespread use of the perpetual inventory system, we illustrate it in this chapter. An appendix to this chapter describes the journal entries for the periodic system.

Improving Stock Appeal

Investors are often eager to invest in a company that has a hot new product. However, when snowboard maker Morrow Snowboards, Inc. issued shares of stock to the public for the fi rst time, some investors expressed reluc- tance to invest in Morrow

because of a number of accounting control problems. To re- duce investor concerns, Morrow implemented a perpetual in- ventory system to improve its control over inventory. In addi- tion, it stated that it would perform a physical inventory count every quarter until it felt that its perpetual inventory system was reliable.

If a perpetual system keeps track of inventory on a daily basis, why do companies ever need to do a physical count? (Go to WileyPLUS for this answer and additional questions.)

INVESTOR INSIGHT Morrow Snowboards, Inc.

1▼ Merchandising Operations and Inventory SystemsDO IT! Indicate whether the following statements are true or false. If false, indicate how to correct the statement.

1. The primary source of revenue for a merchandising company results from performing services for customers.

2. The operating cycle of a service company is usually shorter than that of a merchandis- ing company.

3. Sales revenue less cost of goods sold equals gross profi t.

4. Ending inventory plus the cost of goods purchased equals cost of goods available for sale.

SOLUTION 1. False. The primary source of revenue for a service company results from performing services for customers. 2. True. 3. True. 4. False. Beginning inventory plus the cost of goods purchased equals cost of goods available for sale.

Action Plan ✔ Review merchandising

concepts. ✔ Understand the fl ow of

costs in a merchandising company.

Related exercise material: BE1-1 and DO IT! 5-1.

Companies may purchase inventory for cash or on account (credit). They normally record purchases when they receive the goods from the seller. Every purchase should be supported by business documents that provide written evidence of the transaction. Each cash purchase should be supported by a canceled check or a cash register receipt indicating the items purchased and amounts paid. Compa- nies record cash purchases by an increase (debit) in Inventory and a decrease (credit) in Cash.

Record purchases under a perpetual inventory system. LEARNING OBJECTIVE 2▼

220 5 Merchandising Operations and the Multiple-Step Income Statement

Each purchase should be supported by a purchase invoice, which indicates the total purchase price and other relevant information. However, the purchaser does not prepare a separate purchase invoice. Instead, the purchaser uses as a purchase invoice the copy of the sales invoice sent by the seller. In Illustration 5-5, for example, Sauk Stereo (the buyer) uses as a purchase invoice the sales invoice prepared by PW Audio Supply, Inc. (the seller).

The associated entry for Sauk Stereo for the invoice from PW Audio Supply increases (debits) Inventory and increases (credits) Accounts Payable.

May 4 Inventory 3,800 Accounts Payable 3,800 (To record goods purchased on account from PW Audio Supply)

Under the perpetual inventory system, companies record purchases of mer- chandise for sale in the Inventory account. Thus, REI would increase (debit) Inventory for clothing, sporting goods, and anything else purchased for resale to customers. Not all purchases are debited to Inventory, however. Companies record pur- chases of assets acquired for use and not for resale, such as supplies, equipment, and similar items, as increases to specifi c asset accounts rather than to Inventory. For example, to record the purchase of materials used to make shelf signs or for cash register receipt paper, REI would increase (debit) Supplies.

A L SE= + +3,800 +3,800 Cash Flows no eff ect

27 Circle Drive Harding, Michigan 48281

PW Audio Supply, Inc.

INVOICE NO. 731

Firm Name

Attention of

Address

S O L D

T O

City State Zip

IMPORTANT: ALL RETURNS MUST BE MADE WITHIN 10 DAYS TOTAL

Date 5/4/17 Salesperson Malone Terms 2/10, n/30 FOB Shipping Point

Catalog No. Description Quantity Price Amount

X572Y9820 Printed Circuit Board-prototype 1 2,300 $2,300

A2547Z45 Production Model Circuits 5 300 1,500

$3,800

Sauk Stereo

James Hoover, Purchasing Agent

125 Main Street

Chelsea Illinois 60915

ILLUSTRATION 5-5 Sales invoice used as purchase invoice by Sauk Stereo

▼ HELPFUL HINT To better understand the contents of this invoice, identify these items: 1. Seller 2. Invoice date 3. Purchaser 4. Salesperson 5. Credit terms 6. Freight terms 7. Goods sold: catalog number,

description, quantity, price per unit

8. Total invoice amount

Recording Purchases under a Perpetual System 221

FREIGHT COSTS

The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the goods to the buyer’s place of business. When a common carrier such as a railroad, trucking company, or airline transports the goods, the carrier prepares a freight bill in accord with the sales agreement. Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB mean free on board. Thus, FOB shipping point means that the seller places the goods free on board the carrier, and the buyer pays the freight costs. Conversely, FOB destination means that the seller places the goods free on board to the buyer’s place of business, and the seller pays the freight. For example, the sales invoice in Illustration 5-5 indicates FOB shipping point. Thus, the buyer (Sauk Stereo) pays the freight charges. Illustration 5-6 illustrates these shipping terms.

Ownership passes to

buyer here

Seller Seller

Ownership passes to

buyer here

FOB Shipping Point Buyer pays freight costs

FOB Destination Seller pays freight costs

Buyer Buyer

Public Carrier Co.

ILLUSTRATION 5-6 Shipping terms

Freight Costs Incurred by Buyer When the buyer pays the transportation costs, these costs are considered part of the cost of purchasing inventory. As a result, the account Inventory is increased (debited). For example, if Sauk Stereo (the buyer) pays Public Freight Company $150 for freight charges on May 6, the entry on Sauk Stereo’s books is:

May 6 Inventory 150 Cash 150 (To record payment of freight on goods purchased)

Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The reason: Inventory cost should include all costs to acquire the inventory, including freight necessary to deliver the goods to the buyer. Compa- nies recognize these costs as cost of goods sold when inventory is sold.

Freight Costs Incurred by Seller In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. These costs increase an expense account titled Freight-Out (sometimes called Delivery Expense). For example, if the freight terms on the invoice in Illustration 5-5 had required that PW Audio Supply (the seller) pay the $150 freight charges, the entry by PW Audio Supply would be:

May 4 Freight-Out 150 Cash 150 (To record payment of freight on goods sold)

When the seller pays the freight charges, the seller will usually establish a higher invoice price for the goods, to cover the expense of shipping.

PURCHASE RETURNS AND ALLOWANCES

A purchaser may be dissatisfi ed with the merchandise received because the goods are damaged or defective, of inferior quality, or do not meet the pur- chaser’s specifi cations. In such cases, the purchaser may return the goods to

A L SE= + +150 −150 Cash Flows −150

A L SE= + −150 Exp −150 Cash Flows −150

222 5 Merchandising Operations and the Multiple-Step Income Statement

the seller for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. This transaction is known as a purchase return. Alter- natively, the purchaser may choose to keep the merchandise if the seller is will- ing to grant a reduction of the purchase price. This transaction is known as a purchase allowance. Assume that Sauk Stereo returned goods costing $300 to PW Audio Supply on May 8. The following entry by Sauk Stereo for the returned merchandise decreases (debits) Accounts Payable and decreases (credits) Inventory.

May 8 Accounts Payable 300 Inventory 300 (To record return of goods purchased from PW Audio Supply)

Because Sauk Stereo increased Inventory when the goods were received, Inven- tory is decreased (credited) when Sauk Stereo returns the goods. Suppose instead that Sauk Stereo chose to keep the goods after being granted a $50 allowance (reduction in price). It would reduce (debit) Accounts Payable and reduce (credit) Inventory for $50.

PURCHASE DISCOUNTS

The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages to both parties. The purchaser saves money, and the seller is able to shorten the operating cycle by converting the accounts receivable into cash earlier. The credit terms specify the amount of the cash discount and time period during which it is offered. They also indicate the length of time in which the purchaser is expected to pay the full invoice price. In the sales invoice in Illus- tration 5-5 (page 220), credit terms are 2/10, n/30, which is read “two-ten, net thirty.” This means that a 2% cash discount may be taken on the invoice price, less (“net of”) any returns or allowances, if payment is made within 10 days of the invoice date (the discount period). Otherwise, the invoice price, less any returns or allowances, is due 30 days from the invoice date. Alternatively, the discount period may extend to a specifi ed number of days following the month in which the sale occurs. For example, 1/10 EOM (end of month) means that a 1% discount is available if the invoice is paid within the fi rst 10 days of the next month. When the seller elects not to offer a cash discount for prompt payment, credit terms will specify only the maximum time period for paying the balance due. For example, the credit terms may state the time period as n/30, n/60, or n/10 EOM. This means, respectively, that the buyer must pay the net amount in 30 days, 60 days, or within the fi rst 10 days of the next month. When an invoice is paid within the discount period, the amount of the discount decreases Inventory. Why? Because the merchandiser records inventory at its cost and, by paying within the discount period, it has reduced that cost. To illustrate, assume Sauk Stereo pays the balance due of $3,500 (gross invoice price of $3,800 less purchase returns and allowances of $300) on May 14, the last day of the dis- count period. Since the terms are 2/10, n/30, the cash discount is $70 ($3,500 × 2%) and the amount of cash Sauk Stereo paid is $3,430 ($3,500 − $70). The entry Sauk Stereo makes to record its May 14 payment decreases (debits) Accounts Pay- able by the amount of the gross invoice price, reduces (credits) Inventory by the $70 discount, and reduces (credits) Cash by the net amount owed.

May 14 Accounts Payable 3,500 Cash 3,430 Inventory 70 (To record payment within discount period)

A L SE= + −300 −300 Cash Flows no eff ect

▼ HELPFUL HINT The term net in “net 30” means the remaining amount due after subtracting any returns and allowances and partial payments.

A L SE= + −3,500 −3,430 −70 Cash Flows −3,430

Recording Purchases under a Perpetual System 223

If Sauk Stereo failed to take the discount and instead made full payment of $3,500 on June 3, Sauk Stereo would reduce (debit) Accounts Payable and reduce (credit) Cash for $3,500 each.

June 3 Accounts Payable 3,500 Cash 3,500 (To record payment with no discount taken)

A merchandising company usually should take all available discounts. Passing up the discount may be viewed as paying interest for use of the money. For example, passing up the discount offered by PW Audio Supply would be like Sauk Stereo paying an interest rate of 2% for the use of $3,500 for 20 days. This is the equivalent of an annual interest rate of approxi- mately 36.5% (2% × 365/20). Obviously, it would be better for Sauk Stereo to borrow at prevailing bank interest rates of 6% to 10% than to lose the discount.

SUMMARY OF PURCHASING TRANSACTIONS

The following T-account (with transaction descriptions in red) provides a summary of the effect of the previous transactions on Inventory. Sauk Stereo originally purchased $3,800 worth of inventory for resale. It then returned $300 of goods. It paid $150 in freight charges, and fi nally, it received a $70 discount off the balance owed because it paid within the discount period. This results in a balance in Inventory of $3,580.

A L SE= + −3,500 −3,500 Cash Flows −3,500

Inventory

Purchase May 4 3,800 May 8 300 Purchase return

Freight-in 6 150 14 70 Purchase discount

Balance 3,580

2▼ Purchase TransactionsDO IT! On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The purchase price of the goods paid by De La Hoya is $1,500. On September 8, De La Hoya returns defective goods with a selling price of $200. Record the transactions on the books of De La Hoya Company.

SOLUTION

Sept. 5 Inventory 1,500 Accounts Payable 1,500 (To record goods purchased on account)

8 Accounts Payable 200 Inventory 200 (To record return of defective goods)

Action Plan ✔ Purchaser records goods

at cost. ✔ When goods are returned,

purchaser reduces Inventory.

Related exercise material: BE5-2, BE5-4, DO IT! 5-2, E5-1, E5-2, and E5-4.

224 5 Merchandising Operations and the Multiple-Step Income Statement

In accordance with the revenue recognition principle, companies record sales revenue, like service revenue, when the performance obligation is satisfi ed. Typically, that performance obligation is satisfi ed when the goods are transferred from the seller to the buyer. At this point, the sales transaction is completed and the sales price is established. Sales may be made on credit or for cash. Every sales transaction should be supported by a business document that provides written evidence of the sale. Cash register documents provide evidence of cash sales. A sales invoice, like the one that was shown in Illustration 5-5 (page 220), provides support for each sale. The original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price, and other relevant information. The seller makes two entries for each sale. (1) It increases (debits) Accounts Receivable or Cash, as well as increases (credits) Sales Revenue. (2) It increases (debits) Cost of Goods Sold and decreases (credits) Inventory. As a result, the Inventory account will show at all times the amount of inventory that should be on hand. To illustrate a credit sales transaction, PW Audio Supply records the sale of $3,800 on May 4 to Sauk Stereo (see Illustration 5-5) as follows (assume the merchandise cost PW Audio Supply $2,400).

May 4 Accounts Receivable 3,800 Sales Revenue 3,800 (To record credit sale to Sauk Stereo per invoice #731)

4 Cost of Goods Sold 2,400 Inventory 2,400 (To record cost of merchandise sold on invoice #731 to Sauk Stereo)

For internal decision-making purposes, merchandising companies may use more than one sales account. For example, PW Audio Supply may decide to keep separate sales accounts for its sales of TVs, Blu-ray players, and headsets. REI might use separate accounts for camping gear, children’s clothing, and ski equipment—or it might have even more narrowly defi ned accounts. By using separate sales accounts for major product lines, rather than a single combined sales account, company management can monitor sales trends more closely and respond to changes in sales patterns more strategically. For example, if TV sales are increasing while Blu-ray player sales are decreasing, the company might reevaluate both its advertising and pricing policies on each of these items to ensure they are optimal. On its income statement presented to outside investors, a merchandising company would normally provide only a single sales fi gure—the sum of all of its individual sales accounts. This is done for two reasons. First, providing detail on all of its individual sales accounts would add considerable length to its income statement. Second, companies do not want their competitors to know the details of their operating results. However, at one time Microsoft expanded its disclo- sure of revenue from three to fi ve types. The reason: The additional categories enabled fi nancial statement users to better evaluate the growth of the company’s consumer and Internet businesses.

A L SE= + +3,800 +3,800 Rev Cash Flows no eff ect

A L SE= + −2,400 Exp −2,400 Cash Flows no eff ect

Record sales under a perpetual inventory system. LEARNING

OBJECTIVE 3▼

▼ HELPFUL HINT The merchandiser credits the Sales Revenue account only for sales of goods held for resale. Sales of assets not held for resale, such as equipment or land, are credited directly to the asset account.

ETHICS NOTE Many companies are trying to improve the quality of their fi nancial reporting. For example, General Electric now provides more detail on its revenues and operating profi ts.

▼

Recording Sales under a Perpetual System 225

SALES RETURNS AND ALLOWANCES

We now look at the “fl ip side” of purchase returns and allowances, which the seller records as sales returns and allowances. These are transactions where the seller either accepts goods back from a purchaser (a return) or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods. PW Audio Supply’s entries to record credit for returned goods involve (1) an increase (debit) in Sales Returns and Allowances (a contra account to Sales Revenue) and a decrease (credit) in Accounts Receivable at the $300 selling price, and (2) an increase (debit) in Inventory (assume a $140 cost) and a decrease (credit) in Cost of Goods Sold, as shown below. (We assumed that the goods were not defective. If they were defective, PW Audio Supply would make an entry to the Inventory account to refl ect their decline in value.)

May 8 Sales Returns and Allowances 300 Accounts Receivable 300 (To record credit granted to Sauk Stereo for returned goods)

8 Inventory 140 Cost of Goods Sold 140 (To record cost of goods returned)

Suppose instead that the goods were not returned but the seller granted the buyer an allowance by reducing the purchase price. In this case, the seller would debit Sales Returns and Allowances and credit Accounts Receivable for the amount of the allowance. An allowance has no impact on Inventory or Cost of Goods Sold.

A L SE= + −300 Rev −300 Cash Flows no eff ect

A L SE= + +140 +140 Exp Cash Flows no eff ect

Holly Harmon was a cashier at a national superstore for only a short time when she began stealing merchandise using three methods. Under the fi rst method, her husband or friends took UPC labels from cheaper items and put them on more expensive items. Holly then scanned the goods at the register. Using the second method, Holly scanned an item at the register but then voided the sale and left the merchandise in the shopping cart. A third approach was to put goods into large plastic containers. She scanned the plastic containers but not the goods within them. After Holly quit, a review of past surveillance tapes enabled the store to observe the thefts and to identify the participants.

Total take: $12,000

THE MISSING CONTROLS Human resource controls. A background check would have revealed Holly’s previous criminal record. She would not have been hired as a cashier.

Physical controls. Software can fl ag high numbers of voided transactions or a high number of sales of low-priced goods. Random comparisons of video records with cash register records can ensure that the goods reported as sold on the register are the same goods that are shown being purchased on the video recording. Finally, employees should be aware that they are being monitored.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 251–259.

ANATOMY OF A FRAUD1

1The “Anatomy of a Fraud” stories in this textbook are adapted from Fraud Casebook: Lessons from the Bad Side of Business, edited by Joseph T. Wells (Hoboken, NJ: John Wiley & Sons, Inc., 2007). Used by permission. The names of some of the people and organizations in the stories are fi ctitious, but the facts in the stories are true.

At the end of “Anatomy of a Fraud” stories, which describe real-world frauds, we discuss the missing control activity that would likely have presented or uncovered the fraud.

226 5 Merchandising Operations and the Multiple-Step Income Statement

Sales Returns and Allowances is a contra revenue account to Sales Revenue, which means it is offset against a revenue account on the income statement. The normal balance of Sales Returns and Allowances is a debit. Companies use a con- tra account, instead of debiting Sales Revenue, to disclose in the accounts and in the income statement the amount of sales returns and allowances. Disclosure of this information is important to management. Excessive returns and allowances suggest problems—inferior merchandise, ineffi ciencies in fi lling orders, errors in billing customers, or mistakes in delivery or shipment of goods. Moreover, a decrease (debit) recorded directly to Sales Revenue would obscure the relative importance of sales returns and allowances as a percentage of sales. It also could distort comparisons between total sales in different accounting periods. At the end of the accounting period, if the company anticipates that sales returns and allowances will be material, the company should make an adjusting entry to estimate the amount of returns. In some industries, such as those relating to the sale of books and periodicals, returns are often material. The accounting for situations where returns must be estimated is addressed in advanced accounting courses.

SALES DISCOUNTS

As mentioned in our discussion of purchase transactions, the seller may offer the cus- tomer a cash discount—called by the seller a sales discount—for the prompt pay- ment of the balance due. Like a purchase discount, a sales discount is based on the invoice price less returns and allowances, if any. The seller increases (debits) the Sales Discounts account for discounts that are taken. The entry by PW Audio Supply to record the cash receipt on May 14 from Sauk Stereo within the discount period is:

May 14 Cash 3,430 Sales Discounts 70 Accounts Receivable 3,500 (To record collection within 2/10, n/30

discount period from Sauk Stereo)

Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit. Sellers use this account, instead of debiting Sales Revenue, to disclose the amount of cash discounts taken by customers. If the customer does not take the discount, PW Audio Supply increases (debits) Cash for $3,500 and decreases (credits) Accounts Receivable for the same amount at the date of collection. At the end of the accounting period, if the amount of potential discounts is material, the company should make an adjusting entry to estimate the discounts. This would not usually be the case for sales discounts but might be necessary for other types of discounts such as volume discounts, which are addressed in more advanced accounting courses. The following T-accounts summarize the three sales-related transactions and show their combined effect on net sales.

A L SE= + +3,430 −70 Rev −3,500 Cash Flows +3,430

The Point of No Returns?

In most industries, sales returns are relatively minor. But returns of consumer electronics can re- ally take a bite out of profi ts. Recently, the marketing execu- tives at Costco Wholesale Corp. faced a diffi cult decision. Costco has always prided itself on its generous return policy. Most

goods have had an unlimited grace period for returns. A new policy will require that certain electronics must be returned within 90 days of their purchase. The reason? The cost of returned products such as high-defi nition TVs, computers, and iPods cut an estimated 8¢ per share off Costco’s earnings per share, which was $2.30.

Source: Kris Hudson, “Costco Tightens Policy on Returning Electronics,” Wall Street Journal (February 27, 2007), p. B4.

If a company expects signifi cant returns, what are the implications for revenue recognition? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Costco Wholesale Corp.

Multiple-Step and Comprehensive Income Statements 227

Sales Revenue Sales Returns and Allowances Sales Discounts

3,800 300 70

Net Sales $3,430

3▼ Sales TransactionsDO IT! On September 5, De La Hoya Company buys merchandise on account from Junot Diaz Company. The selling price of the goods is $1,500, and the cost to Diaz Company was $800. On September 8, De La Hoya returns goods with a selling price of $200 and a cost of $105. Record the transactions on the books of Junot Diaz Company.

SOLUTION

Sept. 5 Accounts Receivable 1,500 Sales Revenue 1,500 (To record credit sale)

5 Cost of Goods Sold 800 Inventory 800 (To record cost of goods sold)

Sept. 8 Sales Returns and Allowances 200 Accounts Receivable 200 (To record credit granted for receipt of returned goods)

8 Inventory 105 Cost of Goods Sold 105 (To record cost of goods returned)

Action Plan ✔ Seller records both the

sale and the cost of goods sold at the time of the sale.

✔ When goods are returned, the seller records the return in a contra account, Sales Returns and Allowances, and reduces Accounts Receivable.

✔ Any goods returned increase Inventory and reduce Cost of Goods Sold. The inventory should be recorded at the lower of its cost or its fair value (scrap value).

Related exercise material: BE5-2, BE5-3, DO IT! 5-3, E5-2, E5-3, and E5-4.

LEARNING OBJECTIVE 4 Prepare a multiple-step income statement and a comprehensive income statement.▼

SINGLE-STEP INCOME STATEMENT

Companies widely use two forms of the income statement. One is the single-step income statement. The statement is so named because only one step, subtract- ing total expenses from total revenues, is required in determining net income (or net loss). In a single-step statement, all data are classifi ed into two categories: (1) reve- nues, which include both operating revenues and nonoperating revenues and gains (for example, interest revenue and gain on sale of equipment); and (2) expenses, which include cost of goods sold, operating expenses, and nonoperating expenses and losses (for example, interest expense, loss on sale of equipment, or income tax expense). The single-step income statement is the form we have used thus far in the text. Illustration 5-7 (page 228) shows a single-step statement for REI. There are two primary reasons for using the single-step form. (1) A company does not realize any type of profi t or income until total revenues exceed total expenses, so it makes sense to divide the statement into these two categories. (2) The form is simple and easy to read.

228 5 Merchandising Operations and the Multiple-Step Income Statement

MULTIPLE-STEP INCOME STATEMENT

A second form of the income statement is the multiple-step income statement. The multiple-step income statement is often considered more useful because it highlights the components of net income. The REI income statement in Illustra- tion 5-8 is an example. The multiple-step income statement has three important line items: gross profi t, income from operations, and net income. They are determined as follows.

1. Subtract cost of goods sold from net sales to determine gross profi t.

2. Deduct operating expenses from gross profi t to determine income from operations.

3. Add or subtract the results of activities not related to operations to determine net income.

INTERNATIONAL NOTE The IASB and FASB are involved in a joint project to evaluate the format of fi nancial statements. The fi rst phase of that project involves a focus on how to best present revenues and expenses. One longer-term result of the project may be an income statement format that better refl ects how businesses are run.

For the year ended

January 3, December 28, 2015 2013

Revenues Net sales $2,217,131 $2,017,476

Expenses Cost of goods sold 1,257,002 1,148,668 Payroll-related expenses 423,061 393,505 Occupancy, general and administrative 355,190 345,643 Patronage refunds and other 110,611 100,802 Income taxes 27,149 10,017

2,173,013 1,998,635

Net income $ 44,118 $ 18,841

RECREATIONAL EQUIPMENT, INC. Income Statements

(in thousands)

Real World

ILLUSTRATION 5-7 Single-step income statements

For the year ended

January 3, December 28, 2015 2013

Net sales $2,217,131 $2,017,476 Cost of goods sold 1,257,002 1,148,668

Gross profi t 960,129 868,808 Operating expenses Payroll-related expenses 423,061 393,505 Occupancy, general and administrative 355,190 345,643

Total operating expenses 778,251 739,148

Income from operations 181,878 129,660 Other revenues and gains Other revenues ‒0‒ ‒0‒ Other expenses and losses Patronage refunds and other 110,611 100,802

Income before income taxes 71,267 28,858 Income tax expense 27,149 10,017

Net income $ 44,118 $ 18,841

RECREATIONAL EQUIPMENT, INC. Income Statements

(in thousands)

Real World

ILLUSTRATION 5-8 Multiple-step income statements

Multiple-Step and Comprehensive Income Statements 229

Note that companies report income tax expense in a separate section of the income statement before net income. The net incomes in Illustrations 5-7 and 5-8 are the same. The two income statements differ in the amount of detail displayed and the order presented. The following discussion provides additional informa- tion about the components of a multiple-step income statement.

Sales The income statement for a merchandising company typically presents gross sales for the period. The company deducts sales returns and allowances and sales discounts (both contra accounts) from sales revenue in the income statement to arrive at net sales. Illustration 5-9 shows the sales section of the income state- ment for PW Audio Supply.

PW AUDIO SUPPLY, INC. Income Statement (partial)

ILLUSTRATION 5-9 Statement presentation of sales section

Gross Profi t The excess of net sales over cost of goods sold is gross profi t. It is determined by deducting cost of goods sold from net sales. As shown in Illustration 5-8, REI had a gross profi t of $960 million for the year ended January 3, 2015. This com- putation uses net sales, which takes into account sales returns and allowances and sales discounts. On the basis of the PW Audio Supply sales data presented in Illustration 5-9 (net sales of $460,000) and the cost of goods sold (assume a balance of $316,000), PW Audio Supply’s gross profi t is $144,000, computed as follows.

ALTERNATIVE TERMINOLOGY Gross profi t is sometimes referred to as gross margin.

Net sales $ 460,000 Cost of goods sold 316,000

Gross profi t $144,000

Gross profi t $144,000 Operating expenses 114,000

Income from operations $ 30,000

It is important to understand what gross profi t is—and what it is not. Gross profi t represents the merchandising profi t of a company. Because operating expenses have not been deducted, it is not a measure of the overall profi t of a company. Nevertheless, management and other interested parties closely watch the amount and trend of gross profi t. Comparisons of current gross profi t with past amounts and rates and with those in the industry indicate the effectiveness of a company’s purchasing and pricing policies.

Operating Expenses Operating expenses are the next component in measuring net income for a mer- chandising company. At REI, for example, operating expenses were $778 million for the year ended January 3, 2015. At PW Audio Supply, operating expenses were $114,000. The fi rm determines its income from operations by subtracting operating expenses from gross profi t. Thus, income from operations is $30,000, as shown below.

Sales Sales revenue $ 480,000 Less: Sales returns and allowances $12,000 Sales discounts 8,000 20,000

Net sales $460,000

230 5 Merchandising Operations and the Multiple-Step Income Statement

Nonoperating Activities Nonoperating activities consist of various revenues and expenses and gains and losses that are unrelated to the company’s main line of operations. When nonoperating items are included, the label “Income from operations” (or “Oper- ating income”) precedes them. This label clearly identifi es the results of the com- pany’s normal operations, an amount determined by subtracting cost of goods sold and operating expenses from net sales. The results of nonoperating activities are shown in the categories “Other revenues and gains” and “Other expenses and losses.” Illustration 5-10 lists examples of each.

Other Revenues and Gains

Interest revenue from notes receivable and marketable securities. Dividend revenue from investments in capital stock. Rent revenue from subleasing a portion of the store. Gain from the sale of property, plant, and equipment.

Other Expenses and Losses

Interest expense on notes and loans payable. Casualty losses from such causes as vandalism and accidents. Loss from the sale or abandonment of property, plant, and equipment. Loss from strikes by employees and suppliers.

ILLUSTRATION 5-10 Examples of nonoperating activities

Nonoperating income is sometimes very signifi cant. For example, in one quarter, Sears Holdings earned more than half of its net income from invest- ments in derivative securities. The distinction between operating and nonoperating activities is crucial to external users of fi nancial data. These users view operating income as sustainable and many nonoperating activities as non-recurring. When forecasting next year’s income, analysts put the most weight on this year’s operating income and less weight on this year’s nonoperating activities.

Disclosing More Details

After Enron, increased investor criticism and regulator scrutiny forced many companies to im- prove the clarity of their fi nancial disclosures. For example, IBM began pro- viding more detail regard- ing its “Other gains and losses.” It had previously included these items in its selling, general, and administrative expenses,

with little disclosure. For example, previously if IBM sold off one of its buildings at a gain, it included this gain in the selling, gen- eral, and administrative expense line item, thus reducing that expense. This made it appear that the company had done a bet- ter job of controlling operating expenses than it actually had. As another example, when eBay recently sold the remain- der of its investment in Skype to Microsoft, it reported a gain in “Other revenues and gains” of $1.7 billion. Since eBay’s total income from operations was $2.4 billion, it was very im- portant that the gain from the Skype sale not be buried in operating income.

Why have investors and analysts demanded more accuracy in isolating “Other gains and losses” from operating items? (Go to WileyPLUS for this answer and additional questions.)

ETHICS INSIGHT IBM

ImageRite/Getty Images, Inc.

Nonoperating activities are reported in the income statement immediately after operating activities. Included among “Other revenues and gains” in Illustra- tion 5-11 (page 231) are Interest Revenue and Gain on Disposal of Plant Assets. Included in “Other expenses and losses” are Interest Expense and Casualty Loss from Vandalism.

ETHICS NOTE Companies manage earnings in various ways. ConAgra Foods recorded a non-recurring gain for $186 million from the sale of Pilgrim’s Pride stock to help meet an earnings projection for the quarter.

▼

Multiple-Step and Comprehensive Income Statements 231

In Illustration 5-11, we have provided the multiple-step income statement of PW Audio Supply. This statement provides more detail than that of REI and thus is useful as a guide for homework. For homework problems, use the multiple-step form of the income statement unless the requirements state otherwise.

ILLUSTRATION 5-11 Multiple-step income statement

Calculation of gross profi t

Calculation of income from operations

Results of activities not related to operations

PW AUDIO SUPPLY, INC. Income Statement

For the Year Ended December 31, 2017

COMPREHENSIVE INCOME STATEMENT

Chapter 2 discussed the fair value principle. Accounting standards require com- panies to mark the recorded values of certain types of assets and liabilities to their fair values at the end of each reporting period. In some instances, the unrealized gains or losses that result from adjusting recorded amounts to fair value are included in net income. However, in other cases, these unrealized gains and losses are not included in net income. Instead, these excluded items are reported as part of a more inclusive earnings measure, called comprehensive income. Examples of such items include certain adjustments to pension plan assets, gains and losses on foreign currency translation, and unrealized gains and losses on certain types of investments. Items that are excluded from net income but included in comprehensive income are either reported in a combined state- ment of net income and comprehensive income, or in a separate comprehensive income statement. The comprehensive income statement presents items that are not included in the determination of net income, referred to as other compre- hensive income. Illustration 5-12 (page 232) shows how comprehensive income is presented in a separate comprehensive income statement. It assumes that PW Audio Supply had an unrealized gain of $2,700 with $400 of related tax expense. Use this format when preparing your homework.

Sales Sales revenue $480,000 Less: Sales returns and allowances $12,000 Sales discounts 8,000 20,000

Net sales 460,000 Cost of goods sold 316,000

Gross profi t 144,000 Operating expenses Salaries and wages expense 64,000 Utilities expense 17,000 Advertising expense 16,000 Depreciation expense 8,000 Freight-out 7,000 Insurance expense 2,000

Total operating expenses 114,000

Income from operations 30,000 Other revenues and gains Interest revenue 3,000 Gain on disposal of plant assets 600 3,600

Other expenses and losses Interest expense 1,800 Casualty loss from vandalism 200 2,000

Income before income taxes 31,600 Income tax expense 10,100

Net income $ 21,500

232 5 Merchandising Operations and the Multiple-Step Income Statement

Net income $21,500 Other comprehensive income Unrealized holding gain on investment securities (net of $400 tax) 2,300

Comprehensive income $23,800

PW AUDIO SUPPLY, INC. Comprehensive Income Statement

For the Year Ended December 31, 2017

ILLUSTRATION 5-12 Combined statement of net income and comprehensive income

SOLUTION

4▼ Multiple-Step Income StatementDO IT! The following information is available for Art Center Corp. for the year ended December 31, 2017.

Other revenues and gains $ 8,000 Sales revenue $462,000 Other expenses and losses 3,000 Operating expenses 187,000 Cost of goods sold 147,000 Sales discounts 20,000 Other comprehensive income 10,000

Prepare a multiple-step income statement and comprehensive income statement for Art Center Corp. The company has a tax rate of 25%. This rate also applies to other compre- hensive income.

Action Plan ✔ Subtract cost of goods

sold from net sales to determine gross profi t.

✔ Subtract operating expenses from gross profi t to determine income from operations.

✔ Add/subtract nonoperating items to determine income before tax.

✔ Multiply the tax rate by income before tax to determine tax expense.

Sales Sales revenue $462,000 Sales discounts 20,000

Net sales 442,000 Cost of goods sold 147,000

Gross profi t 295,000 Operating expenses 187,000

Income from operations 108,000 Other revenues and gains $8,000 Other expenses and losses 3,000 5,000

Income before income taxes 113,000 Income tax expense 28,250

Net income $ 84,750

ART CENTER CORP. Income Statement

For the Year Ended December 31, 2017

Net income $84,750 Other comprehensive income (net of $2,500 tax) 7,500

Comprehensive income $92,250

ART CENTER CORP. Comprehensive Income Statement

For the Year Ended December 31, 2017

Related exercise material: BE5-5, BE5-6, BE5-7, DO IT! 5-4, E5-5, E5-6, E5-7, E5-8, E5-9, E5-10, and E5-11.

Cost of Goods Sold under a Periodic System 233

LEARNING OBJECTIVE 5 Determine cost of goods sold under a periodic inventory system.▼ Determining cost of goods sold is different when a periodic inventory system is used rather than a perpetual system. As you have seen, a company using a perpetual system makes an entry to record cost of goods sold and to reduce inventory each time a sale is made. A company using a periodic system does not determine cost of goods sold until the end of the period. At the end of the period, the company performs a count to determine the ending balance of inven- tory. It then calculates cost of goods sold by subtracting ending inventory from the goods available for sale. Cost of goods available for sale is the sum of beginning inventory plus purchases, as shown in Illustration 5-13.

Beginning Inventory + Cost of Goods Purchased Cost of Goods Available for Sale − Ending Inventory Cost of Goods Sold

ILLUSTRATION 5-13 Basic formula for cost of goods sold using the periodic system

Another difference between the two approaches is that the perpetual system directly adjusts the Inventory account for any transaction that affects inventory (such as freight costs, purchase returns, and purchase discounts). The periodic system does not do this. Instead, it creates different accounts for purchases, freight costs, purchase returns, and purchase discounts. These various accounts are shown in Illustration 5-14, which presents the calculation of cost of goods sold for PW Audio Supply using the periodic approach. Note that the basic ele- ments from Illustration 5-13 are highlighted in Illustration 5-14. You will learn more in Chapter 6 about how to determine cost of goods sold using the periodic system.

ILLUSTRATION 5-14 Cost of goods sold for a merchandiser using a periodic inventory system

PW AUDIO SUPPLY, INC. Cost of Goods Sold

For the Year Ended December 31, 2017

The use of the periodic inventory system does not affect the form of presen- tation in the balance sheet. As under the perpetual system, a company reports inventory in the current assets section. Appendix 5A provides further detail on the use of the periodic system.

▼ HELPFUL HINT The far right column identifi es the primary items that make up cost of goods sold of $316,000. The middle column explains cost of goods purchased of $320,000. The left column reports contra purchase items of $17,200.

Cost of goods sold Inventory, January 1 $ 36,000 Purchases $325,000 Less: Purchase returns and allowances $10,400 Purchase discounts 6,800 17,200

Net purchases 307,800 Add: Freight-in 12,200

Cost of goods purchased 320,000

Cost of goods available for sale 356,000 Inventory, December 31 40,000

Cost of goods sold $316,000

234 5 Merchandising Operations and the Multiple-Step Income Statement

SOLUTION (a) Cost of goods purchased = $160,000:

Purchases − Purchase returns − Purchase discounts + Freight-in and allowances $162,500 − $5,200 − $3,400 + $6,100 = $160,000 (b) Cost of goods sold = $158,000: Beginning inventory + Cost of goods purchased − Ending inventory $18,000 + $160,000 − $20,000 = $158,000

5▼ Cost of Goods Sold—Periodic SystemDO IT! Aerosmith Company’s accounting records show the following at the year-end December 31, 2017.

Purchase Discounts $ 3,400 Freight-In 6,100 Purchases 162,500 Beginning Inventory 18,000 Ending Inventory 20,000 Purchase Returns and Allowances 5,200

Assuming that Aerosmith Company uses the periodic system, compute (a) cost of goods purchased and (b) cost of goods sold.

Action Plan ✔ To determine cost of

goods purchased, adjust purchases for returns, discounts, and freight-in.

✔ To determine cost of goods sold, add cost of goods purchased to beginning inventory, and subtract ending inventory.

Related exercise material: BE5-8, BE5-9, BE5-10, DO IT! 5-5, E5-12, and E5-13.

LEARNING OBJECTIVE 6 Compute and analyze gross profi t rate and profi t margin.▼

GROSS PROFIT RATE

A company’s gross profi t may be expressed as a percentage by dividing the amount of gross profi t by net sales. This is referred to as the gross profi t rate. For PW Audio Supply, the gross profi t rate is 31.3% ($144,000 ÷ $460,000). Analysts generally consider the gross profi t rate to be more informative than

the gross profi t amount because it expresses a more meaningful (quali- tative) relationship between gross profi t and net sales. For example, a gross profi t amount of $1,000,000 may sound impressive. But if it was the result of sales of $100,000,000, the company’s gross profi t rate was only 1%. Illustration 5-15 demonstrates that gross profi t rates differ greatly across industries.

Industry

74.8%

10% 20% 30% 40% 50% 60% 70% 80%

70.9%

51%

44.5%

21.4%

30.4%

Software and programming

Pharmaceutical

Semiconductors

Footwear

Food processing

Chemical manufacturing

Gross Profit Rate

ILLUSTRATION 5-15 Gross profi t rate by industry

DECISION TOOLS The gross profi t rate helps com- panies decide if the prices of their goods are in line with changes in the cost of inventory.

Gross Profi t Rate and Profi t Margin 235

A decline in a company’s gross profi t rate might have several causes. The company may have begun to sell products with a lower “markup”—for example, budget blue jeans versus designer blue jeans. Increased competition may have resulted in a lower selling price. Or, maybe the company was forced to pay higher prices to its suppliers and was not able to pass these costs on to its customers. The gross profi t rates for REI and Dick’s Sporting Goods, and the industry average, are presented in Illustration 5-16.

REI’s gross profi t rate increased from 43.1% in 2013 to 43.3% in 2014. What might cause changes in REI’s gross profi t rate? When the economy changes, retailers also often adjust their selling prices. Changes in national weather pat- terns can also affect the amount of time people spend outdoors—and therefore impact their purchases of REI merchandise. Why does REI’s gross profit rate differ so much from that of Dick’s Sport- ing Goods and the industry average? The gross profit rate often differs across retailers because of differences in the nature of their goods. First, REI focuses on outdoor equipment, while Dick’s also sells sporting goods and hunting gear. The markup may differ significantly in these different product sectors. Also, although REI and Dick’s both sell outdoor equipment, the quality of the equipment they sell differs. REI tends to sell more “high-end” goods, while Dick’s tends to sell goods in a more “affordable” range. Higher-quality goods often receive a higher markup, but the retailer also sells fewer of them. In general, retailers adopt either a high-volume–low-margin approach (e.g., Wal-Mart) or a low-volume–high-margin approach (e.g., Saks Fifth Avenue). The strategic choice is often revealed in differences in the companies’ gross profit rates.

PROFIT MARGIN

The profi t margin measures the percentage of each dollar of sales that results in net income. We compute this ratio by dividing net income by net sales (revenue) for the period. How do the gross profi t rate and profi t margin differ? The gross profi t rate measures the margin by which selling price exceeds cost of goods sold. The profi t margin measures the extent by which selling price covers all expenses (including cost of goods sold). A company can improve its profi t margin by either increasing its gross profi t rate and/or by controlling its operating expenses and other costs. For example, at one time Radio Shack reported increased profi t margins which it accomplished by closing stores and slashing costs. Eventually, however, it was forced to fi le for bankruptcy as sales continued to decline.

DECISION TOOLS

The profi t margin helps companies decide if they are maintaining an adequate margin between sales and expenses.

Gross Profit Rate = Gross Profit Net Sales

REI Dick’s Sporting Industry ($ in thousands) Goods Average

$960,129 = 43.3% 43.1% 31.3% 34.0% $2,217,131

2014 2013 2014 2014

ILLUSTRATION 5-16 Gross profi t rate

236 5 Merchandising Operations and the Multiple-Step Income Statement

Profi t margins for REI and Dick’s Sporting Goods and the industry average are presented in Illustration 5-18.

REI’s profi t margin increased from 0.9% to 2.0% between 2013 and 2014. This means that the company generated 2.0¢ of profi t on each dollar of sales. This increase occurred partly because the gross profi t rate increased. A change in the profi t margin can be caused by a change in the gross profi t rate, a change in the amount of operating expenses relative to sales, or a change in the amount of other items (other revenues and gains, or other expenses and losses) relative to sales. From Illustration 5-16, we know that REI’s gross profi t rate increased slightly. From analyzing the information in Illustration 5-8, we see that operating expenses as a percentage of sales decreased from 36.6% ($739,148 ÷ $2,017,476) in 2013 to 35.1% ($778,251 ÷ $2,217,131) in 2014. Therefore, in 2014, most of the increase in REI’s profi t margin occurred because of the decline in operating expenses as a percentage of sales. How does REI compare to its competitors? Its profi t margin was lower than Dick’s in 2014 and was less than the industry average. Thus, its profi t margin does not suggest exceptional profi tability.

ILLUSTRATION 5-18 Profi t margin Profit Margin = Net Income

Net Sales

REI Dick’s Sporting Industry ($ in thousands) Goods Average

$44,118 = 2.0% 0.9% 5.4% 5.1% $2,217,131

2014 2013 2014 2014

Profi t margins vary across industries. Businesses with high turnovers, such as grocery stores (Safeway and Kroger) and discount stores (Target and Wal- Mart), generally experience low profi t margins. Low-turnover businesses, such as high-end jewelry stores (Tiffany and Co.) or major drug manufacturers (Merck), have high profi t margins. Illustration 5-17 shows profi t margins from a variety of industries.

Industry

19.7%

10% 20% 30%

15.3%

15%

10%

7.6%

6.4%

Software and programming

Semiconductors

Pharmaceutical

Footwear

Chemical manufacturing

Food processing

Profit Margin

ILLUSTRATION 5-17 Profi t margins by industry

Gross Profi t Rate and Profi t Margin 237

Helen Sessions/Alamy

PEOPLE, PLANET, AND PROFIT INSIGHT PepsiCo Inc.

KEEPING AN EYE ON CASH

In Chapter 4, you learned that earnings have high quality if they provide a full and transparent depiction of how a company performed. In order to quickly assess earnings quality, analysts sometimes employ the quality of earnings ratio. It is calculated as net cash provided by operating activities divided by net income.

In general, a measure signifi cantly less than 1 suggests that a company may be using more aggressive accounting techniques in order to accelerate income recognition (record income in earlier periods). A measure signifi cantly greater than 1 suggests that a company is using conservative accounting techniques, which cause it to delay the recognition of income. Measures that are signifi cantly less than 1 do not provide defi nitive evi- dence of low-quality earnings. Low measures do, however, indicate that ana- lysts should investigate the causes of the difference between net income and net cash provided by operating activities. Examples of factors that would cause differences are presented in Chapter 4 (page 179). Here are recent quality of earnings ratios for a number of well-known com- panies, all of which have measures in excess of 1.

Quality of Earnings Ratio = Net Cash Provided by Operating Activities

Net Income

Company Name Net Cash Provided by Quality of ($ in millions) Operating Activities Net Income Earnings Ratio

DuPont $4,741 $1,769 2.7 Intel $11,170 $4,369 2.6 Nike $1,736 $1,487 1.2 Microsoft $19,037 $14,569 1.3 Wal-Mart $26,249 $14,335 1.8

÷ =

Selling Green

Here is a question an executive of PepsiCo Inc. was asked: Should PepsiCo market green? The executive indicated that the company should, as he be- lieves it’s the No. 1 thing consumers all over the world care about. Here are some of his thoughts on this issue:

“Sun Chips are part of the food business I run. It’s a ’healthy snack.’ We decided that Sun Chips, if it’s a healthy snack, should be made in facilities that have a net-zero footprint. In other words,

I want off the electric grid everywhere we make Sun Chips. We did that. Sun Chips should be made in a facility that puts back more water than it uses. It does that. And we partnered with our suppli- ers and came out with the world’s fi rst compostable chip package.

Now, there was an issue with this package: It was louder than the New York subway, louder than jet engines taking off. What would a company that’s committed to green do: walk away or stay committed? If your people are passionate, they’re going to fi x it for you as long as you stay committed. Six months later, the compostable bag has half the noise of our current package. So the view today is: we should market green, we should be proud to do it . . . it has to be a 360 process, both internal and external. And if you do that, you can monetize environ- mental sustainability for the shareholders.”

Source: “Four Problems—and Solutions,” Wall Street Journal (March 7, 2011), p. R2.

What is meant by “monetize environmental sustainability” for shareholders? (Go to WileyPLUS for this answer and additional questions.)

238 5 Merchandising Operations and the Multiple-Step Income Statement

Like REI, Mountain Equipment Cooperative (MEC) is a retailer of outdoor equipment organized as a cooperative (though MEC only sells to its members, who pay a one-time fee of $5). Also like REI, MEC has a signifi cant commitment to sustain- ability. Many of its stores employ state-of-the-art building techniques to minimize energy use, and it pledges 1% of annual sales revenue to environmental causes. Since MEC is a Canadian company, it follows International Financial Reporting Standards (IFRS) rather than U.S. GAAP. The A Look at IFRS section at the end of each chapter of this textbook discusses some of the main accounting differences that you would need to be aware of to make a thorough comparison of REI and MEC. Here is recent data for MEC.

Year ended

($ in thousands) 12/28/14 12/29/13

Net income $ 60 $ 361 Sales revenue 336,071 320,871 Cost of goods sold 226,099 215,614

INSTRUCTIONS

Using the basic facts in the table, evaluate the following components of MEC’s profi tability for the years ended December 28, 2014, and December 29, 2013.

Profi t margin Gross profi t rate

How do MEC’s profi t margin and gross profi t rate compare to those of REI and Dick’s Sporting Goods for 2014?

USING DECISION TOOLS—MOUNTAIN EQUIPMENT COOPERATIVE

▼ Gross Profi t Rate and Profi t MarginDO IT!

Rachel Rose, Inc. reported the following in its 2017 and 2016 income statements.

2017 2016

Net sales $80,000 $120,000 Cost of goods sold 40,000 60,000 Operating expenses 14,000 28,000 Income tax expense 8,000 12,000

Net income $18,000 $ 20,000

Determine the company’s gross profi t rate and profi t margin. Discuss the cause for changes in the ratios.

SOLUTION

Gross profit rate

Profit margin $18,000 ÷ $80,000 = 22.5% $20,000 ÷ $120,000 = 16.7%

The company’s gross profi t rate remained constant. However, its profi t margin increased signifi cantly due to a sharp decline in its operating costs as a percentage of sales, which declined from 23% ($28,000 ÷ $120,000) in 2016 to 17.5% ($14,000 ÷ $80,000) in 2017.

2017

($80,000 − $40,000) = 50%

$80,000

2016

($120,000 − $60,000) = 50%

$120,000

Action Plan ✔ To determine gross profi t

rate, divide gross profi t by net sales.

✔ To fi nd profi t margin, divide net income by net sales.

Related exercise material: BE5-11, BE5-12, BE5-13, DO IT! 5-6, E5-7, E5-8, E5-9, and E5-14.

Appendix 5A: Periodic Inventory System 239

SOLUTION Year ended

($ in thousands) 12/28/14 12/29/13

Profi t margin $60

$336,071 = 0.0%

$361 $320,871

= 0.1%

Gross profi t rate $109,972* $336,071 = 32.7%

$105,257** $320,871 = 32.8%

*$336,071 − $226,099 **$320,871 − $215,614

MEC’s profi t margin (income per dollar of sales) remained constant at 0.0%. This is well below both REI’s (2.0%) and Dick’s (5.4%). Thus, MEC is not as effective at turning its sales into net income as these two competitors. MEC’s gross profi t rate declined slightly from 32.8% to 32.7%. This suggests that its ability to maintain its markup above its cost of goods sold declined slightly during this period. MEC’s gross profi t rate of 32.7% is lower than REI’s (43.3%) but higher than Dick’s (31.3%). Dick’s gross profi t is depressed by the fact that it sells many low-margin products. REI is superior to MEC both in its ability to maintain its markup above its costs of goods sold (its gross profi t rate) and in its ability to control operating costs (its profi t margin).

APPENDIX 5A: Record purchases and sales of inventory under a periodic inventory system.

LEARNING OBJECTIVE *7▼

As described in this chapter, companies may use one of two basic systems of accounting for inventories: (1) the perpetual inventory system or (2) the periodic inventory system. In the chapter, we focused on the characteristics of the per- petual inventory system. In this appendix, we discuss and illustrate the periodic inventory system. One key difference between the two systems is the point at which the company computes cost of goods sold. For a visual reminder of this difference, you may want to refer back to Illustration 5-4 on page 218.

RECORDING MERCHANDISE TRANSACTIONS

In a periodic inventory system, companies record revenues from the sale of merchandise when sales are made, just as in a perpetual system. Unlike the per- petual system, however, companies do not attempt on the date of sale to record the cost of the merchandise sold. Instead, they take a physical inventory count at the end of the period to determine (1) the cost of the merchandise then on hand and (2) the cost of the goods sold during the period. And, under a periodic system, companies record purchases of merchandise in the Purchases account rather than the Inventory account. Purchase returns and allowances, purchase discounts, and freight costs on purchases are recorded in separate accounts. To illustrate the recording of merchandise transactions under a periodic inven- tory system, we will use purchase/sale transactions between PW Audio Supply, Inc. and Sauk Stereo, as illustrated for the perpetual inventory system in this chapter.

RECORDING PURCHASES OF MERCHANDISE

On the basis of the sales invoice (Illustration 5-5, shown on page 220) and receipt of the merchandise ordered from PW Audio Supply, Sauk Stereo records the $3,800 purchase as follows.

May 4 Purchases 3,800 Accounts Payable 3,800 (To record goods purchased on

account from PW Audio Supply)

Purchases is a temporary account whose normal balance is a debit.

240 5 Merchandising Operations and the Multiple-Step Income Statement

FREIGHT COSTS

When the purchaser directly incurs the freight costs, it debits the account Freight- In (or Transportation-In). For example, if Sauk Stereo pays Public Freight Company $150 for freight charges on its purchase from PW Audio Supply on May 6, the entry on Sauk Stereo’s books is as follows.

May 6 Freight-In (Transportation-In) 150 Cash 150 (To record payment of freight on

goods purchased)

Like Purchases, Freight-In is a temporary account whose normal balance is a debit. Freight-In is part of cost of goods purchased. The reason is that cost of goods purchased should include any freight charges necessary to bring the goods to the purchaser. Freight costs are not subject to a purchase discount. Purchase discounts apply on the invoice cost of the merchandise.

Purchase Returns and Allowances Sauk Stereo returns goods costing $300 to PW Audio Supply and prepares the following entry to recognize the return.

May 8 Accounts Payable 300 Purchase Returns and Allowances 300 (To record return of goods purchased

from PW Audio Supply)

Purchase Returns and Allowances is a temporary account whose normal balance is a credit.

Purchase Discounts On May 14, Sauk Stereo pays the balance due on account to PW Audio Supply, taking the 2% cash discount allowed by PW Audio Supply for payment within 10 days. Sauk Stereo records the payment and discount as follows.

May 14 Accounts Payable ($3,800 − $300) 3,500 Purchase Discounts ($3,500 × .02) 70 Cash 3,430 (To record payment within the

discount period)

Purchase Discounts is a temporary account whose normal balance is a credit.

RECORDING SALES OF MERCHANDISE

The seller, PW Audio Supply, records the sale of $3,800 of merchandise to Sauk Stereo on May 4 (sales invoice No. 731, Illustration 5-5, page 220) as follows.

May 4 Accounts Receivable 3,800 Sales Revenue 3,800 (To record credit sale to Sauk Stereo

per invoice #731)

Sales Returns and Allowances To record the returned goods received from Sauk Stereo on May 8, PW Audio Supply records the $300 sales return as follows.

May 8 Sales Returns and Allowances 300 Accounts Receivable 300 (To record credit granted to Sauk Stereo

for returned goods)

Review and Practice 241

Sales Discounts On May 14, PW Audio Supply receives payment of $3,430 on account from Sauk Stereo. PW Audio Supply honors the 2% cash discount and records the payment of Sauk Stereo’s account receivable in full as follows.

May 14 Cash 3,430 Sales Discounts ($3,500 × .02) 70 Accounts Receivable ($3,800 − $300) 3,500 (To record collection within 2/10, n/30

discount period from Sauk Stereo)

COMPARISON OF ENTRIES—PERPETUAL VS. PERIODIC

ENTRIES ON SAUK STEREO’S BOOKS

Transaction Perpetual Inventory System Periodic Inventory System

May 4 Purchase of Inventory 3,800 Purchases 3,800 merchandise on credit. Accounts Payable 3,800 Accounts Payable 3,800

May 6 Freight costs on Inventory 150 Freight-In 150 purchases. Cash 150 Cash 150

May 8 Purchase returns and Accounts Payable 300 Accounts Payable 300 allowances. Inventory 300 Purchase Returns and Allowances 300

May 14 Payment on account Accounts Payable 3,500 Accounts Payable 3,500 with a discount. Cash 3,430 Cash 3,430 Inventory 70 Purchase Discounts 70

ENTRIES ON PW AUDIO SUPPLY’S BOOKS

Transaction Perpetual Inventory System Periodic Inventory System

May 4 Sale of merchandise Accounts Receivable 3,800 Accounts Receivable 3,800 on credit. Sales Revenue 3,800 Sales Revenue 3,800

Cost of Goods Sold 2,400 No entry for cost of Inventory 2,400 goods sold

May 8 Return of merchandise Sales Returns and Sales Returns and sold. Allowances 300 Allowances 300 Accounts Receivable 300 Accounts Receivable 300

Inventory 140 No entry Cost of Goods Sold 140

May 14 Cash received on Cash 3,430 Cash 3,430 account with a Sales Discounts 70 Sales Discounts 70 discount. Accounts Receivable 3,500 Accounts Receivable 3,500

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Describe merchandising operations and inventory systems. Because of the presence of inventory, a mer- chandising company has sales revenue, cost of goods sold, and gross profi t. To account for inventory, a mer- chandising company must choose between a perpetual inventory system and a periodic inventory system.

2 Record purchases under a perpetual inventory system. The Inventory account is debited for all purchases of mer- chandise and for freight costs, and it is credited for pur- chase discounts and purchase returns and allowances.

3 Record sales under a perpetual inventory system. When inventory is sold, Accounts Receivable (or Cash)

▼

is debited and Sales Revenue is credited for the sell- ing price of the merchandise. At the same time, Cost of Goods Sold is debited and Inventory is credited for the cost of inventory items sold. Separate contra revenue accounts are maintained for Sales Returns and Allow- ances and Sales Discounts. These accounts are debited as needed to record returns, allowances, or discounts related to the sale.

4 Prepare a multiple-step income statement and a com- prehensive income statement. In a single-step income statement, companies classify all data under two catego- ries, revenues or expenses, and net income is determined in one step. A multiple-step income statement shows numerous steps in determining net income, includ- ing results of nonoperating activities. A comprehensive income statement adds or subtracts any items of other comprehensive income to net income to arrive at com- prehensive income.

5 Determine cost of goods sold under a periodic inventory system. The periodic system uses multiple accounts to keep track of transactions that affect inventory. To determine cost of goods sold, fi rst calculate cost of goods purchased by adjusting purchases for returns, allowances, discounts, and freight-in. Then calculate cost of goods sold by adding cost of goods pur- chased to beginning inventory and subtracting ending inventory.

6 Compute and analyze gross profi t rate and profi t margin. Profi tability is affected by gross profi t, as mea- sured by the gross profi t rate, and by management’s ability to control costs, as measured by the profi t margin.

*7 Record purchases and sales of inventory under a periodic inventory system. To record purchases, entries are required for (a) cash and credit purchases, (b) purchase returns and allowances, (c) purchase discounts, and (d) freight costs. To record sales, entries are required for (a) cash and credit sales, (b) sales returns and allowances, and (c) sales discounts.

242 5 Merchandising Operations and the Multiple-Step Income Statement

Comprehensive income An income measure that includes gains and losses that are excluded from the determina- tion of net income. (p. 231).

Comprehensive income statement A statement that pre- sents items that are not included in the determination of net income, referred to as other comprehensive in- come. (p. 231).

Contra revenue account An account that is offset against a revenue account on the income statement. (p. 226).

Cost of goods sold The total cost of merchandise sold during the period. (p. 216).

Gross profi t The excess of net sales over the cost of goods sold. (p. 229).

Gross profi t rate Gross profi t expressed as a percent- age by dividing the amount of gross profi t by net sales. (p. 234).

Net sales Sales less sales returns and allowances and sales discounts. (p. 229).

Periodic inventory system An inventory system in which a company does not maintain detailed records of goods on hand throughout the period and determines the cost of goods sold only at the end of an accounting period. (p. 218).

Perpetual inventory system A detailed inventory system in which a company maintains the cost of each inven- tory item, and the records continuously show the inven- tory that should be on hand. (p. 217).

Profi t margin Measures the percentage of each dollar of sales that results in net income, computed by dividing net income by net sales. (p. 235).

Purchase allowance A deduction made to the selling price of merchandise, granted by the seller, so that the buyer will keep the merchandise. (p. 222).

Purchase discount A cash discount claimed by a buyer for prompt payment of a balance due. (p. 222).

Purchase invoice A document that provides support for each purchase. (p. 220).

Purchase return A return of goods from the buyer to the seller for cash or credit. (p. 222).

Quality of earnings ratio A measure used to indicate the extent to which a company’s earnings provide a full and transparent depiction of its performance; computed as net cash provided by operating activities divided by net income. (p. 237).

Sales discount A reduction given by a seller for prompt payment of a credit sale. (p. 226).

GLOSSARY REVIEW▼

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Is the price of goods keeping pace with changes in the cost of inventory?

Gross profi t and net sales Gross profi t =

Gross profi t rate Net sales

Is the company maintaining an adequate margin between sales and expenses?

Net income and net sales Profi t margin

Net income Net sales

Higher value suggests favorable return on each dollar of sales.

Higher ratio suggests the average margin between selling price and inventory cost is increasing. Too high a margin may result in lost sales.

Sales invoice A document that provides support for each sale. (p. 224).

Sales returns and allowances Transactions in which the seller either accepts goods back from the purchaser

(a return) or grants a reduction in the purchase price (an allowance) so that the buyer will keep the goods. (p. 225).

Sales revenue Primary source of revenue for a merchan- dising company. (p. 216).

Practice Multiple-Choice Questions 243

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

1. Which of the following statements about a periodic inventory system is true? (a) Companies determine cost of goods sold only at

the end of the accounting period. (b) Companies continuously maintain detailed records

of the cost of each inventory purchase and sale. (c) The periodic system provides better control over

inventories than a perpetual system. (d) The increased use of computerized systems has

increased the use of the periodic system. 2. Under a perpetual inventory system, when goods are

purchased for resale by a company: (a) purchases on account are debited to Inventory. (b) purchases on account are debited to Purchases. (c) purchase returns are debited to Purchase Returns

and Allowances. (d) freight costs are debited to Freight-Out.

3. Which sales accounts normally have a debit balance? (a) Sales Discounts. (b) Sales Returns and Allowances. (c) Both (a) and (b). (d) Neither (a) nor (b).

4. A company makes a credit sale of $750 on June 13, terms 2/10, n/30, on which it grants a return of $50 on June 16. What amount is received as payment in full on June 23? (a) $700. (c) $685. (b) $686. (d) $650.

5. To record the sale of goods for cash in a perpetual inventory system: (a) only one journal entry is necessary to record cost

of goods sold and reduction of inventory. (b) only one journal entry is necessary to record the

receipt of cash and the sales revenue. (c) two journal entries are necessary: one to record

the receipt of cash and sales revenue, and one to record the cost of goods sold and reduction of inventory.

(d) two journal entries are necessary: one to record the receipt of cash and reduction of inventory, and one to record the cost of goods sold and sales revenue.

6. Gross profi t will result if: (a) operating expenses are less than net income. (b) net sales are greater than operating expenses. (c) net sales are greater than cost of goods sold. (d) operating expenses are greater than cost of goods

sold. 7. If net sales are $400,000, cost of goods sold is $310,000,

and operating expenses are $60,000, what is the gross profi t? (a) $30,000. (c) $340,000. (b) $90,000. (d) $400,000.

8. The multiple-step income statement for a merchan- dising company shows each of these features except:

(LO 1)

(LO 2)

(LO 3)

(LO 4)

(a) gross profi t. (b) cost of goods sold. (c) a sales section. (d) an investing activities section.

9. If beginning inventory is $60,000, cost of goods pur- chased is $380,000, and ending inventory is $50,000, what is cost of goods sold under a periodic system? (a) $390,000. (c) $330,000. (b) $370,000. (d) $420,000.

10. Bufford Corporation had reported the following amounts at December 31, 2017: sales revenue $184,000, ending inventory $11,600, beginning in- ventory $17,200, purchases $60,400, purchase dis- counts $3,000, purchase returns and allowances $1,100, freight-in $600, and freight-out $900. Calcu- late the cost of goods available for sale. (a) $69,400. (c) $56,900. (b) $74,100. (d) $197,700.

11. Which of the following would affect the gross profi t rate? (Assume sales remains constant.) (a) An increase in advertising expense. (b) A decrease in depreciation expense. (c) An increase in cost of goods sold. (d) A decrease in insurance expense.

12. The gross profi t rate is equal to: (a) net income divided by sales. (b) cost of goods sold divided by sales. (c) net sales minus cost of goods sold, divided by net sales. (d) sales minus cost of goods sold, divided by cost of

goods sold. 13. During the year ended December 31, 2017, Bjornstad

Corporation had the following results: net sales $267,000, cost of goods sold $107,000, net income $92,400, operating expenses $55,400, and net cash provided by operating activities $108,950. What was the company’s profi t margin? (a) 40%. (c) 20.5%. (b) 60%. (d) 34.6%.

14. A quality of earnings ratio: (a) is computed as net income divided by net cash

provided by operating activities. (b) that is less than 1 indicates that a company might

be using aggressive accounting tactics. (c) that is greater than 1 indicates that a company

might be using aggressive accounting tactics. (d) is computed as net cash provided by operating

activities divided by total assets. *15. When goods are purchased for resale by a company

using a periodic inventory system: (a) purchases on account are debited to Inventory. (b) purchases on account are debited to Purchases. (c) purchase returns are debited to Purchase Returns

and Allowances. (d) freight costs are debited to Purchases.

(LO 5)

(LO 6)

(LO 7)

SOLUTIONS 1. (a) Under the periodic inventory system, cost of goods sold is determined only at the end of the accounting period.

The other choices are incorrect because (b) detailed records of the cost of each inventory purchase and sale are main- tained continuously when a perpetual, not periodic, system is used; (c) the perpetual system provides better control over inventories than a periodic system; and (d) the increased use of computerized systems has increased the use of the perpetual, not periodic, system.

2. (a) Under a perpetual inventory system, when a company purchases goods for resale, purchases on account are debited to the Inventory account, not (b) Purchases or (c) Purchase Returns and Allowances. Choice (d) is incorrect because freight costs are also debited to the Inventory account, not the Freight-Out account.

3. (c) Both Sales Discounts and Sales Returns and Allowances normally have a debit balance. Choices (a) and (b) are both correct, but (c) is the better answer. Choice (d) is incorrect as both (a) and (b) are correct.

4. (b) The full amount of $686 is paid within 10 days of the purchase ($750 − $50) − [($750 − $50) × 2%]. The other choices are incorrect because (a) does not consider the discount of $14; (c) the amount of the discount is based upon the amount after the return is granted ($700 × 2%), not the amount before the return of merchandise ($750 × 2%); and (d) does not constitute payment in full on June 23.

5. (c) Two journal entries are necessary: one to record the receipt of cash and sales revenue, and one to record the cost of goods sold and reduction of inventory. The other choices are incorrect because (a) only considers the recognition of the expense and ignores the revenue, (b) only considers the recognition of revenue and leaves out the expense or cost of merchandise sold, and (d) the receipt of cash and sales revenue, not reduction of inventory, are paired together, and the cost of goods sold and reduction of inventory, not sales revenue, are paired together.

6. (c) Gross profi t will result if net sales are greater than cost of goods sold. The other choices are incorrect because (a) operating expenses and net income are not used in the computation of gross profi t; (b) gross profi t results when net sales are greater than cost of goods sold, not operating expenses; and (d) gross profi t results when net sales, not operating expenses, are greater than cost of goods sold.

7. (b) Gross profi t = Net sales ($400,000) − Cost of goods sold ($310,000) = $90,000, not (a) $30,000, (c) $340,000, or (d) $400,000.

8. (d) An investing activities section appears on the statement of cash fl ows, not on a multiple-step income statement. Choices (a) gross profi t, (b) cost of goods sold, and (c) a sales section are all features of a multiple-step income statement.

9. (a) Beginning inventory ($60,000) + Cost of goods purchased ($380,000) − Ending inventory ($50,000) = Cost of goods sold ($390,000), not (b) $370,000, (c) $330,000, or (d) $420,000.

10. (b) Beginning inventory ($17,200) + Purchases ($60,400) − Purchases discounts ($3,000) − Purchase returns and allow- ances ($1,100) + Freight-in ($600) = Cost of goods available for sale ($74,100). The other choices are therefore incorrect.

11. (c) Gross profi t rate = Gross profi t ÷ Net sales. Therefore, any changes in sale revenue, sales returns and allowances, sales discounts, or cost of goods sold will affect the ratio. Changes in (a) advertising expense, (b) depreciation expense, or (d) insurance expense will not affect the computation of the gross profi t rate.

12. (c) Gross profi t rate = Gross profi t (Net sales − Cost of goods sold) ÷ Net sales. The other choices are therefore incorrect. 13. (d) Net income ($92,400) ÷ Net sales ($267,000) = Profi t margin of 34.6%, not (a) 40%, (b) 60%, or (c) 20.5%. 14. (b) A quality of earnings ratio that is less than 1 indicates that a company might be using aggressive accounting tactics.

The other choices are incorrect because (a) Quality of earnings = Net cash provided by operating activities ÷ Net income, not vice versa; (c) a ratio that is signifi cantly greater than 1 suggests that a company is using conservative accounting techniques, and (d) Quality of earnings = Net cash provided by operating activities ÷ Net income (not Total assets).

*15. (b) Purchases for resale are debited to the Purchases account. The other choices are incorrect because (a) purchases on account are debited to Purchases, not Inventory; (c) Purchase Returns and Allowances are always credited; and (d) freight costs are debited to Freight-In, not Purchases.

244 5 Merchandising Operations and the Multiple-Step Income Statement

1. On June 10, Vareen Company purchased $8,000 of merchandise from Harrah Company, FOB shipping point, terms 3/10, n/30. Vareen pays the freight costs of $400 on June 11. Damaged goods totaling $300 are returned to Harrah for credit on June 12. The fair value of these goods in $70. On June 19, Vareen pays Harrah Company in full, less the purchase discount. Both companies use a perpetual inventory system.

INSTRUCTIONS

(a) Prepare separate entries for each transaction on the books of Vareen Company.

(b) Prepare separate entries for each transaction for Harrah Company. The merchandise purchased by Vareen on June 10 had cost Harrah $4,800.

Prepare purchase and sales entries.

(LO 2, 3)

PRACTICE EXERCISES▼

Practice Exercises 245

SOLUTION

1. (a) June 10 Inventory 8,000 Accounts Payable 8,000

11 Inventory 400 Cash 400

12 Accounts Payable 300 Inventory 300

19 Accounts Payable ($8,000 − $300) 7,700 Inventory ($7,700 × 3%) 231 Cash ($7,700 − $231) 7,469

(b) June 10 Accounts Receivable 8,000 Sales Revenue 8,000 Cost of Goods Sold 4,800 Inventory 4,800

12 Sales Returns and Allowances 300 Accounts Receivable 300 Inventory 70 Cost of Goods Sold 70

19 Cash ($7,700 − $231) 7,469 Sales Discounts ($7,700 × 3%) 231 Accounts Receivable ($8,000 − $300) 7,700

2. In its income statement for the year ended December 31, 2017, Marten Company reported the following condensed data.

Interest expense $ 70,000 Net sales $2,200,000 Operating expenses 725,000 Interest revenue 25,000 Cost of goods sold 1,300,000 Loss on disposal of plant assets 17,000 Income tax expense 10,000

INSTRUCTIONS

(a) Prepare a multiple-step income statement.

(b) Prepare a single-step income statement.

Prepare multiple-step and single-step income statements.

(LO 4)

SOLUTION

2. (a)

Net sales $2,200,000 Cost of goods sold 1,300,000

Gross profi t 900,000 Operating expenses 725,000

Income from operations 175,000 Other revenues and gains Interest revenue $25,000 Other expenses and losses Interest expense $70,000 Loss on disposal of plant assets 17,000 87,000 (62,000)

Income before income taxes 113,000 Income tax expense 10,000

Net income $ 103,000

MARTEN COMPANY Income Statement

For the Year Ended December 31, 2017

246 5 Merchandising Operations and the Multiple-Step Income Statement

(b)

Revenues Net sales $2,200,000 Interest revenue 25,000

Total revenues 2,225,000 Expenses Cost of goods sold $1,300,000 Operating expenses 725,000 Interest expense 70,000 Loss on disposal of plant assets 17,000 Income tax expense 10,000 Total expenses 2,122,000

Net income $ 103,000

MARTEN COMPANY Income Statement

For the Year Ended December 31, 2017

The adjusted trial balance for the year ended December 31, 2017, for Dykstra Company is shown below.

DYKSTRA COMPANY Adjusted Trial Balance

For the Year Ended December 31, 2017

Debit Credit

Cash $ 14,500 Accounts Receivable 11,100 Inventory 29,000 Prepaid Insurance 2,500 Equipment 95,000 Accumulated Depreciation—Equipment $ 18,000 Notes Payable 25,000 Accounts Payable 10,600 Common Stock 70,000 Retained Earnings 11,000 Dividends 12,000 Sales Revenue 536,800 Sales Returns and Allowances 6,700 Sales Discounts 5,000 Cost of Goods Sold 363,400 Freight-Out 7,600 Advertising Expense 12,000 Salaries and Wages Expense 56,000 Utilities Expense 18,000 Rent Expense 24,000 Depreciation Expense 9,000 Insurance Expense 4,500 Interest Expense 3,600 Interest Revenue 2,500

$673,900 $673,900

INSTRUCTIONS

Prepare a multiple-step income statement for Dykstra Company. Assume a tax rate of 30%.

Prepare a multiple-step income statement.

(LO 4)

PRACTICE PROBLEM▼

Questions 247

SOLUTION

Sales Sales revenue $536,800 Less: Sales returns and allowances $ 6,700 Sales discounts 5,000 11,700

Net sales 525,100 Cost of goods sold 363,400

Gross profi t 161,700 Operating expenses Salaries and wages expense 56,000 Rent expense 24,000 Utilities expense 18,000 Advertising expense 12,000 Depreciation expense 9,000 Freight-out 7,600 Insurance expense 4,500

Total operating expenses 131,100

Income from operations 30,600 Other revenues and gains Interest revenue 2,500 Other expenses and losses Interest expense 3,600

Income before income taxes 29,500 Income tax expense 8,850

Net income $ 20,650

DYKSTRA COMPANY Income Statement

For the Year Ended December 31, 2017

1. (a) “The steps in the accounting cycle for a mer- chandising company differ from the steps in the accounting cycle for a service company.” Do you agree or disagree?

(b) Is the measurement of net income in a merchan- dising company conceptually the same as in a service company? Explain.

2. How do the components of revenues and expenses differ between a merchandising company and a ser- vice company?

3. Maria Lopez, CEO of Sales Bin Stores, is con- sidering a recommendation made by both the com- pany’s purchasing manager and director of fi nance that the company should invest in a sophisticated

new perpetual inventory system to replace its periodic system. Explain the primary difference between the two systems, and discuss the potential benefi ts of a perpetual inventory system.

4. (a) Explain the income measurement process in a merchandising company.

(b) How does income measurement differ between a merchandising company and a service company?

5. Waymon Co. has net sales of $100,000, cost of goods sold of $70,000, and operating expenses of $18,000. What is its gross profi t?

6. Masie Ascot believes revenues from credit sales may be recorded before they are collected in cash. Do you agree? Explain.

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS▼

248 5 Merchandising Operations and the Multiple-Step Income Statement

7. (a) What is the primary source document for record- ing (1) cash sales and (2) credit sales?

(b) Using XXs for amounts, give the journal entry for each of the transactions in part (a), assuming per- petual inventory.

8. A credit sale is made on July 10 for $900, terms 1/15, n/30. On July 12, the purchaser returns $100 of goods for credit. Give the journal entry on July 19 to record the receipt of the balance due within the discount period.

9. As the end of Smyle Company’s fi scal year ap- proached, it became clear that the company had con- siderable excess inventory. Marvin Ross, the head of marketing and sales, ordered salespeople to “add 20% more units to each order that you ship. The custom- ers can always ship the extra back next period if they decide they don’t want it. We’ve got to do it to meet this year’s sales goal.” Discuss the accounting implications of Marvin’s action.

10. To encourage bookstores to buy a broader range of book titles and to discourage price discounting, the pub- lishing industry allows bookstores to return unsold books to the publisher. This results in very signifi cant returns each year. To ensure proper recognition of revenues, how should publishing companies account for these returns?

11. Goods costing $1,900 are purchased on account on July 15 with credit terms of 2/10, n/30. On July 18, the pur- chaser receives a $300 credit from the supplier for dam- aged goods. Give the journal entry on July 24 to record payment of the balance due within the discount period.

12. Scribe Company reports net sales of $800,000, gross profi t of $560,000, and net income of $230,000. What are its operating expenses?

13. Mai Company has always provided its customers with payment terms of 1/10, n/30. Members of its sale force have commented that competitors are offering customers 2/10, n/45. Explain what these terms mean, and discuss the implications to Mai of switching its payment terms to those of its competitors.

14. In its year-end earnings announcement press re- lease, Ransome Corp. announced that its earnings in- creased by $15 million relative to the previous year. This represented a 20% increase. Inspection of its income statement reveals that the company reported a $20 mil- lion gain under “Other revenues and gains” from the sale of one of its factories. Discuss the implications of this gain from the perspective of a potential investor.

15. Identify the distinguishing features of an income state- ment for a merchandising company.

16. Why is the normal operating cycle for a merchandising company likely to be longer than for a service company?

17. What title does Apple use for gross profi t? By how much did its total gross profi t change, and in what direction, in 2014?

18. What merchandising account(s) will appear in the post-closing trial balance?

19. What types of businesses are most likely to use a per- petual inventory system?

20. Identify the accounts that are added to or deducted from purchases to determine the cost of goods pur- chased under a periodic system. For each account, indicate (a) whether it is added or deducted, and (b) its normal balance.

21. In the following cases, use a periodic inventory system to identify the item(s) designated by the letters X and Y. (a) Purchases − X − Y = Net purchases. (b) Cost of goods purchased − Net purchases = X. (c) Beginning inventory + X = Cost of goods available

for sale. (d) Cost of goods available for sale − Cost of goods

sold = X. 22. What two ratios measure factors that affect

profi tability?

23. What factors affect a company’s gross profi t rate—that is, what can cause the gross profi t rate to increase and what can cause it to decrease?

24. Earl Massey, director of marketing, wants to reduce the selling price of his company’s products by 15% to increase market share. He says, “I know this will reduce our gross profi t rate, but the increased number of units sold will make up for the lost mar- gin.” Before this action is taken, what other factors does the company need to consider?

25. Mark Coney is considering investing in Wiggles Pet Food Company. Wiggles’ net income increased consid- erably during the most recent year even though many other companies in the same industry reported disap- pointing earnings. Mark wants to know whether the company’s earnings provide a reasonable depiction of its results. What initial step can Mark take to help de- termine whether he needs to investigate further?

*26. On July 15, a company purchases on account goods costing $1,900, with credit terms of 2/10, n/30. On July 18, the company receives a $400 credit memo from the supplier for damaged goods. Give the journal entry on July 24 to record payment of the balance due within the discount period assuming a periodic inventory system.

BE5-1 Presented here are the components in Salas Company’s income statement. Determine the missing amounts.

Sales Cost of Gross Operating Net Revenue Goods Sold Profit Expenses Income

$ 71,200 (b) $ 30,000 (d) $12,100 $108,000 $70,000 (c) (e) $29,500 (a) $71,900 $109,600 $46,200 (f)

Compute missing amounts in determining net income.

(LO 1, 4), AP

BRIEF EXERCISES▼

Brief Exercises 249

BE5-2 Rita Company buys merchandise on account from Linus Company. The selling price of the goods is $900 and the cost of the goods sold is $590. Both companies use perpetual inventory systems. Journalize the transactions on the books of both companies.

BE5-3 Prepare the journal entries to record the following transactions on Borst Company’s books using a perpetual inventory system. (a) On March 2, Borst Company sold $800,000 of merchandise to McLeena Company,

terms 2/10, n/30. The cost of the merchandise sold was $540,000. (b) On March 6, McLeena Company returned $140,000 of the merchandise purchased on

March 2. The cost of the merchandise returned was $94,000. (c) On March 12, Borst Company received the balance due from McLeena Company.

BE5-4 From the information in BE5-3, prepare the journal entries to record these transac- tions on McLeena Company’s books under a perpetual inventory system.

BE5-5 Barto Company provides this information for the month ended October 31, 2017: sales on credit $300,000, cash sales $150,000, sales discounts $5,000, and sales returns and allowances $19,000. Prepare the sales section of the income statement based on this information.

BE5-6 Explain where each of these items would appear on a multiple-step income state- ment: gain on disposal of plant assets, cost of goods sold, depreciation expense, and sales returns and allowances.

BE5-7 The following information relates to Karen Weigel Inc. for the year 2017.

Retained earnings, January 1, 2017 $48,000 Advertising expense $ 1,800 Dividends during 2017 5,000 Rent expense 10,400 Service revenue 62,500 Utilities expense 3,100 Salaries and wages expense 28,000 Other comprehensive income (net of tax) 400

After analyzing the data, (a) compute net income and (b) prepare a comprehensive income statement for the year ending December 31, 2017.

BE5-8 Silas Company sold goods with a total selling price of $800,000 during the year. It purchased goods for $380,000 and had beginning inventory of $67,000. A count of its end- ing inventory determined that goods on hand was $50,000. What was its cost of goods sold?

BE5-9 Assume that Spacey Company uses a periodic inventory system and has these account balances: Purchases $404,000, Purchase Returns and Allowances $13,000, Purchase Discounts $9,000, and Freight-In $16,000. Determine net purchases and cost of goods purchased.

BE5-10 Assume the same information as in BE5-9 and also that Spacey Company has beginning inventory of $60,000, ending inventory of $90,000, and net sales of $612,000. Determine the amounts to be reported for cost of goods sold and gross profi t.

BE5-11 Dublin Corporation reported net sales of $250,000, cost of goods sold of $150,000, operating expenses of $50,000, net income of $32,500, beginning total assets of $520,000, and ending total assets of $600,000. Calculate each of the following values and explain what they mean: (a) profi t margin and (b) gross profi t rate.

BE5-12 Garten Corporation reported net sales $800,000, cost of goods sold $520,000, op- erating expenses $210,000, and net income $68,000. Calculate the following values and explain what they mean: (a) profi t margin and (b) gross profi t rate.

BE5-13 Cabo Corporation reported net income of $346,000, cash of $67,800, and net cash provided by operating activities of $221,200. What does this suggest about the quality of the company’s earnings? What further steps should be taken?

*BE5-14 Prepare the journal entries to record these transactions on Kimble Company’s books using a periodic inventory system. (a) On March 2, Kimble Company purchased $800,000 of merchandise from Poe Company,

terms 2/10, n/30. (b) On March 6, Kimble Company returned $95,000 of the merchandise purchased on March 2. (c) On March 12, Kimble Company paid the balance due to Poe Company.

Journalize perpetual inventory entries.

(LO 2, 3), AP

Journalize sales transactions.

(LO 3), AP

Journalize purchase transactions.

(LO 2), AP Prepare sales section of income statement.

(LO 4), AP

Identify placement of items on a multiple-step income statement.

(LO 4), AP

Prepare a comprehensive income statement.

(LO 4), AP

Determine cost of goods sold using basic periodic formula.

(LO 5), AP

Compute net purchases and cost of goods purchased.

(LO 5), AP

Compute cost of goods sold and gross profi t.

(LO 5), AP

Calculate profi tability ratios.

(LO 6), AP

Calculate profi tability ratios.

(LO 6), AP

Evaluate quality of earnings.

(LO 6), C

Journalize purchase transactions.

(LO 7), AP

250 5 Merchandising Operations and the Multiple-Step Income Statement

Indicate whether the following statements are true or false.

1. A merchandising company reports gross profit but a service company does not. 2. Under a periodic inventory system, a company determines the cost of goods sold each

time a sale occurs. 3. A service company is likely to use accounts receivable but a merchandising company

is not likely to do so. 4. Under a periodic inventory system, the cost of goods on hand at the beginning of the

accounting period plus the cost of goods purchased less the cost of goods on hand at the end of the accounting period equals cost of goods sold.

On October 5, Iverson Company buys merchandise on account from Lasse Company. The selling price of the goods is $5,000, and the cost to Lasse Company is $3,000. On October 8, Iverson returns defective goods with a selling price of $640 and a scrap value of $240. Record the transactions of Iverson Company, assuming a perpetual approach.

Assume information similar to that in DO IT! 5-2. That is: On October 5, Iverson Company buys merchandise on account from Lasse Company. The selling price of the goods is $5,000, and the cost to Lasse Company is $3,000. On October 8, Iverson returns defective goods with a selling price of $640 and a scrap value of $240. Record the transac- tions on the books of Lasse Company, assuming a perpetual approach.

The following information is available for Berlin Corp. for the year ended December 31, 2017:

Other revenues and gains $ 12,700 Sales revenue $592,000 Other expenses and losses 13,300 Operating expenses 186,000 Cost of goods sold 156,000 Sales returns and Other comprehensive income 5,400 allowances 40,000

Prepare a multiple-step income statement for Berlin Corp. and comprehensive income statement. The company has a tax rate of 30%. This rate also applies to the other compre- hensive income.

Clean Lake Corporation’s accounting records show the following at year-end December 31, 2017:

Purchase Discounts $ 5,900 Beginning Inventory $31,720 Freight-In 8,400 Ending Inventory 27,950 Freight-Out 11,100 Purchase Returns and Purchases 162,500 Allowances 3,600

Assuming that Clean Lake Corporation uses the periodic system, compute (a) cost of goods purchased and (b) cost of goods sold.

Owen Wise, Inc. reported the following in its 2017 and 2016 income statements.

2017 2016

Net sales $150,000 $120,000 Cost of goods sold 90,000 72,000 Operating expenses 32,000 16,000 Income tax expense 18,000 10,000

Net income $ 10,000 $ 22,000

Determine the company’s gross profi t rate and profi t margin for both years. Discuss the cause for changes in the ratios.

DO IT! 5-1Answer general questions about merchandisers.

(LO 1), C

DO IT! 5-2Record transactions of purchasing company.

(LO 2), AP

DO IT! 5-3Record transactions of selling company.

(LO 3), AP

DO IT! 5-4Prepare multiple-step income statement and comprehensive income statement.

(LO 4 ), AP

DO IT! 5-5Determine cost of goods sold using periodic system.

(LO 5), AP

DO IT! 5-6Compute and analyze profi tability ratios.

(LO 6), AN

EXERCISES▼DO IT!

E5-1 This information relates to Rice Co. 1. On April 5, purchased merchandise from Jax Company for $28,000, terms 2/10, n/30. 2. On April 6, paid freight costs of $700 on merchandise purchased from Jax. 3. On April 7, purchased equipment on account for $30,000.

Journalize purchase transactions.

(LO 2), AP

EXERCISES▼

Exercises 251

4. On April 8, returned $3,600 of April 5 merchandise to Jax Company. 5. On April 15, paid the amount due to Jax Company in full.

Instructions (a) Prepare the journal entries to record the transactions listed above on Rice Co.’s books.

Rice Co. uses a perpetual inventory system. (b) Assume that Rice Co. paid the balance due to Jax Company on May 4 instead of April 15.

Prepare the journal entry to record this payment.

E5-2 Assume that on September 1, Office Depot had an inventory that included a variety of calculators. The company uses a perpetual inventory system. During September, these transactions occurred.

Sept. 6 Purchased calculators from Dragoo Co. at a total cost of $1,650, terms n/30. 9 Paid freight of $50 on calculators purchased from Dragoo Co. 10 Returned calculators to Dragoo Co. for $66 credit because they did not

meet specifications. 12 Sold calculators costing $520 for $690 to Fryer Book Store, terms n/30. 14 Granted credit of $45 to Fryer Book Store for the return of one calculator

that was not ordered. The calculator cost $34. 20 Sold calculators costing $570 for $760 to Heasley Card Shop, terms n/30.

Instructions Journalize the September transactions.

E5-3 The following transactions are for Alonzo Company. 1. On December 3, Alonzo Company sold $500,000 of merchandise to Arte Co., terms

1/10, n/30. The cost of the merchandise sold was $330,000. 2. On December 8, Arte Co. was granted an allowance of $25,000 for merchandise

purchased on December 3. 3. On December 13, Alonzo Company received the balance due from Arte Co.

Instructions (a) Prepare the journal entries to record these transactions on the books of Alonzo Com-

pany. Alonzo uses a perpetual inventory system. (b) Assume that Alonzo Company received the balance due from Arte Co. on January 2

of the following year instead of December 13. Prepare the journal entry to record the receipt of payment on January 2.

E5-4 On June 10, Pais Company purchased $9,000 of merchandise from McGiver Company, terms 3/10, n/30. Pais pays the freight costs of $400 on June 11. Goods total- ing $600 are returned to McGiver for credit on June 12. On June 19, Pais Company pays McGiver Company in full, less the purchase discount. Both companies use a perpetual inventory system.

Instructions (a) Prepare separate entries for each transaction on the books of Pais Company. (b) Prepare separate entries for each transaction for McGiver Company. The merchan-

dise purchased by Pais on June 10 cost McGiver $5,000, and the goods returned cost McGiver $310.

E5-5 The adjusted trial balance of Doqe Company shows these data pertaining to sales at the end of its fiscal year, October 31, 2017: Sales Revenue $900,000, Freight-Out $14,000, Sales Returns and Allowances $22,000, and Sales Discounts $13,500.

Instructions Prepare the sales section of the income statement.

E5-6 Presented below is information for Lieu Co. for the month of January 2017.

Cost of goods sold $212,000 Rent expense $ 32,000 Freight-out 7,000 Sales discounts 8,000 Insurance expense 12,000 Sales returns and allowances 20,000 Salaries and wages expense 60,000 Sales revenue 370,000 Income tax expense 5,000 Other comprehensive income (net of $400 tax) 2,000

Journalize perpetual inventory entries.

(LO 2, 3), AP

Journalize sales transactions.

(LO 3), AP

Journalize perpetual inventory entries.

(LO 2, 3), AP

Prepare sales section of income statement.

(LO 4), AP

Prepare an income statement, a comprehensive income statement, and calculate profi tability ratios.

(LO 4, 6), AP

252 5 Merchandising Operations and the Multiple-Step Income Statement

Instructions (a) Prepare an income statement using the format presented in Illustration 5-11. (b) Prepare a comprehensive income statement. (c) Calculate the profi t margin and the gross profi t rate.

E5-7 Financial information is presented here for two companies.

Yoste Noone Company Company

Sales revenue $90,000 ? Sales returns and allowances ? $ 5,000 Net sales 84,000 100,000 Cost of goods sold 58,000 ? Gross profit ? 40,000 Operating expenses 14,380 ? Net income ? 17,000

Instructions (a) Fill in the missing amounts. Show all computations. (b) Calculate the profi t margin and the gross profi t rate for each company. (c) Discuss your fi ndings in part (b).

E5-8 In its income statement for the year ended December 31, 2017, Darren Company reported the following condensed data.

Salaries and wages Loss on disposal of plant expense $465,000 assets $ 83,500 Cost of goods sold 987,000 Sales revenue 2,210,000 Interest expense 71,000 Income tax expense 25,000 Interest revenue 65,000 Sales discounts 160,000 Depreciation expense 310,000 Utilities expense 110,000

Instructions (a) Prepare a multiple-step income statement. (b) Calculate the profi t margin and gross profi t rate. (c) In 2016, Darren had a profi t margin of 5%. Is the decline in 2017 a cause for concern?

(Ignore income tax effects.)

E5-9 Suppose in its income statement for the year ended June 30, 2017, The Clorox Company reported the following condensed data (dollars in millions).

Salaries and wages expense $ 460 Research and Depreciation expense 90 development expense $ 114 Sales revenue 5,730 Income tax expense 276 Interest expense 161 Loss on disposal of plant assets 46 Advertising expense 499 Cost of goods sold 3,104 Sales returns and Rent expense 105 allowances 280 Utilities expense 60

Instructions (a) Prepare a multiple-step income statement. (b) Calculate the gross profi t rate and the profi t margin and explain what each means. (c) Assume the marketing department has presented a plan to increase advertising expenses

by $340 million. It expects this plan to result in an increase in both net sales and cost of goods sold of 25%. (Hint: Increase both sales revenue and sales returns and allowances by 25%.) Redo parts (a) and (b) and discuss whether this plan has merit. (Assume a tax rate of 34%, and round all amounts to whole dollars.)

E5-10 In its income statement for the year ended December 31, 2017, Laine Inc. reported the following condensed data.

Operating expenses $ 725,000 Interest revenue $ 33,000 Cost of goods sold 1,256,000 Loss on disposal of plant assets 17,000 Interest expense 70,000 Net sales 2,200,000 Income tax expense 47,000 Other comprehensive income (net of $1,200 tax) 8,300

Compute missing amounts and calculate profi tability ratios.

(LO 4, 6), AP

Prepare multiple-step income statement and calculate profi tability ratios.

(LO 4, 6), AP

Prepare multiple-step income statement and calculate profi tability ratios.

(LO 4, 6), AP

Prepare an income statement and comprehensive income statement.

(LO 4), AP

Exercises 253

Instructions (a) Prepare an income statement. (b) Prepare a comprehensive income statement.

E5-11 The following selected accounts from the Blue Door Corporation’s general ledger are presented below for the year ended December 31, 2017:

Advertising expense $ 55,000 Interest revenue $ 30,000 Common stock 250,000 Inventory 67,000 Cost of goods sold 1,085,000 Rent revenue 24,000 Depreciation expense 125,000 Retained earnings 535,000 Dividends 150,000 Salaries and wages expense 675,000 Freight-out 25,000 Sales discounts 8,500 Income tax expense 70,000 Sales returns and Insurance expense 15,000 allowances 41,000 Interest expense 70,000 Sales revenue 2,400,000

Instructions Prepare a multiple-step income statement.

E5-12 The trial balance of Mendez Company at the end of its fiscal year, August 31, 2017, includes these accounts: Beginning Inventory $18,700, Purchases $154,000, Sales Revenue $190,000, Freight-In $8,000, Sales Returns and Allowances $3,000, Freight-Out $1,000, and Purchase Returns and Allowances $5,000. The ending inventory is $21,000.

Instructions Prepare a cost of goods sold section (periodic system) for the year ending August 31, 2017.

E5-13 Below is a series of cost of goods sold sections for companies B, M, O, and S.

B M O S

Beginning inventory $ 250 $ 120 $ 700 $ (j) Purchases 1,500 1,080 (g) 43,590 Purchase returns and allowances 80 (d) 290 (k) Net purchases (a) 1,040 7,410 42,290 Freight-in 130 (e) (h) 2,240 Cost of goods purchased (b) 1,230 8,050 (l) Cost of goods available for sale 1,800 1,350 (i) 49,530 Ending inventory 310 (f) 1,150 6,230 Cost of goods sold (c) 1,230 7,600 43,300

Instructions Fill in the lettered blanks to complete the cost of goods sold sections.

E5-14 Dorsett Corporation reported sales revenue of $257,000, net income of $45,300, cash of $9,300, and net cash provided by operating activities of $23,200. Accounts receivable have increased at three times the rate of sales during the last 3 years.

Instructions (a) Explain what is meant by high quality of earnings. (b) Evaluate the quality of the company’s earnings. Discuss your fi ndings. (c) What factors might have contributed to the company’s quality of earnings?

*E5-15 This information relates to Alfie Co. 1. On April 5, purchased merchandise from Bach Company for $27,000, terms 2/10,

n/30. 2. On April 6, paid freight costs of $1,200 on merchandise purchased from Bach

Company. 3. On April 7, purchased equipment on account for $30,000. 4. On April 8, returned some of the April 5 merchandise to Bach Company, which cost

$3,600. 5. On April 15, paid the amount due to Bach Company in full.

Prepare a multiple-step income statement.

(LO 4), AP

Prepare cost of goods sold section using periodic system.

(LO 5), AP

Prepare cost of goods sold section using periodic system.

(LO 5), AP

Evaluate quality of earnings.

(LO 6), C

Journalize purchase transactions.

(LO 7), AP

254 5 Merchandising Operations and the Multiple-Step Income Statement

Instructions (a) Prepare the journal entries to record these transactions on the books of Alfi e Co. using

a periodic inventory system. (b) Assume that Alfi e Co. paid the balance due to Bach Company on May 4 instead of

April 15. Prepare the journal entry to record this payment.

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P5-1A Winters Hardware Store completed the following merchandising transactions in the month of May. At the beginning of May, Winters’ ledger showed Cash of $8,000 and Common Stock of $8,000.

May 1 Purchased merchandise on account from Black Wholesale Supply for $8,000, terms 1/10, n/30.

2 Sold merchandise on account for $4,400, terms 2/10, n/30. The cost of the mer- chandise sold was $3,300.

5 Received credit from Black Wholesale Supply for merchandise returned $200. 9 Received collections in full, less discounts, from customers billed on May 2. 10 Paid Black Wholesale Supply in full, less discount. 11 Purchased supplies for cash $900. 12 Purchased merchandise for cash $3,100. 15 Received $230 refund for return of poor-quality merchandise from supplier on

cash purchase. 17 Purchased merchandise from Wilhelm Distributors for $2,500, terms 2/10, n/30. 19 Paid freight on May 17 purchase $250. 24 Sold merchandise for cash $5,500. The cost of the merchandise sold was $4,100. 25 Purchased merchandise from Clasps Inc. for $800, terms 3/10, n/30. 27 Paid Wilhelm Distributors in full, less discount. 29 Made refunds to cash customers for returned merchandise $124. The returned

merchandise had cost $90. 31 Sold merchandise on account for $1,280, terms n/30. The cost of the merchan-

dise sold was $830.

Winters Hardware’s chart of accounts includes Cash, Accounts Receivable, Inventory, Supplies, Accounts Payable, Common Stock, Sales Revenue, Sales Returns and Allowances, Sales Discounts, and Cost of Goods Sold.

Instructions (a) Journalize the transactions using a perpetual inventory system. (b) Post the transactions to T-accounts. Be sure to enter the beginning cash and common

stock balances. (c) Prepare an income statement through gross profi t for the month of May 2017. (d) Calculate the profi t margin and the gross profi t rate. (Assume operating expenses were

$1,400.)

P5-2A Powell Warehouse distributes hardback books to retail stores and extends credit terms of 2/10, n/30 to all of its customers. During the month of June, the following mer- chandising transactions occurred.

June 1 Purchased books on account for $1,040 (including freight) from Catlin Publishers, terms 2/10, n/30.

3 Sold books on account to Garfunkel Bookstore for $1,200. The cost of the merchandise sold was $720.

6 Received $40 credit for books returned to Catlin Publishers. 9 Paid Catlin Publishers in full. 15 Received payment in full from Garfunkel Bookstore. 17 Sold books on account to Bell Tower for $1,200. The cost of the merchandise

sold was $730.

Journalize, post, and prepare partial income statement, and calculate ratios.

(LO 2, 3, 4, 6), AP

Journalize purchase and sale transactions under a perpetual system.

(LO 2, 3), AP

PROBLEMS: SET A▼

Problems: Set A 255

20 Purchased books on account for $720 from Priceless Book Publishers, terms 1/15, n/30.

24 Received payment in full from Bell Tower. 26 Paid Priceless Book Publishers in full. 28 Sold books on account to General Bookstore for $1,300. The cost of the

merchandise sold was $780. 30 Granted General Bookstore $130 credit for books returned costing $80.

Instructions Journalize the transactions for the month of June for Powell Warehouse, using a perpetual inventory system.

P5-3A At the beginning of the current season on April 1, the ledger of Granite Hills Pro Shop showed Cash $2,500, Inventory $3,500, and Common Stock $6,000. The following transactions were completed during April 2017.

Apr. 5 Purchased golf bags, clubs, and balls on account from Arnie Co. $1,500, terms 3/10, n/60.

7 Paid freight on Arnie purchase $80. 9 Received credit from Arnie Co. for merchandise returned $200. 10 Sold merchandise on account to members $1,340, terms n/30. The merchandise

sold had a cost of $820. 12 Purchased golf shoes, sweaters, and other accessories on account from Woods

dise sold was $550. 21 Paid Woods Sportswear in full. 27 Granted an allowance to members for clothing that did not fi t properly $80. 30 Received payments on account from members $1,220.

The chart of accounts for the pro shop includes Cash, Accounts Receivable, Inventory, Accounts Payable, Common Stock, Sales Revenue, Sales Returns and Allowances, and Cost of Goods Sold.

Instructions (a) Journalize the April transactions using a perpetual inventory system. (b) Using T-accounts, enter the beginning balances in the ledger accounts and post the

April transactions. (c) Prepare a trial balance on April 30, 2017. (d) Prepare an income statement through gross profi t for the month of April 2017.

P5-4A Wolford Department Store is located in midtown Metropolis. During the past several years, net income has been declining because suburban shopping centers have been attracting business away from city areas. At the end of the company’s fi scal year on November 30, 2017, these accounts appeared in its adjusted trial balance.

Accounts Payable $ 26,800 Accounts Receivable 17,200 Accumulated Depreciation—Equipment 68,000 Cash 8,000 Common Stock 35,000 Cost of Goods Sold 614,300 Freight-Out 6,200 Equipment 157,000 Depreciation Expense 13,500 Dividends 12,000 Gain on Disposal of Plant Assets 2,000 Income Tax Expense 10,000 Insurance Expense 9,000 Interest Expense 5,000 Inventory 26,200 Notes Payable 43,500 Prepaid Insurance 6,000

Journalize, post, and prepare trial balance and partial income statement.

(LO 2, 3, 4), AP

Prepare fi nancial statements and calculate profi tability ratios.

(LO 4, 6), AP

256 5 Merchandising Operations and the Multiple-Step Income Statement

Advertising Expense $ 33,500 Rent Expense 34,000 Retained Earnings 14,200 Salaries and Wages Expense 117,000 Salaries and Wages Payable 6,000 Sales Returns and Allowances 20,000 Sales Revenue 904,000 Utilities Expense 10,600

Additional data: Notes payable are due in 2021.

Instructions (a) Prepare a multiple-step income statement, a retained earnings statement, and a clas-

sifi ed balance sheet. (b) Calculate the profi t margin and the gross profi t rate. (c) The vice president of marketing and the director of human resources have devel-

oped a proposal whereby the company would compensate the sales force on a strictly commission basis. Given the increased incentive, they expect net sales to increase by 15%. As a result, they estimate that gross profi t will increase by $40,443 and expenses by $58,600. Compute the expected new net income. (Hint: You do not need to prepare an income statement.) Then, compute the revised profi t margin and gross profi t rate. Comment on the effect that this plan would have on net income and on the ratios, and evaluate the merit of this proposal. (Ignore income tax effects.)

P5-5A An inexperienced accountant prepared this condensed income statement for Simon Company, a retail fi rm that has been in business for a number of years.

SIMON COMPANY Income Statement

For the Year Ended December 31, 2017

Revenues Net sales $850,000 Other revenues 22,000

872,000 Cost of goods sold 555,000

Gross profi t 317,000 Operating expenses Selling expenses 109,000 Administrative expenses 103,000

212,000

Net earnings $105,000

As an experienced, knowledgeable accountant, you review the statement and determine the following facts.

1. Net sales consist of sales $911,000, less freight-out on merchandise sold $33,000, and sales returns and allowances $28,000.

2. Other revenues consist of sales discounts $18,000 and rent revenue $4,000. 3. Selling expenses consist of salespersons’ salaries $80,000, depreciation on equipment

$10,000, advertising $13,000, and sales commissions $6,000. The commissions rep- resent commissions paid. At December 31, $3,000 of commissions have been earned by salespersons but have not been paid. All compensation should be recorded as Sal- aries and Wages Expense.

4. Administrative expenses consist of office salaries $47,000, dividends $18,000, utilities $12,000, interest expense $2,000, and rent expense $24,000, which includes prepayments totaling $6,000 for the first quarter of 2018.

Instructions Prepare a correct detailed multiple-step income statement. Assume a 25% tax rate.

P5-6A The trial balance of People’s Choice Wholesale Company contained the following accounts shown at December 31, the end of the company’s fi scal year.

(a) Net income $ 32,900 Tot. assets $146,400

Prepare a correct multiple-step income statement.

(LO 4), AP

Net income $67,500 Journalize, post, and prepare adjusted trial balance and fi nancial statements.

(LO 4), AP

Problems: Set A 257

PEOPLE’S CHOICE WHOLESALE COMPANY Trial Balance

December 31, 2017 Debit Credit

Cash $ 31,400 Accounts Receivable 37,600 Inventory 70,000 Land 92,000 Buildings 200,000 Accumulated Depreciation—Buildings $ 60,000 Equipment 83,500 Accumulated Depreciation—Equipment 40,500 Notes Payable 54,700 Accounts Payable 17,500 Common Stock 160,000 Retained Earnings 67,200 Dividends 10,000 Sales Revenue 922,100 Sales Discounts 6,000 Cost of Goods Sold 709,900 Salaries and Wages Expense 51,300 Utilities Expense 11,400 Maintenance and Repairs Expense 8,900 Advertising Expense 5,200 Insurance Expense 4,800

$1,322,000 $1,322,000

Adjustment data:

1. Depreciation is $8,000 on buildings and $7,000 on equipment. (Both are operating expenses.)

2. Interest of $4,500 is due and unpaid on notes payable at December 31. 3. Income tax due and unpaid at December 31 is $24,000.

Other data: $15,000 of the notes payable are payable next year.

Instructions (a) Journalize the adjusting entries. (b) Create T-accounts for all accounts used in part (a). Enter the trial balance amounts

into the T-accounts and post the adjusting entries. (c) Prepare an adjusted trial balance. (d) Prepare a multiple-step income statement and a retained earnings statement for the

year, and a classifi ed balance sheet at December 31, 2017.

P5-7A At the end of Oates Department Store’s fi scal year on November 30, 2017, these accounts appeared in its adjusted trial balance.

Freight-In $ 5,060 Inventory (beginning) 41,300 Purchases 613,000 Purchase Discounts 7,000 Purchase Returns and Allowances 6,760 Sales Revenue 902,000 Sales Returns and Allowances 20,000

Additional facts:

1. Inventory on November 30, 2017, is $36,200. 2. Note that Oates Department Store uses a periodic system.

Instructions Prepare an income statement through gross profit for the year ended November 30, 2017.

P5-8A Zhou Inc. operates a retail operation that purchases and sells snowmobiles, among other outdoor products. The company purchases all inventory on credit and uses a peri- odic inventory system. The Accounts Payable account is used for recording inventory pur- chases only; all other current liabilities are accrued in separate accounts. You are provided with the following selected information for the fi scal years 2015 through 2018, inclusive.

Determine cost of goods sold and gross profi t under a periodic system.

(LO 4, 5), AP

Gross profi t $272,600

Calculate missing amounts and assess profi tability.

(LO 4, 5, 6), AN

258 5 Merchandising Operations and the Multiple-Step Income Statement

2015 2016 2017 2018

Income Statement Data Sales revenue $96,890 $ (e) $82,220 Cost of goods sold (a) 28,060 26,490

Gross profi t 67,800 59,620 (i) Operating expenses 63,640 (f) 52,870

Net income $ (b) $ 3,510 $ (j)

Balance Sheet Data Inventory $13,000 $ (c) $14,700 $ (k) Accounts payable 5,800 6,500 4,600 (l)

Additional Information Purchases of inventory on account $25,890 $ (g) $24,050 Cash payments to suppliers (d) (h) 24,650

Instructions (a) Calculate the missing amounts. (b) The vice presidents of sales, marketing, production, and fi nance are discussing the

company’s results with the CEO. They note that sales declined over the 3-year fi scal period, 2016−2018. Does that mean that profi tability necessarily also declined? Explain, computing the gross profi t rate and the profi t margin for each fi scal year to help support your answer.

*P5-9A At the beginning of the current season on April 1, the ledger of Granite Hills Pro Shop showed Cash $2,500, Inventory $3,500, and Common Stock $6,000. The following transactions occurred during April 2017.

Apr. 5 Purchased golf bags, clubs, and balls on account from Arnie Co. $1,500, terms 3/10, n/60.

7 Paid freight on Arnie Co. purchases $80. 9 Received credit from Arnie Co. for merchandise returned $200. 10 Sold merchandise on account to members $1,340, terms n/30. 12 Purchased golf shoes, sweaters, and other accessories on account from Woods

Sportswear $830, terms 1/10, n/30. 14 Paid Arnie Co. in full. 17 Received credit from Woods Sportswear for merchandise returned $30. 20 Made sales on account to members $810, terms n/30. 21 Paid Woods Sportswear in full. 27 Granted credit to members for clothing that did not fi t properly $80. 30 Received payments on account from members $1,220.

The chart of accounts for the pro shop includes Cash, Accounts Receivable, Inventory, Accounts Payable, Common Stock, Sales Revenue, Sales Returns and Allowances, Pur- chases, Purchase Returns and Allowances, Purchase Discounts, and Freight-In.

Instructions (a) Journalize the April transactions using a periodic inventory system. (b) Using T-accounts, enter the beginning balances in the ledger accounts and post the

April transactions. (c) Prepare a trial balance on April 30, 2017. (d) Prepare an income statement through gross profi t, assuming inventory on hand at

April 30 is $4,263.

Journalize, post, and prepare trial balance and partial income statement under a periodic system.

(LO 5, 7), AP

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

Comprehensive Accounting Cycle Review 259

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 4.)

CC5 Because Natalie has had such a successful fi rst few months, she is considering other opportunities to develop her business. One opportunity is to become the exclusive distrib- utor of a line of fi ne European mixers. Natalie comes to you for advice on how to account for these mixers.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to see the completion of this problem.

CONTINUING PROBLEM Cookie Creations▼

COMPREHENSIVE ACCOUNTING CYCLE REVIEW ACR5-1 On December 1, 2017, Devine Distributing Company had the following account balances.

Debit Credit

Cash $ 7,200 Accumulated Depreciation— Accounts Receivable 4,600 Equipment $ 2,200 Inventory 12,000 Accounts Payable 4,500 Supplies 1,200 Salaries and Wages Payable 1,000 Equipment 22,000 Common Stock 15,000 $47,000 Retained Earnings 24,300

$47,000

During December, the company completed the following summary transactions.

Dec. 6 Paid $1,600 for salaries due employees, of which $600 is for December and $1,000 is for November salaries payable.

8 Received $1,900 cash from customers in payment of account (no discount allowed).

10 Sold merchandise for cash $6,300. The cost of the merchandise sold was $4,100. 13 Purchased merchandise on account from Hecht Co. $9,000, terms 2/10, n/30. 15 Purchased supplies for cash $2,000. 18 Sold merchandise on account $12,000, terms 3/10, n/30. The cost of the mer-

chandise sold was $8,000. 20 Paid salaries $1,800. 23 Paid Hecht Co. in full, less discount. 27 Received collections in full, less discounts, from customers billed on

December 18.

Adjustment data:

1. Accrued salaries payable $800. 2. Depreciation $200 per month. 3. Supplies on hand $1,500. 4. Income tax due and unpaid at December 31 is $200.

Instructions (a) Journalize the December transactions using a perpetual inventory system. (b) Enter the December 1 balances in the ledger T-accounts and post the December trans-

actions. Use Cost of Goods Sold, Depreciation Expense, Salaries and Wages Expense, Sales Revenue, Sales Discounts, Supplies Expense, Income Tax Expense, and Income Taxes Payable.

(c) Journalize and post adjusting entries. (d) Prepare an adjusted trial balance. (e) Prepare an income statement and a retained earnings statement for December and a

classifi ed balance sheet at December 31.

ACR5-2 On November 1, 2017, IKonk, Inc. had the following account balances. The com- pany uses the perpetual inventory method.

(d) Totals $65,500 (e) Net income $540

260 5 Merchandising Operations and the Multiple-Step Income Statement

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT5-1 The fi nancial statements for Apple Inc. appear in Appendix A at the end of this textbook.

Instructions Answer these questions using the Consolidated Income Statement.

(a) What was the percentage change in total revenue and in net income from 2013 to 2014? (b) What was the profi t margin in each of the 3 years? (Use “Total Revenue.”) Comment

on the trend. (c) What was Apple’s gross profi t rate in each of the 3 years? (Use “Net Sales” amounts.)

Comment on the trend.

Financial Reporting

▼

Debit Credit

Cash $ 9,000 Accumulated Depreciation— Accounts Receivable 2,240 Equipment $ 1,000 Supplies 860 Accounts Payable 3,400 Equipment 25,000 Unearned Service Revenue 4,000 $37,100 Salaries and Wages Payable 1,700 Common Stock 20,000 Retained Earnings 7,000

$37,100

During November, the following summary transactions were completed.

Nov. 8 Paid $3,550 for salaries due employees, of which $1,850 is for November and $1,700 is for October.

10 Received $1,900 cash from customers in payment of account. 11 Purchased merchandise on account from Dimas Discount Supply for $8,000,

terms 2/10, n/30. 12 Sold merchandise on account for $5,500, terms 2/10, n/30. The cost of the mer-

chandise sold was $4,000. 15 Received credit from Dimas Discount Supply for merchandise returned $300. 19 Received collections in full, less discounts, from customers billed on sales of

$5,500 on November 12. 20 Paid Dimas Discount Supply in full, less discount. 22 Received $2,300 cash for services performed in November. 25 Purchased equipment on account $5,000. 27 Purchased supplies on account $1,700. 28 Paid creditors $3,000 of accounts payable due. 29 Paid November rent $375. 29 Paid salaries $1,300. 29 Performed services on account and billed customers $700 for those services. 29 Received $675 from customers for services to be performed in the future.

Adjustment data:

1. Supplies on hand are valued at $1,600. 2. Accrued salaries payable are $500. 3. Depreciation for the month is $250. 4. $650 of services related to the unearned service revenue has not been performed by

month-end.

Instructions (a) Enter the November 1 balances in ledger T-accounts. (b) Journalize the November transactions. (c) Post to the ledger accounts. You will need to add some accounts. (d) Journalize and post adjusting entries. (e) Prepare an adjusted trial balance at November 30. (f) Prepare a multiple-step income statement and a retained earnings statement for

November and a classifi ed balance sheet at November 30. (g) Journalize and post closing entries.

Expand Your Critical Thinking 261

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT5-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information contained in these fi nancial statements, determine the fol-

lowing values for each company. (1) Profit margin for 2014. (For VF, use “Total Revenues.”) (2) Gross profit for 2014. (3) Gross profit rate for 2014. (4) Operating income for 2014. (5) Percentage change in operating Income from 2014 to 2013. (For Columbia, use

Income from operations.) (b) What conclusions concerning the relative profi tability of the two companies can be

drawn from these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT5-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Finan- cial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information contained in these fi nancial statements, determine the

following values for each company. (1) Profit margin for 2014. (For Amazon, use “Total net sales.”) (2) Gross profit for 2014. (3) Gross profit rate for 2014. (4) Operating income for 2014. (5) Percentage change in operating income from 2014 to 2013. (b) What conclusions concerning the relative profitability of the two companies can be

drawn from these data?

INTERPRETING FINANCIAL STATEMENTS

CT5-4 Recently, it was announced that two giant French retailers, Carrefour SA and Promodes SA, would merge. A headline in the Wall Street Journal blared, “French Retailers Create New Wal-Mart Rival.” While Wal-Mart’s total sales would still exceed those of the combined company, Wal-Mart’s international sales are far less than those of the combined company. This is a serious concern for Wal-Mart, since its primary opportunity for future growth lies outside of the United States. Below are basic fi nancial data for the combined corporation (in euros) and Wal-Mart (in U.S. dollars). Even though their results are presented in different currencies, by em- ploying ratios we can make some basic comparisons.

Carrefour Wal-Mart (in millions) (in millions)

Sales revenue €70,486 $256,329 Cost of goods sold 54,630 198,747 Net income 1,738 9,054 Total assets 39,063 104,912 Current assets 14,521 34,421 Current liabilities 13,660 37,418 Total liabilities 29,434 61,289

Instructions Compare the two companies by answering the following.

(a) Calculate the gross profi t rate for each of the companies, and discuss their relative abilities to control cost of goods sold.

(b) Calculate the profi t margin, and discuss the companies’ relative profi tability. (c) Calculate the current ratio and debt to assets ratio for each of the two companies, and

discuss their relative liquidity and solvency. (d) What concerns might you have in relying on this comparison?

Financial Analysis

▼

Financial Analysis

▼

262 5 Merchandising Operations and the Multiple-Step Income Statement

REAL-WORLD FOCUS

CT5-5 Purpose: No fi nancial decision-maker should ever rely solely on the fi nancial information reported in the annual report to make decisions. It is important to keep abreast of fi nancial news. This activity demonstrates how to search for fi nancial news on the Internet.

Address: http://biz.yahoo.com/i, or go to www.wiley.com/college/kimmel

Steps 1. Type in either Wal-Mart, Target Corp., or Kmart. 2. Choose News. 3. Select an article that sounds interesting to you and that would be relevant to an inves-

tor in these companies.

Instructions (a) What was the source of the article (e.g., Reuters, Businesswire, Prnewswire)? (b) Assume that you are a personal fi nancial planner and that one of your clients owns

stock in the company. Write a brief memo to your client summarizing the article and explaining the implications of the article for their investment.

DECISION-MAKING ACROSS THE ORGANIZATION

CT5-6 Three years ago, Karen Suez and her brother-in-law Reece Jones opened Gigasales Department Store. For the fi rst 2 years, business was good, but the following condensed income statement results for 2017 were disappointing.

GIGASALES DEPARTMENT STORE Income Statement

For the Year Ended December 31, 2017

Net sales $700,000 Cost of goods sold 560,000

Gross profi t 140,000

Operating expenses Selling expenses $100,000 Administrative expenses 20,000

120,000

Net income $ 20,000

Karen believes the problem lies in the relatively low gross profi t rate of 20%. Reece believes the problem is that operating expenses are too high. Karen thinks the gross profi t rate can be improved by making two changes. (1) Increase average selling prices by 15%; this increase is expected to lower sales volume so that total sales dollars will increase only 4%. (2) Buy merchandise in larger quantities and take all purchase discounts. These changes to purchasing practices are expected to increase the gross profi t rate from its cur- rent rate of 20% to a new rate of 25%. Karen does not anticipate that these changes will have any effect on operating expenses. Reece thinks expenses can be cut by making these two changes. (1) Cut 2018 sales salaries of $60,000 in half and give sales personnel a commission of 2% of net sales. (2) Reduce store deliveries to one day per week rather than twice a week; this change will reduce 2018 delivery expenses of $40,000 by 40%. Reece feels that these changes will not have any effect on net sales. Karen and Reece come to you for help in deciding the best way to improve net income.

Instructions With the class divided into groups, answer the following.

(a) Prepare a condensed income statement for 2018 assuming (1) Karen’s changes are implemented and (2) Reece’s ideas are adopted.

(b) What is your recommendation to Karen and Reece? (c) Prepare a condensed income statement for 2018 assuming both sets of proposed

changes are made. (d) Discuss the impact that other factors might have. For example, would increasing the

quantity of inventory increase costs? Would a salary cut affect employee morale? Would decreased morale affect sales? Would decreased store deliveries decrease cus- tomer satisfaction? What other suggestions might be considered?

Financial Analysis

Writing

Group Project

▼

Expand Your Critical Thinking 263

COMMUNICATION ACTIVITY

CT5-7 The following situation is presented in chronological order.

1. Aikan decides to buy a surfboard. 2. He calls Surfi ng Hawaii Co. to inquire about their surfboards. 3. Two days later, he requests Surfi ng Hawaii Co. to make him a surfboard. 4. Three days later, Surfi ng Hawaii Co. sends him a purchase order to fi ll out. 5. He sends back the purchase order. 6. Surfi ng Hawaii Co. receives the completed purchase order. 7. Surfi ng Hawaii Co. completes the surfboard. 8. Aikan picks up the surfboard. 9. Surfi ng Hawaii Co. bills Aikan. 10. Surfi ng Hawaii Co. receives payment from Aikan.

Instructions In a memo to the president of Surfi ng Hawaii Co., answer the following questions.

(a) When should Surfi ng Hawaii Co. record the sale? (b) Suppose that with his purchase order, Aikan is required to make a down payment.

Would that change your answer to part (a)?

ETHICS CASE

CT5-8 Tabitha Andes was just hired as the assistant treasurer of Southside Stores, a specialty chain store company that has nine retail stores concentrated in one metro- politan area. Among other things, the payment of all invoices is centralized in one of the departments Tabitha will manage. Her primary responsibility is to maintain the company’s high credit rating by paying all bills when due and to take advantage of all cash discounts. Pete Wilson, the former assistant treasurer who has been promoted to treasurer, is training Tabitha in her new duties. He instructs Tabitha that she is to continue the prac- tice of preparing all checks “net of discount” and dating the checks the last day of the dis- count period. “But,” Pete continues, “we always hold the checks at least 4 days beyond the discount period before mailing them. That way we get another 4 days of interest on our money. Most of our creditors need our business and don’t complain. And, if they scream about our missing the discount period, we blame it on the mailroom or the post offi ce. We’ve only lost one discount out of every hundred we take that way. I think everybody does it. By the way, welcome to our team!”

Instructions (a) What are the ethical considerations in this case? (b) What stakeholders are harmed or benefi ted? (c) Should Tabitha continue the practice started by Pete? Does she have any choice?

ALL ABOUT YOU

CT5-9 There are many situations in business where it is difficult to determine the proper period in which to record revenue. Suppose that after graduation with a degree in finance, you take a job as a manager at a consumer electronics store called FarWest Electronics. The company has expanded rapidly in order to compete with Best Buy. FarWest has also begun selling gift cards. The cards are available in any dollar amount and allow the holder of the card to purchase an item for up to 2 years from the time the card is purchased. If the card is not used during those 2 years, it expires.

Instructions Answer the following questions.

At what point should the revenue from the gift cards be recognized? Should the revenue be recognized at the time the card is sold, or should it be recorded when the card is re- deemed? Explain the reasoning to support your answers.

FASB CODIFICATION ACTIVITY

CT5-10 If your school has a subscription to the FASB Codifi cation, go to http://aaahg.org/ ascLogin.cfm to log in and prepare responses to the following.

(a) Access the glossary (“Master Glossary”) to answer the following. (1) What is the defi nition provided for inventory? (2) What is a customer? (b) What guidance does the Codifi cation provide concerning reporting inventories above cost?

264 5 Merchandising Operations and the Multiple-Step Income Statement

A Look at IFRS

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

KEY POINTS Following are the key similarities and differences between GAAP and IFRS related to inventories.

Similarities • Under both GAAP and IFRS, a company can choose to use either a perpetual or a periodic

inventory system. • The definition of inventories is basically the same under GAAP and IFRS. • As indicated above, the basic accounting entries for merchandising are the same under

both GAAP and IFRS. • Both GAAP and IFRS require that income statement information be presented for

multiple years. For example, IFRS requires that 2 years of income statement informa- tion be presented, whereas GAAP requires 3 years.

Differences • Under GAAP, companies generally classify income statement items by function. Classi-

fication by function leads to descriptions like administration, distribution, and manu- facturing. Under IFRS, companies must classify expenses either by nature or by function. Classification by nature leads to descriptions such as the following: salaries, depreciation expense, and utilities expense. If a company uses the functional-expense method on the income statement, disclosure by nature is required in the notes to the financial statements.

• Presentation of the income statement under GAAP follows either a single-step or multiple-step format. IFRS does not mention a single-step or multiple-step approach.

• Under IFRS, revaluation of land, buildings, and intangible assets is permitted. The initial gains and losses resulting from this revaluation are reported as adjustments to equity, often referred to as other comprehensive income. The effect of this difference is that the use of IFRS result in more transactions affecting equity (other comprehen- sive income) but not net income.

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

LEARNING OBJECTIVE 8 Compare the accounting for merchandising under GAAP and IFRS.▼

A Look at IFRS 265

presented both by function and by nature. The new financial statement format was heav- ily influenced by suggestions from financial statement analysts.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. Which of the following would not be included in the definition of inventory under

IFRS? (a) Photocopy paper held for sale by an office-supply store. (b) Stereo equipment held for sale by an electronics store. (c) Used office equipment held for sale by the human relations department of a

plastics company. (d) All of the above would meet the definition.

2. Which of the following would not be a line item of a company reporting costs by nature? (a) Depreciation expense. (c) Interest expense. (b) Salaries expense. (d) Manufacturing expense.

3. Which of the following would not be a line item of a company reporting costs by function? (a) Administration. (c) Utilities expense. (b) Manufacturing. (d) Distribution.

4. Which of the following statements is false? (a) IFRS specifically requires use of a multiple-step income statement. (b) Under IFRS, companies can use either a perpetual or periodic system. (c) The proposed new format for financial statements was heavily influenced by the

suggestions of financial statement analysts. (d) The new income statement format will try to de-emphasize the focus on the “net

income” line item.

IFRS EXERCISES IFRS5-1 Explain the difference between the “nature-of-expense” and “function-of- expense” classifications.

IFRS5-2 For each of the following income statement line items, state whether the item is a “by nature” expense item or a “by function” expense item.

________ Cost of goods sold. ________ Utilities expense. ________ Depreciation expense. ________ Delivery expense. ________ Salaries and wages expense. ________ General and administrative expenses. ________ Selling expenses.

IFRS5-3 Matilda Company reported the following amounts (in euros) in 2017: Net income, €150,000; Unrealized gain related to revaluation of buildings, €10,000; and Unre- alized loss on non-trading securities, €(35,000). Determine Matilda’s total comprehensive income for 2017.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS5-4 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Use Louis Vuitton’s annual report to answer the following questions.

(a) Does Louis Vuitton use a multiple-step or a single-step income statement format? Explain how you made your determination.

(b) Instead of “interest expense,” what label does Louis Vuitton use for interest costs that it incurs?

(c) Using the notes to the company’s financial statements, determine the following: (1) Composition of the inventory. (2) Amount of inventory (gross) before impairment.

Answers to IFRS Self-Test Questions 1. c 2. d 3. c 4. a

Reporting and Analyzing Inventory 6 In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual

inventory system. In this chapter, we explain the methods used to calculate the cost of inventory on

hand at the balance sheet date and the cost of goods sold. We conclude by illustrating methods for

analyzing inventory.

CHAPTER PREVIEW

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

• Classifying inventory • Determining inventory

quantities▼1 Discuss how to classify and determine inventory.

DO IT!

1 Rules of Ownership

▼

Explain the statement presentation and analysis of inventory.

• Presentation • Lower-of-cost-or-market • Analysis • Adjustments for LIFO reserve

DO IT!

3 3a LCM Basis3b Inventory Turnover

▼2

Apply inventory cost fl ow methods and discuss their fi nancial effects.

• Specifi c identifi cation • Cost fl ow assumptions • Financial statement and tax

effects • Using inventory cost fl ow

methods consistently

DO IT!

2 Cost Flow Methods

Let’s talk inventory—big, bulldozer-size inventory. Caterpillar Inc. is the world’s largest manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. It sells its products in over 200 countries, making it one of the most successful U.S. exporters.

In the past, Caterpillar’s profi t- ability suffered, but today it is very successful. A big part of this turnaround can be attrib- uted to effective management of its inventory. Imagine what it costs Caterpillar to have too many bulldozers sitting around in inventory—a situation the company defi nitely wants to avoid. Yet, Caterpillar must also make sure it has enough inventory to meet demand.

At one time during a 7-year period, Caterpillar’s sales increased by 100%, while its inventory increased by only 50%. To achieve this dramatic reduction in the amount of resources tied up in inventory, while continuing to meet customers’ needs, Caterpillar used a two-pronged approach. First, it completed a factory modernization program, which dramatically increased its production effi ciency. The program reduced by 60% the amount of inventory the company processed at any one time.

It also reduced by an incredible 75% the time it takes to manufacture a part.

Second, Caterpillar dramatically improved its parts distribution system. It ships more than

100,000 items daily from its 23 distribution centers strategically located around the world (10 million square feet of warehouse space— remember, we’re talking bulldozers). The company can virtually guarantee that it can get any part to anywhere in the world within 24 hours.

These changes led to record exports, profi ts, and revenues for Caterpillar. It would have seemed that things couldn’t have been better. But industry analysts, as well as the company’s managers, thought otherwise. In order to maintain Caterpillar’s position as the industry leader, management began another major overhaul of inventory production and inventory management processes. The goal: to cut the number of repairs in half, increase productivity by 20%, and increase inventory turnover by 40%.

In short, Caterpillar’s ability to manage its inventory has been a key reason for its past success and will very likely play a huge part in its future profi tability as well.

FEATURE STORY

“Where Is That Spare Bulldozer

Blade?”

James Porter/Workbook Stock/Getty Images, Inc.

268 6 Reporting and Analyzing Inventory

LEARNING OBJECTIVE 1 Discuss how to classify and determine inventory.▼

Two important steps in the reporting of inventory at the end of the accounting period are the classifi cation of inventory based on its degree of completeness and the determination of inventory amounts.

CLASSIFYING INVENTORY

How a company classifi es its inventory depends on whether the fi rm is a merchan- diser or a manufacturer. In a merchandising company, such as those described in Chapter 5, inventory consists of many different items. For example, in a gro- cery store, canned goods, dairy products, meats, and produce are just a few of the inventory items on hand. These items have two common characteristics: (1) they are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers need only one inventory classifi cation, merchandise inventory, to describe the many different items that make up the total inventory. In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: fi n- ished goods, work in process, and raw materials. Finished goods inventory is manufactured items that are completed and ready for sale. Work in process is that portion of manufactured inventory that has begun the production process but is not yet complete. Raw materials are the basic goods that will be used in production but have not yet been placed into production. For example, Caterpillar classifi es earth-moving tractors completed and ready for sale as fi nished goods. It classifi es the tractors on the assembly line in various stages of production as work in process. The steel, glass, tires, and other components that are on hand waiting to be used in the production of tractors are identifi ed as raw materials. Illustration 6-1 shows an excerpt from Note 7 of Caterpillar’s annual report.

▼ HELPFUL HINT Regardless of the classifi cation, companies report all inventories under Current Assets on the balance sheet.

ILLUSTRATION 6-1 Composition of Caterpillar’s inventory

December 31

(millions of dollars) 2014 2013 2012

Raw materials $ 2,986 $ 2,966 $ 3,573 Work-in-process 2,455 2,589 2,920 Finished goods 6,504 6,785 8,767 Other 260 285 287

Total inventories $12,205 $12,625 $15,547

By observing the levels and changes in the levels of these three inven- tory types, fi nancial statement users can gain insight into management’s production plans. For example, low levels of raw materials and high levels of fi nished goods suggest that management believes it has enough inven- tory on hand, and production will be slowing down—perhaps in anticipation of a recession. Conversely, high levels of raw materials and low levels of fi nished goods probably signal that management is planning to step up production. Many companies have signifi cantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, companies manufacture or purchase goods only when needed. Dell is famous for having developed a system for making computers in response to individual customer requests. Even though it makes computers to meet a customer’s particular speci- fi cations, Dell is able to assemble the computer and put it on a truck in less

Classifying and Determining Inventory 269

than 48 hours. The success of a JIT system depends on reliable suppliers. By integrating its information systems with those of its suppliers, Dell reduced its inventories to nearly zero. This is a huge advantage in an industry where prod- ucts become obsolete nearly overnight. The accounting concepts discussed in this chapter apply to the inventory classifi cations of both merchandising and manufacturing companies. Our focus throughout most of this chapter is on merchandise inventory. Additional issues specifi c to manufacturing companies are discussed in managerial accounting courses.

A Big Hiccup

JIT can save a company a lot of money, but it isn’t without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese auto- makers experienced just such a disruption when a 6.8-magnitude earthquake caused major dam- age to the company that pro- duces 50% of their piston rings. The rings themselves cost only $1.50, but you cannot make a car without them. As a result, the automakers were forced to shut

down production for a few days—a loss of tens of thousands of cars. Similarly, a major snowstorm halted production at the Canadian plants of Ford. A Ford spokesperson said, “Because the plants run with just-in-time inventory, we don’t have large stockpiles of parts sitting around. When you have a somewhat signifi cant disruption, you can pretty quickly run out of parts.”

Sources: Amy Chozick, “A Key Strategy of Japan’s Car Makers Backfi res,” Wall Street Journal (July 20, 2007); and Kate Linebaugh, “Canada Military Evacuates Motorists Stranded by Snow,” Wall Street Journal (December 15, 2010).

What steps might the companies take to avoid such a serious disruption in the future? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Ford

DETERMINING INVENTORY QUANTITIES

No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory for the following reasons. The fi rst is to check the accuracy of their perpetual inventory records. The second is to determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Companies using a periodic inventory system must take a physical inventory for two different purposes: to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period. Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.

Taking a Physical Inventory Companies take the physical inventory at the end of the accounting period. Taking a physical inventory involves actually counting, weighing, or measur- ing each kind of inventory on hand. In many companies, taking an inventory is a formidable task. Retailers such as Target, True Value Hardware, or Home Depot have thousands of different inventory items. An inventory count is gener- ally more accurate when a limited number of goods are being sold or received during the counting. Consequently, companies often “take inventory” when the business is closed or when business is slow. Many retailers close early on a cho- sen day in January—after the holiday sales and returns, when inventories are at their lowest level—to count inventory. Wal-Mart, for example, has a year-end of January 31.

ETHICS NOTE In a famous fraud, a salad oil company fi lled its storage tanks mostly with water. The oil rose to the top, so auditors thought the tanks were full of oil. The company also said it had more tanks than it really did: it repainted numbers on the tanks to confuse auditors.

▼

270 6 Reporting and Analyzing Inventory

Determining Ownership of Goods One challenge in determining inventory quantities is making sure a company owns the inventory. To determine ownership of goods, two questions must be answered: Do all of the goods included in the count belong to the company? Does the company own any goods that were not included in the count?

GOODS IN TRANSIT A complication in determining ownership is goods in transit (on board a truck, train, ship, or plane) at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count, the com- pany must determine ownership of these goods. Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale, as shown in Illustration 6-2 and described below.

Falsifying Inventory to Boost Income Managers at women’s apparel maker Leslie Fay were convicted of falsifying inventory records to boost net income in an attempt to increase manage- ment bonuses. In another case, executives at Craig Consumer Electronics were accused of de- frauding lenders by manipulating

inventory records. The indictment said the company classifi ed “defective goods as new or refurbished” and claimed that it owned certain shipments “from overseas suppliers” when, in fact, Craig either did not own the shipments or the shipments did not exist.

What effect does an overstatement of inventory have on a company’s fi nancial statements? (Go to WileyPLUS for this answer and additional questions.)

ETHICS INSIGHT Leslie Fay

ILLUSTRATION 6-2 Terms of sale

Ownership passes to

buyer here

Seller Seller

Ownership passes to

buyer here

FOB Shipping Point Buyer pays freight costs

FOB Destination Seller pays freight costs

Buyer Buyer

Public Carrier Co.

1. When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

2. When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.

CONSIGNED GOODS In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods. For example, you might have a used car that you would like to sell. If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold. Under this agreement, the dealer would not take ownership of the car, which would still belong to you. If an inventory count were taken, the car would not be included in the dealer’s inventory because the dealer does not own it.

Inventory Methods and Financial Effects 271

Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell. Today, even some manufacturers are making consignment agreements with their suppliers in order to keep their inventory levels low.

Ted Nickerson, CEO of clock manufacturer Dally Industries, had expensive tastes. To support this habit, Ted took out large loans, which he collateralized with his shares of Dally Industries stock. If the price of Dally’s stock fell, he was required to provide the bank with more shares of stock. To achieve target net income fi gures and thus maintain the stock price, Ted coerced employees in the company to alter inventory fi gures. Inventory quantities were manipulated by changing the amounts on inventory control tags after the year-end physical inventory count. For example, if a tag said there were 20 units of a particular item, the tag was changed to 220. Similarly, the unit costs that were used to determine the value of ending i nventory were increased from, for example, $125 per unit to $1,250. Both of these fraudulent changes had the effect of increasing the amount of reported ending inventory. This reduced cost of goods sold and increased net income.

Total take: $245,000

THE MISSING CONTROL Independent internal verifi cation. The company should have spot-checked its inventory records periodically, verifying that the number of units in the records agreed with the amount on hand and that the unit costs agreed with vendor price sheets.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 502–509.

ANATOMY OF A FRAUD

1▼ Rules of OwnershipDO IT!

Action Plan ✔ Apply the rules of owner-

ship to goods held on consignment.

✔ Apply the rules of owner- ship to goods in transit.

SOLUTION The goods of $15,000 held on consignment should be deducted from the inventory count. The goods of $10,000 purchased FOB shipping point should be added to the inventory count. Item 3 was treated correctly. Sold goods of $12,000 which were in transit FOB ship- ping point should not be included in the ending inventory. Inventory should be $195,000 ($200,000 2 $15,000 1 $10,000).

Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. You have been given the information listed below. Discuss how this information affects the reported cost of inventory.

1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.

2. The company did not include in the count purchased goods of $10,000, which were in transit (terms: FOB shipping point).

3. The company did not include in the count inventory that had been sold with a cost of $12,000, which was in transit (terms: FOB shipping point).

Related exercise material: BE6-1, DO IT! 6-1, E6-1, E6-2, and E6-3.

Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are added to the cost of inventory, but the

Apply inventory cost fl ow methods and discuss their fi nancial effects.

LEARNING OBJECTIVE 2▼

272 6 Reporting and Analyzing Inventory

cost of shipping goods to a customer is a selling expense. After a company has determined the quantity of units of inventory, it applies unit costs to the quanti- ties to determine the total cost of the inventory and the cost of goods sold. This process can be complicated if a company has purchased inventory items at dif- ferent times and at different prices. For example, assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700, $750, and $800. During the year, Crivitz sold two TVs at $1,200 each. These facts are summarized in Illustration 6-3.

ILLUSTRATION 6-3 Data for inventory costing example

Purchases February 3 1 TV at $700 March 5 1 TV at $750 May 22 1 TV at $800 Sales June 1 2 TVs for $2,400 ($1,200 3 2)

Cost of goods sold will differ depending on which two TVs the company sold. For example, it might be $1,450 ($700 1 $750), or $1,500 ($700 1 $800), or $1,550 ($750 1 $800). In this section, we discuss alternative costing methods available to Crivitz.

SPECIFIC IDENTIFICATION

If Crivitz can positively identify which particular units it sold and which are still in ending inventory, it can use the specifi c identifi cation method of inventory costing. For example, if Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 1 $800), and its ending inven- tory is $750 (see Illustration 6-4). Using this method, companies can accurately determine ending inventory and cost of goods sold.

Cost of goods sold = $700 + $800 = $1,500 Ending inventory = $750

SOLD $800

SOLD $700

$750

Ending inventory

ILLUSTRATION 6-4 Specifi c identifi cation method

ETHICS NOTE A major disadvantage of the

specifi c identifi cation method is that management may be

able to manipulate net income. For example, it can boost

net income by selling units purchased at a low cost, or

reduce net income by selling units purchased at a high cost.

▼ Specifi c identifi cation requires that companies keep records of the original cost of each individual inventory item. Historically, specifi c identifi cation was possible only when a company sold a limited variety of high-unit-cost items that could be identifi ed clearly from the time of purchase through the time of sale. Examples of such products are cars, pianos, or expensive antiques. Today, with bar coding, electronic product codes, and radio frequency iden- tifi cation, it is theoretically possible to do specifi c identifi cation with nearly any type of product. The reality is, however, that this practice is still relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost fl ow assumptions, about which units were sold.

Inventory Methods and Financial Effects 273

COST FLOW ASSUMPTIONS

Because specifi c identifi cation is often impractical, other cost fl ow methods are permitted. These differ from specifi c identifi cation in that they assume fl ows of costs that may be unrelated to the actual physical fl ow of goods. There are three assumed cost fl ow methods:

1. First-in, fi rst-out (FIFO)

2. Last-in, fi rst-out (LIFO)

3. Average-cost

There is no accounting requirement that the cost fl ow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost fl ow method. To demonstrate the three cost fl ow methods, we will use a periodic inven- tory system. We assume a periodic system because very few companies use perpetual LIFO, FIFO, or average-cost to cost their inventory and related cost of goods sold. Instead, companies that use perpetual systems, as shown in Chap- ter 5, often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average-cost as shown in this chapter and adjust cost of goods sold to this recal- culated number.1

To illustrate the three inventory cost fl ow methods, we will use the data for Houston Electronics’ Astro condensers, shown in Illustration 6-5.

Houston Electronics had a total of 1,000 units available to sell during the period (beginning inventory plus purchases). The total cost of these 1,000 units is $12,000, referred to as cost of goods available for sale. A physical inventory taken at December 31 determined that there were 450 units in ending inventory. Therefore, Houston sold 550 units (1,000 2 450) during the period. To determine the cost of the 550 units that were sold (the cost of goods sold), we assign a cost

1Also, some companies use a perpetual system to keep track of units, but they do not make an entry for perpetual cost of goods sold. In addition, fi rms that employ LIFO tend to use dollar-value LIFO, a method discussed in upper-level courses. FIFO periodic and FIFO perpetual give the same result. Therefore, fi rms should not incur the additional cost to use FIFO perpetual. Few fi rms use perpetual average-cost because of the added cost of recordkeeping. Finally, for instructional purposes, we believe it is easier to demonstrate the cost fl ow assumptions under the periodic system, which makes it more pedagogically appropriate.

(Beginning Inventory 1 Purchases) 2 Ending Inventory 5 Cost of Goods Sold

From Chapter 5, the cost of goods sold formula in a periodic system is:

ILLUSTRATION 6-5 Data for Houston ElectronicsHOUSTON ELECTRONICS

Astro Condensers

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total units available for sale 1,000 $12,000 Units in ending inventory 450

Units sold 550

274 6 Reporting and Analyzing Inventory

to the ending inventory and subtract that value from the cost of goods available for sale. The value assigned to the ending inventory depends on which cost fl ow method we use. No matter which cost fl ow assumption we use, though, the sum of cost of goods sold plus the cost of the ending inventory must equal the cost of goods available for sale—in this case, $12,000.

First-In, First-Out (FIFO) The fi rst-in, fi rst-out (FIFO) method assumes that the earliest goods pur- chased are the fi rst to be sold. FIFO often parallels the actual physical fl ow of merchandise because it generally is good business practice to sell the oldest units fi rst. Under the FIFO method, therefore, the costs of the earliest goods purchased are the fi rst to be recognized in determining cost of goods sold, regardless of which units were actually sold. (Note that this does not mean that the oldest units are sold fi rst, but that the costs of the oldest units are recognized fi rst. In a bin of picture hangers at the hardware store, for example, no one really knows, nor would it matter, which hangers are sold fi rst.) Illustration 6-6 shows the alloca- tion of the cost of goods available for sale at Houston Electronics under FIFO.

ILLUSTRATION 6-6 Allocation of costs—FIFO method

▼ HELPFUL HINT Note the sequencing of the allocation: (1) compute ending inventory, and (2) determine cost of goods sold.

▼ HELPFUL HINT Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.

Under FIFO, since it is assumed that the fi rst goods purchased were the fi rst goods sold, ending inventory is based on the prices of the most recent units pur- chased. That is, under FIFO, companies determine the cost of the ending inven- tory by taking the unit cost of the most recent purchase and working back- ward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the most recent prices.

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total 1,000 $12,000

Cost of goods sold$1,000

$2,200

$5,200

$600

$3,000

$6,200

Ending inventory

$5,800 Warehous

Units Total Date Units Cost Cost

Nov. 27 400 $13 $ 5,200 Cost of goods available for sale $12,000 Aug. 24 50 12 600 Less: Ending inventory 5,800

Total 450 $5,800 Cost of goods sold $ 6,200

Inventory Methods and Financial Effects 275

The last purchase was 400 units at $13 on November 27. The remaining 50 units are priced using the unit cost of the second most recent purchase, $12, on August 24. Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale. Illustration 6-7 demonstrates that companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of the fi rst 550 units acquired. Note that of the 300 units purchased on August 24, only 250 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 50 of these units were assumed unsold and thus included in ending inventory.

ILLUSTRATION 6-8 Allocation of costs—LIFO method

▼ HELPFUL HINT Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—fi rst in still here.

ILLUSTRATION 6-7 Proof of cost of goods sold Date Units Unit Cost Total Cost

Jan. 1 100 $10 $ 1,000 Apr. 15 200 11 2,200 Aug. 24 250 12 3,000

Total 550 $6,200

Last-In, First-Out (LIFO) The last-in, fi rst-out (LIFO) method assumes that the latest goods purchased are the fi rst to be sold. LIFO seldom coincides with the actual physical fl ow of inventory. (Exceptions include goods stored in piles, such as coal or hay, where goods are removed from the top of the pile as they are sold.) Under the LIFO method, the costs of the latest goods purchased are the fi rst to be recognized in determining cost of goods sold. Illustration 6-8 shows the allocation of the cost of goods available for sale at Houston Electronics under LIFO.

ILLUSTRATION 6-8 Allocation of costs—LIFO method

▼ HELPFUL HINT Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—fi rst in still here.

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total 1,000 $12,000

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

Unit Total Date Units Cost Cost

Jan. 1 100 $10 $ 1,000 Cost of goods available for sale $12,000 Apr. 15 200 11 2,200 Less: Ending inventory 5,000 Aug. 24 150 12 1,800 Cost of goods sold $ 7,000 Total 450 $5,000

COST OF GOODS AVAILABLE FOR SALE

Cost of goods sold

$1,000

$2,200

$5,200

$1,800

$1,800 $7,000

Ending inventory

$5,000 Warehous

276 6 Reporting and Analyzing Inventory

Under LIFO, since it is assumed that the fi rst goods sold were those that were most recently purchased, ending inventory is based on the prices of the oldest units purchased. That is, under LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods avail- able for sale and working forward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the earliest prices. The fi rst purchase was 100 units at $10 in the January 1 beginning inventory. Then, 200 units were purchased at $11. The remaining 150 units needed are priced at $12 per unit (August 24 purchase). Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale. Illustration 6-9 demonstrates that we can also calculate cost of goods sold by pricing the 550 units sold using the prices of the last 550 units acquired. Note that of the 300 units purchased on August 24, only 150 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 150 of these units were assumed unsold and thus included in ending inventory.

ILLUSTRATION 6-9 Proof of cost of goods sold Date Units Unit Cost Total Cost

Nov. 27 400 $13 $ 5,200 Aug. 24 150 12 1,800

Total 550 $7,000

Under a periodic inventory system, which we are using here, all goods pur- chased during the period are assumed to be available for the fi rst sale, regardless of the date of purchase.

Average-Cost The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. Illustration 6-10 presents the formula and a sample computation of the weighted-average unit cost.

ILLUSTRATION 6-10 Formula for weighted-average unit cost

Cost of Goods Total Units Weighted- Available 4 Available 5 Average for Sale for Sale Unit Cost

$12,000 4 1,000 5 $12.00

The company then applies the weighted-average unit cost to the units on hand to determine the cost of the ending inventory. Illustration 6-11 shows the allocation of the cost of goods available for sale at Houston Electronics using average-cost.

Inventory Methods and Financial Effects 277

We can verify the cost of goods sold under this method by multiplying the units sold times the weighted-average unit cost (550 3 $12 5 $6,600). Note that this method does not use the simple average of the unit costs. The simple aver- age is $11.50 ($10 1 $11 1 $12 1 $13 5 $46; $46 4 4). The average-cost method instead uses the average weighted by the quantities purchased at each unit cost.

FINANCIAL STATEMENT AND TAX EFFECTS OF COST FLOW METHODS

Each of the three assumed cost fl ow methods is acceptable for use under GAAP. For example, Reebok International Ltd. and Wendy’s Interna- tional currently use the FIFO method of inventory costing. Campbell Soup Company, Krogers, and Walgreens use LIFO for part or all of their inventory. Bristol-Myers Squibb, Starbucks, and Motorola use the average-cost method. In fact, a company may also use more than one cost fl ow method at the same time. Stanley Black & Decker Manufacturing Company, for example, uses LIFO for domestic inventories and FIFO for foreign inventories. Illustration 6-12 (in the margin) shows the use of the three cost fl ow methods in 500 large U.S. companies. The reasons companies adopt different inventory cost fl ow methods are var- ied, but they usually involve at least one of the following three factors: (1) income statement effects, (2) balance sheet effects, or (3) tax effects.

Income Statement Effects To understand why companies might choose a particular cost fl ow method, let’s examine the effects of the different cost fl ow assumptions on the fi nancial

ILLUSTRATION 6-11 Allocation of costs—average- cost method

DECISION TOOLS

Analyzing fi nancial statement and tax effects helps users determine which inventory costing method best meets the company’s objectives.

24% LIFO

45% FIFO

16% Average-

Cost

15% Other

ILLUSTRATION 6-12 Use of cost fl ow methods in major U.S. companies

COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total 1,000 $12,000

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

$12,000 4 1,000 5 $ 12.00 Cost of goods available for sale $12,000 Unit Total Less: Ending inventory 5,400 Units

3 Cost

5 Cost Cost of goods sold $ 6,600

450 $12.00 $5,400

Cost of goods sold

$12,000 – $5,400 = $6,600

Cost per unit

$12,000––––––––– 1,000 units

= $12 per unit

Warehous e

450 units × $12= $5,400

Ending inventory

278 6 Reporting and Analyzing Inventory

statements of Houston Electronics. The condensed income statements in Illus- tration 6-13 assume that Houston sold its 550 units for $18,500, had operating expenses of $9,000, and is subject to an income tax rate of 30%.

HOUSTON ELECTRONICS Condensed Income Statements

FIFO LIFO Average-Cost

Sales revenue $18,500 $18,500 $18,500

Beginning inventory 1,000 1,000 1,000 Purchases 11,000 11,000 11,000

Cost of goods available for sale 12,000 12,000 12,000 Less: Ending inventory 5,800 5,000 5,400

Cost of goods sold 6,200 7,000 6,600

Gross profi t 12,300 11,500 11,900 Operating expenses 9,000 9,000 9,000

Income before income taxes 3,300 2,500 2,900 Income tax expense (30%) 990 750 870

Net income $ 2,310 $ 1,750 $ 2,030

ILLUSTRATION 6-13 Comparative effects of cost fl ow methods

Note the cost of goods available for sale ($12,000) is the same under each of the three inventory cost fl ow methods. However, the ending inventories and the costs of goods sold are different. This difference is due to the unit costs that the company allocated to cost of goods sold and to ending inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes. For Houston, an $800 difference exists between FIFO and LIFO cost of goods sold. In periods of changing prices, the cost fl ow assumption can have signifi cant impacts both on income and on evaluations of income, such as the following.

1. In a period of infl ation, FIFO produces a higher net income because lower unit costs of the fi rst units purchased are matched against revenue.

2. In a period of infl ation, LIFO produces a lower net income because higher unit costs of the last goods purchased are matched against revenue.

3. If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the lowest net income and LIFO the highest.

4. Regardless of whether prices are rising or falling, average-cost produces net income between FIFO and LIFO.

To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income. Others believe that LIFO presents a more realistic net income number. That is, LIFO matches the more recent costs against current revenues to pro- vide a better measure of net income. During periods of infl ation, many chal- lenge the quality of non-LIFO earnings, noting that failing to match current costs against current revenues leads to an understatement of cost of goods sold and an overstatement of net income. As some indicate, net income computed using FIFO creates “paper or phantom profi ts”—that is, earnings that do not really exist.

Balance Sheet Effects A major advantage of the FIFO method is that in a period of infl ation, the costs allocated to ending inventory will approximate their current cost. For example,

Inventory Methods and Financial Effects 279

for Houston Electronics, 400 of the 450 units in the ending inventory are costed under FIFO at the higher November 27 unit cost of $13. Conversely, a major shortcoming of the LIFO method is that in a period of infl ation, the costs allocated to ending inventory may be signifi cantly understated in terms of current cost. The understatement becomes greater over prolonged periods of infl ation if the inventory includes goods purchased in one or more prior accounting periods. For example, Caterpillar has used LIFO for 50 years. Its balance sheet shows ending inventory of $14.5 billion. But the inventory’s actual current cost if FIFO had been used is $17.0 billion.

Tax Effects We have seen that both inventory on the balance sheet and net income on the income statement are higher when companies use FIFO in a period of infl ation. Yet, many companies use LIFO. Why? The reason is that LIFO results in the low- est income taxes (because of lower net income) during times of rising prices. For example, in Illustration 6-13 income taxes are $750 under LIFO, compared to $990 under FIFO. The tax savings of $240 makes more cash available for use in the business.

▼ HELPFUL HINT A tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes, they must also use it for fi nancial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its fi nancial statements.

KEEPING AN EYE ON CASH

FIFO LIFO Average-Cost

Cash received from customers $18,500 $18,500 $18,500 Cash purchases of goods 11,000 11,000 11,000 Cash paid for operating expenses ($9,000 2 $4,600 ) 4,400 4,400 4,400 Cash paid for taxes 990 750 870

Net cash provided by operating activities $ 2,110 $ 2,350 $ 2,230

You have just seen that when prices are rising the use of LIFO can have a big effect on taxes. The lower taxes paid using LIFO can significantly increase cash flows. To demonstrate the effect of the cost flow assumptions on cash flow, we will calculate net cash provided by operating activities using the data for Houston Electronics from Illustration 6-13. To simplify our example, we assume that Houston’s sales and purchases are all cash transactions. We also assume that operating expenses, other than $4,600 of depreciation, are cash transactions.

Is LIFO Fair?

ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its inventory for fi nancial reporting and tax purposes. In one recent year, this resulted in a cost of goods sold fi gure that was $5.6 billion higher than under FIFO. By increas- ing cost of goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say that LIFO provides an unfair “tax dodge.” As Congress looks for more sources of tax rev- enue, some lawmakers favor the

elimination of LIFO. Supporters of LIFO argue that the method is conceptually sound because it matches current costs with current revenues. In addition, they point out that this matching provides protection against infl ation. International accounting standards do not allow the use of LIFO. Because of this, the net income of foreign oil companies such as BP and Royal Dutch Shell are not directly comparable to U.S. companies, which can make analysis diffi cult.

Source: David Reilly, “Big Oil’s Accounting Methods Fuel Criticism,” Wall Street Journal (August 8, 2006), p. C1.

What are the arguments for and against the use of LIFO? (Go to WileyPLUS for this answer and additional questions.)

Bloomberg/Getty Images

INTERNATIONAL INSIGHT ExxonMobil Corporation

280 6 Reporting and Analyzing Inventory

LIFO has the highest net cash provided by operating activities because it results in the lowest tax payments. Since cash flow is the lifeblood of any organization, the choice of inventory method is very important.

LIFO also impacts the quality of earnings ratio. Recall that the quality of earnings ratio is net cash provided by operating activities divided by net income. Here, we calculate the quality of earnings ratio under each cost flow assumption.

LIFO has the highest quality of earnings ratio for two reasons. (1) It has the highest net cash provided by operating activities, which increases the ratio’s numerator. (2) It reports a conservative measure of net income, which decreases the ratio’s denominator. As discussed earlier, LIFO provides a conservative measure of net income because it does not include the phantom profits reported under FIFO.

FIFO LIFO Average-Cost

Net income (from Illustration 6-13) $2,310 $1,750 $2,030 Quality of earnings ratio 0.91 1.34 1.1

USING INVENTORY COST FLOW METHODS CONSISTENTLY

Whatever cost fl ow method a company chooses, it should use that method consistently from one accounting period to another. Consistent application enhances the ability to analyze a company’s fi nancial statements over succes- sive time periods. In contrast, using the FIFO method one year and the LIFO method the next year would make it diffi cult to compare the net incomes of the two years. Although consistent application is preferred, it does not mean that a com- pany may never change its method of inventory costing. When a company adopts a different method, it should disclose in the fi nancial statements the change and its effects on net income. A typical disclosure is shown in Illustration 6-14, using information from recent fi nancial statements of Quaker Oats (now a unit of PepsiCo).

▼ HELPFUL HINT As you learned in Chapter 2, consistency and comparability are important characteristics of accounting information.

2▼ Cost Flow MethodsDO IT! The accounting records of Shumway Ag Implement show the following data.

Beginning inventory 4,000 units at $3 Purchases 6,000 units at $4 Sales 7,000 units at $12

Determine (a) the cost of goods available for sale and (b) the cost of goods sold during the period under a periodic system using (i) FIFO, (ii) LIFO, and (iii) average-cost.

ILLUSTRATION 6-14 Disclosure of change in cost fl ow method

QUAKER OATS Notes to the Financial Statements

Note 1: Effective July 1, the Company adopted the LIFO cost flow assumption for valuing the majority of U.S. Grocery Products inventories. The Company believes that the use of the LIFO method better matches current costs with current rev- enues. The effect of this change on the current year was to decrease net income by $16.0 million.

Real World

Inventory Presentation and Analysis 281

SOLUTION (a) Cost of goods available for sale: (4,000 × $3) + (6,000 × $4) = $36,000 (b) Cost of goods sold using:

(i) FIFO: $36,000 − (3,000* × $4) = $24,000 (ii) LIFO: $36,000 − (3,000 × $3) = $27,000 (iii) Average-cost: Weighted-average price = ($36,000 4 10,000) = $3.60

$36,000 − (3,000 × $3.60) = $25,200

*(4,000 + 6,000 − 7,000)

Action Plan ✔ Understand the periodic

inventory system. ✔ Allocate costs between

goods sold and goods on hand (ending inventory) for each cost fl ow method.

✔ Compute cost of goods sold for each cost fl ow method.

Related exercise material: BE6-2, BE6-3, BE6-5, DO IT! 6-2, E6-4, E6-5, E6-6, E6-7, and E6-8.

3▼ Explain the statement presentation and analysis of inventory. PRESENTATION

As indicated in Chapter 5, inventory is classifi ed in the balance sheet as a current asset immediately below receivables. In a multiple-step income statement, cost of goods sold is subtracted from net sales. There also should be disclosure of (1) the major inventory classifi cations, (2) the basis of accounting (cost, or lower-of-cost- or-market), and (3) the cost method (FIFO, LIFO, or average-cost).

Wal-Mart Stores, Inc., for example, in its January 31, 2014, balance sheet reported inventories of $44,858 million under current assets. The accompanying notes to the fi nancial statements, as shown in Illustration 6-15, disclosed the fol- lowing information.

LEARNING OBJECTIVE

ILLUSTRATION 6-15 Inventory disclosures by Wal-Mart

Note 1. Summary of Signifi cant Accounting Policies

Inventories

The Company values inventories at the lower of cost or market as determined primarily by the retail method of accounting, using the last-in, fi rst-out (“LIFO”) method for substantially all of the WalMart U.S. segment’s inventories. The WalMart International segment’s inventories are primarily valued by the retail method of ac- counting, using the fi rst-in, fi rst-out (“FIFO”) method. The retail method of account- ing results in inventory being valued at the lower of cost or market since permanent markdowns are currently taken as a reduction of the retail value of inventory. The Sam’s Club segment’s inventories are valued based on the weighted-average cost us- ing the LIFO method. At January 31, 2014 and 2013, the Company’s inventories valued at LIFO approximate those inventories as if they were valued at FIFO.

WAL-MART STORES, INC. Notes to the Financial Statements

Real World

As indicated in this note, Wal-Mart values its inventories at the lower-of-cost-or- market using LIFO and FIFO.

LOWER-OF-COST-OR-MARKET

The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to changes in technology or changes in fashions. These circumstances sometimes call for inventory valuation methods other than those presented so far. For example, at one time, purchasing managers at Ford decided to make a large purchase of palladium, a precious metal used in vehicle emission devices. They made this large purchase because they feared a future shortage.

282 6 Reporting and Analyzing Inventory

The shortage did not materialize, and by the end of the year the price of pal- ladium had plummeted. Ford’s inventory was then worth $1 billion less than its original cost. Do you think Ford’s inventory should have been stated at cost, in accordance with the historical cost principle, or at its lower replacement cost? As you probably reasoned, this situation requires a departure from the cost basis of accounting. This is done by valuing the inventory at the lower-of-cost- or-market (LCM) in the period in which the price decline occurs. LCM is a basis whereby inventory is stated at the lower of either its cost or market value as determined by current replacement cost. LCM is an example of the accounting convention of conservatism. Conservatism means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income. Companies apply LCM to the items in inventory after they have used one of the cost fl ow methods (specifi c identifi cation, FIFO, LIFO, or average-cost) to deter- mine cost. Under the LCM basis, market is defi ned as current replacement cost, not selling price. For a merchandising company, current replacement cost is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Current replacement cost is used because a decline in the replacement cost of an item usually leads to a decline in the selling price of the item. To illustrate the application of LCM, assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. LCM produces the results shown in Illustration 6-16. Note that the amounts shown in the fi nal column are the lower-of-cost-or-market amounts for each item.

INTERNATIONAL NOTE Under U.S. GAAP, companies cannot reverse inventory write- downs if inventory increases in value in subsequent periods. IFRS permits companies to reverse write-downs in some circumstances.

ILLUSTRATION 6-16 Computation of lower-of-cost- or-market

Cost Market Lower-of-Cost- Units per Unit per Unit or-Market

Flat-screen TVs 100 $600 $550 $ 55,000 ($550 × 100) Satellite radios 500 90 104 45,000 ($90 × 500) Blu-ray players 850 50 48 40,800 ($48 × 850) CDs 3,000 5 6 15,000 ($5 × 3,000) Total inventory $155,800

Adherence to LCM is important. Acer Inc. recently took a charge of $150 million on personal computers, which declined in value before they could be sold. A Chinese manufacturer of silicon wafers for solar energy panels, LDK Solar Co., was accused of violating LCM. When the fi nancial press reported accusations that two-thirds of its inventory of silicon was unsuitable for processing, the company’s stock price fell by 40%.

SOLUTION The lower value for each inventory type is gas $79,000, wood $250,000, and pellet $101,000. The total inventory value is the sum of these fi gures, $430,000.

LCM Basis

Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.

Cost Market

Gas $ 84,000 $ 79,000 Wood 250,000 280,000 Pellet 112,000 101,000

Determine the value of the company’s inventory under the lower-of-cost-or-market approach.Action Plan ✔ Determine whether cost or

market value is lower for each inventory type.

✔ Sum the lower value of each inventory type to determine the total value of inventory.

3a▼DO IT!

Related exercise material: BE6-7, DO IT! 6-3a, E6-9, and E6-10.

Inventory Presentation and Analysis 283

ANALYSIS

For companies that sell goods, managing inventory levels can be one of the most critical tasks. Having too much inventory on hand costs the company money in storage costs, interest cost (on funds tied up in inventory), and costs associated with the obsolescence of technical goods (e.g., computer chips) or shifts in fash- ion (e.g., clothes). But having too little inventory on hand results in lost sales. In this section, we discuss some issues related to evaluating inventory levels.

Inventory Turnover The inventory turnover is calculated as cost of goods sold divided by average inventory. It indicates the liquidity of inventory by measuring the number of times the average inventory “turns over” (is sold) during the year. Inventory turnover can be divided into 365 days to compute days in inventory, which indicates the average number of days inventory is held. High inventory turnover (low days in inventory) indicates the com- pany has minimal funds tied up in inventory—that it has a minimal amount of inventory on hand at any one time. Although minimizing the funds tied up in inventory is effi cient, too high an inventory turnover may indicate that the com- pany is losing sales opportunities because of inventory shortages. For example, investment analysts at one time suggested that Offi ce Depot had gone too far in reducing its inventory—they said they were seeing too many empty shelves. Thus, management should closely monitor this ratio to achieve the best balance between too much and too little inventory. In Chapter 5, we discussed the increasingly competitive environment of retail- ers, such as Wal-Mart and Target. Wal-Mart has implemented just-in-time inven- tory procedures as well as many technological innovations to improve the effi ciency of its inventory management. The following data are available for Wal-Mart.

DECISION TOOLS

Inventory turnover and days in inventory help users determine how long an item is in inventory.

(in millions) 2014 2013

Ending inventory $ 44,858 $43,803 Cost of goods sold 358,069

Illustration 6-17 presents the inventory turnovers and days in inventory for Wal- Mart and Target, using data from the fi nancial statements of those corporations for 2014 and 2013.

Inventory Turnover 5 Cost of Goods Sold Average Inventory

Days in Inventory 5 365

Inventory Turnover

Wal-Mart Industry Ratio ($ in millions) Target Average

2014 2013 2014 2014

Inventory turnover $358,069 ($44,858 1 $43,803)/2

= 8.1 times 8.3 times 6.1 times 8.4 times

Days in inventory 365 days 8.1

= 45.1 days 44.0 days 59.8 days 43.5 days

ILLUSTRATION 6-17 Inventory turnovers and days in inventory

284 6 Reporting and Analyzing Inventory

The calculations in Illustration 6-17 show that Wal-Mart turns its inventory more frequently than Target (8.1 times for Wal-Mart versus 6.1 times for Target). Consequently, the average time an item spends on a Wal-Mart shelf is shorter (45.1 days for Wal-Mart versus 59.8 days for Target). This analysis suggests that Wal-Mart is more effi cient than Target in its inven- tory management. Wal-Mart’s sophisticated inventory tracking and distribution system allows it to keep minimum amounts of inventory on hand, while still keeping the shelves full of what customers are looking for.

ADJUSTMENTS FOR LIFO RESERVE

Earlier, we noted that using LIFO rather than FIFO can result in signifi- cant differences in the results reported in the balance sheet and the income statement. With increasing prices, FIFO will result in higher income than LIFO. On the balance sheet, FIFO will result in higher reported inventory. The financial statement differences from using LIFO normally increase the longer a company uses LIFO.

Use of different inventory cost fl ow assumptions complicates ana- lysts’ attempts to compare companies’ results. Fortunately, companies using LIFO are required to report the difference between inventory reported using LIFO and inventory using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost fl ow methods.

Illustration 6-18 presents an excerpt from the notes to Caterpillar’s 2014 fi nancial statements that discloses and discusses Caterpillar’s LIFO reserve.

DECISION TOOLS Adjusting inventory from LIFO to FIFO helps users analyze the impact of LIFO on the company’s reported income.

Inventories: Inventories are stated at the lower of cost or market. Cost is principally determined using the last-in, fi rst-out (LIFO) method . . . . If the FIFO (fi rst-in, fi rst- out) method had been in use, inventories would have been $2,430, $2,504, and $2,750 million higher than reported at December 31, 2014, 2013, and 2012, respectively.

CATERPILLAR INC. Notes to the Financial Statements

Real World

ILLUSTRATION 6-18 Caterpillar’s LIFO reserve

Too Many TVs or Too Few?

Financial analysts closely monitor the inventory man- agement practices of com- panies. For example, some analysts following Sony expressed concern because the company built up its in- ventory of televisions in an attempt to sell 25 million liquid crystal display (LCD) TVs—a 60% increase over the prior year. A year earlier, Sony had cut its inventory

levels so that its quarterly days in inventory was down to 38 days, compared to 61 days for the same quarter a year before that. But in the next year, as a result of its inventory build-up, days in inventory rose to 59 days. Management said that it didn’t think that Sony’s inventory levels were too high. However, analysts were concerned that the company would have to engage in very heavy discounting in order to sell off its inventory. Analysts noted that the losses from discounting can be “punishing.”

Source: Daisuke Wakabayashi, “Sony Pledges to Corral Inventory,” Wall Street Journal Online (November 2, 2010).

For Sony, what are the advantages and disadvantages of having a low days in inventory measure? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Sony

Inventory Presentation and Analysis 285

Caterpillar has used LIFO for over 50 years. Thus, the cumulative difference between LIFO and FIFO refl ected in the Inventory account is very large. In fact, the 2014 LIFO reserve of $2,430 million is 20% of the 2014 LIFO inventory of $12,205 million. Such a huge difference would clearly distort any comparisons you might try to make with one of Caterpillar’s competitors that used FIFO. To adjust Caterpillar’s inventory balance, we add the LIFO reserve to reported inventory, as shown in Illustration 6-19. That is, if Caterpillar had used FIFO all along, its inventory would be $14,635 million, rather than $12,205 million.

ILLUSTRATION 6-19 Conversion of inventory from LIFO to FIFO

(in millions) 2014 inventory using LIFO $ 12,205 2014 LIFO reserve 2,430

2014 inventory assuming FIFO $14,635

The LIFO reserve can have a signifi cant effect on ratios that analysts com- monly use. Using the LIFO reserve adjustment, Illustration 6-20 calculates the value of the current ratio (current assets ÷ current liabilities) for Caterpillar under both the LIFO and FIFO cost fl ow assumptions.

($ in millions) LIFO FIFO

Current ratio $38,867 $27,877

5 1.39:1 $38,867 1 $2,430 $27,877

5 1.48:1

ILLUSTRATION 6-20 Impact of LIFO reserve on ratios

As Illustration 6-20 shows, if Caterpillar used FIFO, its current ratio would be 1.48:1 rather than 1.39:1 under LIFO. Thus, Caterpillar’s liquidity appears stronger if a FIFO assumption were used in valuing inventories.

CNH Global, a competitor of Caterpillar, uses FIFO to account for its inven- tory. Comparing Caterpillar to CNH without converting Caterpillar’s inventory to FIFO would lead to distortions and potentially erroneous decisions.

3b▼ Inventory TurnoverDO IT! Early in 2017, Westmoreland Company switched to a just-in-time inventory system. Its sales, cost of goods sold, and inventory amounts for 2016 and 2017 are shown below.

2016 2017

Sales revenue $2,000,000 $1,800,000 Cost of goods sold 1,000,000 910,000 Beginning inventory 290,000 210,000 Ending inventory 210,000 50,000

Determine the inventory turnover and days in inventory for 2016 and 2017. Discuss the changes in the amount of inventory, the inventory turnover and days in inventory, and the amount of sales across the two years.

SOLUTION

2016 2017

Inventory turnover $1,000,000 $910,000 ($290,000 + $210,000)/2 = 4 ($210,000 + $50,000)/2 = 7

Days in inventory 365 ÷ 4 = 91.3 days 365 ÷ 7 = 52.1 days

Action Plan ✔ To fi nd the inventory

turnover, divide cost of goods sold by average inventory.

✔ To determine days in inventory, divide 365 days by the inventory turnover.

✔ Just-in-time inventory reduces the amount of inventory on hand, which reduces carrying costs. Reducing inventory levels by too much has potential negative implications for sales.

286 6 Reporting and Analyzing Inventory

The company experienced a very signifi cant decline in its ending inventory as a result of the just-in-time inventory. This decline improved its inventory turnover and its days in inventory. However, its sales declined by 10%. It is possible that this decline was caused by the dramatic reduction in the amount of inventory that was on hand, which increased the likelihood of “stockouts.” To determine the optimal inventory level, management must weigh the benefi ts of reduced inventory against the potential lost sales caused by stockouts.

Related exercise material: BE6-8, DO IT! 6-3b, E6-11, E6-12, and E6-13.

The Manitowoc Company is located in Manitowoc, Wisconsin. In recent years, it has made a series of strategic acquisitions to grow and enhance its market-leading positions in each of its three business segments: (1) cranes and related products (crawler cranes, tower cranes, and boom trucks), (2) food service equipment (commercial ice-cube machines, ice-beverage dispensers, and commercial refrigeration equipment), and (3) marine operations (shipbuilding and ship-repair services). The company reported inventory of $644.5 million for 2014 and of $720.8 million for 2013. Here is the inventory note taken from the 2014 fi nancial statements.

Manitowoc carries inventory at the lower-of-cost-or-market using the fi rst-in, fi rst-out (FIFO) method for approximately 84% and 87% of total inventory for 2014 and 2013, respectively. The remainder of the inventory is costed using the last-in, fi rst- out (LIFO) method.

Additional facts (amounts in millions): 2014 Current liabilities $1,011.3 2014 Current assets (as reported) 1,186.1 2014 Cost of goods sold 2,900.4

INSTRUCTIONS

Answer the following questions. 1. Why does the company report its inventory in three components? 2. Why might the company use two methods (LIFO and FIFO) to account for its inventory? 3. Perform each of the following. (a) Calculate the inventory turnover and days in inventory using the LIFO inventory. (b) Calculate the 2014 current ratio using LIFO and the current ratio using FIFO. Discuss the difference.

USING DECISION TOOLS—MANITOWOC COMPANY

Inventories: The components of inventories at December 31, 2014 and December 31, 2013 are summarized as follows:

(in millions) 2014 2013

Inventories—gross: Raw materials $226.2 $259.0 Work-in-process 103.7 130.2 Finished goods 414.8 436.8

Total inventories—gross 744.7 826.0 Excess and obsolete inventory reserve (64.0) (69.0)

Net inventories at FIFO cost 680.7 757.0 Excess of FIFO costs over LIFO value (36.2) (36.2)

Inventories—net (as reported on balance sheet) $644.5 $720.8

THE MANITOWOC COMPANY Notes to the Financial Statements

Appendix 6A: Inventory Cost Flow Methods in Perpetual Inventory Systems 287

SOLUTION 1. The Manitowoc Company is a manufacturer, so it purchases raw materials and makes them into fi nished products. At the

end of each period, it has some goods that have been started but are not yet complete (work in process). By reporting all three components of inventory, a company reveals important information about its inventory posi-

tion. For example, if amounts of raw materials have increased signifi cantly compared to the previous year, we might assume the company is planning to step up production. On the other hand, if levels of fi nished goods have increased relative to last year and raw materials have declined, we might conclude that sales are slowing down—that the company has too much inventory on hand and is cutting back production.

2. Companies are free to choose different cost fl ow assumptions for different types of inventory. A company might choose to use FIFO for a product that is expected to decrease in price over time. One common reason for choosing a method other than LIFO is that many foreign countries do not allow LIFO; thus, the company cannot use LIFO for its foreign operations.

3. (a)

Inventory turnover = Cost of goods sold = $2,900.4 = 4.2 Average inventory ($644.5 + $720.8)/2 Days in = 365 = 365 = 86.9 days inventory Inventory turnover 4.2 (b) Current ratio

LIFO FIFO Current assets = $1,186.1 = 1.17:1 $1,186.1 + $36.2 = 1.21:1 Current liabilities $1,011.3 $1,011.3 This represents a 3.4% increase in the current ratio [(1.21 − 1.17)/1.17].

Each of the inventory cost fl ow methods described in the chapter for a periodic inventory system may be used in a perpetual inventory system. To illustrate the application of the three assumed cost fl ow methods (FIFO, LIFO, and average- cost), we will use the data shown in Illustration 6A-1 and in this chapter for Houston Electronics’ Astro condensers.

APPENDIX 6A: Apply inventory cost fl ow methods to perpetual inventory records.

LEARNING OBJECTIVE *4▼

FIRST-IN, FIRST-OUT (FIFO)

Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 24. Illustra- tion 6A-2 (page 288) shows the inventory under a FIFO method perpetual system.

ILLUSTRATION 6A-1 Inventoriable units and costs

Unit Total Balance Date Explanation Units Cost Cost in Units

1/1 Beginning inventory 100 $10 $ 1,000 100 4/15 Purchase 200 11 2,200 300 8/24 Purchase 300 12 3,600 600 9/10 Sale 550 50 11/27 Purchase 400 13 5,200 450

$12,000

HOUSTON ELECTRONICS Astro Condensers

288 6 Reporting and Analyzing Inventory

The ending inventory in this situation is $5,800, and the cost of goods sold is $6,200 [(100 @ $10) + (200 @ $11) + (250 @ $12)]. The results under FIFO in a perpetual system are the same as in a periodic system. (See Illustration 6-6 on page 274 where, similarly, the ending inventory is $5,800 and cost of goods sold is $6,200.) Regardless of the system, the fi rst costs in are the costs assigned to cost of goods sold.

LAST-IN, FIRST-OUT (LIFO)

Under the LIFO method using a perpetual system, the cost of the most recent purchase prior to sale is allocated to the units sold. Therefore, the cost of the goods sold on September 10 consists of all the units from the August 24 and April 15 purchases plus 50 of the units in beginning inventory. The ending inventory under the LIFO method is computed in Illustration 6A-3.

Date Purchases Cost of Goods Sold Balance

Jan. 1 (100 @ $10) $ 1,000 Apr. 15 (200 @ $11) $2,200 (100 @ $10) (200 @ $11) $3,200 Aug. 24 (300 @ $12) $3,600 (100 @ $10) (200 @ $11) $ 6,800 (300 @ $12) Sept. 10 (100 @ $10) (200 @ $11) (250 @ $12) ( 50 @ $12) $ 600

$6,200 Nov. 27 (400 @ $13) $5,200 ( 50 @ $12) $5,800 (400 @ $13)

ILLUSTRATION 6A-2 Perpetual system—FIFO

Date Purchases Cost of Goods Sold Balance

Jan. 1 (100 @ $10) $ 1,000 Apr. 15 (200 @ $11) $2,200 (100 @ $10) (200 @ $11) $ 3,200 Aug. 24 (300 @ $12) $3,600 (100 @ $10) (200 @ $11) $ 6,800 (300 @ $12) Sept. 10 (300 @ $12) (200 @ $11) ( 50 @ $10) ( 50 @ $10) $ 500

$6,300 Nov. 27 (400 @ $13) $5,200 ( 50 @ $10) $5,700 (400 @ $13)

ILLUSTRATION 6A-3 Perpetual system—LIFO

The use of LIFO in a perpetual system will usually produce cost allocations that differ from use of LIFO in a periodic system. In a perpetual system, the lat- est units purchased prior to each sale are allocated to cost of goods sold. In contrast, in a periodic system, the latest units purchased during the period are allocated to cost of goods sold. Thus, when a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous sale. See Illus- tration 6-9 (on page 276) where the proof shows the 400 units at $13 purchased on November 27 applied to the sale of 550 units on September 10. As shown above, under the LIFO perpetual system the 400 units at $13 purchased on November 27 are all applied to the ending inventory. The ending inventory in this LIFO perpetual illustration is $5,700 and cost of goods sold is $6,300. Compare this to the LIFO periodic illustration (Illustra- tion 6-8 on page 275) where the ending inventory is $5,000 and cost of goods sold is $7,000.

Appendix 6B: Inventory Errors 289

AVERAGE-COST

The average-cost method in a perpetual inventory system is called the moving- average method. Under this method, the company computes a new average after each purchase. The average cost is computed by dividing the cost of goods available for sale by the units on hand. The average cost is then applied to (1) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determine the ending inventory amount. Illustration 6A-4 shows the application of the average-cost method by Houston Electronics.

Date Purchases Cost of Goods Sold Balance

Jan. 1 (100 @ $10) $1,000 Apr. 15 (200 @ $11) $2,200 (300 @ $10.667) $3,200 Aug. 24 (300 @ $12) $3,600 (600 @ $11.333) $6,800 Sept. 10 (550 @ $11.333) ( 50 @ $11.333) $ 567

$6,233 Nov. 27 (400 @ $13) $5,200 (450 @ $12.816) $5,767

ILLUSTRATION 6A-4 Perpetual system—average-cost method

As indicated above, the company computes a new average each time it makes a purchase. On April 15, after 200 units are purchased for $2,200, a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand. The average unit cost is $10.667 ($3,200 ÷ 300). On August 24, after 300 units are purchased for $3,600, a total of 600 units costing $6,800 ($1,000 + $2,200 + $3,600) are on hand at an average cost per unit of $11.333 ($6,800 ÷ 600). Houston Electronics uses this unit cost of $11.333 in costing sales until another purchase is made, when the company computes a new unit cost. Accordingly, the unit cost of the 550 units sold on September 10 is $11.333, and the total cost of goods sold is $6,233. On November 27, following the purchase of 400 units for $5,200, there are 450 units on hand costing $5,767 ($567 + $5,200) with a new average cost of $12.816 ($5,767 ÷ 450). Compare this moving-average cost under the perpetual inventory system to Illustration 6-11 (on page 277) showing the weighted-average method under a periodic inventory system.

APPENDIX 6B: Indicate the effects of inventory errors on the fi nancial statements.

LEARNING OBJECTIVE *5▼

Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because companies do not properly recognize the trans- fer of legal title to goods that are in transit. When inventory errors occur, they affect both the income statement and the balance sheet.

INCOME STATEMENT EFFECTS

The ending inventory of one period automatically becomes the beginning inven- tory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two periods. The effects on cost of goods sold can be computed by entering incorrect data in the formula in Illustration 6B-1 and then substituting the correct data.

Beginning Inventory

Cost of Goods

Purchased 2

Ending Inventory

Cost of Goods Sold

ILLUSTRATION 6B-1 Formula for cost of goods sold

290 6 Reporting and Analyzing Inventory

If beginning inventory is understated, cost of goods sold will be under- stated. If ending inventory is understated, cost of goods sold will be overstated. Illustration 6B-2 shows the effects of inventory errors on the current year’s income statement.

ILLUSTRATION 6B-2 Effects of inventory errors on current year’s income statement

Cost of Inventory Error Goods Sold Net Income

Beginning inventory understated Understated Overstated Beginning inventory overstated Overstated Understated Ending inventory understated Overstated Understated Ending inventory overstated Understated Overstated

An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. This is shown in Illustra- tion 6B-3. Note that the understatement of ending inventory in 2016 results in an understatement of beginning inventory in 2017 and an overstatement of net income in 2017. Over the two years, total net income is correct because the errors offset each other. Notice that total two-year income using incorrect data is $35,000 ($22,000 + $13,000), which is the same as the total two-year income of $35,000 ($25,000 + $10,000) using correct data. Also note in this example that an error in the begin- ning inventory does not result in a corresponding error in the ending inventory for that period. The correctness of the ending inventory depends entirely on the accuracy of taking and costing the inventory at the balance sheet date under the periodic inventory system.

BALANCE SHEET EFFECTS

The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation: Assets = Liabilities + Stockholders’ Equity. Errors in the ending inventory have the effects shown in Illustration 6B-4.

ETHICS NOTE Inventory fraud increases during recessions. Such fraud includes

pricing inventory at amounts in excess of its actual value,

or claiming to have inventory when no inventory exists.

Inventory fraud is usually done to overstate ending inventory,

thereby understating cost of goods sold and creating higher

income.

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ILLUSTRATION 6B-3 Effects of inventory errors on two years’ income statements

SAMPLE COMPANY Condensed Income Statements

2016 2017

Incorrect Correct Incorrect Correct

Sales revenue $80,000 $80,000 $90,000 $90,000 Beginning inventory $20,000 $20,000 $12,000 $15,000 Cost of goods purchased 40,000 40,000 68,000 68,000

Cost of goods available for sale 60,000 60,000 80,000 83,000 Ending inventory 12,000 15,000 23,000 23,000

Cost of goods sold 48,000 45,000 57,000 60,000

Gross profi t 32,000 35,000 33,000 30,000 Operating expenses 10,000 10,000 20,000 20,000

Net income $22,000 $25,000 $13,000 $10,000

$(3,000) $3,000 Net income Net income understated overstated

The errors cancel. Thus, the combined total income for the 2-year period is correct.

Review and Practice 291

The effect of an error in ending inventory on the subsequent period was shown in Illustration 6B-3. Recall that if the error is not corrected, the com- bined total net income for the two periods would be correct. Thus, total stock- holders’ equity reported on the balance sheet at the end of 2017 will also be correct.

ILLUSTRATION 6B-4 Effects of ending inventory errors on balance sheet

Ending Inventory Error Assets Liabilities Stockholders’ Equity

Overstated Overstated No effect Overstated Understated Understated No effect Understated

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

3 Explain the statement presentation and analysis of inventory. Companies use the lower-of-cost-or-market (LCM) basis when the current replacement cost (market) is less than cost. Under LCM, companies recognize the loss in the period in which the price decline occurs.

*5 Indicate the effects of inventory errors on the fi nan- cial statements. In the income statement of the current year: (1) An error in beginning inventory will have a reverse effect on net income (e.g., overstatement of inventory results in understatement of net income, and vice versa). (2) An error in ending inventory will have a similar effect on net income (e.g., overstatement of inventory results in overstatement of net income). If ending inventory errors are not corrected in the follow- ing period, their effect on net income for that period is reversed, and total net income for the two years will be correct. In the balance sheet: Ending inventory errors will have the same effect on total assets and total stockholders’ equity and no effect on liabilities.

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292 6 Reporting and Analyzing Inventory

Average-cost method An inventory costing method that uses the weighted-average unit cost to allocate the cost of goods available for sale to ending inventory and cost of goods sold. (p. 276).

Consigned goods Goods held for sale by one party although ownership of the goods is retained by another party. (p. 270).

Current replacement cost The cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. (p. 282).

Days in inventory Measure of the average number of days inventory is held; calculated as 365 divided by inventory turnover. (p. 283).

Finished goods inventory Manufactured items that are completed and ready for sale. (p. 268).

First-in, fi rst-out (FIFO) method An inventory costing method that assumes that the earliest goods purchased are the fi rst to be sold. (p. 274).

FOB destination Freight terms indicating that ownership of goods remains with the seller until the goods reach the buyer. (p. 270).

FOB shipping point Freight terms indicating that owner- ship of goods passes to the buyer when the public carrier accepts the goods from the seller. (p. 270).

Inventory turnover A ratio that indicates the liquidity of inventory by measuring the number of times average inventory is sold during the period; computed by dividing

cost of goods sold by the average inventory during the period. (p. 283).

Just-in-time (JIT) inventory Inventory system in which companies manufacture or purchase goods only when needed. (p. 268).

Last-in, fi rst-out (LIFO) method An inventory costing method that assumes that the latest units purchased are the fi rst to be sold. (p. 275).

LIFO reserve For a company using LIFO, the difference between inventory reported using LIFO and inventory using FIFO. (p. 284).

Lower-of-cost-or-market (LCM) A basis whereby in- ventory is stated at the lower of either its cost or its market value as determined by current replacement cost. (p. 282).

Raw materials Basic goods that will be used in production but have not yet been placed in production. (p. 268).

Specifi c identifi cation method An actual physical-fl ow costing method in which particular items sold and items still in inventory are specifi cally costed to arrive at cost of goods sold and ending inventory. (p. 272).

Weighted-average unit cost Average cost that is weighted by the number of units purchased at each unit cost. (p. 276).

Work in process That portion of manufactured inventory that has begun the production process but is not yet complete. (p. 268).

GLOSSARY REVIEW▼ DECISION TOOLS REVIEW

DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Which inventory costing method should be used?

Are prices increasing, or are they decreasing?

Income statement, balance sheet, and tax effects

How long is an item in inventory?

What is the impact of LIFO on the company’s reported inventory?

Cost of goods sold; beginning and ending inventory

LIFO reserve, cost of goods sold, ending inventory, current assets, current liabilities

A higher inventory turnover or lower average days in inventory suggests that management is reducing the amount of inventory on hand, relative to cost of goods sold.

If these adjustments are material, they can signifi - cantly affect such measures as the current ratio and the inventory turnover.

Depends on objective. In a period of rising prices, income and inventory are higher and cash fl ow is lower under FIFO. LIFO provides opposite results. Average-cost can moderate the impact of changing prices.

Cost of goods sold

Average inventory

Inventory turnover 5

365 days Inventory turnover

Days in inventory

LIFO inventory 1

LIFO reserve 5

FIFO inventory

Practice Multiple-Choice Questions 293

1. When is a physical inventory usually taken? (a) When the company has its greatest amount of

inventory. (b) When a limited number of goods are being sold

or received. (c) At the end of the company’s fi scal year. (d) Both (b) and (c).

2. Which of the following should not be included in the physical inventory of a company? (a) Goods held on consignment from another

company. (b) Goods shipped on consignment to another

company. (c) Goods in transit from another company shipped

FOB shipping point. (d) All of the above should be included.

3. As a result of a thorough physical inventory, Railway Company determined that it had inventory worth $180,000 at December 31, 2017. This count did not take into consideration the following facts. Rogers Consignment Store currently has goods worth $35,000 on its sales fl oor that belong to Railway but are being sold on consignment by Rogers. The selling price of these goods is $50,000. Railway purchased $13,000 of goods that were shipped on December 27, FOB desti- nation, that will be received by Railway on January 3. Determine the correct amount of inventory that Rail- way should report. (a) $230,000. (c) $228,000. (b) $215,000. (d) $193,000.

4. Kam Company has the following units and costs.

Units Unit Cost

Inventory, Jan. 1 8,000 $11 Purchase, June 19 13,000 12 Purchase, Nov. 8 5,000 13

If 9,000 units are on hand at December 31, what is the cost of the ending inventory under FIFO? (a) $99,000. (c) $113,000. (b) $108,000. (d) $117,000.

5. From the data in Question 4, what is the cost of the ending inventory under LIFO? (a) $113,000. (c) $99,000. (b) $108,000. (d) $100,000.

6. Davidson Electronics has the following:

Units Unit Cost

Inventory, Jan. 1 5,000 $ 8 Purchase, April 2 15,000 10 Purchase, Aug. 28 20,000 12

If Davidson has 7,000 units on hand at December 31, the cost of ending inventory under the average-cost method is: (a) $84,000. (c) $56,000. (b) $70,000. (d) $75,250.

7. In periods of rising prices, LIFO will produce: (a) higher net income than FIFO. (b) the same net income as FIFO. (c) lower net income than FIFO. (d) higher net income than average-cost.

(LO 1)

(LO 2)

8. Cost of goods available for sale consists of two elements: beginning inventory and: (a) ending inventory. (b) cost of goods purchased. (c) cost of goods sold. (d) All of the answer choices are correct.

9. Considerations that affect the selection of an inven- tory costing method do not include: (a) tax effects. (b) balance sheet effects. (c) income statement effects. (d) perpetual versus periodic inventory system.

10. The lower-of-cost-or-market rule for inventory is an example of the application of: (a) the conservatism convention. (b) the historical cost principle. (c) the materiality concept. (d) the economic entity assumption.

11. Which of these would cause inventory turn- over to increase the most? (a) Increasing the amount of inventory on hand. (b) Keeping the amount of inventory on hand con-

stant but increasing sales. (c) Keeping the amount of inventory on hand con-

stant but decreasing sales. (d) Decreasing the amount of inventory on hand and

increasing sales. 12. Carlos Company had beginning inventory of $80,000,

ending inventory of $110,000, cost of goods sold of $285,000, and sales of $475,000. Carlos’s days in inventory is: (a) 73 days. (c) 102.5 days. (b) 121.7 days. (d) 84.5 days.

13. Norton Company purchased 1,000 widgets and has 200 widgets in its ending inventory at a cost of $91 each and a current replacement cost of $80 each. The ending inventory under lower-of-cost-or-market is: (a) $91,000. (c) $18,200. (b) $80,000. (d) $16,000.

14. The LIFO reserve is: (a) the difference between the value of the inventory

under LIFO and the value under FIFO. (b) an amount used to adjust inventory to the lower-

of-cost-or-market. (c) the difference between the value of the inventory

under LIFO and the value under average-cost. (d) an amount used to adjust inventory to historical

cost. *15. In a perpetual inventory system:

(a) LIFO cost of goods sold will be the same as in a periodic inventory system.

(b) average costs are based entirely on unit-cost sim- ple averages.

(d) FIFO cost of goods sold will be the same as in a periodic inventory system.

*16. Fran Company’s ending inventory is understated by $4,000. The effects of this error on the current year’s cost of goods sold and net income, respectively, are: (a) understated and overstated.

(LO 2)

(LO 3)

(LO 4)

(LO 5)

PRACTICE MULTIPLE CHOICE QUESTIONS▼

294 6 Reporting and Analyzing Inventory

(b) overstated and understated. (c) overstated and overstated. (d) understated and understated.

* 17. Harold Company overstated its inventory by $15,000 at December 31, 2016. It did not correct the error in 2016 or 2017. As a result, Harold’s stockholders’ equity was: (a) overstated at December 31, 2016, and understated

at December 31, 2017.

(LO 5)

(b) overstated at December 31, 2016, and properly stated at December 31, 2017.

(d) overstated at December 31, 2016, and overstated at December 31, 2017.

SOLUTIONS 1. (d) A physical inventory is usually taken when a limited number of goods are being sold or received, and at the end

6. (d) Under the average-cost method, total cost of goods available for sale needs to be calculated in order to deter- mine average cost per unit. The total cost of goods available is $430,000 = (5,000 × $8) + (15,000 × $10) + (20,000 × $12). The average cost per unit = ($430,000/40,000 total units available for sale) = $10.75. Therefore, ending inven- tory is ($10.75 × 7,000) = $75,250, not (a) $84,000, (b) $70,000, or (c) $56,000.

7. (c) In periods of rising prices, LIFO will produce lower net income than FIFO, not (a) higher than FIFO or (b) the same as FIFO. Choice (d) is incorrect because in periods of rising prices, LIFO will produce lower net income than average-cost. LIFO therefore charges the highest inventory cost against revenues in a period of rising prices.

8. (b) Cost of goods available for sale consists of beginning inventory and cost of goods purchased, not (a) ending inventory or (c) cost of goods sold. Therefore, choice (d) is also incorrect.

9. (d) Perpetual vs. periodic inventory system is not one of the factors that affect the selection of an inventory costing method. The other choices are incorrect because (a) tax effects, (b) balance sheet effects, and (c) income statement effects all affect the selection of an inventory costing method.

10. (a) Conservatism means to use the lowest value for assets and revenues when in doubt. The other choices are incorrect because (b) historical cost means that companies value assets at the original cost, (c) materiality means that an amount is large enough to affect a decision-maker, and (d) economic entity means to keep the company’s transactions separate from the transactions of other entities.

11. (d) Decreasing the amount of inventory on hand will cause the denominator to decrease, causing inventory turn- over to increase. Increasing sales will cause the numerator of the ratio to increase (higher sales means higher COGS), thus causing inventory turnover to increase even more. The other choices are incorrect because (a) increas- ing the amount of inventory on hand causes the denominator of the ratio to increase while the numerator stays the same, causing inventory turnover to decrease; (b) keeping the amount of inventory on hand constant but increasing sales will cause inventory turnover to increase because the numerator of the ratio will increase (higher sales means higher COGS) while the denominator stays the same, which will result in a lesser inventory increase than decreas- ing amount of inventory on hand and increasing sales; and (c) keeping the amount of inventory on hand constant but decreasing sales will cause inventory turnover to decrease because the numerator of the ratio will decrease (lower sales means lower COGS) while the denominator stays the same.

12. (b) Carlos’s days in inventory = 365/Inventory turnover = 365/[$285,000/($80,000 + $110,000)/2)] = 121.7 days, not (a) 73 days, (c) 102.5 days, or (d) 84.5 days.

13. (d) Under the LCM basis, “market” is defi ned as the current replacement cost. Therefore, ending inventory would be valued at 200 widgets × $80 each = $16,000, not (a) $91,000, (b) $80,000, or (c) $18,200.

14. (a) The LIFO reserve is the difference in ending inventory value under LIFO and FIFO. The other choices are therefore incorrect.

Practice Exercises 295

SOLUTION

1. Ending inventory—as reported $650,000

1. Subtract from inventory: The goods belong to Bosnia Corporation. Sergei is merely holding them for Bosnia. (200,000)

2. Add to inventory: The goods belong to Sergei when they were shipped. 40,000

3. Subtract from inventory: Offi ce supplies should be carried in a separate account. They are not considered inventory held for resale. (15,000)

4. Add to inventory: The goods belong to Sergei until they are shipped (Jan. 1). 30,000

*15. (d) FIFO cost of goods sold is the same under both a periodic and a perpetual inventory system. The other choices are incorrect because (a) LIFO cost of goods sold is not the same under a periodic and a perpetual inventory system; (b) average costs are based on a moving average of unit costs, not an average of unit costs; and (c) a new average is computed under the average-cost method after each purchase, not sale.

*16. (b) Because ending inventory is too low, cost of goods sold will be too high (overstated) and since cost of goods sold (an expense) is too high, net income will be too low (understated). Therefore, the other choices are incorrect.

*17. (b) Stockholders’ equity is overstated by $15,000 at December 31, 2016, and is properly stated at December 31, 2017. An ending inventory error in one period will have an equal and opposite effect on cost of goods sold and net income in the next period; after two years, the errors have offset each other. The other choices are incorrect because stockholders’ equity (a) is properly stated, not understated, at December 31, 2017; (c) is overstated, not understated, by $15,000 at December 31, 2016, and is properly stated, not understated, at December 31, 2017; and (d) is properly stated at December 31, 2017, not overstated.

1. Mika Sorbino, an auditor with Martinez CPAs, is performing a review of Sergei Com- pany’s inventory account. Sergei’s did not have a good year and top management is under pressure to boost reported income. According to its records, the inventory balance at year-end was $650,000. However, the following information was not considered when de- termining that amount.

1. Included in the company’s count were goods with a cost of $200,000 that the company is holding on consignment. The goods belong to Bosnia Corporation.

2. The physical count did not include goods purchased by Sergei with a cost of $40,000 that were shipped FOB shipping point on December 28 and did not arrive at Sergei’s warehouse until January 3.

3. Included in the inventory account was $15,000 of offi ce supplies that were stored in the warehouse and were to be used by the company’s supervisors and managers dur- ing the coming year.

4. The company received an order on December 28 that was boxed and was sitting on the loading dock awaiting pick-up on December 31. The shipper picked up the goods on January 1 and delivered them on January 6. The shipping terms were FOB ship- ping point. The goods had a selling price of $40,000 and a cost of $30,000. The goods were not included in the count because they were sitting on the dock.

5. On December 29, Sergei shipped goods with a selling price of $80,000 and a cost of $60,000 to Oman Sales Corporation FOB shipping point. The goods arrived on Janu- ary 3. Oman Sales had only ordered goods with a selling price of $10,000 and a cost of $8,000. However, a Sergei’s sales manager had authorized the shipment and said that if Oman wanted to ship the goods back next week, it could.

6. Included in the count was $30,000 of goods that were parts for a machine that the com- pany no longer made. Given the high-tech nature of Sergei’s products, it was unlikely that these obsolete parts had any other use. However, management would prefer to keep them on the books at cost, “since that is what we paid for them, after all.”

INSTRUCTIONS

Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, saying why you did or did not make an adjustment for each item.

Determine the correct inventory amount.

(LO 1)

PRACTICE EXERCISES▼

296 6 Reporting and Analyzing Inventory

2. Creve Couer Camera Inc. uses the lower-of-cost-or-market basis for its inventory. The following data are available at December 31.

Cost Market Units per Unit per Unit

Cameras: Minolta 5 $160 $156 Canon 7 145 153 Light Meters: Vivitar 12 120 114 Kodak 10 130 142

INSTRUCTIONS

What amount should be reported on Creve Couer Camera’s fi nancial statements, assuming the lower-of-cost-or-market rule is applied?

Determine LCM valuation.

(LO 3)

SOLUTION

2. Inventory at Market Lower-of-Cost- Lower-of-Cost- Cost per Unit per Unit or-Market Units or-Market

Cameras: Minolta $160 $156 $156 5 $ 780 Canon 145 153 145 7 1,015

Light Meters: Vivitar 120 114 114 12 1,368 Kodak 130 142 130 10 1,300

Total $4,463

5. Add to inventory: Oman Sales ordered goods with a cost of $8,000. Sergei should record the corresponding sales revenue of $10,000. Sergei’s decision to ship extra “unordered” goods does not constitute a sale. The manager’s statement that Oman could ship the goods back indicates that Sergei knows this overshipment is not a legitimate sale. The manager acted unethically in an attempt to improve Sergei’s reported income by overshipping. 52,000

6. Subtract from inventory: GAAP require that inventory be valued at the lower-of-cost-or-market. Obsolete parts should be adjusted from cost to zero if they have no other use. (30,000)

Correct inventory $527,000

1. Englehart Company has the following inventory, purchases, and sales data for the month of March.

Inventory: March 1 200 units @ $4.00 $ 800 Purchases: March 10 500 units @ $4.50 2,250 March 20 400 units @ $4.75 1,900 March 30 300 units @ $5.00 1,500 Sales: March 15 500 units March 25 400 units

The physical inventory count on March 31 shows 500 units on hand.

INSTRUCTIONS

Under a periodic inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under (a) the fi rst-in, fi rst-out (FIFO) method; (b) the

Compute inventory and cost of goods sold using three cost fl ow methods in a periodic inventory system.

(LO 2)

PRACTICE PROBLEMS▼

Practice Problems 297

last-in, fi rst-out (LIFO) method; and (c) the average-cost method. (For average-cost, carry cost per unit to three decimal places.)

SOLUTION

1. The cost of goods available for sale is $6,450:

Inventory: March 1 200 units @ $4.00 $ 800 Purchases: March 10 500 units @ $4.50 2,250 March 20 400 units @ $4.75 1,900 March 30 300 units @ $5.00 1,500

Total cost of goods available for sale $6,450

(a) FIFO Method Ending inventory:

Date Units Unit Cost Total Cost

Mar. 30 300 $5.00 $1,500 Mar. 20 200 4.75 950 $2,450

Cost of goods sold: $6,450 − $2,450 = $4,000

(b) LIFO Method Ending inventory:

Date Units Unit Cost Total Cost

Mar. 1 200 $4.00 $ 800 Mar. 10 300 4.50 1,350 $2,150

Cost of goods sold: $6,450 − $2,150 = $4,300

Weighted-average unit cost: $6,450 ÷ 1,400 = $4.607 Ending inventory: 500 × $4.607 = $2,303.50

Cost of goods sold: $6,450 − $2,303.50 = $4,146.50

*2. Practice Problem 1 showed cost of goods sold computations under a periodic inven- tory system. Now let’s assume that Englehart Company uses a perpetual inventory system. The company has the same inventory, purchases, and sales data for the month of March as shown earlier:

Inventory: March 1 200 units @ $4.00 $ 800 Purchases: March 10 500 units @ $4.50 2,250 March 20 400 units @ $4.75 1,900 March 30 300 units @ $5.00 1,500 Sales: March 15 500 units March 25 400 units

The physical inventory count on March 31 shows 500 units on hand.

INSTRUCTIONS

Under a perpetual inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under (a) FIFO, (b) LIFO, and (c) moving-average cost.

Compute inventory and cost of goods sold using three cost fl ow methods in a perpetual inventory system.

(LO 4)

SOLUTION

2. The cost of goods available for sale is $6,450, as follows.

Inventory: 200 units @ $4.00 $ 800 Purchases: March 10 500 units @ $4.50 2,250 March 20 400 units @ $4.75 1,900 March 30 300 units @ $5.00 1,500

Total: 1,400 $6,450

298 6 Reporting and Analyzing Inventory

Under a perpetual inventory system, the cost of goods sold under each cost fl ow method is as follows.

(a) FIFO Method

Date Purchases Cost of Goods Sold Balance

March 1 (200 @ $4.00) $ 800 March 10 (500 @ $4.50) $2,250 (200 @ $4.00) $3,050 (500 @ $4.50) March 15 (200 @ $4.00) (300 @ $4.50) (200 @ $4.50) $ 900 $2,150 March 20 (400 @ $4.75) $1,900 (200 @ $4.50) $2,800 (400 @ $4.75) March 25 (200 @ $4.50) (200 @ $4.75) (200 @ $4.75) $ 950 $1,850 March 30 (300 @ $5.00) $1,500 (200 @ $4.75) $2,450 (300 @ $5.00) Ending inventory $2,450 Cost of goods sold: $2,150 + $1,850 = $4,000

(b) LIFO Method

Date Purchases Cost of Goods Sold Balance

March 1 (200 @ $4.00) $ 800 March 10 (500 @ $4.50) $2,250 (200 @ $4.00) $3,050 (500 @ $4.50) March 15 (500 @ $4.50) $2,250 (200 @ $4.00) $ 800 March 20 (400 @ $4.75) $1,900 (200 @ $4.00)

$2,700 (400 @ $4.75) March 25 (400 @ $4.75) $1,900 (200 @ $4.00) $ 800 March 30 (300 @ $5.00) $1,500 (200 @ $4.00) $2,300 (300 @ $5.00) Ending inventory $2,300 Cost of goods sold: $2,250 1 $1,900 5 $4,150

Date Purchases Cost of Goods Sold Balance

March 1 (200 @ $ 4.00) $ 800 March 10 (500 @ $4.50) $2,250 (700 @ $4.357) $3,050 March 15 (500 @ $4.357) $2,179 (200 @ $4.357) $ 871 March 20 (400 @ $4.75) $1,900 (600 @ $4.618) $2,771 March 25 (400 @ $4.618) $1,847 (200 @ $4.618) $ 924 March 30 (300 @ $5.00) $1,500 (500 @ $4.848) $2,424 Ending inventory $2,424 Cost of goods sold: $2,179 1 $1,847 5 $4,026

⎧ ⎨ ⎩

⎧ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎩

1. “The key to successful business operations is effective inventory management.” Do you agree? Explain.

2. An item must possess two characteristics to be classi- fi ed as inventory. What are these two characteristics?

3. What is just-in-time inventory management? What are its potential advantages?

4. Your friend Will Juritz has been hired to help take the physical inventory in Byrd’s Hardware Store. Explain to Will what this job will entail.

5. (a) Bonita Company ships merchandise to Myan Corporation on December 30. The merchandise reaches the buyer on January 5. Indicate the

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.

QUESTIONS▼

Brief Exercises 299

terms of sale that will result in the goods being in- cluded in (1) Bonita’s December 31 inventory and (2) Myan’s December 31 inventory.

(b) Under what circumstances should Bonita Com- pany include consigned goods in its inventory?

6. Nona Hat Shop received a shipment of hats for which it paid the wholesaler $2,940. The price of the hats was $3,000, but Nona was given a $60 cash discount and required to pay freight charges of $75. What amount should Nona include in inventory? Why?

7. What is the primary basis of accounting for inventories?

8. Ken McCall believes that the allocation of cost of goods available for sale should be based on the actual physical fl ow of the goods. Explain to Ken why this may be both impractical and inappropriate.

9. What is the major advantage and major disadvan- tage of the specifi c identifi cation method of inventory costing?

10. “The selection of an inventory cost fl ow method is a decision made by accountants.” Do you agree? Explain. Once a method has been selected, what ac- counting requirement applies?

11. Which assumed inventory cost fl ow method: (a) usually parallels the actual physical fl ow of mer-

chandise? (b) divides cost of goods available for sale by total

units available for sale to determine a unit cost? (c) assumes that the latest units purchased are the

fi rst to be sold?

12. In a period of rising prices, the inventory reported in Short Company’s balance sheet is close to the current cost of the inventory, whereas King Company’s inven- tory is considerably below its current cost. Identify the inventory cost fl ow method used by each company. Which company probably has been reporting the higher gross profi t?

13. Mamosa Corporation has been using the FIFO cost fl ow method during a prolonged period of infl ation. During the same time period, Mamosa has been paying out all of its net income as dividends. What adverse effects may result from this policy?

14. Oscar Geer, a mid-level product manager for Theresa’s Shoes, thinks his company should switch from LIFO to FIFO. He says, “My bonus is based on net income. If

we switch it will increase net income and increase my bonus. The company would be better off and so would I.” Is he correct? Explain.

15. Discuss the impact the use of LIFO has on taxes paid, cash fl ows, and the quality of earnings ratio relative to the impact of FIFO when prices are increasing.

16. Hank Artisan is studying for the next accounting mid- term examination. What should Hank know about (a) departing from the cost basis of accounting for inven- tories and (b) the meaning of “market” in the lower-of- cost-or-market method?

17. Jackson Music Center has fi ve TVs on hand at the balance sheet date that cost $400 each. The current replacement cost is $350 per unit. Under the lower- of-cost-or-market basis of accounting for inventories, what value should Jackson report for the TVs on the balance sheet? Why?

18. What cost fl ow assumption may be used under the lower-of-cost-or-market basis of accounting for inventories?

19. Why is it inappropriate for a company to include freight-out expense in the Cost of Goods Sold account?

20. Tilton Company’s balance sheet shows Inventory $162,800. What additional disclosures should be made?

21. Under what circumstances might in- ventory turnover be too high—that is, what possible negative consequences might occur?

22. What is the LIFO reserve? What are the con- sequences of ignoring a large LIFO reserve when ana- lyzing a company?

*23. “When perpetual inventory records are kept, the re- sults under the FIFO and LIFO methods are the same as they would be in a periodic inventory system.” Do you agree? Explain.

*24. How does the average-cost method of inventory cost- ing differ between a perpetual inventory system and a periodic inventory system?

*25. Albert Company discovers in 2017 that its ending inventory at December 31, 2016, was $5,000 under- stated. What effect will this error have on (a) 2016 net income, (b) 2017 net income, and (c) the combined net income for the 2 years?

BE6-1 Peete Company identifi es the following items for possible inclusion in the physical inventory. Indicate whether each item should be included or excluded from the inventory taking. (a) 900 units of inventory shipped on consignment by Peete to another company. (b) 3,000 units of inventory in transit from a supplier shipped FOB destination. (c) 1,200 units of inventory sold but being held for customer pickup. (d) 500 units of inventory held on consignment from another company.

BE6-2 In its fi rst month of operations, McLanie Company made three purchases of mer- chandise in the following sequence: (1) 300 units at $6, (2) 400 units at $8, and (3) 500 units at $9. Assuming there are 200 units on hand at the end of the period, compute the

Identify items to be included in taking a physical inventory.

(LO 1), C

Compute ending inventory using FIFO and LIFO.

(LO 2), AP

BRIEF EXERCISES▼

300 6 Reporting and Analyzing Inventory

cost of the ending inventory under (a) the FIFO method and (b) the LIFO method. McLanie uses a periodic inventory system.

BE6-3 Data for McLanie Company are presented in BE6-2. Compute the cost of the ending inventory under the average-cost method. (Round the cost per unit to three decimal places.)

BE6-4 The management of Milque Corp. is considering the effects of various inventory- costing methods on its financial statements and its income tax expense. Assuming that the price the company pays for inventory is increasing, which method will: (a) provide the highest net income? (b) provide the highest ending inventory? (c) result in the lowest income tax expense? (d) result in the most stable earnings over a number of years?

BE6-5 In its first month of operation, Hoffman Company purchased 100 units of inven- tory for $6, then 200 units for $7, and finally 140 units for $8. At the end of the month, 180 units remained. Compute the amount of phantom profit that would result if the company used FIFO rather than LIFO. Explain why this amount is referred to as phantom profit. The company uses the periodic method.

BE6-6 For each of the following cases, state whether the statement is true for LIFO or for FIFO. Assume that prices are rising. (a) Results in a higher quality of earnings ratio. (b) Results in higher phantom profi ts. (c) Results in higher net income. (d) Results in lower taxes. (e) Results in lower net cash provided by operating activities.

BE6-7 Wahlowitz Video Center accumulates the following cost and market data at December 31.

Inventory Cost Market Categories Data Data

Cameras $12,500 $13,400 Camcorders 9,000 9,500 DVDs 13,000 12,200

Compute the lower-of-cost-or-market valuation for the company’s inventory.

BE6-8 Suppose at December 31 of a recent year, the following information (in thousands) was available for sunglasses manufacturer Oakley, Inc.: ending inventory $155,377, beginning inventory $119,035, cost of goods sold $349,114, and sales revenue $761,865. Calculate the inventory turnover and days in inventory for Oakley, Inc. (Round inventory turnover to two decimal places.)

BE6-9 Winnebago Industries, Inc. is a leading manufacturer of motor homes. Suppose Winnebago reported ending inventory at August 29, 2017, of $46,850,000 under the LIFO inventory method. In the notes to its financial statements, assume Winnebago reported a LIFO reserve of $30,346,000 at August 29, 2017. What would Winnebago Industries’ ending inventory have been if it had used FIFO?

*BE6-10 Loggins Department Store uses a perpetual inventory system. Data for product E2-D2 include the following purchases.

Number Unit Date of Units Price

May 7 50 $10 July 28 30 15

On June 1, Loggins sold 25 units, and on August 27, 30 more units. Compute the cost of goods sold using (a) FIFO, (b) LIFO, and (c) average-cost. (Round the cost per unit to three decimal places.)

*BE6-11 Fennick Company reports net income of $92,000 in 2017. However, ending inventory was understated by $7,000. What is the correct net income for 2017? What effect, if any, will this error have on total assets as reported in the balance sheet at December 31, 2017?

Compute the ending inventory using average-cost.

(LO 2), AP

Explain the fi nancial statement effect of inventory cost fl ow assumptions.

(LO 2), C

Explain the fi nancial statement effect of inventory cost fl ow assumptions.

(LO 2), AP

Identify the impact of LIFO versus FIFO.

(LO 2), C

Determine the LCM valuation.

(LO 3), AP

Compute inventory turnover and days in inventory.

(LO 3), AP

Determine ending inventory using LIFO reserve.

(LO 3), AP

Apply cost fl ow methods to perpetual inventory records.

(LO 4), AP

Determine correct fi nancial statement amount.

(LO 5), AN

Exercises 301

Sheldon Company just took its physical inventory on December 31. The count of inventory items on hand at the company’s business locations resulted in a total inven- tory cost of $300,000. In reviewing the details of the count and related inventory transac- tions, you have discovered the following items that had not been considered.

1. Sheldon has sent inventory costing $28,000 on consignment to Richfield Company. All of this inventory was at Richfield’s showrooms on December 31.

2. The company did not include in the count inventory (cost, $20,000) that was sold on December 28, terms FOB shipping point. The goods were in transit on December 31.

3. The company did not include in the count inventory (cost, $13,000) that was pur- chased with terms of FOB shipping point. The goods were in transit on December 31.

Compute the correct December 31 inventory.

The accounting records of Ohm Electronics show the following data.

Beginning inventory 3,000 units at $5 Purchases 8,000 units at $7 Sales 9,400 units at $10

Determine cost of goods sold during the period under a periodic inventory system using (a) the FIFO method, (b) the LIFO method, and (c) the average-cost method. (Round unit cost to three decimal places.)

Jeri Company sells three different categories of tools (small, medium and large). The cost and market value of its inventory of tools are as follows.

Cost Market

Small $ 64,000 $ 61,000 Medium 290,000 260,000 Large 152,000 167,000

Determine the value of the company’s inventory under the lower-of-cost-or-market approach.

Early in 2017, Fedor Company switched to a just-in-time inventory system. Its sales and inventory amounts for 2016 and 2017 are shown below.

2016 2017

Sales revenue $3,120,000 $3,713,000 Cost of goods sold 1,200,000 1,425,000 Beginning inventory 170,000 210,000 Ending inventory 210,000 90,000

DO IT! 6-1 Apply rules of ownership to determine inventory cost.

(LO 1), AN

DO IT! 6-2 Compute cost of goods sold under different cost fl ow methods.

(LO 2), AP

DO IT! 6-3a Compute inventory value under LCM.

(LO 3), AP

Compute inventory turnover and assess inventory level.

(LO 3), AN

DO IT! 6-3b

EXERCISES▼DO IT!

E6-1 Umatilla Bank and Trust is considering giving Pohl Company a loan. Before doing so, it decides that further discussions with Pohl’s accountant may be desirable. One area of particular concern is the Inventory account, which has a year-end balance of $275,000. Discussions with the accountant reveal the following. 1. Pohl sold goods costing $55,000 to Hemlock Company FOB shipping point on

December 28. The goods are not expected to reach Hemlock until January 12. The goods were not included in the physical inventory because they were not in the warehouse.

2. The physical count of the inventory did not include goods costing $95,000 that were shipped to Pohl FOB destination on December 27 and were still in transit at year-end.

3. Pohl received goods costing $25,000 on January 2. The goods were shipped FOB ship- ping point on December 26 by Yanice Co. The goods were not included in the physical count.

Determine the correct inventory amount.

(LO 1), AN

EXERCISES▼

302 6 Reporting and Analyzing Inventory

4. Pohl sold goods costing $51,000 to Ehler of Canada FOB destination on December 30. The goods were received in Canada on January 8. They were not included in Pohl’s physical inventory.

5. Pohl received goods costing $42,000 on January 2 that were shipped FOB destination on December 29. The shipment was a rush order that was supposed to arrive Decem- ber 31. This purchase was included in the ending inventory of $275,000.

Instructions Determine the correct inventory amount on December 31.

E6-2 Farley Bains, an auditor with Nolls CPAs, is performing a review of Ryder Company’s Inventory account. Ryder did not have a good year, and top management is under pressure to boost reported income. According to its records, the inventory balance at year-end was $740,000. However, the following information was not considered when determining that amount. 1. Included in the company’s count were goods with a cost of $228,000 that the company

is holding on consignment. The goods belong to Nader Corporation. 2. The physical count did not include goods purchased by Ryder with a cost of $40,000

that were shipped FOB shipping point on December 28 and did not arrive at Ryder’s warehouse until January 3.

3. Included in the Inventory account was $17,000 of office supplies that were stored in the warehouse and were to be used by the company’s supervisors and managers dur- ing the coming year.

4. The company received an order on December 29 that was boxed and was sitting on the loading dock awaiting pick-up on December 31. The shipper picked up the goods on January 1 and delivered them on January 6. The shipping terms were FOB ship- ping point. The goods had a selling price of $40,000 and a cost of $29,000. The goods were not included in the count because they were sitting on the dock.

5. Included in the count was $50,000 of goods that were parts for a machine that the company no longer made. Given the high-tech nature of Ryder’s products, it was unlikely that these obsolete parts had any other use. However, management would prefer to keep them on the books at cost, “since that is what we paid for them, after all.”

Instructions Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, stating why you did or did not make an adjustment for each item.

E6-3 Gato Inc. had the following inventory situations to consider at January 31, its year-end. (a) Goods held on consignment for Steele Corp. since December 12. (b) Goods shipped on consignment to Logan Holdings Inc. on January 5. (c) Goods shipped to a customer, FOB destination, on January 29 that are still in transit. (d) Goods shipped to a customer, FOB shipping point, on January 29 that are still in transit. (e) Goods purchased FOB destination from a supplier on January 25 that are still in transit. (f) Goods purchased FOB shipping point from a supplier on January 25 that are still in

transit. (g) Offi ce supplies on hand at January 31.

Instructions Identify which of the preceding items should be included in inventory. If the item should not be included in inventory, state in what account, if any, it should have been recorded.

E6-4 Mather sells a snowboard, EZslide, that is popular with snowboard enthusiasts. Below is information relating to Mather’s purchases of EZslide snowboards during Sep- tember. During the same month, 102 EZslide snowboards were sold. Mather uses a periodic inventory system.

Date Explanation Units Unit Cost Total Cost

Sept. 1 Inventory 12 $100 $ 1,200 Sept. 12 Purchases 45 103 4,635 Sept. 19 Purchases 50 104 5,200 Sept. 26 Purchases 20 105 2,100

Totals 127 $13,135

Determine the correct inventory amount.

(LO 1), AN

Identify items in inventory.

(LO 1), K

Compute inventory and cost of goods sold using periodic FIFO, LIFO, and average-cost.

(LO 2), AP

Exercises 303

Instructions Compute the ending inventory at September 30 and the cost of goods sold using the FIFO, LIFO, and average-cost methods. (For average-cost, round the average unit cost to three decimal places.) Prove the amount allocated to cost of goods sold under each method.

E6-5 Rusthe Inc. uses a periodic inventory system. Its records show the following for the month of May, in which 74 units were sold.

Date Explanation Units Unit Cost Total Cost

May 1 Inventory 30 $ 9 $270 15 Purchase 25 10 250 24 Purchase 38 11 418

Total 93 $938

Instructions Calculate the ending inventory at May 31 using the (a) FIFO, (b) LIFO, and (c) average- cost methods. (For average-cost, round the average unit cost to three decimal places.) Prove the amount allocated to cost of goods sold under each method.

E6-6 On December 1, Premium Electronics has three DVD players left in stock. All are identical, all are priced to sell at $85. One of the three DVD players left in stock, with serial #1012, was purchased on June 1 at a cost of $52. Another, with serial #1045, was pur- chased on November 1 for $48. The last player, serial #1056, was purchased on November 30 for $40.

Instructions (a) Calculate the cost of goods sold using the FIFO periodic inventory method, assuming

that two of the three players were sold by the end of December, Premium Electronics’ year-end.

(b) If Premium Electronics used the specifi c identifi cation method instead of the FIFO method, how might it alter its earnings by “selectively choosing” which particular players to sell to the two customers? What would Premium’s cost of goods sold be if the company wished to minimize earnings? Maximize earnings?

E6-7 Jeters Company reports the following for the month of June.

Date Explanation Units Unit Cost Total Cost

June 1 Inventory 120 $5 $ 600 12 Purchase 370 6 2,220 23 Purchase 200 7 1,400 30 Inventory 230

Instructions (a) Compute the cost of the ending inventory and the cost of goods sold under

(1) FIFO, (2) LIFO, and (3) average-cost. (Round average unit cost to three decimal places.)

(b) Which costing method gives the highest ending inventory? The highest cost of goods sold? Why?

(c) How do the average-cost values for ending inventory and cost of goods sold relate to ending inventory and cost of goods sold for FIFO and LIFO?

(d) Explain why the average cost is not $6.

E6-8 The following comparative information is available for Rose Company for 2017.

LIFO FIFO

Sales revenue $86,000 $86,000 Cost of goods sold 38,000 29,000 Operating expenses (including depreciation) 27,000 27,000 Depreciation 10,000 10,000 Cash paid for inventory purchases 32,000 32,000

Calculate inventory and cost of goods sold using FIFO, average- cost, and LIFO in a periodic inventory system.

(LO 2), AP

Calculate cost of goods sold using specifi c identifi cation and FIFO periodic.

(LO 2), AN

Compute inventory and cost of goods sold using periodic FIFO, LIFO, and average-cost.

(LO 2), AP

Evaluate impact of LIFO and FIFO on cash fl ows and earnings quality.

(LO 2), AP

304 6 Reporting and Analyzing Inventory

Instructions (a) Determine net income under each approach. Assume a 30% tax rate. (b) Determine net cash provided by operating activities under each approach. Assume

that all sales were on a cash basis and that income taxes and operating expenses, other than depreciation, were on a cash basis.

(c) Calculate the quality of earnings ratio under each approach and explain your fi ndings. (Round answer to two decimal places.)

E6-9 Digital Camera Shop Inc. uses the lower-of-cost-or-market basis for its inventory. The following data are available at December 31.

Cost Market Units per Unit per Unit

Cameras Minolta 5 $170 $158 Canon 7 145 152 Light Meters Vivitar 12 125 114 Kodak 10 120 135

Instructions What amount should be reported on Digital Camera Shop’s fi nancial statements, assuming the lower-of-cost-or-market rule is applied?

E6-10 Tascon Corporation sells coffee beans, which are sensitive to price fluctuations. The following inventory information is available for this product at December 31, 2017.

Coffee Bean Units Unit Cost Market

Coffea arabica 13,000 bags $5.60 $5.55 Coffea robusta 5,000 bags 3.40 3.50

Instructions Calculate Tascon’s inventory by applying the lower-of-cost-or-market basis.

E6-11 Suppose this information is available for PepsiCo, Inc. for 2015, 2016, and 2017.

(in millions) 2015 2016 2017

Beginning inventory $ 1,926 $ 2,290 $ 2,522 Ending inventory 2,290 2,522 2,618 Cost of goods sold 18,038 20,351 20,099 Sales revenue 39,474 43,251 43,232

Instructions (a) Calculate the inventory turnover for 2015, 2016, and 2017. (Round to one decimal place.) (b) Calculate the days in inventory for 2015, 2016, and 2017. (c) Calculate the gross profi t rate for 2015, 2016, and 2017. (d) Comment on any trends observed in your answers to parts (a), (b), and (c).

E6-12 The following information is available for Zoe’s Activewear Inc. for three recent fiscal years.

2017 2016 2015

Inventory $ 553,000 $ 568,000 $ 332,000 Net sales 1,948,000 1,725,000 1,311,000 Cost of goods sold 1,552,000 1,288,000 947,000

Instructions (a) Calculate the inventory turnover, days in inventory, and gross profi t rate for 2017 and

2016. (b) Based on the ratios calculated in part (a), did Zoe’s liquidity and profi tability improve

or deteriorate in 2017?

E6-13 Deere & Company is a global manufacturer and distributor of agricultural, con- struction, and forestry equipment. Suppose it reported the following information in its 2017 annual report.

Determine LCM valuation.

(LO 3), AP

Determine LCM valuation.

(LO 3), AP

Compute inventory turnover, days in inventory, and gross profi t rate.

(LO 3), AP

Calculate inventory turnover, days in inventory, and gross profi t rate.

(LO 3), AP

Compute inventory turnover and determine the effect of the LIFO reserve on current ratio.

(LO 3), AP

Exercises 305

(in millions) 2017 2016

Inventories (LIFO) $ 2,397 $3,042 Current assets 30,857 Current liabilities 12,753 LIFO reserve 1,367 Cost of goods sold 16,255

Instructions (a) Compute Deere’s inventory turnover and days in inventory for 2017. (Round inventory

turnover to 2 decimal places.) (b) Compute Deere’s current ratio using the 2017 data as presented, and then again after

adjusting for the LIFO reserve. (c) Comment on how ignoring the LIFO reserve might affect your evaluation of Deere’s

liquidity.

*E6-14 Inventory data for Jeters Company are presented in E6-7.

Instructions (a) Calculate the cost of the ending inventory and the cost of goods sold for each cost fl ow

assumption, using a perpetual inventory system. Assume a sale of 410 units occurred on June 15 for a selling price of $8 and a sale of 50 units on June 27 for $9. (Note: For the moving-average method, round unit cost to three decimal places.)

(b) How do the results differ from E6-7? (c) Why is the average unit cost not $6 [($5 + $6 + $7) ÷ 3 = $6]?

*E6-15 Information about Mather is presented in E6-4. Additional data regarding the company’s sales of EZslide snowboards are provided below. Assume that Mather uses a perpetual inventory system.

Date Units

Sept. 5 Sale 8 Sept. 16 Sale 48 Sept. 29 Sale 46

Totals 102

Instructions Compute ending inventory at September 30 using FIFO, LIFO, and moving-average. (Note: For moving-average, round unit cost to three decimal places.)

*E6-16 Dowell Hardware reported cost of goods sold as follows.

2017 2016

Beginning inventory $ 30,000 $ 20,000 Cost of goods purchased 175,000 164,000

Cost of goods available for sale 205,000 184,000 Less: Ending inventory 37,000 30,000

Cost of goods sold $168,000 $154,000

Dowell made two errors: 1. 2016 ending inventory was overstated by $2,000. 2. 2017 ending inventory was understated by $5,000.

Instructions Compute the correct cost of goods sold for each year.

*E6-17 Sheen Company reported these income statement data for a 2-year period.

2017 2016

Sales revenue $250,000 $210,000

Beginning inventory 40,000 32,000 Cost of goods purchased 202,000 173,000

Cost of goods available for sale 242,000 205,000 Less: Ending inventory 55,000 40,000

Cost of goods sold 187,000 165,000

Gross profit $ 63,000 $ 45,000

Calculate inventory and cost of goods sold using three cost fl ow methods in a perpetual inventory system.

(LO 4), AP

Apply cost fl ow methods to perpetual records.

(LO 4), AP

Determine effects of inventory errors.

(LO 5), AN

Prepare correct income statements.

(LO 5), AN

306 6 Reporting and Analyzing Inventory

Sheen Company uses a periodic inventory system. The inventories at January 1, 2016, and December 31, 2017, are correct. However, the ending inventory at December 31, 2016, is overstated by $8,000.

Instructions (a) Prepare correct income statement data for the 2 years. (b) What is the cumulative effect of the inventory error on total gross profi t for the

2 years? (c) Explain in a letter to the president of Sheen Company what has happened—

that is, the nature of the error and its effect on the fi nancial statements.

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

▼ EXERCISES: SET B AND CHALLENGE EXERCISES

P6-1A Pitt Limited is trying to determine the value of its ending inventory as of Febru- ary 28, 2017, the company’s year-end. The accountant counted everything that was in the warehouse as of February 28, which resulted in an ending inventory valuation of $48,000. However, she didn’t know how to treat the following transactions so she didn’t record them.

(a) On February 26, Pitt shipped to a customer goods costing $800. The goods were shipped FOB shipping point, and the receiving report indicates that the customer received the goods on March 2.

(b) On February 26, Martine Inc. shipped goods to Pitt FOB destination. The invoice price was $350 plus $25 for freight. The receiving report indicates that the goods were received by Pitt on March 2.

(c) Pitt had $500 of inventory at a customer’s warehouse “on approval.” The customer was going to let Pitt know whether it wanted the merchandise by the end of the week, March 4.

(d) Pitt also had $400 of inventory at a Belle craft shop, on consignment from Pitt. (e) On February 26, Pitt ordered goods costing $750. The goods were shipped FOB ship-

ping point on February 27. Pitt received the goods on March 1. (f) On February 28, Pitt packaged goods and had them ready for shipping to a customer

FOB destination. The invoice price was $350 plus $25 for freight; the cost of the items was $280. The receiving report indicates that the goods were received by the customer on March 2.

(g) Pitt had damaged goods set aside in the warehouse because they are no longer salea- ble. These goods originally cost $400 and, originally, Pitt expected to sell these items for $600.

Instructions For each of the above transactions, specify whether the item in question should be included in ending inventory, and if so, at what amount. For each item that is not included in ending inventory, indicate who owns it and what account, if any, it should have been recorded in.

P6-2A Mullins Distribution markets CDs of numerous performing artists. At the begin- ning of March, Mullins had in beginning inventory 2,500 CDs with a unit cost of $7. Dur- ing March, Mullins made the following purchases of CDs.

March 5 2,000 @ $8 March 21 5,000 @ $10 March 13 3,500 @ $9 March 26 2,000 @ $11

During March 12,000 units were sold. Mullins uses a periodic inventory system.

Instructions (a) Determine the cost of goods available for sale. (b) Determine (1) the ending inventory and (2) the cost of goods sold under each of the

assumed cost fl ow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the

Determine items and amounts to be recorded in inventory.

(LO 1), AN

Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost with analysis.

(LO 2), AP

(b) Cost of goods sold: FIFO $105,000 LIFO $115,500 Average $109,601

PROBLEMS: SET A▼

Problems: Set A 307

cost of goods sold under the FIFO and LIFO methods. (Note: For average-cost, round cost per unit to three decimal places.)

(c) Which cost fl ow method results in (1) the highest inventory amount for the balance sheet and (2) the highest cost of goods sold for the income statement?

P6-3A Vista Company Inc. had a beginning inventory of 100 units of Product RST at a cost of $8 per unit. During the year, purchases were:

Feb. 20 600 units at $ 9 Aug. 12 400 units at $11 May 5 500 units at $10 Dec. 8 100 units at $12

Vista Company uses a periodic inventory system. Sales totaled 1,500 units.

Instructions (a) Determine the cost of goods available for sale. (b) Determine the ending inventory and the cost of goods sold under each of the assumed

cost fl ow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods. (Round average unit cost to three decimal places.)

(c) Which cost fl ow method results in the lowest inventory amount for the balance sheet? The lowest cost of goods sold for the income statement?

P6-4A The management of National Inc. asks your help in determining the comparative effects of the FIFO and LIFO inventory cost fl ow methods. For 2017, the accounting records show these data.

Inventory, January 1 (10,000 units) $ 35,000 Cost of 120,000 units purchased 468,500 Selling price of 98,000 units sold 750,000 Operating expenses 124,000

Units purchased consisted of 35,000 units at $3.70 on May 10, 60,000 units at $3.90 on August 15, and 25,000 units at $4.20 on November 20. Income taxes are 28%.

Instructions (a) Prepare comparative condensed income statements for 2017 under FIFO and LIFO.

(Show computations of ending inventory.) (b) Answer the following questions for management in the form of a business letter. (1) Which inventory cost fl ow method produces the inventory amount that most closely

approximates the amount that would have to be paid to replace the inventory? Why? (2) Which inventory cost fl ow method produces the net income amount that is a more

likely indicator of next period’s net income? Why? (3) Which inventory cost fl ow method is most likely to approximate the actual physical

fl ow of the goods? Why? (4) How much more cash will be available under LIFO than under FIFO? Why? (5) How much of the gross profi t under FIFO is illusionary in comparison with the

gross profi t under LIFO?

P6-5A You have the following information for Van Gogh Inc. for the month ended Octo- ber 31, 2017. Van Gogh uses a periodic method for inventory.

Date Description Units Unit Cost or Selling Price

Oct. 1 Beginning inventory 60 $24 Oct. 9 Purchase 120 26 Oct. 11 Sale 100 35 Oct. 17 Purchase 100 27 Oct. 22 Sale 60 40 Oct. 25 Purchase 70 29 Oct. 29 Sale 110 40

Instructions (a) Calculate (i) ending inventory, (ii) cost of goods sold, (iii) gross profi t, and (iv) gross

profi t rate under each of the following methods. (1) LIFO. (2) FIFO. (3) Average-cost. (Round cost per unit to three decimal places.) (b) Compare results for the three cost fl ow assumptions.

Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost in a periodic inventory system and assess fi nancial statement effects.

(LO 2), AP

(b) Cost of goods sold: FIFO $14,500 LIFO $15,100 Average $14,824

Compute ending inventory, prepare income statements, and answer questions using FIFO and LIFO.

(LO 2), AN

(a) Gross profi t: FIFO $378,800 LIFO $362,900

Calculate ending inventory, cost of goods sold, gross profi t, and gross profi t rate under periodic method; compare results.

(LO 2), AP

(a) Gross profi t: LIFO $2,970 FIFO $3,310 Average $3,133

308 6 Reporting and Analyzing Inventory

P6-6A You have the following information for Jewels Gems. Jewels uses the periodic method of accounting for its inventory transactions. Jewels only carries one brand and size of diamonds—all are identical. Each batch of diamonds purchased is carefully coded and marked with its purchase cost.

March 1 Beginning inventory 150 diamonds at a cost of $310 per diamond. March 3 Purchased 200 diamonds at a cost of $350 each. March 5 Sold 180 diamonds for $600 each. March 10 Purchased 330 diamonds at a cost of $375 each. March 25 Sold 390 diamonds for $650 each.

Instructions (a) Assume that Jewels Gems uses the specifi c identifi cation cost fl ow method. (1) Demonstrate how Jewels could maximize its gross profi t for the month by specifi -

cally selecting which diamonds to sell on March 5 and March 25. (2) Demonstrate how Jewels could minimize its gross profi t for the month by selecting

which diamonds to sell on March 5 and March 25. (b) Assume that Jewels uses the FIFO cost fl ow assumption. Calculate cost of goods sold.

How much gross profi t would Jewels report under this cost fl ow assumption? (c) Assume that Jewels uses the LIFO cost fl ow assumption. Calculate cost of goods

sold. How much gross profi t would the company report under this cost fl ow assumption?

(d) Which cost fl ow method should Jewels Gems select? Explain.

P6-7A Suppose this information (in millions) is available for the Automotive and Other Operations Divisions of General Motors Corporation for a recent year. General Motors uses the LIFO inventory method.

Beginning inventory $ 13,921 Ending inventory 14,939 LIFO reserve 1,423 Current assets 60,135 Current liabilities 70,308 Cost of goods sold 166,259 Sales revenue 178,199

Instructions (a) Calculate the inventory turnover and days in inventory. (Round to one decimal place.) (b) Calculate the current ratio based on inventory as reported using LIFO. (c) Calculate the current ratio after adjusting for the LIFO reserve. (d) Comment on any difference between parts (b) and (c).

*P6-8A Bieber Inc. is a retailer operating in Calgary, Alberta. Bieber uses the perpetual inventory method. Assume that there are no credit transactions; all amounts are settled in cash. You are provided with the following information for Bieber for the month of January 2017.

Date Description Quantity Unit Cost or Selling Price

Dec. 31 Ending inventory 160 $20 Jan. 2 Purchase 100 22 Jan. 6 Sale 180 40 Jan. 9 Purchase 75 24 Jan. 10 Sale 50 45 Jan. 23 Purchase 100 25 Jan. 30 Sale 130 48

Instructions (a) For each of the following cost fl ow assumptions, calculate (i) cost of goods sold,

(ii) ending inventory, and (iii) gross profi t. (1) LIFO. (2) FIFO. (3) Moving-average. (Round cost per unit to three decimal places.) (b) Compare results for the three cost fl ow assumptions.

Compare specifi c identifi cation, FIFO, and LIFO under periodic method; use cost fl ow assumption to infl uence earnings.

(LO 2), AP

(a) Gross profi t: Maximum $162,500 Minimum $155,350

Compute inventory turnover and days in inventory; compute current ratio based on LIFO and after adjusting for LIFO reserve.

(LO 3), AP

Calculate cost of goods sold, ending inventory, and gross profi t for LIFO, FIFO, and moving- average under the perpetual system; compare results.

(LO 4), AP

(a) Gross profi t: LIFO $7,490 FIFO $7,865 Average $7,763

Comprehensive Accounting Cycle Review 309

*P6-9A Lyon Center began operations on July 1. It uses a perpetual inventory system. Dur- ing July, the company had the following purchases and sales.

Purchases

Date Units Unit Cost Sales Units

July 1 7 $62 July 6 5 July 11 3 $66 July 14 3 July 21 4 $71 July 27 3

Instructions (a) Determine the ending inventory under a perpetual inventory system using (1) FIFO,

(2) moving-average (round unit cost to three decimal places), and (3) LIFO. (b) Which costing method produces the highest ending inventory valuation?

Determine ending inventory under a perpetual inventory system.

(LO 4), AP

(a) FIFO $213 Average $207 LIFO $195

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 5.)

CC6 Natalie is busy establishing both divisions of her business (cookie classes and mixer sales) and completing her business degree. Her goals for the next 11 months are to sell one mixer per month and to give two to three classes per week. Natalie has decided to use a periodic inventory system and now must choose a cost fl ow assumption for her mixer inventory.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to see the completion of this problem.

CONTINUING PROBLEM Cookie Creations▼

COMPREHENSIVE ACCOUNTING CYCLE REVIEW ACR6 On December 1, 2017, Waylon Company had the account balances shown below.

Debit Credit

Cash $ 4,800 Accumulated Depreciation—Equipment $ 1,500 Accounts Receivable 3,900 Accounts Payable 3,000 Inventory 1,800* Common Stock 10,000 Equipment 21,000 Retained Earnings 17,000 $31,500 $31,500

*(3,000 3 $0.60)

The following transactions occurred during December.

Dec. 3 Purchased 4,000 units of inventory on account at a cost of $0.72 per unit. 5 Sold 4,400 units of inventory on account for $0.90 per unit. (Waylon sold 3,000

of the $0.60 units and 1,400 of the $0.72.) 7 Granted the December 5 customer $180 credit for 200 units of inventory

returned costing $144. These units were returned to inventory. 17 Purchased 2,200 units of inventory for cash at $0.80 each. 22 Sold 2,000 units of inventory on account for $0.95 per unit. (Waylon sold 2,000

of the $0.72 units.)

310 6 Reporting and Analyzing Inventory

Adjustment data:

1. Accrued salaries and wages payable $400. 2. Depreciation on equipment $200 per month. 3. Income tax expense was $215, to be paid next year.

Instructions (a) Journalize the December transactions and adjusting entries, assuming Waylon uses

the perpetual inventory method. (b) Enter the December 1 balances in the ledger T-accounts and post the December trans-

actions. In addition to the accounts mentioned above, use the following additional accounts: Income Taxes Payable, Salaries and Wages Payable, Sales Revenue, Sales Returns and Allowances, Cost of Goods Sold, Depreciation Expense, Salaries and Wages Expense, and Income Tax Expense.

(c) Prepare an adjusted trial balance as of December 31, 2017. (d) Prepare an income statement for December 2017 and a classifi ed balance sheet at

December 31, 2017. (e) Compute ending inventory and cost of goods sold under FIFO, assuming Waylon

Company uses the periodic inventory system. (f) Compute ending inventory and cost of goods sold under LIFO, assuming Waylon

Company uses the periodic inventory system.

FINANCIAL REPORTING PROBLEM: Apple Inc.

CT6-1 The notes that accompany a company’s fi nancial statements provide informative details that would clutter the amounts and descriptions presented in the statements. Refer to the fi nancial statements of Apple Inc. in Appendix A. Instructions for accessing and using the company’s complete annual report, including the notes to the fi nancial statements, are also provided in Appendix A.

Instructions Answer the following questions. (Give the amounts in thousands of dollars, as shown in Apple’s annual report.)

(a) What did Apple report for the amount of inventories in its Consolidated Balance Sheet at September 27, 2014? At September 28, 2013?

(b) Compute the dollar amount of change and the percentage change in inventories be- tween 2013 and 2014. Compute inventory as a percentage of current assets for 2014.

(c) What are the cost of sales reported by Apple for 2014, 2013, and 2012? Compute the ratio of cost of sales to net sales in 2014.

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT6-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements for VF Corporation are presented in Appendix C.

Instructions (a) Based on the information in the fi nancial statements, compute these 2014 values for

each company. (1) Inventory turnover. (Use cost of goods sold or cost of sales and inventories.) (2) Days in inventory. (b) What conclusions concerning the management of the inventory can you draw from

these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT6-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Finan- cial statements for Wal-Mart Stores, Inc. are presented in Appendix E.

Financial Reporting

▼

Financial Analysis

▼

Financial Analysis

▼

EXPAND YOUR CRITICAL THINKING

Expand Your Critical Thinking 311

Instructions (a) Based on the information in the fi nancial statements, compute these 2014 values for

each company. (1) Inventory turnover. (Use cost of sales and inventories.) (2) Days in inventory. (b) What conclusions concerning the management of the inventory can you draw from

these data?

INTERPRETING FINANCIAL STATEMENTS

CT6-4 Suppose the following information is from the 2017 annual report of American Greetings Corporation (all dollars in thousands).

Feb. 28, Feb. 28, 2017 2016

Inventories Finished goods $232,893 $244,379 Work in process 7,068 10,516 Raw materials and supplies 49,937 43,861

289,898 298,756 Less: LIFO reserve 86,025 82,085

Total (as reported) $203,873 $216,671

Cost of goods sold $809,956 $780,771 Current assets (as reported) $561,395 $669,340 Current liabilities $343,405 $432,321

The notes to the company’s fi nancial statements also include the following information.

Finished products, work in process, and raw material inventories are carried at the lower-of-cost-or-market. The last-in, fi rst-out (LIFO) cost method is used for approxi- mately 75% of the domestic inventories in 2017 and approximately 70% in 2016. The foreign subsidiaries principally use the fi rst-in, fi rst-out (FIFO) method. Display material and factory supplies are carried at average-cost.

Instructions (a) Defi ne each of the following: fi nished goods, work in process, and raw materials. (b) What might be a possible explanation for why the company uses FIFO for its nondo-

mestic inventories? (c) Calculate the company’s inventory turnover and days in inventory for 2016 and 2017.

(2015 inventory was $182,618.) Discuss the implications of any change in the ratios. (d) What percentage of total inventory does the 2017 LIFO reserve represent? If the com-

pany used FIFO in 2017, what would be the value of its inventory? Do you consider this difference a “material” amount from the perspective of an analyst? Which value accurately represents the value of the company’s inventory?

(e) Calculate the company’s 2017 current ratio with the numbers as reported, then recal- culate after adjusting for the LIFO reserve.

REAL-WORLD FOCUS

CT6-5 Purpose: Use SEC fi lings to learn about a company’s inventory accounting practices.

Address: http://biz.yahoo.com/p/_capgds-bldmch.html

Steps 1. Go to this site and click on the name of an equipment manufacturer other than those

discussed in the chapter. 2. Click on SEC filings. 3. Under “Recent filings” choose Form 10K (annual report) and click on Full Filing at

Edgar Online. 4. Choose option “3,” Online HTML Version.

If the 10K is not listed among the recent fi lings, then click on View All Filings on EDGAR Online.

Instructions Review the 10K to answer the following questions.

312 6 Reporting and Analyzing Inventory

(a) What is the name of the company? (b) How has its inventory changed from the previous year? (c) What is the amount of raw materials, work in process, and fi nished goods inventory? (d) What inventory method does the company use? (e) Calculate the inventory turnover and days in inventory for the current year. (f) If the company uses LIFO, what was the amount of its LIFO reserve?

CT6-6 The July 15, 2010, edition of CFO.com contains an article by Marie Leone entitled “Sucking the LIFO out of Inventory.”

Instructions Read the article, which can be found at www.cfo.com/printable/article.cfm/14508745, and answer the following questions.

(a) What type of company benefi ts most from the use of LIFO? (b) What is the estimated boost in federal tax receipts over 10 years if the use of LIFO for

taxes was not allowed? (c) If the United States decides to adopt International Financial Reporting Standards

(IFRS), what would be the implications for the use of LIFO? (d) What conceptual justifi cation for LIFO do its proponents provide? (e) What types of companies prefer to use FIFO?

DECISION-MAKING ACROSS THE ORGANIZATION

CT6-7 Solar Electronics has enjoyed tremendous sales growth during the last 10 years. How- ever, even though sales have steadily increased, the company’s CEO, Dana Byrnes, is con- cerned about certain aspects of its performance. She has called a meeting with the corporate controller and the vice presidents of fi nance, operations, sales, and marketing to discuss the company’s performance. Dana begins the meeting by making the following observations:

We have been forced to take signifi cant write-downs on inventory during each of the last three years because of obsolescence. In addition, inventory storage costs have soared. We rent four additional warehouses to store our increasingly diverse inven- tory. Five years ago inventory represented only 20% of the value of our total assets. It now exceeds 35%. Yet, even with all of this inventory, “stockouts” (measured by com- plaints by customers that the desired product is not available) have increased by 40% during the last three years. And worse yet, it seems that we constantly must discount merchandise that we have too much of.

Dana asks the group to review the following data and make suggestions as to how the company’s performance might be improved.

(in millions) 2017 2016 2015 2014

Inventory Raw materials $242 $198 $155 $128 Work in process 116 77 49 33 Finished goods 567 482 398 257

Total inventory $925 $757 $602 $418

Current assets $1,800 $1,423 $1,183 $841 Total assets $2,643 $2,523 $2,408 $2,090 Current liabilities $600 $590 $525 $420 Sales revenue $9,428 $8,674 $7,536 $6,840 Cost of goods sold $6,328 $5,474 $4,445 $3,557 Net income $754 $987 $979 $958

Instructions Using the information provided, answer the following questions.

(a) Compute the current ratio, gross profi t rate, profi t margin, inventory turnover, and days in inventory for 2015, 2016, and 2017.

(b) Discuss the trends and potential causes of the changes in the ratios in part (a). (c) Discuss potential remedies to any problems discussed in part (b). (d) What concerns might be raised by some members of management with regard to your

suggestions in part (c)?

Financial Analysis

Writing

Group Project

▼

Expand Your Critical Thinking 313

COMMUNICATION ACTIVITIES

CT6-8 In a discussion of dramatic increases in coffee-bean prices, a Wall Street Journal article noted the following fact about Starbucks.

Before this year’s bean-price hike, Starbucks added several defenses that analysts say could help it maintain earnings and revenue. The company last year began account- ing for its coffee-bean purchases by taking the average price of all beans in inventory.

Prior to this change, the company was using FIFO.

Instructions Your client, the CEO of Superior Coffee, Inc., read this article and sent you an e-mail message requesting that you explain why Starbucks might have taken this action. Your response should explain what impact this change in accounting method has on earnings, why the company might want to do this, and any possible disadvantages of such a change.

*CT6-9 You are the controller of Garton Inc. H. K. Logan, the president, recently mentioned to you that she found an error in the 2016 financial statements which she believes has cor- rected itself. She determined, in discussions with the purchasing department, that 2016 ending inventory was overstated by $1 million. H. K. says that the 2017 ending inventory is correct, and she assumes that 2017 income is correct. H. K. says to you, “What happened has happened—there’s no point in worrying about it anymore.”

Instructions You conclude that H. K. is incorrect. Write a brief, tactful memo to her, clarifying the situation.

ETHICS CASE

CT6-10 Nixon Wholesale Corp. uses the LIFO cost flow method. In the current year, profit at Nixon is running unusually high. The corporate tax rate is also high this year, but it is scheduled to decline significantly next year. In an effort to lower the current year’s net income and to take advantage of the changing income tax rate, the president of Nixon Wholesale instructs the plant accountant to recommend to the purchasing department a large purchase of inventory for delivery 3 days before the end of the year. The price of the inventory to be purchased has doubled during the year, and the purchase will represent a major portion of the ending inventory value.

Instructions (a) What is the effect of this transaction on this year’s and next year’s income statement

and income tax expense? Why? (b) If Nixon Wholesale had been using the FIFO method of inventory costing, would the

president give the same directive? (c) Should the plant accountant order the inventory purchase to lower income? What are

the ethical implications of this order?

ALL ABOUT YOU

CT6-11 Some of the largest business frauds ever perpetrated have involved the misstate- ment of inventory. Two classics were at Leslie Fay and McKesson Corporation.

Instructions There is considerable information regarding inventory frauds available on the Internet. Search for information about one of the two cases mentioned above, or inventory fraud at any other company, and prepare a short explanation of the nature of the inventory fraud.

FASB CODIFICATION ACTIVITY

CT6-12 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.

(a) The primary basis for accounting for inventories is cost. How is cost defi ned in the Codifi cation?

(b) What does the Codifi cation state regarding the use of consistency in the selection or employment of a basis for inventory?

(c) What does the Codifi cation indicate is a justifi cation for the use of the lower-of-cost- or-market for inventory valuation?

314 6 Reporting and Analyzing Inventory

CONSIDERING PEOPLE, PLANET, AND PROFIT

CT6-13 Caterpillar publishes an annual Sustainability Report to explain its position on sustainability, describe its goals, and report on its achievements. The report can be found at http://www.caterpillar.com/sustainability/sustainability-report.

Instructions Access the report and answer the following questions.

(a) Page 66 describes the company’s goals for the year 2020. What are these goals? (b) Page 67 describes the company’s results relative to 2003 with regard to worker safety.

Summarize the company’s progress in this area. (c) Page 68 describes the company’s results regarding energy use. Explain how the com-

pany measures its progress, and comment on its results thus far.

A Look at IFRS

The major IFRS requirements related to accounting and reporting for inventories are the same as GAAP. The major differences are that IFRS prohibits the use of the LIFO cost flow assumption and determines market in the lower-of-cost-or-market inventory valuation differently.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related inventories.

Similarities • IFRS and GAAP account for inventory acquisitions at historical cost and value inven-

tory at the lower-of-cost-or-market subsequent to acquisition. • Who owns the goods—goods in transit or consigned goods—as well as the costs to

include in inventory are essentially accounted for the same under IFRS and GAAP.

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 flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.

• In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP, on the other hand, defines market as replacement cost.

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

LEARNING OBJECTIVE 6 Compare the accounting for inventories under GAAP and IFRS.▼

A Look at IFRS 315

IFRS Practice IFRS SELF-TEST QUESTIONS 1. Which of the following should not be included in the inventory of a company using

IFRS? (a) Goods held on consignment from another company. (b) Goods shipped on consignment to another company. (c) Goods in transit from another company shipped FOB shipping point. (d) None of the above.

2. Which method of inventory costing is prohibited under IFRS? (a) Specific identification. (c) FIFO. (b) LIFO. (d) Average-cost.

IFRS EXERCISES IFRS6-1 Briefly describe some of the similarities and differences between GAAP and IFRS with -respect to the accounting for inventories.

IFRS6-2 LaTour Inc. is based in France and prepares its financial statements (in euros) in accordance with IFRS. In 2017, it reported cost of goods sold of €578 million and aver- age 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.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS6-3 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Using the notes to the company’s financial statements, answer the following questions.

(a) What cost flow assumption does the company use to value inventory? (b) What amount of goods purchased for retail and finished products did the company

report at December 31, 2014?

Answers to IFRS Self-Test Questions 1. a 2. b

As the Feature Story about recording cash sales at Barriques indicates, control of cash is important

to ensure that fraud does not occur. Companies also need controls to safeguard other types of

assets. For example, Barriques undoubtedly has controls to prevent the theft of food and supplies,

and controls to prevent the theft of tableware and dishes from its kitchen.

In this chapter, we explain the essential features of an internal control system and how it prevents

fraud. We also describe how those controls apply to a specifi c asset—cash. The applications include

some controls with which you may be already familiar, such as the use of a bank.

CHAPTER PREVIEW

Fraud, Internal Control, and Cash 7

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

▼1 Defi ne fraud and the principles of internal control.

• Fraud • The Sarbanes-Oxley Act • Internal control • Principles of internal control

activities • Limitations of internal control

DO IT!

1 Control Activities

▼2 Apply internal control principles to cash.

• Cash receipts controls • Cash disbursements controls

DO IT!

2 Control over Cash Receipts

▼3 Identify the control features of a bank account.

• EFT system • Bank statements • Reconciling the bank account

DO IT!

3 Bank Reconciliation

▼4 Explain the reporting of cash and the basic principles of cash management.

• Reporting cash • Managing and monitoring

cash • Cash budgeting

DO IT!

4 4a Reporting Cash 4b Cash Budget

For many years, Barriques in Madison, Wisconsin, has been named the city’s favorite coffeehouse. Barriques not only does a booming business in coffee but also has wonderful baked goods, delicious sandwiches, and a fi ne selection of wines.

“Our customer base ranges from college students to neighborhood residents as well as visitors to our capital city,” says bookkeeper Kerry Stoppleworth, who joined the company shortly after it was founded in 1998. “We are unique because we have customers who come in early on their way to work for a cup of coffee and then will stop back after work to pick up a bottle of wine for dinner. We stay very busy throughout all three parts of the day.”

Like most businesses where purchases are low-cost and high-volume, cash control has to be simple. “We use a computerized point-of-sale (POS) system to keep track of our inventory and allow us to effi ciently ring through an order for a customer,” explains Stoppleworth. “You can either scan a barcode for an item or enter in a code for items that don’t have a barcode such as cups of coffee or bakery items.” The POS system also automatically tracks sales by department and maintains an

electronic journal of all the sales transactions that occur during the day.

“There are two POS stations at each store, and throughout the day any of the staff

may operate them,” says Stopple- worth. At the end of the day, each POS station is reconciled separately. The staff counts the cash in the drawer and enters this amount into the closing totals in the POS system. The POS system then compares the cash and credit amounts, less the cash being carried forward to the

next day (the fl oat), to the shift total in the electronic journal. If there are discrepancies, a recount is done and the journal is reviewed transaction by transaction to identify the problem. The staff then creates a deposit ticket for the cash less the fl oat and puts this in a drop safe with the electronic journal summary report for the manager to review and take to the bank the next day. Ultimately, the bookkeeper reviews all of these documents as well as the deposit receipt that the bank produces to make sure they are all in agreement.

As Stoppleworth concludes, “We keep the closing process and accounting simple so that our staff can concentrate on taking care of our customers and making great coffee and food.”

FEATURE STORY

Minding the Money in Madison

318 7 Fraud, Internal Control, and Cash

LEARNING OBJECTIVE 1 Defi ne fraud and the principles of internal control.▼

The Feature Story describes many of the internal control procedures used by Barriques. These procedures are necessary to discourage employees from fraud- ulent activities.

FRAUD

A fraud is a dishonest act by an employee that results in personal benefi t to the employee at a cost to the employer. Examples of fraud reported in the fi nancial press include the following.

• A bookkeeper in a small company diverted $750,000 of bill payments to a personal bank account over a three-year period.

• A shipping clerk with 28 years of service shipped $125,000 of merchandise to himself.

• A computer operator embezzled $21 million from Wells Fargo Bank over a two-year period.

• A church treasurer “borrowed” $150,000 of church funds to fi nance a friend’s business dealings.

Why does fraud occur? The three main factors that contribute to fraudulent activity are depicted by the fraud triangle in Illustration 7-1. The most important element of the fraud triangle is opportunity. For an employee to commit fraud, the workplace environment must provide opportu-

nities that an employee can exploit. Opportunities occur when the workplace lacks suffi cient controls to deter and detect fraud. For example, inadequate monitoring of employee actions can create opportunities for theft and can embolden employees because they believe they will not be caught. A second factor that contributes to fraud is fi nancial pressure. Employees sometimes commit fraud because of personal fi nancial problems caused by too much debt. Or they might commit fraud because they want to lead a lifestyle that they cannot afford on their current salary. The third factor that contributes to fraud is rationalization. In order to justify their fraud, employees rationalize their dishonest actions. For example, employees sometimes justify fraud because

they believe they are underpaid while the employer is making lots of money. These employees feel justifi ed in stealing because they believe they deserve to be paid more.

THE SARBANES-OXLEY ACT

What can be done to prevent or to detect fraud? After numerous corporate scan- dals came to light in the early 2000s, Congress addressed this issue by passing the Sarbanes-Oxley Act (SOX). Under SOX, all publicly traded U.S. corporations are required to maintain an adequate system of internal control. Corporate exec- utives and boards of directors must ensure that these controls are reliable and effective. In addition, independent outside auditors must attest to the adequacy of the internal control system. Companies that fail to comply are subject to fi nes, and company offi cers can be imprisoned. SOX also created the Public Company Accounting Oversight Board (PCAOB) to establish auditing standards and regu- late auditor activity. One poll found that 60% of investors believe that SOX helps safeguard their stock investments. Many say they would be unlikely to invest in a company that

Opportunity

Financial Pressure

Rationalization

ILLUSTRATION 7-1 Fraud triangle

Fraud and Internal Control 319

fails to follow SOX requirements. Although some corporate executives have criticized the time and expense involved in following SOX requirements, SOX appears to be working well. For example, the chief accounting offi cer of Eli Lily noted that SOX triggered a comprehensive review of how the company docu- ments controls. This review uncovered redundancies and pointed out controls that needed to be added. In short, it added up to time and money well spent. And the fi nance chief at General Electric noted, “We have seen value in SOX. It helps build investors’ trust and gives them more confi dence.”

INTERNAL CONTROL

Internal control is a process designed to provide reasonable assurance regard- ing the achievement of company objectives related to operations, reporting, and compliance. In more detail, the purposes of internal control are to safeguard assets, enhance the reliability of accounting records, increase effi ciency of operations, and ensure compliance with laws and regulations. Internal control systems have fi ve primary components as listed below.1

• A control environment. It is the responsibility of top management to make it clear that the organization values integrity and that unethical activity will not be tolerated. This component is often referred to as the “tone at the top.”

• Risk assessment. Companies must identify and analyze the various fac- tors that create risk for the business and must determine how to manage these risks.

• Control activities. To reduce the occurrence of fraud, management must design policies and procedures to address the specifi c risks faced by the company.

• Information and communication. The internal control system must capture and communicate all pertinent information both down and up the organiza- tion, as well as communicate information to appropriate external parties.

• Monitoring. Internal control systems must be monitored periodically for their adequacy. Signifi cant defi ciencies need to be reported to top manage- ment and/or the board of directors.

1The Committee of Sponsoring Organizations of the Treadway Commission, “Internal Control— Integrated Framework,” www.coso.org/documents/990025p_Executive_Summary_fi nal_may20_e.pdf; and Stephen J. McNally, “The 2013 COSO Framework and SOX Compliance,” Strategic Finance (June 2013).

PEOPLE, PLANET, AND PROFIT INSIGHT

And the Controls Are . . . Internal controls are important for an effective fi nancial report- ing system. The same is true for sustainability reporting. An effec- tive system of internal controls for sustainability reporting will help in the following ways: (1) prevent the unauthorized use of data; (2) provide reasonable assurance that the information is accurate, valid, and complete; and (3) re-

port information that is consistent with overall sustainability

accounting policies. With these types of controls, users will have the confi dence that they can use the sustainability information effectively. Some regulators are calling for even more assurance through audits of this information. Companies that potentially can cause environmental damage through greenhouse gases, as well as companies in the mining and extractive industries, are subject to reporting requirements. And, as demand for more information in the sustainability area expands, the need for audits of this information will grow.

Why is sustainability information important to investors? (Go to WileyPLUS for this answer and additional questions.)

320 7 Fraud, Internal Control, and Cash

PRINCIPLES OF INTERNAL CONTROL ACTIVITIES

Each of the fi ve components of an internal control system is impor- tant. Here, we will focus on one component, the control activities. The reason? These activities are the backbone of the company’s efforts to address the risks it faces, such as fraud. The specifi c control activities used by a company will vary, depending on management’s assessment of the risks faced. This assessment is heavily infl uenced by the size and nature of the company. The six principles of control activities are as follows.

• Establishment of responsibility

• Segregation of duties

• Documentation procedures

• Physical controls

• Independent internal verifi cation

• Human resource controls

We explain these principles in the following sections. You should recognize that they apply to most companies and are relevant to both manual and computerized accounting systems.

Establishment of Responsibility An essential principle of internal control is to assign responsibility to specifi c employees. Control is most effective when only one person is responsible for a given task. To illustrate, assume that the cash on hand at the end of the day in a Safeway supermarket is $10 short of the cash entered in the cash register. If only one per- son has operated the register, the shift manager can quickly determine responsi- bility for the shortage. What happens, though, if two or more individuals work the register? Many retailers solve this problem by having registers with multiple drawers. This makes it possible for more than one person to operate a register but still allows identifi cation of a particular employee with a specifi c drawer. Only the signed-in cashier has access to his or her drawer. Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel. For example, the automated sys- tems used by many companies have mechanisms such as identifying passcodes that keep track of who made a journal entry, who entered a sale, or who went into an inventory storeroom at a particular time. Use of identifying passcodes enables the company to establish responsibility by identifying the particular employee who carried out the activity.

DECISION TOOLS

The six principles of internal control activities help to ensure that a company’s fi nancial statements are adequately supported by internal controls.

It’s your shift now. I’m turning in my cash drawer

and heading home.

Transfer of cash drawers

Maureen Frugali was a training supervisor for claims processing at Colossal Healthcare. As a standard part of the claims-processing training program, Maureen created fi ctitious claims for use by trainees. These fi ctitious claims were then sent to the accounts payable depart- ment. After the training claims had been processed, she was to notify accounts payable of all fi ctitious claims, so that they would not be paid. However, she did not inform accounts payable about every fi ctitious claim. She created some fi ctitious claims for entities that she controlled (that is, she would receive the payment), and she let accounts payable pay her.

Total take: $11 million

THE MISSING CONTROL Establishment of responsibility. The healthcare company did not adequately restrict the responsibility for authorizing and approving claims transactions. The training supervisor should not have been authorized to create claims in the company’s “live” system.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 61–70.

ANATOMY OF A FRAUD

Fraud and Internal Control 321

Segregation of Duties Segregation of duties is indispensable in an internal control system. There are two common applications of this principle:

1. Different individuals should be responsible for related activities.

2. The responsibility for recordkeeping for an asset should be separate from the physical custody of that asset.

The rationale for segregation of duties is this: The work of one employee should, without a duplication of effort, provide a reliable basis for evaluat- ing the work of another employee. For example, the personnel that design and program computerized systems should not be assigned duties related to day-to- day use of the system. Otherwise, they could design the system to benefi t them personally and conceal the fraud through day-to-day use.

SEGREGATION OF RELATED ACTIVITIES Making one individual responsible for related activities increases the potential for errors and irregularities.

Purchasing activities. Companies should, for example, assign related pur- chasing activities to different individuals. Related purchasing activities include ordering merchandise, approving orders, receiving goods, authorizing payment, and paying for goods or services. Various frauds are possible when one person handles related purchasing activities:

• If a purchasing agent is allowed to order goods without supervisory approval, the likelihood of the agent receiving kickbacks from suppliers increases.

• If an employee who orders goods also handles the invoice and receipt of the goods, as well as payment authorization, he or she might authorize payment for a fi ctitious invoice.

These abuses are less likely to occur when companies divide the purchasing tasks.

Sales activities. Similarly, companies should assign related sales activities to different individuals. Related selling activities include making a sale, shipping (or delivering) the goods to the customer, billing the customer, and receiv- ing payment. Various frauds are possible when one person handles related sales activities. For example:

• If a salesperson can make a sale without obtaining supervisory approval, he or she might make sales at unauthorized prices to increase sales commissions.

• A shipping clerk who also has access to accounting records could ship goods to himself.

• A billing clerk who handles billing and cash receipts could understate the amount billed for sales made to friends and relatives.

These abuses are less likely to occur when companies divide the sales tasks. The salespeople make the sale, the shipping department ships the goods on the basis of the sales order, and the billing department prepares the sales invoice after comparing the sales order with the report of goods shipped.

Lawrence Fairbanks, the assistant vice-chancellor of communications at Aesop University, was allowed to make purchases of under $2,500 for his department without external ap- proval. Unfortunately, he also sometimes bought items for himself, such as expensive antiques and other collectibles. How did he do it? He replaced the vendor invoices he received with fake vendor invoices that he created. The fake invoices had descriptions that were more consistent with communications department purchases. He submitted these fake invoices to the accounting department as the basis for their journal entries and to the accounts payable department as the basis for payment.

ANATOMY OF A FRAUD

322 7 Fraud, Internal Control, and Cash

SEGREGATION OF RECORDKEEPING FROM PHYSICAL CUSTODY The accountant should have neither physical custody of the asset nor access to it. Likewise, the custodian of the asset should not maintain or have access to the accounting records. The custodian of the asset is not likely to convert the asset to personal use when one employee maintains the record of the asset, and a differ- ent employee has physical custody of the asset. The separation of accounting responsibility from the custody of assets is especially important for cash and inventories because these assets are very vulnerable to fraud.

Total take: $475,000

THE MISSING CONTROL Segregation of duties. The university had not properly segregated related purchasing activities. Lawrence was ordering items, receiving the items, and receiving the invoice. By receiving the invoice, he had control over the documents that were used to account for the purchase and thus was able to substitute a fake invoice.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 3–15.

Angela Bauer was an accounts payable clerk for Aggasiz Construction Company. Angela prepared and issued checks to vendors and reconciled bank statements. She perpetrated a fraud in this way: She wrote checks for costs that the company had not actually incurred (e.g., fake taxes). A supervisor then approved and signed the checks. Before issuing the check, though, Angela would “white-out” the payee line on the check and change it to personal accounts that she controlled. She was able to conceal the theft because she also reconciled the bank account. That is, nobody else ever saw that the checks had been altered.

Total take: $570,000

THE MISSING CONTROL Segregation of duties. Aggasiz Construction Company did not properly segregate recordkeeping from physical custody. Angela had physical custody of the blank checks, which essentially was control of the cash. She also had recordkeeping responsibility because she prepared the bank reconciliation.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 100–107.

ANATOMY OF A FRAUD

Documentation Procedures Documents provide evidence that transactions and events have occurred. For example, point-of-sale terminals are networked with a company’s computing and accounting records, which results in direct documentation. Similarly, a shipping document indicates that the goods have been shipped, and a sales invoice indi- cates that the company has billed the customer for the goods. By requiring signa- tures (or initials) on the documents, the company can identify the individual(s) responsible for the transaction or event. Companies should document transac- tions when the transactions occur. Companies should establish procedures for documents. First, whenever pos- sible, companies should use prenumbered documents, and all documents should be accounted for. Prenumbering helps to prevent a transaction from being recorded more than once or, conversely, from not being recorded at all. Second, the control system should require that employees promptly forward source documents for accounting entries to the accounting department. This control measure helps to ensure timely recording of the transaction and contributes directly to the accuracy and reliability of the accounting records.

Segregation of Duties (Accountability for assets)

Assistant Cashier B Maintains custody of cash on hand

Accounting Employee A Maintains cash

balances per books

125 Main Street Chelsea, IL 60915

Chelsea Video No. 0123

No. 0124

No. 0125

No. 0126

No. 0127

Firm Name

Attention of

Address

S O L D

T O

City State Zip

Date 5/8/17 Salesperson Malone Invoice No. 731 Invoice Date 5/4/17

Catalogue No. Description Quantity Price Amount

A2547Z45 Production Model Circuits (Inoperative)

1 300 $300

Approved Reid

Highpoint Electronic

Susan Malone, Sales Representative

27 Circle Drive

Harding MI 48281

Prenumbered invoices

Fraud and Internal Control 323

Physical Controls Use of physical controls is essential. Physical controls relate to the safeguard- ing of assets and enhance the accuracy and reliability of the accounting records. Illustration 7-2 (page 324) shows examples of these controls.

To support their reimbursement requests for travel costs incurred, employees at Mod Fashions Corporation’s design center were required to submit receipts. The receipts could include the detailed bill provided for a meal, the credit card receipt provided when the credit card payment is made, or a copy of the employee’s monthly credit card bill that listed the item. A number of the designers who frequently traveled to- gether came up with a fraud scheme: They submitted claims for the same expenses. For example, if they had a meal together that cost $200, one person submitted the detailed meal bill, another submitted the credit card receipt, and a third submitted a monthly credit card bill showing the meal as a line item. Thus, all three received a $200 reimbursement.

Total take: $75,000

THE MISSING CONTROL Documentation procedures. Mod Fashions should require the original, detailed receipt. It should not accept photocopies, and it should not accept credit card statements. In ad- dition, documentation procedures could be further improved by requiring the use of a corporate credit card (rather than personal credit card) for all business expenses.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 79–90.

ANATOMY OF A FRAUD

At Centerstone Health, a large insurance company, the mailroom each day received insurance applications from prospective customers. Mailroom employees scanned the applications into electronic documents before the applications were processed. Once the applications were scanned, they could be accessed online by authorized employees.

Insurance agents at Centerstone Health earn commissions based upon successful applications. The sales agent’s name is listed on the application. However, roughly 15% of the applications are from customers who did not work with a sales agent. Two friends— Alex, an employee in recordkeeping, and Parviz, a sales agent—thought up a way to perpetrate a fraud. Alex identifi ed scanned applications that did not list a sales agent. After business hours, he entered the mailroom and found the hardcopy applications that did not show a sales agent. He wrote in Parviz’s name as the sales agent and then re- scanned the application for processing. Parviz received the commission, which the friends then split.

Total take: $240,000

THE MISSING CONTROL Physical controls. Centerstone Health lacked two basic physical controls that could have prevented this fraud. First, the mailroom should have been locked during non- business hours, and access during business hours should have been tightly controlled. Second, the scanned applications supposedly could be accessed only by authorized employees using their password. However, the password for each employee was the same as the employee’s user-ID. Since employee user-ID numbers were avail- able to all other employees, all employees knew each other’s passwords. Thus, Alex could enter the system using another employee’s password and access the scanned applications.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 316–326.

ANATOMY OF A FRAUD

324 7 Fraud, Internal Control, and Cash

Independent Internal Verifi cation Most internal control systems provide for independent internal verifi cation. This principle involves the review of data prepared by employees. To obtain maxi- mum benefi t from independent internal verifi cation:

1. Companies should verify records periodically or on a surprise basis.

2. An employee who is independent of the personnel responsible for the infor- mation should make the verifi cation.

3. Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action.

Independent internal verifi cation is especially useful in comparing recorded transactions with existing assets. The reconciliation of the electronic journal with the cash in the point-of-sale terminal at Barriques is an example of this internal control principle. Another common example is the reconciliation of a company’s cash balance per books with the cash balance per bank and the verifi - cation of the perpetual inventory records through a count of physical inventory. Illustration 7-3 shows the relationship between this principle and the segrega- tion of duties principle.

Physical Controls

Alarms to prevent break-ins

Locked warehouses and storage cabinets for inventories and records

Safes, vaults, and safety deposit boxes for cash and business papers

Television monitors and garment sensors to deter theft

Computer facilities with passkey access or fingerprint or eyeball scans

Time clocks for recording time worked

ILLUSTRATION 7-2 Physical controls

Accounting Employee Maintains cash

balances per books

Assistant Treasurer Makes monthly comparisons; reports

any unreconcilable differences to treasurer

Assistant Cashier Maintains custody of cash on hand

Segregation of Duties

Independent Internal Verification

ILLUSTRATION 7-3 Comparison of segregation of duties principle with independent internal verifi cation principle

Fraud and Internal Control 325

Large companies often assign independent internal verifi cation to internal auditors. Internal auditors are company employees who continuously evaluate the effectiveness of the company’s internal control systems. They review the activ- ities of departments and individuals to determine whether prescribed internal controls are being followed. They also recommend improvements when needed. In fact, most fraud is discovered by the company through internal mechanisms such as existing internal controls and internal audits. For example, WorldCom was at one time the second largest U.S. telecommunications company. The fraud that caused its bankruptcy (the largest ever when it occurred) involved billions of dollars. It was uncovered by an internal auditor.

Bobbi Jean Donnelly, the offi ce manager for Mod Fashions Corporation’s design center, was responsible for preparing the design center budget and reviewing expense reports submitted by design center employees. Her desire to upgrade her wardrobe got the better of her, and she enacted a fraud that involved fi ling expense-reimbursement requests for her own personal clothing purchases. She was able to conceal the fraud because she was responsible for reviewing all expense reports, including her own. In addition, she sometimes was given ultimate responsibility for signing off on the expense reports when her boss was “too busy.” Also, because she controlled the budget, when she submitted her expenses, she coded them to budget items that she knew were run- ning under budget, so that they would not catch anyone’s attention.

Total take: $275,000

THE MISSING CONTROL Independent internal verifi cation. Bobbi Jean’s boss should have verifi ed her expense reports. When asked what he thought her expenses for a year were, the boss said about $10,000. At $115,000 per year, her actual expenses were more than 10 times what would have been expected. However, because he was “too busy” to verify her expense reports or to review the budget, he never noticed.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 79–90.

ANATOMY OF A FRAUD

Human Resource Controls Human resource control activities include the following.

1. Bond employees who handle cash. Bonding involves obtaining insurance protection against theft by employees. It contributes to the safeguarding of cash in two ways. First, the insurance company carefully screens all individu- als before adding them to the policy and may reject risky applicants. Second, bonded employees know that the insurance company will vigorously prose- cute all offenders.

2. Rotate employees’ duties and require employees to take vacations. These measures deter employees from attempting thefts since they will not be able to permanently conceal their improper actions. Many banks, for ex- ample, have discovered employee thefts when the employee was on vacation or assigned to a new position.

3. Conduct thorough background checks. Many believe that the most im- portant and inexpensive measure any business can take to reduce employee theft and fraud is for the human resources department to conduct thorough background checks. Two tips: (1) Check to see whether job applicants ac- tually graduated from the schools they list. (2) Never use telephone num- bers for previous employers provided by the applicant; always look them up yourself.

If I take a vacation, they will know that I’ve been stealing.

326 7 Fraud, Internal Control, and Cash

LIMITATIONS OF INTERNAL CONTROL

Companies generally design their systems of internal control to provide reason- able assurance of proper safeguarding of assets and reliability of the accounting records. The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefi t. To illustrate, consider shoplifting losses in retail stores. Stores could elimi- nate such losses by having a security guard stop and search customers as they leave the store. But store managers have concluded that the negative effects of such a procedure cannot be justifi ed. Instead, they have attempted to control shoplifting losses by less costly procedures. They post signs saying, “We reserve the right to inspect all packages” and “All shoplifters will be prosecuted.” They

Ellen Lowry was the desk manager and Josephine Rodriquez was the head of house- keeping at the Excelsior Inn, a luxury hotel. The two best friends were so dedicated to their jobs that they never took vacations, and they frequently fi lled in for other employ- ees. In fact, Ms. Rodriquez, whose job as head of housekeeping did not include cleaning rooms, often cleaned rooms herself, “just to help the staff keep up.” These two “dedi- cated” employees, working as a team, found a way to earn a little more cash. Ellen, the desk manager, provided signifi cant discounts to guests who paid with cash. She kept the cash and did not register the guests in the hotel’s computerized system. Instead, she took the room out of circulation “due to routine maintenance.” Because the room did not show up as being used, it did not receive a normal housekeeping assignment. In- stead, Josephine, the head of housekeeping, cleaned the rooms during the guests’ stay.

Total take: $95,000

THE MISSING CONTROL Human resource controls. Ellen, the desk manager, had been fi red by a previous employer after being accused of fraud. If the Excelsior Inn had conducted a thorough background check, it would not have hired her. The hotel fraud was detected when Ellen missed work for a few days due to illness. A system of mandatory vacations and rotating days off would have increased the chances of detecting the fraud before it became so large.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 145–155.

ANATOMY OF A FRAUD

SOX Boosts the Role of Human Resources

Under SOX, a company needs to keep track of employees’ degrees and certifi - cations to ensure that employees continue to meet the specifi ed requirements of a job. Also, to ensure proper employee supervision and proper separation of duties, companies must develop and monitor an organizational chart. When one corporation went through this exer- cise it found that out of 17,000 employ- ees, there were 400 people who did not

report to anyone. The corporation had 35 people who reported to each other. In addition, SOX also mandates that, if an employee complains of an unfair fi ring and mentions fi nancial issues at the company, the human resources department must refer the case to the company audit committee and possibly to its legal counsel.

Why would unsupervised employees or employees who report to each other represent potential internal control threats? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION

Stockbyte/Getty Images, Inc.

▼ HELPFUL HINT Controls may vary with the risk level of the activity. For example, management may consider cash to be high risk and maintaining inventories in the stockroom as lower risk. Thus, management would have stricter controls for cash.

Cash Controls 327

use hidden cameras and store detectives to monitor customer activity, and they install sensor equipment at exits. The human element is an important factor in every system of internal con- trol. A good system can become ineffective as a result of employee fatigue, care- lessness, or indifference. For example, a receiving clerk may not bother to count goods received and may just “fudge” the counts. Occasionally, two or more indi- viduals work together to get around prescribed controls. Such collusion can sig- nifi cantly reduce the effectiveness of a system, eliminating the protection offered by segregation of duties. No system of internal control is perfect. The size of the business also may impose limitations on internal control. Small companies often fi nd it diffi cult to segregate duties or to provide for inde- pendent internal verifi cation. A study by the Association of Certifi ed Fraud Exam- iners (2014 Report to the Nation on Occupational Fraud and Abuse) indicates that businesses with fewer than 100 employees are most at risk for employee theft. In fact, 29% of frauds occurred at companies with fewer than 100 employees. The median loss at small companies was $154,000, which was nearly as high as the median fraud at companies with more than 10,000 employees ($160,000). A $154,000 loss can threaten the very existence of a small company.

1▼ Control ActivitiesDO IT!

Action Plan ✔ Familiarize yourself

with each of the control activities listed on page 320.

✔ Understand the nature of the frauds that each control activity is intended to address.

SOLUTION 1. Violates the control activity of segregation of duties. Recordkeeping should be separate

from physical custody. As a consequence, the employee could embezzle cash and make journal entries to hide the theft.

2. Violates the control activity of human resource controls. Key employees, such as a trea- surer, should be required to take vacations. The treasurer, who manages the company’s cash, might embezzle cash and use his position to conceal the theft.

3. Violates the control activity of documentation procedures. If prenumbered documents are not used, then it is virtually impossible to account for the documents. As a consequence, an employee could write up a dinner sale, receive the cash from the customer, and then throw away the order slip and keep the cash.

Identify which control activity is violated in each of the following situations, and explain how the situation creates an opportunity for a fraud.

1. The person with primary responsibility for reconciling the bank account and making all bank deposits is also the company’s accountant.

2. Wellstone Company’s treasurer received an award for distinguished service because he had not taken a vacation in 30 years.

3. In order to save money on order slips and to reduce time spent keeping track of order slips, a local bar/restaurant does not buy prenumbered order slips.

Related exercise material: BE7-1, BE7-2, BE7-3, DO IT! 7-1, E7-1, and E7-2.

LEARNING OBJECTIVE 2 Apply internal control principles to cash.▼

Cash is the one asset that is readily convertible into any other type of asset. It also is easily concealed and transported, and is highly desired. Because of these characteristics, cash is the asset most susceptible to fraudulent activities. In addition, because of the large volume of cash transactions, numerous errors may occur in executing and recording them. To safeguard cash and to ensure the accuracy of the accounting records for cash, effective internal control over cash is critical.

328 7 Fraud, Internal Control, and Cash

CASH RECEIPTS CONTROLS

Illustration 7-4 shows how the internal control principles explained earlier apply to cash receipts transactions. As you might expect, companies vary consider- ably in how they apply these principles. To illustrate internal control over cash receipts, we will examine control activities for a retail store with both over-the- counter and mail receipts.

Cash Receipts Controls

Different individuals receive cash, record cash receipts, and hold the cash

Documentation Procedures Use remittance advice (mail receipts), cash register tapes or computer records, and deposit slips

Physical Controls Independent Internal Verification Human Resource Controls

Establishment of Responsibility Segregation of Duties

Store cash in safes and bank vaults; limit access to storage areas; use cash registers or point-of-sale terminals

Supervisors count cash receipts daily; assistant treasurer compares total receipts to bank deposits daily

Bond personnel who handle cash; require employees to take vacations; conduct background checks

Only designated personnel are authorized to handle cash receipts (cashiers)

125 Main Street Chelsea, IL 60915

Beyer Video No. 0123

No. 0124

No. 0125

Firm Name

Attention of

Address

S O L D

T O

City State Zip

Date 5/8/12 Salesperson Malone Invoice No. 731 Invoice Date 5/4/12

Catalogue No. Description Quantity Price Amount

z Reid

ILLUSTRATION 7-4 Application of internal control principles to cash receipts

Over-the-Counter Receipts In retail businesses, control of over-the-counter receipts centers on cash regis- ters that are visible to customers. A cash sale is entered in a cash register with the amount clearly visible to the customer. This activity prevents the cashier from entering a lower amount and pocketing the difference. The customer receives an itemized cash register receipt and is expected to count the change received. (One weakness at Barriques in the Feature Story is that customers are only given a receipt if requested.) The cash register’s tape is locked in the register until a supervisor removes it. This tape accumulates the daily trans- actions and totals. Alternatively, cash registers called point-of-sale terminals are often networked with the company’s computers for direct recording in its records. At the end of the clerk’s shift, the clerk counts the cash and sends the cash and the count to the cashier. The cashier counts the cash, prepares a deposit slip, and deposits the cash at the bank. The cashier also sends a duplicate of the deposit slip to the accounting department to indicate cash received. The super- visor removes the cash register tape and sends it to the accounting department (in a non-point-of-sale system) as the basis for a journal entry to record the cash received. The tape is compared to the deposit slip for any discrepancies. Illustra- tion 7-5 summarizes this process.

Cash Controls 329

This system for handling cash receipts uses an important internal control principle—segregation of recordkeeping from physical custody. The supervisor has access to the cash register tape, but not to the cash. The clerk and the cashier have access to the cash, but not to the register tape. In addition, the cash register tape provides documentation and enables independent internal verifi cation with the deposit slip. Use of these three principles of internal control (segregation of recordkeeping from physical custody, documentation, and independent internal verifi cation) provides an effective system of internal control. Any attempt at fraud- ulent activity should be detected unless there is collusion among the employees. In some instances, the amount deposited at the bank will not agree with the cash recorded in the accounting records based on the cash register tape. These differences often result because the clerk hands incorrect change back to the retail customer. In this case, the difference between the actual cash and the amount reported on the cash register tape is reported in a Cash Over and Short account. For example, suppose that the cash register tape indicated sales of $6,956.20 but the amount of cash was only $6,946.10. A cash shortfall of $10.10 exists. To account for this cash shortfall and related cash, the company makes the following entry.

Cash 6,946.10 Cash Over and Short 10.10 Sales Revenue 6,956.20 (To record cash shortfall)

Cash Over and Short is an income statement item. It is reported as miscella- neous expense when there is a cash shortfall, and as miscellaneous revenue when

Clerk Enters sales, counts cash

Sends cash and count to cashier

Counts cash, prepares deposit slips

Delivers cash and deposit slip to bank

Cashier

Supervisor Removes locked cash register tape

Sends cash register tape to accounting dept.

Accounting Department Agrees register tape to deposit slip

and records journal entry

Sends deposit slip copy to accounting

BANK

ILLUSTRATION 7-5 Control of over-the-counter receipts

▼ HELPFUL HINT Flowcharts such as this one enhance the understanding of the fl ow of documents, the processing steps, and the internal control procedures.

A L SE= + +6,946.10 −10.10 +6,956.20 Cash Flows +6,946.10

330 7 Fraud, Internal Control, and Cash

there is an overage. Clearly, the amount should be small. Any material amounts in this account should be investigated.

Mail Receipts All mail receipts should be opened in the presence of at least two mail clerks. These receipts are generally in the form of checks. A mail clerk should endorse each check “For Deposit Only.” This restrictive endorsement reduces the like- lihood that someone could divert the check to personal use. Banks will not give an individual cash when presented with a check that has this type of endorsement. The mail clerks prepare, in triplicate, a list of the checks received each day. This list shows the name of the check issuer, the purpose of the payment, and the amount of the check. Each mail clerk signs the list to establish responsibility for the data. The original copy of the list, along with the checks, is then sent to the cashier’s department. A copy of the list is sent to the accounting department for recording in the accounting records. The clerks also keep a copy. This process provides excellent internal control for the company. By employ- ing two clerks, the chance of fraud is reduced. Each clerk knows he or she is being observed by the other clerk(s). To engage in fraud, they would have to collude. The customers who submit payments also provide control because they will contact the company with a complaint if they are not properly credited for payment. Because the cashier has access to the cash but not the records, and the accounting department has access to the records but not the cash, neither can engage in undetected fraud.

CASH DISBURSEMENTS CONTROLS

Companies disburse cash for a variety of reasons, such as to pay expenses and liabilities or to purchase assets. Generally, internal control over cash disburse- ments is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash. One exception is payments for incidental amounts that are paid out of petty cash.2

Companies generally issue checks only after following specifi ed control pro- cedures. Illustration 7-6 shows how principles of internal control apply to cash disbursements.

Voucher System Controls Most medium and large companies use vouchers as part of their internal control over cash disbursements. A voucher system is a network of approvals by autho- rized individuals, acting independently, to ensure that all disbursements by check are proper. The system begins with the authorization to incur a cost or expense. It ends with the issuance of a check for the liability incurred. A voucher is an authoriza- tion form prepared for each expenditure in a voucher system. Companies require vouchers for all types of cash disbursements except those from petty cash. The starting point in preparing a voucher is to fi ll in the appropriate infor- mation about the liability on the face of the voucher. The vendor’s invoice provides most of the needed information. Then, an employee in accounts pay- able records the voucher (in a journal called a voucher register) and fi les it according to the date on which it is to be paid. The company issues and sends a check on that date, and stamps the voucher “paid.” The paid voucher is sent to the accounting department for recording (in a journal called the check register). A voucher system involves two journal entries, one to record the liability when the voucher is issued and a second to pay the liability that relates to the voucher.

2We explain the operation of a petty cash fund in the appendix to this chapter on pages 347–348.

Cash Controls 331

The use of a voucher system, whether done manually or electronically, improves internal control over cash disbursements. First, the authorization process inherent in a voucher system establishes responsibility. Each individual has responsibility to review the underlying documentation to ensure that it is correct. In addition, the voucher system keeps track of the documents that back up each transaction. By keeping these documents in one place, a super- visor can independently verify the authenticity of each transaction. Consider, for example, the case of Aesop University presented on pages 321–322. Aesop did not use a voucher system for transactions under $2,500. As a consequence, there was no independent verifi cation of the documents, which enabled the employee to submit fake invoices to hide his unauthorized purchases.

Petty Cash Fund As you learned earlier in the chapter, better internal control over cash disburse- ments is possible when companies make payments by check. However, using checks to pay such small amounts as those for postage due, employee working lunches, and taxi fares is both impractical and a nuisance. A common way of han- dling such payments, while maintaining satisfactory control, is to use a petty cash fund. A petty cash fund is a cash fund used to pay relatively small amounts. We explain the operation of a petty cash fund in the appendix at the end of this chapter.

Segregation of Duties Documentation Procedures Use prenumbered checks and account for them in sequence; each check must have an approved invoice; require employees to use corporate credit cards for reimbursable expenses; stamp invoices “paid”

Different individuals approve and make payments; check- signers do not record disbursements

Cash Disbursements Controls

Physical Controls Independent Internal Verification Human Resource Controls

Establishment of Responsibility

Store blank checks in safes, with limited access; print check amounts by machine in indelible ink

Compare checks to invoices; reconcile bank statement monthly

Bond personnel who handle cash; require employees to take vacations; conduct background checks

Only designated personnel are authorized to sign checks (treasurer) and approve vendors

Payments Due

TREASURER

ILLUSTRATION 7-6 Application of internal control principles to cash disbursements

ETHICS NOTE Internal control over a petty cash fund is strengthened by (1) having a supervisor make surprise counts of the fund to confi rm whether the paid petty cash receipts and fund cash equal the fund amount, and (2) canceling or mutilating the paid petty cash receipts so they cannot be resubmitted for reimbursement.

▼

332 7 Fraud, Internal Control, and Cash

2▼ Control over Cash ReceiptsDO IT! L. R. Cortez is concerned about the control over cash receipts in his fast-food restaurant, Big Cheese. The restaurant has two cash registers. At no time do more than two employees take customer orders and enter sales. Work shifts for employees range from 4 to 8 hours. Cortez asks your help in installing a good system of internal control over cash receipts.

SOLUTION Cortez should assign a separate cash register drawer to each employee at the start of each work shift, with register totals set at zero. Each employee should have access to only the assigned register drawer to enter all sales. Each customer should be given a receipt. At the end of the shift, the employee should do a cash count. A separate employee should com- pare the cash count with the register tape (or point-of-sale records) to be sure they agree. In addition, Cortez should install an automated point-of-sale system that would enable the company to compare orders entered in the register to orders processed by the kitchen.

Action Plan ✔ Differentiate among the

internal control principles of (1) establishing respon- sibility, (2) physical con- trols, and (3) independent internal verifi cation.

✔ Design an effective system of internal control over cash receipts.

Related exercise material: BE7-4, BE7-5, DO IT! 7-2, and E7-3.

How Employees Steal

Occupational fraud is using your own occupation for personal gain through the misuse or misap- plication of the company’s resources or assets. This type of fraud is one of three types:

1. Asset misappropriation, such as theft of cash on hand, fraudulent disbursements, false refunds, ghost employees, personal purchases, and fi ctitious employees. This fraud is the most common but the least costly.

2. Corruption, such as bribery, illegal gratuities, and economic extortion. This fraud generally falls in the middle between asset misappropriation and fi nancial statement fraud as regards fre- quency and cost.

3. Financial statement fraud, such as fi ctitious revenues, concealed liabilities and expenses, im- proper disclosures, and improper asset values. This fraud occurs less frequently than other types of fraud but it is the most costly.

The graph below shows the frequency and the median loss for each type of occupational fraud. (Note that the sum of percentages exceeds 100% because some cases of fraud involved more than one type.)

ETHICS INSIGHT

100 20 30 40 50 60 8070 90 100%

Occupational Frauds by Frequency and Loss

Ty pe

o f F

ra ud

( M

ed ia

n L

o ss

)

Percent of Cases

Financial Statement Fraud ($1,000,000)

Corruption ($200,000)

Asset Misappropriation ($130,000)

9.0%

36.8%

85.4%

Source: 2014 Report to the Nations on Occupational Fraud and Abuse, Association of Certifi ed Fraud Examiners, pp. 10–12.

How can companies reduce the likelihood of occupational fraud? (Go to WileyPLUS for this answer and additional questions.)

Control Features of a Bank Account 333

The use of a bank contributes signifi cantly to good internal control over cash. A company safeguards its cash by using a bank as a depository and clear- inghouse for checks received and checks written. The use of a bank checking account minimizes the amount of currency that must be kept on hand. It also facilitates control of cash because a double record is maintained of all bank transactions—one by the business and the other by the bank. The asset account Cash maintained by the company is the “fl ipside” of the bank’s liability account for that company. A bank reconciliation is the process of comparing the bank’s balance with the company’s balance, and explaining the differences to make them agree. Many companies have more than one bank account. For effi ciency of opera- tions and better control, national retailers like Wal-Mart and Target often have regional bank accounts. Similarly, a company such as ExxonMobil with more than 100,000 employees may have a payroll bank account as well as one or more general bank accounts. In addition, a company may maintain several bank accounts in order to have more than one source for short-term loans.

ELECTRONIC FUNDS TRANSFER (EFT) SYSTEM

It is not surprising that companies and banks have developed approaches to transfer funds among parties without the use of paper (deposit tickets, checks, etc.). Such procedures, called electronic funds transfers (EFTs), are dis- bursement systems that use wire, telephone, or computers to transfer cash from one location to another. Use of EFT is quite common. For example, many employees receive no formal payroll checks from their employers. Instead, employers send electronic payroll data to the appropriate banks. Also, com- panies now frequently make regular payments such as those for utilities, rent, and insurance by EFT. EFT transactions normally result in better internal control since no cash or checks are handled by company employees. This does not mean that opportuni- ties for fraud are eliminated. In fact, the same basic principles related to inter- nal control apply to EFT transactions. For example, without proper segregation of duties and authorizations, an employee might be able to redirect electronic payments into a personal bank account and conceal the theft with fraudulent accounting entries.

BANK STATEMENTS

Each month, the company receives from the bank a bank statement showing its bank transactions and balances.3 For example, the statement for Laird Com- pany in Illustration 7-7 (page 334) shows the following: (1) checks paid and other debits (such as debit card transactions or electronic funds transfers for bill pay- ments) that reduce the balance in the depositor’s account, (2) deposits (by direct deposit, automated teller machine, or electronic funds transfer) and other credits that increase the balance in the depositor’s account, and (3) the account balance after each day’s transactions. Remember that bank statements are prepared from the bank’s perspec- tive. For example, every deposit the bank receives is an increase in the bank’s liabilities (an account payable to the depositor). Therefore, in Illustration 7-7, National Bank and Trust credits to Laird Company every deposit it received from

Identify the control features of a bank account. LEARNING OBJECTIVE 3▼

3Our presentation assumes that a company makes all adjustments at the end of the month. In practice, a company may also make journal entries during the month as it reviews information from the bank regarding its account.

334 7 Fraud, Internal Control, and Cash

Laird. The reverse occurs when the bank “pays” a check issued by Laird Com- pany on its checking account balance: Payment reduces the bank’s liability and is therefore debited to Laird’s account with the bank. The bank statement lists in numerical sequence all paid checks along with the date the check was paid and its amount. Upon paying a check, the bank stamps the check “paid”; a paid check is sometimes referred to as a canceled check. In addition, the bank includes with the bank statement memoranda explaining other debits and credits it made to the depositor’s account. A check that is not paid by a bank because of insuffi cient funds in a bank account is called an NSF check (not suffi cient funds). The bank uses a debit memorandum when a previously deposited customer’s check “bounces” because of insuffi cient funds. In such a case, the customer’s bank marks the check NSF (not suffi cient funds) and returns it to the depositor’s bank. The bank then debits (decreases) the depositor’s account, as shown by the symbol NSF in Illustration 7-7, and sends the NSF check and debit memorandum to the depositor as notifi - cation of the charge. The NSF check creates an account receivable for the deposi- tor and reduces cash in the bank account.

RECONCILING THE BANK ACCOUNT

Because the bank and the company maintain independent records of the com- pany’s checking account, you might assume that the respective balances will

▼ HELPFUL HINT Essentially, the bank statement is a copy of the bank’s records sent to the customer or made available online for review.

National Bank & Trust Midland, Michigan 48654 Member FDIC

ACCOUNT STATEMENT

LAIRD COMPANY 77 WEST CENTRAL AVENUE MIDLAND, MICHIGAN 48654

Statement Date/Credit Line Closing Date

April 30, 2017

457923

ACCOUNT NUMBER

Balance Last Statement

Deposits and Credits Checks and Debits Balance This StatementNo. Total Amount No. Total Amount

13,256.90 20 34,805.10 26 32,154.55 15,907.45

Amounts Deducted from Account (debits)

Amounts Added to Account (credits) Daily Balance

Date No. Amount

4–2 4–3 4–5 4–4 4–3 4–8 4–7 4–7 4–8 4–11 4–12

4–29 4–29 4–30 4–30 4–30

435 EFT 436 437 438 439 440 EFT 441 442 443

NSF 459 DM DM 461

644.95 1,000.00 2,260.00 1,185.79

776.65 1,781.70 1,487.90

320.00 2,100.00 1,585.60 1,226.00

425.60 1,080.30

120.00 30.00

500.15

Date Amount

4–2 4–3 4–5 4–7 4–8 4–9 EFT 4–11 4–12 4–13

4–27 4–29 4–30

4,276.85 2,137.50 1,350.47

982.46 1,320.28 1,035.00 2,720.00

757.41 1,218.56

1,545.57 2,929.45 2,128.60

Date Amount

4–2 4–3 4–4 4–5 4–7 4–8 4–9 4–11 4–12

4–27 4–29 4–30

16,888.80 18,249.65 17,063.86 15,154.33 14,648.89 11,767.47 12,802.47 13,936.87 13,468.28

13,005.45 14,429.00 15,907.45

Symbols: CM DM

Credit Memo Debit Memo

EC INT

Error Correction Interest Earned

NSF SC

Not Sufficient Funds Service Charge

EFT Electronic Funds Transfer

ILLUSTRATION 7-7 Bank statement

Control Features of a Bank Account 335

always agree. In fact, the two balances are seldom the same at any given time, and both balances differ from the “correct or true” balance. Therefore, it is neces- sary to make the balance per books and the balance per bank agree with the cor- rect or true amount—a process called reconciling the bank account. The need for reconciliation has two causes:

1. Time lags that prevent one of the parties from recording the transaction in the same period.

2. Errors by either party in recording transactions.

Time lags occur frequently. For example, several days may elapse between the time a company pays by check and the date the bank pays the check. Similarly, when a company uses the bank’s night depository to make its deposits, there will be a difference of one day between the time the company records the receipts and the time the bank does so. A time lag also occurs whenever the bank mails a debit or credit memorandum to the company. You might think that if a company never writes checks (for example, if a small company uses only a debit card or electronic bill funds transfers), it does not need to reconcile its account. However, the possibility of errors or fraud still necessitates periodic reconciliation. The incidence of errors or fraud depends on the effectiveness of the internal controls maintained by the company and the bank. Bank errors are infrequent. However, either party could accidentally record a $450 check as $45 or $540. In addition, the bank might mistakenly charge a check drawn by C. D. Berg to the account of C. D. Burg.

Reconciliation Procedure In reconciling the bank account, it is customary to reconcile the balance per books and balance per bank to their adjusted (correct or true) cash balances. To obtain maximum benefi t from a bank reconciliation, an employee who has no other responsibilities related to cash should prepare the reconcili- ation. When companies do not follow the internal control principle of indepen- dent internal verifi cation in preparing the reconciliation, cash embezzlements may escape unnoticed. For example, in the Anatomy of a Fraud box on page 322, a bank reconciliation by someone other than Angela Bauer might have exposed her embezzlement. Illustration 7-8 (page 336) shows the reconciliation process. The starting point in preparing the reconciliation is to enter the balance per bank statement and balance per books on a schedule. The following steps should reveal all the reconciling items that cause the difference between the two balances.

RECONCILING ITEMS PER BANK On the bank side of the reconciliation, the items to reconcile are deposits in transit (amounts added), outstanding checks (amounts deducted), and bank errors (if any). By adjusting the bank balance for these items, a company brings that balance up to date.

Step 1. Deposits in transit (1). Compare the individual deposits on the bank statement with the deposits in transit from the preceding bank recon- ciliation and with the deposits per company records or copies of dupli- cate deposit slips. Deposits recorded by the depositor that have not been recorded by the bank represent deposits in transit. Add these deposits to the balance per bank.

Step 2. Outstanding checks (2). Compare the paid checks shown on the bank statement or the paid checks returned with the bank statement with (a) checks outstanding from the preceding bank reconciliation, and (b) checks issued by the company as recorded in the cash payments journal. Issued checks recorded by the company that have not been paid by the bank represent outstanding checks. Deduct outstanding checks from the balance per bank.

336 7 Fraud, Internal Control, and Cash

Step 3. Bank errors (1/2). Note any errors made by the bank that were dis- covered in the previous steps. For example, if the bank processed a deposit of $1,693 as $1,639 in error, the difference of $54 ($1,693 − $1,639) is added to the balance per bank on the bank reconciliation. All errors made by the bank are reconciling items in determining the adjusted cash balance per the bank.

RECONCILING ITEMS PER BOOKS Reconciling items on the book side relate to amounts not yet recorded on the company’s books and include adjustments from deposits and other amounts added, payments and other amounts deducted, and company errors (if any).

Step 1. Other deposits (1). Compare the other deposits on the bank statement with the company records. Any unrecorded amounts should be added to the balance per books. For example, if the bank statement shows electronic funds transfers from customers paying their accounts online, these amounts should be added to the balance per books on the bank

Adjustments to the bank balance

Correct Cash Balance

Cash Balances

Adjustments to the book balance

Per Bank Statement Per Books

Deposits in transit (+)

$$$$$

Outstanding checks (–)

Pay to the order of

Bank errors (+ /–)

“Oops” BANK

EFT collections and other deposits (+)

$$$

NSF (bounced) checks (–)

Pay to the order of

Service charges and other payments (–)

Company errors (+ /–)

“Oops”

ILLUSTRATION 7-8 Bank reconciliation adjustments

▼ HELPFUL HINT Deposits in transit and outstanding checks are reconciling items because of time lags.

Control Features of a Bank Account 337

reconciliation to update the company’s records unless they had previ- ously been recorded by the company.

Step 2. Other payments (2). Similarly, any unrecorded other payments should be deducted from the balance per books. For example, if the bank state- ment shows service charges (such as debit and credit card fees and other bank service charges), this amount is deducted from the balance per books on the bank reconciliation to make the company’s records agree with the bank’s records. Normally, the company will already have recorded electronic payments. However, if this has not been the case then these payments must be deducted from the balance per books on the bank reconciliation to make the company’s records agree with the bank’s records.

Step 3. Book errors (1/2). Note any errors made by the depositor that have been discovered in the previous steps. For example, say a company wrote check No. 493 to a supplier in the amount of $1,226 on April 12, but the accounting clerk recorded the check amount as $1,262. The error of $36 ($1,262 2 $1,226) is added to the balance per books because the company reduced the balance per books by $36 too much when it recorded the check as $1,262 instead of $1,226. Only errors made by the company, not the bank, are included as reconciling items in determin- ing the adjusted cash balance per books.

Bank Reconciliation Illustrated Illustration 7-7 (page 334) presented the bank statement for Laird Company which the company accessed online. It shows a balance per bank of $15,907.45 on April 30, 2017. On this date the balance of cash per books is $11,709.45. From the foregoing steps, Laird determines the following reconciling items for the bank.

Step 1. Deposits in transit (1): April 30 deposit (received by bank on May 1). $2,201.40

Step 2. Outstanding checks (2): No. 453, $3,000.00; No. 457, $1,401.30; No. 460, $1,502.70. 5,904.00

Step 3. Bank errors (1/2): None.

Reconciling items per books are as follows:

Step 1. Other deposits (1): Unrecorded electronic receipt from customer on account on April 9 determined from the bank statement. $1,035.00

Step 2. Other payments (2): The electronic payments on April 3 and 7 were previously recorded by the company when they were initiated. Unrecorded charges determined from the bank statement are as follows:

Returned NSF check on April 29 425.60 Debit and credit card fees on April 30 120.00 Bank service charges on April 30 30.00

Step 3. Company errors (1): Check No. 443 was correctly written by Laird for $1,226 and was correctly paid by the bank on April 12. However, it was recorded as $1,262 on Laird’s books. 36.00

▼ HELPFUL HINT Note in the bank statement in Illustration 7-7 that the bank has paid checks No. 459 and 461, but check No. 460 is not listed. Thus, this check is outstanding. If a complete bank statement were provided, checks No. 453 and 457 also would not be listed. Laird obtains the amounts for these three checks from its cash payments records.

338 7 Fraud, Internal Control, and Cash

Entries from Bank Reconciliation The depositor (that is, the company) next must record each reconciling item used to determine the adjusted cash balance per books. If the company does not journalize and post these items, the Cash account will not show the correct bal- ance. The adjusting entries for the Laird Company bank reconciliation on April 30 are as follows.

COLLECTION OF ELECTRONIC FUNDS TRANSFER A payment of an account by a customer is recorded in the same way, whether the cash is received through the mail or electronically. The entry is as follows.

Apr. 30 Cash 1,035 Accounts Receivable 1,035 (To record receipt of electronic

funds transfer)

BOOK ERROR An examination of the cash disbursements journal shows that check No. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is as follows.

Apr. 30 Cash 36 Accounts Payable—Andrea Company 36 (To correct error in recording check

No. 443)

NSF CHECK As indicated earlier, an NSF check becomes an accounts receivable to the depositor. The entry is as follows.

Apr. 30 Accounts Receivable—J. R. Baron 425.60 Cash 425.60 (To record NSF check)

BANK CHARGES EXPENSE Fees for processing debit and credit card transactions are normally debited to the Bank Charges Expense account, as are bank service charges. We have chosen to combine and record these in one journal entry, as shown on the next page, although they also could be journalized separately.

A L SE= + +1,035 −1,035 Cash Flows +1,035

A L SE= + +36 +36 Cash Flows +36

A L SE= + +425.60 −425.60 Cash Flows −425.60

Illustration 7-9 shows Laird’s bank reconciliation.

▼ HELPFUL HINT These entries are adjusting entries. In prior chapters, we considered Cash an account that did not require adjustment because we had not yet explained a bank reconciliation.

ALTERNATIVE TERMINOLOGY The terms adjusted cash balance, true cash balance, and correct cash balance are used interchangeably.

ILLUSTRATION 7-9 Bank reconciliation

Cash balance per bank statement $ 15,907.45 Add: Deposits in transit 2,201.40

18,108.85 Less: Outstanding checks

No. 453 $3,000.00 No. 457 1,401.30 No. 460 1,502.70 5,904.00

Adjusted cash balance per bank $12,204.85

Cash balance per books $ 11,709.45 Add: Electronic funds transfer received $1,035.00 Error in recording check No. 443 36.00 1,071.00

12,780.45 Less: NSF check 425.60

Debit and credit card fees 120.00 Bank service charge 30.00 575.60

Adjusted cash balance per books $12,204.85

LAIRD COMPANY Bank Reconciliation

April 30, 2017

Control Features of a Bank Account 339

Apr. 30 Bank Charge Expense 150 Cash 150 (To record charges for debit and credit

card fees of $120 and bank service charges of $30)

A L SE= + −150 Exp

−150 Cash Flows −150

ILLUSTRATION 7-10 Adjusted balance in Cash account

Cash

Apr. 30 Bal. 11,709.45 Apr. 30 425.60 30 1,035.00 30 150.00 30 36.00

Apr. 30 Bal. 12,204.85

What entries does the bank make? If the company discovers any bank errors in preparing the reconciliation, it should notify the bank so the bank can make the necessary corrections on its records. The bank does not make any entries for deposits in transit or outstanding checks. Only when these items reach the bank will the bank record these items.

Madoff’s Ponzi Scheme

No recent fraud has generated more interest and rage than the one perpetrated by Bernard Madoff. Madoff was an elite New York investment fund man- ager who was highly regarded by securities regulators. Investors fl ocked to him because he deliv- ered steady returns of between 10% and 15%, no matter whether the market was going up or going down. However, for many years, Madoff did not actually invest the cash that people gave to him.

Instead, he was running a Ponzi scheme: He paid returns to existing investors using cash received from new investors. As

long as the size of his investment fund continued to grow from new investments at a rate that exceeded the amounts that he needed to pay out in returns, Madoff was able to operate his fraud smoothly. To conceal his misdeeds, Madoff fabricated false invest- ment statements that were provided to investors. In addition, Madoff hired an auditor that never verifi ed the accuracy of the investment records but automatically issued unqualifi ed opin- ions each year. A competing fund manager warned the SEC a number of times over a nearly 10-year period that he thought Madoff was engaged in fraud. The SEC never aggressively investigated the allegations. Investors, many of which were charitable organizations, lost more than $18 billion. Madoff was sentenced to a jail term of 150 years.

How was Madoff able to conceal such a giant fraud? (Go to WileyPLUS for this answer and additional questions.)

Mary Altaff er/©AP/Wide World Photos

3▼ Bank ReconciliationDO IT! Sally Kist owns Linen Kist Fabrics. Sally asks you to explain how she should treat the fol- lowing reconciling items when reconciling the company’s bank account: (1) a debit memo- randum for an NSF check, (2) a credit memorandum for an electronic funds transfer from one of the company’s customers received by the bank, (3) outstanding checks, and (4) a deposit in transit.

After Laird posts the entries, the Cash account will appear as in Illus- tration 7-10. The adjusted cash balance in the ledger should agree with the adjusted cash balance per books in the bank reconciliation in Illustration 7-9 (page 338).

INVESTOR INSIGHT

340 7 Fraud, Internal Control, and Cash

SOLUTION

Sally should treat the reconciling items as follows.

(1) NSF check: Deduct from balance per books.

(2) Electronic funds transfer received by bank: Add to balance per books.

(3) Outstanding checks: Deduct from balance per bank.

(4) Deposit in transit: Add to balance per bank.

Related exercise material: BE7-8, BE7-9, BE7-10, BE7-11, DO IT! 7-3, E7-6, E7-7, E7-8, E7-9, E7-10, and E7-11.

Action Plan ✔ Understand the purpose

of a bank reconciliation. ✔ Identify time lags and

explain how they cause reconciling items.

LEARNING OBJECTIVE 4 Explain the reporting of cash and the basic principles of cash management.▼

REPORTING CASH

Cash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository. Checks that are dated later than the current date (post-dated checks) are not included in cash. Companies report cash in two different statements: the balance sheet and the statement of cash fl ows. The balance sheet reports the amount of cash available at a given point in time. The statement of cash fl ows shows the sources and uses of cash during a period of time. The statement of cash fl ows was introduced in Chapters 1 and 2 and will be discussed in much detail in Chapter 12. In this sec- tion, we discuss some important points regarding the presentation of cash in the balance sheet. When presented in a balance sheet, cash on hand, cash in banks, and petty cash are often combined and reported simply as Cash. Because it is the most liquid asset owned by the company, cash is listed fi rst in the current assets section of the balance sheet.

Cash Equivalents Many companies use the designation “Cash and cash equivalents” in reporting cash. (See Illustration 7-11 for an example.) Cash equivalents are short-term, highly liquid investments that are both:

1. Readily convertible to known amounts of cash, and

2. So near their maturity that their market value is relatively insensitive to changes in interest rates. (Generally only investments with maturities of three months or less qualify under this defi nition.)

Assets Current assets Cash and cash equivalents $2,844 Short-term investments 959 Restricted cash 122

DELTA AIR LINES, INC. Balance Sheet (partial)

December 31, 2013 (in millions)

Real World

ILLUSTRATION 7-11 Balance sheet presentation of cash

Reporting Cash and Cash Management 341

Examples of cash equivalents are Treasury bills, commercial paper (short-term corporate notes), and money market funds. All typically are purchased with cash that is in excess of immediate needs. Occasionally a company will have a net negative balance in its bank account. In this case, the company should report the negative balance among current liabilities. For example, farm equipment manufacturer Ag-Chem at one time reported “Checks outstanding in excess of cash balances” of $2,145,000 among its current liabilities.

Restricted Cash A company may have restricted cash, cash that is not available for general use but rather is restricted for a special purpose. For example, landfi ll companies are often required to maintain a fund of restricted cash to ensure they will have adequate resources to cover closing and clean-up costs at the end of a landfi ll site’s useful life. McKesson Corp. recently reported restricted cash of $962 million to be paid out as the result of investor lawsuits. Cash restricted in use should be reported separately on the balance sheet as restricted cash. If the company expects to use the restricted cash within the next year, it reports the amount as a current asset. When this is not the case, it reports the restricted funds as a noncurrent asset. Illustration 7-11 shows restricted cash reported in the fi nancial statements of Delta Air Lines. The company is required to maintain restricted cash as collateral to support insurance obligations related to workers’ compensation claims. Delta does not have access to these funds for general use, and so it must report them separately, rather than as part of cash and cash equivalents.

ETHICS NOTE Recently, some companies were forced to restate their fi nancial statements because they had too broadly interpreted which types of investments could be treated as cash equivalents. By reporting these items as cash equivalents, the companies made themselves look more liquid.

▼

DECISION TOOLS

Reporting restricted cash helps users determine the amount of cash avail- able for a company’s general use.

4a▼ Reporting CashDO IT! Indicate whether each of the following statements is true or false. If false, indicate how to correct the statement.

1. Cash and cash equivalents are comprised of coins, currency (paper money), money orders, and NSF checks.

2. Restricted cash is classifi ed as either a current asset or noncurrent asset, depending on the circumstances.

3. A company may have a negative balance in its bank account. In this case, it should offset this negative balance against cash and cash equivalents on the balance sheet.

4. Because cash and cash equivalents often includes short-term investments, accounts receivable should be reported as the fi rst item on the balance sheet.

Action Plan ✔ Understand how

companies present cash and restricted cash on the balance sheet.

✔ Review the designations of cash equivalents and restricted cash, and how companies typically handle them.

SOLUTION 1. False. NSF checks should be reported as receivables, not cash and cash equivalents. 2. True. 3. False. Companies that have a negative balance in their bank accounts should report the negative balance as a current liability. 4. False. Cash equivalents are readily convertible to known amounts of cash, and so near maturity (less than 3 months) that they are considered more liquid than accounts receivable and therefore are reported before accounts receivable on the balance sheet.

Related exercise material: BE7-12, DO IT! 7-4a, and E7-12.

MANAGING AND MONITORING CASH

Many companies struggle, not because they fail to generate sales, but because they cannot manage their cash. A real-life example of this is a clothing manufactur- ing company owned by Sharon McCollick. McCollick gave up a stable, high-paying

342 7 Fraud, Internal Control, and Cash

marketing job with Intel Corporation to start her own company. Soon she had more orders from stores such as JC Penney and Dayton Hudson (now Target) than she could fi ll. Yet she found herself on the brink of fi nancial disaster, owing three mortgage payments on her house and $2,000 to the IRS. Her company could generate sales, but it was not collecting cash fast enough to support its operations. The bottom line is that a business must have cash.4

A merchandising company’s operating cycle is generally shorter than that of a manufacturing company. Illustration 7-12 shows the cash to cash operating cycle of a merchandising operation.

4Adapted from T. Petzinger, Jr., “The Front Lines—Sharon McCollick Got Mad and Tore Down a Bank’s Barriers,” Wall Street Journal (May 19, 1995), p. B1.

Sell Inventory

Merchandising Company

Cash

InventoryAccountsReceivable

Receive Cash Buy Inventory

MAIL

TVTV TV

ILLUSTRATION 7-12 Operating cycle of a merchandising company

To understand cash management, consider the operating cycle of Sharon McCollick’s clothing manufacturing company. First, it purchases cloth. Let’s assume that it purchases the cloth on credit provided by the supplier, so the com- pany owes its supplier money. Second, employees convert the cloth to clothing. Now the company also owes its employees money. Third, it sells the clothing to retailers, on credit. McCollick’s company will have no money to repay suppli- ers or employees until it receives payments from customers. In a manufacturing operation, there may be a signifi cant lag between the original purchase of raw materials and the ultimate receipt of cash from customers. Managing the often-precarious balance created by the ebb and fl ow of cash during the operating cycle is one of a company’s greatest challenges. The objec- tive is to ensure that a company has suffi cient cash to meet payments as they come due, yet minimize the amount of non-revenue-generating cash on hand.

Basic Principles of Cash Management Management of cash is the responsibility of the company treasurer. Any com- pany can improve its chances of having adequate cash by following fi ve basic principles of cash management.

1. Increase the speed of receivables collection. Money owed Sharon McCollick by her customers is money that she cannot use. The more quickly customers pay her, the more quickly she can use those funds. Thus, rather than have an average collection period of 30 days, she may want an average collection period of 15 days. However, she must carefully weigh any attempt to force her customers to pay earlier against the possibility that she may anger or alienate them. Perhaps her competitors are willing to provide a 30-day grace period. As noted in Chapter 5, one common way to encourage customers to pay more quickly is to offer cash discounts for early payment under such terms as 2/10, n/30.

Reporting Cash and Cash Management 343

2. Keep inventory levels low. Maintaining a large inventory of cloth and fi nished clothing is costly. It ties up large amounts of cash, as well as warehouse space. Increasingly, companies are using techniques to reduce the inventory on hand, thus conserving their cash. Of course, if Sharon McCollick has inadequate inven- tory, she will lose sales. The proper level of inventory is an important decision.

3. Monitor payment of liabilities. Sharon McCollick should monitor when her bills are due, so she avoids paying them too early. Let’s say her supplier allows 30 days for payment. If she pays in 10 days, she has lost the use of that cash for 20 days. Therefore, she should use the full payment period. But, she should not pay late. This could damage her credit rating (and future borrowing ability). Also, late payments to suppliers can damage important supplier relationships and may even threaten a supplier’s viability. McCollick’s company also should conserve cash by taking cash discounts offered by suppliers, when possible.

4. Plan the timing of major expenditures. To maintain operations or to grow, all companies must make major expenditures. These often require some form of outside fi nancing. To increase the likelihood of obtaining outside fi nanc- ing, Sharon McCollick should carefully consider the timing of major expen- ditures in light of her company’s operating cycle. If at all possible, she should make any major expenditure when the company normally has excess cash— usually during the off-season.

5. Invest idle cash. Cash on hand earns nothing. An important part of the trea- surer’s job is to ensure that the company invests any excess cash, even if it is only overnight. Many businesses, such as Sharon McCollick’s clothing com- pany, are seasonal. During her slow season, when she has excess cash, she should invest it.

To avoid a cash crisis, it is very important that investments of idle cash be highly liquid and risk-free. A liquid investment is one with a market in which someone is always willing to buy or sell the investment. A risk-free investment means there is no concern that the party will default on its prom- ise to pay its principal and interest. For example, using excess cash to pur- chase stock in a small company because you heard that it was probably going to increase in value in the near term is totally inappropriate. First, the stock of small companies is often illiquid. Second, if the stock suddenly decreases in value, you might be forced to sell the stock at a loss in order to pay your bills as they come due. The most common form of liquid investments is interest- paying U.S. government securities.

Illustration 7-13 summarizes these fi ve principles of cash management.

INTERNATIONAL NOTE International sales complicate cash management. For example, if Nike must repay a Japanese supplier 30 days from today in Japanese yen, Nike will be concerned about how the exchange rate of U.S. dollars for yen might change during those 30 days. Often, corporate treasurers make investments known as hedges to lock in an exchange rate to reduce the company’s exposure to exchange-rate fl uctuation.

Expand factory

$ high

$ low

Payments due

Warehous e

1. Increase the speed of receivables collection

3. Monitor payment of liabilities

2. Keep inventory low

4. Plan timing of major expenditures

T-Bill

5. Invest idle cash

ILLUSTRATION 7-13 Five principles of sound cash management

344 7 Fraud, Internal Control, and Cash

CASH BUDGETING

Because cash is so vital to a company, planning the company’s cash needs is a key business activity. It enables the company to plan ahead to cover possible cash shortfalls and to make investments of idle funds. The cash budget shows anticipated cash fl ows, usually over a one- to two-year period. In this section, we introduce the basics of cash budget- ing. More advanced discussion of cash budgets and budgets in general

is provided in managerial accounting texts. As shown in Illustration 7-14, the cash budget contains three sections—cash receipts, cash disbursements, and fi nancing—and the beginning and ending cash balances.

DECISION TOOLS

The cash budget helps users deter- mine if the company will be able to meet its projected cash needs.

ILLUSTRATION 7-14 Basic form of cash budget

Beginning cash balance $X,XXX Add: Cash receipts (itemized) X,XXX

Total available cash X,XXX Less: Cash disbursements (itemized) X,XXX

Excess (defi ciency) of available cash over cash disbursements X,XXX

Financing Add: Borrowings X,XXX Less: Repayments X,XXX

Ending cash balance $X,XXX

ANY COMPANY Cash Budget

The Cash receipts section includes expected receipts from the company’s principal source(s) of cash, such as cash sales and collections from customers on credit sales. This section also shows anticipated receipts of interest and divi- dends, and proceeds from planned sales of investments, plant assets, and the company’s capital stock. The Cash disbursements section shows expected payments for inventory, labor, overhead, and selling and administrative expenses. It also includes pro- jected payments for income taxes, dividends, investments, and plant assets. Note that it does not include depreciation since depreciation expense does not use cash. The Financing section shows expected borrowings and repayments of bor- rowed funds plus interest. Financing is needed when there is a cash defi ciency or when the cash balance is less than management’s minimum required balance. Companies must prepare multi-period cash budgets in sequence because the ending cash balance of one period becomes the beginning cash balance for the next period. In practice, companies often prepare cash budgets for the next 12 months on a monthly basis. To minimize detail, we will assume that Hayes Company prepares an annual cash budget by quarters. Preparing a cash budget requires making some assump- tions. For example, Hayes makes assumptions regarding collection of accounts receivable, sales of securities, payments for materials and salaries, and purchases of property, plant, and equipment. The accuracy of the cash budget is very depen- dent on the accuracy of these assumptions. In Illustration 7–15, we present the cash budget for Hayes. The budget indi- cates that the company will need $3,000 of fi nancing in the second quarter to maintain a minimum cash balance of $15,000. Since there is an excess of avail- able cash over disbursements of $22,500 at the end of the third quarter, Hayes will repay the borrowing, plus $100 interest, in that quarter.

A cash budget contributes to more effective cash management. For example, it can show when a company will need additional fi nancing well before

Reporting Cash and Cash Management 345

the actual need arises. Conversely, it can indicate when the company will have excess cash available for investments or other purposes.

ILLUSTRATION 7-15 Sample cash budget

Quarter

1 2 3 4

Beginning cash balance $ 38,000 $ 25,500 $ 15,000 $ 19,400 Add: Cash receipts Collections from customers 168,000 198,000 228,000 258,000 Sale of securities 2,000 0 0 0

Total receipts 170,000 198,000 228,000 258,000

Total available cash 208,000 223,500 243,000 277,400 Less: Cash disbursements Inventory 23,200 27,200 31,200 35,200 Salaries 62,000 72,000 82,000 92,000 Selling and administrative expenses (excluding depreciation) 94,300 99,300 104,300 109,300 Purchase of truck 0 10,000 0 0 Income tax expense 3,000 3,000 3,000 3,000

Total disbursements 182,500 211,500 220,500 239,500

Excess (defi ciency) of available cash over disbursements 25,500 12,000 22,500 37,900 Financing Add: Borrowings 0 3,000 0 0 Less: Repayments—plus $100 interest 0 0 3,100 0

Ending cash balance $ 25,500 $ 15,000 $ 19,400 $ 37,900

HAYES COMPANY Cash Budget

For the Year Ending December 31, 2017

4b▼ Cash BudgetDO IT! Martian Company’s management wants to maintain a minimum monthly cash balance of $15,000. At the beginning of March, the cash balance is $16,500, expected cash receipts for March are $210,000, and cash disbursements are expected to be $220,000. How much cash, if any, must Martian borrow to maintain the desired minimum monthly balance?

Action Plan ✔ Add the beginning cash

balance to receipts to determine total available cash.

✔ Subtract disbursements to determine excess or defi ciency.

✔ Compare excess or defi ciency with desired minimum cash to determine borrowing needs.

SOLUTION Beginning cash balance $ 16,500 Add: Cash receipts for March 210,000

Total available cash 226,500 Less: Cash disbursements for March 220,000

Excess of available cash over cash disbursements 6,500 Financing Add: Borrowings 8,500

Ending cash balance $ 15,000

To maintain the desired minimum cash balance of $15,000, Martian Company must borrow $8,500 of cash.

Related exercise material: BE7-13, DO IT! 7-4b, and E7-14.

346 7 Fraud, Internal Control, and Cash

Presented below is hypothetical fi nancial information for Mattel Corporation from the year ended December 31, 2016. Mattel is a toy manufacturing company, at one time named by Fortune magazine as one of the top 100 companies for which to work.

Selected Financial Information Year Ended December 31, 2016

(in millions)

Net cash provided by operating activities $325 Capital expenditures 162 Dividends paid 80 Total expenses 680 Depreciation expense 40 Cash balance 206

Also provided below are estimates of the company’s sources and uses of cash during the year ended December 31, 2017. This information should be used to prepare a cash budget for 2017.

Projected Sources and Uses of Cash (in millions)

Beginning cash balance $206 Cash receipts from sales of product 355 Cash receipts from sale of short-term investments 20 Cash payments for inventory 357 Cash payments for selling and administrative costs 201 Cash payments for property, plant, and equipment 45 Cash payments for taxes 17

Mattel’s management believes it should maintain a balance of $200 million cash.

INSTRUCTIONS

(a) Using the hypothetical projected sources and uses of cash information presented above, prepare a cash budget for 2017 for Mattel Corporation.

(b) Comment on the company’s cash adequacy, and discuss steps that might be taken to improve its cash position.

USING DECISION TOOLS—MATTEL CORPORATION

SOLUTION (a)

MATTEL CORPORATION Cash Budget

For the Year Ending December 31, 2017 (in millions)

Beginning cash balance $206 Add: Cash receipts From sales of product $355 From sale of short-term investments 20 375

Total available cash 581 Less: Cash disbursements Payments for inventory 357 Payments for selling and administrative costs 201 Payments for property, plant, and equipment 45 Payments for taxes 17

Total disbursements 620

Excess (defi ciency) of available cash over disbursements (39) Financing Add: Borrowings 239

Ending cash balance $200

Appendix 7A: Operation of a Petty Cash Fund 347

(b) Using these hypothetical data, Mattel’s cash position appears adequate. For 2017, Mattel is projecting a cash shortfall. This is not necessarily of concern, but it should be investigated. Its primary line of business is toys. Most toys are sold during December. We would expect Mattel’s cash position to vary signifi cantly during the course of the year. After the holiday season, once its customers have paid Mattel, it probably has a lot of excess cash. However, when it is making and selling its product but has not yet been paid, it may need to borrow to meet any temporary cash shortfalls.

If Mattel’s management is concerned with its cash position, it could take the following steps. (1) Offer its custom- ers cash discounts for early payment, such as 2/10, n/30. (2) Implement inventory management techniques to reduce the need for large inventories of such things as the plastics used to make its toys. (3) Carefully time payments to sup- pliers by keeping track of when payments are due, so as not to pay too early. (4) If it has plans for major expenditures, time those expenditures to coincide with its seasonal period of excess cash.

APPENDIX 7A: Explain the operation of a petty cash fund. LEARNING OBJECTIVE *5▼

The operation of a petty cash fund involves (1) establishing the fund, (2) making payments from the fund, and (3) replenishing the fund.

ESTABLISHING THE PETTY CASH FUND

Two essential steps in establishing a petty cash fund are (1) appointing a petty cash custodian who will be responsible for the fund, and (2) determining the size of the fund. Ordinarily, a company expects the amount in the fund to cover an - ticipated disbursements for a three- to four-week period. When the company establishes the petty cash fund, it issues a check payable to the petty cash custodian for the stipulated amount. If Laird Company decides to establish a $100 fund on March 1, the entry in general journal form is as follows.

Mar. 1 Petty Cash 100 Cash 100 (To establish a petty cash fund)

The fund custodian cashes the check and places the proceeds in a locked petty cash box or drawer. Most petty cash funds are established on a fi xed-amount basis. Moreover, the company will make no additional entries to the Petty Cash account unless the stipulated amount of the fund is changed. For example, if Laird decides on July 1 to increase the size of the fund to $250, it would debit Petty Cash $150 and credit Cash $150.

MAKING PAYMENTS FROM PETTY CASH

The custodian of the petty cash fund has the authority to make payments from the fund that conform to prescribed management policies. Usually, management limits the size of expenditures that come from petty cash and does not permit use of the fund for certain types of transactions (such as making short-term loans to employees). Each payment from the fund must be documented on a prenumbered petty cash receipt (or petty cash voucher). The signatures of both the custodian and the individual receiving payment are required on the receipt. If other supporting documents such as a freight bill or invoice are available, they should be attached to the petty cash receipt. The custodian keeps the receipts in the petty cash box until the fund is replenished. As a result, the sum of the petty cash receipts and money in the fund should equal the established total at all times. This means that management can make surprise counts at any time by an independent person, such as an internal auditor, to determine the correctness of the fund. The company does not make an accounting entry to record a payment at the time it is taken from petty cash. It is considered both inexpedient and unneces- sary to do so. Instead, the company recognizes the accounting effects of each payment when the fund is replenished.

A L SE= + +100 −100 Cash Flows no eff ect

ETHICS NOTE Petty cash funds are authorized and legitimate. In contrast, “slush” funds are unauthorized and hidden (under the table).

▼

▼ HELPFUL HINT From the standpoint of internal control, the petty cash receipt satisfi es two principles: (1) establishment of responsibility (signature of custodian), and (2) documentation procedures.

348 7 Fraud, Internal Control, and Cash

REPLENISHING THE PETTY CASH FUND

When the money in the petty cash fund reaches a minimum level, the company replenishes the fund. The petty cash custodian initiates a request for reimburse- ment. This individual prepares a schedule (or summary) of the payments that have been made and sends the schedule, supported by petty cash receipts and other documentation, to the treasurer’s offi ce. The receipts and supporting documents are examined in the treasurer’s offi ce to verify that they were proper payments from the fund. The treasurer then approves the request, and a check is prepared to restore the fund to its established amount. At the same time, all supporting docu- mentation is stamped “paid” so that it cannot be submitted again for payment. To illustrate, assume that on March 15 the petty cash custodian requests a check for $87. The fund contains $13 cash and petty cash receipts for postage $44, supplies $38, and miscellaneous expenses $5. The entry, in general journal form, to record the check is as follows.

Mar. 15 Postage Expense 44 Supplies 38 Miscellaneous Expense 5 Cash 87 (To replenish petty cash fund)

Note that the reimbursement entry does not affect the Petty Cash account. Replenishment changes the composition of the fund by replacing the petty cash receipts with cash, but it does not change the balance in the fund. Occasionally, in replenishing a petty cash fund the company may need to recog- nize a cash shortage or overage. To illustrate, assume in the preceding example that the custodian had only $12 in cash in the fund plus the receipts as listed. The request for reimbursement would therefore be for $88, and the following entry would be made.

Mar. 15 Postage Expense 44 Supplies 38 Miscellaneous Expense 5

Cash Over and Short 1 Cash 88 (To replenish petty cash fund)

Conversely, if the custodian had $14 in cash, the reimbursement request would be for $86, and Cash Over and Short would be credited for $1. A debit balance in Cash Over and Short is reported in the income statement as miscellaneous expense; a credit balance is reported as miscellaneous revenue. The company closes Cash Over and Short to Income Summary at the end of the year. Companies should replenish a petty cash fund at the end of the accounting period, regardless of the cash in the fund. Replenishment at this time is necessary in order to recognize the effects of the petty cash payments on the fi nancial statements. Internal control over a petty cash fund is strengthened by (1) having a super- visor make surprise counts of the fund to ascertain whether the paid petty cash receipts and fund cash equal the designated amount, and (2) canceling or mutilat- ing the paid petty cash receipts so they cannot be resubmitted for reimbursement.

▼ HELPFUL HINT Replenishing involves three internal control procedures: segregation of duties, documentation procedures, and independent internal verifi cation.

A L SE= + −44 Exp

+38 −5 Exp

−87 Cash Flows −87

A L SE= + −44 Exp

+38 −5 Exp −1 Exp

−88 Cash Flows −88

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Defi ne fraud and the principles of internal control. A fraud is a dishonest act by an employee that results in per- sonal benefi t to the employee at a cost to the employer. The fraud triangle refers to the three factors that contribute to

fraudulent activity by employees: opportunity, fi nancial pressure, and rationalization. Internal control consists of all the related methods and measures adopted within an organization to safeguard assets, enhance the reliability of

▼

Decision Tools Review 349

accounting records, increase effi ciency of operations, and ensure compliance with laws and regulations. The principles of internal control are establishment of responsibility, segregation of duties, documentation proce- dures, physical controls, independent internal verifi cation, and human resource controls.

2 Apply internal control principles to cash. Internal con- trols over cash receipts include (a) designating only person- nel such as cashiers to handle cash; (b) assigning the duties of receiving cash, recording cash, and having custody of cash to different individuals; (c) obtaining remittance advices for mail receipts, cash register tapes or computer records for over-the-counter receipts, and deposit slips for bank deposits; (d) using company safes and bank vaults to store cash with access limited to authorized personnel, and using cash registers or point-of-sale terminals in executing over-the-counter receipts; (e) making independent daily counts of register receipts and daily comparisons of total receipts with total deposits; and (f) conducting background checks and bonding personnel who handle cash, as well as requiring them to take vacations. Internal controls over cash disbursements include (a) having only specifi ed individuals such as the treasurer autho- rized to sign checks and approve vendors; (b) assigning the duties of approving items for payment, paying the items, and recording the payment to different individuals; (c) using pre- numbered checks and accounting for all checks, with each check supported by an approved invoice; after payment, stamping each approved invoice “paid”; (d) storing blank checks in a safe or vault with access restricted to autho- rized personnel, and using a machine with indelible ink to imprint amounts on checks; (e) comparing each check with

the approved invoice before issuing the check, and making monthly reconciliations of bank and book balances; and (f) bonding personnel who handle cash, requiring employees to take vacations, and conducting background checks.

3 Identify the control features of a bank account. In rec- onciling the bank account, it is customary to reconcile the balance per books and the balance per bank to their adjusted balance. The steps reconciling the Cash account are to determine deposits in transit and electronic funds transfers received by bank, outstanding checks, errors by the depositor or the bank, and unrecorded bank memoranda.

4 Explain the reporting of cash and the basic principles of cash management. Cash is listed fi rst in the current assets sec- tion of the balance sheet. Companies often report cash together with cash equivalents. Cash restricted for a special purpose is reported separately as a current asset or as a noncurrent asset, depending on when the company expects to use the cash.

The basic principles of cash management include (a) in- crease the speed of receivables collection, (b) keep inventory levels low, (c) monitor the timing of payment of liabilities, (d) plan timing of major expenditures, and (e) invest idle cash.

The three main elements of a cash budget are the cash receipts section, cash disbursements section, and fi nanc- ing section.

*5 Explain the operation of a petty cash fund. In operating a petty cash fund, a company establishes the fund by appointing a custodian and determining the size of the fund. The custo- dian makes payments from the fund for documented expendi- tures. The company replenishes the fund as needed, and at the end of each accounting period. Accounting entries to record payments are made each time the fund is replenished.

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Are the company’s fi nancial statements supported by adequate internal controls?

Auditor’s report, manage- ment discussion and analysis, articles in fi nancial press

The principles of internal control activities are (1) establishment of responsibility, (2) segregation of duties, (3) documentation procedures, (4) physical controls, (5) independent internal verifi cation, and (6) human resource controls.

If any indication is given that these or other controls are lacking, use the fi nancial statements with caution.

Is all of the company’s cash available for general use?

Will the company be able to meet its projected cash needs?

Balance sheet and notes to fi nancial statements

Cash budget (typically available only to management)

The company reports restricted cash in assets section of balance sheet.

The cash budget shows projected sources and uses of cash. If cash uses exceed internal cash sources, then the company must look for outside sources.

A restriction on the use of cash limits management’s ability to use those resources for general obligations. This might be considered when assessing liquidity.

Two issues: (1) Are management’s projections reasonable? (2) If outside sources are needed, are they available?

350 7 Fraud, Internal Control, and Cash

Bank reconciliation The process of comparing the bank’s account balance with the company’s balance, and ex- plaining the differences to make them agree. (p. 333).

Bank statement A statement received monthly from the bank that shows the depositor’s bank transactions and balances. (p. 333).

Bonding Obtaining insurance protection against theft by employees. (p. 325).

Cash Resources that consist of coins, currency, checks, money orders, and money on hand or on deposit in a bank or similar depository. (p. 340).

Cash budget A projection of anticipated cash fl ows, usu- ally over a one- to two-year period. (p. 344).

Cash equivalents Short-term, highly liquid investments that can be readily converted to a specifi c amount of cash and which are relatively insensitive to interest rate changes. (p. 340).

Deposits in transit Deposits recorded by the depositor that have not been recorded by the bank. (p. 335).

Electronic funds transfer (EFT) A disbursement system that uses wire, telephone, or computer to transfer cash from one location to another. (p. 333).

Fraud A dishonest act by an employee that results in personal benefi t to the employee at a cost to the employer. (p. 318).

Fraud triangle The three factors that contribute to fraud- ulent activity by employees: opportunity, fi nancial pres- sure, and rationalization. (p. 318).

Internal auditors Company employees who continuously evaluate the effectiveness of the company’s internal con- trol systems. (p. 325).

Internal control A process designed to provide reason- able assurance regarding the achievement of company objectives related to operations, reporting, and compli- ance. (p. 319).

NSF check A check that is not paid by a bank because of insuffi cient funds in a bank account. (p. 334).

Outstanding checks Checks issued and recorded by a company that have not been paid by the bank. (p. 335).

Petty cash fund A cash fund used to pay relatively small amounts. (p. 331).

Restricted cash Cash that is not available for general use but instead is restricted for a particular purpose. (p. 341).

Sarbanes-Oxley Act (SOX) Law that requires publicly traded companies to maintain adequate systems of internal control. (p. 318).

Treasurer Employee responsible for the management of a company’s cash. (p. 342).

Voucher An authorization form prepared for each expen- diture in a voucher system. (p. 330).

Voucher system A network of approvals by authorized individuals, acting independently, to ensure that all dis- bursements by check are proper. (p. 330).

GLOSSARY REVIEW▼

1. Which of the following is not an element of the fraud triangle? (a) Rationalization. (c) Segregation of duties. (b) Financial pressure. (d) Opportunity.

2. Internal control is used in a business to enhance the ac- curacy and reliability of its accounting records and to: (a) safeguard its assets. (b) prevent fraud. (c) produce correct fi nancial statements. (d) deter employee dishonesty.

3. The principles of internal control do not include: (a) establishment of responsibility. (b) documentation procedures. (c) management responsibility. (d) independent internal verifi cation.

4. Physical controls do not include: (a) safes and vaults to store cash. (b) independent bank reconciliations. (c) locked warehouses for inventories. (d) bank safety deposit boxes for important papers.

5. Which of the following was not a result of the Sar- banes-Oxley Act? (a) Companies must fi le fi nancial statements with

the Internal Revenue Service. (b) All publicly traded companies must maintain ad-

equate internal controls.

(LO 1)

(c) The Public Company Accounting Oversight Board was created to establish auditing stan- dards and regulate auditor activity.

(d) Corporate executives and boards of directors must ensure that controls are reliable and effective, and they can be fi ned or imprisoned for failure to do so.

6. Which of the following control activities is not rel- evant when a company uses a computerized (rather than manual) accounting system? (a) Establishment of responsibility. (b) Segregation of duties. (c) Independent internal verifi cation. (d) All of these control activities are relevant to a

computerized system. 7. Permitting only designated personnel such as ca-

shiers to handle cash receipts is an application of the principle of: (a) segregation of duties. (b) establishment of responsibility. (c) independent internal verifi cation. (d) human resource controls.

8. The use of prenumbered checks in disbursing cash is an application of the principle of: (a) establishment of responsibility. (b) segregation of duties. (c) physical controls. (d) documentation procedures.

(LO 1)

(LO 2)

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

Practice Multiple-Choice Questions 351

current asset. 14. Which of the following would not be an example of

good cash management? (a) Provide discounts to customers to encourage

early payment. (b) Invest temporary excess cash in stock of a small

company. (c) Carefully monitor payments so that payments

are not made early. (d) Employ just-in-time inventory methods to keep

inventory low. 15. Which of the following is not one of the sec-

tions of a cash budget? (a) Cash receipts section. (b) Cash disbursements section. (c) Financing section. (d) Cash from operations section.

*16. A check is written to replenish a $100 petty cash fund when the fund contains receipts of $94 and $4 in cash. In recording the check: (a) debit Cash Over and Short for $2. (b) debit Petty Cash for $94. (c) credit Cash for $94. (d) credit Petty Cash for $2.

(LO 4)

(LO 5)

9. The control features of a bank account do not include: (a) having bank auditors verify the correctness of

the bank balance per books. (b) minimizing the amount of cash that must be kept

on hand. (c) providing a double record of all bank transactions. (d) safeguarding cash by using a bank as a depository.

10. In a bank reconciliation, deposits in transit are: (a) deducted from the book balance. (b) added to the book balance. (c) added to the bank balance. (d) deducted from the bank balance.

11. The reconciling item in a bank reconciliation that will result in an adjusting entry by the depositor is: (a) outstanding checks. (c) a bank error. (b) deposit in transit. (d) bank service charges.

12. Which of the following items in a cash drawer at November 30 is not cash? (a) Money orders. (b) Coins and currency. (c) An NSF check. (d) A customer check dated November 28.

13. Which statement correctly describes the re- porting of cash? (a) Cash cannot be combined with cash equivalents. (b) Restricted cash funds may be combined with

cash.

(LO 3)

(LO 4)

SOLUTIONS 1. (c) Segregation of duties is not an element of the fraud triangle. The other choices are fraud triangle elements.

2. (a) Safeguarding assets is one of the purposes of using internal control. The other choices are incorrect because while internal control can help to (b) prevent fraud, (c) produce correct fi nancial statements, and (d) deter employee dishon- esty, these are not the main purposes of using it.

3. (c) Management responsibility is not one of the principles of internal control. The other choices are true statements.

4. (b) Independent bank reconciliations are not a physical control. The other choices are true statements.

5. (a) Filing fi nancial statements with the IRS is not a result of the Sarbanes-Oxley Act (SOX); SOX focuses on the preven- tion or detection of fraud. The other choices are results of SOX.

6. (d) Establishment of responsibility, segregation of duties, and independent internal verifi cation are all relevant to a computerized system. Although choices (a), (b), and (c) are correct, choice (d) is the better answer.

7. (b) Permitting only designated personnel to handle cash receipts is an application of the principle of establishment of responsibility, not (a) segregation of duties, (c) independent internal verifi cation, or (d) human resource controls.

8. (d) The use of prenumbered checks in disbursing cash is an application of the principle of documentation procedures, not (a) establishment of responsibility, (b) segregation of duties, or (c) physical controls.

9. (a) Having bank auditors verify the correctness of the bank balance per books is not one of the control features of a bank account. The other choices are true statements.

10. (c) Deposits in transit are added to the bank balance on a bank reconciliation, not (a) deducted from the book balance, (b) added to the book balance, or (d) deducted from the bank balance.

11. (d) Because the depositor does not know the amount of the bank service charges until the bank statement is received, an adjusting entry must be made when the statement is received. The other choices are incorrect because (a) outstanding checks do not require an adjusting entry by the depositor because the checks have already been recorded in the depositor’s books, (b) deposits in transit do not require an adjusting entry by the depositor because the deposits have already been recorded in the depositor’s books, and (c) bank errors do not require an adjusting entry by the depositor, but the depositor does need to inform the bank of the error so it can be corrected.

12. (c) An NSF check should not be considered cash. The other choices are true statements.

13. (c) Cash is listed fi rst in the current assets section. The other choices are incorrect because (a) cash and cash equiva- lents can be appropriately combined when reporting cash on the balance sheet, (b) restricted cash is not to be com- bined with cash when reporting cash on the balance sheet, and (d) restricted funds can be reported as current assets if they will be used within one year.

352 7 Fraud, Internal Control, and Cash

SOLUTION

Procedure IC Good or Weak? Related Internal Control Principle

1. Good Independent internal verifi cation 2. Good Physical controls 3. Good Human resource controls 4. Weak Establishment of responsibility 5. Weak Segregation of duties

14. (b) Investing excess cash to purchase stock in a small company is inappropriate because the stock of small companies is often not easily converted to cash. Choices (a) providing discounts to customers to encourage early payment, (c) carefully monitoring payments so that cash is held until just before the payment date of liabilities, and (d) keeping inventory levels low are all good cash management practices.

15. (d) Cash from operations is not a section of a cash budget. Choices (a) cash receipts section, (b) cash disbursements section, and (c) fi nancing section are all elements of a cash budget.

*16. (a) When this check is recorded, the company should debit Cash Over and Short for the shortage of $2 (total of the receipts plus cash in the drawer ($98) versus $100), not (b) debit Petty Cash for $94, (c) credit Cash for $94, or (d) credit Petty Cash for $2.

1. Listed below are fi ve procedures followed by Shepherd Company.

1. Total cash receipts are compared to bank deposits daily by someone who has no other cash responsibilities.

2. Time clocks are used for recording time worked by employees.

3. Employees are required to take vacations.

4. Any member of the sales department can approve credit sales.

5. Sam Hill ships goods to customers, bills customers, and receives payment from customers.

INSTRUCTIONS

Indicate whether each procedure is an example of good internal control or of weak inter- nal control. If it is an example of good internal control, indicate which internal control principle is being followed. If it is an example of weak internal control, indicate which internal control principle is violated. Use the table below.

Procedure IC Good or Weak? Related Internal Control Principle

1. 2. 3. 4. 5.

Indicate whether procedure is good or weak internal control.

(LO 1, 2)

PRACTICE EXERCISES▼

2. The information below relates to the Cash account in the ledger of Ansel Company.

Balance June 1—$17,450; Cash deposited—$64,000. Balance June 30—$17,704; Checks written—$63,746.

The June bank statement shows a balance of $16,422 on June 30 and the following memoranda.

Credits Debits

Collection of $1,530 through NSF check: Anne Adams $425 electronic funds transfer $1,530 Safety deposit box rent $55 Interest earned on checking account $35

At June 30, deposits in transit were $4,750, and outstanding checks totaled $2,383.

Prepare bank reconciliation and adjusting entries.

(LO 3)

Practice Problem 353

INSTRUCTIONS

(a) Prepare the bank reconciliation at June 30.

(b) Prepare the adjusting entries at June 30, assuming (1) the NSF check was from a customer on account, and (2) no interest had been accrued on the note.

SOLUTION

2. (a) ANSEL COMPANY

Bank Reconciliation June 30

Cash balance per bank statement $16,422 Add: Deposits in transit 4,750

21,172 Less: Outstanding checks 2,383

Adjusted cash balance per bank $18,789

Cash balance per books $17,704 Add: Electronic funds transfer received $1,530 Interest earned 35 1,565

19,269 Less: NSF check 425 Safety deposit box rent 55 480

Adjusted cash balance per books $18,789

(b) June 30 Cash 1,530 Accounts Receivable 1,530

30 Cash 35 Interest Revenue 35

30 Accounts Receivable (Anne Adams) 425 Cash 425

30 Bank Charges Expense 55 Cash 55

Trillo Company’s bank statement for May 2017 shows these data.

Balance May 1 $12,650 Balance May 31 $14,280 Debit memorandum: Credit memorandum: NSF check 175 Collection of electronic funds transfer 505

The cash balance per books at May 31 is $13,319. Your review of the data reveals the following.

1. The NSF check was from Hup Co., a customer.

2. Outstanding checks at May 31 total $2,410.

3. Deposits in transit at May 31 total $1,752.

4. A Trillo Company check for $352 dated May 10 cleared the bank on May 25. This check, which was a payment on account, was journalized for $325.

INSTRUCTIONS

(a) Prepare a bank reconciliation at May 31.

(b) Journalize the entries required by the reconciliation.

Prepare bank reconciliation and journalize entries.

(LO 3)

PRACTICE PROBLEM▼

SOLUTION

(a) Cash balance per bank statement $14,280 Add: Deposits in transit 1,752

16,032 Less: Outstanding checks 2,410

Adjusted cash balance per bank $13,622

Cash balance per books $13,319 Add: Electronic funds transfer received 505

13,824 Less: NSF check $175 Error in recording check ($352 − $325) 27 202 Adjusted cash balance per books $13,622

(b) May 31 Cash 505 Accounts Receivable 505 (To record receipt of electronic funds transfer)

31 Accounts Receivable (Hup Co.) 175 Cash 175 (To record NSF check from Hup Co.)

31 Accounts Payable 27 Cash 27 (To correct error in recording check)

354 7 Fraud, Internal Control, and Cash

1. A local bank reported that it lost $150,000 as the result of employee fraud. Ray Fairburn is not clear on what is meant by “employee fraud.” Explain the meaning of fraud to Ray and give an example of fraud that might occur at a bank.

2. Fraud experts often say that there are three primary factors that contribute to employee fraud. Identify the three factors and explain what is meant by each.

3. Identify the fi ve components of a good internal control system.

4. “Internal control is concerned only with enhancing the accuracy of the accounting records.” Do you agree? Explain.

5. Discuss how the Sarbanes-Oxley Act has increased the importance of internal control to top managers of a company.

6. What principles of internal control apply to most businesses?

7. In the corner grocery store, all sales clerks make change out of one cash register drawer. Is this a viola- tion of internal control? Why?

8. Branden Doyle is reviewing the principle of segrega- tion of duties. What are the two common applications of this principle?

9. How do documentation procedures contribute to good internal control?

10. What internal control objectives are met by physical controls?

11. (a) Explain the control principle of independent inter- nal verifi cation.

(b) What practices are important in applying this principle?

12. As the company accountant, explain the follow- ing ideas to the management of Ortiz Company. (a) The concept of reasonable assurance in internal

control. (b) The importance of the human factor in internal

control.

13. Discuss the human resources department’s in- volvement in internal controls.

14. Robbins Inc. owns the following assets at the balance sheet date.

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS▼

Brief Exercises 355

Cash in bank—savings account $ 8,000 Cash on hand 1,100 Cash refund due from the IRS 1,000 Checking account balance 12,000 Postdated checks 500

What amount should be reported as Cash in the balance sheet?

15. What principle(s) of internal control is (are) involved in making daily cash counts of over-the-counter receipts?

16. Assume that Kohl’s Department Stores installed new cash registers in its stores. How do cash registers improve internal control over cash receipts?

17. At Lazlo Wholesale Company, two mail clerks open all mail receipts. How does this strengthen internal control?

18. “To have maximum effective internal control over cash disbursements, all payments should be made by check.” Is this true? Explain.

19. Pauli Company’s internal controls over cash disburse- ments provide for the treasurer to sign checks imprinted by a checkwriter after comparing the check with the approved invoice. Identify the internal control prin- ciples that are present in these controls.

20. How do these principles apply to cash disbursements? (a) Physical controls. (b) Human resource controls.

21. What is the essential feature of an electronic funds transfer (EFT) procedure?

22. “The use of a bank contributes signifi cantly to good internal control over cash.” Is this true? Why?

23. Hank Cook is confused about the lack of agreement between the cash balance per books and the balance per bank. Explain the causes for the lack of agreement to Hank and give an example of each cause.

24. Identify the basic principles of cash management.

25. Trisha Massey asks for your help concerning an NSF check. Explain to Trisha (a) what an NSF check is, (b) how it is treated in a bank reconciliation, and (c) whether it will require an adjusting entry on the com- pany’s books.

26. (a) Describe cash equivalents and explain how they

are reported. (b) How should restricted cash funds be reported on

the balance sheet?

27. What was Apple’s balance in cash and cash equivalents at December 31, 2014? Did it report any restricted cash? How did Apple defi ne cash equivalents?

*28. (a) Identify the three activities that pertain to a petty cash fund, and indicate an internal control prin- ciple that is applicable to each activity.

(b) When are journal entries required in the operation of a petty cash fund?

BE7-1 Match each situation with the fraud triangle factor (opportunity, fi nancial pressure, or rationalization) that best describes it. (a) An employee’s monthly credit card payments are nearly 75% of their monthly earnings. (b) An employee earns minimum wage at a fi rm that has reported record earnings for

each of the last fi ve years. (c) An employee has an expensive gambling habit. (d) An employee has check-writing and -signing responsibilities for a small company, and

is also responsible for reconciling the bank account.

BE7-2 Pat Buhn is the new owner of Young Co. She has heard about internal control but is not clear about its importance for her business. Explain to Pat the four purposes of internal control, and give her one application of each purpose for Young Co.

BE7-3 The internal control procedures in Dayton Company result in the following provi- sions. Identify the principles of internal control that are being followed in each case. (a) Employees who have physical custody of assets do not have access to the accounting

records. (b) Each month, the assets on hand are compared to the accounting records by an internal

auditor. (c) A prenumbered shipping document is prepared for each shipment of goods to

customers.

BE7-4 Jolson Company has the following internal control procedures over cash receipts. Identify the internal control principle that is applicable to each procedure. (a) All over-the-counter receipts are entered in cash registers. (b) All cashiers are bonded. (c) Daily cash counts are made by cashier department supervisors. (d) The duties of receiving cash, recording cash, and having custody of cash are assigned

to different individuals. (e) Only cashiers may operate cash registers.

Identify fraud triangle concepts.

(LO 1), C

Explain the importance of internal control.

(LO 1), C

Identify internal control principles.

(LO 1), C

Identify the internal control principles applicable to cash receipts.

(LO 2), C

BRIEF EXERCISES▼

356 7 Fraud, Internal Control, and Cash

BE7-5 While examining cash receipts information, the accounting department deter- mined the following information: opening cash balance $150, cash on hand $1,125.74, and cash sales per register tape $988.62. Prepare the required journal entry based upon the cash count sheet.

BE7-6 Tott Company has the following internal control procedures over cash disburse- ments. Identify the internal control principle that is applicable to each procedure. (a) Company checks are prenumbered. (b) The bank statement is reconciled monthly by an internal auditor. (c) Blank checks are stored in a safe in the treasurer’s offi ce. (d) Only the treasurer or assistant treasurer may sign checks. (e) Check-signers are not allowed to record cash disbursement transactions.

BE7-7 Luke Roye is uncertain about the control features of a bank account. Explain the control benefi ts of (a) a checking account and (b) a bank statement.

BE7-8 The following reconciling items are applicable to the bank reconciliation for Forde Co. Indicate how each item should be shown on a bank reconciliation. (a) Outstanding checks. (b) Bank debit memorandum for service charge. (c) Bank credit memorandum for collecting an electronic funds transfer. (d) Deposit in transit.

BE7-9 Using the data in BE7-8, indicate (a) the items that will result in an adjustment to the depositor’s records and (b) why the other items do not require adjustment.

BE7-10 At July 31, Planter Company has this bank information: cash balance per bank $7,291, outstanding checks $762, deposits in transit $1,350, and a bank service charge $40. Determine the adjusted cash balance per bank at July 31.

BE7-11 In the month of November, Fiesta Company Inc. wrote checks in the amount of $9,750. In December, checks in the amount of $11,762 were written. In November, $8,800 of these checks were presented to the bank for payment, and $10,889 in December. What is the amount of outstanding checks at the end of November? At the end of December?

BE7-12 Spahn Company has these cash balances: cash in bank $12,742, payroll bank account $6,000, and plant expansion fund cash $25,000. Explain how each balance should be reported on the balance sheet.

BE7-13 The following information is available for Bonkers Company for the month of January: expected cash receipts $59,000, expected cash disbursements $67,000, and cash balance on January 1, $12,000. Management wishes to maintain a minimum cash balance of $9,000. Prepare a basic cash budget for the month of January.

*BE7-14 On March 20, Harbor’s petty cash fund of $100 is replenished when the fund contains $19 in cash and receipts for postage $40, supplies $26, and travel expense $15. Prepare the journal entry to record the replenishment of the petty cash fund.

Make journal entry using cash count sheet.

(LO 2), AP

Identify the internal control principles applicable to cash disbursements.

(LO 2), C

Identify the control features of a bank account.

(LO 3), C Indicate location of reconciling items in a bank reconciliation.

(LO 3), C

Identify reconciling items that require adjusting entries.

(LO 3), C Prepare partial bank reconciliation.

(LO 3), AP

Analyze outstanding checks.

(LO 3), AP

Explain the statement presentation of cash balances.

(LO 4), C

Prepare a cash budget.

(LO 4), AP

Prepare entry to replenish a petty cash fund.

(LO 5), AP

Identify which control activity is violated in each of the following situations, and explain how the situation creates an opportunity for fraud or inappropriate accounting practices.

1. Once a month, the sales department sends sales invoices to the accounting department to be recorded.

2. Steve Nicoles orders merchandise for Binn Company; he also receives merchandise and authorizes payment for merchandise.

3. Several clerks at Draper’s Groceries use the same cash register drawer.

Wes Unsel is concerned with control over mail receipts at Wooden Sporting Goods. All mail receipts are opened by Mel Blount. Mel sends the checks to the

DO IT! 7-1Identify violations of control activities.

(LO 1), C

DO IT! 7-2

Design system of internal control over cash receipts.

(LO 2), C

EXERCISES▼DO IT!

accounting department, where they are stamped “For Deposit Only.” The accounting department records and deposits the mail receipts weekly. Wes asks your help in installing a good system of internal control over mail receipts.

Ned Douglas owns Ned’s Blankets. Ned asks you to explain how he should treat the following reconciling items when reconciling the company’s bank account.

1. Outstanding checks. 2. A deposit in transit. 3. The bank charged to our account a check written by another company. 4. A debit memorandum for a bank service charge.

Indicate whether each of the following statements is true or false.

1. A company has the following assets at the end of the year: cash on hand $40,000, cash refund due from customer $30,000, and checking account balance $22,000. Cash and cash equivalents is therefore $62,000.

2. A company that has received NSF checks should report these checks as a current liability on the balance sheet.

3. Restricted cash that is a current asset is reported as part of cash and cash equivalents. 4. A company has cash in the bank of $50,000, petty cash of $400, and stock investments

of $100,000. Total cash and cash equivalents is therefore $50,400.

Stern Corporation’s management wants to maintain a minimum monthly cash balance of $8,000. At the beginning of September, the cash balance is $12,270, expected cash receipts for September are $97,200, and cash disbursements are expected to be $115,000. How much cash, if any, must Stern borrow to maintain the desired minimum monthly balance? Determine your answer by using the basic form of the cash budget.

DO IT! 7-3 Explain treatment of items in bank reconciliation.

(LO 3), K

DO IT! 7-4a Analyze statements about the reporting of cash.

(LO 4), AP

DO IT! 7-4b Prepare a cash budget.

(LO 4), AP

Exercises 357

E7-1 Bank employees use a system known as the “maker-checker” system. An employee will record an entry in the appropriate journal, and then a supervisor will verify and approve the entry. These days, as all of a bank’s accounts are computerized, the employee first enters a batch of entries into the computer, and then the entries are posted automati- cally to the general ledger account after the supervisor approves them on the system. Access to the computer system is password-protected and task-specific, which means that the computer system will not allow the employee to approve a transaction or the supervisor to record a transaction.

Instructions Identify the principles of internal control inherent in the “maker-checker” procedure used by banks.

E7-2 Ricci’s Pizza operates strictly on a carryout basis. Customers pick up their orders at a counter where a clerk exchanges the pizza for cash. While at the counter, the customer can see other employees making the pizzas and the large ovens in which the pizzas are baked.

Instructions Identify the six principles of internal control and give an example of each principle that you might observe when picking up your pizza. (Note: It may not be possible to observe all the principles.)

E7-3 The following control procedures are used in Keaton Company for over-the-counter cash receipts. 1. Each store manager is responsible for interviewing applicants for cashier jobs. They

are hired if they seem honest and trustworthy. 2. All over-the-counter receipts are registered by three clerks who share a cash register

with a single cash drawer. 3. To minimize the risk of robbery, cash in excess of $100 is stored in an unlocked brief-

case in the stock room until it is deposited in the bank. 4. At the end of each day, the total receipts are counted by the cashier on duty and rec-

onciled to the cash register total. 5. The company accountant makes the bank deposit and then records the day’s receipts.

Identify the principles of internal control.

(LO 1), C

Identify the principles of internal control.

(LO 1), C

List internal control weaknesses over cash receipts and suggest improvements.

(LO 2), E

EXERCISES▼

358 7 Fraud, Internal Control, and Cash

Instructions (a) For each procedure, explain the weakness in internal control and identify the control

principle that is violated. (b) For each weakness, suggest a change in the procedure that will result in good internal

control.

E7-4 The following control procedures are used in Bunny’s Boutique Shoppe for cash disbursements. 1. Each week, 100 company checks are left in an unmarked envelope on a shelf behind

the cash register. 2. The store manager personally approves all payments before she signs and issues checks. 3. The store purchases used goods for resale from people that bring items to the store.

Since that can occur anytime that the store is open, all employees are authorized to purchase goods for resale by disbursing cash from the register. The purchase is docu- mented by having the store employee write on a piece of paper a description of the item that was purchased and the amount that was paid. The employee then signs the paper and puts it in the register.

4. After payment, bills are “filed” in a paid invoice folder. 5. The company accountant prepares the bank reconciliation and reports any discrepan-

cies to the owner.

Instructions (a) For each procedure, explain the weakness in internal control and identify the internal

control principle that is violated. (b) For each weakness, suggest a change in the procedure that will result in good internal

control.

E7-5 At Martinez Company, checks are not prenumbered because both the purchasing agent and the treasurer are authorized to issue checks. Each signer has access to unissued checks kept in an unlocked file cabinet. The purchasing agent pays all bills pertaining to goods purchased for resale. Prior to payment, the purchasing agent determines that the goods have been received and verifies the mathematical accuracy of the vendor’s invoice. After payment, the invoice is filed by vendor name and the purchasing agent records the payment in the cash disbursements journal. The treasurer pays all other bills following approval by authorized employees. After payment, the treasurer stamps all bills “paid,” files them by payment date, and records the checks in the cash disbursements journal. Martinez Company maintains one checking account that is reconciled by the treasurer.

Instructions (a) List the weaknesses in internal control over cash disbursements. (b) Identify improvements for correcting these weaknesses.

E7-6 Rachel Sells is unable to reconcile the bank balance at January 31. Rachel’s recon- ciliation is shown here.

Cash balance per bank $3,677.20 Add: NSF check 450.00 Less: Bank service charge 28.00

Adjusted balance per bank $4,099.20

Cash balance per books $3,975.20 Less: Deposits in transit 590.00 Add: Outstanding checks 770.00

Adjusted balance per books $4,155.20

Instructions (a) What is the proper adjusted cash balance per bank? (b) What is the proper adjusted cash balance per books? (c) Prepare the adjusting journal entries necessary to determine the adjusted cash bal-

ance per books.

E7-7 At April 30, the bank reconciliation of Back 40 Company shows three outstanding checks: No. 254 $650, No. 255 $700, and No. 257 $410. The May bank statement and the May cash payments journal are given here.

List internal control weaknesses for cash disbursements and suggest improvements.

(LO 2), E

Identify internal control weak- nesses for cash disbursements and suggest improvements.

(LO 2), E

Prepare bank reconciliation and adjusting entries.

(LO 3), AP

Determine outstanding checks.

(LO 3), AP

Exercises 359

Instructions Using step 2 in the reconciliation procedure (see page 335), list the outstanding checks at May 31.

E7-8 The following information pertains to Lance Company. 1. Cash balance per bank, July 31, $7,328. 2. July bank service charge not recorded by the depositor $38. 3. Cash balance per books, July 31, $7,364. 4. Deposits in transit, July 31, $2,700. 5. $2,016 collected for Lance Company in July by the bank through electronic funds

transfer. The collection has not been recorded by Lance Company. 6. Outstanding checks, July 31, $686.

Instructions (a) Prepare a bank reconciliation at July 31, 2017. (b) Journalize the adjusting entries at July 31 on the books of Lance Company.

E7-9 This information relates to the Cash account in the ledger of Howard Company.

Balance September 1—$16,400; Cash deposited—$64,000 Balance September 30—$17,600; Checks written—$62,800

The September bank statement shows a balance of $16,500 at September 30 and the fol- lowing memoranda.

Credits Debits

Collection of electronic funds transfer $1,830 NSF check: H. Kane $560 Interest earned on checking account 45 Safety deposit box rent 60

At September 30, deposits in transit were $4,738 and outstanding checks totaled $2,383.

Instructions (a) Prepare the bank reconciliation at September 30, 2017. (b) Prepare the adjusting entries at September 30, assuming the NSF check was from a

customer on account.

E7-10 The cash records of Upton Company show the following.

For July: 1. The June 30 bank reconciliation indicated that deposits in transit total $580. During

July, the general ledger account Cash shows deposits of $16,900, but the bank state- ment indicates that only $15,600 in deposits were received during the month.

2. The June 30 bank reconciliation also reported outstanding checks of $940. During the month of July, Upton Company books show that $17,500 of checks were issued, yet the bank statement showed that $16,400 of checks cleared the bank in July.

For September: 3. In September, deposits per bank statement totaled $25,900, deposits per books were

$26,400, and deposits in transit at September 30 were $2,200. 4. In September, cash disbursements per books were $23,500, checks clearing the bank

were $24,000, and outstanding checks at September 30 were $2,100.

There were no bank debit or credit memoranda, and no errors were made by either the bank or Upton Company.

Prepare bank reconciliation and adjusting entries.

(LO 3), AP

Prepare bank reconciliation and adjusting entries.

(LO 3), AP

Compute deposits in transit and outstanding checks for two bank reconciliations.

(LO 3), AP

Bank Statement Checks Paid

Date Check No. Amount

5-4 254 $650 5-2 257 410 5-17 258 159 5-12 259 275 5-20 260 925 5-29 263 480 5-30 262 750

Cash Payments Journal Checks Issued

Date Check No. Amount

5-2 258 $159 5-5 259 275 5-10 260 925 5-15 261 500 5-22 262 750 5-24 263 480 5-29 264 360

360 7 Fraud, Internal Control, and Cash

Instructions Answer the following questions. (a) In situation 1, what were the deposits in transit at July 31? (b) In situation 2, what were the outstanding checks at July 31? (c) In situation 3, what were the deposits in transit at August 31? (d) In situation 4, what were the outstanding checks at August 31?

E7-11 Perth Inc.’s bank statement from Main Street Bank at August 31, 2017, gives the following information.

Balance, August 1 $18,400 Bank debit memorandum: August deposits 71,000 Safety deposit box fee $ 25 Checks cleared in August 68,678 Service charge 50 Bank credit memorandum: Balance, August 31 20,692 Interest earned 45

A summary of the Cash account in the ledger for August shows the following: balance, August 1, $18,700; receipts $74,000; disbursements $73,570; and balance, August 31, $19,130. Analysis reveals that the only reconciling items on the July 31 bank reconcili- ation were a deposit in transit for $4,800 and outstanding checks of $4,500. In addition, you determine that there was an error involving a company check drawn in August: A check for $400 to a creditor on account that cleared the bank in August was journalized and posted for $40.

Instructions (a) Determine deposits in transit. (b) Determine outstanding checks. (Hint: You need to correct disbursements for the

check error.) (c) Prepare a bank reconciliation at August 31. (d) Journalize the adjusting entry(ies) to be made by Perth Inc. at August 31.

E7-12 A new accountant at Wyne Inc. is trying to identify which of the amounts shown below should be reported as the current asset “Cash and cash equivalents” in the year-end balance sheet, as of April 30, 2017. 1. $60 of currency and coin in a locked box used for incidental cash transactions. 2. A $10,000 U.S. Treasury bill, due May 31, 2017. 3. $260 of April-dated checks that Wyne has received from customers but not yet

deposited. 4. An $85 check received from a customer in payment of its April account, but postdated

to May 1. 5. $2,500 in the company’s checking account. 6. $4,800 in its savings account. 7. $75 of prepaid postage in its postage meter. 8. A $25 IOU from the company receptionist.

Instructions (a) What balance should Wyne report as its “Cash and cash equivalents” balance at April

30, 2017? (b) In what account(s) and in what fi nancial statement(s) should the items not included

in “Cash and cash equivalents” be reported?

E7-13 Lance, Art, and Wayne have joined together to open a law practice but are struggling to manage their cash flow. They haven’t yet built up sufficient clientele and revenues to support their legal practice’s ongoing costs. Initial costs, such as advertising, renovations to their premises, and the like, all result in outgoing cash flow at a time when little is com- ing in. Lance, Art, and Wayne haven’t had time to establish a billing system since most of their clients’ cases haven’t yet reached the courts, and the lawyers didn’t think it would be right to bill them until “results were achieved.” Unfortunately, Lance, Art, and Wayne’s suppliers don’t feel the same way. Their suppli- ers expect them to pay their accounts payable within a few days of receiving their bills. So far, there hasn’t even been enough money to pay the three lawyers, and they are not sure how long they can keep practicing law without getting some money into their pockets.

Instructions Can you provide any suggestions for Lance, Art, and Wayne to improve their cash man- agement practices?

Prepare bank reconciliation and adjusting entries.

(LO 3), AP

Identify reporting of cash.

(LO 4), AP

Review cash management practices.

(LO 4), C

Problems: Set A 361

E7-14 Rigley Company expects to have a cash balance of $46,000 on January 1, 2017. These are the relevant monthly budget data for the first two months of 2017. 1. Collections from customers: January $71,000 and February $146,000. 2. Payments to suppliers: January $40,000 and February $75,000. 3. Wages: January $30,000 and February $40,000. Wages are paid in the month they are

incurred. 4. Administrative expenses: January $21,000 and February $24,000. These costs include

depreciation of $1,000 per month. All other costs are paid as incurred. 5. Selling expenses: January $15,000 and February $20,000. These costs are exclusive of

depreciation. They are paid as incurred. 6. Sales of short-term investments in January are expected to realize $12,000 in cash.

Rigley has a line of credit at a local bank that enables it to borrow up to $25,000. The company wants to maintain a minimum monthly cash balance of $20,000.

Instructions Prepare a cash budget for January and February.

*E7-15 During October, Bismark Light Company experiences the following transactions in establishing a petty cash fund.

Oct. 1 A petty cash fund is established with a check for $150 issued to the petty cash custodian.

31 A check was written to reimburse the fund and increase the fund to $200. A count of the petty cash fund disclosed the following items:

Currency $59.00 Coins 0.70 Expenditure receipts (vouchers): Supplies $26.10 Telephone, Internet, and fax 16.40 Postage 39.70 Freight-out 6.80

Instructions Journalize the entries in October that pertain to the petty cash fund.

*E7-16 Kael Company maintains a petty cash fund for small expenditures. These trans- actions occurred during the month of August.

Aug. 1 Established the petty cash fund by writing a check payable to the petty cash custodian for $200.

15 Replenished the petty cash fund by writing a check for $175. On this date, the fund consisted of $25 in cash and these petty cash receipts: freight-out $74.40, entertainment expense $36, postage expense $33.70, and miscellaneous expense $27.50.

16 Increased the amount of the petty cash fund to $400 by writing a check for $200. 31 Replenished the petty cash fund by writing a check for $283. On this date,

the fund consisted of $117 in cash and these petty cash receipts: postage expense $145, entertainment expense $90.60, and freight-out $46.40.

Instructions (a) Journalize the petty cash transactions. (b) Post to the Petty Cash account. (c) What internal control features exist in a petty cash fund?

Prepare a cash budget for two months.

(LO 4), AP

Prepare journal entries for a petty cash fund.

(LO 5), AP

Journalize and post petty cash fund transactions.

(LO 5), AP

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P7-1A Gary Theater is in the Hoosier Mall. A cashier’s booth is located near the entrance to the theater. Two cashiers are employed. One works from 1:00 to 5:00 P.M., the other from 5:00 to 9:00 P.M. Each cashier is bonded. The cashiers receive cash from customers and operate a machine that ejects serially numbered tickets. The rolls of tickets are inserted

PROBLEMS: SET A▼

Identify internal control weaknesses for cash receipts.

(LO 2), C

362 7 Fraud, Internal Control, and Cash

and locked into the machine by the theater manager at the beginning of each cashier’s shift. After purchasing a ticket, the customer takes the ticket to a doorperson stationed at the entrance of the theater lobby some 60 feet from the cashier’s booth. The doorperson tears the ticket in half, admits the customer, and returns the ticket stub to the customer. The other half of the ticket is dropped into a locked box by the doorperson. At the end of each cashier’s shift, the theater manager removes the ticket rolls from the machine and makes a cash count. The cash count sheet is initialed by the cashier. At the end of the day, the manager deposits the receipts in total in a bank night deposit vault located in the mall. In addition, the manager sends copies of the deposit slip and the ini- tialed cash count sheets to the theater company treasurer for verification and to the com- pany’s accounting department. Receipts from the first shift are stored in a safe located in the manager’s office.

Instructions (a) Identify the internal control principles and their application to the cash receipts trans-

actions of Gary Theater. (b) If the doorperson and cashier decided to collaborate to misappropriate cash, what

actions might they take?

P7-2A Blue Bayou Middle School wants to raise money for a new sound system for its auditorium. The primary fund-raising event is a dance at which the famous disc jockey Kray Zee will play classic and not-so-classic dance tunes. Grant Hill, the music and theater instructor, has been given the responsibility for coordinating the fund-raising efforts. This is Grant’s fi rst experience with fund-raising. He decides to put the eighth-grade choir in charge of the event; he will be a relatively passive observer. Grant had 500 unnumbered tickets printed for the dance. He left the tickets in a box on his desk and told the choir students to take as many tickets as they thought they could sell for $5 each. In order to ensure that no extra tickets would be floating around, he told them to dispose of any unsold tickets. When the students received payment for the tickets, they were to bring the cash back to Grant, and he would put it in a locked box in his desk drawer. Some of the students were responsible for decorating the gymnasium for the dance. Grant gave each of them a key to the money box and told them that if they took money out to purchase materials, they should put a note in the box saying how much they took and what it was used for. After 2 weeks, the money box appeared to be getting full, so Grant asked Lynn Dandi to count the money, prepare a deposit slip, and deposit the money in a bank account that Grant had opened. The day of the dance, Grant wrote a check from the account to pay Kray Zee. The DJ said, however, that he accepted only cash and did not give receipts. So Grant took $200 out of the cash box and gave it to Kray. At the dance, Grant had Dana Uhler working at the entrance to the gymnasium, collecting tickets from students and selling tickets to those who had not pre-purchased them. Grant estimated that 400 students attended the dance. The following day, Grant closed out the bank account, which had $250 in it, and gave that amount plus the $180 in the cash box to Principal Sanchez. Principal Sanchez seemed surprised that, after generating roughly $2,000 in sales, the dance netted only $430 in cash. Grant did not know how to respond.

Instructions Identify as many internal control weaknesses as you can in this scenario, and suggest how each could be addressed.

P7-3A On July 31, 2017, Keeds Company had a cash balance per books of $6,140. The statement from Dakota State Bank on that date showed a balance of $7,690.80. A compari- son of the bank statement with the Cash account revealed the following facts.

1. The bank service charge for July was $25. 2. The bank collected $1,520 for Keeds Company through electronic funds transfer. 3. The July 31 receipts of $1,193.30 were not included in the bank deposits for July.

These receipts were deposited by the company in a night deposit vault on July 31. 4. Company check No. 2480 issued to L. Taylor, a creditor, for $384 that cleared the bank

in July was incorrectly entered in the cash payments journal on July 10 for $348. 5. Checks outstanding on July 31 totaled $1,860.10. 6. On July 31, the bank statement showed an NSF charge of $575 for a check received by

the company from W. Krueger, a customer, on account.

Identify internal control weak- nesses in cash receipts and cash disbursements.

(LO 2), C

Prepare a bank reconciliation and adjusting entries.

(LO 3), AP

Problems: Set A 363

Instructions (a) Prepare the bank reconciliation as of July 31. (b) Prepare the necessary adjusting entries at July 31.

P7-4A The bank portion of the bank reconciliation for Bogalusa Company at October 31, 2017, is shown below.

BOGALUSA COMPANY Bank Reconciliation

October 31, 2017

Cash balance per bank $12,367.90 Add: Deposits in transit 1,530.20

13,898.10

Less: Outstanding checks

Check Number Check Amount

2451 $1,260.40 2470 684.20 2471 844.50 2472 426.80 2474 1,050.00 4,265.90

Adjusted cash balance per bank $ 9,632.20

The adjusted cash balance per bank agreed with the cash balance per books at October 31. The November bank statement showed the following checks and deposits.

Bank Statement

Checks Deposits

Date Number Amount Date Amount

11-1 2470 $ 684.20 11-1 $ 1,530.20 11-2 2471 844.50 11-4 1,211.60 11-5 2474 1,050.00 11-8 990.10 11-4 2475 1,640.70 11-13 2,575.00 11-8 2476 2,830.00 11-18 1,472.70 11-10 2477 600.00 11-21 2,945.00 11-15 2479 1,750.00 11-25 2,567.30 11-18 2480 1,330.00 11-28 1,650.00 11-27 2481 695.40 11-30 1,186.00 11-30 2483 575.50 Total $16,127.90 11-29 2486 940.00

Total $12,940.30

The cash records per books for November showed the following.

(a) Adjusted cash bal. $7,024.00

Prepare a bank reconciliation and adjusting entries from detailed data.

(LO 3), AP

Cash Payments Journal

Date Number Amount Date Number Amount

11-1 2475 $1,640.70 11-20 2483 $ 575.50 11-2 2476 2,830.00 11-22 2484 829.50 11-2 2477 600.00 11-23 2485 974.80 11-4 2478 538.20 11-24 2486 940.00 11-8 2479 1,705.00 11-29 2487 398.00 11-10 2480 1,330.00 11-30 2488 800.00 11-15 2481 695.40 Total $14,469.10 11-18 2482 612.00

Cash Receipts Journal

Date Amount

11-3 $ 1,211.60 11-7 990.10 11-12 2,575.00 11-17 1,472.70 11-20 2,954.00 11-24 2,567.30 11-27 1,650.00 11-29 1,186.00 11-30 1,304.00

Total $15,910.70

364 7 Fraud, Internal Control, and Cash

The bank statement contained two bank memoranda:

1. A credit of $2,242 for the collection for Bogalusa Company of an electronic funds transfer. 2. A debit for the printing of additional company checks $85.

At November 30, the cash balance per books was $11,073.80 and the cash balance per bank statement was $17,712.50. The bank did not make any errors, but Bogalusa Com- pany made two errors.

Instructions (a) Using the steps in the reconciliation procedure described on pages 355–356, prepare a

bank reconciliation at November 30, 2017. (b) Prepare the adjusting entries based on the reconciliation. (Note: The correction of any

errors pertaining to recording checks should be made to Accounts Payable. The correction of any errors relating to recording cash receipts should be made to Accounts Receivable.)

P7-5A Timmins Company of Emporia, Kansas, spreads herbicides and applies liquid fer- tilizer for local farmers. On May 31, 2017, the company’s Cash account per its general ledger showed a balance of $6,738.90. The bank statement from Emporia State Bank on that date showed the following balance.

EMPORIA STATE BANK

Checks and Debits Deposits and Credits Daily Balance

XXX XXX 5-31 6,968.00

A comparison of the details on the bank statement with the details in the Cash account revealed the following facts.

1. The statement included a debit memo of $40 for the printing of additional company checks.

2. Cash sales of $883.15 on May 12 were deposited in the bank. The cash receipts jour- nal entry and the deposit slip were incorrectly made for $933.15. The bank credited Timmins Company for the correct amount.

3. Outstanding checks at May 31 totaled $276.25, and deposits in transit were $1,880.15. 4. On May 18, the company issued check No. 1181 for $685 to H. Moses, on account.

The check, which cleared the bank in May, was incorrectly journalized and posted by Timmins Company for $658.

5. $2,690 was collected by the bank for Timmins Company on May 31 through electronic funds transfer.

6. Included with the canceled checks was a check issued by Tomins Company to C. Pernod for $360 that was incorrectly charged to Timmins Company by the bank.

7. On May 31, the bank statement showed an NSF charge of $380 for a check issued by Sara Ballard, a customer, to Timmins Company on account.

Instructions (a) Prepare the bank reconciliation at May 31, 2017. (b) Prepare the necessary adjusting entries for Timmins Company at May 31, 2017.

P7-6A Daisey Company is a very profi table small business. It has not, however, given much consideration to internal control. For example, in an attempt to keep clerical and offi ce expenses to a minimum, the company has combined the jobs of cashier and book- keeper. As a result, Bret Turrin handles all cash receipts, keeps the accounting records, and prepares the monthly bank reconciliations. The balance per the bank statement on October 31, 2017, was $18,380. Outstand- ing checks were No. 62 for $140.75, No. 183 for $180, No. 284 for $253.25, No. 862 for $190.71, No. 863 for $226.80, and No. 864 for $165.28. Included with the statement was a credit memorandum of $185 indicating the collection of a note receivable for Daisey Company by the bank on October 25. This memorandum has not been recorded by Daisey. The company’s ledger showed one Cash account with a balance of $21,877.72. The balance included undeposited cash on hand. Because of the lack of internal controls, Bret took for personal use all of the undeposited receipts in excess of $3,795.51. He then prepared the following bank reconciliation in an effort to conceal his theft of cash.

(a) Adjusted cash bal. $13,176.80

Prepare a bank reconciliation and adjusting entries.

(LO 3), AP

(a) Adjusted cash bal. $8,931.90

Prepare a comprehensive bank reconciliation with theft and internal control defi ciencies.

(LO 1, 2, 3), E

Problems: Set A 365

Cash balance per books, October 31 $21,877.72 Add: Outstanding checks No. 862 $190.71 No. 863 226.80 No. 864 165.28 482.79

22,360.51 Less: Undeposited receipts 3,795.51

Unadjusted balance per bank, October 31 18,565.00 Less: Bank credit memorandum 185.00

Cash balance per bank statement, October 31 $18,380.00

Instructions (a) Prepare a correct bank reconciliation. (Hint: Deduct the amount of the theft from the

adjusted balance per books.) (b) Indicate the three ways that Bret attempted to conceal the theft and the dollar amount

involved in each method. (c) What principles of internal control were violated in this case?

P7-7A You are provided with the following information taken from Moynahan Inc.’s March 31, 2017, balance sheet.

Cash $ 11,000 Accounts receivable 20,000 Inventory 36,000 Property, plant, and equipment, net of depreciation 120,000 Accounts payable 22,400 Common stock 150,000 Retained earnings 11,600

Additional information concerning Moynahan Inc. is as follows.

1. Gross profit is 25% of sales. 2. Actual and budgeted sales data:

March (actual) $46,000 April (budgeted) 70,000

3. Sales are both cash and credit. Cash collections expected in April are:

March $18,400 (40% of $46,000) April 42,000 (60% of $70,000)

$60,400

4. Half of a month’s purchases are paid for in the month of purchase and half in the following month. Cash disbursements expected in April are:

Purchases March $22,400 Purchases April 28,100

$50,500

5. Cash operating costs are anticipated to be $11,200 for the month of April. 6. Equipment costing $2,500 will be purchased for cash in April. 7. The company wishes to maintain a minimum cash balance of $9,000. An open line of

credit is available at the bank. All borrowing is done at the beginning of the month, and all repayments are made at the end of the month. The interest rate is 12% per year, and interest expense is accrued at the end of the month and paid in the following month.

Instructions Prepare a cash budget for the month of April. Determine how much cash Moynahan Inc. must borrow, or can repay, in April.

P7-8A Bastille Corporation prepares monthly cash budgets. Here are relevant data from operating budgets for 2017.

January February

Sales $360,000 $400,000 Purchases 120,000 130,000 Salaries 84,000 81,000 Administrative expenses 72,000 75,000 Selling expenses 79,000 88,000

(a) Adjusted cash bal. $21,018.72

Prepare a cash budget.

(LO 4), AP

Apr. borrowings $1,800

Prepare a cash budget.

(LO 4), AP

366 7 Fraud, Internal Control, and Cash

All sales and purchases are on account. Budgeted collections and disbursement data are given below. All other expenses are paid in the month incurred. Administrative expenses include $1,000 of depreciation per month.

Other data.

1. Collections from customers: January $326,000; February $378,000. 2. Payments for purchases: January $110,000; February $135,000. 3. Other receipts: January: collection of December 31, 2016, notes receivable $15,000;

February: proceeds from sale of securities $4,000. 4. Other disbursements: February $10,000 cash dividend.

The company’s cash balance on January 1, 2017, is expected to be $46,000. The company wants to maintain a minimum cash balance of $40,000.

Instructions Prepare a cash budget for January and February.Jan. 31 cash bal. $43,000

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 6.)

CC7 Part 1 Natalie is struggling to keep up with the recording of her accounting trans- actions. She is spending a lot of time marketing and selling mixers and giving her cookie classes. Her friend John is an accounting student who runs his own accounting service. He has asked Natalie if she would like to have him do her accounting. John and Natalie meet and discuss her business.

Part 2 Natalie decides that she cannot afford to hire John to do her accounting. One way that she can ensure that her Cash account does not have any errors and is accurate and up-to-date is to prepare a bank reconciliation at the end of each month. Natalie would like you to help her.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to see the com- pletion of this problem.

CONTINUING PROBLEM Cookie Creations▼

COMPREHENSIVE ACCOUNTING CYCLE REVIEW CP7 On December 1, 2017, Ravenwood Company had the following account balances.

Debit Credit

Cash $18,200 Accumulated Depreciation— Notes Receivable 2,000 Equipment $ 3,000 Accounts Receivable 7,500 Accounts Payable 6,100 Inventory 16,000 Common Stock 50,000 Prepaid Insurance 1,600 Retained Earnings 14,200 Equipment 28,000 $73,300 $73,300

Expand Your Critical Thinking 367

During December, the company completed the following transactions.

Dec. 7 Received $3,600 cash from customers in payment of account (no discount allowed). 12 Purchased merchandise on account from Greene Co. $12,000, terms 1/10, n/30. 17 Sold merchandise on account $16,000, terms 2/10, n/30. The cost of the

merchandise sold was $10,000. 19 Paid salaries $2,200. 22 Paid Greene Co. in full, less discount. 26 Received collections in full, less discounts, from customers billed on December 17. 31 Received $2,700 cash from customers in payment of account (no discount allowed).

Adjustment data:

1. Depreciation $200 per month. 2. Insurance expired $400. 3. Income tax expense was $425. It was unpaid at December 31.

Instructions (a) Journalize the December transactions. (Assume a perpetual inventory system.) (b) Enter the December 1 balances in the ledger T-accounts and post the December trans-

actions. Use Cost of Goods Sold, Depreciation Expense, Insurance Expense, Salaries and Wages Expense, Sales Revenue, Sales Discounts, Income Taxes Payable, and Income Tax Expense.

(c) The statement from Lyon County Bank on December 31 showed a balance of $25,930. A comparison of the bank statement with the Cash account revealed the following facts.

1. The bank collected the $2,000 note receivable for Ravenwood Company on Decem- ber 15 through electronic funds transfer.

2. The December 31 receipts were deposited in a night deposit vault on December 31. These deposits were recorded by the bank in January.

3. Checks outstanding on December 31 totaled $1,210. 4. On December 31, the bank statement showed a NSF charge of $680 for a check

received by the company from M. Lawrence, a customer, on account.

Prepare a bank reconciliation as of December 31 based on the available information. (Hint: The cash balance per books is $26,100. This can be proven by fi nding the bal- ance in the Cash account from parts (a) and (b).)

(d) Journalize the adjusting entries resulting from the bank reconciliation and adjust- ment data.

(e) Post the adjusting entries to the ledger T-accounts. (f) Prepare an adjusted trial balance. (g) Prepare an income statement for December and a classifi ed balance sheet at

December 31.

(f) Totals $89,500 (g) Net income $ 2,455 Total assets $73,180

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT7-1 The fi nancial statements of Apple Inc. are presented in Appendix A. Instructions for accessing and using the company’s complete annual report, including the notes to its fi nancial statements, are also provided in Appendix A.

Instructions Using the fi nancial statements and reports, answer these questions about Apple’s internal controls and cash.

(a) What comments, if any, are made about cash in the “Report of Independent Registered Public Accounting Firm”?

(b) What data about cash and cash equivalents are shown in the consolidated balance sheet (statement of fi nancial position)?

(c) What activities are identifi ed in the consolidated statement of cash fl ows as being responsible for the changes in cash during 2014?

(d) How are cash equivalents defi ned in the Notes to Consolidated Financial Statements? (e) Read the section of the report titled “Management’s Report on Internal Control Over

Financial Reporting.” Summarize the statements made in that section of the report.

Financial Reporting

▼

368 7 Fraud, Internal Control, and Cash

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT7-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions Answer the following questions for each company.

(a) What is the balance in cash and cash equivalents at December 31, 2014? (b) What percentage of total assets does cash represent for each company over the last

2 years? Has it changed signifi cantly for either company? (c) How much cash was provided by operating activities during 2014? (d) Comment on your fi ndings in parts (a) through (c).

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT7-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Finan- cial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions Answer the following questions for each company.

(a) What is the balance in cash and cash equivalents at December 31, 2014? (b) What percentage of total assets does cash represent for each company over the last

two years? Has it changed signifi cantly for either company? (c) How much cash was provided by operating activities during 2014? (d) Comment on your fi ndings in parts (a) through (c).

INTERPRETING FINANCIAL STATEMENTS

CT7-4 The international accounting fi rm Ernst & Young performed a global survey on fraud. The results of that survey are summarized in a report titled “Driving Ethical Growth—New Markets, New Challenges” (Ernst & Young, 13th Global Fraud Survey). You can fi nd this report by doing an Internet search on the title, or go to https:// webforms.ey.com/Publication/vwLUAssets/EY-13th-Global-Fraud-Survey/$FILE/ EY-13th-Global-Fraud-Survey.pdf.

Instructions Read the Executive Summary section, and then skim the remainder of the report to an- swer the following questions.

(a) What was the global percentage of companies that experienced fraud during the period covered by the survey, and what country had the highest rate?

(b) What percentage of survey respondents were asked to participate in an anti-bribery/ anti-corruption (ABAC) risk assessment in the last two years prior to the survey?

(c) What percentage of C-suite executives have not attended ABAC training? (d) According to Figure 3, what source of cybercrime concerns respondents the most?

REAL-WORLD FOCUS

CT7-5 The Financial Accounting Standards Board (FASB) is a private organization established to improve accounting standards and fi nancial reporting. The FASB conducts extensive research before issuing a “Statement of Financial Accounting Stan- dards,” which represents an authoritative expression of generally accepted accounting principles.

Address: www.fasb.org, or go to www.wiley.com/college/kimmel

Steps Choose About FASB.

Financial Analysis

▼

Financial Analysis

▼

Expand Your Critical Thinking 369

Instructions Answer the following questions.

(a) What is the mission of the FASB? (b) How are topics added to the FASB technical agenda? (Hint: See Project Plans in Our

Rules of Procedure.) (c) What characteristics make the FASB’s procedures an “open” decision-making process?

(Hint: See Due Process in Our Rules of Procedure.)

CT7-6 The Public Company Accounting Oversight Board (PCAOB) was created as a result of the Sarbanes-Oxley Act. It has oversight and enforcement responsibilities over account- ing fi rms in the United States.

Address: http://www.pcaobus.org/, or go to www.wiley.com/college/kimmel

Instructions Answer the following questions.

(a) What is the mission of the PCAOB? (b) Briefl y summarize its responsibilities related to inspections. (c) Briefl y summarize its responsibilities related to enforcement.

CT7-7 The website www.cpa2biz.com has an article dated February 4, 2010, by Mary Schaeffer entitled “Emerging Issues: Demise of Paper Checks.”

Instructions Go to the website and do a search on the article title. Read the article and answer the fol- lowing questions.

(a) How many different forms of payment types does the article list? What are the pay- ment types?

(b) What problems does the shift away from paper checks to alternative payment options present for companies?

(c) What fi ve controls does the article suggest incorporating, to decrease problems associ- ated with multiple payment options?

DECISION-MAKING ACROSS THE ORGANIZATION

CT7-8 Alternative Distributor Corp., a distributor of groceries and related products, is headquartered in Medford, Massachusetts. During a recent audit, Alternative Distributor Corp. was advised that existing internal controls necessary for the company to develop reliable fi nancial statements were inad- equate. The audit report stated that the current system of accounting for sales, receivables, and cash receipts constituted a material weakness. Among other items, the report focused on nontimely deposit of cash receipts, exposing Alternative Distributor to potential loss or misappropriation, excessive past due accounts receivable due to lack of collection efforts, disregard of advantages offered by vendors for prompt payment of invoices, absence of appropriate segregation of duties by personnel consistent with appropriate control objec- tives, inadequate procedures for applying accounting principles, lack of qualifi ed manage- ment personnel, lack of supervision by an outside board of directors, and overall poor recordkeeping.

Instructions (a) Identify the principles of internal control violated by Alternative Distributor Corp. (b) Explain why managers of various functional areas in the company should be con-

cerned about internal controls.

COMMUNICATION ACTIVITY

CT7-9 As a new auditor for the CPA fi rm of Blacke and Whyte, you have been assigned to review the internal controls over mail cash receipts of Simon Company. Your review

Financial Analysis

Writing

Group Project

▼

370 7 Fraud, Internal Control, and Cash

reveals that checks are promptly endorsed “For Deposit Only,” but no list of the checks is prepared by the person opening the mail. The mail is opened either by the cashier or by the employee who maintains the accounts receivable records. Mail receipts are deposited in the bank weekly by the cashier.

Instructions Write a letter to Frank Simon, owner of Simon Company, explaining the weaknesses in internal control and your recommendations for improving the system.

ETHICS CASES

CT7-10 Banks charge fees for “bounced” checks—that is, checks that exceed the balance in the account. It has been estimated that processing bounced checks costs a bank roughly $1.50 per check. Thus, the profi t margin on bounced checks is very high. Recognizing this, some banks have started to process checks from largest to smallest. By doing this, they maximize the number of checks that bounce if a customer overdraws an account. For example, NationsBank (now Bank of America) projected a $14 million increase in fee revenue as a result of processing largest checks fi rst. In response to criticism, banks have responded that their customers prefer to have large checks processed fi rst, because those tend to be the most important. At the other extreme, some banks will cover their custom- ers’ bounced checks, effectively extending them an interest-free loan while their account is overdrawn.

Instructions Answer each of the following questions.

(a) Carl Roen had a balance of $1,500 in his checking account at First National Bank on a day when the bank received the following fi ve checks for processing against his account.

Check Number Amount Check Number Amount

3150 $ 35 3165 $ 550 3162 400 3166 1,510 3169 180

Assuming a $30 fee assessed by the bank for each bounced check, how much fee revenue would the bank generate if it processed checks (1) from largest to smallest, (2) from smallest to largest, and (3) in order of check number?

(b) Do you think that processing checks from largest to smallest is an ethical business practice?

(c) In addition to ethical issues, what other issues must a bank consider in deciding whether to process checks from largest to smallest?

(d) If you were managing a bank, what policy would you adopt on bounced checks?

CT7-11 The National Fraud Information Center (NFIC) was originally established in 1992 by the National Consumers League, the oldest nonprofi t consumer organization in the United States, to fi ght the growing menace of telemarketing fraud by improving pre- vention and enforcement. It maintains a website that provides many useful fraud-related resources.

Address: www.fraud.org/scamsagainstbusinesses/bizscams.htm or go to www.wiley. com/college/kimmel

Instructions Go to the site and fi nd an item of interest to you. Write a short summary of your fi ndings.

ALL ABOUT YOU

CT7-12 The print and electronic media are full of stories about potential security risks that can arise from your personal computer. It is important to keep in mind, however, that there are also many ways that your identity can be stolen other than from your computer. The federal government provides many resources to help protect you from identity thieves.

A Look at IFRS 371

Fraud can occur anywhere. And because the three main factors that contribute to fraud are universal in nature, the principles of internal control activities are used globally by companies. While Sarbanes-Oxley (SOX) does not apply to international companies, most large international companies have internal controls similar to those indicated in the chapter. IFRS and GAAP are also very similar in accounting for cash. IAS No. 1 (revised), “Presentation of Financial Statements,” is the only standard that discusses issues specifi- cally related to cash.

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to fraud, internal control, and cash.

Similarities • The fraud triangle discussed in this chapter is applicable to all international com-

panies. Some of the major frauds on an international basis are Parmalat (Italy), Royal Ahold (the Netherlands), and Satyam Computer Services (India).

• Rising economic crime poses a growing threat to companies, with 34% of all organiza- tions worldwide being victims of fraud in a recent 12-month period.

• Accounting scandals both in the United States and internationally have re-ignited the debate over the relative merits of GAAP, which takes a “rules-based” approach to accounting, versus IFRS, which takes a “principles-based” approach. The FASB announced that it intends to introduce more principles-based standards.

• On a lighter note, at one time the Ig Nobel Prize in Economics went to the CEOs of those companies involved in the corporate accounting scandals of that year for “adapting the mathematical concept of imaginary numbers for use in the business world.” A parody of the Nobel Prizes, the Ig Nobel Prizes (read Ignoble, as not noble) are given each year in early October for 10 achievements that “first make people laugh, and then make them think.” Organized by the scientific humor magazine Annals of Improbable Research (AIR), they are presented by a group that includes genuine Nobel laureates at a ceremony at Harvard University’s Sanders Theater (see en.wikipedia.org/wiki/Ig_Nobel_Prize).

• Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most companies have these systems in place, many have never completely documented them, nor had an independent auditor attest to their effective- ness. Both of these actions are required under SOX.

LEARNING OBJECTIVE 6 Compare the accounting procedures for fraud, internal control, and cash under GAAP and IFRS.▼

A Look at IFRS

Instructions Go to http://onguardonline.gov/idtheft.html, and click Games, then click ID Theft Faceoff. Complete the quiz provided there.

FASB CODIFICATION ACTIVITY

CT7-13 If your school has a subscription to the FASB Codifi cation, go to http://aaahq. org/ascLogin.cfm to log in and prepare responses to the following.

(a) How is cash defi ned in the Codifi cation? (b) How are cash equivalents defi ned in the Codifi cation? (c) What are the disclosure requirements related to cash and cash equivalents?

372 7 Fraud, Internal Control, and Cash

• Companies find that internal control review is a costly process but badly needed. One study estimates the cost of SOX compliance for U.S. companies 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 com- panies operate. One study of first compliance with the internal-control testing provisions documented material weaknesses for about 13% of companies reporting in a two-year period (PricewaterhouseCoopers’ Global Economic Crime Survey, 2005).

• The accounting and internal control procedures related to cash are essentially the same under both IFRS and this textbook. In addition, the definition used for cash equiv- alents is the same.

• Most companies report cash and cash equivalents together under IFRS, as shown in this textbook. In addition, IFRS follows the same accounting policies related to the reporting of restricted cash.

Differences • The SOX internal control standards apply only to companies listed on U.S. exchanges.

There is continuing debate over whether foreign issuers should have to comply with this extra layer of regulation.

LOOKING TO THE FUTURE Ethics has become a very important aspect of reporting. Different cultures have different perspectives on bribery and other questionable activities, and consequently penalties for engaging in such activities vary considerably across countries. High-quality international accounting requires both high-quality accounting stand- ards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is movement to improve international auditing standards. The International Auditing and Assurance Standards Board (IAASB) functions as an independent standard-setting body. It works to establish high-quality auditing and assurance and quality-control standards throughout the world. Whether the IAASB adopts internal control provisions similar to those in SOX remains to be seen. You can follow developments in the international audit arena at http://www.ifac.org/iaasb/.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. Non-U.S companies that follow IFRS:

(a) do not normally use the principles of internal control activities described in this textbook.

(b) often offset cash with accounts payable on the balance sheet. (c) are not required to follow SOX. (d) None of the above.

2. The Sarbanes-Oxley Act applies to: (a) all U.S. companies listed on U.S. exchanges. (b) all companies that list stock on any stock exchange in any country. (c) all European companies listed on European exchanges. (d) Both (a) and (c).

3. High-quality international accounting requires both high-quality accounting stand- ards and: (a) a reconsideration of SOX to make it less onerous. (b) high-quality auditing standards. (c) government intervention to ensure that the public interest is protected. (d) the development of new principles of internal control activities.

IFRS EXERCISE IFRS7-1 Some people argue that the internal control requirements of the Sarbanes-Oxley Act (SOX) put U.S. companies at a competitive disadvantage to companies outside the United States. Discuss the competitive implications (both pros and cons) of SOX.

A Look at IFRS 373

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS7-2 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Using the notes to the company’s financial statements, what are Louis Vuitton’s account- ing policies related to cash and cash equivalents?

Answers to IFRS Self-Test Questions 1. c 2. a 3. b

In this chapter, we discuss some of the decisions related to reporting and analyzing receivables. As

indicated in the Feature Story, receivables are a signifi cant asset on the books of Nike. Receivables

are important to companies in other industries as well because a large portion of sales in the

United States are credit sales. As a consequence, companies must pay close attention to their

receivables balances and manage them carefully. In this chapter, we will look at the accounting and

management of receivables at Nike and one of its competitors, Skechers USA.

CHAPTER PREVIEW

Reporting and Analyzing Receivables 8

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

• Types of receivables • Recognizing accounts

receivable

▼1 Explain how companies recognize accounts receivable.

DO IT!

1 Recognizing Accounts Receivable

▼ ▼

Explain how companies recognize, value, and dispose of notes receivable.

Describe the statement presentation of receivables and the principles of receivables management.

• Determining the maturity date • Computing interest • Recognizing notes receivable • Valuing notes receivable • Disposing of notes receivable

• Financial statement presentation of receivables

• Managing receivables • Evaluating liquidity of

receivables • Accelerating cash receipts

DO IT!

Notes Receivable

Analysis of Receivables

▼2

Describe how companies value accounts receivable and record their disposition.

• Valuing accounts receivable • Disposing of accounts

receivable

DO IT!

2 2a Bad Debt Expense 2b Factoring

What major U.S corporation got its start 38 years ago with a waffl e iron? Hint: It doesn’t sell food. Another hint: Swoosh. Another hint: “Just do it.” That’s right, Nike. In 1971, Nike co-founder Bill Bowerman put a piece of rubber into a kitchen waffl e iron, and the trademark waffl e sole was born. It seems fair to say that at Nike, “They don’t make ’em like they used to.”

Nike was co-founded by Bower- man and Phil Knight, a member of Bowerman’s University of Oregon track team. Each began in the shoe business independently during the early 1960s. Bowerman got his start by making hand-crafted running shoes for his University of Oregon track team. Knight, after completing graduate school, started a small business importing low-cost, high-quality shoes from Japan. In 1964, the two joined forces, each contributing $500, and formed Blue Ribbon Sports, a partnership that marketed Japanese shoes.

It wasn’t until 1971 that the company began manufac- turing its own line of shoes. With the new shoes came a new corporate name–Nike–the Greek goddess of victory. It is hard to imagine that the company that now boasts a stable full of world-class athletes as promoters at one time had part-time employees selling shoes out of car trunks at track meets on a cash-and-carry basis.

As the business grew, Nike sold its shoes to sport- ing good shops and department stores on a credit basis. This necessitated receivables management. Today, with sales of $20.8 billion and accounts receivable of $3.1 billion, managing accounts

receivable is vitally important to Nike’s success. If it makes a major mistake with its receivables, it will defi nitely affect the bottom line.

In recent years, Nike has expanded its product line to a diverse range of products, including perfor- mance equipment such as soccer

balls and golf clubs. While this has increased sales revenue, it has also complicated Nike’s receivables management efforts. Now, instead of selling shoes at a limited number of retail outlets, it sells its vast number of products to a diverse array of stores, large and small. For example, Nike golf clubs are sold at local country clubs and golf shops across the country, while soccer equipment can be sold directly to customers through Internet sales. This diversifi cation of its customer list complicates matters because Nike has to approve each new store or customer for credit sales, monitor cash collections, and pursue slow-paying accounts. That’s a lot of work. Maybe cash-and-carry wasn’t so bad after all.

FEATURE STORY

What’s Cooking?

376 8 Reporting and Analyzing Receivables

LEARNING OBJECTIVE 1 Explain how companies recognize accounts receivable.▼

The term receivables refers to amounts due from individuals and companies. Receivables are claims that are expected to be collected in cash. The manage- ment of receivables is a very important activity for any company that sells goods or services on credit. Receivables are important because they represent one of a company’s most liquid assets. For many companies, receivables are also one of the largest assets. For example, receivables represent 18.5% of the assets of Nike. Illustration 8-1 lists receivables as a percentage of total assets for fi ve other well-known compa- nies in a recent year.

Receivables as a Company Percentage of Total Assets

Ford Motor Company 43.2% General Electric 41.5 Minnesota Mining and Manufacturing Company (3M) 12.7 DuPont Co. 11.7 Intel Corporation 3.9

ILLUSTRATION 8-1 Receivables as a percentage of assets

TYPES OF RECEIVABLES

The relative signifi cance of a company’s receivables as a percentage of its assets depends on various factors: its industry, the time of year, whether it extends long- term fi nancing, and its credit policies. To refl ect important differences among receivables, they are frequently classifi ed as (1) accounts receivable, (2) notes receivable, and (3) other receivables.

Accounts receivable are amounts customers owe on account. They result from the sale of goods and services. Companies generally expect to collect accounts receivable within 30 to 60 days. They are usually the most signifi cant type of claim held by a company. Notes receivable are a written promise (as evidenced by a formal instru- ment) for amounts to be received. The note normally requires the collection of interest and extends for time periods of 60–90 days or longer. Notes and accounts receivable that result from sales transactions are often called trade receivables.

Other receivables include nontrade receivables such as interest receivable, loans to company offi cers, advances to employees, and income taxes refundable. These do not generally result from the operations of the business. Therefore, they are generally classifi ed and reported as separate items in the balance sheet.

RECOGNIZING ACCOUNTS RECEIVABLE

Recognizing accounts receivable is relatively straightforward. A service organi- zation records a receivable when it performs a service on account. A merchan- diser records accounts receivable at the point of sale of merchandise on account. When a merchandiser sells goods, it increases (debits) Accounts Receivable and increases (credits) Sales Revenue. The seller may offer terms that encourage early payment by providing a dis- count. Sales returns also reduce receivables. The buyer might fi nd some of the goods unacceptable and choose to return the unwanted goods. To review, assume that Jordache Co. on July 1, 2017, sells merchandise on account to Polo Company for $1,000, terms 2/10, n/30. On July 5, Polo returns merchandise with a sales price of $100 to Jordache Co. On July 11, Jordache receives payment from Polo Company for the balance due. The journal entries to

ETHICS NOTE Companies report receivables

from employees separately in the fi nancial statements.

The reason: Sometimes these receivables are not the result of

an “arm’s-length” transaction.

▼

Recognition of Accounts Receivable 377

record these transactions on the books of Jordache Co. are as follows. (Cost of goods sold entries are omitted.)

July 1 Accounts Receivable—Polo Company 1,000 Sales Revenue 1,000 (To record sales on account)

July 5 Sales Returns and Allowances 100 Accounts Receivable—Polo Company 100 (To record merchandise returned)

July 11 Cash ($900 − $18) 882 Sales Discounts ($900 × .02) 18 Accounts Receivable—Polo Company 900 (To record collection of accounts receivable)

Some retailers issue their own credit cards. When you use a retailer’s credit card (JCPenney, for example), the retailer charges interest on the balance due if not paid within a specifi ed period (usually 25–30 days). To illustrate, assume that you use your JCPenney credit card to purchase clothing with a sales price of $300 on June 1, 2017. JCPenney will increase (debit) Accounts Receivable for $300 and increase (credit) Sales Revenue for $300 (cost of goods sold entry omitted), as follows.

June 1 Accounts Receivable 300 Sales Revenue 300 (To record sales on account)

Assuming that you owe $300 at the end of the month and JCPenney charges 1.5% per month on the balance due, the adjusting entry that JCPenney makes to record interest revenue of $4.50 ($300 × 1.5%) on June 30 is as follows.

June 30 Accounts Receivable 4.50 Interest Revenue 4.50 (To record interest on amount due)

Interest revenue is often substantial for many retailers.

▼ HELPFUL HINT These entries are the same as those described in Chapter 5. For simplicity, we have omitted inventory and cost of goods sold from this set of journal entries and from end-of-chapter material.

A L SE= + +300 +300 Rev Cash Flows no eff ect

A L SE= + +4.50 +4.50 Rev Cash Flows no eff ect

Tasanee was the accounts receivable clerk for a large non-profi t foundation that provided performance and exhibition space for the performing and visual arts. Her responsibilities included activities normally assigned to an accounts receivable clerk, such as recording rev- enues from various sources (donations, facility rental fees, ticket revenue, and bar receipts). However, she was also responsible for handling all cash and checks from the time they were received until the time she deposited them, as well as preparing the bank reconciliation. Tasanee took advantage of her situation by falsifying bank deposits and bank reconciliations so that she could steal cash from the bar receipts. Since nobody else logged the donations or matched the donation receipts to pledges prior to Tasanee receiving them, she was able to offset the cash that was stolen against donations that she received but didn’t record. Her crime was made easier by the fact that her boss, the company’s controller, only did a very superfi cial review of the bank reconciliation and thus didn’t notice that some numbers had been cut out from other documents and taped onto the bank reconciliation.

Total take: $1.5 million

THE MISSING CONTROLS Segregation of duties. The foundation should not have allowed an accounts receivable clerk, whose job was to record receivables, to also handle cash, record cash, and make deposits, and especially prepare the bank reconciliation.

Independent internal verifi cation. The controller was supposed to perform a thorough re- view of the bank reconciliation. Because he did not, he was terminated from his position.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 183–194.

ANATOMY OF A FRAUD

378 8 Reporting and Analyzing Receivables

1▼ Recognizing Accounts ReceivableDO IT

Action Plan ✔ Prepare entry to record

the receivable and related return.

✔ Compute the sales discount and related entry.

On May 1, Wilton sold merchandise on account to Bates for $50,000 terms 3/15, net 45. On May 4, Bates returns merchandise with a sales price of $2,000. On May 16, Wilton receives payment from Bates for the balance due. Prepare journal entries to record the May transactions on Wilton’s books. (You may ignore cost of goods sold entries and explanations.)

SOLUTION

May 1 Accounts Receivable—Bates 50,000 Sales Revenue 50,000

4 Sales Returns and Allowances 2,000 Accounts Receivable—Bates 2,000

16 Cash ($48,000 2 $1,440) 46,560 Sales Discounts ($48,000 3 .03) 1,440 Accounts Receivable—Bates 48,000

Related exercise material: BE8-1, BE8-2, DO IT! 8-1, E8-1, and E8-2.

LEARNING OBJECTIVE 2 Describe how companies value accounts receivable and record their disposition.▼

VALUING ACCOUNTS RECEIVABLE

Once companies record receivables in the accounts, the next question is: How should they report receivables in the fi nancial statements? Companies report accounts receivable on the balance sheet as an asset. Determining the amount to report is sometimes diffi cult because some receivables will become uncollectible. Although each customer must satisfy the credit requirements of the seller before the credit sale is approved, inevitably some accounts receivable become uncollectible. For example, a corporate customer may not be able to pay because it experienced a sales decline due to an economic downturn. Similarly, individu- als may be laid off from their jobs or be faced with unexpected hospital bills. The seller records these losses that result from extending credit as Bad Debt Expense. Such losses are a normal and necessary risk of doing business on a credit basis. When U.S. home prices fell, home foreclosures rose, and the economy in general slowed as a result of the fi nancial crisis of 2008, lenders experienced huge increases in their bad debt expense. For example, during a recent quarter Wachovia, a large U.S. bank now owned by Wells Fargo, increased bad debt expense from $108 million to $408 million. Similarly, American Express increased its bad debt expense by 70%. Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method and (2) the allowance method. We explain both methods in the following sections.

Direct Write-Off Method for Uncollectible Accounts Under the direct write-off method, when a company determines receivables from a particular company to be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that Warden Co. writes off M. E. Doran’s $200 balance as uncollectible on December 12. Warden’s entry is as follows.

ALTERNATIVE TERMINOLOGY You will sometimes see Bad Debt Expense called Uncollectible Accounts Expense.

Valuation and Disposition of Accounts Receivable 379

Dec. 12 Bad Debt Expense 200 Accounts Receivable—M. E. Doran 200 (To record write-off of M. E. Doran account)

Under this method, bad debt expense will show only actual losses from uncol- lectibles. The company reports accounts receivable at its gross amount without any adjustment for estimated losses for bad debts. Use of the direct write-off method can reduce the usefulness of both the income statement and balance sheet. Consider the following example. In 2017, Quick Buck Computer Company decided it could increase its revenues by offer- ing computers to college students without requiring any money down and with no credit-approval process. It went on campuses across the country and sold one million computers at a selling price of $800 each. This promotion increased Quick Buck’s revenues and receivables by $800 million, a huge success! The 2017 balance sheet and income statement looked wonderful. Unfortunately, during 2018, nearly 40% of the college student customers defaulted on their loans. The 2018 income statement and balance sheet looked terrible. Illustra- tion 8-2 shows the effect of these events on the fi nancial statements using the direct write-off method.

A L SE= + −200 Exp

−200 Cash Flows no eff ect

Year 2017 Year 2018

Huge sales promotion. Sales increase dramatically.

Accounts receivable increases dramatically.

Customers default on loans. Bad debt expense increases dramatically.

Accounts receivable plummets.

Net income

ILLUSTRATION 8-2 Effects of direct write-off method

Under the direct write-off method, companies often record bad debt expense in a period different from the period in which they recorded the revenue. Thus, no attempt is made to match bad debt expense to sales revenue in the income statement. Nor does the company try to show accounts receivable in the balance sheet at the amount actually expected to be received. Consequently, unless a com- pany expects bad debt losses to be insignifi cant, the direct write-off method is not acceptable for fi nancial reporting purposes.

Allowance Method for Uncollectible Accounts The allowance method of accounting for bad debts involves estimating uncol- lectible accounts at the end of each period. This provides better matching of expenses with revenues on the income statement. It also ensures that receivables are stated at their cash (net) realizable value on the balance sheet. Cash (net) realizable value is the net amount a company expects to receive in cash from receivables. It excludes amounts that the company estimates it will not collect. Estimated uncollectible receivables therefore reduce receivables on the balance sheet through use of the allowance method. Companies must use the allowance method for fi nancial reporting pur- poses when bad debts are material in amount. It has three essential features:

1. Companies estimate uncollectible accounts receivable and match them against revenues in the same accounting period in which the revenues are recorded.

▼ HELPFUL HINT In this context, material means signifi cant or important to fi nancial statement users.

380 8 Reporting and Analyzing Receivables

2. Companies record estimated uncollectibles as an increase (a debit) to Bad Debt Expense and an increase (a credit) to Allowance for Doubtful Accounts through an adjusting entry at the end of each period. Allowance for Doubtful Accounts is a contra account to Accounts Receivable.

3. Companies debit actual uncollectibles to Allowance for Doubtful Accounts and credit them to Accounts Receivable at the time the specifi c account is written off as uncollectible.

RECORDING ESTIMATED UNCOLLECTIBLES To illustrate the allowance method, assume that Hampson Furniture has credit sales of $1,200,000 in 2017, of which $200,000 remains uncollected at December 31. The credit manager estimates that $12,000 of these sales will prove uncollectible. The adjusting entry to record the estimated uncollectibles increases (debits) Bad Debt Expense and increases (credits) Allowance for Doubtful Accounts, as follows.

Dec. 31 Bad Debt Expense 12,000 Allowance for Doubtful Accounts 12,000 (To record estimate of uncollectible accounts)

Companies report Bad Debt Expense in the income statement as an operating expense (usually as a selling expense). Thus, Hampson matches the estimated uncollectibles with sales in 2017 because the expense is recorded in the same year the company makes the sales. Allowance for Doubtful Accounts shows the estimated amount of claims on customers that companies expect will become uncollectible in the future. Com- panies 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 specifi c write-offs when they occur. The company deducts the allowance account from Accounts Receivable in the cur- rent assets section of the balance sheet, as shown in Illustration 8-3.

A L SE= + −12,000 Exp

−12,000 Cash Flows no eff ect

Current assets Cash $ 14,800 Accounts receivable $200,000 Less: Allowance for doubtful accounts 12,000 188,000 Inventory 310,000 Supplies 25,000

Total current assets $537,800

HAMPSON FURNITURE Balance Sheet (partial)

ILLUSTRATION 8-3 Presentation of allowance for doubtful accounts

The amount of $188,000 in Illustration 8-3 represents the expected cash realizable value of the accounts receivable at the statement date. Companies do not close Allowance for Doubtful Accounts at the end of the fi scal year.

RECORDING THE WRITE-OFF OF AN UNCOLLECTIBLE ACCOUNT Various methods are used to collect past-due accounts. When a company exhausts all means of collecting a past-due account and collection appears unlikely, the company writes off the account. In the credit card industry, it is standard practice to write off accounts that are 210 days past due. To prevent premature or unauthorized write-offs, authorized management personnel should formally approve each write-off. To maintain segregation of duties, the employee authorized to write off accounts should not have daily responsibilities related to cash or receivables.

Valuation and Disposition of Accounts Receivable 381

To illustrate a receivables write-off, assume that the vice president of fi nance of Hampson Furniture on March 1, 2018, authorizes a write-off of the $500 bal- ance owed by R. A. Ware. The entry to record the write-off is as follows.

Mar. 1 Allowance for Doubtful Accounts 500 Accounts Receivable—R. A. Ware 500 (Write-off of R. A. Ware account)

The company does not increase Bad Debt Expense when the write-off occurs. Under the allowance method, a company debits every bad debt write-off to the allowance account and not 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 estimated bad debts. Instead, the entry to record the write-off of an uncollectible account reduces both Accounts Receivable and Allowance for Doubtful Accounts. After posting, the general led- ger accounts appear as shown in Illustration 8-4.

A L SE= + +500 −500 Cash Flows no eff ect

RECOVERY OF AN UNCOLLECTIBLE ACCOUNT Occasionally, a company collects from a customer after the account has been written off as uncollectible. The com- pany must make 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, R. A. Ware pays the $500 amount that Hampson Furniture had written off on March 1. Hampson makes these entries:

(1) July 1 Accounts Receivable—R. A. Ware 500 Allowance for Doubtful Accounts 500 (To reverse write-off of R. A. Ware account)

(2) 1 Cash 500 Accounts Receivable—R. A. Ware 500 (To record collection from R. A. Ware)

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 is an increase in Cash and an increase in Allowance for Doubtful Accounts for $500. Accounts Receivable and Allowance for Doubtful Accounts both increase in entry (1) for two reasons. First, the company made an error in judgment when it wrote off the account receivable. Second, R. A. Ware did pay, and therefore the Accounts Receivable account should show this reinstatement and collection for possible future credit purposes.

A L SE= + +500 −500 Cash Flows no eff ect

A L SE= + +500 −500 Cash Flows +500

▼ HELPFUL HINT Like the write-off, a recovery does not involve the income statement.

Accounts Receivable

Jan. 1 Bal. 200,000 Mar. 1 500

Mar. 1 Bal. 199,500

Allowance for Doubtful Accounts

Mar. 1 500 Jan. 1 Bal. 12,000

Mar. 1 Bal. 11,500

ILLUSTRATION 8-4 General ledger balances after write-off

Before Write-Off After Write-Off

Accounts receivable $ 200,000 $ 199,500 Allowance for doubtful accounts 12,000 11,500

Cash realizable value $188,000 $188,000

ILLUSTRATION 8-5 Cash realizable value comparison

A write-off affects only balance sheet accounts. Cash realizable value in the balance sheet, therefore, remains the same before and after the write-off, as shown in Illustration 8-5.

382 8 Reporting and Analyzing Receivables

ESTIMATING THE ALLOWANCE For Hampson Furniture in Illustration 8-3, the amount of the expected uncollectibles was given. However, in “real life,” com- panies must estimate the amount of expected uncollectible accounts if they use the allowance method. Illustration 8-6 shows an excerpt from the notes to Nike’s fi nancial statements discussing its use of the allowance method.

Allowance for Uncollectible Accounts Receivable

We make ongoing estimates relating to the ability to collect our accounts receivable and maintain an allowance for estimated losses resulting from the inability of our customers to make required payments. In determining the amount of the allowance, we consider our historical level of credit losses and make judgments about the cred- itworthiness of signifi cant customers based on ongoing credit evaluations. Since we cannot predict future changes in the fi nancial stability of our customers, actual future losses from uncollectible accounts may differ from our estimates.

NIKE, INC. Notes to the Financial Statements

Real World

ILLUSTRATION 8-6 Nike’s allowance method disclosure

Frequently, companies estimate the allowance as a percentage of the outstand- ing receivables. Under the percentage-of-receivables basis, management estab- lishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts. For example, suppose Steffen Company has an ending balance in Accounts Receivable of $200,000 and an unadjusted credit balance in Allowance for Doubtful Accounts of $1,500. It estimates that 5% of its accounts receivable will eventually be uncollectible. It should report a balance in Allowance for Doubtful Accounts of $10,000 (.05 × $200,000). To increase the balance in Allowance for Doubtful Accounts from $1,500 to $10,000, the com- pany debits (increases) Bad Debt Expense and credits (increases) Allowance for Doubtful Accounts by $8,500 ($10,000 − $1,500).

To more accurately estimate the ending balance in the allowance account, a company often prepares a schedule, called aging the accounts receivable. This schedule classifi es customer balances by the length of time they have been unpaid. After the company arranges the accounts by age, it determines the expected bad debt losses by applying percentages, based on past experi- ence, to the totals of each category. The longer a receivable is past due, the less likely it is to be collected. As a result, the estimated percentage of uncol-

lectible debts increases as the number of days past due increases. Illustration 8-7

▼ HELPFUL HINT Where appropriate, the percentage-of-receivables basis may use only a single percentage rate.

Allowance for Doubtful Accounts

Dec. 31 Unadj. Bal. 1,500 Dec. 31 Adj. 8,500

Dec. 31 Bal. 10,000

DECISION TOOLS An aging schedule helps users determine if the amount of past due accounts is increasing and which accounts require management’s attention.

▼ HELPFUL HINT The older categories have higher percentages because the longer an account is past due, the less likely it is to be collected.

Number of Days Past Due Not

Yet Due 1–30 31–60 61–90 Over 90Total

$ 540

Customer T. E. Adert R. C. Bortz B. A. Carl O. L. Diker T. O. Ebbet

Total estimated uncollectible accounts

Others

Estimated percentage uncollectible 2%

$ 300

500

26,200

$ 2,228

$ 600

450 300

700 600

36,950 $39,600

$ 100

300 1,500

$1,900

$ 200

200

1,600 $2,000

$ 250

300 2,450

$3,000

$ 300

200

5,200 $5,700$27,000

$ 228

$ 300

10%

$ 400

20%

$ 760

40%

Formulas Data Review ViewPage LayoutInsert

A P18 fx

CB D E F G

Worksheet.xlsWorksheet.xls Home

2 3

ILLUSTRATION 8-7 Aging schedule

Valuation and Disposition of Accounts Receivable 383

shows an aging schedule for Dart Company. Note the increasing uncollectible percentages from 2% to 40%. Total estimated uncollectible accounts for Dart Company ($2,228) represent the existing customer claims expected to become uncollectible in the future. Thus, this amount represents the required balance in Allowance for Doubt- ful Accounts at the balance sheet date. Accordingly, the amount of bad debt expense that should be recorded in the adjusting entry is the difference between the required balance and the existing balance in the allowance account. The existing, unadjusted balance in Allowance for Doubtful Accounts is the net result of the beginning balance (a normal credit balance) less the write- offs of specifi c accounts during the year (debits to the allowance account). For example, if the unadjusted trial balance shows Allowance for Doubt- ful Accounts with a credit balance of $528, then an adjusting entry for $1,700 ($2,228 − $528) is necessary:

Dec. 31 Bad Debt Expense 1,700 Allowance for Doubtful Accounts 1,700 (To adjust allowance account to total estimated uncollectibles)

After Dart posts the adjusting entry, its accounts appear as shown in Illustration 8-8.

A L SE= + −1,700 Exp −1,700 Cash Flows no eff ect

Bad Debt Expense

Dec. 31 Adj. 1,700

Allowance for Doubtful Accounts

Dec. 31 Unadj. Bal. 528 Dec. 31 Adj. 1,700

Dec. 31 Bal. 2,228

ILLUSTRATION 8-8 Bad debt accounts after posting

An important aspect of accounts receivable management is simply maintain- ing a close watch on the accounts. Studies have shown that accounts more than 60 days past due lose approximately 50% of their value if no payment activity occurs within the next 30 days. For each additional 30 days that pass, the collect- ible value halves once again. Occasionally, the allowance account will have a debit balance prior to adjust- ment. This occurs because the debits to the allowance account from write-offs during the year exceeded the beginning balance in the account which was based on previous estimates for bad debts. In such a case, the company adds the debit balance to the required balance when it makes the adjusting entry. Thus, if there was a $500 debit balance in the allowance account before adjustment, the adjusting entry would be for $2,728 ($2,228 + $500) to arrive at a credit balance of $2,228 as shown below.

Dec. 31 Bad Debt Expense 2,728 Allowance for Doubtful Accounts 2,728 (To adjust allowance account to total estimated uncollectibles)

After Dart posts the adjusting entry, its accounts appear as shown in Illustration 8-9.

A L SE= + −2,728 Exp −2,728 Cash Flows no eff ect

Bad Debt Expense

Dec. 31 Adj. 2,728

Allowance for Doubtful Accounts

Dec. 31 Unadj. Bal. 500 Dec. 31 Adj. 2,728

Dec. 31 Bal. 2,228

ILLUSTRATION 8-9 Bad debt accounts after posting

384 8 Reporting and Analyzing Receivables

The percentage-of-receivables basis provides an estimate of the cash realizable value of the receivables. It also provides a reasonable matching of expenses to revenue. The following note regarding accounts receivable comes from the annual report of the shoe company Skechers USA.

The likelihood of a material loss on an uncollectible account would be mainly depen- dent on deterioration in the overall economic conditions in a particular country or region. Reserves are fully provided for all probable losses of this nature. For receiv- ables that are not specifi cally identifi ed as high risk, we provide a reserve based upon our historical loss rate as a percentage of sales. Gross trade accounts receivable were $293.1 million and $241.9 million, and the allowance for bad debts, returns, sales allowances and customer chargebacks were $21.0 million and $15.9 million, at December 31, 2014 and 2013, respectively. Our credit losses charged to expense for the years ended December 31, 2014, 2013 and 2012 were $11.8 million, $2.6 million and $1.5 million, respectively. In addition, we recorded sales return and allowance expense (recoveries) for the years ended December 31, 2014, 2013 and 2012 of $2.3 million, $0.2 million and $(0.4) million, respectively.

SKECHERS USA Notes to the Financial Statements

Real World

ILLUSTRATION 8-10 Skechers USA’s note disclosure of accounts receivable

Cookie Jar Allowances

There are many pressures on com- panies to achieve earnings targets. For managers, poor earnings can lead to dismissal or lack of promo- tion. It is not surprising then that management may be tempted to look for ways to boost their earn- ings number.

One way a company can achieve greater earnings is to lower its esti- mate of what is needed in its Allow- ance for Doubtful Accounts (some-

times referred to as “tapping the cookie jar”). For example, suppose a company has an Allowance for Doubtful Accounts

of $10 million and decides to reduce this balance to $9 million. As a result of this change, Bad Debt Expense decreases by $1 million and earnings increase by $1 million.

Large banks such as JP Morgan Chase, Wells Fargo, and Bank of America recently decreased their Allowance for Doubt- ful Accounts by over $4 billion. These reductions came at a time when these big banks were still suffering from lower mortgage lending and trading activity, both of which lead to lower earn- ings. They justifi ed these reductions in the allowance balances by noting that credit quality and economic conditions had im- proved. This may be so, but it sure is great to have a cookie jar that might be tapped when a boost in earnings is needed.

How might investors determine that a company is managing its earnings? (Go to WileyPLUS for this answer and additional questions.)

ETHICS INSIGHT

SOLUTION Brule should make the following entry to bring the debit balance in Allowance for Doubt- ful Accounts up to a normal, credit balance of $3,000 (10% × $30,000):

Bad Debt Expense [(10% × $30,000) + $2,000] 5,000 Allowance for Doubtful Accounts 5,000 (To record estimate of uncollectible accounts)

2a▼ Bad Debt ExpenseDO IT! Brule Corporation has been in business for 5 years. The unadjusted trial balance at the end of the current year shows Accounts Receivable $30,000, Sales Revenue $180,000, and Allowance for Doubtful Accounts with a debit balance of $2,000. Brule estimates bad debts to be 10% of accounts receivable. Prepare the entry necessary to adjust Allowance for Doubtful Accounts.

Action Plan ✔ Estimate the amount the

company does not expect to collect.

✔ Consider the existing balance in the allowance account when using the percentage-of-receivables basis.

✔ Report receivables at their cash (net) realizable value—that is, the amount the company expects to collect in cash. Related exercise material: BE8-3, BE8-4, BE8-5, DO IT! 8-2a, E8-3, E8-4, E8-5, and E8-6.

Valuation and Disposition of Accounts Receivable 385

DISPOSING OF ACCOUNTS RECEIVABLE

Sale of Receivables to a Factor A common way to accelerate receivables collection is a sale to a factor. A factor is a fi nance company or bank that buys receivables from businesses for a fee and then collects the payments directly from the customers. Factoring was traditionally associated with the textiles, apparel, footwear, furniture, and home furnishing industries. It has now spread to other types of businesses and is a multibillion dollar industry. For example, Sears, Roebuck & Co. (now Sears Holdings) once sold $14.8 billion of customer accounts receiv- able. McKesson at one time had a pre-arranged agreement allowing it to sell up to $700 million of its receivables. Factoring arrangements vary widely, but typically the factor charges a com- mission. It often ranges from 1% to 3% of the amount of receivables purchased. To illustrate, assume that Hendredon Furniture factors $600,000 of receivables to Federal Factors, Inc. Federal Factors assesses a service charge of 2% of the amount of receivables sold. The following journal entry records Hendredon’s sale of receivables on April 2, 2017.

Apr. 2 Cash 588,000 Service Charge Expense (2% × $600,000) 12,000 Accounts Receivable 600,000 (To record the sale of accounts receivable)

If Hendredon sells its receivables, it records the service charge expense as a selling expense. If the company sells receivables infrequently, it may report this amount under “Other expenses and losses” in the income statement.

National Credit Card Sales Approximately one billion credit cards were in use recently—more than three credit cards for every man, woman, and child in this country. A common type of credit card is a national credit card such as Visa and MasterCard. Three parties are involved when national credit cards are used in making retail sales: (1) the credit card issuer, who is independent of the retailer; (2) the retailer; and (3) the customer. A retailer’s acceptance of a national credit card is another form of selling—factoring—the receivable by the retailer. The use of national credit cards translates to more sales and zero bad debts for the retailer. Both are powerful reasons for a retailer to accept such cards. Illustration 8-11 (page 386) shows the major advantages of national credit cards to the retailer. In exchange for these advantages, the retailer pays the credit card issuer a fee of 2% to 4% of the invoice price for its services. The retailer considers sales resulting from the use of Visa and MasterCard as cash sales. Upon notifi cation of a credit card charge from a retailer, the bank that issued the card immediately adds the amount to the seller’s bank balance. Companies therefore record these credit card charges in the same manner as checks deposited from a cash sale. To illustrate, Morgan Marie purchases $1,000 of compact discs for her res- taurant from Sondgeroth Music Co., and she charges this amount on her Visa First Bank Card. The service fee that First Bank charges Sondgeroth Music is 3%. Sondgeroth Music’s entry to record this transaction on March 22, 2017, is as follows.

Mar. 22 Cash 970 Service Charge Expense 30 Sales Revenue 1,000 (To record Visa credit card sales)

INTERNATIONAL NOTE GAAP has less stringent requirements regarding the sale of receivables. Thus, GAAP companies can more easily use factoring transactions as a form of fi nancing without showing a related liability on their books. Some argue that this type of so-called “off-balance-sheet fi nancing” would be more diffi cult to achieve under IFRS.

A L SE= + +588,000 −12,000 Exp −600,000

Cash Flows +588,000

ETHICS NOTE In exchange for lower interest rates, some companies have eliminated the 25-day grace period before fi nance charges kick in. Be sure you read the fi ne print in any credit agreement you sign.

▼

A L SE= + +970 −30 Exp

+1,000 Rev

Cash Flows +970

386 8 Reporting and Analyzing Receivables

Issuer maintains customer accounts

Issuer does credit investigation of customer

Issuer undertakes collection process and absorbs any losses

Retailer receives cash more quickly from credit card issuer

Credit card issuer

RetailerCustomer

ILLUSTRATION 8-11 Advantages of credit cards to the retailer

How Does a Credit Card Work?

Most of you know how to use a credit card, but do you know what happens in the transaction and how the transaction is pro- cessed? Suppose that you use a Visa card to purchase some new ties at Nordstrom. The salesperson swipes your card, which allows the information on the magnetic strip on the back of the card to be read. The salesperson then enters in the

amount of the purchase. The machine contacts the Visa com- puter, which routes the call back to the bank that issued your Visa card. The issuing bank verifi es that the account exists, that the card is not stolen, and that you have not exceeded

your credit limit. At this point, the slip is printed, which you sign. Visa acts as the clearing agent for the transaction. It trans- fers funds from the issuing bank to Nordstrom’s bank account. Generally this transfer of funds, from sale to the receipt of funds in the merchant’s account, takes two to three days. In the meantime, Visa puts a pending charge on your ac- count for the amount of the tie purchase; that amount counts immediately against your available credit limit. At the end of the billing period, Visa sends you an invoice (your credit card bill) which shows the various charges you made, and the amounts that Visa expended on your behalf, for the month. You then must “pay the piper” for your stylish new ties.

Assume that Nordstrom prepares a bank reconciliation at the end of each month. If some credit card sales have not been processed by the bank, how should Nordstrom treat these transactions on its bank reconciliation? (Go to WileyPLUS for this answer and additional questions.)

Michael Braun/iStockphoto

2b▼ FactoringDO IT! Peter M. Kell Wholesalers Co. needs to raise $120,000 in cash to safely cover next Friday’s employee payroll. Kell has reached its debt ceiling. Kell’s present balance of outstanding receivables totals $750,000. Kell decides to factor $125,000 of its receivables on September 7, 2017, to alleviate this cash crunch. Record the entry that Kell would make when it raises the needed cash. (Assume a 1% service charge.)

ACCOUNTING ACROSS THE ORGANIZATION Nordstrom

Notes Receivable: Recognition, Valuation, and Disposition 387

SOLUTION Assuming that Kell Co. factors $125,000 of its accounts receivable at a 1% service charge, it would make this entry:

Sept. 7 Cash 123,750 Service Charge Expense (1% × $125,000) 1,250 Accounts Receivable 125,000 (To record sale of receivables to factor)

Related exercise material: BE8-6, DO IT! 8-2b, E8-7, E8-8, and E8-9.

Action Plan ✔ Consider sale of

receivables to a factor. ✔ Weigh cost of factoring

against benefi t of having cash in hand.

We promise to pay

to the order of

dollars

for value received with annual interest at

$1,000

2 months after date

Wilma Company

One Thousand and no/100 – – – – – – – – – – –

Chicago, Illinois May 1, 2017

Interest Rate

Amount

Payee

Amount

Date of NoteDate Due

Brent Company

Treasurer

Maker

ILLUSTRATION 8-12 Promissory note

LEARNING OBJECTIVE 3 Explain how companies recognize, value, and dispose of notes receivable.▼

Companies also may grant credit in exchange for a formal credit instrument known as a promissory note. A promissory note is a written promise to pay a specifi ed amount of money on demand or at a defi nite time. Promissory notes may be used (1) when individuals and companies lend or borrow money, (2) when the amount of the transaction and the credit period exceed normal limits, and (3) in settlement of accounts receivable. In a promissory note, the party making the promise to pay is called the maker. The party to whom payment is to be made is called the payee. The promissory note may specifi cally identify the payee by name or may designate the payee sim- ply as the bearer of the note. In the note shown in Illustration 8-12, Brent Company is the maker, and Wilma Company is the payee. To Wilma Company, the promissory note is a note receivable. To Brent Company, the note is a note payable.

Notes receivable give the holder a stronger legal claim to assets than do accounts receivable. Like accounts receivable, notes receivable can be read- ily sold to another party. Promissory notes are negotiable instruments (as are checks), which means that, when sold, the seller can transfer them to another party by endorsement. Companies frequently accept notes receivable from customers who need to extend the payment of an outstanding account receivable. Companies also often require notes from high-risk customers. In some industries (e.g., the pleasure

▼ HELPFUL HINT For this note, the maker, Brent Company, credits Notes Payable. The payee, Wilma Company, debits Notes Receivable.

388 8 Reporting and Analyzing Receivables

and sport boat industry), all credit sales are supported by notes. 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. On the following pages, we look at these issues. Before we do, however, we need to consider two issues that do not apply to accounts receiv- able: determining the maturity date and computing interest.

DETERMINING THE MATURITY DATE

The maturity date of a promissory note may be stated in one of three ways: (1) on demand, (2) on a stated date, and (3) at the end of a stated period of time. When it is stated to be at the end of a period of time, the parties to the note will need to determine the maturity date. When the life of a note is expressed in terms of months, you fi nd the date when it matures by counting the months from the date of issue. For example, the maturity date of a three-month note dated May 1 is August 1. A note drawn on the last day of a month matures on the last day of a subsequent month. That is, a July 31 note due in two months matures on September 30. When the due date is stated in terms of days, you need to count the exact number of days to determine the maturity date. In counting, omit the date the note is issued but include the due date.

COMPUTING INTEREST

Illustration 8-13 gives the basic formula for computing interest on an interest- bearing note.

▼ HELPFUL HINT The maturity date of a 60-day note dated July 17 is determined as follows.

Term of note 60 days July (31 − 17) 14 August 31 45 September 15 (Maturity date)

Face Value

Annual Time

of Note × Interest × in Terms of = Interest

Rate One Year

ILLUSTRATION 8-13 Formula for computing interest

The interest rate specifi ed on the note is an annual rate of interest. The time factor in the computation expresses the fraction of a year that the note is out- standing. When the maturity date is stated in days, the time factor is frequently the number of days divided by 360. When counting days, omit the date the note is issued but include the due date. When the due date is stated in months, the time factor is the number of months divided by 12. Illustration 8-14 shows computation of interest for various time periods.

Terms of Note Interest Computation

Face × Rate × Time = Interest $ 730, 12%, 120 days $ 730 × 12% × 120�360 = $ 29.20 $1,000, 9%, 6 months $1,000 × 9% × 6�12 = $ 45.00 $2,000, 6%, 1 year $2,000 × 6% × 1�1 = $120.00

ILLUSTRATION 8-14 Computation of interest

There are different ways to calculate interest. For example, the computation in Illustration 8-14 assumes 360 days for the year. Financial institutions use 365 days to compute interest. For homework problems, assume 360 days to sim- plify computations.

RECOGNIZING NOTES RECEIVABLE

To illustrate the basic entry for notes receivable, we will use Brent Company’s $1,000, two-month, 8% promissory note dated May 1. Assuming that Brent

Notes Receivable: Recognition, Valuation, and Disposition 389

Company wrote the note to settle an open account, Wilma Company makes the following entry for the receipt of the note.

May 1 Notes Receivable 1,000 Accounts Receivable—Brent Company 1,000 (To record acceptance of Brent Company note)

The company records the note receivable at its face value, the value shown on the face of the note. No interest revenue is reported when the company accepts the note because the revenue recognition principle does not recognize revenue until the performance obligation is satisfi ed. Interest is earned (accrued) as time passes. If a company issues cash in exchange for a note, the entry is a debit to Notes Receivable and a credit to Cash in the amount of the loan.

VALUING NOTES RECEIVABLE

Like accounts receivable, companies report short-term notes receivable at their cash (net) realizable value. The notes receivable allowance account is Allow- ance for Doubtful Accounts. Valuing short-term notes receivable is the same as valuing accounts receivable. The computations and estimations involved in determining cash realizable value and in recording the proper amount of bad debt expense and related allowance are similar. Long-term notes receivable, however, pose additional estimation problems. As an example, we need only look at the problems large U.S. banks sometimes have in collecting their receivables. Loans to less-developed countries are particu- larly worrisome. Developing countries need loans for development but often fi nd repayment diffi cult. In some cases, developed nations have intervened to provide fi nancial assistance to the fi nancially troubled borrowers so as to minimize the political and economic turmoil to the borrower and to ensure the survival of the lender.

A L SE= + +1,000 −1,000 Cash Flows no eff ect

Can Fair Value Be Unfair?

The FASB and the In- ternational Accounting Standards Board (IASB) are considering propos- als for how to account for fi nancial instruments. The FASB has proposed that loans and receiv- ables be accounted for at their fair value (the amount they could cur- rently be sold for), as are most investments.

The FASB believes that this would provide a more accurate view of a company’s fi nancial position. It might be especially useful as an early warning when a bank is in trouble because of poor-quality loans. But, banks argue that fair values are diffi - cult to estimate accurately. They are also concerned that vola- tile fair values could cause large swings in a bank’s reported net income.

Source: David Reilly, “Banks Face a Mark-to-Market Challenge,” Wall Street Journal Online (March 15, 2010).

What are the arguments in favor of and against fair value accounting for loans and receivables? (Go to WileyPLUS for this answer and additional questions.)

INTERNATIONAL INSIGHT

DISPOSING OF NOTES RECEIVABLE

Notes may be held to their maturity date, at which time the face value plus accrued interest is due. In some situations, the maker of the note defaults, and the payee must make an appropriate adjustment. In other situations, similar to

390 8 Reporting and Analyzing Receivables

accounts receivable, the holder of the note speeds up the conversion to cash by selling the receivables (as described later in this chapter).

Honor of Notes Receivable A note is honored when its maker pays in full at its maturity date. For each interest-bearing note, the amount due at maturity is the face value of the note plus interest for the length of time specifi ed on the note. To illustrate, assume that Wolder Co. lends Higley Inc. $10,000 on June 1, accepting a fi ve-month, 9% interest note. In this situation, interest is $375 ($10,000 × 9% × 512—). The amount due, the maturity value, is $10,375 ($10,000 + $375). To obtain payment, Wolder (the payee) must present the note either to Higley Inc. (the maker) or to the maker’s agent, such as a bank. If Wolder presents the note to Higley Inc. on November 1, the maturity date, Wolder’s entry to record the collection is as follows.

Nov. 1 Cash 10,375 Notes Receivable 10,000 Interest Revenue ($10,000 × 9% × 512—) 375 (To record collection of Higley Inc. note and interest)

Accrual of Interest Receivable Suppose instead that Wolder Co. prepares fi nancial statements as of September 30. The timeline in Illustration 8-15 presents this situation.

▼ HELPFUL HINT The number of days of interest that should be accrued at September 30 for a 90-day note issued on August 16 is 45 days (15 days in August plus 30 days in September).

4 months 1 monthJune 1 Sept. 30 Nov. 1

Receives $375

Earns $300 Earns $75

ILLUSTRATION 8-15 Timeline of interest earned

To refl ect interest earned but not yet received, Wolder must accrue interest on September 30. In this case, the adjusting entry by Wolder is for four months of interest, or $300, as shown below.

Sept. 30 Interest Receivable ($10,000 × 9% × 412— ) 300 Interest Revenue 300 (To accrue 4 months’ interest on Higley note)

At the note’s maturity on November 1, Wolder receives $10,375. This amount represents repayment of the $10,000 note as well as fi ve months of interest, or $375, as shown below. The $375 is comprised of the $300 Interest Receivable accrued on September 30 plus $75 earned during October. Wolder’s entry to record the honoring of the Higley note on November 1 is as follows.

Nov. 1 Cash [$10,000 + ($10,000 × 9% × 512— )] 10,375 Notes Receivable 10,000 Interest Receivable 300 Interest Revenue ($10,000 × 9% × 112— ) 75 (To record collection of Higley Inc. note and interest)

In this case, Wolder credits Interest Receivable because the receivable was estab- lished in the adjusting entry on September 30.

A L SE= + +10,375 −10,000 +375 Rev Cash Flows +10,375

A L SE= + +300 +300 Rev Cash Flows no eff ect

A L SE= + +10,375 −10,000 −300 +75 Rev Cash Flows +10,375

Receivables Presentation and Management 391

Dishonor of Notes Receivable A dishonored (defaulted) note is a note that is not paid in full at maturity. A dishonored note receivable is no longer negotiable. However, the payee still has a claim against the maker of the note for both the note and the interest. If the lender expects that it eventually will be able to collect, the two parties negotiate new terms to make it easier for the borrower to repay the debt. If there is no hope of collection, the payee should write off the face value of the note.

3▼ Notes ReceivableDO IT! Gambit Stores accepts from Leonard Co. a $3,400, 90-day, 6% note dated May 10 in settle- ment of Leonard’s overdue open account. The note matures on August 8. What entry does Gambit make at the maturity date, assuming Leonard pays the note and interest in full at that time?

SOLUTION The interest payable at maturity date is $51, computed as follows.

Face × Rate × Time = Interest

$3,400 × 6% × 90

360 = $51

Gambit Stores records this entry at the maturity date:

Cash 3,451 Notes Receivable 3,400 Interest Revenue 51 (To record collection of Leonard note and interest)

Action Plan ✔ Compute the accrued

interest. ✔ Prepare the entry for

payment of the note and the interest.

Related exercise material: BE8-7, BE8-8, DO IT! 8-3, E8-10, and E8-11.

LEARNING OBJECTIVE 4 Describe the statement presentation of receivables and the principles of receivables management.▼

If a company has signifi cant receivables, analysts carefully review the company’s fi nancial statement disclosures to evaluate how well the company is managing its receivables.

FINANCIAL STATEMENT PRESENTATION OF RECEIVABLES

Companies should identify in the balance sheet or in the notes to the fi nan- cial statements each of the major types of receivables. Short-term receivables are reported in the current assets section of the balance sheet, below short- term investments. Short-term investments appear before short-term receivables because these investments are nearer to cash. Companies report both the gross amount of receivables and the allowance for doubtful accounts. Receivables represent 60% of the total assets of heavy equipment manufacturer Deere & Company. Illustration 8-16 (page 392) shows a presentation of receivables for Deere & Company from its balance sheet and notes in a recent year. In the income statement, companies report bad debt expense under “Selling expenses” in the operating expenses section. They show interest revenue under “Other revenues and gains” in the nonoperating section of the income statement.

392 8 Reporting and Analyzing Receivables

If a company has signifi cant risk of uncollectible accounts or other problems with its receivables, it is required to discuss this possibility in the notes to the fi nancial statements.

MANAGING RECEIVABLES

Managing accounts receivable involves fi ve steps:

1. Determine to whom to extend credit.

2. Establish a payment period.

3. Monitor collections.

4. Evaluate the liquidity of receivables.

5. Accelerate cash receipts from receivables when necessary.

Extending Credit Every entrepreneur struggles with fi nancing issues. For example, the very fi rst order that Apple’s founders received was 50 circuit boards for a computer hobby shop. To produce the $25,000 order, Steve Jobs and Steve Wozniak needed $15,000 of parts. To purchase the parts, they borrowed $5,000 from friends but then were turned down when they applied for a bank loan for the $10,000 balance. They approached two parts suppliers in an effort to negotiate a purchase on credit, but both suppliers said no. Finally, a third supplier agreed to sell them the parts on 30-day credit after he called the computer hobby shop to confi rm that it had, in fact, placed a $25,000 order to purchase goods. A critical part of managing receivables is determining who should be extended credit and who should not. Many companies increase sales by being generous with their credit policy. However, they sometimes extend credit to risky custom- ers who do not pay. But if your credit policy is too tight, you will lose sales. If it is too loose, you may sell to “deadbeats” who will pay either very late or not at all. One CEO noted that prior to getting his credit and collection department in order, his salespeople had 300 square feet of offi ce space per person, while the people in credit and collections had six people crammed into a single 300-square- foot space. Although this focus on sales boosted sales revenue, it had very expen- sive consequences in bad debt expense. Companies can take certain steps to help minimize losses due to bad debts when they decide to relax credit standards for new customers. They might require risky customers to provide letters of credit or bank guarantees. Then, if the cus- tomer does not pay, the bank that provided the guarantee will do so. Particularly risky customers might be required to pay cash on delivery. For example, at one time retailer Linens’n Things, Inc. reported that its largest suppliers were requiring

Receivables Receivables from unconsolidated subsidiaries $ 30 Trade accounts and notes receivable 3,278 Financing receivables 27,583 Restricted fi nancing receivables 4,616 Other receivables 1,500

Total receivables 37,007 Less: Allowance for doubtful trade receivables 175

Net receivables $36,832

DEERE & COMPANY Balance Sheet (partial)

(in millions)

Real World

ILLUSTRATION 8-16 Balance sheet presentation of receivables

Receivables Presentation and Management 393

cash payment before delivery. The suppliers had cut off shipments because the company had been slow in paying. Kmart’s suppliers also required it to pay cash in advance when it was fi nancially troubled. In addition, companies should ask potential customers for references from banks and suppliers, to determine their payment history. It is important to check references of potential new customers as well as periodically to check the fi nan- cial health of continuing customers. Many resources are available for investigat- ing customers. For example, The Dun & Bradstreet Reference Book of American Business (www.dnb.com) lists millions of companies and provides credit ratings for many of them.

Bad Information Can Lead to Bad Loans

Many factors contributed to the recent credit crisis. One signifi cant factor that resulted in many bad loans was a failure by lenders to investigate loan customers suffi - ciently. For example, Countrywide Financial Corporation wrote many loans under its “Fast and Easy” loan program. That program al- lowed borrowers to provide little or no documentation for their in- come or their assets. Other lend-

ers had similar programs, which earned the nickname “liars’ loans.” One study found that in these situations, 60% of

applicants overstated their incomes by more than 50% in order to qualify for a loan. Critics of the banking industry say that because loan offi cers were compensated for loan volume, and because banks were selling the loans to investors rather than holding them, the lenders had little incentive to investi- gate the borrowers’ creditworthiness.

Sources: Glenn R. Simpson and James R. Hagerty, “Countrywide Loss Focuses Attention on Underwriting,” Wall Street Journal (April 30, 2008), p. B1; and Michael Corkery, “Fraud Seen as Driver in Wave of Foreclosures,” Wall Street Journal (December 21, 2007), p. A1.

What steps should the banks have taken to ensure the accuracy of fi nancial information provided on loan applications? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Countrywide Financial Corporation

Establishing a Payment Period Companies that extend credit should determine a required payment period and communicate that policy to their customers. It is important that the payment period is consistent with that of competitors. For example, if you require pay- ment within 15 days but your competitors allow payment within 45 days, you may lose sales to your competitors. To match your competitors’ generous terms yet still encourage prompt payment of accounts, you might allow up to 45 days to pay but offer a sales discount for people paying within 15 days.

Monitoring Collections We discussed preparation of the accounts receivable aging schedule earlier in the chapter (pages 382–383). Companies should prepare an accounts receivable aging schedule at least monthly. In addition to estimating the allowance for doubtful accounts, the aging schedule has other uses. It helps managers estimate the timing of future cash infl ows, which is very important to the treasurer’s efforts to prepare a cash budget. It provides information about the overall collection expe- rience of the company and identifi es problem accounts. For example, manage- ment would compute and compare the percentage of receivables that are over 90 days past due. Illustration 8-17 (page 394) contains an excerpt from the notes to Skechers’ fi nancial statements discussing how it monitors receivables.

DECISION TOOLS

Monitoring the accounts receivable aging schedule helps users deter- mine if the company’s credit risk is increasing.

394 8 Reporting and Analyzing Receivables

The aging schedule identifi es problem accounts that the company needs to pursue with phone calls, letters, and occasionally legal action. Sometimes, special arrangements must be made with problem accounts. For example, it was reported that Intel Corporation (a major manufacturer of computer chips) required that Packard Bell (at one time one of the largest U.S. sellers of personal computers) exchange its past-due account receivable for an interest-bearing note receivable. This caused concern within the investment community. The move suggested that Packard Bell was in trouble, which worried Intel investors con- cerned about Intel’s accounts receivable. If a company has signifi cant concentrations of credit risk, it must discuss this

risk in the notes to its fi nancial statements. A concentration of credit risk is a threat of nonpayment from a single large customer or class of customers that could adversely affect the fi nancial health of the com- pany. Illustration 8-18 shows an excerpt from the credit risk note from the 2014 annual report of Skechers. Skechers reports that its fi ve largest customers account for 15.7% of its net sales.

To minimize the likelihood of uncollectibility, customers’ credit-worthiness is reviewed periodically based on external credit reporting services, fi nancial statements issued by the customer and our experience with the account, and it is adjusted accordingly. When a customer’s account becomes signifi cantly past due, we generally place a hold on the account and discontinue further shipments to that customer, minimizing further risk of loss.

SKECHERS USA Notes to the Financial Statements

Real World

ILLUSTRATION 8-17 Note on monitoring Skechers’ receivables

We Depend Upon a Relatively Small Group of Customers for a Large Portion of Our Sales.

During 2014, 2013 and 2012, our net sales to our fi ve largest customers accounted for approximately 15.7%, 18.1% and 18.1% of total net sales, respectively. No customer accounted for more than 10.0% of our net sales during 2014, 2013 and 2012. No customer accounted for more than 10.0% of net trade receivables at December 31, 2014 and 2013. Although we have long-term relationships with many of our custom- ers, our customers do not have a contractual obligation to purchase our products and we cannot be certain that we will be able to retain our existing major customers. Furthermore, the retail industry regularly experiences consolidation, contractions and closings which may result in our loss of customers or our inability to collect ac- counts receivable of major customers. If we lose a major customer, experience a sig- nifi cant decrease in sales to a major customer or are unable to collect the accounts receivable of a major customer, our business could be harmed.

SKECHERS USA Notes to the Financial Statements

Real World

ILLUSTRATION 8-18 Excerpt from Skechers’ note on concentration of credit risk

DECISION TOOLS Identifying risky credit customers helps users determine if the company has signifi cant concentrations of credit risk.

This note to Skechers’ fi nancial statements indicates it has a relatively high con- centration of credit risk. A default by any of these large customers could have a signifi cant negative impact on its fi nancial performance.

EVALUATING LIQUIDITY OF RECEIVABLES

Investors and managers keep a watchful eye on the relationship among sales, accounts receivable, and cash collections. If sales increase, then accounts receivable are also expected to increase. But a disproportionate increase in accounts receivable might signal trouble. Perhaps the company increased its

Receivables Presentation and Management 395

sales by loosening its credit policy, and these receivables may be diffi cult or impossible to collect. Such receivables are considered less liquid. Recall that liquidity is measured by how quickly certain assets can be converted to cash. The ratio that analysts use to assess the liquidity of receivables is the accounts receivable turnover, computed by dividing net credit sales (net sales less cash sales) by the average net accounts receiv- able during the year. This ratio measures the number of times, on average, a company collects receivables during the period. Unless sea- sonal factors are signifi cant, average accounts receivable outstanding can be computed from the beginning and ending balances of the net receivables.1

A popular variant of the accounts receivable turnover is the average collection period, which measures the average amount of time that a receiv- able is outstanding. This is done by dividing the accounts receivable turnover into 365 days. Companies use the average collection period to assess the effec- tiveness of a company’s credit and collection policies. The average collection period should not greatly exceed the credit term period (i.e., the time allowed for payment). The following data (in millions) are available for Nike.

For the year ended March 31,

2014 2013

Sales $27,799 $25,313 Accounts receivable (net) 3,434 3,117

Illustration 8-19 shows the accounts receivable turnover and average collection period for Nike and Skechers, along with comparative industry data. These cal- culations assume that all sales were credit sales.

1If seasonal factors are signifi cant, determine the average accounts receivable balance by using monthly or quarterly amounts.

Nike’s accounts receivable turnover was 8.5 times in 2014, with a correspond- ing average collection period of 42.9 days. This was slightly faster than its 2013 collection period. It was slower than the industry average collection period of 29.9 days and higher than Skechers, which was 38 days. What this means is that Nike turned its receivables into cash more slowly than most other companies

DECISION TOOLS

The accounts receivable turnover and the average collection period help users determine if a company’s collections are being made in a timely fashion.

Accounts Receivable Turnover = Net Credit SalesAverage Net Accounts Receivable

Average Collection Period = 365Accounts Receivable Turnover

Nike Skechers Industry Ratio ($ in millions) USA Average

2014 2013 2014 2014

Accounts receivable $27,799 ($3,434 + $3,117)/2

= 8.5 times 8.1 times 9.6 times 12.2 times turnover

Average collection 365 days 8.5

= 42.9 days 45.1 days 38.0 days 29.9 days period

ILLUSTRATION 8-19 Accounts receivable turnover and average collection period

396 8 Reporting and Analyzing Receivables

in its industry. Therefore, it was less likely to pay its current obligations than a company with a quicker accounts receivable turnover (all else equal) and is more likely to need outside fi nancing to meet cash shortfalls. In some cases, accounts receivable turnover may be misleading. Some large retail chains that issue their own credit cards encourage customers to use these cards for purchases. If customers pay slowly, the stores earn a healthy return on the outstanding receivables in the form of interest at rates of 18% to 22%. On the other hand, companies that sell (factor) their receivables on a consistent basis will have a faster turnover than those that do not. Thus, to interpret accounts receivable turnover, you must know how a company manages its receivables. In general, the faster the turnover, the greater the reliability of the current ratio for assessing liquidity.

ACCELERATING CASH RECEIPTS

In the normal course of events, companies collect accounts receivable in cash and remove them from the books. However, as credit sales and receivables have grown in size and signifi cance, the “normal course of events” has changed. Two common expressions apply to the collection of receivables: (1) “Time is money”—that is, waiting for the normal collection process costs money. (2) “A bird in the hand is worth two in the bush”—that is, getting the cash now is better than getting it later or not at all. Therefore, in order to accelerate the receipt of cash from receivables, companies frequently sell their receivables to another company for cash, thereby shortening the cash-to-cash operating cycle. There are three reasons for the sale of receivables. The fi rst is their size. In recent years, for competitive reasons, sellers (retailers, wholesalers, and manufacturers) often have provided fi nancing to purchasers of their goods. For example, many major companies in the automobile, truck, industrial and farm equipment, computer, and appliance industries have created companies that accept responsibility for accounts receivable fi nancing. Caterpillar has Cater- pillar Financial Services, General Electric has GE Capital, and Ford has Ford Motor Credit Corp. (FMCC). These companies are referred to as captive fi nance companies because they are owned by the company selling the product. The purpose of captive fi nance companies is to encourage the sale of the com- pany’s products by assuring fi nancing to buyers. However, the parent companies involved do not necessarily want to hold large amounts of receivables, so they may sell them. Second, companies may sell receivables because they may be the only reasonable source of cash. When credit is tight, companies may not be able to borrow money in the usual credit markets. Even if credit is available, the cost of borrowing may be prohibitive. A fi nal reason for selling receivables is that billing and collection are often time-consuming and costly. As a result, it is often easier for a retailer to sell the receivables to another party that has expertise in billing and collection mat- ters. Credit card companies such as MasterCard, Visa, American Express, and Discover specialize in billing and collecting accounts receivable. Illustration 8-20 summarizes the basic principles of managing accounts receivable.

Receivables Presentation and Management 397

1. Determine to whom to extend credit

2. Determine a payment period

15 days

Cash quick, but lose

sales

S M Tu W Th F S

18 19 20 21 22 24 25 26 27 28

23 29 30

1 2 3 4 5 6 7 8 10 11 13 14 15 16 1712

30 days

Happy customers but less cash

available

Payments DuePayments Due S M Tu W Th F S

18 19 20 21 22 24 25 26 27 28

23 29 30

1 2 3 4 5 6 7 8 10 11 13 14 15 16 1712

3. Monitor collections

CashUncollected receivables

5. Accelerate cash receipts from receivables

4. Evaluate the liquidity of receivables

RECEIV ABLES

FOR SA LE

BIG SALETODAY!!

Hi, you owe our company money

ILLUSTRATION 8-20 Managing receivables

KEEPING AN EYE ON CASH

A lot of companies report strong sales growth but have cash flow problems. How can this be? The reason for the difference is timing: Sales revenue is recorded when goods are delivered even if cash is not received until later. For example, Nike had sales of $27,799 million during 2014. Does that mean it received cash of $27,799 million from its customers? Most likely not. So how do we determine the amount of cash related to sales revenue that is actually received from customers? We analyze the changes that take place in Accounts Receivable. To illustrate, suppose Bestor Corporation started the year with $10,000 in accounts receivable. During the year, it had credit sales of $100,000. At the end of the year, the balance in accounts receivable was $25,000. As a result, accounts receivable increased $15,000 during the year. How much cash did Bestor collect from customers during the year? Using the following T-account, we can deter- mine that collections were $85,000.

Accounts Receivable

Beginning balance 10,000 85,000 Collections Sales 100,000

Ending balance 25,000

As shown, the difference between sales and cash collections is explained by the change in Accounts Receivable. Accounts Receivable increased by $15,000. Therefore, since credit sales were $100,000, cash collections were only $85,000. To illustrate another situation, let’s use Nike (see data on page 395). Recall that it had net credit sales of $27,799 million. Its ending receivables balance was $3,434 million, and its beginning receivables balance was $3,117 million—an increase of $317 million. Given this change, we can determine that the cash col- lected from customers during the year was $27,482 million ($27,799 − $317). This is shown in the following T-account.

398 8 Reporting and Analyzing Receivables

Accounts Receivable

Beginning balance 3,117 27,482 Collections Sales 27,799

Ending balance 3,434 ▼ Analysis of ReceivablesDO IT!

In 2017, Lebron James Company had net credit sales of $923,795 for the year. It had a beginning accounts receivable (net) balance of $38,275 and an ending accounts receivable (net) balance of $35,988. Compute Lebron James Company’s (a) accounts receivable turn- over and (b) average collection period in days.

SOLUTION (a)

Net credit sales ÷ Average net = Accounts receivable

accounts receivable turnover

$923,795 ÷ $38,275 + $35,988 = 24.9 times 2

(b)

Days in year ÷ Accounts receivable = Average collection

turnover period in days

365 ÷ 24.9 times = 14.7 days

Action Plan ✔ Review the formula to

compute the accounts receivable turnover.

✔ Make sure that both the beginning and ending accounts receivable are considered in the computation.

✔ Review the formula to compute the average collection period in days.

Related exercise material: BE8-10, BE8-11, DO IT! 8-4, E8-14, and E8-15.

The information below was taken from the 2014 fi nancial statements of adidas. Similar to Nike and Skechers, adidas sells shoes as well as other products.

USING DECISION TOOLS—ADIDAS

ADIDAS AG Selected Financial Information

(in millions)

2014 2013

Sales $14,534 $14,203

Current assets Cash and cash equivalents $ 1,683 $ 1,587 Short-term investment securities 5 41 Accounts receivable (net) 1,946 1,809 Merchandise inventories 2,526 2,634 Other 1,187 786

Total current assets $ 7,347 $ 6,857

Total current liabilities $ 4,378 $ 4,732

INSTRUCTIONS

Comment on adidas’ accounts receivable management and liquidity relative to that of Nike, using (1) the current ratio and (2) the accounts receivable turnover and average collection period. Nike’s current ratio was 2.72:1. The other ratio values for Nike were calculated earlier in the chapter (page 395).

Review and Practice 399

SOLUTION 1. Here is the 2014 current ratio (Current assets 4 Current liabilities) for each company.

Nike adidas

2.72:1 $7,347

$4,378 = 1.68:1

Nike’s current ratio far exceeds that of adidas. In fact, Nike’s might be excessive. A company of its size would not normally want to have so much capital tied up in current assets.

2. The accounts receivable turnover and average collection period for each company are:

Nike adidas

Accounts receivable turnover 8.5 times $14,534 ($1,946 + $1,809)/2

= 7.7 times

Average collection period 42.9 days 365 7.7

= 47.4 days

adidas’ accounts receivable turnover of 7.7 compared to Nike’s 8.5, and its average collection period of 47.4 days versus Nike’s 42.9 days, suggest that adidas is able to collect from its customers slightly less quickly. It is important to note, however, that adidas is a German corporation. It reports under IFRS. A thorough comparison of adidas and Nike would require consideration of differences in the treatment of accounts receivable under IFRS and GAAP.

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Explain how companies recognize accounts receivable. Receivables are frequently classifi ed as accounts, notes, and other. Accounts receivable are amounts customers owe on account. Notes receivable represent claims that are evidenced by formal instruments of credit. Other receiv- ables include nontrade receivables such as interest receiv- able, loans to company offi cers, advances to employees, and income taxes refundable. Companies record accounts receivable when they per- form a service on account or at the point-of-sale of mer- chandise on account. Sales returns and allowances and cash discounts reduce the amount received on accounts receivable.

2 Describe how companies value accounts receivable and record their disposition. The two methods of accounting for uncollectible accounts are the allowance method and the direct write-off method. Under the allowance method, companies estimate uncollectible accounts as a percentage of receivables. It emphasizes the cash realizable value of the accounts receivable. An aging schedule is frequently used with this approach.

3 Explain how companies recognize, value, and dispose of notes receivable. The formula for computing interest is Face value of note × Annual interest rate × Time in terms of one year. Notes can be held to maturity, at which time the borrower (maker) pays the face value plus accrued interest and the payee removes the note from the accounts. In many cases, however, similar to accounts receivable, the

holder of the note speeds up the conversion by selling the receivable to another party. In some situations, the maker of the note dishonors the note (defaults), and the note is written off.

4 Describe the statement presentation of receivables and the principles of receivables management. Compa- nies should identify each major type of receivable in the balance sheet or in the notes to the fi nancial statements. Short-term receivables are considered current assets. Companies report the gross amount of receivables and the allowance for doubtful accounts. They report bad debt and service charge expenses in the income statement as operating (selling) expenses, and interest revenue as other revenues and gains in the nonoperating section of the statement. To properly manage receivables, management must (a) determine to whom to extend credit, (b) establish a payment period, (c) monitor collections, (d) evaluate the liquidity of receivables, and (e) accelerate cash receipts from receivables when necessary. The accounts receiv- able turnover and the average collection period both are useful in analyzing management’s effectiveness in man- aging receivables. The accounts receivable aging sched- ule also provides useful information. If the company needs additional cash, management can accelerate the collection of cash from receivables by selling (factoring) its receivables or by allowing customers to pay with bank credit cards.

▼

400 8 Reporting and Analyzing Receivables

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Is the amount of past due accounts increasing? Which accounts require management’s attention?

List of outstanding receivables and their due dates

Prepare an aging schedule showing the receivables in various stages: outstanding 0–30 days, 31–60 days, 61–90 days, and over 90 days.

Is the company’s credit risk increasing?

Does the company have signifi cant concentrations of credit risk?

Are collections being made in a timely fashion?

Customer account balances and due dates

Note to the fi nancial statements on concentrations of credit risk

Net credit sales and average net accounts receivable balance

Accounts receivable ag- ing schedule

If risky credit customers are identifi ed, the fi nancial health of those customers should be evaluated to gain an independent assessment of the potential for a material credit loss.

Compute and compare the percentage of receivables over 90 days old.

If a material loss appears likely, the potential negative impact of that loss on the company should be carefully evaluated, along with the adequacy of the allowance for doubtful accounts.

Average collection period should be consistent with corporate credit policy. An increase may suggest a decline in fi nancial health of customers.

Accounts in the older categories require follow-up: letters, phone calls, and possible renegotiation of terms.

Accounts

receivable = turnover

Average

collection =

period

Accounts receivable Amounts customers owe on account. (p. 376).

Accounts receivable turnover A measure of the liquidity of accounts receivable, computed by dividing net credit sales by average net accounts receivable. (p. 395).

Aging the accounts receivable A schedule of customer balances classifi ed by the length of time they have been unpaid. (p. 382).

Allowance method A method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period. (p. 379).

Average collection period The average amount of time that a receivable is outstanding, calculated by dividing 365 days by the accounts receivable turnover. (p. 395).

Bad Debt Expense An expense account to record losses from extending credit. (p. 378).

Cash (net) realizable value The net amount a company expects to receive in cash from receivables. (p. 379).

Concentration of credit risk The threat of nonpayment from a single large customer or class of customers that could adversely affect the fi nancial health of the com- pany. (p. 394).

Direct write-off method A method of accounting for bad debts that involves charging receivable balances to Bad

Debt Expense at the time receivables from a particular company are determined to be uncollectible. (p. 378).

Dishonored (defaulted) note A note that is not paid in full at maturity. (p. 391).

Factor A fi nance company or bank that buys receivables from businesses for a fee and then collects the payments directly from the customers. (p. 385).

Maker The party in a promissory note who is making the promise to pay. (p. 387).

Notes receivable Written promise (as evidenced by a for- mal instrument) for amounts to be received. (p. 376).

Payee The party to whom payment of a promissory note is to be made. (p. 387).

Percentage-of-receivables basis A method of estimat- ing the amount of bad debt expense whereby manage- ment establishes a percentage relationship between the amount of receivables and the expected losses from uncollectible accounts. (p. 382).

Promissory note A written promise to pay a specifi ed amount of money on demand or at a defi nite time. (p. 387).

Receivables Amounts due from individuals and compa- nies that are expected to be collected in cash. (p. 376).

Trade receivables Notes and accounts receivable that re- sult from sales transactions. (p. 376).

GLOSSARY REVIEW▼

Net credit sales

Average net accounts receivable

365 days Accounts

receivable turnover

1. A receivable that is evidenced by a formal instrument and that normally requires the payment of interest is: (a) an account receivable. (b) a trade receivable. (c) a note receivable. (d) a classifi ed receivable.

2. Receivables are frequently classifi ed as: (a) accounts receivable, company receivables, and

other receivables. (b) accounts receivable, notes receivable, and em-

ployee receivables. (c) accounts receivable and general receivables. (d) accounts receivable, notes receivable, and other

receivables. 3. Kersee Company on June 15 sells merchandise on

account to Eng Co. for $1,000, terms 2/10, n/30. On June 20, Eng Co. returns merchandise worth $300 to Kersee Company. On June 24, payment is re- ceived from Eng Co. for the balance due. What is the amount of cash received? (a) $700. (c) $686. (b) $680. (d) None of the above.

4. Accounts and notes receivable are reported in the current assets section of the balance sheet at: (a) cash (net) realizable value (b) net book value. (c) lower-of-cost-or-market value. (d) invoice cost.

5. Net credit sales for the month are $800,000. The ac- counts receivable balance is $160,000. The allowance is calculated as 7.5% of the receivables balance using the percentage-of-receivables basis. If Allowance for Doubtful Accounts has a credit balance of $5,000 be- fore adjustment, what is the balance after adjustment? (a) $12,000. (c) $17,000. (b) $7,000. (d) $31,000.

6. In 2017, Patterson Wholesale Company had net credit sales of $750,000. On January 1, 2017, Allowance for Doubtful Accounts had a credit balance of $18,000. During 2017, $30,000 of uncollectible accounts re- ceivable were written off. Past experience indicates that the allowance should be 10% of the balance in receivables (percentage-of-receivables basis). If the accounts receivable balance at December 31 was $200,000, what is the required adjustment to Allow- ance for Doubtful Accounts at December 31, 2017? (a) $20,000. (c) $32,000. (b) $75,000. (d) $30,000.

7. An analysis and aging of the accounts receivable of Raja Company at December 31 reveal these data:

Accounts receivable $800,000 Allowance for doubtful accounts per

books before adjustment (credit) 50,000 Amounts expected to become

uncollectible 65,000

What is the cash realizable value of the accounts receivable at December 31, after adjustment? (a) $685,000. (c) $800,000. (b) $750,000. (d) $735,000.

8. Which of these statements about Visa credit card sales is incorrect?

(LO 1)

(LO 2, 4)

(LO 2)

(a) The credit card issuer conducts the credit inves- tigation of the customer.

(b) The retailer is not involved in the collection process. (c) The retailer must wait to receive payment from

the issuer. (d) The retailer receives cash more quickly than it

would from individual customers. 9. Good Stuff Retailers accepted $50,000 of Citibank

Visa credit card charges for merchandise sold on July 1. Citibank charges 4% for its credit card use. The en- try to record this transaction by Good Stuff Retailers will include a credit to Sales Revenue of $50,000 and a debit(s) to: (a) Cash $48,000 and Service Charge Expense $2,000. (b) Accounts Receivable $48,000 and Service Charge

Expense $2,000. (c) Cash $50,000. (d) Accounts Receivable $50,000.

10. A company can accelerate its cash receipts by all of the following except: (a) offering discounts for early payment. (b) accepting national credit cards for customer

purchases. (c) selling receivables to a factor. (d) writing off receivables.

11. Hughes Company has a credit balance of $5,000 in its Allowance for Doubtful Accounts before any ad- justments are made at the end of the year. Based on review and aging of its accounts receivable at the end of the year, Hughes estimates that $60,000 of its re- ceivables are uncollectible. The amount of bad debt expense which should be reported for the year is: (a) $5,000. (c) $60,000. (b) $55,000. (d) $65,000.

12. Use the same information as in Question 11, except that Hughes has a debit balance of $5,000 in its Allowance for Doubtful Accounts before any adjustments are made at the end of the year. In this situation, the amount of bad debt expense that should be reported for the year is: (a) $5,000. (c) $60,000. (b) $55,000. (d) $65,000.

13. Which of these statements about promissory notes is incorrect? (a) The party making the promise to pay is called the

maker. (b) The party to whom payment is to be made is

called the payee. (c) A promissory note is not a negotiable instrument. (d) A promissory note is more liquid than an account

receivable. 14. Michael Co. accepts a $1,000, 3-month, 12% promis-

sory note in settlement of an account with Tani Co. The entry to record this transaction is: (a) Notes Receivable 1,030 Accounts Receivable 1,030 (b) Notes Receivable 1,000 Accounts Receivable 1,000 (c) Notes Receivable 1,000 Sales Revenue 1,000 (d) Notes Receivable 1,020 Accounts Receivable 1,020

(LO 2)

(LO 3)

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

Practice Multiple-Choice Questions 401

402 8 Reporting and Analyzing Receivables

15. Schleis Co. holds Murphy Inc.’s $10,000, 120-day, 9% note. The entry made by Schleis Co. when the note is collected, assuming no interest has previously been accrued, is: (a) Cash 10,300 Notes Receivable 10,300 (b) Cash 10,000 Notes Receivable 10,000 (c) Accounts Receivable 10,300 Notes Receivable 10,000 Interest Revenue 300 (d) Cash 10,300 Notes Receivable 10,000 Interest Revenue 300

16. If a company is concerned about extending credit to a risky customer, it could do any of the following except: (a) require the customer to pay cash in advance. (b) require the customer to provide a letter of credit

or a bank guarantee.

(LO 3)

(LO 4)

(d) provide the customer a lengthy payment period to increase the chance of paying.

17. Eddy Corporation had net credit sales dur- ing the year of $800,000 and cost of goods sold of $500,000. The balance in receivables at the begin- ning of the year was $100,000 and at the end of the year was $150,000. What was the accounts receivable turnover and average collection period in days? (a) 4.0 and 91.3 days. (c) 6.4 and 57 days. (b) 5.3 and 68.9 days. (d) 8.0 and 45.6 days.

18. Prall Corporation sells its goods on terms of 2/10, n/30. It has an accounts receivable turnover of 7. What is its average collection period (days)? (a) 2,555 (c) 52 (b) 30 (d) 210

(LO 4)

SOLUTIONS 1. (c) A note receivable represent claims for which formal instruments of credit are issued as evidence of the debt. The

note normally requires the payment of the principal and interest on a specifi c date. Choices (a) account receivable, (b) trade receivable, and (d) classifi ed receivable rarely require the payment of interest if paid within a 30-day period.

2. (d) Receivables are frequently classifi ed as accounts receivable, notes receivable, and other receivables. The other choices are incorrect because receivables are not frequently classifi ed as (a) company receivables, (b) employee receiv- ables, or (c) general receivables.

3. (c) Because payment is made within the discount period of 10 days, the amount received is $700 ($1,000 − $300 return) minus the discount of $14 ($700 × 2%), for a cash amount of $686, not (a) $700 or (b) $680. Choice (d) is wrong as there is a correct answer.

4. (a) Accounts and notes receivable are reported in the current assets section of the balance sheet at cash (net) realiz- able value, not (b) net book value, (c) lower-of-cost-or-market value, or (d) invoice cost.

5. (a) The ending balance required in the allowance account is 7.5% × $160,000, or $12,000. Since there is already a balance of $5,000 in Allowance for Doubtful Accounts, the difference of $7,000 should be added, resulting in a balance of $12,000, not (b) $7,000, (c) $17,000, or (d) $31,000.

6. (c) After the write-offs are recorded, Allowance for Doubtful Accounts will have a debit balance of $12,000 ($18,000 credit beginning balance combined with a $30,000 debit for the write-offs). The desired balance, using the percentage- of-receivables basis, is a credit balance of $20,000 ($200,000 × 10%). In order to have an ending balance of $20,000, the required adjustment to Allowance for Doubtful Accounts is $32,000, not (a) $20,000, (b) $75,000, or (d) $30,000.

7. (d) The cash realizable value of the accounts receivable is Accounts Receivable ($800,000) less the expected ending balance in Allowance for Doubtful Accounts after adjustments ($65,000) = $735,000, not (a) $685,000, (b) $750,000, or (c) $800,000.

8. (c) There is no wait for payment. The retailer receives payment at the time the credit card is accepted from the cus- tomer. The other choices are true statements.

9. (a) The entry includes a credit to Sales Revenue for $50,000, a $48,000 debit to Cash, and a debit to Service Charge Expense for $2,000. The other choices are therefore incorrect.

10. (d) Writing off receivables will result in a company failing to collect any money. Instead, choices (a) offering discounts for early payment, (b) accepting national credit cards for customer purchases, and (c) selling receivables to a factor will all allow a company to accelerate its cash receipts.

11. (b) By crediting Allowance for Doubtful Accounts for $55,000, the new balance will be the required balance of $60,000. This adjusting entry debits Bad Debt Expense for $55,000 and credits Allowance for Doubtful Accounts for $55,000, not (a) $5,000, (c) $60,000, or (d) $65,000.

12. (d) By crediting Allowance for Doubtful Accounts for $65,000, the new balance will be the required balance of $60,000. This adjusting entry debits Bad Debt Expense for $65,000 and credits Allowance for Doubtful Accounts for $65,000, not (a) $5,000, (b) $55,000, or (c) $60,000.

13. (c) Promissory notes are negotiable instruments, meaning if sold, the seller can transfer to another party by endorse- ment. The other choices are true statements.

14. (b) On the date Michael accepts the note, Notes Receivable is debited for $1,000 and Accounts Receivable is credited for $1,000. Interest is accrued only with the passage of time. The other choices are therefore incorrect.

15. (d) When Schleis receives payment, it will increase cash, reduce the notes receivable account, and recognize interest earned for the term of the note. Interest = $10,000 × 9% × 120/360 5 $300. Total cash received = $10,000 + $300 = $10,300. The other choices are therefore incorrect.

16. (d) A longer payment period will increase the chances the customer will not pay. The other choices are incorrect as companies might require risky customers to (a) pay cash in advance, (b) provide letters of credit or bank guarantees, or (c) ask for references from banks and suppliers to determine their payment history.

17. (c) Accounts receivable turnover = Net credit sales ($800,000) ÷ Average net accounts receivable [($100,000 + $150,000)/2] = 6.4. The average collection period in days = (365 ÷ 6.4) 5 57 days. The other choices are therefore incorrect.

18. (c) Average collection period = Number of days in the year (365) ÷ Accounts receivable turnover (7) = 52 days, not (a) 2.555, (b) 30, or (d) 210.

Practice Exercises 403

1. The ledger of J.C. Cobb Company at the end of the current year shows Accounts Receiv- able $150,000, Sales Revenue $850,000, and Sales Returns and Allowances $30,000.

INSTRUCTIONS

(a) If J.C. Cobb uses the direct write-off method to account for uncollectible accounts, journalize the adjusting entry at December 31, assuming J.C. Cobb determines that M. Jack’s $1,500 balance is uncollectible.

(b) If Allowance for Doubtful Accounts has a credit balance of $2,400 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 10% of accounts receivable.

(c) If Allowance for Doubtful Accounts has a debit balance of $200 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 6% of accounts receivable.

Journalize entries to record allowance for doubtful accounts using two different bases.

(LO 2)

PRACTICE EXERCISES▼

SOLUTION

1. (a) Dec. 31 Bad Debt Expense 1,500 Accounts Receivable—M. Jack 1,500

(b) Dec. 31 Bad Debt Expense 12,600 Allowance for Doubtful Accounts [($150,000 × 10%) − $2,400] 12,600 (c) Dec. 31 Bad Debt Expense 9,200 Allowance for Doubtful Accounts [($150,000 × 6%) + $200] 9,200

SOLUTION

2. (a) 2017 Oct. 1 Notes Receivable 16,000 Cash 16,000 Dec. 11 Notes Receivable 6,750 Sales Revenue 6,750

2. Troope Supply Co. has the following transactions related to notes receivable during the last 3 months of 2017.

Oct. 1 Loaned $16,000 cash to Juan Vasquez on a 1-year, 10% note. Dec. 11 Sold goods to A. Palmer, Inc., receiving a $6,750, 90-day, 8% note. 16 Received a $6,400, 6-month, 9% note in exchange for J. Nicholas’s outstanding

accounts receivable. 31 Accrued interest revenue on all notes receivable.

INSTRUCTIONS

(a) Journalize the transactions for Troope Supply Co.

(b) Record the collection of the Vasquez note at its maturity in 2018.

Journalize entries for notes receivable transactions.

(LO 3)

404 8 Reporting and Analyzing Receivables

Dec. 16 Notes Receivable 6,400 Accounts Receivable—Nicholas 6,400

31 Interest Receivable 454 Interest Revenue* 454

*Calculation of interest revenue: Vasquez’s note: $16,000 × 10% × 3/12 = $400 Palmer’s note: 6,750 × 8% × 20/360 = 30 Nicholas’s note: 6,400 × 9% × 15/360 = 24

Total accrued interest $454

(b) 2018 Oct. 1 Cash 17,600 Interest Receivable 400 Interest Revenue** 1,200 Notes Receivable 16,000

**($16,000 × 10% × 9/12)

Presented here are selected transactions related to B. Dylan Corp.

Mar. 1 Sold $20,000 of merchandise to Potter Company, terms 2/10, n/30. 11 Received payment in full from Potter Company for balance due on existing

accounts receivable. 12 Accepted Juno Company’s $20,000, 6-month, 12% note for balance due on out-

standing account receivable. 13 Made B. Dylan Corp. credit card sales for $13,200. 15 Made Visa credit sales totaling $6,700. A 5% service fee is charged by Visa. Apr. 11 Sold accounts receivable of $8,000 to Harcot Factor. Harcot Factor assesses a

service charge of 2% of the amount of receivables sold. 13 Received collections of $8,200 on B. Dylan Corp. credit card sales. May 10 Wrote off as uncollectible $16,000 of accounts receivable. (B. Dylan Corp. uses

the percentage-of-receivables basis to estimate bad debts.) June 30 The balance in accounts receivable at the end of the fi rst 6 months is $200,000.

The company estimates that 10% of accounts receivable will become uncollect- ible. At June 30, the credit balance in the allowance account prior to adjustment is $3,500. Recorded bad debt expense.

July 16 One of the accounts receivable written off in May pays the amount due, $4,000, in full.

INSTRUCTIONS

Prepare the journal entries for the transactions. (Omit cost of goods sold entries.)

Prepare entries for various receivables transactions.

(LO 1, 2, 3)

PRACTICE PROBLEM▼

SOLUTION*

Mar. 1 Accounts Receivable—Potter Company 20,000 Sales Revenue 20,000 (To record sales on account)

11 Cash 19,600 Sales Discounts (2% × $20,000) 400 Accounts Receivable—Potter Company 20,000 (To record collection of accounts receivable)

12 Notes Receivable 20,000 Accounts Receivable—Juno Company 20,000 (To record acceptance of Juno Company note)

13 Accounts Receivable 13,200 Sales Revenue 13,200 (To record company credit card sales)

15 Cash 6,365 Service Charge Expense (5% × $6,700) 335 Sales Revenue 6,700 (To record credit card sales)

Apr. 11 Cash 7,840 Service Charge Expense (2% × $8,000) 160 Accounts Receivable 8,000 (To record sale of receivables to factor)

13 Cash 8,200 Accounts Receivable 8,200 (To record collection of accounts receivable)

May 10 Allowance for Doubtful Accounts 16,000 Accounts Receivable 16,000 (To record write-off of accounts receivable)

June 30 Bad Debt Expense 16,500 Allowance for Doubtful Accounts 16,500 [($200,000 × 10%) − $3,500] (To record estimate of uncollectible accounts)

July 16 Accounts Receivable 4,000 Allowance for Doubtful Accounts 4,000 (To reverse write-off of accounts receivable)

Cash 4,000 Accounts Receivable 4,000 (To record collection of accounts receivable)

*Cost of goods sold entries are omitted here as well as in homework material.

Questions 405

1. What is the difference between an account receivable and a note receivable?

2. What are some common types of receivables other than accounts receivable or notes receivable?

3. What are the essential features of the allowance method of accounting for bad debts?

4. Lance Morrow cannot understand why the cash real- izable value does not decrease when an uncollectible account is written off under the allowance method. Clarify this point for Lance.

5. Sarasota Company has a credit balance of $2,200 in Allowance for Doubtful Accounts before adjustment. The estimated uncollectibles under the percentage- of-receivables basis is $5,100. Prepare the adjusting entry.

6. What types of receivables does Apple report on its bal- ance sheet? Does it use the allowance method or the direct write-off method to account for uncollectibles?

7. How are bad debts accounted for under the direct write-off method? What are the disadvantages of this method?

8. Tawnya Dobbs, the vice president of sales for Tropical Pools and Spas, wants the company’s credit department to be less restrictive in granting credit. “How can we sell anything when you guys won’t ap- prove anybody?” she asks. Discuss the pros and cons of “easy credit.” What are the accounting implications?

9. JCPenney Company accepts both its own credit cards and national credit cards. What are the advantages of accepting both types of cards?

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

QUESTIONS▼

406 8 Reporting and Analyzing Receivables

10. An article in the Wall Street Journal in- dicated that companies are selling their receivables at a record rate. Why do companies sell their receiv- ables?

11. Calico Corners decides to sell $400,000 of its accounts receivable to Fast Cash Factors Inc. Fast Cash Factors assesses a service charge of 3% of the amount of re- ceivables sold. Prepare the journal entry that Calico Corners makes to record this sale.

12. Your roommate is uncertain about the advantages of a promissory note. Compare the advantages of a note receivable with those of an account receivable.

13. How may the maturity date of a promissory note be stated?

14. Compute the missing amounts for each of the follow- ing notes.

Annual Total Principal Interest Rate Time Interest

(a) 6% 60 days $ 270 $30,000 8% 3 years (d) $60,000 (b) 5 months $2,500 $50,000 11% (c) $2,750 15. Mendosa Company dishonors a note at maturity. What

are the options available to the lender?

16. General Motors Company has accounts receivable and notes receivable. How should the receivables be re- ported on the balance sheet?

17. What are the steps to good receivables management?

18. How might a company monitor the risk re- lated to its accounts receivable?

19. What is meant by a concentration of credit risk?

20. The president of Ericson Inc. proudly an- nounces her company’s improved liquidity since its current ratio has increased substantially from one year to the next. Does an increase in the current ratio always indicate improved liquidity? What other ratio or ratios might you review to determine whether or not the increase in the current ratio is an improvement in fi nancial health?

21. Since hiring a new sales director, Tilton Inc. has enjoyed a 50% increase in sales. The CEO has also noticed, however, that the company’s average collection period has increased from 17 days to 38 days. What might be the cause of this increase? What are the implications to management of this increase?

22. The Coca-Cola Company’s accounts re- ceivable turnover was 9.05 in 2014, and its average amount of net receivables during the period was $3,424 million. What is the amount of its net credit sales for the period? What is the average collection period in days?

23. Douglas Corp. has experienced tremendous sales growth this year, but it is always short of cash. What is one explanation for this occurrence?

24. How can the amount of collections from customers be determined?

BE8-1 Presented below are three receivables transactions. Indicate whether these re- ceivables are reported as accounts receivable, notes receivable, or other receivables on a balance sheet. (a) Advanced $10,000 to an employee. (b) Received a promissory note of $34,000 for services performed. (c) Sold merchandise on account for $60,000 to a customer.

BE8-2 Record the following transactions on the books of Jarvis Co. (Omit cost of goods sold entries.) (a) On July 1, Jarvis Co. sold merchandise on account to Stacey Inc. for $23,000, terms

2/10, n/30. (b) On July 8, Stacey Inc. returned merchandise worth $2,400 to Jarvis Co. (c) On July 11, Stacey Inc. paid for the merchandise.

BE8-3 At the end of 2016, Safer Co. has accounts receivable of $700,000 and an allowance for doubtful accounts of $25,000. On January 24, 2017, it is learned that the company’s receivable from Madonna Inc. is not collectible and therefore management authorizes a write-off of $4,300. (a) Prepare the journal entry to record the write-off. (b) What is the cash realizable value of the accounts receivable (1) before the write-off

and (2) after the write-off?

BE8-4 Assume the same information as BE8-3 and that on March 4, 2017, Safer Co. receives payment of $4,300 in full from Madonna Inc. Prepare the journal entries to record this transaction.

Identify different types of receivables.

(LO 1), C

Record basic accounts receivable transactions.

(LO 1), AP

Prepare entry for write-off, and determine cash realizable value.

(LO 2), AP

Prepare entries for collection of bad debt write-off.

(LO 2), AP

BRIEF EXERCISES▼

DO IT! Exercises 407

BE8-5 Byrd Co. uses the percentage-of-receivables basis to record bad debt expense and concludes that 2% of accounts receivable will become uncollectible. Accounts receivable are $400,000 at the end of the year, and the allowance for doubtful accounts has a credit balance of $2,800. (a) Prepare the adjusting journal entry to record bad debt expense for the year. (b) If the allowance for doubtful accounts had a debit balance of $900 instead of a credit

balance of $2,800, prepare the adjusting journal entry for bad debt expense.

BE8-6 Consider these transactions: (a) Tastee Restaurant accepted a Visa card in payment of a $200 lunch bill. The bank

charges a 3% fee. What entry should Tastee make? (b) Martin Company sold its accounts receivable of $65,000. What entry should Martin

make, given a service charge of 3% on the amount of receivables sold?

BE8-7 Compute interest and find the maturity date for the following notes.

Date of Interest Note Principal Rate (%) Terms

(a) June 10 $80,000 6% 60 days (b) July 14 $50,000 7% 90 days (c) April 27 $12,000 8% 75 days

BE8-8 Presented below are data on three promissory notes. Determine the missing amounts.

Date of Maturity Annual Total Note Terms Date Principal Interest Rate Interest

(a) April 1 60 days ? $600,000 9% ? (b) July 2 30 days ? 90,000 ? $600 (c) March 7 6 months ? 120,000 10% ?

BE8-9 On January 10, 2017, Masterson Co. sold merchandise on account to Tompkins for $8,000, terms n/30. On February 9, Tompkins gave Masterson Co. a 7% promissory note in settlement of this account. Prepare the journal entry to record the sale and the settlement of the accounts receivable. (Omit cost of goods sold entries.)

BE8-10 During its first year of operations, Fertig Company had credit sales of $3,000,000, of which $400,000 remained uncollected at year-end. The credit manager estimates that $18,000 of these receivables will become uncollectible. (a) Prepare the journal entry to record the estimated uncollectibles. (Assume an unad-

justed balance of zero in Allowance for Doubtful Accounts.) (b) Prepare the current assets section of the balance sheet for Fertig Company, assuming

that in addition to the receivables it has cash of $90,000, merchandise inventory of $180,000, and supplies of $13,000.

(c) Calculate the accounts receivable turnover and average collection period. Assume that average net accounts receivable were $300,000. Explain what these measures tell us.

BE8-11 Suppose the 2017 financial statements of 3M Company report net sales of $23.1 billion. Accounts receivable (net) are $3.2 billion at the beginning of the year and $3.25 billion at the end of the year. Compute 3M’s accounts receivable turnover. Compute 3M’s average collection period for accounts receivable in days.

BE8-12 Kennewick Corp. had a beginning balance in accounts receivable of $70,000 and an ending balance of $91,000. Credit sales during the period were $598,000. Determine cash collections.

Prepare entry using percentage- of-receivables method.

(LO 2), AP

Prepare entries for credit card sale and sale of accounts receivable.

(LO 2), AP

Compute interest and determine maturity dates on notes.

(LO 3), AP

Determine maturity dates and compute interest and rates on notes.

(LO 3), AP

Prepare entry for note receivable exchanged for accounts receivable.

(LO 3), AP

Prepare entry for estimated uncollectibles and classifi cations, and compute ratios.

(LO 2, 4), AP

Analyze accounts receivable.

(LO 4), AP

Determine cash collections.

(LO 4), AP

On March 1, Lincoln sold merchandise on account to Amelia Company for $28,000, terms 1/10, net 45. On March 6, Amelia returns merchandise with a sales price of $1,000. On March 11, Lincoln receives payment from Amelia for the balance due. Prepare journal entries to record the March transactions on Lincoln’s books. (You may ignore cost of goods sold entries and explanations.)

DO IT! 8-1 Prepare entries to recognize accounts receivable.

(LO 1), AP

EXERCISES▼DO IT!

Mantle Company has been in business several years. At the end of the current year, the unadjusted trial balance shows:

Accounts Receivable $ 310,000 Dr. Sales Revenue 2,200,000 Cr. Allowance for Doubtful Accounts 5,700 Cr.

Bad debts are estimated to be 7% of receivables. Prepare the entry to adjust Allowance for Doubtful Accounts.

Neumann Distributors is a growing company whose ability to raise capital has not been growing as quickly as its expanding assets and sales. Neumann’s local banker has indicated that the company cannot increase its borrowing for the foreseeable future. Neumann’s suppliers are demanding payment for goods acquired within 30 days of the in- voice date, but Neumann’s customers are slow in paying for their purchases (60–90 days). As a result, Neumann has a cash fl ow problem. Neumann needs $160,000 to cover next Friday’s payroll. Its balance of outstand- ing accounts receivable totals $800,000. To alleviate this cash crunch, the company sells $170,000 of its receivables. Record the entry that Neumann would make. (Assume a 2% service charge.)

Buffet Wholesalers accepts from Gates Stores a $6,200, 4-month, 9% note dated May 31 in settlement of Gates’ overdue account. The maturity date of the note is September 30. What entry does Buffet make at the maturity date, assuming Gates pays the note and interest in full at that time?

In 2017, Bismark Company has net credit sales of $1,600,000 for the year. It had a beginning accounts receivable (net) balance of $108,000 and an ending accounts receivable (net) balance of $120,000. Compute Bismark Company’s (a) accounts receivable turnover and (b) average collection period in days.

DO IT! 8-2aPrepare entry for uncollectible accounts.

(LO 2), AP

DO IT! 8-2bPrepare entry for factored accounts.

(LO 2), AP

DO IT! 8-3Prepare entries for notes receivable.

(LO 3), AP

DO IT! 8-4Compute ratios for receivables.

(LO 4), AP

408 8 Reporting and Analyzing Receivables

E8-1 On January 6, Jacob Co. sells merchandise on account to Harley Inc. for $9,200, terms 1/10, n/30. On January 16, Harley pays the amount due.

Instructions Prepare the entries on Jacob Co.’s books to record the sale and related collection. (Omit cost of goods sold entries.)

E8-2 On January 10, Molly Amise uses her Lawton Co. credit card to purchase merchan- dise from Lawton Co. for $1,700. On February 10, Molly is billed for the amount due of $1,700. On February 12, Molly pays $1,100 on the balance due. On March 10, Molly is billed for the amount due, including interest at 1% per month on the unpaid balance as of February 12.

Instructions Prepare the entries on Lawton Co.’s books related to the transactions that occurred on January 10, February 12, and March 10. (Omit cost of goods sold entries.)

E8-3 At the beginning of the current period, Rose Corp. had balances in Accounts Receiv- able of $200,000 and in Allowance for Doubtful Accounts of $9,000 (credit). During the period, it had net credit sales of $800,000 and collections of $763,000. It wrote off as uncol- lectible accounts receivable of $7,300. However, a $3,100 account previously written off as uncollectible was recovered before the end of the current period. Uncollectible accounts are estimated to total $25,000 at the end of the period. (Omit cost of goods sold entries.)

Instructions (a) Prepare the entries to record sales and collections during the period. (b) Prepare the entry to record the write-off of uncollectible accounts during the period. (c) Prepare the entries to record the recovery of the uncollectible account during the period. (d) Prepare the entry to record bad debt expense for the period. (e) Determine the ending balances in Accounts Receivable and Allowance for Doubtful

Accounts. (f) What is the net realizable value of the receivables at the end of the period?

Prepare entries for recognizing accounts receivable.

(LO 1), AP

Prepare entries for recognizing accounts receivable.

(LO 1), AP

Journalize receivables transactions.

(LO 1, 2), AP

EXERCISES▼

Exercises 409

E8-4 The ledger of Macarty Company at the end of the current year shows Accounts Receivable $78,000, Credit Sales $810,000, and Sales Returns and Allowances $40,000.

Instructions (a) If Macarty uses the direct write-off method to account for uncollectible accounts,

journalize the adjusting entry at December 31, assuming Macarty determines that Matisse’s $900 balance is uncollectible.

(b) If Allowance for Doubtful Accounts has a credit balance of $1,100 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 10% of accounts receivable.

(c) If Allowance for Doubtful Accounts has a debit balance of $500 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 8% of accounts receivable.

E8-5 Godfreid Company has accounts receivable of $95,400 at March 31, 2017. Credit terms are 2/10, n/30. At March 31, 2017, there is a $2,100 credit balance in Allowance for Doubtful Accounts prior to adjustment. The company uses the percentage-of-receivables basis for estimating uncollectible accounts. The company’s estimates of bad debts are as shown below.

Balance, March 31 Estimated Percentage Age of Accounts 2017 2016 Uncollectible

Current $65,000 $75,000 2% 1–30 days past due 12,900 8,000 5 31–90 days past due 10,100 2,400 30 Over 90 days past due 7,400 1,100 50

$95,400 $86,500

Instructions (a) Determine the total estimated uncollectibles. (b) Prepare the adjusting entry at March 31, 2017, to record bad debt expense. (c) Discuss the implications of the changes in the aging schedule from 2016 to 2017.

E8-6 On December 31, 2016, when its Allowance for Doubtful Accounts had a debit balance of $1,400, Dallas Co. estimates that 9% of its accounts receivable balance of $90,000 will become uncollectible and records the necessary adjustment to Allowance for Doubtful Accounts. On May 11, 2017, Dallas Co. determined that B. Jared’s account was uncollectible and wrote off $1,200. On June 12, 2017, Jared paid the amount previously written off.

Instructions Prepare the journal entries on December 31, 2016, May 11, 2017, and June 12, 2017.

E8-7 On March 3, Plume Appliances sells $710,000 of its receivables to Western Factors Inc. Western Factors Inc. assesses a service charge of 4% of the amount of receivables sold.

Instructions Prepare the entry on Plume Appliances’ books to record the sale of the receivables.

E8-8 On May 10, Keene Company sold merchandise for $4,000 and accepted the customer’s Best Business Bank MasterCard. At the end of the day, the Best Business Bank MasterCard receipts were deposited in the company’s bank account. Best Business Bank charges a 3.8% service charge for credit card sales.

Instructions Prepare the entry on Keene Company’s books to record the sale of merchandise.

E8-9 On July 4, Mazie’s Restaurant accepts a Visa card for a $250 dinner bill. Visa charges a 4% service fee.

Instructions Prepare the entry on Mazie’s books related to the transaction.

Prepare entries to record allowance for doubtful accounts.

(LO 2), AP

Determine bad debt expense, and prepare the adjusting entry.

(LO 2), AP

Prepare entry for estimated uncollectibles, write-off, and recovery.

(LO 2), AP

Prepare entry for sale of accounts receivable.

(LO 2), AP

Prepare entry for credit card sale.

(LO 2), AP

Prepare entry for credit card sale.

(LO 2), AP

410 8 Reporting and Analyzing Receivables

E8-10 Moses Supply Co. has the following transactions related to notes receivable during the last 2 months of the year. The company does not make entries to accrue interest except at December 31.

Nov. 1 Loaned $60,000 cash to C. Bohr on a 12-month, 7% note. Dec. 11 Sold goods to K. R. Pine, Inc., receiving a $3,600, 90-day, 8% note. 16 Received a $12,000, 180-day, 9% note to settle an open account from

A. Murdock. 31 Accrued interest revenue on all notes receivable.

Instructions Journalize the transactions for Moses Supply Co. (Omit cost of goods sold entries.)

E8-11 These transactions took place for Bramson Co.

2016 May 1 Received a $5,000, 12-month, 6% note in exchange for an outstanding

account receivable from R. Stoney. Dec. 31 Accrued interest revenue on the R. Stoney note.

2017 May 1 Received principal plus interest on the R. Stoney note. (No interest has

been accrued since December 31, 2016.)

Instructions Record the transactions in the general journal. The company does not make entries to accrue interest except at December 31.

E8-12 Eileen Corp. had the following balances in receivable accounts at October 31, 2017 (in thousands): Allowance for Doubtful Accounts $52, Accounts Receivable $2,910, Other Receivables $189, and Notes Receivable $1,353.

Instructions Prepare the balance sheet presentation of Eileen Corp.’s receivables in good form.

E8-13 The following is a list of activities that companies perform in relation to their receivables. 1. Selling receivables to a factor. 2. Reviewing company ratings in The Dun and Bradstreet Reference Book of American

Business. 3. Collecting information on competitors’ payment period policies. 4. Preparing monthly accounts receivable aging schedule and investigating problem

accounts. 5. Calculating the accounts receivable turnover and average collection period.

Instructions Match each of the activities listed above with a purpose of the activity listed below. (a) Determine to whom to extend credit. (b) Establish a payment period. (c) Monitor collections. (d) Evaluate the liquidity of receivables. (e) Accelerate cash receipts from receivable when necessary.

E8-14 Suppose the following information was taken from the 2017 financial statements of FedEx Corporation, a major global transportation/delivery company.

(in millions) 2017 2016

Accounts receivable (gross) $ 3,587 $ 4,517 Accounts receivable (net) 3,391 4,359 Allowance for doubtful accounts 196 158 Sales revenue 35,497 37,953 Total current assets 7,116 7,244

Instructions Answer each of the following questions. (a) Calculate the accounts receivable turnover and the average collection period for 2017

for FedEx.

Prepare entries for notes receivable transactions.

(LO 3), AP

Journalize notes receivable transactions.

(LO 3), AP

Prepare a balance sheet presentation of receivables.

(LO 4), AP

Identify the principles of receivables management.

(LO 4), K

Compute ratios to evaluate a company’s receivables balance.

(LO 4), AN

Problems: Set A 411

(b) Is accounts receivable a material component of the company’s total current assets? (c) Evaluate the balance in FedEx’s allowance for doubtful accounts.

E8-15 The following ratios are available for Ming Inc.

2017 2016

Current ratio 1.3:1 1.5:1 Accounts receivable turnover 12 times 10 times Inventory turnover 11 times 9 times

Instructions (a) Is Ming’s short-term liquidity improving or deteriorating in 2017? Be specifi c in your

answer, referring to relevant ratios. (b) Do changes in turnover ratios affect profi tability? Explain. (c) Identify any steps Ming might have taken, or might wish to take, to improve its man-

agement of its accounts receivable and inventory turnovers.

E8-16 In a recent annual report, Office Depot, Inc. notes that the company entered into an agreement to sell all of its credit card program receivables to financial service companies.

Instructions Explain why Office Depot, a financially stable company with positive cash flow, would choose to sell its receivables.

E8-17 Bailey Corp. significantly reduced its requirements for credit sales. As a result, sales during the current year increased dramatically. It had receivables at the beginning of the year of $38,000 and ending receivables of $191,000. Credit sales were $380,000.

Instructions (a) Determine cash collections during the period. (b) Discuss how your fi ndings in part (a) would affect Bailey Corp.’s quality of earnings

ratio. (Do not compute.) (c) What concerns might you have regarding Bailey’s accounting?

Evaluate liquidity.

(LO 4), AN

Identify reason for sale of receivables.

(LO 4), C

Determine cash fl ows and evaluate quality of earnings.

(LO 4), AN

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P8-1A Rianna.com uses the allowance method of accounting for bad debts. The company produced the following aging of the accounts receivable at year-end.

Journalize transactions related to bad debts.

(LO 2), AP

PROBLEMS: SET A▼

Number of Days Outstanding

Total 0–30 31–60 61–90 91–120 Over 120

Accounts receivable $377,000 $222,000 $90,000 $38,000 $15,000 $12,000

% uncollectible 1% 4% 5% 8% 10%

Estimated bad debts

Instructions (a) Calculate the total estimated bad debts based on the above information. (b) Prepare the year-end adjusting journal entry to record the bad debts using the aged

uncollectible accounts receivable determined in (a). Assume the unadjusted balance in Allowance for Doubtful Accounts is a $4,000 debit.

(c) Of the above accounts, $5,000 is determined to be specifi cally uncollectible. Prepare the journal entry to write off the uncollectible account.

(a) Tot. est. bad debts $10,120

412 8 Reporting and Analyzing Receivables

(d) The company collects $5,000 subsequently on a specifi c account that had previously been determined to be uncollectible in (c). Prepare the journal entry(ies) necessary to restore the account and record the cash collection.

(e) Comment on how your answers to (a)–(d) would change if Rianna.com used 3% of total accounts receivable, rather than aging the accounts receivable. What are the advantages to the company of aging the accounts receivable rather than applying a percentage to total accounts receivable?

P8-2A At December 31, 2016, Suisse Imports reported this information on its balance sheet.

Accounts receivable $600,000 Less: Allowance for doubtful accounts 37,000

During 2017, the company had the following transactions related to receivables.

1. Sales on account $2,500,000 2. Sales returns and allowances 50,000 3. Collections of accounts receivable 2,200,000 4. Write-offs of accounts receivable deemed uncollectible 41,000 5. Recovery of bad debts previously written off as uncollectible 15,000

Instructions (a) Prepare the journal entries to record each of these fi ve transactions. Assume that no

cash discounts were taken on the collections of accounts receivable. (Omit cost of goods sold entries.)

(b) Enter the January 1, 2017, balances in Accounts Receivable and Allowance for Doubt- ful Accounts, post the entries to the two accounts (use T-accounts), and determine the balances.

(c) Prepare the journal entry to record bad debt expense for 2017, assuming that aging the accounts receivable indicates that estimated bad debts are $46,000.

(d) Compute the accounts receivable turnover and average collection period.

P8-3A Presented below is an aging schedule for Bryan Company.

Prepare journal entries related to bad debt expense, and compute ratios.

(LO 2, 4), AP

(b) A/R bal. $809,000

Journalize transactions related to bad debts.

(LO 2), AP

At December 31, 2016, the unadjusted balance in Allowance for Doubtful Accounts is a credit of $8,000.

Instructions (a) Journalize and post the adjusting entry for bad debts at December 31, 2016. (Use

T-accounts.) (b) Journalize and post to the allowance account these 2017 events and transactions:

1. March 1, a $600 customer balance originating in 2016 is judged uncollectible. 2. May 1, a check for $600 is received from the customer whose account was written

off as uncollectible on March 1.

Not Yet Number of Days Past Due

Customer Total Due 1–30 31–60 61–90 Over 90

Aneesh $ 24,000 $ 9,000 $15,000 Bird 30,000 $ 30,000 Cope 50,000 5,000 5,000 $40,000 DeSpears 38,000 $38,000 Others 120,000 72,000 35,000 13,000

$262,000 $107,000 $49,000 $28,000 $40,000 $38,000

Estimated percentage uncollectible 3% 7% 12% 24% 60%

Total estimated bad debts $ 42,400 $ 3,210 $ 3,430 $ 3,360 $ 9,600 $22,800

Problems: Set A 413

(c) Journalize the adjusting entry for bad debts at December 31, 2017, assuming that the unadjusted balance in Allowance for Doubtful Accounts is a debit of $1,400 and the aging schedule indicates that total estimated bad debts will be $36,700.

P8-4A Here is information related to Morgane Company for 2017.

Total credit sales $1,500,000 Accounts receivable at December 31 840,000 Bad debts written off 37,000

Instructions (a) What amount of bad debt expense will Morgane Company report if it uses the direct

write-off method of accounting for bad debts? (b) Assume that Morgane Company decides to estimate its bad debt expense based on 4%

of accounts receivable. What amount of bad debt expense will the company record if Allowance for Doubtful Accounts has a credit balance of $3,000?

(c) Assume the same facts as in part (b), except that there is a $1,000 debit balance in Allowance for Doubtful Accounts. What amount of bad debt expense will Morgane record?

(d) What is a weakness of the direct write-off method of reporting bad debt expense?

P8-5A At December 31, 2017, the trial balance of Malone Company contained the follow- ing amounts before adjustment.

Debit Credit

Accounts Receivable $180,000 Allowance for Doubtful Accounts $ 1,500 Sales Revenue 875,000

Instructions (a) Prepare the adjusting entry at December 31, 2017, to record bad debt expense, assum-

ing that the aging schedule indicates that $10,200 of accounts receivable will be uncol- lectible.

(b) Repeat part (a), assuming that instead of a credit balance there is a $1,500 debit bal- ance in Allowance for Doubtful Accounts.

(c) During the next month, January 2018, a $2,100 account receivable is written off as uncollectible. Prepare the journal entry to record the write-off.

(d) Repeat part (c), assuming that Malone Company uses the direct write-off method instead of the allowance method in accounting for uncollectible accounts receivable.

(e) What are the advantages of using the allowance method in accounting for uncollectible accounts as compared to the direct write-off method?

P8-6A On January 1, 2017, Harvee Company had Accounts Receivable of $54,200 and Al- lowance for Doubtful Accounts of $3,700. Harvee Company prepares fi nancial statements annually. During the year, the following selected transactions occurred.

Jan. 5 Sold $4,000 of merchandise to Rian Company, terms n/30. Feb. 2 Accepted a $4,000, 4-month, 9% promissory note from Rian Company for

balance due. 12 Sold $12,000 of merchandise to Cato Company and accepted Cato’s $12,000,

2-month, 10% note for the balance due. 26 Sold $5,200 of merchandise to Malcolm Co., terms n/10. Apr. 5 Accepted a $5,200, 3-month, 8% note from Malcolm Co. for balance due. 12 Collected Cato Company note in full. June 2 Collected Rian Company note in full. 15 Sold $2,000 of merchandise to Gerri Inc. and accepted a $2,000, 6-month,

12% note for the amount due.

Instructions Journalize the transactions. (Omit cost of goods sold entries.)

Compute bad debt amounts.

(LO 2), AP

Journalize entries to record transactions related to bad debts.

(LO 2), AP

Journalize various receivables transactions.

(LO 1, 3), AP

414 8 Reporting and Analyzing Receivables

P8-7A The president of Mossy Enterprises asks if you could indicate the impact certain transactions have on the following ratios.

Accounts Average Current Receivable Collection Ratio Turnover Period Transaction (2:1) (103) (36.5 days)

1. Received $5,000 on cash sale. The cost of the goods sold was $2,600.

2. Recorded bad debt expense of $500 using allowance method.

3. Wrote off a $100 account receivable as uncollectible (Uses allowance method.)

4. Recorded $2,500 sales on account. The cost of the goods sold was $1,500.

Instructions Complete the table, indicating whether each transaction will increase (I), decrease (D), or have no effect (NE) on the specific ratios provided for Mossy Enterprises.

P8-8A Milton Company closes its books on its July 31 year-end. The company does not make entries to accrue for interest except at its year-end. On June 30, the Notes Receivable account balance is $23,800. Notes Receivable include the following.

Date Maker Face Value Term Maturity Date Interest Rate

April 21 Coote Inc. $ 6,000 90 days July 20 8% May 25 Brady Co. 7,800 60 days July 24 10% June 30 BMG Corp. 10,000 6 months December 31 6%

During July, the following transactions were completed.

July 5 Made sales of $4,500 on Milton credit cards. 14 Made sales of $600 on Visa credit cards. The credit card service charge is 3%. 20 Received payment in full from Coote Inc. on the amount due. 24 Received payment in full from Brady Co. on the amount due.

Instructions (a) Journalize the July transactions and the July 31 adjusting entry for accrued interest

receivable. (Interest is computed using 360 days; omit cost of goods sold entries.) (b) Enter the balances at July 1 in the receivable accounts and post the entries to all of the

receivable accounts. (Use T-accounts.) (c) Show the balance sheet presentation of the receivable accounts at July 31.

P8-9A Suppose the amounts presented here are basic fi nancial information (in millions) from the 2017 annual reports of Nike and adidas.

Nike adidas

Sales revenue $19,176.1 $10,381 Allowance for doubtful accounts, beginning 78.4 119 Allowance for doubtful accounts, ending 110.8 124 Accounts receivable balance (gross), beginning 2,873.7 1,743 Accounts receivable balance (gross), ending 2,994.7 1,553

Instructions Calculate the accounts receivable turnover and average collection period for both com- panies. Comment on the difference in their collection experiences.

Explain the impact of transactions on ratios.

(LO 4), C

Prepare entries for various credit card and notes receivable transactions.

(LO 2, 3, 4), AP

(b) A/R bal. $ 4,500

Calculate and interpret various ratios.

(LO 4), AN

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

Comprehensive Accounting Cycle Review 415

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 7.)

CC8 One of Natalie’s friends, Curtis Lesperance, runs a coffee shop where he sells spe- cialty coffees and prepares and sells muffi ns and cookies. He is eager to buy one of Natalie’s fi ne European mixers, which would enable him to make larger batches of muffi ns and cookies. However, Curtis cannot afford to pay for the mixer for at least 30 days. He asks Natalie if she would be willing to sell him the mixer on credit. Natalie comes to you for advice.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to see the com- pletion of this problem.

CONTINUING PROBLEM Cookie Creations▼

COMPREHENSIVE ACCOUNTING CYCLE REVIEW ACR8 Hudson Corporation’s balance sheet at December 31, 2016, is presented below.

HUDSON CORPORATION Balance Sheet

December 31, 2016

Cash $13,100 Accounts payable $ 8,750 Accounts receivable 19,780 Common stock 20,000 Allowance for doubtful accounts (800) Retained earnings 12,730 Inventory 9,400

$41,480 $41,480

During January 2017, the following transactions occurred. Hudson uses the perpetual inventory method.

Jan. 1 Hudson accepted a 4-month, 8% note from Betheny Company in payment of Betheny’s $1,200 account.

3 Hudson wrote off as uncollectible the accounts of Walter Corporation ($450) and Drake Company ($280).

8 Hudson purchased $17,200 of inventory on account. 11 Hudson sold for $25,000 on account inventory that cost $17,500. 15 Hudson sold inventory that cost $700 to Jack Rice for $1,000. Rice charged this

amount on his Visa First Bank card. The service fee charged Hudson by First Bank is 3%.

17 Hudson collected $22,900 from customers on account. 21 Hudson paid $16,300 on accounts payable. 24 Hudson received payment in full ($280) from Drake Company on the account

written off on January 3. 27 Hudson purchased advertising supplies for $1,400 cash. 31 Hudson paid other operating expenses, $3,218.

Adjustment data:

1. Interest is recorded for the month on the note from January 1. 2. Bad debts are expected to be 6% of the January 31, 2017, accounts receivable. 3. A count of advertising supplies on January 31, 2017, reveals that $560 remains unused. 4. The income tax rate is 30%. (Hint: Prepare the income statement up to “Income before

taxes” and multiply by 30% to compute the amount; round to whole dollars.)

Instructions (You may want to set up T-accounts to determine ending balances.)

(a) Prepare journal entries for the transactions listed above and adjusting entries. (Include entries for cost of goods sold using the perpetual inventory system.)

(b) Prepare an adjusted trial balance at January 31, 2017. (c) Prepare an income statement and a retained earnings statement for the month ending

January 31, 2017, and a classifi ed balance sheet as of January 31, 2017.

416 8 Reporting and Analyzing Receivables

(in millions) 2017 2016

Accounts receivable $ 270.4 $ 259.7 Allowance for uncollectible accounts 10.6 11.4 Sales revenue 2,981.8 2,871.8 Total current assets 1,044.9 999.3

Note 19. Concentrations of Credit Risk

Financial instruments which potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable. The Company sells its con- sumer products to a wide variety of retailers, including mass merchandisers, home centers, independent hardware stores, nurseries, garden outlets, warehouse clubs, food and drug stores and local and regional chains. Professional products are sold to

THE SCOTTS COMPANY Notes to the Financial Statements

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT8-1 Refer to the fi nancial statements of Apple Inc. in Appendix A.

Instructions (a) Calculate the accounts receivable turnover and average collection period for 2014.

(Assume all sales were credit sales.) (b) Did Apple have any potentially signifi cant credit risks in 2014? (c) What conclusions can you draw from the information in parts (a) and (b)?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT8-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information contained in these fi nancial statements, compute the follow-

ing 2014 values for each company. (1) Accounts receivable turnover. (For VF, use “Net sales.” Assume all sales were credit

sales.) (2) Average collection period for accounts receivable. (b) What conclusions concerning the management of accounts receivable can be drawn

from these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT8-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Finan- cial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information contained in these fi nancial statements, compute the follow-

ing values for each company for the most recent fi scal year. (1) Accounts receivable turnover. (For Amazon.com, use “Net product sales.” Assume

all sales were credit sales.) (2) Average collection period for accounts receivable. (b) What conclusions concerning the management of accounts receivable can be drawn

from these data?

INTERPRETING FINANCIAL STATEMENTS

CT8-4 Suppose the information below is from the 2017 fi nancial statements and ac- companying notes of The Scotts Company, a major manufacturer of lawn-care products.

Financial Reporting

▼

Financial Analysis

▼

Financial Analysis

▼

Financial Analysis

▼

Instructions Answer each of the following questions.

(a) Calculate the accounts receivable turnover and average collection period for 2017 for the company.

(b) Is accounts receivable a material component of the company’s total 2017 current assets?

(d) Evaluate the credit risk of Scotts’ 2017 concentrated receivables. (e) Comment on the informational value of Scotts’ Note 19 on concentrations of credit

risk.

REAL-WORLD FOCUS

CT8-5 Purpose: To learn more about factoring from websites that provide factoring services.

Address: www.ccapital.net, or go to www.wiley.com/college/kimmel

Instructions Go to the website, click on Invoice Factoring, and answer the following questions.

(a) What are some of the benefi ts of factoring? (b) What is the range of the percentages of the typical discount rate? (c) If a company factors its receivables, what percentage of the value of the receivables

can it expect to receive from the factor in the form of cash, and how quickly will it receive the cash?

CT8-6 The August 31, 2009, issue of the Wall Street Journal includes an article by Serena Ng and Cari Tuna entitled “Big Firms Are Quick to Collect, Slow to Pay.”

Instructions Read the article and answer the following questions.

Expand Your Critical Thinking 417

commercial nurseries, greenhouses, landscape services and growers of specialty agri- culture crops. Concentrations of accounts receivable at September 30, net of accounts receivable pledged under the terms of the New MARP Agreement whereby the pur- chaser has assumed the risk associated with the debtor’s fi nancial inability to pay ($146.6 million and $149.5 million for 2017 and 2016, respectively), were as follows.

2017 2016

Due from customers geographically located in North America 53% 52% Applicable to the consumer business 61% 54% Applicable to Scotts LawnService®, the professional businesses (primarily distributors), Smith & Hawken® and Morning Song® 39% 46% Top 3 customers within consumer business as a percent of total consumer accounts receivable 0% 0%

The remainder of the Company’s accounts receivable at September 30, 2017 and 2016, were generated from customers located outside of North America, primary retailers, distributors, nurseries and growers in Europe. No concentrations of custom- ers of individual customers within this group account for more than 10% of the Com- pany’s accounts receivable at either balance sheet date. The Company’s three largest customers are reported within the Global Consumer segment, and are the only customers that individually represent more than 10% of reported consolidated net sales for each of the last three fi scal years. These three cus- tomers accounted for the following percentages of consolidated net sales for the fi scal years ended September 30:

Largest 2nd Largest 3rd Largest Customer Customer Customer

2017 21.0% 13.5% 13.4% 2016 20.2% 10.9% 10.2% 2015 21.5% 11.2% 10.5%

(a) How many days did InBev tell its suppliers that it was going to take to pay? How many days did it take previously?

(b) What steps did General Electric take to free up cash? How much cash did it free up?

(c) On average, how many days did companies with more than $5 billion take to pay sup- pliers, and how many days did they take to collect from their customers? How did this compare to companies with less than $500 million in sales?

(d) Are there any risks involved with being too tough in negotiating delayed payment terms with suppliers?

DECISION-MAKING ACROSS THE ORGANIZATION

CT8-7 Emilio and René Santos own Club Fandango. From its inception, Club Fandango has sold merchandise on either a cash or credit basis, but no credit cards have been ac- cepted. During the past several months, the Santos have begun to question their credit- sales policies. First, they have lost some sales because of their refusal to accept credit cards. Second, representatives of two metropolitan banks have convinced them to accept their national credit cards. One bank, Business National Bank, has stated that (1) its credit card fee is 4% and (2) it pays the retailer 96 cents on each $1 of sales within 3 days of re- ceiving the credit card billings. The Santos decide that they should determine the cost of carrying their own credit sales. From the accounting records of the past 3 years, they accumulate these data:

2017 2016 2015

Net credit sales $500,000 $600,000 $400,000 Collection agency fees for slow-paying customers 2,900 2,600 1,600 Salary of part-time accounts receivable clerk 4,400 4,400 4,400

Credit and collection expenses as a percentage of net credit sales are as follows: uncol- lectible accounts 1.6%, billing and mailing costs .5%, and credit investigation fee on new customers .2%. Emilio and René also determine that the average accounts receivable balance out- standing during the year is 5% of net credit sales. The Santos estimate that they could earn an average of 10% annually on cash invested in other business opportunities.

Instructions With the class divided into groups, answer the following.

(a) Prepare a tabulation for each year showing total credit and collection expenses in dollars and as a percentage of net credit sales.

(b) Determine the net credit and collection expenses in dollars and as a percentage of sales after considering the revenue not earned from other investment opportunities. (Note: The income lost on the cash held by the bank for 3 days is considered to be immaterial.)

COMMUNICATION ACTIVITY

CT8-8 Chien Corporation is a recently formed business selling the “World’s Best Doormat.” The corporation is selling doormats faster than Chien can make them. It has been sell- ing the product on a credit basis, telling customers to “pay when they can.” Oddly, even though sales are tremendous, the company is having trouble paying its bills.

Instructions Write a memo to the president of Chien Corporation discussing these questions:

(a) What steps should be taken to improve the company’s ability to pay its bills? (b) What accounting steps should be taken to measure its success in improving collections

and in recording its collection success? (c) If the corporation is still unable to pay its bills, what additional steps can be taken with

its receivables to ease its liquidity problems?

ETHICS CASE

CT8-9 As its year-end approaches, it appears that Mendez Corporation’s net income will increase 10% this year. The president of Mendez Corporation, nervous that the

Financial Analysis

Writing

Group Project

▼

418 8 Reporting and Analyzing Receivables

stockholders might expect the company to sustain this 10% growth rate in net income in future years, suggests that the controller increase the allowance for doubtful accounts to 4% of receivables in order to lower this year’s net income. The president thinks that the lower net income, which refl ects a 6% growth rate, will be a more sustainable rate of growth for Mendez Corporation in future years. The controller of Mendez Corpora- tion believes that the company’s yearly allowance for doubtful accounts should be 2% of receivables.

Instructions (a) Who are the stakeholders in this case? (b) Does the president’s request pose an ethical dilemma for the controller? (c) Should the controller be concerned with Mendez Corporation’s growth rate in estimat-

ing the allowance? Explain your answer.

ALL ABOUT YOU

CT8-10 Credit card usage in the United States is substantial. Many startup companies use credit cards as a way to help meet short-term fi nancial needs. The most common forms of debt for startups are use of credit cards and loans from relatives. Suppose that you start up Fantastic Sandwich Shop. You invested your savings of $20,000 and borrowed $70,000 from your relatives. Although sales in the fi rst few months are good, you see that you may not have suffi cient cash to pay expenses and maintain your inventory at acceptable levels, at least in the short term. You decide you may need to use one or more credit cards to fund the possible cash shortfall.

Instructions (a) Go to the Internet and fi nd two sources that provide insight into how to compare

credit card terms. (b) Develop a list, in descending order of importance, as to what features are most impor-

tant to you in selecting a credit card for your business. (c) Examine the features of your present credit card. (If you do not have a credit card,

select a likely one online for this exercise.) Given your analysis above, what are the three major disadvantages of your present credit card?

FASB CODIFICATION ACTIVITY

CT8-11 If your school has a subscription to the FASB Codifi cation, go to http://aaahq.org/ ascLogin.cfm to log in and prepare responses to the following.

(a) How are receivables defi ned in the Codifi cation? (b) What are the conditions under which losses from uncollectible receivables (Bad Debt

Expense) should be reported?

A Look at IFRS 419

LEARNING OBJECTIVE 5 Compare the accounting for receivables under GAAP and IFRS.▼

A Look at IFRS

The basic accounting and reporting issues related to the recognition, measurement, and disposition of receivables are essentially the same between IFRS and GAAP.

KEY POINTS Following are the key similarities and differences between GAAP and IFRS related to the accounting for receivables.

420 8 Reporting and Analyzing Receivables

Similarities • The recording of receivables, recognition of sales returns and allowances and sales

discounts, and the allowance method to record bad debts are the same between GAAP and IFRS.

• Both IFRS and GAAP often use the term impairment to indicate that a receivable or a percentage of receivables may not be collected.

• The FASB and IASB have worked to implement fair value measurement (the amount they currently could be sold for) for financial instruments, such as receivables. Both Boards have faced bitter opposition from various factions.

Differences • Although IFRS implies that receivables with different characteristics should be reported

separately, there is no standard that mandates this segregation. • IFRS and GAAP differ in the criteria used to determine how to record a factoring trans-

action. IFRS uses a combination approach focused on risks and rewards and loss of control. GAAP uses loss of control as the primary criterion. In addition, IFRS permits partial derecognition of receivables; GAAP does not.

LOOKING TO THE FUTURE The question of recording fair values for financial instruments will continue to be an important issue to resolve as the Boards work toward convergence. Both the IASB and the FASB have indicated that they believe that financial statements would be more transparent and understandable if companies recorded and reported all financial instru- ments at fair value. That said, in IFRS 9, which was issued in 2009, 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. Critics say that this can result in two companies with identi- cal securities accounting for those securities in different ways. A proposal by the FASB would require that practically all equity instruments be reported at fair value, and that debt instruments may or may not be reported at fair value depending on whether cer- tain criteria are met.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. 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 a result of company loans to

employees. (d) Receivables include amounts resulting from transactions with customers.

2. In recording a factoring transaction: (a) IFRS focuses on loss of control. (b) GAAP focuses on loss of control and risks and rewards. (c) IFRS and GAAP allow partial derecognition. (d) IFRS allows partial derecognition.

3. Under IFRS: (a) the entry to record estimated uncollected accounts is the same as GAAP. (b) it is always acceptable to use the direct write-off method. (c) all financial instruments are recorded at fair value. (d) None of the above.

A Look at IFRS 421

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS8-1 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Use the company’s annual report to answer the following questions.

(a) What is the accounting policy related to accounting for trade accounts receivable? (b) According to the notes to the financial statements, what accounted for the difference

between gross trade accounts receivable and net accounts receivable? (c) According to the notes to the financial statements, what was the major reason why the

balance in receivables increased relative to the previous year? (d) Using information in the notes to the financial statements, determine what percent-

age the provision for impairment of receivables was as a percentage of total trade receivables for 2014 and 2013. How did the ratio change from 2013 to 2014, and what does this suggest about the company’s receivables?

Answers to IFRS Self-Test Questions 1. a 2. d 3. a

For airlines and many other companies, making the right decisions regarding long-lived assets is critical

because these assets represent huge investments. The discussion in this chapter is in two parts: plant

assets and intangible assets. Plant assets are the property, plant, and equipment (physical assets) that

commonly come to mind when we think of what a company owns. Intangible assets, such as copyrights

and patents, lack physical substance but can be extremely valuable and vital to a company’s success.

CHAPTER PREVIEW

Reporting and Analyzing Long-Lived Assets 9

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

▼1 Explain the accounting for plant asset expenditures.

• Determining the cost of plant assets

• Expenditures during useful life

• To buy or lease?

DO IT!

1 Cost of Plant Assets

▼2 Apply depreciation methods to plant assets.

• Factors in computing depreciation

• Depreciation methods • Revising depreciation • Impairments

DO IT!

2 2a Straight-Line

Depreciation 2b Revised Depreciation

▼3 Explain how to account for the disposal of plant assets.

• Sale of plant assets • Retirement of plant assets

DO IT!

3 Plant Asset Disposals

▼5 Discuss how long-lived assets are reported and analyzed.

• Presentation • Analysis

DO IT!

5 Asset Turnover

▼4 Identify the basic issues related to reporting intangible assets.

• Accounting for intangible assets

• Types of intangible assets

DO IT!

4 Classifi cation Concepts

So, you’re interested in starting a new business. Have you thought about the airline industry? Today, the most profi table airlines in the industry are not well-known majors like American Airlines and United. In fact, most giant, older airlines seem to be either bankrupt or on the verge of bankruptcy. In a recent year, fi ve major airlines representing 24% of total U.S. capacity were operating under bankruptcy protection.

Not all airlines are hurting. The growth and profi t- ability in the airline industry today is found at relative newcomers like Southwest Airlines and JetBlue Airways. These and other new airlines compete primarily on ticket prices. During a recent fi ve-year period, the low-fare airline market share increased by 47%, reaching 22% of U.S. airline capacity.

Southwest was the fi rst upstart to make it big. It did so by taking a different approach. It bought small, new, fuel-effi cient planes. Also, instead of the “hub-and-spoke” approach used by the majors, it opted for direct, short hop, no frills fl ights. It was all about controlling costs—getting the most out of its effi cient new planes.

JetBlue, founded by former employees of South- west, was recently ranked as the number 1 airline in the United States by the airline rating company

SkyTrax. Management initially attempted to differentiate JetBlue by offering amenities not found on other airlines, such as seatback entertainment systems, while adopting Southwest’s low-fare model. This approach was success- ful during JetBlue’s early years, as it enjoyed both profi tability and rapid

growth. However, more recently the company has had to take aggressive steps to rein in costs in order to return to profi tability.

In the past, upstarts such as Valujet chose a different approach. The company bought planes that were 20 to 30 years old (known in the industry as zombies), which allowed it to quickly add planes to its fl eet. Valujet started with a $3.4 million investment and grew to be worth $630 million in its fi rst three years.

But with high fuel costs, airlines are no longer in the market for old planes which generally can’t be operated effi ciently. Today, success in the airline business comes from owning the newest and most effi cient equipment, and knowing how to get the most out of it.

FEATURE STORY

A Tale of Two Airlines

424 9 Reporting and Analyzing Long-Lived Assets

LEARNING OBJECTIVE 1 Explain the accounting for plant asset expenditures.▼

Plant assets are resources that have physical substance (a defi nite size and shape), are used in the operations of a business, and are not intended for sale to custom- ers. They are called various names—property, plant, and equipment; plant and equipment; and fi xed assets. By whatever name, these assets are expected to be of service to the company for a number of years. Except for land, plant assets decline in service potential (ability to produce revenue) over their useful lives. Plant assets are critical to a company’s success because they determine the company’s capacity and therefore its ability to satisfy customers. With too few planes, for example, JetBlue Airways and Southwest Airlines would lose custom- ers to their competitors. But with too many planes, they would be fl ying with empty seats. Management must constantly monitor its needs and acquire assets accordingly. Failure to do so results in lost business opportunities or ineffi cient use of existing assets and, eventually, poor fi nancial results. It is important for a company to (1) keep assets in good operating condition, (2) replace worn-out or outdated assets, and (3) expand its productive assets as needed. The decline of rail travel in the United States can be traced in part to the failure of railroad companies to maintain and update their assets. Conversely, the growth of air travel in this country can be attributed in part to the general willing- ness of airline companies to follow these essential guidelines. For many companies, investments in plant assets are substantial. Illustra- tion 9-1 shows the percentages of plant assets in relation to total assets in various companies in a recent year.

73%

10 20 30 40 50 Plant assets as a percentage of total assets

60 70 80 90%

39%

18%

53%

69%

Wendy's

JetBlue Airways

Wal-Mart Stores

Nordstrom

Caterpillar

Microsoft

ILLUSTRATION 9-1 Percentages of plant assets in relation to total assets

DETERMINING THE COST OF PLANT ASSETS

The historical cost principle requires that companies record plant assets at cost. Thus, JetBlue Airways and Southwest Airlines record their planes at cost. Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use. For example, when Boeing buys equipment, the purchase price, freight costs paid by Boeing, and installation costs are all part of the cost of the equipment. Determining which costs to include in a plant asset account and which costs not to include is very important. If a cost is not included in a plant asset account, then it must be expensed immediately. Such costs are referred to as revenue expenditures. On the other hand, costs that are not expensed immediately but are instead included in a plant asset account are referred to as capital expendi- tures. JetBlue reported capital expenditures of $730 million during 2014. This distinction is important; it has immediate, and often material, implications for the income statement. Some companies, in order to boost current income, have improperly capitalized expenditures that they should have expensed. For exam- ple, suppose that a company improperly capitalizes to a building account $1,000 of

Plant Asset Expenditures 425

maintenance costs incurred at the end of the year. (That is, the costs are included in the asset account Buildings rather than being expensed immediately as Maintenance and Repairs Expense.) If the company is allocating the cost of the building as an expense (depreciating it) over a 40-year life, then the maintenance cost of $1,000 will be incorrectly spread across 40 years instead of being expensed in the current year. As a result, the company will understate current-year expenses by approximately $1,000 and will overstate current-year income by approximately $1,000. Thus, deter- mining which costs to capitalize and which to expense is very important. Cost is measured by the cash paid in a cash transaction or by the cash equiv- alent price paid when companies use noncash assets in payment. The cash equivalent price is equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. Once cost is established, it becomes the basis of accounting for the plant asset over its useful life. Current fair value is not used to increase the recorded cost after acquisition. We explain the application of the historical cost principle to each of the major classes of plant assets in the following sections.

Land Companies often use land as a building site for a manufacturing plant or offi ce site. The cost of land includes (1) the cash purchase price, (2) closing costs such as title and attorney’s fees, (3) real estate brokers’ commissions, and (4) accrued property taxes and other liens on the land assumed by the purchaser. For exam- ple, if the cash price is $50,000 and the purchaser agrees to pay accrued taxes of $5,000, the cost of the land is $55,000. All necessary costs incurred in making land ready for its intended use increase (debit) the Land account. When a company acquires vacant land, its cost includes expenditures for clearing, draining, fi lling, and grading. If the land has a building on it that must be removed to make the site suitable for construction of a new building, the company includes all demolition and removal costs, less any proceeds from salvaged materials, in the Land account. To illustrate, assume that Hayes Company acquires real estate at a cash cost of $100,000. The property contains an old warehouse that is removed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials). Additional expenditures are for the attorney’s fee $1,000 and the real estate bro- ker’s commission $8,000. Given these factors, the cost of the land is $115,000, computed as shown in Illustration 9-2.

INTERNATIONAL NOTE IFRS is more fl exible regard- ing asset valuation. Companies revalue to fair value when they believe this information is more relevant.

ILLUSTRATION 9-2 Computation of cost of landLand

Cash price of property $ 100,000 Net removal cost of warehouse 6,000 Attorney’s fee 1,000 Real estate broker’s commission 8,000

Cost of land $115,000

When Hayes records the acquisition, it debits Land and credits Cash for $115,000.

Land Improvements Land improvements are structural additions with limited lives that are made to land, such as driveways, parking lots, fences, landscaping, and underground sprin- klers. The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use. For example, the cost of a new com- pany parking lot includes the amount paid for paving, fencing, and lighting. Thus, the company would debit the total of all of these costs to Land Improvements. Land improvements have limited useful lives. Even when well-maintained, they will eventually need to be replaced. As a result, companies expense (depreciate) the cost of land improvements over their useful lives.

426 9 Reporting and Analyzing Long-Lived Assets

Buildings Buildings are facilities used in operations, such as stores, offi ces, factories, ware- houses, and airplane hangars. Companies charge to the Buildings account all nec- essary expenditures relating to the purchase or construction of a building. When a building is purchased, such costs include the purchase price, closing costs (attorney’s fees, title insurance, etc.), and real estate broker’s commission. Costs to make the building ready for its intended use consist of expenditures for remodeling rooms and offi ces and replacing or repairing the roof, fl oors, electrical wiring, and plumbing. When a new building is constructed, its cost consists of the contract price plus pay- ments made by the owner for architects’ fees, building permits, and excavation costs. In addition, companies add certain interest costs to the cost of a building. Interest costs incurred to fi nance a construction project are included in the cost of the asset when a signifi cant period of time is required to get the asset ready for use. In these circumstances, interest costs are considered as necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed building is limited to interest costs incurred during the construction period. When con- struction has been completed, subsequent interest payments on funds borrowed to fi nance the construction are recorded as increases (debits) to Interest Expense.

Equipment Equipment includes assets used in operations, such as store check-out counters, offi ce furniture, factory machinery, and delivery trucks. JetBlue Airways’ equip- ment includes aircraft, in-fl ight entertainment systems, and trucks for ground operations. The cost of equipment consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. It also includes expenditures required in assembling, installing, and testing the unit. However, companies treat as expenses the costs of motor vehicle licenses and accident insurance on company trucks and cars. Such items are annual recur- ring expenditures and do not benefi t future periods. Two criteria apply in determining the cost of equipment: (1) the frequency of the cost—one time or recurring, and (2) the benefi t period—the life of the asset or one year. To illustrate, assume that Lenard Company purchases a delivery truck on January 1 at a cash price of $22,000. Related expenditures are sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the delivery truck is $23,820, computed as shown in Illustration 9-3.

ILLUSTRATION 9-3 Computation of cost of delivery truck

Delivery Truck

Cash price $ 22,000 Sales taxes 1,320 Painting and lettering 500

Cost of delivery truck $23,820

Lenard treats the cost of a motor vehicle license as an expense and the cost of an insurance policy as a prepaid asset. Thus, the company records the purchase of the truck and related expenditures as follows.

Equipment 23,820 License Expense 80 Prepaid Insurance 1,600 Cash 25,500 (To record purchase of delivery truck and related expenditures)

For another example, assume Merten Company purchases factory machinery at a cash price of $50,000. Related expenditures are sales taxes $3,000, insurance during shipping $500, and installation and testing $1,000. The cost of the factory machinery is $54,500, computed as shown in Illustration 9-4.

A L SE= + +23,820

−80 Exp +1,600 −25,500 Cash Flows −25,500

Plant Asset Expenditures 427

ILLUSTRATION 9-4 Computation of cost of factory machinery

Factory Machinery

Cash price $ 50,000 Sales taxes 3,000 Insurance during shipping 500 Installation and testing 1,000

Cost of factory machinery $54,500

SEA L= + +54,500 −54,500 Cash Flows −54,500

Thus, Merten records the purchase and related expenditures as follows.

Equipment 54,500 Cash 54,500 (To record purchase of factory machinery and related expenditures)

EXPENDITURES DURING USEFUL LIFE

During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, and improvements. Ordinary repairs are expenditures to maintain the operating effi ciency and expected productive life of the unit. They usually are fairly small amounts that occur frequently throughout the service life. Examples are motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on factory machinery. Ordinary repairs are debited to Maintenance and Repairs Expense as incurred. In contrast, additions and improvements are costs incurred to increase the operating effi ciency, productive capacity, or expected useful life of the plant asset. These expenditures are usually material in amount and occur infrequently during the period of ownership. Expenditures for additions and improvements increase the company’s investment in productive facilities and are generally debited to the plant asset affected. Thus, they are capital expenditures. The accounting for capital expenditures varies depending on the nature of the expenditure. Northwest Airlines at one time spent $120 million to spruce up 40 jets. The improvements were designed to extend the lives of the planes, meet stricter gov- ernment noise limits, and save money. The capital expenditure was expected to extend the life of the jets by 10 to 15 years and save about $560 million compared to the cost of buying new planes. The jets were, on average, 24 years old.

Bernie Ebbers was the founder and CEO of the phone company WorldCom. The company engaged in a series of increasingly large, debt-fi nanced acquisitions of other companies. These acquisitions made the company grow quickly, which made the stock price increase dramatically. However, because the acquired companies all had different accounting sys- tems, WorldCom’s fi nancial records were a mess. When WorldCom’s performance started to fl atten out, Bernie coerced WorldCom’s accountants to engage in a number of fraudu- lent activities to make net income look better than it really was and thus prop up the stock price. One of these frauds involved treating $7 billion of line costs as capital expenditures. The line costs, which were rental fees paid to other phone companies to use their phone lines, had always been properly expensed in previous years. Capitalization delayed ex- pense recognition to future periods and thus boosted current-period profi ts.

Total take: $7 billion

THE MISSING CONTROLS Documentation procedures. The company’s accounting system was a disorganized collec- tion of non-integrated systems, which resulted from a series of corporate acquisitions. Top management took advantage of this disorganization to conceal its fraudulent activities.

Independent internal verifi cation. A fraud of this size should have been detected by a routine comparison of the actual physical assets with the list of physical assets shown in the accounting records.

ANATOMY OF A FRAUD

428 9 Reporting and Analyzing Long-Lived Assets

TO BUY OR LEASE?

In this chapter, we focus on purchased assets, but we want to expose you briefl y to an alternative—leasing. A lease is a contractual agreement in which the owner of an asset (the lessor) allows another party (the lessee) to use the asset for a period of time at an agreed price. In many industries, leasing is quite common. For example, one-third of heavy-duty commercial trucks are leased. Some advantages of leasing an asset versus purchasing it are:

1. Reduced risk of obsolescence. Frequently, lease terms allow the party using the asset (the lessee) to exchange the asset for a more modern one if it becomes outdated. This is much easier than trying to sell an obsolete asset.

2. Little or no down payment. To purchase an asset, most companies must borrow money, which usually requires a down payment of at least 20%. Leas- ing an asset requires little or no down payment.

3. Shared tax advantages. Startup companies typically earn little or no profi t in their early years, and so they have little need for the tax deductions avail- able from owning an asset. In a lease, the lessor gets the tax advantage be- cause it owns the asset. It often will pass these tax savings on to the lessee in the form of lower lease payments.

4. Assets and liabilities not reported. Many companies prefer to keep assets and especially liabilities off their books. Reporting lower assets improves the return on assets (discussed later in this chapter). Reporting fewer liabilities makes the company look less risky. Certain types of leases, called operating leases, allow the lessee to account for the transaction as a rental, with nei- ther an asset nor a liability recorded.

Airlines often choose to lease many of their airplanes in long-term lease agree- ments. In recent fi nancial statements, JetBlue Airways stated that it leased 60 of its 169 planes under operating leases. Because operating leases are accounted for as rentals, these 60 planes were not presented on its balance sheet. Under another type of lease, a capital lease, lessees show both the asset and the liability on the balance sheet. The lessee accounts for capital lease agree- ments in a way that is very similar to debt-fi nanced purchases: The lessee shows the leased item as an asset on its balance sheet, and the obligation owed to the lessor as a liability. The lessee depreciates the leased asset in a manner similar to purchased assets. Only four of JetBlue’s aircraft were held under capital leases. We discuss leasing further in Chapter 10.1

Many U.S. Firms Use Leases

Leasing is big business for U.S. companies. For example, in a re- cent year leasing accounted for about 33% of all business invest- ment ($264 billion). Who does the most leasing? Interestingly, major banks such as Continental Bank, J.P. Morgan Leasing, and US Bancorp Equip- ment Finance are the major lessors. Also, many companies have estab- lished separate leasing companies,

such as Boeing Capital Corporation, Dell Financial Services, and John Deere Capital Corporation. As an example of the magnitude of leasing, leased planes account for nearly 40% of the U.S. fl eet of commercial airlines. Lease Finance Corporation in Los Angeles owns more planes than any airline in the world. Leasing is also becoming increasingly common in the hotel industry. Marriott, Hilton, and InterContinental are increasingly choosing to lease hotels that are owned by someone else.

Why might airline managers choose to lease rather than purchase their planes? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION

1The FASB is currently considering a new approach for accounting for leases.

Depreciation Methods 429

1▼ Cost of Plant AssetsDO IT!

Action Plan ✔ Identify expenditures

made in order to get deliv- ery equipment ready for its intended use.

✔ Expense operating costs incurred during the useful life of the equipment.

SOLUTION The fi rst four payments ($15,000 purchase price, $900 sales taxes, $500 delivery, and $200 painting and lettering) are expenditures necessary to make the truck ready for its intended use. Thus, the cost of the truck is $16,600. The payments for insurance and the license are operating expenses incurred annually during the useful life of the asset.

Assume that Drummond Corp. purchases a delivery truck for $15,000 cash plus sales taxes of $900 and delivery costs of $500. The buyer also pays $200 for painting and lettering, $600 for an annual insurance policy, and $80 for a motor vehicle license. Explain how the company should account for each of these costs.

Related exercise material: BE9-1, BE9-2, BE9-3, DO IT! 9-1, E9-1, E9-2, and E9-3.

LEARNING OBJECTIVE 2 Apply depreciation methods to plant assets.▼

As explained in Chapter 4, depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and system- atic manner. Such cost allocation is designed to properly match expenses with revenues (see Illustration 9-5).

Depreciation allocation

Year 1 Year 2 Year 3

Year 4 Year 5 Year 6

ILLUSTRATION 9-5 Depreciation as a cost allocation concept

Depreciation affects the balance sheet through accumulated depreciation, which companies report as a deduction from plant assets. It affects the income state- ment through depreciation expense. It is important to understand that depreciation is a cost allocation process, not an asset valuation process. No attempt is made to measure the change in an asset’s fair value during ownership. Thus, the book value—cost less accumu- lated depreciation—of a plant asset may differ signifi cantly from its fair value. In fact, if an asset is fully depreciated, it can have zero book value but still have a signifi cant fair value. Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each of these classes is considered to be a depre- ciable asset because the usefulness to the company and the revenue-producing ability of each class decline over the asset’s useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact as long as the land is owned. In fact, in many cases, the usefulness of land increases over time because of the scarcity of good sites. Thus, land is not a depreciable asset. During a depreciable asset’s useful life, its revenue-producing ability declines because of wear and tear. A delivery truck that has been driven 100,000 miles will be less useful to a company than one driven only 800 miles.

▼ HELPFUL HINT Remember that depreciation is the process of allocating cost over the useful life of an asset. It is not a measure of value.

▼ HELPFUL HINT Land does not depreciate because it does not wear out.

430 9 Reporting and Analyzing Long-Lived Assets

A decline in revenue-producing ability may also occur because of obsoles- cence. Obsolescence is the process by which an asset becomes out of date before it physically wears out. The rerouting of major airlines from Chicago’s Midway Airport to Chicago-O’Hare International Airport because Midway’s runways were too short for giant jets is an example. Similarly, many companies replace their computers long before they originally planned to do so because technological improvements make their old hardware obsolete.

Recognizing depreciation for an asset does not result in the accumu- lation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset’s cost that the company has charged to expense to date; it is not a cash fund.

FACTORS IN COMPUTING DEPRECIATION

Three factors affect the computation of depreciation, as shown in Illustration 9-6.

ETHICS NOTE When a business is acquired, proper allocation of the purchase price to various asset classes is important since different depreciation treatment can materially affect income. For example, buildings are depreciated, but land is not.

▼

1. Cost. Earlier in the chapter, we explained the considerations that affect the cost of a depreciable asset. Remember that companies record plant assets at cost, in accordance with the historical cost principle.

2. Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset for its owner. Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. Useful life is an estimate. In making the estimate, management considers such factors as the intended use of the asset, repair and maintenance policies, and vulnerability of the asset to obsolescence. The company’s past experience with similar assets is often helpful in deciding on expected useful life.

3. Salvage value. Salvage value is an estimate of the asset’s value at the end of its useful life for its owner. Companies may base the value on the asset’s worth as scrap or on its expected trade-in value. Like useful life, salvage value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.

DEPRECIATION METHODS

Although a number of methods exist, depreciation is generally computed using one of three methods:

1. Straight-line

2. Declining-balance

3. Units-of-activity

Like the alternative inventory methods discussed in Chapter 6, each of these depre- ciation methods is acceptable under generally accepted accounting principles.

Cost: all expenditures necessary to acquire the asset and make it ready for intended use Useful life: estimate of the

expected life based on need for repair, service life, and vulnerability to obsolescence

Salvage value: estimate of the asset’s value at the end of its useful life

ILLUSTRATION 9-6 Three factors in computing depreciation

▼ HELPFUL HINT Depreciation expense is reported on the income statement. Accumulated depreciation is reported on the balance sheet as a deduction from plant assets.

Depreciation Methods 431

Management selects the method it believes best measures an asset’s contri- bution to revenue over its useful life. Once a company chooses a method, it should apply that method consistently over the useful life of the asset. Con- sistency enhances the ability to analyze fi nancial statements over multiple years. Our illustration of depreciation methods, both here and in the chapter appen- dix, is based on the following data relating to a small delivery truck purchased by Bill’s Pizzas on January 1, 2017.

Cost $13,000 Expected salvage value $1,000 Estimated useful life (in years) 5 Estimated useful life (in miles) 100,000

Illustration 9-7 shows the distribution of the primary depreciation methods in a sample of the largest U.S. companies. Clearly, straight-line depreciation is the most widely used approach. In fact, because some companies use more than one method, straight-line depreciation is used for some or all of the depre- ciation taken by more than 95% of U.S. companies. For this reason, we illus- trate procedures for straight-line depreciation and discuss the alternative depre- ciation approaches only at a conceptual level. This coverage introduces you to the basic idea of depreciation as an allocation concept without entangling you in too much procedural detail. (Also, note that many calculators are preprogrammed to perform the basic depreciation methods.) Details on the alternative approaches are presented in Appendix 9A (pages 449–451). No matter what method is used, the total amount depreciated over the useful life of the asset is its depreciable cost. Depreciable cost is equal to the cost of the asset less its salvage value.

Straight-Line Method Under the straight-line method, companies expense an equal amount of depre- ciation each year of the asset’s useful life. Management must choose the useful life of an asset based on its own expectations and experience. To compute the annual depreciation expense, we divide depreciable cost by the estimated useful life. As indicated above, depreciable cost represents the total amount subject to depreciation; it is calculated as the cost of the plant asset less its salvage value. Illustration 9-8 shows the computation of depreciation expense in the fi rst year for Bill’s Pizzas’ delivery truck.

ILLUSTRATION 9-7 Use of depreciation methods in major U.S. companies

83% Straight-line

4% Declining-balance 5% Units-of-activity

8% Other

ILLUSTRATION 9-8 Formula for straight-line method Cost

− Salvage = Depreciable Value Cost

$13,000 − $1,000 = $12,000

Depreciable ÷ Useful Life = Depreciation Cost (in years) Expense $12,000 ÷ 5 = $2,400

Alternatively, we can compute an annual rate at which the company depre- ciates the delivery truck. In this case, the rate is 20% (100% ÷ 5 years). When an annual rate is used under the straight-line method, the company applies the percentage rate to the depreciable cost of the asset, as shown in the depreciation schedule in Illustration 9-9 (page 432).

432 9 Reporting and Analyzing Long-Lived Assets

Note that the depreciation expense of $2,400 is the same each year. The book value at the end of the useful life is equal to the estimated $1,000 salvage value. What happens when an asset is purchased during the year, rather than on January 1 as in our example? In that case, it is necessary to prorate the annual depreciation for the portion of a year used. If Bill’s Pizzas had purchased the delivery truck on April 1, 2017, the company would use the truck for 9 months in 2017. The depreciation for 2017 would be $1,800 ($12,000 × 20% × 912 of a year). As indicated earlier, the straight-line method predominates in practice. For example, such large companies as Campbell Soup, Marriott, and General Mills use the straight-line method. It is simple to apply, and it matches expenses with revenues appropriately when the use of the asset is reasonably uniform throughout the service life. The types of assets that give equal benefi ts over useful life gener- ally are those for which daily use does not affect productivity. Examples are offi ce furniture and fi xtures, buildings, warehouses, and garages for motor vehicles.

ILLUSTRATION 9-9 Straight-line depreciation schedule

Computation Annual End of Year

Depreciable × Depreciation = Depreciation Accumulated Book Year Cost Rate Expense Depreciation Value

2017 $12,000 20% $ 2,400 $ 2,400 $10,600* 2018 12,000 20 2,400 4,800 8,200 2019 12,000 20 2,400 7,200 5,800 2020 12,000 20 2,400 9,600 3,400 2021 12,000 20 2,400 12,000 1,000

Total $12,000

*$13,000 − $2,400

BILL’S PIZZAS

Bill’s Pizzas

$2,400

20 17

20 18

20 19

20 20

20 21

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2a▼ Straight-Line DepreciationDO IT!

Action Plan ✔ Calculate depreciable cost

(Cost − Salvage value). ✔ Divide the depreciable cost

by the asset’s estimated useful life.

On January 1, 2017, Iron Mountain Ski Corporation purchased a new snow-grooming machine for $50,000. The machine is estimated to have a 10-year life with a $2,000 salvage value. What journal entry would Iron Mountain Ski Corporation make at December 31, 2017, if it uses the straight-line method of depreciation?

SOLUTION

Depreciation expense = Cost − Salvage value

Useful life = $50,000 − $2,000

10 = $4,800

Iron Mountain would record the fi rst year’s depreciation as follows.

Dec. 31 Depreciation Expense 4,800 Accumulated Depreciation—Equipment 4,800 (To record annual depreciation on snow-

grooming machine)

Related exercise material: BE9-4, DO IT! 9-2a, E9-4, and E9-5.

Declining-Balance Method The declining-balance method computes depreciation expense using a con- stant rate applied to a declining book value. This method is called an accelerated- depreciation method because it results in higher depreciation in the early years of an asset’s life than does the straight-line approach. However, because the total amount of depreciation (the depreciable cost) taken over an asset’s life is the same no matter what approach is used, the declining-balance method produces

Depreciation Methods 433

a decreasing annual depreciation expense over the asset’s useful life. In early years, declining-balance depreciation expense will exceed straight-line. In later years, it will be less than straight-line. Managers might choose an accelerated approach if they think that an asset’s utility will decline quickly. Companies can apply the declining-balance approach at different rates, which result in varying speeds of depreciation. A common declining-balance rate is double the straight-line rate. Using that rate, the method is referred to as the double-declining-balance method. If we apply the double-declining-balance method to Bill’s Pizzas’ delivery truck, assuming a fi ve-year life, we get the pattern of depreciation shown in Illus- tration 9-10. Illustration 9A-2 (page 450) presents the computations behind these numbers. Again, note that total depreciation over the life of the truck is $12,000, the depreciable cost.

ILLUSTRATION 9-10 Declining-balance depreciation schedule

Units-of-Activity Method As indicated earlier, useful life can be expressed in ways other than a time period. Under the units-of-activity method, useful life is expressed in terms of the total units of production or the use expected from the asset. The units-of-activity method is ideally suited to factory machinery: Companies can measure produc- tion in terms of units of output or in terms of machine hours used in operat- ing the machinery. It is also possible to use the method for such items as deliv- ery equipment (miles driven) and airplanes (hours in use). The units-of-activity method is generally not suitable for such assets as buildings or furniture because activity levels are diffi cult to measure for these assets. Applying the units-of-activity method to the delivery truck owned by Bill’s Pizzas, we fi rst must know some basic information. Bill’s expects to be able to drive the truck a total of 100,000 miles. Illustration 9-11 shows depreciation over the fi ve-year life based on an assumed mileage pattern. Illustration 9A-4 (page 451) presents the computations used to arrive at these results.

Annual End of Year

Depreciation Accumulated Book Year Expense Depreciation Value

2017 $ 5,200 $ 5,200 $7,800 2018 3,120 8,320 4,680 2019 1,872 10,192 2,808 2020 1,123 11,315 1,685 2021 685 12,000 1,000

Total $12,000

BILL’S PIZZAS

Bill’s

Pizzas

$5,000 4,000 3,000 2,000 1,000

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ILLUSTRATION 9-11 Units-of-activity depreciation schedule

Units of Annual End of Year

Activity Depreciation Accumulated Book Year (miles) Expense Depreciation Value

2017 15,000 $ 1,800 $ 1,800 $11,200 2018 30,000 3,600 5,400 7,600 2019 20,000 2,400 7,800 5,200 2020 25,000 3,000 10,800 2,200 2021 10,000 1,200 12,000 1,000

Total 100,000 $12,000

BILL’S PIZZAS

B ill

’s P

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$5,000 4,000 3,000 2,000 1,000

20 17

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Year

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434 9 Reporting and Analyzing Long-Lived Assets

As the name implies, under units-of-activity depreciation, the amount of depreciation is proportional to the activity that took place during that period. For example, the delivery truck was driven twice as many miles in 2018 as in 2017, and depreciation was exactly twice as much in 2018 as it was in 2017.

Management’s Choice: Comparison of Methods Illustration 9-12 compares annual and total depreciation expense for Bill’s Pizzas under the three methods.

Annual depreciation expense varies considerably among the methods, but total depreciation expense is the same ($12,000) for the fi ve-year period. Each method is acceptable in accounting because each recognizes the decline in service potential of the asset in a rational and systematic manner. Illustration 9-13 graphs the depreciation expense pattern under each method.

Straight-line Declining-balance Units-of-activity

Key: $5,000

4,000

3,000

2,000

1,000

0 2017 2018 2019 2020 2021

Year

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ILLUSTRATION 9-13 Patterns of depreciation

Depreciation and Income Taxes The Internal Revenue Service (IRS) allows corporate taxpayers to deduct depre- ciation expense when computing taxable income. However, the tax regulations of the IRS do not require the taxpayer to use the same depreciation method on the tax return that it uses in preparing fi nancial statements. Consequently, many large corporations use straight-line depreciation in their fi nancial statements in order to maximize net income; at the same time, they use a special accelerated-depreciation method on their tax returns in order to minimize their income taxes. For tax purposes, taxpayers must use on their tax returns either the straight-line method or a special accelerated-depreciation method called the Modifi ed Accelerated Cost Recovery System (MACRS).

Depreciation Disclosure in the Notes Companies must disclose the choice of depreciation method in their fi nancial statements or in related notes that accompany the statements. Illustration 9-14 shows excerpts from the “Property and equipment” notes from the fi nancial state- ments of Southwest Airlines.

▼ HELPFUL HINT Depreciation per fi nancial statements is usually different from depreciation per tax returns.

ILLUSTRATION 9-12 Comparison of depreciation methods

Straight- Declining- Units-of- Year Line Balance Activity 2017 $ 2,400 $ 5,200 $ 1,800 2018 2,400 3,120 3,600 2019 2,400 1,872 2,400 2020 2,400 1,123 3,000 2021 2,400 685 1,200

$12,000 $12,000 $12,000

Depreciation Methods 435

From this note, we learn that Southwest Airlines uses the straight-line method to depreciate its planes over periods of 23 to 25 years.

REVISING PERIODIC DEPRECIATION

Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicates that annual depreciation is either inadequate or excessive, the company should change the depreciation expense amount. When a change in an estimate is required, the company makes the change in current and future years but not to prior periods. Thus, when making the change, the company (1) does not change previously recorded depreciation expense, but (2) revises depreciation expense for current and future years. The rationale for this treatment is that continual restatement of prior periods would adversely affect users’ confi dence in fi nancial statements. To determine the new annual depreciation expense, the company fi rst com- putes the asset’s depreciable cost at the time of the revision. It then allocates the revised depreciable cost to the remaining useful life. To illustrate, assume that Bill’s Pizzas decides at the end of 2020 (prior to the year-end adjusting entries) to extend the estimated useful life of the truck one year (a total life of six years) and increase its salvage value to $2,200. The com- pany has used the straight-line method to depreciate the asset to date. Deprecia- tion per year was $2,400 [($13,000 − $1,000) ÷ 5]. Accumulated depreciation after three years (2017–2019) is $7,200 ($2,400 × 3), and book value is $5,800 ($13,000 − $7,200). The new annual depreciation is $1,200, computed on Decem- ber 31, 2020, as follows.

Property and equipment Depreciation is provided by the straight-line method to esti- mated residual values over periods ranging from 23 to 25 years for fl ight equipment and 5 to 30 years for ground property and equipment once the asset is placed in service. . . . Amortization of property under capital leases is on a straight-line basis over the lease term and is included in depreciation and amortization expense.

SOUTHWEST AIRLINES Notes to the Financial Statements

Real World

ILLUSTRATION 9-14 Disclosure of depreciation policies

▼ HELPFUL HINT Use a step-by-step approach: (1) determine new depreciable cost; (2) divide by remaining useful life.

Bill’s Pizzas does not make a special entry for the change in estimate. On Decem- ber 31, 2020, during the preparation of adjusting entries, it records depreciation expense of $1,200 instead of the amount recorded in previous years. Companies must disclose in the fi nancial statements signifi cant changes in estimates. Although a company may have a legitimate reason for changing an estimated life, fi nancial statement users should be aware that some compa- nies might change an estimate simply to achieve fi nancial statement goals. For example, extending an asset’s estimated life reduces depreciation expense and increases current period income. In a recent year, AirTran Airways (now owned by Southwest Airlines) increased the estimated useful lives of some of its planes from 25 to 30 years and increased the estimated lives of related aircraft parts from 5 years to 30 years. It disclosed that the change in estimate decreased its net loss for the year by approximately $0.6 million, or about $0.01 per share. Whether these changes were appropriate

ILLUSTRATION 9-15 Revised depreciation computation

Book value, 1/1/20 $ 5,800 Less: New salvage value 2,200

Depreciable cost $ 3,600

Remaining useful life 3 years (2020–2022)

Revised annual depreciation ($3,600 ÷ 3) $1,200

436 9 Reporting and Analyzing Long-Lived Assets

depends on how reasonable it is to assume that planes will continue to be used for a long time. Our Feature Story suggests that although in the past many planes lasted a long time, it is also clear that because of high fuel costs, airlines are now scrapping many of their old, ineffi cient planes.

IMPAIRMENTS

As noted earlier, the book value of plant assets is rarely the same as the fair value. In instances where the value of a plant asset declines substantially, its fair value might fall materially below book value. This may happen because a machine has become obsolete, or the market for the product made by the machine has dried up or has become very competitive. A permanent decline in the fair value of an asset is referred to as an impairment. So as not to over- state the asset on the books, the company records a write-down, whereby the asset’s cost is reduced to its new fair value during the year in which the decline in value occurs. Recently, Disney recorded a $200 million write-down on its action movie John Carter. Disney spent more than $300 million producing the fi lm. In the past, some companies improperly delayed recording losses on impair- ments until a year when it was “convenient” to do so—when the impact on the company’s reported results was minimized. For example, in a year when a com- pany has record profi ts, it can afford to write down some of its bad assets without hurting its reported results too much. As discussed in Chapter 4, the practice of timing the recognition of gains and losses to achieve certain income results is known as earnings management. Earnings management reduces earnings quality. To minimize earnings management, accounting standards now require immediate loss recognition on impaired assets. Write-downs can create problems for users of fi nancial statements. Critics of write-downs note that after a company writes down assets, its depreciation expense will be lower in all subsequent periods. Some companies improperly infl ate asset write-downs in bad years, when they are going to report poor results anyway. (This practice is referred to as “taking a big bath.”) Then in subsequent years, when the company recovers, its results will look even better because of lower depreciation expense.

2b▼ Revised DepreciationDO IT!

Action Plan ✔ Calculate depreciable cost. ✔ Divide depreciable cost

by new remaining life.

Chambers Corporation purchased a piece of equipment for $36,000. It estimated a 6-year life and $6,000 salvage value. Thus, straight-line depreciation was $5,000 per year [($36,000 − $6,000) ÷ 6]. At the end of year three (before the depreciation adjustment), it estimated the new total life to be 10 years and the new salvage value to be $2,000. Compute the revised depreciation.

SOLUTION Original depreciation expense = [($36,000 − $6,000) ÷ 6] = $5,000 Accumulated depreciation after 2 years = 2 × $5,000 = $10,000 Book value = $36,000 − $10,000 = $26,000

Book value after 2 years of depreciation $26,000 Less: New salvage value 2,000

Depreciable cost $24,000

Remaining useful life 8 years

Revised annual depreciation ($24,000 ÷ 8) $ 3,000

Related exercise material: BE9-6, DO IT! 9-2b, and E9-6.

Plant Asset Disposals 437

Whatever the disposal method, the company must determine the book value of the plant asset at the time of disposal in order to determine the gain or loss. Recall that the book value is the difference between the cost of the plant asset and the accumulated depreciation to date. If the disposal does not occur on the fi rst day of the year, the company must record depreciation for the fraction of the year to the date of disposal. The company then eliminates the book value by reducing (debiting) Accumulated Depreciation for the total depreciation associated with that asset to the date of disposal and reducing (crediting) the asset account for the cost of the asset. A gain or loss on disposal may be needed to balance this entry, as discussed next.

SALE OF PLANT ASSETS

In a disposal by sale, the company compares the book value of the asset with the proceeds received from the sale. If the proceeds from the sale exceed the book value of the plant asset, a gain on disposal occurs. If the proceeds from the sale are less than the book value of the plant asset sold, a loss on disposal occurs. Only by coincidence will the book value and the fair value of the asset be the same at the time the asset is sold. Gains and losses on sales of plant assets are therefore quite common. As an example, Delta Air Lines at one time reported a $94 million gain on the sale of fi ve Boeing B-727-200 aircraft and fi ve Lockheed L-1011-1 aircraft.

Gain on Sale To illustrate a gain on sale of plant assets, assume that on July 1, 2017, Wright Company sells offi ce furniture for $16,000 cash. The offi ce furniture origi- nally cost $60,000 and as of January 1, 2017, had accumulated depreciation of $41,000. Depreciation for the fi rst six months of 2017 is $8,000. Wright records depreciation expense and updates accumulated depreciation to July 1 as follows.

July 1 Depreciation Expense 8,000 Accumulated Depreciation—Equipment 8,000 (To record depreciation expense for the first 6 months of 2017)

After the accumulated depreciation balance is updated, the company com- putes the gain or loss as the difference between the proceeds from sale and the book value at the date of disposal. Wright Company has a gain on disposal of $5,000, as computed in Illustration 9-17 (page 438).

Explain how to account for the disposal of plant assets. LEARNING OBJECTIVE 3▼ Companies dispose of plant assets that are no longer useful to them. Illustration 9-16 shows the three ways in which companies make plant asset disposals.

Equipment is scrapped or discarded.

Retirement Equipment is sold to another party.

Sale Existing equipment is traded for new equipment.

Exchange

Lowy Co. Lowy Co.Piper Co. Piper Co.

ILLUSTRATION 9-16 Methods of plant asset disposal

A L SE= + −8,000 Exp

−8,000 Cash Flows no eff ect

438 9 Reporting and Analyzing Long-Lived Assets

Wright records the sale and the gain on sale of the plant asset as follows.

July 1 Cash 16,000 Accumulated Depreciation—Equipment 49,000 Equipment 60,000 Gain on Disposal of Plant Assets 5,000 (To record sale of office furniture

at a gain)

Companies report a gain on disposal of plant assets in the “Other revenues and gains” section of the income statement. Recently, the shares of Sears Holdings Corporation rose 19% when the company announced its intention to sell 1,200 stores to raise cash.

Loss on Sale Assume that instead of selling the offi ce furniture for $16,000, Wright sells it for $9,000. In this case, Wright experiences a loss of $2,000, as computed in Illustration 9-18.

A L SE= + +16,000 +49,000 −60,000

+5,000 Rev Cash Flows +16,000

Wright records the sale and the loss on sale of the plant asset as follows.

July 1 Cash 9,000 Accumulated Depreciation—Equipment 49,000 Loss on Disposal of Plant Assets 2,000 Equipment 60,000 (To record sale of office furniture at

a loss)

Companies report a loss on disposal of the plant asset in the “Other expenses and losses” section of the income statement.

RETIREMENT OF PLANT ASSETS

Companies simply retire, rather than sell, some assets at the end of their useful lives. For example, some productive assets used in manufacturing may have very specifi c uses, and they consequently have no ready market when the company no longer needs them. In such a case, the asset is simply retired. Companies record retirement of an asset as a special case of a disposal where no cash is received. They decrease (debit) Accumulated Depreciation for the full amount of depreciation taken over the life of the asset and decrease (credit) the asset account for the original cost of the asset. The loss (a gain is not possible on a retirement) is equal to the asset’s book value on the date of retirement.2

A L SE= + +9,000 +49,000

−2,000 Exp −60,000 Cash Flows +9,000

2More advanced courses discuss the accounting for exchanges, the third method of plant asset disposal.

ILLUSTRATION 9-17 Computation of gain on disposal Cost of offi ce furniture $60,000

Less: Accumulated depreciation ($41,000 + $8,000) 49,000 Book value at date of disposal 11,000 Proceeds from sale 16,000

Gain on disposal of plant asset $ 5,000

ILLUSTRATION 9-18 Computation of loss on disposal Cost of offi ce furniture $60,000

Less: Accumulated depreciation 49,000

Book value at date of disposal 11,000 Proceeds from sale 9,000

Loss on disposal of plant asset $ 2,000

Intangible Assets 439

3▼ Plant Asset DisposalsDO IT!

Action Plan ✔ Compare the asset’s book

value and its fair value to determine whether a gain or loss has occurred.

✔ Make sure that both the Equipment account and Accumulated Depreciation—Equipment are reduced upon disposal.

SOLUTION 1. Sale of truck for cash:

Cash 17,000 Accumulated Depreciation—Equipment 16,000 Equipment 30,000 Gain on Disposal of Plant Assets 3,000 [$17,000 − ($30,000 − $16,000)] (To record sale of truck at a gain)

2. Retirement of truck:

Accumulated Depreciation—Equipment 16,000 Loss on Disposal of Plant Assets 14,000 Equipment 30,000 (To record retirement of truck at a loss)

Overland Trucking has an old truck that cost $30,000 and has accumulated depreciation of $16,000. Assume two different situations:

1. The company sells the old truck for $17,000 cash.

2. The truck is worthless, so the company simply retires it.

What entry should Overland use to record each scenario?

Related exercise material: BE9-7, BE9-8, DO IT! 9-3, E9-7, E9-8, and E9-9.

LEARNING OBJECTIVE 4 Identify the basic issues related to reporting intangible assets.▼

Intangible assets are rights, privileges, and competitive advantages that result from ownership of long-lived assets that do not possess physical substance. Many companies’ most valuable assets are intangible. Some widely known intangibles are Microsoft’s patents, McDonald’s franchises, the trade name iPod, and Nike’s trademark “swoosh.” As you will learn in this section, fi nancial statements report numerous intan- gibles. Yet, many other fi nancially signifi cant intangibles are not reported. To give an example, according to its fi nancial statements in a recent year, Google had total stockholders’ equity of $22.7 billion. But its market value—the total market price of all its shares on that same date—was roughly $178.5 billion. Thus, its actual market value was about $155.8 billion greater than the amount reported for stockholders’ equity on the balance sheet. It is not uncommon for a company’s reported book value to differ from its market value because balance sheets are reported at historical cost. But such an extreme difference seriously diminishes the usefulness of the balance sheet to decision-makers. In the case of Google, the difference is due to unrecorded intangibles. For many high-tech or so-called intellectual-property companies, most of their value is from intangibles, many of which are not reported under current accounting rules. Intangibles may be evidenced by contracts, licenses, and other documents. Intangibles may arise from the following sources:

1. Government grants, such as patents, copyrights, licenses, trademarks, and trade names.

2. Acquisition of another business in which the purchase price includes a pay- ment for goodwill.

3. Private monopolistic arrangements arising from contractual agreements, such as franchises and leases.

440 9 Reporting and Analyzing Long-Lived Assets

ACCOUNTING FOR INTANGIBLE ASSETS

Companies record intangible assets at cost. Cost is comprised of all expenditures necessary for the company to acquire the right, privilege, or competitive advan- tage. Intangibles are categorized as having either a limited life or an indefi nite life. If an intangible has a limited life, the company allocates its cost over the asset’s useful life using a process similar to depreciation. The process of allocat- ing to expense the cost of intangibles is referred to as amortization. The cost of intangible assets with indefi nite lives should not be amortized. To record amortization of an intangible asset, a company increases (deb- its) Amortization Expense and decreases (credits) the specifi c intangible asset. (Alternatively, some companies choose to credit a contra account, such as Accumulated Amortization. For homework, you should directly credit the spe- cifi c intangible asset.) Intangible assets are typically amortized on a straight-line basis. For example, the legal life of a patent is 20 years. Companies amortize the cost of a patent over its 20-year life or its useful life, whichever is shorter. To illustrate the computation of patent amortization, assume that National Labs purchases a pat- ent at a cost of $60,000 on June 30. If National estimates the useful life of the patent to be eight years, the annual amortization expense is $7,500 ($60,000 ÷ 8) per year. National records $3,750 ($7,500 × 612) of amortization for the six-month period ended December 31 as follows.

Dec. 31 Amortization Expense 3,750 Patents 3,750 (To record patent amortization)

When a company has signifi cant intangibles, analysts should evaluate the rea- sonableness of the useful life estimates that the company discloses in the notes to

its fi nancial statements. In determining useful life, the company should consider obsolescence, inadequacy, and other factors. These may cause a patent or other intangible to become economically ineffective before the end of its legal life. For example, suppose Intel obtained a patent on a new computer chip it had developed. The legal life of the patent is 20 years. From expe-

rience, however, we know that the useful life of a computer chip patent is rarely more than fi ve years. Because new superior chips are developed so rapidly, exist- ing chips become obsolete. Consequently, we would question the amortization expense of Intel if it amortized its patent on a computer chip for a life signifi - cantly longer than a fi ve-year period. Amortizing an intangible over a period that is too long will understate amortization expense, overstate Intel’s net income, and overstate its assets.

TYPES OF INTANGIBLE ASSETS

Patents A patent is an exclusive right issued by the U.S. Patent Offi ce that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent. The saying “A patent is only as good as the money you’re prepared to spend defending it” is very true. Most patents are subject to some type of litigation by competitors. A well-known example is the patent infringement suit brought by Amazon.com against Barnes & Noble.com regarding its online shopping software. If the owner incurs legal costs in successfully defending the patent in an infringe- ment suit, such costs are considered necessary to establish the validity of the patent. Thus, the owner adds those costs to the Patents account and amortizes them over the remaining life of the patent.

A L SE= + −3,750 Exp −3,750 Cash Flows no eff ect

DECISION TOOLS

Evaluating a company’s amortization of intangibles helps users determine if net income is overstated.

Intangible Assets 441

Research and Development Costs Research and development costs are expenditures that may lead to patents, copyrights, new processes, and new products. Many companies spend consider- able sums of money on research and development (R&D) in an ongoing effort to develop new products or processes. For example, in a recent year Google spent over $9.8 billion on research and development. There are uncertainties in iden- tifying the extent and timing of the future benefi ts of these expenditures. As a result, companies usually record research and development costs as an expense when incurred, whether the R&D is successful or not. To illustrate, assume that Laser Scanner Company spent $3 million on research and development that resulted in two highly successful patents. It spent $20,000 on legal fees for the patents. It can include the legal fees in the cost of the patents but cannot include the R&D costs in the cost of the patents. Instead, Laser Scanner records the R&D costs as an expense when incurred. Many disagree with this accounting approach. They argue that to expense these costs leads to understated assets and net income. Others argue that capi- talizing these costs would lead to highly speculative assets on the balance sheet. Who is right is diffi cult to determine.

Copyrights The federal government grants copyrights, which give the owner the exclusive right to reproduce and sell an artistic or published work. Copyrights last for the life of the creator plus 70 years. The cost of the copyright consists of the cost of acquiring and defending it. The cost may be only the small fee paid to the U.S. Copyright Offi ce, or it may amount to a great deal more if a copyright is acquired from another party. The useful life of a copyright generally is signifi cantly shorter than its legal life.

Trademarks and Trade Names A trademark or trade name is a word, phrase, jingle, or symbol that distinguishes or identifi es a particular enterprise or product. Trade names like Wheaties, Monopoly, Sunkist, Kleenex, Coca-Cola, Big Mac, and Jeep create immediate product iden- tifi cation and generally enhance the sale of the product. The creator or original user may obtain the exclusive legal right to the trademark or trade name by regis- tering it with the U.S. Patent Offi ce. Such registration provides 20 years’ protection and may be renewed indefi nitely as long as the trademark or trade name is in use. If a company purchases the trademark or trade name, the cost is the pur- chase price. If the company develops the trademark or trade name itself, the cost includes attorney’s fees, registration fees, design costs, successful legal defense costs, and other expenditures directly related to securing it. Because trademarks and trade names have indefi nite lives, they are not amortized.

▼ HELPFUL HINT Research and development costs are not intangible costs, but because these expenditures may lead to patents and copyrights, we discuss them in this section.

INTERNATIONAL NOTE IFRS allows capitalization of some development costs. This may contribute to differences in R&D expenditures across nations.

We Want to Own Glass

Google, which has trademarked the term “Google Glass,” now wants to trademark the term “Glass.” Why? Because the simple word Glass has marketing advan- tages over the term Google Glass. It is easy to remember and is

more universal. Regulators, however, are balking at Google’s request. They say that the possible trademark is too similar to other existing or pending software trademarks that con- tain the word “glass.” Also, regulators suggest that the term Glass is merely descriptive and therefore lacks trademark

protection. For example, regulators note that a company that makes salsa could not trademark the term “Spicy Salsa.” BorderStylo LLC, which developed a Web-browser exten- sion called Write on Glass, has fi led a notice of opposition to Google’s request. Google is fi ghting back and has sent the trademark examiner a 1,928-page application defense.

Source: Jacob Gershman, “Google Wants to Own ‘Glass’,” Wall Street Journal (April 4, 2014), p. B5.

If Google is successful in registering the term Glass, where will this trademark be reported on its fi nancial statements? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Google

442 9 Reporting and Analyzing Long-Lived Assets

Franchises When you purchase a RAV4 from a Toyota dealer, fi ll up your tank at the corner Shell station, eat lunch at Subway, or make reservations at a Marriott hotel, you are dealing with franchises. A franchise is a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, to perform specifi c services, or to use certain trademarks or trade names, usually within a designated geographic area. Another type of franchise is a license. Licenses granted by a governmental body permit a business to use public property in performing its services. Examples are the use of city streets for a bus line or taxi service; the use of public land for tele- phone, electric, and cable television lines; and the use of airwaves for radio or TV broadcasting. In a recent license agreement, Fox, CBS, and NBC agreed to pay $27.9 billion for the right to broadcast NFL football games over an eight-year period. Franchises and licenses may be granted for a defi nite period of time, or the time period may be indefi nite or perpetual. When a company incurs costs in connection with the acquisition of the franchise or license, it should rec- ognize an intangible asset. Companies record as operating expenses annual payments made under a franchise agreement in the period in which they are incurred. In the case of a limited life, a company amortizes the cost of a franchise (or license) as operating expense over the useful life. If the life is indefi nite or perpetual, the cost is not amortized.

Goodwill Usually, the largest intangible asset that appears on a company’s balance sheet is goodwill. Goodwill represents the value of all favorable attributes that relate to a company that are not attributable to any other specifi c asset. These include exceptional management, desirable location, good customer relations, skilled employees, high-quality products, fair pricing policies, and harmonious relations with labor unions. Goodwill is unique because unlike other assets such as invest- ments, plant assets, and even other intangibles, which can be sold individually in the marketplace, goodwill can be identifi ed only with the business as a whole. If goodwill can be identifi ed only with the business as a whole, how can it be determined? Certainly, many business enterprises have many of the factors cited above (exceptional management, desirable location, and so on). However, to determine the amount of goodwill in these situations would be diffi cult and very subjective. In other words, to recognize goodwill without an exchange transac- tion that puts a value on the goodwill would lead to subjective valuations that do not contribute to the reliability of fi nancial statements. Therefore, companies record goodwill only when there is an exchange transaction that involves the purchase of an entire business. When an entire business is purchased, goodwill is the excess of cost over the fair value of the net assets (assets less liabilities) acquired. In recording the purchase of a business, a company debits the identifi able acquired assets and credits liabilities at their fair values, credits cash for the purchase price, and records the difference as the cost of goodwill. Goodwill is not amortized because it is considered to have an indefi nite life. However, it must be written down if a company determines the value of goodwill has been permanently impaired.

4▼ Classifi cation ConceptsDO IT! Match the statement with the term most directly associated with it.

1. ________ The allocation to expense of the cost of an intangible asset over the asset’s useful life.

Statement Presentation and Analysis 443

Action Plan ✔ Know that the accounting

for intangibles often depends on whether the item has a fi nite or indefi nite life.

✔ Recognize the many similarities and differences between the accounting for plant assets and intangible assets.

SOLUTION 1. Amortization 4. Franchise

2. Intangible assets 5. Research and development costs

3. Copyright

Related exercise material: BE9-9, DO IT! 9-4, E9-11, E9-12, and E9-13.

2. ________ Rights, privileges, and competitive advantages that result from the owner- ship of long-lived assets that do not possess physical substance.

3. ________ An exclusive right granted by the federal government to reproduce and sell an artistic or published work.

4. ________ A right to sell certain products or services or to use certain trademarks or trade names within a designated geographic area.

5. ________ Costs incurred by a company that often lead to patents or new products. These costs must be expensed as incurred.

PRESENTATION

Usually, companies show plant assets in the fi nancial statements under “Property, plant, and equipment,” and they show intangibles separately under “Intangible assets.” Illustration 9-19 shows a typical balance sheet presentation of long-lived assets, adapted from a recent The Coca-Cola Company balance sheet.

Discuss how long-lived assets are reported and analyzed. LEARNING OBJECTIVE 5▼

Property, plant, and equipment Land $ 972 Buildings and improvements 5,539 Machinery and equipment 18,225 Other 522

25,258 Less: Accumulated depreciation 10,625

14,633 Intangible assets Trademarks with indefi nite lives 6,533 Goodwill 12,100 Bottlers’ franchise rights with indefi nite lives 6,689 Other intangible assets 1,050

$26,372

THE COCA-COLA COMPANY Balance Sheet (partial)

(in millions)

Real World

ILLUSTRATION 9-19 Presentation of property, plant, and equipment and intangible assets

When a plant asset is fully depreciated, the plant asset and related accumu- lated depreciation should continue to be reported on the balance sheet without further depreciation or adjustment until the asset is retired. Intangibles do not usually use a contra asset account like the contra asset account Accumulated Depreciation used for plant assets. Instead, companies record amortization of intangibles as a direct decrease (credit) to the asset account. Either within the balance sheet or in the notes, companies should disclose the balances of the major classes of assets, such as land, buildings, and equip- ment, and of accumulated depreciation by major classes or in total. In addition,

444 9 Reporting and Analyzing Long-Lived Assets

PEOPLE, PLANET, AND PROFIT INSIGHT BHP Billiton

Sustainability Report Please Sustainability reports identify how the company is meeting its corporate social respon- sibilities. Many companies, both large and small, are now issuing these reports. For example, companies such

as Disney, Best Buy, Microsoft, Ford, and ConocoPhilips issue these reports. Presented below is an adapted section of a recent BHP Billiton (a global mining, oil, and gas company) sustainability report on its environmental policies. These poli- cies are to (1) take action to address the challenges of climate change, (2) set and achieve targets that reduce pollution, and (3) enhance biodiversity by assessing and considering ecologi- cal values and land-use aspects. Here is how BHP Billiton mea- sures the success or failure of some of these policies:

In addition to the environment, BHP Billiton has sections in its sustainability report that discuss people, safety, health, and community.

Why do you believe companies issue sustainability reports? (Go to WileyPLUS for this answer and additional questions.)

Environment Commentary Target Date

We will maintain total greenhouse gas emissions FY2013 greenhouse gas emissions were lower than 30 June 2017 below FY2006 levels. the FY2006 baseline.

All operations to offset impacts to biodiversity Land and Biodiversity Management Plans were Annual and the related benefi ts derived from ecosystems. developed at all our operations.

We will fi nance the conservation and continuing Two projects of international conservation signifi cance 30 June 2017 management of areas of high biodiversity and were established—the Five Rivers Conservation ecosystem value. Project, in Australia, and the Valdivian Coastal Reserve Conservation Project, in Chile.

ANALYSIS

The presentation of fi nancial statement information about plant assets enables decision makers to analyze the company’s use of its plant assets. We will use two measures to analyze plant assets: return on assets and asset turnover. We also show how profi t margin relates to both.

Return on Assets An overall measure of profi tability is the return on assets. This ratio is com-

puted by dividing net income by average total assets. (Average assets are commonly calculated by adding the beginning and ending values of assets and dividing by 2.) Return on assets indicates the amount of net income generated by each dollar of assets. Thus, the higher the return on assets, the more profi table the company.

Information is provided below related to JetBlue Airways.

JetBlue (in millions)

Net income, 2014 $ 515 Total assets, 12/31/14 7,839 Total assets, 12/31/13 7,350 Net sales, 2014 5,817

DECISION TOOLS

Return on assets helps users deter- mine if a company is using its assets effectively.

they should describe the depreciation and amortization methods used and dis- close the amount of depreciation and amortization expense for the period.

Statement Presentation and Analysis 445

ILLUSTRATION 9-20 Return on assets for JetBlue and SouthwestReturn on Assets =

Net Income Average Total Assets

JetBlue Airways Southwest Industry ($ in millions) Airlines Average

2014 2013 2014 2014

$515 ($7,839 + $7,350)/2

= 6.8% 2.3% 5.7% 4.0%

JetBlue’s return on assets was better than that of Southwest’s and higher than the airline industry. At one time, the airline industry experienced fi nancial diffi - culties as it attempted to cover high labor, fuel, and security costs while offering fares low enough to attract customers. Such diffi culties were refl ected in a low industry average for return on assets. In response, Southwest announced that it would not add additional planes beyond the 700 it already had until it met its investment-return targets. Instead, the company added seats to existing planes and replaced some smaller planes with larger ones.

Marketing ROI as Profi t Indicator

Marketing executives use the basic fi nance concept underlying return on assets to determine “marketing return on investment (ROI).” They calculate marketing ROI as the profi t generated by a marketing initiative divided by the investment in that initiative.

It can be tricky to determine what to include in the “in- vestment” amount and how to attribute profi t to a particular

marketing initiative. However, many fi rms feel that measuring marketing ROI is worth the effort because it allows managers to evaluate the relative effectiveness of various programs. In addition, it helps quantify the benefi ts that marketing provides to the organization. In periods of tight budgets, the market- ing ROI number can provide particularly valuable evidence to help a marketing manager avoid budget cuts.

Source: James O. Mitchel, “Marketing ROI,” LIMRA’s MarketFacts Quarterly (Summer 2004), p. 15.

How does measuring marketing ROI support the overall efforts of the organization? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION

Asset Turnover Asset turnover indicates how effi ciently a company uses its assets to generate sales—that is, how many dollars of sales a company generates for each dollar invested in assets. It is calculated by dividing net sales by average total assets. When we compare two companies in the same industry, the one with the higher asset turnover is operating more effi ciently. It is generating more sales per dollar invested in assets. Illustration 9-21 (page 446) presents the asset turnovers for JetBlue Airways and Southwest Airlines.

DECISION TOOLS

The asset turnover helps users de- termine how effectively a company is generating sales from its assets.

Illustration 9-20 presents the 2014 and 2013 return on assets of JetBlue Airways, Southwest Airlines, and the industry average.

446 9 Reporting and Analyzing Long-Lived Assets

These asset turnover values tell us that for each dollar of assets, JetBlue gen- erates sales of $0.77 and Southwest $0.94. Southwest is more successful in gener- ating sales per dollar invested in assets. The average asset turnover for the airline industry is 0.80 times. In recent years, airlines have reduced both the number of planes used and routes fl own to try to pack more customers on a plane. This would increase the asset turnover. Asset turnovers vary considerably across industries. During a recent year, the average asset turnover for electric utility companies was 0.34. The grocery indus- try had an average asset turnover of 2.89. Asset turnover values, therefore, are only comparable within—not between—industries.

Profi t Margin Revisited In Chapter 5, you learned about profi t margin. That ratio is calculated by divid- ing net income by net sales. It tells how effective a company is in turning its sales into income—that is, how much income each dollar of sales provides. Illustra- tion 9-22 shows that return on assets can be computed as the product of profi t margin and asset turnover.

ILLUSTRATION 9-22 Composition of return on assets Profit × Asset = Return on

Margin Turnover Assets

Net Income Net Sales

× Net Sales Average Total Assets

= Net Income Average Total Assets

This relationship has very important strategic implications for management. From Illustration 9-22, we can see that if a company wants to increase its return on assets, it can do so in two ways: (1) by increasing the margin it generates from each dollar of goods that it sells (the profi t margin), or (2) by increasing the volume of goods that it sells (the asset turnover). For example, most grocery stores have very low profi t margins, often in the range of 1 or 2 cents for every dollar of goods sold. Grocery stores, therefore, focus on asset turnover: They rely on high turnover to increase their return on assets. Alternatively, a store selling luxury goods, such as expensive jewelry, does not generally have a high turnover. Consequently, a seller of luxury goods focuses on having a high profi t margin. Recently, Apple decided to offer a less expensive version of its popular iPod. This new product would provide a lower margin but higher volume than Apple’s more expensive version.

ILLUSTRATION 9-21 Asset turnovers for JetBlue and Southwest Asset Turnover =

Net Sales Average Total Assets

JetBlue Airways Southwest Industry ($ in millions) Airlines Average

2014 2013 2014 2014

$5,817 ($7,839 + $7,350)/2

= 0.77 times 0.75 times 0.94 times 0.80 times

Statement Presentation and Analysis 447

KEEPING AN EYE ON CASH

Depreciation and amortization expense are among the biggest causes of differ- ences between accrual-accounting net income and net cash provided by operat- ing activities. Depreciation and amortization reduce net income, but they do not use up any cash. Therefore, to determine net cash provided by operating activi- ties under a common approach referred to as the indirect method, companies add depreciation and amortization back to net income. For example, if a company reported net income of $175,000 during the year and had depreciation expense of $40,000, net cash provided by operating activities would be $215,000 (assuming no other accrual-accounting differences). The operating activities section of Coca-Cola’s statement of cash flows reports the following adjustment for depreci- ation and amortization.

Cash fl ow from operating activities Net income $7,124 Plus: Depreciation and amortization 1,976

THE COCA-COLA COMPANY Statement of Cash Flows (partial)

(in millions)

Real World

The adjustment for depreciation and amortization was more than twice as big as any other adjustment required to convert net income to net cash provided by operating activities. It is also interesting to examine the statement of cash flows to determine the amount of property, plant, and equipment a company purchased and the cash it

Profit × Asset = Return on Margin Turnover Assets

JetBlue Airways 8.8% × 0.77 = 6.8%

Southwest Airlines 6.1% × 0.94 = 5.7%

ILLUSTRATION 9-23 Components of rate of return for JetBlue and Southwest

JetBlue’s return on asset of 6.8% versus Southwest’s 5.7% means that JetBlue generates 6.8 cents per each dollar invested in assets, while Southwest generates 5.7 cents. Illustration 9-23 reveals that although these two airlines have similar return on asset values, they achieve this return in a slightly different fashion. First, JetBlue’s profi t margin of 8.8% versus Southwest’s 6.1% means that for every dollar of sales, JetBlue generates approximately 8.8 cents of net income, while Southwest generates approximately 6.1 cents. Second, JetBlue’s asset turn- over of 0.77 means that it generates 77 cents of sales per each dollar invested in assets, while Southwest generates 94 cents. Therefore, in 2014, Southwest was more effective at generating sales from its assets, while JetBlue was better at deriving profi t from its sales.

Let’s evaluate the return on assets of JetBlue Airways for 2014 by evaluating its components—profi t margin and asset turnover. See Illustration 9-23.

448 9 Reporting and Analyzing Long-Lived Assets

received from property, plant, and equipment sold in a given year. For example, the investing activities section of Coca-Cola reports the following.

Cash fl ow from investing activities Acquisitions and investments $(17,800) Purchases of property, plant, and equipment (2,406) Proceeds from disposals of property, plant, and equipment 223 Other (268)

THE COCA-COLA COMPANY Statement of Cash Flows (partial)

(in millions)

Real World

As indicated, Coca-Cola made significant purchases and sales of property, plant, and equipment. The level of purchases suggests that Coca-Cola believes that it can earn a reasonable rate of return on these assets.

SOLUTION The asset turnover for Paramour Company is computed as follows.

Net Sales ÷ Average Total Assets = Asset Turnover

$420,000 ÷ $460,000 + $540,000

= .84 2

5▼ Asset TurnoverDO IT! Paramour Company reported net income of $180,000, net sales of $420,000, and had total assets of $460,000 on January 1, 2017, and total assets on December 31, 2017, of $540,000. Determine Paramour’s asset turnover for 2017.

Action Plan ✔ Recognize that the asset

turnover analyzes the productivity of a company’s assets.

✔ Know the formula Net sales ÷ Average total assets equals Asset turnover. Related exercise material: BE9-10, DO IT! 9-5, E9-15, E9-16, and E9-17.

Delta Air Lines, Inc., headquartered in Atlanta, Georgia, is one of the largest airlines in the world. It serves 342 destinations in 61 countries.

INSTRUCTIONS

Review the excerpts from the company’s 2014 annual report presented on page 449 and then answer the following questions.

1. What method does the company use to depreciate its aircraft? Over what period is the company depreciating these aircraft?

2. Compute the company’s return on assets ratio, asset turnover ratio, and profi t margin ratio for 2014 and 2013. Com- ment on your results.

(in millions) 2014 2013

Net income (loss) $ 659 $10,540 Net sales 40,362 37,773 Beginning total assets 52,252 44,550 Ending total assets 54,121 52,252

USING DECISION TOOLS—DELTA AIR LINES

Appendix 9A: Other Depreciation Methods 449

SOLUTION 1. The company depreciates property and equipment using the straight-line approach. It depreciates aircraft over a

21–30-year life. 2. 2014 2013

Return on assets $659 $10,540

($54,121 + $52,252)/2 = 1.2%

($52,252 + $44,550)/2 = 21.8%

Asset turnover $40,362 $37,773

($54,121 + $52,252)/2 = 0.76 times

($52,252 + $44,550)/2 = 0.78 times

Profi t margin

$659 $10,540 $40,362

= 1.6% $37,773

= 27.9%

Delta’s profi t margin and return on assets decreased signifi cantly from 2013 to 2014. (This huge drop occurred because the company had a massive, one-time tax benefi t in 2013.) Its asset turnover decreased slightly.

APPENDIX 9A: Compute periodic depreciation using the declining-balance method and the units-of-activity method.

LEARNING OBJECTIVE *6▼

In this appendix, we show the calculations of the depreciation expense amounts that we used in the chapter for the declining-balance and units-of-activity methods.

DECLINING-BALANCE METHOD

The declining-balance method produces a decreasing annual depreciation expense over the useful life of the asset. The method is so named because the computation of periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset. Annual depreciation expense is com- puted by multiplying the book value at the beginning of the year by the declining- balance depreciation rate. The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year. Book value for the fi rst year is the cost of the asset because the balance in accumulated depreciation at the beginning of the asset’s useful life is zero. In sub- sequent years, book value is the difference between cost and accumulated depre- ciation at the beginning of the year. Unlike other depreciation methods, the declining-balance method ignores salvage value in determining the amount to which the declining-balance rate is applied. Salvage value, however, does

DELTA AIR LINES, INC. Notes to the Financial Statements (Partial)

Long-Lived Assets The following table summarizes our property and equipment:

December 31, (in millions, except for estimated useful life) Estimated Useful Life 2014 2013 Flight equipment 21–30 years $24,313 $23,373 Ground property and equipment 3–40 years 5,198 4,596 Flight and ground equipment under capital leases Shorter of lease term or estimated useful life 1,141 1,296 Advance payments for equipment 617 381 Less: accumulated depreciation and amortization(1) (9,340) (7,792) Total property and equipment, net $21,929 $21,854

(1)Includes accumulated amortization for fl ight and ground equipment under capital leases in the amount of $767 million and $657 million at December 31, 2014 and 2013, respectively.

We record property and equipment at cost and depreciate or amortize these assets on a straight-line basis to their estimated residual values over their estimated useful lives.

450 9 Reporting and Analyzing Long-Lived Assets

limit the total depreciation that can be taken. Depreciation stops when the asset’s book value equals its expected salvage value. Depreciation must be completed by the end of the asset’s useful life. Therefore, in the last year of the asset’s useful life, it is sometimes necessary to adjust the amount of depreciation expense so that the book value equals the expected salvage value. For example, note the adjustment to the fi nal year in Illustration 9A-2. As noted in the chapter, a common declining-balance rate is double the straight-line rate—the double-declining-balance method. If Bill’s Pizzas uses the double-declining-balance method, the depreciation rate is 40% (2 × the straight-line rate of 20%). Illustration 9A-1 presents the formula and computa- tion of depreciation for the fi rst year on the delivery truck.

▼ HELPFUL HINT The straight-line rate is approximated as 1 ÷ Estimated life. In this case, it is 1 ÷ 5 = 20%.

Book Value at Beginning

of Year ×

Declining- Balance

Rate =

Depreciation Expense

$13,000 × 40% = $5,200

ILLUSTRATION 9A-1 Formula for declining-balance method

Illustration 9A-2 presents the depreciation schedule under this method.

BILL’S PIZZAS

Computation Annual End of Year

Book Value Depreciation Depreciation Accumulated Book Year Beginning of Year × Rate = Expense Depreciation Value 2017 $13,000 40% $5,200 $ 5,200 $7,800* 2018 7,800 40 3,120 8,320 4,680 2019 4,680 40 1,872 10,192 2,808 2020 2,808 40 1,123 11,315 1,685 2021 1,685 40 685** 12,000 1,000

*$13,000 − $5,200 **Computation of $674 ($1,685 × 40%) is adjusted to $685 in order for book value to equal salvage value.

ILLUSTRATION 9A-2 Double-declining-balance depreciation schedule

The delivery equipment is 69% depreciated ($8,320 ÷ $12,000) at the end of the second year. Under the straight-line method, it would be depreciated 40% ($4,800 ÷ $12,000) at that time. Because the declining-balance method produces higher depreciation expense in the early years than in the later years, it is consid- ered an accelerated-depreciation method. The declining-balance method is compatible with the expense recognition prin- ciple. It matches the higher depreciation expense in early years with the higher ben- efi ts received in these years. Conversely, it recognizes lower depreciation expense in later years when the asset’s contribution to revenue is likely to be lower. Also, some assets lose their usefulness rapidly because of obsolescence. In these cases, the declining-balance method provides a more appropriate depreciation amount. When an asset is purchased during the year, it is necessary to prorate the declining-balance depreciation in the fi rst year on a time basis. For example, if Bill’s Pizzas had purchased the delivery equipment on April 1, 2017, depreciation for 2017 would be $3,900 ($13,000 × 40% × 912 ). The book value for comput- ing depreciation in 2018 then becomes $9,100 ($13,000 − $3,900), and the 2018 depreciation is $3,640 ($9,100 × 40%).

UNITS-OF-ACTIVITY METHOD

Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset. The units-of-activity

ALTERNATIVE TERMINOLOGY Another term often used is the units-of-production method.

▼ HELPFUL HINT Depreciation stops when the asset’s book value equals its expected salvage value.

Appendix 9A: Other Depreciation Methods 451

method is ideally suited to equipment whose activity can be measured in units of output, miles driven, or hours in use. The units-of-activity method is gener- ally not suitable for assets for which depreciation is a function more of time than of use. To use this method, a company estimates the total units of activity for the entire useful life and divides that amount into the depreciable cost to determine the depreciation cost per unit. It then multiplies the depreciation cost per unit by the units of activity during the year to fi nd the annual depreciation for that year. To illustrate, assume that Bill’s Pizzas estimates it will drive its new delivery truck 15,000 miles in the fi rst year. Illustration 9A-3 presents the formula and computation of depreciation expense in the fi rst year.

Depreciation Depreciable

÷ Total Units

= Cost per

Cost of Activity Unit

$12,000 ÷ 100,000 miles = $0.12

Depreciation Units of Cost per × Activity during =

Depreciation

Unit the Year Expense

$0.12 × 15,000 miles = $1,800

ILLUSTRATION 9A-3 Formula for units-of-activity method

Illustration 9A-4 shows the depreciation schedule, using assumed mileage data.

BILL’S PIZZAS

Computation Annual End of Year

Units of Depreciation Depreciation Accumulated Book Year Activity × Cost/Unit = Expense Depreciation Value 2017 15,000 $0.12 $1,800 $ 1,800 $11,200* 2018 30,000 0.12 3,600 5,400 7,600 2019 20,000 0.12 2,400 7,800 5,200 2020 25,000 0.12 3,000 10,800 2,200 2021 10,000 0.12 1,200 12,000 1,000

*$13,000 − $1,800

ILLUSTRATION 9A-4 Units-of-activity depreciation schedule

The units-of-activity method is not nearly as popular as the straight-line method, primarily because it is often diffi cult to make a reasonable estimate of total activity. However, this method is used by some very large companies, such as Standard Oil Company of California and Boise Cascade Corporation. When the productivity of the asset varies signifi cantly from one period to another, the units-of-activity method results in the best matching of expenses with revenues. This method is easy to apply when assets are purchased during the year. In such a case, companies use the productivity of the asset for the partial year in computing the depreciation.

▼ HELPFUL HINT Depreciation stops when the asset’s book value equals its expected salvage value.

452 9 Reporting and Analyzing Long-Lived Assets

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Explain the accounting for plant asset expenditures. The cost of plant assets includes all expenditures necessary to acquire the asset and make it ready for its intended use. Once cost is established, a company uses that amount as the basis of accounting for the plant asset over its useful life.

2 Apply depreciation methods to plant assets. Deprecia- tion is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Depreciation is not a process of valua- tion, and it is not a process that results in an accumulation of cash. Depreciation refl ects an asset’s decreasing useful- ness and revenue-producing ability, resulting from wear and tear and from obsolescence. The formula for straight-line depreciation is:

Cost − Salvage value Useful life ( in years)

The expense patterns of the three depreciation methods are as follows.

Method Annual Depreciation Pattern

Straight-line Constant amount Declining-balance Decreasing amount Units-of-activity Varying amount

Companies make revisions of periodic depreciation in present and future periods, not retroactively.

3 Explain how to account for the disposal of plant assets. The procedure for accounting for the disposal of a plant asset through sale or retirement is (a) eliminate the book value of the plant asset at the date of disposal; (b) record cash proceeds, if any; and (c) account for the difference between the book value and the cash proceeds as a gain or a loss on disposal.

4 Identify the basic issues related to reporting intangible assets. Companies report intangible assets at their cost less any amounts amortized. If an intangible asset has a limited life, its cost should be allocated (amortized) over its useful life. Intangible assets with indefi nite lives should not be amortized.

5 Discuss how long-lived assets are reported and analyzed. Companies usually show plant assets under “Property, plant, and equipment”; they show intangibles separately under “Intangible assets.” Either within the balance sheet or in the notes, companies disclose the balances of the major classes of assets, such as land, buildings, and equipment, and accumu- lated depreciation by major classes or in total. They describe the depreciation and amortization methods used, and dis- close the amount of depreciation and amortization expense for the period. In the statement of cash fl ows, under the indirect method, depreciation and amortization expense are added back to net income to determine net cash provided by operating activities. The investing section reports cash paid or received to purchase or sell property, plant, and equipment. Plant assets may be analyzed using return on assets and asset turnover. Return on assets consists of two compo- nents: asset turnover and profi t margin.

*6 Compute periodic depreciation using the declining- balance method and the units-of-activity method. The depreciation expense calculation for each of these methods is:

Declining-balance: Book value at

beginning of year × Declining-balance

rate = Depreciation

expense

Units-of-activity: Depreciable

cost ÷ Total units

of activity = Depreciation

cost per unit

Depreciation cost per unit

× Units of activity during year

= Depreciation expense

▼

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Is the company’s amortization of intangibles reasonable?

Estimated useful life of intangibles from notes to fi nancial statements of this company and its competitors

If the company’s estimated useful life signifi cantly exceeds that of competitors or does not seem reasonable in light of the circumstances, the reason for the difference should be investigated.

Too high an estimated useful life will result in understating amortization expense and overstating net income.

Is the company using its assets effectively?

How effective is the company at generating sales from its assets?

Net income and average total assets

Net sales and average total assets

Higher value suggests favor- able effi ciency (use of assets).

Indicates the sales dollars generated per dollar of assets. A high value suggests the company is effective in using its resources to generate sales.

Net income Average total assets

Return on assets

Net sales Average total assets

Asset turnover

Practice Multiple-Choice Questions 453

Accelerated-depreciation method A depreciation method that produces higher depreciation expense in the early years than the straight-line approach. (p. 432).

Additions and improvements Costs incurred to increase the operating effi ciency, productive capacity, or ex- pected useful life of a plant asset. (p. 427).

Amortization The process of allocating to expense the cost of an intangible asset. (p. 440).

Asset turnover Indicates how effi ciently a company uses its assets to generate sales; calculated as net sales di- vided by average total assets. (p. 445).

Capital expenditures Expenditures that increase the company’s investment in plant assets. (p. 424).

Capital lease A contractual agreement allowing one party (the lessee) to use another party’s asset (the lessor); accounted for like a debt-fi nanced purchase by the lessee. (p. 428).

Cash equivalent price An amount equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. (p. 425).

Copyright An exclusive right granted by the federal gov- ernment allowing the owner to reproduce and sell an artistic or published work. (p. 441).

Declining-balance method A depreciation method that applies a constant rate to the declining book value of the asset and produces a decreasing annual deprecia- tion expense over the asset’s useful life. (pp. 432, 449).

Depreciable cost The cost of a plant asset less its salvage value. (p. 431).

Depreciation The process of allocating to expense the cost of a plant asset over its useful life in a rational and sys- tematic manner. (p. 429).

Franchise A contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, to perform specifi c services, or to use certain trademarks or trade names, usually within a designated geographic area. (p. 442).

Goodwill The value of all favorable attributes that relate to a company that are not attributable to any other spe- cifi c asset. (p. 442).

Impairment A permanent decline in the fair value of an asset. (p. 436).

Intangible assets Rights, privileges, and competitive ad- vantages that result from the ownership of long-lived assets that do not possess physical substance. (p. 439).

Lessee A party that has made contractual arrangements to use another party’s asset for a period at an agreed price. (p. 428).

Lessor A party that has agreed contractually to let another party use its asset for a period at an agreed price. (p. 428).

Operating lease A contractual agreement allowing one party (the lessee) to use the asset of another party (the lessor); accounted for as a rental by the lessee. (p. 428).

Ordinary repairs Expenditures to maintain the operat- ing effi ciency and expected productive life of the asset. (p. 427).

Patent An exclusive right issued by the U.S. Patent Offi ce that enables the recipient to manufacture, sell, or other- wise control an invention for a period of 20 years from the date of the grant. (p. 440).

Plant assets Resources that have physical substance, are used in the operations of a business, and are not in- tended for sale to customers. (p. 424).

Research and development costs Expenditures that may lead to patents, copyrights, new processes, and new products; must be expensed as incurred. (p. 441).

Return on assets A profi tability measure that indicates the amount of net income generated by each dollar of assets; computed as net income divided by average total assets. (p. 444).

Revenue expenditures Expenditures that are immedi- ately charged against revenues as an expense. (p. 424).

Straight-line method A depreciation method in which companies expense an equal amount of depreciation for each year of the asset’s useful life. (p. 431).

Trademark (trade name) A word, phrase, jingle, or symbol that distinguishes or identifi es a particular enterprise or product. (p. 441).

Units-of-activity method A depreciation method in which useful life is expressed in terms of the total units of production or use expected from the asset. (pp. 433, 450).

GLOSSARY REVIEW▼

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

1. Corrieten Company purchased equipment and incurred these costs:

Cash price $24,000 Sales taxes 1,200 Insurance during transit 200 Installation and testing 400

Total costs $25,800

What amount should be recorded as the cost of the equipment?

(LO 1) (a) $24,000. (c) $25,400. (b) $25,200. (d) $25,800.

2. Harrington Corporation recently leased a number of trucks from Andre Corporation. In inspect- ing the books of Harrington Corporation, you notice that the trucks have not been recorded as assets on its balance sheet. From this, you can conclude that Harrington is accounting for this transaction as a/an: (a) operating lease. (c) purchase. (b) capital lease. (d) None of the above.

(LO 1)

454 9 Reporting and Analyzing Long-Lived Assets

3. Additions to plant assets are: (a) revenue expenditures. (b) debited to the Repairs and Maintenance Expense

account. (c) debited to the Purchases account. (d) capital expenditures.

4. Depreciation is a process of: (a) valuation. (c) cash accumulation. (b) cost allocation. (d) appraisal.

5. Cuso Company purchased equipment on January 1, 2016, at a total invoice cost of $400,000. The equip- ment has an estimated salvage value of $10,000 and an estimated useful life of 5 years. What is the amount of accumulated depreciation at December 31, 2017, if the straight-line method of depreciation is used? (a) $80,000. (c) $78,000. (b) $160,000. (d) $156,000.

6. A company would minimize its deprecia- tion expense in the fi rst year of owning an asset if it used: (a) a high estimated life, a high salvage value, and

declining-balance depreciation. (b) a low estimated life, a high salvage value, and

straight-line depreciation. (c) a high estimated life, a high salvage value, and

straight-line depreciation. (d) a low estimated life, a low salvage value, and de-

clining-balance depreciation. 7. When there is a change in estimated depreciation:

(a) previous depreciation should be corrected. (b) current and future years’ depreciation should be

revised. (c) only future years’ depreciation should be revised. (d) None of the above.

8. Able Towing Company purchased a tow truck for $60,000 on January 1, 2017. It was originally depre- ciated on a straight-line basis over 10 years with an assumed salvage value of $12,000. On December 31, 2019, before adjusting entries had been made, the company decided to change the remaining estimated life to 4 years (including 2019) and the salvage value to $2,000. What was the depreciation expense for 2019? (a) $6,000. (c) $15,000. (b) $4,800. (d) $12,100.

9. Bennie Razor Company has decided to sell one of its old manufacturing machines on June 30, 2017. The machine was purchased for $80,000 on January 1, 2013, and was depreciated on a straight-line basis for 10 years assuming no salvage value. If the machine was sold for $26,000, what was the amount of the gain or loss recorded at the time of the sale? (a) $18,000 loss. (c) $22,000 gain. (b) $54,000 loss. (d) $46,000 gain.

10. Pierce Company incurred $150,000 of research and development costs in its laboratory to develop a new product. It spent $20,000 in legal fees for a patent granted on January 2, 2017. On July 31, 2017, Pierce paid $15,000 for legal fees in a successful defense of the patent. What is the total amount that should be debited to Patents through July 31, 2017? (a) $150,000. (c) $185,000. (b) $35,000. (d) $170,000.

(LO 1)

(LO 2)

(LO 3)

(LO 4)

11. Indicate which one of these statements is true. (a) Since intangible assets lack physical substance,

they need to be disclosed only in the notes to the fi nancial statements.

(b) Goodwill should be reported as a contra account in the stockholders’ equity section.

(c) Totals of major classes of assets can be shown in the balance sheet, with asset details disclosed in the notes to the fi nancial statements.

(d) Intangible assets are typically combined with plant assets and inventory and then shown in the property, plant, and equipment section.

12. If a company reports goodwill as an intangible asset on its books, what is the one thing you know with certainty? (a) The company is a valuable company worth

investing in. (b) The company has a well-established brand name. (c) The company purchased another company. (d) The goodwill will generate a lot of positive busi-

ness for the company for many years to come. 13. Which of the following statements is false?

(a) If an intangible asset has a fi nite life, it should be amortized.

(b) The amortization period of an intangible asset can exceed 20 years.

(d) Research and development costs are expensed when incurred, except when the research and devel- opment expenditures result in a successful patent.

14. Which of the following measures provides an indication of how effi cient a company is in employing its assets? (a) Current ratio. (c) Debt to assets ratio. (b) Profi t margin. (d) Asset turnover.

15. Lake Coffee Company reported net sales of $180,000, net income of $54,000, beginning total assets of $200,000, and ending total assets of $300,000. What was the company’s asset turnover? (a) 0.90 (c) 0.72 (b) 0.20 (d) 1.39

*16. Kant Enterprises purchased a truck for $11,000 on January 1, 2016. The truck will have an estimated salvage value of $1,000 at the end of 5 years. If you use the units-of-activity method, the balance in ac- cumulated depreciation at December 31, 2017, can be computed by the following formula: (a) ($11,000 ÷ Total estimated activity) ×

Units of activity for 2017. (b) ($10,000 ÷ Total estimated activity) ×

Units of activity for 2017. (c) ($11,000 ÷ Total estimated activity) ×

Units of activity for 2016 and 2017. (d) ($10,000 ÷ Total estimated activity) ×

Units of activity for 2016 and 2017. *17. Jefferson Company purchased a piece of equipment

on January 1, 2017. The equipment cost $60,000 and has an estimated life of 8 years and a salvage value of $8,000. What was the depreciation expense for the asset for 2018 under the double-declining-balance method? (a) $6,500. (c) $15,000. (b) $11,250. (d) $6,562.

(LO 4)

(LO 5)

(LO 6)

SOLUTIONS 1. (d) All of the costs ($1,200 + $200 + $400) in addition to the cash price ($24,000) should be included in the cost of the

equipment because they were necessary expenditures to acquire the asset and make it ready for its intended use. The other choices are therefore incorrect.

2. (a) Operating leases are accounted for as rentals and are not recorded on the balance sheet. The other choices are incorrect because (b) if the leased assets were accounted for as a capital lease or (c) if the assets were purchased, they would be reported on the balance sheet. Choice (d) is wrong as there is a correct answer.

3. (d) When an addition is made to plant assets, it is intended to increase productive capacity, increase the assets’ useful life, or increase the effi ciency of the assets. This is called a capital expenditure. The other choices are incor- rect because (a) additions to plant assets are not revenue expenditures because the additions will have a long-term useful life whereas revenue expenditures are minor repairs and maintenance that do not prolong the life of the assets; (b) additions to plant assets are debited to Plant Assets, not Maintenance and Repairs Expense, because the Maintenance and Repairs Expense account is used to record expenditures not intended to increase the life of the assets; and (c) additions to plant assets are debited to Plant Assets, not Purchases, because the Purchases account is used to record assets intended for resale (inventory).

4. (b) Depreciation is a process of allocating the cost of an asset over its useful life, not a process of (a) valuation, (c) cash accumulation, or (d) appraisal.

5. (d) Accumulated depreciation will be the sum of 2 years of depreciation expense. Annual depreciation for this asset is ($400,000 − $10,000)/5 = $78,000. The sum of 2 years’ depreciation is therefore $156,000 ($78,000 + $78,000), not (a) $80,000, (b) $160,000, or (c) $78,000.

6. (c) A high estimated life spreads the cost over a longer period of time, resulting in a smaller expense each year. The high salvage value limits the cost to be allocated. Straight-line depreciation yields a smaller depreciation charge in the fi rst year than the declining-balance method. The other choices are therefore incorrect.

7. (b) When there is a change in estimated depreciation, the current and future years’ depreciation computation should refl ect the new estimates. The other choices are incorrect because (a) previous years’ depreciation should not be adjusted when new estimates are made for depreciation, and (c) when there is a change in estimated depreciation, the current and future years’ depreciation computation should refl ect the new estimates. Choice (d) is wrong because there is a correct answer.

8. (d) First, calculate accumulated depreciation from January 1, 2017, through December 31, 2018, which is $9,600 {[($60,000 − $12,000)/10 years] × 2 years}. Next, calculate the revised depreciable cost, which is $48,400 ($60,000 − $9,600 − $2,000). Thus, the depreciation expense for 2019 is $12,100 ($48,400/4), not (a) $6,000, (b) $4,800, or (c) $15,000.

9. (a) First, the book value needs to be determined. The accumulated depreciation as of June 30, 2017, is $36,000 [($80,000/10) × 4.5 years]. Thus, the cost of the machine less accumulated depreciation equals $44,000 ($80,000 − $36,000). The loss recorded at the time of sale is $18,000 ($26,000 − $44,000), not (b) $54,000, (c) $22,000, or (d) $46,000.

10. (b) Because the $150,000 was spent developing the patent rather than buying it from another fi rm, it is debited to Re- search and Development Expense. Only the $35,000 spent on legal fees ($20,000 for granting patent and $15,000 for defense) can be debited to Patents, not (a) $150,000, (c) $185,000, or (d) $170,000.

11. (c) Reporting only totals of major classes of assets in the balance sheet is appropriate. Additional details can be shown in the notes to the fi nancial statements. The other choices are false statements.

12. (c) In order to report goodwill, a company must have entered into an exchange transaction that involves the pur- chase of another business. Choices (a) the company is a valuable company worth investing in, (b) the company has a well-established brand name, and (d) the goodwill will generate a lot of positive business for the company for many years to come are not necessarily valid assumptions.

13. (d) Research and development (R&D) costs are expensed when incurred, regardless of whether the research and development expenditures result in a successful patent or not. The other choices are true statements.

14. (d) The asset turnover indicates how effi ciently a company is employing its assets. The other choices are incorrect be- cause (a) the current ratio is an indicator of liquidity and the company’s ability to pay its obligations when they come due, (b) the profi t margin is an indicator of how profi table a company is, and (c) the debt to assets ratio indicates the proportion of assets that are fi nanced by debt rather than by equity.

15. (c) Asset turnover = Net sales ($180,000)/Average total assets [($200,000 + $300,000)/2] = 0.72 times, not (a) 0.90, (b) 0.20, or (d) 1.39 times.

*16. (d) The units-of-activity method takes salvage value into consideration; therefore, the depreciable cost is $10,000. This amount is divided by total estimated activity. The resulting number is multiplied by the units of activity used in 2016 and 2017 to compute the accumulated depreciation at the end of 2017, the second year of the asset’s use. The other choices are therefore incorrect.

*17. (b) For the double-declining method, the depreciation rate would be 25% or (1/8 × 2). For 2017, annual depreciation expense is $15,000 ($60,000 book value × 25%); for 2018, annual depreciation expense is $11,250 [($60,000 − $15,000) × 25%], not (a) $6,500, (c) $15,000, or (d) $6,562.

Practice Multiple-Choice Questions 455

456 9 Reporting and Analyzing Long-Lived Assets

1. Will Smith, the new controller of Alexandria Company, has reviewed the expected use- ful lives and salvage values of selected depreciable assets at the beginning of 2017. Here are his findings:

Accumulated Useful Life

Type of Date Depreciation, (in Years) Salvage Value

Asset Acquired Cost Jan. 1, 2017 Old Proposed Old Proposed

Building Jan. 1, 2009 $900,000 $172,000 40 50 $40,000 $47,600 Warehouse Jan. 1, 2011 120,000 27,600 25 20 5,000 3,600

All assets are depreciated by the straight-line method. Alexandria Company uses a cal- endar year in preparing annual financial statements. After discussion, management has agreed to accept Will’s proposed changes. (The “Proposed” useful life is total life, not remaining life.)

INSTRUCTIONS

(a) Compute the revised annual depreciation on each asset in 2017. (Show computations.)

(b) Prepare the entry (or entries) to record depreciation on the building in 2017.

Compute revised annual depreciation.

(LO 2)

PRACTICE EXERCISES▼

SOLUTION

1. (a)

Type of Asset

Building Warehouse

Book value, 1/1/17 $728,000 $92,400 Less: Salvage value 47,600 3,600

Depreciable cost (1) $680,400 $88,800

Revised remaining useful life in years (2) 42* 14** Revised annual depreciation (1) ÷ (2) $16,200 $6,343

*(50 − 8); **(20 − 6)

(b) Dec. 31 Depreciation Expense 16,200 Accumulated Depreciation— Buildings 16,200

2. Lake Company, organized in 2017, has the following transactions related to intangible assets.

1/2/17 Purchased patent (8-year life) $560,000 4/1/17 Goodwill purchased (indefi nite life) 360,000 7/1/17 10-year franchise; expiration date 7/1/2027 440,000 9/1/17 Research and development costs 185,000

INSTRUCTIONS

Prepare the necessary entries to record these intangibles. All costs incurred were for cash. Make the adjusting entries as of December 31, 2017, recording any necessary amortization and refl ecting all balances accurately as of that date.

Prepare entries to set up appropriate accounts for different intangibles; amortize intangible assets.

(LO 4)

SOLUTION

2. 1/2/17 Patents 560,000 Cash 560,000

4/1/17 Goodwill 360,000 Cash 360,000 (Part of the entry to record purchase

of another company)

7/1/17 Franchises 440,000 Cash 440,000

Practice Problems 457

9/1/17 Research and Development Expense 185,000 Cash 185,000

12/31/17 Amortization Expense ($560,000 ÷ 8) + [($440,000 ÷ 10) × 1/2] 92,000 Patents 70,000 Franchises 22,000

Ending balances, 12/31/17: Patents = $490,000 ($560,000 − $70,000) Goodwill = $360,000 Franchises = $418,000 ($440,000 − $22,000) R&D expense = $185,000

1. DuPage Company purchases a factory machine at a cost of $18,000 on January 1, 2017. Du- Page expects the machine to have a salvage value of $2,000 at the end of its 4-year useful life.

During its useful life, the machine is expected to be used 160,000 hours. Actual annual hourly use was 2017, 40,000; 2018, 60,000; 2019, 35,000; and 2020, 25,000.

INSTRUCTIONS

Prepare depreciation schedules for the following methods: (a) straight-line, (b) units-of- activity, and (c) declining-balance using double the straight-line rate. (Parts (b) and (c) are discussed in the chapter appendix.)

Compute depreciation under different methods.

(LO 2, 6)

PRACTICE PROBLEMS▼

SOLUTION

1. (a) Straight-Line Method

Computation Annual End of Year

Depreciable Depreciation Depreciation Accumulated Book Year Cost* × Rate = Expense Depreciation Value 2017 $16,000 25% $4,000 $ 4,000 $14,000** 2018 16,000 25% 4,000 8,000 10,000 2019 16,000 25% 4,000 12,000 6,000 2020 16,000 25% 4,000 16,000 2,000

*$18,000 − $2,000. **$18,000 − $4,000.

(b) Units-of-Activity Method

Computation Annual End of Year

Units of Depreciable Depreciation Accumulated Book Year Activity × Cost/Unit = Expense Depreciation Value 2017 40,000 $0.10* $4,000 $ 4,000 $14,000 2018 60,000 0.10 6,000 10,000 8,000 2019 35,000 0.10 3,500 13,500 4,500 2020 25,000 0.10 2,500 16,000 2,000

*($18,000 − $2,000) ÷ 160,000.

Computation End of Year

Book Value Annual Beginning of Depreciation Depreciation Accumulated Book Year Year × Rate* = Expense Depreciation Value 2017 $18,000 50% $9,000 $ 9,000 $9,000 2018 9,000 50% 4,500 13,500 4,500 2019 4,500 50% 2,250 15,750 2,250 2020 2,250 50% 250** 16,000 2,000

*¼ × 2. **Adjusted to $250 because ending book value should not be less than expected salvage value.

458 9 Reporting and Analyzing Long-Lived Assets

1. Mrs. Harcross is uncertain about how the historical cost principle applies to plant assets. Explain the prin- ciple to Mrs. Harcross.

2. How is the cost for a plant asset measured in a cash transaction? In a noncash transaction?

3. Barrister Company acquires the land and build- ing owned by Ansel Company. What types of costs may be incurred to make the asset ready for its in- tended use if Barrister Company wants to use only the land? If it wants to use both the land and the building?

4. Distinguish between ordinary repairs and capital expenditures during an asset’s useful life.

5. Breton Inc. needs to upgrade its diagnostic equipment. At the time of purchase, Breton had ex- pected the equipment to last 8 years. Unfortunately, it was obsolete after only 4 years. Nolan Rush, CFO of Breton Inc., is considering leasing new equipment rather than buying it. What are the potential benefi ts of leasing?

6. In a recent newspaper release, the president of Magnusson Company asserted that something has to be done about depreciation. The president said, “Depreciation does not come close to accumulating the cash needed to replace the asset at the end of its useful life.” What is your response to the president?

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS▼

SOLUTION

2. (a) Jan. 1, Accumulated Depreciation—Equipment 24,000* 2018 Loss on Disposal of Plant Assets 4,000 Equipment 28,000 (To record retirement of limousine)

*[($28,000 − $4,000) ÷ 4] × 4

(b) July 1, Depreciation Expense 3,000* 2017 Accumulated Depreciation—Equipment 3,000 (To record depreciation to date of disposal)

*[($28,000 − $4,000) ÷ 4] × 1 2 Cash 5,000 Accumulated Depreciation—Equipment 21,000* Loss on Disposal of Plant Assets 2,000 Equipment 28,000 (To record sale of limousine)

*[($28,000 − $4,000) ÷ 4] × 3.5

2. On January 1, 2014, Skyline Limousine Co. purchased a limousine at an acquisi- tion cost of $28,000. Skyline depreciated the vehicle by the straight-line method using a 4-year service life and a $4,000 salvage value. The company’s fiscal year ends on December 31.

INSTRUCTIONS

Prepare the journal entry or entries to record the disposal of the limousine, assuming that it was: (a) Retired and scrapped with no salvage value on January 1, 2018.

(b) Sold for $5,000 on July 1, 2017.

Record disposal of plant asset.

(LO 3)

Brief Exercises 459

7. Melanie is studying for the next accounting examina- tion. She asks your help on two questions: (a) What is salvage value? (b) How is salvage value used in deter- mining depreciable cost under the straight-line method? Answer Melanie’s questions.

8. Contrast the straight-line method and the units-of-activity method in relation to (a) useful life and (b) the pattern of periodic depreciation over useful life.

9. Contrast the effects of the three depreciation methods on annual depreciation expense.

10. In the fourth year of an asset’s 5-year useful life, the company decides that the asset will have a 6-year ser- vice life. How should the revision of depreciation be recorded? Why?

11. How is a gain or a loss on the sale of a plant asset computed?

12. Marsh Corporation owns a machine that is fully depre- ciated but is still being used. How should Marsh account for this asset and report it in the fi nancial statements?

13. What does Apple use as the estimated useful life on its buildings? On its machinery and equipment? (Hint: You will need to fi nd the notes to Apple’s fi nancial statements online. See the directions for fi nding the notes in Appendix A at the end of the textbook.)

14. What are the similarities and differences between de- preciation and amortization?

15. During a recent management meeting, Bruce Dunn, director of marketing, proposed that the com- pany begin capitalizing its marketing expenditures as goodwill. In his words, “Marketing expenditures create goodwill for the company which benefi ts the company for multiple periods. Therefore it doesn’t make good sense to have to expense it as it is incurred. Besides, if we capitalize it as goodwill, we won’t have to amortize it, and this will boost reported income.” Discuss the merits of Bruce’s proposal.

16. Warwick Company hires an accounting intern who says that intangible assets should always be amortized over their legal lives. Is the intern correct? Explain.

17. Goodwill has been defi ned as the value of all favorable attributes that relate to a business enterprise. What types of attributes could result in goodwill?

18. Kathy Malone, a business major, is working on a case problem for one of her classes. In this case problem, the company needs to raise cash to market a new product it developed. Doug Price, an engineering ma- jor, takes one look at the company’s balance sheet and says, “This company has an awful lot of goodwill. Why

don’t you recommend that they sell some of it to raise cash?” How should Kathy respond to Doug?

19. Under what conditions is goodwill recorded? What is the proper accounting treatment for amortizing goodwill?

20. Often research and development costs provide com- panies with benefi ts that last a number of years. (For example, these costs can lead to the development of a patent that will increase the company’s income for many years.) However, generally accepted accounting principles require that such costs be recorded as an expense when incurred. Why?

21. Suppose in 2017 that Campbell Soup Com- pany reported average total assets of $6,265 million, net sales of $7,586 million, and net income of $736 million. What was Campbell Soup’s return on assets?

22. Cassy Dominic, a marketing executive for Fresh Views Inc., has proposed expanding its product line of framed graphic art by producing a line of lower-quality products. These would require less processing by the company and would provide a lower profit margin. Mel Joss, the company’s CFO, is concerned that this new product line would reduce the company’s return on assets. Discuss the potential effect on return on as- sets that this product might have.

23. Give an example of an industry that would be characterized by (a) a high asset turnover and a low profit margin, and (b) a low asset turnover and a high profit margin.

24. Peyton Corporation and Rogers Corporation operate in the same industry. Peyton uses the straight- line method to account for depreciation, whereas Rogers uses an accelerated method. Explain what complications might arise in trying to compare the results of these two companies.

25. Mesa Corporation uses straight-line depreciation for financial reporting purposes but an accelerated method for tax purposes. Is it acceptable to use different methods for the two purposes? What is Mesa Corporation’s motivation for doing this?

26. You are comparing two companies in the same industry. You have determined that Gore Corp. depreciates its plant assets over a 40-year life, whereas Ross Corp. depreciates its plant assets over a 20-year life. Discuss the implications this has for comparing the results of the two companies.

27. Explain how transactions related to plant assets and intangibles are reported in the statement of cash flows under the indirect method.

BE9-1 These expenditures were incurred by Dobbin Company in purchasing land: cash price $60,000, accrued taxes $5,000, attorney’s fees $2,100, real estate broker’s commission $3,300, and clearing and grading $3,500. What is the cost of the land?

BE9-2 Thoms Company incurs these expenditures in purchasing a truck: cash price $24,000, accident insurance (during use) $2,000, sales taxes $1,080, motor vehicle license $300, and painting and lettering $1,700. What is the cost of the truck?

Determine the cost of land.

(LO 1), AP

Determine the cost of a truck.

(LO 1), AP

BRIEF EXERCISES▼

460 9 Reporting and Analyzing Long-Lived Assets

BE9-3 Krieg Company had the following two transactions related to its delivery truck. 1. Paid $38 for an oil change. 2. Paid $400 to install special shelving units, which increase the operating efficiency of

the truck. Prepare Krieg’s journal entries to record these two transactions.

BE9-4 Gordon Chemicals Company acquires a delivery truck at a cost of $31,000 on Janu- ary 1, 2017. The truck is expected to have a salvage value of $4,000 at the end of its 4-year useful life. Compute annual depreciation for the first and second years using the straight- line method.

BE9-5 Ivy Company purchased land and a building on January 1, 2017. Management’s best estimate of the value of the land was $100,000 and of the building $250,000. However, management told the accounting department to record the land at $230,000 and the build- ing at $120,000. The building is being depreciated on a straight-line basis over 20 years with no salvage value. Why do you suppose management requested this accounting treat- ment? Is it ethical?

BE9-6 On January 1, 2017, the Hermann Company ledger shows Equipment $36,000 and Accumulated Depreciation $13,600. The depreciation resulted from using the straight- line method with a useful life of 10 years and a salvage value of $2,000. On this date, the company concludes that the equipment has a remaining useful life of only 2 years with the same salvage value. Compute the revised annual depreciation.

BE9-7 Prepare journal entries to record these transactions. (a) Echo Company retires its delivery equipment, which cost $41,000. Accumulated depreciation is also $41,000 on this delivery equipment. No salvage value is received. (b) Assume the same information as in part (a), except that accumulated depreciation for the equipment is $37,200 instead of $41,000.

BE9-8 Antone Company sells office equipment on July 31, 2017, for $21,000 cash. The office equipment originally cost $72,000 and as of January 1, 2017, had accumulated depreciation of $42,000. Depreciation for the first 7 months of 2017 is $4,600. Prepare the journal entries to (a) update depreciation to July 31, 2017, and (b) record the sale of the equipment.

BE9-9 Abner Company purchases a patent for $156,000 on January 2, 2017. Its estimated useful life is 6 years. (a) Prepare the journal entry to record amortization expense for the fi rst year. (b) Show how this patent is reported on the balance sheet at the end of the fi rst year.

BE9-10 Suppose in its 2017 annual report that McDonald’s Corporation reports beginning total assets of $28.46 billion, ending total assets of $30.22 billion, net sales of $22.74 bil- lion, and net income of $4.55 billion. (a) Compute McDonald’s return on assets. (b) Compute McDonald’s asset turnover.

BE9-11 Suppose Nike, Inc. reported the following plant assets and intangible assets for the year ended May 31, 2017 (in millions): other plant assets $965.8, land $221.6, patents and trademarks (at cost) $515.1, machinery and equipment $2,094.3, buildings $974.0, goodwill (at cost) $193.5, accumulated amortization $47.7, and accumulated depreciation $2,298.0. Prepare a partial balance sheet for Nike for these items.

BE9-12 Hunt Company reported net income of $157,000. It reported depreciation expense of $12,000 and accumulated depreciation of $47,000. Amortization expense was $8,000. Hunt purchased new equipment during the year for $50,000. Show how this information would be used to determine net cash provided by operating activities under the indirect method.

*BE9-13 Depreciation information for Gordon Chemicals Company is given in BE9-4. Assuming the declining-balance depreciation rate is double the straight-line rate, compute annual depreciation for the fi rst and second years under the declining-balance method.

Prepare entries for delivery truck costs.

(LO 1), AP

Compute straight-line depreciation.

(LO 2), AP

Compute depreciation and evaluate treatment.

(LO 2), AN

Compute revised depreciation.

(LO 2), AP

Journalize entries for disposal of plant assets.

(LO 3), AP

Journalize entries for sale of plant assets.

(LO 3), AP

Account for intangibles—patents.

(LO 4), AP

Compute return on assets and asset turnover.

(LO 5), AP

Classifi cation of long-lived assets on balance sheet.

(LO 5), AP

Determine net cash provided by operating activities.

(LO 5), AP

Compute declining-balance depreciation.

(LO 6), AP

Exercises 461

*BE9-14 Kwik Taxi Service uses the units-of-activity method in computing depreciation on its taxicabs. Each cab is expected to be driven 150,000 miles. Taxi 10 cost $27,500 and is expected to have a salvage value of $500. Taxi 10 was driven 32,000 miles in 2016 and 33,000 miles in 2017. Compute the depreciation for each year.

Compute depreciation using units-of-activity method.

(LO 6), AP

Hummer Company purchased a delivery truck. The total cash payment was $30,020, including the following items.

Negotiated purchase price $24,000 Installation of special shelving 1,100 Painting and lettering 900 Motor vehicle license 180 Annual insurance policy 2,400 Sales tax 1,440

Total paid $30,020

Explain how each of these costs would be accounted for.

On January 1, 2017, Salt Creek Country Club purchased a new riding mower for $15,000. The mower is expected to have a 10-year life with a $1,000 salvage value. What journal entry would Salt Creek make on December 31, 2017, if it uses straight-line depreciation?

Fordon Corporation purchased a piece of equipment for $50,000. It estimated an 8-year life and $2,000 salvage value. At the end of year four (before the depreciation adjustment), it estimated the new total life to be 10 years and the new salvage value to be $4,000. Compute the revised depreciation.

Bylie Company has an old factory machine that cost $50,000. The machine has accumulated depreciation of $28,000. Bylie has decided to sell the machine.

(a) What entry would Bylie make to record the sale of the machine for $25,000 cash? (b) What entry would Bylie make to record the sale of the machine for $15,000 cash?

Match the statement with the term most directly associated with it.

Goodwill Amortization Intangible assets Franchise Research and development costs

1. _______ Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance.

2. _______ The allocation of the cost of an intangible asset to expense in a rational and systematic manner.

3. _______ A right to sell certain products or services, or use certain trademarks or trade names within a designated geographic area.

4. _______ Costs incurred by a company that often lead to patents or new products. These costs must be expensed as incurred.

5. _______ The excess of the cost of a company over the fair value of the net assets required.

For 2017, Sale Company reported beginning total assets of $300,000 and end- ing total assets of $340,000. Its net income for this period was $50,000, and its net sales were $400,000. Compute the company’s asset turnover for 2017.

DO IT! 9-1 Explain accounting for cost of plant assets

(LO 1), C

DO IT! 9-2a Calculate depreciation expense and make journal entry.

(LO 2), AP

DO IT! 9-2b Calculated revised depreciation

(LO 2), AP

DO IT! 9-3 Make journal entries to record plant asset disposal.

(LO 3), AP

DO IT! 9-4 Match intangible assets with concepts.

(LO 4), C

DO IT! 9-5 Calculate asset turnover.

(LO 5), AP

EXERCISES▼DO IT!

E9-1 The following expenditures relating to plant assets were made by Glenn Company during the first 2 months of 2017. 1. Paid $7,000 of accrued taxes at the time the plant site was acquired. 2. Paid $200 insurance to cover a possible accident loss on new factory machinery while

the machinery was in transit.

Determine cost of plant acquisitions.

(LO 1), C

EXERCISES▼

462 9 Reporting and Analyzing Long-Lived Assets

3. Paid $850 sales taxes on a new delivery truck. 4. Paid $21,000 for parking lots and driveways on the new plant site. 5. Paid $250 to have the company name and slogan painted on the new delivery truck. 6. Paid $8,000 for installation of new factory machinery. 7. Paid $900 for a 1-year accident insurance policy on the new delivery truck. 8. Paid $75 motor vehicle license fee on the new truck.

Instructions (a) Explain the application of the historical cost principle in determining the

acquisition cost of plant assets. (b) List the numbers of the transactions, and opposite each indicate the account title to

which each expenditure should be debited.

E9-2 Adama Company incurred the following costs. 1. Sales tax on factory machinery purchased $ 5,000 2. Painting of and lettering on truck immediately upon purchase 700 3. Installation and testing of factory machinery 2,000 4. Real estate broker’s commission on land purchased 3,500 5. Insurance premium paid for first year’s insurance on new truck 880 6. Cost of landscaping on property purchased 7,200 7. Cost of paving parking lot for new building constructed 17,900 8. Cost of clearing, draining, and filling land 13,300 9. Architect’s fees on self-constructed building 10,000

Instructions Indicate to which account Adama would debit each of the costs.

E9-3 On March 1, 2017, Boyd Company acquired real estate, on which it planned to con- struct a small office building, by paying $80,000 in cash. An old warehouse on the property was demolished at a cost of $8,200; the salvaged materials were sold for $1,700. Additional expenditures before construction began included $1,900 attorney’s fee for work concern- ing the land purchase, $5,200 real estate broker’s fee, $9,100 architect’s fee, and $14,000 to put in driveways and a parking lot.

Instructions (a) Determine the amount to be reported as the cost of the land. (b) For each cost not used in part (a), indicate the account to be debited.

E9-4 Alysha Monet has prepared the following list of statements about depreciation. 1. Depreciation is a process of asset valuation, not cost allocation. 2. Depreciation provides for the proper matching of expenses with revenues. 3. The book value of a plant asset should approximate its fair value. 4. Depreciation applies to three classes of plant assets: land, buildings, and equipment. 5. Depreciation does not apply to a building because its usefulness and revenue-producing

ability generally remain intact over time. 6. The revenue-producing ability of a depreciable asset will decline due to wear and tear

and to obsolescence. 7. Recognizing depreciation on an asset results in an accumulation of cash for replace-

ment of the asset. 8. The balance in accumulated depreciation represents the total cost that has been

charged to expense since placing the asset in service. 9. Depreciation expense and accumulated depreciation are reported on the income

statement. 10. Three factors affect the computation of depreciation: cost, useful life, and salvage value.

Instructions Identify each statement as true or false. If false, indicate how to correct the statement.

E9-5 Gotham Company purchased a new machine on October 1, 2017, at a cost of $90,000. The company estimated that the machine has a salvage value of $8,000. The machine is expected to be used for 70,000 working hours during its 8-year life.

Instructions Compute the depreciation expense under the straight-line method for 2017 and 2018, assuming a December 31 year-end.

Determine property, plant, and equipment costs.

(LO 1), C

Determine acquisition costs of land.

(LO 1), AP

Understand depreciation concepts.

(LO 2), C

Determine straight-line depreciation for partial period.

(LO 2), AP

Exercises 463

E9-6 Victor Mineli, the new controller of Santorini Company, has reviewed the expected useful lives and salvage values of selected depreciable assets at the beginning of 2017. Here are his findings:

Accumulated Useful Life

Type of Date Depreciation, (in years) Salvage Value

Asset Acquired Cost Jan. 1, 2017 Old Proposed Old Proposed

Building Jan. 1, 2009 $700,000 $130,000 40 48 $50,000 $35,000 Warehouse Jan. 1, 2012 120,000 23,000 25 20 5,000 3,600

All assets are depreciated by the straight-line method. Santorini Company uses a calen- dar year in preparing annual financial statements. After discussion, management has agreed to accept Victor’s proposed changes. (The “Proposed” useful life is total life, not remaining life.)

Instructions (a) Compute the revised annual depreciation on each asset in 2017. (Show computations.) (b) Prepare the entry (or entries) to record depreciation on the building in 2017.

E9-7 Thieu Co. has delivery equipment that cost $50,000 and has been depreciated $24,000.

Instructions Record entries for the disposal under the following assumptions. (a) It was scrapped as having no value. (b) It was sold for $37,000. (c) It was sold for $20,000.

E9-8 Here are selected 2017 transactions of Akron Corporation.

Jan. 1 Retired a piece of machinery that was purchased on January 1, 2007. The machine cost $62,000 and had a useful life of 10 years with no salvage value.

June 30 Sold a computer that was purchased on January 1, 2015. The computer cost $36,000 and had a useful life of 3 years with no salvage value. The computer was sold for $5,000 cash.

Dec. 31 Sold a delivery truck for $9,000 cash. The truck cost $25,000 when it was purchased on January 1, 2014, and was depreciated based on a 5-year use- ful life with a $4,000 salvage value.

Instructions Journalize all entries required on the above dates, including entries to update depreciation on assets disposed of, where applicable. Akron Corporation uses straight-line depreciation.

E9-9 Shown below are the T-accounts relating to equipment that was purchased for cash by a company on the first day of the current year. The equipment was depreciated on a straight-line basis with an estimated useful life of 10 years and a salvage value of $100. Part of the equipment was sold on the last day of the current year for cash proceeds.

Cash Equipment Accumulated Depreciation—Equipment

Jan. 1 (a) Jan. 1 1,100 Dec. 31 100 Dec. 31 450 Dec. 31 440 Dec. 31 40 31 55

Depreciation Expense Gain on Disposal of Plant Assets

Dec. 31 (b) Dec. 31 (c)

Instructions Prepare the journal entries to record the following and derive the missing amounts: (a) Purchase of equipment on January 1. What was the cash paid? (b) Depreciation recorded on December 31. What was the depreciation expense? (c) Sale of part of the equipment on December 31. What was the gain on disposal?

E9-10 The following situations are independent of one another. 1. An accounting student recently employed by a small company doesn’t understand

why the company is only depreciating its buildings and equipment, but not its land. The student prepared journal entries to depreciate all the company’s property, plant, and equipment for the current year-end.

2. The same student also thinks the company’s amortization policy on its intangible assets is wrong. The company is currently amortizing its patents but not its goodwill.

Compute revised annual depreciation.

(LO 2), AN

Journalize transactions related to disposals of plant assets.

(LO 3), AP

Record disposal of equipment.

(LO 3), AP

Record equipment transactions and determine missing amounts.

(LO 1, 2, 3), AN

Apply accounting concepts.

(LO 1, 2, 3, 4), C

464 9 Reporting and Analyzing Long-Lived Assets

As a result, the student added goodwill to her adjusting entry for amortization at the end of the current year. She told a fellow employee that she felt she had improved the consistency of the company’s accounting policies by making these changes.

3. The same company has a building still in use that has a zero book value but a substan- tial fair value. The student felt that this practice didn’t benefit the company’s users— especially the bank—and wrote the building up to its fair value. After all, she rea- soned, you can write down assets if fair values are lower. Writing them up if fair value is higher is yet another example of the improved consistency that she has brought to the company’s accounting practices.

Instructions Explain whether or not the accounting treatment in each of the above situations is in accordance with generally accepted accounting principles. Explain what accounting prin- ciple or assumption, if any, has been violated and what the appropriate accounting treat- ment should be.

E9-11 These are selected 2017 transactions for Wyle Corporation:

Jan. 1 Purchased a copyright for $120,000. The copyright has a useful life of 6 years and a remaining legal life of 30 years.

Mar. 1 Purchased a patent with an estimated useful life of 4 years and a legal life of 20 years for $54,000.

Sept. 1 Purchased a small company and recorded goodwill of $150,000. Its useful life is indefinite.

Instructions Prepare all adjusting entries at December 31 to record amortization required by the events.

E9-12 On January 1, 2017, Haley Company had a balance of $360,000 of goodwill on its balance sheet that resulted from the purchase of a small business in a prior year. The goodwill had an indefinite life. During 2017, the company had the following additional transactions.

Jan. 2 Purchased a patent (5-year life) $280,000. July 1 Acquired a 9-year franchise; expiration date July 1, 2026, $540,000. Sept. 1 Research and development costs $185,000.

Instructions (a) Prepare the necessary entries to record the transactions related to intangibles. All

costs incurred were for cash. (b) Make the entries as of December 31, 2017, recording any necessary amortization. (c) Indicate what the intangible asset account balances should be on December 31, 2017.

E9-13 Alliance Atlantis Communications Inc. changed its accounting policy to amortize broadcast rights over the contracted exhibition period, which is based on the estimated useful life of the program. Previously, the company amortized broadcast rights over the lesser of 2 years or the contracted exhibition period.

Instructions Write a short memo to your client explaining the implications this has for the

analysis of Alliance Atlantis’s results.

E9-14 The questions listed below are independent of one another.

Instructions Provide a brief answer to each question. (a) Why should a company depreciate its buildings? (b) How can a company have a building that has a zero reported book value but substan-

tial fair value? (c) What are some examples of intangibles that you might fi nd on your college campus? (d) Give some examples of company or product trademarks or trade names. Are trade

names and trademarks reported on a company’s balance sheet?

E9-15 Suppose during 2017 that Federal Express reported the following information (in millions): net sales of $35,497 and net income of $98. Its balance sheet also showed total assets at the beginning of the year of $25,633 and total assets at the end of the year of $24,244.

Prepare adjusting entries for amortization.

(LO 4), AN

Prepare entries to set up appropriate accounts for different intangibles; calculate amortization.

(LO 4), AN

Discuss implications of amortization period.

(LO 4), C

Answer questions on depreciation and intangibles.

(LO 2, 4), C

Calculate asset turnover and return on assets.

(LO 5), AP

Exercises 465

Instructions Calculate the (a) asset turnover and (b) return on assets.

E9-16 Lymen International is considering a significant expansion to its product line. The sales force is excited about the opportunities that the new products will bring. The new products are a significant step up in quality above the company’s current offerings, but offer a complementary fit to its existing product line. Fred Riddick, senior pro- duction department manager, is very excited about the high-tech new equipment that will have to be acquired to produce the new products. Barbara Dyson, the company’s CFO, has provided the following projections based on results with and without the new products.

Without New Products With New Products

Sales revenue $10,000,000 $16,000,000 Net income $500,000 $960,000 Average total assets $5,000,000 $12,000,000

Instructions (a) Compute the company’s return on assets, profi t margin, and asset turnover, both with

and without the new product line. (b) Discuss the implications that your fi ndings in part (a) have for the company’s decision.

E9-17 Linley Company reports the following information (in millions) during a recent year: net sales, $11,408.5; net earnings, $264.8; total assets, ending, $4,312.6; and total assets, beginning, $4,254.3.

Instructions (a) Calculate the (1) return on assets, (2) asset turnover, and (3) profi t margin. (b) Prove mathematically how the profi t margin and asset turnover work together to

explain return on assets, by showing the appropriate calculation. (c) Linley Company owns Northgate (grocery), Linley Theaters, Oz Drugstores, and

Ransome (heavy equipment), and manages commercial real estate, among other activities. Does this diversity of activities affect your ability to interpret the ratios you calculated in (a)? Explain.

E9-18 Mendez Corporation reported net income of $58,000. Depreciation expense for the year was $132,000. The company calculates depreciation expense using the straight-line method, with a useful life of 10 years. Top management would like to switch to a 15-year useful life because depreciation expense would be reduced to $88,000. The CEO says, “Increasing the useful life would increase net income and net cash provided by operating activities.”

Instructions Provide a comparative analysis showing net income and net cash provided by operating activities (ignoring other accrual adjustments) under the indirect method using a 10-year and a 15-year useful life. (Ignore income taxes.) Evaluate the CEO’s suggestion.

*E9-19 Whippet Bus Lines uses the units-of-activity method in depreciating its buses. One bus was purchased on January 1, 2017, at a cost of $100,000. Over its 4-year useful life, the bus is expected to be driven 160,000 miles. Salvage value is expected to be $8,000.

Instructions (a) Compute the depreciation cost per unit. (b) Prepare a depreciation schedule assuming actual mileage was 2017, 40,000; 2018,

52,000; 2019, 41,000; and 2020, 27,000.

*E9-20 Basic information relating to a new machine purchased by Gotham Company is presented in E9-5.

Instructions Using the facts presented in E9-5, compute depreciation using the following methods in the year indicated. (a) Declining-balance using double the straight-line rate for 2017 and 2018. (b) Units-of-activity for 2017, assuming machine usage was 480 hours. (Round deprecia-

tion per unit to the nearest cent.)

Calculate and interpret ratios.

(LO 5), AP

Calculate and interpret ratios.

(LO 5), AP

Determine net cash provided by operating activities.

(LO 5), AN

Compute depreciation under units-of-activity method.

(LO 6), AP

Compute declining-balance and units-of-activity depreciation.

(LO 6), AP

466 9 Reporting and Analyzing Long-Lived Assets

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P9-1A Peete Company was organized on January 1. During the fi rst year of operations, the following plant asset expenditures and receipts were recorded in random order.

Debit

1. Excavation costs for new building $ 23,000 2. Architect’s fees on building plans 33,000 3. Full payment to building contractor 640,000 4. Cost of real estate purchased as a plant site (land $255,000

and building $25,000) 280,000 5. Cost of parking lots and driveways 29,000 6. Accrued real estate taxes paid at time of purchase of real estate 3,170 7. Installation cost of fences around property 6,800 8. Cost of demolishing building to make land suitable for

construction of new building 31,000 9. Real estate taxes paid for the current year on land 6,400

$1,052,370

Credit

10. Proceeds from salvage of demolished building $ 12,000

Instructions Analyze the transactions using the following table column headings. Enter the number of each transaction in the Item column, and enter the amounts in the appropriate columns. For amounts in the Other Accounts column, also indicate the account title.

Item Land Buildings Other Accounts

P9-2A At December 31, 2017, Arnold Corporation reported the following plant assets.

Land $ 3,000,000 Buildings $26,500,000 Less: Accumulated depreciation—buildings 11,925,000 14,575,000

Equipment 40,000,000 Less: Accumulated depreciation—equipment 5,000,000 35,000,000

Total plant assets $52,575,000

During 2018, the following selected cash transactions occurred.

Apr. 1 Purchased land for $2,200,000. May 1 Sold equipment that cost $600,000 when purchased on January 1, 2011.

The equipment was sold for $170,000. June 1 Sold land for $1,600,000. The land cost $1,000,000. July 1 Purchased equipment for $1,100,000. Dec. 31 Retired equipment that cost $700,000 when purchased on December 31,

2008. No salvage value was received.

Instructions (a) Journalize the transactions. (Hint: You may wish to set up T-accounts, post beginning

balances, and then post 2018 transactions.) Arnold uses straight-line depreciation for buildings and equipment. The buildings are estimated to have a 40-year useful life and no salvage value; the equipment is estimated to have a 10-year useful life and no sal- vage value. Update depreciation on assets disposed of at the time of sale or retirement.

(b) Record adjusting entries for depreciation for 2018. (c) Prepare the plant assets section of Arnold’s balance sheet at December 31, 2018.

Determine acquisition costs of land and building.

(LO 1), C

Journalize equipment transactions related to purchase, sale, retirement, and depreciation.

(LO 2, 3, 5), AP

Land $302,170

PROBLEMS: SET A▼

Problems: Set A 467

P9-3A Pine Company had the following assets on January 1, 2017.

Purchase Useful Life Item Cost Date (in years) Salvage Value

Machinery $71,000 Jan. 1, 2007 10 $ -0- Forklift 30,000 Jan. 1, 2014 5 -0- Truck 33,400 Jan. 1, 2012 8 3,000

During 2017, each of the assets was removed from service. The machinery was retired on January 1. The forklift was sold on June 30 for $12,000. The truck was discarded on December 31.

Instructions Journalize all entries required on the above dates, including entries to update depreci- ation, where applicable, on disposed assets. The company uses straight-line depreciation. All depreciation was up to date as of December 31, 2016.

P9-4A At January 1, 2017, Youngstown Company reported the following property, plant, and equipment accounts:

Accumulated depreciation—buildings $ 62,200,000 Accumulated depreciation—equipment 54,000,000 Buildings 97,400,000 Equipment 150,000,000 Land 20,000,000

The company uses straight-line depreciation for buildings and equipment, its year-end is December 31, and it makes adjusting entries annually. The buildings are estimated to have a 40-year useful life and no salvage value; the equipment is estimated to have a 10-year useful life and no salvage value. During 2017, the following selected transactions occurred:

Apr. 1 Purchased land for $4.4 million. Paid $1.1 million cash and issued a 3-year, 6% note payable for the balance. Interest on the note is payable annually each April 1.

May 1 Sold equipment for $300,000 cash. The equipment cost $2.8 million when originally purchased on January 1, 2009.

June 1 Sold land for $3.6 million. Received $900,000 cash and accepted a 3-year, 5% note for the balance. The land cost $1.4 million when purchased on June 1, 2011. Interest on the note is due annually each June 1.

July 1 Purchased equipment for $2.2 million cash. Dec. 31 Retired equipment that cost $1 million when purchased on December 31,

2007. No proceeds were received.

Instructions (a) Record the above transactions. (b) Record any adjusting entries required at December 31. (c) Prepare the property, plant, and equipment section of the company’s statement of

fi nancial position at December 31.

P9-5A The intangible assets section of Amato Corporation’s balance sheet at December 31, 2017, is presented here.

Patents ($60,000 cost less $6,000 amortization) $54,000 Copyrights ($36,000 cost less $25,200 amortization) 10,800

Total $64,800

The patent was acquired in January 2017 and has a useful life of 10 years. The copyright was acquired in January 2011 and also has a useful life of 10 years. The following cash transactions may have affected intangible assets during 2018.

Jan. 2 Paid $46,800 legal costs to successfully defend the patent against infringe- ment by another company.

Jan.–June Developed a new product, incurring $230,000 in research and development costs. A patent was granted for the product on July 1, and its useful life is equal to its legal life. Legal and other costs for the patent were $20,000.

Sept. 1 Paid $40,000 to a quarterback to appear in commercials advertising the company’s products. The commercials will air in September and October.

Oct. 1 Acquired a copyright for $200,000. The copyright has a useful life and legal life of 50 years.

Journalize entries for disposal of plant assets.

(LO 3), AP

Loss on truck disposal $10,600

Record property, plant, and equipment transactions; prepare partial balance sheet.

(LO 1, 2, 3, 5), AP

Total PP&E $138,575,000

Prepare entries to record transactions related to acquisition and amortization of intangibles; prepare the intangible assets section and note.

(LO 4, 5), AP

468 9 Reporting and Analyzing Long-Lived Assets

Instructions (a) Prepare journal entries to record the transactions. (b) Prepare journal entries to record the 2018 amortization expense for intangible assets. (c) Prepare the intangible assets section of the balance sheet at December 31, 2018. (d) Prepare the note to the fi nancial statements on Amato Corporation’s intangible assets

as of December 31, 2018.

P9-6A Due to rapid employee turnover in the accounting department, the following trans- actions involving intangible assets were improperly recorded by Inland Corporation.

1. Inland developed a new manufacturing process, incurring research and develop- ment costs of $160,000. The company also purchased a patent for $40,000. In early January, Inland capitalized $200,000 as the cost of the patents. Patent amortization expense of $10,000 was recorded based on a 20-year useful life.

2. On July 1, 2017, Inland purchased a small company and as a result recorded goodwill of $80,000. Inland recorded a half-year’s amortization in 2017, based on a 20-year life ($2,000 amortization). The goodwill has an indefinite life.

Instructions Prepare all journal entries necessary to correct any errors made during 2017. Assume the books have not yet been closed for 2017.

P9-7A Blythe Corporation and Jacke Corporation, two companies of roughly the same size, are both involved in the manufacture of shoe-tracing devices. Each company depre- ciates its plant assets using the straight-line approach. An investigation of their fi nancial statements reveals the information shown below.

Blythe Corp. Jacke Corp.

Net income $ 240,000 $ 300,000 Sales revenue 1,150,000 1,200,000 Total assets (average) 3,200,000 3,000,000 Plant assets (average) 2,400,000 1,800,000 Intangible assets (goodwill) 300,000 0

Instructions (a) For each company, calculate these values: (1) Return on assets. (2) Profit margin. (3) Asset turnover. (b) Based on your calculations in part (a), comment on the relative effectiveness of the

two companies in using their assets to generate sales. What factors complicate your ability to compare the two companies?

*P9-8A In recent years, Jayme Company has purchased three machines. Because of frequent employee turnover in the accounting department, a different accountant was in charge of selecting the depreciation method for each machine, and various methods have been used. Information concerning the machines is summarized in the table below.

Salvage Useful Life Machine Acquired Cost Value (in years) Depreciation Method

1 Jan. 1, 2015 $96,000 $12,000 8 Straight-line 2 July 1, 2016 85,000 10,000 5 Declining-balance 3 Nov. 1, 2016 66,000 6,000 6 Units-of-activity

For the declining-balance method, Jayme Company uses the double-declining rate. For the units-of-activity method, total machine hours are expected to be 30,000. Actual hours of use in the fi rst 3 years were 2016, 800; 2017, 4,500; and 2018, 6,000.

Instructions (a) Compute the amount of accumulated depreciation on each machine at December 31, 2018. (b) If machine 2 was purchased on April 1 instead of July 1, what would be the deprecia-

tion expense for this machine in 2016? In 2017?

*P9-9A Megan Corporation purchased machinery on January 1, 2017, at a cost of $250,000. The estimated useful life of the machinery is 4 years, with an estimated salvage value at the end of that period of $30,000. The company is considering different depreciation methods that could be used for fi nancial reporting purposes.

Prepare entries to correct errors in recording and amortizing intangible assets.

(LO 4), AP

Calculate and comment on return on assets, profi t margin, and asset turnover.

(LO 5), AN

Compute depreciation under different methods.

(LO 2, 6), AP

(a) Machine 2 $60,520

Compute depreciation under different methods.

(LO 2, 6), AP

Comprehensive Accounting Cycle Review 469

Instructions (a) Prepare separate depreciation schedules for the machinery using the straight-line

method, and the declining-balance method using double the straight-line rate. (Round to the nearest dollar.)

(b) Which method would result in the higher reported 2017 income? In the highest total reported income over the 4-year period?

(c) Which method would result in the lower reported 2017 income? In the lowest total reported income over the 4-year period?

(a) Double-declining- balance expense 2019 $31,250

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 8.)

CC9 Part 1 Now that she is selling mixers and her customers can use credit cards to pay for them, Natalie is thinking of upgrading her website so that she can sell mixers online, to broaden her range of customers. She will need to know how to account for the costs of upgrading the site.

Part 2 Natalie is also thinking of buying a van that will be used only for business. Natalie is concerned about the impact of the van’s cost on her income statement and balance sheet. She has come to you for advice on calculating the van’s depreciation.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to see the com- pletion of this problem.

CONTINUING PROBLEM Cookie Creations▼

COMPREHENSIVE ACCOUNTING CYCLE REVIEW ACR9-1 Milo Corporation’s unadjusted trial balance at December 1, 2017, is presented below.

Debit Credit

Cash $ 22,000 Accounts Receivable 36,800 Notes Receivable 10,000 Interest Receivable –0– Inventory 36,200 Prepaid Insurance 3,600 Land 20,000 Buildings 150,000 Equipment 60,000 Patent 9,000 Allowance for Doubtful Accounts $ 500 Accumulated Depreciation—Buildings 50,000 Accumulated Depreciation—Equipment 24,000 Accounts Payable 27,300 Salaries and Wages Payable –0– Notes Payable (due April 30, 2018) 11,000 Income Taxes Payable –0– Interest Payable –0– Notes Payable (due in 2023) 35,000 Common Stock 50,000 Retained Earnings 63,600 Dividends 12,000 Sales Revenue 900,000

Debit Credit

Interest Revenue –0– Gain on Disposal of Plant Assets –0– Bad Debt Expense –0– Cost of Goods Sold 630,000 Depreciation Expense –0– Income Tax Expense –0– Insurance Expense –0– Interest Expense –0– Other Operating Expenses 61,800 Amortization Expense –0– Salaries and Wages Expense 110,000

$1,161,400 $1,161,400

The following transactions occurred during December.

Dec. 2 Purchased equipment for $16,000, plus sales taxes of $800 (paid in cash). 2 Milo sold for $3,500 equipment which originally cost $5,000. Accumulated

depreciation on this equipment at January 1, 2017, was $1,800; 2017 depre- ciation prior to the sale of equipment was $825.

15 Milo sold for $5,000 on account inventory that cost $3,500. 23 Salaries and wages of $6,600 were paid.

Adjustment data:

1. Milo estimates that uncollectible accounts receivable at year-end are $4,000. 2. The note receivable is a 1-year, 8% note dated April 1, 2017. No interest has been recorded. 3. The balance in prepaid insurance represents payment of a $3,600, 6-month premium

on September 1, 2017. 4. The building is being depreciated using the straight-line method over 30 years. The

salvage value is $30,000. 5. The equipment owned prior to this year is being depreciated using the straight-line

method over 5 years. The salvage value is 10% of cost. 6. The equipment purchased on December 2, 2017, is being depreciated using the

straight-line method over 5 years, with a salvage value of $1,800. 7. The patent was acquired on January 1, 2017, and has a useful life of 9 years from that date. 8. Unpaid salaries at December 31, 2017, total $2,200. 9. Both the short-term and long-term notes payable are dated January 1, 2017, and carry

a 10% interest rate. All interest is payable in the next 12 months. 10. Income tax expense was $15,000. It was unpaid at December 31.

Instructions (a) Prepare journal entries for the transactions listed above and adjusting entries. (b) Prepare an adjusted trial balance at December 31, 2017. (c) Prepare a 2017 income statement and a 2017 retained earnings statement. (d) Prepare a December 31, 2017, balance sheet.

ACR9-2 Aberkonkie Corporation prepares quarterly fi nancial statements. The post- closing trial balance at December 31, 2016, is presented below.

ABERKONKIE CORPORATION Post-Closing Trial Balance

December 31, 2016 Debit Credit

Cash $ 24,300 Accounts Receivable 22,400 Allowance for Doubtful Accounts $ 1,200 Equipment 20,000 Accumulated Depreciation—Equipment 15,000 Buildings 100,000 Accumulated Depreciation—Buildings 15,000 Land 20,000 Accounts Payable 12,370 Common Stock 90,000 Retained Earnings 53,130

$186,700 $186,700

(b) Totals $1,205,775 (c) Net income $51,150 (d) Total assets $247,850

470 9 Reporting and Analyzing Long-Lived Assets

During the first quarter of 2017, the following transaction occurred:

1. On February 1, Aberkonkie collected fees of $12,000 in advance. The company will perform $1,000 of services each month from February 1, 2017, to January 31, 2018.

2. On February 1, Aberkonkie purchased computer equipment for $9,000 plus sales taxes of $600. $3,000 cash was paid with the rest on account. Check #455 was used.

3. On March 1, Aberkonkie acquired a patent with a 10-year life for $9,600 cash. Check #456 was used.

4. On March 28, Aberkonkie recorded the quarter’s sales in a single entry. During this period, Aberkonkie had total sales of $140,000 (not including the sales referred to in item 1 above). All of the sales were on account.

5. On March 29, Aberkonkie collected $133,000 from customers on account. 6 On March 29, Aberkonkie paid $16,370 on accounts payable. Check #457 was used. 7. On March 29, Aberkonkie paid other operating expenses of $97,525. Check #458 was

used. 8. On March 31, Aberkonkie wrote off a receivable of $200 for a customer who declared

bankruptcy. 9. On March 31, Aberkonkie sold for $1,620 equipment that originally cost $11,000. It

had an estimated life of 5 years and salvage of $1,000. Accumulated depreciation as of December 31, 2016, was $8,000 using the straight line method. (Hint: Record depreci- ation on the equipment sold, then record the sale.)

Bank reconciliation data and adjustment data:

1. The company reconciles its bank statement every quarter. Information from the December 31, 2016, bank reconciliation is:

Deposit in transit: 12/30/2016 $5,000 Outstanding checks #440 3,444 #452 333 #453 865 #454 5,845

The bank statement received for the quarter ended March 31, 2017, is as follows:

Beginning balance per bank $ 29,787 Deposits: 1/2/2017, $5,000; 2/2/2017, $12,000; 3/30/2017, $133,000 150,000 Checks: #452, $333; #453, $865; #457, $16,370; #458, $97,525 (115,093) Debit memo: Bank service charge (record as operating expense) (100)

Ending bank balance $ 64,594

2. Record revenue earned from item 1 above. 3. $26,000 of accounts receivable at March 31, 2017, are not past due yet. The bad debt

percentage for these is 4%. The balance of accounts receivable are past due. The bad debt percentage for these is 23.75%. Record bad debt expense. (Hint: You will need to compute the balance in accounts receivable before calculating this.)

4. Depreciation is recorded on the equipment still owned at March 31, 2017. The new equipment purchased in February is being depreciated on a straight-line basis over 5 years and salvage value was estimated at $1,200. The old equipment still owned is being depreciated over a 10-year life using straight-line with no salvage value.

5. Depreciation is recorded on the building on a straight-line basis based on a 30-year life and a salvage value of $10,000.

6. Amortization is recorded on the patent. 7. The income tax rate is 30%. This amount will be paid when the tax return is due in

April. (Hint: Prepare the income statement up to income before taxes and multiply by 30% to compute the amount.)

Instructions (a) Record journal entries for transactions 1–9. (b) Enter the December 31, 2016, balances in ledger accounts using T-accounts. (c) Post the journal entries to the ledger accounts for items 1–9. (d) Prepare an unadjusted trial balance at March 31. (e) Prepare a bank reconciliation in good form. (f) Journalize and post entries related to bank reconciliation and all adjusting entries. (g) Prepare an adjusted trial balance. (h) Prepare an income statement and a retained earnings statement for the quarter ended

March 31, 2017, and a classified balance sheet at March 31, 2017.

(d) Trial balance total $320,730

(e) Adjusted balance per bank $44,325 (f) Total assets $196,590

Comprehensive Accounting Cycle Review 471

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT9-1 The fi nancial statements of Apple Inc. are presented in Appendix A. Instructions for accessing and using the company’s complete annual report, including the notes to the fi nancial statements, are also provided in Appendix A.

Instructions Answer the following questions.

(a) What were the total cost and book value of property, plant, and equipment at Septem- ber 27, 2014?

(b) Using the notes to the financial statements, what method or methods of depreciation are used by Apple for financial reporting purposes?

(c) What was the amount of depreciation and amortization expense for each of the 3 years 2012–2014? (Hint: Use the statement of cash flows.)

(d) Using the statement of cash flows, what are the amounts of property, plant, and equip- ment purchased in 2014 and 2013?

(e) Using the notes to the financial statements, explain how Apple accounted for its intan- gible assets in 2014.

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT9-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C. In- structions for accessing and using the companies’ complete annual reports, including the notes to the fi nancial statements, are also provided in Appendices B and C, respectively.

Instructions (a) Based on the information in these financial statements and the accompanying notes

and schedules, compute the following values for each company in 2014. (1) Return on assets. (2) Profit margin (use “Total Revenue”). (3) Asset turnover. (b) What conclusions concerning the management of plant assets can be drawn from

these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT9-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Fi- nancial statements of Wal-Mart Stores, Inc. are presented in Appendix E. Instructions for accessing and using the companies’ complete annual reports, including the notes to the fi nancial statements, are also provided in Appendices D and E, respectively.

Instructions (a) Based on the information in these financial statements and the accompanying notes

and schedules, compute the following values for each company for the most recent fiscal year.

(1) Return on assets. (2) Profit margin (use “Total Revenue”). (3) Asset turnover. (b) What conclusions concerning the management of plant assets can be drawn from

these data?

INTERPRETING FINANCIAL STATEMENTS

CT9-4 The March 29, 2012, edition of the Wall Street Journal Online contains an article by Miguel Bustillo entitled, “Best Buy Forced to Rethink Big Box.” The article explains how the 1,100 giant stores, which enabled Best Buy to obtain its position as the largest retailer of electronics, are now reducing the company’s profi tability and even threatening its survival. The problem is that many customers go to Best Buy stores to see items but

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472 9 Reporting and Analyzing Long-Lived Assets

then buy them for less from online retailers. As a result, Best Buy recently announced that it would close 50 stores and switch to smaller stores. However, some analysts think that these changes are not big enough. Suppose the following data were extracted from the 2017 and 2012 annual reports of Best Buy. (All amounts are in millions.)

2017 2016 2012 2011

Total assets at year-end $17,849 $18,302 $11,864 $10,294 Net sales 50,272 30,848 Net income 1,277 1,140

Instructions Using the data above, answer the following questions.

(a) How might the return on assets and asset turnover of Best Buy differ from an online retailer?

(b) Compute the profit margin, asset turnover, and return on assets for 2017 and 2012. (c) Present the ratios calculated in part (b) in the equation format shown in Illustra-

tion 9-22 (page 446). (d) Discuss the implications of the ratios calculated in parts (b) and (c).

REAL-WORLD FOCUS

CT9-5 Purpose: Use an annual report to identify a company’s plant assets and the depre- ciation method used.

Address: www.annualreports.com

Steps 1. Select a particular company. 2. Search by company name. 3. Follow instructions below.

Instructions Answer the following questions.

(a) What is the name of the company? (b) What is the Internet address of the annual report? (c) At fiscal year-end, what is the net amount of its plant assets? (d) What is the accumulated depreciation? (e) Which method of depreciation does the company use?

CT9-6 The November 16, 2011, edition of the Wall Street Journal Online contains an article by Maxwell Murphy entitled “The Big Number: 51.”

Instructions Read the article and answer the following questions.

(a) What do the 51 companies referred to in the title have in common? What implications does this have regarding the fair value of a company’s assets?

(b) What significance does the common trait referred to in part (a) have for a company’s goodwill?

(c) How does a company get to record goodwill on its books—that is, what must have occurred for goodwill to show up on a company’s books?

(d) If these companies write down their goodwill, will this reduce their cash?

DECISION-MAKING ACROSS THE ORGANIZATION

CT9-7 Brady Furniture Corp. is nationally recognized for making high-quality products. Management is concerned that it is not fully exploiting its brand power. Brady’s produc- tion managers are also concerned because their plants are not operating at anywhere near full capacity. Management is currently considering a proposal to offer a new line of affordable furniture.

Those in favor of the proposal (including the vice president of production) believe that, by offering these new products, the company could attract a clientele that it is not currently servicing. Also, it could operate its plants at full capacity, thus taking better advantage of its assets.

Financial Analysis

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Expand Your Critical Thinking 473

The vice president of marketing, however, believes that the lower-priced (and lower- margin) product would have a negative impact on the sales of existing products. The vice president believes that $10,000,000 of the sales of the new product will be from customers that would have purchased the more expensive product but switched to the lower-margin product because it was available. (This is often referred to as cannibalization of existing sales.) Top management feels, however, that even with cannibalization, the company’s sales will increase and the company will be better off.

The following data are available.

Current Proposed Results Proposed Results (in thousands) Results without Cannibalization with Cannibalization

Sales revenue $45,000 $60,000 $50,000 Net income $12,000 $13,500 $12,000 Average total assets $100,000 $100,000 $100,000

Instructions (a) Compute Brady’s return on assets, profit margin, and asset turnover, both with and

without the new product line. (b) Discuss the implications that your findings in part (a) have for Brady’s decision. (c) Are there any other options that Brady should consider? What impact would each of

these have on the above ratios?

COMMUNICATION ACTIVITY

CT9-8 The chapter presented some concerns regarding the current accounting standards for research and development expenditures.

Instructions Assume that you are either (a) the president of a company that is very dependent on ongo- ing research and development, writing a memo to the FASB complaining about the cur- rent accounting standards regarding research and development, or (b) the FASB member defending the current standards regarding research and development. Your memo should address the following questions.

1. By requiring expensing of R&D, do you think companies will spend less on R&D? Why or why not? What are the possible implications for the competitiveness of U.S. companies?

2. If a company makes a commitment to spend money for R&D, it must believe it has future benefits. Shouldn’t these costs therefore be capitalized just like the purchase of any long-lived asset that you believe will have future benefits?

ETHICS CASE

CT9-9 Clean Aire Anti-Pollution Company is suffering declining sales of its principal prod- uct, nonbiodegradable plastic cartons. The president, Wade Truman, instructs his control- ler, Kate Rollins, to lengthen asset lives to reduce depreciation expense. A processing line of automated plastic extruding equipment, purchased for $3.5 million in January 2017, was originally estimated to have a useful life of 8 years and a salvage value of $400,000. Depreciation has been recorded for 2 years on that basis. Wade wants the estimated life changed to 12 years total and the straight-line method continued. Kate is hesitant to make the change, believing it is unethical to increase net income in this manner. Wade says, “Hey, the life is only an estimate, and I’ve heard that our competition uses a 12-year life on their production equipment.”

Instructions (a) Who are the stakeholders in this situation? (b) Is the proposed change in asset life unethical, or is it simply a good business practice

by an astute president? (c) What is the effect of Wade’s proposed change on income before taxes in the year of

change?

ALL ABOUT YOU

CT9-10 A company’s tradename is a very important asset to the company, as it creates immediate product identifi cation. Companies invest substantial sums to ensure that their product is well-known to the consumer. Test your knowledge of who owns some famous brands and their impact on the fi nancial statements.

474 9 Reporting and Analyzing Long-Lived Assets

Instructions (a) Provide an answer to the four multiple-choice questions below. (1) Which company owns both Taco Bell and Pizza Hut? (a) McDonald’s. (b) CKE. (c) Yum Brands. (d) Wendy’s. (2) Dairy Queen belongs to: (a) Breyer. (b) Berkshire Hathaway. (c) GE. (d) The Coca-Cola Company. (3) Phillip Morris, the cigarette maker, is owned by: (a) Altria. (b) GE. (c) Boeing. (d) ExxonMobil. (4) AOL, a major Internet provider, belongs to: (a) Microsoft. (b) Cisco. (c) NBC. (d) Time Warner. (b) How do you think the value of these brands is reported on the appropriate company’s

balance sheet?

FASB CODIFICATION ACTIVITY

CT9-11 If your school has a subscription to the FASB Codifi cation, go to http://aaahq. org/ascLogin.cfm to log in and prepare responses to the following.

(a) What does it mean to capitalize an item? (b) What is the definition provided for an intangible asset? (c) Your great-uncle, who is a CPA, is impressed that you are taking an accounting class.

Based on his experience, he believes that depreciation is something that companies do based on past practice, not on the basis of authoritative guidance. Provide the authoritative literature to support the practice of fixed-asset depreciation.

CONSIDERING PEOPLE, PLANET, AND PROFIT

CT9-12 The March 6, 2012, edition of the Wall Street Journal Online contains an article by David Kesmodel entitled “Air War: ‘Winglet’ Versus ‘Sharklet’.” This article demonstrates how a company focused on green technology has also been profi table.

Instructions Read the article and answer the following questions.

(a) Why did Airbus fi le a lawsuit against Aviation Partners? (b) What are the percentage fuel savings provided by Aviation Partners’ Winglets on Boeing

jetliners? How much total jet fuel did Aviation Partners say that its Winglets have provided at the time the article was written?

(c) Describe the history of the relationship between Aviation Partners and Airbus, and the development of the Airbus Sharklet.

(d) What would be the likely accounting implications if Aviation Partners were to lose the lawsuit?

A Look at IFRS 475

LEARNING OBJECTIVE 7 Compare the accounting for long-lived assets under GAAP and IFRS.▼

A Look at IFRS

IFRS follows most of the same principles as GAAP in the accounting for property, plant, and equipment. There are, however, some significant differences in the implementation. IFRS allows the use of revaluation of property, plant, and equipment, and it also requires the use of component depreciation. In addition, there are some significant differences in the accounting for both intangible assets and impairments.

KEY POINTS The following are the key similarities and differences between GAAP and IFRS as related to the recording process for long-lived assets.

476 9 Reporting and Analyzing Long-Lived Assets

Similarities • The definition for plant assets for both IFRS and GAAP is essentially the same. • Both IFRS and GAAP follow the historical cost principle when accounting for property,

plant, and equipment at date of acquisition. Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use.

• Under both IFRS and GAAP, interest costs incurred during construction are capital- ized. Recently, IFRS converged to GAAP requirements in this area.

• The accounting for subsequent expenditures (such as ordinary repairs and additions) is essentially the same under IFRS and GAAP.

• IFRS also views depreciation as an allocation of cost over an asset’s useful life. IFRS permits the same depreciation methods (e.g., straight-line, accelerated, and units-of- activity) as GAAP.

• Under both GAAP and IFRS, changes in the depreciation method used and changes in useful life are handled in current and future periods. Prior periods are not affected. GAAP recently conformed to international standards in the accounting for changes in depreciation methods.

• The accounting for plant asset disposals is essentially the same under IFRS and GAAP. • The definition of intangible assets is essentially the same under IFRS and GAAP. • The accounting for exchanges of nonmonetary assets has recently converged between IFRS

and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recog- nized if the exchange has commercial substance. This is the same framework used in IFRS.

Differences • IFRS uses the term residual value rather than salvage value to refer to an owner’s

estimate of an asset’s value at the end of its useful life for that owner. • IFRS allows companies to revalue plant assets to fair value at the reporting date. Com-

panies that choose to use the revaluation framework must follow revaluation proce- dures. If revaluation is used, it must be applied to all assets in a class of assets. Assets that are experiencing rapid price changes must be revalued on an annual basis, other- wise less frequent revaluation is acceptable.

• IFRS requires component depreciation. Component depreciation specifies that any sig- nificant parts of a depreciable asset that have different estimated useful lives should be separately depreciated. Component depreciation is allowed under GAAP but is seldom used.

• As in GAAP, under IFRS the costs associated with research and development are seg- regated into the two components. Costs in the research phase are always expensed under both IFRS and GAAP. Under IFRS, however, costs in the development phase are capitalized as Development Costs once technological feasibility is achieved.

• IFRS permits revaluation of intangible assets (except for goodwill). GAAP prohibits revaluation of intangible assets.

LOOKING TO THE FUTURE The IASB and FASB have identified a project that would consider expanded recognition of internally generated intangible assets. IFRS permits more recognition of intangibles compared to GAAP.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. Which of the following statements is correct?

(a) Both IFRS and GAAP permit revaluation of property, plant, and equipment and intangible assets (except for goodwill).

(b) IFRS permits revaluation of property, plant, and equipment and intangible assets (except for goodwill).

(d) GAAP permits revaluation of property, plant, and equipment but not intangible assets. 2. Research and development costs are:

(a) expensed under GAAP. (b) expensed under IFRS. (c) expensed under both GAAP and IFRS. (d) None of the above.

A Look at IFRS 477

IFRS EXERCISES IFRS9-1 What is component depreciation, and when must it be used?

IFRS9-2 What is revaluation of plant assets? When should revaluation be applied?

IFRS9-3 Some product development expenditures are recorded as development expenses and others as development costs. Explain the difference between these accounts and how a company decides which classification is appropriate.

INTERNATIONAL FINANCIAL STATEMENT ANALYSIS: Louis Vuitton IFRS9-4 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Use the company’s annual report to answer the following questions.

(a) According to the notes to the financial statements, what method or methods does the company use to depreciate “property, plant, and equipment?” What useful lives does it use to depreciate property, plant, and equipment?

(b) Using the notes to the financial statements, explain how the company accounted for its intangible assets with indefinite lives.

(c) Using the notes to the financial statements, determine (1) the balance in Accumulated Amortization and Impairment for intangible assets (other than goodwill), and (2) the bal- ance in Depreciation (and impairment) for property, plant, and equipment.

Answers to IFRS Self-Test Questions 1. b 2. a

The Feature Story suggests that General Motors (GM) and Ford accumulated tremendous amounts

of debt in their pursuit of auto industry dominance. It is unlikely that they could have grown so large

without this debt, but at times the debt threatened their very existence. Given this risk, why do com panies

borrow money? Why do they sometimes borrow short-term and other times long-term? Besides bank

borrowings, what other kinds of debts do companies incur? In this chapter, we address these issues.

CHAPTER PREVIEW

Reporting and Analyzing Liabilities 10

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

1 Explain how to account for current liabilities.

• What is a current liability? • Notes payable • Sales taxes payable • Unearned revenues • Current maturities of long-

term debt • Payroll and payroll taxes

payable

DO IT!

1 1a Current Liabilities 1b Wages and Payroll

Taxes

2 Describe the major characteristics of bonds.

• Types of bonds • Issuing procedures • Determining the market price

of bonds

DO IT!

2 Bond Terminology

▼ ▼

3 Explain how to account for bond transactions.

4 Discuss how liabilities are reported and analyzed.

• Issuing bonds at face value • Discount or premium on bonds • Issuing bonds at a discount • Issuing bonds at a premium • Redeeming bonds at maturity • Redeeming bonds before

maturity

• Presentation • Analysis

DO IT!

3a Bond Issuance 3b Bond Redemption

Analyzing Liabilities

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Debt can help a company acquire the things it needs to grow. But, it is often the very thing that can also kill a company. A brief history of Maxwell Car Company illustrates the role of debt in the U.S. auto industry. In 1920, Maxwell Car Company was on the brink of fi nancial ruin. Because it was unable to pay its bills, its creditors stepped in and took over. They hired a former General Motors (GM) executive named Walter Chrysler to reorganize the company. By 1925, he had taken over the company and renamed it Chrysler. By 1933, Chrysler was booming, with sales surpassing even those of Ford.

But the next few decades saw Chrysler make a series of blunders. By 1980, with its creditors pounding at the gates, Chrysler was again on the brink of fi nancial ruin.

At that point, Chrysler brought in a former Ford executive named Lee Iacocca to save the company. Iacocca argued that the United States could not afford to let Chrysler fail because of the loss of jobs. He convinced the federal government to grant loan guarantees—promises that if Chrysler failed to pay its

creditors, the government would pay them. Iacocca then streamlined operations and brought out some profi table products. Chrysler repaid all of its

government-guaranteed loans by 1983, seven years ahead of the scheduled fi nal payment.

To compete in today’s global vehicle market, you must be big—really big. So in 1998, Chrysler merged with German automaker Daimler-Benz to form DaimlerChrysler. For a time,

this left just two U.S.-based auto manufacturers—GM and Ford. But in 2007, DaimlerChrysler sold 81% of Chrysler to Cerberus, an investment group, to provide much-needed cash infusions to the automaker. In 2009, Daimler turned over its remaining stake to Cerberus. Three days later, Chrysler fi led for bankruptcy. But by 2010, it was beginning to show signs of a turnaround.

The car companies are giants. GM and Ford typically rank among the top fi ve U.S. fi rms in total assets. But GM and Ford accumulated truckloads of debt on their way to getting big. Although debt made it possible to get so big, the Chrysler story, and GM’s recent bankruptcy, make it clear that debt can also threaten a company’s survival.

FEATURE STORY © Henrik Jonsson/iStockphoto

And Then There Were Two

480 10 Reporting and Analyzing Liabilities

LEARNING OBJECTIVE 1 Explain how to account for current liabilities.▼

WHAT IS A CURRENT LIABILITY?

Liabilities are often defi ned as “creditors’ claims on total assets” and as “exist- ing debts and obligations.” Companies must settle or pay these claims, debts, and obligations at some time in the future by transferring assets or services. The future date on which they are due or payable (the maturity date) is a signifi cant feature of liabilities. As explained in Chapter 2, a current liability is a debt that a company rea- sonably expects to pay (1) from existing current assets or through the creation of other current liabilities, and (2) within one year or the operating cycle, whichever is longer. Debts that do not meet both criteria are long-term liabilities. Financial statement users want to know whether a company’s obligations are current or long-term. A company that has more current liabilities than current assets often lacks liquidity, or short-term debt-paying ability. In addition, users want to know the types of liabilities a company has. If a company declares bank- ruptcy, a specifi c, predetermined order of payment to creditors exists. Thus, the amount and type of liabilities are of critical importance. The different types of current liabilities include notes payable, accounts pay- able, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest. In the sections that follow, we discuss a few of the common types of current liabilities.

NOTES PAYABLE

Companies record obligations in the form of written notes as notes payable. They often use notes payable instead of accounts payable because notes pay- able provide written documentation of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet short-term fi nancing needs. Notes payable usually require the borrower to pay interest. Notes are issued for varying periods of time. Those due for payment within one year of the balance sheet date are usually classifi ed as current liabilities. To illustrate the accounting for notes payable, assume that on September 1, 2017, Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1 with First National Bank. When a company issues an interest-bearing note, the amount of assets it receives generally equals the note’s face value. Cole Williams Co. therefore will receive $100,000 cash and will make the following journal entry.

Sept. 1 Cash 100,000 Notes Payable 100,000

(To record issuance of 12%, 4-month note to First National Bank)

Interest accrues over the life of the note, and the issuer must periodically record that accrual. (You may fi nd it helpful to review the discussion of interest computations that was provided in Chapter 8, page 388, with regard to notes receivable.) If Cole Williams Co. prepares fi nancial statements annually, it makes an adjusting entry at December 31 to recognize four months of interest expense and interest payable of $4,000 ($100,000 × 12% × 412):

Dec. 31 Interest Expense 4,000 Interest Payable 4,000 (To accrue interest for 4 months on First National Bank note)

▼ HELPFUL HINT In previous chapters, we explained the entries for accounts payable and the adjusting entries for some current liabilities.

A L SE= + +100,000 +100,000 Cash Flows +100,000

A L SE= + −4,000 Exp +4,000 Cash Flows no eff ect

Accounting for Current Liabilities 481

In the December 31 fi nancial statements, the current liabilities section of the balance sheet will show notes payable $100,000 and interest payable $4,000. In addition, the company will report interest expense of $4,000 under “Other expenses and losses” in the income statement. At maturity (January 1), Cole Williams Co. must pay the face value of the note ($100,000) plus $4,000 interest ($100,000 × 12% × 412). It records payment of the note and accrued interest as follows.

Jan. 1 Notes Payable 100,000 Interest Payable 4,000 Cash 104,000 (To record payment of First National Bank interest-bearing note and accrued interest at maturity)

Appendix 10C at the end of this chapter discusses the accounting for long-term installment notes payable.

SALES TAXES PAYABLE

Many of the products we purchase at retail stores are subject to sales taxes. Many states are now implementing sales taxes on purchases made on the Internet as well. Sales taxes are expressed as a percentage of the sales price. The selling com- pany collects the tax from the customer when the sale occurs and periodically (usually monthly) remits the collections to the state’s department of revenue. Col- lecting sales taxes is important. For example, the State of New York recently sued Sprint Corporation for $300 million for its alleged failure to collect sales taxes on phone calls. Under most state laws, the selling company must enter separately on the cash register the amount of the sale and the amount of the sales tax collected. (Gasoline sales are a major exception.) The company then uses the cash register readings to credit Sales Revenue and Sales Taxes Payable. For example, if the March 25 cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is as follows.

Mar. 25 Cash 10,600 Sales Revenue 10,000 Sales Taxes Payable 600 (To record daily sales and sales taxes)

When the company remits the taxes to the taxing agency, it decreases (debits) Sales Taxes Payable and decreases (credits) Cash. The company does not report sales taxes as an expense. It simply forwards to the government the amount paid by the customer. Thus, Cooley Grocery serves only as a collection agent for the taxing authority. Sometimes companies do not enter sales taxes separately on the cash regis- ter. To determine the amount of sales in such cases, divide total receipts by 100% plus the sales tax percentage. For example, assume that Cooley Grocery enters total receipts of $10,600. Because the amount received from the sale is equal to the sales price (100%) plus 6% of sales, or 1.06 times the sales total, we can compute sales as follows: $10,600 ÷ 1.06 = $10,000. Thus, we can fi nd the sales tax amount of $600 by either (1) subtracting sales from total receipts ($10,600 − $10,000) or (2) multiplying sales by the sales tax rate ($10,000 × 6%).

UNEARNED REVENUES

A magazine publisher such as Sports Illustrated collects cash when customers place orders for magazine subscriptions. An airline company such as American Airlines often receives cash when it sells tickets for future fl ights. Season tickets for concerts, sporting events, and theatre programs are also paid for in advance.

▼ HELPFUL HINT Check your sales receipts from local retailers to see whether the sales tax is computed separately.

A L SE= + +10,600 +10,000 Rev +600 Cash Flows +10,600

A L SE= + −100,000 −4,000 −104,000 Cash Flows −104,000

482 10 Reporting and Analyzing Liabilities

How do companies account for unearned revenues that are received before goods are delivered or services are performed?

1. When the company receives an advance, it increases (debits) Cash and increases (credits) a current liability account identifying the source of the unearned revenue.

2. When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account.

To illustrate, assume that Superior University sells 10,000 season football tickets at $50 each for its fi ve-game home schedule. The university makes the following entry for the sale of season tickets.

Aug. 6 Cash 500,000 Unearned Ticket Revenue 500,000 (To record sale of 10,000 season tickets)

As each game is completed, Superior records the recognition of $100,000 ($500,000 ÷ 5) of revenue with the following entry.

Sept. 7 Unearned Ticket Revenue 100,000 Ticket Revenue 100,000 (To record football ticket revenues)

The account Unearned Ticket Revenue represents unearned revenue, and Superior reports it as a current liability. As the school recognizes revenue, it reclassifi es the amount from unearned revenue to Ticket Revenue. Unearned revenue is material for some companies. In the airline industry, tickets sold for future fl ights often represent almost 50% of total current liabilities. At United Air Lines, unearned ticket revenue is its largest current liability, recently amounting to more than $1 billion. Illustration 10-1 shows specifi c unearned revenue and revenue accounts used in selected types of businesses.

A L SE= + +500,000 +500,000 Cash Flows +500,000

A L SE= + −100,000 +100,000 Rev Cash Flows no eff ect

Type of Account Title

Business Unearned Revenue Revenue

Airline Unearned Ticket Revenue Ticket Revenue Magazine publisher Unearned Subscription Revenue Subscription Revenue Hotel Unearned Rental Revenue Rental Revenue

ILLUSTRATION 10-1 Unearned revenue and revenue accounts

CURRENT MATURITIES OF LONG-TERM DEBT

Companies often have a portion of long-term debt that comes due in the current year. As an example, assume that Wendy Construction issues a fi ve-year, interest- bearing $25,000 note on January 1, 2016. This note specifi es that each January 1, starting January 1, 2017, Wendy should pay $5,000 of the note. When the com- pany prepares fi nancial statements on December 31, 2016, it should report $5,000 as a current liability and $20,000 as a long-term liability. (The $5,000 amount is the portion of the note that is due to be paid within the next 12 months.) Compa- nies often identify current maturities of long-term debt on the balance sheet as long-term debt due within one year. In a recent year, General Motors had $724 million of such debt. It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. At the balance sheet date, all obligations due within one year are classifi ed as current, and all other obligations are long-term.

Accounting for Current Liabilities 483

PAYROLL AND PAYROLL TAXES PAYABLE

Assume that Susan Alena works 40 hours this week for Pepitone Inc., earning a wage of $10 per hour. Will Susan receive a $400 check at the end of the week? Not likely. The reason: Pepitone is required to withhold amounts from her wages to pay various governmental authorities. For example, Pepitone will withhold amounts for Social Security taxes1 and for federal and state income taxes. If these withhold- ings total $100, Susan will receive a check for only $300. Illustration 10-2 sum- marizes the types of payroll deductions that normally occur for most companies.

SOLUTION 1. $50,000 × 12% × 4/12 = $2,000 2. $23,320 ÷ 1.06 = $22,000; $23,320 − $22,000 = $1,320 3. $15,000 × 2/3 = $10,000

1a▼ Current LiabilitiesDO IT! You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.

1. If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?

2. The cash register total including sales taxes is $23,320, and the sales tax rate is 6%. What is the sales taxes payable?

3. If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue should be recognized by December 31?

Action Plan ✔ Use the interest formula:

Face value of note × Annual interest rate × Time in terms of one year.

✔ Divide total receipts by 100% plus the tax rate to determine sales; then subtract sales from the total receipts.

✔ Determine what fraction of the total unearned rent should be recognized this year.

Related exercise material: BE10-2, BE10-3, BE10-4, DO IT! 10-1a, E10-1, E10-2, E10-3, E10-4, E10-6, and E10-7.

1Social Security taxes are commonly called FICA taxes. In 1937, Congress enacted the Federal Insur- ance Contribution Act (FICA). As can be seen in the journal entry and the payroll tax journal entry on the next page, the employee and employer must make equal contributions to Social Security. The Social Security rate in 2014 was 7.65%. Our examples and homework use 7.65%.

Gross Pay Net PayPayroll Deductions

State and City Income Taxes

CharityFederal Income Tax

FICA Taxes

Insurance, Pensions, and/or Union dues

Insura nce

Policy XYZ UnionMember

ILLUSTRATION 10-2 Payroll deductions

484 10 Reporting and Analyzing Liabilities

As a result of these deductions, companies withhold from employee pay- checks amounts that must be paid to other parties. Pepitone therefore has incurred a liability to pay these third parties and must report this liability in its balance sheet. As a second illustration, assume that Cargo Corporation records its payroll for the week of March 7 with the journal entry shown below.

Mar. 7 Salaries and Wages Expense 100,000 FICA Taxes Payable 7,650 Federal Income Taxes Payable 21,864 State Income Taxes Payable 2,922 Salaries and Wages Payable 67,564 (To record payroll and withholding taxes for the week ending March 7)

Cargo then records payment of this payroll on March 7 as follows.

Mar. 7 Salaries and Wages Payable 67,564 Cash 67,564 (To record payment of the March 7 payroll)

In this case, Cargo reports $100,000 in salaries and wages expense. In addi- tion, it reports liabilities for the salaries and wages payable as well as liabilities to governmental agencies. Rather than pay the employees $100,000, Cargo instead must withhold the taxes and make the tax payments directly. In summary, Cargo is essentially serving as a tax collector. In addition to the liabilities incurred as a result of withholdings, employ- ers also incur a second type of payroll-related liability. With every payroll, the employer incurs liabilities to pay various payroll taxes levied upon the employer. These payroll taxes include the employer’s share of Social Security (FICA) taxes and state and federal unemployment taxes. Based on Cargo’s $100,000 payroll, the company would record the employer’s expense and liability for these payroll taxes as follows.

Mar. 7 Payroll Tax Expense 13,850 FICA Taxes Payable 7,650 Federal Unemployment Taxes Payable 800 State Unemployment Taxes Payable 5,400 (To record employer’s payroll taxes on March 7 payroll)

Companies classify the payroll and payroll tax liability accounts as current liabilities because they must be paid to employees or remitted to taxing authori- ties periodically and in the near term. Taxing authorities impose substantial fi nes and penalties on employers if the withholding and payroll taxes are not computed correctly and paid on time.

A L SE= + −100,000 Exp +7,650 +21,864 +2,922 +67,564 Cash Flows no eff ect

A L SE= + −67,564 −67,564 Cash Flows −67,564

A L SE= + −13,850 Exp +7,650 +800 +5,400 Cash Flows no eff ect

Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fi ll in when regular custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district offi ce, and personally distributed the checks to the “employees.” If a substitute’s check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.

ANATOMY OF A FRAUD

Major Characteristics of Bonds 485

Total take: $150,000

THE MISSING CONTROLS Human resource controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distrib- uted directly to employees at the offi cial school locations by designated employees or direct-deposited into approved employee bank accounts.

Independent internal verifi cation. Budgets should be reviewed monthly to identify situa- tions where actual costs signifi cantly exceed budgeted amounts.

Source: Adapted from Wells, Fraud Casebook (2007), pp. 164–171.

SOLUTION (a) To determine wages payable, reduce wages expense by the withholdings for FICA,

federal income tax, and state income tax.

Sept. 30 Salaries and Wages Expense 60,000 FICA Taxes Payable 3,500 Federal Income Taxes Payable 6,500 State Income Taxes Payable 2,000 Salaries and Wages Payable 48,000

(b) Payroll taxes would be for the company’s share of FICA, as well as for federal and state unemployment tax.

Sept. 30 Payroll Tax Expense 3,740 FICA Taxes Payable 3,500 Federal Unemployment Taxes Payable 90 State Unemployment Taxes Payable 150

1b▼ Wages and Payroll TaxesDO IT! During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (FICA), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state.

Prepare the September 30 journal entries for (a) salaries and wages expense and sala- ries and wages payable, assuming that all September wages will be paid in October, and (b) the company’s payroll tax expense.

Action Plan ✔ Remember that wages

earned are an expense to the company, but withholdings reduce the amount due to be paid to the employee.

✔ Payroll taxes are taxes the company incurs related to its employees.

Related exercise material: BE10-5, BE10-6, DO IT! 10-1b, and E10-5.

Long-term liabilities are obligations that a company expects to pay more than one year in the future. In this section, we explain the accounting for the principal types of obligations reported in the long-term liabilities section of the balance sheet. These obligations often are in the form of bonds or long-term notes. Bonds are a form of interest-bearing note payable issued by corporations, universities, and governmental agencies. Bonds, like common stock, are sold in small denominations (usually $1,000 or multiples of $1,000). As a result, bonds attract many investors. When a corporation issues bonds, it is borrowing money. The person who buys the bonds (the bondholder) is investing in bonds.

Describe the major characteristics of bonds. LEARNING OBJECTIVE 2▼

486 10 Reporting and Analyzing Liabilities

TYPES OF BONDS

Bonds may have different features. In the following sections, we describe some commonly issued types of bonds.

Secured and Unsecured Bonds Secured bonds have specifi c assets of the issuer pledged as collateral for the bonds. Unsecured bonds are issued against the general credit of the borrower. Large corporations with good credit ratings use unsecured bonds extensively. For example, at one time DuPont reported more than $2 billion of unsecured bonds outstanding.

Convertible and Callable Bonds Bonds that can be converted into common stock at the bondholder’s option are convertible bonds. Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity are callable bonds. Convertible bonds have features that are attractive both to bondholders and to the issuer. The con- version feature often gives bondholders an opportunity to benefi t if the market price of the common stock increases substantially. Furthermore, until conver- sion, the bondholder receives interest on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities that do not have a conversion option. Many corporations, such as USAir, United States Steel Corp., and General Motors Corporation, have issued convertible bonds.

ISSUING PROCEDURES

A bond certifi cate is issued to the investor to provide evidence of the investor’s claim against the company. As Illustration 10-3 (page 487) shows, the bond certifi cate provides information such as the name of the company that issued the bonds, the face value of the bonds, the maturity date of the bonds, and the contrac- tual interest rate. The face value is the amount of principal due at the maturity date. The maturity date is the date that the fi nal payment is due to the investor from the issuing company. The contractual interest rate is the rate used to determine the amount of cash interest the issuer pays and the investor receives. Usually, the contractual rate is stated as an annual rate.

DETERMINING THE MARKET PRICE OF BONDS

If your company needed fi nancing and wanted to attract investors to purchase its bonds, how would the market set the price for these bonds? To be more specifi c, assume that Coronet, Inc. issues a zero-interest (pays no interest) bond with a face value of $1,000,000 due in 20 years. For this bond, the only cash Coronet pays to bond investors is $1 million at the end of 20 years. Would investors pay $1 million for this bond? We hope not because $1 million received 20 years from now is not the same as $1 million received today. The term time value of money is used to indicate the relationship between time and money—that a dollar received today is worth more than a dollar prom- ised at some time in the future. If you had $1 million today, you would invest it and earn interest so that at the end of 20 years, your investment would be worth much more than $1 million. Thus, if someone is going to pay you $1 million 20 years from now, you would want to fi nd its equivalent today, or its present value. In other words, you would want to determine the value today of the amount to be received in the future after taking into account current interest rates. The current market price (present value) of a bond is therefore a function of three factors: (1) the dollar amounts to be received, (2) the length of time until the amounts are received, and (3) the market interest rate. The market interest rate is the rate investors demand for loaning funds.

Convert

Bond

Stock

Callable Bonds

Convertible Bonds

Bond

Bond“Hey Harv, call in those

bonds”

ALTERNATIVE TERMINOLOGY The contractual rate is often referred to as the stated rate.

$1 m illion

$1 million

2017

2037

≠

Same dollars at different times are not equal.

Major Characteristics of Bonds 487

To illustrate, assume that Acropolis Company on January 1, 2017, issues $100,000 of 9% bonds, due in fi ve years, with interest payable annually at year- end. The purchaser of the bonds would receive the following two types of cash payments: (1) principal of $100,000 to be paid at maturity, and (2) fi ve $9,000 interest payments ($100,000 × 9%) over the term of the bonds. Illustration 10-4 shows a time diagram depicting both cash fl ows.

Contractual interest rate

Face or par value

Maturity date

Issuer of bonds

ILLUSTRATION 10-3 Bond certifi cate

5-year period 0 1 2 3 4 5

$9,000 $9,000 $9,000 $9,000 $9,000 Interest

$100,000 Principal ILLUSTRATION 10-4 Time diagram depicting cash fl ows

The current market price of a bond is equal to the present value of all the future cash payments promised by the bond. Illustration 10-5 lists and totals the present values of these amounts, assuming the market rate of interest is 9%.

ILLUSTRATION 10-5 Computing the market price of bonds

Present value of $100,000 received in 5 years $ 64,993 Present value of $9,000 received annually for 5 years 35,007

Market price of bonds $100,000

488 10 Reporting and Analyzing Liabilities

Tables are available to provide the present value numbers to be used, or these values can be determined mathematically or with fi nancial calculators.2 Appen- dix G, near the end of the textbook, provides further discussion of the concepts and the mechanics of the time value of money computations.

2▼ Bond TerminologyDO IT! State whether each of the following statements is true or false. If false, indicate how to correct the statement.

_____ 1. Secured bonds have specifi c assets of the issuer pledged as collateral.

_____ 2. Callable bonds can be redeemed by the issuing company at a stated dollar amount prior to maturity.

_____ 3. The contractual interest rate is the rate investors demand for loaning funds.

_____ 4. The face value is the amount of principal the issuing company must pay at the maturity date.

_____ 5. The market price of a bond is equal to its maturity value.

2For those knowledgeable in the use of present value tables, the computations in the example shown in Illustration 10-5 (page 487) are $100,000 × .64993 = $64,993 and $9,000 × 3.88965 = $35,007 (rounded).

Running Hot!

Recently, the market for bonds was running hot. For example, consider these two large deals: Apple Inc. sold $17 billion of debt, which at the time was the largest corporate bond ever sold. But shortly thereafter, it was beat by Verizon Communications Inc., which sold $49 billion of debt. The following chart highlights the increased issuance of bonds.

As one expert noted about these increases, “Companies are taking advantage of this lower-rate environment in the limited period of time it is going to be around.” An interesting aspect of these bond issuances is that companies, like Philip Morris International, Medtronic, Inc., and Simon Properties, are even selling 30-year bonds. These bond issuers are benefi tting from “a massive sentiment shift,” says one bond expert. The belief that the economy will recover is making investors more comfortable holding longer-term bonds, as they search for investments that offer better returns than U.S. Treasury bonds.

Sources: Vipal Monga, “The Big Number,” Wall Street Journal (March 20, 2012), p. B5; and Mike Cherney, “Renewed Embrace of Bonds Sparks Boom,” Wall Street Journal (March 8–9, 2014), p. B5.

What are the advantages for companies of issuing 30-years bonds instead of 5-year bonds? (Go to WileyPLUS for this answer and additional questions.)

INVESTOR INSIGHT

1995

Note: Data reflect each year through March 7. Source: Thomson Reuters.

100

150

$200

2000 2005 2010 2014

Years

$233 billion

($ in

b ill

io ns

)

Accounting for Bond Transactions 489

Action Plan ✔ Review the types of bonds

and the basic terms associated with bonds.

SOLUTION 1. True. 2. True. 3. False. The contractual interest rate is used to determine the amount of cash interest the borrower pays. 4. True. 5. False. The market price of a bond is equal to the present value of all the future cash payments promised by the bond.

Related exercise material: DO IT! 10-2.

3▼ Explain how to account for bond transactions. A corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into common stock. If bond- holders sell their bond investments to other investors, the issuing corporation receives no further money on the transaction, nor does the issuing corporation journalize the transaction (although it does keep records of the names of bond- holders in some cases). Bonds may be issued at face value, below face value (discount), or above face value (premium). Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond. Face value is usually $1,000. Thus, a $1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or $970.

ISSUING BONDS AT FACE VALUE

To illustrate the accounting for bonds issued at face value, assume that Devor Corporation issues 100, fi ve-year, 10%, $1,000 bonds dated January 1, 2017, at 100 (100% of face value). The entry to record the sale is as follows.

Jan. 1 Cash 100,000 Bonds Payable 100,000 (To record sale of bonds at face value)

Devor reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is January 1, 2022 (more than one year away). Over the term (life) of the bonds, companies make entries to record bond interest. Interest on bonds payable is computed in the same manner as interest on notes payable, as explained earlier. If we assume that interest is payable annually on January 1 on the bonds described above, Devor accrues interest of $10,000 ($100,000 × 10% × 1212) on December 31. At December 31, Devor recognizes the $10,000 of interest expense incurred with the following adjusting entry.

Dec. 31 Interest Expense 10,000 Interest Payable 10,000 (To accrue bond interest)

The company classifi es interest payable as a current liability because it is scheduled for payment within the next year. When Devor pays the interest on January 1, 2018, it decreases (debits) Interest Payable and decreases (credits) Cash for $10,000. Devor records the payment on January 1 as follows.

Jan. 1 Interest Payable 10,000 Cash 10,000 (To record payment of bond interest)

DISCOUNT OR PREMIUM ON BONDS

The previous example assumed that the contractual (stated) interest rate and the market (effective) interest rate paid on bonds were the same. Recall that the contractual interest rate is the rate applied to the face (par) value to arrive at

A L SE= + +100,000 +100,000 Cash Flows +100,000

A L SE= + −10,000 Exp +10,000 Cash Flows no eff ect

A L SE= + −10,000 −10,000 Cash Flows −10,000

LEARNING OBJECTIVE

490 10 Reporting and Analyzing Liabilities

the interest paid in a year. The market interest rate is the rate investors demand for loaning funds to the corporation. When the contractual interest rate and the market interest rate are the same, bonds sell at face value. However, market interest rates change daily. The type of bond issued, the state of the economy, current industry conditions, and the company’s individual performance all affect market interest rates. As a result, the contractual and market interest rates often differ. To make bonds salable when the two rates differ, bonds sell below or above face value. To illustrate, suppose that a company issues 10% bonds at a time when other bonds of similar risk are paying 12%. Investors will not be interested in buying the 10% bonds, so their value will fall below their face value. When a bond is sold for less than its face value, the difference between the face value of a bond and its selling price is called a discount. As a result of the decline in the bonds’ selling price, the actual interest rate incurred by the company increases to the level of the current market interest rate. Conversely, if the market rate of interest is lower than the contractual interest rate, investors will have to pay more than face value for the bonds. That is, if the market rate of interest is 8% but the contractual interest rate on the bonds is 10%, the price on the bonds will be bid up. When a bond is sold for more than its face value, the difference between the face value and its selling price is called a premium. Illustration 10-6 shows these relationships graphically.

▼ HELPFUL HINT Bond prices vary inversely with changes in the market interest rate. As market interest rates decline, bond prices increase. When a bond is issued, if the market interest rate is below the contractual rate, the bond price is higher than the face value.

ILLUSTRATION 10-6 Interest rates and bond prices

Bond Contractual

Interest Rate 10%

10%

12%

Market Interest Rate

Bonds Sell at

Issued when

Premium

Face Value

Discount

Issuance of bonds at an amount different from face value is quite common. By the time a company prints the bond certifi cates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same. Thus, the issuance of bonds at a discount does not mean that the fi nancial strength of the issuer is suspect. Conversely, the sale of bonds at a premium does not indicate that the fi nancial strength of the issuer is exceptional.

ISSUING BONDS AT A DISCOUNT

To illustrate the issuance of bonds at a discount, assume that on January 1, 2017, Candlestick Inc. sells $100,000, fi ve-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is as follows.

Jan. 1 Cash 98,000 Discount on Bonds Payable 2,000 Bonds Payable 100,000 (To record sale of bonds at a discount)

Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather it is a contra account, which is deducted from bonds payable on the balance sheet as shown in Illustration 10-7. The $98,000 represents the carrying (or book) value of the bonds. On the date of issue, this amount equals the market price of the bonds.

▼ HELPFUL HINT Some bonds are sold at a discount by design. “Zero-coupon” bonds, which pay no interest, sell at a deep discount to face value.

A L SE= + +98,000 −2,000 +100,000 Cash Flows +98,000

Accounting for Bond Transactions 491

The issuance of bonds below face value causes the total cost of borrowing to differ from the bond interest paid. That is, the issuing corporation not only must pay the contractual interest rate over the term of the bonds but also must pay the face value (rather than the issuance price) at maturity. Therefore, the difference between the issuance price and the face value of the bonds—the discount— is an additional cost of borrowing. The company records this cost as inter- est expense over the life of the bonds. The total cost of borrowing $98,000 for Candlestick Inc. is $52,000, computed as shown in Illustration 10-8.

▼ HELPFUL HINT The carrying value (book value) of bonds issued at a discount is determined by subtracting the balance of the discount account from the balance of the Bonds Payable account.

ILLUSTRATION 10-7 Statement presentation of discount on bonds payable

Long-term liabilities Bonds payable $100,000 Less: Discount on bonds payable 2,000 $98,000

CANDLESTICK INC. Balance Sheet (partial)

ILLUSTRATION 10-8 Computation of total cost of borrowing—bonds issued at discount

Bonds Issued at a Discount

Annual interest payments ($100,000 × 10% = $10,000; $10,000 × 5) $50,000 Add: Bond discount ($100,000 − $98,000) 2,000 Total cost of borrowing $52,000

ILLUSTRATION 10-9 Alternative computation of total cost of borrowing—bonds issued at discount

Bonds Issued at a Discount

Principal at maturity $100,000 Annual interest payments ($10,000 × 5) 50,000 Cash to be paid to bondholders 150,000 Less: Cash received from bondholders 98,000

Total cost of borrowing $ 52,000

Alternatively, we can compute the total cost of borrowing as shown in Illus- tration 10-9.

To follow the expense recognition principle, companies allocate bond dis- count to expense in each period in which the bonds are outstanding. This is referred to as amortizing the discount. Amortization of the discount increases the amount of interest expense reported each period. That is, after the company amortizes the discount, the amount of interest expense it reports in a period will exceed the contractual amount. As shown in Illustration 10-8, for the bonds issued by Candlestick Inc., total interest expense will exceed the contractual interest by $2,000 over the life of the bonds. As the discount is amortized, its balance declines. As a consequence, the carry- ing value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-10. Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond discount.

C ar

ry in

g V

al ue $100,000

Time$98,000

1 2 3 4 5 Years

ILLUSTRATION 10-10 Amortization of bond discount

492 10 Reporting and Analyzing Liabilities

ISSUING BONDS AT A PREMIUM

We can illustrate the issuance of bonds at a premium by now assuming the Can- dlestick Inc. bonds described above sell at 102 (102% of face value) rather than at 98. The entry to record the sale is as follows.

Jan. 1 Cash 102,000 Bonds Payable 100,000 Premium on Bonds Payable 2,000 (To record sale of bonds at a premium)

Candlestick adds the premium on bonds payable to the bonds payable amount on the balance sheet, as shown in Illustration 10-11.

A L SE= + +102,000 +100,000 +2,000 Cash Flows +102,000

ILLUSTRATION 10-11 Statement presentation of bond premium

Long-term liabilities Bonds payable $100,000 Add: Premium on bonds payable 2,000 $102,000

CANDLESTICK INC. Balance Sheet (partial)

ILLUSTRATION 10-12 Computation of total cost of borrowing—bonds issued at a premium

Bonds Issued at a Premium

Annual interest payments ($100,000 × 10% = $10,000; $10,000 × 5) $ 50,000 Less: Bond premium ($102,000 − $100,000) 2,000 Total cost of borrowing $48,000

ILLUSTRATION 10-13 Alternative computation of total cost of borrowing—bonds issued at a premium

Bonds Issued at a Premium

Principal at maturity $100,000 Annual interest payments ($10,000 × 5) 50,000 Cash to be paid to bondholders 150,000 Less: Cash received from bondholders 102,000

Total cost of borrowing $ 48,000

The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid because the borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the premium is con- sidered to be a reduction in the cost of borrowing that reduces bond inter- est expense over the life of the bonds. The total cost of borrowing $102,000 for Candlestick Inc. is $48,000, computed as in Illustration 10-12.

Alternatively, we can compute the cost of borrowing as shown in Illustra- tion 10-13.

Similar to bond discount, companies allocate bond premium to expense in each period in which the bonds are outstanding. This is referred to as amortizing the premium. Amortization of the premium decreases the amount of interest expense reported each period. That is, after the company amortizes the premium, the amount of interest expense it reports in a period will be less than the contrac- tual amount. As shown in Illustration 10-12, for the bonds issued by Candlestick Inc., contractual interest will exceed the interest expense by $2,000 over the life of the bonds.

▼ HELPFUL HINT Both a discount and a premium account are valuation accounts. A valuation account is one that is needed to value properly the item to which it relates.

Accounting for Bond Transactions 493

As the premium is amortized, its balance declines. As a consequence, the carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-14. Appen- dices 10A and 10B at the end of this chapter discuss procedures for amortizing bond premium.

ILLUSTRATION 10-14 Amortization of bond premium

C ar

ry in

g V

al ue

$102,000

$100,000 1 2 3 4 5 Years

Time

REDEEMING BONDS AT MATURITY

Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the company pays and records sepa- rately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as follows.

Bonds Payable 100,000 Cash 100,000 (To record redemption of bonds at maturity)

REDEEMING BONDS BEFORE MATURITY

Bonds may be redeemed before maturity. A company may decide to redeem bonds before maturity in order to reduce interest cost and remove debt from its balance sheet. A company should redeem debt early only if it has suffi cient cash resources.

A L SE= + −100,000 −100,000 Cash Flows −100,000

3a▼ Bond IssuanceDO IT! Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.

Action Plan ✔ Record cash received,

bonds payable at face value, and the difference as a discount or premium.

✔ Report discount as a deduction from bonds payable and premium as an addition to bonds payable.

SOLUTION (a)

Cash 189,000 Discount on Bonds Payable 11,000 Bonds Payable 200,000 (To record sale of bonds at a discount)

(b)

Long-term liabilities Bonds payable $200,000 Less: Discount on bonds payable 11,000 $189,000

Related exercise material: BE10-8, BE10-9, BE10-10, DO IT! 10-3a, E10-8, E10-9, and E10-10.

494 10 Reporting and Analyzing Liabilities

When bonds are redeemed before maturity, it is necessary to (1) eliminate the carrying value of the bonds at the redemption date, (2) record the cash paid, and (3) recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date. To illustrate, assume at the end of the fourth period, Candlestick Inc., having sold its bonds at a premium, redeems the $100,000 face value bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100,400 (principal $100,000 and premium $400). Candle- stick records the redemption at the end of the fourth interest period (January 1, 2021) as follows.

Jan. 1 Bonds Payable 100,000 Premium on Bonds Payable 400 Loss on Bond Redemption 2,600 Cash 103,000 (To record redemption of bonds at 103)

Note that the loss of $2,600 is the difference between the $103,000 cash paid and the $100,400 carrying value of the bonds.

A L SE= + −100,000 −400

−2,600 Exp −103,000 Cash Flows −103,000

PEOPLE, PLANET, AND PROFIT INSIGHT Unilever

How About Some Green Bonds?

Unilever recently began produc- ing popular frozen treats such as Magnums and Cornettos, funded by green bonds. Green bonds are

debt used to fund activities such as renewable-energy projects. In Unilever’s case, the proceeds from the sale of green bonds are used to clean up the company’s manufac- turing operations and cut waste (such as related to energy consumption). The use of green bonds has taken off as companies now have guidelines as to how to disclose and report on these green-bond proceeds. These standardized disclosures provide

transparency as to how these bonds are used and their effect on overall profi tability. Investors are taking a strong interest in these bonds. Invest- ing companies are installing socially responsible investing teams and have started to integrate sustainability into their investment processes. The disclosures of how companies are using the bond proceeds help investors to make better fi nancial decisions.

Source: Ben Edwards, “Green Bonds Catch On.” Wall Street Journal (April 3, 2014), p. C5.

Why might standardized disclosure help investors to better understand how proceeds from the sale or issuance of bonds are used? (Go to WileyPLUS for this answer and additional questions.)

CarpathianPrince/Shutterstock

SOLUTION There is a gain on redemption. The cash paid, $490,000 ($500,000 × 98%), is less than the carrying value of $496,000. The entry is:

Bonds Payable 500,000 Cash 490,000 Discount on Bonds Payable 4,000 Gain on Bond Redemption 6,000 (To record redemption of bonds at 98)

3b▼ Bond RedemptionDO IT! R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds.

Action Plan ✔ Determine and eliminate

the carrying value of the bonds.

✔ Record the cash paid. ✔ Compute and record the

gain or loss (the differ- ence between the fi rst two items).

Related exercise material: BE10-11, DO IT! 10-3b, E10-13, and E10-14.

KEEPING AN EYE ON CASH

The balance sheet presents the balances of a company’s debts at a point in time. The statement of cash flows also presents information about a com- pany’s debts. Information regarding cash inflows and outflows during the year that resulted from the principal portion of debt transactions appears in the “Financing activities” section of the statement of cash flows. Interest expense is reported in the “Operating activities” section even though it resulted from debt transactions. The following statement of cash flows presents the cash flows from financ- ing activities for General Motors Company. From this we learn that the company issued new debt of $31,373 million and repaid debt of $19,524 million.

Presentation and Analysis 495

Disclosure of debt is very important. Failures at Enron, WorldCom, and Global Crossing have made investors very concerned about companies’ debt obligations. Summary data regarding debts may be presented in the balance sheet with detailed data (such as interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule in the notes. Companies should report current maturities of long-term debt as a current liability.

PRESENTATION

Current liabilities are the fi rst category under “Liabilities” on the balance sheet. Companies list each of the principal types of current liabilities separately within the category. Within the current liabilities section, companies often list notes pay- able fi rst, followed by accounts payable. Companies report long-term liabilities in a separate section of the balance sheet immediately following “Current liabilities.” Illustration 10-15 shows an example.

Discuss how liabilities are reported and analyzed. LEARNING OBJECTIVE 4▼

ILLUSTRATION 10-15 Balance sheet presentation of liabilities

Liabilities Current liabilities Notes payable $ 250,000 Accounts payable 125,000 Current maturities of long-term debt 300,000 Accrued liabilities 75,000

Total current liabilities $ 750,000

Long-term liabilities Bonds payable 1,000,000 Less: Discount on bonds payable 80,000 920,000

Notes payable, secured by plant assets 540,000 Lease liability 500,000

Total long-term liabilities 1,960,000

Total liabilities $2,710,000

MARAIS COMPANY Balance Sheet (partial)

ETHICS NOTE Some companies try to minimize the amount of debt reported on their balance sheets by not reporting certain types of commitments as liabilities. This subject is of intense interest in the fi nancial community.

▼

496 10 Reporting and Analyzing Liabilities

Liquidity Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. A commonly used measure of liquidity is the current ratio (presented in Chapter 2). The current ratio is cal- culated as current assets divided by current liabilities. Illustration 10-17 presents the current ratio for General Motors along with the industry average.

ANALYSIS

Careful examination of debt obligations helps you assess a company’s ability to pay its current and long-term obligations. It also helps you determine whether a company can obtain debt fi nancing in order to grow. We will use the following information from the fi nancial statements of General Motors to illustrate the analysis of a company’s liquidity and solvency.

Cash fl ows from fi nancing activities Payments to purchase stock $ (3,277) Proceeds from issuance of debt 31,373 Payments of debt (19,524) Increase in short-term debt 391 Dividends paid (3,165) Other (123)

Net cash provided by (used in) fi nancing activities $ 5,675

GENERAL MOTORS COMPANY Statement of Cash Flows (partial)

2014 (in millions)

Real World

Assets 2014 2013

Total current assets $ 83,670 $ 81,501 Noncurrent assets 94,007 84,843

Total assets $177,677 $166,344

Liabilities and Stockholders’ Equity

Total current liabilities $ 65,701 $ 62,412 Noncurrent liabilities 75,952 60,758

Total liabilities 141,653 123,170 Total stockholders’ equity 36,024 43,174

Total liabilities and stockholders’ equity $177,677 $166,344

GENERAL MOTORS COMPANY Balance Sheets

December 31, 2014 and 2013 (in millions)

Real World

ILLUSTRATION 10-16 Simplifi ed balance sheets for General Motors

General Motors Industry ($ in millions) Average

Ratio 2014 2013 2014

Current $83,670 $65,701

= 1.27:1 $81,501 $62,412

= 1.31:1 1.00:1 Ratio

ILLUSTRATION 10-17 Current ratio

Presentation and Analysis 497

General Motors’ current ratio declined from 1.31:1 to 1.27:1 from 2013 to 2014. Although General Motors’ ratio declined, it still exceeds the industry average current ratio for manufacturers of autos and trucks of 1.00:1. General Motors’ current ratio, like the industry average, is quite low. Many companies today minimize their liquid assets (such as accounts receivable and inventory) in order to improve profi tability measures, such as return on assets. This is particularly true of large companies such as Ford, General Motors, and Toyota. Companies that keep fewer liquid assets on hand must rely on other sources of liquidity. One such source is a bank line of credit. A line of credit is a prearranged agreement between a company and a lender that permits the company, should it be neces- sary, to borrow up to an agreed-upon amount. For example, a recent disclosure regarding debt in General Motors’ annual report states that it has $12 billion of unused lines of credit.

Solvency Solvency ratios measure the ability of a company to survive over a long period of time. The Feature Story in this chapter mentioned that, although there once were many U.S. automobile manufacturers, only three U.S.-based companies remain today. Many of the others went bankrupt. This highlights the fact that when mak- ing a long-term loan or purchasing a company’s stock, you must give consider- ation to a company’s solvency. To reduce the risks associated with having a large amount of debt during an economic downturn, some U.S. automobile manufacturers took two pre- cautionary steps while they enjoyed strong profi ts. First, they built up large balances of cash and cash equivalents to avoid a cash crisis. Second, they were reluctant to build new plants or hire new workers to meet their production needs. Instead, they asked workers to put in overtime, or they “outsourced” work to other companies. In this way, when the economic downturn occurred, they hoped to avoid having to make debt payments on idle production plants and to minimize layoffs. As a result, when the crisis fi rst hit, Ford had cash of $29 billion, about double the amount of cash it would expect to use over a two- year period. In Chapter 2, you learned that one measure of a company’s solvency is the debt to assets ratio. This is calculated as total liabilities (debt) divided by total assets. This ratio indicates the extent to which a company’s assets are fi nanced with debt. Another useful solvency measure is the times interest earned. It provides an indication of a company’s ability to meet interest payments as they come due. It is computed by dividing the sum of net income, interest expense, and income tax expense by interest expense. It uses income before interest expense and taxes because this number best represents the amount available to pay interest. We can use the balance sheet information presented in Illustration 10-16 and the additional information below to calculate solvency ratios for General Motors.

($ in millions) 2014 2013

Net income $4,018 $5,331 Interest expense 403 334 Income tax expense 228 2,127

The debt to assets ratios and times interest earned for General Motors and aver- ages for the industry are shown in Illustration 10-18 (page 498).

DECISION TOOLS

Comparing available lines of credit to current liabilities as well as evaluating liquidity ratios helps users determine if a company can obtain short-term fi nancing when necessary.

DECISION TOOLS

Times interest earned helps users determine if a company can meet its obligations in the long term.

498 10 Reporting and Analyzing Liabilities

Debt to Assets Ratio = Total Liabilities

Total Assets

Times Interest Earned = Net Income + Interest Expense + Income Tax ExpenseInterest Expense

General Motors Industry ($ in millions) Average

Ratio 2014 2013 2014

Debt to $141,653 $177,677

= 80% 74% 62% Assets Ratio

Times Interest $4,018 + $403 + $228 $403

= 11.5 times 23.3 times 3.2 times Earned

ILLUSTRATION 10-18 Solvency ratios

Debt Masking

In the wake of the fi nancial crisis, many fi nancial institutions are wary of reporting too much debt on their fi nancial statements, for fear that investors will consider them too risky. The Securities and Exchange Commission (SEC) is concerned that some companies engage in “debt masking” to make it appear that they use less debt than they actually do. These companies enter into transactions at the end of

the accounting period that essentially remove debt from their books. Shortly after the end of the period, they reverse the transaction and the debt goes back on their books. The Wall Street Journal reported that 18 large banks “had consistently lowered one type of debt at the end of each of the past fi ve quarters, reducing it on average by 42% from quarterly peaks.”

Source: Tom McGinty, Kate Kelly, and Kara Scannell, “Debt ‘Masking’ Under Fire,” Wall Street Journal Online (April 21, 2010).

What implications does debt masking have for an investor that is using the debt to assets ratio to evaluate a company’s solvency? (Go to WileyPLUS for this answer and additional questions.)

INVESTOR INSIGHT

Contingencies One reason a company’s balance sheet might not fully refl ect its poten- tial obligations is due to contingencies. Contingencies are events with uncertain outcomes that may represent potential liabilities. A common type of contingency is lawsuits. Suppose, for example, that you were ana- lyzing the fi nancial statements of a cigarette manufacturer and did not consider the possible negative implications of existing unsettled lawsuits. Your analysis of the company’s fi nancial position would certainly be mis- leading. Other common types of contingencies are product warranties

DECISION TOOLS

Understanding a company’s contin- gent liabilities and signifi cant off- balance-sheet fi nancing helps users determine the potential impact on a company’s fi nancial position.

General Motors’ debt to assets ratio was 80%. The industry average for manufacturers of autos and trucks is 62%. Thus, General Motors is more reliant on debt fi nancing than the average fi rm in the auto and truck industry. In part, General Motors’ heavy reliance on debt is due to its substantial fi nance division. General Motors’ times interest earned decreased from 23.3 times in 2013 to 11.5 in 2014. This means that in 2014 General Motors had earnings before interest and taxes that were more than 11.5 times the amount needed to pay interest. The higher the multiple, the lower the likelihood that the company will default on interest payments. This suggests that while General Motors’ ability to meet inter- est payments was high, the average company in the industry had a lower ability to meet interest payments in 2014.

Presentation and Analysis 499

and environmental cleanup obligations. For example, in a recent year, Novartis AG began offering a money-back guarantee on its blood-pressure medications. This guarantee would necessitate an accrual for the estimated claims that will result from returns. Accounting rules require that companies disclose contingencies in the notes. In some cases, they must accrue them as liabilities. For example, suppose that Waterbury Inc. is sued by a customer for $1 million due to an injury sustained by a defective product. If at the company’s year-end the lawsuit had not yet been resolved, how should Waterbury account for this event? If the company can determine a reasonable estimate of the expected loss and if it is probable it will lose the suit, then the company should accrue for the loss. It records the loss by increasing (debiting) a loss account and increasing (crediting) a liability such as Lawsuit Liability. If both of these conditions are not met, then the company discloses the basic facts regarding this suit in the notes to its fi nancial statements.

Leasing A concern for analysts when they evaluate a company’s liquidity and solvency is whether that company has properly recorded all of its obligations. The bank- ruptcy of Enron Corporation, one of the largest bankruptcies in U.S. history, demonstrated how much damage can result when a company does not properly record or disclose all of its debts. Many would say Enron was practicing off- balance-sheet fi nancing. Off-balance-sheet fi nancing is an intentional effort by a company to structure its fi nancing arrangements so as to avoid showing liabili- ties on its balance sheet. One common type of off-balance-sheet fi nancing results from leasing. Most lessees do not like to report leases on their balance sheets because the lease increases the company’s total liabilities. Recall from Chapter 9 that operating leases are treated like rentals—no asset or liabilities show on the books. Capital leases are treated like a debt-fi nanced purchase—increasing both assets and liabilities. As a result, many companies structure their lease agreements to avoid meeting the criteria of a capital lease.3

Recall from Chapter 9 that many U.S. airlines lease a large portion of their planes without showing any debt related to them on their balance sheets. For example, the total increase in assets and liabilities that would result if Southwest Airlines recorded on the balance sheet its off-balance-sheet “operating” leases would be approximately $3.9 billion. Illustration 10-19 presents Southwest Airlines’ debt to assets ratio for a recent year using the numbers presented in its balance sheet. It also shows the ratio after adjusting for the off-balance-sheet leases. After those adjustments, Southwest has a ratio of 72% versus 66% before. This means that of every dollar of assets, 72 cents was funded by debt. This would be of interest to analysts evaluating Southwest’s solvency.

ETHICS NOTE Accounting standard-setters are attempting to rewrite rules on lease accounting because of concerns that abuse of the current standards is reducing the usefulness of fi nancial statements.

▼

INTERNATIONAL NOTE GAAP accounting for leases is more “rules-based” than IFRS. GAAP relies on precisely defi ned cut-offs to determine whether an item is treated as a capital or operating lease. This rules-based approach may enable companies to structure leases “around the rules.” Creating a jointly prepared leasing standard is a top priority for the IASB and FASB.

Using Numbers as Presented Adjusted for Off-Balance- on Balance Sheet Sheet Leases

Debt to assets ratio

$13,425 $20,200 = 66%

$13,425 + $3,866 $20,200 + $3,866 = 72%

ILLUSTRATION 10-19 Debt to assets ratio adjusted for leases

Critics of off-balance-sheet fi nancing contend that many leases represent unavoidable obligations that meet the defi nition of a liability. Therefore, com- panies should report them as liabilities on the balance sheet. To reduce these concerns, companies are required to report their operating lease obligations for subsequent years in a note. This allows analysts and other fi nancial statement users to adjust a company’s fi nancial statements by adding leased assets and lease liabilities if they feel that this treatment is more appropriate.

3The FASB is currently considering a new approach to lease accounting. If adopted, this new approach would signifi cantly change the accounting for leases.

500 10 Reporting and Analyzing Liabilities

“Covenant-Lite” Debt

In many corporate loans and bond issuances, the lending agreement specifi es debt covenants. These cov- enants typically are specifi c fi nancial measures, such as minimum levels of retained earnings, cash fl ows, times interest earned, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement.

The creditors can then demand immediate repayment, or they can renegotiate the loan’s terms. Covenants protect lenders be- cause they enable lenders to step in and try to get their money back before the borrower gets too deep into trouble.

During the 1990s, most traditional loans specifi ed between three to six covenants or “triggers.” In subsequent years, however, when there was lots of cash available, lenders be- gan reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lend- ers. Then, when the economy declined, these lenders lost big money when companies defaulted.

Sources: Cynthia Koons, “Risky Business: Growth of ‘Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2; and Katy Burne, “More Loans Come with Few Strings Attached,” Wall Street Journal (June 12, 2014).

How can fi nancial ratios such as those covered in this chapter provide protection for creditors? (Go to WileyPLUS for this answer and additional questions.)

Paul Fleet/Alamy

4▼ Analyzing LiabilitiesDO IT! Trout Company provides you with the following balance sheet information as of Decem- ber 31, 2017.

Current assets $10,500 Current liabilities $ 8,000 Long-term assets 24,200 Long-term liabilities 16,000

Total assets $34,700 Stockholders’ equity 10,700

Total liabilities and $34,700 stockholders’ equity

In addition, Trout reported net income for 2017 of $14,000, income tax expense of $2,800, and interest expense of $900.

INSTRUCTIONS (a) Compute the current ratio and working capital for Trout for 2017.

(b) Assume that at the end of 2017, Trout used $2,000 cash to pay off $2,000 of accounts payable. How would the current ratio and working capital have changed?

SOLUTION (a) Current ratio is 1.31:1 ($10,500/$8,000). Working capital is $2,500 ($10,500 − $8,000). (b) Current ratio is 1.42:1 ($8,500/$6,000). Working capital is $2,500 ($8,500 − $6,000). (c) Debt to assets ratio is 69.2% ($24,000/$34,700). Times interest earned is 19.67 times

[($14,000 + $2,800 + $900)/$900].

Action Plan ✔ Use the formula for

the current ratio: Current assets ÷ Current liabilities.

✔ Use the formula for working capital: Current assets − Current liabilities.

✔ Use the formula for the debt to assets ratio: Total liabilities ÷ Total assets. Related exercise material: BE10-14, BE10-15, DO IT! 10-4, E10-16, E10-17, and E10-18.

Ford Motor Company has enjoyed some tremendous successes, including its popular Taurus and Explorer vehicles. Devel- opment of a new vehicle costs billions. A fl op is fi nancially devastating, and the fi nancial effect is magnifi ed if the company has large amounts of outstanding debt. The following balance sheets provide fi nancial information for Ford Motor Company as of December 31, 2014 and 2013.

USING DECISION TOOLS—FORD MOTOR COMPANY

INVESTOR INSIGHT

Using Decision Tools 501

INSTRUCTIONS

1. Evaluate Ford’s liquidity using appropriate ratios, and compare to those of General Motors and to industry averages presented in Illustration 10-17 (page 496).

2. Evaluate Ford’s solvency using appropriate ratios, and compare to those of General Motors and to industry averages presented in Illustration 10-18 (page 498).

3. Comment on Ford’s available lines of credit.

SOLUTION 1. Ford’s liquidity can be measured using the current ratio:

2014 2013

Current ratio

$155,052 $63,612

= 2.44:1

$151,569 $60,417

= 2.51:1

Ford’s current ratio declined from 2013 to 2014. Ford’s 2014 current ratio exceeds the industry average of 1.00:1 and General Motors’.

2. Ford’s solvency can be measured with the debt to assets ratio and the times interest earned:

2014 2013

Debt to assets ratio

$183,353 $208,527

= 88%

$175,703 $202,179

= 87%

Times interest earned

$3,186 + $797 + $1,156 $797

= 6.4 times

$7,175 + $829 − $135 $829

= 9.5 times

The debt to assets ratio suggests that Ford relies very heavily on debt fi nancing. The ratio increased slightly from 2013 to 2014, indicating that the company’s solvency declined slightly. Ford’s reliance on debt, as measured by the debt to assets ratio, exceeds that of General Motors as well as the industry average.

The times interest earned is 6.4 times in 2014 and 9.5 times in 2013. This exceeds the industry average of 3.2 times. While not as high as that of General Motors, it is very strong.

3. Ford has available lines of credit of $12.2 billion. These fi nancing sources signifi cantly improve its liquidity and help reduce the concerns of its short-term creditors.

FORD MOTOR COMPANY Balance Sheets

December 31, 2014 and 2013 (in millions)

Assets 2014 2013

Current assets $155,052 $151,569 Noncurrent assets 53,475 50,610

Total assets $208,527 $202,179

Liabilities and Shareholders’ Equity

Current liabilities $ 63,612 $ 60,417 Noncurrent liabilities 119,741 115,286

Total liabilities 183,353 175,703 Total shareholders’ equity (defi cit) 25,174 26,476

Total liabilities and shareholders’ equity $208,527 $202,179

Other Information

Net income $ 3,186 $ 7,175 Income tax expense (benefi t) 1,156 (135) Interest expense 797 829 Available lines of credit (Automotive Division) 12,200

502 10 Reporting and Analyzing Liabilities

AMORTIZING BOND DISCOUNT

To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. The straight-line method of amortization allocates the same amount to interest expense in each interest period. The calculation is presented in Illustration 10A-1.

APPENDIX 10A: Apply the straight-line method of amortizing bond discount and bond premium.

LEARNING OBJECTIVE *5▼

Number Bond

Bond ÷ of Interest = Discount

Discount

Periods Amortization

ILLUSTRATION 10A-1 Formula for straight-line method of bond discount amortization

In the Candlestick Inc. example (page 490), the company sold $100,000, fi ve-year, 10% bonds on January 1, 2017, for $98,000. This resulted in a $2,000 bond discount ($100,000 − $98,000). The bond discount amortization is $400 ($2,000 ÷ 5) for each of the fi ve amortization periods. Candlestick records the fi rst accrual of bond interest and the amortization of bond discount on December 31 as follows.

Dec. 31 Interest Expense 10,400 Discount on Bonds Payable 400 Interest Payable 10,000 (To record accrued bond interest and amortization of bond discount)

Over the term of the bonds, the balance in Discount on Bonds Payable will decrease annually by the same amount until it has a zero balance at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds. Preparing a bond discount amortization schedule, as shown in Illustration 10A-2, is useful to determine interest expense, discount amortization, and the carrying value of the bond. As indicated, the interest expense recorded each period is $10,400. Also note that the carrying value of the bond increases $400 each period until it reaches its face value of $100,000 at the end of period 5.

A L SE= + −10,400 Exp

+400 +10,000 Cash Flows no eff ect

ALTERNATIVE TERMINOLOGY The amount in the Discount on Bonds Payable account is often referred to as Unamortized Discount on Bonds Payable.

Appendix 10A: Straight-Line Amortization 503

AMORTIZING BOND PREMIUM

The amortization of bond premium parallels that of bond discount. Illustra- tion 10A-3 presents the formula for determining bond premium amortization under the straight-line method.

CANDLESTICK INC. Bond Discount Amortization Schedule

Straight-Line Method—Annual Interest Payments $100,000 of 10%, 5-Year Bonds

Issue date

Formulas Data Review ViewPage LayoutInsert

A P18 fx

B C D E F

Candlestick Inc.xlsCandlestick Inc.xls Home

$2,000

1,600

1,200

800

400

Interest Periods

(D) Unamortized

Discount (D) − (C)

(E) Bond

Carrying Value ($100,000 − D)

$ 98,000

98,400

98,800

99,200

99,600

100,000

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the

annual contractual interest rate (10%) each period.

Column (B) is computed as the interest paid (Column A) plus the discount amortization (Column C).

Column (C) indicates the discount amortization each period.

Column (D) decreases each period by the same amount until it reaches zero at maturity.

Column (E) increases each period by the amount of discount amortization until it equals the

face value at maturity.

$10,000

10,000

$50,000

$10,400

10,400

$52,000

$ 400

400

$2,000

(A) Interest to

Be Paid (10% × $100,000)

(B) Interest Expense to Be Recorded

(A) + (C)

Amortization ($2,000 ÷ 5)

ILLUSTRATION 10A-2 Bond discount amortization schedule

Number Bond

Bond ÷ of Interest = Premium

Premium

Periods Amortization

ILLUSTRATION 10A-3 Formula for straight-line method of bond premium amortization

Continuing our example, assume Candlestick Inc. sells the bonds described above for $102,000, rather than $98,000 (see page 492). This results in a bond premium of $2,000 ($102,000 − $100,000). The premium amortization for each interest period is $400 ($2,000 ÷ 5). Candlestick records the fi rst accrual of interest on December 31 as follows.

Dec. 31 Interest Expense 9,600 Premium on Bonds Payable 400 Interest Payable 10,000 (To record accrued bond interest and amortization of bond premium)

Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity. A bond premium amortization schedule, as shown in Illustration 10A-4 (page 504), is useful to determine interest expense, premium amortization, and the carrying value of the bond. As indicated, the interest expense Candlestick records each period is $9,600. Note that the carrying value of the bond decreases $400 each period until it reaches its face value of $100,000 at the end of period 5.

A L SE= + −9,600 Exp −400 +10,000 Cash Flows no eff ect

504 10 Reporting and Analyzing Liabilities

CANDLESTICK INC. Bond Premium Amortization Schedule

Straight-Line Method—Annual Interest Payments $100,000 of 10%, 5-Year Bonds

Issue date

Formulas Data Review ViewPage LayoutInsert

A P18 fx

B C D E F

Candlestick Inc.xlsCandlestick Inc.xls Home

$2,000

1,600

1,200

800

400

Interest Periods

(D) Unamortized

Premium (D) − (C)

(E) Bond

Carrying Value ($100,000 + D)

$102,000

101,600

101,200

100,800

100,400

100,000

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the

annual contractual interest rate (10%) each period.

Column (B) is computed as the interest paid (Column A) less the premium amortization (Column C).

Column (C) indicates the premium amortization each period.

Column (D) decreases each period by the same amount until it reaches zero at maturity.

Column (E) decreases each period by the amount of premium amortization until it equals the

face value at maturity.

$ 10,000

10,000

$50,000

$ 9,600

9,600

$48,000

$ 400

400

$2,000

(A) Interest to

Be Paid (10% × $100,000)

(B) Interest Expense to Be Recorded

(A) − (C)

Amortization ($2,000 ÷ 5)

ILLUSTRATION 10A-4 Bond premium amortization schedule

To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. However, to com- pletely comply with the expense recognition principle, interest expense as a percentage of carrying value should not change over the life of the bonds. This percentage, referred to as the effective-interest rate, is established when the bonds are issued and remains constant in each interest period. Unlike the straight-line method, the effective-interest method of amortization accom- plishes this result. Under the effective-interest method of amortization, the amortization of bond discount or bond premium results in periodic interest expense equal to a constant percentage of the carrying value of the bonds. The effective-interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate. In contrast, the straight-line method results in constant amounts of amortization and interest expense per period but a varying percentage rate. Companies follow three steps under the effective-interest method:

1. Compute the bond interest expense by multiplying the carrying value of the bonds at the beginning of the interest period by the effective-interest rate.

2. Compute the bond interest paid (or accrued) by multiplying the face value of the bonds by the contractual interest rate.

3. Compute the amortization amount by determining the difference between the amounts computed in steps (1) and (2).

APPENDIX 10B: Apply the effective-interest method of amortizing bond discount and bond premium.

LEARNING OBJECTIVE *6▼

Appendix 10B: Effective-Interest Amortization 505

Illustration 10B-1 depicts these steps.

Both the straight-line and effective-interest methods of amortization result in the same total amount of interest expense over the term of the bonds. Fur- thermore, interest expense each interest period is generally comparable in amount. However, when the amounts are materially different, generally accepted accounting principles (GAAP) require use of the effective-interest method.

AMORTIZING BOND DISCOUNT

In the Candlestick Inc. example (page 490), the company sold $100,000, fi ve-year, 10% bonds on January 1, 2017, for $98,000. This resulted in a $2,000 bond dis- count ($100,000 − $98,000). This discount results in an effective-interest rate of approximately 10.5348%. (The effective-interest rate can be computed using the techniques shown in Appendix G near the end of this textbook.) Preparing a bond discount amortization schedule as shown in Illustration 10B-2 facilitates the recording of interest expense and the discount amortization. Note that interest expense as a percentage of carrying value remains constant at 10.5348%.

▼ HELPFUL HINT Note that the amount of periodic interest expense increases over the life of the bonds when the effective-interest method is used for bonds issued at a discount. The reason is that a constant percentage is applied to an increasing bond carrying value to compute interest expense. The carrying value is increasing because of the amortization of the discount.

(1) (2) (3) Bond Interest Expense Bond Interest Paid

Carrying Value Effective- Face Contractual of Bonds at

× Interest − Amount of × Interest = Amortization

Beginning of Rate Bond Rate

Amount Period

ILLUSTRATION 10B-1 Computation of amortization using effective-interest method

Issue date

$2,000

1,676

1,318

922

484

–0–

Interest Periods

(D) Unamortized

Discount (D) − (C)

(E) Bond

Carrying Value ($100,000 − D)

$ 98,000

98,324

98,682

99,078

99,516

100,000

(A) Interest to

Be Paid (10% × $100,000)

(B) Interest Expense to Be Recorded

(10.5348% × Preceding Bond Carrying Value)

Amortization (B) − (A)

$10,000

10,000

$50,000

$ 324

358

396

438

484

$2,000

$10,324

10,358

10,396

10,438

10,484

$52,000

(10.5348% × $98,000)

(10.5348% × $98,324)

(10.5348% × $98,682)

(10.5348% × $99,078)

(10.5348% × $99,516)

CANDLESTICK INC. Bond Discount Amortization Schedule

Effective-Interest Method—Annual Interest Payments 10% Bonds Issued at 10.5348%

Formulas Data Review ViewPage LayoutInsert

A P18 fx

B C D E F

Candlestick Inc.xlsCandlestick Inc.xls Home

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the annual contractual

interest rate (10%) each period.

Column (B) is computed as the preceding bond carrying value times the annual effective-interest rate (10.5348%).

Column (C) indicates the discount amortization each period.

Column (D) decreases each period until it reaches zero at maturity.

Column (E) increases each period until it equals face value at maturity.

ILLUSTRATION 10B-2 Bond discount amortization schedule

For the fi rst interest period, the computations of bond interest expense and the bond discount amortization are as follows.

506 10 Reporting and Analyzing Liabilities

Bond interest expense ($98,000 × 10.5348%) $10,324 Less: Bond interest paid ($100,000 × 10%) 10,000 Bond discount amortization $ 324

ILLUSTRATION 10B-3 Computation of bond discount amortization

As a result, Candlestick records the accrual of interest and amortization of bond discount on December 31 as follows.

Dec. 31 Interest Expense 10,324 Discount on Bonds Payable 324 Interest Payable 10,000 (To record accrued interest and amortization of bond discount)

For the second interest period, bond interest expense will be $10,358 ($98,324 × 10.5348%), and the discount amortization will be $358. At December 31, Candle- stick makes the following adjusting entry.

Dec. 31 Interest Expense 10,358 Discount on Bonds Payable 358 Interest Payable 10,000 (To record accrued interest and amortization of bond discount)

AMORTIZING BOND PREMIUM

Continuing our example, assume Candlestick Inc. sells the bonds described above for $102,000 rather than $98,000 (see page 492). This would result in a bond premium of $2,000 ($102,000 − $100,000). This premium results in an effective- interest rate of approximately 9.4794%. (The effective-interest rate can be com- puted using the techniques shown in Appendix G near the end of this textbook.) Illustration 10B-4 shows the bond premium amortization schedule.

A L SE= + −10,324 Exp +324 +10,000 Cash Flows no eff ect

A L SE= + −10,358 Exp +358 +10,000 Cash Flows no eff ect

Issue date

$2,000

1,669

1,307

910

476

–0–

Interest Periods

(D) Unamortized

Premium (D) − (C)

(E) Bond

Carrying Value ($100,000 + D)

$102,000

101,669

101,307

100,910

100,476

100,000

(A) Interest to

Be Paid (10% × $100,000)

(B) Interest Expense to Be Recorded

(9.4794% × Preceding Bond Carrying Value)

Amortization (A) − (B)

$10,000

10,000

$50,000

$ 9,669

9,638

9,603

9,566

9,524

$48,000

(9.4794% × $102,000)

(9.4794% × $101,669)

(9.4794% × $101,307)

(9.4794% × $100,910)

(9.4794% × $100,476)

$ 331

362

397

434

476

$2,000

CANDLESTICK INC. Bond Premium Amortization Schedule

Effective-Interest Method—Annual Interest Payments 10% Bonds Issued at 9.4794%

Formulas Data Review ViewPage LayoutInsert

A P18 fx

B C D E F

Candlestick Inc.xlsCandlestick Inc.xls Home

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the contractual

interest rate (10%) each period.

Column (B) is computed as the carrying value of the bonds times the annual effective-interest rate (9.4794%).

Column (C) indicates the premium amortization each period.

Column (D) decreases each period until it reaches zero at maturity.

Column (E) decreases each period until it equals face value at maturity.

*Rounded to eliminate remaining discount resulting from rounding the effective rate.

ILLUSTRATION 10B-4 Bond premium amortization schedule

Appendix 10C: Accounting for Long-Term Notes Payable 507

For the fi rst interest period, the computations of bond interest expense and the bond premium amortization are as follows.

Bond interest paid ($100,000 × 10%) $10,000 Less: Bond interest expense ($102,000 × 9.4794%) 9,669 Bond premium amortization $ 331

ILLUSTRATION 10B-5 Computation of bond premium amortization

The entry Candlestick makes on December 31 is as follows.

Dec. 31 Interest Expense 9,669 Premium on Bonds Payable 331 Interest Payable 10,000 (To record accrued interest and amortization of bond premium)

For the second interest period, interest expense will be $9,638, and the premium amortization will be $362. Note that the amount of periodic interest expense decreases over the life of the bond when companies apply the effective- interest method to bonds issued at a premium. The reason is that a constant per- centage is applied to a decreasing bond carrying value to compute interest expense. The carrying value is decreasing because of the amortization of the premium.

A L SE= + −9,669 Exp

−331 +10,000 Cash Flows no eff ect

The use of notes payable in long-term debt fi nancing is quite common. Long- term notes payable are similar to short-term interest-bearing notes payable except that the terms of the notes exceed one year. In periods of unstable interest rates, lenders may tie the interest rate on long-term notes to changes in the market rate for comparable loans. Examples are the 8.03% adjustable rate notes issued by General Motors and the fl oating-rate notes issued by American Express Company. A long-term note may be secured by a document called a mortgage that pledges title to specifi c assets as security for a loan. Individuals widely use mortgage notes payable to purchase homes, as do many small and some large companies to acquire plant assets. For example, at one time approximately 18% of McDonald’s long-term debt related to mortgage notes on land, buildings, and improvements. Like other long-term notes payable, the mortgage loan terms may stipulate either a fi xed or an adjustable interest rate. Typically, the terms require the borrower to make equal installment payments over the term of the loan. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. While the total amount paid remains constant, the interest decreases each period and the portion applied to the loan principal increases. Companies initially record mortgage notes payable at face value, and sub- sequently make entries for each installment payment. To illustrate, assume that Porter Technology Inc. issues a $500,000, 8%, 20-year mortgage note on Decem- ber 31, 2017, to obtain needed fi nancing for the construction of a new research laboratory. The terms provide for annual installment payments of $50,926 (not including real estate taxes and insurance). The installment payment schedule for the fi rst four years is as follows.

▼ HELPFUL HINT Computer spreadsheet programs can create a schedule of installment loan payments. This allows you to put in the data for your own mortgage loan and get an illustration that really hits home.

APPENDIX 10C: Describe the accounting for long-term notes payable.

LEARNING OBJECTIVE *7▼

508 10 Reporting and Analyzing Liabilities

Porter Technology records the mortgage loan on December 31, 2017, as follows.

Dec. 31 Cash 500,000 Mortgage Payable 500,000 (To record mortgage loan)

On December 31, 2018, Porter records the fi rst installment payment as follows.

Dec. 31 Interest Expense 40,000 Mortgage Payable 10,926 Cash 50,926 (To record annual payment on mortgage)

In the balance sheet, the company reports the reduction in principal for the next year as a current liability, and classifi es the remaining unpaid princi- pal balance as a long-term liability. At December 31, 2018, the total liability is $489,074. Of that amount, $11,800 is current and $477,274 ($489,074 − $11,800) is long-term.

A L SE= + +500,000 +500,000 Cash Flows +500,000

A L SE= + −40,000 Exp −10,926 −50,926

Cash Flows −50,926

(B) (C) (D) (A) Interest Reduction Principal Interest Cash Expense of Principal Balance Period Payment (D) × 8% (A) − (B) (D) − (C)

Issue date $500,000 1 $50,926 $40,000 $10,926 489,074 2 50,926 39,126 11,800 477,274 3 50,926 38,182 12,744 464,530 4 50,926 37,162 13,764 450,766

ILLUSTRATION 10C-1 Mortgage installment payment schedule

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Explain how to account for current liabilities. A current liability is a debt that a company can reasonably expect to pay (a) from existing current assets or through the creation of other current liabilities and (b) within one year or the operating cycle, whichever is longer. The major types of current liabilities are notes payable, accounts payable, sales taxes payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable. When a note payable is interest-bearing, the amount of assets received upon the issuance of the note is generally equal to the face value of the note, and interest expense is accrued over the life of the note. At maturity, the amount paid is equal to the face value of the note plus accrued interest. Companies record sales taxes payable at the time the related sales occur. The company serves as a collec- tion agent for the taxing authority. Sales taxes are not an expense to the company. Companies hold employee with- holding taxes and credit them to appropriate liability accounts, until they remit these taxes to the governmental

taxing authorities. Unearned revenues are initially recorded in an unearned revenue account. As a company recognizes revenue, a transfer from unearned revenue to revenue occurs. Companies report the current maturities of long- term debt as a current liability in the balance sheet.

2 Describe the major characteristics of bonds. The fol- lowing different types of bonds may be issued: secured and unsecured bonds, and convertible and callable bonds.

3 Explain how to account for bond transactions. When companies issue bonds, they debit Cash for the cash pro- ceeds and credit Bonds Payable for the face value of the bonds. In addition, they use the accounts Premium on Bonds Payable and Discount on Bonds Payable to show the bond premium and bond discount, respectively. Bond discount and bond premium are amortized over the life of the bond, which increases or decreases interest expense, respectively.

When companies redeem bonds at maturity, they credit Cash and debit Bonds Payable for the face value of the

▼

bonds. When companies redeem bonds before maturity, they (a) eliminate the carrying value of the bonds at the redemption date, (b) record the cash paid, and (c) recog- nize the gain or loss on redemption.

4 Discuss how liabilities are reported and analyzed. Cur- rent liabilities appear fi rst on the balance sheet, followed by long-term liabilities. Companies should report the nature and amount of each liability in the balance sheet or in schedules in the notes accompanying the statements. They report infl ows and outfl ows of cash related to the principal portion of long-term debt in the fi nancing sec- tion of the statement of cash fl ows.

The liquidity of a company may be analyzed by comput- ing the current ratio. The long-run solvency of a company may be analyzed by computing the debt to assets ratio and the times interest earned. Other factors to consider are contingent liabilities and lease obligations.

*5 Apply the straight-line method of amortizing bond discount and bond premium. The straight-line method of amortization results in a constant amount of amortization and interest expense per period.

*6 Apply the effective-interest method of amortizing bond discount and bond premium. The effective-interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate of interest. When the difference between the straight-line and effective-interest method is material, GAAP requires use of the effective-interest method.

*7 Describe the accounting for long-term notes payable. Each payment consists of (1) interest on the unpaid bal- ance of the loan, and (2) a reduction of loan principal. The interest decreases each period, while the portion applied to the loan principal increases each period.

Glossary Review 509

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Can the company obtain short-term fi nancing when necessary?

Available lines of credit, from notes to the fi nancial statements.

Compare available lines of credit to current liabilities. Also, evaluate liquidity ratios.

If liquidity ratios are low, then lines of credit should be high to compensate.

Can the company meet its obligations in the long term?

Does the company have any contingent liabilities?

Does the company have signifi cant off-balance- sheet fi nancing, such as unrecorded lease obligations?

Interest expense and net income before interest and taxes

Knowledge of events with uncertain negative outcomes

Information on unrecorded obligations, such as a schedule of minimum lease payments from the notes to the fi nancial statements

Notes to fi nancial statements and fi nancial statements

Compare liquidity and solvency ratios with and without unrecorded obligations included

High ratio indicates ability to meet interest payments as scheduled.

If negative outcomes are possible, determine the probability, the amount of loss, and the potential impact on fi nancial statements.

If ratios differ signifi cantly after including unrecorded obligations, these obligations should not be ignored in analysis.

Times interest = earned

Net income + Interest expense +

Income tax expense

Interest expense

Bond certifi cate A legal document that indicates the name of the issuer, the face value of the bonds, and other data such as the contractual interest rate and the maturity date of the bonds. (p. 486).

Bonds A form of interest-bearing notes payable issued by corporations, universities, and governmental agencies. (p. 485).

Callable bonds Bonds that the issuing company can re- deem (buy back) at a stated dollar amount prior to ma- turity. (p. 486).

Capital lease A contractual agreement allowing one party (the lessee) to use the assets of another party (the lessor);

accounted for like a debt-fi nanced purchase by the lessee. (p. 499).

Contingencies Events with uncertain outcomes that may represent potential liabilities. (p. 498).

Contractual (stated) interest rate Rate used to determine the amount of interest the issuer pays and the investor receives. (p. 486).

Convertible bonds Bonds that can be converted into com- mon stock at the bondholder’s option. (p. 486).

Current liability A debt that a company reasonably ex- pects to pay (1) from existing current assets or through the creation of other current liabilities, and (2) within

GLOSSARY REVIEW▼

510 10 Reporting and Analyzing Liabilities

one year or the operating cycle, whichever is longer. (p. 480).

Discount (on a bond) The difference between the face val- ue of a bond and its selling price when a bond is sold for less than its face value. (p. 490).

*Effective-interest method of amortization A method of amortizing bond discount or bond premium that results in periodic interest expense equal to a constant percent- age of the carrying value of the bonds. (p. 504).

*Effective-interest rate Rate established when bonds are issued that maintains a constant value for interest ex- pense as a percentage of bond carrying value in each interest period. (p. 504).

Face value Amount of principal due at the maturity date of the bond. (p. 486).

Long-term liabilities Obligations that a company expects to pay more than one year in the future. (p. 485).

Market interest rate The rate investors demand for loan- ing funds to the corporation. (p. 486).

Maturity date The date on which the fi nal payment on a bond is due from the bond issuer to the investor. (p. 486).

Mortgage note payable A long-term note secured by a mortgage that pledges title to specifi c assets as security for the loan. (p. 507).

Notes payable An obligation in the form of a written note. (p. 480).

Off-balance-sheet fi nancing The intentional effort by a company to structure its fi nancing arrangements so as to avoid showing liabilities on its balance sheet. (p. 499).

Operating lease A contractual agreement allowing one party (the lessee) to use the asset of another party (the lessor); accounted for as a rental. (p. 499).

Premium (on a bond) The difference between the selling price and the face value of a bond when a bond is sold for more than its face value. (p. 490).

Present value The value today of an amount to be received at some date in the future after taking into account cur- rent interest rates. (p. 486).

Secured bonds Bonds that have specifi c assets of the is- suer pledged as collateral. (p. 486).

*Straight-line method of amortization A method of amor- tizing bond discount or bond premium that allocates the same amount to interest expense in each interest period. (p. 502).

Times interest earned A measure of a company’s solvency, calculated by dividing the sum of net income, interest expense, and income tax expense by interest expense. (p. 497).

Time value of money The relationship between time and money. A dollar received today is worth more than a dollar promised at some time in the future. (p. 486).

Unsecured bonds Bonds issued against the general credit of the borrower. (p. 486).

1. The time period for classifying a liability as current is one year or the operating cycle, whichever is: (a) longer. (c) probable. (b) shorter. (d) possible.

2. To be classifi ed as a current liability, a debt must be expected to be paid within: (a) 1 year. (b) the operating cycle. (c) 2 years. (d) (a) or (b), whichever is longer.

3. Ottman Company borrows $88,500 on September 1, 2017, from Farley State Bank by signing an $88,500, 12%, 1-year note. What is the accrued interest at December 31, 2017? (a) $2,655. (c) $4,425. (b) $3,540. (d) $10,620.

4. JD Company borrowed $70,000 on December 1 on a 6-month, 12% note. At December 31: (a) neither the note payable nor the interest payable

is a current liability. (b) the note payable is a current liability but the in-

terest payable is not. (c) the interest payable is a current liability but the

note payable is not. (d) both the note payable and the interest payable

are current liabilities. 5. Alexis Company has total proceeds from sales

of $4,515. If the proceeds include sales taxes of

(LO 1)

5%, what is the amount to be credited to Sales Revenue? (a) $4,000. (c) $4,289.25. (b) $4,300. (d) The correct answer is not given.

6. When recording payroll: (a) gross earnings are recorded as salaries and wages

payable. (b) net pay is recorded as salaries and wages expense. (c) payroll deductions are recorded as liabilities. (d) More than one of the above.

7. No Fault Insurance Company collected a premium of $18,000 for a 1-year insurance policy on April 1. What amount should No Fault report as a current liability for Unearned Insurance Premiums at December 31? (a) $0. (c) $13,500. (b) $4,500. (d) $18,000.

8. Employer payroll taxes do not include: (a) federal unemployment taxes. (b) state unemployment taxes. (c) federal income taxes. (d) FICA taxes.

9. What term is used for bonds that have specifi c assets pledged as collateral? (a) Callable bonds. (c) Secured bonds. (b) Convertible bonds. (d) Discount bonds.

10. The market interest rate: (a) is the contractual interest rate used to determine

the amount of cash interest paid by the borrower.

(LO 1)

(LO 2)

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

bond interest and the amortization of bond discount using the straight-line method will include a: (a) debit to Interest Expense $57,600. (b) debit to Interest Expense $60,000. (c) credit to Discount on Bonds Payable $4,000. (d) credit to Discount on Bonds Payable $2,000.

*18. For the bonds issued in Question 17, what is the car- rying value of the bonds at the end of the third interest period? (a) $492,000. (c) $472,000. (b) $488,000. (d) $464,000.

*19. On January 1, Holly Ester Inc. issued $1,000,000, 10-year, 9% bonds for $938,554. The market rate of interest for these bonds is 10%. Interest is payable annually on December 31. Holly Ester uses the effective-interest method of amortizing bond dis- count. At the end of the fi rst year, Holly Ester should report unamortized bond discount of: (a) $54,900. (c) $51,610. (b) $57,591. (d) $51,000.

*20. On January 1, Nicholas Corporation issued $1,000,000, 14%, 5-year bonds with interest payable on Decem- ber 31. The bonds sold for $1,072,096. The market rate of interest for these bonds was 12%. On the fi rst interest date, using the effective-interest method, the debit entry to Interest Expense is for: (a) $120,000. (c) $128,652. (b) $125,581. (d) $140,000.

*21. Sampson Corp. purchased a piece of equipment by issuing a $20,000, 6% installment note payable. Quarterly payments on the note are $1,165. What will be the reduction in the principal portion of the note payable that results from the fi rst payment? (a) $1,165. (c) $865. (b) $300. (d) $1,200.

*22. Andrews Inc. issues a $497,000, 10% 3-year mort- gage note on January 1. The note will be paid in three annual installments of $200,000, each payable at the end of the year. What is the amount of interest ex- pense that should be recognized by Andrews Inc. in the second year? (a) $16,567. (c) $34,670. (b) $49,700. (d) $346,700.

*23. Howard Corporation issued a 20-year mortgage note payable on January 1, 2017. At December 31, 2017, the unpaid principal balance will be reported as: (a) a current liability. (b) a long-term liability. (c) part current and part long-term liability. (d) interest payable.

(LO 5)

(LO 6)

(LO 7)

(b) is listed in the bond indenture. (c) is the rate investors demand for loaning funds. (d) More than one of the above is true.

11. Laurel Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a pre- mium, this indicates that: (a) the contractual interest rate exceeds the market

interest rate. (b) the market interest rate exceeds the contractual

interest rate. (c) the contractual interest rate and the market in-

terest rate are the same. (d) no relationship exists between the two rates.

12. On January 1, 2017, Kelly Corp. issues $200,000, 5-year, 7% bonds at face value. The entry to record the issuance of the bonds would include a: (a) debit to Cash for $14,000. (b) debit to Bonds Payable for $200,000. (c) credit to Bonds Payable for $200,000. (d) credit to Interest Expense of $14,000.

13. Prescher Corporation issued bonds that pay interest every July 1 and January 1. The entry to accrue bond interest at December 31 includes a: (a) debit to Interest Payable. (b) credit to Cash. (c) credit to Interest Expense. (d) credit to Interest Payable.

14. Goethe Corporation redeems its $100,000 face value bonds at 105 on January 1, following the payment of interest. The carrying value of the bonds at the redemption date is $103,745. The entry to record the redemption will include a: (a) credit of $3,745 to Loss on Bond Redemption. (b) debit of $3,745 to Premium on Bonds Payable. (c) credit of $1,255 to Gain on Bond Redemption. (d) debit of $5,000 to Premium on Bonds Payable.

15. In a recent year, Derek Corporation had net income of $150,000, interest expense of $30,000, and income tax expense of $20,000. What was Derek Cor- poration’s times interest earned for the year? (a) 5.00. (c) 6.67. (b) 4.00. (d) 7.50.

16. Which of the following is not a measure of liquidity? (a) Debt to assets ratio. (b) Working capital. (c) Current ratio. (d) Current cash debt coverage.

*17. On January 1, Xiang Corporation issues $500,000, 5-year, 12% bonds at 96 with interest payable on Jan- uary 1. The entry on December 31 to record accrued

(LO 3)

(LO 4)

(LO 5)

Practice Multiple-Choice Questions 511

SOLUTIONS 1. (a) The time period for classifying a liability as current is one year or the operating cycle, whichever is longer, not

(b) shorter, (c) probable, or (d) possible.

2. (d) To be classifi ed as a current liability, a debt must be expected to be paid within 1 year or the operating cycle, which- ever is longer. Choices (a) and (b) are both correct, but (d) is the better answer. Choice (c) is incorrect.

3. (b) Accrued interest at 12/31/17 is computed as the face value ($88,500) times the interest rate (12%) times the por- tion of the year the debt was outstanding (4 months out of 12), or $3,540 ($88,500 × 12% × 412), not (a) $2,655, (c) $4,425, or (d) $10,620.

4. (d) A current liability is a debt the company reasonably expects to pay (1) from existing current assets or through the creation of other current liabilities, and (2) within the next year or the operating cycle, whichever is longer. Since both

512 10 Reporting and Analyzing Liabilities

the interest payable and the note payable are expected to be paid within one year, they both will be considered current liabilities. The other choices are therefore incorrect.

5. (b) Dividing the total proceeds ($4,515) by one plus the sales tax rate (1.05) will result in the amount of sales to be credited to the Sales Revenue account of $4,300 ($4,515 ÷ 1.05). The other choices are therefore incorrect.

6. (c) Payroll deductions are recorded as liabilities. The other choices are incorrect because (a) gross earnings are re- corded as salaries and wages expense, and (b) net pay is recorded as salaries and wages payable. Choice (d) is wrong as there is only one correct answer.

7. (b) The monthly premium is $1,500 or $18,000 divided by 12. Because No Fault has recognized 9 months of insurance revenue (April 1–December 31), 3 months’ insurance premium is still unearned. The amount that No Fault should report as Unearned Service Revenue is therefore $4,500 (3 months × $1,500), not (a) $0, (c) $13,500, or (d) $18,000.

8. (c) Federal income taxes are a payroll deduction, not an employer payroll tax. The employer is merely a collection agent. The other choices are all included in employer payroll taxes.

9. (c) Secured bonds are those that have specifi c assets of the issuer pledged as collateral. The other choices are incor- rect because (a) callable bonds can be retired or paid off at the discretion of the issuer at a specifi ed price prior to the maturity date, (b) convertible bonds can be converted into common stock at the discretion of the bondholder, and (d) discount bonds is not a term that is generally used when describing bonds.

10. (c) The market interest rate is the rate investors demand for loaning funds to the corporation. The other choices are incorrect because (a) the rate on the bond certifi cate is used to determine the interest payments, (b) the contract inter- est rate is listed in the bond indenture, and (d) there is only one correct answer.

11. (a) When bonds are issued at a premium, this indicates that the contractual interest rate is higher than the market interest rate. The other choices are incorrect because (b) when the market interest rate exceeds the contractual inter- est rate, bonds are sold at a discount; (c) when the contractual interest rate and the market interest rate are the same, bonds will be issued at par; and (d) the relationship between the market rate of interest and the contractual rate of interest determines whether bonds are issued at par, a discount, or a premium.

12. (c) The issuance entry for the bonds includes a debit to Cash for $200,000 and a credit to Bonds Payable for $200,000. The other choices are therefore incorrect.

13. (d) Since the interest has been accrued but not yet paid, it has to be recognized as an increase in expenses and liabilities. The entry would be a debit to Interest Expense and a credit to Interest Payable. The other choices are incorrect because (a) an interest accrual will increase, not decrease, Interest Payable; (b) interest accruals do not affect Cash; and (c) an interest accrual will increase, not decrease, Interest Expense.

14. (b) The entry to record the redemption of bonds will include a debit to Bonds Payable of $100,000, a debit to Premium on Bonds Payable of $3,745 ($103,745 − $100,000), a credit to Cash of $105,000 ($100,000 × 1.05) and a debit to Loss on Bond Redemption of $1,255 ($105,000 − $103,745). The other choices are therefore incorrect.

15. (c) Times interest earned = (Net income + Interest expense + Income tax expense) ÷ Interest expense = ($150,000 + $30,000 + $20,000) ÷ $30,000 = 6.67, not (a) 5.00, (b) 4.00, or (d) 7.50.

16. (a) Debt to assets ratio measures solvency, which is the ability of a company to survive over a long period of time. Choices (b) working capital, (c) current ratio, and (d) current cash debt coverage are all measures of liquidity.

*17. (c) [$500,000 − (96% × $500,000)] = $20,000; $20,000 ÷ 5 = $4,000 of discount to amortize annually. As a result, the entry would involve a credit to Discount on Bonds Payable $4,000. The other choices are therefore incorrect.

*18. (a) The carrying value of bonds increases by the amount of the periodic discount amortization. Discount amortization using the straight-line method is $4,000 each period. Total discount amortization for three periods is $12,000 ($4,000 × 3 periods) which is added to the initial carrying value ($480,000) to arrive at $492,000, the carrying value at the end of the third interest period, not (b) $488,000, (c) $486,000, or (d) $464,000.

*19. (b) The beginning balance of unamortized discount is $61,446 ($1,000,000 − $938,554). The discount amortization is $3,855, the difference between the cash interest payment of $90,000 ($1,000,000 × 9%) and the interest expense recorded of $93,855 ($938,554 × 10%). This discount amortization ($3,855) is then subtracted from the beginning bal- ance of unamortized discount ($61,446), to arrive at a balance of $57,591 at the end of the fi rst year, not (a) $54,900, (c) $51,610, or (d) $51,000.

*20. (c) The debit to Interest Expense = $1,072,096 (initial carrying value of bond) × 12% (market rate) = $128,652, not (a) $120,000, (b) $125,581, or (d) $140,000.

*21. (c) The reduction in the principle portion of the note payable that results from the fi rst payment = $1,165 − ($200,000 × 0.015) = $865, not (a) $1,165, (b) $300, or (d) $1,200.

*22. (c) In the fi rst year, Andrews will recognize $49,700 of interest expense ($497,000 × 10%). After the fi rst payment is made, the amount remaining on the note will be $346,700 [$497,000 principal − ($200,000 payment − $49,700 interest)]. The remaining balance ($346,700) is multiplied by the interest rate (10%) to compute the interest expense to be recog- nized for the second year, $34,670 ($346,700 × 10%), not (a) $16,567, (b) $49,700, or (d) $346,700.

*23. (c) Howard Corporation reports the reduction in principal for the next year as a current liability, and it classifi es the remaining unpaid principal balance as a long-term liability. The other choices are therefore incorrect.

Practice Exercises 513

1. On June 1, JetSet Company borrows $150,000 from First Bank on a 6-month, $150,000, 8% note.

INSTRUCTIONS

(a) Prepare the entry on June 1. (b) Prepare the adjusting entry on June 30. (c) Prepare the entry at maturity (December 1), assuming monthly adjusting entries have

been made through November 30. (d) What was the total fi nancing cost (interest expense)?

Prepare entries for interest-bearing notes.

(LO 1)

PRACTICE EXERCISES▼

SOLUTION

2. January 1, 2017 (a) Cash 900,000 Bonds Payable 900,000

December 31, 2017 (b) Interest Expense 72,000 Interest Payable ($900,000 × 8%) 72,000

January 1, 2018 (c) Interest Payable 72,000 Cash 72,000

January 1, 2027 (d) Bonds Payable 900,000 Cash 900,000

SOLUTION

1. (a) June 1 Cash 150,000 Notes Payable 150,000

(b) June 30 Interest Expense 1,000 Interest Payable

($150,000 × 8% × 1/12) 1,000 (c) Dec. 1 Notes Payable 150,000 Interest Payable

($150,000 × 8% × 6/12) 6,000 Cash 156,000

(d) $6,000

2. Global Airlines Company issued $900,000 of 8%, 10-year bonds on January 1, 2017, at face value. Interest is payable annually on January 1.

INSTRUCTIONS

Prepare the journal entries to record the following events.

(a) The issuance of the bonds. (b) The accrual of interest on December 31. (c) The payment of interest on January 1, 2018. (d) The redemption of bonds at maturity, assuming interest for the last interest period has

been paid and recorded.

Prepare entries for bonds issued at face value.

(LO 3)

*3. Trawler Company borrowed $500,000 on December 31, 2017, by issuing a $500,000, 7% mortgage note payable. The terms call for annual installment payments of $80,000 on December 31. (This exercise is addressed in Appendix 10C.)

INSTRUCTIONS

(a) Prepare the journal entries to record the mortgage loan and the fi rst two installment payments.

(b) Indicate the amount of mortgage note payable to be reported as a current liability and as a long-term liability at December 31, 2018.

Prepare entries to record mortgage note and installment payments.

(LO 7)

514 10 Reporting and Analyzing Liabilities

SOLUTION

3. December 31, 2017 (a) Cash 500,000 Mortgage Payable 500,000

December 31, 2018 Interest Expense ($500,000 × 7%) 35,000 Mortgage Payable 45,000 Cash 80,000

December 31, 2019 Interest Expense [($500,000 − $45,000) × 7%] 31,850 Mortgage Payable 48,150 Cash 80,000 (b) Current: $48,150 Long-term: $406,850 ($500,000 − $45,000 − $48,150)

Snyder Software Inc. successfully developed a new spreadsheet program. However, to produce and market the program, the company needed additional fi nancing. On January 1, 2016, Snyder borrowed money as follows.

1. Snyder issued $500,000, 11%, 10-year bonds. The bonds sold at face value and pay interest on January 1.

2. Snyder issued $1.0 million, 10%, 10-year bonds for $886,996. Interest is payable on January 1. Snyder uses the straight-line method of amortization.

INSTRUCTIONS

(a) For the 11% bonds, prepare journal entries for the following items. (1) The issuance of the bonds on January 1, 2016. (2) Accrue interest expense on December 31, 2016. (3) The payment of interest on January 1, 2017. (b) For the 10-year, 10% bonds: (1) Journalize the issuance of the bonds on January 1, 2016. (2) Prepare the entry for the redemption of the bonds at 101 on January 1, 2019, after

paying the interest due on this date. The carrying value of the bonds at the redemp- tion date was $920,897.

Prepare entries to record issuance of bonds, interest accrual, and bond redemption.

(LO 3, 5)

PRACTICE PROBLEM▼

SOLUTION

(a) (1) 2016 Jan. 1 Cash 500,000 Bonds Payable 500,000 (To record issue of 11%, 10-year

bonds at face value) (2) 2016

Dec. 31 Interest Expense 55,000 Interest Payable 55,000 (To record accrual of bond interest)

(3) 2017 Jan. 1 Interest Payable 55,000 Cash 55,000 (To record payment of accrued

interest) (b) (1) 2016

Jan. 1 Cash 886,996 Discount on Bonds Payable 113,004 Bonds Payable 1,000,000 (To record issuance of bonds at a

discount)

Questions 515

(2) 2019 Jan. 1 Bonds Payable 1,000,000 Loss on Bond Redemption 89,103* Discount on Bonds Payable 79,103 Cash 1,010,000 (To record redemption of bonds at

101) *($1,010,000 − $920,897)

1. Jenny Perez believes a current liability is a debt that can be expected to be paid in one year. Is Jenny correct? Explain.

2. Rayborn Company obtains $20,000 in cash by sign- ing a 9%, 6-month, $20,000 note payable to First Bank on July 1. Rayborn’s fi scal year ends on September 30. What information should be reported for the note payable in the annual fi nancial statements?

3. (a) Your roommate says, “Sales taxes are reported as an expense in the income statement.” Do you agree? Explain.

(b) Leiana’s Cafe has cash proceeds from sales of $8,550. This amount includes $550 of sales taxes. Give the entry to record the proceeds.

4. Carolina University sold 9,000 season football tickets at $100 each for its fi ve-game home schedule. What entries should be made (a) when the tickets are sold and (b) after each game?

5. Identify three taxes commonly withheld by the employer from an employee’s gross pay.

6. (a) Identify three taxes commonly paid by employers on employees’ salaries and wages.

(b) Where in the fi nancial statements does the employer report taxes withheld from employees’ pay?

7. Identify the liabilities classifi ed by Apple as current.

8. (a) What are long-term liabilities? Give two examples. (b) What is a bond?

9. Contrast these types of bonds: (a) Secured and unsecured. (b) Convertible and callable.

10. Explain each of these important terms in issuing bonds: (a) Face value. (b) Contractual interest rate. (c) Bond certifi cate.

11. (a) What is a convertible bond?

(b) Discuss the advantages of a convertible bond from the standpoint of the bondholders and of the issuing corporation.

12. Describe the two major obligations incurred by a com- pany when bonds are issued.

13. Assume that Acorn Inc. sold bonds with a face value of $100,000 for $104,000. Was the market interest rate equal to, less than, or greater than the bonds’ contrac- tual interest rate? Explain.

14. Lee and Jay are discussing how the market price of a bond is determined. Lee believes that the market price of a bond is solely a function of the amount of the principal payment at the end of the term of a bond. Is he right? Discuss.

15. If a 6%, 10-year, $800,000 bond is issued at face value and interest is paid annually, what is the amount of the interest payment at the end of the fi rst period?

16. If the Bonds Payable account has a balance of $700,000 and the Discount on Bonds Payable account has a balance of $36,000, what is the carrying value of the bonds?

17. Which accounts are debited and which are credited if a bond issue originally sold at a premium is redeemed before maturity at 97 immediately following the pay- ment of interest?

18. Penny Lennon, the chief fi nancial offi cer of Johnson Inc., is considering the options available to her for fi nancing the company’s new plant. Short-term interest rates right now are 6%, and long-term rates are 8%. The company’s current ratio is 2.2:1. If she fi nances the new plant with short-term debt, the cur- rent ratio will fall to 1.5:1. Briefl y discuss the issues that Penny should consider.

19. (a) In general, what are the requirements for the fi nan-

cial statement presentation of long-term liabilities? (b) What ratios may be computed to evaluate a com-

pany’s liquidity and solvency?

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.

QUESTIONS▼

516 10 Reporting and Analyzing Liabilities

20. Ernie Sams says that liquidity and solvency are the same thing. Is he correct? If not, how do they differ?

21. The management of Ingolls Corporation is con- cerned because survey data suggest that many po- tential customers do not buy vehicles due to quality concerns. It is considering taking the bold step of in- creasing the length of its warranty from the industry standard of 3 years up to an unprecedented 10 years in an effort to increase confi dence in its quality. Discuss the business as well as accounting implications of this move.

22. Hank Mays needs a few new trucks for his business. He is considering buying the trucks but is concerned that the additional debt he will need to incur will make his liquidity and solvency ratios look bad. What options does he have other than purchasing the trucks, and how will these options affect his fi nan- cial statements?

23. Anglo Corporation has a current ratio of 1.1. Jon has always been told that a corporation’s cur- rent ratio should exceed 2.0. The company maintains that its ratio is low because it has a minimal amount of inventory on hand so as to reduce operating costs. Anglo also has signifi cant available lines of credit. Is Jon still correct? What do some companies do to com- pensate for having fewer liquid assets?

24. What are the implications for analysis if a company has signifi cant operating leases?

25. What criteria must be met before a contin- gency must be recorded as a liability? How should

the contingency be disclosed if the criteria are not met?

*26. Explain the straight-line method of amortiz- ing discount and premium on bonds payable.

*27. Robbins Corporation issues $200,000 of 6%, 5-year bonds on January 1, 2017, at 103. Assuming that the straight-line method is used to amortize the pre- mium, what is the total amount of interest expense for 2017?

*28. Honore Draper is discussing the advantages of the effective-interest method of bond amortization with her accounting staff. What do you think Honore is saying?

*29. Dotsin Corporation issues $400,000 of 9%, 5-year bonds on January 1, 2017, at 104. If Dotsin uses the effective-interest method in amortizing the premium, will the annual interest expense increase or decrease over the life of the bonds? Explain.

*30. Your friend just received a car loan. It is a 7-year in- stallment note. He does not understand the mechanics of how the loan works. Explain the important aspects of the installment note.

*31. Tim Rian, a friend of yours, has recently purchased a home for $125,000, paying $25,000 down and the re- mainder fi nanced by a 6.5%, 20-year mortgage, payable at $745.57 per month. At the end of the fi rst month, Tim receives a statement from the bank indicating that only $203.90 of principal was paid during the month. At this rate, he calculates that it will take over 40 years to pay off the mortgage. Is he right? Discuss.

BE10-1 Busch Company has these obligations at December 31: (a) a note payable for $100,000 due in 2 years, (b) a 10-year mortgage payable of $200,000 payable in ten $20,000 annual payments and (c) interest payable of $15,000 on the mortgage, and (d) accounts payable of $60,000. For each obligation, indicate whether it should be classifi ed as a cur- rent liability, noncurrent liability, or both.

BE10-2 Hive Company borrows $90,000 on July 1 from the bank by signing a $90,000, 7%, 1-year note payable. Prepare the journal entries to record (a) the proceeds of the note and (b) accrued interest at December 31, assuming adjusting entries are made only at the end of the year.

BE10-3 Greenspan Supply does not segregate sales and sales taxes at the time of sale. The register total for March 16 is $10,388. All sales are subject to a 6% sales tax. Compute sales taxes payable and make the entry to record sales taxes payable and sales.

BE10-4 Bramble University sells 3,500 season basketball tickets at $80 each for its 10-game home schedule. Give the entry to record (a) the sale of the season tickets and (b) the revenue recognized after playing the fi rst home game.

BE10-5 Betsy Strand’s regular hourly wage rate is $16, and she receives an hourly rate of $24 for work in excess of 40 hours. During a January pay period, Betsy works 47 hours. Betsy’s federal income tax withholding is $95, and she has no voluntary deductions. Com- pute Betsy Strand’s gross earnings and net pay for the pay period. Assume that the FICA tax rate is 7.65%.

BE10-6 Data for Betsy Strand are presented in BE10-5. Prepare the employer’s journal entries to record (a) Betsy’s pay for the period and (b) the payment of Betsy’s wages. Use January 15 for the end of the pay period and the payment date.

Identify whether obligations are current liabilities.

(LO 1), C

Prepare entries for an interest- bearing note payable.

(LO 1), AP

Compute and record sales taxes payable.

(LO 1), AP

Prepare entries for unearned revenues.

(LO 1), AP

Compute gross earnings and net pay.

(LO 1), AP

Record a payroll and the payment of wages.

(LO 1), AP

BRIEF EXERCISES▼

Brief Exercises 517

BE10-7 Data for Betsy Strand are presented in BE10-5. Prepare the employer’s journal entry to record payroll taxes for the period. Ignore unemployment taxes.

BE10-8 Bridle Inc. issues $300,000, 10-year, 8% bonds at 98. Prepare the journal entry to record the sale of these bonds on March 1, 2017.

BE10-9 Ravine Company issues $400,000, 20-year, 7% bonds at 101. Prepare the journal entry to record the sale of these bonds on June 1, 2017.

BE10-10 Clooney Corporation issued 3,000 7%, 5-year, $1,000 bonds dated January 1, 2017, at face value. Interest is paid each January 1. (a) Prepare the journal entry to record the sale of these bonds on January 1, 2017. (b) Prepare the adjusting journal entry on December 31, 2017, to record interest expense. (c) Prepare the journal entry on January 1, 2018, to record interest paid.

BE10-11 The balance sheet for Gelher Company reports the following information on July 1, 2017.

GELHER COMPANY Balance Sheet (partial)

Long-term liabilities Bonds payable $2,000,000 Less: Discount on bonds payable 45,000 $1,955,000

Gelher decides to redeem these bonds at 102 after paying annual interest. Prepare the journal entry to record the redemption on July 1, 2017.

BE10-12 Presented here are long-term liability items for Stevens Inc. at December 31, 2017. Prepare the long-term liabilities section of the balance sheet for Stevens Inc.

Bonds payable (due 2021) $700,000 Notes payable (due 2019) 80,000 Discount on bonds payable 28,000

BE10-13 Presented here are liability items for O’Brian Inc. at December 31, 2017. Prepare the liabilities section of O’Brian’s balance sheet.

Accounts payable $157,000 FICA taxes payable $ 7,800 Notes payable 20,000 Interest payable 40,000 (due May 1, 2018) Notes payable (due 2019) 80,000 Bonds payable (due 2021) 900,000 Income taxes payable 3,500 Unearned rent revenue 240,000 Sales taxes payable 1,700 Discount on bonds payable 41,000

BE10-14 Suppose the 2017 adidas fi nancial statements contain the following selected data (in millions).

Current assets $4,485 Interest expense $169 Total assets 8,875 Income taxes 113 Current liabilities 2,836 Net income 245 Total liabilities 5,099 Cash 775

Compute the following values and provide a brief interpretation of each. (a) Working capital. (c) Debt to assets ratio. (b) Current ratio. (d) Times interest earned.

BE10-15 Suppose the Canadian National Railway Company’s (CN) total assets in a recent year were $24,004 million and its total liabilities were $14,180 million. That year, CN reported operating lease commitments for its locomotives, freight cars, and equipment totaling $740 million. If these assets had been recorded as capital leases, assume that assets and liabilities would have risen by approximately $740 million. (a) Calculate CN’s debt to assets ratio, fi rst using the fi gures reported, and then after

increasing assets and liabilities for the unrecorded operating leases. (b) Discuss the potential effect of these operating leases on your assessment of CN’s

solvency.

Prepare entries for payroll taxes.

(LO 1), AP

Prepare entries for issuance of bonds.

(LO 3), AP Prepare entries for issuance of bonds.

(LO 3), AP Prepare journal entries for bonds issued at face value.

(LO 3), AP

Prepare journal entry for redemption of bonds.

(LO 3), AP

Prepare statement presentation of long-term liabilities.

(LO 4), AP

Prepare liabilities section of balance sheet.

(LO 4), AP

Analyze solvency.

(LO 4), AP

Analyze solvency.

(LO 4), AN

518 10 Reporting and Analyzing Liabilities

*BE10-16 Alpine Company issues $2 million, 10-year, 7% bonds at 99, with interest pay- able on December 31. The straight-line method is used to amortize bond discount. (a) Prepare the journal entry to record the sale of these bonds on January 1, 2017. (b) Prepare the journal entry to record interest expense and bond discount amortization

on December 31, 2017, assuming no previous accrual of interest.

*BE10-17 Harvard Inc. issues $4 million, 5-year, 8% bonds at 102, with interest payable on January 1. The straight-line method is used to amortize bond premium. (a) Prepare the journal entry to record the sale of these bonds on January 1, 2017. (b) Prepare the journal entry to record interest expense and bond premium amortization

on December 31, 2017, assuming no previous accrual of interest.

*BE10-18 Presented below is the partial bond discount amortization schedule for Rohr Corp., which uses the effective-interest method of amortization.

Interest Bond Interest Interest to Expense to Discount Unamortized Carrying Periods Be Paid Be Recorded Amortization Discount Value

Issue date $38,609 $961,391 1 $45,000 $48,070 $3,070 35,539 964,461 2 45,000 48,223 3,223 32,316 967,684

Instructions (a) Prepare the journal entry to record the payment of interest and the discount amortiza-

tion at the end of period 1. (b) Explain why interest expense is greater than interest paid. (c) Explain why interest expense will increase each period.

*BE10-19 Jenseng Inc. issues a $800,000, 10%, 10-year mortgage note on December 31, 2017, to obtain fi nancing for a new building. The terms provide for annual installment payments of $130,196. Prepare the entry to record the mortgage loan on December 31, 2017, and the fi rst installment payment on December 31, 2018.

Prepare journal entries for bonds issued at a discount.

(LO 5), AP

Prepare journal entries for bonds issued at a premium.

(LO 5), AP

Use effective-interest method of bond amortization.

(LO 6), AP

Prepare entries for long-term notes payable.

(LO 7), AP

You and several classmates are studying for the next accounting examina- tion. They ask you to answer the following questions:

1. If cash is borrowed on a $60,000, 9-month, 10% note on August 1, how much interest expense would be incurred by December 31?

2. The cash register total including sales taxes is $42,000, and the sales tax rate is 5%. What is the sales taxes payable?

3. If $42,000 is collected in advance on November 1 for 6-month magazine subscrip- tions, what amount of subscription revenue should be recognized on December 31?

During the month of February, Hennesey Corporation’s employees earned wages of $74,000. Withholdings related to these wages were $5,661 for Social Security (FICA), $7,100 for federal income tax, and $1,900 for state income tax. Costs incurred for unemployment taxes were $110 for federal and $160 for state.

Prepare the February 28 journal entries for (a) salaries and wages expense and sala- ries and wages payable assuming that all February wages will be paid in March and (b) the company’s payroll tax expense.

State whether each of the following statements is true or false. _______1. Convertible bonds are also known as callable bonds. _______2. The market rate is the rate investors demand for loaning funds. _______3. Semiannual interest payments on bonds are equal to the face value times the

stated rate times 6/12. _______4. The present value of a bond is the value at which it should sell in the market.

Smiley Corporation issues $300,000 of bonds for $315,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.

DO IT! 10-1aAnswer questions about current liabilities.

(LO 1), AP

DO IT! 10-1bPrepare entries for payroll and payroll taxes.

(LO 1), AP

DO IT! 10-2Evaluate statements about bonds.

(LO 2), C

DO IT! 10-3aPrepare journal entry for bond issuance and show balance sheet presentation.

(LO 3), AP

EXERCISES▼DO IT!

Exercises 519

Farmland Corporation issued $400,000 of 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds was $388,000, the company redeemed the bonds at 99. Prepare the entry to record the redemption of the bonds.

Grouper Company provides you with the following balance sheet information as of December 31, 2017.

Current assets $11,500 Current liabilities $12,000 Long-term assets 26,500 Long-term liabilities 14,000

Total assets $38,000 Stockholders’ equity 12,000

Total liabilities and stockholders’ equity $38,000

In addition, Grouper reported net income for 2017 of $16,000, income tax expense of $3,200, and interest expense of $1,300. (a) Compute the current ratio and working capital for Grouper for 2017. (b) Assume that at the end of 2017, Grouper used $3,000 cash to pay off $3,000 of

accounts payable. How would the current ratio and working capital have changed? (c) Compute the debt to assets ratio and the times interest earned for Grouper for

2017.

DO IT! 10-3b Prepare entry for bond redemption.

(LO 3), AP

DO IT! 10-4 Analyze liabilities.

(LO 4), AN

E10-1 Kelly Jones and Tami Crawford borrowed $15,000 on a 7-month, 8% note from Gem State Bank to open their business, JC’s Coffee House. The money was borrowed on June 1, 2017, and the note matures January 1, 2018.

Instructions (a) Prepare the entry to record the receipt of the funds from the loan. (b) Prepare the entry to accrue the interest on June 30. (c) Assuming adjusting entries are made at the end of each month, determine the balance

in the Interest Payable account at December 31, 2017. (d) Prepare the entry required on January 1, 2018, when the loan is paid back.

E10-2 On May 15, Wild Quest Clothiers borrowed some money on a 4-month note to pro- vide cash during the slow season of the year. The interest rate on the note was 8%. At the time the note was due, the amount of interest owed was $480.

Instructions (a) Determine the amount borrowed by Wild Quest. (b) Independent of your answer in part (a), assume the amount borrowed was $18,500.

What was the interest rate if the amount of interest owed was $555? (c) Prepare the entry for the initial borrowing and the repayment for the facts in part (a).

E10-3 On June 1, Marchon Company Ltd. borrows $60,000 from Acme Bank on a 6-month, $60,000, 8% note. The note matures on December 1.

Instructions (a) Prepare the entry on June 1. (b) Prepare the adjusting entry on June 30. (c) Prepare the entry at maturity (December 1), assuming monthly adjusting entries have

been made through November 30. (d) What was the total fi nancing cost (interest expense)?

E10-4 In performing accounting services for small businesses, you encounter the follow- ing situations pertaining to cash sales. 1. Cerviq Company enters sales and sales taxes separately on its cash register. On April

10, the register totals are sales $22,000 and sales taxes $1,100. 2. Quartz Company does not segregate sales and sales taxes. Its register total for April 15

is $13,780, which includes a 6% sales tax.

Instructions Prepare the entries to record the sales transactions and related taxes for (a) Cerviq Com- pany and (b) Quartz Company.

Prepare entries for interest-bearing notes.

(LO 1), AP

Prepare entries for interest-bearing notes.

(LO 1), AP

Prepare entries for interest-bearing notes.

(LO 1), AP

Journalize sales and related taxes.

(LO 1), AP

EXERCISES▼

520 10 Reporting and Analyzing Liabilities

E10-5 During the month of March, Munster Company’s employees earned wages of $64,000. Withholdings related to these wages were $4,896 for Social Security (FICA), $7,500 for federal income tax, $3,100 for state income tax, and $400 for union dues. The company incurred no cost related to these earnings for federal unemployment tax but incurred $700 for state unemployment tax.

Instructions (a) Prepare the necessary March 31 journal entry to record salaries and wages expense

and salaries and wages payable. Assume that wages earned during March will be paid during April.

(b) Prepare the entry to record the company’s payroll tax expense.

E10-6 Season tickets for the Dingos are priced at $320 and include 16 home games. An equal amount of revenue is recognized after each game is played. When the season began, the amount credited to Unearned Ticket Revenue was $1,728,000. By the end of October, $1,188,000 of the Unearned Ticket Revenue had been recognized as revenue.

Instructions (a) How many season tickets did the Dingos sell? (b) How many home games had the Dingos played by the end of October? (c) Prepare the entry for the initial recording of the Unearned Ticket Revenue. (d) Prepare the entry to recognize the revenue after the fi rst home game had been played.

E10-7 Cassini Company Ltd. publishes a monthly sports magazine, Fishing Preview. Sub- scriptions to the magazine cost $28 per year. During November 2017, Cassini sells 6,300 subscriptions for cash, beginning with the December issue. Cassini prepares financial statements quarterly and recognizes subscription revenue at the end of the quarter. The company uses the accounts Unearned Subscription Revenue and Subscription Revenue. The company has a December 31 year-end.

Instructions (a) Prepare the entry in November for the receipt of the subscriptions. (b) Prepare the adjusting entry at December 31, 2017, to record subscription revenue in

December 2017. (c) Prepare the adjusting entry at March 31, 2018, to record subscription revenue in the

fi rst quarter of 2018.

E10-8 On August 1, 2017, Gonzaga Corporation issued $600,000, 7%, 10-year bonds at face value. Interest is payable annually on August 1. Gonzaga’s year-end is December 31.

Instructions Prepare journal entries to record the following events. (a) The issuance of the bonds. (b) The accrual of interest on December 31, 2017. (c) The payment of interest on August 1, 2018.

E10-9 On January 1, Kirkland Company issued $300,000, 8%, 10-year bonds at face value. Interest is payable annually on January 1.

Instructions Prepare journal entries to record the following events. (a) The issuance of the bonds. (b) The accrual of interest on December 31. (c) The payment of interest on January 1.

E10-10 Arroyo Company issued $600,000, 10-year, 6% bonds at 103.

Instructions (a) Prepare the journal entry to record the sale of these bonds on January 1, 2017. (b) Suppose the remaining Premium on Bonds Payable was $10,800 on December 31,

2020. Show the balance sheet presentation on this date. (c) Explain why the bonds sold at a price above the face amount.

Journalize payroll entries.

(LO 1), AP

Journalize unearned revenue transactions.

(LO 1), AP

Journalize unearned subscription revenue.

(LO 1), AP

Prepare journal entries for issuance of bonds and payment and accrual of interest.

(LO 3), AP

Prepare journal entries for issuance of bonds and payment and accrual of interest.

(LO 3), AP

Prepare entries for issuance of bonds, balance sheet presentation, and cause of deviations from face value.

(LO 3), AP

Exercises 521

E10-11 Mobbe Company issued $500,000, 15-year, 7% bonds at 96.

Instructions (a) Prepare the journal entry to record the sale of these bonds on January 1, 2017. (b) Suppose the remaining Discount on Bonds Payable was $12,000 on December 31,

2022. Show the balance sheet presentation on this date. (c) Explain why the bonds sold at a price below the face amount.

E10-12 Assume that the following are independent situations recently reported in the Wall Street Journal. 1. General Electric (GE) 7% bonds, maturing January 28, 2018, were issued at 111.12. 2. Boeing 7% bonds, maturing September 24, 2032, were issued at 99.08.

Instructions (a) Were GE and Boeing bonds issued at a premium or a discount? (b) Explain how bonds, both paying the same contractual interest rate, could be issued at

different prices. (c) Prepare the journal entry to record the issue of each of these two bonds, assuming

each company issued $800,000 of bonds in total.

E10-13 Kale Company issued $350,000 of 8%, 20-year bonds on January 1, 2017, at face value. Interest is payable annually on January 1.

Instructions Prepare the journal entries to record the following events. (a) The issuance of the bonds. (b) The accrual of interest on December 31, 2017. (c) The payment of interest on January 1, 2018. (d) The redemption of the bonds at maturity, assuming interest for the last interest period

has been paid and recorded.

E10-14 The situations presented here are independent of each other.

Instructions For each situation, prepare the appropriate journal entry for the redemption of the bonds. (a) Mikhail Corporation redeemed $140,000 face value, 9% bonds on April 30, 2017, at

101. The carrying value of the bonds at the redemption date was $126,500. The bonds pay annual interest, and the interest payment due on April 30, 2017, has been made and recorded.

(b) Oldman, Inc., redeemed $170,000 face value, 12.5% bonds on June 30, 2017, at 98. The carrying value of the bonds at the redemption date was $184,000. The bonds pay annual interest, and the interest payment due on June 30, 2017, has been made and recorded.

E10-15 Sanchez, Inc. reports the following liabilities (in thousands) on its December 31, 2017, balance sheet and notes to the financial statements.

Accounts payable $4,263.9 Mortgage payable $6,746.7 Accrued pension liability 1,115.2 Operating leases 1,641.7 Unearned rent revenue 1,058.1 Notes payable (due in 2020) 335.6 Bonds payable 1,961.2 Salaries and wages payable 858.1 Current portion of Notes payable (due in 2018) 2,563.6 mortgage payable 1,992.2 Unused operating line of credit 3,337.6 Income taxes payable 265.2 Warranty liability—current 1,417.3

Instructions (a) Identify which of the above liabilities are likely current and which are likely long-term.

List any items that do not fi t in either category. Explain the reasoning for your selection. (b) Prepare the liabilities section of Sanchez’s balance sheet as at December 31, 2017.

E10-16 Suppose McDonald’s 2017 financial statements contain the following selected data (in millions).

Current assets $ 3,416.3 Interest expense $ 473.2 Total assets 30,224.9 Income taxes 1,936.0 Current liabilities 2,988.7 Net income 4,551.0 Total liabilities 16,191.0

Prepare entries for issuance of bonds, balance sheet presentation, and cause of deviations from face value.

(LO 3), AP

Prepare entries for issue of bonds.

(LO 3), AN

Prepare journal entries to record issuance of bonds, payment of interest, and redemption at maturity.

(LO 3), AP

Prepare journal entries for redemption of bonds.

(LO 3), AP

Prepare liabilities section of balance sheet.

(LO 4), AP

Calculate liquidity and solvency ratios; discuss impact of unrecorded obligations on liquidity and solvency.

(LO 4), AP

522 10 Reporting and Analyzing Liabilities

Instructions (a) Compute the following values and provide a brief interpretation of each. (1) Working capital. (3) Debt to assets ratio. (2) Current ratio. (4) Times interest earned. (b) Suppose the notes to McDonald’s fi nancial statements show that subsequent to 2017

the company will have future minimum lease payments under operating leases of $10,717.5 million. If these assets had been purchased with debt, assets and liabilities would rise by approximately $8,800 million. Recompute the debt to assets ratio after adjusting for this. Discuss your result.

E10-17 Suppose 3M Company reported the following financial data for 2017 and 2016 (in millions).

Calculate current ratio before and after paying accounts payable.

(LO 4), AN

Instructions (a) Calculate the current ratio for 3M for 2017 and 2016. (b) Suppose that at the end of 2017, 3M management used $300 million cash to pay off

$300 million of accounts payable. How would its current ratio change?

E10-18 Underwood Boutique reported the following financial data for 2017 and 2016.

UNDERWOOD BOUTIQUE Balance Sheet (partial)

September 30 (in thousands)

2017 2016

Current assets Cash and short-term deposits $2,574 $1,021 Accounts receivable 2,147 1,575 Inventories 1,201 1,010 Other current assets 322 192

Total current assets $6,244 $3,798

Current liabilities $4,503 $2,619

Instructions (a) Calculate the current ratio for Underwood Boutique for 2017 and 2016. (b) Suppose that at the end of 2017, Underwood Boutique used $1.5 million cash to pay

off $1.5 million of accounts payable. How would its current ratio change? (c) At September 30, Underwood Boutique has an undrawn operating line of credit of

$12.5 million. Would this affect any assessment that you might make of Underwood Boutique’s short-term liquidity? Explain.

E10-19 A large retailer was sued nearly 5,000 times in a recent year—about once every 2 hours every day of the year. It has been sued for everything imaginable—ranging from falls on icy parking lots to injuries sustained in shoppers’ stampedes to a murder with a rifle purchased at one of its stores. The company reported the following in the notes to its financial statements:

Calculate current ratio before and after paying accounts payable.

(LO 4), AN

Discuss contingent liabilities.

(LO 4), C

2017 2016

Current assets Cash and cash equivalents $ 3,040 $1,849 Accounts receivable, net 3,250 3,195 Inventories 2,639 3,013 Other current assets 1,866 1,541

Total current assets $10,795 $9,598

Current liabilities $ 4,897 $5,839

3M COMPANY Balance Sheet (partial)

Exercises 523

Instructions (a) Explain why the company does not have to record these contingent liabilities. (b) Comment on any implications for analysis of the fi nancial statements.

*E10-20 Sehr Company issued $500,000, 6%, 30-year bonds on January 1, 2017, at 103. Interest is payable annually on January 1. Sehr uses straight-line amortization for bond premium or discount.

Instructions Prepare the journal entries to record the following events. (a) The issuance of the bonds. (b) The accrual of interest and the premium amortization on December 31, 2017. (c) The payment of interest on January 1, 2018. (d) The redemption of the bonds at maturity, assuming interest for the last interest period

has been paid and recorded.

*E10-21 Motley Company issued $300,000, 8%, 15-year bonds on December 31, 2016, for $288,000. Interest is payable annually on December 31. Motley uses the straight-line method to amortize bond premium or discount.

Instructions Prepare the journal entries to record the following events. (a) The issuance of the bonds. (b) The payment of interest and the discount amortization on December 31, 2017. (c) The redemption of the bonds at maturity, assuming interest for the last interest period

has been paid and recorded.

*E10-22 Woode Corporation issued $400,000, 7%, 20-year bonds on January 1, 2017, for $360,727. This price resulted in an effective-interest rate of 8% on the bonds. Interest is payable annually on January 1. Woode uses the effective-interest method to amortize bond premium or discount.

Instructions Prepare the journal entries to record (round to the nearest dollar): (a) The issuance of the bonds. (b) The accrual of interest and the discount amortization on December 31, 2017. (c) The payment of interest on January 1, 2018.

*E10-23 Hernandez Company issued $380,000, 7%, 10-year bonds on January 1, 2017, for $407,968. This price resulted in an effective-interest rate of 6% on the bonds. Interest is payable annually on January 1. Hernandez uses the effective-interest method to amortize bond premium or discount.

Instructions Prepare the journal entries (rounded to the nearest dollar) to record: (a) The issuance of the bonds. (b) The accrual of interest and the premium amortization on December 31, 2017. (c) The payment of interest on January 1, 2018.

*E10-24 Yancey Co. receives $300,000 when it issues a $300,000, 10%, mortgage note pay- able to finance the construction of a building at December 31, 2017. The terms provide for annual installment payments of $50,000 on December 31.

Instructions Prepare the journal entries to record the mortgage loan and the first two installment payments.

Prepare journal entries to record issuance of bonds, payment of interest, amortization of premium using straight-line, and redemption at maturity.

(LO 3, 5), AP

Prepare journal entries to record issuance of bonds, payment of interest, amortization of discount using straight-line, and redemption at maturity.

(LO 3, 5), AP

Prepare journal entries for issuance of bonds, payment of interest, and amortization of discount using effective-interest method.

(LO 3, 6), AP

Prepare journal entries for issuance of bonds, payment of interest, and amortization of premium using effective-interest method.

(LO 3, 6), AP

Prepare journal entries to record mortgage note and installment payments.

(LO 7), AP

The Company and its subsidiaries are involved from time to time in claims, proceed- ings, and litigation arising from the operation of its business. The Company does not believe that any such claim, proceeding, or litigation, either alone or in the aggregate, will have a material adverse effect on the Company’s financial position or results of its operations.

524 10 Reporting and Analyzing Liabilities

*E10-25 Waite Corporation issued a $50,000, 10%, 10-year installment note payable on January 1, 2017. Payments of $8,137 are made each January 1, beginning January 1, 2018.

Instructions (a) What amounts should be reported under current liabilities related to the note on

December 31, 2017? (b) What should be reported under long-term liabilities?

Determine balance sheet presentation of installment note payable.

(LO 7), AP

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P10-1A On January 1, 2017, the ledger of Romada Company contained these liability accounts.

Accounts Payable $42,500 Sales Taxes Payable 6,600 Unearned Service Revenue 19,000

During January, the following selected transactions occurred.

Jan. 1 Borrowed $18,000 in cash from Apex Bank on a 4-month, 5%, $18,000 note. 5 Sold merchandise for cash totaling $6,254, which includes 6% sales taxes. 12 Performed services for customers who had made advance payments of $10,000.

(Credit Service Revenue.) 14 Paid state treasurer’s department for sales taxes collected in December 2016,

$6,600. 20 Sold 500 units of a new product on credit at $48 per unit, plus 6% sales tax.

During January, the company’s employees earned wages of $70,000. Withholdings related to these wages were $5,355 for Social Security (FICA), $5,000 for federal income tax, and $1,500 for state income tax. The company owed no money related to these earnings for federal or state unemployment tax. Assume that wages earned during January will be paid during February. No entry had been recorded for wages or payroll tax expense as of January 31.

Instructions (a) Journalize the January transactions. (b) Journalize the adjusting entries at January 31 for the outstanding note payable and for

salaries and wages expense and payroll tax expense. (c) Prepare the current liabilities section of the balance sheet at January 31, 2017. Assume

no change in Accounts Payable.

P10-2A Ehler Corporation sells rock-climbing products and also operates an indoor climbing facility for climbing enthusiasts. During the last part of 2017, Ehler had the fol- lowing transactions related to notes payable.

Sept. 1 Issued a $12,000 note to Pippen to purchase inventory. The 3-month note payable bears interest of 6% and is due December 1. (Ehler uses a perpetual inventory system.)

Sept. 30 Recorded accrued interest for the Pippen note. Oct. 1 Issued a $16,500, 8%, 4-month note to Prime Bank to fi nance the purchase

of a new climbing wall for advanced climbers. The note is due February 1. Oct. 31 Recorded accrued interest for the Pippen note and the Prime Bank note. Nov. 1 Issued a $26,000 note and paid $8,000 cash to purchase a vehicle to transport

clients to nearby climbing sites as part of a new series of climbing classes. This note bears interest of 6% and matures in 12 months.

Nov. 30 Recorded accrued interest for the Pippen note, the Prime Bank note, and the vehicle note.

Dec. 1 Paid principal and interest on the Pippen note. Dec. 31 Recorded accrued interest for the Prime Bank note and the vehicle note.

Prepare current liability entries, adjusting entries, and current liabilities section.

(LO 1, 4), AP

Journalize and post note transactions; show balance sheet presentation.

(LO 1, 4), AP

PROBLEMS: SET A▼

Problems: Set A 525

Instructions (a) Prepare journal entries for the transactions noted above. (b) Post the above entries to the Notes Payable, Interest Payable, and Interest Expense

accounts. (Use T-accounts.) (c) Show the balance sheet presentation of notes payable and interest payable at Decem-

ber 31. (d) How much interest expense relating to notes payable did Ehler incur during the year?

P10-3A The following section is taken from Hardesty’s balance sheet at December 31, 2016.

Current liabilities Interest payable $ 40,000 Long-term liabilities Bonds payable (8%, due January 1, 2020) 500,000

Interest is payable annually on January 1. The bonds are callable on any annual interest date.

Instructions (a) Journalize the payment of the bond interest on January 1, 2017. (b) Assume that on January 1, 2017, after paying interest, Hardesty calls bonds having a

face value of $200,000. The call price is 103. Record the redemption of the bonds. (c) Prepare the adjusting entry on December 31, 2017, to accrue the interest on the

remaining bonds.

P10-4A On October 1, 2016, Kristal Corp. issued $700,000, 5%, 10-year bonds at face value. The bonds were dated October 1, 2016, and pay interest annually on October 1. Financial statements are prepared annually on December 31.

Instructions (a) Prepare the journal entry to record the issuance of the bonds. (b) Prepare the adjusting entry to record the accrual of interest on December 31, 2016. (c) Show the balance sheet presentation of bonds payable and bond interest payable on

December 31, 2016. (d) Prepare the journal entry to record the payment of interest on October 1, 2017. (e) Prepare the adjusting entry to record the accrual of interest on December 31, 2017. (f) Assume that on January 1, 2018, Kristal pays the accrued bond interest and calls the

bonds. The call price is 104. Record the payment of interest and redemption of the bonds.

P10-5A Malcolm Company sold $6,000,000, 7%, 15-year bonds on January 1, 2017. The bonds were dated January 1, 2017, and pay interest on December 31. The bonds were sold at 98.

Instructions (a) Prepare the journal entry to record the issuance of the bonds on January 1, 2017. (b) At December 31, 2017, $8,000 of the bond discount had been amortized. Show the long-

term liability balance sheet presentation of the bond liability at December 31, 2017. (c) At January 1, 2019, when the carrying value of the bonds was $5,896,000, the company

redeemed the bonds at 102. Record the redemption of the bonds assuming that interest for the year had already been paid.

P10-6A Suppose you have been presented with selected information taken from the fi nan- cial statements of Southwest Airlines Co., shown on the next page.

Instructions (a) Calculate each of the following ratios for 2017 and 2016. (1) Current ratio. (2) Free cash fl ow. (3) Debt to assets ratio. (4) Times interest earned. (b) Comment on the trend in ratios. (c) Read the company’s note on leases. If the operating leases had instead been accounted

for like a purchase, assets and liabilities would increase by approximately $1,600 mil- lion. Recalculate the debt to assets ratio for 2017 in light of this information, and discuss the implications for analysis.

(b) Interest Payable $590

Prepare journal entries to record interest payments and redemption of bonds.

(LO 3), AP

(b) Loss $6,000

Prepare journal entries to record issuance of bonds, interest, balance sheet presentation, and bond redemption.

(LO 3, 4), AP

(f) Loss $28,000

Prepare journal entries to record issuance of bonds, show balance sheet presentation, and record bond redemption.

(LO 3, 4), AP

Calculate and comment on ratios.

(LO 4), AN

526 10 Reporting and Analyzing Liabilities

*P10-7A The following information is taken from Lassen Corp.’s balance sheet at Decem- ber 31, 2016.

Current liabilities Interest payable $ 96,000 Long-term liabilities Bonds payable (4%, due January 1, 2027) $2,400,000 Less: Discount on bonds payable 24,000 2,376,000

Interest is payable annually on January 1. The bonds are callable on any annual inter- est date. Lassen uses straight-line amortization for any bond premium or discount. From December 31, 2016, the bonds will be outstanding for an additional 10 years (120 months).

Instructions (Round all computations to the nearest dollar.) (a) Journalize the payment of bond interest on January 1, 2017. (b) Prepare the entry to amortize bond discount and to accrue the interest on December

31, 2017. (c) Assume on January 1, 2018, after paying interest, that Lassen Corp. calls bonds

having a face value of $400,000. The call price is 102. Record the redemption of the bonds.

(d) Prepare the adjusting entry at December 31, 2018, to amortize bond discount and to accrue interest on the remaining bonds.

*P10-8A Fong Corporation sold $2,000,000, 7%, 5-year bonds on January 1, 2017. The bonds were dated January 1, 2017, and pay interest on January 1. Fong Corporation uses the straight-line method to amortize bond premium or discount.

Instructions (a) Prepare all the necessary journal entries to record the issuance of the bonds and bond

interest expense for 2017, assuming that the bonds sold at 102.

Prepare journal entries to record interest payments, straight-line discount amortization, and redemption of bonds.

(LO 3, 5), AP

Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation.

(LO 3, 4, 5), AP

2017 2016

Total current assets $ 2,893 $ 4,443 Noncurrent assets 11,415 12,329

Total assets $14,308 $16,772

Current liabilities $ 2,806 $ 4,836 Long-term liabilities 6,549 4,995

Total liabilities 9,355 9,831 Shareholders’ equity 4,953 6,941

Total liabilities and shareholders’ equity $14,308 $16,772

Other information:

2017 2016

Net income (loss) $ 178 $ 645 Income tax expense 100 413 Interest expense 130 119 Cash provided by operations (1,521) 2,845 Capital expenditures 923 1,331 Cash dividends 13 14

Note 8. Leases The majority of the Company’s terminal operations space, as well as 82 aircraft, were under operating leases at December 31, 2017. Future minimum lease payments under noncancelable operating leases are as follows: 2018, $376,000; 2019, $324,000; 2020, $249,000; 2021, $208,000; 2022, $152,000; after 2023, $728,000.

SOUTHWEST AIRLINES CO. Balance Sheet (partial)

December 31 (in millions)

Problems: Set A 527

(b) Prepare journal entries as in part (a) assuming that the bonds sold at 97. (c) Show the balance sheet presentation for the bond issue at December 31, 2017, using

(1) the 102 selling price, and then (2) the 97 selling price.

*P10-9A Saylor Co. sold $3,000,000, 8%, 10-year bonds on January 1, 2017. The bonds were dated January 1, 2017, and pay interest on January 1. The company uses straight- line amortization on bond premiums and discounts. Financial statements are prepared annually.

Instructions (a) Prepare the journal entries to record the issuance of the bonds assuming they sold at: (1) 103. (2) 98. (b) Prepare amortization tables for both assumed sales for the first three interest

payments. (c) Prepare the journal entries to record interest expense for 2017 under both of the bond

issuances assumed in part (a). (d) Show the long-term liabilities balance sheet presentation for both of the bond issu-

ances assumed in part (a) at December 31, 2017.

*P10-10A On January 1, 2017, Lachte Corporation issued $1,800,000 face value, 5%, 10-year bonds at $1,667,518. This price resulted in an effective-interest rate of 6% on the bonds. Lachte uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest January 1.

Instructions (Round all computations to the nearest dollar.) (a) Prepare the journal entry to record the issuance of the bonds on January 1, 2017. (b) Prepare an amortization table through December 31, 2019 (three interest periods) for

this bond issue. (c) Prepare the journal entry to record the accrual of interest and the amortization of the

discount on December 31, 2017. (d) Prepare the journal entry to record the payment of interest on January 1, 2018. (e) Prepare the journal entry to record the accrual of interest and the amortization of the

discount on December 31, 2018.

*P10-11A On January 1, 2017, Opal Company issued $2,000,000 face value, 7%, 10-year bonds at $2,147,202. This price resulted in a 6% effective-interest rate on the bonds. Opal uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest on each January 1.

Instructions (a) Prepare the journal entries to record the following transactions. (1) The issuance of the bonds on January 1, 2017. (2) Accrual of interest and amortization of the premium on December 31, 2017. (3) The payment of interest on January 1, 2018. (4) Accrual of interest and amortization of the premium on December 31, 2018. (b) Show the proper long-term liabilities balance sheet presentation for the liability for

bonds payable at December 31, 2018. (c) Provide the answers to the following questions in narrative form. (1) What amount of interest expense is reported for 2018? (2) Would the bond interest expense reported in 2018 be the same as, greater than, or

less than the amount that would be reported if the straight-line method of amortiza- tion were used?

*P10-12A Laverne purchased a new piece of equipment to be used in its new facility. The $370,000 piece of equipment was purchased with a $50,000 down payment and with cash received through the issuance of a $320,000, 8%, 5-year mortgage payable issued on January 1, 2017. The terms provide for annual installment payments of $80,146 on December 31.

Instructions (Round all computations to the nearest dollar.) (a) Prepare an installment payments schedule for the fi rst three payments of the notes

payable. (b) Prepare the journal entry related to the notes payable for December 31, 2017.

Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation.

(LO 3, 4, 5), AP

Prepare journal entries to record issuance of bonds, payment of interest, and amortization of bond discount using effective-interest method.

(LO 3, 6), AP

Prepare journal entries to record issuance of bonds, payment of interest, and effective-interest amortization, and balance sheet presentation.

(LO 3, 4, 6), AP

(a) (4) Interest Expense $128,162

Prepare installment payments schedule, journal entries, and balance sheet presentation for a mortgage note payable.

(LO 4, 7), AP

528 10 Reporting and Analyzing Liabilities

(c) Show the balance sheet presentation for this obligation for December 31, 2017. (Hint: Be sure to distinguish between the current and long-term portions of the note.)

*P10-13A Hetty Grey has just approached a venture capitalist for fi nancing for her new business venture, the development of a local ski hill. On July 1, 2016, Hetty was loaned $150,000 at an annual interest rate of 7%. The loan is repayable over 5 years in annual installments of $36,584, principal and interest, due each June 30. The fi rst payment is due June 30, 2017. Hetty uses the effective-interest method for amortizing debt. Her ski hill company’s year-end will be June 30.

Instructions (a) Prepare an amortization schedule for the 5 years, 2016–2021. (Round all calculations

to the nearest dollar.) (b) Prepare all journal entries for Hetty Grey for the fi rst 2 fi scal years ended June 30,

2017, and June 30, 2018. (Round all calculations to the nearest dollar.) (c) Show the balance sheet presentation of the note payable as of June 30, 2018. (Hint: Be

sure to distinguish between the current and long-term portions of the note.)

Prepare journal entries to record payments for long-term note payable, and balance sheet presentation.

(LO 4, 7), AP

(b) 6/30/17 Interest Expense $10,500

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

▼ PROBLEMS: SET B AND SET C

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 9.)

CC10 Recall that Cookie Creations borrowed $2,000 from Natalie’s grandmother. Natalie now is thinking of repaying all amounts outstanding on that loan. She needs to know the amounts of interest payable and interest expense to make the correct journal entries for repayment of the loan.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to see the com- pletion of this problem.

CONTINUING PROBLEM Cookie Creations▼

COMPREHENSIVE ACCOUNTING CYCLE REVIEW ACR10 Aimes Corporation’s balance sheet at December 31, 2016, is presented below.

AIMES CORPORATION Balance Sheet

December 31, 2016

Cash $ 30,000 Accounts payable $ 13,750 Inventory 30,750 Interest payable 2,500 Prepaid insurance 5,600 Bonds payable 50,000 Equipment 38,000 Common stock 25,000 $104,350 Retained earnings 13,100

$104,350

During 2017, the following transactions occurred. Aimes uses a perpetual inventory system.

1. Aimes paid $2,500 interest on the bonds on January 1, 2017. 2. Aimes purchased $241,100 of inventory on account. 3. Aimes sold for $480,000 cash inventory which cost $265,000. Aimes also collected

$28,800 sales taxes. 4. Aimes paid $230,000 on accounts payable. 5. Aimes paid $2,500 interest on the bonds on July 1, 2017. 6. The prepaid insurance ($5,600) expired on July 31. 7. On August 1, Aimes paid $10,200 for insurance coverage from August 1, 2017, through

July 31, 2018.

Expand Your Critical Thinking 529

8. Aimes paid $17,000 sales taxes to the state. 9. Paid other operating expenses, $91,000. 10. Redeemed the bonds on December 31, 2017, by paying $48,000 plus $2,500 interest. 11. Issued $90,000 of 8% bonds on December 31, 2017, at 103. The bonds pay interest

every June 30 and December 31.

Adjustment data:

1. Recorded the insurance expired from item 7. 2. The equipment was acquired on December 31, 2016, and will be depreciated on a

straight-line basis over 5 years with a $3,000 salvage value. 3. The income tax rate is 30%. (Hint: Prepare the income statement up to income before

taxes and multiply by 30% to compute the amount.)

Instructions (You may want to set up T-accounts to determine ending balances.) (a) Prepare journal entries for the transactions listed above and adjusting entries. (b) Prepare an adjusted trial balance at December 31, 2017. (c) Prepare an income statement and a retained earnings statement for the year ending

December 31, 2017, and a classifi ed balance sheet as of December 31, 2017.

(b) Totals $687,695 (c) N.I. $72,905

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT10-1 Refer to the fi nancial statements of Apple Inc. in Appendix A.

Instructions Answer the following questions. (a) What were Apple’s total current liabilities at September 27, 2014? What was the

increase/decrease in Apple’s total current liabilities from the prior year? (b) How much were the accounts payable at September 27, 2014? (c) What were the components of total current liabilities on September 27, 2014 (other

than accounts payable already discussed above)?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT10-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information contained in these fi nancial statements, compute the cur-

rent ratio for 2014 for each company. What conclusions concerning the companies’ liquidity can be drawn from these ratios?

(b) Based on the information contained in these fi nancial statements, compute the follow- ing 2014 ratios for each company.

(1) Debt to assets ratio. (2) Times interest earned. What conclusions about the companies’ long-run solvency can be drawn from the

ratios?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT10-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information contained in these fi nancial statements, compute the cur-

rent ratio for the most recent fi scal year for each company. What conclusions concern- ing the companies’ liquidity can be drawn from these ratios?

Financial Reporting

▼

Financial Analysis

▼

Financial Analysis

▼

530 10 Reporting and Analyzing Liabilities

(b) Based on the information contained in these fi nancial statements, compute the follow- ing ratios for each company’s most recent fi scal year.

(1) Debt to assets ratio. (2) Times interest earned. What conclusions about the companies’ long-run solvency can be drawn from the ratios?

INTERPRETING FINANCIAL STATEMENTS

CT10-4 Hechinger Co. and Home Depot are two home improvement retailers. Compared to Hechinger, founded in the early 1900s, Home Depot is a relative newcomer. But in recent years, while Home Depot was reporting large increases in net income, Hechinger was reporting in- creasingly large net losses. Finally, largely due to competition from Home Depot, Hechinger was forced to fi le for bankruptcy. Here are fi nancial data for both companies (in millions).

Hechinger Home Depot

Cash $ 21 $ 62 Receivables 0 469 Total current assets 1,153 4,933 Beginning total assets 1,668 11,229 Ending total assets 1,577 13,465 Beginning current liabilities 935 2,456 Ending current liabilities 938 2,857 Beginning total liabilities 1,392 4,015 Ending total liabilities 1,339 4,716 Interest expense 67 37 Income tax expense 3 1,040 Cash provided (used) by operations (257) 1,917 Net income (93) 1,614 Net sales 3,444 30,219

Instructions Using the data provided, perform the following analysis.

(a) Calculate working capital and the current ratio for each company. Discuss their rela- tive liquidity.

(b) Calculate the debt to assets ratio and times interest earned for each company. Discuss their relative solvency.

(d) The notes to Home Depot’s fi nancial statements indicate that it leases many of its facil- ities using operating leases. If these assets had instead been purchased with debt, assets and liabilities would have increased by approximately $2,347 million. Calculate the company’s debt to assets ratio employing this adjustment. Discuss the implications.

CT10-5 For many years, Borders Group and Barnes and Noble were the dominant book- sellers in the United States. They experienced rapid growth, and in the process they forced many small, independent bookstores out of business. Recently, Borders fi led for bank- ruptcy. It was the victim of its inability to change with the times. It did not develop a viable business plan for dealing with digital books and online sales. Below is fi nancial informa- tion (in millions) for the two companies, taken from the annual reports of each company one year before Borders fi led for bankruptcy.

Borders Barnes and Noble

Current assets $ 978.7 $1,719.5 Total assets 1,415.6 3,705.7 Current liabilities 918.1 1,724.4 Total liabilities 1,257.3 2,802.3 Net income/(loss) (109.4) 36.7 Interest expense 24.1 28.2 Tax expense/(income tax benefit) (31.3) 8.4

Instructions (a) Compute the current ratio for each company. (b) Compute the debt to assets ratio and times interest earned for each company. (Hint: A

tax benefi t means that rather than pay taxes, the company was due a refund because of its losses. For ratio purposes, a tax benefi t is treated the opposite of tax expense.)

Financial Analysis

▼ E

Expand Your Critical Thinking 531

REAL-WORLD FOCUS

CT10-6 Bond or debt securities pay a stated rate of interest. This rate of interest is depen- dent on the risk associated with the investment. Also, bond prices change when the risks associated with those bonds change. Standard & Poor’s provides ratings for companies that issue debt securities.

Address: www.standardandpoors.com/ratings/defi nitions-and-faqs/en/us

Instructions Go to the website shown and answer the following questions.

(a) Explain the meaning of an “A” rating. Explain the meaning of a “C” rating. (b) What types of things can cause a change in a company’s credit rating? (c) Explain the relationship between a company’s credit rating and the merit of an invest-

ment in that company’s bonds.

CT10-7 The September 1, 2009, edition of CFO.com contains an article by Marie Leone and Tim Reason entitled “Dirty Secrets.” You can access this article at www.cfo.com/ article.cfm/14292477?f=singlepage.

Instructions Read the article and answer the following questions.

(a) Summarize the accounting for contingent items that is provided in this textbook. (b) The authors of the article suggest that many companies are basically accounting for con-

tingencies on a cash basis. Is this consistent with the approach you described in part (a)? (c) The article suggests that many companies report one set of liability estimates to insur-

ers and a different (lower) set of numbers in their fi nancial statements. How is this possible, and what are the implications for investors?

(d) How do international accounting standards differ in terms of the amounts reported in these types of situations?

DECISION-MAKING ACROSS THE ORGANIZATION

CT10-8 On January 1, 2015, Picard Corporation issued $3,000,000, 5-year, 8% bonds at 97. The bonds pay interest annually on January 1. By January 1, 2017, the market rate of interest for bonds of risk similar to those of Picard Corporation had risen. As a result, the market price of these bonds was $2,500,000 on January 1, 2017—below their carrying value of $2,946,000.

Geoff Marquis, president of the company, suggests repurchasing all of these bonds in the open market at the $2,500,000 price. But to do so the company will have to issue $2,500,000 (face value) of new 10-year, 12% bonds at par. The president asks you, as con- troller, “What is the feasibility of my proposed repurchase plan?”

Instructions With the class divided into groups, answer the following.

(a) Prepare the journal entry to redeem the 5-year bonds on January 1, 2017. Prepare the journal entry to issue the new 10-year bonds.

(b) Prepare a short memo to the president in response to his request for advice. List the economic factors that you believe should be considered for his repurchase proposal.

COMMUNICATION ACTIVITY

CT10-9 Jerry Hogan, president of Norwest, Inc., is considering the issuance of bonds to fi nance an expansion of his business. He has asked you to do the following: (1) discuss the advantages of bonds over common stock fi nancing, (2) indicate the types of bonds he might issue, and (3) explain the issuing procedures used in bond transactions.

Instructions Write a memorandum to the president, answering his request.

ETHICS CASES

CT10-10 The July 1998 issue of Inc. magazine includes an article by Jeffrey L. Seglin entitled “Would You Lie to Save Your Company?” It recounts the following true situation:

Financial Analysis

Writing

Group Project

▼

532 10 Reporting and Analyzing Liabilities

“A Chief Executive Offi cer (CEO) of a $20-million company that repairs aircraft engines received notice from a number of its customers that engines that it had recently repaired had failed, and that the company’s parts were to blame. The CEO had not yet determined whether his company’s parts were, in fact, the cause of the problem. The Federal Aviation Administration (FAA) had been notifi ed and was investigating the matter.

What complicated the situation was that the company was in the midst of its year- end audit. As part of the audit, the CEO was required to sign a letter saying that he was not aware of any signifi cant outstanding circumstances that could negatively impact the company—in accounting terms, of any contingent liabilities. The auditor was not aware of the customer complaints or the FAA investigation.

The company relied heavily on short-term loans from eight banks. The CEO feared that if these lenders learned of the situation, they would pull their loans. The loss of these loans would force the company into bankruptcy, leaving hundreds of people without jobs. Prior to this problem, the company had a stellar performance record.”

Instructions Answer the following questions.

(a) Who are the stakeholders in this situation? (b) What are the CEO’s possible courses of action? What are the potential results of each

course of action? (Take into account the two alternative outcomes: the FAA determines the company (1) was not at fault, and (2) was at fault.)

company is found to be at fault and is forced into bankruptcy. What losses are incurred by the stakeholders in this situation? Do you think the CEO should suffer legal conse- quences if he decides to conceal the situation?

CT10-11 During the summer of 2002, the fi nancial press reported that Citigroup was be- ing investigated for allegations that it had arranged transactions for Enron so as to inten- tionally misrepresent the nature of the transactions and consequently achieve favorable balance sheet treatment. Essentially, the deals were structured to make it appear that money was coming into Enron from trading activities, rather than from loans.

A July 23, 2002, The New York Times article by Richard Oppel and Kurt Eichenwald en- titled “Citigroup Said to Mold Deal to Help Enron Skirt Rules” suggested that Citigroup inten- tionally kept certain parts of a secret oral agreement out of the written record for fear that it would change the accounting treatment. Critics contend that this had the effect of signifi cantly understating Enron’s liabilities, thus misleading investors and creditors. Citigroup maintains that, as a lender, it has no obligation to ensure that its clients account for transactions prop- erly. The proper accounting, Citigroup insists, is the responsibility of the client and its auditor.

Instructions Answer the following questions.

(a) Who are the stakeholders in this situation? (b) Do you think that a lender, in general, in arranging so-called “structured fi nancing”

has a responsibility to ensure that its clients account for the fi nancing in an appropri- ate fashion, or is this the responsibility of the client and its auditor?

(c) What effect did the fact that the written record did not disclose all characteristics of the transaction probably have on the auditor’s ability to evaluate the accounting treat- ment of this transaction?

(d) The New York Times article noted that in one presentation made to sell this kind of deal to Enron and other energy companies, Citigroup stated that using such an arrange- ment “eliminates the need for capital markets disclosure, keeping structure mechanics private.” Why might a company wish to conceal the terms of a fi nancing arrangement from the capital markets (investors and creditors)? Is this appropriate? Do you think it is ethical for a lender to market deals in this way?

(e) Why was this deal more potentially harmful to shareholders than other off-balance- sheet transactions (for example, lease fi nancing)?

ALL ABOUT YOU

CT10-12 For most U.S. families, medical costs are substantial and rising. But will medical costs be your most substantial expense over your lifetime? Not likely. Will it be housing or food? Again, not likely. The answer: Taxes are likely to be your biggest expense. On average, Americans work 74 days to afford their federal taxes. Companies, too, have large

A Look at IFRS 533

tax burdens. They look very hard at tax issues in deciding where to build their plants and where to locate their administrative headquarters.

Instructions (a) Determine what your state income taxes are if your taxable income is $60,000 and you

fi le as a single taxpayer in the state in which you live. (b) Assume that you own a home worth $200,000 in your community and the tax rate is

2.1%. Compute the property taxes you would pay. (c) Assume that the total gasoline bill for your automobile is $1,200 a year (300 gallons at $4

per gallon). What are the amounts of state and federal taxes that you pay on the $1,200? (d) Assume that your purchases for the year total $9,000. Of this amount, $5,000 was for food

and prescription drugs. What is the amount of sales tax you would pay on these purchases? (Note: Many states do not have a sales tax for food or prescription drug purchases.

Does yours?) (e) Determine what your Social Security taxes are if your income is $60,000. (f) Determine what your federal income taxes are if your taxable income is $60,000 and

you fi le as a single taxpayer. (g) Determine your total taxes paid based on the above calculations, and determine the

percentage of income that you would pay in taxes based on the following formula: Total taxes paid ÷ Total income.

FASB CODIFICATION ACTIVITY

CT10-13 If your school has a subscription to the FASB Codifi cation, go to http://aaahq.org/ asclogin.cfm to log in and prepare responses to the following.

(a) What is the defi nition of current liabilities? (b) What is the defi nition of long-term obligations? (c) What guidance does the Codifi cation provide for the disclosure of long-term obligations?

CONSIDERING PEOPLE, PLANET, AND PROFIT

CT10-14 The December 10, 2011, edition of The Economist contains an article entitled “Helping the Poor to Save: Small Wonder.” This article discusses how many of the world’s poorest people benefi t from borrowing small amounts of money.

Instructions Read the article and answer the following questions. (The article can be accessed by doing an Internet search that includes the title of the article and magazine.)

(a) What monthly rate of interest do people pay on the loans they borrow from the micro- fi nance organizations described in the article? What would these rates be on an annu- alized basis?

(b) The rates described in your answer to part (a) are very high. Explain how somebody can pay such high rates and yet still benefi t from borrowing.

IFRS and GAAP have similar definitions of liabilities but have a different approach for recording certain liabilities.

KEY POINTS Following are the key similarities and differences between GAAP and IFRS as related to accounting for liabilities.

LEARNING OBJECTIVE 8 Compare the accounting for liabilities under GAAP and IFRS.▼

A Look at IFRS

534 10 Reporting and Analyzing Liabilities

Similarities • The basic definition of a liability under GAAP and IFRS is very similar. In a more tech-

nical way, liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

• The accounting for current liabilities such as notes payable, unearned revenue, and payroll taxes payable are similar between GAAP and IFRS.

• IFRS requires that companies classify liabilities as current or noncurrent on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful informa- tion (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity.

• Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months.

• Similar to GAAP, items are normally reported in order of liquidity. Companies some- times show liabilities before assets. Also, they will sometimes show long-term liabilities before current liabilities.

• The basic calculation for bond valuation is the same under GAAP and IFRS. In addi- tion, the accounting for bond liability transactions is essentially the same between GAAP and IFRS.

• IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP also requires the effective-interest method, except that it allows use of the straight-line method where the difference is not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under IFRS a company would record:

Cash 97,000 Bonds Payable 97,000

Differences • The accounting for convertible bonds differs between IFRS and GAAP. Unlike GAAP,

IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.

To illustrate, assume that Harris Corp. issues convertible 7% bonds with a face value of $1,000,000 and receives $1,000,000. Comparable bonds without a conversion feature would have required a 9% rate of interest. To determine how much of the pro- ceeds would be allocated to debt and how much to equity, the promised payments of the bond obligation would be discounted at the market rate of 9%. Suppose that this results in a present value of $850,000. The entry to record the issuance would be:

Cash 1,000,000 Bonds Payable 850,000 Share Premium—Conversion Equity 150,000

• Under IFRS, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position.

LOOKING TO THE FUTURE The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual frame- work project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. Which of the following is false?

(a) Under IFRS, current liabilities must always be presented before noncurrent liabilities. (b) Under IFRS, an item is a current liability if it will be paid within the next 12 months. (c) Under IFRS, current liabilities are sometimes netted against current assets on the

statement of financial position. (d) Under IFRS, a liability is only recognized if it is a present obligation.

A Look at IFRS 535

2. The accounting for bonds payable is: (a) essentially the same under IFRS and GAAP. (b) differs in that GAAP requires use of the straight-line method for amortization of

bond premium and discount. (c) the same except that market prices may be different because the present value

calculations are different between IFRS and GAAP. (d) not covered by IFRS.

3. Stevens Corporation issued 5% convertible bonds with a total face value of $3,000,000 for $3,000,000. If the bonds had not had a conversion feature, they would have sold for $2,600,000. Under IFRS, the entry to record the transaction would require a credit to: (a) Bonds Payable for $3,000,000. (b) Bonds Payable for $400,000. (c) Share Premium—Conversion Equity for $400,000. (d) Discount on Bonds Payable for $400,000.

4. Which of the following is true regarding accounting for amortization of bond discount and premium? (a) Both IFRS and GAAP must use the effective-interest method. (b) GAAP must use the effective-interest method, but IFRS may use either the effective-

interest method or the straight-line method. (c) IFRS is required to use the effective-interest method. (d) GAAP is required to use the straight-line method.

5. The joint projects of the FASB and IASB could potentially: (a) change the definition of liabilities. (b) change the definition of equity. (c) change the definition of assets. (d) All of the above.

IFRS EXERCISES IFRS10-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for liabilities.

IFRS10-2 Ratzlaff Company issues (in euros) €2 million, 10-year, 8% bonds at 97, with interest payable annually on January 1.

Instructions (a) Prepare the journal entry to record the sale of these bonds on January 1, 2017. (b) Assuming instead that the above bonds sold for 104, prepare the journal entry to

record the sale of these bonds on January 1, 2017.

IFRS10-3 Archer Company issued (in pounds) £4,000,000 par value, 7% convertible bonds at 99 for cash. The net present value of the debt without the conversion feature is £3,800,000. Prepare the journal entry to record the issuance of the convertible bonds.

INTERNATIONAL FINANCIAL STATEMENT ANALYSIS: Louis Vuitton IFRS10-4 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Use the company’s annual report to answer the following questions.

(a) What were the total current liabilities for the company as of December 31, 2014? What portion of these current liabilities related to provisions?

(b) According to the notes to the financial statements, what is the composition of long- term gross borrowings?

(d) Determine the amount of fixed-rate and adjustable-rate (floating) borrowings (gross) that the company reports.

Answers to IFRS Self-Test Questions 1. a 2. a 3. c 4. c 5. d

Corporations like Facebook and Google have substantial resources at their disposal. In fact, the

corporation is the dominant form of business organization in the United States in terms of sales,

earnings, and number of employees. All of the 500 largest U.S. companies are corporations. In

this chapter, we look at the essential features of a corporation and explain the accounting for a

corporation’s capital stock transactions.

CHAPTER PREVIEW

Reporting and Analyzing Stockholders’ Equity

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

▼1 Discuss the major characteristics of a corporation.

• Characteristics of a corporation

• Forming a corporation • Stockholder rights • Stock issue considerations • Corporate capital

DO IT!

1 Corporate Organization

▼2 Explain how to account for the issu- ance of common and preferred stock, and the purchase of treasury stock.

• Accounting for common stock

• Accounting for preferred stock

• Treasury stock

DO IT!

2 2a Issuance of Stock 2b Treasury Stock

▼3 Explain how to account for cash divi- dends and describe the effect of stock dividends and stock splits.

• Cash dividends • Dividend preferences • Stock dividends • Stock splits

DO IT!

3 3a Preferred Stock Dividends 3b Stock Dividends;

Stock Splits

▼4 Discuss how stockholders’ equity is reported and analyzed.

• Retained earnings • Retained earnings restrictions • Balance sheet presentation of

stockholders’ equity • Analysis of stockholders’ equity • Debt versus equity decision

DO IT!

4 4a Stockholders’ Equity Section 4b Analyzing Stockholders’

Equity

Suppose you started one of the fastest-growing companies in the history of business. Now suppose that by “going public”—issuing stock of your com- pany to outside investors who are foaming at the mouth for the chance to buy its shares—you would instantly become one of the richest people in the world. Would you hesitate?

That is exactly what Mark Zuckerberg, the founder of Facebook, did. Many people who start high-tech companies go public as soon as possible to cash in on their riches. But Zuckerberg was reluctant to do so. To understand why, you need to understand the advantages and disadvantages of being a public company.

The main motivation for issuing shares to the public is to raise money so you can grow your business. However, unlike a manufacturer or even an online retailer, Facebook doesn’t need major physical resources, it doesn’t have inventory, and it doesn’t really need much money for marketing. But why not go public anyway, so the company would have some extra cash on hand—and so you personally

get rich? As head of a closely held, nonpublic company, Zuckerberg was subject to far fewer regulations than a public company. Prior to going

public, Zuckerberg could basically run the company however he wanted to.

For example, early in 2012, Facebook shocked the investment community by purchasing the photo-sharing service Instagram. The purchase was startling both for its speed (over a weekend) and price ($1 billion). Zuckerberg

basically didn’t seek anyone’s approval. He thought it was a good idea, so he just did it. The structured decision-making process of a public company would make it very diffi cult for a public company to move that fast.

Speed is useful, but it is likely that Facebook will make even bigger acquisitions in the future. To survive among the likes of Microsoft, Google, and Apple, it needs lots of cash. To raise that amount of money, the company really needed to go public. So in 2012, Mark Zuckerberg reluctantly made Facebook a public company, thus becoming one of the richest people in the world.

FEATURE STORY

Oh Well, I Guess I’ll Get Rich

Paul Sakuma/AP/Wide World Photos

538 11 Reporting and Analyzing Stockholders’ Equity

LEARNING OBJECTIVE 1 Discuss the major characteristics of a corporation.▼

A corporation is created by law. As a legal entity, a corporation has most of the rights and privileges of a person. The major exceptions relate to privileges that can be exercised only by a living person, such as the right to vote or to hold public offi ce. Similarly, a corporation is sub- ject to the same duties and responsibilities as a person. For example, it must abide by the law and it must pay taxes.

We can classify corporations in a variety of ways. Two common classifi cations are by purpose and by ownership. A corporation may

be organized for the purpose of making a profi t (such as Facebook or General Motors), or it may be a nonprofi t charitable, medical, or educational corporation (such as the Salvation Army or the American Cancer Society). Classifi cation by ownership differentiates publicly held and privately held corporations. A publicly held corporation may have thousands of stockholders, and its stock is traded on a national securities market such as the New York Stock Exchange. Examples are IBM, Caterpillar, and General Electric. In contrast, a privately held corporation, often referred to as a closely held corporation, usu- ally has only a few stockholders and does not offer its stock for sale to the general public. Privately held companies are generally much smaller than publicly held companies although some notable exceptions exist. Before going public, Face- book was one example. Also, Cargill Inc., a private corporation that trades in grain and other commodities, is one of the largest companies in the United States. This chapter deals primarily with issues related to publicly held companies.

CHARACTERISTICS OF A CORPORATION

Many businesses start as partnerships or sole proprietorships but eventually con- vert to the corporate form. For example, Nike’s founders formed their original organization as a partnership. In 1968, they reorganized the company as a cor- poration. A number of characteristics distinguish a corporation from sole pro- prietorships and partnerships. The most important of these characteristics are explained below.

Separate Legal Existence As an entity separate and distinct from its owners, the corporation acts under its own name rather than in the name of its stockholders. Facebook, for example, buys, owns, and sells property; borrows money; and enters into legally binding contracts in its own name. It may also sue or be sued. It pays taxes as a separate entity. In a partnership, the acts of the owners (partners) bind the partnership. In contrast, the acts of corporate owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you own shares of Facebook stock, you do not have the right to purchase inventory for the com- pany unless you are also designated as an agent of the corporation.

Limited Liability of Stockholders Since a corporation is a separate legal entity, creditors ordinarily have recourse only to corporate assets to satisfy their claims. The liability of stockholders is normally limited to their investment in the corporation. Creditors have no legal claim on the personal assets of the stockholders unless fraud has occurred. Thus, even in the event of bankruptcy of the corporation, stockholders’ losses are gener- ally limited to the amount of capital they have invested in the corporation.

Transferable Ownership Rights Ownership of a corporation is held in shares of capital stock, which are transfer- able units. Stockholders may dispose of part or all of their interest in a corporation

DECISION TOOLS

Understanding the costs and benefi ts of different types of busi- ness organizations helps managers determine if incorporating is in the best interest of the company.

WKK Corp.

Stockholders

WKK Corp.

Legal existence separate from owners

Stockholders

WKK Corp.

Limited liability of stockholders

The Corporate Form of Organization 539

simply by selling their stock. The transfer of an ownership interest in a partner- ship requires the consent of each partner. In contrast, the transfer of stock is entirely at the discretion of the stockholder. It does not require the approval of either the corporation or other stockholders. The transfer of ownership rights among stockholders normally has no effect on the operating activities of the corporation. Nor does it affect the corporation’s assets, liabilities, and total stockholders’ equity. The transfer of ownership rights is a transaction between individual owners. The company does not participate in the transfer of these ownership rights after the original sale of the capital stock.

Ability to Acquire Capital It is relatively easy for a corporation to obtain capital through the issuance of stock. Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable. Also, numerous individuals can become stockholders by investing small amounts of money.

Continuous Life The life of a corporation is stated in its charter. The life may be perpetual or it may be limited to a specifi c number of years. If it is limited, the company extends the period of existence through renewal of the charter. Since a corpora- tion is a separate legal entity, its continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or offi cer. As a result, a successful corporation can have a continuous and perpetual life.

Corporation Management Although stockholders legally own the corporation, they manage it indirectly through a board of directors they elect. Mark Zuckerberg is the chairman of Facebook’s board of directors. The board, in turn, formulates the operating poli- cies for the company. The board also selects offi cers, such as a president and one or more vice presidents, to execute policy and to perform daily management functions. As a result of the Sarbanes-Oxley Act, the board is required to monitor management’s actions closely. Many feel that the failures at Enron, WorldCom, and MF Global could have been avoided by more diligent boards. Illustration 11-1 presents a typical organization chart showing the delegation of responsibility.

STOCK

STOCK = $ $

Ability to acquire capital

STOC K

Transferable ownership rights

Founded in 1892

TRUE GRIT Co.

Continuous life

Vice President Human

Resources

Vice President Operations

Vice President Finance/Chief

Financial Officer

Vice President Marketing

General Counsel / Secretary

Treasurer Controller

Chairman and Board of Directors

Stockholders

President and Chief Executive Officer

ILLUSTRATION 11-1 Corporation organization chart

540 11 Reporting and Analyzing Stockholders’ Equity

The chief executive offi cer (CEO) has overall responsibility for managing the business. As the organization chart shows, the CEO delegates responsibility to other offi cers. The chief accounting offi cer is the controller. The controller (1) maintains the accounting records, (2) ensures an adequate system of internal control, and (3) prepares fi nancial statements, tax returns, and internal reports. The treasurer has custody of the corporation’s funds and oversees the company’s cash position. The organizational structure of a corporation enables a company to hire pro- fessional managers to run the business. On the other hand, the separation of ownership and management often reduces an owner’s ability to actively manage the company.

Government Regulations A corporation is subject to numerous state and federal regulations. For exam- ple, state laws usually prescribe the requirements for issuing stock, the dis- tributions of earnings permitted to stockholders, and acceptable methods for buying back and retiring stock. Federal securities laws govern the sale of capital stock to the general public. Also, publicly held corporations must disclose their fi nancial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports (Forms 10Q and 10K). The Sarbanes-Oxley Act increased the company’s responsibility for the accuracy of these reports. In addition, when a corporate stock is listed and traded on organized securities exchanges, the corporation must comply with the reporting requirements of these exchanges.

ETHICS NOTE Managers who are not owners are often compensated based

on the performance of the company. They thus may

be tempted to exaggerate company performance by

infl ating income fi gures.

▼

WKK Corp.WKK Corp.

State laws SEC laws

Stock exchange requirements

Federal regulations

Government regulations

PEOPLE, PLANET, AND PROFIT INSIGHT

The Impact of Corporate Social Responsibility

A survey conducted by Institutional Shareholder Services, a proxy advisory fi rm, shows that 83% of investors now believe environ- mental and social factors can sig- nifi cantly impact shareholder value over the long term. This belief is clearly visible in the rising level of support for shareholder proposals requesting action related to social and environmental issues.

The following table shows that the number of corporate social responsibility (CSR) related shareholder proposals rose from 150 in 2000 to 191 in 2010. Moreover, those proposals

received average voting support of 18.4% of votes cast versus just 7.5% a decade earlier.

Trends in Shareholder Proposals on Corporate Responsibility

2000 2005 2010

Number of proposals voted 150 155 191 Average voting support 7.5% 9.9% 18.4% Percent proposals receiving >10% support 16.7% 31.2% 52.1%

Source: Investor Responsibility Research Center, Ernst & Young, Seven Questions CEOs and Boards Should Ask About: “Triple Bottom Line” Reporting.

Why are CSR-related shareholder proposals increasing? (Go to WileyPLUS for this answer and additional questions.)

Additional Taxes Owners of proprietorships and partnerships report their share of earnings on their personal income tax returns. The individual owner then pays taxes on this amount. Corporations, on the other hand, must pay federal and state income taxes as a separate legal entity. These taxes can be substantial. They can amount to as much as 40% of taxable income. In addition, stockholders are required to pay taxes on cash dividends. Thus, many argue that corporate income is taxed twice (double taxation)—once at the corporate level and again at the individual level.

Additional taxes

The Corporate Form of Organization 541

Illustration 11-2 shows the advantages and disadvantages of a corporation compared to a sole proprietorship and partnership.

ILLUSTRATION 11-2 Advantages and disadvantages of a corporation

Advantages Disadvantages

• Separate legal existence • Corporation management—separation • Limited liability of stockholders of ownership and management • Transferable ownership rights • Government regulations • Ability to acquire capital • Additional taxes • Continuous life • Corporation management—

professional managers

Other Forms of Business Organization A variety of “hybrid” organizational forms—forms that combine different attributes of partnerships and corporations—now exist. For example, one type of corporate form, called an S corporation, allows for legal treatment as a corporation but tax treatment as a partnership—that is, no double taxation. Because of changes to the S corporation’s rules, more small- and medium-sized businesses now may choose S corporation treatment. One of the primary criteria is that the company cannot have more than 100 shareholders. Other forms of organization include limited partner- ships, limited liability partnerships (LLPs), and limited liability companies (LLCs).

FORMING A CORPORATION

A corporation is formed by grant of a state charter. The charter is a document that describes the name and purpose of the corporation, the types and number of shares of stock that are authorized to be issued, the names of the individuals that formed the company, and the number of shares that these individuals agreed to purchase. Regardless of the number of states in which a corporation has operat- ing divisions, it is incorporated in only one state. It is to the company’s advan- tage to incorporate in a state whose laws are favorable to the corporate form of business organization. For example, although Facebook has its headquarters in California, it is incorporated in Delaware. In fact, more and more corporations have been incorporating in states with rules that favor existing management. For example, Gulf Oil changed its state of incorporation to Delaware to thwart pos- sible unfriendly takeovers. There, certain defensive tactics against takeovers can be approved by the board of directors alone, without a vote by shareholders. Upon receipt of its charter from the state of incorporation, the corporation estab- lishes by-laws. The by-laws establish the internal rules and procedures for conduct- ing the affairs of the corporation. Corporations engaged in interstate commerce must also obtain a license from each state in which they do business. The license subjects the corporation’s operating activities to the general corporation laws of the state.

STOCKHOLDER RIGHTS

When chartered, the corporation begins selling shares of stock. When a corporation has only one class of stock, it is identifi ed as common stock. Each share of com- mon stock gives the stockholder the ownership rights pictured in Illustration 11-3 (page 542). The articles of incorporation or the by-laws state the ownership rights of a share of stock. Proof of stock ownership is evidenced by a printed or engraved form known as a stock certifi cate. As shown in Illustration 11-4 (page 542), the face of the certifi cate shows the name of the corporation, the stockholder’s name, the class and special features of the stock, the number of shares owned, and the signatures of authorized corporate offi cials. Certifi cates are prenumbered to ensure proper control over their use; they may be issued for any quantity of shares.

542 11 Reporting and Analyzing Stockholders’ Equity

1A number of companies have eliminated the preemptive right because they believe it places an unnecessary and cumbersome demand on management. For example, IBM, by stockholder approval, has dropped its preemptive right for stockholders.

Dividends

New shares issued

Before After

14% 14%

Lenders

Creditors

Stockholders GON Corp.

Going o ut of

busines s

Vote in election of board of directors at annual meeting and vote on actions that require stockholder approval.

Share the corporate earnings through receipt of dividends.

Share in assets upon liquidation in proportion to their holdings. This is called a residual claim because owners are paid with assets that remain after all other claims have been paid.

Keep the same percentage ownership when new shares of stock are issued (preemptive right1).

Stockholders have the right to: ILLUSTRATION 11-3 Ownership rights of stockholders

ILLUSTRATION 11-4 A stock certifi cate

STOCK ISSUE CONSIDERATIONS

Although Facebook incorporated in 2004, it did not sell stock to the public until 2012. At that time, Facebook evidently decided it would benefi t from the infusion of cash that a public sale of its shares would bring. When a corporation decides to issue stock, it must resolve a number of basic questions: How many shares

The Corporate Form of Organization 543

should it authorize for sale? How should it issue the stock? What value should it assign to the stock? We address these questions in the following sections.

Authorized Stock Authorized stock is the amount of stock that a corporation is authorized to sell as indicated in its charter. If the corporation has sold all of its authorized stock, then it must obtain permission from the state to change its charter before it can issue additional shares. The authorization of common stock does not result in a formal accounting entry. The reason is that the event has no immediate effect on either corporate assets or stockholders’ equity. However, the corporation discloses in the stock- holders’ equity section of the balance sheet the number of shares authorized. Facebook, for example, has approximately 9 billion authorized shares.

Issuance of Stock A corporation can issue common stock directly to investors. Alternatively, it can issue common stock indirectly through an investment banking fi rm that special- izes in bringing securities to the attention of prospective investors. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation. New issues of stock may be offered for sale to the public through various organized U.S. or foreign securities exchanges. Five of the largest exchanges by value of shares traded are the New York Stock Exchange, Nasdaq stock market, London Stock Exchange, Tokyo Stock Exchange, and Euronext.

INTERNATIONAL NOTE U.S. and U.K. corporations raise most of their capital through millions of outside shareholders and bondholders. In contrast, companies in Germany, France, and Japan acquire fi nancing mostly from large banks or other fi nancial institutions. Consequently, in the latter environment, shareholders are somewhat less important.

The president, chief operating offi cer, and chief fi nancial offi cer of SafeNet, a software encryption company, were each awarded employee stock options by the company’s board of directors as part of their compensation package. Stock options enable an em- ployee to buy a company’s stock sometime in the future at the price that existed when the stock option was awarded. For example, suppose that you received stock options today, when the stock price of your company was $30. Three years later, if the stock price rose to $100, you could “exercise” your options and buy the stock for $30 per share, thereby making $70 per share. After being awarded their stock options, the three em- ployees changed the award dates in the company’s records to dates in the past, when the company’s stock was trading at historical lows. For example, using the previous ex- ample, they would choose a past date when the stock was selling for $10 per share, rather than the $30 price on the actual award date. In our example, this would increase the profi t from exercising the options to $90 per share.

Total take: $1.7 million

THE MISSING CONTROL Independent internal verifi cation. The company’s board of directors should have ensured that the awards were properly administered. For example, the date on the minutes from the board meeting should be compared to the dates that were recorded for the awards. In addition, the dates should again be confi rmed upon exercise.

ANATOMY OF A FRAUD

Par and No-Par Value Stocks Par value stock is capital stock that has been assigned a value per share in the corporate charter. Years ago, par value determined the legal capital that must be retained in the business for the protection of corporate creditors. That amount is not available for withdrawal by stockholders. Thus, in the past, most states required the corporation to sell its shares at par or above. However, the usefulness of par value as a device to protect creditors was lim- ited because par value was often immaterial relative to the value of the com- pany’s stock in the securities markets—even at the time of issue. For example,

544 11 Reporting and Analyzing Stockholders’ Equity

Facebook’s par value is $0.000006 per share, yet its market price recently was $84. Thus, par has no relationship with market price. In the vast majority of cases, it is an immaterial amount. As a consequence, today many states do not require a par value. Instead, they use other means to protect creditors.

No-par value stock is capital stock that has not been assigned a value in the corporate charter. No-par value stock is fairly common today. For example, Nike and Procter & Gamble both have no-par stock. In many states, the board of direc- tors assigns a stated value to the no-par shares.

CORPORATE CAPITAL

Owners’ equity is identifi ed by various names: stockholders’ equity, share- holders’ equity, or corporate capital. The stockholders’ equity section of a corporation’s balance sheet consists of two parts: (1) paid-in (contributed) capital and (2) retained earnings (earned capital). The distinction between paid-in capital and retained earnings is important from both a legal and a fi nancial point of view. Legally, corporations can make distributions of earnings (declare dividends) out of retained earnings in all states. However, in many states they cannot declare dividends out of paid-in capital. Management, stockholders, and others often look to retained earnings for the continued existence and growth of the corporation.

Paid-in Capital Paid-in capital is the total amount of cash and other assets paid in to the cor- poration by stockholders in exchange for capital stock. As noted earlier, when a corporation has only one class of stock, it is common stock.

Retained Earnings Retained earnings is net income that a corporation retains in the business. Net income is recorded in Retained Earnings by a closing entry that debits Income Summary and credits Retained Earnings. Similarly, the Retained Earnings account is reduced by dividends (both cash dividends and stock dividends) by a closing entry that debits Retained Earnings and credits Dividends.

1▼ Corporate OrganizationDO IT! Indicate whether each of the following statements is true or false. If false, indicate how to correct the statement.

______ 1. Similar to partners in a partnership, stockholders of a corporation have unlimited liability.

______ 2. It is relatively easy for a corporation to obtain capital through the issuance of stock.

______ 3. The separation of ownership and management is an advantage of the corporate form of business.

______ 4. The journal entry to record the authorization of capital stock includes a credit to the appropriate capital stock account.

______ 5. All states require a par value per share for capital stock.Action Plan ✔ Review the characteris-

tics of a corporation and understand which are advantages and which are disadvantages.

✔ Understand that corpora- tions raise capital through the issuance of stock, which can be par or no-par.

SOLUTION 1. False. The liability of stockholders is normally limited to their investment in the corpo- ration. 2. True. 3. False. The separation of ownership and management is a disadvan- tage of the corporate form of business. 4. False. The authorization of capital stock does not result in a formal accounting entry. 5. False. Many states do not require a par value.

Related exercise material: BE11-1 and DO IT! 11-1.

Accounting for Common, Preferred, and Treasury Stock 545

LEARNING OBJECTIVE 2 Explain how to account for the issuance of common and preferred stock, and the purchase of treasury stock.▼

A L SE= + +1,000

+1,000 CS Cash Flows +1,000

A L SE= + +5,000

+1,000 CS +4,000 CS

Cash Flows +5,000

ACCOUNTING FOR COMMON STOCK

Let’s now look at how to account for new issues of common stock. The primary objectives in accounting for the issuance of common stock are (1) to identify the specifi c sources of paid-in capital and (2) to maintain the distinction between paid-in capital and retained earnings. As shown below, the issuance of common stock affects only paid-in capital accounts.

Issuing Par Value Common Stock for Cash As discussed earlier, par value does not indicate a stock’s market price. The cash proceeds from issuing par value stock may be equal to, greater than, or less than par value. When a company records the issuance of common stock for cash, it credits the par value of the shares to Common Stock and records in a separate paid-in capital account the portion of the proceeds that is above or below par value. To illustrate, assume that Hydro-Slide, Inc. issues 1,000 shares of $1 par value common stock at par for cash. The entry to record this transaction is as follows.

Cash 1,000 Common Stock 1,000 (To record issuance of 1,000 shares of $1 par

common stock at par)

Now assume Hydro-Slide, Inc. issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share. The amount received above the par value, in this case $4 ($5 − $1), would be credited to Paid-in Capital in Excess of Par Value. The entry is as follows.

Cash 5,000 Common Stock (1,000 × $1) 1,000 Paid-in Capital in Excess of Par Value 4,000 (To record issuance of 1,000 shares of common

stock in excess of par)

The total paid-in capital from these two transactions is $6,000. If Hydro-Slide, Inc. has retained earnings of $27,000, the stockholders’ equity section of the bal- ance sheet is as shown in Illustration 11-5.

▼ HELPFUL HINT Stock is sometimes issued in exchange for services (payment to attorneys or consultants, for example) or for noncash assets (land or buildings). The value recorded for the shares issued is determined by either the market price of the shares or the value of the good or service received, depending upon which amount the company can more readily determine.

ILLUSTRATION 11-5 Stockholders’ equity—paid-in capital in excess of par value

Stockholders’ equity Paid-in capital Common stock $ 2,000 Paid-in capital in excess of par value 4,000

Total paid-in capital 6,000 Retained earnings 27,000

Total stockholders’ equity $33,000

HYDRO-SLIDE, INC. Balance Sheet (partial)

Some companies issue no-par stock with a stated value. For accounting pur- poses, companies treat the stated value in the same way as the par value. For example, if in our Hydro-Slide example the stock was no-par stock with a stated value of $1, the entries would be the same as those presented for the par stock

546 11 Reporting and Analyzing Stockholders’ Equity

except the term “Par Value’’ would be replaced with “Stated Value.’’ If a company issues no-par stock that does not have a stated value, then it credits to the Com- mon Stock account the full amount received. In such a case, there is no need for the Paid-in Capital in Excess of Stated Value account.

ACCOUNTING FOR PREFERRED STOCK

To appeal to a larger segment of potential investors, a corporation may issue an additional class of stock, called preferred stock. Preferred stock has contractual provisions that give it preference or priority over common stock in certain areas. Typically, preferred stockholders have a priority in relation to (1) dividends and (2) assets in the event of liquidation. However, they sometimes do not have voting rights. Facebook had 543 million preferred shares held by investors at the end of 2011, prior to going public. Approximately 6% of U.S. companies have one or more classes of preferred stock. Like common stock, companies issue preferred stock for cash or for noncash consideration. The entries for these transactions are similar to the entries for common stock. When a corporation has more than one class of stock, each paid- in capital account title should identify the stock to which it relates (e.g., Preferred Stock, Common Stock, Paid-in Capital in Excess of Par Value—Preferred Stock, and Paid-in Capital in Excess of Par Value—Common Stock). Assume that Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. The entry to record the issuance is as follows.

Cash 120,000 Preferred Stock 100,000 Paid-in Capital in Excess of Par Value—Preferred Stock 20,000 (To record issuance of 10,000 shares

of $10 par value preferred stock)

Preferred stock has either a par value or no-par value. In the stockholders’ equity section of the balance sheet, companies show preferred stock fi rst because of its dividend and liquidation preferences over common stock.

A L SE= + +120,000

+100,000 PS +20,000 PS

Cash Flows +120,000

How to Read Stock Quotes

Organized exchanges trade the stock of publicly held companies at dollar prices per share estab- lished by the interaction between buyers and sellers. For each listed security, the fi nancial press reports the high and low prices of the stock during the year, the total volume of stock traded on a given day, the high and low prices for the day, and the closing market price, with the net change for the day. Facebook is listed on the Nasdaq exchange. Here is a recent listing for Facebook:

52 Weeks

Stock High Low Volume High Low Close Net Change

Facebook 86.07 54.66 54,156,600 85.59 83.11 84.63 .629

These numbers indicate the following. The high and low market prices for the last 52 weeks have been $86.07 and $54.66. The trading volume for the day was 54,156,600 shares. The high, low, and closing prices for that date were $85.59, $83.11, and $84.63, respectively. The net change for the day was a decrease of $0.629 per share.

For stocks traded on organized exchanges, how are the dollar prices per share established? What factors might infl uence the price of shares in the marketplace? (Go to WileyPLUS for this answer and additional questions.)

INVESTOR INSIGHT Facebook

Emmanuel Dunand/AFP/Getty Images

Accounting for Common, Preferred, and Treasury Stock 547

TREASURY STOCK

Treasury stock is a corporation’s own stock that has been reacquired by the corporation and is being held for future use. A corporation may acquire treasury stock for various reasons:

1. To reissue the shares to offi cers and employees under bonus and stock com- pensation plans.

2. To increase trading of the company’s stock in the securities market. Compa- nies expect that buying their own stock will signal that management believes the stock is underpriced, which they hope will enhance its market price.

3. To have additional shares available for use in acquiring other companies.

4. To reduce the number of shares outstanding and thereby increase earnings per share.

A less frequent reason for purchasing treasury shares is to eliminate hostile shareholders by buying them out. Many corporations have treasury stock. For example, in the United States approximately 65% of companies have treasury stock. During one quarter, companies in the Standard & Poor’s 500-stock index spent a record of about $118 billion to buy treasury stock. In a recent year, Nike purchased more than 6 million treasury shares. At one point, stock repurchases were so substantial that a study by two Federal Reserve economists suggested that a sharp reduc- tion in corporate purchases of treasury shares might result in a sharp drop in the value of the U.S. stock market.

Purchase of Treasury Stock The purchase of treasury stock is generally accounted for by the cost method. This method derives its name from the fact that the Treasury Stock account is maintained at the cost of shares purchased. Under the cost method, companies increase (debit) Treasury Stock by the price paid to reacquire the shares. Treasury Stock decreases by the same amount when the company later sells the shares.

2a▼ Issuance of StockDO IT! Cayman Corporation begins operations on March 1 by issuing 100,000 shares of $1 par value common stock for cash at $12 per share. On March 28, Cayman issues 1,500 shares of $10 par value preferred stock for cash at $30 per share. Journalize the issuance of the common and preferred shares.

Action Plan ✔ In issuing shares for cash,

credit Common Stock for par value per share.

✔ Credit any additional pro- ceeds in excess of par to a separate paid-in capital account.

✔ For the cash equivalent price, use either the fair value of what is given up or the fair value of what is received, whichever is more clearly determinable.

SOLUTION Mar. 1 Cash 1,200,000 Common Stock (100,000 × $1) 100,000 Paid-in Capital in Excess of Par Value— Common Stock 1,100,000 (To record issuance of 100,000 shares

at $12 per share)

Mar. 28 Cash 45,000 Preferred Stock (1,500 × $10) 15,000 Paid-in Capital in Excess of Par Value— Preferred Stock 30,000 (To record issuance of 1,500 shares

at $30 per share)

Related exercise material: BE11-2, BE11-3, BE11-4, DO IT! 11-2a, E11-2, and E11-5.

548 11 Reporting and Analyzing Stockholders’ Equity

To illustrate, assume that on January 1, 2017, the stockholders’ equity section for Mead, Inc. has 100,000 shares of $5 par value common stock outstanding (all issued at par value) and retained earnings of $200,000. Illustration 11-6 shows the stockholders’ equity section of the balance sheet before purchase of treasury stock.

ILLUSTRATION 11-6 Stockholders’ equity with no treasury stock

Stockholders’ equity Paid-in capital Common stock, $5 par value, 400,000 shares authorized, 100,000 shares issued and outstanding $500,000 Retained earnings 200,000

Total stockholders’ equity $700,000

MEAD, INC. Balance Sheet (partial)

A L SE= + −32,000 TS

−32,000 Cash Flows −32,000

On February 1, 2017, Mead acquires 4,000 shares of its stock at $8 per share. The entry is as follows.

Feb. 1 Treasury Stock 32,000 Cash 32,000 (To record purchase of 4,000 shares

of treasury stock at $8 per share)

The Treasury Stock account would increase by the cost of the shares purchased ($32,000). The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change. Companies show treasury stock as a deduction from total paid-in capital and retained earnings in the stockholders’ equity section of the balance sheet. Illus- tration 11-7 shows this presentation for Mead, Inc. Thus, the acquisition of trea- sury stock reduces stockholders’ equity.

▼ HELPFUL HINT Treasury Stock is a contra stockholders’ equity account.

ETHICS NOTE The purchase of treasury

stock reduces the cushion for creditors. To protect creditors,

many states require that a portion of retained earnings

equal to the cost of the treasury stock purchased be restricted from being paid as dividends.

▼

ILLUSTRATION 11-7 Stockholders’ equity with treasury stock

Stockholders’ equity Paid-in capital Common stock, $5 par value, 400,000 shares authorized, 100,000 shares issued and 96,000 shares outstanding $500,000 Retained earnings 200,000

Total paid-in capital and retained earnings 700,000 Less: Treasury stock (4,000 shares) 32,000

Total stockholders’ equity $668,000

MEAD, INC. Balance Sheet (partial)

Company balance sheets disclose both the number of shares issued (100,000) and the number in the treasury (4,000). The difference is the number of shares of stock outstanding (96,000). The term outstanding stock means the number of shares of issued stock that are being held by stockholders. In a bold (and some would say risky) move, Reebok at one time bought back nearly a third of its shares. This repurchase of shares dramatically reduced Ree- bok’s available cash. In fact, the company borrowed signifi cant funds to accom- plish the repurchase. In a press release, management stated that it was repur- chasing the shares because it believed that the stock was severely underpriced. The repurchase of so many shares was meant to signal management’s belief in good future earnings.

Cash Dividends, Stock Dividends, and Stock Splits 549

Skeptics, however, suggested that Reebok’s management repurchased the shares to make it less likely that the company would be acquired by another com- pany (in which case Reebok’s top managers would likely lose their jobs). Acquir- ing companies like to purchase companies with large cash reserves so they can pay off debt used in the acquisition. By depleting its cash through the purchase of treasury shares, Reebok became a less likely acquisition target.

2b▼ Treasury StockDO IT! Santa Anita Inc. purchases 3,000 shares of its $50 par value common stock for $180,000 cash on July 1. It expects to hold the shares in the treasury until resold. Journalize the treasury stock transaction.

Action Plan ✔ Record the purchase of

treasury stock at cost. ✔ Report treasury stock as

a deduction from stock- holders’ equity (contra account) at the bottom of the stockholders’ equity section.

SOLUTION July 1 Treasury Stock 180,000 Cash 180,000 (To record the purchase of 3,000 shares

at $60 per share)

Related exercise material: DO IT! 11-2b, E11-2, and E11-5.

LEARNING OBJECTIVE 3 Explain how to account for cash dividends and describe the effect of stock dividends and stock splits.▼

As noted earlier, a dividend is a distribution by a corporation to its stockholders on a pro rata (proportional to ownership) basis. Pro rata means that if you own, say, 10% of the common shares, you will receive 10% of the dividend. Dividends can take four forms: cash, property, scrip (promissory note to pay cash), or stock. Cash dividends predominate in practice, although companies also declare stock dividends with some frequency. Investors are very interested in a company’s dividend practices. In the fi nan- cial press, dividends are generally reported quarterly as a dollar amount per share. (Sometimes they are reported on an annual basis.) For example, the recent quarterly dividend rate was 24 cents per share for Nike, 22 cents per share for GE, and 25 cents per share for ConAgra Foods. Facebook does not pay dividends.

CASH DIVIDENDS

A cash dividend is a pro rata (proportional to ownership) distribution of cash to stockholders. Cash dividends are not paid on treasury shares. For a corporation to pay a cash dividend, it must have the following:

1. Retained earnings. Payment of dividends from retained earnings is legal in all states. In addition, loan agreements frequently constrain companies to pay dividends only from retained earnings. Many states prohibit payment of dividends from legal capital. However, payment of dividends from paid-in capital in excess of par value is legal in some states.

2. Adequate cash. Recently, Facebook had a balance in retained earnings of $6,099 million but a cash balance of only $4,315 million. If it had wanted to pay a dividend equal to its retained earnings, Facebook would have had to raise $1,784 million more in cash. It would have been unlikely to do this because it would not be able to pay this much in dividends in future years.

550 11 Reporting and Analyzing Stockholders’ Equity

In addition, such a dividend would completely deplete Facebook’s balance in retained earnings, so it would not be able to pay a dividend in the next year unless it had positive net income.

3. Declared dividends. The board of directors has full authority to determine the amount of income to distribute in the form of dividends. Dividends are not a liability until they are declared.

The amount and timing of a dividend are important issues for management to consider. The payment of a large cash dividend could lead to liquidity prob- lems for the company. Conversely, a small dividend or a missed dividend may cause unhappiness among stockholders who expect to receive a reasonable cash payment from the company on a periodic basis. Many companies declare and pay cash dividends quarterly. On the other hand, a number of high-growth com- panies pay no dividends, preferring to conserve cash to fi nance future capital expenditures. Investors monitor a company’s dividend practices. For example, regular divi- dend boosts in the face of irregular earnings can be a warning signal. Companies with high dividends and rising debt may be borrowing money to pay sharehold- ers. On the other hand, low dividends may not be a negative sign because it may mean the company is reinvesting in itself, which may result in high returns through increases in the stock price. Presumably, investors seeking regular divi- dends buy stock in companies that pay periodic dividends, and those seeking growth in the stock price (capital gains) buy stock in companies that retain their earnings rather than pay dividends.

Entries for Cash Dividends Three dates are important in connection with dividends: (1) the declaration date, (2) the record date, and (3) the payment date. Companies make accounting entries on the declaration date and the payment date. On the declaration date, the board of directors formally authorizes the cash dividend and announces it to stockholders. The declaration of a cash dividend commits the corporation to a binding legal obligation. Thus, the company must make an entry to recognize the increase in Cash Dividends and the increase in the liability Dividends Payable. To illustrate, assume that on December 1, 2017, the directors of Media Gen- eral declare a $0.50 per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is $50,000 (100,000 × $0.50). The entry to record the declaration is as follows.

Declaration Date

Dec. 1 Cash Dividends 50,000 Dividends Payable 50,000 (To record declaration of cash dividend)

In Chapter 3, we used an account called Dividends to record a cash divi- dend. Here, we use the more specifi c title Cash Dividends to differentiate from other types of dividends, such as stock dividends. (For homework problems, you should use the Cash Dividends account for recording dividend declarations). Dividends Payable is a current liability. It will normally be paid within the next several months. At the record date, the company determines ownership of the outstanding shares for dividend purposes. The stockholders’ records maintained by the cor- poration supply this information. For Media General, the record date is December 22. No entry is required on the record date.

Record Date

Dec. 22 No entry necessary

A L SE= + −50,000 Div

+50,000 Cash Flows no eff ect

▼ HELPFUL HINT The record date is important in determining the dividend to be paid to each stockholder.

Cash Dividends, Stock Dividends, and Stock Splits 551

On the payment date, the company makes cash dividend payments to the stockholders on record as of December 22. It also records the payment of the dividend. If January 20 is the payment date for Media General, the entry on that date is as follows.

Payment Date

Jan. 20 Dividends Payable 50,000 Cash 50,000 (To record payment of cash dividend)

Note that payment of the dividend on the payment date reduces both current assets and current liabilities, but it has no effect on stockholders’ equity. Cash Dividends is closed to Retained Earnings at the end of the accounting period. Thus, the cumulative effect of the declaration and payment of a cash dividend on a company’s fi nancial statements is to decrease both stockholders’ equity and total assets.

A L SE= + −50,000 −50,000 Cash Flows −50,000

Up, Down, and ??

The decision whether to pay a dividend, and how much to pay, is a very important management decision. As the chart below shows, from 2002 to 2007, many companies substantially increased their dividends, and total divi- dends paid by U.S. companies hit record levels. One reason for the

increase is that Congress lowered, from 39% to 15%, the tax rate paid by investors on dividends received, making dividends more attractive to investors.

Then the fi nancial crisis of 2008 occurred. As a result, in 2009, 804 companies cut their dividends (see chart below), the highest level since Standard & Poor’s started collect- ing data in 1995. In 2010, more companies started to in- crease their dividends. However, potential higher taxes on dividends coming in the future and the possibility of a low- growth economy may stall any signifi cant increase.

ACCOUNTING ACROSS THE ORGANIZATION

Palto/iStockphoto

2,000

1999 2004 2009

1,000

F ir

m s

th at

in cr

ea se

d di

vi de

Firms that decreased dividend

Payouts | Companies that changed dividends

Source: Matt Phillips and Jay Miller, “Last Year’s Dividend Slash Was $58 Billion,” Wall Street Journal (January 8, 2010), p. C5.

What factors must management consider in deciding how large a dividend to pay? (Go to WileyPLUS for this answer and additional questions.)

552 11 Reporting and Analyzing Stockholders’ Equity

DIVIDEND PREFERENCES

Preferred stockholders have the right to share in the distribution of cor- porate income before common stockholders. For example, if the dividend rate on preferred stock is $5 per share, common shareholders cannot receive any dividends in the current year until preferred stockholders have received $5 per share. The fi rst claim to dividends does not, however, guarantee divi- dends. Dividends depend on many factors, such as adequate retained earnings and availability of cash. For preferred stock, companies state the per share dividend amount as a percentage of the par value of the stock or as a specifi ed amount. For example, EarthLink specifi es a 3% dividend. Most preferred stocks have a preference on corporate assets if the corpora- tion fails. This feature provides security for the preferred stockholder. The prefer- ence to assets may be for the par value of the shares or for a specifi ed liquidating value. For example, Commonwealth Edison issued preferred stock that entitled the holders to receive $31.80 per share, plus accrued and unpaid dividends, in the event of involuntary liquidation. The liquidation preference is used in litigation pertaining to bankruptcy lawsuits involving the respective claims of creditors and preferred stockholders.

Cumulative Dividend Preferred stock contracts often contain a cumulative dividend feature. This fea- ture stipulates that preferred stockholders must be paid both current-year divi- dends and any unpaid prior-year dividends before common stockholders are paid dividends. When preferred stock is cumulative, preferred dividends not declared that were supposed to be declared in a given period are called dividends in arrears. To illustrate, assume that Scientifi c Leasing has 5,000 shares of 7%, $100 par value cumulative preferred stock outstanding. Each $100 share pays a $7 dividend (.07 × $100). The annual dividend is $35,000 (5,000 × $7 per share). If dividends are two years in arrears, preferred stockholders are entitled to receive in the current year the dividends as shown in Illustration 11-8.

ILLUSTRATION 11-8 Computation of total dividends to preferred stock

Dividends in arrears ($35,000 × 2) $ 70,000 Current-year dividends 35,000

Total preferred dividends $105,000

No distribution can be made to common stockholders until Scientifi c Leas- ing pays this entire preferred dividend. In other words, companies cannot pay dividends to common stockholders while any preferred stock dividend is in arrears. Dividends in arrears are not considered a liability. No obligation exists until the board of directors formally “declares” that the corporation will pay a dividend. However, companies should disclose in the notes to the fi nan- cial statements the amount of dividends in arrears. Doing so enables investors to assess the impact of this potential obligation on the corporation’s fi nancial position. The investment community does not look favorably upon companies that are unable to meet their dividend obligations. As a fi nancial offi cer noted in discuss- ing one company’s failure to pay its cumulative preferred dividend for a period of time, “Not meeting your obligations on something like that is a major black mark on your record.”

Cash Dividends, Stock Dividends, and Stock Splits 553

STOCK DIVIDENDS

A stock dividend is a pro rata (proportional to ownership) distribution of the corporation’s own stock to stockholders. Whereas a cash dividend is paid in cash, a stock dividend is paid in stock. A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. Unlike a cash dividend, a stock dividend does not decrease total stockholders’ equity or total assets. Because a stock dividend does not result in a distribution of assets, some view it as nothing more than a publicity gesture. Stock dividends are often issued by companies that do not have adequate cash to issue a cash dividend. Such companies may not want to announce that they are not going to issue a cash dividend at their expected time. By issuing a stock dividend, they “save face” by giving the appearance of distributing a dividend. Note that since a stock dividend neither increases nor decreases the assets in the company, inves- tors are not receiving anything they didn’t already own. In a sense, it is like asking for two pieces of pie and having your host take one piece of pie and cut it into two smaller pieces. You are not better off, but you got your two pieces of pie. To illustrate a stock dividend, assume that you have a 2% ownership inter- est in Cetus Inc.; you own 20 of its 1,000 shares of common stock. If Cetus declares a 10% stock dividend, it issues 100 shares (1,000 × 10%) of stock. You receive two shares (2% × 100), but your ownership interest remains at 2% (22 ÷ 1,100). You now own more shares of stock, but your ownership interest has not changed. Moreover, the company disburses no cash and assumes no liabilities.

3a▼ Preferred Stock DividendsDO IT! MasterMind Corporation has 2,000 shares of 6%, $100 par value preferred stock outstand- ing at December 31, 2017. At December 31, 2017, the company declared a $60,000 cash dividend. Determine the dividend paid to preferred stockholders and common stockholders under each of the following scenarios.

1. The preferred stock is noncumulative, and the company has not missed any dividends in previous years.

2. The preferred stock is noncumulative, and the company did not pay a dividend in each of the two previous years.

3. The preferred stock is cumulative, and the company did not pay a dividend in each of the two previous years.

Action Plan ✔ Determine dividends on

preferred shares by mul- tiplying the dividend rate times the par value of the stock times the number of preferred shares.

✔ Understand the cumula- tive feature: If preferred stock is cumulative, then any missed dividends (dividends in arrears) and the current year’s dividend must be paid to preferred stockholders before dividends are paid to common stockholders.

SOLUTION

1. The company has not missed past dividends and the preferred stock is noncumulative. Thus, the preferred stockholders are paid only this year’s dividends. The dividend paid to preferred stockholders would be $12,000 (2,000 × .06 × $100). The dividend paid to common stockholders would be $48,000 ($60,000 − $12,000).

2. The preferred stock is noncumulative. Thus, past unpaid dividends do not have to be paid. The dividend paid to preferred stockholders would be $12,000 (2,000 × .06 × $100). The dividend paid to common stockholders would be $48,000 ($60,000 − $12,000).

3. The preferred stock is cumulative. Thus, dividends that have been missed (dividends in arrears) must be paid. The dividend paid to preferred stockholders would be $36,000 (3 × 2,000 × .06 × $100). Of the $36,000, $24,000 relates to dividends in arrears and $12,000 relates to the current dividend on preferred stock. The dividend paid to common stock- holders would be $24,000 ($60,000 − $36,000).

Related exercise material: DO IT! 11-3a.

554 11 Reporting and Analyzing Stockholders’ Equity

What, then, are the purposes and benefi ts of a stock dividend? Corporations generally issue stock dividends for one of the following reasons:

1. To satisfy stockholders’ dividend expectations without spending cash.

2. To increase the marketability of the stock by increasing the number of shares outstanding and thereby decreasing the market price per share. Decreasing the market price of the stock makes it easier for smaller investors to purchase the shares.

3. To emphasize that the company has permanently reinvested in the business a portion of stockholders’ equity, which therefore is unavailable for cash dividends.

When the dividend is declared, the board of directors determines the size of the stock dividend and the value per share to use to record the transaction. In order to meet legal requirements, the per share amount must be at least equal to the par or stated value. The accounting profession distinguishes between a small stock dividend (less than 20%–25% of the corporation’s issued stock) and a large stock divi- dend (greater than 20%–25%). It recommends that the company use the fair value per share to record small stock dividends. The recommendation is based on the assumption that a small stock dividend will have little effect on the mar- ket price of the shares previously outstanding. Thus, many stockholders con- sider small stock dividends to be distributions of earnings equal to the fair value of the shares distributed. The accounting profession does not specify the value to use to record a large stock dividend. However, companies normally use par or stated value per share. Small stock dividends predominate in practice. In Appendix 11A at the end of the chapter, we illustrate the journal entries for small stock dividends.

Effects of Stock Dividends How do stock dividends affect stockholders’ equity? They change the composi- tion of stockholders’ equity because they result in a transfer of a portion of retained earnings to paid-in capital. However, total stockholders’ equity remains the same. Stock dividends also have no effect on the par or stated value per share, but the number of shares outstanding increases. Illustration 11-9 shows the effects that result when Medland Corp. declares a 10% stock dividend on its $10 par common stock when 50,000 shares were out- standing. The market price was $15 per share.

▼ HELPFUL HINT Because of its effects, a stock dividend is also referred to as capitalizing retained earnings.

In this example, total paid-in capital increased by $75,000 (50,000 shares × 10% × $15), and retained earnings decreased by the same amount. Note also that total stockholders’ equity remains unchanged at $800,000. The number of shares increases by 5,000 (50,000 × 10%).

ILLUSTRATION 11-9 Stock dividend effects Before After

Dividend Change Dividend

Stockholders’ equity Paid-in capital Common stock, $10 par $ 500,000 $ 50,000 $ 550,000 Paid-in capital in excess of par value — 25,000 25,000

Total paid-in capital 500,000 +75,000 575,000 Retained earnings 300,000 −75,000 225,000 Total stockholders’ equity $800,000 $ 0 $800,000

Outstanding shares 50,000 + 5,000 55,000

Par value per share $ 10.00 $ 0 $ 10.00

Cash Dividends, Stock Dividends, and Stock Splits 555

STOCK SPLITS

A stock split, like a stock dividend, involves the issuance of additional shares of stock to stockholders according to their percentage ownership. However, a stock split results in a reduction in the par or stated value per share. The purpose of a stock split is to increase the marketability of the stock by lowering its market price per share. This, in turn, makes it easier for the corporation to issue addi- tional stock. After hitting a peak of 114 stock splits in 1986, the number of splits in the United States has fallen to about 30 per year. Google announced a 2-for-1 split recently when its stock was selling for $650 per share. Like a stock dividend, a stock split increases the number of shares owned by a shareholder, but it does not change the percentage of the total company that the shareholder owns. The effects of a 4-for-1 split are shown in Illustration 11-10.

▼ HELPFUL HINT A stock split changes the par value per share but does not affect any balances in stockholders’ equity.

10 shares

ABC Co. ABC Co.

10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10

“I owned 40 shares before and I own 160 shares now, but I still

own only 1/4 of the company!”

Number of shares owned increases, but percentage of company owned remains the same.

Before stock split

After stock split

ILLUSTRATION 11-10 Effect of stock split for stockholders

The effect of a split on market price is generally inversely proportional to the size of the split. For example, after a recent 2-for-1 stock split, the market price of Nike’s stock fell from $111 to approximately $55.

A No-Split Philosophy

Warren Buffett’s company, Berkshire Hathaway, has two classes of shares. Un- til recently, the company had never split either class of stock. As a result, the class A stock had a market price of $97,000 and the class B sold for about $3,200 per share. Because the price per share is so high, the stock does not trade as frequently as the stock of other compa- nies. Buffett has always opposed stock splits because he feels that a lower stock

price attracts short-term investors. He appears to be correct. For example, while more than 6 million shares of IBM are ex- changed on the average day, only about 1,000 class A shares of Berkshire are traded. Despite Buffett’s aversion to splits, in order to accomplish a recent acquisition, Berkshire decided to split its class B shares 50 to 1.

Source: Scott Patterson, “Berkshire Nears Smaller Baby B’s,” Wall Street Journal Online (January 19, 2010).

Why does Warren Buffett usually oppose stock splits? (Go to WileyPLUS for this answer and additional questions.)

Dietmar Klement/iStockphoto

In a stock split, the company increases the number of shares in the same proportion that it decreases the par or stated value per share. For example, in a 2-for-1 split, the company exchanges one share of $10 par value stock for two shares of $5 par value stock. A stock split does not have any effect on paid-in capital, retained earnings, and total stockholders’ equity. However, the

INVESTOR INSIGHT Berkshire Hathaway

556 11 Reporting and Analyzing Stockholders’ Equity

number of shares outstanding increases. The effects of a 2-for-1 stock split of Medland Corporation’s common stock are shown in Illustration 11-11.

ILLUSTRATION 11-11 Stock split effects Before After

Stock Split Change Stock Split

Stockholders’ equity Paid-in capital Common stock (before: 50,000 $10 par shares;

after: 100,000 $5 par shares) $ 500,000 $ 500,000 Paid-in capital in excess of par value 0 0

Total paid-in capital 500,000 $ 0 500,000 Retained earnings 300,000 0 300,000

Total stockholders’ equity $800,000 $ 0 $800,000

Outstanding shares 50,000 + 50,000 100,000

Par value per share $ 10.00 −$ 5.00 $ 5.00

ILLUSTRATION 11-12 Effects of stock splits and stock dividends differentiated

Item Stock Dividend Stock Split

Total paid-in capital Increase No change Total retained earnings Decrease No change Total par value (common stock) Increase No change Par value per share No change Decrease Shares outstanding Increase Increase Total stockholders’ equity No change No change

Because a stock split does not affect the balances in any stockholders’ equity accounts, a company does not need to journalize a stock split. However, a memorandum entry explaining the effect of the split is typically made. Illustration 11-12 compares the effects of stock dividends and stock splits.

3b▼ Stock Dividends; Stock SplitsDO IT! Due to fi ve years of record earnings at Sing CD Corporation, the market price of its 500,000 shares of $2 par value common stock tripled from $15 per share to $45. During this period, paid-in capital remained the same at $2,000,000. Retained earnings increased from $1,500,000 to $10,000,000. President Joan Elbert is considering either a 10% stock dividend or a 2-for-1 stock split. She asks you to show the before-and-after effects of each option on (a) retained earnings, (b) total stockholders’ equity, and (c) par value per share.

Action Plan ✔ Calculate the stock divi-

dend’s effect on retained earnings by multiplying the number of new shares times the market price of the stock (or par value for a large stock dividend).

✔ Recall that a stock dividend increases the number of shares without affecting total equity.

✔ Recall that a stock split only increases the number of shares outstanding and decreases the par value per share without affecting total equity.

SOLUTION

The stock dividend amount is $2,250,000 [(500,000 × 10%) × $45]. The new balance in re- tained earnings is $7,750,000 ($10,000,000 − $2,250,000). The retained earnings balance after the stock split is the same as it was before the split: $10,000,000. The effects on the stockholders’ equity accounts are as follows.

Original After After Balances Dividend Split

Paid-in capital $ 2,000,000 $ 4,250,000 $ 2,000,000 Retained earnings 10,000,000 7,750,000 10,000,000

Total stockholders’ equity $12,000,000 $12,000,000 $12,000,000

Shares outstanding 500,000 550,000 1,000,000

Par value per share $ 2.00 $ 2.00 $ 1.00

Related exercise material: BE11-6, BE11-7, DO IT! 11-3b, and E11-7.

Presentation and Analysis 557

When expenses exceed revenues, a net loss results. In contrast to net income, a net loss decreases retained earnings. In closing entries, a com- pany debits a net loss to the Retained Earnings account. It does not debit net losses to paid-in capital accounts. To do so would destroy the distinc- tion between paid-in and earned capital. If cumulative losses and dividends exceed cumulative income over a company’s life, a debit balance in Retained Earnings results. A debit balance in Retained Earnings, such as that of Groupon, Inc. in a recent year, is a defi cit. A company reports a defi cit as a deduction in the stockholders’ equity section of the balance sheet, as shown in Illustration 11-14.

LEARNING OBJECTIVE 4 Discuss how stockholders’ equity is reported and analyzed.▼ RETAINED EARNINGS

Retained earnings is net income that a company retains in the business. The balance in retained earnings is part of the stockholders’ claim on the total assets of the corporation. It does not, however, represent a claim on any spe- cifi c asset. Nor can the amount of retained earnings be associated with the balance of any asset account. For example, a $100,000 balance in retained earnings does not mean that there should be $100,000 in cash. The reason is that the company may have used the cash resulting from the excess of rev- enues over expenses to purchase buildings, equipment, and other assets. Illus- tration 11-13 shows recent amounts of retained earnings and cash in selected companies.

ILLUSTRATION 11-13 Retained earnings and cash balances

(in millions)

Retained Company Earnings Cash

Facebook $ 3,159 $3,323 Google 61,262 8,989 Nike 5,695 3,337 Starbucks 4,130 2,576

ILLUSTRATION 11-14 Stockholders’ equity with defi cit

Stockholders’ equity Paid-in capital Common stock $ 70 Paid-in capital in excess of par value 1,885,301

Total paid-in capital 1,885,371 Accumulated defi cit (921,960)

Total paid-in capital and retained earnings 963,411 Less: Treasury stock 198,467

Total stockholders’ equity $ 764,944

GROUPON, INC. Balance Sheet (partial)

(in thousands)

Real World

558 11 Reporting and Analyzing Stockholders’ Equity

RETAINED EARNINGS RESTRICTIONS

The balance in retained earnings is generally available for dividend declarations. Some companies state this fact. In some circumstances, however, there may be retained earnings restrictions. These make a portion of the balance currently unavailable for dividends. Restrictions result from one or more of these causes: legal, contractual, or voluntary. Companies generally disclose retained earnings restrictions in the notes to the fi nancial statements. For example, as shown in Illustration 11-15, Tektronix Inc., a manufacturer of electronic measurement devices, recently had total retained earnings of $774 million, but the unrestricted portion was only $223.8 million.

Certain of the Company’s debt agreements require compliance with debt covenants. The Company had unrestricted retained earnings of $223.8 million after meeting those requirements.

TEKTRONIX INC. Notes to the Financial Statements

Real World

ILLUSTRATION 11-15 Disclosure of unrestricted retained earnings

BALANCE SHEET PRESENTATION OF STOCKHOLDERS’ EQUITY

In the stockholders’ equity section of the balance sheet, companies report paid- in capital, retained earnings, accumulated other comprehensive income, and treasury stock. Within paid-in capital, two classifi cations are recognized:

1. Capital stock, which consists of preferred and common stock. Companies show preferred stock before common stock because of its preferential rights. They report information about the par value, shares authorized, shares issued, and shares outstanding for each class of stock.

2. Additional paid-in capital, which includes the excess of amounts paid in over par or stated value.

As discussed in Chapter 5, in some instances unrealized gains and losses are not included in net income. Instead, these excluded items, referred to as other comprehensive income items, are reported as part of a more inclusive earn- ings measure called comprehensive income. Examples of other comprehensive income items include certain adjustments to pension plan assets, types of for- eign currency gains and losses, and some gains and losses on investments. The items reported as other comprehensive income are closed each year to the Accu- mulated Other Comprehensive Income account. Thus, this account includes the cumulative amount of all previous items reported as other comprehensive income. This account can have either a debit or credit balance depending on whether or not accumulated gains exceed accumulated losses over the years. If accumulated losses exceed gains, then the company reports accumulated other comprehensive loss. Illustration 11-16 presents the stockholders’ equity section of the balance sheet of Graber Inc. The company discloses a retained earnings restriction in the notes. The stockholders’ equity section for Graber Inc. includes most of the accounts discussed in this chapter. The disclosures pertaining to Graber’s com- mon stock indicate that 400,000 shares are issued, 100,000 shares are unissued (500,000 authorized less 400,000 issued), and 390,000 shares are outstanding (400,000 issued less 10,000 shares in treasury).

Presentation and Analysis 559

ILLUSTRATION 11-16 Stockholders’ equity section of balance sheet

Stockholders’ equity Paid-in capital Capital stock 9% preferred stock, $100 par value, cumulative,

10,000 shares authorized, 6,000 shares issued and outstanding $ 600,000 Common stock, no par, $5 stated value, 500,000 shares authorized, 400,000 shares issued, and 390,000 outstanding 2,000,000

Total capital stock 2,600,000 Additional paid-in capital Paid-in capital in excess of par value—preferred stock $ 30,000 Paid-in capital in excess of stated value—common stock 1,050,000

Total additional paid-in capital 1,080,000

Total paid-in capital 3,680,000 Retained earnings (see Note R) 1,050,000

Total paid-in capital and retained earnings 4,730,000 Accumulated other comprehensive income 110,000 Less: Treasury stock (10,000 common shares) 80,000

Total stockholders’ equity $4,760,000

Note R: Retained earnings is restricted for the cost of treasury stock, $80,000.

GRABER INC. Balance Sheet (partial)

INTERNATIONAL NOTE Like GAAP, under IFRS compa- nies typically disclose separate categories of capital on the balance sheet. However, because of varying accounting treatments of certain transactions (such as treasury stock or asset revaluations), some categories used under IFRS vary from those under GAAP.

KEEPING AN EYE ON CASH

The balance sheet presents the balances of a company’s stockholders’ equity accounts at a point in time. Companies report in the financing activities section of the statement of cash flows information regarding cash inflows and outflows during the year that resulted from equity transactions. The excerpt below presents the cash flows from financing activities from the statement of cash flows of Sara Lee Corporation in a recent year. From this information, we learn that the com- pany’s purchases of treasury stock during the period far exceeded its issuances of new common stock, and its financing activities resulted in a net reduction in its cash balance.

Cash fl ows from fi nancing activities Issuances of common stock $ 38 Purchases of common stock (686) Payments of dividends (374) Borrowings of long-term debt 2,895 Repayments of long-term debt (416) Short-term (repayments) borrowings, net (1,720)

Net cash used in fi nancing activities $ (263)

SARA LEE CORPORATION Statement of Cash Flows (partial)

(in millions)

Real World

560 11 Reporting and Analyzing Stockholders’ Equity

4a▼ Stockholders’ Equity SectionDO IT! Jennifer Corporation has issued 300,000 shares of $3 par value common stock. It is autho- rized to issue 600,000 shares. The paid-in capital in excess of par value on the common stock is $380,000. The corporation has reacquired 15,000 shares at a cost of $50,000 and is cur- rently holding those shares. It also had a cumulative other comprehensive loss of $82,000.

The corporation also has 4,000 shares issued and outstanding of 8%, $100 par value preferred stock. It is authorized to issue 10,000 shares. The paid-in capital in excess of par value on the preferred stock is $97,000. Retained earnings is $610,000.

Prepare the stockholders’ equity section of the balance sheet.

Action Plan ✔ Present capital stock fi rst;

list preferred stock before common stock.

✔ Present additional paid-in capital after capital stock.

✔ Report retained earnings after capital stock and additional paid-in capital.

✔ Deduct treasury stock from total paid-in capital and retained earnings.

SOLUTION

Related exercise material: BE11-8, DO IT! 11-4a, E11-8, E11-9, and E11-10.

Stockholders’ equity Paid-in capital Capital stock 8% preferred stock, $100 par value, 10,000 shares authorized, 4,000 shares issued and outstanding $ 400,000 Common stock, $3 par value, 600,000 shares authorized, 300,000 shares issued, and 285,000 shares outstanding 900,000

Total capital stock $1,300,000 Additional paid-in capital Paid-in capital in excess of par value—preferred stock 97,000 Paid-in capital in excess of par value—common stock 380,000

Total additional paid-in capital 477,000

Total paid-in capital 1,777,000 Retained earnings 610,000

Total paid-in capital and retained earnings 2,387,000 Accumulated other comprehensive loss 82,000 Less: Treasury stock (15,000 common shares) (at cost) 50,000

Total stockholders’ equity $2,255,000

JENNIFER CORPORATION Balance Sheet (partial)

ANALYSIS OF STOCKHOLDERS’ EQUITY

Investors are interested in both a company’s dividend record and its earnings performance. Although those two measures are often parallel, that is not always the case. Thus, investors should investigate each one separately.

Dividend Record One way that companies reward stock investors for their investment is to pay

them dividends. The payout ratio measures the percentage of earnings a company distributes in the form of cash dividends to common stock- holders. It is computed by dividing total cash dividends declared to common shareholders by net income. Using the information shown below, the payout ratio for Nike in 2014 and 2013 is calculated in Illus- tration 11-17.

2014 2013

Dividends (in millions) $ 821 $ 727 Net income (in millions) 2,693 2,472

DECISION TOOLS

The payout ratio helps users determine the portion of a com- pany’s earnings that its pays out in dividends.

Presentation and Analysis 561

Nike’s payout ratio was relatively constant at approximately 30%. Companies attempt to set their dividend rate at a level that will be sustainable. Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business. Thus, a low payout ratio is not necessarily bad news. Companies that believe they have many good opportunities for growth, such as Facebook, will reinvest those funds in the company rather than pay dividends. However, low dividend payments, or a cut in dividend payments, might signal that a company has liquidity or solvency problems and is trying to conserve cash by not paying dividends. Thus, investors and analysts should investigate the reason for low dividend payments. Illustration 11-18 lists recent payout ratios of four well-known companies.

Payout Ratio = Cash Dividends Declared on Common Stock

Net Income

($ in millions) 2014 2013

Payout Ratio $821 $2,693

= 30.5% $727 $2,472

= 29.4%

ILLUSTRATION 11-17 Nike’s payout ratio

ILLUSTRATION 11-18 Payout ratios of companiesCompany Payout Ratio

Microsoft 24.5% Kellogg 43.3% Facebook 0% Wal-Mart 49.0%

DECISION TOOLS

Return on common stockholders’ equity helps users determine a company’s return on its common stockholders’ investment.

Earnings Performance Another way to measure corporate performance is through profi t- ability. A widely used ratio that measures profi tability from the com- mon stockholders’ viewpoint is return on common stockholders’ equity (ROE). This ratio shows how many dollars of net income a company earned for each dollar of common stockholders’ equity. It is computed by dividing net income available to common stockholders (Net income – Preferred dividends) by average common stockholders’ equity. Common stockholders’ equity is equal to total stockholders’ equity minus any equity from preferred stock. Using the information on the previous page and the additional information presented below, Illustration 11-19 shows Nike’s return on common stockholders’ equity.

(in millions) 2014 2013 2012

Preferred dividends $ –0– $ –0– $ –0– Common stockholders’ equity 10,824 11,081 10,319 ILLUSTRATION 11-19

Nike’s return on common stockholders’ equity

Return on Common Stockholders’ Equity =

Net Income – Preferred Dividends Average Common Stockholders' Equity

($ in millions) 2014 2013

Return on Common $2,693 – $0 ($10,824 + $11,081)/2 = 24.6%

$2,472 – $0 ($11,081 + $10,319)/2 = 23.1%Stockholders’ Equity

562 11 Reporting and Analyzing Stockholders’ Equity

From 2013 to 2014, Nike’s return on common shareholders’ equity increased. As a company grows larger, it becomes increasingly hard to sustain a high return. In Nike’s case, since many believe the U.S. market for expensive sports shoes is saturated, it will need to grow either along new product lines, such as hiking shoes and golf equipment, or in new markets, such as Europe and Asia.

DEBT VERSUS EQUITY DECISION

When obtaining long-term capital, corporate managers must decide whether to issue bonds or to sell common stock. Bonds have three primary advantages rela- tive to common stock, as shown in Illustration 11-20.

Stockholder control is not affected. Bondholders do not have voting rights, so current owners (stockholders) retain full control of the company.

Tax savings result. Bond interest is deductible for tax purposes; dividends on stock are not.

Return on common stockholders' equity may be higher. Although bond interest expense reduces net income, return on common stockholders' equity often is higher under bond financing because no additional shares of common stock are issued.

Bond Financing Advantages

Ballot

Tax Bill

STOCK $

ILLUSTRATION 11-20 Advantages of bond fi nancing over common stock

Return on assets

Leverage (debt to assets

ratio)

Return on common

stockholders’ equity

ILLUSTRATION 11-21 Components of the return on common stockholders’ equity

How does the debt versus equity decision affect the return on common stock- holders’ equity? Illustration 11-21 shows that the return on common stockholders’ equity is affected by the return on assets and the amount of leverage a company uses—that is, by the company’s reliance on debt (often measured by the debt to assets ratio). If a company wants to increase its return on common stock- holders’ equity, it can either increase its return on assets or increase its reliance on debt fi nancing.

To illustrate the potential effect of debt fi nancing on the return on common stockholders’ equity, assume that Microsystems Inc. currently has 100,000 shares of common stock outstanding issued at $25 per share and no debt. It is consider- ing two alternatives for raising an additional $5 million. Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuing $5 million of 12% bonds at face value. Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%. The alternative effects on the return on common stockholders’ equity are shown in Illustration 11-22.

Presentation and Analysis 563

Note that with long-term debt fi nancing (bonds), net income is $420,000 ($1,050,000 – $630,000) less. However, the return on common stockholders’ equity increases from 14% to 25.2% with the use of debt fi nancing because net income is spread over a smaller amount of common stockholders’ equity. In gen- eral, as long as the return on assets rate exceeds the rate paid on debt, a company will increase the return on common stockholders’ equity by the use of debt. After seeing this illustration, you might ask, why don’t companies rely almost exclusively on debt fi nancing rather than equity? Debt has one major disadvan- tage: Debt reduces solvency. The company locks in fi xed payments that it must make in good times and bad. The company must pay interest on a periodic basis and must pay the principal (face value) of the bonds at matu- rity. A company with fl uctuating earnings and a relatively weak cash position may experience great diffi culty in meeting interest requirements in periods of low earnings. In the extreme, this can result in bankruptcy. With common stock fi nancing, on the other hand, the company can decide to pay low (or no) divi- dends if earnings are low.

ILLUSTRATION 11-22 Effects on return on common stockholders’ equity of issuing debt

Plan A: Plan B: Issue Stock Issue Bonds

Income before interest and taxes $1,500,000 $1,500,000 Interest (12% × $5,000,000) — 600,000 Income before income taxes 1,500,000 900,000 Income tax expense (30%) 450,000 270,000

Net income $1,050,000 $ 630,000

Common stockholders’ equity $7,500,000 $2,500,000

Return on common stockholders’ equity 14% 25.2%

4b▼ Analyzing Stockholders’ EquityDO IT! On January 1, 2017, Siena Corporation purchased 2,000 shares of treasury stock. Other information regarding Siena Corporation is provided below.

2017 2016

Net income $110,000 $110,000 Dividends on preferred stock $10,000 $10,000 Dividends on common stock $1,600 $2,000 Common stockholders’ equity, beginning of year $400,000* $500,000 Common stockholders’ equity, end of year $400,000 $500,000

*Adjusted for purchase of treasury stock.

Compute (a) return on common stockholders’ equity for each year, and (b) discuss its change from 2016 to 2017.

Action Plan ✔ Determine return on

common stockholders’ equity by dividing net income available to common stockholders by average common stockholders’ equity.

SOLUTION (a)

2017 2016

Return on common stock- holders’ equity

($110,000 – $10,000)

($400,000 + $400,000)/2 = 25%

($110,000 – $10,000) ($500,000 + $500,000)/2

= 20%

(b) Between 2016 and 2017, return on common stockholders’ equity improved from 20% to 25%. While this would appear to be good news for the company’s common

564 11 Reporting and Analyzing Stockholders’ Equity

stockholders, this increase should be carefully evaluated. It is important to note that net income did not change during this period. The increase in the ratio was due to the purchase of treasury shares, which reduced the denominator of the ratio. As the com- pany repurchases its own shares, it becomes more reliant on debt and thus increases its risk.

Related exercise material: BE11-10, DO IT! 11-4b, E11-11, E11-12, and E11-13.

adidas is one of Nike’s competitors. In such a competitive and rapidly changing environment, one wrong step can spell fi nancial disaster.

INSTRUCTIONS

The following facts are available from adidas’s annual report. As a German company, adidas reports under International Financial Reporting Standards (IFRS). Using this information, evaluate its (1) payout ratio and (2) earnings per share and re- turn on common stockholders’ equity (ROE). (3) Compare the payout ratio and ROE with those for Nike for 2014 and 2013.

(in millions) 2014 2013 2012

Dividends declared €314 €282 Net income €490 €787 Preferred dividends 0 0 Shares outstanding at end of year 204 209 209 Common stockholders’ equity €5,625 €5,489 €5,304

USING DECISION TOOLS—ADIDAS

SOLUTION 1. A measure to evaluate a company’s dividend record is the payout ratio. For adidas, this measure in 2014 and 2013 is

calculated as shown below.

2014 2013

Payout ratio

€314 €490

= 64.1%

€282 €787

= 35.8%

Nike’s payout ratio was 30.5%. adidas’s payout ratio dramatically increased from 2013 to 2014 and was signifi cantly higher than Nike’s ratio in 2014.

2. There are many measures of earnings performance. Some of those presented thus far in the textbook were earnings per share (page 53) and the return on common stockholders’ equity (this chapter). These measures for adidas in 2014 and 2013 are calculated as shown here.

2014 2013

Earnings per share

€490 – 0 (204 + 209)/2

= €2.37 €787 – 0

(209 + 209)/2 = €3.77

Return on common

stockholders’ equity

€490 – 0 (€5,625 + €5,489)/2

= 8.8%

€787 – 0 (€5,489 + €5,291)/2

= 14.6%

3. Nike’s payout ratio was lower than that of adidas in both years. This means that adidas paid a higher percentage of its earnings as dividends. Nike had a higher return on shareholders’ equity during this 2-year period.

Review and Practice 565

APPENDIX 11A: Prepare entries for stock dividends. LEARNING OBJECTIVE *5▼ To illustrate the accounting for stock dividends, assume that Medland Corpora- tion has a balance of $300,000 in retained earnings and declares a 10% stock div- idend on its 50,000 shares of $10 par value common stock. The current fair value of its stock is $15 per share. The number of shares to be issued is 5,000 (10% × 50,000), and the total amount to be debited to Stock Dividends is $75,000 (5,000 × $15). The entry to record this transaction at the declaration date is as follows.

Stock Dividends 75,000 Common Stock Dividends Distributable 50,000 Paid-in Capital in Excess of Par Value 25,000 (To record declaration of 10% stock dividend)

At the declaration date, Medland increases (debits) Stock Dividends for the fair value of the stock issued, increases (credits) Common Stock Dividends Distribut- able for the par value of the dividend shares (5,000 × $10), and increases (credits) the excess over par (5,000 × $5) to an additional paid-in capital account. Stock Dividends is closed to Retained Earnings at the end of the accounting period. Common Stock Dividends Distributable is a stockholders’ equity account. It is not a liability because assets will not be used to pay the dividend. If Medland prepares a balance sheet before it issues the dividend shares, it reports the dis- tributable account in paid-in capital as an addition to common stock issued, as shown in Illustration 11A-1.

A L SE= + −75,000 Div +50,000 CS +25,000 CS Cash Flows no eff ect

A L SE= + −50,000 CS +50,000 CS

Cash Flows no eff ect

ILLUSTRATION 11A-1 Statement presentation of common stock dividends distributable

Paid-in capital Common stock $500,000 Common stock dividends distributable 50,000 Paid-in capital in excess of par—common stock 25,000

Total paid-in capital $575,000

MEDLAND CORPORATION Balance Sheet (partial)

▼ HELPFUL HINT Note that the dividend account title is distributable, not payable.

When Medland issues the dividend shares, it decreases Common Stock Divi- dends Distributable and increases Common Stock as follows.

Common Stock Dividends Distributable 50,000 Common Stock 50,000 (To record issuance of 5,000 shares in a stock dividend)

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Discuss the major characteristics of a corporation. The major characteristics of a corporation are separate legal exis- tence, limited liability of stockholders, transferable ownership rights, ability to acquire capital, continuous life, corporation management, government regulations, and additional taxes.

2 Explain how to account for the issuance of common and preferred stock, and the purchase of treasury stock. When a company records issuance of common stock for cash, it credits the par value of the shares to Common Stock. It records in a separate paid-in capital account the portion of

▼

the proceeds that is above par value. When no-par common stock has a stated value, the entries are similar to those for par value stock. When no-par common stock does not have a stated value, the entire proceeds from the issue are cred- ited to Common Stock.

Companies generally use the cost method in account- ing for treasury stock. Under this approach, a company debits Treasury Stock at the price paid to reacquire the shares.

3 Explain how to account for cash dividends and describe the effect of stock dividends and stock splits. Companies make entries for dividends at the declaration date and the payment date. At the declaration date, the entries for a cash dividend are debit Cash Dividends and credit Divi- dends Payable.

Preferred stock has contractual provisions that give it priority over common stock in certain areas. Typically, pre- ferred stockholders have a preference as to (1) dividends and (2) assets in the event of liquidation. However, they sometimes do not have voting rights.

The effects of stock dividends and splits are as follows. Small stock dividends transfer an amount equal to the fair value of the shares issued from retained earnings to the paid-in capital accounts. Stock splits reduce the par value per share of the common stock while increasing the num- ber of shares so that the balance in the Common Stock account remains the same.

4 Discuss how stockholders’ equity is reported and analyzed. Additions to retained earnings consist of net

income. Deductions consist of net loss and cash and stock dividends. In some instances, portions of retained earnings are restricted, making that portion unavailable for the pay- ment of dividends.

In the stockholders’ equity section of the balance sheet, companies report paid-in capital and retained earnings and identify specifi c sources of paid-in capital. Within paid-in capital, companies show two classifi cations: capital stock and additional paid-in capital. If a corporation has trea- sury stock, it deducts the cost of treasury stock from total paid-in capital and retained earnings to determine total stockholders’ equity.

A company’s dividend record can be evaluated by looking at what percentage of net income it chooses to pay out in dividends, as measured by the payout ratio (dividends divided by net income). Earnings performance is measured with the return on common stockholders’ equity (income available to common stockholders divided by average common stockhold- ers’ equity).

*5 Prepare entries for stock dividends. To record the dec- laration of a small stock dividend (less than 20%), debit Stock Dividends for an amount equal to the fair value of the shares issued. Record a credit to a temporary stockholders’ equity account—Common Stock Dividends Distributable—for the par value of the shares, and credit the balance to Paid-in Capital in Excess of Par Value. When the shares are issued, debit Common Stock Dividends Distributable and credit Common Stock.

566 11 Reporting and Analyzing Stockholders’ Equity

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Should the company incorporate?

Capital needs, growth expectations, type of business, tax status

Corporations have limited liability, better capital- raising ability, and professional managers. But they suffer from additional taxes, government regulations, and separation of owner- ship from management.

Must carefully weigh the costs and benefi ts in light of the particular circumstances.

What portion of its earnings does the company pay out in dividends?

What is the company’s return on common stockholders’ investment?

Net income and total cash dividends on common stock

Earnings available to common stockholders and average common stockholders’ equity

A low ratio may suggest that the company is retaining its earnings for investment in future growth.

A high measure suggests strong earnings perfor- mance from common stockholders’ perspective.

Cash dividends declared on common stock

Net income Payout ratio =

Net income − Preferred dividends Average common

stockholders’ equity

Return on common stock- holders’ equity

Accumulated Other Comprehensive Income This ac- count includes the cumulative amount of all previ- ous items reported as other comprehensive income. (p. 558).

Authorized stock The amount of stock that a corporation is authorized to sell as indicated in its charter. (p. 543).

Cash dividend A pro rata (proportional to ownership) dis- tribution of cash to stockholders. (p. 549).

GLOSSARY REVIEW▼

Practice Multiple-Choice Questions 567

Charter A document that describes a corporation’s name and purpose, types of stock and number of shares au- thorized, names of individuals involved in the forma- tion, and number of shares each individual has agreed to purchase. (p. 541).

Corporation A company organized as a separate legal entity, with most of the rights and privileges of a person. (p. 538).

Cumulative dividend A feature of preferred stock entitling the stockholder to receive current and unpaid prior-year dividends before common stockholders receive any dividends. (p. 552).

Declaration date The date the board of directors formally authorizes the dividend and announces it to stock- holders. (p. 550).

Defi cit A debit balance in Retained Earnings. (p. 557).

Dividend A distribution by a corporation to its stockholders on a pro rata (proportional to ownership) basis. (p. 549).

Dividends in arrears Preferred dividends that were sup- posed to be declared but were not declared during a given period. (p. 552).

Legal capital The amount of capital that must be retained in the business for the protection of corporate creditors. (p. 543).

No-par value stock Capital stock that has not been as- signed a value in the corporate charter. (p. 544).

Outstanding stock Capital stock that has been issued and is being held by stockholders. (p. 548).

Paid-in capital The amount stockholders paid in to the cor- poration in exchange for shares of ownership. (p. 544).

Par value stock Capital stock that has been assigned a value per share in the corporate charter. (p. 543).

Payment date The date cash dividend payments are made to stockholders. (p. 551).

Payout ratio A measure of the percentage of earnings a company distributes in the form of cash dividends to common stockholders. (p. 560).

Preferred stock Capital stock that has contractual prefer- ences over common stock in certain areas. (p. 546).

Privately held corporation A corporation that has only a few stockholders and whose stock is not available for sale to the general public. (p. 538).

Publicly held corporation A corporation that may have thousands of stockholders and whose stock is traded on a national securities market. (p. 538).

Record date The date when the company determines owner- ship of outstanding shares for dividend purposes. (p. 550).

Retained earnings Net income that a company retains in the business. (p. 544).

Retained earnings restrictions Circumstances that make a portion of retained earnings currently unavailable for dividends. (p. 558).

Return on common stockholders’ equity (ROE) A mea- sure of profi tability from the stockholders’ point of view; computed by dividing net income minus pre- ferred dividends by average common stockholders’ equity. (p. 561).

Stated value The amount per share assigned by the board of directors to no-par stock. (p. 544).

Stock dividend A pro rata (proportional to ownership) distribution of the corporation’s own stock to stock- holders. (p. 553).

Stock split The issuance of additional shares of stock to stockholders accompanied by a reduction in the par or stated value per share. (p. 555).

Treasury stock A corporation’s own stock that has been reacquired by the corporation and is being held for future use. (p. 547).

1. Which of these is not a major advantage of a corporation? (a) Separate legal existence. (b) Continuous life. (c) Government regulations. (d) Transferable ownership rights.

2. A major disadvantage of a corporation is: (a) limited liability of stockholders. (b) additional taxes. (c) transferable ownership rights. (d) None of the above.

3. Which of these statements is false? (a) Ownership of common stock gives the owner a

voting right. (b) The stockholders’ equity section begins with

paid-in capital. (c) The authorization of capital stock does not result

in a formal accounting entry. (d) Legal capital is intended to protect stockholders.

4. ABC Corp. issues 1,000 shares of $10 par value com- mon stock at $12 per share. When the transaction is recorded, credits are made to:

(LO 1)

(LO 2)

(a) Common Stock $10,000 and Paid-in Capital in Excess of Stated Value $2,000.

(b) Common Stock $12,000. (c) Common Stock $10,000 and Paid-in Capital in

Excess of Par Value $2,000. (d) Common Stock $10,000 and Retained Earnings

$2,000. 5. Treasury stock may be repurchased:

(a) to reissue the shares to offi cers and employees under bonus and stock compensation plans.

(b) to signal to the stock market that management believes the stock is underpriced.

(d) More than one of the above. 6. Preferred stock may have priority over common

stock except in: (a) dividend preference. (b) preference to assets in the event of liquidation. (c) cumulative dividends. (d) voting.

(LO 2)

(LO 3)

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

7. U-Bet Corporation has 10,000 shares of 8%, $100 par value, cumulative preferred stock outstanding at De- cember 31, 2017. No dividends were declared in 2015 or 2016. If U-Bet wants to pay $375,000 of dividends in 2017, common stockholders will receive: (a) $0. (c) $215,000. (b) $295,000. (d) $135,000.

8. Entries for cash dividends are required on the: (a) declaration date and the record date. (b) record date and the payment date. (c) declaration date, record date, and payment date. (d) declaration date and the payment date.

9. Which of these statements about stock dividends is true? (a) Stock dividends reduce a company’s cash balance. (b) A stock dividend has no effect on total stockholders’

equity. (c) A stock dividend decreases total stockholders’ equity. (d) A stock dividend ordinarily will increase total

stockholders’ equity. 10. Zealot Inc. has retained earnings of $500,000 and

total stockholders’ equity of $2,000,000. It has 100,000 shares of $8 par value common stock outstanding, which is currently selling for $30 per share. If Zealot declares a 10% stock dividend on its common stock: (a) net income will decrease by $80,000. (b) retained earnings will decrease by $80,000 and to-

tal stockholders’ equity will increase by $80,000. (c) retained earnings will decrease by $300,000 and total

stockholders’ equity will increase by $300,000. (d) retained earnings will decrease by $300,000 and

total paid-in capital will increase by $300,000. 11. In the stockholders’ equity section of the balance

sheet, common stock: (a) is listed before preferred stock. (b) is added to total capital stock. (c) is part of paid-in capital. (d) is part of additional paid-in capital.

(LO 3)

(LO 4)

12. In the stockholders’ equity section, the cost of trea- sury stock is deducted from: (a) total paid-in capital and retained earnings. (b) retained earnings. (c) total stockholders’ equity. (d) common stock in paid-in capital.

13. The return on common stockholders’ equity is usually increased by all of the following, except: (a) an increase in the return on assets ratio. (b) an increase in the use of debt fi nancing. (c) an increase in the company’s stock price. (d) an increase in the company’s net income.

14. Thomas is nearing retirement and would like to invest in a stock that will provide a good steady income. Thomas should choose a stock with a: (a) high current ratio. (b) high dividend payout. (c) high earnings per share. (d) high price-earnings ratio.

15. Jackson Inc. reported net income of $186,000 dur- ing 2017 and paid dividends of $26,000 on common stock. It also paid dividends on its 10,000 shares of 6%, $100 par value, noncumulative preferred stock. Common stockholders’ equity was $1,200,000 on January 1, 2017, and $1,600,000 on December 31, 2017. The company’s return on common stockhold- ers’ equity for 2017 is: (a) 10.0%. (c) 7.1%. (b) 9.0%. (d) 13.3%.

16. If everything else is held constant, earnings per share is increased by: (a) the payment of a cash dividend to common share-

holders. (b) the payment of a cash dividend to preferred

shareholders. (c) the issuance of new shares of common stock. (d) the purchase of treasury stock.

(LO 4)

568 11 Reporting and Analyzing Stockholders’ Equity

SOLUTIONS 1. (c) Government regulations are a disadvantage of a corporation. The other choices are advantages of a corporation.

2. (b) Additional taxes are a disadvantage of a corporation. The other choices are advantages of a corporation.

3. (d) Legal capital is intended to protect creditors, not stockholders. The other choices are true statements.

4. (c) Common Stock should be credited for $10,000 and Paid-in Capital in Excess of Par Value should be credited for $2,000. The stock is par value stock, not stated value stock, and this excess is contributed, not earned, capital. The other choices are therefore incorrect.

5. (d) Treasury stock may be repurchased to reissue the shares as part of bonus and stock compensation plans, to signal to the stock market that the stock is underpriced, and to have additional shares available for use in the acquisition of other companies. Choice (a), (b), (c) are all correct, but (d) is the best answer.

6. (d) Preferred stock usually does not have voting rights and therefore does not have priority over common stock on this issue. The other choices are true statements.

7. (d) The preferred stockholders will receive a total of $240,000 of dividends [dividends in arrears ($80,000 × 2 years) + current-year dividends ($80,000)]. If U-Bet wants to pay a total of $375,000 in 2017, then common stockholders will receive $135,000 ($375,000 − $240,000), not (a) $0, (b) $295,000, or (c) $215,000.

8. (d) Entries are required for dividends on the declaration date and the payment date, but not the record date. The other choices are therefore incorrect.

9. (b) A stock dividend moves amounts from retained earnings to paid-in capital and has no effect on stockholders’ equity or cash. The other choices are therefore incorrect.

10. (d) A 10% stock dividend on the company’s common stock will increase the number of shares issued by 10,000 (100,000 × 10%). At a market price of $30 per share, total paid-in capital will increase by $300,000 (10,000 shares × $30/share) and retained earnings will decrease by that same amount. The other choices are therefore incorrect.

11. (c) Common stock is part of paid-in capital. The other choices are incorrect because common stock (a) is listed after preferred stock, (b) is not added to total capital stock but is part of capital stock, and (d) is part of capital stock, not additional paid-in capital.

12. (a) The cost of treasury stock is deducted from total paid-in capital and retained earnings. The other choices are therefore incorrect.

13. (c) An increase in the company’s stock price has no effect on the return on common stockholders’ equity. The other choices are incorrect because (a) an increase in a fi rm’s return on assets, (b) an increase in a fi rm’s use of debt fi nancing, and (c) an increase in a fi rm’s net income will all increase the return on common stockholders’ equity.

14. (b) Thomas should focus on a high dividend payout. The other choices are incorrect because a stock with a (a) high current ratio, (c) high earnings per share, or (d) high price-earnings ratio may or may not pay dividends on a consistent basis.

15. (b) Return on common stockholders’ equity is net income available to common stockholders divided by aver- age common stockholders’ equity. Net income available to common stockholders is net income less preferred dividends = $126,000 [$186,000 − (10,000 × .06 × $100)]. The company’s return on common stockholders’ equity for the year is therefore 9.0% [$126,000/($1,200,000 + $1,600,000)/2)], not (a) 10.0%, (c) 7.1%, or (d) 13.3%.

16. (d) The purchase of treasury stock reduces the number of shares outstanding, which is the denominator of earn- ings per share (EPS). With a smaller denominator, EPS is larger. The other choices are incorrect because (a) the payment of a cash dividend to common stockholders does not affect the earnings or the number of outstand- ing shares, so EPS will stay the same; (b) the payment of a cash dividend to preferred stockholders will reduce the amount of earnings available to the common stockholders, thus reducing EPS; and (c) the issuance of new shares of common stock would not affect earnings but will increase the number of outstanding shares, thereby reducing EPS.

Practice Exercises 569

SOLUTION

1. June 12 Cash 370,000 Common Stock (60,000 × $5) 300,000 Paid-in Capital in Excess of Par Value— Common Stock 70,000

July 11 Cash (1,000 × $112) 112,000 Preferred Stock (1,000 × $100) 100,000 Paid-in Capital in Excess of Par Value— Preferred Stock (1,000 × $12) 12,000

Nov. 28 Treasury Stock 70,000 Cash 70,000

1. Maci Co. had the following transactions during the current period.

June 12 Issued 60,000 shares of $5 par value common stock for cash of $370,000. July 11 Issued 1,000 shares of $100 par value preferred stock for cash at $112 per

share. Nov. 28 Purchased 2,000 shares of treasury stock for $70,000.

INSTRUCTIONS

Journalize the transactions.

Journalize issuance of common and preferred stock and purchase of treasury stock.

(LO 2)

PRACTICE EXERCISES▼

570 11 Reporting and Analyzing Stockholders’ Equity

SOLUTION

(a) Jan. 10 Cash 3,200,000 Common Stock 2,000,000 Paid-in Capital in Excess of Par Value 1,200,000 (To record issuance of 400,000 shares of $5 par value stock)

Sept. 21 Treasury Stock 90,000 Cash 90,000 (To record purchase of 10,000 shares of treasury stock at cost)

Dec. 24 Cash Dividends 39,000 Dividends Payable 39,000 (To record declaration of 10 cents per

share cash dividend)

2. On January 1, Chong Corporation had 95,000 shares of no-par common stock issued and outstanding. The stock has a stated value of $5 per share. During the year, the following occurred.

Apr. 1 Issued 25,000 additional shares of common stock for $17 per share. June 15 Declared a cash dividend of $1 per share to stockholders of record on June 30. July 10 Paid the $1 cash dividend. Dec. 1 Issued 2,000 additional shares of common stock for $19 per share. 15 Declared a cash dividend on outstanding shares of $1.20 per share to stockholders

of record on December 31.

INSTRUCTIONS

(a) Prepare the entries, if any, on each of the three dividend dates.

(b) How are dividends and dividends payable reported in the fi nancial statements prepared at December 31?

Journalize cash dividends; indicate statement presentation.

(LO 3, 4)

SOLUTION

2. (a) June 15 Cash Dividends (120,000 × $1) 120,000 Dividends Payable 120,000

July 10 Dividends Payable 120,000 Cash 120,000

Dec. 15 Cash Dividends (122,000 × $1.20) 146,400 Dividends Payable 146,400

(b) In the retained earnings statement, dividends of $266,400 will be deducted. In the balance sheet, Dividends Payable of $146,400 will be reported as a current liability.

Rolman Corporation is authorized to issue 1,000,000 shares of $5 par value common stock. In its fi rst year, the company has the following stock transactions.

Jan. 10 Issued 400,000 shares of stock at $8 per share. Sept. 21 Purchased 10,000 shares of common stock for the treasury at $9 per share. Dec. 24 Declared a cash dividend of 10 cents per share on common stock outstanding.

INSTRUCTIONS

(a) Journalize the transactions.

(b) Prepare the stockholders’ equity section of the balance sheet, assuming the company had retained earnings of $150,600 at December 31 and an accumulated other compre- hensive loss of $105,000.

Journalize transactions and prepare stockholders’ equity section.

(LO 2, 3, 4)

PRACTICE PROBLEM▼

Questions 571

(b)

Stockholders’ equity Paid-in capital Capital stock Common stock, $5 par value, 1,000,000 shares authorized, 400,000 shares issued, 390,000 outstanding $2,000,000 Additional paid-in capital Paid-in capital in excess of par value—common stock 1,200,000

Total paid-in capital 3,200,000 Retained earnings 150,600

Total paid-in capital and retained earnings 3,350,600 Accumulated other comprehensive loss 105,000 Less: Treasury stock (10,000 shares) 90,000

Total stockholders’ equity $3,155,600

ROLMAN CORPORATION Balance Sheet (partial)

1. Joe, a student, asks your help in understanding some characteristics of a corporation. Explain each of these to Joe. (a) Separate legal existence. (b) Limited liability of stockholders. (c) Transferable ownership rights.

2. (a) Your friend G. C. Jones cannot understand how the characteristic of corporate management is both an advantage and a disadvantage. Clarify this problem for G. C.

(b) Identify and explain two other disadvantages of a corporation.

3. Nona Jaymes believes a corporation must be incorpo- rated in the state in which its headquarters offi ce is located. Is Nona correct? Explain.

4. What are the basic ownership rights of common stock- holders in the absence of restrictive provisions?

5. A corporation has been defi ned as an entity separate and distinct from its owners. In what ways is a corpo- ration a separate legal entity?

6. What are the two principal components of stock- holders’ equity?

7. The corporate charter of Gage Corporation allows the issuance of a maximum of 100,000 shares of common stock. During its fi rst 2 years of operation, Gage sold 70,000 shares to shareholders and reacquired 4,000

of these shares. After these transactions, how many shares are authorized, issued, and outstanding?

8. Which is the better investment—common stock with a par value of $5 per share or common stock with a par value of $20 per share?

9. For what reasons might a company like IBM repurchase some of its stock (treasury stock)?

10. Monet, Inc. purchases 1,000 shares of its own previ- ously issued $5 par common stock for $11,000. Assum- ing the shares are held in the treasury, what effect does this transaction have on (a) net income, (b) total as- sets, (c) total paid-in capital, and (d) total stockholders’ equity?

11. (a) What are the principal differences between com- mon stock and preferred stock?

(b) Preferred stock may be cumulative. Discuss this feature.

12. Identify the events that result in credits and debits to retained earnings.

13. Indicate how each of these accounts should be classi- fi ed in the stockholders’ equity section of the balance sheet. (a) Common Stock. (b) Paid-in Capital in Excess of Par Value.

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS▼

572 11 Reporting and Analyzing Stockholders’ Equity

14. What three conditions must be met before a cash dividend is paid?

15. Three dates associated with Petrie Company’s cash dividend are May 1, May 15, and May 31. Discuss the signifi cance of each date and give the entry at each date.

16. Contrast the effects of a cash dividend and a stock divi- dend on a corporation’s balance sheet.

17. Doris Angel asks, “Since stock dividends don’t change anything, why declare them?” What is your answer to Doris?

18. Jayne Corporation has 10,000 shares of $15 par value common stock outstanding when it announces a 3-for-1 split. Before the split, the stock had a market price of $120 per share. After the split, how many shares of stock will be outstanding, and what will be the approx- imate market price per share?

19. The board of directors is considering a stock split or a stock dividend. They understand that total stockhold- ers’ equity will remain the same under either action. However, they are not sure of the different effects of

the two actions on other aspects of stockholders’ eq- uity. Explain the differences to the directors.

20. What was the total cost of Apple’s treasury stock at September 27, 2014? What was the amount of the 2014 cash dividend? What was the size of the 2014 stock split?

21. (a) What is the purpose of a retained earnings re- striction?

(b) Identify the possible causes of retained earnings restrictions.

22. Thom Inc.’s common stock has a par value of $1 and a current market price of $15. Explain why these amounts are different.

23. What is the formula for the payout ratio? What does it indicate?

24. Explain the circumstances under which debt fi nancing will increase the return on common stockholders’ equity.

25. Under what circumstances will the return on assets and the return on common stockholders’ equity be equal?

26. Sauer Corp. has a return on assets of 12%. It plans to issue bonds at 8% and use the cash to repurchase stock. What effect will this have on its debt to assets ra- tio and on its return on common stockholders’ equity?

BE11-1 Hana Ascot is planning to start a business. Identify for Hana the advantages and disadvantages of the corporate form of business organization.

BE11-2 On May 10, Pilar Corporation issues 2,500 shares of $5 par value common stock for cash at $13 per share. Journalize the issuance of the stock.

BE11-3 On June 1, Forrest Inc. issues 3,000 shares of no-par common stock at a cash price of $7 per share. Journalize the issuance of the shares.

BE11-4 Layes Inc. issues 8,000 shares of $100 par value preferred stock for cash at $106 per share. Journalize the issuance of the preferred stock.

BE11-5 Basse Corporation has 7,000 shares of common stock outstanding. It declares a $1 per share cash dividend on November 1 to stockholders of record on December 1. The dividend is paid on December 31. Prepare the entries on the appropriate dates to record the declaration and payment of the cash dividend.

BE11-6 The stockholders’ equity section of Mabry Corporation’s balance sheet consists of common stock ($8 par) $1,000,000 and retained earnings $300,000. A 10% stock dividend (12,500 shares) is declared when the market price per share is $19. Show the before-and- after effects of the dividend on (a) the components of stockholders’ equity and (b) the shares outstanding.

BE11-7 Indicate whether each of the following transactions would increase (+), decrease (−), or not affect (N/A) total assets, total liabilities, and total stockholders’ equity.

Stockholders’ Transaction Assets Liabilities Equity

(a) Declared cash dividend. (b) Paid cash dividend declared in (a). (c) Declared stock dividend. (d) Distributed stock dividend declared in (c). (e) Split stock 3-for-1.

Cite advantages and disadvantages of a corporation.

(LO 1), K Journalize issuance of par value common stock.

(LO 2), AP Journalize issuance of no-par common stock.

(LO 2), AP Journalize issuance of preferred stock.

(LO 2), AP Prepare entries for a cash dividend.

(LO 3), AP

Show before-and-after effects of a stock dividend.

(LO 3), AP

Compare impact of cash dividend, stock dividend, and stock split.

(LO 3), K

BRIEF EXERCISES▼

DO IT! Exercises 573

BE11-8 Sudz Corporation has these accounts at December 31: Common Stock, $10 par, 5,000 shares issued, $50,000; Paid-in Capital in Excess of Par Value $22,000; Retained Earnings $42,000; and Treasury Stock, 500 shares, $11,000. Prepare the stockholders’ equity section of the balance sheet.

BE11-9 Hans Miken, president of Miken Corporation, believes that it is a good practice for a company to maintain a constant payout of dividends relative to its earnings. Last year, net income was $600,000, and the corporation paid $120,000 in dividends. This year, due to some unusual circumstances, the corporation had income of $1,600,000. Hans ex- pects next year’s net income to be about $700,000. What was Miken Corporation’s payout ratio last year? If it is to maintain the same payout ratio, what amount of dividends would it pay this year? Is this necessarily a good idea—that is, what are the pros and cons of maintaining a constant payout ratio in this scenario?

BE11-10 SUPERVALU, one of the largest grocery retailers in the United States, is head- quartered in Minneapolis. Suppose the following fi nancial information (in millions) was taken from the company’s 2017 annual report: net sales $44,597, net income $393, begin- ning stockholders’ equity $2,581, and ending stockholders’ equity $2,887. There were no dividends paid on preferred stock. Compute the return on common stockholders’ equity. Provide a brief interpretation of your fi ndings.

BE11-11 Emron Inc. is considering these two alternatives to fi nance its construction of a new $2 million plant: 1. Issuance of 200,000 shares of common stock at the market price of $10 per share. 2. Issuance of $2 million, 6% bonds at face value. Complete the table and indicate which alternative is preferable.

Issue Stock Issue Bonds

Income before interest and taxes $1,500,000 $1,500,000 Interest expense from bonds Income before income taxes Income tax expense (30%) Net income $ $

Outstanding shares 700,000

Earnings per share $ $

*BE11-12 Stossel Corporation has 200,000 shares of $10 par value common stock out- standing. It declares a 12% stock dividend on December 1 when the market price per share is $17. The dividend shares are issued on December 31. Prepare the entries for the declaration and distribution of the stock dividend.

Prepare a stockholders’ equity section.

(LO 4), AP

Evaluate a company’s dividend record.

(LO 4), C

Calculate the return on stockholders’ equity.

(LO 4), AP

Compare bond fi nancing to stock fi nancing.

(LO 4), AP

Prepare entries for a stock dividend.

(LO 5), AP

Indicate whether each of the following statements is true or false.

______ 1. The corporation is an entity separate and distinct from its owners. ______ 2. The liability of stockholders is normally limited to their investment in the

corporation. ______ 3. The relative lack of government regulation is an advantage of the corporate form

of business. ______ 4. There is no journal entry to record the authorization of capital stock. ______ 5. No-par value stock is quite rare today.

Beauty Island Corporation began operations on April 1 by issuing 55,000 shares of $5 par value common stock for cash at $13 per share. In addition, Beauty Island issued 1,000 shares of $1 par value preferred stock for $6 per share. Journalize the issu- ance of the common and preferred shares.

Dinosso Corporation purchased 2,000 shares of its $10 par value common stock for $76,000 on August 1. It will hold these in the treasury until resold. Journalize the treasury stock transaction.

DO IT! 11-1 Analyze statements about corporate organization.

(LO 1), C

DO IT! 11-2a Journalize issuance of stock.

(LO 2), AP

DO IT! 11-2b Journalize treasury stock transaction.

(LO 2), AP

EXERCISES▼DO IT!

574 11 Reporting and Analyzing Stockholders’ Equity

Sparks Corporation has 3,000 shares of 8%, $100 par value preferred stock outstanding at December 31, 2017. At December 31, 2017, the company declared a $105,000 cash dividend. Determine the dividend paid to preferred stockholders and com- mon stockholders under each of the following scenarios. 1. The preferred stock is noncumulative, and the company has not missed any dividends

in previous years. 2. The preferred stock is noncumulative, and the company did not pay a dividend in

each of the two previous years. 3. The preferred stock is cumulative, and the company did not pay a dividend in each of

the two previous years.

Spears Company has had 4 years of record earnings. Due to this success, the market price of its 400,000 shares of $2 par value common stock has increased from $6 per share to $50. During this period, paid-in capital remained the same at $2,400,000. Retained earnings increased from $1,800,000 to $12,000,000. CEO Don Ames is consid- ering either (1) a 15% stock dividend or (2) a 2-for-1 stock split. He asks you to show the before-and-after effects of each option on (a) retained earnings, (b) total stockholders’ equity, and (c) par value per share.

Hoyle Corporation has issued 100,000 shares of $5 par value common stock. It was authorized 500,000 shares. The paid-in capital in excess of par value on the common stock is $263,000. The corporation has reacquired 7,000 shares at a cost of $46,000 and is currently holding those shares. It also had accumulated other comprehensive income of $67,000.

The corporation also has 2,000 shares issued and outstanding of 9%, $100 par value preferred stock. It was authorized 10,000 shares. The paid-in capital in excess of par value on the preferred stock is $23,000. Retained earnings is $372,000. Prepare the stockholders’ equity section of the balance sheet.

On January 1, 2017, Vahsholtz Corporation purchased 5,000 shares of trea- sury stock. Other information regarding Vahsholtz Corporation is provided as follows.

2017 2016

Net income $110,000 $100,000 Dividends on preferred stock $ 30,000 $ 30,000 Dividends on common stock $ 25,000 $ 20,000 Weighted-average number of common shares outstanding 45,000 50,000 Common stockholders’ equity beginning of year $750,000 $600,000 Common stockholders’ equity end of year $830,000 $750,000

Compute (a) return on common stockholders’ equity for each year, and (b) discuss the changes in each.

DO IT! 11-3aDetermine dividends paid to preferred and common stockholders.

(LO 3), AP

DO IT! 11-3bDetermine effects of stock dividend and stock split.

(LO 3), AP

DO IT! 11-4aPrepare stockholders’ equity section.

(LO 4), AP

DO IT! 11-4bCompute return on stock- holders’ equity and discuss changes.

(LO 4), AP

E11-1 During its first year of operations, Mona Corporation had these transactions per- taining to its common stock.

Jan. 10 Issued 30,000 shares for cash at $5 per share. July 1 Issued 60,000 shares for cash at $7 per share.

Instructions (a) Journalize the transactions, assuming that the common stock has a par value of

$5 per share. (b) Journalize the transactions, assuming that the common stock is no-par with a stated

value of $1 per share.

E11-2 Sagan Co. had these transactions during the current period.

June 12 Issued 80,000 shares of $1 par value common stock for cash of $300,000. July 11 Issued 3,000 shares of $100 par value preferred stock for cash at $106 per

share. Nov. 28 Purchased 2,000 shares of treasury stock for $9,000.

Journalize issuance of common stock.

(LO 2), AP

Journalize issuance of common stock and preferred stock and purchase of treasury stock.

(LO 2), AP

EXERCISES▼

Exercises 575

Instructions Prepare the journal entries for the Sagan Co. transactions.

E11-3 Penland Corporation is authorized to issue both preferred and common stock. The par value of the preferred is $50. During the first year of operations, the company had the following events and transactions pertaining to its preferred stock.

Feb. 1 Issued 40,000 shares for cash at $51 per share. July 1 Issued 60,000 shares for cash at $56 per share.

Instructions (a) Journalize the transactions. (b) Post to the stockholders’ equity accounts. (Use T-accounts.) (c) Discuss the statement presentation of the accounts.

E11-4 The stockholders’ equity section of Lachlin Corporation’s balance sheet at Decem- ber 31 is presented here.

LACHLIN CORPORATION Balance Sheet (partial)

Stockholders’ equity Paid-in capital Preferred stock, cumulative, 10,000 shares authorized, 6,000 shares issued and outstanding $ 600,000 Common stock, no par, 750,000 shares authorized, 580,000 shares issued 2,900,000

Total paid-in capital 3,500,000 Retained earnings 1,158,000

Total paid-in capital and retained earnings 4,658,000 Less: Treasury stock (6,000 common shares) 32,000

Total stockholders’ equity $4,626,000

Instructions From a review of the stockholders’ equity section, answer the following questions. (a) How many shares of common stock are outstanding? (b) Assuming there is a stated value, what is the stated value of the common stock? (c) What is the par value of the preferred stock? (d) If the annual dividend on preferred stock is $36,000, what is the dividend rate on pre-

ferred stock? (e) If dividends of $72,000 were in arrears on preferred stock, what would be the balance

reported for retained earnings?

E11-5 Mesa Corporation recently hired a new accountant with extensive experience in accounting for partnerships. Because of the pressure of the new job, the accountant was unable to review what he had learned earlier about corporation accounting. During the first month, he made the following entries for the corporation’s capital stock.

May 2 Cash 104,000 Capital Stock 104,000 (Issued 8,000 shares of $10 par value common stock at $13 per share)

10 Cash 530,000 Capital Stock 530,000 (Issued 10,000 shares of $20 par value preferred stock at $53 per share)

15 Capital Stock 7,200 Cash 7,200 (Purchased 600 shares of common stock for the treasury at $12 per share)

Instructions On the basis of the explanation for each entry, prepare the entries that should have been made for the capital stock transactions.

Journalize preferred stock transactions and indicate statement presentation.

(LO 2, 4), AP

Answer questions about stockholders’ equity section.

(LO 2, 4), C

Prepare correct entries for capital stock transactions.

(LO 2), AN

576 11 Reporting and Analyzing Stockholders’ Equity

E11-6 On January 1, Graves Corporation had 60,000 shares of no-par common stock issued and outstanding. The stock has a stated value of $4 per share. During the year, the following transactions occurred.

Apr. 1 Issued 9,000 additional shares of common stock for $11 per share. June 15 Declared a cash dividend of $1.50 per share to stockholders of record on

June 30. July 10 Paid the $1.50 cash dividend. Dec. 1 Issued 4,000 additional shares of common stock for $12 per share. 15 Declared a cash dividend on outstanding shares of $1.60 per share to stock-

holders of record on December 31.

Instructions (a) Prepare the entries, if any, on each of the three dates that involved dividends. (b) How are dividends and dividends payable reported in the fi nancial statements prepared

at December 31?

E11-7 On October 31, the stockholders’ equity section of Manolo Company’s balance sheet consists of common stock $648,000 and retained earnings $400,000. Manolo is consider- ing the following two courses of action: (1) declaring a 5% stock dividend on the 81,000 $8 par value shares outstanding or (2) effecting a 2-for-1 stock split that will reduce par value to $4 per share. The current market price is $17 per share.

Instructions Prepare a tabular summary of the effects of the alternative actions on the company’s stock- holders’ equity and outstanding shares. Use these column headings: Before Action, After Stock Dividend, and After Stock Split.

E11-8 Wells Fargo & Company, headquartered in San Francisco, is one of the nation’s largest financial institutions. Suppose it reported the following selected accounts (in millions) as of December 31, 2017.

Retained Earnings $41,563 Preferred Stock 8,485 Common Stock—$123 par value, authorized 6,000,000,000 shares; issued 5,245,971,422 shares 8,743 Treasury Stock—67,346,829 common shares (2,450) Paid-in Capital in Excess of Par Value—Common Stock 52,878 Accumulated Other Comprehensive Income 8,327

Instructions Prepare the stockholders’ equity section of the balance sheet for Wells Fargo as of Decem- ber 31, 2017.

E11-9 The following stockholders’ equity accounts, arranged alphabetically, are in the ledger of Ryder Corporation at December 31, 2017.

Common Stock ($2 stated value) $1,600,000 Paid-in Capital in Excess of Par Value—Preferred Stock 45,000 Paid-in Capital in Excess of Stated Value—Common Stock 1,050,000 Preferred Stock (8%, $100 par, noncumulative) 600,000 Retained Earnings 1,334,000 Treasury Stock (12,000 common shares) 72,000

Instructions Prepare the stockholders’ equity section of the balance sheet at December 31, 2017.

E11-10 The following accounts appear in the ledger of Paisan Inc. after the books are closed at December 31, 2017.

Common Stock (no-par, $1 stated value, 400,000 shares authorized, 250,000 shares issued) $ 250,000 Paid-in Capital in Excess of Stated Value—Common Stock 1,200,000 Preferred Stock ($50 par value, 8%, 40,000 shares authorized, 14,000 shares issued) 700,000 Retained Earnings 920,000 Treasury Stock (9,000 common shares) 64,000 Paid-in Capital in Excess of Par Value—Preferred Stock 24,000 Accumulated Other Comprehensive Loss 31,000

Journalize cash dividends and indicate statement presentation.

(LO 3), AP

Compare effects of a stock dividend and a stock split.

(LO 3), AP

Prepare a stockholders’ equity section.

(LO 4), AP

Prepare a stockholders’ equity section.

(LO 4), AP

Prepare a stockholders’ equity section.

(LO 4), AP

Exercises 577

Instructions Prepare the stockholders’ equity section at December 31, assuming $100,000 of retained earnings is restricted for plant expansion. (Use Note R.)

E11-11 The following financial information is available for Flintlock Corporation.

(in millions) 2017 2016

Average common stockholders’ equity $2,532 $2,591 Dividends declared for common stockholders 298 611 Dividends declared for preferred stockholders 40 40 Net income 504 555

Instructions Calculate the payout ratio and return on common stockholders’ equity for 2017 and 2016. Comment on your findings.

E11-12 Suppose the following financial information is available for Walgreen Company.

(in millions) 2017 2016

Average common stockholders’ equity $13,622.5 $11,986.5 Dividends declared for common stockholders 471 394 Dividends declared for preferred stockholders 0 0 Net income 2,006 2,157

Instructions Calculate the payout ratio and return on common stockholders’ equity for 2017 and 2016. Comment on your findings.

E11-13 Kojak Corporation decided to issue common stock and used the $300,000 pro- ceeds to redeem all of its outstanding bonds on January 1, 2017. The following informa- tion is available for the company for 2017 and 2016.

2017 2016

Net income $ 182,000 $ 150,000 Dividends declared for preferred stockholders 8,000 8,000 Average common stockholders’ equity 1,000,000 700,000 Total assets 1,200,000 1,200,000 Current liabilities 100,000 100,000 Total liabilities 200,000 500,000

Instructions (a) Compute the return on common stockholders’ equity for both years. (b) Explain how it is possible that net income increased but the return on common stock-

holders’ equity decreased. (c) Compute the debt to assets ratio for both years, and comment on the implications of

this change in the company’s solvency.

E11-14 Baja Airlines is considering these two alternatives for financing the purchase of a fleet of airplanes:

1. Issue 50,000 shares of common stock at $40 per share. (Cash dividends have not been paid nor is the payment of any contemplated.)

2. Issue 12%, 10-year bonds at face value for $2,000,000.

It is estimated that the company will earn $800,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 90,000 shares of common stock outstanding prior to the new financing.

Instructions Determine the effect on net income and earnings per share for (a) issuing stock and (b) issuing bonds. Assume the new shares or new bonds will be outstanding for the entire year.

E11-15 Cabo Company has $1,000,000 in assets and $1,000,000 in stockholders’ equity, with 40,000 shares outstanding the entire year. It has a return on assets of 10%. During 2016, it had net income of $100,000. On January 1, 2017, it issued $400,000 in debt at 4% and immediately repurchased 20,000 shares for $400,000. Management expected that, had it not issued the debt, it would have had net income of $100,000 in 2017.

Calculate ratios to evaluate dividend and earnings performance.

(LO 4), AP

Calculate ratios to evaluate dividend and earnings performance.

(LO 4), AP

Calculate ratios to evaluate profi tability and solvency.

(LO 4), AN

Compare issuance of stock fi nancing to issuance of bond fi nancing.

(LO 4), AN

Compute ratios and interpret.

(LO 4), AN

578 11 Reporting and Analyzing Stockholders’ Equity

Instructions (a) Determine the company’s net income and earnings per share for 2016 and 2017.

(Ignore taxes in your computations.) (b) Compute the company’s return on common stockholders’ equity for 2016 and 2017. (c) Compute the company’s debt to assets ratio for 2016 and 2017. (d) Discuss the impact that the borrowing had on the company’s profi tability and solvency.

Was it a good idea to borrow the money to buy the treasury stock?

*E11-16 On January 1, 2017, Lenne Corporation had $1,200,000 of common stock outstand- ing that was issued at par and retained earnings of $750,000. The company issued 30,000 shares of common stock at par on July 1 and earned net income of $400,000 for the year.

Instructions Journalize the declaration of a 15% stock dividend on December 10, 2017, for the follow- ing two independent assumptions. (a) Par value is $10 and market price is $15. (b) Par value is $5 and market price is $8.

Journalize stock dividends.

(LO 5), AP

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼ ▼

P11-1A Tidal Corporation was organized on January 1, 2017. It is authorized to issue 20,000 shares of 6%, $50 par value preferred stock and 500,000 shares of no-par common stock with a stated value of $1 per share. The following stock transactions were completed during the fi rst year.

Jan. 10 Issued 70,000 shares of common stock for cash at $4 per share. Mar. 1 Issued 12,000 shares of preferred stock for cash at $53 per share. May 1 Issued 120,000 shares of common stock for cash at $6 per share. Sept. 1 Issued 5,000 shares of common stock for cash at $5 per share. Nov. 1 Issued 3,000 shares of preferred stock for cash at $56 per share.

Instructions (a) Journalize the transactions. (b) Post to the stockholders’ equity accounts. (Use T-accounts.) (c) Prepare the paid-in capital portion of the stockholders’ equity section at December 31,

2017.

P11-2A The stockholders’ equity accounts of Cyrus Corporation on January 1, 2017, were as follows.

Preferred Stock (7%, $100 par noncumulative, 5,000 shares authorized) $ 300,000 Common Stock ($4 stated value, 300,000 shares authorized) 1,000,000 Paid-in Capital in Excess of Par Value—Preferred Stock 15,000 Paid-in Capital in Excess of Stated Value—Common Stock 480,000 Retained Earnings 688,000 Treasury Stock (5,000 common shares) 40,000

During 2017, the corporation had the following transactions and events pertaining to its stockholders’ equity.

Feb. 1 Issued 5,000 shares of common stock for $30,000. Mar. 20 Purchased 1,000 additional shares of common treasury stock at $7 per share. Oct. 1 Declared a 7% cash dividend on preferred stock, payable November 1. Nov. 1 Paid the dividend declared on October 1. Dec. 1 Declared a $0.50 per share cash dividend to common stockholders of record on

December 15, payable December 31, 2017. 31 Determined that net income for the year was $280,000. Paid the dividend

declared on December 1.

Journalize stock transactions, post, and prepare paid-in capital section.

(LO 2, 4), AP

Journalize transactions, post, and prepare a stockholders’ equity section; calculate ratios.

(LO 2, 3, 4), AP

PROBLEMS: SET A

Problems: Set A 579

Instructions (a) Journalize the transactions. (Include entries to close net income and dividends to

Retained Earnings.) (b) Enter the beginning balances in the accounts and post the journal entries to the stock-

holders’ equity accounts. (Use T-accounts.) (c) Prepare the stockholders’ equity section of the balance sheet at December 31, 2017. (d) Calculate the payout ratio, earnings per share, and return on common stockholders’

equity. (Note: Use the common shares outstanding on January 1 and December 31 to determine the average shares outstanding.)

P11-3A On December 31, 2016, Jons Company had 1,300,000 shares of $5 par common stock issued and outstanding. At December 31, 2016, stockholders’ equity had the amounts listed here.

Common Stock $6,500,000 Additional Paid-in Capital 1,800,000 Retained Earnings 1,200,000

Transactions during 2017 and other information related to stockholders’ equity accounts were as follows.

1. On January 10, 2017, issued at $107 per share 120,000 shares of $100 par value, 9% cumulative preferred stock.

2. On February 8, 2017, reacquired 15,000 shares of its common stock for $11 per share. 3. On May 9, 2017, declared the yearly cash dividend on preferred stock, payable June

10, 2017, to stockholders of record on May 31, 2017. 4. On June 8, 2017, declared a cash dividend of $1.20 per share on the common stock

outstanding, payable on July 10, 2017, to stockholders of record on July 1, 2017. 5. Net income for the year was $3,600,000.

Instructions Prepare the stockholders’ equity section of Jons’ balance sheet at December 31, 2017.

P11-4A The ledger of Waite Corporation at December 31, 2017, after the books have been closed, contains the following stockholders’ equity accounts.

Preferred Stock (10,000 shares issued) $1,000,000 Common Stock (300,000 shares issued) 1,500,000 Paid-in Capital in Excess of Par Value—Preferred Stock 200,000 Paid-in Capital in Excess of Stated Value—Common Stock 1,600,000 Retained Earnings 2,860,000

A review of the accounting records reveals this information:

1. Preferred stock is 8%, $100 par value, noncumulative. Since January 1, 2016, 10,000 shares have been outstanding; 20,000 shares are authorized.

2. Common stock is no-par with a stated value of $5 per share; 600,000 shares are authorized.

3. The January 1, 2017, balance in Retained Earnings was $2,380,000. 4. On October 1, 60,000 shares of common stock were sold for cash at $9 per share. 5. A cash dividend of $400,000 was declared and properly allocated to preferred and

common stock on November 1. No dividends were paid to preferred stockholders in 2016.

6. Net income for the year was $880,000. 7. On December 31, 2017, the directors authorized disclosure of a $160,000 restriction

of retained earnings for plant expansion. (Use Note A.)

Instructions (a) Reproduce the Retained Earnings account (T-account) for the year. (b) Prepare the stockholders’ equity section of the balance sheet at December 31.

P11-5A Layes Corporation has been authorized to issue 20,000 shares of $100 par value, 7%, noncumulative preferred stock and 1,000,000 shares of no-par common stock. The corporation assigned a $5 stated value to the common stock. At December 31, 2017, the ledger contained the following balances pertaining to stockholders’ equity.

Preferred Stock $ 150,000 Paid-in Capital in Excess of Par Value—Preferred Stock 20,000 Common Stock 2,000,000

Prepare a stockholders’ equity section.

(LO 2, 3, 4), AP

Tot. stockholders’ equity $23,153,000 Reproduce Retained Earnings account, and prepare a stockholders’ equity section.

(LO 3, 4), AP

(b) Tot. paid-in capital $4,300,000

Prepare entries for stock transactions, and prepare a stockholders’ equity section.

(LO 2, 4), AP

580 11 Reporting and Analyzing Stockholders’ Equity

Paid-in Capital in Excess of Stated Value—Common Stock 1,520,000 Treasury Stock (4,000 common shares) 36,000 Retained Earnings 82,000 Accumulated Other Comprehensive Income 51,000

The preferred stock was issued for $170,000 cash. All common stock issued was for cash. In November 4,000 shares of common stock were purchased for the treasury at a per share cost of $9. No dividends were declared in 2017.

Instructions (a) Prepare the journal entries for the following. (1) Issuance of preferred stock for cash. (2) Issuance of common stock for cash. (3) Purchase of common treasury stock for cash. (b) Prepare the stockholders’ equity section of the balance sheet at December 31, 2017.

P11-6A On January 1, 2017, Kimbel Inc. had these stockholders’ equity balances.

Common Stock, $1 par (2,000,000 shares authorized, 600,000 shares issued and outstanding) $ 600,000 Paid-in Capital in Excess of Par Value 1,500,000 Retained Earnings 700,000 Accumulated Other Comprehensive Income 60,000

During 2017, the following transactions and events occurred. 1. Issued 50,000 shares of $1 par value common stock for $3 per share. 2. Issued 60,000 shares of common stock for cash at $4 per share. 3. Purchased 20,000 shares of common stock for the treasury at $3.80 per share. 4. Declared and paid a cash dividend of $207,000. 5. Earned net income of $410,000. 6. Had other comprehensive income of $17,000.

Instructions Prepare the stockholders’ equity section of the balance sheet at December 31, 2017.

P11-7A Spahn Company manufactures backpacks. During 2017, Spahn issued bonds at 10% interest and used the cash proceeds to purchase treasury stock. The following fi nan- cial information is available for Spahn Company for the years 2017 and 2016.

2017 2016

Sales revenue $ 9,000,000 $ 9,000,000 Net income 2,240,000 2,500,000 Interest expense 500,000 140,000 Tax expense 670,000 750,000 Dividends paid on common stock 890,000 1,026,000 Dividends paid on preferred stock 300,000 300,000 Total assets (year-end) 14,500,000 16,875,000 Average total assets 15,687,500 17,763,000 Total liabilities (year-end) 6,000,000 3,000,000 Avg. total common stockholders’ equity 9,400,000 14,100,000

Instructions (a) Use the information above to calculate the following ratios for both years: (1) return

on assets, (2) return on common stockholders’ equity, (3) payout ratio, (4) debt to assets ratio, and (5) times interest earned.

(b) Referring to your fi ndings in part (a), discuss the changes in the company’s profi tabil- ity from 2016 to 2017.

(d) Based on your fi ndings in (b), was the decision to issue debt to purchase common stock a wise one?

*P11-8A On January 1, 2017, Tacoma Corporation had these stockholders’ equity accounts.

Common Stock ($10 par value, 70,000 shares issued and outstanding) $700,000 Paid-in Capital in Excess of Par Value 500,000 Retained Earnings 620,000

During the year, the following transactions occurred.

(b) Tot. stockholders’ equity $3,787,000

Prepare a stockholders’ equity section.

(LO 2, 3, 4), AP

Tot. stockholders’ equity $3,394,000

Evaluate a company’s profi tability and solvency.

(LO 4), AP

Prepare dividend entries, prepare a stockholders’ equity section, and calculate ratios.

(LO 3, 4, 5), AP

Comprehensive Accounting Cycle Review 581

COMPREHENSIVE ACCOUNTING CYCLE REVIEW ACR11-1 Hawkeye Corporation’s balance sheet at December 31, 2016, is presented below.

HAWKEYE CORPORATION Balance Sheet

December 31, 2016

Cash $ 24,600 Accounts payable $ 25,600 Accounts receivable 45,500 Common stock ($10 par) 80,000 Allowance for doubtful Retained earnings 127,400 accounts (1,500) $233,000 Supplies 4,400 Land 40,000 Buildings 142,000 Accumulated depreciation— buildings (22,000)

$233,000

Journalize transactions and prepare fi nancial statements.

(LO 2, 3, 4), AP

Jan. 15 Declared a $0.50 cash dividend per share to stockholders of record on January 31, payable February 15.

Feb. 15 Paid the dividend declared in January. Apr. 15 Declared a 10% stock dividend to stockholders of record on April 30, distribut-

able May 15. On April 15, the market price of the stock was $14 per share. May 15 Issued the shares for the stock dividend. Dec. 1 Declared a $0.60 per share cash dividend to stockholders of record on Decem-

ber 15, payable January 10, 2018. 31 Determined that net income for the year was $400,000.

Instructions (a) Journalize the transactions. (Include entries to close net income and dividends to

Retained Earnings.) (b) Enter the beginning balances and post the entries to the stockholders’ equity T-accounts.

(Note: Open additional stockholders’ equity accounts as needed.) (c) Prepare the stockholders’ equity section of the balance sheet at December 31. (d) Calculate the payout ratio and return on common stockholders’ equity.

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 10.)

CC11 Part 1 Because Natalie has been so successful with Cookie Creations and her friend Curtis Lesperance has been just as successful with his coffee shop, they conclude that they could benefi t from each other’s business expertise. Curtis and Natalie next evaluate the different types of business organization. Because of the advantage of limited personal liability, they decide to form a corporation. Natalie and Curtis are very excited about this new business venture. They come to you with information they have gathered about their companies and with a number of questions.

Part 2 After establishing their company’s fi scal year to be October 31, Natalie and Curtis began operating Cookie & Coffee Creations Inc. on November 1, 2017. On that date, they issued both preferred and common stock. Natalie and Curtis now want to prepare fi nan- cial information for the fi rst year of operations.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to find the com- pletion of this problem.

CONTINUING PROBLEM Cookie Creations▼

582 11 Reporting and Analyzing Stockholders’ Equity

During 2017, the following transactions occurred.

1. On January 1, 2017, Hawkeye issued 1,200 shares of $40 par, 7% preferred stock for $49,200.

2. On January 1, 2017, Hawkeye also issued 900 shares of the $10 par value common stock for $21,000.

3. Hawkeye performed services for $320,000 on account. 4. On April 1, 2017, Hawkeye collected fees of $36,000 in advance for services to be per-

formed from April 1, 2017, to March 31, 2018. 5. Hawkeye collected $276,000 from customers on account. 6. Hawkeye bought $35,100 of supplies on account. 7. Hawkeye paid $32,200 on accounts payable. 8. Hawkeye reacquired 400 shares of its common stock on June 1, 2017, for $28 per share. 9. Paid other operating expenses of $188,200. 10. On December 31, 2017, Hawkeye declared the annual preferred stock dividend and a

$1.20 per share dividend on the outstanding common stock, all payable on January 15, 2018.

11. An account receivable of $1,700 which originated in 2016 is written off as uncollectible.

Adjustment data:

1. A count of supplies indicates that $5,900 of supplies remain unused at year-end. 2. Recorded revenue from item 4 above. 3. The allowance for doubtful accounts should have a balance of $3,500 at year end. 4. Depreciation is recorded on the building on a straight-line basis based on a 30-year

life and a salvage value of $10,000. 5. The income tax rate is 30%. (Hint: Prepare the income statement up to income before

taxes and multiply by 30% to compute the amount.)

Instructions (You may want to set up T-accounts to determine ending balances.)

(a) Prepare journal entries for the transactions listed above and adjusting entries. (b) Prepare an adjusted trial balance at December 31, 2017. (c) Prepare an income statement and a retained earnings statement for the year ending

December 31, 2017, and a classifi ed balance sheet as of December 31, 2017.

ACR11-2 Karen Noonan opened Clean Sweep Inc. on February 1, 2017. During February, the following transactions were completed.

Feb. 1 Issued 5,000 shares of Clean Sweep common stock for $13,000. Each share has a $1.50 par.

1 Borrowed $8,000 on a 2-year, 6% note payable. 1 Paid $9,020 to purchase used floor and window cleaning equipment from a

company going out of business ($4,820 was for the floor equipment and $4,200 for the window equipment).

1 Paid $220 for February Internet and phone services. 3 Purchased cleaning supplies for $980 on account. 4 Hired 4 employees. Each will be paid $480 per 5-day work week (Monday–

Friday). Employees will begin working Monday, February 9. 5 Obtained insurance coverage for $9,840 per year. Coverage runs from February 1,

2017, through January 31, 2018. Karen paid $2,460 cash for the first quarter of coverage.

5 Discussions with the insurance agent indicated that providing outside window cleaning services would cost too much to insure. Karen sold the window cleaning equipment for $3,950 cash.

16 Billed customers $3,900 for cleaning services performed through February 13, 2017.

17 Received $540 from a customer for 4 weeks of cleaning services to begin February 21, 2017. (By paying in advance, this customer received 10% off the normal weekly fee of $150.)

18 Paid $300 on amount owed on cleaning supplies. 20 Paid $3 per share to buy 300 shares of Clean Sweep common stock from a

shareholder who disagreed with management goals. The shares will be held as treasury shares.

23 Billed customers $4,300 for cleaning services performed through February 20.

(b) Totals $740,690 (c) Net income $81,970

Tot. assets $421,000

Journalize transactions and prepare fi nancial statements.

(LO 2, 3, 4), AP

24 Paid cash for employees’ wages for 2 weeks (February 9–13 and 16–20). 25 Collected $2,500 cash from customers billed on February 16. 27 Paid $220 for Internet and phone services for March. 28 Declared and paid a cash dividend of $0.20 per share.

Instructions

(a) Journalize the February transactions. (You do not need to include an explanation for each journal entry.)

(b) Post to the ledger accounts (Use T-accounts.) (c) Prepare a trial balance at February 28, 2017. (d) Journalize the following adjustments. (Round all amounts to whole dollars.) (1) Services performed for customers through February 27, 2017, but unbilled and

uncollected were $3,800. (2) Received notice that a customer who was billed $200 for services performed

February 10 has fi led for bankruptcy. Clean Sweep does not expect to collect any portion of this outstanding receivable.

(3) Clean Sweep uses the allowance method to estimate bad debts. Clean Sweep estimates that 3% of its month-end receivables will not be collected.

(4) Record 1 month of depreciation for the fl oor equipment. Use the straight-line method, an estimated life of 4 years, and $500 salvage value.

(5) Record 1 month of insurance expense. (6) An inventory count shows $400 of supplies on hand at February 28. (7) One week of services were performed for the customer who paid in advance on

February 17. (8) Accrue for wages owed through February 28, 2017. (9) Accrue for interest expense for 1 month. (10) Karen estimates a 20% income tax rate. (Hint: Prepare an income statement up

to “income before taxes” to help with the income tax calculation.) (e) Post adjusting entries to the T-accounts. (f) Prepare an adjusted trial balance. (g) Prepare a multiple-step income statement, a retained earnings statement, and a

properly classifi ed balance sheet as of February 28, 2017. (h) Journalize closing entries.

Expand Your Critical Thinking 583

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT11-1 The stockholders’ equity section of Apple Inc.’s balance sheet is shown in the Con- solidated Statement of Financial Position in Appendix A. Instructions for accessing and using the company’s complete annual report, including the notes to its fi nancial state- ments, are also provided in Appendix A.

Instructions Answer the following questions.

(a) What is the par or stated value per share of Apple’s common stock? (b) What percentage of Apple’s authorized common stock was issued at September 27,

2014? (Round to the nearest full percent.) (c) How many shares of common stock were outstanding at September 28, 2013, and at

September 27, 2014? (d) Calculate the payout ratio, earnings per share, and return on common stockholders’

equity for 2014.

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT11-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information in these financial statements, compute the 2014 return on

common stockholders’ equity, debt to assets ratio, and return on assets for each company.

Financial Reporting

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Financial Reporting

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(g) Net income $3,117 Tot. assets $26,101

(b) What conclusions concerning the companies’ profitability can be drawn from these ratios? Which company relies more on debt to boost its return to common shareholders?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT11-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Finan- cial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information in these financial statements, compute the 2014 return

on common stockholders’ equity, debt to assets ratio, and return on assets for each company.

(b) What conclusions concerning the companies’ profitability can be drawn from these ratios? Which company relies more on debt to boost its return to common shareholders?

INTERPRETING FINANCIAL STATEMENTS

CT11-4 Marriott Corporation split into two companies: Host Marriott Corporation and Marriott International. Host Marriott retained ownership of the corporation’s vast hotel and other properties, while Marriott International, rather than owning hotels, managed them. The purpose of this split was to free Marriott International from the “baggage” asso- ciated with Host Marriott, thus allowing it to be more aggressive in its pursuit of growth. The following information (in millions) is provided for each corporation for their fi rst full year operating as independent companies.

Host Marriott Marriott International

Sales revenue $1,501 $8,415 Net income (25) 200 Total assets 3,822 3,207 Total liabilities 3,112 2,440 Common stockholders’ equity 710 767

Instructions (a) The two companies were split by the issuance of shares of Marriott International to all

shareholders of the previous combined company. Discuss the nature of this transaction. (b) Calculate the debt to assets ratio for each company. (c) Calculate the return on assets and return on common stockholders’ equity for each

company. (d) The company’s debtholders were fiercely opposed to the original plan to split the two

companies because the original plan had Host Marriott absorbing the majority of the company’s debt. They relented only when Marriott International agreed to absorb a larger share of the debt. Discuss the possible reasons the debtholders were opposed to the plan to split the company.

REAL-WORLD FOCUS

CT11-5 Purpose: Use the stockholders’ equity section of an annual report and identify the major components.

Address: www.annualreports.com

Steps 1. Select a particular company. 2. Search by company name. 3. Follow instructions below.

Instructions Answer the following questions.

(a) What is the company’s name? (b) What classes of capital stock has the company issued?

Financial Analysis

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Financial Analysis

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584 11 Reporting and Analyzing Stockholders’ Equity

(c) For each class of stock: (1) How many shares are authorized, issued, and/or outstanding? (2) What is the par value? (d) What are the company’s retained earnings? (e) Has the company acquired treasury stock? How many shares?

DECISION-MAKING ACROSS THE ORGANIZATION

CT11-6 During a recent period, the fast-food chain Wendy’s International purchased many treasury shares. This caused the number of shares outstanding to fall from 124 mil- lion to 105 million. The following information was drawn from the company’s fi nancial statements (in millions).

Information for the Information for the Year after Purchase Year before Purchase of Treasury Stock of Treasury Stock

Net income $ 193.6 $ 123.4 Total assets 2,076.0 1,837.9 Average total assets 2,016.9 1,889.8 Total common stockholders’ equity 1,029.8 1,068.1 Average common stockholders’ equity 1,078.0 1,126.2 Total liabilities 1,046.3 769.9 Average total liabilities 939.0 763.7 Interest expense 30.2 19.8 Income taxes 113.7 84.3 Cash provided by operations 305.2 233.8 Cash dividends paid on common stock 26.8 31.0 Preferred stock dividends 0 0 Average number of common shares outstanding 109.7 119.9

Instructions Use the information provided to answer the following questions.

(a) Compute earnings per share, return on common stockholders’ equity, and return on assets for both years. Discuss the change in the company’s profitability over this period.

(b) Compute the dividend payout ratio. Also compute the average cash dividend paid per share of common stock (dividends paid divided by the average number of common shares outstanding). Discuss any change in these ratios during this period and the implications for the company’s dividend policy.

(d) Based on your findings in (a) and (c), discuss to what extent any change in the return on common stockholders’ equity was the result of increased reliance on debt.

(e) Does it appear that the purchase of treasury stock and the shift toward more reliance on debt were wise strategic moves?

COMMUNICATION ACTIVITY

CT11-7 Earl Kent, your uncle, is an inventor who has decided to incorporate. Uncle Earl knows that you are an accounting major at U.N.O. In a recent letter to you, he ends with the question, “I’m fi lling out a state incorporation application. Can you tell me the differ- ence among the following terms: (1) authorized stock, (2) issued stock, (3) outstanding stock, and (4) preferred stock?”

Instructions In a brief note, differentiate for Uncle Earl the four different stock terms. Write the letter to be friendly, yet professional.

ETHICS CASES

CT11-8 The R&D division of Pele Corp. has just developed a chemical for sterilizing the vicious Brazilian “killer bees” which are invading Mexico and the southern United States. The president of Pele is anxious to get the chemical on the market because Pele profi ts need a boost—and his job is in jeopardy because of decreasing sales and profi ts. Pele has

Financial Analysis

Writing

Group Project

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Expand Your Critical Thinking 585

an opportunity to sell this chemical in Central American countries, where the laws are much more relaxed than in the United States. The director of Pele’s R&D division strongly recommends further research in the labora- tory to test the side effects of this chemical on other insects, birds, animals, plants, and even humans. He cautions the president, “We could be sued from all sides if the chemical has tragic side effects that we didn’t even test for in the lab.” The president answers, “We can’t wait an additional year for your lab tests. We can avoid losses from such lawsuits by establishing a separate wholly owned corporation to shield Pele Corp. from such lawsuits. We can’t lose any more than our investment in the new corporation, and we’ll invest just the patent covering this chemical. We’ll reap the benefi ts if the chemical works and is safe, and avoid the losses from lawsuits if it’s a disaster.” The following week, Pele creates a new wholly owned corpora- tion called Cabo Inc., sells the chemical patent to it for $10, and watches the spraying begin.

Instructions (a) Who are the stakeholders in this situation? (b) Are the president’s motives and actions ethical? (c) Can Pele shield itself against losses of Cabo Inc.?

CT11-9 Cooper Corporation has paid 60 consecutive quarterly cash dividends (15 years). The last 6 months have been a real cash drain on the company, however, as profi t margins have been greatly narrowed by increasing competition. With a cash balance suffi cient to meet only day-to-day operating needs, the president, Sonny Boyd, has decided that a stock dividend instead of a cash dividend should be declared. He tells Cooper’s fi nancial vice president, Dana Marks, to issue a press release stating that the company is extending its consecutive dividend record with the issuance of a 5% stock dividend. “Write the press release convincing the stock- holders that the stock dividend is just as good as a cash dividend,” he orders. “Just watch our stock rise when we announce the stock dividend; it must be a good thing if that happens.”

Instructions (a) Who are the stakeholders in this situation? (b) Is there anything unethical about president Boyd’s intentions or actions? (c) What is the effect of a stock dividend on a corporation’s stockholders’ equity accounts?

Which would you rather receive as a stockholder—a cash dividend or a stock dividend? Why?

ALL ABOUT YOU

CT11-10 In response to the Sarbanes-Oxley Act, many companies have implemented formal ethics codes. Many other organizations also have ethics codes.

Instructions Obtain the ethics code from an organization that you belong to (e.g., student organization, business school, employer, or a volunteer organization). Evaluate the ethics code based on how clearly it identifi es proper and improper behavior. Discuss its strengths, and how it might be improved.

FASB CODIFICATION ACTIVITY

CT11-11 If your school has a subscription to the FASB Codifi cation, go to http://aaahq. org/ascLogin.cfm to log in and prepare responses to the following.

(a) What is the stock dividend? (b) What is a stock split? (c) At what percentage point does the issuance of additional shares qualify as a stock divi-

dend, as opposed to a stock split?

CONSIDERING PEOPLE, PLANET, AND PROFIT

CT11-12 The January 19, 2012, edition of the Wall Street Journal contains an article by Angus Loten entitled “With New Law, Profi ts Take a Back Seat.”

Instructions Read the article and answer the following questions.

(a) Summarize the nature of the new law that is discussed in the article. (b) What do some proponents of the law say is the “biggest value” of the law? How does

the article say that this would have impacted Ben & Jerry’s?

586 11 Reporting and Analyzing Stockholders’ Equity

(c) What are some criticisms of the law? (d) How does incorporation as a benefit corporation differ from B Corp certification? (e) What are some of the companies that the article cites as either having adopted benefit

corporation standing or are considering it?

A Look at IFRS 587

The accounting for transactions related to stockholders’ equity, such as issuance of shares and purchase of treasury stock, are similar under both IFRS and GAAP. Major differences relate to terminology used, introduction of items such as revaluation surplus, and presen- tation of stockholders’ equity information.

KEY POINTS Following are the key similarities and differences between GAAP and IFRS as related to stockholders’ equity, dividends, retained earnings, and income reporting.

Similarities • Aside from the terminology used, the accounting transactions for the issuance of

shares and the purchase of treasury stock are similar. • Like GAAP, IFRS does not allow a company to record gains or losses on purchases of

its own shares. • The accounting related to prior period adjustment is essentially the same under IFRS

and GAAP. • The income statement using IFRS is called the statement of comprehensive income.

A statement of comprehensive income is presented in a one- or two-statement format. The single-statement approach includes all items of income and expense, as well as each component of other comprehensive income or loss by its individual character- istic. In the two-statement approach, a traditional income statement is prepared. It is then followed by a statement of comprehensive income, which starts with net income or loss and then adds other comprehensive income or loss items. Regardless of which approach is reported, income tax expense is required to be reported.

• The computations related to earnings per share are essentially the same under IFRS and GAAP.

Differences • Under IFRS, the term reserves is used to describe all equity accounts other than those

arising from contributed (paid-in) capital. This would include, for example, reserves related to retained earnings, asset revaluations, and fair value differences.

• Many countries have a different mix of investor groups than in the United States. For example, in Germany, financial institutions like banks are not only major creditors of corporations but often are the largest corporate stockholders as well. In the United States, Asia, and the United Kingdom, many companies rely on substantial investment from private investors.

• There are often terminology differences for equity accounts. The following summarizes some of the common differences in terminology.

LEARNING OBJECTIVE 6 Compare the accounting for stockholders’ equity under GAAP and IFRS.▼

A Look at IFRS

588 11 Reporting and Analyzing Stockholders’ Equity

GAAP IFRS

Common stock Share capital—ordinary Stockholders Shareholders Par value Nominal or face value Authorized stock Authorized share capital Preferred stock Share capital—preference Paid-in capital Issued/allocated share capital Paid-in capital in excess of par— Share premium—ordinary common stock Paid-in capital in excess of par— Share premium—preference preferred stock Retained earnings Retained earnings or Retained profits Retained earnings deficit Accumulated losses Accumulated other comprehensive income General reserve and other reserve

accounts

As an example of how similar transactions use different terminology under IFRS, consider the accounting for the issuance of 1,000 shares of $1 par value common stock for $5 per share. Under IFRS, the entry is as follows.

Cash 5,000 Share Capital—Ordinary 1,000 Share Premium—Ordinary 4,000

• A major difference between IFRS and GAAP relates to the account Revaluation Surplus. Revaluation surplus arises under IFRS because companies are permitted to revalue their property, plant, and equipment to fair value under certain circumstances. This account is part of general reserves under IFRS and is not considered contributed capital.

• IFRS often uses terms such as retained profits or accumulated profit or loss to describe retained earnings. The term retained earnings is also often used.

• Equity is given various descriptions under IFRS, such as shareholders’ equity, owners’ equity, capital and reserves, and shareholders’ funds.

LOOKING TO THE FUTURE The IASB and the FASB are currently working on a project related to financial statement presentation. An important part of this study is to determine whether certain line items, subtotals, and totals should be clearly defined and required to be displayed in the financial statements. For example, it is likely that the statement of stockholders’ equity and its presentation will be examined closely.

Both the IASB and FASB are working toward convergence of any remaining differ- ences related to earnings per share computations. This convergence will deal with highly technical changes beyond the scope of this textbook.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. Which of the following is true?

(a) In the United States, the primary corporate stockholders are financial institutions. (b) Share capital means total assets under IFRS. (c) The IASB and FASB are presently studying how financial statement information

should be presented. (d) The accounting for treasury stock differs extensively between GAAP and IFRS.

2. Under IFRS, the amount of capital received in excess of par value would be credited to: (a) Retained Earnings. (c) Share Premium. (b) Contributed Capital. (d) Par value is not used under IFRS.

3. Which of the following is false? (a) Under GAAP, companies cannot record gains on transactions involving their own

shares. (b) Under IFRS, companies cannot record gains on transactions involving their own

shares. (c) Under IFRS, the statement of stockholders’ equity is a required statement. (d) Under IFRS, a company records a revaluation surplus when it experiences an

increase in the price of its common stock.

A Look at IFRS 589

4. Which of the following does not represent a pair of GAAP/IFRS-comparable terms? (a) Additional paid-in capital/Share premium. (b) Treasury stock/Repurchase reserve. (c) Common stock/Share capital. (d) Preferred stock/Preference shares.

5. The basic accounting for cash dividends and stock dividends: (a) is different under IFRS versus GAAP. (b) is the same under IFRS and GAAP. (c) differs only for the accounting for cash dividends between GAAP and IFRS. (d) differs only for the accounting for stock dividends between GAAP and IFRS.

6. Which item in not considered part of reserves? (a) Unrealized loss on available-for-sale investments. (c) Retained earnings. (b) Revaluation surplus. (d) Issued shares.

7. Under IFRS, a statement of comprehensive income must include: (a) accounts payable. (c) income tax expense. (b) retained earnings. (d) preference stock.

8. Which set of terms can be used to describe total stockholders’ equity under IFRS? (a) Shareholders’ equity, capital and reserves, other comprehensive income. (b) Capital and reserves, shareholders’ equity, shareholders’ funds. (c) Capital and reserves, retained earnings, shareholders’ equity. (d) All of the answer choices are correct.

9. Earnings per share computations related to IFRS and GAAP: (a) are essentially similar. (b) result in an amount referred to as earnings per share. (c) must deduct preferred (preference) dividends when computing earnings per share. (d) All of the answer choices are correct.

IFRS EXERCISES IFRS11-1 On May 10, Jaurez Corporation issues 1,000 shares of $10 par value ordinary shares for cash at $18 per share. Journalize the issuance of the shares.

IFRS11-2 Meenen Corporation has the following accounts at December 31, 2017 (in euros): Share Capital—Ordinary, €10 par, 5,000 shares issued, €50,000; Share Premium— Ordinary €10,000; Retained Earnings €45,000; and Treasury Shares—Ordinary, 500 shares, €11,000. Prepare the equity section of the statement of financial position (balance sheet).

IFRS11-3 Overton Co. had the following transactions during the current period.

Mar. 2 Issued 5,000 shares of $1 par value ordinary shares to attorneys in payment of a bill for $30,000 for services performed in helping the company to incorporate.

June 12 Issued 60,000 shares of $1 par value ordinary shares for cash of $375,000. July 11 Issued 1,000 shares of $100 par value preference shares for cash at $110 per share. Nov. 28 Purchased 2,000 treasury shares for $80,000.

Instructions Journalize the above transactions.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS11-4 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Use the company’s annual report to answer the following questions.

(a) Determine the following amounts at December 31, 2014: (1) total equity, (2) total revaluation reserve, and (3) number of treasury shares.

(b) Examine the equity section of the company’s balance sheet. For each of the following, provide the comparable label that would be used under GAAP: (1) share capital, (2) share premium, and (3) net profit, group share.

(c) Did the company declare and pay any dividends for the year ended December 31, 2014? (d) Compute the company’s return on ordinary shareholders’ equity for the year ended

December 31, 2014. (e) What was Louis Vuitton’s earnings per share for the year ended December 31, 2014?

Answers to IFRS Self-Test Questions 1. c 2. c 3. d 4. b 5. b 6. d 7. c 8. b 9. d

The balance sheet, income statement, and retained earnings statement do not always show the

whole picture of the fi nancial condition of a company or institution. In fact, looking at the fi nancial

statements of some well-known companies, a thoughtful investor might ask questions like these:

How did Eastman Kodak fi nance cash dividends of $649 million in a year in which it earned only

$17 million? How could United Air Lines purchase new planes that cost $1.9 billion in a year in

which it reported a net loss of over $2 billion? How did the companies that spent a combined

fantastic $3.4 trillion on mergers and acquisitions in a recent year fi nance those deals? Answers to

these and similar questions can be found in this chapter, which presents the statement of cash fl ows.

CHAPTER PREVIEW

Statement of Cash Flows 12

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

▼1 Discuss the usefulness and format of the statement of cash fl ows.

• Usefulness of the statement of cash fl ows

• Classifi cation of cash fl ows • Signifi cant noncash activities • Format of the statement of

cash fl ows

DO IT!

Cash Flow Activities

▼2 Prepare a statement of cash fl ows using the indirect method.

• Indirect and direct methods • Indirect method—Computer

Services Company • Step 1: Operating activities • Summary of conversion to

net cash provided by operating activities

• Step 2: Investing and fi nancing activities

• Step 3: Net change in cash

DO IT!

2 2a Net Cash Provided by

Operating Activities 2b Indirect Method

▼3 Use the statement of cash fl ows to evaluate a company.

• The corporate life cycle • Free cash fl ow

DO IT!

Free Cash Flow

Companies must be ready to respond to changes quickly in order to survive and thrive. This requires careful management of cash. One company that managed cash successfully in its early years was Microsoft. During those years, the company paid much of its payroll by giving employees stock options (rights to purchase company stock in the future at a given price) instead of cash. This conserved cash and turned more than a thousand of its employees into millionaires.

In recent years, Microsoft has had a different kind of cash problem. Now that it has reached a more “mature” stage in life, it generates so much cash— roughly $1 billion per month—that it cannot always fi gure out what to do with it. At one time, Microsoft had accumulated $60 billion.

The company said it was accumulating cash to invest in new opportunities, buy other companies, and pay off pending lawsuits. Microsoft’s stockholders complained that holding all this cash was putting a drag on the company’s profi tability. Why? Because Microsoft had the cash invested in very low-yielding government securities. Stockholders felt that the company either should fi nd new investment projects that would bring higher returns, or return some of the cash to stockholders.

Finally, Microsoft announced a plan to return cash to stockholders by paying a special one-time $32 billion dividend. This special dividend was so large that,

according to the U.S. Commerce Department, it caused total personal income in the United States to rise by 3.7% in one month—the largest increase ever recorded by the agency. (It also made the holiday season brighter, especially for retailers in the Seattle area.) Microsoft also doubled its regular annual dividend to $3.50

per share. Further, it announced that it would spend another $30 billion buying treasury stock.

Apple has also encountered this cash “problem.” Apple recently had nearly $100 billion in liquid assets (cash, cash equivalents, and investment securities). It was generating $37 billion of cash per year from its operat- ing activities but spending only about $7 billion on plant assets and purchases of patents. In response to shareholder pressure, Apple announced that it would begin to pay a quarterly dividend of $2.65 per share and buy back up to $10 billion of its stock. Analysts noted that the dividend consumes only $10 billion of cash per year. This leaves Apple wallowing in cash. The rest of us should have such problems.

Source: “Business: An End to Growth? Microsoft’s Cash Bonanza,” The Economist (July 23, 2005), p. 61.

FEATURE STORY

Got Cash?

TonyV3112/Shutterstock

592 12 Statement of Cash Flows

LEARNING OBJECTIVE 1 Discuss the usefulness and format of the statement of cash fl ows.▼

The balance sheet, income statement, and retained earnings statement provide only limited information about a company’s cash fl ows (cash receipts and cash payments). For example, comparative balance sheets show the increase in prop- erty, plant, and equipment during the year. But, they do not show how the addi- tions were fi nanced or paid for. The income statement shows net income. But, it does not indicate the amount of cash generated by operating activities. The retained earnings statement shows cash dividends declared but not the cash divi- dends paid during the year. None of these statements presents a detailed sum- mary of where cash came from and how it was used.

USEFULNESS OF THE STATEMENT OF CASH FLOWS

The statement of cash fl ows reports the cash receipts and cash payments from operating, investing, and fi nancing activities during a period, in a format that reconciles the beginning and ending cash balances. The information in a state- ment of cash fl ows helps investors, creditors, and others assess the following.

1. The entity’s ability to generate future cash fl ows. By examining relation- ships between items in the statement of cash fl ows, investors make predic- tions of the amounts, timing, and uncertainty of future cash fl ows better than they can from accrual-basis data.

2. The entity’s ability to pay dividends and meet obligations. If a company does not have adequate cash, it cannot pay employees, settle debts, or pay divi- dends. Employees, creditors, and stockholders should be particularly interested in this statement because it alone shows the fl ows of cash in a business.

3. The reasons for the difference between net income and net cash pro- vided (used) by operating activities. Net income provides information on the success or failure of a business enterprise. However, some fi nancial state- ment users are critical of accrual-basis net income because it requires many estimates. As a result, users often challenge the reliability of the number. Such is not the case with cash. Many readers of the statement of cash fl ows want to know the reasons for the difference between net income and net cash provided by operating activities. Then they can assess for themselves the reli- ability of the income number.

4. The cash investing and fi nancing transactions during the period. By examining a company’s investing and fi nancing transactions, a fi nancial statement reader can better understand why assets and liabilities changed during the period.

CLASSIFICATION OF CASH FLOWS

The statement of cash fl ows classifi es cash receipts and cash payments as operat- ing, investing, and fi nancing activities. Transactions and other events character- istic of each kind of activity are as follows.

1. Operating activities include the cash effects of transactions that create revenues and expenses. They thus enter into the determination of net income.

2. Investing activities include (a) cash transactions that involve the purchase or disposal of investments and property, plant, and equipment, and (b) lend- ing money and collecting the loans.

3. Financing activities include (a) obtaining cash from issuing debt and repay- ing the amounts borrowed, and (b) obtaining cash from stockholders, repur- chasing shares, and paying dividends.

ETHICS NOTE Though we would discourage reliance on cash fl ows to the

exclusion of accrual accounting, comparing net cash provided by operating activities to net income can reveal important

information about the “quality” of reported net income. Such

a comparison can reveal the extent to which net income

provides a good measure of actual performance.

▼

Usefulness and Format of the Statement of Cash Flows 593

The operating activities category is the most important. It shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company’s ability to generate suffi cient cash to continue as a going concern. Illustration 12-1 lists typical cash receipts and cash payments within each of the three classifi cations. Study the list carefully. It will be very useful in solving homework exercises and problems.

Operating activities

Investing activities

BONDST OCK

Financing activities

CANDY TIME

ILLUSTRATION 12-1 Typical receipt and payment classifi cations

Types of Cash Infl ows and Outfl ows

Operating activities—Income statement items Cash infl ows: From sale of goods or services. From interest received and dividends received. Cash outfl ows: To suppliers for inventory. To employees for wages. To government for taxes. To lenders for interest. To others for expenses.

Investing activities—Changes in investments and long-term assets Cash infl ows: From sale of property, plant, and equipment. From sale of investments in debt or equity securities of other entities. From collection of principal on loans to other entities. Cash outfl ows: To purchase property, plant, and equipment. To purchase investments in debt or equity securities of other entities. To make loans to other entities.

Financing activities—Changes in long-term liabilities and stockholders’ equity Cash infl ows: From sale of common stock. From issuance of debt (bonds and notes). Cash outfl ows: To stockholders as dividends. To redeem long-term debt or reacquire capital stock (treasury stock).

Note the following general guidelines:

1. Operating activities involve income statement items.

2. Investing activities involve cash fl ows resulting from changes in investments and long-term asset items.

3. Financing activities involve cash fl ows resulting from changes in long-term liability and stockholders’ equity items.

Companies classify as operating activities some cash fl ows related to investing or fi nancing activities. For example, receipts of investment revenue (interest and dividends) are classifi ed as operating activities. So are payments of interest to lend- ers. Why are these considered operating activities? Because companies report these items in the income statement, where results of operations are shown.

SIGNIFICANT NONCASH ACTIVITIES

Not all of a company’s signifi cant activities involve cash. Examples of signifi cant noncash activities are:

1. Direct issuance of common stock to purchase assets.

2. Conversion of bonds into common stock.

3. Direct issuance of debt to purchase assets.

4. Exchanges of plant assets.

INTERNATIONAL NOTE The statement of cash fl ows is very similar under GAAP and IFRS. One difference is that, under IFRS, noncash investing and fi nancing activities are not reported in the statement of cash fl ows but instead are reported in the notes to the fi nancial statements.

594 12 Statement of Cash Flows

Darren McCollester/Getty Images, Inc.

Companies do not report in the body of the statement of cash fl ows signifi cant fi nancing and investing activities that do not affect cash. Instead, they report these activities in either a separate schedule at the bottom of the statement of cash fl ows or in a separate note or supplementary schedule to the fi nancial statements. The reporting of these noncash activities in a separate schedule satisfi es the full disclosure principle. In solving homework assignments, you should present signifi cant noncash investing and fi nancing activities in a separate schedule at the bottom of the state- ment of cash fl ows. (See the last entry in Illustration 12-2 for an example.)

▼ HELPFUL HINT Do not include noncash investing and fi nancing activities in the body of the statement of cash fl ows. Report this information in a separate schedule below the statement of cash fl ows.

Net What?

Net income is not the same as net cash provided by operating activities. Below are some results from recent annual reports (dollars in millions), including Target Corporation. Note how the numbers differ greatly across the list even though all these companies engage in retail merchandising.

Net Cash Provided by Company Net Income Operating Activities

Kohl’s Corporation $ 889 $ 1,884 Wal-Mart Stores, Inc. 16,669 25,591 J. C. Penney Company, Inc. (1,388) (1,814) Costco Wholesale Corp. 20,391 3,437 Target Corporation 1,971 6,520

In general, why do differences exist between net income and net cash provided by operating activities? (Go to WileyPLUS for this answer and additional questions.)

ACCOUNTING ACROSS THE ORGANIZATION Target Corporation

FORMAT OF THE STATEMENT OF CASH FLOWS

The general format of the statement of cash fl ows presents the results of the three activities discussed previously—operating, investing, and fi nancing—plus the signifi cant noncash investing and fi nancing activities. Illustration 12–2 shows a widely used form of the statement of cash fl ows.

ILLUSTRATION 12-2 Format of statement of cash fl ows

COMPANY NAME Statement of Cash Flows For the Period Covered

Cash fl ows from operating activities (List of individual items) XX

Net cash provided (used) by operating activities XXX Cash fl ows from investing activities (List of individual infl ows and outfl ows) XX

Net cash provided (used) by investing activities XXX Cash fl ows from fi nancing activities (List of individual infl ows and outfl ows) XX

Net cash provided (used) by fi nancing activities XXX Net increase (decrease) in cash XXX Cash at beginning of period XXX

Cash at end of period XXX

Noncash investing and fi nancing activities (List of individual noncash transactions) XXX

Preparing a Statement of Cash Flows—Indirect Method 595

The cash fl ows from operating activities section always appears fi rst, fol- lowed by the investing activities section and then the fi nancing activities section. The sum of the operating, investing, and fi nancing activities sections equals the net increase or decrease in cash for the period. This amount is added to the beginning cash balance to arrive at the ending cash balance—the same amount reported on the balance sheet.

1▼ Cash Flow ActivitiesDO IT! Action Plan ✔ Identify the three types of

activities used to report all cash infl ows and outfl ows.

✔ Report as operating activities the cash effects of transactions that create revenues and expenses and enter into the determination of net income.

✔ Report as investing activi- ties transactions that (a) acquire and dispose of investments and productive long-lived assets and (b) lend money and collect loans.

✔ Report as fi nancing activities transactions that (a) obtain cash from issuing debt and repay the amounts borrowed and (b) obtain cash from stockholders and pay them dividends.

SOLUTION 1. Financing activity 4. Operating activity

2. Financing activity 5. Operating activity

3. Investing activity

During its fi rst week, Duffy & Stevenson Company had these transactions.

1. Issued 100,000 shares of $5 par value common stock for $800,000 cash.

2. Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest.

3. Purchased two semi-trailer trucks for $170,000 cash.

4. Paid employees $12,000 for salaries and wages.

5. Collected $20,000 cash for services performed.

Classify each of these transactions by type of cash fl ow activity. (Hint: Refer to Illustration 12-1.)

Related exercise material: BE12-1, BE12-2, BE12-3, DO IT! 12-1, E12-1, and E12-2.

LEARNING OBJECTIVE 2 Prepare a statement of cash fl ows using the indirect method.▼

Companies prepare the statement of cash fl ows differently from the three other basic fi nancial statements. First, it is not prepared from an adjusted trial balance. It requires detailed information concerning the changes in account balances that occurred between two points in time. An adjusted trial balance will not provide the necessary data. Second, the statement of cash fl ows deals with cash receipts and payments. As a result, the company adjusts the effects of the use of accrual accounting to determine cash fl ows. The information to prepare this statement usually comes from three sources:

• Comparative balance sheets. Information in the comparative balance sheets indicates the amount of the changes in asset, liability, and stockholders’ equity accounts from the beginning to the end of the period.

• Current income statement. Information in this statement helps determine the amount of net cash provided or used by operating activities during the period.

• Additional information. Such information includes transaction data that are needed to determine how cash was provided or used during the period.

596 12 Statement of Cash Flows

INDIRECT AND DIRECT METHODS

In order to perform Step 1, a company must convert net income from an accrual basis to a cash basis. This conversion may be done by either of two methods: (1) the indirect method or (2) the direct method. Both methods arrive at the same total amount for “Net cash provided by operating activities.” They differ in how they arrive at the amount. The indirect method adjusts net income for items that do not affect cash to determine net cash provided by operating activities. A great majority of compa- nies (98%) use this method. Companies favor the indirect method for two reasons: (1) it is easier and less costly to prepare, and (2) it focuses on the differences between net income and net cash fl ow from operating activities. The direct method shows operating cash receipts and payments. It is prepared by adjusting each item in the income statement from the accrual basis to the cash basis. The FASB has expressed a preference for the direct method but allows the use of either method. The next section illustrates the more popular indirect method. Appendix 12A illustrates the direct method. Appendix 12B demonstrates an approach that employs T-accounts to prepare the statement of cash fl ows. Many students fi nd the T-account approach provides a useful structure. We encourage you to give it a try as you walk through the Computer Services example.

INDIRECT METHOD—COMPUTER SERVICES COMPANY

To explain how to prepare a statement of cash fl ows using the indirect method, we use fi nancial information from Computer Services Company. Illustration 12-4 presents Computer Services’ current- and previous-year balance sheets, its current-year income statement, and related fi nancial information.

The difference between the beginning and ending cash balances can be easily computed from comparative balance sheets.

This step involves analyzing not only the current year's income statement but also comparative balance sheets and selected additional data.

STEP 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions.

STEP 1: Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis.

STEP 3: Compare the net change in cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree.

This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash.

Fina ncin

gInvesting

Buying & selling goods

XYZ Corp.

FOR SA

– =

Year 1 Year 2 Difference

BANK

XYZGoods

ILLUSTRATION 12-3 Three major steps in preparing the statement of cash fl ows

Preparing the statement of cash fl ows from these data sources involves three major steps, explained in Illustration 12-3.

Preparing a Statement of Cash Flows—Indirect Method 597

ILLUSTRATION 12-4 Comparative balance sheets, income statement, and additional information for Computer Services Company

COMPUTER SERVICES COMPANY Comparative Balance Sheets

December 31

Change in Account Balance Assets 2017 2016 Increase/Decrease

Current assets Cash $ 55,000 $ 33,000 $ 22,000 Increase Accounts receivable 20,000 30,000 10,000 Decrease Inventory 15,000 10,000 5,000 Increase Prepaid expenses 5,000 1,000 4,000 Increase Property, plant, and equipment Land 130,000 20,000 110,000 Increase Buildings 160,000 40,000 120,000 Increase Accumulated depreciation—buildings (11,000) (5,000) 6,000 Increase Equipment 27,000 10,000 17,000 Increase Accumulated depreciation—equipment (3,000) (1,000) 2,000 Increase

Total assets $398,000 $138,000

Liabilities and Stockholders’ Equity

Current liabilities Accounts payable $ 28,000 $ 12,000 $ 16,000 Increase Income taxes payable 6,000 8,000 2,000 Decrease Long-term liabilities Bonds payable 130,000 20,000 110,000 Increase Stockholders’ equity Common stock 70,000 50,000 20,000 Increase Retained earnings 164,000 48,000 116,000 Increase

Total liabilities and stockholders’ equity $398,000 $138,000

Additional information for 2017: 1. Depreciation expense was comprised of $6,000 for building and $3,000 for

equipment. 2. The company sold equipment with a book value of $7,000 (cost $8,000, less

accumulated depreciation $1,000) for $4,000 cash. 3. Issued $110,000 of long-term bonds in direct exchange for land. 4. A building costing $120,000 was purchased for cash. Equipment costing $25,000

was also purchased for cash. 5. Issued common stock for $20,000 cash. 6. The company declared and paid a $29,000 cash dividend.

COMPUTER SERVICES COMPANY Income Statement

For the Year Ended December 31, 2017

Sales revenue $507,000 Cost of goods sold $150,000 Operating expenses (excluding depreciation) 111,000 Depreciation expense 9,000 Loss on disposal of plant assets 3,000 Interest expense 42,000 315,000

Income before income tax 192,000 Income tax expense 47,000

Net income $145,000

598 12 Statement of Cash Flows

We now apply the three steps to the information provided for Computer Services.

STEP 1: OPERATING ACTIVITIES

DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CON- VERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS

To determine net cash provided by operating activities under the indirect method, companies adjust net income in numerous ways. A useful starting point is to understand why net income must be converted to net cash provided by operating activities. Under generally accepted accounting principles, most companies use the accrual basis of accounting. As you have learned, this basis requires that a com- pany record revenue when the performance obligation is satisfi ed and record expenses when incurred. Revenues include credit sales for which the company has not yet collected cash. Expenses incurred include some items that it has not yet paid in cash. Thus, under the accrual basis of accounting, net income is not the same as net cash provided by operating activities. Therefore, under the indirect method, companies must adjust net income to convert certain items to the cash basis. The indirect method (or reconciliation method) starts with net income and converts it to net cash provided by operating activities. Illustration 12-5 lists the three types of adjustments.

Net Cash Provided/ Net Income +/− Adjustments = Used by Operating Activities

• Add back noncash expenses, such as depreciation expense and amortization expense.

• Deduct gains and add losses that resulted from investing and fi nancing activities.

• Analyze changes to noncash current asset and current liability accounts.

ILLUSTRATION 12-5 Three types of adjustments to convert net income to net cash provided by operating activities

We explain the three types of adjustments in the next three sections.

Depreciation Expense Computer Services’ income statement reports depreciation expense of $9,000. Although depreciation expense reduces net income, it does not reduce cash. In other words, depreciation expense is a noncash charge. The company must add it back to net income to arrive at net cash provided by operating activities. Computer Services reports depreciation expense as follows in the statement of cash fl ows.

▼ HELPFUL HINT Depreciation is similar to any other expense in that it reduces net income. It differs in that it does not involve a current cash outfl ow. That is why it must be added back to net income to arrive at net cash provided by operating activities.

ILLUSTRATION 12-6 Adjustment for depreciation Cash fl ows from operating activities

Net income $145,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense 9,000

Net cash provided by operating activities $154,000

Preparing a Statement of Cash Flows—Indirect Method 599

As the fi rst adjustment to net income in the statement of cash fl ows, companies frequently list depreciation and similar noncash charges such as amortization of intangible assets and bad debt expense.

Loss on Disposal of Plant Assets Illustration 12-1 states that cash received from the sale of plant assets is reported in the investing activities section. Because of this, companies eliminate from net income all gains and losses resulting from investing activities, to arrive at net cash provided by operating activities. In our example, Computer Services’ income statement reports a $3,000 loss on the disposal of plant assets (book value $7,000, less cash received from sale of equipment $4,000). The company’s loss of $3,000 is eliminated in the operating activities section of the statement of cash fl ows. Illustration 12-7 shows that the $3,000 loss is eliminated by adding $3,000 back to net income to arrive at net cash provided by operating activities.

ILLUSTRATION 12-7 Adjustment for loss on disposal of plant assets

Net cash provided by operating activities $157,000

If a gain on sale occurs, the company deducts the gain from net income in order to determine net cash provided by operating activities. In the case of either a gain or a loss, companies report the actual amount of cash received from the sale, in this case $4,000, as a source of cash in the investing activities sec- tion of the statement of cash fl ows.

Changes to Noncash Current Asset and Current Liability Accounts A fi nal step to reconcile net income to net cash provided by operating activities involves examining all changes in current asset and current liability accounts. The accrual-accounting process records revenues in the period in which the performance obligation is satisfi ed and expenses in the period incurred. For example, Accounts Receivable refl ects amounts owed to the company for sales that have been made but for which cash collections have not yet been received. Prepaid Insurance refl ects insurance that has been paid for but which has not yet expired and therefore has not been expensed. Similarly, Salaries and Wages Payable refl ects salaries expense that has been incurred but has not been paid. As a result, we need to adjust net income for these accruals and prepayments to determine net cash provided by operating activities. Thus, we must analyze the change in each current asset and current liability account to determine its impact on net income and cash.

CHANGES IN NONCASH CURRENT ASSETS. The adjustments required for changes in noncash current asset accounts are as follows. Deduct from net income increases in current asset accounts, and add to net income decreases in current asset accounts, to arrive at net cash provided by operating activi- ties. We observe these relationships by analyzing the accounts of Computer Services.

600 12 Statement of Cash Flows

DECREASE IN ACCOUNTS RECEIVABLE Computer Services’ accounts receivable decreased by $10,000 (from $30,000 to $20,000) during the period. This means that cash receipts were $10,000 higher than sales revenue. The analysis of the Accounts Receivable account in Illustration 12-8 reveals this $10,000 differ- ence. Computer Services had $507,000 in sales revenue (as reported on the income statement), but it collected $517,000 in cash.

ILLUSTRATION 12-8 Analysis of accounts receivable Accounts Receivable

1/1/17 Balance 30,000 Receipts from customers 517,000 Sales revenue 507,000

12/31/17 Balance 20,000

As shown in Illustration 12-9, to adjust net income to net cash provided by operating activities, the company adds to net income the decrease of $10,000 in accounts receivable.

Cash fl ows from operating activities Net income $145,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 9,000 Loss on disposal of plant assets 3,000 Decrease in accounts receivable 10,000 Increase in inventory (5,000) Increase in prepaid expenses (4,000) 13,000

Net cash provided by operating activities $158,000

ILLUSTRATION 12-9 Adjustments for changes in current asset accounts

When the Accounts Receivable balance increases, cash receipts are lower than revenue recorded under the accrual basis. Therefore, the company deducts from net income the amount of the increase in accounts receivable, to arrive at net cash provided by operating activities.

INCREASE IN INVENTORY Computer Services’ inventory increased $5,000 (from $10,000 to $15,000) during the period. The change in the Inventory account refl ects the difference between the amount of inventory purchased and the amount sold. For Computer Services, this means that the cost of merchandise purchased exceeded the cost of goods sold by $5,000. As a result, cost of goods sold does not refl ect $5,000 of cash payments made for merchandise. The company deducts from net income this inventory increase of $5,000 during the period, to arrive at net cash provided by operating activities (see Illustration 12-9). If inventory decreases, the company adds to net income the amount of the change, to arrive at net cash provided by operating activities.

INCREASE IN PREPAID EXPENSES Computer Services’ prepaid expenses increased during the period by $4,000. This means that cash paid for expenses is higher than expenses reported on an accrual basis. In other words, the company has made cash payments in the current period but will not charge expenses to income until future periods (as charges to the income statement). To adjust net income to

Preparing a Statement of Cash Flows—Indirect Method 601

net cash provided by operating activities, the company deducts from net income the $4,000 increase in prepaid expenses (see Illustration 12-9). If prepaid expenses decrease, reported expenses are higher than the expenses paid. Therefore, the company adds to net income the decrease in prepaid expense, to arrive at net cash provided by operating activities.

CHANGES IN CURRENT LIABILITIES. The adjustments required for changes in cur- rent liability accounts are as follows. Add to net income increases in current liability accounts, and deduct from net income decreases in current liability accounts, to arrive at net cash provided by operating activities.

INCREASE IN ACCOUNTS PAYABLE For Computer Services, accounts payable increased by $16,000 (from $12,000 to $28,000) during the period. That means the company received $16,000 more in goods than it actually paid for. As shown in Illustration 12-10, to adjust net income to determine net cash provided by operating activities, the company adds to net income the $16,000 increase in the Accounts Payable account.

DECREASE IN INCOME TAXES PAYABLE When a company incurs income tax expense but has not yet paid its taxes, it records income taxes payable. A change in the Income Taxes Payable account reflects the difference between income tax expense incurred and income taxes actually paid. Computer Services’ Income Taxes Payable account decreased by $2,000. That means the $47,000 of income tax expense reported on the income statement was $2,000 less than the amount of taxes paid during the period of $49,000. As shown in Illustration 12-10, to adjust net income to a cash basis, the company must reduce net income by $2,000.

Net cash provided by operating activities $172,000

ILLUSTRATION 12-10 Adjustments for changes in current liability accounts

Illustration 12-10 shows that after starting with net income of $145,000, the sum of all of the adjustments to net income was $27,000. This resulted in net cash provided by operating activities of $172,000.

SUMMARY OF CONVERSION TO NET CASH PROVIDED BY OPERATING ACTIVITIES—INDIRECT METHOD

As shown in the previous illustrations, the statement of cash fl ows prepared by the indirect method starts with net income. Items are then added or deducted to arrive at net cash provided by operating activities. The required adjustments are of three types:

1. Noncash charges such as depreciation and amortization.

602 12 Statement of Cash Flows

2. Gains and losses from investing and fi nancing transactions, such as the sale of plant assets.

3. Changes in noncash current asset and current liability accounts.

Illustration 12-11 provides a summary of these changes.

ILLUSTRATION 12-11 Adjustments required to convert net income to net cash provided by operating activities

For more than a decade, the top executives at the Italian dairy products company Parmalat engaged in multiple frauds that overstated cash and other assets by more than $1 billion while understating liabilities by between $8 and $12 billion. Much of the fraud involved creating fi ctitious sources and uses of cash. Some of these activities in- corporated sophisticated fi nancial transactions with subsidiaries created with the help of large international fi nancial institutions. However, much of the fraud employed very basic, even sloppy, forgery of documents. For example, when outside auditors requested confi rmation of bank accounts (such as a fake $4.8 billion account in the Cayman Islands), documents were created on scanners, with signatures that were cut and pasted from other documents. These were then passed through a fax machine numerous times to make them look real (if diffi cult to read). Similarly, fi ctitious bills were created in order to divert funds to other businesses owned by the Tanzi family (who controlled Parmalat).

Total take: Billions of dollars

THE MISSING CONTROL Independent internal verifi cation. Internal auditors at the company should have indepen- dently verifi ed bank accounts and major transfers of cash to outside companies that were controlled by the Tanzi family.

ANATOMY OF A FRAUD

2a▼ Net Cash Provided by Operating ActivitiesDO IT! Josh’s PhotoPlus reported net income of $73,000 for 2017. Included in the income state- ment were depreciation expense of $7,000 and a gain on disposal of plant assets of $2,500. Josh’s comparative balance sheets show the following balances.

12/31/17 12/31/16

Accounts Receivable $21,000 $17,000 Accounts Payable 2,200 6,000

Calculate net cash provided by operating activities for Josh’s PhotoPlus.

Adjustment Required to Convert Net Income to Net Cash Provided by Operating Activities

Noncash Depreciation expense Add charges Amortization expense Add

Gains Loss on disposal of plant assets Add and losses Gain on disposal of plant assets Deduct

Changes in Increase in current asset account Deduct current assets Decrease in current asset account Add and Increase in current liability account Add current liabilities Decrease in current liability account Deduct

Preparing a Statement of Cash Flows—Indirect Method 603

STEP 2: INVESTING AND FINANCING ACTIVITIES

ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR DISCLOSE AS NONCASH TRANSACTIONS

INCREASE IN LAND As indicated from the change in the Land account and the additional information, Computer Services purchased land of $110,000 by directly exchanging bonds for land. The exchange of bonds payable for land has no effect on cash. But, it is a signifi cant noncash investing and fi nancing activity that merits disclosure in a separate schedule. (See Illustration 12–13, page 604.)

INCREASE IN BUILDINGS As the additional data indicate, Computer Services acquired an offi ce building for $120,000 cash. This is a cash outfl ow reported in the investing activities section. (See Illustration 12–13.)

INCREASE IN EQUIPMENT The Equipment account increased $17,000. The addi- tional information explains that this was a net increase that resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. These transactions are both investing activities. The company should report each transaction separately. Thus, it reports the purchase of equipment as an outfl ow of cash for $25,000. It reports the sale as an infl ow of cash for $4,000. The T-account below shows the reasons for the change in this account during the year.

▼ HELPFUL HINT The investing and fi nancing activities are measured and reported the same under both the direct and indirect methods.

ETHICS NOTE Because investors and management bonus contracts often focus on cash fl ow from operations, some managers have taken unethical actions to artifi cially increase cash fl ow from operations. For example, Dynegy restated its statement of cash fl ows because it had improperly included in operating activities $300 million that should have been reported as fi nancing activities. This error increased cash from operating activities by 37%.

▼

The following entry shows the details of the equipment sale transaction.

Cash 4,000 Accumulated Depreciation—Equipment 1,000 Loss on Disposal of Plant Assets 3,000 Equipment 8,000

INCREASE IN BONDS PAYABLE The Bonds Payable account increased $110,000. As indicated in the additional information, the company acquired land by directly exchanging bonds for land. It reports this noncash transaction in a separate schedule at the bottom of the statement.

A L SE= + +4,000 +1,000 −3,000 Exp −8,000 Cash Flows +4,000

Equipment

1/1/17 Balance 10,000 Cost of equipment sold 8,000 Purchase of equipment 25,000

12/31/17 Balance 27,000

ILLUSTRATION 12-12 Analysis of equipment

SOLUTION Cash fl ows from operating activities Net income $73,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 7,000 Gain on disposal of plant assets (2,500) Increase in accounts receivable (4,000) Decrease in accounts payable (3,800) (3,300)

Net cash provided by operating activities $69,700

Related exercise material: BE12-4, BE12-5, BE12-6, DO IT! 12-2a, E12-3, and E12-4.

Action Plan ✔ Add noncash charges such

as depreciation back to net income to compute net cash provided by operating activities.

✔ Deduct gains and add back losses from the disposal of plant assets to compute net cash provided by operating activities.

✔ Use changes in noncash current asset and current liability accounts to compute net cash provided by operating activities.

604 12 Statement of Cash Flows

INCREASE IN COMMON STOCK The balance sheet reports an increase in Common Stock of $20,000. The additional information section notes that this increase resulted from the issuance of new shares of stock. This is a cash infl ow reported in the fi nancing activities section.

INCREASE IN RETAINED EARNINGS Retained earnings increased $116,000 during the year. This increase can be explained by two factors: (1) net income of $145,000 increased retained earnings, and (2) dividends of $29,000 decreased retained earnings. The company adjusts net income to net cash provided by oper- ating activities in the operating activities section. Payment of the dividends (not the declaration) is a cash outfl ow that the company reports as a fi nancing activity.

Statement of Cash Flows—2017 Using the previous information, we can now prepare a statement of cash fl ows for 2017 for Computer Services Company, as shown in Illustration 12-13.

▼ HELPFUL HINT When companies issue stocks or bonds for cash, the actual proceeds will appear in the statement of cash fl ows as a fi nancing infl ow (rather than the par value of the stocks or face value of bonds).

COMPUTER SERVICES COMPANY Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2017

Cash fl ows from operating activities Net income $ 145,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 9,000 Loss on disposal of plant assets 3,000 Decrease in accounts receivable 10,000 Increase in inventory (5,000) Increase in prepaid expenses (4,000) Increase in accounts payable 16,000 Decrease in income taxes payable (2,000) 27,000

Net cash provided by operating activities 172,000 Cash fl ows from investing activities Sale of equipment 4,000 Purchase of building (120,000) Purchase of equipment (25,000)

Net cash used by investing activities (141,000) Cash fl ows from fi nancing activities Issuance of common stock 20,000 Payment of cash dividends (29,000)

Net cash used by fi nancing activities (9,000)

Net increase in cash 22,000 Cash at beginning of period 33,000

Cash at end of period $ 55,000

Noncash investing and fi nancing activities Issuance of bonds payable to purchase land $ 110,000

▼ HELPFUL HINT Note that in the investing and fi nancing activities sections, positive numbers indicate cash infl ows (receipts), and negative numbers indicate cash outfl ows (payments).

ILLUSTRATION 12-13 Statement of cash fl ows, 2017—indirect method

STEP 3: NET CHANGE IN CASH

COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE

Illustration 12-13 indicates that the net change in cash during the period was an increase of $22,000. This agrees with the change in Cash account reported on the balance sheet in Illustration 12-4 (page 597).

Preparing a Statement of Cash Flows—Indirect Method 605

ACCOUNTING ACROSS THE ORGANIZATION

Burning Through Our Cash

Box (cloud storage), Cyan (game cre- ator), Fireeye (cyber security), and Mobile Iron (mobile security of data) are a few of the tech companies that recently have issued or are about to is- sue stock to the public. Investors now have to determine whether these tech companies have viable products and high chances for success. An important consideration in eval- uating a tech company is determining its fi nancial fl exibility—its ability to withstand adversity if an economic setback occurs. One way to measure fi nancial fl exibility is to assess a com- pany’s cash burn rate, which determines

how long its cash will hold out if the company is expending more cash than it is receiving. Fireeye, for example, burned cash in excess of $50 million in 2013. But the company also had over $150 million as a cash cushion, so it would take over 30 months before it runs out of cash. And even though Box has a much lower cash burn rate than Fireeye, it still has over a year’s cushion. Compare that to the tech companies in 2000, when over one-quarter of them were on track to run out of cash within a year. And many did. Fortunately, the tech companies of today seem to be better equipped to withstand an economic setback.

Source: Shira Ovide, “Tech Firms’ Cash Hoards Cool Fears of a Meltdown,” Wall Street Journal (May 14, 2014).

What implications does a company’s cash burn rate have for its survival? (See WileyPLUS for this answer and additional questions.)

2b▼ Indirect MethodDO IT! Use the following information to prepare a statement of cash fl ows using the indirect method.

REYNOLDS COMPANY Comparative Balance Sheets

December 31

Change Assets 2017 2016 Increase/Decrease

Cash $ 54,000 $ 37,000 $ 17,000 Increase Accounts receivable 68,000 26,000 42,000 Increase Inventory 54,000 –0– 54,000 Increase Prepaid expenses 4,000 6,000 2,000 Decrease Land 45,000 70,000 25,000 Decrease Buildings 200,000 200,000 –0– Accumulated depreciation—buildings (21,000) (11,000) 10,000 Increase Equipment 193,000 68,000 125,000 Increase Accumulated depreciation—equipment (28,000) (10,000) 18,000 Increase

Totals $569,000 $386,000

Liabilities and Stockholders’ Equity

Accounts payable $ 23,000 $ 40,000 $ 17,000 Decrease Accrued expenses payable 10,000 –0– 10,000 Increase Bonds payable 110,000 150,000 40,000 Decrease Common stock ($1 par) 220,000 60,000 160,000 Increase Retained earnings 206,000 136,000 70,000 Increase

Totals $569,000 $386,000

606 12 Statement of Cash Flows

SOLUTIONAction Plan ✔ Determine net cash

provided/used by operating activities by adjusting net income for items that did not affect cash.

✔ Determine net cash provided/used by investing activities and fi nancing activities.

✔ Determine the net increase/decrease in cash.

REYNOLDS COMPANY Income Statement

For the Year Ended December 31, 2017

Sales revenue $890,000 Cost of goods sold $465,000 Operating expenses 221,000 Interest expense 12,000 Loss on disposal of equipment 2,000 700,000

Income before income taxes 190,000 Income tax expense 65,000

Net income $125,000

REYNOLDS COMPANY Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2017

Cash fl ows from operating activities Net income $ 125,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 33,000 Loss on disposal of equipment 2,000 Increase in accounts receivable (42,000) Increase in inventory (54,000) Decrease in prepaid expenses 2,000 Decrease in accounts payable (17,000) Increase in accrued expenses payable 10,000 (66,000)

Net cash provided by operating activities 59,000 Cash fl ows from investing activities Sale of land 25,000 Sale of equipment 34,000 Purchase of equipment (166,000)

Net cash used by investing activities (107,000) Cash fl ows from fi nancing activities Redemption of bonds (40,000) Sale of common stock 160,000 Payment of dividends (55,000)

Net cash provided by fi nancing activities 65,000

Net increase in cash 17,000 Cash at beginning of period 37,000

Cash at end of period $ 54,000

Related exercise material: BE12-4, BE12-5, BE12-6, BE12-7, DO IT! E12-2b, E12-5, E12-6, and E12-7.

Additional information: 1. Operating expenses include depreciation expense of $33,000. 2. Land was sold at its book value for cash. 3. Cash dividends of $55,000 were declared and paid in 2017. 4. Equipment with a cost of $166,000 was purchased for cash. Equipment with a

cost of $41,000 and a book value of $36,000 was sold for $34,000 cash. 5. Bonds of $40,000 were redeemed at their face value for cash. 6. Common stock ($1 par) of $160,000 was issued for cash.

Using the Statement of Cash Flows to Evaluate a Company 607

LEARNING OBJECTIVE 3 Use the statement of cash fl ows to evaluate a company.▼ Traditionally, investors and creditors used ratios based on accrual accounting. These days, cash-based ratios are gaining increased acceptance among analysts. In this section, we review the corporate life cycle and free cash fl ow.

THE CORPORATE LIFE CYCLE

All products go through a series of phases called the product life cycle. The phases (in order of their occurrence) are introductory phase, growth phase, maturity phase, and decline phase. The introductory phase occurs at the begin- ning of a company’s life, when it purchases fi xed assets and begins to produce and sell products. During the growth phase, the company strives to expand its production and sales. In the maturity phase, sales and production level off. During the decline phase, sales of the product decrease due to a weakening in consumer demand. In the same way that products have life cycles, companies have life cycles as well. Companies generally have more than one product, and not all of a com- pany’s products are in the same phase of the product life cycle at the same time. This sometimes makes it diffi cult to classify a company’s phase. Still, we can characterize a company as being in one of the four phases because the majority of its products are in a particular phase. Illustration 12-14 shows that the phase a company is in affects its cash fl ows. In the introductory phase, we expect that the company will not generate posi- tive cash from operations. That is, cash used in operations will exceed cash gen- erated by operations in the introductory phase. Also, the company spends consid- erable amounts to purchase productive assets such as buildings and equipment. To support its asset purchases, the company issues stock or debt. Thus, during the introductory phase, we expect negative cash from operations, negative cash from investing, and positive cash from fi nancing.

Po si

tiv e

N eg

at iv

Introductory Growth Maturity Decline Phase

C as

h F

lo w

Operating

Investing

Financing

ILLUSTRATION 12-14 Impact of product life cycle on cash fl ows

During the growth phase, we expect to see the company start to generate small amounts of cash from operations. During this phase, net cash provided by operating activities on the statement of cash fl ows is less than net income. One reason net income exceeds cash fl ow from operations during this period is explained by the difference between the cash paid for inventory and the amount

608 12 Statement of Cash Flows

Neil Barclay/Retna

expensed as cost of goods sold. Since the company projects increasing sales, the size of inventory purchases increases. Thus, in the growth phase, the company expenses less inventory on an accrual basis than it purchases on a cash basis. Also, collections on accounts receivable lag behind sales, and accrual sales during a period exceed cash collections during that period. Cash needed for asset acquisitions will continue to exceed net cash provided by operating activities. The company makes up the defi ciency by issuing new stock or debt. Thus, in the growth phase, the company continues to show negative cash from investing activities and positive cash from fi nancing activities. During the maturity phase, net cash provided by operating activities and net income are approximately the same. Cash generated from operations exceeds investing needs. Thus, in the maturity phase, the company starts to pay dividends, retire debt, or buy back stock. Finally, during the decline phase, net cash provided by operating activities decreases. Cash from investing activities might actually become positive as the company sells off excess assets. Cash from fi nancing activities may be negative as the company buys back stock and redeems debt. Consider Microsoft. During its early years, it had signifi cant product devel- opment costs and little revenue. Microsoft was lucky in that its agreement with IBM to provide the operating system for IBM PCs gave it an early steady source of cash to support growth. As noted in the Feature Story, Microsoft conserved cash by paying employees with stock options rather than cash. Today, Microsoft could be characterized as being in the maturity phase. It continues to spend con- siderable amounts on research and development and investment in new assets. In recent years, though, its net cash provided by operating activities has exceeded its net income. Also, cash from operations over this period exceeded cash used for investing, and common stock repurchased exceeded common stock issued. For Microsoft, as for any large company, the challenge is to maintain its growth. In the software industry, where products become obsolete very quickly, the chal- lenge is particularly great.

Operating with Negative Cash

Listed here are amounts (in millions) of net income and net cash provided (used) by operating, invest- ing, and fi nancing activities for a variety of companies at one time. The fi nal column suggests each company's likely phase in the life cycle based on these fi gures.

INVESTOR INSIGHT

Net Cash Net Cash Net Cash Provided Provided Provided (Used) by (Used) by (Used) by Likely Phase Net Operating Investing Financing in Life Company Income Activities Activities Activities Cycle

Amazon.com $ 476 $1,405 $ (42) $ (50) Early maturity LDK Solar (144) (81) (329) 462 Introductory/ early growth United States Steel 879 1,745 (4,675) (1,891) Maturity Kellogg 1,103 1,503 (601) (788) Early decline Southwest Airlines 645 2,845 (1,529) 493 Maturity Starbucks 673 1,331 (1,202) (172) Maturity

Why do companies have negative net cash provided by operating activities during the intro- ductory phase? (Go to WileyPLUS for this answer and additional questions.)

Using the Statement of Cash Flows to Evaluate a Company 609

FREE CASH FLOW

In the statement of cash fl ows, net cash provided by operating activi- ties is intended to indicate the cash-generating capability of the com- pany. Analysts have noted, however, that cash provided by operating activities fails to take into account that a company must invest in new fi xed assets just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. As we discussed in Chapter 2, the measurement of free cash fl ow provides additional insight regarding a company’s cash-generating ability. Free cash fl ow describes the net cash provided by operating activities after adjustment for capital expenditures and dividends. Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash fl ow was $80,000 ($100,000 − $15,000 − $5,000). The company could use this $80,000 either to purchase new assets, pay off debt, or pay an $80,000 dividend. In prac- tice, free cash fl ow is often calculated with the formula in Illustration 12-15. Alter- native defi nitions also exist.

DECISION TOOLS

Free cash fl ows helps users de- termine the amount of cash the company generated to expand operations or pay dividends.

Free Cash

Flow = Net Cash Provided

by Operating Activities − Capital

Expenditures − Cash

Dividends

ILLUSTRATION 12-15 Free cash fl ow

Illustration 12-16 provides basic information excerpted from the 2014 state- ment of cash fl ows of Apple (prior to the payment of its fi rst dividends).

Net cash provided by operating activities $ 59,713 Cash fl ows from investing activities Additions to property and equipment and intangibles $ (9,571) Purchases of investments (217,128) Sales of investments 189,301 Acquisitions of companies (3,765) Maturities of investments 18,810 Other (226)

Net cash used by investing activities (22,579) Cash paid for dividends (11,126)

APPLE INC. Statement of Cash Flows Information (partial)

2014

Real World

ILLUSTRATION 12-16 Apple’s cash fl ow information ($ in millions)

Apple’s free cash fl ow is calculated as shown in Illustration 12-17 (in millions). Apple generated approximately $39 billion of free cash fl ow. This is a tremendous amount of cash generated in a single year. It is available for the acquisition of new assets, the buyback and retirement of stock or debt, or the payment of dividends.

ILLUSTRATION 12-17 Calculation of Apple’s free cash fl ow ($ in millions)

Net cash provided by operating activities $59,713 Less: Expenditures on property, plant, and equipment 9,571 Dividends paid 11,126

Free cash fl ow $39,016

Also note that Apple’s cash from operations of $59.7 billion exceeds its 2014 net income of $39.5 billion by $20.2 billion. This lends additional credibility to

610 12 Statement of Cash Flows

Apple’s income number as an indicator of potential future performance. If any- thing, Apple’s net income might understate its actual performance.

KEEPING AN EYE ON CASH

Cash flow is closely monitored by analysts and investors for many reasons and in a variety of ways. One measure that is gaining increased attention is “price to cash flow.” This is a variant of the price to earnings (P-E) ratio, which has been a staple of analysts for a long time. The difference is that rather than divide the company’s stock price by its earnings per share (an accrual-accounting–based number), the price to cash flow ratio divides the company’s stock price by its cash flow per share. A high measure suggests that the stock price is high relative to the company’s ability to generate cash. A low measure indicates that the company’s stock might be a bargain. The following table provides values for some well-known companies in a recent year. While you should not use this measure as the sole factor in choosing a stock, it can serve as a useful screen by which to identify companies that merit further investigation.

Company Price/Cash Flow Price/EPS

Microsoft 55.6 62.5 Apple 11.1 12.5 Nike 19.1 24.8 Wal-Mart 9.0 15.7 Jet Blue 7.9 11.1

3▼ Free Cash FlowDO IT!

Cash fl ows from operating activities Net income $ 19,000 Adjustments to reconcile net income to net cash

provided by operating activities: Depreciation expense $ 8,100 Loss on disposal of plant assets 1,300 Decrease in accounts receivable 6,900 Increase in inventory (4,000) Decrease in accounts payable (2,000) 10,300

Net cash provided by operating activities 29,300 Cash fl ows from investing activities Sale of investments 1,100 Purchase of equipment (19,000)

Net cash used by investing activities (17,900)

Cash fl ows from fi nancing activities Issuance of stock 10,000 Payment on long-term note payable (5,000) Payment for dividends (9,000)

Net cash used by fi nancing activities (4,000)

Net increase in cash 7,400 Cash at beginning of year 10,000

Cash at end of year $ 17,400

CHICAGO CORPORATION Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2017

Chicago Corporation issued the following statement of cash fl ows for 2017.

Appendix 12A: Statement of Cash Flows—Direct Method 611

SOLUTION (a) Free cash fl ow = $29,300 − $19,000 − $9,000 = $1,300 (b) Net cash provided by operating activities fails to take into account that a company

must invest in new plant assets just to maintain the current level of operation. Com- panies must also maintain dividends at current levels to satisfy investors. The measurement of free cash fl ow provides additional insight regarding a company’s cash-generating ability.

Related exercise material: BE12-9, BE12-10, BE12-11, BE12-12, DO IT! 12-3, E12-9, and E12-10.

(a) Compute free cash fl ow for Chicago Corporation. (b) Explain why free cash fl ow often provides better information than “Net cash provided by operating activities.”

Action Plan ✔ Compute free cash fl ow

as Net cash provided by operating activities − Capital expenditures − Cash dividends.

Intel Corporation is the leading producer of computer chips for personal computers. Its primary competitor is AMD. Finan- cial statement data for Intel are provided below.

USING DECISION TOOLS—INTEL CORPORATION

2014

Net cash provided by operating activities $ 20,418 Net cash used for investing activities (9,905) Net cash used for fi nancing activities (13,626)

Net increase (decrease) in cash and cash equivalents $ (3,113)

Note. Cash spent on property, plant, and equipment in 2014 was $10,105. Cash paid for dividends was $4,409.

INTEL CORPORATION Statement of Cash Flows

For the Year Ended December 31, 2014 (in millions)

SOLUTION Intel’s free cash fl ow is $5,904 million ($20,418 − $10,105 − $4,409). AMD’s is −$193 million. This gives Intel a huge advantage in the ability to move quickly to invest in new projects.

APPENDIX 12A: Prepare a statement of cash fl ows using the direct method.

LEARNING OBJECTIVE *4▼

To explain and illustrate the direct method, we will use the transactions of Computer Services Company for 2017 to prepare a statement of cash fl ows. Illustration 12A-1 (page 612) presents information related to 2017 for the company.

INSTRUCTIONS

Calculate free cash fl ow for Intel and compare it with that of AMD (−$193 million).

612 12 Statement of Cash Flows

Additional information for 2017: 1. Depreciation expense was comprised of $6,000 for building and $3,000 for

equipment. 2. The company sold equipment with a book value of $7,000 (cost $8,000, less

accumulated depreciation $1,000) for $4,000 cash. 3. Issued $110,000 of long-term bonds in direct exchange for land. 4. A building costing $120,000 was purchased for cash. Equipment costing $25,000

was also purchased for cash. 5. Issued common stock for $20,000 cash. 6. The company declared and paid a $29,000 cash dividend.

COMPUTER SERVICES COMPANY Comparative Balance Sheets

December 31

ILLUSTRATION 12A-1 Comparative balance sheets, income statement, and additional information for Computer Services Company

COMPUTER SERVICES COMPANY Income Statement

For the Year Ended December 31, 2017

Income before income tax 192,000 Income tax expense 47,000

Net income $145,000

Change in Account Balance Assets 2017 2016 Increase/Decrease

Total assets $398,000 $138,000

Liabilities and Stockholders’ Equity

Total liabilities and stockholders’ equity $398,000 $138,000

Appendix 12A: Statement of Cash Flows—Direct Method 613

To prepare a statement of cash fl ows under the direct approach, we will apply the three steps outlined in Illustration 12-3 (page 596).

STEP 1: OPERATING ACTIVITIES DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS Under the direct method, companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. To simplify and condense the operating activities section, companies report only major classes of operating cash receipts and cash payments. For these major classes, the difference between cash receipts and cash payments is the net cash provided by operating activities. These relation- ships are as shown in Illustration 12A-2.

From sales of goods and services

to customers

Cash Receipts – Cash Payments = Net Cash Providedby Operating Activities

To suppliers

To employees

For operating expenses

Net cash provided by

operating activities

For interest

For taxes

From receipts of interest and

dividends on loans and investments

Fragile This End Up

ILLUSTRATION 12A-2 Major classes of cash receipts and payments

An effi cient way to apply the direct method is to analyze the items reported in the income statement in the order in which they are listed. We then determine cash receipts and cash payments related to these revenues and expenses. The following pages present the adjustments required to prepare a state- ment of cash fl ows for Computer Services Company using the direct approach.

CASH RECEIPTS FROM CUSTOMERS The income statement for Computer Services reported sales revenue from customers of $507,000. How much of that was cash receipts? To answer that, companies need to consider the change in accounts receivable during the year. When accounts receivable increase during the year, revenues on an accrual basis are higher than cash receipts from customers. Oper- ations led to revenues, but not all of these revenues resulted in cash receipts. To determine the amount of cash receipts, the company deducts from sales revenue the increase in accounts receivable. On the other hand, there may be a decrease in accounts receivable. That would occur if cash receipts from cus- tomers exceeded sales revenue. In that case, the company adds to sales revenue

614 12 Statement of Cash Flows

the decrease in accounts receivable. For Computer Services, accounts receivable decreased $10,000. Thus, cash receipts from customers were $517,000, computed as shown in Illustration 12A-3.

ILLUSTRATION 12A-3 Computation of cash receipts from customers

Sales revenue $ 507,000 Add: Decrease in accounts receivable 10,000

Cash receipts from customers $517,000

Computer Services can also determine cash receipts from customers from an analysis of the Accounts Receivable account, as shown in Illustration 12A-4.

ILLUSTRATION 12A-4 Analysis of accounts receivable Accounts Receivable

1/1/17 Balance 30,000 Receipts from customers 517,000 Sales revenue 507,000

12/31/17 Balance 20,000

▼ HELPFUL HINT The T-account shows that sales revenue plus decrease in accounts receivables equals cash receipts. Illustration 12A-5 shows the relationships among cash receipts from customers,

sales revenue, and changes in accounts receivable.

ILLUSTRATION 12A-5 Formula to compute cash receipts from customers— direct method

Cash Receipts Sales

+ Decrease in Accounts Receivable from =

Revenue or

Customers − Increase in Accounts Receivable

CASH PAYMENTS TO SUPPLIERS Computer Services reported cost of goods sold of $150,000 on its income statement. How much of that was cash payments to suppliers? To answer that, it is fi rst necessary to fi nd purchases for the year. To fi nd purchases, companies adjust cost of goods sold for the change in inventory. When inventory increases during the year, purchases for the year have exceeded cost of goods sold. As a result, to determine the amount of purchases, the company adds to cost of goods sold the increase in inventory. In 2017, Computer Services’ inventory increased $5,000. It computes pur- chases as follows.

Cost of goods sold $ 150,000 Add: Increase in inventory 5,000

Purchases $155,000

ILLUSTRATION 12A-6 Computation of purchases

Purchases $ 155,000 Deduct: Increase in accounts payable 16,000

Cash payments to suppliers $139,000

ILLUSTRATION 12A-7 Computation of cash payments to suppliers

After computing purchases, a company can determine cash payments to suppliers. This is done by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis. As a result, to determine cash payments to suppliers, a company deducts from purchases the increase in accounts pay- able. On the other hand, if cash payments to suppliers exceed purchases, there may be a decrease in accounts payable. In that case, a company adds to pur- chases the decrease in accounts payable. For Computer Services, cash payments to suppliers were $139,000, computed as follows.

Appendix 12A: Statement of Cash Flows—Direct Method 615

Computer Services also can determine cash payments to suppliers from an analysis of the Accounts Payable account, as shown in Illustration 12A-8.

Accounts Payable

Payments to suppliers 139,000 1/1/17 Balance 12,000 Purchases 155,000

12/31/17 Balance 28,000 ▼ HELPFUL HINT The T-account shows that purchases less increase in accounts payable equals payments to suppliers.

ILLUSTRATION 12A-8 Analysis of accounts payable

Illustration 12A-9 shows the relationships among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable.

+ Decrease in

Cash Cost + Increase in Inventory Accounts Payable

Payments = of or or

to Goods − Decrease in Inventory − Increase in

Suppliers Sold

Accounts Payable

ILLUSTRATION 12A-9 Formula to compute cash payments to suppliers—direct method

CASH PAYMENTS FOR OPERATING EXPENSES Computer Services reported on its income statement operating expenses of $111,000. How much of that amount was cash paid for operating expenses? To answer that, we need to adjust this amount for any changes in prepaid expenses and accrued expenses payable. For example, if prepaid expenses increased during the year, cash paid for operating expenses is higher than operating expenses reported on the income statement. To convert operating expenses to cash payments for operating expenses, a company adds the increase in prepaid expenses to operating expenses. On the other hand, if prepaid expenses decrease during the year, it deducts the decrease from operat- ing expenses. Companies must also adjust operating expenses for changes in accrued expenses payable. When accrued expenses payable increase during the year, oper- ating expenses on an accrual basis are higher than they are in a cash basis. As a result, to determine cash payments for operating expenses, a company deducts from operating expenses an increase in accrued expenses payable. On the other hand, a company adds to operating expenses a decrease in accrued expenses pay- able because cash payments exceed operating expenses. Computer Services’ cash payments for operating expenses were $115,000, computed as follows.

Operating expenses $ 111,000 Add: Increase in prepaid expenses 4,000

Cash payments for operating expenses $115,000

ILLUSTRATION 12A-10 Computation of cash payments for operating expenses

Illustration 12A-11 shows the relationships among cash payments for operat- ing expenses, changes in prepaid expenses, and changes in accrued expenses payable.

ILLUSTRATION 12A-11 Formula to compute cash payments for operating expenses—direct method

Cash + Increase in + Decrease in Accrued Payments

Operating Prepaid Expense Expenses Payable

for = or or Operating

Expenses − Decrease in − Increase in Accrued

Expenses Prepaid Expense Expenses Payable

616 12 Statement of Cash Flows

DEPRECIATION EXPENSE AND LOSS ON DISPOSAL OF PLANT ASSETS Computer Services’ depreciation expense in 2017 was $9,000. Depreciation expense is not shown on a statement of cash fl ows under the direct method because it is a non- cash charge. If the amount for operating expenses includes depreciation expense, operating expenses must be reduced by the amount of depreciation to determine cash payments for operating expenses. The loss on disposal of plant assets of $3,000 is also a noncash charge. The loss on disposal of plant assets reduces net income, but it does not reduce cash. Thus, the loss on disposal of plant assets is not shown on the statement of cash fl ows under the direct method. Other charges to expense that do not require the use of cash, such as the amortization of intangible assets and bad debt expense, are treated in the same manner as depreciation.

CASH PAYMENTS FOR INTEREST Computer Services reported on the income state- ment interest expense of $42,000. Since the balance sheet did not include an accrual for interest payable for 2016 or 2017, the amount reported as expense is the same as the amount of interest paid.

CASH PAYMENTS FOR INCOME TAXES Computer Services reported income tax expense of $47,000 on the income statement. Income taxes payable, however, decreased $2,000. This decrease means that income taxes paid were more than income taxes reported in the income statement. Cash payments for income taxes were, therefore, $49,000 as shown below.

Income tax expense $ 47,000 Add: Decrease in income taxes payable 2,000

Cash payments for income taxes $49,000

ILLUSTRATION 12A-12 Computation of cash payments for income taxes

Illustration 12A-13 shows the relationships among cash payments for income taxes, income tax expense, and changes in income taxes payable.

Cash Income Tax

+ Decrease in Income Taxes Payable Payments for = or Income Taxes

Expense − Increase in Income Taxes Payable

ILLUSTRATION 12A-13 Formula to compute cash payments for income taxes— direct method

The operating activities section of the statement of cash fl ows of Computer Services is shown in Illustration 12A-14.

Cash fl ows from operating activities Cash receipts from customers $517,000 Less: Cash payments: To suppliers $139,000 For operating expenses 115,000 For interest expense 42,000 For income taxes 49,000 345,000

Net cash provided by operating activities $172,000

ILLUSTRATION 12A-14 Operating activities section of the statement of cash fl ows

When a company uses the direct method, it must also provide in a separate schedule (not shown here) the net cash fl ows from operating activities as com- puted under the indirect method.

Appendix 12A: Statement of Cash Flows—Direct Method 617

STEP 2: INVESTING AND FINANCING ACTIVITIES

ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR DISCLOSE AS NONCASH TRANSACTIONS

INCREASE IN EQUIPMENT The Equipment account increased $17,000. The addi- tional information explains that this was a net increase that resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. These transactions are investing activities. The company should report each transaction separately. The statement in Illustration 12A-16 reports the purchase of equipment as an outfl ow of cash for $25,000. It reports the sale as an infl ow of cash for $4,000. The T-account below shows the reasons for the change in this account during the year.

▼ HELPFUL HINT The investing and fi nancing activities are measured and reported the same under both the direct and indirect methods.

Equipment

1/1/17 Balance 10,000 Cost of equipment sold 8,000 Purchase of equipment 25,000

12/31/17 Balance 27,000

ILLUSTRATION 12A-15 Analysis of equipment

The following entry shows the details of the equipment sale transaction.

Cash 4,000 Accumulated Depreciation—Equipment 1,000 Loss on Disposal of Plant Assets 3,000 Equipment 8,000

INCREASE IN BONDS PAYABLE The Bonds Payable account increased $110,000. As indicated in the additional information, the company acquired land by directly exchanging bonds for land. Illustration 12A-16 reports this noncash transaction in a separate schedule at the bottom of the statement.

INCREASE IN RETAINED EARNINGS Retained earnings increased $116,000 dur- ing the year. This increase can be explained by two factors: (1) net income of $145,000 increased retained earnings, and (2) dividends of $29,000 decreased retained earnings. The company adjusts net income to net cash provided by oper- ating activities in the operating activities section. Payment of the dividends (not the declaration) is a cash outfl ow that the company reports as a fi nancing activity in Illustration 12A-16.

Statement of Cash Flows—2017 Illustration 12A-16 (page 618) shows the statement of cash fl ows for Computer Services Company.

A L SE= + +4,000 +1,000 −3,000 Exp −8,000 Cash Flows +4,000

618 12 Statement of Cash Flows

COMPUTER SERVICES COMPANY Statement of Cash Flows—Direct Method For the Year Ended December 31, 2017

Cash fl ows from operating activities Cash receipts from customers $ 517,000 Less: Cash payments: To suppliers $ 139,000 For operating expenses 115,000 For income taxes 49,000 For interest expense 42,000 345,000

Net cash provided by operating activities 172,000 Cash fl ows from investing activities Sale of equipment 4,000 Purchase of building (120,000) Purchase of equipment (25,000)

Net cash used by investing activities (141,000) Cash fl ows from fi nancing activities Issuance of common stock 20,000 Payment of cash dividends (29,000) Net cash used by fi nancing activities (9,000)

Net increase in cash 22,000 Cash at beginning of period 33,000

Cash at end of period $ 55,000

Noncash investing and fi nancing activities Issuance of bonds payable to purchase land $ 110,000

ILLUSTRATION 12A-16 Statement of cash fl ows, 2017—direct method

STEP 3: NET CHANGE IN CASH

COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE Illustration 12A-16 indicates that the net change in cash during the period was an increase of $22,000. This agrees with the change in balances in the Cash account reported on the balance sheets in Illustration 12A-1 (page 612).

APPENDIX 12B: Use the T-account approach to prepare a statement of cash fl ows.

LEARNING OBJECTIVE *5▼

Many people like to use T-accounts to provide structure to the preparation of a statement of cash fl ows. The use of T-accounts is based on the accounting equa- tion that you learned in Chapter 1. The basic equation is:

Assets = Liabilities + Equity

Now, let’s rewrite the left-hand side as:

Cash + Noncash Assets = Liabilities + Equity

Next, rewrite the equation by subtracting Noncash Assets from each side to isolate Cash on the left-hand side:

Cash = Liabilities + Equity − Noncash Assets

Finally, if we insert the Δ symbol (which means “change in”), we have:

𝚫 Cash = 𝚫 Liabilities + 𝚫 Equity − 𝚫 Noncash Assets

Appendix 12B: Statement of Cash Flows—T-Account Approach 619

What this means is that the change in cash is equal to the change in all of the other balance sheet accounts. Another way to think about this is that if we analyze the changes in all of the noncash balance sheet accounts, we will explain the change in the Cash account. This, of course, is exactly what we are trying to do with the statement of cash fl ows. To implement this approach, fi rst prepare a large Cash T-account with sections for operating, investing, and fi nancing activities. Then, prepare smaller T-accounts for all of the other noncash balance sheet accounts. Insert the beginning and ending balances for each of these accounts. Once you have done this, then walk through the steps outlined in Illustration 12-3 (page 596). As you walk through the steps, enter debit and credit amounts into the affected accounts. When all of the changes in the T-accounts have been explained, you are done. To demonstrate, we will apply this approach to the example of Computer Services Company that is presented in the chapter. Each of the adjustments in Illustration 12B-1 is num- bered so you can follow them through the T-accounts.

Accounts Receivable

30,000 10,000 (4)

20,000

Inventory

10,000 (5) 5,000

15,000

Prepaid Expenses

1,000 (6) 4,000

5,000

Land

20,000 (9) 110,000

130,000

Retained Earnings

48,000 145,000 (1) (13) 29,000

164,000

Accounts Payable

12,000 16,000 (7)

28,000

Income Taxes Payable

8,000 (8) 2,000

6,000

Bonds Payable

20,000 110,000 (9)

130,000

Common Stock

50,000 20,000 (12)

70,000

Buildings

40,000 (10) 120,000

160,000

Accumulated Depreciation—Buildings

5,000 6,000 (2)

11,000

Equipment

10,000 (11) 25,000 8,000 (3)

27,000

Accumulated Depreciation—Equipment

1,000 (3) 1,000 3,000 (2)

3,000

Cash

Operating (1) Net income 145,000 5,000 Inventory (5) (2) Depreciation expense 9,000 4,000 Prepaid expenses (6) (3) Loss on equipment 3,000 2,000 Income taxes payable (8) (4) Accounts receivable 10,000 (7) Accounts payable 16,000

Net cash provided by operating activities 172,000

Investing (3) Sold equipment 4,000 120,000 Purchased building (10) 25,000 Purchased equipment (11)

141,000 Net cash used by investing activities

Financing (12) Issued common stock 20,000 29,000 Dividend paid (13)

9,000 Net cash used by fi nancing activities

22,000

ILLUSTRATION 12B-1 T-account approach

1. Post net income as a debit to the operating section of the Cash T-account and a credit to Retained Earnings. Make sure to label all adjustments to the Cash T-account. It also helps to number each adjustment so you can trace all of them if you make an error.

620 12 Statement of Cash Flows

2. Post depreciation expense as a debit to the operating section of Cash and a credit to each of the appropriate accumulated depreciation accounts.

3. Post any gains or losses on the sale of property, plant, and equipment. To do this, it is best to fi rst prepare the journal entry that was recorded at the time of the sale and then post each element of the journal entry. For example, for Computer Services the entry was:

Cash 4,000 Accumulated Depreciation—Equipment 1,000 Loss on Disposal of Plant Assets 3,000 Equipment 8,000

The $4,000 cash entry is a source of cash in the investing section of the Cash account. Accumulated Depreciation—Equipment is debited for $1,000. The Loss on Disposal of Plant Assets is a debit to the operating section of the Cash T-account. Finally, Equipment is credited for $8,000.

4–8. Next, post each of the changes to the noncash current asset and current liability accounts. For example, to explain the $10,000 decline in Computer Services’ accounts receivable, credit Accounts Receivable for $10,000 and debit the operating section of the Cash T-account for $10,000.

9. Analyze the changes in the noncurrent accounts. Land was purchased by issuing bonds payable. This requires a debit to Land for $110,000 and a credit to Bonds Payable for $110,000. Note that this is a signifi cant noncash event that requires disclosure at the bottom of the statement of cash fl ows.

10. Buildings is debited for $120,000, and the investing section of the Cash T-account is credited for $120,000 as a use of cash from investing.

11. Equipment is debited for $25,000 and the investing section of the Cash T-account is credited for $25,000 as a use of cash from investing.

12. Common Stock is credited for $20,000 for the issuance of shares of stock, and the fi nancing section of the Cash T-account is debited for $20,000.

13. Retained Earnings is debited to refl ect the payment of the $29,000 divi- dend, and the fi nancing section of the Cash T-account is credited to refl ect the use of Cash.

At this point, all of the changes in the noncash accounts have been explained. All that remains is to subtotal each section of the Cash T-account and compare the total change in cash with the change shown on the balance sheet. Once this is done, the information in the Cash T-account can be used to prepare a statement of cash fl ows.

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Discuss the usefulness and format of the statement of cash fl ows. The statement of cash fl ows provides infor- mation about the cash receipts, cash payments, and net change in cash resulting from the operating, investing, and fi nancing activities of a company during the period. Operating activities include the cash effects of transac- tions that enter into the determination of net income. Invest- ing activities involve cash fl ows resulting from changes in investments and long-term asset items. Financing activities involve cash fl ows resulting from changes in long-term lia- bility and stockholders’ equity items.

2 Prepare a statement of cash fl ows using the indirect method. The preparation of a statement of cash fl ows involves three major steps. (1) Determine net cash pro- vided/used by operating activities by converting net income from an accrual basis to a cash basis. (2) Analyze changes in noncurrent asset and liability accounts and record as investing and fi nancing activities, or disclose as noncash transactions. (3) Compare the net change in cash on the statement of cash fl ows with the change in the Cash account reported on the balance sheet to make sure the amounts agree.

▼

3 Use the statement of cash fl ows to evaluate a company. During the introductory stage, net cash provided by oper- ating activities and net cash provided by investing activi- ties are negative, and net cash provided by fi nancing activi- ties is positive. During the growth stage, net cash provided by operating activities becomes positive but is still not suf- fi cient to meet investing needs. During the maturity stage, net cash provided by operating activities exceeds investing needs, so the company begins to retire debt. During the decline stage, net cash provided by operating activities is reduced, net cash provided by investing activities becomes positive (from selling off assets), and net cash provided by fi nancing activities becomes more negative. Free cash fl ow indicates the amount of cash a company generated during the current year that is available for the payment of dividends or for expansion.

*4 Prepare a statement of cash fl ows using the direct method. The preparation of the statement of cash fl ows

involves three major steps. (1) Determine net cash provided/ used by operating activities by converting net income from an accrual basis to a cash basis. (2) Analyze changes in non- current asset and liability accounts and record as investing and fi nancing activities, or disclose as noncash transac- tions. (3) Compare the net change in cash on the statement of cash fl ows with the change in the Cash account reported on the balance sheet to make sure the amounts agree. The direct method reports cash receipts less cash payments to arrive at net cash provided by operating activities.

*5 Use the T-account approach to prepare a statement of cash fl ows. To use T-accounts to prepare the statement of cash fl ows: (1) prepare a large Cash T-account with sections for operating, investing, and fi nancing activities; (2) pre- pare smaller T-accounts for all other noncash accounts; (3) insert beginning and ending balances for all accounts; and (4) follows the steps in Illustration 12-3 (page 596), enter- ing debit and credit amounts as needed.

Practice Multiple-Choice Questions 621

Direct method A method of determining net cash pro- vided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. The direct method shows operating cash receipts and payments. (p. 596).

Financing activities Cash fl ow activities that include (a) ob- taining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends. (p. 592).

Free cash fl ow Net cash provided by operating activities after adjusting for capital expenditures and cash divi- dends paid. (p. 609).

Indirect method A method of preparing a statement of cash fl ows in which net income is adjusted for items that do not affect cash, to determine net cash provided by operating activities. (p. 596).

Investing activities Cash fl ow activities that include (a) transactions that involve the purchase or disposal of

investments and property, plant, and equipment using cash, and (b) lending money and collecting the loans. (p. 592).

Operating activities Cash fl ow activities that include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income. (p. 592).

Product life cycle A series of phases in a product’s sales and cash fl ows over time. These phases, in order of occurrence, are introductory, growth, maturity, and decline. (p. 607).

Statement of cash fl ows A basic fi nancial statement that provides information about the cash receipts and cash payments of an entity during a period, classifi ed as operating, investing, and fi nancing activities, in a format that reconciles the beginning and ending cash balances. (p. 592).

GLOSSARY REVIEW▼

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

How much cash did the company generate to either expand opera- tions or pay dividends?

Net cash provided by operating activities, cash spent on fi xed assets, and cash dividends

Signifi cant free cash fl ow indicates greater potential to fi nance new investment and pay additional dividends.

Free cash 5 fl ow

Net cash provided

by operating activities

Capital expenditures

− Cash dividends

−

1. Which of the following is incorrect about the state- ment of cash fl ows? (a) It is a fourth basic fi nancial statement. (b) It provides information about cash receipts and

cash payments of an entity during a period.

(LO 1) (c) It reconciles the ending cash account balance to the balance per the bank statement.

(d) It provides information about the operat- ing, investing, and financing activities of the business.

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

2. Which of the following will not be reported in the statement of cash fl ows? (a) The net change in stockholders’ equity during the

year. (b) Cash payments for plant assets during the year. (c) Cash receipts from sales of plant assets during

the year. (d) Sources of fi nancing during the period.

3. The statement of cash fl ows classifi es cash receipts and cash payments by these activities: (a) operating and nonoperating. (b) operating, investing, and fi nancing. (c) fi nancing, operating, and nonoperating. (d) investing, fi nancing, and nonoperating.

4. Which is an example of a cash fl ow from an operat- ing activity? (a) Payment of cash to lenders for interest. (b) Receipt of cash from the sale of common stock. (c) Payment of cash dividends to the company’s

stockholders. (d) None of the above.

5. Which is an example of a cash fl ow from an investing activity? (a) Receipt of cash from the issuance of bonds payable. (b) Payment of cash to repurchase outstanding

common stock. (c) Receipt of cash from the sale of equipment. (d) Payment of cash to suppliers for inventory.

6. Cash dividends paid to stockholders are classifi ed on the statement of cash fl ows as: (a) operating activities. (b) investing activities. (c) a combination of (a) and (b). (d) fi nancing activities.

7. Which is an example of a cash fl ow from a fi nancing activity? (a) Receipt of cash from sale of land. (b) Issuance of debt for cash. (c) Purchase of equipment for cash. (d) None of the above

8. Which of the following is incorrect about the state- ment of cash fl ows? (a) The direct method may be used to report net

cash provided by operating activities. (b) The statement shows the net cash provided

(used) for three categories of activity. (c) The operating activities section is the last section

of the statement. (d) The indirect method may be used to report net

cash provided by operating activities.

Use the indirect method to solve Questions 9 through 11. 9. Net income is $132,000, accounts payable increased

$10,000 during the year, inventory decreased $6,000 during the year, and accounts receivable increased $12,000 during the year. Under the indirect method, what is net cash provided by operating activities? (a) $102,000. (c) $124,000. (b) $112,000. (d) $136,000.

10. Items that are added back to net income in determin- ing net cash provided by operating activities under the indirect method do not include: (a) depreciation expense. (b) an increase in inventory.

(LO 1)

(LO 2)

622 12 Statement of Cash Flows

11. The following data are available for Bill Mack Corporation.

Net income $200,000 Depreciation expense 40,000 Dividends paid 60,000 Gain on sale of land 10,000 Decrease in accounts receivable 20,000 Decrease in accounts payable 30,000

Net cash provided by operating activities is: (a) $160,000. (c) $240,000. (b) $220,000. (d) $280,000.

12. The following are data concerning cash received or paid from various transactions for Orange Peels Corporation.

Sale of land $100,000 Sale of equipment 50,000 Issuance of common stock 70,000 Purchase of equipment 30,000 Payment of cash dividends 60,000

Net cash provided by investing activities is: (a) $120,000. (c) $150,000. (b) $130,000. (d) $190,000.

13. The following data are available for Retique! Increase in accounts payable $ 40,000 Increase in bonds payable 100,000 Sale of investment 50,000 Issuance of common stock 60,000 Payment of cash dividends 30,000

Net cash provided by fi nancing activities is: (a) $90,000. (c) $160,000. (b) $130,000. (d) $170,000.

14. Free cash fl ow provides an indication of a company’s ability to: (a) manage inventory. (b) generate cash to pay dividends. (c) generate cash to invest in new capital expenditures. (d) Both (b) and (c).

15. During the introductory phase of a com- pany’s life cycle, one would normally expect to see: (a) negative cash from operations, negative cash

from investing, and positive cash from fi nancing. (b) negative cash from operations, positive cash

from investing, and positive cash from fi nancing. (c) positive cash from operations, negative cash from

investing, and negative cash from fi nancing. (d) positive cash from operations, negative cash

from investing, and positive cash from fi nancing.

Use the direct method to solve Questions 16 and 17. *16. The beginning balance in accounts receivable is

$44,000, the ending balance is $42,000, and sales during the period are $129,000. What are cash re- ceipts from customers? (a) $127,000. (c) $131,000. (b) $129,000. (d) $141,000.

*17. Which of the following items is reported on a state- ment of cash fl ows prepared by the direct method? (a) Loss on disposal of building. (b) Increase in accounts receivable. (c) Depreciation expense. (d) Cash payments to suppliers.

(LO 2)

(LO 3)

(LO 4)

SOLUTIONS 1. (c) The statement of cash fl ows does not reconcile the ending cash balance to the balance per the bank statement. The

other choices are true statements.

2. (a) The net change in stockholders’ equity during the year is not reported in the statement of cash fl ows. The other choices are true statements.

3. (b) Operating, investing, and fi nancing activities are the three classifi cations of cash receipts and cash payments used in the statement of cash fl ows. The other choices are therefore incorrect.

4. (a) Payment of cash to lenders for interest is an operating activity. The other choices are incorrect because (b) receipt of cash from the sale of common stock is a fi nancing activity, (c) payment of cash dividends to the company’s stockholders is a fi nancing activity, and (d) there is a correct answer.

5. (c) Receipt of cash from the sale of equipment is an investing activity. The other choices are incorrect because (a) the receipt of cash from the issuance of bonds payable is a fi nancing activity, (b) payment of cash to repurchase outstand- ing common stock is a fi nancing activity, and (d) payment of cash to suppliers for inventory is an operating activity.

6. (d) Cash dividends paid to stockholders are classifi ed as a fi nancing activity, not (a) an operating activity, (b) an invest- ing activity, or (c) a combination of (a) and (b).

7. (b) Issuance of debt for cash is a fi nancing activity. The other choices are incorrect because (a) the receipt of cash for the sale of land is an investing activity, (c) the purchase of equipment for cash is an investing activity, and (d) there is a correct answer.

8. (c) The operating section of the statement of cash fl ows is the fi rst, not the last, section of the statement. The other choices are true statements.

9. (d) Net cash provided by operating activities is computed by adjusting net income for the changes in the three current asset/current liability accounts listed. An increase in accounts payable ($10,000) and a decrease in inventory ($6,000) are added to net income ($132,000), while an increase in accounts receivable ($12,000) is subtracted from net income, or $132,000 + $10,000 + $6,000 − $12,000 = $136,000, not (a) $102,000, (b) $112,000, or (c) $124,000.

10. (b) An increase in inventory is subtracted, not added, to net income in determining net cash provided by operating activities. The other choices are incorrect because (a) depreciation expense, (c) amortization expense, and (d) loss on disposal of equipment are all added back to net income in determining net cash provided by operating activities.

11. (b) Net cash provided by operating activities is $220,000 (Net income $200,000 + Depreciation expense $40,000 − Gain on disposal of land $10,000 + Decrease in accounts receivable $20,000 − Decrease in accounts payable $30,000), not (a) $160,000, (c) $240,000, or (d) $280,000.

12. (a) Net cash provided by investing activities is $120,000 (Sale of land $100,000 + Sale of equipment $50,000 − Pur- chase of equipment $30,000), not (b) $130,000, (c) $150,000, or (d) $190,000. Issuance of common stock and payment of cash dividends are fi nancing activities.

13. (b) Net cash provided by fi nancing activities is $130,000 (Increase in bonds payable $100,000 + Issuance of common stock $60,000 − Payment of cash dividends $30,000), not (a) $90,000, (c) $160,000, or (d) $170,000. Increase in ac- counts payable is an operating activity, and sale of investment is an investing activity.

14. (d) Free cash fl ow provides an indication of a company’s ability to generate cash to pay dividends and to invest in new capital expenditures. Choice (a) is incorrect because other measures besides free cash fl ow provide the best measure of a company’s ability to manage inventory. Choices (b) and (c) are true statements, but (d) is the better answer.

15. (a) During the introductory phase of a company’s life cycle, the company will most likely fi nance its operations and investing activities through borrowing or the issuance of stock. This means negative cash from operations and invest- ing, and positive cash from fi nancing. The other choices are incorrect because during the introductory phase of a com- pany’s life cycle, the company will most likely (b) purchase long-term assets which requires a cash outfl ow, (c) fi nance its operations and investing activities through borrowing or the issuance of stock which generates cash infl ows from fi nancing, and (d) use cash to fund operations until it establishes a customer base.

*16. (c) Cash receipts from customers amount to $131,000 ($129,000 + $2,000). The other choices are therefore incorrect. *17. (d) Cash payments to suppliers are reported on a statement of cash fl ows prepared by the direct method. The other choices

are incorrect because (a) loss on disposal of building, (b) increase in accounts receivable, and (c) depreciation expense are reported in the operating activities section of the statement of cash fl ows when the indirect, not direct, method is used.

Practice Exercises 623

1. Furst Corporation had the following transactions.

1. Paid salaries of $14,000.

2. Issued 1,000 shares of $1 par value common stock for equipment worth $16,000.

3. Sold equipment (cost $10,000, accumulated depreciation $6,000) for $3,000.

Prepare journal entries to determine effect on statement of cash fl ows.

(LO 2)

PRACTICE EXERCISES▼

624 12 Statement of Cash Flows

4. Sold land (cost $12,000) for $16,000.

5. Issued another 1,000 shares of $1 par value common stock for $18,000.

6. Recorded depreciation of $20,000.

INSTRUCTIONS

For each transaction above, (a) prepare the journal entry and (b) indicate how it would affect the statement of cash fl ows. Assume the indirect method.

SOLUTION

1. 1. (a) Salaries and Wages Expense 14,000 Cash 14,000

(b) Salaries and wages expense is not reported separately on the statement of cash fl ows. It is part of the computation of net income in the income statement and is included in the net income amount on the statement of cash fl ows.

2. (a) Equipment 16,000 Common Stock 1,000 Paid-in Capital in Excess of Par—Common Stock 15,000

(b) The issuance of common stock for equipment ($16,000) is reported as a noncash fi nancing and investing activity at the bottom of the statement of cash fl ows.

3. (a) Cash 3,000 Loss on Disposal of Plant Assets 1,000 Accumulated Depreciation—Equipment 6,000 Equipment 10,000

(b) The cash receipt ($3,000) is reported in the investing section. The loss ($1,000) is added to net income in the operating section.

4. (a) Cash 16,000 Land 12,000 Gain on Disposal of Plant Assets 4,000

(b) The cash receipt ($16,000) is reported in the investing section. The gain ($4,000) is deducted from net income in the operating section.

5. (a) Cash 18,000 Common Stock 1,000 Paid-in Capital in Excess of Par—Common Stock 17,000

(b) The cash receipt ($18,000) is reported in the fi nancing section.

6. (a) Depreciation Expense 20,000 Accumulated Depreciation—Equipment 20,000

(b) Depreciation expense ($20,000) is added to net income in the operating section.

2. Strong Corporation’s comparative balance sheets are presented below.Prepare statement of cash fl ows and compute free cash fl ow.

(LO 2, 3)

2017 2016

Cash $ 28,200 $ 17,700 Accounts receivable 24,200 22,300 Investments 23,000 16,000 Equipment 60,000 70,000 Accumulated depreciation—equipment (14,000) (10,000)

Total $ 121,400 $ 116,000

Accounts payable $ 19,600 $ 11,100 Bonds payable 10,000 30,000 Common stock 60,000 45,000 Retained earnings 31,800 29,900

Total $ 121,400 $ 116,000

STRONG CORPORATION Comparative Balance Sheets

December 31

Practice Problem 625

Additional information: 1. Net income was $28,300. Dividends declared and paid were $26,400. 2. Equipment which cost $10,000 and had accumulated depreciation of $1,200 was sold

for $4,300. 3. All other changes in noncurrent account balances had a direct effect on cash flows,

except the change in accumulated depreciation.

INSTRUCTIONS

(a) Prepare a statement of cash fl ows for 2017 using the indirect method.

(b) Compute free cash fl ow.

SOLUTION

Cash fl ows from operating activities Net income $ 28,300 Adjustments to reconcile net income

to net cash provided by operating activities: Depreciation expense $ 5,200* Loss on sale of equipment 4,500** Increase in accounts payable 8,500 Increase in accounts receivable (1,900) 16,300

Net cash provided by operating activities 44,600 Cash fl ows from investing activities Sale of equipment 4,300 Purchase of investments (7,000)

Net cash used by investing activities (2,700) Cash fl ows from fi nancing activities Issuance of common stock 15,000 Retirement of bonds (20,000) Payment of dividends (26,400)

Net cash used by fi nancing activities (31,400)

Net increase in cash 10,500 Cash at beginning of period 17,700

Cash at end of period $ 28,200

*[$14,000 − ($10,000 − $1,200)]; **[$4,300 − ($10,000 − $1,200)]

STRONG CORPORATION Statement of Cash Flows

For the Year Ended December 31, 2017

2. (a)

The income statement for Kosinski Manufacturing Company contains the following con- densed information.

Prepare statement of cash fl ows using indirect and direct methods.

(LO 2, 4)

PRACTICE PROBLEM▼

KOSINSKI MANUFACTURING COMPANY Income Statement

For the Year Ended December 31, 2017

Sales revenue $6,583,000 Cost of goods sold $2,810,000 Operating expenses, excluding depreciation 2,086,000 Depreciation expense 880,000 Loss on disposal of equipment 24,000 5,800,000

Income before income taxes 783,000 Income tax expense 353,000

Net income $ 430,000

(b) $44,600 − $0 − $26,400 = $18,200

626 12 Statement of Cash Flows

The $24,000 loss resulting from the sale of machinery resulted from selling equipment for $270,000 cash. Machinery was purchased at a cost of $750,000. The following balances are reported on Kosinski’s comparative balance sheets at December 31.

2017 2016

Cash $672,000 $130,000 Accounts receivable 775,000 610,000 Inventory 834,000 867,000 Accounts payable 521,000 501,000

Income tax expense of $353,000 represents the amount paid in 2017. Dividends declared and paid in 2017 totaled $200,000.

INSTRUCTIONS

(a) Prepare the statement of cash fl ows using the indirect method. *(b) Prepare the statement of cash fl ows using the direct method.

SOLUTION

*(b) KOSINSKI MANUFACTURING COMPANY Statement of Cash Flows—Direct Method For the Year Ended December 31, 2017

Cash flows from operating activities Cash collections from customers $6,418,000* Cash payments: To suppliers $2,757,000** For operating expenses 2,086,000 For income taxes 353,000 5,196,000

Net cash provided by operating activities 1,222,000

Cash flows from investing activities Sale of machinery 270,000 Purchase of machinery (750,000)

Net cash used by investing activities (480,000)

(a) KOSINSKI MANUFACTURING COMPANY Statement of Cash Flows—Indirect Method For the Year Ended December 31, 2017

Cash flows from operating activities Net income $ 430,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 880,000 Loss on disposal of plant assets 24,000 Increase in accounts receivable (165,000) Decrease in inventory 33,000 Increase in accounts payable 20,000 792,000

Net cash provided by operating activities 1,222,000 Cash flows from investing activities Sale of machinery 270,000 Purchase of machinery (750,000)

Net cash used by investing activities (480,000) Cash flows from financing activities Payment of cash dividends (200,000)

Net cash used by financing activities (200,000)

Net increase in cash 542,000 Cash at beginning of period 130,000

Cash at end of period $ 672,000

Questions 627

9. When the total cash infl ows exceed the total cash out- fl ows in the statement of cash fl ows, how and where is this excess identifi ed?

10. Describe the indirect method for determining net cash provided (used) by operating activities.

11. Why is it necessary to convert accrual-basis net in- come to cash-basis net income when preparing a state- ment of cash fl ows?

12. The president of Murquery Company is puzzled. During the last year, the company experi- enced a net loss of $800,000, yet its cash increased $300,000 during the same period of time. Explain to the president how this could occur.

13. Identify fi ve items that are adjustments to convert net income to net cash provided by operating activities under the indirect method.

14. Why and how is depreciation expense reported in a statement of cash fl ows prepared using the indirect method?

15. Why is the statement of cash fl ows useful?

16. During 2017, Slivowitz Company exchanged $1,700,000 of its common stock for land. Indicate how the transaction would be reported on a statement of cash fl ows, if at all.

17. (a) What are the phases of the corporate life cycle? (b) What effect does each phase have on the amounts

reported in a statement of cash fl ows?

1. (a) What is a statement of cash fl ows? (b) Pat Marx maintains that the statement of cash

fl ows is an optional fi nancial statement. Do you agree? Explain.

2. What questions about cash are answered by the statement of cash fl ows?

3. Distinguish among the three activities reported in the statement of cash flows.

4. (a) What are the sources (infl ows) of cash in a state- ment of cash fl ows?

(b) What are the uses (outfl ows) of cash?

5. Why is it important to disclose certain noncash trans- actions? How should they be disclosed?

6. Helen Powell and Paul Tang were discussing the for- mat of the statement of cash fl ows of Baumgarten Co. At the bottom of Baumgarten’s statement of cash fl ows was a separate section entitled “Noncash investing and fi nancing activities.” Give three examples of sig- nifi cant noncash transactions that would be reported in this section.

7. Why is it necessary to use comparative balance sheets, a current income statement, and certain transaction data in preparing a statement of cash fl ows?

8. Contrast the advantages and disadvantages of the direct and indirect methods of preparing the statement of cash fl ows. Are both methods acceptable? Which method is preferred by the FASB? Which method is more popular?

QUESTIONS▼

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.

Cash flows from financing activities Payment of cash dividends (200,000)

Net cash used by financing activities (200,000)

Net increase in cash 542,000 Cash at beginning of period 130,000

Cash at end of period $ 672,000

Direct-Method Computations:

*Computation of cash collections from customers: Sales revenue per the income statement $ 6,583,000 Deduct: Increase in accounts receivable (165,000)

Cash collections from customers $ 6,418,000 **Computation of cash payments to suppliers Cost of goods sold per income statement $ 2,810,000 Deduct: Decrease in inventories (33,000) Deduct: Increase in accounts payable (20,000)

$ 2,757,000

628 12 Statement of Cash Flows

18. Based on its statement of cash fl ows, in what stage of the product life cycle is Apple?

*19. Describe the direct method for determining net cash provided by operating activities.

* 20. Give the formulas under the direct method for com- puting (a) cash receipts from customers and (b) cash payments to suppliers.

*21. Harbinger Inc. reported sales of $2 million for 2017. Accounts receivable decreased $150,000 and accounts payable increased $300,000. Compute cash receipts from customers, assuming that the receivable and payable transactions are related to operations.

*22. In the direct method, why is depreciation expense not re- ported in the cash fl ows from operating activities section?

BE12-1 Each of these items must be considered in preparing a statement of cash fl ows for Irvin Co. for the year ended December 31, 2017. For each item, state how it should be shown in the statement of cash fl ows for 2017. (a) Issued bonds for $200,000 cash. (b) Purchased equipment for $180,000 cash. (c) Sold land costing $20,000 for $20,000 cash. (d) Declared and paid a $50,000 cash dividend.

BE12-2 Classify each item as an operating, investing, or fi nancing activity. Assume all items involve cash unless there is information to the contrary. (a) Purchase of equipment. (d) Cash received from sale of goods. (b) Sale of building. (e) Payment of dividends. (c) Redemption of bonds. (f) Issuance of capital stock.

BE12-3 The following T-account is a summary of the Cash account of Alixon Company.

Cash (Summary Form)

Balance, Jan. 1 8,000 Receipts from customers 364,000 Payments for goods 200,000 Dividends on stock investments 6,000 Payments for operating expenses 140,000 Proceeds from sale of equipment 36,000 Interest paid 10,000 Proceeds from issuance of Taxes paid 8,000 bonds payable 300,000 Dividends paid 40,000

Balance, Dec. 31 316,000

What amount of net cash provided (used) by fi nancing activities should be reported in the statement of cash fl ows?

BE12-4 Miguel, Inc. reported net income of $2.5 million in 2017. Depreciation for the year was $160,000, accounts receivable decreased $350,000, and accounts payable decreased $280,000. Compute net cash provided by operating activities using the indirect approach.

BE12-5 The net income for Mongan Co. for 2017 was $280,000. For 2017, depreciation on plant assets was $70,000, and the company incurred a loss on disposal of plant assets of $28,000. Compute net cash provided by operating activities under the indirect method, assuming there were no other changes in the company’s accounts.

BE12-6 The comparative balance sheets for Gale Company show these changes in non- cash current asset accounts: accounts receivable decreased $80,000, prepaid expenses increased $28,000, and inventories increased $40,000. Compute net cash provided by operating activities using the indirect method, assuming that net income is $186,000.

BE12-7 The T-accounts for Equipment and the related Accumulated Depreciation— Equipment for Goldstone Company at the end of 2017 are shown here.

Equipment Accum. Depr.—Equipment

Beg. bal. 80,000 Disposals 22,000 Disposals 5,100 Beg. bal. 44,500 Acquisitions 41,600 Depr. exp. 12,000

End. bal. 99,600 End. bal. 51,400

In addition, Goldstone’s income statement reported a loss on the disposal of plant assets of $3,500. What amount was reported on the statement of cash flows as “cash flow from sale of equipment”?

Indicate statement presentation of selected transactions.

(LO 1), K

Classify items by activities.

(LO 1), C

Identify fi nancing activity transactions.

(LO 1), AP

Compute net cash provided by operating activities—indirect method.

(LO 2), AP Compute net cash provided by operating activities—indirect method.

(LO 2), AP

Compute net cash provided by operating activities—indirect method.

(LO 2), AP

Determine cash received from sale of equipment.

(LO 2), AN

BRIEF EXERCISES▼

DO IT! Exercises 629

BE12-8 (a) Why is net cash provided by operating activities likely to be lower than reported net

income during the growth phase? (b) Why is net cash from investing activities often positive during the late maturity phase

and during the decline phase?

BE12-9 Suppose during 2017 that Cypress Semiconductor Corporation reported net cash provided by operating activities of $89,303,000, cash used in investing of $43,126,000, and cash used in fi nancing of $7,368,000. In addition, cash spent for fi xed assets during the period was $25,823,000. No dividends were paid. Calculate free cash fl ow.

BE12-10 Sprouts Corporation reported net cash provided by operating activities of $412,000, net cash used by investing activities of $250,000, and net cash provided by fi - nancing activities of $70,000. In addition, cash spent for capital assets during the period was $200,000. No dividends were paid. Calculate free cash fl ow.

BE12-11 Suppose Canwest Global Communications Corp. reported net cash used by op- erating activities of $104,539,000 and sales revenue of $2,867,459,000 during 2017. Cash spent on plant asset additions during the year was $79,330,000. Calculate free cash fl ow.

BE12-12 The management of Uhuru Inc. is trying to decide whether it can increase its dividend. During the current year, it reported net income of $875,000. It had net cash pro- vided by operating activities of $734,000, paid cash dividends of $92,000, and had capital expenditures of $310,000. Compute the company’s free cash fl ow, and discuss whether an increase in the dividend appears warranted. What other factors should be considered?

*BE12-13 Suppose Columbia Sportswear Company had accounts receivable of $299,585,000 at January 1, 2017, and $226,548,000 at December 31, 2017. Assume sales revenue was $1,244,023,000 for the year 2017. What is the amount of cash receipts from customers in 2017?

*BE12-14 Hoffman Corporation reported income taxes of $370,000,000 on its 2017 in- come statement and income taxes payable of $277,000,000 at December 31, 2016, and $528,000,000 at December 31, 2017. What amount of cash payments were made for in- come taxes during 2017?

*BE12-15 Pietr Corporation reports operating expenses of $90,000, excluding depreciation expense of $15,000, for 2017. During the year, prepaid expenses decreased $7,200 and accrued expenses payable increased $4,400. Compute the cash payments for operating expenses in 2017.

Answer questions related to the phases of product life cycle.

(LO 3), C

Calculate free cash fl ow.

(LO 3), AP

Calculate free cash fl ow.

(LO 3), AP

Calculate free cash fl ow.

(LO 3), AP

Calculate and analyze free cash fl ow.

(LO 3), AN

Compute receipts from customers—direct method.

(LO 4), AP

Compute cash payments for income taxes—direct method.

(LO 4), AP

Compute cash payments for operating expenses—direct method.

(LO 4), AP

Moss Corporation had the following transactions.

1. Issued $160,000 of bonds payable. 2. Paid utilities expense. 3. Issued 500 shares of preferred stock for $45,000. 4. Sold land and a building for $250,000. 5. Loaned $30,000 to Dead End Corporation, receiving Dead End’s 1-year, 12% note.

Classify each of these transactions by type of cash flow activity (operating, investing, or financing). (Hint: Refer to Illustration 12-1.)

PK Photography reported net income of $100,000 for 2017. Included in the income statement were depreciation expense of $6,300, patent amortization expense of $4,000, and a gain on disposal of plant assets of $3,600. PK’s comparative balance sheets show the following balances.

12/31/17 12/31/16

Accounts receivable $21,000 $27,000 Accounts payable 9,200 6,000

Calculate net cash provided by operating activities for PK Photography.

DO IT! 12-1 Classify transactions by type of cash fl ow activity.

(LO 1), C

DO IT! 12-2a Calculate net cash from operating activities.

(LO 2), AP

EXERCISES ▼DO IT!

630 12 Statement of Cash Flows

ALEX COMPANY Income Statement

For the Year Ended December 31, 2017

Sales revenue $941,000 Cost of goods sold $475,000 Operating expenses 231,000 Interest expense 12,000 Loss on disposal of equipment 2,000 720,000

Income before income taxes 221,000 Income tax expense 65,000

Net income $156,000

Alex Company reported the following information for 2017.DO IT! 12-2bPrepare statement of cash fl ows—indirect method.

(LO 2), AP ALEX COMPANY Comparative Balance Sheets

December 31

Change Assets 2017 2016 Increase/Decrease Cash $ 59,000 $ 36,000 $ 23,000 Increase Accounts receivable 62,000 22,000 40,000 Increase Inventory 44,000 –0– 44,000 Increase Prepaid expenses 6,000 4,000 2,000 Increase Land 55,000 70,000 15,000 Decrease Buildings 200,000 200,000 –0– Accumulated depreciation—buildings (21,000) (14,000) 7,000 Increase Equipment 183,000 68,000 115,000 Increase Accumulated depreciation—equipment (28,000) (10,000) 18,000 Increase

Totals $560,000 $376,000

Liabilities and Stockholders’ Equity

Accounts payable $ 43,000 $ 40,000 $ 3,000 Increase Accrued expenses payable –0– 10,000 10,000 Decrease Bonds payable 100,000 150,000 50,000 Decrease Common stock ($1 par) 230,000 60,000 170,000 Increase Retained earnings 187,000 116,000 71,000 Increase

Totals $560,000 $376,000

Use this information to prepare a statement of cash fl ows using the indirect method.

Moskow Corporation issued the following statement of cash fl ows for 2017.DO IT! 12-3Compute and discuss free cash fl ow.

(LO 3), AP

Additional information: 1. Operating expenses include depreciation expense of $40,000. 2. Land was sold at its book value for cash. 3. Cash dividends of $85,000 were declared and paid in 2017. 4. Equipment with a cost of $166,000 was purchased for cash. Equipment with a

cost of $51,000 and a book value of $36,000 was sold for $34,000 cash. 5. Bonds of $50,000 were redeemed at their face value for cash. 6. Common stock ($1 par) of $170,000 was issued for cash.

Exercises 631

(a) Compute free cash fl ow for Moskow Corporation. (b) Explain why free cash fl ow often provides better information than “Net cash provided

by operating activities.”

MOSKOW CORPORATION Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2017

Cash fl ows from operating activities Net income $ 59,000 Adjustments to reconcile net income to net cash

provided by operating activities: Depreciation expense $ 9,100 Decrease in accounts receivable 9,500 Increase in inventory (5,000) Decrease in accounts payable (2,200) Loss on disposal of plant assets 3,300 14,700

Net cash provided by operating activities 73,700 Cash fl ows from investing activities Sale of investments 3,100 Purchase of equipment (24,200)

Net cash used by investing activities (21,100) Cash fl ows from fi nancing activities Issuance of stock 20,000 Payment on long-term note payable (10,000) Payment for dividends (13,000)

Net cash used by fi nancing activities (3,000)

Net increase in cash 49,600 Cash at beginning of year 13,000

Cash at end of year $ 62,600

E12-1 Kiley Corporation had these transactions during 2017. (a) Purchased a machine for $30,000, giving a long-term note in exchange. (b) Issued $50,000 par value common stock for cash. (c) Issued $200,000 par value common stock upon conversion of bonds having a face

value of $200,000. (d) Declared and paid a cash dividend of $13,000. (e) Sold a long-term investment with a cost of $15,000 for $15,000 cash. (f) Collected $16,000 from sale of goods. (g) Paid $18,000 to suppliers.

Instructions Analyze the transactions and indicate whether each transaction is an operating activity, investing activity, financing activity, or noncash investing and financing activity.

E12-2 An analysis of comparative balance sheets, the current year’s income statement, and the general ledger accounts of Hailey Corp. uncovered the following items. Assume all items involve cash unless there is information to the contrary. (a) Payment of interest on notes payable. (b) Exchange of land for patent. (c) Sale of building at book value. (d) Payment of dividends. (e) Depreciation. (f) Conversion of bonds into common

stock. (g) Receipt of interest on notes receivable.

Classify transactions by type of activity.

(LO 1), C

Classify transactions by type of activity.

(LO 1), C

EXERCISES▼

(h) Issuance of capital stock. (i) Amortization of patent. (j) Issuance of bonds for land. (k) Purchase of land. (l) Receipt of dividends on investment in

stock. (m) Loss on disposal of plant assets. (n) Retirement of bonds.

632 12 Statement of Cash Flows

Instructions Indicate how each item should be classified in the statement of cash flows (indirect method) using these four major classifications: operating activity (that is, the item would be listed among the adjustments to net income to determine net cash provided by operating activities under the indirect method), investing activity, financing activity, or significant noncash investing and financing activity.

E12-3 Sosa Company reported net income of $190,000 for 2017. Sosa also reported depreciation expense of $35,000 and a loss of $5,000 on the disposal of plant assets. The comparative balance sheets show an increase in accounts receivable of $15,000 for the year, a $17,000 increase in accounts payable, and a $4,000 increase in prepaid expenses.

Instructions Prepare the operating activities section of the statement of cash flows for 2017. Use the indirect method.

E12-4 The current sections of Sunn Inc.’s balance sheets at December 31, 2016 and 2017, are presented here. Sunn’s net income for 2017 was $153,000. Depreciation expense was $27,000.

2017 2016

Current assets Cash $105,000 $ 99,000 Accounts receivable 80,000 89,000 Inventory 168,000 172,000 Prepaid expenses 27,000 22,000

Total current assets $380,000 $382,000

Current liabilities Accrued expenses payable $ 15,000 $ 5,000 Accounts payable 85,000 92,000

Total current liabilities $100,000 $ 97,000

Instructions Prepare the net cash provided by operating activities section of the company’s statement of cash flows for the year ended December 31, 2017, using the indirect method.

E12-5 The following information is available for Stamos Corporation for the year ended December 31, 2017.

Beginning cash balance $ 45,000 Accounts payable decrease 3,700 Depreciation expense 162,000 Accounts receivable increase 8,200 Inventory increase 11,000 Net income 284,100 Cash received for sale of land at book value 35,000 Cash dividends paid 12,000 Income taxes payable increase 4,700 Cash used to purchase building 289,000 Cash used to purchase treasury stock 26,000 Cash received from issuing bonds 200,000

Instructions Prepare a statement of cash flows using the indirect method.

E12-6 The following three accounts appear in the general ledger of Beiber Corp. during 2017.

Equipment

Date Debit Credit Balance

Jan. 1 Balance 160,000 July 31 Purchase of equipment 70,000 230,000 Sept. 2 Cost of equipment constructed 53,000 283,000 Nov. 10 Cost of equipment sold 49,000 234,000

Prepare the operating activities section—indirect method.

(LO 2), AP

Prepare the operating activities section—indirect method.

(LO 2), AP

Prepare statement of cash fl ows—indirect method.

(LO 2), AP

Prepare partial statement of cash fl ows—indirect method.

(LO 2), AN

Exercises 633

Accumulated Depreciation—Equipment

Date Debit Credit Balance

Jan. 1 Balance 71,000 Nov. 10 Accumulated depreciation on equipment sold 16,000 55,000 Dec. 31 Depreciation for year 28,000 83,000

Retained Earnings

Date Debit Credit Balance

Jan. 1 Balance 105,000 Aug. 23 Dividends (cash) 14,000 91,000 Dec. 31 Net income 72,000 163,000

Instructions From the postings in the accounts, indicate how the information is reported on a state- ment of cash flows using the indirect method. The loss on disposal of plant assets was $8,000. (Hint: Cost of equipment constructed is reported in the investing activities section as a decrease in cash of $53,000.)

E12-7 The following are comparative balance sheets for Mitch Company.

MITCH COMPANY Comparative Balance Sheets

December 31

Assets 2017 2016

Cash $ 68,000 $ 22,000 Accounts receivable 88,000 76,000 Inventory 167,000 189,000 Land 80,000 100,000 Equipment 260,000 200,000 Accumulated depreciation—equipment (66,000) (32,000)

Total $597,000 $555,000

Liabilities and Stockholders’ Equity 2017 2016

Accounts payable $ 39,000 $ 43,000 Bonds payable 150,000 200,000 Common stock ($1 par) 216,000 174,000 Retained earnings 192,000 138,000

Total $597,000 $555,000

Additional information:

1. Net income for 2017 was $93,000. 2. Depreciation expense was $34,000. 3. Cash dividends of $39,000 were declared and paid. 4. Bonds payable amounting to $50,000 were redeemed for cash $50,000. 5. Common stock was issued for $42,000 cash. 6. No equipment was sold during 2017. 7. Land was sold for its book value.

Instructions Prepare a statement of cash flows for 2017 using the indirect method.

E12-8 The information in the table is from the statement of cash flows for a com- pany at four different points in time (M, N, O, and P). Negative values are presented in parentheses.

Point in Time

M N O P

Net cash provided by operating activities $ (60,000) $ 30,000 $120,000 $ (10,000) Cash provided by investing activities (100,000) 25,000 30,000 (40,000) Cash provided by financing activities 70,000 (90,000) (50,000) 120,000 Net income (38,000) 10,000 100,000 (5,000)

Prepare a statement of cash fl ows—indirect method.

(LO 2), AP

Identify phases of product life cycle.

(LO 3), C

634 12 Statement of Cash Flows

Instructions For each point in time, state whether the company is most likely in the introductory phase, growth phase, maturity phase, or decline phase. In each case, explain your choice.

E12-9 Suppose the following is 2017 information for PepsiCo, Inc. and The Coca-Cola Company.

($ in millions) PepsiCo Coca-Cola

Net cash provided by operating activities $ 6,796 $ 8,186 Average current liabilities 8,772 13,355 Net income 5,979 6,906 Sales revenue 43,232 30,990 Capital expenditures 2,128 1,993 Dividends paid 2,732 3,800

Instructions Compute free cash flow for both companies and compare.

E12-10 Information for two companies in the same industry, Merrill Corporation and Wingate Corporation, is presented here.

Merrill Wingate Corporation Corporation

Net cash provided by operating activities $ 80,000 $100,000 Average current liabilities 50,000 100,000 Net income 200,000 200,000 Capital expenditures 40,000 70,000 Dividends paid 5,000 10,000

Instructions Compute free cash flow for both companies and compare.

*E12-11 Zimmer Company completed its first year of operations on December 31, 2017. Its initial income statement showed that Zimmer had sales revenue of $198,000 and operating expenses of $83,000. Accounts receivable and accounts payable at year-end were $60,000 and $23,000, respectively. Assume that accounts payable related to operating expenses. Ignore income taxes.

Instructions Compute net cash provided by operating activity using the direct method.

*E12-12 Suppose the 2017 income statement for McDonald’s Corporation shows cost of goods sold $5,178.0 million and operating expenses (including depreciation expense of $1,216.2 million) $10,725.7 million. The comparative balance sheets for the year show that inventory decreased $5.3 million, prepaid expenses increased $42.2 million, accounts payable (merchandise suppliers) increased $15.6 million, and accrued expenses payable increased $199.8 million.

Instructions Using the direct method, compute (a) cash payments to suppliers and (b) cash payments for operating expenses.

*E12-13 The 2017 accounting records of Megan Transport reveal these transactions and events.

Payment of interest $ 10,000 Payment of salaries and wages $ 53,000 Cash sales 48,000 Depreciation expense 16,000 Receipt of dividend revenue 18,000 Proceeds from sale of vehicles 812,000 Payment of income taxes 12,000 Purchase of equipment for cash 22,000 Net income 38,000 Loss on sale of vehicles 3,000 Payment for merchandise 97,000 Payment of dividends 14,000 Payment for land 74,000 Payment of operating expenses 28,000 Collection of accounts receivable 195,000

Instructions Prepare the cash flows from operating activities section using the direct method.

Compare free cash fl ow of two companies.

(LO 3), AN

Compare free cash fl ow of two companies.

(LO 3), AN

Compute cash provided by operating activities—direct method.

(LO 4), AP

Compute cash payments— direct method.

(LO 4), AP

Compute cash fl ow from operating activities—direct method.

(LO 4), AP

Problems: Set A 635

*E12-14 The following information is available for Balboa Corp. for 2017.

Cash used to purchase treasury stock $ 48,100 Cash dividends paid 21,800 Cash paid for interest 22,400 Net income 464,300 Sales revenue 802,000 Cash paid for taxes 99,000 Cash received from customers 566,100 Cash received from sale of building (at book value) 197,600 Cash paid for operating expenses 77,000 Beginning cash balance 11,000 Cash paid for goods and services 279,100 Cash received from issuing common stock 355,000 Cash paid to redeem bonds at maturity 200,000 Cash paid to purchase equipment 113,200

Instructions Prepare a statement of cash flows using the direct method.

*E12-15 The following information is taken from the 2017 general ledger of Preminger Company.

Rent Rent expense $ 30,000 Prepaid rent, January 1 5,900 Prepaid rent, December 31 7,400 Salaries Salaries and wages expense $ 54,000 Salaries and wages payable, January 1 2,000 Salaries and wages payable, December 31 8,000 Sales Sales revenue $160,000 Accounts receivable, January 1 16,000 Accounts receivable, December 31 7,000

Instructions In each case, compute the amount that should be reported in the operating activities section of the statement of cash flows under the direct method.

Prepare statement of cash fl ows—direct method.

(LO 4), AP

Calculate cash fl ows—direct method.

(LO 4), AN

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

P12-1A You are provided with the following information regarding events that occurred at Moore Corporation during 2017 or changes in account balances as of December 31, 2017.

(1) (2) Statement If Operating, Did It of Cash Increase or Decrease Flow Section Reported Cash from Affected Operating Activities?

(a) Depreciation expense was $80,000. (b) Interest Payable account increased $5,000. (c) Received $26,000 from sale of plant assets. (d) Acquired land by issuing common stock to seller. (e) Paid $17,000 cash dividend to preferred

stockholders. (f) Paid $4,000 cash dividend to common stockholders. (g) Accounts Receivable account decreased $10,000. (h) Inventory increased $2,000. (i) Received $100,000 from issuing bonds payable. (j) Acquired equipment for $16,000 cash.

Distinguish among operating, investing, and fi nancing activities.

(LO 1, 2), AP

PROBLEMS: SET A▼

636 12 Statement of Cash Flows

Instructions Moore prepares its statement of cash flows using the indirect approach. Complete the first column of the table, indicating whether each item affects the operating activities section (O) (that is, the item would be listed among the adjustments to net income to determine net cash provided by operating activities under the indirect approach), investing activities section (I), financing activities section (F), or is a noncash (NC) transaction reported in a separate schedule. For those items classified as operating activities (O), indicate whether the item is added (A) or subtracted (S) from net income to determine net cash provided by operating activities.

P12-2A The following account balances relate to the stockholders’ equity accounts of Molder Corp. at year-end.

2017 2016

Common stock, 10,500 and 10,000 shares, respectively, for 2017 and 2016 $160,800 $140,000 Preferred stock, 5,000 shares 125,000 125,000 Retained earnings 300,000 270,000

A small stock dividend was declared and issued in 2017. The market price of the shares was $8,800. Cash dividends were $20,000 in both 2017 and 2016. The common stock has no par or stated value.

Instructions (a) What was the amount of net income reported by Molder Corp. in 2017? (b) Determine the amounts of any cash infl ows or outfl ows related to the common stock

and dividend accounts in 2017. (c) Indicate where each of the cash infl ows or outfl ows identifi ed in (b) would be classifi ed

on the statement of cash fl ows.

P12-3A The income statement of Munsun Company is presented here.

MUNSUN COMPANY Income Statement

For the Year Ended November 30, 2017

Sales revenue $7,600,000 Cost of goods sold Beginning inventory $1,900,000 Purchases 4,400,000

Goods available for sale 6,300,000 Ending inventory 1,600,000

Total cost of goods sold 4,700,000

Gross profi t 2,900,000 Operating expenses Selling expenses 450,000 Administrative expenses 700,000 1,150,000

Net income $1,750,000

Additional information:

1. Accounts receivable decreased $380,000 during the year, and inventory decreased $300,000. 2. Prepaid expenses increased $150,000 during the year. 3. Accounts payable to suppliers of merchandise decreased $350,000 during the year. 4. Accrued expenses payable decreased $100,000 during the year. 5. Administrative expenses include depreciation expense of $110,000.

Instructions Prepare the operating activities section of the statement of cash flows for the year ended November 30, 2017, for Munsun Company, using the indirect method.

*P12-4A Data for Munsun Company are presented in P12-3A.

Instructions Prepare the operating activities section of the statement of cash flows using the direct method.

Determine cash fl ow effects of changes in equity accounts.

(LO 2), AN

(a) Net income $58,800

Prepare the operating activities section—indirect method.

(LO 2), AP

Net cash provided $1,940,000

Prepare the operating activities section—direct method.

(LO 4), AP Net cash provided— oper. act. $1,940,000

Problems: Set A 637

P12-5A Rewe Company’s income statement contained the condensed information below.

REWE COMPANY Income Statement

For the Year Ended December 31, 2017

Service revenue $970,000 Operating expenses, excluding depreciation $614,000 Depreciation expense 55,000 Loss on disposal of plant assets 16,000 685,000

Income before income taxes 285,000 Income tax expense 56,000

Net income $229,000

Rewe’s balance sheets contained the following comparative data at December 31.

2017 2016

Accounts receivable $70,000 $60,000 Accounts payable 41,000 32,000 Income taxes payable 13,000 7,000

Accounts payable pertain to operating expenses.

Instructions Prepare the operating activities section of the statement of cash flows using the indirect method.

*P12-6A Data for Rewe Company are presented in P12-5A.

Instructions Prepare the operating activities section of the statement of cash flows using the direct method.

P12-7A Presented below are the fi nancial statements of Warner Company.

WARNER COMPANY Comparative Balance Sheets

December 31

Assets 2017 2016

Cash $ 35,000 $ 20,000 Accounts receivable 20,000 14,000 Inventory 28,000 20,000 Property, plant, and equipment 60,000 78,000 Accumulated depreciation (32,000) (24,000)

Total $111,000 $108,000

Liabilities and Stockholders’ Equity

Accounts payable $ 19,000 $ 15,000 Income taxes payable 7,000 8,000 Bonds payable 17,000 33,000 Common stock 18,000 14,000 Retained earnings 50,000 38,000

Total $111,000 $108,000

WARNER COMPANY Income Statement

For the Year Ended December 31, 2017

Sales revenue $242,000 Cost of goods sold 175,000

Gross profi t 67,000 Selling expenses $18,000 Administrative expenses 6,000 24,000

Income from operations 43,000 Interest expense 3,000

Income before income taxes 40,000 Income tax expense 8,000

Net income $ 32,000

Prepare the operating activities section—indirect method.

(LO 2), AP

Net cash provided $305,000

Prepare the operating activities section—direct method.

(LO 4), AP

Prepare a statement of cash fl ows—indirect method, and compute free cash fl ow.

(LO 2, 3), AP

Net cash provided $305,000

638 12 Statement of Cash Flows

Additional data: 1. Depreciation expense was $17,500. 2. Dividends declared and paid were $20,000. 3. During the year equipment was sold for $8,500 cash. This equipment cost $18,000

originally and had accumulated depreciation of $9,500 at the time of sale.

Instructions (a) Prepare a statement of cash fl ows using the indirect method. (b) Compute free cash fl ow.

*P12-8A Data for Warner Company are presented in P12-7A. Further analysis reveals the following. 1. Accounts payable pertain to merchandise suppliers. 2. All operating expenses except for depreciation were paid in cash. 3. All depreciation expense is in the selling expense category. 4. All sales and purchases are on account.

Instructions (a) Prepare a statement of cash fl ows for Warner Company using the direct method. (b) Compute free cash fl ow.

P12-9A Condensed fi nancial data of Granger Inc. follow.

GRANGER INC. Comparative Balance Sheets

December 31

Assets 2017 2016

Cash $ 80,800 $ 48,400 Accounts receivable 87,800 38,000 Inventory 112,500 102,850 Prepaid expenses 28,400 26,000 Long-term investments 138,000 109,000 Plant assets 285,000 242,500 Accumulated depreciation (50,000) (52,000)

Total $682,500 $514,750

Liabilities and Stockholders’ Equity

Accounts payable $102,000 $ 67,300 Accrued expenses payable 16,500 21,000 Bonds payable 110,000 146,000 Common stock 220,000 175,000 Retained earnings 234,000 105,450

Total $682,500 $514,750

GRANGER INC. Income Statement Data

For the Year Ended December 31, 2017

Sales revenue $388,460 Less: Cost of goods sold $135,460 Operating expenses, excluding depreciation 12,410 Depreciation expense 46,500 Income tax expense 27,280 Interest expense 4,730 Loss on disposal of plant assets 7,500 233,880

Net income $154,580

Additional information: 1. New plant assets costing $100,000 were purchased for cash during the year. 2. Old plant assets having an original cost of $57,500 and accumulated depreciation of

$48,500 were sold for $1,500 cash.

(a) Net cash provided— oper. act. $38,500

Prepare a statement of cash fl ows—direct method, and compute free cash fl ow.

(LO 3, 4), AP

(a) Net cash provided— oper. act. $38,500

Prepare a statement of cash fl ows—indirect method.

(LO 2), AP

Problems: Set A 639

3. Bonds payable matured and were paid off at face value for cash. 4. A cash dividend of $26,030 was declared and paid during the year.

Instructions Prepare a statement of cash flows using the indirect method.

*P12-10A Data for Granger Inc. are presented in P12-9A. Further analysis reveals that accounts payable pertain to merchandise creditors.

Instructions Prepare a statement of cash flows for Granger Inc. using the direct method.

P12-11A The comparative balance sheets for Spicer Company as of December 31 are presented below.

SPICER COMPANY Comparative Balance Sheets

December 31

Assets 2017 2016

Cash $ 68,000 $ 45,000 Accounts receivable 50,000 58,000 Inventory 151,450 142,000 Prepaid expenses 15,280 21,000 Land 145,000 130,000 Buildings 200,000 200,000 Accumulated depreciation—buildings (60,000) (40,000) Equipment 225,000 155,000 Accumulated depreciation—equipment (45,000) (35,000)

Total $749,730 $676,000

Liabilities and Stockholders’ Equity

Accounts payable $ 44,730 $ 36,000 Bonds payable 300,000 300,000 Common stock, $1 par 200,000 160,000 Retained earnings 205,000 180,000

Total $749,730 $676,000

Additional information: 1. Operating expenses include depreciation expense of $42,000. 2. Land was sold for cash at book value. 3. Cash dividends of $12,000 were paid. 4. Net income for 2017 was $37,000. 5. Equipment was purchased for $92,000 cash. In addition, equipment costing $22,000

with a book value of $10,000 was sold for $8,000 cash. 6. 40,000 shares of $1 par value common stock were issued in exchange for land with a

fair value of $40,000.

Instructions Prepare a statement of cash flows for the year ended December 31, 2017, using the indirect method.

P12-12A You are provided with the following transactions that took place during the year.

Free Cash Transactions Flow ($125,000)

(a) Recorded credit sales $2,500. (b) Collected $1,900 owed by customers. (c) Paid amount owed to suppliers $2,750. (d) Recorded sales returns of $500 and credited the customer’s

account. (e) Purchased new equipment $5,000; signed a long-term note payable

for the cost of the equipment. (f) Purchased a patent and paid $65,000 cash for the asset.

Net cash provided— oper. act. $176,930 Prepare a statement of cash fl ows—direct method.

(LO 4), AP

Net cash provided— oper. act. $176,930

Prepare a statement of cash fl ows—indirect method.

(LO 2), AP

Net cash provided— oper. act. $94,000

Identify the impact of transactions on free cash fl ow.

(LO 3), C

640 12 Statement of Cash Flows

Instructions For each transaction listed, indicate whether it will increase (I), decrease (D), or have no effect (NE) on free cash flow.

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 11.)

CC12 Natalie has prepared the balance sheet and income statement of Cookie & Coffee Creations Inc. and would like you to prepare the statement of cash fl ows.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to find the completion of this problem.

CONTINUING PROBLEM Cookie Creations▼

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT12-1 The fi nancial statements of Apple Inc. are presented in Appendix A.

Instructions Answer the following questions.

(a) What was the amount of net cash provided by operating activities for the year ended September 27, 2014? For the year ended September 28, 2013?

(b) What was the amount of increase or decrease in cash and cash equivalents for the year ended September 27, 2014?

(d) From your analysis of the September 27, 2014, statement of cash fl ows, was the change in accounts receivable a decrease or an increase? Was the change in inven- tories a decrease or an increase? Was the change in accounts payable a decrease or an increase?

(e) What was the net cash used by investing activities for the year ended September 27, 2014?

(f) What was the amount of interest paid in the year ended September 27, 2014? What was the amount of income taxes paid for the same period?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT12-2 Columbia Sportswear Company’s fi nancial statements are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information contained in these fi nancial statements, compute free cash

fl ow for each company. (b) What conclusions concerning the management of cash can be drawn from these

data?

Financial Reporting

▼

Financial Analysis

▼

Expand Your Critical Thinking 641

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT12-3 Amazon.com, Inc.’s fi nancial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information contained in these fi nancial statements, compute free cash

fl ow for each company. (b) What conclusions concerning the management of cash can be drawn from these

data?

REAL-WORLD FOCUS

CT12-4 Purpose: Use the Internet to view SEC fi lings.

Address: biz.yahoo.com/i

Steps 1. Enter a company’s name. 2. Choose Quote. Answer questions (a) and (b). 3. Choose Profile; then choose SEC. Answer questions (c) and (d).

Instructions Answer the following questions.

(a) What company did you select? (b) What is its stock symbol? What is its selling price? (c) What recent SEC fi lings are available for your viewing? (d) Which fi ling is the most recent? What is the date?

CT12-5 The March 4, 2010, edition of the Wall Street Journal Online contains an article by Jeffrey McCracken and Tom McGinty entitled “With Fistfuls of Cash, Firms on Hunt.”

Instructions Read the article and answer the following questions.

(a) How much cash did the nonfi nancial (that is, nonbank-like) fi rms in the Standard & Poor’s 500 have at the end of 2009? How big an increase in cash did this represent over the prior year?

(b) What reasons are given in the article for why companies might not want to keep hoard- ing cash?

(d) Often, companies issue shares of stock to acquire other companies. This represents a signifi cant noncash transaction. At the time the article was written, why were many companies using cash rather than stock to acquire other companies?

(e) In addition to acquisitions, what other steps can companies take to reduce their cash balances?

CT12-6 The November 23, 2011, edition of the Wall Street Journal Online contains an article by John Jannarone entitled “Backlash from Netfl ix Buybacks.”

Instructions Read the article and answer the following questions.

(a) What was the stock price for the shares of common stock issued by Netfl ix in the article? What was the price of the stock a few months previously?

(b) Why did Netfl ix issue new shares at a time when its stock price was so depressed rela- tive to previous valuations for its stock?

(c) What previous actions had Netfl ix taken to reduce its cash balance? (d) What does the article say is the lesson that growth companies should learn from the

Netfl ix example?

Financial Analysis

▼

642 12 Statement of Cash Flows

DECISION-MAKING ACROSS THE ORGANIZATION

CT12-7 Pete Kent and Maria Robles are examining the following statement of cash fl ows for Sullivan Company for the year ended January 31, 2017.

SULLIVAN COMPANY Statement of Cash Flows

For the Year Ended January 31, 2017

Sources of cash From sales of merchandise $385,000 From sale of capital stock 405,000 From sale of investment (purchased below) 80,000 From depreciation 55,000 From issuance of note for truck 20,000 From interest on investments 6,000

Total sources of cash 951,000

Uses of cash For purchase of fixtures and equipment 320,000 For merchandise purchased for resale 258,000 For operating expenses (including depreciation) 170,000 For purchase of investment 75,000 For purchase of truck by issuance of note 20,000 For purchase of treasury stock 10,000 For interest on note payable 3,000

Total uses of cash 856,000

Net increase in cash $ 95,000

Pete claims that Sullivan’s statement of cash fl ows is an excellent portrayal of a superb fi rst year with cash increasing $95,000. Maria replies that it was not a superb fi rst year. Rather, she says, the year was an operating failure, that the statement is presented incorrectly, and that $95,000 is not the actual increase in cash. The cash balance at the beginning of the year was $140,000.

Instructions With the class divided into groups, answer the following. (a) Using the data provided, prepare a statement of cash fl ows in proper form using the

indirect method. The only noncash items in the income statement are depreciation and the gain from the sale of the investment.

(b) With whom do you agree, Pete or Maria? Explain your position.

COMMUNICATION ACTIVITY

CT12-8 Walt Jax, the owner-president of Computer Services Company, is unfamiliar with the statement of cash fl ows that you, as his accountant, prepared. He asks for further explanation.

Instructions Write him a brief memo explaining the form and content of the statement of cash fl ows as shown in Illustration 12-13 (page 604).

ETHICS CASE

CT12-9 Pendleton Automotive Corp. is a medium-sized wholesaler of automotive parts. It has 10 stockholders who have been paid a total of $1 million in cash dividends for 8 consecutive years. The board’s policy requires that, for this dividend to be declared, net cash provided by operating activities as reported in Pendleton Automotive’s current year’s statement of cash fl ows must exceed $1 million. President and CEO Hans Pfi zer’s job is secure so long as he produces annual operating cash fl ows to support the usual dividend. At the end of the current year, controller Kurt Nolte presents president Hans Pfi zer with some disappointing news. The net cash provided by operating activities is calculated by the indirect method to be only $970,000. The president says to Kurt, “We must get that amount above $1 million. Isn’t there some way to increase operating cash fl ow by another $30,000?” Kurt answers, “These fi gures were prepared by my assistant. I’ll go back to my offi ce and see what I can do.” The president replies, “I know you won’t let me down, Kurt.”

Financial Analysis

Writing

Group Project

▼ E

A Look at IFRS 643

Upon close scrutiny of the statement of cash fl ows, Kurt concludes that he can get the operating cash fl ows above $1 million by reclassifying a $60,000, 2-year note payable listed in the fi nancing activities section as “Proceeds from bank loan—$60,000.” He will report the note instead as “Increase in payables—$60,000” and treat it as an adjustment of net income in the operating activities section. He returns to the president, saying, “You can tell the board to declare their usual dividend. Our net cash fl ow provided by operat- ing activities is $1,030,000.” “Good man, Kurt! I knew I could count on you,” exults the president.

Instructions (a) Who are the stakeholders in this situation? (b) Was there anything unethical about the president’s actions? Was there anything uneth-

ical about the controller’s actions? (c) Are the board members or anyone else likely to discover the misclassifi cation?

ALL ABOUT YOU

CT12-10 In this chapter, you learned that companies prepare a statement of cash fl ows in order to keep track of their sources and uses of cash and to help them plan for their future cash needs. Planning for your own short- and long-term cash needs is every bit as important as it is for a company.

Instructions Read the article “Financial ’Uh-oh’? No Problem,” at www.fool.com/personal-fi nance/ saving/fi nancial-uh-oh-no-problem.aspx, and answer the following questions. (a) Describe the three factors that determine how much money you should set aside for

short-term needs. (b) How many months of living expenses does the article suggest to set aside? (c) Estimate how much you should set aside based upon your current situation. Are you

closer to Cliff’s scenario or to Prudence’s?

FASB CODIFICATION ACTIVITY

CT12-11 If your school has a subscription to the FASB Codifi cation, go to http://aaahq.org/ ascLogin.cfm to log in and prepare responses to the following. Use the Master Glossary to determine the proper defi nitions.

(a) What are cash equivalents? (b) What are fi nancing activities? (c) What are investing activities? (d) What are operating activities? (e) What is the primary objective for the statement of cash fl ow? Is working capital the

basis for meeting this objective? (f) Do companies need to disclose information about investing and fi nancing activities

that do not affect cash receipts or cash payments? If so, how should such information be disclosed?

LEARNING OBJECTIVE 6 Compare the procedures for the statement of cash fl ows under GAAP and IFRS.▼

A Look at IFRS

As in GAAP, the statement of cash flows is a required statement for IFRS. In addition, the content and presentation of an IFRS statement of cash flows is similar to the one used for GAAP. However, the disclosure requirements related to the statement of cash flows are more extensive under GAAP. IAS 7 (“Cash Flow Statements”) provides the overall IFRS requirements for cash flow information.

644 12 Statement of Cash Flows

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS as related to the statement of cash flows.

Similarities • Companies preparing financial statements under IFRS must also prepare a statement

of cash flows as an integral part of the financial statements. • Both IFRS and GAAP require that the statement of cash flows should have three major

sections—operating, investing, and financing activities—along with changes in cash and cash equivalents.

• Similar to GAAP, the statement of cash flows can be prepared using either the indirect or direct method under IFRS. In both U.S. and international settings, companies choose for the most part to use the indirect method for reporting net cash flows from operating activities.

• The definition of cash equivalents used in IFRS is similar to that used in GAAP. A major difference is that in certain situations, bank overdrafts are considered part of cash and cash equivalents under IFRS (which is not the case in GAAP). Under GAAP, bank over- drafts are classified as financing activities in the statement of cash flows and are reported as liabilities on the balance sheet.

Differences • IFRS requires that noncash investing and financing activities be excluded from the

statement of cash flows. Instead, these noncash activities should be reported else- where. This requirement is interpreted to mean that noncash investing and financing activities should be disclosed in the notes to the financial statements instead of in the financial statements. Under GAAP, companies may present this information on the face of the statement of cash flows.

• One area where there can be substantial differences between IFRS and GAAP relates to the classification of interest, dividends, and taxes. The following table indicates the differences between the two approaches.

Item IFRS GAAP

Interest paid Operating or financing Operating Interest received Operating or investing Operating Dividends paid Operating or financing Financing Dividends received Operating or investing Operating Taxes paid Operating—unless specific Operating identification with financing or investing activity

• Under IFRS, some companies present the operating section in a single line item, with a full reconciliation provided in the notes to the financial statements. This presentation is not seen under GAAP.

LOOKING TO THE FUTURE Presently, the FASB and the IASB are involved in a joint project on the presentation and organization of information in the financial statements. One interesting approach, revealed in a published proposal from that project, is that in the future the income state- ment and balance sheet would adopt headings similar to those of the statement of cash flows. That is, the income statement and balance sheet would be broken into operating, investing, and financing sections.

IFRS PRACTICE IFRS SELF-TEST QUESTIONS 1. Under IFRS, interest paid can be reported as:

(a) only a financing activity. (b) a financing activity or an investing activity. (c) a financing activity or an operating activity. (d) only an operating activity.

2. IFRS requires that noncash items: (a) be reported in the section to which they relate, that is, a noncash investing activity

would be reported in the investing section.

A Look at IFRS 645

(b) be disclosed in the notes to the financial statements. (c) do not need to be reported. (d) be treated in a fashion similar to cash equivalents.

3. In the future, it appears likely that: (a) the income statement and balance sheet will have headings of operating, investing,

and financing activities, much like the statement of cash flows. (b) cash and cash equivalents will be combined in a single line item. (c) the IASB will not allow companies to use the direct approach to the statement of

cash flows. (d) None of the above.

4. Under IFRS: (a) taxes are always treated as an operating activity. (b) the income statement uses the headings operating, investing, and financing

activities. (c) dividends received can be either an operating or investing activity. (d) dividends paid can be either an operating or investing activity.

5. Which of the following is correct? (a) Under IFRS, the statement of cash flows is optional. (b) IFRS requires use of the direct approach in preparing the statement of cash flows. (c) The majority of companies following GAAP and the majority following IFRS

employ the indirect approach to the statement of cash flows. (d) Under IFRS, companies offset financing activities against investing activities.

IFRS EXERCISES IFRS12-1 Discuss the differences that exist in the treatment of bank overdrafts under GAAP and IFRS.

IFRS12-2 Describe the treatment of each of the following items under IFRS versus GAAP. (a) Interest paid. (c) Dividends paid. (b) Interest received. (d) Dividends received.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS12-3 The financial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its financial statements, are also provided in Appendix F.

Instructions Use the company’s annual report to answer the following questions.

(a) In which section (operating, investing, or financing) does Louis Vuitton report interest paid (finance costs)?

(b) In which section (operating, investing, or financing) does Louis Vuitton report divi- dends received?

Answers to IFRS Self-Test Questions 1. c 2. b 3. a 4. c 5. c

We can all learn an important lesson from Warren Buffett: Study companies carefully if you wish to

invest. Do not get caught up in fads but instead fi nd companies that are fi nancially healthy. Using

some of the basic decision tools presented in this textbook, you can perform a rudimentary analysis

on any company and draw basic conclusions about its fi nancial health. Although it would not be

wise for you to bet your life savings on a company’s stock relying solely on your current level of

knowledge, we strongly encourage you to practice your new skills wherever possible. Only with

practice will you improve your ability to interpret fi nancial numbers.

Before we unleash you on the world of high fi nance, we present a few more important concepts

and techniques as well as one more comprehensive review of corporate fi nancial statements.

We use all of the decision tools presented in this textbook to analyze a single company, with

comparisons to a competitor and industry averages.

CHAPTER PREVIEW

Financial Analysis: The Big Picture 13

LEARNING OBJECTIVES PRACTICE

CHAPTER OUTLINE

• Sustainable income • Quality of earnings▼1

Apply the concepts of sustainable income and quality of earnings.

DO IT!

1 Unusual Items

▼3 Analyze a company’s performance using ratio analysis.

• Price-earnings ratio • Liquidity ratios • Solvency ratios • Profi tability ratios

DO IT!

3 Ratio Analysis

▼2 Apply horizontal analysis and vertical analysis.

• Horizontal analysis • Vertical analysis

DO IT!

2 Horizontal Analysis

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

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A recent issue of Forbes magazine listed Warren Buffett as the second richest person in the world. His estimated wealth was $69 billion, give or take a few million. How much is $69 billion? If you invested $69 billion in an investment earning just 4%, you could spend $7.6 million per day—every day— forever.

So, how does Buffett spend his money? Basically, he doesn’t! He still lives in the same house that he purchased in Omaha, Nebraska, in 1958 for $31,500. He still drives his own car (a Cadillac DTS). And, in case you were thinking that his kids are riding the road to Easy Street, think again. Buffett has committed to donate virtually all of his money to charity before he dies.

How did Buffett amass this wealth? Through careful investing. Buffett epitomizes a “value investor.” He applies the basic techniques he learned in the 1950s from the great value investor Benjamin Graham. He looks for companies that have good long-term potential but are currently underpriced. He invests in companies that have low exposure to debt and that reinvest their earnings for future growth. He does not get caught up in fads or the latest trends.

For example, Buffett sat out on the dot-com mania in the 1990s. When other investors put lots of money into

fl edgling high-tech fi rms, Buffett didn’t bite because he did not fi nd dot-com companies that met his criteria. He didn’t get to enjoy the stock price boom on the way

up, but on the other hand, he didn’t have to ride the price back down to Earth. When the dot-com bubble burst, everyone else was suffering from investment shock. Buffett swooped in and scooped up deals on companies that he had been following for years.

In 2012, the stock market had again reached near record highs. Buffett’s returns had been signifi cantly lagging the market. Only 26% of his investments at that time were in stock, and he was sitting on $38 billion in cash. One commentator noted that “if the past is any guide, just when Buffett seems to look most like a loser, the party is about to end.”

If you think you want to follow Buffett’s example and transform your humble nest egg into a mountain of cash, be warned. His techniques have been widely circulated and emulated, but never practiced with the same degree of success. You should probably start by honing your fi nancial analysis skills. A good way for you to begin your career as a successful investor is to master the funda- mentals of fi nancial analysis discussed in this chapter. Source: Jason Zweig, “Buffett Is Out of Step,” Wall Street Journal (May 7, 2012).

FEATURE STORY

It Pays to Be Patient

Daniel Acker/Bloomberg/Getty Images, Inc.

648 13 Financial Analysis: The Big Picture

LEARNING OBJECTIVE 1 Apply the concepts of sustainable income and quality of earnings.▼

SUSTAINABLE INCOME

The value of a company like Google is a function of the amount, timing, and uncertainty of its future cash fl ows. Google’s current and past income statements are particularly useful in helping analysts predict these future cash fl ows. In using this approach, analysts must make sure that Google’s past income num- bers refl ect its sustainable income, that is, do not include unusual (out-of-the- ordinary) revenues, expenses, gains, and losses. Sustainable income is, there- fore, the most likely level of income to be obtained by a company in the future. Sustainable income differs from actual net income by the amount of unusual rev- enues, expenses, gains, and losses included in the current year’s income. Analysts are interested in sustainable income because it helps them derive an estimate of future earnings without the “noise” of unusual items. Fortunately, an income statement provides information on sustainable income by separating operating transactions from nonoperating transactions. This state- ment also highlights intermediate components of income such as income from operations, income before income taxes, and income from continuing operations. In addition, information on unusual items such as gains or losses on discontinued items and components of other comprehensive income are disclosed. Illustration 13-1 presents a statement of comprehensive income for Cruz Com- pany for the year 2017. A statement of comprehensive income includes not only net income but a broader measure of income called comprehensive income. (Recall that in Chapter 5 we instead presented comprehensive income in a separate state- ment called a comprehensive income statement. Both approaches are allowed under GAAP.) The two major unusual items in this statement are discontinued operations and other comprehensive income (highlighted in red). When estimating future cash fl ows, analysts must consider the implications of each of these components.

In looking at Illustration 13-1, note that Cruz Company’s two major types of unusual items, discontinued operations and other comprehensive income, are reported net of tax. That is, Cruz fi rst calculates income tax expense before income from continuing operations. Then, it calculates income tax expense related to the discontinued operations and other comprehensive income. The general concept is, “Let the tax follow the income or loss.” We discuss discontinued operations and other comprehensive income in more detail next.

ILLUSTRATION 13-1 Statement of comprehensive income

CRUZ COMPANY Statement of Comprehensive Income

For the year ended 2017

Sales revenue $900,000 Cost of goods sold 650,000

Gross profi t 250,000 Operating expenses 100,000

Income from operations 150,000 Other revenues (expenses) and gains (losses) 20,000

Income before income taxes 170,000 Income tax expense 24,000

Income from continuing operations 146,000 Discontinued operations (net of tax) 30,000

Net income 176,000 Other comprehensive income items (net of tax) 10,000

Comprehensive income $186,000

Sustainable Income and Quality of Earnings 649

Discontinued Operations Discontinued operations refers to the disposal of a signifi cant com- ponent of a business, such as the elimination of a major class of cus- tomers or an entire activity. For example, to downsize its operations, General Dynamics Corp. sold its missile business to Hughes Aircraft Co. for $450 million. In its statement of comprehensive income, Gen- eral Dynamics reported the sale in a separate section entitled “Discon- tinued operations.” Following the disposal of a signifi cant component, the company should report on its statement both income from continuing operations and income (or loss) from discontinued operations. The income (loss) from discontinued opera- tions consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component. To illustrate, assume that during 2017 Acro Energy Inc. has income before income taxes of $800,000. During 2017, Acro discontinued and sold its unprofi t- able chemical division. The loss in 2017 from chemical operations (net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate on income, Illustration 13-2 shows Acro’s statement of comprehensive income presentation.

DECISION TOOLS

The discontinued operations sec- tion alerts users to the sale of any of a company’s major components of its business.

▼ HELPFUL HINT Observe the dual disclosures: (1) the results of operation of the discontinued division must be eliminated from the results of continuing operations, and (2) the company must also report the disposal of the division.

ILLUSTRATION 13-2 Statement presentation of discontinued operations

ACRO ENERGY INC. Statement of Comprehensive Income (partial)

For the Year Ended December 31, 2017

Income before income taxes $800,000 Income tax expense 240,000

Income from continuing operations 560,000 Discontinued operations Loss from operation of chemical division,

net of $60,000 income tax savings $140,000 Loss from disposal of chemical division, net of $30,000 income tax savings 70,000 210,000

Net income $350,000

What Does “Non-Recurring” Really Mean?

Many companies incur restructur- ing charges as they attempt to re- duce costs. They often label these items in the income statement as “non-recurring” charges, to sug- gest that they are isolated events, unlikely to occur in future periods. The question for analysts is, are these costs really one-time, “non- recurring events” or do they refl ect problems that the company will be facing for many periods in the

future? If they are one-time events, then they can be largely ignored when trying to predict future earnings. But, some companies report “one-time” restructuring charges over and over again. For example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a 5- or 10-year period. There appears to be no substitute for care- ful analysis of the numbers that comprise net income.

If a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones? (Go to WileyPLUS for this answer and additional questions.)

INVESTOR INSIGHT

Note that the statement uses the caption “Income from continuing opera- tions” and adds a new section “Discontinued operations.” The new section reports both the operating loss and the loss on disposal net of applicable income taxes. This presentation clearly indicates the separate effects of continu- ing operations and discontinued operations on net income.

650 13 Financial Analysis: The Big Picture

Comprehensive Income Most revenues, expenses, gains, and losses are included in net income. However, as discussed in earlier chapters, certain gains and losses that bypass net income are reported as part of a more inclusive earnings measure called comprehensive income. Comprehensive income is the sum of net income and other compre- hensive income items.1

ILLUSTRATION OF COMPREHENSIVE INCOME Accounting standards require that companies adjust most investments in stocks and bonds up or down to their market price at the end of each accounting period. For example, assume that dur- ing 2017, its fi rst year of operations, Stassi Corporation purchased IBM stock for $10,000 as an investment. At the end of 2017, Stassi was still holding the invest- ment, but the stock’s market price was now $8,000. In this case, Stassi is required to reduce the recorded value of its IBM investment by $2,000. The $2,000 differ- ence is an unrealized loss.

Should Stassi include this $2,000 unrealized loss in net income? It depends on whether Stassi classifi es the IBM stock as a trading security or an available- for-sale security. A trading security is bought and held primarily for sale in the near term to generate income on short-term price differences. Companies report unrealized losses on trading securities in the “Other expenses and losses” section of the income statement. The rationale: It is likely that the company will realize the unrealized loss (or an unrealized gain), so the company should report the loss (gain) as part of net income. If Stassi did not purchase the investment for trading purposes, it is classifi ed as available-for-sale. Available-for-sale securities are held with the intent of selling them sometime in the future. Companies do not include unrealized gains or losses on available-for-sale securities in net income. Instead, they report them as part of “Other comprehensive income.” Other comprehensive income is not included in net income.

FORMAT As shown in Chapter 5, one format for reporting other comprehensive income is to report a separate comprehensive income statement. For example, assuming that Stassi Corporation has a net income of $300,000, the unrealized loss would be reported below net income as follows.

1The FASB’S Conceptual Framework describes comprehensive income as including all changes in stockholders’ equity during a period except those changes resulting from investments by stockholders and distributions to stockholders.

As discussed in Chapter 11, companies report the cumulative amount of other comprehensive income from all years as a separate component of stockholders’ equity. To illustrate, assume Stassi has common stock of $3,000,000, retained earnings of $300,000, and accumulated other comprehensive loss of $2,000. (To simplify, we are assuming that this is Stassi’s fi rst year of operations. Since it has only operated for one year, the cumulative amount of other comprehensive income is this year’s loss of $2,000.) Illustration 13-4 shows the balance sheet presentation of the accumulated other comprehensive loss.

ILLUSTRATION 13-3 Lower portion of combined statement of income and comprehensive income

STASSI CORPORATION Comprehensive Income Statement

For the Year Ended December 31, 2017

Net income $300,000 Other comprehensive income Unrealized loss on available-for-sale securities 2,000

Comprehensive income $298,000

Sustainable Income and Quality of Earnings 651

Note that the presentation of the accumulated other comprehensive loss is similar to the presentation of the cost of treasury stock in the stockholders’ equity section. (An unrealized gain would be added in this section of the balance sheet.)

COMPLETE STATEMENT OF COMPREHENSIVE INCOME As seen in Illustration 13-1, as an alternative to preparing a separate comprehensive income statement, many companies report net income and other comprehensive income in a combined statement of comprehensive income. (For your homework in this chapter, use this combined format.) The statement of comprehensive income for Pace Corporation in Illustration 13-5 presents the types of items found on this statement, such as net sales, cost of goods sold, operating expenses, and income taxes. In addition, it shows how companies report discontinued operations and other comprehensive income (highlighted in red).

ILLUSTRATION 13-4 Unrealized loss in stockholders’ equity section

STASSI CORPORATION Balance Sheet (partial)

Stockholders’ equity Common stock $3,000,000 Retained earnings 300,000

Total paid-in capital and retained earnings 3,300,000 Accumulated other comprehensive loss (2,000)

Total stockholders’ equity $3,298,000

ILLUSTRATION 13-5 Complete statement of comprehensive income

PACE CORPORATION Statement of Comprehensive Income

For the Year Ended December 31, 2017

Net sales $440,000 Cost of goods sold 260,000

Gross profi t 180,000 Operating expenses 110,000

Income from operations 70,000 Other revenues and gains 5,600 Other expenses and losses 9,600

Income before income taxes 66,000 Income tax expense ($66,000 × 30%) 19,800 Income from continuing operations 46,200 Discontinued operations Loss from operation of plastics division, net of income tax savings $18,000 ($60,000 × 30%) $42,000 Gain on disposal of plastics division, net of $15,000 income taxes ($50,000 × 30%) 35,000 7,000 Net income 39,200 Other comprehensive income Unrealized gain on available-for-sale securities, net of income taxes ($15,000 × 30%) 10,500 Comprehensive income $ 49,700

Changes in Accounting Principle For ease of comparison, users of fi nancial statements expect companies to prepare their statements on a basis consistent with the preceding period. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. An example is a change in inventory costing methods (such as FIFO to average-cost). Accounting rules permit a change when man- agement can show that the new principle is preferable to the old principle.

DECISION TOOLS

Informing users of a change in accounting principle helps them determine the effect of this change on current and prior periods.

652 13 Financial Analysis: The Big Picture

Larry MacDougal/AP/Wide World Photos

Companies report most changes in accounting principle retroactively.2 That is, they report both the current period and previous periods using the new princi- ple. As a result, the same principle applies in all periods. This treatment improves the ability to compare results across years.

2An exception to the general rule is a change in depreciation methods. The effects of this change are reported in current and future periods. Discussion of this approach is left for more advanced courses.

INVESTOR INSIGHT United Parcel Service (UPS)

More Frequent Ups and Downs

In the past, U.S. companies used a method to account for their pension plans that smoothed out the gains and losses on their pension portfolios by spreading gains and losses over multiple years. Many felt that this ap- proach was benefi cial because it reduced the volatility of reported net income. However, recently some companies have opted to adopt a method that comes

closer to recognizing gains and losses in the period in which they occur. Some of the companies that have adopted this

approach are United Parcel Service (UPS), Honeywell Interna- tional, IBM, AT&T, and Verizon Communications. The CFO at UPS said he favored the new approach because “events that occurred in prior years will no longer distort current-year re- sults. It will result in better transparency by eliminating the noise of past plan performance.” When UPS switched, it re- sulted in a charge of $827 million from the change in account- ing principle.

Source: Bob Sechler and Doug Cameron, “UPS Alters Pension- Plan Accounting,” Wall Street Journal (January 30, 2012).

When predicting future earnings, how should analysts treat the one-time charge that results from a switch to the different approach for accounting for pension plans? (Go to WileyPLUS for this answer and additional questions.)

QUALITY OF EARNINGS

The quality of a company’s earnings is of extreme importance to analysts. A com- pany that has a high quality of earnings provides full and transparent informa- tion that will not confuse or mislead users of the fi nancial statements. Recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their busi- ness. Here are some of the factors affecting quality of earnings.

Alternative Accounting Methods Variations among companies in the application of generally accepted account- ing principles may hamper comparability and reduce quality of earnings. For example, suppose one company uses the FIFO method of inventory costing, while another company in the same industry uses LIFO. If inventory is a signifi - cant asset to both companies, it is unlikely that their current ratios are compa- rable. For example, if General Motors Corporation used FIFO instead of LIFO for inventory valuation, its inventories in a recent year would have been 26% higher, which signifi cantly affects the current ratio (and other ratios as well). In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation and amortization. Although these differ- ences in accounting methods might be detectable from reading the notes to the fi nancial statements, adjusting the fi nancial data to compensate for the different methods is often diffi cult, if not impossible.

Pro Forma Income Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP). In recent

Sustainable Income and Quality of Earnings 653

years, many companies have been also reporting a second measure of income, called pro forma income. Pro forma income usually excludes items that the company thinks are unusual or non-recurring. For example, in a recent year, Cisco Systems (a high-tech company) reported a quarterly net loss under GAAP of $2.7 billion. Cisco reported pro forma income for the same quarter as a profi t of $230 million. This large difference in profi ts between GAAP income numbers and pro forma income is not unusual. For example, during one nine-month period, the 100 largest companies on the Nasdaq stock exchange reported a total pro forma income of $19.1 billion but a total loss as measured by GAAP of $82.3 billion—a difference of about $100 billion! To compute pro forma income, companies generally exclude any items they deem inappropriate for measuring their performance. Many analysts and inves- tors are critical of the practice of using pro forma income because these numbers often make companies look better than they really are. As the fi nancial press noted, pro forma numbers might be called “earnings before bad stuff.” Com- panies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non-recurring expenses. “Cisco’s technique gives readers of fi nancial statements a clear picture of Cisco’s normal business activities,” the company said in a statement issued in response to questions about its pro forma income accounting. Recently, the SEC provided some guidance on how companies should pre- sent pro forma information. Stay tuned: Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company’s sus- tainable income. However, many companies have abused the fl exibility that pro forma numbers allow and have used the measure as a way to put their companies in a more favorable light.

Improper Recognition Because some managers feel pressure from Wall Street to continually increase earnings, they manipulate earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that some companies use is called channel stuffi ng. Offering deep discounts, com- panies encourage customers to buy early (stuff the channel) rather than later. This boosts earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods. To illustrate, Bristol-Myers Squibb at one time indicated that it used sales incentives to encourage wholesalers to buy more drugs than they needed. As a result, the company had to issue revised fi nancial statements showing corrected revenues and income. Another practice is the improper capitalization of operating expenses. WorldCom capitalized over $7 billion of operating expenses in order to report positive net income. In other situations, companies fail to report all their liabili- ties. Enron promised to make payments on certain contracts if fi nancial diffi culty developed, but these guarantees were not reported as liabilities. In addition, dis- closure was so lacking in transparency that it was impossible to understand what was happening at the company.

1▼ Unusual ItemsDO IT! In its proposed 2017 income statement, AIR Corporation reports income before income taxes $400,000, unrealized gain on available-for-sale securities $100,000, income taxes $120,000 (not including unusual items), loss from operation of discontinued fl ower divi- sion $50,000, and loss on disposal of discontinued fl ower division $90,000. The income tax rate is 30%. Prepare a correct statement of comprehensive income, beginning with “Income before income taxes.”

654 13 Financial Analysis: The Big Picture

Action Plan ✔ Show discontinued

operations and other comprehensive income net of tax.

SOLUTION

Related exercise material: BE13-1, BE13-2, DO IT! 13-1, E13-1, and E13-2.

Income before income taxes $400,000 Income tax expense 120,000

Income from continuing operations 280,000 Discontinued operations Loss from operation of fl ower division, net of $15,000 income tax savings $35,000 Loss on disposal of fl ower division, net of $27,000 income tax savings 63,000 98,000

Net income 182,000 Other comprehensive income Unrealized gain on available-for-sale securities, net of $30,000 income taxes 70,000

Comprehensive income $252,000

AIR CORPORATION Statement of Comprehensive Income (partial)

For the Year Ended December 31, 2017

As indicated, in assessing the fi nancial performance of a company, investors are interested in the core or sustainable earnings of a company. In addition, investors are interested in making comparisons from period to period. Throughout this textbook, we have relied on three types of comparisons to improve the decision- usefulness of fi nancial information:

1. Intracompany basis. Comparisons within a company are often useful to de- tect changes in fi nancial relationships and signifi cant trends. For example, a comparison of Kellogg’s current year’s cash amount with the prior year’s cash amount shows either an increase or a decrease. Likewise, a comparison of Kellogg’s year-end cash amount with the amount of its total assets at year-end shows the proportion of total assets in the form of cash.

2. Intercompany basis. Comparisons with other companies provide insight into a company’s competitive position. For example, investors can compare Kellogg’s total sales for the year with the total sales of its competitors in the breakfast cereal area, such as General Mills.

3. Industry averages. Comparisons with industry averages provide informa- tion about a company’s relative position within the industry. For example, fi nancial statement readers can compare Kellogg’s fi nancial data with the averages for its industry compiled by fi nancial rating organizations such as Dun & Bradstreet, Moody’s, and Standard & Poor’s, or with information provided on the Internet by organizations such as Yahoo! on its fi nancial site.

We use three basic tools in fi nancial statement analysis to highlight the sig- nifi cance of fi nancial statement data:

1. Horizontal analysis

2. Vertical analysis

3. Ratio analysis

INTERNATIONAL NOTE As more countries adopt IFRS, the ability of analysts to compare companies from different countries should improve. However, IFRSs are open to widely varying interpretations. In addition, some countries adopt IFRS “with modifi cations.” As a consequence, most cross- country comparisons are still not as transparent as within-country comparisons.

Apply horizontal analysis and vertical analysis. LEARNING

OBJECTIVE 2▼

Horizontal Analysis and Vertical Analysis 655

In previous chapters, we relied primarily on ratio analysis, supplemented with some basic horizontal and vertical analysis. In the remainder of this section, we introduce more formal forms of horizontal and vertical analysis. In the next section, we review ratio analysis in some detail.

HORIZONTAL ANALYSIS

Horizontal analysis, also known as trend analysis, is a technique for evaluating a series of fi nancial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. For example, here are recent net sales fi gures (in thousands) of Chicago Cereal Company:

2014 2013 2012 2011 2010

$11,776 $10,907 $10,177 $9,614 $8,812

If we assume that 2010 is the base year, we can measure all percentage increases or decreases relative to this base-period amount with the formula shown in Illustration 13-6.

DECISION TOOLS

Horizontal analysis helps users compare a company’s fi nancial position and operating results with those of the previous period.

Change Since Base Period =

Current-Year Amount − Base-Year Amount Base-Year Amount

ILLUSTRATION 13-6 Horizontal analysis—computation of changes since base period

For example, we can determine that net sales for Chicago Cereal increased approximately 9.1% [($9,614 − $8,812) ÷ $8,812] from 2010 to 2011. Similarly, we can also determine that net sales increased by 33.6% [($11,776 − $8,812) ÷ $8,812] from 2010 to 2014. Alternatively, we can express current-year sales as a percentage of the base period. To do so, we would divide the current-year amount by the base-year amount, as shown in Illustration 13-7.

Current-period sales expressed as a percentage of the base period for each of the fi ve years, using 2010 as the base period, are shown in Illustration 13-8.

Current Results in Relation to Base Period =

Current-Year Amount Base-Year Amount

ILLUSTRATION 13-7 Horizontal analysis— computation of current year in relation to base year

The large increase in net sales during 2011 would raise questions regarding possible reasons for such a signifi cant change. Chicago Cereal’s 2011 notes to the fi nancial statements explain that the company completed an acquisition of Elf Foods Company during 2011. This major acquisition would help explain the increase in sales highlighted by horizontal analysis. To further illustrate horizontal analysis, we use the fi nancial statements of Chi- cago Cereal Company. Its two-year condensed balance sheets for 2014 and 2013, showing dollar and percentage changes, are presented in Illustration 13-9 (page 656).

CHICAGO CEREAL COMPANY Net Sales (in thousands)

Base Period 2010

2014 2013 2012 2011 2010

$11,776 $10,907 $10,177 $9,614 $8,812 133.6% 123.8% 115.5% 109.1% 100%

ILLUSTRATION 13-8 Horizontal analysis of net sales

656 13 Financial Analysis: The Big Picture

ILLUSTRATION 13-9 Horizontal analysis of balance sheets

▼ HELPFUL HINT When using horizontal analysis, be sure to examine both dollar amount changes and percentage changes. It is not necessarily bad if a company’s earnings are growing at a declining rate. The amount of increase may be the same as or more than the base year, but the percentage change may be less because the base is greater each year.

The comparative balance sheets show that a number of changes occurred in Chicago Cereal’s fi nancial position from 2013 to 2014. In the assets section, cur- rent assets increased $290,000, or 11.9% ($290 ÷ $2,427), and property assets (net) increased $174,000, or 6.2%. Other assets increased $219,000, or 4.0%. In the liabilities section, current liabilities increased $24,000, or 0.6%, while long- term liabilities increased $202,000, or 4.4%. In the stockholders’ equity section, we fi nd that retained earnings increased $806,000, or 31.2%. Illustration 13-10 presents two-year comparative income statements of Chicago Cereal Company for 2014 and 2013, showing dollar and percentage changes.

▼ HELPFUL HINT Note that, in a horizontal analysis, while the amount column is additive (the total is $99,000), the percentage column is not additive (9.9% is not a total).

ILLUSTRATION 13-10 Horizontal analysis of income statements

Horizontal analysis of the income statements shows the following changes. Net sales increased $869,000, or 8.0% ($869 ÷ $10,907). Cost of goods sold increased $515,000, or 8.5% ($515 ÷ $6,082). Selling and administrative expenses

CHICAGO CEREAL COMPANY Condensed Balance Sheets December 31 (in thousands)

Increase (Decrease) during 2014

Assets 2014 2013 Amount Percent

Current assets $ 2,717 $ 2,427 $ 290 11.9 Property assets (net) 2,990 2,816 174 6.2 Other assets 5,690 5,471 219 4.0

Total assets $11,397 $10,714 $683 6.4

Liabilities and Stockholders’ Equity

Current liabilities $ 4,044 $ 4,020 $ 24 0.6 Long-term liabilities 4,827 4,625 202 4.4

Total liabilities 8,871 8,645 226 2.6

Stockholders’ equity Common stock 493 397 96 24.2 Retained earnings 3,390 2,584 806 31.2 Treasury stock (cost) (1,357) (912) (445) 48.8

Total stockholders’ equity 2,526 2,069 457 22.1

Total liabilities and stockholders’ equity $11,397 $10,714 $ 683 6.4

CHICAGO CEREAL COMPANY Condensed Income Statements

For the Years Ended December 31 (in thousands)

Increase (Decrease) during 2014

2014 2013 Amount Percent

Net sales $11,776 $10,907 $869 8.0 Cost of goods sold 6,597 6,082 515 8.5

Gross profi t 5,179 4,825 354 7.3 Selling and administrative expenses 3,311 3,059 252 8.2

Income from operations 1,868 1,766 102 5.8 Interest expense 319 307 12 3.9 Other income (expense), net (2) 13 (15) (115.4)

Income before income taxes 1,547 1,472 75 5.1 Income tax expense 444 468 (24) (5.1)

Net income $ 1,103 $ 1,004 $ 99 9.9

Horizontal Analysis and Vertical Analysis 657

increased $252,000, or 8.2% ($252 ÷ $3,059). Overall, gross profi t increased 7.3% and net income increased 9.9%. The increase in net income can be attributed to the increase in net sales and a decrease in income tax expense. The measurement of changes from period to period in percentages is rela- tively straightforward and quite useful. However, complications can result in making the computations. If an item has no value in a base year or preceding year and a value in the next year, no percentage change can be computed. Like- wise, no percentage change can be computed if a negative amount appears in the base or preceding period and a positive amount exists the following year.

VERTICAL ANALYSIS

Vertical analysis, also called common-size analysis, is a technique for evaluating fi nancial statement data that expresses each item in a fi nan- cial statement as a percentage of a base amount. For example, on a balance sheet we might express current assets as 22% of total assets (total assets being the base amount). Or, on an income statement we might express selling expenses as 16% of net sales (net sales being the base amount). Presented in Illustration 13-11 are the comparative balance sheets of Chicago Cereal for 2014 and 2013, analyzed vertically. The base for the asset items is total assets, and the base for the liability and stockholders’ equity items is total liabilities and stockholders’ equity.

DECISION TOOLS

Vertical analysis helps users compare relationships between fi nancial statement items with those of last year or of competitors.

In addition to showing the relative size of each category on the balance sheets, vertical analysis can show the percentage change in the individual asset, liability, and stockholders’ equity items. In this case, current assets increased $290,000 from 2013 to 2014, and they increased from 22.6% to 23.8% of total assets. Property assets (net) decreased from 26.3% to 26.2% of total assets. Other assets decreased from 51.1% to 50.0% of total assets. Also, retained earnings increased by $806,000 from 2013 to 2014, and total stockholders’ equity increased from 19.3% to 22.1% of total liabilities and stockholders’ equity. This switch to a

ILLUSTRATION 13-11 Vertical analysis of balance sheets

CHICAGO CEREAL COMPANY Condensed Balance Sheets December 31 (in thousands)

2014 2013

Assets Amount Percent* Amount Percent*

Current assets $ 2,717 23.8 $ 2,427 22.6 Property assets (net) 2,990 26.2 2,816 26.3 Other assets 5,690 50.0 5,471 51.1

Total assets $11,397 100.0 $10,714 100.0

Liabilities and Stockholders’ Equity

Current liabilities $ 4,044 35.5 $ 4,020 37.5 Long-term liabilities 4,827 42.4 4,625 43.2

Total liabilities 8,871 77.9 8,645 80.7

Stockholders’ equity Common stock 493 4.3 397 3.7 Retained earnings 3,390 29.7 2,584 24.1 Treasury stock (cost) (1,357) (11.9) (912) (8.5)

Total stockholders’ equity 2,526 22.1 2,069 19.3

Total liabilities and stockholders’ equity $11,397 100.0 $10,714 100.0

*Numbers have been rounded to total 100%.

658 13 Financial Analysis: The Big Picture

higher percentage of equity fi nancing has two causes. First, while total liabilities increased by $226,000, the percentage of liabilities declined from 80.7% to 77.9% of total liabilities and stockholders’ equity. Second, retained earnings increased by $806,000, from 24.1% to 29.7% of total liabilities and stockholders’ equity. Thus, the company shifted toward equity fi nancing by relying less on debt and by increasing the amount of retained earnings. Vertical analysis of the comparative income statements of Chicago Cereal, shown in Illustration 13-12, reveals that cost of goods sold as a percentage of net sales increased from 55.8% to 56.0%, and selling and administrative expenses increased from 28.0% to 28.1%. Net income as a percentage of net sales increased from 9.1% to 9.4%. Chicago Cereal’s increase in net income as a percentage of sales is due primarily to the decrease in interest expense and income tax expense as a percentage of sales.

Vertical analysis also enables you to compare companies of different sizes. For example, one of Chicago Cereal’s competitors is General Mills. General Mills’ sales are 1,000 times larger than those of Chicago Cereal. Vertical analysis enables us to meaningfully compare the condensed income statements of Chicago Cereal and General Mills, as shown in Illustration 13-13.

ILLUSTRATION 13-12 Vertical analysis of income statements

CHICAGO CEREAL COMPANY Condensed Income Statements

For the Years Ended December 31 (in thousands)

2014 2013

Amount Percent* Amount Percent*

Net sales $11,776 100.0 $10,907 100.0 Cost of goods sold 6,597 56.0 6,082 55.8

Gross profi t 5,179 44.0 4,825 44.2 Selling and administrative expenses 3,311 28.1 3,059 28.0

Income from operations 1,868 15.9 1,766 16.2 Interest expense 319 2.7 307 2.8 Other income (expense), net (2) .0 13 .0

Income before income taxes 1,547 13.2 1,472 13.4 Income tax expense 444 3.8 468 4.3

Net income $ 1,103 9.4 $ 1,004 9.1

*Numbers have been rounded to total 100%.

ILLUSTRATION 13-13 Intercompany comparison by vertical analysis

CONDENSED INCOME STATEMENTS For the Years Ended December 31, 2014 (Chicago Cereal), and May 25, 2014 (General Mills)

Chicago General Cereal Mills, Inc. (in thousands) (in millions)

Amount Percent* Amount Percent*

Net sales $11,776 100.0 $17,910 100.0 Cost of goods sold 6,597 56.0 11,540 64.4

Gross profi t 5,179 44.0 6,370 35.6 Selling and administrative expenses 3,311 28.1 3,474 19.4 Non-recurring charges and (gains) 0 — (62) (0.3)

Income from operations 1,868 15.9 2,958 16.5 Other expenses and revenues (including income taxes) 765 6.5 1,134 6.3

Net income $ 1,103 9.4 $ 1,824 10.2

*Numbers have been rounded to total 100%.

Horizontal Analysis and Vertical Analysis 659

Although Chicago Cereal’s net sales are much less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis. Chicago Cereal has a higher gross profi t percentage 44.0%, compared to 35.6% for General Mills. But, Chicago Cereal’s selling and administrative expenses are 28.1% of net sales, while those of General Mills are 19.4% of net sales. Looking at net income, we see that General Mills’ percentage is higher. Chicago Cereal’s net income as a percentage of net sales is 9.4%, compared to 10.2% for General Mills.

This fi nal Anatomy of a Fraud box demonstrates that sometimes relationships between numbers can be used to detect fraud. Financial ratios that appear abnormal or statistical abnormalities in the numbers themselves can reveal fraud. For example, the fact that WorldCom’s line costs, as a percentage of either total expenses or revenues, differed very signifi cantly from its competitors should have alerted people to the possibility of fraud. Or, consider the case of a bank manager, who cooperated with a group of his friends to defraud the bank’s credit card department. The manager’s friends would apply for credit cards and then run up balances of slightly less than $5,000. The bank had a policy of allowing bank personnel to write-off balances of less than $5,000 without seek- ing supervisor approval. The fraud was detected by applying statistical analysis based on Benford’s Law. Benford’s Law states that in a random collection of numbers, the fre- quency of lower digits (e.g., 1, 2, or 3) should be much higher than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the fi rst two digits of amounts written off. There was a spike at 48 and 49, which was not consistent with what would be expected if the numbers were random.

Total take: Thousands of dollars

THE MISSING CONTROL Independent internal verifi cation. While it might be effi cient to allow employees to write off accounts below a certain level, it is important that these write-offs be reviewed and verifi ed periodically. Such a review would likely call attention to an employee with large amounts of write-offs, or in this case, write-offs that were frequently very close to the approval threshold.

Source: Mark J. Nigrini, “I’ve Got Your Number,” Journal of Accountancy Online (May 1999).

ANATOMY OF A FRAUD

▼

Action Plan ✔ Familiarize yourself

with each of the control activities listed on page xxx.

✔ Understand the nature of the frauds that each control activity is intended to address.

2▼ Horizontal AnalysisDO IT!

Action Plan ✔ Find the percentage

change by dividing the amount of the increase by the 2016 amount (base year).

SOLUTION Increase in 2017

Amount Percent

Current assets $ 54,000 30% [($234,000 − $180,000) ÷ $180,000] Plant assets (net) 336,000 80% [($756,000 − $420,000) ÷ $420,000] Total assets $390,000 65% [($990,000 − $600,000) ÷ $600,000]

Summary fi nancial information for Rosepatch Company is as follows.

December 31, 2017 December 31, 2016

Current assets $234,000 $180,000 Plant assets (net) 756,000 420,000

Total assets $990,000 $600,000

Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.

Related exercise material: BE13-4, BE13-6, BE13-7, BE13-9, DO IT! 13-2, E13-3, E13-5, and E13-6.

660 13 Financial Analysis: The Big Picture

In previous chapters, we presented many ratios used for evaluating the fi nancial health and performance of a company. Here, we introduce one more ratio, the price-earnings ratio, and then we provide a summary listing of all ratios pre- sented in the textbook. (Page references to prior discussions are provided if you feel you need to review any individual ratios.) Appendix 13A provides an example of a comprehensive fi nancial analysis employing these ratios.

PRICE-EARNINGS RATIO

Earnings per share is net income available to common stockholders divided by the average number of common shares outstanding. The market price of a com- pany’s stock changes based on investors’ expectations about a company’s future earnings per share. To compare market prices and earnings across fi rms, inves- tors calculate the price-earnings (P-E) ratio. The P-E ratio divides the market price of a share of common stock by earnings per share.

Analyze a company’s performance using ratio analysis. LEARNING OBJECTIVE 3▼

Price-Earnings (P-E) Ratio =

Market Price per Share Earnings per Share

ILLUSTRATION 13-14 Formula for price-earnings (P-E) ratio

The P-E ratio refl ects investors’ assessment of a company’s future earnings. The ratio of price to earnings will be higher if investors think that earnings will increase substantially in the future and therefore are willing to pay more per share of stock. A low price-earnings ratio often signifi es that investors think the company’s future earnings will not be strong. In addition, sometimes a low P-E ratio refl ects the market’s belief that a company has poor-quality earnings. To illustrate, assume that two identical companies each have earnings per share of $5. Suppose one of the companies manipulated its accounting numbers to achieve the $5 fi gure. If investors perceive that fi rm has lower-quality earn- ings, this perception will be refl ected in a lower stock price and, consequently, a lower P-E. Illustration 13-15 shows earnings per share and P-E ratios for fi ve companies for a recent year.

Company Earnings per Share Price-Earnings Ratio

Southwest Airlines $ 1.65 19.5 Google 29.80 27.0 Apple 6.49 15.6 Skechers USA 2.74 34.0 Nike 3.05 28.7

ILLUSTRATION 13-15 Earnings per share and P-E ratios of various companies

LIQUIDITY RATIOS

Liquidity ratios (Illustration 13-16) measure the short-term ability of the com- pany to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.

Ratio Analysis 661

SOLVENCY RATIOS

Solvency ratios (Illustration 13-17) measure the ability of the company to sur- vive over a long period of time. Long-term creditors and stockholders are inter- ested in a company’s long-run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity.

Liquidity Ratios

Working capital Current assets − Current liabilities p. 54

Current ratio Current assets Current liabilities

p. 54

Inventory turnover Cost of goods sold Average inventory

p. 283

Days in inventory 365 days Inventory turnover

p. 283

Accounts receivable turnover Net credit sales Average net accounts receivable

p. 395

Average collection period 365 days Accounts receivable turnover

p. 395

ILLUSTRATION 13-16 Summary of liquidity ratios

How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease.

Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities. Its current ratio is 2:1.

If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabili- ties. Its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily infl uenced by management.

How might management infl uence a company’s current ratio? (Go to WileyPLUS for this answer and additional questions.)

Nova Stock/SuperStock

INVESTOR INSIGHT

PROFITABILITY RATIOS

Profi tability ratios (Illustration 13-18 on page 662) measure the income or oper- ating success of a company for a given period of time. A company’s income, or lack of it, affects its ability to obtain debt and equity fi nancing, its liquidity

Solvency Ratios

Debt to assets ratio Total liabilities Total assets

p. 56

Times interest earned Net income 1 Interest expense 1 Income tax expense Interest expense

p. 497

Free cash fl ow Net cash provided by operating activities

2 Capital expenditures

2 Cash dividends

p. 57

ILLUSTRATION 13-17 Summary of solvency ratios

662 13 Financial Analysis: The Big Picture

Profi tability Ratios

Earnings per share Net income 2 Preferred dividends Weighted-average common shares outstanding

p. 53

Price-earnings ratio Market price per share Earnings per share

p. 660

Gross profi t rate Gross profi t Net sales

p. 234

Profi t margin Net income Net sales

p. 235

Return on assets Net income Average total assets

p. 444

Asset turnover Net sales Average total assets

p. 446

Payout ratio Cash dividends declared on common stock Net income

p. 560

Return on common stockholders’ equity

Net income 2 Preferred dividends Average common stockholders’ equity

p. 561

ILLUSTRATION 13-18 Summary of profi tability ratios

position, and its ability to grow. As a consequence, creditors and investors alike are interested in evaluating profi tability. Profi tability is frequently used as the ultimate test of management’s operating effectiveness.

3▼ Ratio AnalysisDO IT! The condensed fi nancial statements of John Cully Company, for the years ended June 30, 2017 and 2016, are presented on the next page.

INVESTOR INSIGHT

High Ratings Can Bring Low Returns

Moody’s, Standard & Poor’s, and Fitch are three big fi rms that perform fi nancial analysis on publicly traded companies and then publish ratings of the companies’ creditworthiness. Investors and lenders rely heavily on these ratings in making in- vestment and lending decisions.

Some people feel that the collapse of the fi nancial markets was worsened by inadequate research reports and ratings provided by the fi nancial rating agencies. Critics contend that the rating agencies were reluctant to give large companies

low ratings because they feared that by offending them they would lose out on business opportunities. For example, the rating agencies gave many so-called mortgage-backed securi- ties ratings that suggested that they were low risk. Later, many of these very securities became completely worthless. Steps have been taken to reduce the confl icts of interest that lead to these faulty ratings.

Source: Aaron Lucchetti and Judith Burns, “Moody’s CEO Warned Profi t Push Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008).

Why are credit rating agencies important to the fi nancial markets? (Go to WileyPLUS for this answer and additional questions.)

Ratio Analysis 663

(in thousands)

Assets 2017 2016

Current assets Cash and cash equivalents $ 553.3 $ 611.6 Accounts receivable (net) 776.6 664.9 Inventory 768.3 653.5 Prepaid expenses and other current assets 204.4 269.2

Total current assets 2,302.6 2,199.2 Investments 12.3 12.6 Property, plant, and equipment (net) 694.2 647.0 Intangibles and other assets 876.7 849.3

Total assets $3,885.8 $3,708.1

Liabilities and Stockholders’ Equity

Current liabilities $1,497.7 $1,322.0 Long-term liabilities 679.5 637.1 Stockholders’ equity—common 1,708.6 1,749.0

Total liabilities and stockholders’ equity $3,885.8 $3,708.1

JOHN CULLY COMPANY Income Statements

For the Year Ended June 30

(in thousands)

2017 2016

Sales revenue $6,336.3 $5,790.4 Costs and expenses Cost of goods sold 1,617.4 1,476.3 Selling and administrative expenses 4,007.6 3,679.0 Interest expense 13.9 27.1

Total costs and expenses 5,638.9 5,182.4

Income before income taxes 697.4 608.0 Income tax expense 291.3 232.6

Net income $ 406.1 $ 375.4

Compute the following ratios for 2017 and 2016.

(a) Current ratio.

(b) Inventory turnover. (Inventory on 6/30/15 was $599.0.)

(d) Return on assets. (Assets on 6/30/15 were $3,349.9.)

(e) Return on common stockholders’ equity. (Stockholders’ equity on 6/30/15 was $1,795.9.)

(f) Debt to assets ratio.

(g) Times interest earned.

JOHN CULLY COMPANY Balance Sheets

June 30

664 13 Financial Analysis: The Big Picture

SOLUTION 2017 2016

(a) Current ratio: $2,302.6 ÷ $1,497.7 = 1.5:1 $2,199.2 ÷ $1,322.0 = 1.7:1 (b) Inventory turnover: $1,617.4 ÷ [($768.3 + $653.5) ÷ 2] = 2.3 times $1,476.3 ÷ [($653.5 + $599.0) ÷ 2] = 2.4 times (c) Profi t margin: $406.1 ÷ $6,336.3 = 6.4% $375.4 ÷ $5,790.4 = 6.5% (d) Return on assets: $406.1 ÷ [($3,885.8 + $3,708.1) ÷ 2] = 10.7% $375.4 ÷ [($3,708.1 + $3,349.9) ÷ 2] = 10.6% (e) Return on common stockholders’ equity: ($406.1 − $0) ÷ [($1,708.6 + $1,749.0) ÷ 2] = 23.5% ($375.4 − $0) ÷ [($1,749.0 + $1,795.9) ÷ 2] = 21.2% (f) Debt to assets ratio: ($1,497.7 + $679.5) ÷ $3,885.8 = 56.0% ($1,322.0 + $637.1) ÷ $3,708.1 = 52.8% (g) Times interest earned: ($406.1 + $13.9 + $291.3) ÷ $13.9 = 51.2 times ($375.4 + $27.1 + $232.6) ÷ $27.1 = 23.4 times

Related exercise material: BE13-10, BE13-11, BE13-12, BE13-13, BE13-14, BE13-15, DO IT! 13-3, E13-7, E13-8, E13-9, E13-10, E13-11, E13-12, and E13-13.

Action Plan ✔ Remember that the

current ratio includes all current assets.

✔ Use average balances for turnover ratios like inventory, accounts receivable, and return on assets.

In analyzing a company, you should always investigate an extended period of time in order to determine whether the con- dition and performance of the company are changing. The condensed fi nancial statements of Kellogg Company for 2014 and 2013 are presented here.

USING DECISION TOOLS—KELLOGG COMPANY

Assets 2014 2013

Current assets Cash $ 443 $ 273 Accounts receivable (net) 1,276 1,423 Inventories 1,279 1,248 Other current assets 342 323

Total current assets 3,340 3,267 Property (net) 3,769 3,856 Other assets 8,044 8,351

Total assets $15,153 $15,474

Liabilities and Stockholders’ Equity

Current liabilities $ 4,364 $ 3,835 Long-term liabilities 7,938 8,032 Stockholders’ equity—common 2,851 3,607

Total liabilities and stockholders’ equity $15,153 $15,474

KELLOGG COMPANY, INC. Balance Sheets

January 3, 2015, and December 28, 2013 (in millions)

Using Decision Tools 665

2014 2013 Net sales $14,580 $14,792 Cost of goods sold 9,517 8,689 Gross profi t 5,063 6,103 Selling and administrative expenses 4,039 3,266 Income from operations 1,024 2,837 Interest expense 209 235 Other (income) expense, net (3) 3 Income before income taxes 818 2,599 Income tax expense 186 792 Net income $ 632 $ 1,807

KELLOGG COMPANY, INC. Condensed Income Statements

For the Years Ended January 3, 2015, and December 28, 2013 (in millions)

INSTRUCTIONS

Compute the following ratios for Kellogg for 2014 and discuss your fi ndings (2013 values are provided for comparison).

1. Liquidity: (a) Current ratio (2013: .85:1). (b) Inventory turnover (2013: 6.7 times). 2. Solvency: (a) Debt to assets ratio (2013: 77%). (b) Times interest earned (2013: 12.1 times). 3. Profi tability: (a) Return on assets (2013: 11.8%). (b) Profi t margin (2013: 12.2%). (c) Return on common stockholders’ equity (2013: 60%).

SOLUTION 1. Liquidity (a) Current ratio:

2014: $3,340 $4,364

= .77:1 2013: .85:1

(b) Inventory turnover:

2014: $9,517

($1,279 + $1,248)/2 = 7.5 times 2013: 6.7 times

We see that between 2013 and 2014, the current ratio declined, which suggests a decline in liquidity. The inventory turnover increased, which suggests an improvement in liquidity.

2. Solvency (a) Debt to assets ratio:

2014: $4,364 + $7,938

$15,153 = 81% 2013: 77%

(b) Times interest earned:

2014: $632 + $209 + $186

$209 = 4.9 times 2013: 12.1 times

Kellogg’s solvency as measured by the debt to assets ratio decreased in 2014, and its times interest earned declined as well.

666 13 Financial Analysis: The Big Picture

3. Profi tability (a) Return on assets:

2014: $632

($15,153 + $15,474)/2 = 4.1% 2013: 11.8%

(b) Profi t margin:

2014: $632

$14,580 = 4.3% 2013: 12.2%

2014: $632

($2,851 + $3,607)/2 = 20% 2013: 60%

Kellogg’s return on assets declined. Its profi t margin and return on stockholders’ equity also declined. The company experienced a sharp drop in net income.

In previous chapters, we presented many ratios used for evaluating the fi nan- cial health and performance of a company. In this appendix, we provide a com- prehensive review of those ratios and discuss some important relationships among them. Since earlier chapters demonstrated the calculation of each of these ratios, in this appendix we instead focus on their interpretation. Page references to prior discussions point you to any individual ratios you feel you need to review. We used the fi nancial information in Illustrations 13A-1 through 13A-4 to calculate Chicago Cereal Company’s 2014 ratios. You can use these data to review the computations.

APPENDIX 13A: Evaluate a company comprehensively using ratio analysis.

LEARNING OBJECTIVE *4▼

CHICAGO CEREAL COMPANY Balance Sheets

December 31 (in thousands)

ILLUSTRATION 13A-1 Chicago Cereal Company’s balance sheets

Assets 2014 2013

Current assets Cash $ 524 $ 411 Accounts receivable 1,026 945 Inventory 924 824 Prepaid expenses and other current assets 243 247

Total current assets 2,717 2,427 Property assets (net) 2,990 2,816 Intangibles and other assets 5,690 5,471

Total assets $11,397 $10,714

Liabilities and Stockholders’ Equity

Current liabilities $ 4,044 $ 4,020 Long-term liabilities 4,827 4,625 Stockholders’ equity—common 2,526 2,069

Total liabilities and stockholders’ equity $11,397 $10,714

Additional information:

2014 2013

Average number of shares (thousands) 418.7 418.5 Stock price at year-end $52.92 $50.06

Appendix 13A: Comprehensive Illustration of Ratio Analysis 667

CHICAGO CEREAL COMPANY Condensed Income Statements

For the Years Ended December 31 (in thousands)

ILLUSTRATION 13A-2 Chicago Cereal Company’s income statements

ILLUSTRATION 13A-4 Additional information for Chicago Cereal Company

As indicated in the chapter, we can classify ratios into three types for analysis of the primary fi nancial statements:

1. Liquidity ratios. Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

2. Solvency ratios. Measures of the ability of the company to survive over a long period of time.

3. Profi tability ratios. Measures of the income or operating success of a com- pany for a given period of time.

2014 2013

Net sales $11,776 $10,907 Cost of goods sold 6,597 6,082

Gross profi t 5,179 4,825 Selling and administrative expenses 3,311 3,059

Income from operations 1,868 1,766 Interest expense 319 307 Other income (expense), net (2) 13

Income before income taxes 1,547 1,472 Income tax expense 444 468

Net income $ 1,103 $ 1,004

CHICAGO CEREAL COMPANY Condensed Statements of Cash Flows

For the Years Ended December 31 (in thousands)

2014 2013

Cash fl ows from operating activities Cash receipts from operating activities $11,695 $10,841 Cash payments for operating activities 10,192 9,431

Net cash provided by operating activities 1,503 1,410

Cash fl ows from investing activities Purchases of property, plant, and equipment (472) (453) Other investing activities (129) 8

Net cash used in investing activities (601) (445)

Cash fl ows from fi nancing activities Issuance of common stock 163 218 Issuance of debt 2,179 721 Reductions of debt (2,011) (650) Payment of dividends (475) (450) Repurchase of common stock and other items (645) (612)

Net cash provided (used) by fi nancing activities (789) (773)

Increase (decrease) in cash and cash equivalents 113 192 Cash and cash equivalents at beginning of year 411 219

Cash and cash equivalents at end of year $ 524 $ 411

ILLUSTRATION 13A-3 Chicago Cereal Company’s statements of cash fl ows

668 13 Financial Analysis: The Big Picture

As a tool of analysis, ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components of a par- ticular ratio. But, a single ratio by itself is not very meaningful. Accordingly, in this discussion we use the following three comparisons.

1. Intracompany comparisons covering two years for Chicago Cereal (using comparative fi nancial information from Illustrations 13A-1 through 13A-4).

2. Intercompany comparisons using General Mills as one of Chicago Cereal’s competitors.

3. Industry average comparisons based on MSN.com median ratios for man- ufacturers of fl our and other grain mill products and comparisons with other sources. For some of the ratios that we use, industry comparisons are not available (denoted “na”).

LIQUIDITY RATIOS

Liquidity ratios measure the short-term ability of the company to pay its matur- ing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The measures used to determine the company’s short-term debt-paying ability are the current ratio, the accounts receivable turnover, the average collection period, the inventory turnover, and days in inventory.

1. Current ratio. The current ratio expresses the relationship of current assets to current liabilities, computed by dividing current assets by current liabili- ties. It is widely used for evaluating a company’s liquidity and short-term debt-paying ability. The 2014 and 2013 current ratios for Chicago Cereal and comparative data are shown in Illustration 13A-5.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Current ratio Current assets Current liabilities

Short-term debt- paying ability

.67 .60 .67 1.06 54

Chicago Cereal

ILLUSTRATION 13A-5 Current ratio

What do the measures tell us? Chicago Cereal’s 2013 current ratio of .67 means that for every dollar of current liabilities, it has $0.67 of current assets. We sometimes state such ratios as .67:1 to reinforce this interpretation. Its current ratio—and therefore its liquidity—increased signifi cantly in 2014. It is well below the industry average but the same as that of General Mills.

2. Accounts receivable turnover. Analysts can measure liquidity by how quickly a company converts certain assets to cash. Low values of the previous ratios can sometimes be compensated for if some of the company’s current assets are highly liquid.

How liquid, for example, are the receivables? The ratio used to assess the li- quidity of the receivables is the accounts receivable turnover, which measures the number of times, on average, a company collects receivables during the pe- riod. The accounts receivable turnover is computed by dividing net credit sales (net sales less cash sales) by average net accounts receivable during the year. The accounts receivable turnover for Chicago Cereal is shown in Illustration 13A-6.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Accounts Net credit sales Average net accounts receivable

Liquidity of 11.9 12.0 12.2 11.2 395 receivable receivables turnover

Chicago Cereal

ILLUSTRATION 13A-6 Accounts receivable turnover

Appendix 13A: Comprehensive Illustration of Ratio Analysis 669

In computing the rate, we assumed that all Chicago Cereal’s sales are credit sales. Its accounts receivable turnover declined slightly in 2014. The turnover of 11.9 times is higher than the industry average of 11.2 times, and slightly lower than General Mills’ turnover of 12.2 times.

3. Average collection period. A popular variant of the accounts receivable turnover converts it into an average collection period in days. This is done by dividing the accounts receivable turnover into 365 days. The average collection period for Chicago Cereal is shown in Illustration 13A-7.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Average 365 days Accounts receivable turnover

Liquidity of 30.7 30.4 29.9 32.6 395 collection receivables and period collection success

Chicago Cereal

ILLUSTRATION 13A-7 Average collection period

Chicago Cereal’s 2014 accounts receivable turnover of 11.9 times is divided into 365 days to obtain approximately 31 days. This means that the average collection period for receivables is about 31 days. Its average collec- tion period is slightly longer than that of General Mills and shorter than that of the industry.

Analysts frequently use the average collection period to assess the effec- tiveness of a company’s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).

4. Inventory turnover. The inventory turnover measures the number of times average inventory was sold during the period. Its purpose is to measure the li- quidity of the inventory. A high measure indicates that inventory is being sold and replenished frequently. The inventory turnover is computed by dividing the cost of goods sold by the average inventory during the period. Unless sea- sonal factors are signifi cant, average inventory can be computed from the be- ginning and ending inventory balances. Chicago Cereal’s inventory turnover is shown in Illustration 13A-8.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Inventory Cost of goods sold Average inventory

Liquidity of 7.5 7.9 7.4 6.7 283 turnover inventory

Chicago Cereal

ILLUSTRATION 13A-8 Inventory turnover

Chicago Cereal’s inventory turnover decreased slightly in 2014. The turn- over of 7.5 times is higher than the industry average of 6.7 times and similar to that of General Mills. Generally, the faster the inventory turnover, the less cash is tied up in inventory and the less the chance of inventory becoming ob- solete. Of course, a downside of high inventory turnover is that it sometimes results in lost sales because if a company keeps less inventory on hand, it is more likely to run out of inventory when it is needed.

5. Days in inventory. A variant of the inventory turnover is the days in inventory, which measures the average number of days inventory is held. The days in inventory for Chicago Cereal is shown in Illustration 13A-9 (page 670).

670 13 Financial Analysis: The Big Picture

Chicago Cereal’s 2014 inventory turnover of 7.5 divided into 365 is approx- imately 49 days. An average selling time of 49 days is faster than the industry average and similar to that of General Mills. Some of this difference might be explained by differences in product lines across the two companies, although in many ways the types of products of these two companies are quite similar.

Inventory turnovers vary considerably among industries. For example, grocery store chains have a turnover of 10 times and an average selling pe- riod of 37 days. In contrast, jewelry stores have an average turnover of 1.3 times and an average selling period of 281 days. Within a company, there may even be signifi cant differences in inventory turnover among different types of products. Thus, in a grocery store the turnover of perishable items such as produce, meats, and dairy products is faster than the turnover of soaps and detergents.

To conclude, nearly all of these liquidity measures suggest that Chicago Cereal’s liquidity changed little during 2014. Its liquidity appears acceptable when compared to the industry as a whole and when compared to General Mills.

SOLVENCY RATIOS

Solvency ratios measure the ability of the company to survive over a long period of time. Long-term creditors and stockholders are interested in a company’s long- run solvency, particularly its ability to pay interest as it comes due and to repay the face value of debt at maturity. The debt to assets ratio and times interest earned provide information about debt-paying ability. In addition, free cash fl ow provides information about the company’s solvency and its ability to pay addi- tional dividends or invest in new projects.

6. Debt to assets ratio. The debt to assets ratio measures the percentage of total fi nancing provided by creditors. It is computed by dividing total liabilities (both current and long-term debt) by total assets. This ratio indicates the de- gree of fi nancial leveraging. It also provides some indication of the company’s ability to withstand losses without impairing the interests of its creditors. The higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligations. Thus, from the creditors’ point of view, a low ratio of debt to assets is desirable. Chicago Cereal’s debt to assets ratio is shown in Illustration 13A-10.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Days in 365 days Inventory turnover

Liquidity of 48.7 46.2 49.3 54.5 283 inventory inventory and inventory management

Chicago Cereal

ILLUSTRATION 13A-9 Days in inventory

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Debt to Total liabilities Total assets

Percentage of total 78% 81% 55% 55% 56 assets ratio assets provided by creditors

Chicago Cereal

Chicago Cereal’s 2014 ratio of 78% means that creditors have provided fi nancing suffi cient to cover 78% of the company’s total assets. Alternatively, it says that it would have to liquidate 78% of its assets at their book value

ILLUSTRATION 13A-10 Debt to assets ratio

Appendix 13A: Comprehensive Illustration of Ratio Analysis 671

in order to pay off all of its debts. Its ratio is above the industry average of 55%, as well as that of General Mills. This suggests that it is less solvent than the industry average and General Mills. Chicago Cereal’s solvency improved slightly during the year.

The adequacy of this ratio is often judged in light of the company’s earn- ings. Generally, companies with relatively stable earnings, such as public util- ities, have higher debt to assets ratios than cyclical companies with widely fl uctuating earnings, such as many high-tech companies.

Another ratio with a similar meaning is the debt to equity ratio. It shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners. Because this ratio can be computed in several ways, be careful when making comparisons with it. Debt may be defi ned to include only the noncurrent portion of liabilities, and intangible assets may be ex- cluded from stockholders’ equity (which would equal tangible net worth). If debt and assets are defi ned as above (all liabilities and all assets), then when the debt to assets ratio equals 50%, the debt to equity ratio is 1:1.

7. Times interest earned. The times interest earned (also called interest cov- erage) indicates the company’s ability to meet interest payments as they come due. It is computed by dividing the sum of net income, interest expense, and income tax expense by interest expense. Note that this ratio uses income be- fore interest expense and income taxes because this amount represents what is available to cover interest. Chicago Cereal’s times interest earned is shown in Illustration 13A-11.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Times Net Income

1 Interest expense

1 Income tax

expense Interest expense

Ability to meet 5.8 5.8 9.9 5.5 497 interest interest payments earned as they come due

Chicago Cereal

ILLUSTRATION 13A-11 Times interest earned

For Chicago Cereal, the 2014 interest coverage was 5.8, which indicates that income before interest and taxes was 5.8 times the amount needed for interest expense. This is less than the rate for General Mills, but it slightly ex- ceeds the rate for the industry. The debt to assets ratio decreased for Chicago Cereal during 2014, and its times interest earned held constant.

8. Free cash fl ow. One indication of a company’s solvency, as well as of its ability to pay dividends or expand operations, is the amount of excess cash it generated after investing in capital expenditures and paying dividends. This amount is referred to as free cash fl ow. For example, if you generate $100,000 of net cash provided by operating activities but you spend $30,000 on capital expenditures and pay $10,000 in dividends, you have $60,000 ($100,000 − $30,000 − $10,000) to use either to expand operations, pay addi- tional dividends, or pay down debt. Chicago Cereal’s free cash fl ow is shown in Illustration 13A-12.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Free Net cash provided by operating activities

− Capital expenditures

− Cash dividends

Cash available $556 $507 $895 na 57 cash for paying (in thousands) (in millions) fl ow dividends or expanding operations

Chicago Cereal

ILLUSTRATION 13A-12 Free cash fl ow

672 13 Financial Analysis: The Big Picture

Chicago Cereal’s free cash fl ow increased slightly from 2013 to 2014. During both years, the net cash provided by operating activities was more than enough to allow it to acquire additional productive assets and maintain dividend payments. It could have used the remaining cash to reduce debt if necessary. Given that Chicago Cereal is much smaller than General Mills, we would expect its free cash fl ow to be substantially smaller, which it is.

PROFITABILITY RATIOS

Profi tability ratios measure the income or operating success of a company for a given period of time. A company’s income, or the lack of it, affects its ability to obtain debt and equity fi nancing, its liquidity position, and its ability to grow. As a consequence, creditors and investors alike are interested in evaluating profi t- ability. Analysts frequently use profi tability as the ultimate test of management’s operating effectiveness. Throughout this textbook, we have introduced numerous measures of profi t- ability. The relationships among measures of profi tability are very important. Understanding them can help management determine where to focus its efforts to improve profi tability. Illustration 13A-13 diagrams these relationships. Our discussion of Chicago Cereal’s profi tability is structured around this diagram.

Return on assets

Leverage (debt to assets ratio)

Return on common

stockholders’ equity

Profit margin

Asset turnover

ILLUSTRATION 13A-13 Relationships among profi tability measures

9. Return on common stockholders’ equity (ROE). A widely used measure of profi tability from the common stockholder’s viewpoint is the return on common stockholders’ equity (ROE). This ratio shows how many dollars of net income the company earned for each dollar invested by the owners. It is computed by dividing net income minus any preferred dividends—that is, income available to common stockholders—by average common stockholders’ equity. The return on common stockholders’ equity for Chicago Cereal is shown in Illustration 13A-14.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Return on Net Income

2 Preferred dividends

Average common stockholders’ equity

Profi tability of 48% 46% 25% 19% 561 common common stockholders’ stockholders’ equity investment

Chicago Cereal

ILLUSTRATION 13A-14 Return on common stockholders’ equity

Chicago Cereal’s 2014 return on common stockholders’ equity is unusu- ally high at 48%. The industry average is 19% and General Mills’ return is 25%. In the subsequent sections, we investigate the causes of this high return.

Appendix 13A: Comprehensive Illustration of Ratio Analysis 673

10. Return on assets. The return on common stockholders’ equity is affected by two factors: the return on assets and the degree of leverage. The return on assets measures the overall profi tability of assets in terms of the income earned on each dollar invested in assets. It is computed by dividing net in- come by average total assets. Chicago Cereal’s return on assets is shown in Illustration 13A-15.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Return on Net income Average total assets

Overall profi tability 10.0% 9.4% 6.2% 5.3% 444 assets of assets

Chicago Cereal

ILLUSTRATION 13A-15 Return on assets

Chicago Cereal had a 10.0% return on assets in 2014. This rate is signifi - cantly higher than that of General Mills and the industry average.

Note that its rate of return on common stockholders’ equity (48%) is sub- stantially higher than its rate of return on assets (10%). The reason is that it has made effective use of leverage. Leveraging or trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than the rate of return it earns on the assets it purchased with the borrowed funds. Leverage enables management to use money supplied by nonowners to increase the return to owners.

A comparison of the rate of return on assets with the rate of interest paid for borrowed money indicates the profi tability of trading on the equity. If you borrow money at 8% and your rate of return on assets is 11%, you are trading on the equity at a gain. Note, however, that trading on the equity is a two-way street. For example, if you borrow money at 11% and earn only 8% on it, you are trading on the equity at a loss.

Chicago Cereal earns more on its borrowed funds than it has to pay in interest. Thus, the return to stockholders exceeds the return on assets be- cause of the positive benefi t of leverage. Recall from our earlier discussion that Chicago Cereal’s percentage of debt fi nancing, as measured by the ratio of debt to assets (or debt to equity), was higher than General Mills’ and the industry average. It appears that Chicago Cereal’s high return on common stockholders’ equity is due in part to its use of leverage.

11. Profi t margin. The return on assets is affected by two factors, the fi rst of which is the profi t margin. The profi t margin, or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income. It is computed by dividing net income by net sales for the period. Chicago Cereal’s profi t margin is shown in Illustration 13A-16.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Profi t margin Net income Net sales

Net income 9.4% 9.2% 8.2% 6.1% 235 generated by each dollar of sales

Chicago Cereal

ILLUSTRATION 13A-16 Profi t margin

Chicago Cereal experienced a slight increase in its profi t margin from 2013 to 2014 of 9.2% to 9.4%. Its profi t margin was higher than the industry average and that of General Mills.

High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profi t margins. Low-volume businesses such as jewelry stores and airplane manufacturers have high profi t margins.

674 13 Financial Analysis: The Big Picture

12. Asset turnover. The other factor that affects the return on assets is the as- set turnover. The asset turnover measures how effi ciently a company uses its assets to generate sales. It is determined by dividing net sales by average total assets for the period. The resulting number shows the dollars of sales produced by each dollar invested in assets. Illustration 13A-17 shows the asset turnover for Chicago Cereal.

The asset turnover shows that in 2014, Chicago Cereal generated sales of $1.07 for each dollar it had invested in assets. The ratio rose from 2013 to 2014. Its asset turnover is above the industry average and that of General Mills.

Asset turnovers vary considerably among industries. The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.

In summary, Chicago Cereal’s return on assets increased from 9.4% in 2013 to 10.0% in 2014. Underlying this increase was an increased profi tability on each dollar of sales (as measured by the profi t margin) and a rise in the sales-generating effi ciency of its assets (as measured by the asset turnover). We can analyze the combined effects of profi t margin and asset turnover on return on assets for Chicago Cereal as shown in Illustration 13A-18.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Asset turnover Net sales

Average total assets

How effi ciently 1.07 1.02 .76 .87 446 assets are used to generate sales

Chicago Cereal

ILLUSTRATION 13A-17 Asset turnover

ILLUSTRATION 13A-18 Composition of return on assets

13. Gross profi t rate. One factor that strongly infl uences the profi t margin is the gross profi t rate. The gross profi t rate is determined by dividing gross profi t (net sales less cost of goods sold) by net sales. This rate indicates a company’s ability to maintain an adequate selling price above its cost of goods sold.

As an industry becomes more competitive, this ratio declines. For ex- ample, in the early years of the personal computer industry, gross profi t rates were quite high. Today, because of increased competition and a belief that most brands of personal computers are similar in quality, gross profi t rates have become thin. Analysts should closely monitor gross profi t rates over time. Illustration 13A-19 shows Chicago Cereal’s gross profi t rate.

Ratios: Profit

Margin × Asset

Turnover = Return on

Assets

Net Income Net Sales

× Net Sales Average Total Assets

= Net Income Average Total Assets

Chicago Cereal

2014 9.4% × 1.07 times = 10.1%*

2013 9.2% × 1.02 times = 9.4%

*Difference from value in Illustration 13A-15 due to rounding.

Appendix 13A: Comprehensive Illustration of Ratio Analysis 675

Chicago Cereal’s gross profi t rate remained constant from 2013 to 2014.

14. Earnings per share (EPS). Stockholders usually think in terms of the num- ber of shares they own or plan to buy or sell. Expressing net income earned on a per share basis provides a useful perspective for determining profi t- ability. Earnings per share is a measure of the net income earned on each share of common stock. It is computed by dividing net income by the average number of common shares outstanding during the year.

The terms “net income per share” or “earnings per share” refer to the amount of net income applicable to each share of common stock. Therefore, when we compute earnings per share, if there are preferred dividends declared for the period, we must deduct them from net income to arrive at income avail- able to the common stockholders. Chicago Cereal’s earnings per share is shown in Illustration 13A-20.

ILLUSTRATION 13A-19 Gross profi t rate

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Gross profi t Gross profi t Net sales

Margin between 44% 44% 34% 30% 234 rate selling price and cost of goods sold

Chicago Cereal

Note that no industry average is presented in Illustration 13A-20. In- dustry data for earnings per share are not reported, and in fact the Chicago Cereal and General Mills ratios should not be compared. Such comparisons are not meaningful because of the wide variations in the number of shares of outstanding stock among companies. Chicago Cereal’s earnings per share increased 23 cents per share in 2014. This represents a 9.6% increase from the 2013 EPS of $2.40.

15. Price-earnings ratio. The price-earnings ratio is an oft-quoted statistic that measures the ratio of the market price of each share of common stock to the earnings per share. The price-earnings (P-E) ratio refl ects investors’ assessments of a company’s future earnings. It is computed by dividing the market price per share of the stock by earnings per share. Chicago Cereal’s price-earnings ratio is shown in Illustration 13A-21.

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Earnings Net income

− Preferred dividends

Weighted-average common shares outstanding

Net income earned $2.63 $2.40 $2.90 na 53 per share on each share of (EPS) common stock

Chicago Cereal

ILLUSTRATION 13A-20 Earnings per share

ILLUSTRATION 13A-21 Price-earnings ratio

General Mills Industry Page in Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Price-earnings Market price per share

Earnings per share

Relationship between 20.1 20.9 24.3 35.8 660 ratio market price per share and earnings per share

Chicago Cereal

At the end of 2014 and 2013, the market price of Chicago Cereal’s stock was $52.92 and $50.06, respectively.

676 13 Financial Analysis: The Big Picture

In 2014, each share of Chicago Cereal’s stock sold for 20.1 times the amount that was earned on each share. Chicago Cereal’s price-earnings ratio is lower than General Mills’ ratio of 24.3 and lower than the industry average of 35.8 times. Its lower P-E ratio suggests that the market is less optimistic about Chicago Cereal than about General Mills. However, it might also signal that Chicago Cereal’s stock is underpriced.

16. Payout ratio. The payout ratio measures the percentage of earnings dis- tributed in the form of cash dividends. It is computed by dividing cash divi- dends declared on common stock by net income. Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business. The payout ratio for Chicago Cereal is shown in Illustration 13A-22.

General Mills Industry Page in

Ratio Formula Indicates 2014 2013 2014 2014 Textbook

Payout ratio Cash dividends declared on

common stock Net income

Percentage of 43% 45% 54% 37% 560 earnings distributed in the form of cash dividends

Chicago Cereal

ILLUSTRATION 13A-22 Payout ratio

The 2014 and 2013 payout ratios for Chicago Cereal are slightly lower than that of General Mills (54%) but higher than the industry average (37%).

Management has some control over the amount of dividends paid each year, and companies are generally reluctant to reduce a dividend below the amount paid in a previous year. Therefore, the payout ratio will actually in- crease if a company’s net income declines but the company keeps its total dividend payment the same. Of course, unless the company returns to its previous level of profi tability, maintaining this higher dividend payout ratio is probably not possible over the long run.

Before drawing any conclusions regarding Chicago Cereal’s dividend pay- out ratio, we should calculate this ratio over a longer period of time to evaluate any trends and also try to fi nd out whether management’s philosophy regard- ing dividends has changed recently. The “Selected Financial Data” section of Chicago Cereal’s Management Discussion and Analysis shows that over a 5-year period, earnings per share rose 45%, while dividends per share grew only 19%.

In terms of the types of fi nancial information available and the ratios used by various industries, what can be practically covered in this textbook gives you only the “Titanic approach.” That is, you are seeing only the tip of the iceberg compared to the vast databases and types of ratio analysis that are available on computers. The availability of information is not a problem. The real trick is to be discriminat- ing enough to perform relevant analysis and select pertinent comparative data.

LEARNING OBJECTIVES REVIEW

REVIEW AND PRACTICE

1 Apply the concepts of sustainable income and quality of earnings. Sustainable income analysis is useful in evaluating a company’s performance. Sustainable income is the most likely level of income to be obtained by the company in the future. Discontinued operations and other comprehensive

▼

income are presented on the statement of comprehensive income to highlight their unusual nature. Items below income from continuing operations must be presented net of tax.

A high quality of earnings provides full and transparent information that will not confuse or mislead users of the

Glossary Review 677

fi nancial statements. Issues related to quality of earnings are (1) alternative accounting methods, (2) pro forma income, and (3) improper recognition.

2 Apply horizontal analysis and vertical analysis. Horizon- tal analysis is a technique for evaluating a series of data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.

Vertical analysis is a technique that expresses each item in a fi nancial statement as a percentage of a relevant total or a base amount

3 Analyze a company’s performance using ratio analysis. The price-earnings (P-E) ratio refl ects investors’ assess- ment of a company’s future earnings potential. Financial ratios are provided in Illustration 13-16 (liquidity), Illustra- tion 13-17 (solvency), and Illustration 13-18 (profi tability).

*4 Evaluate a company comprehensively using ratio analy- sis. To evaluate a company, ratios (liquidity, solvency, and profi tability) provide clues to underlying conditions, but intracompany, intercompany, and industry average com- parisons are also needed.

DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Has the company sold any major components of its business?

Discontinued operations section of income statement

Anything reported in this section indicates that the company has discontinued a major component of its business.

How do the relationships between items in this year’s fi nancial statements compare with those of last year or those of competitors?

Income statement and balance sheet

Each line item on the income statement should be presented as a percentage of net sales, and each line item on the balance sheet should be presented as a percentage of total assets or total liabilities and stockholders’ equity. These percentages should be investigated for differ- ences either across years in the same company or in the same year across dif- ferent companies. This is called vertical analysis.

Has the company changed any of its accounting principles?

Effect of change in accounting principle on current and prior periods

Management indicates that the new principle is preferable to the old principle.

Examine current and prior years’ reported income, using new-principle basis to assess trends for esti- mating future income.

Any signifi cant differences either across years or between companies should be investigated to determine the cause.

If a major component has been discontinued, its results during the current period should not be included in estimates of future net income.

How do the company’s fi nancial position and operating results compare with those of the previous period?

Income statement and balance sheet

Comparative fi nancial statements should be prepared over at least two years, with the fi rst year reported being the base year. Changes in each line item relative to the base year should be presented both by amount and by percentage. This is called horizontal analysis.

Signifi cant changes should be investigated to deter- mine the reason for the change.

*Accounts receivable turnover A measure of the liquidity of receivables; computed as net credit sales divided by average net accounts receivable. (p. 668).

*Asset turnover A measure of how effi ciently a company uses its assets to generate sales; computed as net sales divided by average total assets. (p. 674).

GLOSSARY REVIEW▼

Available-for-sale securities Securities that are held with the intent of selling them sometime in the future. (p. 650).

*Average collection period The average number of days that receivables are outstanding; calculated as accounts receivable turnover divided into 365 days. (p. 669).

Change in accounting principle Use of an accounting principle in the current year different from the one used in the preceding year. (p. 651).

Comprehensive income The sum of net income and other comprehensive income items. (p. 650).

*Current ratio A measure used to evaluate a company’s li- quidity and short-term debt-paying ability; calculated as current assets divided by current liabilities. (p. 668).

*Days in inventory A measure of the average number of days inventory is held; computed as inventory turnover divided into 365 days. (p. 669).

*Debt to assets ratio A measure of the percentage of total fi nancing provided by creditors; computed as total li- abilities divided by total assets. (p. 670).

Discontinued operations The disposal of a signifi cant component of a business. (p. 649).

*Earnings per share The net income earned by each share of common stock; computed as net income less pre- ferred dividends divided by the weighted-average com- mon shares outstanding. (p. 675).

*Free cash fl ow A measure of solvency. Cash remaining from operating activities after adjusting for capital ex- penditures and dividends paid. (p. 671).

*Gross profi t rate Gross profi t expressed as a percentage of sales; computed as gross profi t divided by net sales. (p. 674).

Horizontal analysis A technique for evaluating a series of fi nancial statement data over a period of time to deter- mine the increase (decrease) that has taken place, ex- pressed as either an amount or a percentage. (p. 655).

*Inventory turnover A measure of the liquidity of inven- tory. Measures the number of times average inventory was sold during the period; computed as cost of goods sold divided by average inventory. (p. 669).

*Leveraging Borrowing money at a lower rate of interest than can be earned by using the borrowed money; also referred to as trading on the equity. (p. 673).

Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. (p. 660).

*Payout ratio A measure of the percentage of earnings dis- tributed in the form of cash dividends; calculated as cash dividends declared on common stock divided by net income. (p. 676).

Price-earnings (P-E) ratio A comparison of the market price of each share of common stock to the earnings per share; computed as the market price of the stock divided by earnings per share. (pp. 660, 675).

Profi tability ratios Measures of the income or operating success of a company for a given period of time. (p. 661).

*Profi t margin A measure of the net income generated by each dollar of sales; computed as net income divided by net sales. (p. 673).

Pro forma income A measure of income that usually ex- cludes items that a company thinks are unusual or non- recurring. (p. 653).

Quality of earnings Indicates the level of full and trans- parent information that is provided to users of the fi - nancial statements. (p. 652).

*Return on assets A profi tability measure that indicates the amount of net income generated by each dollar of assets; calculated as net income divided by average total assets. (p. 673).

*Return on common stockholders’ equity (ROE) A mea- sure of the dollars of net income earned for each dollar invested by the owners; computed as income available to common stockholders divided by average common stockholders’ equity. (p. 672).

Solvency ratios Measures of the ability of a company to survive over a long period of time, particularly to pay interest as it comes due and to repay the balance of debt at its maturity. (p. 661).

Sustainable income The most likely level of income to be obtained by a company in the future. (p. 648).

*Times interest earned A measure of a company’s solvency and ability to meet interest payments as they come due; calculated as the sum of net income, interest expense, and income tax expense divided by interest expense. (p. 671).

*Trading on the equity See leveraging. (p. 673).

Trading securities Securities bought and held primarily for sale in the near term to generate income on short- term price differences. (p. 650).

Vertical analysis A technique for evaluating fi nancial statement data that expresses each item in a fi nancial statement as a percentage of a base amount. (p. 657).

678 13 Financial Analysis: The Big Picture

All of the Practice Multiple-Choice Questions in this chapter employ decision tools. 1. In reporting discontinued operations, the income

statement should show in a special section: (a) gains on the disposal of the discontinued compo-

nent. (b) losses on the disposal of the discontinued com-

ponent. (c) Neither (a) nor (b). (d) Both (a) and (b).

(LO 1)

2. Cool Stools Corporation has income before taxes of $400,000 and a loss on discontinued operations of $100,000. If the income tax rate is 25% on all items, the statement of comprehensive income should show income from continuing operations and discontin- ued operations, respectively, of (a) $325,000 and $100,000. (b) $325,000 and $75,000. (c) $300,000 and $100,000. (d) $300,000 and $75,000.

(LO 1)

PRACTICE MULTIPLE-CHOICE QUESTIONS▼

Practice Multiple-Choice Questions 679

SOLUTIONS 1. (d) Gains and losses from the operations of a discontinued segment and gains and losses on the disposal of the dis-

continued segment are shown in a separate section immediately after continuing operations in the income statement. Choices (a) and (b) are correct, but (d) is the better answer. Choice (c) is wrong as there is a correct answer.

2. (d) Income tax expense = 25% × $400,000 = $100,000; therefore, income from continuing operations = $400,000 − $100,000 = $300,000. The loss on discontinued operations is shown net of tax, $100,000 × 75% = $75,000. The other choices are therefore incorrect.

3. (b) Unrealized gains and losses on available-for-sale securities are part of other comprehensive income. The other choices are incorrect because (a) a gain on the disposal of discontinued operations is reported as an unusual item, (c) loss related to a fl ood is reported among other expenses and losses, and (d) net income is a separate line item.

10. Which measure is useful in evaluating the effi ciency in managing inventories? (a) Inventory turnover. (b) Days in inventory. (c) Both (a) and (b). (d) None of the above.

11. Which of these is not a liquidity ratio? (a) Current ratio. (b) Asset turnover. (c) Inventory turnover. (d) Accounts receivable turnover.

12. Plano Corporation reported net income $24,000, net sales $400,000, and average assets $600,000 for 2017. What is the 2017 profi t margin? (a) 6%. (c) 40%. (b) 12%. (d) 200%.

Use the following fi nancial statement information as of the end of each year to answer Questions 13–17.

2017 2016

Inventory $ 54,000 $ 48,000 Current assets 81,000 106,000 Total assets 382,000 326,000 Current liabilities 27,000 36,000 Total liabilities 102,000 88,000 Common stockholders’ equity 240,000 198,000 Net sales 784,000 697,000 Cost of goods sold 306,000 277,000 Net income 134,000 90,000 Income tax expense 22,000 18,000 Interest expense 12,000 12,000 Dividends paid to

preferred stockholders 4,000 4,000 Dividends paid to common

stockholders 15,000 10,000

13. Compute the days in inventory for 2017. (a) 64.4 days. (c) 6 days. (b) 60.8 days. (d) 24 days.

14. Compute the current ratio for 2017. (a) 1.26:1. (c) 0.80:1. (b) 3.0:1. (d) 3.75:1.

15. Compute the profi t margin for 2017. (a) 17.1%. (c) 37.9%. (b) 18.1%. (d) 5.9%.

16. Compute the return on common stockholders’ equity for 2017. (a) 54.2%. (c) 61.2%. (b) 52.5%. (d) 59.4%.

17. Compute the times interest earned for 2017. (a) 11.2 times. (c) 14.0 times. (b) 65.3 times. (d) 13.0 times.

(LO 3)

3. Which of the following would be considered an “Other comprehensive income” item? (a) Gain on disposal of discontinued operations. (b) Unrealized loss on available-for-sale securities. (c) Loss related to fl ood. (d) Net income.

4. Which situation below might indicate a company has a low quality of earnings? (a) The same accounting principles are used each

year. (b) Revenue is recognized when the performance

obligation is satisfi ed. (c) Maintenance costs are capitalized and then

depreciated. (d) The company’s P-E ratio is high relative to

competitors. 5. In horizontal analysis, each item is expressed as a

percentage of the: (a) net income amount. (b) stockholders’ equity amount. (c) total assets amount. (d) base-year amount.

6. Adams Corporation reported net sales of $300,000, $330,000, and $360,000 in the years 2015, 2016, and 2017, respectively. If 2015 is the base year, what per- centage do 2017 sales represent of the base? (a) 77%. (c) 120%. (b) 108%. (d) 130%.

7. The following schedule is a display of what type of analysis?

Amount Percent

Current assets $200,000 25% Property, plant,

and equipment 600,000 75%

Total assets $800,000

(a) Horizontal analysis. (c) Vertical analysis. (b) Differential analysis. (d) Ratio analysis.

8. In vertical analysis, the base amount for depreciation expense is generally: (a) net sales. (b) depreciation expense in a previous year. (c) gross profi t. (d) fi xed assets.

9. Which measure is an evaluation of a company’s abil- ity to pay current liabilities? (a) Accounts receivable turnover. (b) Current ratio. (c) Both (a) and (b). (d) None of the above.

(LO 1)

(LO 2)

(LO 3)

4. (c) Capitalizing and then depreciating maintenance costs suggests that a company is trying to avoid expensing certain costs by deferring them to future accounting periods to increase current-period income. The other choices are incor- rect because (a) using the same accounting principles each year and (b) recognizing revenue when the performance obligation is satisfi ed is in accordance with GAAP. Choice (d) is incorrect because a high P-E ratio does not suggest that a fi rm has low quality of earnings.

5. (d) Horizontal analysis converts each succeeding year’s balance to a percentage of the base year amount, not (a) net income amount, (b) stockholders’ equity amount, or (c) total assets amount.

6. (c) The trend percentage for 2017 is 120% ($360,000/$300,000), not (a) 77%, (b) 108%, or (d) 130%.

7. (c) The data in the schedule is a display of vertical analysis because the individual asset items are expressed as a per- centage of total assets. The other choices are therefore incorrect. Horizontal analysis is a technique for evaluating a series of data over a period of time.

8. (a) In vertical analysis, net sales is used as the base amount for income statement items, not (b) depreciation expense in a previous year, (c) gross profi t, or (d) fi xed assets.

9. (c) Both the accounts receivable turnover and the current ratio measure a fi rm’s ability to pay current liabilities. Choices (a) and (b) are correct but (c) is the better answer. Choice (d) is incorrect because there is a correct answer.

10. (c) Both inventory turnover and days in inventory measure a fi rm’s effi ciency in managing inventories. Choices (a) and (b) are correct but (c) is the better answer. Choice (d) is incorrect because there is a correct answer.

11. (b) Asset turnover is a measure of profi tability. The other choices are incorrect because the (a) current ratio, (c) inven- tory turnover, and (d) accounts receivable turnover are all measures of a fi rm’s liquidity.

12. (a) Profi t margin = Net income ($24,000) ÷ Net sales ($400,000) = 6%, not (b) 12%, (c) 40%, or (d) 200%. 13. (b) Inventory turnover = Cost of goods sold/Average inventory {$306,000/[($54,000 + $48,000)/2]} = 6 times. Thus,

days in inventory = 60.8 (365/6), not (a) 64.4, (c) 6, or (d) 24 days. 14. (b) Current ratio = Current assets/Current liabilities ($81,000/$27,000) = 3.0:1, not (a) 1.26:1, (c) 0.80:1, or (d) 3.75:1. 15. (a) Profi t margin = Net income/Net sales ($134,000/$784,000) =17.1%, not (b) 18.1%, (c) 37.9%, or (d) 5.9%. 16. (d) Return on common stockholders’ equity = Net income ($134,000) − Dividends to preferred stockholders ($4,000)/

Average common stockholders’ equity [($240,000 + $198,000)/2] = 59.4%, not (a) 54.2%, (b) 52.5%, or (c) 61.2%. 17. (c) Times interest earned = Net income + Interest expense + Income tax expense divided by Interest expense

[($134,000 + $12,000 + $22,000)/$12,000] = 14.0 times, not (a) 11.2, (b) 65.3, or (d) 13.0 times.

680 13 Financial Analysis: The Big Picture

1. The comparative condensed balance sheets of Roadway Corporation are presented below.

ROADWAY CORPORATION Condensed Balance Sheets

December 31

2017 2016

Assets

Current assets $ 76,000 $ 80,000 Property, plant, and equipment (net) 99,000 90,000 Intangibles 25,000 40,000

Total assets $200,000 $210,000

Liabilities and Stockholders’ Equity

Current liabilities $ 40,800 $ 48,000 Long-term liabilities 143,000 150,000 Stockholders’ equity 16,200 12,000

Total liabilities and stockholders’ equity $200,000 $210,000

INSTRUCTIONS

(a) Prepare a horizontal analysis of the balance sheet data for Roadway Corporation using 2016 as a base.

(b) Prepare a vertical analysis of the balance sheet data for Roadway Corporation in columnar form for 2017.

Prepare horizontal and vertical analysis.

(LO 2)

PRACTICE EXERCISES▼

SOLUTION

Practice Exercises 681

2. Rondo Corporation’s comparative balance sheets are presented below.

RONDO CORPORATION Balance Sheets December 31

2017 2016

Cash $ 5,300 $ 3,700 Accounts receivable 21,200 23,400 Inventory 9,000 7,000 Land 20,000 26,000 Buildings 70,000 70,000 Accumulated depreciation—buildings (15,000) (10,000)

Total $110,500 $120,100

Accounts payable $ 10,370 $ 31,100 Common stock 75,000 69,000 Retained earnings 25,130 20,000

Total $110,500 $120,100

Compute ratios.

(LO 3)

ROADWAY CORPORATION Condensed Balance Sheets

December 31

Amount Percent

Assets

Current assets $ 76,000 38.0% Property, plant, and equipment (net) 99,000 49.5% Intangibles 25,000 12.5%

Total assets $200,000 100.0%

Liabilities and Stockholders’ Equity

Current liabilities $ 40,800 20.4% Long-term liabilities 143,000 71.5% Stockholders’ equity 16,200 8.1%

Total liabilities and stockholders’ equity $200,000 100.0%

ROADWAY CORPORATION Condensed Balance Sheet

December 31, 2017

1. (a)

(b)

Percent Increase Change 2017 2016 (Decrease) from 2016

Assets

Current assets $ 76,000 $ 80,000 $ (4,000) (5.0%) Property, plant, and equipment (net) 99,000 90,000 9,000 10.0% Intangibles 25,000 40,000 (15,000) (37.5%)

Total assets $200,000 $210,000 $(10,000) (4.8%)

Liabilities and Stockholders’ Equity

Current liabilities $ 40,800 $ 48,000 $ (7,200) (15.0%) Long-term liabilities 143,000 150,000 (7,000) (4.7%) Stockholders’ equity 16,200 12,000 4,200 35.0%

Total liabilities and stockholders’ equity $200,000 $210,000 $(10,000) (4.8%)

Rondo’s 2017 income statement included net sales of $120,000, cost of goods sold of $70,000, and net income of $14,000.

INSTRUCTIONS

Compute the following ratios for 2017.

(a) Current ratio.

(b) Accounts receivable turnover.

(d) Profi t margin.

682 13 Financial Analysis: The Big Picture

SOLUTION

2. (a) ($5,300 + $21,200 + $9,000)/$10,370 = 3.42 (b) $120,000/[($21,200 + $23,400)/2] = 5.38 (c) $70,000/[($9,000 + $7,000)/2] = 8.8 (d) $14,000/$120,000 = 11.7% (e) $120,000/[($110,500 + $120,100)/2] = 1.04 (f) $14,000/[($110,500 + $120,100)/2] = 12.1% (g) $14,000/[($100,130 + $89,000)/2] = 14.8% (h) $10,370/$110,500 = 9.4%

The events and transactions of Dever Corporation for the year ending December 31, 2017, resulted in the following data.

Cost of goods sold $2,600,000 Net sales 4,400,000 Other expenses and losses 9,600 Other revenues and gains 5,600 Selling and administrative expenses 1,100,000 Income from operations of plastics division 70,000 Gain from disposal of plastics division 500,000 Unrealized loss on available-for-sale securities 60,000

Analysis reveals the following:

1. All items are before the applicable income tax rate of 30%.

2. The plastics division was sold on July 1.

3. All operating data for the plastics division have been segregated.

INSTRUCTIONS

Prepare a statement of comprehensive income for the year.

Prepare a statement of comprehensive income.

(LO 1)

PRACTICE PROBLEM▼

(e) Asset turnover.

(f) Return on assets.

(g) Return on common stockholders’ equity.

(h) Debt to assets ratio.

SOLUTION

Net sales $4,400,000 Cost of goods sold 2,600,000

Gross profi t 1,800,000 Selling and administrative expenses 1,100,000

Income from operations 700,000 Other revenues and gains 5,600 Other expenses and losses 9,600

Income before income taxes 696,000 Income tax expense ($696,000 × 30%) 208,800 Income from continuing operations 487,200

DEVER CORPORATION Statement of Comprehensive Income

For the Year Ended December 31, 2017

Questions 683

Discontinued operations Income from operation of plastics division, net of $21,000 income taxes ($70,000 × 30%) 49,000 Gain from disposal of plastics division, net of $150,000 income taxes ($500,000 × 30%) 350,000 399,000 Net income 886,200 Unrealized loss on available-for-sale securities, net of $18,000 income tax savings ($60,000 × 30%) 42,000 Comprehensive income $844,200

All of the Questions in this chapter employ deci- sion tools.

1. Explain sustainable income. What relationship does this concept have to the treatment of discontinued op- erations on the income statement?

2. Hogan Inc. reported 2016 earnings per share of $3.26 and had no discontinued operations. In 2017, earnings per share on income from continuing opera- tions was $2.99, and earnings per share on net income was $3.49. Do you consider this trend to be favorable? Why or why not?

3. Moosier Inc. has been in operation for 3 years and uses the FIFO method of pricing inventory. During the fourth year, Moosier changes to the average-cost method for all its inventory. How will Moosier report this change?

4. What amount did Apple report as “Other comprehen- sive earnings” in its consolidated statement of com- prehensive income ending September 27, 2014? By what percentage did Apple’s “Comprehensive income” differ from its “Net income”?

5. Identify and explain factors that affect quality of earnings.

6. Explain how the choice of one of the following accounting methods over the other raises or lowers a company’s net income during a period of continuing infl ation. (a) Use of FIFO instead of LIFO for inventory costing. (b) Use of a 6-year life for machinery instead of a

9-year life. (c) Use of straight-line depreciation instead of declining-

balance depreciation.

7. Two popular methods of fi nancial statement analysis are horizontal analysis and vertical analysis. Explain the difference between these two methods.

8. (a) If Erin Company had net income of $300,000 in 2016 and it experienced a 24.5% increase in net income for 2017, what is its net income for 2017?

(b) If 6 cents of every dollar of Erin’s revenue is net income in 2016, what is the dollar amount of 2016 revenue?

9. (a) Gina Jaimes believes that the analysis of fi nancial statements is directed at two characteristics of a company: liquidity and profi tability. Is Gina correct? Explain.

(b) Are short-term creditors, long-term creditors, and stockholders interested in primarily the same characteristics of a company? Explain.

10. (a) Distinguish among the following bases of compar- ison: intracompany, intercompany, and industry averages.

(b) Give the principal value of using each of the three bases of comparison.

11. Name the major ratios useful in assessing (a) liquidity and (b) solvency.

12. Vern Thoms is puzzled. His company had a profi t mar- gin of 10% in 2017. He feels that this is an indication that the company is doing well. Tina Amos, his accountant, says that more information is needed to determine the company’s fi nancial well-being. Who is correct? Why?

13. What does each type of ratio measure? (a) Liquidity ratios. (b) Solvency ratios. (c) Profi tability ratios.

14. What is the difference between the current ratio and working capital?

15. Handi Mart, a retail store, has an accounts re- ceivable turnover of 4.5 times. The industry average is 12.5 times. Does Handi Mart have a collection prob- lem with its receivables?

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS▼

684 13 Financial Analysis: The Big Picture

16. Which ratios should be used to help answer each of these questions? (a) How effi cient is a company in using its assets to

produce sales? (b) How near to sale is the inventory on hand? (c) How many dollars of net income were earned for

each dollar invested by the owners? (d) How able is a company to meet interest charges as

they fall due?

17. At year-end, the price-earnings ratio of General Motors was 11.3, and the price-earnings ratio of Microsoft was 28.14. Which company did the stock market favor? Explain.

18. What is the formula for computing the payout ratio? Do you expect this ratio to be high or low for a growth company?

19. Holding all other factors constant, indicate whether each of the following changes generally sig- nals good or bad news about a company. (a) Increase in profi t margin. (b) Decrease in inventory turnover.

(c) Increase in current ratio. (d) Decrease in earnings per share. (e) Increase in price-earnings ratio. (f) Increase in debt to assets ratio. (g) Decrease in times interest earned.

20. The return on assets for Ayala Corporation is 7.6%. During the same year, Ayala’s return on common stockholders’ equity is 12.8%. What is the explanation for the difference in the two rates?

21. Which two ratios do you think should be of greatest interest in each of the following cases? (a) A pension fund considering the purchase of 20-year

bonds. (b) A bank contemplating a short-term loan. (c) A common stockholder.

22. Keanu Inc. has net income of $200,000, average shares of common stock outstanding of 40,000, and preferred dividends for the period of $20,000. What is Keanu’s earnings per share of common stock? Fred Tyme, the president of Keanu, believes that the computed EPS of the company is high. Comment.

All of the Brief Exercises in this chapter employ decision tools.

BE13-1 On June 30, Flores Corporation discontinued its operations in Mexico. On Sep- tember 1, Flores disposed of the Mexico facility at a pretax loss of $640,000. The appli- cable tax rate is 25%. Show the discontinued operations section of Flores’s statement of comprehensive income.

BE13-2 An inexperienced accountant for Silva Corporation showed the following in the income statement: income before income taxes $450,000 and unrealized gain on available- for-sale securities (before taxes) $70,000. The unrealized gain on available-for-sale securi- ties and income before income taxes are both subject to a 25% tax rate. Prepare a correct statement of comprehensive income.

BE13-3 On January 1, 2017, Bryce Inc. changed from the LIFO method of inventory pric- ing to the FIFO method. Explain how this change in accounting principle should be treated in the company’s fi nancial statements.

BE13-4 Using these data from the comparative balance sheet of Rollaird Company, per- form horizontal analysis.

December 31, 2017 December 31, 2016

Accounts receivable $ 460,000 $ 400,000 Inventory 780,000 650,000 Total assets 3,164,000 2,800,000

BE13-5 Using the data presented in BE13-4 for Rollaird Company, perform vertical analysis.

BE13-6 Net income was $500,000 in 2015, $485,000 in 2016, and $518,400 in 2017. What is the percentage of change from (a) 2015 to 2016, and (b) from 2016 to 2017? Is the change an increase or a decrease?

BE13-7 If Coho Company had net income of $382,800 in 2017 and it experienced a 16% increase in net income over 2016, what was its 2016 net income?

BE13-8 Vertical analysis (common-size) percentages for Palau Company’s sales revenue, cost of goods sold, and expenses are listed here.

Prepare a discontinued operations section of an income statement.

(LO 1), AP

Prepare statement of comprehensive income including unusual items.

(LO 1), AP

Indicate how a change in accounting principle is reported.

(LO 1), C

Prepare horizontal analysis.

(LO 2), AP

Prepare vertical analysis.

(LO 2), AP Calculate percentage of change.

(LO 2), AP

Calculate net income.

(LO 2), AP

Analyze change in net income.

(LO 2), AP

BRIEF EXERCISES▼

Brief Exercises 685

Vertical Analysis 2017 2016 2015

Sales revenue 100.0% 100.0% 100.0% Cost of goods sold 60.5 62.9 64.8 Expenses 26.0 26.6 27.5

Did Palau’s net income as a percent of sales increase, decrease, or remain unchanged over the 3-year period? Provide numerical support for your answer.

BE13-9 Horizontal analysis (trend analysis) percentages for Phoenix Company’s sales revenue, cost of goods sold, and expenses are listed here.

Horizontal Analysis 2017 2016 2015

Sales revenue 96.2% 104.8% 100.0% Cost of goods sold 101.0 98.0 100.0 Expenses 105.6 95.4 100.0

Explain whether Phoenix’s net income increased, decreased, or remained unchanged over the 3-year period.

BE13-10 Suppose these selected condensed data are taken from recent balance sheets of Bob Evans Farms (in thousands).

2017 2016

Cash $ 13,606 $ 7,669 Accounts receivable 23,045 19,951 Inventory 31,087 31,345 Other current assets 12,522 11,909

Total current assets $ 80,260 $ 70,874

Total current liabilities $245,805 $326,203

Compute the current ratio for each year and comment on your results.

BE13-11 The following data are taken from the fi nancial statements of Colby Company.

2017 2016

Accounts receivable (net), end of year $ 550,000 $ 540,000 Net sales on account 4,300,000 4,000,000 Terms for all sales are 1/10, n/45

Compute for each year (a) the accounts receivable turnover and (b) the average collection period. What conclusions about the management of accounts receivable can be drawn from these data? At the end of 2015, accounts receivable was $520,000.

BE13-12 The following data were taken from the income statements of Mydorf Company.

2017 2016

Sales revenue $6,420,000 $6,240,000 Beginning inventory 960,000 840,000 Purchases 4,840,000 4,661,000 Ending inventory 1,020,000 960,000

Compute for each year (a) the inventory turnover and (b) days in inventory. What conclusions concerning the management of the inventory can be drawn from these data?

BE13-13 Staples, Inc. is one of the largest suppliers of offi ce products in the United States. Suppose it had net income of $738.7 million and sales of $24,275.5 million in 2017. Its total assets were $13,073.1 million at the beginning of the year and $13,717.3 million at the end of the year. What is Staples, Inc.’s (a) asset turnover and (b) profi t margin? (Round to two decimals.) Provide a brief interpretation of your results.

Analyze change in net income.

(LO 2), AP

Calculate current ratio.

(LO 3), AP

Evaluate collection of accounts receivable.

(LO 3), AN

Evaluate management of inventory.

(LO 3), AN

Calculate profi tability ratios.

(LO 3), AN

686 13 Financial Analysis: The Big Picture

BE13-14 Hollie Company has stockholders’ equity of $400,000 and net income of $72,000. It has a payout ratio of 18% and a return on assets of 20%. How much did Hollie pay in cash dividends, and what were its average total assets?

BE13-15 Selected data taken from a recent year’s fi nancial statements of trading card company Topps Company, Inc. are as follows (in millions).

Net sales $326.7 Current liabilities, beginning of year 41.1 Current liabilities, end of year 62.4 Net cash provided by operating activities 10.4 Total liabilities, beginning of year 65.2 Total liabilities, end of year 73.2 Capital expenditures 3.7 Cash dividends 6.2

Compute the free cash fl ow. Provide a brief interpretation of your results.

Calculate profi tability ratios.

(LO 3), AN

Calculate and analyze free cash fl ow.

(LO 3), AN

In its proposed 2017 income statement, Hrabik Corporation reports income before income taxes $500,000, income taxes $100,000 (not including unusual items), loss on operation of discontinued music division $60,000, gain on disposal of discontinued music division $40,000, and unrealized loss on available-for-sale securities $150,000. The income tax rate is 20%. Prepare a correct statement of comprehensive income, beginning with income before income taxes.

Summary fi nancial information for Gandaulf Company is as follows.

Dec. 31, 2017 Dec. 31, 2016

Current assets $ 200,000 $ 220,000 Plant assets 1,040,000 780,000

Total assets $1,240,000 $1,000,000

Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.

The condensed fi nancial statements of Murawski Company for the years 2016 and 2017 are presented as follows. (Amounts in thousands.)

DO IT! 13-1Prepare statement of comprehensive income including unusual items.

(LO 1), AP

DO IT! 13-2Prepare horizontal analysis.

(LO 2), AP

DO IT! 13-3Compute ratios.

(LO 3), AP

EXERCISES▼DO IT!

MURAWSKI COMPANY Balance Sheets December 31

2017 2016

Current assets Cash and cash equivalents $ 330 $ 360 Accounts receivable (net) 470 400 Inventory 460 390 Prepaid expenses 120 160

Total current assets 1,380 1,310 Investments 10 10 Property, plant, and equipment 420 380 Intangibles and other assets 530 510

Total assets $2,340 $2,210

Current liabilities $ 900 $ 790 Long-term liabilities 410 380 Stockholders’ equity—common 1,030 1,040

Total liabilities and stockholders’ equity $2,340 $2,210

Exercises 687

Compute the following ratios for 2017 and 2016.

(a) Current ratio. (b) Inventory turnover. (Inventory on 12/31/15 was $340.) (c) Profi t margin. (d) Return on assets. (Assets on 12/31/15 were $1,900.) (e) Return on common stockholders’ equity. (Stockholders’ equity on 12/31/15 was $900.) (f) Debt to assets ratio. (g) Times interest earned.

MURAWSKI COMPANY Income Statements

For the Years Ended December 31

2017 2016

Sales revenue $3,800 $3,460 Costs and expenses Cost of goods sold 955 890 Selling & administrative expenses 2,400 2,330 Interest expense 25 20

Total costs and expenses 3,380 3,240

Income before income taxes 420 220 Income tax expense 126 66

Net income $ 294 $ 154

E13-1 For its fi scal year ending October 31, 2017, Haas Corporation reports the following partial data shown below.

Income before income taxes $540,000 Income tax expense (20% × $420,000) 84,000 Income from continuing operations 456,000 Loss on discontinued operations 120,000

Net income $336,000

The loss on discontinued operations was comprised of a $50,000 loss from operations and a $70,000 loss from disposal. The income tax rate is 20% on all items.

Instructions (a) Prepare a correct statement of comprehensive income beginning with income before

income taxes. (b) Explain in memo form why the income statement data are misleading.

E13-2 Trayer Corporation has income from continuing operations of $290,000 for the year ended December 31, 2017. It also has the following items (before considering income taxes).

1. An unrealized loss of $80,000 on available-for-sale securities. 2. A gain of $30,000 on the discontinuance of a division (comprised of a $10,000 loss

from operations and a $40,000 gain on disposal). 3. A correction of an error in last year’s financial statements that resulted in a $20,000

understatement of 2016 net income.

Assume all items are subject to income taxes at a 20% tax rate.

Instructions Prepare a statement of comprehensive income, beginning with income from continuing operations.

Prepare a correct statement of comprehensive income.

(LO 1), AP

Prepare statement of comprehensive income.

(LO 1), AP

EXERCISES▼

688 13 Financial Analysis: The Big Picture

E13-3 Here is fi nancial information for Glitter Inc.

December 31, 2017 December 31, 2016

Current assets $106,000 $ 90,000 Plant assets (net) 400,000 350,000 Current liabilities 99,000 65,000 Long-term liabilities 122,000 90,000 Common stock, $1 par 130,000 115,000 Retained earnings 155,000 170,000

Instructions Prepare a schedule showing a horizontal analysis for 2017, using 2016 as the base year.

E13-4 Operating data for Joshua Corporation are presented below.

2017 2016

Sales revenue $800,000 $600,000 Cost of goods sold 520,000 408,000 Selling expenses 120,000 72,000 Administrative expenses 60,000 48,000 Income tax expense 30,000 24,000 Net income 70,000 48,000

Instructions Prepare a schedule showing a vertical analysis for 2017 and 2016.

E13-5 Suppose the comparative balance sheets of Nike, Inc. are presented here.

NIKE, INC. Comparative Balance Sheets

May 31 ($ in millions)

Assets 2017 2016

Current assets $ 9,734 $ 8,839 Property, plant, and equipment (net) 1,958 1,891 Other assets 1,558 1,713

Total assets $13,250 $12,443

Liabilities and Stockholders’ Equity

Current liabilities $ 3,277 $ 3,322 Long-term liabilities 1,280 1,296 Stockholders’ equity 8,693 7,825

Total liabilities and stockholders’ equity $13,250 $12,443

Instructions (a) Prepare a horizontal analysis of the balance sheet data for Nike, using 2016 as a base.

(Show the amount of increase or decrease as well.) (b) Prepare a vertical analysis of the balance sheet data for Nike for 2017.

E13-6 Here are the comparative income statements of Delaney Corporation.

DELANEY CORPORATION Comparative Income Statements

For the Years Ended December 31

2017 2016

Net sales $598,000 $500,000 Cost of goods sold 477,000 420,000

Gross profit 121,000 80,000 Operating expenses 80,000 44,000

Net income $ 41,000 $ 36,000

Prepare horizontal analysis.

(LO 2), AP

Prepare vertical analysis.

(LO 2), AP

Prepare horizontal and vertical analyses.

(LO 2), AP

Prepare horizontal and vertical analyses.

(LO 2), AP

Exercises 689

Instructions (a) Prepare a horizontal analysis of the income statement data for Delaney Corporation,

using 2016 as a base. (Show the amounts of increase or decrease.) (b) Prepare a vertical analysis of the income statement data for Delaney Corporation for

both years.

E13-7 Nordstrom, Inc. operates department stores in numerous states. Suppose selected fi nancial statement data (in millions) for 2017 are presented below.

End of Year Beginning of Year

Cash and cash equivalents $ 795 $ 72 Accounts receivable (net) 2,035 1,942 Inventory 898 900 Other current assets 326 303

Total current assets $4,054 $3,217

Total current liabilities $2,014 $1,601

For the year, net credit sales were $8,258 million, cost of goods sold was $5,328 million, and net cash provided by operating activities was $1,251 million.

Instructions Compute the current ratio, accounts receivable turnover, average collection period, inven- tory turnover, and days in inventory at the end of the current year.

E13-8 Gwynn Incorporated had the following transactions involving current assets and current liabilities during February 2017.

Feb. 3 Collected accounts receivable of $15,000. 7 Purchased equipment for $23,000 cash. 11 Paid $3,000 for a 1-year insurance policy. 14 Paid accounts payable of $12,000. 18 Declared cash dividends, $4,000.

Additional information: As of February 1, 2017, current assets were $120,000 and current liabilities were $40,000.

Instructions Compute the current ratio as of the beginning of the month and after each transaction.

E13-9 Lendell Company has these comparative balance sheet data:

LENDELL COMPANY Balance Sheets December 31

2017 2016

Cash $ 15,000 $ 30,000 Accounts receivable (net) 70,000 60,000 Inventory 60,000 50,000 Plant assets (net) 200,000 180,000

$345,000 $320,000

Accounts payable $ 50,000 $ 60,000 Mortgage payable (15%) 100,000 100,000 Common stock, $10 par 140,000 120,000 Retained earnings 55,000 40,000

$345,000 $320,000

Additional information for 2017:

1. Net income was $25,000. 2. Sales on account were $375,000. Sales returns and allowances amounted to $25,000. 3. Cost of goods sold was $198,000. 4. Net cash provided by operating activities was $48,000. 5. Capital expenditures were $25,000, and cash dividends were $10,000.

Compute liquidity ratios.

(LO 3), AP

Perform current ratio analysis.

(LO 3), AP

Compute selected ratios.

(LO 3), AP

690 13 Financial Analysis: The Big Picture

Instructions Compute the following ratios at December 31, 2017.

(a) Current ratio. (b) Accounts receivable turnover. (c) Average collection period. (d) Inventory turnover. (e) Days in inventory. (f) Free cash fl ow.

E13-10 Suppose selected comparative statement data for the giant bookseller Barnes & Noble are presented here. All balance sheet data are as of the end of the fi scal year (in millions).

2017 2016

Net sales $5,121.8 $5,286.7 Cost of goods sold 3,540.6 3,679.8 Net income 75.9 135.8 Accounts receivable 81.0 107.1 Inventory 1,203.5 1,358.2 Total assets 2,993.9 3,249.8 Total common stockholders’ equity 921.6 1,074.7

Instructions Compute the following ratios for 2017.

(a) Profi t margin. (b) Asset turnover. (c) Return on assets. (d) Return on common stockholders’ equity. (e) Gross profi t rate.

E13-11 Here is the income statement for Myers, Inc.

MYERS, INC. Income Statement

For the Year Ended December 31, 2017

Sales revenue $400,000 Cost of goods sold 230,000

Gross profit 170,000 Expenses (including $16,000 interest and $24,000 income taxes) 98,000

Net income $ 72,000

Additional information:

1. Common stock outstanding January 1, 2017, was 32,000 shares, and 40,000 shares were outstanding at December 31, 2017.

2. The market price of Myers stock was $14 in 2017. 3. Cash dividends of $21,000 were paid, $5,000 of which were to preferred stockholders.

Instructions Compute the following measures for 2017.

(a) Earnings per share. (c) Payout ratio. (b) Price-earnings ratio. (d) Times interest earned.

E13-12 Panza Corporation experienced a fi re on December 31, 2017, in which its fi nancial records were partially destroyed. It has been able to salvage some of the records and has ascertained the following balances.

December 31, 2017 December 31, 2016

Cash $ 30,000 $ 10,000 Accounts receivable (net) 72,500 126,000 Inventory 200,000 180,000 Accounts payable 50,000 90,000 Notes payable 30,000 60,000 Common stock, $100 par 400,000 400,000 Retained earnings 113,500 101,000

Compute selected ratios.

(LO 3), AP

Compute selected ratios.

(LO 3), AP

Compute amounts from ratios.

(LO 3), AP

Exercises 691

Additional information:

1. The inventory turnover is 3.8 times. 2. The return on common stockholders’ equity is 22%. The company had no additional

paid-in capital. 3. The accounts receivable turnover is 11.2 times. 4. The return on assets is 18%. 5. Total assets at December 31, 2016, were $605,000.

Instructions Compute the following for Panza Corporation.

(a) Cost of goods sold for 2017. (b) Net credit sales for 2017. (c) Net income for 2017. (d) Total assets at December 31, 2017.

E13-13 The condensed fi nancial statements of Ness Company for the years 2016 and 2017 are presented below.

NESS COMPANY Balance Sheets

December 31 (in thousands)

2017 2016 Current assets Cash and cash equivalents $ 330 $ 360 Accounts receivable (net) 470 400 Inventory 460 390 Prepaid expenses 130 160

Total current assets 1,390 1,310 Property, plant, and equipment (net) 410 380 Investments 10 10 Intangibles and other assets 530 510

Total assets $2,340 $2,210

Current liabilities $ 820 $ 790 Long-term liabilities 480 380 Stockholders’ equity—common 1,040 1,040

Total liabilities and stockholders’ equity $2,340 $2,210

NESS COMPANY Income Statements

For the Year Ended December 31 (in thousands)

2017 2016

Sales revenue $3,800 $3,460 Costs and expenses Cost of goods sold 970 890 Selling & administrative expenses 2,400 2,330 Interest expense 10 20

Total costs and expenses 3,380 3,240

Income before income taxes 420 220 Income tax expense 168 88

Net income $ 252 $ 132

Compute the following ratios for 2017 and 2016.

(a) Current ratio. (b) Inventory turnover. (Inventory on December 31, 2015, was $340.) (c) Profi t margin. (d) Return on assets. (Assets on December 31, 2015, were $1,900.) (e) Return on common stockholders’ equity. (Equity on December 31, 2015, was $900.) (f) Debt to assets ratio. (g) Times interest earned.

Compute ratios.

(LO 3), AP

692 13 Financial Analysis: The Big Picture

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES

▼

All of the Problems in this chapter employ decision tools.

P13-1A Here are comparative statement data for Duke Company and Lord Company, two competitors. All balance sheet data are as of December 31, 2017, and December 31, 2016.

Duke Company Lord Company

2017 2016 2017 2016

Net sales $1,849,000 $546,000 Cost of goods sold 1,063,200 289,000 Operating expenses 240,000 82,000 Interest expense 6,800 3,600 Income tax expense 62,000 28,000

Current assets 325,975 $312,410 83,336 $ 79,467 Plant assets (net) 526,800 500,000 139,728 125,812 Current liabilities 66,325 75,815 35,348 30,281 Long-term liabilities 113,990 90,000 29,620 25,000

Common stock, $10 par 500,000 500,000 120,000 120,000 Retained earnings 172,460 146,595 38,096 29,998

Instructions (a) Prepare a vertical analysis of the 2017 income statement data for Duke Company and

Lord Company. (b) Comment on the relative profi tability of the companies by computing the 2017

return on assets and the return on common stockholders’ equity for both companies.

P13-2A The comparative statements of Wahlberg Company are presented here.

WAHLBERG COMPANY Income Statements

For the Years Ended December 31

2017 2016 Net sales $1,890,540 $1,750,500 Cost of goods sold 1,058,540 1,006,000 Gross profit 832,000 744,500 Selling and administrative expenses 500,000 479,000 Income from operations 332,000 265,500 Other expenses and losses Interest expense 22,000 20,000 Income before income taxes 310,000 245,500 Income tax expense 92,000 73,000 Net income $ 218,000 $ 172,500

WAHLBERG COMPANY Balance Sheets December 31

Assets 2017 2016 Current assets Cash $ 60,100 $ 64,200 Debt investments (short-term) 74,000 50,000 Accounts receivable 117,800 102,800 Inventory 126,000 115,500 Total current assets 377,900 332,500 Plant assets (net) 649,000 520,300 Total assets $1,026,900 $852,800

Prepare vertical analysis and comment on profi tability.

(LO 2, 3), AN

Compute ratios from balance sheets and income statements.

(LO 3), AP

PROBLEMS: SET A▼

Problems: Set A 693

Liabilities and Stockholders’ Equity 2017 2016

Current liabilities Accounts payable $ 160,000 $145,400 Income taxes payable 43,500 42,000

Total current liabilities 203,500 187,400 Bonds payable 220,000 200,000

Total liabilities 423,500 387,400 Stockholders’ equity Common stock ($5 par) 290,000 300,000 Retained earnings 313,400 165,400

Total stockholders’ equity 603,400 465,400

Total liabilities and stockholders’ equity $1,026,900 $852,800

All sales were on account. Net cash provided by operating activities for 2017 was $220,000. Capital expenditures were $136,000, and cash dividends were $70,000.

Instructions Compute the following ratios for 2017.

(a) Earnings per share. (g) Inventory turnover. (b) Return on common stockholders’ equity. (h) Days in inventory. (c) Return on assets. (i) Times interest earned. (d) Current ratio. (j) Asset turnover. (e) Accounts receivable turnover. (k) Debt to assets ratio. (f) Average collection period. (l) Free cash fl ow.

P13-3A Condensed balance sheet and income statement data for Jergan Corporation are presented here.

JERGAN CORPORATION Balance Sheets December 31

2017 2016 2015 Cash $ 30,000 $ 20,000 $ 18,000 Accounts receivable (net) 50,000 45,000 48,000 Other current assets 90,000 95,000 64,000 Investments 55,000 70,000 45,000 Plant and equipment (net) 500,000 370,000 358,000

$725,000 $600,000 $533,000

Current liabilities $ 85,000 $ 80,000 $ 70,000 Long-term debt 145,000 85,000 50,000 Common stock, $10 par 320,000 310,000 300,000 Retained earnings 175,000 125,000 113,000

$725,000 $600,000 $533,000

JERGAN CORPORATION Income Statements

For the Years Ended December 31

2017 2016 Sales revenue $740,000 $600,000 Less: Sales returns and allowances 40,000 30,000

Net sales 700,000 570,000 Cost of goods sold 425,000 350,000

Gross profit 275,000 220,000 Operating expenses (including income taxes) 180,000 150,000

Net income $ 95,000 $ 70,000

Additional information:

1. The market price of Jergan’s common stock was $7.00, $7.50, and $8.50 for 2015, 2016, and 2017, respectively.

2. You must compute dividends paid. All dividends were paid in cash.

Perform ratio analysis, and discuss changes in fi nancial position and operating results.

(LO 3), AN

694 13 Financial Analysis: The Big Picture

Instructions (a) Compute the following ratios for 2016 and 2017. (1) Profi t margin. (5) Price-earnings ratio. (2) Gross profi t rate. (6) Payout ratio. (3) Asset turnover. (7) Debt to assets ratio. (4) Earnings per share. (b) Based on the ratios calculated, discuss briefl y the improvement or lack

thereof in the fi nancial position and operating results from 2016 to 2017 of Jergan Corporation.

P13-4A The following fi nancial information is for Priscoll Company.

PRISCOLL COMPANY Balance Sheets December 31

Assets 2017 2016

Cash $ 70,000 $ 65,000 Debt investments (short-term) 55,000 40,000 Accounts receivable 104,000 90,000 Inventory 230,000 165,000 Prepaid expenses 25,000 23,000 Land 130,000 130,000 Building and equipment (net) 260,000 185,000

Total assets $874,000 $698,000

Liabilities and Stockholders’ Equity

Notes payable $170,000 $120,000 Accounts payable 65,000 52,000 Accrued liabilities 40,000 40,000 Bonds payable, due 2020 250,000 170,000 Common stock, $10 par 200,000 200,000 Retained earnings 149,000 116,000

Total liabilities and stockholders’ equity $874,000 $698,000

PRISCOLL COMPANY Income Statements

For the Years Ended December 31

2017 2016

Sales revenue $882,000 $790,000 Cost of goods sold 640,000 575,000

Gross profit 242,000 215,000 Operating expenses 190,000 167,000

Net income $ 52,000 $ 48,000

Additional information:

1. Inventory at the beginning of 2016 was $115,000. 2. Accounts receivable (net) at the beginning of 2016 were $86,000. 3. Total assets at the beginning of 2016 were $660,000. 4. No common stock transactions occurred during 2016 or 2017. 5. All sales were on account.

Instructions (a) Indicate, by using ratios, the change in liquidity and profi tability of Priscoll Company

from 2016 to 2017. (Note: Not all profi tability ratios can be computed nor can cash- basis ratios be computed.)

(b) The following are three independent situations and a ratio that may be affected. For each situation, compute the affected ratio (1) as of December 31, 2017, and (2) as of December 31, 2018, after giving effect to the situation. Net income for 2018 was $54,000. Total assets on December 31, 2018, were $900,000.

Compute ratios; comment on overall liquidity and profi tability.

(LO 3), AN

Problems: Set B and Set C 695

Situation Ratio

1. 18,000 shares of common stock were Return on common stockholders’ sold at par on July 1, 2018. equity

2. All of the notes payable were paid in 2018. Debt to assets ratio 3. The market price of common stock was Price-earnings ratio

$9 and $12 on December 31, 2017 and 2018, respectively.

P13-5A Suppose selected fi nancial data of Target and Wal-Mart for 2017 are presented here (in millions).

Target Wal-Mart Corporation Stores, Inc.

Income Statement Data for Year

Net sales $65,357 $408,214 Cost of goods sold 45,583 304,657 Selling and administrative expenses 15,101 79,607 Interest expense 707 2,065 Other income (expense) (94) (411) Income tax expense 1,384 7,139

Net income $ 2,488 $ 14,335

Balance Sheet Data (End of Year)

Current assets $18,424 $ 48,331 Noncurrent assets 26,109 122,375

Total assets $44,533 $170,706

Current liabilities $11,327 $ 55,561 Long-term debt 17,859 44,089 Total stockholders’ equity 15,347 71,056

Total liabilities and stockholders’ equity $44,533 $170,706

Beginning-of-Year Balances

Total assets $44,106 $163,429 Total stockholders’ equity 13,712 65,682 Current liabilities 10,512 55,390 Total liabilities 30,394 97,747

Other Data

Average net accounts receivable $ 7,525 $ 4,025 Average inventory 6,942 33,836 Net cash provided by operating activities 5,881 26,249 Capital expenditures 1,729 12,184 Dividends 496 4,217

Instructions (a) For each company, compute the following ratios.

(1) Current ratio. (7) Asset turnover. (2) Accounts receivable turnover. (8) Return on assets. (3) Average collection period. (9) Return on common stockholders’ equity. (4) Inventory turnover. (10) Debt to assets ratio. (5) Days in inventory. (11) Times interest earned. (6) Profi t margin. (12) Free cash fl ow.

(b) Compare the liquidity, solvency, and profi tability of the two companies.

Compute selected ratios, and compare liquidity, profi tability, and solvency for two companies.

(LO 3), AN

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

PROBLEMS: SET B AND SET C▼

696 13 Financial Analysis: The Big Picture

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 through 12.)

CC13 Natalie and Curtis have comparative balance sheets and income statements for Cookie & Coffee Creations Inc. They have been told that they can use these fi nancial state- ments to prepare horizontal and vertical analyses, to calculate fi nancial ratios, to analyze how their business is doing, and to make some decisions they have been considering.

Go to the book’s companion website, at www.wiley.com/college/kimmel, to fi nd the completion of this problem.

CONTINUING PROBLEM Cookie Creations▼

EXPAND YOUR CRITICAL THINKING FINANCIAL REPORTING PROBLEM: Apple Inc.

CT13-1 Your parents are considering investing in Apple Inc. common stock. They ask you, as an accounting expert, to make an analysis of the company for them. Financial statements of Apple are presented in Appendix A. Instructions for accessing and using the company’s complete annual report, including the notes to its fi nancial statements, are also provided in Appendix A.

Instructions (a) Make a 5-year trend analysis, using 2010 as the base year, of (1) net sales and (2) net

income. Comment on the signifi cance of the trend results. (b) Compute for 2014 and 2013 the (1) debt to assets ratio and (2) times interest earned.

(See Note 3 for interest expense.) How would you evaluate Apple’s long-term solvency? (c) Compute for 2014 and 2013 the (1) profi t margin, (2) asset turnover, (3) return on

assets, and (4) return on common stockholders’ equity. How would you evaluate Apple’s profi tability? Total assets at September 29, 2012, were $176,064 million and total stockholders’ equity at September 29, 2012, was $118,210 million.

(d) What information outside the annual report may also be useful to your parents in making a decision about Apple?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT13-2 The fi nancial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of VF Corporation are presented in Appendix C.

Instructions (a) Based on the information in the fi nancial statements, determine each of the following

for each company: (1) The percentage increase (i) in net sales and (ii) in net income from 2013 to 2014. (2) The percentage increase (i) in total assets and (ii) in total stockholders’ equity

from 2013 to 2014. (3) The basic earnings per share for 2014. (b) What conclusions concerning the two companies can be drawn from these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT13-3 The fi nancial statements of Amazon.com, Inc. are presented in Appendix D. Finan- cial statements of Wal-Mart Stores, Inc. are presented in Appendix E.

Instructions (a) Based on the information in the fi nancial statements, determine each of the following

for each company: (1) The percentage increase (i) in net sales and (ii) in net income from 2013 to 2014. (2) The percentage increase (i) in total assets and (ii) in total stockholders’ equity

from 2013 to 2014. (3) The basic earnings per share for 2014. (b) What conclusions concerning the two companies can be drawn from these data?

Financial Reporting

▼

Financial Analysis

▼

Financial Analysis

▼

Expand Your Critical Thinking 697

INTERPRETING FINANCIAL STATEMENTS

CT13-4 The Coca-Cola Company and PepsiCo, Inc. provide refreshments to every corner of the world. Suppose selected data from recent consolidated fi nancial statements for The Coca-Cola Company and for PepsiCo, Inc. are presented here (in millions).

Coca-Cola PepsiCo

Total current assets $17,551 $12,571 Total current liabilities 13,721 8,756 Net sales 30,990 43,232 Cost of goods sold 11,088 20,099 Net income 6,824 5,946 Average (net) accounts receivable for the year 3,424 4,654 Average inventories for the year 2,271 2,570 Average total assets 44,595 37,921 Average common stockholders’ equity 22,636 14,556 Average current liabilities 13,355 8,772 Average total liabilities 21,960 23,466 Total assets 48,671 39,848 Total liabilities 23,872 23,044 Income taxes 2,040 2,100 Interest expense 355 397 Net cash provided by operating activities 8,186 6,796 Capital expenditures 1,993 2,128 Cash dividends 3,800 2,732

Instructions (a) Compute the following liquidity ratios for Coca-Cola and for PepsiCo and comment on

the relative liquidity of the two competitors. (1) Current ratio. (4) Inventory turnover. (2) Accounts receivable turnover. (5) Days in inventory. (3) Average collection period. (b) Compute the following solvency ratios for the two companies and comment on the

relative solvency of the two competitors. (1) Debt to assets ratio. (2) Times interest earned. (3) Free cash fl ow. (c) Compute the following profi tability ratios for the two companies and comment on the

relative profi tability of the two competitors. (1) Profi t margin. (2) Asset turnover. (3) Return on assets. (4) Return on common stockholders’ equity.

REAL-WORLD FOCUS

CT13-5 Purpose: To employ comparative data and industry data to evaluate a company’s performance and fi nancial position.

Address: http://www.msn.com/en-us/money, or go to www.wiley.com/college/kimmel

Steps (1) Identify two competing companies. (2) Go to the above address. (3) Type in the fi rst company’s stock symbol or name. (Use “symbol look-up.”) (4) Under the “Fundamentals” heading, use the Growth, Profi tability, Financial health,

Price ratios, and Management effectiveness tabs to answer parts (a), (b), and (c) below.

Instructions (a) Evaluate the company’s liquidity relative to the industry averages and to the competitor

that you chose. (b) Evaluate the company’s solvency relative to the industry averages and to the competitor

that you chose. (c) Evaluate the company’s profi tability relative to the industry averages and to the com-

petitor that you chose.

Financial Analysis

▼

698 13 Financial Analysis: The Big Picture

CT13-6 The April 25, 2012, edition of the Wall Street Journal contains an article by Spencer Jakab entitled “Amazon’s Valuation Is Hard to Justify.”

Instructions Read the article and answer the following questions. (a) Explain what is meant by the statement that “On a split-adjusted basis, today’s share

price is the equivalent of $1,166.” (b) The article says that Amazon.com nearly doubled its capital spending on items such as

fulfi llment centers (sophisticated warehouses where it fi nds, packages, and ships goods to customers). Discuss the implications that this spending would have on the company’s return on assets in the short-term and in the long-term.

(c) How does Amazon’s P-E ratio compare to that of Apple, Netfl ix, and Wal-Mart? What does this suggest about investors’ expectations about Amazon’s future earnings?

(d) What factor does the article cite as a possible hurdle that might reduce Amazon’s ability to raise its operating margin back to previous levels?

DECISION-MAKING ACROSS THE ORGANIZATION

CT13-7 You are a loan offi cer for White Sands Bank of Taos. Paul Jason, president of P. Jason Corporation, has just left your offi ce. He is interested in an 8-year loan to expand the company’s operations. The borrowed funds would be used to purchase new equipment. As evidence of the company’s debt-worthiness, Jason provided you with the following facts.

2017 2016

Current ratio 3.1 2.1 Asset turnover 2.8 2.2 Net income Up 32% Down 8% Earnings per share $3.30 $2.50

Jason is a very insistent (some would say pushy) man. When you told him that you would need additional information before making your decision, he acted offended and said, “What more could you possibly want to know?” You responded that, at a minimum, you would need complete, audited fi nancial statements.

Instructions With the class divided into groups, answer the following.

(a) Explain why you would want the fi nancial statements to be audited. (b) Discuss the implications of the ratios provided for the lending decision you are to

make. That is, does the information paint a favorable picture? Are these ratios relevant to the decision?

COMMUNICATION ACTIVITY

CT13-8 Larry Dundee is the chief executive offi cer of Palmer Electronics. Dundee is an expert engineer but a novice in accounting. Dundee asks you, as an accounting student, to explain (a) the bases for comparison in analyzing Palmer’s fi nancial statements and (b) the limitations, if any, in fi nancial statement analysis.

Instructions Write a memo to Larry Dundee that explains the basis for comparison and the factors affecting quality of earnings.

ETHICS CASE

CT13-9 René Kelly, president of RL Industries, wishes to issue a press release to bolster her company’s image and maybe even its stock price, which has been gradually falling. As controller, you have been asked to provide a list of 20 fi nancial ratios and other operating statistics for RL Industries’ fi rst-quarter fi nancials and operations. Two days after you provide the data requested, Erin Lourdes, the public relations di- rector of RL, asks you to prove the accuracy of the fi nancial and operating data contained

Financial Analysis

Writing

Group Project

▼

A Look at IFRS 699

in the press release written by the president and edited by Erin. In the news release, the president highlights the sales increase of 25% over last year’s fi rst quarter and the positive change in the current ratio from 1.5:1 last year to 3:1 this year. She also emphasizes that production was up 50% over the prior year’s fi rst quarter. You note that the release contains only positive or improved ratios and none of the negative or deteriorated ratios. For instance, no mention is made that the debt to assets ratio has increased from 35% to 55%, that inventories are up 89%, and that although the current ratio improved, the accounts receivable turnover fell from 12 to 9. Nor is there any mention that the reported profi t for the quarter would have been a loss had not the estimated lives of RL plant and machinery been increased by 30%. Erin emphasized, “The Pres wants this release by early this afternoon.”

Instructions (a) Who are the stakeholders in this situation? (b) Is there anything unethical in the president’s actions? (c) Should you as controller remain silent? Does Erin have any responsibility?

ALL ABOUT YOU

CT13-10 In this chapter, you learned how to use many tools for performing a fi nancial analysis of a company. When making personal investments, however, it is most likely that you won’t be buying stocks and bonds in individual companies. Instead, when most people want to invest in stock, they buy mutual funds. By investing in a mutual fund, you reduce your risk because the fund diversifi es by buying the stock of a variety of different compa- nies, bonds, and other investments, depending on the stated goals of the fund. Before you invest in a fund, you will need to decide what type of fund you want. For example, do you want a fund that has the potential of high growth (but also high risk), or are you looking for lower risk and a steady stream of income? Do you want a fund that invests only in U.S. companies, or do you want one that invests globally? Many resources are available to help you with these types of decisions.

Instructions Go to http://web.archive.org/web/20050210200843/http://www.cnb1.com/invallocmdl. htm and complete the investment allocation questionnaire. Add up your total points to determine the type of investment fund that would be appropriate for you.

FASB CODIFICATION ACTIVITY

CT13-11 If your school has a subscription to the FASB Codifi cation, go to http://aaahq.org/ ascLogin.cfm to log in and prepare responses to the following. Use the Master Glossary for determining the proper defi nitions. (a) Discontinued operations. (b) Comprehensive income.

The tools of financial statement analysis are the same throughout the world. Techniques such as vertical and horizontal analysis, for example, are tools used by analysts regardless of whether GAAP- or IFRS-related financial statements are being evaluated. In addition, the ratios provided in the textbook are the same ones that are used internationally.

The beginning of this chapter relates to the income statement. As in GAAP, the income statement is a required statement under IFRS. In addition, the content and presentation of an IFRS income statement is similar to the one used for GAAP. IAS 1 (revised), “Presentation

LEARNING OBJECTIVE 5 Compare fi nancial statement analysis and income statement presentation under GAAP and IFRS.▼

A Look at IFRS

700 13 Financial Analysis: The Big Picture

of Financial Statements,” provides general guidelines for the reporting of income state- ment information. In general, the differences in the presentation of financial statement information are relatively minor.

RELEVANT FACTS Following are the key similarities between GAAP and IFRS as related to financial state- ment analysis and income statement presentation. There are no significant differences between the two standards.

• The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used.

• The basic objectives of the income statement are the same under both GAAP and IFRS. As indicated in the textbook, a very important objective is to ensure that users of the income statement can evaluate the sustainable income of the company. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from unu- sual items in order to better predict a company’s future profitability.

• The basic accounting for discontinued operations is the same under IFRS and GAAP.

• The accounting for changes in accounting principles and changes in accounting esti- mates are the same for both GAAP and IFRS.

• Both GAAP and IFRS follow the same approach in reporting comprehensive income.

LOOKING TO THE FUTURE The FASB and the IASB are working on a project that would rework the structure of financial statements. Recently, the IASB decided to require a statement of comprehen- sive income, similar to what was required under GAAP. In addition, another part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number— net income.

IFRS Practice IFRS SELF-TEST QUESTIONS 1. The basic tools of financial analysis are the same under both GAAP and IFRS except

that: (a) horizontal analysis cannot be done because the format of the statements is some-

times different. (b) analysis is different because vertical analysis cannot be done under IFRS. (c) the current ratio cannot be computed because current liabilities are often reported

before current assets in IFRS statements of position. (d) None of the above.

2. Presentation of comprehensive income must be reported under IFRS in: (a) the statement of stockholders’ equity. (b) the income statement ending with net income. (c) the notes to the financial statements. (d) a statement of comprehensive income.

3. In preparing its income statement for 2017, Parmalane assembles the following information.

Sales revenue $500,000 Cost of goods sold 300,000 Operating expenses 40,000 Loss on discontinued operations 20,000

Ignoring income taxes, what is Parmalane’s income from continuing operations for 2017 under IFRS? (a) $260,000. (b) $250,000. (c) $240,000. (d) $160,000.

A Look at IFRS 701

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton IFRS13-1 The fi nancial statements of Louis Vuitton are presented in Appendix F. Instruc- tions for accessing and using the company’s complete annual report, including the notes to its fi nancial statements, are also provided in Appendix F.

Instructions Use the company’s 2014 annual report to answer the following questions.

(a) What was the company’s profit margin for 2014? Has it increased or decreased from 2013?

(b) What was the company’s operating profit for 2014? (c) The company reported comprehensive income of €3,267 billion in 2014. What are the

other comprehensive gains and losses recorded in 2014?

Answers to IFRS Self-Test Questions 1. d 2. d 3. d

Once each year, a corporation communicates to its stockholders and other interested parties by issuing a complete set of audited fi nancial statements. The annual report , as this communication is called, summarizes the fi nancial results of the company’s operations for the year and its plans for the future. Many annual reports are attractive, multicolored, glossy public relations pieces, containing pictures of corporate offi cers and directors as well as photos and descriptions of new products and new buildings. Yet the basic function of every annual report is to report fi nancial information, almost all of which is a product of the corpora- tion’s accounting system. The content and organization of corporate annual reports have become fairly standardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional fi nancial portions of the annual report:

• Financial Highlights

• Letter to the Stockholders

• Management’s Discussion and Analysis

• Financial Statements

• Notes to the Financial Statements

• Management’s Responsibility for Financial Reporting

• Management’s Report on Internal Control over Financial Reporting

• Report of Independent Registered Public Accounting Firm

• Selected Financial Data

The offi cial SEC fi ling of the annual report is called a Form 10-K, which often omits the public relations pieces found in most standard annual reports. On the following pages, we present Apple Inc.’s fi nancial statements taken from the company’s 2014 Form 10-K. To access Apple’s Form 10-K, including notes to the fi nancial statements, follow these steps:

1. Go to http://investor.apple.com.

2. Select the Financial Information tab.

3. Select the 10-K annual report dated September 29, 2014.

4. The Notes to Consolidated Financial Statements begin on page 50.

Specimen Financial Statements: Apple Inc.

A-1

A-2 A Specimen Financial Statements: Apple Inc.

CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts)

Years ended

September 27, 2014

September 28, 2013

September 29, 2012

Net sales $ 182,795 $ 170,910 $ 156,508

Cost of sales 112,258 106,606 87,846

Gross margin 70,537 64,304 68,662

Operating expenses:

Research and development 6,041 4,475 3,381

Selling, general and administrative 11,993 10,830 10,040

Total operating expenses 18,034 15,305 13,421

Operating income 52,503 48,999 55,241

Other income/(expense), net 980 1,156 522

Income before provision for income taxes 53,483 50,155 55,763

Provision for income taxes 13,973 13,118 14,030

Net income $ 39,510 $ 37,037 $ 41,733

Earnings per share:

Basic $ 6.49 $ 5.72 $ 6.38

Diluted $ 6.45 $ 5.68 $ 6.31

Shares used in computing earnings per share:

Basic 6,085,572 6,477,320 6,543,726

Diluted 6,122,663 6,521,634 6,617,483

Cash dividends declared per common share $ 1.82 $ 1.64 $ 0.38

See accompanying Notes to Consolidated Financial Statements.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions)

Years ended

September 27, 2014

September 28, 2013

September 29, 2012

Net income $ 39,510 $ 37,037 $ 41,733

Other comprehensive income/(loss):

Change in foreign currency translation, net of tax effects of $50, $35 and $13, respectively (137) (112) (15)

Change in unrecognized gains/losses on derivative instruments:

Change in fair value of derivatives, net of tax benefit/(expense) of $(297), $(351) and $73, respectively 1,390 522 (131)

Adjustment for net losses/(gains) realized and included in net income, net of tax expense/(benefit) of $(36), $255 and $220, respectively 149 (458) (399)

Total change in unrecognized gains/losses on derivative instruments, net of tax 1,539 64 (530)

Change in unrealized gains/losses on marketable securities:

Change in fair value of marketable securities, net of tax benefit/ (expense) of $(153), $458 and $(421), respectively 285 (791) 715

Adjustment for net losses/(gains) realized and included in net income, net of tax expense/(benefit) of $71, $82 and $68, respectively (134) (131) (114)

Total change in unrealized gains/losses on marketable securities, net of tax 151 (922) 601

Total other comprehensive income/(loss) 1,553 (970) 56

Total comprehensive income $ 41,063 $ 36,067 $ 41,789

See accompanying Notes to Consolidated Financial Statements.

Specimen Financial Statements: Apple Inc. A-3

CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value)

September 27, 2014

September 28, 2013

ASSETS:

Current assets:

Cash and cash equivalents $ 13,844 $ 14,259

Short-term marketable securities 11,233 26,287

Accounts receivable, less allowances of $86 and $99, respectively 17,460 13,102

Inventories 2,111 1,764

Deferred tax assets 4,318 3,453

Vendor non-trade receivables 9,759 7,539

Other current assets 9,806 6,882

Total current assets 68,531 73,286

Long-term marketable securities 130,162 106,215

Property, plant and equipment, net 20,624 16,597

Goodwill 4,616 1,577

Acquired intangible assets, net 4,142 4,179

Other assets 3,764 5,146

Total assets $ 231,839 $ 207,000

LIABILITIES AND SHAREHOLDERS’ EQUITY:

Current liabilities:

Accounts payable $ 30,196 $ 22,367

Accrued expenses 18,453 13,856

Deferred revenue 8,491 7,435

Commercial paper 6,308 0

Total current liabilities 63,448 43,658

Deferred revenue – non-current 3,031 2,625

Long-term debt 28,987 16,960

Other non-current liabilities 24,826 20,208

Total liabilities 120,292 83,451

Commitments and contingencies

Shareholders’ equity:

Common stock and additional paid-in capital, $0.00001 par value; 12,600,000 shares authorized; 5,866,161 and 6,294,494 shares issued and outstanding, respectively 23,313 19,764

Retained earnings 87,152 104,256

Accumulated other comprehensive income/(loss) 1,082 (471)

Total shareholders’ equity 111,547 123,549

Total liabilities and shareholders’ equity $ 231,839 $ 207,000

See accompanying Notes to Consolidated Financial Statements.

A-4 A Specimen Financial Statements: Apple Inc.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands)

Common Stock and Additional Paid-In Capital Retained

Earnings

Accumulated Other

Comprehensive Income/(Loss)

Total Shareholders’

EquityShares Amount

Balances as of September 24, 2011 6,504,937 $ 13,331 $ 62,841 $ 443 $ 76,615

Net income 0 0 41,733 0 41,733

Other comprehensive income/(loss) 0 0 0 56 56

Dividends and dividend equivalents declared 0 0 (2,523) 0 (2,523)

Share-based compensation 0 1,740 0 0 1,740

Common stock issued, net of shares withheld for employee taxes 69,521 200 (762) 0 (562)

Tax benefit from equity awards, including transfer pricing adjustments 0 1,151 0 0 1,151

Balances as of September 29, 2012 6,574,458 16,422 101,289 499 118,210

Net income 0 0 37,037 0 37,037

Other comprehensive income/(loss) 0 0 0 (970) (970)

Dividends and dividend equivalents declared 0 0 (10,676) 0 (10,676)

Repurchase of common stock (328,837) 0 (22,950) 0 (22,950)

Share-based compensation 0 2,253 0 0 2,253

Common stock issued, net of shares withheld for employee taxes 48,873 (143) (444) 0 (587)

Tax benefit from equity awards, including transfer pricing adjustments 0 1,232 0 0 1,232

Balances as of September 28, 2013 6,294,494 19,764 104,256 (471) 123,549

Net income 0 0 39,510 0 39,510

Other comprehensive income/(loss) 0 0 0 1,553 1,553

Dividends and dividend equivalents declared 0 0 (11,215) 0 (11,215)

Repurchase of common stock (488,677) 0 (45,000) 0 (45,000)

Share-based compensation 0 2,863 0 0 2,863

Common stock issued, net of shares withheld for employee taxes 60,344 (49) (399) 0 (448)

Tax benefit from equity awards, including transfer pricing adjustments 0 735 0 0 735

Balances as of September 27, 2014 5,866,161 $ 23,313 $ 87,152 $ 1,082 $111,547

See accompanying Notes to Consolidated Financial Statements.

Specimen Financial Statements: Apple Inc. A-5

CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions)

Years ended

September 27, 2014

September 28, 2013

September 29, 2012

Cash and cash equivalents, beginning of the year $ 14,259 $ 10,746 $ 9,815

Operating activities:

Net income 39,510 37,037 41,733

Adjustments to reconcile net income to cash generated by operating activities:

Depreciation and amortization 7,946 6,757 3,277

Share-based compensation expense 2,863 2,253 1,740

Deferred income tax expense 2,347 1,141 4,405

Changes in operating assets and liabilities:

Accounts receivable, net (4,232) (2,172) (5,551)

Inventories (76) (973) (15)

Vendor non-trade receivables (2,220) 223 (1,414)

Other current and non-current assets 167 1,080 (3,162)

Accounts payable 5,938 2,340 4,467

Deferred revenue 1,460 1,459 2,824

Other current and non-current liabilities 6,010 4,521 2,552

Cash generated by operating activities 59,713 53,666 50,856

Investing activities:

Purchases of marketable securities (217,128) (148,489) (151,232)

Proceeds from maturities of marketable securities 18,810 20,317 13,035

Proceeds from sales of marketable securities 189,301 104,130 99,770

Payments made in connection with business acquisitions, net (3,765) (496) (350)

Payments for acquisition of property, plant and equipment (9,571) (8,165) (8,295)

Payments for acquisition of intangible assets (242) (911) (1,107)

Other 16 (160) (48)

Cash used in investing activities (22,579) (33,774) (48,227)

Financing activities:

Proceeds from issuance of common stock 730 530 665

Excess tax benefits from equity awards 739 701 1,351

Taxes paid related to net share settlement of equity awards (1,158) (1,082) (1,226)

Dividends and dividend equivalents paid (11,126) (10,564) (2,488)

Repurchase of common stock (45,000) (22,860) 0

Proceeds from issuance of long-term debt, net 11,960 16,896 0

Proceeds from issuance of commercial paper, net 6,306 0 0

Cash used in financing activities (37,549) (16,379) (1,698)

Increase/(decrease) in cash and cash equivalents (415) 3,513 931

Cash and cash equivalents, end of the year $ 13,844 $ 14,259 $ 10,746

Supplemental cash flow disclosure:

Cash paid for income taxes, net $ 10,026 $ 9,128 $ 7,682

Cash paid for interest $ 339 $ 0 $ 0

See accompanying Notes to Consolidated Financial Statements.

Columbia Sportswear Company is a leader in outdoor sportswear. The following are Columbia’s fi nancial statements as presented in its 2014 annual report. To access Columbia’s complete annual report, including notes to the fi nancial statements, fol- low these steps:

1. Go to www.columbia.com.

2. Select Financial Information and then Annual Reports under the Investor Relations tab near the bottom of the page.

3. Select the 2014 Annual Report.

4. The Notes to Consolidated Financial Statements begin on page 50.

Specimen Financial Statements: Columbia Sportswear Company

COLUMBIA SPORTSWEAR COMPANY

CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)

Year Ended December 31, 2014 2013 2012

Net sales $ 2,100,590 $ 1,684,996 $ 1,669,563 Cost of sales 1,145,639 941,341 953,169 Gross profit 954,951 743,655 716,394 Selling, general and administrative expenses 763,063 625,656 596,635 Net licensing income 6,956 13,795 13,769 Income from operations 198,844 131,794 133,528 Interest income, net 1,004 503 379 Interest expense on note payable to related party (Note 22) (1,053) — — Other non-operating expense (274) (871) — Income before income tax 198,521 131,426 133,907 Income tax expense (Note 11) (56,662) (37,823 ) (34,048 ) Net income 141,859 93,603 99,859 Net income (loss) attributable to non-controlling interest 4,686 (738) — Net income attributable to Columbia Sportswear Company $ 137,173 $ 94,341 $ 99,859 Earnings per share attributable to Columbia Sportswear Company (Note 17):

Basic $ 1.97 $ 1.37 $ 1.48 Diluted 1.94 1.36 1.46

Weighted average shares outstanding (Note 17): Basic 69,807 68,756 67,680 Diluted 70,681 69,434 68,264

B-1

See accompanying notes to consolidated financial statements

B-2 B Specimen Financial Statements: Columbia Sportswear Company

COLUMBIA SPORTSWEAR COMPANY

CONSOLIDATED BALANCE SHEETS (In thousands)

December 31, 2014 2013

ASSETS Current Assets:

Cash and cash equivalents $ 413,558 $ 437,489 Short-term investments 27,267 91,755 Accounts receivable, net (Note 6) 344,390 306,878 Inventories 384,650 329,228 Deferred income taxes (Note 11) 57,001 52,041 Prepaid expenses and other current assets 39,175 33,081

Total current assets 1,266,041 1,250,472 Property, plant, and equipment, net (Note 7) 291,563 279,373 Intangible assets, net (Notes 3, 8) 143,731 36,288 Goodwill (Notes 3, 8) 68,594 14,438 Other non-current assets 22,280 25,017

Total assets $ 1,792,209 $ 1,605,588 LIABILITIES AND EQUITY

Current Liabilities: Accounts payable $ 214,275 $ 173,557 Accrued liabilities (Note 10) 144,288 120,397 Income taxes payable (Note 11) 14,388 7,251 Deferred income taxes (Note 11) 169 49

Total current liabilities 373,120 301,254 Note payable to related party (Note 22) 15,728 — Other long-term liabilities (Notes 12, 13) 35,435 29,527 Income taxes payable (Note 11) 9,388 13,984 Deferred income taxes (Note 11) 3,304 7,959

Total liabilities 436,975 352,724 Commitments and contingencies (Note 14) Shareholders’ Equity:

Preferred stock; 10,000 shares authorized; none issued and outstanding — — Common stock (no par value); 250,000 shares authorized; 69,828 and 69,190 issued and outstanding

(Note 15) 72,700 52,325 Retained earnings 1,255,070 1,157,733 Accumulated other comprehensive income (Note 18) 15,833 35,360

Total Columbia Sportswear Company shareholders’ equity 1,343,603 1,245,418 Non-controlling interest (Note 5) 11,631 7,446

Total equity 1,355,234 1,252,864 Total liabilities and equity $ 1,792,209 $ 1,605,588

Year Ended December 31, 2014 2013 2012 Net income $ 141,859 $ 93,603 $ 99,859 Other comprehensive loss:

Unrealized holding gains (losses) on available-for-sale securities (net of tax (expense) benefit of ($5), ($2), and $4, respectively) 10 3 (7)

Unrealized gains (losses) on derivative transactions (net of tax (expense) benefit of ($1,507), $9 and ($171), respectively) 7,751 (1,261 ) (4,745 )

Foreign currency translation adjustments (net of tax benefit (expense) of $1,023, ($191) and ($59), respectively) (27,789 ) (9,861 ) 4,518

Other comprehensive loss (20,028 ) (11,119 ) (234 ) Comprehensive income 121,831 82,484 99,625 Comprehensive income (loss) attributable to non-controlling interest 4,185 (554 ) — Comprehensive income attributable to Columbia Sportswear Company $ 117,646 $ 83,038 $ 99,625

See accompanying notes to consolidated financial statements

COLUMBIA SPORTSWEAR COMPANY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands)

Specimen Financial Statements: Columbia Sportswear Company B-3

COLUMBIA SPORTSWEAR COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)

Year Ended December 31,

2014 2013 2012

Cash flows from operating activities:

Net income $ 141,859 $ 93,603 $ 99,859 Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization 54,017 40,871 40,892 Loss on disposal or impairment of property, plant, and equipment 481 9,344 1,582 Deferred income taxes (6,978 ) 8,818 7,140 Stock-based compensation 11,120 8,878 7,833 Excess tax benefit from employee stock plans (4,927 ) (1,532 ) (1,016 ) Changes in operating assets and liabilities:

Accounts receivable (31,478 ) 27,442 18,166 Inventories (62,086 ) 34,089 2,951 Prepaid expenses and other current assets (4,869 ) 5,166 (2,025 ) Other assets 4,291 (4,215 ) (1,259 ) Accounts payable 41,941 31,711 (12,330 ) Accrued liabilities 35,051 12,210 (5,199 ) Income taxes payable 1,166 5,534 (11,052 ) Other liabilities 6,195 2,356 3,126

Net cash provided by operating activities 185,783 274,275 148,668 Cash flows from investing activities:

Acquisition of business, net of cash acquired (188,467 ) — — Purchases of short-term investments (48,243 ) (125,390 ) (83,969 ) Sales of short-term investments 112,895 78,636 42,319 Capital expenditures (60,283 ) (69,443 ) (50,491 ) Proceeds from sale of property, plant, and equipment 71 111 7,099

Net cash used in investing activities (184,027 ) (116,086 ) (85,042 ) Cash flows from financing activities:

Proceeds from credit facilities 52,356 69,136 100,654 Repayments on credit facilities (52,205 ) (69,292 ) (100,498 ) Proceeds from issuance of common stock under employee stock plans 22,277 19,537 14,600 Tax payments related to restricted stock unit issuances (3,141 ) (2,291 ) (1,486 ) Excess tax benefit from employee stock plans 4,927 1,532 1,016 Repurchase of common stock (15,000 ) — (206 ) Proceeds from note payable to related party 16,072 — — Capital contribution from non-controlling interest — 8,000 — Cash dividends paid (39,836 ) (31,298 ) (29,780 )

Net cash used in financing activities (14,550 ) (4,676 ) (15,700 ) Net effect of exchange rate changes on cash (11,137 ) (6,805 ) 1,821 Net increase (decrease) in cash and cash equivalents (23,931 ) 146,708 49,747 Cash and cash equivalents, beginning of year 437,489 290,781 241,034 Cash and cash equivalents, end of year $ 413,558 $ 437,489 $ 290,781

See accompanying notes to consolidated financial statements

Supplemental disclosures of cash flow information: Cash paid during the year for income taxes $ 53,958 $ 22,771 $ 43,696

Supplemental disclosures of non-cash investing activities: Capital expenditures incurred but not yet paid 7,196 5,195 5,313

B-4 B Specimen Financial Statements: Columbia Sportswear Company

COLUMBIA SPORTSWEAR COMPANY

CONSOLIDATED STATEMENTS OF EQUITY (In thousands)

See accompanying notes to consolidated financial statements

Columbia Sportswear Company Shareholders' Equity

Common Stock

Retained Earnings

Accumulated Other Comprehensive

Income Non-

Controlling Interest Total

Shares Outstanding Amount

BALANCE, JANUARY 1, 2012 67,276 $ 3,037 $ 1,024,611 $ 46,897 $ — $ 1,074,545 Net income — — 99,859 — — 99,859 Other comprehensive income (loss):

Unrealized holding losses on available-for-sale securities, net — — — (7 ) — (7)

Unrealized holding losses on derivative transactions, net — — — (4,745) — (4,745 )

Foreign currency translation adjustment, net — — — 4,518 — 4,518 Cash dividends ($0.44 per share) — — (29,780) — — (29,780 ) Issuance of common stock under employee stock plans, net 882 13,114 — — — 13,114 Tax adjustment from stock plans — 1,036 — — — 1,036 Stock-based compensation expense — 7,833 — — — 7,833 Repurchase of common stock (8) (206) — — — (206 ) BALANCE, DECEMBER 31, 2012 68,150 24,814 1,094,690 46,663 — 1,166,167 Net income (loss) — — 94,341 — (738) 93,603 Other comprehensive income (loss):

Unrealized holding gains on available-for-sale securities, net — — — 3 — 3

Unrealized holding losses on derivative transactions, net — — — (1,261) — (1,261 )

Foreign currency translation adjustment, net — — — (10,045) 184 (9,861) Cash dividends ($0.46 per share) — — (31,298) — — (31,298 ) Issuance of common stock under employee stock plans, net 1,040 17,246 — — — 17,246 Capital contribution from non-controlling interest — — — — 8,000 8,000 Tax adjustment from stock plans — 1,387 — — — 1,387 Stock-based compensation expense — 8,878 — — — 8,878 BALANCE, DECEMBER 31, 2013 69,190 52,325 1,157,733 35,360 7,446 1,252,864 Net income — — 137,173 — 4,686 141,859 Other comprehensive income (loss):

Unrealized holding gains on available-for-sale securities, net — — — 10 — 10

Unrealized holding gains on derivative transactions, net — — — 7,751 — 7,751 Foreign currency translation adjustment, net — — — (27,288) (501) (27,789)

Cash dividends ($0.57 per share) — — (39,836) — — (39,836 ) Issuance of common stock under employee stock plans, net 1,059 19,136 — — — 19,136 Tax adjustment from stock plans — 5,119 — — — 5,119 Stock-based compensation expense — 11,120 — — — 11,120 Repurchase of common stock (421) (15,000) — — — (15,000 ) BALANCE, DECEMBER 31, 2014 69,828 $ 72,700 $ 1,255,070 $ 15,833 $ 11,631 $ 1,355,234

VF Corporation is a leader in outdoor sportswear. The following are VF’s fi nancial statements as presented in its 2014 annual report. To access VF’s complete annual report, including notes to the fi nancial statements, follow these steps:

1. Go to www.vfc.com.

2. Select the Investor Relations link and then select Financial Reports.

3. Select the 2014 Annual Report on Form 10-K.

4. The Notes to Consolidated Financial Statements begin on page F-10.

Specimen Financial Statements: VF Corporation

C-1

C-2 C Specimen Financial Statements: VF Corporation

Specimen Financial Statements: VF Corporation C-3

Amazon.com, Inc. is the world’s largest online retailer. It also produces con- sumer electronics—notably the Kindle e-book reader and the Kindle Fire Tablet computer—and is a major provider of cloud computing services. The following are Amazon’s fi nancial statements as presented in the company’s 2014 annual report. To access Amazon’s complete annual report, including notes to the fi nan- cial statements, follow these steps:

1. Go to www.amazon.com.

2. Select the Investor Relations link at the bottom of the page and then select the 2014 Annual Report under Annual Reports and Proxies.

3. The Notes to Consolidated Financial Statements begin on page 43.

Specimen Financial Statements: Amazon.com, Inc.

D-1

D-2 D Specimen Financial Statements: Amazon.com, Inc.

Specimen Financial Statements: Amazon.com, Inc. D-3

The following are Wal-Mart Stores, Inc.’s fi nancial statements as presented in the company’s 2015 annual report. To access Wal-Mart’s complete annual report, including notes to the fi nancial statements, follow these steps:

1. Go to http://corporate.walmart.com.

2. Select Financial Information and then Annual Reports & Proxies under the Investors tab.

3. Select the 2015 Annual Report (Wal-Mart’s fi scal year ends January 31).

4. The Notes to Consolidated Financial Statements begin on page 40.

Specimen Financial Statements: Wal-Mart Stores, Inc.

E-1

Wal-Mart Stores, Inc. Consolidated Statements of Income

See accompanying notes.

Fiscal Years Ended January 31, (Amounts in millions, except per share data) 2015 2014 2013 Revenues:

Net sales $ 482,229 $ 473,076 $ 465,604 Membership and other income 3,422 3,218 3,047

Total revenues 485,651 476,294 468,651 Costs and expenses:

Cost of sales 365,086 358,069 352,297 Operating, selling, general and administrative expenses 93,418 91,353 88,629

Operating income 27,147 26,872 27,725 Interest:

Debt 2,161 2,072 1,977 Capital leases 300 263 272 Interest income (113 ) (119 ) (186 )

Interest, net 2,348 2,216 2,063 Income from continuing operations before income taxes 24,799 24,656 25,662 Provision for income taxes: Current 8,504 8,619 7,976 Deferred (519 ) (514 ) (18 ) Total provision for income taxes 7,985 8,105 7,958 Income from continuing operations 16,814 16,551 17,704 Income from discontinued operations, net of income taxes 285 144 52 Consolidated net income 17,099 16,695 17,756 Less consolidated net income attributable to noncontrolling interest (736 ) (673 ) (757 ) Consolidated net income attributable to Walmart $ 16,363 $ 16,022 $ 16,999 Basic net income per common share:

Basic income per common share from continuing operations attributable to Walmart $ 5.01 $ 4.87 $ 5.03 Basic income per common share from discontinued operations attributable to Walmart 0.06 0.03 0.01

Basic net income per common share attributable to Walmart $ 5.07 $ 4.90 $ 5.04 Diluted net income per common share:

Diluted income per common share from continuing operations attributable to Walmart $ 4.99 $ 4.85 $ 5.01 Diluted income per common share from discontinued operations attributable to Walmart 0.06 0.03 0.01

Diluted net income per common share attributable to Walmart $ 5.05 $ 4.88 $ 5.02 Weighted-average common shares outstanding:

Basic 3,230 3,269 3,374 Diluted 3,243 3,283 3,389

Dividends declared per common share $ 1.92 $ 1.88 $ 1.59

E-2 E Specimen Financial Statements: Wal-Mart Stores, Inc.

Wal-Mart Stores, Inc. Consolidated Statements of Comprehensive Income

See accompanying notes.

Fiscal Years Ended January 31, (Amounts in millions) 2015 2014 2013 Consolidated net income $ 17,099 $ 16,695 $ 17,756

Less consolidated net income attributable to nonredeemable noncontrolling interest (736 ) (606 ) (684 ) Less consolidated net income attributable to redeemable noncontrolling interest — (67 ) (73 )

Consolidated net income attributable to Walmart 16,363 16,022 16,999 Other comprehensive income (loss), net of income taxes

Currency translation and other (4,179 ) (3,146 ) 1,042 Derivative instruments (470 ) 207 136 Minimum pension liability (69 ) 153 (166 )

Other comprehensive income (loss), net of income taxes (4,718 ) (2,786 ) 1,012 Less other comprehensive income (loss) attributable to nonredeemable noncontrolling interest 546 311 (138 ) Less other comprehensive income (loss) attributable to redeemable noncontrolling interest — 66 (51 )

Other comprehensive income (loss) attributable to Walmart (4,172 ) (2,409 ) 823 Comprehensive income, net of income taxes 12,381 13,909 18,768

Less comprehensive income (loss) attributable to nonredeemable noncontrolling interest (190 ) (295 ) (822 ) Less comprehensive income (loss) attributable to redeemable noncontrolling interest — (1 ) (124 )

Comprehensive income attributable to Walmart $ 12,191 $ 13,613 $ 17,822

Specimen Financial Statements: Wal-Mart Stores, Inc. E-3

Wal-Mart Stores, Inc. Consolidated Balance Sheets

As of January 31, (Amounts in millions) 2015 2014 ASSETS Current assets:

Cash and cash equivalents $ 9,135 $ 7,281 Receivables, net 6,778 6,677 Inventories 45,141 44,858 Prepaid expenses and other 2,224 1,909 Current assets of discontinued operations — 460

Total current assets 63,278 61,185 Property and equipment:

Property and equipment 177,395 173,089 Less accumulated depreciation (63,115 ) (57,725 )

Property and equipment, net 114,280 115,364 Property under capital leases:

Property under capital leases 5,239 5,589 Less accumulated amortization (2,864 ) (3,046 )

Property under capital leases, net 2,375 2,543 Goodwill 18,102 19,510 Other assets and deferred charges 5,671 6,149 Total assets $ 203,706 $ 204,751 LIABILITIES, REDEEMABLE NONCONTROLLING INTEREST, AND EQUITY Current liabilities:

Short-term borrowings $ 1,592 $ 7,670 Accounts payable 38,410 37,415 Accrued liabilities 19,152 18,793 Accrued income taxes 1,021 966 Long-term debt due within one year 4,810 4,103 Obligations under capital leases due within one year 287 309 Current liabilities of discontinued operations — 89

Total current liabilities 65,272 69,345 Long-term debt 41,086 41,771 Long-term obligations under capital leases 2,606 2,788 Deferred income taxes and other 8,805 8,017 Redeemable noncontrolling interest — 1,491 Commitments and contingencies Equity:

Common stock 323 323 Capital in excess of par value 2,462 2,362 Retained earnings 85,777 76,566 Accumulated other comprehensive income (loss) (7,168 ) (2,996 )

Total Walmart shareholders' equity 81,394 76,255 Nonredeemable noncontrolling interest 4,543 5,084

See accompanying notes.

Total equity 85,937 81,339 Total liabilities, redeemable noncontrolling interest, and equity $ 203,706 $ 204,751

E-4 E Specimen Financial Statements: Wal-Mart Stores, Inc.

Wal-Mart Stores, Inc. Consolidated Statement of Shareholders' Equity and Redeemable Noncontrolling Interest

See accompanying notes.

Accumulated Total Capital in Other Walmart Nonredeemable Redeemable

(Amounts in millions)

Common Stock Excess of Retained Comprehensive Shareholders' Noncontrolling Total Noncontrolling Shares Amount Par Value Earnings Income (Loss) Equity Interest Equity Interest

Balances as of February 1, 2012 3,418 $ 342 $ 3,692 $ 68,691 $ (1,410) $ 71,315 $ 4,446 $ 75,761 $ 404 Consolidated net income — — — 16,999 — 16,999 684 17,683 73 Other comprehensive income, net of income taxes — — — — 823 823 138 961 51 Cash dividends declared ($1.59 per share) — — — (5,361 ) — (5,361 ) — (5,361 ) — Purchase of Company stock (115 ) (11 ) (357 ) (7,341) — (7,709 ) — (7,709 ) — Nonredeemable noncontrolling interest of acquired entity — — — — — — 469 469 — Other 11 1 285 (10 ) — 276 (342 ) (66 ) (9) Balances as of January 31, 2013 3,314 332 3,620 72,978 (587) 76,343 5,395 81,738 519 Consolidated net income — — — 16,022 — 16,022 595 16,617 78 Other comprehensive loss, net of income taxes — — — — (2,409 ) (2,409) (311 ) (2,720) (66) Cash dividends declared ($1.88 per share) — — — (6,139 ) — (6,139 ) — (6,139 ) — Purchase of Company stock (87 ) (9) (294 ) (6,254) — (6,557 ) — (6,557 ) — Redemption value adjustment of redeemable noncontrolling interest

—

(1,019 )

—

(1,019 )

—

(1,019 )

1,019

Other 6 — 55 (41 ) — 14 (595 ) (581) (59) Balances as of January 31, 2014 3,233 323 2,362 76,566 (2,996) 76,255 5,084 81,339 1,491 Consolidated net income — — — 16,363 — 16,363 736 17,099 — Other comprehensive income, net of income taxes — — — — (4,172 ) (4,172) (546 ) (4,718) — Cash dividends declared ($1.92 per share) — — — (6,185 ) — (6,185 ) — (6,185 ) — Purchase of Company stock (13 ) (1) (29) (950) — (980) — (980 ) — Purchase of redeemable noncontrolling interest — — — — — — — — (1,491 ) Other 8 1 129 (17 ) — 113 (731 ) (618) — Balances as of January 31, 2015 3,228 $ 323 $ 2,462 $ 85,777 $ (7,168) $ 81,394 $ 4,543 $ 85,937 $ —

Specimen Financial Statements: Wal-Mart Stores, Inc. E-5

Wal-Mart Stores, Inc. Consolidated Statements of Cash Flows

See accompanying notes.

Fiscal Years Ended January 31, (Amounts in millions) 2015 2014 2013 Cash flows from operating activities:

Consolidated net income $ 17,099 $ 16,695 $ 17,756 Income from discontinued operations, net of income taxes (285 ) (144 ) (52 ) Income from continuing operations 16,814 16,551 17,704 Adjustments to reconcile income from continuing operations to net cash provided by operating activities:

Depreciation and amortization 9,173 8,870 8,478 Deferred income taxes (503 ) (279 ) (133 ) Other operating activities 785 938 602 Changes in certain assets and liabilities, net of effects of acquisitions:

Receivables, net (569 ) (566 ) (614 ) Inventories (1,229 ) (1,667 ) (2,759 ) Accounts payable 2,678 531 1,061 Accrued liabilities 1,249 103 271 Accrued income taxes 166 (1,224 ) 981

Net cash provided by operating activities 28,564 23,257 25,591 Cash flows from investing activities:

Payments for property and equipment (12,174 ) (13,115 ) (12,898 ) Proceeds from the disposal of property and equipment 570 727 532 Proceeds from the disposal of certain operations 671 — — Other investing activities (192 ) (138 ) (271 )

Net cash used in investing activities (11,125 ) (12,526 ) (12,637 ) Cash flows from financing activities:

Net change in short-term borrowings (6,288 ) 911 2,754 Proceeds from issuance of long-term debt 5,174 7,072 211 Payments of long-term debt (3,904 ) (4,968 ) (1,478 ) Dividends paid (6,185 ) (6,139 ) (5,361 ) Purchase of Company stock (1,015 ) (6,683 ) (7,600 ) Dividends paid to noncontrolling interest (600 ) (426 ) (282 ) Purchase of noncontrolling interest (1,844 ) (296 ) (132 ) Other financing activities (409 ) (260 ) (58 )

Net cash used in financing activities (15,071 ) (10,789 ) (11,946 ) Effect of exchange rates on cash and cash equivalents (514 ) (442 ) 223 Net increase (decrease) in cash and cash equivalents 1,854 (500 ) 1,231 Cash and cash equivalents at beginning of year 7,281 7,781 6,550 Cash and cash equivalents at end of year $ 9,135 $ 7,281 $ 7,781 Supplemental disclosure of cash flow information: Income taxes paid 8,169 8,641 7,304 Interest paid 2,433 2,362 2,262

Louis Vuitton is a French company and is one of the leading international fash- ion houses in the world. Louis Vuitton has been named the world’s most valuable luxury brand. Note that its fi nancial statements are IFRS-based and are presented in euros (€). To access the company’s complete fi nancial statements, follow these steps:

1. Go to www.lvmh.com/investor-relations.

2. Select All publications, then the Reports tab, and then 2014 Consolidated fi nancial statements.

3. Note that the comments (notes) to the fi nancial statements begin on page 7.

Specimen Financial Statements: Louis Vuitton

F-1

CONSOLIDATED INCOME STATEMENT

(EUR millions, except for earnings per share) Notes 2014 2013(1) 2012(1)

Revenue 23-24 30,638 29,016 27,970 Cost of sales (10,801) (9,997) (9,863)

Gross margin 19,837 19,019 18,107

Marketing and selling expenses (11,744) (10,767) (10,013) General and administrative expenses (2,373) (2,212) (2,151) Income (loss) from joint ventures and associates 7 (5) (23) (19)

Profit from recurring operations 23-24 5,715 6,017 5,924

Other operating income and expenses 25 (284) (119) (182)

Operating profit 5,431 5,898 5,742

Cost of net financial debt (115) (101) (138) Other financial income and expenses 3,062 (97) 126

Net financial income (expense) 26 2,947 (198) (12)

Income taxes 27 (2,273) (1,753) (1,821)

Net profit before minority interests 6,105 3,947 3,909

Minority interests 17 (457) (511) (484)

Net profit, Group share 5,648 3,436 3,425

Basic Group share of net earnings per share (EUR) 28 11.27 6.87 6.86 Number of shares on which the calculation is based 501,309,369 500,283,414 499,133,643

Diluted Group share of net earnings per share (EUR) 28 11.21 6.83 6.82 Number of shares on which the calculation is based 503,861,733 503,217,497 502,229,952

(1) The financial statements as of December 31, 2013 and 2012 have been restated to reflect the retrospective application as of January 1, 2012 of IFRS 11 Joint Arrangements. See Note 1.2.

F-2 F Specimen Financial Statements: Louis Vuitton

CONSOLIDATED STATEMENT OF COMPREHENSIVE GAINS AND LOSSES

(EUR millions) 2014 2013(1) 2012(1)

Net profit before minority interests 6,105 3,947 3,909

Translation adjustments 534 (346) (99) Tax impact 104 (48) (18)

638 (394) (117)

Change in value of available for sale financial assets 494 963 (27) Amounts transferred to income statement (3,326) (16) (14) Tax impact 184 (35) (6)

(2,648) 912 (47)

Change in value of hedges of future foreign currency cash flows (30) 304 182 Amounts transferred to income statement (163) (265) 13 Tax impact 57 (17) (50)

(136) 22 145

Gains and losses recognized in equity, transferable to income statement (2,146) 540 (19)

Change in value of vineyard land (17) 369 85 Amounts transferred to consolidated reserves (10) - - Tax impact 9 (127) (28)

(18) 242 57

Employee benefit commitments: change in value resulting from actuarial gains and losses (161) 80 (101) Tax impact 52 (22) 29

(109) 58 (72)

Gains and losses recognized in equity, not transferable to income statement (127) 300 (15)

Comprehensive income 3,832 4,787 3,875 Minority interests (565) (532) (469)

Comprehensive income, Group share 3,267 4,255 3,406

(1) The financial statements as of December 31, 2013 and 2012 have been restated to reflect the retrospective application as of January 1, 2012 of IFRS 11 Joint Arrangements. See Note 1.2.

Specimen Financial Statements: Louis Vuitton F-3

CONSOLIDATED BALANCE SHEET

ASSETS Notes 2014 2013(1) (2) 2012(1)

(EUR millions)

Brands and other intangible fixed assets 3 13,031 12,596 11,322 Goodwill 4 8,810 9,058 7,709 Property, plant and equipment 6 10,387 9,621 8,694 Investments in joint ventures and associates 7 519 480 483 Non-current available for sale financial assets 8 580 7,080 6,004 Other non-current assets 9 489 457 519 Deferred tax 27 1,436 913 952

Non-current assets 35,252 40,205 35,683

Inventories and work in progress 10 9,475 8,492 7,994 Trade accounts receivable 11 2,274 2,174 1,972 Income taxes 354 223 201 Other current assets 12 1,916 1,856 1,813 Cash and cash equivalents 14 4,091 3,226 2,187

Current assets 18,110 15,971 14,167

Total assets 53,362 56,176 49,850

LIABILITIES AND EQUITY Notes 2014 2013(1) (2) 2012(1)

(EUR millions)

Share capital 15.1 152 152 152 Share premium account 15.1 2,655 3,849 3,848 Treasury shares and LVMH-share settled derivatives 15.2 (374) (451) (414) Cumulative translation adjustment 15.4 492 (8) 342 Revaluation reserves 1,019 3,900 2,731 Other reserves 12,171 16,001 14,340 Net profit, Group share 5,648 3,436 3,425

Equity, Group share 21,763 26,879 24,424 Minority interests 17 1,240 1,028 1,084

Total equity 23,003 27,907 25,508

Long-term borrowings 18 5,054 4,149 3,825 Non-current provisions 19 2,291 1,797 1,772 Deferred tax 27 4,392 4,280 3,884 Other non-current liabilities 20 6,447 6,404 5,456

Non-current liabilities 18,184 16,630 14,937

Short-term borrowings 18 4,189 4,674 2,950 Trade accounts payable 3,606 3,297 3,118 Income taxes 549 357 442 Current provisions 19 332 324 335 Other current liabilities 21 3,499 2,987 2,560

Current liabilities 12,175 11,639 9,405

Total liabilities and equity 53,362 56,176 49,850

(1) The financial statements as of December 31, 2013 and 2012 have been restated to reflect the retrospective application as of January 1, 2012 of IFRS 11 Joint Arrangements. See Note 1.2. (2) The consolidated balance sheet as of December 31, 2013 has been restated to reflect the finalized purchase price allocation for Loro Piana. See Note 2.

F-4 F Specimen Financial Statements: Louis Vuitton

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY

(EUR millions) Number Share Share Treasury Cumulative Revaluation reserves Net profit Total equity of shares capital premium shares and translation and other account LVMH- adjustment Available Hedges Vineyard Employee reserves Group Minority Total share for sale of future land benefit share interests settled financial foreign commit-

derivatives assets currency ments cash flows

Notes 15.1 15.2 15.4 17

As of December 31, 2011 507,815,624 152 3,801 (485) 431 1,990 (15) 714 (28) 15,811 22,371 1,055 23,426

Gains and losses recognized in equity (89) (47) 133 44 (60) - (19) (15) (34) Net profit 3,425 3,425 484 3,909 Comprehensive income - - - (89) (47) 133 44 (60) 3,425 3,406 469 3,875 Stock option plan and similar expenses 50 50 3 53 (Acquisition) / disposal of treasury shares and LVMH-share settled derivatives 24 (12) 12 - 12 Exercise of LVMH share subscription options 1,344,975 94 94 - 94 Retirement of LVMH shares (997,250) (47) 47 - - - Capital increase in subsidiaries - 8 8 Interim and final dividends paid (1,447) (1,447) (317) (1,764) Changes in control of consolidated entities (12) (12) (11) (23) Acquisition and disposal of minority interests’ shares (40) (40) (25) (65) Purchase commitments for minority interests’ shares (10) (10) (98) (108) As of December 31, 2012 508,163,349 152 3,848 (414) 342 1,943 118 758 (88) 17,765 24,424 1,084 25,508

Gains and losses recognized in equity (350) 912 18 188 51 - 819 21 840 Net profit 3,436 3,436 511 3,947 Comprehensive income - - - (350) 912 18 188 51 3,436 4,255 532 4,787 Stock option plan and similar expenses 31 31 3 34 (Acquisition) / disposal of treasury shares and LVMH-share settled derivatives (103) (7) (110) - (110) Exercise of LVMH share subscription options 1,025,418 67 67 - 67 Retirement of LVMH shares (1,395,106) (66) 66 - - - Capital increase in subsidiaries - 8 8 Interim and final dividends paid (1,500) (1,500) (228) (1,728) Acquisition of a controlling interest in Loro Piana(1) - 235 235 Changes in control of consolidated entities 1 1 (1) - Acquisition and disposal of minority interests’ shares (73) (73) (76) (149) Purchase commitments for minority interests’ shares(1) (216) (216) (529) (745) As of December 31, 2013 507,793,661 152 3,849 (451) (8) 2,855 136 946 (37) 19,437 26,879 1,028 27,907

Gains and losses recognized in equity 500 (2,648) (122) (15) (96) - (2,381) 108 (2,273) Net profit 5,648 5,648 457 6,105 Comprehensive income - - - 500 (2,648) (122) (15) (96) 5,648 3,267 565 3,832 Stock option plan and similar expenses 37 37 2 39 (Acquisition) / disposal of treasury shares and LVMH-share settled derivatives 27 (17) 10 - 10 Exercise of LVMH share subscription options 980,323 59 59 - 59 Retirement of LVMH shares (1,062,271) (50) 50 - - - Capital increase in subsidiaries - 3 3 Interim and final dividends paid (1,579) (1,579) (328) (1,907) Distribution in kind of Hermès shares. See Note 8. (1,203) (5,652) (6,855) - (6,855) Changes in control of consolidated entities (5) (5) 11 6 Acquisition and disposal of minority interests’ shares (2) (2) 32 30 Purchase commitments for minority interests’ shares (48) (48) (73) (121) As of December 31, 2014 507,711,713 152 2,655 (374) 492 207 14 931 (133) 17,819 21,763 1,240 23,003

(1) The consolidated balance sheet as of December 31, 2013 has been restated to reflect the finalized purchase price allocation for Loro Piana. See Note 2.

Specimen Financial Statements: Louis Vuitton F-5

CONSOLIDATED CASH FLOW STATEMENT

(EUR millions) Notes 2014 2013(1) 2012(1)

I. OPERATING ACTIVITIES AND OPERATING INVESTMENTS Operating profit 5,431 5,898 5,742 Income / (loss) and dividends from joint ventures and associates(a) 7 26 49 37 Net increase in depreciation, amortization and provisions 1,895 1,435 1,289 Other computed expenses (188) (29) (59) Other adjustments (84) (76) (52)

Cash from operations before changes in working capital 7,080 7,277 6,957 Cost of net financial debt: interest paid (116) (111) (152) Income taxes paid(a) (1,639) (1,832) (1,880)

Net cash from operating activities before changes in working capital 5,325 5,334 4,925 Change in working capital 14.1 (718) (620) (810)

Net cash from operating activities 4,607 4,714 4,115 Operating investments 14.2 (1,775) (1,657) (1,694)

Net cash from operating activities and operating investments (free cash flow) 2,832 3,057 2,421

II. FINANCIAL INVESTMENTS Purchase of non-current available for sale financial assets 8 (57) (197) (131) Proceeds from sale of non-current available for sale financial assets 8 160 38 36 Dividends received(a) 8 69 71 179 Income tax related to financial investments(a) (237) (11) (21) Impact of purchase and sale of consolidated investments 2.4 (167) (2,161) (59)

Net cash from (used in) financial investments (232) (2,260) 4

III. TRANSACTIONS RELATING TO EQUITY Capital increases of LVMH SE 15.1 59 66 95 Capital increases of subsidiaries subscribed by minority interests 17 3 7 8 Acquisition and disposals of treasury shares and LVMH-share settled derivatives 15.2 1 (113) 5 Interim and final dividends paid by LVMH SE 15.3 (1,619)(b) (1,501) (1,447) Income taxes paid related to interim and final dividends paid(a) (79) (137) (73) Interim and final dividends paid to minority interests in consolidated subsidiaries 17 (336) (220) (314) Purchase and proceeds from sale of minority interests 2.4 10 (150) (206)

Net cash from (used in) transactions relating to equity (1,961) (2,048) (1,932)

Change in cash before financing activities 639 (1,251) 493

IV. FINANCING ACTIVITIES Proceeds from borrowings 2,407 3,095 1,028 Repayment of borrowings (2,100) (1,057) (1,494) Purchase and proceeds from sale of current available for sale financial assets 13 (106) 101 (67)

Net cash from (used in) financing activities 201 2,139 (533)

V. EFFECT OF EXCHANGE RATE CHANGES 27 47 (43)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (I+II+III+IV+V) 867 935 (83)

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 14 2,916 1,981 2,064 CASH AND CASH EQUIVALENTS AT END OF PERIOD 14 3,783 2,916 1,981

TOTAL INCOME TAXES PAID (1,955) (1,980) (1,974)

Transactions included in the table above, generating no change in cash: - acquisition of assets by means of finance leases 5 7 5

(a) Restated to reflect the amended presentation of dividends received and income tax paid starting in 2014. See Note 1.4. (b) The distribution in kind of Hermès shares had no impact on cash, apart from related income tax effects. See Note 8.

(1) The financial statements as of December 31, 2013 and 2012 have been restated to reflect the retrospective application as of January 1, 2012 of IFRS 11 Joint Arrangements. See Note 1.2.

Would you rather receive $1,000 today or a year from now? You should prefer to receive the $1,000

today because you can invest the $1,000 and then earn interest on it. As a result, you will have more

than $1,000 a year from now. What this example illustrates is the concept of the time value of money.

Everyone prefers to receive money today rather than in the future because of the interest factor.

APPENDIX PREVIEW

Time Value of Money G

LEARNING OBJECTIVE 1 Compute interest and future values.▼

NATURE OF INTEREST

Interest is payment for the use of another person’s money. It is the difference between the amount borrowed or invested (called the principal) and the amount repaid or collected. The amount of interest to be paid or collected is usually stated as a rate over a specifi c period of time. The rate of interest is generally stated as an annual rate.

LEARNING OBJECTIVES

APPENDIX OUTLINE

• Nature of interest • Future value of a single amount • Future value of an annuity

▼1 Compute interest and future values.

• Present value of a single sum • Present value of an annuity • Useful fi nancial calculator applications

Use a fi nancial calculator to solve time value of money problems. 3

2 Compute present values.

• Present value variables • Present value of a single amount • Present value of an annuity • Time periods and discounting • Present value of a long-term note or bond

▼ ▼

G-1

G-2 G Time Value of Money

The amount of interest involved in any fi nancing transaction is based on three elements:

1. Principal (p): The original amount borrowed or invested.

2. Interest Rate (i): An annual percentage of the principal.

3. Time (n): The number of periods that the principal is borrowed or invested.

Simple Interest Simple interest is computed on the principal amount only. It is the return on the principal for one period. Simple interest is usually expressed as shown in Illustration G-1.

ILLUSTRATION G-1 Interest computation Interest 5

Principal 3

Rate 3

Time p i n

For example, if you borrowed $5,000 for 2 years at a simple interest rate of 12% annually, you would pay $1,200 in total interest, computed as follows.

Interest 5 p 3 i 3 n

5 $5,000 3 .12 3 2 5 $1,200

Compound Interest Compound interest is computed on principal and on any interest earned that has not been paid or withdrawn. It is the return on (or growth of) the principal for two or more time periods. 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 you deposit $1,000 in Bank Two, where it will earn simple interest of 9% per year, and you deposit another $1,000 in Citizens Bank, where it will earn com- pound interest of 9% per year compounded annually. Also assume that in both cases you will not withdraw any cash until three years from the date of deposit. Illustration G-2 shows the computation of interest to be received and the accu- mulated year-end balances.

Simple Interest Calculation

Year 1

Year 2

Year 3

$1,000.00 × 9%

90.00

270.00

$1,090.00

$1,180.00

$1,270.00

$25.03 Difference

Simple Interest

Accumulated Year-End Balance

Bank Two

Compound Interest Calculation

Year 1

Year 2

Year 3

$1,000.00 × 9%

$1,090.00 × 9%

$1,188.10 × 9%

90.00

98.10

106.93

295.03

$1,090.00

$1,188.10

$1,295.03

Compound Interest

Accumulated Year-End Balance

Citizens Bank

ILLUSTRATION G-2 Simple versus compound interest

Note in Illustration G-2 that simple interest uses the initial principal of $1,000 to compute the interest in all three years. Compound interest uses the accumulated balance (principal plus interest to date) at each year-end to compute interest in the succeeding year—which explains why your compound interest account is larger. Obviously, if you had a choice between investing your money at simple interest or at compound interest, you would choose compound interest, all other things—

Interest and Future Values G-3

especially risk—being equal. In the example, compounding provides $25.03 of additional interest income. For practical purposes, compounding assumes that unpaid interest earned becomes a part of the principal, and the accumulated balance at the end of each year becomes the new principal on which interest is earned during the next year. Illustration G-2 indicates that you should invest your money at the bank that compounds interest. Most business situations use compound interest. Simple interest is generally applicable only to short-term situations of one year or less.

FUTURE VALUE OF A SINGLE AMOUNT

The future value of a single amount is the value at a future date of a given amount invested, assuming compound interest. For example, in Illustration G-2, $1,295.03 is the future value of the $1,000 investment earning 9% for three years. The $1,295.03 is determined more easily by using the following formula.

FV = p × (1 + i)n ILLUSTRATION G-3 Formula for future value

where:

FV = future value of a single amount p = principal (or present value; the value today) i = interest rate for one period n = number of periods

The $1,295.03 is computed as follows.

FV = p × (1 + i)n = $1,000 × (1 + .09)3 = $1,000 × 1.29503 = $1,295.03

The 1.29503 is computed by multiplying (1.09 × 1.09 × 1.09), where 1.09 is 1 plus the interest rate of 9%. Thus, 1.29503 represents the 9% rate compounded for three years. The amounts in this example can be depicted in the time diagram shown in Illustration G-4.

Present Value (p)

0 $1,000

1 2 3 $1,295.03

i = 9% Future Value

n = 3 years

ILLUSTRATION G-4 Time diagram

Another method used to compute the future value of a single amount involves a compound interest table. This table shows the future value of 1 for n periods. Table 1 (page G-4) is such a table. In Table 1, n is the number of compounding periods, the percentages are the periodic interest rates, and the 5-digit decimal numbers in the respective col- umns are the future value of 1 factors. To use Table 1, you multiply the principal amount by the future value factor for the specifi ed number of periods and inter- est rate. For example, the future value factor for two periods at 9% is 1.18810. Multiplying this factor by $1,000 equals $1,188.10—which is the accumulated balance at the end of year 2 in the Citizens Bank example in Illustration G-2. The

G-4 G Time Value of Money

$1,295.03 accumulated balance at the end of the third year is calculated from Table 1 by multiplying the future value factor for three periods (1.29503) by the $1,000. The demonstration problem in Illustration G-5 shows how to use Table 1.

TABLE 1 Future Value of 1

(n) Periods 4% 5% 6% 7% 8% 9% 10% 11% 12% 15%

0 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1 1.04000 1.05000 1.06000 1.07000 1.08000 1.09000 1.10000 1.11000 1.12000 1.15000 2 1.08160 1.10250 1.12360 1.14490 1.16640 1.18810 1.21000 1.23210 1.25440 1.32250 3 1.12486 1.15763 1.19102 1.22504 1.25971 1.29503 1.33100 1.36763 1.40493 1.52088 4 1.16986 1.21551 1.26248 1.31080 1.36049 1.41158 1.46410 1.51807 1.57352 1.74901 5 1.21665 1.27628 1.33823 1.40255 1.46933 1.53862 1.61051 1.68506 1.76234 2.01136

6 1.26532 1.34010 1.41852 1.50073 1.58687 1.67710 1.77156 1.87041 1.97382 2.31306 7 1.31593 1.40710 1.50363 1.60578 1.71382 1.82804 1.94872 2.07616 2.21068 2.66002 8 1.36857 1.47746 1.59385 1.71819 1.85093 1.99256 2.14359 2.30454 2.47596 3.05902 9 1.42331 1.55133 1.68948 1.83846 1.99900 2.17189 2.35795 2.55803 2.77308 3.51788 10 1.48024 1.62889 1.79085 1.96715 2.15892 2.36736 2.59374 2.83942 3.10585 4.04556

11 1.53945 1.71034 1.89830 2.10485 2.33164 2.58043 2.85312 3.15176 3.47855 4.65239 12 1.60103 1.79586 2.01220 2.25219 2.51817 2.81267 3.13843 3.49845 3.89598 5.35025 13 1.66507 1.88565 2.13293 2.40985 2.71962 3.06581 3.45227 3.88328 4.36349 6.15279 14 1.73168 1.97993 2.26090 2.57853 2.93719 3.34173 3.79750 4.31044 4.88711 7.07571 15 1.80094 2.07893 2.39656 2.75903 3.17217 3.64248 4.17725 4.78459 5.47357 8.13706

16 1.87298 2.18287 2.54035 2.95216 3.42594 3.97031 4.59497 5.31089 6.13039 9.35762 17 1.94790 2.29202 2.69277 3.15882 3.70002 4.32763 5.05447 5.89509 6.86604 10.76126 18 2.02582 2.40662 2.85434 3.37993 3.99602 4.71712 5.55992 6.54355 7.68997 12.37545 19 2.10685 2.52695 3.02560 3.61653 4.31570 5.14166 6.11591 7.26334 8.61276 14.23177 20 2.19112 2.65330 3.20714 3.86968 4.66096 5.60441 6.72750 8.06231 9.64629 16.36654

0 $20,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

i = 6% Future

Value = ?Present Value (p)

n = 18 years

John and Mary Rich invested $20,000 in a savings account paying 6% interest at the time their son, Mike, was born. The money is to be used by Mike for his college education. On his 18th birthday, Mike withdraws the money from his savings account. How much did Mike withdraw from his account?

Answer: The future value factor from Table 1 is 2.85434 (18 periods at 6%). The future value of $20,000 earning 6% per year for 18 years is $57,086.80 ($20,000 × 2.85434).

ILLUSTRATION G-5 Demonstration problem—Using Table 1 for FV of 1

FUTURE VALUE OF AN ANNUITY

The preceding discussion involved the accumulation of only a single principal sum. Individuals and businesses frequently encounter situations in which a

Interest and Future Values G-5

series of equal dollar amounts are to be paid or received at evenly spaced time intervals (periodically), such as loans or lease (rental) contracts. A series of pay- ments or receipts of equal dollar amounts is referred to as an annuity. The future value of an annuity is the sum of all the payments (receipts) plus the accumulated compound interest on them. In computing the future value of an annuity, it is necessary to know (1) the interest rate, (2) the number of pay- ments (receipts), and (3) the amount of the periodic payments (receipts). To illustrate the computation of the future value of an annuity, assume that you invest $2,000 at the end of each year for three years at 5% interest compounded annually. This situation is depicted in the time diagram in Illustration G-6.

0 1 2 3

$2,000 Present Value $2,000 $2,000

i = 5% Future Value = ?

n = 3 years

ILLUSTRATION G-6 Time diagram for a three-year annuity

The $2,000 invested at the end of year 1 will earn interest for two years (years 2 and 3), and the $2,000 invested at the end of year 2 will earn interest for one year (year 3). However, the last $2,000 investment (made at the end of year 3) will not earn any interest. Using the future value factors from Table 1, the future value of these periodic payments is computed as shown in Illustration G-7.

The fi rst $2,000 investment is multiplied by the future value factor for two periods (1.1025) because two years’ interest will accumulate on it (in years 2 and 3). The second $2,000 investment will earn only one year’s interest (in year 3) and therefore is multiplied by the future value factor for one year (1.0500). The fi nal $2,000 investment is made at the end of the third year and will not earn any interest. Thus, n = 0 and the future value factor is 1.00000. Consequently, the future value of the last $2,000 invested is only $2,000 since it does not accumulate any interest. Calculating the future value of each individual cash fl ow is required when the periodic payments or receipts are not equal in each period. However, when the periodic payments (receipts) are the same in each period, the future value can be computed by using a future value of an annuity of 1 table. Table 2 (page G-6) is such a table. Table 2 shows the future value of 1 to be received periodically for a given number of payments. It assumes that each payment is made at the end of each period. We can see from Table 2 that the future value of an annuity of 1 factor for

ILLUSTRATION G-7 Future value of periodic payment computation

Invested at Number of End of Compounding Amount Future Value of Future Year Periods Invested × 1 Factor at 5% = Value 1 2 $2,000 1.10250 $2,205 2 1 2,000 1.05000 2,100 3 0 2,000 1.00000 2,000

3.15250 $6,305

G-6 G Time Value of Money

three payments at 5% is 3.15250. The future value factor is the total of the three individual future value factors as shown in Illustration G-7. Multiplying this amount by the annual investment of $2,000 produces a future value of $6,305. The demonstration problem in Illustration G-8 shows how to use Table 2.

TABLE 2 Future Value of an Annuity of 1

(n) Payments 4% 5% 6% 7% 8% 9% 10% 11% 12% 15%

1 1.00000 1.00000 1.00000 1.0000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 2 2.04000 2.05000 2.06000 2.0700 2.08000 2.09000 2.10000 2.11000 2.12000 2.15000 3 3.12160 3.15250 3.18360 3.2149 3.24640 3.27810 3.31000 3.34210 3.37440 3.47250 4 4.24646 4.31013 4.37462 4.4399 4.50611 4.57313 4.64100 4.70973 4.77933 4.99338 5 5.41632 5.52563 5.63709 5.7507 5.86660 5.98471 6.10510 6.22780 6.35285 6.74238

6 6.63298 6.80191 6.97532 7.1533 7.33592 7.52334 7.71561 7.91286 8.11519 8.75374 7 7.89829 8.14201 8.39384 8.6540 8.92280 9.20044 9.48717 9.78327 10.08901 11.06680 8 9.21423 9.54911 9.89747 10.2598 10.63663 11.02847 11.43589 11.85943 12.29969 13.72682 9 10.58280 11.02656 11.49132 11.9780 12.48756 13.02104 13.57948 14.16397 14.77566 16.78584 10 12.00611 12.57789 13.18079 13.8164 14.48656 15.19293 15.93743 16.72201 17.54874 20.30372

11 13.48635 14.20679 14.97164 15.7836 16.64549 17.56029 18.53117 19.56143 20.65458 24.34928 12 15.02581 15.91713 16.86994 17.8885 18.97713 20.14072 21.38428 22.71319 24.13313 29.00167 13 16.62684 17.71298 18.88214 20.1406 21.49530 22.95339 24.52271 26.21164 28.02911 34.35192 14 18.29191 19.59863 21.01507 22.5505 24.21492 26.01919 27.97498 30.09492 32.39260 40.50471 15 20.02359 21.57856 23.27597 25.1290 27.15211 29.36092 31.77248 34.40536 37.27972 47.58041

16 21.82453 23.65749 25.67253 27.8881 30.32428 33.00340 35.94973 39.18995 42.75328 55.71747 17 23.69751 25.84037 28.21288 30.8402 33.75023 36.97351 40.54470 44.50084 48.88367 65.07509 18 25.64541 28.13238 30.90565 33.9990 37.45024 41.30134 45.59917 50.39593 55.74972 75.83636 19 27.67123 30.53900 33.75999 37.3790 41.44626 46.01846 51.15909 56.93949 63.43968 88.21181 20 29.77808 33.06595 36.78559 40.9955 45.76196 51.16012 57.27500 64.20283 72.05244 102.44358

0 1 2 3 4

$2,500 Present Value $2,500 $2,500 $2,500

i = 6% Future Value = ?

n = 4 years

John and Char Lewis’s daughter, Debra, has just started high school. They decide to start a college fund for her and will invest $2,500 in a savings account at the end of each year she is in high school (4 payments total). The account will earn 6% interest compounded annually. How much will be in the college fund at the time Debra graduates from high school?

Answer: The future value factor from Table 2 is 4.37462 (4 payments at 6%). The future value of $2,500 invested each year for 4 years at 6% interest is $10,936.55 ($2,500 × 4.37462).

ILLUSTRATION G-8 Demonstration problem—Using Table 2 for FV of an annuity of 1

Note that we can apply the same concepts in situations where the future value and interest rate are known, but the payment must be calculated. Suppose, for example, that in Illustration G-8 that the amount that Debra needs to accumulate in her college fund by the end of four years is $10,936.55. If Debra earns 6% on

Present Values G-7

her four annual payments, we can solve for the amount of the annuity payments by dividing $10,936.55 by the future value factor of 4.37462 to determine the pay- ment amount of $2,500.

LEARNING OBJECTIVE

Compute present values.2▼ PRESENT VALUE VARIABLES

The present value is the value now of a given amount to be paid or received in the future, assuming compound interest. The present value, like the future value, is based on three variables: (1) the dollar amount to be received (future amount), (2) the length of time until the amount is received (number of periods), and (3) the interest rate (the discount rate). The process of determining the present value is referred to as discounting the future amount. Present value computations are used in measuring many items. For example, the present value of principal and interest payments is used to determine the market price of a bond. Determining the amount to be reported for notes payable and lease liabilities also involves present value computations. In addition, capi- tal budgeting and other investment proposals are evaluated using present value computations. Finally, all rate of return and internal rate of return computations involve present value techniques.

PRESENT VALUE OF A SINGLE AMOUNT

To illustrate present value, assume that you want to invest a sum of money today that will provide $1,000 at the end of one year. What amount would you need to invest today to have $1,000 one year from now? If you want a 10% rate of return, the investment or present value is $909.09 ($1,000 ÷ 1.10). The formula for cal- culating present value is shown in Illustration G-9.

Present Value (PV ) = Future Value (FV ) ÷ (1 + i)n ILLUSTRATION G-9 Formula for present value

The computation of $1,000 discounted at 10% for one year is as follows.

PV = FV ÷ (1 + i)n = $1,000 ÷ (1 + .10)1 = $1,000 ÷ 1.10 = $909.09

The future amount ($1,000), the discount rate (10%), and the number of periods (1) are known. The variables in this situation are depicted in the time diagram in Illustration G-10.

i = 10%

n = 1 year

Present Value (?)

$909.09

Future Value

$1,000

ILLUSTRATION G-10 Finding present value if discounted for one period

G-8 G Time Value of Money

If the single amount of $1,000 is to be received in two years and discounted at 10% [PV = $1,000 ÷ (1 + .10)2], its present value is $826.45 [($1,000 ÷ 1.21), depicted in Illustration G-11.

i = 10%

Present Value (?)

Future Value

2 n = 2 years$826.45 $1,000

ILLUSTRATION G-11 Finding present value if discounted for two periods

The present value of 1 may also be determined through tables that show the present value of 1 for n periods. In Table 3 (see below), n is the number of discounting periods involved. The percentages are the periodic interest rates or discount rates, and the 5-digit decimal numbers in the respective columns are the present value of 1 factors. When using Table 3, the future value is multiplied by the present value factor specifi ed at the intersection of the number of periods and the discount rate.

TABLE 3 Present Value of 1

(n) Periods 4% 5% 6% 7% 8% 9% 10% 11% 12% 15%

1 .96154 .95238 .94340 .93458 .92593 .91743 .90909 .90090 .89286 .86957 2 .92456 .90703 .89000 .87344 .85734 .84168 .82645 .81162 .79719 .75614 3 .88900 .86384 .83962 .81630 .79383 .77218 .75132 .73119 .71178 .65752 4 .85480 .82270 .79209 .76290 .73503 .70843 .68301 .65873 .63552 .57175 5 .82193 .78353 .74726 .71299 .68058 .64993 .62092 .59345 .56743 .49718

6 .79031 .74622 .70496 .66634 .63017 .59627 .56447 .53464 .50663 .43233 7 .75992 .71068 .66506 .62275 .58349 .54703 .51316 .48166 .45235 .37594 8 .73069 .67684 .62741 .58201 .54027 .50187 .46651 .43393 .40388 .32690 9 .70259 .64461 .59190 .54393 .50025 .46043 .42410 .39092 .36061 .28426 10 .67556 .61391 .55839 .50835 .46319 .42241 .38554 .35218 .32197 .24719

11 .64958 .58468 .52679 .47509 .42888 .38753 .35049 .31728 .28748 .21494 12 .62460 .55684 .49697 .44401 .39711 .35554 .31863 .28584 .25668 .18691 13 .60057 .53032 .46884 .41496 .36770 .32618 .28966 .25751 .22917 .16253 14 .57748 .50507 .44230 .38782 .34046 .29925 .26333 .23199 .20462 .14133 15 .55526 .48102 .41727 .36245 .31524 .27454 .23939 .20900 .18270 .12289

16 .53391 .45811 .39365 .33873 .29189 .25187 .21763 .18829 .16312 .10687 17 .51337 .43630 .37136 .31657 .27027 .23107 .19785 .16963 .14564 .09293 18 .49363 .41552 .35034 .29586 .25025 .21199 .17986 .15282 .13004 .08081 19 .47464 .39573 .33051 .27615 .23171 .19449 .16351 .13768 .11611 .07027 20 .45639 .37689 .31180 .25842 .21455 .17843 .14864 .12403 .10367 .06110

For example, the present value factor for one period at a discount rate of 10% is .90909, which equals the $909.09 ($1,000 × .90909) computed in Illustration G-10. For two periods at a discount rate of 10%, the present value factor is .82645, which equals the $826.45 ($1,000 × .82645) computed previously. Note that a higher discount rate produces a smaller present value. For exam- ple, using a 15% discount rate, the present value of $1,000 due one year from now is $869.57, versus $909.09 at 10%. Also note that the further removed from the present the future value is, the smaller the present value. For example, using the same discount rate of 10%, the present value of $1,000 due in fi ve years is $620.92. The present value of $1,000 due in one year is $909.09, a difference of $288.17.

Present Values G-9

The following two demonstration problems (Illustrations G-12 and G-13) illustrate how to use Table 3.

PRESENT VALUE OF AN ANNUITY

The preceding discussion involved the discounting of only a single future amount. Businesses and individuals frequently engage in transactions in which a series of equal dollar amounts are to be received or paid at evenly spaced time intervals (periodically). Examples of a series of periodic receipts or payments are loan agreements, installment sales, mortgage notes, lease (rental) contracts, and pen- sion obligations. As discussed earlier, these periodic receipts or payments are annuities. The present value of an annuity is the value now of a series of future receipts or payments, discounted assuming compound interest. In computing the present value of an annuity, it is necessary to know (1) the discount rate, (2) the number of payments (receipts), and (3) the amount of the periodic receipts or payments. To illustrate the computation of the present value of an annuity, assume that you

i = 9%

PV = ?

Today

$5,000

4 years1

Determine the amount you must deposit today in your super savings account, paying 9% interest, in order to accumulate $5,000 for a down payment 4 years from now on a new car.

Answer: The present value factor from Table 3 is .70843 (4 periods at 9%). The present value of $5,000 to be received in 4 years discounted at 9% is $3,542.15 ($5,000 × .70843).

2 n = 4

ILLUSTRATION G-13 Demonstration problem—Using Table 3 for PV of 1

i = 8%

PV = ?

Now

$10,000

3 years1

Suppose you have a winning lottery ticket and the state gives you the option of taking $10,000 3 years from now or taking the present value of $10,000 now. The state uses an 8% rate in discounting. How much will you receive if you accept your winnings now?

Answer: The present value factor from Table 3 is .79383 (3 periods at 8%). The present value of $10,000 to be received in 3 years discounted at 8% is $7,938.30 ($10,000 × .79383).

n = 3

ILLUSTRATION G-12 Demonstration problem—Using Table 3 for PV of 1

G-10 G Time Value of Money

will receive $1,000 cash annually for three years at a time when the discount rate is 10%. This situation is depicted in the time diagram in Illustration G-14. Illus- tration G-15 shows the computation of its present value in this situation.

This method of calculation is required when the periodic cash fl ows are not uniform in each period. However, when the future receipts are the same in each period, an annuity table can be used. As illustrated in Table 4 below, an annuity table shows the present value of 1 to be received periodically for a given number of payments. It assumes that each payment is made at the end of each period.

TABLE 4 Present Value of an Annuity of 1

(n) Payments 4% 5% 6% 7% 8% 9% 10% 11% 12% 15%

1 .96154 .95238 .94340 .93458 .92593 .91743 .90909 .90090 .89286 .86957 2 1.88609 1.85941 1.83339 1.80802 1.78326 1.75911 1.73554 1.71252 1.69005 1.62571 3 2.77509 2.72325 2.67301 2.62432 2.57710 2.53130 2.48685 2.44371 2.40183 2.28323 4 3.62990 3.54595 3.46511 3.38721 3.31213 3.23972 3.16986 3.10245 3.03735 2.85498 5 4.45182 4.32948 4.21236 4.10020 3.99271 3.88965 3.79079 3.69590 3.60478 3.35216

6 5.24214 5.07569 4.91732 4.76654 4.62288 4.48592 4.35526 4.23054 4.11141 3.78448 7 6.00205 5.78637 5.58238 5.38929 5.20637 5.03295 4.86842 4.71220 4.56376 4.16042 8 6.73274 6.46321 6.20979 5.97130 5.74664 5.53482 5.33493 5.14612 4.96764 4.48732 9 7.43533 7.10782 6.80169 6.51523 6.24689 5.99525 5.75902 5.53705 5.32825 4.77158 10 8.11090 7.72173 7.36009 7.02358 6.71008 6.41766 6.14457 5.88923 5.65022 5.01877

11 8.76048 8.30641 7.88687 7.49867 7.13896 6.80519 6.49506 6.20652 5.93770 5.23371 12 9.38507 8.86325 8.38384 7.94269 7.53608 7.16073 6.81369 6.49236 6.19437 5.42062 13 9.98565 9.39357 8.85268 8.35765 7.90378 7.48690 7.10336 6.74987 6.42355 5.58315 14 10.56312 9.89864 9.29498 8.74547 8.24424 7.78615 7.36669 6.98187 6.62817 5.72448 15 11.11839 10.37966 9.71225 9.10791 8.55948 8.06069 7.60608 7.19087 6.81086 5.84737

16 11.65230 10.83777 10.10590 9.44665 8.85137 8.31256 7.82371 7.37916 6.97399 5.95424 17 12.16567 11.27407 10.47726 9.76322 9.12164 8.54363 8.02155 7.54879 7.11963 6.04716 18 12.65930 11.68959 10.82760 10.05909 9.37189 8.75563 8.20141 7.70162 7.24967 6.12797 19 13.13394 12.08532 11.15812 10.33560 9.60360 8.95012 8.36492 7.83929 7.36578 6.19823 20 13.59033 12.46221 11.46992 10.59401 9.81815 9.12855 8.51356 7.96333 7.46944 6.25933

Table 4 shows that the present value of an annuity of 1 factor for three payments at 10% is 2.48685.1 This present value factor is the total of the three

1The difference of .00001 between 2.48686 and 2.48685 is due to rounding.

i = 10%

2Today 3 years

PV = ? $1,000 $1,000$1,000

1 n = 3

ILLUSTRATION G-14 Time diagram for a three-year annuity

ILLUSTRATION G-15 Present value of a series of future amounts computation

Present Value of 1 Future Amount × Factor at 10% = Present Value $1,000 (1 year away) .90909 $ 909.09 1,000 (2 years away) .82645 826.45 1,000 (3 years away) .75132 751.32

2.48686 $2,486.86

Present Values G-11

individual present value factors, as shown in Illustration G-15. Applying this amount to the annual cash fl ow of $1,000 produces a present value of $2,486.85. The following demonstration problem (Illustration G-16) illustrates how to use Table 4.

Note that the same concepts apply in situations when the price and inter- est rate are known, but the payment must be calculated. Suppose, for exam- ple, that in Illustration G-16 that the price of the lease contract is $21,628.68 and that Kildare Company wants to fi nance the lease contract by making fi ve annual lease payments when the annual rate of interest is 12%. In this case, rather than solving for the present value, we need to solve for the amount of the annual payment. To do this, we divide the price (the present value) of $21,628.68 by the present value factor of 3.60478 to arrive at an annual pay- ment of $6,000.

TIME PERIODS AND DISCOUNTING

In the preceding calculations, the discounting was done on an annual basis using an annual interest rate. Discounting may also be done over shorter periods of time such as monthly, quarterly, or semiannually. When the time frame is less than one year, it is necessary to convert the annual interest rate to the applicable time frame. Assume, for example, that the investor in Illustration G-14 received $500 semiannually for three years instead of $1,000 annually. In this case, the number of periods becomes six (3 × 2), the discount rate is 5% (10% ÷ 2), the present value factor from Table 4 is 5.07569 (6 periods at 5%), and the present value of the future cash fl ows is $2,537.85 (5.07569 × $500). This amount is slightly higher than the $2,486.86 computed in Illustration G-15 because interest is computed twice during the same year. That is, during the second half of the year, interest is earned on the fi rst half-year’s interest.

PRESENT VALUE OF A LONG-TERM NOTE OR BOND

The present value (or market price) of a long-term note or bond is a function of three variables: (1) the payment amounts, (2) the length of time until the amounts are paid, and (3) the discount rate. Our example uses a fi ve-year bond issue. The fi rst variable (dollars to be paid) is made up of two elements: (1) a series of interest payments (an annuity) and (2) the principal amount (a single sum). To

i = 12%

PV = ?

Today

$6,000

5 years1

Kildare Company has just signed a capitalizable lease contract for equip- ment that requires rental payments of $6,000 each, to be paid at the end of each of the next 5 years. The appropriate discount rate is 12%. What is the present value of the rental payments—that is, the amount used to capitalize the leased equipment?

Answer: The present value factor from Table 4 is 3.60478 (5 payments at 12%). The present value of 5 payments of $6,000 each discounted at 12% is $21,628.68 ($6,000 × 3.60478).

$6,000 $6,000

2 3

$6,000 $6,000

n = 5

ILLUSTRATION G-16 Demonstration problem—Using Table 4 for PV of an annuity of 1

G-12 G Time Value of Money

compute the present value of the bond, both the interest payments and the princi- pal amount must be discounted—two different computations. The time diagrams for a bond due in fi ve years are shown in Illustration G-17.

ILLUSTRATION G-17 Time diagrams for the present value of a bond

Interest Rate (i)

1 yr.

PV = ?

Today

Principal Amount

5 yr.

Diagram for

Principal 2 yr. 3 yr. 4 yr.

Annuity

1 yr.

PV = ?

Today 5 yr.

Diagram for

Interest 2 yr. 3 yr. 4 yr.

Interest Rate (i) Annuity Annuity Annuity Annuity

n = 5

ILLUSTRATION G-18 Time diagram for present value of a 10%, fi ve-year bond paying interest semiannually

i = 5%

PV = ?

Today

Principal Amount $100,000

Diagram for

Principal 5 6

PV = ?

Today 10

Diagram for

Interest 5 6

i = 5% $5,000

$5,000 $5,000 $5,000 $5,000$5,000 $5,000 $5,000 $5,000

n = 10

$5,000

Interest Payments

When the investor’s market interest rate is equal to the bond’s contractual inter- est rate, the present value of the bonds will equal the face value of the bonds. To illustrate, assume a bond issue of 10%, fi ve-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. If the discount rate is the same as the contractual rate, the bonds will sell at face value. In this case, the investor will receive (1) $100,000 at maturity and (2) a series of ten $5,000 interest payments [($100,000 × 10%) ÷ 2] over the term of the bonds. The length of time is expressed in terms of interest periods—in this case—10, and the discount rate per interest period, 5%. The following time diagram (Illustration G-18) depicts the variables involved in this discounting situation.

Using Financial Calculators G-13

Illustration G-19 shows the computation of the present value of these bonds.

Now assume that the investor’s required rate of return is 12%, not 10%. The future amounts are again $100,000 and $5,000, respectively, but now a discount rate of 6% (12% ÷ 2) must be used. The present value of the bonds is $92,639, as computed in Illustration G-20.

Conversely, if the discount rate is 8% and the contractual rate is 10%, the present value of the bonds is $108,111, computed as shown in Illustration G-21.

The above discussion relied on present value tables in solving present value problems. Calculators may also be used to compute present values without the use of these tables. Many calculators, especially fi nancial calculators, have pres- ent value (PV) functions that allow you to calculate present values by merely inputting the proper amount, discount rate, periods, and pressing the PV key. We discuss the use of fi nancial calculators in the next section.

LEARNING OBJECTIVE 3 Use a fi nancial calculator to solve time value of money problems.▼

Business professionals, once they have mastered the underlying time value of money concepts, often use a fi nancial calculator to solve these types of problems. To use fi nancial calculators, you enter the time value of money variables into the

ILLUSTRATION G-19 Present value of principal and interest—face value

10% Contractual Rate—10% Discount Rate

Present value of principal to be received at maturity $100,000 × PV of 1 due in 10 periods at 5% $100,000 × .61391 (Table 3) $ 61,391 Present value of interest to be received periodically over the term of the bonds $5,000 × PV of 1 due periodically for 10 periods at 5% $5,000 × 7.72173 (Table 4) 38,609* Present value of bonds $100,000

*Rounded

ILLUSTRATION G-20 Present value of principal and interest—discount

10% Contractual Rate—12% Discount Rate

Present value of principal to be received at maturity $100,000 × .55839 (Table 3) $ 55,839 Present value of interest to be received periodically over the term of the bonds $5,000 × 7.36009 (Table 4) 36,800 Present value of bonds $92,639

ILLUSTRATION G-21 Present value of principal and interest—premium

10% Contractual Rate—8% Discount Rate

Present value of principal to be received at maturity $100,000 × .67556 (Table 3) $ 67,556 Present value of interest to be received periodically over the term of the bonds $5,000 × 8.11090 (Table 4) 40,555 Present value of bonds $108,111

G-14 G Time Value of Money

calculator. Illustration G-22 shows the fi ve most common keys used to solve time value of money problems.2

2On many calculators, these keys are actual buttons on the face of the calculator; on others, they appear on the display after the user accesses a present value menu.

N FVPMTPVI

ILLUSTRATION G-22 Financial calculator keys

where:

N = number of periods I = interest rate per period (some calculators use I/YR or i) PV = present value (occurs at the beginning of the fi rst period) PMT = payment (all payments are equal, and none are skipped) FV = future value (occurs at the end of the last period)

In solving time value of money problems in this appendix, you will generally be given three of four variables and will have to solve for the remaining variable. The fi fth key (the key not used) is given a value of zero to ensure that this variable is not used in the computation.

PRESENT VALUE OF A SINGLE SUM

To illustrate how to solve a present value problem using a fi nancial calculator, assume that you want to know the present value of $84,253 to be received in fi ve years, discounted at 11% compounded annually. Illustration G-23 depicts this problem.

? 0 84,253

–50,000

Inputs: 5

Answer:

N FVPMTPVI

ILLUSTRATION G-23 Calculator solution for present value of a single sum

Illustration G-23 shows you the information (inputs) to enter into the calculator: N = 5, I = 11, PMT = 0, and FV = 84,253. You then press PV for the answer: −$50,000. As indicated, the PMT key was given a value of zero because a series of payments did not occur in this problem.

Plus and Minus The use of plus and minus signs in time value of money problems with a fi nancial calculator can be confusing. Most fi nancial calculators are programmed so that the positive and negative cash fl ows in any problem offset each other. In the pres- ent value problem above, we identifi ed the $84,253 future value initial investment as a positive (infl ow); the answer −$50,000 was shown as a negative amount, refl ecting a cash outfl ow. If the 84,253 were entered as a negative, then the fi nal answer would have been reported as a positive 50,000. Hopefully, the sign convention will not cause confusion. If you understand what is required in a problem, you should be able to interpret a positive or nega- tive amount in determining the solution to a problem.

Using Financial Calculators G-15

Compounding Periods In the previous problem, we assumed that compounding occurs once a year. Some fi nancial calculators have a default setting, which assumes that compound- ing occurs 12 times a year. You must determine what default period has been pro- grammed into your calculator and change it as necessary to arrive at the proper compounding period.

Rounding Most fi nancial calculators store and calculate using 12 decimal places. As a result, because compound interest tables generally have factors only up to fi ve decimal places, a slight difference in the fi nal answer can result. In most time value of money problems in this textbook, the fi nal answer will not include more than two decimal places.

PRESENT VALUE OF AN ANNUITY

To illustrate how to solve a present value of an annuity problem using a fi nancial calculator, assume that you are asked to determine the present value of rental receipts of $6,000 each to be received at the end of each of the next fi ve years, when discounted at 12%, as pictured in Illustration G-24.

Inputs: 5 12 ? 6,000 0

Answer: –21,628.66

N FVPMTPVI

ILLUSTRATION G-24 Calculator solution for present value of an annuity

In this case, you enter N = 5, I = 12, PMT = 6,000, FV = 0, and then press PV to arrive at the answer of −$21,628.66.

USEFUL APPLICATIONS OF THE FINANCIAL CALCULATOR

With a fi nancial calculator, you can solve for any interest rate or for any number of periods in a time value of money problem. Here are some examples of these applications.

Auto Loan Assume you are fi nancing the purchase of a used car with a three-year loan. The loan has a 9.5% stated annual interest rate, compounded monthly. The price of the car is $6,000, and you want to determine the monthly payments, assuming that the payments start one month after the purchase. This problem is pictured in Illustration G-25.

Inputs: 36 9.5 6,000 ? 0

Answer:

N FVPVI

–192.20

PMT

ILLUSTRATION G-25 Calculator solution for auto loan payments

To solve this problem, you enter N = 36 (12 × 3), I = 9.5, PV = 6,000, FV = 0, and then press PMT. You will fi nd that the monthly payments will be $192.20. Note that the payment key is usually programmed for 12 payments per year. Thus, you must change the default (compounding period) if the payments are other than monthly.

G-16 G Time Value of Money

Mortgage Loan Amount Say you are evaluating fi nancing options for a loan on a house (a mortgage). You decide that the maximum mortgage payment you can afford is $700 per month. The annual interest rate is 8.4%. If you get a mortgage that requires you to make monthly payments over a 15-year period, what is the maximum home loan you can afford? Illustration G-26 depicts this problem.

Inputs: 180 8.4 ? 0

Answer:

N FVPMTPVI

–700

71,509.81

ILLUSTRATION G-26 Calculator solution for mortgage amount

LEARNING OBJECTIVES REVIEW

REVIEW

1 Compute interest and future values. Simple interest is computed on the principal only, while compound interest is computed on the principal and any interest earned that has not been withdrawn.

To solve for future value of a single amount, prepare a time diagram of the problem. Identify the principal amount, the number of compounding periods, and the interest rate. Using the future value of 1 table, multiply the principal amount by the future value factor specifi ed at the intersec- tion of the number of periods and the interest rate.

To solve for future value of an annuity, prepare a time diagram of the problem. Identify the amount of the periodic payments (receipts), the number of payments (receipts), and the interest rate. Using the future value of an annuity of 1 table, multiply the amount of the payments by the future value factor specifi ed at the intersection of the number of periods and the interest rate.

2 Compute present value. The following three variables are fundamental to solving present value problems: (1) the future amount, (2) the number of periods, and (3) the interest rate (the discount rate).

To solve for present value of a single amount, prepare a time diagram of the problem. Identify the future amount, the number of discounting periods, and the discount (interest) rate. Using the present value of a single amount table, multiply the future amount by the present value fac- tor specifi ed at the intersection of the number of periods and the discount rate.

To solve for present value of an annuity, prepare a time diagram of the problem. Identify the amount of future

periodic receipts or payments (annuities), the number of payments (receipts), and the discount (interest) rate. Using the present value of an annuity of 1 table, multiply the amount of the annuity by the present value factor speci- fi ed at the intersection of the number of payments and the interest rate.

To compute the present value of notes and bonds, deter- mine the present value of the principal amount and the present value of the interest payments. Multiply the prin- cipal amount (a single future amount) by the present value factor (from the present value of 1 table) intersecting at the number of periods (number of interest payments) and the discount rate. To determine the present value of the series of interest payments, multiply the amount of the interest payment by the present value factor (from the present value of an annuity of 1 table) intersecting at the number of periods (number of interest payments) and the discount rate. Add the present value of the principal amount to the present value of the interest payments to arrive at the present value of the note or bond.

3 Use a fi nancial calculator to solve time value of money problems. Financial calculators can be used to solve the same and additional problems as those solved with time value of money tables. Enter into the fi nancial cal- culator the amounts for all of the known elements of a time value of money problem (periods, interest rate, payments, future or present value), and it solves for the unknown element. Particularly useful situations involve interest rates and compounding periods not presented in the tables.

▼

You enter N = 180 (12 × 15 years), I = 8.4, PMT = −700, FV = 0, and press PV. With the payments-per-year key set at 12, you fi nd a present value of $71,509.81— the maximum home loan you can afford, given that you want to keep your mort- gage payments at $700. Note that by changing any of the variables, you can quickly conduct “what-if” analyses for different situations.

Brief Exercises G-17

Annuity A series of equal dollar amounts to be paid or received at evenly spaced time intervals (periodically). (p. G-5).

Compound interest The interest computed on the prin- cipal and any interest earned that has not been paid or withdrawn. (p. G-2).

Discounting the future amount(s) The process of deter- mining present value. (p. G-7).

Future value of an annuity The sum of all the payments (receipts) plus the accumulated compound interest on them. (p. G-5).

Future value of a single amount The value at a future date of a given amount invested, assuming compound interest. (p. G-3).

Interest Payment for the use of another person’s money. (p. G-1).

Present value The value now of a given amount to be paid or received in the future, assuming compound interest. (p. G-7).

Present value of an annuity The value now of a series of future receipts or payments, discounted assuming com- pound interest. (p. G-9).

Principal The amount borrowed or invested. (p. G-1).

Simple interest The interest computed on the principal only. (p. G-2).

GLOSSARY REVIEW▼

Many additional resources are available for practice in WileyPLUS.

BRIEF EXERCISES▼

(Use tables to solve exercises BEG-1 to BEG-23.)

BEG-1 Jozy Altidore invested $6,000 at 5% annual interest, and left the money invested without withdrawing any of the interest for 12 years. At the end of the 12 years, Jozy with- drew the accumulated amount of money. (a) What amount did Jozy withdraw, assuming the investment earns simple interest? (b) What amount did Jozy withdraw, assuming the investment earns interest compounded annually?

BEG-2 For each of the following cases, indicate (a) what interest rate columns and (b) what number of periods you would refer to in looking up the future value factor.

(1) In Table 1 (future value of 1):

Annual Number of Rate Years Invested Compounded

Case A 5% 3 Annually Case B 12% 4 Semiannually

(2) In Table 2 (future value of an annuity of 1):

Annual Number of Rate Years Invested Compounded

Case A 3% 8 Annually Case B 8% 6 Semiannually

BEG-3 Liam Company signed a lease for an offi ce building for a period of 12 years. Under the lease agreement, a security deposit of $9,600 is made. The deposit will be returned at the expiration of the lease with interest compounded at 4% per year. What amount will Liam receive at the time the lease expires?

Compute the future value of a single amount.

(LO 1), AP

Use future value tables.

(LO 1), C

Compute the future value of a single amount.

(LO 1), AP

G-18 G Time Value of Money

BEG-4 Bates Company issued $1,000,000, 10-year bonds and agreed to make annual sinking fund deposits of $78,000. The deposits are made at the end of each year into an account paying 6% annual interest. What amount will be in the sinking fund at the end of 10 years?

BEG-5 Andrew and Emma Garfi eld invested $8,000 in a savings account paying 5% an- nual interest when their daughter, Angela, was born. They also deposited $1,000 on each of her birthdays until she was 18 (including her 18th birthday). How much was in the savings account on her 18th birthday (after the last deposit)?

BEG-6 Hugh Curtin borrowed $35,000 on July 1, 2017. This amount plus accrued interest at 8% compounded annually is to be repaid on July 1, 2022. How much will Hugh have to repay on July 1, 2022?

BEG-7 Sara has just graduated from college. She has determined that to purchase a home in 8 years she needs to accumulate $20,000 for a down payment. If Sara can earn 6% per year on her savings, what is the amount of the annual annuity payment that Sara must make at the end of each year for 8 years?

BEG-8 For each of the following cases, indicate (a) what interest rate columns and (b) what number of periods you would refer to in looking up the discount rate.

(1) In Table 3 (present value of 1):

Annual Number of Discounts Rate Years Involved per Year

Case A 12% 7 Annually Case B 8% 11 Annually Case C 10% 8 Semiannually

(2) In Table 4 (present value of an annuity of 1):

Annual Number of Number of Frequency of Rate Years Involved Payments Involved Payments

Case A 10% 20 20 Annually Case B 10% 7 7 Annually Case C 6% 5 10 Semiannually

BEG-9 (a) What is the present value of $25,000 due 9 periods from now, discounted at 10%? (b) What is the present value of $25,000 to be received at the end of each of 6

periods, discounted at 9%?

BEG-10 Messi Company is considering an investment that will return a lump sum of $900,000 6 years from now. What amount should Messi Company pay for this investment to earn an 8% return?

BEG-11 Lloyd Company earns 6% on an investment that will return $450,000 8 years from now. What is the amount Lloyd should invest now to earn this rate of return?

BEG-12 Robben Company is considering investing in an annuity contract that will return $40,000 annually at the end of each year for 15 years. What amount should Robben Com- pany pay for this investment if it earns an 8% return?

BEG-13 Kaehler Enterprises earns 5% on an investment that pays back $80,000 at the end of each of the next 6 years. What is the amount Kaehler Enterprises invested to earn the 5% rate of return?

BEG-14 Dempsey Railroad Co. is about to issue $400,000 of 10-year bonds paying an 11% interest rate, with interest payable semiannually. The discount rate for such securities is 10%. How much can Dempsey expect to receive for the sale of these bonds?

BEG-15 Assume the same information as BEG-14 except that the discount rate is 12% instead of 10%. In this case, how much can Dempsey expect to receive from the sale of these bonds?

Compute the future value of an annuity.

(LO 1), AP

Compute the future value of a single amount and of an annuity.

(LO 1), AP

Compute the future value of a single amount.

(LO 1), AP

Compute the annuity payment amount of a known future value.

(LO 1), AP

Use present value tables.

(LO 2), C

Determine present values.

(LO 2), AP

Compute the present value of a single amount investment.

(LO 2), AP

Compute the present value of a single amount investment.

(LO 2), AP Compute the present value of an annuity investment.

(LO 2), AP

Compute the present value of an annual investment.

(LO 2), AP

Compute the present value of bonds.

(LO 2), AP

Compute the present value of bonds.

(LO 2), AP

Brief Exercises G-19

BEG-16 Neymar Taco Company receives a $75,000, 6-year note bearing interest of 4% (paid annually) from a customer at a time when the discount rate is 6%. What is the pres- ent value of the note received by Neymar?

BEG-17 Gleason Enterprises issued 6%, 8-year, $2,500,000 par value bonds that pay in- terest semiannually on October 1 and April 1. The bonds are dated April 1, 2017, and are issued on that date. The discount rate of interest for such bonds on April 1, 2017, is 8%. What cash proceeds did Gleason receive from issuance of the bonds?

BEG-18 Frazier Company issues a 10%, 5-year mortgage note on January 1, 2017, to obtain fi nancing for new equipment. Land is used as collateral for the note. The terms provide for semiannual installment payments of $48,850. What are the cash proceeds received from the issuance of the note?

BEG-19 If Colleen Mooney invests $4,765.50 now and she will receive $12,000 at the end of 12 years, what annual rate of interest will Colleen earn on her investment? (Hint: Use Table 3.)

BEG-20 Tim Howard has been offered the opportunity of investing $36,125 now. The in- vestment will earn 11% per year and at the end of that time will return Tim $75,000. How many years must Tim wait to receive $75,000? (Hint: Use Table 3.)

BEG-21 Joanne Quick made an investment of $10,271.38. From this investment, she will receive $1,200 annually for the next 15 years starting one year from now. What rate of interest will Joanne’s investment be earning for her? (Hint: Use Table 4.)

BEG-22 Kevin Morales invests $7,793.83 now for a series of $1,300 annual returns begin- ning one year from now. Kevin will earn a return of 9% on the initial investment. How many annual payments of $1,300 will Kevin receive? (Hint: Use Table 4.)

BEG-23 Sophie Corp. purchased a new blending machine for $3,150.15. It paid $500 down and fi nanced the remaining $2,650.15. It is required to pay 10 annual payments at the end of each year at an annual rate of interest of 11%. What is the amount of the annual payment?

BEG-24 Carly Simon wishes to invest $18,000 on July 1, 2017, and have it accumulate to $50,000 by July 1, 2027. Use a fi nancial calculator to determine at what exact annual rate of interest Carly must invest the $18,000.

BEG-25 On July 17, 2016, Keith Urban borrowed $42,000 from his grandfather to open a clothing store. Starting July 17, 2017, Keith has to make 10 equal annual payments of $6,500 each to repay the loan. Use a fi nancial calculator to determine what interest rate Keith is paying.

BEG-26 As the purchaser of a new house, Carrie Underwood has signed a mortgage note to pay the Nashville National Bank and Trust Co. $8,400 every 6 months for 20 years, at the end of which time she will own the house. At the date the mortgage is signed, the purchase price was $198,000 and Underwood made a down payment of $20,000. The fi rst payment will be made 6 months after the date the mortgage is signed. Using a fi nancial calculator, compute the exact rate of interest earned on the mortgage by the bank.

BEG-27 Using a fi nancial calculator, solve for the unknowns in each of the following situations. (a) On June 1, 2016, Jennifer Lawrence purchases lakefront property from her neighbor,

Josh Hutcherson, and agrees to pay the purchase price in seven payments of $16,000 each, the fi rst payment to be payable June 1, 2017. (Assume that interest compounded at an annual rate of 7.35% is implicit in the payments.) What is the purchase price of the property?

Compute the present value of a note.

(LO 2), AP

Compute the present value of bonds.

(LO 2), AP

Compute the present value of a note.

(LO 2), AP

Compute the interest rate on a single amount.

(LO 2), AP

Compute the number of periods of a single amount.

(LO 2), AP

Compute the interest rate on an annuity.

(LO 2), AP

Compute the number of periods of an annuity.

(LO 2), AP

Compute the annuity payment amount of a known present value.

(LO 2), AP

Determine interest rate.

(LO 3), AP

Determine interest rate.

(LO 3), AP

Determine interest rate.

(LO 3), AP

Various time value of money situations.

(LO 3), AP

G-20 G Time Value of Money

(b) On January 1, 2016, Gerrard Corporation purchased 200 of the $1,000 face value, 8% coupon, 10-year bonds of Sterling Inc. The bonds mature on January 1, 2026, and pay interest annually beginning January 1, 2017. Gerrard purchased the bonds to yield 10.65%. How much did Gerrard pay for the bonds?

BEG-28 Using a fi nancial calculator, provide a solution to each of the following situations. (a) Lynn Anglin owes a debt of $42,000 from the purchase of her new sport utility vehicle.

The debt bears annual interest of 7.8% compounded monthly. Lynn wishes to pay the debt and interest in equal monthly payments over 8 years, beginning one month hence. What equal monthly payments will pay off the debt and interest?

(b) On January 1, 2017, Roger Molony offers to buy Dave Feeney’s used snowmobile for $8,000, payable in fi ve equal annual installments, which are to include 7.25% interest on the unpaid balance and a portion of the principal. If the fi rst payment is to be made on December 31, 2017, how much will each payment be?

Various time value of money situations.

(LO 3), AP

Some companies believe in aggressive growth through investing in the stock of existing companies.

Besides purchasing stock, companies also purchase other securities such as bonds issued by

corporations or by governments. Companies can make investments for a short or long period of time,

as a passive investment, or with the intent to control another company. As you will see in this appendix,

the way in which a company accounts for its investments is determined by a number of factors.

APPENDIX PREVIEW

Reporting and Analyzing Investments

LEARNING OBJECTIVE 1 Explain how to account for debt investments.▼

WHY CORPORATIONS INVEST

Corporations purchase investments in debt or equity securities generally for one of three reasons. First, a corporation may have excess cash that it does not need for the immediate purchase of operating assets. For example, many companies

LEARNING OBJECTIVES

APPENDIX OUTLINE

• Why corporations invest • Accounting for debt investments▼1

Explain how to account for debt investments.

• Categories of securities • Balance sheet presentation • Presentation of realized and unrealized gain or loss • Statement of cash fl ows presentation

Discuss how debt and stock invest- ments are reported in the fi nancial statements.

2 Explain how to account for stock investments. • Holdings of less than 20% • Holdings between 20% and 50% • Holdings of more than 50%

▼ ▼

H-1

H-2 H Reporting and Analyzing Investments

experience seasonal fl uctuations in sales. A Cape Cod marina has more sales in the spring and summer than in the fall and winter. The reverse is true for an Aspen ski shop. Thus, at the end of an operating cycle, many companies may have cash on hand that is temporarily idle until the start of another operating cycle. These companies may invest the excess funds to earn—through interest and dividends— a greater return than they would get by just holding the funds in the bank. Illustra- tion H-1 shows the role that such temporary investments play in the operating cycle.

A second reason some companies such as banks purchase investments is to generate earnings from investment income. Although banks make most of their earnings by lending money, they also generate earnings by investing in primarily debt securities. Banks purchase investment securities because loan demand var- ies both seasonally and with changes in the economic climate. Thus, when loan demand is low, a bank must fi nd other uses for its cash. Some companies attempt to generate investment income through specula- tive investments. That is, they are speculating that the investment will increase in value and thus result in positive returns. Therefore, they invest mostly in the common stock of other corporations. Third, companies also invest for strategic reasons. A company may purchase a noncontrolling interest in another company in a related industry in which it wishes to establish a presence. Or, a company can exercise some infl uence over one of its customers or suppliers by purchasing a signifi cant, but not control- ling, interest in that company. Another option is for a corporation to purchase a controlling interest in another company in order to enter a new industry without incurring the costs and risks associated with starting from scratch. In summary, businesses invest in other companies for the reasons shown in Illustration H-2.

Accounts Receivable

Inventory

Invest Temporary InvestmentsSellCash

ILLUSTRATION H-1 Temporary investments and the operating cycle

Low-risk, highly liquid, short-term securities such as government-issued securities

Banks and financial institutions often purchase debt securities, while mutual funds and index funds purchase both debt and stock securities

To generate earnings

To house excess cash until needed

Stocks of companies in a related industry or in an unrelated industry that the company wishes to enter

Reason Typical Investment

To meet strategic goals

BANK

I need 1,000 Treasury bills by tonight.

ILLUSTRATION H-2 Why corporations invest

Accounting for Debt Investments H-3

ACCOUNTING FOR DEBT INVESTMENTS

Debt investments are investments in government and corporation bonds. In accounting for debt investments, companies must make entries to record (1) the acquisition, (2) the interest revenue, and (3) the sale.

Recording Acquisition of Bonds At acquisition, debt investments are recorded at cost. Cost includes all expen- ditures necessary to acquire these investments, such as the price paid plus bro- kerage fees (commissions), if any. For example, assume that Kuhl Corporation acquires 50 Doan Inc. 8%, 10-year, $1,000 bonds on January 1, 2017, at a cost of $50,000. Kuhl records the investment as:

Jan. 1 Debt Investments 50,000 Cash 50,000 (To record purchase of 50 Doan Inc.

bonds)

Recording Bond Interest The Doan Inc. bonds pay interest of $4,000 annually on January 1 ($50,000 × 8%). If Kuhl Corporation’s fi scal year ends on December 31, it accrues the interest of $4,000 earned since January 1. The adjusting entry is:

Dec. 31 Interest Receivable 4,000 Interest Revenue 4,000 (To accrue interest on Doan Inc. bonds)

Kuhl reports Interest Receivable as a current asset in the balance sheet. It reports Interest Revenue under “Other revenues and gains” in the income statement. Kuhl records receipt of the interest on January 1 as follows.

Jan. 1 Cash 4,000 Interest Receivable 4,000 (To record receipt of accrued interest)

A credit to Interest Revenue at this time would be incorrect. Why? Because the company earned and accrued the interest revenue in the preceding accounting period.

Recording Sale of Bonds When Kuhl Corporation sells the bond investments, it credits the investment account for the cost of the bonds. The company records as a gain or loss any dif- ference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds. Assume, for example, that Kuhl receives net proceeds of $54,000 on the sale of the Doan Inc. bonds on January 1, 2018, after receiving the interest due. Since the securities cost $50,000, Kuhl has realized a gain of $4,000. It records the sale as follows.

Jan. 1 Cash 54,000 Debt Investments 50,000 Gain on Sale of Debt Investments 4,000 (To record sale of Doan Inc. bonds)

Kuhl reports the gain on the sale of debt investments under “Other revenues and gains” in the income statement and reports losses under “Other expenses and losses.”

A L SE= + +50,000 −50,000 Cash Flows −50,000

A L SE= + +4,000

+4,000 Rev Cash Flows no eff ect

A L SE= + +4,000 −4,000 Cash Flows +4,000

A L SE= + +54,000 −50,000

+4,000 Rev Cash Flows +54,000

▼ HELPFUL HINT The accounting for short-term debt investments and long-term debt investments is similar. Any exceptions are discussed in more advanced courses.

H-4 H Reporting and Analyzing Investments

LEARNING OBJECTIVE 2 Explain how to account for stock investments.▼

Stock investments are investments in the capital stock of corporations. When a company holds stock (and/or debt) of several different corporations, the group of securities is an investment portfolio. The accounting for investments in common stock depends on the extent of the investor’s infl uence over the operating and fi nancial affairs of the issuing cor- poration (the investee). Illustration H-3 shows the general guidelines.

Investor's Ownership Interest in Investee's

Common Stock Presumed Influence

on Investee Accounting Guidelines

Less than 20% Cost methodInsignificant

Between 20% and 50%

Equity methodSignificant

More than 50% Consolidated financial statements

Controlling

STOCK

ILLUSTRATION H-3 Accounting guidelines for stock investments

A L SE= + +40,000 −40,000 Cash Flows −40,000

Companies are required to use judgment instead of blindly following the guidelines.1 We explain and illustrate the application of each guideline next.

HOLDINGS OF LESS THAN 20%

In the accounting for stock investments of less than 20%, companies use the cost method. Under the cost method, companies record the investment at cost and recognize revenue only when cash dividends are received.

Recording Acquisition of Stock At acquisition, stock investments are recorded at cost. Cost includes all expendi- tures necessary to acquire these investments, such as the price paid plus broker- age fees (commissions), if any. Assume, for example, that on July 1, 2017, Sanchez Corporation acquires 1,000 shares (10% ownership) of Beal Corporation common stock at $40 per share. The entry for the purchase is:

July 1 Stock Investments 40,000 Cash 40,000 (To record purchase of 1,000 shares of

Beal common stock)

1Among the factors that companies should consider in determining an investor’s infl uence are whether (1) the investor has representation on the investee’s board of directors, (2) the investor participates in the investee’s policy-making process, (3) there are material transactions between the investor and the investee, and (4) the common stock held by other stockholders is concentrated or dispersed.

Accounting for Stock Investments H-5

A L SE= + +2,000

+2,000 Rev Cash Flows +2,000

A L SE= + +39,500

−500 Exp −40,000 Cash Flows +39,500

Recording Dividends During the time the company holds the stock, it makes entries for any cash divi- dends received. Thus, if Sanchez Corporation receives a $2 per share dividend on December 31, the entry is:

Dec. 31 Cash (1,000 × $2) 2,000 Dividend Revenue 2,000 (To record receipt of a cash dividend)

Sanchez reports Dividend Revenue under “Other revenues and gains” in the income statement.

Recording Sale of Stock When a company sells a stock investment, it recognizes the difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the stock as a gain or a loss. Assume, for instance, that Sanchez Corporation receives net proceeds of $39,500 on the sale of its Beal Corporation stock on February 10, 2018. Because the stock cost $40,000, Sanchez has incurred a loss of $500. It records the sale as:

Feb. 10 Cash 39,500 Loss on Sale of Stock Investments 500 Stock Investments 40,000 (To record sale of Beal common stock)

Sanchez reports the loss account under “Other expenses and losses” in the income statement and shows a gain on sale under “Other revenues and gains.”

HOLDINGS BETWEEN 20% AND 50%

When an investor company owns only a small portion of the shares of stock of another company, the investor cannot exercise control over the investee. But when an investor owns between 20% and 50% of the common stock of a corpora- tion, it is presumed that the investor has signifi cant infl uence over the fi nancial and operating activities of the investee. The investor probably has a representa- tive on the investee’s board of directors. Through that representative, the investor begins to exercise some control over the investee—and the investee company in some sense becomes part of the investor company. For example, even prior to purchasing all of Turner Broadcasting, Time Warner owned 20% of Turner. Because it exercised signifi cant control over major decisions made by Turner, Time Warner used an approach called the equity method. Under the equity method, the investor records its share of the net income of the investee in the year when it is earned. An alternative might be to delay recognizing the investor’s share of net income until a cash dividend is declared. But that approach would ignore the fact that the investor and investee are, in some sense, one company, making the investor better off by the investee’s earned income. Under the equity method, the company initially records the investment in common stock at cost. After that, it adjusts the investment account annually to show the investor’s equity in the investee. Each year, the investor does the fol- lowing. (1) It increases (debits) the investment account and increases (credits) revenue for its share of the investee’s net income.2 (2) The investor also decreases (credits) the investment account for the amount of dividends received. The invest- ment account is reduced for dividends received because payment of a dividend decreases the net assets of the investee.

2Conversely, the investor increases (debits) a loss account and decreases (credits) the investment account for its share of the investee’s net loss.

H-6 H Reporting and Analyzing Investments

Recording Acquisition of Stock Assume that Milar Corporation acquires 30% of the common stock of Beck Com- pany for $120,000 on January 1, 2017. The entry to record this transaction is:

Jan. 1 Stock Investments 120,000 Cash 120,000 (To record purchase of Beck

common stock)

Recording Revenue and Dividends For 2017, Beck reports net income of $100,000. It declares and pays a $40,000 cash dividend. Milar must record (1) its share of Beck’s income, $30,000 (30% × $100,000), and (2) the reduction in the investment account for the dividends received, $12,000 (30% × $40,000). The entries are:

(1)

Dec. 31 Stock Investments 30,000 Revenue from Stock Investments 30,000 (To record 30% equity in Beck’s 2017

net income)

(2)

Dec. 31 Cash 12,000 Stock Investments 12,000 (To record dividends received)

After Milar posts the transactions for the year, the investment and revenue accounts are as shown in Illustration H-4.

A L SE= + +120,000 −120,000 Cash Flows −120,000

A L SE= + +30,000

+30,000 Rev Cash Flows no eff ect

A L SE= + +12,000 −12,000 Cash Flows +12,000

ILLUSTRATION H-4 Investment and revenue accounts after posting

Revenue from Stock Stock Investments Investments

Jan. 1 120,000 Dec. 31 12,000 Dec. 31 30,000 Dec. 31 30,000

Dec. 31 Bal. 138,000

During the year, the investment account increased by $18,000. This $18,000 is explained as follows: (1) Milar records a $30,000 increase in revenue from its stock investment in Beck, and (2) Milar records a $12,000 decrease due to divi- dends received from its stock investment in Beck. Note that the difference between reported revenue under the cost method and reported revenue under the equity method can be signifi cant. For example, Milar would report only $12,000 of dividend revenue (30% × $40,000) if it used the cost method.

HOLDINGS OF MORE THAN 50%

A company that owns more than 50% of the common stock of another entity is known as the parent company. The entity whose stock is owned by the parent company is called the subsidiary (affi liated) company. Because of its stock own- ership, the parent company has a controlling interest in the subsidiary company. When a company owns more than 50% of the common stock of another company, it usually prepares consolidated fi nancial statements. Consolidated fi nancial statements present the assets and liabilities controlled by the parent company. They also present the total revenues and expenses of the subsidiary companies. Companies prepare consolidated statements in addition to the fi nancial statements for the individual parent and subsidiary companies.

Reporting Investments in Financial Statements H-7

As noted earlier, prior to acquiring all of Turner Broadcasting, Time Warner accounted for its investment in Turner using the equity method. Time Warner’s net investment in Turner was reported in a single line item—Other investments. After the merger, Time Warner instead consolidated Turner’s results with its own. Under this approach, Time Warner included the individual assets and liabilities of Turner with its own assets. That is, Turner’s plant and equipment were added to Time Warner’s plant and equipment, its receivables were added to Time War- ner’s receivables, and so on. A similar sort of consolidation went on when AOL merged with Time Warner.

Consolidated statements are useful to the stockholders, board of direc- tors, and management of the parent company. Consolidated statements indi- cate to creditors, prospective investors, and regulatory agencies the magnitude and scope of operations of the companies under common control. For example, regulators and the courts undoubtedly used the consolidated statements of AT&T to determine whether a breakup of the company was in the public interest. Illus- tration H-5 lists three companies that prepare consolidated statements and some of the companies they have owned.

▼ HELPFUL HINT If the parent (A) has three wholly owned subsidiaries (B, C, and D), there are four separate legal entities but only one economic entity from the viewpoint of the shareholders of the parent company.

PepsiCo Cendant The Walt Disney Company Frito-Lay Howard Johnson Capital Cities/ABC, Inc. Tropicana Ramada Inn Disneyland, Disney World Quaker Oats Century 21 Mighty Ducks Pepsi-Cola Coldwell Banker Anaheim Angels Gatorade Avis ESPN

ILLUSTRATION H-5 Examples of consolidated companies and their subsidiaries

3The FASB is currently considering a new approach to reporting investment securities. If adopted, the new approach could signifi cantly change the reporting of investments. 4This category is provided for completeness. The accounting and valuation issues related to held-to- maturity securities are discussed in more advanced accounting courses.

LEARNING OBJECTIVE 3 Discuss how debt and stock investments are reported in the fi nancial statements.▼

The value of debt and stock investments may fl uctuate greatly during the time they are held. For example, in a 12-month period, the stock of Time Warner hit a high of 581⁄2 and a low of 9. In light of such price fl uctuations, how should com- panies value investments at the balance sheet date? Valuation could be at cost, at fair value, or at the lower-of-cost-or-market value. Many people argue that fair value offers the best approach because it repre- sents the expected cash realizable value of securities. Fair value is the amount for which a security could be sold in a normal market. Others counter that unless a security is going to be sold soon, the fair value is not relevant because the price of the security will likely change again.

CATEGORIES OF SECURITIES

For purposes of valuation and reporting at a fi nancial statement date, debt and stock investments are classifi ed into three categories of securities3:

1. Trading securities are bought and held primarily for sale in the near term to generate income on short-term price differences.

2. Available-for-sale securities are held with the intent of selling them some- time in the future.

3. Held-to-maturity securities are debt securities that the investor has the intent and ability to hold to maturity.4

INTERNATIONAL NOTE A recent U.S. accounting standard gives companies the “option” of applying fair value accounting, rather than historical cost, to certain types of assets and liabilities. This makes U.S. accounting closer to international standards.

H-8 H Reporting and Analyzing Investments

Illustration H-6 shows the valuation guidelines for these securities. These guide- lines apply to all debt securities and to those stock investments in which the holdings are less than 20%.

At fair value with changes reported in net income

Trading (both debt and stock)

At fair value with changes reported in the stockholders’ equity section

Available-for-Sale (both debt and stock)

At amortized cost

Held-to-Maturity (debt only)

“We’ll sell within 10

days.”

“We’ll hold the stock for a while

to see how it performs.”

“We intend to hold until maturity.”

Trading Securities Trading securities are held with the intention of selling them in a short period of time (generally less than three months and sometimes less than a full day). Trading means frequent buying and selling. As indicated in Illustration H-6, companies adjust trading securities to fair value at the end of each period (an approach referred to as mark-to-market accounting). They report changes from cost as part of net income. The changes are reported as unrealized gains or losses because the securities have not been sold. The unrealized gain or loss is the difference between the total cost of trading securities and their total fair value. Companies classify trading securities as a current asset. As an example, Illustration H-7 shows the costs and fair values for invest- ments classifi ed as trading securities for Pace Corporation on December 31, 2017. Pace has an unrealized gain of $7,000 because total fair value ($147,000) is $7,000 greater than total cost ($140,000).

ILLUSTRATION H-6 Valuation guidelines for securities

▼ HELPFUL HINT Companies report an unrealized gain or loss in the income statement because of the likelihood that the securities will be sold at fair value since they are a short-term investment.

ILLUSTRATION H-7 Valuation of trading securities Trading Securities, December 31, 2017

Investments Cost Fair Value Unrealized Gain (Loss) Yorkville Company bonds $ 50,000 $ 48,000 $(2,000) Kodak Company stock 90,000 99,000 9,000

Total $140,000 $147,000 $ 7,000

The fact that trading securities are a short-term investment increases the like- lihood that Pace will sell them at fair value for a gain. Pace records fair value and the unrealized gain through an adjusting entry at the time it prepares fi nancial statements. In this entry, the company uses a valuation allowance account, Fair Value Adjustment—Trading, to record the difference between the total cost and the total fair value of the securities. The adjusting entry for Pace is:

Dec. 31 Fair Value Adjustment—Trading 7,000 Unrealized Gain—Income 7,000 (To record unrealized gain on trading

securities)

The use of the Fair Value Adjustment—Trading account enables the company to maintain a record of the investment cost. Actual cost is needed to determine the gain or loss realized when the securities are sold. The company adds the debit balance (or subtracts a credit balance) of the Fair Value Adjustment—Trading

A L SE= + +7,000

+7,000 Rev Cash Flows no eff ect

Reporting Investments in Financial Statements H-9

account to the cost of the investments to arrive at a fair value for the trading securities. The fair value of the securities is the amount companies report on the balance sheet. They report the unrealized gain on the income statement under “Other revenues and gains.” The term income in the account title indicates that the gain affects net income. If the total cost of the trading securities is greater than total fair value, an unrealized loss has occurred. In such a case, the adjusting entry is a debit to Unrealized Loss—Income and a credit to Fair Value Adjustment—Trading. Com- panies report the unrealized loss under “Other expenses and losses” in the income statement. The fair value adjustment account is carried forward into future account- ing periods. No entries are made to this account during the period. At the end of each reporting period, a company adjusts the balance in the account to the difference between cost and fair value at that time. It closes the Unrealized Gain—Income account or Unrealized Loss—Income account at the end of the reporting period.

Available-for-Sale Securities As indicated earlier, available-for-sale securities are held with the intent of selling them sometime in the future. If the intent is to sell the securities within the next year or operating cycle, a company classifi es the securities as current assets in the balance sheet. Otherwise, it classifi es them as long-term assets in the investments section of the balance sheet. Companies also report available-for-sale securities at fair value. The proce- dure for determining fair value and unrealized gain or loss for these securities is the same as that for trading securities. To illustrate, assume that Elbert Corpora- tion has two securities that are classifi ed as available-for-sale. Illustration H-8 provides information on the cost, fair value, and amount of the unrealized gain or loss on December 31, 2017. There is an unrealized loss of $9,537 because total cost ($293,537) is $9,537 more than total fair value ($284,000).

ILLUSTRATION H-8 Valuation of available-for-sale securities

Available-for-Sale Securities, December 31, 2017 Investments Cost Fair Value Unrealized Gain (Loss)

Campbell Soup Corporation 8% bonds $ 93,537 $103,600 $10,063 Hershey Foods stock 200,000 180,400 (19,600)

Total $293,537 $284,000 $ (9,537)

A L SE= + −9,537 Eq

−9,537 Cash Flows no eff ect

▼ HELPFUL HINT The entry is the same regardless of whether the securities are considered short-term or long- term.

Both the adjusting entry and the reporting of the unrealized loss from Elbert’s available-for-sale securities differ from those illustrated for trading securities. The differences result because these securities are not going to be sold in the near term. Thus, prior to actual sale it is much more likely that changes in fair value may reverse the unrealized loss. Therefore, Elbert does not report an unrealized loss in the income statement. Instead, the company reports it as an item of other comprehensive income in the comprehensive income statement, as discussed in Chapter 5. In the adjusting entry, Elbert identifi es the fair value adjustment account with available-for-sale securities, and identifi es the unrealized gain or loss account with stockholders’ equity. The adjusting entry for Elbert to record the unrealized loss of $9,537 is:

Dec. 31 Unrealized Gain or Loss—Equity 9,537 Fair Value Adjustment—Available-for-Sale 9,537 (To record unrealized loss on

available-for-sale securities)

H-10 H Reporting and Analyzing Investments

If total fair value exceeds total cost, Elbert would record the adjusting entry as an increase (debit) to Fair Value Adjustment—Available-for-Sale and a credit to Unrealized Gain or Loss—Equity. Elbert’s unrealized loss of $9,537 would appear in the comprehensive income statement as shown in Illustration H-9.

ETHICS NOTE Recently, the SEC accused

investment bank Morgan Stanley of overstating the value

of certain bond investments by $75 million. The SEC stated

that, in applying fair value accounting, Morgan Stanley

used its own more optimistic assumptions rather than relying

on external pricing sources.

▼

For available-for-sale securities, the company carries forward the Unrealized Gain or Loss—Equity account to future periods. At each future balance sheet date, the account is adjusted with the fair value adjustment account to show the difference between cost and fair value at that time.

BALANCE SHEET PRESENTATION

In the balance sheet presentation, companies must classify investments as either short-term or long-term.

Short-Term Investments Short-term investments (also called marketable securities) are securities held by a company that are (1) readily marketable and (2) intended to be converted into cash within the next year or operating cycle, whichever is longer. Investments that do not meet both criteria are classifi ed as long-term investments.

READILY MARKETABLE An investment is readily marketable when it can be sold easily whenever the need for cash arises. Short-term paper5 meets this criterion because a company can readily sell it to other investors. Stocks and bonds traded on organized securities markets, such as the New York Stock Exchange, are readily marketable because they can be bought and sold daily. In contrast, there may be only a limited market for the securities issued by small corporations and no market for the securities of a privately held company.

INTENT TO CONVERT Intent to convert means that management intends to sell the investment within the next year or operating cycle, whichever is longer. Generally, this criterion is satisfi ed when the investment is considered a resource that the company will use whenever the need for cash arises. For example, a ski resort may invest idle cash during the summer months with the intent to sell the securities to buy supplies and equipment shortly before the next winter season. This investment is considered short-term even if lack of snow cancels the next ski season and eliminates the need to convert the securities into cash as intended. Because of their high liquidity, companies list short-term investments imme- diately below Cash in the current assets section of the balance sheet. Short-term investments are reported at fair value. For example, Weber Corporation would report its trading securities as shown in Illustration H-10.

▼ HELPFUL HINT Trading securities are always classifi ed as short-term. Available-for-sale securities can be either short-term or long-term.

5Short-term paper includes (1) certifi cates of deposits (CDs) issued by banks, (2) money market certifi cates issued by banks and savings and loan associations, (3) Treasury bills issued by the U.S. government, and (4) commercial paper issued by corporations with good credit ratings.

ILLUSTRATION H-9 Comprehensive income statement

Net income $118,000 Other comprehensive income Unrealized loss on available-for-sale securities (9,537)

Comprehensive income $108,463

ELBERT CORPORATION Comprehensive Income Statement

For the Year Ended December 31, 2017

Reporting Investments in Financial Statements H-11

Long-Term Investments Companies generally report long-term investments in a separate section of the balance sheet immediately below “Current assets,” as shown in Illustration H-11. Long-term investments in available-for-sale securities are reported at fair value. Investments in common stock accounted for under the equity method are reported at equity.

ILLUSTRATION H-12 Nonoperating items related to investments

Other Revenue and Gains Other Expenses and Losses

Interest Revenue Loss on Sale of Investments Dividend Revenue Unrealized Loss—Income Gain on Sale of Investments Unrealized Gain—Income

ILLUSTRATION H-10 Balance sheet presentation of short-term investments

Current assets Cash $21,000 Short-term investments, at fair value 60,000

WEBER CORPORATION Balance Sheet (partial)

ILLUSTRATION H-11 Balance sheet presentation of long-term investments

Investments Bond sinking fund $100,000 Investments in stock of less than 20% owned companies, at fair value 50,000 Investment in stock of 20%–50% owned company, at equity 150,000

Total investments $300,000

WEBER CORPORATION Balance Sheet (partial)

PRESENTATION OF REALIZED AND UNREALIZED GAIN OR LOSS

Companies must present in the fi nancial statements gains and losses on invest- ments, whether realized or unrealized. In the income statement, companies report gains and losses, as well as interest and dividend revenue, in the nonoper- ating activities section under the categories listed in Illustration H-12.

As discussed in Chapter 11, companies report the cumulative amount of other comprehensive income items from the current and previous years as a separate component of stockholders’ equity. To illustrate, assume that Muzzillo Inc. has common stock of $3,000,000, retained earnings of $1,500,000, and an accumu- lated other comprehensive loss of $100,000. Illustration H-13 shows the fi nancial statement presentation of the accumulated other comprehensive loss.

ILLUSTRATION H-13 Unrealized loss in stockholders’ equity section

Stockholders’ equity Common stock $3,000,000 Retained earnings 1,500,000

Total paid-in capital and retained earnings 4,500,000 Accumulated other comprehensive loss (100,000)

Total stockholders’ equity $4,400,000

MUZZILLO INC. Balance Sheet (partial)

H-12 H Reporting and Analyzing Investments

Note that the presentation of the accumulated other comprehensive loss is similar to the presentation of the cost of treasury stock in the stockholders’ equity section. (It decreases stockholders’ equity.) Accumulated other comprehensive income would be added in this section. Companies must report, as part of a more inclusive measure called compre- hensive income, items such as unrealized gains and losses on available-for-sale securities, which affect stockholders’ equity but are not included in the calcula- tion of net income. Comprehensive income is discussed more fully in Chapter 13.

STATEMENT OF CASH FLOWS PRESENTATION

As shown previously in Illustrations H-10, H-11, and H-13, the balance sheet pre- sents a company’s investment accounts at a point in time. The “Investing activities” section of the statement of cash fl ows reports information on the cash infl ows and outfl ows during the period that resulted from investment transactions. Illustration H-14 presents the cash fl ows from investing activities from a recent statement of cash fl ows of The Walt Disney Company. From this informa- tion, we learn that Disney received $1,530 million from the sale or redemption of investments during the year.

ILLUSTRATION H-14 Statement of cash fl ows presentation of investment activities

Investing Activities Investments in parks, resorts and other property $(1,566) Acquisitions (588) Dispositions — Proceeds from sale of investments 1,530 Other 6

Cash used by investing activities $ (618)

THE WALT DISNEY COMPANY Statement of Cash Flows (partial)

(in millions)

Real World

LEARNING OBJECTIVES REVIEW

REVIEW

1 Explain how to account for debt investments. Corpora- tions invest for three common reasons: (a) they have excess cash, (b) they view investment income as a signifi cant rev- enue source, and (c) they have strategic goals such as gain- ing control of a competitor or supplier or moving into a new line of business. Entries for investments in debt securities are required when companies purchase bonds, receive or accrue interest, and sell bonds.

2 Explain how to account for stock investments. Entries for investments in common stock are required when com- panies purchase stock, receive dividends, and sell stock. When ownership is less than 20%, the cost method is used—the investment is recorded at cost. When owner- ship is between 20% and 50%, the equity method should be used—the investor records its share of the net income of the investee in the year it is earned. When ownership is

more than 50%, consolidated fi nancial statements should be prepared. When a company owns more than 50% of the common stock of another company, consolidated fi nancial state- ments are usually prepared. These statements are espe- cially useful to the stockholders, board of directors, and management of the parent company.

3 Discuss how debt and stock investments are reported in the fi nancial statements. Investments in debt and stock securities are classifi ed as trading, available-for-sale, or held- to-maturity for valuation and reporting purposes. Trading securities are reported as current assets at fair value, with changes from cost reported in net income. Available-for-sale securities are also reported at fair value, with the changes from cost reported as items of other comprehensive income. Available-for-sale securities are classifi ed as short-term or long-term depending on their expected realization.

▼

Questions H-13

Short-term investments are securities held by a company that are readily marketable and intended to be converted to cash within the next year or operating cycle, whichever

is longer. Investments that do not meet both criteria are classifi ed as long-term investments.

Available-for-sale securities Securities that are held with the intent of selling them sometime in the future. (p. H-7).

Consolidated fi nancial statements Financial statements that present the assets and liabilities controlled by the parent company and the total revenues and expenses of the subsidiary companies. (p. H-6).

Controlling interest Ownership of more than 50% of the common stock of another entity. (p. H-6).

Cost method An accounting method in which the invest- ment in common stock is recorded at cost and revenue is recognized only when cash dividends are received. (p. H-4).

Debt investments Investments in government and corpo- ration bonds. (p. H-3).

Equity method An accounting method in which the in- vestment in common stock is initially recorded at cost, and the investment account is then adjusted annually to show the investor’s equity in the investee. (p. H-5).

Fair value Amount for which a security could be sold in a normal market. (p. H-7).

Held-to-maturity securities Debt securities that the inves- tor has the intent and ability to hold to maturity. (p. H-7).

Long-term investments Investments that are not readily marketable or that management does not intend to con- vert into cash within the next year or operating cycle, whichever is longer. (p. H-10).

Mark-to-market A method of accounting for certain in- vestments that requires that they be adjusted to their fair value at the end of each period. (p. H-8).

Parent company A company that owns more than 50% of the common stock of another entity. (p. H-6).

Short-term investments (marketable securities) Invest- ments that are readily marketable and intended to be converted into cash within the next year or operating cycle, whichever is longer. (p. H-10).

Stock investments Investments in the capital stock of cor- porations. (p. H-4).

Subsidiary (affi liated) company A company in which more than 50% of its stock is owned by another com- pany. (p. H-6).

Trading securities Securities bought and held primarily for sale in the near term to generate income on short- term price differences. (p. H-7).

GLOSSARY REVIEW▼

1. What are the reasons that companies invest in securities?

2. (a) What is the cost of an investment in bonds? (b) When is interest on bonds recorded?

3. Geena Jaymes is confused about losses and gains on the sale of debt investments. Explain these issues to Geena: (a) How the gain or loss is computed. (b) The statement presentation of gains and losses.

4. Heliy Company sells bonds that cost $40,000 for $45,000, including $1,000 of accrued interest. In re- cording the sale, Heliy books a $5,000 gain. Is this cor- rect? Explain.

5. What is the cost of an investment in stock?

6. To acquire Gaines Corporation stock, Palmer Co. pays $61,500 in cash. What entry should be made for this investment, assuming the stock is readily marketable?

7. (a) When should a long-term investment in common stock be accounted for by the equity method?

(b) When is revenue recognized under the equity method?

8. Stetson Corporation uses the equity method to ac- count for its ownership of 30% of the common stock of Pike Packing. During 2017, Pike reported a net in- come of $80,000 and declares and pays cash dividends of $10,000. What recognition should Stetson Corpora- tion give to these events?

9. What constitutes “signifi cant infl uence” when an in- vestor’s fi nancial interest is less than 50%?

10. Distinguish between the cost and equity methods of accounting for investments in stocks.

11. What are consolidated fi nancial statements?

12. What are the valuation guidelines for trading and available-for-sale investments at a balance sheet date?

Many additional resources are available for practice in WileyPLUS.

QUESTIONS▼

H-14 H Reporting and Analyzing Investments

13. Pat Ernst is the controller of J-Products, Inc. At December 31, the end of its fi rst year of operations, the company’s investments in trading securities cost $74,000 and have a fair value of $70,000. Indicate how Pat would report these data in the fi nancial statements prepared on December 31.

14. Using the data in Question 13, how would Pat report the data if the investments were long-term and the securities were classifi ed as available-for-sale?

15. Boise Company’s investments in available-for-sale secu- rities at December 31 show total cost of $202,000 and total fair value of $210,000. Prepare the adjusting entry.

16. Using the data in Question 15, prepare the adjusting entry, assuming the securities are classifi ed as trading securities.

17. Where is Accumulated Other Comprehensive Loss reported on the balance sheet?

18. Bargain Wholesale Supply owns stock in Cyrus Cor- poration, which it intends to hold indefi nitely because of some negative tax consequences if sold. Should the investment in Cyrus be classifi ed as a short-term in- vestment? Why?

BEH-1 Craig Corporation purchased debt investments for $40,800 on January 1, 2017. On July 1, 2017, Craig received cash interest of $1,660. Journalize the purchase and the receipt of interest. Assume no interest has been accrued.

BEH-2 On August 1, Snow Company buys 1,000 shares of BCN common stock for $35,600 cash. On December 1, the stock investments are sold for $38,000 in cash. Journalize the purchase and sale of the common stock.

BEH-3 Tote Company owns 25% of Toppe Company. For the current year, Toppe reports net income of $150,000 and declares and pays a $60,000 cash dividend. Record Tote’s equity in Toppe’s net income and the receipt of dividends from Toppe.

BEH-4 Cost and fair value data for the trading securities of Lecler Company at December 31, 2017, are $62,000 and $59,600, respectively. Prepare the adjusting entry to record the securities at fair value.

BEH-5 For the data presented in BEH-4, show the financial statement presentation of the trading securities and related accounts.

BEH-6 In its first year of operations, Machin Corporation purchased available-for-sale stock securities costing $72,000 as a long-term investment. At December 31, 2017, the fair value of the securities is $69,000. Prepare the adjusting entry to record the securities at fair value.

BEH-7 For the data presented in BEH-6, show the financial statement presentation of the securities and related accounts. Assume the securities are noncurrent.

BEH-8 Perth Corporation has these long-term investments: common stock of Vejas Co. (10% ownership) held as available-for-sale securities, cost $108,000, fair value $112,000; common stock of Penn Inc. (30% ownership), cost $210,000, equity $230,000; and a bond sinking fund of $150,000. Prepare the investments section of the balance sheet.

Journalize entries for stock investments.

(LO 2), AP

Journalize transactions under the equity method.

(LO 2), AP

Prepare adjusting entry using fair value.

(LO 3), AP

Indicate statement presentation using fair value.

(LO 3), AN Prepare adjusting entry using fair value.

(LO 3), AP

Indicate statement presentation using fair value.

(LO 3), AN Prepare investments section of balance sheet.

(LO 3), AP

BRIEF EXERCISES▼

Journalize entries for debt investments.

(LO 1), AP

EH-1 Chopin Corporation had these transactions pertaining to debt investments:

Jan. 1 Purchased 90 10%, $1,000 Martine Co. bonds for $90,000 cash. Interest is payable semiannually on July 1 and January 1.

July 1 Received semiannual interest on Martine Co. bonds. July 1 Sold 30 Martine Co. bonds for $32,000.

Journalize debt investment transactions, and accrue interest.

(LO 1), AP

EXERCISES▼

Exercises H-15

Instructions (a) Journalize the transactions. (b) Prepare the adjusting entry for the accrual of interest at December 31.

EH-2 Soylent Company had these transactions pertaining to stock investments:

Feb. 1 Purchased 1,200 shares of BJ common stock (2% of outstanding shares) for $8,400.

July 1 Received cash dividends of $2 per share on BJ common stock. Sept. 1 Sold 500 shares of BJ common stock for $5,400. Dec. 1 Received cash dividends of $1 per share on BJ common stock.

Instructions (a) Journalize the transactions. (b) Explain how dividend revenue and the gain (loss) on sale should be reported in the

income statement.

EH-3 Cooper Inc. had these transactions pertaining to investments in common stock:

Jan. 1 Purchased 1,200 shares of Gate Corporation common stock (5% of outstanding shares) for $59,200 cash.

July 1 Received a cash dividend of $7 per share. Dec. 1 Sold 900 shares of Gate Corporation common stock for $47,200 cash. 31 Received a cash dividend of $7 per share.

Instructions Journalize the transactions.

EH-4 On January 1, Lyon Corporation purchased a 25% equity investment in Shane Cor- poration for $150,000. At December 31, Shane declared and paid a $80,000 cash dividend and reported net income of $380,000.

Instructions (a) Journalize the transactions. (b) Determine the amount to be reported as an investment in Shane stock at December 31.

EH-5 These are two independent situations:

1. Sosey Cosmetics acquired 12% of the 300,000 shares of common stock of Elite Fash- ion at a total cost of $14 per share on March 18, 2017. On June 30, Elite declared and paid a $75,000 dividend. On December 31, Elite reported net income of $244,000 for the year. At December 31, the market price of Elite Fashion was $16 per share. The stock is classified as available-for-sale.

2. Williams Inc. obtained significant influence over Kasey Corporation by buying 25% of Kasey’s 30,000 outstanding shares of common stock at a total cost of $11 per share on January 1, 2017. On June 15, Kasey declared and paid a cash dividend of $35,000. On December 31, Kasey reported a net income of $120,000 for the year.

Instructions Prepare all the necessary journal entries for 2017 for (a) Sosey Cosmetics and (b) Williams Inc.

EH-6 At December 31, 2017, the trading securities for Gwynn, Inc. are as follows.

Security Cost Fair Value

A $18,100 $16,000 B 12,500 14,800 C 23,000 18,000

Total $53,600 $48,800

Instructions (a) Prepare the adjusting entry at December 31, 2017, to report the securities at fair value. (b) Show the balance sheet and income statement presentation at December 31, 2017,

after adjustment to fair value.

EH-7 Data for investments in stock classified as trading securities are presented in EH-6. Assume instead that the investments are classified as available-for-sale securities with the same cost and fair value data. The securities are considered to be a long-term investment.

Journalize stock investment transactions, and explain income statement presentation.

(LO 2, 3), AN

Journalize transactions for investments in stock.

(LO 2), AP

Journalize and post transactions under the equity method.

(LO 2), AP

Journalize entries under cost and equity methods.

(LO 2), AP

Prepare adjusting entry to record fair value, and indicate statement presentation.

(LO 3), AP

Prepare adjusting entry to record fair value, and indicate statement presentation.

(LO 3), AN

H-16 H Reporting and Analyzing Investments

Instructions (a) Prepare the adjusting entry at December 31, 2017, to report the securities at fair value. (b) Show the statement presentation at December 31, 2017, after adjustment to fair value. (c) Pam Jenks, a member of the board of directors, does not understand the

reporting of the unrealized gains or losses on trading securities and available-for-sale securities. Write a letter to Ms. Jenks explaining the reporting and the purposes it serves.

EH-8 Weston Company has these data at December 31, 2017, the end of its first year of operations.

Securities Cost Fair Value

Trading $110,000 $122,000 Available-for-sale 100,000 96,000

The available-for-sale securities are held as a long-term investment.

Instructions (a) Prepare the adjusting entries to report each class of securities at fair value. (b) Indicate the statement presentation of each class of securities and the related unreal-

ized gain (loss) accounts.

Prepare adjusting entries for fair value, and indicate statement presentation for two classes of securities.

(LO 3), AN

PH-1 Penn Farms is a grower of hybrid seed corn for Bend Genetics Corporation. It has had two exceptionally good years and has elected to invest its excess funds in bonds. The following selected transactions relate to bonds acquired as an investment by Penn Farms, whose fi scal year ends on December 31.

2017

Jan. 1 Purchased at par $600,000 of Dover Corporation 10-year, 7% bonds dated January 1, 2017, directly from the issuing corporation.

July 1 Received the semiannual interest on the Dover bonds. Dec. 31 Accrual of interest at year-end on the Dover bonds.

Assume that all intervening transactions and adjustments have been properly recorded and the number of bonds owned has not changed from December 31, 2017, to December 31, 2019.

2020

Jan. 1 Received the semiannual interest on the Dover bonds. Jan. 1 Sold $300,000 of Dover bonds at 110. July 1 Received the semiannual interest on the Dover bonds. Dec. 31 Accrual of interest at year-end on the Dover bonds.

Instructions Journalize the listed transactions for the years 2017 and 2020.

PH-2 In January 2017, the management of Northern Company concludes that it has suf- fi cient cash to purchase some short-term investments in debt and stock securities. During the year, the following transactions occurred.

Feb. 1 Purchased 1,200 shares of LAF common stock for $51,600. Mar. 1 Purchased 500 shares of NCL common stock for $18,500. Apr. 1 Purchased 70 $1,000, 8% TRC bonds for $70,000. Interest is payable semi-

annually on April 1 and October 1. July 1 Received a cash dividend of $0.80 per share on the LAF common stock. Aug. 1 Sold 200 shares of LAF common stock at $42 per share. Sept. 1 Received $2 per share cash dividend on the NCL common stock. Oct. 1 Received the semiannual interest on the TRC bonds. Oct. 1 Sold the TRC bonds for $75,700.

At December 31, the fair values of the LAF and NCL common stocks were $39 and $30 per share, respectively.

Journalize debt investment transactions.

(LO 1), AN

Journalize investment transac- tions, prepare adjusting entry, and show fi nancial statement presentation.

(LO 1, 2, 3), AN

PROBLEMS▼

Problems H-17

Instructions (a) Journalize the transactions and post to the accounts Debt Investments and Stock

Investments. (Use the T-account form.) (b) Prepare the adjusting entry at December 31, 2017, to report the investments at fair

value. All securities are considered to be trading securities. (c) Show the balance sheet presentation of investment securities at December 31, 2017. (d) Identify the income statement accounts and give the statement classifi cation of each

account.

PH-3 On December 31, 2016, the end of its fi rst year of operations, Botani Associates owned the following securities that are held as long-term investments.

Common Stock Shares Cost

C Co. 1,000 $48,000 D Co. 5,000 36,000 E Co. 1,200 24,000

On this date, the total fair value of the securities was equal to its cost. The securities are not held for infl uence or control over the investees. In 2017, the following transactions occurred.

July 1 Received $2.00 per share semiannual cash dividend on D Co. common stock. Aug. 1 Received $0.50 per share cash dividend on C Co. common stock. Sept. 1 Sold 1,000 shares of D Co. common stock for cash at $9 per share. Oct. 1 Sold 300 shares of C Co. common stock for cash at $53 per share. Nov. 1 Received $1 per share cash dividend on E Co. common stock. Dec. 15 Received $0.50 per share cash dividend on C Co. common stock. 31 Received $2.20 per share semiannual cash dividend on D Co. common

stock.

At December 31, the fair values per share of the common stocks were C Co. $47, D Co. $7, and E Co. $24.

Instructions (a) Journalize the 2017 transactions and post to the account Stock Investments. (Use the

T-account form.) (b) Prepare the adjusting entry at December 31, 2017, to show the securities at fair value.

The stock should be classifi ed as available-for-sale securities. (c) Show the balance sheet presentation of the investments and the unrealized gain (loss)

at December 31, 2017. At this date, Botani Associates has common stock $2,000,000 and retained earnings $1,200,000.

PH-4 Wellman Company acquired 30% of the outstanding common stock of Grinwold Inc. on January 1, 2017, by paying $1,800,000 for 60,000 shares. Grinwold declared and paid a $0.50 per share cash dividend on June 30 and again on December 31, 2017. Grinwold reported net income of $800,000 for the year.

Instructions (a) Prepare the journal entries for Wellman Company for 2017, assuming Wellman cannot

exercise signifi cant infl uence over Grinwold. (Use the cost method.) (b) Prepare the journal entries for Wellman Company for 2017, assuming Wellman can

exercise signifi cant infl uence over Grinwold. (Use the equity method.) (c) The board of directors of Wellman Company is confused about the differences

between the cost and equity methods. Prepare a memorandum for the board that explains each method and shows in tabular form the account balances under each method at December 31, 2017.

PH-5 Here is Kalvin Company’s portfolio of long-term available-for-sale securities at December 31, 2016, the end of its fi rst year of operations.

Cost

1,400 shares of Batone Inc. common stock $73,500 1,200 shares of Mendez Corporation common stock 84,000 800 shares of P. Tillman Corporation preferred stock 33,600

Journalize transactions, prepare adjusting entry for stock investments, and show balance sheet presentation.

(LO 2, 3), AN

Prepare entries under cost and equity methods, and prepare memorandum.

(LO 2), AN

Journalize stock transactions, and show balance sheet presentation.

(LO 2, 3), AN

H-18 H Reporting and Analyzing Investments

On December 31, the total cost of the portfolio equaled the total fair value. Kalvin had the following transactions related to the securities during 2017.

Jan. 20 Sold 1,400 shares of Batone Inc. common stock at $55 per share. 28 Purchased 400 shares of $10 par value common stock of P. Wahl Corporation

at $78 per share. 30 Received a cash dividend of $1.25 per share on Mendez Corporation

common stock. Feb. 8 Received cash dividends of $0.40 per share on P. Tillman Corporation pre-

ferred stock. 18 Sold all 800 shares of P. Tillman preferred stock at $35 per share. July 30 Received a cash dividend of $1.10 per share on Mendez Corporation common

stock. Sept. 6 Purchased an additional 600 shares of the $10 par value common stock of

P. Wahl Corporation at $82 per share. Dec. 1 Received a cash dividend of $1.50 per share on P. Wahl Corporation com-

mon stock.

At December 31, 2017, the fair values of the securities were:

Mendez Corporation common stock $65 per share P. Wahl Corporation common stock $77 per share

Kalvin uses separate account titles for each investment, such as Investment in Mendez Corporation Common Stock.

Instructions (a) Prepare journal entries to record the transactions. (b) Post to the investment accounts. (Use separate T-accounts for each investment.) (c) Prepare the adjusting entry at December 31, 2017, to report the portfolio at fair value. (d) Show the balance sheet presentation at December 31, 2017.

PH-6 The following data, presented in alphabetical order, are taken from the records of Manfreid Corporation.

Accounts payable $ 150,000 Accounts receivable 90,000 Accumulated depreciation—buildings 180,000 Accumulated depreciation—equipment 52,000 Allowance for doubtful accounts 6,000 Bonds payable (10%, due 2028) 350,000 Buildings 900,000 Cash 63,000 Common stock ($5 par value; 500,000 shares authorized, 240,000 shares issued) 1,200,000 Debt investments 400,000 Discount on bonds payable 20,000 Dividends payable 50,000 Equipment 275,000 Goodwill 190,000 Income taxes payable 70,000 Inventory 170,000 Land 410,000 Notes payable (due 2018) 70,000 Paid-in capital in excess of par value 464,000 Prepaid insurance 16,000 Retained earnings 310,000 Stock investments (Horton Inc. stock, 30% ownership, at equity) 240,000 Stock investments (short-term, at fair value) 128,000

Instructions Prepare a balance sheet at December 31, 2017.

Prepare a balance sheet.

(LO 3), AP

A Abitibi Consolidated Inc., 30 Acer Inc., 282 adidas, 398–399, 564 AIG, 7 AirTran Airways, 435 Amazon.com, D.1–3, 13, 35, 38,

83, 145, 209, 216, 218, 261, 310–311, 368, 416, 440, 472, 529–530, 584, 641, 696

American Airlines, 423, 481 American Cancer Society, 538 American Eagle Outfitters,

68, 77 American Express, 396 American Greetings Corporation,

311 Apple Inc., A.1–5, 37, 39–40, 83,

89, 129, 144, 153, 209, 260, 310, 355, 367, 392, 416, 446, 472, 529, 583, 591, 609–610, 640, 696

AT&T, 652

B Bank of America, 370, 384 Bank One Corporation, 99 Barnes & Noble.com, 440 Barnes and Noble, 530 Barriques, 316, 317, 318,

324, 328 Berkshire Hathaway, 555 Best Buy Co., Inc., 44, 52–

53, 54–55, 56–57, 58, 63, 162, 444

BHP Billiton, 444 Boeing Capital Corporation, 428 Boeing Company, 74, 85–86 Boise Cascade Corporation, 451 Borders Group, 530 Box, 605 BP, 279 Bristol-Myers Squibb, 173,

277, 653

C Cal State – Northridge Stdt

Union, 30 California State University –

Fullerton, 6 Callaway Golf Company, 75 Campbell Soup Company, 35,

277, 432, 459 Canadian National Railway

Company (CN), 517 Cargill Inc., 538 Carrefour SA, 261 Caterpillar Financial Services, 396 Caterpillar Inc., 267, 268, 284–

285, 314, 396, 538 CBS, 442 Cerberus, 479 Chicago Cubs, 104 Chieftain International, Inc., 145 Chrysler, 479 Cisco Systems, 175, 653 Citigroup, 5, 6, 53, 152 Clif Bar & Company, 5, 41 CNH Global, 285 Coca-Cola Company, 5, 406, 443,

447–448, 697 Columbia Sportswear Company,

B.1–4, 9–10, 18–20, 38, 44, 83, 144–145, 209, 261, 310, 368, 416, 472, 529, 583–584, 629, 640, 696

ConAgra Foods, 172–173, 230 ConocoPhilips, 444 Continental Bank, 428 Costco Wholesale Corp., 226 Countrywide Financial

Corporation, 393 Craig Consumer Electronics, 270 Credit Suisse Group, 110 Cyan, 605

D Daimler-Benz, 479 Dally Industries, 271

Dayton Hudson, 342 Deere & Company, 304–305,

391–392 Deere Capital Corporation, 428 Dell Computer, 268 Dell Financial Services, 428 Deloitte & Touche, 19 Delta Air Lines, 60, 152, 340,

341, 433, 437, 448 Dewey & LeBoeuf LLP, 8 Dick’s Sporting Goods, 235, 236 Discover, 396 Disney, 436, 444 Dow Chemical, 13 Dun & Bradstreet, 654 Dunkin’ Donuts, 60 Dynegy, 603

E Eastman Kodak, 590 eBay, 230 Enron, 7, 495, 499, 539 Ernst & Young, 368 ExxonMobil, 5, 279, 333

F Facebook, 12, 536, 537, 538,

541, 542, 546, 549–550, 561 Faital Inc., 118 FedEx Corporation, 410–411 Fireeye, 605 Fitch, 662 Ford Motor Company, 6, 110,

217, 269, 282, 396, 444, 478, 479, 497, 500–501

Ford Motor Credit Corp. (FMCC), 396

Fox, 442 Franklin Corporation, 46, 47, 48,

49, 88

G Gap, Inc., 83–84 GE Capital, 396

I-1

COMPANY INDEX

I-2 Company Index

General Dynamics Corp., 649 General Electric (GE), 147, 224,

396, 418, 521, 538 General Mills, 432, 659, 669–

672, 675–676 General Motors (GM), 5, 92,

308, 406, 478, 479, 495–497, 498, 507, 538, 652

Global Crossing, 495 Goldman Sachs, 6 Google, Inc., 12, 44, 48, 50, 439,

441, 536, 555, 648 Graber Inc., 558–559 Grant Thornton LLP, 30 Green Bay Packers, 91, 146 Groupon, Inc., 150, 151, 180–

181, 557

H H. J. Heinz Company, 67–68, 75 HealthSouth, 7 Hechinger Co., 530 Hewlett-Packard, 53 Hilton, 428 Home Depot, 269, 530 Honeywell International, 652 Hughes Aircraft Co., 649

I IBM, 538, 555, 608, 650, 652 InBev, 418 Intel Corporation, 342, 394, 611 InterContinental, 428 IT&T, 3

J J. P. Morgan Leasing, 428 JC Penney, 342, 377, 405 JetBlue Airways, 423, 424, 428,

444–445, 447 Jordache Co., 376–377 JPMorgan Chase Bank, 35, 99, 384

K Kansas Farmers’ Vertically

Integrated Cooperative, Inc., 121–122

Kellogg Company, Inc., 33, 654, 664–665

Kmart, 262, 393 Kohl’s Department Stores, 355 Krispy Kreme Doughnuts,

Inc., 134 Kroger, 236, 277

L LDK Solar Co., 282 Leslie Fay, 270, 313

Linens’ n Things, 392 Louis Vuitton, F.1–5, 89, 149,

213, 265, 315, 373, 421, 477, 535, 589, 645, 701

M Manitowoc Company, 286–287 Marriott, 428, 432, 442 Massachusetts General Hospital, 6 MasterCard, 385, 396 Mattel Corporation, 346–347 Maxwell Car Company, 479 McDonald’s Corporation, 6, 439,

521, 629 McDonnell Douglas, 85 McKesson Corporation, 216,

313, 341, 385 Medtronic, Inc., 488 Merck and Co., 31, 236 Merrill Lynch, 6 MF Global Holdings Ltd, 91, 539 Microsoft, 5, 92, 108, 230, 439,

444, 591, 608 Mobile Iron, 605 Moody’s, 654, 662 Morgan Stanley, H.10 Morrow Snowboards, Inc., 219 The Motley Fool, 45 Motorola, 277 Mountain Equipment Cooperative

(MEC), 238–239

N NationsBank, 370 Netflix, 641 Nike, Inc., 34, 50, 343, 374, 375,

376, 382, 395, 439, 460, 538, 544, 547, 555, 560–562, 688

Nordstrom, Inc., 76, 386, 689 North Face, 20, 35 Northwest Airlines, 427

O Oakley, Inc., 300 Office Depot, 216, 251, 283, 411 Office Max, 173 Oracle Corporation, 30

P Packard Bell, 394 PairGain Technologies, 45 Parmalat, 602 PepsiCo Inc., 237, 279, 697 Philip Morris International, 488 Pilgrim’s Pride, 173 Polo Company, 376 PricewaterhouseCoopers, 40 Proctor & Gamble, 6, 544, 649

Promodes SA, 261 Prudential Real Estate, 6

Q Quaker Oats, 279

R Radio Shack, 235 RBC Financial Group, 194 Reebok International Ltd., 277,

548–549 REI (Recreational Equipment

Inc.), 215, 216, 220, 228–229, 231, 235, 236

REL Consultancy Group, 55 Royal Dutch Shell, 279 Ryan Company, Inc., 200

S SafeNet, 543 Safeway, 236 Saks Fifth Avenue, 235 Salvation Army, 538 Sara Lee Corporation, 559 Sears Holdings, 194, 385 Simon Properties, 488 Skechers USA, 374, 384, 394, 395 Skype, 230 SkyTrax Management, 423 Sony, 108, 284 Southwest Airlines, 30, 33, 47,

194, 423, 424, 434–435, 445– 446, 447, 526

Sportsco Investments, 30 Standard & Poor’s, 654, 662 Standard Oil Company, 451 Stanley Black & Decker

Manufacturing Company, 277 Staples, Inc., 685 Starbucks, 277, 313 Subway, 442

T Target, 81, 236, 262, 269, 283,

284, 333, 342, 594, 695 Tektronix Inc., 558 Tesla Motors, Inc., 48 Texas Instruments, Inc., 75 3M Company, 407, 522 Tiffany and Co., 236 Time Warner, H.5, H.7 Tootsie Roll, 92 Topps Company, Inc., 686 Toronto Blue Jays, 194 Toyota, 442, 497 True Value Hardware, 269 Turner Broadcasting, H.5, H.7 Tweeter Home Entertainment, 63

Company Index I-3

U Ultimate Electronics, 194 Unilever, 494 United Airlines, 423, 482,

590 United Parcel Service

(UPS), 652 United Stationers, 216 US Bancorp Equipment

Finance, 428

V Valujet, 423 Verizon Communications, Inc.,

488, 652

VF Corporation, C.1–3, 20, 144– 145, 209, 261, 310, 368, 416, 472, 529, 583–584, 640, 696

Visa, 385, 396

W Wachovia, 378 Walgreens, 216, 277 Wal-Mart Stores, Inc., E.1–5, 38,

81, 83, 145, 209, 215, 216, 235, 236, 261, 262, 269, 281, 283– 284, 310–311, 333, 368, 416, 472, 529–530, 584, 641, 695, 696

Walt Disney Company, H.12, 49, 60

Waste Management Company, 99 Wells Fargo & Company, 378,

384, 576 Wendy’s International, 277 Winnebago Industries,

Inc., 300 Wolfe Company, 133–134 WorldCom, 7, 173, 427, 495,

539, 653, 659

X Xerox, 38, 173

Y Yahoo! Inc., 78

A Accelerated-depreciation

method, 432, 453 Accounting. See also Accrual-

basis accounting cash-basis, 153–154, 185 for debt investments, H-3 defined, 5, 21 mark-to-market, H-8, H-13 for stock investments,

H-4–H-12 Accounting cycle

defined, 92 required steps in, 178 summary of, 177–180

Accounting equation accounts receivable, 96 balancing accounting

equation, 93 defined, 13, 22 expanded, 94 illustrated, 13

Accounting information system, 90–149

accounting cycle and, 92 accounting transactions and,

92–100 debits and credits and, 100–106 defined, 9, 92, 123 recording process, 106–118 trial balance and, 119–121

Accounting principle, change in, 651–652, 678

Accounting transactions, 92–100 accuracy and, 99 analyzing, 93–99, 111 balancing accounting

equation, 93 basic form of, 100 defined, 92, 123 hiring of new employees, 98 identification process, 93 investment of cash by

stockholders, 94

note issued in exchange for cash, 94–95

occurrence of, 92 payment of cash for employee

salaries, 98 payment of dividends, 98 payment of rent, 96–97 purchase of equipment for

cash, 95 purchase of insurance policy

for cash, 97 purchase of supplies on

account, 97 receipt of cash in advance

from customer, 95 services performed for cash, 96 source documents, 106 summary of, 99

Accounts, 100–106 chart of, 109–110, 123 debit and credit procedures,

101–104 debits and credits, 101 defined, 100, 123 permanent, 175, 185 stockholders’ equity

relationships, 104–105 summary of debit/credit

rules, 105 T-account, 100, 123, 618–620 temporary, 175, 185 uncollectible, 378–384

Accounts payable defined, 10 increase in, 600–601

Accounts receivable, 376–387 actual losses and, 379 aging, 382, 400 aging schedule, monitoring, 393 allowance estimation and,

382–384 allowance method, 379–

384, 400 average, 395

bad debt expense, 378, 400 decrease in, 600 defined, 10, 96, 376, 400 direct write-off method, 378–

379, 400 disposing of, 385–387 fraud, 377 percentage-of-receivables basis,

382, 400 recognizing, 376–378 recording estimated

uncollectibles and, 380 recording write-offs and,

380–381 recovery of uncollectible

accounts and, 381 reportable amount

determination, 378 reporting with accounting

equation, 96 turnover, 395, 400, 668–

669, 677 valuing, 378–384

Accrual-basis accounting accounting cycle summary,

177–178 accrual versus cash basis of

accounting, 153–154 adjusting entries, 154–174 basis of, 152–155 as basis of international

standards, 153 cash-basis accounting versus,

153–154 closing the books, 175–176 concepts, 150–213 defined, 153, 184 expense recognition principle,

152, 185 revenue recognition principle,

152, 185 Accruals, 163–170

expenses, 164–167, 184 interest, 165–166

I-5

SUBJECT INDEX

I-6 Subject Index

Accruals (Continued) prior entries and, 163 revenues, 163–164, 184 salaries, 166–167 types of, 155

Accrued expenses, 164–167 accounting for, 167 adjusting entries for, 165 defined, 164, 184 interest, 165–166 salaries, 166–167

Accrued revenues, 163–164, 184 Accumulated depreciation, 48 Accumulated Other Comprehensive

Income, 558, 566 Accumulated profit or loss, 587 Accuracy, importance of, 99 Acquisition of bonds, recording,

H-3 Acquisition of stock, recording,

H-4, H-6 Additional cost of borrowing, 491 Additional paid-in capital, 558 Additions and improvements,

plant assets, 427, 453 Adjusted cash balance, 338 Adjusted trial balance. See also

Trial balance defined, 170, 185 financial statement preparation

from, 171–172 illustrated example, 171 preparing, 170–174 purpose of, 170

Adjusting entries accruals, 155, 156–162 accrued expenses, 165 accrued revenues, 164 cash flow and, 157 deferrals, 155, 156–162 defined, 185 ethics, 164 GAAP versus IFRS, 212–213 illustrated example, 168–169 improper, 173 need for, 154–155 prepaid expenses, 156–160 relationships summary,

167–169 trial balance and, 154–155,

170–174 types of, 155 unearned revenues, 160–162

Administrative expenses, 10 Aging the accounts receivable,

382, 400 Allowance method

defined, 379, 400

estimating the allowance, 382–384

recording estimated uncollectibles, 380

recording write-off, 380–381 recovery of uncollectible

account, 381 Allowances

debit balance and, 383 estimating, 382

Alternative accounting methods, quality of earnings, 652

Amortization amount computation, 504 bond discount, 491, 502–503,

505–506 bond premium, 492–493, 503–

504, 506–507 defined, 440, 453 effective-interest method, 504–

507, 510 intangible assets, 440 straight-line, 502–504, 510

Annual rate, depreciation and, 431 Annual reports

auditors’s report, 19 defined, 18, 21, A-1 filing of, A-1 Form 10-K, A-1 management discussion and

analysis (MD&A), 18 notes to the financial

statements, 18 Annuities

defined, G-5, G-9, G-17 future value of, G-4–G-7, G-17 present value of, G-9–G-11,

G-15, G-17 time diagram, G-5, G-10

Asset turnover defined, 445, 453, 674, 677 example use of, 445–446 as profitability ratio, 674 use of, 445

Assets current, 46–48, 55, 65 debit/credit procedures

for, 102 defined, 9, 21 depreciable, 429 intangible, 48–49, 65 misappropriation, 332 return on, 444–445, 446,

673, 678 valuation of, 425

Auditors, 19, 325, 350 Auditors’s report

defined, 19, 21

example illustration, 19 Authorized stock, 543, 558 Auto loan application, financial

calculator, G-15 Available-for-sale securities

defined, 650, 678, H-7, H-13 valuation of, H-9

Average collection period, 395, 400, 669, 678

Average-cost method, 276–277 allocation of costs, 277 defined, 276, 292 formula, 276 periodic, 273 perpetual inventory system, 289

B Bad debt expense, 378, 400 Balance sheets

Amazon.com, Inc., D-3 Apple Inc., A-3 basic accounting equation, 13 classified, 46–51, 53–56, 64 Columbia Sportswear

Company, B-2 comparative, 595, 597 cost flow methods and,

278–279 defined, 11, 13, 22 example illustration, 13, 16 horizontal analysis, 656 interrelationship, 15–16 inventory error effects, 289–290 Louis Vuitton, F-3 presentation of liabilities, 495 presentation of stockholders’

equity, 558–559 short-term investments, H-10 use of, 14 vertical analysis, 657 VF Corporation, C-1 Wal-Mart Stores, Inc., E-3

Bank accounts canceled check and, 334 control features, 333–340 electronic funds transfers

(EFTs), 333, 338, 350 NSF check and, 334, 350 reconciliation, 333, 334–339 statements, 333–334

Bank charges expense, 338–339 Bank errors, 336 Bank line of credit, 497 Bank reconciliation, 334–339

bank charges expense, 338–339

bank errors, 336 book errors, 337

Subject Index I-7

collection of electronic funds transfer, 338

defined, 333, 335, 350 deposits in transit, 335, 350 entries from, 338–339 fraud and, 335 illustrated, 337–338 items per bank, 335–336 items per books, 336–337 other deposits, 336–337 other payments, 337 outstanding checks, 335, 350 procedure, 335–337 reason for, 335

Bank statements, 333–334, 350 Basic accounting equation, 13,

22, 93 Benford’s Law, 659 Bond certificates, 486, 487, 509 Bonding, 325, 350 Bonds, 485–494

accounting for transactions, 489–494

acquisition of, recording, H-3 additional cost of borrowing,

491 amortization amount

computation, 504 amortizing the discount, 491 amortizing the premium,

492–493 callable, 486, 509 carrying (or book) value,

490, 494 contractual interest rate, 486,

489–490, 509 convertible, 486, 509 defined, 9, 485, 509 discount on, 489–490, 510 effective-interest method of

amortization, 504–507 face value, 486, 490 interest, recording, H-3 interest expense, 491, 504 interest paid computation, 504 interest payable as current

liability, 489 interest payments, 487 issuing at a discount, 490–491 issuing at face value, 489 issuing at premium, 492–493 issuing below face value, 491 issuing procedures, 486 market interest rate, 486,

490, 510 market price determination,

486–488 maturity date, 486, 510

premium on, 489–490, 510 present value, 486, 510 prices, 490 principal, 487 redeeming at maturity, 493 redeeming before maturity,

493–494 sale of, recording, H-3 secured, 486, 510 straight-line amortization,

502–504 types of, 486 unsecured, 486, 510 zero-coupon, 490

Bonds payable as financing activity, 9 increase in, 603–604, 617

Book errors, 337 Book value

of bonds, 490, 494 declining, 449 defined, 160, 185 in depreciation, 429

Buffett, Warren, 646, 647 Buildings

constructed, 426 increase in, 603, 617 as plant asset, 426 purchased, 426

Business activities financing, 9, 120 investing, 9, 120 operating, 9–10, 120 types of, 8–9

Business documents, 224 Business organization

selection of, 4–5 taxes and legal liability

and, 4 types of, 4

Buyers, freight costs incurred by, 217

By-laws, 541

C Callable bonds, 486, 509 Canceled checks, 334 Capital expenditures

for additions and improvements, 427

defined, 424, 453 Capital leases, 428, 499, 509 Capital stock, 558. See also

Common stock; Preferred stock

Captive finance companies, 396 Carrying value. See Book value Cash

as asset, 9 budgets, 344–345, 350 burn rate, 605 defined, 350 disbursements, 344 equipment purchase for, 95, 112 equivalents, 340–341 excess, investing and, H-1–H-2 fraud, 327, 602 GAAP versus IFRS and,

371–373 insurance policy purchase for,

97, 114 investing and financing

transactions, 592 investment by stockholders,

94, 111 management, 341–343 negative, operating with, 608 net change in (direct

method), 618 net change in (indirect

method), 604 note issued in exchange for,

94–95, 112 payment of rent with, 114 receipt in advance from

customer, 95, 113 receipts, 344 reporting, 340–341 restricted, 341, 350 sales, 385 services performed for, 96, 113

Cash (net) realizable value, 379, 389, 400

Cash controls, 327–332 disbursements, 330–332 flowcharts, 329 mail receipts, 330 over-the-counter receipts,

328–330 overview of, 327 petty cash fund, 331, 347–

348, 350 receipts, 328–330 voucher system controls,

330–331, 350 Cash dividends. See also Dividends

adequate cash and, 549–550 declaration date, 550, 567 declared dividends and, 550 defined, 549, 566 entries for, 550–551 payment date, 551, 567 payment requirements,

549–550 record date, 550, 567 retained earnings and, 549

I-8 Subject Index

Cash equivalent price, 425, 453 Cash flows. See also Statements

of cash flows adjusting entries and, 157 classification of, 592–593 determination of, 595 ethics, 603 financing activities, 592, 593 free, 609–610, 621, 671–672 future, 592 investing activities, 592, 593 monitoring of, 610 operating activities, 592,

593, 595 product life cycle impact on, 607

Cash management, 342–343 Cash payments

for income taxes, 616 for interest, 616 major classes of, 613 for operating expenses, 615 to suppliers, 614–615

Cash receipts acceleration of, 396 computation of, 614 from customers, 613–614 major classes of, 613

Cash register documents, 224 Cash-basis accounting, 153–

154, 185 Certified public accountant

(CPA), 19, 22 Change in accounting principle,

651–652, 678 Channel stuffing, 653 Chart of accounts, 109–110, 123 Charters, 541, 567 Check register, 330 Checks, outstanding, 335, 350 Classified balance sheet, 46–51

current assets, 46–48 current liabilities, 50 current ratio and, 54, 55 debt to assets ratio and, 56 defined, 46, 64 example illustration, 47 GAAP versus IFRS, 87–88 intangible assets, 48–49 liquidity and, 53–55 liquidity ratios and, 54–55 long-term investments, 48 long-term liabilities, 50 property, plant, and

equipment, 48 solvency and, 55–56 stockholders’ equity, 50 using, 53–56 working capital and, 54

Closing entries defined, 175, 185 journalized, 176 posting of, 177 preparing, 175–176

Closing the books, 175–179 preparing closing entries,

175–176 preparing post-closing trial

balance, 176–177 process, 176 temporary versus permanent

accounts and, 175 virtual close, 175

Collection agents, 481 Collection monitoring, receivables

and, 393–394 Collection period, average, 395,

400, 669, 678 Collusion, 327 Common stock. See also

Stockholders’ equity accounting for, 545–546 bond financing advantages

over, 562 debit/credit procedures for,

102–103 defined, 22, 50, 541, 544 as financing activity, 9 increase in, 604, 617 issuance of, 543, 545 par value, issuing for cash,

545–546 Company officers, 5 Comparability, financial

information, 59, 60, 64 Comparative balance sheets,

595, 597 Comparative effects of

methods, 278 Component depreciation, 476 Composition, of current assets, 55 Compound interest, G-2–

G-3, G-17 Compounding periods, G-15 Comprehensive income, 650–651

complete statement of, 651 defined, 231, 650, 678, H-12 format, 650–651 illustration of, 650

Comprehensive income statement, 231–232, 651

Concentration of credit risk, 394, 400

Confirmatory value, financial information, 60

Conservatism, 282 Consigned goods, 270–271, 292

Consistency, financial information, 60, 65

Consolidated financial statements. See also Financial statements

Amazon.com, Inc., D-1–D-3 Apple Inc., A-1–A-5 Columbia Sportswear Com-

pany, B-1–B-4 defined, H-6, H-13 VF Corporation, C-1–C-3 Wal-Mart Stores, Inc., E-1–E-5

Contingencies defined, 498, 509 as liability, 498–499 reasonable estimate of, 499

Continuous life, corporations and, 539

Contra account, 490 Contra asset accounts, 159, 185 Contra revenue account, 226 Contractual interest rate, 486, 509 Control activities. See also Internal

controls defined, 319 documentation procedures,

322–323 human resource controls,

325–326 independent internal

verification, 324–325 physical controls, 323–324 principles of, 320–325 purchasing, 321 responsibility establishment, 320 sales, 321 segregation of duties, 321–322

Control environment, 319 Controller, 540 Controlling interest, H-6, H-13 Controls. See Internal controls Convertible bonds, 486, 509 Copyrights, 441, 453 Corporate capital, 544 Corporate life cycle

decline phase, 608 defined, 607 growth phase, 607–608 introductory phase, 607 maturity phase, 608

Corporate social responsibility, 540 Corporations

ability to acquire capital, 539 additional taxes, 540–541 characteristics of, 538–541 charter, 541, 567 classification by ownership, 538 classification by purpose, 538 continuous life, 539

Subject Index I-9

controller, 540 defined, 4, 22, 538, 567 ethics, 540 forming, 541 government regulations

and, 540 investments and, H-1–H-2 by-laws, 541 license, 541 limited liability of stockholders,

538 management, 539–540 organization chart, 539 privately held, 538, 567 publicly held, 538, 567 S corporation, 541 separate legal existence, 538 stockholder rights, 541–542 transferable ownership rights,

538–539 treasurer, 540 types of, 4

Correct cash balance, 338 Corruption, 332 Cost allocation, 429 Cost constraint, 62, 65 Cost factor, in depreciation, 430 Cost flow assumptions, 272–277 Cost flow methods, 271–281

average-cost, 276–277, 292 balance sheet effects, 278–279 comparative effects, 278 first-in, first-out (FIFO),

274–275, 292 income statement effects,

277–278 last-in, first-out (LIFO), 275–

276, 292 overview of, 271–272 periodic inventory system, 273 perpetual inventory records,

287–289 specific identification, 272, 292 tax effects, 279 use consistency, 280

Cost method stock investments, H-4, H-13 treasury stock purchase, 547

Cost of goods available for sale, 273

Cost of goods sold in cross profit calculation, 229 defined, 10 periodic inventory system,

233–234 perpetual inventory system, 233 proof of, 275, 276 recalculation of, 273

Costs current replacement, 282,

292 flow of, 217 freight, 221, 240 research and development,

441, 453 weighted-average unit,

276, 292 CPA (certified public accountant),

19, 22 Credit

abbreviation, 101 balance, 101 defined, 101, 123 equal debit, 101–102 extending, 392–393 rules summary, 105

Credit card sales, 385–386 Credit cards

advantages to retailer, 386 finance charges, 385 how they work, 386 sales, 385

Credit procedures, 101–104 for assets and liabilities, 102 for common stock, 102–103 for dividends, 103 overview, 101–102 for retained earnings, 102–103 for revenues and expenses, 104 for stockholders’ equity,

102–104 Credit risk, concentration of,

394, 400 Crediting, 101 Creditors, 6, 9 Cumulative dividends, 552, 567 Current assets, 46–48

composition of, 55 defined, 46, 65 example illustration, 47 listing of, 46 types of, 46

Current liabilities, 480–485 changes to, 599–601 current maturities of long-term

debt, 482 defined, 50, 65, 480, 509–510 example illustration, 50 interest payable as, 489 notes payable, 480–481 payroll and payroll taxes

payable, 483–484 sales taxes payable, 481 unearned revenues, 481–482

Current maturities of long-term debt, 482

Current ratio classified balance sheet and,

54, 55 defined, 54, 65, 668, 678 example illustration, 55 as liquidity ratio, 496–497, 668 managing, 661

Current replacement cost, 282, 292

Customers cash receipts from, 613–614 as external users, 6 receipt of cash from, 95, 113

D Days in inventory, 283, 669–

670, 678 Debit

abbreviation, 101 balance, 101 defined, 101, 123 equal credit, 101–102 rules summary, 105

Debit balance allowance account and, 383 defined, 101

Debit procedures, 101–104 for assets and liabilities, 102 for common stock, 102–103 for dividends, 103 overview, 101–102 for retained earnings, 102–103 for revenues and expenses, 104 for stockholders’ equity,

102–104 Debiting, 101 Debt. See also Liabilities

defined, 13 good, 56

Debt covenants, 500 Debt investments, H-3, H-13 Debt masking, 498 Debt to assets ratio

defined, 56, 65, 670, 678 example illustration, 56 as solvency ratio, 670–671

Debt to equity ratio, 671 Debt versus equity decision,

562–563 Declaration date, 550, 567 Declining-balance method,

432–433, 449–450 accelerated-depreciation

method, 432, 450, 453 declining book value, 449 defined, 432, 449, 453 depreciation schedule,

450, 453

I-10 Subject Index

Declining-balance method (Continued)

double-declining-balance method, 433, 450

formula, 450 Deferrals, 156–162

depreciation, 158–160 insurance, 158 prepaid expenses, 156–160 supplies, 157 types of, 155 unearned revenues, 160–162

Deficits, 557, 567 Deposits in transit, 335, 350 Depreciable assets, 429 Depreciable cost, 431, 453 Depreciation, 429–436

accelerated-depreciation method, 432, 450, 453

accumulated, 48 adjusting entries for,

158–160 as allocation concept, 159 annual rate, 431 book value and, 160, 429 cash fund and, 430 comparison of methods, 434 component, 476 as contra asset account, 159 as cost allocation process, 429 cost factor, 430 declining-balance method,

432–433, 449–450, 453 defined, 48, 159, 185, 429, 453 depreciable cost, 431, 453 depreciation schedule, 431 disclosure in notes, 434–435 double-declining-balance

method, 450 ethics and, 430 as expense, 598 factors in computing, 430 fair value and, 429 impairments, 436, 453 on income statement, 430 income taxes and, 434 land and, 429 methods, 430–435 obsolescence and, 430 patterns of, 434 plant asset classes, 429 prorating, 432 recognizing, 430 revising, 434–435 salvage value and, 430 statement presentation and,

159–160 straight-line, 431–432, 453

units-of-activity method, 433– 434, 450–451, 453

useful life and, 158, 185, 430 Depreciation expense

direct method (statement of cash flows), 616

indirect method (statement of cash flows), 598–599

Depreciation schedules declining-balance, 450, 453 defined, 431 straight-line, 433 units-of-activity, 433, 451

Direct method (statement of cash flows). See also Statements of cash flows

cash payments for income taxes, 616

cash payments for interest, 616 cash payments for operating

expenses, 615 cash payments to suppliers,

614–615 cash receipts from customers,

613–614 defined, 513, 596, 621 depreciation expense, 616 financing activities, 617 increase in bonds payable, 617 increase in buildings, 617 increase in common stock, 617 increase in equipment, 617 increase in land, 617 increase in retained

earnings, 617 investing activities, 617 major steps in, 613–618 net change in cash, 618 operating activities, 613–616 preparation using, 611–618 separate schedule for net cash

flows, 616 statement of cash flow

preparation, 617–618 Direct write-off method, 378–

379, 400 Discontinued operations, 649, 678 Discount period, 222 Discounting the future amount,

G-7, G-17 Discounts

amortizing, 491, 502–503 on bonds, 489–490 defined, 510 effective interest method of

amortization, 505–506 issuing bonds at, 490–491 Korean, 59

present value of principal and interest, G-13

purchase, 222–223, 240 sales, 226–227, 240 straight-line amortization,

502–503 time periods and, G-11

Dishonored (defaulted) note, 391, 400

Dividend record, 560–561 Dividends, 549–556

in arrears, 552, 567 cash, 549–551, 566 cumulative, 552, 567 debit/credit procedures for, 103 declared, 550 defined, 9, 22, 98, 549, 567 guarantee, 552 payment as cash outflow, 617 payment of, 98, 116 preferences, 552 recording, H-5, H-6 reporting of, 549 stock, 553–556, 565, 567

Documentation procedures, 322–323, 427

Dollar-value LIFO, 273 Double taxation, 540 Double-declining-balance

method, 433 Double-entry system, 101–102, 123 The Dun & Bradstreet Reference

Book of American Business, 393

E Earnings, quality of, 172–173,

185, 652–653, 678 Earnings management, 172,

185, 436 Earnings per share (EPS)

defined, 53, 56, 675, 678 example illustration, 53, 675 as profitability ratio, 675

Earnings performance, stockholders’ equity, 561–562

Economic entity assumption, 61, 65

Effective interest method of amortization

bond discount, 505–506 bond premium, 506–507 constant percentage

rate, 504 defined, 504, 510 interest expense, 505 steps, 505

Subject Index I-11

Effective interest rate, 504, 510 Electronic funds transfers

(EFTs), 333, 338, 350 Employees

bonding, 325, 350 hiring of, 98, 115 salaries, cash payment for,

98, 116 stealing and, 332

EPS. See Earnings per share Equipment

defined, 9 increase in, 603, 617 as plant asset, 426–427 purchase for cash, 95, 112

Equity method, H-5, H-13 Equity versus debt decision,

562–563 Equivalents, 350 Errors, 119 Ethics

adjusting entries, 164 cases, steps in analyzing, 7 cash equivalents and, 341 cash flows, 603 convenient overstatement

and, 110 corporations, 540 credit card finance

charges, 385 depreciation and, 430 dilemmas, solving, 7 documents, 107 earnings management, 230 economic entity assumption

and, 61 employee theft and, 332 errors and irregularities, 119 fair value accounting, H-10 in financial reporting, 7 financial reporting, 224 income statement and, 12 inventory, 270 leasing, 499 liabilities, 495 petty cash fund, 331 physical inventory, 269 receivables, 376 treasury stock, 548

Exclusive right, 49 Expense recognition principle,

152, 185 Expenses

accrued, 164–167, 184 bank charges, 338–339 debit/credit procedures for, 104 defined, 10, 22 forms of, 10

operating, 229 as operating activity, 10 prepaid, 156–160, 185 single-step income statement,

227 stockholders’ equity and,

96, 104 External users, 6

F Face value

bonds, 486, 490 defined, 389, 510 issuing bonds at, 489 present value of principal and

interest, G-13 Factoring, 385–387 Factors, 385, 400 Fair value

defined, H-7, H-13 in depreciation, 429 ethics, H-10 per share, 554 permanent decline in, 436 principle, 65 reporting, 61 of securities, H-8 total, H-8 unfairness of, 389 U.S. accounting standard, H-7

Faithful representation, 60, 65 FIFO. See First-in, first-out Finance directors, 5 Financial Accounting Standards

Board (FASB) accounting for financial

instruments, 389 Accounting Standards

Codification, 41 defined, 59, 65 fair value principle, 61 IASB joint project, 228 IASB standard convergence, 88

Financial analysis basic tools in, 654 GAAP versus IFRS, 699–700 horizontal analysis, 655–

657, 678 quality of earnings, 652–653, 678 ratio analysis, 660–664 sustainable income, 648–652 vertical analysis, 657–659, 678

Financial calculators, G-13–G-16 applications of, G-15–G-16 for auto loan, G-15 compounding periods, G-15 for mortgage loan amount, G-16 plus and minus, G-14

for present value of a single sum, G-14–G-15

for present value of annuity, G-15

rounding, G-15 Financial flexibility, 605 Financial information

comparability, 59, 60, 64 complete, 60 confirmatory value, 60 consistency, 60, 65 enhancing qualities of,

59–60 external users of, 6 faithful representation, 60, 65 free from error, 60 internal users of, 5 materiality, 60, 65 relevance, 60, 65 timeliness, 59, 60, 65 understandability, 59, 60, 65 useful, 59 verifiability, 59, 60, 65

Financial reporting assumptions in, 60–61 concepts, 58–63 cost constraint and, 62, 65 economic entity assumption,

61, 65 ethics in, 7, 224 fair value principle, 61, 65 full disclosure principle, 62, 65 going concern assumption,

61, 65 historical cost principle,

61, 65 measurement principles, 61 monetary unit assumption,

61, 65 periodicity assumption, 61, 65 principles in, 61–62 standard-setting environment

and, 58–59 useful information qualities,

59–60 Financial statements, 2–89

balance sheet, 11, 13–14, 22 consistent preparation

of, 651 consolidated, H-6, H-13 defined, 11 depreciation and, 159–160 example, 16 fraud, 332 income statement, 11–12, 22 interrelationship of, 15 Louis Vuitton, F-1–F-5 notes to, 18, 22

I-12 Subject Index

Financial statements, (Continued) preparing from adjusted trial

balance, 171–172 ratio analysis, 51–58 of receivables, 391–392 retained earnings statement,

11, 12–13, 22 statement of cash flows, 11,

14, 22 types of, 11

Financing activities cash flows, 592, 593 defined, 9, 120, 621 direct method (statement of

cash flows), 617 indirect method (statement of

cash flows), 603–604 Finished goods inventory, 268, 283 First-in, first-out (FIFO), 274–275

allocation of costs, 274 defined, 274, 292 LIFO conversion to, 285 “paper or phantom profits,”

278 periodic, 273 perpetual inventory system,

287–288 Fiscal year, 152, 185 FISH assumption, 275 Fixed assets. See Property, plant,

and equipment Flow of costs, 217 FOB (free on board), 217 FOB destination, 217, 270, 292 FOB shipping point, 217, 270, 292 Form 10-K, A-1 Franchises, 442, 453 Fraud. See also Internal controls

accounts receivable, 377 bank reconciliation and, 335 cash, 327, 602 defined, 318, 350 examples of, 225, 320, 321,

322, 323, 324, 325, 326 financial pressure and, 318 financial statement, 332 GAAP versus IFRS and, 371–373 inventory, 290 net income, 427 opportunity and, 318 payroll, 484 rationalization and, 318 Sarbanes-Oxley Act (SOX)

and, 318–319 stockholders’ equity, 543

Fraud triangle, 318, 350 Free cash flow

calculation of, 57, 609–610

defined, 57, 65, 609, 621, 671, 678

as solvency ratio, 671–672 Free on board (FOB), 217 Freight costs

periodic inventory system, 240 perpetual inventory system, 217

Full disclosure principle, 62, 65

Future value. See also Time value of money

of annuity, G-4–G-7, G-17 formula for, G-3 of periodic payment

computation, G-5 of single amount, G-3–G-4,

G-17

G Gain on disposal, plant assets,

437–438 General journal

adjusting entries, 168 defined, 107, 123

General ledger adjusting entries, 169 defined, 109, 123 illustrated example, 118

Generally accepted accounting principles (GAAP)

adjusting entries, 212–213 capital disclosure categories,

558 cash, 371–373 classified balance sheet, 87–88 defined, 42, 58, 65 effective interest method of

amortization, 505 financial statement analysis,

699–700 for fraud, 371–373 income statement presentation,

699–700 internal controls, 371–373 inventory and, 314–315 leases, 499 liabilities, 533–534 long-lived assets, 475–476 merchandising operations,

264–265 receivables, 419–420 recording process, 148–149 sales of receivables, 385 statement of cash flows, 593,

643–644 stockholders’ equity, 587–588

Gift cards, 162 Going concern assumption, 61, 65

Goods consigned, 270–271, 292 earliest, 274 latest, 275 in transit, 270

Goodwill defined, 442, 453 as intangible asset, 49, 442

Government regulations, corporations and, 540

Gross margin, 229 Gross profit

calculation, 229 defined, 229 multiple-step income

statement, 228 as percentage, 234

Gross profit rate defined, 234, 674, 678 illustrated, 235, 675 by industry, 234 profit margin versus, 235 as profitability ratio, 674–675

H Held-to-maturity securities, H-7,

H-13 Hiring of new employees, 98, 115 Historical cost principle, 61,

65, 424 Honor of notes receivable, 390 Horizontal analysis, 655–657.

See also Financial analysis of balance sheets, 656 computation, 655 defined, 655, 678 of income statements, 656 of net sales, 655

Human element, internal controls and, 327

Human resource controls activities, 325 missing, 225, 326, 485

I IASB. See International

Accounting Standards Board IFRS. See International Financial

Reporting Standards Impairments, 436, 453 Improper adjusting entries, 173 Improper recognition, quality of

earnings, 653 Income

comprehensive, 231, 650, 678, H-11

from operations, 228, 230 pro forma, 652–653, 678 sustainable, 648–652, 678

Subject Index I-13

Income statements comprehensive, 231–232 cost flow methods and,

277–278 current, 595 defined, 11, 22 depreciation, 430 earnings per share (EPS)

and, 53 ethics and, 12 example illustration, 12, 16 GAAP versus IFRS, 699–700 horizontal analysis, 656 interrelationship, 15–16 inventory error effects, 289–290 Louis Vuitton, F-1 multiple-step, 228–231 net income and, 11 non-recurring charges, 649 ratio analysis with, 52–53 single-step, 227–228 using, 52–53 vertical analysis, 658 VF Corporation, C-2 Wal-Mart Stores, Inc., E-1

Income Summary closing the books and, 176 defined, 175, 185

Income taxes cash payments for, 616 defined, 10 depreciation and, 434 as operating activity, 10

Income taxes payable decrease in, 601 as operating activity, 10

Independent internal verification, 324–325, 377, 427, 485, 543, 602

Indirect method (statement of cash flows). See also Statements of cash flows

accounts payable increase, 601 accounts receivable decrease, 600 bonds payable increase, 603 buildings increase, 603 common stock increase, 604 conversion to net cash

summary, 601–602 current liabilities, 599–601 defined, 596, 621 depreciation expense, 598–599 equipment increase, 603 financing activities, 603–604 income taxes payable

decrease, 601 inventory increase, 600 investing activities, 603–604

land increase, 603 loss on disposal of plant assets,

599–601 net change in cash, 604 noncash current assets,

599–601 operating activities, 598–603 prepaid expenses increase,

600–601 retained earnings

increase, 604 statement of cash flows

preparation, 604 Industry averages, 654 Industry-average comparisons,

51, 668 Inflating revenue, 173 Insurance, adjusting entries for,

157–158 Insurance policies, 97, 114 Intangible assets, 439–443. See also

Long-lived assets accounting for, 440 amortization of, 440, 453 copyrights, 441, 453 at cost, 440 defined, 48, 65, 422,

439, 453 example illustration, 49 franchises, 442, 453 goodwill, 442, 453 limited life and, 440 patents, 440, 453 presentation of, 443–444 research and development

costs, 441, 453 sources of, 439 trademarks (trade names),

441, 453 types of, 48–49, 440–443

Intent to convert, investments, H-10

Intercompany basis, 654 Intercompany comparisons,

51, 668 Interest

accrued, 165–166 bond, recording, H-3 cash payments for, 616 compound, G-2–G-3, G-17 defined, G-1, G-17 elements of, G-2 expense, 10, 491, 504 notes receivable, 388 paying, 223 payments, 487 revenue, 10 simple, G-2, G-17

Interest payable as current liability, 489 as operating activity, 10

Interest rates annual, 388 contractual, 486, 489–490, 509 defined, G-2 effective, 504, 510 market, 486, 490, 510

Interest receivable, 376, 390 Internal auditors, 325, 350 Internal controls. See also

Fraud bank account, 333–340 bank statements and,

333–334 cash, 327–332 cash budgeting, 344–345 cash managing and monitoring,

341–343 cash reporting, 340–341 collusion and, 327 control activities, 319 control environment, 319 defined, 319, 350 documentation procedures

and, 322–323, 427 flowcharts, 329 GAAP versus IFRS and,

371–373 human element and, 327 human resource, 225, 325–

326, 485 independent internal verification

and, 324–325, 377, 427, 485, 543, 602

information and communication, 319

limitations of, 326–327 missing, 225, 320, 322, 323,

324, 325, 326, 377, 427, 485, 543, 602

monitoring, 319 petty cash fund, 331, 347–

348, 350 physical, 225, 323–324 principles of activities,

320–325 reasonable assurance and, 326 responsibility establishment

and, 320 risk assessment, 319 risk level and, 326 segregation of duties and,

321–322, 377 segregation of record-keeping

from physical custody and, 322, 329

I-14 Subject Index

Internal controls (Continued) segregation of related activities

and, 321–322 size of business and, 327 system components, 319 voucher system, 330–331, 350

Internal users, 5 International Accounting

Standards Board (IASB) defined, 59, 65 FASB joint project, 88, 228

International Financial Reporting Standards (IFRS)

accumulated profit or loss, 587 adjusting entries, 212–213 asset valuation, 425 cash, 371–373 classified balance sheet, 87–88 defined, 42, 59, 65 financial statement analysis,

699–700 for fraud, 371–373 income statement presentation,

699–700 internal controls, 371–373 inventory and, 314–315 liabilities, 533–534 long-lived assets, 475–476 merchandising operations,

264–265 receivables, 419–420 recording process, 148–149 reserves, 587 statement of cash flows, 593,

643–644 statement of comprehensive

income, 587 stockholders’ equity, 587–588

Intracompany basis, 654 Intracompany comparisons,

51, 668 Inventory, 266–315

analysis, 283–284 beginning, 290 classifying, 268–269 consigned goods and, 270–

271, 292 conversion from LIFO to

FIFO, 285 days in, 283, 292, 669–670, 678 defined, 10 ending, 290, 291 ethics, 270 finished goods, 268, 283 fraud, 290 GAAP versus IFRS, 314–315 goods in transit and, 270 increase in, 600

just-in-time (JIT), 268–269, 283, 292

LIFO reserve adjustments and, 284–285

lower-of-cost-or-market, 281– 282, 292

manufactured, 268 merchandising, 268 as operating activity, 10 ownership of goods

determination and, 270–271

physical, 269 presentation, 281 quantities, determining,

269–271 raw materials and, 268, 292 turnover, 283–284, 292, 669, 678 work in process and, 268, 292

Inventory cost flow, 271–281 assumptions, 272–277 average-cost, 276–277, 292 balance sheet effects, 278–279 comparative effects of

methods, 278 first-in, first-out (FIFO), 274–

275, 292 income statement effects,

277–278 last-in, first-out (LIFO), 275–

276, 292 method use consistency, 280 overview of, 271–272 periodic inventory system, 273 perpetual inventory records,

287–289 specific identification method,

272, 292 tax effects, 279 weighted-average unit cost

and, 276, 292 Inventory errors, 289–291

balance sheet effects, 290–291

income statement effects, 289–290

Investees, H-4 Investing activities

cash flows, 592, 593 defined, 9, 120, 621 direct method (statement of

cash flows), 617 indirect method (statement of

cash flows), 603–604 Investment portfolios, H-4 Investments

available-for-sale securities, H-7, H-9–H-10, H-13

balance sheet presentation of, H-11

corporations and, H-1–H-2 debt, H-3, H-13 for earnings generation, H-2 excess cash and, H-1–H-2 held-to-maturity securities,

H-7, H-13 idle cash, 343 intent to convert, H-10 as investing activity, 9 liquid, 343 long-term, H-11, H-13 nonoperating items related

to, H-11 presentation of realized/

unrealized gain or loss, H-11–H-12

readily marketable, H-10 reasons for, H-1–H-2 risk-free, 343 short-term, H-10–H-11, H-13 statement of cash flows, H-12 stock, H-4–H-12, H-13 for strategic reasons, H-2 trading securities, H-7,

H-8–H-9, H-13 Investors, 6 Invoices

contents of, 220 purchase, 220 sales, 224

Irregularities, 119 Issuance of stock, 543

J Journalizing, 107, 108 Journals

defined, 106, 123 entry features, 108 general, 107, 123 recording in, 106–108 transfer to ledgers, 106

Just-in-time (JIT) inventory defined, 268, 292 example of, 268–269 procedures, 283

K Korean discount, 59

L Labor unions, 6 Land

improvements, 425 increase in, 603, 617 as not depreciable asset, 429 as plant asset, 425

Subject Index I-15

Last-in, first-out (LIFO), 275–276 allocation of costs, 275 conformity rule, 279 conversion to FIFO, 285 cost of ending inventory, 276 defined, 275, 292 dollar-value, 273 fairness of, 279 periodic, 273 perpetual inventory system,

288 reserve, 284–285, 292

LCM (lower-of-cost-or-market), 281–282, 292

Leases capital, 428, 499, 509 defined, 428 ethics, 499 GAAP versus IFRS, 499 liabilities and, 499 operating, 428, 499, 510

Ledgers, 106, 109, 118, 123 Legal capital, 543, 567 Lessee, 428, 453 Lessor, 428, 453 Leveraging, 673, 678 Liabilities

analysis, 496–500 bank line of credit and, 497 bonds, 485–494 contingencies, 498–499, 509 current, 50, 65, 480–485,

509–510 debit/credit procedures for, 102 debt covenants, 500 debt masking, 498 defined, 9, 22 ethics, 495 GAAP versus IFRS, 533–534 leasing, 499 liquidity ratios, 496–497 long-term, 50, 65, 480, 485, 510 off-balance-sheet financing,

499, 510 payment of, monitoring, 343 presentation of, 495 solvency ratios, 497–498 times interest earned and,

497, 510 License, corporation, 541 LIFO. See Last-in, first-out LIFO conformity rule, 279 LIFO reserve, 284–285, 292 Limited liability companies

(LLCs), 4 Limited liability of stockholders,

corporations and, 538 Limited life, 440

Liquid investments, 343 Liquidity

defined, 53, 65 liabilities and, 496–497 receivables, evaluating,

394–396 working capital and, 54

Liquidity ratios accounts receivable turnover

and, 668–669 average collection period,

669, 678 current ratio, 54, 55, 496–

497, 668 days in inventory, 669–670, 678 defined, 52, 54, 65, 496, 660,

667, 678 inventory turnover, 669, 678 summary of, 661

LISH assumption, 274 Long-lived assets

analyzing, 444–447 GAAP versus IFRS, 475–476 intangible assets, 422, 439–443 plant assets, 422, 424–439 presentation of, 443–444 profit margin, 446–447 return on, 444–445, 446, 453 turnover, 445–446, 453

Long-term debt. See Long-term liabilities

Long-term investments. See also Investments

balance sheet presentation of, H-11

characteristics of, 48 defined, 48, 65, H-13

Long-term liabilities bonds, 485–494 current maturities of, 482 defined, 50, 65, 480, 485, 510 example illustration, 50 notes payable, 507–508

Long-term notes/bonds present value of, G-11–G-13 time diagram, G-12

Losses accounts receivable, 379 on disposal of plant assets,

438, 599, 616 net, 557

Lower-of-cost-or-market (LCM), 281–282, 292

M Madoff’s Ponzi scheme, 339 Mail receipts, 330 Makers, 387, 400

Management cash, 341–343 corporation, 539–540 earnings, 436 of receivables, 392–394, 397

Management discussion and analysis (MD&A), 18

Manufacturing operations, inventory, 268

Market interest rate, 486, 490, 510

Marketable securities, H-10, H-13

Marketing expenses, 10 Marketing managers, 5 Marketing return on investment

(ROI), 445 Mark-to-market accounting, H-8,

H-13 Matching principle, 152 Material disposal, 167 Materiality, 60, 65 Maturity date

bonds, 486 defined, 486, 510 notes receivable, 388

Maturity value, 390 MD&A (management discussion

and analysis), 18 Merchandise transactions,

recording under periodic inventory system, 239

Merchandising inventory, 268 Merchandising operations,

214–265 comprehensive income

statement and, 231–232 cost of goods sold, 216 flow of costs, 217–219 GAAP versus IFRS,

264–265 gross profit rate and profit

margin, 234–238 inventory, 268 multiple-step income statement

and, 228–231 operating cycles, 216–

217, 342 periodic inventory system and,

218, 233–234 perpetual inventory system

and, 217–218, 219–227 retail, 216 sales revenue, 216 single-step income statement

and, 227–228 wholesale, 216

Merchandising profit, 229

I-16 Subject Index

Modified Accelerated Cost Recovery System (MACRS), 434

Monetary unit assumption, 61, 65 Monitoring

cash, 341–343 internal controls, 319 payment of liabilities, 343

Mortgage loan application, financial calculator, G-16

Mortgage notes payable, 507, 510

Mortgages, 507 Multiple-step income statement,

228–231 defined, 228 gross profit, 228 income from operations, 228 net income, 228 nonoperating activities,

230–231 operating expenses, 229 sales, 229

N Net cash flows, 616 Net change in cash

direct method, 618 indirect method, 604

Net income defined, 10, 22 income statement and, 11 multiple-step income

statement, 228 net cash difference, 592 as performance measure, 592

Net loss, 10, 22, 557 Net sales, 228, 655 No par value stock, 544 Noncash activities, 593–594 Noncash current assets, changes

to, 599–601 Nonoperating activities

defined, 230 reporting of, 230–231

Non-recurring charges, 649 No-par value stock, 543, 544 Normal balance

assets and liabilities, 102 common stock, 103 dividends, 103 retained earnings, 103 revenues and expenses, 104

Notes payable current liabilities, 480–481 defined, 480, 510 as financing activity, 9 issue of, 94–95, 112

as long-term liability, 507–508 mortgage, 507, 510

Notes receivable, 387–391 accrual of interest receivable,

390 cash (net) realizable value, 389 defined, 376 dishonor of, 391, 400 disposing of, 389–391 face value, 389 honor of, 390 interest computation, 388 makers, 387, 400 maturity date determination,

388 maturity value, 390 payees, 387, 400 promissory notes and, 387, 400 recognizing, 388–389 valuing, 389

Notes to the financial statements, 18, 22

NSF check, 334, 350

O Obsolescence, 430 Off-balance-sheet financing,

499, 510 One-time items, 172 Operating activities

as business activity, 9–10 cash flows, 592, 593, 595 defined, 9, 120, 621 direct method (statement of

cash flows), 613–616 indirect method (statement of

cash flows), 598–603 Operating cycles

defined, 46, 65 merchandising operations,

216–217, 342 Operating expenses

cash payments for, 615 multiple-step income

statement, 229 Operating leases, 428, 453,

499, 510 Opposite form, 102 Ordinary repairs, 427, 453 Other expenses and losses, 230 Other revenues and gains, 230 Outstanding stock, 543, 548 Over-the-counter receipts,

328–330 Ownership of goods, determining,

270–271 Ownership rights, transferable,

538–539

P Paid-in capital

additional, 558 capital stock, 558 defined, 544, 567 stock dividends and, 553

“Paper or phantom profits,” 278 Par value, 543–544 Par value stock, 543–544, 545–

546, 567 Parent company, H-6, H-13 Partnerships, 4, 22 Patents, 440, 453 Payees, 387, 400 Payment date, 551, 567 Payment period, receivables

and, 393 Payments. See also Cash payments

of dividends, 98, 116 for employee salaries,

98, 116 from petty cash, 347 of rent, 96–97, 114

Payout ratio defined, 560, 567, 676, 678 example, 560–561 as profitability ratio, 676

Payroll, 483–484 Payroll taxes payable, 483–484 PCAOB (Public Company

Accounting Oversight Board), 59, 65

Percentage-of-receivables basis, 382, 400

Periodic inventory system cost flow assumptions, 273 cost of goods sold under,

233–234 defined, 218, 239 freight costs, 240 purchase discounts, 240 purchase returns and

allowances, 240 recording merchandise

transactions, 239 recording purchases of

merchandise, 239 recording sales of merchandise,

240–241 sales discounts, 241 sales returns and allowances,

240–241 Periodicity assumption, 61,

65, 185 Permanent accounts, 175, 185 Perpetual inventory system.