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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.

*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-

▼

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 t