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BUS550-FinancialandManagerialAccounting5thedition.pdf

Financial & managerial Accounting

John J. Wild

Ken W. Shaw

Barbara Chiappetta

5th edition

information for decisions

5th edition

fin a n c ia l &

m a n a g er ia l

a c c o u n t in g

Wild Shaw

chiappetta

9 7 8 0 0 7 8 0 2 5 6 0 0

9 0 0 0 0

www.mhhe.com

ISBN 978-0-07-802560-0 MHID 0-07-802560-5

E A N

Get Connected.

Studying anytime, anywhere has never been easier... With Connect Plus Accounting for Financial and Managerial Accounting, 5e, you receive the most advanced study tools as well as a fully integrated, media-rich E-book.

What kind of study tools?

LearnSmart™—no two students are alike. LearnSmart™ uses a series of adaptive questions to pinpoint exactly what you know and what you don’t know. The result is your own learning path that helps you retain more knowledge, learn faster, and study more efficiently.

Guided Examples give you a narrated, animated, step-by-step walkthrough of an exercise similar to the one you’ve been assigned by your instructor, allowing you to identify, review, and reinforce the concepts and activities covered in class.

Interactive Presentations provide important chapter material through an engaging, hands-on presentation, bringing the text content to life.

The Media-Rich E-book allows your instructor to share notes with you and your classmates. You can also insert and review your own notes, highlight the text, search for specific information, and interact with media resources.

Connect Plus Accounting gives you a complete digital solution that allows you to access your course materials from any computer, anytime.

If Connect Plus Accounting sounds good to you, start a three-week FREE TRIAL today!

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It’s that simple to begin using Connect Plus Accounting today.

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The integrated solutions for Wild’s Financial and Managerial Accounting 5e have been proven to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. Known for its engaging style, the Wild solution employs the use of current companies, LearnSmart, and instant feedback on practice problems to help students engage with course materials, comprehend the content, and achieve higher outcomes in the course.

McGraw-Hill’s adaptive learning component, LearnSmart, provides assignable modules that help students master core concepts and come to class more prepared.

In addition, Interactive Presentations deliver learning objectives in an interactive environment, giving students access to course-critical content anytime, anywhere.

Finally, our new Intelligent Response Technology-based content offers students an intelligent homework experience that helps them stay focused on learning instead of navigating the technology.

McGraw-Hill LearnSmart™ is an adaptive learning program that identifies what an individual student knows and doesn’t know. LearnSmart’s adaptive learning path helps students learn faster, study more efficiently, and retain more knowledge.

Intelligent Response Technology (IRT) is Connect Accounting’s new student

interface for end-of-chapter assessment content. Intelligent Response Technology

provides a general journal application that looks and feels more like what you would find in a general ledger software

package, improves answer acceptance to reduce student frustration with formatting

issues (such as rounding), and, for select questions, provides an expanded

table that guides students through the process of solving the problem.

Connect Accounting’s Interactive Presentations teach each chapter’s core learning objectives and concepts through an engaging, hands-on presentation, bringing the text content to life. Interactive Presentations harness the full power of technology to truly engage and appeal to all learning styles. Interactive Presentations are ideal in all class formats—online, face-to-face, or hybrid.

Get Connected.

FEATURES

PROVEN EFFECTIVE

LearnSmart™

Intelligent Response Technology

Interactive Presentations

accounting

®

The integrated solutions for Wild’s Financial and Managerial Accounting 5e have been proven to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. Known for its engaging style, the Wild solution employs the use of current companies, LearnSmart, and instant feedback on practice problems to help students engage with course materials, comprehend the content, and achieve higher outcomes in the course.

McGraw-Hill’s adaptive learning component, LearnSmart, provides assignable modules that help students master core concepts and come to class more prepared.

In addition, Interactive Presentations deliver learning objectives in an interactive environment, giving students access to course-critical content anytime, anywhere.

Finally, our new Intelligent Response Technology-based content offers students an intelligent homework experience that helps them stay focused on learning instead of navigating the technology.

McGraw-Hill LearnSmart™ is an adaptive learning program that identifies what an individual student knows and doesn’t know. LearnSmart’s adaptive learning path helps students learn faster, study more efficiently, and retain more knowledge.

Intelligent Response Technology (IRT) is Connect Accounting’s new student

interface for end-of-chapter assessment content. Intelligent Response Technology

provides a general journal application that looks and feels more like what you would find in a general ledger software

package, improves answer acceptance to reduce student frustration with formatting

issues (such as rounding), and, for select questions, provides an expanded

table that guides students through the process of solving the problem.

Connect Accounting’s Interactive Presentations teach each chapter’s core learning objectives and concepts through an engaging, hands-on presentation, bringing the text content to life. Interactive Presentations harness the full power of technology to truly engage and appeal to all learning styles. Interactive Presentations are ideal in all class formats—online, face-to-face, or hybrid.

Get Connected.

FEATURES

PROVEN EFFECTIVE

LearnSmart™

Intelligent Response Technology

Interactive Presentations

accounting

®

Get Engaged.

Lecture Capture

eBooks

Connect Plus includes a media-rich eBook that allows you to share your notes with

your students. Your students can insert and review their own notes,

highlight the text, search for specific information, and interact

with media resources. Using an eBook with Connect Plus gives your students a complete digital solution

that allows them to access their materials from any computer.

Make your classes available anytime, anywhere. With simple, one-click recording, students can search for a word or phrase and be taken to the exact place in your lecture that they need to review.

Get Engaged.

Lecture Capture

eBooks

Connect Plus includes a media-rich eBook that allows you to share your notes with

your students. Your students can insert and review their own notes,

highlight the text, search for specific information, and interact

with media resources. Using an eBook with Connect Plus gives your students a complete digital solution

that allows them to access their materials from any computer.

Make your classes available anytime, anywhere. With simple, one-click recording, students can search for a word or phrase and be taken to the exact place in your lecture that they need to review.

Financial and Managerial Accounting

John J. Wild University of Wisconsin at Madison

Ken W. Shaw University of Missouri at Columbia

Barbara Chiappetta Nassau Community College

INFORMATION FOR DECISIONS

5thedition

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FINANCIAL AND MANAGERIAL ACCOUNTING: INFORMATION FOR DECISIONS, FIFTH EDITION Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Previous editions © 2011, 2009, and 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-0-07-802560-0 MHID 0-07-802560-5

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Library of Congress Cataloging-in-Publication Data Wild, John J. Financial and managerial accounting: information for decisions / John J. Wild, University of

Wisconsin at Madison, Ken W. Shaw, University of Missouri at Columbia, Barbara Chiappetta, Nassau Community College.—5th edition.

pages cm Includes index. ISBN 978-0-07-802560-0 (alk. paper)—ISBN 0-07-802560-5 (alk. paper) 1. Accounting. 2. Managerial accounting. I. Shaw, Ken W. II. Chiappetta, Barbara. III. Title. HF5636.W674 2013 658.15911—dc23

2012037525

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill, and McGraw-Hill does not guarantee the accuracy of the information presented at these sites.

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Adapting to the Needs of Today's Students

Enhancements in technology have changed the spectrum of

how we live and learn in the world today. Being able to

download and work with learning tools on smart phones,

tablets, or laptop computers empowers students to drive their

own learning by putting increasingly intelligent technology

into their hands.

No two students are alike, and whether the goal is to

become an accountant or a businessperson or simply to be

an informed consumer of accounting information, Financial

and Managerial Accounting (FinMan) has helped generations

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With FinMan on your side, you’ll be provided with engaging

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Its chapter-opening vignettes showcase dynamic, successful

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FinMan also delivers innovative technology to help student

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restrictive format that adapts to the needs of today’s students.

Our new content features:

• a general journal interface that looks and feels more like

that found in practice.

• an auto-calculation feature that allows students to focus on

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• a smart (auto-fill) drop-down design.

The end result is content that better prepares students for

the real world. Connect Accounting also includes digitally

based, interactive adaptive learning tools that provide an

opportunity to engage students more effectively by offering

varied instructional methods and more personalized learning

paths that build on different learning styles, interests, and

abilities, allowing students to work at their own pace.

McGraw-Hill LearnSmart™ is an intelligent learning system

that uses a series of adaptive questions to pinpoint each

student’s knowledge gaps. LearnSmart then provides an

optimal learning path for each student, so that they spend less

time in areas they already know and more time in areas they

don’t. The result is LearnSmart’s adaptive learning path that

helps students retain more knowledge, learn faster, and study

more efficiently.

Our Interactive Presentations teach each chapter’s core

learning objectives in a rich multimedia format, bringing the

content to life. Your students will come to class prepared

when you assign Interactive Presentations. Students can also

review the Interactive Presentations as they study.

Guided Examples provide students with narrated, animated,

step-by-step walkthroughs of algorithmic versions of assigned

exercises. Students appreciate the Guided Examples because

they can help students learn accounting and complete

assignments when outside of class.

Connect Plus Accounting integrates a media-rich online

version of the textbook with Connect Accounting.

"This is an excellent book that is well-written and contains excellent illustrations. It has the

best online supplements of any of the texts that I have reviewed. . . . This is an excellent

book that I would recommend to all of my colleagues." — KAREN CRISONINO, County College of Morris

Financial and Managerial Accounting, 5e

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JOHN J. WILD is a distinguished profes- sor of accounting at the University of Wisconsin at Madison. He previously held appointments at Michigan State University and the University of Manchester in England. He received his BBA, MS, and PhD from the University of Wisconsin.

Professor Wild teaches accounting courses at both the undergraduate and graduate levels. He has received numerous teaching honors, includ-

ing the Mabel W. Chipman Excellence-in-Teaching Award, the depart- mental Excellence-in-Teaching Award, and the Teaching Excellence Award from the 2003 and 2005 business graduates at the University of Wisconsin. He also received the Beta Alpha Psi and Roland F. Salmonson Excellence-in-Teaching Award from Michigan State University. Professor Wild has received several research honors and is a past KPMG Peat Marwick National Fellow and is a recipient of fellowships from the American Accounting Association and the Ernst and Young Foundation.

Professor Wild is an active member of the American Accounting Association and its sections. He has served on several committees of these organizations, including the Outstanding Accounting Educator Award, Wildman Award, National Program Advisory, Publications, and Research Committees. Professor Wild is author of Fundamental Accounting Principles, Financial Accounting, Managerial Accounting, and College Accounting, each published by McGraw-Hill/Irwin. His research articles on accounting and analysis appear in The Accounting Review, Journal of Accounting Research, Journal of Accounting and Economics, Contemporary Accounting Research, Journal of Accounting, Auditing and Finance, Journal of Accounting and Public Policy, and other journals. He is past associate editor of Contemporary Accounting Research and has served on several editorial boards including The Accounting Review.

In his leisure time, Professor Wild enjoys hiking, sports, travel, people, and spending time with family and friends.

KEN W. SHAW is an associate professor of accounting and the Deloitte Professor of Accounting at the University of Missouri. He previously was on the faculty at the University of Maryland at College Park. He received an accounting degree from Bradley University and an MBA and PhD from the University of Wisconsin. He is a Certified Public Accountant with work experience in public accounting.

Professor Shaw teaches financial accounting at the undergraduate and graduate levels. He received the Williams-Keepers LLC Teaching Excellence award in 2007, was voted the “Most Influential Professor” by three School of Accountancy graduating classes, and is a two-time recipient of the O’Brien Excellence in Teaching Award. He is the advisor to his School’s chapter of the Association of Certified Fraud Examiners.

Professor Shaw is an active member of the American Accounting Association and its sections. He has served on many committees of these organizations and presented his research papers at national and regional meetings. Professor Shaw’s research appears in the Journal of Accounting Research; Contemporary Accounting Research; Journal of Financial and Quantitative Analysis; Journal of the American Taxation Association; Strategic Management Journal; Journal of Accounting, Auditing, and Finance; Journal of Financial Research; and other journals. He has served on the editorial boards of Issues in Accounting Education and the Journal of Business Research. Professor Shaw is co-author of Fundamental Accounting Principles, Managerial Accounting, and College Accounting, published by McGraw-Hill.

In his leisure time, Professor Shaw enjoys tennis, cycling, music, and coaching his children’s sports teams.

About the Authors

BARBARA CHIAPPETTA received her BBA in Accountancy and MS in Education from Hofstra University and is a tenured full professor at Nassau Community College. For the past two decades, she has been an active executive board member of the Teachers of Accounting at Two-Year Colleges (TACTYC), serving 10 years as vice president and as president from 1993 through 1999. As an active member of the American Accounting

Association, she has served on the Northeast Regional Steering Committee, chaired the Curriculum Revision Committee of the Two- Year Section, and participated in numerous national committees. Professor Chiappetta has been inducted into the American Accounting Association Hall of Fame for the Northeast Region. She had also

received the Nassau Community College dean of instruction’s Faculty Distinguished Achievement Award. Professor Chiappetta was honored with the State University of New York Chancellor’s Award for Teaching Excellence in 1997. As a confirmed believer in the benefits of the active learning pedagogy, Professor Chiappetta has authored Student Learning Tools, an active learning workbook for a first-year accounting course, published by McGraw-Hill/Irwin.

In her leisure time, Professor Chiappetta enjoys tennis and partici- pates on a U.S.T.A. team. She also enjoys the challenge of bridge. Her husband, Robert, is an entrepreneur in the leisure sport industry. She has two sons—Michael, a lawyer, specializing in intellectual property law in New York, and David, a composer, pursuing a career in music for film in Los Angeles.

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Dear Colleagues/Friends,

As we roll out the new edition of Financial and Managerial Accounting, we thank

each of you who provided suggestions to improve our textbook. As teachers, we

know how important it is to select the right book for our course. This new edition

reflects the advice and wisdom of many dedicated reviewers, symposium and

workshop participants, students, and instructors. Our book consistently rates

number one in customer loyalty because of you. Together, we have created

the most readable, concise, current, accurate, and innovative accounting book

available today.

Throughout the writing process, we steered this book in the manner you direct-

ed. Reviewers, instructors, and students say this book’s enhanced presentation,

graphics, and technology cater to different learning styles and helps students

better understand accounting. Connect Plus Accounting offers new features to

improve student learning and to assist instructor teaching and grading. You and

your students will find all these tools easy to apply.

We owe the success of this book to you and other instructors who graciously

took time to help us focus on the changing demands of today’s students and

their learning needs. We feel fortunate to have witnessed our profession’s

extraordinary devotion to teaching. Your feedback and suggestions are reflected

in everything we write. Please accept our heartfelt thanks for your dedication in

helping today’s students learn, understand, and appreciate accounting.

With kindest regards,

John J. Wild Ken W. Shaw Barbara Chiappetta

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Adapting to the Needs of McGraw-Hill Connect Plus Accounting is a complete online assignment, learning, and textbook assessment solution that connects your students with the tools and resources needed to achieve success through faster learning, more efficient studying, and higher retention of knowledge. Key features found in Connect Plus Accounting include:

Intelligent Response Technology Intelligent Response Technology is Connect Accounting's new student interface for end-of-chapter assessment content. Intelligent Response Technology provides a general journal application that looks and feels more like what you would find in a general ledger software package, improves answer acceptance to reduce student frustra- tion with formatting issues (such as rounding), and, for select questions, provides an expanded table that guides students through the process of solving the problem.

"I love how the general journal was set up. It felt like what I would be filling out if I had an accounting job."

—Student, Chabot Community College

"I like that this system was formatted like real-world accounting is." —Student, Rose State College

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Today's Students!

Connect Accounting helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. Connect grades homework automatically and gives imme- diate feedback on any questions students may have missed.

"This system has improved the journal entry and T-account set-up processes to more accurately resemble the way it is done in class."

—Student, Tallahassee Community College

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Interactive Presentations Connect Accounting's Interactive Presentations teach each chapter's core learning objec- tives and concepts through an engaging, hands-on presenta- tion, bringing the text content to life. Interactive Presentations harness the full power of tech- nology to truly engage and appeal to all learning styles. Interactive Presentations are ideal in all class formats—online, face-to-face, or hybrid.

Adapting to the Needs of

Integrated eBooks Connect Plus includes a media-rich eBook. With it, you can share your notes with your students, and they can insert their own notes, highlight the text, search for specific infor- mation, and review their materials. Using an eBook with Connect gives your students a complete digital solution that allows them to access their materials from any computer. And over time, as more and more students use mobile devices, our eBooks will even enable them to learn on the go.

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Guided Examples Guided Examples provide narrated, animated, and step- by-step walkthroughs of algorithmic ver- sions of assigned exercises in Connect Accounting, allowing the student to iden- tify, review, or reinforce the concepts and activities covered in class. Guided Examples provide immediate feedback and focus on the areas where students need the most guidance.

LearnSmart No two students are alike. McGraw-Hill LearnSmart™ is an intelligent learning system that uses a series of adaptive questions to pinpoint each student's knowl- edge gaps. LearnSmart then provides an opti- mal learning path for each student, so that they spend less time in areas they already know and more time in areas they don't. The result is that LearnSmart's adaptive learning path helps students retain more knowledge, learn faster, and study more efficiently.

Student Resource Library The Connect Accounting Student Study Center gives access to addi- tional resources such as recorded lec- tures, online practice materials, an eBook, and more.

Today's Students!

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Simple Assignment Management and Smart Grading With Connect Plus Accounting, creating assignments is easier than ever, so you can spend more time teaching and less time managing. Connect Accounting enables you to:

• Create and deliver assignments easily with select end-of-chapter questions and test bank items. • Go paperless with the eBook and online submission and grading of student assignments. • Have assignments scored automatically, giving students immediate feedback on their work and side-by-

side comparisons with correct answers. • Reinforce classroom concepts with practice tests and instant quizzes.

McGraw-Hill’s solutions are proven to improve student performance. With Connect Accounting, students can access a wealth of engaging resources to help them study more effectively and perform at a higher level on homework and exams. Connect Accounting also allows instructors to assign McGraw-Hill’s world class content and assess student performance.

The integrated solutions for Financial and Managerial Accounting have been specifically designed to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. McGraw-Hill’s adaptive learning component, LearnSmart, pro- vides assignable modules that help students master chapter core content and come to class more prepared. In addition, Interactive Presentations deliver learning objectives in an interactive environment, giving stu- dents access to course-critical content anytime, anywhere. Known for its engaging style, the FinMan solution employs the use of current companies, LearnSmart, and our instant feedback on practice problems to help students engage with our materials, comprehend the content, and achieve higher outcomes in the course.

Alternate Chapter Options This edition of Financial and Managerial Accounting features five alternate chapters that can be substituted for the traditional chapters through McGraw-Hill Learning Solutions or Create. These chapters provide alternate methods of teaching and learning chapter material and are fully supported in Connect. Alternate chapters available include:

• Chapter 5 - "Inventories and Cost of Sales" featuring the periodic inventory method • Chapter 10 - "Long-Term Liabilities" featuring the effective interest method • Chapter 12 - "Reporting on the Statement of Cash Flows" featuring the direct method • Chapter 16 - "Process Cost Accounting" featuring the First-In, First-Out method • Chapter 20 - "Master Budgets and Planning" featuring manufacturing budgets Contact your publisher's representative or learning solutions specialist for more information.

Adapting to the Needs of

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Today's Instructors

Instructor Library The Connect Accounting Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture. The Connect Accounting Instructor Library includes: access to the eBook version of the text, PowerPoint files, Solutions Manual, Instructor Resource Manual, and Test Bank.

Student Reporting Connect Accounting keeps instructors informed about how each stu- dent, section, and class is performing, allowing for more productive use of lecture and office hours. The reporting function enables you to:

• View scored work immediately and track individual or group per- formance with assignment and grade reports.

• Access an instant view of student or class performance relative to learning objectives.

• Collect data and generate reports required by many accreditation organizations, such as AACSB and AICPA.

• Identify low-performance students with the "At Risk" student report.

Tegrity: Lectures 24/7

Make your classes available anytime, anywhere. With simple one-click recording, instructors can record lectures, presentations, and step-by-step problem solutions with Tegrity. Using Tegrity with Connect Accounting, instructors can post recordings directly to Connect for student viewing. Students can also search for a word or phrase and be taken to the exact place in your lecture that they need to review.

To learn more about Tegrity watch a two-minute Flash demo at http://tegritycampus.mhhe.com.

McGraw-Hill Customer Experience Group Contact Information

At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why

our services don’t stop after you purchase our products. You can e-mail our Product Specialists 24 hours a day

to get product training online. Or you can search our knowledge bank of Frequently Asked Questions on

our support Website. For Customer Support, call 800-331-5094 or visit www.mhhe.com/support. One of our

Technical Support Analysts will be able to assist you in a timely fashion.

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We offer an Online Learning Center (OLC) that follows Financial and Managerial Accounting chapter by chapter. It doesn’t require any building or maintenance on your part. It’s ready to go the moment you and your students type in the URL: www.mhhe.com/wildFINMAN5e As students study and learn from Financial and Managerial Accounting, they can visit the Student Edition of the OLC Website to work with a multitude of helpful tools:

A secured Instructor Edition stores essential course materials to save you prep time before class. Everything you need to run a lively classroom and an efficient course is included. All resources available to students, plus . . .

• Instructor’s Resource Manual • Solutions Manual • Solutions to Excel Template Assignments • Test Bank • Solutions to Sage 50 Complete Accounting and QuickBooks templates

The OLC Website also serves as a doorway to other technology solutions, like course management systems.

• Generic Template Working Papers • Chapter Learning Objectives • Interactive Chapter Quizzes

• PowerPoint® Presentations • Excel Template Assignments

How Can Text-Related Web Resources Enrich My Course? Online Learning Center (OLC)

McGraw-Hill CampusTM

McGraw-Hill Campus™ is a new one-stop teaching and learning experience available to users of any learning management system. This complimentary integration allows faculty and students to enjoy single sign-on (SSO) access to all McGraw-Hill Higher Education materials and synchronized grade-book with our award-winning McGraw-Hill Connect platform. McGraw-Hill Campus provides faculty with instant access to all McGraw-Hill Higher Education teaching materials (eTextbooks, test banks, PowerPoint slides, animations and learning objects, and so on), allowing them to browse, search, and use any instructor ancillary content in our vast library at no additional cost to instructor or students. Students enjoy SSO access to a variety of free (quizzes, flash cards, narrated presentations, and so on) and subscription-based products (McGraw-Hill Connect). With this integration enabled, faculty and students will never need to create another account to access McGraw-Hill products and services. For more information on McGraw-Hill Campus please visit our website at www.mhcampus.com.

McGraw-Hill Higher Education and Blackboard have teamed up. What does this mean for you?

1. Single sign-on. Now you and your students can access McGraw-Hill's Connect™ and Create™ right from within your Blackboard course —all with one single sign-on.

2. Deep integration of content and tools. You get single sign-on with Connect and Create, you also get integration of McGraw-Hill content and content engines right in Blackboard. Whether you're choosing a book for your course or building Connect assignments, all the tools you need are right where you want them—inside Blackboard.

3. One grade book. Keeping several grade books and manually synchronizing grades in Blackboard is no longer necessary. When a student completes an integrated Connect assignment, the grade for that assignment automatically (and instantly) feeds your Blackboard grade center.

4. A solution for everyone. Whether your institution is already using Blackboard or you just want to try Blackboard on your own, we have a solution for you. McGraw-Hill and Blackboard can now offer you easy access to industry-leading technology and content, whether your campus hosts it, or we do. Be sure to ask your local McGraw-Hill representative for details.

Online Course Management

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xiii

ALEKS: A Superior, Student-Friendly Accounting Experience:

• Artificial Intelligence Fills Individual Student Knowledge Gaps

• Cycle of Learning & Assessment Increases Learning Momentum & Engages Students

• Adaptive, Open-Response Environment Avoids Multiple-Choice Questions

• Customizable Curriculum Aligns with Your Course Syllabi and Textbooks

• Dynamic, Automated Reports Monitor Detailed Student & Class Progress

To learn more, visit: www.aleks.com/highered/business

ALEKS is a registered trademark of ALEKS Corporation.

How Can Adaptive Online Learning Improve Student Performance?

CourseSmart CourseSmart is a new way to find and buy eTextbooks. CourseSmart has the largest selection of eTextbooks available anywhere, offering thousands of the most commonly adopted textbooks from a wide variety of higher educa- tion publishers. CourseSmart eTextbooks are available in one standard online reader with full text search, notes, highlighting, and email tools for sharing between classmates. Visit www.CourseSmart.com for more information on ordering.

"After I adopted ALEKS for my Principles of Accounting course, I got fewer and shorter lines for my office hours, and the class average jumped 10-15 percent overall. It’s a win-win situation." —Professor Fatma Cebenoyan, Hunter College, NY

Significantly Increase Student Success and Retention

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Using Accounting for Decisions Whether we prepare, analyze, or apply accounting informa- tion,  one skill remains essential: decision-making. To help develop good decision-making habits and to illustrate the relevance of accounting, our book uses a unique pedagogical framework we call the Decision Center. This framework is comprised of a variety of approaches and subject areas, giving students insight into every aspect of business decision-making; see three examples to the right and one below. Answers to Decision Maker and Ethics boxes are at the end of each chapter.

CAP Model The Conceptual/Analytical/Procedural (CAP) Model allows courses to be specially designed to meet your teaching needs or those of a diverse faculty. This model identifies learning ob- jectives, textual materials, assignments, and test items by C, A, or P, allowing different instructors to teach from the same ma- terials, yet easily customize their courses toward a conceptual, analytical, or procedural approach (or a combination thereof) based on personal preferences.

Innovative Textbook Features

"We are very impressed with the text itself. The updated look, colors, illustrations, . . . the inclusion of IFRS information will help the transition in the future— which is a good thing. We have the flexibility to pick and choose for now with the way you have laid out the information."

—Bob Urell, Irvine Valley College

Global View This section explains international accounting practices relating to the material covered in that chapter. This section is purposefully located at the end of each chapter so that each instructor can decide what emphasis, if at all, is to be assigned to it. The aim of this Global View section is to describe accounting practices and to identify the similarities and differences in international accounting practices versus that in the United States. As we move toward global convergence in accounting practices, and as we witness the likely conversion of U.S. GAAP to IFRS, the importance of student familiarity with international accounting grows. This innovative section helps us begin down that path of learning and teaching global accounting practices.

Learning Objectives

CONCEPTUAL

C1 Explain the steps in processing transactions and the role of source documents. (p. 50)

C2 Describe an account and its use in recording transactions. (p. 51) C3 Describe a ledger and a chart of accounts. (p. 54) C4 Define debits and credits and explain double-entry accounting. (p. 55)

ANALYTICAL

A1 Analyze the impact of transactions on accounts and financial statements. (p. 59) A2 Compute the debt ratio and describe its use in analyzing financial condition. (p. 69)

PROCEDURAL

P1 Record transactions in a journal and post entries to a ledger. (p. 56) P2 Prepare and explain the use of a trial balance. (p. 65)

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We explained that accounting under U.S. GAAP is similar, but n tion discusses differences in adjusting accounts, preparing finan liabilities on a balance sheet.

Adjusting Accounts Both U.S. GAAP and IFRS includ ing accounts. Although some variations exist in revenue and ex all of the adjustments in this chapter are accounted for identica ters we describe how certain assets and liabilities can result i value measurements.

Preparing Financial Statements Both U.S. GAAP an cial statements following the same process discussed in this cha GAAP and IFRS require current items to be separated from noncu a classified balance sheet). U.S. GAAP balance sheets report curr liquid to least liquid, where liquid refers to the ease of converting nearest to maturity to furthest from maturity, maturity refers to the balance sheets normally present noncurrent items first (and equity ment. Other differences with financial statements exist, which we i the following example of IFRS reporting for its assets, liabilities,

GLOBAL VIEW

PIAGGIO Balance Sheet (in thousands of

December 31, 2011

Assets Noncurrent assets Total equity . . . . .

PIAGGIO

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xiv

Women Entrepreneurs The Center for Women’s Business Research reports that women-owned businesses, such as Nom Nom Truck, are growing and that they:

• Total approximately 11 million and employ nearly 20 million workers. • Generate $2.5 trillion in annual sales and tend to embrace technology. • Are philanthropic—70% of owners volunteer at least once per month. • Are more likely funded by individual investors (73%) than venture firms (15%). ■

Decision Insight

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Payables Manager As a new accounts payable manager, you are being trained by the outgoing man- ager. She explains that the system prepares checks for amounts net of favorable cash discounts, and the checks are dated the last day of the discount period. She also tells you that checks are not mailed until five days later, adding that “the company gets free use of cash for an extra five days, and our department looks better. When a supplier complains, we blame the computer system and the mailroom.” Do you continue this payment policy? ■ [Answer—p. 208]

Decision Ethics

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Entrepreneur You purchase a batch of products on terms of 3y10, ny90, but your company has limited cash and you must borrow funds at an 11% annual rate if you are to pay within the discount period. Is it to your advantage to take the purchase discount? Explain. ■ [Answer—p. 208]

Decision Maker

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Total Asset Turnover Decision Analysis

A1 Compute total asset turnover and apply it to analyze a company’s use of assets.

A company’s assets are important in determining its ability to generate sales and earn income. Managers devote much attention to deciding what assets a company acquires, how much it invests in assets, and how to use assets most efficiently and effectively. One important measure of a company’s ability to use its as- sets is total asset turnover, defined in Exhibit 8.18.

EXHIBIT 8.18 Total Asset TurnoverTotal asset turnover 5

Net sales Average total assets

The numerator reflects the net amounts earned from the sale of products and services. The denominator reflects the average total resources devoted to operating the company and generating sales.

ill l ’ l k l i hibi 8 19 f i i M l

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“I like the layout of the text and the readability. The illustrations and comics in the book make the text seem less intimidating and boring for students. The PowerPoint slides are easy to understand and use, the pictorials are great, and the text has great coverage of accounting material. The addition of IFRS information and the updates to the opening stories are great. I like that the decision insights are about businesses the students can relate to (i.e., Facebook, women start-up businesses, etc)."

—Jeannie Liu, Chaffey College

Bring Accounting To Life

xv

Chapter Preview With Flowchart This feature provides a handy textual/ visual guide at the start of every chapter. Students can now begin their reading with a clear understanding of what they will learn and when, allowing them to stay more focused and organized along the way.

Long-Term Liabilities

Bond Issuances

• Issuance at par • Issuance at a discount • Issuance at a premium • Bond pricing

Bond Basics

• Bond financing • Bond trading • Issuance procedures

Bond Retirement

• At maturity • Before maturity • By conversion

Long-Term Notes

• Installment notes • Mortgage terms

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Quick Check These short question/answer features reinforce the material immediately preceding them. They allow the reader to pause and refl ect on the topics described, then receive immediate feedback before going on to new topics. Answers are pro- vided at the end of each chapter.

12. Give an example of a natural resource and of an intangible asset. 13. A company pays $650,000 for an ore deposit. The deposit is estimated to have 325,000 tons

of ore that will be mined over the next 10 years. During the first year, it mined, processed, and sold 91,000 tons. What is that year’s depletion expense?

14. On January 6, 2013, a company pays $120,000 for a patent with a remaining 17-year legal life to produce a toy expected to be marketable for three years. Prepare entries to record its acquisition and the December 31, 2013, amortization entry.

Quick Check Answers — p. 421

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Marginal Student Annotations These annotations provide students with additional hints, tips, and examples to help them more fully understand the concepts and retain what they have learned. The annotations also include notes on global implications of accounting and further examples.

when an insurance fee, called a premium, is pai account Prepaid Insurance. Over time, the exp this asset account and reported in expenses on in Prepaid Insurance and is reported on the bala accounts that will expire or be used before the statements are prepared. In this case, the prepa

Point: Prepaid accounts that apply to current and future periods are assets. These assets are adjusted at the end of each period to reflect only those amounts that have not yet expired, and to record as expenses those amounts that have expired.

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xvi

Demonstration Problems present both a problem and a complete solution, allowing students to review the entire problem-solving process and achieve success.

Chapter Summaries provide students with a review organized by learning objectives. Chapter Summaries are a component of the CAP model (see page xiv), which recaps each conceptual, analytical, and procedural objective.

Key Terms are bolded in the text and repeated at the end of the chapter with page numbers indi- cating their location. The book also includes a com- plete Glossary of Key Terms.

Quick Study assignments are short exercises that often focus on one learning objective. Most are included in Connect Account- ing. There are usually 8-10 Quick Study assignments per chapter.

Problem Sets A & B are proven problems that can be assigned as homework or for in-class projects. All problems are coded according to the CAP model (see page xiv), and Set A is included in Connect Accounting.

Exercises are one of this book’s many strengths and a competitive advantage. There are about 10-15 per chapter and most are included in Connect Accounting.

Multiple Choice Quiz questions quickly test chapter knowledge before a student moves on to complete Quick Studies, Exercises, and Problems.

Once a student has finished reading the chapter, how well he or she retains the material can depend greatly on the questions, exer- cises, and problems that reinforce it. This book leads the way in comprehensive, accurate assignments.

Outstanding Assignment Material

Use the following adjusted trial balance and additional information to complete the requirements.

DEMONSTRATION PROBLEM 1

KC ANTIQUES

Adjusted Trial Balance

December 31, 2013

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Store supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,600

Accumulated depreciation—Equipment $ 16 600

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dditional information to complete the requirements.

KCC AAAAAANNNNTIQUES

usttteeeeddddd TTTrial Balance

ceeemmmmmmmbbber 31, 2013

Debit Credit

. . . . . . . . . . . . . . . . . $ 7,000

. . . . . . . . . . . . . . . . . 13,000

. . . . . . . . . . . . . . . . . 60,000

. . . . . . . . . . . . . . . . . 1,500

. . . . . . . . . . . . . . . . . 45,600

ipment $ 16 600

PLANNING THE SOLUTION ● Compute the total cost of merchandise purchases for 2013. ● To prepare the multiple-step statement, first compute net sales. Then, to compute cost of goods sold,

add the net cost of merchandise purchases for the year to beginning inventory and subtract the cost of ending inventory. Subtract cost of goods sold from net sales to get gross profit. Then classify expenses

lli l d d i i i

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SOLUTION TO DEMONSTRATION PROBLEM 1 1.

Invoice cost of merchandise purchases . . . . . . . . $150,000 Less: Purchases discounts received . . . . . . . . . . . . 2,500 Purchase returns and allowances . . . . . . . . . 2,700 Add: Cost of transportation-in . . . . . . . . . . . . . . . 5,000 Total cost of merchandise purchases . . . . . . . . . . $149,800

2. Multiple-step income statement

KC ANTIQUES

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,250 Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 Sales returns and allowances . . . . . . . . . . . . . . . . . . . 6,000 11,000 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,250 Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,350

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KK a c p

Appropriated retained earnings (p. 482)

Authorized stock (p. 469)

Basic earnings per share (p. 485)

Book value per common share (p. 486)

Book value per preferred share (p. 486)

Call price (p. 479)

Callable preferred stock (p. 479)

Discount on stock (p. 471)

Dividend in arrears (p. 477)

Dividend yield (p. 486)

Earnings per share (EPS) (p. 485)

Financial leverage (p. 479)

Large stock dividend (p. 474)

Liquidating cash dividend (p. 474)

Preemptive right (p. 468)

Preferred stock (p. 476)

Premium on stock (p. 471)

Price-earnings (PE) ratio (p. 485)

Prior period adjustments (p. 483)

Proxy (p. 467)

Restricted retained earnings (p. 482)

Key Terms

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ue per prefe ed s a e (p. 486)

e

pr

a c a eve age (p. 479) o pe od adjust e ts (p. 83)

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 507 mhhe.com/wildFINMAN5e

2. A company reports net income of $75,000. Its weighted- average common shares outstanding is 19,000. It has no other stock outstanding. Its earnings per share is:

a. $4.69 b. $3.95 c. $3.75 d. $2.08 e. $4.41

1. A corporation issues 6,000 shares of $5 par value common stock for $8 cash per share. The entry to record this transaction includes:

a. A debit to Paid-In Capital in Excess of Par Value for $18,000.

b. A credit to Common Stock for $48,000. c. A credit to Paid-In Capital in Excess of Par Value for

$30,000. d. A credit to Cash for $48,000.

A di C S k f $30 000

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d. $2.08 e. $4.41

o Paid In Capital in Excess of Par Value for

Cash for $48,000. $

Units Unit Cost

Beginning inventory on January 1 . . . . . . . . . 320 $3.00

Purchase on January 9 . . . . . . . . . . . . . . . . . 80 3.20

Purchase on January 25 . . . . . . . . . . . . . . . . 100 3.34

Information: A company reports the following beginning inventory and purchase January. On January 26, the company sells 350 units. 150 units remain in ending inven

QUICK STUDY

QS 5-1 Perpetual: Inventory costing with FIFO

P1

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Exercise 5-2 Inventory costs

C2

ers, purchased the contents of an estate for $75,000. Terms of the purchase he cost of transporting the goods to Walberg Associates’ warehouse was ed the shipment at a cost of $300. Prior to putting the goods up for sale, they cost of $980. Determine the cost of the inventory acquired from the estate.

d $20,000 of goods to Harlow Co., and Harlow Co. has arranged to sell y the consignor and the consignee. Which company should include any ventory? shipped $12,500 of merchandise FOB destination to Harlow Co. Which $12,500 of merchandise in transit as part of its year-end inventory?

EXERCISES

Exercise 5-1 Inventory ownership C1

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PROBLEM SET A

Problem 5-1A Perpetual: Alternative cost flows

P1

Information: W purchases and s 80 units from be of 40 units from

Date

Mar. 1

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a S

D tDateDate

Mar. 1 into the following purchases

ale consisted of 8 units from le consisted of 12 units from pril 25 purchase.)

PROBLEM SET B

Problem 5-1B Perpetual: Alternative cost flows

P1 Units Sold at Retail

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xvii

The End of the Chapter Is Only the Beginning Our valuable and proven assignments aren’t just confi ned to the book. From problems that require technological solutions to materials found exclusively online, this book’s end-of-chapter material is fully integrated with its technology package.

• Quick Studies, Exercises, and Problems available in Connect are marked with an icon.

• Problems supported by the Sage 50 Complete Accounting or Quickbooks are marked with an icon.

• Problems supported with Microsoft Excel template assignments are marked with an icon.

• Assignments that focus on global accounting practices and companies are often identified with an icon.

accounting

Helps Students Master Key Concepts

"The serial problems are excellent…. I like the continuation of the same problem to the next chapters if applicable. I use the Quick Studies as practice problems. . . . Students have commented that this really works for them if they work (these questions) before attempting the assigned exercises and problems. I also like the discussion (questions) and make this an assignment. You have done an outstanding job presenting accounting to our students."

—Jerri Tittle, Rose State College

mhhe.com/wildFINMAN5e

Beyond the Numbers exercises ask students to use accounting fi gures and understand their meaning. Students also learn how accounting applies to a variety of business situations. These creative and fun exercises are all new or updated, and are divided into sections:

• Reporting in Action • Comparative Analysis • Ethics Challenge • Communicating in Practice

• Taking It To The Net • Teamwork in Action • Hitting the Road • Entrepreneurial Decision • Global Decision

BTN 12-1 Refer to Polaris’ financial statements in Appendix A to answer the following. 1. Is Polaris’ statement of cash flows prepared under the direct method or the indirect method? How

do you know? 2. For each year 2011, 2010, and 2009, is the amount of cash provided by operating activities more or

less than the cash paid for dividends? 3. What is the largest amount in reconciling the difference between net income and cash flow from

operating activities in 2011? In 2010? In 2009? 4. Identify the largest cash inflow and outflow for investing and for financing activities in 2012 and in 2010.

Fast Forward

5. Obtain Polaris’ financial statements for a year ending after December 31, 2011, from either its Website (Polaris.com) or the SEC’s database (www .sec.gov). Since December 31, 2011, what are Polaris’

Beyond the Numbers

REPORTING IN ACTION A1

Polaris

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Serial Problem uses a continuous running case study to illustrate chapter concepts in a familiar context. The Se- rial Problem can be followed continuously from the fi rst chapter or picked up at any later point in the book; enough information is provided to ensure students can get right to work.

SERIAL PROBLEM Success Systems

A1 P1 P2

(This serial problem started in Chapter 1 and continues through most of the chapters. If the Chapter 1 segment was not completed, the problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany this book.)

SP 2 On October 1, 2013, Adria Lopez launched a computer services company called Success Systems, which provides consulting services, computer system installations, and custom program development. Adria adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2013. The company’s initial chart of accounts follows.

Account No. Account No.

Cash . . . . . . . . . . . . . . . . . . . . . . 101 A. Lopez, Capital . . . . . . . . . . . . . . . . . . . 301

Accounts Receivable . . . . . . . . . 106 A. Lopez, Withdrawals . . . . . . . . . . . . . . 302

Computer Supplies . . . . . . . . . . 126 Computer Services Revenue . . . . . . . . . 403

Prepaid Insurance . . . . . . . . . . . 128 Wages Expense . . . . . . . . . . . . . . . . . . . . 623

Prepaid Rent . . . . . . . . . . . . . . . 131 Advertising Expense . . . . . . . . . . . . . . . . 655

Office Equipment . . . . . . . . . . . 163 Mileage Expense . . . . . . . . . . . . . . . . . . . 676

Computer Equipment . . . . . . . . 167 Miscellaneous Expenses . . . . . . . . . . . . . 677

Accounts Payable . . . . . . . . . . . 201 Repairs Expense — Computer. . . . . . . . . 684

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Enhancements in This Edition

Chapter 1 Twitter NEW opener with new entrepreneurial assignment Streamlined and reorganized discussion of the users of accounting information Updated salary information and new margin notes on the value of education New presentation on the ‘fraud triangle’ and its relevance to accounting and internal control New discussion on the joint role of the FASB and IASB in standard setting Revised layout for accounting principles and assumptions New information on the Dodd-Frank act and its relevance to accounting New survey data from executives on the impact of fraud in the economic downturn New world map on the adoption of IFRS or a variant of IFRS across countries New company (Dell) for the return on assets section of Decision Analysis

Chapter 2 Nom Nom Truck NEW opener with new entrepreneurial assignment Reorganized discussion and presentation of assets, liabilities, and equity accounts Revised description of journalizing and posting of transactions New headings on each general journal for this chapter’s major illustration introducing our unique four-step transaction analysis Revised global view and new Piaggio’s (abbreviated) balance sheet Updated debt ratio discussion using recent Skechers’s information

Chapter 3 ash&dans NEW opener with new entrepreneurial assignment New layout for the types of adjustments New example of unearned revenues using USA Today Enhanced and emphasized the innovative three-step process for adjusting accounts Updated IFRS and FASB revenue recognition convergence

Added six new Quick Studies to directly apply the three-step adjustment process Expanded explanation of temporary and permanent accounts Revised visual display of four-step closing process Enhanced display of general ledger for ease in learning

Chapter 4 Faithful Fish NEW opener with new entrepreneurial assignment Enhanced exhibit on transportation costs and FOB terms, with inclusion of entries New discussion of online ordering, tracking numbers, RFID, and FOB Revised the two-step explanation of recording merchandise sales New discussion on the importance and risks of accounting for sales returns Revised visual display of a sales invoice Revised discussion of merchandising purchases and sales New Volkswagen example of IFRS income statement

Chapter 5 Feverish Ice Cream NEW opener with new entrepreneurial assignment Enhanced exhibit that visually shows cost flows from inventory to financial statements, with superior info-graphics Added new discussion on inventory controls New explanatory boxes added to selected exhibits as learning aids Expanded assignments covering perpetual and periodic inventory measurement New material on IFRS and inventory methods

Chapter 6 CHEESEBOY NEW opener with new entrepreneurial assignment New discussion of payroll controls Expanded presentation of ‘Hacker’s Guide’ New discussion of the lock box and its purpose New data on sources of fraud complaints

New evidence on methods to override controls New visual on document to bond (insure) an employee New example of MLB controls, or lack thereof

Chapter 7 Under Armour NEW opener with new entrepreneurial assignment Added explanation of credit card sales New discussion of mobile payment systems using mini-card-readers and iPads New illustration comparing bad debts recognition under the allowance method versus the direct write-off method Revised exhibit on aging of accounts receivable, including all detailed accounts New illustration on why the banker’s rule is commonly applied

Chapter 8 BizChair.com NEW opener with new entrepreneurial assignment New learning boxes added to selected exhibits identifying salvage value New explanation on how asset purchases occurring on different days of the month are commonly processed New example of extraordinary repairs applied to the stealth bomber New notes added to emphasize that depreciation is cost allocation, and not valuation New explanation on how drugmakers fight patent expirations New information on the Mickey Mouse Protection Act for intangibles New goodwill example using Google’s purchase of YouTube

Chapter 9 SmartIT Staffing NEW opener with new entrepreneurial assignment Revised unearned revenues example based on Rihanna ticket sales Added explanation on the role of sellers as tax collection ‘agents’ for the government New information on franchise costs and how they are accounted for Added select formulas to enhance the exhibit on payroll deductions

Updated payroll rates to 2012 with discussion on likely adjustments for 2013 and 2014 Added discussion on maximum withholding allowances claimed New discussion on IRS actions against companies that fail to pay employment taxes New evidence on payroll fraud, its median loss, and time taken to uncover such frauds

Chapter 10 barley & birch NEW opener with new entrepreneurial assignment New explanation on why debt (credit) financing is less costly than equity financing New margin graphics (four) illustrating how a debt’s carrying value is periodically adjusted until it equals maturity value at the end of its life New margin boxes on calculator functions to compute the price of bonds New explanation of what is investment grade debt New discussion on the role of unreported liabilities and the 2008-2009 financial crisis Reference to changes in lease accounting New discussion of collateral and its role in debt financing New separate appendix learning objectives on amortizing a discount or a premium using effective interest

Chapter 11 Groupon NEW opener with new entrepreneurial assignment New discussion of Facebook’s IPO and the role of accounting information New reference to corporate governance New reference to state laws and where companies incorporate New examples using Target for stock quotes and Google for stock splits New discussion of fraudulent information dissemination and stock prices Updated the global view on equity accounting

This edition’s revisions are driven by instructors and students. General revisions to the entire book follow (including chapter-by-chapter revisions):

• Revised and updated assignments throughout

• Updated ratio/tool analysis and data for each chapter

• New material on International Financial Reporting Standards (IFRS) in most chapters, including global examples

• New and revised entrepreneurial examples and elements

• Revised serial problem through nearly all chapters

• New art program, visual info-graphics, and text layout

• New Polaris (maker of ATVs, snowmobiles, motorcycles, and electric vehicles) annual report with comparisons to competitors, including Arctic Cat, KTM (IFRS), and Piaggio (IFRS) with new assignments

• Updated graphics added to each chapter’s analysis section

• New technology content integrated and referenced in the book

• Updated Global View section in each chapter

• New innovative assignments sprinkled throughout the book

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For Better Learning

Chapter 12 TOMS NEW opener with new entrepreneurial assignment Revised graphics to better illustrate cash inflows and outflows for operating, investing, and financing activities Revised graphic to better reflect cash and cash equivalents Added discussion on the use of T-accounts for reconstructing transactions impacting cash New margin clarification for computing free cash flow New discussion on the potential for IASB and FASB to issue guidance for the statement of cash flow that would require the direct method… stay tuned

Chapter 13 Motley Fool REVISED opener with new entrepreneurial assignment New companies—Polaris, Arctic Cat, KTM and Piaggio—data throughout the chapter, exhibits, and illustrations New boxed discussion on the role of financial statement analysis to fight and prevent fraud Enhanced horizontal, vertical, ratio analysis using new companies and industry data Streamlined global view section

Chapter 14 Back to the Roots NEW opener with new entrepreneurial assignment New analytical learning objective Updated ACFE statistics on fraud costs New exhibit and discussion on fraud occurrence and average fraud loss by industry Revised discussion of direct and indirect costs and related exhibit for added clarity New summary of cost classifications and associated managerial decisions New Decision Analysis to focus on raw materials inventory turnover and days’ sales in raw materials inventory Moved discussion of types of manufacturing costs to appear before presentation of manufacturer’s financial statements Expanded discussion of financial statements for service companies New end of chapter assignments on raw materials inventory management and cost classification for service companies Moved cycle time discussion to Chapter 23

Chapter 15 Astor and Black NEW opener with new entrepreneurial assignment Reorganized discussion of job order costing for service companies New discussion of accounting for nonmanufacturing costs and their role in pricing decisions Added new journal entries for indirect materials and indirect labor for improved learning

Chapter 16 Three Twins Ice Cream NEW opener with new entrepreneurial assignment Revised comparison of job order and process costing systems New comparison of reports produced from job order and process costing systems Added details for accounts used in the entry to record sales in process costing Added new process costing assignments Revisions to two learning objectives

Chapter 17 Belgium Brewing Company NEW opener with new entrepreneurial assignment New section on activity-based costing for service providers Enhanced discussions and exhibits on overhead allocation methods New Decision Insight on the use of activity-based costing for business decisions New section on the costs of quality Added several new assignments for better learning

Chapter 18 Leather Head Sports NEW opener with new entrepreneurial assignment New graphics on relations between per-unit fixed and variable costs and volume Revised discussion of per-unit fixed and variable costs Moved discussion of margin of safety to section on break-even Revised discussion of assumptions in CVP analysis Enhanced the formatting and layout of several key exhibits New discussion and examples of using the contribution margin income statement to perform sensitivity analyses and compute sales needed for target income Revised data for estimating cost behavior New discussion on the use of RFID tags to control inventory costs and for error-reduction

Chapter 19 Samanta Shoes REVISED opener with entrepreneurial assignment New Global View with reference to McDonald’s international operations Revised section on limitations of variable costing New discussion of absorption costing and IFRS Revised several exhibits for better learning Enhanced examples of absorption and variable costing and their differences Added new assignments for better learning

Chapter 20 Freshii NEW opener with new entrepreneurial assignment New discussion on incentive compensation and budgeting Expanded global view on foreign currency exchange rates and budgeting Updated discussion on Apple’s cash cushion Added new end of chapter assignments

Chapter 21 Folsom Custom Skis NEW opener with new entrepreneurial assignment New discussion on budgeting for service providers Revised several exhibits for learning clarity Revised discussion of predicting activity levels New enhanced exhibit on framework for understanding total overhead variance, including formulas Revised discussion of controllable and volume variances

Chapter 22 United By Blue NEW opener with new entrepreneurial assignment Revised discussion linking direct and indirect expenses to controllable and uncontrollable costs Highlighted four-step process to prepare departmental income statements Moved discussion and illustration of profit margin and investment turnover to main body of chapter Added discussion on cycle time and cycle efficiency New exhibit on how to prepare departmental performance reports Edited discussion of example on preparing departmental performance reports New discussion on issues in computing return on (assets) investment and residual income New discussion on the link between executive compensation and company performance

Updated global view on division reporting and its explanation for added clarity

Chapter 23 Charlie’s Brownies NEW opener with new entrepreneurial assignment New discussion on outsourcing of information and technology services Simplified discussions and exhibits for several examples of managerial decisions Streamlining of selected explanations

Chapter 24 Gamer Grub REVISED opener with new entrepreneurial assignment Updated graphic on industry cost of capital estimates New presentation on payback periods for health care providers New discussion on link between CEO compensation and IRR Simplified computation of the accounting rate of return New example showing calculation of net present value with salvage value New exhibit showing formula for computing average investment Enhanced graphics on NPV and IRR decision rules

Appendix C myYearbook (MeetMe Inc.) NEW opener with new entrepreneurial assignment New discussion of the two optional presentations for comprehensive income per FASB guidance in 2012 Revised discussion of accounting for securities New reference to Greek debt in the context of international operations

Appendix D New examples of LLPs and their prevalence among professional services New discussion of the potential for multiple drawing accounts in practice Revised and streamlined three-step process to liquidate a partnership

Appendix E Expanded discussion and examples of hackers and internal controls New pneumonic tool for system principles Enhanced exhibit on system components New discussion on voice recognition controls New discussion on cloud computing, its implications to accounting, and its risks New references to XBRL, Great Plains, and QuickBooks in accounting Updated discussion and examples for ERP

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Instructor’s Resource CD-ROM ISBN13: 9780077598624 ISBN10: 0077598628

This is your all-in-one resource. It allows you to create custom presentations from your own materials or from the follow- ing text-specific materials provided in the CD’s asset library:

• Instructor’s Resource Manual Written by April Mohr, Jefferson Community and Technical College, SW.

This manual contains (for each chap- ter) a Lecture Outline, a chart linking all assignment materials to Learning Objectives, and additional visuals with transparency masters.

• Solutions Manual

Written by John J. Wild, Ken W. Shaw, and Anita Kroll, University of Wisconsin–Madison.

• Test Bank

Revised by Laurie Hays, Western Michigan University.

• PowerPoint® Presentations Prepared by Anna Boulware, St. Charles Community College.

Presentations allow for revision of lecture slides, and includes a viewer, allowing screens to be shown with or without the software.

Working Papers Vol. 1, Chapters 1-13 ISBN13: 9780077598709 ISBN10: 0077598709

Vol. 2, Chapters 12-24 ISBN13: 9780077598723 ISBN10: 0077598725

Written by John J. Wild.

Connect Accounting with LearnSmart Two Semester Access Code Card ISBN13: 9780077598594 ISBN10: 0077598598

Connect Plus Accounting with LearnSmart Two Semester Access Code Card ISBN13: 9780077598617 ISBN10: 007759861x

Carol Yacht's Sage 50 Complete Accounting 2013 Student Guide and Templates ISBN13: 9780077796860 ISBN10: 0077796861

Prepared by Carol Yacht.

To better prepare students for account- ing in the real world, selected end-of- chapter material in the text is tied to Sage 50 Complete Accounting 2013 soft- ware (formerly Peachtree). The accompa- nying student guide provides a step-by- step walkthrough for students on how to complete the problem in the software.

QuickBooks Pro 2013 Student Guide and Templates ISBN13: 9780077598686 ISBN10: 0077598687

Prepared by Carol Yacht.

To better prepare students for account- ing in the real world, selected end-of- chapter material in the text is tied to QuickBooks software. The accompanying student guide provides a step-by-step walkthrough for students on how to complete the problem in the software.

Instructor Supplements

Student Supplements

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Assurance of Learning Ready

Many educational institutions today are focused on the notion of assur- ance of learning, an important element of some accreditation standards. Financial and Managerial Accounting is designed specifi cally to support your

assurance of learning initiatives with a simple, yet powerful solution. Each test bank question for Financial and Managerial Accounting maps to a specifi c chapter learning objective listed in the text. You can use our test bank software, EZ Test Online or Connect Accounting to easily query for learn- ing objectives that directly relate to the learning objectives for your course. You can then use the reporting features of EZ Test to aggregate student results in similar fashion, making the collection and presentation of assurance of learning data simple and easy.

AACSB Statement

The McGraw-Hill Companies is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Financial and Managerial Accounting recognizes the curricula guidelines detailed in the AACSB stan-

dards for business accreditation by connecting selected questions in the test bank to the six general knowledge and skill guidelines in the AACSB standards. The statements contained in Financial and Managerial Accounting are provided only as a guide for the users of this textbook. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Financial and Managerial Accounting and the teaching package make no claim of any specifi c AACSB qualifi cation or evaluation, we have within Financial and Managerial Accounting labeled select questions according to the six general knowledge and skills areas.

"Connect certainly offers so much for the students and at the same time helps the professors. The professors can offer more learning opportunities to the students without intensive time investment."

—Constance Hylton, George Mason University

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Khaled Abdou, Penn State University - Berks

Anne Marie Anderson, Raritan Valley Community College

Elaine Anes, Heald College -Fresno

Jerome Apple, University of Akron

Thomas Arcuri, Florida State University

Jack Aschkenazi, American Intercontinental University

Sidney Askew, Borough of Manhattan Community College

Lawrence Awopetu, University of Arkansas -Pine Bluff

Jon Backman, Spartanburg Community College

Charles Baird, University of Wisconsin-Stout

Richard Barnhart, Grand Rapids Community College

Judy Benish, Fox Valley Tech College

Patricia Bentley, Keiser University

Jaswinder Bhangal, Chabot College

Sandra Bitenc, University of Texas at Arlington

Susan Blizzard, San Antonio College

Marvin Blye, Wor-Wic Community College

Patrick Borja, Citrus College

Anna Boulware, St. Charles Community College

Gary Bower, Community College of Rhode Island-Flanagan

Billy Brewster, University of Texas at Arlington

Leslee Brock, Southwest Mississippi Community College

Gregory Brookins, Santa Monica College

Regina Brown, Eastfield College

Marci Butterfield, University of Utah

Roy Carson, Anne Arundel Community College

Deborah Carter, Coahoma Community College

Roberto Castaneda, DeVry University Online

Amy Chataginer, Mississippi Gulf Coast Community College

Gerald Childs, Waukesha County Technical College

Colleen Chung, Miami Dade College- Kendall

Shifei Chung, Rowan University

Robert Churchman, Harding University

Marilyn Ciolino, Delgado Community College

Thomas Clement, University of North Dakota

Oyinka Coakley, Broward College

Susan Cockrell, Birmingham-Southern College

Lisa Cole, Johnson County Community College

Robbie R. Coleman, Northeast Mississippi Community College

Jackie Conrecode, Florida Gulf Coast University

Debora Constable, Georgia Perimeter College

Cheryl Corke, Genesse Community College

James Cosby, John Tyler Community College

Ken Couvillion, Delta College

Karen Crisonino, County College of Morris

Loretta Darche, Southwest Florida College

Judy Daulton, Piedmont Technical College

Dorothy Davis, University of Louisiana-Monroe

Stan Davis, University of Tennessee at Chattanooga

Walter DeAguero, Saddleback College

Mike Deschamps, MiraCosta College

Pamela Donahue, Northern Essex Community College

Steve Doster, Shawnee State University

Larry Dragosavac, Edison Community College

Samuel Duah, Bowie State University

Robert Dunlevy, Montgomery County Community College

Ron Dustin, Fresno City College

Jerrilyn Eisenhauer, Tulsa Community College-Southeast

Ronald Elders, Virginia College

Terry Elliott, Morehead State University

Albert Fisher, College of Southern Nevada

Annette Fisher, Glendale Community College

Acknowledgments John J. Wild, Ken W. Shaw, Barbara Chiappetta, and McGraw-Hill/Irwin would like to recog- nize the following instructors for their valuable feedback and involvement in the development of Financial and Managerial Accounting, 5e. We are thankful for their suggestions, counsel, and encouragement.

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David Flannery, Bryant and Stratton College

Hollie Floberg, Tennessee Wesleyan College

Linda Flowers, Houston Community College

Jeannie Folk, College of DuPage

Rebecca Foote, Middle Tennessee State University

Paul Franklin, Kaplan University

Tim Garvey, Westwood College

Barbara Gershman, Northern Virginia Community College- Woodbridge

Mike Glasscock, Amarillo College

Diane Glowacki, Tarrant County College

Ernesto Gonzalez, Florida National College

Gloria Grayless, Sam Houston State University

Ann Gregory, South Plains College

Rameshwar Gupta, Jackson State University

Pat Halliday, Santa Monica College

Keith Hallmark, Calhoun Community College

Rebecca Hancock, El Paso Community College-Valley Verde

Mechelle Harris, Bossier Parish Community College

Tracey Hawkins, University of Cincinnati-Clermont College

Thomas Hayes, University of Arkansas-Ft. Smith

Laurie Hays, Western Michigan University

Rita Hays, Southwestern Oklahoma State University

Roger Hehman, University of Cincinnati-Clermont College

Cheri Hernandez, Des Moines Area Community College

Margaret Hicks, Howard University

Melanie Hicks, Liberty University

James Higgins, Holy Family University

Patricia Holmes, Des Moines Area Community College

Barbara Hopkins, Northern Virginia Community College-Manassas

Wade Hopkins, Heald College

Les Hubbard, Solano College

Deborah Hudson, Gaston College

James Hurst, National College

Constance Hylton, George Mason University

Christine Irujo, Westfield State University

Todd Jensen, Sierra College

Fred Jex, Macomb Community College

Gina M. Jones, Aims Community College

Jeff Jones, College of Southern Nevada

Rita Jones, Columbus State University

Sandra Jordan, Florida State College at Jacksonville

Dmitriy Kalyagin, Chabot College

Thomas Kam, Hawaii Pacific University

Naomi Karolinski, Monroe Community College

Shirly A. Kleiner, Johnson County Community College

Tamara Kowalczyk, Appalachian State University

Anita Kroll, University of Wisconsin-Madison

David Krug, Johnson County Community College

Christopher Kwak, DeAnza College

Jeanette Landin, Empire College

Beth Lasky, Delgado Community College

David Laurel, South Texas College

Charles Lewis, Houston Community College

Danny Litt, University of California Los Angeles

Jeannie Liu, Chaffey College

James L. Lock, Northern Virginia Community College

Debra Luna, El Paso Community College

Amado Mabul, Heald College

Lori Major, Luzerne County Community College

Jennifer Malfitano, Delaware County Community College

Maria Mari, Miami Dade College-Kendall

Thomas S. Marsh, Northern Virginia Community College- Annandale

Karen Martinson, University of Wisconsin-Stout

Brenda Mattison, Tri-County Technical College

Stacie Mayes, Rose State College

Donald McWilliams, Jackson State University

Jeanine Metzler, Northampton Community College

Theresa Michalow, Moraine Valley Community College

Kathleen Michele Francois, WECA – Madison

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Julie Miller, Chippewa Valley Tech College

Tim Miller, El Camino College

John Minchin, California Southern University

Edna C. Mitchell, Polk State College

Jill Mitchell, Northern Virginia Community College

Angela Mott, Northeast Mississippi Community College

Timothy Murphy, Diablo Valley College

Kathleen O’Donnell, Onondaga Community College

Ahmed Omar, Burlington County College

Margaret Parilo, Cosumnes River College

Paige Paulsen, Salt Lake Community College

Yvonne Phang, Borough of Manhattan Community College

Gary Pieroni, Diablo Valley College

James Racic, Lakeland Community College

David Ravetch, University of California Los Angeles

Ruthie Reynolds, Howard University

Cecile Roberti, Community College of Rhode Island

Patrick Rogan, Cosumnes River College

Paul Rogers, Community College of Beaver County

Helen Roybark, Radford University

Alphonse Ruggiero, Suffolk County Community College

Arjan Sadhwani, South University

Kin Kin Sandhu, Heald College

Marcia Sandvold, Des Moines Area Community College

Richard Sarkisian, Camden County College

Gary Schader, Kean University

Tracy Schmeltzer, Wayne Community College

Debbie Schmidt, Cerritos College

Darlene Schnuck, Waukesha County Technical College

Elizabeth Serapin, Columbia Southern University

Geeta Shankhar, University of Dayton

Regina Shea, Community College of Baltimore County—Essex

James Shelton, Liberty University

Jay Siegel, Union County College

Jaye Simpson, Tarrant County College

Gerald Singh, New York City College of Technology

Erik Slayter, California Polytechnic State University San Luis Obispo

Lois Slutsky, Broward College-South

Gerald Smith, University of Northern Iowa

Kathleen Sobieralski, University of Maryland University College

Charles Spector, State University of New York at Oswego

Diane Stark, Phoenix College

Thomas Starks, Heald College

Carolyn L. Strauch, Crowder College

Latazia Stuart, Fortis University Online

David Sulzen, Ferrum College

Dominique Svarc, William Rainey Harper College

Linda Sweeney, Sam Houston State University

Margaret Tanner, University of Arkansas—Ft. Smith

Ulysses Taylor, Fayetteville State University

Anthony Teng, Saddleback College

Paula Thomas, Middle Tennessee State University

Teresa Thompson, Chaffey Community College

Leslie Thysell, John Tyler Community College

Jerri Tittle, Rose State College

Melanie Torborg, Globe University

Shafi Ullah, Broward College

Bob Urell, Irvine Valley College

Adam Vitalis, University of Wisconsin-Madison

Patricia Walczak, Lansing Community College

Terri Walsh, Seminole State College-Oviedo

Shunda Ware, Atlanta Technical College

Dave Welch, Franklin University

Jean Wells-Jessup, Howard University

Christopher Widmer, Tidewater Community College

Andrew Williams, Edmonds Community College

Gayle Williams, Sacramento City College

Kenneth L. Wild, University of London

Jonathan M. Wild, University of Wisconsin

John Woodward, Polk State College

Wanda Wong, Chabot College

Patricia Worsham, Norco College, Riverside Community College

Lynnette Yerbury, Salt Lake Community College

Judy Zander, Grossmont College

Mary Zenner, College of Lake County

Jane Zlojutro, Northwestern Michigan College

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In addition to the helpful and generous colleagues listed above, we thank the entire McGraw-Hill/Irwin Financial and Managerial Accounting, 5e team, including Tim Vertovec, Steve Schuetz, Christina Sanders, Aaron Downey of Matrix Productions, Lori Koetters, Matthew Baldwin, Carol Bielski, Patricia Plumb, Jeremy Cheshareck, Ron Nelms, Xin Lin, Julie Hankins, and Brian Nacik. We also thank the great marketing and sales support staff, including Michelle Heaster and Kathleen Klehr. Many talented educa- tors and professionals worked hard to create the supplements for this book, and for their efforts we’re grateful. Finally, many more people we either did not meet or whose efforts we did not personally witness nevertheless helped to make this book everything that it is, and we thank them all.

John J. Wild Ken W. Shaw Barbara Chiappetta

"This textbook does address many learning styles and at the same time allows for many teaching styles ... our faculty have been very pleased with the continued revisions and supplements. From paper working papers ... to continually improved homework sites and e-books. I’m a ‘Wild’ fan!" —Rita Hays, Southwestern Oklahoma State University

The authors extend a special thank you to our contributing and technology supplement authors: Contributing Authors: Anita Kroll, University of Wisconsin; Kathleen O'Donnell, Onondaga Community College Accuracy Checkers: Dave Krug, Johnson County Community College; Albert Fisher, College of Southern Nevada; Judy Zander,

Grossmont College; Ann McCarthy, Eastern Carolina University; Mark McCarthy, East Carolina University; and Helen Roybark, Radford University

LearnSmart Authors: April Mohr, Jefferson Community and Technical College, SW; Anna Boulware, St. Charles Community College; Brenda Mattison, Tri County Technical College; and Dominique Svarc, William Rainey Harper College

Online Quizzes: Constance Hylton, George Mason University Interactive Presentations: Jeannie Folk, College of DuPage PowerPoint: Anna Boulware, St. Charles Community College Instructor Resource Manual: April Mohr, Jefferson Community and Technical College, SW Test Bank: Laurie Hays, Western Michigan University QuickBooks and Sage 50 Complete Accounting: Carol Yacht Excel Templates: Jack Terry

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Brief Contents

1 Introducing Accounting in Business 2 2 Analyzing and Recording

Transactions 50

3 Adjusting Accounts and Preparing Financial Statements 96

4 Accounting for Merchandising Operations 160

5 Inventories and Cost of Sales 208 6 Cash and Internal Controls 256 7 Accounts and Notes Receivable 300 8 Long-Term Assets 334 9 Current Liabilities 376 10 Long-Term Liabilities 420 11 Corporate Reporting and Analysis 464 12 Reporting Cash Flows 508 13 Analysis of Financial Statements 562 14 Managerial Accounting Concepts and

Principles 608

15 Job Order Costing and Analysis 652 16 Process Costing and Analysis 690

17 Activity Based Costing and Analysis 736 18 Cost Behavior and Cost-Volume-Profit

Analysis 776

19 Variable Costing and Performance Reporting 814

20 Master Budgets and Performance Planning 846

21 Flexible Budgets and Standard Costs 894 22 Performance Measurement and

Responsibility Accounting 940

23 Relevant Costing for Managerial Decisions 984

24 Capital Budgeting and Investment Analysis 1014

Appendix A Financial Statement Information A-1

Appendix B Time Value of Money B Appendix C Investments and International

Operations C

*Appendix D Accounting for Partnerships *Appendix E Accounting with Special Journals

xxvi

* Appendices D&E are available on the book’s Website, mhhe.com/wildFINMAN5e, and as print copy from a McGraw-Hill representative.

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Preface iii

1 Introducing Accounting in Business 2

Importance of Accounting 4 Users of Accounting Information 5 Opportunities in Accounting 6

Fundamentals of Accounting 7 Ethics—A Key Concept 7 Fraud Triangle 8 Generally Accepted Accounting Principles 9 International Standards 9 Conceptual Framework and Convergence 10 Sarbanes–Oxley (SOX) 13 Dodd-Frank 14

Transaction Analysis and the Accounting Equation 15

Accounting Equation 15 Transaction Analysis 16 Summary of Transactions 19

Financial Statements 20 Income Statement 20 Statement of Retained Earnings 20 Balance Sheet 20 Statement of Cash Flows 22

Global View 22 Decision Analysis—Return on Assets 23 Appendix 1A Return and Risk Analysis 27 Appendix 1B Business Activities and the Accounting

Equation 27

2 Analyzing and Recording Transactions 50

Analyzing and Recording Process 52 Source Documents 52 The Account and Its Analysis 53

Analyzing and Processing Transactions 56 Ledger and Chart of Accounts 56 Debits and Credits 57 Double-Entry Accounting 57

Journalizing and Posting Transactions 58 Analyzing Transactions—An Illustration 61 Accounting Equation Analysis 65

Trial Balance 67 Preparing a Trial Balance 67 Using a Trial Balance to Prepare Financial Statements 68

Global View 70 Decision Analysis—Debt Ratio 71

3 Adjusting Accounts and Preparing Financial Statements 96

Timing and Reporting 98 The Accounting Period 98 Accrual Basis versus Cash Basis 99 Recognizing Revenues and Expenses 100

Adjusting Accounts 100 Frameworks for Adjustments 100 Prepaid (Deferred) Expenses 101 Unearned (Deferred) Revenues 104 Accrued Expenses 105 Accrued Revenues 107 Links to Financial Statements 109 Adjusted Trial Balance 110

Preparing Financial Statements 110 Closing Process 112

Temporary and Permanent Accounts 112 Recording Closing Entries 112 Post-Closing Trial Balance 114 Accounting Cycle 116

Classified Balance Sheet 117 Classification Structure 117 Classification Categories 118

Global View 120 Decision Analysis—Profit Margin and Current

Ratio 121 Appendix 3A Alternative Accounting for

Prepayments 125 Appendix 3B Work Sheet as a Tool 127 Appendix 3C Reversing Entries 129

Contents

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xxviii Contents

4 Accounting for Merchandising Operations 160

Merchandising Activities 162 Reporting Income for a Merchandiser 162 Reporting Inventory for a Merchandiser 163 Operating Cycle for a Merchandiser 163 Inventory Systems 163

Accounting for Merchandise Purchases 164 Purchase Discounts 165 Purchase Returns and Allowances 166 Transportation Costs and Ownership Transfer 167

Accounting for Merchandise Sales 169 Sales of Merchandise 169 Sales Discounts 170 Sales Returns and Allowances 170

Completing the Accounting Cycle 172 Adjusting Entries for Merchandisers 172 Preparing Financial Statements 173 Closing Entries for Merchandisers 173 Summary of Merchandising Entries 173

Financial Statement Formats 174 Multiple-Step Income Statement 175 Single-Step Income Statement 176 Classified Balance Sheet 176

Global View 177 Decision Analysis—Acid-Test and Gross Margin

Ratios 178 Appendix 4A Periodic Inventory System 183 Appendix 4B Work Sheet—Perpetual System 187

5 Inventories and Cost of Sales 208

Inventory Basics 210 Determining Inventory Items 210 Determining Inventory Costs 211 Internal Controls and Taking a Physical Count 211

Inventory Costing under a Perpetual System 211 Inventory Cost Flow Assumptions 212 Inventory Costing Illustration 213 Specific Identification 213 First-In, First-Out 215 Last-In, First-Out 215 Weighted Average 216 Financial Statement Effects of Costing Methods 218 Consistency in Using Costing Methods 219

Valuing Inventory at LCM and the Effects of Inventory Errors 219

Lower of Cost or Market 219 Financial Statement Effects of Inventory Errors 220

Global View 222 Decision Analysis—Inventory Turnover and Days’

Sales in Inventory 223 Appendix 5A Inventory Costing under a Periodic

System 229 Appendix 5B Inventory Estimation Methods 234

6 Cash and Internal Controls 256

Internal Control 258 Purpose of Internal Control 258 Principles of Internal Control 259 Technology and Internal Control 261 Limitations of Internal Control 262

Control of Cash 263 Cash, Cash Equivalents, and Liquidity 263 Cash Management 264 Control of Cash Receipts 264 Control of Cash Disbursements 266

Banking Activities as Controls 270 Basic Bank Services 270 Bank Statement 272 Bank Reconciliation 273

Global View 276 Decision Analysis—Days’ Sales Uncollected 277 Appendix 6A Documentation and Verification 280 Appendix 6B Control of Purchase

Discounts 283

7 Accounts and Notes Receivable 300

Accounts Receivable 302 Recognizing Accounts Receivable 302 Valuing Accounts Receivable—Direct Write-Off Method 306 Valuing Accounts Receivable—Allowance Method 307 Estimating Bad Debts—Percent of Sales Method 308 Estimating Bad Debts—Percent of Receivables Method 309 Estimating Bad Debts—Aging of Receivables Method 310

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Notes Receivable 312 Computing Maturity and Interest 312 Recognizing Notes Receivable 313 Valuing and Settling Notes 314

Disposal of Receivables 315 Selling Receivables 315 Pledging Receivables 315

Global View 316 Decision Analysis—Accounts Receivable Turnover 317

8 Long-Term Assets 334 SECTION 1—PLANT ASSETS 336 Cost Determination 337

Land 337 Land Improvements 338 Buildings 338 Machinery and Equipment 338 Lump-Sum Purchase 338

Depreciation 339 Factors in Computing Depreciation 339 Depreciation Methods 340 Partial-Year Depreciation 344 Change in Estimates for Depreciation 345 Reporting Depreciation 345

Additional Expenditures 346 Ordinary Repairs 347 Betterments and Extraordinary Repairs 347

Disposals of Plant Assets 348 Discarding Plant Assets 348 Selling Plant Assets 348

SECTION 2—NATURAL RESOURCES 350 Cost Determination and Depletion 350 Plant Assets Used in Extracting 351

SECTION 3—INTANGIBLE ASSETS 351 Cost Determination and Amortization 351 Types of Intangibles 352

Global View 354 Decision Analysis—Total Asset Turnover 355 Appendix 8A Exchanging Plant Assets 358

9 Current Liabilities 376 Characteristics of Liabilities 378

Defining Liabilities 378 Classifying Liabilities 378 Uncertainty in Liabilities 379

Known Liabilities 380 Accounts Payable 380 Sales Taxes Payable 380 Unearned Revenues 381 Short-Term Notes Payable 381 Payroll Liabilities 383 Multi-Period Known Liabilities 386

Estimated Liabilities 387 Health and Pension Benefits 387 Vacation Benefits 388 Bonus Plans 388 Warranty Liabilities 388 Multi-Period Estimated Liabilities 389

Contingent Liabilities 390 Accounting for Contingent Liabilities 390 Reasonably Possible Contingent Liabilities 390 Uncertainties that Are Not Contingencies 391

Global View 391 Decision Analysis—Times Interest Earned Ratio 392 Appendix 9A Payroll Reports, Records,

and Procedures 395 Appendix 9B Corporate Income Taxes 401

10 Long-Term Liabilities 420 Basics of Bonds 422

Bond Financing 422 Bond Trading 423 Bond-Issuing Procedures 424

Bond Issuances 424 Issuing Bonds at Par 424 Bond Discount or Premium 425 Issuing Bonds at a Discount 425 Issuing Bonds at a Premium 428 Bond Pricing 430

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Bond Retirement 431 Bond Retirement at Maturity 431 Bond Retirement before Maturity 431 Bond Retirement by Conversion 432

Long-Term Notes Payable 432 Installment Notes 433 Mortgage Notes and Bonds 434

Global View 435 Decision Analysis—Debt Features and the Debt-to-

Equity Ratio 436 Appendix 10A Present Values of Bonds and Notes 440 Appendix 10B Effective Interest Amortization 442 Appendix 10C Issuing Bonds between Interest

Dates 444 Appendix 10D Leases and Pensions 446

11 Corporate Reporting and Analysis 464

Corporate Form of Organization 466 Characteristics of Corporations 466 Corporate Organization and Management 467 Stockholders of Corporations 468 Basics of Capital Stock 469

Common Stock 470 Issuing Par Value Stock 470 Issuing No-Par Value Stock 471 Issuing Stated Value Stock 472 Issuing Stock for Noncash Assets 472

Dividends 473 Cash Dividends 473 Stock Dividends 474 Stock Splits 476

Preferred Stock 476 Issuance of Preferred Stock 477 Dividend Preference of Preferred Stock 477 Convertible Preferred Stock 478 Callable Preferred Stock 479 Reasons for Issuing Preferred Stock 479

Treasury Stock 480 Purchasing Treasury Stock 480 Reissuing Treasury Stock 481 Retiring Stock 482

Reporting of Equity 482 Statement of Retained Earnings 482 Statement of Stockholders’ Equity 483 Reporting Stock Options 483

Global View 484 Decision Analysis—Earnings per Share, Price-

Earnings Ratio, Dividend Yield, and Book Value per Share 485

12 Reporting Cash Flows 508

Basics of Cash Flow Reporting 510 Purpose of the Statement of Cash Flows 510 Importance of Cash Flows 510 Measurement of Cash Flows 511 Classification of Cash Flows 511 Noncash Investing and Financing 513 Format of the Statement of Cash Flows 513 Preparing the Statement of Cash Flows 514

Cash Flows from Operating 516 Indirect and Direct Methods of Reporting 516 Application of the Indirect Method of Reporting 517 Summary of Adjustments for Indirect Method 522

Cash Flows from Investing 523 Three-Stage Process of Analysis 523 Analysis of Noncurrent Assets 523 Analysis of Other Assets 524

Cash Flows from Financing 525 Three-Stage Process of Analysis 525 Analysis of Noncurrent Liabilities 525 Analysis of Equity 526 Proving Cash Balances 527

Global View 527 Decision Analysis—Cash Flow Analysis 528 Appendix 12A Spreadsheet Preparation of the Statement

of Cash Flows 532 Appendix 12B Direct Method of Reporting Operating

Cash Flows 535

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13 Analysis of Financial Statements 562

Basics of Analysis 564 Purpose of Analysis 564 Building Blocks of Analysis 564 Information for Analysis 565 Standards for Comparisons 565 Tools of Analysis 566

Horizontal Analysis 566 Comparative Statements 566 Trend Analysis 569

Vertical Analysis 571 Common-Size Statements 571 Common-Size Graphics 573

Ratio Analysis 574 Liquidity and Efficiency 575 Solvency 579 Profitability 580 Market Prospects 581 Summary of Ratios 582

Global View 584 Decision Analysis—Analysis Reporting 584 Appendix 13A Sustainable Income 588

14 Managerial Accounting Concepts and Principles 608

Managerial Accounting Basics 610 Purpose of Managerial Accounting 610 Nature of Managerial Accounting 611 Managerial Decision Making 613 Fraud and Ethics in Managerial Accounting 613

Managerial Cost Concepts 614 Types of Cost Classifications 614 Identification of Cost Classifications 617 Cost Concepts for Service Companies 617

Reporting Manufacturing Activities 618 Manufacturer’s Costs 618 Manufacturer’s Balance Sheet 619 Manufacturer’s Income Statement 620 Flow of Manufacturing Activities 622 Manufacturing Statement 623 Trends in Managerial Accounting 625

Global View 627 Decision Analysis—Raw Materials Inventory Turnover

and Days’ Sales of Raw Materials Inventory 628

15 Job Order Costing and Analysis 652

Job Order Cost Accounting 654 Cost Accounting System 654 Job Order Production 654 Job Order Costing of Services 655 Events in Job Order Costing 655 Job Cost Sheet 656

Job Order Cost Flows and Reports 658 Materials Cost Flows and Documents 658 Labor Cost Flows and Documents 660 Overhead Cost Flows and Documents 661 Summary of Cost Flows 663

Adjusting Factory Overhead 665 Factory Overhead T-Account 665 Underapplied or Overapplied Overhead 666

Global View 666 Decision Analysis—Pricing for Services 667

16 Costing and Analysis 692

Process Operations 692 Comparing Job Order and Process Operations 693 Organization of Process Operations 693 GenX Company—An Illustration 693

Process Cost Accounting 695 Comparing Job Order and Process Cost Accounting Systems 695 Direct and Indirect Costs 695 Accounting for Materials Costs 696 Accounting for Labor Costs 697 Accounting for Factory Overhead 697

Equivalent Units of Production 699 Accounting for Goods in Process 699 Differences in Equivalent Units for Materials, Labor, and Overhead 699

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Process Costing Illustration 700 Step 1: Determine the Physical Flow of Units 701 Step 2: Compute Equivalent Units of Production 701 Step 3: Compute the Cost per Equivalent Unit 702 Step 4: Assign and Reconcile Costs 702 Transfers to Finished Goods Inventory and Cost of Goods Sold 705 Trends in Process Operations 707

Global View 707 Decision Analysis—Hybrid Costing System 707 Appendix 16A FIFO Method of Process Costing 709

17 Activity-Based Costing and Analysis 736

Assigning Overhead Costs 738 Plantwide Overhead Rate Method 739 Departmental Overhead Rate Method 740 Activity-Based Costing Rates and Method 743

Applying Activity-Based Costing 744 Step 1: Identify Activities and the Costs They Cause 744 Step 2: Trace Overhead Costs to Cost Pools 745 Step 3: Determine Activity Rates 746 Step 4: Assign Overhead Costs to Cost Objects 746

Assessing Activity-Based Costing 748 Advantages of Activity-Based Costing 748 Disadvantages of Activity-Based Costing 750 ABC for Service Providers 750 Types of Activities 750

Global View 752 Decision Analysis—Customer Profitability 752

18 Cost Behavior and Cost-Volume- Profit Analysis 776

Identifying Cost Behavior 778 Fixed Costs 778 Variable Costs 780 Mixed Costs 780 Step-Wise Costs 780 Curvilinear Costs 781

Measuring Cost Behavior 781 Scatter Diagrams 782 High-Low Method 782 Least-Squares Regression 783 Comparison of Cost Estimation Methods 784

Using Break-Even Analysis 784 Contribution Margin and Its Measures 784 Computing the Break-Even Point 785 Computing the Margin of Safety 786 Preparing a Cost-Volume-Profit Chart 787 Making Assumptions in Cost-Volume-Profit Analysis 788

Applying Cost-Volume-Profit Analysis 789 Computing Income from Sales and Costs 789 Computing Sales for a Target Income 790 Using Sensitivity Analysis 792 Computing a Multiproduct Break-Even Point 793

Global View 795 Decision Analysis—Degree of Operating Leverage 795 Appendix 18A Using Excel to Estimate Least-Squares

Regression 797

19 Variable Costing and Performance Reporting 814

Introducing Variable Costing and Absorption Costing 816

Computing Unit Cost 817

Performance Reporting (Income) Implications 818 Units Produced Equal Units Sold 818 Units Produced Exceed Units Sold 820 Units Produced Are Less Than Units Sold 821 Summarizing Income Reporting 822 Converting Income under Variable Costing to Absorption Costing 823

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Contents xxxiii

Comparing Variable Costing and Absorption Costing 823

Planning Production 823 Setting Prices 825 Controlling Costs 826 Limitations of Reports Using Variable Costing 826 Variable Costing for Service Firms 827

Global View 827 Decision Analysis—Break-Even Analysis 827

20 Master Budgets and Performance Planning 846

Budget Process 848 Strategic Budgeting 848 Benchmarking Budgets 848 Budgeting and Human Behavior 849 Budgeting as a Management Tool 849 Budgeting Communication 849

Budget Administration 850 Budget Committee 850 Budget Reporting 850 Budget Timing 851

Master Budget 852 Master Budget Components 852 Operating Budgets 854 Capital Expenditures Budget 858 Financial Budgets 858

Global View 862 Decision Analysis—Activity-Based Budgeting 862 Appendix 20A Production and Manufacturing

Budgets 868

21 Flexible Budgets and Standard Costs 894

SECTION 1—FLEXIBLE BUDGETS 896 Budgetary Process 896

Budgetary Control and Reporting 896 Fixed Budget Performance Report 897 Budget Reports for Evaluation 898

Flexible Budget Reports 898 Purpose of Flexible Budgets 898 Preparation of Flexible Budgets 898 Flexible Budget Performance Report 900

SECTION 2—STANDARD COSTS 901 Materials and Labor Standards 902

Identifying Standard Costs 902 Setting Standard Costs 902

Cost Variances 903 Cost Variance Analysis 903 Cost Variance Computation 903 Computing Materials and Labor Variances 904

Overhead Standards and Variances 907 Setting Overhead Standards 907 Predicting Activity Levels 908 Computing Overhead Cost Variances 908

Global View 910 Decision Analysis—Sales Variances 911 Appendix 21A: Expanded Overhead Variances and

Standard Cost Accounting System 916

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22 Performance Measurement and Responsibility Accounting 940

Responsibility Accounting 942 Motivation for Departmentalization 942 Departmental Evaluation 942 Controllable versus Uncontrollable Costs 943

Cost Centers 944 Responsibility Accounting System 944 Evaluating Cost Center Performance 944

Profit Center 945 Direct and Indirect Expenses 945 Allocation of Indirect Expenses 946 Departmental Income Statements 947 Departmental Contribution to Overhead 951

Evaluating Investment Center Performance 953 Financial Performance Evaluation Measures 953 Nonfinancial Performance Evaluation Measures 955

Global View 957 Decision Analysis—Cycle Time and Cycle

Efficiency 957 Appendix 22A Transfer Pricing 961 Appendix 22B Joint Costs and Their Allocation 962

23 Relevant Costing for Managerial Decisions 984

Decisions and Information 986 Decision Making 986 Relevant Costs 986

Managerial Decision Scenarios 987 Additional Business 987 Make or Buy 989 Scrap or Rework 990 Sell or Process 990 Sales Mix Selection 991 Segment Elimination 993 Keep or Replace Equipment 993 Qualitative Decision Factors 994

Decision Analysis—Setting Product Price 994

24 Capital Budgeting and Investment Analysis 1014

Introduction to Capital Budgeting 1016

Methods Not Using Time Value of Money 1016 Payback Period 1016 Accounting Rate of Return 1019

Methods Using Time Value of Money 1020 Net Present Value 1020 Internal Rate of Return 1023 Comparison of Capital Budgeting Methods 1025

Global View 1026 Decision Analysis—Break-Even Time 1026 Appendix 24A Using Excel to Compute Net Present

Value and Internal Rate of Return 1029

Appendix A Financial Statement Information A-1 Polaris A-2 Arctic Cat A-10 KTM A-14 Piaggio A-18 Appendix B Time Value of Money B Appendix C Investments and International Operations C *Appendix D Accounting for Partnerships *Appendix E Accounting with Special Journals Glossary G

Credits CR

Index IND

Chart of Accounts CA

* Appendices D&E are available on the book’s Website, mhhe.com/wildFINMAN5e, and as print copy from a McGraw-Hill representative.

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Financial and Managerial Accounting INFORMATION FOR DECISIONS

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Learning Objectives

CONCEPTUAL

C1 Explain the purpose and importance of accounting. (p. 4) C2 Identify users and uses of, and opportunities in, accounting. (p. 5) C3 Explain why ethics are crucial to accounting. (p. 7) C4 Explain generally accepted accounting principles and define and apply several

accounting principles. (p. 9)

C5 Appendix 1B—Identify and describe the three major activities of organizations. (p. 27)

ANALYTICAL

A1 Define and interpret the accounting equation and each of its components. (p. 15)

A2 Compute and interpret return on assets. (p. 23) A3 Appendix 1A—Explain the relation between return and risk. (p. 27)

PROCEDURAL

P1 Analyze business transactions using the accounting equation. (p. 16) P2 Identify and prepare basic financial statements and explain how they

interrelate. (p. 20)

Introducing Accounting in Business 1

A Look at This Chapter

Accounting is crucial in our information age. In this chapter, we discuss the importance of accounting to different types of organizations and describe its many users and uses. We explain that ethics are essential to accounting. We also explain business transactions and how they are reflected in financial statements.

A Look Ahead

Chapter 2 describes and analyzes business transactions. We explain the analysis and recording of transactions, the ledger and trial balance, and the double- entry system. More generally, Chapters 2 and 3 use the accounting cycle to show how financial statements reflect business activities.

Learning Objectives are classified as conceptual, analytical, or procedural.

2

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Accounting for Twitter SAN FRANCISCO—“We came across the word ‘twitter,’ and it was just perfect,” recalls Jack Dorsey (right of photo). “The defini- tion was ‘a short burst of inconsequential information,’ and ‘chirps from birds,’ and that’s exactly what the product was.” Today, Twitter boasts over 200 million users. Founded by Jack, along with Biz Stone and Evan Williams (left), Twitter (Twitter.com) is “facilitating connections between businesses and individuals in meaningful and relevant ways,” says Jack. Along the way, the young entrepreneurs had to learn accounting and the details of preparing and interpreting financial statements. “There is so much going on here,” explains Biz when describ- ing Twitter’s business model. However, admits Evan, “We did a poor job of communicating.” Important questions involving busi- ness formation, transaction analysis, and financial reporting arose. The entrepreneurs eventually met those challenges and, in the process, set Twitter apart. “If you stand pat,” says Evan, “you risk being stagnant.” Information is the focus within Twitter’s accounting records and systems. Jack recalls that when they launched Twitter, there were all these reasons why they would not succeed. He applied their similar “can-do” approach to accounting information. “My whole philosophy is making tech [and accounting] more acces- sible and human,” says Jack. This includes using accounting in- formation to make key business decisions. Twitter is the language of micro-blogging, and accounting is the language of business. “Twitter is so many things: a messaging

service, a customer-service tool, a real-time search,” explains Biz, and the accounting system had to capture those things. Biz adds that Twitter is exploring additional “interesting ways to generate rev- enue.” That revenue-stream is reflected in its financial statements, which are based on transaction analysis and accounting concepts. Twitter’s revenues exhibit growth and reflect what experts call the monetizing of its business. A recent study by the mar- keting firm SocialTwist found that the click-through rate was 19 for Twitter, which is the number of clicks on an embedded link. This compares with 3 clicks for Facebook links. Twitter’s reve- nues in the recent year were estimated at $45 million, which are projected to exceed $100 million next year. Twitter also tracks its expenses and asset purchases. Twitter owners have an esti- mated valuation of between $5 and $10 billion! The three entrepreneurs emphasize that accounting records must be in order for Twitter to realize its full potential. Many ex- perts predict a public offering of its stock within the next two years, which could generate untold wealth. Still, Evan recog- nizes that “so many people here [at Twitter] contribute to that success.” He also emphasizes that learning is a key to their busi- ness success. “I realized,” insists Evan, “I could buy accounting books and learn something that people spent years learning.”

[Sources: Twitter Website, January 2013; Entrepreneur, December 2010; USA Today, May 2009; Smedio.com, June 2011; San Francisco Chronicle, March 2011; SocialTwist.com, October 2010; The Wall Street Journal, February 2011]

“There is so much going on here . . .” —BIZ STONE (CENTER)

Decision Insight A Decision Feature launches each chapter showing the relevance of accounting for a real entrepreneur. An Entrepreneurial Decision problem at the end of the assignments returns to this feature with a mini-case.

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Chapter Preview

Today’s world is one of information — its preparation, commu- nication, analysis, and use. Accounting is at the core of this information age. Knowledge of accounting gives us career opportunities and the insight to take advantage of them. This book introduces concepts, procedures, and analyses that help us

make better decisions, including career choices. In this chapter we describe accounting, the users and uses of accounting infor- mation, the forms and activities of organizations, and several ac- counting principles. We also introduce transaction analysis and financial statements.

Fundamentals of Accounting

• Ethics—key concept • Generally accepted

accounting principles • International standards

Importance of Accounting

• Accounting information users

• Opportunities in accounting

Transaction Analysis

• Accounting equation • Transaction

analysis—illustrated

Financial Statements

• Income statement • Statement of retained

earnings • Balance sheet • Statement of cash flows

EXHIBIT 1.1 Accounting Activities

Select transactions and events Input, measure, and log Prepare, analyze, and interpret

Identifying Recording Communicating

A Preview opens each chapter with a summary of topics covered.

Real company names are printed in bold magenta.

Why is accounting so popular on campus? Why are there so many openings for accounting jobs? Why is accounting so important to companies? Why do politicians and business leaders focus on accounting regulations? The answer is that we live in an information age, where that information, and its reliability, impacts us all. Accounting is an information and measurement system that identifies, records, and communi- cates relevant, reliable, and comparable information about an organization’s business activities. Identifying business activities requires that we select relevant transactions and events. Examples are the sale of iPhones by Apple and the receipt of ticket money by TicketMaster. Recording business activities requires that we keep a chronological log of transactions and events measured in dollars. Communicating business activities requires that we prepare accounting reports such as financial statements, which we analyze and interpret. (The financial statements and notes of Polaris are shown in Appendix A near the end of this book. This appendix also shows the financial statements of Arctic Cat, KTM, and Piaggio.) Exhibit 1.1 summarizes accounting activities. Accounting is part of our everyday lives. Our most common contact with accounting is through credit approvals, checking accounts, tax forms, and payroll. These experiences tend to focus on the recordkeeping parts of accounting. Recordkeeping, or bookkeeping, is the record- ing of transactions and events, either manually or electronically. This is just one part of account- ing. Accounting also identifies and communicates information on transactions and events, and it includes the crucial processes of analysis and interpretation. Technology is a key part of modern business and plays a major role in accounting. Technology reduces the time, effort, and cost of recordkeeping while improving clerical accuracy. Some small organizations continue to perform various accounting tasks manually, but even they are impacted

IMPORTANCE OF ACCOUNTING

C1 Explain the purpose and importance of accounting.

4

Introducing Accounting in Business

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Chapter 1 Introducing Accounting in Business 5

by technology. As technology makes more information available, the demand for accounting in- creases and so too the skills for applying that information. Consulting, planning, and other finan- cial services are now closely linked to accounting. These services require sorting through data, interpreting their meaning, identifying key factors, and analyzing their implications.

Users of Accounting Information Accounting is called the language of business because all organizations set up an accounting information system to communicate data to help people make better decisions. Exhibit 1.2 shows that accounting serves many users (this is a partial listing) who can be divided into two groups: external users and internal users.

Margin notes further enhance the textual material.

Point: Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting. The best software and recordkeeping cannot make up for lack of accounting knowledge.

Internal usersExternal users

A A 000039

EXHIBIT 1.2 Users of Accounting Information

Infographics reinforce key concepts through visual learning.

External Information Users External users of accounting information are not directly involved in running the organization. They include shareholders (investors), lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. External users have limited access to an organization’s information. Yet their business decisions depend on information that is reliable, relevant, and comparable. Financial accounting is the area of accounting aimed at serving external users by providing them with general-purpose financial statements. The term general-purpose refers to the broad range of purposes for which external users rely on these statements. Following is a partial list of external users and some decisions they make with ac- counting information.

● Lenders (creditors) loan money or other resources to an organization. Banks, savings and loans, co-ops, and mortgage and finance companies are lenders. Lenders look for informa- tion to help them assess whether an organization is likely to repay its loans with interest.

● Shareholders (investors) are the owners of a corporation. They use accounting reports in de- ciding whether to buy, hold, or sell stock.

● Directors are typically elected to a board of directors to oversee their interests in an organiza- tion. Since directors are responsible to shareholders, their information needs are similar.

● External (independent) auditors examine financial statements to verify that they are prepared according to generally accepted accounting principles.

● Nonexecutive employees and labor unions use financial statements to judge the fairness of wages, assess job prospects, and bargain for better wages.

● Regulators often have legal authority over certain activities of organizations. For example, the Internal Revenue Service (IRS) and other tax authorities require organizations to file accounting reports in computing taxes. Other regulators include utility boards that use ac- counting information to set utility rates and securities regulators that require reports for com- panies that sell their stock to the public.

● Voters, legislators, and government officials use accounting information to monitor and eval- uate government receipts and expenses.

● Contributors to nonprofit organizations use accounting information to evaluate the use and impact of their donations.

C2 Identify users and uses of, and opportunities in, accounting.

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6 Chapter 1 Introducing Accounting in Business

● Suppliers use accounting information to judge the soundness of a customer before making sales on credit.

● Customers use financial reports to assess the staying power of potential suppliers.

Internal Information Users Internal users of accounting information are those di- rectly involved in managing and operating an organization. They use the information to help improve the efficiency and effectiveness of an organization. Managerial accounting is the area of accounting that serves the decision-making needs of internal users. Internal reports are not subject to the same rules as external reports and instead are designed with the special needs of internal users in mind. Following is a partial list of internal users and some decisions they make with accounting information.

● Research and development managers need information about projected costs and revenues of any proposed changes in products and services.

● Purchasing managers need to know what, when, and how much to purchase. ● Human resource managers need information about em ployees’ payroll, benefits, perfor-

mance, and compensation. ● Production managers depend on information to monitor costs and ensure quality. ● Distribution managers need reports for timely, accurate, and efficient delivery of products

and services. ● Marketing managers use reports about sales and costs to target consumers, set prices, and

monitor consumer needs, tastes, and price concerns. ● Service managers require information on the costs and benefits of looking after products and

services.

Opportunities in Accounting Accounting information is in all aspects of our lives. When we earn money, pay taxes, in- vest savings, budget earnings, and plan for the future, we use accounting. Accounting has four broad areas of opportunities: financial, managerial, taxation, and accounting-related. Exhibit 1.3 lists selected opportunities in each area.

• Preparation • Analysis • Auditing • Regulatory • Consulting • Planning • Criminal investigation

• Preparation • Planning • Regulatory • Investigations • Consulting • Enforcement • Legal services • Estate plans

• General accounting • Cost accounting • Budgeting • Internal auditing • Consulting • Controller • Treasurer • Strategy

• Lenders • Consultants • Analysts • Traders • Directors • Underwriters • Planners • Appraisers

• FBI investigators • Market researchers • Systems designers • Merger services • Business valuation • Forensic accounting • Litigation support • Entrepreneurs

Opportunities in Accounting

Financial Taxation Accounting-relatedManagerial

EXHIBIT 1.3 Accounting Opportunities

Exhibit 1.4 shows that the majority of opportunities are in private accounting, which are employees working for businesses. Public accounting offers the next largest number of op-

portunities, which involve services such as audit- ing and tax advice. Still other opportunities exist in government and not-for-profit agencies, includ- ing business regulation and investigation of law violations.

Accounting specialists are highly regarded and their professional standing is often denoted by a certificate. Certified public accountants (CPAs) must meet education and experience requirements,

EXHIBIT 1.4 Accounting Jobs by Area

Private accounting

58% Public

accounting 23%

Government, not-for-profit and

education 19%

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Chapter 1 Introducing Accounting in Business 7

pass an examination, and exhibit ethical character. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), personal financial specialist (PFS), certified fraud examiner (CFE), and certified forensic accountant (CrFA). Demand for accounting specialists is strong. Exhibit 1.5 reports average annual salaries for several accounting positions. Salary variation depends on location, company size, professional designation, experience, and other factors. For example, salaries for chief financial officers (CFO) range from under $100,000 to more than $1 million per year. Likewise, salaries for book- keepers range from under $30,000 to more than $80,000.

Point: Census Bureau (2011) reports that for workers 25 and over, higher education yields higher average pay: Advanced degree . . . . . . . . . . $81,568 Bachelor’s degree . . . . . . . . . . 57,326 High school degree . . . . . . . . 36,876 No high school degree. . . . . . 26,124

Point: The largest accounting firms are Deloitte, Ernst & Young, KPMG, and Price- waterhouseCoopers.

Point: For updated salary information: Abbott-Langer.com www.AICPA.org Kforce.com

EXHIBIT 1.5 Accounting Salaries for Selected Fields

Field Title (experience) 2011 Salary 2016 Estimate*

Public Accounting Partner . . . . . . . . . . . . . . . . . . . . . . . . . . . $202,000 $223,000

Manager (6 – 8 years) . . . . . . . . . . . . . . . . 97,500 107,500

Senior (3 – 5 years) . . . . . . . . . . . . . . . . . . 75,000 83,000

Junior (0 – 2 years) . . . . . . . . . . . . . . . . . . 57,500 63,500

Private Accounting CFO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242,000 267,000

Controller/Treasurer . . . . . . . . . . . . . . . 157,500 174,000

Manager (6 – 8 years) . . . . . . . . . . . . . . . . 91,500 101,000

Senior (3 – 5 years) . . . . . . . . . . . . . . . . . . 74,500 82,000

Junior (0 – 2 years) . . . . . . . . . . . . . . . . . . 53,000 58,500

Recordkeeping Full-charge bookkeeper . . . . . . . . . . . . . 59,500 65,500

Accounts manager . . . . . . . . . . . . . . . . . . 52,000 57,500

Payroll manager . . . . . . . . . . . . . . . . . . . . 55,500 61,000

Accounting clerk (0 – 2 years) . . . . . . . . . 38,500 42,500

* Estimates assume a 2% compounded annual increase over current levels (rounded to nearest $500).

Quick Check is a chance to stop and reflect on key points.

1. What is the purpose of accounting? 2. What is the relation between accounting and recordkeeping? 3. Identify some advantages of technology for accounting. 4. Who are the internal and external users of accounting information? 5. Identify at least five types of managers who are internal users of accounting information.

Quick Check Answers — p. 29

Point: U.S. Bureau of Labor (June 2011) reports higher education is associated with a lower unemployment rate: Bachelor’s degree or more . . . . 4.4% High school degree . . . . . . . . . . 10.0% No high school degree. . . . . . . . 14.3%

Accounting is guided by principles, standards, concepts, and assumptions. This section de- scribes several of these key fundamentals of accounting.

Ethics—A Key Concept The goal of accounting is to provide useful information for decisions. For information to be use- ful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior. Identifying the ethical path is sometimes difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions. For example, accounting users are less likely to trust an auditor’s report if the auditor’s pay depends on the client’s success . To avoid such con- cerns, ethics rules are often set. For example, auditors are banned from direct investment in their

FUNDAMENTALS OF ACCOUNTING

Point: Sarbanes-Oxley Act requires each issuer of securities to disclose whether it has adopted a code of ethics for its senior officers and the contents of that code.

C3 Explain why ethics are crucial to accounting.

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8 Chapter 1 Introducing Accounting in Business

client and cannot accept pay that depends on figures in the client’s reports. Exhibit 1.6 gives guidelines for making ethical decisions. Accountants face many ethical choices as they prepare financial reports. These choices can affect the price a buyer pays and the wages paid to workers. They can even affect the success of products and services. Misleading information can lead to a wrongful closing of a division that harms workers, customers, and suppliers. There is an old saying: Good ethics are good business. Some people extend ethics to social responsibility, which refers to a concern for the impact of actions on society. An organization’s social responsibility can include donations to hospitals, colleges, community programs, and law enforcement. It also can include programs to reduce pollution, increase product safety, improve worker conditions, and support continuing education. These programs are not limited to large companies. For example, many small businesses offer discounts to students and senior citizens. Still others help sponsor events such as the Special Olympics and summer reading programs.

Point: The American Institute of Certified Public Accountants’ Code of Professional Conduct is available at www.AICPA.org.

EXHIBIT 1.6 Guidelines for Ethical Decision Making

Use personal ethics to recognize an ethical concern.

Consider all good and bad consequences.

Choose best option after weighing all consequences.

Identify ethical concerns Analyze options Make ethical decision

Decision Insight boxes highlight relevant items from practice.

Virtuous Returns Virtue is not always its own reward. Compare the S&P 500 with the Domini Social Index (DSI), which covers 400 companies that have especially good records of social responsibility. We see that returns for companies with socially responsible behavior are roughly on par with those of the S&P 500 for the past 10-year period (Domini.com, 2011 Annual Report). Copyright © 2005 by KLD Research & Analytics, Inc. The “Domini 400 Social Index” is a service mark of

KLD Research & Analytics. ■ 6

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DSEFX S&P 500

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$12,932 S&P 500

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Decision Insight

Fraud Triangle The fraud triangle is a model created by a criminologist that asserts the following three factors must exist for a person to commit fraud: opportunity, pressure, and rationalization. Opportunity is one side of the fraud triangle. A person must envision a way to commit fraud with a low perceived risk of getting caught. Employers can directly reduce this risk. An example of some control on opportunity is a pre-employment background check. Pressure, or incentive, is another side of the fraud triangle. A person must have some pressure to commit fraud. Ex- amples are unpaid bills and addictions. Rationalization, or attitude, is the third side of the fraud triangle. A person who rationalizes fails to see the criminal nature of the fraud or justifies the action. It is important to recognize that all three factors of the fraud triangle must usually exist for fraud to occur. The absence of one or more factors suggests fraud is unlikely. The key to dealing with fraud is to focus on prevention. It is less expensive and more effec- tive to prevent fraud from happening than it is to try to detect the crime. By the time the fraud is

O pp

or tu

ni ty

Rationalization

Financial Pressure

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Chapter 1 Introducing Accounting in Business 9

Generally Accepted Accounting Principles Financial accounting is governed by concepts and rules known as generally accepted accounting principles (GAAP). We must understand these principles to best use accounting data. GAAP aims to make information relevant, reliable, and comparable. Relevant information affects deci- sions of users. Reliable information is trusted by users. Comparable information is helpful in contrasting organizations. In the United States, the Securities and Exchange Commission (SEC), a government agency, has the legal authority to set GAAP. The SEC also oversees proper use of GAAP by companies that raise money from the public through issuances of their stock and debt. Those companies that issue their stock on U.S. exchanges include both U.S. SEC registrants (companies incorporated in the United States) and non-U.S. SEC registrants (companies incorporated under non-U.S. laws). The SEC has largely delegated the task of setting U.S. GAAP to the Financial Accounting Stan- dards Board (FASB), which is a private-sector group that sets both broad and specific principles.

International Standards In today’s global economy, there is increased demand by external users for comparability in ac- counting reports. This demand often arises when companies wish to raise money from lenders and investors in different countries. To that end, the International Accounting Standards Board (IASB), an independent group (consisting of individuals from many countries), issues Interna- tional Financial Reporting Standards (IFRS) that identify preferred accounting practices. If standards are harmonized, one company can potentially use a single set of financial state- ments in all financial markets. Differences between U.S. GAAP and IFRS are decreasing as the FASB and IASB pursue a convergence process aimed to achieve a single set of accounting stan- dards for global use. More than 115 countries now require or permit companies to prepare fi- nancial reports following IFRS. Further, non-U.S. SEC registrants can use IFRS in financial reports filed with the SEC (with no reconciliation to U.S. GAAP). This means there are two sets of accepted accounting principles in the United States: (1) U.S. GAAP for U.S. SEC registrants and (2) either IFRS or U.S. GAAP for non-U.S. SEC registrants. The SEC is encouraging the FASB to change U.S. GAAP over a period of several years by endorsing, and thereby incorporating, individual IFRS standards into U.S. GAAP. This endorse- ment process would still allow the FASB to modify IFRS when necessary. The SEC would:

● Maintain its statutory oversight of the FASB, including authority to prescribe accounting principles and standards for U.S. issuers.

● Contribute to oversight and governance of the IASB through its involvement on the IFRS Foundation Monitoring Board.

Point: State ethics codes require CPAs who audit financial statements to disclose areas where those statements fail to comply with GAAP. If CPAs fail to report noncompliance, they can lose their licenses and be subject to criminal and civil actions and fines.

C4 Explain generally accepted accounting principles and define and apply several accounting principles.

They Fought the Law Our economic and social welfare depends on reliable accounting. Some individuals forgot that and are now paying their dues. They include Raj Rajaratnam (in photo), an investor, convicted of trading stocks using inside information; Bernard Madoff of Madoff Investment Securities, convicted of falsifying securities records; Bernard Ebbers of WorldCom, convicted of an $11 billion accounting scandal; Andrew Fastow of Enron, guilty of hiding debt and inflating income; and Ramalinga Raju of Satyam Computers, accused of over- stating assets by $1.5 billion. ■

Decision Insight

discovered, the money is gone and chances are slim that it will be recovered. Additionally, it is costly and time-consuming to investigate a fraud.

Both internal and external users rely on internal controls to reduce the likelihood of fraud. Inter- nal controls are procedures set up to protect company property and equipment, ensure reliable ac- counting reports, promote efficiency, and encourage adherence to company policies. Examples are good records, physical controls (locks, passwords, guards), and independent reviews.

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10 Chapter 1 Introducing Accounting in Business

Principles and Assumptions of Ac counting Accounting principles (and assump- tions) are of two types. General principles are the basic assumptions, concepts, and guidelines for preparing financial statements. Specific principles are detailed rules used in reporting busi- ness transactions and events. General principles stem from long-used accounting practices. Spe- cific principles arise more often from the rulings of authoritative groups.

IFRS Like the FASB, the IASB uses a conceptual framework to aid in revising or drafting new standards. However, unlike the FASB, the IASB’s conceptual framework is used as a reference when specific guidance is lack- ing. The IASB also requires that transactions be accounted for according to their substance (not only their legal form), and that financial statements give a fair presentation, whereas the FASB narrows that scope to fair presentation in accordance with U.S. GAAP. ■

Conceptual Framework and Convergence The FASB and IASB are attempting to converge and enhance the conceptual framework that guides standard setting. The FASB framework consists broadly of the following:

● Objectives—to provide information useful to investors, creditors, and others.

● Qualitative Characteristics—to require information that is relevant, reliable, and comparable.

● Elements—to define items that financial statements can contain.

● Recognition and Measurement—to set criteria that an item must meet for it to be recognized as an element; and how to mea- sure that element.

For updates on this joint FASB and IASB conceptual framework convergence we can check with FASB.org or ifrs.org Websites. We must remember that U.S. GAAP and IFRS are two similar, but not identical, systems. However, their similarities greatly outweigh any differ- ences. The remainder of this section describes key principles and assumptions of accounting.

Objectives of financial accounting

Recognition and measurement

Qualitative characteristics Elements

Principles and Scruples Auditors, directors, and lawyers are using principles to improve accounting reports. Examples include accounting restatements at Navistar, financial restatements at Nortel, accounting reviews at Echostar, and expense adjustments at Electronic Data Sys- tems. Principles-based accounting has led accounting firms to drop cli- ents deemed too risky. Examples include Grant Thornton’s resignation as auditor of Fremont General due to alleged failures in providing infor- mation when promised, and Ernst and Young’s resignation as auditor of Catalina Marketing due to alleged accounting errors. ■

Decision Insight

The FASB would continue, but its role would be to provide input and support to the IASB in crafting high-quality, global standards. The FASB is to develop a transition plan to effect these changes over the next five years or so. For updates on this roadmap, we can check with the AICPA (IFRS.com), FASB (FASB.org), and IASB (ifrs.org).

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Chapter 1 Introducing Accounting in Business 11

We need to under- stand both general and specific principles to effectively use ac- counting information. Several general prin- ciples are des cribed in this section that are relied on in later chap- ters. General princi- ples (in purple font with white shading) and assumptions (in red font with white shading) are portrayed as building blocks of GAAP in Exhibit 1.7. The specific principles are described as we encoun- ter them in the book.

Accounting Principles General principles consist of at least four basic principles, four assump- tions, and two constraints.

● Measurement The measurement principle, also called the cost principle, usually prescribes that accounting information is based on actual cost (with a potential for subsequent adjustments to market). Cost is mea sured on a cash or equal-to-cash basis. This means if cash is given for a ser vice, its cost is meas ured as the amount of cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or re- ceived. The cost principle emphasizes reliability and verifiability, and information based on cost is considered objective. Objectivity means that information is supported by independent, unbi- ased evidence; it demands more than a person’s opinion. To illustrate, suppose a company pays $5,000 for equipment. The cost principle requires that this purchase be recorded at $5,000. It makes no difference if the owner thinks this equipment is worth $7,000. Later in the book we introduce fair value measures.

● Revenue recognition Revenue (sales) is the amount received from selling products and ser- vices. The revenue recognition principle provides guidance on when a company must rec- ognize revenue. To recognize means to record it. If revenue is recognized too early, a company would look more profitable than it is. If revenue is recognized too late, a company would look less profitable than it is. Three concepts are important to revenue recognition. (1) Revenue is recognized when earned. The earnings process is normally complete when services are per- formed or a seller transfers ownership of products to the buyer. (2) Proceeds from selling products and services need not be in cash. A common noncash proceed received by a seller is a customer’s promise to pay at a future date, called credit sales. (3) Revenue is measured by the cash received plus the cash value of any other items received.

● Expense recognition The expense recognition principle, also called the matching principle, prescribes that a company record the expenses it incurred to generate the revenue reported. The principles of matching and revenue recognition are key to modern accounting.

● Full disclosure The full disclosure principle prescribes that a company report the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.

Example: When a bookstore sells a textbook on credit is its earnings process complete? Answer: A bookstore can record sales for these books minus an amount expected for returns.

GAAPGAAP

Measurement

Full disclosure

Revenue recognition

Expense recognition

Business entity

Time period

Monetary unit

Going concern

Materiality Benefits > Cost

Principles

Assumptions

Constraints

EXHIBIT 1.7 Building Blocks for GAAP

Point: The cost principle is also called the historical cost principle.

Revenues for the Green Bay Packers, New England Patriots, New York Giants, and other professional football teams include ticket sales, television and cable broadcasts, radio rights, concessions, and advertising. Revenues from ticket sales are earned when the NFL team plays each game. Advance ticket sales are not revenues; instead, they represent a liability until the NFL team plays the game for which the ticket was sold. At that point, the liability is removed and revenues are reported. ■

Decision Insight

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12 Chapter 1 Introducing Accounting in Business

Point: Abuse of the entity assumption was a main culprit in Enron’s collapse.

Point: For currency conversion: xe.com

Accounting Assumptions There are four accounting assumptions: the going-concern assump- tion, the monetary unit assumption, the time period assumption, and the business entity assumption.

● Going concern The going-concern assumption means that accounting information reflects a pre- sumption that the business will continue operating instead of being closed or sold. This implies, for example, that property is reported at cost instead of, say, liquidation values that assume closure.

● Monetary unit The monetary unit assumption means that we can express transactions and events in monetary, or money, units. Money is the common denominator in business. Exam- ples of monetary units are the dollar in the United States, Canada, Australia, and Singapore; and the peso in Mexico, the Philippines, and Chile. The monetary unit a company uses in its accounting reports usually depends on the country where it operates, but many companies today are expressing reports in more than one monetary unit.

● Time period The time period assumption presumes that the life of a company can be di- vided into time periods, such as months and years, and that useful reports can be prepared for those periods.

● Business entity The business entity assumption means that a business is accounted for sep- arately from other business entities, including its owner. The reason for this assumption is that separate information about each business is necessary for good decisions. A business entity can take one of three legal forms: proprietorship, partnership, or corporation.

1. A sole proprietorship, or simply proprietorship, is a business owned by one person in which that person and the company are viewed as one entity for tax and liability purposes. No special legal requirements must be met to start a proprietorship. It is a separate entity for accounting purposes, but it is not a separate legal entity from its owner. This means, for example, that a court can order an owner to sell personal belongings to pay a propri- etorship’s debt. This unlimited liability of a proprietorship is a disadvantage. However, an advantage is that a proprietorship’s income is not subject to a business income tax but is instead reported and taxed on the owner’s personal income tax return. Pro prietorship at- tributes are summarized in Exhibit 1.8, including those for partnerships and corporations.

EXHIBIT 1.8 Attributes of Businesses

Attribute Present Proprietorship Partnership Corporation

One owner allowed . . . . . . . . . . . . yes no yes

Business taxed . . . . . . . . . . . . . . . . no no yes

Limited liability . . . . . . . . . . . . . . . . no* no* yes

Business entity . . . . . . . . . . . . . . . . yes yes yes

Legal entity . . . . . . . . . . . . . . . . . . . no no yes

Unlimited life . . . . . . . . . . . . . . . . . no no yes

* Proprietorships and partnerships that are set up as LLCs provide limited liability.

2. A partnership is a business owned by two or more people, called partners, which are jointly liable for tax and other obligations. Like a proprietorship, no special legal require- ments must be met in starting a partnership. The only requirement is an agreement bet- ween partners to run a business to gether. The agreement can be either oral or written and usually indicates how income and losses are to be shared. A partnership, like a proprietor- ship, is not legally separate from its owners. This means that each partner’s share of profits is reported and taxed on that partner’s tax return. It also means unlimited liability for its partners. However, at least three types of partnerships limit liability. A limited partnership (LP) includes a general partner(s) with unlimited liability and a limited partner(s) with lia- bility restricted to the amount invested. A limited liability partnership (LLP) restricts part- ners’ liabilities to their own acts and the acts of individuals under their control. This protects an innocent partner from the negligence of another partner, yet all partners remain respon- sible for partnership debts. A limited liability company (LLC) offers the limited liability of a corporation and the tax treatment of a partnership (and proprietorship). Most proprietor- ships and partnerships are now organized as LLCs.

3. A corporation, also called C corporation, is a business legally separate from its owner or owners, meaning it is responsible for its own acts and its own debts. Separate legal status

Point: Proprietorships and partnerships are usually managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who appoint managers to run the business.

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Chapter 1 Introducing Accounting in Business 13

means that a corporation can conduct business with the rights, duties, and responsibilities of a person. A corporation acts through its managers, who are its legal agents. Separate legal status also means that its owners, who are called shareholders (or stockholders), are not personally liable for corporate acts and debts. This limited liability is its main ad- vantage. A main disadvantage is what’s called double taxation—meaning that (1) the cor- poration income is taxed and (2) any distribution of income to its owners through dividends is taxed as part of the owners’ personal income, usually at the 15% rate. (For lower in- come taxpayers, the dividend tax is less than 15%, and in some cases zero.) An S corpora- tion, a corporation with special attributes, does not owe corporate income tax. Owners of S corporations report their share of corporate income with their personal income. Owner- ship of all corporations is divided into units called shares or stock. When a corporation issues only one class of stock, we call it common stock (or capital stock). Decision Ethics boxes are role-

playing exercises that stress ethics in accounting and business.

Entrepreneur You and a friend develop a new design for in-line skates that improves speed by 25% to 30%. You plan to form a business to manufacture and market those skates. You and your friend want to minimize taxes, but your prime concern is potential lawsuits from individuals who might be injured on these skates. What form of organization do you set up? ■ [Answer—p. 28]

Decision Ethics

Company Alleged Accounting Abuses

Enron . . . . . . . . . . . . . . . . . . . . . . . . . Inflated income, hid debt, and bribed officials

WorldCom . . . . . . . . . . . . . . . . . . . . . Understated expenses to inflate income and hid debt

Fannie Mae . . . . . . . . . . . . . . . . . . . . . Inflated income

Adelphia Communications . . . . . . . . . Understated expenses to inflate income and hid debt

AOL Time Warner . . . . . . . . . . . . . . . . Inflated revenues and income

Xerox. . . . . . . . . . . . . . . . . . . . . . . . . . Inflated income

Bristol-Myers Squibb . . . . . . . . . . . . . . Inflated revenues and income

Nortel Networks . . . . . . . . . . . . . . . . Understated expenses to inflate income

Global Crossing . . . . . . . . . . . . . . . . . . Inflated revenues and income

Tyco . . . . . . . . . . . . . . . . . . . . . . . . . . Hid debt, and CEO evaded taxes

Halliburton . . . . . . . . . . . . . . . . . . . . . Inflated revenues and income

Qwest Communications . . . . . . . . . . . Inflated revenues and income

Point: An audit examines whether financial statements are prepared using GAAP. It does not attest to absolute accuracy of the statements.

Accounting Constraints There are two basic constraints on financial reporting.

● Materiality The materiality constraint prescribes that only information that would influ- ence the decisions of a reasonable person need be disclosed. This constraint looks at both the importance and relative size of an amount.

● Benefit exceeds cost The cost-benefit constraint prescribes that only information with ben- efits of disclosure greater than the costs of providing it need be disclosed.

Conservatism and industry practices are also sometimes referred to as accounting constraints.

Sarbanes–Oxley (SOX) Congress passed the Sarbanes–Oxley Act, also called SOX, to help curb financial abuses at companies that issue their stock to the public. SOX requires that these public companies apply both accounting oversight and stringent internal controls. The desired results include more transparency, accountability, and truthfulness in reporting transactions. Compliance with SOX requires documentation and verification of internal controls and in- creased emphasis on internal control effectiveness. Failure to comply can yield financial penal- ties, stock market delisting, and criminal prosecution of executives. Management must issue a report stating that internal controls are effective. CEOs and CFOs who knowingly sign off on bogus accounting reports risk millions of dollars in fines and years in prison. Auditors also must verify the effectiveness of internal controls. A listing of some of the more publicized accounting scandals in recent years follows.

Point: BusinessWeek reports that ex- ternal audit costs run about $35,000 for start-ups, up from $15,000 pre-SOX.

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14 Chapter 1 Introducing Accounting in Business

To reduce the risk of accounting fraud, companies set up governance systems. A company’s governance system includes its owners, managers, employees, board of directors, and other important stakeholders, who work together to reduce the risk of accounting fraud and increase confidence in accounting reports.

The impact of SOX regulations for accounting and business is discussed throughout this book. Ethics and investor confidence are key to company success. Lack of confidence in ac- counting numbers impacts company value as evidenced by huge stock price declines for Enron, WorldCom, Tyco, and ImClone after accounting misconduct was uncovered.

Dodd-Frank Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd- Frank, in a desire to (1) promote accountability and transparency in the financial system, (2) put an end to the notion of “too big to fail,” (3) protect the taxpayer by ending bailouts, and (4) protect consumers from abusive financial services. It includes provisions whose impacts are unknown until regulators set detailed rules. However, a few proposals are notable and include the following:

● Exemption from Section 404(b) of SOX for smaller public entities (whose public value is less than $75 million) from the requirement to obtain an external audit on the effectiveness of internal control over financial reporting.

● Independence for all members of the compensation committee (including additional disclo- sures); in the event of an accounting restatement, an entity must set policies mandating re- covery (“clawback”) of excess incentive compensation.

● Requires the SEC, when sanctions exceed $1 million, to pay whistle-blowers between 10% and 30% of the sanction.

0% 10% 30%20% 40%

Increased fraud awareness 39%

Greater fraud assessment 22%

Expanded internal auditing 20%

Economic Downturn, Fraud Upturn? Executives polled show that 80% believe that the economic downturn has or will have a significant impact on fraud control in their companies (Deloitte 2010). The top three responses to the question “What activity would best counter this increased fraud risk?” are tallied in the graphic to the right. ■

Decision Insight

6. What are internal controls and why are they important? 7. What three-step guidelines can help people make ethical decisions? 8. Why are ethics and social responsibility valuable to organizations? 9. Why are ethics crucial in accounting? 10. Who sets U.S. accounting rules? 11. How are U.S. companies affected by international accounting standards? 12. How are the objectivity concept and cost principle related? 13. Why is the business entity assumption important? 14. Why is the revenue recognition principle important? 15. What are the three basic forms of business organization? 16. Identify the owners of corporations and the terminology for ownership units.

Quick Check Answers — p. 29

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Chapter 1 Introducing Accounting in Business 15

Key terms are printed in bold and defined again in the end- of-book glossary.

Point: The phrases “on credit” and “on account” imply that cash payment will occur at a future date.

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B il l

In v o

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B il l

Lones

Bes t Bu

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To understand accounting information, we need to know how an accounting system captures relevant data about transactions, and then classifies, records, and reports data.

Accounting Equation The accounting system reflects two basic aspects of a company: what it owns and what it owes. As- sets are resources a company owns or controls. Examples are cash, supplies, equipment, and land, where each carries expected benefits. The claims on a company’s assets—what it owes—are sepa- rated into owner and nonowner claims. Liabilities are what a company owes its nonowners (credi- tors) in future payments, products, or services. Equity (also called owner’s equity or capital) refers to the claims of its owner(s). Together, liabilities and equity are the source of funds to acquire assets. The relation of assets, liabilities, and equity is reflected in the following accounting equation:

Assets 5 Liabilities 1 Equity

Liabilities are usually shown before equity in this equation because creditors’ claims must be paid before the claims of owners. (The terms in this equation can be rearranged; for example, Assets 2 Liabilities 5 Equity.) The accounting equation applies to all transactions and events, to all companies and forms of organization, and to all points in time. For example, Apple’s assets equal $116,371, its liabilities equal $39,756, and its equity equals $76,615 ($ in millions). Let’s now look at the accounting equation in more detail.

Assets Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are Web servers for an online services company, musical instru- ments for a rock band, and land for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or prod- uct on credit is said to have an account receivable from that customer.

Liabilities Liabilities are creditors’ claims on assets. These claims reflect company obliga- tions to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts pay- able to suppliers, notes payable to banks, and taxes payable to the government.

Equity Equity is the owner’s claim on assets, and is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. A corporation’s equity—often called stockholders’ or shareholders’ equity—has two parts: contributed capital and retained earnings. Contributed capital refers to the amount that stockholders invest in the company—included under the title common stock. Retained earnings refer to income (revenues less expenses) that has not been distributed to its stockholders. The distribution of assets to stockholders is called dividends, which reduce retained earnings. Revenues increase retained earnings (via net income) and are resources generated from a company’s earnings ac- tivities. Examples are consulting services provided, sales of products, facilities rented to others, and commissions from services. Expenses decrease retained earnings and are the cost of assets or services used to earn revenues. Examples are costs of employee time, use of supplies, and ad- vertising, utilities, and insurance services from others. In sum, retained earnings is the accumu- lated revenues less the accumulated expenses and dividends since the company began. This breakdown of equity yields the following expanded accounting equation:

TRANSACTION ANALYSIS AND THE ACCOUNTING EQUATION

A1 Define and interpret the accounting equation and each of its components.

Net income occurs when revenues exceed expenses. Net income increases equity. A net loss occurs when expenses exceed revenues, which decreases equity.

Equity

Assets 5 Liabilities 1 Contributed Capital 1 Retained Earnings

5 Liabilities 1 Common Stock 2 Dividends 1 Revenues 2 Expenses

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16 Chapter 1 Introducing Accounting in Business

Transaction Analysis Business activities can be described in terms of transactions and events. External transactions are exchanges of value between two entities, which yield changes in the accounting equation. An example is the sale of ad space by Twitter. Internal transactions are exchanges within an entity, which may or may not affect the accounting equation. An example is Twitter’s use of its supplies, which are reported as expenses when used. Events refer to happenings that affect the accounting equation and are reliably measured. They include business events such as changes in the market value of certain assets and liabilities and natural events such as floods and fires that destroy assets and create losses. They do not include, for example, the signing of service or product contracts, which by themselves do not impact the accounting equation. This section uses the accounting equation to analyze 11 selected transactions and events of FastForward, a start-up consulting (service) business, in its first month of operations. Remem- ber that each transaction and event leaves the equation in balance and that assets always equal the sum of liabilities and equity.

Transaction 1: Investment by Owner On December 1, Chas Taylor forms a consult- ing business, named FastForward and set up as a corporation, that focuses on assessing the perfor- mance of footwear and accessories. Taylor owns and manages the business. The marketing plan for the business is to focus primarily on publishing online reviews and consulting with clubs, ath- letes, and others who place orders for footwear and accessories with manufacturers. Taylor person- ally invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, the cash (an asset) and the stockholders’ equity each equal $30,000. The source of increase in equity is the owner’s investment (stock issu- ance), which is included in the column titled Common Stock. The effect of this transaction on FastForward is reflected in the accounting equation as follows (we label the equity entries):

P1 Analyze business transactions using the accounting equation.

Point: There are 3 basic types of company operations: (1) Services — providing customer services for profit, (2) Merchandisers — buying products and re-selling them for profit, and (3) Manufacturers — creating products and selling them for profit.

Assets 5 Liabilities 1 Equity

Cash 5 Common Stock

(1) 1$30,000 5 1$30,000 owner investment

Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of brand name footwear for performance testing over the next few months. This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It merely changes the form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The supplies of footwear are assets because of the expected future benefits from the test results of their performance. This transaction is reflected in the accounting equation as follows:

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 5 Common Stock

Old Bal. $30,000 5 $30,000

(2) 22,500 1 $2,500 _______ _______ _______ New Bal. $27,500 1 $ 2,500 5 $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Web Info Most organizations maintain Websites that include accounting data—see Polaris Industries (Polaris.com) as an example. Polaris makes off-road vehicles such as all-terrain vehicles (ATV) and snowmobiles; it also makes on-road vehicles such as motorcy- cles and small electric vehicles. The SEC keeps an online database called EDGAR (www. SEC.gov/edgar.shtml), which has accounting information for thousands of companies that issue stock to the public. The annual report filing for most publicly traded U.S. companies is known as Form 10-K, and the quarterly filing is Form 10-Q. Information services such as Finance.Google.com and Finance.Yahoo.com offer online data and analysis. ■

Decision Insight

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Chapter 1 Introducing Accounting in Business 17

Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to ac- quire equipment for testing footwear. Like transaction 2, transaction 3 is an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its expected fu- ture benefits from testing footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance.

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Common Stock

Old Bal. $27,500 1 $2,500 5 $30,000

(3) 226,000 1 $26,000 ________ ______ _________ _______ New Bal. $ 1,500 1 $2,500 1 $ 26,000 5 $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Accounts 1 Common Stock Payable

Old Bal. $1,500 1 $2,500 1 $26,000 5 $30,000

(4) 1 7,100 1$7,100 ______ ______ _______ ________ _______ New Bal. $1,500 1 $9,600 1 $26,000 5 $ 7,100 1 $30,000

$37,100 $37,100

⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Transaction 5: Provide Services for Cash FastForward earns revenues by selling online ad space to manufacturers and by consulting with clients about test results on footwear and accessories. It earns net income only if its revenues are greater than its expenses incurred in earning them. In one of its first jobs, FastForward provides consulting services to a power- walking club and immediately collects $4,200 cash. The accounting equation reflects this in- crease in cash of $4,200 and in equity of $4,200. This increase in equity is identified in the far right column under Revenues because the cash received is earned by providing consulting services.

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues Payable Stock

Old Bal. $1,500 1 $9,600 1 $26,000 5 $7,100 1 $30,000

(5) 14,200 1 $4,200 consulting _______ ______ ________ ______ ________ _______ New Bal. $5,700 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $ 4,200

$41,300 $41,300

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 rent to the landlord of the building where its facilities are located. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is reflected in the following accounting equation as transaction 6. FastForward also pays the biweekly $700 salary of the company’s only employee. This is reflected in the accounting equation as transac- tion 7. Both transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, as opposed to assets, because their benefits are used in December (they

Transaction 4: Purchase Supplies on Credit Taylor decides more supplies of foot- wear and accessories are needed. These additional supplies total $7,100, but as we see from the accounting equation in transaction 3, FastForward has only $1,500 in cash. Taylor arranges to purchase them on credit from CalTech Supply Company. Thus, FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases assets by $7,100 in sup- plies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount. The effects of this purchase follow:

Example: If FastForward pays $500 cash in transaction 4, how does this partial payment affect the liability to CalTech? What would be FastForward’s cash balance? Answers: The liability to CalTech would be reduced to $6,600 and the cash balance would be reduced to $1,000.

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18 Chapter 1 Introducing Accounting in Business

have no future benefits after December). These transactions also use up an asset (cash) in carry- ing out FastForward’s operations. The accounting equation shows that both transactions reduce cash and equity. The far right column identifies these decreases as Expenses.

Transaction 8: Provide Services and Facilities for Credit FastForward provides consulting services of $1,600 and rents its test facilities for $300 to a podiatric services center. The rental involves allowing members to try recommended footwear and accessories at FastForward’s testing area. The center is billed for the $1,900 total. This transaction results in a new asset, called accounts receivable, from this client. It also yields an increase in equity from the two revenue components reflected in the Revenues column of the accounting equation:

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $4,000 1 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $4,200 2 $1,700

(8) 1 $1,900 1 1,600 consulting

1 300 rental ______ _______ ______ _______ ______ _______ ______ ________ New Bal. $4,000 1 $ 1,900 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Transaction 9: Receipt of Cash from Accounts Receivable The client in trans- action 8 (the podiatric center) pays $1,900 to FastForward 10 days after it is billed for consult- ing services. This transaction 9 does not change the total amount of assets and does not affect liabilities or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward rendered the services in transaction 8, not when the cash is now collected. This emphasis on the earnings process instead of cash flows is a goal of the revenue recognition principle and yields useful information to users. The new balances follow:

By definition, increases in expenses yield decreases in equity.

Point: Receipt of cash is not always a revenue.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $4,000 1 $1,900 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

(9) 11,900 2 1,900 _______ _______ ______ _______ ______ _______ ______ ______ New Bal. $5,900 1 $ 0 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Transaction 10: Payment of Accounts Payable FastForward pays CalTech Sup- ply $900 cash as partial payment for its earlier $7,100 purchase of supplies (transaction 4), leav- ing $6,200 unpaid. The accounting equation shows that this transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an expense even though cash flows out of FastForward (instead the expense is recorded when FastForward derives the benefits from these supplies).

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Payable Stock

Old Bal. $5,700 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $4,200

(6) 21,000 2 $1,000 rent _______ ______ _______ ______ _______ _______ ________ Bal. 4,700 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200 2 1,000

(7) 2 700 2 700 salaries _______ ______ _______ ______ _______ _______ ________ New Bal. $4,000 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $4,200 2 $ 1,700

$39,600 $39,600

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

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Chapter 1 Introducing Accounting in Business 19

Transaction 11: Payment of Cash Dividend FastForward declares and pays a $200 cash dividend to its owner (the sole shareholder). Dividends (decreases in equity) are not re- ported as expenses because they are not part of the company’s earnings process. Since dividends are not company expenses, they are not used in computing net income.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $5,900 1 $ 0 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

(10) 2 900 2 900 ______ ________ ______ _______ ______ _______ ______ ______ New Bal. $5,000 1 $ 0 1 $9,600 1 $26,000 5 $6,200 1 $30,000 1 $6,100 2 $1,700

$40,600 $40,600

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 2 Dividends 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $5,000 1 $ 0 1 $9,600 1 $26,000 5 $6,200 1 $30,000 1 $6,100 2 $1,700

(11) 2 200 2 $200 dividend ______ ______ ______ _______ ______ _______ _____ ______ ______ New Bal. $4,800 1 $ 0 1 $9,600 1 $26,000 5 $6,200 1 $30,000 2 $200 1 $6,100 2 $1,700

$40,400 $40,400

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

By definition, increases in dividends yield decreases in equity.

Summary of Transactions We summarize in Exhibit 1.9 the effects of these 11 transactions of FastForward using the accounting equation. First, we see that the accounting equation remains in balance after each transaction. Second, transactions can be analyzed by their effects on components of the

EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 2 Dividends 1 Revenues 2 Expenses Receivable Payable Stock

(1) $30,000 5 $30,000

(2) 2 2,500 1 $2,500 ________ _______ ________ Bal. 27,500 1 2,500 5 30,000

(3) 226,000 1 $26,000 ________ _______ __________ ________ Bal. 1,500 1 2,500 1 26,000 5 30,000

(4) 1 7,100 1$7,100 ________ _______ __________ _________ ________ Bal. 1,500 1 9,600 1 26,000 5 7,100 1 30,000

(5) 1 4,200 1 $4,200 ________ _______ __________ _________ ________ _______ Bal. 5,700 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200

(6) 2 1,000 2 $1,000 ________ _______ __________ _________ ________ _______ _______ Bal. 4,700 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200 2 1,000

(7) 2 700 2 700 ________ _______ __________ _________ ________ _______ _______ Bal. 4,000 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200 2 1,700

(8) 1 $1,900 1 1,600

1 300 ________ _______ _______ __________ _________ ________ _______ _______ Bal. 4,000 1 1,900 1 9,600 1 26,000 5 7,100 1 30,000 1 6,100 2 1,700

(9) 1 1,900 2 1,900 ________ _______ _______ __________ _________ ________ _______ _______ Bal. 5,900 1 0 1 9,600 1 26,000 5 7,100 1 30,000 1 6,100 2 1,700

(10) 2 900 2 900 ________ _______ _______ __________ _________ ________ _______ _______ Bal. 5,000 1 0 1 9,600 1 26,000 5 6,200 1 30,000 1 6,100 2 1,700

(11) 2 200 2 $200 ________ _______ _______ __________ _________ ________ _____ _______ _______ Bal. $ 4,800 1 $ 0 1 $ 9,600 1 $ 26,000 5 $ 6,200 1 $ 30,000 2 $ 200 1 $6,100 2 $ 1,700

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20 Chapter 1 Introducing Accounting in Business

accounting equation. For example, in transactions 2, 3, and 9, one asset increased while an- other asset decreased by equal amounts.

Point: Knowing how financial statements are prepared improves our analysis of them. We develop the skills for analysis of financial statements throughout the book. Chapter 13 focuses on financial statement analysis.

17. When is the accounting equation in balance, and what does that mean? 18. How can a transaction not affect any liability and equity accounts? 19. Describe a transaction increasing equity and one decreasing it. 20. Identify a transaction that decreases both assets and liabilities.

Quick Check Answers — p. 29

This section introduces us to how financial statements are prepared from the analysis of busi- ness transactions. The four financial statements and their purposes are:

1. Income statement — describes a company’s revenues and expenses along with the result- ing net income or loss over a period of time due to earnings activities.

2. Statement of retained earnings— explains changes in equity from net income (or loss) and from any dividends over a period of time.

3. Balance sheet — describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.

4. Statement of cash flows — identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

We prepare these financial statements, in this order, using the 11 selected transactions of Fast- Forward. (These statements are technically called unadjusted — we explain this in Chapters 2 and 3.)

Income Statement FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is conveniently taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from transactions 5 and 8 and rental revenue of $300 from transaction 8. Expenses are reported after revenues. (For convenience in this chapter, we list larger amounts first, but we can sort expenses in different ways.) Rent and salary expenses are from transactions 6 and 7. Expenses reflect the costs to generate the revenues reported. Net income (or loss) is reported at the bottom of the statement and is the amount earned in December. Stockholders’ investments and dividends are not part of income.

Statement of Retained Earnings The statement of retained earnings reports information about how retained earnings changes over the reporting period. This statement shows beginning retained earnings, events that in- crease it (net income), and events that decrease it (dividends and net loss). Ending retained earnings is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of retained earnings is the second report in Exhibit 1.10. The beginning balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports the beginning balance equal to that as of the end of the prior reporting period (such as from November 30). Fast- Forward’s statement shows the $4,400 of net income earned during the period. This links the income statement to the statement of retained earnings (see line 1 ). The statement also re- ports the $200 cash dividend and FastForward’s end-of-period retained earnings balance.

Balance Sheet FastForward’s balance sheet is the third report in Exhibit 1.10. This statement refers to Fast- Forward’s financial condition at the close of business on December 31. The left side of the balance

FINANCIAL STATEMENTS

P2 Identify and prepare basic financial statements and explain how they interrelate.

Point: Net income is sometimes called earnings or profit.

Point: The statement of retained earnings is also called the statement of changes in retained earnings. Note: Beg. Retained Earnings 1 Net Income 2 Dividends 5 End. Retained Earnings

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Chapter 1 Introducing Accounting in Business 21

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2013

Retained earnings, December 1, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400 _______

4,400

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 _______

Retained earnings, December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,200 _______ _______

FASTFORWARD Statement of Cash Flows

For Month Ended December 31, 2013

Cash flows from operating activities

Cash received from clients ($4,200 1 $1,900). . . . . . . . . . $ 6,100

Cash paid for supplies ($2,500 1 $900) . . . . . . . . . . . . . . . (3,400)

Cash paid for rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,000)

Cash paid to employee . . . . . . . . . . . . . . . . . . . . . . . . . . . . (700) ________ Net cash provided by operating activities . . . . . . . . . . . . . $ 1,000

Cash flows from investing activities

Purchase of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . (26,000) ________ Net cash used by investing activities . . . . . . . . . . . . . . . . . (26,000)

Cash flows from financing activities

Investments by stockholder. . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Dividends to stockholder . . . . . . . . . . . . . . . . . . . . . . . . . . (200) ________ Net cash provided by financing activities . . . . . . . . . . . . . . 29,800 _________ Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800

Cash balance, December 1, 2013 . . . . . . . . . . . . . . . . . . . . . . 0 _________ Cash balance, December 31, 2013 . . . . . . . . . . . . . . . . . . . . . $ 4,800 _________ _________

FASTFORWARD Income Statement

For Month Ended December 31, 2013

Revenues

Consulting revenue ($4,200 1 $1,600). . . . . . . . . . . . . . . . . $ 5,800

Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 _________ Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 _________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 __________ Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,400 ____________ ____________

Point: The income statement, the statement of retained earnings, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time.

FASTFORWARD Balance Sheet

December 31, 2013

Assets Liabilities

Cash . . . . . . . . . . . . $ 4,800 Accounts payable . . . . . . . . . . . . . $ 6,200 _______ Supplies . . . . . . . . . 9,600 Total liabilities . . . . . . . . . . . . . . . 6,200

Equipment . . . . . . . . 26,000 Equity

Common stock . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . 4,200 _______ Total equity . . . . . . . . . . . . . . . . . 34,200 _______ _______ Total assets . . . . . . . $ 40,400 Total liabilities and equity . . . . . . $ 40,400 _______ _______ _______ _______

Point: A single ruled line denotes an addition or subtraction. Final totals are double underlined. Negative amounts are often in parentheses.

EXHIBIT 1.10 Financial Statements and Their Links

Point: A statement’s heading identifies the company, the statement title, and the date or time period.

1

3

Point: Arrow lines show how the statements are linked. 1 Net income is used to compute equity. 2 Retained earnings is used to prepare the balance sheet. 3 Cash from the balance sheet is used to reconcile the statement of cash flows.

2

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22 Chapter 1 Introducing Accounting in Business

sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity balance is $34,200. Line 2 shows the link between the ending balance of the statement of retained earnings and the retained earnings balance on the balance sheet. (This presentation of the balance sheet is called the account form: assets on the left and lia- bilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Either presentation is acceptable.) As always, we see the accounting equation applies: Assets of $40,400 5 Liabilities of $6,200 1 Equity of $34,200.

Statement of Cash Flows FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the $5,100 cash paid for supplies, rent, and employee salaries. Outflows are in parentheses to denote subtrac- tion. Net cash provided by operating activities for December is $1,000. If cash paid exceeded the $5,100 cash received, we would call it “cash used by operating activities.” The second section re- ports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include the long-term borrowing and repaying of cash from lenders and the cash investments from, and dividends to, stockholders. FastForward reports $30,000 from the owner’s initial investment and the $200 cash dividend. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows FastForward increased its cash balance by $4,800 in December. Since it started with no cash, the ending balance is also $4,800 — see line 3 . We see that cash flow numbers are different from income statement (accrual) numbers, which is common.

Point: Statement of cash flows has three main sections: operating, investing, and financing.

Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year).

Point: Investing activities refer to long-term asset investments by the company, not to owner investments.

21. Explain the link between the income statement and the statement of retained earnings. 22. Describe the link between the balance sheet and the statement of retained earnings. 23. Discuss the three major sections of the statement of cash flows.

Quick Check Answers — p. 29

Accounting according to U.S. GAAP is similar, but not identical, to IFRS. Throughout the book we use this last section to identify major similarities and differences between IFRS and U.S. GAAP for the mate- rials in each chapter.

Basic Principles Both U.S. GAAP and IFRS include broad and similar guidance for accounting. However, neither system specifies particular account names nor the detail required. (A typical chart of accounts is shown near the end of this book.) IFRS does require certain minimum line items be reported in the balance sheet along with other minimum disclosures that U.S. GAAP does not. On the other hand, U.S. GAAP requires disclosures for the current and prior two years for the income statement, statement of cash flows, and statement of retained earnings (equity), while IFRS requires disclosures for the current and prior year. Still, the basic principles behind these two systems are similar.

Transaction Analysis Both U.S. GAAP and IFRS apply transaction analysis identically as shown in this chapter. Although some variations exist in revenue and expense recognition and other principles, all of the transactions in this chapter are accounted for identically under these two systems. It is often said that U.S. GAAP is more rules-based whereas IFRS is more principles-based. The main difference on the rules versus principles focus is with the approach in deciding how to account for certain transactions. Under U.S. GAAP, the approach is more focused on strictly following the accounting rules; under IFRS, the approach is more focused on a review of the situation and how accounting can best reflect it. This dif- ference typically impacts advanced topics beyond the introductory course.

Financial Statements Both U.S. GAAP and IFRS prepare the same four basic financial statements. To illustrate, a condensed version of Piaggio’s income statement follows (numbers are in Euros thousands).

GLOBAL VIEW

PIAGGIO

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Chapter 1 Introducing Accounting in Business 23

Piaggio manufactures two-, three- and four-wheel vehicles, and is Europe’s leading manufacturer of motorcy- cles and scooters. Similar condensed versions can be prepared for the other three statements (see Appendix A).

PIAGGIO Income Statement (in € thousands) For Year Ended December 31, 2011

Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,516,463

Cost for materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 904,060

Cost for services, leases, employees, depreciation, and other expenses . . . . . . . . . 533,045

Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,305

Net income (profit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,053

Gold shading marks jurisdictions that permit or require IFRS for some or all domestic companies; light tan marks jurisdictions that have either modified or delayed implementation of IFRS.

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COSTA RICA

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CUBA

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DOMINICAN REPUBLIC

TRINIDAD AND TOBAGO

AFGHANISTAN

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KYRGYZSTAN

INDIA

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PAKISTAN

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PORTUGAL SPAIN

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London Kiev

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San Francisco

Chicago

Montreal

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Los Angeles

Havana

Dallas

Miami

Atlanta

Seattle

Anchorage

Lima

Rio De Janeiro

São Paulo

Honolulu

Cape Town

Kinshasa

Lagos

Baghdad

Tehran

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Bangkok

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Status of IFRS Accounting impacts companies across the world, which requires us to take a global view. IFRS is now adopted or accepted in over 115 countries, including over 30 member-states of the EU (see gold and light tan shading in the map below). Teal shading in the map reflects a system other than IFRS. The FASB and IASB continue to work on the convergence of IFRS and U.S. GAAP. Further, the SEC has a “roadmap” for ultimate use of IFRS by U.S. companies. Currently, the roadmap extends out over the next several years.

Return on Assets Decision Analysis

A Decision Analysis section at the end of each chapter is devoted to financial statement analysis. We or- ganize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profit- ability, and (4) market prospects — Chapter 13 has a ratio listing with definitions and groupings by area. When analyzing ratios, we need benchmarks to identify good, bad, or average levels. Common bench- marks include the company’s prior levels and those of its competitors.

Decision Analysis (a section at the end of each chapter) introduces and explains ratios helpful in decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 13.

A2 Compute and interpret return on assets.

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24 Chapter 1 Introducing Accounting in Business

This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Dell has its marketing department compute return on assets for every order. Return on assets (ROA), also called return on investment (ROI ), is defined in Exhibit 1.11.

Net income is from the annual income statement, and average total assets is computed by adding the begin- ning and ending amounts for that same period and dividing by 2. To illustrate, Dell reports net income of $3,492 million for fiscal year 2012. At the beginning of fiscal 2012, its total assets are $38,599 million and at the end of fiscal 2012, they total $44,533 million. Dell’s return on assets for fiscal 2012 is:

Return on assets 5 $3,492 million

($38,599 million 1 $44,533 million) y2 5 8.4%

Is an 8.4% return on assets good or bad for Dell? To help answer this question, we compare (benchmark) Dell’s return with its prior performance, the returns of competitors (such as Hewlett-Packard, IBM, and Lenovo), and the returns from alternative investments. Dell’s return for each of the prior five years is in the second column of Exhibit 1.12, which ranges from 4.8% to 11.1%.

EXHIBIT 1.11 Return on Assets Return on assets 5

Net income Average total assets

Dell shows a fairly stable pattern of good returns that reflect its productive use of assets. There is a de- cline in its 2009–2010 returns reflecting the recessionary period. We compare Dell’s return to the normal return for similar manufacturers of computers (third column). Industry averages are available from services such as Dun & Bradstreet’s Industry Norms and Key Ratios and The Risk Management Association An- nual Statement Studies. When compared to the industry, Dell performs slightly above average.

Return on Assets

Fiscal Year Dell Industry

2012 . . . . . . . . . . . . . . . 8.4% 6.9%

2011 . . . . . . . . . . . . . . . 7.3 6.5

2010 . . . . . . . . . . . . . . . 4.8 4.7

2009 . . . . . . . . . . . . . . . 9.2 7.2

2008 . . . . . . . . . . . . . . . 11.1 8.1 2012 2011 2009 2008

0%

2%

4%

6%

8%

10%

12%

Return on Assets: Industry Dell

2010

EXHIBIT 1.12 Dell and Industry Returns

Business Owner You own a small winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 19% return on its assets. The industry return for this manufacturer is 14%. Do you purchase this manufacturer? ■ [Answer—p. 29]

Decision Maker

Each Decision Analysis section ends with a role-playing scenario to show the usefulness of ratios.

The Demonstration Problem is a review of key chapter content. The Planning the Solution offers strategies in solving the problem.

After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month of business.

a. On August 1, Worthy invested $3,000 cash and $15,000 of equipment in Expressions in exchange for its common stock.

b. On August 2, Expressions paid $600 cash for furniture for the shop. c. On August 3, Expressions paid $500 cash to rent space in a strip mall for August. d. On August 4, it purchased $1,200 of equipment on credit for the shop (using a long-term note payable). e. On August 5, Expressions opened for business. Cash received from haircutting services in the first

week and a half of business (ended August 15) was $825. f. On August 15, it provided $100 of haircutting services on account. g. On August 17, it received a $100 check for services previously rendered on account.

DEMONSTRATION PROBLEM

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Chapter 1 Introducing Accounting in Business 25

h. On August 17, it paid $125 cash to an assistant for hours worked during the grand opening. i. Cash received from services provided during the second half of August was $930. j. On August 31, it paid a $400 installment toward principal on the note payable entered into on August 4. k. On August 31, it paid $900 cash in dividends to Worthy (sole shareholder).

Required

1. Arrange the following asset, liability, and equity titles in a table similar to the one in Exhibit 1.9: Cash; Accounts Receivable; Furniture; Store Equipment; Note Payable; Common Stock; Dividends; Reve- nues; and Expenses. Show the effects of each transaction using the accounting equation.

2. Prepare an income statement for August. 3. Prepare a statement of retained earnings for August. 4. Prepare a balance sheet as of August 31. 5. Prepare a statement of cash flows for August. 6. Determine the return on assets ratio for August.

PLANNING THE SOLUTION ● Set up a table like Exhibit 1.9 with the appropriate columns for accounts. ● Analyze each transaction and show its effects as increases or decreases in the appropriate columns. Be

sure the accounting equation remains in balance after each transaction. ● Prepare the income statement, and identify revenues and expenses. List those items on the statement,

compute the difference, and label the result as net income or net loss. ● Use information in the Equity columns to prepare the statement of retained earnings. ● Use information in the last row of the transactions table to prepare the balance sheet. ● Prepare the statement of cash flows; include all events listed in the Cash column of the transactions

table. Classify each cash flow as operating, investing, or financing. ● Calculate return on assets by dividing net income by average assets.

SOLUTION TO DEMONSTRATION PROBLEM 1.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Furni- 1 Store 5 Note 1 Common 2 Dividends 1 Revenues 2 Expenses Receiv- ture Equip- Payable Stock able ment

a. $3,000 $15,000 $18,000

b. 2 600 1 $600 ______ _____ _______ ________ Bal. 2,400 1 1 600 1 15,000 5 18,000

c. 2 500 2 $500 ______ _____ _______ ________ _____ Bal. 1,900 1 1 600 1 15,000 5 18,000 2 500

d. 1 1,200 1$1,200 ______ _____ _______ _________ ________ _____ Bal. 1,900 1 1 600 1 16,200 5 1,200 1 18,000 2 500

e. 1 825 1 $ 825 ______ _____ _______ _________ ________ _______ _____ Bal. 2,725 1 1 600 1 16,200 5 1,200 1 18,000 1 825 2 500

f. 1 $100 1 100 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 2,725 1 100 1 600 1 16,200 5 1,200 1 18,000 1 925 2 500

g. 1 100 2 100 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 2,825 1 0 1 600 1 16,200 5 1,200 1 18,000 1 925 2 500

h. 2 125 2 125 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 2,700 1 0 1 600 1 16,200 5 1,200 1 18,000 1 925 2 625

i. 1 930 1 930 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 3,630 1 0 1 600 1 16,200 5 1,200 1 18,000 1 1,855 2 625

j. 2 400 2 400 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 3,230 1 0 1 600 1 16,200 5 800 1 18,000 1 1,855 2 625

k. 2 900 2 $900 ______ _____ _____ _______ _________ ________ _____ _______ _____ Bal. $ 2,330 1 0 1 $600 1 $ 16,200 5 $ 800 1 $ 18,000 2 $900 1 $1,855 2 $625 ______ _____ _____ _______ _________ ________ _____ _______ _____ ______ _____ _____ _______ _________ ________ _____ _______ _____

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26 Chapter 1 Introducing Accounting in Business

EXPRESSIONS Income Statement

For Month Ended August 31

Revenues Haircutting services revenue . . . . . . . . . $1,855 Expenses Rent expense . . . . . . . . . . . . . . . . . . . . . $500 Wages expense . . . . . . . . . . . . . . . . . . . . 125 Total expenses . . . . . . . . . . . . . . . . . . . . 625 Net Income . . . . . . . . . . . . . . . . . . . . . . . . $1,230

2.

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . $ 2,330 Note payable . . . . . . . . . . . . . . . . . . . $ 800 Furniture . . . . . . . . . . . . . . 600 Equity Store equipment . . . . . . . . 16,200 Common stock . . . . . . . . . . . . . . . . 18,000 Retained earnings. . . . . . . . . . . . . . . . 330 Total equity . . . . . . . . . . . . . . . . . . . . 18,330 Total assets . . . . . . . . . . . . $19,130 Total liabilities and equity . . . . . . . . . $19,130

4.

EXPRESSIONS Statement of Cash Flows

For Month Ended August 31

Cash flows from operating activities Cash received from customers . . . . . . . . . . . . . . . . . . . . . $1,855 Cash paid for rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500) Cash paid for wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (125) Net cash provided by operating activities . . . . . . . . . . . . $1,230 Cash flows from investing activities Cash paid for furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . (600) Cash flows from financing activities Cash investments from stockholders . . . . . . . . . . . . . . . . 3,000 Cash dividends to stockholders . . . . . . . . . . . . . . . . . . . . (900) Partial repayment of (long-term) note payable . . . . . . . . (400) Net cash provided by financing activities . . . . . . . . . . . . . 1,700 Net increase in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330 Cash balance, August 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Cash balance, August 31. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330

5.

3.

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1* . . . . . . . . $ 0 Plus: Net income . . . . . . . . . . . . . . . . 1,230 1,230 Less: Dividend to owner . . . . . . . . . . 900 Retained earnings, August 31 . . . . . . . . . $ 330

* If Expressions had been an existing business from a prior period, the beginning retained earnings balance would equal the retained earnings balance from the end of the prior period.

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Chapter 1 Introducing Accounting in Business 27

6. Return on assets 5 Net income

Average assets 5

$1,230

($18,000* 1 $19,130)y2 5

$1,230

$18,565 5 6.63%

* Uses the initial $18,000 investment as the beginning balance for the start-up period only.

APPENDIX

Return and Risk Analysis This appendix explains return and risk analysis and its role in business and accounting. Net income is often linked to return. Return on assets (ROA) is stated in ratio form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest return such as 4%. If we invest in a savings account or in U.S. Treasury bills, we expect a return of around 2% to 7%. We could also invest in a company’s stock, or even start our own business. How do we decide among these investment options? The answer depends on our trade-off between return and risk. Risk is the uncertainty about the return we will earn. All business investments involve risk, but some in- vestments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The reason that savings accounts pay such a low return is the low risk of not being repaid with interest (the government guarantees most savings accounts from default). If we buy a share of eBay or any other company, we might obtain a large return. However, we have no guarantee of any return; there is even the risk of loss.

The bar graph in Exhibit 1A.1 shows recent re- turns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds provide a low expected return, but they also offer low risk since they are backed by the U.S. govern- ment. High-risk corporate bonds offer a much larger potential return but with much higher risk. The trade-off between return and risk is a nor- mal part of business. Higher risk implies higher, but riskier, expected returns. To help us make better decisions, we use accounting information to assess both return and risk.

1A A3 Explain the relation between return and risk.

EXHIBIT 1A.1 Average Returns for Bonds with Different Risks

Annual Return

U.S. Treasury

Low-risk corporate

Medium-risk corporate

High-risk corporate

0% 2% 4% 6% 8% 10%12%

10.9%

8.3%

5.8%

3.8%

APPENDIX

Business Activities and the Accounting Equation This appendix explains how the accounting equation is derived from business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning involves defining an organization’s ideas, goals, and actions. Most public corporations use the Management Discussion and Analysis section in their annual reports to communicate plans. However, planning is not cast in stone. This adds risk to both setting plans and analyzing them.

Financing Financing activities provide the means organizations use to pay for resources such as land, buildings, and equipment to carry out plans. Organizations are careful in acquiring and managing financ- ing activities because they can determine success or failure. The two sources of financing are owner and nonowner. Owner financing refers to resources contributed by the owner along with any income the owner leaves in the organization. Nonowner (or creditor) financing refers to resources contributed by creditors (lenders). Financial management is the task of planning how to obtain these resources and to set the right mix between owner and creditor financing.

Investing Investing activities are the acquiring and disposing of resources (assets) that an organization uses to acquire and sell its products or services. Assets are funded by an organization’s financing. Organiza- tions differ on the amount and makeup of assets. Some require land and factories to operate. Others need only an office. Determining the amount and type of assets for operations is called asset management. Invested

1B

Point: Management must understand accounting data to set financial goals, make financing and investing decisions, and evaluate operating performance.

C5 Identify and describe the three major activities of organizations.

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28 Chapter 1 Introducing Accounting in Business

amounts are referred to as assets. Financing is made up of creditor and owner financing, which hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This basic equality is called the accounting equation and can be written as: Assets 5 Liabilities 1 Equity.

Operating Operating activities involve using resources to research, develop, purchase, produce, distribute, and market products and services. Sales and revenues are the inflow of assets from selling products and services. Costs and expenses are the outflow of assets to support operating activities. Strategic man- agement is the process of determining the right mix of operating activities for the type of organization, its plans, and its market.

Exhibit 1B.1 summarizes business activities. Planning is part of each activity and gives them meaning and focus. In- vesting (assets) and financing (liabilities and equity) are set opposite each other to stress their balance. Operating activities are below investing and financing activities to show that oper- ating activities are the result of investing and financing.

Point: Investing (assets) and financing (liabilities plus equity) totals are always equal.

P lan

n in

gP la

n n

in g

Planning

In v o

ic e

B il l

In v o

ic e

B il l

Lones

Bes t Bu

y S toc

k

EXHIBIT 1B.1 Activities of Organizations

A Summary organized by learning objectives concludes each chapter.

C1 Explain the purpose and importance of accounting. Account-ing is an information and measurement system that aims to iden- tify, record, and communicate relevant, reliable, and comparable information about business activities. It helps assess opportunities, products, investments, and social and community responsibilities.

C2 Identify users and uses of, and opportunities in, accounting. Users of accounting are both internal and external. Some users and uses of accounting include (a) managers in controlling, monitor- ing, and planning; (b) lenders for measuring the risk and return of loans; (c) shareholders for assessing the return and risk of stock; (d) directors for overseeing management; and (e) employees for judging employment opportunities. Opportunities in accounting include finan- cial, managerial, and tax accounting. They also include accounting- related fields such as lending, consulting, managing, and planning.

C3 Explain why ethics are crucial to accounting. The goal of accounting is to provide useful information for decision mak- ing. For information to be useful, it must be trusted. This demands ethical behavior in accounting.

C4 Explain generally accepted accounting principles and de-fine and apply several accounting principles. Generally ac- cepted accounting principles are a common set of standards applied by accountants. Accounting principles aid in producing relevant, reli- able, and comparable information. Four principles underlying finan- cial statements were introduced: cost, revenue recognition, matching, and full disclosure. Financial statements also reflect four assump- tions: going-concern, monetary unit, time period, and business entity.

C5B Identify and describe the three major activities of organizations. Organizations carry out three major activities: financing, investing, and operating. Financing is the means used to pay for resources such as land, buildings, and machines. Investing

Summary refers to the buying and selling of resources used in acquiring and selling products and services. Operating activities are those neces- sary for carrying out the organization’s plans.

A1 Define and interpret the accounting equation and each of its components. The accounting equation is: Assets 5 Liabilities 1 Equity. Assets are resources owned by a company. Liabilities are credi- tors’ claims on assets. Equity is the owner’s claim on assets (the resid- ual ). The expanded accounting equation is: Assets 5 Liabilities 1 [Common Stock 2 Dividends 1 Revenues 2 Expenses].

A2 Compute and interpret return on assets. Return on assets is computed as net income divided by average assets. For exam- ple, if we have an average balance of $100 in a savings account and it earns $5 interest for the year, the return on assets is $5/$100, or 5%.

A3A Explain the relation between return and risk. Return refers to income, and risk is the uncertainty about the return we hope to make. All investments involve risk. The lower the risk of an investment, the lower is its expected return. Higher risk implies higher, but riskier, expected return.

P1 Analyze business transactions using the accounting equa-tion. A transaction is an exchange of economic consideration between two parties. Examples include exchanges of products, ser- vices, money, and rights to collect money. Transactions always have at least two effects on one or more components of the accounting equation. This equation is always in balance.

P2 Identify and prepare basic financial statements and explain how they interrelate. Four financial statements report on an organization’s activities: balance sheet, income statement, statement of retained earnings, and statement of cash flows.

Entrepreneur (p. 13) You should probably form the business as a corporation if potential lawsuits are of prime concern. The corporate form of organization protects your personal property from lawsuits

directed at the business and places only the corporation’s resources at risk. A downside of the corporate form is double taxation: The corpo- ration must pay taxes on its income, and you normally must pay taxes

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 1 Introducing Accounting in Business 29

on any money distributed to you from the business (even though the corporation already paid taxes on this money). You should also exam- ine the ethical and socially responsible aspects of starting a business in which you anticipate injuries to others. Formation as an LLC or S corp. should also be explored.

Business Owner (p. 24) The 19% return on assets for the manu- facturer exceeds the 14% industry return (and many others). This is a

positive factor for a potential purchase. Also, the purchase of this manufacturer is an opportunity to spread your risk over two busi- nesses as opposed to one. Still, you should hesitate to purchase a business whose return of 19% is lower than your current resort’s return of 21%. You are probably better off directing efforts to in- crease investment in your resort, assuming you can continue to earn a 21% return.

1. Accounting is an information and measurement system that identifies, records, and communicates relevant information to help people make better decisions.

2. Recordkeeping, also called bookkeeping, is the recording of financial transactions and events, either manually or electro n- ically. Recordkeeping is essential to data reliability; but accounting is this and much more. Accounting includes identi- fying, measuring, recording, reporting, and analyzing business events and transactions.

3. Technology offers increased accuracy, speed, efficiency, and convenience in accounting.

4. External users of accounting include lenders, shareholders, di- rectors, customers, suppliers, regulators, lawyers, brokers, and the press. Internal users of accounting include managers, offi- cers, and other internal decision makers involved with strategic and operating decisions.

5. Internal users (managers) include those from research and de- velopment, purchasing, human resources, production, distribu- tion, marketing, and servicing.

6. Internal controls are procedures set up to protect assets, ensure reliable accounting reports, promote efficiency, and encourage adherence to company policies. Internal controls are crucial for relevant and reliable information.

7. Ethical guidelines are threefold: (1) identify ethical concerns using personal ethics, (2) analyze options considering all good and bad consequences, and (3) make ethical decisions after weighing all consequences.

8. Ethics and social responsibility yield good behavior, and they often result in higher income and a better working environment.

9. For accounting to provide useful information for decisions, it must be trusted. Trust requires ethics in accounting.

10. Two major participants in setting rules include the SEC and the FASB. (Note: Accounting rules reflect society’s needs, not those of accountants or any other single constituency.)

11. Most U.S. companies are not directly affected by international accounting standards. International standards are put forth as preferred accounting practices. However, stock exchanges and other parties are increasing the pressure to narrow differences in worldwide accounting practices. International accounting stan- dards are playing an important role in that process.

12. The objectivity concept and cost principle are related in that most users consider information based on cost as objective. Information prepared using both is considered highly reliable and often relevant.

13. Users desire information about the performance of a specific entity. If information is mixed between two or more entities, its usefulness decreases.

14. The revenue recognition principle gives preparers guidelines on when to recognize (record) revenue. This is important; for ex- ample, if revenue is recognized too early, the statements report revenue sooner than it should and the business looks more prof- itable than it is. The reverse is also true.

15. The three basic forms of business organization are sole propri- etorships, partnerships, and corporations.

16. Owners of corporations are called shareholders (or stockhold- ers). Corporate ownership is divided into units called shares (or stock). The most basic of corporate shares is common stock (or capital stock).

17. The accounting equation is: Assets 5 Liabilities 1 Equity. This equation is always in balance, both before and after each transaction.

18. A transaction that changes the makeup of assets would not affect liability and equity accounts. FastForward’s transactions 2 and 3 are examples. Each exchanges one asset for another.

19. Earning revenue by performing services, as in FastForward’s trans- action 5, increases equity (and assets). Incurring expenses while servicing clients, such as in transactions 6 and 7, decreases equity (and assets). Other examples include owner investments (stock is- suances) that increase equity and dividends that decrease equity.

20. Paying a liability with an asset reduces both asset and liability totals. One example is FastForward’s transaction 10 that reduces a payable by paying cash.

21. An income statement reports a company’s revenues and ex- penses along with the resulting net income or loss. A statement of retained earnings shows changes in retained earnings, includ- ing that from net income or loss. Both statements report trans- actions occurring over a period of time.

22. The balance sheet describes a company’s financial position (as- sets, liabilities, and equity) at a point in time. The retained earn- ings amount in the balance sheet is obtained from the statement of retained earnings.

23. Cash flows from operating activities report cash receipts and payments from the primary business the company engages in. Cash flows from investing activities involve cash transactions from buying and selling long-term assets. Cash flows from fi- nancing activities include long-term cash borrowings and re- payments to lenders and the cash investments from, and dividends to, the stockholders.

Guidance Answers to Quick Checks

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30 Chapter 1 Introducing Accounting in Business

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 47 mhhe.com/wildFINMAN5e

1. A building is offered for sale at $500,000 but is currently as- sessed at $400,000. The purchaser of the building believes the building is worth $475,000, but ultimately purchases the build- ing for $450,000. The purchaser records the building at:

a. $50,000 b. $400,000 c. $450,000 d. $475,000 e. $500,000 2. On December 30, 2012, KPMG signs a $150,000 contract to

provide accounting services to one of its clients in 2013. KPMG has a December 31 year-end. Which accounting principle or assumption requires KPMG to record the accounting services revenue from this client in 2013 and not 2012?

a. Business entity assumption b. Revenue recognition principle c. Monetary unit assumption d. Cost principle e. Going-concern assumption 3. If the assets of a company increase by $100,000 during the

year and its liabilities increase by $35,000 during the same

year, then the change in equity of the company during the year must have been:

a. An increase of $135,000. b. A decrease of $135,000. c. A decrease of $65,000. d. An increase of $65,000. e. An increase of $100,000. 4. Brunswick borrows $50,000 cash from Third National Bank.

How does this transaction affect the accounting equation for Brunswick?

a. Assets increase by $50,000; liabilities increase by $50,000; no effect on equity.

b. Assets increase by $50,000; no effect on liabilities; equity increases by $50,000.

c. Assets increase by $50,000; liabilities decrease by $50,000; no effect on equity.

d. No effect on assets; liabilities increase by $50,000; equity increases by $50,000.

e. No effect on assets; liabilities increase by $50,000; equity decreases by $50,000.

Accounting (p. 4)

Accounting equation (p. 15)

Assets (p. 15)

Audit (p. 13)

Auditors (p. 13)

Balance sheet (p. 20)

Bookkeeping (p. 4)

Business entity assumption (p. 12)

Common stock (p. 13)

Conceptual framework (p. 10)

Contributed capital (p. 15)

Corporation (p. 12)

Cost-benefit constraint (p. 13)

Cost principle (p. 11)

Dividends (p. 15)

Dodd-Frank Wall Street Reform and Consumer Protection Act (p. 14)

Equity (p. 15)

Ethics (p. 7)

Events (p. 16)

Expanded accounting equation (p. 15)

Expense recognition principle (p. 11)

Expenses (p. 15)

External transactions (p. 16)

External users (p. 5)

Financial accounting (p. 5)

Financial Accounting Standards Board (FASB) (p. 9)

Full disclosure principle (p. 11)

Generally accepted accounting principles (GAAP) (p. 9)

Going-concern assumption (p. 12)

Income (p. 15)

Income statement (p. 20)

Internal transactions (p. 16)

Internal users (p. 6)

International Accounting Standards Board (IASB) (p. 9)

International Financial Reporting Standards (IFRS) (p. 9)

Liabilities (p. 15)

Managerial accounting (p. 6)

Matching principle (p. 11)

Materiality constraint (p. 13)

Measurement principle (p. 11)

Monetary unit assumption (p. 12)

Net income (p. 15)

Net loss (p. 15)

Partnership (p. 12)

Proprietorship (p. 12)

Recordkeeping (p. 4)

Retained earnings (p. 15)

Return (p. 27)

Return on assets (p. 24)

Revenue recognition principle (p. 11)

Revenues (p. 15)

Risk (p. 27)

Sarbanes–Oxley Act (p. 13)

Securities and Exchange Commission (SEC) (p. 9)

Shareholders (p. 13)

Shares (p. 13)

Sole proprietorship (p. 12)

Statement of cash flows (p. 20)

Statement of retained earnings (p. 20)

Stock (p. 13)

Stockholders (p. 13)

Time period assumption (p. 12)

Key Terms

A list of key terms with page references concludes each chapter (a complete glossary is at the end of the book).

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Chapter 1 Introducing Accounting in Business 31

5. Geek Squad performs services for a customer and bills the customer for $500. How would Geek Squad record this transaction?

a. Accounts receivable increase by $500; revenues increase by $500.

b. Cash increases by $500; revenues increase by $500.

c. Accounts receivable increase by $500; revenues decrease by $500.

d. Accounts receivable increase by $500; accounts payable increase by $500.

e. Accounts payable increase by $500; revenues increase by $500.

1. What is the purpose of accounting in society? 2. Technology is increasingly used to process accounting data.

Why then must we study and understand accounting? 3. Identify four kinds of external users and describe how they

use accounting information. 4. What are at least three questions business owners and

managers might be able to answer by looking at accounting information?

5. Identify three actual businesses that offer services and three actual businesses that offer products.

6. Describe the internal role of accounting for organizations. 7. Identify three types of services typically offered by accounting

professionals. 8. What type of accounting information might be useful to

the marketing managers of a business? 9. Why is accounting described as a service activity? 10. What are some accounting-related professions? 11. How do ethics rules affect auditors’ choice of clients? 12. What work do tax accounting professionals perform in addi-

tion to preparing tax returns? 13. What does the concept of objectivity imply for information

reported in financial statements? Why? 14. A business reports its own office stationery on the balance

sheet at its $400 cost, although it cannot be sold for more than $10 as scrap paper. Which accounting principle and/or assump- tion justifies this treatment?

15. Why is the revenue recognition principle needed? What does it demand?

16. Describe the three basic forms of business organization and their key attributes.

17. Define (a) assets, (b) liabilities, (c) equity, and (d ) net assets.

Discussion Questions

A(B) Superscript letter A (B) denotes assignments based on Appendix 1A (1B).

Icon denotes assignments that involve decision making.

18. What events or transactions change equity? 19. Identify the two main categories of accounting principles. 20. What do accountants mean by the term revenue? 21. Define net income and explain its computation. 22. Identify the four basic financial statements of a business. 23. What information is reported in an income statement? 24. Give two examples of expenses a business might incur. 25. What is the purpose of the statement of retained earnings? 26. What information is reported in a balance sheet? 27. The statement of cash flows reports on what major activities? 28. Define and explain return on assets. 29.A Define return and risk. Discuss the trade-off between

them. 30.B Describe the three major business activities in organizations. 31.B Explain why investing (assets) and financing (liabilities and equity) totals are always equal. 32. Refer to the financial statements of Polaris in

Appendix A near the end of the book. To what level of significance are dollar amounts rounded? What time period does its income statement cover?

33. Identify the dollar amounts of Arctic Cat’s 2011 assets, liabilities, and equity as reported in its statements in Appendix A near the end of the book.

34. Refer to KTM’s 2011 balance sheet in Appendix A near the end of the book. Confirm that its total as- sets equal its total liabilities plus total equity.

35. Access the SEC EDGAR database (www.sec. gov) and retrieve Polaris’s 2011 10-K (filed Febru- ary 27, 2012). Identify its auditor. What responsibility does its independent auditor claim regarding Polaris’s financial statements?

Polaris

Polaris

Arctic Cat

KTM

Connect reproduces assignments online, in static or algorithmic mode, which allows instructors to monitor, promote, and assess student learning. It can be used for practice, homework, or exams.

Reading and interpreting accounting reports requires some knowledge of accounting terminology. (a)  Identify the meaning of these accounting-related acronyms: GAAP, SEC, FASB, IASB and IFRS. (b) Briefly explain the importance of the knowledge base or organization that is referred to for each of the accounting-related acronyms.

QUICK STUDY

QS 1-1 Identifying accounting terms C1

Quick Study exercises give readers a brief test of key elements.

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32 Chapter 1 Introducing Accounting in Business

QS 1-2 Identifying accounting users

C2

Identify the following users as either external users (E) or internal users (I). a. Customers d. Business press g. Shareholders j. FBI and IRS b. Suppliers e. Managers h. Lenders k. Consumer group c. Brokers f. District attorney i. Controllers l. Sales staff

QS 1-4 Accounting opportunities C2

There are many job opportunities for those with accounting knowledge. Identify at least three main areas of opportunities for accounting professionals. For each area, identify at least three job possibilities linked to accounting.

QS 1-5 Identifying ethical concerns C3

Accounting professionals must sometimes choose between two or more acceptable methods of accounting for business transactions and events. Explain why these situations can involve difficult matters of ethical concern.This icon highlights

assignments that enhance decision-making skills.

QS 1-6 Identifying accounting principles

C4

Identify which accounting principle or assumption best describes each of the following practices: a. In December 2012, Chavez Landscaping received a customer’s order and cash prepayment to install

sod at a new house that would not be ready for installation until March 2013. Chavez should record the revenue from the customer order in March 2013, not in December 2012.

b. If $51,000 cash is paid to buy land, the land is reported on the buyer’s balance sheet at $51,000. c. Jo Keene owns both Sailing Passions and Dockside Supplies. In preparing financial statements for

Dockside Supplies, Keene makes sure that the expense transactions of Sailing Passions are kept sepa- rate from Dockside’s transactions and financial statements.

QS 1-7 Applying the accounting equation A1

a. Total assets of Charter Company equal $700,000 and its equity is $420,000. What is the amount of its liabilities?

b. Total assets of Martin Marine equal $500,000 and its liabilities and equity amounts are equal to each other. What is the amount of its liabilities? What is the amount of its equity?

QS 1-9 Identifying transactions and events P1

Accounting provides information about an organization’s business transactions and events that both affect the accounting equation and can be reliably measured. Identify at least two examples of both (a) business transactions and (b) business events that meet these requirements.

QS 1-10 Identifying and computing assets, liabilities, and equity P1

Use Polaris’s December 31, 2011, financial statements, in Appendix A near the end of the book, to answer the following: a. Identify the dollar amounts of Polaris’ 2011 (1) assets, (2) liabilities, and (3) equity. b. Using Polaris’ amounts from part a, verify that Assets 5 Liabilities 1 Equity.

QS 1-8 Applying the accounting equation

A1

Use the accounting equation to compute the missing financial statement amounts (a), (b), and (c).

Company

3

1 2

85,000

$ 75,000 (b)

20,000

$ (a) 25,000

(c)

$ 40,000 70,000

Assets 5 1Liabilities Equity

QS 1-11 Identifying items with financial statements

P2

Indicate in which financial statement each item would most likely appear: income statement (I), balance sheet (B), statement of retained earnings (E), or statement of cash flows (CF). a. Assets d. Equipment g. Net decrease (or increase) in cash b. Cash from operating activities e. Expenses h. Revenues c. Dividends f. Liabilities i. Total liabilities and equity

QS 1-3 Explaining internal control

C1

An important responsibility of many accounting professionals is to design and implement internal control procedures for organizations. Explain the purpose of internal control procedures. Provide two examples of internal controls applied by companies.

Polaris

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Chapter 1 Introducing Accounting in Business 33

In a recent year’s financial statements, Home Depot reported the following results. Compute and interpret Home Depot’s return on assets (assume competitors average a 8.0% return on assets).

Sales . . . . . . . . . . . . . . . . . . . . . . $67,997 million

Net income . . . . . . . . . . . . . . . . 3,338 million

Average total assets . . . . . . . . . . 40,501 million

QS 1-12 Computing and interpreting return on assets

A2

Part A. Identify the following users of accounting information as either an internal (I) or an exter- nal (E) user. _______ 1. Research and development director _______ 5. Distribution managers _______ 2. Human resources director _______ 6. Creditors _______ 3. Nonexecutive employee _______ 7. Production supervisors _______ 4. Shareholders _______ 8. Purchasing manager

Part B. Identify the following questions as most likely to be asked by an internal (I) or an external (E) user of accounting information. _______ 1. What are reasonable payroll benefits

and wages? _______ 2. Should we make a five-year loan

to that business? _______ 3. What are the costs of our product’s

ingredients? _______ 4. Do income levels justify the current

stock price?

_______ 5. Should we spend further research on our product?

_______ 6. Which firm reports the highest sales and income?

_______ 7. What are the costs of our service to customers?

Exercise 1-3 Identifying accounting users and uses

C2

_______ 6. Establishing revenues generated from a product.

_______ 7. Determining employee tasks behind a service.

Exercise 1-2 Classifying activities reflected in the accounting system

C1

Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities. Classify the following activities as part of the identifying (I), recording (R), or communicating (C) aspects of accounting. _______ 1. Analyzing and interpreting reports.

_______ 2. Presenting financial information. _______ 3. Maintaining a log of service costs. _______ 4. Measuring the costs of a product. _______ 5. Preparing financial statements.

Answer each of the following questions related to international accounting standards. a. The International Accounting Standards Board (IASB) issues preferred accounting practices that are

referred to as what? b. The FASB and IASB are working on a convergence process for what purpose? c. The SEC has proposed a roadmap for use of IFRS by U.S. companies. What is the proposed time period

(as suggested by the SEC) for the FASB to endorse IFRS (with necessary exceptions) as U.S. GAAP?

QS 1-13 International accounting standards C4

This icon highlights assignments that focus on IFRS-related content.

EXERCISES

Exercise 1-1 Describing accounting responsibilities

C2

Many accounting professionals work in one of the following three areas: A. Managerial accounting B. Financial accounting C. Tax accounting Identify the area of accounting that is most involved in each of the following responsibilities:

1. Internal auditing. 5. Investigating violations of tax laws. 2. External auditing. 6. Planning transactions to minimize taxes. 3. Cost accounting. 7. Preparing external financial statements. 4. Budgeting. 8. Reviewing reports for SEC compliance.

Assume the following role and describe a situation in which ethical considerations play an important part in guiding your decisions and actions: a. You are a student in an introductory accounting course. b. You are a manager with responsibility for several employees. c. You are an accounting professional preparing tax returns for clients. d. You are an accounting professional with audit clients that are competitors in business.

Exercise 1-4 Identifying ethical concerns

C3

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34 Chapter 1 Introducing Accounting in Business

Exercise 1-6 Learning the language of business

C1 – C3

Match each of the numbered descriptions with the term or phrase it best reflects. Indicate your answer by writing the letter for the term or phrase in the blank provided. A. Audit C. Ethics E. SEC G. Net income B. GAAP D. Tax accounting F. Public accountants H. IASB

1. Principles that determine whether an action is right or wrong. 2. Accounting professionals who provide services to many clients. 3. An accounting area that includes planning future transactions to minimize taxes paid. 4. An examination of an organization’s accounting system and records that adds credibility to

financial statements. 5. Amount a business earns after paying all expenses and costs associated with its sales and revenues.

Exercise 1-5 Identifying accounting principles and assumptions

C4

Match each of the numbered descriptions with the principle or assumption it best reflects. Enter the letter for the appropriate principle or assumption in the blank space next to each description. A. General accounting principle E. Specific accounting principle B. Cost principle F. Matching principle C. Business entity assumption G. Going-concern assumption D. Revenue recognition principle H. Full disclosure principle

1. Usually created by a pronouncement from an authoritative body. 2. Financial statements reflect the assumption that the business continues operating. 3. Derived from long-used and generally accepted accounting practices. 4. Every business is accounted for separately from its owner or owners. 5. Revenue is recorded only when the earnings process is complete. 6. Information is based on actual costs incurred in transactions. 7. A company records the expenses incurred to generate the revenues reported. 8. A company reports details behind financial statements that would impact users’ decisions.

Exercise 1-7 Distinguishing business organizations

C4

The following describe several different business organizations. Determine whether the description refers to a sole proprietorship, partnership, or corporation. a. Ownership of Zander Company is divided into 1,000 shares of stock. b. Wallingford is owned by Trent Malone, who is personally liable for the company’s debts. c. Micah Douglas and Nathan Logan own Financial Services, a financial services provider. Neither

Douglas nor Logan has personal responsibility for the debts of Financial Services. d. Riley and Kay own Speedy Packages, a courier service. Both are personally liable for the debts of the

business. e. IBC Services does not have separate legal existence apart from the one person who owns it. f. Physio Products does not pay income taxes and has one owner. g. AJ pays its own income taxes and has two owners.

Exercise 1-8 Using the accounting equation

A1 P1

Answer the following questions. (Hint: Use the accounting equation.) a. Office Store has assets equal to $123,000 and liabilities equal to $47,000 at year-end. What is the total

equity for Office Store at year-end? b. At the beginning of the year, Addison Company’s assets are $300,000 and its equity is $100,000. During

the year, assets increase $80,000 and liabilities increase $50,000. What is the equity at the end of the year? c. At the beginning of the year, Quaker Company’s liabilities equal $70,000. During the year, assets in-

crease by $60,000, and at year-end assets equal $190,000. Liabilities decrease $5,000 during the year. What are the beginning and ending amounts of equity?

Check (c) Beg. equity, $60,000

Exercise 1-9 Using the accounting equation

A1

Determine the missing amount from each of the separate situations a, b, and c below.

Assets (a) $ ? (b) 100,000 (c) 154,000

$ 20,000 34,000

?

$ 45,000 ? 40,000

5 1Liabilities Equity

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Chapter 1 Introducing Accounting in Business 35

Provide an example of a transaction that creates the described effects for the separate cases a through g. a. Decreases an asset and decreases equity. e. Increases an asset and decreases an asset. b. Increases an asset and increases a liability. f. Increases a liability and decreases equity. c. Decreases a liability and increases a liability. g. Increases an asset and increases equity. d. Decreases an asset and decreases a liability.

Exercise 1-10 Identifying effects of transactions on the accounting equation

P1

Check Net income, $6,000

Exercise 1-11 Identifying effects of transactions using the accounting equation

P1

Lena Holden began a professional practice on June 1 and plans to prepare financial statements at the end of each month. During June, Holden (the owner) completed these transactions: a. Owner invested $60,000 cash in the company along with equipment that had a $15,000 market value

in exchange for its common stock. b. The company paid $1,500 cash for rent of office space for the month. c. The company purchased $10,000 of additional equipment on credit (payment due within 30 days). d. The company completed work for a client and immediately collected the $2,500 cash earned. e. The company completed work for a client and sent a bill for $8,000 to be received within 30 days. f. The company purchased additional equipment for $6,000 cash. g. The company paid an assistant $3,000 cash as wages for the month. h. The company collected $5,000 cash as a partial payment for the amount owed by the client in trans-

action e. i. The company paid $10,000 cash to settle the liability created in transaction c. j. The company paid $1,000 cash in dividends to the owner (sole shareholder).

Required

Create a table like the one in Exhibit 1.9, using the following headings for columns: Cash; Accounts Re- ceivable; Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Then use additions and subtractions to show the effects of the transactions on individual items of the accounting equation. Show new balances after each transaction.

Assets 5 Liabilities 1 Equity

Accounts Office Office Trans- Receiv- Sup- Furni- Accounts Common action Cash 1 able 1 plies 1 ture 5 Payable 1 Stock 1 Revenues

a. $40,000 1 $ 0 1 $ 0 1 $ 0 5 $ 0 1 $40,000 1 $ 0

b. 38,000 1 0 1 3,000 1 0 5 1,000 1 40,000 1 0

c. 30,000 1 0 1 3,000 1 8,000 5 1,000 1 40,000 1 0

d. 30,000 1 6,000 1 3,000 1 8,000 5 1,000 1 40,000 1 6,000

e. 31,000 1 6,000 1 3,000 1 8,000 5 1,000 1 40,000 1 7,000

Exercise 1-12 Analysis using the accounting equation

P1

Zen began a new consulting firm on January 5. The accounting equation showed the following balances after each of the company’s first five transactions. Analyze the accounting equation for each transaction and describe each of the five transactions with their amounts.

Exercise 1-13 Identifying effects of transactions on accounting equation

P1

The following table shows the effects of five transactions (a through e) on the assets, liabilities, and equity of Trista’s Boutique. Write short descriptions of the probable nature of each transaction.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Office 1 Land 5 Accounts 1 Common 1 Revenues Receivable Supplies Payable Stock

$ 21,000 1 $ 0 1 $3,000 1 $19,000 5 $ 0 1 $43,000 1 $ 0 a. 2 4,000 1 4,000 b. 1 1,000 11,000 c. 1 1,900 1 1,900 d. 2 1,000 21,000 e. 1 1,900 2 1,900 ________ _______ _______ ________ _________ _______ _______ $ 17,900 1 $ 0 1 $4,000 1 $23,000 5 $ 0 1 $43,000 1 $1,900 ________ _______ _______ ________ _________ _______ _______ ________ _______ _______ ________ _________ _______ _______

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36 Chapter 1 Introducing Accounting in Business

Exercise 1-15 Preparing a statement of retained earnings P2

Use the information in Exercise 1-14 to prepare an October statement of retained earnings for Real Answers.

Check Net income, $2,110

Exercise 1-14 Preparing an income statement

P2

On October 1, Keisha King organized Real Answers, a new consulting firm; on October 3, the owner con- tributed $84,000 cash. On October 31, the com pany’s records show the following items and amounts. Use this information to prepare an October income statement for the business.

Cash . . . . . . . . . . . . . . . . . . . . . $11,360 Cash dividends . . . . . . . . . . . . . . . . $ 2,000 Accounts receivable . . . . . . . . 14,000 Consulting fees earned . . . . . . . . . . 14,000 Office supplies . . . . . . . . . . . . . 3,250 Rent expense . . . . . . . . . . . . . . . . . 3,550 Land . . . . . . . . . . . . . . . . . . . . . 46,000 Salaries expense . . . . . . . . . . . . . . . 7,000 Office equipment . . . . . . . . . . 18,000 Telephone expense . . . . . . . . . . . . . 760 Accounts payable . . . . . . . . . . . 8,500 Miscellaneous expenses . . . . . . . . . 580 Common stock . . . . . . . . . . . . 84,000

Exercise 1-16 Preparing a balance sheet P2

Use the information in Exercise 1-14 (if completed, you can also use your solution to Exercise 1-15) to prepare an October 31 balance sheet for Real Answers.

Exercise 1-19 Identifying sections of the statement of cash flows

P2

Indicate the section where each of the following would appear on the statement of cash flows. O. Cash flows from operating activity I. Cash flows from investing activity F. Cash flows from financing activity

1. Cash paid for advertising 5. Cash paid for rent 2. Cash paid for wages 6. Cash paid on an account payable 3. Cash paid for dividends 7. Cash received from stock issued 4. Cash purchase of equipment 8. Cash received from clients

Exercise 1-18 Analysis of return on assets

A2

Swiss Group reports net income of $40,000 for 2013. At the beginning of 2013, Swiss Group had $200,000 in assets. By the end of 2013, assets had grown to $300,000. What is Swiss Group’s 2013 return on assets? How would you assess its performance if competitors average a 10% return on assets?

Exercise 1-17 Preparing a statement of cash flows

P2

Use the information in Exercise 1-14 to prepare an October 31 statement of cash flows for Real Answers. Also assume the following: a. The owner’s initial investment consists of $38,000 cash and $46,000 in land in exchange for its com-

mon stock. b. The company’s $18,000 equipment purchase is paid in cash. c. The accounts payable balance of $8,500 consists of the $3,250 office supplies purchase and $5,250 in

employee salaries yet to be paid. d. The company’s rent, telephone, and miscellaneous expenses are paid in cash. e. No cash has been collected on the $14,000 consulting fees earned.Check Net increase in cash, $11,360

Exercise 1-20B

Identifying business activities

C5

Match each transaction or event to one of the following activities of an organization: financing activities (F), investing activities (I), or operating activities (O). a. An owner contributes resources to the business in exchange for its common stock. b. An organization sells some of its land. c. An organization purchases equipment. d. An organization advertises a new product. e. The organization borrows money from a bank.

Exercise 1-21 Preparing an income statement for a global company

P2

Nintendo Company reports the following income statement accounts for the year ended March 31, 2011. (Japanese yen in millions.)

Use this information to prepare Nintendo’s income statement for the year ended March 31, 2011.

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¥1,014,345 Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 626,379 Selling, general and administrative expenses . . . . . . . . . 216,889 Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,456

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Chapter 1 Introducing Accounting in Business 37

Check (1b) $41,500

(2c) $1,600

(3) $55,875

Required

1. Answer the following questions about Company A: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is the amount of liabilities on December 31, 2013? 2. Answer the following questions about Company B: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is net income for year 2013? 3. Calculate the amount of assets for Company C on December 31, 2013. 4. Calculate the amount of stock issuances for Company D during year 2013. 5. Calculate the amount of liabilities for Company E on December 31, 2012.

The following financial statement information is from five separate companies:

Company Company Company Company Company A B C D E

December 31, 2012

Assets . . . . . . . . . . . . . . . . . . . . . . . . . $55,000 $34,000 $24,000 $60,000 $119,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . 24,500 21,500 9,000 40,000 ?

December 31, 2013

Assets . . . . . . . . . . . . . . . . . . . . . . . . . 58,000 40,000 ? 85,000 113,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . ? 26,500 29,000 24,000 70,000

During year 2013

Stock issuances . . . . . . . . . . . . . . . . . 6,000 1,400 9,750 ? 6,500

Net income (loss) . . . . . . . . . . . . . . . 8,500 ? 8,000 14,000 20,000

Cash dividends . . . . . . . . . . . . . . . . . 3,500 2,000 5,875 0 11,000

PROBLEM SET A

Problem 1-1A Computing missing information using accounting knowledge

A1 P1

Problem Set B located at the end of Problem Set A is provided for each problem to reinforce the learning process.

Identify how each of the following separate transactions affects financial statements. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from financing activities, and cash flows from investing activities. For increases, place a “1” in the column or columns. For decreases, place a “2” in the column or columns. If both an increase and a decrease occur, place a “1y2” in the column or columns. The first transaction is completed as an example.

Problem 1-2A Identifying effects of transactions on financial statements

A1 P1

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Financing Investing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests cash for its stock 1 1 1

2 Receives cash for services provided

3 Pays cash for employee wages

4 Incurs legal costs on credit

5 Borrows cash by signing long-term note payable

6 Pays cash dividend

7 Buys land by signing note payable

8 Provides services on credit

9 Buys office equipment for cash

10 Collects cash on receivable from (8)

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38 Chapter 1 Introducing Accounting in Business

Problem 1-3A Preparing an income statement

P2

The following is selected financial information for Elko Energy Company for the year ended December 31, 2013: revenues, $55,000; expenses, $40,000; net income, $15,000.

Required

Prepare the 2013 calendar-year income statement for Elko Energy Company.

Problem 1-4A Preparing a balance sheet

P2

The following is selected financial information for Amity Company as of December 31, 2013: liabilities, $44,000; equity, $46,000; assets, $90,000.

Required

Prepare the balance sheet for Amity Company as of December 31, 2013.

Problem 1-5A Preparing a statement of cash flows

P2

Following is selected financial information of ABM Company for the year ended December 31, 2013.

Cash used by investing activities . . . . . . . . . $(2,000)

Net increase in cash . . . . . . . . . . . . . . . . . . 1,200

Cash used by financing activities . . . . . . . . . (2,800)

Cash from operating activities . . . . . . . . . . 6,000

Cash, December 31, 2012 . . . . . . . . . . . . . . 2,300

Required

Prepare the 2013 statement of cash flows for ABM Company. Check Cash balance, Dec. 31, 2013, $3,500

Problem 1-6A Preparing a statement of retained earnings

P2

Following is selected financial information for Kasio Co. for the year ended December 31, 2013.

Retained Earnings, Dec. 31, 2013 . . . . . . . . $14,000 Cash dividends . . . . . . . . . . . . . . . . . . . . . $1,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Retained Earnings, Dec. 31, 2012 . . . . . . . . 7,000

Required

Prepare the 2013 statement of retained earnings for Kasio.

Holden Graham started The Graham Co., a new business that began operations on May 1. The Graham Co. completed the following transactions during its first month of operations.

May 1 H. Graham invested $40,000 cash in the company in exchange for its common stock. 1 The company rented a furnished office and paid $2,200 cash for May’s rent. 3 The company purchased $1,890 of office equipment on credit. 5 The company paid $750 cash for this month’s cleaning services. 8 The company provided consulting services for a client and immediately collected $5,400 cash. 12 The company provided $2,500 of consulting services for a client on credit. 15 The company paid $750 cash for an assistant’s salary for the first half of this month. 20 The company received $2,500 cash payment for the services provided on May 12. 22 The company provided $3,200 of consulting services on credit. 25 The company received $3,200 cash payment for the services provided on May 22. 26 The company paid $1,890 cash for the office equipment purchased on May 3. 27 The company purchased $80 of advertising in this month’s (May) local paper on credit; cash

payment is due June 1. 28 The company paid $750 cash for an assistant’s salary for the second half of this month. 30 The company paid $300 cash for this month’s telephone bill. 30 The company paid $280 cash for this month’s utilities. 31 The company paid $1,400 cash in dividends to the owner (sole shareholder).

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Office Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Show effects of the transactions on the accounts of the accounting equation by recording increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance.

3. Prepare an income statement for May, a statement of retained earnings for May, a May 31 balance sheet, and a statement of cash flows for May.

Problem 1-7A Analyzing transactions and preparing financial statements

C4 P1 P2

mhhe.com/wildFINMAN5e

Check (2) Ending balances: Cash, $42,780; Expenses, $5,110

(3) Net income, $5,990; Total assets, $44,670

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Chapter 1 Introducing Accounting in Business 39

Helga Ander started a new business and completed these transactions during December.

Dec. 1 Helga Ander transferred $65,000 cash from a personal savings account to a checking account in the name of Ander Electric in exchange for its common stock.

2 The company rented office space and paid $1,000 cash for the December rent. 3 The company purchased $13,000 of electrical equipment by paying $4,800 cash and agreeing to

pay the $8,200 balance in 30 days. 5 The company purchased office supplies by paying $800 cash. 6 The company completed electrical work and immediately collected $1,200 cash for these services. 8 The company purchased $2,530 of office equipment on credit. 15 The company completed electrical work on credit in the amount of $5,000. 18 The company purchased $350 of office supplies on credit. 20 The company paid $2,530 cash for the office equipment purchased on December 8. 24 The company billed a client $900 for electrical work completed; the balance is due in 30 days. 28 The company received $5,000 cash for the work completed on December 15. 29 The company paid the assistant’s salary of $1,400 cash for this month. 30 The company paid $540 cash for this month’s utility bill. 31 The company paid $950 cash in dividends to the owner (sole shareholder).

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Re- ceivable; Office Supplies; Office Equipment; Electrical Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions to show the effects of each transaction on the accounts in the account- ing equation. Show new balances after each transaction.

3. Use the increases and decreases in the columns of the table from part 2 to prepare an income state- ment, a statement of retained earnings, and a statement of cash flows—each of these for the current month. Also prepare a balance sheet as of the end of the month.

Analysis Component

4. Assume that the owner investment transaction on December 1 was $49,000 cash instead of $65,000 and that Ander Electric obtained another $16,000 in cash by borrowing it from a bank. Explain the effect of this change on total assets, total liabilities, and total equity.

Problem 1-8A Analyzing transactions and preparing financial statements

C4 P1 P2

mhhe.com/wildFINMAN5e

Check (2) Ending balances: Cash, $59,180, Accounts Payable, $8,550

(3) Net income, $4,160; Total assets, $76,760

Problem 1-9A Analyzing effects of transactions

C4 P1 P2 A1

Isabel Lopez started Biz Consulting, a new business, and completed the following transactions during its first year of operations. a. I. Lopez invests $70,000 cash and office equipment valued at $10,000 in the company in exchange for

its common stock. b. The company purchased a $150,000 building to use as an office. Biz paid $20,000 in cash and signed

a note payable promising to pay the $130,000 balance over the next ten years. c. The company purchased office equipment for $15,000 cash. d. The company purchased $1,200 of office supplies and $1,700 of office equipment on credit. e. The company paid a local newspaper $500 cash for printing an announcement of the office’s opening. f. The company completed a financial plan for a client and billed that client $2,800 for the service. g. The company designed a financial plan for another client and immediately collected an $4,000 cash fee. h. The company paid $3,275 cash in dividends to the owner (sole shareholder). i. The company received $1,800 cash as partial payment from the client described in transaction f. j. The company made a partial payment of $700 cash on the equipment purchased in transaction d. k. The company paid $1,800 cash for the office secretary’s wages for this period.

Required

1. Create a table like the one in Exhibit 1.9, using the following headings for the columns: Cash; Ac- counts Receivable; Office Supplies; Office Equipment; Building; Accounts Payable; Notes Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions within the table created in part 1 to show the dollar effects of each trans- action on individual items of the accounting equation. Show new balances after each transaction.

3. Once you have completed the table, determine the company’s net income.

Check (2) Ending balances: Cash, $34,525; Expenses, $2,300; Notes Payable, $130,000

(3) Net income, $4,500

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40 Chapter 1 Introducing Accounting in Business

Coca-Cola and PepsiCo both produce and market beverages that are direct competitors. Key financial figures (in $ millions) for these businesses over the past year follow.

Key Figures ($ millions) Coca-Cola PepsiCo

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $46,542 $66,504

Net income . . . . . . . . . . . . . . . . . . . 8,634 6,462

Average assets . . . . . . . . . . . . . . . . . 76,448 70,518

Required

1. Compute return on assets for (a) Coca-Cola and (b) PepsiCo. 2. Which company is more successful in its total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested?

Analysis Component

4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.)

Problem 1-10A Computing and interpreting return on assets

A2

Check (1a) 11.3%; (1b) 9.2%

Kyzera manufactures, markets, and sells cellular telephones. The average total assets for Kyzera is $250,000. In its most recent year, Kyzera reported net income of $65,000 on revenues of $475,000.

Required

1. What is Kyzera’s return on assets? 2. Does return on assets seem satisfactory for Kyzera given that its competitors average a 12% return on

assets? 3. What are total expenses for Kyzera in its most recent year? 4. What is the average total amount of liabilities plus equity for Kyzera?

Check (3) $410,000 (4) $250,000

Problem 1-11A Determining expenses, liabilities, equity, and return on assets

A1 A2

Problem 1-13AB

Describing organizational activities

C5

A start-up company often engages in the following transactions in its first year of operations. Classify those transactions in one of the three major categories of an organization’s business activities. F. Financing I. Investing O. Operating

1. Owner investing land in business. 5. Purchasing equipment. 2. Purchasing a building. 6. Selling and distributing products. 3. Purchasing land. 7. Paying for advertising. 4. Borrowing cash from a bank. 8. Paying employee wages.

Problem 1-12AA

Identifying risk and return

A3

All business decisions involve aspects of risk and return.

Required

Identify both the risk and the return in each of the following activities: 1. Investing $2,000 in a 5% savings account. 2. Placing a $2,500 bet on your favorite sports team. 3. Investing $10,000 in Yahoo! stock. 4. Taking out a $15,000 college loan toward earning an accounting degree.

Problem 1-14AB

Describing organizational activities C5

An organization undertakes various activities in pursuit of business success. Identify an organization’s three major business activities, and describe each activity.

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Chapter 1 Introducing Accounting in Business 41

The following financial statement information is from five separate companies. PROBLEM SET B

Problem 1-1B Computing missing information using accounting knowledge

A1 P1

Company Company Company Company Company V W X Y Z

December 31, 2012

Assets . . . . . . . . . . . . . . . . . . . . . . . . $54,000 $80,000 $141,500 $92,500 $144,000

Liabilities . . . . . . . . . . . . . . . . . . . . . 25,000 60,000 68,500 51,500 ?

December 31, 2013

Assets . . . . . . . . . . . . . . . . . . . . . . . . 59,000 100,000 186,500 ? 170,000

Liabilities . . . . . . . . . . . . . . . . . . . . . 36,000 ? 65,800 42,000 42,000

During year 2013

Stock issuances . . . . . . . . . . . . . . . . 5,000 20,000 ? 48,100 60,000

Net income or (loss) . . . . . . . . . . . . ? 40,000 18,500 24,000 32,000

Cash dividends . . . . . . . . . . . . . . . . 5,500 2,000 0 20,000 8,000

Check (1b) $23,000

(2c) $22,000

(4) $135,100

Required

1. Answer the following questions about Company V: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is the net income or loss for the year 2013? 2. Answer the following questions about Company W: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is the amount of liabilities on December 31, 2013? 3. Calculate the amount of stock issuances for Company X during 2013. 4. Calculate the amount of assets for Company Y on December 31, 2013. 5. Calculate the amount of liabilities for Company Z on December 31, 2012.

Identify how each of the following separate transactions affects financial statements. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from financing activities, and cash flows from investing activities. For increases, place a “1” in the column or columns. For de- creases, place a “2” in the column or columns. If both an increase and a decrease occur, place “1y2” in the column or columns. The first transaction is completed as an example.

Problem 1-2B Identifying effects of transactions on financial statements A1 P1

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Financing Investing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests cash for its stock 1 1 1

2 Buys building by signing note payable

3 Pays cash for salaries incurred

4 Provides services for cash

5 Pays cash for rent incurred

6 Incurs utilities costs on credit

7 Buys store equipment for cash

8 Pays cash dividend

9 Provides services on credit

10 Collects cash on receivable from (9)

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42 Chapter 1 Introducing Accounting in Business

Problem 1-4B Preparing a balance sheet

P2

The following is selected financial information for TLC Company as of December 31, 2013.

Required

Prepare the balance sheet for TLC Company as of December 31, 2013.

Liabilities . . . . . . . . $64,000 Equity . . . . . . . . $50,000 Assets . . . . . . . . $114,000

Problem 1-5B Preparing a statement of cash flows

P2

Selected financial information of HalfLife Company for the year ended December 31, 2013, follows.

Required

Prepare the 2013 statement of cash flows for HalfLife Company.

Cash from investing activities . . . . . . . . . . . $1,600

Net increase in cash . . . . . . . . . . . . . . . . . . 400

Cash from financing activities . . . . . . . . . . . . 1,800

Cash used by operating activities . . . . . . . . (3,000)

Cash, December 31, 2012 . . . . . . . . . . . . . . 1,300

Problem 1-6B Preparing a statement of retained earnings

P2 Retained Earnings, Dec. 31, 2013 . . . . . . . . $47,000 Cash dividends . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Retained Earnings, Dec. 31, 2012 . . . . . . . . 49,000

Following is selected financial information of ATV Company for the year ended December 31, 2013.

Required

Prepare the 2013 statement of retained earnings for ATV Company.

Problem 1-7B Analyzing transactions and preparing financial statements

C4 P1 P2

Holly Nikolas launched a new business, Holly’s Maintenance Co., that began operations on June 1. The following transactions were completed by the company during that first month.

June 1 H. Nikolas invested $130,000 cash in the company in exchange for its common stock. 2 The company rented a furnished office and paid $6,000 cash for June’s rent. 4 The company purchased $2,400 of equipment on credit. 6 The company paid $1,150 cash for this month’s advertising of the opening of the business. 8 The company completed maintenance services for a customer and immediately collected $850

cash. 14 The company completed $7,500 of maintenance services for City Center on credit. 16 The company paid $800 cash for an assistant’s salary for the first half of the month. 20 The company received $7,500 cash payment for services completed for City Center on June 14. 21 The company completed $7,900 of maintenance services for Paula’s Beauty Shop on credit. 24 The company completed $675 of maintenance services for Build-It Coop on credit. 25 The company received $7,900 cash payment from Paula’s Beauty Shop for the work completed on

June 21. 26 The company made payment of $2,400 cash for equipment purchased on June 4. 28 The company paid $800 cash for an assistant’s salary for the second half of this month. 29 The company paid $4,000 cash in dividends to the owner (sole shareholder). 30 The company paid $150 cash for this month’s telephone bill. 30 The company paid $890 cash for this month’s utilities.

Problem 1-3B Preparing an income statement

P2 Revenues . . . . . . . $68,000 Expenses . . . . . . . . $40,000 Net income . . . . . . . $28,000

Selected financial information for Offshore Co. for the year ended December 31, 2013, follows.

Required

Prepare the 2013 income statement for Offshore Company.

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Chapter 1 Introducing Accounting in Business 43

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Re- ceivable; Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Show the effects of the transactions on the accounts of the accounting equation by recording increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance.

3. Prepare a June income statement, a June statement of retained earnings, a June 30 balance sheet, and a June statement of cash flows.

Check (2) Ending balances: Cash, $130,060; Expenses, $9,790

(3) Net income, $7,135; Total assets, $133,135

Truro Excavating Co., owned by Raul Truro, began operations in July and completed these transactions during that first month of operations.

July 1 R. Truro invested $80,000 cash in the company in exchange for its common stock. 2 The company rented office space and paid $700 cash for the July rent. 3 The company purchased excavating equipment for $5,000 by paying $1,000 cash and agreeing

to pay the $4,000 balance in 30 days. 6 The company purchased office supplies for $600 cash. 8 The company completed work for a customer and immediately collected $7,600 cash for the

work. 10 The company purchased $2,300 of office equipment on credit. 15 The company completed work for a customer on credit in the amount of $8,200. 17 The company purchased $3,100 of office supplies on credit. 23 The company paid $2,300 cash for the office equipment purchased on July 10. 25 The company billed a customer $5,000 for work completed; the balance is due in 30 days. 28 The company received $8,200 cash for the work completed on July 15. 30 The company paid an assistant’s salary of $1,560 cash for this month. 31 The company paid $295 cash for this month’s utility bill. 31 The company paid $1,800 cash in dividends to the owner (sole shareholder).

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Re- ceivable; Office Supplies; Office Equipment; Excavating Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions to show the effects of each transaction on the accounts in the account- ing equation. Show new balances after each transaction.

3. Use the increases and decreases in the columns of the table from part 2 to prepare an income state- ment, a statement of retained earnings, and a statement of cash flows—each of these for the current month. Also prepare a balance sheet as of the end of the month.

Analysis Component

4. Assume that the $5,000 purchase of excavating equipment on July 3 was financed from an owner in- vestment of another $5,000 cash in the business in exchange for more common stock (instead of the purchase conditions described in the transaction). Explain the effect of this change on total assets, total liabilities, and total equity.

Problem 1-8B Analyzing transactions and preparing financial statements

C4 P1 P2

Check (2) Ending balances: Cash, $87,545; Accounts Payable, $7,100

(3) Net income, $18,245; Total assets, $103,545

Problem 1-9B Analyzing effects of transactions

C4 P1 P2 A1

Nico Mitchell started a new business, Nico’s Solutions, and completed the following transactions during its first year of operations. a. N. Mitchell invests $90,000 cash and office equipment valued at $20,000 in the company in exchange

for its common stock. b. The company purchased a $150,000 building to use as an office. It paid $40,000 in cash and signed

a note payable promising to pay the $110,000 balance over the next ten years. c. The company purchased office equipment for $25,000 cash.

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44 Chapter 1 Introducing Accounting in Business

Key Figures ($ millions) AT&T Verizon

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $126,723 $110,875

Net income . . . . . . . . . . . . . . . . . . . 4,184 10,198

Average assets . . . . . . . . . . . . . . . . . 269,868 225,233

AT&T and Verizon produce and market telecommunications products and are competitors. Key financial figures (in $ millions) for these businesses over the past year follow.

Required

1. Compute return on assets for (a) AT&T and (b) Verizon. 2. Which company is more successful in the total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested?

Analysis Component

4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.)

Problem 1-10B Computing and interpreting return on assets

A2

Check (1a) 1.6%; (1b) 4.5%

d. The company purchased $1,200 of office supplies and $1,700 of office equipment on credit. e. The company paid a local newspaper $750 cash for printing an announcement of the office’s

opening. f. The company completed a financial plan for a client and billed that client $2,800 for the service. g. The company designed a financial plan for another client and immediately collected a $4,000 cash

fee. h. The company paid $11,500 cash in dividends to the owner (sole shareholder). i. The company received $1,800 cash from the client described in transaction f. j. The company made a payment of $700 cash on the equipment purchased in transaction d. k. The company paid $2,500 cash for the office secretary’s wages.

Required

1. Create a table like the one in Exhibit 1.9, using the following headings for the columns: Cash; Ac- counts Receivable; Office Supplies; Office Equipment; Building; Accounts Payable; Notes Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions within the table created in part 1 to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction.

3. Once you have completed the table, determine the company’s net income.

Check (2) Ending balances: Cash, $15,350; Expenses, $3,250; Notes Payable, $110,000 (3) Net income, $3,550

Problem 1-11B Determining expenses, liabilities, equity, and return on assets

A1 A2

Carbondale Company manufactures, markets, and sells snowmobile and snowmobile equipment and accessories. The average total assets for Carbondale is $3,000,000. In its most recent year, Carbondale reported net income of $201,000 on revenues of $1,400,000.

Required

1. What is Carbondale Company’s return on assets? 2. Does return on assets seem satisfactory for Carbondale given that its competitors average a 9.5% re-

turn on assets? 3. What are the total expenses for Carbondale Company in its most recent year? 4. What is the average total amount of liabilities plus equity for Carbondale Company?

Check (3) $1,199,000

(4) $3,000,000

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Chapter 1 Introducing Accounting in Business 45

SP 1 On October 1, 2013, Adria Lopez launched a computer services company, Success Systems, that is organized as a corporation and provides consulting services, computer system installations, and custom program development. Lopez adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2013.

Required

Create a table like the one in Exhibit 1.9 using the following headings for columns: Cash; Accounts Receivable; Computer Supplies; Computer System; Office Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Then use additions and subtractions within the table created to show the dollar effects for each of the following October transactions for Success Systems on the indi- vidual items of the accounting equation. Show new balances after each transaction.

Oct. 1 A. Lopez invested $55,000 cash, a $20,000 computer system, and $8,000 of office equipment in the company in exchange for its common stock.

3 The company purchased $1,420 of computer supplies on credit from Harris Office Products. 6 The company billed Easy Leasing $4,800 for services performed in installing a new Web

server. 8 The company paid $1,420 cash for the computer supplies purchased from Harris Office Prod-

ucts on October 3. 10 The company hired Lyn Addie as a part-time assistant for $125 per day, as needed. 12 The company billed Easy Leasing another $1,400 for services performed. 15 The company received $4,800 cash from Easy Leasing as partial payment toward its account. 17 The company paid $805 cash to repair computer equipment damaged when moving it. 20 The company paid $1,940 cash for advertisements published in the local newspaper.

This serial problem starts in this chapter and continues throughout most chapters of the book. It is most readily solved if you use the Working Papers that accompany this book (but working papers are not required).

SERIAL PROBLEM Success Systems

C4 P1

Problem 1-14BB

Describing organizational activities C5

Identify in outline format the three major business activities of an organization. For each of these activi- ties, identify at least two specific transactions or events normally undertaken by the business’s owners or its managers.

Problem 1-13BB

Describing organizational activities

C5

A start-up company often engages in the following activities during its first year of operations. Classify each of the following activities into one of the three major activities of an organization. F. Financing I. Investing O. Operating

1. Providing client services. 5. Supervising workers. 2. Obtaining a bank loan. 6. Owner investing money in business. 3. Purchasing machinery. 7. Renting office space. 4. Research for its products. 8. Paying utilities expenses.

Problem 1-12BA

Identifying risk and return

A3

All business decisions involve aspects of risk and return.

Required

Identify both the risk and the return in each of the following activities: 1. Stashing $500 cash under your mattress. 2. Placing a $250 bet on a horse running in the Kentucky Derby. 3. Investing $20,000 in Nike stock. 4. Investing $35,000 in U.S. Savings Bonds.

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46 Chapter 1 Introducing Accounting in Business

BTN 1-2 Key comparative figures ($ thousands) for both Polaris and Arctic Cat follow.

Required

1. What is the total amount of assets invested in (a) Polaris and (b) Arctic Cat? 2. What is the return on assets for (a) Polaris and (b) Arctic Cat? Polaris’s beginning-year assets equal

$1,061,647 (in thousands) and Arctic Cat’s beginning-year assets equal $246,084 (in thousands). 3. How much are expenses for (a) Polaris and (b) Arctic Cat? 4. Is return on assets satisfactory for (a) Polaris and (b) Arctic Cat? (Assume competitors average an 18%

return.) 5. What can you conclude about Polaris and Arctic Cat from these computations?

Key Figure Polaris Arctic Cat

Liabilities 1 Equity . . . . . . . . . . $1,228,024 $272,906

Net income . . . . . . . . . . . . . . . 227,575 13,007

Revenues and sales . . . . . . . . . 2,656,949 464,651

COMPARATIVE ANALYSIS A1 A2 A3

Check (2b) 5.0%

Polaris Arctic Cat

Beyond the Numbers

Required

1. What is the total amount of assets invested in Polaris? 2. What is Polaris’s return on assets for 2011? Its assets at December 31, 2010, equal $1,061,647

(in thousands). 3. How much are total expenses for Polaris for the year ended December 31, 2011? 4. Does Polaris’s return on assets for 2011 seem satisfactory if competitors average an 18% return?

Fast Forward

5. Access Polaris’s financial statements (Form 10-K) for years ending after December 31, 2011, from its Website (Polaris.com) or from the SEC Website (www.sec.gov) and compute its return on assets for those years. Compare the December 31, 2011, year-end return on assets to any subsequent years’ re- turns you are able to compute, and interpret the results.

Check (2) 19.9%

Beyond the Numbers (BTN) is a special problem section aimed to refine communication, conceptual, analysis, and research skills. It includes many activities helpful in developing an active learning environment.

BTN 1-1 Key financial figures for Polaris’s fiscal year ended December 31, 2011, follow.

Key Figure In Thousands

Liabilities 1 Equity . . . . . . . . . $1,228,024

Net income . . . . . . . . . . . . . . 227,575

Revenues . . . . . . . . . . . . . . . . 2,656,949

REPORTING IN ACTION A1 A2 A3

Polaris

22 The company received $1,400 cash from Easy Leasing toward its account. 28 The company billed IFM Company $5,208 for services performed. 31 The company paid $875 cash for Lyn Addie’s wages for seven days of work this month. 31 The company paid $3,600 cash in dividends to the owner (sole shareholder).

Check Ending balances: Cash, $52,560; Revenues, $11,408; Expenses, $3,620

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Chapter 1 Introducing Accounting in Business 47

BTN 1-6 Teamwork is important in today’s business world. Successful teams schedule convenient meetings, maintain regular communications, and cooperate with and support their members. This as- signment aims to establish support/learning teams, initiate discussions, and set meeting times.

Required

1. Form teams and open a team discussion to determine a regular time and place for your team to meet between each scheduled class meeting. Notify your instructor via a memorandum or e-mail message as to when and where your team will hold regularly scheduled meetings.

2. Develop a list of telephone numbers and/or e-mail addresses of your teammates.

TEAMWORK IN ACTION C1

BTN 1-5 Visit the EDGAR database at (www.sec.gov). Access the Form 10-K report of Rocky Mountain Chocolate Factory (ticker RMCF) filed on May 24, 2011, covering its 2011 fiscal year.

Required

1. Item 6 of the 10-K report provides comparative financial highlights of RMCF for the years 2007–2011. How would you describe the revenue trend for RMCF over this five-year period?

2. Has RMCF been profitable (see net income) over this five-year period? Support your answer.

TAKING IT TO THE NET A2

BTN 1-4 Refer to this chapter’s opening feature about Twitter. Assume that the owners desire to expand their online services to meet people’s demands regarding online services. They eventually decide to meet with their banker to discuss a loan to allow Twitter to expand.

Required

1. Prepare a half-page report outlining the information you would request from the owners if you were the loan officer.

2. Indicate whether the information you request and your loan decision are affected by the form of busi- ness organization for Twitter.

COMMUNICATING IN PRACTICE A1 C2

BTN 1-3 Craig Thorne works in a public accounting firm and hopes to eventually be a partner. The man- agement of Allnet Company invites Thorne to prepare a bid to audit Allnet’s financial statements. In dis- cussing the audit fee, Allnet’s management suggests a fee range in which the amount depends on the reported profit of Allnet. The higher its profit, the higher will be the audit fee paid to Thorne’s firm.

Required

1. Identify the parties potentially affected by this audit and the fee plan proposed. 2. What are the ethical factors in this situation? Explain. 3. Would you recommend that Thorne accept this audit fee arrangement? Why or why not? 4. Describe some ethical considerations guiding your recommendation.

ETHICS CHALLENGE C3 C4

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48 Chapter 1 Introducing Accounting in Business

BTN 1-9 KTM (KTM.com) is a leading manufacturer of offroad and street motorcycles, and it com- petes to some extent with both Polaris and Arctic Cat. Key financial figures for KTM follow.

Required

1. Identify any concerns you have in comparing KTM’s income and revenue figures to those of Polaris and Arctic Cat (in BTN 1-2) for purposes of making business decisions.

2. Identify any concerns you have in comparing KTM’s return on assets ratio to those of Polaris and Arctic Cat (computed for BTN 1-2) for purposes of making business decisions.

Key Figure* Euro in Thousands

Average assets . . . . . . . . . . . . . . . . . . 465,550

Net income . . . . . . . . . . . . . . . . . . . . 20,818

Revenue . . . . . . . . . . . . . . . . . . . . . . . 526,801

Return on assets . . . . . . . . . . . . . . . . 4.5%

* Figures prepared in accordance with International Financial Reporting Standards.

GLOBAL DECISION A1 A2 A3

KTM Polaris Arctic Cat

BTN 1-8 You are to interview a local business owner. (This can be a friend or relative.) Opening lines of communication with members of the business community can provide personal benefits of business net- working. If you do not know the owner, you should call ahead to introduce yourself and explain your posi- tion as a student and your assignment requirements. You should request a 30-minute appointment for a face-to-face or phone interview to discuss the form of organization and operations of the business. Be prepared to make a good impression.

Required

1. Identify and describe the main operating activities and the form of organization for this business. 2. Determine and explain why the owner(s) chose this particular form of organization. 3. Identify any special advantages and/or disadvantages the owner(s) experiences in operating with this

form of business organization.

HITTING THE ROAD C2

BTN 1-7 Refer to this chapter’s opening feature about Twitter. Assume that the owners decide to open a new Website devoted to micro-blogging for accountants and those studying accounting. This new com- pany will be called AccounTwit.

Required

1. AccounTwit obtains a $500,000 loan and the three owners contribute $250,000 in total from their own savings in exchange for common stock in the new company.

a. What is the new company’s total amount of liabilities plus equity? b. What is the new company’s total amount of assets? 2. If the new company earns $80,250 in net income in the first year of operation, compute its return on assets

(assume average assets equal $750,000). Assess its performance if competitors average a 10% return.

ENTREPRENEURIAL DECISION A1 P1

Check (2) 10.7%

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Chapter 1 Introducing Accounting in Business 49

1. c; $450,000 is the actual cost incurred. 2. b; revenue is recorded when earned. 3. d;

4. a 5. a

Assets 5 Liabilities 1 Equity

1$100,000 5 135,000 1 ?

Change in equity 5 $100,000 2 $35,000 5 $65,000

ANSWERS TO MULTIPLE CHOICE QUIZ

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Learning Objectives

CONCEPTUAL

C1 Explain the steps in processing transactions and the role of source documents. (p. 52)

C2 Describe an account and its use in recording transactions. (p. 53) C3 Describe a ledger and a chart of accounts. (p. 56) C4 Define debits and credits and explain double-entry accounting. (p. 57)

ANALYTICAL

A1 Analyze the impact of transactions on accounts and financial statements. (p. 61) A2 Compute the debt ratio and describe its use in analyzing financial condition. (p. 71)

PROCEDURAL

P1 Record transactions in a journal and post entries to a ledger. (p. 58) P2 Prepare and explain the use of a trial balance. (p. 67) P3 Prepare financial statements from business transactions. (p. 68)

A Look at This Chapter

This chapter focuses on the accounting process. We describe transactions and source documents, and we explain the analysis and recording of transactions. The accounting equation, T-account, general ledger, trial balance, and debits and credits are key tools in the accounting process.

A Look Back

Chapter 1 defined accounting and introduced financial statements. We described forms of organizations and identified users and uses of accounting. We defined the accounting equation and applied it to transaction analysis.

Analyzing and Recording Transactions 2

A Look Ahead

Chapter 3 extends our focus on processing information. We explain the importance of adjusting accounts and the procedures in preparing financial statements.

50

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Some Like It Hot

LOS ANGELES—“We call our customers Nomsters!” exclaims Misa. “There’s an entire Nom Nom movement.” Nom Nom Truck (NomNomTruck.com) is a mobile food business and the brainchild of Misa Chien and Jennifer Green. (Nom Nom is drawn from the sound “nom nom nom” when eating something “oh so tasty.”) Their specialty is the Vietnamese baguette sand- wich, called banh mi, a sort of Vietnamese subsandwich. “It’s portable, it’s fast, and has a fresh taste that you can’t get from a burrito or hamburger,” states Jennifer. To pursue their business ambitions, Misa and Jennifer took business courses. They learned about recordkeeping processes, transaction analysis, inventory accounting, and financial state- ment reporting. “We did lose a lot of money initially,” explains Misa. “We didn’t have the right pricing structure.” With careful analysis of their accounting reports, Misa and Jennifer solved the problem. Their business is now profitable and they have a reliable accounting system to help them make good business decisions. “We had to account for product expenses, trucking ex- penses, supplier payments, and other expenses such as sala- ries, rent and insurance,” explains Misa. At the same time, the

two have grown sales and expanded their food offerings. “Sales have definitely increased,” says Misa. “People totally embraced us!” The two insist that it is crucial to track and account for all revenues and expenses, including what is invested in the busi- ness. They maintain that success requires proper accounting for and analysis of the financial side. “There was a point when we couldn’t keep up,” recounts Misa. Given the importance of ac- counting, “we [now] have a bookkeeper and an accountant!” The women emphasize the value of a great business model along with a sound accounting system. “It’s really easy to bal- ance both now that we’ve been in the business for awhile,” ex- plains Misa. “The bigger message of our company”, says Jennifer, “is that each of us can succeed no matter what our starting point”. “You have to be responsible for yourself,” adds Misa. “We want to make people happy through our food!”

[Sources: Nom Nom Truck Website, January 2013; Inc., June 2011; Bundle.com, October 2010; VirgoBlue.net, September 2011; CNNMoney, October 2011.]

“You can still excel if you work really hard and follow your dreams!”

—MISA CHIEN (ON LEFT)

Decision Insight

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Chapter Preview

Financial statements report on the financial performance and condition of an organization. Knowledge of their preparation, organization, and analysis is important. A main goal of this chapter is to illustrate how transactions are recorded, how

they are reflected in financial statements, and how they impact analysis of financial statements. Debits and credits are intro- duced and identified as a tool in helping analyze and process transactions.

Analyzing and Recording Transactions

Analyzing and Processing Transactions

• General ledger • Double-entry accounting • Journalizing and posting • An illustration

Analyzing and Recording Process

• Source documents • The account and its

analysis • Types of accounts

Trial Balance

• Trial balance preparation • Search for and correction

of errors • Trial balance use

The accounting process identifies business transactions and events, analyzes and records their effects, and summarizes and presents information in reports and financial statements. These re- ports and statements are used for making investing, lending, and other business decisions. The steps in the accounting process that focus on analyzing and recording transactions and events are shown in Exhibit 2.1.

EXHIBIT 2.1 The Analyzing and Recording Process

Record relevant transact ions and events in a journal

Post journal information to ledger accounts

Prepare and analyze the trial balance

Analyze each transaction

and event from source documents

Journal Dec. 1 30,000

30,000 Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Journal Dec. 1 30,000

30,000 Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Ledger

Cash no.101

Supplies no.126

Journal Dec. 1 30,000

30,000 Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Ledger

Cash no.101

Supplies no.126

FastForward Trial Balance

Cash $ 3,950 Supplies 9,720 Prepaid Insurance 2,400 Equipment 26,000

Date Debit Credit

1 Deposit 30,000

Total 30,000

Services Contract Bank Statement

1 Deposit 30,000

Total 30,000

1 Deposit 30,000

Total 30,000

Client Billing Bank Statement

1 Deposit 30,000

Total 30,000

1 Deposit 30,000

Total 30,000

Note Payable Bank Statement

1 Deposit 30,000

Total 30,000

1 Deposit 30,000

Total 30,000

Purchase Ticket

1 Deposit 30,000

Total 30,000

Bank Statement

C1 Explain the steps in processing transactions and the role of source documents.

ANALYZING AND RECORDING PROCESS

Business transactions and events are the starting points. Relying on source documents, the transactions and events are analyzed using the accounting equation to understand how they affect company performance and financial position. These effects are recorded in accounting records, informally referred to as the accounting books, or simply the books. Additional steps such as posting and then preparing a trial balance help summarize and classify the effects of transactions and events. Ultimately, the accounting process provides information in useful reports or financial statements to decision makers.

Source Documents Source documents identify and describe transactions and events entering the accounting process. They are the sources of accounting information and can be in either hard copy or electronic form. Examples are sales tickets, checks, purchase orders, bills from suppliers, employee earnings 52

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Chapter 2 Analyzing and Recording Transactions 53

records, and bank statements. To illustrate, when an item is purchased on credit, the seller usually prepares at least two copies of a sales invoice. One copy is given to the buyer. Another copy, often sent electronically, results in an entry in the seller’s information system to record the sale. Sellers use invoices for recording sales and for control; buyers use them for recording purchases and for monitoring purchasing activity. Many cash registers record information for each sale on a tape or electronic file locked inside the register. This record can be used as a source document for recording sales in the accounting records. Source documents, especially if obtained from outside the organiza- tion, provide objective and reliable evidence about transactions and events and their amounts.

Point: To ensure that all sales are rung up on the register, most sellers require customers to have their receipts to exchange or return purchased items.

Asset Accounts Assets are resources owned or controlled by a company, and those re- sources have expected future benefits. Most accounting systems include (at a minimum) sepa- rate accounts for the assets described here.

Cash A Cash account reflects a company’s cash balance. All increases and decreases in cash are recorded in the Cash account. It includes money and any medium of exchange that a bank accepts for deposit (coins, checks, money orders, and checking account balances).

Accounts Receivable Accounts receivable are held by a seller and refer to promises of payment from customers to sellers. These transactions are often called credit sales or sales on account (or on credit). Accounts receivable are increased by credit sales and are decreased by customer payments. A company needs a separate record for each customer, but for now, we use the simpler practice of recording all increases and decreases in receivables in a single account called Accounts Receivable.

Note Receivable A note receivable, or promissory note, is a written promise of another entity to pay a definite sum of money on a specified future date to the holder of the note. A company holding a promissory note signed by another entity has an asset that is recorded in a Note (or Notes) Receivable account.

Prepaid Accounts Prepaid accounts (also called prepaid expenses) are assets that represent pre- payments of future expenses (not current expenses). When the expenses are later incurred, the amounts in prepaid accounts are transferred to expense accounts. Common examples of prepaid accounts include prepaid insurance, prepaid rent, and prepaid services (such as club memberships). Prepaid accounts expire with the passage of time (such as with rent) or through use (such as with prepaid meal tickets). When financial statements are prepared, prepaid accounts are adjusted so that (1) all expired and used prepaid accounts are recorded as regular expenses and (2) all unexpired and unused prepaid accounts are recorded as assets (reflecting future use in future periods). To illustrate,

Point: Customers and others who owe a company are called its debtors.

Point: A college parking fee is a prepaid account from the student’s standpoint. At the beginning of the term, it represents an asset that entitles a student to park on or near campus. The benefits of the parking fee expire as the term progresses. At term-end, prepaid parking (asset) equals zero as it has been entirely recorded as parking expense.

EXHIBIT 2.2 Accounts Organized by the Accounting Equation5 1

SuppliesInventoryAccounts ReceivableCash Wages PayableUnearned RevenuesAccounts Payable

Asset Accounts Liability Accounts

Paid-In CapitalDividendsCommon Stock

Equity Accounts

The Account and Its Analysis An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item. Information from an account is analyzed, summarized, and presented in reports and financial statements. The general ledger, or simply ledger, is a record containing all ac- counts used by a company. The ledger is often in electronic form. While most companies’ led- gers contain similar accounts, a company often uses one or more unique accounts because of its type of operations. As shown in Exhibit 2.2, accounts are classified into three general categories based on the accounting equation: asset, liability, or equity.

C2 Describe an account and its use in recording transactions.

Cashier Your manager requires that you, as cashier, immediately enter each sale. Recently, lunch hour traf- fic has increased and the assistant manager asks you to avoid delays by taking customers’ cash and making change without entering sales. The assistant manager says she will add up cash and enter sales after lunch. She says that, in this way, the register will always match the cash amount when the manager arrives at three o’clock. What do you do? ■ [Answer—p. 76]

Decision Ethics

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54 Chapter 2 Analyzing and Recording Transactions

when an insurance fee, called a premium, is paid in advance, the cost is typically recorded in the asset account Prepaid Insurance. Over time, the expiring portion of the insurance cost is removed from this asset account and reported in expenses on the income statement. Any unexpired portion remains in Prepaid Insurance and is reported on the balance sheet as an asset. (An exception exists for prepaid accounts that will expire or be used before the end of the current accounting period when financial statements are prepared. In this case, the prepayments can be recorded immediately as expenses.)

Supplies Accounts Supplies are assets until they are used. When they are used up, their costs are reported as expenses. The costs of unused supplies are recorded in a Supplies asset account. Supplies are often grouped by purpose — for example, office supplies and store supplies. Office supplies include stationery, paper, toner, and pens. Store supplies include packaging materials, plastic and paper bags, gift boxes and cartons, and cleaning materials. The costs of these unused supplies can be recorded in an Office Supplies or a Store Supplies asset account. When supplies are used, their costs are transferred from the asset accounts to expense accounts.

Equipment Accounts Equipment is an asset. When equipment is used and gets worn down, its cost is gradually reported as an expense (called depreciation). Equipment is often grouped by its purpose — for example, office equipment and store equipment. Office equipment includes computers, print ers, desks, chairs, and shelves. Costs incurred for these items are recorded in an Office Equip ment asset account. The Store Equipment account includes the costs of assets used in a store, such as counters, showcases, ladders, hoists, and cash registers.

Buildings Accounts Buildings such as stores, offices, warehouses, and factories are assets because they provide expected future benefits to those who control or own them. Their costs are recorded in a Buildings asset account. When several buildings are owned, separate accounts are sometimes kept for each of them.

Land The cost of land owned by a business is recorded in a Land account. The cost of build- ings located on the land is separately recorded in one or more building accounts.

Point: Prepaid accounts that apply to current and future periods are assets. These assets are adjusted at the end of each period to reflect only those amounts that have not yet expired, and to record as expenses those amounts that have expired.

Point: Some assets are described as intangible because they do not have physical existence or their benefits are highly uncertain. A recent balance sheet for Coca-Cola Company shows nearly $1 billion in intangible assets.

Liability Accounts Liabilities are claims (by creditors) against assets, which means they are obligations to transfer assets or provide products or services to others. Creditors are indi- viduals and organizations that have rights to receive payments from a company. If a company fails to pay its obligations, the law gives creditors a right to force the sale of that company’s as- sets to obtain the money to meet creditors’ claims. When assets are sold under these conditions, creditors are paid first, but only up to the amount of their claims. Any remaining money, the residual, goes to the owners of the company. Creditors often use a balance sheet to help decide whether to loan money to a company. A loan is less risky if the borrower’s liabilities are small in comparison to assets because this means there are more resources than claims on resources. Common liability accounts are described here.

Accounts Payable Accounts payable refer to oral or implied promises to pay later, which usu- ally arise from purchases of merchandise. Payables can also arise from purchases of supplies, equipment, and services. Accounting systems keep separate records about each creditor. We describe these individual records in Chapter 4.

Note Payable A note payable refers to a formal promise, usually denoted by the signing of a promissory note, to pay a future amount. It is recorded in either a short-term Note Payable account or a long-term Note Payable account, depending on when it must be repaid. We explain details of short- and long-term classification in Chapter 3.

Point: Accounts payable are also called trade payables.

Women Entrepreneurs The Center for Women’s Business Research reports that women-owned businesses, such as Nom Nom Truck, are growing and that they:

• Total approximately 11 million and employ nearly 20 million workers. • Generate $2.5 trillion in annual sales and tend to embrace technology. • Are philanthropic—70% of owners volunteer at least once per month. • Are more likely funded by individual investors (73%) than venture firms (15%). ■

Decision Insight

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Chapter 2 Analyzing and Recording Transactions 55

Unearned Revenue Accounts Unearned revenue refers to a liability that is settled in the future when a company delivers its products or services. When customers pay in advance for products or services (before revenue is earned), the revenue recognition principle requires that the seller consider this payment as unearned revenue. Examples of unearned revenue include magazine subscrip tions collected in advance by a publisher, sales of gift certificates by stores, and season ticket sales by sports teams. The seller would record these in liability accounts such as Unearned Subscriptions, Unearned Store Sales, and Unearned Ticket Revenue. When prod- ucts and services are later delivered, the earned portion of the unearned revenue is transferred to revenue accounts such as Subscription Fees, Store Sales, and Ticket Sales.1

Accrued Liabilities Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. These are often recorded in separate liability accounts by the same title. If they are not large in amount, one or more ledger accounts can be added and reported as a single amount on the balance sheet. (Financial state- ments often have amounts reported that are a summation of several ledger accounts.)

Point: If a subscription is canceled, the publisher is expected to refund the unused portion to the subscriber.

1 In practice, account titles vary. As one example, Subscription Fees is sometimes called Subscription Fees Revenue, Subscription Fees Earned, or Earned Subscription Fees. As another example, Rent Earned is sometimes called Rent Revenue, Rental Revenue, or Earned Rent Revenue. We must use good judgment when reading financial statements because titles can differ even within the same industry. For example, product sales are called sales at Polaris, net sales at Arctic Cat, and net revenues at Piaggio. Generally, the term revenues or fees is more commonly used with service businesses, and net sales or sales with product businesses.

EXHIBIT 2.3 Expanded Accounting Equation

Paid-In CapitalDividendsCommon Stock

� � SuppliesInventoryAccounts ReceivableCash

Asset Accounts

Equity Accounts

Wages PayableUnearned RevenuesAccount Payable

Liability Accounts

� � � � Common Stock Revenues Expenses

Common Stock

Dividends

Dividends Revenues Expenses

Point: Equity is also called net assets.Equity Accounts The owner’s claim on a company’s assets is called equity, or stockholders’ equity, or shareholders’ equity. Equity is the owners’ residual interest in the assets of a business after deducting liabilities. Equity is impacted by four types of accounts: common stock, divi- dends, revenues, and expenses. We show this visually in Exhibit 2.3 by expanding the accounting equation. (As Chapter 1 explains, the accounts for dividends, revenues, and expenses are re- flected in the retained earnings account, and that account is reported in the balance sheet.)

Revenue Spread The New York Giants have Unearned Revenues of about $100 million in advance ticket sales. When the team plays its home games, it settles this liability to its ticket holders and then transfers the amount earned to Ticket Revenues. ■

Decision Insight

Common Stock When an owner invests in a company in exchange for common stock, the invested amount is recorded in an account titled Common Stock. Any further owner invest- ments are recorded in this account.

Dividends When the company pays any cash dividends, it decreases both the company’s assets and its total equity. Dividends are not expenses of the business. They are simply the opposite of owner investments. A Dividends account is used in recording asset distributions to stockholders (owners).

Revenue Accounts Revenues and expenses also impact equity. Examples of revenue accounts are Sales, Commissions Earned, Profess ional Fees Earned, Rent Revenue, and Interest Revenue. Revenues increase equity and result from products and services provided to customers.

Point: The Dividends account is some- times referred to as a contra equity ac- count because it reduces the normal balance of equity.

Point: The withdrawal of assets by the owners of a corporation is called a dividend.

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56 Chapter 2 Analyzing and Recording Transactions

Expense Accounts Examples of expense accounts are Advertising Expense, Store Supplies Ex- pense, Office Salaries Expense, Office Supplies Expense, Rent Expense, Utilities Expense, and In- surance Expense. Expenses decrease equity and result from assets and services used in a company’s operations. The variety of revenues and expenses can be seen by looking at the chart of accounts that follows the index at the back of this book. (Different companies sometimes use different ac- count titles than those in this book’s chart of accounts. For example, some might use Interest Rev- enue instead of Interest Earned, or Rental Expense instead of Rent Expense. It is important only that an account title describe the item it represents.)

These numbers provide a three-digit code that is useful in recordkeeping. In this case, the first digit assigned to asset accounts is a 1, the first digit assigned to liability accounts is a 2, and so on. The second and third digits relate to the accounts’ subcategories. Exhibit 2.4 shows a partial

Asset accounts Liability accounts Equity accounts Revenue accounts Expense accounts

Chart of Accounts

101–199 201–299 301–399 401–499 501–699

This section explains several tools and processes that comprise an accounting system. These in- clude a ledger, T-account, debits and credits, double-entry accounting, journalizing, and posting.

Ledger and Chart of Accounts The collection of all accounts and their balances for an information system is called a ledger (or general ledger). If accounts are in files on a hard drive, the sum of those files is the ledger. If the accounts are pages in a file, that file is the ledger. A company’s size and diversity of operations affect the number of accounts needed. A small company can get by with as few as 20 or 30 ac- counts; a large company can require several thousand. The chart of accounts is a list of all ledger accounts and includes an identification number assigned to each account. A small busi- ness might use the following numbering system for its accounts:

ANALYZING AND PROCESSING TRANSACTIONS

C3 Describe a ledger and a chart of accounts.

EXHIBIT 2.4 Partial Chart of Accounts for FastForward

406 Rental revenue 622 Salaries expense 637 Insurance expense 640 Rent expense 652 Supplies expense 690 Utilities expense

236 Unearned consulting revenue 307 Common stock 318 Retained earnings 319 Dividends 403 Consulting revenue

Acct. No. Account Name

101 Cash 106 Accounts receivable 126 Supplies 128 Prepaid insurance 167 Equipment 201 Accounts payable

Acct. No. Account Name

Chart of Accounts

Acct. No. Account Name

Sporting Accounts The Miami Heat, Los Angeles Lakers, and the other NBA teams have the following major revenue and expense accounts:

Revenues Expenses

Basketball ticket sales Team salaries TV & radio broadcast fees Game costs Advertising revenues NBA franchise costs Basketball playoff receipts Promotional costs ■

Decision Insight

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Chapter 2 Analyzing and Recording Transactions 57

chart of accounts for FastForward, the focus company of Chapter 1. (Please review the more complete chart of accounts that follows the index at the back of this book.)

Debits and Credits A T-account represents a ledger account and is a tool used to understand the effects of one or more transactions. Its name comes from its shape like the letter T. The layout of a T- account, shown in Exhibit 2.5, is (1) the account title on top, (2) a left, or debit side, and (3) a right, or credit, side. The left side of an account is called the debit side, often abbreviated Dr. The right side is called the credit side, abbreviated Cr.2 To enter amounts on the left side of an account is to debit the account. To enter amounts on the right side is to credit the account. Do not make the error of thinking that the terms debit and credit mean increase or decrease. Whether a debit or a credit is an increase or decrease depends on the account. For an account where a debit is an increase, the credit is a decrease; for an account where a debit is a decrease, the credit is an in- crease. The difference between total debits and total credits for an account, including any begin- ning balance, is the account balance. When the sum of debits exceeds the sum of credits, the account has a debit balance. It has a credit balance when the sum of credits exceeds the sum of debits. When the sum of debits equals the sum of credits, the account has a zero balance.

Double-Entry Accounting Double-entry accounting requires that for each transaction:

● At least two accounts are involved, with at least one debit and one credit. ● The total amount debited must equal the total amount credited. ● The accounting equation must not be violated.

This means the sum of the debits for all entries must equal the sum of the credits for all entries, and the sum of debit account balances in the ledger must equal the sum of credit account balances. The system for recording debits and credits follows from the usual accounting equation — see Exhibit 2.6. Two points are important here. First, like any simple mathematical relation, net increases or decreases on one side have equal net effects on the other side. For example, a net increase in assets must be accompanied by an identical net increase on the liabilities and equity

C4 Define debits and credits and explain double-entry accounting.

EXHIBIT 2.5 The T-Account

Point: Think of debit and credit as accounting directions for left and right.

“Total debits equal total credits for

each entry.”

EXHIBIT 2.6 Debits and Credits in the Accounting EquationDebit for

increases

Credit for decreases

� �

� �

Debit for decreases

Credit for increases

� �

Debit for decreases

Credit for increases

Assets Liabilities Equity

Normal Normal Normal

2 These abbreviations are remnants of 18th-century English recordkeeping practices where the terms debitor and creditor were used instead of debit and credit. The abbreviations use the first and last letters of these terms, just as we still do for Saint (St.) and Doctor (Dr.).

side. Recall that some transactions affect only one side of the equation, meaning that two or more accounts on one side are affected, but their net effect on this one side is zero. Second, the left side is the normal balance side for assets, and the right side is the normal balance side for liabilities and equity. This matches their layout in the accounting equation where assets are on the left side of this equation, and liabilities and equity are on the right. Recall that equity increases from revenues and stock issuances, and it decreases from ex- penses and dividends. These important equity relations are conveyed by expanding the accounting equation to include debits and credits in double-entry form as shown in Exhibit 2.7. Increases (credits) to common stock and revenues increase equity; increases (debits) to dividends and expenses decrease equity. The normal balance of each account (asset, liability, common stock, dividends, revenue, or expense) refers to the left or right (debit or credit) side

Point: Debits and credits do not mean favorable or unfavorable. A debit to an asset increases it, as does a debit to an expense. A credit to a liability increases it, as does a credit to a revenue.

(Left side) (Right side)

Debit Credit

Account Title

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58 Chapter 2 Analyzing and Recording Transactions

where increases are recorded. Understanding these diagrams and rules is required to prepare, analyze, and interpret financial statements. The T-account for FastForward’s Cash account, reflecting its first 11 transactions (from Exhibit 1.9), is shown in Exhibit 2.8. The total increases in its Cash account are $36,100, the total decreases are $31,300, and the account’s debit balance is $4,800. (We illustrate use of T-accounts later in this chapter.)

2

5 1 2 1 2 Dr. for

increases Cr. for

decreases

Assets Liabilities Dividends Revenues ExpensesCommon Stock

1 12 12 2 12 21

Dr. for decreases

Cr. for increases

1

Dr. for increases

Cr. for decreases

Dr. for decreases

Cr. for increases

Dr. for increases

Cr. for decreases

Dr. for decreases

Cr. for increases

Equity

Normal Normal Normal Normal Normal Normal

EXHIBIT 2.7 Debit and Credit Effects for Component Accounts

Point: The ending balance is on the side with the larger dollar amount. Also, a plus (1) and minus (2) are not used in a T-account.

EXHIBIT 2.8 Computing the Balance for a T-Account

Cash

Receive investment by owner for stock 30,000 Purchase of supplies 2,500

Consulting services revenue earned 4,200 Purchase of equipment 26,000

Collection of account receivable 1,900 Payment of rent 1,000

Payment of salary 700

Payment of account payable 900

Payment of cash dividend 200

Balance 4,800

1. Identify examples of accounting source documents. 2. Explain the importance of source documents. 3. Identify each of the following as either an asset, a liability, or equity: (a) Prepaid Rent,

(b) Unearned Fees, (c) Building, (d) Wages Payable, and (e) Office Supplies. 4. What is an account? What is a ledger? 5. What determines the number and types of accounts a company uses? 6. Does debit always mean increase and credit always mean decrease? 7. Describe a chart of accounts.

Quick Check Answers — p. 77

Journalizing and Posting Transactions Processing transactions is a crucial part of accounting. The four usual steps of this process are depicted in Exhibit 2.9. Steps 1 and 2 — involving transaction analysis and the accounting equation— were introduced in prior sections. This section extends that discussion and focuses on steps 3 and 4 of the accounting process. Step 3 is to record each transaction chronologically in a journal. A journal gives a complete record of each transaction in one place. It also shows debits and credits for each transaction. The process of recording transactions in a journal is called journalizing. Step 4 is to transfer (or post) entries from the journal to the ledger. The process of transferring journal entry information to the ledger is called posting.

Journalizing Transactions The process of journalizing transactions requires an under- standing of a journal. While companies can use various journals, every company uses a general journal. It can be used to record any transaction and includes the following information about each transaction: a date of transaction, b titles of affected accounts, c dollar amount of each

P1 Record transactions in a journal and post entries to a ledger.

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Chapter 2 Analyzing and Recording Transactions 59

debit and credit, and d explanation of the transaction. Exhibit 2.10 shows how the first two trans- actions of FastForward are recorded in a general journal. This process is similar for manual and computerized systems. Computerized journals are often designed to look like a manual journal page, and also include error-checking routines that ensure debits equal credits for each entry. Shortcuts allow recordkeepers to select account names and numbers from pull-down menus.

EXHIBIT 2.10 Partial General Journal for FastForward

Dec. 1

Dec. 2

Cash

Cash

Common Stock Receive investment by owner.

Purchase supplies for cash.

Supplies

Account Titles and Explanation PRDate

30,000

2,500

Debit

30,000

2,500

Credit

2013 a

b

d

c

General Journal

To record entries in a general journal, apply these steps; refer to the entries in Exhibit 2.10 when reviewing these steps.

a. Date the transaction: Enter the year at the top of the first column and the month and day on the first line of each journal entry.

b. Enter titles of accounts debited and then enter amounts in the Debit column on the same line. Account titles are taken from the chart of accounts and are aligned with the left margin of the Account Titles and Explanation column.

c. Enter titles of accounts credited and then enter amounts in the Credit column on the same line. Account titles are from the chart of accounts and are indented from the left margin of the Account Titles and Explanation column to distinguish them from debited accounts.

d. Enter a brief explanation of the transaction on the line below the entry (it often references a source document). This explanation is indented about half as far as the credited account titles to avoid confusing it with accounts, and it is italicized.

Point: There are no exact rules for writing journal entry explanations. An explanation should be short yet describe why an entry is made.

Services Contract

Step 3: Record journal entry.

Dec. 1 30,000 30,000

Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Step 1: Identify transactions and source documents.

Deposit

TOTAL

30,0001

t

Step 4: Post entry to ledger.

S

Debit for

increase s

1

Credit fo r

decrease s

2

5 1

2 1 Debit for

decrease s

Credit fo r

increase s

2 1 Debit for

decrease s

Credit fo r

increase s

Assets Liabiliti

es Equity

ep 2: Analyze transactions using the accounting equation.

Bank Statement

Client Billing Note Payable

Purchase Ticket

General Journal General Journa

l

Ledger

Assets = Liabilities + Equity

Cas h

EXHIBIT 2.9 Steps in Processing Transactions

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60 Chapter 2 Analyzing and Recording Transactions

A blank line is left between each journal entry for clarity. When a transaction is first recorded, the posting reference (PR) column is left blank (in a manual system). Later, when posting entries to the ledger, the identification numbers of the individual ledger accounts are entered in the PR column.

Point: The fundamental concepts of a manual (pencil-and-paper) system are identical to those of a computerized information system.

The balance column account format is similar to a T-account in having columns for debits and credits. It is different in including transaction date and explanation columns. It also has a column with the balance of the account after each entry is recorded. To illustrate, FastForward’s Cash account in Exhibit 2.11 is debited on December 1 for the $30,000 owner investment, yield- ing a $30,000 debit balance. The account is credited on December 2 for $2,500, yielding a $27,500 debit balance. On December 3, it is credited again, this time for $26,000, and its debit balance is reduced to $1,500. The Cash account is debited for $4,200 on December 10, and its debit balance increases to $5,700; and so on.

Point: Explanations are typically included in ledger accounts only for unusual transactions or events.

EXHIBIT 2.11 Cash Account in Balance Column Format

Dec. 2 Dec. 3 Dec. 10

Dec. 1 2013

G1 G1 G1 G1

30,000

4,200

2,500 26,000

30,000 27,500 1,500 5,700

Date PR Cash

General Ledger

Debit Credit Account No. 101

BalanceExplanation

EXHIBIT 2.12 Posting an Entry to the Ledger

Dec. 1 2013

Cash Common Stock

Receive investment by owner.

Account Titles and Explanation PRDate

30,000

Debit

30,000

Credit

307 101

General Journal

General Ledger

Dec. 1

2013

G1 30,000 30,000

Date PR

Cash

Debit Credit

Account no. 101

BalanceExplanation

Dec. 1

2013

G1 30,000 30,000

Date PR

Common Stock

Debit Credit

Account no. 307

BalanceExplanation

Key: Enter the debit account number from the Ledger in the PR column of the journal.

3

4

1

2

Identify credit account in Ledger: enter date, journal page, amount, and balance. Enter the credit account number from the Ledger in the PR column of the journal.

4

3

1

2

Identify debit account in Ledger: enter date, journal page, amount, and balance.

IFRS IFRS requires that companies report the following four basic financial statements with explanatory notes:

• Balance sheet • Statement of changes in equity (or statement of recognized revenue and expense) • Income statement • Statement of cash flows

IFRS does not prescribe specific formats; and comparative information is required for the preceding period only. ■

Balance Column Account T-accounts are simple and direct means to show how the accounting process works. However, actual accounting systems need more structure and there- fore use balance column accounts, such as that in Exhibit 2.11.

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Chapter 2 Analyzing and Recording Transactions 61

The heading of the Balance column does not show whether it is a debit or credit balance. In- stead, an account is assumed to have a normal balance. Unusual events can sometimes temporarily give an account an abnormal balance. An abnormal balance refers to a balance on the side where decreases are recorded. For example, a customer might mistakenly overpay a bill. This gives that customer’s account receivable an abnormal (credit) balance. An abnormal balance is often identified by circling it or by entering it in red or some other unusual color. A zero bal- ance for an account is usually shown by writing zeros or a dash in the Balance column to avoid confusion between a zero balance and one omitted in error.

Posting Journal Entries Step 4 of processing transactions is to post journal entries to ledger accounts (see Exhibit 2.9). To ensure that the ledger is up-to-date, entries are posted as soon as pos- sible. This might be daily, weekly, or when time permits. All entries must be posted to the ledger before financial statements are prepared to ensure that account balances are up-to-date. When en- tries are posted to the ledger, the debits in journal entries are transferred into ledger accounts as debits, and credits are transferred into ledger accounts as credits. Exhibit 2.12 shows the four steps to post a journal entry. First, identify the ledger account that is debited in the entry; then, in the ledger, enter the entry date, the journal and page in its PR column, the debit amount, and the new balance of the ledger account. (The letter G shows it came from the General Journal.) Second, enter the ledger account number in the PR column of the journal. Steps 3 and 4 repeat the first two steps for credit entries and amounts. The posting process creates a link between the ledger and the journal entry. This link is a useful cross-reference for tracing an amount from one record to another.

Analyzing Transactions — An Illustration We return to the activities of FastForward to show how double-entry accounting is useful in analyz- ing and processing transactions. Analysis of each transaction follows the four steps of Exhibit 2.9.

Step 1 Identify the transaction and any source documents. Step 2 Analyze the transaction using the accounting equation. Step 3 Record the transaction in journal entry form applying double-entry accounting. Step 4 Post the entry (for simplicity, we use T-accounts to represent ledger accounts).

Study each transaction thoroughly before proceeding to the next. The first 11 transactions are from Chapter 1, and we analyze five additional December transactions of FastForward (num- bered 12 through 16) that were omitted earlier.

Point: A journal is often referred to as the book of original entry. The ledger is referred to as the book of final entry because financial statements are pre- pared from it.

Point: In the Demonstration Problem at the chapter end we show how to use “balance column accounts” for the ledger.

Point: Computerized systems often provide a code beside a balance such as dr. or cr. to identify its balance. Posting is automatic and immediate with accounting software.

A1 Analyze the impact of transactions on accounts and financial statements.

FASTForward1. Receive investment by Owner

2 Analyze Assets 5 Liabilities 1 Equity Cash Common Stock 130,000 5 0 130,000

1 Identify FastForward receives $30,000 cash from Chas Taylor in exchange for common stock

3 Record (1) Cash 101 30,000 Common Stock 307 30,000

4 Post

(1) 30,000

Cash 101

(1) 30,000

Common Stock 307

Date Account Titles and Explanation PR Debit Credit

(2) 2,500

Supplies 126

(1) 30,000 (2) 2,500

Cash 101

4 Post

2. Purchase Supplies for Cash

1 Identify FastForward pays $2,500 cash for supplies.

2 Analyze Assets 5 Liabilities 1 Equity Cash Supplies 22,500 12,500 5 0 1 0

Changes the composition of assets but not the total.

3 Record (2) Supplies 126 2,500 Cash 101 2,500

Date Account Titles and Explanation PR Debit Credit

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62 Chapter 2 Analyzing and Recording Transactions

4. Purchase Supplies on Credit

1 Identify FastForward purchases $7,100 of supplies on credit from a supplier.

3 Record (4) Supplies 126 7,100 Accounts Payable 201 7,100

(4) 7,100

Accounts Payable 201

4 Post

(2) 2,500

(4) 7,100

Supplies 126

2 Analyze Assets 5 Liabilities 1 Equity Supplies Accounts

Payable 17,100 5 17,100 1 0

Date Account Titles and Explanation PR Debit Credit

5. Provide Services for Cash

1 Identify FastForward provides consulting services and immediately collects $4,200 cash.

2 Analyze Assets 5 Liabilities 1 Equity Cash Consulting Revenue 14,200 5 0 14,200

3 Record (5) Cash 101 4,200 Consulting Revenue 403 4,200

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

Cash 101

(5) 4,200

Consulting Revenue 403

4 Post

Date Account Titles and Explanation PR Debit Credit

3. Purchase Equipment for Cash

1 Identify FastForward pays $26,000 cash for equipment.

Changes the composition of assets but not the total.

3 Record (3) Equipment 167 26,000 Cash 101 26,000

(3) 26,000

Equipment 167 4 Post

(1) 30,000 (2) 2,500

(3) 26,000

Cash 101

2 Analyze Assets 5 Liabilities 1 Equity Cash Equipment

226,000 126,000 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

6. Payment of Expense in Cash

1 Identify FastForward pays $1,000 cash for December rent.

2 Analyze Assets 5 Liabilities 1 Equity Cash Rent Expense 21,000 5 0 21,000

3 Record (6) Rent Expense 640 1,000 Cash 101 1,000

4 Post

(6) 1,000

Rent Expense 640

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(6) 1,000

Cash 101 Date Account Titles and Explanation PR Debit Credit

Point: Salary usually refers to compensation for an employee who receives a fixed amount for a given time period, whereas wages usually refers to compensation based on time worked.

7. Payment of Expense in Cash

1 Identify FastForward pays $700 cash for employee salary.

2 Analyze Assets 5 Liabilities 1 Equity Cash Salaries Expense 2700 5 0 2700

3 Record (7) Salaries Expense 622 700 Cash 101 700

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(6) 1,000

(7) 700

Cash 101

(7) 700

Salaries Expense 622 4 Post

Date Account Titles and Explanation PR Debit Credit

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Chapter 2 Analyzing and Recording Transactions 63

3 Record (11) Dividends 319 200 Cash 101 200

Date Account Titles and Explanation PR Debit Credit

11. Payment of Cash Dividend

1 Identify FastForward pays $200 cash for dividends.

2 Analyze

4 Post

(11) 200

Dividends 319

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(7) 700

(10) 900

(11) 200

Cash 101

Assets 5 Liabilities 1 Equity

Cash Dividends 2200 5 0 2200

8. Provide Consulting and Rental Services on Credit

Point: Transaction 8 is a compound journal entry, which affects three or more accounts.

1 Identify FastForward provides consulting services of $1,600 and rents its test facilities for $300. The customer is billed $1,900 for these services.

2 Analyze

3 Record (8) Accounts Receivable 106 1,900 Consulting Revenue 403 1,600

Rental Revenue 406 300

4 Post

(8) 1,900

Accounts Receivable 106

(5) 4,200

(8) 1,600

Consulting Revenue 403

(8) 300

Rental Revenue 406

Assets 5 Liabilities 1 Equity

Accounts Consulting Rental Receivable Revenue Revenue

11,900 5 0 11,600 1300

Date Account Titles and Explanation PR Debit Credit

Point: The revenue recognition principle requires revenue to be recognized when earned, which is when the company provides products and services to a customer. This is not necessarily the same time that the customer pays. A customer can pay before or after products or services are provided.

9. Receipt of Cash on Account

1 Identify FastForward receives $1,900 cash from the client billed in transaction 8.

2 Analyze

3 Record (9) Cash 101 1,900 Accounts Receivable 106 1,900

4 Post

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(7) 700

Cash 101

(8) 1,900 (9) 1,900

Accounts Receivable 106

Assets 5 Liabilities 1 Equity

Accounts Cash Receivable

11,900 21,900 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

10. Partial Payment of Accounts Payable

1 Identify FastForward pays CalTech Supply $900 cash toward the payable of transaction 4.

2 Analyze

3 Record (10) Accounts Payable 201 900 Cash 101 900

4 Post

(10) 900 (4) 7,100

Accounts Payable 201

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(7) 700

(10) 900

Cash 101

Assets 5 Liabilities 1 Equity

Cash Accounts Payable 2900 5 2900 1 0

Date Account Titles and Explanation PR Debit Credit

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64 Chapter 2 Analyzing and Recording Transactions

Point: Luca Pacioli, a 15th-century monk, is considered a pioneer in accounting and the first to devise double-entry accounting.

12. Receipt of Cash for Future Services

1 Identify FastForward receives $3,000 cash in advance of providing consulting services to a customer.

2 Analyze

Accepting $3,000 cash obligates FastForward to perform future services and is a liability. No revenue is earned until services are provided.

3 Record (12) Cash 101 3,000 Unearned Consulting

Revenue 236 3,000 (12) 3,000

Unearned Consulting Revenue 236

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

Cash 101 4 Post

Assets 5 Liabilities 1 Equity

Unearned Cash Consulting Revenue

13,000 5 13,000 1 0

Date Account Titles and Explanation PR Debit Credit

13. Pay Cash for Future Insurance Coverage

1 Identify FastForward pays $2,400 cash (insurance premium) for a 24-month insurance policy. Coverage begins on December 1.

2 Analyze

Changes the composition of assets from cash to prepaid insurance. Expense is incurred as insur- ance coverage expires.

3 Record (13) Prepaid Insurance 128 2,400 Cash 101 2,400

(13) 2,400

Prepaid Insurance 128

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

Cash 101

4 Post

Assets 5 Liabilities 1 Equity

Prepaid Cash Insurance

22,400 12,400 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

14. Purchase Supplies for Cash

1 Identify FastForward pays $120 cash for supplies.

2 Analyze

3 Record (14) Supplies 126 120 Cash 101 120

(2) 2,500

(4) 7,100

(14) 120

Supplies 126

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

Cash 101

4 Post

Assets 5 Liabilities 1 Equity

Cash Supplies 2120 1120 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

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Chapter 2 Analyzing and Recording Transactions 65

Accounting Equation Analysis Exhibit 2.13 shows the ledger accounts (in T-account form) of FastForward after all 16 transac- tions are recorded and posted and the balances computed. The accounts are grouped into three major columns corresponding to the accounting equation: assets, liabilities, and equity. Note several important points. First, as with each transaction, the totals for the three columns must obey the accounting equation. Specifically, assets equal $42,470 ($4,350 1 $0 1 $9,720 1 $2,400 1 $26,000); liabilities equal $9,200 ($6,200 1 $3,000); and equity equals $33,270 ($30,000 2 $200 1 $5,800 1 $300 2 $1,400 2 $1,000 2 $230). These numbers prove the ac- counting equation: Assets of $42,470 5 Liabilities of $9,200 1 Equity of $33,270. Second, the common stock, dividends, revenue, and expense accounts reflect the transactions that change equity. The latter three account categories underlie the statement of retained earnings. Third, the revenue and expense account balances will be summarized and reported in the income state- ment. Fourth, increases and decreases in the cash account make up the elements reported in the statement of cash flows.

Point: Technology does not provide the judgment required to analyze most business transactions. Analysis requires the expertise of skilled and ethical professionals.

Debit and Credit Rules Increase Accounts (normal bal.) Decrease

Asset . . . . . . . . . . . . . Debit Credit

Liability . . . . . . . . . . . Credit Debit

Common Stock . . . . . Credit Debit

Dividends . . . . . . . . . Debit Credit

Revenue . . . . . . . . . . Credit Debit

Expense . . . . . . . . . . . Debit Credit

15. Payment of Expense in Cash

1 Identify FastForward pays $230 cash for December utili- ties expense.

3 Record (15) Utilities Expense 690 230 Cash 101 230

(15) 230

Utilities Expense 690

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 230

Cash 101

4 Post

2 Analyze Assets 5 Liabilities 1 Equity Utilities Cash Expense 2230 5 0 2230

Date Account Titles and Explanation PR Debit Credit

16. Payment of Expense in Cash

2 Analyze Assets 5 Liabilities 1 Equity Cash Salaries Expense 2700 5 0 2700

1 Identify FastForward pays $700 cash in employee salary for work performed in the latter part of December.

Point: We could merge transactions 15 and 16 into one compound entry.

3 Record (16) Salaries Expense 622 700 Cash 101 700

(7) 700

(16) 700

Salaries Expense 622

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 230

(16) 700

Cash 101

4 Post

Date Account Titles and Explanation PR Debit Credit

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66 Chapter 2 Analyzing and Recording Transactions

8. What types of transactions increase equity? What types decrease equity? 9. Why are accounting systems called double-entry? 10. For each transaction, double-entry accounting requires which of the following? (a) Debits

to asset accounts must create credits to liability or equity accounts, (b) a debit to a liability account must create a credit to an asset account, or (c) total debits must equal total credits.

11. An owner invests $15,000 cash along with equipment having a market value of $23,000 in a company in exchange for common stock. Prepare the necessary journal entry.

12. Explain what a compound journal entry is. 13. Why are posting reference numbers entered in the journal when entries are posted to ledger

accounts?

Quick Check Answers — p. 77

EXHIBIT 2.13 Ledger for FastForward (in T-Account Form)

Assets 5 Liabilities 1 Equity

$42,470 5 $9,200 1 $33,270

Cash 101

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 230

(16) 700

Balance 4,350

Accounts Receivable 106

(8) 1,900 (9) 1,900

Balance 0

Supplies 126

(2) 2,500

(4) 7,100

(14) 120

Balance 9,720

Prepaid Insurance 128

(13) 2,400

Equipment 167

(3) 26,000

Accounts Payable 201

(10) 900 (4) 7,100

Balance 6,200

Common Stock 307

(1) 30,000

Dividends 319

(11) 200

Consulting Revenue 403

(5) 4,200

(8) 1,600

Balance 5,800

Rental Revenue 406

(8) 300

Rent Expense 640

(6) 1,000

Utilities Expense 690

(15) 230

Accounts in this white area reflect those reported on the income statement.

Salaries Expense 622

(7) 700

(16) 700

Balance 1,400

Unearned Consulting Revenue 236

(12) 3,000

General Ledger

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Chapter 2 Analyzing and Recording Transactions 67

Double-entry accounting requires the sum of debit account balances to equal the sum of credit account balances. A trial balance is used to confirm this. A trial balance is a list of accounts and their balances at a point in time. Account balances are reported in their appropriate debit or credit columns of a trial balance. A trial balance can be used to confirm this and to follow up on any abnormal or unusual balances. Exhibit 2.14 shows the trial balance for FastForward after its 16 entries have been posted to the ledger. (This is an unadjusted trial balance — Chapter 3 ex- plains the necessary adjustments.)

TRIAL BALANCE

Preparing a Trial Balance Preparing a trial balance involves three steps:

1. List each account title and its amount (from ledger) in the trial balance. If an account has a zero balance, list it with a zero in its normal balance column (or omit it entirely).

2. Compute the total of debit balances and the total of credit balances. 3. Verify ( prove) total debit balances equal total credit balances.

The total of debit balances equals the total of credit balances for the trial balance in Exhibit 2.14. Equality of these two totals does not guarantee that no errors were made. For example, the column totals still will be equal when a debit or credit of a correct amount is made to a wrong account. Another error that does not cause unequal column totals occurs when equal debits and credits of an incorrect amount are entered.

Searching for and Correcting Errors If the trial balance does not balance (when its columns are not equal), the error (or errors) must be found and corrected. An efficient way to search for an error is to check the journalizing, posting, and trial balance preparation

Point: A trial balance is not a financial statement but a mechanism for checking equality of debits and credits in the ledger. Financial statements do not have debit and credit columns.

Point: The ordering of accounts in a trial balance typically follows their identification number from the chart of accounts.

EXHIBIT 2.14 Trial Balance (Unadjusted)

Cash

Accounts receivable

Supplies

Prepaid insurance

Equipment

Accounts payable

Unearned consulting revenue

Common stock

Dividends

Consulting revenue

Rental revenue

Salaries expense

Rent expense

Utilities expense

45,300

6,200

3,000

30,000

5,800

300

FASTFORWARD Trial Balance

December 31, 2013

Debit Credit

Totals

$

4,350

0

9,720

2,400

26,000

200

1,400

1,000

230

45,300$

$

$

P2 Prepare and explain the use of a trial balance.

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68 Chapter 2 Analyzing and Recording Transactions

in reverse order. Step 1 is to verify that the trial balance columns are correctly added. If step 1 fails to find the error, step 2 is to verify that account balances are accurately entered from the ledger. Step 3 is to see whether a debit (or credit) balance is mistakenly listed in the trial balance as a credit (or debit). A clue to this error is when the difference between total debits and total credits equals twice the amount of the incorrect account balance. If the error is still undiscovered, Step 4 is to recompute each account balance in the ledger. Step 5 is to verify that each journal entry is properly posted. Step 6 is to verify that the original journal entry has equal debits and credits. At this point, the errors should be uncovered.3

If an error in a journal entry is discovered before the error is posted, it can be corrected in a manual system by drawing a line through the incorrect information. The correct information is written above it to create a record of change for the auditor. Many computerized systems allow the operator to replace the incorrect information directly. If an error in a journal entry is not discovered until after it is posted, we do not strike through both erroneous entries in the journal and ledger. Instead, we correct this error by creating a cor- recting entry that removes the amount from the wrong account and records it to the correct ac- count. As an example, suppose a $100 purchase of supplies is journalized with an incorrect debit to Equipment, and then this incorrect entry is posted to the ledger. The Supplies ledger account balance is understated by $100, and the Equipment ledger account balance is overstated by $100. The correcting entry is: debit Supplies and credit Equipment (both for $100).

Using a Trial Balance to Prepare Financial Statements This section shows how to prepare financial statements from the trial balance in Exhibit 2.14 and from information on the December transactions of FastForward. These statements differ from those in Chapter 1 because of several additional transactions. These statements are also more precisely called unadjusted statements because we need to make some further accounting adjust- ments (described in Chapter 3).

How financial statements are linked in time is illustrated in Exhibit 2.15. A balance sheet reports on an organiza- tion’s financial position at a point in time. The income statement, statement of retained earnings, and statement of cash flows report on financial perfor- mance over a period of time. The three statements in the middle column of Ex- hibit 2.15 link balance sheets from the beginning to the end of a reporting pe- riod. They explain how financial posi- tion changes from one point to another.

Preparers and users (including regu- latory agencies) determine the length of the reporting period. A one-year, or annual, reporting period is common, as are semiannual, quarterly, and monthly periods. The one-year reporting period

Example: If a credit to Unearned Revenue was incorrectly posted from the journal as a credit to the Revenue ledger account, would the ledger still balance? Would the financial statements be correct? Answers: The ledger would balance, but liabilities would be under- stated, equity would be overstated, and income would be overstated (all because of overstated revenues).

Point: The IRS requires companies to keep records that can be audited.

3 Transposition occurs when two digits are switched, or transposed, within a number. If transposition is the only error, it yields a difference between the two trial balance totals that is evenly divisible by 9. For example, assume that a $691 debit in an entry is incorrectly posted to the ledger as $619. Total credits in the trial balance are then larger than total debits by $72 ($691 2 $619). The $72 error is evenly divisible by 9 (72y9 5 8). The first digit of the quotient (in our example it is 8) equals the difference between the digits of the two transposed numbers (the 9 and the 1). The number of digits in the quotient also tells the location of the transposition, starting from the right. The quotient in our example had only one digit (8), so it tells us the transposition is in the first digit. Consider another example where a transposi- tion error involves posting $961 instead of the correct $691. The difference in these numbers is $270, and its quotient is 30 (270y9). The quotient has two digits, so it tells us to check the second digit from the right for a transposition of two numbers that have a difference of 3.

EXHIBIT 2.15 Links between Financial Statements across Time

Point in time Point in timePeriod of time

Beginning balance sheet

Ending balance sheet

Income statement

Statement of retained earnings

Statement of cash flows

P3 Prepare financial statements from business transactions.

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Chapter 2 Analyzing and Recording Transactions 69

FASTFORWARD Balance Sheet

December 31, 2013

Assets Liabilities

Cash . . . . . . . . . . . . $ 4,350 Accounts payable . . . . . . . . $ 6,200

Supplies . . . . . . . . . . 9,720 Unearned revenue . . . . . . . 3,000

Prepaid insurance . . 2,400 Total liabilities . . . . . . . . . . . 9,200

Equipment . . . . . . . 26,000 Equity

Common stock . . . . . . . . . . 30,000

Retained earnings . . . . . . . . 3,270

Total equity . . . . . . . . . . . . . 33,270

Total assets . . . . . . . $42,470 Total liabilities and equity . . $42,470

is known as the accounting, or fiscal, year. Businesses whose accounting year begins on January 1 and ends on December 31 are known as calendar-year companies. Polaris is a calendar-year company. Many companies choose a fiscal year ending on a date other than December 31. Arctic Cat is a noncalendar-year company as reflected in the headings of its March 31 year-end financial statements in Appendix A near the end of the book.

Income Statement An income statement reports the revenues earned less the expenses incurred by a business over a period of time. FastForward’s income statement for December is shown at the top of Exhibit 2.16. Information about revenues and expenses is conveniently taken from the trial balance in Exhibit 2.14. Net income of $3,470 is reported at the bottom of the statement. Owner investments and dividends are not part of income.

Statement of Retained Earnings The statement of retained earnings reports informa- tion about how retained earnings change over the reporting period. FastForward’s statement of retained earnings is the second report in Exhibit 2.16. It shows the $3,470 of net income, the

Point: A statement’s heading lists the 3 W’s: Who — name of organization, What — name of statement, When — statement’s point in time or period of time.

Point: Arrow lines show how the statements are linked.

Point: To foot a column of numbers is to add them.

EXHIBIT 2.16 Financial Statements and Their Links

FASTFORWARD Income Statement

For Month Ended December 31, 2013

Revenues Consulting revenue ($4,200 1 $1,600) . . . . . . . . . $ 5,800

Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,630

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,470

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2013

Retained earnings, December 1, 2013 . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,470

3,470

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . 200

Retained earnings, December 31, 2013 . . . . . . . . . . . $ 3,270

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70 Chapter 2 Analyzing and Recording Transactions

$200 dividend, and the $3,270 end-of-period balance. (The beginning balance in the statement of retained earnings is rarely zero; an exception is for the first period of operations. The begin- ning balance in January 2014 is $3,270, which is December’s ending balance.)

Balance Sheet The balance sheet reports the financial position of a company at a point in time, usually at the end of a month, quarter, or year. FastForward’s balance sheet is the third report in Exhibit 2.16. This statement refers to financial condition at the close of business on December 31. The left side of the balance sheet lists its assets: cash, supplies, prepaid insur- ance, and equipment. The upper right side of the balance sheet shows that it owes $6,200 to creditors and $3,000 in services to customers who paid in advance. The equity section shows an ending balance of $33,270. Note the link between the ending balance of the statement of retained earnings and the retained earnings balance. (Recall that this presentation of the bal- ance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity. Either presentation is acceptable.)

14. Where are dollar signs typically entered in financial statements? 15. If a $4,000 debit to Equipment in a journal entry is incorrectly posted to the ledger as a

$4,000 credit, and the ledger account has a resulting debit balance of $20,000, what is the effect of this error on the Trial Balance column totals?

16. Describe the link between the income statement and the statement of retained earnings. 17. Explain the link between the balance sheet and the statement of retained earnings. 18. Define and describe revenues and expenses. 19. Define and describe assets, liabilities, and equity.

Quick Check Answers — p. 77

Presentation Issues Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports such as trial balances. The usual practice is to put dollar signs beside only the first and last numbers in a column. Polaris’s financial statements in Ap- pendix A show this. When amounts are entered in a journal, ledger, or trial balance, commas are optional to indicate thousands, millions, and so forth. However, commas are always used in fi- nancial statements. Companies also commonly round amounts in reports to the nearest dollar, or even to a higher level. Polaris is typical of many companies in that it rounds its financial state- ment amounts to the nearest thousand (or million). This decision is based on the perceived im- pact of rounding for users’ business decisions.

Point: Knowing how financial statements are prepared improves our analysis of them.

Point: An income statement is also called an earnings statement, a statement of operations, or a P&L (profit and loss) statement. A balance sheet is also called a statement of financial position.

Point: While revenues increase equity, and expenses decrease equity, the amounts are not reported in detail in the statement of retained earnings. In- stead, their effects are reflected through net income.

Financial accounting according to U.S. GAAP is similar, but not identical, to IFRS. This section discusses differences in analyzing and recording transactions, and with the preparation of financial statements.

Analyzing and Recording Transactions Both U.S. GAAP and IFRS include broad and similar guidance for financial accounting. As the FASB and IASB work toward a common conceptual framework over the next few years, even those differences will fade. Further, both U.S. GAAP and IFRS apply transaction

GLOBAL VIEW

Entrepreneur You open a wholesale business selling entertainment equipment to retail outlets. You find that most of your customers demand to buy on credit. How can you use the balance sheets of these customers to decide which ones to extend credit to? ■ [Answer—p. 76]

Decision Maker

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Chapter 2 Analyzing and Recording Transactions 71

Decision AnalysisDebt Ratio

analysis and recording as shown in this chapter—using the same debit and credit system and accrual account- ing. Although some variations exist in revenue and expense recognition and other accounting principles, all of the transactions in this chapter are accounted for identically under these two systems.

Financial Statements Both U.S. GAAP and IFRS prepare the same four basic financial state- ments. A few differences within each statement do exist and we will discuss those throughout the book. For example, both U.S. GAAP and IFRS require balance sheets to separate current items from noncurrent items. However, while U.S. GAAP balance sheets report current items first, IFRS balance sheets normally (but are not required to) present noncurrent items first, and equity before liabilities. To illustrate, a con- densed version of Piaggio’s balance sheet follows (numbers using Euros in thousands).

PIAGGIO Balance Sheet (in thousands of Euros)

December 31, 2011

Assets Equity and Liabilities

Noncurrent assets . . . . . . . . 1,010,476 Total equity . . . . . . . . . . . . . . . . . . . 446,218

Current assets . . . . . . . . . . . . 509,708 Noncurrent liabilities . . . . . . . . . . . . 429,689

Current liabilities . . . . . . . . . . . . . . . 644,277

Total assets . . . . . . . . . . . . . . 1,520,184 Total equity and liabilities . . . . . . . . 1,520,184

Accounting Controls and Assurance Accounting systems depend on control procedures that assure the proper principles were applied in processing accounting information. The passage of SOX leg- islation strengthened U.S. control procedures in recent years. However, global standards for control are diverse and so are enforcement activities. Consequently, while global accounting standards are converg- ing, their application in different countries can yield different outcomes depending on the quality of their auditing standards and enforcement.

A2 Compute the debt ratio and describe its use in analyzing financial condition.

An important business objective is gathering information to help assess a company’s risk of failing to pay its debts. Companies finance their assets with either liabilities or equity. A company that finances a rela- tively large portion of its assets with liabilities is said to have a high degree of financial leverage. Higher financial leverage involves greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). The risk that a company might not be able to meet such required payments is higher if it has more liabilities (is more highly leveraged). One way to assess the risk associ- ated with a company’s use of liabilities is to compute the debt ratio as in Exhibit 2.17.

Debt ratio 5 Total liabilities

Total assets

EXHIBIT 2.17 Debt Ratio

Accounting Control Recording valid transactions, and not recording fraudulent transactions, enhances the quality of financial statements. The graph here shows the percentage of employ- ees in  information technology that report observing specific types of misconduct within the past year [Source: KPMG 2009]. ■

Percent Citing Misconduct

0% 10% 30%20%

Breaching database controls 23%

Mishandling private information 22%

Breaching customer privacy 16%

Falsifying accounting data 9%

Decision Insight

PIAGGIO

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72 Chapter 2 Analyzing and Recording Transactions

To see how to apply the debt ratio, let’s look at Skechers’s liabilities and assets. The company designs, markets, and sells footwear for men, women, and children under the Skechers brand. Exhibit 2.18 com- putes and reports its debt ratio at the end of each year from 2006 to 2011.

Point: Compare the equity amount to the liability amount to assess the extent of owner versus nonowner financing.

Skechers’s debt ratio ranges from a low of 0.23 to a high of 0.39—also, see graph in margin. Its ratio is lower, compared with the industry ratio. This analysis implies a low risk from its financial leverage. Is financial leverage good or bad for Skechers? To answer that question we need to compare the com- pany’s return on the borrowed money to the rate it is paying creditors. If the company’s return is higher, it is successfully borrowing money to make more money. A company’s success with making money from borrowed money can quickly turn unprofitable if its own return drops below the rate it is paying creditors.

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

$ in millions 2011 2010 2009 2008 2007 2006

Total liabilities . . . . . . . . . . . . $ 389 $ 359 $246 $204 $201 $288

Total assets . . . . . . . . . . . . . . $1,282 $1,305 $996 $876 $828 $737

Debt ratio . . . . . . . . . . . . . 0.30 0.28 0.25 0.23 0.24 0.39

Industry debt ratio . . . . . . . . 0.47 0.49 0.51 0.50 0.46 0.48

Liabilities($)Skechers: Assets($) Debt ratio(%)

$0 2008200920102011 2007 2006

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$1000 $1100 $1200

$1300

$900 00

15%

0.0%

30%

45%

$800

(This problem extends the demonstration problem of Chapter 1.) After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred dur- ing its first month.

a. On August 1, Worthy invested $3,000 cash and $15,000 of equipment in Expressions in exchange for common stock.

b. On August 2, Expressions paid $600 cash for furniture for the shop. c. On August 3, Expressions paid $500 cash to rent space in a strip mall for August. d. On August 4, it purchased $1,200 of equipment on credit for the shop (using a long-term note payable). e. On August 5, Expressions opened for business. Cash received from haircutting services in the first week

and a half of business (ended August 15) was $825. f. On August 15, it provided $100 of haircutting services on account. g. On August 17, it received a $100 check for services previously rendered on account. h. On August 17, it paid $125 to an assistant for hours worked during the grand opening. i. Cash received from services provided during the second half of August was $930. j. On August 31, it paid a $400 installment toward principal on the note payable entered into on August 4. k. On August 31, it paid $900 cash in dividends to Worthy (sole shareholder).

Required

1. Open the following ledger accounts in balance column format (account numbers are in parentheses): Cash (101); Accounts Receivable (102); Furniture (161); Store Equipment (165); Note Payable (240); Common Stock (307); Dividends (319); Haircutting Services Revenue (403); Wages Expense (623); and Rent Expense (640). Prepare general journal entries for the transactions.

2. Post the journal entries from (1) to the ledger accounts.

DEMONSTRATION PROBLEM

Investor You consider buying stock in Converse. As part of your analysis, you compute its debt ratio for 2011, 2012, and 2013 as: 0.35, 0.74, and 0.94, respectively. Based on the debt ratio, is Converse a low-risk investment? Has the risk of buying Converse stock changed over this period? (The industry debt ratio aver- ages 0.40.) ■ [Answer—p. 76]

Decision Maker

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Chapter 2 Analyzing and Recording Transactions 73

3. Prepare a trial balance as of August 31. 4. Prepare an income statement for August. 5. Prepare a statement of retained earnings for August. 6. Prepare a balance sheet as of August 31. 7. Determine the debt ratio as of August 31.

Extended Analysis

8. In the coming months, Expressions will experience a greater variety of business transactions. Identify which accounts are debited and which are credited for the following transactions. (Hint: We must use some accounts not opened in part 1.)

a. Purchase supplies with cash. b. Pay cash for future insurance coverage. c. Receive cash for services to be provided in the future. d. Purchase supplies on account.

PLANNING THE SOLUTION ● Analyze each transaction and use the debit and credit rules to prepare a journal entry for each. ● Post each debit and each credit from journal entries to their ledger accounts and cross-reference each

amount in the posting reference (PR) columns of the journal and ledger. ● Calculate each account balance and list the accounts with their balances on a trial balance. ● Verify that total debits in the trial balance equal total credits. ● To prepare the income statement, identify revenues and expenses. List those items on the statement,

compute the difference, and label the result as net income or net loss. ● Use information in the ledger to prepare the statement of retained earnings. ● Use information in the ledger to prepare the balance sheet. ● Calculate the debt ratio by dividing total liabilities by total assets. ● Analyze the future transactions to identify the accounts affected and apply debit and credit rules.

SOLUTION TO DEMONSTRATION PROBLEM 1. General journal entries:

Aug. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 3,000

Store Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 15,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 18,000

Owner’s investment for stock.

2 Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 600

Purchased furniture for cash.

3 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 500

Paid rent for August.

4 Store Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 1,200

Note Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 1,200

Purchased additional equipment on credit.

15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 825

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . 403 825

Cash receipts from first half of August.

Date Account Titles and Explanation PR Debit Credit Page 1

[continued on next page]

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74 Chapter 2 Analyzing and Recording Transactions

15 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . 403 100

To record revenue for services provided on account.

17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 100

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

To record cash received as payment on account.

17 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623 125

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 125

Paid wages to assistant.

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 930

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . 403 930

Cash receipts from second half of August.

31 Note Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 400

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 400

Paid an installment on the note payable.

31 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 900

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 900

Paid cash dividend.

[continued from previous page]

2. Post journal entries from part 1 to the ledger accounts:

Cash Account No. 101

Date PR Debit Credit Balance

Aug. 1 G1 3,000 3,000

2 G1 600 2,400

3 G1 500 1,900

15 G1 825 2,725

17 G1 100 2,825

17 G1 125 2,700

31 G1 930 3,630

31 G1 400 3,230

31 G1 900 2,330

Accounts Receivable Account No. 102

Date PR Debit Credit Balance

Aug. 15 G1 100 100

17 G1 100 0

Furniture Account No. 161

Date PR Debit Credit Balance

Aug. 2 G1 600 600

Store Equipment Account No. 165

Date PR Debit Credit Balance

Aug. 1 G1 15,000 15,000

4 G1 1,200 16,200

Note Payable Account No. 240

Date PR Debit Credit Balance

Aug. 4 G1 1,200 1,200 31 G1 400 800

Common Stock Account No. 307

Date PR Debit Credit Balance

Aug. 1 G1 18,000 18,000

Dividends Account No. 319

Date PR Debit Credit Balance

Aug. 31 G1 900 900

Haircutting Services Revenue Account No. 403

Date PR Debit Credit Balance

Aug. 15 G1 825 825 15 G1 100 925 31 G1 930 1,855

Wages Expense Account No. 623

Date PR Debit Credit Balance

Aug. 17 G1 125 125

Rent Expense Account No. 640

Date PR Debit Credit Balance

Aug. 3 G1 500 500

General Ledger

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Chapter 2 Analyzing and Recording Transactions 75

3. Prepare a trial balance from the ledger:

EXPRESSIONS Trial Balance

August 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,330

Accounts receivable . . . . . . . . . . . . . . . 0

Furniture . . . . . . . . . . . . . . . . . . . . . . . . 600

Store equipment . . . . . . . . . . . . . . . . . . 16,200

Note payable . . . . . . . . . . . . . . . . . . . . $ 800

Common stock . . . . . . . . . . . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . 900

Haircutting services revenue . . . . . . . . 1,855

Wages expense . . . . . . . . . . . . . . . . . . . 125

Rent expense . . . . . . . . . . . . . . . . . . . . 500

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . $20,655 $20,655

EXPRESSIONS Income Statement

For Month Ended August 31

Revenues

Haircutting services revenue . . . . . . . . $1,855

Operating expenses

Rent expense . . . . . . . . . . . . . . . . . . . . $500

Wages expense . . . . . . . . . . . . . . . . . . . 125

Total operating expenses . . . . . . . . . . . 625

Net income . . . . . . . . . . . . . . . . . . . . . . . . $1,230

4.

5.

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1 . . . . . . . . . . $ 0 Plus: Net income . . . . . . . . . . . . . . . . . 1,230

1,230 Less: Cash dividends . . . . . . . . . . . . . . 900

Retained earnings, August 31 . . . . . . . . . $ 330

6.

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities

Cash . . . . . . . . . . . . . . . . . . $ 2,330 Note payable . . . . . . . . . . . . . . . . . . $ 800

Furniture . . . . . . . . . . . . . . . 600 Equity

Store equipment . . . . . . . . . 16,200 Common stock . . . . . . . . . . . . . . . . . 18,000

Retained earnings . . . . . . . . . . . . . . . 330

Total equity . . . . . . . . . . . . . . . . . . . . 18,330

Total assets . . . . . . . . . . . . . $19,130 Total liabilities and equity . . . . . . . . . $19,130

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76 Chapter 2 Analyzing and Recording Transactions

7. Debt ratio 5

Total liabilities

Total assets 5

$800

$19,130 5 4.18%

8a. Supplies debited 8c. Cash debited Cash credited Unearned Services Revenue credited 8b. Prepaid Insurance debited 8d. Supplies debited Cash credited Accounts Payable credited

C1 Explain the steps in processing transactions and the role of source documents. The accounting process identifies business transactions and events, analyzes and records their effects, and sum- marizes and prepares information useful in making decisions. Trans- actions and events are the starting points in the accounting process. Source documents identify and describe transactions and events. Examples are sales tickets, checks, purchase orders, bills, and bank statements. Source documents provide objective and reliable evi- dence, making information more useful. The effects of transactions and events are recorded in journals. Posting along with a trial bal- ance helps summarize and classify these effects.

C2 Describe an account and its use in recording transactions. An account is a detailed record of increases and decreases in a specific asset, liability, equity, revenue, or expense. Information from accounts is analyzed, summarized, and presented in reports and financial statements for decision makers.

C3 Describe a ledger and a chart of accounts. The ledger (or general ledger) is a record containing all accounts used by a company and their balances. It is referred to as the books. The chart of accounts is a list of all accounts and usually includes an identifi- cation number assigned to each account.

C4 Define debits and credits and explain double-entry account-ing. Debit refers to left, and credit refers to right. Debits in- crease assets, expenses, and dividends while credits decrease them. Credits increase liabilities, common stock, and revenues; debits decrease them. Double-entry accounting means each transaction affects at least two accounts and has at least one debit and one credit. The system for recording debits and credits follows from the accounting equation. The left side of an account is the normal

Summary balance for assets, dividends, and expenses, and the right side is the normal balance for liabilities, common stock, and revenues.

A1 Analyze the impact of transactions on accounts and finan-cial statements. We analyze transactions using concepts of double-entry accounting. This analysis is performed by determining a transaction’s effects on accounts. These effects are recorded in journals and posted to ledgers.

A2 Compute the debt ratio and describe its use in analyzing financial condition. A company’s debt ratio is computed as total liabilities divided by total assets. It reveals how much of the assets are financed by creditor (nonowner) financing. The higher this ratio, the more risk a company faces because liabilities must be repaid at specific dates.

P1 Record transactions in a journal and post entries to a ledger. Transactions are recorded in a journal. Each entry in a journal is posted to the accounts in the ledger. This provides infor- mation that is used to produce financial statements. Balance column accounts are widely used and include columns for debits, credits, and the account balance.

P2 Prepare and explain the use of a trial balance. A trial bal-ance is a list of accounts from the ledger showing their debit or credit balances in separate columns. The trial balance is a sum- mary of the ledger’s contents and is useful in preparing financial statements and in revealing recordkeeping errors.

P3 Prepare financial statements from business transactions. The balance sheet, the statement of retained earnings, the income statement, and the statement of cash flows use data from the trial balance (and other financial statements) for their preparation.

Cashier The advantages to the process proposed by the assistant manager include improved customer service, fewer delays, and less work for you. However, you should have serious concerns about internal control and the potential for fraud. In particular, the assis- tant manager could steal cash and simply enter fewer sales to match the remaining cash. You should reject her suggestion without the manager’s approval. Moreover, you should have an ethical concern about the assistant manager’s suggestion to ignore store policy.

Entrepreneur We can use the accounting equation (Assets 5 Liabilities 1 Equity) to help us identify risky customers to whom we

would likely not want to extend credit. A balance sheet provides amounts for each of these key components. The lower a customer’s equity is relative to liabilities, the less likely you would extend credit. A low equity means the business has little value that does not already have creditor claims to it.

Investor The debt ratio suggests the stock of Converse is of higher risk than normal and that this risk is rising. The average in- dustry ratio of 0.40 further supports this conclusion. The 2013 debt ratio for Converse is twice the industry norm. Also, a debt ratio ap- proaching 1.0 indicates little to no equity.

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 2 Analyzing and Recording Transactions 77

Account (p. 53)

Account balance, or Balance (p. 60)

Balance column account (p. 60)

Chart of accounts (p. 56)

Compound journal entry (p. 63)

Credit (p. 57)

Creditors (p. 54)

Debit (p. 57)

Debt ratio (p. 71)

Dividends (p. 55)

Double-entry accounting (p. 57)

General journal (p. 58)

General ledger (p. 53)

Journal (p. 58)

Journalizing (p. 58)

Posting (p. 58)

Posting reference (PR) column (p. 60)

Source documents (p. 52)

T-accounts (p. 57)

Trial balance (p. 67)

Unearned revenue (p. 55)

Key Terms

1. Examples of source documents are sales tickets, checks, purchase orders, charges to customers, bills from suppliers, employee earnings records, and bank statements.

2. Source documents serve many purposes, including record- keeping and internal control. Source documents, especially if obtained from outside the organization, provide objective and reliable evidence about transactions and their amounts.

3.

Assets a,c,e

Liabilities

b,d

Equity —

4. An account is a record in an accounting system that records and stores the increases and decreases in a specific asset, liability, equity, revenue, or expense. The ledger is a collection of all the accounts of a company.

5. A company’s size and diversity affect the number of accounts in its accounting system. The types of accounts depend on infor- mation the company needs to both effectively operate and re- port its activities in financial statements.

6. No. Debit and credit both can mean increase or decrease. The particular meaning in a circumstance depends on the type of account. For example, a debit increases the balance of asset, dividends, and expense accounts, but it decreases the balance of liability, common stock, and revenue accounts.

7. A chart of accounts is a list of all of a company’s accounts and their identification numbers.

8. Equity is increased by revenues and by owner investments. Equity is decreased by expenses and dividends.

9. The name double-entry is used because all transactions affect at least two accounts. There must be at least one debit in one ac- count and at least one credit in another account.

10. The answer is (c). 11.

12. A compound journal entry affects three or more accounts. 13. Posting reference numbers are entered in the journal when post-

ing to the ledger as a cross-reference that allows the record- keeper or auditor to trace debits and credits from one record to another.

14. At a minimum, dollar signs are placed beside the first and last numbers in a column. It is also common to place dollar signs beside any amount that appears after a ruled line to indicate that an addition or subtraction has occurred.

15. The Equipment account balance is incorrectly reported at $20,000 — it should be $28,000. The effect of this error under- states the trial balance’s Debit column total by $8,000. This results in an $8,000 difference between the column totals.

16. An income statement reports a company’s revenues and ex- penses along with the resulting net income or loss. A statement of retained earnings reports changes in retained earnings, in- cluding that from net income or loss. Both statements report transactions occurring over a period of time.

17. The balance sheet describes a company’s financial position (assets, liabilities, and equity) at a point in time. The retained earnings amount in the balance sheet is obtained from the state- ment of retained earnings.

18. Revenues are inflows of assets in exchange for products or ser- vices provided to customers as part of the main operations of a business. Expenses are outflows or the using up of assets that result from providing products or services to customers.

19. Assets are the resources a business owns or controls that carry expected future benefits. Liabilities are the obligations of a business, representing the claims of others against the assets of a business. Equity reflects the owner’s claims on the assets of the business after deducting liabilities.

Guidance Answers to Quick Checks

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000

Common Stock . . . . . . . . . . . . . . . . . . . . . 38,000

Investment by owner of cash and equipment.

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78 Chapter 2 Analyzing and Recording Transactions

1. Provide the names of two (a) asset accounts, (b) liability accounts, and (c) equity accounts.

2. What is the difference between a note payable and an account payable?

3. Discuss the steps in processing business transactions. 4. What kinds of transactions can be recorded in a general journal? 5. Are debits or credits typically listed first in general journal en-

tries? Are the debits or the credits indented?

6. Should a transaction be recorded first in a journal or the ledger? Why?

7. If assets are valuable resources and asset accounts have debit balances, why do expense accounts also have debit balances?

8. Why does the recordkeeper prepare a trial balance? 9. If an incorrect amount is journalized and posted to the ac-

counts, how should the error be corrected?

10. Identify the four financial statements of a business. 11. What information is reported in a balance sheet? 12. What information is reported in an income statement?

13. Why does the user of an income statement need to know the time period that it covers?

14. Define (a) assets, (b) liabilities, (c) equity, and (d ) net assets. 15. Which financial statement is sometimes called the statement of

financial position? 16. Review the Polaris balance sheet in Appen-

dix A. Identify three accounts on its balance sheet that carry debit balances and three accounts on its bal- ance sheet that carry credit balances.

17. Review the Arctic Cat balance sheet in Appen- dix A. Identify an asset with the word receivable in its account title and a liability with the word payable in its account title.

18. Locate KTM’s income statement in Appendix A. What is the title of its revenue account?

19. Refer to Piaggio’s balance sheet in Appen dix A. What does Piaggio title its current asset refer- ring to merchandise available for sale?

Discussion Questions

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 93 mhhe.com/wildFINMAN5e

1. Amalia Company received its utility bill for the current period of $700 and immediately paid it. Its journal entry to record this transaction includes a

a. Credit to Utility Expense for $700. b. Debit to Utility Expense for $700. c. Debit to Accounts Payable for $700. d. Debit to Cash for $700. e. Credit to Common Stock for $700. 2. On May 1, Mattingly Lawn Service collected $2,500 cash from a

customer in advance of five months of lawn service. Mattingly’s journal entry to record this transaction includes a

a. Credit to Unearned Lawn Service Fees for $2,500. b. Debit to Lawn Service Fees Earned for $2,500. c. Credit to Cash for $2,500. d. Debit to Unearned Lawn Service Fees for $2,500. e. Credit to Common Stock for $2,500. 3. Liang Shue contributed $250,000 cash and land worth $500,000

to open his new business, Shue Consulting Corporation. Which of the following journal entries does Shue Consulting make to record this transaction?

a. Cash Assets . . . . . . . . . . . 750,000 Common Stock . . . . . . 750,000 b. Common Stock . . . . . . . . 750,000 Assets . . . . . . . . . . . . . . 750,000 c. Cash . . . . . . . . . . . . . . . . . 250,000 Land . . . . . . . . . . . . . . . . . 500,000 Common Stock . . . . . . 750,000

d. Common Stock . . . . . . . . 750,000 Cash . . . . . . . . . . . . . . . 250,000 Land . . . . . . . . . . . . . . . 500,000 4. A trial balance prepared at year-end shows total credits ex-

ceed total debits by $765. This discrepancy could have been caused by

a. An error in the general journal where a $765 increase in Accounts Payable was recorded as a $765 decrease in Accounts Payable.

b. The ledger balance for Accounts Payable of $7,650 being entered in the trial balance as $765.

c. A general journal error where a $765 increase in Accounts Receivable was recorded as a $765 increase in Cash.

d. The ledger balance of $850 in Accounts Receivable was entered in the trial balance as $85.

e. An error in recording a $765 increase in Cash as a credit. 5. Bonaventure Company has total assets of $1,000,000, liabili-

ties of $400,000, and equity of $600,000. What is its debt ratio (rounded to a whole percent)?

a. 250% b. 167% c. 67% d. 150% e. 40%

Icon denotes assignments that involve decision making.

Polaris

Arctic Cat

KTM

PIAGGIO

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Chapter 2 Analyzing and Recording Transactions 79

QUICK STUDY

QS 2-1 Identifying source documents

C1

Identify the items from the following list that are likely to serve as source documents. a. Sales ticket d. Telephone bill g. Balance sheet b. Income statement e. Invoice from supplier h. Prepaid insurance c. Trial balance f. Company revenue account i. Bank statement

QS 2-2 Identifying financial statement items

C2 P3

Identify the financial statement(s) where each of the following items appears. Use I for income statement, E for statement of retained earnings, and B for balance sheet. a. Office equipment d. Prepaid insurance g. Cash b. Cash dividends e. Office supplies h. Unearned rent revenue c. Revenue f. Rent expense i. Accounts payable

QS 2-6 Preparing journal entries

P1

Prepare journal entries for each of the following selected transactions. a. On May 15, DeShawn Tyler opens a landscaping company called Elegant Lawns by investing $70,000

cash along with equipment having a $30,000 value in exchange for common stock. b. On May 21, Elegant Lawns purchases office supplies on credit for $280. c. On May 25, Elegant Lawns receives $7,800 cash for performing landscaping services. d. On May 30, Elegant Lawns receives $1,000 cash in advance of providing landscaping ser vices to a

customer.

QS 2-5 Analyzing debit or credit by account

A1

Identify whether a debit or credit yields the indicated change for each of the following accounts. a. To increase Land f. To decrease Prepaid Rent b. To decrease Cash g. To increase Notes Payable c. To increase Office Expense h. To decrease Accounts Receivable d. To increase Fees Earned i. To increase Common Stock e. To decrease Unearned Revenue j. To increase Store Equipment

QS 2-7 Identifying a posting error

P2

A trial balance has total debits of $20,000 and total credits of $24,500. Which one of the following errors would create this imbalance? Explain. a. A $2,250 debit to Utilities Expense in a journal entry is incorrectly posted to the ledger as a $2,250

credit, leaving the Utilities Expense account with a $3,000 debit balance. b. A $4,500 debit to Salaries Expense in a journal entry is incorrectly posted to the ledger as a $4,500

credit, leaving the Salaries Expense account with a $750 debit balance. c. A $2,250 credit to Consulting Fees Earned in a journal entry is incorrectly posted to the ledger as a

$2,250 debit, leaving the Consulting Fees Earned account with a $6,300 credit balance. d. A $2,250 debit posting to Accounts Receivable was posted mistakenly to Land. e. A $4,500 debit posting to Equipment was posted mistakenly to Cash. f. An entry debiting Cash and crediting Accounts Payable for $4,500 was mistakenly not posted.

QS 2-3 Identifying normal balance

C4

Identify the normal balance (debit or credit) for each of the following accounts. a. Office Supplies d. Wages Expense g. Wages Payable b. Dividends e. Accounts Receivable h. Building c. Fees Earned f. Prepaid Rent i. Common Stock

QS 2-4 Linking debit or credit with normal balance

C4

Indicate whether a debit or credit decreases the normal balance of each of the following accounts. a. Service Revenue e. Common Stock i. Dividends b. Interest Payable f. Prepaid Insurance j. Unearned Revenue c. Accounts Receivable g. Buildings k. Accounts Payable d. Salaries Expense h. Interest Revenue l. Land

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80 Chapter 2 Analyzing and Recording Transactions

QS 2-8 Classifying accounts in financial statements

P3

Indicate the financial statement on which each of the following items appears. Use I for income statement, E for statement of retained earnings, and B for balance sheet. a. Services Revenue e. Equipment i. Dividends b. Interest Payable f. Prepaid Insurance j. Office Supplies c. Accounts Receivable g. Buildings k. Interest Expense d. Salaries Expense h. Rental Revenue l. Insurance Expense

Exercise 2-2 Identifying and classifying accounts

C2

Enter the number for the item that best completes each of the descriptions below. 1. Asset 3. Account 5. Three 2. Equity 4. Liability a. An is a record of increases and decreases in a specific asset, liability, equity, revenue, or

expense item. b. Accounts payable, unearned revenue, and note payable are examples of accounts. c. Accounts receivable, prepaid accounts, supplies, and land are examples of accounts. d. Accounts are arranged into general categories. e. Common stock and dividends are examples of accounts.

Exercise 2-3 Identifying a ledger and chart of accounts

C3

Enter the number for the item that best completes each of the descriptions below. 1. Chart 2. General ledger a. The is a record containing all accounts used by a company. b. A of accounts is a list of all accounts a company uses.

Exercise 2-5 Analyzing account entries and balances

A1

Use the information in each of the following separate cases to calculate the unknown amount. a. Corentine Co. had $152,000 of accounts payable on September 30 and $132,500 on October 31. Total

purchases on account during October were $281,000. Determine how much cash was paid on accounts payable during October.

b. On September 30, Valerian Co. had a $102,500 balance in Accounts Receivable. During October, the company collected $102,890 from its credit customers. The October 31 balance in Accounts Receiv- able was $89,000. Determine the amount of sales on account that occurred in October.

c. During October, Alameda Company had $102,500 of cash receipts and $103,150 of cash disburse- ments. The October 31 Cash balance was $18,600. Determine how much cash the company had at the close of business on September 30.

Exercise 2-4 Identifying type and normal balances of accounts

C4

For each of the following (1) identify the type of account as an asset, liability, equity, revenue, or expense, (2) identify the normal balance of the account, and (3) enter debit (Dr.) or credit (Cr.) to identify the kind of entry that would increase the account balance. a. Cash e. Accounts Receivable i. Fees Earned b. Legal Expense f. Dividends j. Equipment c. Prepaid Insurance g. License Fee Revenue k. Notes Payable d. Land h. Unearned Revenue l. Common Stock

EXERCISES

Exercise 2-1 Steps in analyzing and recording transactions C1

Order the following steps in the accounting process that focus on analyzing and recording transactions. a. Analyze each transaction from source documents. b. Prepare and analyze the trial balance. c. Record relevant transactions in a journal. d. Post journal information to ledger accounts.

QS 2-9 International accounting standards

C4

Answer each of the following questions related to international accounting standards. a. What type of entry system is applied when accounting follows IFRS? b. Identify the number and usual titles of the financial statements prepared under IFRS. c. How do differences in accounting controls and enforcement impact accounting reports prepared across

different countries?

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Chapter 2 Analyzing and Recording Transactions 81

Exercise 2-7 Preparing general journal entries

P1

Prepare general journal entries for the following transactions of a new company called Pose-for-Pics.

Aug. 1 Madison Harris, the owner, invested $6,500 cash and $33,500 of photography equipment in the company in exchange for common stock.

2 The company paid $2,100 cash for an insurance policy covering the next 24 months. 5 The company purchased office supplies for $880 cash. 20 The company received $3,331 cash in photography fees earned. 31 The company paid $675 cash for August utilities.

Exercise 2-8 Preparing T-accounts (ledger) and a trial balance P2

Use the information in Exercise 2-7 to prepare an August 31 trial balance for Pose-for-Pics. Begin by opening these T-accounts: Cash; Office Supplies; Prepaid Insurance; Photography Equipment; Common Stock; Photography Fees Earned; and Utilities Expense. Then, post the general journal entries to these T-accounts (which will serve as the ledger), and prepare the trial balance.

Exercise 2-10 Preparing a trial balance P2

After recording the transactions of Exercise 2-9 in T-accounts and calculating the balance of each account, prepare a trial balance. Use May 31, 2013, as its report date.

Exercise 2-6 Analyzing effects of transactions on accounts

A1

Groro Co. bills a client $62,000 for services provided and agrees to accept the following three items in full payment: (1) $10,000 cash, (2) computer equipment worth $80,000, and (3) to assume responsibility for a $28,000 note payable related to the computer equipment. The entry Groro makes to record this transaction includes which one or more of the following? a. $28,000 increase in a liability account d. $62,000 increase in an asset account b. $10,000 increase in the Cash account e. $62,000 increase in a revenue account c. $10,000 increase in a revenue account f. $62,000 increase in an equity account

Exercise 2-9 Recording effects of transactions in T-accounts

A1

Prepare general journal entries to record the transactions below for Spade Company by using the fol- lowing accounts: Cash; Accounts Receivable; Office Supplies; Office Equipment; Accounts Payable; Common Stock; Dividends; Fees Earned; and Rent Expense. Use the letters beside each transaction to identify entries. After recording the transactions, post them to T-accounts, which serves as the general ledger for this assignment. Determine the ending balance of each T-account. a. Kacy Spade, owner, invested $100,750 cash in the company in exchange for common stock. b. The company purchased office supplies for $1,250 cash. c. The company purchased $10,050 of office equipment on credit. d. The company received $15,500 cash as fees for services provided to a customer. e. The company paid $10,050 cash to settle the payable for the office equipment purchased in transaction c. f. The company billed a customer $2,700 as fees for services provided. g. The company paid $1,225 cash for the monthly rent. h. The company collected $1,125 cash as partial payment for the account receivable created in transaction f. i. The company paid $10,000 cash in dividends to Spade (sole shareholder).

Check Cash ending balance, $94,850

Exercise 2-11 Analyzing and journalizing revenue transactions

A1 P1

Examine the following transactions and identify those that create revenues for Valdez Services, a company owned by Brina Valdez. Prepare general journal entries to record those revenue transactions and explain why the other transactions did not create revenues. a. Brina Valdez invests $39,350 cash in the company in exchange for common stock. b. The company provided $2,300 of services on credit. c. The company provided services to a client and immediately received $875 cash. d. The company received $10,200 cash from a client in payment for services to be provided next year. e. The company received $3,500 cash from a client in partial payment of an account receivable. f. The company borrowed $120,000 cash from the bank by signing a promissory note.

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82 Chapter 2 Analyzing and Recording Transactions

Exercise 2-15 Preparing a balance sheet P3

Use the information in Exercise 2-13 (if completed, you can also use your solution to Exercise 2-14) to prepare an August 31 balance sheet for Help Today.

Exercise 2-13 Preparing an income statement

C3 P3

Carmen Camry operates a consulting firm called Help Today, which began operations on August 1. On August 31, the company’s records show the following accounts and amounts for the month of August. Use this information to prepare an August income statement for the business.

Cash . . . . . . . . . . . . . . . . . . . . . . $ 25,360 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000

Accounts receivable . . . . . . . . . 22,360 Consulting fees earned . . . . . . . . . . . . . . . . . . . . . 27,000

Office supplies . . . . . . . . . . . . . . 5,250 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,550

Land . . . . . . . . . . . . . . . . . . . . . . 44,000 Salaries expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600

Office equipment . . . . . . . . . . . 20,000 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . 860

Accounts payable . . . . . . . . . . . 10,500 Miscellaneous expenses. . . . . . . . . . . . . . . . . . . . . 520

Common stock . . . . . . . . . . . . . 102,000 Check Net income, $10,470

Exercise 2-16 Computing net income

A1

A corporation had the following assets and liabilities at the beginning and end of this year.

Assets Liabilities

Beginning of the year . . . . . . . . . $ 60,000 $20,000

End of the year . . . . . . . . . . . . . 105,000 36,000

Determine the net income earned or net loss incurred by the business during the year for each of the follow- ing separate cases: a. Owner made no investments in the business and no dividends were paid during the year. b. Owner made no investments in the business but dividends were $1,250 cash per month. c. No dividends were paid during the year but the owner did invest an additional $55,000 cash in ex-

change for common stock. d. Dividends were $1,250 cash per month and the owner invested an additional $35,000 cash in ex-

change for common stock.

Exercise 2-17 Analyzing changes in a company’s equity

P3

Compute the missing amount for each of the following separate companies a through d.

Owner investments for stock during the year Dividends during the year

Exercise 2-12 Analyzing and journalizing expense transactions

A1 P1

Examine the following transactions and identify those that create expenses for Valdez Services. Prepare general journal entries to record those expense transactions and explain why the other transactions did not create expenses. a. The company paid $12,200 cash for payment on a 16-month old liability for office supplies. b. The company paid $1,233 cash for the just completed two-week salary of the receptionist. c. The company paid $39,200 cash for equipment purchased. d. The company paid $870 cash for this month’s utilities. e. The company paid $4,500 cash in dividends.

Exercise 2-14 Preparing a statement of retained earnings P3

Use the information in Exercise 2-13 to prepare an August statement of retained earnings for Help Today. (The owner invested a total of $102,000 in the company in exchange for common stock on August 1.)

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Chapter 2 Analyzing and Recording Transactions 83

Exercise 2-19 Preparing general journal entries

P1

Use information from the T-accounts in Exercise 2-18 to prepare general journal entries for each of the seven transactions a through g.

Exercise 2-21 Analyzing a trial balance error

A1 P2

You are told the column totals in a trial balance are not equal. After careful analysis, you discover only one error. Specifically, a correctly journalized credit purchase of an automobile for $18,950 is posted from the journal to the ledger with a $18,950 debit to Automobiles and another $18,950 debit to Accounts Payable. The Automobiles account has a debit balance of $37,100 on the trial balance. Answer each of the following questions and compute the dollar amount of any misstatement.

Exercise 2-20 Identifying effects of posting errors on the trial balance

A1 P2

Posting errors are identified in the following table. In column (1), enter the amount of the difference between the two trial balance columns (debit and credit) due to the error. In column (2), identify the trial balance column (debit or credit) with the larger amount if they are not equal. In column (3), identify the account(s) affected by the error. In column (4), indicate the amount by which the account(s) in column (3) is under- or overstated. Item (a) is completed as an example.

(1) (2) (3) (4) Difference between Column with Identify Amount that Debit and Credit the Larger Account(s) Account(s) Is Description of Posting Error Columns Total Incorrectly Over- or Stated Understated

a. $3,600 debit to Rent Expense is $2,260 Credit Rent Expense Rent Expense posted as a $1,340 debit. understated $2,260

b. $6,500 credit to Cash is posted twice as two credits to Cash.

c. $10,900 debit to the Dividends account is debited to Common Stock.

d. $2,050 debit to Prepaid Insurance is posted as a debit to Insurance Expense.

e. $38,000 debit to Machinery is posted as a debit to Accounts Payable.

f. $5,850 credit to Services Revenue is posted as a $585 credit.

g. $1,390 debit to Store Supplies is not posted.

Exercise 2-18 Interpreting and describing transactions from T-accounts

A1

Assume the following T-accounts reflect Belle Co.’s general ledger and that seven transactions a through g are posted to them. Provide a short description of each transaction. Include the amounts in your descriptions.

(a) 6,000

(e) 4,500

(b) 4,800

(c) 900

(f ) 1,600

(g) 820

Cash

(a) 12,000

Automobiles

(c) 900

(d) 300

Office Supplies

(f ) 1,600 (d) 10,000

Accounts Payable

(b) 4,800

Prepaid Insurance

(a) 25,600

Common Stock

(a) 7,600

(d) 9,700

Equipment

(e) 4,500

Delivery Services Revenue

(g) 820

Gas and Oil Expense

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84 Chapter 2 Analyzing and Recording Transactions

a. Is the debit column total of the trial balance overstated, understated, or correctly stated? b. Is the credit column total of the trial balance overstated, understated, or correctly stated? c. Is the Automobiles account balance overstated, understated, or correctly stated in the trial balance? d. Is the Accounts Payable account balance overstated, understated, or correctly stated in the trial balance? e. If the debit column total of the trial balance is $200,000 before correcting the error, what is the total of

the credit column before correction?

b. Of the six companies, which business relies most heavily on creditor financing? c. Of the six companies, which business relies most heavily on equity financing? d. Which two companies indicate the greatest risk? e. Which two companies earn the highest return on assets? f. Which one company would investors likely prefer based on the risk–return relation?

Exercise 2-22 Interpreting the debt ratio and return on assets

A2

a. Calculate the debt ratio and the return on assets using the year-end information for each of the follow- ing six separate companies ($ thousands).

Case

Company 3

Company 5 Company 6

32,500

92,000 104,500

26,650

31,280 52,250

50,000

40,000 80,000

650

7,520 12,000

Company 1 $90,500 $11,765 $100,000 $20,000

Company 4 147,000 55,860 200,000 21,000

Company 2 64,000 46,720 40,000 3,800

Assets Liabilities Average Assets Net Income

Current liabilities . . . . . . . . €11,519 Noncurrent liabilities . . . . . . . . €7,767

Current assets . . . . . . . . . . . 17,682 Noncurrent assets . . . . . . . . . . 9,826

Total equity . . . . . . . . . . . . . 8,222

Exercise 2-23 Preparing a balance sheet following IFRS

P3

BMW reports the following balance sheet accounts for the year ended December 31, 2011 (euro in millions). Prepare the balance sheet for this company as of December 31, 2011, following the usual IFRS formats.

PROBLEM SET A

Problem 2-1A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Aracel Engineering completed the following transactions in the month of June. a. To launch the company, Jenna Aracel, the owner, invested $100,000 cash, office equipment with a

value of $5,000, and $60,000 of drafting equipment in exchange for common stock. b. The company purchased land worth $49,000 for an office by paying $6,300 cash and signing a long-

term note payable for $42,700. c. The company purchased a portable building with $55,000 cash and moved it onto the land acquired in b. d. The company paid $3,000 cash for the premium on an 18-month insurance policy. e. The company completed and delivered a set of plans for a client and collected $6,200 cash. f. The company purchased $20,000 of additional drafting equipment by paying $9,500 cash and signing

a long-term note payable for $10,500. g. The company completed $14,000 of engineering services for a client. This amount is to be received

in 30 days. h. The company purchased $1,150 of additional office equipment on credit. i. The company completed engineering services for $22,000 on credit. j. The company received a bill for rent of equipment that was used on a recently completed job. The

$1,333 rent cost must be paid within 30 days. k. The company collected $7,000 cash in partial payment from the client described in transaction g. l. The company paid $1,200 cash for wages to a drafting assistant. m. The company paid $1,150 cash to settle the account payable created in transaction h. n. The company paid $925 cash for minor maintenance of its drafting equipment. o. The company paid $9,480 cash in dividends.

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Chapter 2 Analyzing and Recording Transactions 85

p. The company paid $1,200 cash for wages to a drafting assistant. q. The company paid $2,500 cash for advertisements on the Web during June.

Required

1. Prepare general journal entries to record these transactions (use the account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Prepaid Insurance (108); Office Equipment (163); Drafting Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Engineering Fees Earned (402); Wages Expense (601); Equipment Rental Expense (602); Advertising Expense (603); and Repairs Expense (604). Post the journal entries from part 1 to the accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of June.

Problem 2-3A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Karla Tanner opens a Web consulting business called Linkworks and completes the following transactions in its first month of operations.

April 1 Tanner invests $80,000 cash along with office equipment valued at $26,000 in the company in exchange for common stock.

2 The company prepaid $9,000 cash for 12 months’ rent for office space. (Hint: Debit Prepaid Rent for $9,000.)

3 The company made credit purchases for $8,000 in office equipment and $3,600 in office sup- plies. Payment is due within 10 days.

6 The company completed services for a client and immediately received $4,000 cash. 9 The company completed a $6,000 project for a client, who must pay within 30 days. 13 The company paid $11,600 cash to settle the account payable created on April 3. 19 The company paid $2,400 cash for the premium on a 12-month insurance policy. (Hint: Debit

Prepaid Insurance for $2,400.) 22 The company received $4,400 cash as partial payment for the work completed on April 9. 25 The company completed work for another client for $2,890 on credit. 28 The company paid $5,500 cash in dividends. 29 The company purchased $600 of additional office supplies on credit. 30 The company paid $435 cash for this month’s utility bill.

(3) Trial balance totals, $261,733

Check (2) Ending balances: Cash, $22,945; Accounts Receivable, $29,000; Accounts Payable, $1,333

mhhe.com/wildFINMAN5e

Problem 2-2A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Denzel Brooks opens a Web consulting business called Venture Consultants and completes the following transactions in March.

March 1 Brooks invested $150,000 cash along with $22,000 in office equipment in the company in exchange for common stock.

2 The company prepaid $6,000 cash for six months’ rent for an office. (Hint: Debit Prepaid Rent for $6,000.)

3 The company made credit purchases of office equipment for $3,000 and office supplies for $1,200. Payment is due within 10 days.

6 The company completed services for a client and immediately received $4,000 cash. 9 The company completed a $7,500 project for a client, who must pay within 30 days. 12 The company paid $4,200 cash to settle the account payable created on March 3. 19 The company paid $5,000 cash for the premium on a 12-month insurance policy. (Hint: Debit

Prepaid Insurance for $5,000.) 22 The company received $3,500 cash as partial payment for the work completed on March 9. 25 The company completed work for another client for $3,820 on credit. 29 The company paid $5,100 cash in dividends. 30 The company purchased $600 of additional office supplies on credit. 31 The company paid $500 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use the account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of March.

Check (2) Ending balances: Cash, $136,700; Accounts Receivable, $7,820; Accounts Payable, $600 (3) Total debits, $187,920

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86 Chapter 2 Analyzing and Recording Transactions

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of April 30. (3) Total debits, $119,490

Check (2) Ending balances: Cash, $59,465; Accounts Receivable, $4,490; Accounts Payable, $600

Problem 2-4A Computing net income from equity analysis, preparing a balance sheet, and computing the debt ratio

C2 A1 A2 P3

The accounting records of Nettle Distribution show the following assets and liabilities as of December 31, 2012 and 2013.

December 31 2012 2013

Cash . . . . . . . . . . . . . . . . . . . . $ 64,300 $ 15,640

Accounts receivable . . . . . . . . 26,240 19,390

Office supplies . . . . . . . . . . . . . 3,160 1,960

Office equipment . . . . . . . . . . 44,000 44,000

Trucks . . . . . . . . . . . . . . . . . . . 148,000 157,000

Building . . . . . . . . . . . . . . . . . . 0 80,000

Land . . . . . . . . . . . . . . . . . . . . . 0 60,000

Accounts payable . . . . . . . . . . 3,500 33,500

Note payable . . . . . . . . . . . . . . 0 40,000

(3) Debt ratio, 19.4%

Check (2) Net income, $23,290

Late in December 2013, the business purchased a small office building and land for $140,000. It paid $100,000 cash toward the purchase and a $40,000 note payable was signed for the balance. Mr. Nettle had to invest $35,000 cash in the business (in exchange for common stock) to enable it to pay the $100,000 cash. The business also pays $3,000 cash per month for dividends.

Required

1. Prepare balance sheets for the business as of December 31, 2012 and 2013. (Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.)

2. By comparing equity amounts from the balance sheets and using the additional information presented in this problem, prepare a calculation to show how much net income was earned by the business during 2013.

3. Compute the 2013 year-end debt ratio (in percent and rounded to one decimal).

Yi Min started an engineering firm called Min Engineering. He began operations and completed seven transactions in May, which included his initial investment of $18,000 cash. After those seven transactions, the ledger included the following accounts with normal balances.

Required

1. Prepare a trial balance for this business as of the end of May.

Analysis Components

2. Analyze the accounts and their balances and prepare a list that describes each of the seven most likely transactions and their amounts.

3. Prepare a report of cash received and cash paid showing how the seven transactions in part 2 yield the $37,641 ending Cash balance.

Cash . . . . . . . . . . . . . . . . . . . . . . . $37,641

Office supplies . . . . . . . . . . . . . . . . 890

Prepaid insurance . . . . . . . . . . . . . 4,600

Office equipment . . . . . . . . . . . . . 12,900

Accounts payable . . . . . . . . . . . . . 12,900

Common stock . . . . . . . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . 3,329

Engineering fees earned . . . . . . . . 36,000

Rent expense . . . . . . . . . . . . . . . . 7,540

Problem 2-5A Analyzing account balances and reconstructing transactions

C1 C3 A1 P2

Check (1) Trial balance totals, $66,900

(3) Cash paid, $16,359

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Chapter 2 Analyzing and Recording Transactions 87

Problem 2-6A Recording transactions; posting to ledger; preparing a trial balance

C3 A1 P1 P2

Business transactions completed by Hannah Venedict during the month of September are as follows. a. Venedict invested $60,000 cash along with office equipment valued at $25,000 in exchange for com-

mon stock of a new company named HV Consulting. b. The company purchased land valued at $40,000 and a building valued at $160,000. The purchase is

paid with $30,000 cash and a long-term note payable for $170,000. c. The company purchased $2,000 of office supplies on credit. d. Venedict invested her personal automobile in the company in exchange for more common stock. The

automobile has a value of $16,500 and is to be used exclusively in the business. e. The company purchased $5,600 of additional office equipment on credit. f. The company paid $1,800 cash salary to an assistant. g. The company provided services to a client and collected $8,000 cash. h. The company paid $635 cash for this month’s utilities. i. The company paid $2,000 cash to settle the account payable created in transaction c. j. The company purchased $20,300 of new office equipment by paying $20,300 cash. k. The company completed $6,250 of services for a client, who must pay within 30 days. l. The company paid $1,800 cash salary to an assistant. m. The company received $4,000 cash in partial payment on the receivable created in transaction k. n. The company paid $2,800 cash in dividends.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance column

format): Cash (101); Accounts Receivable (106); Office Supplies (108); Office Equipment (163); Automo- biles (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Fees Earned (402); Salaries Expense (601); and Utilities Expense (602). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of September. (3) Trial balance totals, $291,350

Check (2) Ending balances: Cash, $12,665; Office Equipment, $50,900

At the beginning of April, Bernadette Grechus launched a custom computer solutions company called Softworks. The company had the following transactions during April. a. Bernadette Grechus invested $65,000 cash, office equipment with a value of $5,750, and $30,000

of computer equipment in the company in exchange for common stock. b. The company purchased land worth $22,000 for an office by paying $5,000 cash and signing a

long-term note payable for $17,000. c. The company purchased a portable building with $34,500 cash and moved it onto the land acquired in b. d. The company paid $5,000 cash for the premium on a two-year insurance policy. e. The company provided services to a client and immediately collected $4,600 cash. f. The company purchased $4,500 of additional computer equipment by paying $800 cash and signing

a long-term note payable for $3,700. g. The company completed $4,250 of services for a client. This amount is to be received within 30 days. h. The company purchased $950 of additional office equipment on credit. i. The company completed client services for $10,200 on credit. j. The company received a bill for rent of a computer testing device that was used on a recently com-

pleted job. The $580 rent cost must be paid within 30 days. k. The company collected $5,100 cash in partial payment from the client described in transaction i. l. The company paid $1,800 cash for wages to an assistant. m. The company paid $950 cash to settle the payable created in transaction h. n. The company paid $608 cash for minor maintenance of the company’s computer equipment. o. The company paid $6,230 cash in dividends. p. The company paid $1,800 cash for wages to an assistant. q. The company paid $750 cash for advertisements on the Web during April.

PROBLEM SET B

Problem 2-1B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

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88 Chapter 2 Analyzing and Recording Transactions

Check (2) Ending balances: Cash, $17,262; Accounts Receivable, $9,350; Accounts Payable, $580

(3) Trial balance totals, $141,080

Problem 2-3B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Humble Management Services opens for business and completes these transactions in September.

Sept. 1 Henry Humble, the owner, invests $38,000 cash along with office equipment valued at $15,000 in the company in exchange for common stock.

2 The company prepaid $9,000 cash for 12 months’ rent for office space. (Hint: Debit Prepaid Rent for $9,000.)

4 The company made credit purchases for $8,000 in office equipment and $2,400 in office sup- plies. Payment is due within 10 days.

8 The company completed work for a client and immediately received $3,280 cash. 12 The company completed a $15,400 project for a client, who must pay within 30 days. 13 The company paid $10,400 cash to settle the payable created on September 4. 19 The company paid $1,900 cash for the premium on an 18-month insurance policy. (Hint: Debit

Prepaid Insurance for $1,900.)

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Prepaid Insurance (108); Office Equipment (163); Computer Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Pay- able (250); Common Stock (307); Dividends (319); Fees Earned (402); Wages Expense (601); Com- puter Rental Expense (602); Advertising Expense (603); and Repairs Expense (604). Post the journal entries from part 1 to the accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of April.

Problem 2-2B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Zucker Management Services opens for business and completes these transactions in November.

Nov. 1 Matt Zucker, the owner, invested $30,000 cash along with $15,000 of office equipment in the company in exchange for common stock.

2 The company prepaid $4,500 cash for six months’ rent for an office. (Hint: Debit Prepaid Rent for $4,500.)

4 The company made credit purchases of office equipment for $2,500 and of office supplies for $600. Payment is due within 10 days.

8 The company completed work for a client and immediately received $3,400 cash. 12 The company completed a $10,200 project for a client, who must pay within 30 days. 13 The company paid $3,100 cash to settle the payable created on November 4. 19 The company paid $1,800 cash for the premium on a 24-month insurance policy. 22 The company received $5,200 cash as partial payment for the work completed on November 12. 24 The company completed work for another client for $1,750 on credit. 28 The company paid $5,300 cash in dividends. 29 The company purchased $249 of additional office supplies on credit. 30 The company paid $831 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance

column format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of November.

Check (2) Ending balances: Cash, $23,069; Accounts Receivable, $6,750; Accounts Payable, $249

(3) Total debits, $60,599

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Chapter 2 Analyzing and Recording Transactions 89

December 31 2012 2013

Cash . . . . . . . . . . . . . . . . . . . . . $20,000 $ 5,000 Accounts receivable . . . . . . . . . 35,000 25,000 Office supplies . . . . . . . . . . . . . . 8,000 13,500 Office equipment . . . . . . . . . . . 40,000 40,000 Machinery . . . . . . . . . . . . . . . . . 28,500 28,500 Building . . . . . . . . . . . . . . . . . . . 0 250,000 Land . . . . . . . . . . . . . . . . . . . . . . 0 50,000 Accounts payable . . . . . . . . . . . 4,000 12,000 Note payable . . . . . . . . . . . . . . . 0 250,000

Problem 2-4B Computing net income from equity analysis, preparing a balance sheet, and computing the debt ratio

C2 A1 A2 P3

The accounting records of Tama Co. show the following assets and liabilities as of December 31, 2012 and 2013.

Check (2) Net income, $10,500

(3) Debt ratio, 63.6%

Late in December 2013, the business purchased a small office building and land for $300,000. It paid $50,000 cash toward the purchase and a $250,000 note payable was signed for the balance. Joe Tama, the owner, had to invest an additional $15,000 cash (in exchange for common stock) to enable it to pay the $50,000 cash toward the purchase. The business also pays $250 cash per month for dividends.

Required

1. Prepare balance sheets for the business as of December 31, 2012 and 2013. (Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.)

2. By comparing equity amounts from the balance sheets and using the additional information presented in the problem, prepare a calculation to show how much net income was earned by the business during 2013.

3. Calculate the December 31, 2013, debt ratio (in percent and rounded to one decimal).

Problem 2-5B Analyzing account balances and reconstructing transactions

C1 C3 A1 P2

Roshaun Gould started a Web consulting firm called Gould Solutions. He began operations and completed seven transactions in April that resulted in the following accounts, which all have normal balances.

22 The company received $7,700 cash as partial payment for the work completed on September 12.

24 The company completed work for another client for $2,100 on credit. 28 The company paid $5,300 cash in dividends. 29 The company purchased $550 of additional office supplies on credit. 30 The company paid $860 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance

column format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Service Fees Earned (401); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of September. (3) Total debits, $74,330

Check (2) Ending balances: Cash, $21,520; Accounts Receivable, $9,800; Accounts Payable, $550

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90 Chapter 2 Analyzing and Recording Transactions

SERIAL PROBLEM Success Systems

A1 P1 P2

(This serial problem started in Chapter 1 and continues through most of the chapters. If the Chapter 1 segment was not completed, the problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany this book.)

Nuncio Consulting completed the following transactions during June. a. Armand Nuncio, the owner, invested $35,000 cash along with office equipment valued at $11,000

in the new company in exchange for common stock. b. The company purchased land valued at $7,500 and a building valued at $40,000. The purchase is

paid with $15,000 cash and a long-term note payable for $32,500. c. The company purchased $500 of office supplies on credit. d. A. Nuncio invested his personal automobile in the company in exchange for more common stock.

The automobile has a value of $8,000 and is to be used exclusively in the business. e. The company purchased $1,200 of additional office equipment on credit. f. The company paid $1,000 cash salary to an assistant. g. The company provided services to a client and collected $3,200 cash. h. The company paid $540 cash for this month’s utilities. i. The company paid $500 cash to settle the payable created in transaction c. j. The company purchased $3,400 of new office equipment by paying $3,400 cash. k. The company completed $4,200 of services for a client, who must pay within 30 days. l. The company paid $1,000 cash salary to an assistant. m. The company received $2,200 cash in partial payment on the receivable created in transaction k. n. The company paid $1,100 cash in dividends.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts — their account numbers are in parentheses (use the balance

column format): Cash (101); Accounts Receivable (106); Office Supplies (108); Office Equipment (163); Automobiles (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Fees Earned (402); Salaries Expense (601); and Utilities Expense (602). Post the journal entries from part 1 to the ledger accounts and enter the bal- ance after each posting.

3. Prepare a trial balance as of the end of June.

Problem 2-6B Recording transactions; posting to ledger; preparing a trial balance

C3 A1 P1 P2

Check (2) Ending balances: Cash, $17,860; Office Equipment, $15,600

(3) Trial balance totals, $95,100

Required

1. Prepare a trial balance for this business as of the end of April.

Analysis Component

2. Analyze the accounts and their balances and prepare a list that describes each of the seven most likely transactions and their amounts.

3. Prepare a report of cash received and cash paid showing how the seven transactions in part 2 yield the $19,982 ending Cash balance.

Check (1) Trial balance total, $47,650

(3) Cash paid, $15,418

Cash . . . . . . . . . . . . . . . . . . . . . . . $19,982

Office supplies . . . . . . . . . . . . . . . . 760

Prepaid rent . . . . . . . . . . . . . . . . . 1,800

Office equipment . . . . . . . . . . . . . 12,250

Accounts payable . . . . . . . . . . . . . 12,250

Common stock . . . . . . . . . . . . . . . 15,000

Dividends . . . . . . . . . . . . . . . . . . . . 5,200

Consulting fees earned . . . . . . . . . 20,400

Operating expenses . . . . . . . . . . . 7,658

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Chapter 2 Analyzing and Recording Transactions 91

Required

1. Prepare journal entries to record each of the following transactions for Success Systems.

Oct. 1 Adria Lopez invested $55,000 cash, a $20,000 computer system, and $8,000 of office equip- ment in the company in exchange for its common stock.

2 The company paid $3,300 cash for four months’ rent. (Hint: Debit Prepaid Rent for $3,300.)

3 The company purchased $1,420 of computer supplies on credit from Harris Office Products. 5 The company paid $2,220 cash for one year’s premium on a property and liability insurance

policy. (Hint: Debit Prepaid Insurance for $2,220.) 6 The company billed Easy Leasing $4,800 for services performed in installing a new Web

server. 8 The company paid $1,420 cash for the computer supplies purchased from Harris Office Prod-

ucts on October 3. 10 The company hired Lyn Addie as a part-time assistant for $125 per day, as needed. 12 The company billed Easy Leasing another $1,400 for services performed. 15 The company received $4,800 cash from Easy Leasing as partial payment on its account. 17 The company paid $805 cash to repair computer equipment that was damaged when mov-

ing it. 20 The company paid $1,940 cash for advertisements published in the local newspaper. 22 The company received $1,400 cash from Easy Leasing on its account. 28 The company billed IFM Company $5,208 for services performed. 31 The company paid $875 cash for Lyn Addie’s wages for seven days’ work. 31 The company paid $3,600 cash in dividends. Nov. 1 The company reimbursed Adria Lopez in cash for business automobile mileage allowance

(Lopez logged 1,000 miles at $0.32 per mile). 2 The company received $4,633 cash from Liu Corporation for computer services performed. 5 The company purchased computer supplies for $1,125 cash from Harris Office Products. 8 The company billed Gomez Co. $5,668 for services performed. 13 The company received notification from Alex’s Engineering Co. that Success Systems’ bid of

$3,950 for an upcoming project is accepted. 18 The company received $2,208 cash from IFM Company as partial payment of the October 28

bill. 22 The company donated $250 cash to the United Way in the company’s name. 24 The company completed work for Alex’s Engineering Co. and sent it a bill for $3,950. 25 The company sent another bill to IFM Company for the past-due amount of $3,000. 28 The company reimbursed Adria Lopez in cash for business automobile mileage (1,200 miles at

$0.32 per mile). 30 The company paid $1,750 cash for Lyn Addie’s wages for 14 days’ work. 30 The company paid $2,000 cash in dividends. 2. Open ledger accounts (in balance column format) and post the journal entries from part 1 to them. 3. Prepare a trial balance as of the end of November.

Check (2) Cash, Nov. 30 bal., $48,052

(3) Trial bal. totals, $108,659

Account No. Account No.

Cash . . . . . . . . . . . . . . . . . . . . . . 101 Common Stock . . . . . . . . . . . . . . . . . . . . 307

Accounts Receivable . . . . . . . . . 106 Dividends. . . . . . . . . . . . . . . . . . . . . . . . . 319

Computer Supplies . . . . . . . . . . 126 Computer Services Revenue . . . . . . . . . 403

Prepaid Insurance . . . . . . . . . . . 128 Wages Expense . . . . . . . . . . . . . . . . . . . . 623

Prepaid Rent . . . . . . . . . . . . . . . 131 Advertising Expense . . . . . . . . . . . . . . . . 655

Office Equipment . . . . . . . . . . . 163 Mileage Expense . . . . . . . . . . . . . . . . . . . 676

Computer Equipment . . . . . . . . 167 Miscellaneous Expenses . . . . . . . . . . . . . 677

Accounts Payable . . . . . . . . . . . 201 Repairs Expense — Computer. . . . . . . . . 684

SP 2 On October 1, 2013, Adria Lopez launched a computer services company called Success Systems, which provides consulting services, computer system installations, and custom program development. Adria adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2013. The company’s initial chart of accounts follows.

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92 Chapter 2 Analyzing and Recording Transactions

BTN 2-3 Review the Decision Ethics case from the first part of this chapter involving the cashier. The guidance answer suggests that you should not comply with the assistant manager’s request.

Required

Propose and evaluate two other courses of action you might consider, and explain why.

ETHICS CHALLENGE C1

BTN 2-1 Refer to Polaris’s financial statements in Appendix A for the following questions.

Required

1. What amount of total liabilities does it report for each of the fiscal years ended December 31, 2011 and 2010?

2. What amount of total assets does it report for each of the fiscal years ended December 31, 2011 and 2010?

3. Compute its debt ratio for each of the fiscal years ended December 31, 2011 and 2010. (Report ratio in percent and round it to one decimal.)

4. In which fiscal year did it employ more financial leverage (December 31, 2011 or 2010)? Explain.

Fast Forward

5. Access its financial statements (10-K report) for a fiscal year ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Recompute its debt ratio for any subsequent year’s data and compare it with the debt ratio for 2010 and 2011.

Beyond the Numbers

REPORTING IN ACTION A1 A2

Polaris

1. What is the debt ratio for Polaris in the current year and for the prior year? 2. What is the debt ratio for Arctic Cat in the current year and for the prior year? 3. Which of the two companies has the higher degree of financial leverage? What does this imply?

BTN 2-2 Key comparative figures for Polaris and Arctic Cat follow.

Polaris Arctic Cat

Current Prior Current Prior ($ thousands) Year Year Year Year

Total liabilities . . . . . . . . . $ 727,968 $ 690,656 $ 89,870 $ 78,745

Total assets . . . . . . . . . . . 1,228,024 1,061,647 272,906 246,084

COMPARATIVE ANALYSIS A1 A2

Polaris Arctic Cat

BTN 2-4 Lila Corentine is an aspiring entrepreneur and your friend. She is having difficulty understand- ing the purposes of financial statements and how they fit together across time.

Required

Write a one-page memorandum to Corentine explaining the purposes of the four financial statements and how they are linked across time.

COMMUNICATING IN PRACTICE C1 C2 A1 P3

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Chapter 2 Analyzing and Recording Transactions 93

BTN 2-6 The expanded accounting equation consists of assets, liabilities, common stock, dividends, revenues, and expenses. It can be used to reveal insights into changes in a company’s financial position.

Required

1. Form learning teams of six (or more) members. Each team member must select one of the six components and each team must have at least one expert on each component: (a) assets, (b) liabilities, (c) common stock, (d) dividends, (e) revenues, and ( f ) expenses.

2. Form expert teams of individuals who selected the same component in part 1. Expert teams are to draft a report that each expert will present to his or her learning team addressing the following:

a. Identify for its component the (i) increase and decrease side of the account and (ii) normal balance side of the account.

b. Describe a transaction, with amounts, that increases its component. c. Using the transaction and amounts in (b), verify the equality of the accounting equation and then

explain any effects on the income statement and statement of cash flows. d. Describe a transaction, with amounts, that decreases its component. e. Using the transaction and amounts in (d ), verify the equality of the accounting equation and then

explain any effects on the income statement and statement of cash flows. 3. Each expert should return to his/her learning team. In rotation, each member presents his/her expert

team’s report to the learning team. Team discussion is encouraged.

TEAMWORK IN ACTION C1 C2 C4 A1

BTN 2-5 Access EDGAR online (www.sec.gov) and locate the 2011 year 10-K report of Amazon.com (ticker AMZN) filed on February 1, 2012. Review its financial statements reported for years ended 2011, 2010, and 2009 to answer the following questions.

Required

1. What are the amounts of its net income or net loss reported for each of these three years? 2. Does Amazon’s operating activities provide cash or use cash for each of these three years? 3. If Amazon has a 2011 net income of more than $600 million and 2011 operating cash flows of nearly

$4,000 million, how is it possible that its cash balance at December 31, 2011, increases by less than $1,500 million relative to its balance at December 31, 2010?

TAKING IT TO THE NET A1

BTN 2-7 Assume Misa Chien and Jennifer Green of Nom Nom Truck plan on expanding their busi- ness to accommodate more product lines. They are considering financing their expansion in one of two ways: (1) contributing more of their own funds to the business or (2) borrowing the funds from a bank.

Required

Identify at least two issues that Misa and Jennifer should consider when trying to decide on the method for financing their expansion.

ENTREPRENEURIAL DECISION A1 A2 P3

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94 Chapter 2 Analyzing and Recording Transactions

BTN 2-9 Obtain a recent copy of the most prominent newspaper distributed in your area. Research the classified section and prepare a report answering the following questions (attach relevant classified clip- pings to your report). Alternatively, you may want to search the Web for the re quired information. One suitable Website is CareerOneStop (www.CareerOneStop.org). For documentation, you should print copies of Websites accessed. 1. Identify the number of listings for accounting positions and the various accounting job titles. 2. Identify the number of listings for other job titles, with examples, that require or prefer accounting

knowledge/experience but are not specifically accounting positions. 3. Specify the salary range for the accounting and accounting-related positions if provided. 4. Indicate the job that appeals to you, the reason for its appeal, and its requirements.

HITTING THE ROAD C1

BTN 2-8 Angel Martin is a young entrepreneur who operates Martin Music Services, offering singing lessons and instruction on musical instruments. Martin wishes to expand but needs a $30,000 loan. The bank requests Martin to prepare a balance sheet and key financial ratios. Martin has not kept formal re- cords but is able to provide the following accounts and their amounts as of December 31, 2013.

Required

1. Prepare a balance sheet as of December 31, 2013, for Martin Music Services. (Report only the total equity amount on the balance sheet.)

2. Compute Martin’s debt ratio and its return on assets (the latter ratio is defined in Chapter 1). Assume average assets equal its ending balance.

3. Do you believe the prospects of a $30,000 bank loan are good? Why or why not?

Cash . . . . . . . . . . . . . . . $ 3,600 Accounts Receivable . . . . $ 9,600 Prepaid Insurance . . . . . $ 1,500

Prepaid Rent . . . . . . . . 9,400 Store Supplies . . . . . . . . . 6,600 Equipment . . . . . . . . . . . 50,000

Accounts Payable . . . . 2,200 Unearned Lesson Fees . . . 15,600 Total Equity* . . . . . . . . . 62,900

Annual net income . . . 40,000

* The total equity amount reflects all owner investments, dividends, revenues, and expenses as of December 31, 2013.

ENTREPRENEURIAL DECISION A1 A2 P3

Key Figure KTM Polaris Arctic Cat

Return on assets . . . . . . . . . 4.3% 18.5% 4.8%

Debt ratio . . . . . . . . . . . . . . 54.8% 59.3% 32.9%

Required

1. Which company is most profitable according to its return on assets? 2. Which company is most risky according to the debt ratio? 3. Which company deserves increased investment based on a joint analysis of return on assets and the

debt ratio? Explain.

BTN 2-10 KTM (www.KTM.com) is a leading manufacturer of offroad and street motorcycles, and it competes to some extent with both Polaris and Arctic Cat. Key financial ratios for the current fiscal year follow.

GLOBAL DECISION A2

KTM Polaris Arctic Cat

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Chapter 2 Analyzing and Recording Transactions 95

1. b; debit Utility Expense for $700, and credit Cash for $700. 2. a; debit Cash for $2,500, and credit Unearned Lawn Service Fees for

$2,500.

3. c; debit Cash for $250,000, debit Land for $500,000, and credit Common Stock for $750,000.

4. d 5. e; Debt ratio 5 $400,000y$1,000,000 5 40%

ANSWERS TO MULTIPLE CHOICE QUIZ

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Learning Objectives

CONCEPTUAL

C1 Explain the importance of periodic reporting and the time period assumption. (p. 98) C2 Explain accrual accounting and how it improves financial statements. (p. 99) C3 Identify steps in the accounting cycle. (p. 116) C4 Explain and prepare a classified balance sheet. (p. 117)

ANALYTICAL

A1 Explain how accounting adjustments link to financial statements. (p. 109) A2 Compute profit margin and describe its use in analyzing company performance. (p. 121) A3 Compute the current ratio and describe what it reveals about a company’s financial

condition. (p. 121)

PROCEDURAL

P1 Prepare and explain adjusting entries. (p. 100) P2 Explain and prepare an adjusted trial balance. (p. 110) P3 Prepare financial statements from an adjusted trial balance. (p. 110) P4 Describe and prepare closing entries. (p. 112) P5 Explain and prepare a post-closing trial balance. (p. 114) P6 Appendix 3A —Explain the alternatives in accounting for prepaids. (p. 125) P7 Appendix 3B—Prepare a work sheet and explain its usefulness. (p. 127) P8 Appendix 3C—Prepare reversing entries and explain their purpose. (p. 131)

A Look at This Chapter

This chapter explains the timing of reports and the need to adjust accounts. Adjusting accounts is important for recognizing revenues and expenses in the proper period. We describe how to prepare financial statements from an adjusted trial balance, and how the closing process works.

A Look Back

Chapter 2 explained the analysis and recording of transactions. We showed how to apply and interpret company accounts, T-accounts, double-entry accounting, ledgers, postings, and trial balances.

Adjusting Accounts and Preparing Financial Statements 3

A Look Ahead

Chapter 4 looks at accounting for merchandising activities. We describe the sale and purchase of merchandise and their implications for preparing and analyzing financial statements.

96

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Dorm Roomies to Fashion Divas

NEW YORK—”Never in a million years did I think that just three months after graduation I would already have my own business,” recalls Ashley Cook. “It is a lot of work, but a dream come true!” Ashley, along with Danielle Dankner, launched ash&dans (ashanddans.com), an affordable line of scarves and embel- lished jersey pieces, including tops and dresses. “We learn something new everyday,” explains Ashley. “We enjoy both the business side and the creative side and fill each day with equal amounts of both.” Ashley and Danielle explain how they set up an accounting system early on to account for all business activities, including cash, revenues, receivables, and payables. They also had to learn about the deferral and accrual of revenues and expenses. Setting up an accounting system was an important part of their success, explains Ashley. “The reason we were able to make things work was because we were extremely prudent with our money. We kept our costs down to a minimum . . . [and] because we were so careful with our buying, we were able to cover our costs by selling our product and keeping very little inventory.” “It is amazing how much we have developed our business savvy,” says Ashley. This includes monitoring the adjusting of accounts so that revenues and expenses are properly reported

so that good decisions are made. Adds Ashley, “We do every- thing inhouse . . . from design to marketing to PR to sales to accounting.” Financial statement preparation and analysis are tasks that Ashley and Danielle emphasize. Although they insist on timely and accurate accounting reports, Ashley says “we are very happy with how our business started and how it has grown.” To achieve that growth, Ashley and Danielle took time to under- stand accounting adjustments and their effects. It is part of the larger picture. “People love our story.” For that to continue, they insist that a reliable accounting system is necessary . . . other- wise the business side would fail. “We look forward to growing our brand, continually challeng- ing ourselves and coming up with innovative designs,” says Ashley. She also offers a little advice: “Educate yourself and surround yourself with people who know more than you do. Never be afraid to ask questions or take risks.” Adds Danielle, “The most difficult part was simply learning to block out the non-believers.”

[Sources: ash&dans Website, January 2013; Under30CEO, March 2010; ClosetVanity.com, December 2011; Washington Magazine, October 2010; YHP, December 2009]

“Do what you love and love what you do.” —ASHLEY COOK (ON RIGHT)

Decision Insight

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Chapter Preview

Chapters 1 and 2 described how transactions and events are ana- lyzed, journalized, and posted. This chapter describes important adjustments that are often necessary to properly reflect revenues when earned and expenses when incurred. This chapter also de- scribes financial statement preparation. It explains the closing

process that readies revenue, expense, and dividend accounts for the next reporting period and updates retained earnings. It also explains how accounts are classified on a balance sheet to in- crease their usefulness to decision makers.

This section describes the importance of reporting accounting information at regular intervals and its impact for recording revenues and expenses.

The Accounting Period The value of information is often linked to its timeliness. Useful information must reach decision makers frequently and promptly. To provide timely information, accounting systems prepare reports at regular intervals. This results in an accounting process impacted by the time

period (or periodicity) assumption. The time period assumption presumes that an organization’s

activities

can be divided into specific time periods such as a month, a three-month quarter, a six-month interval, or a year. Exhibit 3.1 shows various accounting, or report- ing, periods. Most organizations use a year as their primary accounting period. Reports covering a one-year period are known as annual financial statements. Many organizations also prepare interim financial statements covering one, three, or six months of activity.

C1 Explain the importance of periodic reporting and the time period assumption.

TIMING AND REPORTING

$0 2013 2012 2011 2010 2009

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

Polaris

“Polaris announces annual income of . . .”

EXHIBIT 3.1 Accounting Periods

Jan. Mar. May June July Aug. Sept. Oct. Nov. TimeDec.

1

1 2 3 4

2 3 4 5 6 7 8 9 10 11 12 Monthly

Quarterly

1 2 Semiannually

1 Annually

Feb. Apr.

98

Adjusting Accounts

• Prepaid expenses • Unearned revenues • Accrued expenses • Accrued revenues • Adjusted trial

balance

Timing and Reporting

• Accounting period • Accrual versus

cash • Recognition of

revenues and expenses

Preparing Financial Statements

• Income statement • Statement of

retained earnings • Balance sheet

Closing Process

• Temporary and per- manent accounts

• Closing entries • Post-closing trial

balance • Accounting cycle

summary

Classified Balance Sheet

• Classification structure

• Classification categories

Adjusting Accounts and Preparing Financial Statements

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 99

The annual reporting period is not always a calendar year ending on December 31. An orga- nization can adopt a fiscal year consisting of any 12 consecutive months. It is also acceptable to adopt an annual reporting period of 52 weeks. For example, Gap’s fiscal year consistently ends the final week of January or the first week of February each year. Companies with little seasonal variation in sales often choose the calendar year as their fiscal year. Facebook, Inc., uses calendar year reporting. However, the financial statements of The Kellogg Company (the company that controls characters such as Tony the Tiger, Snap! Crackle! Pop!, and Keebler Elf) reflect a fiscal year that ends on the Saturday nearest December 31. Com- panies experiencing seasonal variations in sales often choose a natural business year end, which is when sales activities are at their lowest level for the year. The natural business year for retailers such as Walmart, Target, and Macy’s usually ends around January 31, after the holiday season.

Accrual Basis versus Cash Basis After external transactions and events are recorded, several accounts still need adjustments be- fore their balances appear in financial statements. This need arises because internal transactions and events remain unrecorded. Accrual basis accounting uses the adjusting process to recog- nize revenues when earned and expenses when incurred (matched with revenues). Cash basis accounting recognizes revenues when cash is received and records expenses when cash is paid. This means that cash basis net income for a period is the difference between cash receipts and cash payments. Cash basis accounting is not consistent with generally ac- cepted accounting principles (neither U.S. GAAP nor IFRS). It is commonly held that accrual accounting better reflects business performance than infor- mation about cash receipts and payments. Accrual accounting also increases the comparability of financial statements from one period to another. Yet cash basis accounting is useful for sev- eral business decisions — which is the reason companies must report a statement of cash flows. To see the difference between these two accounting systems, let’s consider FastForward’s Pre- paid Insurance account. FastForward paid $2,400 for 24 months of insurance coverage that began on December 1, 2013. Accrual accounting requires that $100 of insurance expense be reported on December 2013’s income statement. Another $1,200 of expense is reported in year 2014, and the remaining $1,100 is reported as expense in the first 11 months of 2015. Exhibit 3.2 illustrates this allocation of insurance cost across these three years. Any unexpired premium is reported as a Prepaid Insurance asset on the accrual basis balance sheet.

Alternatively, a cash basis income statement for December 2013 reports insurance expense of $2,400, as shown in Exhibit 3.3. The cash basis income statements for years 2014 and 2015 report no insurance expense. The cash basis balance sheet never reports an insurance asset because it is immediately expensed. This shows that cash basis income for 2013 – 2015 fails to match the cost of insurance with the insurance benefits received for those years and months.

Insurance Expense 2015

Jan $100

May $100

Sept $100

Feb $100

June $100

Oct $100

Mar $100

July $100

Nov $100

Apr $100

Aug $100

Dec $0

Insurance Expense 2013

2013 2014 2015

Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $100

Insurance Expense 2014

Jan $100

May $100

Sept $100

Feb $100

June $100

Oct $100

Mar $100

July $100

Nov $100

Apr $100

Aug $100

Dec $100

Paid $2,400 for 24 months’ insurance beginning

Dec. 1, 2013

Transaction:

EXHIBIT 3.2 Accrual Accounting for Allocating Prepaid Insurance to Expense

Insurance Expense 2015

Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $0

Insurance Expense 2014

Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $0

Insurance Expense 2013

Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $2,400

2013 2014 2015

Paid $2,400 for 24 months’ insurance beginning

Dec. 1, 2013

Transaction:

EXHIBIT 3.3 Cash Accounting for Allocating Prepaid Insurance to Expense

C2 Explain accrual accounting and how it improves financial statements.

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100 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Recognizing Revenues and Expenses We use the time period assumption to divide a company’s activities into specific time periods, but not all activities are complete when financial statements are prepared. Thus, adjustments often are required to get correct account balances.

We rely on two principles in the adjusting process: revenue recognition and expense recogni- tion (the latter is often referred to as matching). Chapter 1 explained that the revenue recogni- tion principle requires that revenue be recorded when earned, not before and not after. Most companies earn revenue when they provide services and products to customers. A major goal of the adjusting process is to have revenue recognized (reported) in the time period when it is earned. The expense recognition (or matching) principle aims to record expenses in the same accounting period as the revenues that are earned as a result of those expenses. This matching of expenses with the revenue benefits is a major part of the adjusting process.

Matching expenses with revenues often requires us to predict certain events. When we use financial statements, we must understand that they require estimates and therefore include mea- sures that are not precise. Walt Disney’s annual report explains that its production costs from movies, such as its Pirates of the Caribbean series, are matched to revenues based on a ratio of current revenues from the movie divided by its predicted total revenues.

1. Describe a company’s annual reporting period. 2. Why do companies prepare interim financial statements? 3. What two accounting principles most directly drive the adjusting process? 4. Is cash basis accounting consistent with the matching principle? Why or why not? 5. If your company pays a $4,800 premium on April 1, 2013, for two years’ insurance coverage,

how much insurance expense is reported in 2014 using cash basis accounting?

Quick Check Answers — p. 132

Adjusting accounts is a three-step process:

ADJUSTING ACCOUNTS

Point: Recording revenue early over- states current-period revenue and income; recording it late understates current-period revenue and income.

Point: Recording expense early over- states current-period expense and understates current-period income; recording it late understates current- period expense and overstates current-period income.

Step 1: Determine what the current account balance equals.

Step 2: Determine what the current account balance should equal.

Step 3: Record an adjusting entry to get from step 1 to step 2.

Framework for Adjustments Adjustments are necessary for transactions and events that extend over more than one period. It is helpful to group adjustments by the timing of cash receipt or cash payment in relation to the recognition of the related revenues or expenses. Exhibit 3.4 identifies four types of adjustments. The left half of this exhibit shows prepaid expenses (including depreciation) and unearned revenues, which reflect transactions when cash is paid or received before a related expense or

P1 Prepare and explain adjusting entries.

Diamond Foods, Inc., a popular snack maker, was recently investigated for postponing expenses related to payments to its walnut growers. This alleged late expense recognition caused income to be overstated in 2011. Further, this misstatement threatened completion of its recent acquisition of Pringles (for more details, see BusinessWeek, January 17, 2012). ■

Decision Insight

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 101

Adjustments

Paid (or received) cash after

expense (or revenue) recognized

Paid (or received) cash before

expense (or revenue) recognized

Accrued

expenses

Accrued

revenues

Unearned (Deferred)

revenues

Prepaid (Deferred)

expenses*

*Includes depreciation

EXHIBIT 3.4 Types of Adjustments

Assets 5 Liabilities 1 Equity 2100 2100

Adjustment (a)

Dec. 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 100

To record first month’s expired insurance.

Dec. 31 100

Insurance Expense 637

Dec. 6 2,400

Balance 2,300

Dec. 31 100

Prepaid Insurance 128

revenue is recognized. They are also called deferrals because the recognition of an expense (or revenue) is deferred until after the related cash is paid (or received). The right half of this ex hibit shows accrued expenses and accrued revenues, which reflect transactions when cash is paid or received after a related expense or revenue is recognized. Adjusting entries are nec- essary for each of these so that revenues, expenses, assets, and liabilities are correctly re- ported. Specifically, an adjusting entry is made at the end of an accounting period to reflect a transaction or event that is not yet recorded. Each adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never the Cash account).

Prepaid (Deferred) Expenses Prepaid expenses refer to items paid for in advance of receiving their benefits. Prepaid expenses are assets. When these assets are used, their costs become expenses. Adjusting entries for prepaids increase expenses and de- crease assets as shown in the T-accounts of Exhibit 3.5. Such adjustments reflect transactions and events that use up pre- paid expenses (including passage of time). To illustrate the accounting for prepaid expenses, we look at prepaid insurance, supplies, and depreciation.

Prepaid Insurance We use our 3-step process for this and all accounting adjustments.

Step 1: We determine that the current balance of FastForward’s prepaid insurance is equal to its $2,400 payment for 24 months of insurance benefits that began on December 1, 2013.

Step 2: With the passage of time, the benefits of the insurance gradually expire and a portion of the Prepaid Insurance asset becomes expense. For instance, one month’s insurance coverage expires by December 31, 2013. This expense is $100, or 1y24 of $2,400, which leaves $2,300.

Step 3: The adjusting entry to record this expense and reduce the asset, along with T-account postings, follows:

Asset

Unadjusted balance

Credit adjustment

Expense

Debit adjustment

Dr. Expense… # Cr. Asset….. #

Decreased Increased EXHIBIT 3.5 Adjusting for Prepaid Expenses

Insurance Dec. 6 Pay insurance premium and record asset

Dec. 31 Coverage expires and record expense

Two-Year Insurance Policy Total cost is $2,400 Monthly cost is $100

Point: Source documents provide information for most daily transactions, and in many businesses the recordkeep- ers record them. Adjustments require more knowledge and are usually handled by senior accounting professionals.

Explanation After adjusting and posting, the $100 balance in Insurance Expense and the $2,300 balance in Prepaid Insurance are ready for reporting in financial statements. Not making the

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102 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Explanation The balance of the Supplies account is $8,670 after posting — equaling the cost of the remaining supplies. Not making the adjustment on or before December 31 would (1) un- derstate expenses by $1,050 and overstate net income by $1,050 for the December income statement and (2) overstate both supplies and equity (because of net income) by $1,050 in the December 31 balance sheet. The following table highlights the adjustment for supplies.

Assets 5 Liabilities 1 Equity 21,050 21,050

Adjustment (b)

Dec. 31 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

To record supplies used.

Dec. 31 1,050

Supplies Expense 652

Dec. 2 2,500

6 7,100

26 120

Balance 8,670

Dec. 31 1,050

Supplies 126

Prepaid Insurance 5 $2,400

Reports $2,400 policy for 24-months’ coverage.

Deduct $100 from Prepaid Insurance Add $100 to Insurance Expense

Record current month’s $100 insurance ex- pense and $100 reduction in prepaid

amount.

Prepaid Insurance 5 $2,300

Reports $2,300 in coverage for remaining 23 months.

Before Adjustment Adjustment After Adjustment

Supplies 5 $9,720

Reports $9,720 in supplies.

Deduct $1,050 from Supplies Add $1,050 to Supplies Expense

Record $1,050 in supplies used and $1,050 as supplies expense.

Supplies 5 $8,670

Reports $8,670 in supplies.

Before Adjustment Adjustment After Adjustment

Supplies

Dec. 2,6,26 Purchase supplies and record asset

Dec. 31 Supplies used and record expense

Supplies Supplies are a prepaid expense requiring adjustment.

Step 1: FastForward purchased $9,720 of supplies in December and some of them were used during this month. When financial statements are prepared at December 31, the cost of supplies used during December must be recognized.

Step 2: When FastForward computes (takes physical count of) its remaining unused supplies at December 31, it finds $8,670 of supplies remaining of the $9,720 total supplies. The $1,050 difference between these two amounts is December’s supplies expense.

Step 3: The adjusting entry to record this expense and reduce the Supplies asset account, along with T-account postings, follows:

Point: We assume that prepaid and unearned items are recorded in balance sheet accounts. An alternative is to record them in income statement accounts; Appendix 3A discusses this alternative. The adjusted financial state- ments are identical.

Other Prepaid Expenses Other prepaid expenses, such as Prepaid Rent, are accounted for exactly as Insurance and Supplies are. We should note that some prepaid expenses are both paid for and fully used up within a single accounting period. One ex ample is when a company pays monthly rent on the first day of each month. This payment creates a prepaid expense on the first day of each month that fully expires by the end of the month. In these special cases, we can record the cash paid with a debit to an expense account instead of an asset account. This practice is described more completely later in the chapter.

ad justment on or before December 31 would (1) understate expenses by $100 and overstate net in- come by $100 for the December income statement and (2) overstate both prepaid insurance (assets) and equity (because of net income) by $100 in the December 31 balance sheet. (Exhibit 3.2 showed that 2014’s adjustments must transfer a total of $1,200 from Prepaid Insurance to Insurance Ex- pense, and 2015’s adjustments must transfer the remaining $1,100 to Insurance Expense.) The fol- lowing table highlights the December 31, 2013, adjustment for prepaid insurance.

Point: Many companies record adjust- ing entries only at the end of each year because of the time and cost necessary.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 103

Depreciation A special category of prepaid expenses is plant assets, which refers to long- term tangible assets used to produce and sell products and services. Plant assets are expected to provide benefits for more than one period. Examples of plant assets are buildings, machines, vehicles, and fixtures. All plant assets, with a general ex ception for land, eventually wear out or decline in usefulness. The costs of these assets are deferred but are gradually reported as ex- penses in the income statement over the assets’ useful lives (benefit periods). Depreciation is the process of allocating the costs of these assets over their expected useful lives. Depreciation expense is recorded with an adjusting entry similar to that for other prepaid expenses.

Step 1: Recall that FastForward purchased equipment for $26,000 in early December to use in earning revenue. This equipment’s cost must be depreciated.

Step 2: The equipment is expected to have a useful life (benefit period) of four years and to be worth about $8,000 at the end of four years. This means the net cost of this equipment over its use- ful life is $18,000 ($26,000 2 $8,000). We can use any of several methods to allocate this $18,000 net cost to expense. FastForward uses a method called straight-line depreciation, which allocates equal amounts of the asset’s net cost to depreciation during its useful life. Dividing the $18,000 net cost by the 48 months in the asset’s useful life gives a monthly cost of $375 ($18,000y48).

Step 3: The adjusting entry to record monthly depreciation expense, along with T-account post- ings, follows:

Explanation After posting the adjustment, the Equipment account ($26,000) less its Accumulated Depreciation ($375) account equals the $25,625 net cost (made up of $17,625 for the 47 remaining months in the benefit period plus the $8,000 value at the end of that time). The $375 balance in the Depreciation Expense account is reported in the December income state- ment. Not making the adjustment at December 31 would (1) understate expenses by $375 and overstate net income by $375 for the December income statement and (2) overstate both assets and equity (because of income) by $375 in the December 31 balance sheet. The following table highlights the adjustment for depreciation.

Point: Depreciation does not neces sarily measure decline in market value.

Point: An asset’s expected value at the end of its useful life is called salvage value.

Point: Plant assets are also called Plant & Equipment, or Property, Plant & Equipment.

Adjustment (c)

Dec. 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 375

Accumulated Depreciation — Equipment . . . . . . . . 375

To record monthly equipment depreciation.

Dec. 31 375

Depreciation 612 Expense — Equipment

Dec. 3 26,000

Equipment 167

Dec. 31 375

Accumulated 168 Depreciation — Equipment

Assets 5 Liabilities 1 Equity 2375 2375

Depreciation Dec. 3 Purchase equipment and record asset

Dec. 31 Allocate asset cost and record depreciation

Equipment, net 5 $26,000

Reports $26,000 in equipment.

Deduct $375 from Equipment, net Add $375 to Depreciation Expense

Record $375 in depreciation and $375 as accumulated depreciation, which is deducted

from equipment.

Equipment, net 5 $25,625

Reports $25,625 in equipment, net of accumulated depreciation.

Before Adjustment Adjustment After Adjustment

Accumulated depreciation is kept in a separate contra account. A contra account is an ac- count linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance. For instance, FastForward’s contra account of Accumulated Depreciation — Equipment is subtracted from the Equipment account in the bal- ance sheet (see Exhibit 3.7). This contra account allows balance sheet readers to know both the full costs of assets and the total depreciation.

Investor A small publishing company signs an aspiring Olympic gymnast to write a book. The company pays the gymnast $500,000 to sign plus future book royalties. A note to the company’s financial statements says that “prepaid expenses include $500,000 in author signing fees to be matched against future expected sales.” Is this accounting for the signing bonus acceptable? How does it affect your analysis? ■ [Answer—p. 132]

Decision Maker

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104 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Unearned (Deferred) Revenues The term unearned revenues refers to cash received in advance of providing products and services. Unearned revenues, also called deferred revenues, are liabilities. When cash is accepted, an obliga- tion to provide products or services is accepted. As products or services are provided, the unearned

revenues become earned revenues. Adjusting entries for unearned revenues involve increas- ing revenues and decreasing unearned reve- nues, as shown in Exhibit 3.8.

An example of unearned revenues is from Gannett Co., Inc., publisher of USA TODAY, which reports unexpired (unearned subscrip-

tions) of $224 million: “Revenue is recognized in the period in which it is earned (as newspapers are delivered).” Unearned revenues are nearly 25% of the current liabilities for Gannett. Another example comes from the Boston Celtics. When the Celtics receive cash from advance ticket sales and broad- cast fees, they record it in an unearned revenue account called Deferred Game Revenues. The Celtics recognize this unearned revenue with adjusting entries on a game-by-game basis. Since the NBA regular season begins in October and ends in April, revenue recognition is mainly limited to this pe- riod. For a recent season, the Celtics’ quarterly revenues were $0 million for July – September; $34 million for October – December; $48 million for January – March; and $17 million for April – June.

EXHIBIT 3.6 Accounts after Three Months of Depreciation Adjustments Dec. 3 26,000

Equipment 167 Accumulated 168

Depreciation — Equipment

Dec. 31 375

Jan. 31 375

Feb. 28 375

Balance 1,125

Unearned Revenues

Thanks for cash in advance. I’ll work now

through Feb. 24

Dec. 26 Cash received in advance and record liability

Dec. 31 Provided services and record revenue

EXHIBIT 3.8 Adjusting for Unearned Revenues Liability

Debit adjustment

Unadjusted balance

Revenue

Credit adjustment

Decreased Increased

Dr. Liability….. # Cr. Revenue… #

Point: To defer is to postpone. We postpone reporting amounts received as revenues until they are earned.

EXHIBIT 3.7 Equipment and Accumulated Depreciation on February 28 Balance Sheet

Assets (at February 28, 2014)

Cash $ ....

Equipment $26,000

Less accumulated depreciation 1,125 24,875

Total Assets $

Commonly titled Equipment, net

The title of the contra account, Accumulated Depreciation, reveals that this account includes to- tal depreciation expense for all prior periods for which the asset was used. To illustrate, the Equip- ment and the Accumulated Depreciation accounts appear as in Exhibit 3.6 on February 28, 2014, after three months of adjusting entries. The $1,125 balance in the accumulated depreciation account can be subtracted from its related $26,000 asset cost. The difference ($24,875) between these two balances is the cost of the asset that has not yet been depreciated. This difference is called the book value, or the net amount, which equals the asset’s costs less its accumulated depreciation. These account balances are reported in the assets section of the February 28 balance sheet in Exhibit 3.7.

Point: The net cost of equipment is also called the depreciable basis.

Point: The cost principle requires an asset to be initially recorded at acquisi- tion cost. Depreciation causes the asset’s book value (cost less accumulated depre- ciation) to decline over time.

Entrepreneur You are preparing an offer to purchase a skate board shop. The depreciation schedule for the shop’s building and equipment shows costs of $175,000 and accumulated depreciation of $155,000. This leaves a net for building and equipment of $20,000. Is this information useful in helping you decide on a purchase offer? ■ [Answer—p. 132]

Decision Maker

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 105

Accounting for unearned revenues is crucial to many companies. For example, the National Retail Federation reports that gift card sales, which are unearned revenues for sellers, exceed $20 billion annually. Gift cards are now the top selling holiday gift; 57.3% of all gift givers planned to give at least one gift card in 2011 (source: NRF Website).

Accrued Expenses Accrued expenses refer to costs that are incurred in a period but are both unpaid and unre- corded. Accrued expenses must be reported on the income statement for the period when incurred. Adjusting entries for recording accrued expenses involve increasing expenses and

This advance payment increases cash and creates an obligation to do consulting work over the next 60 days.

Step 2: As time passes, FastForward earns this payment through consulting. By December 31, it has provided five days’ service and earned 5y60 of the $3,000 unearned revenue. This amounts to $250 ($3,000 3 5y60). The revenue recognition principle implies that $250 of unearned rev- enue must be reported as revenue on the December income statement.

Step 3: The adjusting entry to reduce the liability account and recognize earned revenue, along with T-account postings, follows:

Explanation The adjusting entry transfers $250 from unearned revenue (a liability account) to a revenue account. Not making the adjustment (1) understates revenue and net income by $250 in the December income statement and (2) overstates unearned revenue and understates equity by $250 on the December 31 balance sheet. The following highlights the adjustment for unearned revenue.

Point: Accrued expenses are also called accrued liabilities.

Dec. 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Unearned Consulting Revenue . . . . . . . . . . . . . . . . 3,000

Received advance payment for services over the next 60 days.

Assets 5 Liabilities 1 Equity 13,000 13,000

Unearned Consulting Revenue 5 $3,000

Reports $3,000 in unearned revenue for consulting services promised for

60 days.

Deduct $250 from Unearned Consulting Revenue

Add $250 to Consulting Revenue

Record 5 days of earned consulting revenue, which is 5/60 of unearned

amount.

Unearned Consulting Revenue 5 $2,750

Reports $2,750 in unearned revenue for consulting services owed over

next 55 days.

Before Adjustment Adjustment After Adjustment

Assets 5 Liabilities 1 Equity 2250 1250

Adjustment (d )

Dec. 31 Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . 250

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 250

To record earned revenue that was received in advance ($3,000 3 5y60).

Dec. 5 4,200

12 1,600

31 250

Balance 6,050

Consulting Revenue 403

Dec. 31 250 Dec. 26 3,000

Balance 2,750

Unearned Consulting Revenue 236

Returning to FastForward, it also has unearned revenues. It agreed on December 26 to pro- vide consulting services to a client for a fixed fee of $3,000 for 60 days.

Step 1: On December 26, the client paid the 60-day fee in advance, covering the period December 27 to February 24. The entry to record the cash received in advance is

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106 Chapter 3 Adjusting Accounts and Preparing Financial Statements

increasing liabilities as shown in Exhibit 3.9. This adjustment recognizes expenses in- curred in a period but not yet paid. Com- mon examples of accrued expenses are salaries, interest, rent, and taxes. We use salaries and interest to show how to adjust accounts for accrued expenses.

Accrued Salaries Expense FastForward’s employee earns $70 per day, or $350 for a five-day workweek beginning on Monday and ending on Friday.

Step 1: Its employee is paid every two weeks on Friday. On December 12 and 26, the wages are paid, recorded in the journal, and posted to the ledger.

Step 2: The calendar in Exhibit 3.10 shows three working days after the December 26 payday (29, 30, and 31). This means the employee has earned three days’ salary by the close of business

Explanation Salaries expense of $1,610 is reported on the December income statement and $210 of salaries payable (liability) is reported in the balance sheet. Not making the adjustment (1) understates salaries expense and overstates net income by $210 in the December income statement and (2) understates salaries payable (liabilities) and overstates equity by $210 on the December 31 balance sheet. The following highlights the adjustment for salaries incurred.

Assets 5 Liabilities 1 Equity 1210 2210

Adjustment (e)

Dec. 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

To record three days’ accrued salary (3 3 $70).

Dec. 12 700

26 700

31 210

Balance 1,610

Salaries Expense 622

Dec. 31 210

Salaries Payable 209

EXHIBIT 3.10 Salary Accrual and Paydays

PaydayPaydaySalary expense incurred

Pay period begins

S M T W T F S 1 2 3 4 5 6

7 8 9 10 11 12 13

14 15 16 17 18 19 20

21 22 23 24 25 26 27

28 29 30 31

S M T W T F S 1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 27 28 29 30 31

December January

Point: An employer records salaries expense and a vacation pay liability when employees earn vacation pay.

on Wednesday, December 31, yet this salary cost has not been paid or recorded. The financial statements would be incomplete if FastForward failed to report the added expense and liability to the employee for unpaid salary from December 29, 30, and 31.

Step 3: The adjusting entry to account for accrued salaries, along with T-account postings, follows:

Salaries Payable 5 $0

Reports $0 from employee salaries incurred but not yet paid in cash.

Add $210 to Salaries Payable Add $210 to Salaries Expense

Record 3 days’ salaries owed to employee, but not yet paid, at

$70 per day.

Salaries Payable 5 $210

Reports $210 salaries payable to employee but not yet paid.

Before Adjustment Adjustment After Adjustment

EXHIBIT 3.9 Adjusting for Accrued Expenses Expense

Debit adjustment

Liability

Credit adjustment

Increased Increased

Dr. Expense…. . # Cr. Liability… #

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 107

The $210 debit reflects the payment of the liability for the three days’ salary accrued on Decem- ber 31. The $490 debit records the salary for January’s first seven working days (including the New Year’s Day holiday) as an expense of the new accounting period. The $700 credit records the total amount of cash paid to the employee.

Accrued Revenues The term accrued revenues refers to revenues earned in a period that are both unrecorded and not yet received in cash (or other assets). An example is a technician who bills customers only when the job is done. If one-third of a job is complete by the end of a period, then the technician must record one-third of the expected billing as revenue in that period — even though there is no billing or collection. The adjusting entries for accrued revenues increase assets and in- crease revenues as shown in Exhibit 3.11. Accrued revenues commonly arise from ser- vices, products, interest, and rent. We use service fees and interest to show how to ad- just for accrued revenues.

Accrued Services Revenue Accrued revenues are not recorded until adjusting entries are made at the end of the accounting period. These accrued revenues are earned but unrecorded because either the buyer has not yet paid for them or the seller has not yet billed the buyer. FastForward provides an example.

Step 1: In the second week of December, it agreed to provide 30 days of consulting services to a local fitness club for a fixed fee of $2,700. The terms of the initial agreement call for FastForward to provide services from December 12, 2013, through January 10, 2014, or 30 days of service. The club agrees to pay FastForward $2,700 on January 10, 2014, when the ser vice period is complete.

Step 2: At December 31, 2013, 20 days of services have already been provided. Since the contracted services have not yet been entirely provided, FastForward has neither billed the club nor recorded the services already provided. Still, FastForward has earned two-thirds of the 30-day fee, or $1,800 ($2,700 3 20y30). The revenue recognition principle implies that it must report the $1,800 on the December income statement. The balance sheet also must re- port that the club owes FastForward $1,800.

Point: Accrued revenues are also called accrued assets.

EXHIBIT 3.11 Adjusting for Accrued RevenuesAsset

Debit adjustment

Revenue

Credit adjustment

Increased Increased

Dr. Asset…. . . . . . # Cr. Revenue… #

Accrued Revenues

Jan. 10 Receive cash and reduce receivable

Dec. 31 Record revenue and receivable for services provided but unbilled

Pay me when I'm done

Jan. 9 Salaries Payable (3 days at $70 per day) . . . . . . . . . . . . . 210

Salaries Expense (7 days at $70 per day) . . . . . . . . . . . . 490

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Paid two weeks’ salary including three days accrued in December.

Assets 5 Liabilities 1 Equity 2700 2210 2490

Accrued Interest Expense Companies commonly have accrued interest expense on notes payable and other long-term liabilities at the end of a period. Interest expense is incurred with the passage of time. Unless interest is paid on the last day of an accounting period, we need to adjust for interest expense incurred but not yet paid. This means we must accrue interest cost from the most recent payment date up to the end of the period. The formula for computing accrued interest is:

Principal amount owed 3 Annual interest rate 3 Fraction of year since last payment date.

To illustrate, if a company has a $6,000 loan from a bank at 6% annual interest, then 30 days’ accrued interest expense is $30 — computed as $6,000 3 0.06 3 30y360. The adjusting entry would be to debit Interest Expense for $30 and credit Interest Payable for $30.

Future Payment of Accrued Expenses Adjusting entries for accrued expenses foretell cash transactions in future periods. Specifically, accrued expenses at the end of one ac- counting period result in cash payment in a future period(s). To illustrate, recall that FastForward recorded accrued salaries of $210. On January 9, the first payday of the next period, the follow- ing entry settles the accrued liability (salaries payable) and records salaries expense for seven days of work in January:

Point: Interest computations assume a 360-day year; known as the bankers’ rule.

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108 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Jan. 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700

Accounts Receivable (20 days at $90 per day) . . . . . . 1,800

Consulting Revenue (10 days at $90 per day) . . . . . 900

Received cash for the accrued asset and recorded earned consulting revenue for January.

Assets 5 Liabilities 1 Equity 12,700 1900 21,800

Explanation Accounts receivable are reported on the balance sheet at $1,800, and the $7,850 total of consulting revenue is reported on the income statement. Not making the adjustment would understate (1) both consulting revenue and net income by $1,800 in the December income statement and (2) both accounts receivable (assets) and equity by $1,800 on the Decem- ber 31 balance sheet. The following table highlights the adjustment for accrued revenue.

Example: What is the adjusting entry if the 30-day consulting period began on December 22? Answer: One-third of the fee is earned: Accounts Receivable . . . . . . . 900 Consulting Revenue . . . . 900

Accrued Interest Revenue In addition to the accrued interest expense we described earlier, interest can yield an accrued revenue when a debtor owes money (or other assets) to a company. If a company is holding notes or accounts receivable that produce interest revenue, we must adjust the accounts to record any earned and yet uncollected interest revenue. The adjusting entry is similar to the one for accruing services revenue. Specifically, we debit Interest Receiv- able (asset) and credit Interest Revenue.

Future Receipt of Accrued Revenues Accrued revenues at the end of one accounting period result in cash receipts in a future period(s). To illustrate, recall that FastForward made an adjusting entry for $1,800 to record 20 days’ accrued revenue earned from its consulting contract. When FastForward receives $2,700 cash on January 10 for the entire contract amount, it makes the following entry to remove the accrued asset (accounts receivable) and recognize the revenue earned in January. The $2,700 debit reflects the cash received. The $1,800 credit reflects the re- moval of the receivable, and the $900 credit records the revenue earned in January.

Accounts Receivable 5 $0

Reports $0 from revenue earned but not yet received in cash.

Add $1,800 to Accounts Receivable

Add $1,800 to Consulting Revenue

Record 20 days of earned consulting revenue, which is 20/30 of total

contract amount.

Accounts Receivable 5 $1,800

Reports $1,800 in accounts receivable from consulting

services provided.

Before Adjustment Adjustment After Adjustment

Assets 5 Liabilities 1 Equity 11,800 11,800

Adjustment (f )

Dec. 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 1,800

To record 20 days’ accrued revenue.

Dec. 12 1,900

31 1,800

Balance 1,800

Dec. 22 1,900

Accounts Receivable 106

Dec. 5 4,200

12 1,600

31 250

31 1,800

Balance 7,850

Consulting Revenue 403

Step 3: The year-end adjusting entry to account for accrued services revenue is

Loan Officer The owner of a custom audio, video, and home theater store applies for a business loan. The store’s financial statements reveal large increases in current-year revenues and income. Analysis shows that these increases are due to a promotion that let consumers buy now and pay nothing until January 1 of next year. The store recorded these sales as accrued revenue. Does your analysis raise any concerns? ■ [Answer—p. 132]

Decision Maker

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 109

Links to Financial Statements The process of adjusting accounts is intended to bring an asset or liability account balance to its correct amount. It also updates a related expense or revenue account. These adjustments are necessary for transactions and events that extend over more than one period. (Adjusting entries are posted like any other entry.) Exhibit 3.12 summarizes the four types of transactions requiring adjustment. Understanding this exhibit is important to understanding the adjusting process and its importance to financial statements. Remember that each adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never cash).

Information about some adjustments is not always available until several days or even weeks after the period-end. This means that some adjusting and closing entries are recorded later than, but dated as of, the last day of the period. One example is a company that receives a utility bill on January 10 for costs incurred for the month of December. When it receives the bill, the com- pany records the expense and the payable as of December 31. Other examples include long- distance phone usage and costs of many Web billings. The December income statement reflects these additional expenses incurred, and the December 31 balance sheet includes these payables, although the amounts were not actually known on December 31.

A1 Explain how accounting adjustments link to financial statements.

BEFORE Adjusting

Category Balance Sheet Income Statement Adjusting Entry

Prepaid expenses† Asset overstated Expense understated Dr. Expense

Equity overstated Cr. Asset*

Unearned revenues† Liability overstated Revenue understated Dr. Liability

Equity understated Cr. Revenue

Accrued expenses Liability understated Expense understated Dr. Expense

Equity overstated Cr. Liability

Accrued revenues Asset understated Revenue understated Dr. Asset

Equity understated Cr. Revenue

* For depreciation, the credit is to Accumulated Depreciation (contra asset). † Exhibit assumes that prepaid expenses are initially recorded as assets and that unearned revenues are initially recorded as liabilities.

EXHIBIT 3.12 Summary of Adjustments and Financial Statement Links

6. If an adjusting entry for accrued revenues of $200 at year-end is omitted, what is this error’s effect on the year-end income statement and balance sheet?

7. What is a contra account? Explain its purpose. 8. What is an accrued expense? Give an example. 9. Describe how an unearned revenue arises. Give an example.

Quick Check Answers — p. 132

Financial Officer At year-end, the president instructs you, the financial officer, not to record accrued expenses until next year because they will not be paid until then. The president also directs you to record in current-year sales a recent purchase order from a customer that requires merchandise to be delivered two weeks after the year-end. Your company would report a net income instead of a net loss if you carry out these instructions. What do you do? ■ [Answer—p. 132]

Decision Ethics

Point: CFOs often feel pressure to pursue fraudulent accounting due to pressure applied by their superiors, such as overbearing CEOs or aggressive boards.

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110 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Adjusted Trial Balance An unadjusted trial balance is a list of accounts and balances prepared before adjustments are recorded. An adjusted trial balance is a list of accounts and balances prepared after adjusting entries have been recorded and posted to the ledger. Exhibit 3.13 shows both the unadjusted and the adjusted trial balances for FastForward at December 31, 2013. The order of accounts in the trial balance is usually set up to match the order in the chart of accounts. Several new accounts arise from the adjusting entries.

EXHIBIT 3.13 Unadjusted and Adjusted Trial Balances

Dr. Cr. Dr. Cr.Cr. Dr.

FASTFORWARD Trial Balances

December 31, 2013

Unadjusted Trial Balance Adjustments

Adjusted Trial Balance

(f) $1,800

(d) 250

$ 0

0

200 200

6,200

3,000 30,000

0

$45,300

5,800

300

0 $ 4,350

9,720 2,400

26,000

0

0

0

1,400

1,000

230 $45,300 $3,785

(c) 375 (e) 210 (a) 100

(b) 1,050

1,800 $ 4,350

8,670 2,300

26,000

375 1,610

100 1,000 1,050

230 $47,685

(b) $1,050 (a) 100

(c) 375

(e) 210

$3,785

(d) 250 (f) 1,800

$ 375 6,200

210 2,750

30,000 0

$47,685

7,850

300

Acct. No. 101 106 126 128 167 168 201 209 236 307 318 319

Cash Account Title

Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable Unearned consulting revenue Common stock

403

406 612 622 637 640 652 690

Retained earnings Dividends Consulting revenue

Rental revenue Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals

Each adjustment (see middle columns) is identified by a letter in parentheses that links it to an adjusting entry explained earlier. Each amount in the Adjusted Trial Balance columns is com- puted by taking that account’s amount from the Unadjusted Trial Balance columns and adding or subtracting any adjustment(s). To illustrate, Supplies has a $9,720 Dr. balance in the unad- justed columns. Subtracting the $1,050 Cr. amount shown in the adjustments columns yields an adjusted $8,670 Dr. balance for Supplies. An account can have more than one adjustment, such as for Consulting Revenue. Also, some accounts might not require adjustment for this period, such as Accounts Payable.

P2 Explain and prepare an adjusted trial balance.

P3 Prepare financial statements from an adjusted trial balance.

We can prepare financial statements directly from information in the adjusted trial balance. An adjusted trial balance (see the right-most columns in Exhibit 3.13) includes all accounts and balances appearing in financial statements, and is easier to work from than the entire ledger when preparing financial statements.

PREPARING FINANCIAL STATEMENTS

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 111

Exhibit 3.14 shows how revenue and expense balances are transferred from the adjusted trial bal- ance to the income statement (red lines). The net income and the dividends amount are then used to prepare the statement of retained earnings (black lines). Asset and liability balances on the adjusted trial balance are then transferred to the balance sheet (blue lines). The ending retained earnings is determined on the statement of retained earnings and transferred to the balance sheet (green lines).

EXHIBIT 3.14 Preparing Financial Statements (Adjusted Trial Balance from Exhibit 3.13)

Steps to Prepare Financial Statements

Prepare income statement using revenue and expense accounts from trial balance.

Prepare balance sheet using asset and liability accounts, and common stock, from trial balance; and pull updated retained earnings from step 2.

Prepare statement of retained earnings using retained earnings and dividends from trial balance; and pull net income from step 1.

Prepare statement of cash flows from changes in cash flows for the period (illustrated later in the book).

Step 1

Step 2

Step 4

Step 3

8,670 2,300

1,800 $ 4,350

26,000

101 Cash .................................................. Accounts receivable .......................... Supplies ............................................. Prepaid insurance .............................. Equipment ......................................... Accumulated depreciation—Equip. ... Accounts payable .............................. Salaries payable ................................

106 126 128 167 168 201 209

Unearned consulting revenue ............236

$ 375

210 6,200

2,750 30,000

0 Common stock .................................307 Retained earnings .............................318

$47,685

375 1,610

100 1,000 1,050

230

Consulting revenue ............................403 Rental revenue ................................... 406 Depreciation expense—Equip. ..........612 Salaries expense ................................622 Insurance expense ............................637 Rent expense .....................................640 Supplies expense ..............................652 Utilities expense ................................ Totals .................................................

690

300 7,850

$47,685

200Dividends .........................................319

Step 1 Prepare income statement

Revenues Consulting revenue ........................ $7,850

300 Rental revenue ............................... Total revenues ...............................

Depreciation expense — Equip........ Expenses

Salaries expense ............................ Insurance expense.......................... Rent expense.................................. Supplies expense............................ Utilities expense.............................. Total expenses.................................. Net income........................................

375 1,610 100

230

1,000 1,050

4,365 $3,785

$8,150

Liabilities

Equity

Step 3 Prepare balance sheet

Cash................................................ $ 4,350 Accounts receivable........................ 1,800

8,670 2,300

Supplies.......................................... Prepaid insurance...........................

Total assets ................................... $ 42,745 25,625

$26,000Equipment....................................... 375Less accumulated depreciation......

Accounts payable...........................

Unearned consulting revenue......... 2,750 Salaries payable.............................. 210

6,200

Total liabilities .................................. 9,160

$

Common stock ............................... Retained earnings .......................... Total equity .................................... Total liabilities and equity ..............

33,585

30,000 3,585

Step 2 Prepare statement of retained earnings

$

3,785

$3,585 200Less: Cash dividends ....................

Retained earnings, December 31 ...

Retained earnings, December 1 ..... Plus: Net income ............................ 3,785

0

$ 42,745

Acct.

No. Account Title Debit

FASTFORWARD

Adjusted Trial Balance

December 31, 2013

Credit Assets

FASTFORWARD

Balance Sheet

December 31, 2013

FASTFORWARD

Statement of Retained Earnings

For Month Ended December 31, 2013

FASTFORWARD

Income Statement

For Month Ended December 31, 2013

Point: Sarbanes-Oxley Act requires that financial statements filed with the SEC be certified by the CEO and CFO, including a declaration that the state- ments fairly present the issuer’s opera- tions and financial condition. Violators can receive fines and/or prison terms.

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112 Chapter 3 Adjusting Accounts and Preparing Financial Statements

10. Music-Mart records $1,000 of accrued salaries on December 31. Five days later, on January 5 (the next payday), salaries of $7,000 are paid. What is the January 5 entry?

11. Jordan Air has the following information in its unadjusted and adjusted trial balances. What are the adjusting entries that Jordan Air likely recorded?

Unadjusted Adjusted

Debit Credit Debit Credit

Prepaid insurance . . . . . . . . . . $6,200 $5,900 Salaries payable . . . . . . . . . . $ 0 $1,400

12. What accounts are taken from the adjusted trial balance to prepare an income statement? 13. In preparing financial statements from an adjusted trial balance, what statement is usually

prepared second?

Quick Check Answers — p. 132–133

Revenues Expenses Dividends Income Summary

Temporary Accounts (closed at period-end)

Assets Liabilities Common Stock Retained Earnings

Permanent Accounts (not closed at period-end)

The closing process is an important step at the end of an accounting period after financial state- ments have been completed. It prepares accounts for recording the transactions and the events of the next period. In the closing process we must (1) identify accounts for closing, (2) record and post the closing entries, and (3) prepare a post-closing trial balance. The purpose of the closing process is twofold. First, it resets revenue, expense, and dividends account balances to zero at the end of each period. This is done so that these accounts can properly measure income and dividends for the next period. Second, it helps in summarizing a period’s revenues and ex- penses. This section explains the closing process.

Temporary and Permanent Accounts Temporary (or nominal) accounts accumulate data related to one accounting period. They include all income statement accounts, the dividends account, and the Income Summary account. They are temporary because the accounts are opened at the beginning of a period, used to record transactions and events for that period, and then closed at the end of the period. The closing process applies only to temporary accounts. Permanent (or real) accounts report on activities related to one or more future accounting periods. They carry their ending balances into the next period and generally consist of all balance sheet accounts. These asset, liability, and equity ac- counts are not closed.

Recording Closing Entries To record and post closing entries is to transfer the end-of-period balances in revenue, expense, and dividends accounts to the permanent retained earnings account. Closing entries are neces- sary at the end of each period after financial statements are prepared because

● Revenue, expense, and dividends accounts must begin each period with zero balances. ● Retained earnings must reflect prior periods’ revenues, expenses, and dividends.

CLOSING PROCESS

P4 Describe and prepare closing entries.

We prepare financial statements in the following order: income statement, statement of re- tained earnings, and balance sheet. This order makes sense because the balance sheet uses infor- mation from the statement of retained earnings, which in turn uses information from the income statement. The statement of cash flows is usually the final statement prepared .

Point: Each trial balance amount is used in only one financial statement and, when financial statements are completed, each account will have been used once.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 113

An income statement aims to report revenues and expenses for a specific accounting period. The statement of retained earnings reports similar information, including dividends. Since rev- enue, expense, and dividends accounts must accumulate information separately for each pe- riod, they must start each period with zero balances. To close these accounts, we transfer their balances first to an account called Income Summary. Income Summary is a temporary ac- count (only used for the closing process) that contains a credit for the sum of all revenues (and gains) and a debit for the sum of all expenses (and losses). Its balance equals net income or net loss and it is transferred to retained earnings. Next the dividends account balance is transferred to retained earnings. After these closing entries are posted, the revenue, expense, dividends, and Income Summary accounts have zero balances. These accounts are then said to be closed or cleared. Exhibit 3.15 uses the adjusted account balances of FastForward (from the left side of Exhibit 3.14) to show the four steps necessary to close its temporary accounts. We explain each step.

Point: Retained Earnings is the only permanent account in Exhibit 3.15.

EXHIBIT 3.15 Four-Step Closing Process

Consulting Revenue

Rental Revenue

Balance 7,850

Balance 3004,365 8,150 Balance 3,785

7,850

300 3,785

Balance 200 200

Close income statement credit balances1

Close income statement debit balances2

Close income summary account3

Close dividends account4

Four-Step Closing Process

Balance 0 200 3,785

Balance 3,585

Income Summary

Dividends

Revenue Accounts

Retained Earnings

1

3

4

Expense Accounts Depreciation Expense—Equip.

Balance 375

Salaries Expense

Balance 1,610

Insurance Expense

Balance 100

Rent Expense

Balance 1,000

Supplies Expense

Balance 1,050

Utilities Expense

Balance 230

375

1,610

100

1,000

1,050

230

2

Step 1: Close Credit Balances in Revenue Accounts to Income Summary

The first closing entry transfers credit balances in revenue (and gain) accounts to the Income Summary account. We bring accounts with credit balances to zero by debiting them. For FastForward, this journal entry is step 1 in Exhibit 3.16. This entry closes revenue accounts and leaves them with zero balances. The accounts are now ready to record revenues when they occur in the next period. The $8,150 credit entry to Income Summary equals total revenues for the period.

Step 2: Close Debit Balances in Expense Accounts to Income Summary The second closing entry transfers debit balances in expense (and loss) accounts to the Income Summary account. We bring expense accounts’ debit balances to zero by crediting them. With a balance of zero, these accounts are ready to accumulate a record of expenses for the next period. This second closing entry for FastForward is step 2 in Exhibit 3.16. Exhibit 3.15 shows that posting this entry gives each expense account a zero balance.

Point: It is possible to close revenue and expense accounts directly to retained earnings. Computerized accounting systems do this.

Point: To understand the closing process, focus on its outcomes — updating the retained earnings account balance to its proper ending balance, and getting temporary accounts to show zero balances for purposes of accumulating data for the next period.

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114 Chapter 3 Adjusting Accounts and Preparing Financial Statements

$47,685

8,670 2,300

1,800 $ 4,350

26,000

200

375 1,610

100 1,000 1,050

230

Cash .................................................... Accounts receivable ............................ Supplies .............................................. Prepaid insurance ................................ Equipment ........................................... Accumulated depreciation—Equip...... Accounts payable ................................

Common stock ................................... Retained earnings ............................... Dividends ............................................ Consulting revenue ............................. Rental revenue .................................... Depreciation expense—Equip............. Salaries expense ................................. Insurance expense .............................. Rent expense ...................................... Supplies expense ................................ Utilities expense .................................. Totals ..................................................

FASTFORWARD

Adjusted Trial Balance

December 31, 2013 Dec. 31 Consulting Revenue................................ Rental Revenue....................................... Income Summary............................... To close revenue accounts.

To close Income Summary account.

7,850 300

1,610

8,150

Step 1:

Dec. 31 Income Summary...................................

Salaries Expense............................... Depreciation Expense—Equipment..

Insurance Expense............................ Rent Expense.................................... Supplies Expense.............................. Utilities Expense................................

4,365 375

100 1,000 1,050

230

Step 2:

Dec. 31 Income Summary................................... Retained Earnings..............................

3,785 3,785

Step 3:

$ 375 6,200

Salaries payable .................................. 210 Unearned consulting revenue ............. 2,750

30,000 0

300 7,850

$47,685

To close expense accounts.

CreditDebit

Retained Earnings...................................

To close the dividends account.

Dec. 31 Dividends............................................

200 200

Step 4:

General Journal

EXHIBIT 3.16 Preparing Closing Entries

P5 Explain and prepare a post-closing trial balance.

Step 3: Close Income Summary to Retained Earnings After steps 1 and 2, the bal- ance of Income Summary is equal to December’s net income of $3,785 ($8,150 credit less $4,365 debit). The third closing entry transfers the balance of the Income Summary account to retained earnings. This entry closes the Income Summary account–see step 3 in Exhibit 3.16. The Income Summary account has a zero balance after posting this entry. It continues to have a zero balance until the closing process again occurs at the end of the next period. (If a net loss occurred because expenses exceeded revenues, the third entry is reversed: debit Retained Earnings and credit Income Summary.)

Step 4: Close Dividends Account to Retained Earnings The fourth closing en- try transfers any debit balance in the dividends account to retained earnings—see step 4 in Ex- hibit 3.16. This entry gives the dividends account a zero balance, and the account is now ready to accumulate next period’s dividends. This entry also reduces the retained earnings balance to the $3,585 amount reported on the balance sheet. We could also have selected the accounts and amounts needing to be closed by identifying individual revenue, expense, and dividends accounts in the ledger. This is illustrated in Exhibit 3.16 where we prepare closing entries using the adjusted trial balance. (Information for closing entries is also in the financial statement columns of a work sheet—see Appendix 3B.)

Post-Closing Trial Balance Exhibit 3.17 shows the entire ledger of FastForward as of December 31 after adjusting and clos- ing entries are posted. (The transaction entries are in Chapter 2.) The temporary accounts (rev- enues, expenses, and dividends) have ending balances equal to zero. A post-closing trial balance is a list of permanent accounts and their balances from the led- ger after all closing entries have been journalized and posted. It lists the balances for all ac- counts not closed. These accounts comprise a company’s assets, liabilities, and equity, which are identical to those in the balance sheet. The aim of a post-closing trial balance is to verify that

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EXHIBIT 3.17 General Ledger after the Closing Process for FastForward

Asset Accounts

Liability and Equity Accounts

Revenue and Expense Accounts (Including Income Summary)

Cash Acct. No. 101

Date Explan. PR Debit Credit Balance

2013

Dec. 1 (1) G1 30,000 30,000

2 (2) G1 2,500 27,500

3 (3) G1 26,000 1,500

5 (5) G1 4,200 5,700

6 (13) G1 2,400 3,300

12 (6) G1 1,000 2,300

12 (7) G1 700 1,600

22 (9) G1 1,900 3,500

24 (10) G1 900 2,600

24 (11) G1 200 2,400

26 (12) G1 3,000 5,400

26 (14) G1 120 5,280

26 (15) G1 230 5,050

26 (16) G1 700 4,350

Accounts Receivable Acct. No. 106

Date Explan. PR Debit Credit Balance

2013

Dec. 12 (8) G1 1,900 1,900

22 (9) G1 1,900 0

31 Adj.(f) G1 1,800 1,800

Supplies Acct. No. 126

Date Explan. PR Debit Credit Balance

2013

Dec. 2 (2) G1 2,500 2,500

6 (4) G1 7,100 9,600

26 (14) G1 120 9,720

31 Adj.(b) G1 1,050 8,670

Prepaid Insurance Acct. No. 128

Date Explan. PR Debit Credit Balance

2013

Dec. 6 (13) G1 2,400 2,400

31 Adj.(a) G1 100 2,300

Equipment Acct. No. 167

Date Explan. PR Debit Credit Balance

2013

Dec. 3 (3) G1 26,000 26,000

Accumulated Depreciation — Equipment Acct. No. 168

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(c) G1 375 375

Accounts Payable Acct. No. 201

Date Explan. PR Debit Credit Balance

2013

Dec. 6 (4) G1 7,100 7,100

24 (10) G1 900 6,200

Salaries Payable Acct. No. 209

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(e) G1 210 210

Unearned Consulting Revenue Acct. No. 236

Date Explan. PR Debit Credit Balance

2013

Dec. 26 (12) G1 3,000 3,000

31 Adj.(d) G1 250 2,750

Retained Earnings Acct. No. 318

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Clos.(3) G1 3,785 3,785

31 Clos.(4) G1 200 3,585

Dividends Acct. No. 319

Date Explan. PR Debit Credit Balance

2013

Dec. 24 (11) G1 200 200

31 Clos.(4) G1 200 0

Consulting Revenue Acct. No. 403

Date Explan. PR Debit Credit Balance

2013

Dec. 5 (5) G1 4,200 4,200

12 (8) G1 1,600 5,800

31 Adj.(d) G1 250 6,050

31 Adj.(f) G1 1,800 7,850

31 Clos.(1) G1 7,850 0

Salaries Expense Acct. No. 622

Date Explan. PR Debit Credit Balance

2013

Dec. 12 (7) G1 700 700

26 (16) G1 700 1,400

31 Adj.(e) G1 210 1,610

31 Clos.(2) G1 1,610 0

Supplies Expense Acct. No. 652

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(b) G1 1,050 1,050

31 Clos.(2) G1 1,050 0

Rental Revenue Acct. No. 406

Date Explan. PR Debit Credit Balance

2013

Dec. 12 (8) G1 300 300

31 Clos.(1) G1 300 0

Depreciation Expense — Equipment Acct. No. 612

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(c) G1 375 375

31 Clos.(2) G1 375 0

Insurance Expense Acct. No. 637

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(a) G1 100 100

31 Clos.(2) G1 100 0

Utilities Expense Acct. No. 690

Date Explan. PR Debit Credit Balance

2013

Dec. 26 (15) G1 230 230

31 Clos.(2) G1 230 0

Income Summary Acct. No. 901

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Clos.(1) G1 8,150 8,150

31 Clos.(2) G1 4,365 3,785

31 Clos.(3) G1 3,785 0

Rent Expense Acct. No. 640

Date Explan. PR Debit Credit Balance

2013

Dec. 12 (6) G1 1,000 1,000

31 Clos.(2) G1 1,000 0

Common Stock Acct. No. 307

Date Explan. PR Debit Credit Balance

2013

Dec. 1 (1) G1 30,000 30,000

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116 Chapter 3 Adjusting Accounts and Preparing Financial Statements

(1) total debits equal total credits for permanent accounts and (2) all temporary accounts have zero balances. FastForward’s post-closing trial balance is shown in Exhibit 3.18. The post- closing trial balance usually is the last step in the accounting process.

EXHIBIT 3.18 Post-Closing Trial Balance

FASTFORWARD Post-Closing Trial Balance

December 31, 2013

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,350

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,670

Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Accumulated depreciation—Equipment . . . . . . . . $ 375

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 6,200

Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Unearned consulting revenue . . . . . . . . . . . . . . . . . 2,750

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . 3,585

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $43,120 $43,120

EXHIBIT 3.19 Steps in the Accounting Cycle*

Explanations   1. Analyze transactions Analyze transactions to prepare for journalizing.   2. Journalize Record accounts, including debits and credits, in a journal.   3. Post Transfer debits and credits from the journal to the ledger.   4. Prepare unadjusted trial balance Summarize unadjusted ledger accounts and amounts.   5. Adjust Record adjustments to bring account balances up to date; journalize and post adjustments.   6. Prepare adjusted trial balance Summarize adjusted ledger accounts and amounts.   7. Prepare statements Use adjusted trial balance to prepare financial statements.   8. Close Journalize and post entries to close temporary accounts.   9. Prepare post-closing trial balance Test clerical accuracy of the closing procedures. 10. Reverse (optional) Reverse certain adjustments in the next period—optional step; see Appendix 3C.

* Steps 4, 6, and 9 can be done on a work sheet. A work sheet is useful in planning adjustments, but adjustments (step 5) must always be journalized and posted. Steps 3, 4, 6, and 9 are automatic with a computerized system.

2. Journalize

10. Reverse (Optional)

1. Analyze transactions

Accounting Cycle

3. Post

4. Prepare unadjusted

trial balance

5. Adjust

6. Prepare adjusted

trial balance

9. Prepare post-

closing trial balance

7. Prepare statements

8. Close

Accounting Cycle The term accounting cycle refers to the steps in preparing financial statements. It is called a cycle because the steps are repeated each reporting period. Exhibit 3.19 shows the 10 steps in the cycle, beginning with analyzing trans actions and ending with a post-closing trial balance or

C3 Identify steps in the accounting cycle.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 117

EXHIBIT 3.20 Typical Categories in a Classified Balance Sheet

Assets Liabilities and Equity

Current assets Current liabilities

Noncurrent assets Noncurrent liabilities

Long-term investments Equity

Plant assets

Intangible assets

reversing entries. Steps 1 through 3 usually occur regularly as a company enters into transac- tions. Steps 4 through 9 are done at the end of a period. Reversing entries in step 10 are optional and are explained in Appendix 3C.

Most operating cycles are less than one year. This means most companies use a one-year period in deciding which assets and liabilities are current. A few companies have an operating cycle longer than one year. For instance, producers of certain beverages (wine) and products (ginseng) that require aging for several years have operating cycles longer than one year. A bal- ance sheet lists current assets before noncurrent assets and current liabilities before noncurrent liabilities. This consistency in presentation allows users to quickly identify current assets that are most easily converted to cash and current liabilities that are shortly coming due. Items in current assets and current liabilities are listed in the order of how quickly they will be converted to, or paid in, cash.

14. What are the major steps in preparing closing entries? 15. Why are revenue and expense accounts called temporary? Identify and list the types of

temporary accounts.

16. What accounts are listed on the post-closing trial balance?

Quick Check Answers — p. 133

Our discussion to this point has been limited to unclassified financial statements. This section describes a classified balance sheet. The next chapter describes a classified income statement. An unclassified balance sheet is one whose items are broadly grouped into assets, liabilities, and equity. One example is FastForward’s balance sheet in Exhibit 3.14. A classified balance sheet organizes assets and liabilities into important subgroups that provide more information to decision makers.

Classification Structure A classified balance sheet has no required layout, but it usually contains the categories in Exhibit 3.20. One of the more important classifications is the separation between current and non- current items for both assets and liabilities. Current items are those expected to come due (either collected or owed) within one year or the company’s operating cycle, whichever is longer. The operating cycle is the time span from when cash is used to acquire goods and services until cash is received from the sale of goods and services. “Operating” refers to company operations and “cycle” refers to the circular flow of cash used for company inputs and then cash received from its outputs. The length of a company’s operating cycle depends on its activities. For a ser- vice company, the operating cycle is the time span between (1) paying em ployees who perform the services and (2) receiv ing cash from customers. For a merchandiser selling products, the operating cycle is the time span between (1) paying suppliers for merchandise and (2) receiving cash from customers.

CLASSIFIED BALANCE SHEET

C4 Explain and prepare a classified balance sheet.

Point: Current and Noncurrent are also referred to as Short-Term and Long- Term, respectively.

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118 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Classification Categories This section describes the most common categories in a classified balance sheet. The balance sheet for Snowboarding Components in Exhibit 3.21 shows the typical categories. Its assets are classified as either current or noncurrent. Its noncurrent assets include three main categories: long-term investments, plant assets, and intangible assets. Its liabilities are classified as either current or long-term. Not all companies use the same categories of assets and liabilities for their balance sheets. K2 Sports, a manufacturer of snowboards, reported a balance sheet with only three asset classes: current assets; property, plant and equipment; and other assets.

Current Assets Current assets are cash and other resources that are expected to be sold, collected, or used within one year or the company’s operating cycle, whichever is lon- ger. Examples are cash, short-term investments, accounts receivable, short-term notes

EXHIBIT 3.21 Example of a Classified Balance Sheet

SNOWBOARDING COMPONENTS Balance Sheet

January 31, 2013

Assets

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,500

Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . 2,100

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,500

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,900

Long-term investments

Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Investments in stocks and bonds . . . . . . . . . . . . . . . . . . . 18,000

Land held for future expansion . . . . . . . . . . . . . . . . . . . . 48,000

Total long-term investments . . . . . . . . . . . . . . . . . . . . . . . 67,500

Plant assets

Equipment and buildings . . . . . . . . . . . . . . . . . . . . . . . . . . 203,200

Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . 53,000

Equipment and buildings, net . . . . . . . . . . . . . . . . . . . . . . 150,200

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,200

Total plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223,400

Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,800

Liabilities

Current liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,300

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Current portion of long-term liabilities . . . . . . . . . . . . . . 7,500

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 29,000

Long-term liabilities (net of current portion) . . . . . . . . . 150,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179,000

Equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114,800

Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164,800

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,800

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 119

Point: Plant assets are also called fixed assets; property, plant and equipment; or long-lived assets.

Point: Furniture and fixtures are referred to as F&F, which are classified as noncurrent assets.

Point: Many financial ratios are distorted if accounts are not classified correctly.

Point: Only assets and liabilities are classified as current or noncurrent.

receivable, goods for sale (called merchandise or inventory), and prepaid expenses. The individual prepaid expenses of a company are usually small in amount compared to many other assets and are often combined and shown as a single item. The prepaid expenses likely include items such as prepaid insurance, prepaid rent, office supplies, and store supplies. Prepaid expenses are usually listed last because they will not be converted to cash (instead, they are used).

Long-Term Investments A second major balance sheet classification is long-term (or noncurrent) investments. Notes receivable and investments in stocks and bonds are long- term assets when they are expected to be held for more than the longer of one year or the operating cycle. Land held for future expansion is a long-term investment because it is not used in operations.

Plant Assets Plant assets are tangible assets that are both long-lived and used to produce or sell products and services. Examples are equipment, machinery, buildings, and land that are used to produce or sell products and services. The order listing for plant assets is usually from most liquid to least liquid such as equipment and machinery to buildings and land.

Intangible Assets Intangible assets are long-term resources that benefit business opera- tions, usually lack physical form, and have uncertain benefits. Examples are patents, trade- marks, copyrights, franchises, and goodwill. Their value comes from the privileges or rights granted to or held by the owner. K2 Sports, reported intangible assets of $228 million, which is nearly 20 percent of its total assets. Its intangibles included trademarks, patents, and licensing agreements.

Current Liabilities Current liabilities are obligations due to be paid or settled within one year or the operating cycle, whichever is longer. They are usually settled by paying out current assets such as cash. Current liabilities often include accounts payable, notes payable, wages payable, taxes payable, interest payable, and unearned revenues. Also, any portion of a long- term liability due to be paid within one year or the operating cycle, whichever is longer, is a current liability. Unearned revenues are current liabilities when they will be settled by delivering products or services within one year or the operating cycle, whichever is longer. Current liabili- ties are reported in the order of those to be settled first.

Long-Term Liabilities Long-term liabilities are obligations not due within one year or the operating cycle, whichever is longer. Notes payable, mortgages payable, bonds payable, and lease obligations are common long-term liabilities. If a company has both short- and long-term items in each of these categories, they are commonly separated into two accounts in the ledger.

Equity Equity is the owner’s claim on assets. The equity section for a corporation is divided into two main subsections, common stock and retained earnings.

17. Classify the following assets as (1) current assets, (2) plant assets, or (3) intangible assets: (a) land used in operations, (b) office supplies, (c) receivables from customers due in 10 months, (d ) insurance protection for the next 9 months, (e) trucks used to provide services to customers, (f ) trademarks.

18. Cite at least two examples of assets classified as investments on the balance sheet. 19. Explain the operating cycle for a service company.

Quick Check Answers — p. 133

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120 Chapter 3 Adjusting Accounts and Preparing Financial Statements

We explained that accounting under U.S. GAAP is similar, but not identical, to that under IFRS. This sec- tion discusses differences in adjusting accounts, preparing financial statements, and reporting assets and liabilities on a balance sheet.

Adjusting Accounts Both U.S. GAAP and IFRS include broad and similar guidance for adjust- ing accounts. Although some variations exist in revenue and expense recognition and other principles, all of the adjustments in this chapter are accounted for identically under the two systems. In later chap- ters we describe how certain assets and liabilities can result in different adjusted amounts using fair value measurements.

Preparing Financial Statements Both U.S. GAAP and IFRS prepare the same four basic finan- cial statements following the same process discussed in this chapter. Chapter 2 explained how both U.S. GAAP and IFRS require current items to be separated from noncurrent items on the balance sheet (yield- ing a classified balance sheet). U.S. GAAP balance sheets report current items first. Assets are listed from most liquid to least liquid, where liquid refers to the ease of converting an asset to cash. Liabilities are listed from nearest to maturity to furthest from maturity, maturity refers to the nearness of paying off the liability. IFRS balance sheets normally present noncurrent items first (and equity before liabilities), but this is not a requirement. Other differences with financial statements exist, which we identify in later chapters. Piaggio provides the following example of IFRS reporting for its assets, liabilities, and equity within the balance sheet:

GLOBAL VIEW

PIAGGIO Balance Sheet (in thousands of Euro)

December 31, 2011

Assets Equity and Liabilities Noncurrent assets Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446,218

Intangible assets . . . . . . . . . . . . . . . 649,420 Noncurrent liabilities

Property, plant and equipment. . . . 274,871 Financial liabilities falling due after one year. . . . . . 329,200

Other noncurrent assets . . . . . . . 86,185 Other long-term liabilities . . . . . . . . . . . . . . . . . . . 100,489

Total noncurrent assets . . . . . . . 1,010,476 Total noncurrent liabilities . . . . . . . . . . . . . . . . . 429,689

Current assets Current liabilities

Trade receivables . . . . . . . . . . . . . . 65,560 Financial liabilities falling due within one year . . . . . 170,261

Other receivables . . . . . . . . . . . . . 28,028 Trade payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,263

Short-term tax receivables . . . . . . 27,245 Tax payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,920

Inventories . . . . . . . . . . . . . . . . . . 236,988 Other short-term payables . . . . . . . . . . . . . . . . . . 64,718

Cash and cash equivalents . . . . . . 151,887 Current portion of other long-term provisions . . . 13,115

Total current assets .. . . . . . . . . . 509,708 Total current liabilities . . . . . . . . . . . . . . . . . . . . 644,277

Total assets . . . . . . . . . . . . . . . . . . 1,520,184 Total equity and liabilities . . . . . . . . . . . . . . . . . . . . 1,520,184

IFRS: New revenue recognition rules proposed by the FASB and the IASB re- duce variation between U.S. GAAP and IFRS when accounting for revenue.

Point: IASB and FASB are working to improve financial statements. One pro- posal would reorganize the balance sheet to show assets and liabilities classified as operating, investing, or financing.

PIAGGIO

Closing Process The closing process is identical under U.S. GAAP and IFRS. Although unique accounts can arise under either system, the closing process remains the same.

IFRS Revenue and expense recognition are key to recording accounting adjustments. IFRS tends to be more principles-based relative to U.S. GAAP, which is viewed as more rules-based. A principles-based system depends heavily on control procedures to reduce the potential for fraud or misconduct. Failure in judgment led to improper accounting adjustments at Fannie Mae, Xerox, WorldCom, and others. A KPMG survey of accounting and finance employees found that more than 10% of them had witnessed falsification or ma- nipulation of accounting data within the past year. Internal controls and governance processes are directed at curtailing such behavior. Yet, a 2011 KPMG fraud survey found that one in seven frauds was uncovered by chance, which emphasizes our need to improve internal controls and governance. ■

O pp

or tu

ni ty

Rationalization

Financial Pressure

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 121

Profit Margin and Current Ratio Decision Analysis

A2 Compute profit margin and describe its use in analyzing company performance.

Profit Margin A useful measure of a company’s operating results is the ratio of its net income to net sales. This ratio is called profit margin, or return on sales, and is computed as in Exhibit 3.22.

The Limited’s average profit margin is 5.9% during this 5-year period. This favorably compares to the average industry profit margin of 1.2%. However, Limited’s profit margin has rebounded in the most recent two years—from 2.4% in 2009 to 5.2% and 8.4% for the recent recovery periods (see margin graph). Future success depends on Limited maintaining its market share and increasing its profit margin.

Current Ratio An important use of financial statements is to help assess a company’s ability to pay its debts in the near future. Such analysis affects decisions by suppliers when allowing a company to buy on credit. It also affects decisions by creditors when lending money to a company, including loan terms such as interest rate, due date, and collateral requirements. It can also affect a manager’s decisions about using cash to pay debts when they come due. The current ratio is one measure of a company’s ability to pay its short- term obligations. It is defined in Exhibit 3.24 as current assets divided by current liabilities.

EXHIBIT 3.23 Limited Brands’ Profit Margin

$ in millions 2011 2010 2009 2008 2007

Net income . . . . . . . . . . . . . . . . . $ 805 $ 448 $ 220 $ 718 $ 676

Net sales . . . . . . . . . . . . . . . . . . . $9,613 $8,632 $9,043 $10,134 $10,671

Profit margin . . . . . . . . . . . . . . 8.4% 5.2% 2.4% 7.1% 6.3%

Industry profit margin . . . . . . . . . 2.1% 0.9% 0.3% 1.1% 1.6%

$0 20102011 2009 2008 2007

$1,000

0.0%

2.5%

5.0%

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000 $10,000

RatioMillions

$11,000

7.5%

Limited: Net Income ($) Profit Margin (%)Net Sales ($)

EXHIBIT 3.22 Profit MarginProfit margin 5

Net income Net sales

This ratio is interpreted as reflecting the percent of profit in each dollar of sales. To illustrate how we compute and use profit margin, let’s look at the results of Limited Brands, Inc., in Exhibit 3.23 for its fiscal years 2007 through 2011.

A3 Compute the current ratio and describe what it reveals about a company’s financial condition.

EXHIBIT 3.24 Current RatioCurrent ratio 5

Current assets Current liabilities

Using financial information from Limited Brands, Inc., we compute its current ratio for the recent five- year period. The results are in Exhibit 3.25.

EXHIBIT 3.25 Limited Brands’ Current Ratio

$ in millions 2012 2011 2010 2009 2008 2007

Current assets . . . . . . . . . . . . . . . . $2,368 $2,592 $3,250 $2,867 $2,919 $2,771

Current liabilities . . . . . . . . . . . . . $1,526 $1,504 $1,322 $1,255 $1,374 $1,709

Current ratio . . . . . . . . . . . . . . 1.6 1.7 2.5 2.3 2.1 1.6

Industry current ratio . . . . . . . . . 1.6 1.7 1.9 2.0 2.1 2.3

Limited: Current Liabilities ($) Current RatioCurrent Assets ($)

$0 2011 200920102012 2008 2007

$500 1.5

Millions Ratio

$1,000

$1,500

$2,000

$2,500

$3,500

$3,000

2.0

2.5

Limited Brands’ current ratio averaged 2.0 for its fiscal years 2007 through 2012. The current ratio for each of these years suggests that the company’s short-term obligations can be covered with its short-term assets. However, if its ratio would approach 1.0, Limited would expect to face challenges in covering li- abilities. If the ratio were less than 1.0, current liabilities would exceed current assets, and the company’s

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122 Chapter 3 Adjusting Accounts and Preparing Financial Statements

PLANNING THE SOLUTION ● Analyze each situation to determine which accounts need to be updated with an adjustment. ● Calculate the amount of each adjustment and prepare the necessary journal entries. ● Show the amount of each adjustment in the designated accounts, determine the adjusted balance, and

identify the balance sheet classification of the account. ● Determine each entry’s effect on net income for the year and on total assets, total liabilities, and total

equity at the end of the year.

Effect on Effect on Amount in Effect on Effect on Total Total

Entry the Entry Net Income Total Assets Liabilities Equity

The following information relates to Fanning’s Electronics on December 31, 2013. The company, which uses the calendar year as its annual reporting period, initially records prepaid and unearned items in bal- ance sheet accounts (assets and liabilities, respectively).

a. The company’s weekly payroll is $8,750, paid each Friday for a five-day workweek. Assume December 31, 2013, falls on a Monday, but the employees will not be paid their wages until Friday, January 4, 2014.

b. Eighteen months earlier, on July 1, 2012, the company purchased equipment that cost $20,000. Its use- ful life is predicted to be five years, at which time the equipment is expected to be worthless (zero salvage value).

c. On October 1, 2013, the company agreed to work on a new housing development. The company is paid $120,000 on October 1 in advance of future installation of similar alarm systems in 24 new homes. That amount was credited to the Unearned Services Revenue account. Between October 1 and December 31, work on 20 homes was completed.

d. On September 1, 2013, the company purchased a 12-month insurance policy for $1,800. The transac- tion was recorded with an $1,800 debit to Prepaid Insurance.

e. On December 29, 2013, the company completed a $7,000 service that has not been billed and not re- corded as of December 31, 2013.

Required

1. Prepare any necessary adjusting entries on December 31, 2013, in relation to transactions and events a through e.

2. Prepare T-accounts for the accounts affected by adjusting entries, and post the adjusting entries. Deter- mine the adjusted balances for the Unearned Revenue and the Prepaid Insurance accounts.

3. Complete the following table and determine the amounts and effects of your adjusting entries on the year 2013 income statement and the December 31, 2013, balance sheet. Use up (down) arrows to indicate an increase (decrease) in the Effect columns.

DEMONSTRATION PROBLEM 1

Analyst You are analyzing the financial condition of a company to assess its ability to meet upcoming loan payments. You compute its current ratio as 1.2. You also find that a major portion of accounts receivable is due from one client who has not made any payments in the past 12 months. Removing this receivable from current assets lowers the current ratio to 0.7. What do you conclude? ■ [Answer—p. 132]

Decision Maker

ability to pay short-term obligations could be in doubt. Limited Brand’s liquidity, as evidenced by its current ratio, declines in 2011 and 2012, after growing steadily from 2008–2010.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 123

(a) Dec. 31 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750

Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750

To accrue wages for the last day of the year ($8,750 3 1y5).

(b) Dec. 31 Depreciation Expense — Equipment . . . . . . . . . . . . . . . . 4,000

Accumulated Depreciation — Equipment . . . . . . . . 4,000

To record depreciation expense for the year ($20,000y5 years 5 $4,000 per year).

(c) Dec. 31 Unearned Services Revenue . . . . . . . . . . . . . . . . . . . . . . 100,000

Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

To recognize services revenue earned ($120,000 3 20y24).

(d ) Dec. 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 600

To adjust for expired portion of insurance ($1,800 3 4y12).

(e) Dec. 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

To record services revenue earned.

2. T-accounts for adjusting journal entries a through e.

Accounts Receivable

(e) 7,000

Insurance Expense

(d ) 600

Prepaid Insurance

Unadj. Bal. 1,800

(d ) 600

Adj. Bal. 1,200

Unearned Services Revenue

Unadj. Bal. 120,000

(c) 100,000

Adj. Bal. 20,000

Services Revenue

(c) 100,000

(e) 7,000

Adj. Bal. 107,000

(a) 1,750

Wages Expense

(a) 1,750

Wages Payable

(b) 4,000

Depreciation Expense — Equipment

(b) 4,000

Accumulated Depreciation — Equipment

3. Financial statement effects of adjusting journal entries.

Effect on Effect on Amount in Effect on Effect on Total Total

Entry the Entry Net Income Total Assets Liabilities Equity

a $ 1,750 $ 1,750 ↓ No effect $ 1,750 ↑ $ 1,750 ↓ b 4,000 4,000 ↓ $4,000 ↓ No effect 4,000 ↓ c 100,000 100,000 ↑ No effect $100,000 ↓ 100,000 ↑ d 600 600 ↓ $ 600 ↓ No effect 600 ↓ e 7,000 7,000 ↑ $7,000 ↑ No effect 7,000 ↑

SOLUTION TO DEMONSTRATION PROBLEM 1 1. Adjusting journal entries.

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124 Chapter 3 Adjusting Accounts and Preparing Financial Statements

1. Prepare the annual income statement from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Income Statement

For Year Ended December 31

Revenues Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $57,500

Expenses

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . 1,900

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 250

Depreciation expense—Equipment . . . . . . . . . . 5,970

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,320

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,180

Use the following adjusted trial balance to answer questions 1–3.

DEMONSTRATION PROBLEM 2

CHOI COMPANY Adjusted Trial Balance

December 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 400

Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 830

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,200

Accumulated depreciation—Equipment . . . . . . . . . $ 29,100

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Unearned rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460

Long-term notes payable . . . . . . . . . . . . . . . . . . . . 150,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,340

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Depreciation expense—Equipment . . . . . . . . . . . . 5,970

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $281,880 $281,880

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 125

3. Prepare a balance sheet from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Balance Sheet December 31

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050

Accounts receivable . . . . . . . . . . . . . . . . . 400

Prepaid insurance . . . . . . . . . . . . . . . . . . . 830

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . $217,200

Less accumulated depreciation . . . . . . . . 29,100 188,100

Total assets . . . . . . . . . . . . . . . . . . . . . . . . $192,460

Liabilities

Wages payable . . . . . . . . . . . . . . . . . . . . . . $ 880

Interest payable . . . . . . . . . . . . . . . . . . . . . 3,600

Unearned rent . . . . . . . . . . . . . . . . . . . . . . 460

Long-term notes payable . . . . . . . . . . . . . 150,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . 154,940

Equity

Common stock . . . . . . . . . . . . . . . . . . . . . 10,000

Retained earnings . . . . . . . . . . . . . . . . . . . 27,520

Total equity . . . . . . . . . . . . . . . . . . . . . . . . 37,520

Total liabilities and equity . . . . . . . . . . . . . $192,460

APPENDIX

Alternative Accounting for Prepayments 3A This appendix explains an alternative in accounting for prepaid expenses and unearned revenues.

RECORDING PREPAYMENT OF EXPENSES IN EXPENSE ACCOUNTS An alternative method is to record all prepaid expenses with debits to expense accounts. If any prepaids remain unused or unexpired at the end of an accounting period, then adjusting entries must transfer the cost of the unused portions from expense accounts to prepaid expense (asset) accounts. This alternative method is acceptable. The financial statements are identical under either method, but the adjusting entries

P6 Explain the alternatives in accounting for prepaids.

2. Prepare a statement of retained earnings from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Statement of Retained Earnings

For Year Ended December 31

Retained earnings, December 31 prior year-end . . . . . . . . . . $30,340

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,180

48,520

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Retained earnings, December 31 current year-end . . . . . . . . $27,520

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126 Chapter 3 Adjusting Accounts and Preparing Financial Statements

At the end of its accounting period on December 31, insurance protection for one month has expired. This means $100 ($2,400y24) of insurance coverage expired and is an expense for December. The adjusting entry depends on how the original payment was recorded. This is shown in Exhibit 3A.2.

When these entries are posted to the accounts in the ledger, we can see that these two methods give iden- tical results. The December 31 adjusted account balances in Exhibit 3A.3 show Prepaid Insurance of $2,300 and Insurance Expense of $100 for both methods.

Payment Recorded Payment Recorded as Asset as Expense

Dec. 31 Insurance Expense . . . . . . . . . . . . 100

Prepaid Insurance . . . . . . . . . 100

Dec. 31 Prepaid Insurance . . . . . . . . . . . . . 2,300

Insurance Expense . . . . . . . . 2,300

EXHIBIT 3A.2 Adjusting Entry for Prepaid Expenses for the Two Alternatives

RECORDING PREPAYMENT OF REVENUES IN REVENUE ACCOUNTS As with prepaid expenses, an alternative method is to record all unearned revenues with credits to revenue accounts. If any revenues are unearned at the end of an accounting period, then adjusting entries must transfer the unearned portions from revenue accounts to unearned revenue (liability) accounts. This alter- native method is acceptable. The adjusting entries are different for these two alternatives, but the financial statements are identical. To illustrate the accounting differences between these two methods, let’s look at FastForward’s December 26 receipt of $3,000 for consulting services covering the period December 27 to February 24. FastForward recorded this transaction with a credit to a liability account. The alternative is to record it with a credit to a revenue account, as shown in Exhibit 3A.4.

Payment Recorded as Asset

Prepaid Insurance 128

Dec. 6 2,400 Dec. 31 100

Balance 2,300

Insurance Expense 637

Dec. 31 100

Prepaid Insurance 128

Dec. 31 2,300

Payment Recorded as Expense

Insurance Expense 637

Dec. 6 2,400 Dec. 31 2,300

Balance 100

EXHIBIT 3A.3 Account Balances under Two Alternatives for Recording Prepaid Expenses

EXHIBIT 3A.4 Alternative Initial Entries for Unearned Revenues

Receipt Recorded Receipt Recorded as Liability as Revenue

Dec. 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Unearned Consulting Revenue . . . . . . . . . 3,000

Dec. 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Consulting Revenue . . . . . . . . . . . . . . . . . 3,000

are different. To illustrate the differences between these two methods, let’s look at FastForward’s cash payment of December 6 for 24 months of insurance coverage beginning on December 1. FastForward re- corded that payment with a debit to an asset account, but it could have recorded a debit to an expense ac- count. These alternatives are shown in Exhibit 3A.1.

EXHIBIT 3A.1 Alternative Initial Entries for Prepaid Expenses

Payment Recorded Payment Recorded as Asset as Expense

Dec. 6 Prepaid Insurance . . . . . . . . . 2,400

Cash . . . . . . . . . . . . . . . 2,400

Dec. 6 Insurance Expense . . . . . . . . 2,400

Cash . . . . . . . . . . . . . . . 2,400

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 127

By the end of its accounting period on December 31, FastForward has earned $250 of this revenue. This means $250 of the liability has been satisfied. Depending on how the initial receipt is recorded, the adjusting entry is as shown in Exhibit 3A.5.

After adjusting entries are posted, the two alternatives give identical results. The December 31 adjusted account balances in Exhibit 3A.6 show unearned consulting revenue of $2,750 and consulting revenue of $250 for both methods.

EXHIBIT 3A.5 Adjusting Entry for Unearned Revenues for the Two Alternatives

Receipt Recorded Receipt Recorded as Liability as Revenue

Dec. 31 Unearned Consulting Revenue . . . . . . . . . . . . . 250

Consulting Revenue . . . . . . . . . . . . . . . . . 250

Dec. 31 Consulting Revenue . . . . . . . . . . . . . . . . . . . . . 2,750

Unearned Consulting Revenue . . . . . . . . . 2,750

EXHIBIT 3A.6 Account Balances under Two Alternatives for Recording Unearned Revenues

Unearned Consulting Revenue 236

Dec. 31 2,750

Receipt Recorded as Revenue

Consulting Revenue 403

Dec. 31 2,750 Dec. 26 3,000

Balance 250

Unearned Consulting Revenue 236

Dec. 31 250 Dec. 26 3,000

Balance 2,750

Receipt Recorded as Liability

Consulting Revenue 403

Dec. 31 250

APPENDIX

Work Sheet as a Tool 3B Information preparers use various analyses and internal documents when organizing information for inter- nal and external decision makers. Internal documents are often called working papers. One widely used working paper is the work sheet, which is a useful tool for preparers in working with accounting informa- tion. It is usually not available to external decision makers.

Benefits of a Work Sheet (Spreadsheet) A work sheet is not a required report, yet using a manual or electronic work sheet has several potential benefits. Specifically, a work sheet:

● Aids the preparation of financial statements. ● Reduces the possibility of errors when working with many accounts and adjustments. ● Links accounts and adjustments to their impacts in financial statements. ● Assists in planning and organizing an audit of financial statements—as it can be used to reflect any

adjustments necessary. ● Helps in preparing interim (monthly and quarterly) financial statements when the journalizing and post-

ing of adjusting entries are postponed until the year-end. ● Shows the effects of proposed or “what if” transactions.

Use of a Work Sheet (Spreadsheet) When a work sheet is used to prepare financial state- ments, it is constructed at the end of a period before the adjusting process. The complete work sheet in- cludes a list of the accounts, their balances and adjustments, and their sorting into financial statement columns. It provides two columns each for the unadjusted trial balance, the adjustments, the adjusted trial balance, the income statement, and the balance sheet. To describe and interpret the work sheet, we

Point: Since a work sheet is not a required report or an accounting record, its format is flexible and can be modified by its user to fit his/her preferences.

P7 Prepare a work sheet and explain its usefulness.

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128 Chapter 3 Adjusting Accounts and Preparing Financial Statements

use the information from FastForward. Preparing the work sheet has five important steps. Each step, 1 through 5, is color-coded and explained with reference to Exhibit 3B.1.

Step 1. Enter Unadjusted Trial Balance

The first step in preparing a work sheet is to list the title of every account and its account number that is ex- pected to appear on its financial statements. This includes all accounts in the ledger plus any new ones from adjusting entries. Most adjusting entries — including expenses from salaries, supplies, depreciation, and insurance — are predictable and recurring. The unadjusted balance for each account is then entered in the ap- propriate Debit or Credit column of the unadjusted trial balance columns. The totals of these two columns must be equal. Exhibit 3B.1 shows FastForward’s work sheet after completing this first step. Sometimes blank lines are left on the work sheet based on past experience to indicate where lines will be needed for adjustments to certain accounts. Exhibit 3B.1 shows Consulting Revenue as one example. An alternative is to squeeze ad- justments on one line or to combine the effects of two or more adjustments in one amount. In the unusual case when an account is not predicted, we can add a new line for such an account following the Totals line.

Step 2. Enter Adjustments

The second step in preparing a work sheet is to enter adjustments in the Adjustments columns. The adjust- ments shown are the same ones shown in Exhibit 3.13. An identifying letter links the debit and credit of each adjusting entry. This is called keying the adjustments. After preparing a work sheet, adjusting entries must still be entered in the journal and posted to the ledger. The Adjustments columns provide the infor- mation for those entries.

Step 3. Prepare Adjusted Trial Balance

The adjusted trial balance is prepared by combining the adjustments with the unadjusted balances for each account. As an example, the Prepaid Insurance account has a $2,400 debit balance in the Unadjusted Trial Balance columns. This $2,400 debit is combined with the $100 credit in the Adjustments columns to give Prepaid Insurance a $2,300 debit in the Adjusted Trial Balance columns. The totals of the Adjusted Trial Balance columns confirm the equality of debits and credits.

Step 4. Sort Adjusted Trial Balance Amounts to Financial Statements

This step involves sorting account balances from the adjusted trial balance to their proper financial state- ment columns. Expenses go to the Income Statement Debit column and revenues to the Income Statement Credit column. Assets and Dividends go to the Balance Sheet Debit column. Liabilities, Retained Earn- ings, and Common Stock go to the Balance Sheet Credit column.

Step 5. Total Statement Columns, Compute Income or Loss, and Balance Columns

Each financial statement column (from Step 4) is totaled. The difference between the totals of the Income Statement columns is net income or net loss. This occurs because revenues are entered in the Credit column and expenses in the Debit column. If the Credit total exceeds the Debit total, there is net income. If the Debit total exceeds the Credit total, there is a net loss. For FastForward, the Credit total exceeds the Debit total, giving a $3,785 net income. The net income from the Income Statement columns is then entered in the Balance Sheet Credit col- umn. Adding net income to the last Credit column implies that it is to be added to retained earnings. If a loss occurs, it is added to the Debit column. This implies that it is to be subtracted from retained earnings. The ending balance of retained earnings does not appear in the last two columns as a single amount, but it is computed in the statement of retained earnings using these account balances. When net income or net loss is added to the proper Balance Sheet column, the totals of the last two columns must balance. If they do not, one or more errors have been made. The error can either be mathematical or involve sorting one or more amounts to incorrect columns.

Work Sheet Applications and Analysis A work sheet does not substitute for financial state- ments. It is a tool we can use at the end of an accounting period to help organize data and prepare financial statements. FastForward’s financial statements are shown in Exhibit 3.14. Its income statement amounts are taken from the Income Statement columns of the work sheet. Similarly, amounts for its balance sheet and its statement of retained earnings are taken from the Balance Sheet columns of the work sheet. Work sheets are also useful in analyzing the effects of proposed, or what-if, transactions. This is done by entering financial statement amounts in the Unadjusted (what-if ) columns. Proposed transactions are then entered in the Adjustments columns. We then compute “adjusted” amounts from these proposed transactions. The extended amounts in the financial statement columns show the effects of these proposed transactions. These financial statement columns yield pro forma financial statements because they show the statements as if the proposed transactions occurred.

Point: To avoid omitting the transfer of an account balance, start with the first line (cash) and continue in account order.

2

3

4

5

1

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 129

EXHIBIT 3B.1 Work Sheet

(b) 1,050 (a) 100

(c) 375

(e) 210

(d) 250 (f) 1,800

3,785

(f) 1,800

(d) 250

(c) 375 (e) 210 (a) 100

(b) 1,050

2

3,785

375 6,200

210 2,750

30,000 0

7,850

300

47,685

4,350 1,800 8,670 2,300

26,000

200

375 1,610

100 1,000 1,050

230 47,685

3

7,850

300 375 1,610

100 1,000 1,050

230

4

4,350 1,800 8,670 2,300

26,000

200

375 6,200

210 2,750

30,000 0

Account

Cash Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable Unearned consulting revenue Common stock Retained earnings Dividends Consulting revenue

Rental revenue Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals

Unadjusted

Trial Balance

Adjusted

Trial Balance

Dr.

Adjustments

Cr. Dr. Cr.

Income

Statement

Dr. Cr.

Balance Sheet

Dr. Cr.Dr. Cr.

101 106 126 128 167 168 201 209 236 307 318 319 403

406 612 622 637 640 652 690

No.

1

FASTFORWARD

Work Sheet

For Month Ended December 31, 2013

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

4,350 0

9,720 2,400

26,000

200

0 1,400

0 1,000

0 230

45,300

0 6,200

0 3,000

30,000 0

5,800

300

45,300 Net income Totals

4,365 3,785

8,150

8,150

8,150

43,320

43,320

39,535 3,785

43,320 5

List all accounts from the ledger and those expected

to arise from adjusting entries.

Enter all amounts available from ledger accounts. Column

totals must be equal.

A work sheet collects and summarizes information used to prepare adjusting

entries, financial statements, and closing entries.

APPENDIX

Reversing Entries 3C Reversing entries are optional. They are recorded in response to accrued assets and accrued liabilities that were created by adjusting entries at the end of a reporting period. The purpose of reversing entries is to simplify a company’s recordkeeping. Exhibit 3C.1 shows an example of FastForward’s reversing entries. The top of the exhibit shows the adjusting entry FastForward recorded on December 31 for its employee’s earned but unpaid salary. The entry recorded three days’ salary of $210, which increased December’s total salary expense to $1,610. The entry also recognized a liability of $210. The expense is reported on December’s income statement. The expense account is then closed. The ledger on January 1, 2014, shows a $210 liability and a zero balance in the Salaries Expense account. At this point, the choice is made between using or not using reversing entries.

Point: As a general rule, adjusting entries that create new asset or liability accounts are likely candidates for reversing.

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130 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Accounting without Reversing Entries The path down the left side of Exhibit 3C.1 is de- scribed in the chapter. To summarize here, when the next payday occurs on January 9, we record payment with a compound entry that debits both the expense and liability accounts and credits Cash. Posting that entry creates a $490 balance in the expense account and reduces the liability account balance to zero be- cause the debt has been settled. The disadvantage of this approach is the slightly more complex entry re- quired on January 9. Paying the accrued liability means that this entry differs from the routine entries made on all other paydays. To construct the proper entry on January 9, we must recall the effect of the December 31 adjusting entry. Reversing entries overcome this disadvantage.

Point: Firms that use reversing entries hope that this simplification will reduce errors.

Salaries Expense

Accrue salaries expense on December 31, 2013

No reversing entry recorded on January 1, 2014

WITHOUT Reversing Entries WITH Reversing Entries

Under both approaches, the expense and liability accounts have identical balances after the cash payment on January 9.

210 Salaries Payable 210

Salaries Expense

Salaries Payable

Date 2013

Dec. 12 700 700(7) 26 31

700 1,400 1,610

(16) 210(e)

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 210210

Expl. Debit BalanceCredit

Salaries Expense $490 Salaries Payable $ 0

Reversing entry recorded on January 1, 2014

— OR —

*Circled numbers in the Balance column indicate abnormal balances.

Salaries Expense 490 Salaries Payable 210

Cash 700 Salaries Expense

Salaries Payable

Date 2014

Jan. 9 490 490

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 210210

Expl. Debit BalanceCredit

NO ENTRY

Salaries Expense

Salaries Payable

Date 2014

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 2014

210210

2014

Jan. 9 0210

Expl. Debit BalanceCredit

Salaries Expense 700 Cash 700

Salaries Expense*

Salaries Payable

Date 2014

Jan. 1 Jan. 9 700 490

(e)

Expl. Debit

210

BalanceCredit

Date 2013

Dec. 31 210210 2014

Jan. 1 0210

Expl. Debit BalanceCredit

Salaries Expense*

Salaries Payable

Date 2014

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 2014

Jan. 1

210210

210 0

Expl. Debit BalanceCredit

Salaries Payable 210 Salaries Expense 210

Jan. 1 210

210

210

Pay the accrued and current salaries on January 9, the first payday in 2014

EXHIBIT 3C.1 Reversing Entries for an Accrued Expense

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 131

C1 Explain the importance of periodic reporting and the time period assumption. The value of information is often linked to its timeliness. To provide timely information, accounting systems prepare periodic reports at regular intervals. The time period as- sumption presumes that an organization’s activities can be divided into specific time periods for periodic reporting.

C2 Explain accrual accounting and how it improves financial statements. Accrual accounting recognizes revenue when earned and expenses when incurred—not necessarily when cash in- flows and outflows occur. This information is valuable in assessing a company’s financial position and performance.

C3 Identify steps in the accounting cycle. The accounting cycle consists of 10 steps: (1) analyze transactions, (2) journalize, (3) post, (4) prepare an unadjusted trial balance, (5) adjust accounts, (6) prepare an adjusted trial balance, (7) prepare statements, (8) close, (9) prepare a post-closing trial balance, and (10) prepare (optional) reversing entries.

C4 Explain and prepare a classified balance sheet. Classified bal-ance sheets report assets and liabilities in two categories: current and noncurrent. Noncurrent assets often include long-term invest- ments, plant assets, and intangible assets. A corporation separates eq- uity into common stock and retained earnings.

A1 Explain how accounting adjustments link to financial statements. Accounting adjustments bring an asset or liability account balance to its correct amount. They also update related ex- pense or revenue accounts. Every adjusting entry affects one or more income statement accounts and one or more balance sheet accounts. An adjusting entry never affects cash.

A2 Compute profit margin and describe its use in analyzing company performance. Profit margin is defined as the re- porting period’s net income divided by its net sales. Profit margin reflects on a company’s earnings activities by showing how much income is in each dollar of sales.

A3 Compute the current ratio and describe what it reveals about a company’s financial condition. A company’s current ratio is defined as current assets divided by current liabilities. We use it to evaluate a company’s ability to pay its current liabilities out of current assets.

Summary P1 Prepare and explain adjusting entries. Prepaid expenses refer to items paid for in advance of receiving their benefits. Prepaid expenses are assets. Adjusting entries for prepaids involve increasing (debiting) expenses and decreasing (crediting) assets. Unearned (or prepaid ) revenues refer to cash received in advance of providing products and services. Unearned revenues are liabilities. Adjusting entries for unearned revenues involve increasing (credit- ing) revenues and decreasing (debiting) unearned revenues. Accrued expenses refer to costs incurred in a period that are both unpaid and unrecorded. Adjusting entries for recording accrued expenses in- volve in creasing (debiting) expenses and increasing (crediting) lia- bilities. Accrued revenues refer to revenues earned in a period that are both unrecorded and not yet received in cash. Adjusting entries for recording accrued revenues involve increasing (debiting) assets and increasing (crediting) revenues.

P2 Explain and prepare an adjusted trial balance. An adjusted trial balance is a list of accounts and balances prepared after recording and posting adjusting entries. Financial statements are of- ten prepared from the adjusted trial balance.

P3 Prepare financial statements from an adjusted trial bal-ance. Revenue and expense balances are reported on the in- come statement. Asset, liability, and equity balances are reported on the balance sheet. We usually prepare statements in the following order: income statement, statement of retained earnings, balance sheet, and statement of cash flows.

P4 Describe and prepare closing entries. Closing entries in-volve four steps: (1) close credit balances in revenue (and gain) accounts to Income Summary, (2) close debit balances in expense (and loss) accounts to Income Summary, (3) close Income Summary to the retained earnings, and (4) close dividends account to retained earnings.

P5 Explain and prepare a post-closing trial balance. A post-closing trial balance is a list of permanent accounts and their balances after all closing entries have been journalized and posted. Its purpose is to verify that (1) total debits equal total credits for perma- nent accounts and (2) all temporary accounts have zero balances.

P6A Explain the alternatives in accounting for prepaids. Charging all prepaid expenses to expense accounts when they are

P8 Prepare reversing entries and explain their purpose. Accounting with Reversing Entries The right side of Exhibit 3C.1 shows how a reversing entry on January 1 overcomes the disadvantage of the January 9 entry when not using reversing entries. A reversing entry is the exact opposite of an adjusting entry. For FastForward, the Salaries Payable liabil- ity account is debited for $210, meaning that this account now has a zero balance after the entry is posted. The Salaries Payable account temporarily understates the liability, but this is not a problem since financial statements are not prepared before the liability is settled on January 9. The credit to the Salaries Expense account is unusual because it gives the account an abnormal credit balance. We highlight an abnormal balance by circling it. Because of the reversing entry, the January 9 entry to record payment is straightforward. This entry debits the Salaries Expense account and credits Cash for the full $700 paid. It is the same as all other entries made to record 10 days’ salary for the employee. Notice that after the payment entry is posted, the Salaries Expense account has a $490 balance that reflects seven days’ salary of $70 per day (see the lower right side of Exhibit 3C.1). The zero balance in the Salaries Payable ac- count is now correct. The lower section of Exhibit 3C.1 shows that the expense and liability accounts have exactly the same balances whether reversing entries are used or not. This means that both approaches yield identical results.

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132 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Investor Prepaid expenses are items paid for in advance of receiv- ing their benefits. They are assets and are expensed as they are used up. The publishing company’s treatment of the signing bonus is acceptable provided future book sales can at least match the $500,000 expense. As an investor, you are concerned about the risk of future book sales. The riskier the likelihood of future book sales is, the more likely your analysis is to treat the $500,000, or a portion of it, as an expense, not a prepaid expense (asset).

Entrepreneur Depreciation is a process of cost allocation, not asset valuation. Knowing the depreciation schedule is not especially useful in your estimation of what the building and equipment are cur- rently worth. Your own assessment of the age, quality, and usefulness of the building and equipment is more important.

Loan Officer Your concern in lending to this store arises from analysis of current-year sales. While increased revenues and income are fine, your concern is with collectibility of these promotional sales. If the owner sold products to customers with poor records of

paying bills, then collectibility of these sales is low. Your analysis must assess this possibility and recognize any expected losses.

Financial Officer Omitting accrued expenses and recognizing revenue early can mislead financial statement users. One action is to request a second meeting with the president so you can explain that accruing expenses when incurred and recognizing revenue when earned are required practices. If the president persists, you might dis- cuss the situation with legal counsel and any auditors involved. Your ethical action might cost you this job, but the potential pitfalls for falsification of statements, reputation and personal integrity loss, and other costs are too great.

Analyst A current ratio of 1.2 suggests that current assets are suf- ficient to cover current liabilities, but it implies a minimal buffer in case of errors in measuring current assets or current liabilities. Re- moving the past due receivable reduces the current ratio to 0.7. Your assessment is that the company will have some difficulty meeting its loan payments.

Guidance Answers to Decision Maker and Decision Ethics

purchased is acceptable. When this is done, adjusting entries must transfer any unexpired amounts from expense accounts to asset ac- counts. Crediting all unearned revenues to revenue accounts when cash is received is also acceptable. In this case, the adjusting entries must transfer any unearned amounts from revenue accounts to un- earned revenue accounts.

P7B Prepare a work sheet and explain its usefulness. A work sheet can be a useful tool in preparing and analyzing financial statements. It is helpful at the end of a period in preparing adjusting

entries, an adjusted trial balance, and financial statements. A work sheet usually contains five pairs of columns: Unadjusted Trial Balance, Adjustments, Adjusted Trial Balance, Income Statement, and Balance Sheet & Statement of Equity.

P8C Prepare reversing entries and explain their purpose. Reversing entries are an optional step. They are applied to accrued expenses and revenues. The purpose of reversing entries is to simplify subsequent journal entries. Financial statements are unaffected by the choice to use or not use reversing entries.

1. An annual reporting (or accounting) period covers one year and refers to the preparation of annual financial statements. The an- nual reporting period is not always a calendar year that ends on December 31. An organization can adopt a fiscal year consist- ing of any consecutive 12 months or 52 weeks.

2. Interim financial statements (covering less than one year) are prepared to provide timely information to decision makers.

3. The revenue recognition principle and the expense recogni- tion (matching) principle lead most directly to the adjusting process.

4. No. Cash basis accounting is not consistent with the matching principle because it reports revenue when received, not neces- sarily when earned, and expenses when paid, not necessarily in the period when the expenses were incurred as a result of the revenues earned.

5. No expense is reported in 2014. Under cash basis accounting, the entire $4,800 is reported as an expense in April 2013 when the premium is paid.

6. If the accrued revenues adjustment of $200 is not made, then both revenues and net income are understated by $200 on the current year’s income statement, and both assets and equity are understated by $200 on the balance sheet.

7. A contra account is an account that is subtracted from the balance of a related account. Use of a contra account provides more information than simply reporting a net amount.

8. An accrued expense is a cost incurred in a period that is both unpaid and unrecorded prior to adjusting entries. One example is salaries earned but not yet paid at period-end.

9. An unearned revenue arises when a firm receives cash (or other assets) from a customer before providing the ser vices or prod- ucts to the customer. A magazine subscription paid in advance is one example; season ticket sales is another.

10. Salaries Payable . . . . . . . . . . . . . . . . . . . 1,000 Salaries Expense . . . . . . . . . . . . . . . . . . . 6,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Paid salary including accrual from December. 11. The probable adjusting entries of Jordan Air are: Insurance Expense . . . . . . . . . . . . . . . . . . 300 Prepaid Insurance . . . . . . . . . . . . . . . 300 To record insurance expired. Salaries Expense . . . . . . . . . . . . . . . . . . . . 1,400 Salaries Payable . . . . . . . . . . . . . . . . 1,400 To record accrued salaries.

Guidance Answers to Quick Checks

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 133

12. Revenue accounts and expense accounts. 13. Statement of retained earnings. 14. The major steps in preparing closing entries are to close

(1) credit balances in revenue accounts to Income Summary, (2) debit balances in expense accounts to Income Summary, (3) Income Summary to retained earnings, and (4) any divi- dends account to retained earnings.

15. Revenue (and gain) and expense (and loss) accounts are called temporary because they are opened and closed each period. The Income Summary and Dividends accounts are also temporary.

16. Permanent accounts make up the post-closing trial balance, which consist of asset, liability, and equity accounts.

17. Current assets: (b), (c), (d). Plant assets: (a), (e). Item ( f ) is an intangible asset.

18. Investment in common stock, investment in bonds, and land held for future expansion.

19. For a service company, the operating cycle is the usual time between (1) paying employees who do the services and (2) re- ceiving cash from customers for services provided.

Accounting cycle (p. 116)

Accounting periods (p. 98)

Accrual basis accounting (p. 99)

Accrued expenses (p. 105)

Accrued revenues (p. 107)

Adjusted trial balance (p. 110)

Adjusting entry (p. 101)

Annual financial statements (p. 98)

Book value (p. 104)

Cash basis accounting (p. 99)

Classified balance sheet (p. 117)

Closing entries (p. 112)

Closing process (p. 112)

Contra account (p. 103)

Current assets (p. 118)

Current liabilities (p. 119)

Current ratio (p. 121)

Depreciation (p. 103)

Expense recognition (or matching) principle (p. 100)

Fiscal year (p. 99)

Income Summary (p. 113)

Intangible assets (p. 119)

Interim financial statements (p. 98)

Long-term investments (p. 119)

Long-term liabilities (p. 119)

Natural business year (p. 99)

Operating cycle (p. 117)

Permanent accounts (p. 112)

Plant assets (p. 103)

Post-closing trial balance (p. 114)

Prepaid expenses (p. 101)

Profit margin (p. 121)

Pro forma financial statements (p. 128)

Reversing entries (p. 129)

Straight-line depreciation method (p. 103)

Temporary accounts (p. 112)

Time period assumption (p. 98)

Unadjusted trial balance (p. 110)

Unclassified balance sheet (p. 117)

Unearned revenues (p. 104)

Working papers (p. 127)

Work sheet (p. 127)

Key Terms

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 159 mhhe.com/wildFINMAN5e

1. A company forgot to record accrued and unpaid employee wages of $350,000 at period-end. This oversight would

a. Understate net income by $350,000. b. Overstate net income by $350,000. c. Have no effect on net income. d. Overstate assets by $350,000. e. Understate assets by $350,000. 2. Prior to recording adjusting entries, the Supplies account has a

$450 debit balance. A physical count of supplies shows $125 of unused supplies still available. The required adjusting entry is:

a. Debit Supplies $125; Credit Supplies Expense $125. b. Debit Supplies $325; Credit Supplies Expense $325. c. Debit Supplies Expense $325; Credit Supplies $325. d. Debit Supplies Expense $325; Credit Supplies $125. e. Debit Supplies Expense $125; Credit Supplies $125. 3. On May 1, 2013, a two-year insurance policy was purchased

for $24,000 with coverage to begin immediately. What is the amount of insurance expense that appears on the company’s income statement for the year ended December 31, 2013?

a. $4,000 b. $8,000

c. $12,000 d. $20,000 e. $24,000 4. On November 1, 2013, Stockton Co. receives $3,600 cash from

Hans Co. for consulting services to be provided evenly over the period November 1, 2013, to April 30, 2014—at which time Stockton credited $3,600 to Unearned Consulting Fees. The adjusting entry on December 31, 2013 (Stockton’s year-end) would include a

a. Debit to Unearned Consulting Fees for $1,200. b. Debit to Unearned Consulting Fees for $2,400. c. Credit to Consulting Fees Earned for $2,400. d. Debit to Consulting Fees Earned for $1,200. e. Credit to Cash for $3,600. 5. If a company had $15,000 in net income for the year, and its sales

were $300,000 for the same year, what is its profit margin? a. 20% b. 2,000% c. $285,000 d. $315,000 e. 5%

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134 Chapter 3 Adjusting Accounts and Preparing Financial Statements

1. What is the difference between the cash basis and the accrual basis of accounting?

2. Why is the accrual basis of accounting generally preferred over the cash basis?

3. What type of business is most likely to select a fiscal year that cor- responds to its natural business year instead of the calendar year?

4. What is a prepaid expense and where is it reported in the finan- cial statements?

5. What type of assets require adjusting entries to record depreciation?

6. What contra account is used when recording and reporting the effects of depreciation? Why is it used?

7. Assume Piaggio has unearned revenue. What is unearned revenue and where is it re- ported in financial statements?

8. What is an accrued revenue? Give an example. 9.A If a company initially records prepaid expenses with debits

to expense accounts, what type of account is debited in the adjusting entries for those prepaid expenses?

10. Review the balance sheet of Polaris in Appendix A. Identify one asset account that re- quires adjustment before annual financial statements can be prepared. What would be the effect on the income statement if this asset account were not adjusted? (Number not required, but comment on over- or understating of net income.)

11. Review the balance sheet of Arctic Cat in Appen dix A. Identify the amount for property and equipment. What adjusting entry is necessary (no numbers re- quired) for this account when preparing financial statements?

12. Refer to KTM’s balance sheet in Appendix A. If it made an adjustment for unpaid wages at year- end, where would the accrued wages be reported on its balance sheet?

13. What are the steps in recording closing entries? 14. What accounts are affected by closing entries? What accounts

are not affected? 15. What two purposes are accomplished by recording closing

entries? 16. What is the purpose of the Income Summary account? 17. Explain whether an error has occurred if a post-closing

trial balance includes a Depreciation Expense account. 18.B What tasks are aided by a work sheet? 19.B Why are the debit and credit entries in the Adjustments

columns of the work sheet identified with letters? 20. What is a company’s operating cycle? 21. What classes of assets and liabilities are shown on a typical

classified balance sheet? 22. How is unearned revenue classified on the balance sheet? 23. What are the characteristics of plant assets? 24.C How do reversing entries simplify recordkeeping? 25.C If a company recorded accrued salaries expense of $500 at

the end of its fiscal year, what reversing entry could be made? When would it be made?

26. Refer to the most recent balance sheet for Polaris in Appendix A. What five main noncur- rent asset categories are used on its classified balance sheet?

27. Refer to KTM’s most recent balance sheet in Appen dix A. Identify and list its 7 current assets.

28. Refer to Arctic Cat’s most recent balance sheet in Appen dix A. Identify the three accounts listed as current liabilities.

29. Refer to Piaggio’s financial statements in Appen dix A. What journal entry was likely re- corded as of December 31, 2011, to close its Income Summary account?

Discussion Questions

A(B,C) Superscript letter A(B,C) denotes assignments based on Appendix 3A(3B,3C).

Icon denotes assignments that involve decision making.

PIAGGIO

Polaris

Polaris

KTM

KTM Arctic Cat

Arctic Cat

PIAGGIO

a. On July 1, 2013, Lamis Company paid $1,200 for six months of insurance coverage. No adjustments have been made to the Prepaid Insurance account, and it is now December 31, 2013. Prepare the jour- nal entry to reflect expiration of the insurance as of December 31, 2013.

b. Shandi Company has a Supplies account balance of $5,000 on January 1, 2013. During 2013, it pur- chased $2,000 of supplies. As of December 31, 2013, a supplies inventory shows $800 of supplies available. Prepare the adjusting journal entry to correctly report the balance of the Supplies account and the Supplies Expense account as of December 31, 2013.

QUICK STUDY

QS 3-1 Adjusting prepaid expenses

P1

6. Based on the following information from Repicor Company’s balance sheet, what is Repicor Company’s current ratio?

a. 2.10 b. 1.50 c. 1.00 d. 0.95 e. 0.67

Current assets . . . . $ 75,000 Current liabilities . . . . . 50,000

Investments . . . . . . 30,000 Long-term liabilities . . . 60,000

Plant assets . . . . . . 300,000 Common stock . . . . . . 295,000

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 135

QS 3-2 Adjusting for depreciation

P1

a. Bargains Company purchases $20,000 of equipment on January 1, 2013. The equipment is expected to last five years and be worth $2,000 at the end of that time. Prepare the entry to record one year’s depreciation expense of $3,600 for the equipment as of December 31, 2013.

b. Welch Company purchases $10,000 of land on January 1, 2013. The land is expected to last indefi- nitely. What depreciation adjustment, if any, should be made with respect to the Land account as of December 31, 2013?

QS 3-3 Identifying accounting adjustments

P1

Classify the following adjusting entries as involving prepaid expenses (PE), unearned revenues (UR), accrued expenses (AE), or accrued revenues (AR).

a. To record expiration of prepaid insurance. b. To record revenue earned but not yet billed (nor recorded). c. To record wages expense incurred but not yet paid (nor recorded). d. To record annual depreciation expense. e. To record revenue earned that was previously received as cash in advance.

QS 3-7 Recording and analyzing adjusting entries

A1

Adjusting entries affect at least one balance sheet account and at least one income statement account. For the following entries, identify the account to be debited and the account to be credited. Indicate which of the accounts is the income statement account and which is the balance sheet account. a. Entry to record revenue earned that was previously received as cash in advance. b. Entry to record wage expenses incurred but not yet paid (nor recorded). c. Entry to record revenue earned but not yet billed (nor recorded). d. Entry to record expiration of prepaid insurance. e. Entry to record annual depreciation expense.

a. Tao Co. receives $10,000 cash in advance for 4 months of legal services on October 1, 2013, and records it by debiting Cash and crediting Unearned Revenue both for $10,000. It is now December 31, 2013, and Tao has provided legal services as planned. What adjusting entry should Tao make to ac- count for the work performed from October 1 through December 31, 2013?

b. A. Caden started a new publication called Contest News. Its subscribers pay $24 to receive 12 monthly issues. With every new subscriber, Caden debits Cash and credits Unearned Subscription Revenue for the amounts received. The company has 100 new subscribers as of July 1, 2013. It sends Contest News to each of these subscribers every month from July through December. Assuming no changes in subscribers, prepare the journal entry that Caden must make as of December 31, 2013, to adjust the Subscription Revenue account and the Unearned Subscription Revenue account.

QS 3-5 Adjusting for unearned revenues

A1 P1

QS 3-4 Accruing salaries

A1 P1

Jasmine Culpepper employs one college student every summer in her coffee shop. The student works the five weekdays and is paid on the following Monday. (For example, a student who works Monday through Friday, June 1 through June 5, is paid for that work on Monday, June 8.) Culpepper adjusts her books monthly, if needed, to show salaries earned but unpaid at month-end. The student works the last week of July — Friday is August 1. If the student earns $100 per day, what adjusting entry must Culpepper make on July 31 to correctly record accrued salaries expense for July?

In its first year of operations, Roma Co. earned $45,000 in revenues and received $37,000 cash from these customers. The company incurred expenses of $25,500 but had not paid $5,250 of them at year-end. The company also prepaid $6,750 cash for expenses that would be incurred the next year. Calculate the first year’s net income under both the cash basis and the accrual basis of accounting.

QS 3-6 Computing accrual and cash income C2 A1

QS 3-8 Preparing adjusting entries

P1

During the year, Sereno Co. recorded prepayments of expenses in asset accounts, and cash receipts of unearned revenues in liability accounts. At the end of its annual accounting period, the company must make three adjusting entries: (1) accrue salaries expense, (2) adjust the Unearned Services Revenue account to recognize earned revenue, and (3) record services revenue earned for which cash will be received the following period. For each of these adjusting entries (1), (2), and (3), indicate the account from a through i to be debited and the account to be credited. a. Prepaid Salaries d. Unearned Services Revenue g. Accounts Receivable b. Cash e. Salaries Expense h. Accounts Payable c. Salaries Payable f. Services Revenue i. Equipment

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136 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Given this information, which of the following is likely included among its adjusting entries? a. A $400 debit to Insurance Expense and an $800 debit to Interest Payable. b. A $400 debit to Insurance Expense and an $800 debit to Interest Expense. c. A $400 credit to Prepaid Insurance and an $800 debit to Interest Payable.

QS 3-9 Interpreting adjusting entries

C2 P2

The following information is taken from Brooke Company’s unadjusted and adjusted trial balances.

Unadjusted Adjusted

Debit Credit Debit Credit

Prepaid insurance . . . . . . . . . $4,100 $3,700

Interest payable . . . . . . . . . . $ 0 $800

QS 3-12A

Preparing adjusting entries

P6

Calvin Consulting initially records prepaid and unearned items in income statement accounts. Given this company’s accounting practices, which of the following applies to the preparation of adjusting entries at the end of its first accounting period? a. Unearned fees (on which cash was received in advance earlier in the period) are recorded with a debit

to Consulting Fees Earned and a credit to Unearned Consulting Fees. b. Unpaid salaries are recorded with a debit to Prepaid Salaries and a credit to Salaries Expense. c. The cost of unused office supplies is recorded with a debit to Supplies Expense and a credit to Office

Supplies. d. Earned but unbilled (and unrecorded) consulting fees are recorded with a debit to Unearned Consult-

ing Fees and a credit to Consulting Fees Earned.

QS 3-14 Prepaid (deferred) expenses adjustments

P1

For each separate case below, follow the 3-step process for adjusting the prepaid asset account: Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Prepaid Insurance. The Prepaid Insurance account has a $4,700 debit balance to start the year. A re-

view of insurance policies and payments shows that $900 of unexpired insurance remains at year-end. b. Prepaid Insurance. The Prepaid Insurance account has a $5,890 debit balance at the start of the year.

A review of insurance policies and payments shows $1,040 of insurance has expired by year-end. c. Prepaid Rent. On September 1 of the current year, the company prepaid $24,000 for 2 years of rent for

facilities being occupied that day. The company debited Prepaid Rent and credited Cash for $24,000.

QS 3-10 Determining effects of adjusting entries

A1

In making adjusting entries at the end of its accounting period, Chao Consulting failed to record $3,200 of insurance coverage that had expired. This $3,200 cost had been initially debited to the Prepaid Insurance account. The company also failed to record accrued salaries expense of $2,000. As a result of these two oversights, the financial statements for the reporting period will [choose one] (1) understate assets by $3,200; (2) understate expenses by $5,200; (3) understate net income by $2,000; or (4) overstate liabilities by $2,000.

QS 3-11 Analyzing profit margin

A2

Deklin Company reported net income of $48,025 and net sales of $425,000 for the current year. Calculate the company’s profit margin and interpret the result. Assume that its competitors earn an average profit margin of 15%.

QS 3-13 International accounting standards

P3

Answer each of the following questions related to international accounting standards. a. Do financial statements prepared under IFRS normally present assets from least liquid to most liquid

or vice-versa? b. Do financial statements prepared under IFRS normally present liabilities from furthest from maturity

to nearest to maturity or vice-versa?

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 137

QS 3-15 Prepaid (deferred) expenses adjustments

P1

For each separate case below, follow the 3-step process for adjusting the supplies asset account: Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Supplies. The Supplies account has a $300 debit balance to start the year. No supplies were purchased

during the current year. A December 31 physical count shows $110 of supplies remaining. b. Supplies. The Supplies account has an $800 debit balance to start the year. Supplies of $2,100 were

purchased during the current year and debited to the Supplies account. A December 31 physical count shows $650 of supplies remaining.

c. Supplies. The Supplies account has a $4,000 debit balance to start the year. During the current year, supplies of $9,400 were purchased and debited to the Supplies account. The inventory of supplies available at December 31 totaled $2,660.

QS 3-16 Accumulated depreciation adjustments

P1

For each separate case below, follow the 3-step process for adjusting the accumulated depreciation account: Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Accumulated Depreciation. The Krug Company’s Accumulated Depreciation account has a $13,500

balance to start the year. A review of depreciation schedules reveals that $14,600 of depreciation ex- pense must be recorded for the year.

b. Accumulated Depreciation. The company has only one fixed asset (truck) that it purchased at the start of this year. That asset had cost $44,000, had an estimated life of 5 years, and is expected to have zero value at the end of the 5 years.

c. Accumulated Depreciation. The company has only one fixed asset (equipment) that it purchased at the start of this year. That asset had cost $32,000, had an estimated life of 7 years, and is expected to be valued at $4,000 at the end of the 7 years.

QS 3-17 Unearned (deferred) revenues adjustments

P1

For each separate case below, follow the 3-step process for adjusting the unearned revenue liability account: Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Unearned Rent Revenue. The Krug Company collected $6,000 rent in advance on November 1, deb-

iting Cash and crediting Unearned Rent Revenue. The tenant was paying twelve months rent in ad- vance and occupancy began November 1.

b. Unearned Services Revenue. The company charges $75 per month to spray a house for insects. A customer paid $300 on October 1 in advance for four treatments, which was recorded with a debit to Cash and a credit to Unearned Services Revenue. At year-end, the company has applied three treat- ments for the customer.

c. Unearned Rent Revenue. On September 1, a client paid the company $24,000 cash for six months of rent in advance (the client leased a building and took occupancy immediately). The company recorded the cash as Unearned Rent Revenue.

QS 3-18 Accrued expenses adjustments

P1

For each separate case below, follow the 3-step process for adjusting the accrued expense account: Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Salaries Payable. At year-end, salaries expense of $15,500 has been incurred by the company, but is

not yet paid to employees. b. Interest Payable. At its December 31 year-end, the company owes $250 of interest on a line-of-credit

loan. That interest will not be paid until sometime in January of the next year. c. Interest Payable. At its December 31 year-end, the company holds a mortgage payable that has in-

curred $875 in annual interest that is neither recorded nor paid. The company intends to pay the inter- est on January 7 of the next year.

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138 Chapter 3 Adjusting Accounts and Preparing Financial Statements

QS 3-19 Accrued revenues adjustments

P1

For each separate case below, follow the 3-step process for adjusting the accrued revenue account: Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Accounts Receivable. At year-end, the Krug Company has completed services of $19,000 for a client,

but the client has not yet been billed for those services. b. Interest Receivable. At year-end, the company has earned, but not yet recorded, $390 of interest

earned from its investments in government bonds. c. Accounts Receivable. A painting company collects fees when jobs are complete. The work for one

customer, whose job was bid at $1,300, has been completed, but the customer has not yet been billed.

QS 3-20 Identifying the accounting cycle

C3

List the following steps of the accounting cycle in their proper order. a. Posting the journal entries. b. Journalizing and posting adjusting entries. c. Preparing the adjusted trial balance. d. Journalizing and posting closing entries. e. Analyzing transactions and events.

f. Preparing the financial statements. g. Preparing the unadjusted trial balance. h. Journalizing transactions and events. i. Preparing the post-closing trial balance.

For each of the following items, select the letter that identifies the balance sheet category where the item typically would appear.

1. Land not currently used in operations 2. Notes payable (due in five years) 3. Accounts receivable 4. Trademarks

5. Accounts payable 6. Store equipment 7. Wages payable 8. Cash

QS 3-21 Classifying balance sheet items

C4

The following are common categories on a classified balance sheet. A. Current assets B. Long-term investments C. Plant assets

D. Intangible assets E. Current liabilities F. Long-term liabilities

QS 3-22 Identifying current accounts and computing the current ratio

A3

Compute Chavez Company’s current ratio using the following information.

Accounts receivable . . . . . . . . $18,000 Long-term notes payable . . . . . . . . . . $21,000

Accounts payable . . . . . . . . . . 11,000 Office supplies . . . . . . . . . . . . . . . . . . . 2,800

Buildings . . . . . . . . . . . . . . . . . 45,000 Prepaid insurance . . . . . . . . . . . . . . . . 3,560

Cash . . . . . . . . . . . . . . . . . . . . 7,000 Unearned services revenue . . . . . . . . 3,000

QS 3-23 Prepare closing entries from the ledger P4

The ledger of Mai Company includes the following accounts with normal balances: Common Stock $9,000; Dividends $800; Services Revenue $13,000; Wages Expense $8,400; and Rent Expense $1,600. Prepare the necessary closing entries from the available information at December 31.

QS 3-24 Identify post-closing accounts P5

Identify the accounts listed in QS 3-23 that would be included in a post-closing trial balance.

QS 3-26C

Reversing entries

P8

On December 31, 2012, Yates Co. prepared an adjusting entry for $12,000 of earned but unrecorded management fees. On January 16, 2013, Yates received $26,700 cash in management fees, which included the accrued fees earned in 2012. Assuming the company uses reversing entries, prepare the January 1, 2013, reversing entry and the January 16, 2013, cash receipt entry.

The ledger of Claudell Company includes the following unadjusted normal balances: Prepaid Rent $1,000, Serv ices Revenue $55,600, and Wages Expense $5,000. Adjusting entries are required for (a) prepaid rent expired, $200; (b) accrued services revenue $900; and (c) accrued wages expense $700. Enter these unad- justed balances and the necessary adjustments on a work sheet and complete the work sheet for these accounts. Note: Also include the following accounts: Accounts Receivable, Wages Payable, and Rent Expense.

QS 3-25B

Preparing a partial work sheet

P7

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 139

Exercise 3-2 Preparing adjusting entries

P1

For each of the following separate cases, prepare adjusting entries required of financial statements for the year ended (date of ) December 31, 2013. (Assume that prepaid expenses are initially recorded in asset accounts and that fees collected in advance of work are initially recorded as liabilities.) a. One-third of the work related to $15,000 cash received in advance is performed this period. b. Wages of $8,000 are earned by workers but not paid as of December 31, 2013. c. Depreciation on the company’s equipment for 2013 is $18,531. d. The Office Supplies account had a $240 debit balance on December 31, 2012. During 2013, $5,239 of

office supplies are purchased. A physical count of supplies at December 31, 2013, shows $487 of sup- plies available.

e. The Prepaid Insurance account had a $4,000 balance on December 31, 2012. An analysis of insurance policies shows that $1,200 of unexpired insurance benefits remain at December 31, 2013.

f. The company has earned (but not recorded) $1,050 of interest from investments in CDs for the year ended December 31, 2013. The interest revenue will be received on January 10, 2014.

g. The company has a bank loan and has incurred (but not recorded) interest expense of $2,500 for the year ended December 31, 2013. The company must pay the interest on January 2, 2014.

Check (e) Dr. Insurance Expense, $2,800; (f ) Cr. Interest Revenue, $1,050

EXERCISES

Exercise 3-1 Preparing adjusting entries

P1

Prepare adjusting journal entries for the year ended (date of) December 31, 2013, for each of these separate situations. Assume that prepaid expenses are initially recorded in asset accounts. Also assume that fees col- lected in advance of work are initially recorded as liabilities. a. Depreciation on the company’s equipment for 2013 is computed to be $18,000. b. The Prepaid Insurance account had a $6,000 debit balance at December 31, 2013, before adjusting for

the costs of any expired coverage. An analysis of the company’s insurance policies showed that $1,100 of unexpired insurance coverage remains.

c. The Office Supplies account had a $700 debit balance on December 31, 2012; and $3,480 of office supplies were purchased during the year. The December 31, 2013, physical count showed $298 of sup- plies available.

d. Two-thirds of the work related to $15,000 of cash received in advance was performed this period. e. The Prepaid Insurance account had a $6,800 debit balance at December 31, 2013, before adjusting for

the costs of any expired coverage. An analysis of insurance policies showed that $5,800 of coverage had expired.

f. Wage expenses of $3,200 have been incurred but are not paid as of December 31, 2013.

Check (c) Dr. Office Supplies Expense, $3,882; (e) Dr. Insurance Expense, $5,800

Exercise 3-4 Adjusting and paying accrued expenses

A1

The following three separate situations require adjusting journal entries to prepare financial statements as of April 30. For each situation, present both the April 30 adjusting entry and the subsequent entry during May to record the payment of the accrued expenses. a. On April 1, the company retained an attorney for a flat monthly fee of $3,500. Payment for April legal

services was made by the company on May 12. b. A $900,000 note payable requires 10% annual interest, or $9,000 to be paid at the 20th day of each

month. The interest was last paid on April 20 and the next payment is due on May 20. As of April 30, $3,000 of interest expense has accrued.

c. Total weekly salaries expense for all employees is $10,000. This amount is paid at the end of the day on Friday of each five-day workweek. April 30 falls on Tuesday of this year, which means that the employees had worked two days since the last payday. The next payday is May 3.

Check (b) May 20 Dr. Interest Expense, $6,000

Exercise 3-3 Adjusting and paying accrued wages

C1 P1

Pablo Management has five part-time employees, each of whom earns $250 per day. They are normally paid on Fridays for work completed Monday through Friday of the same week. Assume that December 28, 2013, was a Friday, and that they were paid in full on that day. The next week, the five employees worked only four days because New Year’s Day was an unpaid holiday. (a) Assuming that December 31, 2013, was a Monday, prepare the adjusting entry that would be recorded at the close of that day. (b) Assuming that January 4, 2014, was a Friday, prepare the journal entry that would be made to record payment of the employees’ wages.

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140 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Exercise 3-5 Determining cost flows through accounts

C1 A1

Determine the missing amounts in each of these four separate situations a through d.

a b c d

Supplies available — prior year-end . . . . . . . . . . . . . . . . $ 400 $1,200 $1,260 ?

Supplies purchased during the current year . . . . . . . . . 2,800 6,500 ? $3,000

Supplies available — current year-end . . . . . . . . . . . . . . 650 ? 1,350 700

Supplies expense for the current year . . . . . . . . . . . . . ? 1,200 8,400 4,588

Exercise 3-6 Analyzing and preparing adjusting entries

A1 P3

Following are two income statements for Alexis Co. for the year ended December 31. The left column is prepared before any adjusting entries are recorded, and the right column includes the effects of adjusting entries. The company records cash receipts and payments related to unearned and prepaid items in balance sheet accounts. Analyze the statements and prepare the eight adjusting entries that likely were recorded. (Note: 30% of the $7,000 adjustment for Fees Earned has been earned but not billed, and the other 70% has been earned by performing services that were paid for in advance.)

ALEXIS CO. Income Statements

For Year Ended December 31

Unadjusted Adjusted

Revenues

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,000 $25,000

Commissions earned . . . . . . . . . . . . . . . . . . . . . . . . 36,500 36,500

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,500 61,500

Expenses

Depreciation expense—Computers . . . . . . . . . . . . 0 1,600

Depreciation expense—Office furniture . . . . . . . . . 0 1,850

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500 15,750

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . 0 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 3,800

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . 0 580

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 2,500

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,245 1,335

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,045 28,815

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,455 $32,685

Use the following information to compute profit margin for each separate company a through e.

Net Income Net Sales Net Income Net Sales

a. $ 4,361 $ 44,500 d. $65,646 $1,458,800 b. 97,706 398,800 e. 80,142 435,500 c. 111,281 257,000

Which of the five companies is the most profitable according to the profit margin ratio? Interpret that com- pany’s profit margin ratio.

Exercise 3-7 Computing and interpreting profit margin

A2

Ricardo Construction began operations on December 1. In setting up its accounting procedures, the com- pany decided to debit expense accounts when it prepays its expenses and to credit revenue accounts when customers pay for services in advance. Prepare journal entries for items a through d and the adjusting en- tries as of its December 31 period-end for items e through g. a. Supplies are purchased on December 1 for $2,000 cash. b. The company prepaid its insurance premiums for $1,540 cash on December 2. c. On December 15, the company receives an advance payment of $13,000 cash from a customer for

remodeling work. d. On December 28, the company receives $3,700 cash from another customer for remodeling work to be

performed in January. e. A physical count on December 31 indicates that the Company has $1,840 of supplies available.

Exercise 3-8A

Adjusting for prepaids recorded as expenses and unearned revenues recorded as revenues

P6

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 141

Check (f ) Cr. Insurance Expense, $1,200; (g) Dr. Remodeling Fees Earned, $11,130

f. An analysis of the insurance policies in effect on December 31 shows that $340 of insurance coverage had expired.

g. As of December 31, only one remodeling project has been worked on and completed. The $5,570 fee for this project had been received in advance and recorded as remodeling fees earned.

Costanza Company experienced the following events and transactions during July.

July 1 Received $3,000 cash in advance of performing work for Vivian Solana. 6 Received $7,500 cash in advance of performing work for Iris Haru. 12 Completed the job for Solana. 18 Received $8,500 cash in advance of performing work for Amina Jordan. 27 Completed the job for Haru. 31 None of the work for Jordan has been performed.

a. Prepare journal entries (including any adjusting entries as of the end of the month) to record these events using the procedure of initially crediting the Unearned Fees account when payment is received from a customer in advance of performing services.

b. Prepare journal entries (including any adjusting entries as of the end of the month) to record these events using the procedure of initially crediting the Fees Earned account when payment is received from a customer in advance of performing services.

c. Under each method, determine the amount of earned fees reported on the income statement for July and the amount of unearned fees reported on the balance sheet as of July 31.

Exercise 3-9A

Recording and reporting revenues received in advance

P6

Check (c) Fees Earned—using entries from part b, $10,500

Tangible and other assets . . . . . . . . . . . . . € 255 Intangible assets . . . . . . . . . . . . . . . € 154

Total equity . . . . . . . . . . . . . . . . . . . . . . . . 2,322 Total current liabilities . . . . . . . . . . 345

Receivables and other assets . . . . . . . . . . 1,767 Inventories . . . . . . . . . . . . . . . . . . . 30

Total noncurrent liabilities . . . . . . . . . . . . 3,379 Total liabilities . . . . . . . . . . . . . . . . . 3,724

Cash and cash equivalents . . . . . . . . . . . . 383 Other current assets . . . . . . . . . . . 28

Total current assets . . . . . . . . . . . . . . . . . . 2,208 Total noncurrent assets . . . . . . . . . 3,838

Other noncurrent assets . . . . . . . . . . . . . . 3,429

adidas AG reports the following balance sheet accounts for the year ended December 31, 2011 (euros in mil- lions). Prepare the balance sheet for this company as of December 31, 2011, following usual IFRS practices.

Exercise 3-10 Preparing a balance sheet following IFRS

P3

Exercise 3-11 Preparing financial statements

C3 P3

Use the following adjusted trial balance of Wilson Trucking Company to prepare the (1) income statement and (2) statement of retained earnings, for the year ended December 31, 2013. The retained earnings ac- count balance is $145,000 at December 31, 2012.

Account Title Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . 17,500

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,000

Accumulated depreciation — Trucks . . . . . . . . . $ 36,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . 12,000

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Long-term notes payable . . . . . . . . . . . . . . . . . 53,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . 145,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Trucking fees earned . . . . . . . . . . . . . . . . . . . . . 130,000

Depreciation expense — Trucks . . . . . . . . . . . . 23,500

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . 61,000

Office supplies expense . . . . . . . . . . . . . . . . . . 8,000

Repairs expense — Trucks . . . . . . . . . . . . . . . . . 12,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $410,000 $410,000

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142 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Exercise 3-12 Preparing a classified balance sheet C4

Use the information in the adjusted trial balance reported in Exercise 3-11 to prepare Wilson Trucking Company’s classified balance sheet as of December 31, 2013.

Check Total assets, $249,500

Exercise 3-14 Computing and analyzing the current ratio

A3

Calculate the current ratio in each of the following separate cases (round the ratio to two decimals). Identify the company case with the strongest liquidity position. (These cases represent competing companies in the same industry.)

Current Assets Current Liabilities

Case 1 . . . . . . . . $ 79,040 $ 32,000

Case 2 . . . . . . . . 104,880 76,000

Case 3 . . . . . . . . 45,080 49,000

Case 4 . . . . . . . . 85,680 81,600

Case 5 . . . . . . . . 61,000 100,000

Use the information in the adjusted trial balance reported in Exercise 3-11 to compute the current ratio as of the balance sheet date (round the ratio to two decimals). Interpret the current ratio for the Wilson Truck- ing Company. (Assume that the industry average for the current ratio is 1.5.)

Exercise 3-13 Computing the current ratio

A3

Exercise 3-15A

Preparing reversing entries

P8

The following two events occurred for Trey Co. on October 31, 2013, the end of its fiscal year. a. Trey rents a building from its owner for $2,800 per month. By a prearrangement, the company delayed

paying October’s rent until November 5. On this date, the company paid the rent for both October and November.

b. Trey rents space in a building it owns to a tenant for $850 per month. By prearrangement, the tenant delayed paying the October rent until November 8. On this date, the tenant paid the rent for both October and November.

Required

1. Prepare adjusting entries that the company must record for these events as of October 31. 2. Assuming Trey does not use reversing entries, prepare journal entries to record Trey’s payment of rent

on November 5 and the collection of the tenant’s rent on November 8. 3. Assuming that the company uses reversing entries, prepare reversing entries on November 1 and

the journal entries to record Trey’s payment of rent on November 5 and the collection of the tenant’s rent on November 8.

Following are Nintendo’s revenue and expense accounts for a recent calendar year (yen in millions). Pre- pare the company’s closing entries for its revenues and its expenses.

Net sales . . . . . . . . . . . . . . . . . ¥1,014,345

Cost of sales . . . . . . . . . . . . . . 626,379

Advertising expense . . . . . . . . 96,359

Other expense, net . . . . . . . . . 213,986

Exercise 3-16 Preparing closing entries

P4

Exercise 3-17 Completing a worksheet

P7

The following data are taken from the unadjusted trial balance of the Westcott Company at December 31, 2013. Each account carries a normal balance and the accounts are shown here in alphabetical order.

Accounts Payable . . . . . . . . . . . . . . . . . . . $ 6 Prepaid Insurance . . . . $18 Retained earnings . . . . . $32

Accounts Receivable . . . . . . . . . . . . . . . . . 12 Revenue . . . . . . . . . . . . 75 Dividends . . . . . . . . . . . 6

Accumulated Depreciation—Equip. . . . . 15 Salaries Expense . . . . . . 18 Unearned Revenue . . . . 12

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Supplies . . . . . . . . . . . . 24 Utilities Expense . . . . . . 12

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 39 Common stock . . . . . . . 10

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 143

1. Use the data above to prepare a worksheet. Enter the accounts in proper order and enter their balances in the correct debit or credit column.

2. Use the following adjustment information to complete the worksheet. a. Depreciation on equipment, $3 b. Accrued salaries, $6 c. The $12 of unearned revenue has been earned d. Supplies available at December 31, 2013, $15 e. Expired insurance, $15

For each of the following entries, enter the letter of the explanation that most closely describes it in the space beside each entry. (You can use letters more than once.) A. To record receipt of unearned revenue. B. To record this period’s earning of prior

unearned revenue. C. To record payment of an accrued expense. D. To record receipt of an accrued revenue.

PROBLEM SET A

Problem 3-1A Identifying adjusting entries with explanations

P1

E. To record an accrued expense. F. To record an accrued revenue. G. To record this period’s use of a prepaid expense. H. To record payment of a prepaid expense. I. To record this period’s depreciation expense.

______ 1. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

______ 2. Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . 4,000

______ 3. Unearned Professional Fees . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Professional Fees Earned . . . . . . . . . . . . . . . . . . . . . . 3,000

______ 4. Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200

______ 5. Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

______ 6. Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

______ 7. Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

______ 8. Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

______ 9. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Accounts Receivable (from consulting) . . . . . . . . . . . 9,000

______ 10. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Unearned Professional Fees . . . . . . . . . . . . . . . . . . . . 7,500

______ 11. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

______ 12. Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Arnez Co. follows the practice of recording prepaid expenses and unearned revenues in balance sheet ac- counts. The company’s annual accounting period ends on December 31, 2013. The following information concerns the adjusting entries to be recorded as of that date. a. The Office Supplies account started the year with a $4,000 balance. During 2013, the company pur-

chased supplies for $13,400, which was added to the Office Supplies account. The inventory of sup- plies available at December 31, 2013, totaled $2,554.

Problem 3-2A Preparing adjusting and subsequent journal entries

C1 A1 P1

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144 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Wells Technical Institute (WTI), a school owned by Tristana Wells, provides training to individuals who pay tuition directly to the school. WTI also offers training to groups in off-site locations. Its unadjusted trial balance as of December 31, 2013, follows. WTI initially records prepaid expenses and unearned rev- enues in balance sheet accounts. Descriptions of items a through h that require adjusting entries on December 31, 2013, follow.

Additional Information Items

a. An analysis of WTI’s insurance policies shows that $2,400 of coverage has expired. b. An inventory count shows that teaching supplies costing $2,800 are available at year-end 2013. c. Annual depreciation on the equipment is $13,200. d. Annual depreciation on the professional library is $7,200. e. On November 1, WTI agreed to do a special six-month course (starting immediately) for a client. The

contract calls for a monthly fee of $2,500, and the client paid the first five months’ fees in advance. When the cash was received, the Unearned Training Fees account was credited. The fee for the sixth month will be recorded when it is collected in 2014.

f. On October 15, WTI agreed to teach a four-month class (beginning immediately) for an individual for $3,000 tuition per month payable at the end of the class. The class started on October 15, but no payment has yet been received. (WTI’s accruals are applied to the nearest half-month; for example, October recognizes one-half month accrual.)

g. WTI’s two employees are paid weekly. As of the end of the year, two days’ salaries have accrued at the rate of $100 per day for each employee.

h. The balance in the Prepaid Rent account represents rent for December.

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Problem 3-3A Preparing adjusting entries, adjusted trial balance, and financial statements

A1 P1 P2 P3

Check (1b) Dr. Insurance Expense, $7,120 (1d ) Dr. Depreciation Expense, $30,500

The total premium for each policy was paid in full (for all months) at the purchase date, and the Prepaid Insurance account was debited for the full cost. (Year-end adjusting entries for Prepaid Insurance were properly recorded in all prior years.)

c. The company has 15 employees, who earn a total of $1,960 in salaries each working day. They are paid each Monday for their work in the five-day workweek ending on the previous Friday. Assume that December 31, 2013, is a Tuesday, and all 15 employees worked the first two days of that week. Because New Year’s Day is a paid holiday, they will be paid salaries for five full days on Monday, January 6, 2014.

d. The company purchased a building on January 1, 2013. It cost $960,000 and is expected to have a $45,000 salvage value at the end of its predicted 30-year life. Annual depreciation is $30,500.

e. Since the company is not large enough to occupy the entire building it owns, it rented space to a ten- ant at $3,000 per month, starting on November 1, 2013. The rent was paid on time on November 1, and the amount received was credited to the Rent Earned account. However, the tenant has not paid the December rent. The company has worked out an agreement with the tenant, who has promised to pay both December and January rent in full on January 15. The tenant has agreed not to fall behind again.

f. On November 1, the company rented space to another tenant for $2,800 per month. The tenant paid five months’ rent in advance on that date. The payment was recorded with a credit to the Unearned Rent account.

Required

1. Use the information to prepare adjusting entries as of December 31, 2013. 2. Prepare journal entries to record the first subsequent cash transaction in 2014 for parts c and e.

Months of Policy Date of Purchase Coverage Cost

A April 1, 2011 24 $14,400

B April 1, 2012 36 12,960

C August 1, 2013 12 2,400

b. An analysis of the company’s insurance policies provided the following facts.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 145

Required

1. Prepare T-accounts (representing the ledger) with balances from the unadjusted trial balance. 2. Prepare the necessary adjusting journal entries for items a through h and post them to the T-accounts.

Assume that adjusting entries are made only at year-end. 3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance. 4. Prepare Wells Technical Institute’s income statement and statement of retained earnings for the year

2013 and prepare its balance sheet as of December 31, 2013.

Check (2e) Cr. Training Fees Earned, $5,000; (2f ) Cr. Tuition Fees Earned, $7,500; (3) Adj. Trial balance totals, $345,700; (4) Net income, $49,600

WELLS TECHNICAL INSTITUTE Unadjusted Trial Balance

December 31, 2013

Cash Accounts receivable Teaching supplies Prepaid insurance Prepaid rent Professional library Accumulated depreciation—Professional library Equipment Accumulated depreciation—Equipment Accounts payable Salaries payable Unearned training fees

Tuition fees earned Training fees earned Depreciation expense—Professional library Depreciation expense—Equipment Salaries expense Insurance expense Rent expense Teaching supplies expense Advertising expense Utilities expense Totals

Common stock Retained earnings Dividends

Debit

$ 34,000 0

8,000 12,000 3,000

35,000

80,000

50,000

0 0

50,000 0

33,000 0

6,000 6,400

$ 317,400

Credit

$ 317,400

$ 10,000

15,000 26,000

0 12,500 10,000 80,000

123,900 40,000

A six-column table for JKL Company follows. The first two columns contain the unadjusted trial balance for the company as of July 31, 2013. The last two columns contain the adjusted trial balance as of the same date.

Required

Analysis Component

1. Analyze the differences between the unadjusted and adjusted trial balances to determine the eight ad- justments that likely were made. Show the results of your analysis by inserting these adjustment amounts in the table’s two middle columns. Label each adjustment with a letter a through h and pro- vide a short description of it at the bottom of the table.

Preparation Component

2. Use the information in the adjusted trial balance to prepare the company’s (a) income statement and its statement of retained earnings for the year ended July 31, 2013 (Note: retained earnings at July 31, 2012, was $25,000, and the current-year dividends were $5,000), and (b) the balance sheet as of July 31, 2013.

Problem 3-4A Interpreting unadjusted and adjusted trial balances, and preparing financial statements

A1 P1 P2 P3

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Check (2) Net income, $4,960; Total assets, $124,960

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146 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Unadjusted Adjusted Trial Balance Adjustments Trial Balance

Cash . . . . . . . . . . . . . . . . . . . . . . . $ 34,000 _________________ $ 34,000 Accounts receivable . . . . . . . . . . . 14,000 _________________ 22,000 Office supplies . . . . . . . . . . . . . . . . 16,000 _________________ 2,000 Prepaid insurance . . . . . . . . . . . . . 8,540 _________________ 2,960 Office equipment . . . . . . . . . . . . . 84,000 _________________ 84,000 Accum. depreciation — Office equip. . . . . . . . . . . . . . . . $ 14,000 _________________ $ 20,000 Accounts payable . . . . . . . . . . . . . 9,100 _________________ 10,000 Interest payable . . . . . . . . . . . . . . . 0 _________________ 1,000 Salaries payable . . . . . . . . . . . . . . . 0 _________________ 7,000 Unearned consulting fees . . . . . . . 18,000 _________________ 15,000 Long-term notes payable . . . . . . . 52,000 _________________ 52,000 Common stock . . . . . . . . . . . . . . . 15,000 _________________ 15,000 Retained earnings. . . . . . . . . . . . . . 25,000 _________________ 25,000 Dividends . . . . . . . . . . . . . . . . . . . 5,000 _________________ 5,000 Consulting fees earned . . . . . . . . . 123,240 _________________ 134,240 Depreciation expense — Office equip. . . . . . . . . . . . . . . . 0 _________________ 6,000 Salaries expense . . . . . . . . . . . . . . 67,000 _________________ 74,000 Interest expense . . . . . . . . . . . . . . 1,200 _________________ 2,200 Insurance expense . . . . . . . . . . . . 0 _________________ 5,580 Rent expense . . . . . . . . . . . . . . . . 14,500 _________________ 14,500 Office supplies expense . . . . . . . . 0 _________________ 14,000 Advertising expense . . . . . . . . . . . 12,100 _________________ 13,000 Totals . . . . . . . . . . . . . . . . . . . . . . . $256,340 $256,340

_________________ $279,240 $279,240

The adjusted trial balance for Chiara Company as of December 31, 2013, follows.Problem 3-5A Preparing financial statements from the adjusted trial balance and calculating profit margin

P3 A1 A2

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 Notes receivable (due in 90 days) . . . . . . . . . . . . . . . 168,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Automobiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000 Accumulated depreciation — Automobiles . . . . . . . . . $ 50,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,000 Accumulated depreciation — Equipment . . . . . . . . . . 18,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 Unearned fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . 138,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235,800 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000 Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484,000 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Depreciation expense — Automobiles . . . . . . . . . . . . 26,000 Depreciation expense — Equipment . . . . . . . . . . . . . . 18,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188,000 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . 34,000 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . 58,000 Repairs expense — Automobiles . . . . . . . . . . . . . . . . . 24,800 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,134,800 $1,134,800

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 147

Required

1. Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31, 2013; (b) the statement of retained earnings for the year ended December 31, 2013; and (c) the balance sheet as of December 31, 2013.

2. Calculate the profit margin for year 2013.

Check (1) Total assets, $600,000

Problem 3-6A Determining balance sheet classifications

C4

In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classifica- tion. If the item should not appear on the balance sheet, enter a Z in the blank. A. Current assets B. Long-term investments C. Plant assets

D. Intangible assets E. Current liabilities

12. Accumulated depreciation—Trucks 13. Cash 14. Buildings 15. Store supplies 16. Office equipment 17. Land (used in operations) 18. Repairs expense 19. Office supplies 20. Current portion of long-term

note payable

1. Long-term investment in stock 2. Depreciation expense—Building 3. Prepaid rent 4. Interest receivable 5. Taxes payable 6. Automobiles 7. Notes payable (due in 3 years) 8. Accounts payable 9. Prepaid insurance 10. Common stock 11. Unearned services revenue

F. Long-term liabilities G. Equity

Problem 3-7A Applying the accounting cycle

P1 P2 P3 P4 P5

On April 1, 2013, Jiro Nozomi created a new travel agency, Adventure Travel. The following transactions occurred during the company’s first month.

April 1 Nozomi invested $30,000 cash and computer equipment worth $20,000 in the company in ex- change for common stock.

2 The company rented furnished office space by paying $1,800 cash for the first month’s (April) rent. 3 The company purchased $1,000 of office supplies for cash. 10 The company paid $2,400 cash for the premium on a 12-month insurance policy. Coverage

begins on April 11. 14 The company paid $1,600 cash for two weeks’ salaries earned by employees. 24 The company collected $8,000 cash on commissions from airlines on tickets obtained for

customers. 28 The company paid $1,600 cash for two weeks’ salaries earned by employees. 29 The company paid $350 cash for minor repairs to the company’s computer. 30 The company paid $750 cash for this month’s telephone bill. 30 The company paid $1,500 cash for dividends.

The company’s chart of accounts follows:

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101 Cash 405 Commissions Earned

106 Accounts Receivable 612 Depreciation Expense — Computer Equip.

124 Office Supplies 622 Salaries Expense

128 Prepaid Insurance 637 Insurance Expense

167 Computer Equipment 640 Rent Expense

168 Accumulated Depreciation — Computer Equip. 650 Office Supplies Expense

209 Salaries Payable 684 Repairs Expense

307 Common Stock 688 Telephone Expense

318 Retained Earnings 901 Income Summary

319 Dividends

Required

1. Use the balance column format to set up each ledger account listed in its chart of accounts. 2. Prepare journal entries to record the transactions for April and post them to the ledger accounts. The

company records prepaid and unearned items in balance sheet accounts. 3. Prepare an unadjusted trial balance as of April 30.

Check (3) Unadj. trial balance totals, $58,000

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148 Chapter 3 Adjusting Accounts and Preparing Financial Statements

(4a) Dr. Insurance Expense, $133

(5) Net income, $2,197; Total assets, $51,117

(7) P-C trial balance totals, $51,617

4. Use the following information to journalize and post adjusting entries for the month: a. Two-thirds (or $133) of one month’s insurance coverage has expired. b. At the end of the month, $600 of office supplies are still available. c. This month’s depreciation on the computer equipment is $500. d. Employees earned $420 of unpaid and unrecorded salaries as of month-end. e. The company earned $1,750 of commissions that are not yet billed at month-end. 5. Prepare the adjusted trial balance as of April 30. Prepare the income statement and the statement of

retained earnings for the month of April and the balance sheet at April 30, 2013. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

TYBALT CONSTRUCTION Adjusted Trial Balance

December 31, 2013

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 104 Short-term investments . . . . . . . . . . . . . . . . . . . . . 23,000 126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 168 Accumulated depreciation—Equipment . . . . . . . . $ 20,000 173 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 174 Accumulated depreciation—Building . . . . . . . . . . 50,000 183 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 16,500 203 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 208 Rent payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 213 Property taxes payable . . . . . . . . . . . . . . . . . . . . . . 900 233 Unearned professional fees . . . . . . . . . . . . . . . . . . 7,500 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . 67,000 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 121,400 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 401 Professional fees earned . . . . . . . . . . . . . . . . . . . . 97,000 406 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 407 Dividends earned . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 409 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,100 606 Depreciation expense—Building . . . . . . . . . . . . . . 11,000 612 Depreciation expense—Equipment . . . . . . . . . . . . 6,000 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 633 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,400 652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . 7,400 682 Postage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200 683 Property taxes expense . . . . . . . . . . . . . . . . . . . . . 5,000 684 Repairs expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,900 688 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . 3,200 690 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $411,900 $411,900

The adjusted trial balance for Tybalt Construction as of December 31, 2013, follows.Problem 3-8A Preparing closing entries, financial statements, and ratios

C4 A2 A3 P3 P4

O. Tybalt invested $5,000 cash in the business in exchange for more common stock during year 2013 (the December 31, 2012, credit balance of retained earnings was $121,400). Tybalt Construction is required to make a $7,000 payment on its long-term notes payable during 2014.

Required

1. Prepare the income statement and the statement of retained earnings for the calendar year 2013 and the classified balance sheet at December 31, 2013.

Check (1) Total assets (12/31/2013), $218,100; Net income, $4,300

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 149

2. Prepare the necessary closing entries at December 31, 2013. 3. Use the information in the financial statements to compute these ratios: (a) return on assets (total

assets at December 31, 2012, was $200,000), (b) debt ratio, (c) profit margin ratio (use total revenues as the denominator), and (d ) current ratio. Round ratios to three decimals for parts a and c , and to two decimals for parts b and d .

PROBLEM SET B

Problem 3-1B Identifying adjusting entries with explanations

P1

For each of the following entries, enter the letter of the explanation that most closely describes it in the space beside each entry. (You can use letters more than once.) A. To record payment of a prepaid expense. B. To record this period’s use of a prepaid

expense. C. To record this period’s depreciation

expense. D. To record receipt of unearned revenue.

E. To record this period’s earning of prior unearned revenue.

F. To record an accrued expense. G. To record payment of an accrued expense. H. To record an accrued revenue. I. To record receipt of accrued revenue.

______ 1. Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 ______ 2. Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 ______ 3. Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . 8,000 ______ 4. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Unearned Professional Fees . . . . . . . . . . . . . . . . . . . . 9,000 ______ 5. Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 ______ 6. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 ______ 7. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Accounts Receivable (from services) . . . . . . . . . . . . . 1,500 ______ 8. Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 ______ 9. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 ______ 10. Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 ______ 11. Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 ______ 12. Unearned Professional Fees . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Professional Fees Earned . . . . . . . . . . . . . . . . . . . . . . 6,000

Natsu Co. follows the practice of recording prepaid expenses and unearned revenues in balance sheet accounts. The company’s annual accounting period ends on October 31, 2013. The following information concerns the adjusting entries that need to be recorded as of that date. a. The Office Supplies account started the fiscal year with a $600 balance. During the fiscal year, the

company purchased supplies for $4,570, which was added to the Office Supplies account. The sup- plies available at October 31, 2013, totaled $800.

b. An analysis of the company’s insurance policies provided the following facts.

Problem 3-2B Preparing adjusting and subsequent journal entries

C1 A1 P1

Months of Policy Date of Purchase Coverage Cost

A April 1, 2012 24 $6,000 B April 1, 2013 36 7,200 C August 1, 2013 12 1,320

The total premium for each policy was paid in full (for all months) at the purchase date, and the Prepaid Insurance account was debited for the full cost. (Year-end adjusting entries for Prepaid Insurance were properly recorded in all prior fiscal years.)

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150 Chapter 3 Adjusting Accounts and Preparing Financial Statements

c. The company has four employees, who earn a total of $1,000 for each workday. They are paid each Monday for their work in the five-day workweek ending on the previous Friday. Assume that October 31, 2013, is a Monday, and all four employees worked the first day of that week. They will be paid salaries for five full days on Monday, November 7, 2013.

d. The company purchased a building on November 1, 2010, that cost $175,000 and is expected to have a $40,000 salvage value at the end of its predicted 25-year life. Annual depreciation is $5,400.

e. Since the company does not occupy the entire building it owns, it rented space to a tenant at $1,000 per month, starting on September 1, 2013. The rent was paid on time on September 1, and the amount received was credited to the Rent Earned account. However, the October rent has not been paid. The company has worked out an agreement with the tenant, who has promised to pay both October and November rent in full on November 15. The tenant has agreed not to fall behind again.

f. On September 1, the company rented space to another tenant for $725 per month. The tenant paid five months’ rent in advance on that date. The payment was recorded with a credit to the Unearned Rent account.

Required

1. Use the information to prepare adjusting entries as of October 31, 2013. 2. Prepare journal entries to record the first subsequent cash transaction in November 2013 for parts c and e.

Check (1b) Dr. Insurance Expense, $4,730; (1d ) Dr. Depreciation Expense, $5,400.

Problem 3-3B Preparing adjusting entries, adjusted trial balance, and financial statements

A1 P1 P2 P3

Following is the unadjusted trial balance for Augustus Institute as of December 31, 2013, which initially records prepaid expenses and unearned revenues in balance sheet accounts. The Institute provides one-on- one training to individuals who pay tuition directly to the business and offers extension training to groups in off-site locations. Shown after the trial balance are items a through h that require adjusting entries as of December 31, 2013.

AUGUSTUS INSTITUTE Unadjusted Trial Balance

December 31, 2013

Cash Accounts receivable Teaching supplies Prepaid insurance Prepaid rent Professional library Accumulated depreciation—Professional library Equipment Accumulated depreciation—Equipment Accounts payable Salaries payable Unearned training fees Common stock

Tuition fees earned Training fees earned Depreciation expense—Professional library Depreciation expense—Equipment Salaries expense Insurance expense Rent expense Teaching supplies expense Advertising expense Utilities expense

Totals

0

$

0 0

0

$ 60,000 0

70,000 19,000 3,800

12,000

40,000

20,000

44,200

29,600

19,000 13,400

331,000

Debit

$331,000

$ 2,500

20,000 11,200

0 28,600 11,000

Retained earnings 60,500

129,200 68,000

Credit

Dividends

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 151

Additional Information Items

a. An analysis of the Institute’s insurance policies shows that $9,500 of coverage has expired. b. An inventory count shows that teaching supplies costing $20,000 are available at year-end 2013. c. Annual depreciation on the equipment is $5,000. d. Annual depreciation on the professional library is $2,400. e. On November 1, the Institute agreed to do a special five-month course (starting immediately) for a

client. The contract calls for a $14,300 monthly fee, and the client paid the first two months’ fees in advance. When the cash was received, the Unearned Training Fees account was credited. The last two month’s fees will be recorded when collected in 2014.

f. On October 15, the Institute agreed to teach a four-month class (beginning immediately) to an  individual for $2,300 tuition per month payable at the end of the class. The class started on October 15, but no payment has yet been received. (The Institute’s accruals are applied to the nearest half-month; for example, October recognizes one-half month accrual.)

g. The Institute’s only employee is paid weekly. As of the end of the year, three days’ salaries have ac- crued at the rate of $150 per day.

h. The balance in the Prepaid Rent account represents rent for December.

Required

1. Prepare T-accounts (representing the ledger) with balances from the unadjusted trial balance. 2. Prepare the necessary adjusting journal entries for items a through h, and post them to the T-accounts.

Assume that adjusting entries are made only at year-end. 3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance. 4. Prepare the company’s income statement and statement of retained earnings for the year 2013, and

prepare its balance sheet as of December 31, 2013.

Check (2e) Cr. Training Fees Earned, $28,600; (2f ) Cr. Tuition Fees Earned, $5,750; (3) Adj. trial balance totals, $344,600; (4) Net income, $54,200

Unadjusted Adjusted Trial Balance Adjustments Trial Balance

Cash . . . . . . . . . . . . . . . . . . . . . . . $ 45,000 _________________ $ 45,000

Accounts receivable . . . . . . . . . . . 60,000 _________________ 66,660

Office supplies . . . . . . . . . . . . . . . . 40,000 _________________ 17,000

Prepaid insurance . . . . . . . . . . . . . 8,200 _________________ 3,600

Office equipment . . . . . . . . . . . . . 120,000 _________________ 120,000

Accumulated depreciation — Office equip. . . . . . . . . . . . . . . . $ 20,000 _________________ $ 30,000

Accounts payable . . . . . . . . . . . . . 26,000 _________________ 32,000

Interest payable . . . . . . . . . . . . . . . 0 _________________ 2,150

Salaries payable . . . . . . . . . . . . . . . 0 _________________ 16,000

Unearned consulting fees . . . . . . . 40,000 _________________ 27,800

Long-term notes payable . . . . . . . 75,000 _________________ 75,000

Common stock . . . . . . . . . . . . . . . 4,000 _________________ 4,000

Retained earnings. . . . . . . . . . . . . . 76,200 _________________ 76,200

Dividends . . . . . . . . . . . . . . . . . . . . 20,000 _________________ 20,000

Consulting fees earned . . . . . . . . . 234,600 _________________ 253,460

Depreciation expense — Office equip. . . . . . . . . . . . . . . . 0 _________________ 10,000

Salaries expense . . . . . . . . . . . . . . 112,000 _________________ 128,000

Interest expense . . . . . . . . . . . . . . 8,600 _________________ 10,750

Insurance expense . . . . . . . . . . . . 0 _________________ 4,600

Rent expense . . . . . . . . . . . . . . . . 20,000 _________________ 20,000

Office supplies expense . . . . . . . . 0 _________________ 23,000

Advertising expense . . . . . . . . . . . 42,000 _________________ 48,000

Totals . . . . . . . . . . . . . . . . . . . . . . . $475,800 $475,800 _________________

$516,610 $516,610

A six-column table for Yan Consulting Company follows. The first two columns contain the unadjusted trial balance for the company as of December 31, 2013, and the last two columns contain the adjusted trial balance as of the same date.

Problem 3-4B Interpreting unadjusted and adjusted trial balances, and preparing financial statements

A1 P1 P2 P3

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152 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Required

Analysis Component

1. Analyze the differences between the unadjusted and adjusted trial balances to determine the eight adjustments that likely were made. Show the results of your analysis by inserting these adjustment amounts in the table’s two middle columns. Label each adjustment with a letter a through h and pro- vide a short description of it at the bottom of the table.

Preparation Component

2. Use the information in the adjusted trial balance to prepare this company’s (a) income statement and its statement of retained earnings for the year ended December 31, 2013 (Note: retained earnings at December 31, 2012, was $76,200, and the current-year dividends were $20,000), and (b) the balance sheet as of December 31, 2013.

Check (2) Net income, $9,110; Total assets, $222,260

Problem 3-5B Preparing financial statements from the adjusted trial balance and calculating profit margin

P3 A1 A2

The adjusted trial balance for Speedy Courier as of December 31, 2013, follows.

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Notes receivable (due in 90 days) . . . . . . . . . . . . . 210,000

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

Trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,000

Accumulated depreciation — Trucks . . . . . . . . . . . . $ 58,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000

Accumulated depreciation — Equipment . . . . . . . . 200,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 134,000

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

Unearned delivery fees . . . . . . . . . . . . . . . . . . . . . . 120,000

Long-term notes payable . . . . . . . . . . . . . . . . . . . . 200,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Delivery fees earned . . . . . . . . . . . . . . . . . . . . . . . . 611,800

Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000

Depreciation expense — Trucks . . . . . . . . . . . . . . . 29,000

Depreciation expense — Equipment . . . . . . . . . . . . 48,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,000

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Office supplies expense . . . . . . . . . . . . . . . . . . . . . 31,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . 27,200

Repairs expense — Trucks . . . . . . . . . . . . . . . . . . . . 35,600

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,530,800 $1,530,800

Required

1. Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31, 2013, (b) the statement of retained earnings for the year ended December 31, 2013, and (c) the balance sheet as of December 31, 2013.

2. Calculate the profit margin for year 2013.

Check (1) Total assets, $663,000

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 153

Problem 3-6B Determining balance sheet classifications

C4

1. Commissions earned 2. Interest receivable 3. Long-term investment in stock 4. Prepaid insurance 5. Machinery 6. Notes payable (due in 15 years) 7. Copyrights 8. Current portion of long-term

note payable 9. Accumulated depreciation—Trucks 10. Office equipment

11. Rent receivable 12. Salaries payable 13. Income taxes payable 14. Common stock 15. Office supplies 16. Interest payable 17. Rent revenue 18. Notes receivable (due in 120 days) 19. Land (used in operations) 20. Depreciation expense—Trucks

In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classifica- tion. If the item should not appear on the balance sheet, enter a Z in the blank. A. Current assets B. Long-term investments C. Plant assets D. Intangible assets

E. Current liabilities F. Long-term liabilities G. Equity

Problem 3-7B Applying the accounting cycle

P1 P2 P3 P4 P5

On July 1, 2013, Lula Plume created a new self-storage business, Safe Storage Co. The following transac- tions occurred during the company’s first month.

July 1 Plume invested $30,000 cash and buildings worth $150,000 in the company in exchange for common stock.

2 The company rented equipment by paying $2,000 cash for the first month’s (July) rent. 5 The company purchased $2,400 of office supplies for cash. 10 The company paid $7,200 cash for the premium on a 12-month insurance policy. Coverage

begins on July 11. 14 The company paid an employee $1,000 cash for two weeks’ salary earned. 24 The company collected $9,800 cash for storage fees from customers. 28 The company paid $1,000 cash for two weeks’ salary earned by an employee. 29 The company paid $950 cash for minor repairs to a leaking roof. 30 The company paid $400 cash for this month’s telephone bill. 31 The company paid $2,000 cash for dividends.

The company’s chart of accounts follows:

101 Cash 401 Storage Fees Earned

106 Accounts Receivable 606 Depreciation Expense—Buildings

124 Office Supplies 622 Salaries Expense

128 Prepaid Insurance 637 Insurance Expense

173 Buildings 640 Rent Expense

174 Accumulated Depreciation—Buildings 650 Office Supplies Expense

209 Salaries Payable 684 Repairs Expense

307 Common Stock 688 Telephone Expense

318 Retained Earnings 901 Income Summary

319 Dividends

Check (3) Unadj. trial balance totals, $189,800

Required

1. Use the balance column format to set up each ledger account listed in its chart of accounts. 2. Prepare journal entries to record the transactions for July and post them to the ledger accounts. Record

prepaid and unearned items in balance sheet accounts. 3. Prepare an unadjusted trial balance as of July 31.

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154 Chapter 3 Adjusting Accounts and Preparing Financial Statements

4. Use the following information to journalize and post adjusting entries for the month: a. Two-thirds of one month’s insurance coverage has expired. b. At the end of the month, $1,525 of office supplies are still available. c. This month’s depreciation on the buildings is $1,500. d. An employee earned $100 of unpaid and unrecorded salary as of month-end. e. The company earned $1,150 of storage fees that are not yet billed at month-end. 5. Prepare the adjusted trial balance as of July 31. Prepare the income statement and the statement of

retained earnings for the month of July and the balance sheet at July 31, 2013. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

(5) Net income, $2,725; Total assets, $180,825

(7) P-C trial balance totals, $182,325

(4a) Dr. Insurance Expense, $400

Problem 3-8B Preparing closing entries, financial statements, and ratios

C4 A2 A3 P3 P4

The adjusted trial balance for Anara Co. as of December 31, 2013, follows.

ANARA COMPANY Adjusted Trial Balance

December 31, 2013

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,400 104 Short-term investments . . . . . . . . . . . . . . . . . . . . . 11,200 126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 168 Accumulated depreciation—Equipment . . . . . . . . $ 4,000 173 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 174 Accumulated depreciation—Building . . . . . . . . . . 10,000 183 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 203 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 208 Rent payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,280 213 Property taxes payable . . . . . . . . . . . . . . . . . . . . . . 3,330 233 Unearned professional fees . . . . . . . . . . . . . . . . . . 750 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . 40,000 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 52,800 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 401 Professional fees earned . . . . . . . . . . . . . . . . . . . . 59,600 406 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 407 Dividends earned . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 409 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320 606 Depreciation expense—Building . . . . . . . . . . . . . . 2,000 612 Depreciation expense—Equipment . . . . . . . . . . . . 1,000 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,500 633 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,550 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . 1,525 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 682 Postage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 410 683 Property taxes expense . . . . . . . . . . . . . . . . . . . . . 4,825 684 Repairs expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 679 688 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . 521 690 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,920 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $224,230 $224,230

P. Anara invested $40,000 cash in the business in exchange for more common stock during year 2013 (the December 31, 2012, credit balance of retained earnings was $52,800). Anara Company is required to make a $8,400 payment on its long-term notes payable during 2014.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 155

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can still begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.

SP 3 After the success of the company’s first two months, Adria Lopez continues to operate Success Systems. (Transactions for the first two months are described in the serial problem of Chapter 2.) The November 30, 2013, unadjusted trial balance of Success Systems (reflecting its transactions for October and November of 2013) follows.

SERIAL PROBLEM Success Systems

P1 P2 P3 P4 P5

Required

1. Prepare the income statement and the statement of retained earnings for the calendar year 2013 and the classified balance sheet at December 31, 2013.

2. Prepare the necessary closing entries at December 31, 2013. 3. Use the information in the financial statements to calculate these ratios: (a) return on assets (total as-

sets at December 31, 2012, were $160,000), (b) debt ratio, (c) profit margin ratio (use total revenues as the denominator), and (d ) current ratio. Round ratios to three decimals for parts a and c, and to two decimals for parts b and d.

Check (1) Total assets (12/31/2013), $164,700; Net income, $28,890

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,052 106 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,618 126 Computer supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,545 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,220 131 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300 163 Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 164 Accumulated depreciation—Office equipment . . . . . . . . . . . . $ 0 167 Computer equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 168 Accumulated depreciation—Computer equipment . . . . . . . . 0 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 236 Unearned computer services revenue . . . . . . . . . . . . . . . . . . . 0 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600 403 Computer services revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,659 612 Depreciation expense—Office equipment . . . . . . . . . . . . . . . 0 613 Depreciation expense—Computer equipment . . . . . . . . . . . . 0 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 652 Computer supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 655 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,940 676 Mileage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704 677 Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 684 Repairs expense—Computer . . . . . . . . . . . . . . . . . . . . . . . . . 805

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,659 $108,659

Success Systems had the following transactions and events in December 2013.

Dec. 2 Paid $1,025 cash to Hillside Mall for Success Systems’ share of mall advertising costs. 3 Paid $500 cash for minor repairs to the company’s computer. 4 Received $3,950 cash from Alex’s Engineering Co. for the receivable from November. 10 Paid cash to Lyn Addie for six days of work at the rate of $125 per day. 14 Notified by Alex’s Engineering Co. that Success Systems’ bid of $7,000 on a proposed project

has been accepted. Alex’s paid a $1,500 cash advance to Success Systems. 15 Purchased $1,100 of computer supplies on credit from Harris Office Products. 16 Sent a reminder to Gomez Co. to pay the fee for services recorded on November 8. 20 Completed a project for Liu Corporation and received $5,625 cash.

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156 Chapter 3 Adjusting Accounts and Preparing Financial Statements

22 – 26 Took the week off for the holidays. 28 Received $3,000 cash from Gomez Co. on its receivable. 29 Reimbursed A. Lopez for business automobile mileage (600 miles at $0.32 per mile). 31 The business paid $1,500 cash for dividends.

The following additional facts are collected for use in making adjusting entries prior to preparing financial statements for the company’s first three months: a. The December 31 inventory count of computer supplies shows $580 still available. b. Three months have expired since the 12-month insurance premium was paid in advance. c. As of December 31, Lyn Addie has not been paid for four days of work at $125 per day. d. The computer system, acquired on October 1, is expected to have a four-year life with no salvage value. e. The office equipment, acquired on October 1, is expected to have a five-year life with no salvage value. f. Three of the four months’ prepaid rent has expired.

Required

1. Prepare journal entries to record each of the December transactions and events for Success Systems. Post those entries to the accounts in the ledger.

2. Prepare adjusting entries to reflect a through f. Post those entries to the accounts in the ledger. 3. Prepare an adjusted trial balance as of December 31, 2013. 4. Prepare an income statement for the three months ended December 31, 2013. 5. Prepare a statement of retained earnings for the three months ended December 31, 2013. 6. Prepare a balance sheet as of December 31, 2013. 7. Record and post the necessary closing entries for Success Systems. 8. Prepare a post-closing trial balance as of December 31, 2013.

Check (3) Adjusted trial balance totals, $109,034

(6) Total assets, $83,460

Beyond the Numbers

BTN 3-1 Refer to Polaris’s financial statements in Appendix A to answer the following. 1. Identify and write down the revenue recognition principle as explained in the chapter. 2. Review Polaris’s footnotes to discover how it applies the revenue recognition principle and when it

recognizes revenue. Report what you discover. 3. What is Polaris’s profit margin for fiscal years ended December 31, 2011 and 2010. 4. For the year ended December 31, 2011, what amount is credited to Income Summary to summarize its

revenues earned? 5. For the year ended December 31, 2011, what amount is debited to Income Summary to summarize its

expenses incurred? 6. For the year ended December 31, 2011, what is the balance of its Income Summary account before it

is closed?

Fast Forward

7. Access Polaris’s annual report (10-K) for fiscal years ending after December 31, 2011, at its Website (Polaris.com) or the SEC’s EDGAR database (www .sec.gov). Assess and compare the December 31, 2011, fiscal year profit margin to any subsequent year’s profit margin that you compute.

REPORTING IN ACTION C1 C2 A1 A2 P4

Check (3) Adjusted trial balance totals, $119,034

(6) Total assets, $93,248

Polaris

Check Post-closing trial balance totals, $94,898

BTN 3-2 Key figures for the recent two years of both Polaris and Arctic Cat follow.

Polaris Arctic Cat

($ thousands) Current Year Prior Year Current Year Prior Year

Net income . . . . . . . . . . . . . $ 227,575 $ 147,138 $ 13,007 $ 1,875

Net sales . . . . . . . . . . . . . . . 2,656,949 1,991,139 363,015 350,871

Current assets . . . . . . . . . . . 878,676 808,145 232,040 201,015

Current liabilities . . . . . . . . . 615,531 584,210 87,444 75,320

COMPARATIVE ANALYSIS A2 A3

Polaris Arctic Cat

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 157

ETHICS CHALLENGE C1 C2 A1

BTN 3-3 Jessica Boland works for Sea Biscuit Co. She and Farah Smith, her manager, are preparing adjusting entries for annual financial statements. Boland computes depreciation and records it as

Depreciation Expense — Equipment . . . . . . . . . . . . . . . 123,000

Accumulated Depreciation — Equipment . . . . . . . . . 123,000

Smith agrees with her computation but says the credit entry should be directly to the Equipment account. Smith argues that while accumulated depreciation is technically correct, “it is less hassle not to use a con- tra account and just credit the Equipment account directly. And besides, the balance sheet shows the same amount for total assets under either method.”

Required

1. How should depreciation be recorded? Do you support Boland or Smith? 2. Evaluate the strengths and weaknesses of Smith’s reasons for preferring her method. 3. Indicate whether the situation Boland faces is an ethical problem. Explain.

BTN 3-4 Assume that one of your classmates states that a company’s books should be ongoing and therefore not closed until that business is terminated. Write a half-page memo to this classmate explaining the concept of the closing process by drawing analogies between (1) a scoreboard for an athletic event and the revenue and expense accounts of a business or (2) a sports team’s record book and retained earnings. (Hint: Think about what would happen if the scoreboard is not cleared before the start of a new game.)

COMMUNICATING IN PRACTICE P4

BTN 3-5 Access EDGAR online (www.sec.gov) and locate the 10-K report of The Gap, Inc., (ticker GPS) filed on March 26, 2012. Review its financial statements reported for the year ended January 28, 2012, to answer the following questions.

Required

1. What are Gap’s main brands? 2. What is Gap’s fiscal year-end? 3. What is Gap’s net sales for the period ended January 28, 2012? 4. What is Gap’s net income for the period ended January 28, 2012? 5. Compute Gap’s profit margin for the year ended January 28, 2012. 6. Do you believe Gap’s decision to use a year-end of late January or early February relates to its natural

business year? Explain.

TAKING IT TO THE NET C1 A2

Required

1. Compute profit margins for (a) Polaris and (b) Arctic Cat for the two years of data shown. 2. Which company is more successful on the basis of profit margin? Explain. 3. Compute the current ratio for both years for both companies. 4. Which company has the better ability to pay short-term obligations according to the current ratio? 5. Analyze and comment on each company’s current ratios for the past two years. 6. How do Polaris’s and Arctic Cat’s current ratios compare to their industry (assumed) average ratio of 2.4?

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158 Chapter 3 Adjusting Accounts and Preparing Financial Statements

BTN 3-6 Four types of adjustments are described in the chapter: (1) prepaid expenses, (2) unearned revenues, (3) accrued expenses, and (4) accrued revenues.

Required

1. Form learning teams of four (or more) members. Each team member must select one of the four adjustments as an area of expertise (each team must have at least one expert in each area).

2. Form expert teams from the individuals who have selected the same area of expertise. Expert teams are to discuss and write a report that each expert will present to his or her learning team addressing the following:

a. Description of the adjustment and why it’s necessary. b. Example of a transaction or event, with dates and amounts, that requires adjustment. c. Adjusting entry(ies) for the example in requirement b. d. Status of the affected account(s) before and after the adjustment in requirement c. e. Effects on financial statements of not making the adjustment. 3. Each expert should return to his or her learning team. In rotation, each member should present his or

her expert team’s report to the learning team. Team discussion is encouraged.

TEAMWORK IN ACTION A1 P1

BTN 3-7 Review the opening feature of this chapter dealing with ash&dans and the entrepreneurial owners, Ashley Cook and Danielle Dankner.

Required

1. Assume that ash&dans sells a $300 gift certificate to a customer, collecting the $300 cash in advance. Prepare the journal entry for the (a) collection of the cash for delivery of the gift certificate to the cus- tomer and (b) revenue from the subsequent delivery of merchandise when the gift certificate is used.

2. How can keeping less inventory help to improve ash&dans’s profit margin? 3. Ashley Cook and Danielle Dankner understand that many companies carry considerable inventory,

and they are thinking of carrying additional inventory of merchandise for sale. Ashley and Danielle desire your advice on the pros and cons of carrying such inventory. Provide at least one reason for and one reason against carrying additional inventory.

ENTREPRENEURIAL DECISION A2

BTN 3-8 Select a company that you can visit in person or interview on the telephone. Call ahead to the company to arrange a time when you can interview an employee (preferably an accountant) who helps prepare the annual financial statements. Inquire about the following aspects of its accounting cycle: 1. Does the company prepare interim financial statements? What time period(s) is used for interim

statements? 2. Does the company use the cash or accrual basis of accounting? 3. Does the company use a work sheet in preparing financial statements? Why or why not? 4. Does the company use a spreadsheet program? If so, which software program is used? 5. How long does it take after the end of its reporting period to complete annual statements?

HITTING THE ROAD C1

BTN 3-9 Piaggio (Piaggio.com) manufactures two-, three- and four-wheel vehicles and is Europe’s leading manufacturer of motorcycles and scooters. The following selected information is available from Piaggio’s financial statements.

GLOBAL DECISION A2 A3 C1 C2

PIAGGIO (Euro thousands) Current Year Prior Year

Current assets . . . . . . . . . . . 509,708 575,897

Current liabilities . . . . . . . . . 644,277 616,166

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 159

1. b; the forgotten adjusting entry is: dr. Wages Expense, cr. Wages Payable.

2. c; Supplies used 5 $450 2 $125 5 $325 3. b; Insurance expense 5 $24,000 3 (8y24) 5 $8,000; adjusting entry

is: dr. Insurance Expense for $8,000, cr. Prepaid Insurance for $8,000.

4. a; Consulting fees earned 5 $3,600 3 (2y6) 5 $1,200; adjusting entry is: dr. Unearned Consulting Fee for $1,200, cr. Consulting Fees Earned for $1,200.

5. e; Profit margin 5 $15,000y$300,000 5 5% 6. b

ANSWERS TO MULTIPLE CHOICE QUIZ

Required

1. Locate the notes to its December 31, 2011, financial statements at the company’s Website, and read note 2.2 Accounting Principles—Recognition of Revenues, first paragraph only. When is revenue rec- ognized by Piaggio?

2. Refer to Piaggio’s financials in Appendix A. What is Piaggio’s profit margin for the year ended December 31, 2011?

3. Compute Piaggio’s current ratio for both the current year and the prior year. 4. Comment on any change from the prior year to the current year for the current ratio.

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Learning Objectives

CONCEPTUAL

C1 Describe merchandising activities and identify income components for a merchandising company. (p. 162)

C2 Identify and explain the inventory asset and cost flows of a merchandising company. (p. 163)

ANALYTICAL

A1 Compute the acid-test ratio and explain its use to assess liquidity. (p. 178) A2 Compute the gross margin ratio and explain its use to assess profitability.

(p. 178)

PROCEDURAL

P1 Analyze and record transactions for merchandise purchases using a perpetual system. (p. 164)

P2 Analyze and record transactions for merchandise sales using a perpetual system. (p. 169)

P3 Prepare adjustments and close accounts for a merchandising company. (p. 172) P4 Define and prepare multiple-step and single-step income statements. (p. 174) P5 Appendix 4A—Record and compare merchandising transactions using both

periodic and perpetual inventory systems. (p. 183)

A Look at This Chapter

This chapter emphasizes merchandising activities. We explain how reporting merchandising activities differs from reporting service activities. We also analyze and record merchandise purchases and sales transactions, and explain the adjustments and closing process for merchandisers.

A Look Back

Chapter 3 focused on the final steps of the accounting process. We explained the importance of proper revenue and expense recognition and described the adjusting and closing processes. We also prepared financial statements.

Accounting for Merchandising Operations 4

A Look Ahead

Chapter 5 extends our analysis of merchandising activities and focuses on the valuation of inventory. Topics include the items in inventory, costs assigned, costing methods used, and inventory estimation techniques.

160

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Faithful Business

ATLANTA—“I have a learning disability,” explains Chelsea Eubank. “I went to LD schools and attend Beacon College, the only accredited LD college in America. It will always be with me.” However, Chelsea uses her LD as an opportunity. “It [LD] has made me take risks and focus on what my gifts are.” Explains Chelsea, “I always tell them that everyone has a talent and ev- eryone has a disability. They just need to figure out what their talent is!” For Chelsea, her “goal is to create a clothing line that gives to charity and to become a role model for students with challenges.” That goal has led her to launch Faithful Fish (FaithfulFish.com). Our mission, explains Chelsea, is to de- velop a “clothing line that expresses the customers positive val- ues and lifestyle.” She adds, “We are offering something that is not in the marketplace.” Still, her start-up was a struggle. “We had to go through our business plan and then . . . give a summary of the company,” explains Chelsea. She recalls how the business required a mer- chandising accounting system to account for purchases and sales transactions and to effectively track merchandise. Inven- tory was especially important to account for and monitor.

Chelsea admits, “I don’t really know what I am doing, so I have made mistakes.” To succeed, Chelsea made smart business decisions. She set up an accounting system to capture and communicate costs and sales information. Tracking merchandising activities was necessary to set prices and to manage discounts, allowances, and returns of both sales and purchases. A perpetual inventory system enabled her to stock the right kind and amount of mer- chandise and to avoid the costs of out-of-stock and excess in- ventory. Chelsea stresses that one must “ask people for advice.” To help with the accounting for merchandise, Chelsea admits, “I have a financial manager.” Mastering accounting for merchandising is about more than profits and losses—it is a means to an end for Chelsea. “Faithful Fish gives a portion of all sales to charities.” Adds Chelsea, “I want Faithful Fish to get big enough that I will be able to give over $1,000,000 a year away!”

[Sources: Faithful Fish Website, January 2013; YHP, October 2009; FBEnow.com, August 2009; Entrepreneur Girl, January 2012; EmbracingBeauty.com, March 2011]

“I have a vision, a BIG vision, a HUGE vision!“ —CHELSEA EUBANK

Decision Insight

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Point: Fleming, SuperValu, and SYSCO are wholesalers. Aeropostale, Coach, Target, and Walmart are retailers.

EXHIBIT 4.1 Computing Income for a Merchandising Company versus a Service Company

EqualsMinusEqualsMinus Expenses

Net income

Net sales

Merchandiser

Expenses Net

income Revenues

Service Company

Minus Equals

Gross profit

Cost of goods sold

Chapter Preview

Buyers of merchandise expect many products, discount prices, inventory on demand, and high quality. This chapter introduces the accounting practices used by companies engaged in merchandising. We show how financial statements reflect

merchandising activities and explain the new financial statement items created by merchandising activities. We also analyze and record merchandise purchases and sales, and explain the adjustments and the closing process for these companies.

Accounting for Merchandising Operations

Merchandising Purchases

• Purchase discounts • Purchase returns

and allowances • Transportation costs

Merchandising Activities

• Reporting income • Reporting inventory • Operating cycles • Inventory systems

Merchandising Sales

• Sales of merchandise

• Sales discounts • Sales returns and

allowances

Accounting Cycle

• Adjusting entries • Preparing financial

statements • Closing entries

Financial Statement Formats

• Multiple-step income statement

• Single-step income statement

• Classified balance sheet

Previous chapters emphasized the accounting and reporting activities of service companies. A merchandising company’s activities differ from those of a service company. Merchandise consists of products, also called goods, that a company acquires to resell to customers. A merchandiser earns net income by buying and selling merchandise. Merchandisers are often identified as either wholesalers or retailers. A wholesaler is an intermediary that buys products from manufacturers or other wholesalers and sells them to retailers or other wholesalers. A retailer is an intermediary that buys products from manufacturers or wholesalers and sells them to consumers. Many retailers sell both products and services.

Reporting Income for a Merchandiser Net income for a merchandiser equals revenues from selling merchandise minus both the cost of merchandise sold to customers and the cost of other expenses for the period, see Exhibit 4.1. The

MERCHANDISING ACTIVITIES

usual accounting term for revenues from selling merchandise is sales, and the term used for the expense of buying and preparing the merchandise is cost of goods sold. (Some ser vice companies use the term sales instead of revenues; and cost of goods sold is also called cost of sales.) The income statement for Z-Mart in Exhibit 4.2 illustrates these key components of a merchandiser’s net income. The first two lines show that products are acquired at a cost of $230,400 and sold for $314,700. The third line shows an $84,300 gross profit, also called

C1 Describe merchandising activities and identify income components for a merchandising company.

162

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Chapter 4 Accounting for Merchandising Operations 163

EXHIBIT 4.2 Merchandiser’s Income Statement

Z-MART

Income Statement

For Year Ended December 31, 2013

Net sales . . . . . . . . . . . . . . . . . . . $314,700

Cost of goods sold . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . 84,300

Expenses . . . . . . . . . . . . . . . . . . . 71,400

Net income . . . . . . . . . . . . . . . . . $ 12,900

Point: Mathematically, Exhibit 4.4 says BI 1 NP 5 MAS,

where BI is beginning inventory, NP is net purchases, and MAS is merchandise available for sale. Exhibit 4.4 also says

MAS 5 EI 1 COGS, which can be rewritten as MAS 2 EI 5 COGS or MAS 2 COGS 5 EI, where EI is ending inventory and COGS is cost of goods sold. In both equations above, if we know two of the three values, we can solve for the third.

EXHIBIT 4.4 Merchandiser’s Cost Flow for a Single Time Period

Beginning inventory

Net purchases

5 Merchandise available for sale

Cost of goods sold

Ending inventory

+

+

gross margin, which equals net sales less cost of goods sold. Additional expenses of $71,400 are reported, which leaves $12,900 in net income.

Reporting Inventory for a Merchandiser A merchandiser’s balance sheet includes a current asset called merchandise inventory, an item not on a service company’s balance sheet. Merchandise inventory, or simply inventory, refers to products that a company owns and intends to sell. The cost of this asset includes the cost incurred to buy the goods, ship them to the store, and make them ready for sale.

Operating Cycle for a Merchandiser A merchandising company’s operating cycle begins by purchasing merchandise and ends by collecting cash from selling the merchandise. The length of an operating cycle differs across the types of businesses. Department stores often have operating cycles of two to five months. Operating cycles for grocery merchants usually range from two to eight weeks. A grocer has more operating cycles in a year than, say, clothing or electronics retailers. Exhibit 4.3 illustrates an operating cycle for a merchandiser with credit sales. The cycle moves from (a) cash purchases of merchandise to (b) inven- tory for sale to (c) credit sales to (d ) accounts receiv- able to (e) cash. Companies try to keep their operating cycles short because assets tied up in inventory and receivables are not productive. Cash sales shorten operating cycles.

Inventory Systems Cost of goods sold is the cost of merchandise sold to customers during a period. It is often the largest single expense on a merchandiser’s income statement. Inventory refers to pro d ucts a company owns and expects to sell in its normal operations. Exhibit 4.4 shows that a company’s merchandise available for sale consists of what it begins with (beginning inventory) and what it

EXHIBIT 4.3 Merchandiser’s Operating Cycle

Cash

(b) Merchandise

inventory (d) Accounts

receivable

(a) Purch a s e s

(e ) C

a s h c

o lle

ct ion

(c) Credit sa les

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Date Num

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Term s

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C2 Identify and explain the inventory asset and cost flows of a merchandising company.

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164 Chapter 4 Accounting for Merchandising Operations

purchases (net purchases). The merchandise available is either sold (cost of goods sold) or kept for future sales (ending inventory). Two alternative inventory accounting systems can be used to collect information about cost of goods sold and cost of inventory: perpetual system or periodic system. The perpetual inventory system continually updates accounting records for merchandising transactions — specifically, for those records of inventory available for sale and inventory sold. The periodic inventory system updates the accounting records for merchandise transactions only at the end of a period. Techno- logical advances and competitive pressures have dramatically increased the use of the perpetual system. It gives managers immediate access to detailed information on sales and inventory levels, where they can strategically react to sales trends, cost changes, consumer tastes, and so forth, to increase gross profit. (Some companies use a hybrid system where the perpetual system is used for tracking units available and the periodic system is used to compute cost of sales.)

The following sections, consisting of the next 10 pages on purchasing, selling, and adjusting merchandise, use the perpetual system. Appendix 4A uses the periodic system (with the perpetual results on the side). An instructor can choose to cover either one or both inventory systems.

Point: Growth of superstores such as Costco and Sam’s is fueled by efficient use of perpetual inventory. Such large stores evolved only after scannable UPC codes to help control inventory were invented.

1. Describe a merchandiser’s cost of goods sold. 2. How do we compute gross profit for a merchandising company? 3. Explain why use of the perpetual inventory system has dramatically increased.

Quick Check Answers — p. 189

Nov. 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Purchased merchandise for cash.

Assets 5 Liabilities 1 Equity 11,200 21,200

The cost of merchandise purchased for resale is recorded in the Merchandise Inventory asset account. To illustrate, Z-Mart records a $1,200 cash purchase of merchandise on November 2 as follows:

ACCOUNTING FOR MERCHANDISE PURCHASES

P1 Analyze and record transactions for merchandise purchases using a perpetual system.

Point: The Merchandise Inventory account reflects the cost of goods available for resale. Costs recorded in Merchandise Inventory are sometimes called inventoriable costs.

Point: Lowes and Home Depot offer trade discounts to construction compa- nies and contractors. Trade discounts help create loyalty among customers.

The invoice for this merchandise is shown in Exhibit 4.5. The buyer usually receives the origi- nal invoice, and the seller keeps a copy. This source document serves as the purchase invoice of Z-Mart (buyer) and the sales invoice for Trex (seller). The amount recorded for merchandise inventory includes its purchase cost, shipping fees, taxes, and any other costs necessary to make it ready for sale. This section explains how we compute the recorded cost of merchandise purchases.

Trade Discounts When a manufacturer or wholesaler prepares a catalog of items it has for sale, it usually gives each item a list price, also called a catalog price. However, an item’s intended selling price equals list price minus a given percent called a trade discount. The amount of trade discount usually depends on whether a buyer is a wholesaler, retailer, or final consumer. A wholesaler buying in large quantities is often granted a larger discount than a retailer buying in smaller quantities. A buyer records the net amount of list price minus trade discount. For example, in the November 2 purchase of merchandise by Z-Mart, the merchandise was listed in the seller’s catalog at $2,000 and Z-Mart received a 40% trade discount. This meant that Z-Mart’s purchase price was $1,200, computed as $2,000 2 (40% 3 $2,000). ■

Decision Insight

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Chapter 4 Accounting for Merchandising Operations 165

EXHIBIT 4.5 Invoice

54 6

1

W9797 Cherry Rd. Antigo, WI 54409

See reverse for terms of sale and returns.

Invoice

Date Number

11/2/13 4657-2 2

P.O. Date Salesperson Terms Freight Ship

SubTotal 1,200

1,200

Shipping

Tax

Total

7

6 Freight terms Goods7 Total invoice amount8

1 32 54Seller Invoice date Purchaser Order date Credit termsKey:

INVOICE

CH015

SD099

Challenger X7

Speed Demon

1

1

490

710

490

710

10/30/13 #141 2/10, n/30 FOB Destination Via FedEx

Model No. Description Quantity Price Amount

8

Firm Name

SOLD TO

Attention of

Address

City

State Zip

Tom Novak, Purchasing Agent

10 Michigan Street

Z-Mart

Chicago

Illinois 60521

3

Purchase Discounts The purchase of goods on credit requires a clear statement of expected future payments and dates to avoid misunderstandings. Credit terms for a purchase include the amounts and timing of payments from a buyer to a seller. Credit terms usually reflect an industry’s practices. To illustrate, when sellers require payment within 10 days after the end of the month of the invoice date, the invoice will show credit terms as “ny10 EOM,” which stands for net 10 days after end of month (EOM). When sellers require payment within 30 days after the invoice date, the in- voice shows credit terms of “ny30,” which stands for net 30 days. Exhibit 4.6 portrays credit terms. The amount of time allowed before full payment is due is called the credit period. Sellers can grant a cash discount to encourage buyers to pay earlier. A buyer views a cash discount as a purchase discount. A seller views a cash discount as a sales discount. Any cash discounts are described in the credit terms on the invoice. For example, credit terms of “2y10, ny60” mean that full payment is due within a 60-day credit period, but the buyer can deduct 2% of the invoice amount if payment is made within 10 days of the invoice date. This reduced payment applies only for the discount period.

Point: Since both the buyer and seller know the invoice date, this date is used in setting the discount and credit periods.

EXHIBIT 4.6 Credit Terms

Amount Due

Due: Invoice priceDue: Invoice price minus discount*

*Discount refers to a purchase discount for a buyer and a sales discount for a seller.

Discount* period

Credit period

Date of invoice

Credit Terms

Time

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166 Chapter 4 Accounting for Merchandising Operations

Entrepreneur You purchase a batch of products on terms of 3y10, ny90, but your company has limited cash and you must borrow funds at an 11% annual rate if you are to pay within the discount period. Is it to your advantage to take the purchase discount? Explain. ■ [Answer—p. 188]

Decision Maker

To illustrate how a buyer accounts for a purchase discount, assume that Z-Mart’s $1,200 pur- chase of merchandise is on credit with terms of 2y10, ny30. Its entry is

If Z-Mart pays the amount due on (or before) November 12, the entry is

(a) Nov. 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Purchased merchandise on credit, invoice dated Nov. 2, terms 2y10, ny30.

Assets 5 Liabilities 1 Equity 11,200 11,200

(b) Nov. 12 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 24

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,176

Paid for the $1,200 purchase of Nov. 2 less the discount of $24 (2% 3 $1,200).

Assets 5 Liabilities 1 Equity 224 21,200 21,176

A buyer’s failure to pay within a discount period can be expensive. To illustrate, if Z-Mart does not pay within the 10-day 2% discount period, it can delay payment by 20 more days. This de- lay costs Z-Mart $24, computed as 2% 3 $1,200. Most buyers take advantage of a purchase discount because of the usually high interest rate implied from not taking it.1 Also, good cash management means that no invoice is paid until the last day of the discount or credit period.

The Merchandise Inventory account after these entries reflects the net cost of merchandise purchased, and the Accounts Payable account shows a zero balance. Both ledger accounts, in T-account form, follow:

Point: These entries illustrate what is called the gross method of accounting for purchases with discount terms.

Nov. 2 1,200

Balance 1,176

Nov. 12 24

Merchandise Inventory

Nov. 12 1,200 Nov. 2 1,200

Balance 0

Accounts Payable

1 The implied annual interest rate formula is:

[365 days 4 (Credit period 2 Discount period)] 3 Cash discount rate.

For terms of 2y10, ny30, missing the 2% discount for an additional 20 days is equal to an annual interest rate of 36.5%, computed as [365 daysy(30 days 2 10 days)] 3 2% discount rate. Favorable purchase discounts are those with implied annual interest rates that exceed the purchaser’s annual rate for borrowing money.

Purchase Returns and Allowances Purchase returns refer to merchandise a buyer acquires but then returns to the seller. A purchase allowance is a reduction in the cost of defective or unacceptable merchandise that a buyer acquires. Buyers often keep defective but still marketable merchandise if the seller grants an acceptable allowance. When a buyer returns or takes an allowance on merchandise, the buyer issues a debit memorandum to inform the seller of a debit made to the seller’s account payable in the buyer’s records.

Point: The sender (maker) of a debit memorandum will debit the account pay- able of the memo’s receiver. The memo’s receiver will credit the sender’s account receivable.

Point: Appendix 4A repeats journal entries a through f using a periodic inventory system.

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Chapter 4 Accounting for Merchandising Operations 167

Purchase Allowances To illustrate purchase allowances, assume that on November 15, Z-Mart (buyer) issues a $300 debit memorandum for an allowance from Trex for defective mer- chandise. Z-Mart’s November 15 entry to update its Merchandise Inventory account to reflect the purchase allowance is

(c) Nov. 15 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 300

Allowance for defective merchandise.

Assets 5 Liabilities 1 Equity 2300 2300

Transportation Costs and Ownership Transfer The buyer and seller must agree on who is responsible for paying any freight costs and who bears the risk of loss during transit for merchandising transactions. This is essentially the same as asking at what point ownership transfers from the seller to the buyer. The point of transfer is called the FOB ( free on board ) point, which determines who pays transportation costs (and often other incidental costs of transit such as insurance). Exhibit 4.7 identifies two alternative points of transfer. (1) FOB shipping point, also called FOB factory, means the buyer accepts ownership when the goods depart the seller’s place of business. The buyer is then responsible for paying shipping costs and bearing the risk of damage or loss when goods are in transit. The goods are part of the buyer’s inventory when they are in transit since ownership has transferred to the buyer. 1-800-FLOWERS.COM, a floral and gift

June 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Purchased merchandise, invoice dated June 1, terms 2/10, n/60.

June 3 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 100

Returned merchandise to seller.

June 11 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 18

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 882

Paid for $900 merchandise ($1,000 2 $100) less $18 discount (2% 3 $900).

Example: Assume Z-Mart pays $980 cash for $1,000 of merchandise pur- chased within its 2% discount period. Later, it returns $100 of the original $1,000 merchandise. The return entry is Cash . . . . . . . . . . . . . . . . . . . . . . 98

Merchandise Inventory . . . . 98

The buyer’s allowance for defective merchandise is usually offset against the buyer’s current account payable balance to the seller. When cash is refunded, the Cash account is debited in- stead of Accounts Payable.

Purchase Returns Returns are recorded at the net costs charged to buyers. To illustrate the accounting for returns, suppose Z-Mart purchases $1,000 of merchandise on June 1 with terms 2/10, n/60. Two days later, Z-Mart returns $100 of goods before paying the invoice. When Z-Mart later pays on June 11, it takes the 2% discount only on the $900 remaining bal- ance. When goods are returned, a buyer can take a purchase discount on only the remaining balance of the invoice. The resulting discount is $18 (2% 3 $900) and the cash payment is $882 ($900 2 $18). The following entries reflect this illustration.

Point: In the perpetual system, all purchases, purchase discounts, purchase returns, and cost of sales are recorded in the Merchandise Inventory account. This is different from the periodic system as explained in Appendix 4A.

Payables Manager As a new accounts payable manager, you are being trained by the outgoing man- ager. She explains that the system prepares checks for amounts net of favorable cash discounts, and the checks are dated the last day of the discount period. She also tells you that checks are not mailed until five days later, adding that “the company gets free use of cash for an extra five days, and our department looks better. When a supplier complains, we blame the computer system and the mailroom.” Do you continue this payment policy? ■ [Answer—p. 188]

Decision Ethics

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168 Chapter 4 Accounting for Merchandising Operations

merchandiser, and Bare Escentuals, a cosmetic manufacturer, both use FOB shipping point. (2)  FOB destination means ownership of goods transfers to the buyer when the goods arrive at the buyer’s place of business. The seller is responsible for paying shipping charges and bears the risk of damage or loss in transit. The seller does not record revenue from this sale until the  goods arrive at the destination because this transaction is not complete before that point. Kyocera, a manufacturer, uses FOB destination. Z-Mart’s $1,200 purchase on November 2 is on terms of FOB destination. This means Z-Mart is not responsible for paying transportation costs. When a buyer is responsible for paying trans- portation costs, the payment is made to a carrier or directly to the seller depending on the agree- ment. The cost principle requires that any necessary transportation costs of a buyer (often called transportation-in or freight-in) be included as part of the cost of purchased merchandise. To illustrate, Z-Mart’s entry to record a $75 freight charge from an independent carrier for mer- chandise purchased FOB shipping point is

Point: The party not responsible for shipping costs sometimes pays the car rier. In these cases, the party paying these costs either bills the party responsible or, more commonly, adjusts its account payable or account receivable with the other party. For example, a buyer paying a carrier when terms are FOB destination can decrease its account payable to the seller by the amount of shipping cost.

EXHIBIT 4.7 Ownership Transfer and Transportation Costs

Destination

Ownership Transfers

When Goods Passed to

FOB shipping point Carrier

Transportation Costs Paid by

Carrier Shipping point

Shipping Terms

Seller Buyer

FOB destination Buyer

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . # Cash . . . . . . . . . . . . . . . #

(d ) Nov. 24 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Paid freight costs on purchased merchandise.

Assets 5 Liabilities 1 Equity 175 275

The accounting system described here does not provide separate records (accounts) for total purchases, total purchase discounts, total purchase returns and allowances, and total transportation-in. Yet nearly all companies collect this information in supplementary records because managers need this information to evaluate and control each of these cost elements. Supplementary records, also called supplemental records, refer to information outside the usual general ledger accounts.

Point: Some companies have separate accounts for purchase discounts, returns and allowances, and transportation-in. These accounts are then transferred to Merchandise Inventory at period-end. This is a hybrid system of perpetual and periodic. That is, Merchandise Inventory is updated on a perpetual basis but only for purchases and cost of goods sold.

EXHIBIT 4.8 Itemized Costs of Merchandise Purchases

Z-MART

Itemized Costs of Merchandise Purchases

For Year Ended December 31, 2013

Invoice cost of merchandise purchases . . . . . . . . . . . . $ 235,800

Less: Purchase discounts received . . . . . . . . . . . . . . . . (4,200)

Purchase returns and allowances . . . . . . . . . . . . (1,500)

Add: Costs of transportation-in . . . . . . . . . . . . . . . . . 2,300

Total cost of merchandise purchases . . . . . . . . . $232,400

Point: If we place an order online and receive free shipping, we have terms FOB destination.

A seller records the costs of shipping goods to customers in a Delivery Expense account when the seller is responsible for these costs. Delivery Expense, also called transportation-out or freight-out, is reported as a selling expense in the seller’s income statement. In summary, purchases are recorded as debits to Merchandise Inventory. Any later purchase dis- counts, returns, and allowances are credited (decreases) to Merchandise Inventory. Transportation- in is debited (added) to Merchandise Inventory. Z-Mart’s itemized costs of merchandise purchases for year 2013 are in Exhibit 4.8.

Point: With tracking numbers it is possible to know the exact time shipped goods arrive at their destination.

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Chapter 4 Accounting for Merchandising Operations 169

Sales of Merchandise Each sales transaction for a seller of merchandise involves two parts.

4. How long are the credit and discount periods when credit terms are 2y10, ny60? 5. Identify which items are subtracted from the list amount and not recorded when computing

purchase price: (a) freight-in; (b) trade discount; (c) purchase discount; (d ) purchase return. 6. What does FOB mean? What does FOB destination mean?

Quick Check Answers — p. 189

Merchandising companies also must account for sales, sales discounts, sales returns and allow- ances, and cost of goods sold. A merchandising company such as Z-Mart reflects these items in its gross profit computation, as shown in Exhibit 4.9. This section explains how this informa tion is derived from transactions.

ACCOUNTING FOR MERCHANDISE SALES

1. Revenue received in the form of an asset from the customer. 2. Cost recognized for the merchandise sold to the customer.

Accounting for a sales transaction under the perpetual system requires recording information about both parts. This means that each sales transaction for merchandisers, whether for cash or on credit, requires two entries: one for revenue and one for cost. To illustrate, Z-Mart sold $2,400 of merchandise on credit on November 3. The revenue part of this transaction is recorded as

(e) Nov. 3 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Sold merchandise on credit.

Assets 5 Liabilities 1 Equity 12,400 12,400

P2 Analyze and record transactions for merchandise sales using a perpetual system.

This entry reflects an increase in Z-Mart’s assets in the form of accounts receivable. It also shows the increase in revenue (Sales). If the sale is for cash, the debit is to Cash instead of Accounts Receivable. The cost part of each sales transaction ensures that the Merchandise Inventory account under a perpetual inventory system reflects the updated cost of the merchandise available for sale. For example, the cost of the merchandise Z-Mart sold on November 3 is $1,600, and the entry to record the cost part of this sales transaction is

(e) Nov. 3 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 1,600

To record the cost of Nov. 3 sale.

Assets 5 Liabilities 1 Equity 21,600 21,600

EXHIBIT 4.9 Gross Profit Computation

Z-MART

Computation of Gross Profit

For Year Ended December 31, 2013

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000

Less: Sales discounts . . . . . . . . . . . . . . . . . . . . $4,300

Sales returns and allowances . . . . . . . . . 2,000 6,300

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314,700

Cost of goods sold . . . . . . . . . . . . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . $ 84,300

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170 Chapter 4 Accounting for Merchandising Operations

Sales Discounts Sales discounts on credit sales can benefit a seller by decreasing the delay in receiving cash and reducing future collection efforts. At the time of a credit sale, a seller does not know whether a customer will pay within the discount period and take advantage of a discount. This means the seller usually does not record a sales discount until a customer actually pays within the discount period. To illustrate, Z-Mart completes a credit sale for $1,000 on November 12 with terms of 2y10, ny60. The entry to record the revenue part of this sale is

This entry records the receivable and the revenue as if the customer will pay the full amount. The customer has two options, however. One option is to wait 60 days until January 11 and pay the full $1,000. In this case, Z-Mart records that payment as

The customer’s second option is to pay $980 within a 10-day period ending November 22. If the customer pays on (or before) November 22, Z-Mart records the payment as

Sales Discounts is a contra revenue account, meaning the Sales Discounts account is deducted from the Sales account when computing a company’s net sales (see Exhibit 4.9). Management monitors Sales Discounts to assess the effectiveness and cost of its discount policy.

Sales Returns and Allowances Sales returns refer to merchandise that customers return to the seller after a sale. Many compa- nies allow customers to return merchandise for a full refund. Sales allowances refer to reduc- tions in the selling price of merchandise sold to customers. This can occur with damaged or defective merchandise that a customer is willing to purchase with a decrease in selling price. Sales returns and allowances usually involve dissatisfied customers and the possibility of lost future sales, and managers monitor information about returns and allowances.

Sales Returns To illustrate, recall Z-Mart’s sale of merchandise on November 3 for $2,400 that had cost $1,600. Assume that the customer returns part of the merchandise on

Nov. 12 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold merchandise under terms of 2y10, ny60.

Assets 5 Liabilities 1 Equity 11,000 11,000

Jan. 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment for Nov. 12 sale.

Assets 5 Liabilities 1 Equity 11,000 21,000

Nov. 22 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 980

Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment for Nov. 12 sale less discount.

Assets 5 Liabilities 1 Equity 1980 220

21,000

Point: Published income statements rarely disclose sales discounts, returns and allowances.

Point: Radio-frequency identification (RFID) tags attach to objects for tracking purposes. Such tags help find items in a store, monitor shipments, and help check on production progress.

Suppliers and Demands Large merchandising companies often bombard suppliers with demands. These include discounts for bar coding and technology support systems, and fines for shipping errors. Mer- chandisers’ goals are to reduce inventories, shorten lead times, and eliminate errors. Many colleges now offer programs in supply chain management and logistics to train future employees that can help merchan- disers meet such goals. ■

Decision Insight

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Chapter 4 Accounting for Merchandising Operations 171

( f ) Nov. 6 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 800

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 800

Customer returns merchandise of Nov. 3 sale.

Assets 5 Liabilities 1 Equity 2800 2800

If the merchandise returned to Z-Mart is not defective and can be resold to another customer, Z-Mart returns these goods to its inventory. The entry to restore the cost of such goods to the Merchandise Inventory account is

Nov. 6 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . 600

Returned goods added to inventory.

Assets 5 Liabilities 1 Equity 1600 1600

Nov. 6 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 100

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 100

To record sales allowance on Nov. 3 sale.

Assets 5 Liabilities 1 Equity 2100 2100

Point: The sender (maker) of a credit memorandum will credit the account of the receiver. The receiver of a credit memorandum will debit the sender’s account.

This entry changes if the goods returned are defective. In this case the returned inventory is re- corded at its estimated value, not its cost. To illustrate, if the goods (costing $600) returned to Z-Mart are defective and estimated to be worth $150, the following entry is made: Dr. Merchan- dise Inventory for $150, Dr. Loss from Defective Merchandise for $450, and Cr. Cost of Goods Sold for $600.

Point: Some sellers charge buyers a re-stocking fee for returns.

Sales Allowances To illustrate sales allowances, assume that $800 of the merchandise Z-Mart sold on November 3 is defective but the buyer decides to keep it because Z-Mart of- fers a $100 price reduction. Z-Mart records this allowance as follows:

The seller usually prepares a credit memorandum to confirm a buyer’s return or allowance. A seller’s credit memorandum informs a buyer of the seller’s credit to the buyer’s Account Re- ceivable (on the seller’s books).

7. Why are sales discounts and sales returns and allowances recorded in contra revenue accounts instead of directly in the Sales account?

8. Under what conditions are two entries necessary to record a sales return? 9. When merchandise is sold on credit and the seller notifies the buyer of a price allowance,

does the seller create and send a credit memorandum or a debit memorandum?

Quick Check Answers — p. 189

November 6, and the returned items sell for $800 and cost $600. The revenue part of this transaction must reflect the decrease in sales from the customer’s return of merchandise as follows:

Reversing Returns. On May 3, 2011, Green Mountain Coffee Roasters beat analysts’ earnings estimates by $0.10 per share for the 13-week period ended March 26, 2011. The next day the stock price rose $11.91 per share to close at $75.98 per share, an 18.5% increase over the prior day’s closing price. In the weeks that followed, some analysts raised questions about the quality of Green Mountain’s earnings because of its ac- counting for sales returns. They allege that a large part of that earnings increase was due to an accounting adjustment that reversed much of a reserve that was set up for sales returns in prior periods. ■

Decision Insight

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172 Chapter 4 Accounting for Merchandising Operations

Dec. 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 250

To adjust for $250 shrinkage revealed by a physical count of inventory.

Assets 5 Liabilities 1 Equity 2250 2250

EXHIBIT 4.10 Merchandising Cost Flow in the Accounting Cycle

Beginning inventory

From supplier

Net purchases

Ending inventory

P er

io d

2 P

er io

d 1

To Balance Sheet

To Income Statement

To Balance Sheet

Beginning inventory

Net purchases

Ending inventory

Cost of goods sold

To Income Statement Cost of

goods sold

Merchandise available for sale

Merchandise available for sale

From supplier

Adjusting Entries for Merchandisers Each of the steps in the accounting cycle described in the prior chapter for a service company applies to a merchandiser. This section and the next two further explain three steps of the ac- counting cycle for a merchandiser — adjustments, statement preparation, and closing. Adjusting entries are generally the same for merchandising companies and service com- panies, including those for prepaid expenses (including depreciation), accrued expenses, unearned revenues, and accrued revenues. However, a merchandiser using a perpetual inventory system is usually required to make another adjustment to update the Merchandise Inventory account to reflect any loss of merchandise, including theft and deterioration. Shrinkage is the term used to refer to the loss of inventory and it is computed by comparing a physical count of inventory with recorded amounts. A physical count is usually performed at least once annually.

To illustrate, Z-Mart’s Merchandise Inventory account at the end of year 2013 has a balance of $21,250, but a physical count reveals that only $21,000 of inventory exists. The adjusting entry to record this $250 shrinkage is

Point: About two-thirds of shoplifting losses are thefts by employees.

P3 Prepare adjustments and close accounts for a merchandising company.

Exhibit 4.10 shows the flow of merchandising costs during a period and where these costs are reported at period-end. Specifically, beginning inventory plus the net cost of purchases is the merchandise available for sale. As inventory is sold, its cost is recorded in cost of goods sold on the income statement; what remains is ending inventory on the balance sheet. A period’s ending inventory is the next period’s beginning inventory.

COMPLETING THE ACCOUNTING CYCLE

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Chapter 4 Accounting for Merchandising Operations 173

Point: The Inventory account is not affected by the closing process under a perpetual system.

EXHIBIT 4.11 Closing Entries for a Merchandiser

Step 1: Close Credit Balances in Temporary Accounts to Income Summary.

Step 2: Close Debit Balances in Temporary Accounts to Income Summary.

Dec. 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 To close credit balances in temporary accounts.

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,100 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Sales Returns and Allowances . . . . . . . . . . . . . 2,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . 230,400 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . 3,700 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,800 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . 11,300 To close debit balances in temporary accounts.

Step 3: Close Income Summary to Retained Earnings.

The third closing entry is identical for a merchandising company and a service company. The $12,900 amount is net income reported on the income statement.

Step 4: Close Dividends Account to Retained Earnings.

The fourth closing entry is identical for a merchandising company and a service company. It closes the Dividends account and adjusts the Retained Earnings account to the amount shown on the balance sheet.

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 To close the Income Summary account.

Dec. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 To close the Dividends account.

Preparing Financial Statements The financial statements of a merchandiser, and their preparation, are similar to those for a service company described in Chapters 2 and 3. The income statement mainly differs by the inclusion of cost of goods sold and gross profit. Also, net sales is affected by discounts, returns, and allowances, and some additional expenses are possible such as delivery expense and loss from defective merchandise. The balance sheet mainly differs by the inclusion of merchandise inventory as part of current assets. The statement of retained earnings is un- changed. A work sheet can be used to help prepare these statements, and one is illustrated in Appendix 4B for Z-Mart.

Closing Entries for Merchandisers Closing entries are similar for service companies and merchandising companies using a per- petual system. The difference is that we must close some new temporary accounts that arise from merchandising activities. Z-Mart has several temporary accounts unique to merchandisers: Sales (of goods), Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. Their existence in the ledger means that the first two closing entries for a merchandiser are slightly different from the ones described in the prior chapter for a service company. These differences are set in red boldface in the closing entries of Exhibit 4.11.

Summary of Merchandising Entries Exhibit 4.12 summarizes the key adjusting and closing entries of a merchandiser (using a perpetual inventory system) that are different from those of a service company described in prior chapters (the Demonstration Problem 2 illustrates these merchandising entries).

Point: Staples’s costs of shipping merchandise to its stores is included in its costs of inventories as required by the cost principle.

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174 Chapter 4 Accounting for Merchandising Operations

EXHIBIT 4.12 Summary of Merchandising Entries

Merchandising Transactions Merchandising Entries Dr. Cr.

Purchasing merchandise for Merchandise Inventory . . . . . . . . . . . . . . . . # resale. Cash or Accounts Payable . . . . . . . . . . #

Paying freight costs on Merchandise Inventory . . . . . . . . . . . . . . . . # purchases; FOB shipping point. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . # Purchases Paying within discount period. Accounts Payable . . . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Recording purchase returns or Cash or Accounts Payable . . . . . . . . . . . . . . # allowances. Merchandise Inventory . . . . . . . . . . . . #

Selling merchandise. Cash or Accounts Receivable . . . . . . . . . . . # Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Cost of Goods Sold . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . #

Receiving payment within Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

discount period. Sales Discounts . . . . . . . . . . . . . . . . . . . . . . # Sales

Accounts Receivable . . . . . . . . . . . . . . #

Granting sales returns or Sales Returns and Allowances . . . . . . . . . . . # allowances. Cash or Accounts Receivable . . . . . . . #

Merchandise Inventory . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . #

Paying freight costs on sales; Delivery Expense . . . . . . . . . . . . . . . . . . . . # FOB destination. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . #

Merchandising Events Adjusting and Closing Entries

Adjusting due to shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . . . . # Adjusting (occurs when recorded amount Merchandise Inventory . . . . . . . . . . . . # larger than physical inventory).

Closing temporary accounts Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # with credit balances. Income Summary . . . . . . . . . . . . . . . . #

Closing temporary accounts Income Summary . . . . . . . . . . . . . . . . . . . . #

Closing with debit balances. Sales Returns and Allowances . . . . . . . # Sales Discounts . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . # Delivery Expense . . . . . . . . . . . . . . . . # “Other Expenses” . . . . . . . . . . . . . . . . #

Generally accepted accounting principles do not require companies to use any one presentation format for financial statements so we see many different formats in practice. This section de- scribes two common income statement formats: multiple-step and single-step. The classified balance sheet of a merchandiser is also explained.

FINANCIAL STATEMENT FORMATS

10. When a merchandiser uses a perpetual inventory system, why is it sometimes necessary to adjust the Merchandise Inventory balance with an adjusting entry?

11. What temporary accounts do you expect to find in a merchandising business but not in a service business?

12. Describe the closing entries normally made by a merchandising company.

Quick Check Answers — p. 189

P4 Define and prepare multiple-step and single- step income statements.

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Chapter 4 Accounting for Merchandising Operations 175

Point: Z-Mart did not have any non- operating activities; however, Exhibit 4.13 includes some for illustrative purposes.

EXHIBIT 4.13 Multiple-Step Income Statement

Z-MART

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 321,000

Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,300

Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 6,300

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314,700

Cost of goods sold*. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,300

Operating Expenses

Selling expenses

Depreciation expense—Store equipment . . . . . . . . . . . . . . . . 3,000

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,500

Rent expense—Selling space . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100

Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,300

Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,100

General and administrative expenses

Depreciation expense—Office equipment . . . . . . . . . . . . . . . 700

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,300

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Rent expense—Office space . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Total general and administrative expenses . . . . . . . . . . . . . . . . 29,300

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,400

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900

Other revenues and gains (expenses and losses)

Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Gain on sale of building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,500)

Total other revenue and gains (expenses and losses) . . . . . . . . . . 2,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

Gross profit computation

Nonoperating activities computation

Income from operations computation

Beginning inventory. . . . . . . . . . . . . . $ 19,000 Cost of goods purchased . . . . . . . . . . 232,400 Goods available for sale . . . . . . . . . . . 251,400 Less ending inventory . . . . . . . . . . . . 21,000 Cost of goods sold . . . . . . . . . . . . . . . $230,400

*Cost of goods sold consists of the following:

Multiple-Step Income Statement A multiple-step income statement format shows detailed computations of net sales and other costs and expenses, and reports subtotals for various classes of items. Exhibit 4.13 shows a multiple-step income statement for Z-Mart. The statement has three main parts: (1) gross profit, determined by net sales less cost of goods sold, (2) income from operations, determined by gross profit less operating expenses, and (3) net income, determined by income from operations adjusted for nonoperating items.

Operating expenses are classified into two sections. Selling expenses include the expenses of promoting sales by displaying and advertising merchandise, making sales, and delivering goods to customers. General and administrative expenses support a company’s overall operations and include expenses related to accounting, human resource management, and financial man- agement. Expenses are allocated between sections when they contribute to more than one. Z-Mart allocates rent expense of $9,000 from its store building between two sections: $8,100 to selling expense and $900 to general and administrative expense. Nonoperating activities consist of other expenses, revenues, losses, and gains that are unre- lated to a company’s operations. Other revenues and gains commonly include interest revenue,

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176 Chapter 4 Accounting for Merchandising Operations

Point: Many companies report interest expense and interest revenue in separate categories after operating income and before subtracting income tax expense. As one example, see Arctic Cat’s and KTM’s income statements in Appendix A.

Example: Sometimes interest revenue and interest expense are reported on the income statement as interest, net. To illustrate, if a company has $1,000 of in- terest expense and $600 of interest rev- enue, it might report $400 as interest, net.

dividend revenue, rent revenue, and gains from asset disposals. Other expenses and losses com- monly include interest expense, losses from asset disposals, and casualty losses. When a com- pany has no reportable nonoperating activities, its income from operations is simply labeled net income.

Single-Step Income Statement A single-step income statement is another widely used format and is shown in Exhibit 4.14 for Z-Mart. It lists cost of goods sold as another expense and shows only one subtotal for total expenses. Expenses are grouped into very few, if any, categories. Many companies use formats that combine features of both the single- and multiple-step statements. Provided that income statement items are shown sensibly, management can choose the format. (In later chapters, we describe some items, such as extraordinary gains and losses, that must be reported in certain locations on the income statement.) Similar presentation options are available for the statement of retained earnings and statement of cash flows.

EXHIBIT 4.15 Classified Balance Sheet (partial) of a Merchandiser

Z-MART

Balance Sheet (partial)

December 31, 2013

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,200

Accounts receivable . . . . . . . . . . . . . 11,200

Merchandise inventory . . . . . . . . 21,000

Office supplies . . . . . . . . . . . . . . . . . 550

Store supplies . . . . . . . . . . . . . . . . . . 250

Prepaid insurance . . . . . . . . . . . . . . . 300

Total current assets . . . . . . . . . . . . . $ 41,500

EXHIBIT 4.14 Single-Step Income Statement

Z-MART

Income Statement

For Year Ended December 31, 2013

Revenues

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $314,700

Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Gain on sale of building . . . . . . . . . . . . . . . . . . . 2,500

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . 318,200

Expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . $230,400

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . 42,100

General and administrative expenses . . . . . . . . 29,300

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 303,300

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

Classified Balance Sheet The merchandiser’s classified balance sheet reports merchandise inventory as a current asset, usually after accounts receivable according to an asset’s nearness to liquidity. Inventory is usually less liquid than accounts receivable because inventory must first be sold before cash can be received; but it is more liquid than supplies and prepaid expenses. Exhibit 4.15 shows the current asset section of Z-Mart’s classified balance sheet (other sections are as shown in Chapter 3).

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Chapter 4 Accounting for Merchandising Operations 177

Balance Sheet Presentation Chapters 2 and 3 explained how both U.S. GAAP and IFRS re- quire current items to be separated from noncurrent items on the balance sheet (yielding a classified bal- ance sheet). As discussed, U.S. GAAP balance sheets report current items first. Assets are listed from most liquid to least liquid, whereas liabilities are listed from nearest to maturity to furthest from maturity. IFRS balance sheets normally present noncurrent items first (and equity before liabilities), but this is not a requirement. Piaggio provides an example of IFRS reporting for the balance sheet in Appendix A.

This section discusses similarities and differences between U.S. GAAP and IFRS in accounting and reporting for merchandise purchases and sales, and for the income statement.

Accounting for Merchandise Purchases and Sales Both U.S. GAAP and IFRS include broad and similar guidance for the accounting of merchandise purchases and sales. Specifically, all of the transactions presented and illustrated in this chapter are accounted for identically under the two systems. The closing process for merchandisers also is identical for U.S. GAAP and IFRS. In the next chapter we describe how inventory valuation can, in some cases, be different for the two systems.

Income Statement Presentation We explained that net income, profit, and earnings refer to the same (bottom line) item. However, IFRS tends to use the term profit more than any other term, whereas U.S. statements tend to use net income more than any other term. Both U.S. GAAP and IFRS income statements begin with the net sales or net revenues (top line) item. For merchandisers and manufacturers, this is followed by cost of goods sold. The presentation is similar for the remaining items with the following differences.

● U.S. GAAP offers little guidance about the presentation or order of expenses. IFRS requires separate disclosures for financing costs (interest expense), income tax expense, and some other special items.

● Both systems require separate disclosure of items when their size, nature, or frequency are important. ● IFRS permits expenses to be presented by their function or their nature. U.S. GAAP provides no direc-

tion but the SEC requires presentation by function. ● Neither U.S. GAAP nor IFRS define operating income, which results in latitude in reporting. ● IFRS permits alternative income measures on the income statement; U.S. GAAP does not.

Volkswagen Group provides the following example of income statement reporting. We see the separate disclosure of finance costs, taxes, and other items. We also see the unusual practice of using the minus symbol in an income statement.

GLOBAL VIEW

VOLKSWAGEN GROUP

Income Statement (in Euros million)

For Year Ended December 31, 2011

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,337

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2131,371

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,966

Distribution expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214,582

Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,384

Other operating income (net of other expenses) . . . . . . . . . . . 2,271

Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,271

Finance costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,047

Other financial results (including equity investments). . . . . . . . . 9,702

Profit before tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,926

Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,127

Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,799

Merchandising Shenanigans Accurate invoices are important to both sellers and buyers. Merchandis- ers rely on invoices to make certain they receive all monies for products provided—no more, no less. To achieve this, controls are set up. Still, failures arise. A survey reports that 9% of employees in sales and marketing witnessed false or misleading invoices sent to customers. Another 14% observed employees violating contract terms with customers (KPMG 2009). ■

Decision Insight

VOLKSWAGEN

PIAGGIO

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178 Chapter 4 Accounting for Merchandising Operations

Acid-Test and Gross Margin RatiosDecision Analysis

Acid-Test Ratio For many merchandisers, inventory makes up a large portion of current assets. Inventory must be sold and any resulting accounts receivable must be collected before cash is available. Chapter 3 explained that the current ratio, defined as current assets divided by current liabilities, is useful in assessing a company’s ability to pay current liabilities. Because it is sometimes unreasonable to assume that inventories are a source of payment for current liabilities, we look to other measures. One measure of a merchandiser’s ability to pay its current liabilities (referred to as its liquidity) is the acid- test ratio. It differs from the current ratio by excluding less liquid current assets such as inventory and prepaid expenses that take longer to be converted to cash. The acid-test ratio, also called quick ratio, is defined as quick assets (cash, short-term investments, and current receivables) divided by current liabilities — see Exhibit 4.16.

A1 Compute the acid-test ratio and explain its use to assess liquidity.

EXHIBIT 4.16 Acid-Test (Quick) Ratio Acid-test ratio 5

Cash and cash equivalents 1 Short-term investments 1 Current receivables

Current liabilities

Exhibit 4.17 shows both the acid-test and current ratios of retailer JCPenney for fiscal years 2008 through 2012—also see margin graph. JCPenney’s acid-test ratio reveals a general increase from 2008 through 2011 that exceeds the industry average, and then a marked decline in 2012. Further, JCPenney’s current ratio shows a marked decline in 2012 to 1.84, which suggests that its short-term obligations are less confidently covered with short-term assets compared with prior years.

20102011 2009 2008

0.0 201020112012 2009 2008

0.5

1.0

1.5

2.0

2.5

Acid-Test Ratio Current RatioJCPenney:

EXHIBIT 4.17 JCPenney’s Acid-Test and Current Ratios

($ millions) 2012 2011 2010 2009 2008

Total quick assets . . . . . . . . . . . . . $1,920 $2,956 $3,406 $2,704 $2,845

Total current assets . . . . . . . . . . . 5,081 $6,370 $6,652 $6,220 $6,751

Total current liabilities . . . . . . . . . 2,756 $2,647 $3,249 $2,794 $3,338

Acid-test ratio . . . . . . . . . . . . . . 0.70 1.12 1.05 0.97 0.85

Current ratio . . . . . . . . . . . . . . . 1.84 2.41 2.05 2.23 2.02

Industry acid-test ratio . . . . . . . . . 0.54 0.61 0.59 0.63 0.62

Industry current ratio . . . . . . . . . . 2.01 2.27 2.15 2.31 2.39

A2 Compute the gross margin ratio and explain its use to assess profitability.

Gross Margin Ratio The cost of goods sold makes up much of a merchandiser’s expenses. Without sufficient gross profit, a merchandiser will likely fail. Users often compute the gross margin ratio to help understand this relation. It differs from the profit margin ratio in that it excludes all costs except cost of goods sold. The gross margin ratio (also called gross profit ratio) is defined as gross margin (net sales minus cost of goods sold) divided by net sales — see Exhibit 4.18.

EXHIBIT 4.18 Gross Margin Ratio Gross margin ratio 5

Net sales 2 Cost of goods sold

Net sales

An acid-test ratio less than 1.0 means that current liabilities exceed quick assets. A rule of thumb is that the acid-test ratio should have a value near, or higher than, 1.0 to conclude that a company is unlikely to face near-term liquidity problems. A value much less than 1.0 raises liquidity concerns unless a company can generate enough cash from inventory sales or if much of its liabilities are not due until late in the next period. Similarly, a value slightly larger than 1.0 can hide a liquidity problem if payables are due shortly and receivables are not collected until late in the next period. Analysis of JCPenney shows some need for concern regarding its liquidity as its acid-test ratio is less than one. However, retailers such as JCPenney pay many current liabilities from inventory sales and in all years, JCPenney’s acid-test ratios exceed the industry norm (and its inventory is fairly liquid).

Point: Successful use of a just-in-time inventory system can narrow the gap between the acid-test ratio and the current ratio.

Supplier A retailer requests to purchase supplies on credit from your company. You have no prior experi- ence with this retailer. The retailer’s current ratio is 2.1, its acid-test ratio is 0.5, and inventory makes up most of its current assets. Do you extend credit? ■ [Answer—p. 188]

Decision Maker

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Exhibit 4.19 shows the gross margin ratio of JCPenney for fiscal years 2008 through 2012. For JCPenney, each $1 of sales in 2012 yielded about 36.0¢ in gross margin to cover all other expenses and still produce a net income. This 36.0¢ margin is down from 38.6¢ in 2008. This decrease is not a favorable develop- ment. Success for merchandisers such as JCPenney depends on adequate gross margin. For example, the 2.60¢ decrease in the gross margin ratio, computed as 36.0¢ 2 38.6¢, means that JCPenney has $448.76 million less in gross margin! (This is computed as net sales of $17,260 million multiplied by the 2.6% decrease in gross margin.) Management’s discussion in its annual report attributes this decline to “softer than expected selling environment and the resulting increased promotional activity and the costs associ- ated with implementing our new pricing strategy.”

EXHIBIT 4.19 JCPenney’s Gross Margin Ratio

($ millions) 2012 2011 2010 2009 2008

Gross margin . . . . . . . . . . . . . . . . $ 6,218 $ 6,960 $ 6,910 $ 6,915 $ 7,671

Net sales . . . . . . . . . . . . . . . . . . . $17,260 $17,759 $17,556 $18,486 $19,860

Gross margin ratio . . . . . . . . . 36.0% 39.2% 39.4% 37.4% 38.6%

Use the following adjusted trial balance and additional information to complete the requirements.

DEMONSTRATION PROBLEM 1

Point: The power of a ratio is often its ability to identify areas for more detailed analysis.

KC ANTIQUES

Adjusted Trial Balance

December 31, 2013

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Store supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,600

Accumulated depreciation — Equipment . . . . . . . . . . . $ 16,600

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Sales returns and allowances . . . . . . . . . . . . . . . . . . . . 6,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900

Depreciation expense — Store equipment . . . . . . . . . 4,100

Depreciation expense — Office equipment . . . . . . . . . 1,600

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . 34,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

Rent expense (70% is store, 30% is office) . . . . . . . . . 24,000

Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . 5,750

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . 31,400

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $449,850 $449,850

Financial Officer Your company has a 36% gross margin ratio and a 17% net profit margin ratio. Industry averages are 44% for gross margin and 16% for net profit margin. Do these comparative results concern you? ■ [Answer—p. 189]

Decision Maker

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180 Chapter 4 Accounting for Merchandising Operations

KC Antiques’ supplementary records for 2013 reveal the following itemized costs for merchandising activities:

Invoice cost of merchandise purchases . . . . . . . . $150,000 Purchase discounts received . . . . . . . . . . . . . . . . . 2,500 Purchase returns and allowances . . . . . . . . . . . . . 2,700 Cost of transportation-in . . . . . . . . . . . . . . . . . . . 5,000

Required

1. Use the supplementary records to compute the total cost of merchandise purchases for 2013. 2. Prepare a 2013 multiple-step income statement. (Inventory at December 31, 2012, is $70,100.) 3. Prepare a single-step income statement for 2013. 4. Prepare closing entries for KC Antiques at December 31, 2013. 5. Compute the acid-test ratio and the gross margin ratio. Explain the meaning of each ratio and interpret

them for KC Antiques.

PLANNING THE SOLUTION ● Compute the total cost of merchandise purchases for 2013. ● To prepare the multiple-step statement, first compute net sales. Then, to compute cost of goods sold,

add the net cost of merchandise purchases for the year to beginning inventory and subtract the cost of ending inventory. Subtract cost of goods sold from net sales to get gross profit. Then classify expenses as selling expenses or general and administrative expenses.

● To prepare the single-step income statement, begin with net sales. Then list and subtract the expenses. ● The first closing entry debits all temporary accounts with credit balances and opens the Income Sum-

mary account. The second closing entry credits all temporary accounts with debit balances. The third entry closes the Income Summary account to the retained earnings account, and the fourth entry closes the dividends account to the retained earnings account.

● Identify the quick assets on the adjusted trial balance. Compute the acid-test ratio by dividing quick assets by current liabilities. Compute the gross margin ratio by dividing gross profit by net sales.

SOLUTION TO DEMONSTRATION PROBLEM 1 1.

Invoice cost of merchandise purchases . . . . . . . . $150,000 Less: Purchases discounts received . . . . . . . . . . . . 2,500 Purchase returns and allowances . . . . . . . . . 2,700 Add: Cost of transportation-in . . . . . . . . . . . . . . . 5,000 Total cost of merchandise purchases . . . . . . . . . . $149,800

2. Multiple-step income statement

KC ANTIQUES

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,250 Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 Sales returns and allowances . . . . . . . . . . . . . . . . . . . 6,000 11,000 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,250 Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,350 Expenses Selling expenses Depreciation expense — Store equipment . . . . . . . . . 4,100 Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Rent expense — Selling space . . . . . . . . . . . . . . . . . . . . 16,800 Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . 5,750 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,400 Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 88,050

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Chapter 4 Accounting for Merchandising Operations 181

4.

Dec. 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250 To close credit balances in temporary accounts. Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312,750 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Sales Returns and Allowances . . . . . . . . . . . . . . . . . 6,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . 159,900 Depreciation Expense—Store Equipment . . . . . . . 4,100 Depreciation Expense—Office Equipment . . . . . . 1,600 Sales Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . 30,000 Office Salaries Expense . . . . . . . . . . . . . . . . . . . . . . 34,000 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Store Supplies Expense . . . . . . . . . . . . . . . . . . . . . . 5,750 Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . 31,400 To close debit balances in temporary accounts. Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500 To close the Income Summary account. Dec. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 To close the Dividends account.

5. Acid-test ratio 5 (Cash and equivalents 1 Short-term investments 1 Current receivables)y Current liabilities

5 (Cash 1 Accounts receivabley(Accounts payable 1 Salaries payable) 5 ($7,000 1 $13,000)y($9,000 1 $2,000) 5 $20,000y$11,000 5 1.82

Gross margin ratio 5 Gross profityNet sales 5 $172,350y$332,250 5 0.52 (or 52%)

General and administrative expenses Depreciation expense — Office equipment . . . . . . . . . 1,600 Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 Rent expense — Office space . . . . . . . . . . . . . . . . . . . . 7,200 Total general and administrative expenses . . . . . . . . . . 53,800 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 141,850 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,500

[continued from previous page]

* Cost of goods sold can also be directly computed (applying concepts from Exhibit 4.4):

Merchandise inventory, December 31, 2012 . . . . . . . . . . . . . . $ 70,100

Total cost of merchandise purchases (from part 1) . . . . . . . . . . 149,800

Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219,900

Merchandise inventory, December 31, 2013 . . . . . . . . . . . . . . . 60,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,900

3. Single-step income statement

KC ANTIQUES

Income Statement

For Year Ended December 31, 2013

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $332,250 Expenses Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . $159,900 Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . 88,050 General and administrative expenses . . . . . . . . 53,800 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 301,750 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,500

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182 Chapter 4 Accounting for Merchandising Operations

DEMONSTRATION PROBLEM 2 Prepare journal entries to record the following merchandising transactions for both the seller (BMX) and buyer (Sanuk).

May 4 BMX sold $1,500 of merchandise on account to Sanuk, terms FOB shipping point, ny45, in- voice dated May 4. The cost of the merchandise was $900.

May 6 Sanuk paid transportation charges of $30 on the May 4 purchase from BMX. May 8 BMX sold $1,000 of merchandise on account to Sanuk, terms FOB destination, ny30, invoice

dated May 8. The cost of the merchandise was $700. May 10 BMX paid transportation costs of $50 for delivery of merchandise sold to Sanuk on May 8. May 16 BMX issued Sanuk a $200 credit memorandum for merchandise returned. The merchandise was

purchased by Sanuk on account on May 8. The cost of the merchandise returned was $140. May 18 BMX received payment from Sanuk for purchase of May 8. May 21 BMX sold $2,400 of merchandise on account to Sanuk, terms FOB shipping point, 2y10,

nyEOM. BMX prepaid transportation costs of $100, which were added to the invoice. The cost of the merchandise was $1,440.

May 31 BMX received payment from Sanuk for purchase of May 21, less discount (2% 3 $2,400).

SOLUTION TO DEMONSTRATION PROBLEM 2

BMX (Seller) Sanuk (Buyer)

May 4 Accounts Receivable—Sanuk . . . . . . . 1,500 Merchandise Inventory . . . . . . . . . . . 1,500

Sales . . . . . . . . . . . . . . . . . . . . . . 1,500 Accounts Payable—BMX . . . . . . 1,500

Cost of Goods Sold . . . . . . . . . . . . . . 900

Merchandise Inventory . . . . . . . . 900

6 No entry. Merchandise Inventory . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . 30

8 Accounts Receivable—Sanuk . . . . . . . 1,000 Merchandise Inventory . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . 1,000 Accounts Payable—BMX . . . . . . . 1,000

Cost of Goods Sold . . . . . . . . . . . . . . 700

Merchandise Inventory . . . . . . . . 700

10 Delivery Expense . . . . . . . . . . . . . . . . 50 No entry.

Cash . . . . . . . . . . . . . . . . . . . . . . 50

16 Sales Returns & Allowances . . . . . . . . 200 Accounts Payable—BMX . . . . . . . . . . 200

Accounts Receivable—Sanuk . . . . 200 Merchandise Inventory . . . . . . . . . 200

Merchandise Inventory . . . . . . . . . . . . 140

Cost of Goods Sold . . . . . . . . . . 140

18 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Accounts Payable—BMX . . . . . . . . . . 800

Accounts Receivable—Sanuk . . . . . 800 Cash . . . . . . . . . . . . . . . . . . . . . . . 800

21 Accounts Receivable—Sanuk . . . . . . . 2,400 Merchandise Inventory . . . . . . . . . . . 2,500

Sales . . . . . . . . . . . . . . . . . . . . . . 2,400 Accounts Payable—BMX . . . . . . 2,500

Accounts Receivable—Sanuk . . . . . . . 100

Cash . . . . . . . . . . . . . . . . . . . . . . 100

Cost of Goods Sold . . . . . . . . . . . . . . 1,440

Merchandise Inventory . . . . . . . . 1,440

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 2,452 Accounts Payable—BMX . . . . . . . . . . 2,500

Sales Discounts . . . . . . . . . . . . . . . . . 48 Merchandise Inventory . . . . . . . 48

Accounts Receivable—Sanuk . . . . . 2,500 Cash . . . . . . . . . . . . . . . . . . . . . . 2,452

KC Antiques has a healthy acid-test ratio of 1.82. This means it has more than $1.80 in liquid assets to satisfy each $1.00 in current liabilities. The gross margin of 0.52 shows that KC Antiques spends 48¢ ($1.00 2 $0.52) of every dollar of net sales on the costs of acquiring the merchandise it sells. This leaves 52¢ of every dollar of net sales to cover other expenses incurred in the business and to provide a net profit.

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Chapter 4 Accounting for Merchandising Operations 183

APPENDIX

Periodic Inventory System 4A

P5 Record and compare merchandising transactions using both periodic and perpetual inventory systems.

(b) Periodic Perpetual

Accounts Payable . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . 1,200

Purchase Discounts . . . . 24 Merchandise Inventory . . . . . 24

Cash . . . . . . . . . . . . . . . . 1,176 Cash . . . . . . . . . . . . . . . . . . . . 1,176

(a) Periodic Perpetual

Purchases . . . . . . . . . . . . . . . 1,200 Merchandise Inventory . . . . . . . . . 1,200

Accounts Payable . . . . . 1,200 Accounts Payable . . . . . . . . . . 1,200

(c) Periodic Perpetual

Accounts Payable . . . . . . . . . 300 Accounts Payable . . . . . . . . . . . . . . 300

Purchase Returns and Allowances . . . . . . . 300 Merchandise Inventory . . . . . 300

Purchase Discounts The periodic system uses a temporary Purchase Discounts account that accumu- lates discounts taken on purchase transactions during the period. If payment in (a) is delayed until after the discount period expires, the entry is to debit Accounts Payable and credit Cash for $1,200 each. How- ever, if Z-Mart pays the supplier for the previous purchase in (a) within the discount period, the required payment is $1,176 ($1,200 3 98%) and is recorded as

Purchase Returns and Allowances Z-Mart returned merchandise purchased on November 2 because of defects. In the periodic system, the temporary Purchase Returns and Allowances account accumulates the cost of all returns and allowances during a period. The recorded cost (including discounts) of the defective merchandise is $300, and Z-Mart records the November 15 return with this entry:

Transportation-In Z-Mart paid a $75 freight charge to transport merchandise to its store. In the periodic system, this cost is charged to a temporary Transportation-In account.

A periodic inventory system requires updating the inventory account only at the end of a period to re- flect the quantity and cost of both the goods available and the goods sold. Thus, during the period, the Merchandise Inventory balance remains unchanged. It reflects the beginning inventory balance until it is updated at the end of the period. During the period the cost of merchandise is recorded in a temporary Purchases account. When a company sells merchandise, it records revenue but not the cost of the goods sold. At the end of the period when a company prepares financial statements, it takes a physical count of inventory by counting the quantities and costs of merchandise available. The cost of goods sold is then computed by subtracting the ending inventory amount from the cost of merchandise available for sale.

Recording Merchandise Transactions Under a periodic system, purchases, purchase returns and allowances, purchase discounts, and transportation-in transactions are recorded in separate temporary accounts. At period-end, each of these temporary accounts is closed and the Merchandise Inventory ac- count is updated. To illustrate, journal entries under the periodic inventory system are shown for the most common transactions (codes a through f link these transactions to those in the chapter, and we drop expla- nations for simplicity). For comparison, perpetual system journal entries are shown to the right of each periodic entry, where differences are in green font.

Purchases The periodic system uses a temporary Purchases account that accumulates the cost of all purchase transactions during each period. Z-Mart’s November 2 entry to record the purchase of merchan- dise for $1,200 on credit with terms of 2y10, ny30 is

Point: Purchase Discounts and Pur- chase Returns and Allowances are both classified as contra-purchases accounts and have normal credit balances.

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184 Chapter 4 Accounting for Merchandising Operations

Sales Under the periodic system, the cost of goods sold is not recorded at the time of each sale. (We later show how to compute total cost of goods sold at the end of a period.) Z-Mart’s November 3 entry to record sales of $2,400 in merchandise on credit (when its cost is $1,600) is:

(d ) Periodic Perpetual

Transportation-In . . . . . . . . . 75 Merchandise Inventory . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . 75

( f ) Periodic Perpetual

Sales Returns and Sales Returns and Allowances . . . . . . . . . . . . . . 800 Allowances . . . . . . . . . . . . . . . . . . 800

Accounts Receivable . . . 800 Accounts Receivable . . . . . . 800

Merchandise Inventory . . . . . . . . . 600

Cost of Goods Sold . . . . . . . 600

Periodic Perpetual

Cash . . . . . . . . . . . . . . . . . . . 1,552 Cash . . . . . . . . . . . . . . . . . . . . . . . 1,552

Sales Discounts ($1,600 3 .03) 48 Sales Discounts ($1,600 3 .03) . . . 48

Accounts Receivable . . . 1,600 Accounts Receivable . . . . . . 1,600

(e) Periodic Perpetual

Accounts Receivable . . . . . . 2,400 Accounts Receivable . . . . . . . . . . 2,400

Sales . . . . . . . . . . . . . . . 2,400 Sales . . . . . . . . . . . . . . . . . . . 2,400

Cost of Goods Sold . . . . . . . . . . . 1,600

Merchandise Inventory . . . . 1,600

Sales Returns A customer returned part of the merchandise from the transaction in (e), where the returned items sell for $800 and cost $600. (Recall: The periodic system records only the revenue effect, not the cost effect, for sales transactions.) Z-Mart restores the merchandise to inventory and records the November 6 return as

Sales Discounts To illustrate sales discounts, assume that the remaining $1,600 of receivables (com- puted as $2,400 from e less $800 for f ) has credit terms of 3/10, n/90 and that customers all pay within the discount period. Z-Mart records this payment as

Adjusting and Closing Entries The periodic and perpetual inventory systems have slight differ- ences in adjusting and closing entries. The period-end Merchandise Inventory balance (unadjusted) is $19,000 under the periodic system and $21,250 under the perpetual system. Since the periodic system does not update the Merchandise Inventory balance during the period, the $19,000 amount is the begin- ning inventory. However, the $21,250 balance under the perpetual system is the recorded ending inventory before adjusting for any inventory shrinkage. A physical count of inventory taken at the end of the period reveals $21,000 of merchandise avail- able. The adjusting and closing entries for the two systems are shown in Exhibit 4A.1. The periodic system records the ending inventory of $21,000 in the Merchandise Inventory account (which includes

EXHIBIT 4A.1 Comparison of Adjusting and Closing Entries—Periodic and Perpetual

PERPETUAL

Adjusting Entry—Shrinkage

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . 250

Merchandise Inventory . . . . . . . . . . . . . . 250

PERIODIC

Adjusting Entry—Shrinkage

None

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Chapter 4 Accounting for Merchandising Operations 185

shrinkage) in the first closing entry and removes the $19,000 beginning inventory balance from the account in the second closing entry.2

By updating Merchandise Inventory and closing Purchases, Purchase Discounts, Purchase Returns and Allowances, and Transportation-In, the periodic system transfers the cost of goods sold amount to Income Summary. Review the periodic side of Exhibit 4A.1 and notice that the boldface items affect Income Summary as follows.

[continued from previous page]

PERIODIC

Closing Entries

(1) Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000

Merchandise Inventory . . . . . . . . . . . . . . . 21,000

Purchase Discounts . . . . . . . . . . . . . . . . . . 4,200

Purchase Returns and Allowances . . . . . 1,500

Income Summary . . . . . . . . . . . . . . . . . . 347,700

(2) Income Summary 334,800

Sales Discounts . . . . . . . . . . . . . . . . . . . 4,300

Sales Returns and Allowances . . . . . . . 2,000

Merchandise Inventory . . . . . . . . . . 19,000

Purchases . . . . . . . . . . . . . . . . . . . . . . 235,800

Transportation-In . . . . . . . . . . . . . . . 2,300

Depreciation Expense . . . . . . . . . . . . . . 3,700

Salaries Expense . . . . . . . . . . . . . . . . . . . 43,800

Insurance Expense . . . . . . . . . . . . . . . . 600

Rent Expense . . . . . . . . . . . . . . . . . . . . 9,000

Supplies Expense . . . . . . . . . . . . . . . . . . 3,000

Advertising Expense . . . . . . . . . . . . . . . 11,300

(3) Income Summary . . . . . . . . . . . . . . . . . . . . . 12,900

Retained Earnings . . . . . . . . . . . . . . . . . 12,900

(4) Retained Earnings . . . . . . . . . . . . . . . . . . . . . 4,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . 4,000

PERPETUAL

Closing Entries

(1) Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000

Income Summary . . . . . . . . . . . . . . . . . . 321,000

(2) Income Summary . . . . . . . . . . . . . . . . . . . . . 308,100

Sales Discounts . . . . . . . . . . . . . . . . . . . 4,300

Sales Returns and Allowances . . . . . . . 2,000

Cost of Goods Sold . . . . . . . . . . . . . 230,400

Depreciation Expense . . . . . . . . . . . . . . 3,700

Salaries Expense . . . . . . . . . . . . . . . . . . . 43,800

Insurance Expense . . . . . . . . . . . . . . . . 600

Rent Expense . . . . . . . . . . . . . . . . . . . . 9,000

Supplies Expense . . . . . . . . . . . . . . . . . . 3,000

Advertising Expense . . . . . . . . . . . . . . . 11,300

(3) Income Summary . . . . . . . . . . . . . . . . . . . . . 12,900

Retained Earnings . . . . . . . . . . . . . . . . . 12,900

(4) Retained Earnings . . . . . . . . . . . . . . . . . . . . . 4,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . 4,000

2 This approach is called the closing entry method. An alternative approach, referred to as the adjusting entry method, would not make any entries to Merchandise Inventory in the closing entries of Exhibit 4A.1, but instead would make two adjusting entries. Using Z-Mart data, the two adjusting entries would be: (1) Dr. Income Summary and Cr. Merchandise Inventory for $19,000 each, and (2) Dr. Merchandise Inventory and Cr. Income Summary for $21,000 each. The first entry removes the beginning balance of Merchandise Inventory, and the second entry records the actual ending balance.

This $230,400 effect on Income Summary is the cost of goods sold amount. The periodic system transfers cost of goods sold to the Income Summary account but without using a Cost of Goods Sold account. Also, the periodic system does not separately measure shrinkage. Instead, it computes cost of goods available

Credit to Income Summary in the first closing entry includes amounts from:

Merchandise inventory (ending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

Purchase discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200

Purchase returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Debit to Income Summary in the second closing entry includes amounts from:

Merchandise inventory (beginning) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (19,000)

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (235,800)

Transportation-in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,300)

Net effect on Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(230,400)

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186 Chapter 4 Accounting for Merchandising Operations

for sale, subtracts the cost of ending inventory, and defines the difference as cost of goods sold, which includes shrinkage.

Preparing Financial Statements The financial statements of a merchandiser using the peri- odic system are similar to those for a service company described in prior chapters. The income state- ment mainly differs by the inclusion of cost of goods sold and gross profit—of course, net sales is affected by discounts, returns, and allowances. The cost of goods sold section under the periodic sys- tem follows

The balance sheet mainly differs by the inclusion of merchandise inventory in current assets — see Exhibit 4.15. The statement of retained earnings is unchanged. A work sheet can be used to help pre- pare these statements. The only differences under the periodic system from the work sheet illustrated in Appendix 4B using the perpetual system are highlighted as follows in blue boldface font.

Calculation of Cost of Goods Sold

For Year Ended December 31, 2013

Beginning inventory . . . . . . . . . . . . . . . . . . $ 19,000

Cost of goods purchased . . . . . . . . . . . . . 232,400

Cost of goods available for sale . . . . . . . . 251,400

Less ending inventory . . . . . . . . . . . . . . . . 21,000

Cost of goods sold . . . . . . . . . . . . . . . . . . $230,400

No. Account Dr.

Unadjusted Trial

Balance

Adjusted Trial

Balance Income

Statement Balance SheetAdjustments Dr. Dr. Dr. Dr.Cr. Cr. Cr. Cr. Cr.

101 106 119 126 128 167 168 201 209 307 318

413 414 415 505 506 507 508 612 622 637 640 652 655

8,200 11,200 19,000

3,800 900

34,200

2,000 4,300

235,800

2,300

43,000

9,000

11,300 389,000

16,000

10,000

321,000

1,500 4,200

389,000

(a) 600

(b) 3,000

8,100

(b) 3,000 (a) 600

(c) 3,700

(d) 800

8,100

16,000 800

10,000

321,000

1,500 4,200

393,500

8,200 11,200 19,000

800 300

34,200

2,000 4,300

235,800

2,300

600 9,000 3,000

11,300 393,500

2,000 4,300

235,800

2,300

600 9,000 3,000

11,300 334,800

12,900 347,700

321,000

1,500 4,200

347,700

347,700

8,200 11,200 21,000

800 300

34,200

79,700

79,700

16,000 800

10,000

66,800 12,900 79,700

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17a 17b 17c 17d 18 19 20 21 22 23 24 25 26

19,000 21,000

Cash Accounts receivable Merchandise Inventory Supplies Prepaid insurance Equipment Accumulated depr.—Equip. Accounts payable Salaries payable Common stock Retained earnings

Sales Sales returns and allowances Sales discounts Purchases Purchases returns & allowance Purchases discounts Transportation-in Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Advertising expense Totals Net income Totals

7,400 7,400

4,000 32,600

4,000 32,600 32,600

4,000

3,700

(c) 3,700 (d) 800

3,700 43,800

3,700 43,800

319 Dividends

27

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Chapter 4 Accounting for Merchandising Operations 187

13. What account is used (for journalizing entries) in a perpetual inventory system but not in a periodic system?

14. Which of the following accounts are temporary accounts under a periodic system? (a) Merchandise Inventory; (b) Purchases; (c) Transportation-In.

15. How is cost of goods sold computed under a periodic inventory system? 16. Do reported amounts of ending inventory and net income differ if the adjusting entry method

of recording the change in inventory is used instead of the closing entry method?

Quick Check Answers — p. 189

APPENDIX

Work Sheet—Perpetual System 4B Exhibit 4B.1 shows the work sheet for preparing financial statements of a merchandiser. It differs slightly from the work sheet layout in Chapter 3 — the differences are in red boldface. Also, the adjustments in the work sheet reflect the following: (a) Expiration of $600 of prepaid insurance. (b) Use of $3,000 of sup- plies. (c) Depreciation of $3,700 for equipment. (d ) Accrual of $800 of unpaid salaries. (e) Inventory shrinkage of $250. Once the adjusted amounts are extended into the financial statement columns, the in- formation is used to develop financial statements.

No. Account Dr.

Unadjusted Trial

Balance

Adjusted Trial

Balance Income

Statement Balance SheetAdjustments Dr. Dr. Dr. Dr.Cr. Cr. Cr. Cr. Cr.

101 106 119 126 128 167 168 201 209 307 318

413 414 415 502 612 622 637 640 652 655

8,200 11,200 21,250 3,800 900

34,200

2,000 4,300

230,150

43,000

9,000

11,300 383,300

16,000

10,000

321,000

383,300

(a) 600

(b) 3,000

8,350

(b) 3,000 (a) 600

(c) 3,700

(d) 800

8,350

16,000 800

10,000

321,000

387,800

8,200 11,200 21,000

800 300

34,200

2,000 4,300

230,400 3,700 43,800

600 9,000 3,000

11,300 387,800

2,000 4,300

230,400 3,700

43,800 600

9,000 3,000

11,300 308,100 12,900

321,000

321,000

321,000

321,000

8,200 11,200 21,000

800 300

34,200

79,700

79,700

16,000 800

10,000

66,800 12,900 79,700

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27

Cash Accounts receivable Merchandise Inventory Supplies Prepaid insurance Equipment Accumulated depr.—Equip. Accounts payable Salaries payable Common stock Retained earnings

Sales Sales returns and allowances Sales discounts Cost of goods sold Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Advertising expense Totals Net income Totals

7,400 7,400

4,000 32,600 32,600 32,600

Dividends 4,000 4,000

3,700

(c) 3,700 (d) 800

(e) 250

(e) 250

319

28

EXHIBIT 4B.1 Work Sheet for Merchandiser (using a perpetual system)

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188 Chapter 4 Accounting for Merchandising Operations

C1 Describe merchandising activities and identify income components for a merchandising company. Merchandisers buy products and resell them. Examples of merchan disers include Walmart, Home Depot, The Limited, and Barnes & Noble. A mer- chandiser’s costs on the income statement include an amount for cost of goods sold. Gross profit, or gross margin, equals sales minus cost of goods sold.

C2 Identify and explain the inventory asset and cost flows of a merchandising company. The current asset section of a merchandising company’s balance sheet includes merchandise inventory, which refers to the products a merchandiser sells and are available for sale at the balance sheet date. Cost of merchandise purchases flows into Merchandise Inventory and from there to Cost of Goods Sold on the income statement. Any remaining inventory is reported as a current asset on the balance sheet.

A1 Compute the acid-test ratio and explain its use to assess liquidity. The acid-test ratio is computed as quick assets (cash, short-term investments, and current receivables) divided by current liabilities. It indicates a company’s ability to pay its current liabilities with its existing quick assets. An acid-test ratio equal to or greater than 1.0 is often adequate.

A2 Compute the gross margin ratio and explain its use to assess profitability. The gross margin ratio is computed as gross margin (net sales minus cost of goods sold) divided by net sales. It indicates a company’s profitability before considering other expenses.

P1 Analyze and record transactions for merchandise pur-chases using a perpetual system. For a perpetual inventory system, purchases of inventory (net of trade discounts) are added to the Merchandise Inventory account. Purchase discounts and purchase returns and allowances are subtracted from Merchandise Inventory, and transportation-in costs are added to Merchandise Inventory.

P2 Analyze and record transactions for merchandise sales using a perpetual system. A merchandiser records sales at

Summary list price less any trade discounts. The cost of items sold is trans- ferred from Merchandise Inventory to Cost of Goods Sold. Refunds or credits given to customers for unsatisfactory merchandise are recorded in Sales Returns and Allowances, a contra account to Sales. If merchandise is returned and restored to inventory, the cost of this merchandise is removed from Cost of Goods Sold and transferred back to Merchandise Inventory. When cash discounts from the sales price are offered and customers pay within the discount period, the seller records Sales Discounts, a contra account to Sales.

P3 Prepare adjustments and close accounts for a merchandis-ing company. With a perpetual system, it is often necessary to make an adjustment for inventory shrinkage. This is computed by comparing a physical count of inventory with the Merchandise Inventory balance. Shrinkage is normally charged to Cost of Goods Sold. Temporary accounts closed to Income Summary for a merchandiser include Sales, Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold.

P4 Define and prepare multiple-step and single-step income statements. Multiple-step income statements include greater detail for sales and expenses than do single-step income statements. They also show details of net sales and report expenses in categories reflecting different activities.

P5A Record and compare merchandising transactions using both periodic and perpetual inventory systems. A perpetual inventory system continuously tracks the cost of goods available for sale and the cost of goods sold. A periodic system accumulates the cost of goods purchased during the period and does not compute the amount of inventory or the cost of goods sold until the end of a period. Trans actions involving the sale and purchase of merchandise are recorded and analyzed under both the periodic and perpetual inventory systems. Adjusting and closing entries for both inventory systems are illustrated and explained.

Entrepreneur For terms of 3y10, ny90, missing the 3% discount for an additional 80 days equals an implied annual interest rate of 13.69%, computed as (365 days 4 80 days) 3 3%. Since you can borrow funds at 11% (assuming no other processing costs), it is bet- ter to borrow and pay within the discount period. You save 2.69% (13.69% 2 11%) in interest costs by paying early.

Payables Manager Your decision is whether to comply with prior policy or to create a new policy and not abuse discounts offered by suppliers. Your first step should be to meet with your superior to find out if the late payment policy is the actual policy and, if so, its rationale. If it is the policy to pay late, you must apply your own sense of ethics. One point of view is that the late payment policy is unethical. A deliberate plan to make late payments means the com- pany lies when it pretends to make payment within the discount pe- riod. Another view is that the late payment policy is acceptable. In some markets, attempts to take discounts through late payments are

accepted as a continued phase of “price negotiation.” Also, your company’s suppliers can respond by billing your company for the discounts not accepted because of late payments. However, this is a dubious viewpoint, especially since the prior manager proposes that you dishonestly explain late payments as computer or mail problems and since some suppliers have complained.

Supplier A current ratio of 2.1 suggests sufficient current assets to cover current liabilities. An acid-test ratio of 0.5 suggests, how- ever, that quick assets can cover only about one-half of current liabil- ities. This implies that the retailer depends on money from sales of inventory to pay current liabilities. If sales of inventory decline or profit margins decrease, the likelihood that this retailer will default on its payments increases. Your decision is probably not to extend credit. If you do extend credit, you are likely to closely monitor the retailer’s financial condition. (It is better to hold unsold inventory than uncollectible receivables.)

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 4 Accounting for Merchandising Operations 189

Acid-test ratio (p. 178)

Cash discount (p. 165)

Cost of goods sold (p. 162)

Credit memorandum (p. 171)

Credit period (p. 165)

Credit terms (p. 165)

Debit memorandum (p. 166)

Discount period (p. 165)

EOM (p. 165)

FOB (p. 167)

General and administrative expenses (p. 175)

Gross margin (p. 163)

Gross margin ratio (p. 178)

Gross profit (p. 162)

Inventory (p. 163)

List price (p. 164)

Merchandise (p. 162)

Merchandise inventory (p. 163)

Merchandiser (p. 162)

Multiple-step income statement (p. 175)

Periodic inventory system (p. 164)

Perpetual inventory system (p. 164)

Purchase discount (p. 165)

Retailer (p. 162)

Sales discount (p. 165)

Selling expenses (p. 175)

Shrinkage (p. 172)

Single-step income statement (p. 176)

Supplementary records (p. 168)

Trade discount (p. 164)

Wholesaler (p. 162)

Key Terms

Financial Officer Your company’s net profit margin is about equal to the industry average and suggests typical industry perfor- mance. However, gross margin reveals that your company is paying far more in cost of goods sold or receiving far less in sales price than competitors. Your attention must be directed to finding the problem

with cost of goods sold, sales, or both. One positive note is that your company’s expenses make up 19% of sales (36% 2 17%). This fa- vorably compares with competitors’ expenses that make up 28% of sales (44% 2 16%).

1. Cost of goods sold is the cost of merchandise purchased from a supplier that is sold to customers during a specific period.

2. Gross profit (or gross margin) is the difference between net sales and cost of goods sold.

3. Widespread use of computing and related technology has dramatically increased the use of the perpetual inventory system.

4. Under credit terms of 2y10, ny60, the credit period is 60 days and the discount period is 10 days.

5. (b) trade discount. 6. FOB means “free on board.” It is used in identifying the point

when ownership transfers from seller to buyer. FOB destination means that the seller transfers ownership of goods to the buyer when they arrive at the buyer’s place of business. It also means that the seller is responsible for paying shipping charges and bears the risk of damage or loss during shipment.

7. Recording sales discounts and sales returns and allowances separately from sales gives useful information to managers for internal monitoring and decision making.

8. When a customer returns merchandise and the seller restores the merchandise to inventory, two entries are necessary. One

entry records the decrease in revenue and credits the customer’s account. The second entry debits inventory and reduces cost of goods sold.

9. Credit memorandum—seller credits accounts receivable from buyer.

10. Merchandise Inventory may need adjusting to reflect shrinkage. 11. Sales (of goods), Sales Discounts, Sales Returns and Allow-

ances, and Cost of Goods Sold (and maybe Delivery Expense). 12. Four closing entries: (1) close credit balances in temporary ac-

counts to Income Summary, (2) close debit balances in tempo- rary accounts to Income Summary, (3) close Income Summary to retained earnings, and (4) close dividends account to retained earnings.

13. Cost of Goods Sold. 14. (b) Purchases and (c) Transportation-In. 15. Under a periodic inventory system, the cost of goods sold is

determined at the end of an accounting period by adding the net cost of goods purchased to the beginning inventory and sub- tracting the ending inventory.

16. Both methods report the same ending inventory and income.

Guidance Answers to Quick Checks

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 207 mhhe.com/wildFINMAN5e

1. A company has $550,000 in net sales and $193,000 in gross profit. This means its cost of goods sold equals

a. $743,000 b. $550,000

c. $357,000 d. $193,000 e. $(193,000)

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190 Chapter 4 Accounting for Merchandising Operations

2. A company purchased $4,500 of merchandise on May 1 with terms of 2y10, ny30. On May 6, it returned $250 of that mer- chandise. On May 8, it paid the balance owed for merchandise, taking any discount it is entitled to. The cash paid on May 8 is

a. $4,500 b. $4,250 c. $4,160 d. $4,165 e. $4,410 3. A company has cash sales of $75,000, credit sales of $320,000,

sales returns and allowances of $13,700, and sales discounts of $6,000. Its net sales equal

a. $395,000 b. $375,300 c. $300,300 d. $339,700 e. $414,700

4. A company’s quick assets are $37,500, its current assets are $80,000, and its current liabilities are $50,000. Its acid-test ratio equals

a. 1.600 b. 0.750 c. 0.625 d. 1.333 e. 0.469 5. A company’s net sales are $675,000, its costs of goods sold are

$459,000, and its net income is $74,250. Its gross margin ratio equals

a. 32% b. 68% c. 47% d. 11% e. 34%

A(B) Superscript letter A (B) denotes assignments based on Appendix 4A (4B).

Icon denotes assignments that involve decision making.

1. What items appear in financial statements of merch andising companies but not in the statements of service companies?

2. In comparing the accounts of a merchandising company with those of a service company, what additional accounts would the merchandising company likely use, assuming it employs a perpetual inventory system?

3. Explain how a business can earn a positive gross profit on its sales and still have a net loss.

4. Why do companies offer a cash discount? 5. How does a company that uses a perpetual inventory system

determine the amount of inventory shrinkage? 6. Distinguish between cash discounts and trade discounts. Is the

amount of a trade discount on purchased merchandise recorded in the accounts?

7. What is the difference between a sales discount and a purchase discount?

8. Why would a company’s manager be concerned about the quantity of its purchase returns if its suppliers allow unlimited returns?

9. Does the sender (maker) of a debit memorandum record a debit or a credit in the recipient’s account? What entry (debit or credit) does the recipient record?

10. What is the difference between the single-step and multiple- step income statement formats?

11. Refer to the balance sheet and income statement for Polaris in Appendix A. What does the company title its inventory account? Does the com- pany present a detailed calculation of its cost of sales?

12. Refer to Arctic Cat’s income statement in Appendix A. What title does it use for cost of goods sold?

13. Refer to the income statement for Piaggio in Appendix A. What does Piaggio title its cost of goods sold account?

14. Refer to the income statement of KTM in Appendix A. Does its income statement report a gross profit figure? If yes, what is the amount?

15. Buyers negotiate purchase contracts with suppliers. What type of shipping terms should a buyer attempt to negotiate to minimize freight-in costs?

Discussion Questions

QUICK STUDY

QS 4-1 Applying merchandising terms

C1

Enter the letter for each term in the blank space beside the definition that it most closely matches. A. Sales discount E. FOB shipping point H. Purchase discount B. Credit period F. Gross profit I. Cash discount C. Discount period G. Merchandise inventory J. Trade discount D. FOB destination

Polaris

Arctic Cat

PIAGGIO

KTM

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Chapter 4 Accounting for Merchandising Operations 191

QS 4-3 Recording purchases— perpetual system

P1

Prepare journal entries to record each of the following purchases transactions of a merchandising company. Show supporting calculations and assume a perpetual inventory system.

Nov. 5 Purchased 600 units of product at a cost of $10 per unit. Terms of the sale are 2y10, ny60; the invoice is dated November 5.

Nov. 7 Returned 25 defective units from the November 5 purchase and received full credit. Nov. 15 Paid the amount due from the November 5 purchase, less the return on November 7.

QS 4-4 Recording sales— perpetual system

P2

Prepare journal entries to record each of the following sales transactions of a merchandising company. Show supporting calculations and assume a perpetual inventory system.

Apr. 1 Sold merchandise for $3,000, granting the customer terms of 2y10, EOM; invoice dated April 1. The cost of the merchandise is $1,800.

Apr. 4 The customer in the April 1 sale returned merchandise and received credit for $600. The mer- chandise, which had cost $360, is returned to inventory.

Apr. 11 Received payment for the amount due from the April 1 sale less the return on April 4.

a b c d

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000 $550,000 $38,700 $255,700

Sales discounts . . . . . . . . . . . . . . . . . . . 5,000 17,500 600 4,800

Sales returns and allowances . . . . . . . . 20,000 6,000 5,100 900

Cost of goods sold . . . . . . . . . . . . . . . . 79,750 329,589 24,453 126,500

QS 4-5 Computing and analyzing gross margin

A2

Compute net sales, gross profit, and the gross margin ratio for each separate case a through d. Interpret the gross margin ratio for case a.

QS 4-2 Identifying inventory costs

C2

The cost of merchandise inventory includes which of the following: a. Costs incurred to make the goods ready for sale. b. Costs incurred to ship the goods to the store(s). c. Costs incurred to buy the goods.

d. Both b and c. e. a, b, and c.

A physical count of its July 31 year-end inventory discloses that the cost of the merchandise inventory still available is $35,900. Prepare the entry to record any inventory shrinkage.

Merchandise inventory . . . . . . . . $ 37,800 Sales returns and allowances . . . . . . . . . . . $ 6,500

Retained earnings . . . . . . . . . . . . 115,300 Cost of goods sold . . . . . . . . . . . . . . . . . 105,000

Dividends . . . . . . . . . . . . . . . . . . 7,000 Depreciation expense . . . . . . . . . . . . . . . 10,300

Sales . . . . . . . . . . . . . . . . . . . . . . . 160,200 Salaries expense . . . . . . . . . . . . . . . . . . . 32,500

Sales discounts . . . . . . . . . . . . . . 4,700 Miscellaneous expenses . . . . . . . . . . . . . 5,000

QS 4-6 Accounting for shrinkage— perpetual system

P3

Nix’It Company’s ledger on July 31, its fiscal year-end, includes the following selected accounts that have normal balances (Nix’It uses the perpetual inventory system).

1. Goods a company owns and expects to sell to its customers. 2. Time period that can pass before a customer’s payment is due. 3. Seller’s description of a cash discount granted to buyers in return for early payment. 4. Reduction below list or catalog price that is negotiated in setting the price of goods. 5. Ownership of goods is transferred when the seller delivers goods to the carrier. 6. Purchaser’s description of a cash discount received from a supplier of goods. 7. Reduction in a receivable or payable if it is paid within the discount period. 8. Difference between net sales and the cost of goods sold. 9. Time period in which a cash discount is available. 10. Ownership of goods is transferred when delivered to the buyer’s place of business.

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192 Chapter 4 Accounting for Merchandising Operations

QS 4-7 Closing entries P3

Refer to QS 4-6 and prepare journal entries to close the balances in temporary revenue and expense accounts. Remember to consider the entry for shrinkage that is made to solve QS 4-6.

QS 4-9 Contrasting liquidity ratios A1

Identify similarities and differences between the acid-test ratio and the current ratio. Compare and describe how the two ratios reflect a company’s ability to meet its current obligations.

QS 4-10 Multiple-step income statement

P4

The multiple-step income statement normally includes which of the following: a. Operating expenses are usually classified into (1) selling expenses and (2) general and administrative

expenses. b. Detailed computations of expenses, including subtotals for various expense categories. c. Detailed computations of net sales. d. Both a and c. e. a, b, and c.

QS 4-11A

Contrasting periodic and perpetual systems

P5

Identify whether each description best applies to a periodic or a perpetual inventory system. a. Updates the inventory account only at period-end. b. Requires an adjusting entry to record inventory shrinkage. c. Markedly increased in frequency and popularity in business within the past decade. d. Records cost of goods sold each time a sales transaction occurs. e. Provides more timely information to managers.

QS 4-12A

Recording purchases— periodic system P5

Refer to QS 4-3 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

QS 4-13A

Recording purchases— periodic system P5

Refer to QS 4-4 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

Cash . . . . . . . . . . . . . . . . . . . . $1,490 Prepaid expenses . . . . . . . . . . . . . $ 700

Accounts receivable . . . . . . . . 2,800 Accounts payable . . . . . . . . . . . . . 5,750

Inventory . . . . . . . . . . . . . . . . . 6,000 Other current liabilities . . . . . . . . 850

QS 4-8 Computing and interpreting acid-test ratio

A1

Use the following information on current assets and current liabilities to compute and interpret the acid- test ratio. Explain what the acid-test ratio of a company measures.

Net income . . . . . . . . . . . . . . . . . . . . . . . . . € 670

Financial income . . . . . . . . . . . . . . . . . . . . . 31

Financial expenses . . . . . . . . . . . . . . . . . . . . 115

Operating profit . . . . . . . . . . . . . . . . . . . . . 1,011

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . 257

Income before taxes . . . . . . . . . . . . . . . . . . 927

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . 6,344

Royalty and commission income . . . . . . . . 93

Other operating income . . . . . . . . . . . . . . . 98

Other operating expenses . . . . . . . . . . . . . 5,524

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,344

Income statement information for adidas Group, a German footwear, apparel, and accessories manufacturer, for the year ended December 31, 2011, follows. The company applies IFRS, as adopted by the European Union, and reports its results in millions of Euros. Prepare its calendar year 2011 (1) multiple-step income statement and (2) single-step income statement.

QS 4-14 IFRS income statement presentation

P4

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Chapter 4 Accounting for Merchandising Operations 193

QS 4-15 International accounting standards

C1

Answer each of the following questions related to international accounting standards. a. Explain how the accounting for merchandise purchases and sales is different between accounting un-

der IFRS versus U.S. GAAP. b. Income statements prepared under IFRS usually report an item titled finance costs. What do finance

costs refer to? c. U.S. GAAP prohibits alternative measures of income reported on the income statement. Does IFRS

permit such alternative measures on the income statement?

QS 4-16 Recording discounts taken—perpetual P1

On August 1, Gilmore Company purchased merchandise from Hendren with an invoice price of $60,000 and credit terms of 2y10, ny30. Gilmore Company paid Hendren on August 11. Prepare any required journal entry(ies) for Gilmore Company (the purchaser) on: (a) August 1, and (b) August 11. Assume Gilmore uses the perpetual inventory method.

QS 4-17 Recording discounts missed—perpetual P1

On September 15, Krug Company purchased merchandise inventory from Makarov with an invoice price of $35,000 and credit terms of 2y10, ny30. Krug Company paid Makarov on September 28. Prepare any required journal entry(ies) for Krug Company (the purchaser) on: (a) September 15, and (b) September 28. Assume Krug uses the perpetual inventory method.

Exercise 4-2 Recording entries for merchandise purchases

P1

Prepare journal entries to record the following transactions for a retail store. Assume a perpetual inventory system.

Apr. 2 Purchased merchandise from Lyon Company under the following terms: $4,600 price, invoice dated April 2, credit terms of 2y15, ny60, and FOB shipping point.

3 Paid $300 for shipping charges on the April 2 purchase. 4 Returned to Lyon Company unacceptable merchandise that had an invoice price of $600. 17 Sent a check to Lyon Company for the April 2 purchase, net of the discount and the returned

merchandise. 18 Purchased merchandise from Frist Corp. under the following terms: $8,500 price, invoice dated

April 18, credit terms of 2y10, ny30, and FOB destination. 21 After negotiations, received from Frist a $1,100 allowance on the April 18 purchase. 28 Sent check to Frist paying for the April 18 purchase, net of the discount and allowance. Check April 28, Cr. Cash $7,252

QS 4-18 Merchandise equations and flows

C2

Use the following information (in random order) from a service company and from a merchandiser to compute net income. For the merchandiser, also compute gross profit, the goods available for sale, and the cost of goods sold. Hint: Not all information may be necessary.

Krug Service Company Kleiner Merchandising Company

Expenses. . . . . . . . . . . . . . . . $ 8,500 Accumulated depreciation . . . . . . . . . . $ 700 Revenues . . . . . . . . . . . . . . . 14,000 Beginning inventory . . . . . . . . . . . . . . . 5,000 Dividends . . . . . . . . . . . . . . . 1,600 Common stock . . . . . . . . . . . . . . . . . . 50 Cash . . . . . . . . . . . . . . . . . . . 700 Retained earnings. . . . . . . . . . . . . . . . . 900 Prepaid rent . . . . . . . . . . . . 800 Ending inventory . . . . . . . . . . . . . . . . . 1,700 Accounts payable . . . . . . . . . 200 Operating expenses . . . . . . . . . . . . . . . 1,450 Common stock . . . . . . . . . . 500 Purchases . . . . . . . . . . . . . . . . . . . . . . . 3,900 Retained earnings. . . . . . . . . 2,500 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Equipment . . . . . . . . . . . . . . 1,300 Dividends . . . . . . . . . . . . . . . . . . . . . . . 1,600

The operating cycle of a merchandiser with credit sales includes the following five activities. Starting with merchandise acquisition, identify the chronological order of these five activities. a. inventory made available for sale. b. cash collections from customers. c. credit sales to customers. d. purchases of merchandise. e. accounts receivable accounted for.

EXERCISES

Exercise 4-1 Operating cycle for merchandiser

C2

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194 Chapter 4 Accounting for Merchandising Operations

Exercise 4-7 Analyzing and recording merchandise transactions— both buyer and seller

P1 P2

On May 11, Sydney Co. accepts delivery of $40,000 of merchandise it purchases for resale from Troy Corporation. With the merchandise is an invoice dated May 11, with terms of 3y10, ny90, FOB shipping point. The goods cost Troy $30,000. When the goods are delivered, Sydney pays $345 to Express Shipping for delivery charges on the merchandise. On May 12, Sydney returns $1,400 of goods to Troy, who receives them one day later and restores them to inventory. The returned goods had cost Troy $800. On May 20, Sydney mails a check to Troy Corporation for the amount owed. Troy receives it the following day. (Both Sydney and Troy use a perpetual inventory system.) 1. Prepare journal entries that Sydney Co. records for these transactions. 2. Prepare journal entries that Troy Corporation records for these transactions.

Check (1) May 20, Cr. Cash $37,442

Exercise 4-8 Recording effects of merchandising activities

P1 P2

The following supplementary records summarize Tosca Company’s merchandising activities for year 2013. Set up T-accounts for Merchandise Inventory and Cost of Goods Sold. Then record the summarized activi- ties in those T-accounts and compute account balances.

Check Year-End Merchandise Inventory Dec. 31, $20,000

Cost of merchandise sold to customers in sales transactions . . . . . . . . . . . . . . . . . . . $196,000 Merchandise inventory, December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Invoice cost of merchandise purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192,500 Shrinkage determined on December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Cost of transportation-in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,900 Cost of merchandise returned by customers and restored to inventory . . . . . . . . . . 2,100 Purchase discounts received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 Purchase returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Exercise 4-3 Analyzing and recording merchandise transactions — both buyer and seller

P1 P2

Santa Fe Company purchased merchandise for resale from Mesa Company with an invoice price of $24,000 and credit terms of 3y10, ny60. The merchandise had cost Mesa $16,000. Santa Fe paid within the discount period. Assume that both buyer and seller use a perpetual inventory system. 1. Prepare entries that the buyer should record for (a) the purchase and (b) the cash payment. 2. Prepare entries that the seller should record for (a) the sale and (b) the cash collection. 3. Assume that the buyer borrowed enough cash to pay the balance on the last day of the discount period

at an annual interest rate of 8% and paid it back on the last day of the credit period. Compute how much the buyer saved by following this strategy. (Assume a 365-day year and round dollar amounts to the nearest cent, including computation of interest per day.)Check (3) $465 savings

Exercise 4-5 Recording purchase returns and allowances P1

Refer to Exercise 4-4 and prepare the appropriate journal entries for Baker Co. to record the May 5 pur- chase and each of the three separate transactions a through c. Baker is a retailer that uses a perpetual inventory system and purchases these units for resale.

Exercise 4-6 Sales returns and allowances

C1

Business decision makers desire information on sales returns and allowances. (1) Explain why a company’s manager wants the accounting system to record customers’ returns of unsatisfactory goods in the Sales Returns and Allowances account instead of the Sales account. (2) Explain whether this information would be useful for external decision makers.

Allied Parts was organized on May 1, 2013, and made its first purchase of merchandise on May 3. The purchase was for 2,000 units at a price of $10 per unit. On May 5, Allied Parts sold 1,500 of the units for $14 per unit to Baker Co. Terms of the sale were 2y10, ny60. Prepare entries for Allied Parts to record the May 5 sale and each of the following separate transactions a through c using a perpetual inventory system. a. On May 7, Baker returns 200 units because they did not fit the customer’s needs. Allied Parts restores

the units to its inventory. b. On May 8, Baker discovers that 300 units are damaged but are still of some use and, therefore, keeps

the units. Allied Parts sends Baker a credit memorandum for $600 to compensate for the damage. c. On May 15, Baker discovers that 100 units are the wrong color. Baker keeps 60 of these units because

Allied Parts sends a $120 credit memorandum to compensate. Baker returns the remaining 40 units to Allied Parts. Allied Parts restores the 40 returned units to its inventory.

Exercise 4-4 Recording sales returns and allowances P2

Check (c) Dr. Merchandise Inventory $400

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Chapter 4 Accounting for Merchandising Operations 195

Exercise 4-10 Computing revenues, expenses, and income

C1 C2

Using your accounting knowledge, fill in the blanks in the following separate income statements a through e. Identify any negative amount by putting it in parentheses.

a b c d e

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $62,000 $43,500 $46,000 $ ? $25,600

Cost of goods sold

Merchandise inventory (beginning) . . . . . . . . . . . 8,000 17,050 7,500 8,000 4,560

Total cost of merchandise purchases . . . . . . . . . 38,000 ? ? 32,000 6,600

Merchandise inventory (ending) . . . . . . . . . . . . . ? (3,000) (9,000) (6,600) ?

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 34,050 16,000 ? ? 7,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? ? 3,750 45,600 ?

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,650 12,150 3,600 6,000

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . $ ? $16,850 $ (8,400) $42,000 $ ?

Exercise 4-11 Interpreting a physical count error as inventory shrinkage

A1

A retail company recently completed a physical count of ending merchandise inventory to use in prepar- ing adjusting entries. In determining the cost of the counted inventory, company employees failed to consider that $3,000 of incoming goods had been shipped by a supplier on December 31 under an FOB shipping point agreement. These goods had been recorded in Merchandise Inventory as a purchase, but they were not included in the physical count because they were in transit. Explain how this overlooked fact affects the company’s financial statements and the following ratios: return on assets, debt ratio, cur- rent ratio, and acid-test ratio.

Exercise 4-12 Physical count error and profits

A2

Refer to the information in Exercise 4-11 and explain how the error in the physical count affects the com- pany’s gross margin ratio and its profit margin ratio.

Exercise 4-9 Preparing adjusting and closing entries for a merchandiser

P3

The following list includes selected permanent accounts and all of the temporary accounts from the Decem- ber 31, 2013, unadjusted trial balance of Emiko Co., a business owned by Kumi Emiko. Use these account balances along with the additional information to journalize (a) adjusting entries and (b) closing entries. Emiko Co. uses a perpetual inventory system.

Debit Credit

Merchandise inventory . . . . . . . . . . . . . $ 30,000

Prepaid selling expenses . . . . . . . . . . . . 5,600

Dividends . . . . . . . . . . . . . . . . . . . . . . . 33,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $529,000

Sales returns and allowances . . . . . . . . 17,500

Sales discounts . . . . . . . . . . . . . . . . . . . 5,000

Cost of goods sold . . . . . . . . . . . . . . . . 212,000

Sales salaries expense . . . . . . . . . . . . . . 48,000

Utilities expense . . . . . . . . . . . . . . . . . . 15,000

Selling expenses . . . . . . . . . . . . . . . . . . 36,000

Administrative expenses . . . . . . . . . . . . 105,000

Additional Information

Accrued sales salaries amount to $1,700. Prepaid selling expenses of $3,000 have expired. A physical count of year-end merchandise inventory shows $28,450 of goods still available.

Check Entry to close Income Summary: Cr. Retained Earnings $84,250

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196 Chapter 4 Accounting for Merchandising Operations

Exercise 4-18A

Buyer and seller transactions— periodic system P5

Refer to Exercise 4-7 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used by both the buyer and the seller.

Exercise 4-19A

Recording purchases— periodic system P5

Refer to Exercise 4-14 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

Journalize the following merchandising transactions for Chilton Systems assuming it uses a perpetual inventory system. 1. On November 1, Chilton Systems purchases merchandise for $1,500 on credit with terms of 2y5,

ny30, FOB shipping point; invoice dated November 1. 2. On November 5, Chilton Systems pays cash for the November 1 purchase. 3. On November 7, Chilton Systems discovers and returns $200 of defective merchandise purchased on

November 1 for a cash refund. 4. On November 10, Chilton Systems pays $90 cash for transportation costs with the November 1 purchase. 5. On November 13, Chilton Systems sells merchandise for $1,600 on credit. The cost of the merchan-

dise is $800. 6. On November 16, the customer returns merchandise from the November 13 transaction. The returned

items would sell for $300 and cost $130; the items were not damaged and were returned to inventory.

Exercise 4-14 Preparing journal entries— perpetual system

P1 P2

A company reports the following sales related information: Sales (gross) of $200,000; Sales discounts of $4,000; Sales returns and allowances of $16,000; Sales salaries expense of $10,000. Prepare the net sales portion only of this company’s multiple-step income statement.

Exercise 4-15 Multiple-step income statement

P4

Refer to Exercise 4-2 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

Exercise 4-16A

Recording purchases— periodic system P5

Exercise 4-17A

Recording purchases and sales— periodic system P5

Refer to Exercise 4-3 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used by both the buyer and the seller. (Skip the part 3 requirement.)

Case X Case Y Case Z

Cash . . . . . . . . . . . . . . . . . . . . . . . . $2,000 $ 110 $1,000

Short-term investments . . . . . . . . 0 0 600

Current receivables . . . . . . . . . . . . 350 590 700

Inventory . . . . . . . . . . . . . . . . . . . . 2,650 2,300 4,100

Prepaid expenses . . . . . . . . . . . . . . 200 500 900

Total current assets . . . . . . . . . . . . $5,200 $3,500 $7,300

Current liabilities . . . . . . . . . . . . . . $2,200 $1,200 $3,750

Compute the current ratio and acid-test ratio for each of the following separate cases. (Round ratios to two decimals.) Which company case is in the best position to meet short-term obligations? Explain.

Exercise 4-13 Computing and analyzing acid-test and current ratios

A1

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Chapter 4 Accounting for Merchandising Operations 197

Problem 4-2A Preparing journal entries for merchandising activities— perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Sheng Company, which applies the perpetual inventory system. (Hint: It will help to identify each receivable and payable; for example, record the purchase on August 1 in Accounts Payable — Arotek.)

Aug. 1 Purchased merchandise from Arotek Company for $7,500 under credit terms of 1y10, ny30, FOB destination, invoice dated August 1.

4 At Arotek’s request, Sheng paid $200 cash for freight charges on the August 1 purchase, reduc- ing the amount owed to Arotek.

5 Sold merchandise to Laird Corp. for $5,200 under credit terms of 2y10, ny60, FOB destination, invoice dated August 5. The merchandise had cost $4,000.

8 Purchased merchandise from Waters Corporation for $5,400 under credit terms of 1y10, ny45, FOB shipping point, invoice dated August 8. The invoice showed that at Sheng’s request, Waters paid the $140 shipping charges and added that amount to the bill. (Hint: Discounts are not applied to freight and shipping charges.)

9 Paid $125 cash for shipping charges related to the August 5 sale to Laird Corp. 10 Laird returned merchandise from the August 5 sale that had cost Sheng $400 and been sold for

$600. The merchandise was restored to inventory. 12 After negotiations with Waters Corporation concerning problems with the merchandise pur-

chased on August 8, Sheng received a credit memorandum from Waters granting a price reduction of $700.

Check Aug. 9, Dr. Delivery Expense, $125

Net profit . . . . . . . . . . . . € 2,440.9 Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . €1,025.8

Finance costs . . . . . . . . . . 19.6 Profit before tax expense . . . . . . . . . . . . . . . . . . . . . . . 3,466.7

Net sales . . . . . . . . . . . . . 20,343.1 Research and development expense . . . . . . . . . . . . . . 720.5

Gross profit . . . . . . . . . . . 14,491.6 Selling, general and administrative expense . . . . . . . . . 4,186.9

Other income . . . . . . . . . 193.7 Advertising and promotion expense . . . . . . . . . . . . . . 6,291.6

Cost of sales . . . . . . . . . . 5,851.5

L’Oréal reports the following income statement accounts for the year ended December 31, 2011 (euros in millions). Prepare the income statement for this company for the year ended December 31, 2011, following usual IFRS practices.

Exercise 4-20 Preparing an income statement following IFRS

P4

Prepare journal entries to record the following merchandising transactions of Blink Company, which applies the perpetual inventory system. (Hint: It will help to identify each receivable and payable; for example, record the purchase on July 1 in Accounts Payable —Boden.)

July 1 Purchased merchandise from Boden Company for $6,000 under credit terms of 1y15, ny30, FOB shipping point, invoice dated July 1.

2 Sold merchandise to Creek Co. for $900 under credit terms of 2y10, ny60, FOB shipping point, invoice dated July 2. The merchandise had cost $500.

3 Paid $125 cash for freight charges on the purchase of July 1. 8 Sold merchandise that had cost $1,300 for $1,700 cash. 9 Purchased merchandise from Leight Co. for $2,200 under credit terms of 2y15, ny60, FOB

destination, invoice dated July 9. 11 Received a $200 credit memorandum from Leight Co. for the return of part of the merchandise

purchased on July 9. 12 Received the balance due from Creek Co. for the invoice dated July 2, net of the discount. 16 Paid the balance due to Boden Company within the discount period. 19 Sold merchandise that cost $800 to Art Co. for $1,200 under credit terms of 2y15, ny60, FOB

shipping point, invoice dated July 19. 21 Issued a $200 credit memorandum to Art Co. for an allowance on goods sold on July 19. 24 Paid Leight Co. the balance due after deducting the discount. 30 Received the balance due from Art Co. for the invoice dated July 19, net of discount. 31 Sold merchandise that cost $4,800 to Creek Co. for $7,000 under credit terms of 2y10, ny60,

FOB shipping point, invoice dated July 31.

PROBLEM SET A

Problem 4-1A Preparing journal entries for merchandising activities— perpetual system

P1 P2

Check July 12, Dr. Cash $882 July 16, Cr. Cash $5,940

July 24, Cr. Cash $1,960 July 30, Dr. Cash $980

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198 Chapter 4 Accounting for Merchandising Operations

15 Received balance due from Laird Corp. for the August 5 sale less the return on August 10. 18 Paid the amount due Waters Corporation for the August 8 purchase less the price reduction

granted. 19 Sold merchandise to Tux Co. for $4,800 under credit terms of 1y10, ny30, FOB shipping point,

invoice dated August 19. The merchandise had cost $2,400. 22 Tux requested a price reduction on the August 19 sale because the merchandise did not meet

specifications. Sheng sent Tux a $500 credit memorandum to resolve the issue. 29 Received Tux’s cash payment for the amount due from the August 19 sale. 30 Paid Arotek Company the amount due from the August 1 purchase.

Aug. 18, Cr. Cash $4,793

Aug. 29, Dr. Cash $4,257

Check (2) Gross profit, $67,750; (3) Total expenses, $106,775; Net income, $975

Problem 4-3A Preparing adjusting entries and income statements; and computing gross margin, acid- test, and current ratios

A1 A2 P3 P4

The following unadjusted trial balance is prepared at fiscal year-end for Nelson Company.

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

Cash Merchandise inventory Store supplies Prepaid insurance Store equipment Accumulated depreciation—Store equipment Accounts payable Common stock Retained earnings Dividends Sales Sales discounts

Sales returns and allowances Cost of goods sold Depreciation expense—Store equipment

Salaries expense Insurance expense Rent expense Store supplies expense Advertising expense

Totals

1,000 12,500 5,800 2,400

42,900

2,000

2,200

2,200 38,400

0

35,000 0

15,000 0

9,800

169,200

$

$

NELSON COMPANY Unadjusted Trial Balance

January 31, 2013 Debit Credit

169,200

15,250 10,000 5,000

27,000

111,950

$

$

Rent expense and salaries expense are equally divided between selling activities and the general and administrative activities. Nelson Company uses a perpetual inventory system.

Required

1. Prepare adjusting journal entries to reflect each of the following: a. Store supplies still available at fiscal year-end amount to $1,750. b. Expired insurance, an administrative expense, for the fiscal year is $1,400. c. Depreciation expense on store equipment, a selling expense, is $1,525 for the fiscal year. d. To estimate shrinkage, a physical count of ending merchandise inventory is taken. It shows $10,900

of inventory is still available at fiscal year-end. 2. Prepare a multiple-step income statement for fiscal year 2013. 3. Prepare a single-step income statement for fiscal year 2013. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of January 31, 2013. (Round ratios

to two decimals.)

mhhe.com/wildFINMAN5e

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Chapter 4 Accounting for Merchandising Operations 199

Problem 4-4A Computing merchandising amounts and formatting income statements

C2 P4

Valley Company’s adjusted trial balance on August 31, 2013, its fiscal year-end, follows.

Debit Credit

Merchandise inventory . . . . . . . . . . . . . $ 41,000

Other (noninventory) assets . . . . . . . . 130,400

Total liabilities . . . . . . . . . . . . . . . . . . . . $ 25,000

Common stock . . . . . . . . . . . . . . . . . . . 10,000

Retained earnings. . . . . . . . . . . . . . . . . . 94,550

Dividends . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,600

Sales discounts . . . . . . . . . . . . . . . . . . . 2,250

Sales returns and allowances . . . . . . . . 12,000

Cost of goods sold . . . . . . . . . . . . . . . . 74,500

Sales salaries expense . . . . . . . . . . . . . . 32,000

Rent expense — Selling space . . . . . . . . 8,000

Store supplies expense . . . . . . . . . . . . . 1,500

Advertising expense . . . . . . . . . . . . . . . 13,000

Office salaries expense . . . . . . . . . . . . . 28,500

Rent expense — Office space . . . . . . . . 3,600

Office supplies expense . . . . . . . . . . . . 400

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . $355,150 $355,150

Invoice cost of merchandise purchases . . . . . . . . $92,000

Purchase discounts received . . . . . . . . . . . . . . . . . 2,000

Purchase returns and allowances . . . . . . . . . . . . . 4,500

Costs of transportation-in . . . . . . . . . . . . . . . . . . 4,600

On August 31, 2012, merchandise inventory was $25,400. Supplementary records of merchandising ac- tivities for the year ended August 31, 2013, reveal the following itemized costs.

Required

1. Compute the company’s net sales for the year. 2. Compute the company’s total cost of merchandise purchased for the year. 3. Prepare a multiple-step income statement that includes separate categories for selling expenses and for

general and administrative expenses. 4. Prepare a single-step income statement that includes these expense categories: cost of goods sold,

selling expenses, and general and administrative expenses.

Check (2) $90,100;

(3) Gross profit, $136,850; Net income, $49,850;

(4) Total expenses, $161,500

Problem 4-5A Preparing closing entries and interpreting information about discounts and returns

C2 P3

Use the data for Valley Company in Problem 4-4A to complete the following requirements.

Required

1. Prepare closing entries as of August 31, 2013 (the perpetual inventory system is used).

Analysis Component

2. The company makes all purchases on credit, and its suppliers uniformly offer a 3% sales discount. Does it appear that the company’s cash management system is accomplishing the goal of taking all available discounts? Explain.

3. In prior years, the company experienced a 4% returns and allowance rate on its sales, which means approximately 4% of its gross sales were eventually returned outright or caused the company to grant allowances to customers. How do this year’s results compare to prior years’ results?

(3) Current-year rate, 5.3%

Check (1) $49,850 Dr. to close Income Summary

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200 Chapter 4 Accounting for Merchandising Operations

Problem 4-6AB

Preparing a work sheet for a merchandiser

P3

Refer to the data and information in Problem 4-3A.

Required

Prepare and complete the entire 10-column work sheet for Nelson Company. Follow the structure of Exhibit 4B.1 in Appendix 4B.

Check May 14, Dr. Cash $10,780 May 17, Cr. Cash $9,900

May 30, Dr. Cash $2,352

Prepare journal entries to record the following merchandising transactions of Yarvelle Company, which applies the perpetual inventory system. (Hint: It will help to identify each receivable and payable; for example, record the purchase on May 2 in Accounts Payable—Havel.)

May 2 Purchased merchandise from Havel Co. for $10,000 under credit terms of 1y15, ny30, FOB shipping point, invoice dated May 2.

4 Sold merchandise to Heather Co. for $11,000 under credit terms of 2y10, ny60, FOB shipping point, invoice dated May 4. The merchandise had cost $5,600.

5 Paid $250 cash for freight charges on the purchase of May 2. 9 Sold merchandise that had cost $2,000 for $2,500 cash. 10 Purchased merchandise from Duke Co. for $3,650 under credit terms of 2y15, ny60, FOB

destination, invoice dated May 10. 12 Received a $400 credit memorandum from Duke Co. for the return of part of the merchandise

purchased on May 10. 14 Received the balance due from Heather Co. for the invoice dated May 4, net of the discount. 17 Paid the balance due to Havel Co. within the discount period. 20 Sold merchandise that cost $1,450 to Tameron Co. for $2,800 under credit terms of 2y15, ny60,

FOB shipping point, invoice dated May 20. 22 Issued a $400 credit memorandum to Tameron Co. for an allowance on goods sold from May 20. 25 Paid Duke Co. the balance due after deducting the discount. 30 Received the balance due from Tameron Co. for the invoice dated May 20, net of discount

and allowance. 31 Sold merchandise that cost $3,600 to Heather Co. for $7,200 under credit terms of 2y10, ny60,

FOB shipping point, invoice dated May 31.

PROBLEM SET B

Problem 4-1B Preparing journal entries for merchandising activities— perpetual system

P1 P2

Problem 4-2B Preparing journal entries for merchandising activities— perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Mason Company, which applies the perpetual inventory system. (Hint: It will help to identify each receivable and payable; for example, record the purchase on July 3 in Accounts Payable—OLB.)

July 3 Purchased merchandise from OLB Corp. for $15,000 under credit terms of 1y10, ny30, FOB destination, invoice dated July 3.

4 At OLB’s request, Mason paid $150 cash for freight charges on the July 3 purchase, reducing the amount owed to OLB.

7 Sold merchandise to Brill Co. for $11,500 under credit terms of 2y10, ny60, FOB destination, invoice dated July 7. The merchandise had cost $7,750.

10 Purchased merchandise from Rupert Corporation for $14,200 under credit terms of 1y10, ny45, FOB shipping point, invoice dated July 10. The invoice showed that at Mason’s request, Rupert paid the $500 shipping charges and added that amount to the bill. (Hint: Discounts are not applied to freight and shipping charges.)

11 Paid $300 cash for shipping charges related to the July 7 sale to Brill Co. 12 Brill returned merchandise from the July 7 sale that had cost Mason $1,450 and been sold for

$1,850. The merchandise was restored to inventory. 14 After negotiations with Rupert Corporation concerning problems with the merchandise

purchased on July 10, Mason received a credit memorandum from Rupert granting a price reduction of $2,000.

17 Received balance due from Brill Co. for the July 7 sale less the return on July 12. 20 Paid the amount due Rupert Corporation for the July 10 purchase less the price reduction granted. 21 Sold merchandise to Brown for $11,000 under credit terms of 1y10, ny30, FOB shipping point,

invoice dated July 21. The merchandise had cost $7,000. 24 Brown requested a price reduction on the July 21 sale because the merchandise did not meet

specifications. Mason sent Brown a credit memorandum for $1,300 to resolve the issue. 30 Received Brown’s cash payment for the amount due from the July 21 sale. 31 Paid OLB Corp. the amount due from the July 3 purchase.

Check July 17, Dr. Cash $9,457 July 20, Cr. Cash $12,578

July 30, Dr. Cash $9,603

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Chapter 4 Accounting for Merchandising Operations 201

Debit Credit

Merchandise inventory . . . . . . . . . . . . . . $ 56,500

Other (noninventory) assets . . . . . . . . . 202,600

Total liabilities . . . . . . . . . . . . . . . . . . . . . $ 42,500

Common stock . . . . . . . . . . . . . . . . . . . 10,000

Retained earnings. . . . . . . . . . . . . . . . . . 154,425

[continued on next page]

Problem 4-4B Computing merchandising amounts and formatting income statements

C1 C2 P4

Barkley Company’s adjusted trial balance on March 31, 2013, its fiscal year-end, follows.

The following unadjusted trial balance is prepared at fiscal year-end for Foster Products Company.

Rent expense and salaries expense are equally divided between selling activities and the general and administrative activities. Foster Products Company uses a perpetual inventory system.

Required

1. Prepare adjusting journal entries to reflect each of the following. a. Store supplies still available at fiscal year-end amount to $3,700. b. Expired insurance, an administrative expense, for the fiscal year is $2,800. c. Depreciation expense on store equipment, a selling expense, is $3,000 for the fiscal year. d. To estimate shrinkage, a physical count of ending merchandise inventory is taken. It shows $21,300

of inventory is still available at fiscal year-end. 2. Prepare a multiple-step income statement for fiscal year 2013. 3. Prepare a single-step income statement for fiscal year 2013. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of October 31, 2013. (Round ratios

to two decimals.)

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

Cash Merchandise inventory Store supplies Prepaid insurance Store equipment

Accumulated depreciation—Store equipment Accounts payable Common stock Retained earnings

Dividends Sales Sales discounts Sales returns and allowances Cost of goods sold Depreciation expense—Store equipment Salaries expense Insurance expense Rent expense

Store supplies expense Advertising expense Totals

FOSTER PRODUCTS COMPANY Unadjusted Trial Balance

October 31, 2013

7,400 24,000 9,700 6,600

81,800

1,000

2,000

5,000 75,800

0 63,000

0 26,000

0 17,800

320,100

$

$

Debit Credit

32,000 18,000 3,000

40,000

227,100

320,100

$

$

Problem 4-3B Preparing adjusting entries and income statements; and computing gross margin, acid-test, and current ratios

A1 A2 P3 P4

Check (2) Gross profit, $142,600; (3) Total expenses, $197,100; Net income, $24,000

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202 Chapter 4 Accounting for Merchandising Operations

On March 31, 2012, merchandise inventory was $37,500. Supplementary records of merchandising activities for the year ended March 31, 2013, reveal the following itemized costs.

Dividends . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,650

Sales discounts . . . . . . . . . . . . . . . . . . . 5,875

Sales returns and allowances . . . . . . . . 20,000

Cost of goods sold . . . . . . . . . . . . . . . . 115,600

Sales salaries expense . . . . . . . . . . . . . . 44,500

Rent expense — Selling space . . . . . . . . 16,000

Store supplies expense . . . . . . . . . . . . . 3,850

Advertising expense . . . . . . . . . . . . . . . 26,000

Office salaries expense . . . . . . . . . . . . . 40,750

Rent expense — Office space . . . . . . . . 3,800

Office supplies expense . . . . . . . . . . . . 1,100

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . $539,575 $539,575

[continued from previous page]

Invoice cost of merchandise purchases . . . . . . . . $138,500

Purchase discounts received . . . . . . . . . . . . . . . . . 2,950

Purchase returns and allowances . . . . . . . . . . . . . 6,700

Costs of transportation-in . . . . . . . . . . . . . . . . . . 5,750

Problem 4-6BB

Preparing a work sheet for a merchandiser

P3

Refer to the data and information in Problem 4-3B.

Required

Prepare and complete the entire 10-column work sheet for Foster Products Company. Follow the structure of Exhibit 4B.1 in Appendix 4B.

Required

1. Calculate the company’s net sales for the year. 2. Calculate the company’s total cost of merchandise purchased for the year. 3. Prepare a multiple-step income statement that includes separate categories for selling expenses and for

general and administrative expenses. 4. Prepare a single-step income statement that includes these expense categories: cost of goods sold,

selling expenses, and general and administrative expenses.

Check (2) $134,600;

(3) Gross profit, $191,175; Net income, $55,175;

(4) Total expenses, $251,600

Use the data for Barkley Company in Problem 4-4B to complete the following requirements.

Required

1. Prepare closing entries as of March 31, 2013 (the perpetual inventory system is used).

Analysis Component

2. The company makes all purchases on credit, and its suppliers uniformly offer a 3% sales discount. Does it appear that the company’s cash management system is accomplishing the goal of taking all available discounts? Explain.

3. In prior years, the company experienced a 5% returns and allowance rate on its sales, which means approximately 5% of its gross sales were eventually returned outright or caused the company to grant allowances to customers. How do this year’s results compare to prior years’ results?

Problem 4-5B Preparing closing entries and interpreting information about discounts and returns

C2 P3

Check (1) $55,175 Dr. to close Income Summary

(3) Current-year rate, 6.0%

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Chapter 4 Accounting for Merchandising Operations 203

In response to requests from customers, A. Lopez will begin selling computer software. The company will extend credit terms of 1y10, ny30, FOB shipping point, to all customers who purchase this merchandise. However, no cash discount is available on consulting fees. Additional accounts (Nos. 119, 413, 414, 415, and 502) are added to its general ledger to accommodate the company’s new merchandising activities. Also, Success Systems does not use reversing entries and, therefore, all revenue and expense accounts have zero beginning balances as of January 1, 2014. Its transactions for January through March follow:

Jan. 4 The company paid cash to Lyn Addie for five days’ work at the rate of $125 per day. Four of the five days relate to wages payable that were accrued in the prior year.

5 Adria Lopez invested an additional $25,000 cash in the company in exchange for more common stock.

7 The company purchased $5,800 of merchandise from Kansas Corp. with terms of 1y10, ny30, FOB shipping point, invoice dated January 7.

9 The company received $2,668 cash from Gomez Co. as full payment on its account. 11 The company completed a five-day project for Alex’s Engineering Co. and billed it $5,500,

which is the total price of $7,000 less the advance payment of $1,500. 13 The company sold merchandise with a retail value of $5,200 and a cost of $3,560 to Liu Corp.,

invoice dated January 13. 15 The company paid $600 cash for freight charges on the merchandise purchased on January 7. 16 The company received $4,000 cash from Delta Co. for computer services provided. 17 The company paid Kansas Corp. for the invoice dated January 7, net of the discount. 20 Liu Corp. returned $500 of defective merchandise from its invoice dated January 13. The

returned merchandise, which had a $320 cost, is discarded. (The policy of Success Systems is to leave the cost of defective products in cost of goods sold.)

Check Jan. 11, Dr. Unearned Computer Services Revenue $1,500

No. Account Title Dr. Cr.

210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500

236 Unearned computer services revenue . . . . . . . . . . . 1,500

307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,000

318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,148

319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0

403 Computer services revenue . . . . . . . . . . . . . . . . . . . 0

413 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

414 Sales returns and allowances . . . . . . . . . . . . . . . . . . 0

415 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

502 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 0

612 Depreciation expense—Office equipment . . . . . . . . 0

613 Depreciation expense— Computer equipment . . . . . . . . . . . . . . . . . . . . . 0

623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

652 Computer supplies expense . . . . . . . . . . . . . . . . . . . 0

655 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . 0

676 Mileage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

677 Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . 0

684 Repairs expense—Computer . . . . . . . . . . . . . . . . . . 0

No. Account Title Dr. Cr.

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $58,160

106.1 Alex’s Engineering Co. . . . . . . . . . . . . 0

106.2 Wildcat Services . . . . . . . . . . . . . . . . 0

106.3 Easy Leasing . . . . . . . . . . . . . . . . . . . . 0

106.4 IFM Co. . . . . . . . . . . . . . . . . . . . . . . . . 3,000

106.5 Liu Corp. . . . . . . . . . . . . . . . . . . . . . . 0

106.6 Gomez Co. . . . . . . . . . . . . . . . . . . . . . 2,668

106.7 Delta Co. . . . . . . . . . . . . . . . . . . . . . . 0

106.8 KC, Inc. . . . . . . . . . . . . . . . . . . . . . . . . 0

106.9 Dream, Inc. . . . . . . . . . . . . . . . . . . . . . 0

119 Merchandise inventory . . . . . . . . . . . 0

126 Computer supplies . . . . . . . . . . . . . . . 580

128 Prepaid insurance . . . . . . . . . . . . . . . . 1,665

131 Prepaid rent . . . . . . . . . . . . . . . . . . . . 825

163 Office equipment . . . . . . . . . . . . . . . . 8,000

164 Accumulated depreciation— Office equipment . . . . . . . . . . . . . . $ 400

167 Computer equipment . . . . . . . . . . . . 20,000

168 Accumulated depreciation— Computer equipment . . . . . . . . . . 1,250

201 Accounts payable . . . . . . . . . . . . . . . . 1,100

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 4 Adria Lopez created Success Systems on October 1, 2013. The company has been successful, and its list of customers has grown. To accommodate the growth, the accounting system is modified to set up separate accounts for each customer. The following chart of accounts includes the account number used for each account and any balance as of December 31, 2013. Adria Lopez decided to add a fourth digit with a decimal point to the 106 account number that had been used for the single Accounts Receivable account. This change allows the company to continue using the existing chart of accounts.

SERIAL PROBLEM Success Systems

P1 P2 P3 P4

Check Jan. 20, No entry to Cost of Goods Sold

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204 Chapter 4 Accounting for Merchandising Operations

22 The company received the balance due from Liu Corp., net of both the discount and the credit for the returned merchandise.

24 The company returned defective merchandise to Kansas Corp. and accepted a credit against future purchases. The defective merchandise invoice cost, net of the discount, was $496.

26 The company purchased $9,000 of merchandise from Kansas Corp. with terms of 1y10, ny30, FOB destination, invoice dated January 26.

26 The company sold merchandise with a $4,640 cost for $5,800 on credit to KC, Inc., invoice dated January 26.

31 The company paid cash to Lyn Addie for 10 days’ work at $125 per day. Feb. 1 The company paid $2,475 cash to Hillside Mall for another three months’ rent in advance. 3 The company paid Kansas Corp. for the balance due, net of the cash discount, less the $496

amount in the credit memorandum. 5 The company paid $600 cash to the local newspaper for an advertising insert in today’s paper. 11 The company received the balance due from Alex’s Engineering Co. for fees billed on January 11. 15 The company paid $4,800 cash for dividends. 23 The company sold merchandise with a $2,660 cost for $3,220 on credit to Delta Co., invoice

dated February 23. 26 The company paid cash to Lyn Addie for eight days’ work at $125 per day. 27 The company reimbursed Adria Lopez for business automobile mileage (600 miles at $0.32

per mile). Mar. 8 The company purchased $2,730 of computer supplies from Harris Office Products on credit,

invoice dated March 8. 9 The company received the balance due from Delta Co. for merchandise sold on February 23. 11 The company paid $960 cash for minor repairs to the company’s computer. 16 The company received $5,260 cash from Dream, Inc., for computing services provided. 19 The company paid the full amount due to Harris Office Products, consisting of amounts created

on December 15 (of $1,100) and March 8. 24 The company billed Easy Leasing for $8,900 of computing services provided. 25 The company sold merchandise with a $2,002 cost for $2,800 on credit to Wildcat Services,

invoice dated March 25. 30 The company sold merchandise with a $1,100 cost for $2,220 on credit to IFM Company, in-

voice dated March 30. 31 The company reimbursed Adria Lopez for business automobile mileage (400 miles at $0.32 per

mile).

The following additional facts are available for preparing adjustments on March 31 prior to financial state- ment preparation: a. The March 31 amount of computer supplies still available totals $2,005. b. Three more months have expired since the company purchased its annual insurance policy at a $2,220

cost for 12 months of coverage. c. Lyn Addie has not been paid for seven days of work at the rate of $125 per day. d. Three months have passed since any prepaid rent has been transferred to expense. The monthly rent

expense is $825. e. Depreciation on the computer equipment for January 1 through March 31 is $1,250. f. Depreciation on the office equipment for January 1 through March 31 is $400. g. The March 31 amount of merchandise inventory still available totals $704.

Required

1. Prepare journal entries to record each of the January through March transactions. 2. Post the journal entries in part 1 to the accounts in the company’s general ledger. (Note: Begin with the

ledger’s post-closing adjusted balances as of December 31, 2013.) 3. Prepare a partial work sheet consisting of the first six columns (similar to the one shown in Exhibit 4B.1)

that includes the unadjusted trial balance, the March 31 adjustments (a) through (g), and the adjusted trial balance. Do not prepare closing entries and do not journalize the adjustments or post them to the ledger.

4. Prepare an income statement (from the adjusted trial balance in part 3) for the three months ended March 31, 2014. Use a single-step format. List all expenses without differentiating between selling expenses and general and administrative expenses.

5. Prepare a statement of retained earnings (from the adjusted trial balance in part 3) for the three months ended March 31, 2014.

6. Prepare a classified balance sheet (from the adjusted trial balance) as of March 31, 2014.

(3) Unadj. totals, $161,198; Adj. totals, $163,723;

(4) Net income, $18,686;

Check (2) Ending balances at March 31: Cash, $77,845; Sales, $19,240;

(6) Total assets, $129,909

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BTN 4-1 Refer to Polaris’ financial statements in Appendix A to answer the following.

Required

1. Assume that the amounts reported for inventories and cost of sales reflect items purchased in a form ready for resale. Compute the net cost of goods purchased for the year ended December 31, 2011.

2. Compute the current ratio and acid-test ratio as of December 31, 2011 and 2010. Interpret and com- ment on the ratio results. How does Polaris compare to the industry average of 1.5 for the current ratio and 1.25 for the acid-test ratio?

Fast Forward

3. Access Polaris’ financial statements (form 10-K) for fiscal years ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Recompute and interpret the current ratio and acid-test ratio for these current fiscal years.

Beyond the Numbers

REPORTING IN ACTION A1

BTN 4-3 Amy Martin is a student who plans to attend approximately four professional events a year at her college. Each event necessitates a financial outlay of $100 to $200 for a new suit and accessories. After incurring a major hit to her savings for the first event, Amy developed a different approach. She buys the suit on credit the week before the event, wears it to the event, and returns it the next week to the store for a full refund on her charge card.

Required

1. Comment on the ethics exhibited by Amy and possible consequences of her actions. 2. How does the merchandising company account for the suits that Amy returns?

ETHICS CHALLENGE C1 P2

BTN 4-4 You are the financial officer for Music Plus, a retailer that sells goods for home entertainment needs. The business owner, Vic Velakturi, recently reviewed the annual financial statements you prepared and sent you an e-mail stating that he thinks you overstated net income. He explains that although he has invested a great deal in security, he is sure shoplifting and other forms of inventory shrinkage have occurred, but he does not see any deduction for shrinkage on the income statement. The store uses a perpetual inventory system.

Required

Prepare a brief memorandum that responds to the owner’s concerns.

COMMUNICATING IN PRACTICE C2 P3 P5

Required

1. Compute the dollar amount of gross margin and the gross margin ratio for the two years shown for each of these companies.

2. Which company earns more in gross margin for each dollar of net sales? How do they compare to the industry average of 25.0%?

3. Did the gross margin ratio improve or decline for these companies?

Polaris Arctic Cat

Current Prior Current Prior

($ thousands) Year Year Year Year

Net sales . . . . . . . . . . . . . . $2,656,949 $1,991,139 $464,651 $450,728

Cost of sales . . . . . . . . . . . 1,916,366 1,460,926 363,142 367,492

BTN 4-2 Key comparative figures for both Polaris and Arctic Cat follow. COMPARATIVE ANALYSIS A2

Polaris Arctic Cat

Polaris

Chapter 4 Accounting for Merchandising Operations 205

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206 Chapter 4 Accounting for Merchandising Operations

BTN 4-5 Access the SEC’s EDGAR database (www.sec.gov) and obtain the March 19, 2012, filing of its fiscal 2012 10-K report (for year ended January 28, 2012) for J. Crew Group, Inc. (ticker: JCG).

Required

Prepare a table that reports the gross margin ratios for J. Crew using the revenues and cost of goods sold data from J. Crew’s income statement for each of its most recent three years. Analyze and comment on the trend in its gross margin ratio.

TAKING IT TO THE NET A2 C1

BTN 4-6 Official Brands’ general ledger and supplementary records at the end of its current period re- veal the following.

TEAMWORK IN ACTION C1 C2

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 Merchandise inventory (beginning of period) . . . . . $ 98,000

Sales returns and allowances . . . . . . 20,000 Invoice cost of merchandise purchases . . . . . . . . . . 360,000

Sales discounts . . . . . . . . . . . . . . . . 13,000 Purchase discounts received . . . . . . . . . . . . . . . . . . 9,000

Cost of transportation-in . . . . . . . . 22,000 Purchase returns and allowances . . . . . . . . . . . . . . 11,000

Operating expenses . . . . . . . . . . . . 50,000 Merchandise inventory (end of period) . . . . . . . . . . 84,000

Required

1. Each member of the team is to assume responsibility for computing one of the following items. You are not to duplicate your teammates’ work. Get any necessary amounts to compute your item from the appropriate teammate. Each member is to explain his or her computation to the team in preparation for reporting to the class.

a. Net sales d. Gross profit b. Total cost of merchandise purchases e. Net income c. Cost of goods sold 2. Check your net income with the instructor. If correct, proceed to step 3. 3. Assume that a physical inventory count finds that actual ending inventory is $76,000. Discuss how this

affects previously computed amounts in step 1.

Point: In teams of four, assign the same student a and e. Rotate teams for reporting on a different computation and the analysis in step 3.

Chelsea Eubank sells to various individuals and retailers, ranging from small shops to large chains. Assume that she currently offers credit terms of 1y15, ny60, and ships FOB destination. To improve her cash flow, she is considering changing credit terms to 3y10, ny30. In addition, she proposes to change shipping terms to FOB shipping point. She expects that the increase in discount rate will increase net sales by 9%, but the gross margin ratio (and ratio of cost of sales divided by net sales) is expected to remain unchanged. She also expects that delivery expenses will be zero under this proposal; thus, expenses other than cost of sales are expected to increase only 6%.

Required

1. Prepare a forecasted income statement for the year ended January 31, 2013, based on the proposal. 2. Based on the forecasted income statement alone (from your part 1 solution), do you recommend that

Chelsea implement the new sales policies? Explain. 3. What else should Chelsea consider before deciding whether or not to implement the new policies?

Explain.

BTN 4-7 Refer to the opening feature about Faithful Fish. Assume that Chelsea Eubank reports current annual sales at approximately $1 million and discloses the following income statement.

FAITHFUL FISH

Income Statement

For Year Ended January 31, 2012

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 610,000

Expenses (other than cost of sales) . . . . . . . . . 200,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 190,000

ENTREPRENEURIAL DECISION C1 C2 P4

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Chapter 4 Accounting for Merchandising Operations 207

1. c; Gross profit 5 $550,000 2 $193,000 5 $357,000 2. d; ($4,500 2 $250) 3 (100% 2 2%) 5 $4,165 3. b; Net sales 5 $75,000 1 $320,000 2 $13,700 2 $6,000 5 $375,300

4. b; Acid-test ratio 5 $37,500y$50,000 5 0.750 5. a; Gross margin ratio 5 ($675,000 2 $459,000)y$675,000 5 32%

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 4-8 Arrange an interview (in person or by phone) with the manager of a retail shop in a mall or in the downtown area of your community. Explain to the manager that you are a student studying merchan- dising activities and the accounting for sales returns and sales allowances. Ask the manager what the store policy is regarding returns. Also find out if sales allowances are ever negotiated with customers. Inquire whether management perceives that customers are abusing return policies and what actions management takes to counter potential abuses. Be prepared to discuss your findings in class.

HITTING THE ROAD C1

Point: This activity complements the Ethics Challenge assignment.

Net Sales Cost of Sales

KTM* . . . . . . . . . . . . . 526,801 371,752

Polaris† . . . . . . . . . . . $2,656,949 $1,916,366

Arctic Cat† . . . . . . . . $ 464,651 $ 363,142

* EUR thousands for KTM. † $ thousands for Polaris and Arctic Cat.

BTN 4-9 KTM (www.KTM.com), Polaris, and Arctic Cat are competitors in the global marketplace. Key comparative figures for each company follow.

Required

1. Rank the three companies (highest to lowest) based on the gross margin ratio. 2. Which of the companies uses a multiple-step income statement format? (These companies’ income

statements are in Appendix A.)

GLOBAL DECISION A2 P4

KTM Polaris Arctic Cat

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Learning Objectives

CONCEPTUAL

C1 Identify the items making up merchandise inventory. (p. 210) C2 Identify the costs of merchandise inventory. (p. 211)

ANALYTICAL

A1 Analyze the effects of inventory methods for both financial and tax reporting. (p. 218)

A2 Analyze the effects of inventory errors on current and future financial statements. (p. 220)

A3 Assess inventory management using both inventory turnover and days’ sales in inventory. (p. 223)

PROCEDURAL

P1 Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average. (p. 213)

P2 Compute the lower of cost or market amount of inventory. (p. 219) P3 Appendix 5A—Compute inventory in a periodic system using the methods of

specific identification, FIFO, LIFO, and weighted average. (p. 229)

P4 Appendix 5B—Apply both the retail inventory and gross profit methods to estimate inventory. (p. 234)

A Look at This Chapter

This chapter emphasizes accounting for inventory. We describe methods for assigning costs to inventory and we explain the items and costs making up merchandise inventory. We also discuss methods of estimating and measuring inventory.

A Look Back

Chapter 4 focused on merchandising activities and how they are reported. We analyzed and recorded purchases and sales and explained accounting adjustments and closing for merchandisers.

Inventories and Cost of Sales 5

A Look Ahead

Chapter 6 focuses on internal controls and accounting for cash and cash equivalents. We explain good internal control procedures and their importance to accounting.

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Cool Company

MIAMI—”America is, and will always be, a place of unlimited opportunity for all who dream,” insists Derick Pearson. Derick, along with his soon-to-be-wife Felecia Hatcher, launched Feverish Ice Cream (FeverishIceCream.com) after losing their jobs. Their company sells gourmet ice pops and ice cream con- cocted in their production facility, and the two sell them using ecofriendly, acid green carts and a Scion. Felecia explains that they focus on venues that attract young adults such as music events, campuses, skate parks, and farmers’ markets. Their travels are posted on Twitter and Facebook. The company launch, however, was a challenge. “We pur- chased two tricycle carts that we found on Craigslist,” explains Felecia. “As the business grew, we were able to reinvest more money into it, buy more equipment.” The couple also had to con- front inventory production and sales planning, and had to deal with discounts and allowances. A major challenge was identifying the appropriate inventories while controlling costs. “In the beginning it was just a lot of trial and error,” says Felecia. “We had a lot of melted ice cream!” Ap- plying inventory management, and old fashioned trial-and-error, Felecia and Derick learned to fill orders, collect money, and main- tain the right level and mix of inventory. To help, they set up an inventory system to account for sales and purchases in real time.

The two insist that while it is important to serve custom- ers’ needs, business success demands sound inventory man- agement. Further, that success requires more than good products and perpetual inventor y management. Felecia explains that it requires commitment, patience, energy, faith, and maybe some luck. “It was a crazy idea but we really didn’t have anything to lose,” recalls Felecia. “Loving ice cream fueled a lot of our madness!” While Derick and Felecia continue to measure, monitor, and manage inventories and costs, their success and growth are pushing them into new products and opportunities. “[We are] always about growing as organically as possible,” asserts Felecia. “[Including] sustaining that growth.” Their inventory procedures and accounting systems contribute to their lean business model. “[We] budget every cent, along with saving for future expenses,” explains Derick. “There’s nothing wrong with living simple,” says Felecia. ”Spend money on things that will last, and make do with what you have.” Adds Derick, “We are living examples that dreams do come true!”

[Sources: Feverish Ice Cream Website, January 2013; South Florida Times, November 2011; Palm Beach Post, July 2011; Graves Publishing Company, February 2010; Miami New Times, November 2011]

“We had to be really creative.” —FELECIA HATCHER

Decision Insight

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Chapter Preview

Merchandisers’ activities include the purchasing and reselling of merchandise. We explained accounting for merchandisers in Chap- ter 4, including that for purchases and sales. In this chapter, we ex- tend the study and analysis of inventory by explaining the methods used to assign costs to merchandise inventory and to cost of goods

sold. Retailers, wholesalers, and other merchandising companies that purchase products for resale use the principles and methods described here. Understanding inventory accounting helps in the analysis and interpretation of financial statements and helps people run their businesses.

This section identifies the items and costs making up merchandise inventory. It also describes the importance of internal controls in taking a physical count of inventory.

Determining Inventory Items Merchandise inventory includes all goods that a company owns and holds for sale. This rule holds regardless of where the goods are located when inventory is counted. Certain inventory items require special attention, including goods in transit, goods on consignment, and goods that are damaged or obsolete.

Goods in Transit Does a purchaser’s inventory include goods in transit from a supplier? The answer is that if ownership has passed to the purchaser, the goods are included in the pur- chaser’s inventory. We determine this by reviewing the shipping terms: FOB destination or FOB shipping point. If the purchaser is responsible for paying freight, ownership passes when goods are loaded on the transport vehicle. If the seller is responsible for paying freight, owner- ship passes when goods arrive at their destination.

Goods on Consignment Goods on consignment are goods shipped by the owner, called the consignor, to another party, the consignee. A consignee sells goods for the owner. The con- signor continues to own the consigned goods and reports them in its inventory. Upper Deck, for instance, pays sports celebrities such as Aaron Rodgers of the Green Bay Packers to sign memorabilia, which are offered to shopping networks on consignment. Upper Deck, the con- signor, must report these items in its inventory until sold.

Goods Damaged or Obsolete Damaged and obsolete (and deteriorated) goods are not counted in inventory if they cannot be sold. If these goods can be sold at a reduced price, they are included in inventory at a conservative estimate of their net realizable value. Net realizable value is sales price minus the cost of making the sale. The period when damage or obsolescence (or deterioration) occurs is the period when the loss in value is reported.

C1 Identify the items making up merchandise inventory.

INVENTORY BASICS

Inventories and Cost of Sales

Inventory Costing under a Perpetual System

• Cost flow assumptions • Specific identification • First-in, first-out • Last-in, first-out • Weighted average • Financial statement

effects

Inventory Basics

• Determining inventory items

• Determining inventory costs

• Internal control of inventory

• Taking a physical count

Inventory Valuation and Errors

• Inventory valuation at lower of cost or market

• Financial statement effects of inventory errors

Point: FOB shipping point is also called FOB origin or FOB supplier’s warehouse.

210

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Chapter 5 Inventories and Cost of Sales 211

Point: The Inventory account is a con- trolling account for the inventory subsid- iary ledger. This subsidiary ledger contains a separate record (units and costs) for each separate product, and it can be in electronic or paper form. Subsidiary records assist managers in planning and monitoring inventory.

Fraud: Auditors commonly observe employees as they take a physical inventory. Auditors take their own test counts to monitor the accuracy of a company’s count.

Determining Inventory Costs Merchandise inventory includes costs of expenditures necessary, directly or indirectly, to bring an item to a salable condition and location. This means that the cost of an inventory item in- cludes its invoice cost minus any discount, and plus any incidental costs necessary to put it in a place and condition for sale. Incidental costs can include import tariffs, freight, storage, insur- ance, and costs incurred in an aging process (for example, aging wine or cheese). Accounting principles prescribe that incidental costs be added to inventory. Also, the match- ing (expense recognition) principle states that inventory costs should be recorded against reve- nue in the period when inventory is sold. However, some companies use the materiality constraint (cost-to- benefit constraint) to avoid assigning some incidental costs of acquiring merchandise to inventory. Instead, they expense them to cost of goods sold when incurred. These companies argue either that those incidental costs are immaterial or that the effort in as- signing them outweighs the benefit.

Internal Controls and Taking a Physical Count Events can cause the Inventory account balance to differ from the actual inventory available. Such events include theft, loss, damage, and errors. Thus, nearly all companies take a physical count of inventory at least once each year—informally called taking an inventory. This often occurs at the end of a fiscal year or when inventory amounts are low. This physical count is used to adjust the Inventory account balance to the actual inventory available. A company applies internal controls when taking a physical count of inventory that usually include the following procedures to minimize fraud and to increase reliability:

● Prenumbered inventory tickets are prepared and distributed to the counters—each ticket must be accounted for.

● Counters of inventory are assigned and do not include those responsible for inventory. ● Counters confirm the validity of inventory, including its existence, amount, and quality. ● A second count is taken by a different counter. ● A manager confirms that all inventories are ticketed once, and only once.

C2 Identify the costs of merchandise inventory.

1. What accounting principle most guides the allocation of cost of goods available for sale between ending inventory and cost of goods sold?

2. If Skechers sells goods to Famous Footwear with terms FOB shipping point, which company reports these goods in its inventory while they are in transit?

3. An art gallery purchases a painting for $11,400 on terms FOB shipping point. Additional costs in obtaining and offering the artwork for sale include $130 for transportation-in, $150 for import tariffs, $100 for insurance during shipment, $180 for advertising, $400 for framing, and $800 for office salaries. In computing inventory, what cost is assigned to the painting?

Quick Check Answers — p. 237

Accounting for inventory affects both the balance sheet and the income statement. A major goal in accounting for inventory is to properly match costs with sales. We use the expense rec- ognition (or matching) principle to decide how much of the cost of the goods available for sale

INVENTORY COSTING UNDER A PERPETUAL SYSTEM

Decision Insight

A wireless portable device with a two-way radio allows clerks to quickly record inventory by scanning bar codes and to instantly send and receive inventory data. It gives managers access to up-to-date information on inven- tory and its location. ■

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212 Chapter 5 Inventories and Cost of Sales

is deducted from sales and how much is carried forward as inventory and matched against future sales. Management decisions in accounting for inventory involve the following:

● Items included in inventory and their costs. ● Costing method (specific identification, FIFO, LIFO, or weighted average). ● Inventory system (perpetual or periodic). ● Use of market values or other estimates.

The first point was explained on the prior two pages. The second and third points will be ad- dressed now. The fourth point is the focus at the end of this chapter. Decisions on these points affect the reported amounts for inventory, cost of goods sold, gross profit, income, current assets, and other accounts. One of the most important issues in accounting for inventory is determining the per unit costs assigned to inventory items. When all units are purchased at the same unit cost, this process is simple. When identical items are purchased at different costs, however, a question arises as to which amounts to record in cost of goods sold and which amounts remain in inventory.

Four methods are commonly used to assign costs to inventory and to cost of goods sold: (1) specific identification; (2) first-in, first-out; (3) last-in, first-out; and (4) weighted average.

Exhibit 5.1 shows the frequency in the use of these methods.

Each method assumes a particular pattern for how costs flow through inventory. Each of these four meth- ods is acceptable whether or not the actual physical flow of goods follows the cost flow assumption. Phys- ical flow of goods depends on the type of product and the way it is stored. (Perishable goods such as fresh fruit demand that a business attempt to sell them in a first-in, first-out physical flow. Other products such as crude oil and minerals such as coal, gold, and decora-

tive stone can be sold in a last-in, first-out physical flow.) Physical flow and cost flow need not be the same.

Inventory Cost Flow Assumptions This section introduces inventory cost flow assumptions. For this purpose, assume that three identical units are purchased separately at the following three dates and costs: May 1 at $45, May 3 at $65, and May 6 at $70. One unit is then sold on May 7 for $100. Exhibit 5.2 gives a visual layout of the flow of costs to either the gross profit section of the income statement or the inventory reported on the balance sheet for FIFO, LIFO, and weighted average. (1) FIFO assumes costs flow in the order incurred. The unit purchased on May 1 for $45 is the earliest cost incurred — it is sent to cost of goods sold on the income statement first. The remaining two units ($65 and $70) are reported in inventory on the balance sheet. (2) LIFO assumes costs flow in the reverse order incurred. The unit purchased on May 6 for $70 is the most recent cost incurred — it is sent to cost of goods sold on the income statement. The remaining two units ($45 and $65) are reported in inventory on the balance sheet. (3) Weighted average assumes costs flow at an average of the costs available. The units available at the May 7 sale average $60 in cost, computed as ($45 1 $65 1 $70)y3. One unit’s $60 average cost is sent to cost of goods sold on the income statement. The remaining two units’ average costs are reported in inventory at $120 on the balance sheet. Cost flow assumptions can markedly impact gross profit and inventory numbers. Exhibit 5.2 shows that gross profit as a percent of net sales ranges from 30% to 55% due to nothing else but the cost flow assumption.

Point: It is helpful to recall the cost flow of inventory from Exhibit 4.4.

� Merchandise available for sale

Cost of goods sold

Net purchases

Beginning inventory

Ending inventory

EXHIBIT 5.1 Frequency in Use of Inventory Methods

Weighted Average 20%

*Includes specific identification.

Other* 3%

FIFO 50%

LIFO 27%

The following sections on inventory costing use the perpetual system. Appendix 5A uses the periodic system. An instructor can choose to cover either one or both systems. If the perpetual system is skipped, then read Appendix 5A and return to the Decision Maker box (on page 218) titled “Cost Analyst.”

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Chapter 5 Inventories and Cost of Sales 213

Trekking uses the perpetual inventory system, which means that its merchandise inventory account is continually updated to reflect purchases and sales. (Appendix 5A describes the assignment of costs to inventory using a periodic system.) Regardless of what inventory method or system is used, cost of goods available for sale must be allocated between cost of goods sold and ending inventory.

Specific Identification When each item in inventory can be identified with a specific purchase and invoice, we can use specific identification (also called specific invoice inventory pricing) to assign costs. We also need sales records that identify exactly which items were sold and when. Trekking’s internal documents reveal the following specific unit sales:

August 14 Sold 8 bikes costing $91 each and 12 bikes costing $106 each August 31 Sold 2 bikes costing $91 each, 3 bikes costing $106 each, 15 bikes

costing $115 each, and 3 bikes costing $119 each

Point: The perpetual inventory system is the most dominant system for U.S. businesses.

Point: Beginning inventory units plus purchased units equals units available for sale (UAFS).

$180 3

� $60 each

⎫ ⎬ ⎭

⎫ ⎬ ⎭

2. Last-in, first-out (LIFO) Costs flow in the reverse

order incurred.

3. Weighted average Costs flow at an average

of costs available.

1. First-in, first-out (FIFO) Costs flow in the order

incurred.

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎬ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭ � 2� 1

Income Statement

Net sales.................. $100

Cost of goods sold.. 45

Gross profit.............. $ 55

Balance Sheet

Inventory.................. $135

Income Statement

Net sales.................. $100

Cost of goods sold.. 70

Gross profit.............. $ 30

Balance Sheet

Inventory.................. $110

Income Statement

Net sales.................. $100

Cost of goods sold.. 60

Gross profit.............. $ 40

Balance Sheet

Inventory.................. $120

$65 May 3

$45 May 1

G o o d s

s o l d

G o o d s

s o l d

G o o d s

s o l d

G o o d s

l e f t

G o o d s

l e f t

G o o d s

l e f t

$70 May 6

$65 May 3

$45 May 1

$70 May 6

$70 May 6

$65 May 3

$45 May 1

EXHIBIT 5.2 Cost Flow Assumptions

Inventory Costing Illustration This section provides a comprehensive illustration of inventory costing methods. We use infor- mation from Trekking, a sporting goods store. Among its many products, Trekking carries one type of mountain bike whose sales are directed at resorts that provide inexpensive mountain bikes for complimentary guest use. Its customers usually purchase in amounts of 10 or more bikes. We use Trekking’s data from August. Its mountain bike (unit) inventory at the beginning of August and its purchases and sales during August are shown in Exhibit 5.3. It ends August with 12 bikes remaining in inventory.

P1 Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average.

EXHIBIT 5.3 Purchases and Sales of Goods

Date Activity Units Acquired at Cost Units Sold at Retail Unit Inventory

Aug. 1 Beginning inventory . . . . 10 units @ $ 91 5 $ 910 10 units

Aug. 3 Purchases . . . . . . . . . . . . 15 units @ $106 5 $ 1,590 25 units

Aug. 14 Sales . . . . . . . . . . . . . . . . 20 units @ $130 5 units

Aug. 17 Purchases . . . . . . . . . . . . 20 units @ $115 5 $ 2,300 25 units

Aug. 28 Purchases . . . . . . . . . . . . 10 units @ $119 5 $ 1,190 35 units

Aug. 31 Sales . . . . . . . . . . . . . . . . 23 units @ $150 12 units

Totals . . . . . . . . . . . . . . 55 units $5,990 43 units

Units available for sale Goods available for sale Units sold Units left

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214 Chapter 5 Inventories and Cost of Sales

Applying specific identification, and using the information above and from Exhibit 5.3, we pre- pare Exhibit 5.4. This exhibit starts with 10 bikes at $91 each in beginning inventory. On August 3, 15 more bikes are purchased at $106 each for $1,590. Inventory available now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500. On August 14 (see sales data on previous page), 20 bikes costing $2,000 are sold—leaving 5 bikes costing $500 in inventory. On August 17, 20 bikes costing $2,300 are purchased, and on August 28, another 10 bikes costing $1,190 are purchased, for a total of 35 bikes costing $3,990 in inventory. On August 31 (see sales data on previous page), 23 bikes costing $2,582 are sold, which leaves 12 bikes costing $1,408 in ending inventory. Carefully study this exhibit and the boxed explana- tions to see the flow of costs both in and out of inventory. Each unit, whether sold or remaining in inventory, has its own specific cost attached to it.

When using specific identification, Trekking’s cost of goods sold reported on the income statement totals $4,582, the sum of $2,000 and $2,582 from the third column of Exhibit 5.4. Trekking’s ending inventory reported on the balance sheet is $1,408, which is the final inventory balance from the fourth column of Exhibit 5.4. The purchases and sales entries for Exhibit 5.4 follow (the colored boldface numbers are those impacted by the cost flow assumption):

Point: Specific identification is usually practical for companies with expensive or custom-made inventory. Examples include car dealerships, implement dealers, jewelers, and fashion designers.

Purchases

Aug. 3 Merchandise Inventory . . . . . . . . . 1,590

Accounts Payable . . . . . . . . . 1,590

17 Merchandise Inventory . . . . . . . . . 2,300

Accounts Payable . . . . . . . . . 2,300

28 Merchandise Inventory . . . . . . . . . 1,190

Accounts Payable . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . 2,600

Sales . . . . . . . . . . . . . . . . . . 2,600

14 Cost of Goods Sold . . . . . . . . . . 2,000

Merchandise Inventory . . . . 2,000

31 Accounts Receivable . . . . . . . . . 3,450

Sales . . . . . . . . . . . . . . . . . . 3,450

31 Cost of Goods Sold . . . . . . . . . . 2,582

Merchandise Inventory . . . . 2,582

Point: Three key variables determine the value assigned to ending inventory: (1) inventory quantity, (2) unit costs of inventory, and (3) cost flow assumption.

EXHIBIT 5.4 Specific Identification Computations

For the 20 units sold on Aug. 14, the company specifically identified that 8 of those had cost $91 and 12 had cost $106.

T

“goods in” “goods out” “what’s left”

DFor the 23 units sold on Aug. 31, the company specifically identified each bike sold and its acquisition cost from prior purchases.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug. 1 Beginning balance 10 @ $ 91 5

$ 910

Aug. 3 15 @ $106 5 $1,590 10 @ $ 91

15 @ $106 5 $2,500

Aug. 14 8 @ $ 91 5 $ 728 2 @ $ 91

12 @ $106 5 $1,272 5 $2,000*

3 @ $106 5 $ 500

Aug. 17 20 @ $115 5 $2,300 2 @ $ 91

3 @ $106 5 $2,800

20 @ $115

Aug. 28 10 @ $119 5 $1,190 2 @ $ 91

3 @ $106

20 @ $115 5 $3,990

10 @ $119

Aug. 31 2 @ $ 91 5 $ 182

3 @ $106 5 $ 318 5 @ $115

15 @ $115 5 $1,725 5 $2,582*

7 @ $119 5 $1,408

3 @ $119 5 $ 357

$4,582

* Identification of items sold (and their costs) is obtained from internal documents that track each unit from its purchase to its sale.

r

t

r r s t r

Point: The assignment of costs to the goods sold and to inventory using spe- cific identification is the same for both the perpetual and periodic systems.

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Chapter 5 Inventories and Cost of Sales 215

First-In, First-Out The first-in, first-out (FIFO) method of assigning costs to both inventory and cost of goods sold assumes that inventory items are sold in the order acquired. When sales occur, the costs of the earliest units acquired are charged to cost of goods sold. This leaves the costs from the most recent purchases in ending inventory. Use of FIFO for computing the cost of inventory and cost of goods sold is shown in Exhibit 5.5. This exhibit starts with beginning inventory of 10 bikes at $91 each. On August 3, 15 more bikes costing $106 each are bought for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500. On August 14, 20 bikes are sold—applying FIFO, the first 10 sold cost $91 each and the next 10 sold cost $106 each, for a total cost of $1,970. This leaves 5 bikes costing $106 each, or $530, in inventory. On August 17, 20 bikes costing $2,300 are purchased, and on August 28, another 10 bikes costing $1,190 are purchased, for a total of 35 bikes costing $4,020 in inventory. On August 31, 23 bikes are sold— applying FIFO, the first 5 bikes sold cost $530 and the next 18 sold cost $2,070, which leaves 12 bikes costing $1,420 in ending inventory.

Last-In, First-Out The last-in, first-out (LIFO) method of assigning costs assumes that the most recent purchases are sold first. These more recent costs are charged to the goods sold, and the costs of the earliest purchases are assigned to inventory. As with other methods, LIFO is acceptable even when the

Trekking’s FIFO cost of goods sold reported on its income statement (reflecting the 43 units sold) is $4,570 ($1,970 1 $2,600), and its ending inventory reported on the balance sheet (re- flecting the 12 units unsold) is $1,420. The purchases and sales entries for Exhibit 5.5 follow (the colored boldface numbers are those affected by the cost flow assumption).

Point: Under FIFO, a unit sold is assigned the earliest (oldest) cost from inventory. This leaves the most recent costs in ending inventory.

Purchases

Aug. 3 Merchandise Inventory . . . . . . . . . 1,590

Accounts Payable . . . . . . . . . 1,590

17 Merchandise Inventory . . . . . . . . . 2,300

Accounts Payable . . . . . . . . . 2,300

28 Merchandise Inventory . . . . . . . . . 1,190

Accounts Payable . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . 2,600

Sales . . . . . . . . . . . . . . . . . . 2,600

14 Cost of Goods Sold . . . . . . . . . . 1,970

Merchandise Inventory . . . . 1,970

31 Accounts Receivable . . . . . . . . . 3,450

Sales . . . . . . . . . . . . . . . . . . 3,450

31 Cost of Goods Sold . . . . . . . . . . 2,600

Merchandise Inventory . . . . 2,600

Point: The “Goods Purchased” column is identical for all methods. Data are taken from Exhibit 5.3.

EXHIBIT 5.5 FIFO Computations — Perpetual System

R

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug. 1 Beginning balance 10 @ $ 91 5 $ 910

Aug. 3 15 @ $106 5 $1,590 10 @ $ 91

15 @ $106 5 $2,500

Aug. 14 10 @ $ 91 5 $ 910

10 @ $106 5 $1,060 5 $1,970 5 @

$106 5 $ 530

Aug. 17 20 @ $115 5 $2,300 5 @ $106

20 @ $115 5 $2,830

Aug. 28 10 @ $119 5 $1,190 5 @ $106

20 @ $115 5 $4,020

10 @ $119

Aug. 31 5 @ $106 5 $ 530 2 @ $115

18 @ $115 5 $2,070 5 $2,600

10 @ $119 5 $1,420

$4,570

r

r

r

r s r

For the 20 units sold on Aug. 14, the first 10 sold are assigned the earliest cost of $91 (from beg. bal.). The next 10 sold are assigned the next earliest cost of $106.

T

For the 23 units sold on Aug. 31, the first 5 sold are assigned the earliest available cost of $106 (from Aug. 3 purchase). The next 18 sold are assigned the next earliest cost of $115 (from Aug. 17 purchase).

Point: LOSH (last ones still here) can help remember what costs are in FIFO ending inventory.

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216 Chapter 5 Inventories and Cost of Sales

physical flow of goods does not follow a last-in, first-out pattern. One appeal of LIFO is that by assigning costs from the most recent purchases to cost of goods sold, LIFO comes closest to matching current costs of goods sold with revenues (compared to FIFO or weighted average). Exhibit 5.6 shows the LIFO computations. It starts with beginning inventory of 10 bikes at $91 each. On August 3, 15 more bikes costing $106 each are bought for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500. On August 14, 20 bikes are sold—applying LIFO, the first 15 sold are from the most recent purchase costing $106 each, and the next 5 sold are from the next most recent purchase costing $91 each, for a total cost of $2,045. This leaves 5 bikes costing $91 each, or $455, in inventory. On August 17, 20 bikes costing $2,300 are purchased, and on August 28, another 10 bikes costing $1,190 are purchased, for a total of 35 bikes costing $3,945 in inventory. On August 31, 23 bikes are sold—applying LIFO, the first 10 bikes sold are from the most recent purchase costing $1,190, and the next 13 sold are from the next most recent purchase costing $1,495, which leaves 12 bikes costing $1,260 in ending inventory.

EXHIBIT 5.6 LIFO Computations— Perpetual System

R

For the 20 units sold on Aug. 14, the first 15 sold are assigned the most recent cost of $106. The next 5 sold are assigned the next most recent cost of $91.

T

For the 23 units sold on Aug. 31, the first 10 sold are assigned the most recent cost of $119. The next 13 sold are assigned the next most recent cost of $115.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug. 1 Beginning balance 10 @ $ 91 5 $ 910

Aug. 3 15 @ $106 5 $1,590 10 @ $ 91

15 @ $106 5 $ 2,500

Aug. 14 15 @ $106 5 $1,590

5 @ $ 91 5 $ 455 5 $2,045 5 @ $ 91 5 $ 455

Aug. 17 20 @ $115 5 $2,300 5 @ $ 91

20 @ $115 5 $ 2,755

Aug. 28 10 @ $119 5 $1,190 5 @ $ 91

20 @ $115 5 $ 3,945

10 @ $119

Aug. 31 10 @ $119 5 $1,190 5 @ $ 91

13 @ $115 5 $1,495 5 $2,685

7 @ $115 5 $1,260

$4,730

Trekking’s LIFO cost of goods sold reported on the income statement is $4,730 ($2,045 1 $2,685), and its ending inventory reported on the balance sheet is $1,260. The purchases and sales entries for Exhibit 5.6 follow (the colored boldface numbers are those affected by the cost flow assumption).

Purchases

Aug. 3 Merchandise Inventory . . . . . . . . . 1,590

Accounts Payable . . . . . . . . . 1,590

17 Merchandise Inventory . . . . . . . . . 2,300

Accounts Payable . . . . . . . . . 2,300

28 Merchandise Inventory . . . . . . . . . 1,190

Accounts Payable . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . 2,600

Sales . . . . . . . . . . . . . . . . . . 2,600

14 Cost of Goods Sold . . . . . . . . . . 2,045

Merchandise Inventory . . . . 2,045

31 Accounts Receivable . . . . . . . . . 3,450

Sales . . . . . . . . . . . . . . . . . . 3,450

31 Cost of Goods Sold . . . . . . . . . . 2,685

Merchandise Inventory . . . . 2,685

Weighted Average The weighted average (also called average cost) method of assigning cost requires that we use the weighted average cost per unit of inventory at the time of each sale. Weighted average cost per unit at the time of each sale equals the cost of goods available for sale divided by the units avail- able. The results using weighted average (WA) for Trekking are shown in Exhibit 5.7. This exhibit starts with beginning inventory of 10 bikes at $91 each. On August 3, 15 more bikes costing $106 each are bought for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500. The average cost per bike for that inventory is $100, computed as $2,500y(10 bikes 1 15 bikes). On August 14, 20 bikes are sold— applying

Point: Under LIFO, a unit sold is assigned the most recent (latest) cost from inventory. This leaves the oldest costs in inventory.

Point: FOSH (first ones still here) can help remember what costs are in LIFO ending inventory.

Point: Grocers prefer a FIFO physical flow of milk cartons. Consumers prefer a LIFO flow as they desire a long refrigerator life and reach for recently stocked milk. However, the cost flow in accounting need not match the physical flow in the store.

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Chapter 5 Inventories and Cost of Sales 217

WA, the 20 sold are assigned the $100 average cost, for a total cost of $2,000. This leaves 5 bikes with an average cost of $100 each, or $500, in inventory. On August 17, 20 bikes cost- ing $2,300 are purchased, and on August 28, another 10 bikes costing $1,190 are purchased, for a total of 35 bikes costing $3,990 in inventory at August 28. The average cost per bike for the August 28 inventory is $114, computed as $3,990y(5 bikes 1 20 bikes 1 10 bikes). On August 31, 23 bikes are sold—applying WA, the 23 sold are assigned the $114 average cost, for a total cost of $2,622. This leaves 12 bikes costing $1,368 in ending inventory. Trekking’s cost of goods sold reported on the income statement (reflecting the 43 units sold) is $4,622 ($2,000 1 $2,622), and its ending inventory reported on the balance sheet (reflecting the 12 units unsold) is $1,368. The purchases and sales entries for Exhibit 5.7 follow (the colored boldface numbers are those affected by the cost flow assumption).

Point: Under weighted average, a unit sold is assigned the average cost of all items currently available for sale at the date of each sale. This means a new average cost is computed after each purchase.

Point: Cost of goods available for sale (COGAFS), units available for sale (UAFS), and units in ending inventory are identical for all methods.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug. 1 Beginning balance 10 @ $ 91 5 $ 910

Aug. 3 15 @ $106 5 $1,590 10 @ $ 91

15 @ $106 5 $2,500 (or $100 per unit)a

Aug. 14 20 @ $100 5 $2,000 5 @ $100 5 $ 500 (or $100 per unit)b

Aug. 17 20 @ $115 5 $2,300 5 @ $100

20 @ $115 5 $2,800 (or $112 per unit)c

Aug. 28 10 @ $119 5 $1,190 5 @ $100

20 @ $115 5 $3,990 (or $114 per unit)d

10 @ $119

Aug. 31 23 @ $114 5 $2,622 12 @ $114 5 $1,368 (or $114 per unit)e

$4,622

a $100 per unit 5 ($2,500 inventory balance 4 25 units in inventory). b $100 per unit 5 ($500 inventory balance 4 5 units in inventory). c $112 per unit 5 ($2,800 inventory balance 4 25 units in inventory). d $114 per unit 5 ($3,990 inventory balance 4 35 units in inventory). e $114 per unit 5 ($1,368 inventory balance 4 12 units in inventory).

EXHIBIT 5.7 Weighted Average Computations—Perpetual System

↓ For the 20 units sold on Aug. 14, the cost assigned is the $100 average cost per unit from the inventory balance column at the time of sale.

For the 23 units sold on Aug. 31, the cost assigned is the $114 average cost per unit from the inventory balance column at the time of sale.

This completes computations under the four most common perpetual inventory costing methods. Advances in technology have greatly reduced the cost of a perpetual inventory system. Many companies now ask whether they can afford not to have a perpetual inventory system because timely access to inventory information is a competitive advantage and it can help reduce the amount of inventory, which reduces costs.

Purchases

Aug. 3 Merchandise Inventory . . . . . . . . . 1,590 Accounts Payable . . . . . . . . . 1,590 17 Merchandise Inventory . . . . . . . . . 2,300 Accounts Payable . . . . . . . . . 2,300 28 Merchandise Inventory . . . . . . . . . 1,190 Accounts Payable . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . 2,600 Sales . . . . . . . . . . . . . . . . . . 2,600 14 Cost of Goods Sold . . . . . . . . . . 2,000 Merchandise Inventory . . . . 2,000 31 Accounts Receivable . . . . . . . . . 3,450 Sales . . . . . . . . . . . . . . . . . . 3,450 31 Cost of Goods Sold . . . . . . . . . . 2,622 Merchandise Inventory . . . . 2,622

Inventory Control Inventory safeguards include restricted access, use of authorized requisitions, security measures, and controlled environments to prevent damage. Proper accounting includes matching inventory received with purchase order terms and quality requirements, preventing misstatements, and controlling access to inventory records. A study reports that 23% of employees in purchasing and procurement observed inappropriate kickbacks or gifts from suppliers. Another study reports that submission of fraudulent supplier invoices is now common, and perpetrators are often employees (KPMG 2011). ■

Decision Insight

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218 Chapter 5 Inventories and Cost of Sales

EXHIBIT 5.8 Financial Statement Effects of Inventory Costing Methods

TREKKING COMPANY

For Month Ended August 31

Specific Weighted

Identification FIFO LIFO Average

Income Statement

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,050 $ 6,050 $ 6,050 $ 6,050

Cost of goods sold . . . . . . . . . . . . . 4,582 4,570 4,730 4,622

Gross profit . . . . . . . . . . . . . . . . . . 1,468 1,480 1,320 1,428

Expenses . . . . . . . . . . . . . . . . . . . . . . . 450 450 450 450

Income before taxes . . . . . . . . . . . . . . 1,018 1,030 870 978

Income tax expense (30%) . . . . . . . . . 305 309 261 293

Net income . . . . . . . . . . . . . . . . . . . $ 713 $ 721 $ 609 $ 685

Balance Sheet

Inventory . . . . . . . . . . . . . . . . . . . . . $1,408 $1,420 $1,260 $1,368

Financial Statement Effects of Costing Methods When purchase prices do not change, each inventory costing method assigns the same cost amounts to inventory and to cost of goods sold. When purchase prices are different, how- ever, the methods nearly always assign different cost amounts. We show these differences in Exhibit 5.8 using Trekking’s data.

A1 Analyze the effects of inventory methods for both financial and tax reporting.

Point: LIFO inventory is often less than the inventory’s replacement cost because LIFO inventory is valued using the oldest inventory purchase costs.

Point: Managers prefer FIFO when costs are rising and incentives exist to report higher income for reasons such as bonus plans, job security, and reputation.

This exhibit reveals two important results. First, when purchase costs regularly rise, as in Trekking’s case, the following occurs:

● FIFO assigns the lowest amount to cost of goods sold — yielding the highest gross profit and net income.

● LIFO assigns the highest amount to cost of goods sold — yielding the lowest gross profit and net income, which also yields a temporary tax advantage by postponing payment of some income tax.

● Weighted average yields results between FIFO and LIFO. ● Specific identification always yields results that depend on which units are sold.

Second, when costs regularly decline, the reverse occurs for FIFO and LIFO. Namely, FIFO gives the highest cost of goods sold—yielding the lowest gross profit and income. However, LIFO then gives the lowest cost of goods sold—yielding the highest gross profit and income. All four inventory costing methods are acceptable. However, a company must disclose the inventory method it uses in its financial statements or notes. Each method offers certain advan- tages as follows:

● FIFO assigns an amount to inventory on the balance sheet that approximates its current cost; it also mimics the actual flow of goods for most businesses.

● LIFO assigns an amount to cost of goods sold on the income statement that approximates its current cost; it also better matches current costs with revenues in computing gross profit.

● Weighted average tends to smooth out erratic changes in costs. ● Specific identification exactly matches the costs of items with the revenues they generate.

Tax Effects of Costing Methods Trekking’s segment income statement in Exhibit 5.8 includes income tax expense (at a rate of 30%) because it was formed as a corporation. Since

Cost Analyst Your supervisor says she finds managing product costs easier if the balance sheet reflects inventory values that closely reflect replacement cost. Which inventory costing method do you advise adopting? ■ [Answer—p. 236]

Decision Maker

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Chapter 5 Inventories and Cost of Sales 219

inventory costs affect net income, they have potential tax effects. Trekking gains a temporary tax advantage by using LIFO. Many companies use LIFO for this reason.

Companies can and often do use different costing methods for financial reporting and tax report- ing. The only exception is when LIFO is used for tax reporting; in this case, the IRS requires that it also be used in financial statements—called the LIFO conformity rule.

Consistency in Using Costing Methods The consistency concept prescribes that a company use the same accounting methods period after period so that financial statements are comparable across periods — the only exception is when a change from one method to another will improve its financial reporting. The full- disclosure principle prescribes that the notes to the statements report this type of change, its justification, and its effect on income. The consistency concept does not require a company to use one method exclusively. For example, it can use different methods to value different categories of inventory.

4. Describe one advantage for each of the inventory costing methods: specific identification, FIFO, LIFO, and weighted average.

5. When costs are rising, which method reports higher net income—LIFO or FIFO? 6. When costs are rising, what effect does LIFO have on a balance sheet compared to FIFO? 7. A company takes a physical count of inventory at the end of 2012 and finds that ending

inventory is understated by $10,000. Would this error cause cost of goods sold to be overstated or understated in 2012? In year 2013? If so, by how much?

Quick Check Answers — p. 237

This section examines the role of market costs in determining inventory on the balance sheet and also the financial statement effects of inventory errors.

Lower of Cost or Market We explained how to assign costs to ending inventory and cost of goods sold using one of four costing methods (FIFO, LIFO, weighted average, or specific identification). However, account- ing principles require that inventory be reported at the market value (cost) of replacing inven- tory when market value is lower than cost. Merchandise inventory is then said to be reported on the balance sheet at the lower of cost or market (LCM).

Computing the Lower of Cost or Market Market in the term LCM is defined as the current replacement cost of purchasing the same inventory items in the usual manner. A decline in replacement cost reflects a loss of value in inventory. When the recorded cost of inventory is higher than the replacement cost, a loss is recognized. When the recorded cost is lower, no ad- justment is made. LCM is applied in one of three ways: (1) to each individual item separately, (2) to major categories of items, or (3) to the whole of inventory. The less similar the items that make up inventory, the more likely companies are to apply LCM to individual items or categories. With the increasing application of technology and inventory tracking, companies increasingly apply

VALUING INVENTORY AT LCM AND THE EFFECTS OF INVENTORY ERRORS

P2 Compute the lower of cost or market amount of inventory.

Point: LIFO conformity rule may be revised if IFRS is adopted for U.S. companies as IFRS currently does not permit LIFO (see Global View).

Inventory Manager Your compensation as inventory manager includes a bonus plan based on gross profit. Your superior asks your opinion on changing the inventory costing method from FIFO to LIFO. Since costs are expected to continue to rise, your superior predicts that LIFO would match higher current costs against sales, thereby lowering taxable income (and gross profit). What do you recommend? ■ [Answer—p. 236]

Decision Ethics

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220 Chapter 5 Inventories and Cost of Sales

EXHIBIT 5.9 Lower of Cost or Market Computations

Inventory Per Unit

Total Total

LCM Applied

Items Units Cost Market Cost Market to Items

Cycles

Roadster . . . . . . . . . 20 $8,000 $7,000 $160,000 $140,000 $ 140,000

Sprint . . . . . . . . . . . 10 5,000 6,000 50,000 60,000 50,000

Off-Road

Trax-4 . . . . . . . . . . . 8 5,000 6,500 40,000 52,000 40,000

Blazer . . . . . . . . . . . 5 9,000 7,000 45,000 35,000 35,000

Totals . . . . . . . . . . . . $295,000 $265,000

$140,000 is the lower of $160,000 or $140,000

Market amount of $265,000 is lower than the $295,000 recorded cost

Point: Advances in technology encourage the individual-item approach for LCM.

Global: IFRS requires LCM applied to individual items; this results in the most conservative inventory amount.

LCM to each individual item separately. Accordingly, we show that method only; however, advanced courses cover the other two methods. To illustrate LCM, we apply it to the ending inventory of a motorsports retailer in Exhibit 5.9.

LCM Applied to Individual Items When LCM is applied to individual items of inventory, the number of comparisons equals the number of items. For Roadster, $140,000 is the lower of the $160,000 cost and the $140,000 market. For Sprint, $50,000 is the lower of the $50,000 cost and the $60,000 market. For Trax-4, $40,000 is the lower of the $40,000 cost and the $52,000 market. For Blazer, $35,000 is the lower of the $45,000 cost and the $35,000 market. This yields a $265,000 reported inventory, computed from $140,000 for Roadster plus $50,000 for Sprint plus $40,000 for Trax-4 plus $35,000 for Blazer. The retailer The Buckle applies LCM and reports that its “inventory is stated at the lower of cost or market. Cost is determined using the average cost method.”

Recording the Lower of Cost or Market Inventory must be adjusted downward when market is less than cost. To illustrate, if LCM is applied to the individual items of inventory in Exhibit 5.9, the Merchandise Inventory account must be adjusted from the $295,000 recorded cost down to the $265,000 market amount as follows.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 30,000

To adjust inventory cost to market.

Beginning inventory

Net purchases

Ending inventory

Cost of goods sold� � �

Accounting rules require that inventory be adjusted to market when market is less than cost, but inventory normally cannot be written up to market when market exceeds cost. If recording in- ventory down to market is acceptable, why are companies not allowed to record inventory up to market? One view is that a gain from a market increase should not be realized until a sales trans- action verifies the gain. However, this view also applies when market is less than cost. A second and primary reason is the conservatism constraint, which prescribes the use of the less opti- mistic amount when more than one estimate of the amount to be received or paid exists and these estimates are about equally likely.

Financial Statement Effects of Inventory Errors Companies must take care in both taking a physical count of inventory and in assigning a cost to it. An inventory error causes misstatements in cost of goods sold, gross profit, net income, cur- rent assets, and equity. It also causes misstatements in the next period’s statements because end- ing inventory of one period is the beginning inventory of the next. As we consider the financial statement effects in this section, it is helpful if we recall the following inventory relation.

A2 Analyze the effects of inventory errors on current and future financial statements.

Income Statement Effects Exhibit 5.10 shows the effects of inventory errors on key amounts in the current and next periods’ income statements. Let’s look at row 1 and year 1. We

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Chapter 5 Inventories and Cost of Sales 221

see that understating ending inventory overstates cost of goods sold. This can be seen from the above inventory relation where we subtract a smaller ending inventory amount in computing cost of goods sold. Then a higher cost of goods sold yields a lower income. To understand year 2 of row 1, remember that an understated ending inventory for year 1 becomes an understated beginning inventory for year 2. Using the above inventory relation, we see that if beginning inventory is understated, then cost of goods sold is understated (because we are starting with a smaller amount). A lower cost of goods sold yields a higher income. Turning to overstatements, let’s look at row 2 and year 1. If ending inventory is overstated, we use the inventory relation to see that cost of goods sold is understated. A lower cost of goods sold yields a higher income. For year 2 of row 2, we again recall that an overstated ending inventory for year 1 becomes an overstated beginning inventory for year 2. If beginning inventory is overstated, we use the inventory relation to see that cost of goods sold is overstated. A higher cost of goods sold yields a lower income.

EXHIBIT 5.10 Effects of Inventory Errors on the Income Statement

Year 1 Year 2

Ending Inventory Cost of Goods Sold Net Income Cost of Goods Sold Net Income

Understated . . . . . . . . . Overstated Understated Understated Overstated

Overstated* . . . . . . . . . Understated Overstated Overstated Understated

* This error is less likely under a perpetual system versus a periodic because it implies more inventory than is recorded (or less shrinkage than expected). Management will normally follow up and discover and correct this error before it impacts any accounts.

To illustrate, consider an inventory error for a company with $100,000 in sales for each of the years 2012, 2013, and 2014. If this company maintains a steady $20,000 inventory level during this period and makes $60,000 in purchases in each of these years, its cost of goods sold is $60,000 and its gross profit is $40,000 each year.

Ending Inventory Understated—Year 1 Assume that this company errs in computing its 2012 ending inventory and reports $16,000 instead of the correct amount of $20,000. The effects of this error are shown in Exhibit 5.11. The $4,000 understatement of 2012 ending inventory causes a $4,000 overstatement in 2012 cost of goods sold and a $4,000 understatement in both gross profit and net income for 2012. We see that these effects match the effects predicted in Exhibit 5.10.

EXHIBIT 5.11 Effects of Inventory Errors on Three Periods’ Income Statements

Income Statements

2012 2013 2014

Sales . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000 $100,000

Cost of goods sold

Beginning inventory . . . . . . . . $20,000 $16,000* $20,000

Cost of goods purchased . . . . . 60,000 60,000 60,000

Goods available for sale . . . . . 80,000 76,000 80,000

Ending inventory . . . . . . . . . . . 16,000* 20,000 20,000

Cost of goods sold . . . . . . . . . 64,000† 56,000† 60,000

Gross profit . . . . . . . . . . . . . . . . . 36,000 44,000 40,000

Expenses . . . . . . . . . . . . . . . . . . . 10,000 10,000 10,000

Net income . . . . . . . . . . . . . . . . . $ 26,000 $ 34,000 $ 30,000

* Correct amount is $20,000. † Correct amount is $60,000.

Ending Inventory Understated—Year 2 The 2012 understated ending inventory becomes the 2013 understated beginning inventory. We see in Exhibit 5.11 that this error causes an understatement in 2013 cost of goods sold and a $4,000 overstatement in both gross profit and net income for 2013.

Ending Inventory Understated—Year 3 Exhibit 5.11 shows that the 2012 ending inventory error affects only that period and the next. It does not affect 2014 results or any period there- after. An inventory error is said to be self-correcting because it always yields an offsetting error in the next period. This does not reduce the severity of inventory errors. Managers, lenders, owners, and others make important decisions from analysis of income and costs.

Correct income is $30,000 for each year

Example: If 2012 ending inventory in Exhibit 5.11 is overstated by $3,000 (not understated by $4,000), what is the effect on cost of goods sold, gross profit, assets, and equity? Answer: Cost of goods sold is understated by $3,000 in 2012 and overstated by $3,000 in 2013. Gross profit and net income are overstated in 2012 and understated in 2013. Assets and equity are overstated in 2012.

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222 Chapter 5 Inventories and Cost of Sales

We can also do an analysis of beginning inventory errors. The income statement effects are the opposite of those for ending inventory.

Balance Sheet Effects Balance sheet effects of an inventory error can be seen by consider- ing the accounting equation: Assets 5 Liabilities 1 Equity. For example, understating ending in- ventory understates both current and total assets. An understatement in ending inventory also yields an understatement in equity because of the understatement in net income. Exhibit 5.12 shows the effects of inventory errors on the current period’s balance sheet amounts. Errors in beginning inventory do not yield misstatements in the end-of-period balance sheet, but they do affect that current period’s income statement.

EXHIBIT 5.12 Effects of Inventory Errors on Current Period’s Balance Sheet

Ending Inventory Assets Equity

Understated . . . . . . . . . . . . . . Understated Understated Overstated . . . . . . . . . . . . . . . Overstated Overstated

8. Use LCM applied separately to the following individual items to compute ending inventory.

Product Units Unit Recorded Cost Unit Market Cost

A . . . . . . . . . . . 20 $ 6 $ 5 B . . . . . . . . . . . 40 9 8 C . . . . . . . . . . 10 12 15

Quick Check Answers — p. 237

This section discusses differences between U.S. GAAP and IFRS in the items and costs making up merchan- dise inventory, in the methods to assign costs to inventory, and in the methods to estimate inventory values.

Items and Costs Making Up Inventory Both U.S. GAAP and IFRS include broad and similar guidance for the items and costs making up merchandise inventory. Specifically, under both accounting systems, merchandise inventory includes all items that a company owns and holds for sale. Further, mer- chandise inventory includes costs of expenditures necessary, directly or indirectly, to bring those items to a salable condition and location.

Assigning Costs to Inventory Both U.S. GAAP and IFRS allow companies to use specific identi- fication in assigning costs to inventory. Further, both systems allow companies to apply a cost flow assumption. The usual cost flow assumptions are: FIFO, Weighted Average, and LIFO. However, IFRS does not (cur- rently) allow use of LIFO. As the convergence project progresses, this prohibition may or may not persist.

Estimating Inventory Costs The value of inventory can change while it awaits sale to customers. That value can decrease or increase.

Decreases in Inventory Value Both U.S. GAAP and IFRS require companies to write down (reduce the cost recorded for) inventory when its value falls below the cost recorded. This is referred to as the lower of cost or market method explained in this chapter. U.S. GAAP prohibits any later increase in the recorded value of that inventory even if that decline in value is reversed through value increases in later periods. However, IFRS allows reversals of those write downs up to the original acquisition cost. For example, if Polaris wrote down its 2011 inventory from $298 million to $250 million, it could not reverse this in fu- ture periods even if its value increased to more than $298 million. However, if Polaris applied IFRS, it could reverse that previous loss. (Another difference is that value refers to replacement cost under U.S. GAAP, but net realizable value under IFRS.)

Increases in Inventory Value Neither U.S. GAAP nor IFRS allow inventory to be adjusted upward be- yond the original cost. (One exception is that IFRS requires agricultural assets such as animals, forests, and plants to be measured at fair value less point-of-sale costs.)

GLOBAL VIEW

Point: A former internal auditor at Coca-Cola alleges that just before midnight at a prior calendar year-end, fully loaded Coke trucks were ordered to drive about 2 feet away from the loading dock so that Coke could record millions of dollars in extra sales.

Polaris

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Chapter 5 Inventories and Cost of Sales 223

Inventory Turnover and Days’ Sales in Inventory Decision Analysis

A3 Assess inventory management using both inventory turnover and days’ sales in inventory.

Inventory Turnover Earlier chapters described two important ratios useful in evaluating a company’s short-term liquidity: cur- rent ratio and acid-test ratio. A merchandiser’s ability to pay its short-term obligations also depends on how quickly it sells its merchandise inventory. Inventory turnover, also called merchandise inventory turnover or, simply, turns, is one ratio used to assess this and is defined in Exhibit 5.13.

Inventory turnover 5 Cost of goods sold

Average inventory

EXHIBIT 5.13 Inventory Turnover

EXHIBIT 5.14 Days’ Sales in InventoryDays’ sales in inventory 5

Ending inventory

Cost of goods sold 3 365

Nokia provides the following description of its inventory valuation procedures:

Inventories are stated at the lower of cost or net realizable value. Cost . . . approximates actual cost on a FIFO (First-in First-out) basis. Net realizable value is the amount that can be realized from the sale of the inventory in the normal course of business after allowing for the costs of realization.

This ratio reveals how many times a company turns over (sells) its inventory during a period. If a company’s inventory greatly varies within a year, average inventory amounts can be computed from interim periods such as quarters or months. Users apply inventory turnover to help analyze short-term liquidity and to assess whether management is doing a good job controlling the amount of inventory available. A low ratio compared to that of competi- tors suggests inefficient use of assets. The company may be holding more inventory than it needs to support its sales volume. Similarly, a very high ratio compared to that of competitors suggests inventory might be too low. This can cause lost sales if customers must back-order merchandise. Inventory turnover has no simple rule except to say a high ratio is preferable provided inventory is adequate to meet demand.

Days’ Sales in Inventory To better interpret inventory turnover, many users measure the adequacy of inventory to meet sales demand. Days’ sales in inventory, also called days’ stock on hand, is a ratio that reveals how much inventory is avail- able in terms of the number of days’ sales. It can be interpreted as the number of days one can sell from in- ventory if no new items are purchased. This ratio is often viewed as a measure of the buffer against out-of-stock inventory and is useful in evaluating liquidity of inventory. It is defined in Exhibit 5.14.

Point: We must take care when comparing turnover ratios across companies that use different costing methods (such as FIFO and LIFO).

Point: Inventory turnover is higher and days’ sales in inventory is lower for industries such as foods and other perishable products. The reverse holds for nonperishable product industries.

Days’ sales in inventory focuses on ending inventory and it estimates how many days it will take to con- vert inventory at the end of a period into accounts receivable or cash. Days’ sales in inventory focuses on ending inventory whereas inventory turnover focuses on average inventory.

Analysis of Inventory Management Inventory management is a major emphasis for merchandisers. They must both plan and control inventory purchases and sales. Toys “R” Us is one of those merchandisers. Its inventory in fiscal year 2011 was $2,104 million. This inventory constituted 58% of its current assets and 24% of its total assets. We apply the analysis tools in this section to Toys “R” Us, as shown in Exhibit 5.15—also see margin graph.

Point: Days’ sales in inventory for many Ford models has risen: Freestyle, 122 days; Montego, 109 days; Five Hundred, 118 days. The industry average is 73 days. (BusinessWeek)

Decision Insight

Short Shelf Life Whole Foods Market, Inc., is committed to foods that are fresh, wholesome, and safe to eat. To fulfill those values, Whole Foods Market focuses on inventory management. It turns its inventory 20 times a year with days’ sales in inventory of 19 days. ■

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224 Chapter 5 Inventories and Cost of Sales

Its 2011 inventory turnover of 4.6 times means that Toys “R” Us turns over its inventory 4.6 times per year, or once every 79 days (365 days 4 4.6). We prefer inventory turnover to be high provided inventory is not out of stock and the company is not losing customers. The second metric, the 2011 days’ sales in inventory of 86 days, reveals that it is carrying 86 days of sales in inventory. This inventory buffer seems more than adequate. The increased days’ sales in inventory suggests that Toys “R” Us would benefit from further management efforts to increase inventory turnover and reduce inventory levels.

($ millions) 2011 2010 2009 2008

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $8,939 $8,790 $8,976 $8,987

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,104 $1,810 $1,781 $1,998

Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . . 4.6 times 4.9 times 4.8 times 4.9 times

Industry inventory turnover . . . . . . . . . . . . . . . . . . . . 3.3 times 3.5 times 3.2 times 3.4 times

Days’ sales in inventory . . . . . . . . . . . . . . . . . . . . 86 days 75 days 72 days 81 days

Industry days’ sales in inventory . . . . . . . . . . . . . . . . . 132 days 129 days 124 days 135 days

EXHIBIT 5.15 Inventory Turnover and Days’ Sales in Inventory for Toys “R” Us

4.0 2011 2010 2009 2008

60

70

80

Days’ Sales in Inventory

Inventory Turnover

6.0

5.5

5.0

4.5

90

Toys ‘R’ Us: Days’ Sales in Inventory Inventory Turnover

Information: Craig Company buys and sells one product. Its beginning inventory, purchases, and sales during calendar year 2013 follow:

DEMONSTRATION PROBLEM 1–PERPETUAL METHOD

Date Activity Units Acquired at Cost Units Sold at Retail Unit Inventory

Jan. 1 Beg. Inventory . . . . 400 units @ $14 5 $ 5,600 400 units Jan. 15 Sale . . . . . . . . . . . . 200 units @ $30 200 units March 10 Purchase . . . . . . . . 200 units @ $15 5 $ 3,000 400 units April 1 Sale . . . . . . . . . . . . 200 units @ $30 200 units May 9 Purchase . . . . . . . . 300 units @ $16 5 $ 4,800 500 units Sept. 22 Purchase . . . . . . . . 250 units @ $20 5 $ 5,000 750 units Nov. 1 Sale . . . . . . . . . . . . 300 units @ $35 450 units Nov. 28 Purchase . . . . . . . . 100 units @ $21 5 $ 2,100 550 units Totals . . . . . . . . . . 1,250 units $20,500 700 units

Additional tracking data for specific identification: (1) January 15 sale — 200 units @ $14, (2) April 1 sale — 200 units @ $15, and (3) November 1 sale — 200 units @ $14 and 100 units @ $20.

Required

1. Calculate the cost of goods available for sale. 2. Apply the four different methods of inventory costing (FIFO, LIFO, weighted average, and specific identi-

fication) to calculate ending inventory and cost of goods sold under each method using the perpetual system. 3. Compute gross profit earned by the company for each of the four costing methods in part 2. Also,

report the inventory amount reported on the balance sheet for each of the four methods.

© 2002 Thaves. All rights reserved. Reprint permission granted by the Thaves in conjunction with the Cartoonist Group.

Entrepreneur Analysis of your retail store yields an inventory turnover of 5.0 and a days’ sales in inventory of 73 days. The industry norm for inventory turnover is 4.4 and for days’ sales in inventory is 74 days. What is your assessment of inventory management? ■ [Answer—p. 236]

Decision Maker

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Chapter 5 Inventories and Cost of Sales 225

4. In preparing financial statements for year 2013, the financial officer was instructed to use FIFO but failed to do so and instead computed cost of goods sold according to LIFO, which led to a $1,400 overstatement in cost of goods sold from using LIFO. Determine the impact on year 2013’s income from the error. Also determine the effect of this error on year 2014’s income. Assume no income taxes.

5. Management wants a report that shows how changing from FIFO to another method would change net income. Prepare a table showing (1) the cost of goods sold amount under each of the four methods, (2) the amount by which each cost of goods sold total is different from the FIFO cost of goods sold, and (3) the effect on net income if another method is used instead of FIFO.

PLANNING THE SOLUTION ● Compute cost of goods available for sale by multiplying the units of beginning inventory and each pur-

chase by their unit costs to determine the total cost of goods available for sale. ● Prepare a perpetual FIFO table starting with beginning inventory and showing how inventory changes

after each purchase and after each sale (see Exhibit 5.5). ● Prepare a perpetual LIFO table starting with beginning inventory and showing how inventory changes

after each purchase and after each sale (see Exhibit 5.6). ● Make a table of purchases and sales recalculating the average cost of inventory prior to each sale to ar-

rive at the weighted average cost of ending inventory. Total the average costs associated with each sale to determine cost of goods sold (see Exhibit 5.7).

● Prepare a table showing the computation of cost of goods sold and ending inventory using the specific identification method (see Exhibit 5.4).

● Compare the year-end 2013 inventory amounts under FIFO and LIFO to determine the misstatement of year 2013 income that results from using LIFO. The errors for year 2013 and 2014 are equal in amount but opposite in effect.

● Create a table showing cost of goods sold under each method and how net income would differ from FIFO net income if an alternate method is adopted.

SOLUTION TO DEMONSTRATION PROBLEM 1. Cost of goods available for sale (this amount is the same for all methods).

2a. FIFO perpetual method.

Date Units Unit Cost Cost

Jan. 1 Beg. Inventory . . . . . . . . . . 400 $14 $ 5,600 March 10 Purchase . . . . . . . . . . . . . . 200 15 3,000 May 9 Purchase . . . . . . . . . . . . . . 300 16 4,800 Sept. 22 Purchase . . . . . . . . . . . . . . 250 20 5,000 Nov. 28 Purchase . . . . . . . . . . . . . . 100 21 2,100 Total goods available for sale . . . . . . . . . 1,250 $20,500

r r s r s

Date Goods Purchased Cost of Goods Sold Inventory Balance

Jan. 1 Beginning balance 400 @ $14 5 $ 5,600

Jan. 15 200 @ $14 5 $2,800 200 @ $14 5 $ 2,800

Mar. 10 200 @ $15 5 $3,000 200 @ $14 5 $ 5,800

200 @ $15

April 1 200 @ $14 5 $2,800 200 @ $15 5 $ 3,000

May 9 300 @ $16 5 $4,800 200 @ $15 5 $ 7,800

300 @ $16

Sept. 22 250 @ $20 5 $5,000 200 @ $15 300 @ $16 5 $12,800 250 @ $20

Nov. 1 200 @ $15 5 $3,000 200 @ $16 5 $ 8,200

100 @ $16 5 $1,600 250 @ $20

Nov. 28 100 @ $21 5 $2,100 200 @ $16 250 @ $20 5 $10,300 100 @ $21

Total cost of goods sold $10,200

Point: Students often mistakenly assume that the costing acronym refers to what remains in inventory. For exam- ple, it is important to realize that FIFO refers to costs that are assumed to flow into COGS; namely, the first units pur- chased are assumed to be the first ones to flow out to cost of goods sold. For FIFO, this means that the goods pur- chased most recently are assumed to be in ending inventory.

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226 Chapter 5 Inventories and Cost of Sales

Note to students: In a classroom situation, once we compute cost of goods available for sale, we can compute the amount for either cost of goods sold or ending inventory — it is a matter of preference. In practice, the costs of items sold are identified as sales are made and immediately transferred from the inventory account to the cost of goods sold account. The previous solution showing the line-by-line ap- proach illustrates actual application in practice. The following alternate solutions illustrate that, once the concepts are understood, other solution approaches are available. Although this is only shown for FIFO, it could be shown for all methods.

Alternate Methods to Compute FIFO Perpetual Numbers

[FIFO Alternate No. 1: Computing cost of goods sold first]

Cost of goods available for sale (from part 1) . . . . . . . . . . . . $ 20,500

Cost of goods sold

Jan. 15 Sold (200 @ $14) . . . . . . . . . . . . . . . . . . . . . . . $2,800

April 1 Sold (200 @ $14) . . . . . . . . . . . . . . . . . . . . . . . 2,800

Nov. 1 Sold (200 @ $15 and 100 @ $16) . . . . . . . . . . 4,600 10,200

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,300

[FIFO Alternate No. 2: Computing ending inventory first]

Cost of goods available for sale (from part 1) . . . . . . . . . $ 20,500

Ending inventory*

Nov. 28 Purchase (100 @ $21) . . . . . . . . . . . . . . . . $2,100

Sept. 22 Purchase (250 @ $20) . . . . . . . . . . . . . . . . 5,000

May 9 Purchase (200 @ $16) . . . . . . . . . . . . . . . . 3,200

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,300

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,200

* Since FIFO assumes that the earlier costs are the first to flow out, we determine ending inventory by assigning the most recent costs to the remaining items.

2b. LIFO perpetual method.

r

r

r

Date Goods Purchased Cost of Goods Sold Inventory Balance

Jan. 1 Beginning balance 400 @ $14 5 $ 5,600

Jan. 15 200 @ $14 5 $2,800 200 @ $14 5 $ 2,800

Mar. 10 200 @ $15 5 $3,000 200 @ $14 5 $ 5,800

200 @ $15

April 1 200 @ $15 5 $3,000 200 @ $14 5 $ 2,800

May 9 300 @ $16 5 $4,800 200 @ $14 5 $ 7,600

300 @ $16

Sept. 22 250 @ $20 5 $5,000 200 @ $14

300 @ $16 5 $12,600

250 @ $20

Nov. 1 250 @ $20 5 $5,000 200 @ $14 5 $ 6,800

50 @ $16 5 $ 800 250 @ $16

Nov. 28 100 @ $21 5 $2,100 200 @ $14

250 @ $16 5 $ 8,900

100 @ $21

Total cost of goods sold $11,600

s

s

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Chapter 5 Inventories and Cost of Sales 227

2c. Weighted average perpetual method.

r

r

r

Date Goods Purchased Cost of Goods Sold Inventory Balance

Jan. 1 Beginning balance 400 @ $14 5 $ 5,600

Jan. 15 200 @ $14 5 $2,800 200 @ $14 5 $ 2,800

Mar. 10 200 @ $15 5 $3,000 200 @ $14 5 $ 5,800

200 @ $15

(avg. cost is $14.5)

April 1 200 @ $14.5 5 $2,900 200 @ $14.5 5 $ 2,900

May 9 300 @ $16 5 $4,800 200 @ $14.5 5 $ 7,700

300 @ $16

(avg. cost is $15.4)

Sept. 22 250 @ $20 5 $5,000 200 @ $14.5

300 @ $16 5 $ 12,700

250 @ $20

(avg. cost is $16.93)

Nov. 1 300 @ $16.93 5 $5,079 450 @ $16.93 5 $ 7,618.5

Nov. 28 100 @ $21 5 $2,100 450 @ $16.93 5

$9,718.5

100 @ $21

Total cost of goods sold* $10,779

* The cost of goods sold ($10,779) plus ending inventory ($9,718.5) is $2.5 less than the cost of goods available for sale ($20,500) due to rounding.

s

2d. Specific identification method.

Date Goods Purchased Cost of Goods Sold Inventory Balance

Jan. 1 Beginning balance 400 @ $14 5 $ 5,600

Jan. 15 200 @ $14 5 $2,800 200 @ $14 5 $ 2,800

Mar. 10 200 @ $15 5 $3,000 200 @ $14 5 $

5,800

200 @ $15

April 1 200 @ $15 5 $3,000 200 @ $14 5 $ 2,800

May 9 300 @ $16 5 $4,800 200 @ $14 5 $ 7,600

300 @ $16

Sept. 22 250 @ $20 5 $5,000 200 @ $14

300 @ $16 5 $ 12,600

250 @ $20

Nov. 1 200 @ $14 5 $2,800 300 @ $16 5 $ 7,800

100 @ $20 5 $2,000 150 @ $20

Nov. 28 100 @ $21 5 $2,100 300 @ $16

150 @ $20 5 $ 9,900

100 @ $21

Total cost of goods sold $10,600

r r s

s r

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228 Chapter 5 Inventories and Cost of Sales

4. Mistakenly using LIFO when FIFO should have been used overstates cost of goods sold in year 2013 by $1,400, which is the difference between the FIFO and LIFO amounts of ending inventory. It under- states income in 2013 by $1,400. In year 2014, income is overstated by $1,400 because of the understatement in beginning inventory.

5. Analysis of the effects of alternative inventory methods.

Weighted Specific

FIFO LIFO Average Identification

Income Statement

Sales* . . . . . . . . . . . . . . . . . . . . . . . . $ 22,500 $22,500 $ 22,500 $22,500

Cost of goods sold . . . . . . . . . . . . 10,200 11,600 10,779 10,600

Gross profit . . . . . . . . . . . . . . . . . $ 12,300 $10,900 $ 11,721 $11,900

Balance Sheet

Inventory . . . . . . . . . . . . . . . . . . . . $10,300 $ 8,900 $9,718.5 $ 9,900

* Sales 5 (200 units 3 $30) 1 (200 units 3 $30) 1 (300 units 3 $35) 5 $22,500

3.

Difference from Effect on Net

FIFO Cost of Income If Adopted

Cost of Goods Sold Goods Sold Instead of FIFO

FIFO . . . . . . . . . . . . . . . . . . . . . . $10,200 — —

LIFO . . . . . . . . . . . . . . . . . . . . . . 11,600 1$1,400 $1,400 lower

Weighted average . . . . . . . . . . . 10,779 1 579 579 lower

Specific identification . . . . . . . . . 10,600 1 400 400 lower

Refer to the information in Demonstration Problem 1 to answer the following requirements.

Required

1. Calculate the cost of goods available for sale. 2. Apply the four different methods of inventory costing (FIFO, LIFO, weighted average, and specific

identification) to calculate ending inventory and cost of goods sold under each method using the periodic system.

3. Compute gross profit earned by the company for each of the four costing methods in part 2. Also, report the inventory amount reported on the balance sheet for each of the four methods.

4. In preparing financial statements for year 2013, the financial officer was instructed to use FIFO but failed to do so and instead computed cost of goods sold according to LIFO. Determine the impact of the error on year 2013’s income. Also determine the effect of this error on year 2014’s income. Assume no income taxes.

SOLUTION TO DEMONSTRATION PROBLEM 1. The solution is identical to the solution for part 1 of Demonstration Problem 1. 2a. FIFO periodic method (FIFO under periodic and perpetual yields identical results).

DEMONSTRATION PROBLEM 2–PERIODIC METHOD

Cost of goods available for sale (from part 1) . . . . . . . . . $ 20,500

Ending inventory*

Nov. 28 Purchase (100 @ $21) . . . . . . . . . . . . . . . . $2,100

Sept. 22 Purchase (250 @ $20) . . . . . . . . . . . . . . . . 5,000

May 9 Purchase (200 @ $16) . . . . . . . . . . . . . . . . 3,200

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,300

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,200

* Since FIFO assumes that the earlier costs are the first to flow out, we determine ending inventory by assigning the most recent costs to the remaining items.

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Chapter 5 Inventories and Cost of Sales 229

2b. LIFO periodic method.

2c. Weighted average periodic method.

Step 1: 400 units @ $14 5 $ 5,600

200 units @ $15 5 3,000

300 units @ $16 5 4,800

250 units @ $20 5 5,000

100 units @ $21 5 2,100

1,250 $20,500

Step 2: $20,500y1,250 units 5 $16.40 weighted average cost per unit

Step 3: Total cost of 1,250 units available for sale . . . . . . . . . . . . . . . . . . . . $20,500

Less ending inventory priced on a weighted average cost basis: 550 units at $16.40 each . . . . . . . . . . . . . . . . . . . . . . . . 9,020

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,480

4. The solution is identical to the solution for part 4 of Demonstration Problem 1.

APPENDIX

Inventory Costing under a Periodic System 5A This section illustrates inventory costing methods. We use information from Trekking, a sporting goods store. Among its products, Trekking carries one type of mountain bike whose sales are directed at resorts that provide inexpensive mountain bikes for complimentary guest use. These resorts usually purchase in amounts of 10 or more bikes. We use Trekking’s data from August. Its mountain bike (unit) inventory at the beginning of August and its purchases and sales during August are in Exhibit 5A.1. It ends August with 12 bikes in inventory. Trekking uses the periodic inventory system, which means that its

P3 Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average.

2d. Specific identification method. The solution is identical to the solution shown in part 2d of Demonstration Problem 1. This is because specific identification is not a cost flow assumption; instead, this method specifically identifies each item in inventory and each item that is sold.

Weighted Specific

FIFO LIFO Average Identification

Income Statement

Sales* . . . . . . . . . . . . . . . . . . . . . . . . $ 22,500 $22,500 $ 22,500 $22,500

Cost of goods sold . . . . . . . . . . . . 10,200 12,650 11,480 10,600

Gross profit . . . . . . . . . . . . . . . . . $ 12,300 $ 9,850 $ 11,020 $11,900

Balance Sheet

Inventory . . . . . . . . . . . . . . . . . . . . $10,300 $ 7,850 $ 9,020 $ 9,900

* Sales 5 (200 units 3 $30) 1 (200 units 3 $30) 1 (300 units 3 $35) 5 $22,500

3.

Cost of goods available for sale (from part 1) . . . . . . . . . . $ 20,500

Ending inventory*

January 1 Purchase (400 @ $14) . . . . . . . . . . . . . . . $5,600

March 10 Purchase (150 @ $15) . . . . . . . . . . . . . . . 2,250

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,850

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,650

* Since LIFO assumes that the most recent (newest) costs are the first to flow out, we determine ending inventory by assigning the earliest (oldest) costs to the remaining items.

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230 Chapter 5 Inventories and Cost of Sales

EXHIBIT 5A.1 Purchases and Sales of Goods

merchandise inventory account is updated at the end of each period (monthly for Trekking) to reflect purchases and sales. Regardless of what inventory method or system is used, cost of goods available for sale must be allocated between cost of goods sold and ending inventory.

Specific Identification When each item in inventory can be identified with a specific purchase and invoice, we can use specific identification (also called specific invoice inventory pricing) to assign costs. We also need sales records that identify exactly which items were sold and when. Trekking’s inter- nal data reveal the following specific unit sales:

August 14 Sold 8 bikes costing $91 each and 12 bikes costing $106 each August 31 Sold 2 bikes costing $91 each, 3 bikes costing $106 each, 15 bikes

costing $115 each, and 3 bikes costing $119 each

Applying specific identification and using the information above, we prepare Exhibit 5A.2. This exhibit starts with 10 bikes at $91 each in beginning inventory. On August 3, 15 more bikes are purchased at $106 each for $1,590. Inventory available now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500. On August 14 (see sales data above), 20 bikes costing $2,000 are sold— leaving

Point: Three key variables determine the dollar value of ending inventory: (1) inventory quantity, (2) costs of inven- tory, and (3) cost flow assumption.

T

EXHIBIT 5A.2 Specific Identification Computations

“goods in” “goods out” “what’s left”

r r

t r

Date Goods Purchased Cost of Goods Sold Inventory Balance

Aug. 1 Beginning balance 10 @ $ 91 5 $ 910

Aug. 3 15 @ $106 5 $1,590 10 @ $ 91

15 @ $106 5 $2,500

Aug. 14 8 @ $ 91 5 $ 728 2 @ $ 91

12 @ $106 5 $1,272 5 $2,000*

3 @ $106 5 $ 500

Aug. 17 20 @ $115 5 $2,300 2 @ $ 91

3 @ $106 5 $2,800 20 @ $115

Aug. 28 10 @ $119 5 $1,190 2 @ $ 91

3 @ $106

20 @ $115 5 $3,990

10 @ $119

Aug. 31 2 @ $ 91 5 $ 182

3 @ $106 5 $ 318 5 @ $115

15 @ $115 5 $1,725 5 $2,582*

7 @ $119 5 $1,408

3 @ $119 5 $ 357

$4,582

* Identification of items sold (and their costs) is obtained from internal documents that track each unit from its purchase to its sale.

r

T

s t

For the 23 units sold on Aug. 31, the company specifically identified each bike sold and its acquisition cost from prior purchases.

For the 20 units sold on Aug. 14, the company specifically identified that 8 of those had cost $91 and 12 had cost $106.

Date Activity Units Acquired at Cost Units Sold at Retail Unit Inventory

Aug. 1 Beginning inventory . . . . 10 units @ $ 91 5 $ 910 10 units

Aug. 3 Purchases . . . . . . . . . . . . 15 units @ $106 5 $ 1,590 25 units

Aug. 14 Sales . . . . . . . . . . . . . . . . 20 units @ $130 5 units

Aug. 17 Purchases . . . . . . . . . . . . 20 units @ $115 5 $ 2,300 25 units

Aug. 28 Purchases . . . . . . . . . . . . 10 units @ $119 5 $ 1,190 35 units

Aug. 31 Sales . . . . . . . . . . . . . . . . 23 units @ $150 12 units

Totals . . . . . . . . . . . . . . 55 units $5,990 43 units

Units available for sale Goods available for sale Units sold Units left

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Chapter 5 Inventories and Cost of Sales 231

5 bikes costing $500 in inventory. On August 17, 20 bikes costing $2,300 are purchased, and on August 28, another 10 bikes costing $1,190 are purchased, for a total of 35 bikes costing $3,990 in inventory. On August 31 (see sales data above), 23 bikes costing $2,582 are sold, which leaves 12 bikes costing $1,408 in ending inventory. Carefully study Exhibit 5A.2 to see the flow of costs both in and out of inventory. Each unit, whether sold or remaining in inventory, has its own specific cost attached to it. When using specific identification, Trekking’s cost of goods sold reported on the income statement totals $4,582, the sum of $2,000 and $2,582 from the third column of Exhibit 5A.2. Trekking’s ending inventory reported on the balance sheet is $1,408, which is the final inventory balance from the fourth column. The purchases and sales entries for Exhibit 5A.2 follow (the colored boldface numbers are those impacted by the cost flow assumption):

Point: The assignment of costs to the goods sold and to inventory using spe- cific identification is the same for both the perpetual and periodic systems.

Point: Specific identification is usually practical only for companies with expen- sive, custom-made inventory. Examples include car dealerships, implement dealers such as John Deere, jewelers, and fashion designers.

Purchases

Aug. 3 Purchases . . . . . . . . . . . . . . . . . . . 1,590

Accounts Payable . . . . . . . . . 1,590

17 Purchases . . . . . . . . . . . . . . . . . . . 2,300

Accounts Payable . . . . . . . . . 2,300

28 Purchases . . . . . . . . . . . . . . . . . . . 1,190

Accounts Payable . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . . . 2,600

Sales . . . . . . . . . . . . . . . . . . . 2,600

31 Accounts Receivable . . . . . . . . . . . 3,450

Sales . . . . . . . . . . . . . . . . . . . 3,450

Adjusting Entry

31 Merchandise Inventory . . . . . . . . . 1,408

Income Summary . . . . . . . . . 498

Merchandise Inventory . . . . 910

First-In, First-Out The first-in, first-out (FIFO) method of assigning costs to both inventory and cost of goods sold assumes that inventory items are sold in the order acquired. When sales occur, the costs of the earliest units acquired are charged to cost of goods sold. This leaves the costs from the most recent purchases in ending inventory. Use of FIFO for computing the cost of inventory and cost of goods sold is shown in Exhibit 5A.3. This exhibit starts with computing $5,990 in total units available for sale—this is from Exhibit 5A.1. Applying FIFO, we know that the 12 units in ending inventory will be reported at the cost of the most re- cent 12 purchases. Reviewing purchases in reverse order, we assign costs to the 12 bikes in ending inven- tory as follows: $119 cost to 10 bikes and $115 cost to 2 bikes. This yields 12 bikes costing $1,420 in ending inventory. We then subtract this $1,420 in ending inventory from $5,990 in cost of goods available to get $4,570 in cost of goods sold.

EXHIBIT 5A.3 FIFO Computations — Periodic System

Total cost of 55 units available for sale (from Exhibit 5A.1) . . . . . . . . . $5,990

Less ending inventory priced using FIFO

10 units from August 28 purchase at $119 each . . . . . . . . . . . . . . . $1,190

2 units from August 17 purchase at $115 each . . . . . . . . . . . . . . . . 230

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,420

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,570

R Exhibit 5A.1 shows that the 12 units in ending inventory consist of 10 units from the latest purchase on Aug. 28 and 2 units from the next latest purchase on Aug. 17.

Purchases

Aug. 3 Purchases . . . . . . . . . . . . . . . . . . . . 1,590

Accounts Payable . . . . . . . . . . 1,590

17 Purchases . . . . . . . . . . . . . . . . . . . . 2,300

Accounts Payable . . . . . . . . . . 2,300

28 Purchases . . . . . . . . . . . . . . . . . . . . 1,190

Accounts Payable . . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . . . 2,600

Sales . . . . . . . . . . . . . . . . . . . . 2,600

31 Accounts Receivable . . . . . . . . . . . 3,450

Sales . . . . . . . . . . . . . . . . . . . . 3,450

Adjusting Entry

31 Merchandise Inventory . . . . . . . . . . 1,420

Income Summary . . . . . . . . . 510

Merchandise Inventory . . . . . 910

Point: The assignment of costs to the goods sold and to inventory using FIFO is the same for both the perpetual and periodic systems.

Trekking’s ending inventory reported on the balance sheet is $1,420, and its cost of goods sold reported on the income statement is $4,570. These amounts are the same as those computed using the perpetual sys- tem. This always occurs because the most recent purchases are in ending inventory under both systems. The purchases and sales entries for Exhibit 5A.3 follow (the colored boldface numbers are those affected by the cost flow assumption).

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232 Chapter 5 Inventories and Cost of Sales

Trekking’s ending inventory reported on the balance sheet is $1,122, and its cost of goods sold reported on the income statement is $4,868. When LIFO is used with the periodic system, cost of goods sold is assigned costs from the most recent purchases for the period. With a perpetual system, cost of goods sold is assigned costs from the most recent purchases at the point of each sale. The purchases and sales entries for Exhibit 5A.4 follow (the colored boldface numbers are those affected by the cost flow assumption).

Last-In, First-Out The last-in, first-out (LIFO) method of assigning costs assumes that the most recent purchases are sold first. These more recent costs are charged to the goods sold, and the costs of the earliest purchases are assigned to inventory. LIFO results in costs of the most recent purchases be- ing assigned to cost of goods sold, which means that LIFO comes close to matching current costs of goods sold with revenues. Use of LIFO for computing cost of inventory and cost of goods sold is shown in Exhibit 5A.4. This exhibit starts with computing $5,990 in total units available for sale—this is from Exhibit 5A.1. Applying LIFO, we know that the 12 units in ending inventory will be reported at the cost of the earliest 12 purchases. Reviewing the earliest purchases in order, we assign costs to the 12 bikes in ending inven- tory as follows: $91 cost to 10 bikes and $106 cost to 2 bikes. This yields 12 bikes costing $1,122 in end- ing inventory. We then subtract this $1,122 in ending inventory from $5,990 in cost of goods available to get $4,868 in cost of goods sold.

EXHIBIT 5A.4 LIFO Computations— Periodic System

Total cost of 55 units available for sale (from Exhibit 5A.1) . . . . . . . . . . $5,990

Less ending inventory priced using LIFO

10 units in beginning inventory at $91 each . . . . . . . . . . . . . . . . . . . $910

2 units from August 3 purchase at $106 each . . . . . . . . . . . . . . . . . . 212

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,122

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,868

R Exhibit 5A.1 shows that the 12 units in ending inventory consist of 10 units from the earliest purchase (beg. inv.) and 2 units from the next earliest purchase on Aug. 3.

Purchases

Aug. 3 Purchases . . . . . . . . . . . . . . . . . . . . 1,590

Accounts Payable . . . . . . . . . 1,590

17 Purchases . . . . . . . . . . . . . . . . . . . . 2,300

Accounts Payable . . . . . . . . . 2,300

28 Purchases . . . . . . . . . . . . . . . . . . . . 1,190

Accounts Payable . . . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . . . 2,600

Sales . . . . . . . . . . . . . . . . . . . 2,600

31 Accounts Receivable . . . . . . . . . . . 3,450

Sales . . . . . . . . . . . . . . . . . . . 3,450

Adjusting Entry

31 Merchandise Inventory . . . . . . . . . 1,122

Income Summary . . . . . . . . . 212

Merchandise Inventory . . . . . . 910

EXHIBIT 5A.5 Weighted Average Cost per Unit

Step 1: 10 units @ $ 91 5 $ 910

15 units @ $106 5 1,590

20 units @ $115 5 2,300

10 units @ $119 5 1,190

55 $5,990

Step 2: $5,990y55 units 5 $108.91 weighted average cost per unit

Weighted Average The weighted average or WA (also called average cost) method of assign- ing cost requires that we use the average cost per unit of inventory at the end of the period. Weighted average cost per unit equals the cost of goods available for sale divided by the units available. The weighted average method of assigning cost involves three important steps. The first two steps are shown in Exhibit 5A.5. First, multiply the per unit cost for beginning inventory and each particular purchase by the corresponding number of units (from Exhibit 5A.1). Second, add these amounts and divide by the total number of units available for sale to find the weighted average cost per unit.

Example: In Exhibit 5A.5, if 5 more units had been purchased at $120 each, what would be the weighted average cost per unit? Answer: $109.83 ($6,590y60)

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Chapter 5 Inventories and Cost of Sales 233

EXHIBIT 5A.6 Weighted Average Computations — Periodic

Step 3: Total cost of 55 units available for sale (from Exhibit 5A.1) . . . . . . . . . . $ 5,990

Less ending inventory priced on a weighted average cost basis: 12 units at $108.91 each (from Exhibit 5A.5) . . . . . . . . . . . 1,307

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,683

The third step is to use the weighted average cost per unit to assign costs to inventory and to the units sold as shown in Exhibit 5A.6.

Trekking’s ending inventory reported on the balance sheet is $1,307, and its cost of goods sold reported on the income statement is $4,683 when using the weighted average (periodic) method. The purchases and sales entries for Exhibit 5A.6 follow (the colored boldface numbers are those affected by the cost flow assumption).

Purchases

Aug. 3 Purchases . . . . . . . . . . . . . . . . . . . . 1,590

Accounts Payable . . . . . . . . . . 1,590

17 Purchases . . . . . . . . . . . . . . . . . . . . 2,300

Accounts Payable . . . . . . . . . . 2,300

28 Purchases . . . . . . . . . . . . . . . . . . . . 1,190

Accounts Payable . . . . . . . . . . 1,190

Sales

Aug. 14 Accounts Receivable . . . . . . . . . . . 2,600

Sales . . . . . . . . . . . . . . . . . . . . 2,600

31 Accounts Receivable . . . . . . . . . . . 3,450

Sales . . . . . . . . . . . . . . . . . . . . 3,450

Adjusting Entry

31 Merchandise Inventory . . . . . . . . . 1,307

Income Summary . . . . . . . . . 397

Merchandise Inventory . . . . . 910

Point: Weighted average usually yields different results for the perpetual and the periodic systems because under a per- petual system it recomputes the per unit cost prior to each sale, whereas under a periodic system, the per unit cost is com- puted only at the end of a period.

Point: LIFO inventory is often less than the inventory’s replacement cost because LIFO inventory is valued using the oldest inventory purchase costs.

Financial Statement Effects When purchase prices do not change, each inventory costing method assigns the same cost amounts to inventory and to cost of goods sold. When purchase prices are different, however, the methods nearly always assign different cost amounts. We show these differences in Exhibit 5A.7 using Trekking’s data.

EXHIBIT 5A.7 Financial Statement Effects of Inventory Costing Methods

TREKKING COMPANY

For Month Ended August 31

Specific Weighted

Identification FIFO LIFO Average

Income Statement

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,050 $ 6,050 $ 6,050 $ 6,050

Cost of goods sold . . . . . . . . . . . . . 4,582 4,570 4,868 4,683

Gross profit . . . . . . . . . . . . . . . . . . 1,468 1,480 1,182 1,367

Expenses . . . . . . . . . . . . . . . . . . . . . . . 450 450 450 450

Income before taxes . . . . . . . . . . . . . . 1,018 1,030 732 917

Income tax expense (30%) . . . . . . . . . 305 309 220 275

Net income . . . . . . . . . . . . . . . . . . . $ 713 $ 721 $ 512 $ 642

Balance Sheet

Inventory . . . . . . . . . . . . . . . . . . . . . $1,408 $1,420 $1,122 $1,307

This exhibit reveals two important results. First, when purchase costs regularly rise, as in Trekking’s case, observe the following:

● FIFO assigns the lowest amount to cost of goods sold — yielding the highest gross profit and net income. ● LIFO assigns the highest amount to cost of goods sold — yielding the lowest gross profit and net

income, which also yields a temporary tax advantage by postponing payment of some income tax. ● Weighted average yields results between FIFO and LIFO. ● Specific identification always yields results that depend on which units are sold.

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234 Chapter 5 Inventories and Cost of Sales

P4 Apply both the retail inventory and gross profit methods to estimate inventory.

APPENDIX

Inventory Estimation Methods Inventory sometimes requires estimation for two reasons. First, companies often require interim state- ments (financial statements prepared for periods of less than one year), but they only annually take a physical count of inventory. Second, companies may require an inventory estimate if some casualty such as fire or flood makes taking a physical count impossible. Estimates are usually only required for compa- nies that use the periodic system. Companies using a perpetual system would presumably have updated inventory data. This appendix describes two methods to estimate inventory.

Retail Inventory Method To avoid the time-consuming and expensive process of taking a physi- cal inventory each month or quarter, some companies use the retail inventory method to estimate cost of goods sold and ending inventory. Some companies even use the retail inventory method to prepare the an- nual statements. Home Depot, for instance, says in its annual report: “Inventories are stated at the lower of cost (first-in, first-out) or market, as determined by the retail inventory method.” A company may also estimate inventory for audit purposes or when inventory is damaged or destroyed.

The retail inventory method uses a three-step process to estimate ending inventory. We need to know the amount of inventory a company had at the beginning of the period in both cost and retail amounts. We al-

ready explained how to compute the cost of inventory. The retail amount of inventory refers to its dollar amount measured using selling prices of inventory items. We also need to know the net amount of goods purchased (mi- nus returns, allowances, and dis- counts) in the period, both at cost and at retail. The amount of net sales at retail is also needed. The process is shown in Exhibit 5B.1.

The reasoning behind the retail inventory method is that if we can get a good estimate of the cost-to- retail ratio, we can multi- ply ending inventory at retail by this ratio to estimate ending in-

ventory at cost. We show in Exhibit 5B.2 how these steps are applied to estimate ending inventory for a typical company. First, we find that $100,000 of goods (at retail selling prices) were available for sale. We see that $70,000 of these goods were sold, leaving $30,000 (retail value) of merchandise in ending inven- tory. Second, the cost of these goods is 60% of the $100,000 retail value. Third, since cost for these goods is 60% of retail, the estimated cost of ending inventory is $18,000.

5B

Second, when costs regularly decline, the reverse occurs for FIFO and LIFO. FIFO gives the highest cost of goods sold—yielding the lowest gross profit and income. And LIFO gives the lowest cost of goods sold—yielding the highest gross profit and income. All four inventory costing methods are acceptable in practice. A company must disclose the inventory method it uses. Each method offers certain advantages as follows:

● FIFO assigns an amount to inventory on the balance sheet that approximates its current cost; it also mimics the actual flow of goods for most businesses.

● LIFO assigns an amount to cost of goods sold on the income statement that approximates its current cost; it also better matches current costs with revenues in computing gross profit.

● Weighted average tends to smooth out erratic changes in costs. ● Specific identification exactly matches the costs of items with the revenues they generate.

Point: When a retailer takes a physical inventory, it can restate the retail value of inventory to a cost basis by applying the cost-to-retail ratio. It can also esti- mate the amount of shrinkage by com- paring the inventory computed with the amount from a physical inventory.

EXHIBIT 5B.1 Retail Inventory Method of Inventory Estimation

Step 2

Step 1

Step 3

Goods available for sale at retail

Net sales at retail

Ending inventory at retail

Goods available for sale at cost

Goods available for sale at retail

Cost-to- retail ratio

Ending inventory at retail

Cost-to- retail ratio

Estimated ending inventory

at cost �

Example: What is the cost of ending inventory in Exhibit 5B.2 if the cost of beginning inventory is $22,500 and its retail value is $34,500? Answer: $30,000 3 62% 5 $18,600

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Chapter 5 Inventories and Cost of Sales 235

EXHIBIT 5B.2 Estimated Inventory Using the Retail Inventory Method

At Cost At Retail

Goods available for sale

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,500 $ 34,500

Cost of goods purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,500 65,500

Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 100,000

Step 1: Deduct net sales at retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Ending inventory at retail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000

Step 2: Cost-to-retail ratio: ($60,000 4 $100,000) 5 60%

Step 3: Estimated ending inventory at cost ($30,000 3 60%) . . . . . . . . . $18,000

s

Point: A retailer such as Target can speed up its year-end physical count by using the retail inventory method. Inventory counters can record the item’s retail price without having to look up the cost of each item.

Gross Profit Method The gross profit method estimates the cost of ending inventory by applying the gross profit ratio to net sales (at retail). This type of estimate often is needed when inventory is destroyed, lost, or stolen. These cases require an inventory estimate so that a company can file a claim with its insurer. Users also apply this method to see whether inventory amounts from a physical count are reasonable. This method uses the historical relation between cost of goods sold and net sales to estimate the proportion of cost of goods sold making up current sales. This cost of goods sold estimate is then sub- tracted from cost of goods avail- able for sale to estimate the ending inventory at cost. These two steps are shown in Exhibit 5B.3.

To illustrate, assume that a company’s inventory is destroyed by fire in March 2013. When the fire occurs, the company’s accounts show the following balances for January through March: sales, $31,500; sales returns, $1,500; inventory (January 1, 2013), $12,000; and cost of goods purchased, $20,500. If this company’s gross profit ratio is 30%, then 30% of each net sales dollar is gross profit and 70% is cost of goods sold. We show in Exhibit 5B.4 how this 70% is used to estimate lost inventory of $11,500. To understand this exhibit, think of subtracting the cost of goods sold from the goods available for sale to get the ending inventory.

EXHIBIT 5B.3 Gross Profit Method of Inventory Estimation

Step 2

Step 1 Net sales at retail

1.0 − gross profit ratio

Estimated cost of

goods sold

Goods available for sale at cost

Estimated cost of

goods sold

Estimated ending

inventory at cost

� Point: A fire or other catastrophe can result in an insurance claim for lost inventory or income. Backup and off-site storage of data help ensure coverage for such losses.

Point: Reliability of the gross profit method depends on an accurate and stable estimate of the gross profit ratio.

EXHIBIT 5B.4 Estimated Inventory Using the Gross Profit Method

Goods available for sale

Inventory, January 1, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000

Cost of goods purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,500

Goods available for sale (at cost) . . . . . . . . . . . . . . . . . . . . . . 32,500

Net sales at retail ($31,500 2 $1,500) . . . . . . . . . . . . . . . . . . . . $30,000

Step 1: Estimated cost of goods sold ($30,000 3 70%) . . . . . . . . (21,000) 3 0.70

Step 2: Estimated March inventory at cost . . . . . . . . . . . . . . . . . . $11,500

9. Using the retail method and the following data, estimate the cost of ending inventory.

Cost Retail

Beginning inventory . . . . . . . . . . . . . . . $324,000 $530,000 Cost of goods purchased . . . . . . . . . . 195,000 335,000 Net sales . . . . . . . . . . . . . . . . . . . . . . . 320,000

Quick Check Answer — p. 237

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236 Chapter 5 Inventories and Cost of Sales

C1 Identify the items making up merchandise inventory. Merchandise inventory refers to goods owned by a company and held for resale. Three special cases merit our attention. Goods in transit are reported in inventory of the company that holds owner- ship rights. Goods on consignment are reported in the consignor’s inventory. Goods damaged or obsolete are reported in inventory at their net realizable value.

C2 Identify the costs of merchandise inventory. Costs of mer-chandise inventory include expenditures necessary to bring an item to a salable condition and location. This includes its invoice cost minus any discount plus any added or incidental costs neces- sary to put it in a place and condition for sale.

A1 Analyze the effects of inventory methods for both financial and tax reporting. When purchase costs are rising or falling, the inventory costing methods are likely to assign different costs to inventory. Specific identification exactly matches costs and revenues. Weighted average smooths out cost changes. FIFO assigns an amount to inventory closely approximating current replacement cost. LIFO assigns the most recent costs incurred to cost of goods sold and likely better matches current costs with revenues.

A2 Analyze the effects of inventory errors on current and future financial statements. An error in the amount of end- ing inventory affects assets (inventory), net income (cost of goods sold), and equity for that period. Since ending inventory is next period’s beginning inventory, an error in ending inventory affects next period’s cost of goods sold and net income. Inventory errors in one period are offset in the next period.

A3 Assess inventory management using both inventory turn-over and days’ sales in inventory. We prefer a high inventory turnover, provided that goods are not out of stock and customers are not turned away. We use days’ sales in inventory to assess the likelihood of goods being out of stock. We prefer a small number of days’ sales in inventory if we can serve customer needs and provide a buffer for uncertainties.

P1 Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted aver- age. Costs are assigned to the cost of goods sold account each time a

Summary sale occurs in a perpetual system. Specific identification assigns a cost to each item sold by referring to its actual cost (for example, its net invoice cost). Weighted average assigns a cost to items sold by dividing the current balance in the inventory account by the total items available for sale to determine cost per unit. We then multiply the number of units sold by this cost per unit to get the cost of each sale. FIFO assigns cost to items sold assuming that the earliest units purchased are the first units sold. LIFO assigns cost to items sold assuming that the most recent units purchased are the first units sold.

P2 Compute the lower of cost or market amount of inventory. Inventory is reported at market cost when market is lower than recorded cost, called the lower of cost or market (LCM) inventory. Market is typically measured as replacement cost. Lower of cost or market can be applied separately to each item, to major categories of items, or to the entire inventory.

P3A Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average. Periodic inventory systems allocate the cost of goods available for sale between cost of goods sold and ending inventory at the end of a period. Specific identification and FIFO give identical results whether the periodic or perpetual system is used. LIFO assigns costs to cost of goods sold assuming the last units purchased for the period are the first units sold. The weighted average cost per unit is computed by dividing the total cost of beginning inventory and net purchases for the period by the total number of units available. Then, it multiplies cost per unit by the number of units sold to give cost of goods sold.

P4B Apply both the retail inventory and gross profit methods to estimate inventory. The retail inventory method involves three steps: (1) goods available at retail minus net sales at retail equals ending inventory at retail, (2) goods available at cost divided by goods available at retail equals the cost-to-retail ratio, and (3) ending inventory at retail multiplied by the cost-to-retail ratio equals estimated ending inventory at cost. The gross profit method involves two steps: (1) net sales at retail multiplied by 1 minus the gross profit ratio equals estimated cost of goods sold, and (2) goods available at cost minus estimated cost of goods sold equals esti- mated ending inventory at cost.

Cost Analyst Explain to your supervisor that when inventory costs are increasing, FIFO results in an inventory valuation that ap- proximates replacement cost. The most recently purchased goods are assigned to ending inventory under FIFO and are likely closer to re- placement values than earlier costs that would be assigned to inventory if LIFO were used.

Inventory Manager It seems your company can save (or at least postpone) taxes by switching to LIFO, but the switch is likely to reduce bonus money that you think you have earned and deserve. Since the U.S. tax code requires companies that use LIFO for tax reporting also to use it for financial reporting, your options are further constrained. Your best decision is to tell your superior about the tax savings with

LIFO. You also should discuss your bonus plan and how this is likely to hurt you unfairly. You might propose to compute inventory under the LIFO method for reporting purposes but use the FIFO method for your bonus calculations. Another solution is to revise the bonus plan to re- flect the company’s use of the LIFO method.

Entrepreneur Your inventory turnover is markedly higher than the norm, whereas days’ sales in inventory approximates the norm. Since your turnover is already 14% better than average, you are prob- ably best served by directing attention to days’ sales in inventory. You should see whether you can reduce the level of inventory while maintaining service to customers. Given your higher turnover, you should be able to hold less inventory.

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 5 Inventories and Cost of Sales 237

Use the following information from Marvel Company for the month of July to answer questions 1 through 4.

July 1 Beginning inventory . . . . . . . . 75 units @ $25 each July 3 Purchase . . . . . . . . . . . . . . . . . 348 units @ $27 each July 8 Sale . . . . . . . . . . . . . . . . . . . . . 300 units July 15 Purchase . . . . . . . . . . . . . . . . . 257 units @ $28 each July 23 Sale . . . . . . . . . . . . . . . . . . . . . 275 units

1. Perpetual: Assume that Marvel uses a perpetual FIFO inven- tory system. What is the dollar value of its ending inventory?

a. $2,940 d. $2,852 b. $2,685 e. $2,705 c. $2,625 2. Perpetual: Assume that Marvel uses a perpetual LIFO inven-

tory system. What is the dollar value of its ending inventory? a. $2,940 d. $2,852 b. $2,685 e. $2,705 c. $2,625 3. Perpetual: Assume that Marvel uses a perpetual specific identi-

fication inventory system. Its ending inventory consists of 20 units from beginning inventory, 40 units from the July 3 pur- chase, and 45 units from the July 15 purchase. What is the dol- lar value of its ending inventory?

a. $2,940 d. $2,852 b. $2,685 e. $2,840 c. $2,625

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 254 mhhe.com/wildFINMAN5e

4. Periodic: Assume that Marvel uses a periodic FIFO inventory system. What is the dollar value of its ending inventory?

a. $2,940 d. $2,852 b. $2,685 e. $2,705 c. $2,625 5. Periodic: A company reports the following beginning in-

ventory and purchases, and it ends the period with 30 units in inventory.

a. Compute ending inventory using the FIFO periodic system. b. Compute cost of goods sold using the LIFO periodic

system. 6. A company has cost of goods sold of $85,000 and ending in-

ventory of $18,000. Its days’ sales in inventory equals: a. 49.32 days d. 77.29 days b. 0.21 days e. 1,723.61 days c. 4.72 days

Beginning inventory . . . . . . . . . 100 units at $10 cost per unit Purchase 1. . . . . . . . . . . . . . . . . 40 units at $12 cost per unit Purchase 2. . . . . . . . . . . . . . . . . 20 units at $14 cost per unit

1. The matching principle. 2. Famous Footwear reports these goods in its inventory. 3. Total cost assigned to the painting is $12,180, computed as

$11,400 1 $130 1 $150 1 $100 1 $400. 4. Specific identification exactly matches costs and revenues.

Weighted average tends to smooth out cost changes. FIFO assigns an amount to inventory that closely approximates current replace- ment cost. LIFO assigns the most recent costs incurred to cost of goods sold and likely better matches current costs with revenues.

5. FIFO—it gives a lower cost of goods sold, a higher gross profit, and a higher net income when costs are rising.

6. When costs are rising, LIFO gives a lower inventory figure on the balance sheet as compared to FIFO. FIFO’s inventory amount approximates current replacement costs.

7. Cost of goods sold would be overstated by $10,000 in 2012 and understated by $10,000 in year 2013.

8. The reported LCM inventory amount (using items) is $540, com- puted as [(20 3 $5) 1 (40 3 $8) 1 (10 3 $12)].

9.B Estimated ending inventory (at cost) is $327,000. It is computed as follows:

Step 1: ($530,000 1 $335,000) 2 $320,000 5 $545,000

Step 2:

$324,000 1 $195,000

$530,000 1 $335,000 5 60%

Step 3: $545,000 3 60% 5 $327,000

Guidance Answers to Quick Checks

Average cost (p. 216, 232)

Conservatism constraint (p. 220)

Consignee (p. 210)

Consignor (p. 210)

Consistency concept (p. 219)

Days’ sales in inventory (p. 223)

First-in, first-out (FIFO) (p. 215)

Gross profit method (p. 235)

Interim statements (p. 234)

Inventory turnover (p. 223)

Last-in, first-out (LIFO) (p. 215)

Lower of cost or market (LCM) (p. 219)

Net realizable value (p. 210)

Retail inventory method (p. 234)

Specific identification (p. 213, 230)

Weighted average (p. 216, 232)

Key Terms

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238 Chapter 5 Inventories and Cost of Sales

1. Describe how costs flow from inventory to cost of goods sold for the following methods: (a) FIFO and (b) LIFO.

2. Where is the amount of merchandise inventory disclosed in the financial statements?

3. Why are incidental costs sometimes ignored in inventory cost- ing? Under what accounting constraint is this permitted?

4. If costs are declining, will the LIFO or FIFO method of inventory valuation yield the lower cost of goods sold? Why?

5. What does the full-disclosure principle prescribe if a company changes from one acceptable accounting method to another?

6. Can a company change its inventory method each accounting period? Explain.

7. Does the accounting concept of consistency preclude any changes from one accounting method to another?

8. If inventory errors are said to correct themselves, why are accounting users concerned when such errors are made?

9. Explain the following statement: “Inventory errors correct themselves.”

10. What is the meaning of market as it is used in determining the lower of cost or market for inventory?

11. What guidance does the accounting constraint of conserva- tism offer?

12. What factors contribute to (or cause) inventory shrinkage? 13.B When preparing interim financial statements, what two

methods can companies utilize to estimate cost of goods sold and ending inventory?

14. Refer to Polaris’ financial statements in Appen- dix A. On December 31, 2011, what percent of current assets are represented by inventory?

15. Refer to Arctic Cat’s financial statements in Appendix A and compute its cost of goods available for sale for the year ended March 31, 2011.

16. Refer to KTM’s financial statements in Appendix A. Compute its cost of goods available for sale for the year ended December 31, 2011.

17. Refer to Piaggio’s financial statements in Ap- pendix A. What percent of its current assets are inventory as of December 31, 2011 and 2010?

Discussion Questions

B Superscript letter A (B) denotes assignments based on Appendix 5A (5B).

Icon denotes assignments that involve decision making.

QS 5-2 Perpetual: Inventory costing with LIFO P1

Refer to the information in QS 5-1 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on LIFO. (Round per unit costs and inventory amounts to cents.)

QS 5-4A

Periodic: Inventory costing with FIFO P3

Refer to the information in QS 5-1 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

Check $465

QS 5-3 Perpetual: Inventory costing with weighted average P1

Refer to the information in QS 5-1 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

Units Unit Cost

Beginning inventory on January 1 . . . . . . . . . 320 $3.00

Purchase on January 9 . . . . . . . . . . . . . . . . . 80 3.20

Purchase on January 25 . . . . . . . . . . . . . . . . 100 3.34

Information: A company reports the following beginning inventory and purchases for the month of January. On January 26, the company sells 350 units. 150 units remain in ending inventory at January 31.

QUICK STUDY

QS 5-1 Perpetual: Inventory costing with FIFO

P1

Required

Assume the perpetual inventory system is used and then determine the costs assigned to ending inventory when costs are assigned based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

Polaris

Arctic Cat

KTM

PIAGGIO

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Chapter 5 Inventories and Cost of Sales 239

QS 5-7 Computing goods available for sale P1

Wattan Company reports beginning inventory of 10 units at $60 each. Every week for four weeks it purchases an additional 10 units at respective costs of $61, $62, $65 and $70 per unit for weeks 1 through 4. Calculate the cost of goods available for sale and the units available for sale for this four- week period. Assume that no sales occur during those four weeks.

QS 5-8 Perpetual: Assigning costs with FIFO

P1

Information: Trey Monson starts a merchandising business on December 1 and enters into the following three inventory purchases. During December, Monson sells 15 units for $20 each on December 15.

Purchases on December 7 10 units @ $ 6.00 cost

Purchases on December 14 20 units @ $12.00 cost

Purchases on December 21 15 units @ $14.00 cost

Required

Monson uses a perpetual inventory system. Determine the costs assigned to the December 31 ending inventory based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-5A

Periodic: Inventory costing with LIFO P3

Refer to the information in QS 5-1 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the LIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-6A

Periodic: Inventory costing with weighted average P3

Refer to the information in QS 5-1 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

QS 5-9 Perpetual: Inventory costing with LIFO P1

Refer to the information in QS 5-8 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the LIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-11 Perpetual: Inventory costing with specific identification P1

Refer to the information in QS 5-8 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on specific identification. Of the units sold, eight are from the December 7 purchase and seven are from the December 14 purchase. (Round per unit costs and inventory amounts to cents.)

QS 5-12A

Periodic: Inventory costing with FIFO P3

Refer to the information in QS 5-8 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the FIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-13 Periodic: Inventory costing with LIFO P3

Refer to the information in QS 5-8 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the LIFO method. (Round per unit costs and inventory amounts to cents.)

QS 5-14A

Periodic: Inventory costing with weighted average P3

Refer to the information in QS 5-8 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

QS 5-10 Perpetual: Inventory costing with weighted average P1

Refer to the information in QS 5-8 and assume the perpetual inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on the weighted average method. (Round per unit costs and inventory amounts to cents.)

Check End. Inv. 5 $360

QS 5-15A

Periodic: Inventory costing with specific identification P3

Refer to the information in QS 5-8 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory when costs are assigned based on specific identification. Of the units sold, eight are from the December 7 purchase and seven are from the December 14 purchase. (Round per unit costs and inventory amounts to cents.)

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240 Chapter 5 Inventories and Cost of Sales

QS 5-21 Analyzing inventory A3

Endor Company begins the year with $150,000 of goods in inventory. At year-end, the amount in inventory has increased to $180,000. Cost of goods sold for the year is $1,200,000. Compute Endor’s inventory turnover and days’ sales in inventory. Assume that there are 365 days in the year.

QS 5-19 Applying LCM to inventories

P2

Ames Trading Co. has the following products in its ending inventory. Compute lower of cost or market for inventory applied separately to each product.

Product Quantity Cost per Unit Market per Unit

Mountain bikes . . . . . . . . 11 $600 $550

Skateboards . . . . . . . . . . . 13 350 425

Gliders . . . . . . . . . . . . . . . 26 800 700

QS 5-20 Inventory errors

A2

In taking a physical inventory at the end of year 2013, Grant Company forgot to count certain units. Explain how this error affects the following: (a) 2013 cost of goods sold, (b) 2013 gross profit, (c) 2013 net income, (d ) 2014 net income, (e) the combined two-year income, and ( f ) income for years after 2014.

QS 5-22B

Estimating inventories—gross profit method

P4

Kauai Store’s inventory is destroyed by a fire on September 5, 2013. The following data for year 2013 are available from the accounting records. Estimate the cost of the inventory destroyed.

Jan. 1 inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . $190,000

Jan. 1 through Sept. 5 purchases (net) . . . . . . . . . $352,000

Jan. 1 through Sept. 5 sales (net) . . . . . . . . . . . . . . $685,000

Year 2013 estimated gross profit rate . . . . . . . . . 44%

Answer each of the following questions related to international accounting standards. a. Explain how the accounting for items and costs making up merchandise inventory is different be-

tween IFRS and U.S. GAAP. b. Can companies reporting under IFRS apply a cost flow assumption in assigning costs to inventory? If

yes, identify at least two acceptable cost flow assumptions. c. Both IFRS and U.S. GAAP apply the lower of cost or market method for reporting inventory values.

If inventory is written down from applying the lower of cost or market method, explain in general terms how IFRS and U.S. GAAP differ in accounting for any subsequent period reversal of that re- ported decline in inventory value.

QS 5-23 International accounting standards

C1 C2 P2

QS 5-18 Inventory costs

C2

A car dealer acquires a used car for $14,000, terms FOB shipping point. Additional costs in obtaining and offering the car for sale include $250 for transportation-in, $900 for import duties, $300 for insurance during shipment, $150 for advertising, and $1,250 for sales staff salaries. For computing inventory, what cost is assigned to the used car?

QS 5-17 Inventory ownership

C1

Homestead Crafts, a distributor of handmade gifts, operates out of owner Emma Finn’s house. At the end of the current period, Emma reports she has 1,300 units (products) in her basement, 20 of which were damaged by water and cannot be sold. She also has another 350 units in her van, ready to deliver per a customer order, terms FOB destination, and another 80 units out on consignment to a friend who owns a retail store. How many units should Emma include in her company’s period-end inventory?

Identify the inventory costing method best described by each of the following separate statements. Assume a period of increasing costs. 1. Yields a balance sheet inventory amount often markedly less than its replacement cost. 2. Results in a balance sheet inventory amount approximating replacement cost. 3. Provides a tax advantage (deferral) to a corporation when costs are rising. 4. Recognizes (matches) recent costs against net sales. 5. The preferred method when each unit of product has unique features that markedly affect cost.

QS 5-16 Contrasting inventory costing methods

A1

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Chapter 5 Inventories and Cost of Sales 241

Exercise 5-2 Inventory costs

C2

Walberg Associates, antique dealers, purchased the contents of an estate for $75,000. Terms of the purchase were FOB shipping point, and the cost of transporting the goods to Walberg Associates’ warehouse was $2,400. Walberg Associates insured the shipment at a cost of $300. Prior to putting the goods up for sale, they cleaned and refurbished them at a cost of $980. Determine the cost of the inventory acquired from the estate.

1. Harris Company has shipped $20,000 of goods to Harlow Co., and Harlow Co. has arranged to sell the goods for Harris. Identify the consignor and the consignee. Which company should include any unsold goods as part of its inventory?

2. At year-end, Harris Co. had shipped $12,500 of merchandise FOB destination to Harlow Co. Which company should include the $12,500 of merchandise in transit as part of its year-end inventory?

EXERCISES

Exercise 5-1 Inventory ownership C1

Exercise 5-3 Perpetual: Inventory costing methods

P1

Information: Laker Company reported the following January purchases and sales data for its only product.

Required

The Company uses a perpetual inventory system. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d ) LIFO. (Round per unit costs and inventory amounts to cents.) For specific identification, ending inventory consists of 200 units, where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning inventory.

Date Activities Units Acquired at Cost Units Sold at Retail

Jan. 1 Beginning inventory . . . . . . . . . . 140 units @ $6.00 5 $ 840

Jan. 10 Sales . . . . . . . . . . . . . . . . . . . . . . 100 units @ $15

Jan. 20 Purchase . . . . . . . . . . . . . . . . . . . 60 units @ $5.00 5 300

Jan. 25 Sales . . . . . . . . . . . . . . . . . . . . . . 80 units @ $15

Jan. 30 Purchase . . . . . . . . . . . . . . . . . . . 180 units @ $4.50 5 810

Totals . . . . . . . . . . . . . . . . . . . . . 380 units $1,950 180 units

Check Ending inventory: LIFO, $930; WA, $918

Use the data in Exercise 5-3 to prepare comparative income statements for the month of January for Laker Company similar to those shown in Exhibit 5.8 for the four inventory methods. Assume expenses are $1,250, and that the applicable income tax rate is 40%. (Round amounts to cents.) 1. Which method yields the highest net income? 2. Does net income using weighted average fall between that using FIFO and LIFO? 3. If costs were rising instead of falling, which method would yield the highest net income?

Exercise 5-4 Perpetual: Income effects of inventory methods

A1

Exercise 5-5A

Periodic: Inventory costing P3 Refer to the information in Exercise 5-3 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d ) LIFO. (Round per unit costs and inventory amounts to cents.)

Exercise 5-6A

Periodic: Income effects of inventory methods

A1

Use the data in Exercise 5-5 to prepare comparative income statements for the month of January for the company similar to those shown in Exhibit 5.8 for the four inventory methods. Assume expenses are $1,250, and that the applicable income tax rate is 40%. (Round amounts to cents.)

Required

1. Which method yields the highest net income? 2. Does net income using weighted average fall between that using FIFO and LIFO? 3. If costs were rising instead of falling, which method would yield the highest net income?

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242 Chapter 5 Inventories and Cost of Sales

Exercise 5-8 Specific identification P1

Refer to the information in Exercise 5-7. Ending inventory consists of 45 units from the March 14 purchase, 75 units from the July 30 purchase, and all 100 units from the October 26 purchase. Using the specific identification method, calculate (a) the cost of goods sold and (b) the gross profit. (Round amounts to cents.)

Check LCM 5 $7,394

Exercise 5-10 Lower of cost or market

P2

Martinez Company’s ending inventory includes the following items. Compute the lower of cost or market for ending inventory applied separately to each product.

Per Unit

Product Units Cost Market

Helmets . . . . . . . . . 24 $50 $54

Bats . . . . . . . . . . . . 17 78 72

Shoes . . . . . . . . . . . 38 95 91

Uniforms . . . . . . . . 42 36 36

Exercise 5-7 Perpetual: Inventory costing methods—FIFO and LIFO

P1

Information: Hemming Co. reported the following current-year purchases and sales for its only product.

Required

Hemming uses a perpetual inventory system. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. Compute the gross margin for each method. (Round amounts to cents.)

Date Activities Units Acquired at Cost Units Sold at Retail

Jan. 1 Beginning inventory . . . . . . . . 200 units @ $10 5 $ 2,000

Jan. 10 Sales . . . . . . . . . . . . . . . . . . . . 150 units @ $40

Mar. 14 Purchase . . . . . . . . . . . . . . . . 350 units @ $15 5 5,250

Mar. 15 Sales . . . . . . . . . . . . . . . . . . . . 300 units @ $40

July 30 Purchase . . . . . . . . . . . . . . . . 450 units @ $20 5 9,000

Oct. 5 Sales . . . . . . . . . . . . . . . . . . . . 430 units @ $40

Oct. 26 Purchase . . . . . . . . . . . . . . . . 100 units @ $25 5 2,500

Totals . . . . . . . . . . . . . . . . . . . 1,100 units $18,750 880 units

Check Ending inventory: LIFO, $4,150

Exercise 5-9A

Periodic: Inventory costing

P3

Refer to the information in Exercise 5-7 and assume the periodic inventory system is used. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. Then (c) compute the gross margin for each method.

1. Compute its current ratio, inventory turnover, and days’ sales in inventory for 2013 using (a) LIFO numbers and (b) FIFO numbers. (Round answers to one decimal.)

2. Comment on and interpret the results of part 1.

Cruz Company uses LIFO for inventory costing and reports the following financial data. It also recomputed inventory and cost of goods sold using FIFO for comparison purposes.

2013 2012

LIFO inventory . . . . . . . . . . . . . . . . . . . $160 $110

LIFO cost of goods sold . . . . . . . . . . . . 740 680

FIFO inventory . . . . . . . . . . . . . . . . . . . 240 110

FIFO cost of goods sold . . . . . . . . . . . . 660 645

Current assets (using LIFO) . . . . . . . . . 220 180

Current liabilities . . . . . . . . . . . . . . . . . 200 170

Exercise 5-11 Comparing LIFO numbers to FIFO numbers; ratio analysis

A1 A3

Check (1) FIFO: Current ratio, 1.5; Inventory turnover, 3.8 times

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Chapter 5 Inventories and Cost of Sales 243

Exercise 5-12 Analysis of inventory errors

A2

Vibrant Company had $850,000 of sales in each of three consecutive years 2012–2014, and it purchased merchandise costing $500,000 in each of those years. It also maintained a $250,000 physical inventory from the beginning to the end of that three-year period. In accounting for inventory, it made an error at the end of year 2012 that caused its year-end 2012 inventory to appear on its statements as $230,000 rather than the correct $250,000. 1. Determine the correct amount of the company’s gross profit in each of the years 2012 – 2014. 2. Prepare comparative income statements as in Exhibit 5.11 to show the effect of this error on the com-

pany’s cost of goods sold and gross profit for each of the years 2012 – 2014.

Check 2012 reported gross profit, $330,000

2013 2012 2011

Cost of goods sold . . . . . . . . . $643,825 $426,650 $391,300

Ending inventory . . . . . . . . . . . 97,400 87,750 92,500

Exercise 5-13 Inventory turnover and days’ sales in inventory

A3

Use the following information for Palmer Co. to compute inventory turnover for 2013 and 2012, and its days’ sales in inventory at December 31, 2013 and 2012. (Round answers to one decimal.) Comment on Palmer’s efficiency in using its assets to increase sales from 2012 to 2013.

Exercise 5-14A

Periodic: Cost flow assumptions

P3

Martinez Co. reported the following current-year data for its only product. The company uses a periodic inventory system, and its ending inventory consists of 150 units—50 from each of the last three purchases. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d ) LIFO. (Round per unit costs and inventory amounts to cents.) Which method yields the highest net income?

Jan. 1 Beginning inventory . . . . . . . . 96 units @ $2.00 5 $ 192

Mar. 7 Purchase . . . . . . . . . . . . . . . . . 220 units @ $2.25 5 495

July 28 Purchase . . . . . . . . . . . . . . . . . 544 units @ $2.50 5 1,360

Oct. 3 Purchase . . . . . . . . . . . . . . . . . 480 units @ $2.80 5 1,344

Dec. 19 Purchase . . . . . . . . . . . . . . . . . 160 units @ $2.90 5 464

Totals . . . . . . . . . . . . . . . . . . . 1,500 units $3,855 Check Inventory; LIFO, $313.50; FIFO, $435.00

Exercise 5-15 Periodic: Cost flow assumptions

P3

Flora’s Gifts reported the following current-monthly data for its only product. The company uses a periodic inventory system, and its ending inventory consists of 60 units—50 units from the January 6 purchase, and 10 units from the January 25 purchase. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d ) LIFO. (Round per unit costs and inventory amounts to cents.) Which method yields the lowest net income?

Check Inventory: LIFO, $180.00; FIFO, $131.40

Jan. 1 Beginning inventory . . . . . . . . 138 units @ $3.00 5 $ 414

Jan. 6 Purchase . . . . . . . . . . . . . . . . . 300 units @ $2.80 5 840

Jan. 17 Purchase . . . . . . . . . . . . . . . . . 540 units @ $2.30 5 1,242

Jan. 25 Purchase . . . . . . . . . . . . . . . . . 22 units @ $2.00 5 44

Totals . . . . . . . . . . . . . . . . . . . 1,000 units $2,540

Exercise 5-16B

Estimating ending inventory— retail method

P4

In 2013, Dakota Company had net sales (at retail) of $260,000. The following additional information is available from its records at the end of 2013. Use the retail inventory method to estimate Dakota’s 2013 ending inventory at cost.

Check End. Inventory, $35,860

At Cost At Retail

Beginning inventory . . . . . . . . . . . . . $ 63,800 $128,400

Cost of goods purchased . . . . . . . . 115,060 196,800

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244 Chapter 5 Inventories and Cost of Sales

Information: Montoure Company uses a perpetual inventory system. It entered into the following calendar-year 2013 purchases and sales transactions. (For specific identification, units sold consist of 600 units from beginning inventory, 300 from the February 10 purchase, 200 from the March 13 purchase, 50 from the August 21 purchase, and 250 from the September 5 purchase.)

Problem 5-3A Perpetual: Alternative cost flows

P1

Exercise 5-17B

Estimating ending inventory— gross profit method

P4

On January 1, JKR Shop had $225,000 of inventory at cost. In the first quarter of the year, it purchased $795,000 of merchandise, returned $11,550, and paid freight charges of $18,800 on purchased merchandise, terms FOB shipping point. The company’s gross profit averages 30%, and the store had $1,000,000 of net sales (at retail) in the first quarter of the year. Use the gross profit method to estimate its cost of inventory at the end of the first quarter.

Problem 5-2AA

Periodic: Alternative cost flows

P1

Refer to the information in Problem 5-1A and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Exercise 5-18 Accounting for inventory following IFRS

P2

Samsung Electronics reports the following regarding its accounting for inventories.

Inventories are stated at the lower of cost or net realizable value. Cost is determined using the average cost method, except for materials-in-transit. Inventories are reduced for the estimated losses arising from excess, obsolescence, and the decline in value. This reduction is determined by estimating market value based on future customer demand. The losses on inventory obsolescence are recorded as a part of cost of sales.

1. What cost flow assumption(s) does Samsung apply in assigning costs to its inventories? 2. If at year-end 2011 there was an increase in the value of its inventories such that there was a reversal

of W550 (W is Korean won) million for the 2010 write-down, how would Samsung account for this under IFRS? Would Samsung’s accounting be different for this reversal if it reported under U.S. GAAP? Explain.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Check (3) Ending Inventory: FIFO, $14,800; LIFO, $13,680, WA, $14,352

(4) LIFO gross profit, $17,980

PROBLEM SET A

Problem 5-1A Perpetual: Alternative cost flows

P1

Information: Warnerwoods Company uses a perpetual inventory system. It entered into the following purchases and sales transactions for March. (For specific identification, the March 9 sale consisted of 80 units from beginning inventory and 340 units from the March 5 purchase; the March 29 sale consisted of 40 units from the March 18 purchase and 120 units from the March 25 purchase.)

Date Activities Units Acquired at Cost Units Sold at Retail

Mar. 1 Beginning inventory . . . . . . . . . . 100 units @ $50.00 per unit

Mar. 5 Purchase . . . . . . . . . . . . . . . . . . . 400 units @ $55.00 per unit

Mar. 9 Sales . . . . . . . . . . . . . . . . . . . . . . 420 units @ $85.00 per unit

Mar. 18 Purchase . . . . . . . . . . . . . . . . . . . 120 units @ $60.00 per unit

Mar. 25 Purchase . . . . . . . . . . . . . . . . . . . 200 units @ $62.00 per unit

Mar. 29 Sales . . . . . . . . . . . . . . . . . . . . . . 160 units @ $95.00 per unit

Totals . . . . . . . . . . . . . . . . . . . . . 820 units 580 units

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Chapter 5 Inventories and Cost of Sales 245

Date Activities Units Acquired at Cost Units Sold at Retail

Jan. 1 Beginning inventory . . . . . . . . . . 600 units @ $45.00 per unit

Feb. 10 Purchase . . . . . . . . . . . . . . . . . . . 400 units @ $42.00 per unit

Mar. 13 Purchase . . . . . . . . . . . . . . . . . . . 200 units @ $27.00 per unit

Mar. 15 Sales . . . . . . . . . . . . . . . . . . . . . . 800 units @ $75.00 per unit

Aug. 21 Purchase . . . . . . . . . . . . . . . . . . . 100 units @ $50.00 per unit

Sept. 5 Purchase . . . . . . . . . . . . . . . . . . . 500 units @ $46.00 per unit

Sept. 10 Sales . . . . . . . . . . . . . . . . . . . . . . 600 units @ $75.00 per unit

Totals . . . . . . . . . . . . . . . . . . . . . 1,800 units 1,400 units

Problem 5-4AA

Periodic: Alternative cost flows

P1

Refer to the information in Problem 5-3A and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. If the company’s manager earns a bonus based on a percentage of gross profit, which method of inven- tory costing will the manager likely prefer?

Check (3) Ending inventory: FIFO, $18,400; LIFO, $18,000; WA, $17,760; . (4) LIFO gross profit,

$45,800

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d ) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. If the company’s manager earns a bonus based on a percent of gross profit, which method of inventory costing will the manager likely prefer?

Problem 5-5A Lower of cost or market

P2

A physical inventory of Liverpool Company taken at December 31 reveals the following.

Audio equipment

Video equipment

Car audio equipment

Receivers CD players MP3 players Speakers

Handheld LCDs VCRs Camcorders

CD/MP3 radios Satellite radios

Per Unit Units CostItem Market

345 260 326 204

480 291 212

185 170

$ 90 111 86 52

150 93

310

70 97

$ 98 100 95 41

125 84

322

84 105

Required

1. Calculate the lower of cost or market for the inventory applied separately to each item. 2. If the market amount is less than the recorded cost of the inventory, then record the LCM adjustment

to the Merchandise Inventory account.

Check (1) $273,054

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246 Chapter 5 Inventories and Cost of Sales

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Problem 5-6A Analysis of inventory errors

A2

Navajo Company’s financial statements show the following. The company recently discovered that in making physical counts of inventory, it had made the following errors: Inventory on December 31, 2012, is understated by $56,000, and inventory on December 31, 2013, is overstated by $20,000.

Required

1. For each key financial statement figure — (a), (b), (c), and (d) above — prepare a table similar to the following to show the adjustments necessary to correct the reported amounts.

Check (1) Corrected net income: 2012, $286,000; 2013, $209,000; 2014, $261,000

Figure: 2012 2013 2014

Reported amount . . . . . . . . . . . . . . . . . . . . . .

Adjustments for: 12/31/2012 error . . . . . . . . .

12/31/2013 error . . . . . . . .

Corrected amount . . . . . . . . . . . . . . . . . . . . .

Analysis Component

2. What is the error in total net income for the combined three-year period resulting from the inventory errors? Explain.

3. Explain why the understatement of inventory by $56,000 at the end of 2012 results in an understate- ment of equity by the same amount in that year.

For Year Ended December 31 2012 2013 2014

(a) Cost of goods sold . . . . . . . . . . . . . . . . $ 615,000 $ 957,000 $ 780,000

(b) Net income . . . . . . . . . . . . . . . . . . . . . . 230,000 285,000 241,000

(c) Total current assets . . . . . . . . . . . . . . . . 1,255,000 1,365,000 1,200,000

(d ) Total equity . . . . . . . . . . . . . . . . . . . . . . 1,387,000 1,530,000 1,242,000

Problem 5-8AA

Periodic: Income comparisons and cost flows

A1 P3

Information: QP Corp. sold 4,000 units of its product at $50 per unit in year 2013 and incurred operating expenses of $5 per unit in selling the units. It began the year with 700 units in inventory and made succes- sive purchases of its product as follows.

Jan. 1 Beginning inventory . . . . . . . . 700 units @ $18.00 per unit

Feb. 20 Purchase . . . . . . . . . . . . . . . . . 1,700 units @ $19.00 per unit

May 16 Purchase . . . . . . . . . . . . . . . . . 800 units @ $20.00 per unit

Oct. 3 Purchase . . . . . . . . . . . . . . . . . 500 units @ $21.00 per unit

Dec. 11 Purchase . . . . . . . . . . . . . . . . . 2,300 units @ $22.00 per unit

Total . . . . . . . . . . . . . . . . . . . . 6,000 units

Problem 5-7AA

Periodic: Alternative cost flows

P3

Information: Seminole Company began year 2013 with 23,000 units of product in its January 1 inventory costing $15 each. It made successive purchases of its product in year 2013 as follows. The company uses a periodic inventory system. On December 31, 2013, a physical count reveals that 40,000 units of its product remain in inventory.

Mar. 7 . . . . . . . . 30,000 units @ $18.00 each

May 25 . . . . . . . . 39,000 units @ $20.00 each

Aug. 1 . . . . . . . . 23,000 units @ $25.00 each

Nov. 10 . . . . . . . . 35,000 units @ $26.00 each

Required

1. Compute the number and total cost of the units available for sale in year 2013. 2. Compute the amounts assigned to the 2013 ending inventory and the cost of goods sold using (a) FIFO,

(b) LIFO, and (c) weighted average. (Round all amounts to cents.)

Check (2) Cost of goods sold: FIFO, $2,115,000; LIFO, $2,499,000; WA, $2,310,000

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Chapter 5 Inventories and Cost of Sales 247

Required

1. Prepare comparative income statements similar to Exhibit 5.8 for the three inventory costing methods of FIFO, LIFO, and weighted average. (Round all amounts to cents.) Include a detailed cost of goods sold section as part of each statement. The company uses a periodic inventory system, and its income tax rate is 40%.

2. How would the financial results from using the three alternative inventory costing methods change if the Company had been experiencing declining costs in its purchases of inventory?

3. What advantages and disadvantages are offered by using (a) LIFO and (b) FIFO? Assume the continu- ing trend of increasing costs.

Problem 5-9AB

Retail inventory method

P4

The records of Alaska Company provide the following information for the year ended December 31.

At Cost At Retail

January 1 beginning inventory . . . . . . . . . $ 469,010 $ 928,950

Cost of goods purchased . . . . . . . . . . . . 3,376,050 6,381,050

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,595,800

Sales returns . . . . . . . . . . . . . . . . . . . . . . 42,800

Required

1. Use the retail inventory method to estimate the company’s year-end inventory at cost. 2. A year-end physical inventory at retail prices yields a total inventory of $1,686,900. Prepare a calcula-

tion showing the company’s loss from shrinkage at cost and at retail.

Check (1) Inventory, $924,182 cost;

(2) Inventory shortage at cost, $36,873

Problem 5-10AB

Gross profit method

P4

Wayward Company wants to prepare interim financial statements for the first quarter. The company wishes to avoid making a physical count of inventory. Wayward’s gross profit rate averages 34%. The fol- lowing information for the first quarter is available from its records.

Required

Use the gross profit method to estimate the company’s first quarter ending inventory.

January 1 beginning inventory . . . . . . . . . $ 302,580

Cost of goods purchased . . . . . . . . . . . . 941,040

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,211,160

Sales returns . . . . . . . . . . . . . . . . . . . . . . 8,410

Check Estimated ending inventory, $449,805

Information: TDS Company uses a perpetual inventory system. It entered into the following purchases and sales transactions for April. (For specific identification, the April 9 sale consisted of 8 units from beginning inventory and 27 units from the April 6 purchase; the April 30 sale consisted of 12 units from beginning inventory 3 units from the April 6 purchase and 10 units from the April 25 purchase.)

PROBLEM SET B

Problem 5-1B Perpetual: Alternative cost flows

P1 Date Activities Units Acquired at Cost Units Sold at Retail

Apr. 1 Beginning inventory . . . . . . . . 20 units @ $3,000.00 per unit

Apr. 6 Purchase . . . . . . . . . . . . . . . . . 30 units @ $3,500.00 per unit

Apr. 9 Sales . . . . . . . . . . . . . . . . . . . . 35 units @ $12,000.00 per unit

Apr. 17 Purchase . . . . . . . . . . . . . . . . . 5 units @ $4,500.00 per unit

Apr. 25 Purchase . . . . . . . . . . . . . . . . . 10 units @ $4,800.00 per unit

Apr. 30 Sales . . . . . . . . . . . . . . . . . . . . 25 units @ $14,000.00 per unit

Total . . . . . . . . . . . . . . . . . . . . 65 units 60 units

Check (1) Net income: FIFO, $61,200; LIFO, $57,180; WA, $59,196

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248 Chapter 5 Inventories and Cost of Sales

Problem 5-2BA

Periodic: Alternative cost flows

P1

Refer to the information in Problem 5-1B and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Problem 5-3B Perpetual: Alternative cost flows

P1

Information: Aloha Company uses a perpetual inventory system. It entered into the following calendar- year 2013 purchases and sales transactions. (For specific identification, the May 9 sale consisted of 80 units from beginning inventory and 100 units from the May 6 purchase; the May 30 sale consisted of 200 units from the May 6 purchase and 100 units from the May 25 purchase.)

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. If the company’s manager earns a bonus based on a percent of gross profit, which method of inventory costing will the manager likely prefer?

Check (3) Ending inventory: FIFO, $88,800; LIFO, $62,500; WA, $75,600;

(4) LIFO gross profit, $449,200

Date Activities Units Acquired at Cost Units Sold at Retail

May 1 Beginning inventory . . . . . . . . 150 units @ $300.00 per unit

May 6 Purchase . . . . . . . . . . . . . . . . . 350 units @ $350.00 per unit

May 9 Sales . . . . . . . . . . . . . . . . . . . . 180 units @ $1,200.00 per unit

May 17 Purchase . . . . . . . . . . . . . . . . . 80 units @ $450.00 per unit

May 25 Purchase . . . . . . . . . . . . . . . . . 100 units @ $458.00 per unit

May 30 Sales . . . . . . . . . . . . . . . . . . . . 300 units @ $1,400.00 per unit

Total . . . . . . . . . . . . . . . . . . . . 680 units 480 units

Problem 5-4BA

Periodic: Alternative cost flows

P1

Refer to the information in Problem 5-3B and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Analysis Component

5. If the company’s manager earns a bonus based on a percentage of gross profit, which method of inven- tory costing will the manager likely prefer?

Required

1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and

(d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for each of the four costing methods in part 3.

Check (3) Ending inventory: FIFO, $24,000; LIFO, $15,000; WA, $20,000;

(4) LIFO gross profit, $549,500

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Chapter 5 Inventories and Cost of Sales 249

Problem 5-5B Lower of cost or market

P2

A physical inventory of Office Necessities taken at December 31 reveals the following.

Office furniture

Filing cabinets

Office equipment

Desks Credenzas Chairs Bookshelves

Two-drawer Four-drawer Lateral

Copiers Fax machines

Telephones

Per Unit Units CostItem Market

536 395 687 421

114 298 75

370 475

$261 227 49 93

81 135 104

168 317

$305 256 43 82

70 122 118

200 288

302 125 117

Required

1. Compute the lower of cost or market for the inventory applied separately to each item. 2. If the market amount is less than the recorded cost of the inventory, then record the LCM adjustment

to the Merchandise Inventory account.

Check (1) $580,054

Analysis Component

2. What is the error in total net income for the combined three-year period resulting from the inventory errors? Explain.

3. Explain why the overstatement of inventory by $18,000 at the end of 2012 results in an overstatement of equity by the same amount in that year.

Check (1) Corrected net income: 2012, $157,800; 2013, $256,270; 2014, $158,910

Figure: 2012 2013 2014

Reported amount . . . . . . . . . . . . . . . . . . . . . .

Adjustments for: 12/31/2012 error . . . . . . . . .

12/31/2013 error . . . . . . . . .

Corrected amount . . . . . . . . . . . . . . . . . . . . .

Required

1. For each key financial statement figure — (a), (b), (c), and (d ) above — prepare a table similar to the following to show the adjustments necessary to correct the reported amounts.

Problem 5-6B Analysis of inventory errors

A2

Hallam Company’s financial statements show the following. The company recently discovered that in making physical counts of inventory, it had made the following errors: Inventory on December 31, 2012, is overstated by $18,000, and inventory on December 31, 2013, is understated by $26,000.

For Year Ended December 31 2012 2013 2014

(a) Cost of goods sold . . . . . . . . . . . . . . . . $207,200 $213,800 $197,030

(b) Net income . . . . . . . . . . . . . . . . . . . . . 175,800 212,270 184,910

(c) Total current assets . . . . . . . . . . . . . . . 276,000 277,500 272,950

(d ) Total equity . . . . . . . . . . . . . . . . . . . . . . 314,000 315,000 346,000

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250 Chapter 5 Inventories and Cost of Sales

Problem 5-7BA

Periodic: Alternative cost flows

P3

Information: Seneca Co. began year 2013 with 6,500 units of product in its January 1 inventory costing $35 each. It made successive purchases of its product in year 2013 as follows. The company uses a peri- odic inventory system. On December 31, 2013, a physical count reveals that 8,500 units of its product remain in inventory.

Jan. 4 . . . . . . . . 11,500 units @ $33 each

May 18 . . . . . . . . 13,400 units @ $32 each

July 9 . . . . . . . . 11,000 units @ $29 each

Nov. 21 . . . . . . . . 7,600 units @ $27 each

Check (2) Cost of goods sold: FIFO, $1,328,700; LIFO, $1,266,500; WA, $1,294,800

Required

1. Compute the number and total cost of the units available for sale in year 2013. 2. Compute the amounts assigned to the 2013 ending inventory and the cost of goods sold using (a) FIFO,

(b) LIFO, and (c) weighted average. (Round all amounts to cents.)

Problem 5-8BA

Periodic: Income comparisons and cost flows

A1 P3

Information: Shepard Company sold 4,000 units of its product at $100 per unit in year 2013 and incurred operating expenses of $15 per unit in selling the units. It began the year with 840 units in inventory and made successive purchases of its product as follows.

Jan. 1 Beginning inventory . . . . . . . . 840 units @ $58 per unit

April 2 Purchase . . . . . . . . . . . . . . . . . 600 units @ $59 per unit

June 14 Purchase . . . . . . . . . . . . . . . . . 1,205 units @ $61 per unit

Aug. 29 Purchase . . . . . . . . . . . . . . . . . 700 units @ $64 per unit

Nov. 18 Purchase . . . . . . . . . . . . . . . . . 1,655 units @ $65 per unit

Total . . . . . . . . . . . . . . . . . . . . 5,000 units

Required

1. Prepare comparative income statements similar to Exhibit 5.8 for the three inventory costing methods of FIFO, LIFO, and weighted average. (Round all amounts to cents.) Include a detailed cost of goods sold section as part of each statement. The company uses a periodic inventory system, and its income tax rate is 40%.

2. How would the financial results from using the three alternative inventory costing methods change if the company had been experiencing decreasing prices in its purchases of inventory?

3. What advantages and disadvantages are offered by using (a) LIFO and (b) FIFO? Assume the continu- ing trend of increasing costs.

Check (1) Net income: LIFO, $52,896; FIFO, $57,000; WA, $55,200

Problem 5-9BB

Retail inventory method

P4

The records of Macklin Co. provide the following information for the year ended December 31.

At Cost At Retail

January 1 beginning inventory . . . . . . . . . $ 90,022 $115,610

Cost of goods purchased . . . . . . . . . . . . 502,250 761,830

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 782,300

Sales returns . . . . . . . . . . . . . . . . . . . . . . 3,460

Check (1) Inventory, $66,555 cost; (2) Inventory shortage at

cost, $12,251.25

Required

1. Use the retail inventory method to estimate the company’s year-end inventory. 2. A year-end physical inventory at retail prices yields a total inventory of $80,450. Prepare a calculation

showing the company’s loss from shrinkage at cost and at retail.

Problem 5-10BB

Gross profit method

P4

Otingo Equipment Co. wants to prepare interim financial statements for the first quarter. The company wishes to avoid making a physical count of inventory. Otingo’s gross profit rate averages 35%. The following information for the first quarter is available from its records.

January 1 beginning inventory . . . . . . . . . $ 802,880

Cost of goods purchased . . . . . . . . . . . . 2,209,636

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,760,260

Sales returns . . . . . . . . . . . . . . . . . . . . . . 79,300

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Chapter 5 Inventories and Cost of Sales 251

Required

Use the gross profit method to estimate the company’s first quarter ending inventory. Check Estim. ending inventory,

$619,892

SERIAL PROBLEM Success Systems

P2 A3

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.)

SP 5 Part A

Adria Lopez of Success Systems is evaluating her inventory to determine whether it must be adjusted based on lower of cost or market rules. Her company has three different types of software in its inventory and the following information is available for each.

Per Unit

Inventory Items Units Cost Market

Office productivity . . . . . . . . 3 $ 76 $ 74

Desktop publishing . . . . . . . . 2 103 100

Accounting . . . . . . . . . . . . . . 3 90 96

Required

1. Compute the lower of cost or market for ending inventory assuming Lopez applies the lower of cost or market rule to inventory as a whole. Must Lopez adjust the reported inventory value? Explain.

2. Assume that Lopez had instead applied the lower of cost or market rule to each product in inventory. Under this assumption, must Lopez adjust the reported inventory value? Explain.

Part B

Selected accounts and balances for the three months ended March 31, 2014, for Success Systems follow.

Required

1. Compute inventory turnover and days’ sales in inventory for the three months ended March 31, 2014. 2. Assess the company’s performance if competitors average 15 times for inventory turnover and 29 days

for days’ sales in inventory.

January 1 beginning inventory . . . . . . . . . $ 0

Cost of goods sold . . . . . . . . . . . . . . . . . 14,052

March 31 ending inventory . . . . . . . . . . . 704

BTN 5-1 Refer to Polaris’ financial statements in Appendix A to answer the following.

Required

1. What amount of inventories did Polaris report as a current asset on December 31, 2011? On December 31, 2010?

2. Inventories represent what percent of total assets on December 31, 2011? On December 31, 2010? 3. Comment on the relative size of Polaris’ inventories compared to its other types of assets. 4. What accounting method did Polaris use to compute inventory amounts on its balance sheet? 5. Compute inventory turnover for fiscal year ended December 31, 2011, and days’ sales in inventory as

of December 31, 2011.

Beyond the Numbers

REPORTING IN ACTION C2 A3

Polaris

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252 Chapter 5 Inventories and Cost of Sales

Fast Forward

6. Access Polaris’ financial statements for fiscal years ended after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Answer questions 1 through 5 using the current Polaris information and compare results to those prior years.

BTN 5-2 Comparative figures for Polaris and Arctic Cat follow.

Polaris Arctic Cat

Current One Year Two Years Current One Year Two Years

($ thousands) Year Prior Prior Year Prior Prior

Inventory . . . . . . . . . . . $ 298,042 $ 235,927 $ 179,315 $ 61,478 $ 81,361 $ 120,804

Cost of sales . . . . . . . . 1,916,366 1,460,926 1,172,668 363,142 367,492 480,441

Required

1. Compute inventory turnover for each company for the most recent two years shown. 2. Compute days’ sales in inventory for each company for the three years shown. 3. Comment on and interpret your findings from parts 1 and 2. Assume an industry average for inventory

turnover of 5.

COMPARATIVE ANALYSIS A3

BTN 5-3 Golf Challenge Corp. is a retail sports store carrying golf apparel and equipment. The store is at the end of its second year of operation and is struggling. A major problem is that its cost of inventory has continually increased in the past two years. In the first year of operations, the store assigned inventory costs using LIFO. A loan agreement the store has with its bank, its prime source of financing, requires the store to maintain a certain profit margin and current ratio. The store’s owner is currently looking over Golf Challenge’s preliminary financial statements for its second year. The numbers are not favorable. The only way the store can meet the required financial ratios agreed on with the bank is to change from LIFO to FIFO. The store originally decided on LIFO because of its tax advantages. The owner recalculates ending inventory using FIFO and submits those numbers and statements to the loan officer at the bank for the required bank review. The owner thankfully reflects on the available latitude in choosing the inventory costing method.

Required

1. How does Golf Challenge’s use of FIFO improve its net profit margin and current ratio? 2. Is the action by Golf Challenge’s owner ethical? Explain.

ETHICS CHALLENGE A1

BTN 5-4 You are a financial adviser with a client in the wholesale produce business that just completed its first year of operations. Due to weather conditions, the cost of acquiring produce to resell has escalated during the later part of this period. Your client, Javonte Gish, mentions that because her business sells perishable goods, she has striven to maintain a FIFO flow of goods. Although sales are good, the increas- ing cost of inventory has put the business in a tight cash position. Gish has expressed concern regarding the ability of the business to meet income tax obligations.

Required

Prepare a memorandum that identifies, explains, and justifies the inventory method you recommend your client, Ms. Gish, adopt.

COMMUNICATING IN PRACTICE A1

Polaris Arctic Cat

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Chapter 5 Inventories and Cost of Sales 253

BTN 5-5 Access the September 24, 2011, 10-K report for Apple, Inc. (Ticker AAPL), filed on October 26, 2011, from the EDGAR filings at www.sec.gov.

Required

1. What products are manufactured by Apple? 2. What inventory method does Apple use? (Hint: See the Note 1 to its financial statements.) 3. Compute its gross margin and gross margin ratio for the 2011 fiscal year. Comment on your

computations—assume an industry average of 40% for the gross margin ratio. 4. Compute its inventory turnover and days’ sales in inventory for the year ended September 24, 2011.

Comment on your computations—assume an industry average of 40 for inventory turnover and 9 for days’ sales in inventory.

TAKING IT TO THE NET A3

BTN 5-6 Each team member has the responsibility to become an expert on an inventory method. This expertise will be used to facilitate teammates’ understanding of the concepts relevant to that method. 1. Each learning team member should select an area for expertise by choosing one of the following

inventory methods: specific identification, LIFO, FIFO, or weighted average. 2. Form expert teams made up of students who have selected the same area of expertise. The instructor

will identify where each expert team will meet. 3. Using the following data, each expert team must collaborate to develop a presentation that illustrates

the relevant concepts and procedures for its inventory method. Each team member must write the pre- sentation in a format that can be shown to the learning team.

Data

The company uses a perpetual inventory system. It had the following beginning inventory and current year purchases of its product.

Concepts and Procedures to Illustrate in Expert Presentation

a. Identify and compute the costs to assign to the units sold. (Round per unit costs to three decimals.) b. Identify and compute the costs to assign to the units in ending inventory. (Round inventory bal-

ances to the dollar.) c. How likely is it that this inventory costing method will reflect the actual physical flow of goods?

How relevant is that factor in determining whether this is an acceptable method to use? d. What is the impact of this method versus others in determining net income and income taxes? e. How closely does the ending inventory amount reflect replacement cost? 4. Re-form learning teams. In rotation, each expert is to present to the team the presentation developed in

part 3. Experts are to encourage and respond to questions.

Jan. 10 30 units (specific cost: 30 @ $100)

Feb. 15 100 units (specific cost: 100 @ $120)

Oct. 5 350 units (specific cost: 100 @ $150 and 250 @ $200)

The company transacted sales on the following dates at a $350 per unit sales price.

Jan. 1 Beginning inventory. . . . . . . . . 50 units @ $100 5 $ 5,000

Jan. 14 Purchase . . . . . . . . . . . . . . . . . 150 units @ $120 5 18,000

Apr. 30 Purchase . . . . . . . . . . . . . . . . . 200 units @ $150 5 30,000

Sept. 26 Purchase . . . . . . . . . . . . . . . . . 300 units @ $200 5 60,000

TEAMWORK IN ACTION A1 P1

Point: Step 1 allows four choices or areas for expertise. Larger teams will have some duplication of choice, but the specific identification method should not be duplicated.

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254 Chapter 5 Inventories and Cost of Sales

1. a; FIFO perpetual

Date Goods Purchased Cost of Goods Sold Inventory Balance

July 1 75 units @ $25 5 $ 1,875

July 3 348 units @ $27 5 $9,396 75 units @ $25

348 units @ $27 5 $ 11,271

July 8 75 units @ $25 123 units @ $27 5 $ 3,321

225 units @ $27 5 $ 7,950

July 15 257 units @ $28 5 $7,196 123 units @ $27

257 units @ $28 5 $ 10,517

July 23 123 units @ $27 105 units @ $28 5 $ 2,940

152 units @ $28 5 $ 7,577

$15,527

r r

r r

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 5-8 Visit four retail stores with another classmate. In each store, identify whether the store uses a bar-coding system to help manage its inventory. Try to find at least one store that does not use bar-coding. If a store does not use bar-coding, ask the store’s manager or clerk whether he or she knows which type of inventory method the store employs. Create a table that shows columns for the name of store visited, type of merchandise sold, use or nonuse of bar-coding, and the inventory method used if bar-coding is not employed. You might also inquire as to what the store’s inventory turnover is and how often physical in- ventory is taken.

HITTING THE ROAD C1 C2

BTN 5-9 Following are key figures (Euro in thousands) for Piaggio (www.piaggio.com), which is a leading manufacturer of two-, three- and four-wheel vehicles, and is Europe’s leading manufacturer of motorcycles and scooters.

GLOBAL DECISION A3

Euro in thousands Current Year One Year Prior Two Years Prior

Inventory . . . . . . . . . . . . 236,988 240,066 252,496

Cost of sales . . . . . . . . . 1,061,900 1,023,100 1,019,800

Required

1. Use these data and those from BTN 5-2 to compute (a) inventory turnover and (b) days’ sales in inven- tory for the most recent two years shown for Piaggio, Polaris, and Arctic Cat.

2. Comment on and interpret your findings from part 1.

BTN 5-7 Review the chapter’s opening feature highlighting Derick Pearson and Felecia Hatcher and their company, Feverish Ice Cream. Assume that Feverish Ice Cream consistently maintains an inventory level of $30,000, meaning that its average and ending inventory levels are the same. Also assume its an- nual cost of sales is $120,000. To cut costs, Derick and Felecia propose to slash inventory to a constant level of $15,000 with no impact on cost of sales. They plan to work with suppliers to get quicker deliveries and to order smaller quantities more often.

Required

1. Compute the company’s inventory turnover and its days’ sales in inventory under (a) current condi- tions and (b) proposed conditions.

2. Evaluate and comment on the merits of their proposal given your analysis for part 1. Identify any con- cerns you might have about the proposal.

ENTREPRENEURIAL DECISION A3

Polaris Arctic Cat

PIAGGIO

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Chapter 5 Inventories and Cost of Sales 255

3. e; Specific identification (perpetual and periodic are identical for specific identification)—Ending inventory computation.

4. a; FIFO periodic. Ending inventory computation: 105 units @ $28 each 5 $2,940; The FIFO periodic inventory compu-

tation is identical to the FIFO perpetual inventory computation (see question 1).

5. a; FIFO periodic inventory 5 (20 3 $14) 1 (10 3 $12) 5 $400 a; LIFO periodic cost of goods sold 5 (20 3 $14) 1 (40 3 $12) 1 (70 3 $10)

5 $1,460

6. d; Days’ sales in inventory 5 (Ending inventoryyCost of goods sold 3 365) 5 ($18,000y$85,000) 3 365 5 77.29 days

20 units @ $25 $ 500

40 units @ $27 1,080

45 units @ $28 1,260

105 units $2,840

2. b; LIFO perpetual

r

r r

r s

Date Goods Purchased Cost of Goods Sold Inventory Balance

July 1 75 units @ $25 5 $ 1,875

July 3 348 units @ $27 5 $9,396 75 units @ $25

348 units @ $27 5 $ 11,271

July 8 300 units @ $27 5 $ 8,100 75 units @ $25

48 units @ $27 5 $ 3,171

July 15 257 units @ $28 5 $7,196 75 units @ $25

48 units @ $27

257 units @ $28 5 $ 10,367

July 23 257 units @ $28 75 units @ $25

18 units @ $27 5 $ 7,682

30 units @ $27 5 $ 2,685

$15,782

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Learning Objectives

CONCEPTUAL

C1 Define internal control and identify its purpose and principles. (p. 258) C2 Define cash and cash equivalents and explain how to report them. (p. 263)

ANALYTICAL

A1 Compute the days’ sales uncollected ratio and use it to assess liquidity. (p. 277)

PROCEDURAL

P1 Apply internal control to cash receipts and disbursements. (p. 264) P2 Explain and record petty cash fund transactions. (p. 268) P3 Prepare a bank reconciliation. (p. 273)

P4 Appendix 6A—Describe the use of documentation and verification to control cash disbursements. (p. 280)

P5 Appendix 6B—Apply the net method to control purchase discounts. (p. 283)

A Look at This Chapter

This chapter extends our study of accounting to internal control and the analysis of cash. We describe procedures that are good for internal control. We also explain the control of and the accounting for cash, including control features of banking activities.

A Look Back

Chapters 4 and 5 focused on merchandising activities and accounting for inventory. We explained inventory systems, accounting for inventory transactions, and assigning costs to inventory.

Cash and Internal Controls 6

A Look Ahead

Chapter 7 focuses on receivables. We explain how to account and report on receivables and their related accounts. This includes estimating uncollectible receivables and computing interest earned.

256

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Cheese Wiz

BOSTON—Michael Inwald did his research: 2.2 billion grilled cheese sandwiches are consumed by Americans each year. His conclusion: The country is one big cheeseball! Given the cheese wiz he is, Michael, known to his friends as Cheeseboy, opened a fast-food grilled cheese take-out joint named CHEESEBOY (CheeseBoy.com). “I’m somewhat obsessed with cheese!” admits Michael. That obsession has led to several CHEESEBOY locations, and he is readying for a national franchise program. “Giving our customers an amazing grilled cheese experi- ence, all-around, is very critical to us,” insists Michael. He currently offers customers a grilled cheese experience with four bread options, five cheese options, and a range of toppings. He also provides the classic tomato soup combo, along with other soup options. “The most challenging part of my business is . . . to create the perfect experience,” explains Michael. Although the grilled cheese experience is key to his success, Michael’s management of internal controls and cash is equally impressive. Several control procedures monitor business activi- ties and safeguard assets. An example is his inventory control system. Explains Michael, quality ingredients are crucial to

customer satisfaction, and monitoring controls ensure the quality of his ingredients. Similar controls are applied throughout his store. Michael explains that such controls raise productivity, cut expenses, and enhance the customer experience. His store’s cash management practices are equally impres- sive, including controls over cash receipts, disbursements, and petty cash. The use of bank reconciliations further helps with his store’s control and management of cash. “Take basic account- ing,” explains Michael, “I was able to say, ‘I’m going to need to know how to balance my books.’” Michael explains that he takes advantage of available banking services to enhance controls over cash. Internal controls are crucial when on a busy day his stores bring in thousands of customers, and their cash. “We have put the infrastructure in place to ensure that (the growth) goes as smoothly as possible,” explains Michael. “We’re definitely going to be moving at what feels like light speed.”

[Sources: CHEESEBOY Website, January 2013; CNNMoney, July 2011; BOLDFACERS, August 2011; The Patriot Ledger, November 2011; Boston Business Journal, December 2011; The New Journal, February 2012.]

“Entrepreneurship is the antithesis of stability.” —MICHAEL INWALD

Decision Insight

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Chapter Preview

This section describes internal control and its fundamental principles. We also discuss the im- pact of technology on internal control and the limitations of control procedures.

Purpose of Internal Control Managers (or owners) of small businesses often control the entire operation. These managers usually purchase all assets, hire and manage employees, negotiate all contracts, and sign all checks. They know from personal contact and observation whether the business is actually re- ceiving the assets and services paid for. Most companies, however, cannot maintain this close personal supervision. They must delegate responsibilities and rely on formal procedures rather than personal contact in controlling business activities.

Internal Control System Managers use an internal control system to monitor and con- trol business activities. An internal control system consists of the policies and procedures managers use to

● Protect assets. ● Promote efficient operations. ● Ensure reliable accounting. ● Urge adherence to company policies.

A properly designed internal control system is a key part of systems design, analysis, and per formance. Managers place a high priority on internal control systems because they can prevent avoidable losses, help managers plan operations, and monitor company and employee perfor- mance. For example, internal controls for health care must protect patient records and privacy. Internal controls do not provide guarantees, but they lower the company’s risk of loss.

Sarbanes-Oxley Act (SOX) The Sarbanes-Oxley Act (SOX) requires the managers and auditors of companies whose stock is traded on an exchange (called public companies) to docu- ment and certify the system of internal controls. Following are some of the specific requirements:

● Auditors must evaluate internal controls and issue an internal control report. ● Auditors of a client are restricted as to what consulting services they can provide that client. ● The person leading an audit can serve no more than seven years without a two-year break. ● Auditors’ work is overseen by the Public Company Accounting Oversight Board (PCAOB). ● Harsh penalties exist for violators—sentences up to 25 years in prison with severe fines.

C1 Define internal control and identify its purpose and principles.

INTERNAL CONTROL

We all are aware of theft and fraud. They affect us in several ways: We lock doors, chain bikes, review credit card statements, and acquire alarm systems. A company also takes actions to safe- guard, control, and manage what it owns. Experience tells us that small companies are most vulnerable, usually due to weak internal controls. It is management’s responsibility to set up

policies and procedures to safeguard a company’s assets, especially cash. To do so, management and employees must understand and apply principles of internal control. This chapter describes these principles and how to apply them. It focuses special attention on cash because it is easily transferable and is often at high risk of loss.

Control of Cash

• Cash, cash equiva- lents, and liquidity

• Control of receipts • Control of

disbursements

Cash and Internal Controls

Internal Control

• Purpose of controls • Principles of controls • Technology and

controls • Limitations of controls

Banking Activities as Controls

• Basic bank services • Bank statement • Bank reconciliation

258

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Chapter 6 Cash and Internal Controls 259

SOX has markedly impacted companies, and the costs of its implementation are high. Impor- tantly, Section 404 of SOX requires that managers document and assess the effectiveness of all internal control processes that can impact financial reporting. The benefits include greater con- fidence in accounting systems and their related reports. However, the public continues to debate the costs versus the benefits of SOX as nearly all business activities of these companies are im- pacted by SOX. Section 404 of SOX requires that managers document and assess their internal controls and that auditors provide an opinion on managers’ documentation and assessment. Costs of complying with Section 404 for companies is reported to average $4 million (source: Financial Executives Institute).

Principles of Internal Control Internal control policies and procedures vary from company to company according to such fac- tors as the nature of the business and its size. Certain fundamental internal control principles apply to all companies. The principles of internal control are to

1. Establish responsibilities. 2. Maintain adequate records. 3. Insure assets and bond key employees. 4. Separate recordkeeping from custody of assets. 5. Divide responsibility for related transactions. 6. Apply technological controls. 7. Perform regular and independent reviews.

This section explains these seven principles and describes how internal control procedures minimize the risk of fraud and theft. These procedures also increase the reliability and accuracy of accounting records. A framework for how these seven principles improve the quality of financial reporting is provided by the Committee of Sponsoring Organizations (COSO) (www.COSO.org). Specifically, these principles link to five aspects of internal control: control activities, control environment, risk assessment, monitoring, and communication.

Establish Responsibilities Proper internal control means that responsibility for a task is clearly established and assigned to one person. When a problem occurs in a company where responsibility is not identified, determining who is at fault is difficult. For instance, if two sales- clerks share the same cash register and there is a cash shortage, neither clerk can be held account- able. To prevent this problem, one clerk might be given responsibility for handling all cash sales. Alternately, a company can use a register with separate cash drawers for each clerk. Most of us have waited at a retail counter during a shift change while employees swap cash drawers.

Maintain Adequate Records Good recordkeeping is part of an internal control system. It helps protect assets and ensures that employees use prescribed procedures. Reliable records are also a source of information that managers use to monitor company activities. When detailed records of equipment are kept, for instance, items are unlikely to be lost or stolen without detection. Similarly, transactions are less likely to be entered in wrong accounts if a chart of accounts is set up and care- fully used. Many preprinted forms and internal documents are also designed for use in a good inter- nal control system. When sales slips are properly designed, for instance, sales personnel can record needed information efficiently with less chance of errors or delays to customers. When sales slips are prenumbered and controlled, each one issued is the responsibility of one salesperson, preventing the salesperson from pocketing cash by making a sale and destroying the sales slip. Computerized point-of-sale systems achieve the same control results.

Insure Assets and Bond Key Employees Good internal control means that assets are adequately insured against casualty and that employees handling large amounts of cash and easily transferable assets are bonded. An employee is bonded when a company purchases an in- surance policy, or a bond, against losses from theft by that employee. Bonding reduces the risk of loss. It also discourages theft because bonded employees know an independent bonding company will be involved when theft is uncovered and is unlikely to be sympathetic with an employee in- volved in theft. (A common question on job applications is whether you are bonded or bondable.)

...a control system is only as strong as its weakest link

Point: Many companies have a manda- tory vacation policy for employees who handle cash. When another employee must cover for the one on vacation, it is more difficult to hide cash frauds.

Point: Sarbanes-Oxley Act (SOX) requires that each annual report contain an internal control report, which must: (1) state managers’ responsibility for establishing and maintaining adequate internal controls for financial reporting; and (2) assess the effectiveness of those controls.

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260 Chapter 6 Cash and Internal Controls

Perform Regular and Independent Reviews Changes in personnel, stress of time pressures, and technological advances present opportunities for shortcuts and lapses. To counter these factors, regular reviews of internal control systems are needed to ensure that procedures are followed. These reviews are preferably done by internal auditors not directly involved in the activities. Their impartial perspective encourages an evaluation of the efficiency as well as the effectiveness of the internal control system. Many companies also pay for audits by indepen- dent, external auditors. These external auditors test the company’s financial records to give an opinion as to whether its financial statements are presented fairly. Before external auditors de- cide on how much testing is needed, they evaluate the effectiveness of the internal control sys- tem. This evaluation is often helpful to a client. Independent, external audits are usually performed by auditors who work for public accounting firms.

Separate Recordkeeping from Custody of Assets A person who controls or has access to an asset must not keep that asset’s accounting records. This principle reduces the risk of theft or waste of an asset because the person with control over it knows that another person keeps its records. Also, a recordkeeper who does not have access to the asset has no reason to falsify records. This means that to steal an asset and hide the theft from the records, two or more people must collude—or agree in secret to commit the fraud. Some payroll cash checking services require fingerprint ID before the payroll check is cashed.

Divide Responsibility for Related Transactions Good internal control divides responsibility for a transaction or a series of related transactions between two or more individu- als or departments. This is to ensure that the work of one individual acts as a check on the other. This principle, often called separation of duties, is not a call for duplication of work. Each em- ployee or department should perform unduplicated effort. Examples of transactions with divided responsibility are placing purchase orders, receiving merchandise, and paying vendors. These tasks should not be given to one individual or department. Assigning responsibility for two or more of these tasks to one party increases mistakes and perhaps fraud. Having an independent person, for example, check incoming goods for quality and quantity encourages more care and attention to detail than having the person who placed the order do the checking. Added protec- tion can result from identifying a third person to approve payment of the invoice. A company can even designate a fourth person with authority to write checks as another protective measure.

Apply Technological Controls Cash registers, check protectors, time clocks, and personal identification scanners are examples of devices that can improve internal control. Technology often improves the effectiveness of controls. A cash register with a locked-in tape or electronic file makes a record of each cash sale. A check protector perforates the amount of a check into its face and makes it difficult to alter the amount. A time clock registers the exact time an employee both arrives at and departs from the job. Mechanical change and currency counters quickly and accurately count amounts, and personal scanners limit access to only authorized individuals. Each of these and other technological controls are an effective part of many internal control systems. Some companies video record workers as they clock in and out, which discourages them from clocking in or out for others.

Point: There’s a new security device—a person’s ECG (electrocardiogram) reading—that is as unique as a fingerprint and a lot harder to lose or steal than a PIN. ECGs can be read through fingertip touches. An ECG also shows that a living person is actually there, whereas finger- print and facial recognition software can be fooled.

Face Reading Face-recognition software snaps a digital picture of the face and converts key facial features—say, the distance between the eyes—into a series of numerical values. These can be stored on an ID or ATM card as a simple bar code to prohibit unauthorized access. ■

Decision Insight

Tagging Assets A novel technique exists for marking physical assets. It involves embedding a less than one-inch-square tag of fibers that creates a unique optical signature recordable by scanners. Manufacturers hope to em- bed tags in everything from compact discs and credit cards to designer clothes for purposes of internal control and efficiency. ■

Decision Insight

Point: COSO organizes control components into five types:

• Control environment • Control activities • Risk assessment • Monitoring • Information and communication

Point: The Association of Certified Fraud Examiners (acfe.com) estimates that employee fraud costs small companies more than $100,000 per incident.

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Chapter 6 Cash and Internal Controls 261

Technology and Internal Control The fundamental principles of internal control are relevant no matter what the techno logical state of the accounting system, from purely manual to fully automated systems. Technology impacts an internal control system in several important ways. Perhaps the most obvious is that technology allows us quicker access to databases and information. Used effectively, technology greatly improves managers’ abilities to monitor and control business activities. This section describes some technological impacts we must be alert to.

Reduced Processing Errors Techno logically advanced systems reduce the number of errors in processing information. Provided the software and data entry are correct, the risk of mechanical and mathematical errors is nearly eliminated. However, we must remember that erroneous software or data entry does exist. Also, less human involvement in data processing can cause data entry errors to go undiscovered. Moreover, errors in software can produce consistent but erroneous processing of transactions. Continually checking and monitoring all types of systems are important.

More Extensive Testing of Records A company’s review and audit of electronic rec- ords can include more extensive testing when information is easily and rapidly accessed. When accounting records are kept manually, auditors and others likely select only small samples of data to test. When data are accessible with computer technology, however, auditors can quickly analyze large samples or even the entire database.

Limited Evidence of Processing Many data processing steps are increasingly done by computer. Accordingly, fewer hard-copy items of documentary evidence are available for re- view. Yet technologically advanced systems can provide new evidence. They can, for instance, record who made the entries, the date and time, the source of the entry, and so on. Technology can also be designed to require the use of passwords or other identification before access to the system is granted. This means that internal control depends more on the design and operation of the information system and less on the analysis of its resulting documents.

Crucial Separation of Duties Technological advances in accounting information sys- tems often yield some job eliminations or consolidations. While those who remain have the special skills necessary to operate advanced programs and equipment, a company with a re- duced workforce risks losing its crucial separation of duties. The company must establish ways to control and monitor employees to minimize risk of error and fraud. For instance, the person who designs and programs the information system must not be the one who operates it. The company must also separate control over programs and files from the activities related to cash receipts and disbursements. For instance, a computer operator should not control check-writing activities. Achieving acceptable separation of duties can be especially difficult and costly in small companies with few employees.

Increased E-Commerce Technology has encouraged the growth of e-commerce. Amazon.com and eBay are examples of companies that have suc- cessfully exploited e-commerce. Most companies have some e-commerce transac- tions. All such transactions involve at least three risks. (1) Credit card number theft is a risk of using, transmitting, and storing such data online. This increases the cost of e-commerce. (2) Computer viruses are malicious programs that attach themselves to innocent files for purposes of infecting and harming other files and programs. (3)  Impersonation online can result in charges of sales to bogus ac- counts, purchases of inappropriate materials, and the unknowing giving up of con- fidential information to hackers. Companies use both firewalls and encryption to

Point: Information on Internet fraud can be found at these Websites: sec.gov/investor/pubs/cyberfraud.htm

ftc.gov/bcp/consumer.shtm www.fraud.org

Copyright 2004 by Randy Glasbergen. www.glasbergen.com

Point: Evidence of any internal control failure for a company reduces user confidence in its financial statements.

Point: We look to several sources when assessing a company’s internal controls. Sources include the auditor’s report, management report on controls (if available), management discussion and analysis, and financial press.

Entrepreneur As owner of a start-up information services company, you hire a systems analyst. The analyst sees that your company only employs two workers. She recommends you improve controls and says that as owner you must serve as a compensating control. What does the analyst mean? ■ [Answer—p. 285]

Decision Maker

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262 Chapter 6 Cash and Internal Controls

combat some of these risks—firewalls are points of entry to a system that require passwords to continue, and encryption is a mathematical process to rearrange contents that cannot be read without the process code. Nearly 5% of Americans already report being victims of identity theft, and roughly 10 million say their privacy has been compromised.

Hacker’s Guide to Cyberspace

Hacker’s Guide toCyberspace

Pharming Viruses attached to e-mails and Websites load software onto your PC that monitors keystrokes; when you sign on to financial Websites, it steals your passwords.

Phishing Hackers send e-mails to you posing as banks; you are asked for infor- mation using fake Websites where they reel in your passwords and personal data.

WI-Phishing Cybercrooks set up wireless networks hoping you use them to connect to the Web; your passwords and data are stolen as you use their network.

Bot-Networking Hackers send remote-control programs to your PC that take control to send out spam and viruses; they even rent your bot to other cybercrooks.

Typo-Squatting Hackers set up Websites with addresses similar to legit outfits; when you make a typo and hit their sites, they infect your PC with viruses or take them over as bots.

Hackers also have their own self-identification system... • Hackers, or external attackers, crack systems and take data for illicit gains (as unauthorized users). • Rogue insiders, or internal attackers, crack systems and take data for illicit gains or revenge (as authorized users). • Ethical hackers, or good-guys or white-hat hackers, crack systems and reveal vulnerabilities to enhance controls. • Crackers, or criminal hackers, crack systems illegally for illicit gains, fame, or revenge.

iPad

Limitations of Internal Control All internal control policies and procedures have limitations that usually arise from either (1) the human element or (2) the cost–benefit principle. Internal control policies and procedures are applied by people. This human element creates several potential limitations that we can categorize as either (1) human error or (2) human fraud. Human error can occur from negligence, fatigue, misjudgment, or confusion. Human fraud in- volves intent by people to defeat internal controls, such as management override, for personal gain. Fraud also includes collusion to thwart the separation of duties. The human element high- lights the importance of establishing an internal control environment to convey management’s commitment to internal control policies and procedures. Human fraud is driven by the triple- threat of fraud:

● Opportunity—refers to internal control deficiencies in the workplace. ● Pressure—refers to financial, family, society, and other stresses to succeed. ● Rationalization—refers to employees justifying fraudulent behavior.

The second major limitation on internal control is the cost–benefit principle, which dictates that the costs of internal controls must not exceed their benefits. Analysis of costs and benefits must consider all factors, including the impact on morale. Most companies, for instance, have a legal right to read employees’ e-mails, yet companies seldom exercise that right unless they are confronted with evidence of potential harm to the company. The same holds for drug testing, phone tapping, and hidden cameras. The bottom line is that managers must establish internal control policies and procedures with a net benefit to the company.

Point: Cybercrime.gov pursues computer and intellectual property crimes, including that of e-commerce.

Winnings and Controls Certified Fraud Examiners Website reports the following: Andrew Cameron stole Jacqueline Boanson’s credit card. Cameron headed to the racetrack and promptly charged two bets for $150 on the credit card—winning $400. Unfortunately for Cameron the racetrack refused to pay him cash as its internal control policy is to credit winnings from bets made on a credit card to that same card. Cameron was later nabbed; and the racetrack let Ms. Boanson keep the winnings. ■

Decision Insight

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Chapter 6 Cash and Internal Controls 263

Cash is a necessary asset of every company. Most companies also own cash equivalents (de- fined below), which are assets similar to cash. Cash and cash equivalents are the most liquid of all assets and are easily hidden and moved. Cash is also the most desired asset as other assets must be fenced (sold in a secondary market). An effective system of internal controls protects cash assets and it should meet three basic guidelines:

1. Handling cash is separate from recordkeeping of cash. 2. Cash receipts are promptly deposited in a bank. 3. Cash disbursements are made by check.

The first guideline applies separation of duties to minimize errors and fraud. When duties are separated, two or more people must collude to steal cash and conceal this action in the account- ing records. The second guideline uses immediate (say, daily) deposits of all cash receipts to produce a timely independent record of the cash received. It also reduces the likelihood of cash theft (or loss) and the risk that an employee could personally use the money before depositing it. The third guideline uses payments by check to develop an independent bank record of cash disbursements. This guideline also reduces the risk of cash theft (or loss). This section begins with definitions of cash and cash equivalents. Discussion then focuses on controls and accounting for both cash receipts and disbursements. The exact procedures used to achieve control over cash vary across companies. They depend on factors such as company size, number of employees, volume of cash transactions, and sources of cash.

Cash, Cash Equivalents, and Liquidity Good accounting systems help in managing the amount of cash and controlling who has access to it. Cash is the usual means of payment when paying for assets, services, or liabilities. Liquidity refers to a company’s ability to pay for its near-term obligations. Cash and similar assets are called liquid assets because they can be readily used to settle such obligations. A company needs liquid assets to effectively operate. Cash includes currency and coins along with the amounts on deposit in bank accounts, checking accounts (called demand deposits), and many savings accounts (called time deposits). Cash also

CONTROL OF CASH

1. Principles of internal control suggest that (choose one): (a) Responsibility for a series of related transactions (such as placing orders, receiving and paying for merchandise) should be assigned to one employee; (b) Responsibility for individual tasks should be shared by more than one employee so that one serves as a check on the other; or (c) Employees who handle considerable cash and easily transferable assets should be bonded.

2. What are some impacts of computing technology on internal control? 3. Many companies require each employee to take at least one week (five consecutive days) of

vacation per year. Why is a “forced vacation” policy good for internal control?

Quick Check Answers — p. 285

C2 Define cash and cash equivalents and explain how to report them.

Ball Control Ryan Braun of the Milwaukee Brewers won an appeal of a 50-game Major League Baseball (MLB) suspension for a positive drug test. Ryan maintained that MLB did not maintain control over his sample through the testing process and raised the risk that his sample was tainted. This control failure led to dismissal of that particular test result and him winning the appeal. Controls are crucial when people’s livelihoods and reputations are on the line. ■

Decision Insight

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264 Chapter 6 Cash and Internal Controls

includes items that are acceptable for deposit in these accounts such as customer checks, cashier’s checks, certified checks, and money orders. Cash equivalents are short-term, highly liquid invest- ment assets meeting two criteria: (1) readily convertible to a known cash amount and (2) suffi- ciently close to their due date so that their market value is not sensitive to interest rate changes. Only investments purchased within three months of their due date usually satisfy these criteria. Examples of cash equivalents are short-term investments in assets such as U.S. Treasury bills and money market funds. To increase their return, many companies invest idle cash in cash equivalents. Most companies combine cash equivalents with cash as a single item on the balance sheet.

Cash Management When companies fail, one of the most common causes is their inability to manage cash. Companies must plan both cash receipts and cash payments. The goals of cash management are twofold:

1. Plan cash receipts to meet cash payments when due. 2. Keep a minimum level of cash necessary to operate.

The treasurer of the company is responsible for cash management. Effective cash management involves applying the following cash management principles.

● Encourage collection of receivables. The more quickly customers and others pay the com- pany, the more quickly that company can use the money. Some companies have cash-only sales policies. Others might offer discounts for payments received early.

● Delay payment of liabilities. The more delayed a company is in paying others, the more time it has to use the money. Some companies regularly wait to pay their bills until the last possible day allowed—although, a company must take care not to hurt its credit standing.

● Keep only necessary levels of assets. The less money tied up in idle assets, the more money to invest in productive assets. Some companies maintain just-in-time inventory; meaning they plan inventory to be available at the same time orders are filled. Others might lease out ex- cess warehouse space or rent equipment instead of buying it.

● Plan expenditures. Money should be spent only when it is available. Companies must look at seasonal and business cycles to plan expenditures.

● Invest excess cash. Excess cash earns no return and should be invested. Excess cash from seasonal cycles can be placed in a bank account or other short-term investment for income. Excess cash beyond what’s needed for regular business should be invested in productive assets like factories and inventories.

Control of Cash Receipts Internal control of cash receipts ensures that cash received is properly recorded and deposited. Cash receipts can arise from transactions such as cash sales, collections of customer accounts, receipts of interest earned, bank loans, sales of assets, and owner investments. This section ex- plains internal control over two important types of cash receipts: over-the-counter and by mail.

Over-the-Counter Cash Receipts For purposes of internal control, over-the-counter cash receipts from sales should be recorded on a cash register at the time of each sale. To help ensure that correct amounts are entered, each register should be located so customers can read the amounts entered. Clerks also should be required to enter each sale before wrapping mer- chandise and to give the customer a receipt for each sale. The design of each cash register should provide a permanent, locked-in record of each transaction. In many systems, the register is directly linked with computing and accounting services. Less advanced registers simply print a record of each transaction on a paper tape or electronic file locked inside the register.

P1 Apply internal control to cash receipts and disbursements.

Point: Google reports cash and cash equivalents of $9,983 million in its balance sheet. This amount makes up nearly 15% of its total assets.

Days’ Cash Expense Coverage The ratio of cash (and cash equivalents) to average daily cash expenses indicates the number of days a company can operate without additional cash inflows. It reflects on company liquidity and on the potential of excess cash. ■

Decision Insight

Point: The most liquid assets are usu- ally reported first on a balance sheet; the least liquid assets are reported last.

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Chapter 6 Cash and Internal Controls 265

Cash Cash

Register Sheet

NameDateSer.No Rank Signature

Fastforward Los Angeles

Deposit

Paid in by _______________ ________________________ Credit account of C & L Computer LTD ________________________

Date _______ Notes _______

Coin _______

$

9821 0058 478211006

$

$

Supervisor reads register data, prepares register sheet (and keeps copy), and sends

both to company cashier

Cashier prepares cash records, deposit slip, and

journal entry

Sales Department Cashier Department

Cash sheets Received from............................

Amount dollar ..............................

Authorized Signature

Cash sheets Received from............................

Amount dollar ..............................

Authorised Signature

Register Sheet

NameDateSer.No Rank Signature

Clerk rings up cash sales on register; clerk prepares cash count sheet (and keeps copy) and sends to

company cashier along with the cash

Cash over and short. Sometimes errors in making change are discovered from differences between the cash in a cash register and the record of the amount of cash receipts. Although a clerk is careful, one or more customers can be given too much or too little change. This means that at the end of a work period, the cash in a cash register might not equal the record of cash receipts. This difference is reported in the Cash Over and Short account, also called Cash Short and Over, which is an income statement account recording the income effects of cash overages and cash shortages. To illustrate, if a cash register’s record shows $550 but the count of cash in the register is $555, the entry to record cash sales and its overage is

Point: Retailers often require cashiers to restrictively endorse checks immedi- ately on receipt by stamping them “For deposit only.”

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . 5

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550

To record cash sales and a cash overage.

Assets 5 Liabilities 1 Equity 1555 1 5

1550

On the other hand, if a cash register’s record shows $625 but the count of cash in the register is $621, the entry to record cash sales and its shortage is

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625

To record cash sales and a cash shortage.

Assets 5 Liabilities 1 Equity 1621 2 4

1625

Since customers are more likely to dispute being shortchanged than being given too much change, the Cash Over and Short account usually has a debit balance at the end of an accounting period. A debit balance reflects an expense. It is reported on the income statement as part of general and administrative expenses. (Since the amount is usually small, it is often combined

Point: Merchants begin a business day with a change fund in their cash register. The accounting for a change fund is simi- lar to that for petty cash, including that for cash shortages or overages.

Point: Convenience stores sometimes display a sign: Cashier has no access to cash in locked floor (or wall) safe. Such signs help thwart theft and holdups because of lack of access to the floor (or wall) safe.

Proper internal control prescribes that custody over cash should be separate from its recordkeep- ing. For over-the-counter cash receipts, this separation begins with the cash sale. The clerk who has access to cash in the register should not have access to its locked-in record. At the end of the clerk’s work period, the clerk should count the cash in the register, record the amount, and turn over the cash and a record of its amount to the company cashier. The cashier, like the clerk, has access to the cash but should not have access to accounting records (or the register tape or file). A third employee, often a supervisor, compares the record of total register transactions (or the register tape or file) with the cash receipts reported by the cashier. This record is the basis for a journal entry recording over-the- counter cash receipts. The third employee has access to the records for cash but not to the actual cash. The clerk and the cashier have access to cash but not to the accounting records. None of them can make a mistake or divert cash without the difference being revealed—see the following diagram.

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266 Chapter 6 Cash and Internal Controls

with other small expenses and reported as part of miscellaneous expenses—or as part of miscel- laneous revenues if it has a credit balance.)

Cash Receipts by Mail Control of cash receipts that arrive through the mail starts with the person who opens the mail. Preferably, two people are assigned the task of, and are present for, opening the mail. In this case, theft of cash receipts by mail requires collusion between these two employees. Specifically, the person(s) opening the mail enters a list (in triplicate) of money received. This list should contain a record of each sender’s name, the amount, and an explanation of why the money is sent. The first copy is sent with the money to the cashier. A second copy is sent to the recordkeeper in the accounting area. A third copy is kept by the clerk(s) who opened the mail. The cashier deposits the money in a bank, and the recordkeeper records the amounts received in the accounting records. This process reflects good internal control. That is, when the bank balance is reconciled by another person (explained later in the chapter), errors or acts of fraud by the mail clerks, the cashier, or the recordkeeper are revealed. They are revealed because the bank’s record of cash deposited must agree with the records from each of the three. Moreover, if the mail clerks do not report all receipts correctly, customers will question their account balances. If the cashier does not deposit all receipts, the bank balance does not agree with the recordkeeper’s cash balance. The recordkeeper and the person who reconciles the bank balance do not have access to cash and therefore have no opportunity to divert cash to themselves. This system makes errors and fraud highly unlikely. The exception is employee collusion.

Control of Cash Disbursements Control of cash disbursements is especially important as most large thefts occur from payment of fic- titious invoices. One key to controlling cash disbursements is to require all expenditures to be made by check. The only exception is small payments made from petty cash. Another key is to deny access to the accounting records to anyone other than the owner who has the authority to sign checks. A small business owner often signs checks and knows from personal contact that the items being paid for are actually received. This arrangement is impossible in large businesses. Instead, internal control procedures must be substituted for personal contact. Such procedures are designed to assure the check signer that the obligations recorded are properly incurred and should be paid. This section describes these and other internal control procedures, including the voucher system and petty cash system. A method for management of cash disburse ments for purchases is described in Appendix 6B.

Cash Budget Projected cash receipts and cash disbursements are often summarized in a cash budget. Provided that sufficient cash exists for effective operations, companies wish to minimize the cash they hold because of its risk of theft and its low return versus other invest- ment opportunities.

Point: Collusion implies that two or more individuals are knowledgeable or involved with the activities of the other(s).

Perpetual Accounting Walmart uses a network of information links with its point-of-sale cash registers to coordinate sales, purchases, and distribution. Its supercenters, for instance, ring up 15,000 separate sales on heavy days. By using cash register information, the company can fix pricing mistakes quickly and capitalize on sales trends. Interestingly, Sam Walton, the founder, was a self-described distruster of computers. ■

Decision Insight

Lock Box Some companies do not receive cash in the mail but, instead, elect to have customers send deposits directly to the bank using a lock box system. Bank employees are charged with receipting the cash and depositing it in the correct business bank account. ■

Decision Insight

Voucher System of Control A voucher system is a set of procedures and approvals designed to control cash disbursements and the acceptance of obligations. The voucher system of control establishes procedures for

● Verifying, approving, and recording obligations for eventual cash disbursement. ● Issuing checks for payment of verified, approved, and recorded obligations.

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Chapter 6 Cash and Internal Controls 267

10 Michigan Street Chicago, IL 60521

Pay to the order of $

Date.................... 20 .......

Dollars

Memo ...............................................

99-DT/101

No. 119CheckZ-Mart November 12

1,200Trex NO INVOICE APPROVALDocument

By Date

Receiving Report

Date:...............

Request purchase of the following item(s):

Model No. D escription

Total

Quantity Price Amou nt

Invoice

Purchase Order

Purchase Requisition

Cashier

Accounting

Receiving

Supplier (vendor)

Purchasing

Sender

Requesting

Accounting

Supplier (vendor)

Accounting; Requesting; and Purchasing

Cashier

Supplier; Requesting; Receiving; and Accounting

Purchasing; and Accounting

Receiver(s)

Voucher

13

EXHIBIT 6.1 Document Flow in a Voucher System

A voucher system should be applied not only to purchases of inventory but to all expendi- tures. To illustrate, when a company receives a monthly telephone bill, it should review and verify the charges, prepare a voucher (file), and insert the bill. This transaction is then recorded with a journal entry. If the amount is currently due, a check is issued. If not, the voucher is filed for payment on its due date. If no voucher is prepared, verifying the invoice and its amount after several days or weeks can be difficult. Also, without records, a dishonest employee could col- lude with a dishonest supplier to get more than one payment for an obligation, payment for ex- cessive amounts, or payment for goods and services not received. An effective voucher system helps prevent such frauds.

Point: A voucher is an internal document (or file).

Point: The basic purposes of paper and electronic documents are similar. However, the internal control system must change to reflect different risks, including confidential and competitive- sensitive information that is at greater risk in electronic systems.

A reliable voucher system follows standard procedures for every transaction. This applies even when multiple purchases are made from the same supplier. A voucher system’s control over cash disbursements begins when a company incurs an obligation that will result in payment of cash. A key factor in this system is that only approved departments and individuals are authorized to incur such obligations. The system often limits the type of obligations that a department or individual can incur. In a large retail store, for instance, only a purchasing department should be authorized to incur obligations for merchandise inven- tory. Another key factor is that procedures for purchasing, receiving, and paying for merchandise are divided among several departments (or individuals). These departments include the one re- questing the purchase, the purchasing department, the receiving department, and the accounting department. To coordinate and control responsibilities of these departments, a company uses several different business documents. Exhibit 6.1 shows how documents are accumulated in a voucher, which is an internal document (or file) used to accumulate information to control cash disbursements and to ensure that a transaction is properly recorded. This specific example begins with a purchase requisition and concludes with a check drawn against cash. Appendix 6A describes the documentation and verification necessary for a voucher system of control. It also describes the internal control objective served by each document.

Point: MCI, formerly WorldCom, paid a whopping $500 million in SEC fines for accounting fraud. Among the charges were that it inflated earnings by as much as $10 billion. Its CEO, Bernard Ebbers, was sentenced to 25 years.

Cyber Setup The FTC is on the cutting edge of cyber sleuthing. Opportunists in search of easy money are lured to WeMarket4U. net/SundaeStation and WeMarket4U.net/FatFoe. Take the bait and you get warned. The top 5 fraud complaints as compiled by the Federal Trade Commission are shown to the right. ■

Identity theft

10

0

20

30

19%

11%

5% 4%4%

Percent of all fraud complaints

Debt collection

Internet services

Lotteries and

prizes

Shop at home &

catalog sales

Decision Insight

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268 Chapter 6 Cash and Internal Controls

4. Why must a company hold liquid assets? 5. Why does a company hold cash equivalent assets in addition to cash? 6. Identify at least two assets that are classified as cash equivalents. 7. Good internal control procedures for cash include which of the following? (a) All cash

disbursements, other than those for very small amounts, are made by check; (b) One employee counts cash received from sales and promptly deposits cash receipts; or (c) Cash receipts by mail are opened by one employee who is then responsible for recording and depositing them.

8. Should all companies require a voucher system? At what point in a company’s growth would you recommend a voucher system?

Quick Check Answers — p. 285

P2 Explain and record petty cash fund transactions. Petty Cash System of Control A basic principle for controlling cash disbursements is that all payments must be made by check. An exception to this rule is made for petty cash dis- bursements, which are the small payments required for items such as postage, courier fees, minor repairs, and low-cost supplies. To avoid the time and cost of writing checks for small amounts, a company sets up a petty cash fund to make small payments. (Petty cash activities are part of an imprest system, which designates advance money to establish the fund, to with- draw from the fund, and to reimburse the fund.)

Operating a petty cash fund. Establishing a petty cash fund requires estimating the total amount of small payments likely to be made during a short period such as a week or month. A check is then drawn by the company cashier for an amount slightly in excess of this estimate. This check is recorded with a debit to the Petty Cash account (an asset) and a credit to Cash. The check is cashed, and the currency is given to an employee designated as the petty cashier or petty cash custodian. The petty cashier is responsible for keeping this cash safe, making payments from the fund, and keeping records of it in a secure place referred to as the petty cashbox. When each cash disbursement is made, the person receiving payment should sign a prenum- bered petty cash receipt, also called petty cash ticket—see Exhibit 6.2. The petty cash receipt is then placed in the petty cashbox with the remaining money. Under this system, the sum of all re- ceipts plus the remaining cash equals the total fund amount. A $100 petty cash fund, for instance, contains any combination of cash and petty cash receipts that totals $100 (examples are $80 cash plus $20 in receipts, or $10 cash plus $90 in receipts). Each disbursement reduces cash and in- creases the amount of receipts in the petty cashbox.

Point: A petty cash fund is used only for business expenses.

EXHIBIT 6.2 Petty Cash Receipt

For

Date

Charge to Amount

PETTY CASH RECEIPT

Z-Mart No. 9

Approved by

Received by

The petty cash fund should be reimbursed when it is nearing zero and at the end of an ac- counting period when financial statements are prepared. For this purpose, the petty cashier sorts the paid receipts by the type of expense or account and then totals the receipts. The petty cashier presents all paid receipts to the company cashier, who stamps all receipts paid so they cannot be reused, files them for recordkeeping, and gives the petty cashier a check for their sum. When this check is cashed and the money placed in the cashbox, the total money in the cashbox is restored to its original amount. The fund is now ready for a new cycle of petty cash payments.

Illustrating a petty cash fund. To illustrate, assume Z-Mart establishes a petty cash fund on November 1 and designates one of its office employees as the petty cashier. A $75 check is

Point: Petty cash receipts with either no signature or a forged signature usually indicate misuse of petty cash. Companies respond with surprise petty cash counts for verification.

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Chapter 6 Cash and Internal Controls 269

drawn, cashed, and the proceeds given to the petty cashier. The entry to record the setup of this petty cash fund is

Nov. 1 Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

To establish a petty cash fund.

Assets 5 Liabilities 1 Equity 175 275

After the petty cash fund is established, the Petty Cash account is not debited or credited again unless the amount of the fund is changed. (A fund should be increased if it requires reimburse- ment too frequently. On the other hand, if the fund is too large, some of its money should be redeposited in the Cash account.) Next, assume that Z-Mart’s petty cashier makes several November payments from petty cash. Each person who received payment is required to sign a receipt. On November 27, after making a $26.50 cash payment for tile cleaning, only $3.70 cash remains in the fund. The petty cashier then summarizes and totals the petty cash receipts as shown in Exhibit 6.3.

Point: Reducing or eliminating a petty cash fund requires a credit to Petty Cash.

Point: Although individual petty cash disbursements are not evidenced by a check, the initial petty cash fund is evi- denced by a check, and later petty cash expenditures are evidenced by a check to replenish them in total.

The petty cash payments report and all receipts are given to the company cashier in exchange for a $71.30 check to reimburse the fund. The petty cashier cashes the check and puts the $71.30 cash in the petty cashbox. The company records this reimbursement as follows.

EXHIBIT 6.3 Petty Cash Payments Report

Z-MART

Petty Cash Payments Report

Miscellaneous Expenses

Nov. 2 Cleaning of LCD panels . . . . . . . . . . . . . . . . . . . . . . . . . . $20.00

Nov. 27 Tile cleaning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26.50 $ 46.50

Merchandise Inventory (transportation-in)

Nov. 5 Transport of merchandise purchased . . . . . . . . . . . . . . . . 6.75

Nov. 20 Transport of merchandise purchased . . . . . . . . . . . . . . . . 8.30 15.05

Delivery Expense

Nov. 18 Customer’s package delivered . . . . . . . . . . . . . . . . . . . . . 5.00

Office Supplies Expense

Nov. 15 Purchase of office supplies immediately used . . . . . . . . . 4.75

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $71.30

Point: This report can also include receipt number and names of those who approved and received cash payment (see Demo Problem 2).

Nov. 27 Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . 46.50

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 15.05

Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.00

Office Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . 4.75

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71.30

To reimburse petty cash.

Assets 5 Liabilities 1 Equity 271.30 246.50

215.05 2 5.00 2 4.75

A petty cash fund is usually reimbursed at the end of an accounting period so that expenses are recorded in the proper period, even if the fund is not low on money. If the fund is not reim- bursed at the end of a period, the financial statements would show both an overstated cash asset and understated expenses (or assets) that were paid out of petty cash. Some companies do not reimburse the petty cash fund at the end of each period under the notion that this amount is im- material to users of financial statements.

Increasing or decreasing a petty cash fund. A decision to increase or decrease a petty cash fund is often made when reimbursing it. To illustrate, assume Z-Mart decides to increase its petty cash fund from $75 to $100 on November 27 when it reimburses the fund. The entries

Point: To avoid errors in recording petty cash reimbursement, follow these steps: (1) prepare payments report, (2) compute cash needed by subtracting cash remaining from total fund amount, (3) record entry, and (4) check “Dr. 5 Cr.” in entry. Any difference is Cash Over and Short.

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270 Chapter 6 Cash and Internal Controls

Alternatively, if Z-Mart decreases the petty cash fund from $75 to $55 on November 27, the entry is to (1) credit Petty Cash for $20 (decreasing the fund from $75 to $55) and (2) debit Cash for $20 (reflecting the $20 transfer from Petty Cash to Cash).

Cash over and short. Sometimes a petty cashier fails to get a receipt for payment or overpays for the amount due. When this occurs and the fund is later reimbursed, the petty cash payments report plus the cash remaining will not total to the fund balance. This mistake causes the fund to be short. This shortage is recorded as an expense in the reimbursing entry with a debit to the Cash Over and Short account. (An overage in the petty cash fund is recorded with a credit to Cash Over and Short in the reimbursing entry.) To illustrate, prepare the June 1 entry to reimburse a $200 petty cash fund when its payments report shows $178 in miscellaneous expenses and $15 cash remains.

Event Petty Cash Cash Expenses

Set up fund . . . . . Dr. Cr. —

Reimburse fund . . — Cr. Dr.

Increase fund . . . . Dr. Cr. —

Decrease fund . . . Cr. Dr. —

Summary of Petty Cash Accounting

required are to (1) reimburse the fund as usual (see the preceding November 27 entry) and (2) increase the fund amount as follows.

Nov. 27 Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

To increase the petty cash fund amount.

$200 Petty Cash Fund

$15 Cash $7 Short $178 Receipts

For

Date

Charge to Amount

PETTY CASH RECEIPT Z-Mart No. 9

Approved by

Received by

June 1 Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . 178

Cash Over and Short . . . . . . . . . . . . . . . . . . . . . . . . 7

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

To reimburse petty cash.

9. Why are some cash payments made from a petty cash fund and not by check? 10. Why should a petty cash fund be reimbursed at the end of an accounting period? 11. Identify at least two results of reimbursing a petty cash fund. 12. Assume that we are auditing a company for the first time. Our audit procedures for petty

cash require a surprise audit of the petty cash fund. We approach the petty cash custodian to conduct the audit and she says: “I’m busy right now. Can we do this after lunch?” Do we accommodate the request?

Quick Check Answers — pp. 285–286

Banks (and other financial institutions) provide many services, including helping companies control cash. Banks safeguard cash, provide detailed and independent records of cash transac- tions, and are a source of cash financing. This section describes these services and the docu- ments provided by banking activities that increase managers’ control over cash.

Basic Bank Services This section explains basic bank services—such as the bank account, the bank deposit, and checking—that contribute to the control of cash.

BANKING ACTIVITIES AS CONTROLS

Warning Signs There are clues to internal control violations. Warning signs from accounting include (1) an increase in customer refunds—could be fake, (2) missing documents—could be used for fraud, (3) differences between bank deposits and cash receipts—could be cash embezzled, and (4) delayed recording—could reflect fraudulent records. Warning signs from employees include (1) lifestyle change— could be embezzlement, (2) too close with suppliers—could signal fraudulent transactions, and (3) failure to leave job, even for vacations—could conceal fraudulent activities. ■

Decision Insight

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Chapter 6 Cash and Internal Controls 271

Bank Account, Deposit, and Check A bank account is a record set up by a bank for a customer. It permits a customer to deposit money for safekeeping and helps control withdraw- als. To limit access to a bank account, all persons authorized to write checks on the account must sign a signature card, which bank employees use to verify signatures on checks. Many companies have more than one bank account to serve different needs and to handle special transactions such as payroll. Each bank deposit is supported by a deposit ticket, which lists items such as currency, coins, and checks deposited along with their corresponding dollar amounts. The bank gives the cus- tomer a copy of the deposit ticket or a deposit receipt as proof of the deposit. Exhibit 6.4 shows one type of deposit ticket.

Point: Online banking services include the ability to stop payment on a check, move money between accounts, get up-to-date balances, and identify cleared checks and deposits.

EXHIBIT 6.4 Deposit Ticket

C H

E C

K S

L

IS T

S

IN G

LY D

O L

L A

R S

C E

N T

S

1 14

-2 87

/9 39

90 50

2 82

-7 59

/3 39

82 80

3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 2 0

2 1

2 2

T O

TA L

E N

T E

R T

O TA

L O

N T

H E

F R

O N

T O

F T

H IS

T IC

K E

T

76 -9

07 /9

19 30

20

20 3

50

DEPOSIT TICKET

..................................... (Memo)

Checks and other items are received for deposit subject to the provisions of the uniform commercial code or any applicable collection agreement

USE OTHER SIDE FOR ADDITIONAL LISTINGS. BE SURE EACH ITEM IS PROPERLY ENDORSED

99-DT/101

Date .................. 20 ......... CURRENCY

TOTAL

NET DEPOSIT

36 October 2

Deposit checks

13

203 240

240

50

50 00

00

CASH COIN

LIST CHECKS SINGLY

TOTAL FROM OTHER SIDE

Front

Back

901 Main Street Hillcrest, NY 11749

To withdraw money from an account, the depositor can use a check, which is a document signed by the depositor instructing the bank to pay a specified amount of money to a designated recipient. A check involves three parties: a maker who signs the check, a payee who is the re- cipient, and a bank (or payer) on which the check is drawn. The bank provides a depositor the checks that are serially numbered and imprinted with the name and address of both the depositor and bank. Both checks and deposit tickets are imprinted with identification codes in magnetic ink for computer processing. Exhibit 6.5 shows one type of check. It is accompanied with an optional remittance advice explaining the payment. When a remittance advice is unavailable, the memo line is often used for a brief explanation.

Electronic Funds Transfer Electronic funds transfer (EFT) is the electronic transfer of cash from one party to another. No paper documents are necessary. Banks simply transfer cash from one account to another with a journal entry. Companies are increasingly using EFT because of its convenience and low cost. For instance, it can cost up to 50 cents to process a check through the banking system, whereas EFT cost is near zero. We now commonly see items such as payroll, rent, utilities, insurance, and interest payments being handled by EFT. The bank statement lists cash withdrawals by EFT with the checks and other deductions. Cash receipts by EFT are listed with deposits and other additions. A bank statement is sometimes a depositor’s only notice of an EFT. Automated teller machines (ATMs) are one form of EFT, which allows bank customers to deposit, withdraw, and transfer cash.

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272 Chapter 6 Cash and Internal Controls

Bank Statement Usually once a month, the bank sends each depositor a bank statement showing the activity in the account. Although a monthly statement is common, companies often regularly access infor- mation on their banking transactions. (Companies can choose to record any accounting adjust- ments required from the bank statement immediately or later, say, at the end of each day, week, month, or when reconciling a bank statement.) Different banks use different formats for their bank statements, but all of them include the following items of information:

1. Beginning-of-period balance of the depositor’s account. 2. Checks and other debits decreasing the account during the period. 3. Deposits and other credits increasing the account during the period. 4. End-of-period balance of the depositor’s account.

This information reflects the bank’s records. Exhibit 6.6 shows one type of bank statement. Identify each of these four items in that statement. Part A of Exhibit 6.6 summarizes changes in the account. Part B lists paid checks along with other debits. Part C lists deposits and cred- its to the account, and part D shows the daily account balances. In reading a bank statement note that a depositor’s account is a liability on the bank’s records. This is so because the money belongs to the depositor, not the bank. When a depositor increases the account balance, the bank records it with a credit to that liability account. This means that debit memos from the bank produce credits on the depositor’s books, and credit memos from the bank produce debits on the depositor’s books. Enclosed with a bank statement is a list of the depositor’s canceled checks (or the actual can- celed checks) along with any debit or credit memoranda affecting the account. Increasingly, banks are showing canceled checks electronically via online access to accounts. Canceled checks are checks the bank has paid and deducted from the customer’s account during the period. Other deductions that can appear on a bank statement include (1) service charges and fees as- sessed by the bank, (2) checks deposited that are uncollectible, (3) corrections of previous errors, (4) withdrawals through automated teller machines (ATMs), and (5) periodic payments arranged in advance by a depositor. (Most company checking accounts do not allow ATM withdrawals because of the company’s desire to make all disbursements by check.) Except for service charges, the bank notifies the depositor of each deduction with a debit memorandum when the bank

EXHIBIT 6.5 Check with Remittance Advice

Pay to the order of

Date Description Gross Amount Deductions Net Amount

VideoBuster Company, Hillcrest, NY

Detach this portion before cashing

$

.................... 20 .......

Dollars

Memo

99-DT/101

No. 438 Check

Maker

Payee

Payer

Remittance Advice

901 Main Street Hillcrest, NY 11749

Hillcrest Lighting

Lighting design, Invoice No. 4658

October 3

55.

$55.00 $55.0010/3/13

13

Fifty Five Dollars and

Store Lighting Design

Point: Good internal control is to deposit all cash receipts daily and make all payments for goods and services by check. This controls access to cash and creates an independent record of all cash activities.

Global: If cash is in more than one currency, a company usually translates these amounts into U.S. dollars using the exchange rate as of the balance sheet date. Also, a company must disclose any restrictions on cash accounts located outside the U.S.

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Chapter 6 Cash and Internal Controls 273

Member FDIC

VideoBuster Company 901 Main Street Hillcrest, NY 11749

October 31, 2013 Statement Date

494 504 2 Account Number

Previous Balance

Symbols: CM–Credit Memo DM–Debit Memo

EC–Error Correction IN–Interest Earned

NSF–Non-Sufficient Funds EFT–Electronic Funds Transfer

SC–Service Charge OD–Overdraft

< Reconcile the account immediately. >

Checks and Debits Deposits and Credits Daily Balance

Total Checks and Debits Total Deposits and Credits Current Balance

1,609.58

Date 10/03 10/01 1,609.5810/02119 55.00 240.00

No. Amount Date Amount Date Amount

723.00 1,163.42 2,050.00

10/09 10/02 1,849.5810/09120 200.00 180.00 10/10 10/03 1,794.5810/15121 120.00 100.00 EFT

10/14 10/10 1,654.5810/23122 70.00 485.00 CM 10/12 10/09 1,774.5810/16 150.00

10/16 10/12 1,631.5810/31123 25.00 8.42 IN 10/23 10/14 1,561.58125 15.00

10/26 127 50.00

10/25 10/15 1,661.58 1,786.58

10/29 10/23

2,226.5810/25 2,256.58

10/26 2,176.58 10/29 2,041.58 10/31 2,050.00

128 135.00

20.00 NSF 10/1610.00 DM

23.00 DM

C DB

A

Bank Statement

Point: Many banks separately report other debits and credits apart from checks and deposits.

Book Balance

Cash Account

Cash receipts Cash disbursements Balance

Bank Statement Checks & debits ...... # Deposits & credits.... # Balance.................... #

Bank balance.............. # Add & deduct: • Timing differences # • Any errors # Adjusted bank bal....... #

Book balance.............. # Add & deduct: • Timing differences # • Any errors # Adjusted book bal....... #

Bank Reconciliation Bank Balance

#

# #

reduces the balance. A copy of each debit memorandum is usually sent with the statement (again, this information is often available earlier via online access and notifications).

Transactions that increase the depositor’s account include amounts the bank collects on behalf of the depositor and the corrections of previous errors. Credit memoranda notify the depositor of all increases when they are recorded. A copy of each credit memorandum is often sent with the bank statement. Banks that pay interest on checking accounts often compute the amount of interest earned on the average cash balance and credit it to the depositor’s account each period. In Exhibit 6.6, the bank credits $8.42 of interest to the account.

Bank Reconciliation When a company deposits all cash receipts and makes all cash payments (except petty cash) by check, it can use the bank statement for proving the accuracy of its cash records. This is done using a bank reconciliation, which is a report explaining any differences between the checking account balance according to the depositor’s records and the balance reported on the bank statement. The figure below reflects this process, which we describe in the following sections.

P3 Prepare a bank reconciliation.

Purpose of Bank Reconciliation The balance of a checking account reported on the bank statement rarely equals the balance in the depositor’s accounting records. This is usually due to information that one party has that the other does not. We must therefore prove the ac- curacy of both the depositor’s records and those of the bank. This means we must reconcile the

EXHIBIT 6.6 Bank Statement

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274 Chapter 6 Cash and Internal Controls

two balances and explain or account for any differences in them. Among the factors causing the bank statement balance to differ from the depositor’s book balance are these:

● Outstanding checks. Outstanding checks are checks written (or drawn) by the depositor, deducted on the depositor’s records, and sent to the payees but not yet received by the bank for payment at the bank statement date.

● Deposits in transit (also called outstanding deposits). Deposits in transit are deposits made and recorded by the depositor but not yet recorded on the bank statement. For example, companies can make deposits (in the night depository) at the end of a business day after the bank is closed. If such a deposit occurred on a bank statement date, it would not appear on this period’s statement. The bank would record such a deposit on the next business day, and it would appear on the next period’s bank statement. Deposits mailed to the bank near the end of a period also can be in transit and unrecorded when the statement is prepared.

● Deductions for uncollectible items and for services. A company sometimes deposits an- other party’s check that is uncollectible (usually meaning the balance in that party’s account is not large enough to cover the check). This check is called a nonsufficient funds (NSF) check. The bank would have initially credited the depositor’s account for the amount of the check. When the bank learns the check is uncollectible, it debits (reduces) the de positor’s account for the amount of that check. The bank may also charge the depositor a fee for pro- cessing an uncollectible check and notify the depositor of the deduction by sending a debit memorandum. The depositor should record each deduction when a debit memorandum is received, but an entry is sometimes not made until the bank reconciliation is prepared. Other possible bank charges to a depositor’s account that are first reported on a bank statement in- clude printing new checks and service fees.

● Additions for collections and for interest. Banks sometimes act as collection agents for their depositors by collecting notes and other items. Banks can also receive electronic funds transfers to the depositor’s account. When a bank collects an item, it is added to the deposi- tor’s account, less any service fee. The bank also sends a credit memorandum to notify the depositor of the transaction. When the memorandum is received, the depositor should record it; yet it sometimes remains unrecorded until the bank reconciliation is prepared. The bank statement also includes a credit for any interest earned.

● Errors. Both banks and depositors can make errors. Bank errors might not be dis covered until the depositor prepares the bank reconciliation. Also, depositor errors are sometimes discovered when the bank balance is reconciled. Error testing includes: (a) comparing depos- its on the bank statement with deposits in the accounting records and (b) comparing canceled checks on the bank statement with checks recorded in the accounting records.

Illustration of a Bank Reconciliation We follow nine steps in preparing the bank reconciliation. It is helpful to refer to the bank reconciliation in Exhibit 6.7 when studying steps 1 through 9 .

Forms of Check Fraud (CkFraud.org)

• Forged signatures—legitimate blank checks with fake payer signature

• Forged endorsements—stolen check that is endorsed and cashed by someone other than the payee

• Counterfeit checks—fraudulent checks with fake payer signature

• Altered checks—legitimate check altered (such as changed payee or amount) to benefit perpetrator

• Check kiting—deposit check from one bank account (without sufficient funds) into a second bank account

VIDEOBUSTER

Bank Reconciliation

October 31, 2013

Bank statement balance . . . . . . . . . . $ 2,050.00 Book balance . . . . . . . . . . . . . . . . . . . . $ 1,404.58

Add Add

Deposit of Oct. 31 in transit . . . . 145.00 Collect $500 note less $15 fee . . . . $485.00

2,195.00 Interest earned . . . . . . . . . . . . . . . . 8.42 493.42

Deduct 1,898.00

Outstanding checks Deduct

No. 124 . . . . . . . . . . . . . . . . . . . $150.00 Check printing charge . . . . . . . . . . . 23.00

No. 126 . . . . . . . . . . . . . . . . . . . 200.00 350.00 NSF check plus service fee . . . . . . . 30.00 53.00

Adjusted bank balance $1,845.00 Adjusted book balance . . . . . . . . . $1,845.00

1

2

3

4

5

6

7

8

← ←

Balances are equal (reconciled)9

EXHIBIT 6.7 Bank Reconciliation

Point: The person preparing the bank reconciliation should not be responsible for processing cash receipts, managing checks, or maintaining cash records.

Point: Small businesses with few em- ployees often allow recordkeepers to both write checks and keep the general ledger. If this is done, it is essential that the owner do the bank reconciliation.

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Chapter 6 Cash and Internal Controls 275

Identify the bank statement balance of the cash account (balance per bank). VideoBuster’s bank balance is $2,050.

Identify and list any unrecorded deposits and any bank errors understating the bank balance. Add them to the bank balance. VideoBuster’s $145 deposit placed in the bank’s night de- pository on October 31 is not recorded on its bank statement.

Identify and list any outstanding checks and any bank errors overstating the bank balance. Deduct them from the bank balance. VideoBuster’s comparison of canceled checks with its books shows two checks outstanding: No. 124 for $150 and No. 126 for $200.

Compute the adjusted bank balance, also called the corrected or reconciled balance. Identify the company’s book balance of the cash account (balance per book). VideoBuster’s

book balance is $1,404.58. Identify and list any unrecorded credit memoranda from the bank, any interest earned, and

errors understating the book balance. Add them to the book balance. VideoBuster’s bank statement includes a credit memorandum showing the bank collected a note receivable for the company on October 23. The note’s proceeds of $500 (minus a $15 collection fee) are cred- ited to the company’s account. VideoBuster’s bank statement also shows a credit of $8.42 for interest earned on the average cash balance. There was no prior notification of this item, and it is not yet recorded.

Identify and list any unrecorded debit memoranda from the bank, any service charges, and errors overstating the book balance. Deduct them from the book balance. Debits on Video- Buster’s bank statement that are not yet recorded include (a) a $23 charge for check printing and (b) an NSF check for $20 plus a related $10 processing fee. (The NSF check is dated October 16 and was included in the book balance.)

Compute the adjusted book balance, also called corrected or reconciled balance. Verify that the two adjusted balances from steps 4 and 8 are equal. If so, they are reconciled.

If not, check for accuracy and missing data to achieve reconciliation.

Adjusting Entries from a Bank Reconciliation A bank reconciliation often identi- fies unrecorded items that need recording by the company. In VideoBuster’s reconciliation, the ad- justed balance of $1,845 is the correct balance as of October 31. But the company’s accounting records show a $1,404.58 balance. We must prepare journal entries to adjust the book balance to the correct balance. It is important to remember that only the items reconciling the book balance require adjustment. A review of Exhibit 6.7 indicates that four entries are required for VideoBuster.

Collection of note. The first entry is to record the proceeds of its note receivable collected by the bank less the expense of having the bank perform that service.

1

2

3

4 5

6

Point: Outstanding checks are identi- fied by comparing canceled checks on the bank statement with checks recorded. This includes identifying any outstanding checks listed on the previous period’s bank reconciliation that are not included in the canceled checks on this period’s bank statement.

7

8 9 Point: Adjusting entries can be

combined into one compound entry.

Oct. 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485 Collection Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 To record the collection fee and proceeds for a note collected by the bank.

Assets 5 Liabilities 1 Equity 1485 215 2500

Oct. 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.42 Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.42 To record interest earned on the cash balance in the checking account.

Assets 5 Liabilities 1 Equity 18.42 18.42

Oct. 31 Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Check printing charge.

Assets 5 Liabilities 1 Equity 223 223

Interest earned. The second entry records interest credited to its account by the bank.

Check printing. The third entry records expenses for the check printing charge.

NSF check. The fourth entry records the NSF check that is returned as uncollectible. The $20 check was originally received from T. Woods in payment of his account and then deposited. The

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276 Chapter 6 Cash and Internal Controls

Oct. 31 Accounts Receivable—T. Woods . . . . . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

To charge Woods’ account for $20 NSF check and $10 bank fee.

Assets 5 Liabilities 1 Equity 130 230

Point: The company will try to collect the entire NSF amount of $30 from customer.

bank charged $10 for handling the NSF check and deducted $30 total from VideoBuster’s account. This means the entry must reverse the effects of the original entry made when the check was received and must record (add) the $10 bank fee.

After these four entries are recorded, the book balance of cash is adjusted to the correct amount of $1,845 (computed as $1,404.58 1 $485 1 $8.42 2 $23 2 $30). The Cash T-account to the side shows the same computation, where entries are keyed to the numerical codes in Exhibit 6.7.

Point: The Demo Problem 1 shows an adjusting entry for an error correction.

Cash

Unadj. bal. 1,404.58

485.00 23.00

8.42 30.00

Adj. bal. 1,845.00

7

7

6

6

Percent Citing These Root Causes to Override Controls

0% 20% 80%60%40%

Collusion to circumvent good controls

Weak internal controls exploited

49% 74%

36% 15%

15% 11%

Reckless dishonesty regardless of controls

2007 Survey 2011 Survey

Fraud A survey reports that 74% of employees had ‘personally seen’ or had ‘firsthand knowledge of’ fraud or misconduct within the past year. Another survey found that fraudsters exploited weak internal controls in 74% of the frauds—up from 47% four years earlier—see graphic (KPMG 2011). ■

13. What is a bank statement? 14. What is the meaning of the phrase to reconcile a bank balance? 15. Why do we reconcile the bank statement balance of cash and the depositor’s book balance

of cash?

16. List at least two items affecting the bank balance side of a bank reconciliation and indicate whether the items are added or subtracted.

17. List at least three items affecting the book balance side of a bank reconciliation and indicate whether the items are added or subtracted.

Quick Check Answers — p. 286

This section discusses similarities and differences between U.S. GAAP and IFRS regarding internal con- trols and in the accounting and reporting of cash.

Internal Control Purposes, Principles, and Procedures Both U.S. GAAP and IFRS aim for high-quality financial reporting. That aim translates into enhanced internal controls worldwide. Specifi- cally, the purposes and principles of internal control systems are fundamentally the same across the globe. However, culture and other realities suggest different emphases on the mix of control procedures, and some sensitivity to different customs and environments when establishing that mix. Nevertheless, the discussion in this chapter applies internationally. Nokia provides the following description of its control activities.

GLOBAL VIEW

Nokia has an internal audit function that acts as an independent appraisal function by examining and evalu- ating the adequacy and effectiveness of the company’s system of internal control.

Decision Insight

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Chapter 6 Cash and Internal Controls 277

Control of Cash Accounting definitions for cash are similar for U.S. GAAP and IFRS. The need for control of cash is universal and applies globally. This means that companies worldwide desire to apply cash management procedures as explained in this chapter and aim to control both cash receipts and dis- bursements. Accordingly, systems that employ tools such as cash monitoring mechanisms, verification of documents, and petty cash processes are applied worldwide. The basic techniques explained in this chap- ter are part of those control procedures.

Banking Activities as Controls There is a global demand for banking services, bank state- ments, and bank reconciliations. To the extent feasible, companies utilize banking services as part of their effective control procedures. Further, bank statements are similarly used along with bank reconciliations to control and monitor cash.

IFRS Internal controls are crucial to companies that convert from U.S. GAAP to IFRS. Major risks include mis- statement of financial information and fraud. Other risks are ineffective communication of the impact of this change for investors, creditors and others, and management’s inability to certify the effectiveness of controls over financial reporting. ■

Decision Analysis

Days’ sales uncollected 5 Accounts receivable

Net sales 3 365

EXHIBIT 6.8 Days’ Sales Uncollected

We use days’ sales uncollected to estimate how much time is likely to pass before the current amount of accounts receivable is received in cash. For evaluation purposes, we need to compare this estimate to that for other companies in the same industry. We also make comparisons between current and prior periods. To illustrate, we select data from the annual reports of two toy manufacturers, Hasbro and Mattel. Their days’ sales uncollected figures are shown in Exhibit 6.9.

EXHIBIT 6.9 Analysis Using Days’ Sales Uncollected

Company Figure ($ millions) 2011 2010 2009 2008 2007

Hasbro Accounts receivable . . . . . . . . . . $1,035 $961 $1,039 $612 $655

Net sales . . . . . . . . . . . . . . . . . . $4,286 $4,002 $4,068 $4,022 $3,838

Days’ sales uncollected . . . . 88 days 88 days 93 days 56 days 62 days

Mattel Accounts receivable . . . . . . . . . . $1,247 $1,146 $749 $874 $991

Net sales . . . . . . . . . . . . . . . . . . $6,266 $5,856 $5,431 $5,918 $5,970

Days’ sales uncollected . . . . 73 days 71 days 50 days 54 days 61 days

Days’ Sales Uncollected

A1 Compute the days’ sales uncollected ratio and use it to assess liquidity.

An important part of cash management is monitoring the receipt of cash from receivables. If customers and others who owe money to a company are delayed in payment, then that company can find it difficult to pay its obligations when they are due. A company’s customers are crucial partners in its cash manage- ment. Many companies attract customers by selling to them on credit. This means that cash receipts from customers are delayed until accounts receivable are collected. One measure of how quickly a company can convert its accounts receivable into cash is the days’ sales uncollected, also called days’ sales in receivables. This measure is computed by dividing the current balance of receivables by net credit sales over the year just completed and then multiplying by 365 (num- ber of days in a year). Since net credit sales usually are not reported to external users, the net sales (or revenues) figure is commonly used in the computation as in Exhibit 6.8.

Days’ sales uncollected for Hasbro in 2011 is computed as ($1,035y$4,286) 3 365 days 5 88 days. This means that it will take about 88 days to collect cash from ending accounts receivable. This number reflects one or more of the following factors: a company’s ability to collect receivables, customer financial health, customer payment strategies, and discount terms. To further assess days’ sales uncollected for Hasbro, we compare it to four prior years and to those of Mattel. We see that Hasbro’s days’ sales uncollected has worsened since 2008 as it takes much longer to collect its receivables relative to 2007 and 2008. In com- parison, Mattel has also worsened from 50 days in 2009 up to 73 days in 2011. For all years, Mattel is superior to Hasbro on this measure of cash management. The less time that money is tied up in receivables often translates into increased profitability.

2011 2010 2009 2008 2007

40

35

30

45

50

55

60

65

70

95

90

85

80

75

Days

Mattel HasbroDays’ Sales Uncollected:

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278 Chapter 6 Cash and Internal Controls

Sales Representative The sales staff is told to take action to help reduce days’ sales uncollected for cash management purposes. What can you, a salesperson, do to reduce days’ sales uncollected? ■ [Answer—p. 285]

Decision Maker

Prepare a bank reconciliation for Jamboree Enterprises for the month ended November 30, 2013. The fol- lowing information is available to reconcile Jamboree Enterprises’ book balance of cash with its bank statement balance as of November 30, 2013:

a. After all posting is complete on November 30, the company’s book balance of Cash has a $16,380 debit balance, but its bank statement shows a $38,520 balance.

b. Checks No. 2024 for $4,810 and No. 2026 for $5,000 are outstanding. c. In comparing the canceled checks on the bank statement with the entries in the accounting records, it

is found that Check No. 2025 in payment of rent is correctly drawn for $1,000 but is erroneously entered in the accounting records as $880.

d. The November 30 deposit of $17,150 was placed in the night depository after banking hours on that date, and this amount does not appear on the bank statement.

e. In reviewing the bank statement, a check written by Jumbo Enterprises in the amount of $160 was erroneously drawn against Jamboree’s account.

f. A credit memorandum enclosed with the bank statement indicates that the bank collected a $30,000 note and $900 of related interest on Jamboree’s behalf. This transaction was not recorded by Jamboree prior to receiving the statement.

g. A debit memorandum for $1,100 lists a $1,100 NSF check received from a customer, Marilyn Welch. Jamboree had not recorded the return of this check before receiving the statement.

h. Bank service charges for November total $40. These charges were not recorded by Jamboree before receiving the statement.

PLANNING THE SOLUTION ● Set up a bank reconciliation with a bank side and a book side (as in Exhibit 6.7). Leave room to both

add and deduct items. Each column will result in a reconciled, equal balance. ● Examine each item a through h to determine whether it affects the book or the bank balance and whether

it should be added or deducted from the bank or book balance. ● After all items are analyzed, complete the reconciliation and arrive at a reconciled balance between the

bank side and the book side. ● For each reconciling item on the book side, prepare an adjusting entry. Additions to the book side require an

adjusting entry that debits Cash. Deductions on the book side require an adjusting entry that credits Cash.

SOLUTION TO DEMONSTRATION PROBLEM 1

DEMONSTRATION PROBLEM 1

Point: Generally, the party that is not the initial recorder of an item, but is later informed, includes that item on its “book” of the bank reconciliation. For example, the bank records an NSF check and then informs the company. The com- pany, as not the initial recorder of the item, reports it on the book side of its reconciliation.

JAMBOREE ENTERPRISES

Bank Reconciliation

November 30, 2013

Bank statement balance . . . . . $ 38,520 Book balance . . . . . . . . . . . . . . $ 16,380

Add Add

Deposit of Nov. 30 . . . . . . . $17,150 Collection of note . . . . . . . . $30,000

Bank error (Jumbo) . . . . . . . 160 17,310 Interest earned . . . . . . . . . . 900 30,900

55,830 47,280

Deduct Deduct

Outstanding checks NSF check (M. Welch) . . . . 1,100

No. 2024 . . . . . . . . . . . . . 4,810 Recording error (# 2025) . . . 120

No. 2026 . . . . . . . . . . . . . 5,000 9,810 Service charge . . . . . . . . . . . 40 1,260

Adjusted bank balance . . . $46,020 Adjusted book balance . . . . $46,020

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Chapter 6 Cash and Internal Controls 279

Nov. 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,900

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Interest Earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

To record collection of note with interest.

Nov. 30 Accounts Receivable—M. Welch . . . . . . . . . . . . . . . . . . . 1,100

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100

To reinstate account due from an NSF check.

Nov. 30 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

To correct recording error on check no. 2025.

Nov. 30 Bank Service Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

To record bank service charges.

Required Adjusting Entries for Jamboree

Point: Error correction can alterna- tively involve (1) reversing the error en- try, and (2) recording the correct entry.

Bacardi Company established a $150 petty cash fund with Eminem as the petty cashier. When the fund balance reached $19 cash, Eminem prepared a petty cash payment report, which follows.

DEMONSTRATION PROBLEM 2

Petty Cash Payments Report

Receipt No. Account Charged Approved by Received by

12 Delivery Expense . . . . . . . . . . . . . $ 29 Eminem A. Smirnoff

13 Merchandise Inventory . . . . . . . . . 18 Eminem J. Daniels

15 (Omitted) . . . . . . . . . . . . . . . . . . . 32 Eminem C. Carlsberg

16 Miscellaneous Expense . . . . . . . . . 41 (Omitted) J. Walker

Total . . . . . . . . . . . . . . . . . . . . . . . $120

Required

1. Identify four internal control weaknesses from the payment report. 2. Prepare general journal entries to record: a. Establishment of the petty cash fund. b. Reimbursement of the fund. (Assume for this part only that petty cash receipt no. 15 was issued for

miscellaneous expenses.) 3. What is the Petty Cash account balance immediately before reimbursement? Immediately after

reimbursement?

SOLUTION TO DEMONSTRATION PROBLEM 2 1. Four internal control weaknesses are a. Petty cash ticket no. 14 is missing. Its omission raises questions about the petty cashier’s manage-

ment of the fund. b. The $19 cash balance means that $131 has been withdrawn ($150 2 $19 5 $131). However, the

total amount of the petty cash receipts is only $120 ($29 1 $18 1 $32 1 $41). The fund is $11 short of cash ($131 2 $120 5 $11). Was petty cash receipt no. 14 issued for $11? Management should investigate.

c. The petty cashier (Eminem) did not sign petty cash receipt no. 16. This omission could have been an oversight on his part or he might not have authorized the payment. Management should investigate.

d. Petty cash receipt no. 15 does not indicate which account to charge. This omission could have been an oversight on the petty cashier’s part. Management could check with C. Carlsberg and the petty cashier (Eminem) about the transaction. Without further information, debit Miscellaneous Expense.

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280 Chapter 6 Cash and Internal Controls

2. Petty cash general journal entries. a. Entry to establish the petty cash fund. b. Entry to reimburse the fund.

Petty Cash . . . . . . . . . . . . . . . . . . . . . 150 Delivery Expense . . . . . . . . . . . . . . . . . . . . . 29

Cash . . . . . . . . . . . . . . . . . . . . . . 150 Merchandise Inventory . . . . . . . . . . . . . . . . . 18

Miscellaneous Expense ($41 1 $32) . . . . . . 73

Cash Over and Short . . . . . . . . . . . . . . . . . . 11

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

3. The Petty Cash account balance always equals its fund balance, in this case $150. This account balance does not change unless the fund is increased or decreased.

APPENDIX

Documentation and Verification6A This appendix describes the important business documents of a voucher system of control.

Purchase Requisition Department managers are usually not allowed to place orders directly with suppliers for control purposes. Instead, a department manager must inform the purchasing department of its needs by preparing and signing a purchase requisition, which lists the merchandise needed and re- quests that it be purchased—see Exhibit 6A.1. Two copies of the purchase requisition are sent to the pur- chasing department, which then sends one copy to the accounting department. When the accounting department receives a purchase requisition, it creates and maintains a voucher for this transaction. The requesting department keeps the third copy.

PURCHASE REQUISITION

For Purchasing Department use only: Order Date P.O. No.

Z-Mart

Request purchase of the following item(s):

No. 917

10/30/13 P98

Date October 28, 2013

Preferred Vendor Trex From Sporting Goods Department

To Purchasing Department

Reason for Request Replenish inventory

Approval for Request

DESCRIPTION

SpeedDemon 1

QUANTITY

Challenger X7 1

MODEL NO.

CH 015

SD 099

EXHIBIT 6A.1 Purchase Requisition

P4 Describe the use of documentation and verification to control cash disbursements.

Purchase Order A purchase order is a document the purchasing department uses to place an order with a vendor (seller or supplier). A purchase order authorizes a vendor to ship ordered merchandise at the stated price and terms —see Exhibit 6A.2. When the purchasing department receives a purchase requisition, it prepares at least five copies of a purchase order. The copies are distributed as follows: copy 1 to the ven- dor as a purchase request and as authority to ship merchandise; copy 2, along with a copy of the purchase requisition, to the accounting department, where it is entered in the voucher and used in approving payment of the invoice; copy 3 to the requesting department to inform its manager that action is being taken; copy 4 to the receiving department without order quantity so it can compare with goods received and provide inde- pendent count of goods received; and copy 5 retained on file by the purchasing department.

Point: A voucher system is designed to uniquely meet the needs of a specific business. Thus, we should read this appendix as one example of a common voucher system design, but not the only design.

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Chapter 6 Cash and Internal Controls 281

PURCHASE ORDERZ-Mart 10 Michigan Street

Chicago, Illinois 60521 No. P98

To: Trex W9797 Cherry Road Antigo, Wisconsin 54409

Date 10/30/13

2/15, n/30

FOB Destination As soon as possibleShip by

Terms

Request shipment of the following item(s):

All shipments and invoices must include purchase order number

ORDERED BY

Model No. Description

SpeedDemon 1

Quantity Price Amount

710 710 CH 015 SD 099

Challenger X7 1 490 490

EXHIBIT 6A.2 Purchase Order

Invoice An invoice is an itemized statement of goods prepared by the vendor listing the customer’s name, items sold, sales prices, and terms of sale. An invoice is also a bill sent to the buyer from the sup- plier. From the vendor’s point of view, it is a sales invoice. The buyer, or vendee, treats it as a purchase invoice. When receiving a purchase order, the vendor ships the ordered merchandise to the buyer and in- cludes or mails a copy of the invoice covering the shipment to the buyer. The invoice is sent to the buyer’s accounting department where it is placed in the voucher. (Refer back to Exhibit 4.5, which shows Z-Mart’s purchase invoice.)

Receiving Report Many companies maintain a separate department to receive all merchandise and purchased assets. When each shipment arrives, this receiving department counts the goods and checks them for damage and agreement with the purchase order. It then prepares four or more copies of a receiving re- port, which is used within the company to notify the appropriate persons that ordered goods have been re- ceived and to describe the quantities and condition of the goods. One copy is sent to accounting and placed in the voucher. Copies are also sent to the requesting department and the purchasing department to notify them that the goods have arrived. The receiving department retains a copy in its files.

Invoice Approval When a receiving report arrives, the accounting department should have copies of the following documents in the voucher: purchase requisition, purchase order, and invoice. With the information in these documents, the accounting department can record the purchase and approve its pay- ment. In approving an invoice for payment, it checks and compares information across all documents. To facilitate this checking and to ensure that no step is omitted, it often uses an invoice approval, also called check authorization—see Exhibit 6A.3. An invoice approval is a checklist of steps necessary for approving an invoice for recording and payment. It is a separate document either filed in the voucher or preprinted (or stamped) on the voucher.

EXHIBIT 6A.3 Invoice Approval

INVOICE APPROVAL

Purchase requisition

Purchase order

Receiving report

Invoice:

Price

Calculations

Terms

Approved for payment

917

P98

R85

4657

10/28/13TZ

JW

SK

JK

JK

JK

BC

10/30/13

11/03/13

11/12/13

11/12/13

11/12/13

11/12/13

BY DATEDOCUMENT

Point: Shipping terms and credit terms are shown on the purchase order.

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282 Chapter 6 Cash and Internal Controls

As each step in the checklist is approved, the person initials the invoice approval and records the cur- rent date. Final approval implies the following steps have occurred:

1. Requisition check: Items on invoice are requested per purchase requisition. 2. Purchase order check: Items on invoice are ordered per purchase order. 3. Receiving report check: Items on invoice are received per receiving report. 4. Invoice check: Price: Invoice prices are as agreed with the vendor. Calculations: Invoice has no mathematical errors. Terms: Terms are as agreed with the vendor.

Voucher Once an invoice has been checked and approved, the voucher is complete. A complete voucher is a record summarizing a transaction. Once the voucher certifies a transaction, it authorizes re- cording an obligation. A voucher also contains approval for paying the obligation on an appropriate date. The physical form of a voucher varies across companies. Many are designed so that the invoice and other related source documents are placed inside the voucher, which can be a folder. Completion of a voucher usually requires a person to enter certain information on both the inside and outside of the voucher. Typical information required on the inside of a voucher is shown in Exhibit 6A.4, and that for the outside is shown in Exhibit 6A.5. This information is taken from the invoice and the sup- porting documents filed in the voucher. A complete voucher is sent to an authorized individual (often called an auditor). This person performs a final review, approves the accounts and amounts for debiting (called the accounting distribution), and authorizes recording of the voucher.

Point: Recording a purchase is initiated by an invoice approval, not an invoice. An invoice approval verifies that the amount is consistent with that requested, ordered, and received. This controls and verifies purchases and related liabilities.

Point: Auditors, when auditing inven- tory, check a sampling of purchases by reviewing the purchase order, receiving report, and invoice.

EXHIBIT 6A.4 Inside of a Voucher Chicago, Illinois

Date

For the following: (attach all invoices and supporting documents)

Oct. 28, 2013 Trex

Voucher No. 4657

Pay to AntigoCity Wiscon

sinState

TERMS TERMS

Nov. 2, 2013 2/15, n/30 Invoice No. 4657 Less discount

Net amount payable

Payment approved

1,200 24 1,176

Auditor

Z-Mart

DATE OF INVOICE INVOICE NUMBER AND OTHER DETAILS

After a voucher is approved and recorded (in a journal called a voucher register), it is filed by its due date. A check is then sent on the payment date from the cashier, the voucher is marked “paid,” and the voucher is sent to the accounting department and recorded (in a journal called the check register). The person issuing checks relies on the approved voucher and its signed supporting documents as proof that an obligation has been incurred and must be paid. The purchase requisition and purchase order confirm the purchase was authorized. The receiving report shows that items have been received, and the invoice approval form verifies that the invoice has been checked for errors. There is little chance for error and even less chance for fraud without collusion unless all the documents and signa- tures are forged.

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Chapter 6 Cash and Internal Controls 283

EXHIBIT 6A.5 Outside of a Voucher

Voucher No. 4657 November 12, 2013Due Date

TrexPay to AntigoCity

WisconsinState

1,200 Summary of charges: Total charges Discount Net payment

24 1,176

Record of payment: Paid Check No.

Accounting Distribution ACCOUNT DEBITED

Merch. Inventory Store Supplies Office Supplies Sales Salaries Other

Total Vouch. Pay. Cr.

1,200

1,200

AMOUNT

APPENDIX

Control of Purchase Discounts 6B This appendix explains how a company can better control its cash disbursements to take advantage of favorable purchases discounts. Chapter 4 described the entries to record the receipt and payment of an invoice for a merchandise purchase with and without discount terms. Those entries were prepared under what is called the gross method of recording purchases, which initially records the invoice at its gross amount ignoring any cash discount. The net method is another means of recording purchases, which initially records the invoice at its net amount of any cash discount. The net method gives management an advantage in controlling and monitor- ing cash payments involving purchase discounts. To explain, when invoices are recorded at gross amounts, the amount of any discounts taken is deducted from the balance of the Merchandise Inventory account when cash payment is made. This means that the amount of any discounts lost is not reported in any account or on the income statement. Lost discounts re- corded in this way are unlikely to come to the attention of management. When purchases are recorded at net amounts, a Discounts Lost expense account is recorded and brought to management’s attention. Manage- ment can then seek to identify the reason for discounts lost such as oversight, carelessness, or unfavorable terms. (Chapter 4 explains how managers assess whether a discount is favorable or not.)

Perpetual Inventory System To illustrate, assume that a company purchases merchandise on November 2 at a $1,200 invoice price with terms of 2y10, ny30. Its November 2 entries under the gross and net methods are

Merchandise Inventory . . . . . . . . . . . . 1,200 Merchandise Inventory . . . . . . . . . . . . 1,176

Accounts Payable . . . . . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . 1,176

Gross Method—Perpetual Net Method—Perpetual

Accounts Payable . . . . . . . . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . . . . . 1,176

Merchandise Inventory . . . . . . . . 24 Cash . . . . . . . . . . . . . . . . . . . . . . . 1,176

Cash . . . . . . . . . . . . . . . . . . . . . . 1,176

Gross Method—Perpetual Net Method—Perpetual

If the invoice is paid on November 12 within the discount period, it records the following:

P5 Apply the net method to control purchase discounts.

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284 Chapter 6 Cash and Internal Controls

If the invoice is not paid within the discount period, it records the following November 12 entry (which is the date corresponding to the end of the discount period):

Accounts Payable . . . . . . . . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . . . . . 1,200

Cash . . . . . . . . . . . . . . . . . . . . . . . 1,200 Cash . . . . . . . . . . . . . . . . . . . . . . . 1,200

Gross Method—Perpetual Net Method—Perpetual

No entry Discounts Lost . . . . . . . . . . . . . . . . . 24

Accounts Payable . . . . . . . . . . . . . 24

Gross Method—Perpetual Net Method—Perpetual

Then, when the invoice is later paid on December 2, outside the discount period, it records the following:

(The discount lost can be recorded when the cash payment is made with a single entry. However, in this case, when financial statements are prepared after a discount is lost and before the cash payment is made, an adjusting entry is required to recognize any unrecorded discount lost in the period when incurred.)

Periodic Inventory System The preceding entries assume a perpetual inventory system. If a company is using a periodic system, its November 2 entries under the gross and net methods are

Purchases . . . . . . . . . . . . . . . . . . . . . . . 1,200 Purchases . . . . . . . . . . . . . . . . . . . . . . . 1,176

Accounts Payable . . . . . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . 1,176

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . . . . . 1,200

Cash . . . . . . . . . . . . . . . . . . . . . . 1,200 Cash . . . . . . . . . . . . . . . . . . . . . . . 1,200

Gross Method—Periodic Net Method—Periodic

No entry Discounts Lost . . . . . . . . . . . . . . . . . 24

Accounts Payable . . . . . . . . . . . . . 24

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . . . . . 1,176

Purchases Discounts . . . . . . . . . . 24 Cash . . . . . . . . . . . . . . . . . . . . . . . 1,176

Cash . . . . . . . . . . . . . . . . . . . . . . . 1,176

Gross Method—Periodic Net Method—Periodic

If the invoice is paid on November 12 within the discount period, it records the following:

If the invoice is not paid within the discount period, it records the following November 12 entry:

Then, when the invoice is later paid on December 2, outside the discount period, it records the following:

C1 Define internal control and identify its purpose and princi-ples. An internal control system consists of the policies and procedures managers use to protect assets, ensure reliable account- ing, promote efficient operations, and urge adherence to company policies. It can prevent avoidable losses and help managers both plan operations and monitor company and human performance. Principles of good internal control include establishing responsibili- ties, maintaining adequate records, insuring assets and bonding em- ployees, separating recordkeeping from custody of assets, dividing responsibilities for related transactions, applying technological con- trols, and performing regular independent reviews.

Summary C2 Define cash and cash equivalents and explain how to report them. Cash includes currency, coins, and amounts on (or accept- able for) deposit in checking and savings accounts. Cash equivalents are short-term, highly liquid investment assets readily convertible to a known cash amount and sufficiently close to their maturity date so that market value is not sensitive to interest rate changes. Cash and cash equivalents are liquid assets because they are readily converted into other assets or can be used to pay for goods, services, or liabilities.

A1 Compute the days’ sales uncollected ratio and use it to as-sess liquidity. Many companies attract customers by selling to them on credit. This means that cash receipts from customers are

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Chapter 6 Cash and Internal Controls 285

delayed until accounts receivable are collected. Users want to know how quickly a company can convert its accounts receivable into cash. The days’ sales uncollected ratio, one measure reflecting company liquidity, is computed by dividing the ending balance of receivables by annual net sales, and then multiplying by 365.

P1 Apply internal control to cash receipts and disbursements. Internal control of cash receipts ensures that all cash received is properly recorded and deposited. Attention focuses on two impor- tant types of cash receipts: over-the-counter and by mail. Good in- ternal control for over-the-counter cash receipts includes use of a cash register, customer review, use of receipts, a permanent transac- tion record, and separation of the custody of cash from its record- keeping. Good internal control for cash receipts by mail includes at least two people assigned to open mail and a listing of each sender’s name, amount, and explanation. (Banks offer several services that promote the control and safeguarding of cash.)

P2 Explain and record petty cash fund transactions. Petty cash disbursements are payments of small amounts for items such as postage, courier fees, minor repairs, and supplies. A company usually sets up one or more petty cash funds. A petty cash fund cashier is responsible for safekeeping the cash, making payments from this fund, and keeping receipts and records. A Petty Cash account is debited only when the fund is established or increased in amount. When the fund is replenished, petty cash disbursements are recorded with debits to expense (or asset) accounts and a credit to cash.

P3 Prepare a bank reconciliation. A bank reconciliation proves the accuracy of the depositor’s and the bank’s records. The bank statement balance is adjusted for items such as outstanding checks and unrecorded deposits made on or before the bank state- ment date but not reflected on the statement. The book balance is adjusted for items such as service charges, bank collections for the depositor, and interest earned on the account.

P4A Describe the use of documentation and verification to control cash disbursements. A voucher system is a set of procedures and approvals designed to control cash disbursements and acceptance of obligations. The voucher system of control relies on several important documents, including the voucher and its supporting files. A key factor in this system is that only approved departments and individuals are authorized to incur certain obligations.

P5B Apply the net method to control purchase discounts. The net method aids management in monitoring and controlling purchase discounts. When invoices are recorded at gross amounts, the amount of discounts taken is deducted from the balance of the In- ventory account. This means that the amount of any discounts lost is not reported in any account and is unlikely to come to the attention of management. When purchases are recorded at net amounts, a Dis- counts Lost account is brought to management’s attention as an oper- ating expense. Management can then seek to identify the reason for discounts lost, such as oversight, carelessness, or unfavorable terms.

Entrepreneur To achieve proper separation of duties, a mini- mum of three employees are required. Transaction authorization, re- cording, and asset custody are ideally handled by three employees. Many small businesses do not employ three workers. In such cases, an owner must exercise more oversight to make sure that the lack of separation of duties does not result in fraudulent transactions.

Sales Representative A salesperson can take several steps to reduce days’ sales uncollected. These include (1) decreasing the ratio of sales on account to total sales by encouraging more cash sales, (2) identifying customers most delayed in their payments and encouraging earlier payments or cash sales, and (3) applying stricter credit policies to eliminate credit sales to customers that never pay.

Guidance Answers to Decision Maker and Decision Ethics

1. (c) 2. Technology reduces processing errors. It also allows more ex-

tensive testing of records, limits the amount of hard evidence, and highlights the importance of separation of duties.

3. When employees are forced to take vacations, their ability to hide any fraudulent behavior decreases because others must perform the vacationers’ duties. A replacement employee potentially can uncover fraudulent behavior or falsified records. A forced vacation policy is especially important for employees in sensitive positions of handling money or in control of easily transferable assets.

4. A company holds liquid assets so that it can purchase other as- sets, buy services, and pay obligations.

5. It owns cash equivalents because they yield a return greater than what cash earns (and are readily exchanged for cash).

6. Examples of cash equivalents are 90-day (or less) U.S. Treasury bills, money market funds, and commercial paper (notes).

7. (a) 8. A voucher system is used when an owner/manager can no lon-

ger control purchasing procedures through personal supervision and direct participation.

9. If all cash payments are made by check, numerous checks for small amounts must be written. Since this practice is expensive and time-consuming, a petty cash fund is often established for making small (immaterial) cash payments.

10. If the petty cash fund is not reimbursed at the end of an account- ing period, the transactions involving petty cash are not yet recorded and the petty cash asset is overstated.

11. First, petty cash transactions are recorded when the petty cash fund is reimbursed. Second, reimbursement provides cash to allow the fund to continue being used. Third, reimbursement identifies any cash shortage or overage in the fund.

Guidance Answers to Quick Checks

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286 Chapter 6 Cash and Internal Controls

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 299 mhhe.com/wildFINMAN5e

1. A company needs to replenish its $500 petty cash fund. Its petty cash box has $75 cash and petty cash receipts of $420. The journal entry to replenish the fund includes

a. A debit to Cash for $75. b. A credit to Cash for $75. c. A credit to Petty Cash for $420. d. A credit to Cash Over and Short for $5. e. A debit to Cash Over and Short for $5.

2. The following information is available for Hapley Company: • The November 30 bank statement shows a $1,895 balance. • The general ledger shows a $1,742 balance at November 30. • A $795 deposit placed in the bank’s night depository on

November 30 does not appear on the November 30 bank statement.

• Outstanding checks amount to $638 at November 30. • A customer’s $335 note was collected by the bank in

November. A collection fee of $15 was deducted by the bank and the difference deposited in Hapley’s account.

• A bank service charge of $10 is deducted by the bank and appears on the November 30 bank statement.

How will the customer’s note appear on Hapley’s November 30 bank reconciliation?

a. $320 appears as an addition to the book balance of cash. b. $320 appears as a deduction from the book balance of cash. c. $320 appears as an addition to the bank balance of cash.

d. $320 appears as a deduction from the bank balance of cash. e. $335 appears as an addition to the bank balance of cash. 3. Using the information from question 2, what is the reconciled

balance on Hapley’s November 30 bank reconciliation? a. $2,052 b. $1,895 c. $1,742 d. $2,201 e. $1,184 4. A company had net sales of $84,000 and accounts receivable of

$6,720. Its days’ sales uncollected is a. 3.2 days b. 18.4 days c. 230.0 days d. 29.2 days e. 12.5 days 5.B A company records its purchases using the net method. On

August 1, it purchases merchandise on account for $6,000 with terms of 2y10, ny30. The August 1 journal entry to record this transaction includes a

a. Debit to Merchandise Inventory for $6,000. b. Debit to Merchandise Inventory for $5,880. c. Debit to Merchandise Inventory for $120. d. Debit to Accounts Payable for $5,880. e. Credit to Accounts Payable for $6,000.

12. If we accommodate the custodian’s request, we reduce effective- ness of this audit procedure. If the custodian uses the lunch pe- riod to fix any shortages or irregularities in the petty cash fund, we risk not discovering such problems when we defer our audit.

13. A bank statement is a report prepared by the bank describing the activities in a depositor’s account.

14. To reconcile a bank balance means to explain the difference be- tween the cash balance in the depositor’s accounting records and the cash balance on the bank statement.

15. The purpose of the bank reconciliation is to determine whether the bank or the depositor has made any errors and whether the

bank has entered any transactions affecting the account that the depositor has not recorded.

16. Unrecorded deposits—added Outstanding checks—subtracted 17. Interest earned—added Debit memos—subtracted Credit memos—added NSF checks—subtracted Bank service charges—subtracted

Bank reconciliation (p. 273)

Bank statement (p. 272)

Canceled checks (p. 272)

Cash (p. 263)

Cash equivalents (p. 264)

Cash Over and Short (p. 265)

Check (p. 271)

Check register (p. 282)

Committee of Sponsoring Organizations (COSO) (p. 259)

Days’ sales uncollected (p. 277)

Deposit ticket (p. 271)

Deposits in transit (p. 274)

Discounts lost (p. 283)

Electronic funds transfer (EFT) (p. 271)

Gross method (p. 283)

Internal control system (p. 258)

Invoice (p. 281)

Invoice approval (p. 281)

Liquid assets (p. 263)

Liquidity (p. 263)

Net method (p. 283)

Outstanding checks (p. 274)

Petty cash (p. 268)

Principles of internal control (p. 259)

Purchase order (p. 280)

Purchase requisition (p. 280)

Receiving report (p. 281)

Sarbanes-Oxley Act (p. 258)

Section 404 (of SOX) (p. 259)

Signature card (p. 271)

Vendee (p. 281)

Vendor (p. 280)

Voucher (p. 267)

Voucher register (p. 282)

Voucher system (p. 266)

Key Terms

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Chapter 6 Cash and Internal Controls 287

1. List the seven broad principles of internal control. 2. Internal control procedures are important in every busi-

ness, but at what stage in the development of a business do they become especially critical?

3. Why should responsibility for related transactions be di- vided among different departments or individuals?

4. Why should the person who keeps the records of an asset not be the person responsible for its custody?

5. When a store purchases merchandise, why are individual departments not allowed to directly deal with suppliers?

6. What are the limitations of internal controls? 7. Which of the following assets is most liquid? Which is least

liquid? Inventory, building, accounts receivable, or cash.

8. What is a petty cash receipt? Who should sign it? 9. Why should cash receipts be deposited on the day of receipt? 10. Polaris’ statement of cash flows in Appendix A

describes changes in cash and cash equivalents for the year ended December 31, 2011. What total amount is

provided (used) by investing activities? What amount is pro- vided (used) by financing activities?

11. Refer to Arctic Cat’s financial statements in Appendix A. Identify Arctic Cat’s net earnings (income) for the year ended March 31, 2011. Is its net earnings equal to the increase in cash and cash equivalents for the year? Explain the difference between net earnings and the increase in cash and cash equivalents.

12. Refer to KTM’s balance sheet in Appendix A. How does its cash (titled “liquid assets”) compare with its other current assets (both in amount and percent) as of December 31, 2011? Compare and assess its cash at Decem- ber 31, 2011, with its cash at December 31, 2010.

13. Piaggio’s balance sheet in Appendix A re- ports that cash and equivalents decreased dur- ing the year ended December 31, 2011. Identify the cash generated (or used) by operating activities, by investing activi- ties, and by financing (funding) activities.

Discussion Questions

A(B) Superscript letter A(B) denotes assignments based on Appendix 6A (6B).

Icon denotes assignments that involve decision making.

QS 6-3 Internal control for cash

P1

A good system of internal control for cash provides adequate procedures for protecting both cash receipts and cash disbursements. 1. What are three basic guidelines that help achieve this protection? 2. Identify two control systems or procedures for cash disbursements.

QS 6-5 Petty cash accounting

P2

1. The petty cash fund of the Brooks Agency is established at $150. At the end of the current period, the fund contained $28 and had the following receipts: film rentals, $24, refreshments for meetings, $46 (both expenditures to be classified as Entertainment Expense); postage, $30; and printing, $22. Pre- pare journal entries to record (a) establishment of the fund and (b) reimbursement of the fund at the end of the current period.

2. Identify the two events that cause a Petty Cash account to be credited in a journal entry.

QS 6-2 Cash and equivalents

C2

Good accounting systems help in managing cash and controlling who has access to it. 1. What items are included in the category of cash? 2. What items are included in the category of cash equivalents? 3. What does the term liquidity refer to?

QS 6-4 Bank reconciliation

P3

1. For each of the following items, indicate whether its amount (i) affects the bank or book side of a bank reconciliation and (ii) represents an addition or a subtraction in a bank reconciliation.

a. Interest on cash balance d. Outstanding checks g. Outstanding deposits b. Bank service charges e. Credit memos c. Debit memos f. NSF checks 2. Which of the items in part 1 require an adjusting journal entry?

An internal control system consists of all policies and procedures used to protect assets, ensure reliable accounting, promote efficient operations, and urge adherence to company policies. 1. What is the main objective of internal control procedures? How is that objective achieved? 2. Why should recordkeeping for assets be separated from custody over those assets? 3. Why should the responsibility for a transaction be divided between two or more individuals or

departments?

QUICK STUDY

QS 6-1 Internal control objectives

C1

Polaris

Arctic Cat

KTM

PIAGGIO

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288 Chapter 6 Cash and Internal Controls

QS 6-6 Bank reconciliation

P3

Nolan Company deposits all cash receipts on the day when they are received and it makes all cash payments by check. At the close of business on June 30, 2013, its Cash account shows an $22,352 debit balance. Nolan’s June 30 bank statement shows $21,332 on deposit in the bank. Prepare a bank reconciliation for the Company using the following information. a. Outstanding checks as of June 30 total $3,713. b. The June 30 bank statement included a $41 debit memorandum for bank services; the company has

not yet recorded the cost of these services. c. In reviewing the bank statement, a $90 check written by the Company was mistakenly recorded in the

company’s books at $99. d. June 30 cash receipts of $4,724 were placed in the bank’s night depository after banking hours and

were not recorded on the June 30 bank statement. e. The bank statement included a $23 credit for interest earned on the cash in the bank.

QS 6-9A

Documents in a voucher system

P4

Management uses a voucher system to help control and monitor cash disbursements. Identify and describe at least four key documents that are part of a voucher system of control.

2013 2012

Accounts receivable . . . . . . . . $ 85,692 $ 80,485

Net sales . . . . . . . . . . . . . . . . . 2,691,855 2,396,858

QS 6-8 Days’ sales uncollected

A1

The following annual account balances are taken from Armour Sports at December 31.

What is the change in the number of days’ sales uncollected between years 2012 and 2013? (Round the number of days to one decimal.) According to this analysis, is the company’s collection of receivables improving? Explain.

QS 6-11 International accounting and internal controls

C1 P1

Answer each of the following related to international accounting standards. a. Explain how the purposes and principles of internal controls are different between accounting sys-

tems reporting under IFRS versus U.S. GAAP. b. Cash presents special internal control challenges. How do internal controls for cash differ for account-

ing systems reporting under IFRS versus U.S. GAAP? How do the procedures applied differ across those two accounting systems?

Franco Company is a rapidly growing start-up business. Its recordkeeper, who was hired six months ago, left town after the company’s manager discovered that a large sum of money had disappeared over the past three months. An audit disclosed that the recordkeeper had written and signed several checks made pay- able to her fiancé and then recorded the checks as salaries expense. The fiancé, who cashed the checks but never worked for the company, left town with the recordkeeper. As a result, the company incurred an un- insured loss of $184,000. Evaluate Franco’s internal control system and indicate which principles of inter- nal control appear to have been ignored.

EXERCISES

Exercise 6-1 Analyzing internal control

C1

QS 6-10B

Purchase discounts P5 An important part of cash management is knowing when, and if, to take purchase discounts. a. Which accounting method uses a Discounts Lost account? b. What is the advantage of this method for management?

QS 6-7 Reviewing bank statements

P3

An entrepreneur commented that a bank reconciliation may not be necessary as she regularly reviews her online bank statement for any unusual items and errors. a. Describe how a bank reconciliation and an online review (or reading) of the bank statement are not

equivalent. b. Identify and explain at least two frauds or errors that would be uncovered through a bank reconcilia-

tion and that would not be uncovered through an online review of the bank statement.

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Chapter 6 Cash and Internal Controls 289

Exercise 6-2 Control of cash receipts by mail

P1

Some of Crown Company’s cash receipts from customers are received by the company with the regular mail. The company’s recordkeeper opens these letters and deposits the cash received each day. (a) Identify any internal control problem(s) in this arrangement. (b) What changes to its internal control system do you recommend?

Exercise 6-3 Internal control recommendations

C1

What internal control procedures would you recommend in each of the following situations? 1. A concession company has one employee who sells towels, coolers, and sunglasses at the beach. Each

day, the employee is given enough towels, coolers, and sunglasses to last through the day and enough cash to make change. The money is kept in a box at the stand.

2. An antique store has one employee who is given cash and sent to garage sales each weekend. The employee pays cash for any merchandise acquired that the antique store resells.

Exercise 6-4 Cash, liquidity, and return

C2

Good accounting systems help with the management and control of cash and cash equivalents. 1. Define and contrast the terms liquid asset and cash equivalent. 2. Why would companies invest their idle cash in cash equivalents? 3. Identify five principles of effective cash management.

Exercise 6-6 Petty cash fund with a shortage

P2

Waupaca Company establishes a $350 petty cash fund on September 9. On September 30, the fund shows $104 in cash along with receipts for the following expenditures: transportation-in, $40; postage expenses, $123; and miscellaneous expenses, $80. The petty cashier could not account for a $3 shortage in the fund. The company uses the perpetual system in accounting for merchandise inventory. Prepare (1) the September 9 entry to establish the fund, (2) the September 30 entry to reimburse the fund, and (3) an October 1 entry to increase the fund to $400.

Check (2) Cr. Cash $246 and (3) Cr. Cash $50

Exercise 6-7 Bank reconciliation and adjusting entries

P3

Prepare a table with the following headings for a monthly bank reconciliation dated September 30.

Not Shown

Bank Balance Book Balance

on the

Add Deduct Add Deduct Adjust Reconciliation

For each item 1 through 12, place an x in the appropriate column to indicate whether the item should be added to or deducted from the book or bank balance, or whether it should not appear on the reconciliation. If the book balance is to be adjusted, place a Dr. or Cr. in the Adjust column to indicate whether the Cash balance should be debited or credited. At the left side of your table, number the items to correspond to the following list. 1. NSF check from customer is returned on September 25 but not yet recorded by this company. 2. Interest earned on the September cash balance in the bank. 3. Deposit made on September 5 and processed by the bank on September 6. 4. Checks written by another depositor but charged against this company’s account. 5. Bank service charge for September. 6. Checks outstanding on August 31 that cleared the bank in September. 7. Check written against the company’s account and cleared by the bank; erroneously not recorded by

the company’s recordkeeper. 8. Principal and interest on a note receivable to this company is collected by the bank but not yet

recorded by the company. 9. Checks written and mailed to payees on October 2. 10. Checks written by the company and mailed to payees on September 30. 11. Night deposit made on September 30 after the bank closed. 12. Special bank charge for collection of note in part 8 on this company’s behalf.

Exercise 6-5 Petty cash fund accounting

P2

Palmona Co. establishes a $200 petty cash fund on January 1. On January 8, the fund shows $38 in cash along with receipts for the following expenditures: postage, $74; transportation-in, $29; delivery expenses, $16; and miscellaneous expenses, $43. Palmona uses the perpetual system in accounting for merchandise inventory. Prepare journal entries to (1) establish the fund on January 1, (2) reimburse it on January 8, and (3) both reimburse the fund and increase it to $450 on January 8, assuming no entry in part 2. (Hint: Make two separate entries for part 3.)

Check (3) Cr. Cash $162 (total)

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290 Chapter 6 Cash and Internal Controls

Exercise 6-10 Bank reconciliation

P3

Del Gato Clinic deposits all cash receipts on the day when they are received and it makes all cash payments by check. At the close of business on June 30, 2013, its Cash account shows a $11,589 debit balance. Del Gato Clinic’s June 30 bank statement shows $10,555 on deposit in the bank. Prepare a bank reconciliation for Del Gato Clinic using the following information: a. Outstanding checks as of June 30 total $1,829. b. The June 30 bank statement included a $16 debit memorandum for bank services. c. Check No. 919, listed with the canceled checks, was correctly drawn for $467 in payment of a utility

bill on June 15. Del Gato Clinic mistakenly recorded it with a debit to Utilities Expense and a credit to Cash in the amount of $476.

d. The June 30 cash receipts of $2,856 were placed in the bank’s night depository after banking hours and were not recorded on the June 30 bank statement.

Check Reconciled bal., $11,582

Exercise 6-11 Adjusting entries from bank reconciliation P3

Prepare the adjusting journal entries that Del Gato Clinic must record as a result of preparing the bank reconciliation in Exercise 6-10.

Exercise 6-12 Liquid assets and accounts receivable

A1

Bargains Co. reported annual net sales for 2012 and 2013 of $665,000 and $747,000, respectively. Its year- end balances of accounts receivable follow: December 31, 2012, $61,000; and December 31, 2013, $93,000. (a) Calculate its days’ sales uncollected at the end of each year. Round the number of days to one decimal. (b) Evaluate and comment on any changes in the amount of liquid assets tied up in receivables.

Exercise 6-13A

Documents in a voucher system

P4

Match each document in a voucher system in column one with its description in column two. Document Description 1. Purchase requisition 2. Purchase order 3. Invoice 4. Receiving report 5. Invoice approval 6. Voucher

A. An itemized statement of goods prepared by the vendor listing the customer’s name, items sold, sales prices, and terms of sale.

B. An internal file used to store documents and information to control cash disbursements and to ensure that a transaction is properly au thorized and recorded.

C. A document used to place an order with a vendor that authorizes the ven- dor to ship ordered merchandise at the stated price and terms.

D. A checklist of steps necessary for the approval of an invoice for record- ing and payment; also known as a check authorization.

E. A document used by department managers to inform the purchasing department to place an order with a vendor.

F. A document used to notify the appropriate persons that ordered goods have arrived, including a description of the quantities and condition of goods.

Exercise 6-8 Voucher system

P1

The voucher system of control is designed to control cash disbursements and the acceptance of obligations. 1. The voucher system of control establishes procedures for what two processes? 2. What types of expenditures should be overseen by a voucher system of control? 3. When is the voucher initially prepared? Explain.

Exercise 6-9 Bank reconciliation

P3

Wright Company deposits all cash receipts on the day when they are received and it makes all cash payments by check. At the close of business on May 31, 2013, its Cash account shows a $27,500 debit balance. The company’s May 31 bank statement shows $25,800 on deposit in the bank. Prepare a bank reconciliation for the company using the following information. a. The May 31 bank statement included a $100 debit memorandum for bank services; the company has

not yet recorded the cost of these services. b. Outstanding checks as of May 31 total $5,600. c. May 31 cash receipts of $6,200 were placed in the bank’s night depository after banking hours and

were not recorded on the May 31 bank statement. d. In reviewing the bank statement, a $400 check written by Smith Company was mistakenly drawn

against Wright’s account. e. A debit memorandum for $600 refers to a $600 NSF check from a customer; the company has not yet

recorded this NSF check. Check Reconciled bal., $26,800

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Chapter 6 Cash and Internal Controls 291

Exercise 6-14B

Record invoices at gross or net amounts

P5

Piere Imports uses the perpetual system in accounting for merchandise inventory and had the following transactions during the month of October. Prepare entries to record these transactions assuming that Piere Imports records invoices (a) at gross amounts and (b) at net amounts.

Oct. 2 Purchased merchandise at a $3,000 price, invoice dated October 2, terms 2y10, ny30. 10 Received a $500 credit memorandum (at full invoice price) for the return of merchandise that it

purchased on October 2. 17 Purchased merchandise at a $5,400 price, invoice dated October 17, terms 2y10, ny30. 27 Paid for the merchandise purchased on October 17, less the discount. 31 Paid for the merchandise purchased on October 2. Payment was delayed because the invoice

was mistakenly filed for payment today. This error caused the discount to be lost.

For each of these five separate cases, identify the principle(s) of internal control that is violated. Recommend what the business should do to ensure adherence to principles of internal control. 1. Chi Han records all incoming customer cash receipts for her employer and posts the customer pay-

ments to their respective accounts. 2. At Tico Company, Julia and Justine alternate lunch hours. Julia is the petty cash custodian, but if

someone needs petty cash when he is at lunch, Jose fills in as custodian. 3. Nori Nozumi posts all patient charges and payments at the Hopeville Medical Clinic. Each night Nori

backs up the computerized accounting system to a tape and stores the tape in a locked file at her desk. 4. Benedict Shales prides himself on hiring quality workers who require little supervision. As office

manager, Benedict gives his employees full discretion over their tasks and for years has seen no reason to perform independent reviews of their work.

5. Carla Farah’s manager has told her to reduce costs. Cala decides to raise the deductible on the plant’s property insurance from $5,000 to $10,000. This cuts the property insurance premium in half. In a related move, she decides that bonding the plant’s employees is a waste of money since the company has not experienced any losses due to employee theft. Cala saves the entire amount of the bonding insurance premium by dropping the bonding insurance.

PROBLEM SET A

Problem 6-1A Analyzing internal control

C1

Problem 6-2A Establish, reimburse, and increase petty cash

P2

Nakashima Gallery had the following petty cash transactions in February of the current year.

Feb. 2 Wrote a $400 check, cashed it, and gave the proceeds and the petty cashbox to Chloe Addison, the petty cashier.

5 Purchased bond paper for the copier for $14.15 that is immediately used. 9 Paid $32.50 COD shipping charges on merchandise purchased for resale, terms FOB shipping

point. Nakashima uses the perpetual system to account for merchandise inventory. 12 Paid $7.95 postage to express mail a contract to a client. 14 Reimbursed Adina Sharon, the manager, $68 for business mileage on her car. 20 Purchased stationery for $67.77 that is immediately used. 23 Paid a courier $20 to deliver merchandise sold to a customer, terms FOB destination. 25 Paid $13.10 COD shipping charges on merchandise purchased for resale, terms FOB shipping

point. 27 Paid $54 for postage expenses. 28 The fund had $120.42 remaining in the petty cash box. Sorted the petty cash receipts by ac-

counts affected and exchanged them for a check to reimburse the fund for expenditures. 28 The petty cash fund amount is increased by $100 to a total of $500.

Required

1. Prepare the journal entry to establish the petty cash fund. 2. Prepare a petty cash payments report for February with these categories: delivery expense, mileage ex-

pense, postage expense, merchandise inventory (for transportation-in), and office supplies expense. Sort the payments into the appropriate categories and total the expenditures in each category.

3. Prepare the journal entries (in dollars and cents) for part 2 to both (a) reimburse and (b) increase the fund amount.

Check (3a & 3b) Total Cr. to Cash $379.58

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292 Chapter 6 Cash and Internal Controls

Problem 6-3A Establish, reimburse, and adjust petty cash

P2

Kiona Co. set up a petty cash fund for payments of small amounts. The following transactions involving the petty cash fund occurred in May (the last month of the company’s fiscal year).

May 1 Prepared a company check for $300 to establish the petty cash fund. 15 Prepared a company check to replenish the fund for the following expenditures made since May 1. a. Paid $88 for janitorial services. b. Paid $53.68 for miscellaneous expenses. c. Paid postage expenses of $53.50. d. Paid $47.15 to The County Gazette (the local newspaper) for an advertisement. e. Counted $62.15 remaining in the petty cash box. 16 Prepared a company check for $200 to increase the fund to $500. 31 The petty cashier reports that $288.20 cash remains in the fund. A company check is drawn to

replenish the fund for the following expenditures made since May 15. f. Paid postage expenses of $147.36. g. Reimbursed the office manager for business mileage, $23.50. h. Paid $34.75 to deliver merchandise to a customer, terms FOB destination. 31 The company decides that the May 16 increase in the fund was too large. It reduces the fund by

$100, leaving a total of $400.

Required

1. Prepare journal entries (in dollars and cents) to establish the fund on May 1, to replenish it on May 15 and on May 31, and to reflect any increase or decrease in the fund balance on May 16 and May 31.

Analysis Component

2. Explain how the company’s financial statements are affected if the petty cash fund is not replenished and no entry is made on May 31.

Problem 6-4A Prepare a bank reconciliation and record adjustments

P3

The following information is available to reconcile Branch Company’s book balance of cash with its bank statement cash balance as of July 31, 2013. a. On July 31, the company’s Cash account has a $27,497 debit balance, but its July bank statement

shows a $27,233 cash balance. b. Check No. 3031 for $1,482 and Check No. 3040 for $558 were outstanding on the June 30 bank rec-

onciliation. Check No. 3040 is listed with the July canceled checks, but Check No. 3031 is not. Also, Check No. 3065 for $382 and Check No. 3069 for $2,281, both written in July, are not among the canceled checks on the July 31 statement.

c. In comparing the canceled checks on the bank statement with the entries in the accounting records, it is found that Check No. 3056 for July rent was correctly written and drawn for $1,270 but was errone- ously entered in the accounting records as $1,250.

d. A credit memorandum enclosed with the July bank statement indicates the bank collected $8,000 cash on a non-interest-bearing note for Branch, deducted a $45 collection fee, and credited the remainder to its account. Branch had not recorded this event before receiving the statement.

e. A debit memorandum for $805 lists a $795 NSF check plus a $10 NSF charge. The check had been received from a customer, Evan Shaw. Branch has not yet recorded this check as NSF.

f. Enclosed with the July statement is a $25 debit memorandum for bank services. It has not yet been recorded because no previous notification had been received.

g. Branch’s July 31 daily cash receipts of $11,514 were placed in the bank’s night depository on that date, but do not appear on the July 31 bank statement.

Required

1. Prepare the bank reconciliation for this company as of July 31, 2013. 2. Prepare the journal entries necessary to bring the company’s book balance of cash into conformity

with the reconciled cash balance as of July 31, 2013.

Analysis Component

3. Assume that the July 31, 2013, bank reconciliation for this company is prepared and some items are treated incorrectly. For each of the following errors, explain the effect of the error on (i) the adjusted bank statement cash balance and (ii) the adjusted cash account book balance.

a. The company’s unadjusted cash account balance of $27,497 is listed on the reconciliation as $27,947. b. The bank’s collection of the $8,000 note less the $45 collection fee is added to the bank statement

cash balance on the reconciliation.

Check (1) Reconciled balance, $34,602; (2) Cr. Note Receivable $8,000

Check (1) Cr. to Cash: May 15, $237.85; May 16, $200.00

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Chapter 6 Cash and Internal Controls 293

Problem 6-5A Prepare a bank reconciliation and record adjustments

P3

Chavez Company most recently reconciled its bank statement and book balances of cash on August 31 and it reported two checks outstanding, No. 5888 for $1,028.05 and No. 5893 for $494.25. The following information is available for its September 30, 2013, reconciliation.

From the September 30 Bank Statement

16,800.45

Date 09/03

9,620.05 11,272.85 18,453.25

09/04 09/07

09/20 09/17

09/22 09/22 09/28 09/29

PREVIOUS BALANCE TOTAL CHECKS AND DEBITS TOTAL DEPOSITS AND CREDITS CURRENT BALANCE

CHECKS AND DEBITS DEPOSITS AND CREDITS DAILY BALANCE

08/31 16,800.4509/055888 1,028.05 1,103.75 No. Amount Date Amount Date Amount

09/03 15,772.4009/125902 719.90 2,226.90 09/04 15,052.5009/215901 1,824.25 4,093.00

09/07 14,332.0009/305905 937.00 12.50 IN 09/05 16,156.2509/25 2,351.70

09/12 16,558.9009/305903 399.10 1,485.00 CM 09/17 15,958.655904

5907 5909

2,090.00 09/20 15,021.65

19,114.65 09/22

18,977.2509/25 16,625.55

09/28 18,763.40 09/29 16,955.75 09/30 18,453.25

213.85 09/211,807.65

600.25 NSF

From Chavez Company’s Accounting Records

Cash Acct. No. 101

Date Explanation PR Debit Credit Balance

Aug. 31 Balance 15,278.15

Sept. 30 Total receipts R12 11,458.10 26,736.25

30 Total disbursements D23 9,332.05 17,404.20

Cash Receipts Deposited

Cash

Date Debit

Sept. 5 1,103.75

12 2,226.90

21 4,093.00

25 2,351.70

30 1,682.75

11,458.10

Cash Disbursements

Check Cash

No. Credit

5901 1,824.25

5902 719.90

5903 399.10

5904 2,060.00

5905 937.00

5906 982.30

5907 213.85

5908 388.00

5909 1,807.65

9,332.05

Additional Information

Check No. 5904 is correctly drawn for $2,090 to pay for computer equipment; however, the recordkeeper misread the amount and entered it in the accounting records with a debit to Computer Equipment and a credit to Cash of $2,060. The NSF check shown in the statement was originally received from a customer, S. Nilson, in payment of her account. Its return has not yet been recorded by the company. The credit

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294 Chapter 6 Cash and Internal Controls

Check (1) Reconciled balance, $18,271.45 (2) Cr. Note Receivable $1,500.00

PROBLEM SET B

Problem 6-1B Analyzing internal control

C1

For each of these five separate cases, identify the principle(s) of internal control that is violated. Recommend what the business should do to ensure adherence to principles of internal control. 1. Latisha Tally is the company’s computer specialist and oversees its computerized payroll system. Her

boss recently asked her to put password protection on all office computers. Latisha has put a password in place that allows only the boss access to the file where pay rates are changed and personnel are added or deleted from the payroll.

2. Marker Theater has a computerized order-taking system for its tickets. The system is active all week and backed up every Friday night.

3. Sutton Company has two employees handling acquisitions of inventory. One employee places pur- chase orders and pays vendors. The second employee receives the merchandise.

4. The owner of Super Pharmacy uses a check protector to perforate checks, making it difficult for any- one to alter the amount of the check. The check protector is on the owner’s desk in an office that con- tains company checks and is normally unlocked.

5. Lavina Company is a small business that has separated the duties of cash receipts and cash disbursements. The employee responsible for cash disbursements reconciles the bank account monthly.

memorandum is from the collection of a $1,500 note for Chavez Company by the bank. The bank deducted a $15 collection fee. The collection and fee are not yet recorded.

Required

1. Prepare the September 30, 2013, bank reconciliation for this company. 2. Prepare the journal entries (in dollars and cents) to adjust the book balance of cash to the reconciled

balance.

Analysis Component

3. The bank statement reveals that some of the prenumbered checks in the sequence are missing. Describe three situations that could explain this.

Problem 6-2B Establish, reimburse, and increase petty cash

P2

Blues Music Center had the following petty cash transactions in March of the current year.

March 5 Wrote a $250 check, cashed it, and gave the proceeds and the petty cashbox to Jen Rouse, the petty cashier.

6 Paid $12.50 COD shipping charges on merchandise purchased for resale, terms FOB shipping point. Blues uses the perpetual system to account for merchandise inventory.

11 Paid $10.75 delivery charges on merchandise sold to a customer, terms FOB destination. 12 Purchased file folders for $14.13 that are immediately used. 14 Reimbursed Bob Geldof, the manager, $11.65 for office supplies purchased and used. 18 Purchased printer paper for $20.54 that is immediately used. 27 Paid $45.10 COD shipping charges on merchandise purchased for resale, terms FOB shipping

point. 28 Paid postage expenses of $18. 30 Reimbursed Geldof $56.80 for business car mileage. 31 Cash of $61.53 remained in the fund. Sorted the petty cash receipts by accounts affected and

exchanged them for a check to reimburse the fund for expenditures. 31 The petty cash fund amount is increased by $50 to a total of $300.

Required

1. Prepare the journal entry to establish the petty cash fund. 2. Prepare a petty cash payments report for March with these categories: delivery expense, mileage ex-

pense, postage expense, merchandise inventory (for transportation-in), and office supplies expense. Sort the payments into the appropriate categories and total the expenses in each category.

3. Prepare the journal entries (in dollars and cents) for part 2 to both (a) reimburse and (b) increase the fund amount.

Check (2) Total expenses $189.47

(3a & 3b) Total Cr. to Cash $238.47

Problem 6-3B Establishing, reimbursing, and adjusting petty cash

P2

Moya Co. establishes a petty cash fund for payments of small amounts. The following transactions involv- ing the petty cash fund occurred in January (the last month of the company’s fiscal year).

Jan. 3 A company check for $150 is written and made payable to the petty cashier to establish the petty cash fund.

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Chapter 6 Cash and Internal Controls 295

14 A company check is written to replenish the fund for the following expenditures made since January 3.

a. Purchased office supplies for $14.29 that are immediately used up. b. Paid $19.60 COD shipping charges on merchandise purchased for resale, terms FOB ship-

ping point. Moya uses the perpetual system to account for inventory. c. Paid $38.57 to All-Tech for minor repairs to a computer. d. Paid $12.82 for items classified as miscellaneous expenses. e. Counted $62.28 remaining in the petty cash box. 15 Prepared a company check for $50 to increase the fund to $200. 31 The petty cashier reports that $17.35 remains in the fund. A company check is written to replen-

ish the fund for the following expenditures made since January 14. f. Paid $50 to The Smart Shopper for an advertisement in January’s newsletter. g. Paid $48.19 for postage expenses. h. Paid $78 to Smooth Delivery for delivery of merchandise, terms FOB destination. 31 The company decides that the January 15 increase in the fund was too little. It increases the fund

by another $50, leaving a total of $250.

Required

1. Prepare journal entries (in dollars and cents) to establish the fund on January 3, to replenish it on January 14 and January 31, and to reflect any increase or decrease in the fund balance on January 15 and 31.

Analysis Component

2. Explain how the company’s financial statements are affected if the petty cash fund is not replenished and no entry is made on January 31.

The following information is available to reconcile Severino Co.’s book balance of cash with its bank statement cash balance as of December 31, 2013. a. The December 31 cash balance according to the accounting records is $32,878.30, and the bank state-

ment cash balance for that date is $46,822.40. b. Check No. 1273 for $4,589.30 and Check No. 1282 for $400, both written and entered in the account-

ing records in December, are not among the canceled checks. Two checks, No. 1231 for $2,289 and No. 1242 for $410.40, were outstanding on the most recent November 30 reconciliation. Check No. 1231 is listed with the December canceled checks, but Check No. 1242 is not.

c. When the December checks are compared with entries in the accounting records, it is found that Check No. 1267 had been correctly drawn for $3,456 to pay for office supplies but was erroneously entered in the accounting records as $3,465.

d. Two debit memoranda are enclosed with the statement and are unrecorded at the time of the reconcili- ation. One debit memorandum is for $762.50 and dealt with an NSF check for $745 received from a customer, Titus Industries, in payment of its account. The bank assessed a $17.50 fee for processing it. The second debit memorandum is a $99 charge for check printing. Severino did not record these transactions before receiving the statement.

e. A credit memorandum indicates that the bank collected $19,000 cash on a note receivable for the company, deducted a $20 collection fee, and credited the balance to the company’s Cash account. Severino did not record this transaction before receiving the statement.

f. Severino’s December 31 daily cash receipts of $9,583.10 were placed in the bank’s night depository on that date, but do not appear on the December 31 bank statement.

Required

1. Prepare the bank reconciliation for this company as of December 31, 2013. 2. Prepare the journal entries (in dollars and cents) necessary to bring the company’s book balance of

cash into conformity with the reconciled cash balance as of December 31, 2013.

Analysis Component

3. Explain the nature of the communications conveyed by a bank when the bank sends the depositor (a) a debit memorandum and (b) a credit memorandum.

Check (1) Reconciled balance, $51,005.80; (2) Cr. Note Receivable $19,000.00

Problem 6-4B Prepare a bank reconciliation and record adjustments

P3

Check (1) Cr. to Cash: Jan. 14, $87.72; Jan. 31 (total), $232.65

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296 Chapter 6 Cash and Internal Controls

Problem 6-5B Prepare a bank reconciliation and record adjustments

P3

Shamara Systems most recently reconciled its bank balance on April 30 and reported two checks outstand- ing at that time, No. 1771 for $781 and No. 1780 for $1,425.90. The following information is available for its May 31, 2013, reconciliation.

From the May 31 Bank Statement

PREVIOUS BALANCE TOTAL CHECKS AND DEBITS TOTAL DEPOSITS AND CREDITS CURRENT BALANCE

CHECKS AND DEBITS DEPOSITS AND CREDITS DAILY BALANCE

18,290.70

Date 05/01 04/3005/041771

No. Amount Date Amount Date Amount

13,094.80 16,566.80 21,762.70

05/02 05/0105/141783 05/04 05/0205/221782

1784 05/18 05/1105/26 05/11 05/0405/25

05/25 05/141787 05/26 05/181785

178805/29 05/31

05/22

05/26 05/29 05/31

05/25

2,438.00 2,898.00 1,801.80

2,079.00 7,350.00 CM

18,290.70 17,509.70 17,127.20

16,830.10 18,279.70

19,728.10 19,296.30 21,098.10 20,415.60

21,776.70 22,430.70

21,762.70

781.00 382.50

1,285.50

431.80 NSF 8,032.50

63.90 654.00

14.00 SC

1,449.60

From Shamara Systems’ Accounting Records

Cash Receipts Deposited

Cash

Date Debit

May 4 2,438.00

14 2,898.00

22 1,801.80

26 2,079.00

31 2,727.30

11,944.10

Cash Disbursements

Check Cash

No. Credit

1782 1,285.50

1783 382.50

1784 1,449.60

1785 63.90

1786 353.10

1787 8,032.50

1788 644.00

1789 639.50

12,850.60

Cash Acct. No. 101

Date Explanation PR Debit Credit Balance

Apr. 30 Balance 16,083.80

May 31 Total receipts R7 11,944.10 28,027.90

31 Total disbursements D8 12,850.60 15,177.30

Additional Information

Check No. 1788 is correctly drawn for $654 to pay for May utilities; however, the recordkeeper misread the amount and entered it in the accounting records with a debit to Utilities Expense and a credit to Cash for $644. The bank paid and deducted the correct amount. The NSF check shown in the statement was originally received from a customer, W. Sox, in payment of her account. The company has not yet re- corded its return. The credit memorandum is from a $7,400 note that the bank collected for the company.

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Chapter 6 Cash and Internal Controls 297

The bank deducted a $50 collection fee and deposited the remainder in the company’s account. The col- lection and fee have not yet been recorded.

Required

1. Prepare the May 31, 2013, bank reconciliation for Shamara Systems. 2. Prepare the journal entries (in dollars and cents) to adjust the book balance of cash to the reconciled

balance.

Analysis Component

3. The bank statement reveals that some of the prenumbered checks in the sequence are missing. Describe three possible situations to explain this.

Check (1) Reconciled balance, $22,071.50; (2) Cr. Note Receivable $7,400.00

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 6 Adria Lopez receives the March bank statement for Success Systems on April 11, 2014. The March 31 bank statement shows an ending cash balance of $77,354. A comparison of the bank statement with the general ledger Cash account, No. 101, reveals the following. a. A. Lopez notices that the bank erroneously cleared a $500 check against her account in March that

she did not issue. The check documentation included with the bank statement shows that this check was actually issued by a company named Sierra Systems.

b. On March 25, the bank issued a $50 debit memorandum for the safety deposit box that Success Systems agreed to rent from the bank beginning March 25.

c. On March 26, the bank issued a $102 debit memorandum for printed checks that Success Systems ordered from the bank.

d. On March 31, the bank issued a credit memorandum for $33 interest earned on Success Systems’ checking account for the month of March.

e. A. Lopez notices that the check she issued for $128 on March 31, 2014, has not yet cleared the bank. f. A. Lopez verifies that all deposits made in March do appear on the March bank statement. g. The general ledger Cash account, No. 101, shows an ending cash balance per books of $77,845 as of

March 31 (prior to any reconciliation).

Required

1. Prepare a bank reconciliation for Success Systems for the month ended March 31, 2014. 2. Prepare any necessary adjusting entries. Use Miscellaneous Expenses, No. 677, for any bank charges.

Use Interest Revenue, No. 404, for any interest earned on the checking account for the month of March.

SERIAL PROBLEM Success Systems

P3

Check (1) Adj. bank bal. $77,726

Beyond the Numbers

BTN 6-1 Refer to Polaris’ financial statements in Appendix A to answer the following.

1. For both years ended December 31, 2011 and 2010, identify the total amount of cash and cash equiva- lents. Determine the percent (rounded to one decimal) that this amount represents of total current assets, total current liabilities, total shareholders’ equity, and total assets for both years. Comment on any trends.

2. For years ended December 31, 2011 and 2010, use the information in the statement of cash flows to determine the percent change (rounded to one decimal) between the beginning and ending year amounts of cash and cash equivalents.

3. Compute the days’ sales uncollected (rounded to two decimals) as of December 31, 2011 and 2010. Has the collection of receivables improved? Are accounts receivable an important asset for Polaris? Explain.

Fast Forward

4. Access Polaris’ financial statements for fiscal years ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Recompute its days’ sales uncollected for years ending after December 31, 2011. Compare this to the days’ sales uncollected for 2011 and 2010.

REPORTING IN ACTION C2 A1

Polaris

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298 Chapter 6 Cash and Internal Controls

BTN 6-2 Key comparative figures for Polaris and Arctic Cat follow.COMPARATIVE ANALYSIS A1 Polaris Arctic Cat

Current Prior Current Prior

($ thousands) Year Year Year Year

Accounts receivable . . . . . . . . $ 115,302 $ 89,294 $ 23,732 $ 29,227

Net sales . . . . . . . . . . . . . . . . . 2,656,949 1,991,139 363,015 350,871

Required

Compute days’ sales uncollected (rounded to two decimals) for these companies for each of the two years shown. Comment on any trends for the companies. Which company has the largest percent change (rounded to two decimals) in days’ sales uncollected?

BTN 6-3 Harriet Knox, Ralph Patton, and Marcia Diamond work for a family physician, Dr. Gwen Conrad, who is in private practice. Dr. Conrad is knowledgeable about office management practices and has segregated the cash receipt duties as follows. Knox opens the mail and prepares a triplicate list of money received. She sends one copy of the list to Patton, the cashier, who deposits the receipts daily in the bank. Diamond, the rec- ordkeeper, receives a copy of the list and posts payments to patients’ accounts. About once a month the office clerks have an expensive lunch they pay for as follows. First, Patton endorses a patient’s check in Dr. Conrad’s name and cashes it at the bank. Knox then destroys the remittance advice accompanying the check. Finally, Diamond posts payment to the customer’s account as a miscellaneous credit. The three justify their actions by their relatively low pay and knowledge that Dr. Conrad will likely never miss the money.

Required

1. Who is the best person in Dr. Conrad’s office to reconcile the bank statement? 2. Would a bank reconciliation uncover this office fraud? 3. What are some procedures to detect this type of fraud? 4. Suggest additional internal controls that Dr. Conrad could implement.

ETHICS CHALLENGE C1

BTN 6-4B Assume you are a business consultant. The owner of a company sends you an e-mail expressing concern that the company is not taking advantage of its discounts offered by vendors. The company currently uses the gross method of recording purchases. The owner is considering a review of all invoices and payments from the previous period. Due to the volume of purchases, however, the owner recognizes that this is time-consuming and costly. The owner seeks your advice about monitoring pur- chase discounts in the future. Provide a response in memorandum form.

COMMUNICATING IN PRACTICE P5

BTN 6-5 Visit the Association of Certified Fraud Examiners Website at acfe.com. Find and open the file “2010 Report to the Nation.” Read the two-page Executive Summary and fill in the following blanks. (The report is under its Fraud Resources tab or under its About the ACFE tab [under Press Room]; we can also use the Search tab.) 1. The median loss caused by occupational frauds was $________. 2. Nearly ___________ of fraud cases involved losses of at least $1 million in losses. 3. Companies lose ___% of their annual revenues to fraud; this figure translates to a potential total fraud

loss of more than $______ trillion. 4. The typical length of fraud schemes was _____ months from the time the fraud began until it was

detected. 5. Less than ___% of victim organizations conducted surprise audits, however these organizations have

lower fraud losses and detect fraud more quickly than those without surprise audits. 6. Asset misappropriation schemes were most common at ___% of cases with a median loss of $______. 7. Financial statement fraud schemes made up less than ___% of cases with a median loss of more than

$______ million. 8. Corruption schemes comprised ___% of cases with a median loss of $______. 9. Less than ___% of the perpetrators had convictions prior to committing their frauds.

TAKING IT TO THE NET C1 P1

Polaris Arctic Cat

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Chapter 6 Cash and Internal Controls 299

BTN 6-6 Organize the class into teams. Each team must prepare a list of 10 internal controls a consumer could observe in a typical retail department store. When called upon, the team’s spokesperson must be pre- pared to share controls identified by the team that have not been shared by another team’s spokesperson.

TEAMWORK IN ACTION C1

BTN 6-9 The following information is from Piaggio (www.Piaggio.com), which manufactures two-, three- and four-wheel vehicles, and is Europe’s leading manufacturer of motorcycles and scooters.

GLOBAL DECISION C2 A1

Euro in thousands Current Year Prior Year

Cash . . . . . . . . . . . . . . . . . . . . . 151,887 154,859

Accounts receivable . . . . . . . . . 65,560 90,421

Current assets . . . . . . . . . . . . . 509,708 575,897

Total assets . . . . . . . . . . . . . . . . 1,520,184 1,545,722

Current liabilities . . . . . . . . . . . 644,277 616,166

Shareholders’ equity . . . . . . . . . 446,218 442,890

Net sales . . . . . . . . . . . . . . . . . . 1,516,463 1,485,351

Required

1. For each year, compute the percentage (rounded to one decimal) that cash represents of current assets, total assets, current liabilities, and shareholders’ equity. Comment on any trends in these percentages.

2. Determine the percentage change (rounded to one decimal) between the current and prior year cash balances.

3. Compute the days’ sales uncollected (rounded to one decimal) at the end of both the current year and the prior year. Has the collection of receivables improved? Explain.

BTN 6-7 Review the opening feature of this chapter that highlights Michael Inwald and his company CHEESEBOY.

Required

1. List the seven principles of internal control and explain how Michael could implement each of them in his stores.

2. Do you believe that Michael will need to add controls as his business expands? Explain.

ENTREPRENEURIAL DECISION C1 P1

BTN 6-8 Visit an area of your college that serves the student community with either products or ser- vices. Some examples are food services, libraries, and bookstores. Identify and describe between four and eight internal controls being implemented.

HITTING THE ROAD C1

1. e; The entry follows. 4. d; ($6,720y$84,000) 3 365 5 29.2 days 5. b; The entry follows.

2. a; recognizes cash collection of note by bank. 3. a; the bank reconciliation follows.

ANSWERS TO MULTIPLE CHOICE QUIZ

Debits to expenses (or assets) . . . . . . . . . 420

Cash Over and Short . . . . . . . . . . . . . . . . 5

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 425

Bank Reconciliation

November 30

Balance per bank statement . . . . . . $1,895

Add: Deposit in transit . . . . . . . . . . 795

Deduct: Outstanding checks . . . . . . (638)

Reconciled balance . . . . . . . . . . . . . $2,052

Balance per books . . . . . . . . . . . . . . $1,742

Add: Note collected less fee . . . . . . 320

Deduct: Service charge . . . . . . . . . . (10)

Reconciled balance . . . . . . . . . . . . . $2,052

Merchandise Inventory* . . . . . . . . 5,880

Accounts Payable . . . . . . . . . . 5,880

*$6,000 3 98%

PIAGGIO

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Learning Objectives

CONCEPTUAL

C1 Describe accounts receivable and how they occur and are recorded. (p. 302) C2 Describe a note receivable, the computation of its maturity date, and the

recording of its existence. (p. 312)

C3 Explain how receivables can be converted to cash before maturity. (p. 315)

ANALYTICAL

A1 Compute accounts receivable turnover and use it to help assess financial condition. (p. 317)

PROCEDURAL

P1 Apply the direct write-off method to account for accounts receivable. (p. 306) P2 Apply the allowance method and esti mate uncollectibles based on sales and

accounts receivable. (p. 308)

P3 Record the honoring and dishonoring of a note and adjustments for interest. (p. 314)

A Look at This Chapter

This chapter emphasizes receivables. We explain that they are liquid assets and describe how companies account for and report them. We also discuss the importance of estimating uncollectibles.

A Look Back

Chapter 6 focused on internal control and reporting for cash. We described internal control procedures and the accounting for and management of cash.

Accounts and Notes Receivable 7

A Look Ahead

Chapter 8 focuses on plant assets, natural resources, and intangible assets. We explain how to account for, report, and analyze these long-term assets.

300

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Sweat Equity

BALTIMORE, MD—“There was a void in apparel and I decided to fill it,” says Kevin Plank, the founder of Under Armour (UnderArmour.com), which is a manufacturer of athletic ap- parel. Kevin invested his life savings of $20,000 and began by working out of his grandma’s basement. As sales grew, Kevin partnered with a factory in Ohio and hit it off with the factory manager, Sal Fasciana. Sal spent many evenings and weekends teaching Kevin about accounting and cost controls. “I said, ‘OK, kid. This is the way it’s going to be done,’ ” recalls Sal. That attention to details carried over to where Kevin learned to monitor receivables. Decisions on credit sales and policies for extending credit can make or break a start-up. Kevin applied well what Sal taught him. He ensured that credit sales were extended to customers in good credit standing. Kevin knows his clients, including who pays and when. Says Kevin, we understand our customers—inside and out—including cash payment patterns that allow us to estimate uncollectibles and minimize bad debts. His financial report says, “We make on- going estimates relating to the collectibility of our accounts re- ceivable and maintain a reserve for estimated losses resulting from the inability of our customers to make required payments.”

A commitment to quality customers is propelling Under Armour’s sales and shattering Kevin’s most optimistic goals. “It’s about educating consumers . . . investing in the product.” Kevin has also issued notes receivable to select employees. Both accounts and notes receivables receive his attention. His financial report states that they “review the allowance for doubt- ful accounts monthly.” “When I first started . . . I was a young punk who thought he knew everything,” explains Kevin. While he admits that insight and ingenuity are vital, he knows accounting reports must show profits for long-term success. “Most people out there are saying we’re going to trip up at some point,” says Kevin. “Our job is to prove them wrong.” His evolving fabrics continue to lead the in- dustry in removing perspiration. He also gives us a new per- spective on Thomas Edison’s assertion that: genius is 99 percent perspiration and 1 percent inspiration.

[Sources: Under Armour Website, January 2013; Under Armour 10-K Report, Filed February 2012; FastCompany, 2005; USA Today, December 2004; Inc.com, 2003 and 2004; Entrepreneur’s Journey, November 2007; Fortune, October 2011; Forbes, December 2011]

“Create what the industry is missing.” —KEVIN PLANK (CENTER)

Decision Insight

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Chapter Preview

This chapter focuses on accounts receivable and short-term notes receivable. We describe each of these assets, their uses, and how they are accounted for and reported in financial state- ments. This knowledge helps us use accounting information to

make better business decisions. It can also help in predicting future company performance and financial condition as well as in managing one’s own business.

A receivable is an amount due from another party. The two most common receivables are accounts receivable and notes receivable. Other receivables include interest receivable, rent receivable, tax refund receivable, and receivables from employees. Accounts receivable are amounts due from customers for credit sales. This section begins by describing how accounts receivable occur. It includes receivables that occur when customers use credit cards issued by third parties and when a company gives credit directly to customers. When a company does extend credit directly to customers, it (1) maintains a separate account receivable for each cus- tomer and (2) accounts for bad debts from credit sales.

Recognizing Accounts Receivable Accounts receivable occur from credit sales to customers. The amount of credit sales has in- creased in recent years, reflecting several factors including an efficient financial system. Retail- ers such as Costco and Best Buy hold millions of dollars in accounts receivable. Similar amounts are held by wholesalers such as SUPERVALU and SYSCO. Exhibit 7.1 shows recent dollar amounts of receivables and their percent of total assets for four well-known companies.

C1 Describe accounts receivable and how they occur and are recorded.

ACCOUNTS RECEIVABLE

EXHIBIT 7.1 Accounts Receivable for Selected Companies

Percent of total assets

0 5 10 15 20 25 30 35 40 45 50 55 60

John Deere 57%

$89 Mil. Abercrombie

& Fitch

Pfizer 7.2%

2.9%

Callaway Golf 16%

$27,502 Mil.

$116 Mil.

$13,608 Mil.

Sales on Credit Credit sales are recorded by increasing (debiting) Accounts Receivable. A company must also maintain a separate account for each customer that tracks how much that cus- tomer purchases, has already paid, and still owes. This information provides the basis for sending bills to customers and for other business analyses. To maintain this information, companies that extend credit directly to their customers keep a separate account receivable for each one of them.

302

Notes Receivable

• Computing maturity and interest

• Recognizing notes receivable

• Valuing and settling notes

Accounts Receivable

• Recognizing accounts receivable

• Valuing accounts receivable

• Estimating bad debts

Disposal of Receivables

• Selling receivables • Pledging receivables

Accounts and Notes Receivable

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Chapter 7 Accounts and Notes Receivable 303

The general ledger continues to have a single Accounts Receivable account (called a control account) along with the other financial statement accounts, but a supplementary record is created to maintain a separate account for each customer. This supplementary record is called the accounts receivable ledger (or accounts receivable subsidiary ledger). Exhibit 7.2 shows the relation between the Accounts Receivable account in the general ledger and its individual customer accounts in the accounts receivable ledger for TechCom, a small electronics wholesaler. This exhibit reports a $3,000 ending balance of TechCom’s accounts receivable for June 30. TechCom’s transactions are mainly in cash, but it has two major credit customers: CompStore and RDA Electronics. Its schedule of accounts receiv- able shows that the $3,000 balance of the Accounts Receivable account in the general ledger equals the total of its two customers’ balances in the accounts receivable ledger.

EXHIBIT 7.2 General Ledger and the Accounts Receivable Ledger (before July 1 transactions)

General Ledger

Date

June 30

Debit

3,0003,0003,000

PR Accounts Receivable

Accounts Receivable Ledger

Date

June 30

Debit Balance

1,0001,0001,000

PR RDA Electronics

Date

June 30

Debit Credit Balance

2,0002,0002,000

PR CompStore

RDA Electronics………… $1,000 CompStore……………… 2,000

Total……………………… $3,000

TechCom Schedule of Accounts Receivable

Credit Balance Credit

To see how accounts receivable from credit sales are recognized in the accounting records, we look at two transactions on July 1 between TechCom and its credit customers — see Ex- hibit 7.3. The first is a credit sale of $950 to CompStore. A credit sale is posted with both a debit to the Accounts Receivable account in the general ledger and a debit to the customer ac- count in the accounts receivable ledger. The second transaction is a collection of $720 from RDA Electronics from a prior credit sale. Cash receipts from a credit customer are posted with a credit to the Accounts Receivable account in the general ledger and flow through to credit the customer account in the accounts receivable ledger. (Posting debits or credits to Accounts Receivable in two separate ledgers does not violate the requirement that debits equal credits. The equality of debits and credits is maintained in the general ledger. The accounts receivable ledger is a supplementary record providing information on each customer.)

EXHIBIT 7.3 Accounts Receivable Transactions

Assets 5 Liabilities 1 Equity 1 950 1950

Assets 5 Liabilities 1 Equity 1720 2720

July 1 Accounts Receivable — CompStore . . . . . . . . . . . . . . . . 950

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

To record credit sales*

July 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720

Accounts Receivable — RDA Electronics . . . . . . . . 720

To record collection of credit sales.

* We omit the entry to Dr. Cost of Sales and Cr. Merchandise Inventory to focus on sales and receivables.

Exhibit 7.4 shows the general ledger and the accounts receivable ledger after recording the two July 1 transactions. The general ledger shows the effects of the sale, the collection, and the resulting balance of $3,230. These events are also reflected in the individual customer accounts:

General Ledger

Date

June 30 July 1 July 1

Debit Credit Balance

3,000 3,950 3,230

3,000 3,950 3,230

3,000 950

720

RDA Electronics………… $ 280 CompStore……………… 2,950

Total……………………… $3,230

PR Accounts Receivable

Accounts Receivable Ledger

Date

June 30 July 1

Debit Credit Balance

1,0001,0001,000 720 280

PR RDA Electronics

Date

June 30 July 1

Debit Credit Balance

2,0002,000 2,9502,950

2,000 950

PR CompStore

TechCom Schedule of Accounts Receivable

EXHIBIT 7.4 General Ledger and the Accounts Receivable Ledger (after July 1 transactions)

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304 Chapter 7 Accounts and Notes Receivable

RDA Electronics has an ending balance of $280, and CompStore’s ending balance is $2,950. The $3,230 sum of the individual accounts equals the debit balance of the Accounts Receivable ac- count in the general ledger. Like TechCom, many large retailers such as Target and JCPenney sell on credit. Many also maintain their own credit cards to grant credit to approved customers and to earn interest on any balance not paid within a specified period of time. This allows them to avoid the fee charged by credit card companies. The entries in this case are the same as those for TechCom except for the possibility of added interest revenue. If a customer owes interest on a bill, we debit Interest Re- ceivable and credit Interest Revenue for that amount. (Many retailers require clerks to ask cus- tomers during checkout if they wish to apply for a store credit card—sweeteners are often used such as: save 10% off today’s purchases if you apply now.)

Credit Card Sales Many companies allow their customers to pay for products and ser- vices using third-party credit cards such as Visa, MasterCard, or American Express, and debit cards (also called ATM or bank cards). This practice gives customers the ability to make purchases without cash or checks. Once credit is established with a credit card company or bank, the customer does not have to open an account with each store. Customers using these cards can make single monthly payments instead of several payments to different creditors and can defer their payments. Many sellers allow customers to use third-party credit cards and debit cards instead of grant- ing credit directly for several reasons. First, the seller does not have to evaluate each customer’s credit standing or make decisions about who gets credit and how much. Second, the seller avoids the risk of extending credit to customers who cannot or do not pay. This risk is trans- ferred to the card company. Third, the seller typically receives cash from the card company sooner than had it granted credit directly to customers. Fourth, a variety of credit options for customers offers a potential increase in sales volume. Sears historically offered credit only to customers using a Sears card but later changed its policy to permit customers to charge pur- chases to third-party credit card companies in a desire to increase sales. It reported: “SearsCharge increased its share of Sears retail sales even as the company expanded the payment options available to its customers with the acceptance . . . of Visa, MasterCard, and American Express in addition to the [Sears] Card.” There are guidelines in how companies account for credit card and debit card sales. Some credit cards, but nearly all debit cards, credit a seller’s Cash account immediately upon de- posit. In this case the seller deposits a copy of each card sales receipt in its bank account just as it deposits a customer’s check. The majority of credit cards, however, require the seller to remit a copy (often electronically) of each receipt to the card company. Until payment is re- ceived, the seller has an account receivable from the card company. In both cases, the seller pays a fee for services provided by the card company, often ranging from 1% to 5% of card sales. This charge is deducted from the credit to the seller’s account or the cash payment to the seller. (Many retailers accept MasterCard and Visa, but not American Express. The reason is that American Express usually charges retailers a higher percentage fee than other credit card companies.)

Point: Visa USA now transacts more than $1 trillion from its credit, debit, and prepaid cards.

The procedures used in accounting for credit card sales depend on whether cash is received immediately on deposit or cash receipt is delayed until the credit card company makes the payment.

Point: Web merchants pay twice as much in credit card association fees as other retailers because they suffer 10 times as much fraud.

Debit Card vs. Credit Card A buyer’s debit card purchase reduces the buyer’s cash account balance at the card company, which is often a bank. Since the buyer’s cash account balance is a liability (with a credit balance) for the card company to the buyer, the card company would debit that account for a buyer’s pur- chase—hence, the term debit card. A credit card reflects authorization by the card company of a line of credit for the buyer with preset interest rates and payment terms—hence, the term credit card. Most card companies waive interest charges if the buyer pays its balance each month. ■

Decision Insight

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Chapter 7 Accounts and Notes Receivable 305

Cash Received Immediately on Deposit To illustrate, if TechCom has $100 of credit card sales with a 4% fee, and its $96 cash is received immediately on deposit, the entry is

Assets 5 Liabilities 1 Equity 196 1100

24

July 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

Credit Card Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

To record credit card sales less a 4% credit card expense.*

* We omit the entry to Dr. Cost of Sales and Cr. Merchandise Inventory to focus on credit card expense.

Assets 5 Liabilities 1 Equity 196 296

July 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

Accounts Receivable — Credit Card Co. . . . . . . . . . . . . . . . . . 96

To record cash receipt.

Assets 5 Liabilities 1 Equity 196 1100

24

July 15 Accounts Receivable—Credit Card Co. . . . . . . . . . . . . . . . . 96

Credit Card Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

To record credit card sales less 4% credit card expense.*

* We omit the entry to Dr. Cost of Sales and Cr. Merchandise Inventory to focus on credit card expense.

When cash is later received from the credit card company, usually through electronic funds transfer, the entry is

1. In recording credit card sales, when do you debit Accounts Receivable and when do you debit Cash? 2. A company accumulates sales receipts and remits them to the credit card company for

payment. When are the credit card expenses recorded? When are these expenses incurred?

Quick Check Answers — p. 321

Some firms report credit card expense in the income statement as a type of discount deducted from sales to get net sales. Other companies classify it as a selling expense or even as an admin- istrative expense. Arguments can be made for each approach.

Point: Third-party credit card costs can be large. JCPenney reported third-party credit card costs exceeding $10 million.

Cash Received Some Time after Deposit However, if instead TechCom must remit elec- tronically the credit card sales receipts to the credit card company and wait for the $96 cash payment, the entry on the date of sale is

Cabbie Credit Card Sales Thirty New York cabs rolled out the first phase of a new mobile payment system for taxis. These 30 cabs are equipped with an iPad encased in a metal housing that includes a credit card reader. The iPad allows fares to swipe their card, sign their name on the screen with their finger, and then receive a receipt on their phone either by text or email. Taxi drivers are also able to interact with the system, dubbed “Checker,” using their own iPhone app. ■

Decision Insight

Installment Sales and Receivables Many companies allow their credit customers to make periodic payments over several months. For example, Ford Motor Company reports more than $70 billion in installment receivables. The seller refers to such assets as installment accounts (or finance) receivable, which are amounts owed by customers from credit sales for which payment is required in periodic amounts over an extended time period. Source documents for installment accounts receivable include sales slips or invoices describing the sales transactions. The customer is usually charged interest. Although installment accounts receivable can have credit periods of more than one year, they are classified as current assets if the seller regularly offers customers such terms.

Entrepreneur As a small retailer, you are considering allowing customers to buy merchandise using credit cards. Until now, your store accepted only cash and checks. What analysis do you use to make this decision? ■ [Answer—p. 320]

Decision Maker

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306 Chapter 7 Accounts and Notes Receivable

Jan. 23 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable — J. Kent . . . . . . . . . . . . . . . . . 520

To write off an uncollectible account.

Assets 5 Liabilities 1 Equity 2520 2520

Mar. 11 Accounts Receivable — J. Kent . . . . . . . . . . . . . . . . . . . . . 520

Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . 520

To reinstate account previously written off.

Mar. 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable —J. Kent . . . . . . . . . . . . . . . . . 520

To record full payment of account.

Assets 5 Liabilities 1 Equity 1520 1520

Assets 5 Liabilities 1 Equity 1520 2520

The debit in this entry charges the uncollectible amount directly to the current period’s Bad Debts Expense account. The credit removes its balance from the Accounts Receivable account in the general ledger (and its subsidiary ledger).

Recovering a Bad Debt Although uncommon, sometimes an account written off is later collected. This can be due to factors such as continual collection efforts or a customer’s good fortune. If the account of J. Kent that was written off directly to Bad Debts Expense is later col- lected in full, the following two entries record this recovery:

Point: If a customer fails to pay within the credit period, most companies send out repeated billings and make other efforts to collect.

Assessing the Direct Write-Off Method Examples of companies that use the direct write-off method include Rand Medical Billing, Gateway Distributors, Microwave Satellite Technologies, First Industrial Realty, New Frontier Energy, and Sub Surface Waste Man- agement. The following disclosure by Pharma-Bio Serv is typical of the justification for this method: Bad debts are accounted for using the direct write-off method whereby an expense is recognized only when a specific account is determined to be uncollectible. The effect of using this method approximates that of the allowance method. Companies must weigh at least two accounting concepts when considering the use of the direct write-off method: the (1) matching principle and (2) materiality constraint.

Matching principle applied to bad debts. The matching (expense recognition) principle re- quires expenses to be reported in the same accounting period as the sales they helped produce. This means that if extending credit to customers helped produce sales, the bad debts expense linked to those sales is matched and reported in the same period. The direct write-off method usually does not best match sales and expenses because bad debts expense is not recorded until an account becomes uncollectible, which often occurs in a period after that of the credit sale. To match bad debts expense with the sales it produces therefore requires a company to estimate future uncollectibles.

Materiality constraint applied to bad debts. The materiality constraint states that an amount can be ignored if its effect on the financial statements is unimportant to users’ business decisions. The materiality constraint permits the use of the direct write-off method when bad debts expenses are very small in relation to a company’s other financial statement items such as sales and net income.

Point: Harley-Davidson reports $150 million of credit losses matched against $4,962 million of finance receivables.

Valuing Accounts Receivable—Direct Write-Off Method When a company directly grants credit to its customers, it expects that some customers will not pay what they promised. The accounts of these customers are uncollectible accounts, commonly called bad debts. The total amount of uncollectible accounts is an expense of selling on credit. Why do companies sell on credit if they expect some accounts to be uncollectible? The answer is that companies believe that granting credit will increase total sales and net income enough to offset bad debts. Companies use two methods to account for uncollectible accounts: (1) direct write-off method and (2) allowance method. We describe both.

Recording and Writing Off Bad Debts The direct write-off method of accounting for bad debts records the loss from an uncollectible account receivable when it is determined to be uncollectible. No attempt is made to predict bad debts expense. To illustrate, if TechCom determines on January 23 that it cannot collect $520 owed to it by its customer J. Kent, it recog- nizes the loss using the direct write-off method as follows:

Point: Managers realize that some portion of credit sales will be uncol- lectible, but which credit sales are uncollectible is unknown.

P1 Apply the direct write-off method to account for accounts receivable.

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Chapter 7 Accounts and Notes Receivable 307

Valuing Accounts Receivable—Allowance Method The allowance method of accounting for bad debts matches the estimated loss from uncollect- ible accounts receivable against the sales they helped produce. We must use estimated losses because when sales occur, management does not know which customers will not pay their bills. This means that at the end of each period, the allowance method requires an estimate of the total bad debts expected to result from that period’s sales. This method has two advantages over the direct write-off method: (1) it records estimated bad debts expense in the period when the re- lated sales are recorded and (2) it reports accounts receivable on the balance sheet at the esti- mated amount of cash to be collected.

Recording Bad Debts Expense The allowance method esti- mates bad debts expense at the end of each accounting period and re- cords it with an adjusting entry. TechCom, for instance, had credit sales of $300,000 during its first year of operations. At the end of the first year, $20,000 of credit sales remained uncollected. Based on the experience of similar busi- nesses, TechCom estimated that $1,500 of its accounts receivable would be uncollectible. This estimated expense is recorded with the following adjusting entry:

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 1,500

To record estimated bad debts.

Assets 5 Liabilities 1 Equity 21,500 21,500

The estimated Bad Debts Expense of $1,500 is reported on the income statement (as either a selling expense or an administrative expense) and offsets the $300,000 credit sales it helped produce. The Allowance for Doubtful Accounts is a contra asset account. A contra account is used instead of reducing accounts receivable directly because at the time of the adjusting entry, the company does not know which customers will not pay. After the bad debts adjusting entry is  posted, TechCom’s account balances (in T-account form) for Accounts Receivable and its Allowance for Doubtful Accounts are as shown in Exhibit 7.5.

Point: Credit approval is usually not assigned to the selling dept. because its goal is to increase sales, and it may approve customers at the cost of increased bad debts. Instead, approval is assigned to a separate credit-granting or administrative dept.

Dec. 31 20,000

Accounts Receivable

Dec. 31 1,500

Allowance for Doubtful Accounts EXHIBIT 7.5 General Ledger Entries after Bad Debts Adjusting Entry

The Allowance for Doubtful Accounts credit balance of $1,500 has the effect of reducing ac- counts receivable to its estimated realizable value. Realizable value refers to the expected pro- ceeds from converting an asset into cash. Although credit customers owe $20,000 to TechCom, only $18,500 is expected to be realized in cash collections from these customers. In the balance sheet, the Allowance for Doubtful Accounts is subtracted from Accounts Receivable and is often reported as shown in Exhibit 7.6.

Point: Bad Debts Expense is also called Uncollectible Accounts Expense. The Allow- ance for Doubtful Accounts is also called Allowance for Uncollectible Accounts.

EXHIBIT 7.6 Balance Sheet Presentation of the Allowance for Doubtful Accounts

Current assets

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Less allowance for doubtful accounts . . . . . . . . . . . . . . . 1,500 $18,500

EXHIBIT 7.7 Alternative Presentation of the Allowance for Doubtful Accounts

Current assets

Accounts receivable (net of $1,500 doubtful accounts) . . . . . . . . . $18,500

Sometimes the Allowance for Doubtful Accounts is not reported separately. This alternative presentation is shown in Exhibit 7.7 (also see Appendix A).

Writing Off a Bad Debt When specific accounts are identified as uncollectible, they are written off against the Allowance for Doubtful Accounts. To illustrate, TechCom decides that J. Kent’s $520 account is uncollectible and makes the following entry to write it off.

Jan. 23 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . 520

Accounts Receivable — J. Kent . . . . . . . . . . . . . . . . . 520

To write off an uncollectible account.

Assets 5 Liabilities 1 Equity 1520 2520

Point: Under direct write-off, expense is recorded each time an account is written off. Under the allowance method, expense is recorded with an adjusting entry equal to the total estimated uncollectibles for that period’s sales.

Bad Debts Expense Recognized in

Direct write-off method . . . . The future when account is deemed uncollectible Allowance method . . . . . . . Current period to yield realizable Accts. Rec. bal.

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308 Chapter 7 Accounts and Notes Receivable

EXHIBIT 7.9 Realizable Value before and after Write-Off of a Bad Debt

Before Write-Off After Write-Off

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 19,480 Less allowance for doubtful accounts . . . . . . . . . . . . . . . . . 1,500 980 Estimated realizable accounts receivable . . . . . . . . . $18,500 $18,500

The write-off does not affect the realizable value of accounts receivable as shown in Exhibit 7.9. Neither total assets nor net income is affected by the write-off of a specific account. Instead, both assets and net income are affected in the period when bad debts expense is predicted and recorded with an adjusting entry.

Point: In posting a write-off, the ledger’s Explanation column indicates the reason for this credit so it is not misinterpreted as payment in full.

Recovering a Bad Debt When a customer fails to pay and the account is written off as uncol- lectible, his or her credit standing is jeopardized. To help restore credit standing, a customer some- times volunteers to pay all or part of the amount owed. A company makes two entries when collecting an account previously written off by the allowance method. The first is to reverse the write-off and reinstate the customer’s account. The second entry records the collection of the reinstated account. To illustrate, if on March 11 Kent pays in full his account previously written off, the entries are

Assets 5 Liabilities 1 Equity 1520 2520 Assets 5 Liabilities 1 Equity 1520 2520

Mar. 11 Accounts Receivable — J. Kent . . . . . . . . . . . . . . . . . . . . . 520 Allowance for Doubtful Accounts . . . . . . . . . . . . . . 520 To reinstate account previously written off. Mar. 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520 Accounts Receivable — J. Kent . . . . . . . . . . . . . . . . . 520 To record full payment of account.

Example: If TechCom used a collection agency and paid a 35% commission on $520 collected from Kent, how is this recorded? Answer: Cash . . . . . . . . . . . . . . . . . . 338 Collection Expense . . . . . . 182 Accts. Recble. — J. Kent . . . . . . 520

In this illustration, Kent paid the entire amount previously written off, but sometimes a customer pays only a portion of the amount owed. A question then arises as to whether the entire balance of the account or just the amount paid is returned to accounts receivable. This is a matter of judgment. If we believe this customer will later pay in full, we return the entire amount owed to accounts receivable, but if we expect no further collection, we return only the amount paid.

Estimating Bad Debts—Percent of Sales Method The allowance method requires an estimate of bad debts expense to prepare an adjusting entry at the end of each accounting period. There are two common methods. One is based on the income statement relation between bad debts expense and sales. The second is based on the balance sheet relation between accounts receivable and the allowance for doubtful accounts.

Dec. 31 20,000 Jan. 23 520

Accounts Receivable

Jan. 23 520 Dec. 31 1,500

Allowance for Doubtful AccountsEXHIBIT 7.8 General Ledger Entries after Write-Off

Point: The Bad Debts Expense account is not debited in the write-off entry because it was recorded in the period when sales occurred.

Posting this write-off entry to the Accounts Receivable account removes the amount of the bad debt from the general ledger (it is also posted to the accounts receivable subsidiary ledger). The general ledger accounts now appear as in Exhibit 7.8 (assuming no other transactions affecting these accounts).

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b a l a

cc o u n ts

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JP M

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D is

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M B

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A m

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P a yP

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C a rd

V IS

A 1,200

680

7265 5653

30

PayPal PayPal is legally just a money transfer agent, but it is increasingly challenging big credit card brands—see chart. PayPal is successful because: (1) online credit card process- ing fees often exceed $0.15 per dollar, but PayPal’s fees are under $0.10 per dollar. (2) PayPal’s merchant fraud losses are under 0.2% of revenues, which compares to nearly 2% for online merchants using credit cards. ■

Decision Insight

P2 Apply the allowance method and estimate uncollectibles based on sales and accounts receivable.

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Chapter 7 Accounts and Notes Receivable 309

The percent of sales method, also referred to as the income statement method, is based on the idea that a given percent of a company’s credit sales for the period is uncollectible. To illustrate, assume that Musicland has credit sales of $400,000 in year 2013. Based on past experience, Musicland estimates 0.6% of credit sales to be uncollectible. This implies that Musicland expects $2,400 of bad debts expense from its sales (computed as $400,000 3 0.006). The adjusting entry to record this estimated expense is

Point: Focus is on credit sales because cash sales do not produce bad debts. If cash sales are a small or stable percent of credit sales, total sales can be used.

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 2,400

To record estimated bad debts.

Assets 5 Liabilities 1 Equity 22,400 22,400

The allowance account ending balance on the balance sheet for this method would rarely equal the bad debts expense on the income statement. This is so because unless a company is in its first period of operations, its allowance account has a zero balance only if the prior amounts written off as uncollectible exactly equal the prior estimated bad debts expenses. (When com- puting bad debts expense as a percent of sales, managers monitor and adjust the percent so it is not too high or too low.)

Estimating Bad Debts—Percent of Receivables Method The accounts receivable methods, also referred to as balance sheet methods, use balance sheet rela- tions to estimate bad debts — mainly the relation between accounts receivable and the allowance amount. The goal of the bad debts adjusting entry for these methods is to make the Allowance for Doubtful Accounts balance equal to the portion of accounts receivable that is estimated to be uncol- lectible. The estimated balance for the allowance account is obtained in one of two ways: (1) com- puting the percent uncollectible from the total accounts receivable or (2) aging accounts receivable. The percent of accounts receivable method assumes that a given percent of a company’s re- ceivables is uncollectible. This percent is based on past experience and is impacted by current conditions such as economic trends and customer difficulties. The total dollar amount of all re- ceivables is multiplied by this percent to get the estimated dollar amount of uncollectible accounts—reported in the balance sheet as the Allowance for Doubtful Accounts. To illustrate, assume that Musicland has $50,000 of accounts receivable on December 31, 2013. Experience suggests 5% of its receivables is uncollectible. This means that after the ad- justing entry is posted, we want the Allowance for Doubtful Accounts to show a $2,500 credit balance (5% of $50,000). We are also told that its beginning balance is $2,200, which is 5% of the $44,000 accounts receivable on December 31, 2012—see Exhibit 7.10.

Point: When using an accounts receivable method for estimating uncollectibles, the allowance account balance is adjusted to equal the estimate of uncollectibles.

Point: When using the percent of sales method for estimating uncollectibles, the estimate of bad debts is the number used in the adjusting entry.

Prior year estimate of allowance for

doubtful accounts

Adjusting entry

Current year estimate of allowance for doubtful accounts

Current year write-offs

Dec. 31, 2012, bal. 2,200

Dec. 31, 2013, bal.

Dec. 31 adjustment 2,300

2,500

Feb. 6 800

July 10 700

Nov. 20 500

Unadjusted bal. 200

Allowance for Doubtful Accounts EXHIBIT 7.10 Allowance for Doubtful Accounts after Bad Debts Adjusting Entry

During 2013, accounts of customers are written off on February 6, July 10, and November 20. Thus, the account has a $200 credit balance before the December 31, 2013, adjustment. The adjusting entry to give the allowance account the estimated $2,500 balance is

Assets 5 Liabilities 1 Equity 22,300 22,300

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 2,300

To record estimated bad debts.

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310 Chapter 7 Accounts and Notes Receivable

Estimating Bad Debts—Aging of Receivables Method The aging of accounts receivable method uses both past and current receivables information to estimate the allowance amount. Specifically, each receivable is classified by how long it is past its due date. Then estimates of uncollectible amounts are made assuming that the longer an amount is past due, the more likely it is to be uncollectible. Classifications are often based on 30-day periods. After the amounts are classified (or aged), experience is used to estimate the percent of each uncollectible class. These percents are applied to the amounts in each class and then totaled to get the estimated balance of the Allowance for Doubtful Ac counts. This compu- tation is performed by setting up a schedule such as Exhibit 7.11.

Exhibit 7.11 lists each customer’s individual balances assigned to one of five classes based on its days past due. The amounts in each class are totaled and multiplied by the estimated per- cent of uncollectible accounts for each class. The percents used are regularly reviewed to reflect changes in the company and economy. To explain, Musicland has $3,700 in accounts receivable that are 31 to 60 days past due. Its management estimates 10% of the amounts in this age class are uncollectible, or a total of $370 (computed as $3,700 3 10%). Similar analysis is done for each of the other four classes. The final total of $2,270 ($740 1 $325 1 370 1 $475 1 $360) shown in the first column is the estimated balance for the Allowance for Doubtful Accounts. Exhibit 7.12 shows that since the allowance

EXHIBIT 7.12 Computation of the Required Adjustment for the Accounts Receivable Method

Unadjusted balance . . . . . . . . . . . . . $ 200 credit

Estimated balance . . . . . . . . . . . . . . 2,270 credit

Required adjustment . . . . . . . . . $2,070 credit

EXHIBIT 7.11 Aging of Accounts Receivable

Each receivable is grouped by how long it

is past its due date

MUSICLAND Schedule of Accounts Receivable by Age

December 31, 2013

Customer

Carlie Abbott…………… 5,890$ $

$ $ $ $ $

5,890

Jamie Allen…………….. 710 710$

Chavez Andres………… 10,500

Balicia Company.……… 2,800

Zamora Services……….

Total receivables*..….

Percent uncollectible…..

Estimated uncollectible..

× 2% × 5% × 10% × 25% × 40%

21,000

$50,000

$ 2,270$ 2,270

$37,000

740 325 370 475 360

$6,500 $3,700

Texas Rawhide..…........ 9,100 6,110 2,990

$1,900 900$

20,810 190

1,900$ $ 900

200$ 10,300

Totals Not Yet

Due

1 to 30 Days

Past Due

31 to 60 Days

Past Due

61 to 90 Days

Past Due

Over 90 Days Past Due

Each age group is multiplied by its estimated

bad debts percent

Estimated bad debts for each group are totaled

12–23

9–11

6–8

3–5

2

1

>24

0% 100%

M o

n th

s p

a st

d u

e

89%

76%

58%

43%

15%

27%

6% Bad debts percentage Aging Pains Unlike wine, accounts receivable do not improve with age. Experience shows that the longer a receivable is past due, the lower is the likelihood of its collec- tion. An aging schedule uses this knowledge to estimate bad debts. The chart here is from a survey that reported esti- mates of bad debts for receivables grouped by how long they were past their due dates. Each company sets its own estimates based on its customers and its experiences with those customers’ payment patterns. ■

Decision Insight

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Chapter 7 Accounts and Notes Receivable 311

account has an unadjusted credit balance of $200, the required adjustment to the Allowance for Doubtful Accounts is $2,070. (We could also use a T-account for this analysis as shown in the margin.) This yields the following end-of-period adjusting entry:

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,070

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 2,070

To record estimated bad debts.

Assets 5 Liabilities 1 Equity 22,070 22,070

Alternatively, if the allowance account had an unadjusted debit balance of $500 (instead of the $200 credit balance), its required adjustment would be computed as follows. (Again, a T-account can be used for this analysis as shown in the margin.)

Point: A debit balance implies that write-offs for that period exceed the total allowance.

The aging of accounts receivable method is an examination of specific accounts and is usually the most reliable of the estimation methods.

Estimating Bad Debts—Summary of Methods Exhibit 7.13 summarizes the prin- ciples guiding all three estimation methods and their focus of analysis. Percent of sales, with its income statement focus, does a good job at matching bad debts expense with sales. The accounts receivable methods, with their balance sheet focus, do a better job at reporting ac- counts receivable at realizable value.

EXHIBIT 7.13 Methods to Estimate Bad Debts

Income Statement Focus

Percent of Sales [Emphasis on Matching]

Sales × Rate = Bad Debts Expense

Percent of Receivables [Emphasis on Realizable Value]

Aging of Receivables [Emphasis on Realizable Value]

Balance Sheet Focus

Bad Debts Estimation

Allowance for Doubtful Accounts

× Rate = Accounts

Receivable Allowance

for Doubtful Accounts

Accounts Receivable

(by Age)

Rates (by Age)

or

or

Allowance for Doubtful Accounts

Unadj. bal. 200 Req. adj. 2,070

Estim. bal. 2,270

Assets 5 Liabilities 1 Equity 22,770 22,770

Allowance for Doubtful Accounts

Unadj. bal. 500 Req. adj. 2,770

Estim. bal. 2,270

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,770

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 2,770

To record estimated bad debts.

The entry to record the end-of-period adjustment for this alternative case is

Unadjusted balance $ 500 debit

Estimated balance 2,270 credit

Required adjustment . . . . . $ 2,770 creditAdjusting entry amount

Current year estimate of allowance for doubtful accounts

. . . . . . . . .

. . . . . . . . . .

Labor Union Chief One week prior to labor contract negotiations, financial statements are released showing no income growth. A 10% growth was predicted. Your analysis finds that the company increased its allowance for uncollectibles from 1.5% to 4.5% of receivables. Without this change, income would show a 9% growth. Does this analysis impact negotiations? ■ [Answer—p. 321]

Decision Maker

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312 Chapter 7 Accounts and Notes Receivable

3. Why must bad debts expense be estimated if such an estimate is possible? 4. What term describes the balance sheet valuation of Accounts Receivable less the Allowance

for Doubtful Accounts?

5. Why is estimated bad debts expense credited to a contra account (Allowance for Doubtful Accounts) rather than to the Accounts Receivable account?

6. SnoBoard Company’s year-end balance in its Allowance for Doubtful Accounts is a credit of $440. By aging accounts receivable, it estimates that $6,142 is uncollectible. Prepare SnoBoard’s year-end adjusting entry for bad debts.

7. Record entries for these transactions assuming the allowance method is used: Jan. 10 The $300 account of customer Cool Jam is determined uncollectible.

April 12 Cool Jam unexpectedly pays in full the account deemed uncollectible on Jan. 10.

Quick Check Answers — p. 321

C2 Describe a note receivable, the computation of its maturity date, and the recording of its existence.

A promissory note is a written promise to pay a specified amount of money, usually with inter- est, either on demand or at a definite future date. Promissory notes are used in many transac- tions, including paying for products and services, and lending and borrowing money. Sellers sometimes ask for a note to replace an account receivable when a customer requests additional time to pay a past-due account. For legal reasons, sellers generally prefer to receive notes when the credit period is long and when the receivable is for a large amount. If a lawsuit is needed to collect from a customer, a note is the buyer’s written acknowledgment of the debt, its amount, and its terms. Exhibit 7.14 shows a simple promissory note dated July 10, 2013. For this note, Julia Browne promises to pay TechCom or to its order (according to TechCom’s instructions) a specified amount of money ($1,000), called the principal of a note, at a definite future date (October 8, 2013). As the one who signed the note and promised to pay it at maturity, Browne is the maker of the note. As the person to whom the note is payable, TechCom is the payee of the note. To Browne, the note is a liability called a note payable. To TechCom, the same note is an asset called a note receivable. This note bears interest at 12%, as written on the note. Interest is the charge for using the money until its due date. To a borrower, interest is an expense. To a lender, it is revenue.

NOTES RECEIVABLE

EXHIBIT 7.14 Promissory Note

Principal

Date of note

Due date

Payee

Interest rate

Maker

Promissory Note

Amount: ............

...................... after date ........................... promise to pay to the order of

$1,000 Date: ....................July 10, 2013

Ninety days I

12%

First National Bank of Los Angeles, CA

TechCom Company Los Angeles, CA

One thousand and no/100 ---------------------------------------------------- Dollars

for value received with interest at the annual rate of ..........

payable at ............................................................ Julia BrowneJulia Browne

Computing Maturity and Interest This section describes key computations for notes including the determination of maturity date, period covered, and interest computation.

Maturity Date and Period The maturity date of a note is the day the note (principal and interest) must be repaid. The period of a note is the time from the note’s (contract) date to

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Chapter 7 Accounts and Notes Receivable 313

its maturity date. Many notes mature in less than a full year, and the period they cover is often expressed in days. When the time of a note is expressed in days, its maturity date is the specified number of days after the note’s date. As an example, a five-day note dated June 15 matures and is due on June 20. A 90-day note dated July 10 matures on October 8. This October 8 due date is computed as shown in Exhibit 7.15. The period of a note is sometimes expressed in months or years. When months are used, the note matures and is payable in the month of its maturity on the same day of the month as its original date. A nine-month note dated July 10, for instance, is payable on April 10. The same analysis applies when years are used.

EXHIBIT 7.15 Maturity Date Computation

Days in July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Minus the date of the note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Days remaining in July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Add days in August . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Add days in September . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Days to equal 90 days, or maturity date of October 8 . . . . . . . . . 8

Period of the note in days . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

July 11–31

Aug. 1–31

Sept. 1–30

Oct. 1–8

Interest Computation Interest is the cost of borrowing money for the borrower or, alter- natively, the profit from lending money for the lender. Unless otherwise stated, the rate of inter- est on a note is the rate charged for the use of the principal for one year. The formula for computing interest on a note is shown in Exhibit 7.16.

EXHIBIT 7.16 Computation of Interest Formula

Principal Annual Time expressed of the note

3 interest rate

3 in fraction of year

5 Interest

To simplify interest computations, a year is commonly treated as having 360 days (called the banker’s rule in the business world and widely used in commercial transactions). We treat a year as having 360 days for interest computations in the examples and assignments. Using the promissory note in Exhibit 7.14 where we have a 90-day, 12%, $1,000 note, the total interest is computed as follows:

$1,000 3 12% 3 90

360 5 $1,000 3 0.12 3 0.25 5 $30

Recognizing Notes Receivable Notes receivable are usually recorded in a single Notes Receivable account to simplify record- keeping. The original notes are kept on file, including information on the maker, rate of interest, and due date. (When a company holds a large number of notes, it sometimes sets up a controlling account and a subsidiary ledger for notes. This is similar to the handling of accounts receivable.) To illustrate the recording for the receipt of a note, we use the $1,000, 90-day, 12% promissory note in Exhibit 7.14. TechCom received this note at the time of a product sale to Julia Browne. This transaction is recorded as follows:

July 10* Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold goods in exchange for a 90-day, 12% note.

* We omit the entry to Dr. Cost of Sales and Cr. Merchandise Inventory to focus on sales and receivables.

Assets 5 Liabilities 1 Equity 11,000 11,000

When a seller accepts a note from an overdue customer as a way to grant a time extension on a past-due account receivable, it will often collect part of the past-due balance in cash. This partial payment forces a concession from the customer, reduces the customer’s debt (and the seller’s risk), and produces a note for a smaller amount. To illustrate, assume that Tech- Com agreed to accept $232 in cash along with a $600, 60-day, 15% note from Jo Cook to

Point: Notes receivable often are a major part of a company’s assets. Likewise, notes payable often are a large part of a company’s liabilities.

Point: If the banker’s rule is not followed, interest is computed as:

$1,000 3 12% 3 90y365 5 $29.589041

The banker’s rule would yield $30, which is easier to account for than $29.589041.

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314 Chapter 7 Accounts and Notes Receivable

settle her $832 past-due account. TechCom made the following entry to record receipt of this cash and note:

Oct. 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Accounts Receivable — J. Cook . . . . . . . . . . . . . . . . 832

Received cash and note to settle account.

Assets 5 Liabilities 1 Equity 1232 1600 2832

Valuing and Settling Notes Recording an Honored Note The principal and interest of a note are due on its matu- rity date. The maker of the note usually honors the note and pays it in full. To illustrate, when J. Cook pays the note above on its due date, TechCom records it as follows:

P3 Record the honoring and dishonoring of a note and adjustments for interest.

Dec. 4 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Collect note with interest of $600 3 15% 3 60y360.

Assets 5 Liabilities 1 Equity 1615 115 2600

Oct. 14 Accounts Receivable — G. Hart . . . . . . . . . . . . . . . . . . . . 816

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 800

To charge account of G. Hart for a dishonored note and interest of $800 3 12% 3 60y360.

Assets 5 Liabilities 1 Equity 1816 116 2800

Interest Revenue, also called Interest Earned, is reported on the income statement.

Recording a Dishonored Note When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. The act of dishonoring a note does not relieve the maker of the obligation to pay. The payee should use every legitimate means to collect. How do companies report this event? The balance of the Notes Receivable account should include only those notes that have not matured. Thus, when a note is dishonored, we remove the amount of this note from the Notes Receivable account and charge it back to an account receivable from its maker. To illustrate, TechCom holds an $800, 12%, 60-day note of Greg Hart. At maturity, Hart dishonors the note. TechCom records this dishonoring of the note as follows:

Point: When posting a dishonored note to a customer’s account, an expla- nation is included so as not to misinter- pret the debit as a sale on account.

Dec. 31 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

To record accrued interest earned.

Assets 5 Liabilities 1 Equity 115 115

Charging a dishonored note back to the account of its maker serves two purposes. First, it removes the amount of the note from the Notes Receivable account and records the dishonored note in the maker’s account. Second, and more important, if the maker of the dishonored note applies for credit in the future, his or her account will reveal all past dealings, including the dishonored note. Restoring the account also reminds the company to continue collection efforts from Hart for both principal and interest. The entry records the full amount, including interest, to ensure that it is included in collection efforts.

Recording End-of-Period Interest Adjustment When notes receivable are out- standing at the end of a period, any accrued interest earned is computed and recorded. To illus- trate, on December 16, TechCom accepts a $3,000, 60-day, 12% note from a customer in granting an extension on a past-due account. When TechCom’s accounting period ends on December 31, $15 of interest has accrued on this note ($3,000 3 12% 3 15y360). The follow- ing adjusting entry records this revenue:

Point: Reporting the details of notes is consistent with the full disclosure principle, which requires financial statements (including footnotes) to report all relevant information.

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Chapter 7 Accounts and Notes Receivable 315

Interest Revenue appears on the income statement, and Interest Receivable appears on the balance sheet as a current asset. When the December 16 note is collected on February 14, TechCom’s entry to record the cash receipt is

Assets 5 Liabilities 1 Equity 13,060 145

215 23,000

Feb. 14 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,060

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . 15

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Received payment of note and its interest.

Total interest earned on the 60-day note is $60. The $15 credit to Interest Receivable on February 14 reflects the collection of the interest accrued from the December 31 adjusting entry. The $45 interest earned reflects TechCom’s revenue from holding the note from January 1 to February 14 of the current period.

8. Irwin purchases $7,000 of merchandise from Stamford on December 16, 2013. Stamford accepts Irwin’s $7,000, 90-day, 12% note as payment. Stamford’s accounting period ends on December 31, and it does not make reversing entries. Prepare entries for Stamford on December 16, 2013, and December 31, 2013.

9. Using the information in Quick Check 8, prepare Stamford’s March 16, 2014, entry if Irwin dishonors the note.

10. What is the maturity date of a 60-day note signed by the maker on September 15?

Quick Check Answers — p. 321

Companies can convert receivables to cash before they are due. Reasons for this include the need for cash or the desire not to be involved in collection activities. Converting receivables is usually done either by (1) selling them or (2) using them as security for a loan. A recent survey shows that about 20% of companies obtain cash from either selling receivables or pledging them as se- curity. In some industries such as textiles, apparel and furniture, this is common practice.

Selling Receivables A company can sell all or a portion of its receivables to a finance company or bank. The buyer, called a factor, charges the seller a factoring fee and then the buyer takes ownership of the re- ceivables and receives cash when they come due. By incurring a factoring fee, the seller re- ceives cash earlier and can pass the risk of bad debts to the factor. The seller can also choose to avoid costs of billing and accounting for the receivables. To illustrate, if TechCom sells $20,000 of its accounts receivable and is charged a 4% factoring fee, it records this sale as follows:

DISPOSAL OF RECEIVABLES

C3 Explain how receivables can be converted to cash before maturity.

Global: Firms in export sales increas- ingly sell their receivables to factors.

Aug. 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

Factoring Fee Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Sold accounts receivable for cash, less 4% fee.

Assets 5 Liabilities 1 Equity 119,200 2800 220,000

The accounting for sales of notes receivable is similar to that for accounts receivable. The detailed entries are covered in advanced courses. Remember: When factoring receivables, the company sell- ing receivables always receives less cash than the amount of receivables sold due to factoring fees.

Pledging Receivables A company can raise cash by borrowing money and pledging its receivables as security for the loan. Pledging receivables does not transfer the risk of bad debts to the lender because the

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316 Chapter 7 Accounts and Notes Receivable

borrower retains ownership of the receivables. If the borrower defaults on the loan, the lender has a right to be paid from the cash receipts of the receivable when collected. To illustrate, when TechCom borrows $35,000 and pledges its receivables as security, it records this transac- tion as follows:

Aug. 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Borrowed money with a note secured by pledging receivables.

Assets 5 Liabilities 1 Equity 135,000 135,000

Since pledged receivables are committed as security for a specific loan, the borrower’s finan- cial statements disclose the pledging of them. TechCom, for instance, includes the follow- ing note with its statements: Accounts receivable of $40,000 are pledged as security for a $35,000 note payable. Inventory and accounts receivable are two assets commonly demanded by bank- ers as collateral when making business loans.

This section discusses similarities and differences between U.S. GAAP and IFRS regarding the recogni- tion, measurement, and disposition of receivables.

Recognition of Receivables Both U.S. GAAP and IFRS have similar asset criteria that apply to recognition of receivables. Further, receivables that arise from revenue-generating activities are subject to broadly similar criteria for U.S. GAAP and IFRS. Specifically, both refer to the realization principle and an earnings process. The realization principle under U.S. GAAP implies an arm’s-length transaction oc- curs, whereas under IFRS this notion is applied in terms of reliable measurement and likelihood of eco- nomic benefits. Regarding U.S. GAAP’s reference to an earnings process, IFRS instead refers to risk transfer and ownership reward. While these criteria are broadly similar, differences do exist, and they arise mainly from industry-specific guidance under U.S. GAAP, which is very limited under IFRS.

Valuation of Receivables Both U.S. GAAP and IFRS require that receivables be reported net of estimated uncollectibles. Further, both systems require that the expense for estimated uncollectibles be re- corded in the same period when any revenues from those receivables are recorded. This means that for ac- counts receivable, both U.S. GAAP and IFRS require the allowance method for uncollectibles (unless uncollectibles are immaterial). The allowance method using percent of sales, percent of receivables, and aging was explained in this chapter. Nokia reports the following for its allowance for uncollectibles:

GLOBAL VIEW

Management specifically analyzes accounts receivables and historical bad debt, customer concentrations, customer creditworthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance.

Disposition of Receivables Both U.S. GAAP and IFRS apply broadly similar rules in recording dispositions of receivables. Those rules are discussed in this chapter. We should be aware of an important difference in terminology. Companies reporting under U.S. GAAP disclose Bad Debts Expense, which is also referred to as Provision for Bad Debts or the Provision for Uncollectible Accounts. For U.S. GAAP, provision here refers to expense. Under IFRS, the term provision usually refers to a liability whose amount or timing (or both) is uncertain.

Analyst/Auditor: What’s the Proper Allowance? You are reviewing accounts receivable. Over the past five years, the allowance account as a percentage of gross accounts receivable shows a steady downward trend. What does this finding suggest? ■ [Answer—p. 321]

Decision Maker

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Chapter 7 Accounts and Notes Receivable 317

Accounts Receivable Turnover Decision Analysis

A1 Compute accounts receivable turnover and use it to help assess financial condition.

For a company selling on credit, we want to assess both the quality and liquidity of its accounts receivable. Quality of receivables refers to the likelihood of collection without loss. Experience shows that the longer receivables are outstanding beyond their due date, the lower the likelihood of collection. Liquidity of receivables refers to the speed of collection. Accounts receivable turnover is a measure of both the quality and liquidity of accounts receivable. It indicates how often, on aver- age, receivables are received and collected during the period. The formula for this ratio is shown in Exhibit 7.17.

EXHIBIT 7.18 Rate of Accounts Receivable Turnover for TechCom

Jan. Feb. March Apr. May June July Aug. Sept. Oct. Nov. Dec.

5.1 times per year

54321

EXHIBIT 7.17 Accounts Receivable TurnoverAccounts receivable turnover 5

Net sales Average accounts receivable, net

We prefer to use net credit sales in the numerator because cash sales do not create receivables. However, since financial statements rarely report net credit sales, our analysis uses net sales. The denominator is the average accounts receivable balance, computed as (Beginning balance 1 Ending balance) 4 2. TechCom has an accounts receivable turnover of 5.1. This indicates its average accounts receivable balance is con- verted into cash 5.1 times during the period. Exhibit 7.18 shows graphically this turnover activity for TechCom.

Point: Credit risk ratio is computed by dividing the Allowance for Doubtful Accounts by Accounts Receivable. The higher this ratio, the higher is credit risk.

Accounts receivable turnover also reflects how well management is doing in granting credit to customers in a desire to increase sales. A high turnover in comparison with competitors suggests that management should consider using more liberal credit terms to increase sales. A low turnover suggests management should consider stricter credit terms and more aggressive collection efforts to avoid having its resources tied up in accounts receivable. To illustrate, we take fiscal year data from two competitors: Dell and Apple. Exhibit 7.19 shows ac- counts receivable turnover for both companies.

EXHIBIT 7.19 Analysis Using Accounts Receivable Turnover

Company Figure ($ millions) 2011 2010 2009 2008

Dell Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 61,494 $52,902 $61,101 $61,133

Average accounts receivable, net . . . . . . . . . . . $ 6,165 $ 5,284 $ 5,346 $ 5,292

Accounts receivable turnover . . . . . . . . . . 10.0 10.0 11.4 11.6

Apple Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,249 $65,225 $42,905 $37,491

Average accounts receivable, net . . . . . . . . . . . $ 5,440 $ 4,436 $ 2,892 $ 2,030

Accounts receivable turnover . . . . . . . . . . 19.9 14.7 14.8 18.5

2011 2010 2009 2008

11

10

9

12

13

14

15

16

18

17

20

19

Turnover

Apple DellAccounts Receivable Turnover:

Dell’s 2011 turnover is 10.0, computed as $61,494y$6,165 ($ millions). This means that Dell’s average accounts receivable balance was converted into cash 10.0 times in 2011. Its turnover was flat in 2011, but it had been slightly declining in recent years. Apple’s turnover exceeds that for Dell in each of the past 4 years. Is either company’s turnover too high? Since sales are stable or markedly growing over this time period, each company’s turnover rate does not appear to be too high. Instead, both Dell and Apple seem to be doing well in managing receivables. This is especially true given the

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318 Chapter 7 Accounts and Notes Receivable

recent recessionary period. Turnover for competitors is generally in the range of 7 to 12 for this same period.1

1 As an estimate of average days’ sales uncollected, we compute how many days (on average) it takes to collect receivables as follows: 365 days 4 accounts receivable turnover. An increase in this average collection period can signal a decline in customers’ financial condition.

DEMONSTRATION PROBLEM Clayco Company completes the following selected transactions during year 2013.

July 14 Writes off a $750 account receivable arising from a sale to Briggs Company that dates to 10 months ago. (Clayco Company uses the allowance method.)

30 Clayco Company receives a $1,000, 90-day, 10% note in exchange for merchandise sold to Sumrell Company (the merchandise cost $600).

Aug. 15 Receives $2,000 cash plus a $10,000 note from JT Co. in exchange for merchandise that sells for $12,000 (its cost is $8,000). The note is dated August 15, bears 12% interest, and matures in 120 days.

Nov. 1 Completed a $200 credit card sale with a 4% fee (the cost of sales is $150). The cash is received immediately from the credit card company.

3 Sumrell Company refuses to pay the note that was due to Clayco Company on October 28. Prepare the journal entry to charge the dishonored note plus accrued interest to Sumrell Com- pany’s accounts receivable.

5 Completed a $500 credit card sale with a 5% fee (the cost of sales is $300). The payment from the credit card company is received on Nov. 9.

15 Received the full amount of $750 from Briggs Company that was previously written off on July 14. Record the bad debts recovery.

Dec. 13 Received payment of principal plus interest from JT for the August 15 note.

Required

1. Prepare journal entries to record these transactions on Clayco Company’s books. 2. Prepare an adjusting journal entry as of December 31, 2013, assuming the following: a. Bad debts are estimated to be $20,400 by aging accounts receivable. The unadjusted balance of the

Allowance for Doubtful Accounts is $1,000 debit. b. Alternatively, assume that bad debts are estimated using the percent of sales method. The Allowance

for Doubtful Accounts had a $1,000 debit balance before adjustment, and the company estimates bad debts to be 1% of its credit sales of $2,000,000.

PLANNING THE SOLUTION ● Examine each transaction to determine the accounts affected, and then record the entries. ● For the year-end adjustment, record the bad debts expense for the two approaches.

Family Physician Your medical practice is barely profitable, so you hire a health care analyst. The analyst highlights several points including the following: “Accounts receivable turnover is too low. Tighter credit policies are recommended along with discontinuing service to those most delayed in payments.” How do you interpret these recommendations? What actions do you take? ■ [Answer—p. 321]

Decision Maker

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Chapter 7 Accounts and Notes Receivable 319

SOLUTION TO DEMONSTRATION PROBLEM 1.

July 14 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . 750

Accounts Receivable—Briggs Co. . . . . . . . . . . . . . . 750

Wrote off an uncollectible account.

July 30 Notes Receivable—Sumrell Co. . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold merchandise for a 90-day, 10% note.

July 30 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 600

To record the cost of July 30 sale.

Aug. 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Notes Receivable—JT Co. . . . . . . . . . . . . . . . . . . . . . . . 10,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Sold merchandise to customer for $2,000 cash and $10,000 note.

Aug. 15 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 8,000

To record the cost of Aug. 15 sale.

Nov. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

Credit Card Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

To record credit card sale less a 4% credit card expense.

Nov. 1 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 150

To record the cost of Nov. 1 sale.

Nov. 3 Accounts Receivable—Sumrell Co. . . . . . . . . . . . . . . . . 1,025

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Notes Receivable—Sumrell Co. . . . . . . . . . . . . . . . 1,000

To charge account of Sumrell Company for a $1,000 dishonored note and interest of $1,000 3 10% 3 90y360.

Nov. 5 Accounts Receivable—Credit Card Co. . . . . . . . . . . . . . 475

Credit Card Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

To record credit card sale less a 5% credit card expense.

Nov. 5 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 300

To record the cost of Nov. 5 sale.

Nov. 9 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475

Accounts Receivable—Credit Card Co. . . . . . . . . . 475

To record cash receipt from Nov. 5 sale.

Nov. 15 Accounts Receivable—Briggs Co. . . . . . . . . . . . . . . . . . 750

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 750

To reinstate the account of Briggs Company previously written off.

Nov. 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750

Accounts Receivable—Briggs Co. . . . . . . . . . . . . . 750

Cash received in full payment of account.

Dec. 13 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,400

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Note Receivable—JT Co. . . . . . . . . . . . . . . . . . . . . 10,000

Collect note with interest of $10,000 3 12% 3 120y360.

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320 Chapter 7 Accounts and Notes Receivable

2a. Aging of accounts receivable method.

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,400

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 21,400

To adjust allowance account from a $1,000 debit balance to a $20,400 credit balance.

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Allowance for Doubtful Accounts . . . . . . . . . . . . . . 20,000

To provide for bad debts as 1% 3 $2,000,000 in credit sales.

2b. Percent of sales method.*

* For the income statement approach, which requires estimating bad debts as a percent of sales or credit sales, the Allowance account balance is not considered when making the adjusting entry.

C1 Describe accounts receivable and how they occur and are recorded. Accounts receivable are amounts due from custom- ers for credit sales. A subsidiary ledger lists amounts owed by each customer. Credit sales arise from at least two sources: (1) sales on credit and (2) credit card sales. Sales on credit refers to a company’s granting credit directly to customers. Credit card sales involve cus- tomers’ use of third-party credit cards.

C2 Describe a note receivable, the computation of its maturity date, and the recording of its existence. A note receivable is a written promise to pay a specified amount of money at a definite future date. The maturity date is the day the note (principal and in- terest) must be repaid. Interest rates are normally stated in annual terms. The amount of interest on the note is computed by expressing time as a fraction of one year and multiplying the note’s principal by this fraction and the annual interest rate. A note received is re- corded at its principal amount by debiting the Notes Receivable ac- count. The credit amount is to the asset, product, or service provided in return for the note.

C3 Explain how receivables can be converted to cash before maturity. Receivables can be converted to cash before matu- rity in three ways. First, a company can sell accounts receivable to a factor, who charges a factoring fee. Second, a company can borrow money by signing a note payable that is secured by pledging the ac- counts receivable. Third, notes receivable can be discounted at (sold to) a financial institution.

A1 Compute accounts receivable turnover and use it to help assess financial condition. Accounts receivable turnover is a measure of both the quality and liquidity of accounts receivable.

Summary The accounts receivable turnover measure indicates how often, on average, receivables are received and collected during the period. Accounts receivable turnover is computed as net sales divided by average accounts receivable.

P1 Apply the direct write-off method to account for accounts receivable. The direct write-off method charges Bad Debts Ex- pense when accounts are written off as uncollectible. This method is acceptable only when the amount of bad debts expense is immaterial.

P2 Apply the allowance method and estimate uncollectibles based on sales and accounts receivable. Under the allowance method, bad debts expense is recorded with an adjustment at the end of each accounting period that debits the Bad Debts Expense ac- count and credits the Allowance for Doubtful Accounts. The uncol- lectible accounts are later written off with a debit to the Allowance for Doubtful Accounts. Uncollectibles are estimated by focusing on either (1) the income statement relation between bad debts expense and credit sales or (2) the balance sheet relation between accounts receivable and the allowance for doubtful accounts. The first ap- proach emphasizes the matching principle using the income state- ment. The second approach emphasizes realizable value of accounts receivable using the balance sheet.

P3 Record the honoring and dishonoring of a note and adjust-ments for interest. When a note is honored, the payee debits the money received and credits both Notes Receivable and Interest Revenue. Dishonored notes are credited to Notes Receivable and debited to Accounts Receivable (to the account of the maker in an attempt to collect), and Interest Revenue is recorded for interest earned for the time the note is held.

Entrepreneur Analysis of credit card sales should weigh the benefits against the costs. The primary benefit is the potential to in- crease sales by attracting customers who prefer the convenience of credit cards. The primary cost is the fee charged by the credit card company for providing this service. Analysis should therefore esti-

mate the expected increase in dollar sales from allowing credit card sales and then subtract (1) the normal costs and expenses and (2) the credit card fees associated with this expected increase in dollar sales. If your analysis shows an increase in profit from allowing credit card sales, your store should probably accept them.

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 7 Accounts and Notes Receivable 321

Accounts receivable (p. 302)

Accounts receivable turnover (p. 317)

Aging of accounts receivable (p. 310)

Allowance for Doubtful Accounts (p. 307)

Allowance method (p. 307)

Bad debts (p. 306)

Key Terms

Labor Union Chief Yes, this information is likely to impact your negotiations. The obvious question is why the company mark- edly increased this allowance. The large increase in this allowance means a substantial increase in bad debts expense and a decrease in earnings. This change (coming immediately prior to labor contract discussions) also raises concerns since it reduces the union’s bargain- ing power for increased compensation. You want to ask management for supporting documentation justifying this increase. You also want data for two or three prior years and similar data from competitors. These data should give you some sense of whether the change in the allowance for uncollectibles is justified.

Analyst/Auditor The downward trend suggests the company is reducing the relative amount charged to bad debts expense each year. This may reflect the company’s desire to increase net income. On the

other hand, it might be that collections have improved and the lower provision for bad debts is justified. If this is not the case, the lower allowances might be insufficient for bad debts.

Family Physician The recommendations are twofold. First, the analyst suggests more stringent screening of patients’ credit stand- ing. Second, the analyst suggests dropping patients who are most overdue in payments. You are likely bothered by both suggestions. They are probably financially wise recommendations, but you are troubled by eliminating services to those less able to pay. One alternative is to follow the recommendations while implementing a care program directed at patients less able to pay for services. This allows you to continue services to patients less able to pay and lets you discontinue services to patients able but unwilling to pay.

1. If cash is immediately received when credit card sales receipts are deposited, the company debits Cash at the time of sale. If the company does not receive payment until after it submits re- ceipts to the credit card company, it debits Accounts Receivable at the time of sale. (Cash is later debited when payment is received from the credit card company.)

2. Credit card expenses are usually recorded and incurred at the time of their related sales, not when cash is received from the credit card company.

3. If possible, bad debts expense must be matched with the sales that gave rise to the accounts receivable. This requires that companies estimate future bad debts at the end of each period before they learn which accounts are uncollectible.

4. Realizable value (also called net realizable value). 5. The estimated amount of bad debts expense cannot be credited

to the Accounts Receivable account because the specific cus- tomer accounts that will prove uncollectible cannot yet be iden- tified and removed from the accounts receivable subsidiary ledger. Moreover, if only the Accounts Receivable account is credited, its balance would not equal the sum of its subsidiary account balances.

6.

Guidance Answers to Quick Checks

Dec. 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . 5,702

Allowance for Doubtful Accounts . . . . . . 5,702

7. Jan. 10 Allowance for Doubtful Accounts . . . . . . . . . . 300

Accounts Receivable — Cool Jam . . . . . . . 300

Apr. 12 Accounts Receivable — Cool Jam . . . . . . . . . . . 300

Allowance for Doubtful Accounts . . . . . . 300

Apr. 12 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Accounts Receivable — Cool Jam . . . . . . . 300

8. Dec. 16 Note Receivable — Irwin . . . . . . . . . . . . . . . . . 7,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Dec. 31 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . 35

Interest Revenue . . . . . . . . . . . . . . . . . . . 35

($7,000 3 12% 3 15y360)

9. Mar. 16 Accounts Receivable — Irwin . . . . . . . . . . . . . . 7,210

Interest Revenue . . . . . . . . . . . . . . . . . . . 175

Interest Receivable . . . . . . . . . . . . . . . . . . 35

Notes Receivable—Irwin . . . . . . . . . . . . . 7,000

10. The note matures on November 14, computed as follows:

Days in September . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Minus the date of the note . . . . . . . . . . . . . . . . . . . (15)

Days remaining in September . . . . . . . . . . . . . . . . . 15

Add days in October . . . . . . . . . . . . . . . . . . . . . . . . 31

Add days in November to equal 60 days. . . . . . . . . 14

Period of the note in days . . . . . . . . . . . . . . . . . . . . 60

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322 Chapter 7 Accounts and Notes Receivable

Direct write-off method (p. 306)

Interest (p. 312)

Maker of the note (p. 312)

Matching (expense recognition) principle (p. 306)

Materiality constraint (p. 306)

Maturity date of a note (p. 312)

Payee of the note (p. 312)

Principal of a note (p. 312)

Promissory note (or note) (p. 312)

Realizable value (p. 307)

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 333 mhhe.com/wildFINMAN5e

3. Total interest to be earned on a $7,500, 5%, 90-day note is a. $93.75 b. $375.00 c. $1,125.00 d. $31.25 e. $125.00 4. A company receives a $9,000, 8%, 60-day note. The maturity

value of the note is a. $120 b. $9,000 c. $9,120 d. $720 e. $9,720 5. A company has net sales of $489,600 and average accounts re-

ceivable of $40,800. What is its accounts receivable turnover? a. 0.08 b. 30.41 c. 1,341.00 d. 12.00 e. 111.78

1. A company’s Accounts Receivable balance at its December 31 year-end is $125,650, and its Allowance for Doubtful Accounts has a credit balance of $328 before year-end adjustment. Its net sales are $572,300. It estimates that 4% of outstanding accounts receivable are uncollectible. What amount of Bad Debts Ex- pense is recorded at December 31?

a. $5,354 b. $328 c. $5,026 d. $4,698 e. $34,338 2. A company’s Accounts Receivable balance at its December 31

year-end is $489,300, and its Allowance for Doubtful Accounts has a debit balance of $554 before year-end adjustment. Its net sales are $1,300,000. It estimates that 6% of outstanding ac- counts receivable are uncollectible. What amount of Bad Debts Expense is recorded at December 31?

a. $29,912 b. $28,804 c. $78,000 d. $29,358 e. $554

1. How do sellers benefit from allowing their customers to use credit cards?

2. Why does the direct write-off method of accounting for bad debts usually fail to match revenues and expenses?

3. Explain the accounting constraint of materiality. 4. Why might a business prefer a note receivable to an account

receivable? 5. Explain why writing off a bad debt against the Allowance for

Doubtful Accounts does not reduce the estimated realizable value of a company’s accounts receivable.

6. Why does the Bad Debts Expense account usually not have the same adjusted balance as the Allowance for Doubtful Accounts?

7. Refer to the financial statements and notes of Polaris in Appendix A. In its presentation of ac- counts receivable on the balance sheet, how does it title

accounts receivable? What does it report for its allowance as of December 31, 2011?

8. Refer to the balance sheet of Arctic Cat in Appendix A. Does it use the direct write-off method or allowance method in accounting for its accounts receivable? What is the realizable value of its receivable’s balance as of March 31, 2011?

9. Refer to the financial statements of KTM in Appen- dix A. What does KTM title its accounts receivable on its consolidated balance sheet? What are KTM’s accounts receivable at December 31, 2011?

10. Refer to the December 31, 2011, financial statements of Piaggio in Appendix A. What does it title its accounts receivable on its statement of financial position? Does Piaggio report its accounts receivable as current or non-current asset?

Discussion Questions

Icon denotes assignments that involve decision making.

Polaris

Arctic Cat

KTM

PIAGGIO

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Chapter 7 Accounts and Notes Receivable 323

QS 7-2 Allowance method for bad debts

P2

Gomez Corp. uses the allowance method to account for uncollectibles. On January 31, it wrote off a $800 account of a customer, C. Green. On March 9, it receives a $300 payment from Green. 1. Prepare the journal entry or entries for January 31. 2. Prepare the journal entry or entries for March 9; assume no additional money is expected from Green.

QS 7-3 Percent of accounts receivable method

P2

Warner Company’s year-end unadjusted trial balance shows accounts receivable of $99,000, allowance for doubtful accounts of $600 (credit), and sales of $280,000. Uncollectibles are estimated to be 1.5% of ac- counts receivable. 1. Prepare the December 31 year-end adjusting entry for uncollectibles. 2. What amount would have been used in the year-end adjusting entry if the allowance account had a

year-end unadjusted debit balance of $300?

QS 7-4 Percent of sales method P2

Assume the same facts as in QS 7-3, except that Warner estimates uncollectibles as 0.5% of sales. Prepare the December 31 year-end adjusting entry for uncollectibles.

QS 7-5 Note receivable C2

On August 2, 2013, Jun Co. receives a $6,000, 90-day, 12% note from customer Ryan Albany as payment on his $6,000 account. (1) Compute the maturity date for this note. (2) Prepare Jun’s journal entry for August 2.

QS 7-6 Note receivable P3

Refer to the information in QS 7-5 and prepare the journal entry assuming the note is honored by the cus- tomer on October 31, 2013.

QS 7-7 Note receivable P3

Dominika Company’s December 31 year-end unadjusted trial balance shows a $10,000 balance in Notes Receivable. This balance is from one 6% note dated December 1, with a period of 45 days. Prepare any necessary journal entries for December 31 and for the note’s maturity date assuming it is honored.

QS 7-8 Disposing receivables C3

Record the sale by Balus Company of $125,000 in accounts receivable on May 1. Balus is charged a 2.5% factoring fee.

QS 7-9 Direct write-off method P1

Solstice Company determines on October 1 that it cannot collect $50,000 of its accounts receivable from its customer P. Moore. Apply the direct write-off method to record this loss as of October 1.

QS 7-10 Recovering a bad debt P1

Refer to the information in QS 7-9. On October 30, P. Moore unexpectedly paid his account in full to Solstice Company. Record Solstice’s entry(ies) to reflect this recovery of this bad debt.

QS 7-12 International accounting standards

C1

Answer each of the following related to international accounting standards. a. Explain (in general terms) how the accounting for recognition of receivables is different between

IFRS and U.S. GAAP. b. Explain (in general terms) how the accounting for valuation of receivables is different between IFRS

and U.S. GAAP.

QS 7-11 Accounts receivable turnover

A1

The following data are taken from the comparative balance sheets of Ruggers Company. Compute and interpret its accounts receivable turnover for year 2013 (competitors average a turnover of 7.5).

2013 2012

Accounts receivable, net . . . . . . . . . $153,400 $138,500

Net sales . . . . . . . . . . . . . . . . . . . . . 861,105 910,600

QUICK STUDY

QS 7-1 Credit card sales

C1

Prepare journal entries for the following credit card sales transactions (the company uses the perpetual in- ventory system). 1. Sold $20,000 of merchandise, that cost $15,000, on MasterCard credit cards. The net cash receipts

from sales are immediately deposited in the seller’s bank account. MasterCard charges a 5% fee. 2. Sold $5,000 of merchandise, that cost $3,000, on an assortment of credit cards. Net cash receipts are

received 5 days later, and a 4% fee is charged.

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324 Chapter 7 Accounts and Notes Receivable

EXERCISES

Exercise 7-1 Accounts receivable subsidiary ledger; schedule of accounts receivable

C1

Morales Company recorded the following selected transactions during November 2013.

Dexter Company applies the direct write-off method in accounting for uncollectible accounts. Prepare journal entries to record the following selected transactions of Dexter.

March 11 Dexter determines that it cannot collect $45,000 of its accounts receivable from its customer Lester Company.

29 Lester Company unexpectedly pays its account in full to Dexter Company. Dexter records its recovery of this bad debt.

Exercise 7-3 Direct write-off method

P1

At year-end (December 31), Chan Company estimates its bad debts as 0.5% of its annual credit sales of $975,000. Chan records its Bad Debts Expense for that estimate. On the following February 1, Chan decides that the $580 account of P. Park is uncollectible and writes it off as a bad debt. On June 5, Park unexpectedly pays the amount previously written off. Prepare the journal entries of Chan to record these transactions and events of December 31, February 1, and June 5.

Exercise 7-4 Percent of sales method; write-off

P2

At each calendar year-end, Mazie Supply Co. uses the percent of accounts receivable method to estimate bad debts. On December 31, 2013, it has outstanding accounts receivable of $55,000, and it estimates that 2% will be uncollectible. Prepare the adjusting entry to record bad debts expense for year 2013 under the assumption that the Allowance for Doubtful Accounts has (a) a $415 credit balance before the adjustment and (b) a $291 debit balance before the adjustment.

Exercise 7-5 Percent of accounts receivable method

P2

Nov. 5 Accounts Receivable—Ski Shop . . . . . . . . . . . . . . . . . . . 4,615

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,615

10 Accounts Receivable—Welcome Enterprises . . . . . . . . 1,350

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,350

13 Accounts Receivable—Zia Natara . . . . . . . . . . . . . . . . . 832

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 832

21 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 209

Accounts Receivable—Zia Natara . . . . . . . . . . . . . 209

30 Accounts Receivable—Ski Shop . . . . . . . . . . . . . . . . . . . 2,713

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,713

Levine Company uses the perpetual inventory system and allows customers to use two credit cards in charg- ing purchases. With the Suntrust Bank Card, Levine receives an immediate credit to its account when it de- posits sales receipts. Suntrust assesses a 4% service charge for credit card sales. The second credit card that Levine accepts is the Continental Card. Levine sends its accumulated receipts to Continental on a weekly basis and is paid by Continental about a week later. Continental assesses a 2.5% charge on sales for using its card. Prepare journal entries to record the following selected credit card transactions of Levine Company.

Apr. 8 Sold merchandise for $8,400 (that had cost $6,000) and accepted the customer’s Suntrust Bank Card. The Suntrust receipts are immediately deposited in Levine’s bank account.

12 Sold merchandise for $5,600 (that had cost $3,500) and accepted the customer’s Continental Card. Transferred $5,600 of credit card receipts to Continental, requesting payment.

20 Received Continental’s check for the April 12 billing, less the service charge.

Exercise 7-2 Accounting for credit card sales

C1

Daley Company estimates uncollectible accounts using the allowance method at December 31. It prepared the following aging of receivables analysis.

Exercise 7-6 Aging of receivables method

P2 Days Past Due

Total 0 1 to 30 31 to 60 61 to 90 Over 90

Accounts receivable . . . . . . . . . $570,000 $396,000 $90,000 $36,000 $18,000 $30,000

Percent uncollectible . . . . . . . . 1% 2% 5% 7% 10%

1. Open a general ledger having T-accounts for Accounts Receivable, Sales, and Sales Returns and Al- lowances. Also open an accounts receivable subsidiary ledger having a T-account for each customer. Post these entries to both the general ledger and the accounts receivable ledger.

2. Prepare a schedule of accounts receivable (see Exhibit 7.4) and compare its total with the balance of the Accounts Receivable controlling account as of November 30.

Check Accounts Receivable ending balance, $9,301

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Chapter 7 Accounts and Notes Receivable 325

a. Estimate the balance of the Allowance for Doubtful Accounts using the aging of accounts receivable method.

b. Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $3,600 credit.

c. Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $100 debit.

Exercise 7-7 Percent of receivables method

P2

Refer to the information in Exercise 7-6 to complete the following requirements. a. Estimate the balance of the Allowance for Doubtful Accounts assuming the company uses 4.5% of

total accounts receivable to estimate uncollectibles, instead of the aging of receivables method. b. Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the

unadjusted balance in the Allowance for Doubtful Accounts is a $12,000 credit. c. Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the

unadjusted balance in the Allowance for Doubtful Accounts is a $1,000 debit.

Exercise 7-8 Writing off receivables

P2

Refer to the information in Exercise 7-6 to complete the following requirements. a. On February 1 of the next period, the company determined that $6,800 in customer accounts is

uncollectible; specifically, $900 for Oakley Co. and $5,900 for Brookes Co. Prepare the journal entry to write off those accounts.

b. On June 5 of that next period, the company unexpectedly received a $900 payment on a customer ac- count, Oakley Company, that had previously been written off in part a. Prepare the entries necessary to reinstate the account and to record the cash received.

Exercise 7-10 Selling and pledging accounts receivable

C3

On June 30, Petrov Co. has $128,700 of accounts receivable. Prepare journal entries to record the following selected July transactions. Also prepare any footnotes to the July 31 financial statements that result from these transactions. (The company uses the perpetual inventory system.)

July 4 Sold $7,245 of merchandise (that had cost $5,000) to customers on credit. 9 Sold $20,000 of accounts receivable to Main Bank. Main charges a 4% factoring fee. 17 Received $5,859 cash from customers in payment on their accounts. 27 Borrowed $10,000 cash from Main Bank, pledging $12,500 of accounts receivable as security

for the loan.

Exercise 7-11 Honoring a note

P3

Prepare journal entries to record these selected transactions for Vitalo Company (no reversing entries are recorded).

Nov. 1 Accepted a $6,000, 180-day, 8% note dated November 1 from Kelly White in granting a time extension on her past-due account receivable.

Dec. 31 Adjusted the year-end accounts for the accrued interest earned on the White note. Apr. 30 White honors her note when presented for payment; February has 28 days for the current year.

Exercise 7-9 Estimating bad debts

P2

At December 31, Folgeys Coffee Company reports the following results for its calendar year.

Cash sales . . . . . . . . . . . . $900,000

Credit sales . . . . . . . . . . . 300,000

Its year-end unadjusted trial balance includes the following items.

a. Prepare the adjusting entry to record Bad Debts Expense assuming uncollectibles are estimated to be 1.5% of credit sales.

b. Prepare the adjusting entry to record Bad Debts Expense assuming uncollectibles are estimated to be 0.5% of total sales.

c. Prepare the adjusting entry to record Bad Debts Expense assuming uncollectibles are estimated to be 6% of year-end accounts receivable.

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . $125,000 debit

Allowance for doubtful accounts . . . . . . . . . . . . 5,000 debit

Check Dr. Bad Debts Expense: (a) $4,500

(c) $12,500

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326 Chapter 7 Accounts and Notes Receivable

Prepare journal entries to record the following selected transactions of Ridge Company.

Mar. 21 Accepted a $9,500, 180-day, 8% note dated March 21 from Tamara Jackson in granting a time extension on her past-due account receivable.

Sept. 17 Jackson dishonors her note when it is presented for payment. Dec. 31 After exhausting all legal means of collection, Ridge Company writes off Jackson’s account

against the Allowance for Doubtful Accounts.

Exercise 7-12 Dishonoring a note

P3

Refer to the information in Exercise 7-13 and prepare the journal entries for the following selected transac- tions of Dulcinea Company for 2013.

2013

Jan. 27 Received Lee’s payment for principal and interest on the note dated December 13. Mar. 3 Accepted a $5,000, 10%, 90-day note dated March 3 in granting a time extension on the past-

due account receivable of Tomas Company. 17 Accepted a $2,000, 30-day, 9% note dated March 17 in granting Hiroshi Cheng a time extension

on his past-due account receivable. Apr. 16 Cheng dishonors his note when presented for payment. May 1 Wrote off the Cheng account against the Allowance for Doubtful Accounts. June 1 Received the Tomas payment for principal and interest on the note dated March 3.

Exercise 7-14 Notes receivable transactions

P3

Check Jan. 27, Dr. Cash $9,595

June 1, Dr. Cash $5,125

Hitachi, Ltd., reports total revenues of ¥9,315,807 million for its fiscal year ending March 31, 2011, and its March 31, 2011, unadjusted trial balance reports a debit balance for trade receivables (gross) of ¥2,127,682 million. a. Prepare the adjusting entry to record its Bad Debts Expense assuming uncollectibles are estimated to

be 0.4% of total revenues and its unadjusted trial balance reports a credit balance of ¥10,000 million. b. Prepare the adjusting entry to record Bad Debts Expense assuming uncollectibles are estimated to be

2.1% of year-end trade receivables (gross) and its unadjusted trial balance reports a credit balance of ¥10,000 million.

Exercise 7-16 Accounting for bad debts following IFRS

P2

Prepare journal entries for the following selected transactions of Dulcinea Company for 2012.

2012

Dec. 13 Accepted a $9,500, 45-day, 8% note dated December 13 in granting Miranda Lee a time extension on her past-due account receivable.

31 Prepared an adjusting entry to record the accrued interest on the Lee note.

Exercise 7-13 Notes receivable transactions

C2

Check Dec. 31, Cr. Interest Revenue $38

The following information is from the annual financial statements of Raheem Company. Compute its ac- counts receivable turnover for 2012 and 2013. Compare the two years results and give a possible explana- tion for any change (competitors average a turnover of 11).

Exercise 7-15 Accounts receivable turnover

A1

2013 2012 2011

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $405,140 $335,280 $388,000

Accounts receivable, net (year-end) . . . . . . . . . 44,800 41,400 34,800

PROBLEM SET A

Problem 7-1A Sales on account and credit card sales

C1

Mayfair Co. allows select customers to make purchases on credit. Its other customers can use either of two credit cards: Zisa or Access. Zisa deducts a 3% service charge for sales on its credit card and credits the bank account of Mayfair immediately when credit card receipts are deposited. Mayfair deposits the Zisa credit card receipts each business day. When customers use Access credit cards, Mayfair accumulates the receipts for several days before submitting them to Access for payment. Access deducts a 2% service charge and usually pays within one week of being billed. Mayfair completes the following transactions in June. (The terms of all credit sales are 2/15, n/30, and all sales are recorded at the gross price.)

June 4 Sold $650 of merchandise (that had cost $400) on credit to Natara Morris. 5 Sold $6,900 of merchandise (that had cost $4,200) to customers who used their Zisa cards.

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Chapter 7 Accounts and Notes Receivable 327

6 Sold $5,850 of merchandise (that had cost $3,800) to customers who used their Access cards. 8 Sold $4,350 of merchandise (that had cost $2,900) to customers who used their Access cards. 10 Submitted Access card receipts accumulated since June 6 to the credit card company for

payment. 13 Wrote off the account of Abigail McKee against the Allowance for Doubtful Accounts. The

$429 balance in McKee’s account stemmed from a credit sale in October of last year. 17 Received the amount due from Access. 18 Received Morris’s check in full payment for the purchase of June 4.

Required

Prepare journal entries to record the preceding transactions and events. (The company uses the perpetual inventory system. Round amounts to the nearest dollar.)

Check June 17, Dr. Cash $9,996

Problem 7-2A Accounts receivable transactions and bad debts adjustments

C1 P2

Liang Company began operations on January 1, 2012. During its first two years, the company completed a number of transactions involving sales on credit, accounts receivable collections, and bad debts. These transactions are summarized as follows:

2012

a. Sold $1,345,434 of merchandise (that had cost $975,000) on credit, terms n/30. b. Wrote off $18,300 of uncollectible accounts receivable. c. Received $669,200 cash in payment of accounts receivable. d. In adjusting the accounts on December 31, the company estimated that 1.5% of accounts receivable

will be uncollectible.

2013

e. Sold $1,525,634 of merchandise (that had cost $1,250,000) on credit, terms n/30. f. Wrote off $27,800 of uncollectible accounts receivable. g. Received $1,204,600 cash in payment of accounts receivable. h. In adjusting the accounts on December 31, the company estimated that 1.5% of accounts receivable

will be uncollectible.

Required

Prepare journal entries to record Liang’s 2012 and 2013 summarized transactions and its year-end adjust- ments to record bad debts expense. (The company uses the perpetual inventory system and it applies the allowance method for its accounts receivable. Round amounts to the nearest dollar.)

Check (d) Dr. Bad Debts Expense $28,169

(h) Dr. Bad Debts Expense $32,199

Problem 7-3A Estimating and reporting bad debts

P2

At December 31, 2013, Hawke Company reports the following results for its calendar year.

In addition, its unadjusted trial balance includes the following items.

Required

1. Prepare the adjusting entry for this company to recognize bad debts under each of the following inde- pendent assumptions.

a. Bad debts are estimated to be 1.5% of credit sales. b. Bad debts are estimated to be 1% of total sales. c. An aging analysis estimates that 5% of year-end accounts receivable are uncollectible. 2. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31,

2013, balance sheet given the facts in part 1a. 3. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31,

2013, balance sheet given the facts in part 1c.

Cash sales . . . . . . . . . . $1,905,000

Credit sales . . . . . . . . . 5,682,000

Accounts receivable . . . . . . . . . . . . . . . . . . . $1,270,100 debit

Allowance for doubtful accounts . . . . . . . . . 16,580 debit

Check Bad Debts Expense: (1a) $85,230, (1c) $80,085

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328 Chapter 7 Accounts and Notes Receivable

Jarden Company has credit sales of $3.6 million for year 2013. On December 31, 2013, the company’s Allowance for Doubtful Accounts has an unadjusted credit balance of $14,500. Jarden prepares a schedule of its December 31, 2013, accounts receivable by age. On the basis of past experience, it estimates the percent of receivables in each age category that will become uncollectible. This information is summarized here.

Problem 7-4A Aging accounts receivable and accounting for bad debts

P2

Required

1. Estimate the required balance of the Allowance for Doubtful Accounts at December 31, 2013, using the aging of accounts receivable method.

2. Prepare the adjusting entry to record bad debts expense at December 31, 2013.

Analysis Component

3. On June 30, 2014, Jarden Company concludes that a customer’s $4,750 receivable (created in 2013) is uncollectible and that the account should be written off. What effect will this action have on Jarden’s 2014 net income? Explain.

Check (2) Dr. Bad Debts Expense $27,150

Not yet due

1 to 30 days past due

31 to 60 days past due

61 to 90 days past due

Over 90 days past due

Age of Accounts Receivable

Expected Percent Uncollectible

December 31, 2013 Accounts Receivable

1.25%

2.00

6.50

32.75

68.00

$830,000

254,000

86,000

38,000

12,000

The following selected transactions are from Ohlmeyer Company.

2012

Dec. 16 Accepted a $10,800, 60-day, 8% note dated this day in granting Danny Todd a time extension on his past-due account receivable.

31 Made an adjusting entry to record the accrued interest on the Todd note.

2013

Feb. 14 Received Todd’s payment of principal and interest on the note dated December 16. Mar. 2 Accepted an $6,100, 8%, 90-day note dated this day in granting a time extension on the past-

due account receivable from Midnight Co. 17 Accepted a $2,400, 30-day, 7% note dated this day in granting Ava Privet a time extension on

her past-due account receivable. Apr. 16 Privet dishonored her note when presented for payment. June 2 Midnight Co. refuses to pay the note that was due to Ohlmeyer Co. on May 31. Prepare the journal

entry to charge the dishonored note plus accrued interest to Midnight Co.’s accounts receivable. July 17 Received payment from Midnight Co. for the maturity value of its dishonored note plus interest

for 46 days beyond maturity at 8%. Aug. 7 Accepted an $7,450, 90-day, 10% note dated this day in granting a time extension on the past-

due account receivable of Mulan Co. Sept. 3 Accepted a $2,100, 60-day, 10% note dated this day in granting Noah Carson a time extension

on his past-due account receivable. Nov. 2 Received payment of principal plus interest from Carson for the September 3 note. Nov. 5 Received payment of principal plus interest from Mulan for the August 7 note. Dec. 1 Wrote off the Privet account against Allowance for Doubtful Accounts.

Required

1. Prepare journal entries to record these transactions and events. (Round amounts to the nearest dollar.)

Analysis Component

2. What reporting is necessary when a business pledges receivables as security for a loan and the loan is still outstanding at the end of the period? Explain the reason for this requirement and the accounting principle being satisfied.

Problem 7-5A Analyzing and journalizing notes receivable transactions

C2 C3 P3

Check Feb. 14, Cr. Interest Revenue $108

June 2, Cr. Interest Revenue $122

Nov. 2, Cr. Interest Revenue $35

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Chapter 7 Accounts and Notes Receivable 329

PROBLEM SET B

Problem 7-1B Sales on account and credit card sales

C1

Archer Co. allows select customers to make purchases on credit. Its other customers can use either of two credit cards: Commerce Bank or Aztec. Commerce Bank deducts a 3% service charge for sales on its credit card and immediately credits the bank account of Archer when credit card receipts are deposited. Archer deposits the Commerce Bank credit card receipts each business day. When customers use the Aztec card, Archer accumulates the receipts for several days and then submits them to Aztec for payment. Aztec deducts a 2% service charge and usually pays within one week of being billed. Archer completed the following transactions in August (terms of all credit sales are 2/10, n/30; and all sales are recorded at the gross price).

Aug. 4 Sold $3,700 of merchandise (that had cost $2,000) on credit to McKenzie Carpenter. 10 Sold $5,200 of merchandise (that had cost $2,800) to customers who used their Commerce

Bank credit cards. 11 Sold $1,250 of merchandise (that had cost $900) to customers who used their Aztec cards. 14 Received Carpenter’s check in full payment for the purchase of August 4. 15 Sold $3,240 of merchandise (that had cost $1,758) to customers who used their Aztec cards. 18 Submitted Aztec card receipts accumulated since August 11 to the credit card company for

payment. 22 Wrote off the account of Craw Co. against the Allowance for Doubtful Accounts. The $498

balance in Craw City’s account stemmed from a credit sale in November of last year. 25 Received the amount due from Aztec.

Required

Prepare journal entries to record the preceding transactions and events. (The company uses the perpetual inventory system. Round amounts to the nearest dollar.)

Problem 7-2B Accounts receivable transactions and bad debts adjustments

C1 P2

Sherman Co. began operations on January 1, 2012, and completed several transactions during 2012 and 2013 that involved sales on credit, accounts receivable collections, and bad debts. These transactions are summarized as follows.

2012

a. Sold $685,350 of merchandise (that had cost $500,000) on credit, terms n/30. b. Received $482,300 cash in payment of accounts receivable. c. Wrote off $9,350 of uncollectible accounts receivable. d. In adjusting the accounts on December 31, the company estimated that 1% of accounts receivable

will be uncollectible.

2013

e. Sold $870,220 of merchandise (that had cost $650,000) on credit, terms n/30. f. Received $990,800 cash in payment of accounts receivable. g. Wrote off $11,090 of uncollectible accounts receivable. h. In adjusting the accounts on December 31, the company estimated that 1% of accounts receivable

will be uncollectible.

Required

Prepare journal entries to record Sherman’s 2012 and 2013 summarized transactions and its year-end adjusting entry to record bad debts expense. (The company uses the perpetual inventory system and it applies the allowance method for its accounts receivable. Round amounts to the nearest dollar.)

Check Aug. 25, Dr. Cash $4,400

Check (d) Dr. Bad Debts Expense $11,287

(h) Dr. Bad Debts Expense $9,773

Problem 7-3B Estimating and reporting bad debts

P2

At December 31, 2013, Ingleton Company reports the following results for the year:

In addition, its unadjusted trial balance includes the following items:

Cash sales . . . . . . . . . $1,025,000

Credit sales . . . . . . . . 1,342,000

Accounts receivable . . . . . . . . . . . . . . . . . . . $575,000 debit

Allowance for doubtful accounts . . . . . . . . . 7,500 credit

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330 Chapter 7 Accounts and Notes Receivable

Required

1. Prepare the adjusting entry for Ingleton Co. to recognize bad debts under each of the following inde- pendent assumptions.

a. Bad debts are estimated to be 2.5% of credit sales. b. Bad debts are estimated to be 1.5% of total sales. c. An aging analysis estimates that 6% of year-end accounts receivable are uncollectible. 2. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31,

2013, balance sheet given the facts in part 1a. 3. Show how Accounts Receivable and the Allowance for Doubtful Accounts appear on its December 31,

2013, balance sheet given the facts in part 1c.

Check Bad debts expense: (1b) $35,505, (1c) $27,000

Hovak Company has credit sales of $4.5 million for year 2013. At December 31, 2013, the company’s Allowance for Doubtful Accounts has an unadjusted debit balance of $3,400. Hovak prepares a schedule of its December 31, 2013, accounts receivable by age. On the basis of past experience, it estimates the percent of receivables in each age category that will become uncollectible. This information is summarized here.

Problem 7-4B Aging accounts receivable and accounting for bad debts

P2

Not yet due

1 to 30 days past due

31 to 60 days past due

61 to 90 days past due

Over 90 days past due

Age of Accounts Receivable

Expected Percent Uncollectible

December 31, 2013 Accounts Receivable

$396,400

277,800

48,000

6,600

2,800

2.0%

4.0

8.5

39.0

82.0

Required

1. Compute the required balance of the Allowance for Doubtful Accounts at December 31, 2013, using the aging of accounts receivable method.

2. Prepare the adjusting entry to record bad debts expense at December 31, 2013.

Analysis Component

3. On July 31, 2014, Hovak concludes that a customer’s $3,455 receivable (created in 2013) is uncollect- ible and that the account should be written off. What effect will this action have on Hovak’s 2014 net income? Explain.

Check (2) Dr. Bad Debts Expense $31,390

The following selected transactions are from Springer Company.

2012

Nov. 1 Accepted a $4,800, 90-day, 8% note dated this day in granting Steve Julian a time extension on his past-due account receivable.

Dec. 31 Made an adjusting entry to record the accrued interest on the Julian note.

2013

Jan. 30 Received Julian’s payment for principal and interest on the note dated November 1. Feb. 28 Accepted a $12,600, 8%, 30-day note dated this day in granting a time extension on the past-

due account receivable from King Co. Mar. 1 Accepted a $6,200, 60-day, 12% note dated this day in granting Myron Shelley a time exten-

sion on his past-due account receivable. 30 The King Co. dishonored its note when presented for payment. April 30 Received payment of principal plus interest from M. Shelley for the March 1 note. June 15 Accepted a $2,000, 72-day, 8% note dated this day in granting a time extension on the past-due

account receivable of Ryder Solon. 21 Accepted a $9,500, 90-day, 8% note dated this day in granting J. Felton a time extension on his

past-due account receivable. Aug. 26 Received payment of principal plus interest from R. Solon for the note of June 15. Sep. 19 Received payment of principal plus interest from J. Felton for the June 21 note. Nov. 30 Wrote off King’s account against Allowance for Doubtful Accounts.

Problem 7-5B Analyzing and journalizing notes receivable transactions

C2 C3 P3

Check Jan. 30, Cr. Interest Revenue $32

April 30, Cr. Interest Revenue $124

Sep. 19, Cr. Interest Revenue $190

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Chapter 7 Accounts and Notes Receivable 331

Required

1. Prepare journal entries to record these transactions and events. (Round amounts to the nearest dollar.)

Analysis Component

2. What reporting is necessary when a business pledges receivables as security for a loan and the loan is still outstanding at the end of the period? Explain the reason for this requirement and the accounting principle being satisfied.

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 7 Adria Lopez, owner of Success Systems, realizes that she needs to begin accounting for bad debts expense. Assume that Success Systems has total revenues of $43,853 during the first three months of 2014, and that the Accounts Receivable balance on March 31, 2014, is $22,720.

Required

1. Prepare the adjusting entry needed for Success Systems to recognize bad debts expense on March 31, 2014, under each of the following independent assumptions (assume a zero unadjusted balance in the Allowance for Doubtful Accounts at March 31).

a. Bad debts are estimated to be 1% of total revenues. (Round amounts to the dollar.) b. Bad debts are estimated to be 2% of accounts receivable. (Round amounts to the dollar.) 2. Assume that Success Systems’ Accounts Receivable balance at June 30, 2014, is $20,250 and that one

account of $100 has been written off against the Allowance for Doubtful Accounts since March 31, 2014. If Adria Lopez uses the method prescribed in Part 1b, what adjusting journal entry must be made to recognize bad debts expense on June 30, 2014?

3. Should Adria Lopez consider adopting the direct write-off method of accounting for bad debts expense rather than one of the allowance methods considered in part 1? Explain.

SERIAL PROBLEM Success Systems

P1 P2

Check (2) Bad Debts Expense, $51

Beyond the Numbers

BTN 7-1 Refer to Polaris’ financial statements in Appendix A to answer the following. 1. What is the amount of Polaris’ accounts receivable as of December 31, 2011? 2. Compute Polaris’ accounts receivable turnover as of December 31, 2011. 3. How long does it take, on average, for the company to collect receivables? Do you believe that cus-

tomers actually pay the amounts due within this short period? Explain. 4. Polaris’ most liquid assets include (a) cash and cash equivalents, (b) receivables, and (c) inventory.

Compute the percentage that these liquid assets make up of current liabilities as of December 31, 2011. Do the same computations for December 31, 2010. Comment on the company’s ability to satisfy its cur- rent liabilities as of its 2011 year-end compared to its 2010 year-end.

5. What criteria did Polaris use to classify items as cash equivalents?

Fast Forward

6. Access Polaris’ financial statements for fiscal years after December 31, 2011, at its Website (www.Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Recompute parts 2 and 4 and comment on any changes since December 31, 2011.

REPORTING IN ACTION A1

BTN 7-2 Comparative figures for Polaris and Arctic Cat follow. COMPARATIVE ANALYSIS A1 P2

Polaris Arctic Cat

One Two One Two

Current Year Years Current Year Years

($ thousands) Year Prior Prior Year Prior Prior

Accounts receivable, net . . . . . . . . $ 115,302 $ 89,294 $ 90,405 $ 23,732 $ 29,227 $ 38,231

Net sales . . . . . . . . . . . . . . 2,659,949 1,991,139 1,565,887 464,651 450,728 563,613

Polaris

Polaris Arctic Cat

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332 Chapter 7 Accounts and Notes Receivable

Required

1. Compute the accounts receivable turnover for Polaris and Arctic Cat for each of the two most recent years using the data shown.

2. Using results from part 1, compute how many days it takes each company, on average, to collect receivables. Compare the collection periods for Polaris and Arctic Cat, and suggest at least one expla- nation for the difference.

3. Which company is more efficient in collecting its accounts receivable? Explain.

Hint: Average collection period equals 365 divided by the accounts receivable turnover.

BTN 7-3 Anton Blair is the manager of a medium-size company. A few years ago, Blair persuaded the owner to base a part of his compensation on the net income the company earns each year. Each December he estimates year-end financial figures in anticipation of the bonus he will receive. If the bonus is not as high as he would like, he offers several recommendations to the accountant for year-end adjustments. One of his favorite recommendations is for the controller to reduce the estimate of doubtful accounts.

Required

1. What effect does lowering the estimate for doubtful accounts have on the income statement and bal- ance sheet?

2. Do you believe Blair’s recommendation to adjust the allowance for doubtful accounts is within his right as manager, or do you believe this action is an ethics violation? Justify your response.

3. What type of internal control(s) might be useful for this company in overseeing the manager’s recom- mendations for accounting changes?

ETHICS CHALLENGE P2

BTN 7-4 As the accountant for Pure-Air Distributing, you attend a sales managers’ meeting devoted to a discussion of credit policies. At the meeting, you report that bad debts expense is estimated to be $59,000 and accounts receivable at year-end amount to $1,750,000 less a $43,000 allowance for doubtful accounts. Sid Omar, a sales manager, expresses confusion over why bad debts expense and the allowance for doubt- ful accounts are different amounts. Write a one-page memorandum to him explaining why a difference in bad debts expense and the allowance for doubtful accounts is not unusual. The company estimates bad debts expense as 2% of sales.

COMMUNICATING IN PRACTICE P2

BTN 7-6 Each member of a team is to participate in estimating uncollectibles using the aging schedule and percents shown in Problem 7-4A. The division of labor is up to the team. Your goal is to accurately complete this task as soon as possible. After estimating uncollectibles, check your estimate with the in- structor. If the estimate is correct, the team then should prepare the adjusting entry and the presentation of accounts receivable (net) for the December 31, 2013, balance sheet.

TEAMWORK IN ACTION P2

BTN 7-7 Kevin Plank of Under Armour is introduced in the chapter’s opening feature. Kevin currently sells his products through multiple outlets. Assume that he is considering two new selling options.

Plan A. Under Armour would begin selling additional products online directly to customers, which are only currently sold directly to stores. These new online customers would use their credit cards. It currently has the capability of selling through its Website with no additional investment in hardware or software. Credit sales are expected to increase by $250,000 per year. Costs associated with this plan are: cost of these sales will be $135,500, credit card fees will be 4.75% of sales, and additional recordkeeping and shipping costs

ENTREPRENEURIAL DECISION C1

BTN 7-5 Access eBay’s, January 31, 2012, filing of its 10-K report for the year ended December 31, 2011, at www.sec.gov.

Required

1. What is the amount of eBay’s net accounts receivable at December 31, 2011, and at December 31, 2010? 2. “Financial Statement Schedule II” to its financial statements lists eBay’s allowance for doubtful ac-

counts (including authorized credits). For the two years ended December 31, 2011 and 2010, com- pute its allowance for doubtful accounts (including authorized credits) as a percent of gross accounts receivable.

3. Do you believe that these percentages are reasonable based on what you know about eBay? Explain.

TAKING IT TO THE NET C1

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Chapter 7 Accounts and Notes Receivable 333

BTN 7-8 Many commercials include comments similar to the following: “We accept VISA” or “We do not accept American Express.” Conduct your own research by contacting at least five companies via in- terviews, phone calls, or the Internet to determine the reason(s) companies discriminate in their use of credit cards. Collect information on the fees charged by the different cards for the companies contacted. (The instructor can assign this as a team activity.)

HITTING THE ROAD C1

BTN 7-9 Key information from Piaggio (www.Piaggio.com), which manufactures two-, three- and four- wheel vehicles, and is Europe’s leading manufacturer of motorcycles and scooters, follows.

GLOBAL DECISION C1 P2

Euro in thousands Current Year Prior Year

Accounts receivable, net* . . . . . . . . 65,560 90,421

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 1,516,463 1,485,351

*Piaggio refers to it as “Trade receivables.”

1. Compute the accounts receivable turnover for the current year. 2. How long does it take on average for Piaggio to collect receivables? 3. Refer to BTN 7-2. How does Piaggio compare to Polaris and Arctic Cat in terms of its accounts receiv-

able turnover and its collection period?

will be 6% of sales. These online sales will reduce the sales to stores by $35,000 because some customers will now purchase items online. Sales to stores have a 25% gross margin percentage.

Plan B. Under Armour would expand its market to more stores. It would make additional credit sales of $500,000 to those stores. Costs associated with those sales are: cost of sales will be $375,000, additional recordkeeping and shipping will be 4% of sales, and uncollectible accounts will be 6.2% of sales.

Required

1. Compute the additional annual net income or loss expected under (a) Plan A and (b) Plan B. 2. Should Under Armour pursue either plan? Discuss both the financial and nonfinancial factors relevant

to this decision.

1. d; Desired balance in Allowance for Doubtful Accounts 5 $ 5,026 cr. ($125,650 3 0.04)

Current balance in Allowance for Doubtful Accounts 5 (328) cr. Bad Debts Expense to be recorded 5 $ 4,698 2. a; Desired balance in Allowance for Doubtful Accounts 5 $29,358 cr. ($489,300 3 0.06)

Current balance in Allowance for Doubtful Accounts 5 554 dr. Bad Debts Expense to be recorded 5 $29,912 3. a; $7,500 3 0.05 3 90y360 5 $93.75

4. c; Principal amount . . . . . . . . . . . . $9,000 Interest accrued . . . . . . . . . . . . . 120 ($9,000 3 0.08 3 60y360) Maturity value . . . . . . . . . . . . . . $9,120 5. d; $489,600y$40,800 5 12

ANSWERS TO MULTIPLE CHOICE QUIZ

Check (1b) Additional net income, $74,000

Polaris Arctic Cat

PIAGGIO

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Learning Objectives

CONCEPTUAL

C1 Explain the cost principle for computing the cost of plant assets. (p. 337) C2 Explain depreciation for partial years and changes in estimates. (p. 344) C3 Distinguish between revenue and capital expenditures, and account

for them. (p. 346)

ANALYTICAL

A1 Compute total asset turnover and apply it to analyze a company’s use of assets. (p. 355)

PROCEDURAL

P1 Compute and record depreciation using the straight-line, units-of-production, and declining-balance methods. (p. 340)

P2 Account for asset disposal through discarding or selling an asset. (p. 348) P3 Account for natural resource assets and their depletion. (p. 350) P4 Account for intangible assets. (p. 351)

P5 Appendix 8A—Account for asset exchanges. (p. 358)

A Look at This Chapter

This chapter introduces us to long-term assets. We explain how to account for a long-term asset’s cost, the allocation of an asset’s cost to periods benefiting from it, the recording of additional costs after an asset is purchased, and the disposal of an asset.

A Look Back

Chapters 6 and 7 focused on short-term assets: cash, cash equivalents, and receivables. We explained why they are known as liquid assets and described how companies account and report for them.

Long-Term Assets 8

A Look Ahead

Chapter 9 focuses on current liabilities. We explain how they are computed, recorded, and reported in financial statements. We also explain the accounting for company payroll and contingencies.

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Sitting Pretty

CANTON, GA—“It is never too early to start,” explains Sean Belnick. “Just do the research and find a way.” Sean’s way was to create BizChair.com to sell office chairs more efficiently. “I was inspired to create BizChair.com through my fascination with selling things on the Internet,” admits Sean. “Before selling of- fice chairs, I would sell Pokemon cards . . . on eBay. I started with $500 advertising and $100 for Website hosting . . . I was 14 at the time.” From those modest beginnings Sean has continued to expand his business beyond office chairs and now sells stack chairs, folding chairs, recliners, and a range of office, home, and medical equipment. “Business has been really good,” says Sean. However, long-term assets such as warehousing facilities, office structures, packing equipment, and delivery and conveyor systems are expensive. Sean explains that financing equipment, machinery, and similar assets is a challenge. “Most likely [because of asset funding limitations] we stayed in the office chair market for a while before expanding into office furniture and home furniture as well as some other segments,” explains Sean. “If we had done that faster, we could have cemented a larger position as a market leader.” Further, Sean had to work out depreciation schedules and estimate payback for different asset purchases as his business grew.

BizChair.com is now sitting pretty—employing over 150 workers, offering greater product selection, and generat- ing tens of millions in annual sales. Still, a constant challenge for Sean is maintaining the right kind and amount of assets to meet business demands and be profitable. Sean admits he had to learn how “to properly read and create a balance sheet and income statement, and how to create pro-forma financial statements [which] have helped me ultimately run the company better.” Sean says BizChair.com’s success depends on continued monitoring and control of asset costs. Each of his tangible and intangible assets commands Sean’s attention. He accounts for, manages, and focuses on recovering all costs of those long- term assets. “I love the excitement, the future growth pros- pects, as well as watching the company grow and prosper,” explains Sean. He recently oversaw a 150,000-square-foot ware- house expansion to make room for more inventory. His success in asset management permits BizChair.com “to focus on growth and continued expansion of the business.” Adds Sean, “I’m like any other kid!”

[Sources: BizChair.com Website, January 2013; Cherokee Tribune, June 2011; Goizueta Magazine, Winter 2009 and October 2010; Retire@21 June 2010; Under30CEO, January 2011]

Don’t be afraid to take risks . . . [but] not careless risks.” —SEAN BELNICK

Decision Insight

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Chapter Preview

This chapter focuses on long-term assets, which can be grouped into plant assets, natural resource assets, and intangible assets. Plant assets make up a large part of assets on most balance sheets, and they yield depreciation, often one of the largest expenses on income statements. The acquisition or building of a plant asset is often referred to as a capital expenditure. Capital expenditures are important events because they impact

both  the  short- and long-term success of a company. Natural resource assets and intangible assets have similar impacts. This chapter describes the purchase and use of these assets. We also explain what distinguishes these assets from other types of assets, how to determine their cost, how to allocate their costs to periods benefiting from their use, and how to dispose of them.

Natural Resources

Long-Term Assets

• Cost determination • Depletion • Plant assets used in

extracting resources

Plant Assets

• Cost determination • Depreciation • Additional expenditures • Disposals

Intangible Assets

• Cost determination • Amortization • Types of intangibles

Plant assets are tangible assets used in a company’s operations that have a useful life of more than one accounting period. Plant assets are also called plant and equipment; prop erty, plant, and equipment; or fixed assets. For many companies, plant assets make up the single largest class of

assets they own. Exhibit 8.1 shows plant assets as a per- cent of total assets for several companies. Not only do they make up a large percent of many companies’ assets, but their dollar values are large. McDonald’s plant assets, for instance, are reported at more than $22 billion, and Walmart reports plant assets of more than $107 billion.

Plant assets are set apart from other assets by two important features. First, plant assets are used in operations. This makes them different from, for instance, inventory that is held for sale and not used in operations. The distinctive feature here is use, not type of asset. A company that purchases a computer to resell it reports it on the balance sheet as inventory. If the same com- pany purchases this computer to use in operations, however, it is a plant asset. Another example is land held for future expansion, which is reported as a long-term investment. However, if this land holds a factory used in operations, the land is part of plant assets. Another example is equipment held for use in the event of a breakdown or for peak periods of production, which is reported in plant assets. If this same equipment is removed from use and held for sale, how- ever, it is not reported in plant assets. The second important feature is that plant assets have useful lives extending over more than one accounting period. This makes plant assets different from current assets such as supplies that are normally consumed in a short time period after they are placed in use.

EXHIBIT 8.1 Plant Assets of Selected Companies

As a Percent of Total Assets 0 20 40 60 80

eBay

McDonald's 69%$22,835 mil.

Boston Beer 53%$144 mil.

Walmart 60%$107,878 mil.

7%$1,986 mil.

Section 1 — Plant Assets

Point: The phrase capital-intensive refers to companies with large amounts invested in plant assets. Exhibit 8.1 reveals that McDonalds is more capital- intensive than eBay.

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Chapter 8 Long-Term Assets 337

The accounting for plant assets reflects these two features. Since plant assets are used in op- erations, we try to match their costs against the revenues they generate. Also, since their useful lives extend over more than one period, our matching of costs and revenues must extend over several periods. Specifically, we value plant assets (balance sheet effect) and then, for many of them, we allocate their costs to periods benefiting from their use (income statement effect). An important exception is land; land cost is not allocated to expense when we expect it to have an indefinite life. Exhibit 8.2 shows four main issues in accounting for plant assets: (1) computing the costs of plant assets, (2) allocating the costs of most plant assets (less any salvage amounts) against rev- enues for the periods they benefit, (3) accounting for expenditures such as repairs and improve- ments to plant assets, and (4) recording the disposal of plant assets. The following sections discuss these issues.

EXHIBIT 8.2 Issues in Accounting for Plant Assets

Acquisition 1. Compute cost

Disposal 4. Record disposal

2. Allocate cost to periods benefited 3. Account for subsequent expenditures

Use

Decline in asset value over its useful life

Point: It can help to view plant assets as prepaid expenses that benefit several future accounting periods.

Plant assets are recorded at cost when acquired. This is consistent with the cost principle. Cost includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use. The cost of a factory machine, for instance, includes its invoice cost less any cash discount for early payment, plus any necessary freight, unpacking, assembling, installing, and testing costs. Examples are the costs of building a base or foundation for a machine, providing elec- trical hookups, and testing the asset before using it in operations. To be recorded as part of the cost of a plant asset, an expenditure must be normal, reasonable, and necessary in preparing it for its intended use. If an asset is damaged during unpacking, the re- pairs are not added to its cost. Instead, they are charged to an expense account. Nor is a paid traffic fine for moving heavy machinery on city streets without a proper permit part of the machinery’s cost; but payment for a proper permit is included in the cost of machinery. Charges are sometimes incurred to modify or customize a new plant asset. These charges are added to the asset’s cost. We explain in this section how to determine the cost of plant assets for each of its four major classes.

Land When land is purchased for a building site, its cost includes the total amount paid for the land, in- cluding any real estate commissions, title insurance fees, legal fees, and any accrued property taxes paid by the purchaser. Payments for surveying, clearing, grading, and draining also are included in the cost of land. Other costs include government assessments, whether incurred at the time of pur- chase or later, for items such as public roadways, sewers, and sidewalks. These assessments are in- cluded because they permanently add to the land’s value. Land purchased as a building site sometimes includes structures that must be removed. In such cases, the total purchase price is charged to the Land account as is the cost of removing the structures, less any amounts recovered through sale of salvaged materials. To illustrate, assume that Starbucks paid $167,000 cash to ac- quire land for a retail store. This land had an old service garage that was removed at a net cost of

COST DETERMINATION

C1 Explain the cost principle for computing the cost of plant assets.

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338 Chapter 8 Long-Term Assets

EXHIBIT 8.3 Computing Cost of Land

Cash price of land . . . . . . . . . . . . . . . . $ 167,000

Net cost of garage removal . . . . . . . . 13,000

Closing costs . . . . . . . . . . . . . . . . . . . . 10,000

Cost of land . . . . . . . . . . . . . . . . . . . $190,000

$13,000 ($15,000 in costs less $2,000 proceeds from salvaged mate rials). Additional closing costs total $10,000, consisting of brokerage fees ($8,000), legal fees ($1,500), and title costs ($500). The cost of this land to Starbucks is $190,000 and is computed as shown in Exhibit 8.3.

Land Improvements Land has an indefinite (unlimited) life and is not usually used up over time. Land improve- ments such as parking lot surfaces, driveways, fences, shrubs, and lighting systems, however, have limited useful lives and are used up. While the costs of these improvements increase the usefulness of the land, they are charged to a separate Land Improvement account so that their costs can be allocated to the periods they benefit.

Buildings A Building account is charged for the costs of purchasing or constructing a building that is used in operations. When purchased, a building’s costs usually include its purchase price, brokerage

fees, taxes, title fees, and attorney fees. Its costs also include all expenditures to ready it for its intended use, including any nec- essary repairs or renovations such as wiring, lighting, flooring, and wall coverings. When a company constructs a building or any plant asset for its own use, its costs include materials and labor plus a reasonable amount of indirect overhead cost. Over- head includes the costs of items such as heat, lighting, power, and depreciation on machinery used to construct the asset. Costs of construction also include design fees, building permits, and

insurance during construction. However, costs such as insurance to cover the asset after it is placed in use are operating expenses.

Machinery and Equipment The costs of machinery and equipment consist of all costs normal and necessary to purchase them and prepare them for their intended use. These include the purchase price, taxes, trans- porta tion charges, insurance while in transit, and the installing, assembling, and testing of the machinery and equipment.

Lump-Sum Purchase Plant assets sometimes are purchased as a group in a single transaction for a lump-sum price. This transaction is called a lump-sum purchase, or group, bulk, or basket purchase. When this occurs, we allocate the cost of the purchase among the different types of assets acquired based on their relative market values, which can be estimated by appraisal or by using the tax- assessed valuations of the assets. To illustrate, assume CarMax paid $90,000 cash to acquire a group of items consisting of land appraised at $30,000, land improvements appraised at $10,000, and a building appraised at $60,000. The $90,000 cost is allocated on the basis of these appraised values as shown in Exhibit 8.4.

Example: If appraised values in Exhibit 8.4 are land, $24,000; land improvements, $12,000; and building, $84,000, what cost is assigned to the building? Answer: (1) $24,000 1 $12,000 1 $84,000

5 $120,000 (total appraisal) (2) $84,000y$120,000 5 70%

(building’s percent of total) (3) 70% 3 $90,000 5 $63,000

(building’s apportioned cost)

EXHIBIT 8.4 Computing Costs in a Lump-Sum Purchase

Appraised Value Percent of Total Apportioned Cost

Land . . . . . . . . . . . . . . . . . . . . . $ 30,000 30% ($30,000y$100,000) $27,000 ($90,000 3 30%) Land improvements . . . . . . . . . 10,000 10 ($10,000y$100,000) 9,000 ($90,000 3 10%) Building . . . . . . . . . . . . . . . . . . 60,000 60 ($60,000y$100,000) 54,000 ($90,000 3 60%) Totals . . . . . . . . . . . . . . . . . . . . $100,000 100% $ 90,000

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Chapter 8 Long-Term Assets 339

1. Identify the asset class for each of the following: (a) supplies, (b) office equipment, (c) inventory, (d ) land for future expansion, and (e) trucks used in operations.

2. Identify the account charged for each of the following: (a) the purchase price of a vacant lot to be used in operations and (b) the cost of paving that same vacant lot.

3. Compute the amount recorded as the cost of a new machine given the following payments related to its purchase: gross purchase price, $700,000; sales tax, $49,000; purchase discount taken, $21,000; freight cost — terms FOB shipping point, $3,500; normal assembly costs, $3,000; cost of necessary machine platform, $2,500; cost of parts used in maintaining machine, $4,200.

Quick Check Answers — p. 361

Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use. Depreciation does not measure the decline in the asset’s market value each period, nor does it measure the asset’s physical deterioration. Since depreciation re- flects the cost of using a plant asset, depreciation charges are only recorded when the asset is actu- ally in service. This section describes the factors we must consider in computing depreciation, the depreciation methods used, revisions in depreciation, and depreciation for partial periods.

Factors in Computing Depreciation Factors that determine depreciation are (1) cost, (2) salvage value, and (3) useful life.

Cost The cost of a plant asset consists of all necessary and reasonable expenditures to acquire it and to prepare it for its intended use.

Salvage Value The total amount of depreciation to be charged off over an asset’s benefit period equals the asset’s cost minus its salvage value. Salvage value, also called residual value or scrap value, is an estimate of the asset’s value at the end of its benefit period. This is the amount the owner expects to receive from disposing of the asset at the end of its benefit period. If the asset is expected to be traded in on a new asset, its salvage value is the expected trade-in value.

Useful Life The useful life of a plant asset is the length of time it is productively used in a company’s operations. Useful life, also called service life, might not be as long as the asset’s total productive life. For example, the productive life of a computer can be eight years or more. Some companies, however, trade in old computers for new ones every two years. In this case, these computers have a two-year useful life, meaning the cost of these computers (less their expected trade-in values) is charged to depreciation expense over a two-year period. Several variables often make the useful life of a plant asset difficult to predict. A major vari- able is the wear and tear from use in operations. Two other variables, inadequacy and obsoles- cence, also require consideration. Inadequacy refers to the insufficient capacity of a company’s plant assets to meet its growing productive demands. Obsolescence refers to the condition of a plant asset that is no longer useful in producing goods or ser vices with a competitive advantage because of new inventions and improvements. Both inadequacy and obsolescence are difficult to predict because of demand changes, new inventions, and improvements. A company usually disposes of an inadequate or obsolete asset before it wears out. A company is often able to better predict a new asset’s useful life when it has past experience with a similar asset. When it has no such experience, a company relies on the experience of oth- ers or on engineering studies and judgment. In note 1 of its annual report, Tootsie Roll, a snack food manufacturer, reports the following useful lives:

DEPRECIATION

Point: If we expect additional costs in preparing a plant asset for disposal, the salvage value equals the expected amount from disposal less any disposal costs.

Point: Depreciation is cost allocation, not asset valuation.

Point: Land is recorded at cost but not depreciated because it normally retains its value over time.

Point: Useful life and salvage value are estimates. Estimates require judgment based on all available information.

Buildings . . . . . . . . . . . . . . . . . . . . . . 20 – 35 years

Machinery and Equipment . . . . . . . . 5 – 20 years

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340 Chapter 8 Long-Term Assets

Depreciation Methods Depreciation methods are used to allocate a plant asset’s cost over the accounting periods in its useful life. The most frequently used method of depreciation is the straight-line method. An- other common depreciation method is the units-of-production method. We explain both of these methods in this section. This section also describes accelerated depreciation methods, with a focus on the declining-balance method. The computations in this section use information about a machine that inspects athletic shoes before packaging. Manufac turers such as Converse, Reebok, adidas, and Fila use this ma- chine. Data for this machine are in Exhibit 8.5.

EXHIBIT 8.5 Data for Athletic Shoe- Inspecting Machine

Cost . . . . . . . . . . . . . . . . . . . . . . . $10,000

Salvage value . . . . . . . . . . . . . . . . 1,000

Depreciable cost . . . . . . . . . . . . . $ 9,000

Useful life

Accounting periods . . . . . . . . . 5 years

Units inspected . . . . . . . . . . . . 36,000 shoes

Dec. 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Accumulated Depreciation — Machinery . . . . . . . . 1,800

To record annual depreciation.

Assets 5 Liabilities 1 Equity 21,800 21,800

Example: If the salvage value of the machine is $2,500, what is the annual depreciation? Answer: ($10,000 2 $2,500)y5 years 5 $1,500

The $1,800 Depreciation Expense is reported on the income statement among operating expenses. The $1,800 Accumulated Depreciation is a contra asset account to the Machinery account in the balance sheet. The graph on the left in Exhibit 8.7 shows the $1,800 per year expenses reported

EXHIBIT 8.6 Straight-Line Depreciation Formula and Example

Cost 2 Salvage value Useful life in periods

5 5 $10,000 2 $1,000

$1,800 per year 5 years

If this machine is purchased on December 31, 2012, and used throughout its predicted useful life of five years, the straight-line method allocates an equal amount of depreciation to each of the years 2013 through 2017. We make the following adjusting entry at the end of each of the five years to record straight-line depreciation of this machine.

Straight-Line Method Straight-line depreciation charges the same amount of expense to each period of the asset’s useful life. A two-step process is used. We first compute the depreciable cost of the asset, also called the cost to be depreciated. It is computed by subtract- ing the asset’s salvage value from its total cost. Second, depreciable cost is divided by the num- ber of accounting periods in the asset’s useful life. The formula for straight-line depreciation, along with its computation for the inspection machine just described, is shown in Exhibit 8.6.

P1 Compute and record depreciation using the straight-line, units-of- production, and declining- balance methods.

Life Line Life expectancy of plant assets is often in the eye of the beholder. For instance, Hershey Foods and Tootsie Roll are competi- tors and apply similar manufacturing processes, yet their equipment’s life expectancies are different. Hershey depreciates equipment over 3 to 15 years, but Tootsie Roll depreciates them over 5 to 20 years. Such differences markedly impact financial statements. ■

Decision Insight

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Chapter 8 Long-Term Assets 341

in each of the five years. The graph on the right shows the amounts reported on each of the six December 31 balance sheets.

EXHIBIT 8.7 Financial Statement Effects of Straight-Line Depreciation

For Year Ended December 31

Depreciation Expense (on Income Statement)

Asset Book Value (on Balance Sheet)

D o

ll a rs

2012 2013 2014 2015 2016 2017

$1,800

600

1,200

As of December 31

D o

ll a rs

2012 2013 2014 2015 2016 2017

$10,000

2,000

6,000

4,000

8,000

The net balance sheet amount is the asset book value, or simply book value, and is computed as  the asset’s total cost less its accumulated depreciation. For example, at the end of year 2 (December 31, 2014), its book value is $6,400 and is reported in the balance sheet as follows:

The book value of this machine declines by $1,800 each year due to depreciation. The left-side graphic in Exhibit 8.7 reveals why this method is called straight-line. We also can compute the straight-line depreciation rate, defined as 100% divided by the number of periods in the asset’s useful life. For the inspection machine, this rate is 20% (100% 4 5 years, or 1y5 per period). We use this rate, along with other information, to compute the machine’s straight-line depreciation schedule shown in Exhibit 8.8. Note three points in this exhibit. First, depreciation expense is the same each period. Second, accumulated depreciation is the sum of current and prior periods’ depreciation expense. Third, book value declines each period until it equals salvage value at the end of the machine’s useful life.

Point: Depreciation requires estimates for salvage value and useful life. Ethics are relevant when managers might be tempted to choose estimates to achieve desired results on financial statements.

EXHIBIT 8.8 Straight-Line Depreciation Schedule

Depreciation for the Period End of Period

Annual Depreciable Depreciation Depreciation Accumulated Book

Period Cost* Rate Expense Depreciation Value†

2012 — — — — $10,000

2013 $9,000 20% $1,800 $1,800 8,200

2014 9,000 20 1,800 3,600 6,400

2015 9,000 20 1,800 5,400 4,600

2016 9,000 20 1,800 7,200 2,800

2017 9,000 20 1,800 9,000 1,000

* $10,000 2 $1,000. † Book value is total cost minus accumulated depreciation.

Units-of-Production Method The straight-line method charges an equal share of an asset’s cost to each period. If plant assets are used up in about equal amounts each account- ing period, this method produces a reasonable matching of expenses with revenues. How- ever, the use of some plant assets varies greatly from one period to the next. A builder, for instance, might use a piece of construction equipment for a month and then not use it again for several months. When equipment use varies from period to period, the units- of-production depreciation method can better match expenses with revenues. Units-of- production depre- ciation charges a varying amount to expense for each period of an asset’s useful life depend- ing on its usage.

Book value 5 Cost 2 Accumulated depreciation

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Less accumulated depreciation . . . . . . . . 3,600 $6,400 Book value

Salvage value (not depreciated)

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342 Chapter 8 Long-Term Assets

A two-step process is used to compute units-of-production depreciation. We first compute depreciation per unit by subtracting the asset’s salvage value from its total cost and then di- viding by the total number of units expected to be produced during its useful life. Units of production can be expressed in product or other units such as hours used or miles driven. The second step is to compute depreciation expense for the period by multiplying the units pro- duced in the period by the depreciation per unit. The formula for units-of- production depre- ciation, along with its computation for the machine described in Exhibit 8.5, is shown in Exhibit 8.9. (7,000 shoes are inspected and sold in its first year.)

Using data on the number of shoes inspected by the machine, we can compute the units-of- production depreciation schedule shown in Exhibit 8.10. For example, depreciation for the first year is $1,750 (7,000 shoes at $0.25 per shoe). Depreciation for the second year is $2,000 (8,000 shoes at $0.25 per shoe). Other years are similarly computed. Exhibit 8.10 shows that (1) depreciation expense depends on unit output, (2) accumulated depreciation is the sum of current and prior periods’ depreciation expense, and (3) book value declines each period until it equals salvage value at the end of the asset’s useful life. Deltic Timber is one of many compa- nies using the units-of-production depreciation method. It reports that depreciation “is calcu- lated over the estimated useful lives of the assets by using the units of production method for machinery and equipment.”

Example: Refer to Exhibit 8.10. If the number of shoes inspected in 2017 is 5,500, what is depreciation for 2017? Answer: $1,250 (never depreciate below salvage value)

EXHIBIT 8.10 Units-of-Production Depreciation Schedule

Depreciation for the Period End of Period

Annual Number of Depreciation per Depreciation Accumulated Book

Period Units Unit Expense Depreciation Value

2012 — — — — $10,000

2013 7,000 $0.25 $1,750 $1,750 8,250

2014 8,000 0.25 2,000 3,750 6,250

2015 9,000 0.25 2,250 6,000 4,000

2016 7,000 0.25 1,750 7,750 2,250

2017 5,000 0.25 1,250 9,000 1,000

Point: In the DDB method, double refers to the rate and declining balance refers to book value. The rate is applied to beginning book value each period.

Declining-Balance Method An accelerated depreciation method yields larger depre- ciation expenses in the early years of an asset’s life and less depreciation in later years. The most common accelerated method is the declining-balance method of depreciation, which uses a depreciation rate that is a multiple of the straight-line rate and applies it to the asset’s beginning-of-period book value. The amount of depreciation declines each period because book value declines each period. A common depreciation rate for the declining-balance method is double the straight-line rate. This is called the double-declining-balance (DDB) method. This method is applied in three steps: (1) compute the asset’s straight-line depreciation rate, (2) double the straight-line rate, and (3) compute depreciation expense by multiplying this rate by the asset’s beginning-of-period book value. To illustrate, let’s return to the machine in Exhibit 8.5 and apply the double-declining- balance method to compute depreciation expense. Exhibit 8.11 shows the first-year deprecia- tion computation for the machine. The three-step process is to (1) divide 100% by five years to determine the straight-line rate of 20%, or 1y5, per year, (2) double this 20% rate to get the

$0.25 per shoe 3 7,000 shoes 5 $1,750 Depreciation expense 5 Depreciation per unit 3 Units produced in period

Depreciation per unit 5 Cost 2 Salvage value

Step 1

Step 2

Total units of production 5

$10,000 2 $1,000

36,000 shoes 5 $0.25 per shoe

EXHIBIT 8.9 Units-of-Production Depreciation Formula and Example

Salvage value (not depreciated)

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Chapter 8 Long-Term Assets 343

declining-balance rate of 40%, or 2y5, per year, and (3) compute depreciation expense as 40%, or 2y5, multiplied by the beginning-of-period book value.

The double-declining-balance depreciation schedule is shown in Exhibit 8.12. The schedule follows the formula except for year 2017, when depreciation expense is $296. This $296 is not equal to 40% 3 $1,296, or $518.40. If we had used the $518.40 for depreciation expense in 2017, the ending book value would equal $777.60, which is less than the $1,000 salvage value. Instead, the $296 is computed by subtracting the $1,000 salvage value from the $1,296 book value at the beginning of the fifth year (the year when DDB depreciation cuts into salvage value).

Example: What is the DDB depreciation expense in year 2016 if the salvage value is $2,000? Answer: $2,160 2 $2,000 5 $160

Comparing Depreciation Methods Exhibit 8.13 shows depreciation expense for each year of the machine’s useful life under each of the three depreciation methods. While deprecia- tion expense per period differs for different methods, total depreciation expense of $9,000 is the same over the machine’s useful life.

EXHIBIT 8.13 Depreciation Expense for the Different MethodsStraight-LinePeriod Double-Declining-Balance

2015 2016 2017 Totals

2014 2013

1,800 1,800 1,800

$9,000

1,800 $1,800

Units-of-Production

2,250 1,750 1,250

$9,000

2,000 $1,750

1,440 2,400

$4,000

864 296

$9,000

Each method starts with a total cost of $10,000 and ends with a salvage value of $1,000. The difference is the pattern in depreciation expense over the useful life. The book value of the asset when using straight-line is always greater than the book value from using double-declining- balance, except at the beginning and end of the asset’s useful life, when it is the same. Also, Double-Declining-Balance

D e

p re

c ia

ti o

n E

x p

e n

s e

Straight-Line Units-of-Production

$200 2013 2014 2015 2016 2017

$500

$800

$1,100

$1,400

$1,700

$2,000

$2,300

$2,600

$2,900

$3,200

$3,500

$3,800

$4,100

Straight-line rate 5 100% 4 Useful life 5 100% 4 5 years 5 20%

Double-declining-balance rate 5 2 3 Straight-line rate 5 2 3 20% 5 40%

Depreciation expense 5 Double-declining-balance rate 3 Beginning-period book value 40% 3 $10,000 5 $4,000 (for 2013)

Step 1

Step 2

Step 3

* To simplify: DDB depreciation 5 (2 3 Beginning-period book value)yUseful life.

EXHIBIT 8.11 Double-Declining-Balance Depreciation Formula*

EXHIBIT 8.12 Double-Declining-Balance Depreciation Schedule

Depreciation for the Period End of Period

Annual Beginning of Depreciation Depreciation Accumulated Book

Period Period Book Value Rate Expense Depreciation Value

2012 — — — — $10,000

2013 $10,000 40% $4,000 $4,000 6,000

2014 6,000 40 2,400 6,400 3,600

2015 3,600 40 1,440 7,840 2,160

2016 2,160 40 864 8,704 1,296

2017 1,296 40 296* 9,000 1,000

* Year 2017 depreciation is $1,296 2 $1,000 5 $296 (never depreciate book value below salvage value).

Salvage value (not depreciated)

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344 Chapter 8 Long-Term Assets

the straight-line method yields a steady pattern of depreciation expense while the units-of- production depreciation depends on the number of units produced. Each of these methods is acceptable because it allocates cost in a systematic and rational manner.

Depreciation for Tax Reporting The records a company keeps for financial account- ing purposes are usually separate from the records it keeps for tax accounting purposes. This is so because financial accounting aims to report useful information on financial performance and position, whereas tax accounting reflects government objectives in raising revenues. Differences between these two accounting systems are normal and expected. Depreciation is a common ex- ample of how the records differ. For example, many companies use accelerated depreciation in computing taxable income. Reporting higher depreciation expense in the early years of an asset’s life reduces the company’s taxable income in those years and increases it in later years, when the depreciation expense is lower. The company’s goal here is to postpone its tax payments. The U.S. federal income tax law has rules for depreciating assets. These rules include the Modified Accelerated Cost Recovery System (MACRS), which allows straight-line depre- ciation for some assets but requires accelerated depreciation for most kinds of assets. MACRS separates depreciable assets into different classes and defines the depreciable life and rate for each class. MACRS is not acceptable for financial reporting because it often allocates costs over an arbitrary period that is less than the asset’s useful life and it fails to estimate salvage value. Details of MACRS are covered in tax accounting courses.

Partial-Year Depreciation Plant assets are purchased and disposed of at various times. When an asset is purchased (or disposed of) at a time other than the beginning or end of an accounting period, depreciation is recorded for part of a year. This is done so that the year of purchase or the year of disposal is charged with its share of the asset’s depreciation. To illustrate, assume that the machine in Exhibit 8.5 is purchased and placed in service on October 8, 2012, and the annual accounting period ends on December 31. Since this machine is purchased and used for nearly three months in 2012, the calendar-year income statement should report depreciation expense on the machine for that part of the year. Normally, depreciation as- sumes that the asset is purchased on the first day of the month nearest the actual date of pur- chase. In this case, since the purchase occurred on October 8, we assume an October 1 purchase date. This means that three months’ depreciation is recorded in 2012. Using straight-line depre- ciation, we compute three months’ depreciation of $450 as follows.

$10,000 2 $1,000

5 years 3

3

12 5 $450

A similar computation is necessary when an asset disposal occurs during a period. To illustrate, assume that the machine is sold on June 24, 2017. Depreciation is recorded for the period January 1 through June 24 when it is disposed of. This partial year’s depreciation, computed to the nearest whole month, is

$10,000 2 $1,000

5 years 3

6

12 5 $900

Point: Understanding depreciation for financial accounting will help in learning MACRS for tax accounting. Rules for MACRS are available from www.IRS.gov.

Point: Assets purchased on days 1 through 15 of a month are usually recorded as purchased on the 1st of that month. Assets purchased on days 16 to the month-end are recorded as if purchased on the 1st of the next month.

Example: If the machine’s salvage value is zero and purchase occurs on Oct. 8, 2012, how much depreciation is recorded at Dec. 31, 2012? Answer: $10,000y5 3 3y12 5 $500

C2 Explain depreciation for partial years and changes in estimates.

Declining-balance, 4%

Units-of-production, 4%

Straight-line, 87%

Accelerated and other,

5%

In Vogue About 87% of companies use straight-line depreciation for plant assets, 4% use units-of-production, and 4% use declining-balance. Another 5% use an un- specified accelerated method — most likely declining- balance. ■

Decision Insight

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Chapter 8 Long-Term Assets 345

Change in Estimates for Depreciation Depreciation is based on estimates of salvage value and useful life. During the useful life of an asset, new information may indicate that these estimates are inaccurate. If our estimate of an asset’s useful life and/or salvage value changes, what should we do? The answer is to use the new estimate to compute depreciation for current and future periods. This means that we revise the depreciation expense computation by spreading the cost yet to be depreciated over the re- maining useful life. This approach is used for all depreciation methods. Let’s return to the machine described in Exhibit 8.8 using straight-line depreciation. At the beginning of this asset’s third year, its book value is $6,400, computed as $10,000 minus $3,600. Assume that at the beginning of its third year, the estimated number of years remaining in its useful life changes from three to four years and its estimate of salvage value changes from $1,000 to $400. Straight-line depreciation for each of the four remaining years is computed as shown in Exhibit 8.14.

Point: Remaining depreciable cost equals book value less revised salvage value at the point of revision.

Point: Income is overstated (and depreciation understated) when useful life is too high; when useful life is too low, the opposite results.

Thus, $1,500 of depreciation expense is recorded for the machine at the end of the third through sixth years — each year of its remaining useful life. Since this asset was depreciated at $1,800 per year for the first two years, it is tempting to conclude that depreciation expense was overstated in the first two years. However, these expenses reflected the best information available at that time. We do not go back and restate prior years’ financial statements for this type of new information. Instead, we adjust the current and future periods’ statements to reflect this new information. Revising an esti- mate of the useful life or salvage value of a plant asset is referred to as a change in an accounting estimate and is reflected in current and future financial statements, not in prior statements.

Reporting Depreciation Both the cost and accumulated depreciation of plant assets are reported on the balance sheet or in its notes. Dale Jarrett Racing Adventure, for instance, reports the following.

Example: If at the beginning of its second year the machine’s remaining useful life changes from four to three years and salvage value from $1,000 to $400, how much straight-line depreciation is recorded in remaining years? Answer: Revised depreciation 5 ($8,200 2 $400)y3 5 $2,600.

Point: A company usually keeps rec- ords for each asset showing its cost and depreciation to date. The combined records for individual assets are a type of plant asset subsidiary ledger.

Office furniture and equipment . . . . . . . . . . $ 54,593

Shop and track equipment . . . . . . . . . . . . . . 202,973

Race vehicles and other . . . . . . . . . . . . . . . . 975,084

Property and equipment, gross . . . . . . . . 1,232,650

Less accumulated depreciation . . . . . . . . . . 628,355

Property and equipment, net . . . . . . . . . $ 604,295

Many companies also show plant assets on one line with the net amount of cost less accumu- lated depreciation. When this is done, the amount of accumulated depreciation is disclosed in a note. Apple reports only the net amount of its property, plant and equipment in its balance sheet. To satisfy the full-disclosure principle, Apple describes its depreciation methods in its Note 1 and the amounts comprising plant assets in its Note 5—see its 10-K at www.sec.gov. Reporting both the cost and accumulated depreciation of plant assets helps users compare the assets of different companies. For example, a company holding assets costing $50,000 and accumu- lated depreciation of $40,000 is likely in a situation different from a company with new assets cost- ing $10,000. While the net undepreciated cost of $10,000 is the same in both cases, the first company may have more productive capacity available but likely is facing the need to replace older assets. These insights are not provided if the two balance sheets report only the $10,000 book values. Users must remember that plant assets are reported on a balance sheet at their undepreciated costs (book value), not at fair (market) values. This emphasis on costs rather than fair values is based on the going- concern assumption described in Chapter 1. This assumption states that, unless there is evidence to the contrary, we assume that a company continues in business. This implies that plant assets are held and used long enough to recover their cost through the sale of products and services. Because plant assets are not for sale, their fair values are not reported. An exception is

EXHIBIT 8.14 Computing Revised Straight-Line Depreciation

Book value 2 Revised salvage value

Revised remaining useful life 5

$6,400 2 $400

4 years 5 $1,500 per year

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346 Chapter 8 Long-Term Assets

when there is a permanent decline in the fair value of an asset relative to its book value, called an asset impairment. In this case the company writes the asset down to this fair value (details for the two-step process for assessing and computing the impairment loss are in advanced courses). Accumulated Depreciation is a contra asset account with a normal credit balance. It does not reflect funds accumulated to buy new assets when the assets currently owned are replaced. If a company has funds available to buy assets, the funds are shown on the balance sheet among liquid assets such as Cash or Investments.

Example: Assume equipment carries a book value of $800 ($900 cost less $100 accumulated depreciation) and a fair (market) value of $750, and this $50 decline in value meets the 2-step impairment test. The entry to record this impairment is: Impairment Loss . . . . . . . . . $50 Accum Depr-Equip. . . . . . $50

4. On January 1, 2013, a company pays $77,000 to purchase office furniture with a zero salvage value. The furniture’s useful life is somewhere between 7 and 10 years. What is the year 2013 straight-line depreciation on the furniture using (a) a 7-year useful life and (b) a 10-year useful life?

5. What does the term depreciation mean in accounting? 6. A company purchases a machine for $96,000 on January 1, 2013. Its useful life is five years or

100,000 units of product, and its salvage value is $8,000. During 2013, 10,000 units of product are produced. Compute the book value of this machine on December 31, 2013, assuming (a) straight-line depreciation and (b) units-of-production depreciation.

7. In early January 2013, a company acquires equipment for $3,800. The company estimates this equipment to have a useful life of three years and a salvage value of $200. Early in 2015, the company changes its estimates to a total four-year useful life and zero salvage value. Using the straight-line method, what is depreciation for the year ended 2015?

Quick Check Answers — p. 361

After a company acquires a plant asset and puts it into service, it often makes additional expen- ditures for that asset’s operation, maintenance, repair, and improvement. In recording these expenditures, it must decide whether to capitalize or expense them (to capitalize an expenditure is to debit the asset account). The issue is whether these expenditures are reported as current period expenses or added to the plant asset’s cost and depreciated over its remaining useful life. Revenue expenditures, also called income statement expenditures, are additional costs of plant assets that do not materially increase the asset’s life or productive capabilities. They are recorded as expenses and deducted from revenues in the current period’s income statement. Examples of reve- nue expenditures are cleaning, repainting, adjustments, and lubricants. Capital expenditures, also called balance sheet expenditures, are additional costs of plant assets that provide benefits extend- ing beyond the current period. They are debited to asset accounts and reported on the balance sheet. Capital expenditures increase or improve the type or amount of service an asset provides. Examples are roofing replacement, plant expansion, and major overhauls of machinery and equipment. Financial statements are affected for several years by the accounting choice of recording costs as either revenue expenditures or capital expenditures. This decision is based on whether the expenditures are identified as ordinary repairs or as betterments and extraordinary repairs.

ADDITIONAL EXPENDITURES

C3 Distinguish between revenue and capital expenditures, and account for them.

Financial Statement Effect

Expense Accounting Timing

Revenue Income stmt. Expensed expenditure account debited currently

Capital Balance sheet Expensed expenditure account debited in future

Controller You are the controller for a struggling company. Its operations require regular investments in equipment, and depreciation is its largest expense. Its competitors frequently replace equipment — often depreciated over three years. The company president instructs you to revise useful lives of equipment from three to six years and to use a six-year life on all new equipment. What actions do you take? ■ [Answer—p. 360]

Decision Ethics

Entrepreneur Your start-up Internet services company needs cash, and you are preparing financial state- ments to apply for a short-term loan. A friend suggests that you treat as many expenses as possible as capital expenditures. What are the impacts on financial statements of this suggestion? What do you think is the aim of this suggestion? ■ [Answer—p. 361]

Decision Maker

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Chapter 8 Long-Term Assets 347

Ordinary Repairs Ordinary repairs are expenditures to keep an asset in normal, good operating condition. They are necessary if an asset is to perform to expectations over its useful life. Ordinary repairs do not extend an asset’s useful life beyond its original estimate or increase its productivity beyond orig- inal expectations. Examples are normal costs of cleaning, lubricating, adjusting, oil changing, and replacing small parts of a machine. Ordinary repairs are treated as revenue expenditures. This means their costs are reported as expenses on the current period income statement. Following this rule, Brunswick reports that “maintenance and repair costs are expensed as incurred.” If Brunswick’s current year repair costs are $9,500, it makes the following entry.

Point: Many companies apply the materiality constraint to treat low-cost plant assets (say, less than $500) as revenue expenditures. This practice is referred to as a “capitalization policy.”

Dec. 31 Repairs Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

To record ordinary repairs of equipment.

Assets 5 Liabilities 1 Equity 29,500 29,500

Betterments and Extraordinary Repairs Accounting for betterments and extraordinary repairs is similar—both are treated as capital expenditures.

Betterments (Improvements) Betterments, also called improvements, are expenditures that make a plant asset more efficient or productive. A betterment often involves adding a compo- nent to an asset or replacing one of its old components with a better one and does not always in- crease an asset’s useful life. An example is replacing manual controls on a machine with automatic controls. One special type of betterment is an addition, such as adding a new wing or dock to a warehouse. Since a betterment benefits future periods, it is debited to the asset account as a capital expenditure. The new book value (less salvage value) is then depreciated over the asset’s remain- ing useful life. To illustrate, suppose a company pays $8,000 for a machine with an eight-year useful life and no salvage value. After three years and $3,000 of depreciation, it adds an automated control system to the machine at a cost of $1,800. This results in reduced labor costs in future periods. The cost of the betterment is added to the Machinery account with this entry.

Example: Assume a firm owns a Web server. Identify each cost as a revenue or capital expenditure: (1) purchase price, (2) necessary wiring, (3) platform for operation, (4) circuits to increase capacity, (5) cleaning after each month of use, (6) repair of a faulty switch, and (7) replaced a worn fan. Answer: Capital expenditures: 1, 2, 3, 4; revenue expenditures: 5, 6, 7.

Jan. 2 Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

To record installation of automated system.

Assets 5 Liabilities 1 Equity 11,800 21,800

After the betterment is recorded, the remaining cost to be depreciated is $6,800, computed as $8,000 2 $3,000 1 $1,800. Depreciation expense for the remaining five years is $1,360 per year, computed as $6,800y5 years.

Extraordinary Repairs (Replacements) Extraordinary repairs are expenditures extending the asset’s useful life beyond its original estimate. Extraordinary repairs are capital expenditures because they benefit future periods. Their costs are debited to the asset account (or to accumulated depreciation). For example, Delta Air Lines reports, “modifications that . . . extend the useful lives of airframes or engines are capitalized and amortized [depreciated] over the remaining estimated useful life of the asset.”

Point: Both extraordinary repairs and betterments require revising future depreciation.

Extraordinary Bombers If we owned a 20-year-old truck and planned to use it in our work for another 40 years, we would ex- pect some extraordinary repairs in future years. A similar situation confronts Whiteman Air Force Base, home to the B-2 stealth bomber, which rolled out of a Northrop Grumman hangar in the 1980s. The plan is to keep those bat-winged bombers flying until 2058. The Pentagon is moving forward with a $2 billion, 10-year effort to modernize the bombers’ defensive capabilities. ■

Decision Insight

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348 Chapter 8 Long-Term Assets

EXHIBIT 8.15 Accounting for Disposals of Plant Assets

1. Record depreciation up to the date of disposal—this also updates Accumulated Depreciation.

2. Record the removal of the disposed asset’s account balances—including its Accumulated Depreciation.

3. Record any cash (and/or other assets) received or paid in the disposal.

4. Record any gain or loss—computed by comparing the disposed asset’s book value with the market value of any assets received.*

* An exception to step 4 is the case of an exchange that lacks commercial substance—see Appendix 8A.

Discarding Plant Assets A plant asset is discarded when it is no longer useful to the company and it has no market value. To illustrate, assume that a machine costing $9,000 with accumulated depreciation of $9,000 is discarded. When accumulated depreciation equals the asset’s cost, it is said to be fully depreci- ated (zero book value). The entry to record the discarding of this asset is

P2 Account for asset disposal through discarding or selling an asset.

June 5 Accumulated Depreciation—Machinery . . . . . . . . . . . . 9,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

To discard fully depreciated machinery.

Assets 5 Liabilities 1 Equity 19,000 29,000

July 1 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Accumulated Depreciation—Equipment . . . . . . . . 500

To record 6 months’ depreciation ($1,000 3 6y12).

Assets 5 Liabilities 1 Equity 2500 2500

This entry reflects all four steps of Exhibit 8.15. Step 1 is unnecessary since the machine is fully depreciated. Step 2 is reflected in the debit to Accumulated Depreciation and credit to Machin- ery. Since no other asset is involved, step 3 is irrelevant. Finally, since book value is zero and no other asset is involved, no gain or loss is recorded in step 4. How do we account for discarding an asset that is not fully depreciated or one whose depre- ciation is not up-to-date? To answer this, consider equipment costing $8,000 with accumulated depreciation of $6,000 on December 31 of the prior fiscal year-end. This equipment is being depreciated using the straight-line method over eight years with zero salvage. On July 1 of the current year it is discarded. Step 1 is to bring depreciation up-to-date.

Point: Recording depreciation expense up-to-date gives an up-to-date book value for determining gain or loss.

Steps 2 through 4 of Exhibit 8.15 are reflected in the second (and final) entry.

July 1 Accumulated Depreciation—Equipment . . . . . . . . . . . . 6,500

Loss on Disposal of Equipment . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

To discard equipment with a $1,500 book value.

Assets 5 Liabilities 1 Equity 16,500 21,500 28,000

Plant assets are disposed of for several reasons. Some are discarded because they wear out or become obsolete. Others are sold because of changing business plans. Regardless of the reason, disposals of plant assets occur in one of three basic ways: discarding, sale, or exchange. The general steps in accounting for a disposal of plant assets are described in Exhibit 8.15.

DISPOSALS OF PLANT ASSETS

This loss is computed by comparing the equipment’s $1,500 book value ($8,000 2 $6,000 2 $500) with the zero net cash proceeds. The loss is reported in the Other Expenses and Losses section of the income statement. Discarding an asset can sometimes require a cash payment that would increase the loss.

Selling Plant Assets Companies often sell plant assets when they restructure or downsize operations. To illustrate the accounting for selling plant assets, we consider BTO’s March 31 sale of equipment that cost $16,000 and has accumulated depreciation of $12,000 at December 31 of the prior calen- dar year-end. Annual depreciation on this equipment is $4,000 computed using straight-line

Point: Gain or loss is determined by comparing “value given” (book value) to “value received.”

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Chapter 8 Long-Term Assets 349

depreciation. Step 1 of this sale is to record depreciation expense and update accumulated depreciation to March 31 of the current year.

March 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accumulated Depreciation—Equipment . . . . . . . . 1,000

To record 3 months’ depreciation ($4,000 3 3y12).

Assets 5 Liabilities 1 Equity 21,000 21,000

March 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . 13,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

To record sale of equipment for no gain or loss.

Assets 5 Liabilities 1 Equity 13,000

113,000 216,000

March 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . 13,000

Gain on Disposal of Equipment . . . . . . . . . . . . . . . 4,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

To record sale of equipment for a $4,000 gain.

Assets 5 Liabilities 1 Equity 17,000 14,000

113,000 216,000

March 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Loss on Disposal of Equipment . . . . . . . . . . . . . . . . . . . 500

Accumulated Depreciation—Equipment . . . . . . . . . . . . 13,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

To record sale of equipment for a $500 loss.

Assets 5 Liabilities 1 Equity 12,500 2500

113,000 216,000

8. Early in the fifth year of a machine’s six-year useful life, it is overhauled, and its useful life is extended to nine years. This machine originally cost $108,000 and the overhaul cost is $12,000. Prepare the entry to record the overhaul cost.

9. Explain the difference between revenue expenditures and capital expenditures and how both are recorded.

10. What is a betterment? How is a betterment recorded? 11. A company acquires equipment on January 10, 2013, at a cost of $42,000. Straight-line depreciation

is used with a five-year life and $7,000 salvage value. On June 27, 2014, the company sells this equipment for $32,000. Prepare the entry(ies) for June 27, 2014.

Quick Check Answers — p. 361

Steps 2 through 4 of Exhibit 8.15 can be reflected in one final entry that depends on the amount received from the asset’s sale. We consider three different possibilities.

Sale at Book Value If BTO receives $3,000 cash, an amount equal to the equipment’s book value as of March 31 (book value 5 $16,000 2 $12,000 2 $1,000), no gain or loss occurs on disposal. The entry is

Sale price 5 Book value → No gain or loss

Sale above Book Value If BTO receives $7,000, an amount that is $4,000 above the equipment’s $3,000 book value as of March 31, a gain on disposal occurs. The entry is

Sale price . Book value → Gain

Sale below Book Value If BTO receives $2,500, an amount that is $500 below the equipment’s $3,000 book value as of March 31, a loss on disposal occurs. The entry is

Sale price , Book value → Loss

IFRS Unlike U.S. GAAP, IFRS requires an annual review of useful life and salvage value estimates. IFRS also permits revaluation of plant assets to market value if market value is reliably determined. ■

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350 Chapter 8 Long-Term Assets

Section 2— Natural Resources

P3 Account for natural resource assets and their depletion.

Natural resources are assets that are physically consumed when used. Examples are standing tim- ber, mineral deposits, and oil and gas fields. Since they are consumed when used, they are often called wasting assets. These assets represent soon-to-be inventories of raw materials that will be converted into one or more products by cutting, mining, or pumping. Until that conversion takes place, they are noncurrent assets and are shown in a balance sheet using titles such as timberlands, mineral deposits, or oil reserves. Natural resources are reported under either plant assets or their own separate category. Alcoa, for instance, reports its natural resources under the balance sheet title Properties, plants and equipment. In a note to its financial statements, Alcoa reports a separate amount for Land and land rights, including mines. Weyerhaeuser, on the other hand, reports its timber holdings in a separate balance sheet category titled Timber and timberlands.

Cost Determination and Depletion Natural resources are recorded at cost, which includes all expenditures necessary to acquire the re- source and prepare it for its intended use. Depletion is the process of allocating the cost of a natural resource to the period when it is consumed. Natural resources are reported on the balance sheet at cost less accumulated depletion. The depletion expense per period is usually based on units ex- tracted from cutting, mining, or pumping. This is similar to units-of-production depreciation. Exxon Mobil uses this approach to amortize the costs of discovering and operating its oil wells. To illustrate depletion of natural resources, let’s consider a mineral deposit with an estimated 250,000 tons of available ore. It is purchased for $500,000, and we expect zero salvage value. The depletion charge per ton of ore mined is $2, com- puted as $500,000 4 250,000 tons. If 85,000 tons are mined and sold in the first year, the depletion charge for that year is $170,000. These computations are detailed in Exhibit 8.16.

EXHIBIT 8.16 Depletion Formula and Example

Depletion expense 5 Depletion per unit 3 Units extracted and sold in period 5 $2 3 85,000 5 $170,000

Depletion per unit 5 Cost 2 Salvage value

Total units of capacity 5

$500,000 2 $0

250,000 tons 5 $2 per ton

Step 1

Step 2

Depletion expense for the first year is recorded as follows.

Dec. 31 Depletion Expense—Mineral Deposit . . . . . . . . . . . . . . 170,000

Accumulated Depletion—Mineral Deposit . . . . . . 170,000

To record depletion of the mineral deposit.

Assets 5 Liabilities 1 Equity 2170,000 2170,000

The period-end balance sheet reports the mineral deposit as shown in Exhibit 8.17.

EXHIBIT 8.17 Balance Sheet Presentation of Natural Resources

Mineral deposit . . . . . . . . . . . . . . . . . . . . . . $500,000

Less accumulated depletion . . . . . . . . 170,000 $330,000

Since all 85,000 tons of the mined ore are sold during the year, the entire $170,000 of depletion is reported on the income statement. If some of the ore remains unsold at year-end, however, the depletion related to the unsold ore is carried forward on the balance sheet and reported as

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Chapter 8 Long-Term Assets 351

Ore Inventory, a current asset. To illustrate, and continuing with our example, assume that 40,000 tons are mined in the second year, but only 34,000 tons are sold. We record depletion of $68,000 (34,000 tons 3 $2 depletion per unit) and the remaining Ore Inventory of $12,000 (6,000 tons 3 $2 depletion per unit) as follows.

Dec. 31 Depletion Expense—Mineral Deposit . . . . . . . . . . . . . . 68,000

Ore Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Accumulated Depletion—Mineral Deposit . . . . . . 80,000

To record depletion and inventory of mineral deposit.

Assets 5 Liabilities 1 Equity 280,000 268,000 112,000

Section 3—Intangible Assets

P4 Account for intangible assets. Intangible assets are nonphysical assets (used in operations) that confer on their owners long- term rights, privileges, or competitive advantages. Examples are patents, copyrights, licenses, leaseholds, franchises, goodwill, and trademarks. Lack of physical substance does not necessarily imply an intangible asset. Notes and accounts receivable, for instance, lack physical substance, but they are not intangibles. This section identifies the more common types of intangible assets and explains the accounting for them.

Cost Determination and Amortization An intangible asset is recorded at cost when purchased. Intangibles are then separated into those with limited lives or indefinite lives. If an intangible has a limited life, its cost is systematically allocated to expense over its estimated useful life through the process of amortization. If an intangible asset has an indefinite life — meaning that no legal, regulatory, contractual, competi- tive, economic, or other factors limit its useful life—it should not be amortized. (If an intangible with an indefinite life is later judged to have a limited life, it is amortized over that limited life.) Amortization of intangible assets is similar to depreciation of plant assets and the depletion of natural resources in that it is a process of cost allocation. However, only the straight-line method is used for amortizing intangibles unless the company can show that another method is pre- ferred. The effects of amortization are recorded in a contra account (Accumulated Amortiza- tion). The gross acquisition cost of intangible assets is disclosed in the balance sheet along with their accumulated amortization (these disclosures are new). The eventual disposal of an intangible asset involves removing its book value, recording any other asset(s) received or given up, and recognizing any gain or loss for the difference.

Plant Assets Used in Extracting The conversion of natural resources by mining, cutting, or pumping usually requires machinery, equipment, and buildings. When the usefulness of these plant assets is directly related to the deple tion of a natural resource, their costs are depreciated using the units-of-production method in proportion to the depletion of the natural resource. For example, if a machine is permanently installed in a mine and 10% of the ore is mined and sold in the period, then 10% of the ma- chine’s cost (less any salvage value) is allocated to depreciation expense. The same procedure is used when a machine is abandoned once resources have been extracted. If, however, a machine will be moved to and used at another site when extraction is complete, the machine is depreci- ated over its own useful life.

Asset Control Long-term assets must be safeguarded against theft, misuse, and other damages. Controls take many forms depending on the asset, including use of security tags, the legal monitoring of  rights infringements, and approvals of all asset disposals. A study reports that 43% of employees in operations and service areas witnessed the wasting, mismanaging, or abusing of assets in the past year (KPMG 2011). ■

Decision Insight

Point: Depreciation, depletion, and amortization are related in that each describes cost allocation.

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352 Chapter 8 Long-Term Assets

Many intangibles have limited lives due to laws, contracts, or other asset characteristics. Ex- amples are patents, copyrights, and leaseholds. Other intangibles such as goodwill, trademarks, and trade names have lives that cannot be easily determined. The cost of intangible assets is amortized over the periods expected to benefit by their use, but in no case can this period be longer than the asset’s legal existence. The values of some intangible assets such as goodwill continue indefinitely into the future and are not amortized. (An intangible asset that is not am- ortized is tested annually for impairment—if necessary, an impairment loss is recorded. Details for this test are in advanced courses.)

Intangible assets are often shown in a separate section of the balance sheet immediately after plant assets. Callaway Golf, for instance, follows this approach in reporting over $120 million of intangible assets in its balance sheet. Companies usually disclose their amortization periods for intangibles. The remainder of our discussion focuses on accounting for specific types of in- tangible assets.

Types of Intangibles Patents The federal government grants patents to encourage the invention of new technol- ogy, mechanical devices, and production processes. A patent is an exclusive right granted to its owner to manufacture and sell a patented item or to use a process for 20 years. When patent rights are purchased, the cost to acquire the rights is debited to an account called Patents. If the owner engages in lawsuits to successfully defend a patent, the cost of lawsuits is debited to the Patents account. However, the costs of research and development leading to a new patent are expensed when incurred. A patent’s cost is amortized over its estimated useful life (not to exceed 20 years). If we pur- chase a patent costing $25,000 with a useful life of 10 years, we make the following adjusting entry at the end of each of the 10 years to amortize one-tenth of its cost.

Point: Goodwill is not amortized; instead, it is annually tested for impairment.

Point: The cost to acquire a Website address is an intangible asset.

Dec. 31 Amortization Expense—Patents . . . . . . . . . . . . . . . . . . . 2,500

Accumulated Amortization—Patents . . . . . . . . . . . 2,500

To amortize patent costs over its useful life.

Assets 5 Liabilities 1 Equity 22,500 22,500

The $2,500 debit to Amortization Expense appears on the income statement as a cost of the product or service provided under protection of the patent. The Accumulated Amortization— Patents account is a contra asset account to Patents.

Copyrights A copyright gives its owner the exclusive right to publish and sell a musical, literary, or artistic work during the life of the creator plus 70 years, although the useful life of most copyrights is much shorter. The costs of a copyright are amortized over its useful life. The only identifiable cost of many copyrights is the fee paid to the Copyright Office of the federal government or international agency granting the copyright. If this fee is immaterial, it is charged directly to an expense account; but if the identifiable costs of a copyright are material, they are capitalized (recorded in an asset account) and periodically amortized by debiting an account called Amortization Expense—Copyrights.

Mention “drug war” and most people think of illegal drug trade. But another drug war is under way: Brand-name drugmakers are fighting to stop generic copies of their products from hitting the market once patents expire. Delaying a generic rival can yield millions in extra sales. One way drugmakers fight pat- ent expirations is to alter drug delivery. The first patent might require a patient to take a pill 43/day. When that patent expires, the drugmaker can “improve” the drug’s delivery release system to 23/day, and then 13/day, and so forth. ■

Decision Insight

Prescriptions That Specify Generics

1980 1990 2000 2010

60%

0%

20%

40%

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Chapter 8 Long-Term Assets 353

Franchises and Licenses Franchises and licenses are rights that a company or government grants an entity to deliver a product or service under specified conditions. Many organizations grant franchise and license rights — McDonald’s, Pizza Hut, and Major League Baseball are just a few examples. The costs of franchises and licenses are debited to a Franchises and Licenses asset account and are amortized over the lives of the agreements. If an agreement is for an indefinite or perpetual period, those costs are not amortized.

Trademarks and Trade Names Companies often adopt unique symbols or select unique names and brands in marketing their products. A trademark or trade (brand) name is a symbol, name, phrase, or jingle identified with a company, product, or service. Examples are Nike swoosh, Marlboro Man, Big Mac, Coca-Cola, and Corvette. Ownership and exclusive right to use a trademark or trade name is often established by showing that one company used it before another. Ownership is best established by registering a trademark or trade name with the government’s Patent Office. The cost of developing, maintaining, or enhancing the value of a trademark or trade name (such as advertising) is charged to expense when incurred. If a trade- mark or trade name is purchased, however, its cost is debited to an asset account and then amor- tized over its expected life. If the company plans to renew indefinitely its right to the trademark or trade name, the cost is not amortized.

Goodwill Goodwill has a specific meaning in accounting. Goodwill is the amount by which a company’s value exceeds the value of its individual assets and liabilities. This usually implies that the company as a whole has certain valuable attributes not measured among its individual assets and liabilities. These can include superior management, skilled workforce, good supplier or customer relations, quality products or services, good location, or other competitive advantages. To keep accounting information from being too subjective, goodwill is not recorded unless an entire company or business segment is purchased. Purchased goodwill is measured by taking the purchase price of the company and subtracting the market value of its individual net assets (excluding goodwill). For instance, Google paid $1.19 billion to acquire YouTube; about $1.13 of the $1.19 billion was for goodwill. Goodwill is measured as the excess of the cost of an acquired entity over the value of the ac- quired net assets. Goodwill is recorded as an asset, and it is not amortized. Instead, goodwill is annually tested for impairment. If the book value of goodwill does not exceed its fair (market) value, goodwill is not impaired. However, if the book value of goodwill does exceed its fair value, an impairment loss is recorded equal to that excess. (Details of this test are in advanced courses.)

Leaseholds Property is rented under a contract called a lease. The property’s owner, called the lessor, grants the lease. The one who secures the right to possess and use the property is called the lessee. A leasehold refers to the rights the lessor grants to the lessee under the terms of the lease. A leasehold is an intangible asset for the lessee. Certain leases require no advance payment from the lessee but require monthly rent payments. In this case, we do not set up a Leasehold account. Instead, the monthly payments are debited to a Rent Expense account. If a long-term lease requires the lessee to pay the final period’s rent in ad- vance when the lease is signed, the lessee records this advance payment with a debit to the Lease- hold account. Since the advance payment is not used until the final period, the Leasehold account balance remains intact until that final period when its balance is transferred to Rent Expense. (Some long-term leases give the lessee essentially the same rights as a purchaser. This results in a tangible asset and a liability reported by the lessee. Chapter 10 describes these so-called capital leases.)

Point: McDonald’s “golden arches” are one of the world’s most valuable trade- marks, yet this asset is not shown on McDonald’s balance sheet.

Point: Amortization of goodwill is different for financial accounting and tax accounting. The IRS requires the amorti- zation of goodwill over 15 years.

Example: Assume goodwill carries a book value of $500 and has an implied fair value of $475, and this $25 decline in value meets the 2-step impairment test. The entry to record this impairment is: Impairment Loss . . . . . . . . . $25 Goodwill . . . . . . . . . . . . . $25

Mickey Mouse Protection Act The Walt Disney Company successfully lobbied Congress to extend copyright protection from the life of the creator plus 50 years to life of the creator plus 70 years. This extension allows the company to protect its characters for 20 additional years before the right to use them enters the pub- lic domain. Mickey Mouse is now protected by copyright law until 2023. The law is officially termed the Copyright Term Extension Act (CTEA) but it is also known as the Mickey Mouse Protection Act. ■

Decision Insight

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354 Chapter 8 Long-Term Assets

A long-term lease can increase in value when current rental rates for similar property rise while the required payments under the lease remain constant. This increase in value of a lease is not reported on the lessee’s balance sheet. However, if the property is subleased and the new tenant makes a cash payment to the original lessee for the rights under the old lease, the new tenant debits this payment to a Leasehold account, which is amortized to Rent Expense over the remaining life of the lease.

Leasehold Improvements A lessee sometimes pays for alterations or improvements to the leased property such as partitions, painting, and storefronts. These alterations and improvements are called leasehold improvements, and the lessee debits these costs to a Leasehold Improve- ments account. Since leasehold improvements become part of the property and revert to the lessor at the end of the lease, the lessee amortizes these costs over the life of the lease or the life of the improvements, whichever is shorter. The amortization entry debits Amortization Expense— Leasehold Improvements and credits Accumulated Amortization — Leasehold Improvements.

Other Intangibles There are other types of intangible assets such as software, noncompete covenants, customer lists, and so forth. Our accounting for them is the same. First, we record the intangible asset’s costs. Second, we determine whether the asset has a limited or indefinite life. If limited, we allocate its costs over that period. If indefinite, its costs are not amortized.

12. Give an example of a natural resource and of an intangible asset. 13. A company pays $650,000 for an ore deposit. The deposit is estimated to have 325,000 tons

of ore that will be mined over the next 10 years. During the first year, it mined, processed, and sold 91,000 tons. What is that year’s depletion expense?

14. On January 6, 2013, a company pays $120,000 for a patent with a remaining 17-year legal life to produce a toy expected to be marketable for three years. Prepare entries to record its acquisition and the December 31, 2013, amortization entry.

Quick Check Answers — p. 361

Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation is re- corded on a straight-line basis over the expected useful lives of the assets. Maintenance, repairs and renewals are generally charged to expense during the financial period in which they are incurred. However, major renovations are capitalized and included in the carrying amount of the asset . . . Major renovations are depreciated over the remaining useful life of the related asset.

This section discusses similarities and differences between U.S. GAAP and IFRS in accounting and re- porting for plant assets and intangible assets.

Accounting for Plant Assets Issues involving cost determination, depreciation, additional ex- penditures, and disposals of plant assets are subject to broadly similar guidance for both U.S. GAAP and IFRS. Although differences exist, the similarities vastly outweigh the differences. Nokia describes its accounting for plant assets as follows:

GLOBAL VIEW

One area where notable differences exist is in accounting for changes in the value of plant assets (between the time they are acquired and when disposed of ). Namely, how does IFRS and U.S. GAAP treat de- creases and increases in the value of plant assets subsequent to acquisition?

Decreases in the Value of Plant Assets When the value of plant assets declines after acquisition, but be- fore disposition, both U.S. GAAP and IFRS require companies to record those decreases as impairment losses. While the test for impairment uses a different base between U.S. GAAP and IFRS, a more funda- mental difference is that U.S. GAAP revalues impaired plant assets to fair value whereas IFRS revalues them to a recoverable amount (defined as fair value less costs to sell).

Point: A leasehold account implies existence of future benefits that the lessee controls because of a prepayment. It also meets the definition of an asset.

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Chapter 8 Long-Term Assets 355

Increases in the Value of Plant Assets U.S. GAAP prohibits companies from recording increases in the value of plant assets. However, IFRS permits upward asset revaluations. Namely, under IFRS, if an im- pairment was previously recorded, a company would reverse that impairment to the extent necessary and record that increase in income. If the increase is beyond the original cost, that increase is recorded in com- prehensive income.

Accounting for Intangible Assets For intangible assets, the accounting for cost determination, amortization, additional expenditures, and disposals is subject to broadly similar guidance for U.S. GAAP and IFRS. Although differences exist, the similarities vastly outweigh differences. Again, and consistent with the accounting for plant assets, U.S. GAAP and IFRS handle decreases and increases in the value of intan- gible assets differently. However, IFRS requirements for recording increases in the value of intangible assets are so restrictive that such increases are rare. Nokia describes its accounting for intangible assets as follows:

Total Asset Turnover Decision Analysis

A1 Compute total asset turnover and apply it to analyze a company’s use of assets.

A company’s assets are important in determining its ability to generate sales and earn income. Managers devote much attention to deciding what assets a company acquires, how much it invests in assets, and how to use assets most efficiently and effectively. One important measure of a company’s ability to use its as- sets is total asset turnover, defined in Exhibit 8.18.

EXHIBIT 8.18 Total Asset TurnoverTotal asset turnover 5

Net sales Average total assets

The numerator reflects the net amounts earned from the sale of products and services. The denominator reflects the average total resources devoted to operating the company and generating sales. To illustrate, let’s look at total asset turnover in Exhibit 8.19 for two competing companies: Molson Coors and Boston Beer.

EXHIBIT 8.19 Analysis Using Total Asset Turnover

Company Figure ($ millions) 2011 2010 2009 2008 2007

Molson Coors Net sales . . . . . . . . . . . . . . . . $ 3,515.7 $ 3,254.4 $ 3,032.4 $ 4,774.3 $ 6,190.6

Average total assets . . . . . . . $12,560.7 $12,359.4 $11,203.9 $11,934.1 $12,527.5

Total asset turnover . . . . 0.28 0.26 0.27 0.40 0.49

Boston Beer Net sales . . . . . . . . . . . . . . . . $ 513.000 $ 463.798 $ 415.053 $ 398.400 $ 341.647

Average total assets . . . . . . . $ 265.509 $ 260.733 $ 241.347 $ 208.856 $ 176.215

Total asset turnover . . . . 1.93 1.78 1.72 1.91 1.94

Molson Coors Boston BeerTotal Asset Turnover:

20102011

0.7 0.4 0.1

1.0 1.3 1.6 1.9 2.2

200720082009

To show how we use total asset turnover, let’s look at Molson Coors. We express Molson Coors’s use of as- sets in generating net sales by saying “it turned its assets over 0.28 times during 2011.” This means that each $1.00 of assets produced $0.28 of net sales. Is a total asset turnover of 0.28 good or bad? It is safe to say that all companies desire a high total asset turnover. Like many ratio analyses, however, a company’s total asset turnover must be interpreted in comparison with those of prior years and of its competitors. Interpreting the total asset turnover also requires an understanding of the company’s operations. Some operations are capital intensive, meaning that a relatively large amount is invested in assets to generate sales. This suggests a rela- tively lower total asset turnover. Other companies’ operations are labor intensive, meaning that they generate sales more by the efforts of people than the use of assets. In that case, we expect a higher total asset turnover. Companies with low total asset turnover require higher profit margins (examples are hotels and real estate); companies with high total asset turnover can succeed with lower profit margins ( examples are food stores and toy merchandisers). Molson Coors’s turnover recently declined and is now much lower than that for Boston Beer and many other competitors. Total asset turnover for Molson Coors’s competitors, available in industry publications such as Dun & Bradstreet, is generally in the range of 0.5 to 1.0 over this same period. Overall, Molson Coors must improve relative to its competitors on total asset turnover.

Point: An estimate of plant asset useful life equals the plant asset cost divided by depreciation expense.

Point: The plant asset age is estimated by dividing accumulated depreciation by depreciation expense. Older plant assets can signal needed asset replacements; they may also signal less efficient assets.

[Intangible assets] are capitalized and amortized using the straight-line method over their useful lives. Where an indication of impairment exists, the carrying amount of any intangible asset is assessed and written down to its recoverable amount.

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356 Chapter 8 Long-Term Assets

DEMONSTRATION PROBLEM On July 14, 2013, Tulsa Company pays $600,000 to acquire a fully equipped factory. The purchase involves the following assets and information.

Appraised Salvage Useful Depreciation

Asset Value Value Life Method

Land . . . . . . . . . . . . . . . . . . . . . $160,000 Not depreciated

Land improvements . . . . . . . . . 80,000 $ 0 10 years Straight-line

Building . . . . . . . . . . . . . . . . . . 320,000 100,000 10 years Double-declining-balance

Machinery . . . . . . . . . . . . . . . . 240,000 20,000 10,000 units Units-of-production*

Total . . . . . . . . . . . . . . . . . . . . . $800,000

* The machinery is used to produce 700 units in 2013 and 1,800 units in 2014.

Required

1. Allocate the total $600,000 purchase cost among the separate assets. 2. Compute the 2013 (six months) and 2014 depreciation expense for each asset, and compute the com-

pany’s total depreciation expense for both years. 3. On the last day of calendar year 2015, Tulsa discarded machinery that had been on its books for five

years. The machinery’s original cost was $12,000 (estimated life of five years) and its salvage value was $2,000. No depreciation had been recorded for the fifth year when the disposal occurred. Journal- ize the fifth year of depreciation (straight-line method) and the asset’s disposal.

4. At the beginning of year 2015, Tulsa purchased a patent for $100,000 cash. The company estimated the patent’s useful life to be 10 years. Journalize the patent acquisition and its amortization for the year 2015.

5. Late in the year 2015, Tulsa acquired an ore deposit for $600,000 cash. It added roads and built mine shafts for an additional cost of $80,000. Salvage value of the mine is estimated to be $20,000. The company estimated 330,000 tons of available ore. In year 2015, Tulsa mined and sold 10,000 tons of ore. Journalize the mine’s acquisition and its first year’s depletion.

6.A On the first day of 2015, Tulsa exchanged the machinery that was acquired on July 14, 2013, along with $5,000 cash for machinery with a $210,000 market value. Journalize the exchange of these assets assum- ing the exchange lacked commercial substance. (Refer to background information in parts 1 and 2.)

PLANNING THE SOLUTION ● Complete a three-column table showing the following amounts for each asset: appraised value, percent

of total value, and apportioned cost. ● Using allocated costs, compute depreciation for 2013 (only one-half year) and 2014 (full year) for each

asset. Summarize those computations in a table showing total depreciation for each year. ● Remember that depreciation must be recorded up-to-date before discarding an asset. Calculate and record

depreciation expense for the fifth year using the straight-line method. Since salvage value is not received at the end of a discarded asset’s life, the amount of any salvage value becomes a loss on disposal. Record the loss on the disposal as well as the removal of the discarded asset and its related accumulated depreciation.

● Record the patent (an intangible asset) at its purchase price. Use straight-line amortization over its use- ful life to calculate amortization expense.

● Record the ore deposit (a natural resource asset) at its cost, including any added costs to ready the mine for use. Calculate depletion per ton using the depletion formula. Multiply the depletion per ton by the amount of tons mined and sold to calculate depletion expense for the year.

● Remember that gains and losses on asset exchanges that lack commercial substance are not recognized. Make a journal entry to add the acquired machinery to the books and to remove the old machinery, along with its accumulated depreciation, and to record the cash given in the exchange.

Environmentalist A paper manufacturer claims it cannot afford more environmental controls. It points to its low total asset turnover of 1.9 and argues that it cannot compete with companies whose total asset turnover is much higher. Examples cited are food stores (5.5) and auto dealers (3.8). How do you respond? ■ [Answer—p. 361]

Decision Maker

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Chapter 8 Long-Term Assets 357

Total depreciation expense for each year:

2. Depreciation for each asset. (Land is not depreciated.)

Land Improvements

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000 Salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Depreciable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000 Useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 years Annual depreciation expense ($60,000y10 years) . . . . . . . . . . . . $ 6,000 2013 depreciation ($6,000 3 6y12) . . . . . . . . . . . . . . . . . . . . $ 3,000

2014 depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000

Building

Straight-line rate 5 100%y10 years 5 10% Double-declining-balance rate 5 10% 3 2 5 20% 2013 depreciation ($240,000 3 20% 3 6y12) . . . . . . . . . . . . $ 24,000

2014 depreciation [($240,000 2 $24,000) 3 20%] . . . . . . . . . $ 43,200

Machinery

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 180,000 Salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Depreciable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 160,000 Total expected units of production . . . . . . . . . . . . . . . . . . . . . . . . 10,000 units Depreciation per unit ($160,000y10,000 units) . . . . . . . . . . . . . . $ 16 2013 depreciation ($16 3 700 units) . . . . . . . . . . . . . . . . . . . . $ 11,200

2014 depreciation ($16 3 1,800 units) . . . . . . . . . . . . . . . . . . $ 28,800

Depreciation Expense — Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Accumulated Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

To record depreciation on date of disposal: ($12,000 2 $2,000)y5

Accumulated Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Loss on Disposal of Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

To record the discarding of machinery with a $2,000 book value.

3. Record the depreciation up-to-date on the discarded asset.

Record the removal of the discarded asset and its loss on disposal.

Appraised Percent of Apportioned

Asset Value Total Value Cost

Land . . . . . . . . . . . . . . . . . . . . . $160,000 20% $120,000 ($600,000 3 20%) Land improvements . . . . . . . . . 80,000 10 60,000 ($600,000 3 10%) Building . . . . . . . . . . . . . . . . . . 320,000 40 240,000 ($600,000 3 40%) Machinery . . . . . . . . . . . . . . . . 240,000 30 180,000 ($600,000 3 30%) Total . . . . . . . . . . . . . . . . . . . . . $800,000 100% $ 600,000

2013 2014

Land improvements . . . . . . . . . $ 3,000 $ 6,000

Building . . . . . . . . . . . . . . . . . . 24,000 43,200

Machinery . . . . . . . . . . . . . . . . 11,200 28,800

Total . . . . . . . . . . . . . . . . . . . . . $38,200 $78,000

SOLUTION TO DEMONSTRATION PROBLEM 1. Allocation of the total cost of $600,000 among the separate assets.

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358 Chapter 8 Long-Term Assets

Depletion Expense—Ore Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Accumulated Depletion—Ore Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

To record depletion expense: ($680,000 2 $20,000)y330,000 tons 5 $2 per ton. 10,000 tons mined and sold 3 $2 5 $20,000 depletion.

Ore Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680,000

To record ore deposit acquisition and its related costs.

5.

Amortization Expense—Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Accumulated Amortization—Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

To record amortization expense: $100,000y10 years 5 $10,000.

Patent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

To record patent acquisition.

4.

6. Record the asset exchange: The book value on the exchange date is $180,000 (cost) 2 $40,000 (ac- cumulated depreciation). The book value of the machinery given up in the exchange ($140,000) plus the $5,000 cash paid is less than the $210,000 value of the machine acquired. The entry to record this exchange of assets that lacks commercial substance does not recognize the $65,000 “gain.”

Machinery (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145,000*

Accumulated Depreciation—Machinery (old) . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Machinery (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

To record asset exchange that lacks commercial substance.

* Market value of the acquired asset of $210,000 minus $65,000 “gain.”

APPENDIX

Exchanging Plant Assets8A Many plant assets such as machinery, automobiles, and office equipment are disposed of by exchanging them for newer assets. In a typical exchange of plant assets, a trade-in allowance is received on the old asset and the balance is paid in cash. Accounting for the exchange of assets depends on whether the transaction has commercial substance (per SFAS 153, commercial substance implies that it alters the com- pany’s future cash flows). If an asset exchange has commercial substance, a gain or loss is recorded based on the difference between the book value of the asset(s) given up and the market value of the asset(s) re- ceived. If an asset exchange lacks commercial substance, no gain or loss is recorded, and the asset(s) re- ceived is recorded based on the book value of the asset(s) given up. An exchange has commercial substance if the company’s future cash flows change as a result of the transaction. This section describes the accounting for the exchange of assets.

Exchange with Commercial Substance: A Loss A company acquires $42,000 in new equipment. In ex- change, the company pays $33,000 cash and trades in old equipment. The old equipment originally cost $36,000 and has accumulated depreciation of $20,000, which implies a $16,000 book value at the time of exchange. We are told this exchange has commercial substance and that the old equipment has a trade-in al- lowance of $9,000. This exchange yields a loss as computed in the middle (Loss) columns of Exhibit 8A.1; the loss is computed as Asset received 2 Assets given 5 $42,000 2 $49,000 5 $(7,000). We can also com- pute the loss as Trade-in allowance 2 Book value of asset given 5 $9,000 2 $16,000 5 $(7,000).

P5A Account for asset exchanges.

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Chapter 8 Long-Term Assets 359

The entry to record this asset exchange is

Jan. 3 Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000

Loss on Exchange of Assets . . . . . . . . . . . . . . . . . . . . . . 7,000

Accumulated Depreciation—Equipment (old) . . . . . . . . 20,000

Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

To record exchange (with commercial substance) of old equipment and cash for new equipment.

Assets 5 Liabilities 1 Equity 142,000 27,000 120,000 236,000 233,000

Exchange with Commercial Substance: A Gain Let’s assume the same facts as in the preceding asset ex- change except that the new equipment received has a market value of $52,000 instead of $42,000. We are told that this exchange has commercial substance and that the old equipment has a trade-in allowance of $19,000. This exchange yields a gain as computed in the right-most (Gain) columns of Exhibit 8A.1; the gain is computed as Asset received 2 Assets given 5 $52,000 2 $49,000 5 $3,000. We can also compute the gain as Trade-in allowance 2 Book value of asset given 5 $19,000 2 $16,000 5 $3,000. The entry to record this asset exchange is

Point: Parenthetical notes to “new” and “old” equipment are for illustration only. Both the debit and credit are to the same Equipment account.

Jan. 3 Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000

Accumulated Depreciation — Equipment (old) . . . . . . . 20,000

Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

Gain on Exchange of Assets . . . . . . . . . . . . . . . . . . 3,000

To record exchange (with commercial substance) of old equipment and cash for new equipment.

Assets 5 Liabilities 1 Equity 152,000 13,000 120,000 236,000 233,000

Point: No gain or loss is recorded for exchanges without commercial substance.

The $3,000 gain recorded when the transaction has commercial substance is not recognized in this entry because of the rule prohibiting recording a gain or loss on asset exchanges without commercial substance. The $49,000 recorded for the new equipment equals its cash price ($52,000) less the unrecognized gain ($3,000) on the exchange. The $49,000 cost re- corded is called the cost basis of the new machine. This cost basis is the amount we use to compute depreciation and its book value. The cost basis of the new asset also can be computed by summing the book values of the assets given up as shown in Exhibit 8A.2. The same analysis and approach are taken for a loss on an asset exchange without com- mercial substance.

EXHIBIT 8A.2 Cost Basis of New Asset When Gain Not Recorded on Asset Exchange without Commercial Substance

Jan. 3 Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000

Accumulated Depreciation — Equipment (old) . . . . . . . 20,000

Equipment (old) . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

To record exchange (without commercial substance) of old equipment and cash for new equipment.

Assets 5 Liabilities 1 Equity 149,000 120,000 236,000 233,000

Exchanges without Commercial Substance Let’s assume the same facts as in the preced ing asset exchange involving new equipment received with a market value of $52,000, but let’s instead assume the transaction lacks commercial substance. The entry to record this asset exchange is

EXHIBIT 8A.1 Computing Gain or Loss on Asset Exchange with Commercial Substance

Asset Exchange Has Commercial Substance Loss Gain

Market value of asset received . . . . . . . . . . . . . . . . . . . . . . . $ 42,000 $ 52,000

Book value of assets given:

Equipment ($36,000 2 $20,000) . . . . . . . . . . . . . . . . . . . $16,000 $16,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000 49,000 33,000 49,000

Gain (loss) on exchange . . . . . . . . . . . . . . . . . . . . . . . . . $(7,000) $ 3,000

Cost of old equipment . . . . . . . . . . . . . $ 36,000

Less accumulated depreciation . . . . . . . 20,000

Book value of old equipment . . . . . . . . 16,000

Cash paid in the exchange . . . . . . . . . . 33,000

Cost recorded for new

equipment . . . . . . . . . . . . . . . . . . . $49,000

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360 Chapter 8 Long-Term Assets

15. A company trades an old Web server for a new one. The cost of the old server is $30,000, and its accumulated depreciation at the time of the trade is $23,400. The new server has a cash price of $45,000. Prepare entries to record the trade under two different assumptions where the company receives a trade-in allowance of (a) $3,000 and the exchange has commercial substance, and (b) $7,000 and the exchange lacks commercial substance.

Quick Check Answer — p. 361

C1 Explain the cost principle for computing the cost of plant assets. Plant assets are set apart from other tangible assets by two important features: use in operations and useful lives longer than one period. Plant assets are recorded at cost when purchased. Cost includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use. The cost of a lump-sum purchase is allocated among its individual assets.

C2 Explain depreciation for partial years and changes in estimates. Partial-year depreciation is often required because assets are bought and sold throughout the year. Depreciation is re- vised when changes in estimates such as salvage value and useful life occur. If the useful life of a plant asset changes, for instance, the remaining cost to be depreciated is spread over the remaining (revised) useful life of the asset.

C3 Distinguish between revenue and capital expenditures, and account for them. Revenue expenditures expire in the current period and are debited to expense accounts and matched with cur- rent revenues. Ordinary repairs are an example of revenue expendi- tures. Capital expenditures benefit future periods and are debited to asset accounts. Examples of capital expenditures are extraordinary repairs and betterments.

A1 Compute total asset turnover and apply it to analyze a company’s use of assets. Total asset turnover measures a company’s ability to use its assets to generate sales. It is defined as net sales divided by average total assets. While all companies desire a high total asset turnover, it must be interpreted in comparison with those for prior years and its competitors.

P1 Compute and record depreciation using the straight-line, units-of-production, and declining-balance methods. De- preciation is the process of allocating to expense the cost of a plant asset over the accounting periods that benefit from its use. Deprecia- tion does not measure the decline in a plant asset’s market value or its physical deterioration. Three factors determine depreciation:

Summary cost, salvage value, and useful life. Salvage value is an estimate of the asset’s value at the end of its benefit period. Useful (service) life is the length of time an asset is productively used. The straight-line method divides cost less salvage value by the asset’s useful life to determine depreciation expense per period. The units-of-production method divides cost less salvage value by the estimated number of units the asset will produce over its life to determine deprecia- tion per unit. The declining-balance method multiplies the asset’s beginning-of-period book value by a factor that is often double the straight-line rate.

P2 Account for asset disposal through discarding or selling an asset. When a plant asset is discarded or sold, its cost and ac- cumulated depreciation are removed from the accounts. Any cash proceeds from discarding or selling an asset are recorded and com- pared to the asset’s book value to determine gain or loss.

P3 Account for natural resource assets and their depletion. The cost of a natural resource is recorded in a noncurrent asset account. Depletion of a natural resource is recorded by allocating its cost to depletion expense using the units-of-production method. Depletion is credited to an Accumulated Depletion account.

P4 Account for intangible assets. An intangible asset is recorded at the cost incurred to purchase it. The cost of an intangible asset with a definite useful life is allocated to expense using the straight-line method, and is called amortization. Goodwill and in- tangible assets with an indefinite useful life are not amortized— they are annually tested for impairment. Intangi ble assets include patents, copyrights, leaseholds, goodwill, and trademarks.

P5A Account for asset exchanges. For an asset exchange with commercial substance, a gain or loss is recorded based on the difference between the book value of the asset given up and the market value of the asset received. For an asset exchange without commercial substance, no gain or loss is recorded, and the asset received is recorded based on the book value of the asset given up.

Controller The president’s instructions may reflect an honest and reasonable prediction of the future. Since the company is struggling financially, the president may have concluded that the normal pattern of replacing assets every three years cannot continue. Perhaps the strategy is to avoid costs of frequent replacements and stretch use of equipment a few years longer until financial conditions improve.

However, if you believe the president’s decision is unprincipled, you might confront the president with your opinion that it is unethical to change the estimate to increase income. Another possibility is to wait and see whether the auditor will prohibit this change in estimate. In either case, you should insist that the statements be based on reason- able estimates.

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 8 Long-Term Assets 361

Accelerated depreciation method (p. 342)

Amortization (p. 351)

Asset book value (p. 341)

Betterments (p. 347)

Capital expenditures (p. 346)

Change in an accounting estimate (p. 345)

Copyright (p. 352)

Cost (p. 337)

Declining-balance method (p. 342)

Depletion (p. 350)

Depreciation (p. 339)

Extraordinary repairs (p. 347)

Franchises (p. 353)

Goodwill (p. 353)

Impairment (pp. 346, 352)

Inadequacy (p. 339)

Indefinite life (p. 351)

Intangible assets (p. 351)

Key Terms

Environmentalist The paper manufacturer’s comparison of its total asset turnover with food stores and auto dealers is misdirected. These other industries’ turnovers are higher because their profit mar- gins are lower (about 2%). Profit margins for the paper industry are usually 3% to 3.5%. You need to collect data from competitors in the paper industry to show that a 1.9 total asset turnover is about the norm for this industry. You might also want to collect data on this company’s revenues and expenses, along with compensation data for its high- ranking officers and employees.

Entrepreneur Treating an expense as a capital expenditure means that reported expenses will be lower and income higher in the short run. This is so because a capital expenditure is not expensed immediately but is spread over the asset’s useful life. Treating an ex- pense as a capital expenditure also means that asset and equity totals are reported at larger amounts in the short run. This continues until the asset is fully depreciated. Your friend is probably trying to help, but the suggestion is misguided. Only an expenditure benefiting future periods is a capital expenditure.

1. a. Supplies—current assets b. Office equipment—plant assets c. Inventory—current assets d. Land for future expansion—long-term investments e. Trucks used in operations—plant assets 2. a. Land b. Land Improvements 3. $700,000 1 $49,000 2 $21,000 1 $3,500 1 $3,000 1 $2,500 5 $737,000 4. a. Straight-line with 7-year life: ($77,000y7) 5 $11,000 b. Straight-line with 10-year life: ($77,000y10) 5 $7,700 5. Depreciation is a process of allocating the cost of plant assets to

the accounting periods that benefit from the assets’ use. 6. a. Book value using straight-line depreciation:

$96,000 2 [($96,000 2 $8,000)y5] 5 $78,400 b. Book value using units of production:

$96,000 2 [($96,000 2 $8,000) 3 (10,000y100,000)] 5 $87,200 7. ($3,800 2 $200)y3 5 $1,200 (original depreciation per year) $1,200 3 2 5 $2,400 (accumulated depreciation) ($3,800 2 $2,400)y2 5 $700 (revised depreciation)

8.

9. A revenue expenditure benefits only the current period and should be charged to expense in the current period. A capital expenditure yields benefits that extend beyond the end of the current period and should be charged to an asset.

10. A betterment involves modifying an existing plant asset to make it more efficient, usually by replacing part of the asset with an improved or superior part. The cost of a betterment is debited to the asset account.

Guidance Answers to Quick Checks

(b) Equipment (new)* . . . . . . . . . . . . . . . . . . . . . . . 44,600

Accumulated Depreciation — Equipment (old) . . 23,400

Equipment (old) . . . . . . . . . . . . . . . . . . . . . 30,000

Cash ($45,000 2 $7,000) . . . . . . . . . . . . . 38,000

* Includes $400 unrecognized gain.

11.

12. Examples of natural resources are timberlands, mineral depos- its, and oil reserves. Examples of intangible assets are patents, copyrights, leaseholds, leasehold improvements, goodwill, trademarks, and licenses.

13. ($650,000y325,000 tons) 3 91,000 tons 5 $182,000 14.

15.

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . 3,500

Accumulated Depreciation . . . . . . . . . . . . . . . . 3,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . 10,500

Gain on Sale of Equipment . . . . . . . . . . . . . . . . 500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000

Jan. 6 Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Dec. 31 Amortization Expense . . . . . . . . . . . . . . 40,000*

Accumulated Amortization—Patents . . . . . . . . 40,000

* $120,000y3 years 5 $40,000.

(a) Equipment (new) . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Loss on Exchange of Assets . . . . . . . . . . . . . . . . 3,600

Accumulated Depreciation—Equipment (old) . . . 23,400

Equipment (old) . . . . . . . . . . . . . . . . . . . . . 30,000

Cash ($45,000 2 $3,000) . . . . . . . . . . . . . 42,000

Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

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362 Chapter 8 Long-Term Assets

A Superscript letter A denotes assignments based on Appendix 8A.

Icon denotes assignments that involve decision making.

1. What characteristics of a plant asset make it different from other assets?

2. What is the general rule for cost inclusion for plant assets? 3. What is different between land and land improvements? 4. Why is the cost of a lump-sum purchase allocated to the indi-

vidual assets acquired?

5. Does the balance in the Accumulated Depreciation — Machinery account represent funds to replace the machinery when it wears out? If not, what does it represent?

6. Why is the Modified Accelerated Cost Recovery System not generally accepted for financial accounting purposes?

Discussion Questions

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 375 mhhe.com/wildFINMAN5e

1. A company paid $326,000 for property that included land, land improvements, and a building. The land was appraised at $175,000, the land improvements were appraised at $70,000, and the building was appraised at $105,000. What is the alloca- tion of property costs to the three assets purchased?

a. Land, $150,000; Land Improvements, $60,000; Building, $90,000

b. Land, $163,000; Land Improvements, $65,200; Building, $97,800

c. Land, $150,000; Land Improvements, $61,600; Building, $92,400

d. Land, $159,000; Land Improvements, $65,200; Building, $95,400

e. Land, $175,000; Land Improvements, $70,000; Building, $105,000

2. A company purchased a truck for $35,000 on January 1, 2013. The truck is estimated to have a useful life of four years and an estimated salvage value of $1,000. Assuming that the company uses straight-line depreciation, what is the depreciation ex- pense on the truck for the year ended December 31, 2014?

a. $8,750 b. $17,500 c. $8,500 d. $17,000 e. $25,500 3. A company purchased machinery for $10,800,000 on January 1,

2013. The machinery has a useful life of 10 years and an

estimated salvage value of $800,000. What is the depreciation expense on the machinery for the year ended December 31, 2014, assuming that the double-declining-balance method is used?

a. $2,160,000 b. $3,888,000 c. $1,728,000 d. $2,000,000 e. $1,600,000 4. A company sold a machine that originally cost $250,000 for

$120,000 when accumulated depreciation on the machine was $100,000. The gain or loss recorded on the sale of this machine is

a. $0 gain or loss. b. $120,000 gain. c. $30,000 loss. d. $30,000 gain. e. $150,000 loss. 5. A company had average total assets of $500,000, gross sales of

$575,000, and net sales of $550,000. The company’s total asset turnover is

a. 1.15 b. 1.10 c. 0.91 d. 0.87 e. 1.05

Land improvements (p. 338)

Lease (p. 353)

Leasehold (p. 353)

Leasehold improvements (p. 354)

Lessee (p. 353)

Lessor (p. 353)

Licenses (p. 353)

Limited life (p. 351)

Modified Accelerated Cost Recovery System (MACRS) (p. 344)

Natural resources (p. 350)

Obsolescence (p. 339)

Ordinary repairs (p. 347)

Patent (p. 352)

Plant asset age (p. 355)

Plant assets (p. 336)

Revenue expenditures (p. 346)

Salvage value (p. 339)

Straight-line depreciation (p. 340)

Total asset turnover (p. 355)

Trademark or trade (brand) name (p. 353)

Units-of-production depreciation (p. 341)

Useful life (p. 339)

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Chapter 8 Long-Term Assets 363

16. How is total asset turnover computed? Why would a finan- cial statement user be interested in total asset turnover?

17. On its recent balance sheet in Appendix A, Polaris lists its plant assets as “Property and equipment, net.” What does “net” mean in this title?

18. Refer to Arctic Cat’s recent balance sheet in Appendix A. What property, plant and equip- ment assets does Arctic Cat list on its balance sheet? What is the book value of its total net property, plant and equipment assets at March 31, 2011?

19. Refer to KTM’s balance sheet in Appendix A. What does it title its plant assets? What is the book value of its plant assets at December 31, 2011?

20. Refer to the December 31, 2011, balance sheet of Piaggio in Appendix A. What long-term as- sets discussed in this chapter are reported by the company?

7. What accounting concept justifies charging low-cost plant asset purchases immediately to an expense account?

8. What is the difference between ordinary repairs and extra- ordinary repairs? How should each be recorded?

9. Identify events that might lead to disposal of a plant asset. 10. What is the process of allocating the cost of natural resources

to expense as they are used? 11. Is the declining-balance method an acceptable way to compute

depletion of natural resources? Explain. 12. What are the characteristics of an intangible asset? 13. What general procedures are applied in accounting for the

acquisition and potential cost allocation of intangible assets? 14. When do we know that a company has goodwill? When

can goodwill appear in a company’s balance sheet? 15. Assume that a company buys another business and pays for

its goodwill. If the company plans to incur costs each year to maintain the value of the goodwill, must it also amortize this goodwill?

QS 8-2 Cost of plant assets C1

Kegler Bowling installs automatic scorekeeping equipment with an invoice cost of $190,000. The electrical work required for the installation costs $20,000. Additional costs are $4,000 for delivery and $13,700 for sales tax. During the installation, a component of the equipment is carelessly left on a lane and hit by the automatic lane-cleaning machine. The cost of repairing the component is $1,850. What is the total recorded cost of the automatic scorekeeping equipment?

QS 8-3 Straight-line depreciation

P1

On January 2, 2013, the Cerritos Band acquires sound equipment for concert performances at a cost of $65,800. The band estimates it will use this equipment for four years, during which time it anticipates performing about 200 concerts. It estimates that after four years it can sell the equipment for $2,000. During year 2013, the band performs 45 concerts. Compute the year 2013 depreciation using the straight- line method.

QS 8-4 Units-of-production depreciation

P1

Refer to the information in QS 8-3. Compute the year 2013 depreciation using the units-of-production method.

QS 8-5 Computing revised depreciation

C2

Refer to the facts in QS 8-3. Assume that the Cerritos Band uses straight-line depreciation but realizes at the start of the second year that due to concert bookings beyond expectations, this equipment will last only a total of three years. The salvage value remains unchanged. Compute the revised depreciation for both the second and third years.

QS 8-6 Double-declining-balance method P1

A fleet of refrigerated delivery trucks is acquired on January 5, 2013, at a cost of $830,000 with an estimated useful life of eight years and an estimated salvage value of $75,000. Compute the depreciation expense for the first three years using the double-declining-balance method.

QS 8-7 Recording plant asset impairment C2

Assume a company’s equipment carries a book value of $16,000 ($16,500 cost less $500 accumulated depreciation) and a fair value of $14,750, and that the $1,250 decline in fair value in comparison to the book value meets the 2-step impairment test. Prepare the entry to record this $1,250 impairment.

Identify the main difference between (1) plant assets and current assets, (2) plant assets and inventory, and (3) plant assets and long-term investments.

QUICK STUDY

QS 8-1 Defining assets C1

Polaris

Arctic Cat

KTM

PIAGGIO

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364 Chapter 8 Long-Term Assets

QS 8-8 Revenue and capital expenditures

C3

1. Classify the following as either revenue or capital expenditures. a. Paid $40,000 cash to replace a compressor on a refrigeration system that extends its useful life

by four years. b. Paid $200 cash per truck for the cost of their annual tune-ups. c. Paid $175 for the monthly cost of replacement filters on an air-conditioning system. d. Completed an addition to an office building for $225,000 cash. 2. Prepare the journal entries to record transactions a and d of part 1.

QS 8-9 Disposal of assets P2

Hortez Co. owns equipment that cost $76,800, with accumulated depreciation of $40,800. Hortez sells the equipment for cash. Record the sale of the equipment assuming Hortez sells the equipment for (1) $47,000 cash, (2) $36,000 cash, and (3) $31,000 cash.

QS 8-10 Natural resources and depletion

P3

Corentine Company acquires an ore mine at a cost of $1,400,000. It incurs additional costs of $400,000 to access the mine, which is estimated to hold 1,000,000 tons of ore. The estimated value of the land after the ore is removed is $200,000. 1. Prepare the entry(ies) to record the cost of the ore mine. 2. Prepare the year-end adjusting entry if 180,000 tons of ore are mined and sold the first year.

QS 8-11 Classify assets

P3 P4

Which of the following assets are reported on the balance sheet as intangible assets? Which are reported as natural resources? (a) Oil well, (b) trademark, (c) leasehold, (d ) gold mine, (e) building, ( f ) copyright, (g) franchise, (h) timberland.

QS 8-12 Intangible assets and amortization P4

On January 4 of this year, Freckles Boutique incurs a $105,000 cost to modernize its store. Improvements include new floors, ceilings, wiring, and wall coverings. These improvements are estimated to yield benefits for 10 years. Freckles leases its store and has eight years remaining on the lease. Prepare the entry to record (1) the cost of modernization and (2) amortization at the end of this current year.

QS 8-13 Computing total asset turnover

A1

Aneko Company reports the following ($ 000s): net sales of $14,800 for 2013 and $13,990 for 2012; end- of-year total assets of $19,100 for 2013 and $17,900 for 2012. Compute its total asset turnover for 2013, and assess its level if competitors average a total asset turnover of 2.0 times.

QS 8-14A

Asset exchange

P5

Caleb Co. owns a machine that costs $42,400 with accumulated depreciation of $18,400. Caleb exchanges the machine for a newer model that has a market value of $52,000. (1) Record the exchange assuming Caleb paid $30,000 cash and the exchange has commercial substance. (2) Record the exchange assuming Caleb pays $22,000 cash and the exchange lacks commercial substance.

QS 8-15 International accounting standards

C1 C3

Answer each of the following related to international accounting standards. a. Accounting for plant assets involves cost determination, depreciation, additional expenditures, and

disposals. Is plant asset accounting broadly similar or dissimilar between IFRS and U.S. GAAP? Identify one notable difference between IFRS and U.S. GAAP in accounting for plant assets.

b. Describe how IFRS and U.S. GAAP treat increases in the value of plant assets subsequent to their acquisition (but before their disposition).

EXERCISES

Exercise 8-1 Cost of plant assets

C1

Rizio Co. purchases a machine for $12,500, terms 2y10, ny60, FOB shipping point. The seller prepaid the $360 freight charges, adding the amount to the invoice and bringing its total to $12,860. The machine requires special steel mounting and power connections costing $895. Another $475 is paid to assemble the machine and get it into operation. In moving the machine to its steel mounting, $180 in damages occurred. Materials costing $40 are used in adjusting the machine to produce a satisfactory product. The adjustments are normal for this machine and are not the result of the damages. Compute the cost recorded for this machine. (Rizio pays for this machine within the cash discount period.)

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Chapter 8 Long-Term Assets 365

Exercise 8-2 Recording costs of assets

C1

Cala Manufacturing purchases a large lot on which an old building is located as part of its plans to build a new plant. The negotiated purchase price is $280,000 for the lot plus $110,000 for the old building. The company pays $33,500 to tear down the old building and $47,000 to fill and level the lot. It also pays a total of $1,540,000 in construction costs — this amount consists of $1,452,200 for the new building and $87,800 for lighting and paving a parking area next to the building. Prepare a single journal entry to record these costs incurred by Cala, all of which are paid in cash.

Exercise 8-3 Lump-sum purchase of plant assets C1

Liltua Company pays $375,280 for real estate plus $20,100 in closing costs. The real estate consists of land appraised at $157,040; land improvements appraised at $58,890; and a building appraised at $176,670. Allocate the total cost among the three purchased assets and prepare the journal entry to record the purchase.

Exercise 8-4 Straight-line depreciation P1

In early January 2013, NewTech purchases computer equipment for $154,000 to use in operating activities for the next four years. It estimates the equipment’s salvage value at $25,000. Prepare a table showing depreciation and book value for each of the four years assuming straight-line depreciation.

Exercise 8-5 Double-declining-balance depreciation P1

Refer to the information in Exercise 8-4. Prepare a table showing depreciation and book value for each of the four years assuming double-declining-balance depreciation.

Exercise 8-6 Straight-line depreciation

P1

Ramirez Company installs a computerized manufacturing machine in its factory at the beginning of the year at a cost of $43,500. The machine’s useful life is estimated at 10 years, or 385,000 units of product, with a $5,000 salvage value. During its second year, the machine produces 32,500 units of product. Determine the machine’s second-year depreciation under the straight-line method.

Exercise 8-7 Units-of-production depreciation

P1

Refer to the information in Exercise 8-6. Determine the machine’s second-year depreciation using the units-of-production method.

Exercise 8-8 Double-declining-balance depreciation P1

Refer to the information in Exercise 8-6. Determine the machine’s second-year depreciation using the double-declining-balance method.

Exercise 8-9 Straight-line, partial-year depreciation C2

On April 1, 2012, Cyclone’s Backhoe Co. purchases a trencher for $280,000. The machine is expected to last five years and have a salvage value of $40,000. Compute depreciation expense for both 2012 and 2013 assuming the company uses the straight-line method.

Exercise 8-10 Double-declining-balance, partial-year depreciation C2

Refer to the information in Exercise 8-9. Compute depreciation expense for both 2012 and 2013 assuming the company uses the double-declining-balance method.

Exercise 8-11 Revising depreciation

C2

Apex Fitness Club uses straight-line depreciation for a machine costing $23,860, with an estimated four- year life and a $2,400 salvage value. At the beginning of the third year, Apex determines that the machine has three more years of remaining useful life, after which it will have an estimated $2,000 salvage value. Compute (1) the machine’s book value at the end of its second year and (2) the amount of depreciation for each of the final three years given the revised estimates. Check (2) $3,710

Exercise 8-12 Straight-line depreciation and income effects P1

Tory Enterprises pays $238,400 for equipment that will last five years and have a $43,600 salvage value. By using the equipment in its operations for five years, the company expects to earn $88,500 annually, after deducting all expenses except depreciation. Prepare a table showing income before depreciation, depreciation expense, and net (pretax) income for each year and for the total five-year period, assuming straight-line depreciation.

Exercise 8-13 Double-declining-balance depreciation P1

Refer to the information in Exercise 8-12. Prepare a table showing income before depreciation, depreciation expense, and net (pretax) income for each year and for the total five-year period, assuming double-declining-balance depreciation is used.

Check Year 3 NI, $54,170

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366 Chapter 8 Long-Term Assets

Exercise 8-14 Extraordinary repairs; plant asset age

C3

Veradis Company owns a building that appears on its prior year-end balance sheet at its original $572,000 cost less $429,000 accumulated depreciation. The building is depreciated on a straight-line basis assuming a 20-year life and no salvage value. During the first week in January of the current calendar year, major structural repairs are completed on the building at a $68,350 cost. The repairs extend its useful life for 5 years beyond the 20 years originally estimated. 1. Determine the building’s age (plant asset age) as of the prior year-end balance sheet date. 2. Prepare the entry to record the cost of the structural repairs that are paid in cash. 3. Determine the book value of the building immediately after the repairs are recorded. 4. Prepare the entry to record the current calendar year’s depreciation.

Check (3) $211,350

Exercise 8-15 Ordinary repairs, extraordinary repairs and betterments

C3

Oki Company pays $264,000 for equipment expected to last four years and have a $29,000 salvage value. Prepare journal entries to record the following costs related to the equipment. 1. During the second year of the equipment’s life, $22,000 cash is paid for a new component expected to

increase the equipment’s productivity by 10% a year. 2. During the third year, $6,250 cash is paid for normal repairs necessary to keep the equipment in good

working order. 3. During the fourth year, $14,870 is paid for repairs expected to increase the useful life of the equipment

from four to five years.

Exercise 8-16 Disposal of assets

P2

Diaz Company owns a milling machine that cost $250,000 and has accumulated depreciation of $182,000. Prepare the entry to record the disposal of the milling machine on January 3 under each of the following independent situations. 1. The machine needed extensive repairs, and it was not worth repairing. Diaz disposed of the machine,

receiving nothing in return. 2. Diaz sold the machine for $35,000 cash. 3. Diaz sold the machine for $68,000 cash. 4. Diaz sold the machine for $80,000 cash.

Exercise 8-17 Partial-year depreciation; disposal of plant asset

P2

Rayya Co. purchases and installs a machine on January 1, 2013, at a total cost of $105,000. Straight-line depreciation is taken each year for four years assuming a seven-year life and no salvage value. The machine is disposed of on July 1, 2017, during its fifth year of service. Prepare entries to record the partial year’s depreciation on July 1, 2017, and to record the disposal under the following separate assumptions: (1) the machine is sold for $45,500 cash and (2) Rayya receives an insurance settlement of $25,000 resulting from the total destruction of the machine in a fire.

Exercise 8-18 Depletion of natural resources

P1 P3

On April 2, 2013, Montana Mining Co. pays $3,721,000 for an ore deposit containing 1,525,000 tons. The company installs machinery in the mine costing $213,500, with an estimated seven-year life and no salvage value. The machinery will be abandoned when the ore is completely mined. Montana begins mining on May 1, 2013, and mines and sells 166,200 tons of ore during the remaining eight months of 2013. Prepare the December 31, 2013, entries to record both the ore deposit depletion and the mining machinery depreciation. Mining machinery depreciation should be in proportion to the mine’s depletion.

Exercise 8-19 Amortization of intangible assets

P4

Milano Gallery purchases the copyright on an oil painting for $418,000 on January 1, 2013. The copyright legally protects its owner for 10 more years. The company plans to market and sell prints of the original for 11 years. Prepare entries to record the purchase of the copyright on January 1, 2013, and its annual amortization on December 31, 2013.

Exercise 8-20 Goodwill

P4

On January 1, 2013, Robinson Company purchased Franklin Company at a price of $2,500,000. The fair market value of the net assets purchased equals $1,800,000. 1. What is the amount of goodwill that Robinson records at the purchase date? 2. Explain how Robinson would determine the amount of goodwill amortization for the year ended

December 31, 2013. 3. Robinson Company believes that its employees provide superior customer service, and through their

efforts, Robinson Company believes it has created $900,000 of goodwill. How would Robinson Company record this goodwill?

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Chapter 8 Long-Term Assets 367

Exercise 8-21 Cash flows related to assets

C1

Refer to the statement of cash flows for Arctic Cat in Appendix A for the fiscal year ended March 31, 2011, to answer the following. 1. What amount of cash is used to purchase property and equipment? 2. How much depreciation and amortization are recorded? 3. What total amount of net cash is used in investing activities?

Exercise 8-22 Evaluating efficient use of assets

A1

Lok Co. reports net sales of $5,856,480 for 2012 and $8,679,690 for 2013. End-of-year balances for total assets are 2011, $1,686,000; 2012, $1,800,000; and 2013, $1,982,000. (a) Compute Lok’s total asset turnover for 2012 and 2013. (b) Comment on Lok’s efficiency in using its assets if its competitors average a total asset turnover of 3.0.

Exercise 8-24A

Recording plant asset disposals

P2 P5

On January 2, 2013, Bering Co. disposes of a machine costing $44,000 with accumulated depreciation of $24,625. Prepare the entries to record the disposal under each of the following separate assumptions. 1. The machine is sold for $18,250 cash. 2. The machine is traded in for a newer machine having a $60,200 cash price. A $25,000 trade-in allowance

is received, and the balance is paid in cash. Assume the asset exchange lacks commercial substance. 3. The machine is traded in for a newer machine having a $60,200 cash price. A $15,000 trade-in allowance

is received, and the balance is paid in cash. Assume the asset exchange has commercial substance.

Check (2) Dr. Machinery (new), $54,575

Exercise 8-23A

Exchanging assets

P5

Gilly Construction trades in an old tractor for a new tractor, receiving a $29,000 trade-in allowance and paying the remaining $83,000 in cash. The old tractor had cost $96,000, and straight-line accumulated depreciation of $52,500 had been recorded to date under the assumption that it would last eight years and have a $12,000 salvage value. Answer the following questions assuming the exchange has commercial substance. 1. What is the book value of the old tractor at the time of exchange? 2. What is the loss on this asset exchange? 3. What amount should be recorded (debited) in the asset account for the new tractor?

Check (2) $14,500

Exercise 8-25 Accounting for plant assets under IFRS

C2 P1 P2

Volkswagen Group reports the following information for property, plant and equipment as of December 31, 2010, along with additions, disposals, depreciation, and impairments for the year ended December 31, 2010 (euros in millions):

1. Prepare Volkswagen’s journal entry to record its depreciation for 2010. 2. Prepare Volkswagen’s journal entry to record its additions for 2010 assuming they are paid in cash and

are treated as “betterments (improvements)” to the assets. 3. Prepare Volkswagen’s journal entry to record its €2,522 in disposals for 2010 assuming it receives

€700 cash in return and the accumulated depreciation on the disposed assets totals €1,322. 4. Volkswagen reports €451 of impairments. Do these impairments increase or decrease the property,

plant and equipment account? And, by what amount?

Property, plant and equipment, net . . . . . . . . . . . . . . . . . . . . €25,847

Additions to property, plant and equipment . . . . . . . . . . . . 5,634

Disposals of property, plant and equipment . . . . . . . . . . . . . 2,522

Depreciation on property, plant and equipment . . . . . . . . . 4,731

Impairments to property, plant and equipment . . . . . . . . . . 451

mhhe.com/wildFINMAN5e

Timberly Construction negotiates a lump-sum purchase of several assets from a company that is going out of business. The purchase is completed on January 1, 2013, at a total cash price of $900,000 for a building, land, land improvements, and four vehicles. The estimated market values of the assets are building, $508,800; land, $297,600; land improvements, $28,800; and four vehicles, $124,800. The company’s fiscal year ends on December 31.

Required

1. Prepare a table to allocate the lump-sum purchase price to the separate assets purchased (round per- cents to the nearest 1%). Prepare the journal entry to record the purchase.

PROBLEM SET A

Problem 8-1A Plant asset costs; depreciation methods C1 P1

Arctic Cat

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368 Chapter 8 Long-Term Assets

2. Compute the depreciation expense for year 2013 on the building using the straight-line method, as- suming a 15-year life and a $27,000 salvage value.

3. Compute the depreciation expense for year 2013 on the land improvements assuming a five-year life and double-declining-balance depreciation.

Analysis Component

4. Defend or refute this statement: Accelerated depreciation results in payment of less taxes over the asset’s life.

Check (2) $30,000

(3) $10,800

Problem 8-4A Computing and revising depreciation; selling plant assets

C2 P1 P2

Yoshi Company completed the following transactions and events involving its delivery trucks.

2012

Jan. 1 Paid $20,515 cash plus $1,485 in sales tax for a new delivery truck estimated to have a five-year life and a $2,000 salvage value. Delivery truck costs are recorded in the Trucks account.

Dec. 31 Recorded annual straight-line depreciation on the truck.

Problem 8-3A Computing and revising depreciation; revenue and capital expenditures

C1 C2 C3

Champion Contractors completed the following transactions and events involving the purchase and opera- tion of equipment in its business.

2012

Jan. 1 Paid $287,600 cash plus $11,500 in sales tax and $1,500 in transportation (FOB shipping point) for a new loader. The loader is estimated to have a four-year life and a $20,600 salvage value. Loader costs are recorded in the Equipment account.

Jan. 3 Paid $4,800 to enclose the cab and install air conditioning in the loader to enable operations under harsher conditions. This increased the estimated salvage value of the loader by another $1,400.

Dec. 31 Recorded annual straight-line depreciation on the loader.

2013

Jan. 1 Paid $5,400 to overhaul the loader’s engine, which increased the loader’s estimated useful life by two years.

Feb. 17 Paid $820 to repair the loader after the operator backed it into a tree. Dec. 31 Recorded annual straight-line depreciation on the loader.

Required

Prepare journal entries to record these transactions and events.

Check Dec. 31, 2012, Dr. Depr. Expense—Equip., $70,850

Check Dec. 31, 2013, Dr. Depr. Expense—Equip., $43,590

Problem 8-2A Asset cost allocation; straight-line depreciation

C1 P1

In January 2013, Mitzu Co. pays $2,600,000 for a tract of land with two buildings on it. It plans to demol- ish Building 1 and build a new store in its place. Building 2 will be a company office; it is appraised at $644,000, with a useful life of 20 years and an $60,000 salvage value. A lighted parking lot near Building 1 has improvements (Land Improvements 1) valued at $420,000 that are expected to last another 12 years with no salvage value. Without the buildings and improve ments, the tract of land is valued at $1,736,000. The company also incurs the following additional costs:

Required

1. Prepare a table with the following column headings: Land, Building 2, Building 3, Land Improve- ments 1, and Land Improvements 2. Allocate the costs incurred by Mitzu to the appropriate columns and total each column (round percents to the nearest 1%).

2. Prepare a single journal entry to record all the incurred costs assuming they are paid in cash on January 1, 2013.

3. Using the straight-line method, prepare the December 31 adjusting entries to record depreciation for the 12 months of 2013 when these assets were in use.

Cost to demolish Building 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 328,400

Cost of additional land grading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,400

Cost to construct new building (Building 3), having a useful life of 25 years and a $392,000 salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,202,000

Cost of new land improvements (Land Improvements 2) near Building 2 having a 20-year useful life and no salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . 164,000

Check (1) Land costs, $2,115,800; Building 2 costs, $598,000

(3) Depr.—Land Improv. 1 and 2, $32,500 and $8,200

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Chapter 8 Long-Term Assets 369

2013

Dec. 31 Due to new information obtained earlier in the year, the truck’s estimated useful life was changed from five to four years, and the estimated salvage value was increased to $2,400. Re- corded annual straight-line depreciation on the truck.

2014

Dec. 31 Recorded annual straight-line depreciation on the truck. Dec. 31 Sold the truck for $5,300 cash.

Required

Prepare journal entries to record these transactions and events.

Check Dec. 31, 2013, Dr. Depr. Expense—Trucks, $5,200

Dec. 31, 2014, Dr. Loss on Disposal of Trucks, $2,300

Problem 8-6A Disposal of plant assets

C1 P1 P2

Onslow Co. purchases a used machine for $178,000 cash on January 2 and readies it for use the next day at an $2,840 cost. On January 3, it is installed on a required operating platform costing $1,160, and it is further readied for operations. The company predicts the machine will be used for six years and have a $14,000 salvage value. Depreciation is to be charged on a straight-line basis. On December 31, at the end of its fifth year in operations, it is disposed of.

Required

1. Prepare journal entries to record the machine’s purchase and the costs to ready and install it. Cash is paid for all costs incurred.

2. Prepare journal entries to record depreciation of the machine at December 31 of (a) its first year in operations and (b) the year of its disposal.

3. Prepare journal entries to record the machine’s disposal under each of the following separate as sumptions: (a) it is sold for $15,000 cash; (b) it is sold for $50,000 cash; and (c) it is destroyed in a fire and the insurance company pays $30,000 cash to settle the loss claim.

Check (2b) Depr. Exp., $28,000

(3c) Dr. Loss from Fire, $12,000

Problem 8-7A Natural resources

P3

On July 23 of the current year, Dakota Mining Co. pays $4,715,000 for land estimated to contain 5,125,000 tons of recoverable ore. It installs machinery costing $410,000 that has a 10-year life and no salvage value and is capable of mining the ore deposit in eight years. The machinery is paid for on July 25, seven days before mining operations begin. The company removes and sells 480,000 tons of ore during its first five months of operations ending on December 31. Depreciation of the machinery is in proportion to the mine’s depletion as the machinery will be abandoned after the ore is mined.

Required

Prepare entries to record (a) the purchase of the land, (b) the cost and installation of machinery, (c) the first five months’ depletion assuming the land has a net salvage value of zero after the ore is mined, and (d ) the first five months’ depreciation on the machinery.

Analysis Component

Describe both the similarities and differences in amortization, depletion, and depreciation.

Check (c) Depletion, $441,600 (d ) Depreciation, $38,400

Check Year 4: units-of-production depreciation, $4,300; DDB depreciation, $12,187

Problem 8-5A Depreciation methods

P1

A machine costing $257,500 with a four-year life and an estimated $20,000 salvage value is installed in Luther Company’s factory on January 1. The factory manager estimates the machine will produce 475,000 units of product during its life. It actually produces the following units: year 1, 220,000; year 2, 124,600; year 3, 121,800; and year 4, 15,200. The total number of units produced by the end of year 4 exceeds the original estimate — this difference was not predicted. (The machine must not be depreciated below its es- timated salvage value.)

Required

Prepare a table with the following column headings and compute depreciation for each year (and total depreciation of all years combined) for the machine under each depreciation method.

Year Straight-Line Units-of-Production Double-Declining-Balance

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370 Chapter 8 Long-Term Assets

Problem 8-8A Intangible assets

P4

On July 1, 2008, Falk Company signed a contract to lease space in a building for 15 years. The lease con- tract calls for annual (prepaid) rental payments of $80,000 on each July 1 throughout the life of the lease and for the lessee to pay for all additions and improvements to the leased property. On June 25, 2013, Falk decides to sublease the space to Ryan & Associates for the remaining 10 years of the lease—Ryan pays $200,000 to Falk for the right to sublease and it agrees to assume the obligation to pay the $80,000 annual rent to the building owner beginning July 1, 2013. After taking possession of the leased space, Ryan pays for improving the office portion of the leased space at a $130,000 cost. The improvements are paid for by Ryan on July 5, 2013, and are estimated to have a useful life equal to the 16 years remaining in the life of the building.

Required

1. Prepare entries for Ryan to record (a) its payment to Falk for the right to sublease the building space, (b) its payment of the 2013 annual rent to the building owner, and (c) its payment for the office improvements.

2. Prepare Ryan’s year-end adjusting entries required at December 31, 2013, to (a) amortize the $200,000 cost of the sublease, (b) amortize the office improvements, and ( c) record rent expense.

Check Dr. Rent Expense for (2a) $10,000, (2c) $40,000

Nagy Company negotiates a lump-sum purchase of several assets from a contractor who is relocating. The purchase is completed on January 1, 2013, at a total cash price of $1,800,000 for a building, land, land improvements, and five trucks. The estimated market values of the assets are building, $890,000; land, $427,200; land improvements, $249,200; and five trucks, $213,600. The company’s fiscal year ends on December 31.

Required

1. Prepare a table to allocate the lump-sum purchase price to the separate assets purchased (round per- cents to the nearest 1%). Prepare the journal entry to record the purchase.

2. Compute the depreciation expense for year 2013 on the building using the straight-line method, as- suming a 12-year life and a $120,000 salvage value.

3. Compute the depreciation expense for year 2013 on the land improvements assuming a 10-year life and double-declining-balance depreciation.

Analysis Component

4. Defend or refute this statement: Accelerated depreciation results in payment of more taxes over the asset’s life.

PROBLEM SET B

Problem 8-1B Plant asset costs; depreciation methods

C1 P1

Check (2) $65,000

(3) $50,400

Problem 8-2B Asset cost allocation; straight- line depreciation

C1 P1

In January 2013, ProTech Co. pays $1,550,000 for a tract of land with two buildings. It plans to demolish Building A and build a new shop in its place. Building B will be a company office; it is appraised at $482,800, with a useful life of 15 years and a $99,500 salvage value. A lighted parking lot near Building B has improvements (Land Improvements B) valued at $142,000 that are expected to last another five years with no salvage value. Without the buildings and improvements, the tract of land is valued at $795,200. The company also incurs the following additional costs.

Cost to demolish Building A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 122,000

Cost of additional land grading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174,500

Cost to construct new building (Building C), having a useful life of 20 years and a $258,000 salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,458,000

Cost of new land improvements (Land Improvements C) near Building C, having a 10-year useful life and no salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,500

Required

1. Prepare a table with the following column headings: Land, Building B, Building C, Land Improve- ments B, and Land Improvements C. Allocate the costs incurred by ProTech to the appropriate col- umns and total each column (round percents to the nearest 1%).

2. Prepare a single journal entry to record all incurred costs assuming they are paid in cash on January 1, 2013.

3. Using the straight-line method, prepare the December 31 adjusting entries to record depreciation for the 12 months of 2013 when these assets were in use.

Check (1) Land costs, $1,164,500; Building B costs, $527,000

(3) Depr.—Land Improv. B and C, $31,000 and $10,350

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Chapter 8 Long-Term Assets 371

Problem 8-3B Computing and revising depreciation; revenue and capital expenditures

C1 C2 C3

Mercury Delivery Service completed the following transactions and events involving the purchase and operation of equipment for its business.

2012

Jan. 1 Paid $25,860 cash plus $1,810 in sales tax for a new delivery van that was estimated to have a five-year life and a $3,670 salvage value. Van costs are recorded in the Equipment account.

Jan. 3 Paid $1,850 to install sorting racks in the van for more accurate and quicker delivery of pack- ages. This increases the estimated salvage value of the van by another $230.

Dec. 31 Recorded annual straight-line depreciation on the van.

2013

Jan. 1 Paid $2,064 to overhaul the van’s engine, which increased the van’s estimated useful life by two years.

May 10 Paid $800 to repair the van after the driver backed it into a loading dock. Dec. 31 Record annual straight-line depreciation on the van. (Round to the nearest dollar.)

Required

Prepare journal entries to record these transactions and events.

Check Dec. 31, 2013, Dr. Depr. Expense—Equip., $3,760

Check Dec. 31, 2012, Dr. Depr. Expense—Equip., $5,124

Problem 8-4B Computing and revising depreciation; selling plant assets

C2 P1 P2

York Instruments completed the following transactions and events involving its machinery.

2012

Jan. 1 Paid $107,800 cash plus $6,470 in sales tax for a new machine. The machine is estimated to have a six-year life and a $9,720 salvage value.

Dec. 31 Recorded annual straight-line depreciation on the machinery.

2013

Dec. 31 Due to new information obtained earlier in the year, the machine’s estimated useful life was changed from six to four years, and the estimated salvage value was increased to $14,345. Re- corded annual straight-line depreciation on the machinery.

2014

Dec. 31 Recorded annual straight-line depreciation on the machinery. Dec. 31 Sold the machine for $25,240 cash.

Required

Prepare journal entries to record these transactions and events.

Check Dec. 31, 2013, Dr. Depr. Expense—Machinery, $27,500

Dec. 31, 2014, Dr. Loss on Disposal of Machinery, $16,605

Problem 8-6B Disposal of plant assets

C1 P1 P2

On January 1, Walker purchases a used machine for $150,000 and readies it for use the next day at a cost of $3,510. On January 4, it is mounted on a required operating platform costing $4,600, and it is further readied for operations. Management estimates the machine will be used for seven years and have an $18,110 salvage value. Depreciation is to be charged on a straight-line basis. On December 31, at the end of its sixth year of use, the machine is disposed of.

Problem 8-5B Depreciation methods

P1

On January 2, Manning Co. purchases and installs a new machine costing $324,000 with a five-year life and an estimated $30,000 salvage value. Management estimates the machine will produce 1,470,000 units of product during its life. Actual production of units is as follows: year 1, 355,600; year 2, 320,400; year 3, 317,000; year 4, 343,600; and year 5, 138,500. The total number of units produced by the end of year 5 exceeds the original estimate — this difference was not predicted. (The machine must not be depreciated below its estimated salvage value.)

Required

Prepare a table with the following column headings and compute depreciation for each year (and total depreciation of all years combined) for the machine under each depreciation method.

Check DDB Depreciation, Year 3, $46,656; U-of-P Depreciation, Year 4, $68,720

Year Straight-Line Units-of-Production Double-Declining-Balance

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372 Chapter 8 Long-Term Assets

Required

1. Prepare journal entries to record the machine’s purchase and the costs to ready and install it. Cash is paid for all costs incurred.

2. Prepare journal entries to record depreciation of the machine at December 31 of (a) its first year in operations and (b) the year of its disposal.

3. Prepare journal entries to record the machine’s disposal under each of the following separate as- sumptions: (a) it is sold for $28,000 cash; (b) it is sold for $52,000 cash; and (c) it is destroyed in a fire and the insurance company pays $25,000 cash to settle the loss claim.

Check (2b) Depr. Exp., $20,000

(3c) Dr. Loss from Fire, $13,110

Problem 8-7B Natural resources

P3

On February 19 of the current year, Quartzite Co. pays $5,400,000 for land estimated to contain 4 mil- lion tons of recoverable ore. It installs machinery costing $400,000 that has a 16-year life and no salvage value and is capable of mining the ore deposit in 12 years. The machinery is paid for on March 21, eleven days before mining operations begin. The company removes and sells 254,000 tons of ore during its first nine months of operations ending on December 31. Depreciation of the machinery is in propor- tion to the mine’s depletion as the machinery will be abandoned after the ore is mined.

Required

Prepare entries to record (a) the purchase of the land, (b) the cost and installation of the machinery, (c) the first nine months’ depletion assuming the land has a net salvage value of zero after the ore is mined, and (d ) the first nine months’ depreciation on the machinery.

Analysis Component

Describe both the similarities and differences in amortization, depletion, and depreciation.

Check (c) Depletion, $342,900; (d ) Depreciation, $25,400

Check Dr. Rent Expense: (2a) $8,000, (2c) $36,000

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 8 Selected ledger account balances for Success Systems follow.

SERIAL PROBLEM Success Systems

P1 A1

For Three Months For Three Months

Ended December 31, 2013 Ended March 31, 2014

Office equipment . . . . . . . . . . . . . . . . . $ 8,000 $ 8,000

Accumulated depreciation— Office equipment . . . . . . . . . . . . . . . 400 800

Computer equipment . . . . . . . . . . . . . . 20,000 20,000

Accumulated depreciation— Computer equipment . . . . . . . . . . . . 1,250 2,500

Total revenue . . . . . . . . . . . . . . . . . . . . . 31,284 43,853

Total assets . . . . . . . . . . . . . . . . . . . . . . 93,248 129,909

Problem 8-8B Intangible assets

P4

On January 1, 2006, Mason Co. entered into a 12-year lease on a building. The lease contract requires (1) annual (prepaid) rental payments of $36,000 each January 1 throughout the life of the lease and (2) for the lessee to pay for all additions and improvements to the leased property. On January 1, 2013, Mason decides to sublease the space to Stewart Co. for the remaining five years of the lease — Stewart pays $40,000 to Mason for the right to sublease and agrees to assume the obligation to pay the $36,000 annual rent to the building owner beginning January 1, 2013. After taking possession of the leased space, Stewart pays for improving the office portion of the leased space at a $20,000 cost. The improvements are paid for by Stewart on January 3, 2013, and are estimated to have a useful life equal to the 13 years remaining in the life of the building.

Required

1. Prepare entries for Stewart to record (a) its payment to Mason for the right to sublease the building space, (b) its payment of the 2013 annual rent to the building owner, and (c) its payment for the office improvements.

2. Prepare Stewart’s year-end adjusting entries required on December 31, 2013, to (a) amortize the $40,000 cost of the sublease, (b) amortize the office improvements, and ( c) record rent expense.

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Chapter 8 Long-Term Assets 373

Beyond the Numbers

BTN 8-1 Refer to the financial statements of Polaris in Appendix A to answer the following. 1. What percent of the original cost of Polaris’ property and equipment remains to be depreciated as of

December 31, 2011, and at December 31, 2010? Assume these assets have no salvage value. 2. Over what length(s) of time is Polaris depreciating its major categories of property and equipment? 3. What is the change in total property and equipment (before accumulated depreciation) for the year

ended December 31, 2011? What is the amount of cash provided (used) by investing activities for property and equipment for the year ended December 31, 2011? What is one possible explanation for the difference between these two amounts?

4. Compute its total asset turnover for the year ended December 31, 2011, and the year ended December 31, 2010. Assume total assets at December 31, 2008, are $763,653 ($ thousands).

Fast Forward

5. Access Polaris’ financial statements for fiscal years ending after December 31, 2011, at its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Recompute Polaris’ total asset turn- over for the additional years’ data you collect. Comment on any differences relative to the turnover computed in part 4.

REPORTING IN ACTION A1

BTN 8-3 Flo Choi owns a small business and manages its accounting. Her company just finished a year in which a large amount of borrowed funds was invested in a new building addition as well as in equip- ment and fixture additions. Choi’s banker requires her to submit semiannual financial statements so he can monitor the financial health of her business. He has warned her that if profit margins erode, he might raise the interest rate on the borrowed funds to reflect the increased loan risk from the bank’s point of view. Choi knows profit margin is likely to decline this year. As she prepares year-end adjusting entries, she decides to apply the following depre ciation rule: All asset additions are considered to be in use on the first day of the following month. (The previous rule assumed assets are in use on the first day of the month nearest to the purchase date.)

ETHICS CHALLENGE C1

Required

1. Assume that Success Systems does not acquire additional office equipment or computer equipment in 2014. Compute amounts for the year ended December 31, 2014, for Depreciation Expense — Office Equip- ment and for Depreciation Expense—Computer Equipment (assume use of the straight-line method).

2. Given the assumptions in part 1, what is the book value of both the office equipment and the computer equipment as of December 31, 2014?

3. Compute the three-month total asset turnover for Success Systems as of March 31, 2014. Use total reve- nue for the numerator and average the December 31, 2013, total assets and the March 31, 2014, total assets for the denominator. Interpret its total asset turnover if competitors average 2.5 for annual periods. (Round turnover to two decimals.)

Check (3) Three-month (annual) turnover 5 0.393 (1.572 annual)

BTN 8-2 Comparative figures for Polaris and Arctic Cat follow. COMPARATIVE ANALYSIS A1

Polaris Arctic Cat

One Two One Two

Current Year Years Current Year Years

($ thousands) Year Prior Prior Year Prior Prior

Total assets . . . . . . . . . . . . $1,228,024 $1,061,647 $ 763,653 $272,906 $246,084 $251,165

Net sales . . . . . . . . . . . . . . 2,656,949 1,991,139 1,565,887 464,651 450,728 563,613

Required

1. Compute total asset turnover for the most recent two years for Polaris and Arctic Cat using the data shown.

2. Which company is more efficient in generating net sales given the total assets it employs? Assume an industry average of 1.0 for asset turnover.

Polaris

Polaris

Arctic Cat

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374 Chapter 8 Long-Term Assets

Required

1. Identify decisions that managers like Choi must make in applying depreciation methods. 2. Is Choi’s rule an ethical violation, or is it a legitimate decision in computing depreciation? 3. How will Choi’s new depreciation rule affect the profit margin of her business?

BTN 8-4 Teams are to select an industry, and each team member is to select a different company in that industry. Each team member is to acquire the financial statements (Form 10-K) of the company selected — see the company’s Website or the SEC’s EDGAR database (www.sec.gov). Use the financial statements to compute total asset turnover. Communicate with teammates via a meeting, e-mail, or telephone to discuss the meaning of this ratio, how different companies compare to each other, and the industry norm. The team must prepare a one-page report that describes the ratios for each company and identifies the conclusions reached during the team’s discussion.

COMMUNICATING IN PRACTICE A1

BTN 8-5 Access the Yahoo! (ticker: YHOO) 10-K report for the year ended December 31, 2011, filed on February 29, 2012, at www.sec.gov.

Required

1. What amount of goodwill is reported on Yahoo!’s balance sheet? What percentage of total assets does its goodwill represent? Is goodwill a major asset for Yahoo!? Explain.

2. Locate Note 5 to its financial statements. Identify the change in goodwill from December 31, 2010, to December 31, 2011. Comment on the change in goodwill over this period.

3. Locate Note 6 to its financial statements. What are the three categories of intangible assets that Yahoo! reports at December 31, 2011? What proportion of total assets do the intangibles represent?

4. What does Yahoo! indicate is the life of “Trade names, trademarks, and domain names” according to its Note 6? Comment on the difference between the estimated useful life and the legal life of Yahoo!’s trademark.

TAKING IT TO THE NET P4

BTN 8-6 Each team member is to become an expert on one depreciation method to facilitate teammates’ understanding of that method. Follow these procedures: a. Each team member is to select an area for expertise from one of the following depreciation methods:

straight-line, units-of-production, or double-declining-balance. b. Expert teams are to be formed from those who have selected the same area of expertise. The instructor

will identify the location where each expert team meets. c. Using the following data, expert teams are to collaborate and develop a presentation answering the

requirements. Expert team members must write the presentation in a format they can show to their learning teams.

Data and Requirements On January 8, 2011, Whitewater Riders purchases a van to transport rafters back to the point of departure at the conclusion of the rafting adventures they operate. The cost of the van is $44,000. It has an estimated salvage value of $2,000 and is expected to be used for four years and driven 60,000 miles. The van is driven 12,000 miles in 2011, 18,000 miles in 2012, 21,000 in 2013, and 10,000 in 2014. 1. Compute the annual depreciation expense for each year of the van’s estimated useful life. 2. Explain when and how annual depreciation is recorded. 3. Explain the impact on income of this depreciation method versus others over the van’s life. 4. Identify the van’s book value for each year of its life and illustrate the reporting of this amount for

any one year. d. Re-form original learning teams. In rotation, experts are to present to their teams the results from

part c. Experts are to encourage and respond to questions.

TEAMWORK IN ACTION P1

Point: This activity can follow an over- view of each method. Step 1 allows for three areas of expertise. Larger teams will have some duplication of areas, but the straight-line choice should not be duplicated. Expert teams can use the book and consult with the instructor.

BTN 8-7 Review the chapter’s opening feature involving BizChair.com. Assume that the company cur- rently has net sales of $8,000,000, and that it is planning an expansion that will increase net sales by $4,000,000. To accomplish this expansion, BizChair.com must increase its average total assets from $2,500,000 to $3,000,000.

Required

1. Compute the company’s total asset turnover under (a) current conditions and (b) proposed conditions. 2. Evaluate and comment on the merits of the proposal given your analysis in part 1. Identify any con-

cerns you would express about the proposal.

ENTREPRENEURIAL DECISION A1

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Chapter 8 Long-Term Assets 375

BTN 8-8 Team up with one or more classmates for this activity. Identify companies in your community or area that must account for at least one of the following assets: natural resource; patent; lease; leasehold improvement; copyright; trademark; or goodwill. You might find a company having more than one type of asset. Once you identify a company with a specific asset, describe the accounting this company uses to allocate the cost of that asset to the periods benefited from its use.

HITTING THE ROAD P3 P4

Cost of machine . . . . . . . . . . . . . . . . . $250,000

Accumulated depreciation . . . . . . . . . 100,000

Book value . . . . . . . . . . . . . . . . . . . . . 150,000

Cash received . . . . . . . . . . . . . . . . . 120,000

Loss on sale . . . . . . . . . . . . . . . . . . . . $ 30,000

Appraisal Value % Total Cost Allocated

Land . . . . . . . . . . . . . . . . . . . . $175,000 50% $326,000 $163,000

Land improvements . . . . . . . . 70,000 20 326,000 65,200

Building . . . . . . . . . . . . . . . . . 105,000 30 326,000 97,800

Totals . . . . . . . . . . . . . . . . . . . . $350,000 $326,000

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b;

2. c; ($35,000 2 $1,000)y4 years 5 $8,500 per year. 3. c; 2013: $10,800,000 3 (2 3 10%) 5 $2,160,000 2014: ($10,800,000 2 $2,160,000) 3 (2 3 10%) 5 $1,728,000 4. c;

5. b; $550,000y$500,000 5 1.10

BTN 8-9 Piaggio (www.Piaggio.com), Polaris, and Arctic Cat are all competitors in the global market- place. Comparative figures for these companies’ recent annual accounting periods follow.

GLOBAL DECISION A1

Required

1. Compute total asset turnover for the most recent two years for Piaggio using the data shown. 2. Which company is most efficient in generating net sales given the total assets it employs?

(in thousands, Piaggio (Euro thousands) Polaris Arctic Cat

except Current Prior Two Years Current Prior Current Prior

turnover) Year Year Prior Year Year Year Year

Total assets . . . . . . . . . . . . . . 1,520,184 1,545,722 1,564,820 $1,228,024 $1,061,647 $272,906 $246,084

Net sales . . . . . . . . . . . . . . . . 1,516,463 1,485,351 1,486,882 2,656,949 1,991,139 464,651 450,728

Total asset turnover . . . . . . . . ? ? — 2.32 2.18 1.79 1.81

PIAGGIO Polaris Arctic Cat

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Learning Objectives

CONCEPTUAL

C1 Describe current and long-term liabilities and their characteristics. (p. 378) C2 Identify and describe known current liabilities. (p. 380) C3 Explain how to account for contingent liabilities. (p. 390)

ANALYTICAL

A1 Compute the times interest earned ratio and use it to analyze liabilities. (p. 392)

PROCEDURAL

P1 Prepare entries to account for short-term notes payable. (p. 381) P2 Compute and record employee payroll deductions and liabilities. (p. 384) P3 Compute and record employer payrollexpenses and liabilities. (p. 385) P4 Account for estimated liabilities, including warranties and bonuses. (p. 387) P5 Appendix 9A—Identify and describe the details of payroll reports, records,

and procedures. (p. 395)

A Look at This Chapter

This chapter explains how to identify, compute, record, and report current liabilities in financial statements. We also analyze and interpret these liabilities, including those related to employee costs.

A Look Back

Chapter 8 focused on long-term assets including plant assets, natural resources, and intangibles. We showed how to account for and analyze those assets.

Current Liabilities 9

A Look Ahead

Chapter 10 focuses on long-term liabilities. We explain how to value, record, amortize, and report these liabilities in financial statements.

376

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Basement to Boardroom

INDIANAPOLIS—Karen Cooper had labored for several years in the industry and saw a demand for information technology (IT) workers. “I felt,” insists Karen, “that I could build a model com- pany that would provide the highest level of [IT] services.” Launched from her basement in 2005, Karen started SmartIT Staffing (Smart-ITstaffing.com). “With more than 15 years of staffing experience and a passion for recruiting,” explains Karen, “I decided to start an IT staffing company” to serve the human resource needs of modern businesses. Karen’s commitment to help businesses use information wisely carries over to her own financial house. “When we started,” recalls Karen, “there were just a handful of faithful clients who believed in us.” To increase her odds of success, she focused on the important task of managing liabilities for payroll, supplies, employee wages, training, and taxes. Karen insists that effective management of liabilities, especially payroll and employee benefits, is crucial. She stresses that monitoring and controlling liabilities is a must. To help control liabilities, Karen points to how she began by working out of her basement to limit liabilities. “Now,” says

Karen, “we’re at a point where I feel we’re on the verge of some really significant growth.” By controlling liabilities, she is able to grow her company and increase the odds of financial success. Creative reduction of liabilities, such as launching from one’s basement, can mean success or failure. Karen continues to monitor liabilities and payment patterns. “I’m so glad to be part of the [accounting success stories],” explains Karen, and to use that knowledge “to help me man- age this growth.” She insists that accounting for and monitor- ing liabilities are a key to a successful start-up. Her company now generates sufficient income to pay for liabilities and pro- duces revenue growth for expansion. And, Karen no longer works from her basement! “Our growth and success is a tes- tament,” explains Karen, “to the service, quality, execution, and overall value we bring to clients.”

[Sources: SmartIT Staffing Website, January 2013; INC. (Top Ten Black Entrepreneurs), September 2010; Black Web, September 2010; Inside Indiana Business, July 2010; Business Courier, January 2011; Cincinnati USA Regional Chamber, February 2011.]

“Provide the highest level of service, value, and integrity.”

—KAREN COOPER

Decision Insight

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Chapter Preview

Previous chapters introduced liabilities such as accounts payable, notes payable, wages payable, and unearned revenues. This chapter further explains these liabilities and additional ones such as warranties, taxes, payroll, vacation pay, and bonuses. It also

describes contingent liabilities and introduces long-term liabilities. The focus is on how to define, classify, measure, report, and ana- lyze these liabilities so that this information is useful to business decision makers.

This section discusses important characteristics of liabilities and how liabilities are classified and reported.

Defining Liabilities A liability is a probable future payment of assets or services that a company is presently obligated to make as a result of past transactions or events. This definition includes three crucial factors:

1. A past transaction or event. 2. A present obligation. 3. A future payment of assets or services.

These three important elements are portrayed visually in Exhibit 9.1. Liabilities reported in financial statements exhibit those characteristics. No liability is reported when one or more of those characteristics is absent. For example, most companies expect to pay wages to their em- ployees in upcoming months and years, but these future payments are not liabilities because no past event such as employee work resulted in a present obligation. Instead, such liabilities arise when employees perform their work and earn the wages.

CHARACTERISTICS OF LIABILITIES

Classifying Liabilities Information about liabilities is more useful when the balance sheet identifies them as either cur- rent or long term. Decision makers need to know when obligations are due so they can plan for them and take appropriate action.

EXHIBIT 9.1 Characteristics of a Liability

Due to a past

event ...

Past Present Future

Company has a present obligation

... For future

sacrifices

Supplies

Payable

C1 Describe current and long-term liabilities and their characteristics.

Point: Account titles using “payable” refer to liabilities.

378

Known Liabilities

• Accounts payable • Sales taxes payable • Unearned revenues • Short-term notes • Payroll liabilities

Liability Characteristics

• Definition • Classification • Uncertainty

Estimated Liabilities

• Health and pension benefits

• Vacation benefits • Bonus plans • Warranty liabilities

Contingent Liabilities

• Accounting for contingencies

• Reasonably possible contingencies

Current Liabilities

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Chapter 9 Current Liabilities 379

Current Liabilities Current liabilities, also called short-term liabilities, are obligations due within one year or the company’s operating cycle, whichever is longer. They are expected to be paid using current assets or by creating other current liabilities. Common examples of current liabilities are accounts payable, short-term notes payable, wages payable, warranty liabilities, lease liabilities, taxes payable, and unearned revenues. Current liabilities differ across companies because they depend on the type of company op- erations. MGM Mirage, for instance, included the following current liabilities related to its gaming, hospitality and entertainment operations ($000s):

Point: Improper classification of liabili- ties can distort ratios used in financial statement analysis and business decisions.

Advance deposits and ticket sales . . . . . . . . . $ 97,753

Casino outstanding chip liability . . . . . . . . . . . 290,238

Casino front money deposits . . . . . . . . . . . . . 111,763

Harley-Davidson reports a much different set of current liabilities. It discloses current liabilities made up of items such as warranty, recall, and dealer incentive liabilities.

Long-Term Liabilities A company’s obligations not expected to be paid within the longer of one year or the company’s operating cycle are reported as long-term liabilities. They can include long-term notes payable, warranty liabilities, lease liabilities, and bonds payable. They are sometimes reported on the balance sheet in a single long-term liabilities total or in multiple categories. Domino’s Pizza, for instance, reports long-term liabilities of $1,485 million. They are reported after current liabilities. A single liability also can be divided between the current and noncurrent sections if a company expects to make payments toward it in both the short and long term. Domino’s reports long-term debt, $1,451,000,000; and current portion of long- term debt, $835,000, which is less than 1%. The second item is reported in current liabilities. We sometimes see liabilities that do not have a fixed due date but instead are payable on the creditor’s demand. These are reported as current liabilities because of the possibility of payment in the near term. Exhibit 9.2 shows amounts of current liabilities and as a percent of total lia- bilities for selected companies.

Point: The current ratio is overstated if a company fails to classify any portion of long-term debt due next period as a cur- rent liability.

Uncertainty in Liabilities Accounting for liabilities involves addressing three important questions: Whom to pay? When to pay? How much to pay? Answers to these questions are often decided when a liability is in- curred. For example, if a company has a $100 account payable to a specific individual, payable on March 15, the answers are clear. The company knows whom to pay, when to pay, and how much to pay. However, the answers to one or more of these questions are uncertain for some liabilities.

Uncertainty in Whom to Pay Liabilities can involve uncer- tainty in whom to pay. For instance, a company can create a liability with a known amount when issuing a note that is payable to its holder. In this case, a specific amount is payable to the note’s holder at a specified

date, but the company does not know who the holder is until that date. Despite this uncertainty, the company reports this liability on its balance sheet.

Point: An accrued expense is an unpaid expense, and is also called an accrued liability.

EXHIBIT 9.2 Current Liabilities of Selected Companies

As a percent of total liabilities

0 20 6040 80

Six Flags $222 mil.

Bowl America 55%

Apple 70%

100

$3.1 mil.

$27,970 mil.

12%

Columbia Sportswear 87%$267 mil.

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380 Chapter 9 Current Liabilities

Uncertainty in When to Pay A company can have an obligation of a known amount to a known credi- tor but not know when it must be paid. For example, a legal services firm can accept fees in advance from a client who plans to use the firm’s services in the future. This means that the firm has a liability that it settles by provid- ing services at an unknown future date. Although this un- certainty exists, the legal firm’s balance sheet must report

this liability. These types of obligations are reported as current liabilities because they are likely to be settled in the short term.

Uncertainty in How Much to Pay A company can be aware of an obligation but not know how much will be required to settle it. For exam- ple, a company using electrical power is billed only after the meter has been read. This cost is incurred and the liability created before a bill is re-

ceived. A liability to the power company is reported as an estimated amount if the balance sheet is prepared before a bill arrives.

S M T W T F S

JANUARY 1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 27 28 29 30 31

IFRS records a contingent liability when an obligation exists from a past event if there is a ‘probable’ outflow of resources and the amount can be estimated reliably. However, IFRS defines probable as ‘more likely than not’ while U.S. GAAP defines it as ‘likely to occur.’ ■

IFRS

1. What is a liability? Identify its crucial characteristics. 2. Is every expected future payment a liability? 3. If a liability is payable in 15 months, is it classified as current or long term?

Quick Check Answers — p. 403

Most liabilities arise from situations with little uncertainty. They are set by agreements, contracts, or laws and are measurable. These liabilities are known liabilities, also called definitely determin- able liabilities. Known liabilities include accounts payable, notes payable, payroll, sales taxes, un- earned revenues, and leases. We describe how to account for these known liabilities in this section.

Accounts Payable Accounts payable, or trade accounts payable, are amounts owed to suppliers, also called vendors, for products or services purchased on credit. Accounting for accounts payable is primarily explained and illustrated in our discussion of merchandising activities in Chapters 4 and 5.

Sales Taxes Payable Nearly all states and many cities levy taxes on retail sales. Sales taxes are stated as a percent of selling prices. The seller collects sales taxes from customers when sales occur and remits these collections (often monthly) to the proper government agency. Since sellers currently owe these collections to the government, this amount is a current liability. Home Depot, for instance, re- ports sales taxes payable of $391 million in its recent annual report. To illustrate, if Home Depot sells materials on August 31 for $6,000 cash that are subject to a 5% sales tax, the revenue por- tion of this transaction is recorded as follows:

KNOWN LIABILITIES

Aug. 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,300

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Sales Taxes Payable ($6,000 3 0.05) . . . . . . . . . . . . 300

To record cash sales and 5% sales tax.

Assets 5 Liabilities 1 Equity 16,300 1300 16,000

C2 Identify and describe known current liabilities.

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Chapter 9 Current Liabilities 381

Reward Programs Gift card sales now exceed $100 billion annually, and reward (also called loyalty) pro- grams are growing. There are no exact rules for how retailers account for rewards. When Best Buy launched its “Reward Zone,” shoppers earned $5 on each $125 spent and had 90 days to spend it. Retailers make assumptions about how many reward program dollars will be spent and how to report it. Best Buy sets up a liability and reduces revenue by the same amount. Talbots does not reduce revenue but instead increases selling expense. Men’s Wearhouse records rewards in cost of goods sold, whereas Neiman Marcus sub- tracts them from revenue. The FASB continues to review reward programs. ■

Decision Insight

Sales Taxes Payable is debited and Cash credited when it re- mits these collections to the government. Sales Taxes Payable is not an expense. It arises because laws require sellers to collect this cash from customers for the government.1

Unearned Revenues Unearned revenues (also called deferred revenues, collections in advance, and prepayments) are amounts received in ad- vance from customers for future pro ducts or services. Ad- vance ticket sales for sporting events or music concerts are examples. Rihanna, for instance, has “deferred revenues” from advance ticket sales. To illus trate, assume that Rihanna sells $5 million in tickets for eight concerts; the entry is

June 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000

Unearned Ticket Revenue . . . . . . . . . . . . . . . . . . . . 5,000,000

To record sale of concert tickets.

Assets 5 Liabilities 1 Equity 15,000,000 15,000,000

Oct. 31 Unearned Ticket Revenue . . . . . . . . . . . . . . . . . . . . . . . . . 625,000

Ticket Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000

To record concert ticket revenues earned.

Assets 5 Liabilities 1 Equity 2625,000 1625,000

When a concert is played, Rihanna would record revenue for the portion earned.

Unearned Ticket Revenue is an unearned revenue account and is reported as a current liability. Unearned revenues also arise with airline ticket sales, magazine subscriptions, construction projects, hotel reservations, and custom orders.

1 Sales taxes can be computed from total sales receipts when sales taxes are not separately identified on the register. To il- lustrate, assume a 5% sales tax and $420 in total sales receipts (which includes sales taxes). Sales are computed as follows:

Sales 5 Total sales receiptsy(1 1 Sales tax percentage) 5 $420y1.05 5 $400

Thus, the sales tax amount equals total sales receipts minus sales, or $420 2 $400 5 $20. Sellers are required to act as “agents” for the government and collect sales tax. This extra work can be offset by the sellers’ ability to use or invest that cash until it must be paid to the government.

Point: To defer a revenue means to postpone recognition of a revenue col- lected in advance until it is earned. Sport teams must defer recognition of ticket sales until games are played.

Point: Required characteristics for negotiability of a note: (1) unconditional promise, (2) in writing, (3) specific amount, and (4) definite due date.

Short-Term Notes Payable A short-term note payable is a written promise to pay a specified amount on a definite future date within one year or the company’s operating cycle, whichever is longer. These promissory notes are negotiable (as are checks), meaning they can be transferred from party to party by endorsement. The written documentation provided by notes is helpful in resolving disputes and for pursuing legal actions involving these liabilities. Most notes payable bear interest to com- pensate for use of the money until payment is made. Short-term notes payable can arise from many transactions. A company that purchases merchandise on credit can sometimes extend the credit period by signing a note to replace an account payable. Such notes also can arise when money is borrowed from a bank. We describe both of these cases.

P1 Prepare entries to account for short-term notes payable.

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382 Chapter 9 Current Liabilities

Note Given to Extend Credit Period A company can replace an account payable with a note payable. A common example is a creditor that requires the substitution of an interest-bearing note for an overdue account payable that does not bear interest. A less common situation occurs when a debtor’s weak financial condition motivates the creditor to accept a note, sometimes for a lesser amount, and to close the account to ensure that this customer makes no additional credit purchases. To illustrate, let’s assume that on August 23, Brady Company asks to extend its past-due $600 account payable to McGraw. After some negotiations, McGraw agrees to accept $100 cash and a 60-day, 12%, $500 note payable to replace the account payable. Brady records the transaction with this entry:

Aug. 23 Accounts Payable—McGraw . . . . . . . . . . . . . . . . . . . . . . 600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Notes Payable—McGraw . . . . . . . . . . . . . . . . . . . . 500

Gave $100 cash and a 60-day, 12% note for payment on account.

Assets 5 Liabilities 1 Equity 2100 2600

1500

Oct. 22 Notes Payable—McGraw . . . . . . . . . . . . . . . . . . . . . . . . 500

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510

Paid note with interest ($500 3 12% 3 60y360).

Assets 5 Liabilities 1 Equity 2510 2500 210

Point: Accounts payable are detailed in a subsidiary ledger, but notes payable are sometimes not. A file with copies of notes can serve as a subsidiary ledger.

Signing the note does not resolve Brady’s debt. Instead, the form of debt is changed from an account payable to a note payable. McGraw prefers the note payable over the account payable because it earns interest and it is written documentation of the debt’s existence, term, and amount. When the note comes due, Brady pays the note and interest by giving McGraw a check for $510. Brady records that payment with this entry:

Interest expense is computed by multiplying the principal of the note ($500) by the annual interest rate (12%) for the fraction of the year the note is outstanding (60 daysy360 days).

Note Given to Borrow from Bank A bank nearly always requires a borrower to sign a promissory note when making a loan. When the note matures, the borrower repays the note with an amount larger than the amount borrowed. The difference between the amount borrowed and the amount repaid is interest. This section considers a type of note whose signer promises to pay principal (the amount borrowed) plus interest. In this case, the face value of the note equals principal. Face value is the value shown on the face (front) of the note. To illustrate, assume that a company needs $2,000 for a project and borrows this money from a bank at 12% annual inter- est. The loan is made on September 30, 2013, and is due in 60 days. Specifically, the borrowing company signs a note with a face value equal to the amount borrowed. The note includes a state- ment similar to this: “I promise to pay $2,000 plus interest at 12% within 60 days after Septem- ber 30.” This simple note is shown in Exhibit 9.3.

Point: Commercial companies com- monly compute interest using a 360-day year. This is known as the banker’s rule.

Point: When money is borrowed from a bank, the loan is reported as an asset (receivable) on the bank’s balance sheet.

EXHIBIT 9.3 Note with Face Value Equal to Amount Borrowed

plus interest at the annual rate of .

Dollars

Promissory Note

Face Value Date

after date, promise to pay to the order of

Janet Lee

2013

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Chapter 9 Current Liabilities 383

End-of-period interest adjustment. When the end of an accounting period occurs between the signing of a note payable and its maturity date, the expense recognition (matching) principle requires us to record the accrued but unpaid interest on the note. To illustrate, let’s return to the note in Exhibit 9.3, but assume that the company borrows $2,000 cash on December 16, 2013, instead of September 30. This 60-day note matures on February 14, 2014, and the company’s fiscal year ends on December 31. Thus, we need to record interest expense for the final 15 days in December. This means that one-fourth (15 days/60 days) of the $40 total interest is an expense of year 2013. The borrower records this expense with the following adjusting entry:

Sept. 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Borrowed $2,000 cash with a 60-day, 12%, $2,000 note.

Assets 5 Liabilities 1 Equity 12,000 12,000

The borrower records its receipt of cash and the new liability with this entry:

When principal and interest are paid, the borrower records payment with this entry:

Nov. 29 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,040

Paid note with interest ($2,000 3 12% 3 60y360).

Assets 5 Liabilities 1 Equity 22,040 22,000 240

2013

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

To record accrued interest on note ($2,000 3 12% 3 15y360).

Assets 5 Liabilities 1 Equity 110 210

2014

Feb. 14 Interest Expense* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,040

Paid note with interest. *($2,000 3 12% 3 45y360)

Assets 5 Liabilities 1 Equity 22,040 210 230

22,000

Example: If this note is dated Dec. 1 instead of Dec. 16, how much expense is recorded on Dec. 31? Answer: $2,000 3 12% 3 30y360 5 $20

When this note matures on February 14, the borrower must recognize 45 days of interest ex- pense for year 2014 and remove the balances of the two liability accounts:

Payroll Liabilities An employer incurs several expenses and liabilities from having employees. These expenses and liabilities are often large and arise from salaries and wages earned, from employee ben- efits, and from payroll taxes levied on the employer. Boston Beer, for instance, reports payroll-related current liabilities of more than $9.6 million from accrued “employee wages, benefits and reimbursements.” We discuss payroll liabilities and related accounts in this section. Appendix 9A describes details about payroll reports, records, and procedures.

Employee Payroll Deductions Gross pay is the total compensation an employee earns including wages, salaries, commissions, bonuses, and any compensation earned before deductions

Many franchisors such as Baskin-Robbins, Dunkin’ Donuts, and Cold Stone Creamery, use notes to help entrepreneurs acquire their own franchises, including using notes to pay for the franchise fee and any equipment. Payments on these notes are usually collected monthly and often are secured by the franchisees’ assets. For example, a McDonald’s franchise can cost from under $200,000 to over $2 million, depending on the type selected, see FranchiseFoundations.com. ■

Decision Insight

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384 Chapter 9 Current Liabilities

such as taxes. (Wages usually refer to payments to employees at an hourly rate. Salaries usually refer to payments to employees at a monthly or yearly rate.) Net pay, also called take-home pay, is gross pay less all deductions. Payroll deductions, commonly called withholdings, are amounts withheld from an employee’s gross pay, either required or voluntary. Required deductions result from laws and include income taxes and Social Security taxes. Voluntary deductions, at an em- ployee’s option, include pension and health contributions, health and life insurance premiums, union dues, and charitable giving. Exhibit 9.4 shows the typical payroll deductions of an employee. The employer withholds payroll deductions from employees’ pay and is obligated to transmit this money to the designated organization. The employer records payroll deductions as current liabili- ties until these amounts are transmitted. This section discusses the major payroll deductions.

EXHIBIT 9.4 Payroll Deductions

Federal Income Tax

State and Local Income Taxes

Voluntary Deductions

FICA Taxes (Medicare)

FICA Taxes (Social Security)

Gross Pay

minus deductions

Net pay = Gross pay – Deductions

Net Pay

Employee FICA taxes. The federal Social Security system provides retirement, disability, sur- vivorship, and medical benefits to qualified workers. Laws require employers to withhold Federal Insurance Contributions Act (FICA) taxes from employees’ pay to cover costs of the system. Employers usually separate FICA taxes into two groups: (1) retirement, disability, and survivorship and (2) medical. For the first group, the Social Security system provides monthly cash payments to qualified retired workers for the rest of their lives. These payments are often called Social Security benefits. Taxes related to this group are often called Social Security taxes. For the second group, the system provides monthly payments to deceased workers’ surviving families and to disabled work- ers who qualify for assistance. These payments are commonly called Medicare benefits; like those in the first group, they are paid with Medicare taxes (part of FICA taxes). Law requires employers to withhold FICA taxes from each employee’s salary or wages on each payday. The taxes for Social Security and Medicare are computed separately. For example, for 2012, the amount scheduled to be withheld from each employee’s pay for Social Security tax is 6.2% of the first $110,100 the employee earns in the calendar year, or a maximum of $6,826.20. The Medicare tax is 1.45% of all amounts the employee earns; there is no maximum limit to Medicare tax. (Politicians could pass a 2013 or 2014 adjustment; for example, politi- cians reduced the 2012 employee share from 6.2% to 4.2%.) Employers must pay withheld taxes to the Internal Revenue Service (IRS) on specific filing dates during the year. Employers who fail to send the withheld taxes to the IRS on time can be assessed substantial penalties. Until all the taxes are sent to the IRS, they are included in em- ployers’ current liabilities. For any changes in rates or with the maximum earnings level, check the IRS Website at www.IRS.gov or the SSA Website at www.SSA.gov.

Employee income tax. Most employers are required to withhold federal income tax from each employee’s paycheck. The amount withheld is computed using tables published by the IRS. The amount depends on the employee’s annual earnings rate and the number of withholding

Point: The sources of U.S. tax receipts are roughly as follows: 50% Personal income tax 35 FICA and FUTA taxes 10 Corporate income tax 5 Other taxes

Point: Deductions at some companies, such as those for insurance coverage, are “required” under its own labor contracts.

Point: Part-time employees may claim “exempt from withholding” if they did not have any income tax liability in the prior year and do not expect any in the current year.

P2 Compute and record employee payroll deductions and liabilities.

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Chapter 9 Current Liabilities 385

allowances the employee claims. Allowances reduce the amount of taxes one owes the govern- ment. The more allowances one claims, the less tax the employer will withhold. Employees can claim allowances for themselves and their dependents. They also can claim additional allowances if they expect major declines in their taxable income for medical expenses. (An employee who claims more allowances than appropriate is subject to a fine.) Most states and many local govern- ments require employers to withhold income taxes from employees’ pay and to remit them promptly to the proper government agency. Until they are paid, withholdings are reported as a current liability on the employer’s balance sheet.

Employee voluntary deductions. Beyond Social Security, Medicare, and income taxes, em- ployers often withhold other amounts from employees’ earnings. These withholdings arise from employee requests, contracts, unions, or other agreements. They can include amounts for chari- table giving, medical and life insurance premiums, pension contributions, and union dues. Until they are paid, such withholdings are reported as part of employers’ current liabilities.

Recording employee payroll deductions. Employers must accrue payroll expenses and lia- bilities at the end of each pay period. To illustrate, assume that an employee earns a salary of $2,000 per month. At the end of January, the employer’s entry to accrue payroll expenses and liabilities for this employee is

Point: IRS withholding tables are based on projecting weekly (or other period) pay into an annual figure.

Point: Is there a maximum to the withholding allowances one can claim? Recall, the more allowances, the lower the withholding. However, an employee that claims, say, over 10 allowances on the W-4 is likely to receive an IRS inquiry asking to justify the number of allowances.

Jan. 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

FICA—Social Security Taxes Payable (6.2%) . . . . . . 124

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . . 29

Employee Federal Income Taxes Payable* . . . . . . . . 213

Employee Medical Insurance Payable* . . . . . . . . . . 85

Employee Union Dues Payable* . . . . . . . . . . . . . . . 25

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524

To record accrued payroll for January.

* Amounts taken from employer’s accounting records.

Assets 5 Liabilities 1 Equity 1124 22,000 129 1213 185 125 11,524

Employer Payroll Taxes Employers must pay payroll taxes in addition to those required of employees. Employer taxes include FICA and unemployment taxes.

Employer FICA tax. Employers must pay FICA taxes on their payroll to employees. For 2012, the employer must pay Social Security tax of 6.2% on the first $110,100 earned by each employee, and 1.45% Medicare tax on all earnings of each employee. An employer’s tax is credited to the same FICA Taxes Payable accounts used to record the Social Security and Medi- care taxes withheld from employees. (A self-employed person must pay both the employee and employer FICA taxes.)

P3 Compute and record employer payroll expenses and liabilities.

Salaries Expense (debit) shows that the employee earns a gross salary of $2,000. The first five payables (credits) show the liabilities the employer owes on behalf of this employee to cover FICA taxes, income taxes, medical insurance, and union dues. The Salaries Payable account (credit) records the $1,524 net pay the employee receives from the $2,000 gross pay earned. When the employee is paid, another entry (or a series of entries) is required to record the check written and distributed (or funds transferred). The entry to record cash payment to this em- ployee is to debit Salaries Payable and credit Cash for $1,524.

Salaries Payable . . . . 1,524 Cash . . . . . . . . . . . 1,524

Pay or Else “Failure to pay employment taxes is stealing from the employees of the business,” said IRS Commissioner Mark W. Everson. “The IRS pursues business owners who don’t follow the law, and those who embrace these schemes face civil or criminal sanctions.” There are many reasons employers do not withhold or pay employment taxes. For some, they attempt to use the government as a “bank to borrow money for a short time,” some others collect the taxes and keep it, and still others object to U.S. tax laws. Regardless, federal law requires employment tax withholding and payment by employers. (IRS.gov/newsroom).

Decision Insight

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386 Chapter 9 Current Liabilities

Federal and state unemployment taxes. The federal government participates with states in a joint federal and state unemployment insurance program. Each state administers its program. These programs provide unemployment benefits to qualified workers. The federal government approves state programs and pays a portion of their administrative expenses. Federal Unemployment Taxes (FUTA). Employers are subject to a federal unemployment tax on wages and salaries paid to their employees. For the year 2012, employers were required to pay FUTA taxes of as much as 6.2% of the first $7,000 earned by each employee. This federal tax can be reduced by a credit of up to 5.4% for taxes paid to a state program. As a result, the net federal unemployment tax is often only 0.8%.

State Unemployment Taxes (SUTA). All states support their unemployment insurance programs by placing a payroll tax on employers. (A few states require employees to make a contribution. In the book’s assignments, we assume that this tax is only on the employer.) In most states, the base rate for SUTA taxes is 5.4% of the first $7,000 paid each employee. This base rate is adjusted ac- cording to an employer’s merit rating. The state assigns a merit rating that reflects a company’s stability or instability in employing workers. A good rating reflects stability in employment and means an employer can pay less than the 5.4% base rate. A low rating reflects high turnover or seasonal hirings and layoffs. To illustrate, an employer with 50 employees each of whom earns $7,000 or more per year saves $15,400 annually if it has a merit rating of 1.0% versus 5.4%. This is computed by comparing taxes of $18,900 at the 5.4% rate to only $3,500 at the 1.0% rate.

Recording employer payroll taxes. Employer payroll taxes are an added expense beyond the wages and salaries earned by employees. These taxes are often recorded in an entry separate from the one recording payroll expenses and deductions. To illustrate, assume that the $2,000 recorded salaries expense from the previous example is earned by an employee whose earnings have not yet reached $5,000 for the year. This means the entire salaries expense for this period is subject to tax because year-to-date pay is under $7,000. Also assume that the federal unem- ployment tax rate is 0.8% and the state unemployment tax rate is 5.4%. Consequently, the FICA portion of the employer’s tax is $153, computed by multiplying both the 6.2% and 1.45% by the $2,000 gross pay. Moreover, state unemployment (SUTA) taxes are $108 (5.4% of the $2,000 gross pay), and federal unemployment (FUTA) taxes are $16 (0.8% of $2,000). The entry to record the employer’s payroll tax expense and related liabilities is

Example: If the employer’s merit rat- ing in this example reduces its SUTA rate to 2.9%, what is its SUTA liability? Answer: SUTA payable 5 $2,000 3 2.9%5 $58

Multi-Period Known Liabilities Many known liabilities extend over multiple periods. These often include unearned revenues and notes payable. For example, if Sports Illustrated sells a four-year magazine subscription, it records amounts received for this subscription in an Unearned Subscription Revenues ac- count. Amounts in this account are liabilities, but are they current or long term? They are both. The portion of the Unearned Subscription Revenues account that will be fulfilled in the next year is reported as a current liability. The remaining portion is reported as a long-term liability. The same analysis applies to notes payable. For example, a borrower reports a three-year note payable as a long-term liability in the first two years it is outstanding. In the third year, the borrower reclassifies this note as a current liability since it is due within one year or the operating

Assets 5 Liabilities 1 Equity 1124 2277 129 1108 116

Jan. 31 Payroll Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

FICA—Social Security Taxes Payable (6.2%) . . . . . 124

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . . 29

State Unemployment Taxes Payable . . . . . . . . . . . . 108

Federal Unemployment Taxes Payable . . . . . . . . . . 16

To record employer payroll taxes.

Point: Internal control is important for payroll accounting. Managers must monitor (1) employee hiring, (2) time- keeping, (3) payroll listings, and (4) payroll payments. Poor controls led the U.S. Army to pay nearly $10 million to deserters, fictitious soldiers, and other unauthorized entities.

Point: If Sports Illustrated offers you a sweatshirt of your favorite team if you subscribe, it must account for the sweat- shirts using a promotions liability account.

Web Designer You take a summer job working for a family friend who runs a small IT service. On your first payday, the owner slaps you on the back, gives you full payment in cash, winks, and adds: “No need to pay those high taxes, eh.” What action, if any, do you take? ■ [Answer—p. 402]

Decision Ethics

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Chapter 9 Current Liabilities 387

cycle, whichever is longer. The current portion of long-term debt refers to that part of long- term debt due within one year or the operating cycle, whichever is longer. Long-term debt is reported under long-term liabilities, but the current portion due is reported under current liabilities. To illustrate, assume that a $7,500 debt is paid in installments of $1,500 per year for five years. The $1,500 due within the year is reported as a current liability. No journal entry is necessary for this reclassification. Instead, we simply classify the amounts for debt as either current or long term when the balance sheet is prepared. Some known liabilities are rarely reported in long-term liabilities. These include accounts payable, sales taxes, and wages and salaries.

4. Why does a creditor prefer a note payable to a past-due account payable? 5. A company pays its one employee $3,000 per month. This company’s FUTA rate is 0.8% on

the first $7,000 earned; its SUTA rate is 4.0% on the first $7,000; its Social Security tax rate is 6.2% of the first $110,100; and its Medicare tax rate is 1.45% of all amounts earned. The entry to record this company’s March payroll includes what amount for total payroll taxes expense?

6. Identify whether the employer or employee or both incurs each of the following: (a) FICA taxes, (b) FUTA taxes, (c) SUTA taxes, and (d ) withheld income taxes.

Quick Check Answers — p. 403

Dec. 31 Employee Benefits Expense . . . . . . . . . . . . . . . . . . . . . . . 20,000

Employee Medical Insurance Payable . . . . . . . . . . . 8,000

Employee Retirement Program Payable . . . . . . . . . 12,000

To record costs of employee benefits.

Assets 5 Liabilities 1 Equity 18,000 220,000 112,000

An estimated liability is a known obligation that is of an uncertain amount but that can be rea- sonably estimated. Common examples are employee benefits such as pensions, health care and vacation pay, and warranties offered by a seller. We discuss each of these in this section. Other examples of estimated liabilities include property taxes and certain contracts to provide future services.

Health and Pension Benefits Many companies provide employee benefits beyond salaries and wages. An employer often pays all or part of medical, dental, life, and disability insurance. Many employers also contrib- ute to pension plans, which are agreements by employers to provide benefits (payments) to employees after retirement. Many companies also provide medical care and insurance benefits to their retirees. When payroll taxes and charges for employee benefits are totaled, payroll cost often exceeds employees’ gross earnings by 25% or more. To illustrate, assume that an employer agrees to (1) pay an amount for medical insurance equal to $8,000 and (2) contribute an additional 10% of the employees’ $120,000 gross salary to a retirement program. The entry to record these accrued benefits is

ESTIMATED LIABILITIES

P4 Account for estimated liabilities, including warranties and bonuses.

Point: Some accounting systems do make an entry to transfer the current amount due out of Long-Term Debt and into the Current Portion of Long-Term Debt as follows:

Long-Term Debt . . . . . . . . . . 1,500

Current Portion of L-T Debt . . . 1,500

Ceridian Connection (Oct. 2010) reports: 8.5% of workplace fraud is tied to payroll. $72,000 is median loss per payroll fraud. 24 months is median time to uncover payroll fraud.

Liability Limits Probably the greatest number of frauds involve payroll. Companies must safeguard payroll activities. Controls include proper approvals and processes for employee additions, deletions, and pay rate changes. A common fraud is a manager adding a fictitious employee to the payroll and then cashing the fictitious employee’s check. A study reports that 28% of employees in operations and service areas witnessed violations of employee wage, overtime, or benefit rules in the past year (KPMG 2009). Another 21% observed falsifying of time and expense reports. ■

Decision Insight

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388 Chapter 9 Current Liabilities

Vacation Benefits Many employers offer paid vacation benefits, also called paid absences or compensated absences. To illustrate, assume that salaried employees earn 2 weeks’ vacation per year. This benefit in- creases employers’ payroll expenses because employees are paid for 52 weeks but work for only 50 weeks. Total annual salary is the same, but the cost per week worked is greater than the amount paid per week. For example, if an employee is paid $20,800 for 52 weeks but works only 50 weeks, the total weekly expense to the employer is $416 ($20,800y50 weeks) instead of the $400 cash paid weekly to the employee ($20,800y52 weeks). The $16 difference between these two amounts is recorded weekly as follows:

Vacation Benefits Expense . . . . . . . . . . . . . . . . . . . . . . . . 16

Vacation Benefits Payable . . . . . . . . . . . . . . . . . . . . . 16

To record vacation benefits accrued.

Assets 5 Liabilities 1 Equity 116 216

Dec. 31 Employee Bonus Expense* . . . . . . . . . . . . . . . . . . . . . . . 10,000

Bonus Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

To record expected bonus costs.

Assets 5 Liabilities 1 Equity 110,000 210,000

* Bonus Expense (B) equals 5% of pre-bonus net income, which equals $210,000 minus the bonus; this is computed as:

B 5 0.05 ($210,000 2 B) B 5 $10,500 2 0.05B 1.05B 5 $10,500 B 5 $10,500y1.05 5 $10,000

When the bonus is paid, Bonus Payable is debited and Cash is credited for $10,000.

Vacation Benefits Expense is an operating expense, and Vacation Benefits Payable is a current liability. When the employee takes a vacation, the employer reduces (debits) the Vacation Ben- efits Payable and credits Cash (no additional expense is recorded).

Bonus Plans Many companies offer bonuses to employees, and many of the bonuses depend on net income. To illustrate, assume that an employer offers a bonus to its employees equal to 5% of the com- pany’s annual pre-bonus net income (to be equally shared by all). The company’s expected annual pre-bonus net income is $210,000. The year-end adjusting entry to record this benefit is

Point: Kodak recently reported $46 million in warranty obligations.

Warranty Liabilities A warranty is a seller’s obligation to replace or correct a product (or service) that fails to perform as expected within a specified period. Most new cars, for instance, are sold with a warranty cover- ing parts for a specified period of time. Ford Motor Company reported almost $7 billion in “dealer and customer allowances and claims” in its annual report. To comply with the full dis- closure and matching principles, the seller reports the expected warranty expense in the period when revenue from the sale of the product or service is reported. The seller reports this warranty obligation as a liability, although the existence, amount, payee, and date of future sacrifices are uncertain. This is because such warranty costs are probable and the amount can be estimated using, for instance, past experience with warranties. To illustrate, a dealer sells a used car for $16,000 on December 1, 2013, with a maximum one-year or 12,000-mile warranty covering parts. This dealer’s experience shows that warranty

1 YEAR WARRANTY

President SEAL MOTOR

Box: 25515 River Heights PO Newyork

E

XC LUSIV

E

W

A R

R ANT

Y

1 YEAR

“ALL PARTS”

Vacation Benefits Payable . . . . # Cash . . . . . . . . . . . . . . . . . . . #

Postgame Spoils Baseball was the first pro sport to set up a pension, originally up to $100 per month depending on years played. Many former players now take home six-figure pensions. Cal Ripken Jr.’s pension when he reaches 62 is estimated at $160,000 per year (he played 21 seasons). The requirement is only 43 games for a full pension and just one game for full medical benefits. ■

Decision Insight

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Chapter 9 Current Liabilities 389

expense averages about 4% of a car’s selling price, or $640 in this case ($16,000 3 4%). The dealer records the estimated expense and liability related to this sale with this entry:

2013

Dec. 1 Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640

Estimated Warranty Liability . . . . . . . . . . . . . . . . . . 640

To record estimated warranty expense.

Assets 5 Liabilities 1 Equity 1640 2640

2014

Jan. 9 Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . 200

Auto Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . 200

To record costs of warranty repairs.

Assets 5 Liabilities 1 Equity 2200 2200

This entry alternatively could be made as part of end-of-period adjustments. Either way, the estimated warranty expense is reported on the 2013 income statement and the warranty liability on the 2013 balance sheet. To further extend this example, suppose the customer returns the car for warranty repairs on January 9, 2014. The dealer performs this work by replacing parts costing $200. The entry to record partial settlement of the estimated warranty liability is

Point: Recognition of warranty liabili- ties is necessary to comply with the matching and full disclosure principles.

This entry reduces the balance of the estimated warranty liability. Warranty expense was pre- viously recorded in 2013, the year the car was sold with the warranty. Finally, what happens if total warranty expenses are more or less than the estimated 4%, or $640? The answer is that management should monitor actual warranty expenses to see whether the 4% rate is accurate. If experience reveals a large difference from the estimate, the rate for current and future sales should be changed. Differences are expected, but they should be small.

Point: Both U.S. GAAP and IFRS ac- count for restructuring costs in a manner similar to accounting for warranties.

Multi-Period Estimated Liabilities Estimated liabilities can be both current and long term. For example, pension liabilities to em- ployees are long term to workers who will not retire within the next period. For employees who are retired or will retire within the next period, a portion of pension liabilities is current. Other examples include employee health benefits and warranties. Specifically, many warranties are for 30 or 60 days in length. Estimated costs under these warranties are properly reported in current liabilities. Many other automobile warranties are for three years or 36,000 miles. A portion of these warranties is reported as long term.

7. Estimated liabilities involve an obligation to pay which of these? (a) An uncertain but reasonably estimated amount owed on a known obligation or (b) A known amount to a specific entity on an uncertain due date.

8. A car is sold for $15,000 on June 1, 2013, with a one-year warranty on parts. Warranty expense is estimated at 1.5% of selling price at each calendar year-end. On March 1, 2014, the car is returned for warranty repairs costing $135. The amount recorded as warranty expense on March 1 is (a) $0; (b) $60; (c) $75; (d ) $135; (e) $225.

Quick Check Answers — p. 403

Warranty contracts as a percentage of sales . . . . 4% Warranty contracts as a percentage of operating profit . . . . . . . . . . . . . . . . . . . . . . . 45% Profit margin on warranty contracts . . . . . . . . . . 60%

Guaranteed Profits When we purchase a new laptop at Best Buy, a sales clerk commonly asks: Want the Black Tie Protection Plan?” Best Buy earns about a 60% profit margin on such warranty contracts, and those contracts are a large part of its profit—see table to the side [BusinessWeek]. ■

Decision Insight

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390 Chapter 9 Current Liabilities

A contingent liability is a potential obligation that depends on a future event arising from a past transaction or event. An example is a pending lawsuit. Here, a past transaction or event leads to a lawsuit whose result depends on the outcome of the suit. Future payment of a contingent lia- bility depends on whether an uncertain future event occurs.

Accounting for Contingent Liabilities Accounting for contingent liabilities depends on the likelihood that a future event will occur and the ability to estimate the future amount owed if this event occurs. Three different possibilities are identified in the following chart: record liability, disclose in notes, or no disclosure.

CONTINGENT LIABILITIES

C3 Explain how to account for contingent liabilities.

The conditions that determine each of these three possibilities follow:

1. The future event is probable (likely) and the amount owed can be reasonably estimated. We then record this amount as a liability. Examples are the estimated liabilities described earlier such as warranties, vacation pay, and income taxes.

2. The future event is reasonably possible (could occur). We disclose information about this type of contingent liability in notes to the financial statements.

3. The future event is remote (unlikely). We do not record or disclose information on remote contingent liabilities.

Reasonably Possible Contingent Liabilities This section identifies and discusses contingent liabilities that commonly fall in the second category — when the future event is reasonably possible. Disclosing information about contin- gencies in this category is motivated by the full-disclosure principle, which requires informa- tion relevant to decision makers be reported and not ignored.

Potential Legal Claims Many companies are sued or at risk of being sued. The accounting issue is whether the defendant should recognize a liability on its balance sheet or disclose a con- tingent liability in its notes while a lawsuit is outstanding and not yet settled. The answer is that a potential claim is recorded in the accounts only if payment for damages is probable and the amount can be reasonably estimated. If the potential claim cannot be reasonably estimated or is less than probable but reasonably possible, it is disclosed. Ford Motor Company, for example, includes the following note in its annual report: “Various legal actions, governmental investigations and proceedings and claims are pending . . . arising out of alleged defects in our products.”

Debt Guarantees Sometimes a company guarantees the payment of debt owed by a sup- plier, customer, or another company. The guarantor usually discloses the guarantee in its financial statement notes as a contingent liability. If it is probable that the debtor will default, the guarantor needs to record and report the guarantee in its financial statements as a liability. The Boston Celtics report a unique guarantee when it comes to coaches and players: “Certain of the contracts provide for guaranteed payments which must be paid even if the employee [player] is injured or terminated.”

Point: A contingency is an if. Namely, if a future event occurs, then financial consequences are likely for the entity.

Point: A sale of a note receivable is often a contingent liability. It becomes a liability if the original signer of the note fails to pay it at maturity.

Nonestimable

Estimable

Possible

Remote

Probable

Contingent liability

Future event is Amount owed is Record liability

No disclosure

Disclose in notes

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Chapter 9 Current Liabilities 391

Other Contingencies Other examples of contingencies include environmental dam- ages, possible tax assessments, insurance losses, and government investigations. Sunoco, for instance, reports that “federal, state and local laws . . . result in liabilities and loss contingencies. Su- noco accrues . . . cleanup costs [that] are probable and reasonably estimable. Management believes it is reasonably possible (i.e., less than probable but greater than remote) that additional . . . losses will be incurred.” Many of Sunoco’s contingencies are revealed only in notes.

Point: Auditors and managers often have different views about whether a contingency is recorded, disclosed, or omitted.

Uncertainties that Are Not Contingencies All organizations face uncertainties from future events such as natural disasters and the develop- ment of new competing products or services. These uncertainties are not contingent liabilities be- cause they are future events not arising from past transactions. Accordingly, they are not disclosed.

9. A future payment is reported as a liability on the balance sheet if payment is contingent on a future event that (a) is reasonably possible but the payment cannot be reasonably estimated; (b) is probable and the payment can be reasonably estimated; or (c) is not probable but the payment is known.

10. Under what circumstances is a future payment reported in the notes to the financial statements as a contingent liability?

Quick Check Answers — p. 403

This section discusses similarities and differences between U.S. GAAP and IFRS in accounting and reporting for current liabilities.

Characteristics of Liabilities The definitions and characteristics of current liabilities are broadly similar for both U.S. GAAP and IFRS. Although differences exist, the similarities vastly outweigh any differences. Remembering that “provision” is typically used under IFRS to refer to what is titled “liability” under U.S. GAAP, Nokia describes its recognition of liabilities as follows:

GLOBAL VIEW

Provisions are recognized when the Group has a present legal or constructive obligation as a result of past events, it is probable that an outflow of resources will be required to settle the obligation and a reliable estimate of the amount can be made.

Known (Determinable) Liabilities When there is little uncertainty surrounding current liabili- ties, both U.S. GAAP and IFRS require companies to record them in a similar manner. This correspon- dence in accounting applies to accounts payable, sales taxes payable, unearned revenues, short-term notes, and payroll liabilities. Of course, tax regulatory systems of countries are different, which implies use of different rates and levels. Still, the basic approach is the same.

Pricing Priceless What’s it worth to see from one side of the Grand Canyon to the other? What’s the cost when gulf coast beaches are closed due to an oil well disaster? A method to measure environmental liabilities is contingent valuation, by which people answer such questions. Regula- tors use their answers to levy fines and assess punitive damages. ■

Decision Insight

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392 Chapter 9 Current Liabilities

Times Interest Earned RatioDecision Analysis

A company incurs interest expense on many of its current and long-term liabilities. Examples extend from its short-term notes and the current portion of long-term liabilities to its long-term notes and bonds. Inter- est expense is often viewed as a fixed expense because the amount of these liabilities is likely to remain in one form or another for a substantial period of time. This means that the amount of interest is unlikely to vary due to changes in sales or other operating activities. While fixed expenses can be advantageous when a company is growing, they create risk. This risk stems from the possibility that a company might be un- able to pay fixed expenses if sales decline. To illustrate, consider Diego Co.’s results for 2013 and two possible outcomes for year 2014 in Exhibit 9.5.

Expenses excluding interest are at, and expected to remain at, 75% of sales. Expenses such as these that change with sales volume are called variable expenses. However, interest expense is at, and expected to remain at, $60,000 per year due to its fixed nature. The middle numerical column of Exhibit 9.5 shows that Diego’s income increases by 83% to $165,000 if sales increase by 50% to $900,000. In contrast, the far right column shows that income decreases by 83% if sales decline by 50%. These results reveal that the amount of fixed interest expense affects a com- pany’s risk of its ability to pay interest, which is numerically reflected in the times interest earned ratio in Exhibit 9.6.

EXHIBIT 9.6 Times Interest Earned Times interest earned 5

Income before interest expense and income taxes

Interest expense

A1 Compute the times interest earned ratio and use it to analyze liabilities.

EXHIBIT 9.5 Actual and Projected Results

$0 Sales Decrease Sales Flat Sales Increase

$100 1.0

0.0

5.0

4.0

7.0

6.0

Times Interest Earned

$200

$300

$400

$500

$600

$700

$800

$900

$000s

2.0

3.0

8.0

Net Income Times Interest EarnedSales

2014 Projections

($ thousands) 2013 Sales Increase Sales Decrease

Sales . . . . . . . . . . . . . . . . . . . . . . . . $600 $900 $300

Expenses (75% of sales) . . . . . . . . . 450 675 225

Income before interest . . . . . . . . . 150 225 75

Interest expense (fixed) . . . . . . . . . 60 60 60

Net income . . . . . . . . . . . . . . . . . . $ 90 $165 $ 15

For 2013, Diego’s times interest earned is computed as $150,000y$60,000, or 2.5 times. This ratio sug- gests that Diego faces low to moderate risk because its sales must decline sharply before it would be un- able to cover its interest expenses. (Diego is an LLC and does not pay income taxes.) Experience shows that when times interest earned falls below 1.5 to 2.0 and remains at that level or lower for several periods, the default rate on liabilities increases sharply. This reflects increased risk for companies and their creditors. We also must interpret the times interest earned ratio in light of information about the variability of a company’s income before interest. If income is stable from year to year or if it is growing, the company can afford to take on added risk by borrowing. If its income greatly varies from year to year, fixed interest expense can increase the risk that it will not earn enough income to pay interest.

Estimated Liabilities When there is a known current obligation that involves an uncertain amount, but one that can be reasonably estimated, both U.S. GAAP and IFRS require similar treatment. This treat- ment extends to many obligations such as those arising from vacations, warranties, restructurings, pen- sions, and health care. Both accounting systems require that companies record estimated expenses related to these obligations when they can reasonably estimate the amounts. Nokia reports wages, salaries and bonuses of €6,284 million. It also reports pension expenses of €445 million.

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Chapter 9 Current Liabilities 393

The following transactions and events took place at Kern Company during its recent calendar-year reporting period (Kern does not use reversing entries).

a. In September 2013, Kern sold $140,000 of merchandise covered by a 180-day warranty. Prior experience shows that costs of the warranty equal 5% of sales. Compute September’s warranty expense and prepare the adjusting journal entry for the warranty liability as recorded at September 30. Also prepare the journal entry on October 8 to record a $300 cash expenditure to provide warranty service on an item sold in September.

b. On October 12, 2013, Kern arranged with a supplier to replace Kern’s overdue $10,000 account pay- able by paying $2,500 cash and signing a note for the remainder. The note matures in 90 days and has a 12% interest rate. Prepare the entries recorded on October 12, December 31, and January 10, 2014, related to this transaction.

c. In late December, Kern learns it is facing a product liability suit filed by an unhappy customer. Kern’s lawyer advises that although it will probably suffer a loss from the lawsuit, it is not possible to estimate the amount of damages at this time.

d. Sally Bline works for Kern. For the pay period ended November 30, her gross earnings are $3,000. Bline has $800 deducted for federal income taxes and $200 for state income taxes from each paycheck. Additionally, a $35 premium for her health care insurance and a $10 donation for the United Way are deducted. Bline pays FICA Social Security taxes at a rate of 6.2% and FICA Medicare taxes at a rate of 1.45%. She has not earned enough this year to be exempt from any FICA taxes. Journalize the accrual of salaries expense of Bline’s wages by Kern.

e. On November 1, Kern borrows $5,000 cash from a bank in return for a 60-day, 12%, $5,000 note. Record the note’s issuance on November 1 and its repayment with interest on December 31.

f.B Kern has estimated and recorded its quarterly income tax payments. In reviewing its year-end tax ad- justments, it identifies an additional $5,000 of income tax expense that should be recorded. A portion of this additional expense, $1,000, is deferrable to future years. Record this year-end income taxes expense adjusting entry.

g. For this calendar-year, Kern’s net income is $1,000,000, its interest expense is $275,000, and its income taxes expense is $225,000. Calculate Kern’s times interest earned ratio.

PLANNING THE SOLUTION ● For a, compute the warranty expense for September and record it with an estimated liability. Record the

October expenditure as a decrease in the liability. ● For b, eliminate the liability for the account payable and create the liability for the note payable. Com-

pute interest expense for the 80 days that the note is outstanding in 2013 and record it as an addi tional liability. Record the payment of the note, being sure to include the interest for the 10 days in 2014.

● For c, decide whether the company’s contingent liability needs to be disclosed or accrued (recorded) according to the two necessary criteria: probable loss and reasonably estimable.

● For d, set up payable accounts for all items in Bline’s paycheck that require deductions. After deducting all necessary items, credit the remaining amount to Salaries Payable.

● For e, record the issuance of the note. Calculate 60 days’ interest due using the 360-day convention in the interest formula.

● For f, determine how much of the income taxes expense is payable in the current year and how much needs to be deferred.

● For g, apply and compute times interest earned.

DEMONSTRATION PROBLEM

Entrepreneur You wish to invest in a franchise for either one of two national chains. Each franchise has an expected annual net income after interest and taxes of $100,000. Net income for the first franchise includes a regular fixed interest charge of $200,000. The fixed interest charge for the second franchise is $40,000. Which franchise is riskier to you if sales forecasts are not met? Does your decision change if the first franchise has more variability in its income stream? ■ [Answer—p. 402]

Decision Maker

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394 Chapter 9 Current Liabilities

SOLUTION TO DEMONSTRATION PROBLEM a. Warranty expense 5 5% 3 $140,000 5 $7,000

Sept. 30 Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Estimated Warranty Liability . . . . . . . . . . . . . . . . . . 7,000

To record warranty expense for the month.

Oct. 8 Estimated Warranty Liability . . . . . . . . . . . . . . . . . . . . . . 300

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

To record the cost of the warranty service.

Oct. 12 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Paid $2,500 cash and gave a 90-day, 12% note to extend the due date on the account.

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

To accrue interest on note payable.

Jan. 10 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,725

Paid note with interest, including the accrued interest payable.

b. Interest expense for 2013 5 12% 3 $7,500 3 80y360 5 $200 Interest expense for 2014 5 12% 3 $7,500 3 10y360 5 $25

Nov. 30 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000.00

FICA—Social Security Taxes Payable (6.2%) . . . . . 186.00

FICA—Medicare Taxes Payable (1.45%) . . . . . . . . . 43.50

Employee Federal Income Taxes Payable . . . . . . . . 800.00

Employee State Income Taxes Payable . . . . . . . . . . 200.00

Employee Medical Insurance Payable . . . . . . . . . . . 35.00

Employee United Way Payable . . . . . . . . . . . . . . . . 10.00

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,725.50

To record Bline’s accrued payroll.

c. Disclose the pending lawsuit in the financial statement notes. Although the loss is probable, no liability can be accrued since the loss cannot be reasonably estimated.

d.

e. Nov. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Borrowed cash with a 60-day, 12% note.

When the note and interest are paid 60 days later, Kern Company records this entry:

Dec. 31 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100

Paid note with interest ($5,000 3 12% 3 60y360).

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Chapter 9 Current Liabilities 395

f. Dec. 31 Income Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . 4,000

Deferred Income Tax Liability . . . . . . . . . . . . . . . . . 1,000

To record added income taxes expense and the deferred tax liability.

g. Times interest earned 5 $1,000,000 1 $275,000 1 $225,000

$275,000 5 5.45 times

APPENDIX

Payroll Reports, Records, and Procedures 9A Understanding payroll procedures and keeping adequate payroll reports and records are essential to a com- pany’s success. This appendix focuses on payroll accounting and its reports, records, and procedures.

Payroll Reports Most employees and employers are required to pay local, state, and federal payroll taxes. Payroll expenses involve liabilities to individual employees, to federal and state governments, and to other organizations such as insurance companies. Beyond paying these liabilities, employers are re- quired to prepare and submit reports explaining how they computed these payments.

Reporting FICA Taxes and Income Taxes The Federal Insurance Contributions Act (FICA) requires each employer to file an Internal Revenue Service (IRS) Form 941, the Employer’s Quarterly Federal Tax Return, within one month after the end of each calendar quarter. A sample Form 941 is shown in Ex- hibit 9A.1 for Phoenix Sales & Service, a landscape design company. Accounting information and software are helpful in tracking payroll transactions and reporting the accumulated information on Form 941. Specifically, the employer reports total wages subject to income tax withholding on line 2 of Form 941. (For simplicity, this appendix uses wages to refer to both wages and salaries.) The income tax withheld is reported on line 3. The combined amount of employee and employer FICA (Social Secu- rity) taxes for Phoenix Sales & Service is reported on line 5a (taxable Social Security wages, $36,599 3 12.4% 5 $4,538.28). The 12.4% is the sum of the Social Security tax withheld, computed as 6.2% tax withheld from the employee wages for the quarter plus the 6.2% tax levied on the employer. The com- bined amount of employee Medicare wages is reported on line 5c. The 2.9% is the sum of 1.45% with- held from employee wages for the quarter plus 1.45% tax levied on the employer. Total FICA taxes are reported on line 5d and are added to the total income taxes withheld of $3,056.47 to yield a total of $8,656.12. For this year, assume that income up to $110,100 is subject to Social Security tax. There is no income limit on amounts subject to Medicare tax. Congress sets annual limits on the amount owed for Social Security tax.

Federal depository banks are authorized to accept deposits of amounts payable to the federal government. Deposit requirements depend on the amount of tax owed. For example, when the sum of FICA taxes plus the employee income taxes is less than $2,500 for a quarter, the taxes can be paid when Form 941 is filed. Companies with large payrolls are often required to pay monthly or even semiweekly.

Reporting FUTA Taxes and SUTA Taxes An employer’s federal unemployment taxes (FUTA) are reported on an annual basis by filing an Annual Federal Unemployment Tax Return, IRS Form 940. It must be mailed on or before January 31 following the end of each tax year. Ten more days are allowed if all re- quired tax deposits are filed on a timely basis and the full amount of tax is paid on or before January 31. FUTA payments are made quarterly to a federal depository bank if the total amount due exceeds $500. If $500 or less is due, the taxes are remitted annually. Requirements for paying and reporting state unem- ployment taxes (SUTA) vary depending on the laws of each state. Most states require quarterly payments and reports.

P5 Identify and describe the details of payroll reports, records, and procedures.

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EXHIBIT 9A.1 Form 941 Department of the Treasury — Internal Revenue Service

(EIN) Employer identification number

Name (not your trade name)

Trade name (if any)

Address Suite or room number

State ZIP code

Report for this Quarter ... (Check one.)

1: January, February, March

2: April, May, June

3: July, August, September

4: October, November, December

941Form

Part 1: Answer these questions for this quarter.

1

4 5

6

7

8 Total taxes after adjustments (Combine lines 6 and 7h.)

9

10

11

12

13

5a

5b

5c

5d

7e

7f

7g Special additions to social security and Medicare (attach Form 941c)

7h

Number of employees who received wages, tips, or other compensation for the pay period including: Mar. 12 (Quarter 1), June 12 (Quarter 2), Sept. 12 (Quarter 3), Dec. 12 (Quarter 4)

2 Wages, tips, and other compensation

3 Total income tax withheld from wages, tips, and other compensation

If no wages, tips, and other compensation are subject to social security or Medicare tax Check and go to line 6. Taxable social security and Medicare wages and tips:

Column 1 Column 2

Taxable social security wages � .124 =

Taxable social security tips

Taxable Medicare wages & tips � .029 =

Total social security and Medicare taxes (Column 2, lines 5a + 5b + 5c = line 5d)

Total taxes before adjustments (lines 3 + 5d = line 6)

TAX ADJUSTMENTS (Read the instructions for line 7 before completing lines 7a through 7h.):

Current quarter’s fractions of cents

Current quarter’s sick pay

Current quarter’s adjustments for tips and group-term life insurance

Current year’s income tax withholding (attach Form 941c)

Prior quarters’ social security and Medicare taxes (attach Form 941c)

Special additions to federal income tax (attach Form 941c)

TOTAL ADJUSTMENTS (Combine all amounts: lines 7a through 7g.)

Advance earned income credit (EIC) payments made to employees

Total taxes after adjustment for advance EIC (lines 8 – line 9 = line 10)

Total deposits for this quarter, including overpayment applied from a prior quarter

Balance due (If line 10 is more than line 11, write the difference here.) Make checks payable to United States Treasury.

Overpayment (If line 11 is more than line 10, write the difference here.) Check one Apply to next return. Send a refund.

� .124 =

7a

7b

7c

7d

1

2

3

6

8

9

10

11

12

5d

7h

.

.

.

.

.

. . . .

.

.

.

.

.

.

8 6 3 2 1 4 5 8 7

1

36,599

36,599 00

.36,599 00

4,538 28

1,061 37

00

5,599 65

8,656

3,079 11

2,049 77

3,527 24

8,656 12

12

0 00

.0 00 0 00

8,656 12

8,656 12

8,656 12

3,056 47

enter the final date you paid wages .

If your business has closed or you stopped paying wages

Part 2: Tell us about your deposit schedule and tax liability for this quarter.

.

.

.

If you are unsure about whether you are a monthly schedule depositor or a semiweekly schedule depositor, see Pub. 15 (Circular E), section 11.

14

15

16

17

Write the state abbreviation for the state where you made your deposits OR write “MU” if you made your deposits in multiple states.

Check one: Line 10 is less than $2,500. Go to Part 3.

You were a monthly schedule depositor for the entire quarter. Fill out your tax liability for each month. Then go to Part 3.

.

Tax liability: Month 1

Month 2

Month 3

Total liability for quarter Total must equal line 10.

You were a semiweekly schedule depositor for any part of this quarter. Fill out Schedule B (Form 941): Report of Tax Liability for Semiweekly Schedule Depositors, and attach it to this form.

Check here, and

If you are a seasonal employer and you do not have to file a return for every quarter of the year

Do you want to allow an employee, a paid tax preparer, or another person to discuss this return with the IRS? See the instructions for details.

Yes. Designee’s name

Phone Personal Identification Number (PIN)

Part 3: Tell us about your business. If a question does NOT apply to your business, leave it blank.

Check here.

Part 4: May we speak with your third-party designee?

( ) –

No.

Part 5: Sign here. You MUST fill out both sides of this form and SIGN it.

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete.

Sign your name here

Print name and title

Date / / Phone ( ) –

/ /

Employer’s QUARTERLY Federal Tax Return

Phoenix Sales & Service

1214 Mill Road

85621AZPhoenix

Number Street

City

A Z

.

.

.

.

.

.

.

396

Point: Line 5a shows the matching nature of the FICA tax as 6.2% 3 2, or 12.4%; which is shown as 0.124.

Point: Auditors rely on the four 941 forms filed during a year when auditing a company’s annual wage and salaries expense account.

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Chapter 9 Current Liabilities 397

Reporting Wages and Salaries Employers are required to give each employee an annual report of his or her wages subject to FICA and federal income taxes along with the amounts of these taxes withheld. This report is called a Wage and Tax Statement, or Form W-2. It must be given to employees before January 31 following the year covered by the report. Exhibit 9A.2 shows Form W-2 for one of the em- ployees at Phoenix Sales & Service. Copies of the W-2 Form must be sent to the Social Security Ad- ministration, where the amount of the employee’s wages subject to FICA taxes and FICA taxes withheld are posted to each employee’s Social Security account. These posted amounts become the basis for determining an employee’s retirement and survivors’ benefits. The Social Security Administration also transmits to the IRS the amount of each employee’s wages subject to federal income taxes and the amount of taxes withheld.

2 The Gross Pay column shows regular hours worked on the first line multiplied by the regular pay rate—this equals regular pay. Overtime hours multiplied by the overtime premium rate equals overtime premium pay reported on the second line. If employers are engaged in interstate commerce, federal law sets a minimum overtime rate of pay to employees. For this company, workers earn 150% of their regular rate for hours in excess of 40 per week.

EXHIBIT 9A.2 Form W-2Department of Treasury—Internal Revenue ServiceForm

Copy 1–For State, City, or Local Tax Department

Wage and Tax StatementW-2

a Control number

AR101

86-3214587

OMB No. 1545-0006

b Employer identification number (EIN)

4,910.00 1 Wages, tips, other compensation

4,910.00 3 Social security wages

4,910.00 5 Medicare wages and tips

7 Social security tips

9 Advance EIC payment

11 Nonqualified plans 12a Code

12b Code

12c Code

12d Code

333.37 2 Federal income tax withheld

304.42 4 Social security tax withheld

71.20 6 Medicare tax withheld

8 Allocated tips

10 Dependent care benefits

333-22-9999 d Employee’s social security number

Robert J. e Employee’s first name and initial

AZ 15 State 16 State wages, tips, etc.

13-902319 4,910.00 17 State income tax

26.68 18 Local wages, tips, etc. 19 Local income taxEmployer’s state ID number

f Employee’s address and ZIP code

Austin Last name

c Employer’s name, address and ZIP code

Phoenix Sales & Service 1214 Mill Road

Phoenix, AZ 85621

18 Roosevelt Blvd., Apt. C Tempe, AZ 86322

13 Statutoryemployee Retirement

plan Third-party

sick pay

14 Other

20 Locality name

Payroll Records Employers must keep payroll records in addition to reporting and paying taxes. These records usually include a payroll register and an individual earnings report for each employee.

Payroll Register A payroll register usually shows the pay period dates, hours worked, gross pay, deduc- tions, and net pay of each employee for each pay period. Exhibit 9A.3 shows a payroll register for Phoenix Sales & Service. It is organized into nine columns:

Col. 1 Employee identification (ID); Employee name; Social Security number (SS No.); Reference (check number); and Date (date check issued)

Col. 2 Pay Type (regular and overtime) Col. 3 Pay Hours (number of hours worked as regular and overtime) Col. 4 Gross Pay (amount of gross pay)2

Col. 5 FIT (federal income taxes withheld); FUTA (federal unemployment taxes) Col. 6 SIT (state income taxes withheld); SUTA (state unemployment taxes) Col. 7 FICA-SS_EE (social security taxes withheld, employee); FICA-SS_ER (social security taxes,

employer) Col. 8 FICA-Med_EE (medicare tax withheld, employee); FICA-Med_ER (medicare tax, employer) Col. 9 Net pay (Gross pay less amounts withheld from employees)

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398 Chapter 9 Current Liabilities

EXHIBIT 9A.3 Payroll Register

0.00

Pay

Type

Pay

Hours

Gross

Pay

Gross Pay

FUTA SUTA FICA-SS_ER

FIT SIT FICA-SS_EE FICA-Med_EE

FICA-Med_ER

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

Regular Overtime

40.00

40.00 1.00

40.00

40.00

40.00

40.00 2.00

240.00 3.00

400.00

400.00

560.00 21.00

560.00

560.00

560.00

560.00

560.00

560.00

560.00

42.00

581.00

602.00

3,200.00 63.00

3,263.00

2301.67

228.99

23.20

252.97

24.65

248.33

24.82

24.48

24.48

24.48

268.57

234.24

268.57

226.11 288.10

224.15

215.12

216.25

215.12

25.49

25.49

215.12

22.74

23.87

215.69

24.24

210.80

22.32

2202.30

2202.30

234.72

234.72

234.72

234.72

234.72

234.72

237.32

237.32

236.02

236.02

224.80

224.80

247.31

247.31

28.12

28.12

28.12

28.12

28.12

28.12

28.73

28.73

28.42

28.42

25.80

25.80

Net

Pay

338.09

479.35

503.75

443.10

480.18

443.10

2,687.57

Accounting System: Exhibit A.3

0.00 0.00

0.00

0.00

0.00

AR101 Robert Austin 333-22-9999 9001, 10/8/13 CJ102 Judy Cross 299-11-9201 9002, 10/8/13 DJ103 John Diaz 444-11-9090 9003, 10/8/13 KK104 Kay Keife 909-11-3344 9004, 10/8/13 ML105 Lee Miller 444-56-3211 9005, 10/8/13 SD106 Dale Sears 909-33-1234 9006, 10/8/13 Totals

Employee ID

Employee

SS No.

Refer., Date

[blank][blank][blank][blank]

0.00

0.00

Phoenix Sales & Service Payroll Register

For Week Ended Oct. 8, 2013

Net pay for each employee is computed as gross pay minus the items on the first line of columns 5 – 8. The employer’s payroll tax for each employee is computed as the sum of items on the third line of columns 5 – 8. A payroll register includes all data necessary to record payroll. In some software programs the entries to record payroll are made in a special payroll journal.

Payroll Check Payment of payroll is usually done by check or electronic funds transfer. Exhibit 9A.4 shows a payroll check for a Phoenix employee. This check is accompanied with a detachable statement of earnings (at top) showing gross pay, deductions, and net pay.

Employee Earnings Report An employee earnings report is a cumulative record of an employee’s hours worked, gross earnings, deductions, and net pay. Payroll information on this report is taken from the payroll register. The employee earnings report for R. Austin at Phoenix Sales & Service is shown in Exhibit 9A.5. An employee earnings report accumulates information that can show when an employee’s earnings reach the tax-exempt points for FICA, FUTA, and SUTA taxes. It also gives data an employer needs to prepare Form W-2.

Payroll Procedures Employers must be able to compute federal income tax for payroll purposes. This section explains how we compute this tax and how to use a payroll bank account.

Computing Federal Income Taxes To compute the amount of taxes withheld from each employee’s wages, we need to determine both the employee’s wages earned and the employee’s number of withholding

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Chapter 9 Current Liabilities 399

AR101 Robert Austin 333-22-9999 10/8/13 10/8/13

EMPLOYEE NO. EMPLOYEE NAME SOCIAL SECURITY NO. PAY PERIOD END

YEAR TO DATETHIS CHECKITEMTOTALHOURSRATEITEM

CHECK DATE

40.00

HOURS WORKED

400.00

GROSS THIS PERIOD

400.00

GROSS YEAR TO DATE

$338.09

NET CHECK

9001

CHECK No.

(Detach and retain for your records)

Regular Overtime

10.00 15.00

40.00

Three Hundred Thirty–Eight and 9/100 Dollars

Gross Fed. Income tax FICA-Soc. Sec. FICA-Medicare State Income tax

400.00 -28.99 -24.80 -5.80 -2.32

400.00 -28.99 -24.80 -5.80 -2.32

PHOENIX SALES & SERVICE 1214 Mill Road Phoenix, AZ 85621 602-555-8900

Phoenix Bank and Trust Phoenix, AZ 85621 3312-87044

No. 9001

AUTHORIZED SIGNATURE

400.00

.................... 20 .......DATE October 8 13 Check No. .............9001

Robert Austin 18 Roosevelt Blvd., Apt C Tempe, AZ 86322

Pay to the order of

$ **************$338.09*

Amount .........................................................................................................

EXHIBIT 9A.4 Check and Statement of Earnings

EXHIBIT 9A.5 Employee Earnings Report

[blank][blank] Date

Reference

Gross

Pay

[blank] [blank]

FIT SIT FICA-SS_EE FICA-Med_EE

FUTA SUTA FICA-SS_ER FICA-Med_ER Net

Pay

2,483.88

338.09

338.09

338.09

338.09

338.09

1,690.45

4,174.33

Beginning Balance for Robert Austin

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

AR101 Robert Austin 333-22-9999

Total 12/01/13 thru 12/31/13

Employee ID

Employee

SS No.

Year-to-date Total for Robert Austin

12/03/13 9049

12/10/13 9055

12/17/13 9061

12/24/13 9067

12/31/13 9073

4,910.00

2,000.00

400.00

400.00

400.00

400.00

400.00

2,910.00

239.28

2333.37

216.00

2144.95

23.20

23.20

23.20

228.99

228.99

23.20

228.99

228.99

228.99

223.28

2188.42

23.20

2304.42

2304.42

2124.00

2124.00

224.80

224.80

224.80

224.80

224.80

224.80

224.80

224.80

224.80

2180.42

2180.42

224.80

271.20

271.20

229.00

229.00

25.80

25.80

25.80

25.80

25.80

25.80

25.80

25.80

25.80

242.20

242.20

25.80

2132.57

226.68

254.00

211.60

210.80

210.80

210.80

22.32

22.32

210.80

22.32

22.32

22.32

278.57

215.08

210.80

Accounting System: Exhibit A.5

Phoenix Sales & Service Employee Earnings Report

For Month Ended Dec. 31, 2013

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400 Chapter 9 Current Liabilities

Payroll Bank Account Companies with few employees often pay them with checks drawn on the com- pany’s regular bank account. Companies with many employees often use a special payroll bank account to pay employees. When this account is used, a company either (1) draws one check for total payroll on the regular bank account and deposits it in the payroll bank account or (2) executes an electronic funds transfer to the payroll bank account. Individual payroll checks are then drawn on this payroll bank ac- count. Since only one check for the total payroll is drawn on the regular bank account each payday, use of a special payroll bank account helps with internal control. It also helps in reconciling the regular bank account. When companies use a payroll bank account, they usually include check numbers in the payroll register. The payroll register in Exhibit 9A.3 shows check numbers in column 1. For instance, Check No. 9001 is issued to Robert Austin. With this information, the payroll register serves as a supplementary record of wages earned by and paid to employees.

Who Pays What Payroll Taxes and Benefits We conclude this appendix with the following table identifying who pays which payroll taxes and which common employee benefits such as medical, disability, pension, charitable, and union costs. Who pays which employee benefits, and what portion, is subject to agreements between companies and their workers. Also, self-employed workers must pay both the employer and employee FICA taxes for Social Security and Medicare.

EXHIBIT 9A.6 Wage Bracket Withholding Table SINGLE Persons—WEEKLY Payroll Period

If the wages are–

At least

$600 610 620 630 640 650 660 670 680 690 700 710 720 730 740

$610 620 630 640 650 660 670 680 690 700 710 720 730 740 750

$76 79 81 84 86 89 91 94 96 99

101 104 106 109 111

$67 69 70 72 73 75 76 78 81 83 86 88 91 93 96

$58 59 61 62 64 65 67 68 70 71 73 74 76 78 80

$49 50 52 53 55 56 58 59 61 62 64 65 67 68 70

$39 41 42 44 45 47 48 50 51 53 54 56 57 59 60

$30 32 33 35 36 38 39 41 42 44 45 47 48 50 51

$21 22 24 25 27 28 30 31 33 34 35 37 39 40 42

$12 13 15 16 18 19 21 22 24 25 27 28 30 31 33

$6 7 8 9

10 11 12 13 14 16 17 19 20 22 23

$0 1 2 3 4 5 6 7 8 9

10 11 12 13 14

$0 0 0 0 0 0 0 1 2 3 4 5 6 7 8

But less than

And the number of withholding allowances claimed is—

0 1 2 3 4 5 6 7 8 9 10

The amount of income tax to be withheld is—

Employer Payroll Taxes and Costs

• FICA—Social Security Taxes

• FICA—Medicare Taxes

• FUTA (Federal Unemployment Taxes)

• SUTA (State Unemployment Taxes)

• Share of medical coverage, if any

• Share of pension coverage, if any

• Share of other benefits, if any

Employee Payroll Deductions

• FICA—Social Security taxes

• FICA—Medicare taxes

• Federal Income taxes

• State and local income taxes

• Share of medical coverage, if any

• Share of pension coverage, if any

• Share of other benefits, if any

allowances. Each employee records the number of withholding allowances claimed on a withholding allowance certificate, Form W-4, filed with the employer. When the number of withholding allowances increases, the amount of income taxes withheld decreases. Employers often use a wage bracket withholding table similar to the one shown in Exhibit 9A.6 to compute the federal income taxes withheld from each employee’s gross pay. The table in Exhibit 9A.6 is for a single employee paid weekly. Tables are also provided for married employees and for biweekly, semimonthly, and monthly pay periods (most payroll software includes these tables). When using a wage bracket withholding table to compute federal income tax withheld from an employee’s gross wages, we need to locate an employee’s wage bracket within the first two columns. We then find the amount withheld by looking in the withholding allowance column for that employee.

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Chapter 9 Current Liabilities 401

11. What three items determine the amount deducted from an employee’s wages for federal income taxes?

12. What amount of income tax is withheld from the salary of an employee who is single with three withholding allowances and earnings of $675 in a week? (Hint: Use the wage bracket withholding table in Exhibit 9A.6.)

13. Which of the following steps are executed when a company draws one check for total payroll and deposits it in a special payroll bank account? (a) Write a check to the payroll bank account for the total payroll and record it with a debit to Salaries Payable and a credit to Cash. (b) Deposit a check (or transfer funds) for the total payroll in the payroll bank account. (c) Issue individual payroll checks drawn on the payroll bank account. (d ) All of the above.

Quick Check Answers — p. 403

APPENDIX

Corporate Income Taxes 9B This appendix explains current liabilities involving income taxes for corporations.

Income Tax Liabilities Corporations are subject to income taxes and must estimate their income tax liability when preparing financial statements. Since income tax expense is created by earning income, a liability is incurred when income is earned. This tax must be paid quarterly under federal regulations. To illustrate, consider a corporation that prepares monthly financial statements. Based on its income in Janu- ary 2013, this corporation estimates that it owes income taxes of $12,100. The following adjusting entry records this estimate:

Jan. 31 Income Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,100

Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . 12,100

To accrue January income taxes.

Assets 5 Liabilities 1 Equity 112,100 212,100

The tax liability is recorded each month until the first quarterly payment is made. If the company’s esti- mated taxes for this first quarter total $30,000, the entry to record its payment is

Apr. 10 Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Paid estimated quarterly income taxes based on first quarter income.

Assets 5 Liabilities 1 Equity 230,000 230,000

This process of accruing and then paying estimated income taxes continues through the year. When annual financial statements are prepared at year-end, the corporation knows its actual total income and the actual amount of income taxes it must pay. This information allows it to properly record income taxes expense for the fourth quarter so that the total of the four quarters’ expense amounts equals the actual taxes paid to the government.

Deferred Income Tax Liabilities An income tax liability for corporations can arise when the amount of income before taxes that the corporation reports on its income statement is not the same as the amount of income reported on its income tax return. This difference occurs because income tax laws and GAAP measure income differently. (Differences between tax laws and GAAP arise because Congress uses tax laws to generate receipts, stimulate the economy, and influence behavior, whereas GAAP are intended to provide financial information useful for business decisions. Also, tax accounting often follows the cash basis, whereas GAAP follows the accrual basis.) Some differences between tax laws and GAAP are temporary. Temporary differences arise when the tax return and the income statement report a revenue or expense in different years. As an example, com- panies are often able to deduct higher amounts of depreciation in the early years of an asset’s life and smaller amounts in later years for tax reporting in comparison to GAAP. This means that in the early years, depreciation for tax reporting is often more than depreciation on the income statement. In later

Point: IRS Statistics of Income Bulletin (Winter 2012) reports the following average (effective) income tax rate for different categories of U.S. income earners:

Top 1% . . . . . . . . . . . . . . 24%

Top 5% . . . . . . . . . . . . . . 20%

Top 10% . . . . . . . . . . . . . 18%

Bottom 50% . . . . . . . . . . 1.85%

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402 Chapter 9 Current Liabilities

years, depreciation for tax reporting is often less than depreciation on the income statement. When tempo- rary differences exist between taxable income on the tax return and the income before taxes on the income statement, corporations compute income taxes expense based on the income reported on the income state- ment. The result is that income taxes expense reported in the income statement is often different from the amount of income taxes payable to the government. This difference is the deferred income tax liability. To illustrate, assume that in recording its usual quarterly income tax payments, a corporation computes $25,000 of income taxes expense. It also determines that only $21,000 is currently due and $4,000 is de- ferred to future years (a timing difference). The entry to record this end-of-period adjustment is

Dec. 31 Income Taxes Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . 21,000

Deferred Income Tax Liability . . . . . . . . . . . . . . . . . 4,000

To record tax expense and deferred tax liability.

Assets 5 Liabilities 1 Equity 121,000 225,000 14,000

The credit to Income Taxes Payable reflects the amount currently due to be paid. The credit to Deferred In- come Tax Liability reflects tax payments deferred until future years when the temporary difference reverses. Temporary differences also can cause a company to pay income taxes before they are reported on the income statement as expense. If so, the company reports a Deferred Income Tax Asset on its balance sheet.

C1 Describe current and long-term liabilities and their char-acteristics. Liabilities are probable future payments of assets or services that past transactions or events obligate an entity to make. Current liabilities are due within one year or the operating cycle, whichever is longer. All other liabilities are long term.

C2 Identify and describe known current liabilities. Known (determinable) current liabilities are set by agreements or laws and are measurable with little uncertainty. They include accounts payable, sales taxes payable, unearned revenues, notes payable, payroll liabilities, and the current portion of long-term debt.

C3 Explain how to account for contingent liabilities. If an uncertain future payment depends on a probable future event and the amount can be reasonably estimated, the payment is re- corded as a liability. The uncertain future payment is reported as a contingent liability (in the notes) if (a) the future event is reasonably possible but not probable or (b) the event is probable but the pay- ment amount cannot be reasonably estimated.

A1 Compute the times interest earned ratio and use it to ana-lyze liabilities. Times interest earned is computed by dividing a company’s net income before interest expense and income taxes by the amount of interest expense. The times interest earned ratio reflects a company’s ability to pay interest obligations.

P1 Prepare entries to account for short-term notes payable. Short-term notes payable are current liabilities; most bear

Summary interest. When a short-term note’s face value equals the amount bor- rowed, it identifies a rate of interest to be paid at maturity.

P2 Compute and record employee payroll deductions and liabilities. Employee payroll deductions include FICA taxes, income taxes, and voluntary deductions such as for pensions and charities. They make up the difference between gross and net pay.

P3 Compute and record employer payroll expenses and liabili-ties. An employer’s payroll expenses include employees’ gross earnings, any employee benefits, and the payroll taxes levied on the employer. Payroll liabilities include employees’ net pay amounts, withholdings from employee wages, any employer-promised bene- fits, and the employer’s payroll taxes.

P4 Account for estimated liabilities, including warranties and bonuses. Liabilities for health and pension benefits, warran- ties, and bonuses are recorded with estimated amounts. These items are recognized as expenses when incurred and matched with reve- nues generated.

P5A Identify and describe the details of payroll reports, records, and procedures. Employers report FICA taxes and federal in- come tax withholdings using Form 941. FUTA taxes are reported on Form 940. Earnings and deductions are reported to each employee and the federal government on Form W-2. An employer’s payroll records often include a payroll register for each pay period, payroll checks and statements of earnings, and individual employee earnings reports.

Web Designer You need to be concerned about being an accom- plice to unlawful payroll activities. Not paying federal and state taxes on wages earned is illegal and unethical. Such payments also will not provide the employee with Social Security and some Medicare credits. The best course of action is to request payment by check. If this fails to change the owner’s payment practices, you must consider quitting this job.

Entrepreneur Risk is partly reflected by the times interest earned ratio. This ratio for the first franchise is 1.5 [($100,000 1

$200,000)y$200,000], whereas the ratio for the second franchise is 3.5 [($100,000 1 $40,000)y$40,000]. This analysis shows that the first franchise is more at risk of incurring a loss if its sales decline. The second question asks about variability of income. If income greatly varies, this increases the risk an owner will not earn sufficient income to cover interest. Since the first franchise has the greater vari- ability, it is a riskier investment.

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 9 Current Liabilities 403

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 419 mhhe.com/wildFINMAN5e

1. On December 1, a company signed a $6,000, 90-day, 5% note payable, with principal plus interest due on March 1 of the fol- lowing year. What amount of interest expense should be ac- crued at December 31 on the note?

a. $300 b. $25 c. $100 d. $75 e. $0 2. An employee earned $50,000 during the year. FICA tax for

social security is 6.2% and FICA tax for Medicare is 1.45%. The employer’s share of FICA taxes is

a. Zero, since the employee’s pay exceeds the FICA limit. b. Zero, since FICA is not an employer tax. c. $3,100 d. $725 e. $3,825

3. Assume the FUTA tax rate is 0.8% and the SUTA tax rate is 5.4%. Both taxes are applied to the first $7,000 of an employ- ee’s pay. What is the total unemployment tax an employer must pay on an employee’s annual wages of $40,000?

a. $2,480 b. $434 c. $56 d. $378 e. Zero; the employee’s wages exceed the $7,000 maximum. 4. A company sells big screen televisions for $3,000 each. Each

television has a two-year warranty that covers the replacement of defective parts. It is estimated that 1% of all tele visions sold will be returned under warranty at an average cost of $250 each. During July, the company sold 10,000 big screen televi- sions, and 80 were serviced under the warranty during July at a total cost of $18,000. The credit balance in the Estimated

1. A liability involves a probable future payment of assets or ser- vices that an entity is presently obligated to make as a result of past transactions or events.

2. No, an expected future payment is not a liability unless an exist- ing obligation was created by a past event or transaction.

3. In most cases, a liability due in 15 months is classified as long term. It is classified as a current liability if the company’s operating cycle is 15 months or longer.

4. A creditor prefers a note payable instead of a past-due account payable so as to (a) charge interest and/or (b) have evidence of the debt and its terms for potential litigation or disputes.

5. $1,000* 3 (.008) 1 $1,000* 3 (.04) 1 $3,000 3 (.062) 1 $3,000 3 (.0145) 5 $277.50

6. (a) FICA taxes are incurred by both employee and employer. (b) FUTA taxes are incurred by the employer. (c) SUTA taxes are incurred by the employer. (d ) Withheld income taxes are incurred by the employee. 7. (a) 8. (a) Warranty expense was previously estimated and recorded. 9. (b) 10. A future payment is reported in the notes as a contingent liability if

(a) the uncertain future event is probable but the amount of pay- ment cannot be reasonably estimated or (b) the uncertain future event is not probable but has a reasonable possibility of occurring.

11. An employee’s marital status, gross earnings and number of withholding allowances determine the deduction for federal income taxes.

12. $59 13. (d )

Guidance Answers to Quick Checks

* $1,000 of the $3,000 March pay is subject to FUTA and SUTA—the entire $6,000 pay from January and February was subject to them.

Contingent liability (p. 390)

Current liabilities (p. 379)

Current portion of long-term debt (p. 387)

Deferred income tax liability (p. 402)

Employee benefits (p. 387)

Employee earnings report (p. 398)

Estimated liability (p. 387)

Federal depository bank (p. 395)

Federal Insurance Contributions Act (FICA) Taxes (p. 384)

Federal Unemployment Taxes (FUTA) (p. 386)

Form 940 (p. 395)

Form 941 (p. 395)

Form W-2 (p. 397)

Form W-4 (p. 400)

Gross pay (p. 383)

Known liabilities (p. 380)

Long-term liabilities (p. 379)

Merit rating (p. 386)

Net pay (p. 384)

Payroll bank account (p. 400)

Payroll deductions (p. 384)

Payroll register (p. 397)

Short-term note payable (p. 381)

State Unemployment Taxes (SUTA) (p. 386)

Times interest earned (p. 392)

Wage bracket withholding table (p. 400)

Warranty (p. 388)

Key Terms

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404 Chapter 9 Current Liabilities

A(B) Superscript letter A (B) denotes assignments based on Appendix 9A (9B).

Icon denotes assignments that involve decision making.

1. What is the difference between a current and a long-term liability?

2. What is an estimated liability? 3. What are the three important questions concerning the un-

certainty of liabilities? 4. If $988 is the total of a sale that includes its sales tax of 4%,

what is the selling price of the item only? 5. What is the combined amount (in percent) of the employee and

employer Social Security tax rate? 6. What is the current Medicare tax rate? This rate is applied to

what maximum level of salary and wages? 7. Which payroll taxes are the employee’s responsibility and

which are the employer’s responsibility? 8. What determines the amount deducted from an employee’s

wages for federal income taxes? 9. What is an employer’s unemployment merit rating? How are

these ratings assigned to employers? 10. Why are warranty liabilities usually recognized on the

balance sheet as liabilities even when they are uncertain? 11. Suppose that a company has a facility located where disas-

trous weather conditions often occur. Should it report a probable

loss from a future disaster as a liability on its balance sheet? Explain.

12.A What is a wage bracket withholding table? 13.A What amount of income tax is withheld from the salary of an employee who is single with two withholding allow-

ances and earning $725 per week? What if the employee earned $625 and has no withholding allowances? (Use Exhibit 9A.6.)

14. Refer to Polaris’ balance sheet in Appendix A. What accrued expenses (liabilities) does Polaris re- port at December 31, 2011?

15. Refer to Arctic Cat’s balance sheet in Appen- dix A. What is the amount of Arctic Cat’s ac- counts payable as of March 31, 2011?

16. Refer to KTM’s balance sheet in Appendix A. List KTM’s current liabilities as of December 31, 2011.

17. Refer to Piaggio’s recent balance sheet in Appen dix A. What current liabilities related to income taxes are on its balance sheet? Explain the meaning of each income tax account identified.

Discussion Questions

Warranty Liability account at July 1 was $26,000. What is the company’s warranty expense for the month of July?

a. $51,000 b. $1,000 c. $25,000 d. $33,000 e. $18,000 5. Employees earn vacation pay at the rate of 1 day per month.

During October, 150 employees qualify for one vacation day

each. Their average daily wage is $175 per day. What is the amount of vacation benefit expense for October?

a. $26,250 b. $175 c. $2,100 d. $63,875 e. $150

QUICK STUDY

QS 9-1 Classifying liabilities C1

Which of the following items are normally classified as a current liability for a company that has a 15-month operating cycle? 1. Note payable due in 18 months. 4. Salaries payable. 2. Note payable maturing in 2 years. 5. FICA taxes payable. 3. Portion of long-term note due in 15 months. 6. Note payable due in 11 months.

QS 9-3 Accounting for sales taxes

C2

Dextra Computing sells merchandise for $6,000 cash on September 30 (cost of merchandise is $3,900). The sales tax law requires Dextra to collect 5% sales tax on every dollar of merchandise sold. Record the entry for the $6,000 sale and its applicable sales tax. Also record the entry that shows the remittance of the 5% tax on this sale to the state government on October 15.

QS 9-2 Unearned revenue C2

Ticketsales, Inc., receives $5,000,000 cash in advance ticket sales for a four-date tour of Bon Jovi. Record the advance ticket sales on October 31. Record the revenue earned for the first concert date of November 5, assuming it represents one-fourth of the advance ticket sales.

Polaris

Arctic Cat

KTM

PIAGGIO

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Chapter 9 Current Liabilities 405

QS 9-5 Interest-bearing note transactions P1

On November 7, 2013, Mura Company borrows $160,000 cash by signing a 90-day, 8% note payable with a face value of $160,000. (1) Compute the accrued interest payable on December 31, 2013, (2) prepare the journal entry to record the accrued interest expense at December 31, 2013, and (3) prepare the journal entry to record payment of the note at maturity.

QS 9-6 Record employee payroll taxes

P2

On January 15, the end of the first biweekly pay period of the year, North Company’s payroll register showed that its employees earned $35,000 of sales salaries. Withholdings from the employees’ salaries include FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $6,500 of federal income taxes, $772.50 of medical insurance deductions, and $120 of union dues. No employee earned more than $7,000 in this first period. Prepare the journal entry to record North Company’s January 15 (employee) payroll expenses and liabilities. (Round amounts to cents.)

QS 9-7 Record employer payroll taxes

P3

Merger Co. has ten employees, each of whom earns $2,000 per month and has been employed since January 1. FICA Social Security taxes are 6.2% of the first $110,100 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. FUTA taxes are 0.8% and SUTA taxes are 5.4% of the first $7,000 paid to each employee. Prepare the March 31 journal entry to record the March payroll taxes expenses. (Round amounts to cents.)

QS 9-10 Recording warranty repairs

P4

On September 11, 2012, Home Store sells a mower for $500 with a one-year warranty that covers parts. Warranty expense is estimated at 8% of sales. On July 24, 2013, the mower is brought in for repairs covered under the warranty requiring $35 in materials taken from the Repair Parts Inventory. Prepare the September 11, 2012, entry to record the mower sale, and the July 24, 2013, entry to record the warranty repairs.

QS 9-4 Accounting for contingent liabilities

C3

The following legal claims exist for Huprey Co. Identify the accounting treatment for each claim as either (a) a liability that is recorded or (b) an item described in notes to its financial statements. 1. Huprey (defendant) estimates that a pending lawsuit could result in damages of $1,250,000; it is rea-

sonably possible that the plaintiff will win the case. 2. Huprey faces a probable loss on a pending lawsuit; the amount is not reasonably estimable. 3. Huprey estimates damages in a case at $3,500,000 with a high probability of losing the case.

QS 9-11 Times interest earned A1

Compute the times interest earned for Park Company, which reports income before interest expense and income taxes of $1,885,000, and interest expense of $145,000. Interpret its times interest earned (assume that its competitors average a times interest earned of 4.0).

The payroll records of Speedy Software show the following information about Marsha Gottschalk, an em- ployee, for the weekly pay period ending September 30, 2013. Gottschalk is single and claims one allow- ance. Compute her Social Security tax (6.2%), Medicare tax (1.45%), federal income tax withholding, state income tax (1.0%), and net pay for the current pay period. (Use the withholding table in Exhibit 9A.6 and round tax amounts to the nearest cent.)

QS 9-12A

Net pay and tax computations

P5

Total (gross) earnings for current pay period . . . . . . . . . . $ 740

Cumulative earnings of previous pay periods . . . . . . . . . . $9,700 Check Net pay, $579.99

QS 9-13B

Record deferred income tax liability P4

Sera Corporation has made and recorded its quarterly income tax payments. After a final review of taxes for the year, the company identifies an additional $40,000 of income tax expense that should be recorded. A portion of this additional expense, $6,000, is deferred for payment in future years. Record Sera’s year- end adjusting entry for income tax expense.

Answer each of the following related to international accounting standards. a. In general, how similar or different are the definitions and characteristics of current liabilities between

IFRS and U.S. GAAP? b. Companies reporting under IFRS often reference a set of current liabilities with the title financial lia-

bilities. Identify two current liabilities that would be classified under financial liabilities per IFRS. (Hint: Nokia provides examples in this chapter.)

QS 9-14 International accounting standards

C1 C2

QS 9-8 Accounting for bonuses P4

Noura Company offers an annual bonus to employees if the company meets certain net income goals. Prepare the journal entry to record a $15,000 bonus owed to its workers (to be shared equally) at calendar year-end.

QS 9-9 Accounting for vacations

P4

Chavez Co.’s salaried employees earn four weeks vacation per year. It pays $312,000.00 in total employee salaries for 52 weeks but its employees work only 48 weeks. This means Chavez’s total weekly expense is $6,500 ($312,000y48 weeks) instead of the $6,000 cash paid weekly to the employees ($312,000y52 weeks). Record Chavez’s weekly vacation benefits expense.

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406 Chapter 9 Current Liabilities

Exercise 9-2 Recording known current liabilities

C2

Prepare any necessary adjusting entries at December 31, 2013, for Piper Company’s year-end financial statements for each of the following separate transactions and events. 1. Piper Company records an adjusting entry for $10,000,000 of previously unrecorded cash sales (cost-

ing $5,000,000) and its sales taxes at a rate of 4%. 2. The company earned $50,000 of $125,000 previously received in advance for services.

Exercise 9-3 Accounting for contingent liabilities

C3

Prepare any necessary adjusting entries at December 31, 2013, for Melbourn Company’s year-end financial statements for each of the following separate transactions and events. 1. Melbourn Company guarantees the $100,000 debt of a supplier. The supplier will probably not default

on the debt. 2. A disgruntled employee is suing Melbourn Company. Legal advisers believe that the company will

probably need to pay damages, but the amount cannot be reasonably estimated.

Exercise 9-7 Payroll-related journal entries P2

Using the data in situation a of Exercise 9-6, prepare the employer’s September 30 journal entries to record salary expense and its related payroll liabilities for this employee. The employee’s federal income taxes withheld by the employer are $80 for this pay period. (Round amounts to cents.)

Exercise 9-8 Payroll-related journal entries P3

Using the data in situation a of Exercise 9-6, prepare the employer’s September 30 journal entries to record the employer’s payroll taxes expense and its related liabilities. (Round amounts to cents.)

EXERCISES

Exercise 9-1 Classifying liabilities

C1

The following items appear on the balance sheet of a company with a two-month operating cycle. Identify the proper classification of each item as follows: C if it is a current liability, L if it is a long-term liability, or N if it is not a liability.

1. Notes payable (due in 120 days). 2. Notes payable (mature in five years). 3. Notes payable (due in 6 to 12 months). 4. Current portion of long-term debt. 5. Notes payable (due in 13 to 24 months).

6. Sales taxes payable. 7. Accounts receivable. 8. Wages payable. 9. FUTA taxes payable. 10. Salaries payable.

Exercise 9-4 Accounting for note payable

P1

Sylvestor Systems borrows $110,000 cash on May 15, 2013, by signing a 60-day, 12% note. 1. On what date does this note mature? 2. Suppose the face value of the note equals $110,000, the principal of the loan. Prepare the journal en-

tries to record (a) issuance of the note and (b) payment of the note at maturity.Check (2b) Interest expense, $2,200

Exercise 9-5 Interest-bearing notes payable with year-end adjustments

P1

Keesha Co. borrows $200,000 cash on November 1, 2013, by signing a 90-day, 9% note with a face value of $200,000. 1. On what date does this note mature? (Assume that February of 2013 has 28 days.) 2. How much interest expense results from this note in 2013? (Assume a 360-day year.) 3. How much interest expense results from this note in 2014? (Assume a 360-day year.) 4. Prepare journal entries to record (a) issuance of the note, (b) accrual of interest at the end of 2013, and

(c) payment of the note at maturity.

Check (2) $3,000 (3) $1,500

BMX Company has one employee. FICA Social Security taxes are 6.2% of the first $110,100 paid to its em- ployee, and FICA Medicare taxes are 1.45% of gross pay. For BMX, its FUTA taxes are 0.8% and SUTA taxes are 2.9% of the first $7,000 paid to its employee. Compute BMX’s amounts for each of these four taxes as applied to the employee’s gross earnings for September under each of three separate situations (a), (b), and (c). (Round amounts to cents.)

Exercise 9-6 Computing payroll taxes

P2 P3

Gross Pay through August Gross Pay for September

a. $ 6,400 $ 800

b. 18,200 2,100

c. 103,800 8,000

Check (a) FUTA, $4.80; SUTA, $17.40

Exercise 9-9 Warranty expense and liability computations and entries P4

Hitzu Co. sold a copier costing $4,800 with a two-year parts warranty to a customer on August 16, 2013, for $6,000 cash. Hitzu uses the perpetual inventory system. On November 22, 2014, the copier requires on-site re- pairs that are completed the same day. The repairs cost $209 for materials taken from the Repair Parts Inventory.

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Chapter 9 Current Liabilities 407

Exercise 9-11 Accounting for estimated liabilities

P4

Prepare any necessary adjusting entries at December 31, 2013, for Maxum Company’s year-end financial statements for each of the following separate transactions and events. 1. Employees earn vacation pay at a rate of one day per month. During December, 20 employees qualify

for one vacation day each. Their average daily wage is $160 per employee. 2. During December, Maxum Company sold 12,000 units of a product that carries a 60-day warranty.

December sales for this product total $460,000. The company expects 10% of the units to need war- ranty repairs, and it estimates the average repair cost per unit will be $15.

Exercise 9-12 Computing and interpreting times interest earned

A1

Use the following information from separate companies a through f to compute times interest earned. Which company indicates the strongest ability to pay interest expense as it comes due? (Round ratios to two decimals.)

Net Income (Loss) Interest Expense Income Taxes

a. $115,000 $44,000 $ 35,000 b. 110,000 16,000 50,000 c. 100,000 12,000 70,000 d. 235,000 14,000 130,000 e. 59,000 14,000 30,000 f. (5,000) 10,000 0

Check (b) 11.00

These are the only repairs required in 2014 for this copier. Based on experience, Hitzu expects to incur warranty costs equal to 4% of dollar sales. It records warranty expense with an adjusting entry at the end of each year. 1. How much warranty expense does the company report in 2013 for this copier? 2. How much is the estimated warranty liability for this copier as of December 31, 2013? 3. How much warranty expense does the company report in 2014 for this copier? 4. How much is the estimated warranty liability for this copier as of December 31, 2014? 5. Prepare journal entries to record (a) the copier’s sale; (b) the adjustment on December 31, 2013, to

recognize the warranty expense; and (c) the repairs that occur in November 2014.

Check (1) $240

(4) $31

Exercise 9-10 Computing and recording bonuses P4

For the year ended December 31, 2013, Lopez Company has implemented an employee bonus program equal to 3% of Lopez’s net income, which employees will share equally. Lopez’s net income (prebonus) is expected to be $500,000, and bonus expense is deducted in computing net income. 1. Compute the amount of the bonus payable to the employees at year-end (use the method described in

the chapter and round to the nearest dollar). 2. Prepare the journal entry at December 31, 2013, to record the bonus due the employees. 3. Prepare the journal entry at January 19, 2014, to record payment of the bonus to employees.

Check (1) $14,563

Lenny Florita, an unmarried employee, works 48 hours in the week ended January 12. His pay rate is $14 per hour, and his wages are subject to no deductions other than FICA — Social Security, FICA — Medicare, and federal income taxes. He claims two withholding allowances. Compute his regular pay, overtime pay (for this company, workers earn 150% of their regular rate for hours in excess of 40 per week), and gross pay. Then compute his FICA tax deduction (use 6.2% for the Social Security portion and 1.45% for the Medicare portion), income tax deduction (use the wage bracket withholding table of Exhibit 9A.6), total deductions, and net pay. (Round tax amounts to the nearest cent.) Check Net pay, $596.30

Exercise 9-14A

Gross and net pay computation

P5

Exercise 9-13B

Accounting for income taxes

P4

Nishi Corporation prepares financial statements for each month-end. As part of its accounting process, es- timated income taxes are accrued each month for 30% of the current month’s net income. The income taxes are paid in the first month of each quarter for the amount accrued for the prior quarter. The following infor- mation is available for the fourth quarter of year 2013. When tax computations are completed on January 20, 2014, Nishi determines that the quarter’s Income Taxes Payable account balance should be $28,300 on December 31, 2013 (its unadjusted balance is $24,690).

October 2013 net income . . . . . . . . . . $28,600 November 2013 net income . . . . . . . . 19,100 December 2013 net income . . . . . . . . . 34,600

1. Determine the amount of the accounting adjustment (dated as of December 31, 2013) to produce the proper ending balance in the Income Taxes Payable account.

2. Prepare journal entries to record (a) the December 31, 2013, adjustment to the Income Taxes Payable account and (b) the January 20, 2014, payment of the fourth-quarter taxes.

Check (1) $3,610

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408 Chapter 9 Current Liabilities

Exercise 9-15 Recording payroll

P2 P3

The following monthly data are taken from Ramirez Company at July 31: Sales salaries, $300,000; Office salaries, $60,000; Federal income taxes withheld, $90,000; State income taxes withheld, $20,000; Social security taxes withheld, $22,320; Medicare taxes withheld, $5,220; Medical insurance premiums, $7,000; Life insurance premiums, $4,000; Union dues deducted, $1,000; and Salaries subject to unemployment taxes, $50,000. The employee pays forty percent of medical and life insurance premiums. Prepare journal entries to record: (1) accrued payroll, including employee deductions, for July; (2) cash payment of the net payroll (salaries payable) for July; (3) accrued employer payroll taxes, and other related employment expenses, for July—assume that FICA taxes are identical to those on employees and that SUTA taxes are 5.4% and FUTA taxes are 0.8%; and (4) cash payment of all liabilities related to the July payroll.

Exercise 9-16 Computing payroll taxes

P2 P3

Mester Company has 10 employees. FICA Social Security taxes are 6.2% of the first $110,100 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. FUTA taxes are 0.8% and SUTA taxes are 5.4% of the first $7,000 paid to each employee. Cumulative pay for the current year for each of its employees follows.

Employee Cumulative Pay Employee Cumulative Pay Employee Cumulative Pay

Steve S. . . . . . . . $ 6,000 Christina S. . . . . $156,600 Lori K. . . . . . . . . . $116,600 Tim V. . . . . . . . . . 60,000 Kathleen K. . . . . 106,900 Matt B. . . . . . . . . . 36,800 Brent G. . . . . . . . 87,000 Michelle H. . . . . 110,100 Sankha B. . . . . . . . 4,000

a. Prepare a table with the following column headings: Employee; Cumulative Pay; Pay Subject to FICA Social Security Taxes; Pay Subject to FICA Medicare Taxes; Pay Subject to FUTA Taxes; Pay Subject to SUTA Taxes. Compute the amounts in this table for each employee and total the columns.

b. For the company, compute each total for: FICA Social Security taxes, FICA Medicare taxes, FUTA taxes, and SUTA taxes. (Hint: Remember to include in those totals any employee share of taxes that the company must collect.) (Round amounts to cents.)

Exercise 9-17 Preparing payroll register and related entries P5

Stark Company has five employees. Employees paid by the hour receive a $10 per hour pay rate for the regular 40-hour work week plus one and one-half times the hourly rate for each overtime hour beyond the 40-hours per week. Hourly employees are paid every two weeks, but salaried employees are paid monthly on the last biweekly payday of each month. FICA Social Security taxes are 6.2% of the first $110,100 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. FUTA taxes are 0.8% and SUTA taxes are 5.4% of the first $7,000 paid to each employee. The company has a benefits plan that includes medical insurance, life insurance, and retirement funding for employees. Under this plan, employees must contribute 5 percent of their gross income as a payroll withholding, which the company matches with double the amount. Following is the partially completed payroll register for the biweekly period ending August 31, which is the last payday of August.

Cumulative Pay (Excludes Current Period)

Current Period Gross Pay FUTA

Pay Hours

Gross Pay

Pay Type

SIT

FIT

SUTA

Kathleen

Anthony

Nichole

Zoey

Gracie

Totals

Employee

$108,300.00

6,800.00

15,000.00

6,500.00

5,000.00

141,600.00

Regular Overtime

Regular Overtime

Regular Overtime

Salary

Salary

0

4

74

8

80

80

---

---

388.00

21.00

22.00

2,380.00

90.00

25.00

100.00

110.00

80.00

300.00 $2,000.00

20.00

0.00

740.00

500.00

$7,000.00

FICA-SS_EE FICA-Med_EE

FICA-SS_ER FICA-Med_ER

EE-Ben_Plan Withholding ER-Ben_Plan Withholding

Employee Net Pay

* Table abbreviations follow those in Exhibit 9A.3 (see pages 397–398); and, “Ben_Plan” refers to employee (EE) or employer (ER) withholding for the benefits plan.

a. Complete this payroll register by filling in all cells for the pay period ended August 31. Hint: See Exhibit 9A.5 for guidance. (Round amounts to cents.)

b. Prepare the August 31 journal entry to record the accrued biweekly payroll and related liabilities for deductions.

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Chapter 9 Current Liabilities 409

c. Prepare the August 31 journal entry to record the employer’s cash payment of the net payroll of part b. d. Prepare the August 31 journal entry to record the employer’s payroll taxes including the contribution

to the benefits plan. e. Prepare the August 31 journal entry to pay all liabilities (expect net payroll in part c) for this biweekly

period.

Problem 9-2A Payroll expenses, withholdings, and taxes P2 P3

Paloma Co. Stars has four employees. FICA Social Security taxes are 6.2% of the first $110,100 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. Also, for the first $7,000 paid to each employee, the company’s FUTA taxes are 0.8% and SUTA taxes are 2.15%. The company is preparing its payroll cal- culations for the week ended August 25. Payroll records show the following information for the company’s four employees.

Volvo Group reports the following information for its product warranty costs as of December 31, 2011, along with provisions and utilizations of warranty liabilities for the year ended December 31, 2011 (SEK in millions).

Provision for product warranty Warranty provisions are estimated with consideration of historical claims statistics, the warranty period, the average time-lag between faults occurring and claims to the company and anticipated changes in quality indexes. Estimated costs for product warranties are charged to cost of sales when the products are sold. Differences between actual warranty claims and the estimated claims generally affect the recognized expense and provisions in future periods. Refunds from suppliers, that decrease Volvo’s warranty costs, are recognized to the extent these are considered to be certain. At December 31, 2011 (2010) warranty cost provisions amounted to 8,652 (7,841).

1. Prepare Volvo’s journal entry to record its estimated warranty liabilities (provisions) for 2011. 2. Prepare Volvo’s journal entry to record its costs (utilizations) related to its warranty program for 2011.

Assume those costs involve replacements taken out of Inventory, with no cash involved. 3. How much warranty expense does Volvo report for 2011?

Product warranty liabilities, December 31, 2010 . . . . . . . . . . . . . . . . SEK 7,841

Additional provisions to product warranty liabilities . . . . . . . . . . . . . 7,749

Utilizations and reductions of product warranty liabilities . . . . . . . . (6,938)

Product warranty liabilities, December 31, 2011 . . . . . . . . . . . . . . . . 8,652

Exercise 9-18 Accounting for current liabilities under IFRS

P4

Tyrell Co. entered into the following transactions involving short-term liabilities in 2012 and 2013.

2012

Apr. 20 Purchased $40,250 of merchandise on credit from Locust, terms are 1y10, ny30. Tyrell uses the perpetual inventory system.

May 19 Replaced the April 20 account payable to Locust with a 90-day, $35,000 note bearing 10% an- nual interest along with paying $5,250 in cash.

July 8 Borrowed $80,000 cash from National Bank by signing a 120-day, 9% interest-bearing note with a face value of $80,000.

___?____ Paid the amount due on the note to Locust at the maturity date. ___?____ Paid the amount due on the note to National Bank at the maturity date. Nov. 28 Borrowed $42,000 cash from Fargo Bank by signing a 60-day, 8% interest-bearing note with a

face value of $42,000. Dec. 31 Recorded an adjusting entry for accrued interest on the note to Fargo Bank.

2013

___?____ Paid the amount due on the note to Fargo Bank at the maturity date.

Required

1. Determine the maturity date for each of the three notes described. 2. Determine the interest due at maturity for each of the three notes. (Assume a 360-day year.) 3. Determine the interest expense to be recorded in the adjusting entry at the end of 2012. 4. Determine the interest expense to be recorded in 2013. 5. Prepare journal entries for all the preceding transactions and events for years 2012 and 2013.

PROBLEM SET A

Problem 9-1A Short-term notes payable transactions and entries

P1

mhhe.com/wildFINMAN5e

Check (2) Locust, $875 (3) $308 (4) $252

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410 Chapter 9 Current Liabilities

Current Week Income Tax WithholdingName

Gross Pay through 8/18

$109,000

36,650

Gross Pay

400 30

1

2

3

4

5

6

7

Dahlia

Trey

Kiesha

Chee

7,100

1,050

$2,000

900

450

$284

145

39

In addition to gross pay, the company must pay one-half of the $60 per employee weekly health insur- ance; each employee pays the remaining one-half. The company also contributes an extra 8% of each employee’s gross pay (at no cost to employees) to a pension fund.

Required

Compute the following for the week ended August 25 (round amounts to the nearest cent):

1. Each employee’s FICA withholdings for Social Security. 2. Each employee’s FICA withholdings for Medicare. 3. Employer’s FICA taxes for Social Security. 4. Employer’s FICA taxes for Medicare. 5. Employer’s FUTA taxes. 6. Employer’s SUTA taxes. 7. Each employee’s net (take-home) pay. 8. Employer’s total payroll-related expense for each employee.

(4) $54.38

(5) $3.20

(7) Total net pay, $2,900.92

Check (3) $176.70

On January 8, the end of the first weekly pay period of the year, Regis Company’s payroll register showed that its employees earned $22,760 of office salaries and $65,840 of sales salaries. Withholdings from the employees’ salaries include FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $12,860 of federal income taxes, $1,340 of medical insurance deductions, and $840 of union dues. No employee earned more than $7,000 in this first period.

Required

1. Calculate FICA Social Security taxes payable and FICA Medicare taxes payable. Prepare the journal entry to record Regis Company’s January 8 (employee) payroll expenses and liabilities. (Round amounts to cents.)

2. Prepare the journal entry to record Regis’s (employer) payroll taxes resulting from the January 8 pay- roll. Regis’s merit rating reduces its state unemployment tax rate to 4% of the first $7,000 paid each employee. The federal unemployment tax rate is 0.8%. (Round amounts to cents.)

Problem 9-3A Entries for payroll transactions

P2 P3

Check (1) Cr. Salaries Payable, $66,782.10

(2) Dr. Payroll Taxes Expense, $11,030.70

mhhe.com/wildFINMAN5e

On October 29, 2012, Lobo Co. began operations by purchasing razors for resale. Lobo uses the perpetual inventory method. The razors have a 90-day warranty that requires the company to replace any nonwork- ing razor. When a razor is returned, the company discards it and mails a new one from Merchandise Inventory to the customer. The company’s cost per new razor is $20 and its retail selling price is $75 in both 2012 and 2013. The manufacturer has advised the company to expect warranty costs to equal 8% of dollar sales. The following transactions and events occurred.

2012

Nov. 11 Sold 105 razors for $7,875 cash. 30 Recognized warranty expense related to November sales with an adjusting entry. Dec. 9 Replaced 15 razors that were returned under the warranty. 16 Sold 220 razors for $16,500 cash. 29 Replaced 30 razors that were returned under the warranty. 31 Recognized warranty expense related to December sales with an adjusting entry.

2013

Jan. 5 Sold 150 razors for $11,250 cash. 17 Replaced 50 razors that were returned under the warranty. 31 Recognized warranty expense related to January sales with an adjusting entry.

Problem 9-4A Warranty expense and liability estimation

P4

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Chapter 9 Current Liabilities 411

Shown here are condensed income statements for two different companies (both are organized as LLCs and pay no income taxes).

Miller Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Variable expenses (80%) . . . . . . . . . 800,000

Income before interest . . . . . . . . . . 200,000

Interest expense (fixed) . . . . . . . . . 60,000

Net income . . . . . . . . . . . . . . . . . . . $ 140,000

Weaver Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Variable expenses (60%) . . . . . . . . . 600,000

Income before interest . . . . . . . . . . 400,000

Interest expense (fixed) . . . . . . . . . 260,000

Net income . . . . . . . . . . . . . . . . . . . $ 140,000

Problem 9-5A Computing and analyzing times interest earned

A1

Required

1. Compute times interest earned for Miller Company. 2. Compute times interest earned for Weaver Company. 3. What happens to each company’s net income if sales increase by 30%? 4. What happens to each company’s net income if sales increase by 50%? 5. What happens to each company’s net income if sales increase by 80%? 6. What happens to each company’s net income if sales decrease by 10%? 7. What happens to each company’s net income if sales decrease by 20%? 8. What happens to each company’s net income if sales decrease by 40%?

Analysis Component

9. Comment on the results from parts 3 through 8 in relation to the fixed-cost strategies of the two com- panies and the ratio values you computed in parts 1 and 2.

Check (3) Miller net income, $200,000 (43% increase)

(6) Weaver net income, $100,000 (29% decrease)

Check (3) $900 (4) $1,050 Cr. (5) $950 Cr.

Required

1. Prepare journal entries to record these transactions and adjustments for 2012 and 2013. 2. How much warranty expense is reported for November 2012 and for December 2012? 3. How much warranty expense is reported for January 2013? 4. What is the balance of the Estimated Warranty Liability account as of December 31, 2012? 5. What is the balance of the Estimated Warranty Liability account as of January 31, 2013?

Francisco Company has 10 employees, each of whom earns $2,800 per month and is paid on the last day of each month. All 10 have been employed continuously at this amount since January 1. Francisco uses a payroll bank account and special payroll checks to pay its employees. On March 1, the following accounts and balances exist in its general ledger: a. FICA — Social Security Taxes Payable, $3,472; FICA — Medicare Taxes Payable, $812. (The balances of

these accounts represent total liabilities for both the employer’s and employees’ FICA taxes for the February payroll only.)

b. Employees’ Federal Income Taxes Payable, $4,000 (liability for February only). c. Federal Unemployment Taxes Payable, $448 (liability for January and February together). d. State Unemployment Taxes Payable, $2,240 (liability for January and February together). During March and April, the company had the following payroll transactions.

Mar. 15 Issued check payable to Swift Bank, a federal depository bank authorized to accept employers’ payments of FICA taxes and employee income tax withholdings. The $8,284 check is in pay- ment of the February FICA and employee income taxes.

31 Recorded the March payroll and transferred funds from the regular bank account to the payroll bank account. Issued checks payable to each employee in payment of the March payroll. The payroll register shows the following summary totals for the March pay period.

Problem 9-6AA

Entries for payroll transactions

P2 P3 P5

Check March 31: Salaries Payable, $21,858

Salaries Federal

Office Shop Gross FICA Income Net

Salaries Salaries Pay Taxes* Taxes Pay

$11,200 $16,800 $28,000 $1,736 $4,000 $21,858

$ 406

* FICA taxes are Social Security and Medicare, respectively.

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412 Chapter 9 Current Liabilities

31 Recorded the employer’s payroll taxes resulting from the March payroll. The company has a merit rating that reduces its state unemployment tax rate to 4.0% of the first $7,000 paid each employee. The federal rate is 0.8%.

Apr. 15 Issued check to Swift Bank in payment of the March FICA and employee income taxes. 15 Issued check to the State Tax Commission for the January, February, and March state unem-

ployment taxes. Mailed the check and the first quarter tax return to the Commission. 30 Issued check payable to Swift Bank in payment of the employer’s FUTA taxes for the first quar-

ter of the year. 30 Mailed Form 941 to the IRS, reporting the FICA taxes and the employees’ federal income tax

withholdings for the first quarter.

Required

Prepare journal entries to record the transactions and events for both March and April.

March 31: Dr. Payroll Taxes Expenses, $2,814

April 15: Cr. Cash, $8,284 (Swift Bank)

PROBLEM SET B

Problem 9-1B Short-term notes payable transactions and entries

P1

Warner Co. entered into the following transactions involving short-term liabilities in 2012 and 2013.

2012

Apr. 22 Purchased $5,000 of merchandise on credit from Fox Products, terms are 1y10, ny30. Warner uses the perpetual inventory system.

May 23 Replaced the April 22 account payable to Fox Products with a 60-day, $4,600 note bearing 15% annual interest along with paying $400 in cash.

July 15 Borrowed $12,000 cash from Spring Bank by signing a 120-day, 10% interest-bearing note with a face value of $12,000.

_______ ? Paid the amount due on the note to Fox Products at maturity. _______ ? Paid the amount due on the note to Spring Bank at maturity. Dec. 6 Borrowed $8,000 cash from City Bank by signing a 45-day, 9% interest-bearing note with a

face value of $8,000. 31 Recorded an adjusting entry for accrued interest on the note to City Bank.

2013

_______ ? Paid the amount due on the note to City Bank at maturity.

Required

1. Determine the maturity date for each of the three notes described. 2. Determine the interest due at maturity for each of the three notes. (Assume a 360-day year.) 3. Determine the interest expense to be recorded in the adjusting entry at the end of 2012. 4. Determine the interest expense to be recorded in 2013. 5. Prepare journal entries for all the preceding transactions and events for years 2012 and 2013.

Check (2) Fox, $115 (3) $50 (4) $40

Problem 9-2B Payroll expenses, withholdings, and taxes

P2 P3

Fishing Guides Co. has four employees. FICA Social Security taxes are 6.2% of the first $110,100 paid to each employee, and FICA Medicare taxes are 1.45% of gross pay. Also, for the first $7,000 paid to each employee, the company’s FUTA taxes are 0.8% and SUTA taxes are 1.75%. The company is preparing its payroll calcula- tions for the week ended September 30. Payroll records show the following information for the company’s four employees.

Current Week Income Tax WithholdingName

Gross Pay through 9/23 Gross Pay

1

2

3

4

5

6

7

Ahmed

Carlos

June

Marie

$108,500

36,650

6,650

22,200

$2,500

1,515

475

1,000

$198

182

32

68

In addition to gross pay, the company must pay one-half of the $50 per employee weekly health insurance; each employee pays the remaining one-half. The company also contributes an extra 5% of each employee’s gross pay (at no cost to employees) to a pension fund.

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Chapter 9 Current Liabilities 413

Required

Compute the following for the week ended September 30 (round amounts to the nearest cent): 1. Each employee’s FICA withholdings for

Social Security. 2. Each employee’s FICA withholdings for Medicare. 3. Employer’s FICA taxes for Social Security. 4. Employer’s FICA taxes for Medicare.

Check (3) $284.58 (4) $79.61

(5) $2.80 (7) Total net pay, $4,545.81

5. Employer’s FUTA taxes. 6. Employer’s SUTA taxes. 7. Each employee’s net (take-home) pay. 8. Employer’s total payroll-related expense

for each employee.

Tavella Company’s first weekly pay period of the year ends on January 8. On that date, the column totals in Tavella’s payroll register indicate its sales employees earned $34,745, its office employees earned $21,225, and its delivery employees earned $1,030 in salaries. The employees are to have withheld from their salaries FICA Social Security taxes at the rate of 6.2%, FICA Medicare taxes at the rate of 1.45%, $8,625 of federal income taxes, $1,160 of medical insurance deductions, and $138 of union dues. No employee earned more than $7,000 in the first pay period.

Required

1. Calculate FICA Social Security taxes payable and FICA Medicare taxes payable. Prepare the journal entry to record Tavella Company’s January 8 (employee) payroll expenses and liabilities. (Round amounts to cents.)

2. Prepare the journal entry to record Tavella’s (employer) payroll taxes resulting from the January 8 payroll. Tavella’s merit rating reduces its state unemployment tax rate to 3.4% of the first $7,000 paid each employee. The federal unemployment tax rate is 0.8%. (Round amounts to cents.)

Problem 9-3B Entries for payroll transactions

P2 P3

Check (1) Cr. Salaries Payable, $42,716.50

(2) Dr. Payroll Taxes Expense, $6,754.50

On November 10, 2013, Lee Co. began operations by purchasing coffee grinders for resale. Lee uses the perpetual inventory method. The grinders have a 60-day warranty that requires the company to replace any nonworking grinder. When a grinder is returned, the company discards it and mails a new one from Merchandise Inventory to the customer. The company’s cost per new grinder is $24 and its retail selling price is $50 in both 2013 and 2014. The manufacturer has advised the company to expect warranty costs to equal 10% of dollar sales. The following transactions and events occurred.

2013

Nov. 16 Sold 50 grinders for $2,500 cash. 30 Recognized warranty expense related to November sales with an adjusting entry. Dec. 12 Replaced six grinders that were returned under the warranty. 18 Sold 200 grinders for $10,000 cash. 28 Replaced 17 grinders that were returned under the warranty. 31 Recognized warranty expense related to December sales with an adjusting entry.

2014

Jan. 7 Sold 40 grinders for $2,000 cash. 21 Replaced 36 grinders that were returned under the warranty. 31 Recognized warranty expense related to January sales with an adjusting entry.

Required

1. Prepare journal entries to record these transactions and adjustments for 2013 and 2014. 2. How much warranty expense is reported for November 2013 and for December 2013? 3. How much warranty expense is reported for January 2014? 4. What is the balance of the Estimated Warranty Liability account as of December 31, 2013? 5. What is the balance of the Estimated Warranty Liability account as of January 31, 2014?

Problem 9-4B Warranty expense and liability estimation

P4

Check (3) $200 (4) $698 Cr. (5) $34 Cr.

Ellis Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $240,000

Variable expenses (50%) . . . . . . . . . 120,000

Income before interest . . . . . . . . . . 120,000

Interest expense (fixed) . . . . . . . . . 90,000

Net income . . . . . . . . . . . . . . . . . . . $ 30,000

Seidel Company

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $240,000

Variable expenses (75%) . . . . . . . . . 180,000

Income before interest . . . . . . . . . . 60,000

Interest expense (fixed) . . . . . . . . . 30,000

Net income . . . . . . . . . . . . . . . . . . . $ 30,000

Shown here are condensed income statements for two different companies (both are organized as LLCs and pay no income taxes).

Problem 9-5B Computing and analyzing times interest earned

A1

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414 Chapter 9 Current Liabilities

Salaries Federal

Office Shop Gross FICA Income Net

Salaries Salaries Pay Taxes* Taxes Pay

$3,800 $4,200 $8,000 $496 $1,050 $6,338

$116

* FICA taxes are Social Security and Medicare, respectively.

Problem 9-6BA

Entries for payroll transactions

P2 P3 P5

MLS Company has five employees, each of whom earns $1,600 per month and is paid on the last day of each month. All five have been employed continuously at this amount since January 1. MLS uses a payroll bank account and special payroll checks to pay its employees. On June 1, the following accounts and bal- ances exist in its general ledger: a. FICA—Social Security Taxes Payable, $992; FICA—Medicare Taxes Payable, $232. (The balances of

these accounts represent total liabilities for both the employer’s and employees’ FICA taxes for the May payroll only.)

b. Employees’ Federal Income Taxes Payable, $1,050 (liability for May only). c. Federal Unemployment Taxes Payable, $88 (liability for April and May together). d. State Unemployment Taxes Payable, $440 (liability for April and May together). During June and July, the company had the following payroll transactions.

June 15 Issued check payable to Security Bank, a federal depository bank authorized to accept em- ployers’ payments of FICA taxes and employee income tax withholdings. The $2,274 check is in payment of the May FICA and employee income taxes.

30 Recorded the June payroll and transferred funds from the regular bank account to the payroll bank account. Issued checks payable to each employee in payment of the June payroll. The payroll register shows the following summary totals for the June pay period.

Check June 30: Cr. Salaries Payable, $6,338

30 Recorded the employer’s payroll taxes resulting from the June payroll. The company has a merit rating that reduces its state unemployment tax rate to 4.0% of the first $7,000 paid each employee. The federal rate is 0.8%.

July 15 Issued check payable to Security Bank in payment of the June FICA and employee income taxes. 15 Issued check to the State Tax Commission for the April, May and June state unemployment

taxes. Mailed the check and the second quarter tax return to the State Tax Commission. 31 Issued check payable to Security Bank in payment of the employer’s FUTA taxes for the first

quarter of the year. 31 Mailed Form 941 to the IRS, reporting the FICA taxes and the employees’ federal income tax

withholdings for the second quarter.

Required

Prepare journal entries to record the transactions and events for both June and July.

Check June 30: Dr. Payroll Taxes Expenses, $612

July 15: Cr. Cash $2,274 (Security Bank)

Required

1. Compute times interest earned for Ellis Company. 2. Compute times interest earned for Seidel Company. 3. What happens to each company’s net income if sales increase by 10%? 4. What happens to each company’s net income if sales increase by 40%? 5. What happens to each company’s net income if sales increase by 90%? 6. What happens to each company’s net income if sales decrease by 20%? 7. What happens to each company’s net income if sales decrease by 50%? 8. What happens to each company’s net income if sales decrease by 80%?

Analysis Component

9. Comment on the results from parts 3 through 8 in relation to the fixed-cost strategies of the two com- panies and the ratio values you computed in parts 1 and 2.

Check (4) Ellis net income, $78,000 (160% increase)

(6) Seidel net income, $18,000 (40% decrease)

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Chapter 9 Current Liabilities 415

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 9 Review the February 26 and March 25 transactions for Success Systems (SP 4) from Chapter 4.

Required

1. Assume that Lyn Addie is an unmarried employee. Her $1,000 of wages are subject to no deductions other than FICA Social Security taxes, FICA Medicare taxes, and federal income taxes. Her federal income taxes for this pay period total $159. Compute her net pay for the eight days’ work paid on February 26. (Round amounts to the nearest cent.)

2. Record the journal entry to reflect the payroll payment to Lyn Addie as computed in part 1. 3. Record the journal entry to reflect the (employer) payroll tax expenses for the February 26 payroll pay-

ment. Assume Lyn Addie has not met earnings limits for FUTA and SUTA—the FUTA rate is 0.8% and the SUTA rate is 4% for Success Systems. (Round amounts to the nearest cent.)

4. Record the entry(ies) for the merchandise sold on March 25 if a 4% sales tax rate applies.

SERIAL PROBLEM Success Systems

P2 P3 C2

CP 9 Bug-Off Exterminators provides pest control services and sells extermination products manufac- tured by other companies. The following six-column table contains the company’s unadjusted trial bal- ance as of December 31, 2013.

COMPREHENSIVE PROBLEM Bug-Off Exterminators (Review of Chapters 1–9)

BUG-OFF EXTERMINATORS

December 31, 2013

Unadjusted Adjusted

Trial Balance Adjustments Trial Balance

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,000 Accounts receivable . . . . . . . . . . . . . . . . . 4,000 Allowance for doubtful accounts . . . . . . . $ 828 Merchandise inventory . . . . . . . . . . . . . . . 11,700 Trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 Accum. depreciation—Trucks . . . . . . . . . . 0 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Accum. depreciation—Equipment . . . . . . 12,200 Accounts payable . . . . . . . . . . . . . . . . . . . . 5,000 Estimated warranty liability . . . . . . . . . . . . 1,400 Unearned services revenue . . . . . . . . . . . 0 Interest payable . . . . . . . . . . . . . . . . . . . . . 0 Long-term notes payable . . . . . . . . . . . . . 15,000 Common stock . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . 49,700 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Extermination services revenue . . . . . . . . 60,000 Interest revenue . . . . . . . . . . . . . . . . . . . . 872 Sales (of merchandise) . . . . . . . . . . . . . . . 71,026 Cost of goods sold . . . . . . . . . . . . . . . . . . 46,300 Depreciation expense—Trucks . . . . . . . . 0 Depreciation expense—Equipment . . . . . 0 Wages expense . . . . . . . . . . . . . . . . . . . . . 35,000 Interest expense . . . . . . . . . . . . . . . . . . . . 0 Rent expense . . . . . . . . . . . . . . . . . . . . . . 9,000 Bad debts expense . . . . . . . . . . . . . . . . . . 0 Miscellaneous expense . . . . . . . . . . . . . . . 1,226 Repairs expense . . . . . . . . . . . . . . . . . . . . 8,000 Utilities expense . . . . . . . . . . . . . . . . . . . . 6,800 Warranty expense . . . . . . . . . . . . . . . . . . 0 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $226,026 $226,026

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416 Chapter 9 Current Liabilities

The following information in a through h applies to the company at the end of the current year. a. The bank reconciliation as of December 31, 2013, includes the following facts.

Cash balance per bank . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,100

Cash balance per books . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000

Outstanding checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Deposit in transit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,450

Interest earned (on bank account) . . . . . . . . . . . . . . . . . . 52

Bank service charges (miscellaneous expense) . . . . . . . . 15

Original cost . . . . . . . . . . . . . . . . $32,000

Expected salvage value . . . . . . . . 8,000

Useful life (years) . . . . . . . . . . . . 4

Reported on the bank statement is a canceled check that the company failed to record. (Information from the bank reconciliation allows you to determine the amount of this check, which is a payment on an account payable.)

b. An examination of customers’ accounts shows that accounts totaling $679 should be written off as uncollectible. Using an aging of receivables, the company determines that the ending balance of the Allowance for Doubtful Accounts should be $700.

c. A truck is purchased and placed in service on January 1, 2013. Its cost is being depreciated with the straight-line method using the following facts and estimates.

d. Two items of equipment (a sprayer and an injector) were purchased and put into service in early January 2011. They are being depreciated with the straight-line method using these facts and estimates.

Sprayer Injector

Original cost . . . . . . . . . . . . . . . . $27,000 $18,000

Expected salvage value . . . . . . . . 3,000 2,500

Useful life (years) . . . . . . . . . . . . 8 5

e. On August 1, 2013, the company is paid $3,840 cash in advance to provide monthly service for an apartment complex for one year. The company began providing the services in August. When the cash was received, the full amount was credited to the Extermination Services Revenue account.

f. The company offers a warranty for the services it sells. The expected cost of providing warranty ser- vice is 2.5% of the extermination services revenue of $57,760 for 2013. No warranty expense has been recorded for 2013. All costs of servicing warranties in 2013 were properly debited to the Estimated Warranty Liability account.

g. The $15,000 long-term note is an 8%, five-year, interest-bearing note with interest payable annually on December 31. The note was signed with First National Bank on December 31, 2013.

h. The ending inventory of merchandise is counted and determined to have a cost of $11,700. Bug-Off uses a perpetual inventory system.

Required

1. Use the preceding information to determine amounts for the following items. a. Correct (reconciled) ending balance of Cash, and the amount of the omitted check. b. Adjustment needed to obtain the correct ending balance of the Allowance for Doubtful Accounts. c. Depreciation expense for the truck used during year 2013. d. Depreciation expense for the two items of equipment used during year 2013. e. The adjusted 2013 ending balances of the Extermination Services Revenue and Unearned Services

Revenue accounts. f. The adjusted 2013 ending balances of the accounts for Warranty Expense and Estimated Warranty

Liability. g. The adjusted 2013 ending balances of the accounts for Interest Expense and Interest Payable.

(Round amounts to nearest whole dollar.)

Check (1a) Cash bal. $15,750 (1b) $551 credit

(1f ) Estim. warranty liability, $2,844 Cr.

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Chapter 9 Current Liabilities 417

2. Use the results of part 1 to complete the six-column table by first entering the appropriate adjustments for items a through g and then completing the adjusted trial balance columns. (Hint: Item b requires two adjustments.)

3. Prepare journal entries to record the adjustments entered on the six-column table. Assume Bug-Off’s adjusted balance for Merchandise Inventory matches the year-end physical count.

4. Prepare a single-step income statement, a statement of retained earnings (cash dividends during 2013 were $10,000), and a classified balance sheet.

(4) Net income, $9,274; Total assets, $82,771

(2) Adjusted trial balance totals, $238,207

BTN 9-1 Refer to the financial statements of Polaris in Appendix A to answer the following. 1. Compute times interest earned for the fiscal years ended 2011, 2010, and 2009. Comment on Polaris’ abil-

ity to cover its interest expense for this period. Assume an industry average of 20 for times interest earned. 2. Polaris’ current liabilities include “Sales promotions and incentives”; assume that this account re-

flects “Loyalty reward liabilities.” Is this a known or an estimated liability? Explain how this liability is created.

3. Does Polaris have any commitments or contingencies? If yes, then briefly explain them.

Fast Forward

4. Access Polaris’ financial statements for fiscal years ending after December 31, 2011, at its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Compute its times interest earned for years ending after December 31, 2011, and compare your results to those in part 1.

Beyond the Numbers

REPORTING IN ACTION A1 P4

BTN 9-2 Key figures for Polaris and Arctic Cat follow. COMPARATIVE ANALYSIS A1

Required

1. Compute times interest earned for the three years’ data shown for each company. 2. Comment on which company appears stronger in its ability to pay interest obligations if income

should decline. Assume an industry average of 20.

BTN 9-3 Cameron Bly is a sales manager for an automobile dealership. He earns a bonus each year based on revenue from the number of autos sold in the year less related warranty expenses. Actual warranty expenses have varied over the prior 10 years from a low of 3% of an automobile’s selling price to a high of 10%. In the past, Bly has tended to estimate warranty expenses on the high end to be conservative. He must work with the dealership’s accountant at year-end to arrive at the warranty expense accrual for cars sold each year. 1. Does the warranty accrual decision create any ethical dilemma for Bly? 2. Since warranty expenses vary, what percent do you think Bly should choose for the current year?

Justify your response.

ETHICS CHALLENGE P4

BTN 9-4 Dusty Johnson is the accounting and finance manager for a manufacturer. At year-end, he must determine how to account for the company’s contingencies. His manager, Tom Pretti, objects to Johnson’s proposal to recognize an expense and a liability for warranty service on units of a new product introduced in the fourth quarter. Pretti comments, “There’s no way we can estimate this warranty cost. We don’t owe anyone anything until a product fails and it is returned. Let’s report an expense if and when we do any warranty work.”

Required

Prepare a one-page memorandum for Johnson to send to Pretti defending his proposal.

COMMUNICATING IN PRACTICE C3

Polaris Arctic Cat

One Two One Two

Current Year Years Current Year Years

($ thousands) Year Prior Prior Year Prior Prior

Net income . . . . . . . . . . . . $227,575 $147,138 $101,017 $13,007 $1,875 $(9,508)

Income taxes . . . . . . . . . . . 119,051 71,403 50,157 5,224 (777) (6,247)

Interest expense . . . . . . . . 3,987 2,680 4,111 11 250 1,015

Polaris Arctic Cat

Polaris

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418 Chapter 9 Current Liabilities

BTN 9-6 Assume that your team is in business and you must borrow $6,000 cash for short-term needs. You have been shopping banks for a loan, and you have the following two options. A. Sign a $6,000, 90-day, 10% interest-bearing note dated June 1. B. Sign a $6,000, 120-day, 8% interest-bearing note dated June 1.

Required

1. Discuss these two options and determine the best choice. Ensure that all teammates concur with the decision and understand the rationale.

2. Each member of the team is to prepare one of the following journal entries. a. Option A — at date of issuance. b. Option B — at date of issuance. c. Option A — at maturity date. d. Option B — at maturity date. 3. In rotation, each member is to explain the entry he or she prepared in part 2 to the team. Ensure that

all team members concur with and understand the entries. 4. Assume that the funds are borrowed on December 1 (instead of June 1) and your business operates on

a calendar-year reporting period. Each member of the team is to prepare one of the following entries. a. Option A — the year-end adjustment. b. Option B — the year-end adjustment. c. Option A — at maturity date. d. Option B — at maturity date. 5. In rotation, each member is to explain the entry he or she prepared in part 4 to the team. Ensure that

all team members concur with and understand the entries.

TEAMWORK IN ACTION C2 P1

BTN 9-5 Access the February 24, 2012, filing of the December 31, 2011, annual 10-K report of McDonald’s Corporation (Ticker: MCD), which is available from www.sec.gov.

Required

1. Identify the current liabilities on McDonald’s balance sheet as of December 31, 2011. 2. What portion (in percent) of McDonald’s long-term debt matures within the next 12 months? 3. Use the consolidated statement of income for the year ended December 31, 2011, to compute

McDonald’s times interest earned ratio. Comment on the result. Assume an industry average of 15.0.

TAKING IT TO THE NET C1 A1

ENTREPRENEURIAL DECISION A1

BTN 9-7 Review the chapter’s opening feature about Karen Cooper, and her start-up company, SmartIT Staffing. Assume that she is considering expanding her business to open an office in Europe. Assume her current income statement is as follows.

SmartIT Staffing currently has no interest-bearing debt. If it expands to open a European location, it will require a $300,000 loan. SmartIT Staffing has found a bank that will loan it the money on a 7% note pay- able. The company believes that, at least for the first few years, sales at its European location will be $250,000, and that all expenses will follow the same patterns as its current locations.

Required

1. Prepare an income statement (showing three separate columns for current operations, European, and total) for the company assuming that it borrows the funds and expands to Europe. Annual revenues for current operations are expected to remain at $1,000,000.

SMARTIT STAFFING

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Operating expenses (55%) . . . . . . . . 550,000

Net income . . . . . . . . . . . . . . . . . . . . $ 450,000

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Chapter 9 Current Liabilities 419

BTN 9-8 Check your phone book or the Social Security Administration Website (www.ssa.gov) to locate the Social Security office near you. Visit the office to request a personal earnings and estimate form. Fill out the form and mail according to the instructions. You will receive a statement from the Social Se- curity Administration regarding your earnings history and future Social Security benefits you can receive. (Formerly the request could be made online. The online service has been discontinued and is now under review by the Social Security Administration due to security concerns.) It is good to request an earnings and benefit statement every 5 to 10 years to make sure you have received credit for all wages earned and for which you and your employer have paid taxes into the system.

HITTING THE ROAD P2

1. b; $6,000 3 0.05 3 30y360 5 $25 2. e; $50,000 3 (.062 1 .0145) 5 $3,825 3. b; $7,000 3 (.008 1 .054) 5 $434

4. c; 10,000 television sets 3 .01 3 $250 5 $25,000 5. a; 150 employees 3 $175 per day 3 1 vacation day earned 5 $26,250

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 9-9 KTM, Polaris, and Arctic Cat are all competitors in the global marketplace. Comparative figures for KTM (www.KTM.com), along with selected figures from Polaris and Arctic Cat, follow.

GLOBAL DECISION A1

KTM

(EUR thousands) Polaris Arctic Cat

Current Prior Current Prior Current Prior

Key Figures Year Year Year Year Year Year

Net income . . . . . . . . . . . . . . . . . 20,818 2,660 — — — —

Income taxes . . . . . . . . . . . . . . . . 1,709* (229) — — — —

Interest expense . . . . . . . . . . . . . 9,693 4,256 — — — —

Times interest earned . . . . . . . . . ? ? 87.9 82.5 1,658.4 5.4

* KTM’s income taxes is a “positive” for the current year, which is not normal and occurs because of tax loss carryforwards that are explained in advanced courses.

Required

1. Compute the times interest earned ratio for the most recent two years for KTM using the data shown. 2. Which company of the three presented provides the best coverage of interest expense? Explain.

2. Compute the company’s times interest earned under the expansion assumptions in part 1. 3. Assume sales at its European location are $400,000. Prepare an income statement (with columns for

current operations, European, and total) for the company and compute times interest earned. 4. Assume sales at its European location are $100,000. Prepare an income statement (with columns for

current operations, European, and total) for the company and compute times interest earned. 5. Comment on your results from parts 1 through 4.

KTM Polaris Arctic Cat

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Learning Objectives

CONCEPTUAL

C1 Explain the types and payment patterns of notes. (p. 432) C2 Appendix 10A—Explain and compute the present value of an amount(s) to be paid at

a future date(s). (p. 440)

C3 Appendix 10C—Describe interest accrual when bond payment periods differ from accounting periods. (p. 444)

C4 Appendix 10D—Describe accounting for leases and pensions. (p. 446) ANALYTICAL

A1 Compare bond financing with stock financing. (p. 422) A2 Assess debt features and their implications. (p. 436) A3 Compute the debt-to-equity ratio and explain its use. (p. 436)

PROCEDURAL

P1 Prepare entries to record bond issuance and interest expense. (p. 424) P2 Compute and record amortization of bond discount using straight-line method. (p. 425) P3 Compute and record amortization of bond premium using straight-line method. (p. 428) P4 Record the retirement of bonds. (p. 431) P5 Prepare entries to account for notes. (p. 434) P6 Appendix 10B—Compute and record amortization of bond discount using

effective interest method. (p. 442)

P7 Appendix 10B—Compute and record amortization of bond premium using effective interest method. (p. 443)

A Look at This Chapter

This chapter describes the accounting for and analysis of bonds and notes. We explain their characteristics, payment patterns, interest computations, retirement, and reporting requirements. An appendix to this chapter introduces leases and pensions.

A Look Back

Chapter 9 focused on how current liabilities are identified, computed, recorded, and reported. Attention was directed at notes, payroll, sales taxes, warranties, employee benefits, and contingencies.

Long-Term Liabilities 10

A Look Ahead

Chapter 11 focuses on corporate equity transactions, including stock issuances and dividends. We also explain how to report and analyze income, earnings per share, and retained earnings.

420

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Hippie Biz

WASHINGTON, DC—“Being a modern hippie is knowing when, where, and how to let both your hippie and modern sides come forth,” declares Kyle Smitley. “The eco-friendly world is full of spontaneity and tree-hugging.” The hippie in her led Kyle to launch barley & birch (barleyandbirch.com), an American-made 100% certified organic clothing line, which pledges to give much of its profits to environmental and social causes. “I started barley & birch to make a difference,” insists Kyle. “I wanted to . . . make every single facet of the line carbon neutral.” Kyle is driven to make her business a success. “As a young entrepreneur with no experience, I was a sitting duck,” admits Kyle. “There were people that either didn’t take me seriously or wanted to take my money.” Launching her fledgling business presented challenges. She especially focused on the important task of managing liabilities to suppliers, shippers, and others in the supply chain. Kyle insists that effective management of liabilities, espe- cially long-term financing from sources such as bonds and notes, is crucial to success. In her case, she launched barley & birch with a loan, or notes payable, from ACCION. “I obtained a $10,000 business loan,” explains Kyle. Interest payments,

principal repayments, and operating expenses had to be controlled. “The best advice I ever received was from my father, an accountant,” says Kyle. “He told me to be realistic about my budget and that it is easy to spend all of your money on lots of little things that have the risk of killing your business.” Kyle continues to monitor liabilities and their payment patterns, and she is not shy about striving to better learn the accounting side. “I am never done working,” says Kyle. “I am al- ways frantically catching up!” She insists that accounting for and monitoring liabilities of long-term financing are important ingredi- ents to a successful start-up. Her company now generates sufficient income to pay for interest and principal on long-term debt and is on target for a goal of $2 million in sales this year. Still, the larger message of barley & birch is about eco- friendly products and carbon neutrality. “Money only makes me excited if I can give it away,” explains Kyle. “The business is only a tool. It is the car, and philanthropy is the engine.”

[Sources: barley & birch Website, January 2013; Modern Hippie Mag, January 2010; Ladies Who Launch, June 2010; YHP Website, November 2009; DePauw University News, March 2011; The Toledo Times, May 2012]

“I really enjoy the concept of being a modern hippie.” —KYLE SMITLEY

Decision Insight

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Chapter Preview

Individuals, companies, and governments issue bonds to finance their activities. In return for financing, bonds promise to repay the lender with interest. This chapter explains the basics of bonds and the accounting for their issuance and retirement. The chapter also describes long-term notes as another financing source. We

explain how present value concepts impact both the accounting for and reporting of bonds and notes. Appendixes to this chapter discuss present value concepts applicable to liabilities, effective interest amortization, and the accounting for leases and pensions.

Long-Term Liabilities

Bond Issuances

• Issuance at par • Issuance at a discount • Issuance at a premium • Bond pricing

Bond Basics

• Bond financing • Bond trading • Issuance procedures

Bond Retirement

• At maturity • Before maturity • By conversion

Long-Term Notes

• Installment notes • Mortgage terms

This section explains the basics of bonds and a company’s motivation for issuing them.

Bond Financing Projects that demand large amounts of money often are funded from bond issuances. (Both for-profit and nonprofit companies, as well as governmental units, such as nations, states, cit- ies, and school districts, issue bonds.) A bond is its issuer’s written promise to pay an amount identified as the par value of the bond with interest. The par value of a bond, also called the face amount or face value, is paid at a specified future date known as the bond’s maturity date. Most bonds also require the issuer to make semiannual interest payments. The amount of inter- est paid each period is determined by multiplying the par value of the bond by the bond’s contract rate of interest for that same period. This section explains both advantages and disad- vantages of bond financing.

Advantages of Bonds There are three main advantages of bond financing:

1. Bonds do not affect owner control. Equity financing reflects ownership in a company, whereas bond financing does not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of all owner decisions. A person who owns a $1,000, 11%, 20-year bond has no ownership right. This person, or bond- holder, is to receive from the bond issuer 11% interest, or $110, each year the bond is outstanding and $1,000 when it matures in 20 years.

2. Interest on bonds is tax deductible. Bond interest payments are tax deductible for the issuer, but equity payments (distributions) to owners are not. To illustrate, assume that a corporation with no bond financing earns $15,000 in income before paying taxes at a 40% tax rate, which amounts to $6,000 ($15,000 3 40%) in taxes. If a portion of its financing is in bonds, however, the resulting bond interest is deducted in computing taxable income. That is, if bond interest expense is $10,000, the taxes owed would be $2,000 ([$15,000 2 $10,000] 3 40%), which is less than the $6,000 owed with no bond financing.

3. Bonds can increase return on equity. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverage or trading on the equity.

To illustrate the third point, consider Magnum Co., which has $1 million in equity and is plan- ning a $500,000 expansion to meet increasing demand for its product. Magnum predicts the

BASICS OF BONDS

A1 Compare bond financing with stock financing.

Point: Financial leverage reflects issu- ance of bonds, notes, or preferred stock.

422

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Chapter 10 Long-Term Liabilities 423

Quotes The IBM bond quote here is interpreted (left to right) as Bonds, issuer name; Rate, contract interest rate (5.7%); Mat, matures in year 2017 when principal is paid; Yld, yield rate (4.7%) of bond at current price; Vol, daily dollar worth ($130,000) of trades (in 1,000s); Close, closing price (121.18) for the day as percentage of par value; Chg, change (10.24%) in closing price from prior day’s close. ■

Decision Insight

$500,000 expansion will yield $125,000 in additional income before paying any interest. It cur- rently earns $100,000 per year and has no interest expense. Magnum is considering three plans. Plan A is to not expand. Plan B is to expand and raise $500,000 from equity financing. Plan C is to expand and issue $500,000 of bonds that pay 10% annual interest ($50,000). Exhibit 10.1 shows how these three plans affect Magnum’s net income, equity, and return on equity (net income/equity). The owner(s) will earn a higher return on equity if expansion occurs. Moreover, the preferred expansion plan is to issue bonds. Projected net income under Plan C ($175,000) is smaller than under Plan B ($225,000), but the return on equity is larger because of less equity investment. Plan C has another advantage if income is taxable. This illustration reflects a gen- eral rule: Return on equity increases when the expected rate of return from the new assets is higher than the rate of interest expense on the debt financing.

EXHIBIT 10.1 Financing with Bonds versus Equity

Plan A: Plan B: Plan C:

Do Not Equity Bond

Expand Financing Financing

Income before interest expense . . . . . . . . $ 100,000 $ 225,000 $ 225,000

Interest expense . . . . . . . . . . . . . . . . . . . . . — — (50,000)

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 100,000 $ 225,000 $ 175,000

Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000 $1,500,000 $1,000,000

Return on equity . . . . . . . . . . . . . . . . . . 10.0% 15.0% 17.5%

Example: Compute return on equity for all three plans if Magnum currently earns $150,000 instead of $100,000. Answer ($ 000s): Plan A 5 15% ($150y$1,000) Plan B 5 18.3% ($275y$1,500) Plan C 5 22.5% ($225y$1,000)

Point: Debt financing is desirable when interest is tax deductible, when owner control is preferred, and when return on equity exceeds the debt’s interest rate.

Point: The phrase: debt is cheaper than equity, refers in part to interest expense on bonds being tax deductible whereas dividends on stock are not.

Disadvantages of Bonds The two main disadvantages of bond financing are these:

1. Bonds can decrease return on equity. When a company earns a lower return with the bor- rowed funds than it pays in interest, it decreases its return on equity. This downside risk of financial leverage is more likely to arise when a company has periods of low income or net losses.

2. Bonds require payment of both periodic interest and the par value at maturity. Bond pay- ments can be especially burdensome when income and cash flow are low. Equity financ- ing, in contrast, does not require any payments because cash withdrawals (dividends) are paid at the discretion of the owner (or board).

A company must weigh the risks and returns of the disadvantages and advantages of bond financing when deciding whether to issue bonds to finance operations.

Bond Trading Bonds are securities that can be readily bought and sold. A large number of bonds trade on both the New York Exchange and the American Exchange. A bond issue consists of a number of bonds, usually in denominations of $1,000 or $5,000, and is sold to many different lenders. After bonds are issued, they often are bought and sold by investors, meaning that any particular bond probably has a number of owners before it matures. Since bonds are exchanged (bought and sold) in the market, they have a market value (price). For convenience, bond market values are expressed as a percent of their par (face) value. For example, a company’s bonds might be trading at 1031⁄2, meaning they can be bought or sold for 103.5% of their par value. Bonds can also trade below par value. For instance, if a company’s bonds are trading at 95, they can be bought or sold at 95% of their par value.

Bonds Rate Mat Yld Vol Close Chg

IBM 5.7 17 4.7 130 121.18 10.24%

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424 Chapter 10 Long-Term Liabilities

Bond-Issuing Procedures State and federal laws govern bond issuances. Bond issuers also want to ensure that they do not violate any of their existing contractual agreements when issuing bonds. Authorization of bond issuances includes the number of bonds authorized, their par value, and the contract interest rate. The legal document identifying the rights and obligations of both the bond holders and the

issuer is called the bond indenture, which is the legal con tract between the issuer and the bondholders (and specifies how often interest is paid). A bondholder may also receive a bond certificate as evidence of the compa- ny’s debt. A bond certificate, such as that shown in Exhibit 10.2, includes specifics such as the issuer’s name, the par value, the contract interest rate, and the maturity date. Many companies reduce costs by not issuing paper certificates to bondholders.1

EXHIBIT 10.2 Bond Certificate

Point: Indenture refers to a bond’s legal contract; debenture refers to an unsecured bond.

1 The issuing company normally sells its bonds to an investment firm called an underwriter, which resells them to the public. An issuing company can also sell bonds directly to investors. When an underwriter sells bonds to a large num- ber of investors, a trustee represents and protects the bondholders’ interests. The trustee monitors the issuer to ensure that it complies with the obligations in the bond indenture. Most trustees are large banks or trust companies. The trustee writes and accepts the terms of a bond indenture before it is issued. When bonds are offered to the public, called floating an issue, they must be registered with the Securities and Exchange Commission (SEC). SEC registration re- quires the issuer to file certain financial information. Most company bonds are issued in par value units of $1,000 or $5,000. A baby bond has a par value of less than $1,000, such as $100.

Point: The spread between the dealer’s cost and what buyers pay can be huge. Dealers earn more than $25 billion in annual spread revenue.

Global: In the United Kingdom, government bonds are called gilts— short for gilt-edged investments.

2013

Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Sold bonds at par.

Assets 5 Liabilities 1 Equity 1800,000 1800,000

2013

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Paid semiannual interest (9% 3 $800,000 3 1⁄2 year).

Assets 5 Liabilities 1 Equity 236,000 236,000

This entry reflects increases in the issuer’s cash and long-term liabilities. The issuer records the first semiannual interest payment as follows.

P1 Prepare entries to record bond issuance and interest expense.

This section explains accounting for bond issuances at par, below par (discount), and above par (premium). It also describes how to amortize a discount or premium and record bonds issued between interest payment dates.

Issuing Bonds at Par To illustrate an issuance of bonds at par value, suppose a company receives authorization to issue $800,000 of 9%, 20-year bonds dated January 1, 2013, that mature on December 31, 2032, and pay interest semiannually on each June 30 and December 31. After accepting the bond indenture on behalf of the bondholders, the trustee can sell all or a portion of the bonds to an underwriter. If all bonds are sold at par value, the issuer records the sale as follows.

BOND ISSUANCES

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Chapter 10 Long-Term Liabilities 425

The issuer pays and records its semiannual interest obligation every six months until the bonds mature. When they mature, the issuer records its payment of principal as follows.

2032

Dec. 31 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Paid bond principal at maturity.

Assets 5 Liabilities 1 Equity 2800,000 2800,000

Bond Discount or Premium The bond issuer pays the interest rate specified in the indenture, the contract rate, also referred to as the coupon rate, stated rate, or nominal rate. The annual interest paid is determined by multiplying the bond par value by the contract rate. The contract rate is usually stated on an an- nual basis, even if interest is paid semiannually. For example, if a company issues a $1,000, 8% bond paying interest semiannually, it pays annual interest of $80 (8% 3 $1,000) in two semian- nual payments of $40 each. The contract rate sets the amount of interest the issuer pays in cash, which is not necessarily the bond interest expense actually incurred by the issuer. Bond interest expense depends on the bond’s market value at issuance, which is determined by market expectations of the risk of lending to the issuer. The bond’s market rate of interest is the rate that borrowers are willing to pay and lenders are willing to accept for a particular bond and its risk level. As the risk level increases, the rate increases to compensate purchasers for the bonds’ increased risk. Also, the market rate is generally higher when the time period until the bond matures is longer due to the risk of adverse events oc- curring over a longer time period. Many bond issuers try to set a contract rate of interest equal to the market rate they expect as of the bond issuance date. When the contract rate and market rate are equal, a bond sells at par value, but when they are not equal, a bond does not sell at par value. Instead, it is sold at a pre- mium above par value or at a discount below par value. Exhibit 10.3 shows the relation between the contract rate, market rate, and a bond’s issue price.

Issuing Bonds at a Discount A discount on bonds payable occurs when a company issues bonds with a contract rate less than the market rate. This means that the issue price is less than par value. To illustrate, assume that Fila announces an offer to issue bonds with a $100,000 par value, an 8% annual contract rate (paid semiannually), and a two-year life. Also assume that the market rate for Fila bonds is

EXHIBIT 10.3 Relation between Bond Issue Price, Contract Rate, and Market Rate

Bond Sets Market Sets Bond Price Determined

Contract rate > Market rate Bond sells at premium

Contract rate = Market rate Bond sells at par

Contract rate < Market rate Bond sells at discount

Contract rate Market rate

1. A company issues $10,000 of 9%, 5-year bonds dated January 1, 2013, that mature on December 31, 2017, and pay interest semiannually on each June 30 and December 31. Prepare the entry to record this bond issuance and the first semiannual interest payment.

2. How do you compute the amount of interest a bond issuer pays in cash each year? 3. When the contract rate is above the market rate, do bonds sell at a premium or a discount?

Do purchasers pay more or less than the par value of the bonds?

Quick Check Answers — p. 449

P2 Compute and record amortization of bond discount.

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426 Chapter 10 Long-Term Liabilities

10%. These bonds then will sell at a discount since the contract rate is less than the market rate. The exact issue price for these bonds is stated as 96.454 (implying 96.454% of par value, or $96,454); we show how to compute this issue price later in the chapter. These bonds obligate the issuer to pay two separate types of future cash flows:

1. Par value of $100,000 cash at the end of the bonds’ two-year life. 2. Cash interest payments of $4,000 (4% 3 $100,000) at the end of each semiannual period

during the bonds’ two-year life.

The exact pattern of cash flows for the Fila bonds is shown in Exhibit 10.4.

Point: The difference between the con- tract rate and the market rate of interest on a new bond issue is usually a fraction of a percent. We use a difference of 2% to emphasize the effects.

EXHIBIT 10.4 Cash Flows for Fila Bonds

$100,000

$4,000 $4,000 $4,000 $4,000

o o o o o

0 6 mo. 12 mo. 18 mo. 24 mo.

Dec. 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,454

Discount on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . 3,546

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Sold bonds at a discount on their issue date.

Assets 5 Liabilities 1 Equity 196,454 1100,000

23,546

When Fila accepts $96,454 cash for its bonds on the issue date of December 31, 2013, it records the sale as follows.

Point: Book value at issuance always equals the issuer’s cash borrowed.

These bonds are reported in the long-term liability section of the issuer’s December 31, 2013, bal- ance sheet as shown in Exhibit 10.5. A discount is deducted from the par value of bonds to yield the carrying (book) value of bonds. Discount on Bonds Payable is a contra liability account.

Amortizing a Bond Discount Fila receives $96,454 for its bonds; in return it must pay bondholders $100,000 after two years (plus semiannual interest payments). The $3,546 discount is paid to bondholders at maturity and is part of the cost of using the $96,454 for two years. The upper portion of panel A in Exhibit 10.6 shows that total bond interest expense of $19,546 is the difference between the total amount repaid to bondholders ($116,000) and the amount borrowed from bondholders ($96,454). Alternatively, we can compute total bond interest expense as the sum of the four interest payments and the bond discount. This alternative computation is shown in the lower portion of panel A. The total $19,546 bond interest expense must be allocated across the four semiannual periods in the bonds’ life, and the bonds’ carrying value must be updated at each balance sheet date. This is accomplished using the straight-line method (or the effective interest method in Appen- dix 10B). Both methods systematically reduce the bond discount to zero over the two-year life. This process is called amortizing a bond discount.

Point: Zero-coupon bonds do not pay periodic interest (contract rate is zero). These bonds always sell at a discount because their 0% contract rate is always below the market rate.

EXHIBIT 10.5 Balance Sheet Presentation of Bond Discount

Long-term liabilities

Bonds payable, 8%, due December 31, 2015 . . . . . . . . . $100,000

Less discount on bonds payable . . . . . . . . . . . . . . . 3,546 $96,454 carrying (book) value

The following section on discount amortization uses the straight-line method. Appendix 10B uses the effective interest method. An instructor can choose to cover either one or both methods. If the straight-line method is skipped, then read Appendix 10B and return to the section (on page 428) titled “Issuing Bonds at a Premium.”

Straight-Line Method The straight-line bond amortization method allocates an equal portion of the total bond interest expense to each interest period. To apply the straight-line method to Fila’s bonds, we divide the total bond interest expense of $19,546 by 4 (the number of semian nual periods in the bonds’ life). This gives a bond interest expense of $4,887 per period, which is $4,886.5 rounded to the nearest dollar per period (all computations, including those for assignments, are rounded to the nearest whole dollar). Alternatively, we can find this

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Chapter 10 Long-Term Liabilities 427

EXHIBIT 10.6 Interest Computation and Entry for Bonds Issued at a Discount

number by first dividing the $3,546 discount by 4, which yields the $887 amount of discount to be amortized each interest period. When the $887 is added to the $4,000 cash payment, the bond interest expense for each period is $4,887. Panel B of Exhibit 10.6 shows how the issuer records bond interest expense and updates the balance of the bond liability account at the end of each of the four semiannual interest periods (June 30, 2014, through December 31, 2015). Exhibit 10.7 shows the pattern of decreases in the Discount on Bonds Payable account and the pattern of increases in the bonds’ carrying value. The following points summarize the discount bonds’ straight-line amortization:

1. At issuance, the $100,000 par value consists of the $96,454 cash received by the issuer plus the $3,546 discount.

2. During the bonds’ life, the (unam- ortized) discount decreases each period by the $887 amortization ($3,546y4), and the carrying value (par value less unamortized dis- count) increases each period by $887.

3. At maturity, the unamortized discount equals zero, and the carrying value equals the $100,000 par value that the issuer pays the holder.

We see that the issuer incurs a $4,887 bond interest expense each period but pays only $4,000 cash. The $887 unpaid portion of this expense is added to the bonds’ carrying value. (The total $3,546 unamortized discount is “paid” when the bonds mature; $100,000 is paid at maturity but only $96,454 was received at issuance.)

EXHIBIT 10.7 Straight-Line Amortization of Bond Discount

Semiannual Unamortized Carrying

Period-End Discount* Value†

(0) 12/31/2013 . . . . . . . . $3,546 $ 96,454

(1) 6/30/2014 . . . . . . . . 2,659 97,341

(2) 12/31/2014 . . . . . . . . 1,772 98,228

(3) 6/30/2015 . . . . . . . . 885 99,115

(4) 12/31/2015 . . . . . . . . 0‡ 100,000

* Total bond discount (of $3,546) less accumulated periodic amortization ($887 per semiannual interest period).

† Bond par value (of $100,000) less unamortized discount. ‡ Adjusted for rounding.

The two columns always sum to par value for a discount bond.

Panel A: Interest Computations

Amount repaid to bondholders

Four interest payments of $4,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 16,000

Par value at maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Total repaid to bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116,000

Less amount borrowed from bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (96,454)

Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,546

Alternative Computation

Four payments of $4,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 16,000

Plus discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,546

Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,546

Bond interest expense (per interest period)

5 Total bond interest expense

Number of interest periods 5

$19,546 4

5 $4,887

Panel B: Entry to Record Interest Payment and Amortization

2014 – 2015

June 30 and Bond Interest Expense . . . . . . . . . . . . . . . . . . 4,887

Dec. 31 Discount on Bonds Payable . . . . . . . . . . . 887

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

To record semiannual interest and discount amortization (straight-line method).

Discount 4 periods

Par value 3 contract rate

Equal

Ratings Game Many bond buyers rely on rating services to assess bond risk. The best known are Standard & Poor’s, Moody’s, and Fitch. These services focus on the issuer’s financial statements and other factors in setting rat- ings. Standard & Poor’s ratings, from best quality to default, are AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Ratings can include a plus (1) or minus (2) to show relative standing within a category. Bonds rated in the A and B range are re- ferred to as investment grade; lower-rated bonds are considered much riskier. ■

Decision Insight

$96,000

$100,000

$104,000 Carrying value

12 /3

1/ 20

13

6/ 30

/2 01

4

12 /3

1/ 20

14

6/ 30

/2 01

5

12 /3

1/ 20

15

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428 Chapter 10 Long-Term Liabilities

Five-year, 6% bonds with a $100,000 par value are issued at a price of $91,893. Interest is paid semiannually, and the bonds’ market rate is 8% on the issue date. Use this information to answer the following questions:

4. Are these bonds issued at a discount or a premium? Explain your answer. 5. What is the issuer’s journal entry to record the issuance of these bonds? 6. What is the amount of bond interest expense recorded at the first semiannual period using

the straight-line method?

Quick Check Answers — p. 449

P3 Compute and record amortization of bond premium.

Issuing Bonds at a Premium When the contract rate of bonds is higher than the market rate, the bonds sell at a price higher than par value. The amount by which the bond price exceeds par value is the premium on bonds. To illustrate, assume that Adidas issues bonds with a $100,000 par value, a 12% annual contract rate, semiannual interest payments, and a two-year life. Also assume that the market rate for Adidas bonds is 10% on the issue date. The Adidas bonds will sell at a premium because the contract rate is higher than the market rate. The issue price for these bonds is stated as 103.546 (implying 103.546% of par value, or $103,546); we show how to compute this issue price later in the chapter. These bonds obligate the issuer to pay out two separate future cash flows:

1. Par value of $100,000 cash at the end of the bonds’ two-year life. 2. Cash interest payments of $6,000 (6% 3 $100,000) at the end of each semiannual period

during the bonds’ two-year life.

The exact pattern of cash flows for the Adidas bonds is shown in Exhibit 10.8.

EXHIBIT 10.8 Cash Flows for Adidas Bonds

$100,000

$6,000 $6,000 $6,000 $6,000

o o o o o

0 6 mo. 12 mo. 18 mo. 24 mo.

Dec. 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,546

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . 3,546

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Sold bonds at a premium on their issue date.

Assets 5 Liabilities 1 Equity 1103,546 1100,000

13,546

When Adidas accepts $103,546 cash for its bonds on the issue date of December 31, 2013, it records this transaction as follows.

These bonds are reported in the long-term liability section of the issuer’s December 31, 2013, bal- ance sheet as shown in Exhibit 10.9. A premium is added to par value to yield the carrying (book) value of bonds. Premium on Bonds Payable is an adjunct (also called accretion) liability account.

Amortizing a Bond Premium Adidas receives $103,546 for its bonds; in return, it pays bondholders $100,000 after two years (plus semiannual interest payments). The $3,546 premium not repaid to issuer’s bondholders at maturity goes to reduce the issuer’s expense of using the $103,546 for two years. The upper portion of panel A of Exhibit 10.10 shows that total bond inter- est expense of $20,454 is the difference between the total amount repaid to bondholders ($124,000) and the amount borrowed from bondholders ($103,546). Alternatively, we can compute total bond

EXHIBIT 10.9 Balance Sheet Presentation of Bond Premium

Long-term liabilities

Bonds payable, 12%, due December 31, 2015 . . . . . . . . . $100,000

Plus premium on bonds payable . . . . . . . . . . . . . . . . 3,546 $103,546

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Chapter 10 Long-Term Liabilities 429

Straight-Line Method The straight-line method allocates an equal portion of total bond interest expense to each of the bonds’ semiannual interest periods. To apply this method to Adidas bonds, we divide the two years’ total bond interest expense of $20,454 by 4 (the number of semiannual periods in the bonds’ life). This gives a total bond inter- est expense of $5,113 per period, which is $5,113.5 rounded down so that the journal entry balances and for simplicity in presentation (alternatively, one could carry cents). Panel B of Exhibit 10.10 shows how the issuer records bond inter- est expense and updates the balance of the bond liability account for each semi- annual period (June 30, 2014, through December 31, 2015). Exhibit 10.11 shows the pattern of decreases in the unamortized Premium on Bonds Pay- able account and in the bonds’ carrying value. The following points summarize straight-line amortization of the premium bonds:

1. At issuance, the $100,000 par value plus the $3,546 premium equals the $103,546 cash received by the issuer.

2. During the bonds’ life, the (unamortized) premium decreases each period by the $887 amortization ($3,546y4), and the carrying value decreases each period by the same $887.

EXHIBIT 10.10 Interest Computation and Entry for Bonds Issued at a Premium

Panel A: Interest Computations

Amount repaid to bondholders

Four interest payments of $6,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 24,000

Par value at maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Total repaid to bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,000

Less amount borrowed from bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (103,546)

Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,454

Alternative Computation

Four payments of $6,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 24,000

Less premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,546)

Total bond interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,454

Bond interest expense (per interest period)

5 Total bond interest expense

Number of interest periods 5

$20,454 4

5 $5,113

Panel B: Entry to Record Interest Payment and Amortization

2014 – 2015

June 30 and Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . 5,113

Dec. 31 Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . 887

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

To record semiannual interest and premium amortization (straight-line method ).

Premium 4 periods

Par value 3 contract rate

Equal

Point: A premium decreases Bond Interest Expense; a discount increases it.

interest expense as the sum of the four interest payments less the bond premium. The premium is subtracted because it will not be paid to bondholders when the bonds mature; see the lower portion of panel A. Total bond interest expense must be allocated over the four semiannual periods using the straight-line method (or the effective interest method in Appendix 10B).

Point: The phrase: ability to service debt, refers to making interest and principal payments on time.

EXHIBIT 10.11 Straight-Line Amortization of Bond Premium

Semiannual Unamortized Carrying

Period-End Premium* Value†

(0) 12/31/2013 . . . . . . . . $3,546 $103,546

(1) 6/30/2014 . . . . . . . . 2,659 102,659

(2) 12/31/2014 . . . . . . . . 1,772 101,772

(3) 6/30/2015 . . . . . . . . 885 100,885

(4) 12/31/2015 . . . . . . . . 0‡ 100,000

* Total bond premium (of $3,546) less accumulated periodic amortization ($887 per semiannual interest period).

† Bond par value (of $100,000) plus unamortized premium. ‡ Adjusted for rounding.

During the bond life, carrying value is adjusted to par and the amortized premium to zero.

The following section on premium amortization uses the straight-line method. Appendix 10B uses the effective interest method. An instructor can choose to cover either one or both methods. If the straight-line method is skipped, then read Appendix 10B and return to the section (next page) titled “Bond Pricing.”

$96,000

$100,000

$104,000

12 /3

1/ 20

13

6/ 30

/2 01

4

12 /3

1/ 20

14

6/ 30

/2 01

5

12 /3

1/ 20

15

Carrying value

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430 Chapter 10 Long-Term Liabilities

Bond Pricing Prices for bonds traded on an organized exchange are often published in newspapers and through online services. This information normally includes the bond price (called quote), its contract rate, and its current market (called yield) rate. However, only a fraction of bonds are traded on organized exchanges. To compute the price of a bond, we apply present value concepts. This section explains how to use present value concepts to price the Fila discount bond and the Adidas premium bond described earlier.

Present Value of a Discount Bond The issue price of bonds is found by computing the present value of the bonds’ cash payments, discounted at the bonds’ market rate. When comput- ing the present value of the Fila bonds, we work with semiannual compounding periods because this is the time between interest payments; the annual market rate of 10% is considered a semian- nual rate of 5%. Also, the two-year bond life is viewed as four semiannual periods. The price computation is twofold: (1) Find the present value of the $100,000 par value paid at maturity and (2) find the present value of the series of four semiannual payments of $4,000 each; see Exhibit 10.4. These present values can be found by using present value tables. Appendix B at the end of this book shows present value tables and describes their use. Table B.1 at the end of Appendix B is used for the single $100,000 maturity payment, and Table B.3 in Appendix B is used for the $4,000 series of interest payments. Specifically, we go to Table B.1, row 4, and across to the 5% column to identify the present value factor of 0.8227 for the maturity payment. Next, we go to Table B.3, row 4, and across to the 5% column, where the present value factor is 3.5460 for the series of interest payments. We compute bond price by multiplying the cash flow payments by their corresponding present value factors and adding them together; see Exhibit 10.12.

Point: InvestingInBonds.com is a bond research and learning source.

Point: A bond’s market value (price) at issuance equals the present value of its future cash payments, where the interest (discount) rate used is the bond’s market rate.

Point: Many calculators have present value functions for computing bond prices.

Point: Calculator inputs defined: N Number of semiannual periods I/Yr Market rate per semiannual period FV Future (maturity) value PMT Payment (interest) per semiannual

period PV Price (present value)

EXHIBIT 10.12 Computing Issue Price for the Fila Discount Bonds

Present Value Present

Cash Flow Table Factor Amount Value

$100,000 par (maturity) value . . . . . . . . . B.1 0.8227 3 $100,000 5 $ 82,270

$4,000 interest payments . . . . . . . . . . . . . B.3 3.5460 3 4,000 5 14,184

Price of bond . . . . . . . . . . . . . . . . . . . . . $96,454

Present Value of a Premium Bond We find the issue price of the Adidas bonds by using the market rate to compute the present value of the bonds’ future cash flows. When computing the present value of these bonds, we again work with semiannual compounding periods because this is the time between interest payments. The annual 10% market rate is applied as a semiannual rate of 5%, and the two-year bond life is viewed as four semiannual periods. The computation is twofold: (1) Find the present value of the $100,000 par value paid at maturity and (2) find the present value of the series of four payments of $6,000 each; see Exhibit 10.8. These present values can be found by using present value tables. First, go to Table B.1, row 4, and across to the 5% column where the present value factor is 0.8227 for the maturity payment. Second, go to Table B.3, row 4, and across to the 5% column, where the present value factor is 3.5460 for the series of interest payments. The bonds’ price is computed by multiplying the cash flow payments by their corresponding present value factors and adding them together; see Exhibit 10.13.

Point: There are nearly 5 million individual U.S. bond issues, ranging from huge treasuries to tiny municipalities. This compares to about 12,000 individual U.S. stocks that are traded.

EXHIBIT 10.13 Computing Issue Price for the Adidas Premium Bonds

Present Value Present

Cash Flow Table Factor Amount Value

$100,000 par (maturity) value . . . . . . . . . B.1 0.8227 3 $100,000 5 $ 82,270

$6,000 interest payments . . . . . . . . . . . . B.3 3.5460 3 6,000 5 21,276

Price of bond . . . . . . . . . . . . . . . . . . . . $103,546

The next section describes bond pricing. An instructor can choose to cover bond pricing or not. Assignments requiring the next section are Quick Study 10-4 and Exercises 10-9 and 10-10.

3. At maturity, the unamortized premium equals zero, and the carrying value equals the $100,000 par value that the issuer pays the holder.

DC

CC

Calculator

N 5 4 I/Yr 5 5

PMT 5 6,000 FV 5 100,000

PV 5 103,546

Calculator

N 5 4 I/Yr 5 5

PMT 5 4,000 FV 5 100,000

PV 5 96,454

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Chapter 10 Long-Term Liabilities 431

On December 31, 2012, a company issues 16%, 10-year bonds with a par value of $100,000. Inter- est is paid on June 30 and December 31. The bonds are sold to yield a 14% annual market rate at an issue price of $110,592. Use this information to answer questions 7 through 9:

7. Are these bonds issued at a discount or a premium? Explain your answer. 8. Using the straight-line method to allocate bond interest expense, the issuer records the

second interest payment (on December 31, 2013) with a debit to Premium on Bonds Payable in the amount of (a) $7,470, (b) $530, (c) $8,000, or (d ) $400.

9. How are these bonds reported in the long-term liability section of the issuer’s balance sheet as of December 31, 2013?

Quick Check Answers — p. 449

P4 Record the retirement of bonds. This section describes the retirement of bonds (1) at maturity, (2) before maturity, and (3) by conversion to stock.

Bond Retirement at Maturity The carrying value of bonds at maturity always equals par value. For example, both Exhibits 10.7 (a discount) and 10.11 (a premium) show that the carrying value of bonds at the end of their lives equals par value ($100,000). The retirement of these bonds at maturity, assuming interest is already paid and entered, is recorded as follows:

BOND RETIREMENT

2015

Dec. 31 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

To record retirement of bonds at maturity.

Assets 5 Liabilities 1 Equity 2100,000 2100,000

Bond Retirement before Maturity Issuers sometimes wish to retire some or all of their bonds prior to maturity. For instance, if inter- est rates decline greatly, an issuer may wish to replace high-interest-paying bonds with new low- interest bonds. Two common ways to retire bonds before maturity are to (1) exercise a call option or (2) purchase them on the open market. In the first instance, an issuer can reserve the right to retire bonds early by issuing callable bonds. The bond indenture can give the issuer an option to call the bonds before they mature by paying the par value plus a call premium to bondholders. In the second case, the issuer retires bonds by repurchasing them on the open market at their current price. Whether bonds are called or repurchased, the issuer is unlikely to pay a price that exactly equals their carrying value. When a difference exists between the bonds’ carrying value and the amount paid, the issuer records a gain or loss equal to the difference. To illustrate the accounting for retiring callable bonds, assume that a company issued callable bonds with a par value of $100,000. The call option requires the issuer to pay a call premium of $3,000 to bondholders in addition to the par value. Next, assume that after the June 30, 2013, interest payment, the bonds have a carrying value of $104,500. Then on July 1, 2013, the issuer calls these bonds and pays $103,000 to bondholders. The issuer recognizes a $1,500 gain from

Point: Bond retirement is also referred to as bond redemption.

Point: Gains and losses from retiring bonds were previously reported as extraordinary items. New standards require that they now be judged by the “unusual and infrequent” criteria for reporting purposes.

Unreported Liabilities Drove U.S. Financial Crisis? Many argue that unreported liabilities were a major cause of the financial crisis. They assert that “off-balance-sheet accounting” encouraged bad loans, securitizations, and derivatives that drove much of the crisis. It is argued that balance sheets failed to report many of these liabilities. For example, because bank liabilities used to finance assets were not transparent, the markets failed to penalize banks that used derivatives and variable interest entities (VIEs) to take exces- sive risks. Arguably, such accounting is fraudulent. ■

Decision Insight

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432 Chapter 10 Long-Term Liabilities

Jan. 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Paid-In Capital in Excess of Par Value . . . . . . . . . . . 70,000

To record retirement of bonds by conversion.

Assets 5 Liabilities 1 Equity 2100,000 130,000 170,000

An issuer usually must call all bonds when it exercises a call option. However, to retire as many or as few bonds as it desires, an issuer can purchase them on the open market. If it retires less than the entire class of bonds, it recognizes a gain or loss for the difference between the carrying value of those bonds retired and the amount paid to acquire them.

Bond Retirement by Conversion Holders of convertible bonds have the right to convert their bonds to stock. When conversion oc- curs, the bonds’ carrying value is transferred to equity accounts and no gain or loss is recorded. (We further describe convertible bonds in the Decision Analysis section of this chapter.) To illustrate, assume that on January 1 the $100,000 par value bonds of Converse, with a carrying value of $100,000, are converted to 15,000 shares of $2 par value common stock. The entry to record this conversion follows (the market prices of the bonds and stock are not relevant to this entry; the material in Chapter 11 is helpful in understanding this transaction):Convertible Bond

10. Six years ago, a company issued $500,000 of 6%, eight-year bonds at a price of 95. The current carrying value is $493,750. The company decides to retire 50% of these bonds by buying them on the open market at a price of 1021⁄2. What is the amount of gain or loss on the retirement of these bonds?

Quick Check Answer — p. 449

C1 Explain the types and payment patterns of notes. Like bonds, notes are issued to obtain assets such as cash. Unlike bonds, notes are typically transacted with a single lender such as a bank. An issuer initially records a note at its selling price—that is, the note’s face value minus any discount or plus any premium. Over the note’s life, the amount of interest expense allocated to each period is computed by multiplying the market rate (at issuance of the note) by the beginning-of-period note balance. The note’s carry- ing (book) value at any time equals its face value minus any unamortized discount or plus any unamortized premium; carrying value is also computed as the present value of all remaining payments, discounted using the market rate at issuance.

LONG-TERM NOTES PAYABLE

the difference between the bonds’ carrying value of $104,500 and the retirement price of $103,000. The issuer records this bond retirement as follows.

July 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 4,500

Gain on Bond Retirement . . . . . . . . . . . . . . . . . . . . 1,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,000

To record retirement of bonds before maturity.

Assets 5 Liabilities 1 Equity 2103,000 2100,000 11,500

24,500

D 20%D

20%

CC 17%

CC 15%

CC 18%

Junk Bonds Junk bonds are company bonds with low credit ratings due to a higher than average likelihood of default. On the upside, the high risk of junk bonds can yield high returns if the issuer sur vives and repays its debt. ■

Decision Insight

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Chapter 10 Long-Term Liabilities 433

Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Borrowed $60,000 by signing an 8%, six-year installment note.

Assets 5 Liabilities 1 Equity 160,000 160,000

EXHIBIT 10.14 Installment Note: Equal Total Payments

Payments

(A) (B) (C) (D) (E) Period Debit Debit Credit Ending Beginning

Balance Interest Notes Ending

Date Expense 1 Payable 5 Cash Balance 8% 3 (A) (D) 2 (B) (computed) (A) 2 (C)

(1) 12/31/2013 . . . . . . . $60,000 $51,821

(2) 12/31/2014 . . . . . . . . 51,821 42,988

(3) 12/31/2015 . . . . . . . . 42,988 33,448

(4) 12/31/2016 . . . . . . . . 33,448 23,145

(5) 12/31/2017 . . . . . . . . 23,145 12,018

(6) 12/31/2018 . . . . . . . . 12,018 0

$17,874 $60,000 $77,874

2016

2015

2017

2018

2013

2014

0 $2,500 $5,000 $7,500 $12,500$10,000 $15,000

Equal Total

Payments

Decreasing Accrued Interest

Increasing Principal

Component

E n

d o

f Y e a r

$8,179$4,800

$8,833$4,146

$9,540$3,439

$10,303$2,676

$11,127$1,852

$12,018$961

Cash Payment Pattern

Interest Principal

$ 4,800 $ 8,179 $12,979

4,146 8,833 12,979

3,439 9,540 12,979

2,676 10,303 12,979

1,852 11,127 12,979

961 12,018 12,979

Payments on an installment note normally include the accrued interest expense plus a portion of the amount borrowed (the principal). This section describes an installment note with equal payments. The equal total payments pattern consists of changing amounts of both interest and principal. To illustrate, assume that Foghog borrows $60,000 by signing a $60,000 note that requires six equal payments of $12,979 at the end of each year. (The present value of an annuity of six annual payments of $12,979, discounted at 8%, equals $60,000; we show this computation in footnote 2 on the next page.) The $12,979 includes both interest and principal, the amounts of which change with each payment. Exhibit 10.14 shows the pattern of equal total payments and its two parts, interest and principal. Column A shows the note’s beginning balance. Column B shows accrued

Point: Most consumer notes are installment notes that require equal total payments.

Years 2013 2014 2015 2016 2017 2018

$ 1

2 ,9

7 9

$ 1

2 ,9

7 9

$ 1

2 ,9

7 9

$ 1

2 ,9

7 9

$ 1

2 ,9

7 9

$ 1

2 ,9

7 9

Installment Notes An installment note is an obligation requiring a series of payments to the lender. Installment notes are common for franchises and other businesses when lenders and borrowers agree to spread payments over several periods. To illustrate, assume that Foghog borrows $60,000 from a bank to purchase equipment. It signs an 8% installment note requiring six annual payments of principal plus interest and it records the note’s issuance at January 1, 2013, as follows.

Point: Banks sometimes reject loans when risk of default by borrowers is high. Then, bonds can serve as another way borrowers can finance operations or expansion.

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434 Chapter 10 Long-Term Liabilities

interest for each year at 8% of the beginning note balance. Column C shows the impact on the note’s principal, which equals the difference between the total payment in column D and the in- terest expense in column B. Column E shows the note’s year-end balance. Although the six cash payments are equal, accrued interest decreases each year because the principal balance of the note declines. As the amount of interest decreases each year, the portion of each payment applied to principal increases. This pattern is graphed in the lower part of Exhibit 10.14. Foghog uses the amounts in Exhibit 10.14 to record its first two payments (for years 2013 and 2014) as follows:

P5 Prepare entries to account for notes.

Foghog records similar entries but with different amounts for each of the remaining four payments. After six years, the Notes Payable account balance is zero.2

2013

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,179

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,979

To record first installment payment.

Assets 5 Liabilities 1 Equity 212,979 28,179 24,800

2014

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,146

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,833

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,979

To record second installment payment.

Assets 5 Liabilities 1 Equity 212,979 28,833 24,146

2 Table B.3 in Appendix B is used to compute the dollar amount of the six payments that equal the initial note balance of $60,000 at 8% interest. We go to Table B.3, row 6, and across to the 8% column, where the present value factor is 4.6229. The dollar amount is then computed by solving this relation:

Table Present Value Factor Dollar Amount Present Value B.3 4.6229 3 ? 5 $60,000

The dollar amount is computed by dividing $60,000 by 4.6229, yielding $12,979.

Example: Suppose the $60,000 installment loan has an 8% interest rate with eight equal annual payments. What is the annual payment? Answer (using Table B.3): $60,000y5.7466 5 $10,441

Point: The Truth-in-Lending Act requires lenders to provide information about loan costs including finance charges and interest rate.

Global: Countries vary in the prefer- ence given to debtholders vs. stockhold- ers when a company is in financial distress. Some countries such as Germany, France, and Japan give prefer- ence to stockholders over debtholders.

Mortgage Notes and Bonds A mortgage is a legal agreement that helps protect a lender if a borrower fails to make required payments on notes or bonds. A mortgage gives the lender a right to be paid from the cash pro- ceeds of the sale of a borrower’s assets identified in the mortgage. A legal document, called a mortgage contract, describes the mortgage terms.

Mortgage notes carry a mortgage contract pledging title to specific assets as security for the note. Mortgage notes are especially popular in the purchase of homes and the acquisition of plant assets. Less common mortgage bonds are backed by the issuer’s assets. Accounting for mort- gage notes and bonds is similar to that for unsecured notes and bonds, except that the mortgage agreement must be disclosed. For example, TIBCO Software reports that its “mortgage note pay- able . . . is collateralized by the commercial real property acquired [corporate headquarters].”

Missing Debt A study reports that 13% of employees in finance and accounting witnessed the falsifying or manipulating of accounting information in the past year (KPMG 2009). This includes nondisclosure of special concern with long-term liabilities. Another study reports that most people committing fraud (36%) work in the finance function of their firm (KPMG 2011). For example, Enron violated GAAP to keep debt off its balance sheet. ■

Decision Insight

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Chapter 10 Long-Term Liabilities 435

11. Which of the following is true for an installment note requiring a series of equal total cash payments? (a) Payments consist of increasing interest and decreasing principal; (b) payments consist of changing amounts of principal but constant interest; or (c) payments consist of decreasing interest and increasing principal.

12. How is the interest portion of an installment note payment computed? 13. When a borrower records an interest payment on an installment note, how are the balance

sheet and income statement affected?

Quick Check Answers — p. 449

This section discusses similarities and differences between U.S. GAAP and IFRS in accounting and reporting for long-term liabilities such as bonds and notes.

Accounting for Bonds and Notes The definitions and characteristics of bonds and notes are broadly similar for both U.S. GAAP and IFRS. Although slight differences exist, accounting for bonds and notes under U.S. GAAP and IFRS is similar. Specifically, the accounting for issuances (including recording discounts and premiums), market pricing, and retirement of both bonds and notes follows the procedures in this chapter. Nokia describes its accounting for bonds, which follows the amortized cost approach explained in this chapter (and in Appendix 10B), as follows: Loans payable [bonds] are recog- nized initially at fair value, net of transaction costs incurred. In the subsequent periods, they are stated at amortized cost. Both U.S. GAAP and IFRS allow companies to account for bonds and notes using fair value (different from the amortized value described in this chapter). This method is referred to as the fair value option. This method is similar to that applied in measuring and accounting for debt and equity securities. Fair value is the amount a company would receive if it settled a liability (or sold an asset) in an orderly transac- tion as of the balance sheet date. Companies can use several sources of inputs to determine fair value, and those inputs fall into three classes (ranked in order of preference):

Level 1: Observable quoted market prices in active markets for identical items. Level 2: Observable inputs other than those in Level 1 such as prices from inactive markets or from simi-

lar, but not identical, items. Level 3: Unobservable inputs reflecting a company’s assumptions about value.

The procedures for marking liabilities to fair value at each balance sheet date are in advanced courses.

Accounting for Leases and Pensions Both U.S. GAAP and IFRS require companies to dis- tinguish between operating leases and capital leases; the latter is referred to as finance leases under IFRS. The accounting and reporting for leases are broadly similar for both U.S. GAAP and IFRS. The main dif- ference is the criteria for identifying a lease as a capital lease are more general under IFRS. However, the basic approach applies. For pensions, both U.S. GAAP and IFRS require companies to record costs of retirement benefits as employees work and earn them. The basic methods are similar in accounting and reporting for pensions.

GLOBAL VIEW

Point: Lease accounting is expected to change over the next year or so.

Entrepreneur You are a furniture retailer planning a Super Bowl sale on a home theater seating that re- quires no payments for two years. At the end of two years, buyers must pay the full amount. The system’s suggested retail price is $4,100, but you are willing to sell it today for $3,000 cash. What is your sale price if payment will not occur for two years and the market interest rate is 10%? ■ [Answer—p. 449]

Decision Maker

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436 Chapter 10 Long-Term Liabilities

Debt Features and the Debt-to-Equity RatioDecision Analysis

A2 Assess debt features and their implications.

Collateral agreements can reduce the risk of loss for both bonds and notes. Unsecured bonds and notes are riskier because the issuer’s obligation to pay interest and principal has the same priority as all other unse- cured liabilities in the event of bankruptcy. If a company is unable to pay its debts in full, the unsecured creditors (including the holders of debentures) lose all or a portion of their balances. These types of legal agreements and other characteristics of long-term liabilities are crucial for effective business decisions. The first part of this section describes the different types of features sometimes included with bonds and notes. The second part explains and applies the debt-to-equity ratio.

Features of Bonds and Notes This section describes common features of debt securities.

Secured or Unsecured Secured bonds (and notes) have specific as- sets of the issuer pledged (or mortgaged) as collateral. This arrangement gives holders added protection against the issuer’s default. If the issuer fails to pay interest or par value, the secured holders can demand that the collateral be sold and the proceeds used to pay the obligation. Unsecured bonds (and notes), also called debentures, are backed by the issuer’s general credit standing. Unsecured debt is riskier than secured debt. Subordinated debentures are liabilities that are

not repaid until the claims of the more senior, unsecured (and secured) liabilities are settled.

Term or Serial Term bonds (and notes) are scheduled for maturity on one specified date. Serial bonds (and notes) mature at more than one date (often in series) and thus are usually repaid over a number of periods. For instance, $100,000 of serial bonds might mature at the rate of $10,000 each year from 6 to 15 years after they are issued. Many bonds are sinking fund bonds, which to reduce the holder’s risk require the issuer to create a sinking fund of assets set aside at specified amounts and dates to repay the bonds.

Registered or Bearer Bonds issued in the names and addresses of their holders are registered bonds. The issuer makes bond payments by sending checks (or cash transfers) to registered holders. A reg- istered holder must notify the issuer of any ownership change. Registered bonds offer the issuer the practical advantage of not having to actually issue bond certificates. Bonds payable to whoever holds them (the bearer) are called bearer bonds or unregistered bonds. Sales or exchanges might not be recorded, so the holder of a bearer bond is presumed to be its rightful owner. As a result, lost bearer bonds are difficult to replace. Many bearer bonds are also coupon bonds. This term reflects interest coupons that are attached to the bonds. When each coupon matures, the holder presents it to a bank or broker for collection. At maturity, the holder follows the same process and pre sents the bond certificate for collection. Issuers of coupon bonds cannot deduct the related interest expense for taxable income. This is to prevent abuse by taxpayers who own coupon bonds but fail to report interest income on their tax returns.

Convertible and/or Callable Convertible bonds (and notes) can be exchanged for a fixed number of shares of the issuing corporation’s common stock. Convertible debt offers holders the potential to participate in future increases in stock price. Holders still receive periodic interest while the debt is held and the par value if they hold the debt to ma- turity. In most cases, the holders decide whether and when to convert debt to stock. Callable bonds (and notes) have an option exercisable by the issuer to retire them at a stated dollar amount before maturity.

Secured Debt Unsecured Debt

Convertible Debt Callable Debt

Debt-to-Equity Ratio Beyond assessing different characteristics of debt as just described, we want to know the level of debt, especially in relation to total equity. Such knowledge helps us assess the risk of a company’s financing

A3 Compute the debt-to-equity ratio and explain its use.

Point: More than a million municipal bonds, or “munis,” exist, and many are tax exempt. Munis are issued by state, city, town, and county governments to pay for public projects including schools, libraries, roads, bridges, and stadiums.

Collateral Lenders prefer that more liquid assets serve as collateral for loans. These usually are current assets such as accounts receivable or inventory. The reason is if borrowers default and collateral must be seized, then lenders desire assets that are easily sold to recover losses. ■

Decision Insight

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Chapter 10 Long-Term Liabilities 437

structure. A company financed mainly with debt is more risky because liabilities must be repaid— usually with periodic interest—whereas equity financing does not. A measure to assess the risk of a company’s financing structure is the debt-to-equity ratio (see Exhibit 10.15).

EXHIBIT 10.15 Debt-to-Equity RatioDebt-to-equity 5

Total liabilities Total equity

The debt-to-equity ratio varies across companies and industries. Industries that are more variable and less stable tend to have lower ratios, while more stable industries tend to have higher ratios. To apply the debt- to-equity ratio, let’s look at this measure for Cedar Fair in Exhibit 10.16.

Cedar Fair’s 2011 debt-to-equity ratio is 12.1, meaning that debtholders contributed $12.10 for each $1 contributed by equityholders. This implies a fairly risky financing structure for Cedar Fair. A similar concern is drawn from a comparison of Cedar Fair with its competitors, where the 2011 industry ratio is 8.5. Analysis across the years shows that Cedar Fair’s financing structure has grown to a risky level in recent years. Given its sluggish revenues and increasing operating expenses in recent years (see its annual report), Cedar Fair is increasingly at risk of financial distress. 0.0 20102011

2.0

4.0

6.0

8.0

10.0

16.0

18.0

20.0

12.0

14.0

2009 2008 2007

IndustryDebt-to-Equity Ratio: Six FlagsIndustryDebt-to-Equity Ratio: Six FlagsIndustryDebt-to-Equity Ratio: Six FlagsDebt-to-Equity Ratio: Industry Cedar Fair

EXHIBIT 10.16 Cedar Fair’s Debt-to-Equity Ratio

($ millions) 2011 2010 2009 2008 2007

Total liabilities . . . . . . . . . . . . . . . . $1,915,837 $1,945,308 $2,017.577 $2,079.297 $2,133.576

Total equity . . . . . . . . . . . . . . . . . . $ 158.720 $ 137.136 $ 127.862 $ 106.786 $ 285.092

Debt-to-equity . . . . . . . . . . . . . . 12.1 14.2 15.8 19.5 7.5

Industry debt-to-equity . . . . . . . . 8.5 9.3 11.4 10.3 5.7

Water Sports Company (WSC) patented and successfully test-marketed a new product. To expand its abil- ity to produce and market the new product, WSC needs to raise $800,000 of financing. On January 1, 2013, the company obtained the money in two ways:

a. WSC signed a $400,000, 10% installment note to be repaid with five equal annual installments to be made on December 31 of 2013 through 2017.

b. WSC issued five-year bonds with a par value of $400,000. The bonds have a 12% annual contract rate and pay interest on June 30 and December 31. The bonds’ annual market rate is 10% as of January 1, 2013.

Required

1. For the installment note, (a) compute the size of each annual payment, (b) prepare an amortization table such as Exhibit 10.14, and (c) prepare the journal entry for the first payment.

2. For the bonds, (a) compute their issue price; (b) prepare the January 1, 2013, journal entry to record their issuance; (c) prepare an amortization table using the straight-line method; (d) prepare the June 30, 2013, journal entry to record the first interest payment; and (e) prepare a journal entry to record retiring the bonds at a $416,000 call price on January 1, 2015.

3.B Redo parts 2(c), 2(d), and 2(e) assuming the bonds are amortized using the effective interest method.

DEMONSTRATION PROBLEM

Bond Investor You plan to purchase debenture bonds from one of two companies in the same industry that are similar in size and performance. The first company has $350,000 in total liabilities, and $1,750,000 in equity. The second company has $1,200,000 in total liabilities, and $1,000,000 in equity. Which company’s debenture bonds are less risky based on the debt-to-equity ratio? ■ [Answer—p. 449]

Decision Maker

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438 Chapter 10 Long-Term Liabilities

PLANNING THE SOLUTION ● For the installment note, divide the borrowed amount by the annuity factor (from Table B.3) using

the 10% rate and five payments to compute the amount of each payment. Prepare a table similar to Exhibit 10.14 and use the numbers in the table’s first line for the journal entry.

● Compute the bonds’ issue price by using the market rate to find the present value of their cash flows (use tables found in Appendix B). Then use this result to record the bonds’ issuance. Next, prepare an amortization table like Exhibit 10.11 (and Exhibit 10B.2) and use it to get the numbers needed for the journal entry. Also use the table to find the carrying value as of the date of the bonds’ retirement that you need for the journal entry.

SOLUTION TO DEMONSTRATION PROBLEM Part 1: Installment Note

a. Annual payment 5 Note balanceyAnnuity factor 5 $400,000y3.7908 5 $105,519 (The annuity factor is for five payments and a rate of 10%.)

b. An amortization table follows.

c. Journal entry for December 31, 2013, payment.

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,519

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,519

To record first installment payment.

Part 2: Bonds (Straight-Line Amortization)

a. Compute the bonds’ issue price.

Present Value Present Cash Flow Table Factor* Amount Value

Par (maturity) value . . . . . . . . B.1 in App. B (PV of 1) 0.6139 3 400,000 5 $245,560

Interest payments . . . . . . . . . . B.3 in App. B (PV of annuity) 7.7217 3 24,000 5 185,321

Price of bond . . . . . . . . . . . . . . $430,881

* Present value factors are for 10 payments using a semiannual market rate of 5%.

b. Journal entry for January 1, 2013, issuance.

Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430,881

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . 30,881

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Sold bonds at a premium.

(1) 12/31/2013 (2) 12/31/2014 (3) 12/31/2015 (4) 12/31/2016 (5) 12/31/2017

$ 40,000 33,448 26,241 18,313 9,593

$127,595

$105,519 105,519 105,519 105,519 105,519

$527,595

$334,481 262,410 183,132

95,926 0

Annual Period Ending

Payments

$400,000 334,481 262,410 183,132

95,926

(a)

Beginning Balance

(b) Debit

Interest Expense

$ 65,519 72,071 79,278 87,206 95,926

$400,000

(c) Debit Notes

Payable

(d) Credit

Cash

(e)

Ending Balance

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Chapter 10 Long-Term Liabilities 439

c. Straight-line amortization table for premium bonds.

Semiannual Unamortized Carrying

Period-End Premium Value

(0) 1/1/2013 . . . . . . . . $30,881 $430,881

(1) 6/30/2013 . . . . . . . . 27,793 427,793

(2) 12/31/2013 . . . . . . . . 24,705 424,705

(3) 6/30/2014 . . . . . . . . 21,617 421,617

(4) 12/31/2014 . . . . . . . . 18,529 418,529

(5) 6/30/2015 . . . . . . . . 15,441 415,441

(6) 12/31/2015 . . . . . . . . 12,353 412,353

(7) 6/30/2016 . . . . . . . . 9,265 409,265

(8) 12/31/2016 . . . . . . . . 6,177 406,177

(9) 6/30/2017 . . . . . . . . 3,089 403,089

(10) 12/31/2017 . . . . . . . . 0* 400,000

* Adjusted for rounding.

d. Journal entry for June 30, 2013, bond payment.

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 20,912

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 3,088

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Paid semiannual interest on bonds.

e. Journal entry for January 1, 2015, bond retirement.

Jan. 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . 18,529

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416,000

Gain on Retirement of Bonds . . . . . . . . . . . . . . . . 2,529

To record bond retirement (carrying value as of Dec. 31, 2014).

Part 3: Bonds (Effective Interest Amortization)B

c. The effective interest amortization table for premium bonds.

* Adjusted for rounding

(0) 1/1/2013 (1) 6/30/2013 (2) 12/31/2013 (3) 6/30/2014 (4) 12/31/2014 (5) 6/30/2015 (6) 12/31/2015

(7) 6/30/2016 (8) 12/31/2016 (9) 6/30/2017

(10) 12/31/2017

$30,881 28,425 25,846 23,138 20,295 17,310 14,176 10,885 7,429 3,800

0

$430,881 428,425 425,846 423,138 420,295 417,310 414,176 410,885 407,429 403,800 400,000

$ 24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000

$240,000

$ 21,544 21,421 21,292 21,157 21,015 20,866 20,709 20,544 20,371 20,200*

$209,119

$ 2,456 2,579 2,708 2,843 2,985 3,134 3,291 3,456 3,629 3,800

$30,881

(A) Cash

Interest Paid 6% 3 $400,000

(B) Interest Expense

5% 3 Prior (E)

(C) Premium

Amortization (A) 2 (B)

(D) Unamortized

Premium Prior (D) 2 (C)

(E) Carrying

Value $400,000 1 (D)

Semiannual Interest Period

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440 Chapter 10 Long-Term Liabilities

d. Journal entry for June 30, 2013, bond payment.

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 21,544

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 2,456

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Paid semiannual interest on bonds.

Jan. 1 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 20,295

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416,000

Gain on Retirement of Bonds . . . . . . . . . . . . . . . . . 4,295

To record bond retirement (carrying value as of December 31, 2014).

e. Journal entry for January 1, 2015, bond retirement.

APPENDIX

Present Values of Bonds and Notes This appendix explains how to apply present value techniques to measure a long-term liability when it is created and to assign interest expense to the periods until it is settled. Appendix B at the end of the book provides additional discussion of present value concepts.

Present Value Concepts The basic present value concept is that cash paid (or received) in the future has less value now than the same amount of cash paid (or received) today. To illustrate, if we must pay $1 one year from now, its present value is less than $1. To see this, assume that we borrow $0.9259 today that must be paid back in one year with 8% interest. Our interest expense for this loan is computed

as $0.9259 3 8%, or $0.0741. When the $0.0741 interest is added to the $0.9259 borrowed, we get the $1 payment necessary to repay our loan with in- terest. This is formally computed in Exhibit 10A.1. The $0.9259 borrowed is the present value of the $1 future payment. More generally, an amount bor- rowed equals the present value of the future pay-

ment. (This same interpretation applies to an investment. If $0.9259 is invested at 8%, it yields $0.0741 in revenue after one year. This amounts to $1, made up of principal and interest.) To extend this example, assume that we owe $1 two years from now instead of one year, and the 8% interest is compounded annually. Compounded means that interest during the second period is based on the total of the amount borrowed plus the interest accrued from the first period. The second period’s interest is then computed as 8% multiplied by the sum of the amount borrowed plus interest earned in the first period. Exhibit 10A.2 shows how we compute the present value of $1 to be paid in two years. This amount is $0.8573. The first year’s interest of $0.0686 is added to the principal so that the second year’s interest is based on $0.9259. Total interest for this two-year period is $0.1427, computed as $0.0686 plus $0.0741.

10A

C2 Explain and compute the present value of an amount(s) to be paid at a future date(s).

EXHIBIT 10A.1 Components of a One-Year Loan

Amount borrowed . . . . . . . . . . . . . $0.9259

Interest for one year at 8% . . . . . . . . . 0.0741

Amount owed after 1 year . . . . . . . . . $ 1.0000

Point: Benjamin Franklin is said to have described compounding as “the money, money makes, makes more money.”

EXHIBIT 10A.2 Components of a Two-Year Loan

Amount borrowed . . . . . . . . . . . . . . . . . . . . . . . . $0.8573

Interest for first year ($0.8573 3 8%) . . . . . . . . . . . 0.0686

Amount owed after 1 year . . . . . . . . . . . . . . . . . . . . 0.9259

Interest for second year ($0.9259 3 8%) . . . . . . . . . 0.0741

Amount owed after 2 years . . . . . . . . . . . . . . . . . . . $ 1.0000

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Chapter 10 Long-Term Liabilities 441

Present Value Tables The present value of $1 that we must repay at some future date can be computed by using this formula: 1y(1 1 i)n. The symbol i is the interest rate per period and n is the number of periods until the future payment must be made. Applying this formula to our two-year loan, we get $1y(1.08)2, or $0.8573. This is the same value shown in Exhibit 10A.2. We can use this formula to find any present value. However, a simpler method is to use a present value table, which lists pres- ent values computed with this formula for various interest rates and time periods. Many people find it helpful in learning present value concepts to first work with the table and then move to using a calculator. Exhibit 10A.3 shows a present value table for a future payment of 1 for up to 10 periods at three different interest rates. Present values in this table are rounded to four decimal places. This table is drawn from the larger and more complete Table B.1 in Appendix B at the end of the book. Notice that the first value in the 8% column is 0.9259, the value we computed earlier for the present value of a $1 loan for one year at 8% (see Exhibit 10A.1). Go to the second row in the same 8% column and find the present value of 1 discounted at 8% for two years, or 0.8573. This $0.8573 is the present value of our obligation to repay $1 after two periods at 8% interest (see Exhibit 10A.2).

Applying a Present Value Table To il- lustrate how to measure a liability using a present value table, assume that a company plans to bor- row cash and repay it as follows: $2,000 after one year, $3,000 after two years, and $5,000 after three years. How much does this company receive today if the interest rate on this loan is 10%? To answer, we need to compute the present value of the three future payments, discounted at 10%. This computation is shown in Exhibit 10A.4 us- ing present values from Exhibit 10A.3. The company can borrow $8,054 today at 10% interest in exchange for its promise to make these three payments at the scheduled dates.

Present Value of an Annuity The $8,054 present value for the loan in Exhibit 10A.4 equals the sum of the present values of the three payments. When payments are not equal, their combined present value is best computed by adding the individual present values as shown in Exhibit 10A.4. Sometimes payments follow an annuity, which is a series of equal payments at equal time intervals. The present value of an annuity is readily computed. To illustrate, assume that a company must repay a 6% loan with a $5,000 payment at each year-end for the next four years. This loan amount equals the present value of the four payments discounted at 6%. Exhibit 10A.5 shows how to compute this loan’s present value of $17,326 by multiplying each pay- ment by its matching present value factor taken from Exhibit 10A.3. However, the series of $5,000 payments is an annuity, so we can compute its present value with either of two shortcuts. First, the third column of Exhibit 10A.5 shows that the sum of the present values of 1 at 6% for periods 1 through 4 equals 3.4651. One shortcut is to multiply this total of 3.4651 by the $5,000 annual payment to get the combined present value of $17,326. It requires one multiplication instead of four.

Example: Use Exhibit 10A.3 to find the present value of $1 discounted for 2 years at 6%. Answer: $0.8900

EXHIBIT 10A.3 Present Value of 1

Rate

Periods 6% 8% 10%

1 0.9434 0.9259 0.9091

2 0.8900 0.8573 0.8264

3 0.8396 0.7938 0.7513

4 0.7921 0.7350 0.6830

5 0.7473 0.6806 0.6209

6 0.7050 0.6302 0.5645

7 0.6651 0.5835 0.5132

8 0.6274 0.5403 0.4665

9 0.5919 0.5002 0.4241

10 0.5584 0.4632 0.3855

EXHIBIT 10A.5 Present Value of a Series of Equal Payments (Annuity) by Discounting Each Payment

Present Present

Value of Value of

Periods Payments 1 at 6% Payments

1 $5,000 0.9434 $ 4,717

2 5,000 0.8900 4,450

3 5,000 0.8396 4,198

4 5,000 0.7921 3,961

Present value of all payments . . . . . . . 3.4651 $17,326

EXHIBIT 10A.4 Present Value of a Series of Unequal Payments

Present Present

Value of Value of

Periods Payments 1 at 10% Payments

1 $2,000 0.9091 $ 1,818

2 3,000 0.8264 2,479

3 5,000 0.7513 3,757

Present value of all payments . . . . . . . $8,054

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442 Chapter 10 Long-Term Liabilities

The second shortcut uses an annuity table such as the one shown in Exhibit 10A.6, which is drawn from the more complete Table B.3 in Appendix B. We go directly to the annuity table to get the present value factor for a specific number of payments and interest rate. We then multiply this factor by the amount of the payment to find the present value of the annuity. Specifically, find the row for four peri- ods and go across to the 6% column, where the fac- tor is 3.4651. This factor equals the present value of an annuity with four payments of 1, discounted at 6%. We then multiply 3.4651 by $5,000 to get the $17,326 present value of the annuity.

Compounding Periods Shorter Than a Year The present value examples all involved

periods of one year. In many situations, however, interest is compounded over shorter periods. For exam- ple, the interest rate on bonds is usually stated as an annual rate but interest is often paid every six months (semiannually). This means that the present value of interest payments from such bonds must be com- puted using interest periods of six months. Assume that a borrower wants to know the present value of a series of 10 semiannual payments of $4,000 made over five years at an annual interest rate of 12%. The interest rate is stated as an annual rate of 12%, but it is actually a rate of 6% per semiannual interest period. To compute the present value of this series of $4,000 payments, go to row 10 of Exhibit 10A.6 and across to the 6% column to find the factor 7.3601. The present value of this annuity is $29,440 (7.3601 3 $4,000). Appendix B further describes present value concepts and includes more complete present value tables and assignments.

Example: If this borrower makes five semiannual payments of $8,000, what is the present value of this annuity at a 12% rate? Answer: 4.2124 3 $8,000 5 $33,699

14. A company enters into an agreement to make four annual year-end payments of $1,000 each, starting one year from now. The annual interest rate is 8%. The present value of these four payments is (a) $2,923, (b) $2,940, or (c) $3,312.

15. Suppose a company has an option to pay either (a) $10,000 after one year or (b) $5,000 after six months and another $5,000 after one year. Which choice has the lower present value?

Quick Check Answers — p. 449

APPENDIX

Effective Interest Amortization Effective Interest Amortization of a Discount Bond The straight-line method yields changes in the bonds’ carrying value while the amount for bond interest expense remains constant. This gives the impression of a changing interest rate when users divide a constant bond interest expense over a changing carrying value. As a result, accounting standards allow use of the straight-line method only when its results do not differ materially from those obtained using the effective interest method. The effective interest method, or simply interest method, allocates total bond interest expense over the bonds’ life in a way that yields a constant rate of interest. This constant rate of interest is the market rate at the issue date. Thus, bond interest expense for a period equals the carrying value of the bond at the beginning of that period multiplied by the market rate when issued. Exhibit 10B.1 shows an effective interest amortization table for the Fila bonds (as described in Exhibit 10.4). The key difference between the effective interest and straight-line methods lies in com- puting bond interest expense. Instead of assigning an equal amount of bond interest expense to each

10B

Point: The effective interest method computes bond interest expense using the market rate at issuance. This rate is applied to a changing carrying value.

EXHIBIT 10A.6 Present Value of an Annuity of 1

Rate

Periods 6% 8% 10%

1 0.9434 0.9259 0.9091

2 1.8334 1.7833 1.7355

3 2.6730 2.5771 2.4869

4 3.4651 3.3121 3.1699

5 4.2124 3.9927 3.7908

6 4.9173 4.6229 4.3553

7 5.5824 5.2064 4.8684

8 6.2098 5.7466 5.3349

9 6.8017 6.2469 5.7590

10 7.3601 6.7101 6.1446

Example: Use Exhibit 10A.6 to find the present value of an annuity of eight $15,000 payments with an 8% interest rate. Answer: $15,000 3 5.7466 5 $86,199

P6 Appendix 10B—Compute and record amortization of bond discount using effective interest method.

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Chapter 10 Long-Term Liabilities 443

period, the effective interest method assigns a bond interest expense amount that increases over the life of a discount bond. Both methods allocate the same $19,546 of total bond interest expense to the bonds’ life, but in different patterns. Specifically, the amortization table in Exhibit 10B.1 shows that the balance of the discount (column D) is amortized until it reaches zero. Also, the bonds’ carrying value (column E) changes each period until it equals par value at maturity. Compare columns D and E to the corresponding columns in Exhibit 10.7 to see the amortization patterns. Total bond interest expense is $19,546, consisting of $16,000 of semiannual cash payments and $3,546 of the original bond discount, the same for both methods.

EXHIBIT 10B.1 Effective Interest Amortization of Bond DiscountBonds: $100,000 Par Value, Semiannual Interest Payments, Two-Year Life,

4% Semiannual Contract Rate, 5% Semiannual Market Rate

$4,000 4,000 4,000 4,000

$16,000

(A) Cash

Interest Paid

$4,823 4,864 4,907 4,952

$19,546

(B) Bond

Interest Expense

$ 823 864 907 952

$3,546

(C)

Discount Amortization

2,723 $3,546

1,859 952

0

(D)

Unamortized Discount

Semiannual Interest

Period-End

12/31/2013 6/30/2014 12/31/2014 6/30/2015

12/31/2015

(0) (1) (2) (3) (4)

97,277 $ 96,454

98,141 99,048

100,000

(E)

Carrying Value

Column (A) is the par value ($100,000) multiplied by the semiannual contract rate (4%). Column (B) is the prior period’s carrying value multiplied by the semiannual market rate (5%). Column (C) is the difference between interest paid and bond interest expense, or [(B) 2 (A)]. Column (D) is the prior period’s unamortized discount less the current period’s discount amortization. Column (E) is the par value less unamortized discount, or [$100,000 2 (D)].

2014

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 4,823

Discount on Bonds Payable . . . . . . . . . . . . . . . . . . 823

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

To record semiannual interest and discount amortization (effective interest method).

Assets 5 Liabilities 1 Equity 24,000 1823 24,823

Effective Interest Amortization of a Premium Bond Exhibit 10B.2 shows the amortiza- tion table using the effective interest method for the Adidas bonds (as described in Exhibit 10.8). Column A lists the semiannual cash payments. Column B shows the amount of bond interest expense, computed as the 5% semiannual market rate at issuance multiplied by the beginning-of-period carrying value. The amount of cash paid in column A is larger than the bond interest expense because the cash payment is based on the higher 6% semiannual contract rate. The excess cash payment over the interest expense reduces the principal. These amounts are shown in column C. Column E shows the carrying value after

Except for differences in amounts, journal entries recording the expense and updating the liability bal- ance are the same under the effective interest method and the straight-line method. We can use the num- bers in Exhibit 10B.1 to record each semiannual entry during the bonds’ two-year life (June 30, 2014, through December 31, 2015). For instance, we record the interest payment at the end of the first semian- nual period as follows:

P7 Appendix 10B—Compute and record amortization of bond premium using effective interest method.

$96,000

$100,000

$104,000 Carrying value

12 /3

1/ 20

13

6/ 30

/2 01

4

12 /3

1/ 20

14

6/ 30

/2 01

5

12 /3

1/ 20

15

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444 Chapter 10 Long-Term Liabilities

deducting the amortized premium in column C from the prior period’s carrying value. Column D shows the premium’s reduction by periodic amortization. When the issuer makes the first semiannual interest payment, the effect of premium amortization on bond interest expense and bond liability is recorded as follows:

2014

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 5,177

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . 823

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

To record semiannual interest and premium amortization (effective interest method).

Assets 5 Liabilities 1 Equity 26,000 2823 25,177

Similar entries with different amounts are recorded at each payment date until the bond matures at the end of 2015. The effective interest method yields decreasing amounts of bond interest expense and increasing amounts of premium amortization over the bonds’ life.

EXHIBIT 10B.2 Effective Interest Amortization of Bond Premium

Semiannual Interest

Period-End

(4)

12/31/2013 6/30/2014 12/31/2014 6/30/2015

12/31/2015

(0) (1) (2) (3)

$6,000 6,000 6,000 6,000

$24,000

(A) Cash

Interest Paid

$5,177 5,136 5,093 5,048

$20,454

(B) Bond

Interest Expense

$ 823 864 907 952

$3,546

(C)

Premium Amortization

2,723 $3,546

1,859 952

0

(D)

Unamortized Premium

102,723 $103,546

101,859 100,952

100,000

(E)

Carrying Value

Bonds: $100,000 Par Value, Semiannual Interest Payments, Two-Year Life, 6% Semiannual Contract Rate, 5% Semiannual Market Rate

Column (A) is the par value ($100,000) multiplied by the semiannual contract rate (6%). Column (B) is the prior period’s carrying value multiplied by the semiannual market rate (5%). Column (C) is the difference between interest paid and bond interest expense, or [(A) 2 (B)]. Column (D) is the prior period’s unamortized premium less the current period’s premium amortization. Column (E) is the par value plus unamortized premium, or [$100,000 1 (D)].

APPENDIX

Issuing Bonds between Interest Dates An issuer can sell bonds at a date other than an interest payment date. When this occurs, the buyers nor- mally pay the issuer the purchase price plus any interest accrued since the prior interest payment date. This accrued interest is then repaid to these buyers on the next interest payment date. To illustrate, suppose Avia sells $100,000 of its 9% bonds at par on March 1, 2013, 60 days after the stated issue date. The inter- est on Avia bonds is payable semiannually on each June 30 and December 31. Since 60 days have passed, the issuer collects accrued interest from the buyers at the time of issuance. This amount is $1,500 ($100,000 3 9% 3 60⁄360 year). This case is reflected in Exhibit 10C.1.

10C C3 Describe interest accrual when bond payment

periods differ from accounting periods.

IFRS Unlike U.S. GAAP, IFRS requires that interest expense be computed using the effective interest method with no exemptions. ■

$96,000

$100,000

$104,000

12 /3

1/ 20

13

6/ 30

/2 01

4

12 /3

1/ 20

14

6/ 30

/2 01

5

12 /3

1/ 20

15

Carrying value

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Chapter 10 Long-Term Liabilities 445

Avia records the issuance of these bonds on March 1, 2013, as follows:

Mar. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,500

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Sold bonds at par with accrued interest.

Assets 5 Liabilities 1 Equity 1101,500 1100,000

11,500

June 30 Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

Paid semiannual interest on the bonds.

Assets 5 Liabilities 1 Equity 24,500 21,500 23,000

Liabilities for interest payable and bonds payable are recorded in separate accounts. When the June 30, 2013, semiannual interest date arrives, Avia pays the full semiannual interest of $4,500 ($100,000 3 9% 3 1⁄2 year) to the bondholders. This payment includes the four months’ interest of $3,000 earned by the bond- holders from March 1 to June 30 plus the repayment of the 60 days’ accrued interest collected by Avia when the bonds were sold. Avia records this first semiannual interest payment as follows:

Example: How much interest is col- lected from a buyer of $50,000 of Avia bonds sold at par 150 days after the contract issue date? Answer: $1,875 (com- puted as $50,000 3 9% 3 150⁄360 year)

The practice of collecting and then repaying accrued interest with the next interest payment is to simplify the issuer’s administrative efforts. To explain, suppose an issuer sells bonds on 15 or 20 different dates be- tween the stated issue date and the first interest payment date. If the issuer does not collect accrued interest from buyers, it needs to pay different amounts of cash to each of them according to the time that passed after purchasing the bonds. The issuer needs to keep detailed records of buyers and the dates they bought bonds. Issuers avoid this recordkeeping by having each buyer pay accrued interest at purchase. Issuers then pay the full semiannual interest to all buyers, regardless of when they bought bonds.

Accruing Bond Interest Expense If a bond’s interest period does not coincide with the issu- er’s accounting period, an adjusting entry is needed to recognize bond interest expense accrued since the most recent interest payment. To illustrate, assume that the stated issue date for Adidas bonds described in Exhibit 10.10 is September 1, 2013, instead of December 31, 2013, and that the bonds are sold on September 1, 2013. As a result, four months’ interest (and premium amortization) accrue before the end of the 2013 calendar year. Interest for this period equals $3,409, or 4⁄6 of the first six months’ interest of $5,113. Also, the premium amortization is $591, or 4⁄6 of the first six months’ amortization of $887. The sum of the bond interest expense and the amortization is $4,000 ($3,409 1 $591), which equals 4⁄6 of the $6,000 cash payment due on February 28, 2014. Adidas records these effects with an adjusting entry at December 31, 2013.

Point: Computation of accrued bond interest may use months instead of days for simplicity purposes. For example, the accrued interest computation for the Adidas bonds is based on months.

Dec. 31 Bond Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 3,409

Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . 591

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

To record four months’ accrued interest and premium amortization.

Assets 5 Liabilities 1 Equity 2591 23,409 14,000

EXHIBIT 10C.1 Accruing Interest between Interest Payment Dates

Bondholder pays $1,500 to issuer

Issuer pays $4,500 to bondholder

Stated issue date January 1

Date of sale March 1

First interest date June 30

$3,000 earned $1,500 accrued

Similar entries are made on each December 31 throughout the bonds’ two-year life. When the $6,000 cash payment occurs on each February 28 interest payment date, Adidas must recognize bond interest expense and amortization for January and February. It must also eliminate the interest payable liability

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446 Chapter 10 Long-Term Liabilities

created by the December 31 adjusting entry. For example, Adidas records its payment on February 28, 2014, as follows:

The interest payments made each August 31 are recorded as usual because the entire six-month interest period is included within this company’s calendar-year reporting period.

Feb. 28 Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Bond Interest Expense ($5,113 3 2⁄6) . . . . . . . . . . . . . . . 1,704

Premium on Bonds Payable ($887 3 2⁄6) . . . . . . . . . . . . 296

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

To record 2 months’ interest and amortization, and eliminate accrued interest liability.

Assets 5 Liabilities 1 Equity 26,000 24,000 21,704

2296

16. On May 1, a company sells 9% bonds with a $500,000 par value that pay semiannual interest on each January 1 and July 1. The bonds are sold at par plus interest accrued since January 1. The issuer records the first semiannual interest payment on July 1 with (a) a debit to Interest Payable for $15,000, (b) a debit to Bond Interest Expense for $22,500, or (c) a credit to Interest Payable for $7,500.

Quick Check Answer — p. 449

APPENDIX

Leases and Pensions This appendix briefly explains the accounting and analysis for both leases and pensions.

Lease Liabilities A lease is a contractual agreement between a lessor (asset owner) and a lessee (as- set renter or tenant) that grants the lessee the right to use the asset for a period of time in return for cash (rent) payments. Nearly one-fourth of all equipment purchases are financed with leases. The advantages of lease financing include the lack of an immediate large cash payment and the potential to deduct rental payments in computing taxable income. From an accounting perspective, leases can be classified as either operating or capital leases. (Lease accounting will change over the next few years, whereby operating leases are likely to be accounted for similar to capital leases . . . stay tuned!)

Operating Leases Operating leases are short-term (or cancelable) leases in which the lessor retains the risks and rewards of ownership. Examples include most car and apartment rental agreements. The lessee records such lease payments as expenses; the lessor records them as revenue. The lessee does not report the leased item as an asset or a liability (it is the lessor’s asset). To illustrate, if an employee of Amazon leases a car for $300 at an airport while on company business, Amazon (lessee) records this cost as follows:

10D C4 Describe accounting for leases and pensions.

Point: Home Depot reports that its rental expenses from operating leases total more than $900 million.

July 4 Rental Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

To record lease rental payment.

Assets 5 Liabilities 1 Equity 2300 2300

Bond Rater You work for Moody’s rating service and its your job to assist in assigning a rating to a bond that reflects its risk to bondholders. Identify factors you consider in assessing bond risk. Indicate the likely levels (relative to the norm) for the factors you identify for a bond that sells at a discount. ■ [Answer—p. 449]

Decision Maker

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Chapter 10 Long-Term Liabilities 447

3 A capital lease meets any one or more of four criteria: (1) transfers title of leased asset to lessee, (2) contains a bar- gain purchase option, (3) has a lease term that is 75% or more of the leased asset’s useful life, or (4) has a present value of lease payments that is 90% or more of the leased asset’s market value. 4 Most lessees try to keep leased assets and lease liabilities off their balance sheets by failing to meet any one of the four criteria of a capital lease. This is because a lease liability increases a company’s total liabilities, making it more difficult to obtain additional financing. The acquisition of assets without reporting any related liabilities (or other asset outflows) on the balance sheet is called off-balance-sheet financing.

Capital Leases Capital leases are long-term (or noncancelable) leases by which the lessor transfers substantially all risks and rewards of ownership to the lessee.3 Examples include most leases of airplanes and department store buildings. The lessee records the leased item as its own asset along with a lease lia- bility at the start of the lease term; the amount recorded equals the present value of all lease payments. To illustrate, assume that K2 Co. enters into a six-year lease of a building in which it will sell sporting equip- ment. The lease transfers all building ownership risks and rewards to K2 (the present value of its $12,979 annual lease payments is $60,000). K2 records this transaction as follows:

2013

Jan. 1 Leased Asset — Building . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

To record leased asset and lease liability.

Assets 5 Liabilities 1 Equity 160,000 160,000

Point: Home Depot reports “certain locations . . . are leased under capital leases.” The net present value of this Lease Liability is about $400 million.

Dec. 31 Depreciation Expense — Building . . . . . . . . . . . . . . . . . . 10,000

Accumulated Depreciation — Building . . . . . . . . . . . 10,000

To record depreciation on leased asset.

Assets 5 Liabilities 1 Equity 210,000 210,000

K2 reports the leased asset as a plant asset and the lease liability as a long-term liability. The portion of the lease liability expected to be paid in the next year is reported as a current liability.4 At each year-end, K2 records depreciation on the leased asset (assume straight-line depreciation, six-year lease term, and no salvage value) as follows:

2013

Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,179

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,979

To record first annual lease payment.*

Assets 5 Liabilities 1 Equity 212,979 28,179 24,800

Payments

(A) (B) (C) (D) (E) Debit Debit Credit Ending Beginning Interest Balance

Period Balance on Lease 1 Lease 5 Cash of Lease Ending of Lease Liability Liability Lease Liability Date Liability 8% 3 (A) (D) 2 (B) Payment (A) 2 (C)

12/31/2013 . . . . . . . . . $60,000 $ 4,800 $ 8,179 $12,979 $51,821

12/31/2014 . . . . . . . . . 51,821 4,146 8,833 12,979 42,988

12/31/2015 . . . . . . . . . 42,988 3,439 9,540 12,979 33,448

12/31/2016 . . . . . . . . . 33,448 2,676 10,303 12,979 23,145

12/31/2017 . . . . . . . . . 23,145 1,852 11,127 12,979 12,018

12/31/2018 . . . . . . . . . 12,018 961 12,018 12,979 0

$17,874 $60,000 $77,874

* These numbers are computed from a lease payment schedule. For simplicity, we use the same numbers from Exhibit 10.14 for this lease payment schedule — with different headings as follows:

K2 also accrues interest on the lease liability at each year-end. Interest expense is computed by multi- plying the remaining lease liability by the interest rate on the lease. Specifically, K2 records its annual interest expense as part of its annual lease payment ($12,979) as follows (for its first year):

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448 Chapter 10 Long-Term Liabilities

Pension Liabilities A pension plan is a contractual agreement between an employer and its em- ployees for the employer to provide benefits (payments) to employees after they retire. Most employers pay the full cost of the pension, but sometimes employees pay part of the cost. An employer records its payment into a pension plan with a debit to Pension Expense and a credit to Cash. A plan administrator receives payments from the employer, invests them in pension assets, and makes benefit payments to pension recipients (retired employees). Insurance and trust companies often serve as pension plan administrators. Many pensions are known as defined benefit plans that define future benefits; the employer’s contribu- tions vary, depending on assumptions about future pension assets and liabilities. Several disclosures are necessary in this case. Specifically, a pension liability is reported when the accumulated benefit obligation is more than the plan assets, a so-called underfunded plan. The accumulated benefit obligation is the present value of promised future pension payments to retirees. Plan assets refer to the market value of assets the plan administrator holds. A pension asset is reported when the accumulated benefit obligation is less than the plan assets, a so-called overfunded plan. An employer reports pension expense when it re- ceives the benefits from the employees’ services, which is sometimes decades before it pays pension benefits to employees. (Other Postretirement Benefits refer to nonpension benefits such as health care and life insurance benefits. Similar to a pension, costs of these benefits are estimated and liabilities accrued when the employees earn them.)

Point: Fringe benefits are often 40% or more of salaries and wages, and pension benefits make up nearly 15% of fringe benefits.

Point: Two types of pension plans are (1) defined benefit plan — the retirement benefit is defined and the employer estimates the contribution necessary to pay these benefits—and (2) defined contri- bution plan — the pension contribution is defined and the employer and/or em- ployee contributes amounts specified in the pension agreement.

C1 Explain the types and payment patterns of notes. Notes re-paid over a period of time are called installment notes and usu- ally follow one of two payment patterns: (1) decreasing payments of interest plus equal amounts of principal or (2) equal total payments. Mortgage notes also are common.

C2A Explain and compute the present value of an amount(s) to be paid at a future date(s). The basic concept of present value is that an amount of cash to be paid or received in the future is worth less than the same amount of cash to be paid or received today. An- other important present value concept is that interest is compounded, meaning interest is added to the balance and used to determine interest for succeeding periods. An annuity is a series of equal payments oc- curring at equal time intervals. An annuity’s present value can be com- puted using the present value table for an annuity (or a calculator).

C3C Describe interest accrual when bond payment periods differ from accounting periods. Issuers and buyers of debt record the interest accrued when issue dates or accounting periods do not coincide with debt payment dates.

C4D Describe accounting for leases and pensions. A lease is a rental agreement between the lessor and the lessee. When the lessor retains the risks and rewards of asset ownership (an operating lease), the lessee debits Rent Expense and credits Cash for its lease payments. When the lessor substantially transfers the risks and re- wards of asset ownership to the lessee (a capital lease), the lessee capitalizes the leased asset and records a lease liability. Pension agreements can result in either pension assets or pension liabilities.

A1 Compare bond financing with stock financing. Bond financing is used to fund business activities. Advantages of bond financing versus stock include (1) no effect on owner control, (2) tax savings, and (3) increased earnings due to financial leverage. Disadvantages include (1) interest and principal payments and (2) amplification of poor performance.

A2 Assess debt features and their implications. Certain bonds are secured by the issuer’s assets; other bonds, called deben- tures, are unsecured. Serial bonds mature at different points in time;

Summary term bonds mature at one time. Registered bonds have each bond- holder’s name recorded by the issuer; bearer bonds are payable to the holder. Convertible bonds are exchangeable for shares of the issuer’s stock. Callable bonds can be retired by the issuer at a set price. Debt features alter the risk of loss for creditors.

A3 Compute the debt-to-equity ratio and explain its use. Both creditors and equity holders are concerned about the relation between the amount of liabilities and the amount of equity. A compa- ny’s financing structure is at less risk when the debt-to-equity ratio is lower, as liabilities must be paid and usually with periodic interest.

P1 Prepare entries to record bond issuance and interest expense. When bonds are issued at par, Cash is debited and Bonds Payable is credited for the bonds’ par value. At bond interest payment dates (usually semiannual), Bond Interest Expense is deb- ited and Cash credited—the latter for an amount equal to the bond par value multiplied by the bond contract rate.

P2 Compute and record amortization of bond discount using straight-line method. Bonds are issued at a discount when the contract rate is less than the market rate, making the issue (selling) price less than par. When this occurs, the issuer records a credit to Bonds Payable (at par) and debits both Discount on Bonds Payable and Cash. The amount of bond interest expense assigned to each period is computed using the straight-line method.

P3 Compute and record amortization of bond premium using straight-line method. Bonds are issued at a premium when the contract rate is higher than the market rate, making the issue (selling) price greater than par. When this occurs, the issuer records a debit to Cash and credits both Premium on Bonds Payable and Bonds Payable (at par). The amount of bond interest expense as- signed to each period is computed using the straight-line method. The Premium on Bonds Payable is allocated to reduce bond interest expense over the life of the bonds.

P4 Record the retirement of bonds. Bonds are retired at matu-rity with a debit to Bonds Payable and a credit to Cash at par value. The issuer can retire the bonds early by exercising a call

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Chapter 10 Long-Term Liabilities 449

option or purchasing them in the market. Bondholders can also re- tire bonds early by exercising a conversion feature on convertible bonds. The issuer recognizes a gain or loss for the difference be- tween the amount paid and the bond carrying value.

P5 Prepare entries to account for notes. Interest is allocated to each period in a note’s life by multiplying its beginning- period carrying value by its market rate at issuance. If a note is repaid with equal payments, the payment amount is computed by dividing the borrowed amount by the present value of an annuity factor (taken from a present value table) using the market rate and the number of payments.

P6B Compute and record amortization of bond discount using effective interest method. Bonds are issued at a discount

when the contract rate is less than the market rate, making the issue (selling) price less than par. The amount of bond interest expense assigned to each period, including amortization of the discount, is computed using the effective interest method.

P7B Compute and record amortization of bond premium using effective interest method. Bonds are issued at a premium when the contract rate is higher than the market rate, making the issue (selling) price greater than par. The amount of bond interest expense assigned to each period, including amortization of the premium, is computed using the effective interest method.

Entrepreneur This is a “present value” question. The market in- terest rate (10%) and present value ($3,000) are known, but the pay- ment required two years later is unknown. This amount ($3,630) can be computed as $3,000 3 1.10 3 1.10. Thus, the sale price is $3,630 when no payments are received for two years. The $3,630 received two years from today is equivalent to $3,000 cash today.

Bond Investor The debt-to-equity ratio for the first company is 0.2 ($350,000y$1,750,000) and for the second company is 1.2 ($1,200,000y$1,000,000), suggesting that the financing structure of

the second company is more risky than that of the first company. Consequently, as a buyer of unsecured debenture bonds, you prefer the first company (all else equal).

Bond Rater Bonds with longer repayment periods (life) have higher risk. Also, bonds issued by companies in financial difficulties or facing higher than normal uncertainties have higher risk. More- over, companies with higher than normal debt and large fluctuations in earnings are considered of higher risk. Discount bonds are more risky on one or more of these factors.

Guidance Answers to Decision Maker

2. Multiply the bond’s par value by its contract rate of interest. 3. Bonds sell at a premium when the contract rate exceeds the

market rate and the purchasers pay more than their par value. 4. The bonds are issued at a discount, meaning that issue price is

less than par value. A discount occurs because the bond contract rate (6%) is less than the market rate (8%).

5.

6. $3,811 (total bond interest expense of $38,107 divided by 10 periods; or the $3,000 semiannual cash payment plus the $8,107 discount divided by 10 periods).

7. The bonds are issued at a premium, meaning issue price is higher than par value. A premium occurs because the bonds’ contract rate (16%) is higher than the market rate (14%).

8. (b) For each semiannual period: $10,592y20 periods 5 $530 premium amortization.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,893

Discount on Bonds Payable . . . . . . . . . . . . . . . . . . . 8,107

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

1. 9.

10. $9,375 loss, computed as the difference between the repurchase price of $256,250 [50% of ($500,000 3 102.5%)] and the car- rying value of $246,875 (50% of $493,750).

11. (c) 12. The interest portion of an installment payment equals the peri-

od’s beginning loan balance multiplied by the market interest rate at the time of the note’s issuance.

13. On the balance sheet, the account balances of the related liabil- ity (note payable) and asset (cash) accounts are decreased. On the income statement, interest expense is recorded.

14. (c), computed as 3.3121 3 $1,000 5 $3,312. 15. The option of paying $10,000 after one year has a lower present

value. It postpones paying the first $5,000 by six months. More generally, the present value of a further delayed payment is always lower than a less delayed payment.

16. (a) Reflects payment of accrued interest recorded back on May 1; $500,000 3 9% 3 4⁄12 5 $15,000.

Guidance Answers to Quick Checks

2013

Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . 10,000

June 30 Bond Interest Expense . . . . . . . . . . . . . . . . . 450

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 450

Bonds payable, 16%, due 12/31/2022 . . . . . . . . . $100,000

Plus premium on bonds payable . . . . . . . . . . . . 9,532* $109,532

* Original premium balance of $10,592 less $530 and $530 amortized on 6/30/2013 and 12/31/2013, respectively.

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450 Chapter 10 Long-Term Liabilities

Annuity (p. 441)

Bearer bonds (p. 436)

Bond (p. 422)

Bond certificate (p. 424)

Bond indenture (p. 424)

Callable bonds (p. 436)

Capital leases (p. 446)

Carrying (book) value of bonds (p. 426)

Contract rate (p. 425)

Convertible bonds (p. 436)

Coupon bonds (p. 436)

Debt-to-equity ratio (p. 437)

Discount on bonds payable (p. 425)

Effective interest method (p. 442)

Fair value option (p. 435)

Installment note (p. 433)

Lease (p. 446)

Market rate (p. 425)

Mortgage (p. 434)

Off-balance-sheet financing (p. 447)

Operating leases (p. 446)

Par value of a bond (p. 422)

Pension plan (p. 448)

Premium on bonds (p. 428)

Registered bonds (p. 436)

Secured bonds (p. 436)

Serial bonds (p. 436)

Sinking fund bonds (p. 436)

Straight-line bond amortization (p. 426)

Term bonds (p. 436)

Unsecured bonds (p. 436)

Key Terms

B(C,D) Superscript letter B(C, D) denotes assignments based on Appendix 10B (10C, 10D).

Icon denotes assignments that involve decision making.

1. What is the main difference between notes payable and bonds payable?

2. What is the main difference between a bond and a share of stock? 3. What is the advantage of issuing bonds instead of obtain-

ing financing from the company’s owners? 4. What is a bond indenture? What provisions are usually

included in it?

5. What are the duties of a trustee for bondholders? 6. What are the contract rate and the market rate for bonds? 7. What factors affect the market rates for bonds? 8.B Does the straight-line or effective interest method produce an interest expense allocation that yields a constant

rate of interest over a bond’s life? Explain.

Discussion Questions

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 463 mhhe.com/wildFINMAN5e

1. A bond traded at 971⁄2 means that a. The bond pays 971⁄2% interest. b. The bond trades at $975 per $1,000 bond. c. The market rate of interest is below the contract rate of in-

terest for the bond. d. The bonds can be retired at $975 each. e. The bond’s interest rate is 21⁄2%. 2. A bondholder that owns a $1,000, 6%, 15-year bond has a. The right to receive $1,000 at maturity. b. Ownership rights in the bond issuing entity. c. The right to receive $60 per month until maturity. d. The right to receive $1,900 at maturity. e. The right to receive $600 per year until maturity. 3. A company issues 8%, 20-year bonds with a par value of

$500,000. The current market rate for the bonds is 8%. The amount of interest owed to the bondholders for each semiannual interest payment is

a. $40,000. b. $0. c. $20,000.

d. $800,000. e. $400,000. 4. A company issued 5-year, 5% bonds with a par value of

$100,000. The company received $95,735 for the bonds. Using the straight-line method, the company’s interest expense for the first semiannual interest period is

a. $2,926.50. b. $5,853.00. c. $2,500.00. d. $5,000.00. e. $9,573.50. 5. A company issued 8-year, 5% bonds with a par value of

$350,000. The company received proceeds of $373,745. Inter- est is payable semiannually. The amount of premium amortized for the first semiannual interest period, assuming straight-line bond amortization, is

a. $2,698. b. $23,745. c. $8,750. d. $9,344. e. $1,484.

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Chapter 10 Long-Term Liabilities 451

9.C Why does a company that issues bonds between interest dates collect accrued interest from the bonds’ purchasers? 10. If you know the par value of bonds, the contract rate, and

the market rate, how do you compute the bonds’ price? 11. What is the issue price of a $2,000 bond sold at 981⁄4? What is

the issue price of a $6,000 bond sold at 1011⁄2? 12. Describe the debt-to-equity ratio and explain how creditors and

owners would use this ratio to evaluate a company’s risk. 13. What obligation does an entrepreneur (owner) have to in-

vestors that purchase bonds to finance the business? 14. Refer to Polaris’ annual report in Appendix A. Is

there any indication that Polaris has issued long- term debt?

15. By what amount did KTM’s long-term interest- bearing loans increase or decrease in 2011?

16. Refer to the statement of cash flows for Piaggio in Appendix A. For the year ended December 31, 2011, what was the amount for repayment of bank loans?

17. Refer to the statements for Arctic Cat in Appendix A. For the year ended March 31, 2011, what is its debt-to-equity ratio? What does this ratio tell us?

18.D When can a lease create both an asset and a liability for the lessee? 19.D Compare and contrast an operating lease with a capital lease. 20.D Describe the two basic types of pension plans.

QS 10-2B

Effective Interest: Bond computations

P1 P7

Garcia Company issues 10%, 15-year bonds with a par value of $240,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 8%, which implies a selling price of 1171⁄4. The effective interest method is used to allocate interest expense. 1. What are the issuer’s cash proceeds from issuance of these bonds? 2. What total amount of bond interest expense will be recognized over the life of these bonds? 3. What amount of bond interest expense is recorded on the first interest payment date?

QS 10-3 Journalize bond issuance P1

Prepare the journal entries for the issuance of the bonds in both QS 10-1 and QS 10-2. Assume that both bonds are issued for cash on January 1, 2013.

QS 10-4 Computing bond price P1

Using the bond details in both QS 10-1 and QS 10-2, confirm that the bonds’ selling prices given in each problem are approximately correct (within $100 of each other). Use the present value tables B.1 and B.3 in Appendix B.

Round dollar amounts to the nearest whole dollar.

Enviro Company issues 8%, 10-year bonds with a par value of $250,000 and semiannual interest payments. On the issue date, the annual market rate for these bonds is 10%, which implies a selling price of 871⁄2. The straight-line method is used to allocate interest expense. 1. What are the issuer’s cash proceeds from issuance of these bonds? 2. What total amount of bond interest expense will be recognized over the life of these bonds? 3. What is the amount of bond interest expense recorded on the first interest payment date?

QUICK STUDY

QS 10-1 Straight-Line: Bond computations

P1 P2

QS 10-5 Recording bond issuance and discount amortization P1 P2

Semiannual Period-End Unamortized Discount Carrying Value

(0) 12/31/2012 . . . . . . . . . . . . . $7,360 $92,640

(1) 6/30/2013 . . . . . . . . . . . . . 6,624 93,376

(2) 12/31/2013 . . . . . . . . . . . . . 5,888 94,112

Sylvestor Company issues 10%, five-year bonds, on December 31, 2012, with a par value of $100,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on December 31, 2012; (b) the first interest payment on June 30, 2013; and (c) the second interest payment on December 31, 2013.

QS 10-6 Bond retirement by call option

P4

On July 1, 2013, Advocate Company exercises a $8,000 call option (plus par value) on its outstanding bonds that have a carrying value of $416,000 and par value of $400,000. The company exercises the call option after the semiannual interest is paid on June 30, 2013. Record the entry to retire the bonds.

QS 10-7 Bond retirement by stock conversion P4

On January 1, 2013, the $2,000,000 par value bonds of Spitz Company with a carrying value of $2,000,000 are converted to 1,000,000 shares of $1.00 par value common stock. Record the entry for the conversion of the bonds.

Polaris

KTM

PIAGGIO

Arctic Cat

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452 Chapter 10 Long-Term Liabilities

QS 10-9 Computing payments for an installment note C1

Murray Company borrows $340,000 cash from a bank and in return signs an installment note for five annual payments of equal amount, with the first payment due one year after the note is signed. Use Table B.3 in Appendix B to compute the amount of the annual payment for each of the following annual market rates: (a) 4%, (b) 8%, and (c) 12%.

QS 10-8 Bond features and terminology

A2

Enter the letter of the description A through H that best fits each term or phrase 1 through 8. A. Records and tracks the bondholders’ names. B. Is unsecured; backed only by the issuer’s credit standing. C. Has varying maturity dates for amounts owed. D. Identifies rights and responsibilities of the issuer and the bondholders. E. Can be exchanged for shares of the issuer’s stock. F. Is unregistered; interest is paid to whoever possesses them. G. Maintains a separate asset account from which bondholders are paid at maturity. H. Pledges specific assets of the issuer as collateral. 1. Registered bond 5. Convertible bond 2. Serial bond 6. Bond indenture 3. Secured bond 7. Sinking fund bond 4. Bearer bond 8. Debenture

QS 10-11C

Issuing bonds between interest dates P1

Madrid Company plans to issue 8% bonds on January 1, 2013, with a par value of $4,000,000. The company sells $3,600,000 of the bonds on January 1, 2013. The remaining $400,000 sells at par on March 1, 2013. The bonds pay interest semiannually as of June 30 and December 31. Record the entry for the March 1 cash sale of bonds.

QS 10-12D

Recording operating leases C4 Jin Li, an employee of ETrain.com, leases a car at O’Hare airport for a three-day business trip. The rental cost is $250. Prepare the entry by ETrain.com to record Jin Li’s short-term car lease cost.

QS 10-13D

Recording capital leases C4 Algoma, Inc., signs a five-year lease for office equipment with Office Solutions. The present value of the lease payments is $15,499. Prepare the journal entry that Algoma records at the inception of this capital lease.

QS 10-14 International liabilities disclosures

P1

Vodafone Group Plc reports the following information among its bonds payable as of March 31, 2011 (pounds in millions).

Financial Long-Term Liabilities Measured at Amortised Cost

(£ millions) Nominal (par) Value Carrying Value Fair Value

4.625% (US dollar 500 million) bond due July 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . £311 £338 £327

QS 10-10 Debt-to-equity ratio

A2

Compute the debt-to-equity ratio for each of the following companies. Which company appears to have a riskier financing structure? Explain.

Atlanta Company Spokane Company

Total liabilities . . . . . . . . . $429,000 $ 548,000

Total equity . . . . . . . . . . . 572,000 1,827,000

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Chapter 10 Long-Term Liabilities 453

a. What is the par value of the 4.625% bond issuance? What is its book (carrying) value? b. Was the 4.625% bond sold at a discount or a premium? Explain.

Exercise 10-2 Straight-Line: Amortization of bond discount

P2

Tano issues bonds with a par value of $180,000 on January 1, 2013. The bonds’ annual contract rate is 8%, and interest is paid semiannually on June 30 and December 31. The bonds mature in three years. The annual market rate at the date of issuance is 10%, and the bonds are sold for $170,862. 1. What is the amount of the discount on these bonds at issuance? 2. How much total bond interest expense will be recognized over the life of these bonds? 3. Prepare an amortization table like the one in Exhibit 10.7 for these bonds; use the straight-line method

to amortize the discount.

Exercise 10-3B

Effective Interest: Amortization of bond discount

P6

Stanford issues bonds dated January 1, 2013, with a par value of $500,000. The bonds’ annual contract rate is 9%, and interest is paid semiannually on June 30 and December 31. The bonds mature in three years. The annual market rate at the date of issuance is 12%, and the bonds are sold for $463,140. 1. What is the amount of the discount on these bonds at issuance? 2. How much total bond interest expense will be recognized over the life of these bonds? 3. Prepare an amortization table like the one in Exhibit 10B.7 for these bonds; use the effective interest

method to amortize the discount.

Exercise 10-4 Straight-Line: Amortization of bond premium

P3

Quatro Co. issues bonds dated January 1, 2013, with a par value of $400,000. The bonds’ annual contract rate is 13%, and interest is paid semiannually on June 30 and December 31. The bonds mature in three years. The annual market rate at the date of issuance is 12%, and the bonds are sold for $409,850. 1. What is the amount of the premium on these bonds at issuance? 2. How much total bond interest expense will be recognized over the life of these bonds? 3. Prepare an amortization table like the one in Exhibit 10.11 for these bonds; use the straight-line

method to amortize the premium.

QS 10-15 International liabilities disclosures and interpretations

P1

Refer to the information in QS 10-14 for Vodafone Group Plc. The following price quotes (from Yahoo! Finance Bond Center) relate to its bonds payable. For example, the price quote indicates that the 4.625% bonds have a market price of 98.0 (98.0% of par value), resulting in a yield to maturity of 4.899%.

Price Contract Rate (coupon) Maturity Date Market Rate (YTM)

98.0 . . . . . . . . . 4.625% 15-Jul-2018 4.899%

a. Assuming that the 4.625% bonds were originally issued at par value, what does the market price reveal about interest rate changes since bond issuance? (Assume that Vodafone’s credit rating has remained the same.)

b. Does the change in market rates since the issuance of these bonds affect the amount of interest ex- pense reported on Vodafone’s income statement? Explain.

c. How much cash would Vodafone need to pay to repurchase the 4.625% bonds at the quoted market price of 98.0? (Assume no interest is owed when the bonds are repurchased.)

d. Assuming that the 4.625% bonds remain outstanding until maturity, at what market price will the bonds sell on the due date in 2018?

Round dollar amounts to the nearest whole dollar. Assume no reversing entries are used.

On January 1, 2013, Boston Enterprises issues bonds that have a $3,400,000 par value, mature in 20 years, and pay 9% interest semiannually on June 30 and December 31. The bonds are sold at par. 1. How much interest will Boston pay (in cash) to the bondholders every six months? 2. Prepare journal entries to record (a) the issuance of bonds on January 1, 2013; (b) the first interest

payment on June 30, 2013; and (c) the second interest payment on December 31, 2013. 3. Prepare the journal entry for issuance assuming the bonds are issued at (a) 98 and (b) 102.

EXERCISES

Exercise 10-1 Recording bond issuance and interest

P1

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454 Chapter 10 Long-Term Liabilities

Exercise 10-5B

Effective Interest: Amortization of bond premium P7

Refer to the bond details in Exercise 10-4 and prepare an amortization table like the one in Exhibit 10B.2 for these bonds using the effective interest method to amortize the premium.

Exercise 10-8 Straight-Line: Recording bond issuance and premium amortization

P1 P3

Woodwick Company issues 10%, five-year bonds, on December 31, 2012, with a par value of $200,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on December 31, 2012; (b) the first interest payment on June 30, 2013; and (c) the second interest payment on December 31, 2013.

Semiannual Period-End Unamortized Premium Carrying Value

(0) 12/31/2012 . . . . . . . . . . . . . . . . . $16,222 $216,222

(1) 6/30/2013 . . . . . . . . . . . . . . . . . 14,600 214,600

(2) 12/31/2013 . . . . . . . . . . . . . . . . . 12,978 212,978

Exercise 10-9 Computing bond interest and price; recording bond issuance

P2

Bringham Company issues bonds with a par value of $800,000 on their stated issue date. The bonds mature in 10 years and pay 6% annual interest in semiannual payments. On the issue date, the annual market rate for the bonds is 8%. 1. What is the amount of each semiannual interest payment for these bonds? 2. How many semiannual interest payments will be made on these bonds over their life? 3. Use the interest rates given to determine whether the bonds are issued at par, at a discount, or at a

premium. 4. Compute the price of the bonds as of their issue date. 5. Prepare the journal entry to record the bonds’ issuance.

Check (4) $691,287

Exercise 10-10 Computing bond interest and price; recording bond issuance

P3

Citywide Company issues bonds with a par value of $150,000 on their stated issue date. The bonds mature in five years and pay 10% annual interest in semiannual payments. On the issue date, the annual market rate for the bonds is 8%. 1. What is the amount of each semiannual interest payment for these bonds? 2. How many semiannual interest payments will be made on these bonds over their life? 3. Use the interest rates given to determine whether the bonds are issued at par, at a discount, or at a

premium.

Semiannual Period-End Unamortized Discount Carrying Value

(0) 12/31/2013 . . . . . . . . . . . . . . . . . $13,466 $186,534

(1) 6/30/2014 . . . . . . . . . . . . . . . . . 11,782 188,218

(2) 12/31/2014 . . . . . . . . . . . . . . . . . 10,098 189,902

Exercise 10-6 Straight-Line: Recording bond issuance and discount amortization

P1 P2

Paulson Company issues 6%, four-year bonds, on December 31, 2013, with a par value of $200,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on December 31, 2013; (b) the first interest payment on June 30, 2014; and (c) the second interest payment on December 31, 2014.

Semiannual Period-End Unamortized Discount Carrying Value

(0) 12/31/2013 . . . . . . . . . . . . . . . . . $12,000 $188,000

(1) 6/30/2014 . . . . . . . . . . . . . . . . . 9,000 191,000

(2) 12/31/2014 . . . . . . . . . . . . . . . . . 6,000 194,000

(3) 6/30/2015 . . . . . . . . . . . . . . . . . 3,000 197,000

(4) 12/31/2015 . . . . . . . . . . . . . . . . . 0 200,000

Exercise 10-7 Straight-Line: Recording bond issuance and discount amortization

P1 P2

Dobbs Company issues 5%, two-year bonds, on December 31, 2013, with a par value of $200,000 and semiannual interest payments. Use the following bond amortization table and prepare journal entries to record (a) the issuance of bonds on December 31, 2013; (b) the first through fourth interest payments on each June 30 and December 31; and (c) the maturity of the bond on December 31, 2015.

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Chapter 10 Long-Term Liabilities 455

4. Compute the price of the bonds as of their issue date. 5. Prepare the journal entry to record the bonds’ issuance.

Check (4) $162,172

Exercise 10-11 Straight-Line: Bond computations, amortization, and bond retirement

P2 P4

On January 1, 2013, Shay issues $700,000 of 10%, 15-year bonds at a price of 973⁄4. Six years later, on January 1, 2019, Shay retires 20% of these bonds by buying them on the open market at 1041⁄2. All interest is accounted for and paid through December 31, 2018, the day before the purchase. The straight-line method is used to amortize any bond discount. 1. How much does the company receive when it issues the bonds on January 1, 2013? 2. What is the amount of the discount on the bonds at January 1, 2013? 3. How much amortization of the discount is recorded on the bonds for the entire period from January 1,

2013, through December 31, 2018? 4. What is the carrying (book) value of the bonds as of the close of business on December 31, 2018?

What is the carrying value of the 20% soon-to-be-retired bonds on this same date? 5. How much did the company pay on January 1, 2019, to purchase the bonds that it retired? 6. What is the amount of the recorded gain or loss from retiring the bonds? 7. Prepare the journal entry to record the bond retirement at January 1, 2019.

Check (6) $8,190 loss

Exercise 10-12C

Recording bond issuance with accrued interest

C4 P1

On May 1, 2013, Brussels Enterprises issues bonds dated January 1, 2013, that have a $3,400,000 par value, mature in 20 years, and pay 9% interest semiannually on June 30 and December 31. The bonds are sold at par plus four months’ accrued interest. 1. How much accrued interest do the bond purchasers pay Brussels on May 1, 2013? 2. Prepare Brussels’ journal entries to record (a) the issuance of bonds on May 1, 2013; (b) the first

interest payment on June 30, 2013; and (c) the second interest payment on December 31, 2013. Check (1) $102,000

Exercise 10-13 Straight-Line: Amortization and accrued bond interest expense

P1 P2

Duval Co. issues four-year bonds with a $100,000 par value on June 1, 2013, at a price of $95,948. The annual contract rate is 7%, and interest is paid semiannually on November 30 and May 31. 1. Prepare an amortization table like the one in Exhibit 10.7 for these bonds. Use the straight-line method

of interest amortization. 2. Prepare journal entries to record the first two interest payments and to accrue interest as of December 31,

2013.

Exercise 10-14 Installment note with equal total payments C1 P5

On January 1, 2013, Eagle borrows $100,000 cash by signing a four-year, 7% installment note. The note requires four equal total payments of accrued interest and principal on December 31 of each year from 2013 through 2016. 1. Compute the amount of each of the four equal total payments. 2. Prepare an amortization table for this installment note like the one in Exhibit 10.14.

Check (1) $29,523

Exercise 10-15 Installment note entries P5

Use the information in Exercise 10-14 to prepare the journal entries for Eagle to record the loan on January 1, 2013, and the four payments from December 31, 2013, through December 31, 2016.

Exercise 10-16 Applying debt-to-equity ratio

A3

Montclair Company is considering a project that will require a $500,000 loan. It presently has total liabili- ties of $220,000, and total assets of $610,000. 1. Compute Montclair’s (a) present debt-to-equity ratio and (b) the debt-to-equity ratio assuming it bor-

rows $500,000 to fund the project. 2. Evaluate and discuss the level of risk involved if Montclair borrows the funds to pursue the project.

Exercise 10-17D

Identifying capital and operating leases

C4

Indicate whether the company in each separate case 1 through 3 has entered into an operating lease or a capital lease. 1. The lessor retains title to the asset, and the lease term is three years on an asset that has a five-year

useful life. 2. The title is transferred to the lessee, the lessee can purchase the asset for $1 at the end of the lease, and

the lease term is five years. The leased asset has an expected useful life of six years. 3. The present value of the lease payments is 95% of the leased asset’s market value, and the lease term

is 70% of the leased asset’s useful life.

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456 Chapter 10 Long-Term Liabilities

Exercise 10-18D

Accounting for capital lease

C4

Harbor (lessee) signs a five-year capital lease for office equipment with a $10,000 annual lease payment. The present value of the five annual lease payments is $41,000, based on a 7% interest rate. 1. Prepare the journal entry Harbor will record at inception of the lease. 2. If the leased asset has a five-year useful life with no salvage value, prepare the journal entry Harbor

will record each year to recognize depreciation expense related to the leased asset.

Exercise 10-19D

Analyzing lease options

C2 C3 C4

General Motors advertised three alternatives for a 25-month lease on a new Blazer: (1) zero dollars down and a lease payment of $1,750 per month for 25 months, (2) $5,000 down and $1,500 per month for 25 months, or (3) $38,500 down and no payments for 25 months. Use the present value Table B.3 in Ap- pendix B to determine which is the best alternative (assume you have enough cash to accept any alternative and the annual interest rate is 12% compounded monthly).

Problem 10-2A Straight-Line: Amortization of bond discount P1 P2

Hillside issues $4,000,000 of 6%, 15-year bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. The bonds are issued at a price of $3,456,448.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line discount amortization,

and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of an amortization table like Exhibit 10.7 using the straight-line method. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $4,143,552

(4) 12/31/2014 carrying value, $3,528,920

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Exercise 10-20 Accounting for long-term liabilities under IFRS

P1

Heineken N.V. reports the following information for its Loans and Borrowings as of December 31, 2010, including proceeds and repayments for the year ended December 31, 2010 (euros in millions).

Loans and borrowings (noncurrent liabilities)

Loans and borrowings, December 31, 2010 . . . . . . . . . . . . . . . . . . . . € 8,078

Proceeds (cash) from issuances of loans and borrowings . . . . . . . . . 1,920

Repayments (in cash) of loans and borrowings . . . . . . . . . . . . . . . . . (3,127)

1. Prepare Heineken’s journal entry to record its cash proceeds from issuances of its loans and borrow- ings for 2010. Assume that the par value of these issuances is €2,000.

2. Prepare Heineken’s journal entry to record its cash repayments of its loans and borrowings for 2010. Assume that the par value of these issuances is €3,000, and the premium on them is €32.

3. Compute the discount or premium on its loans and borrowings as of December 31, 2010, assuming that the par value of these liabilities is €8,000.

4. Given the facts in part 3 and viewing the entirety of loans and borrowings as one issuance, was the contract rate on these loans and borrowings higher or lower than the market rate at the time of issu- ance? Explain. (Assume that Heineken’s credit rating has remained the same.)

PROBLEM SET A

Problem 10-1A Computing bond price and recording issuance

P1

Round dollar amounts to the nearest whole dollar. Assume no reversing entries are used.

Hartford Research issues bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. The bonds have a $40,000 par value and an annual contract rate of 10%, and they mature in 10 years.

Required

For each of the following three separate situations, (a) determine the bonds’ issue price on January 1, 2013, and (b) prepare the journal entry to record their issuance. 1. The market rate at the date of issuance is 8%. 2. The market rate at the date of issuance is 10%. 3. The market rate at the date of issuance is 12%.

Check (1) Premium, $4,537

(3) Discount, $4,588

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Chapter 10 Long-Term Liabilities 457

Problem 10-4A Straight-Line: Amortization of bond premium

P1 P3

Ellis issues 6.5%, five-year bonds dated January 1, 2013, with a $250,000 par value. The bonds pay inter- est on June 30 and December 31 and are issued at a price of $255,333. The annual market rate is 6% on the issue date.

Required

1. Calculate the total bond interest expense over the bonds’ life. 2. Prepare a straight-line amortization table like Exhibit 10.11 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments.

mhhe.com/wildFINMAN5e

Check (2) 6/30/2015 carrying value, $252,668

Problem 10-3A Straight Line: Amortization of bond premium

P1 P3

Refer to the bond details in Problem 10-2A, except assume that the bonds are issued at a price of $4,895,980.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line premium amortiza-

tion, and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of an amortization table like Exhibit 10.7 using the straight-line method. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $2,704,020

(4) 12/31/2014 carrying value, $4,776,516

Problem 10-5AB

Effective Interest: Amortization of bond premium; computing bond price P1 P7

Refer to the bond details in Problem 10-4A.

Required

1. Compute the total bond interest expense over the bonds’ life. 2. Prepare an effective interest amortization table like the one in Exhibit 10B.2 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments. 4. Use the market rate at issuance to compute the present value of the remaining cash flows for these

bonds as of December 31, 2015. Compare your answer with the amount shown on the amortization table as the balance for that date (from part 2) and explain your findings.

Check (2) 6/30/2015 carrying value, $252,865

(4) $252,326

Problem 10-6A Straight-Line: Amortization of bond

P1 P2 P3

Legacy issues $325,000 of 5%, four-year bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. They are issued at $292,181 and their market rate is 8% at the issue date.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare a straight-line amortization table like the one in Exhibit 10.7 for the bonds’ first two years. 4. Prepare the journal entries to record the first two interest payments.

Analysis Component

5. Assume the market rate on January 1, 2013, is 4% instead of 8%. Without providing numbers, describe how this change affects the amounts reported on Legacy’s financial statements.

Check (2) $97,819

(3) 12/31/2014 carrying value, $308,589

Problem 10-7AB

Effective Interest: Amortization of bond discount P1 P6

Refer to the bond details in Problem 10-6A.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like the one in Exhibit 10B.1 for the bonds’ first two

years. 4. Prepare the journal entries to record the first two interest payments.

Check (2) $97,819

(3) 12/31/2014 carrying value, $307,308

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458 Chapter 10 Long-Term Liabilities

Problem 10-9A Installment notes

C1 P5

On November 1, 2013, Norwood borrows $200,000 cash from a bank by signing a five-year installment note bearing 8% interest. The note requires equal total payments each year on October 31.

Required

1. Compute the total amount of each installment payment. 2. Complete an amortization table for this installment note similar to the one in Exhibit 10.14. 3. Prepare the journal entries in which Leetch records (a) accrued interest as of December 31, 2013

(the end of its annual reporting period), and (b) the first annual payment on the note.

Check (2) 10/31/2017 ending balance, $46,382

Problem 10-10A Applying the debt-to-equity ratio

A3

At the end of the current year, the following information is available for both Pulaski Company and Scott Company.

Pulaski Company Scott Company

Total assets . . . . . . . . . . $900,000 $450,000

Total liabilities . . . . . . . . 360,000 240,000

Total equity . . . . . . . . . . 540,000 210,000

Required

1. Compute the debt-to-equity ratios for both companies. 2. Comment on your results and discuss the riskiness of each company’s financing structure.

Problem 10-11AD

Capital lease accounting

C4

Rogers Company signs a five-year capital lease with Packer Company for office equipment. The annual lease payment is $10,000 (due at the end of each year), and the interest rate is 8%.

Required

1. Compute the present value of Roger’s five-year lease payments. 2. Prepare the journal entry to record Roger’s capital lease at its inception. 3. Complete a lease payment schedule for the five years of the lease with the following headings. Assume

that the beginning balance of the lease liability (present value of lease payments) is $79,854. (Hint: To find the amount allocated to interest in year 1, multiply the interest rate by the beginning-of-year lease liability. The amount of the annual lease payment not allocated to interest is allocated to principal. Reduce the lease liability by the amount allocated to principal to update the lease liability at each year-end.)

4. Use straight-line depreciation and prepare the journal entry to depreciate the leased asset at the end of year 1. Assume zero salvage value and a five-year life for the office equipment.

Beginning Ending Period Balance of Interest on Reduction of Cash Balance of Ending Lease Lease Lease Lease Lease Date Liability Liability Liability Payment Liability

Check (1) $39,927

(3) Year 3 ending balance, $17,833

Ike issues $180,000 of 11%, three-year bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. They are issued at $184,566. Their market rate is 10% at the issue date.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like Exhibit 10B.2 for the bonds’ first two years. 4. Prepare the journal entries to record the first two interest payments. 5. Prepare the journal entry to record the bonds’ retirement on January 1, 2015, at 98.

Analysis Component

6. Assume that the market rate on January 1, 2013, is 12% instead of 10%. Without presenting numbers, describe how this change affects the amounts reported on Ike’s financial statements.

Problem 10-8AB

Effective Interest: Amortization of bond; retiring bonds

P1 P4 P6 P7

Check (3) 6/30/2014 carrying value, $182,448

(5) $5,270 gain

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Chapter 10 Long-Term Liabilities 459

PROBLEM SET B

Problem 10-1B Computing bond price and recording issuance

P1

Round dollar amounts to the nearest whole dollar. Assume no reversing entries are used.

Flagstaff Systems issues bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. The bonds have a $90,000 par value and an annual contract rate of 12%, and they mature in five years.

Required

For each of the following three separate situations, (a) determine the bonds’ issue price on January 1, 2013, and (b) prepare the journal entry to record their issuance. 1. The market rate at the date of issuance is 10%. 2. The market rate at the date of issuance is 12%. 3. The market rate at the date of issuance is 14%.

Check (1) Premium, $6,948

(3) Discount, $6,326

Problem 10-2B Straight-Line: Amortization of bond discount

P1 P2

Romero issues $3,400,000 of 10%, 10-year bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. The bonds are issued at a price of $3,010,000.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line discount amortization,

and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of an amortization table like Exhibit 10.7 using the straight-line method. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $3,790,000

(4) 6/30/2014 carrying value, $3,068,500

Problem 10-4B Straight-Line: Amortization of bond premium

P1 P3

Ripkin Company issues 9%, five-year bonds dated January 1, 2013, with a $320,000 par value. The bonds pay interest on June 30 and December 31 and are issued at a price of $332,988. Their annual market rate is 8% on the issue date.

Required

1. Calculate the total bond interest expense over the bonds’ life. 2. Prepare a straight-line amortization table like Exhibit 10.11 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments.

Check (2) 6/30/2015 carrying value, $326,493

Problem 10-3B Straight-line: Amortization of bond premium

P1 P3

Refer to the bond details in Problem 10-2B, except assume that the bonds are issued at a price of $4,192,932.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. For each semiannual period, compute (a) the cash payment, (b) the straight-line premium amortiza-

tion, and (c) the bond interest expense. 3. Determine the total bond interest expense to be recognized over the bonds’ life. 4. Prepare the first two years of an amortization table like Exhibit 10.7 using the straight-line method. 5. Prepare the journal entries to record the first two interest payments.

Check (3) $2,607,068

(4) 6/30/2014 carrying value, 4,073,991

Problem 10-5BB

Effective Interest: Amortization of bond premium; computing bond price P1 P7

Refer to the bond details in Problem 10-4B.

Required

1. Compute the total bond interest expense over the bonds’ life. 2. Prepare an effective interest amortization table like the one in Exhibit 10B.2 for the bonds’ life. 3. Prepare the journal entries to record the first two interest payments. 4. Use the market rate at issuance to compute the present value of the remaining cash flows for these

bonds as of December 31, 2015. Compare your answer with the amount shown on the amortization table as the balance for that date (from part 2) and explain your findings.

Check (2) 6/30/2015 carrying value, $327,136

(4) $325,807

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460 Chapter 10 Long-Term Liabilities

Problem 10-8BB

Effective Interest: Amortization of bond; retiring bonds

P1 P4 P6 P7

Valdez issues $450,000 of 13%, four-year bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. They are issued at $493,608, and their market rate is 10% at the issue date.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like the one in Exhibit 10B.2 for the bonds’ first two

years. 4. Prepare the journal entries to record the first two interest payments. 5. Prepare the journal entry to record the bonds’ retirement on January 1, 2015, at 106.

Analysis Component

6. Assume that the market rate on January 1, 2013, is 14% instead of 10%. Without presenting numbers, describe how this change affects the amounts reported on Valdez’s financial statements.

Check (3) 6/30/2014 carrying value, $479,202

(5) $3,088 loss

Problem 10-9B Installment notes

C1 P5

On October 1, 2013, Gordon Enterprises borrows $150,000 cash from a bank by signing a three-year install- ment note bearing 10% interest. The note requires equal total payments each year on September 30.

Required

1. Compute the total amount of each installment payment. 2. Complete an amortization table for this installment note similar to the one in Exhibit 10.14. 3. Prepare the journal entries to record (a) accrued interest as of December 31, 2013 (the end of its

annual reporting period) and (b) the first annual payment on the note.

Check (2) 9/30/2015 ending balance, $54,836

Problem 10-10B Applying the debt-to-equity ratio

A3

At the end of the current year, the following information is available for both Atlas Company and Bryan Company.

Atlas Company Bryan Company

Total assets . . . . . . . . . . $180,000 $750,000

Total liabilities . . . . . . . . 81,000 562,500

Total equity . . . . . . . . . . 99,000 187,500

Required

1. Compute the debt-to-equity ratios for both companies. 2. Comment on your results and discuss what they imply about the relative riskiness of these companies.

Problem 10-6B Straight-Line: Amortization of bond discount

P1 P2

Gomez issues $240,000 of 6%, 15-year bonds dated January 1, 2013, that pay interest semiannually on June 30 and December 31. They are issued at $198,494, and their market rate is 8% at the issue date.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the life of the bonds. 3. Prepare a straight-line amortization table like the one in Exhibit 10.7 for the bonds’ first two years. 4. Prepare the journal entries to record the first two interest payments.

Check (2) $257,506

(3) 6/30/2014 carrying value, $202,646

Refer to the bond details in Problem 10-6B.

Required

1. Prepare the January 1, 2013, journal entry to record the bonds’ issuance. 2. Determine the total bond interest expense to be recognized over the bonds’ life. 3. Prepare an effective interest amortization table like the one in Exhibit 10B.1 for the bonds’ first two

years. 4. Prepare the journal entries to record the first two interest payments.

Problem 10-7BB

Effective Interest: Amortization of bond discount

P1 P6

Check (2) $257,506; (3) 6/30/2014 carrying

value, $200,803

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Chapter 10 Long-Term Liabilities 461

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 10 Adria Lopez has consulted with her local banker and is considering financing an expansion of her business by obtaining a long-term bank loan. Selected account balances at March 31, 2014, for Success Systems follow.

SERIAL PROBLEM Success Systems

A1 A3

Total assets . . . . . . . . $129,909 Total liabilities . . . . . . . $875 Total equity . . . . . . . $129,034

Required

1. The bank has offered a long-term secured note to Success Systems. The bank’s loan procedures require that a client’s debt-to-equity ratio not exceed 0.8. As of March 31, 2014, what is the maximum amount that Success Systems could borrow from this bank (rounded to nearest dollar)?

2. If Success Systems borrows the maximum amount allowed from the bank, what percentage of assets would be financed (a) by debt and (b) by equity?

3. What are some factors Adria Lopez should consider before borrowing the funds?

Check (1) $102,352

BTN 10-1 Refer to Polaris’ financial statements in Appendix A to answer the following. 1. Identify the items, if any, that make up Polaris’ long-term debt as reported on its balance sheet at

December 31, 2011. 2. Assume that Polaris has $100,000 thousand in convertible debentures that carry a 4.25% contract rate

of interest. How much annual cash interest must be paid on those convertible debentures? 3. How much cash did it generate from issuance of debt for the year-ended December 31, 2011? How

much cash did it use for repayments of debt for that same year?

Fast Forward

4. Access Polaris’ financial statements for the years ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www .sec.gov). Has it issued additional long-term debt since the year-end December 31, 2011? If yes, identify the amount(s).

Beyond the Numbers

REPORTING IN ACTION A1 A2

Beginning Ending Period Balance of Interest on Reduction of Cash Balance of Ending Lease Lease Lease Lease Lease Date Liability Liability Liability Payment Liability

Braun Company signs a five-year capital lease with Verdi Company for office equipment. The annual lease payment is $20,000 (due at the end of each year), and the interest rate is 10%.

Required

1. Compute the present value of Braun’s lease payments. 2. Prepare the journal entry to record Braun’s capital lease at its inception. 3. Complete a lease payment schedule for the five years of the lease with the following headings. As-

sume that the beginning balance of the lease liability (present value of lease payments) is $75,816. (Hint: To find the amount allocated to interest in year 1, multiply the interest rate by the beginning-of- year lease liability. The amount of the annual lease payment not allocated to interest is allocated to principal. Reduce the lease liability by the amount allocated to principal to update the lease liability at each year-end.)

Problem 10-11BD

Capital lease accounting

C4

Check (1) $75,816

(3) Year 3 ending balance, $34,712

4. Use straight-line depreciation and prepare the journal entry to depreciate the leased asset at the end of year 1. Assume zero salvage value and a five-year life for the office equipment.

Polaris

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462 Chapter 10 Long-Term Liabilities

BTN 10-3 Traverse County needs a new county government building that would cost $10 million. The politicians feel that voters will not approve a municipal bond issue to fund the building since it would in- crease taxes. They opt to have a state bank issue $10 million of tax-exempt securities to pay for the build- ing construction. The county then will make yearly lease payments (of principal and interest) to repay the obligation. Unlike conventional municipal bonds, the lease payments are not binding obligations on the county and, therefore, require no voter approval.

Required

1. Do you think the actions of the politicians and the bankers in this situation are ethical? 2. How do the tax-exempt securities used to pay for the building compare in risk to a conventional

municipal bond issued by Traverse County?

ETHICS CHALLENGE C4 A1

BTN 10-5 Access the March 22, 2012, filing of the 10-K report of Home Depot for the year ended January 31, 2012, from www.sec.gov (Ticker: HD). Refer to Home Depot’s balance sheet, including its note 4 (on debt).

Required

1. Identify Home Depot’s long-term liabilities and the amounts for those liabilities from Home Depot’s balance sheet at January 31, 2012.

2. Review Home Depot’s note 4. The note reports that as of January 31, 2012, it had $2.961 billion of “5.875% Senior Notes; due December 16, 2036; interest payable semiannually on June 16 and December 16.” These notes have a face value of $3.0 billion and were originally issued at $2.958 billion.

a. Why would Home Depot issue $3.0 billion of its notes for only $2.958 billion? b. How much cash interest must Home Depot pay each June 16 and December 16 on these notes?

TAKING IT TO THE NET A2

BTN 10-4 Your business associate mentions that she is considering investing in corporate bonds cur- rently selling at a premium. She says that since the bonds are selling at a premium, they are highly valued and her investment will yield more than the going rate of return for the risk involved. Reply with a memo- randum to confirm or correct your associate’s interpretation of premium bonds.

COMMUNICATING IN PRACTICE P3

BTN 10-6B Break into teams and complete the following requirements related to effective interest amortization for a premium bond. 1. Each team member is to independently prepare a blank table with proper headings for amortization of

a bond premium. When all have finished, compare tables and ensure that all are in agreement.

Parts 2 and 3 require use of these facts: On January 1, 2013, McElroy issues $100,000, 9%, five-year bonds at 104.1. The market rate at issuance is 8%. McElroy pays interest semiannually on June 30 and December 31. 2. In rotation, each team member must explain how to complete one line of the bond amortization table,

including all computations for his or her line. (Round amounts to the nearest dollar.) All members are to fill in their tables during this process. You need not finish the table; stop after all members have explained a line.

TEAMWORK IN ACTION P2 P3

BTN 10-2 Key figures for Polaris and Arctic Cat follow.COMPARATIVE ANALYSIS A3

Polaris Arctic Cat

Current Prior Current Prior

($ thousands) Year Year Year Year

Total assets . . . . . . . . . . . $1,228,024 $1,061,647 $272,906 $246,084

Total liabilities . . . . . . . . . 727,968 690,656 89,870 78,745

Total equity . . . . . . . . . . . 500,056 370,991 183,036 167,339

Required

1. Compute the debt-to-equity ratios for Polaris and Arctic Cat for both the current year and the prior year.

2. Use the ratios you computed in part 1 to determine which company’s financing structure is least risky. Assume an industry average of 0.64 for debt-to-equity.

Polaris Arctic Cat

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Chapter 10 Long-Term Liabilities 463

BTN 10-7 Kyle Smitley is the founder of barley & birch. Assume that her company currently has $250,000 in equity, and she is considering a $100,000 expansion to meet increased demand. The $100,000 expansion would yield $16,000 in additional annual income before interest expense. Assume that the business currently earns $40,000 annual income before interest expense of $10,000, yielding a return on equity of 12% ($30,000y$250,000). To fund the expansion, she is considering the issuance of a 10-year, $100,000 note with annual interest payments (the principal due at the end of 10 years).

Required

1. Using return on equity as the decision criterion, show computations to support or reject the expansion if interest on the $100,000 note is (a) 10%, (b) 15%, (c) 16%, (d) 17%, and (e) 20%.

2. What general rule do the results in part 1 illustrate?

ENTREPRENEURIAL DECISION A1

BTN 10-8 Visit your city or county library. Ask the librarian to help you locate the recent financial records of your city or county government. Examine those records.

Required

1. Determine the amount of long-term bonds and notes currently outstanding. 2. Read the supporting information to your municipality’s financial statements and record a. The market interest rate(s) when the bonds and/or notes were issued. b. The date(s) when the bonds and/or notes will mature. c. Any rating(s) on the bonds and/or notes received from Moody’s, Standard & Poor’s, or another

rating agency.

HITTING THE ROAD A1

BTN 10-9 Piaggio (www.piaggio.com), Polaris, and Arctic Cat are competitors in the global market- place. Selected results from these companies follow.

GLOBAL DECISION A3 Piaggio Polaris Arctic Cat

(Euro thousands) ($ thousands) ($ thousands)

Current Prior Current Prior Current Prior

Key Figures Year Year Year Year Year Year

Total assets . . . . . . . . . . . . . . . . €1,520,184 €1,545,722 $1,228,024 $1,061,647 $272,906 $246,084

Total liabilities . . . . . . . . . . . . . . 1,073,966 1,102,832 727,968 690,656 89,870 78,745

Total equity . . . . . . . . . . . . . . . . 446,218 442,890 500,056 370,991 183,036 167,339

Debt-to-equity ratio . . . . . . . . . ? ? 1.46 1.86 0.49 0.47

Required

1. Compute Piaggio’s debt-to-equity ratios for the current year and the prior year. 2. Use the data provided and the ratios computed in part 1 to determine which company’s financing

structure is least risky.

1. b 2. a 3. c; $500,000 3 0.08 3 1⁄2 year 5 $20,000

4. a; Cash interest paid 5 $100,000 3 5% 3 1⁄2 year 5 $2,500 Discount amortization 5 ($100,000 2 $95,735)y10 periods 5 $426.50 Interest expense 5 $2,500.00 1 $426.50 5 $2,926.50 5. e; ($373,745 2 $350,000)y16 periods 5 $1,484

ANSWERS TO MULTIPLE CHOICE QUIZ

3. In rotation, each team member is to identify a separate column of the table and indicate what the final number in that column will be and explain the reasoning.

4. Reach a team consensus as to what the total bond interest expense on this bond issue will be if the bond is not retired before maturity.

5. As a team, prepare a list of similarities and differences between the amortization table just prepared and the amortization table if the bond had been issued at a discount.

Hint: Rotate teams to report on parts 4 and 5. Consider requiring entries for issuance and interest payments.

Polaris Arctic Cat

PIAGGIO

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Learning Objectives

CONCEPTUAL

C1 Identify characteristics of corporations and their organization. (p. 466) C2 Explain characteristics of, and distribute dividends between, common and

preferred stock. (p. 476)

C3 Explain the items reported in retained earnings. (p. 482)

ANALYTICAL

A1 Compute earnings per share and describe its use. (p. 485) A2 Compute price-earnings ratio and describe its use in analysis. (p. 485) A3 Compute dividend yield and explain its use in analysis. (p. 486) A4 Compute book value and explain its use in analysis. (p. 486)

PROCEDURAL

P1 Record the issuance of corporate stock. (p. 470) P2 Record transactions involving cash dividends, stock dividends, and stock

splits. (p. 473)

P3 Record purchases and sales of treasury stock and the retirement of stock. (p. 480)

A Look at This Chapter

This chapter emphasizes details of the corporate form of organization. The accounting concepts and procedures for equity transactions are explained. We also describe how to report and analyze income, earnings per share, and retained earnings.

A Look Back

Chapter 10 focused on long-term liabilities, which are a main part of most companies’ financing. We explained how to value, record, amortize, and report these liabilities in financial statements.

Corporate Reporting and Analysis 11

A Look Ahead

Chapter 12 focuses on reporting and analyzing a company’s cash flows. Special emphasis is directed at the statement of cash flows and the methods for reporting that statement.

464

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The Groupon Clipper

CHICAGO—“I’ve never been driven to create a huge company and make a lot of money or run my own business,” insists Andrew Mason. “I’ve always just been motivated to be working on interesting things.” What interested Andrew was the launch of a Website called Groupon (Groupon.com). “A Groupon is, es- sentially, a voucher that’s worth money that you can take into a business and use like cash,” explains Andrew. “It’s a great way to explore your city and find out about really cool, local things to do.” Andrew explains that his success would not have been pos- sible without equity financing and knowledge of business opera- tions. To make it happen, says Andrew, he studied corporate formation, equity issuance, stock types, retaining earnings, and dividend policies. After that analysis, Andrew set up Groupon as a corporation, which had several benefits given his business goals and strategies. With his corporate structure in place, Andrew was ready to attack the market. “We found a way to make e-commerce work for local businesses online,” asserts Andrew. “We found a way to deliver effective marketing results for brick and mortar businesses.” The success of Andrew’s corporate structure and his equity financing brings both opportunities and challenges. The positive

is being part of empowering consumers. “We get crazy emails that feel like they’re written by a PR company or something, from our customers about how their marriage was at its end and then Groupon came along and they started going out more,” says Andrew. “Now they’re happier than ever. We’re affecting people’s lives in real ways.” The challenge is effectively using accounting as a tool to achieve those objectives. That includes his knowledge of corporate formation, stock types, and equity transactions. The SEC, for in- stance, has raised some questions about Groupon’s revenue and expense recognition policies. Admits Andrew, “There are things we would’ve done differently and we would’ve loved to avoid.” Nevertheless, Groupon had the largest initial public stock offering of any Internet company since Google. Its value sky- rocketed to $18 billion on the first day of trading. “It caught me by surprise,” says Andrew. “It was just this rocket ship ride that you couldn’t let go. And, you didn’t want to let go either!”

[Sources: Groupon Website, January 2013; Mixergy.com, July 2010; The Wall Street Journal, December 2010; Time, February 2011; CBS News, 60 Minutes, January 2012]

“Focus on trying to make the product awesome for consumers.”

—ANDREW MASON

Decision Insight

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Chapter Preview

This chapter focuses on equity transactions. The first part of the chapter describes the basics of the corporate form of organization and explains the accounting for common and preferred stock. We then focus on several special financing transactions, including

cash and stock dividends, stock splits, and treasury stock. The final section considers accounting for retained earnings, includ- ing prior period adjustments, retained earnings restrictions, and reporting guidelines.

A corporation is an entity created by law that is separate from its owners. It has most of the rights and privileges granted to individuals. Owners of corporations are called stockholders or shareholders. Corporations can be separated into two types. A privately held (or closely held ) corporation does not offer its stock for public sale and usually has few stockholders. A publicly held corporation offers its stock for public sale and can have thousands of stockholders. Public sale usually refers to issuance and trading on an organized stock market.

Characteristics of Corporations Corporations represent an important type of organization. Their unique characteristics offer advantages and disadvantages.

Advantages of Corporate Characteristics

● Separate legal entity: A corporation conducts its affairs with the same rights, duties, and respon sibilities of a person. It takes actions through its agents, who are its officers and managers.

● Limited liability of stockholders: Stockholders are liable for neither corporate acts nor corporate debt.

● Transferable ownership rights: The transfer of shares from one stockholder to another usu- ally has no effect on the corporation or its operations except when this causes a change in the directors who control or manage the corporation.

● Continuous life: A corporation’s life continues indefinitely because it is not tied to the phys- ical lives of its owners.

● Lack of mutual agency for stockholders: A corporation acts through its agents, who are its officers and managers. Stockholders, who are not its officers and managers, do not have the power to bind the corporation to contracts — referred to as lack of mutual agency.

● Ease of capital accumulation: Buying stock is attractive to investors because (1) stockhold- ers are not liable for the corporation’s acts and debts, (2) stocks usually are transferred easily, (3) the life of the corporation is un limited, and (4) stockholders are not corpo rate agents. These advantages enable corporations to accumulate large amounts of capital from the com- bined investments of many stockholders.

CORPORATE FORM OF ORGANIZATION

C1 Identify characteristics of corporations and their organization.

Point: The business entity assumption requires a corporation to be ac- counted for separately from its owners (shareholders).

Global: U.S., U.K., and Canadian corporations finance much of their operations with stock issuances, but companies in countries such as France, Germany, and Japan finance mainly with note and bond issuances.

466

Common Stock

• Par value • No-par value • Stated value • Stock for non-

cash assets

Corporations

• Characteristics • Organization

and manage- ment

• Stockholders • Stock basics

Dividends

• Cash dividends

• Stock dividends

• Stock splits

Preferred Stock

• Issuance • Dividend

preferences • Convertible

preferred • Callable

preferred

Reporting on Equity

• Statement of retained earnings

• Statement of stockholders’ equity

• Stock options

Treasury Stock

• Purchasing treasury stock

• Reissuing treasury stock

• Retiring stock

Corporate Reporting and Analysis

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Chapter 11 Corporate Reporting and Analysis 467

Disadvantages of Corporate Characteristics

● Government regulation: A corporation must meet requirements of a state’s incorporation laws, which subject the corporation to state regulation and control. Proprietorships and partnerships avoid many of these regulations and governmental reports.

● Corporate taxation: Corporations are subject to the same property and payroll taxes as propri- etorships and partnerships plus additional taxes. The most burdensome of these are federal and state income taxes that together can take 40% or more of corporate pretax income. Moreover, corporate income is usually taxed a second time as part of stockholders’ personal income when they receive cash distributed as dividends. This is called double taxation. (The usual dividend tax is 15%; however, it is less than 15% for lower income taxpayers, and in some cases zero.)

Point: Proprietorships and partner- ships are not subject to income taxes. Their income is taxed as the personal income of their owners.

Point: Double taxation is less severe when a corporation’s owner- manager collects a salary that is taxed only once as part of his or her personal income.

Point: A corporation is not required to have an office in its state of incorporation. Delaware is viewed as having favorable corporate laws and about half of all corporations listed on the NYSE are incorporated there.

Corporate Organization and Management This section describes the incorporation, costs, and management of corporate organizations.

Incorporation A corporation is created by obtaining a charter from a state government. A char- ter application usually must be signed by the prospective stockholders called incorporators or pro- moters and then filed with the proper state official. When the application process is complete and fees paid, the charter is issued and the corporation is formed. Investors then purchase the corporation’s stock, meet as stockholders, and elect a board of directors. Directors oversee a corporation’s affairs.

Organization Expenses Organization expenses (also called organization costs) are the costs to organize a corporation; they include legal fees, promoters’ fees, and amounts paid to obtain a charter. The corporation records (debits) these costs to an expense account called Orga- nization Expenses. Organization costs are expensed as incurred because it is difficult to deter- mine the amount and timing of their future benefits.

Management of a Corporation The ultimate control of a corporation rests with stockholders who control a corporation by electing its board of directors, or simply, directors. Each stockholder usually has one vote for each share of stock owned. This control relation is shown in Exhibit 11.1. Direc- tors are responsible for and have final authority for manag- ing corporate activities. A board can act only as a collective body and usually limits its actions to setting general policy. A corporation usually holds a stockholder meeting at least once a year to elect directors and transact business as its bylaws require. A group of stockholders owning or controlling votes of more than a 50% share of a corpora- tion’s stock can elect the board and control the corporation. Stockholders who do not attend stockholders’ meetings must have an opportunity to delegate their voting rights to an agent by signing a proxy, a document that gives a des- ignated agent the right to vote the stock. Day-to-day direction of corporate business is delegated to executive officers appointed by the board. A corporation’s chief executive officer (CEO) is often its president. Several vice presidents, who report to the president, are commonly assigned specific areas of management responsibility such as finance, production, and marketing. One person often has the dual role of chairperson of the board of directors and CEO. In this case, the president is usually desig- nated the chief operating officer (COO).

Point: Bylaws are guidelines that govern the behavior of individuals employed by and managing the corporation.

Stockholders

Board of Directors

President, Vice President, and Other Officers

Employees of the Corporation

Corporate governance is the system by which companies are directed and controlled.

EXHIBIT 11.1 Corporate Structure

Stock Financing Mark Zuckerberg took his company, Facebook, public by issuing its first shares on the Nasdaq exchange in 2012. This initial public offering (IPO) of Facebook shares raised billions in equity financing. It also raised the importance of accounting reports versus market hype. The IPO of Facebook shares comes 8 years after the company was founded by Zuckerberg in his college dorm room. ■

Decision Insight

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468 Chapter 11 Corporate Reporting and Analysis

Global: Some corporate labels are: Country Label

United States . . . . . . . . . Inc. France . . . . . . . . . . . . . . SA United Kingdom Public . . . . . . . . . . . . . PLC Private . . . . . . . . . . . . Ltd Germany & Austria Public . . . . . . . . . . . . . AG Private . . . . . . . . . . . . GmbH Sweden & Finland . . . . . AB Italy . . . . . . . . . . . . . . . . SpA Netherlands . . . . . . . . . NV Australia . . . . . . . . . . . . AG Mexico . . . . . . . . . . . . . . SA Bahamas . . . . . . . . . . . . IBC

Stockholders of Corporations This section explains stockholder rights, stock purchases and sales, and the role of registrar and transfer agents.

Rights of Stockholders When investors buy stock, they acquire all specific rights the corporation’s charter grants to stockholders. They also acquire general rights granted stockhold- ers by the laws of the state in which the company is incorporated. When a corporation has only one class of stock, it is identified as common stock. State laws vary, but common stockholders usually have the general right to

1. Vote at stockholders’ meetings (or register proxy votes electronically). 2. Sell or otherwise dispose of their stock. 3. Purchase their proportional share of any common stock later issued by the corporation.

This preemptive right protects stockholders’ proportionate interest in the corporation. For example, a stockholder who owns 25% of a corporation’s common stock has the first opportunity to buy 25% of any new common stock issued.

4. Receive the same dividend, if any, on each common share of the corporation. 5. Share in any assets remaining after creditors and preferred stockholders are paid when,

and if, the corporation is liquidated. Each common share receives the same amount.

Stockholders also have the right to receive timely financial reports.

Stock Certificates and Transfer Investors who buy a corporation’s stock, sometimes receive a stock certificate as proof of share ownership. Many corporations issue only one cer-

tificate for each block of stock purchased. A cer- tificate can be for any num- ber of shares. Exhibit 11.2 shows a stock certificate of the Green Bay Packers. A certificate shows the com- pany name, stockholder name, number of shares, and other crucial information. Issuance of certificates is becoming less common. Instead, many stockholders maintain accounts with the corporation or their stock- brokers and never receive actual certificates.

Registrar and Transfer Agents If a corporation’s stock is traded on a major stock exchange, the corporation must have a registrar and a transfer agent. A registrar keeps stock- holder records and prepares official lists of stockholders for stockholder meetings and dividend payments. A transfer agent assists with purchases and sales of shares by receiving and issuing certificates as necessary. Registrars and transfer agents are usually large banks or trust compa- nies with computer facilities and staff to do this work.

EXHIBIT 11.2 Stock Certificate

Point: The Green Bay Packers is the only nonprofit, community-owned major league professional sports team. The NFL now prohibits any other teams from becoming community-owned.

Seed Money Sources for start-up money include (1) “angel” investors such as family, friends, or anyone who believes in a company, (2) employees, inves- tors, and even suppliers who can be paid with stock, and (3) venture capitalists (investors) who have a record of entrepreneurial success. See the National Venture Capital Association (NVCA.org) for information. ■

Decision Insight

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Chapter 11 Corporate Reporting and Analysis 469

Basics of Capital Stock Capital stock is a general term that refers to any shares issued to obtain capital (owner financ- ing). This section introduces terminology and accounting for capital stock.

Authorized Stock Authorized stock is the number of shares that a corporation’s charter allows it to sell. The number of authorized shares usually exceeds the number of shares issued (and outstanding), often by a large amount. (Outstanding stock refers to issued stock held by stockholders.) No formal journal entry is required for stock authorization. A corporation must apply to the state for a change in its charter if it wishes to issue more shares than previously authorized. A corporation discloses the number of shares authorized in the equity section of its balance sheet or notes. Apple’s balance sheet reports 1.8 billion common shares authorized as of the start of its 2012 fiscal year.

Selling (Issuing) Stock A corporation can sell stock directly or indirectly. To sell

directly, it advertises its stock issuance to potential buyers. This type of issuance is most common with privately held corporations. To sell indirectly, a corporation pays a brokerage house (investment banker) to issue its stock. Some brokerage houses underwrite an indirect issuance of stock; that is, they buy the stock from the corporation and take all gains or losses from its resale.

Market Value of Stock Market value per share is the price at which a stock is bought and sold. Expected future earnings, dividends, growth, and other company and economic factors influence market value. Traded stocks’ market values are available daily in newspapers such as The Wall Street Journal and online. The current market value of previously issued shares (for example, the price of stock in trades between investors) does not impact the issuing corporation’s stockholders’ equity.

Classes of Stock When all authorized shares have the same rights and characteristics, the stock is called common stock. A corporation is sometimes authorized to issue more than one class of stock, including preferred stock and different classes of common stock. American Greetings, for instance, has two types of common stock: Class A stock has 1 vote per share and Class B stock has 10 votes per share.

Par Value Stock Par value stock is stock that is assigned a par value, which is an amount assigned per share by the corporation in its charter. For example, Monster Worldwide, Inc.’s common stock has a par value of $0.001. Other commonly assigned par values are $10, $5, $1 and $0.01. There is no restriction on the assigned par value. In many states, the par value of a stock establishes minimum legal capital, which refers to the least amount that the buyers of stock must contribute to the corporation or be subject to paying at a future date. For example, if a corporation issues 1,000 shares of $10 par value stock, the corporation’s minimum legal capital in these states would be $10,000. Minimum legal capital is intended to protect a corporation’s creditors. Since creditors cannot demand payment from stockholders’ personal assets, their claims are limited to the corporation’s assets and any minimum legal capital. At liquidation, creditor claims are paid before any amounts are distributed to stockholders.

No-Par Value Stock No-par value stock, or simply no-par stock, is stock not assigned a value per share by the corporate charter. Its advantage is that it can be issued at any price with- out the possibility of a minimum legal capital deficiency.

Point: Managers are motivated to set a low par value when minimum legal capital or state issuance taxes are based on par value.

Point: Minimum legal capital was intended to protect creditors by requiring a minimum level of net assets.

Point: Par, no-par, and stated value do not set the stock’s market value.

Subcategories of Authorized Stock

Authorized

Authorized & Issued

Authorized, Issued and

Outstanding

The inner-most box shows that shares issued decline if a company buys back its stock previously issued.

Pricing Stock A prospectus accompanies a stock’s initial public offering (IPO), giving financial informa- tion about the company issuing the stock. A prospectus should help answer these questions to price an IPO: (1) Is the underwriter reliable? (2) Is there growth in revenues, profits, and cash flows? (3) What is manage- ment’s view of operations? (4) Are current owners selling? (5) What are the risks? ■

Decision Insight

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470 Chapter 11 Corporate Reporting and Analysis

Stated Value Stock Stated value stock is no-par stock to which the directors assign a “stated” value per share. Stated value per share becomes the minimum legal capital per share in this case.

Stockholders’ Equity A corporation’s equity is known as stockholders’ equity, also called shareholders’ equity or corpo- rate capital. Stockholders’ equity consists of (1) paid-in (or contributed) capital and (2) retained earnings; see Exhibit 11.3. Paid-in capital is the total amount of cash and other assets the corporation receives from its stockholders in exchange for its stock. Retained earnings is the cumulative net income (and loss) not distributed as dividends to its stockholders.

Point: Paid-in capital comes from stock-related transactions, whereas re- tained earnings comes from operations; if retained earnings has a debit balance, it is often titled Accumulated Deficit.

EXHIBIT 11.3 Equity Composition

Corporation

To ta

l P a id

-In C

a p

ita l

Common Stock

Normal bal.

Retained Earnings

Normal bal.

Normal bal.

Paid-In Capital in Excess of Par

1. Which of the following is not a characteristic of the corporate form of business? (a) Ease of capital accumulation, (b) Stockholder responsibility for corporate debts, (c) Ease in transferability of ownership rights, or (d) Double taxation.

2. Why is a corporation’s income said to be taxed twice? 3. Is it more common for a company to issue common stock with a par value of $10 or $.001?

Explain why.

Quick Check Answers — p. 491

Accounting for the issuance of common stock affects only paid-in (contributed) capital accounts; no retained earnings accounts are affected.

Issuing Par Value Stock Par value stock can be issued at par, at a premium (above par), or at a discount (below par). In each case, stock can be exchanged for either cash or noncash assets.

Issuing Par Value Stock at Par When common stock is issued at par value, we record amounts for both the asset(s) received and the par value stock issued. To illustrate, the entry to record Dillon Snowboards’ issuance of 30,000 shares of $10 par value stock for $300,000 cash on June 5, 2013, follows:

COMMON STOCK

Exhibit 11.4 shows the stockholders’ equity of Dillon Snowboards at year-end 2013 (its first year of operations) after income of $65,000 and no dividend payments.

Assets 5 Liabilities 1 Equity 1300,000 1300,000

June 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . 300,000

Issued 30,000 shares of $10 par value common stock at par.

P1 Record the issuance of corporate stock.

$10 par value 3 30,000 shares

Stock Quote The Target stock quote is interpreted as (left to right): Hi,  highest price in past 52 weeks; Lo,  lowest price in past 52 weeks; Sym, company exchange symbol; Div, dividends paid per share in past year; Yld %, dividend divided by closing price; PE, stock price per share divided by earnings per share; Vol mil., number (in millions) of shares traded; Hi, highest price for the day; Lo, lowest price for the day; Close, closing price for the day; Net Chg, change in closing price from prior day. ■

Decision Insight

52 Weeks Yld Vol Net

Hi Lo Sym Div % PE mil. Hi Lo Close Chg

58.95 45.28 TGT 1.20 2.07 13.5 668 58.06 57.40 57.63 20.30

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Chapter 11 Corporate Reporting and Analysis 471

EXHIBIT 11.4 Stockholders’ Equity for Stock Issued at Par

Stockholders’ Equity

Common Stock — $10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $365,000

Issuing Par Value Stock at a Premium A premium on stock occurs when a corpo- ration sells its stock for more than par (or stated) value. To illustrate, if Dillon Snowboards issues its $10 par value common stock at $12 per share, its stock is sold at a $2 per share pre- mium. The premium, known as paid-in capital in excess of par value, is reported as part of equity; it is not revenue and is not listed on the income statement. The entry to record Dillon Snowboards’ issuance of 30,000 shares of $10 par value stock for $12 per share on June 5, 2013, follows:

Point: A premium is the amount by which issue price exceeds par (or stated) value. It is recorded in the “Paid-In Capital in Excess of Par Value, Common Stock” account; also called “Additional Paid-In Capital, Common Stock.”

Assets 5 Liabilities 1 Equity 1360,000 1300,000

160,000

June 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . 300,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . 60,000

Sold and issued 30,000 shares of $10 par value common stock at $12 per share. [$12 issue price 2 $10 par value]

3 30,000 shares

$10 par value 3 30,000 shares

The Paid-In Capital in Excess of Par Value account is added to the par value of the stock in the equity section of the balance sheet as shown in Exhibit 11.5.

Point: The Paid-In Capital terminology is interchangeable with Contributed Capital.

EXHIBIT 11.5 Stockholders’ Equity for Stock Issued at a Premium

Stockholders’ Equity

Common Stock — $10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $425,000

Issuing Par Value Stock at a Discount A discount on stock occurs when a corpora- tion sells its stock for less than par (or stated) value. Most states prohibit the issuance of stock at a discount. In states that allow stock to be issued at a discount, its buyers usually become contingently liable to creditors for the discount. If stock is issued at a discount, the amount by which issue price is less than par is debited to a Discount on Common Stock account, a contra to the common stock account, and its balance is subtracted from the par value of stock in the eq- uity section of the balance sheet. This discount is not an expense and does not appear on the income statement.

Issuing No-Par Value Stock When no-par stock is issued and is not assigned a stated value, the amount the corporation re- ceives becomes legal capital and is recorded as Common Stock. This means that the entire pro- ceeds are credited to a no-par stock account. To illustrate, a corporation records its October 20 issuance of 1,000 shares of no-par stock for $40 cash per share as follows:

Point: Retained earnings can be negative, reflecting accumulated losses. Pandora Media had an accumulated deficit of $101 million at the start of 2012.

Assets 5 Liabilities 1 Equity 140,000 140,000

Oct. 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Common Stock, No-Par Value . . . . . . . . . . . . . . . . 40,000

Issued 1,000 shares of no-par value common stock at $40 per share. $40 issue price 3 1,000 no-par shares

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472 Chapter 11 Corporate Reporting and Analysis

Issuing Stated Value Stock When no-par stock is issued and assigned a stated value, its stated value becomes legal capital and is credited to a stated value stock account. Assuming that stated value stock is issued at an amount in excess of stated value (the usual case), the excess is credited to Paid-In Capital in Excess of Stated Value, Common Stock, which is reported in the stockholders’ equity section. To illustrate, a corporation that issues 1,000 shares of no-par common stock having a stated value of $40 per share in return for $50 cash per share records this as follows:

Assets 5 Liabilities 1 Equity 150,000 140,000

110,000

Oct. 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Common Stock, $40 Stated Value . . . . . . . . . . . . . . 40,000

Paid-In Capital in Excess of Stated Value, Common Stock . . . . . . . . . . . . . . . . . . . . . 10,000

Issued 1,000 shares of $40 per share stated value stock at $50 per share.

Frequency of Stock Types

Par 88% Stated 3%

No-Par 9%

[$50 issue price 2 $40 stated value] 3 1,000 shares

$40 stated value 3 1,000 shares

Issuing Stock for Noncash Assets A corporation can receive assets other than cash in exchange for its stock. (It can also assume liabilities on the assets received such as a mortgage on property received.) The corporation re- cords the assets received at their market values as of the date of the transaction. The stock given in exchange is recorded at its par (or stated) value with any excess recorded in the Paid-In Capital in Excess of Par (or Stated) Value account. (If no-par stock is issued, the stock is re- corded at the assets’ market value.) To illustrate, the entry to record receipt of land valued at $105,000 in return for issuance of 4,000 shares of $20 par value common stock on June 10 is

Point: Stock issued for noncash assets should be recorded at the market value of either the stock or the noncash asset, whichever is more clearly determinable.

Assets 5 Liabilities 1 Equity 1105,000 180,000

125,000

June 10 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000

Common Stock, $20 Par Value . . . . . . . . . . . . . . . . 80,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Exchanged 4,000 shares of $20 par value common stock for land.$105,000 asset value 2 $80,000 stock value

$20 par value 3 4,000 shares

A corporation sometimes gives shares of its stock to promoters in exchange for their ser vices in organizing the corporation, which the corporation records as Organization Expenses. The entry to record receipt of services valued at $12,000 in organizing the corporation in return for 600 shares of $15 par value common stock on June 5 is

Point: Any type of stock can be issued for noncash assets.

Assets 5 Liabilities 1 Equity 212,000 19,000 13,000

June 5 Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Common Stock, $15 Par Value . . . . . . . . . . . . . . . . 9,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Gave promoters 600 shares of $15 par value common stock in exchange for their services.

$12,000 services value 2 $9,000 stock value

$15 par value 3 600 shares

4. A company issues 7,000 shares of its $10 par value common stock in exchange for equipment valued at $105,000. The entry to record this transaction includes a credit to (a) Paid-In Capital in Excess of Par Value, Common Stock, for $35,000. (b) Retained Earnings for $35,000. (c) Common Stock, $10 Par Value, for $105,000.

5. What is a premium on stock issuance? 6. Who is protected by the minimum legal capital requirement?

Quick Check Answers — p. 491

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Chapter 11 Corporate Reporting and Analysis 473

Common Dividend Payable is a current liability. The date of record for the Z-Tech dividend is January 22. No formal journal entry is needed on the date of record. The February 1 date of payment requires an entry to record both the settlement of the liability and the reduction of the cash balance, as follows:

This section describes both cash and stock dividend transactions.

Cash Dividends The decision to pay cash dividends rests with the board of directors and involves more than evaluating the amounts of retained earnings and cash. The directors, for instance, may decide to keep the cash to invest in the corporation’s growth, to meet emergencies, to take advantage of unexpected opportunities, or to pay off debt. Alternatively, many corporations pay cash divi- dends to their stockholders at regular dates. These cash flows provide a return to investors and almost always affect the stock’s market value.

Accounting for Cash Dividends Dividend payment involves three important dates: declaration, record, and payment. Date of declara- tion is the date the directors vote to declare and pay a dividend. This cre- ates a legal liability of the corporation to its stockholders. Date of record is the future date specified by the directors for identifying those stock- holders listed in the corporation’s records to receive dividends. The date of record usually follows the date of declaration by at least two weeks. Persons who own stock on the date of record receive dividends. Date of payment is the date when the corporation makes payment; it follows the date of record by enough time to allow the corporation to arrange checks, money transfers, or other means to pay dividends. To illustrate, the entry to record a January 9 declaration of a $1 per share cash dividend by the directors of Z-Tech, Inc., with 5,000 outstanding shares is

DIVIDENDS

Percent of Corporations Paying Dividends

0% 20% 40% 60% 80% 100%

Cash Dividend to Preferred

Cash Dividend to Common

75%

22%

P2 Record transactions involving cash dividends, stock dividends, and stock splits.

Assets 5 Liabilities 1 Equity 15,000 25,000

Date of Declaration

Jan. 9 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Common Dividend Payable . . . . . . . . . . . . . . . . . . . 5,000

Declared $1 per common share cash dividend.1 $1 per share declared dividend 3 5,000 shares

1 An alternative entry is to debit Dividends instead of Retained Earnings. The balance in Dividends is then closed to Retained Earnings at the end of the reporting period. The effect is the same: Retained Earnings is decreased and a Dividend Payable is increased. For simplicity, all assignments in this chapter use the Retained Earnings account to record dividend declarations.

Assets 5 Liabilities 1 Equity 25,000 25,000

Date of Payment

Feb. 1 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . 5,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Paid $1 per common share cash dividend.

Point: The Retained Earnings Deficit account is also called Accumulated Deficit.

Point: It is often said a dividend is a distribution of retained earnings, but it is more precise to describe a dividend as a distribution of assets to satisfy stockholder claims.

Deficits and Cash Dividends A corporation with a debit (abnormal) balance for re- tained earnings is said to have a retained earnings deficit, which arises when a company incurs cumulative losses and/or pays more dividends than total earnings from current and prior years. A deficit is reported as a deduction on the balance sheet, as shown in Exhibit 11.6. Most states prohibit a corporation with a deficit from paying a cash dividend to its stockholders. This legal restriction is designed to protect creditors by preventing distribution of assets to stockholders when the company may be in financial difficulty.

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474 Chapter 11 Corporate Reporting and Analysis

Stock Dividends A stock dividend, declared by a corporation’s directors, is a distribution of additional shares of the corporation’s own stock to its stockholders without the receipt of any payment in return. Stock dividends and cash dividends are different. A stock dividend does not reduce assets and equity but instead transfers a portion of equity from retained earnings to contrib- uted capital.

Reasons for Stock Dividends Stock dividends exist for at least two reasons. First, directors are said to use stock dividends to keep the market price of the stock affordable. For example, if a corporation continues to earn income but does not issue cash dividends, the price of its common stock likely increases. The price of such a stock may become so high that it dis- courages some investors from buying the stock (especially in lots of 100 and 1,000). When a corporation has a stock dividend, it increases the number of outstanding shares and lowers the per share stock price. Another reason for a stock dividend is to provide evidence of manage- ment’s confidence that the company is doing well and will continue to do well.

Accounting for Stock Dividends A stock dividend affects the components of equity by transferring part of retained earnings to contributed capital accounts, sometimes described as capitalizing retained earnings. Accounting for a stock dividend depends on whether it is a small or large stock dividend. A small stock dividend is a distribution of 25% or less of pre- viously outstanding shares. It is recorded by capitalizing retained earnings for an amount equal to the market value of the shares to be distributed. A large stock dividend is a distribu- tion of more than 25% of previously outstanding shares. A large stock dividend is recorded by capitalizing retained earnings for the minimum amount required by state law governing the corporation. Most states require capitalizing retained earnings equal to the par or stated value of the stock. To illustrate stock dividends, we use the equity section of Quest’s balance sheet shown in Exhibit 11.7 just before its declaration of a stock dividend on December 31.

EXHIBIT 11.6 Stockholders’ Equity with a Deficit

Common stock — $10 par value, 5,000 shares authorized, issued, and outstanding . . . . . . . . . $50,000

Retained earnings deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000)

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,000

Point: Amazon.com has never declared a cash dividend.

Some state laws allow cash dividends to be paid by returning a portion of the capital contributed by stockholders. This type of dividend is called a liquidating cash dividend, or simply liquidating dividend, because it returns a part of the original investment back to the stockholders. This requires a debit entry to one of the contributed capital accounts instead of Retained Earnings at the declaration date.

7. What type of an account is the Common Dividend Payable account? 8. What three crucial dates are involved in the process of paying a cash dividend? 9. When does a dividend become a company’s legal obligation?

Quick Check Answers — p. 492

EXHIBIT 11.7 Stockholders’ Equity before Declaring a Stock Dividend

Stockholders’ Equity (before dividend)

Common stock — $10 par value, 15,000 shares authorized, 10,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $143,000

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Chapter 11 Corporate Reporting and Analysis 475

Recording a small stock dividend. Assume that Quest’s directors declare a 10% stock divi- dend on December 31. This stock dividend of 1,000 shares, computed as 10% of its 10,000 is- sued and outstanding shares, is to be distributed on January 20 to the stockholders of record on January 15. Since the market price of Quest’s stock on December 31 is $15 per share, this small stock dividend declaration is recorded as follows:

Point: Small stock dividends are recorded at market value.

Date of Declaration—Small Stock Dividend

Dec. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Common Stock Dividend Distributable . . . . . . . . . 10,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Declared a 1,000-share (10%) stock dividend.

Assets 5 Liabilities 1 Equity 215,000 110,000 15,000

10% dividend 3 10,000 issued shares 3 $10 par value

10% dividend 3 10,000 issued shares 3 [$15 market price 2 $10 par value]

The $10,000 credit in the declaration entry equals the par value of the shares and is recorded in Common Stock Dividend Distributable, an equity account. Its balance exists only until the shares are issued. The $5,000 credit equals the amount by which market value exceeds par value. This amount increases the Paid-In Capital in Excess of Par Value account in anticipa- tion of the issuance of shares. In general, the balance sheet changes in three ways when a stock dividend is declared. First, the amount of equity attributed to common stock increases; for Quest, from $100,000 to $110,000 for 1,000 additional declared shares. Second, paid-in capital in excess of par increases by the excess of market value over par value for the declared shares. Third, retained earnings decreases, reflecting the transfer of amounts to both common stock and paid-in capital in excess of par. The stockholders’ equity of Quest is shown in Exhibit 11.8 after its 10% stock dividend is declared on December 31—the items impacted are in bold.

Point: The term Distributable (not Payable) is used for stock dividends. A stock dividend is never a liability because it never reduces assets.

Point: The credit to Paid-In Capital in Excess of Par Value is recorded when the stock dividend is declared. This account is not affected when stock is later distributed.

Point: A stock dividend does not affect assets.

Assets 5 Liabilities 1 Equity 210,000 110,000

Date of Payment—Small Stock Dividend

Jan. 20 Common Stock Dividend Distributable . . . . . . . . . . . . . 10,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . 10,000

To record issuance of common stock dividend.

Point: Large stock dividends are recorded at par or stated value.

EXHIBIT 11.8 Stockholders’ Equity after Declaring a Stock Dividend

Stockholders’ Equity (after dividend)

Common stock — $10 par value, 15,000 shares authorized, 10,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Common stock dividend distributable —1,000 shares . . . . . . . . 10,000

Paid-in capital in excess of par value, common stock . . . . . . . . . 13,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $143,000

No entry is made on the date of record for a stock dividend. On January 20, the date of payment, Quest distributes the new shares to stockholders and records this entry:

The combined effect of these stock dividend entries is to transfer (or capitalize) $15,000 of re- tained earnings to paid-in capital accounts. The amount of capitalized retained earnings equals the market value of the 1,000 issued shares ($15 3 1,000 shares). A stock dividend has no effect on the ownership percent of individual stockholders.

Recording a large stock dividend. A corporation capitalizes retained earnings equal to the minimum amount required by state law for a large stock dividend. For most states, this amount is the par or stated value of the newly issued shares. To illustrate, suppose Quest’s board de- clares a stock dividend of 30% instead of 10% on December 31. Since this dividend is more

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476 Chapter 11 Corporate Reporting and Analysis

than 25%, it is treated as a large stock dividend. Thus, the par value of the 3,000 dividend shares is capitalized at the date of declaration with this entry:

This transaction decreases retained earnings and increases contributed capital by $30,000. On the date of payment the company debits Common Stock Dividend Distributable and credits Common Stock for $30,000. The effects from a large stock dividend on balance sheet accounts are similar to those for a small stock dividend except for the absence of any effect on paid-in capital in excess of par.

Stock Splits A stock split is the distribution of additional shares to stockholders according to their percent owner- ship. When a stock split occurs, the corporation “calls in” its outstanding shares and issues more than one new share in exchange for each old share. Splits can be done in any ratio, including 2-for-1, 3-for-1, or higher. In 2012, Google directors approved a 2-for-1 stock split. Stock splits reduce the par or stated value per share. The reasons for stock splits are similar to those for stock dividends. To illustrate, CompTec has 100,000 outstanding shares of $20 par value common stock with a current market value of $88 per share. A 2-for-1 stock split cuts par value in half as it replaces 100,000 shares of $20 par value stock with 200,000 shares of $10 par value stock. Market value is reduced from $88 per share to about $44 per share. The split does not affect any equity amounts reported on the balance sheet or any individual stockholder’s percent ownership. Both the Paid-In Capital and Retained Earnings accounts are unchanged by a split, and no journal entry is made. The only effect on the accounts is a change in the stock account description. CompTec’s 2-for-1 split on its $20 par value stock means that after the split, it changes its stock account title to Com- mon Stock, $10 Par Value. This stock’s description on the balance sheet also changes to reflect the additional authorized, issued, and outstanding shares and the new par value. The difference between stock splits and large stock dividends is often blurred. Many companies report stock splits in their financial statements without calling in the original shares by simply changing their par value. This type of “split” is really a large stock dividend and results in additional shares issued to stockholders by capitalizing retained earnings or transferring other paid-in capital to Common Stock. This approach avoids administrative costs of splitting the stock. Harley- Davidson recently declared a 2-for-1 stock split executed in the form of a 100% stock dividend.Point: A reverse stock split is the

opposite of a stock split. It increases both the market value per share and the par or stated value per share with a split ratio less than 1-for-1, such as 1-for-2. A reverse split results in fewer shares. Markets often read bad news into reverse splits.

Point: Berkshire Hathaway has resisted a stock split. Its recent stock price was $120,000 per share.

STOCK

Before 5;;1 Split: 1 share, $50 par

After 5;1 Split: 5 shares, $10 par

STOCK

Assets 5 Liabilities 1 Equity 230,000 130,000

Date of Declaration—Large Stock Dividend

Dec. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Common Stock Dividend Distributable . . . . . . . . . 30,000

Declared a 3,000-share (30%) stock dividend.

30% dividend 3 10,000 issued shares 3 $10 par value

10. How does a stock dividend impact assets and retained earnings? 11. What distinguishes a large stock dividend from a small stock dividend? 12. What amount of retained earnings is capitalized for a small stock dividend?

Quick Check Answers — p. 492

A corporation can issue two basic kinds of stock, common and preferred. Preferred stock has special rights that give it priority (or senior status) over common stock in one or more areas. Spe- cial rights typically include a preference for receiving dividends and for the distribution of assets if the corporation is liquidated. Preferred stock carries all rights of common stock unless the

PREFERRED STOCK

C2 Explain characteristics of, and distribute dividends between, common and preferred stock.

Entrepreneur A company you cofounded and own stock in announces a 50% stock dividend. Has the value of your stock investment increased, decreased, or remained the same? Would it make a difference if it was a 3-for-2 stock split executed in the form of a dividend? ■ [Answer—p. 491]

Decision Maker

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Chapter 11 Corporate Reporting and Analysis 477

corporate charter nullifies them. Most preferred stock, for instance, does not confer the right to vote. Exhibit 11.9 shows that preferred stock is issued by about one-fourth of corporations. All corporations issue common stock. (While rare, not all common stock carries voting rights; Google’s C class common shares are non-voting.)

Issuance of Preferred Stock Preferred stock usually has a par value. Like common stock, it can be sold at a price different from par. Preferred stock is recorded in its own separate capital accounts. To illustrate, if Dillon Snowboards issues 50 shares of $100 par value preferred stock for $6,000 cash on July 1, 2013, the entry is

EXHIBIT 11.9 Corporations and Preferred StockNo

Preferred Stock 73%

Issued Preferred

Stock 27%

Assets 5 Liabilities 1 Equity 16,000 15,000

11,000

July 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Preferred Stock, $100 Par Value . . . . . . . . . . . . . . . 5,000

Paid-In Capital in Excess of Par Value, Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Issued preferred stock for cash. $6,000 cash 2 [$100 par value 3 50 shares]

$100 par value 3 50 shares

The equity section of the year-end balance sheet for Dillon Snowboards, including preferred stock, is shown in Exhibit 11.10. (This exhibit assumes that common stock was issued at par.) Issuing no-par preferred stock is similar to issuing no-par common stock. Also, the entries for issuing preferred stock for noncash assets are similar to those for common stock.

Dividend Preference of Preferred Stock Preferred stock usually carries a preference for dividends, meaning that preferred stockholders are allocated their dividends before any dividends are allocated to common stockholders. The dividends allocated to preferred stockholders are usually expressed as a dollar amount per share or a percent applied to par value. A preference for dividends does not ensure dividends. If the directors do not declare a dividend, neither the preferred nor the common stockholders receive one.

Cumulative or Noncumulative Dividend Most preferred stocks carry a cumulative dividend right. Cumulative preferred stock has a right to be paid both the current and all prior periods’ unpaid dividends before any dividend is paid to common stockholders. When preferred stock is cumulative and the directors either do not declare a dividend to preferred stockholders or declare one that does not cover the total amount of cumulative dividend, the unpaid dividend amount is called dividend in arrears. Accumulation of dividends in arrears on cumulative preferred stock does not guarantee they will be paid. Noncumulative preferred stock confers no right to prior periods’ unpaid dividends if they were not declared in those prior periods. To illustrate the difference between cumulative and noncumulative preferred stock, assume that a corporation’s outstanding stock includes (1) 1,000 shares of $100 par, 9% preferred

EXHIBIT 11.10 Stockholders’ Equity with Common and Preferred Stock

Stockholders’ Equity

Common stock—$10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Preferred stock—$100 par value; 1,000 shares authorized;

50 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Paid-in capital in excess of par value, preferred stock . . . . . . . . . . . . . . 1,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $371,000

Point: Dividend preference does not imply that preferred stockholders receive more dividends than common stockholders, nor does it guarantee a dividend.

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478 Chapter 11 Corporate Reporting and Analysis

stock—yielding $9,000 per year in potential dividends, and (2) 4,000 shares of $50 par value common stock. During 2012, the first year of operations, the directors declare cash dividends of $5,000. In year 2013, they declare cash dividends of $42,000. See Exhibit 11.11 for the allocation of dividends for these two years. Allocation of year 2013 dividends depends on whether the preferred stock is noncumulative or cumulative. With noncumulative preferred, the preferred stockholders never receive the $4,000 skipped in 2012. If the preferred stock is cumulative, the $4,000 in arrears is paid in 2013 before any other dividends are paid.

A liability for a dividend does not exist until the directors declare a dividend. If a preferred dividend date passes and the corporation’s board fails to declare the dividend on its cumulative preferred stock, the dividend in arrears is not a liability. The full-disclosure principle requires a corporation to report (usually in a note) the amount of preferred dividends in arrears as of the balance sheet date.

Participating or Nonparticipating Dividend Nonparticipating preferred stock has a feature that limits dividends to a maximum amount each year. This maximum is often stated as a percent of the stock’s par value or as a specific dollar amount per share. Once pre- ferred stockholders receive this amount, the common stockholders receive any and all additional dividends. Participating preferred stock has a feature allowing preferred stockholders to share with common stockholders in any dividends paid in excess of the percent or dollar amount stated on the preferred stock. This participation feature does not apply until common stockhold- ers receive dividends equal to the preferred stock’s dividend percent. Many corporations are authorized to issue participating preferred stock but rarely do, and most managers never expect to issue it.2

Convertible Preferred Stock Preferred stock is more attractive to investors if it carries a right to exchange preferred shares for a fixed number of common shares. Convertible preferred stock gives holders the option to

2 Participating preferred stock is usually authorized as a defense against a possible corporate takeover by an “un- friendly” investor (or a group of investors) who intends to buy enough voting common stock to gain control. Taking a term from spy novels, the financial world refers to this type of plan as a poison pill that a company swallows if enemy investors threaten its capture. A poison pill usually works as follows: A corporation’s common stockholders on a given date are granted the right to purchase a large amount of participating preferred stock at a very low price. This right to purchase preferred shares is not transferable. If an unfriendly investor buys a large block of common shares (whose right to purchase participating preferred shares does not transfer to this buyer), the board can issue preferred shares at a low price to the remaining common shareholders who retained the right to purchase. Future dividends are then divided between the newly issued participating preferred shares and the common shares. This usually transfers value from common shares to preferred shares, causing the unfriendly investor’s common stock to lose much of its value and reduces the potential benefit of a hostile takeover.

EXHIBIT 11.11 Allocation of Dividends (noncumulative vs. cumulative preferred stock)

Preferred Common

Preferred Stock Is Noncumulative

Year 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 0

Year 2013

Step 1: Current year’s preferred dividend . . . . . . . . $ 9,000

Step 2: Remainder to common . . . . . . . . . . . . . . . . . $33,000

Preferred Stock Is Cumulative

Year 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 0

Year 2013

Step 1: Dividend in arrears . . . . . . . . . . . . . . . . . . . . $ 4,000

Step 2: Current year’s preferred dividend . . . . . . . . 9,000

Step 3: Remainder to common . . . . . . . . . . . . . . . . . $29,000

Totals for year 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000 $29,000

Example: What dividends do cumulative preferred stockholders receive in 2013 if the corporation paid only $2,000 of dividends in 2012? How does this affect dividends to common stockholders in 2013? Answers: $16,000 ($7,000 dividends in arrears, plus $9,000 current preferred dividends). Dividends to common stockholders decrease to $26,000.

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Chapter 11 Corporate Reporting and Analysis 479

exchange their preferred shares for common shares at a specified rate. When a company pros- pers and its common stock increases in value, convertible preferred stockholders can share in this success by converting their preferred stock into more valuable common stock.

Callable Preferred Stock Callable preferred stock gives the issuing corporation the right to purchase (retire) this stock from its holders at specified future prices and dates. The amount paid to call and retire a pre- ferred share is its call price, or redemption value, and is set when the stock is issued. The call price normally includes the stock’s par value plus a premium giving holders additional return on their investment. When the issuing corporation calls and retires a preferred stock, the terms of the agreement often require it to pay the call price and any dividends in arrears.

Point: The issuing corporation has the right, or option, to retire its callable preferred stock.

IFRS Like U.S. GAAP, IFRS requires that preferred stocks be classified as debt or equity based on analysis of the stock’s contractual terms. However, IFRS uses different criteria for such classification. ■

Reasons for Issuing Preferred Stock Corporations issue preferred stock for several reasons. One is to raise capital without sacrificing control. For example, suppose a company’s organizers have $100,000 cash to invest and orga- nize a corporation that needs $200,000 of capital to start. If they sell $200,000 worth of com- mon stock (with $100,000 to the organizers), they would have only 50% control and would need to negotiate extensively with other stockholders in making policy. However, if they issue $100,000 worth of common stock to themselves and sell outsiders $100,000 of 8%, cumulative preferred stock with no voting rights, they retain control. A second reason to issue preferred stock is to boost the return earned by common stock- holders. To illustrate, suppose a corporation’s organizers expect to earn an annual after-tax income of $24,000 on an investment of $200,000. If they sell and issue $200,000 worth of common stock, the $24,000 income produces a 12% return on the $200,000 of common stockholders’ equity. However, if they issue $100,000 of 8% preferred stock to outsiders and $100,000 of common stock to themselves, their own return increases to 16% per year, as shown in Exhibit 11.12.

EXHIBIT 11.12 Return to Common Stockholders When Preferred Stock Is Issued

Net (after-tax) income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,000

Less preferred dividends at 8% . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,000)

Balance to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . $16,000

Return to common stockholders ($16,000y$100,000) . . . . . . . . 16%

Point: Financial leverage also occurs when debt is issued and the interest rate paid on it is less than the rate earned from using the assets the creditors lend the company.

Common stockholders earn 16% instead of 12% because assets contributed by preferred stockholders are invested to earn $12,000 while the preferred dividend is only $8,000. Use of preferred stock to increase return to common stockholders is an example of financial leverage (also called trading on the equity). As a general rule, when the dividend rate on preferred stock is less than the rate the corporation earns on its assets, the effect of issuing preferred stock is to increase (or lever) the rate earned by common stockholders. Other reasons for issuing preferred stock include its appeal to some investors who believe that the corporation’s common stock is too risky or that the expected return on common stock is too low.

Concert Organizer Assume that you alter your business strategy from organizing concerts targeted at under 1,000 people to those targeted at between 5,000 to 20,000 people. You also incorporate because of increased risk of lawsuits and a desire to issue stock for financing. It is important that you control the company for decisions on whom to schedule. What types of stock do you offer? ■ [Answer—p. 491]

Decision Maker

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480 Chapter 11 Corporate Reporting and Analysis

Cyber then purchases 1,000 of its own shares for $11,500 on May 1, which is recorded as follows:

13. In what ways does preferred stock often have priority over common stock? 14. Increasing the return to common stockholders by issuing preferred stock is an example of

(a) Financial leverage. (b) Cumulative earnings. (c) Dividend in arrears. 15. A corporation has issued and outstanding (i) 9,000 shares of $50 par value, 10% cumulative,

nonparticipating preferred stock and (ii) 27,000 shares of $10 par value common stock. No dividends have been declared for the two prior years. During the current year, the corporation declares $288,000 in dividends. The amount paid to common shareholders is (a) $243,000. (b) $153,000. (c) $135,000.

Quick Check Answers — p. 492

Corporations acquire shares of their own stock for several reasons: (1) to use their shares to acquire another corporation, (2) to purchase shares to avoid a hostile takeover of the company, (3) to reissue them to employees as compensation, and (4) to maintain a strong market for their stock or to show management confidence in the current price.

A corporation’s reacquired shares are called treasury stock, which is similar to unis- sued stock in several ways: (1) neither treasury stock nor unissued stock is an asset, (2) neither receives cash dividends or stock dividends, and (3) neither allows the exercise of voting rights. However, treasury stock does differ from unissued stock in one major way: The corporation can resell treasury stock at less than par without having the buyers incur a liability, provided it was originally issued at par value or higher. Treasury stock purchases also require management to exercise ethical sensitivity because funds are being paid to specific stockholders instead of all stockholders. Managers must be sure the pur- chase is in the best interest of all stockholders. These concerns cause companies to fully disclose treasury stock transactions.

Purchasing Treasury Stock Purchasing treasury stock reduces the corporation’s assets and equity by equal amounts. (We describe the cost method of accounting for treasury stock, which is the most widely used method. The par value method is another method explained in advanced courses.) To illustrate, Exhibit 11.13 shows Cyber Corporation’s account balances before any treasury stock purchase (Cyber has no liabilities).

TREASURY STOCK

Corporations and Treasury Stock

With Treasury

Stock 62%

No Treasury Stock 38%

P3 Record purchases and sales of treasury stock and the retirement of stock.

EXHIBIT 11.13 Account Balances before Purchasing Treasury Stock

Assets Stockholders’ Equity

Cash . . . . . . . . . . . . . . $ 30,000 Common stock — $10 par; 10,000 shares

Other assets . . . . . . . . 95,000 authorized, issued, and outstanding . . . . . . . . . . . $100,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Total assets . . . . . . . . . $125,000 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . $125,000

Assets 5 Liabilities 1 Equity 211,500 211,500

May 1 Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Purchased 1,000 treasury shares at $11.50 per share.$11.50 cost per share 3 1,000 shares

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Chapter 11 Corporate Reporting and Analysis 481

The treasury stock purchase reduces Cyber’s cash, total assets, and total equity by $11,500 but does not reduce the balance of either the Common Stock or the Retained Earnings account. The equity reduction is reported by deducting the cost of treasury stock in the equity section. Also, two disclosures are evident. First, the stock description reveals that 1,000 issued shares are in treasury, leaving only 9,000 shares still outstanding. Second, the description for retained earn- ings reveals that it is partly restricted.

Reissuing Treasury Stock Treasury stock can be reissued by selling it at cost, above cost, or below cost.

Selling Treasury Stock at Cost If treasury stock is reissued at cost, the entry is the re- verse of the one made to record the purchase. For instance, if on May 21 Cyber reissues 100 of the treasury shares purchased on May 1 at the same $11.50 per share cost, the entry is

This entry reduces equity through the debit to the Treasury Stock account, which is a contra equity account. Exhibit 11.14 shows account balances after this transaction.

EXHIBIT 11.14 Account Balances after Purchasing Treasury Stock

Assets Stockholders’ Equity

Cash . . . . . . . . . . . $ 18,500 Common stock — $10 par; 10,000 shares

Other assets . . . . . 95,000 authorized and issued; 1,000 shares in treasury . . . . . . $100,000

Retained earnings, $11,500 restricted by treasury stock purchase . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Less cost of treasury stock . . . . . . . . . . . . . . . . . . . . . (11,500)

Total assets . . . . . . $113,500 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . $113,500

Point: The Treasury Stock account is not an asset. Treasury stock does not carry voting or dividend rights.

Point: Treasury stock does not represent ownership. A company cannot own a part of itself.

Assets 5 Liabilities 1 Equity 11,150 11,150

May 21 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,150

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . 1,150

Received $11.50 per share for 100 treasury shares costing $11.50 per share.

Point: The phrase treasury stock is believed to arise from the fact that reac- quired stock is held in a corporation’s treasury.

Point: The Paid-In Capital, Treasury Stock account can have a zero or credit balance but never a debit balance.

Selling Treasury Stock above Cost If treasury stock is sold for more than cost, the amount received in excess of cost is credited to the Paid-In Capital, Treasury Stock account. This account is reported as a separate item in the stockholders’ equity section. No gain is ever reported from the sale of treasury stock. To illustrate, if Cyber receives $12 cash per share for 400 treasury shares costing $11.50 per share on June 3, the entry is

Selling Treasury Stock below Cost When treasury stock is sold below cost, the en- try to record the sale depends on whether the Paid-In Capital, Treasury Stock account has a credit balance. If it has a zero balance, the excess of cost over the sales price is debited to Retained Earnings. If the Paid-In Capital, Treasury Stock account has a credit balance, it is debited for the excess of the cost over the selling price but not to exceed the balance in this account. When the credit balance in this paid-in capital account is eliminated, any remaining difference between the cost and selling price is debited to Retained Earnings. To illustrate, if Cyber sells its remaining 500 shares of treasury stock at $10 per share on July 10, equity is

Point: A treasury stock purchase is also called a stock buyback.

June 3 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . 4,600

Paid-In Capital, Treasury Stock . . . . . . . . . . . . 200

Received $12 per share for 400 treasury shares costing $11.50 per share.

Assets 5 Liabilities 1 Equity 14,800 14,600

1200

[$12 issue price 2 $11.50 cost per share] 3 400 shares

$11.50 cost per share 3 400 shares

$11.50 cost per share 3 100 shares

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482 Chapter 11 Corporate Reporting and Analysis

reduced by $750 (500 shares 3 $1.50 per share excess of cost over selling price), as shown in this entry:

Assets 5 Liabilities 1 Equity 15,000 2200

2550 15,750

July 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Paid-In Capital, Treasury Stock . . . . . . . . . . . . . . . . 200

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . 5,750

Received $10 per share for 500 treasury shares costing $11.50 per share.

This entry eliminates the $200 credit balance in the paid-in capital account created on June 3 and then reduces the Retained Earnings balance by the remaining $550 excess of cost over selling price. A company never reports a loss (or gain) from the sale of treasury stock.

Retiring Stock A corporation can purchase its own stock and retire it. Retiring stock reduces the number of issued shares. Retired stock is the same as authorized and unissued shares. Purchases and retirements of stock are permissible under state law only if they do not jeopardize the interests of creditors and stockholders. When stock is purchased for retirement, we remove all capital amounts related to the retired shares. If the purchase price exceeds the net amount removed, this excess is debited to Re- tained Earnings. If the net amount removed from all capital accounts exceeds the purchase price, this excess is credited to the Paid-In Capital from Retirement of Stock account. A company’s as- sets and equity are always reduced by the amount paid for the retiring stock.

Point: Recording stock retirement results in canceling the equity from the original issuance of the shares.

[$10 issue price 2 $11.50 cost per share] 3 500 shares; not to exceed $200

For any amount exceeding $200

$11.50 cost per share 3 500 shares

16. Purchase of treasury stock (a) has no effect on assets; (b) reduces total assets and total equity by equal amounts; or (c) is recorded with a debit to Retained Earnings.

17. Southern Co. purchases shares of Northern Corp. Should either company classify these shares as treasury stock?

18. How does treasury stock affect the authorized, issued, and outstanding shares? 19. When a company purchases treasury stock, (a) retained earnings are restricted by the amount

paid; (b) Retained Earnings is credited; or (c) it is retired.

Quick Check Answers — p. 492

Statement of Retained Earnings Retained earnings generally consist of a company’s cumulative net income less any net losses and dividends declared since its inception. Retained earnings are part of stockholders’ claims on the company’s net assets, but this does not imply that a certain amount of cash or other assets is available to pay stockholders. For example, Abercrombie & Fitch has $2,320,571 thousand in retained earnings, but only $583,495 thousand in cash. This section describes events and transactions affecting retained earnings and how retained earnings are reported.

Restrictions and Appropriations The term restricted retained earnings refers to both statutory and contractual restrictions. A common statutory (or legal) restriction is to limit treasury stock purchases to the amount of retained earnings. The balance sheet in Exhibit 11.14 provides an example. A common contractual restriction involves loan agreements that restrict paying dividends beyond a specified amount or percent of retained earnings. Restrictions are usually described in the notes. The term appropriated retained earnings refers to a voluntary

REPORTING OF EQUITY

C3 Explain the items reported in retained earnings.

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Chapter 11 Corporate Reporting and Analysis 483

Point: Accounting for changes in estimates is sometimes criticized as two wrongs to make a right. Consider a change in an asset’s life. Depreciation neither before nor after the change is the amount computed if the revised estimate were originally selected. Regulators chose this approach to avoid restating prior period numbers.

Many items reported in financial statements are based on estimates. Future events are certain to reveal that some of these estimates were inaccurate even when based on the best data avail- able at the time. These inaccuracies are not considered errors and are not reported as prior period adjustments. Instead, they are identified as changes in accounting estimates and are accounted for in current and future periods. To illustrate, we know that depreciation is based on estimated useful lives and salvage values. As time passes and new information becomes avail- able, managers may need to change these estimates and the resulting depreciation expense for current and future periods.

Closing Process The closing process was explained earlier in the book as: (1) Close credit balances in revenue accounts to Income Summary, (2) Close debit balances in expense accounts to Income Summary, and (3) Close Income Summary to Retained Earnings. If dividends are re- corded in a Dividends account, and not as an immediate reduction to Retained Earnings (as shown in this chapter), a fourth step is necessary to close the Dividends account to Retained Earnings.

Statement of Stockholders’ Equity Instead of a separate statement of retained earnings, companies commonly report a statement of stockholders’ equity that includes changes in retained earnings. A statement of stockholders’ equity lists the beginning and ending balances of key equity accounts and describes the changes that occur during the period. The companies in Appendix A report such a statement. The usual format is to provide a column for each component of equity and use the rows to describe events occurring in the period. Exhibit 11.16 shows a condensed statement for Apple.

Reporting Stock Options The majority of corporations whose shares are publicly traded issue stock options, which are rights to purchase common stock at a fixed price over a specified period. As the stock’s price rises, the option’s value increases. Starbucks and Home Depot offer stock options to both full- and part-time employees. Stock options are said to motivate managers and employees to (1) focus on company performance, (2) take a long-run perspective, and (3) remain with the company. A stock option is like having an investment with no risk (“a carrot with no stick”).

transfer of amounts from the Retained Earnings account to the Appropriated Retained Earnings account to inform users of special activities that require funds.

Prior Period Adjustments Prior period adjustments are corrections of material errors in prior period financial statements. These errors include arithmetic mistakes, unacceptable ac- counting, and missed facts. Prior period adjustments are reported in the statement of retained earnings (or the statement of stockholders’ equity), net of any income tax effects. Prior period adjustments result in changing the beginning balance of retained earnings for events occurring prior to the earliest period reported in the current set of financial statements. To illustrate, as- sume that ComUS makes an error in a 2011 journal entry for the purchase of land by incorrectly debiting an expense account. When this is discovered in 2013, the statement of retained earn- ings includes a prior period adjustment, as shown in Exhibit 11.15. This exhibit also shows the usual format of the statement of retained earnings.

Point: If a year 2011 error is discovered in 2012, the company records the adjustment in 2012. But if the finan- cial statements include 2011 and 2012 figures, the statements report the correct amounts for 2011, and a note describes the correction.

ComUS

Statement of Retained Earnings

For Year Ended December 31, 2013

Retained earnings, Dec. 31, 2012, as previously reported . . . . . . . . . . . . . . . . . . . . . . . . . $4,745,000

Prior period adjustment

Cost of land incorrectly expensed (net of $63,000 income taxes) . . . . . . . . . 147,000

Retained earnings, Dec. 31, 2012, as adjusted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,892,000

Plus net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,224,300

Less cash dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (301,800)

Retained earnings, Dec. 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,814,500

EXHIBIT 11.15 Statement of Retained Earnings with a Prior Period Adjustment

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484 Chapter 11 Corporate Reporting and Analysis

To illustrate, Quantum grants each of its employees the option to purchase 100 shares of its $1 par value common stock at its current market price of $50 per share anytime within the next 10 years. If the stock price rises to $70 per share, an employee can exercise the option at a gain of $20 per share (acquire a $70 stock at the $50 option price). With 100 shares, a single employee would have a total gain of $2,000, computed as $20 3 100 shares. Companies report the cost of stock options in the income statement. Measurement of this cost is explained in advanced courses.

EXHIBIT 11.16 Statement of Stockholders’ Equity

APPLE

Statement of Stockholders’ Equity

Common Common

Stock Stock Retained Total

($ millions, shares in thousands) Shares Amount Earnings Other Equity

Balance, Sept. 25, 2010 . . . . . . . . . . . . . . . . 915,970 $10,668 $37,169 $ (46) $47,791

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — 25,922 — 25,922

Issuance of Common Stock . . . . . . . . . . . . . . . 13,307 1,729 (250) — 1,479

Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 934 — 489 1,423

Cash Dividends ($0.00 per share) . . . . . . . . . . — — — — —

Balance, Sept. 24, 2011 . . . . . . . . . . . . . . . . 929,277 $13,331 $62,841 $443 $76,615

This section discusses similarities and differences between U.S. GAAP and IFRS in accounting and reporting for equity.

Accounting for Common Stock The accounting for and reporting of common stock under U.S. GAAP and IFRS are similar. Specifically, procedures for issuing common stock at par, at a premium, at a discount, and for noncash assets are similar across the two systems. However, we must be aware of legal and cultural differences across the world that can impact the rights and responsibilities of common share- holders. Piaggio’s terminology is a bit different as it uses the phrase “share capital” in reference to what U.S. GAAP would title “common shares” (see Appendix A).

Accounting for Dividends Accounting for and reporting of dividends under U.S. GAAP and IFRS are consistent. This applies to cash dividends, stock dividends, and stock splits. For Piaggio, a “the company will pay a dividend equal to 0.082 Euro . . . for all ordinary shares.” Piaggio, like many other companies, follows a dividend policy set by management and its board.

Accounting for Preferred Stock Accounting and reporting for preferred stock are similar for U.S. GAAP and IFRS, but there are some important differences. First, preferred stock that is redeemable at the option of the preferred stockholders is reported between liabilities and equity in U.S. GAAP balance sheets. However, that same stock is reported as a liability in IFRS balance sheets. Second, the issue price of convertible preferred stock (and bonds) is recorded entirely under preferred stock (or bonds) and none is assigned to the conversion feature under U.S. GAAP. However, IFRS requires that a portion of the issue price be allocated to the conversion feature when it exists. Piaggio has no preferred stock.

Accounting for Treasury Stock Both U.S. GAAP and IFRS apply the principle that companies do not record gains or losses on transactions involving their own stock. This applies to purchases, reissuances, and retirements of treasury stock. Consequently, the accounting for treasury stock explained in this chapter is consistent with that under IFRS. However, IFRS in this area is less detailed than that of U.S. GAAP.

GLOBAL VIEW

Apple

Pump ’n Dump Fraudulent information can be used by the owners of a company’s stock to pump it up and claim it is undervalued, which causes naïve investors to seek to acquire the stock and drive up its price. After that, those behind the release of fraudulent information dump the stock at an inflated price. When later information reveals that the stock is overvalued, its price declines and investors still holding the stock lose value. This scheme is called pump ’n dump. Jonathan Lebed, at 15 years old, is one of the most infamous cases of pump ’n dump, in which he allegedly made about $1 million. ■

Decision Insight

PIAGGIO

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Chapter 11 Corporate Reporting and Analysis 485

Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per Share

Decision Analysis

A1 Compute earnings per share and describe its use.

A2 Compute price-earnings ratio and describe its use in analysis.

Earnings per Share The income statement reports earnings per share, also called EPS or net income per share, which is the amount of income earned per each share of a company’s outstanding common stock. The basic earnings per share formula is shown in Exhibit 11.17. When a company has no preferred stock, then preferred dividends are zero. The weighted-average common shares outstanding is measured over the income reporting period; its computation is explained in advanced courses.

To illustrate, assume that Quantum Co. earns $40,000 net income in 2013 and declares dividends of $7,500 on its noncumulative preferred stock. (If preferred stock is noncumulative, the income available [numerator] is the current period net income less any preferred dividends declared in that same period. If preferred stock is cumulative, the income available [numerator] is the current period net income less the preferred dividends whether declared or not.) Quantum has 5,000 weighted-average common shares outstanding during 2013. Its basic EPS3 is

EXHIBIT 11.17 Basic Earnings per ShareBasic earnings per share 5

Net income 2 Preferred dividends Weighted-average common shares outstanding

Basic earnings per share 5 $40,000 2 $7,500

5,000 shares 5 $6.50

3 A corporation can be classified as having either a simple or complex capital structure. The term simple capital struc- ture refers to a company with only common stock and nonconvertible preferred stock outstanding. The term complex capital structure refers to companies with dilutive securities. Dilutive securities include options, rights to purchase common stock, and any bonds or preferred stock that are convertible into common stock. A company with a complex capital structure must often report two EPS figures: basic and diluted. Diluted earnings per share is computed by adding all dilutive securities to the denominator of the basic EPS computation. It reflects the decrease in basic EPS assuming that all dilutive securities are converted into common shares.

EXHIBIT 11.18 Price-Earnings RatioPrice-earnings ratio 5

Market value (price) per share

Earnings per share

Price-Earnings Ratio A stock’s market value is determined by its expected future cash flows. A comparison of a company’s EPS and its market value per share reveals information about market expectations. This comparison is traditionally made using a price-earnings (or PE) ratio, expressed also as price earnings, price to earn- ings, or PE. Some analysts interpret this ratio as what price the market is willing to pay for a company’s current earnings stream. Price-earnings ratios can differ across companies that have similar earnings because of either higher or lower expectations of future earnings. The price-earnings ratio is defined in Exhibit 11.18.

Point: The average PE ratio of stocks in the 1950 – 2012 period is about 14.

Point: Average PE ratios for U.S. stocks increased over the past two decades. Some analysts interpret this as a signal the market is overpriced. But higher ratios can at least partly reflect accounting changes that have reduced reported earnings.

This ratio is often computed using EPS from the most recent period (for Amazon, its PE is 138; for Altria, its PE is 19). However, many users compute this ratio using expected EPS for the next period. Some analysts view stocks with high PE ratios (higher than 20 to 25) as more likely to be overpriced and stocks with low PE ratios (less than 5 to 8) as more likely to be underpriced. These investors prefer to sell or avoid buying stocks with high PE ratios and to buy or hold stocks with low PE ratios. However, investment decision making is rarely so simple as to rely on a single ratio. For instance, a stock with a high PE ratio can prove to be a good investment if its earnings continue to increase beyond current expectations. Similarly, a stock with a low PE ratio can prove to be a poor investment if its earnings decline below expectations.

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486 Chapter 11 Corporate Reporting and Analysis

Dividend Yield Investors buy shares of a company’s stock in anticipation of receiving a return from either or both cash dividends and stock price increases. Stocks that pay large dividends on a regular basis, called income stocks, are attractive to investors who want recurring cash flows from their investments. In contrast, some stocks pay little or no dividends but are still attractive to investors because of their expected stock price increases. The stocks of companies that distribute little or no cash but use their cash to finance expansion are called growth stocks. One way to help identify whether a stock is an income stock or a growth stock is to analyze its dividend yield. Dividend yield, defined in Exhibit 11.19, shows the annual amount of cash dividends distributed to common shares relative to their market value.

A3 Compute dividend yield and explain its use in analysis.

EXHIBIT 11.19 Dividend Yield Dividend yield 5

Annual cash dividends per share

Market value per share

Dividend yield can be computed for current and prior periods using actual dividends and stock prices and for future periods using expected values. Exhibit 11.20 shows recent dividend and stock price data for Amazon and Altria Group to compute dividend yield.

EXHIBIT 11.20 Dividend and Stock Price Information

Cash Dividends Market Value

Company per Share per Share Dividend Yield

Amazon . . . . . . . . . . . . $0.00 $189 0.0%

Altria Group. . . . . . . . . 1.64 32 5.3

Point: The payout ratio equals cash dividends declared on common stock divided by net income. A low payout ratio suggests that a company is retaining earnings for future growth.

A4 Compute book value and explain its use in analysis.

Dividend yield is zero for Amazon, implying it is a growth stock. An investor in Amazon would look for increases in stock prices (and eventual cash from the sale of stock). Altria has a dividend yield of 5.3%, implying it is an income stock for which dividends are important in assessing its value.

Book Value per Share Case 1: Common Stock (Only) Outstanding. Book value per common share, defined in Exhibit 11.21, reflects the amount of equity applicable to common shares on a per share basis. To illustrate, we use Dillon Snowboards’ data from Exhibit 11.4. Dillon has 30,000 outstanding common shares, and the stockhold- ers’ equity applicable to common shares is $365,000. Dillon’s book value per common share is $12.17, computed as $365,000 divided by 30,000 shares.

EXHIBIT 11.22 Book Value per Preferred Share Book value per preferred share 5

Stockholders’ equity applicable to preferred shares

Number of preferred shares outstanding

EXHIBIT 11.21 Book Value per Common Share Book value per common share 5

Stockholders’ equity applicable to common shares

Number of common shares outstanding

Point: Book value per share is also referred to as stockholders’ claim to assets on a per share basis.

Case 2: Common and Preferred Stock Outstanding. To compute book value when both common and pre- ferred shares are outstanding, we allocate total equity between the two types of shares. The book value per preferred share is computed first; its computation is shown in Exhibit 11.22.

The equity applicable to preferred shares equals the preferred share’s call price (or par value if the preferred is not callable) plus any cumulative dividends in arrears. The remaining equity is the portion applicable to common shares. To illustrate, consider LTD’s equity in Exhibit 11.23. Its preferred stock is callable at $108 per share, and two years of cumulative preferred dividends are in arrears.

Money Manager You plan to invest in one of two companies identified as having identical future prospects. One has a PE of 19 and the other a PE of 25. Which do you invest in? Does it matter if your estimate of PE for these two companies is 29 as opposed to 22? ■ [Answer—p. 491]

Decision Maker

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Chapter 11 Corporate Reporting and Analysis 487

The book value computations are in Exhibit 11.24. Equity is first allocated to preferred shares before the book value of common shares is computed.

Book value per share reflects the value per share if a company is liquidated at balance sheet amounts. Book value is also the starting point in many stock valuation models, merger negotiations, price setting for public utilities, and loan contracts. The main limitation in using book value is the potential difference between recorded value and market value for assets and liabilities. Investors often adjust their analysis for estimates of these differences.

EXHIBIT 11.23 Stockholders’ Equity with Preferred and Common Stock

Stockholders’ Equity

Preferred stock — $100 par value, 7% cumulative, 2,000 shares authorized, 1,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . $100,000

Common stock — $25 par value, 12,000 shares authorized, 10,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $447,000

EXHIBIT 11.24 Computing Book Value per Preferred and Common Share

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $447,000

Less equity applicable to preferred shares

Call price (1,000 shares 3 $108) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,000

Dividends in arrears ($100,000 3 7% 3 2 years) . . . . . . . . . . . . . . . . . . . . . 14,000 (122,000)

Equity applicable to common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $325,000

Book value per preferred share ($122,000y1,000 shares) . . . . . . . . . . $ 122.00

Book value per common share ($325,000y10,000 shares) . . . . . . . . . $ 32.50

Barton Corporation began operations on January 1, 2012. The following transactions relating to stock- holders’ equity occurred in the first two years of the company’s operations.

2012

Jan. 1 Authorized the issuance of 2 million shares of $5 par value common stock and 100,000 shares of $100 par value, 10% cumulative, preferred stock.

Jan. 2 Issued 200,000 shares of common stock for $12 cash per share. Jan. 3 Issued 100,000 shares of common stock in exchange for a building valued at $820,000 and mer-

chandise inventory valued at $380,000. Jan. 4 Paid $10,000 cash to the company’s founders for organization activities. Jan. 5 Issued 12,000 shares of preferred stock for $110 cash per share.

2013

June 4 Issued 100,000 shares of common stock for $15 cash per share.

Required

1. Prepare journal entries to record these transactions. 2. Prepare the stockholders’ equity section of the balance sheet as of December 31, 2012, and

December 31, 2013, based on these transactions. 3. Prepare a table showing dividend allocations and dividends per share for 2012 and 2013 assuming

Barton declares the following cash dividends: 2012, $50,000, and 2013, $300,000.

DEMONSTRATION PROBLEM 1

Investor You are considering investing in BMX, whose book value per common share is $4 and price per common share on the stock exchange is $7. From this information, are BMX’s net assets priced higher or lower than its recorded values? ■ [Answer—p. 491]

Decision Maker

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488 Chapter 11 Corporate Reporting and Analysis

4. Prepare the January 2, 2012, journal entry for Barton’s issuance of 200,000 shares of common stock for $12 cash per share assuming

a. Common stock is no-par stock without a stated value. b. Common stock is no-par stock with a stated value of $10 per share.

PLANNING THE SOLUTION ● Record journal entries for the transactions for 2012 and 2013. ● Determine the balances for the 2012 and 2013 equity accounts for the balance sheet. ● Prepare the contributed capital portion of the 2012 and 2013 balance sheets. ● Prepare a table similar to Exhibit 11.11 showing dividend allocations for 2012 and 2013. ● Record the issuance of common stock under both specifications of no-par stock.

SOLUTION TO DEMONSTRATION PROBLEM 1 1. Journal entries.

2012

Jan. 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000

Common Stock, $5 Par Value . . . . . . . . . . . . . . . . . 1,000,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400,000

Issued 200,000 shares of common stock.

Jan. 3 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 820,000

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000

Common Stock, $5 Par Value . . . . . . . . . . . . . . . . . 500,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000

Issued 100,000 shares of common stock.

Jan. 4 Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Paid founders for organization costs.

Jan. 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Preferred Stock, $100 Par Value . . . . . . . . . . . . . . . 1,200,000

Paid-In Capital in Excess of Par Value, Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Issued 12,000 shares of preferred stock.

2013

June 4 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000

Common Stock, $5 Par Value . . . . . . . . . . . . . . . . . 500,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Issued 100,000 shares of common stock.

2. Balance sheet presentations (at December 31 year-end).

2013 2012

Stockholders’ Equity

Preferred stock — $100 par value, 10% cumulative, 100,000 shares authorized, 12,000 shares issued and outstanding . . . . . . . . . . . . . . . $1,200,000 $1,200,000

Paid-in capital in excess of par value, preferred stock . . . . . . . . . . . . . . . . . . . . 120,000 120,000

Total paid-in capital by preferred stockholders . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 1,320,000

Common stock — $5 par value, 2,000,000 shares authorized, 300,000 shares issued and outstanding in 2012, and 400,000 shares issued and outstanding in 2013 . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 1,500,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . . . . 3,100,000 2,100,000

Total paid-in capital by common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . 5,100,000 3,600,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,420,000 $4,920,000

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Chapter 11 Corporate Reporting and Analysis 489

3. Dividend allocation table.

Common Preferred

2012 ($50,000)

Preferred — current year (12,000 shares 3 $10 5 $120,000) . . . . . . . . . . . . $ 0 $ 50,000

Common — remainder (300,000 shares outstanding) . . . . . . . . . . . . . . . . . . . 0 0

Total for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 50,000

2013 ($300,000)

Preferred — dividend in arrears from 2012 ($120,000 2 $50,000) . . . . . . . . $ 0 $ 70,000

Preferred — current year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 120,000

Common — remainder (400,000 shares outstanding) . . . . . . . . . . . . . . . . . . . 110,000 0

Total for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $110,000 $190,000

Dividends per share

2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.00 $ 4.17

2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.28 $ 15.83

4. Journal entries. a. For 2012 (no-par stock without a stated value):

Jan. 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000

Common Stock, No-Par Value . . . . . . . . . . . . . . . . 2,400,000

Issued 200,000 shares of no-par common stock at $12 per share.

Jan. 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000

Common Stock, $10 Stated Value . . . . . . . . . . . . . . 2,000,000

Paid-In Capital in Excess of Stated Value, Common Stock . . . . . . . . . . . . . . . 400,000

Issued 200,000 shares of $10 stated value common stock at $12 per share.

b. For 2012 (no-par stock with a stated value):

DEMONSTRATION PROBLEM 2 Precision Company began year 2013 with the following balances in its stockholders’ equity accounts.

Common stock — $10 par, 500,000 shares authorized, 200,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . $2,000,000

Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . 1,000,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,000,000

All outstanding common stock was issued for $15 per share when the company was created. Prepare jour- nal entries to account for the following transactions during year 2013.

Jan. 10 The board declared a $0.10 cash dividend per share to shareholders of record Jan. 28. Feb. 15 Paid the cash dividend declared on January 10. Mar. 31 Declared a 20% stock dividend. The market value of the stock is $18 per share. May 1 Distributed the stock dividend declared on March 31. July 1 Purchased 30,000 shares of treasury stock at $20 per share. Sept. 1 Sold 20,000 treasury shares at $26 cash per share. Dec. 1 Sold the remaining 10,000 shares of treasury stock at $7 cash per share.

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490 Chapter 11 Corporate Reporting and Analysis

PLANNING THE SOLUTION ● Calculate the total cash dividend to record by multiplying the cash dividend declared by the number of

shares as of the date of record. ● Decide whether the stock dividend is a small or large dividend. Then analyze each event to determine

the accounts affected and the appropriate amounts to be recorded.

SOLUTION TO DEMONSTRATION PROBLEM 2

Jan. 10 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Common Dividend Payable . . . . . . . . . . . . . . . . . . . 20,000

Declared a $0.10 per share cash dividend.

Feb. 15 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . 20,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Paid $0.10 per share cash dividend.

Mar. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000

Common Stock Dividend Distributable . . . . . . . . . 400,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 320,000

Declared a small stock dividend of 20% or 40,000 shares; market value is $18 per share.

May 1 Common Stock Dividend Distributable . . . . . . . . . . . . . 400,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Distributed 40,000 shares of common stock.

July 1 Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Purchased 30,000 common shares at $20 per share.

Sept. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520,000

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . 400,000

Paid-In Capital, Treasury Stock . . . . . . . . . . . . . . . . 120,000

Sold 20,000 treasury shares at $26 per share.

Dec. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Paid-In Capital, Treasury Stock . . . . . . . . . . . . . . . . . . . . 120,000

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . 200,000

Sold 10,000 treasury shares at $7 per share.

C1 Identify characteristics of corporations and their organiza-tion. Corporations are legal entities whose stockholders are not liable for its debts. Stock is easily transferred, and the life of a corporation does not end with the incapacity of a stockholder. A cor- poration acts through its agents, who are its officers and managers. Corporations are regulated and subject to income taxes. Authorized stock is the stock that a corporation’s charter authorizes it to sell. Is- sued stock is the portion of authorized shares sold. Par value stock is a value per share assigned by the charter. No-par value stock is stock not assigned a value per share by the charter. Stated value stock is no-par stock to which the directors assign a value per share.

C2 Explain characteristics of, and distribute dividends be-tween, common and preferred stock. Preferred stock has a priority (or senior status) relative to common stock in one or more areas, usually (1) dividends and (2) assets in case of liquidation. Preferred stock usually does not carry voting rights and can be

Summary convertible or callable. Convertibility permits the holder to convert preferred to common. Callability permits the issuer to buy back preferred stock under specified conditions. Preferred stockholders usually hold the right to dividend distributions before common stockholders. When preferred stock is cumulative and in arrears, the amount in arrears must be distributed to preferred before any divi- dends are distributed to common.

C3 Explain the items reported in retained earnings. Stock-holders’ equity is made up of (1) paid-in capital and (2) re- tained earnings. Paid-in capital consists of funds raised by stock issuances. Retained earnings consists of cumulative net income (losses) not distributed. Many companies face statutory and con- tractual restrictions on retained earnings. Corporations can volun- tarily appropriate retained earnings to inform others about their disposition. Prior period adjustments are corrections of errors in prior financial statements.

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Chapter 11 Corporate Reporting and Analysis 491

A1 Compute earnings per share and describe its use. A company with a simple capital structure computes basic EPS by dividing net income less any preferred dividends by the weighted-average num- ber of outstanding common shares. A company with a complex capital structure must usually report both basic and diluted EPS.

A2 Compute price-earnings ratio and describe its use in analysis. A common stock’s price-earnings (PE) ratio is computed by dividing the stock’s market value (price) per share by its EPS. A stock’s PE is based on expectations that can prove to be better or worse than eventual performance.

A3 Compute dividend yield and explain its use in analysis. Dividend yield is the ratio of a stock’s annual cash dividends per share to its market value (price) per share. Dividend yield can be compared with the yield of other companies to determine whether the stock is expected to be an income or growth stock.

A4 Compute book value and explain its use in analysis. Book value per common share is equity applicable to common shares divided by the number of outstanding common shares. Book value per preferred share is equity applicable to preferred shares divided by the number of outstanding preferred shares.

P1 Record the issuance of corporate stock. When stock is is-sued, its par or stated value is credited to the stock account and any excess is credited to a separate contributed capital account. If a stock has neither par nor stated value, the entire proceeds are cred- ited to the stock account. Stockholders must contribute assets equal to minimum legal capital or be potentially liable for the deficiency.

P2 Record transactions involving cash dividends, stock dividends, and stock splits. Cash dividends involve three events. On the date of declaration, the directors bind the company to pay the dividend. A dividend declaration reduces retained earn- ings and creates a current liability. On the date of record, recipi- ents of the dividend are identified. On the date of payment, cash is paid to stockholders and the current liability is removed. Neither a stock dividend nor a stock split alters the value of the company. However, the value of each share is less due to the distribution of additional shares. The distribution of additional shares is accord- ing to individual stockholders’ ownership percent. Small stock dividends (#25%) are recorded by capitalizing retained earnings equal to the market value of distributed shares. Large stock divi- dends (.25%) are recorded by capitalizing retained earnings equal to the par or stated value of distributed shares. Stock splits do not necessitate journal entries but do necessitate changes in the description of stock.

P3 Record purchases and sales of treasury stock and the retirement of stock. When a corporation purchases its own previously issued stock, it debits the cost of these shares to Treasury Stock. Treasury stock is subtracted from equity in the balance sheet. If treasury stock is reissued, any proceeds in excess of cost are cred- ited to Paid-In Capital, Treasury Stock. If the proceeds are less than cost, they are debited to Paid-In Capital, Treasury Stock to the extent a credit balance exists. Any remaining amount is debited to Retained Earnings. When stock is retired, all accounts related to the stock are removed.

Entrepreneur The 50% stock dividend provides you no direct income. A stock dividend often reveals management’s optimistic ex- pectations about the future and can improve a stock’s marketability by making it affordable to more investors. Accordingly, a stock dividend usually reveals “good news” and because of this, it likely increases (slightly) the market value for your stock. The same con- clusions apply to the 3-for-2 stock split.

Concert Organizer You have two basic options: (1) different classes of common stock or (2) common and preferred stock. Your objective is to issue to yourself stock that has all or a majority of the voting power. The other class of stock would carry limited or no vot- ing rights. In this way, you maintain control and are able to raise the necessary funds.

Money Manager Since one company requires a payment of $19 for each $1 of earnings, and the other requires $25, you would prefer

the stock with the PE of 19; it is a better deal given identical pros- pects. You should make sure these companies’ earnings computations are roughly the same, for example, no extraordinary items, unusual events, and so forth. Also, your PE estimates for these companies do matter. If you are willing to pay $29 for each $1 of earnings for these companies, you obviously expect both to exceed current market expectations.

Investor Book value reflects recorded values. BMX’s book value is $4 per common share. Stock price reflects the market’s expectation of net asset value (both tangible and intangible items). BMX’s mar- ket value is $7 per common share. Comparing these figures suggests BMX’s market value of net assets is higher than its recorded values (by an amount of $7 versus $4 per share).

Guidance Answers to Decision Maker and Decision Ethics

1. (b) 2. A corporation pays taxes on its income, and its stockholders

normally pay personal income taxes (at the 15% rate or lower) on any cash dividends received from the corporation.

3. Companies desire to minimize the amount of legal capital. It is more likely that the par value of common stock will be $0.001 per share than $10 per share.

4. (a) 5. A stock premium is an amount in excess of par (or stated) value

paid by purchasers of newly issued stock. 6. Minimum legal capital intends to protect creditors of a corpora-

tion by obligating stockholders to some minimum level of equity financing and by constraining a corporation from exces- sive payments to stockholders.

Guidance Answers to Quick Checks

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492 Chapter 11 Corporate Reporting and Analysis

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 507 mhhe.com/wildFINMAN5e

2. A company reports net income of $75,000. Its weighted- average common shares outstanding is 19,000. It has no other stock outstanding. Its earnings per share is:

a. $4.69 b. $3.95 c. $3.75 d. $2.08 e. $4.41

1. A corporation issues 6,000 shares of $5 par value common stock for $8 cash per share. The entry to record this transaction includes:

a. A debit to Paid-In Capital in Excess of Par Value for $18,000.

b. A credit to Common Stock for $48,000. c. A credit to Paid-In Capital in Excess of Par Value for

$30,000. d. A credit to Cash for $48,000. e. A credit to Common Stock for $30,000.

7. Common Dividend Payable is a current liability account. 8. The date of declaration, date of record, and date of payment. 9. A dividend is a legal liability at the date of declaration, on

which date it is recorded as a liability. 10. A stock dividend does not transfer assets to stockholders, but it

does require an amount of retained earnings to be transferred to a contributed capital account(s).

11. A small stock dividend is 25% or less of the previous outstand- ing shares. A large stock dividend is more than 25%.

12. Retained earnings equal to the distributable shares’ market value should be capitalized for a small stock dividend.

13. Typically, preferred stock has a preference in receipt of divi- dends and in distribution of assets.

14. (a) 15. (b)

16. (b) 17. No. The shares are an investment for Southern Co. and are

issued and outstanding shares for Northern Corp. 18. Treasury stock does not affect the number of authorized or

issued shares, but it reduces the outstanding shares. 19. (a)

Total cash dividend . . . . . . . . . . . . . . . . . . . . . . $288,000

To preferred shareholders . . . . . . . . . . . . . . . . 135,000*

Remainder to common shareholders . . . . . . . . $153,000

* 9,000 3 $50 3 10% 3 3 years 5 $135,000.

Appropriated retained earnings (p. 482)

Authorized stock (p. 469)

Basic earnings per share (p. 485)

Book value per common share (p. 486)

Book value per preferred share (p. 486)

Call price (p. 479)

Callable preferred stock (p. 479)

Capital stock (p. 469)

Changes in accounting estimates (p. 483)

Common stock (p. 468)

Complex capital structure (p. 485)

Convertible preferred stock (p. 478)

Corporation (p. 466)

Cumulative preferred stock (p. 477)

Date of declaration (p. 473)

Date of payment (p. 473)

Date of record (p. 473)

Diluted earnings per share (p. 485)

Dilutive securities (p. 485)

Discount on stock (p. 471)

Dividend in arrears (p. 477)

Dividend yield (p. 486)

Earnings per share (EPS) (p. 485)

Financial leverage (p. 479)

Large stock dividend (p. 474)

Liquidating cash dividend (p. 474)

Market value per share (p. 469)

Minimum legal capital (p. 469)

Noncumulative preferred stock (p. 477)

Nonparticipating preferred stock (p. 478)

No-par value stock (p. 469)

Organization expenses (p. 467)

Paid-in capital (p. 470)

Paid-in capital in excess of par value (p. 471)

Participating preferred stock (p. 478)

Par value (p. 469)

Par value stock (p. 469)

Preemptive right (p. 468)

Preferred stock (p. 476)

Premium on stock (p. 471)

Price-earnings (PE) ratio (p. 485)

Prior period adjustments (p. 483)

Proxy (p. 467)

Restricted retained earnings (p. 482)

Retained earnings (p. 470)

Retained earnings deficit (p. 473)

Reverse stock split (p. 476)

Simple capital structure (p. 485)

Small stock dividend (p. 474)

Stated value stock (p. 470)

Statement of stockholders’ equity (p. 483)

Stock dividend (p. 474)

Stock options (p. 483)

Stock split (p. 476)

Stockholders’ equity (p. 470)

Treasury stock (p. 480)

Key Terms

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Chapter 11 Corporate Reporting and Analysis 493

3. A company has 5,000 shares of $100 par preferred stock and 50,000 shares of $10 par common stock outstanding. Its total stockholders’ equity is $2,000,000. Its book value per common share is:

a. $100.00 b. $ 10.00 c. $ 40.00 d. $ 30.00 e. $ 36.36 4. A company paid cash dividends of $0.81 per share. Its earnings

per share is $6.95 and its market price per share is $45.00. Its dividend yield is:

a. 1.8% b. 11.7%

c. 15.4% d. 55.6% e. 8.6% 5. A company’s shares have a market value of $85 per share.

Its net income is $3,500,000, and its weighted-average common shares outstanding is 700,000. Its price-earnings ratio is:

a. 5.9 b. 425.0 c. 17.0 d. 10.4 e. 41.2

1. What are organization expenses? Provide examples. 2. How are organization expenses reported? 3. Who is responsible for directing a corporation’s affairs? 4. What is the difference between authorized shares and outstand-

ing shares? 5. What is the preemptive right of common stockholders? 6. List the general rights of common stockholders. 7. What is the difference between the market value per share and

the par value per share? 8. What is the difference between the par value and the call price

of a share of preferred stock? 9. Why would an investor find convertible preferred stock

attractive? 10. Identify and explain the importance of the three dates relevant

to corporate dividends. 11. Why is the term liquidating dividend used to describe cash

dividends debited against paid-in capital accounts? 12. How does declaring a stock dividend affect the corpora-

tion’s assets, liabilities, and total equity? What are the effects of the eventual distribution of that stock?

13. What is the difference between a stock dividend and a stock split?

14. Courts have ruled that a stock dividend is not taxable in- come to stockholders. What justifies this decision?

15. How does the purchase of treasury stock affect the purchaser’s assets and total equity?

16. Why do laws place limits on treasury stock purchases? 17. How are EPS results computed for a corporation with a simple

capital structure? 18. What is a stock option? 19. How is book value per share computed for a corporation with

no preferred stock? What is the main limitation of using book value per share to value a corporation?

20. Refer to Polaris’ 2011 balance sheet in Appendix A. How many shares of common stock are autho- rized? How many shares of voting common stock are issued?

21. Refer to the 2011 balance sheet for Arctic Cat in Appendix A. What is the par value per share of its common stock? Suggest a rationale for the amount of par value it assigned.

22. Refer to the financial statements for Piaggio in Appendix A. How much were its cash payments for treasury stock purchases for the year ended December 31, 2011?

Discussion Questions

Icon denotes assignments that involve decision making.

Of the following statements, which are true for the corporate form of organization? 1. Ownership rights cannot be easily transferred. 2. Owners have unlimited liability for corporate debts. 3. Capital is more easily accumulated than with most other forms of organization. 4. Corporate income that is distributed to shareholders is usually taxed twice. 5. It is a separate legal entity. 6. It has a limited life. 7. Owners are not agents of the corporation.

QUICK STUDY

QS 11-1 Characteristics of corporations

C1

Polaris

Arctic Cat

PIAGGIO

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494 Chapter 11 Corporate Reporting and Analysis

QS 11-3 Issuance of common stock

P1

Prepare the journal entry to record Zende Company’s issuance of 75,000 shares of $5 par value common stock assuming the shares sell for: a. $5 cash per share. b. $6 cash per share.

QS 11-4 Issuance of par and stated value common stock

P1

Prepare the journal entry to record Jevonte Company’s issuance of 36,000 shares of its common stock assuming the shares have a: a. $2 par value and sell for $18 cash per share. b. $2 stated value and sell for $18 cash per share.

QS 11-5 Issuance of common stock

P1

Prepare the issuer’s journal entry for each separate transaction. (a) On March 1, Atlantic Co. issues 42,500 shares of $4 par value common stock for $297,500 cash. (b) On April 1, OP Co. issues no-par value common stock for $70,000 cash. (c) On April 6, MPG issues 2,000 shares of $25 par value common stock for $45,000 of inventory, $145,000 of machinery, and acceptance of an $94,000 note payable.

QS 11-6 Issuance of preferred stock

P1 P2

a. Prepare the journal entry to record Tamasine Company’s issuance of 5,000 shares of $100 par value 7% cumulative preferred stock for $102 cash per share.

b. Assuming the facts in part 1, if Tamasine declares a year-end cash dividend, what is the amount of dividend paid to preferred shareholders? (Assume no dividends in arrears.)

QS 11-7 Accounting for cash dividends

P2

Prepare journal entries to record the following transactions for Emerson Corporation.

July 15 Declared a cash dividend payable to common stockholders of $165,000. August 15 Date of record is August 15 for the cash dividend declared on July 15. August 31 Paid the dividend declared on July 15.

QS 11-9 Dividend allocation between classes of shareholders

C2

Stockholders’ equity of Ernst Company consists of 80,000 shares of $5 par value, 8% cumulative preferred stock and 250,000 shares of $1 par value common stock. Both classes of stock have been outstanding since the company’s inception. Ernst did not declare any dividends in the prior year, but it now declares and pays a $110,000 cash dividend at the current year-end. Determine the amount distributed to each class of stockholders for this two-year-old company.

QS 11-11 Accounting for changes in estimates; error adjustments

C3

Answer the following questions related to a company’s activities for the current year: 1. A review of the notes payable files discovers that three years ago the company reported the entire

amount of a payment (principal and interest) on an installment note payable as interest expense. This mistake had a material effect on the amount of income in that year. How should the correction be reported in the current year financial statements?

QS 11-2 Issuance of no-par common stock

P1

Prepare the journal entry to record Autumn Company’s issuance of 63,000 shares of no-par value common stock assuming the shares: a. Sell for $29 cash per share. b. Are exchanged for land valued at $1,827,000.

Common stock — $5 par value, 375,000 shares authorized, 200,000 shares issued and outstanding . . . . . . . . . $1,000,000

Paid-in capital in excess of par value, common stock . . . . . . . . . 600,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,433,000

QS 11-8 Accounting for small stock dividend

P2

The stockholders’ equity section of Jun Company’s balance sheet as of April 1 follows. On April 2, Jun declares and distributes a 10% stock dividend. The stock’s per share market value on April 2 is $20 (prior to the dividend). Prepare the stockholders’ equity section immediately after the stock dividend.

QS 11-10 Purchase and sale of treasury stock P3

On May 3, Zirbal Corporation purchased 4,000 shares of its own stock for $36,000 cash. On November 4, Zirbal reissued 850 shares of this treasury stock for $8,500. Prepare the May 3 and November 4 journal entries to record Zirbal’s purchase and reissuance of treasury stock.

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Chapter 11 Corporate Reporting and Analysis 495

QS 11-13 Basic earnings per share A1

Epic Company earned net income of $900,000 this year. The number of common shares outstanding during the entire year was 400,000, and preferred shareholders received a $20,000 cash dividend. Compute Epic Company’s basic earnings per share.

Exercise 11-2 Accounting for par, stated, and no-par stock issuances

P1

Rodriguez Corporation issues 19,000 shares of its common stock for $152,000 cash on February 20. Prepare journal entries to record this event under each of the following separate situations. 1. The stock has a $2 par value. 2. The stock has neither par nor stated value. 3. The stock has an $5 stated value.

QS 11-14 Price-earnings ratio A2

Compute Topp Company’s price-earnings ratio if its common stock has a market value of $20.54 per share and its EPS is $3.95. Would an analyst likely consider this stock potentially overpriced- or underpriced or neither? Explain.

QS 11-15 Dividend yield A3

Foxburo Company expects to pay a $2.34 per share cash dividend this year on its common stock. The current market value of Foxburo stock is $32.50 per share. Compute the expected dividend yield on the Foxburo stock. Would you classify the Foxburo stock as a growth or an income stock? Explain.

QS 11-16 Book value per common share

A4

The stockholders’ equity section of Montel Company’s balance sheet follows. The preferred stock’s call price is $40. Determine the book value per share of the common stock.

Preferred stock—5% cumulative, $10 par value, 20,000 shares authorized, issued and outstanding . . . . . . . . . . $ 200,000

Common stock—$5 par value, 200,000 shares authorized, 150,000 shares issued and outstanding . . . . . . . . . 750,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,850,000

QS 11-17 International equity disclosures

P1

Air France-KLM reports the following equity information for its fiscal year ended March 31, 2012 (euros in millions). Prepare its journal entry, using its account titles, to record the issuance of capital stock assuming that its entire par value stock was issued on March 31, 2012, for cash.

March 31 2012

Issued capital . . . . . . . . . . . . . . . . . . € 300

Additional paid-in capital . . . . . . . . 2,971

Describe how each of the following characteristics of organizations applies to corporations. EXERCISES

Exercise 11-1 Characteristics of corporations

C1

1. Owner authority and control 5. Duration of life

2. Ease of formation 6. Owner liability

3. Transferability of ownership 7. Legal status

4. Ability to raise large capital amounts 8. Tax status of income

2. After using an expected useful life of seven years and no salvage value to depreciate its office equipment over the preceding three years, the company decided early this year that the equipment will last only two more years. How should the effects of this decision be reported in the current year financial statements?

QS 11-12 Basic earnings per share A1

Murray Company reports net income of $770,000 for the year. It has no preferred stock, and its weighted- average common shares outstanding is 280,000 shares. Compute its basic earnings per share.

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496 Chapter 11 Corporate Reporting and Analysis

Exercise 11-3 Recording stock issuances

P1

Prepare journal entries to record the following four separate issuances of stock. 1. A corporation issued 4,000 shares of $5 par value common stock for $35,000 cash. 2. A corporation issued 2,000 shares of no-par common stock to its promoters in exchange for their

efforts, estimated to be worth $40,000. The stock has a $1 per share stated value. 3. A corporation issued 2,000 shares of no-par common stock to its promoters in exchange for their

efforts, estimated to be worth $40,000. The stock has no stated value. 4. A corporation issued 1,000 shares of $50 par value preferred stock for $60,000 cash.

Exercise 11-5 Identifying characteristics of preferred stock

C2

Match each description 1 through 6 with the characteristic of preferred stock that it best describes by writ- ing the letter of that characteristic in the blank next to each description. A. Callable B. Convertible C. Cumulative D. Noncumulative E. Nonparticipating F. Participating

1. Holders of the stock are entitled to receive current and all past dividends before common stockholders receive any dividends.

2. The issuing corporation can retire the stock by paying a prespecified price. 3. Holders of the stock can receive dividends exceeding the stated rate under certain conditions. 4. Holders of the stock are not entitled to receive dividends in excess of the stated rate. 5. Holders of this stock can exchange it for shares of common stock. 6. Holders of the stock lose any dividends that are not declared in the current year.

Exercise 11-4 Stock issuance for noncash assets

P1

Sudoku Company issues 7,000 shares of $7 par value common stock in exchange for land and a building. The land is valued at $45,000 and the building at $85,000. Prepare the journal entry to record issuance of the stock in exchange for the land and building.

1. Assume that the company declares and immediately distributes a 50% stock dividend. This event is recorded by capitalizing retained earnings equal to the stock’s par value. Answer these questions about stockholders’ equity as it exists after issuing the new shares.

a. What is the retained earnings balance? b. What is the amount of total stockholders’ equity? c. How many shares are outstanding? 2. Assume that the company implements a 3-for-2 stock split instead of the stock dividend in part 1.

Answer these questions about stockholders’ equity as it exists after issuing the new shares. a. What is the retained earnings balance? b. What is the amount of total stockholders’ equity? c. How many shares are outstanding? 3. Explain the difference, if any, to a stockholder from receiving new shares distributed under a large

stock dividend versus a stock split.

Exercise 11-6 Stock dividends and splits

P2

On June 30, 2013, Sharper Corporation’s common stock is priced at $62 per share before any stock divi- dend or split, and the stockholders’ equity section of its balance sheet appears as follows.

Common stock—$10 par value, 120,000 shares authorized, 50,000 shares issued and outstanding . . . . . . . . . $ 500,000

Paid-in capital in excess of par value, common stock . . . . . . . . 200,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 660,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,360,000

Check (1b) $1,360,000

(2a) $660,000

Exercise 11-7 Stock dividends and per share book values

P2

The stockholders’ equity of TVX Company at the beginning of the day on February 5 follows:

Common stock—$10 par value, 150,000 shares authorized, 60,000 shares issued and outstanding . . . . . . . . . . $ 600,000

Paid-in capital in excess of par value, common stock . . . . . . . . . 425,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,575,000

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Chapter 11 Corporate Reporting and Analysis 497

On February 5, the directors declare a 20% stock dividend distributable on February 28 to the February 15 stockholders of record. The stock’s market value is $40 per share on February 5 before the stock dividend. The stock’s market value is $33.40 per share on February 28. 1. Prepare entries to record both the dividend declaration and its distribution. 2. One stockholder owned 800 shares on February 5 before the dividend. Compute the book value per

share and total book value of this stockholder’s shares immediately before and after the stock dividend of February 5.

3. Compute the total market value of the investor’s shares in part 2 as of February 5 and February 28.

Check (2) Book value per share: before, $26.250; after, $21.875

Exercise 11-8 Dividends on common and noncumulative preferred stock

C2

York’s outstanding stock consists of 80,000 shares of noncumulative 7.5% preferred stock with a $5 par value and also 200,000 shares of common stock with a $1 par value. During its first four years of opera- tion, the corporation declared and paid the following total cash dividends:

Determine the amount of dividends paid each year to each of the two classes of stockholders: preferred and common. Also compute the total dividends paid to each class for the four years combined.

Check 4-year total paid to preferred, $108,000

2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000

Exercise 11-9 Dividends on common and cumulative preferred stock C2

Use the data in Exercise 11-8 to determine the amount of dividends paid each year to each of the two classes of stockholders assuming that the preferred stock is cumulative. Also determine the total dividends paid to each class for the four years combined.

Exercise 11-11 Preparing a statement of retained earnings

C3

The following information is available for Amos Company for the year ended December 31, 2013. a. Balance of retained earnings, December 31, 2012, prior to discovery of error, $1,375,000. b. Cash dividends declared and paid during 2013, $43,000. c. It neglected to record 2011 depreciation expense of $55,500, which is net of $4,500 in income taxes. d. The company earned $126,000 in 2013 net income. Prepare a 2013 statement of retained earnings for Amos Company.

Common stock—$10 par value, 72,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . . . . $ 720,000

Paid-in capital in excess of par value, common stock . . . . . . . . 216,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 864,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800,000

Exercise 11-10 Recording and reporting treasury stock transactions

P3

On October 10, the stockholders’ equity of Sherman Systems appears as follows:

1. Prepare journal entries to record the following transactions for Sherman Systems. a. Purchased 5,000 shares of its own common stock at $25 per share on October 11. b. Sold 1,000 treasury shares on November 1 for $31 cash per share. c. Sold all remaining treasury shares on November 25 for $20 cash per share. 2. Explain how the company’s equity section changes after the October 11 treasury stock purchase, and

prepare the revised equity section of its balance sheet at that date.

Check (1c) Dr. Retained Earnings, $14,000

Exercise 11-12 Earnings per share

A1

Ecker Company reports $2,700,000 of net income for 2013 and declares $388,020 of cash dividends on its preferred stock for 2013. At the end of 2013, the company had 678,000 weighted-average shares of com- mon stock. 1. What amount of net income is available to common stockholders for 2013? 2. What is the company’s basic EPS for 2013? Check (2) $3.41

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498 Chapter 11 Corporate Reporting and Analysis

Exercise 11-13 Earnings per share

A1

Kelley Company reports $960,000 of net income for 2013 and declares $120,000 of cash dividends on its preferred stock for 2013. At the end of 2013, the company had 400,000 weighted-average shares of com- mon stock. 1. What amount of net income is available to common stockholders for 2013? 2. What is the company’s basic EPS for 2013? Round your answer to the nearest whole cent.Check (2) $2.10

Determine the book value per share of the preferred and common stock under two separate situations. 1. No preferred dividends are in arrears. 2. Three years of preferred dividends are in arrears.

Check (1) Book value of common, $16.06

Exercise 11-16 Book value per share

A4

The equity section of Cyril Corporation’s balance sheet shows the following:

Preferred stock—6% cumulative, $25 par value, $30 call price, 10,000 shares issued and outstanding . . . . . . . . . . . . . . . . . $ 250,000

Common stock — $10 par value, 80,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,585,000

Exercise 11-17 Accounting for equity under IFRS

C3 P1

Unilever Group reports the following equity information for the years ended December 31, 2009 and 2010 (euros in millions).

December 31 2010 2009

Share capital . . . . . . . . . . . . . . . € 484 € 484

Share premium . . . . . . . . . . . . . 134 131

Other reserves . . . . . . . . . . . . . (5,406) (5,900)

Retained profit . . . . . . . . . . . . . 19,273 17,350

Shareholders’ equity . . . . . . . . . €14,485 €12,065

Exercise 11-14 Price-earnings ratio computation and interpretation

A2

Compute the price-earnings ratio for each of these four separate companies. Which stock might an analyst likely investigate as being potentially undervalued by the market? Explain.

1 2 3 4

$12.00 10.00 7.50

50.00

Company Earnings per Share

Market Value per Share

$176.40 96.00 93.75

250.00

Exercise 11-15 Dividend yield computation and interpretation

A3

Compute the dividend yield for each of these four separate companies. Which company’s stock would probably not be classified as an income stock? Explain.

1 2 3 4

$16.06 13.86 3.96 0.96

Company Annual Cash

Dividend per Share Market Value

per Share $220.00 132.00 72.00 80.00

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Chapter 11 Corporate Reporting and Analysis 499

1. For each of the three account titles share capital, share premium, and retained profit, match it with the usual account title applied under U.S. GAAP from the following options:

a. Paid-in capital in excess of par value, common stock b. Retained earnings c. Common stock, par value 2. Prepare Unilever’s journal entry, using its account titles, to record the issuance of capital stock assum-

ing that its entire par value stock was issued on December 31, 2009, for cash. 3. What were Unilever’s 2010 dividends assuming that only dividends and income impacted retained

profit for 2010 and that its 2010 income totaled €4,232?

Exercise 11-18 Cash dividends, treasury stock, and statement of retained earnings

C3 P2 P3

Alexander Corporation reports the following components of stockholders’ equity on December 31, 2013:

In year 2014, the following transactions affected its stockholders’ equity accounts.

Jan. 2 Purchased 3,000 shares of its own stock at $25 cash per share. Jan. 7 Directors declared a $1.50 per share cash dividend payable on Feb. 28 to the Feb. 9 stockhold-

ers of record. Feb. 28 Paid the dividend declared on January 7. July 9 Sold 1,200 of its treasury shares at $30 cash per share. Aug. 27 Sold 1,500 of its treasury shares at $20 cash per share. Sept. 9 Directors declared a $2 per share cash dividend payable on October 22 to the September 23

stockholders of record. Oct. 22 Paid the dividend declared on September 9. Dec. 31 Closed the $52,000 credit balance (from net income) in the Income Summary account to

Retained Earnings.

Required

1. Prepare journal entries to record each of these transactions for 2014. 2. Prepare a statement of retained earnings for the year ended December 31, 2014. 3. Prepare the stockholders’ equity section of the company’s balance sheet as of December 31, 2014.

Common stock—$25 par value, 50,000 shares authorized, 30,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . $ 750,000

Paid-in capital in excess of par value, common stock . . . . . . . . . 50,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,140,000

Kinkaid Co. is incorporated at the beginning of this year and engages in a number of transactions. The following journal entries impacted its stockholders’ equity during its first year of operations.

PROBLEM SET A

Problem 11-1A Stockholders’ equity transactions and analysis

C2 P1

a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Common Stock, $25 Par Value . . . . . . . . . . . . . . . . 250,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 50,000

b. Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Common Stock, $25 Par Value . . . . . . . . . . . . . . . . 125,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 25,000

c. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81,500

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,500

Common Stock, $25 Par Value . . . . . . . . . . . . . . . . 50,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 30,000

[continued on next page]

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500 Chapter 11 Corporate Reporting and Analysis

Common stock—$10 par value, 100,000 shares authorized, 40,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . . . 60,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $730,000

d. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Common Stock, $25 Par Value . . . . . . . . . . . . . . . . 75,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 45,000

[continued from previous page]

Required

1. Explain the transaction(s) underlying each journal entry (a) through (d ). 2. How many shares of common stock are outstanding at year-end? 3. What is the amount of minimum legal capital (based on par value) at year-end? 4. What is the total paid-in capital at year-end? 5. What is the book value per share of the common stock at year-end if total paid-in capital plus retained

earnings equals $695,000?

Check (2) 20,000 shares

(3) $500,000

(4) $650,000

Common stock, $12 par value . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000

Paid-in capital in excess of par value, common stock . . . . . . . . . 90,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Problem 11-3A Equity analysis—journal entries and account balances

P2

At September 30, the end of Beijing Company’s third quarter, the following stockholders’ equity accounts are reported.

In the fourth quarter, the following entries related to its equity are recorded:

Oct. 2 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Common Dividend Payable . . . . . . . . . . . . . . . . . . . 60,000

Oct. 25 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . 60,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Oct. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Common Stock Dividend Distributable . . . . . . . . . 36,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 39,000

[continued on next page]

Problem 11-2A Cash dividends, treasury stock, and statement of retained earnings

C3 P2 P3

Kohler Corporation reports the following components of stockholders’ equity on December 31, 2013:

In year 2014, the following transactions affected its stockholders’ equity accounts.

Jan. 1 Purchased 4,000 shares of its own stock at $20 cash per share. Jan. 5 Directors declared a $2 per share cash dividend payable on Feb. 28 to the Feb. 5 stockholders

of record. Feb. 28 Paid the dividend declared on January 5. July 6 Sold 1,500 of its treasury shares at $24 cash per share. Aug. 22 Sold 2,500 of its treasury shares at $17 cash per share. Sept. 5 Directors declared a $2 per share cash dividend payable on October 28 to the September 25

stockholders of record. Oct. 28 Paid the dividend declared on September 5. Dec. 31 Closed the $388,000 credit balance (from net income) in the Income Summary account to

Retained Earnings.

Required

1. Prepare journal entries to record each of these transactions for 2014. 2. Prepare a statement of retained earnings for the year ended December 31, 2014. 3. Prepare the stockholders’ equity section of the company’s balance sheet as of December 31, 2014.

Check (2) Retained earnings, Dec. 31, 2014, $504,500.

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Chapter 11 Corporate Reporting and Analysis 501

Required

1. Explain the transaction(s) underlying each journal entry. 2. Complete the following table showing the equity account balances at each indicated date (include the

balances from September 30).

Nov. 5 Common Stock Dividend Distributable . . . . . . . . . . . . . 36,000

Common Stock, $12 Par Value . . . . . . . . . . . . . . . . 36,000

Dec. 1 Memo — Change the title of the common stock account to reflect the new par value of $4.

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000

[continued from previous page]

Check Total equity: Oct. 2, $710,000; Dec. 31, $920,000

Oct. 2 Oct. 25 Oct. 31 Nov. 5 Dec. 1 Dec. 31

Common stock . . . . . . . . . . . . . . . . . . . . . $_____ $_____ $_____ $_____ $_____ $_____

Common stock dividend distributable . . . . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____ _____

Paid-in capital in excess of par, common stock . . . . . . . . _____ _____ _____ _____ _____ _____

Retained earnings . . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____ _____

Total equity . . . . . . . . . . . . . . . . . . . . . . . . . $_____ $_____ $_____ $_____ $_____ $_____

Problem 11-4A Analysis of changes in stockholders’ equity accounts

C3 P2 P3

The equity sections from Atticus Group’s 2013 and 2014 year-end balance sheets follow.

Stockholders’ Equity (December 31, 2013)

Common stock—$4 par value, 100,000 shares authorized, 40,000 shares issued and outstanding . . . . . . . . . . . . . . . . $160,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . 120,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000

Stockholders’ Equity (December 31, 2014)

Common stock—$4 par value, 100,000 shares authorized, 47,400 shares issued, 3,000 shares in treasury . . . . . . . . . $189,600

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . . 179,200

Retained earnings ($30,000 restricted by treasury stock) . . . . . . . . . . . 400,000

768,800

Less cost of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (30,000)

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $738,800

The following transactions and events affected its equity during year 2014.

Jan. 5 Declared a $0.50 per share cash dividend, date of record January 10. Mar. 20 Purchased treasury stock for cash. Apr. 5 Declared a $0.50 per share cash dividend, date of record April 10. July 5 Declared a $0.50 per share cash dividend, date of record July 10. July 31 Declared a 20% stock dividend when the stock’s market value is $12 per share. Aug. 14 Issued the stock dividend that was declared on July 31. Oct. 5 Declared a $0.50 per share cash dividend, date of record October 10.

Required

1. How many common shares are outstanding on each cash dividend date? 2. What is the total dollar amount for each of the four cash dividends? 3. What is the amount of the capitalization of retained earnings for the stock dividend? 4. What is the per share cost of the treasury stock purchased? 5. How much net income did the company earn during year 2014?

Check (3) $88,800

(4) $10

(5) $248,000

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502 Chapter 11 Corporate Reporting and Analysis

Preferred stock—5% cumulative, $___ par value, 1,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000

Common stock—$___ par value, 4,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000

Problem 11-5A Computation of book values and dividend allocations

C2 A4

Raphael Corporation’s common stock is currently selling on a stock exchange at $85 per share, and its current balance sheet shows the following stockholders’ equity section:

Required (Round per share amounts to cents.)

1. What is the current market value (price) of this corporation’s common stock? 2. What are the par values of the corporation’s preferred stock and its common stock? 3. If no dividends are in arrears, what are the book values per share of the preferred stock and the com-

mon stock? 4. If two years’ preferred dividends are in arrears, what are the book values per share of the preferred

stock and the common stock? 5. If two years’ preferred dividends are in arrears and the preferred stock is callable at $55 per share,

what are the book values per share of the preferred stock and the common stock? 6. If two years’ preferred dividends are in arrears and the board of directors declares cash dividends of

$11,500, what total amount will be paid to the preferred and to the common shareholders? What is the amount of dividends per share for the common stock?

Analysis Component

7. What are some factors that can contribute to a difference between the book value of common stock and its market value (price)?

Check (4) Book value of common, $56.25

(5) Book value of common, $55

(6) Dividends per common share, $1.00

a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . 3,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 117,000

b. Organization Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . 1,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 39,000

c. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,300

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,300

Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . 800

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 39,200

d. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Common Stock, $1 Par Value . . . . . . . . . . . . . . . . . 1,200

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . 58,800

PROBLEM SET B

Problem 11-1B Stockholders’ equity transactions and analysis

C2 P1

Weiss Company is incorporated at the beginning of this year and engages in a number of transactions. The following journal entries impacted its stockholders’ equity during its first year of operations.

Required

1. Explain the transaction(s) underlying each journal entry (a) through (d ). 2. How many shares of common stock are outstanding at year-end? 3. What is the amount of minimum legal capital (based on par value) at year-end?

Check (2) 6,000 shares

(3) $6,000

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Chapter 11 Corporate Reporting and Analysis 503

4. What is the total paid-in capital at year-end? 5. What is the book value per share of the common stock at year-end if total paid-in capital plus retained

earnings equals $283,000?

(4) $260,000

Problem 11-2B Cash dividends, treasury stock, and statement of retained earnings

C3 P2 P3

Balthus Corp. reports the following components of stockholders’ equity on December 31, 2013:

Common stock—$1 par value, 320,000 shares authorized, 200,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . $ 200,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . 1,400,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,160,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,760,000

It completed the following transactions related to stockholders’ equity in year 2014:

Jan. 10 Purchased 40,000 shares of its own stock at $12 cash per share. Mar. 2 Directors declared a $1.50 per share cash dividend payable on March 31 to the March 15 stock-

holders of record. Mar. 31 Paid the dividend declared on March 2. Nov. 11 Sold 24,000 of its treasury shares at $13 cash per share. Nov. 25 Sold 16,000 of its treasury shares at $9.50 cash per share. Dec. 1 Directors declared a $2.50 per share cash dividend payable on January 2 to the December 10

stockholders of record. Dec. 31 Closed the $1,072,000 credit balance (from net income) in the Income Summary account to

Retained Earnings.

Required

1. Prepare journal entries to record each of these transactions for 2014. 2. Prepare a statement of retained earnings for the year ended December 31, 2014. 3. Prepare the stockholders’ equity section of the company’s balance sheet as of December 31, 2014.

Check (2) Retained earnings, Dec. 31, 2014, $2,476,000

Problem 11-3B Equity analysis—journal entries and account balances

P2

At December 31, the end of Chilton Communication’s third quarter, the following stockholders’ equity accounts are reported:

Common stock, $10 par value . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 960,000

Paid-in capital in excess of par value, common stock . . . . . . . . . 384,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000

In the fourth quarter, the following entries related to its equity are recorded:

Jan. 17 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Common Dividend Payable . . . . . . . . . . . . . . . . . . . 96,000

Feb. 5 Common Dividend Payable . . . . . . . . . . . . . . . . . . . . . . . 96,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Feb. 28 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252,000

Common Stock Dividend Distributable . . . . . . . . . 120,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 132,000

Mar. 14 Common Stock Dividend Distributable . . . . . . . . . . . . . 120,000

Common Stock, $10 Par Value . . . . . . . . . . . . . . . . 120,000

Mar. 25 Memo — Change the title of the common stock account to reflect the new par value of $5.

Mar. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000

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504 Chapter 11 Corporate Reporting and Analysis

Required

1. Explain the transaction(s) underlying each journal entry. 2. Complete the following table showing the equity account balances at each indicated date (include the

balances from December 31).

Jan. 17 Feb. 5 Feb. 28 Mar. 14 Mar. 25 Mar. 31

Common stock . . . . . . . . . . . . . . . . . . . . $______ $______ $______ $______ $______ $______

Common stock dividend distributable . . . . . . . . . . . . . . . . . . . . ______ ______ ______ ______ ______ ______

Paid-in capital in excess of par, common stock . . . . . . . . ______ ______ ______ ______ ______ ______

Retained earnings . . . . . . . . . . . . . . . . . . ______ ______ ______ ______ ______ ______

Total equity . . . . . . . . . . . . . . . . . . . . . . . $______ $______ $______ $______ $______ $______Check Total equity: Jan. 17, $2,848,000; Mar. 31, $3,568,000

Stockholders’ Equity (December 31, 2013)

Common stock — $20 par value, 30,000 shares authorized, 17,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . $340,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . 60,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $670,000

Stockholders’ Equity (December 31, 2014)

Common stock — $20 par value, 30,000 shares authorized, 19,000 shares issued, 1,000 shares in treasury . . . . . . . . . . . . . . . . . $380,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . . . 104,000

Retained earnings ($40,000 restricted by treasury stock) . . . . . . . . . . 295,200

779,200

Less cost of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,000)

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $739,200

Problem 11-4B Analysis of changes in stockholders’ equity accounts

C3 P2 P3

The equity sections from Hovo Corporation’s 2013 and 2014 balance sheets follow.

The following transactions and events affected its equity during year 2014.

Feb. 15 Declared a $0.40 per share cash dividend, date of record five days later. Mar. 2 Purchased treasury stock for cash. May 15 Declared a $0.40 per share cash dividend, date of record five days later. Aug. 15 Declared a $0.40 per share cash dividend, date of record five days later. Oct. 4 Declared a 12.5% stock dividend when the stock’s market value is $42 per share. Oct. 20 Issued the stock dividend that was declared on October 4. Nov. 15 Declared a $0.40 per share cash dividend, date of record five days later.

Required

1. How many common shares are outstanding on each cash dividend date? 2. What is the total dollar amount for each of the four cash dividends? 3. What is the amount of the capitalization of retained earnings for the stock dividend? 4. What is the per share cost of the treasury stock purchased? 5. How much net income did the company earn during year 2014?

Check (3) $84,000

(4) $40

(5) $136,000

Problem 11-5B Computation of book values and dividend allocations

C2 A4

Soltech Company’s common stock is currently selling on a stock exchange at $90 per share, and its cur- rent balance sheet shows the following stockholders’ equity section.

Preferred stock — 8% cumulative, $___ par value, 1,500 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 375,000

Common stock—$___ par value, 18,000 shares authorized, issued, and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400,000

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Chapter 11 Corporate Reporting and Analysis 505

Required (Round per share amounts to cents.)

1. What is the current market value (price) of this corporation’s common stock? 2. What are the par values of the corporation’s preferred stock and its common stock? 3. If no dividends are in arrears, what are the book values per share of the preferred stock and the com-

mon stock? (Round per share values to the nearest cent.) 4. If two years’ preferred dividends are in arrears, what are the book values per share of the preferred

stock and the common stock? (Round per share values to the nearest cent.) 5. If two years’ preferred dividends are in arrears and the preferred stock is callable at $280 per share,

what are the book values per share of the preferred stock and the common stock? (Round per share values to the nearest cent.)

6. If two years’ preferred dividends are in arrears and the board of directors declares cash dividends of $100,000, what total amount will be paid to the preferred and to the common shareholders? What is the amount of dividends per share for the common stock? (Round per share values to the nearest cent.)

Analysis Component

7. Discuss why the book value of common stock is not always a good estimate of its market value.

Check (4) Book value of common, $109.17

(5) Book value of common, $106.67

(6) Dividends per common share, $0.56

Beyond the Numbers

BTN 11-1 Refer to Polaris’ financial statements in Appendix A to answer the following.

1. How many shares of common stock are issued and outstanding at December 31, 2011 and 2010? How do these numbers compare with the basic weighted-average common shares outstanding at December 31, 2011 and 2010?

2. What is the book value of its entire common stock at December 31, 2011? 3. What is the total amount of cash dividends paid to common stockholders for the years ended December

31, 2011 and 2010? 4. Identify and compare basic EPS amounts across years 2011, 2010, and 2009. Identify and comment on

any notable changes. 5. How many shares does Polaris hold in treasury stock, if any, as of December 31, 2011 and 2010?

Fast Forward

6. Access Polaris’ financial statements for fiscal years ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Has the number of common shares outstanding increased since that date? Has the company increased the total amount of cash dividends paid compared to the total amount for year 2011?

REPORTING IN ACTION C2 A1 A4

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 11 Adria Lopez created Success Systems on October 1, 2013. The company has been successful, and Adria plans to expand her business. She believes that an additional $86,000 is needed and is investigating three funding sources. a. Adria’s sister Cicely is willing to invest $86,000 in the business as a common shareholder. Since Adria

currently has about $129,000 invested in the business, Cicely’s investment will mean that Adria will maintain about 60% ownership, and Cicely will have 40% ownership of Success Systems.

b. Adria’s uncle Marcello is willing to invest $86,000 in the business as a preferred shareholder. Marcello would purchase 860 shares of $100 par value, 7% preferred stock.

c. Adria’s banker is willing to lend her $86,000 on a 7%, 10-year note payable. She would make monthly payments of $1,000 per month for 10 years.

Required

1. Prepare the journal entry to reflect the initial $86,000 investment under each of the options (a), (b), and (c).

2. Evaluate the three proposals for expansion, providing the pros and cons of each option. 3. Which option do you recommend Adria adopt? Explain.

SERIAL PROBLEM Success Systems

P1 C1 C2

Polaris

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506 Chapter 11 Corporate Reporting and Analysis

Required

1. Compute the book value per common share for each company using these data. 2. Compute the basic EPS for each company using these data. 3. Compute the dividend yield for each company using these data. Does the dividend yield of any of the

companies characterize it as an income or growth stock? Explain. 4. Compute, compare, and interpret the price-earnings ratio for each company using these data.

Key Figures Polaris Arctic Cat

Net income (in thousands) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $227,575 $ 13,007

Cash dividends declared per common share . . . . . . . . . . . . . . . . . . . . . . . $ 0.90 $ —

Common shares outstanding (in thousands) . . . . . . . . . . . . . . . . . . . . . . . 68,430 18,301

Weighted-average common shares outstanding (in thousands) . . . . . . . . 68,792 18,232

Market value (price) per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 72.10 $ 33.70

Equity applicable to common shares (in thousands) . . . . . . . . . . . . . . . . . $500,056 $183,036

BTN 11-2 Key comparative figures for Polaris and Arctic Cat follow.COMPARATIVE ANALYSIS A1 A2 A3 A4

BTN 11-3 Harriet Moore is an accountant for New World Pharmaceuticals. Her duties include tracking research and development spending in the new product development division. Over the course of the past six months, Harriet notices that a great deal of funds have been spent on a particular project for a new drug. She hears “through the grapevine” that the company is about to patent the drug and expects it to be a major advance in antibiotics. Harriet believes that this new drug will greatly improve company perfor- mance and will cause the company’s stock to increase in value. Harriet decides to purchase shares of New World in order to benefit from this expected increase.

Required

What are Harriet’s ethical responsibilities, if any, with respect to the information she has learned through her duties as an accountant for New World Pharmaceuticals? What are the implications to her planned purchase of New World shares?

ETHICS CHALLENGE C3

BTN 11-4 Teams are to select an industry, and each team member is to select a different company in that industry. Each team member then is to acquire the selected company’s financial statements (or Form 10-K) from the SEC site (www.sec.gov). Use these data to identify basic EPS. Use the financial press (or finance.yahoo.com) to determine the market price of this stock, and then compute the price-earnings ratio. Communicate with teammates via a meeting, e-mail, or telephone to discuss the meaning of this ratio, how companies compare, and the industry norm. The team must prepare a single memorandum reporting the ratio for each company and identifying the team conclusions or consensus of opinion. The memorandum is to be duplicated and distributed to the instructor and teammates.

COMMUNICATING IN PRACTICE A1 A2

Hint: Make a transparency of each team’s memo for a class discussion.

BTN 11-5 Access the February 24, 2012, filing of the 2011 calendar-year 10-K report of McDonald’s, (ticker MCD) from www.sec.gov.

Required

1. Review McDonald’s balance sheet and identify how many classes of stock it has issued. 2. What are the par values, number of authorized shares, and issued shares of the classes of stock you

identified in part 1? 3. Review its statement of cash flows and identify what total amount of cash it paid in 2011 to purchase

treasury stock. 4. What amount did McDonald’s pay out in common stock cash dividends for 2011?

TAKING IT TO THE NET C1 C3

BTN 11-6 This activity requires teamwork to reinforce understanding of accounting for treasury stock. 1. Write a brief team statement (a) generalizing what happens to a corporation’s financial position when it

engages in a stock “buyback” and (b) identifying reasons why a corporation would engage in this activity. 2. Assume that an entity acquires 100 shares of its $100 par value common stock at a cost of $134 cash

per share. Discuss the entry to record this acquisition. Next, assign each team member to prepare one of the following entries (assume each entry applies to all shares):

a. Reissue treasury shares at cost. b. Reissue treasury shares at $150 per share.

TEAMWORK IN ACTION P3

Hint: Instructor should be sure each team accurately completes part 1 before proceeding.

Polaris Arctic Cat

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Chapter 11 Corporate Reporting and Analysis 507

c. Reissue treasury shares at $120 per share; assume the paid-in capital account from treasury shares has a $1,500 balance.

d. Reissue treasury shares at $120 per share; assume the paid-in capital account from treasury shares has a $1,000 balance.

e. Reissue treasury shares at $120 per share; assume the paid-in capital account from treasury shares has a zero balance.

3. In sequence, each member is to present his/her entry to the team and explain the similarities and dif- ferences between that entry and the previous entry.

BTN 11-7 Assume that Andrew Mason of Groupon decides to launch a new Website to market dis- count services to consumers. This chain, named Servon, requires $500,000 of start-up capital. Andrew contributes $375,000 of personal assets in return for 15,000 shares of common stock, but he must raise another $125,000 in cash. There are two alternative plans for raising the additional cash. Plan A is to sell 3,750 shares of common stock to one or more investors for $125,000 cash. Plan B is to sell 1,250 shares of cumulative preferred stock to one or more investors for $125,000 cash (this preferred stock would have a $100 par value, an annual 8% dividend rate, and be issued at par). 1. If the new business is expected to earn $72,000 of after-tax net income in the first year, what rate of

return on beginning equity will Andrew earn under each alternative plan? Which plan will provide the higher expected return?

2. If the new business is expected to earn $16,800 of after-tax net income in the first year, what rate of return on beginning equity will Andrew earn under each alternative plan? Which plan will provide the higher expected return?

3. Analyze and interpret the differences between the results for parts 1 and 2.

ENTREPRENEURIAL DECISION C2 P2

BTN 11-8 Review 30 to 60 minutes of financial news programming on television. Take notes on com- panies that are catching analysts’ attention. You might hear reference to over- and undervaluation of firms and to reports about PE ratios, dividend yields, and earnings per share. Be prepared to give a brief descrip- tion to the class of your observations.

HITTING THE ROAD A1 A2 A3

BTN 11-9 Financial information for KTM Corporation (www.KTM.com) follows: GLOBAL DECISION A1 C3

Required

1. Compute book value per share for KTM. 2. Compute earnings per share (EPS) for KTM. 3. Compare KTM’s dividends per share with its EPS. Is KTM paying out a large or small amount of its

income as dividends? Explain.

Net income (in thousands) . . . . . . . . . . . . . . . . . . . . . . . . . € 20,818

Cash dividends declared (in thousands) . . . . . . . . . . . . . . . € 0

Cash dividends declared per share . . . . . . . . . . . . . . . . . . . € 0.00

Number of shares outstanding (in thousands)* . . . . . . . . . 10,509

Equity applicable to shares (in thousands) . . . . . . . . . . . . . €219,775

* Assume that for KTM the year-end number of shares outstanding approximates the weighted-average shares outstanding.

1. e; Entry to record this stock issuance is: 3. d; Preferred stock 5 5,000 3 $100 5 $500,000 Book value per share 5 ($2,000,000 2 $500,000)y50,000 shares 5

$30 per common share

4. a; $0.81y$45.00 5 1.8% 5. c; Earnings per share 5 $3,500,000y700,000 shares 5 $5 per share PE ratio 5 $85y$5 5 17.0

2. b; $75,000y19,000 shares 5 $3.95 per share

ANSWERS TO MULTIPLE CHOICE QUIZ

Cash (6,000 3 $8) . . . . . . . . . . . . . . . . . . . . . . 48,000

Common Stock (6,000 3 $5) . . . . . . . . . . . 30,000

Paid-In Capital in Excess of Par Value, Common Stock . . . . . . . . . . . . . . . . . . . . . 18,000

KTM

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Learning Objectives

CONCEPTUAL

C1 Distinguish between operating, investing, and financing activities, and describe how noncash investing and financing activities are disclosed. (p. 511)

ANALYTICAL

A1 Analyze the statement of cash flows and apply the cash flow on total assets ratio. (p. 528)

PROCEDURAL

P1 Prepare a statement of cash flows. (p. 514) P2 Compute cash flows from operating activities using the indirect

method. (p. 517)

P3 Determine cash flows from both investing and financing activities. (p. 523) P4 Appendix 12A—Illustrate use of a spreadsheet to prepare a statement

of cash flows. (p. 532)

P5 Appendix 12B—Compute cash flows from operating activities using the direct method. (p. 535)

A Look at This Chapter

This chapter focuses on reporting and analyzing cash inflows and cash outflows. We emphasize how to prepare and interpret the statement of cash flows.

A Look Back

Chapter 11 focused on corporate equity transactions, including stock issuances and dividends. We also explained how to report and analyze income, earnings per share, and retained earnings.

Reporting Cash Flows 12

A Look Ahead

Chapter 13 focuses on tools to help us analyze financial statements. We also describe comparative analysis and the application of ratios for financial analysis.

508

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I’m a Sole Man . . .

Marina del Rey—“Five years ago in Argentina I met some volun- teers who were helping children get shoes,” explains Blake Mycoskie. “I wanted to help them but I wanted to find a more sustainable way to give them shoes.” Later, while “sitting in a field on a farm one day, I had an epiphany,” says Blake. “I’m going to start a shoe company, and for every pair I sell, I’m going to give one pair to a kid in need.” With that goal, Blake launched his shoe company named TOMS (TOMS.com), which is short for Tomorrow’s Shoes. “When we first started, we were just trying to learn how to make shoes,” ad- mits Blake. Yet he had to be conscious of profits and cash flows. “It’s very hard in the first few years because you have so much overhead and start-up cost already, and then you throw in giving away shoes,” explains Blake. “It’s very tough financially, but it’s a sacrifice that we make with a smile because it’s why we’re here.” Can TOMS be profitable? “I don’t think TOMS will ever be a super, super profitable company,” admits Blake. “I think it can be profitable, and I think it can do a lot of good, and that’s all we really want anyways. So, I think as a profit strategy, it might not make sense, but as a life strategy for me, it definitely makes sense.” Is TOMS sustainable? “Sustainable, to me, means that we are able to sell shoes and have enough profit built in to give a pair away,” explains Blake. “Sustainability to us is based on the question: can we continue to give those kids shoes year after

year?” Blake points out that this strategy has cash flow implica- tions, especially for operating and investing cash outflows. He emphasizes the importance of monitoring and tracking cash in- flows and cash outflows. “We had some cash flow issues in years two and three,” admits Blake. “We went a year where every day someone was calling us, yelling, asking for money.” Blake eventually learned to monitor and control cash flows for each of his operating, investing, and financing activities. “We’re [now] very stable, from a cash flow standpoint,” he says. His focus on controlling cash flows led him to low cost strate- gies such as selling online and using free social media for adver- tising. Analyzing TOMS’s statement of cash flows, and its individual cash inflows and outflows, helps him stay on track. “We’re not going to make as much . . . and the margins are definitely lower,” he admits. “But what we do helps us get pub- licity . . . [and] we can’t find anyone who matches one for one!” Cash management has not curtailed Blake’s approach to life. “I live on a boat in Marina del Rey,” exclaims Blake. “I wake up when the sun finds its way into my bedroom. I kind of do my own thing.”

[Sources: TOMS Website, January 2013; The Wall Street Journal, January 2012; Fast Company, September 2011; TIME, January 2007; TreeHugger Radio, September 2008; INC., January 2010; The Oprah Magazine, September 2011]]

“I love people who take risk, have ideas, and put it all on the line.”

—BLAKE MYCOSKIE

Decision Insight

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Chapter Preview

A company cannot achieve or maintain profits with out carefully managing cash. Managers and other users of information pay attention to a company’s cash position and the events and trans- actions affecting cash. This chapter explains how we prepare, analyze, and interpret a statement of cash flows. It also discusses

the importance of cash flow information for predicting future performance and making managerial decisions. More generally, effectively using the statement of cash flows is crucial for man- aging and analyzing the operating, investing, and financing activi- ties of businesses.

This section describes the basics of cash flow reporting, including its purpose, measurement, classification, format, and preparation.

Purpose of the Statement of Cash Flows The purpose of the statement of cash flows is to report cash receipts (inflows) and cash pay- ments (outflows) during a period. This includes separately identifying the cash flows related to operating, investing, and financing activities. The statement of cash flows does more than simply report changes in cash. It is the detailed disclosure of individual cash flows that makes this state- ment useful to users. Information in this statement helps users answer questions such as these:

● How does a company obtain its cash? ● Where does a company spend its cash? ● What explains the change in the cash balance?

The statement of cash flows addresses important questions such as these by summarizing, clas- sifying, and reporting a company’s cash inflows and cash outflows for each period.

Importance of Cash Flows Information about cash flows can influence decision makers in important ways. For instance, we look more favorably at a company that is financing its expenditures with cash from opera- tions than one that does it by selling its assets. Information about cash flows helps users decide whether a company has enough cash to pay its existing debts as they mature. It is also relied upon to evaluate a company’s ability to meet unexpected obligations and pursue unexpected opportunities. External information users especially want to assess a com pany’s ability to take advantage of new business opportunities. Internal users such as managers use cash flow infor- mation to plan day-to-day operating activities and make long-term investment decisions. Macy’s striking turnaround is an example of how analysis and management of cash flows can lead to improved financial stability. Several years ago Macy’s obtained temporary protec- tion from bankruptcy, at which time it desperately needed to improve its cash flows. It did so by engaging in aggressive cost-cutting measures. As a result, Macy’s annual cash flow rose to $210 million, up from a negative cash flow of $38.9 million in the prior year. Macy’s eventually met its financial obligations and then successfully merged with Federated Department Stores.

BASICS OF CASH FLOW REPORTING

Point: Internal users rely on the state- ment of cash flows to make investing and financing decisions. External users rely on this statement to assess the amount and timing of a company’s cash flows.

510

Cash Flows from Operating

• Indirect and direct methods of reporting

• Application of indirect method of reporting

• Summary of indirect method adjustments

Basics of Cash Flow Reporting

• Purpose • Importance • Measurement • Classification • Noncash activities • Format and preparation

Cash Flows from Investing

• Three-stage process of analysis

• Analysis of noncur- rent assets

• Analysis of other assets

Cash Flows from Financing

• Three-stage process of analysis

• Analysis of non- current liabilities

• Analysis of equity

Reporting Cash Flows

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Chapter 12 Reporting Cash Flows 511

Cash Savvy “A lender must have a complete understanding of a borrower’s cash flows to assess both the borrowing needs and repayment sources. This requires information about the major types of cash in- flows and outflows. I have seen many companies, whose financial statements indicate good profitability, experience severe financial problems because the owners or managers lacked a good understanding of cash flows.”—Mary E. Garza, Bank of America ■

Decision Insight

The case of W. T. Grant Co. is a classic example of the importance of cash flow information in predicting a company’s future performance and financial strength. Grant reported net income of more than $40 million per year for three consecutive years. At that same time, it was experiencing an alarming decrease in cash provided by operations. For instance, net cash outflow was more than $90 million by the end of that three-year period. Grant soon went bankrupt. Users who relied solely on Grant’s income numbers were unpleasantly surprised. This reminds us that cash flows as well as income statement and balance sheet information are crucial in making business decisions.

EXHIBIT 12.1 Cash Flows from Operating Activities

Cash Outflows

Cash Inflows

OPERATING From customers for cash sales

From collections on credit sales

From cash dividends received

From borrowers for interest

From lawsuit settlements

To salaries and wages To suppliers for

goods and services

To governments for taxes and fines

To lenders for interest

To charities

Operating Activities

Operating Activities

Measurement of Cash Flows Cash flows are defined to include both cash and cash equivalents. The statement of cash flows ex- plains the difference between the beginning and ending balances of cash and cash equivalents. We continue to use the phrases cash flows and the statement of cash flows, but we must remember that both phrases refer to cash and cash equivalents. Recall that a cash equivalent must satisfy two criteria: (1) be readily convertible to a known amount of cash and (2) be sufficiently close to its maturity so its market value is unaffected by interest rate changes. In most cases, a debt security must be within three months of its maturity to satisfy these criteria. Companies must disclose and follow a clear policy for determining cash and cash equivalents and apply it consistently from pe- riod to period. American Express, for example, defines its cash equivalents as “time deposits and other highly liquid investments with original maturities of 90 days or less.”

Classification of Cash Flows Since cash and cash equivalents are combined, the statement of cash flows does not report transac- tions between cash and cash equivalents such as cash paid to purchase cash equivalents and cash received from selling cash equivalents. However, all other cash receipts and cash payments are clas- sified and reported on the statement as operating, investing, or financing activities. Individual cash receipts and payments for each of these three categories are labeled to identify their originating transactions or events. A net cash inflow (source) occurs when the receipts in a category exceed the payments. A net cash outflow (use) occurs when the payments in a category exceed the receipts.

Operating Activities Operating activities include those transactions and events that de- termine net income. Examples are the production and purchase of merchandise, the sale of goods and services to customers, and the expenditures to administer the business. Not all items in income, such as unusual gains and losses, are operating activities (we discuss these exceptions later in the chapter). Exhibit 12.1 lists the more common cash inflows and outflows from op erating activities. (Although cash receipts and cash payments from buying and selling trading

Cash Equivalents

C1 Distinguish between operating, investing, and financing activities, and describe how noncash investing and financing activities are disclosed.

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512 Chapter 12 Reporting Cash Flows

Cash Monitoring Cash flows can be delayed or accelerated at the end of a period to improve or reduce current period cash flows. Also, cash flows can be misclassified. Cash outflows reported under operations are interpreted as expense payments. However, cash outflows reported under investing activities are inter- preted as a positive sign of growth potential. Thus, managers face incentives to misclassify cash flows. For these reasons, cash flow reporting warrants our scrutiny. ■

Decision Insight

Financing Activities Financing activities include those transactions and events that af- fect long-term liabilities and equity. Examples are (1) obtaining cash from issuing debt and re- paying the amounts borrowed and (2) receiving cash from or distributing cash to owners. These activities involve transactions with a company’s owners and creditors. They also often involve borrowing and repaying principal amounts relating to both short- and long-term debt. GAAP requires that payments of interest expense be classified as operating activities. Also, cash pay- ments to settle credit purchases of merchandise, whether on account or by note, are operating activities. Exhibit 12.3 lists examples of cash flows from financing activities.

securities are often reported under operating activities, new standards require that these receipts and payments be classified based on the nature and purpose of those securities.)

Investing Activities Investing activities generally include those transactions and events that affect long-term assets—namely, the purchase and sale of long-term assets. They also include (1) the purchase and sale of short-term investments in the securities of other entities, other than cash equivalents and trading securities and (2) lending and collecting money for notes receivable. Exhibit 12.2 lists examples of cash flows from investing activities. Proceeds from collecting the principal amounts of notes deserve special mention. If the note results from sales to customers, its cash receipts are classified as operating activities whether short-term or long-term. If the note results from a loan to another party apart from sales, however, the cash receipts from collecting the note principal are classified as an investing ac tivity. The FASB re- quires that the collection of interest on loans be reported as an operating activity.

Point: The FASB requires that cash dividends received and cash interest received be reported as operating activities.

EXHIBIT 12.2 Cash Flows from Investing Activities

INVESTING

To purchase long-term productive assets

To purchase investments in securities

To make loans to others

Cash Outflows Investing Activities

From collecting principal on loans

From selling (discounting)

of notes

From selling long-term productive assets

Cash Inflows

Investing Activities

From selling investments in

securities

EXHIBIT 12.3 Cash Flows from Financing Activities

To pay dividends to shareholders

To purchase treasury stock

To repay cash loans

To pay withdrawals by owners

From issuing its own equity stock

From issuing notes and bonds

From issuing short- and long-term debt

From contributions by owners

FINANCING Cash Outflows Financing

Activities

Cash Inflows

Financing Activities

Point: Interest payments on a loan are classified as operating activities, but payments of loan principal are financing activities.

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Chapter 12 Reporting Cash Flows 513

Noncash Investing and Financing When important investing and financing activities do not affect cash receipts or payments, they are still disclosed at the bottom of the statement of cash flows or in a note to the statement because of their importance and the full-disclosure principle. One example of such a transaction is the purchase of long-term assets using a long-term note payable (loan). This transaction in- volves both investing and financing activities but does not affect any cash inflow or outflow and is not reported in any of the three sections of the statement of cash flows. This disclosure rule also extends to transactions with partial cash receipts or payments. To illustrate, assume that Goorin purchases land for $12,000 by paying $5,000 cash and trading in used equipment worth $7,000. The investing section of the statement of cash flows reports only the $5,000 cash outflow for the land purchase. The $12,000 investing transaction is only partially described in the body of the statement of cash flows, yet this information is potentially important to users because it changes the makeup of assets. Goorin could either describe the transaction in a footnote or include information at the bottom of its statement that lists the $12,000 land purchase along with the cash financing of $5,000 and a $7,000 trade-in of equipment. As another example, Borg Co. acquired $900,000 of assets in exchange for $200,000 cash and a $700,000 long-term note, which should be reported as follows:

Fair value of assets acquired . . . . . . . . . . $900,000

Less cash paid . . . . . . . . . . . . . . . . . . . . . . 200,000

Liabilities incurred or assumed . . . . . . . . $700,000

Exhibit 12.4 lists transactions commonly disclosed as noncash investing and financing activities.

EXHIBIT 12.4 Examples of Noncash Investing and Financing Activities

● Retirement of debt by issuing equity stock. ● Conversion of preferred stock to common stock. ● Lease of assets in a capital lease transaction. ● Purchase of long-term assets by issuing a note or bond. ● Exchange of noncash assets for other noncash assets. ● Purchase of noncash assets by issuing equity or debt.

Format of the Statement of Cash Flows Accounting standards require companies to include a statement of cash flows in a complete set of financial statements. This statement must report information about a company’s cash receipts and cash payments during the period. Exhibit 12.5 shows the usual format. A company must report cash flows from three activities: operating, investing, and financing. The statement

Point: A stock dividend transaction in- volving a transfer from retained earnings to common stock or a credit to contrib- uted capital is not considered a noncash investing and financing activity because the company receives no consideration for shares issued.

Point: Positive cash flows for a section are titled net cash “provided by” or “from.” Negative cash flows are labeled as net cash “used by.”

EXHIBIT 12.5 Format of the Statement of Cash Flows

COMPANY NAME

Statement of Cash Flows

For period Ended date

Cash flows from operating activities

[List of individual inflows and outflows]

Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . $ #

Cash flows from investing activities

[List of individual inflows and outflows]

Net cash provided (used) by investing activities . . . . . . . . . . . . . . . . . . . #

Cash flows from financing activities

[List of individual inflows and outflows]

Net cash provided (used) by financing activities . . . . . . . . . . . . . . . . . . . #

Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Cash (and equivalents) balance at prior period-end . . . . . . . . . . . #

Cash (and equivalents) balance at current period-end . . . . . . . . . $ #

Separate schedule or note disclosure of any “noncash investing and financing transactions” is required.

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514 Chapter 12 Reporting Cash Flows

Entrepreneur You are considering purchasing a start-up business that recently reported a $110,000 annual net loss and a $225,000 annual net cash inflow. How are these results possible? ■ [Answer—p. 540]

Decision Maker

explains how transactions and events impact the prior period-end cash (and cash equivalents) balance to produce its current period-end balance.

1. Does a statement of cash flows report the cash payments to purchase cash equivalents? Does it report the cash receipts from selling cash equivalents?

2. Identify the three categories of cash flows reported separately on the statement of cash flows. 3. Identify the cash activity category for each transaction: (a) purchase equipment for cash,

(b) cash payment of wages, (c) sale of common stock for cash, (d ) receipt of cash dividends from stock investment, (e) cash collection from customers, (f ) notes issued for cash.

Quick Check Answers — p. 540

Preparing the Statement of Cash Flows Preparing a statement of cash flows involves five steps: 1 compute the net increase or decrease in cash; 2 compute and report the net cash provided or used by operating activities (using either the direct or indirect method; both are explained); 3 compute and report the net cash provided or used by investing activities; 4 compute and report the net cash provided or used by financing activities; and 5 compute the net cash flow by combining net cash provided or used by operat- ing, investing, and financing activities and then prove it by adding it to the beginning cash bal- ance to show that it equals the ending cash balance.

Computing the net increase or net decrease in cash is a simple but crucial computation. It equals the current period’s cash balance minus the prior period’s cash balance. This is the bottom-line figure for the statement of cash flows and is a check on accuracy. The information we need to prepare a statement of cash flows comes from various sources including comparative balance sheets at the beginning and end of the period, and an income statement for the period. There are two alternative approaches to preparing the statement: (1) analyzing the Cash account and (2) analyzing noncash accounts.

Analyzing the Cash Account A company’s cash receipts and cash payments are recorded in the Cash account in its general ledger. The Cash account is therefore a natural place to look for information about cash flows from operating, investing, and financing activities. To illustrate, re- view the summarized Cash T-account of Genesis, Inc., in Exhibit 12.6. Individual cash transac- tions are summarized in this Cash account according to the major types of cash receipts and cash payments. For instance, only the total of cash receipts from all customers is listed. Individual cash transactions underlying these totals can number in the thousands. Accounting software is available to provide summarized cash accounts. Preparing a statement of cash flows from Exhibit 12.6 requires determining whether an individual cash inflow or outflow is an operating, investing, or financing activity, and then listing

P1 Prepare a statement of cash flows.

Point: View the change in cash as a target number (or check figure) that we will fully explain and prove in the statement of cash flows.

Step 1 Compute net increase or decrease in cash

Step 2 Compute net cash from operating activities

Step 3 Compute net cash from investing activities

Step 4 Compute net cash from financing activities

Step 5 Prove and report beginning and ending cash balances

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Chapter 12 Reporting Cash Flows 515

each by activity. This yields the statement shown in Exhibit 12.7. However, preparing the statement of cash flows from an analysis of the summarized Cash account has two limitations. First, most companies have many individual cash receipts and payments, making it difficult to review them all. Accounting software minimizes this burden, but it is still a task requiring professional judgment for many transactions. Second, the Cash account does not usually carry an adequate description of each cash transaction, making assignment of all cash transactions according to activity difficult.

EXHIBIT 12.6 Summarized Cash Account

Cash

Accounting System:

File Maintain Tasks Analysis Options Reports Window HelpEdit

Payments for merchandise .................................. Payments for wages and operating expenses ..... Payments for interest ........................................... Payments for taxes .............................................. Payments for assets ............................................ Payments for notes retirement ............................. Payments for dividends .......................................

Balance, Dec. 31, 2012 ............ Receipts from customers ......... Receipts from asset sales ........ Receipts from stock issuance ..

Balance, Dec. 31, 2013 ............

12,000 570,000 12,000 15,000

17,000

319,000 218,000

8,000 5,000

10,000 18,000 14,000

Analyzing Noncash Accounts A second approach to preparing the statement of cash flows is analyzing noncash accounts. This approach uses the fact that when a company records cash inflows and outflows with debits and credits to the Cash account (see Exhibit 12.6), it also records credits and debits in noncash accounts (reflecting double-entry accounting). Many of these noncash accounts are balance sheet accounts—for instance, from the sale of land for cash. Others are reve- nue and expense accounts that are closed to equity. For instance, the sale of services for cash yields a credit to Services Revenue that is closed to Retained Earnings for a corporation. In sum, all cash transactions eventually affect noncash balance sheet accounts. Thus, we can determine cash in- flows and outflows by analyzing changes in noncash balance sheet accounts. Exhibit 12.8 uses the accounting equation to show the relation between the Cash account and the noncash balance sheet accounts. This exhibit starts with the accounting equation at the

1 Cash change

EXHIBIT 12.7 Statement of Cash Flows— Direct Method

3 Cash from investing

4 Cash from financing

5 Cash proved

2 Cash from operating

GENESIS

Statement of Cash Flows

For Year Ended December 31, 2013

Cash flows from operating activities

Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . $570,000

Cash paid for merchandise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (319,000)

Cash paid for wages and other operating expenses . . . . . . . . . (218,000)

Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,000)

Cash paid for taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)

Net cash provided by operating activities . . . . . . . . . . . . . . . . . $20,000

Cash flows from investing activities

Cash received from sale of plant assets . . . . . . . . . . . . . . . . . . . 12,000

Cash paid for purchase of plant assets . . . . . . . . . . . . . . . . . . . (10,000)

Net cash provided by investing activities . . . . . . . . . . . . . . . . . . 2,000

Cash flows from financing activities

Cash received from issuing stock . . . . . . . . . . . . . . . . . . . . . . . 15,000

Cash paid to retire notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (18,000)

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000)

Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . (17,000)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Cash balance at prior year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Cash balance at current year-end . . . . . . . . . . . . . . . . . . . . . . . . . $17,000

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516 Chapter 12 Reporting Cash Flows

e-Cash Every credit transaction on the Net leaves a trail that a hacker or a marketer can pick up. Enter e-cash—or digital money. The encryption of e-cash protects your money from snoops and thieves and cannot be traced, even by the issuing bank. ■

Decision Insight

top. It is then expanded in line (2) to separate cash from noncash asset accounts. Line (3) moves noncash asset accounts to the right-hand side of the equality where they are subtracted. This shows that cash equals the sum of the liability and equity accounts minus the noncash asset ac- counts. Line (4) points out that changes on one side of the accounting equation equal changes on the other side. It shows that we can explain changes in cash by analyzing changes in the non- cash accounts consisting of liability accounts, equity accounts, and noncash asset accounts. By analyzing noncash balance sheet accounts and any related income statement accounts, we can prepare a statement of cash flows.

Information to Prepare the Statement Information to prepare the statement of cash flows usually comes from three sources: (1) comparative balance sheets, (2) the cur- rent income statement, and (3) additional information. Comparative balance sheets are used to compute changes in noncash accounts from the beginning to the end of the period. The current income statement is used to help compute cash flows from operating activities. Ad- ditional information often includes details on transactions and events that help explain both the cash flows and noncash investing and financing activities.

Additional Information

Income StatementIncome StatementIncome Statement

Balance SheetsBalance Sheets

Indirect and Direct Methods of Reporting Cash flows provided (used) by operating activities are reported in one of two ways: the direct method or the indirect method. These two different methods apply only to the operating activities section.

The direct method separately lists each major item of operating cash re- ceipts (such as cash received from customers) and each major item of oper- ating cash payments (such as cash paid for merchandise). The cash payments are subtracted from cash receipts to determine the net cash provided (used) by operating activities. The operating activities section of Exhibit 12.7 re- flects the direct method of reporting operating cash flows.

The indirect method reports net income and then adjusts it for items necessary to obtain net cash provided or used by operating activities. It does not report individual items of cash inflows and cash outflows from operating activities. Instead, the indirect method reports the necessary adjustments to reconcile net income to net cash provided or used by operating activities. The operating activities section for Genesis prepared under the indirect method is shown in Exhibit 12.9. The net cash amount provided by oper- ating activities is identical under both the direct and indirect methods.

CASH FLOWS FROM OPERATING

Operating

Assets

Cash Noncash assets Liabilities

Liabilities

Equity

Equity

Cash

Changes

in cash

account

1

15

5

5

5

1

1 Equity

Changes in

noncash

accounts

(1)

(2)

(3)

(4)

Noncash assetsLiabilities 2

EXHIBIT 12.8 Relation between Cash and Noncash Accounts

Information on changes in cash is obtained from analyzing either the Cash account or the noncash accounts

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Chapter 12 Reporting Cash Flows 517

EXHIBIT 12.9 Operating Activities Section— Indirect Method

Cash flows from operating activities

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 38,000

Adjustments to reconcile net income to net cash provided by operating activities

Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . (20,000)

Increase in merchandise inventory . . . . . . . . . . . . . . . . . . (14,000)

Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . (2,000)

Decrease in accounts payable . . . . . . . . . . . . . . . . . . . . . . (5,000)

Decrease in interest payable . . . . . . . . . . . . . . . . . . . . . . . (1,000)

Increase in income taxes payable . . . . . . . . . . . . . . . . . . . 10,000

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Loss on sale of plant assets . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Gain on retirement of notes . . . . . . . . . . . . . . . . . . . . . . . (16,000)

Net cash provided by operating activities . . . . . . . . . . $20,000

The next section describes the indirect method. Appendix 12B describes the direct method. An instructor can choose to cover either one or both methods. Neither section depends on the other. If the indirect method is skipped, then read Appendix 12B and return to the section (six pages ahead) titled “Cash Flows from Investing.”

This equality always exists. The difference in these methods is with the computation and pre- sentation of this amount. The FASB recommends the direct method, but because it is not re- quired and the indirect method is arguably easier to compute, nearly all companies report operating cash flows using the indirect method. To illustrate, we prepare the operating activities section of the statement of cash flows for Genesis. Exhibit 12.10 shows the December 31, 2012 and 2013, balance sheets of Genesis along with its 2013 income statement. We use this information to prepare a statement of cash flows that explains the $5,000 increase in cash for 2013 as reflected in its balance sheets. This $5,000 is computed as Cash of $17,000 at the end of 2013 minus Cash of $12,000 at the end of 2012. Genesis discloses additional information on its 2013 transactions:

a. The accounts payable balances result from merchandise inventory purchases. b. Purchased $70,000 in plant assets by paying $10,000 cash and issuing $60,000 of notes

payable. c. Sold plant assets with an original cost of $30,000 and accumulated depreciation of $12,000

for $12,000 cash, yielding a $6,000 loss. d. Received $15,000 cash from issuing 3,000 shares of common stock. e. Paid $18,000 cash to retire notes with a $34,000 book value, yielding a $16,000 gain. f. Declared and paid cash dividends of $14,000.

Point: To better understand the direct and indirect methods of reporting operat- ing cash flows, identify similarities and dif- ferences between Exhibits 12.7 and 12.11.

Application of the Indirect Method of Reporting Net income is computed using accrual accounting, which recognizes revenues when earned and expenses when incurred. Revenues and expenses do not necessarily reflect the receipt and pay- ment of cash. The indirect method of computing and reporting net cash flows from operating activities involves adjusting the net income figure to obtain the net cash provided or used by operating activities. This includes subtracting noncash increases (credits) from net income and adding noncash charges (debits) back to net income. To illustrate, the indirect method begins with Genesis’s net income of $38,000 and adjusts it to obtain net cash provided by operating activities of $20,000. Exhibit 12.11 shows the results of the indirect method of reporting operating cash flows, which adjusts net income for three types of adjustments. There are adjustments 1 to reflect changes in noncash current assets and current liabilities related to operating activities, 2 to income statement items involving operat- ing activities that do not affect cash inflows or outflows, and 3 to eliminate gains and losses resulting from investing and financing activities (not part of operating activities). This section describes each of these adjustments.

Point: Noncash credits refer to revenue amounts reported on the income state- ment that are not collected in cash this period. Noncash charges refer to expense amounts reported on the income state- ment that are not paid this period.

P2 Compute cash flows from operating activities using the indirect method.

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518 Chapter 12 Reporting Cash Flows

1 Adjustments for Changes in Current Assets and Current Liabilities This section describes adjustments for changes in noncash current assets and current liabilities.

Adjustments for changes in noncash current assets. Changes in noncash current assets nor- mally result from operating activities. Examples are sales affecting accounts receivable and building usage affecting prepaid rent. Decreases in noncash current assets yield the following adjustment:

Decreases in noncash current assets are added to net income.

To see the logic for this adjustment, consider that a decrease in a noncash current asset such as accounts receivable suggests more available cash at the end of the period compared to the begin- ning. This is so because a decrease in accounts receivable implies higher cash receipts than re- flected in sales. We add these higher cash receipts (from decreases in noncash current assets) to net income when computing cash flow from operations. In contrast, an increase in noncash current assets such as accounts receivable implies less cash receipts than reflected in sales. As another example, an increase in prepaid rent indicates that more cash is paid for rent than is deducted as rent expense. Increases in noncash current assets yield the following adjustment:

Increases in noncash current assets are subtracted from net income.

To illustrate, these adjustments are applied to the noncash current assets in Exhibit 12.10. Accounts receivable. Accounts receivable increase $20,000, from a beginning balance of $40,000 to an ending balance of $60,000. This increase implies that Genesis collects less cash than is reported in sales. That is, some of these sales were in the form of accounts receivable and

EXHIBIT 12.10 Financial Statements

Point: Operating activities are typically those that determine income, which are often reflected in changes in current assets and current liabilities.

GENESIS

Balance Sheets

December 31, 2013 and 2012

2013 2012

Assets

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,000 $ 12,000

Accounts receivable . . . . . . . . . . . . . 60,000 40,000

Merchandise inventory . . . . . . . . . . . 84,000 70,000

Prepaid expenses . . . . . . . . . . . . . . . 6,000 4,000

Total current assets . . . . . . . . . . . . . . 167,000 126,000

Long-term assets

Plant assets . . . . . . . . . . . . . . . . . . . . 250,000 210,000

Accumulated depreciation . . . . . . . . (60,000) (48,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . $357,000 $288,000

Liabilities

Current liabilities

Accounts payable . . . . . . . . . . . . . . . . $ 35,000 $ 40,000

Interest payable . . . . . . . . . . . . . . . . . 3,000 4,000

Income taxes payable . . . . . . . . . . . . 22,000 12,000

Total current liabilities . . . . . . . . . . . . 60,000 56,000

Long-term notes payable . . . . . . . . . . . 90,000 64,000

Total liabilities . . . . . . . . . . . . . . . . . . . . 150,000 120,000

Equity

Common stock, $5 par . . . . . . . . . . . . . 95,000 80,000

Retained earnings . . . . . . . . . . . . . . . . . 112,000 88,000

Total equity . . . . . . . . . . . . . . . . . . . . . . 207,000 168,000

Total liabilities and equity . . . . . . . . . . . $357,000 $288,000

GENESIS

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $590,000

Cost of goods sold . . . . . . . . . . . . . . . . $300,000

Wages and other operating expenses . . 216,000

Interest expense . . . . . . . . . . . . . . . . . . 7,000

Depreciation expense . . . . . . . . . . . . . . 24,000 (547,000)

43,000

Other gains (losses)

Gain on retirement of notes . . . . . . 16,000

Loss on sale of plant assets . . . . . . . . (6,000) 10,000

Income before taxes . . . . . . . . . . . . . . . 53,000

Income taxes expense . . . . . . . . . . . . . . (15,000)

Net income . . . . . . . . . . . . . . . . . . . . . . $ 38,000

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Chapter 12 Reporting Cash Flows 519

that amount increased during the period. To see this it is helpful to use account analysis. This usually involves setting up a T-account and reconstructing its major entries to compute cash re- ceipts or payments. The following reconstructed Accounts Receivable T-account reveals that cash receipts are less than sales:

Merchandise Inventory

Bal., Dec. 31, 2012 70,000 Purchases 5 314,000 Cost of goods sold 300,000

Bal., Dec. 31, 2013 84,000

Accounts Receivable

Bal., Dec. 31, 2012 40,000

Sales 590,000 Cash receipts 5 570,000

Bal., Dec. 31, 2013 60,000

Numbers in black are taken from Exhibit 12.10. The red number is the computed (plug) figure.

We see that sales are $20,000 greater than cash receipts. This $20,000— as reflected in the $20,000 increase in Accounts Receivable—is subtracted from net income when computing cash provided by operating activities (see Exhibit 12.11). Merchandise inventory. Merchandise inventory increases by $14,000, from a $70,000 begin- ning balance to an $84,000 ending balance. This increase implies that Genesis had greater cash purchases than cost of goods sold. This larger amount of cash purchases is in the form of inven- tory, as reflected in the following account analysis:

Point: Refer to Exhibit 12.10 and identify the $5,000 change in cash. This change is what the statement of cash flows explains; it serves as a check.

EXHIBIT 12.11 Statement of Cash Flows— Indirect Method

GENESIS

Statement of Cash Flows

For Year Ended December 31, 2013

Cash flows from operating activities

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 38,000

Adjustments to reconcile net income to net cash provided by operating activities

Increase in accounts receivable. . . . . . . . . . . . . . . . . (20,000)

Increase in merchandise inventory . . . . . . . . . . . . . . (14,000)

Increase in prepaid expenses . . . . . . . . . . . . . . . . . . (2,000)

Decrease in accounts payable . . . . . . . . . . . . . . . . . . (5,000)

Decrease in interest payable . . . . . . . . . . . . . . . . . . . (1,000)

Increase in income taxes payable . . . . . . . . . . . . . . . 10,000

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Loss on sale of plant assets . . . . . . . . . . . . . . . . . . . . 6,000

Gain on retirement of notes . . . . . . . . . . . . . . . . . . . (16,000)

Net cash provided by operating activities . . . . . . . . . . . . $20,000

Cash flows from investing activities

Cash received from sale of plant assets . . . . . . . . . . . . . . 12,000

Cash paid for purchase of plant assets . . . . . . . . . . . . . . . (10,000)

Net cash provided by investing activities . . . . . . . . . . . . . 2,000

Cash flows from financing activities

Cash received from issuing stock . . . . . . . . . . . . . . . . . . . 15,000

Cash paid to retire notes . . . . . . . . . . . . . . . . . . . . . . . . . (18,000)

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000)

Net cash used in financing activities . . . . . . . . . . . . . . . . . (17,000)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Cash balance at prior year-end . . . . . . . . . . . . . . . . . . . . . . . 12,000

Cash balance at current year-end . . . . . . . . . . . . . . . . . . . . . $17,000

⎫ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎭

{

3

2

1

Point: The statement of cash flows is usually the last prepared of the four required financial statements.

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520 Chapter 12 Reporting Cash Flows

The amount by which purchases exceed cost of goods sold — as reflected in the $14,000 in- crease in inventory — is subtracted from net income when computing cash provided by operat- ing activities (see Exhibit 12.11). Prepaid expenses. Prepaid Expenses increase $2,000, from a $4,000 beginning balance to a $6,000 ending balance, implying that Genesis’s cash payments exceed its recorded prepaid expenses. These higher cash payments increase the amount of Prepaid Expenses, as reflected in its reconstructed T-account:

Prepaid Expenses

Bal., Dec. 31, 2012 4,000 Cash payments 5 218,000 Wages and other operating exp. 216,000

Bal., Dec. 31, 2013 6,000

Cash payments 5 319,000

Bal., Dec. 31, 2012 40,000

Purchases 314,000

Bal., Dec. 31, 2013 35,000

Accounts Payable

Cash paid for interest 5 8,000

Bal., Dec. 31, 2012 4,000

Interest expense 7,000

Bal., Dec. 31, 2013 3,000

Interest Payable

The amount by which cash payments exceed the recorded operating expenses — as reflected in the $2,000 increase in Prepaid Expenses — is subtracted from net income when computing cash provided by operating activities (see Exhibit 12.11).

Adjustments for changes in current liabilities. Changes in current liabilities normally result from operating activities. An example is a purchase that affects accounts payable. Increases in current liabilities yield the following adjustment to net income when computing operating cash flows:

Increases in current liabilities are added to net income.

To see the logic for this adjustment, consider that an increase in the Accounts Payable account suggests that cash payments are less than the related (cost of goods sold) expense. As another example, an increase in wages payable implies that cash paid for wages is less than the recorded wages expense. Since the recorded expense is greater than the cash paid, we add the increase in wages payable to net income to compute net cash flow from operations. Conversely, when current liabilities decrease, the following adjustment is required:

Decreases in current liabilities are subtracted from net income.

To illustrate, these adjustments are applied to the current liabilities in Exhibit 12.10. Accounts payable. Accounts payable decrease $5,000, from a beginning balance of $40,000 to an ending balance of $35,000. This decrease implies that cash payments to suppliers exceed purchases by $5,000 for the period, which is reflected in the reconstructed Accounts Payable T-account:

The amount by which cash payments exceed purchases — as reflected in the $5,000 decrease in Accounts Payable — is subtracted from net income when computing cash provided by operating activities (see Exhibit 12.11). Interest payable. Interest payable decreases $1,000, from a $4,000 beginning balance to a $3,000 ending balance. This decrease indicates that cash paid for interest exceeds interest expense by $1,000, which is reflected in the Interest Payable T-account:

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Chapter 12 Reporting Cash Flows 521

The amount by which cash paid exceeds recorded expense — as reflected in the $1,000 decrease in Interest Payable—is subtracted from net income (see Exhibit 12.11). Income taxes payable. Income taxes payable increase $10,000, from a $12,000 be ginning balance to a $22,000 ending balance. This increase implies that reported income taxes exceed the cash paid for taxes, which is reflected in the Income Taxes Payable T-account:

Cash paid for taxes 5 5,000

Bal., Dec. 31, 2012 12,000

Income taxes expense 15,000

Bal., Dec. 31, 2013 22,000

Income Taxes Payable

Summary Adjustments for Changes in

Current Assets and Current Liabilities

Account Increases Decreases

Noncash current Deduct Add assets . . . . . . . from NI to NI

Current Add Deduct liabilities . . . . . . to NI from NI

The amount by which cash paid falls short of the reported taxes expense — as reflected in the $10,000 increase in Income Taxes Payable — is added to net income when computing cash pro- vided by operating activities (see Exhibit 12.11).

2 Adjustments for Operating Items Not Providing or Using Cash The in- come statement usually includes some expenses that do not reflect cash outflows in the period. Examples are depreciation, amortization, depletion, and bad debts expense. The indirect method for reporting operating cash flows requires that

Expenses with no cash outflows are added back to net income.

To see the logic of this adjustment, recall that items such as depreciation, amortization, depletion, and bad debts originate from debits to expense accounts and credits to noncash accounts. These entries have no cash effect, and we add them back to net income when computing net cash flows from operations. Adding them back cancels their deductions. Similarly, when net income includes revenues that do not reflect cash inflows in the period, the indirect method for reporting operating cash flows requires that

Revenues with no cash inflows are subtracted from net income.

We apply these adjustments to the Genesis operating items that do not provide or use cash.

Depreciation. Depreciation expense is the only Genesis operating item that has no effect on cash flows in the period. We must add back the $24,000 depreciation expense to net income when computing cash provided by operating activities. (We later explain that any cash outflow to acquire a plant asset is reported as an investing activity.)

3 Adjustments for Nonoperating Items Net income often includes losses that are not part of operating activities but are part of either investing or financing activities. Examples are a loss from the sale of a plant asset and a loss from retirement of notes payable. The indirect method for reporting operating cash flows requires that

Nonoperating losses are added back to net income.

To see the logic, consider that items such as a plant asset sale and a notes retirement are nor- mally recorded by recognizing the cash, removing all plant asset or notes accounts, and recog- nizing any loss or gain. The cash received or paid is not part of operating activities but is part of either investing or financing activities. No operating cash flow effect occurs. However, because the nonoperating loss is a deduction in computing net income, we need to add it back to net in- come when computing cash flow from operations. Adding it back cancels the deduction. Similarly, when net income includes gains not part of operating activities, the indirect method for reporting operating cash flows requires that

Nonoperating gains are subtracted from net income.

To illustrate these adjustments, we consider the nonoperating items of Genesis.

Point: An income statement reports revenues, gains, expenses, and losses on an accrual basis. The statement of cash flows reports cash received and cash paid for operating, financing, and investing activities.

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522 Chapter 12 Reporting Cash Flows

Loss on sale of plant assets. Genesis reports a $6,000 loss on sale of plant assets as part of net income. This loss is a proper deduction in computing income, but it is not part of op erating activities. Instead, a sale of plant assets is part of investing activities. Thus, the $6,000 nonoper- ating loss is added back to net income (see Exhibit 12.11). Adding it back cancels the loss. We later explain how to report the cash inflow from the asset sale in investing activities.

Gain on retirement of debt. A $16,000 gain on retirement of debt is properly included in net income, but it is not part of operating activities. This means the $16,000 nonoperating gain must be subtracted from net income to obtain net cash provided by operating activities (see Exhibit 12.11). Subtracting it cancels the recorded gain. We later describe how to report the cash outflow to retire debt.

Summary of Adjustments for Indirect Method Exhibit 12.12 summarizes the most common adjustments to net income when computing net cash provided or used by operating activities under the indirect method.

The computations in determining cash provided or used by operating activities are different for the indirect and direct methods, but the result is identical. Both methods yield the same $20,000 figure for cash from operating activities for Genesis; see Exhibits 12.7 and 12.11.

4. Determine the net cash provided or used by operating activities using the following data: net income, $74,900; decrease in accounts receivable, $4,600; increase in inventory, $11,700; decrease in accounts payable, $1,000; loss on sale of equipment, $3,400; payment of cash dividends, $21,500.

5. Why are expenses such as depreciation and amortization added to net income when cash flow from operating activities is computed by the indirect method?

6. A company reports net income of $15,000 that includes a $3,000 gain on the sale of plant assets. Why is this gain subtracted from net income in computing cash flow from operating activities using the indirect method?

Quick Check Answers — p. 540

EXHIBIT 12.12 Summary of Selected Adjustments for Indirect Method

Net Income

1Decrease in noncash current asset

2Increase in noncash current asset Adjustments for changes in current 1Increase in current liability* assets and current liabilities

2Decrease in current liability*

1Depreciation, depletion, and amortization

Adjustments for operating items not providing or using cash 1Losses from disposal of long-term assets and retirement of debt

Adjustments for nonoperating items 2Gains from disposal of long-term assets and retirement of debt

Net cash provided (used) by operating activities

* Excludes current portion of long-term debt and any (nonsales-related) short-term notes payable — both are financing activities.

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎪ ⎬ ⎪ ⎭

⎫ ⎬ ⎭

3

2

1

Point: By adding back nonoperating items such as ‘Loss on sale of plant assets’ to net income, we get operating income, which is the starting point for the operating section of the statement of cash flows.

Cash or Income The difference between net income and operating cash flows can be large and sometimes reflects on the quality of earnings. This bar chart shows the net income and operating cash flows of three companies. Operating cash flows can be either higher or lower than net income. ■

Decision Insight

$ Millions

Starbucks

Gap

Harley

$0 $300 $600 $900 $1,200 $1,500

$833

$1,363

$599

$885

$1,246

$1,612

Net Income

Operating Cash Flows

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Chapter 12 Reporting Cash Flows 523

The third major step in preparing the statement of cash flows is to compute and report cash flows from investing activities. We normally do this by identifying changes in (1) all noncurrent asset accounts and (2) the current accounts for both notes receivable and investments in securi- ties (excluding trading securities). We then analyze changes in these accounts to determine their effect, if any, on cash and report the cash flow effects in the investing activities section of the state- ment of cash flows. Reporting of investing activities is identical under the direct method and indirect method.

Three-Stage Process of Analysis Information to compute cash flows from investing activities is usually taken from beginning and ending balance sheets and the income statement. We use a three-stage process to determine cash provided or used by investing activities: (1) identify changes in investing-related accounts, (2) explain these changes using reconstruction analysis, and (3) report their cash flow effects.

Analysis of Noncurrent Assets Information about the Genesis transactions provided earlier reveals that the company both pur- chased and sold plant assets during the period. Both transactions are investing activities and are analyzed for their cash flow effects in this section.

Plant Asset Transactions The first stage in analyzing the Plant Assets account and its related Accumulated Depreciation is to identify any changes in these accounts from compara- tive balance sheets in Exhibit 12.10. This analysis reveals a $40,000 increase in plant assets from $210,000 to $250,000 and a $12,000 increase in accumulated depreciation from $48,000 to $60,000. The second stage is to explain these changes. Items b and c of the additional information for Genesis (page 517) are relevant in this case. Recall that the Plant Assets account is affected by both asset purchases and sales, while its Accumulated Depreciation account is normally increased from depreciation and decreased from the removal of accumulated depreciation in asset sales. To explain changes in these accounts and to identify their cash flow effects, we prepare reconstructed entries from prior transactions; they are not the actual entries by the preparer. To illustrate, item b reports that Genesis purchased plant assets of $70,000 by issuing $60,000 in notes payable to the seller and paying $10,000 in cash. The reconstructed entry for analysis of item b follows:

CASH FLOWS FROM INVESTING

This entry reveals a $10,000 cash outflow for plant assets and a $60,000 noncash investing and financing transaction involving notes exchanged for plant assets. Next, item c reports that Genesis sold plant assets costing $30,000 (with $12,000 of accumulated depreciation) for $12,000 cash, resulting in a $6,000 loss. The reconstructed entry for analysis of item c follows:

Point: Investing activities include (1) purchasing and selling long-term assets, (2) lending and collecting on notes receivable, and (3) purchasing and selling short-term investments other than cash equivalents and trading securities.

Point: Financing and investing info is available in ledger accounts to help explain changes in comparative balance sheets. Post references lead to relevant entries and explanations.

Reconstruction Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Reconstruction Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . 12,000

Loss on Sale of Plant Assets . . . . . . . . . . . . . . . . . . . . . . 6,000

Plant Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

P3 Determine cash flows from both investing and financing activities.

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524 Chapter 12 Reporting Cash Flows

This entry reveals a $12,000 cash inflow from assets sold. The $6,000 loss is computed by com- paring the asset book value to the cash received and does not reflect any cash inflow or outflow. We also reconstruct the entry for Depreciation Expense using information from the income statement.

Reconstruction Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Accumulated Depreciation . . . . . . . . . . . . . . . . . . . 24,000

Noncash investing and financing activity

Purchased plant assets with issuance of notes . . . . . . . . . . $60,000

Cash flows from investing activities

Cash received from sale of plant assets . . . . . . . . . . . . . . . $12,000

Cash paid for purchase of plant assets . . . . . . . . . . . . . . . . (10,000)

Sale 12,000

Bal., Dec. 31, 2012 48,000

Depr. expense 24,000

Bal., Dec. 31, 2013 60,000

Accumulated Depreciation — Plant Assets

Bal., Dec. 31, 2012 210,000

Purchase 70,000

Bal., Dec. 31, 2013 250,000

Sale 30,000

Plant Assets

This entry shows that Depreciation Expense results in no cash flow effect. These three recon- structed entries are reflected in the following plant asset and related T-accounts.

Example: If a plant asset costing $40,000 with $37,000 of accumulated depreciation is sold at a $1,000 loss, what is the cash flow? What is the cash flow if this asset is sold at a gain of $3,000? Answers: 1$2,000; 1$6,000.

Point: When determining cash flows from investing, T-account analysis is key to reconstructing accounts and amounts.

This reconstruction analysis is complete in that the change in plant assets from $210,000 to $250,000 is fully explained by the $70,000 purchase and the $30,000 sale. Also, the change in accumulated depreciation from $48,000 to $60,000 is fully explained by depreciation expense of $24,000 and the removal of $12,000 in accumulated depreciation from an asset sale. (Prepar- ers of the statement of cash flows have the entire ledger and additional information at their disposal, but for brevity reasons only the information needed for reconstructing accounts is given.) The third stage looks at the reconstructed entries for identification of cash flows. The two identified cash flow effects are reported in the investing section of the statement as follows (also see Exhibit 12.7 or 12.11):

The $60,000 portion of the purchase described in item b and financed by issuing notes is a non- cash investing and financing activity. It is reported in a note or in a separate schedule to the statement as follows:

Analysis of Other Assets Many other asset transactions (including those involving current notes receivable and invest- ments in certain securities) are considered investing activities and can affect a company’s cash flows. Since Genesis did not enter into other investing activities impacting assets, we do not need to extend our analysis to these other assets. If such transactions did exist, we would analyze them using the same three-stage process illustrated for plant assets.

7. Equipment costing $80,000 with accumulated depreciation of $30,000 is sold at a loss of $10,000. What is the cash receipt from this sale? In what section of the statement of cash flows is this transaction reported?

Quick Check Answer — p. 540

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Chapter 12 Reporting Cash Flows 525

The fourth major step in preparing the statement of cash flows is to compute and report cash flows from financing activities. We normally do this by identifying changes in all noncurrent liability accounts (including the current portion of any notes and bonds) and the equity ac- counts. These accounts include long-term debt, notes payable, bonds payable, common stock, and retained earnings. Changes in these accounts are then analyzed using available information to determine their effect, if any, on cash. Results are reported in the financing activities section of the statement. Reporting of financing activities is identical under the direct method and indirect method.

Three-Stage Process of Analysis We again use a three-stage process to determine cash provided or used by financing activities: (1) identify changes in financing-related accounts, (2) explain these changes using reconstruc- tion analysis, and (3) report their cash flow effects.

Analysis of Noncurrent Liabilities Information about Genesis provided earlier reveals two transactions involving noncurrent liabil- ities. We analyzed one of those, the $60,000 issuance of notes payable to purchase plant assets. This transaction is reported as a significant noncash investing and financing activity in a foot- note or a separate schedule to the statement of cash flows. The other remaining transaction in- volving noncurrent liabilities is the cash retirement of notes payable.

Notes Payable Transactions The first stage in analysis of notes is to review the com- parative balance sheets from Exhibit 12.10. This analysis reveals an increase in notes payable from $64,000 to $90,000. The second stage explains this change. Item e of the additional information for Genesis (page 517) reports that notes with a carrying value of $34,000 are retired for $18,000 cash, resulting in a $16,000 gain. The reconstructed entry for analysis of item e follows:

CASH FLOWS FROM FINANCING

Point: Financing activities generally refer to changes in the noncurrent liability and the equity accounts. Exam- ples are (1) receiving cash from issuing debt or repaying amounts borrowed and (2) receiving cash from or distributing cash to owners.

Reconstruction Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000

Gain on retirement of debt . . . . . . . . . . . . . . . . . . 16,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

This entry reveals an $18,000 cash outflow for retirement of notes and a $16,000 gain from comparing the notes payable carrying value to the cash received. This gain does not reflect any cash inflow or outflow. Also, item b of the additional information reports that Genesis pur- chased plant assets costing $70,000 by issuing $60,000 in notes payable to the seller and paying $10,000 in cash. We reconstructed this entry when analyzing investing activities: It showed a $60,000 increase to notes payable that is reported as a noncash investing and financing transac- tion. The Notes Payable account reflects (and is fully explained by) these reconstructed entries as follows:

Cash flows from financing activities

Cash paid to retire notes . . . . . . . . . . . . . . . . . . . $(18,000)

Retired notes 34,000

Bal., Dec. 31, 2012 64,000

Issued notes 60,000

Bal., Dec. 31, 2013 90,000

Notes Payable

The third stage is to report the cash flow effect of the notes retirement in the financing section of the statement as follows (also see Exhibit 12.7 or 12.11):

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526 Chapter 12 Reporting Cash Flows

Analysis of Equity The Genesis information reveals two transactions involving equity accounts. The first is the issuance of common stock for cash. The second is the declaration and payment of cash dividends. We analyze both.

Common Stock Transactions The first stage in analyzing common stock is to review the comparative balance sheets from Exhibit 12.10, which reveal an increase in common stock from $80,000 to $95,000. The second stage explains this change. Item d of the additional information (page 517) reports that 3,000 shares of common stock are issued at par for $5 per share. The reconstructed entry for analysis of item d follows:

Reconstruction Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Bal., Dec. 31, 2012 80,000

Issued stock 15,000

Bal., Dec. 31, 2013 95,000

Common Stock

Cash flows from financing activities

Cash received from issuing stock . . . . . . . . . . . . . $15,000

Reconstruction Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Cash dividend 14,000

Bal., Dec. 31, 2012 88,000

Net income 38,000

Bal., Dec. 31, 2013 112,000

Retained Earnings

This entry reveals a $15,000 cash inflow from stock issuance and is reflected in (and explains) the Common Stock account as follows:

The third stage discloses the cash flow effect from stock issuance in the financing section of the statement as follows (also see Exhibit 12.7 or 12.11):

Retained Earnings Transactions The first stage in analyzing the Retained Earnings account is to review the comparative balance sheets from Exhibit 12.10. This reveals an increase in retained earnings from $88,000 to $112,000. The second stage explains this change. Item f of the additional information (page 517) reports that cash dividends of $14,000 are paid. The reconstructed entry follows:

This entry reveals a $14,000 cash outflow for cash dividends. Also see that the Retained Earnings account is impacted by net income of $38,000. (Net income was analyzed under the operating section of the statement of cash flows.) The reconstructed Retained Earnings account follows:

The third stage reports the cash flow effect from the cash dividend in the financing section of the statement as follows (also see Exhibit 12.7 or 12.11):

Cash flows from financing activities

Cash paid for dividends. . . . . . . . . . . . . . . . . . . . . $(14,000)

Point: Financing activities not affecting cash flow include declaration of a cash dividend, declaration of a stock dividend, payment of a stock dividend, and a stock split.

Global: There are no requirements to separate domestic and international cash flows, leading some users to ask, “Where in the world is cash flow?”

We now have identified and explained all of the Genesis cash inflows and cash outflows and one noncash investing and financing transaction. Specifically, our analysis has reconciled changes in all noncash balance sheet accounts.

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Chapter 12 Reporting Cash Flows 527

Reporter Management is in labor contract negotiations and grants you an interview. It highlights a recent $600,000 net loss that involves a $930,000 extraordinary loss and a total net cash outflow of $550,000 (which includes net cash outflows of $850,000 for investing activities and $350,000 for financing activities). What is your assessment of this company? ■ [Answer—p. 540]

Decision Maker

Net cash provided by operating activities . . . . . . . . $ 20,000

Net cash provided by investing activities . . . . . . . . . 2,000

Net cash used in financing activities . . . . . . . . . . . . . (17,000)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Cash balance at 2012 year-end . . . . . . . . . . . . . . . . . 12,000

Cash balance at 2013 year-end . . . . . . . . . . . . . . . . . $ 17,000

Proving Cash Balances The fifth and final step in preparing the statement is to report the beginning and ending cash balances and prove that the net change in cash is explained by operating, investing, and financing cash flows. This step is shown here for Genesis.

The preceding table shows that the $5,000 net increase in cash, from $12,000 at the beginning of the period to $17,000 at the end, is reconciled by net cash flows from operating ($20,000 inflow), investing ($2,000 inflow), and financing ($17,000 outflow) activities. This is formally reported at the bottom of the statement of cash flows as shown in both Exhibits 12.7 and 12.11.

The statement of cash flows, which explains changes in cash (including cash equivalents) from period to period, is required under both U.S. GAAP and IFRS. This section discusses similarities and differences between U.S. GAAP and IFRS in reporting that statement.

Reporting Cash Flows from Operating Both U.S. GAAP and IFRS permit the reporting of cash flows from operating activities using either the direct or indirect method. Further, the basic require- ments underlying the application of both methods are fairly consistent across these two accounting sys- tems. Appendix A shows that both KTM and Piaggio report their cash flows from operating activities using the indirect method, and in a manner similar to that explained in this chapter. Further, the definition of cash and cash equivalents is roughly similar for U.S. GAAP and IFRS. There are, however, some differences between U.S. GAAP and IFRS in reporting operating cash flows. We mention two of the more notable. First, U.S. GAAP requires cash inflows from interest revenue and dividend revenue be classified as operating, whereas IFRS permits classification under operating or in- vesting provided that this classification is consistently applied across periods. Nokia reports its cash from interest received under operating, consistent with U.S. GAAP (no mention is made of any dividends re- ceived). Second, U.S. GAAP requires cash outflows for interest expense be classified as operating, whereas IFRS again permits classification under operating or financing provided that it is consistently applied across periods. (Some believe that interest payments, like dividends payments, are better classified as financing because they represent payments to financiers.) Piaggio reports cash outflows for interest under operating, which is consistent with U.S. GAAP and acceptable under IFRS.

Reporting Cash Flows from Investing and Financing U.S. GAAP and IFRS are broadly similar in computing and classifying cash flows from investing and financing activities. A quick review of these two sections for both KTM’s and Piaggio’s statement of cash flows shows a structure similar to that explained in this chapter. One notable exception is that U.S. GAAP requires cash outflows for income tax be classified as operating, whereas IFRS permits the splitting of those cash flows among operating, invest- ing, and financing depending on the sources of that tax. Both KTM and Piaggio report their cash outflows for income tax under operating, which is similar to U.S. GAAP.

GLOBAL VIEW

KTM PIAGGIO

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Cash Flow AnalysisDecision Analysis

Analyzing Cash Sources and Uses Most managers stress the importance of understanding and predicting cash flows for business decisions. Creditors evaluate a company’s ability to generate cash before deciding whether to lend money. Investors also assess cash inflows and outflows before buying and selling stock. Information in the statement of cash flows helps address these and other questions such as (1) How much cash is generated from or used in op- erations? (2) What expenditures are made with cash from operations? (3) What is the source of cash for debt payments? (4) What is the source of cash for distributions to owners? (5) How is the increase in investing activities financed? (6) What is the source of cash for new plant assets? (7) Why is cash flow from operations different from income? (8) How is cash from financing used? To effectively answer these questions, it is important to separately analyze investing, financing, and operating activities. To illustrate, consider data from three different companies in Exhibit 12.13. These companies operate in the same industry and have been in business for several years.

528 Chapter 12 Reporting Cash Flows

EXHIBIT 12.13 Cash Flows of Competing Companies

($ thousands) BMX ATV Trex

Cash provided (used) by operating activities . . . . . . . . . $90,000 $40,000 $(24,000)

Cash provided (used) by investing activities

Proceeds from sale of plant assets . . . . . . . . . . . . . . . 26,000

Purchase of plant assets . . . . . . . . . . . . . . . . . . . . . . . (48,000) (25,000)

Cash provided (used) by financing activities

Proceeds from issuance of debt . . . . . . . . . . . . . . . . . 13,000

Repayment of debt . . . . . . . . . . . . . . . . . . . . . . . . . . . (27,000)

Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . $15,000 $15,000 $ 15,000

A1 Analyze the statement of cash flows and apply the cash flow on total assets ratio.

Each company generates an identical $15,000 net increase in cash, but its sources and uses of cash flows are very different. BMX’s operating activities provide net cash flows of $90,000, allowing it to purchase plant assets of $48,000 and repay $27,000 of its debt. ATV’s operating activities provide $40,000 of cash flows, limiting its purchase of plant assets to $25,000. Trex’s $15,000 net cash increase is due to selling plant assets and incurring additional debt. Its operating activities yield a net cash outflow of $24,000. Overall, analysis of these cash flows reveals that BMX is more capable of generating future cash flows than is ATV or Trex.

Cash Flow on Total Assets Cash flow information has limitations, but it can help measure a company’s ability to meet its obligations, pay dividends, expand operations, and obtain financing. Users often compute and analyze a cash-based ratio similar to return on total assets except that its numerator is net cash flows from operating activities. The cash flow on total assets ratio is in Exhibit 12.14.

EXHIBIT 12.14 Cash Flow on Total Assets Cash flow on total assets 5

Cash flow from operations

Average total assets

This ratio reflects actual cash flows and is not affected by accounting income recognition and mea- surement. It can help business decision makers estimate the amount and timing of cash flows when plan- ning and analyzing operating activities. To illustrate, the 2011 cash flow on total assets ratio for Nike is 12.3%—see Exhibit 12.15. Is a 12.3% ratio good or bad? To answer this question, we compare this ratio with the ratios of prior years (we could also compare its ratio with those of its competitors and the market). Nike’s cash flow on total assets ratio

Free Cash Flows Many investors use cash flows to value company stock. However, cash-based valua- tion models often yield different stock values due to differences in measurement of cash flows. Most mod- els require cash flows that are “free” for distribution to shareholders. These free cash flows are defined as cash flows available to shareholders after operating asset reinvestments and debt payments. Knowledge of the statement of cash flows is key to proper computation of free cash flows. A company’s growth and finan- cial flexibility depend on adequate free cash flows. ■

Decision Insight

Point: CFO (Cash flow from operations) Less: Capital Expenditures Less: Debt Repayments

5 FCF (free cash flows)

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Chapter 12 Reporting Cash Flows 529

for several prior years is in the second column of Exhibit 12.15. Results show that its 12.3% return is the lowest return over the past several years. This is probably reflective of the recent recessionary period.

EXHIBIT 12.15 Nike’s Cash Flow on Total Assets

Cash Flow on Return on

Year Total Assets Total Assets

2011 . . . . . . . . . 12.3% 14.5%

2010 . . . . . . . . . 22.9 13.8

2009 . . . . . . . . . 13.5 11.6

2008 . . . . . . . . . 16.7 16.3

2007 . . . . . . . . . 18.3 14.5

As an indicator of earnings quality, some analysts compare the cash flow on total assets ratio to the return on total assets ratio. Nike’s return on total assets is provided in the third column of Exhibit 12.15. Nike’s cash flow on total assets ratio exceeds its return on total assets in four of the five years, leading some analysts to infer that Nike’s earnings quality is high for that period because more earnings are real- ized in the form of cash.

Point: The following ratio helps assess whether operating cash flow is adequate to meet long-term obligations: Cash coverage of debt 5 Cash flow from operations 4 Noncurrent liabilities. A low ratio suggests a higher risk of in- solvency; a high ratio suggests a greater ability to meet long-term obligations.

Point: Cash flow ratios are often used by financial analysts.

Umlauf’s comparative balance sheets, income statement, and additional information follow.

DEMONSTRATION PROBLEM

UMLAUF COMPANY

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . $446,100

Cost of goods sold . . . . . . . . . . . . $222,300

Other operating expenses . . . . . . 120,300

Depreciation expense . . . . . . . . . . 25,500 (368,100)

78,000

Other gains (losses)

Loss on sale of equipment . . . . 3,300

Loss on retirement of bonds . . 825 (4,125)

Income before taxes . . . . . . . . . . . 73,875

Income taxes expense . . . . . . . . . (13,725)

Net income . . . . . . . . . . . . . . . . . . $ 60,150

UMLAUF COMPANY

Balance Sheets

December 31, 2013 and 2012

2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 43,050 $ 23,925

Accounts receivable . . . . . . . . . . . . . . . . . . 34,125 39,825

Merchandise inventory . . . . . . . . . . . . . . . . 156,000 146,475

Prepaid expenses . . . . . . . . . . . . . . . . . . . . 3,600 1,650

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . 135,825 146,700

Accum. depreciation — Equipment . . . . . . . . (61,950) (47,550)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $310,650 $311,025

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . $ 28,800 $ 33,750

Income taxes payable . . . . . . . . . . . . . . . . . 5,100 4,425

Dividends payable . . . . . . . . . . . . . . . . . . . . 0 4,500

Bonds payable . . . . . . . . . . . . . . . . . . . . . . . 0 37,500

Common stock, $10 par . . . . . . . . . . . . . . . 168,750 168,750

Retained earnings . . . . . . . . . . . . . . . . . . . . 108,000 62,100

Total liabilities and equity . . . . . . . . . . . . . . $310,650 $311,025

Cash Flow Ratios Analysts use various other cash-based ratios, including the following two:

(1)

Cash coverage of growth 5 Operating cash flow

Cash outflow for plant assets

where a low ratio (less than 1) implies cash inadequacy to meet asset growth, whereas a high ratio implies cash adequacy for asset growth.

(2)

Operating cash flow to sales 5 Operating cash flow

Net sales

When this ratio substantially and consistently differs from the operating income to net sales ratio, the risk of accounting improprieties increases. ■

Decision Insight

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530 Chapter 12 Reporting Cash Flows

Additional Information

a. Equipment costing $21,375 with accumulated depreciation of $11,100 is sold for cash. b. Equipment purchases are for cash. c. Accumulated Depreciation is affected by depreciation expense and the sale of equipment. d. The balance of Retained Earnings is affected by dividend declarations and net income. e. All sales are made on credit. f. All merchandise inventory purchases are on credit. g. Accounts Payable balances result from merchandise inventory purchases. h. Prepaid expenses relate to “other operating expenses.”

Required

1. Prepare a statement of cash flows using the indirect method for year 2013. 2.B Prepare a statement of cash flows using the direct method for year 2013.

PLANNING THE SOLUTION ● Prepare two blank statements of cash flows with sections for operating, investing, and financing

activities using the (1) indirect method format and (2) direct method format. ● Compute the cash paid for equipment and the cash received from the sale of equipment using the addi-

tional information provided along with the amount for depreciation expense and the change in the bal- ances of equipment and accumulated depreciation. Use T-accounts to help chart the effects of the sale and purchase of equipment on the balances of the Equipment account and the Accumulated Deprecia- tion account.

● Compute the effect of net income on the change in the Retained Earnings account balance. Assign the difference between the change in retained earnings and the amount of net income to dividends declared. Adjust the dividends declared amount for the change in the Dividends Payable balance.

● Compute cash received from customers, cash paid for merchandise, cash paid for other operating expenses, and cash paid for taxes as illustrated in the chapter.

● Enter the cash effects of reconstruction entries to the appropriate section(s) of the statement. ● Total each section of the statement, determine the total net change in cash, and add it to the beginning

balance to get the ending balance of cash.

SOLUTION TO DEMONSTRATION PROBLEM Supporting computations for cash receipts and cash payments.

(1) *Cost of equipment sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,375

Accumulated depreciation of equipment sold . . . . . . . . . . . (11,100)

Book value of equipment sold . . . . . . . . . . . . . . . . . . . . . . . 10,275

Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . (3,300)

Cash received from sale of equipment . . . . . . . . . . . . . . . . $ 6,975

Cost of equipment sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,375

Less decrease in the equipment account balance . . . . . . . . (10,875)

Cash paid for new equipment . . . . . . . . . . . . . . . . . . . . . . . $ 10,500

(2) Loss on retirement of bonds . . . . . . . . . . . . . . . . . . . . . . . . $ 825

Carrying value of bonds retired . . . . . . . . . . . . . . . . . . . . . . 37,500

Cash paid to retire bonds . . . . . . . . . . . . . . . . . . . . . . . . . . $ 38,325

(3) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,150

Less increase in retained earnings . . . . . . . . . . . . . . . . . . . . 45,900

Dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,250

Plus decrease in dividends payable . . . . . . . . . . . . . . . . . . . 4,500

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,750

(4)B Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 446,100

Add decrease in accounts receivable . . . . . . . . . . . . . . . . . 5,700

Cash received from customers . . . . . . . . . . . . . . . . . . . . . . $451,800

[continued on next page]

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Chapter 12 Reporting Cash Flows 531

Bal., Dec. 31, 2012 146,700

Cash purchase 10,500

Bal., Dec. 31, 2013 135,825

Sale 21,375

Equipment

Sale 11,100

Bal., Dec. 31, 2012 47,550

Depr. expense 25,500

Bal., Dec. 31, 2013 61,950

Accumulated Depreciation — Equipment

(5)B Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 222,300

Plus increase in merchandise inventory . . . . . . . . . . . . . . . . 9,525

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231,825

Plus decrease in accounts payable . . . . . . . . . . . . . . . . . . . . 4,950

Cash paid for merchandise . . . . . . . . . . . . . . . . . . . . . . . . . $236,775

(6)B Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $ 120,300

Plus increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . 1,950

Cash paid for other operating expenses . . . . . . . . . . . . . . . $122,250

(7)B Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,725

Less increase in income taxes payable . . . . . . . . . . . . . . . . (675)

Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,050

[continued from previous page]

* Supporting T-account analysis for part 1 follows:

UMLAUF COMPANY

Statement of Cash Flows (Indirect Method)

For Year Ended December 31, 2013

Cash flows from operating activities

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,150

Adjustments to reconcile net income to net cash provided by operating activities

Decrease in accounts receivable . . . . . . . . . . . . . . . . 5,700

Increase in merchandise inventory . . . . . . . . . . . . . . (9,525)

Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . (1,950)

Decrease in accounts payable . . . . . . . . . . . . . . . . . . (4,950)

Increase in income taxes payable . . . . . . . . . . . . . . . . 675

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . 25,500

Loss on sale of plant assets . . . . . . . . . . . . . . . . . . . . 3,300

Loss on retirement of bonds . . . . . . . . . . . . . . . . . . . 825

Net cash provided by operating activities . . . . . . . . . . . $79,725

Cash flows from investing activities

Cash received from sale of equipment . . . . . . . . . . . . . 6,975

Cash paid for equipment . . . . . . . . . . . . . . . . . . . . . . . . (10,500)

Net cash used in investing activities . . . . . . . . . . . . . . . . (3,525)

Cash flows from financing activities

Cash paid to retire bonds payable . . . . . . . . . . . . . . . . . (38,325)

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . (18,750)

Net cash used in financing activities . . . . . . . . . . . . . . . . (57,075)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,125

Cash balance at prior year-end . . . . . . . . . . . . . . . . . . . . . 23,925

Cash balance at current year-end . . . . . . . . . . . . . . . . . . . $43,050

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532 Chapter 12 Reporting Cash Flows

APPENDIX

Spreadsheet Preparation of the Statement of Cash Flows

This appendix explains how to use a spreadsheet to prepare the statement of cash flows under the indirect method.

Preparing the Indirect Method Spreadsheet Analyzing noncash accounts can be challeng- ing when a company has a large number of accounts and many operating, investing, and financing transac- tions. A spreadsheet, also called work sheet or working paper, can help us organize the information needed to prepare a statement of cash flows. A spreadsheet also makes it easier to check the accuracy of our work. To illustrate, we return to the comparative balance sheets and income statement shown in Exhibit 12.10. We use the following identifying letters a through g to code changes in accounts, and letters h through m for additional information, to prepare the statement of cash flows: a. Net income is $38,000. b. Accounts receivable increase by $20,000. c. Merchandise inventory increases by $14,000. d. Prepaid expenses increase by $2,000. e. Accounts payable decrease by $5,000. f. Interest payable decreases by $1,000. g. Income taxes payable increase by $10,000. h. Depreciation expense is $24,000. i. Plant assets costing $30,000 with accumulated depreciation of $12,000 are sold for $12,000 cash.

This yields a loss on sale of assets of $6,000. j. Notes with a book value of $34,000 are retired with a cash payment of $18,000, yielding a $16,000

gain on retirement.

12A

P4 Illustrate use of a spreadsheet to prepare a statement of cash flows.

UMLAUF COMPANY

Statement of Cash Flows (Direct Method)

For Year Ended December 31, 2013

Cash flows from operating activities

Cash received from customers . . . . . . . . . . . . . . . . . . . . $451,800

Cash paid for merchandise . . . . . . . . . . . . . . . . . . . . . . . . (236,775)

Cash paid for other operating expenses . . . . . . . . . . . . . (122,250)

Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . (13,050)

Net cash provided by operating activities . . . . . . . . . . . . $79,725

Cash flows from investing activities

Cash received from sale of equipment . . . . . . . . . . . . . . 6,975

Cash paid for equipment . . . . . . . . . . . . . . . . . . . . . . . . . (10,500)

Net cash used in investing activities . . . . . . . . . . . . . . . . . (3,525)

Cash flows from financing activities

Cash paid to retire bonds payable . . . . . . . . . . . . . . . . . . (38,325)

Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . (18,750)

Net cash used in financing activities . . . . . . . . . . . . . . . . . (57,075)

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,125

Cash balance at prior year-end . . . . . . . . . . . . . . . . . . . . . . 23,925

Cash balance at current year-end . . . . . . . . . . . . . . . . . . . . $43,050

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Chapter 12 Reporting Cash Flows 533

k. Plant assets costing $70,000 are purchased with a cash payment of $10,000 and an issuance of notes payable for $60,000.

l. Issued 3,000 shares of common stock for $15,000 cash. m. Paid cash dividends of $14,000. Exhibit 12A.1 shows the indirect method spreadsheet for Genesis. We enter both beginning and ending balance sheet amounts on the spreadsheet. We also enter information in the Analysis of Changes columns (keyed to the additional information items a through m) to explain changes in the accounts and determine the cash flows for operating, investing, and financing activities. Information about noncash investing and financing activities is reported near the bottom.

EXHIBIT 12A.1 Spreadsheet for Preparing Statement of Cash Flows— Indirect Method

Debit

Analysis of Changes

Credit Dec. 31,

2013 Dec. 31,

2012

GENESIS Spreadsheet for Statement of Cash Flows—Indirect Method

For Year Ended December 31, 2013

Cash Balance Sheet—Debit Bal. Accounts

Accounts receivable Merchandise inventory Prepaid expenses Plant assets

Accumulated depreciation Balance Sheet—Credit Bal. Accounts

Accounts payable Interest payable Income taxes payable Notes payable Common stock, $5 par value Retained earnings

Operating activities Statement of Cash Flows

Purchase of plant assets with notes Noncash Investing and Financing Activities

Net income Increase in accounts receivable Increase in merchandise inventory Increase in prepaid expenses Decrease in accounts payable Decrease in interest payable Increase in income taxes payable Depreciation expense Loss on sale of plant assets Gain on retirement of notes

Investing activities Receipts from sale of plant assets Payment for purchase of plant assets

Financing activities Payment to retire notes Receipts from issuing stock

$336,000 210,000

4,000 70,000 40,000

$ 12,000

80,000 88,000

$336,000

64,000 12,000 4,000

40,000 $ 48,000

14,000

34,000

1,000 5,000

12,000

15,000 38,000

60,000 10,000

24,000

95,000 112,000

$417,000

90,000 22,000 3,000

35,000 $ 60,000

(b) (c) (d) (k1)

(i) (e) (f)

(j)

(m)

(a)

(g) (h) (i)

(i)

(l)

(k2)

(i)

(h)

(g) (k2) (l) (a)

(b) (c) (d) (e) (f)

(j)

(k1)

(j)

(k1)

70,000 2,000

14,000 $ 20,000

38,000

10,000 24,000 6,000

12,000

15,000

60,000

5,000 1,000

16,000

10,000

18,000

Payment of cash dividends (m) 14,000

60,000

2,000 14,000

20,000

$337,000 $337,000

$ 30,000 $417,000 250,000

6,000 84,000 60,000

$ 17,000

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534 Chapter 12 Reporting Cash Flows

Entering the Analysis of Changes on the Spreadsheet The following sequence of pro- cedures is used to complete the spreadsheet after the beginning and ending balances of the balance sheet accounts are entered:

1 Enter net income as the first item in the Statement of Cash Flows section for computing operating cash inflow (debit) and as a credit to Retained Earnings.

2 In the Statement of Cash Flows section, adjustments to net income are entered as debits if they in- crease cash flows and as credits if they decrease cash flows. Applying this same rule, adjust net in- come for the change in each noncash current asset and current liability account related to operating activities. For each adjustment to net income, the offsetting debit or credit must help reconcile the beginning and ending balances of a current asset or current liability account.

3 Enter adjustments to net income for income statement items not providing or using cash in the period. For each adjustment, the offsetting debit or credit must help reconcile a noncash balance sheet account.

4 Adjust net income to eliminate any gains or losses from investing and financing activities. Because the cash from a gain must be excluded from operating activities, the gain is entered as a credit in the op- erating activities section. Losses are entered as debits. For each adjustment, the related debit and/or credit must help reconcile balance sheet accounts and involve reconstructed entries to show the cash flow from investing or financing activities.

5 After reviewing any unreconciled balance sheet accounts and related information, enter the remaining reconciling entries for investing and financing activities. Examples are purchases of plant assets, issu- ances of long-term debt, stock issuances, and dividend payments. Some of these may require entries in the noncash investing and financing section of the spreadsheet (reconciled).

6 Check accuracy by totaling the Analysis of Changes columns and by determining that the change in each balance sheet account has been explained (reconciled).

We illustrate these steps in Exhibit 12A.1 for Genesis:

Point: Analysis of the changes on the spreadsheet are summarized here:

1. Cash flows from operating activities generally affect net income, current assets, and current liabilities.

2. Cash flows from investing activities generally affect noncurrent asset accounts.

3. Cash flows from financing activities generally affect noncurrent liability and equity accounts.

Step Entries

. . . . . . . . . . . (a)

. . . . . . . . . . . (b) through (g)

. . . . . . . . . . . (h)

. . . . . . . . . . . (i) through ( j)

. . . . . . . . . . . (k) through (m)

1 2

3 4

5

Since adjustments i, j, and k are more challenging, we show them in the following debit and credit format. These entries are for purposes of our understanding; they are not the entries actually made in the journals. Changes in the Cash account are identified as sources or uses of cash.

i. Loss from sale of plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Receipt from sale of plant assets (source of cash) . . . . . . . . . . . . . . . 12,000

Plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

To describe sale of plant assets.

j. Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000

Payments to retire notes (use of cash) . . . . . . . . . . . . . . . . . . . . 18,000

Gain on retirement of notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

To describe retirement of notes.

k1. Plant assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Payment to purchase plant assets (use of cash) . . . . . . . . . . . . . 10,000

Purchase of plant assets financed by notes . . . . . . . . . . . . . . . . . . 60,000

To describe purchase of plant assets.

k2. Purchase of plant assets financed by notes . . . . . . . . . . . . . . . . . . . . . . 60,000

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

To issue notes for purchase of assets.

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Chapter 12 Reporting Cash Flows 535

APPENDIX

Direct Method of Reporting Operating Cash Flows 12B We compute cash flows from operating activities under the direct method by adjusting accrual-based income statement items to the cash basis. The usual approach is to adjust income statement accounts related to operating activities for changes in their related balance sheet accounts as follows:

P5 Compute cash flows from operating activities using the direct method.

The framework for reporting cash receipts and cash payments for the operating section of the cash flow statement under the direct method follows. We consider cash receipts first and then cash payments.

� or � Cash receipts

or cash payments

Revenue or

expense

Adjustments for changes in related

balance sheet accounts �

Landlord

Renters Dividends

Operations Interest Taxes

Operating cash

payments2

Operating cash

receipts1

Net cash provided

(used) by operating

activities 5

Customers

Suppliers Employees

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Rental Agreemen

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Interest

Operating Cash Receipts A review of Exhibit 12.10 and the additional information reported by Genesis suggests only one potential cash receipt: sales to customers. This section, therefore, starts with sales to customers as reported on the income statement and then adjusts it as necessary to obtain cash re- ceived from customers to report on the statement of cash flows.

Cash Received from Customers If all sales are for cash, the amount received from customers equals the sales reported on the income statement. When some or all sales are on account, however, we must adjust the amount of sales for the change in Accounts Receivable. It is often helpful to use account analysis to do this. This usually involves setting up a T-account and reconstructing its major entries, with emphasis on cash receipts and payments. To illustrate, we use a T-account that includes accounts receivable balances for Genesis on December 31, 2012 and 2013. The beginning balance is $40,000 and the ending balance is $60,000. Next, the income statement shows sales of $590,000, which we enter on the debit side of this account. We now can reconstruct the Accounts Receivable account to determine the amount of cash re- ceived from customers as follows:

Point: An accounts receivable increase implies that cash received from customers is less than sales (the converse is also true).

Bal., Dec. 31, 2012 40,000

Sales 590,000

Bal., Dec. 31, 2013 60,000

Cash receipts 5 570,000

Accounts Receivable

EXHIBIT 12B.1 Major Classes of Operating Cash Flows

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536 Chapter 12 Reporting Cash Flows

This T-account shows that the Accounts Receivable balance begins at $40,000 and increases to $630,000 from sales of $590,000, yet its ending balance is only $60,000. This implies that cash receipts from custom- ers are $570,000, computed as $40,000 1 $590,000 2 [?] 5 $60,000. This computation can be rearranged to express cash received as equal to sales of $590,000 minus a $20,000 increase in accounts receivable. This computation is summarized as a general rule in Exhibit 12B.2. The statement of cash flows in Exhibit 12.7 reports the $570,000 cash received from customers as a cash inflow from operating activities.

Example: If the ending balance of accounts receivable is $20,000 (instead of $60,000), what is cash received from customers? Answer: $610,000

Cash received from customers 5 Sales 1 Decrease in accounts receivable

or 2 Increase in accounts receivable

EXHIBIT 12B.2 Formula to Compute Cash Received from Customers— Direct Method

Other Cash Receipts While Genesis’s cash receipts are limited to collections from customers, we often see other types of cash receipts, most commonly cash receipts involving rent, interest, and dividends. We compute cash received from these items by subtracting an increase in their respective receivable or adding a decrease. For instance, if rent receivable increases in the period, cash received from renters is less than rent revenue reported on the income statement. If rent receivable decreases, cash received is more than reported rent revenue. The same logic applies to interest and dividends. The formulas for these computations are summarized later in this appendix.

Operating Cash Payments A review of Exhibit 12.10 and the additional Genesis information shows four operating expenses: cost of goods sold; wages and other operating expenses; interest expense; and taxes expense. We analyze each expense to compute its cash amounts for the statement of cash flows. (We then examine depreciation and the other losses and gains.)

Cash Paid for Merchandise We compute cash paid for merchandise by analyzing both cost of goods sold and merchandise inventory. If all merchandise purchases are for cash and the ending balance of Merchandise Inventory is unchanged from the beginning balance, the amount of cash paid for merchan- dise equals cost of goods sold — an uncommon situation. Instead, there normally is some change in the Merchandise Inventory balance. Also, some or all merchandise purchases are often made on credit, and this yields changes in the Accounts Payable balance. When the balances of both Merchandise Inventory and Accounts Payable change, we must adjust the cost of goods sold for changes in both accounts to compute cash paid for merchandise. This is a two-step adjustment. First, we use the change in the account balance of Merchandise Inventory, along with the cost of goods sold amount, to compute cost of purchases for the period. An increase in merchandise inventory implies that we bought more than we sold, and we add this inventory increase to cost of goods sold to compute cost of purchases. A decrease in merchandise inventory implies that we bought less than we sold, and we subtract the inventory decrease from cost of goods sold to compute purchases. We illustrate the first step by reconstructing the Merchandise Inventory account of Genesis:

Point: Net income is measured using accrual accounting. Cash flows from operations are measured using cash basis accounting.

The beginning balance is $70,000, and the ending balance is $84,000. The income statement shows that cost of goods sold is $300,000, which we enter on the credit side of this account. With this information, we determine the amount for cost of purchases to be $314,000. This computation can be rearranged to express cost of purchases as equal to cost of goods sold of $300,000 plus the $14,000 increase in inventory. The second step uses the change in the balance of Accounts Payable, and the amount of cost of pur- chases, to compute cash paid for merchandise. A decrease in accounts payable implies that we paid for more goods than we acquired this period, and we would then add the accounts payable decrease to cost of purchases to compute cash paid for merchandise. An increase in accounts payable implies that we paid for less than the amount of goods acquired, and we would subtract the accounts payable increase from purchases to compute cash paid for merchandise. The second step is applied to Genesis by reconstructing its Accounts Payable account:

Bal., Dec. 31, 2012 70,000

Purchases 5 314,000

Bal., Dec. 31, 2013 84,000

Cost of goods sold 300,000

Merchandise Inventory

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Chapter 12 Reporting Cash Flows 537

Cash payments 5 319,000

Bal., Dec. 31, 2012 40,000

Purchases 314,000

Bal., Dec. 31, 2013 35,000

Accounts Payable

Its beginning balance of $40,000 plus purchases of $314,000 minus an ending balance of $35,000 yields cash paid of $319,000 (or $40,000 1 $314,000 2 [?] 5 $35,000). Alternatively, we can express cash paid for merchandise as equal to purchases of $314,000 plus the $5,000 decrease in accounts payable. The $319,000 cash paid for merchandise is reported on the statement of cash flows in Exhibit 12.7 as a cash outflow under operating activities. We summarize this two-step adjustment to cost of goods sold to compute cash paid for merchandise inventory in Exhibit 12B.3.

Example: If the ending balances of Inventory and Accounts Payable are $60,000 and $50,000, respectively (in- stead of $84,000 and $35,000), what is cash paid for merchandise? Answer: $280,000

EXHIBIT 12B.3 Two Steps to Compute Cash Paid for Merchandise — Direct MethodPurchases 5 Cost of goods sold

1 Increase in merchandise inventory or

2 Decrease in merchandise inventory

Cash paid for merchandise 5 Purchases 1 Decrease in accounts payable

or 2 Increase in accounts payable

Step 2

Step 1

Cash Paid for Wages and Operating Expenses (Excluding Depreciation) The income statement of Genesis shows wages and other operating expenses of $216,000 (see Exhibit 12.10). To compute cash paid for wages and other operating expenses, we adjust this amount for any changes in their related bal- ance sheet accounts. We begin by looking for any prepaid expenses and accrued liabilities related to wages and other operating expenses in the balance sheets of Genesis in Exhibit 12.10. The balance sheets show prepaid expenses but no accrued liabilities. Thus, the adjustment is limited to the change in prepaid expenses. The amount of adjustment is computed by assuming that all cash paid for wages and other operating expenses is initially debited to Prepaid Expenses. This assumption allows us to reconstruct the Prepaid Expenses account:

Bal., Dec. 31, 2012 4,000

Cash payments 5 218,000

Bal., Dec. 31, 2013 6,000

Wages and other operating exp. 216,000

Prepaid Expenses

Point: A decrease in prepaid expenses implies that reported expenses include an amount(s) that did not require a cash outflow in the period.

Prepaid Expenses increase by $2,000 in the period, meaning that cash paid for wages and other operating expenses exceeds the reported expense by $2,000. Alternatively, we can express cash paid for wages and other operating expenses as equal to its reported expenses of $216,000 plus the $2,000 increase in prepaid expenses.1

Exhibit 12B.4 summarizes the adjustments to wages (including salaries) and other operating expenses. The Genesis balance sheet did not report accrued liabilities, but we include them in the formula to explain the adjustment to cash when they do exist. A decrease in accrued liabilities implies that we paid cash for more goods or services than received this period, so we add the decrease in accrued liabilities to the ex- pense amount to obtain cash paid for these goods or services. An increase in accrued liabilities implies that we paid cash for less than what was acquired, so we subtract this increase in accrued liabilities from the expense amount to get cash paid.

1 The assumption that all cash payments for wages and operating expenses are initially debited to Prepaid Expenses is not necessary for our analysis to hold. If cash payments are debited directly to the expense account, the total amount of cash paid for wages and other operating expenses still equals the $216,000 expense plus the $2,000 increase in Prepaid Expenses (which arise from end-of-period adjusting entries).

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538 Chapter 12 Reporting Cash Flows

Cash paid for interest and income taxes Computing operating cash flows for interest and taxes is similar to that for operating expenses. Both require adjustments to their amounts reported on the income state- ment for changes in their related balance sheet accounts. We begin with the Genesis income statement showing interest expense of $7,000 and income taxes expense of $15,000. To compute the cash paid, we adjust interest expense for the change in interest payable and then the income taxes expense for the change in income taxes payable. These computations involve reconstructing both liability accounts:

Cash paid for interest 5 8,000

Bal., Dec. 31, 2012 4,000

Interest expense 7,000

Bal., Dec. 31, 2013 3,000

Interest Payable

Cash paid for taxes 5 5,000

Bal., Dec. 31, 2012 12,000

Income taxes expense 15,000

Bal., Dec. 31, 2013 22,000

Income Taxes Payable

These accounts reveal cash paid for interest of $8,000 and cash paid for income taxes of $5,000. The for- mulas to compute these amounts are in Exhibit 12B.5. Both of these cash payments are reported as operat- ing cash outflows on the statement of cash flows in Exhibit 12.7.

EXHIBIT 12B.4 Formula to Compute Cash Paid for Wages and Operating Expenses — Direct Method

Cash paid for wages and other

operating expenses 5

Wages and other

operating expenses

1 Increase in prepaid expenses

or Decrease in prepaid

expenses 2

1

2

Decrease in accrued liabilities

or Increase in accrued

liabilities

EXHIBIT 12B.5 Formulas to Compute Cash Paid for Both Interest and Taxes— Direct Method

1 Decrease in interest payable or

2 Increase in interest payable

1 Decrease in income taxes payable or

2 Increase in income taxes payable

Cash paid for taxes

5 Income taxes expenses

Cash paid for interest

5 Interest expense

Analysis of Additional Expenses, Gains, and Losses Genesis has three additional items reported on its income statement: depreciation, loss on sale of assets, and gain on retirement of debt. We must consider each for its potential cash effects.

Depreciation Expense Depreciation expense is $24,000. It is often called a noncash expense because depreciation has no cash flows. Depreciation expense is an allocation of an asset’s depreciable cost. The cash outflow with a plant asset is reported as part of investing activities when it is paid for. Thus, depre- ciation expense is never reported on a statement of cash flows using the direct method; nor is depletion or amortization expense.

Loss on Sale of Assets Sales of assets frequently result in gains and losses reported as part of net income, but the amount of recorded gain or loss does not reflect any cash flows in these transactions. Asset sales result in cash inflow equal to the cash amount received, regardless of whether the asset was sold at a gain or a loss. This cash inflow is reported under investing activities. Thus, the loss or gain on a sale of assets is never reported on a statement of cash flows using the direct method.

Gain on Retirement of Debt Retirement of debt usually yields a gain or loss reported as part of net in- come, but that gain or loss does not reflect cash flow in this transaction. Debt retirement results in cash outflow equal to the cash paid to settle the debt, regardless of whether the debt is retired at a gain or loss.

Point: The direct method is usu- ally viewed as user friendly because less accounting knowledge is required to understand and use it.

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Chapter 12 Reporting Cash Flows 539

This cash outflow is reported under financing activities; the loss or gain from retirement of debt is never reported on a statement of cash flows using the direct method.

Summary of Adjustments for Direct Method Exhibit 12B.6 summarizes common adjust- ments for net income to yield net cash provided (used) by operating activities under the direct method.

EXHIBIT 12B.6 Summary of Selected Adjustments for Direct Method

From Income

Item Statement Adjustments to Obtain Cash Flow Numbers

Receipts

From sales Sales Revenue 1Decrease in Accounts Receivable

2Increase in Accounts Receivable

From rent Rent Revenue 1Decrease in Rent Receivable

2Increase in Rent Receivable

From interest Interest Revenue 1Decrease in Interest Receivable

2Increase in Interest Receivable

From dividends Dividend 1Decrease in Dividends Receivable

Revenue 2Increase in Dividends Receivable

Payments

To suppliers Cost of Goods 1Increase in Inventory 1Decrease in Accounts Payable

Sold 2Decrease in Inventory 2Increase in Accounts Payable

For operations Operating 1Increase in Prepaids 1Decrease in Accrued Liabilities

Expense 2Decrease in Prepaids 2Increase in Accrued Liabilities

To employees Wages (Salaries) 1Decrease in Wages (Salaries) Payable

Expense 2Increase in Wages (Salaries) Payable

For interest Interest Expense 1Decrease in Interest Payable

2Increase in Interest Payable

For taxes Income Tax 1Decrease in Income Tax Payable

Expense 2Increase in Income Tax Payable

IFRS Currently, U.S. GAAP and IFRS allow cash flows from operating activities to be reported using either the indirect method or the direct method. The IASB and FASB are working on joint guidance that would require the direct method for the operating section with the indirect method’s operating section disclosed in the footnotes. Stay tuned . . . ■

8. Net sales in a period are $590,000, beginning accounts receivable are $120,000, and ending accounts receivable are $90,000. What cash amount is collected from customers in the period?

9. The Merchandise Inventory account balance decreases in the period from a beginning balance of $32,000 to an ending balance of $28,000. Cost of goods sold for the period is $168,000. If the Accounts Payable balance increases $2,400 in the period, what is the cash amount paid for merchandise inventory?

10. This period’s wages and other operating expenses total $112,000. Beginning-of-period prepaid expenses totaled $1,200, and its ending balance is $4,200. There were no beginning-of-period accrued liabilities, but end-of-period wages payable equal $5,600. How much cash is paid for wages and other operating expenses?

Quick Check Answers — p. 540

Direct Method Format of Operating Activities Section Exhibit 12.7 shows the Genesis statement of cash flows using the direct method. Major items of cash inflows and cash outflows are listed separately in the operating activities section. The format requires that operating cash outflows be sub- tracted from operating cash inflows to get net cash provided (used) by operating activities. The FASB recommends that the operating activities section of the statement of cash flows be reported using the di- rect method, which is considered more useful to financial statement users. However, the FASB requires a reconciliation of net income to net cash provided (used) by operating activities when the direct method is used (which can be reported in the notes). This reconciliation is similar to preparation of the operating activities section of the statement of cash flows using the indirect method.

Point: Some preparers argue that it is easier to prepare a statement of cash flows using the indirect method. This likely explains its greater frequency in financial statements.

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540 Chapter 12 Reporting Cash Flows

C1 Distinguish between operating, investing, and financing activities, and describe how noncash investing and financing activities are disclosed. The purpose of the statement of cash flows is to report major cash receipts and cash payments relating to operat- ing, investing, or financing activities. Operating activities include transactions and events that determine net income. Investing activi- ties include transactions and events that mainly affect long-term as- sets. Financing activities include transactions and events that mainly affect long-term liabilities and equity. Noncash investing and financ- ing activities must be disclosed in either a note or a separate schedule to the statement of cash flows. Examples are the retirement of debt by issuing equity and the exchange of a note payable for plant assets.

A1 Analyze the statement of cash flows and apply the cash flow on total assets ratio. To understand and predict cash flows, us- ers stress identification of the sources and uses of cash flows by oper- ating, investing, and financing activ ities. Emphasis is on operating cash flows since they derive from continuing operations. The cash flow on total assets ratio is defined as operating cash flows divided by average total assets. Analysis of current and past values for this ratio can reflect a company’s ability to yield regular and positive cash flows. It is also viewed as a measure of earnings quality.

P1 Prepare a statement of cash flows. Preparation of a statement of cash flows involves five steps: (1) Compute the net increase or decrease in cash; (2) compute net cash provided or used by operat- ing activities (using either the direct or indirect method); (3) compute net cash provided or used by investing activities; (4) compute net cash

Summary provided or used by financing activities; and (5) report the beginning and ending cash balance and prove that it is explained by net cash flows. Noncash investing and financing activities are also disclosed.

P2 Compute cash flows from operating activities using the in-direct method. The indirect method for reporting net cash provided or used by operating activities starts with net income and then adjusts it for three items: (1) changes in noncash current assets and current liabilities related to operating activities, (2) revenues and expenses not providing or using cash, and (3) gains and losses from investing and financing activities.

P3 Determine cash flows from both investing and financing activities. Cash flows from both investing and financing activities are determined by identifying the cash flow effects of transactions and events affecting each balance sheet account related to these activities. All cash flows from these activities are identified when we can explain changes in these accounts from the beginning to the end of the period.

P4A Illustrate use of a spreadsheet to prepare a statement of cash flows. A spreadsheet is a useful tool in preparing a state-

ment of cash flows. Six key steps (see Appendix 12A) are applied when using the spreadsheet to prepare the statement.

P5B Compute cash flows from operating activities using the direct method. The direct method for reporting net cash pro- vided or used by operating activities lists major operating cash inflows less cash outflows to yield net cash inflow or outflow from operations.

Entrepreneur Several factors might explain an increase in net cash flows when a net loss is reported, including (1) early recognition of expenses relative to revenues generated (such as research and de- velopment), (2) cash advances on long-term sales contracts not yet recognized in income, (3) issuances of debt or equity for cash to fi- nance expansion, (4) cash sale of assets, (5) delay of cash payments, and (6) cash prepayment on sales. Analysis needs to focus on the components of both the net loss and the net cash flows and their implications for future performance.

Reporter Your initial reaction based on the company’s $600,000 loss with a $550,000 decrease in net cash flows is not positive. How- ever, closer scrutiny reveals a more positive picture of this company’s performance. Cash flow from operating activities is $650,000, com- puted as [?] 2 $850,000 2 $350,000 5 $(550,000). You also note that net income before the extraordinary loss is $330,000, computed as [?] 2 $930,000 5 $(600,000).

Guidance Answers to Decision Maker

1. No to both. The statement of cash flows reports changes in the sum of cash plus cash equivalents. It does not report transfers between cash and cash equivalents.

2. The three categories of cash inflows and outflows are operating activities, investing activities, and financing activities.

3. a. Investing c. Financing e. Operating b. Operating d. Operating f. Financing 4. $74,900 1 $4,600 2 $11,700 2 $1,000 1 $3,400 5

$70,200 5. Expenses such as depreciation and amortization do not require

current cash outflows. Therefore, adding these expenses back to

net income eliminates these noncash items from the net income number, converting it to a cash basis.

6. A gain on the sale of plant assets is subtracted from net income because a sale of plant assets is not an operating activity; it is an investing activity for the amount of cash received from its sale. Also, such a gain yields no cash effects.

7. $80,000 2 $30,000 2 $10,000 5 $40,000 cash receipt. The $40,000 cash receipt is reported as an investing activity.

8. $590,000 1 ($120,000 2 $90,000) 5 $620,000 9. $168,000 2 ($32,000 2 $28,000) 2 $2,400 5 $161,600 10. $112,000 1 ($4,200 2 $1,200) 2 $5,600 5 $109,400

Guidance Answers to Quick Checks

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Chapter 12 Reporting Cash Flows 541

Cash flow on total assets (p. 528)

Direct method (p. 516)

Financing activities (p. 512)

Indirect method (p. 516)

Investing activities (p. 512)

Operating activities (p. 511)

Statement of cash flows (p. 510)

Key Terms

Multiple Choice Quiz Answers on p. 561 mhhe.com/wildFINMAN5e

Additional Quiz Questions are available at the book’s Website.

1. A company uses the indirect method to determine its cash flows from operating activities. Use the following information to de- termine its net cash provided or used by operating activities.

c. $73,440. d. $68,000. e. $5,440. 4. The following information is available regarding a company’s

annual salaries and wages. What amount of cash is paid for salaries and wages?

Net income . . . . . . . . . . . . . . . . . . . . . . . . $15,200

Depreciation expense . . . . . . . . . . . . . . . . 10,000

Cash payment on note payable . . . . . . . . . 8,000

Gain on sale of land . . . . . . . . . . . . . . . . . 3,000

Increase in inventory . . . . . . . . . . . . . . . . 1,500

Increase in accounts payable . . . . . . . . . . 2,850

Salaries and wages expense . . . . . . . . . . . . . . . . . . . $255,000

Salaries and wages payable, prior year-end . . . . . . . . 8,200

Salaries and wages payable, current year-end . . . . . . 10,900

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $545,000

Merchandise inventory, prior year-end . . . . . . . . . . . 105,000

Merchandise inventory, current year-end . . . . . . . . . 112,000

Accounts payable, prior year-end . . . . . . . . . . . . . . . 98,500

Accounts payable, current year-end . . . . . . . . . . . . . 101,300

a. $23,550 used by operating activities b. $23,550 provided by operating activities c. $15,550 provided by operating activities d. $42,400 provided by operating activities e. $20,850 provided by operating activities 2. A machine with a cost of $175,000 and accumulated depre-

ciation of $94,000 is sold for $87,000 cash. The amount re- ported as a source of cash under cash flows from investing activities is

a. $81,000. b. $6,000. c. $87,000. d. Zero; this is a financing activity. e. Zero; this is an operating activity. 3. A company settles a long-term note payable plus interest by

paying $68,000 cash toward the principal amount and $5,440 cash for interest. The amount reported as a use of cash under cash flows from financing activities is

a. Zero; this is an investing activity. b. Zero; this is an operating activity.

a. $252,300 b. $257,700 c. $255,000 d. $274,100 e. $235,900 5. The following information is available for a company. What

amount of cash is paid for merchandise for the current year?

a. $545,000 b. $554,800 c. $540,800 d. $535,200 e. $549,200

1. What is the reporting purpose of the statement of cash flows? Identify at least two questions that this statement can answer.

2. What are some investing activities reported on the statement of cash flows?

3. What are some financing activities reported on the statement of cash flows?

4. Describe the direct method of reporting cash flows from operating activities.

5. When a statement of cash flows is prepared using the direct method, what are some of the operating cash flows?

6. Describe the indirect method of reporting cash flows from operating activities.

Discussion Questions

Icon denotes assignments that involve decision making.

A(B) Superscript letter A (B) denotes assignments based on Appendix 12A (12B).

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542 Chapter 12 Reporting Cash Flows

7. Where on the statement of cash flows is the payment of cash dividends reported?

8. Assume that a company purchases land for $1,000,000, paying $400,000 cash and borrowing the remainder with a long-term note payable. How should this transaction be re- ported on a statement of cash flows?

9. On June 3, a company borrows $200,000 cash by giving its bank a 90-day, interest-bearing note. On the statement of cash flows, where should this be reported?

10. If a company reports positive net income for the year, can it  also show a net cash outflow from operating activities? Explain.

11. Is depreciation a source of cash flow? 12. Refer to Polaris’ statement of cash flows in

Appendix A. (a) Which method is used to com- pute its net cash provided by operating activities? (b) Its balance

sheet shows an increase in accounts (trade) receivables from 2010 to 2011; why is this increase in accounts (trade) receivables subtracted when computing net cash provided by operating ac- tivities for the year ended December 31, 2011?

13. Refer to Arctic Cat’s statement of cash flows in Appendix A. What are its cash flows from financing activities for the year ended March 31, 2011? List the items and amounts.

14. Refer to KTM’s 2011 statement of cash flows in Appendix A. List its cash flows from operating activities, investing activities, and financing activities.

15. Refer to Piaggio’s statement of cash flows in Appendix A. What investing activities result in cash outflows for the year ended December 31, 2011? List items and amounts.

QS 12-3 Indirect: Computing cash from operations

P2

Use the following information to determine this company’s cash flows from operating activities using the indirect method.

MOSS COMPANY

Selected Balance Sheet Information

December 31, 2013 and 2012

2013 2012

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . $84,650 $26,800

Accounts receivable . . . . . . . . . 25,000 32,000

Inventory . . . . . . . . . . . . . . . . . . 60,000 54,100

Current liabilities

Accounts payable . . . . . . . . . . . . 30,400 25,700

Income taxes payable . . . . . . . . 2,050 2,200

MOSS COMPANY

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $515,000

Cost of goods sold . . . . . . . . . . . . . 331,600

Gross profit . . . . . . . . . . . . . . . . . . . 183,400

Operating expenses

Depreciation expense . . . . . . . . . $ 36,000

Other expenses . . . . . . . . . . . . . 121,500 157,500

Income before taxes . . . . . . . . . . . . 25,900

Income taxes expense . . . . . . . . . . 7,700

Net income . . . . . . . . . . . . . . . . . . . $ 18,200

QUICK STUDY

QS 12-1 Statement of cash flows

C1

The statement of cash flows is one of the four primary financial statements. 1. Describe the content and layout of a statement of cash flows, including its three sections. 2. List at least three transactions classified as investing activities in a statement of cash flows. 3. List at least three transactions classified as financing activities in a statement of cash flows. 4. List at least three transactions classified as significant noncash financing and investing activities in the

statement of cash flows.

QS 12-2 Transaction classification by activity

C1

Classify the following cash flows as operating, investing, or financing activities. 1. Sold long-term investments for cash. 6. Issued common stock for cash. 2. Received cash payments from customers. 7. Received cash interest on a note. 3. Paid cash for wages and salaries. 8. Paid cash interest on outstanding notes. 4. Purchased inventories for cash. 9. Received cash from sale of land at a loss. 5. Paid cash dividends. 10. Paid cash for property taxes on building.

Polaris

Arctic Cat

KTM

PIAGGIO

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Chapter 12 Reporting Cash Flows 543

At December 31 2013 2012

Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $132,000 $ 184,500

Accumulated depreciation—Furniture . . . . . . . . . (88,700) (110,700)

QS 12-4 Computing cash from asset sales

P3

The following selected information is from Ellerby Company’s comparative balance sheets.

The income statement reports depreciation expense for the year of $18,000. Also, furniture costing $52,500 was sold for its book value. Compute the cash received from the sale of furniture.

QS 12-5 Computing financing cash flows

P3

The following selected information is from the Princeton Company’s comparative balance sheets.

At December 31 2013 2012

Common stock, $10 par value . . . . . . . . . $105,000 $100,000

Paid-in capital in excess of par . . . . . . . . . 567,000 342,000

Retained earnings . . . . . . . . . . . . . . . . . . . 313,500 287,500

The company’s net income for the year ended December 31, 2013, was $48,000. 1. Compute the cash received from the sale of its common stock during 2013. 2. Compute the cash paid for dividends during 2013.

CRUZ, INC.

Comparative Balance Sheets

December 31, 2013

2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,800 $ 24,000

Accounts receivable, net . . . . . . . . . . . . . . . 41,000 51,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,800 95,800

Prepaid expenses . . . . . . . . . . . . . . . . . . . . 5,400 4,200

Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,000 119,000

Accum. depreciation—Furniture . . . . . . . . (17,000) (9,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $319,000 $285,000

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . $ 15,000 $ 21,000

Wages payable . . . . . . . . . . . . . . . . . . . . . . . 9,000 5,000

Income taxes payable . . . . . . . . . . . . . . . . . 1,400 2,600

Notes payable (long-term) . . . . . . . . . . . . . 29,000 69,000

Common stock, $5 par value . . . . . . . . . . . 229,000 179,000

Retained earnings . . . . . . . . . . . . . . . . . . . . 35,600 8,400

Total liabilities and equity . . . . . . . . . . . . . . $319,000 $285,000

CRUZ, INC.

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $488,000

Cost of goods sold . . . . . . . . . . . . . . 314,000

Gross profit . . . . . . . . . . . . . . . . . . . . 174,000

Operating expenses

Depreciation expense . . . . . . . . . . $37,600

Other expenses . . . . . . . . . . . . . . 89,100 126,700

Income before taxes . . . . . . . . . . . . . 47,300

Income taxes expense . . . . . . . . . . . 17,300

Net income . . . . . . . . . . . . . . . . . . . . $ 30,000

Use the following balance sheets and income statement to answer QS 12-6 through QS 12-11. QS 12-6 Indirect: Computing cash from operations P2

Required

Use the indirect method to prepare the cash provided or used from operating activities section only of the statement of cash flows for this company.

QS 12-7 Computing cash from asset sales

P3

Refer to the data in QS 12-6. Furniture costing $55,000 is sold at its book value in 2013. Acquisitions of furniture total $45,000 cash, on which no depreciation is necessary because it is acquired at year-end. What is the cash inflow related to the sale of furniture?

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544 Chapter 12 Reporting Cash Flows

QS 12-8 Computing financing cash outflows P3

Refer to the data in QS 12-6. 1. Assume that all common stock is issued for cash. What amount of cash dividends is paid during 2013? 2. Assume that no additional notes payable are issued in 2013. What cash amount is paid to reduce the

notes payable balance in 2013?

QS 12-9B

Direct: Computing cash received from customers P5

Refer to the data in QS 12-6. 1. How much cash is received from sales to customers for year 2013? 2. What is the net increase or decrease in cash for year 2013?

QS 12-11B

Direct: Computing cash from operations P5

Refer to the data in QS 12-6. Use the direct method to prepare the cash provided or used from operating activities section only of the statement of cash flows for this company.

QS 12-10B

Direct: Computing operating cash outflows P5

Refer to the data in QS 12-6. 1. How much cash is paid to acquire merchandise inventory during year 2013? 2. How much cash is paid for operating expenses during year 2013?

QS 12-12 Analyses of sources and uses of cash A1

Financial data from three competitors in the same industry follow. 1. Which of the three competitors is in the strongest position as shown by its statement of cash flows? 2. Analyze and compare the strength of Moore’s cash flow on total assets ratio to that of Sykes.

Cash provided (used) by investing activities Cash provided (used) by operating activities

Proceeds from sale of operating assets Purchase of operating assets

Cash provided (used) by financing activities Proceeds from issuance of debt Repayment of debt

Net increase (decrease) in cash

Average total assets

(28,000)

(6,000) $ 36,000

$ 790,000

$ 70,000

(34,000)

$ 26,000

$ 625,000

$ 60,000

26,000

23,000

$ 25,000

$ 300,000

$ (24,000)

Moore Sykes Kritch($ thousands)

QS 12-13A

Noncash accounts on a spreadsheet P4

When a spreadsheet for a statement of cash flows is prepared, all changes in noncash balance sheet accounts are fully explained on the spreadsheet. Explain how these noncash balance sheet accounts are used to fully account for cash flows on a spreadsheet.

QS 12-14 Indirect: Computing cash flows from operations

P2

For each of the following separate cases, compute cash flows from operations. The list includes all balance sheet accounts related to operating activities.

Case X Case Y Case Z

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000 $100,000 $72,000

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . 30,000 8,000 24,000

Accounts receivable increase (decrease) . . . . . . . . 40,000 20,000 (4,000)

Inventory increase (decrease) . . . . . . . . . . . . . . . . . (20,000) (10,000) 10,000

Accounts payable increase (decrease) . . . . . . . . . . 24,000 (22,000) 14,000

Accrued liabilities increase (decrease) . . . . . . . . . . (44,000) 12,000 (8,000)

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Chapter 12 Reporting Cash Flows 545

QS 12-17 Indirect: Preparation of statement of cash flows

P1

Use the following financial statements and additional information to (1) prepare a statement of cash flows for the year ended December 31, 2014, using the indirect method, and (2) analyze and briefly discuss the statement prepared in part 1 with special attention to operating activities and to the company’s cash level.

MONTGOMERY INC.

Comparative Balance Sheets

December 31, 2014 and 2013

2014 2013

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,400 $ 30,550

Accounts receivable, net . . . . . . . . . . . . . . . 10,050 12,150

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,100 70,150

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . 49,900 41,500

Accum. depreciation—Equipment . . . . . . . (22,500) (15,300)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $157,950 $139,050

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . $ 23,900 $ 25,400

Salaries payable . . . . . . . . . . . . . . . . . . . . . . 500 600

Common stock, no par value . . . . . . . . . . . 110,000 100,000

Retained earnings . . . . . . . . . . . . . . . . . . . . 23,550 13,050

Total liabilities and equity . . . . . . . . . . . . . . $157,950 $139,050

MONTGOMERY INC.

Income Statement

For Year Ended December 31, 2014

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $45,575

Cost of goods sold . . . . . . . . . . . . . . (18,950)

Gross profit . . . . . . . . . . . . . . . . . . . . 26,625

Operating expenses

Depreciation expense . . . . . . . . . . $7,200

Other expenses . . . . . . . . . . . . . . 5,550

Total operating expense . . . . . . . . . . 12,750

Income before taxes . . . . . . . . . . . . . 13,875

Income tax expense . . . . . . . . . . . . . 3,375

Net income . . . . . . . . . . . . . . . . . . . . $10,500

Additional Information

a. No dividends are declared or paid in 2014. b. Issued additional stock for $10,000 cash in 2014. c. Purchased equipment for cash in 2014; no equipment was sold in 2014.

QS 12-18 International cash flow disclosures

C1

Answer each of the following related to international accounting standards. 1. Which method, indirect or direct, is acceptable for reporting operating cash flows under IFRS? 2. For each of the following four cash flows, identify whether it is reported under the operating, investing,

or financing section (or some combination) within the indirect format of the statement of cash flows reported under IFRS and under U.S. GAAP.

Cash Flow Source US GAAP Reporting IFRS Reporting

a. Interest paid . . . . . . . . . . . . . .

b. Dividends paid . . . . . . . . . . . .

c. Interest received . . . . . . . . . . .

d. Dividends received . . . . . . . . .

QS 12-15 Computing cash flows from investing

P3

Compute cash flows from investing activities using the following company information.

Sale of short-term investments . . . . . . . . . . $ 6,000

Cash collections from customers . . . . . . . . . 16,000

Purchase of used equipment . . . . . . . . . . . . . 5,000

Depreciation expense . . . . . . . . . . . . . . . . . . 2,000

QS 12-16 Computing cash flows from financing

P3

Compute cash flows from financing activities using the following company information.

Additional short-term borrowings . . . . . . . . . . $20,000

Purchase of short-term investments . . . . . . . . 5,000

Cash dividends paid . . . . . . . . . . . . . . . . . . . . . 16,000

Interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

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546 Chapter 12 Reporting Cash Flows

EXERCISES

Exercise 12-1 Indirect: Cash flow classification

C1

The following transactions and events occurred during the year. Assuming that this company uses the indirect method to report cash provided by operating activities, indicate where each item would appear on its statement of cash flows by placing an x in the appropriate column.

Statement of Cash Flows

Noncash Not

Investing Reported on

Operating Investing Financing and Financing Statement

Activities Activities Activities Activities or in Notes

a. Declared and paid a cash dividend . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

b. Recorded depreciation expense . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

c. Paid cash to settle long-term note payable . . . . . . . . . _____ _____ _____ _____ _____

d. Prepaid expenses increased in the year . . . . . . . . . . . . _____ _____ _____ _____ _____

e. Accounts receivable decreased in the year . . . . . . . . . _____ _____ _____ _____ _____

f. Purchased land by issuing common stock . . . . . . . . . . . _____ _____ _____ _____ _____

g. Paid cash to purchase inventory . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

h. Sold equipment for cash, yielding a loss . . . . . . . . . . . . _____ _____ _____ _____ _____

i. Accounts payable decreased in the year . . . . . . . . . . . _____ _____ _____ _____ _____

j. Income taxes payable increased in the year . . . . . . . . . . _____ _____ _____ _____ _____

Exercise 12-2B

Direct: Cash flow classification

C1 P5

The following transactions and events occurred during the year. Assuming that this company uses the direct method to report cash provided by operating activities, indicate where each item would appear on the statement of cash flows by placing an x in the appropriate column.

Statement of Cash Flows

Noncash Not

Investing Reported on

Operating Investing Financing and Financing Statement

Activities Activities Activities Activities or in Notes

a. Retired long-term notes payable by issuing common stock . . . . . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

b. Paid cash toward accounts payable . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

c. Sold inventory for cash . . . . . . . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

d. Paid cash dividend that was declared in a prior period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

e. Accepted six-month note receivable in exchange for plant assets . . . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

f. Recorded depreciation expense . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

g. Paid cash to acquire treasury stock . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

h. Collected cash from sales . . . . . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

i. Borrowed cash from bank by signing a nine-month note payable . . . . . . . . . . . . . . _____ _____ _____ _____ _____

j. Paid cash to purchase a patent . . . . . . . . . . . . . . . . . . . _____ _____ _____ _____ _____

Exercise 12-3 Indirect: Cash flows from operating activities

P2

Fitzpatrick Company’s calendar-year 2013 income statement shows the following: Net Income, $374,000; Depreciation Expense, $44,000; Amortization Expense, $7,200; Gain on Sale of Plant Assets, $6,000. An examination of the company’s current assets and current liabilities reveals the following changes (all from operating activities): Accounts Receivable decrease, $17,100; Merchandise Inventory decrease, $42,000; Prepaid Expenses increase, $4,700; Accounts Payable decrease, $8,200; Other Payables increase, $1,200. Use the indirect method to compute cash flow from operating activities.

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Chapter 12 Reporting Cash Flows 547

Exercise 12-4 Indirect: Cash flow from operations

P2

Salud Company reports net income of $400,000 for the year ended December 31, 2013. It also reports $80,000 depreciation expense and a $20,000 gain on the sale of machinery. Its comparative balance sheets reveal a $40,000 increase in accounts receivable, $6,000 increase in accounts payable, $12,000 decrease in prepaid expenses, and $2,000 decrease in wages payable.

Required

Prepare only the operating activities section of the statement of cash flows for 2013 using the indirect method.

Exercise 12-5B

Direct: Computation of cash flows

P5

For each of the following three separate cases, use the information provided about the calendar-year 2014 operations of Sahim Company to compute the required cash flow information.

Case X: Compute cash received from customers:

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $515,000

Accounts receivable, December 31, 2013 . . . . . . . . . . 27,200

Accounts receivable, December 31, 2014 . . . . . . . . . . 33,600

Case Y: Compute cash paid for rent:

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $139,800

Rent payable, December 31, 2013 . . . . . . . . . . . . . . . . . 7,800

Rent payable, December 31, 2014 . . . . . . . . . . . . . . . . . 6,200

Case Z: Compute cash paid for merchandise:

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . $525,000

Merchandise inventory, December 31, 2013 . . . . . . . . . 158,600

Accounts payable, December 31, 2013 . . . . . . . . . . . . . 66,700

Merchandise inventory, December 31, 2014 . . . . . . . . . 130,400

Accounts payable, December 31, 2014 . . . . . . . . . . . . . 82,000

Exercise 12-6 Indirect: Cash flows from operating activities

P2

Information: The following income statement and information about changes in noncash current assets and current liabilities are reported.

SONAD COMPANY

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,828,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 991,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 837,000

Operating expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . . $245,535

Depreciation expense . . . . . . . . . . . . . . . . . . 44,200

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . 49,600

Amortization expenses—Patents . . . . . . . . . 4,200

Utilities expense . . . . . . . . . . . . . . . . . . . . . . 18,125 361,660

475,340

Gain on sale of equipment . . . . . . . . . . . . . . . . 6,200

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 481,540

Accounts receivable . . . . . . . . . . $30,500 increase Accounts payable . . . . . . . . $12,500 decrease

Merchandise inventory . . . . . . . . 25,000 increase Salaries payable . . . . . . . . . 3,500 decrease

Changes in current asset and current liability accounts for the year that relate to operations follow.

Required

Prepare only the cash flows from operating activities section of the statement of cash flows using the indirect method.

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548 Chapter 12 Reporting Cash Flows

Exercise 12-9 Cash flows from financing activities

P3

Use the following information to determine this company’s cash flows from financing activities. a. Net income was $35,000. b. Issued common stock for $64,000 cash. c. Paid cash dividend of $14,600. d. Paid $50,000 cash to settle a note payable at its $50,000 maturity value. e. Paid $12,000 cash to acquire its treasury stock. f. Purchased equipment for $39,000 cash.

IKIBAN INC.

Income Statement

For Year Ended June 30, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $678,000

Cost of goods sold . . . . . . . . . . . . . . . . . 411,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . 267,000

Operating expenses

Depreciation expense . . . . . . . . . . . . . $58,600

Other expenses . . . . . . . . . . . . . . . . . 67,000

Total operating expenses . . . . . . . . . . . . 125,600

141,400

Other gains (losses)

Gain on sale of equipment . . . . . . . . . 2,000

Income before taxes . . . . . . . . . . . . . . . . 143,400

Income taxes expense . . . . . . . . . . . . . . 43,890

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 99,510

Exercise 12-10 Indirect: Preparation of statement of cash flows P1

Information: The following financial statements and additional information are reported.

IKIBAN INC.

Comparative Balance Sheets

June 30, 2013 and 2012

2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,500 $ 44,000

Accounts receivable, net . . . . . . . . . . . . . . . . 65,000 51,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,800 86,500

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 4,400 5,400

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,000 115,000

Accum. depreciation—Equipment . . . . . . . . (27,000) (9,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $317,700 $292,900

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 30,000

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . 6,000 15,000

Income taxes payable . . . . . . . . . . . . . . . . . . 3,400 3,800

Notes payable (long term) . . . . . . . . . . . . . . 30,000 60,000

Common stock, $5 par value . . . . . . . . . . . . 220,000 160,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . 33,300 24,100

Total liabilities and equity . . . . . . . . . . . . . . . $317,700 $292,900

Additional Information

a. A $30,000 note payable is retired at its $30,000 carrying (book) value in exchange for cash. b. The only changes affecting retained earnings are net income and cash dividends paid. c. New equipment is acquired for $57,600 cash. d. Received cash for the sale of equipment that had cost $48,600, yielding a $2,000 gain. e. Prepaid Expenses and Wages Payable relate to Other Expenses on the income statement. f. All purchases and sales of merchandise inventory are on credit.

Required

(1) prepare a statement of cash flows for the year ended June 30, 2013, using the indirect method, and (2) compute the company’s cash flow on total assets ratio for its fiscal year 2013.

Exercise 12-8 Cash flows from investing activities

P3

Use the following information to determine this company’s cash flows from investing activities. a. Equipment with a book value of $65,300 and an original cost of $133,000 was sold at a loss of $14,000. b. Paid $89,000 cash for a new truck. c. Sold land costing $154,000 for $198,000 cash, yielding a gain of $44,000. d. Long-term investments in stock were sold for $60,800 cash, yielding a gain of $4,150.

Check (b) Cash dividends, $90,310

(d) Cash from equip. sale, $10,000

Exercise 12-7B

Direct: Cash flows from operating activities P5

Refer to the information about Sonad Company in Exercise 12-6. Use the direct method to prepare only the cash provided or used by operating activities section of the statement of cash flows for this company.

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Chapter 12 Reporting Cash Flows 549

Exercise 12-11B

Direct: Preparation of statement of cash flows P1

Refer to the information in Exercise 12-10. Using the direct method, prepare the statement of cash flows for the year ended June 30, 2013.

Arundel Company disclosed the following information for its recent calendar year. Exercise 12-13 Indirect: Reporting and interpreting cash flows from operations

P2

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . 84,000

Utilities expense . . . . . . . . . . . . . . . . . . . . 14,000

Depreciation expense . . . . . . . . . . . . . . . . 14,600

Other expenses . . . . . . . . . . . . . . . . . . . . 3,400

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (16,000)

Accounts receivable decrease . . . . . . . . . . . $ 24,000

Purchased a machine . . . . . . . . . . . . . . . . . . . 10,000

Salaries payable increase . . . . . . . . . . . . . . . . 18,000

Other accrued liabilities decrease . . . . . . . . 8,000

Required

1. Prepare the operating activities section of the statement of cash flows using the indirect method. 2. What were the major reasons that this company was able to report a net loss but positive cash flow

from operations? 3. Of the potential causes of differences between cash flow from operations and net income, which are

the most important to investors?

Required

Prepare the operating activities section of the statement of cash flows for Hampton Company using the indirect method.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000

Expenses

Cost of goods sold . . . . . . . . . . . . . . 100,000

Salaries expense . . . . . . . . . . . . . . . . 24,000

Depreciation expense . . . . . . . . . . . . 12,000

Net income . . . . . . . . . . . . . . . . . . . . . . $ 24,000

Accounts receivable increase . . . . . . . . $ 10,000

Inventory decrease . . . . . . . . . . . . . . . . 16,000

Salaries payable increase . . . . . . . . . . . . 1,000

Exercise 12-12 Indirect: Reporting cash flows from operations

P2

Hampton Company reports the following information for its recent calendar year.

Exercise 12-14 Indirect: Cash flows spreadsheet

P4

Complete the following spreadsheet in preparation of the statement of cash flows. (The statement of cash flows is not required.) Prepare the spreadsheet as in Exhibit 12A.1; report operating activities under the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following transactions and events a through h. a. Net income for the year was $100,000. b. Dividends of $80,000 cash were declared and paid. c. Scoreteck’s only noncash expense was $70,000 of depreciation. d. The company purchased plant assets for $70,000 cash. e. Notes payable of $20,000 were issued for $20,000 cash. f. Change in accounts receivable. g. Change in merchandise inventory. h. Change in accounts payable.

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550 Chapter 12 Reporting Cash Flows

Debit

Analysis of Changes

Credit Dec. 31,

2013 Dec. 31,

2012

SCORETECK CORPORATION Spreadsheet for Statement of Cash Flows—Indirect Method

For Year Ended December 31, 2013

Cash Balance Sheet—Debit Bal. Accounts

Accounts receivable Merchandise inventory Plant assets

Accumulated depreciation Balance Sheet—Credit Bal. Accounts

Accounts payable Notes payable Common stock Retained earnings

Operating activities Statement of Cash Flows

Net income Increase in accounts receivable Decrease in merchandise inventory

Investing activities

Decrease in accounts payable Depreciation expense

Cash paid to purchase plant assets Financing activities

Cash paid for dividends Cash from issuance of notes

$1,050,000 600,000 250,000 120,000

$ 80,000

$1,050,000 230,000 200,000 370,000 150,000

$100,000

$1,150,000 250,000 200,000 390,000 140,000

$ 170,000

$1,150,000 670,000 230,000 190,000

$ 60,000

Exercise 12-15B

Direct: Preparation of statement of cash flows and supporting note

P1

Use the following information about the cash flows of Ferron Company to prepare a complete statement of cash flows (direct method) for the year ended December 31, 2013. Use a note disclosure for any noncash investing and financing activities.

Cash and cash equivalents balance, December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000

Cash and cash equivalents balance, December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148,000

Cash received as interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500

Cash paid for salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76,500

Bonds payable retired by issuing common stock (no gain or loss on retirement) . . . . . . . . . . 185,500

Cash paid to retire long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash received from sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,250

Cash received in exchange for six-month note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Land purchased by issuing long-term note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,250

Cash paid for store equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,750

Cash dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Cash paid for other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495,000

Cash paid for merchandise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254,500

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Chapter 12 Reporting Cash Flows 551

Exercise 12-17 Analyses of cash flow on total assets A1

A company reported average total assets of $1,240,000 in 2012 and $1,510,000 in 2013. Its net operating cash flow in 2012 was $102,920 and $138,920 in 2013. Calculate its cash flow on total assets ratio for both years. Comment on the results and any change in performance.

Net income . . . . . . . . . . . . . . . . . . . € 784

Depreciation and amortization . . . . 3,037

Gains on disposals and other . . . . . (883)

Net decrease in working capital . . . (1,183)

Cash paid for dividends . . . . . . . . . . (290)

Cash paid for purchase of treasury stock and other . . . €  (199)

Cash paid for other financing activities . . . . . . . . . . . . . (2,282)

Cash from disposal of plant assets and intangibles . . . . 189

Cash paid for plant assets and intangibles . . . . . . . . . (3,921)

Cash and cash equivalents, December 31, 2010 . . . . . . . 10,442

Exercise 12-18 Indirect: Statement of cash flows under IFRS

P1

Peugeot S.A. reports the following financial information for the year ended December 31, 2011 (euros in millions). Prepare its statement of cash flows under the indirect method.

Forten Company, a merchandiser, recently completed its calendar-year 2013 operations. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, and (5) Other Expenses are paid in advance and are initially debited to Prepaid Expenses. The company’s balance sheets and income statement follow.

PROBLEM SET A

Problem 12-1A Indirect: Statement of cash flows

A1 P1 P2 P3

The following summarized Cash T-account reflects the total debits and total credits to the Cash account of Thomas Corporation for calendar year 2013. (1) Use this information to prepare a complete statement of cash flows for year 2013. The cash provided or used by operating activities should be reported using the direct method. (2) Refer to the statement of cash flows prepared for part 1 to answer the following questions a through d: (a) Which section — operating, investing, or financing — shows the largest cash (i) inflow and (ii) outflow? (b) What is the largest individual item among the investing cash outflows? (c) Are the cash proceeds larger from issuing notes or issuing stock? (d ) Does the company have a net cash inflow or outflow from borrow- ing activities?

Cash

Accounting System:

File Maintain Tasks Analysis Options Reports Window HelpEdit

Balance, Dec. 31, 2012 .................. Receipts from customers ............... Receipts from dividends ................ Receipts from land sale ................. Receipts from machinery sale ....... Receipts from issuing stock .......... Receipts from borrowing ...............

Balance, Dec. 31, 2013 .................. $ ?

333,000 5,000,000

208,400 220,000 710,000

1,540,000 3,600,000

Payments for merchandise ...................... Payments for wages ................................ Payments for rent ..................................... Payments for interest ................................ Payments for taxes ................................... Payments for machinery ........................... Payments for long-term investments ........ Payments for note payable ....................... Payments for dividends ............................ Payments for treasury stock .....................

2,590,000 550,000 320,000 218,000 450,000

2,236,000 1,260,000

386,000 500,000 218,000

Exercise 12-16B

Direct: Preparation of statement of cash flows from Cash T-account

P1

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552 Chapter 12 Reporting Cash Flows

Additional Information on Year 2013 Transactions

a. The loss on the cash sale of equipment was $5,125 (details in b). b. Sold equipment costing $46,875, with accumulated depreciation of $30,125, for $11,625 cash. c. Purchased equipment costing $96,375 by paying $30,000 cash and signing a long-term note payable

for the balance. d. Borrowed $4,000 cash by signing a short-term note payable. e. Paid $50,125 cash to reduce the long-term notes payable. f. Issued 2,500 shares of common stock for $20 cash per share. g. Declared and paid cash dividends of $50,100.

Required

1. Prepare a complete statement of cash flows; report its operating activities using the indirect method. Disclose any noncash investing and financing activities in a note.

Analysis Component

2. Analyze and discuss the statement of cash flows prepared in part 1, giving special attention to the wisdom of the cash dividend payment.

FORTEN COMPANY

Comparative Balance Sheets

December 31, 2013 and 2012

2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,800 $ 73,500

Accounts receivable . . . . . . . . . . . . . . . . . . . 65,810 50,625

Merchandise inventory . . . . . . . . . . . . . . . . . 275,656 251,800

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 1,250 1,875

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 157,500 108,000

Accum. depreciation—Equipment . . . . . . . . . (36,625) (46,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $513,391 $439,800

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 53,141 $114,675

Short-term notes payable . . . . . . . . . . . . . . . 10,000 6,000

Long-term notes payable . . . . . . . . . . . . . . . 65,000 48,750

Common stock, $5 par value . . . . . . . . . . . . 162,750 150,250

Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . 37,500 0

Retained earnings . . . . . . . . . . . . . . . . . . . . . 185,000 120,125

Total liabilities and equity . . . . . . . . . . . . . . . $513,391 $439,800

FORTEN COMPANY

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $582,500

Cost of goods sold . . . . . . . . . . . . . . . . 285,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . 297,500

Operating expenses

Depreciation expense . . . . . . . . . . . . $ 20,750

Other expenses . . . . . . . . . . . . . . . . . 132,400 153,150

Other gains (losses)

Loss on sale of equipment . . . . . . . . (5,125)

Income before taxes . . . . . . . . . . . . . . . 139,225

Income taxes expense . . . . . . . . . . . . . 24,250

Net income . . . . . . . . . . . . . . . . . . . . . . $114,975

Check Cash from operating activities, $40,900

Problem 12-2AA

Indirect: Cash flows spreadsheet

P1 P2 P3 P4

Refer to the information reported about Forten Company in Problem 12-1A.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1; report its operating activities using the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $114,975. b. Accounts receivable increased. c. Merchandise inventory increased. d. Prepaid expenses decreased. e. Accounts payable decreased. f. Depreciation expense was $20,750. g. Sold equipment costing $46,875, with accumulated depreciation of $30,125, for $11,625 cash. This

yielded a loss of $5,125. h. Purchased equipment costing $96,375 by paying $30,000 cash and (i.) by signing a long-term note

payable for the balance.

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Chapter 12 Reporting Cash Flows 553

j. Borrowed $4,000 cash by signing a short-term note payable. k. Paid $50,125 cash to reduce the long-term notes payable. l. Issued 2,500 shares of common stock for $20 cash per share. m. Declared and paid cash dividends of $50,100.

Check Analysis of Changes column totals, $600,775

Additional Information on Year 2013 Transactions

a. Purchased equipment for $36,000 cash. b. Issued 12,000 shares of common stock for $5 cash per share. c. Declared and paid $89,000 in cash dividends.

Required

Prepare a complete statement of cash flows; report its cash inflows and cash outflows from operating ac- tivities according to the indirect method.

Check Cash from operating activities, $122,000

Problem 12-4A Indirect: Statement of cash flows

P1 P2 P3

Golden Corp., a merchandiser, recently completed its 2013 operations. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, (5) Other Expenses are all cash expenses, and (6) any change in Income Taxes Payable reflects the accrual and cash payment of taxes. The company’s balance sheets and income statement follow.

GOLDEN CORPORATION

Comparative Balance Sheets

December 31, 2013 and 2012

2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 164,000 $107,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . 83,000 71,000

Merchandise inventory . . . . . . . . . . . . . . . . . . 601,000 526,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335,000 299,000

Accum. depreciation—Equipment . . . . . . . . . (158,000) (104,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,025,000 $899,000

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . . $ 87,000 $ 71,000

Income taxes payable . . . . . . . . . . . . . . . . . . . 28,000 25,000

Common stock, $2 par value . . . . . . . . . . . . . 592,000 568,000

Paid-in capital in excess of par value, common stock . . . . . . . . . . . . 196,000 160,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . 122,000 75,000

Total liabilities and equity . . . . . . . . . . . . . . . . $1,025,000 $899,000

GOLDEN CORPORATION

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $1,792,000

Cost of goods sold . . . . . . . . . . . . . 1,086,000

Gross profit . . . . . . . . . . . . . . . . . . . 706,000

Operating expenses

Depreciation expense . . . . . . . . . $ 54,000

Other expenses . . . . . . . . . . . . . . 494,000 548,000

Income before taxes . . . . . . . . . . . . 158,000

Income taxes expense . . . . . . . . . . 22,000

Net income . . . . . . . . . . . . . . . . . . . $ 136,000

mhhe.com/wildFINMAN5e

Refer to Forten Company’s financial statements and related information in Problem 12-1A.

Required

Prepare a complete statement of cash flows; report its operating activities according to the direct method. Disclose any noncash investing and financing activities in a note.

Problem 12-3AB

Direct: Statement of cash flows P1 P3 P5 Check Cash used in financing activities, $(46,225)

Refer to the information reported about Golden Corporation in Problem 12-4A.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1; report operating activities under the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $136,000. b. Accounts receivable increased.

Problem 12-5AA

Indirect: Cash flows spreadsheet

P1 P2 P3 P4

mhhe.com/wildFINMAN5e

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554 Chapter 12 Reporting Cash Flows

Check Analysis of Changes column totals, $481,000

Problem 12-7A Indirect: Computing cash flows from operations

P2

Lansing Company’s 2013 income statement and selected balance sheet data at December 31, 2012 and 2013, follow.

LANSING COMPANY

Income Statement

For Year Ended December 31, 2013

Sales revenue . . . . . . . . . . . . . . . . . . $97,200

Expenses

Cost of goods sold . . . . . . . . . . . 42,000

Depreciation expense . . . . . . . . . 12,000

Salaries expense . . . . . . . . . . . . . 18,000

Rent expense . . . . . . . . . . . . . . . 9,000

Insurance expense . . . . . . . . . . . 3,800

Interest expense . . . . . . . . . . . . . 3,600

Utilities expense . . . . . . . . . . . . . 2,800

Net income . . . . . . . . . . . . . . . . . . . $ 6,000

LANSING COMPANY

Selected Balance Sheet Accounts

At December 31 2013 2012

Accounts receivable . . . . . $5,600 $5,800

Inventory . . . . . . . . . . . . . . 1,980 1,540

Accounts payable . . . . . . . . 4,400 4,600

Salaries payable . . . . . . . . . 880 700

Utilities payable . . . . . . . . . 220 160

Prepaid insurance . . . . . . . 260 280

Prepaid rent . . . . . . . . . . . 220 180

Required

Prepare the cash flows from operating activities section only of the company’s 2013 statement of cash flows using the indirect method.

Check Cash from operating activities, $17,780

Problem 12-8AB

Direct: Computing cash flows from operations

P5

Refer to the information in Problem 12-7A.

Required

Prepare the cash flows from operating activities section only of the company’s 2013 statement of cash flows using the direct method.

PROBLEM SET B

Problem 12-1B Indirect: Statement of cash flows

A1 P1 P2 P3

Gazelle Corporation, a merchandiser, recently completed its calendar-year 2013 operations. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, and (5) Other Expenses are paid in advance and are initially debited to Prepaid Expenses. The company’s balance sheets and income statement follow.

c. Merchandise inventory increased. d. Accounts payable increased. e. Income taxes payable increased. f. Depreciation expense was $54,000. g. Purchased equipment for $36,000 cash. h. Issued 12,000 shares at $5 cash per share. i. Declared and paid $89,000 of cash dividends.

Refer to Golden Corporation’s financial statements and related information in Problem 12-4A.

Required

Prepare a complete statement of cash flows; report its cash flows from operating activities according to the direct method.

Problem 12-6AB

Direct: Statement of cash flows P1 P3 P5

Check Cash used in financing activities, $(29,000)

mhhe.com/wildFINMAN5e

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Chapter 12 Reporting Cash Flows 555

Additional Information on Year 2013 Transactions

a. The loss on the cash sale of equipment was $2,100 (details in b). b. Sold equipment costing $51,000, with accumulated depreciation of $22,850, for $26,050 cash. c. Purchased equipment costing $113,250 by paying $43,250 cash and signing a long-term note payable

for the balance. d. Borrowed $5,000 cash by signing a short-term note payable. e. Paid $47,500 cash to reduce the long-term notes payable. f. Issued 3,000 shares of common stock for $15 cash per share. g. Declared and paid cash dividends of $53,600.

Required

1. Prepare a complete statement of cash flows; report its operating activities using the indirect method. Disclose any noncash investing and financing activities in a note.

Analysis Component

2. Analyze and discuss the statement of cash flows prepared in part 1, giving special attention to the wisdom of the cash dividend payment.

GAZELLE CORPORATION

Comparative Balance Sheets

December 31, 2013 and 2012

2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $123,450 $ 61,550

Accounts receivable . . . . . . . . . . . . . . . . . . . 77,100 80,750

Merchandise inventory . . . . . . . . . . . . . . . . . 240,600 250,700

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 15,100 17,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 262,250 200,000

Accum. depreciation—Equipment . . . . . . . . . (110,750) (95,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $607,750 $515,000

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 17,750 $102,000

Short-term notes payable . . . . . . . . . . . . . . . 15,000 10,000

Long-term notes payable . . . . . . . . . . . . . . . 100,000 77,500

Common stock, $5 par . . . . . . . . . . . . . . . . . 215,000 200,000

Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . 30,000 0

Retained earnings . . . . . . . . . . . . . . . . . . . . . 230,000 125,500

Total liabilities and equity . . . . . . . . . . . . . . . $607,750 $515,000

GAZELLE CORPORATION

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,185,000

Cost of goods sold . . . . . . . . . . . . . . . . 595,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . 590,000

Operating expenses

Depreciation expense . . . . . . . . . . . . $ 38,600

Other expenses . . . . . . . . . . . . . . . . 362,850

Total operating expenses . . . . . . . . . . . 401,450

188,550

Other gains (losses)

Loss on sale of equipment . . . . . . . . (2,100)

Income before taxes . . . . . . . . . . . . . . . 186,450

Income taxes expense . . . . . . . . . . . . . 28,350

Net income . . . . . . . . . . . . . . . . . . . . . . $ 158,100

Check Cash from operating activities, $130,200

Problem 12-2BA

Indirect: Cash flows spreadsheet

P1 P2 P3 P4

Refer to the information reported about Gazelle Corporation in Problem 12-1B.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1; report its operating activities using the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $158,100. b. Accounts receivable decreased. c. Merchandise inventory decreased. d. Prepaid expenses decreased. e. Accounts payable decreased. f. Depreciation expense was $38,600.

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556 Chapter 12 Reporting Cash Flows

Check Analysis of Changes column totals, $681,950

Problem 12-4B Indirect: Statement of cash flows

P1 P2 P3

Satu Company, a merchandiser, recently completed its 2013 operations. For the year, (1) all sales are credit sales, (2) all credits to Accounts Receivable reflect cash receipts from customers, (3) all purchases of inventory are on credit, (4) all debits to Accounts Payable reflect cash payments for inventory, (5) Other Expenses are cash expenses, and (6) any change in Income Taxes Payable reflects the accrual and cash payment of taxes. The company’s balance sheets and income statement follow.

SATU COMPANY

Comparative Balance Sheets

December 31, 2013 and 2012

2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,750 $ 28,400

Accounts receivable . . . . . . . . . . . . . . . . . . . 20,222 25,860

Merchandise inventory . . . . . . . . . . . . . . . . . 165,667 140,320

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 107,750 77,500

Accum. depreciation — Equipment . . . . . . . . . (46,700) (31,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $305,689 $241,080

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 20,372 $157,530

Income taxes payable . . . . . . . . . . . . . . . . . . 2,100 6,100

Common stock, $5 par value . . . . . . . . . . . . 40,000 25,000

Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . 68,000 20,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . 175,217 32,450

Total liabilities and equity . . . . . . . . . . . . . . . $305,689 $241,080

SATU COMPANY

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $750,800

Cost of goods sold . . . . . . . . . . . . . 269,200

Gross profit . . . . . . . . . . . . . . . . . . . 481,600

Operating expenses

Depreciation expense . . . . . . . . . $ 15,700

Other expenses . . . . . . . . . . . . . . 173,933 189,633

Income before taxes . . . . . . . . . . . . 291,967

Income taxes expense . . . . . . . . . . . 89,200

Net income . . . . . . . . . . . . . . . . . . . $202,767

Additional Information on Year 2013 Transactions

a. Purchased equipment for $30,250 cash. b. Issued 3,000 shares of common stock for $21 cash per share. c. Declared and paid $60,000 of cash dividends.

Required

Prepare a complete statement of cash flows; report its cash inflows and cash outflows from operating activities according to the indirect method.

Check Cash from operating activities, $57,600

Check Cash used in financing activities, $(51,100)

Problem 12-3BB

Direct: Statement of cash flows P1 P3 P5

Refer to Gazelle Corporation’s financial statements and related information in Problem 12-1B.

Required

Prepare a complete statement of cash flows; report its operating activities according to the direct method. Disclose any noncash investing and financing activities in a note.

g. Sold equipment costing $51,000, with accumulated depreciation of $22,850, for $26,050 cash. This yielded a loss of $2,100.

h. Purchased equipment costing $113,250 by paying $43,250 cash and (i.) by signing a long-term note payable for the balance.

j. Borrowed $5,000 cash by signing a short-term note payable. k. Paid $47,500 cash to reduce the long-term notes payable. l. Issued 3,000 shares of common stock for $15 cash per share. m. Declared and paid cash dividends of $53,600.

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Chapter 12 Reporting Cash Flows 557

Problem 12-5BA

Indirect: Cash flows spreadsheet

P1 P2 P3 P4

Refer to the information reported about Satu Company in Problem 12-4B.

Required

Prepare a complete statement of cash flows using a spreadsheet as in Exhibit 12A.1; report operating ac- tivities under the indirect method. Identify the debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. a. Net income was $202,767. b. Accounts receivable decreased. c. Merchandise inventory increased. d. Accounts payable decreased. e. Income taxes payable decreased. f. Depreciation expense was $15,700. g. Purchased equipment for $30,250 cash. h. Issued 3,000 shares at $21 cash per share. i. Declared and paid $60,000 of cash dividends.

Check Analysis of Changes column totals, $543,860

Problem 12-8BB

Direct: Computing cash flows from operations

P5

Refer to the information in Problem 12-7B.

Required

Prepare the cash flows from operating activities section only of the company’s 2013 statement of cash flows using the direct method.

SALT LAKE COMPANY

Income Statement

For Year Ended December 31, 2013

Sales revenue . . . . . . . . . . . . . . . . . . $156,000

Expenses

Cost of goods sold . . . . . . . . . . . 72,000

Depreciation expense . . . . . . . . . 32,000

Salaries expense . . . . . . . . . . . . . 20,000

Rent expense . . . . . . . . . . . . . . . 5,000

Insurance expense . . . . . . . . . . . 2,600

Interest expense . . . . . . . . . . . . . 2,400

Utilities expense . . . . . . . . . . . . . 2,000

Net income . . . . . . . . . . . . . . . . . . . $ 20,000

SALT LAKE COMPANY

Selected Balance Sheet Accounts

At December 31 2013 2012

Accounts receivable . . . . . . . . $3,600 $3,000

Inventory . . . . . . . . . . . . . . . . . 860 980

Accounts payable . . . . . . . . . . 2,400 2,600

Salaries payable . . . . . . . . . . . . 900 600

Utilities payable . . . . . . . . . . . . 200 0

Prepaid insurance . . . . . . . . . . 140 180

Prepaid rent . . . . . . . . . . . . . . 100 200

Problem 12-7B Indirect: Computing cash flows from operations

P2

Salt Lake Company’s 2013 income statement and selected balance sheet data at December 31, 2012 and 2013, follow.

Check Cash from operating activities, $51,960

Required

Prepare the cash flows from operating activities section only of the company’s 2013 statement of cash flows using the indirect method.

Problem 12-6BB

Direct: Statement of cash flows

P1 P3 P5

Refer to Satu Company’s financial statements and related information in Problem 12-4B.

Required

Prepare a complete statement of cash flows; report its cash flows from operating activities according to the direct method.

Check Cash provided by financing activities, $3,000

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558 Chapter 12 Reporting Cash Flows

SUCCESS SYSTEMS

Comparative Balance Sheets

December 31, 2013, and March 31, 2014

2014 2013

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 77,845 $58,160

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . 22,720 5,668

Merchandise inventory . . . . . . . . . . . . . . . . . . . . 704 0

Computer supplies . . . . . . . . . . . . . . . . . . . . . . . 2,005 580

Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . 1,110 1,665

Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 825 825

Office equipment . . . . . . . . . . . . . . . . . . . . . . . . 8,000 8,000

Accumulated depreciation — Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . (800) (400)

Computer equipment . . . . . . . . . . . . . . . . . . . . . 20,000 20,000

Accumulated depreciation — Computer equipment . . . . . . . . . . . . . . . . . . . (2,500) (1,250)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $129,909 $93,248

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 1,100

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 875 500

Unearned computer service revenue . . . . . . . . . 0 1,500

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000 83,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 21,034 7,148

Total liabilities and equity . . . . . . . . . . . . . . . . . . $129,909 $93,248

SUCCESS SYSTEMS

Income Statement

For Three Months Ended March 31, 2014

Computer services revenue . . . . . . . . . . $25,160

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . 18,693

Total revenue . . . . . . . . . . . . . . . . . . . . . . 43,853

Cost of goods sold . . . . . . . . . . . . . . . . . $14,052

Depreciation expense — Office equipment . . . . . . . . . . . . . . . . 400

Depreciation expense — Computer equipment . . . . . . . . . . . . . 1,250

Wages expense . . . . . . . . . . . . . . . . . . . . 3,250

Insurance expense . . . . . . . . . . . . . . . . . 555

Rent expense . . . . . . . . . . . . . . . . . . . . . 2,475

Computer supplies expense . . . . . . . . . . 1,305

Advertising expense . . . . . . . . . . . . . . . . 600

Mileage expense . . . . . . . . . . . . . . . . . . . 320

Repairs expense — Computer . . . . . . . . 960

Total expenses . . . . . . . . . . . . . . . . . . . . 25,167

Net income . . . . . . . . . . . . . . . . . . . . . . . $18,686

Required

Prepare a statement of cash flows for Success Systems using the indirect method for the three months ended March 31, 2014. Recall that the owner Adria Lopez contributed $25,000 to the business in exchange for additional stock in the first quarter of 2014 and has received $4,800 in cash dividends.

Check Cash flows used by operations: $(515)

BTN 12-1 Refer to Polaris’ financial statements in Appendix A to answer the following. 1. Is Polaris’ statement of cash flows prepared under the direct method or the indirect method? How

do you know? 2. For each year 2011, 2010, and 2009, is the amount of cash provided by operating activities more or

less than the cash paid for dividends? 3. What is the largest amount in reconciling the difference between net income and cash flow from

operating activities in 2011? In 2010? In 2009? 4. Identify the largest cash inflow and outflow for investing and for financing activities in 2012 and in 2010.

Fast Forward

5. Obtain Polaris’ financial statements for a year ending after December 31, 2011, from either its Website (Polaris.com) or the SEC’s database (www .sec.gov). Since December 31, 2011, what are Polaris’ largest cash outflows and cash inflows in the investing and in the financing sections of its statement of cash flows?

Beyond the Numbers

REPORTING IN ACTION A1

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 12 Adria Lopez, owner of Success Systems, decides to prepare a statement of cash flows for her business. (Although the serial problem allowed for various ownership changes in earlier chapters, we will prepare the statement of cash flows using the following financial data.)

SERIAL PROBLEM Success Systems (Indirect)

P1 P2 P3

Polaris

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Chapter 12 Reporting Cash Flows 559

BTN 12-2 Key figures for Polaris and Arctic Cat follow. COMPARATIVE ANALYSIS A1

Required

1. Compute the recent two years’ cash flow on total assets ratios for Polaris and Arctic Cat. 2. What does the cash flow on total assets ratio measure? 3. Which company has the highest cash flow on total assets ratio for the periods shown? 4. Does the cash flow on total assets ratio reflect on the quality of earnings? Explain.

Polaris Arctic Cat

Current 1 Year 2 Years Current 1 Year 2 Years

($ thousands) Year Prior Prior Year Prior Prior

Operating cash flows . . . . . . . . . . $ 302,530 $ 297,619 $193,201 $ (5,123) $ 29,315 $ 19,591

Total assets . . . . . . . . . . . . . . . . . . 1,228,024 1,061,647 763,653 272,906 246,084 251,165

BTN 12-3 Katie Murphy is preparing for a meeting with her banker. Her business is finishing its fourth year of operations. In the first year, it had negative cash flows from operations. In the second and third years, cash flows from operations were positive. However, inventory costs rose significantly in year 4, and cash flows from operations will probably be down 25%. Murphy wants to secure a line of credit from her banker as a financing buffer. From experience, she knows the banker will scrutinize operating cash flows for years 1 through 4 and will want a projected number for year 5. Murphy knows that a steady progression upward in operating cash flows for years 1 through 4 will help her case. She decides to use her discretion as owner and considers several business actions that will turn her operating cash flow in year 4 from a decrease to an increase.

Required

1. Identify two business actions Murphy might take to improve cash flows from operations. 2. Comment on the ethics and possible consequences of Murphy’s decision to pursue these actions.

ETHICS CHALLENGE C1 A1

BTN 12-4 Your friend, Diana Wood, recently completed the second year of her business and just re- ceived annual financial statements from her accountant. Wood finds the income statement and balance sheet informative but does not understand the statement of cash flows. She says the first section is espe- cially confusing because it contains a lot of additions and subtractions that do not make sense to her. Wood adds, “The income statement tells me the business is more profitable than last year and that’s most impor- tant. If I want to know how cash changes, I can look at comparative balance sheets.”

Required

Write a half-page memorandum to your friend explaining the purpose of the statement of cash flows. Speculate as to why the first section is so confusing and how it might be rectified.

COMMUNICATING IN PRACTICE C1

BTN 12-5 Access the March 30, 2012, filing of the 10-K report (for year ending December 31, 2011) of Mendocino Brewing Company, Inc., at www .sec.gov.

Required

1. Does Mendocino Brewing use the direct or indirect method to construct its consolidated statement of cash flows?

2. For the year ended December 31, 2011, what is the largest item in reconciling the net income to net cash provided by operating activities?

3. In the recent two years, has the company been more successful in generating operating cash flows or in generating net income? Identify the figures to support the answer.

4. In the year ended December 31, 2011, what was the largest cash outflow for investing activities and for financing activities?

5. What item(s) does Mendocino Brewing report as supplementary cash flow information? 6. Does Mendocino Brewing report any noncash financing activities for 2011? Identify them, if any.

TAKING IT TO THE NET A1

Polaris Arctic Cat

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560 Chapter 12 Reporting Cash Flows

TEAMWORK IN ACTION C1 A1 P2 P5

BTN 12-6 Team members are to coordinate and independently answer one question within each of the following three sections. Team members should then report to the team and confirm or correct teammates’ answers. 1. Answer one of the following questions about the statement of cash flows. a. What are this statement’s reporting objectives? b. What two methods are used to prepare it? Identify similarities and differences between them. c. What steps are followed to prepare the statement? d. What types of analyses are often made from this statement’s information? 2. Identify and explain the adjustment from net income to obtain cash flows from operating activities

using the indirect method for one of the following items. a. Noncash operating revenues and expenses. b. Nonoperating gains and losses. c. Increases and decreases in noncash current assets. d. Increases and decreases in current liabilities. 3.B Identify and explain the formula for computing cash flows from operating activities using the direct

method for one of the following items. a. Cash receipts from sales to customers. b. Cash paid for merchandise inventory. c. Cash paid for wages and operating expenses. d. Cash paid for interest and taxes.

Note: For teams of more than four, some pairing within teams is necessary. Use as an in-class activity or as an assign- ment. If used in class, specify a time limit on each part. Conclude with reports to the entire class, using team rotation. Each team can prepare responses on a transparency.

ENTREPRENEURIAL DECISION C1 A1

BTN 12-7 Review the chapter’s opener involving TOMS and its young entrepreneurial owner, Blake Mycoskie.

Required

1. In a business such as TOMS, monitoring cash flow is always a priority. Even though TOMS now has thousands in annual sales and earns a positive net income, explain how cash flow can lag behind net income.

2. TOMS is a privately owned corporation. What are potential sources of financing for its future expansion?

HITTING THE ROAD C1

BTN 12-9 Visit The Motley Fool’s Website (Fool.com). Enter the Fool’s School (at Fool.com/School). Identify and select the link How to Value Stocks. (Please note the site may ask you to register with your email ad- dress. Registration is free and grants access to full articles on the site.)

Required

1. Click on Introduction to Valuation Methods, and then Cash-Flow-Based Valuations. How does the Fool’s school define cash flow? What is the school’s reasoning for this definition?

2. Per the school’s instruction, why do analysts focus on earnings before interest and taxes (EBIT)? 3. Visit other links at this Website that interest you such as “How to Read a Balance Sheet,” or find

out what the “Fool’s Ratio” is. Write a half-page report on what you find.

C1 A1 BTN 12-8 Jenna and Matt Wilder are completing their second year operating Mountain High, a downhill ski area and resort. Mountain High reports a net loss of $(10,000) for its second year, which includes an $85,000 extraordinary loss from fire. This past year also involved major purchases of plant assets for renovation and expansion, yielding a year-end total asset amount of $800,000. Mountain High’s net cash outflow for its second year is $(5,000); a summarized version of its statement of cash flows follows:

Required

Write a one-page memorandum to the Wilders evaluating Mountain High’s current performance and assessing its future. Give special emphasis to cash flow data and their interpretation.

Net cash flow provided by operating activities . . . . . . . . . $295,000

Net cash flow used by investing activities . . . . . . . . . . . . . (310,000)

Net cash flow provided by financing activities . . . . . . . . . . 10,000

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Chapter 12 Reporting Cash Flows 561

BTN 12-10 Key comparative information for Piaggio (www.piaggio.com), which manufactures two-, three- and four-wheel vehicles, and is Europe’s leading manufacturer of motorcycles and scooters, follows.

GLOBAL DECISION C1

Required

1. Compute the recent two years’ cash flow on total assets ratio for Piaggio. 2. How does Piaggio’s ratio compare to Polaris’ and Arctic Cat’s ratios from BTN 12-2?

(Euro in thousands) Current Year 1 Year Prior 2 Years Prior

Operating cash flows . . . . . . . . 155,624 122,541 123,237

Total assets . . . . . . . . . . . . . . . . 1,520,184 1,545,722 1,564,820

1. b; 3. d; FASB requires cash interest paid to be reported under operating. 4. a; Cash paid for salaries and wages 5 $255,000 1 $8,200 2

$10,900 5 $252,300

5. e; Increase in inventory 5 $112,000 2 $105,000 5 $7,000 Increase in accounts payable 5 $101,300 2 $98,500 5 $2,800 Cash paid for merchandise 5 $545,000 1 $7,000 2

$2,800 5 $549,200

ANSWERS TO MULTIPLE CHOICE QUIZ

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $15,200

Depreciation expense . . . . . . . . . . . . . . . . . . 10,000

Gain on sale of land . . . . . . . . . . . . . . . . . . . (3,000)

Increase in inventory . . . . . . . . . . . . . . . . . . (1,500)

Increase in accounts payable . . . . . . . . . . . . . 2,850

Net cash provided by operations . . . . . . . . . $23,550

2. c; cash received from sale of machine is reported as an investing activity.

PIAGGIO Polaris Arctic Cat

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Learning Objectives

CONCEPTUAL

C1 Explain the purpose and identify the building blocks of analysis. (p. 564) C2 Describe standards for comparisons in analysis. (p. 565)

ANALYTICAL

A1 Summarize and report results of analysis. (p. 584) A2 Appendix 13A—Explain the form and assess the content of a complete income

statement. (p. 588)

PROCEDURAL

P1 Explain and apply methods of horizontal analysis. (p. 566) P2 Describe and apply methods of vertical analysis. (p. 571) P3 Define and apply ratio analysis.(p. 574)

A Look at This Chapter

This chapter emphasizes the analysis and interpretation of financial statement information. We learn to apply horizontal, vertical, and ratio analyses to better understand company performance and financial condition.

A Look Back

Chapter 12 focused on reporting and analyzing cash inflows and cash outflows. We explained how to prepare, analyze, and interpret the statement of cash flows.

Analysis of Financial Statements 13

A Look Ahead

Chapter 14 introduces us to managerial accounting. We discuss its purposes, concepts, and roles in helping managers gather and organize information for decisions. We also explain basic management principles.

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In Search of Truth

ALEXANDRIA, VA—In Shakespeare’s Elizabethan comedy As You Like It, only the fool could speak truthfully to the King without get- ting his head lopped off. Inspired by Shakespeare’s stage charac- ter, Tom and David Gardner vowed to become modern-day fools who tell it like it is. With under $10,000 in start-up money, the brothers launched The Motley Fool (Fool.com). And befitting of a Shakespearean play, the two say they are “dedicated to educat- ing, amusing, and enriching individuals in search of the truth.” The Gardners do not fear the wrath of any King, real or fic- tional. They are intent on exposing the truth, as they see it, “that the financial world preys on ignorance and fear.” As Tom ex- plains, “There is such a great need in the general populace for financial information.” Who can argue, given their brilliant suc- cess through practically every medium, including their Website, radio shows, newspaper columns, online store, investment newsletters, and global expansion. Despite the brothers’ best efforts, however, ordinary people still do not fully use information available in financial statements.

For instance, discussions keep appearing on The Motley Fool’s online bulletin board that can be easily resolved using reliable and published accounting data. So, it would seem that the Fools must continue their work of “educating and enriching” individuals and showing them the advantages of financial state- ment analysis. Following The Motley Fool’s objectives, this chapter intro- duces horizontal and vertical analyses—tools used to reveal crucial trends and insights from financial information. It also ex- pands on ratio analysis, which gives insight into a company’s financial condition and performance. By arming ourselves with the information contained in this chapter and the investment advice of The Motley Fool, we can be sure to not play the fool in today’s financial world.

[Sources: Motley Fool Website, January 2013; Washington Business Journal, January 2011; What to Do with Your Money Now, June 2002; USA Weekend, July 2004; Washington Post, November 2007; Money after 40, April 2007]

“What goes on at The Motley Fool . . . is similar to what goes on in a library.”

—TOM GARDNER (DAVID GARDNER ON LEFT)

Decision Insight

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Chapter Preview

This chapter shows how we use financial statements to evaluate a company’s financial performance and condition. We explain fi- nancial statement analysis, its basic building blocks, the informa- tion available, standards for comparisons, and tools of analysis. Three major analysis tools are presented: horizontal analysis,

vertical analysis, and ratio analysis. We apply each of these tools using Polaris’s financial statements, and we introduce compara- tive analysis using Arctic Cat and KTM (and sometimes Piaggio). This chapter expands and organizes the ratio analyses introduced at the end of each chapter.

Financial statement analysis applies analytical tools to general-purpose financial statements and related data for making business decisions. It involves transforming accounting data into more useful information. Financial statement analysis reduces our reliance on hunches, guesses, and intuition as well as our uncertainty in decision making. It does not lessen the need for expert judgment; instead, it provides us an effective and systematic basis for making business decisions. This section describes the purpose of financial statement analysis, its in- formation sources, the use of comparisons, and some issues in computations.

Purpose of Analysis Internal users of accounting information are those involved in strategically managing and operating the company. They include managers, officers, internal auditors, consultants, budget directors, and market researchers. The purpose of financial statement analysis for these users is to provide strategic information to improve company efficiency and effectiveness in providing products and services. External users of accounting information are not directly involved in running the company. They include shareholders, lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. External users rely on financial statement analysis to make better and more in- formed decisions in pursuing their own goals. We can identify other uses of financial statement analysis. Shareholders and creditors assess company prospects to make investing and lending decisions. A board of directors analyzes finan- cial statements in monitoring management’s decisions. Employees and unions use financial state- ments in labor negotiations. Suppliers use financial statement information in establishing credit terms. Customers analyze financial statements in deciding whether to establish supply relationships. Public utilities set customer rates by analyzing financial statements. Auditors use financial state- ments in assessing the “fair presentation” of their clients’ financial results. Analyst services such as Dun & Bradstreet, Moody’s, and Standard & Poor’s use financial statements in making buy- sell recommendations and in setting credit ratings. The common goal of these users is to evaluate company performance and financial condition. This includes evaluating (1) past and current per- formance, (2) current financial position, and (3) future performance and risk.

Building Blocks of Analysis Financial statement analysis focuses on one or more elements of a company’s financial condi- tion or performance. Our analysis emphasizes four areas of inquiry—with varying degrees of

BASICS OF ANALYSIS

Analysis of Financial Statements

Horizontal Analysis

• Comparative balance sheets

• Comparative income statements

• Trend analysis

Basics of Analysis

• Purpose • Building blocks • Information • Standards for

comparisons • Tools

Vertical Analysis

• Common-size balance sheet

• Common-size income statement

• Common-size graphics

Ratio Analysis

• Liquidity and efficiency

• Solvency • Profitability • Market prospects • Ratio summary

C1 Explain the purpose and identify the building blocks of analysis.

Point: Financial statement analysis tools are also used for personal financial investment decisions.

Point: Financial statement analysis is a topic on the CPA, CMA, CIA, and CFA exams.

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Chapter 13 Analysis of Financial Statements 565

importance. These four areas are described and illustrated in this chapter and are considered the building blocks of financial statement analysis:

● Liquidity and efficiency—ability to meet short-term obligations and to efficiently generate revenues.

● Solvency—ability to generate future revenues and meet long-term obligations. ● Profitability—ability to provide financial rewards sufficient to attract and retain financing. ● Market prospects—ability to generate positive market expectations.

Applying the building blocks of financial statement analysis involves determining (1) the objectives of analysis and (2) the relative emphasis among the building blocks. We distinguish among these four building blocks to emphasize the different aspects of a company’s financial condition or performance, yet we must remember that these areas of analysis are interrelated. For instance, a company’s operating performance is affected by the availability of financing and short-term liquidity conditions. Similarly, a company’s credit standing is not limited to satisfac- tory short-term liquidity but depends also on its profitability and efficiency in using assets. Early in our analysis, we need to determine the relative emphasis of each building block. Em- phasis and analysis can later change as a result of evidence collected.

Solvency Market prospects

Liquidity &

efficiency

Profitability

Information for Analysis Some users, such as managers and regulatory authorities, are able to receive special financial reports prepared to meet their analysis needs. However, most users must rely on general- purpose financial statements that include the (1) income statement, (2) balance sheet, (3) state- ment of stockholders’ equity (or statement of retained earnings), (4) statement of cash flows, and (5) notes to these statements. Financial reporting refers to the communication of financial information useful for making in- vestment, credit, and other business decisions. Financial reporting includes not only general-purpose financial statements but also information from SEC 10-K or other filings, press releases, share- holders’ meetings, forecasts, management letters, auditors’ reports, and Webcasts. Management’s Discussion and Analysis (MD&A) is one example of useful information out- side traditional financial statements. Polaris’s MD&A (available at Polaris.com), for example, begins with an overview, followed by critical accounting policies and restatements of previous statements. It then discusses operating results followed by financial condition (liquidity, capital resources, and cash flows). The final few parts discuss legal proceedings, market risk of finan- cial instruments, disclosure controls, and internal controls. The MD&A is an excellent starting point in understanding a company’s business activities.

Income Statement Income Statement

Balance Sheet Balance Sheet

Statement of Statement of Stockholders' Equity

Stockholders' Equity

Statement of Statement ofCash Flows Cash Flows

NotesNotes

Income Statement

Balance Sheet

Statement of Stockholders' Equity

Statement ofCash Flows

Notes

Chips and Brokers The phrase blue chips refers to stock of big, profitable companies. The phrase comes from poker; where the most valuable chips are blue. The term brokers refers to those who execute orders to buy or sell stock. The term comes from wine retailers—individuals who broach (break) wine casks. ■

Decision Insight

Analysis Online Many Websites offer free access and screening of companies by key numbers such as earnings, sales, and book value. For instance, Investor’s Business Daily has information for more than 10,000 stocks (www.investors.com). ■

Decision Insight

Standards for Comparisons When interpreting measures from financial statement analysis, we need to decide whether the measures indicate good, bad, or average performance. To make such judgments, we need stan- dards (benchmarks) for comparisons that include the following:

● Intracompany—The company under analysis can provide standards for comparisons based on its own prior performance and relations between its financial items. Polaris’s current net income, for instance, can be compared with its prior years’ net income and in relation to its revenues or total assets.

C2 Describe standards for comparisons in analysis.

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566 Chapter 13 Analysis of Financial Statements

Point: Each chapter’s Reporting in Action problems engage students in intracom- pany analysis, whereas Comparative Analy- sis problems require competitor analysis (Polaris vs. Arctic Cat vs. KTM).

● Competitor—One or more direct competitors of the company being analyzed can provide standards for comparisons. Coca-Cola’s profit margin, for instance, can be compared with PepsiCo’s profit margin.

● Industry—Industry statistics can provide standards of comparisons. Such statistics are avail- able from services such as Dun & Bradstreet, Standard & Poor’s, and Moody’s.

● Guidelines (rules of thumb)—General standards of comparisons can develop from experi- ence. Examples are the 2:1 level for the current ratio or 1:1 level for the acid-test ratio. Guidelines, or rules of thumb, must be carefully applied because context is crucial.

All of these comparison standards are useful when properly applied, yet measures taken from a selected competitor or group of competitors are often best. Intracompany and industry mea sures are also important. Guidelines or rules of thumb should be applied with care, and then only if they seem reasonable given past experience and industry norms.

Tools of Analysis Three of the most common tools of financial statement analysis are

1. Horizontal analysis—Comparison of a com pany’s financial condition and performance across time.

2. Vertical analysis—Comparison of a company’s financial condition and performance to a base amount.

3. Ratio analysis—Measurement of key relations between financial statement items.

The remainder of this chapter describes these analysis tools and how to apply them.

1. Who are the intended users of general-purpose financial statements? 2. General-purpose financial statements consist of what information? 3. Which of the following is least useful as a basis for comparison when analyzing ratios?

(a) Company results from a different economic setting. (b) Standards from past experience. (c) Rule-of-thumb standards. (d ) Industry averages.

4. What is the preferred basis of comparison for ratio analysis?

Quick Check Answers — p. 591

Analysis of any single financial number is of limited value. Instead, much of financial statement analysis involves identifying and describing relations between numbers, groups of numbers, and changes in those numbers. Horizontal analysis refers to examination of finan- cial statement data across time. [The term horizontal analysis arises from the left-to-right (or

right-to-left) movement of our eyes as we review comparative financial statements across time.]

Comparative Statements Comparing amounts for two or more successive periods often helps in analyzing financial state- ments. Comparative financial statements facilitate this comparison by showing financial amounts in side-by-side columns on a single statement, called a comparative format. Using

HORIZONTAL ANALYSIS

P1 Explain and apply methods of horizontal analysis.

2012 Report 2013 Report

Fraud Fighters. Horizontal, vertical, and ratio analysis tools can uncover fraud by identifying amounts out of line with expectations. One can then follow up and ask questions that can either identify a logical reason for such results or confirm/raise suspicions of fraud. Many past fraud schemes could have been identified much earlier had people applied these tools and pressured management for explanations. ■

Decision Insight

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Chapter 13 Analysis of Financial Statements 567

figures from Polaris’s financial statements, this section explains how to compute dollar changes and percent changes for comparative statements.

Computation of Dollar Changes and Percent Changes Comparing financial state- ments over relatively short time periods—two to three years—is often done by analyzing changes in line items. A change analysis usually includes analyzing absolute dollar amount changes and percent changes. Both analyses are relevant because dollar changes can yield large percent changes inconsistent with their importance. For instance, a 50% change from a base figure of $100 is less important than the same percent change from a base amount of $100,000 in the same statement. Reference to dollar amounts is necessary to retain a proper perspective and to assess the impor- tance of changes. We compute the dollar change for a financial statement item as follows:

Dollar change 5 Analysis period amount 2 Base period amount

Analysis period is the point or period of time for the financial statements under analysis, and base period is the point or period of time for the financial statements used for comparison purposes. The prior year is commonly used as a base period. We compute the percent change by dividing the dol- lar change by the base period amount and then multiplying this quantity by 100 as follows:

Percent change (%) 5 Analysis period amount 2 Base period amount

Base period amount 3 100

We can always compute a dollar change, but we must be aware of a few rules in working with percent changes. To illustrate, look at four separate cases in this chart:

Change Analysis Analysis Base

Case Period Period Dollar Percent

A $ 1,500 $(4,500) $ 6,000 —

B (1,000) 2,000 (3,000) —

C 8,000 — 8,000 —

D 0 10,000 (10,000) (100%)

When a negative amount appears in the base period and a positive amount in the analysis period (or vice versa), we cannot compute a meaningful percent change; see cases A and B. Also, when no value is in the base period, no percent change is computable; see case C. Finally, when an item has a value in the base period and zero in the analysis period, the decrease is 100 percent; see case D. It is common when using horizontal analysis to compare amounts to either average or median values from prior periods (average and median values smooth out erratic or unusual fluctua- tions).1 We also commonly round percents and ratios to one or two decimal places, but practice on this matter is not uniform. Computations are as detailed as necessary, which is judged by whether rounding potentially affects users’ decisions. Computations should not be excessively detailed so that important relations are lost among a mountain of decimal points and digits.

Comparative Balance Sheets Comparative balance sheets consist of balance sheet amounts from two or more balance sheet dates arranged side by side. Its usefulness is often im- proved by showing each item’s dollar change and percent change to highlight large changes. Analysis of comparative financial statements begins by focusing on items that show large dollar or percent changes. We then try to identify the reasons for these changes and, if possible, determine whether they are favorable or unfavorable. We also follow up on items with small changes when we expected the changes to be large.

1 Median is the middle value in a group of numbers. For instance, if five prior years’ incomes are (in 000s) $15, $19, $18, $20, and $22, the median value is $19. When there are two middle numbers, we can take their average. For in- stance, if four prior years’ sales are (in 000s) $84, $91, $96, and $93, the median is $92 (computed as the average of $91 and $93).

Example: What is a more significant change, a 70% increase on a $1,000 ex- pense or a 30% increase on a $400,000 expense? Answer: The 30% increase.

Example: When there is a value in the base period and zero in the analysis period, the decrease is 100%. Why isn’t the reverse situation an increase of 100%? Answer: A 100% increase of zero is still zero.

Point: Spreadsheet programs can help with horizontal, vertical, and ratio analyses, including graphical depictions of financial relations.

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568 Chapter 13 Analysis of Financial Statements

Exhibit 13.1 shows comparative balance sheets for Polaris Industries, Inc. (PII). A few items stand out. Accounts receivable and inventories are asset categories showing substantial increases. The inventory build up and accounts receivable increase are likely reflective of the recession. Cash and cash equivalents have decreased substantially. Some of these resources were applied to pay off the long-term debt that came due in 2011. Polaris added property, plant, and equipment, and the increase in Goodwill reflects acquisition activity. Of course, its sizable total asset growth of 15.7% must be accompanied by future income to validate Polaris’s growth strategy. We likewise see substantial increases on the financing side, the most notable ones (in amount) being accounts payable and accrued liabilities totaling $130,633 thousand. The in- crease in these items is probably related to the recessionary period covering this report. Polaris also reinvested much of its income as reflected in the $36,622 thousand increase in retained earnings. Again, we must monitor these increases in investing and financing activities to be sure they are reflected in increased operating performance.

EXHIBIT 13.1 Comparative Balance Sheets

POLARIS INDUSTRIES INC.

Comparative Balance Sheets

December 31, 2011 and 2010

Dollar Percent

(in thousands) 2011 2010 Change Change

Assets

Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . $ 325,336 $ 393,927 $ (68,591) (17.4)%

Trade receivables, net . . . . . . . . . . . . . . . . . . . . . . . . . . 115,302 89,294 26,008 29.1

Inventories, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298,042 235,927 62,115 26.3

Prepaid expenses and other . . . . . . . . . . . . . . . . . . . . . 37,608 21,628 15,980 73.9

Income taxes receivable. . . . . . . . . . . . . . . . . . . . . . . . . 24,723 — 24,723 —

Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77,665 67,369 10,296 15.3

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 878,676 808,145 70,531 8.7

Property, plant and equipment, net . . . . . . . . . . . . . . . . 213,778 184,011 29,767 16.2

Investments in finance and other affiliates . . . . . . . . . . 47,251 38,178 9,073 23.8

Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,601 — 10,601 —

Goodwill and other intangible assets, net . . . . . . . . . . 77,718 31,313 46,405 148.2

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,228,024 $1,061,647 $166,377 15.7

Liabilities

Current portion of long-term liablities . . . . . . . . . . . . . $ 2,653 $ 100,000 $ (97,347) (97.3)%

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146,743 113,248 33.495 29.6

Accrued liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465,496 368,358 97,138 26.4

Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 639 2,604 (1,965) (75.5)

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . 615,531 584,210 31,321 5.4

Long term income taxes payable . . . . . . . . . . . . . . . . . . 7,837 5,509 2,328 42.3

Deferred income tax liability . . . . . . . . . . . . . . . . . . . . . — 937 (937) (100.0)

Capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . 4,600 — 4,600 —

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000 0 0.0

Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 727,968 690,656 37,312 5.4

Stockholders’ Equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684 685 (1) (0.1)

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . 165,518 79,239 86,279 108.9

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,831 285,169 36,662 12.9

Accumulated other comprehensive income . . . . . . . . 12,023 5,898 6,125 103.8

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . 500,056 370,991 129,065 34.8

Total liabilities and stockholders’ equity . . . . . . . . . . . . $1,228,024 $1,061,647 $166,377 15.7

Point: Business consultants use com- parative statement analysis to provide management advice.

Polaris

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Chapter 13 Analysis of Financial Statements 569

Comparative Income Statements Comparative income statements are prepared sim- ilarly to comparative balance sheets. Amounts for two or more periods are placed side by side, with additional columns for dollar and percent changes. Exhibit 13.2 shows Polaris’s compara- tive income statements.

Trend percent (%) 5 Analysis period amount

Base period amount 3 100

Point: Index refers to the comparison of the analysis period to the base period. Percents determined for each period are called index numbers.

Polaris has substantial revenue growth of 33.4% in 2011. This finding helps support manage- ment’s growth strategy as reflected in the comparative balance sheets. Polaris evidences an ability to control cost of goods sold (31.2% increase) and other operating expenses, which all increased but at lower rates than the growth in revenues. Polaris’s net income growth of 54.7% on revenue growth of 33.4% is very good.

Trend Analysis Trend analysis, also called trend percent analysis or index number trend analysis, is a form of horizontal analysis that can reveal patterns in data across successive periods. It involves com- puting trend percents for a series of financial numbers and is a variation on the use of percent changes. The difference is that trend analysis does not subtract the base period amount in the numerator. To compute trend percents, we do the following:

1. Select a base period and assign each item in the base period a weight of 100%. 2. Express financial numbers as a percent of their base period number.

Specifically, a trend percent, also called an index number, is computed as follows:

Point: Percent change can also be computed by dividing the current period by the prior period and subtracting 1.0. For example, the 33.4% revenue increase of Exhibit 13.2 is computed as: ($2,656,949y$1,991,139) 2 1.

$0 2012 2006 2009 2004

$100

Millions Rati

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

Financial Results

400 600 1,200

To illustrate trend analysis, we use the Polaris data shown in Exhibit 13.3.

EXHIBIT 13.3 Revenue and Expenses

(in thousands) 2011 2010 2009 2008 2007

Sales . . . . . . . . . . . . . . . . . . . . . $2,656,949 $1,991,139 $1,565,887 $1,948,254 $1,780,009

Cost of sales . . . . . . . . . . . . . . 1,916,366 1,460,926 1,172,668 1,502,546 1,386,989

Operating expenses . . . . . . . . . 414,751 326,348 245,320 284,114 262,269

EXHIBIT 13.2 Comparative Income Statements

POLARIS INDUSTRIES INC.

Comparative Income Statements

For Years Ended December 31, 2011 and 2010

Dollar Percent

(in thousands, except per share) 2011 2010 Change Change

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,656,949 $1,991,139 $665,810 33.4%

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . 1,916,366 1,460,926 455,440 31.2

Gross profit . . . . . . . . . . . . . . . . . . . . . . . 740,583 530,213 210,370 39.7

Selling and marketing . . . . . . . . . . . . . . . . 178,725 142,353 36,372 25.6

Research and development . . . . . . . . . . . . 105,631 84,940 20,691 24.4

General and administrative . . . . . . . . . . . . 130,395 99,055 31,340 31.6

Total operating expenses . . . . . . . . . . . . . 414,751 326,348 88,403 27.1

Income from financial services . . . . . . . . . 24,092 16,856 7,236 42.9

Operating income . . . . . . . . . . . . . . . . . . 349,924 220,721 129,203 58.5

Non-operating expense, net . . . . . . . . . . 3,298 2,180 1,118 51.3

Income before income taxes . . . . . . . . . . 346,626 218,541 128,085 58.6

Provision for income taxes . . . . . . . . . . . . 119,051 71,403 47,648 66.7

Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 227,575 $ 147,138 $ 80,437 54.7

Basic net income per share . . . . . . . . . . . $ 3.31 $ 2.20 $ 1.11 50.5

Diluted net income per share . . . . . . . . . $ 3.20 $ 2.14 $ 1.06 49.5

Polaris

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570 Chapter 13 Analysis of Financial Statements

2011 2010 2009 2008 2007

Sales . . . . . . . . . . . . . . . . . . . . . 149.3% 111.9% 88.0% 109.5% 100.0%

Cost of sales . . . . . . . . . . . . . . 138.2 105.3 84.5 108.3 100.0

Operating expenses . . . . . . . . 158.1 124.4 93.5 108.3 100.0

EXHIBIT 13.4 Trend Percents for Revenue and Expenses

Point: Trend analysis expresses a per- cent of base, not a percent of change.

These data are from Polaris’s current and prior financial statements. The base period is 2007 and the trend percent is computed in each subsequent year by dividing that year’s amount by its 2007 amount. For instance, the revenue trend percent for 2011 is 149.3%, computed as $2,656,949y$1,780,009. The trend percents—using the data from Exhibit 13.3—are shown in Exhibit 13.4.

Graphical depictions often aid analysis of trend percents. Exhibit 13.5 shows the trend per- cents from Exhibit 13.4 in a line graph, which can help us identify trends and detect changes in direction or magnitude. It reveals that the trend line for revenue consistently falls short

of that for operating expenses. Moreover, the magnitude of that difference has grown. This result does not bode well for Polaris because profitability of the company will suffer if oper- ating expenses cannot be con- trolled. Management must try to better control these costs in future years. The trend line for cost of goods sold is much more encouraging since revenue growth outpaces the growth in

cost of goods sold for each year from 2008–2011. This trend shows that Polaris is able to in- crease its gross profit margin in each of these years. Exhibit 13.6 compares Polaris’s revenue trend line to that of Arctic Cat and KTM for this same period. Polaris is able to grow its revenue in each year relative to its base year except for 2008. In

this respect Polaris soundly out- performs its competitors, as Arctic Cat’s and KTM’s revenues fall sharply each year from 2008–2010 before rebounding in 2011. These data indicate that Polaris’s prod- ucts and services have met with greater consumer acceptance.

Trend analysis of financial statement items can include com- parisons of relations between items on different financial state-

ments. For instance, Exhibit 13.7 compares Polaris’s revenue and total assets. The rate of in- crease in total assets (159.5%) is less than the increase in revenues (723.8%) since 2007. Is this result favorable or not? The answer is that Polaris was less efficient in using its assets in 2011. Management has not generated revenues sufficient to compensate for this asset growth.

EXHIBIT 13.5 Trend Percent Lines for Revenue and Expenses of Polaris

2007 2008 2009 2010 2011

Year

T re

n d

Revenue Cost of sales Operating expenses

50%

100%

200%

150%

EXHIBIT 13.6 Trend Percent Lines—Polaris, Arctic Cat and KTM

2007 2008 2009 2010 2011

Year

Tr e n

d

Polaris Arctic cat KTM

50%

100%

200%

150%

Trend Percent

(in thousands) 2011 2007 (2011 vs. 2007)

Sales . . . . . . . . . . . . . . $2,656,949 $1,780,009 149.3%

Total assets . . . . . . . . 1,228,024 769,881 159.5

EXHIBIT 13.7 Revenue and Asset Data for Polaris

Polaris Arctic Cat

KTM

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Chapter 13 Analysis of Financial Statements 571

Vertical analysis is a tool to evaluate individual financial statement items or a group of items in terms of a specific base amount. We usually define a key aggregate figure as the base, which for an income statement is usually revenue and for a balance sheet is usually total assets. This section explains vertical analysis and applies it to Polaris. [The term vertical analysis arises from the up-down (or down-up) movement of our eyes as we review common-size financial statements. Vertical analysis is also called common-size analysis.]

Common-Size Statements The comparative statements in Exhibits 13.1 and 13.2 show the change in each item over time, but they do not emphasize the relative importance of each item. We use common-size financial statements to reveal changes in the relative importance of each financial statement item. All individual amounts in common-size statements are redefined in terms of common-size percents. A common-size percent is measured by dividing each individual financial statement amount under analysis by its base amount:

VERTICAL ANALYSIS

Sales Expenses Income

10,000 6,000 4,000

Income Statement

P2 Describe and apply methods of vertical analysis.

Common-size percent (%) 5 Analysis amount

Base amount 3 100

Common-Size Balance Sheets Common-size statements express each item as a percent of a base amount, which for a common-size balance sheet is usually total assets. The base amount is assigned a value of 100%. (This implies that the total amount of liabilities plus equity equals 100% since this amount equals total assets.) We then compute a common-size percent for each asset, liability, and equity item using total assets as the base amount. When we present a company’s successive balance sheets in this way, changes in the mixture of assets, liabilities, and equity are apparent. Exhibit 13.8 shows common-size comparative balance sheets for Polaris. Some relations that stand out on both a magnitude and percentage basis include (1) a 10.6% point decline in cash and equivalents, (2) a 2.1% point increase in inventories, (3) a 3.4% point increase in goodwill and intangibles, (4) a 9.2% point decline in the current portion of long-term liabilities, (5) a 3.2% increase in accrued liabilities, and (6) a 6.0% increase in paid-in capital. Some of these changes reflect a company with reduced cash flow, inventory buildup, and less ability to pay off liabilities. A potential concern is whether Polaris can continue to generate sufficient revenue and income to support its operations and its payment of expenses.

Point: The base amount in common- size analysis is an aggregate amount from that period’s financial statement.

Point: Common-size statements often are used to compare two or more companies in the same industry.

Point: Common-size statements are also useful in comparing firms that report in different currencies.

Overall we must remember that an important role of financial statement analysis is identify- ing questions and areas of interest, which often direct us to important factors bearing on a company’s future. Accordingly, financial statement analysis should be seen as a continuous process of refining our understanding and expectations of company performance and financial condition.

Auditor Your tests reveal a 3% increase in sales from $200,000 to $206,000 and a 4% decrease in expenses from $190,000 to $182,400. Both changes are within your “reasonableness” criterion of 65%, and thus you don’t pursue additional tests. The audit partner in charge questions your lack of follow-up and mentions the joint relation between sales and expenses. To what is the partner referring? ■ [Answer—p. 590]

Decision Maker

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572 Chapter 13 Analysis of Financial Statements

Common-Size Income Statements Analysis also benefits from use of a common-size income statement. Revenue is usually the base amount, which is assigned a value of 100%. Each common-size income statement item appears as a percent of revenue. If we think of the 100% revenue amount as representing one sales dollar, the remaining items show how each revenue dollar is distributed among costs, expenses, and income. Exhibit 13.9 shows common-size comparative income statements for each dollar of Polaris’s revenue. The past two years’ common-size numbers are similar with a few excep- tions. The good news is that Polaris has gained 1.2 cents in earnings per revenue dollar— evidenced by the 7.4% to 8.6% increase in earnings as a percentage of revenue. This implies that management is effectively controlling costs. Much of this is attributed to the decline in operating expenses from 16.4% to 15.6% as a percentage of revenue. Analysis here shows that common-size percents for successive income statements can uncover potentially impor- tant changes in a company’s expenses. Evidence of no changes, especially when changes are expected, is also informative.

EXHIBIT 13.8 Common-Size Comparative Balance Sheets

POLARIS INDUSTRIES INC.

Common-Size Comparative Balance Sheets

December 31, 2011 and 2010

Common-Size

Percents*

(in thousands) 2011 2010 2011 2010

Assets

Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . $ 325,336 $ 393,927 26.5% 37.1%

Trade receivables, net . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,302 89,294 9.4 8.4

Inventories, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298,042 235,927 24.3 22.2

Prepaid expenses and other. . . . . . . . . . . . . . . . . . . . . . 37,608 21,628 3.1 2.0

Income taxes receivable . . . . . . . . . . . . . . . . . . . . . . . . . 24,723 — 2.0 —

Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77,665 67,369 6.3 6.3

Total current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . 878,676 808,145 71.6 76.1

Property, plant and equipment, net . . . . . . . . . . . . . . . . 213,778 184,011 17.4 17.3

Investments in finance and other affiliates . . . . . . . . . . . 47,251 38,178 3.8 3.6

Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,601 — 0.9 0.0

Goodwill and other intangible assets, net . . . . . . . . . . . 77,718 31,313 6.3 2.9

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,228,024 $1,061,647 100.0% 100.0%

Liabilities

Current portion of long-term liabilities. . . . . . . . . . . . . $ 2,653 $ 100,000 0.2% 9.4%

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146,743 113,248 11.9 10.7

Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465,496 368,358 37.9 34.7

Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 639 2,604 0.1 0.2

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . 615,531 584,210 50.1 55.0

Long term income taxes payable . . . . . . . . . . . . . . . . . . 7,837 5,509 0.6 0.5

Deferred income tax liability . . . . . . . . . . . . . . . . . . . . . — 937 0.0 0.1

Capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 — 0.4 0.0

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000 8.1 9.4

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 727,968 690,656 59.3 65.1

Stockholders’ Equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684 685 0.1 0.1

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . 165,518 79,239 13.5 7.5

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,831 285,169 26.2 26.9

Accumulated other comprehensive income . . . . . . . . . 12,023 5,898 1.0 0.6

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . 500,056 370,991 40.7 34.9

Total liabilities and stockholders’ equity . . . . . . . . . . . . $1,228,024 $1,061,647 100.0% 100.0%

* Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

Global: International companies some- times disclose “convenience” financial statements, which are statements trans- lated in other languages and currencies. However, these statements rarely adjust for differences in accounting principles across countries.

Polaris

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Chapter 13 Analysis of Financial Statements 573

EXHIBIT 13.9 Common-Size Comparative Income Statements

Common-Size Graphics Two of the most common tools of common-size analysis are trend analysis of common-size statements and graphical analysis. The trend analysis of common-size statements is similar to that of comparative statements discussed under vertical analysis. It is not illustrated here be- cause the only difference is the substitution of common-size percents for trend percents. Instead, this section discusses graphical analysis of common-size statements. An income statement readily lends itself to common-size graphical analysis. This is so be- cause revenues affect nearly every item in an income statement. Exhibit 13.10 shows Polaris’s 2011 common-size income statement in graphical form. This pie chart highlights the contribu- tion of each cost component of revenue for net income (for this graph, financial services income and non-operating expenses are included in general and administrative costs).

Exhibit 13.11 previews more complex graphical analyses available and the insights they pro- vide. The data for this exhibit are taken from Polaris’s Segments footnote. Polaris has at least two reportable segments: (1) United States, and (2) outside the United States (titled Non-U.S.).

EXHIBIT 13.10 Common-Size Graphic of Income Statement

Net income

8.6% Income taxes

4.5%

Selling and

marketing 6.7%

Research and

development

4.0%

General and

administrative

4.1%

Cost of

sales

72.1%

EXHIBIT 13.11 Revenue and Total Asset Breakdown by Segment

United States Segment

Non-U.S. Segment

0% 75% 100%50%25%

57.7%

78.0%

70.2%U.S. revenue

U.S. assets

29.8%

22.0%

Non-U.S. revenue

Non-U.S. assets

Segment assets as percent of total

Segment revenue as percent of total

Polaris

POLARIS INDUSTRIES INC.

Common-Size Comparative Income Statements

For Years Ended December 31, 2011 and 2010

Common-Size

Percents*

(in thousands) 2011 2010 2011 2010

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,656,949 $1,991,139 100.0% 100.0%

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,916,366 1,460,926 72.1 73.4

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 740,583 530,213 27.9 26.6

Selling and marketing . . . . . . . . . . . . . . . . . . . . . . 178,725 142,353 6.7 7.1

Research and development . . . . . . . . . . . . . . . . . 105,631 84,940 4.0 4.3

General and administrative . . . . . . . . . . . . . . . . . 130,395 99,055 4.9 5.0

Total operating expenses . . . . . . . . . . . . . . . . . . . 414,751 326,348 15.6 16.4

Income from financial services . . . . . . . . . . . . . . 24,092 16,856 0.9 0.8

Operating income . . . . . . . . . . . . . . . . . . . . . . . . 349,924 220,721 13.2 11.1

Non-operating expenses, net. . . . . . . . . . . . . . . . 3,298 2,180 0.1 0.1

Income before income taxes . . . . . . . . . . . . . . . . 346,626 218,541 13.1 11.0

Provision for income taxes . . . . . . . . . . . . . . . . . 119,051 71,403 4.5 3.6

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 227,575 $ 147,138 8.6% 7.4%

* Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

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574 Chapter 13 Analysis of Financial Statements

The upper set of bars in Exhibit 13.11 shows the per- cent of revenues from, and the assets invested in, its U.S. segment. Its U.S. segment generates 70.2% of its revenue, as 78.0% of its assets are in the United States. The lower set of bars shows that 29.8% of its revenue is generated outside the United States, with 22.0% of its assets located outside the United States. This can lead to questions about the revenue generated per assets invested across different countries. This type of information can help users in de- termining strategic analyses and actions.

Graphical analysis is also useful in identifying (1) sources of financing including the distribution among current liabilities, noncurrent liabilities, and equity cap ital and (2) focuses of investing activities, including the distribution among current and noncurrent assets. To illus- trate, Exhibit 13.12 shows a common-size graphical display of Polaris’s assets. Common-size balance sheet analysis can be extended to examine the composition of these subgroups. For instance, in assessing liquidity of current assets, knowing what proportion of current assets consists of inventories is usually important, and not simply what proportion inventories are of total assets. Common-size financial statements are also useful in comparing different companies. Exhibit 13.13 shows

common-size graphics of Polaris, Arctic Cat and KTM on financing sources. This graphic high- lights the larger percent of equity financing for Arctic Cat versus Polaris and KTM. It also highlights the much larger noncurrent (debt) financing of KTM versus Polaris and Arctic Cat. Comparison of a company’s common-size statements with competitors’ or industry common-size statistics alerts us to differences in the structure or distribution of its financial statements but not to their dollar magnitude.

EXHIBIT 13.12 Common-Size Graphic of Asset Components

Cash and cash equivalents 26.5%

Trade receivables, net 9.4%

Inventories, net 24.3%

Other current assets 5.1%

Deferred tax (current) asset 6.3%

Investments 3.8%

Property, plant and equipment 17.4%

Goodwill and other intangibles 6.3%

Deferred tax (noncurrent) asset 0.9%

EXHIBIT 13.13 Common-Size Graphic of Financing Sources—Competitor Analysis

0.9%

Polaris Arctic Cat KTM

32.0% 22.5%

32.2%

45.3% 67.1%

40.7%

Current liabilities

Equity

Noncurrent liabilities

50.1%

9.2%

5. Which of the following is true for common-size comparative statements? (a) Each item is expressed as a percent of a base amount. (b) Total assets often are assigned a value of 100%. (c) Amounts from successive periods are placed side by side. (d ) All are true. (e) None is true.

6. What is the difference between the percents shown on a comparative income statement and those shown on a common-size comparative income statement?

7. Trend percents are (a) shown on comparative income statements and balance sheets, (b) shown on common-size comparative statements, or (c) also called index numbers.

Quick Check Answers — p. 591

Ratios are among the more widely used tools of financial analysis because they provide clues to and symptoms of underlying conditions. A ratio can help us uncover conditions and trends dif- ficult to detect by inspecting individual components making up the ratio. Ratios, like other analysis tools, are usually future oriented; that is, they are often adjusted for their probable future trend and magnitude, and their usefulness depends on skillful interpretation.

RATIO ANALYSIS

P3 Define and apply ratio analysis.

Polaris Arctic Cat

KTM

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Chapter 13 Analysis of Financial Statements 575

A ratio expresses a mathematical relation between two quantities. It can be expressed as a per- cent, rate, or proportion. For instance, a change in an account balance from $100 to $250 can be expressed as (1) 150% increase, (2) 2.5 times, or (3) 2.5 to 1 (or 2.5:1). Computation of a ratio is a simple arithmetic operation, but its interpretation is not. To be meaningful, a ratio must refer to an economically important relation. For example, a direct and crucial relation exists between an item’s sales price and its cost. Accordingly, the ratio of cost of goods sold to sales is meaningful. In con- trast, no obvious relation exists between freight costs and the balance of long-term investments. This section describes an important set of financial ratios and its application. The selected ratios are organized into the four building blocks of financial statement analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects. All of these ratios were explained at relevant points in prior chapters. The purpose here is to organize and apply them under a summary framework. We use four common standards, in varying degrees, for comparisons: intracompany, competitor, industry, and guidelines.

Liquidity and Efficiency Liquidity refers to the availability of resources to meet short-term cash requirements. It is af- fected by the timing of cash inflows and outflows along with prospects for future performance. Analysis of liquidity is aimed at a company’s funding requirements. Efficiency refers to how productive a company is in using its assets. Efficiency is usually measured relative to how much revenue is generated from a certain level of assets. Both liquidity and efficiency are important and complementary. If a company fails to meet its current obligations, its continued existence is doubtful. Viewed in this light, all other mea sures of analysis are of secondary importance. Although accounting measurements assume the company’s continued existence, our analysis must always assess the validity of this assumption using liquidity measures. Moreover, inefficient use of assets can cause liquidity problems. A lack of liquidity often precedes lower profitability and fewer opportunities. It can foretell a loss of owner control. To a company’s creditors, lack of liquidity can yield delays in collecting interest and principal payments or the loss of amounts due them. A company’s customers and suppliers of goods and services also are affected by short-term liquidity problems. Implications include a company’s inability to execute contracts and potential damage to important customer and supplier relationships. This section de- scribes and illustrates key ratios relevant to assessing liquidity and efficiency.

Working Capital and Current Ratio The amount of current assets less current liabili- ties is called working capital, or net working capital. A company needs adequate working capi- tal to meet current debts, to carry sufficient inventories, and to take advantage of cash discounts. A company that runs low on working capital is less likely to meet current obligations or to con- tinue operating. When evaluating a company’s working capital, we must not only look at the dollar amount of current assets less current liabilities, but also at their ratio. The current ratio is defined as follows (see Chapter 3 for additional explanation):

Current ratio 5 Current assets

Current liabilities

Drawing on information in Exhibit 13.1, Polaris’s working capital and current ratio for both 2011 and 2010 are shown in Exhibit 13.14. Also, Arctic Cat (2.65), KTM (1.77), and the In- dustry’s current ratio (7) are shown in the margin. Polaris’s 2011 ratio (1.43) is between the competitors’ ratios, and it does not appear in danger of defaulting on loan payments. A high current ratio suggests a strong li- quidity position and an ability to meet current obligations. A company can, how- ever, have a current ratio that is too high. An excessively high current ratio means that the company has invested too much in current assets compared to its current

EXHIBIT 13.14 Polaris’s Working Capital and Current Ratio

(in thousands) 2011 2010

Current assets . . . . . . . . . $878,676 $808,145

Current liabilities . . . . . . . 615,531 584,210

Working capital . . . . . . $263,145 $223,935

Current ratio

$878,676y$615,531 5 1.43 to 1 $808,145y$584,210 5 1.38 to 1

Current ratio Arctic Cat 5 2.65 KTM 5 1.77 Industry 5 1.9

Point: Some sources for industry norms are Annual Statement Studies by Robert Morris Associates, Industry Norms & Key Business Ratios by Dun & Bradstreet, Standard & Poor’s Industry Surveys, and Reuters.com/finance.

RatiosRatiosRatios

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576 Chapter 13 Analysis of Financial Statements

obligations. An excessive investment in current assets is not an efficient use of funds because current assets normally generate a low return on investment (compared with long-term assets). Many users apply a guideline of 2:1 (or 1.5:1) for the current ratio in helping evaluate a com- pany’s debt-paying ability. A company with a 2:1 or higher current ratio is generally thought to be a good credit risk in the short run. Such a guideline or any analysis of the current ratio must recognize at least three additional factors: (1) type of business, (2) composition of current as- sets, and (3) turnover rate of current asset components.

Type of business. A service company that grants little or no credit and carries few inventories can probably operate on a current ratio of less than 1:1 if its revenues generate enough cash to pay its current liabilities. On the other hand, a company selling high-priced clothing or furniture requires a higher ratio because of difficulties in judging customer demand and cash receipts. For instance, if demand falls, inventory may not generate as much cash as expected. Accordingly, analysis of the current ratio should include a comparison with ratios from successful companies in the same indus- try and from prior periods. We must also recognize that a company’s accounting methods, espe- cially choice of inventory method, affect the current ratio. For instance, when costs are rising, a company using LIFO tends to report a smaller amount of current assets than when using FIFO.

Composition of current assets. The composition of a company’s current assets is important to an evaluation of short-term liquidity. For instance, cash, cash equivalents, and short-term invest- ments are more liquid than accounts and notes receivable. Also, short-term receivables normally are more liquid than inventory. Cash, of course, can be used to immediately pay current debts. Items such as accounts receivable and inventory, however, normally must be converted into cash before payment is made. An excessive amount of receivables and inventory weakens a company’s ability to pay current liabilities. The acid-test ratio (see below) can help with this assessment.

Turnover rate of assets. Asset turnover mea sures a company’s efficiency in using its assets. One relevant measure of asset efficiency is the revenue generated. A measure of total asset turn- over is revenues divided by total assets, but evaluation of turnover for individual assets is also useful. We discuss both receivables turnover and inventory turnover on the next page.

Point: When a firm uses LIFO in a period of rising costs, the standard for an adequate current ratio usually is lower than if it used FIFO.

Acid-Test Ratio Quick assets are cash, short-term investments, and current receivables. These are the most liquid types of current assets. The acid-test ratio, also called quick ratio, and introduced in Chapter 4, reflects on a company’s short-term liquidity.

Acid-test ratio 5 Cash 1 Short-term investments 1 Current receivables

Current liabilities

Polaris’s acid-test ratio is computed in Exhibit 13.15. Polaris’s 2011 acid-test ratio (0.72) is between that for Arctic Cat (1.70) and KTM (0.63), but less than the 1:1 common guideline for

EXHIBIT 13.15 Acid-Test Ratio

(in thousands) 2011 2010

Cash and equivalents . . . . . . . . . $325,336 $393,927

Current receivables . . . . . . . . . . 115,302 89,294

Total quick assets . . . . . . . . . . . . $440,638 $483,221

Current liabilities . . . . . . . . . . . . $615,531 $584,210

Acid-test ratio

$440,638y$615,531 . . . . . . . . 0.72 to 1 $483,221y$584,210 . . . . . . . . 0.83 to 1

Acid-test ratio Arctic Cat 5 1.70 KTM 5 0.63 Industry 5 0.9

Banker A company requests a one-year, $200,000 loan for expansion. This company’s current ratio is 4:1, with current assets of $160,000. Key competitors carry a current ratio of about 1.9:1. Using this information, do you approve the loan application? Does your decision change if the application is for a 10-year loan? ■ [Answer—p. 591]

Decision Maker

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Chapter 13 Analysis of Financial Statements 577

an acceptable acid-test ratio. The ratio for Arctic Cat exceeds the 0.9 industry norm. As with analysis of the current ratio, we need to consider other factors. For instance, the frequency with which a company converts its current assets into cash affects its working capital requirements. This implies that analysis of short-term liquidity should also include an analysis of receivables and inventories, which we consider next.

Accounts Receivable Turnover We can measure how frequently a company converts its receivables into cash by computing the accounts receivable turnover. This ratio is defined as follows (see Chapter 7 for additional explanation):

Global: Ratio analysis helps overcome currency translation problems, but it does not overcome differences in accounting principles.

Accounts receivable turnover 5 Net sales

Average accounts receivable, net

Inventory turnover 5 Cost of goods sold

Average inventory

$1,916,366

($235,927 1 $298,042) y2 5 7.18 times

Days’ sales uncollected 5 Accounts receivable, net

Net sales 3 365

Using Polaris’s cost of goods sold and inventories information, we compute its inventory turnover for 2011 as follows (if the beginning and ending inventories for the year do not represent the usual inventory amount, an average of quarterly or monthly inventories can be used).

Polaris’s inventory turnover of 7.18 is more than Arctic Cat’s 5.08 and KTM’s 3.34, and the in- dustry’s 4.0. A company with a high turnover requires a smaller investment in inventory than one producing the same sales with a lower turnover. Inventory turnover can be too high, how- ever, if the inventory a company keeps is so small that it restricts sales volume.

Days’ Sales Uncollected Accounts receivable turnover provides insight into how frequently a company collects its accounts. Days’ sales uncollected is one measure of this activity, which is defined as follows (Chapter 6 provides additional explanation):

Any short-term notes receivable from customers are normally included in the numerator.

$2,656,949

($89,294 1 $115,302) y2 5 26.0 times

Accounts receivable turnover Arctic Cat 5 17.5 KTM 5 9.5 Industry 5 15.0

Inventory turnover Arctic Cat 5 5.08 KTM 5 3.34 Industry 5 4.0

Short-term receivables from customers are often included in the denominator along with ac- counts receivable. Also, accounts receivable turnover is more precise if credit sales are used for the numerator, but external users generally use net sales (or net revenues) because information about credit sales is typically not reported. Polaris’s 2011 accounts receivable turnover is com- puted as follows ($ millions).

Point: Some users prefer using gross accounts receivable (before subtracting the allowance for doubtful accounts) to avoid the influence of a manager’s bad debts estimate.

Polaris’s value of 26.0 exceeds that of Arctic Cat’s 17.5 and KTM’s 9.5. Accounts receivable turnover is high when accounts receivable are quickly collected. A high turnover is favorable because it means the company need not commit large amounts of funds to accounts receivable. However, an accounts receivable turnover can be too high; this can occur when credit terms are so restrictive that they negatively affect sales volume.

Inventory Turnover How long a company holds inventory before selling it will affect working capital requirements. One measure of this effect is inventory turnover, also called mer- chandise turnover or merchandise inventory turnover, which is defined as follows (see Chap- ter 5 for additional explanation):

Point: Ending accounts receivable can be substituted for the average balance in computing accounts receivable turnover if the difference between ending and average receivables is small.

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578 Chapter 13 Analysis of Financial Statements

Polaris’s 2011 days’ sales uncollected follows.

$115,302

$2,656,949 3 365 5 15.8 days

$298,042

$1,916,366 3 365 5 56.8 days

Total asset turnover 5 Net sales

Average total assets

$2,656,949

($1,061,647 1 $1,228,024) y2 5 2.32 times

Days’ sales in inventory 5 Ending inventory

Cost of goods sold 3 365

Both Arctic Cat’s days’ sales uncollected of 18.6 days and KTM’s 37.1 days are more than the 15.8 days for Polaris. Days’ sales uncollected is more meaningful if we know company credit terms. A rough guideline states that days’ sales uncollected should not exceed 11⁄

3 times the days

in its (1) credit period, if discounts are not offered or (2) discount period, if favorable discounts are offered.

Days’ Sales in Inventory Days’ sales in inventory is a useful mea sure in evaluating inventory liquidity. Days’ sales in inventory is linked to inventory in a way that days’ sales uncollected is linked to receivables. We compute days’ sales in inventory as follows (Chapter 5 provides additional explanation).

Day’s sales uncollected Arctic Cat 5 18.6 KTM 5 37.1

Polaris’s days’ sales in inventory for 2011 follows.

If the products in Polaris’s inventory are in demand by customers, this formula estimates that its inventory will be converted into receivables (or cash) in 56.8 days. If all of Polaris’s sales were credit sales, the conversion of inventory to receivables in 56.8 days plus the conversion of receivables to cash in 15.8 days implies that inventory will be converted to cash in about 72.6 days (56.8 1 15.8).

Total Asset Turnover Total asset turnover reflects a company’s ability to use its assets to generate sales and is an important indication of operating efficiency. The definition of this ratio follows (Chapter 8 offers additional explanation).

Polaris’s total asset turnover for 2011 follows and is greater than that for both Arctic Cat (1.79) and KTM (1.13).

8. Information from Paff Co. at Dec. 31, 2012, follows: cash, $820,000; accounts receivable, $240,000; inventories, $470,000; plant assets, $910,000; accounts payable, $350,000; and income taxes payable, $180,000. Compute its (a) current ratio and (b) acid-test ratio.

9. On Dec. 31, 2013, Paff Company (see question 8) had accounts receivable of $290,000 and inventories of $530,000. During 2013, net sales amounted to $2,500,000 and cost of goods sold was $750,000. Compute (a) accounts receivable turnover, (b) days’ sales uncollected, (c) inventory turnover, and (d ) days’ sales in inventory.

Quick Check Answers — p. 591

Total asset turnover Arctic Cat 5 1.79 KTM 5 1.13 Industry 5 1.3

Days’ sales in inventory Arctic Cat 5 61.8 KTM 5 111.9 Industry 5 75

Point: Average collection period is estimated by dividing 365 by the accounts receivable turnover ratio. For example, 365 divided by an accounts receivable turnover of 6.1 indicates a 60-day average collection period.

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Chapter 13 Analysis of Financial Statements 579

Solvency Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations. All of a company’s business activities—financing, investing, and operating— affect its solvency. Analysis of solvency is long term and uses less precise but more encompassing measures than liquidity. One of the most important components of solvency analysis is the com- position of a company’s capital structure. Capital structure refers to a company’s financing sources. It ranges from relatively permanent equity financing to riskier or more temporary short- term financing. Assets represent security for financiers, ranging from loans secured by specific assets to the assets available as general security to unsecured creditors. This section describes the tools of solvency analysis. Our analysis focuses on a company’s ability to both meet its ob- ligations and provide security to its creditors over the long run. Indicators of this ability include debt and equity ratios, the relation between pledged assets and secured liabilities, and the com- pany’s capacity to earn sufficient income to pay fixed interest charges.

Debt and Equity Ratios One element of solvency analysis is to assess the portion of a company’s assets contributed by its owners and the portion contributed by creditors. This rela- tion is reflected in the debt ratio (also described in Chapter 2). The debt ratio expresses total liabilities as a percent of total assets. The equity ratio provides complementary information by expressing total equity as a percent of total assets. Polaris’s debt and equity ratios follow.

Polaris’s financial statements reveal more debt than equity. A company is considered less risky if its capital structure (equity and long-term debt) contains more equity. One risk factor is the required payment for interest and principal when debt is outstanding. Another factor is the greater the stockholder financing, the more losses a company can absorb through equity before the assets become inadequate to satisfy creditors’ claims. From the stockholders’ point of view, if a company earns a return on borrowed capital that is higher than the cost of borrowing, the difference represents increased income to stockholders. The inclusion of debt is described as financial leverage because debt can have the effect of increasing the return to stockholders. Companies are said to be highly leveraged if a large portion of their assets is financed by debt.

Debt-to-Equity Ratio The ratio of total liabilities to equity is another measure of sol- vency. We compute the ratio as follows (Chapter 10 offers additional explanation).

Debt-to-equity ratio 5 Total liabilities

Total equity

$727,968y$500,056 5 1.46

Polaris’s debt-to-equity ratio for 2011 is

Polaris’s 1.46 debt-to-equity ratio is higher than the 0.49 ratio for Arctic Cat and the industry ratio of 0.8. Consistent with our inferences from the debt ratio, Polaris’s capital structure has more debt than equity, which increases risk. Recall that debt must be repaid with interest, while equity does not. These debt requirements can be burdensome when the industry and/or the economy experience a downturn. A larger debt-to-equity ratio also implies less opportunity to expand through use of debt financing.

Times Interest Earned The amount of income before deductions for interest ex- pense and income taxes is the amount available to pay interest expense. The following

(in thousands) 2011 Ratios

Total liabilities . . . . . . . . . . . . . . . . . . $ 727,968 59.3% [Debt ratio]

Total equity . . . . . . . . . . . . . . . . . . . . 500,056 40.7 [Equity ratio]

Total liabilities and equity . . . . . . . . . $1,228,024 100.0%

Point: For analysis purposes, Minority Interest is usually included in equity.

Debt ratio :: Equity ratio

Arctic Cat 5 32.9% :: 67.1%

KTM 5 54.8% :: 45.2%

Industry 5 45% :: 55%

Point: Bank examiners from the FDIC and other regulatory agencies use debt and equity ratios to monitor compliance with regulatory capital requirements imposed on banks and S&Ls.

Debt-to-equity Arctic Cat 5 0.49 KTM 5 1.21 Industry 5 0.8

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580 Chapter 13 Analysis of Financial Statements

times interest earned ratio reflects the creditors’ risk of loan repayments with interest (see Chapter 9 for additional explanation).

Times interest earned 5 Income before interest expense and income taxes

Interest expense

The larger this ratio, the less risky is the company for creditors. One guideline says that credi- tors are reasonably safe if the company earns its fixed interest expense two or more times each year. Polaris’s times interest earned ratio follows (Appendix A reveals interest expense of $3,987). Polaris’s 87.9 result suggests that its creditors have little risk of nonrepayment.

$227,575 1 $3,987 1 $119,051

$3,987 5 87.9 times

Profit margin 5 Net income

Net sales 5

$227,575

$2,656,949 5 8.6%

$227,575

($1,061,647 1 $1,228,024) y2 5 19.9%

Return on total assets 5 Net income

Average total assets

Profitability We are especially interested in a company’s ability to use its assets efficiently to produce profits (and positive cash flows). Profitability refers to a company’s ability to generate an adequate re- turn on invested capital. Return is judged by assessing earnings relative to the level and sources of financing. Profitability is also relevant to solvency. This section describes key profitability measures and their importance to financial statement analysis.

Profit Margin A company’s operating efficiency and profitability can be expressed by two components. The first is profit margin, which reflects a company’s ability to earn net income from sales (Chapter 3 offers additional explanation). It is measured by expressing net income as a percent of sales (sales and revenues are similar terms). Polaris’s profit margin follows.

To evaluate profit margin, we must consider the industry. For instance, an appliance company might require a profit margin between 10% and 15%; whereas a retail supermarket might require a profit margin of 1% or 2%. Both profit margin and total asset turnover make up the two basic components of operating efficiency. These ratios reflect on management because managers are ultimately responsible for operating efficiency. The next section explains how we use both measures to analyze return on total assets.

Return on Total Assets Return on total assets is defined as follows.

Polaris’s 2011 return on total assets is

Point: The times interest earned ratio and the debt and equity ratios are of special interest to bank lending officers.

Times interest earned Arctic Cat 5 2.7 KTM 5 3.2

Profit margin Arctic Cat 5 2.8% KTM 5 3.9% Industry 5 3%

Return on total assets Arctic Cat 5 5.0% KTM 5 4.5% Industry 5 4%

Bears and Bulls A bear market is a declining market. The phrase comes from bear-skin jobbers who often sold the skins before the bears were caught. The term bear was then used to describe investors who sold shares they did not own in anticipation of a price decline. A bull market is a rising market. This phrase comes from the once popular sport of bear and bull baiting. The term bull came to mean the opposite of bear. ■

Decision Insight

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Chapter 13 Analysis of Financial Statements 581

Polaris’s 19.9% return on total assets is higher than that for many businesses and is higher than Arctic Cat’s return of 5.0% and the industry’s 4% return. We also should evaluate any trend in the rate of return. The following equation shows the important relation between profit margin, total asset turn- over, and return on total assets.

Profit margin 3 Total asset turnover 5 Return on total assets

or

Net income Net sales

3 Net sales

Average total assets 5

Net income Average total assets

Both profit margin and total asset turnover contribute to overall operating efficiency, as mea- sured by return on total assets. If we apply this formula to Polaris, we get

This analysis shows that Polaris’s superior return on assets versus that of Arctic Cat is driven mainly by its higher profit margin.

Return on Common Stockholders’ Equity Perhaps the most important goal in op- erating a company is to earn net income for its owner(s). Return on common stockholders’ equity measures a company’s success in reaching this goal and is defined as follows.

Return on common stockholders’ equity 5 Net income 2 Preferred dividends

Average common stockholders’ equity

Polaris’s 2011 return on common stockholders’ equity is computed as follows:

The denominator in this computation is the book value of common equity (minority interest, also called noncontrolling interest, is often included in common equity for this ratio). In the numera- tor, the dividends on cumulative preferred stock are subtracted whether they are declared or are in arrears. If preferred stock is noncumulative, its dividends are subtracted only if declared. Polaris’s return on common stockholders’ equity (52.3%) is far superior to Arctic Cat’s (7.4%) and KTM’s (10.5%).

Market Prospects Market measures are useful for analyzing corpo ra tions with publicly traded stock. These market measures use stock price, which reflects the market’s (public’s) expectations for the company. This includes expectations of both company return and risk—as the market perceives it.

Point: Many analysts add back Interest expense 3 (1 2 Tax rate) to net income in computing return on total assets.

8.6% 3 2.32 5 19.9% (with rounding) Arctic Cat: 2.8% 3 1.79 5 5.0% (with rounding)

$227,575 2 $0

($370,991 1 $500,056) y2 5 52.3%

Return on common equity Arctic Cat 5 7.4% KTM 5 10.5% Industry 5 6%

A A A A A A A A A A A A A

521 789 506 505 567 152 726 ----- 359 657 254 658 236

521 789 506 505 567 152 726 ----- 359 657 254 658 236

521 789 506 505 567 152 726 ----- 359 657 254 658 236

521 789 506 505 567 152 726 0 359 657 254 658 236

521 789 506 505 567 152 726 ----- 359 657 254 658 236

–012 003

–006 –009 –013 003

–001 ------ –003 008

–003 –003 –003

000027 000028 000029 000030 000031 000032 000033 000034 000035 000036 000037 000038 000039

Wall Street Wall Street is synonymous with financial markets, but its name comes from the street location of the original New York Stock Exchange. The street’s name derives from stockades built by early settlers to protect New York from pirate attacks. ■

Decision Insight

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582 Chapter 13 Analysis of Financial Statements

Dividend yield 5 Annual cash dividends per share

Market price per share

Polaris’s dividend yield, based on its fiscal year-end market price per share of $55.98 and its policy of $0.90 cash dividends per share, is computed as follows.

Predicted earnings per share for the next period is often used in the denominator of this compu- tation. Reported earnings per share for the most recent period is also commonly used. In both cases, the ratio is used as an indicator of the future growth and risk of a company’s earnings as perceived by the stock’s buyers and sellers. The market price of Polaris’s common stock at the start of fiscal year 2012 was $55.98. Using Polaris’s $3.31 basic earnings per share, we compute its price-earnings ratio as follows (some analysts compute this ratio using the median of the low and high stock price).

Point: PE ratio can be viewed as an in- dicator of the market’s expected growth and risk for a stock. High expected risk suggests a low PE ratio. High expected growth suggests a high PE ratio.

$55.98

$3.31 5 16.9

PE (year-end) Arctic Cat 5 21.9 KTM 5 18.9

Polaris’s price-earnings ratio is less than that for Arctic Cat, but is slightly higher than the norm for the recessionary period 2009–2012.

Dividend Yield Dividend yield is used to compare the dividend-paying performance of dif- ferent investment alternatives. We compute dividend yield as follows (Chapter 11 offers addi- tional explanation).

Point: Some investors avoid stocks with high PE ratios under the belief they are “overpriced.” Alternatively, some in- vestors sell these stocks short—hoping for price declines.

$0.90

$55.98 5 1.6%

Dividend yield Arctic Cat 5 0.0% KTM 5 2.4%

Some companies, such as Arctic Cat, do not declare and pay dividends because they wish to reinvest the cash.

Summary of Ratios Exhibit 13.16 summarizes the major financial statement analysis ratios illustrated in this chapter and throughout the book. This summary includes each ratio’s title, its formula, and the purpose for which it is commonly used.

Point: Corporate PE ratios and divi- dend yields are found in daily stock mar- ket quotations listed in The Wall Street Journal, Investor’s Business Daily, or other publications and Web services.

Ticker Prices Ticker prices refer to a band of moving data on a monitor carrying up-to-the-minute stock prices. The phrase comes from ticker tape, a 1-inch-wide strip of paper spewing stock prices from a printer that  ticked as it ran. Most of today’s investors have never seen actual ticker tape, but the phrase survives. ■

Decision Insight

Price-earnings ratio 5 Market price per common share

Earnings per share

Price-Earnings Ratio Computation of the price-earnings ratio follows (Chapter 11 pro- vides additional explanation).

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Chapter 13 Analysis of Financial Statements 583

Ratio Formula Measure of

Liquidity and Efficiency

Current ratio 5 Current assets

Current liabilities Short-term debt-paying ability

Acid-test ratio 5 Cash 1 Short-term investments 1 Current receivables

Current liabilities Immediate short-term debt-paying ability

Accounts receivable turnover 5 Net sales

Average accounts receivable, net Efficiency of collection

Inventory turnover 5 Cost of goods sold

Average inventory Efficiency of inventory management

Days’ sales uncollected 5 Accounts receivable, net

Net sales 3 365 Liquidity of receivables

Days’ sales in inventory 5 Ending inventory

Cost of goods sold 3 365 Liquidity of inventory

Total asset turnover 5 Net sales

Average total assets Efficiency of assets in producing sales

Solvency

Debt ratio 5 Total liabilities Total assets

Creditor financing and leverage

Equity ratio 5 Total equity

Total assets Owner financing

Debt-to-equity ratio 5 Total liabilities Total equity

Debt versus equity financing

Times interest earned 5

Income before interest expense and income taxes

Interest expense Protection in meeting interest payments

Profitability

Profit margin ratio 5

Net income Net sales

Net income in each sales dollar

Gross margin ratio 5 Net sales 2 Cost of goods sold

Net sales Gross margin in each sales dollar

Return on total assets 5 Net income

Average total assets Overall profitability of assets

Return on common stockholders’ equity 5 Net income 2 Preferred dividends

Average common stockholders’ equity Profitability of owner investment

Book value per common share 5 Shareholders’ equity applicable to common shares

Number of common shares outstanding Liquidation at reported amounts

Basic earnings per share 5 Net income 2 Preferred dividends

Weighted-average common shares outstanding Net income per common share

Market Prospects

Price-earnings ratio 5 Market price per common share

Earnings per share Market value relative to earnings

Dividend yield 5 Annual cash dividends per share

Market price per share Cash return per common share

* Additional ratios also examined in previous chapters included credit risk ratio; plant asset useful life; plant asset age; days’ cash expense coverage; cash coverage of growth; cash coverage of debt; free cash flow; cash flow on total assets; and payout ratio.

EXHIBIT 13.16 Financial Statement Analysis Ratios*

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584 Chapter 13 Analysis of Financial Statements

Analysis ReportingDecision Analysis

Understanding the purpose of financial statement analysis is crucial to the usefulness of any analysis. This understanding leads to efficiency of effort, effectiveness in application, and relevance in focus. The pur- pose of most financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation. A financial statement analysis report helps by directly addressing the building

A1 Summarize and report results of analysis.

The analysis and interpretation of financial statements is, of course, impacted by the accounting system in effect. This section discusses similarities and differences for analysis of financial statements when pre- pared under U.S. GAAP vis-à-vis IFRS.

Horizontal and Vertical Analyses Horizontal and vertical analyses help eliminate many differ- ences between U.S. GAAP and IFRS when analyzing and interpreting financial statements. Financial numbers are converted to percentages that are, in the best case scenario, consistently applied across and within periods. This enables users to effectively compare companies across reporting regimes. However, when fundamental differences in reporting regimes impact financial statements, such as with certain rec- ognition rule differences, the user must exercise caution when drawing conclusions. Some users will re- formulate one set of numbers to be more consistent with the other system to enable comparative analysis. This reformulation process is covered in advanced courses. The important point is that horizontal and vertical analyses help strip away differences between the reporting regimes, but several key differences sometimes remain and require adjustment of the numbers.

Ratio Analysis Ratio analysis of financial statement numbers has many of the advantages and disad- vantages of horizontal and vertical analyses discussed above. Importantly, ratio analysis is useful for busi- ness decisions, with some possible changes in interpretation depending on what is and what is not included in accounting measures across U.S. GAAP and IFRS. Still, we must take care in drawing inferences from a comparison of ratios across reporting regimes because what a number measures can differ across re- gimes. Piaggio offers the following example of its own ratio analysis applied to gross margin: “Gross industrial margin, defined as the difference between ‘net revenues’ and ‘cost to sell,’ decreased slightly compared to the previous year . . . in relation to net turnover, it was equal to 30.0% (31.1% in the first half of 2010). The decrease as a percentage, due mainly to the different mix of products sold on markets in EMEA and the Americas, and in India and Asia SEA, was within 1.1 percentage points.”

GLOBAL VIEW

Not Created Equal Financial regulation has several goals. Two of them are to ensure adequate account- ing disclosure and to strengthen corporate governance. For disclosure purposes, companies must now pro- vide details of related-party transactions and material off-balance-sheet agreements. This is motivated by several major frauds. For corporate governance, the CEO and CFO must now certify the fairness of financial statements and the effectiveness of internal controls. Yet, concerns remain. A study reports that 23% of management and administrative employees observed activities that posed a conflict of interest in the past year (KPMG 2009). Another 12% witnessed the falsifying or manipulating of accounting information. The bot- tom line: All financial statements are not of equal quality. ■

Decision Insight

10. Which ratio best reflects a company’s ability to meet immediate interest payments? (a) Debt ratio. (b) Equity ratio. (c) Times interest earned.

11. Which ratio best measures a company’s success in earning net income for its owner(s)? (a) Profit margin. (b) Return on common stockholders’ equity. (c) Price-earnings ratio. (d) Dividend yield.

12. If a company has net sales of $8,500,000, net income of $945,000, and total asset turnover of 1.8 times, what is its return on total assets?

Quick Check Answers — p. 591

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Chapter 13 Analysis of Financial Statements 585 Chapter 13 Analysis of Financial Statements 585

blocks of analysis and by identifying weaknesses in inference by requiring explanation: It forces us to organize our reasoning and to verify its flow and logic. A report also serves as a communication link with readers, and the writing process reinforces our judgments and vice versa. Finally, the report helps us (re)evaluate evidence and refine conclusions on key building blocks. A good analysis report usually con- sists of six sections:

1. Executive summary—brief focus on important analysis results and conclusions.

2. Analysis overview—background on the company, its industry, and its economic setting.

3. Evidential matter—financial statements and information used in the analysis, including ratios, trends, comparisons, statistics, and all analytical measures assembled; often organized under the building blocks of analysis.

4. Assumptions—identification of important assumptions regarding a company’s industry and economic environment, and other important assumptions for estimates.

5. Key factors—list of important favorable and unfavorable factors, both quantitative and qualitative, for company performance; usually organized by areas of analysis.

6. Inferences—forecasts, estimates, interpretations, and conclusions drawing on all sections of the report.

We must remember that the user dictates relevance, meaning that the analysis report should include a brief table of contents to help readers focus on those areas most relevant to their decisions. All irrelevant matter must be eliminated. For example, decades-old details of obscure transactions and detailed miscues of the analysis are irrelevant. Ambiguities and qualifications to avoid responsibility or hedging inferences must be eliminated. Finally, writing is important. Mistakes in grammar and errors of fact compromise the report’s credibility.

Use the following financial statements of Precision Co. to complete these requirements. 1. Prepare comparative income statements showing the percent increase or decrease for year 2013 in

comparison to year 2012. 2. Prepare common-size comparative balance sheets for years 2013 and 2012. 3. Compute the following ratios as of December 31, 2013, or for the year ended December 31, 2013, and

identify its building block category for financial statement analysis. a. Current ratio b. Acid-test ratio c. Accounts receivable turnover d. Days’ sales uncollected e. Inventory turnover f. Debt ratio g. Debt-to-equity ratio h. Times interest earned i. Profit margin ratio j. Total asset turnover k. Return on total assets l. Return on common stockholders’ equity

DEMONSTRATION PROBLEM

Short Selling Short selling refers to selling stock before you buy it. Here’s an example: You borrow 100 shares of Nike stock, sell them at $40 each, and receive money from their sale. You then wait. You hope that Nike’s stock price falls to, say, $35 each and you can replace the borrowed stock for less than you sold it for, reaping a profit of $5 each less any transaction costs. ■

Decision Insight

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586 Chapter 13 Analysis of Financial Statements

PRECISION COMPANY

Comparative Income Statements

For Years Ended December 31, 2013 and 2012

2013 2012

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,486,000 $2,075,000

Cost of goods sold . . . . . . . . . . . . . . . . . 1,523,000 1,222,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . 963,000 853,000

Operating expenses

Advertising expense . . . . . . . . . . . . . . 145,000 100,000

Sales salaries expense . . . . . . . . . . . . . 240,000 280,000

Office salaries expense . . . . . . . . . . . . 165,000 200,000

Insurance expense . . . . . . . . . . . . . . . 100,000 45,000

Supplies expense . . . . . . . . . . . . . . . . . 26,000 35,000

Depreciation expense . . . . . . . . . . . . . 85,000 75,000

Miscellaneous expenses . . . . . . . . . . . 17,000 15,000

Total operating expenses . . . . . . . . . . 778,000 750,000

Operating income . . . . . . . . . . . . . . . . . . 185,000 103,000

Interest expense . . . . . . . . . . . . . . . . . . . 44,000 46,000

Income before taxes . . . . . . . . . . . . . . . . 141,000 57,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . 47,000 19,000

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 94,000 $ 38,000

Earnings per share . . . . . . . . . . . . . . . . . . $ 0.99 $ 0.40

PRECISION COMPANY

Comparative Balance Sheets

December 31, 2013 and 2012

2013 2012

Assets

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $ 79,000 $ 42,000

Short-term investments . . . . . . . . . . . 65,000 96,000

Accounts receivable, net . . . . . . . . . . . 120,000 100,000

Merchandise inventory . . . . . . . . . . . . 250,000 265,000

Total current assets . . . . . . . . . . . . . . . 514,000 503,000

Plant assets

Store equipment, net . . . . . . . . . . . . . 400,000 350,000

Office equipment, net . . . . . . . . . . . . . 45,000 50,000

Buildings, net . . . . . . . . . . . . . . . . . . . . 625,000 675,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000

Total plant assets . . . . . . . . . . . . . . . . . 1,170,000 1,175,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . $1,684,000 $1,678,000

Liabilities

Current liabilities

Accounts payable . . . . . . . . . . . . . . . . . $ 164,000 $ 190,000

Short-term notes payable . . . . . . . . . . 75,000 90,000

Taxes payable . . . . . . . . . . . . . . . . . . . . 26,000 12,000

Total current liabilities . . . . . . . . . . . . . 265,000 292,000

Long-term liabilities

Notes payable (secured by mortgage on buildings) . . . . . . . . . . 400,000 420,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . 665,000 712,000

Stockholders’ Equity

Common stock, $5 par value . . . . . . . . . 475,000 475,000

Retained earnings . . . . . . . . . . . . . . . . . . 544,000 491,000

Total stockholders’ equity . . . . . . . . . . . 1,019,000 966,000

Total liabilities and equity . . . . . . . . . . . . $1,684,000 $1,678,000

PLANNING THE SOLUTION ● Set up a four-column income statement; enter the 2013 and 2012 amounts in the first two columns and then

enter the dollar change in the third column and the percent change from 2012 in the fourth column. ● Set up a four-column balance sheet; enter the 2013 and 2012 year-end amounts in the first two columns

and then compute and enter the amount of each item as a percent of total assets. ● Compute the required ratios using the data provided. Use the average of beginning and ending amounts

when appropriate (see Exhibit 13.16 for definitions).

SOLUTION TO DEMONSTRATION PROBLEM 1.

PRECISION COMPANY

Comparative Income Statements

For Years Ended December 31, 2013 and 2012

Increase

(Decrease) in 2013

2013 2012 Amount Percent

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,486,000 $2,075,000 $411,000 19.8%

Cost of goods sold . . . . . . . . . . . . . . . 1,523,000 1,222,000 301,000 24.6

Gross profit . . . . . . . . . . . . . . . . . . . . . 963,000 853,000 110,000 12.9

[continued on next page]

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Chapter 13 Analysis of Financial Statements 587

Operating expenses

Advertising expense . . . . . . . . . . . . 145,000 100,000 45,000 45.0

Sales salaries expense . . . . . . . . . . . 240,000 280,000 (40,000) (14.3)

Office salaries expense . . . . . . . . . . 165,000 200,000 (35,000) (17.5)

Insurance expense . . . . . . . . . . . . . . 100,000 45,000 55,000 122.2

Supplies expense . . . . . . . . . . . . . . . 26,000 35,000 (9,000) (25.7)

Depreciation expense . . . . . . . . . . . 85,000 75,000 10,000 13.3

Miscellaneous expenses . . . . . . . . . 17,000 15,000 2,000 13.3

Total operating expenses . . . . . . . . . 778,000 750,000 28,000 3.7

Operating income . . . . . . . . . . . . . . . . 185,000 103,000 82,000 79.6

Interest expense . . . . . . . . . . . . . . . . . 44,000 46,000 (2,000) (4.3)

Income before taxes . . . . . . . . . . . . . . 141,000 57,000 84,000 147.4

Income taxes . . . . . . . . . . . . . . . . . . . . 47,000 19,000 28,000 147.4

Net income . . . . . . . . . . . . . . . . . . . . . $ 94,000 $ 38,000 $ 56,000 147.4

Earnings per share . . . . . . . . . . . . . . . . $ 0.99 $ 0.40 $ 0.59 147.5

[continued from previous page]

2. PRECISION COMPANY

Common-Size Comparative Balance Sheets

December 31, 2013 and 2012

Common-Size

December 31 Percents

2013 2012 2013* 2012*

Assets

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $ 79,000 $ 42,000 4.7% 2.5%

Short-term investments . . . . . . . . . . . 65,000 96,000 3.9 5.7

Accounts receivable, net . . . . . . . . . . . 120,000 100,000 7.1 6.0

Merchandise inventory . . . . . . . . . . . . 250,000 265,000 14.8 15.8

Total current assets . . . . . . . . . . . . . . . 514,000 503,000 30.5 30.0

Plant assets

Store equipment, net . . . . . . . . . . . . . 400,000 350,000 23.8 20.9

Office equipment, net . . . . . . . . . . . . . 45,000 50,000 2.7 3.0

Buildings, net . . . . . . . . . . . . . . . . . . . . 625,000 675,000 37.1 40.2

Land . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000 5.9 6.0

Total plant assets . . . . . . . . . . . . . . . . . 1,170,000 1,175,000 69.5 70.0

Total assets . . . . . . . . . . . . . . . . . . . . . . . $1,684,000 $1,678,000 100.0 100.0

Liabilities

Current liabilities

Accounts payable . . . . . . . . . . . . . . . . $ 164,000 $ 190,000 9.7% 11.3%

Short-term notes payable . . . . . . . . . . 75,000 90,000 4.5 5.4

Taxes payable . . . . . . . . . . . . . . . . . . . . 26,000 12,000 1.5 0.7

Total current liabilities . . . . . . . . . . . . . 265,000 292,000 15.7 17.4

Long-term liabilities

Notes payable (secured by mortgage on buildings) . . . . . . . . . . . 400,000 420,000 23.8 25.0

Total liabilities . . . . . . . . . . . . . . . . . . . . . 665,000 712,000 39.5 42.4

Stockholders’ equity

Common stock, $5 par value . . . . . . . . . 475,000 475,000 28.2 28.3

Retained earnings . . . . . . . . . . . . . . . . . . 544,000 491,000 32.3 29.3

Total stockholders’ equity . . . . . . . . . . . 1,019,000 966,000 60.5 57.6

Total liabilities and equity . . . . . . . . . . . . $1,684,000 $1,678,000 100.0 100.0

* Columns do not always exactly add to 100 due to rounding.

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588 Chapter 13 Analysis of Financial Statements

3. Ratios for 2013: a. Current ratio: $514,000y$265,000 5 1.9 :1 (liquidity and efficiency) b. Acid-test ratio: ($79,000 1 $65,000 1 $120,000)y$265,000 5 1.0 :1 (liquidity and efficiency) c. Average receivables: ($120,000 1 $100,000)y2 5 $110,000 Accounts receivable turnover: $2,486,000y$110,000 5 22.6 times (liquidity and efficiency) d. Days’ sales uncollected: ($120,000y$2,486,000) 3 365 5 17.6 days (liquidity and efficiency) e. Average inventory: ($250,000 1 $265,000)y2 5 $257,500 Inventory turnover: $1,523,000y$257,500 5 5.9 times (liquidity and efficiency) f. Debt ratio: $665,000y$1,684,000 5 39.5% (solvency) g. Debt-to-equity ratio: $665,000y$1,019,000 5 0.65 (solvency) h. Times interest earned: $185,000y$44,000 5 4.2 times (solvency) i. Profit margin ratio: $94,000y$2,486,000 5 3.8% (profitability) j. Average total assets: ($1,684,000 1 $1,678,000)y2 5 $1,681,000 Total asset turnover: $2,486,000y$1,681,000 5 1.48 times (liquidity and efficiency) k. Return on total assets: $94,000y$1,681,000 5 5.6% or 3.8% 3 1.48 5 5.6% (profitability) l. Average total common equity: ($1,019,000 1 $966,000)y2 5 $992,500 Return on common stockholders’ equity: $94,000y$992,500 5 9.5% (profitability)

APPENDIX

Sustainable Income When a company’s revenue and expense transactions are from normal, continuing operations, a simple income statement is usually adequate. When a company’s activities include income-related events not part of its normal, continuing operations, it must disclose information to help users understand these events and predict future performance. To meet these objectives, companies separate the income statement into continuing operations, discontinued segments, extraordinary items, comprehensive income, and earnings per share. For illustration, Exhibit 13A.1 shows such an income statement for ComUS. These separate distinctions help us measure sustainable income, which is the income level most likely to continue into the future. Sustainable income is commonly used in PE ratios and other market-based mea sures of performance.

Continuing Operations The first major section ( 1 ) shows the revenues, expenses, and income from continuing operations. Users especially rely on this information to predict future operations. Many users view this section as the most important. Earlier chapters explained the items comprising income from continuing operations.

Discontinued Segments A business segment is a part of a company’s operations that serves a particular line of business or class of customers. A segment has assets, liabilities, and financial results of operations that can be distinguished from those of other parts of the company. A company’s gain or loss from selling or closing down a segment is separately reported. Section 2 of Exhibit 13A.1 reports both (1) income from operating the discontinued segment for the current period prior to its disposal and (2) the loss from disposing of the segment’s net assets. The income tax effects of each are reported separately from the income taxes expense in section 1 .

Extraordinary Items Section 3 reports extraordinary gains and losses, which are those that are both unusual and infrequent. An unusual gain or loss is abnormal or otherwise unrelated to the compa- ny’s regular activities and environment. An infrequent gain or loss is not expected to recur given the company’s operating environment. Reporting extraordinary items in a separate category helps users pre- dict future performance, absent the effects of extraordinary items. Items usually considered extraordinary include (1) expropriation (taking away) of property by a foreign government, (2) condemning of property by a domestic government body, (3) prohibition against using an asset by a newly enacted law, and (4) losses and gains from an unusual and infrequent calamity (“act of God”). Items not considered extraor- dinary include (1) write-downs of inventories and write-offs of receivables, (2) gains and losses from disposing of segments, and (3) financial effects of labor strikes.

13A A2 Explain the form and assess the content of

a complete income statement.

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Chapter 13 Analysis of Financial Statements 589

EXHIBIT 13A.1 Income Statement (all-inclusive) for a Corporation

ComUS

Income Statement

For Year Ended December 31, 2013

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,478,000

Operating expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,950,000

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Other selling, general, and administrative expenses . . . . . . . . . . . . . . . . . . . . 515,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,520,000)

Other gains (losses)

Loss on plant relocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (45,000)

Gain on sale of surplus land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000

Income from continuing operations before taxes . . . . . . . . . . . . . . . . . . . . . . . . 1,985,000

Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (595,500)

Income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,389,500

Discontinued segment

Income from operating Division A (net of $180,000 taxes) . . . . . . . . . . . . . . . . 420,000

Loss on disposal of Division A (net of $66,000 tax benefit) . . . . . . . . . . . . . . . . (154,000) 266,000

Income before extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,655,500

Extraordinary items

Gain on land expropriated by state (net of $85,200 taxes) . . . . . . . . . . . . . . . . 198,800

Loss from earthquake damage (net of $270,000 tax benefit) . . . . . . . . . . . . . . . (630,000) (431,200)

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,224,300

Earnings per common share (200,000 outstanding shares)

Income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6.95

Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.33

Income before extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.28

Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2.16)

Net income (basic earnings per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6.12

1

2

3

4

⎫ ⎪ ⎬ ⎪ ⎭

⎫ ⎪ ⎬ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

Gains and losses that are neither unusual nor infrequent are reported as part of continuing operations. Gains and losses that are either unusual or infrequent, but not both, are reported as part of continuing operations but after the normal revenues and expenses.

Point: Changes in principles are sometimes required when new accounting standards are issued.

Earnings per Share The final section 4 of the income statement in Exhibit 13A.1 reports earnings per share for each of the three subcategories of income (continuing operations, discontinued segments, and extraordinary items) when they exist. Earnings per share is discussed in Chapter 11.

Changes in Accounting Principles The consistency concept directs a company to apply the same accounting principles across periods. Yet a company can change from one acceptable accounting principle (such as FIFO, LIFO, or weighted-average) to another as long as the change improves the useful- ness of information in its financial statements. A footnote would describe the accounting change and why it is an improvement. Changes in accounting principles require retrospective application to prior periods’ financial state- ments. Retrospective application involves applying a different accounting principle to prior periods as if that principle had always been used. Retrospective application enhances the consistency of financial information between periods, which improves the usefulness of information, especially with comparative

Small Business Owner You own an orange grove near Jacksonville, Florida. A bad frost destroys about one-half of your oranges. You are currently preparing an income statement for a bank loan. Can you claim the loss of oranges as extraordinary? ■ [Answer—p. 591]

Decision Maker

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590 Chapter 13 Analysis of Financial Statements

13. Which of the following is an extraordinary item? (a) a settlement paid to a customer injured while using the company’s product, (b) a loss to a plant from damages caused by a meteorite, or (c) a loss from selling old equipment.

14. Identify the four major sections of an income statement that are potentially reportable. 15. A company using FIFO for the past 15 years decides to switch to LIFO. The effect of this

event on prior years’ net income is (a) reported as if the new method had always been used; (b) ignored because it is a change in an accounting estimate; or (c) reported on the current year income statement.

Quick Check Answers — p. 591

analyses. (Prior to 2005, the cumulative effect of changes in accounting principles was recognized in net income in the period of the change.) Accounting standards also require that a change in depreciation, amortization, or depletion method for long-term operating assets is accounted for as a change in account- ing estimate—that is, prospectively over current and future periods. This reflects the notion that an entity should change its depreciation, amortization, or depletion method only with changes in estimated asset benefits, the pattern of benefit usage, or information about those benefits.

C1 Explain the purpose and identify the building blocks of analysis. The purpose of financial statement analysis is to help users make better business decisions. Internal users want informa- tion to improve company efficiency and effectiveness in providing products and services. External users want information to make bet- ter and more informed decisions in pursuing their goals. The com- mon goals of all users are to evaluate a company’s (1) past and current performance, (2) current financial position, and (3) future performance and risk. Financial statement analysis focuses on four “building blocks” of analysis: (1) liquidity and efficiency—ability to meet short-term obligations and efficiently generate revenues; (2) solvency—ability to generate future revenues and meet long- term obligations; (3) profitability—ability to provide financial rewards sufficient to attract and retain financing; and (4) market prospects—ability to generate positive market expectations.

C2 Describe standards for comparisons in analysis. Standards for comparisons include (1) intracompany—prior performance and relations between financial items for the company under analy- sis; (2) competitor—one or more direct competitors of the company; (3) industry—industry statistics; and (4) guidelines (rules of thumb)—general standards developed from past experiences and personal judgments.

A1 Summarize and report results of analysis. A financial state-ment analysis report is often organized around the building blocks of analysis. A good report separates interpretations and con- clusions of analysis from the information underlying them. An anal- ysis report often consists of six sections: (1) executive summary, (2) analysis overview, (3) evidential matter, (4) assumptions, (5) key factors, and (6) inferences.

Summary A2A Explain the form and assess the content of a complete income statement. An income statement has four potential sections: (1) continuing operations, (2) discontinued segments, (3) extraordinary items, and (4) earnings per share.

P1 Explain and apply methods of horizontal analysis. Horizontal analysis is a tool to evaluate changes in data across time. Two important tools of horizontal analysis are com- parative statements and trend analysis. Comparative statements show amounts for two or more successive periods, often with changes disclosed in both absolute and percent terms. Trend analysis is used to reveal important changes occurring from one period to the next.

P2 Describe and apply methods of vertical analysis. Verti-cal analysis is a tool to evaluate each financial statement item or group of items in terms of a base amount. Two tools of vertical analysis are common-size statements and graphical analyses. Each item in common-size statements is expressed as a percent of a base amount. For the balance sheet, the base amount is usually total assets, and for the income statement, it is usually sales.

P3 Define and apply ratio analysis. Ratio analysis provides clues to and symptoms of underlying conditions. Ratios, properly interpreted, identify areas requiring further investi gation. A ratio expresses a mathematical relation between two quantities such as a percent, rate, or proportion. Ratios can be organized into the building blocks of analysis: (1) liquidity and efficiency, (2) sol- vency, (3) profitability, and (4) market prospects.

Auditor The joint relation referred to is the combined increase in sales and the decrease in expenses yielding more than a 5% increase in income. Both individual accounts (sales and expenses) yield per- cent changes within the 65% acceptable range. However, a joint

analysis suggests a different picture. For example, consider a joint analysis using the profit margin ratio. The client’s profit margin is 11.46% ($206,000 2 $182,400y$206,000) for the current year com- pared with 5.0% ($200,000 2 $190,000y$200,000) for the prior

Guidance Answers to Decision Maker

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Chapter 13 Analysis of Financial Statements 591

Multiple Choice Quiz Answers on p. 607 mhhe.com/wildFINMAN5e

Additional Quiz Questions are available at the book’s Website.

1. A company’s sales in 2012 were $300,000 and in 2013 were $351,000. Using 2012 as the base year, the sales trend percent for 2013 is:

a. 17% b. 85%

c. 100% d. 117% e. 48%

year—yielding a 129% increase in profit margin! This is what con- cerns the partner, and it suggests expanding audit tests to verify or refute the client’s figures.

Banker Your decision on the loan application is positive for at least two reasons. First, the current ratio suggests a strong ability to meet short-term obligations. Second, current assets of $160,000 and a current ratio of 4:1 imply current liabilities of $40,000 (one-fourth of current assets) and a working capital excess of $120,000. This working capital excess is 60% of the loan amount. However, if the application is for a 10-year loan, our decision is less optimistic. The

current ratio and working capital suggest a good safety margin, but indications of inefficiency in operations exist. In particular, a 4:1 cur- rent ratio is more than double its key competitors’ ratio. This is characteristic of inefficient asset use.

Small Business Owner The frost loss is probably not extraor- dinary. Jacksonville experiences enough recurring frost damage to make it difficult to argue this event is both unusual and infrequent. Still, you want to highlight the frost loss and hope the bank views this uncommon event separately from continuing operations.

1. General-purpose financial statements are intended for a variety of users interested in a company’s financial condition and performance—users without the power to require specialized financial reports to meet their specific needs.

2. General-purpose financial statements include the income state- ment, balance sheet, statement of stockholders’ (owners’) eq- uity, and statement of cash flows plus the notes related to these statements.

3. a 4. Data from one or more direct competitors are usually preferred

for comparative purposes. 5. d 6. Percents on comparative income statements show the increase

or decrease in each item from one period to the next. On common-size comparative income statements, each item is shown as a percent of net sales for that period.

7. c 8. (a) ($820,000 1 $240,000 1 $470,000)y ($350,000 1 $180,000) 5 2.9 to 1.

(b) ($820,000 1 $240,000)y($350,000 1 $180,000) 5 2:1. 9. (a) $2,500,000y[($290,000 1 $240,000)y2] 5 9.43 times. (b) ($290,000y$2,500,000) 3 365 5 42 days. (c) $750,000y[($530,000 1 $470,000)y2] 5 1.5 times. (d) ($530,000y$750,000) 3 365 5 258 days. 10. c 11. b

12.

Profit margin 3

Total asset turnover

5 Return on total assets

$945,000

$8,500,000 3 1.8 5 20%

13. (b) 14. The four (potentially reportable) major sections are income

from continuing operations, discontinued segments, extraordi- nary items, and earnings per share.

15. (a); known as retrospective application.

Guidance Answers to Quick Checks

Business segment (p. 588)

Common-size financial statement (p. 571)

Comparative financial statements (p. 566)

Efficiency (p. 565)

Equity ratio (p. 579)

Extraordinary gains and losses (p. 588)

Financial reporting (p. 565)

Financial statement analysis (p. 564)

General-purpose financial statements (p. 565)

Horizontal analysis (p. 566)

Infrequent gain or loss (p. 588)

Liquidity (p. 565)

Market prospects (p. 565)

Profitability (p. 565)

Ratio analysis (p. 566)

Solvency (p. 565)

Unusual gain or loss (p. 588)

Vertical analysis (p. 566)

Working capital (p. 575)

Key Terms

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592 Chapter 13 Analysis of Financial Statements

1. Explain the difference between financial reporting and finan- cial statements.

2. What is the difference between comparative financial state- ments and common-size comparative statements?

3. Which items are usually assigned a 100% value on (a) a common-size balance sheet and (b) a common-size income statement?

4. What three factors would influence your evaluation as to whether a company’s current ratio is good or bad?

5. Suggest several reasons why a 2:1 current ratio might not be adequate for a particular company.

6. Why is working capital given special attention in the pro- cess of analyzing balance sheets?

7. What does the number of days’ sales uncollected indicate? 8. What does a relatively high accounts receivable turnover

indicate about a company’s short-term liquidity?

9. Why is a company’s capital structure, as measured by debt and equity ratios, important to financial statement analysts?

10. How does inventory turnover provide information about a company’s short-term liquidity?

11. What ratios would you compute to evaluate management performance?

12. Why would a company’s return on total assets be different from its return on common stockholders’ equity?

13. Where on the income statement does a company report an un- usual gain not expected to occur more often than once every two years or so?

14. Refer to Polaris’ financial statements in Appendix A. Com pute its profit margin for the years ended December 31, 2011, and December 31, 2010.

15. Refer to Arctic Cat’s financial statements in Appendix A to compute its equity ratio as of March 31, 2011, and March 31, 2010.

16. Refer to Piaggio’s financial statements in Appendix A. Compute its debt ratio as of December 31, 2011, and December 31, 2010.

17. Use KTM’s financial statements in Appendix A to compute its return on total assets for fiscal year ended December 31, 2011.

Discussion Questions

A Superscript letter A denotes assignments based on Appendix 13A.

Icon denotes assignments that involve decision making.

Use the following information for questions 2 through 5.

2. What is Galloway Company’s current ratio? a. 0.69 b. 1.31

c. 3.88 d. 6.69 e. 2.39 3. What is Galloway Company’s acid-test ratio? a. 2.39 b. 0.69 c. 1.31 d. 6.69 e. 3.88 4. What is Galloway Company’s debt ratio? a. 25.78% b. 100.00% c. 74.22% d. 137.78% e. 34.74% 5. What is Galloway Company’s equity ratio? a. 25.78% b. 100.00% c. 34.74% d. 74.22% e. 137.78%

GALLOWAY COMPANY

Balance Sheet

December 31, 2013

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 86,000

Accounts receivable . . . . . . . . . . . . 76,000

Merchandise inventory . . . . . . . . . . 122,000

Prepaid insurance . . . . . . . . . . . . . . 12,000

Long-term investments . . . . . . . . . . 98,000

Plant assets, net . . . . . . . . . . . . . . . . 436,000

Total assets . . . . . . . . . . . . . . . . . . . $830,000

Liabilities and Equity

Current liabilities . . . . . . . . . . . . . . . $124,000

Long-term liabilities . . . . . . . . . . . . . 90,000

Common stock . . . . . . . . . . . . . . . . 300,000

Retained earnings . . . . . . . . . . . . . . 316,000

Total liabilities and equity . . . . . . . . $830,000

Polaris

KTM

PIAGGIO

Arctic Cat

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Chapter 13 Analysis of Financial Statements 593

Which of the following items (a) through (i) are part of financial reporting but are not included as part of general-purpose financial statements? (a) balance sheet, (b) financial statement notes, (c) statement of shareholders’ equity, (d) prospectus, (e) stock price information and analysis, ( f ) statement of cash flows, (g) management discussion and analysis of financial performance, (h) income statement, (i) company news releases.

QUICK STUDY

QS 13-1 Financial reporting C1

QS 13-5 Standard of comparison C2

What are four possible standards of comparison used to analyze financial statement ratios? Which of these is generally considered to be the most useful? Which one is least likely to provide a good basis for comparison?

QS 13-6 Ratio interpretation

P3

For each ratio listed, identify whether the change in ratio value from 2012 to 2013 is usually regarded as favorable or unfavorable.

Ratio 2013 2012 Ratio 2013 2012

1. Profit margin 9% 8% 5. Accounts receivable turnover 5.5 6.7

2. Debt ratio 47% 42% 6. Basic earnings per share $1.25 $1.10

3. Gross margin 34% 46% 7. Inventory turnover 3.6 3.4

4. Acid-test ratio 1.00 1.15 8. Dividend yield 2.0% 1.2%

Team Project: Assume that the two companies apply for a one-year loan from the team. Identify additional information the companies must provide before the team can make a loan decision.

QS 13-7 Analysis of short-term financial condition

A1

The following information is available for Morgan Company and Parker Company, similar firms operating in the same industry. Write a half-page report comparing Morgan and Parker using the available informa- tion. Your discussion should include their ability to meet current obligations and to use current assets efficiently.

Morgan Parker 2014 2013 2012 2014 2013 2012

Current ratio Acid-test ratio Accounts receivable turnover Merchandise inventory turnover

1.7 1.0

30.5 24.2

Working capital $70,000

1.6 1.1

25.2 21.9

$58,000

2.1 1.2

29.2 17.1

$52,000

3.2 2.8

16.4 14.5

$131,000

2.7 2.5

15.2 13.0

$103,000

1.9 1.6

16.0 12.6

$78,000

Microsoft Excel - Book1

File Edit View Insert Format Tools Data Accounting Window Help

QS 13-2 Trend percents

P1

Use the following information for Tide Corporation to determine the 2012 and 2013 trend percents for net sales using 2012 as the base year.

($ thousands) 2013 2012

Net sales . . . . . . . . . . . . . . . . $801,810 $453,000

Cost of goods sold . . . . . . . . 392,887 134,088

QS 13-3 Common-size analysis P2

Refer to the information in QS 13-2. Use that information for Tide Corporation to determine the 2012 and 2013 common-size percents for cost of goods sold using net sales as the base.

QS 13-4 Horizontal analysis

P1

Compute the annual dollar changes and percent changes for each of the following accounts.

2013 2012

Short-term investments . . . . . . . . $374,634 $234,000

Accounts receivable . . . . . . . . . . . 97,364 101,000

Notes payable . . . . . . . . . . . . . . . . 0 88,000

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594 Chapter 13 Analysis of Financial Statements

QS 13-8A

Error adjustments

A2

A review of the notes payable files discovers that three years ago the company reported the entire amount of a payment (principal and interest) on an installment note payable as interest expense. This mistake had a material effect on the amount of income in that year. How should the correction be reported in the current year financial statements?

Exercise 13-2 Identifying financial ratios

C2

1. Which two ratios are key components in measuring a company’s operating efficiency? Which ratio summarizes these two components?

2. What measure reflects the difference between current assets and current liabilities? 3. Which two short-term liquidity ratios measure how frequently a company collects its accounts?

Exercise 13-3 Computation and analysis of trend percents

P1

Compute trend percents for the following accounts, using 2011 as the base year (round the percents to whole numbers). State whether the situation as revealed by the trends appears to be favorable or unfavorable for each account.

2015 2014 2013 2012 2011

Sales . . . . . . . . . . . . . . . . . . . . . $282,880 $270,800 $252,600 $234,560 $150,000

Cost of goods sold . . . . . . . . . 128,200 122,080 115,280 106,440 67,000

Accounts receivable . . . . . . . . 18,100 17,300 16,400 15,200 9,000

Exercise 13-4 Determination of income effects from common-size and trend percents

P1 P2

Common-size and trend percents for Rustynail Company’s sales, cost of goods sold, and expenses follow. Determine whether net income increased, decreased, or remained unchanged in this three-year period.

Common-Size Percents Trend Percents

2014 2013 2012 2014 2013 2012

Sales . . . . . . . . . . . . . . . . . . . . 100.0% 100.0% 100.0% 105.4% 104.2% 100.0%

Cost of goods sold . . . . . . . . 63.4 61.9 59.1 103.0 101.1 100.0

Total expenses . . . . . . . . . . . . 15.3 14.8 15.1 95.0 91.0 100.0

QS 13-9 International ratio analysis

C2

Answer each of the following related to international accounting and analysis. a. Identify a limitation to using ratio analysis when examining companies reporting under different ac-

counting systems such as IFRS versus U.S. GAAP. b. Identify an advantage to using horizontal and vertical analyses when examining companies reporting

under different currencies.

EXERCISES

Exercise 13-1 Building blocks of analysis

C1

Match the ratio to the building block of financial statement analysis to which it best relates. A. Liquidity and efficiency C. Profitability B. Solvency D. Market prospects 1. Equity ratio 6. Accounts receivable turnover 2. Return on total assets 7. Debt-to-equity 3. Dividend yield 8. Times interest earned 4. Book value per common share 9. Gross margin ratio 5. Days’ sales in inventory 10. Acid-test ratio

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Chapter 13 Analysis of Financial Statements 595

Exercise 13-5 Common-size percent computation and interpretation

P2

Express the following comparative income statements in common-size percents and assess whether or not this company’s situation has improved in the most recent year (round the percents to one decimal).

GOMEZ CORPORATION

Comparative Income Statements

For Years Ended December 31, 2013 and 2012

2013 2012

Sales . . . . . . . . . . . . . . . . . . . . . $740,000 $625,000

Cost of goods sold . . . . . . . . . 560,300 290,800

Gross profit . . . . . . . . . . . . . . . 179,700 334,200

Operating expenses . . . . . . . . 128,200 218,500

Net income . . . . . . . . . . . . . . . $ 51,500 $115,700

Exercise 13-6 Analysis of efficiency and financial leverage

A1

Roak Company and Clay Company are similar firms that operate in the same industry. Clay began opera- tions in 2013 and Roak in 2010. In 2015, both companies pay 7% interest on their debt to creditors. The following additional information is available.

Roak Company Clay Company

2015 2014 2013 2015 2014 2013

Total asset turnover . . . . . . . . . . 3.1 2.8 3.0 1.7 1.5 1.1

Return on total assets . . . . . . . . 9.0% 9.6% 8.8% 5.9% 5.6% 5.3%

Profit margin ratio . . . . . . . . . . . 2.4% 2.5% 2.3% 2.8% 3.0% 2.9%

Sales . . . . . . . . . . . . . . . . . . . . . . $410,000 $380,000 $396,000 $210,000 $170,000 $110,000

Write a half-page report comparing Roak and Clay using the available information. Your analysis should include their ability to use assets efficiently to produce profits. Also comment on their success in employing financial leverage in 2015.

Exercise 13-7 Common-size percents

P2

Simon Company’s year-end balance sheets follow. Express the balance sheets in common-size percents. Round amounts to the nearest one-tenth of a percent. Analyze and comment on the results.

At December 31 2014 2013 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,800 $ 35,625 $ 37,800

Accounts receivable, net . . . . . . . . . . . . . . . . . . . 89,500 62,500 50,200

Merchandise inventory . . . . . . . . . . . . . . . . . . . . 112,500 82,500 54,000

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . 10,700 9,375 5,000

Plant assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . 278,500 255,000 230,500

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $523,000 $445,000 $377,500

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $129,900 $ 75,250 $ 51,250

Long-term notes payable secured by mortgages on plant assets . . . . . . . . . . . . . . . 98,500 101,500 83,500

Common stock, $10 par value . . . . . . . . . . . . . . 163,500 163,500 163,500

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 131,100 104,750 79,250

Total liabilities and equity . . . . . . . . . . . . . . . . . . $523,000 $445,000 $377,500

Exercise 13-8 Liquidity analysis

P3

Refer to Simon Company’s balance sheets in Exercise 13-7. Analyze its year-end short-term liquidity position at the end of 2014, 2013, and 2012 by computing (1) the current ratio and (2) the acid-test ratio. Comment on the ratio results. (Round ratio amounts to two decimals.)

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596 Chapter 13 Analysis of Financial Statements

Exercise 13-13A

Income statement categories

A2

In 2013, Randa Merchandising, Inc., sold its interest in a chain of wholesale outlets, taking the company completely out of the wholesaling business. The company still operates its retail outlets. A listing of the major sections of an income statement follows: A. Income (loss) from continuing operations B. Income (loss) from operating, or gain (loss) from disposing, a discontinued segment C. Extraordinary gain (loss) Indicate where each of the following income-related items for this company appears on its 2013 income statement by writing the letter of the appropriate section in the blank beside each item.

Section Item Debit Credit

_______ 1. Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,900,000

_______ 2. Gain on state’s condemnation of company property (net of tax) . . . . . . . . . . . . . . 230,000

_______ 3. Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000

_______ 4. Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . 217,000

_______ 5. Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . 232,500

_______ 6. Gain on sale of wholesale business segment (net of tax) . . . . . . . . . . . . . . . . . . . . . . . . . 775,000

_______ 7. Loss from operating wholesale business segment (net of tax) . . . . . . . . . . . . . . . . . . . . . . . . . 444,000

_______ 8. Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640,000

Exercise 13-9 Liquidity analysis and interpretation

P3

Refer to the Simon Company information in Exercise 13-7. The company’s income statements for the years ended December 31, 2014 and 2013, follow. Assume that all sales are on credit and then compute: (1) days’ sales uncollected, (2) accounts receivable turnover, (3) inventory turnover, and (4) days’ sales in inventory. Comment on the changes in the ratios from 2013 to 2014. (Round amounts to one decimal.)

For Year Ended December 31 2014 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $673,500 $532,000

Cost of goods sold . . . . . . . . . . . . . . $411,225 $345,500

Other operating expenses . . . . . . . . 209,550 134,980

Interest expense . . . . . . . . . . . . . . . . 12,100 13,300

Income taxes . . . . . . . . . . . . . . . . . . . 9,525 8,845

Total costs and expenses . . . . . . . . . 642,400 502,625

Net income . . . . . . . . . . . . . . . . . . . . $ 31,100 $ 29,375

Earnings per share . . . . . . . . . . . . . . . $ 1.90 $ 1.80

Exercise 13-10 Risk and capital structure analysis P3

Refer to the Simon Company information in Exercises 13-7 and 13-9. Compare the company’s long-term risk and capital structure positions at the end of 2014 and 2013 by computing these ratios: (1) debt and equity ratios—percent rounded to one decimal, (2) debt-to-equity ratio—rounded to two decimals, and (3) times interest earned—rounded to one decimal. Comment on these ratio results.

Exercise 13-11 Efficiency and profitability analysis P3

Refer to Simon Company’s financial information in Exercises 13-7 and 13-9. Evaluate the company’s effi- ciency and profitability by computing the following for 2014 and 2013: (1) profit margin ratio—percent rounded to one decimal, (2) total asset turnover—rounded to one decimal, and (3) return on total assets— percent rounded to one decimal. Comment on these ratio results.

Exercise 13-12 Profitability analysis

P3

Refer to Simon Company’s financial information in Exercises 13-7 and 13-9. Additional information about the company follows. To help evaluate the company’s profitability, compute and interpret the fol- lowing ratios for 2014 and 2013: (1) return on common stockholders’ equity—percent rounded to one decimal, (2) price-earnings ratio on December 31—rounded to one decimal, and (3) dividend yield— percent rounded to one decimal.

Common stock market price, December 31, 2014 . . . . . . . . $30.00

Common stock market price, December 31, 2013 . . . . . . . . 28.00

Annual cash dividends per share in 2014 . . . . . . . . . . . . . . . . 0.29

Annual cash dividends per share in 2013 . . . . . . . . . . . . . . . . 0.24

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Chapter 13 Analysis of Financial Statements 597

Exercise 13-14A

Income statement presentation

A2

Use the financial data for Randa Merchandising, Inc., in Exercise 13-13 to prepare its income statement for calendar year 2013. (Ignore the earnings per share section.)

Exercise 13-15 Ratio analysis under different currencies

P3

Nintendo Company, Ltd., reports the following financial information as of, or for the year ended, March 31, 2011. Nintendo reports its financial statements in both Japanese yen and U.S. dollars as shown (amounts in millions).

1. Compute Nintendo’s current ratio, net profit margin, and sales-to-total-assets using the financial infor- mation reported in (a) yen and (b) dollars. Round amounts to two decimals.

2. What can we conclude from a review of the results for part 1?

Current assets . . . . . . . . . . ¥1,468,706 $17,695,254

Total assets . . . . . . . . . . . . . 1,634,297 19,690,330

Current liabilities . . . . . . . . 333,301 4,015,683

Net sales . . . . . . . . . . . . . . . 1,014,345 12,221,031

Net income . . . . . . . . . . . . . 77,621 935,200

Selected comparative financial statements of Korbin Company follow. PROBLEM SET A

Problem 13-1A Ratios, common-size statements, and trend percents

P1 P2 P3

KORBIN COMPANY

Comparative Income Statements

For Years Ended December 31, 2014, 2013, and 2012

2014 2013 2012

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $555,000 $340,000 $278,000

Cost of goods sold . . . . . . . . . . . . . 283,500 212,500 153,900

Gross profit . . . . . . . . . . . . . . . . . . . 271,500 127,500 124,100

Selling expenses . . . . . . . . . . . . . . . 102,900 46,920 50,800

Administrative expenses . . . . . . . . . 50,668 29,920 22,800

Total expenses . . . . . . . . . . . . . . . . 153,568 76,840 73,600

Income before taxes . . . . . . . . . . . . 117,932 50,660 50,500

Income taxes . . . . . . . . . . . . . . . . . . 40,800 10,370 15,670

Net income . . . . . . . . . . . . . . . . . . . $ 77,132 $ 40,290 $ 34,830

KORBIN COMPANY

Comparative Balance Sheets

December 31, 2014, 2013, and 2012

2014 2013 2012

Assets

Current assets . . . . . . . . . . . . . . . . . . $ 52,390 $ 37,924 $ 51,748

Long-term investments . . . . . . . . . . . 0 500 3,950

Plant assets, net . . . . . . . . . . . . . . . . . 100,000 96,000 60,000

Total assets . . . . . . . . . . . . . . . . . . . . $152,390 $134,424 $115,698

Liabilities and Equity

Current liabilities . . . . . . . . . . . . . . . $ 22,800 $ 19,960 $ 20,300

Common stock . . . . . . . . . . . . . . . . . 72,000 72,000 60,000

Other paid-in capital . . . . . . . . . . . . . 9,000 9,000 6,000

Retained earnings . . . . . . . . . . . . . . . 48,590 33,464 29,398

Total liabilities and equity . . . . . . . . . $152,390 $134,424 $115,698

Required

1. Compute each year’s current ratio. (Round ratio amounts to one decimal.) 2. Express the income statement data in common-size percents. (Round percents to two decimals.)

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598 Chapter 13 Analysis of Financial Statements

3. Express the balance sheet data in trend percents with 2012 as the base year. (Round percents to two decimals.)

Analysis Component

4. Comment on any significant relations revealed by the ratios and percents computed.

Check (3) 2014, Total assets trend, 131.71%

Problem 13-2A Calculation and analysis of trend percents

A1 P1

Selected comparative financial statements of Haroun Company follow.

HAROUN COMPANY

Comparative Income Statements

For Years Ended December 31, 2014–2008

($ thousands) 2014 2013 2012 2011 2010 2009 2008

Sales . . . . . . . . . . . . . . . . . . . . . $1,694 $1,496 $1,370 $1,264 $1,186 $1,110 $928

Cost of goods sold . . . . . . . . . 1,246 1,032 902 802 752 710 586

Gross profit . . . . . . . . . . . . . . . 448 464 468 462 434 400 342

Operating expenses . . . . . . . . 330 256 234 170 146 144 118

Net income . . . . . . . . . . . . . . . $ 118 $ 208 $ 234 $ 292 $ 288 $ 256 $224

HAROUN COMPANY

Comparative Balance Sheets

December 31, 2014–2008

($ thousands) 2014 2013 2012 2011 2010 2009 2008

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 58 $ 78 $ 82 $ 84 $ 88 $ 86 $ 89

Accounts receivable, net . . . . . . . . . 490 514 466 360 318 302 216

Merchandise inventory . . . . . . . . . . 1,838 1,364 1,204 1,032 936 810 615

Other current assets . . . . . . . . . . . . 36 32 14 34 28 28 9

Long-term investments . . . . . . . . . . 0 0 0 146 146 146 146

Plant assets, net . . . . . . . . . . . . . . . . 2,020 2,014 1,752 944 978 860 725

Total assets . . . . . . . . . . . . . . . . . . . . $4,442 $4,002 $3,518 $2,600 $2,494 $2,232 $1,800

Liabilities and Equity

Current liabilities . . . . . . . . . . . . . . . $1,220 $1,042 $ 718 $ 614 $ 546 $ 522 $ 282

Long-term liabilities . . . . . . . . . . . . . 1,294 1,140 1,112 570 580 620 400

Common stock . . . . . . . . . . . . . . . . 1,000 1,000 1,000 850 850 650 650

Other paid-in capital . . . . . . . . . . . . 250 250 250 170 170 150 150

Retained earnings . . . . . . . . . . . . . . . 678 570 438 396 348 290 318

Total liabilities and equity . . . . . . . . . $4,442 $4,002 $3,518 $2,600 $2,494 $2,232 $1,800

Required

1. Compute trend percents for all components of both statements using 2008 as the base year. (Round percents to one decimal.)

Analysis Component

2. Analyze and comment on the financial statements and trend percents from part 1.

Check (1) 2014, Total assets trend, 246.8%

Problem 13-3A Transactions, working capital, and liquidity ratios

P3

Plum Corporation began the month of May with $700,000 of current assets, a current ratio of 2.50:1, and an acid-test ratio of 1.10:1. During the month, it completed the following transactions (the company uses a perpetual inventory system).

May 2 Purchased $50,000 of merchandise inventory on credit. 8 Sold merchandise inventory that cost $55,000 for $110,000 cash. 10 Collected $20,000 cash on an account receivable. 15 Paid $22,000 cash to settle an account payable. mhhe.com/wildFINMAN5e

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Chapter 13 Analysis of Financial Statements 599

17 Wrote off a $5,000 bad debt against the Allowance for Doubtful Accounts account. 22 Declared a $1 per share cash dividend on its 50,000 shares of outstanding common stock. 26 Paid the dividend declared on May 22. 27 Borrowed $100,000 cash by giving the bank a 30-day, 10% note. 28 Borrowed $80,000 cash by signing a long-term secured note. 29 Used the $180,000 cash proceeds from the notes to buy new machinery.

Required

Prepare a table showing Plum’s (1) current ratio, (2) acid-test ratio, and (3) working capital, after each transaction. Round ratios to two decimals.

Check May 22: Current ratio, 2.19; Acid-test ratio, 1.11

May 29: Current ratio, 1.80; Working capital, $325,000

Problem 13-5A Comparative ratio analysis

A1 P3

Summary information from the financial statements of two companies competing in the same industry follows.

Problem 13-4A Calculation of financial statement ratios

P3

Selected year-end financial statements of Cabot Corporation follow. (All sales were on credit; selected balance sheet amounts at December 31, 2012, were inventory, $48,900; total assets, $189,400; common stock, $90,000; and retained earnings, $22,748.)

Required

Compute the following: (1) current ratio, (2) acid-test ratio, (3) days’ sales uncollected, (4) inventory turn- over, (5) days’ sales in inventory, (6) debt-to-equity ratio, (7) times interest earned, (8) profit margin ratio, (9) total asset turnover, (10) return on total assets, and (11) return on common stockholders’ equity. Round to one decimal place, except for part 6 round to two decimals.

Check Acid-test ratio, 2.2 to 1: Inventory turnover, 7.3

CABOT CORPORATION

Balance Sheet

December 31, 2013

Assets Liabilities and Equity

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000 Accounts payable . . . . . . . . . . . . . . . . . . . . $ 17,500

Short-term investments . . . . . . . . . . 8,400 Accrued wages payable . . . . . . . . . . . . . . . . 3,200

Accounts receivable, net . . . . . . . . . . 29,200 Income taxes payable . . . . . . . . . . . . . . . . . 3,300

Notes receivable (trade)* . . . . . . . . . 4,500 Long-term note payable, secured

Merchandise inventory . . . . . . . . . . . 32,150 by mortgage on plant assets . . . . . . . . . . 63,400

Prepaid expenses . . . . . . . . . . . . . . . 2,650 Common stock . . . . . . . . . . . . . . . . . . . . . . 90,000

Plant assets, net . . . . . . . . . . . . . . . . . 153,300 Retained earnings . . . . . . . . . . . . . . . . . . . . 62,800

Total assets . . . . . . . . . . . . . . . . . . . . $240,200 Total liabilities and equity . . . . . . . . . . . . . . $240,200

* These are short-term notes receivable arising from customer (trade) sales.

CABOT CORPORATION

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . $448,600

Cost of goods sold . . . . . . . . . . 297,250

Gross profit . . . . . . . . . . . . . . . . 151,350

Operating expenses . . . . . . . . . 98,600

Interest expense . . . . . . . . . . . . 4,100

Income before taxes . . . . . . . . . 48,650

Income taxes . . . . . . . . . . . . . . . 19,598

Net income . . . . . . . . . . . . . . . . $ 29,052

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600 Chapter 13 Analysis of Financial Statements

Barco Kyan Barco Kyan

Company Company Company Company

Data from the current year-end balance sheets Data from the current year’s income statement

Assets Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $770,000 $880,200

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,500 $ 34,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . 585,100 632,500

Accounts receivable, net . . . . . . . . . . . . . . . 37,400 57,400 Interest expense . . . . . . . . . . . . . . . . . . . . . . 7,900 13,000

Current notes receivable (trade) . . . . . . . . 9,100 7,200 Income tax expense . . . . . . . . . . . . . . . . . . . 14,800 24,300

Merchandise inventory . . . . . . . . . . . . . . . . 84,440 132,500 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 162,200 210,400

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 5,000 6,950 Basic earnings per share . . . . . . . . . . . . . . . . 4.51 5.11

Plant assets, net . . . . . . . . . . . . . . . . . . . . . . 290,000 304,400

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $445,440 $542,450

Beginning-of-year balance sheet data

Liabilities and Equity Accounts receivable, net . . . . . . . . . . . . . . . . $ 29,800 $ 54,200

Current liabilities . . . . . . . . . . . . . . . . . . . . . $ 61,340 $ 93,300 Current notes receivable (trade) . . . . . . . . . 0 0

Long-term notes payable . . . . . . . . . . . . . . . 80,800 101,000 Merchandise inventory . . . . . . . . . . . . . . . . . 55,600 107,400

Common stock, $5 par value . . . . . . . . . . . 180,000 206,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . 398,000 382,500

Retained earnings . . . . . . . . . . . . . . . . . . . . 123,300 142,150 Common stock, $5 par value . . . . . . . . . . . . 180,000 206,000

Total liabilities and equity . . . . . . . . . . . . . . $445,440 $542,450 Retained earnings . . . . . . . . . . . . . . . . . . . . . 98,300 93,600

Debit Credit

a. Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,000

b. Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 34,000

c. Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,850

d. Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000

e. Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106,400

f. Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,600

g. Gain from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000

h. Accumulated depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174,500

i. Loss from operating a discontinued segment (pretax) . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,250

j. Gain on insurance recovery of tornado damage (pretax and extraordinary) . . . . . . . . . 29,120

k. Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 998,500

l. Depreciation expense—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000

m. Correction of overstatement of prior year’s sales (pretax) . . . . . . . . . . . . . . . . . . . . . . . 16,000

n. Gain on sale of discontinued segment’s assets (pretax) . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000

o. Loss from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,750

p. Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?

q. Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482,500

Required

1. For both companies compute the (a) current ratio, (b) acid-test ratio, (c) accounts (including notes) re- ceivable turnover, (d ) inventory turnover, (e) days’ sales in inventory, and ( f ) days’ sales uncollected. Identify the company you consider to be the better short-term credit risk and explain why. Round to one decimal place.

2. For both companies compute the (a) profit margin ratio, (b) total asset turnover, (c) return on total as- sets, and (d ) return on common stockholders’ equity. Assuming that each company paid cash divi- dends of $3.80 per share and each company’s stock can be purchased at $75 per share, compute their (e) price-earnings ratios and ( f ) dividend yields. Round to one decimal place. Identify which compa- ny’s stock you would recommend as the better investment and explain why.

Check (1) Kyan: Accounts receivable turnover, 14.8; Inventory turnover, 5.3

(2) Barco: Profit margin, 21.1%; PE, 16.6

Problem 13-6AA

Income statement computations and format

A2

Selected account balances from the adjusted trial balance for Olinda Corporation as of its calendar year- end December 31, 2013, follow.

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Chapter 13 Analysis of Financial Statements 601

Required

Answer each of the following questions by providing supporting computations. 1. Assume that the company’s income tax rate is 30% for all items. Identify the tax effects and after-tax

amounts of the four items labeled pretax. 2. What is the amount of income from continuing operations before income taxes? What is the amount of

the income taxes expense? What is the amount of income from continuing operations? 3. What is the total amount of after-tax income (loss) associated with the discontinued segment? 4. What is the amount of income (loss) before the extraordinary items? 5. What is the amount of net income for the year?

Check (3) $11,025

(4) $221,375

(5) $241,759

Selected comparative financial statement information of Bluegrass Corporation follows. PROBLEM SET B

Problem 13-1B Ratios, common-size statements, and trend percents

P1 P2 P3

BLUEGRASS CORPORATION

Comparative Balance Sheets

December 31, 2014, 2013, and 2012

2014 2013 2012

Assets

Current assets . . . . . . . . . . . . . . . . . . $ 54,860 $ 32,660 $ 36,300

Long-term investments . . . . . . . . . . . 0 1,700 10,600

Plant assets, net . . . . . . . . . . . . . . . . . 112,810 113,660 79,000

Total assets . . . . . . . . . . . . . . . . . . . . $167,670 $148,020 $125,900

Liabilities and Equity

Current liabilities . . . . . . . . . . . . . . . $ 22,370 $ 19,180 $ 16,500

Common stock . . . . . . . . . . . . . . . . . 46,500 46,500 37,000

Other paid-in capital . . . . . . . . . . . . . 13,850 13,850 11,300

Retained earnings . . . . . . . . . . . . . . . 84,950 68,490 61,100

Total liabilities and equity . . . . . . . . . $167,670 $148,020 $125,900

BLUEGRASS CORPORATION

Comparative Income Statements

For Years Ended December 31, 2014, 2013, and 2012

2014 2013 2012

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $198,800 $166,000 $143,800

Cost of goods sold . . . . . . . . . . . . . 108,890 86,175 66,200

Gross profit . . . . . . . . . . . . . . . . . . . 89,910 79,825 77,600

Selling expenses . . . . . . . . . . . . . . . 22,680 19,790 18,000

Administrative expenses . . . . . . . . . 16,760 14,610 15,700

Total expenses . . . . . . . . . . . . . . . . 39,440 34,400 33,700

Income before taxes . . . . . . . . . . . . 50,470 45,425 43,900

Income taxes . . . . . . . . . . . . . . . . . . 6,050 5,910 5,300

Net income . . . . . . . . . . . . . . . . . . . $ 44,420 $ 39,515 $ 38,600

Required

1. Compute each year’s current ratio. (Round ratio amounts to one decimal.) 2. Express the income statement data in common-size percents. (Round percents to two decimals.) 3. Express the balance sheet data in trend percents with 2012 as the base year. (Round percents to two

decimals.)

Analysis Component

4. Comment on any significant relations revealed by the ratios and percents computed.

Check (3) 2014, Total assets trend, 133.18%

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602 Chapter 13 Analysis of Financial Statements

Required

1. Compute trend percents for all components of both statements using 2008 as the base year. (Round percents to one decimal.)

Analysis Component

2. Analyze and comment on the financial statements and trend percents from part 1.

Problem 13-2B Calculation and analysis of trend percents

A1 P1

Problem 13-3B Transactions, working capital, and liquidity ratios P3

Selected comparative financial statements of Tripoly Company follow.

Koto Corporation began the month of June with $300,000 of current assets, a current ratio of 2.5:1, and an acid-test ratio of 1.4:1. During the month, it completed the following transactions (the company uses a perpetual inventory system).

June 1 Sold merchandise inventory that cost $75,000 for $120,000 cash. 3 Collected $88,000 cash on an account receivable. 5 Purchased $150,000 of merchandise inventory on credit. 7 Borrowed $100,000 cash by giving the bank a 60-day, 10% note. 10 Borrowed $120,000 cash by signing a long-term secured note. 12 Purchased machinery for $275,000 cash. 15 Declared a $1 per share cash dividend on its 80,000 shares of outstanding common stock. 19 Wrote off a $5,000 bad debt against the Allowance for Doubtful Accounts account. 22 Paid $12,000 cash to settle an account payable. 30 Paid the dividend declared on June 15.

Required

Prepare a table showing the company’s (1) current ratio, (2) acid-test ratio, and (3) working capital after each transaction. Round ratios to two decimals.

TRIPOLY COMPANY

Comparative Income Statements

For Years Ended December 31, 2014–2008

($ thousands) 2014 2013 2012 2011 2010 2009 2008

Sales . . . . . . . . . . . . . . . . . . . . . $560 $610 $630 $680 $740 $770 $860

Cost of goods sold . . . . . . . . . 276 290 294 314 340 350 380

Gross profit . . . . . . . . . . . . . . . 284 320 336 366 400 420 480

Operating expenses . . . . . . . . 84 104 112 126 140 144 150

Net income . . . . . . . . . . . . . . . $200 $216 $224 $240 $260 $276 $330

TRIPOLY COMPANY

Comparative Balance Sheets

December 31, 2014–2008

($ thousands) 2014 2013 2012 2011 2010 2009 2008

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 44 $ 46 $ 52 $ 54 $ 60 $ 62 $ 68

Accounts receivable, net . . . . . . . . . 130 136 140 144 150 154 160

Merchandise inventory . . . . . . . . . . 166 172 178 180 186 190 208

Other current assets . . . . . . . . . . . 34 34 36 38 38 40 40

Long-term investments . . . . . . . . . . 36 30 26 110 110 110 110

Plant assets, net . . . . . . . . . . . . . . . . 510 514 520 412 420 428 454

Total assets . . . . . . . . . . . . . . . . . . . $920 $932 $952 $938 $964 $984 $1,040

Liabilities and Equity

Current liabilities . . . . . . . . . . . . . . $148 $156 $186 $190 $210 $260 $280

Long-term liabilities . . . . . . . . . . . . 92 120 142 148 194 214 260

Common stock . . . . . . . . . . . . . . . . 160 160 160 160 160 160 160

Other paid-in capital . . . . . . . . . . . . 70 70 70 70 70 70 70

Retained earnings . . . . . . . . . . . . . . 450 426 394 370 330 280 270

Total liabilities and equity . . . . . . . . $920 $932 $952 $938 $964 $984 $1,040

Check (1) 2014, Total assets trend, 88.5%

Check June 1: Current ratio, 2.88; Acid-test ratio, 2.40

June 30: Working capital, $(10,000); Current ratio, 0.97

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Chapter 13 Analysis of Financial Statements 603

Problem 13-4B Calculation of financial statement ratios

P3

Selected year-end financial statements of Overton Corporation follow. (All sales were on credit; selected balance sheet amounts at December 31, 2012, were inventory, $17,400; total assets, $94,900; common stock, $35,500; and retained earnings, $18,800.)

Required

Compute the following: (1) current ratio, (2) acid-test ratio, (3) days’ sales uncollected, (4) inventory turn- over, (5) days’ sales in inventory, (6) debt-to-equity ratio, (7) times interest earned, (8) profit margin ratio, (9) total asset turnover, (10) return on total assets, and (11) return on common stockholders’ equity. Round to one decimal place, except for part 6 round to two decimals.

Check Acid-test ratio, 1.6 to 1; Inventory turnover, 15.3

OVERTON CORPORATION

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . $315,500 Cost of goods sold . . . . . . . . . . 236,100 Gross profit . . . . . . . . . . . . . . . . 79,400 Operating expenses . . . . . . . . . 49,200 Interest expense . . . . . . . . . . . . 2,200 Income before taxes . . . . . . . . . 28,000 Income taxes . . . . . . . . . . . . . . . 4,200 Net income . . . . . . . . . . . . . . . . $ 23,800

OVERTON CORPORATION

Balance Sheet

December 31, 2013

Assets Liabilities and Equity

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100 Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 11,500 Short-term investments . . . . . . . . . . 6,900 Accrued wages payable . . . . . . . . . . . . . . . . 3,300 Accounts receivable, net . . . . . . . . . . 12,100 Income taxes payable . . . . . . . . . . . . . . . . . 2,600 Notes receivable (trade)* . . . . . . . . . 3,000 Long-term note payable, secured Merchandise inventory . . . . . . . . . . . 13,500 by mortgage on plant assets . . . . . . . . . . 30,000

Prepaid expenses . . . . . . . . . . . . . . . 2,000 Common stock, $5 par value . . . . . . . . . . . 35,000

Plant assets, net . . . . . . . . . . . . . . . . . 73,900 Retained earnings . . . . . . . . . . . . . . . . . . . . 35,100

Total assets . . . . . . . . . . . . . . . . . . . . $117,500 Total liabilities and equity . . . . . . . . . . . . . . $117,500

* These are short-term notes receivable arising from customer (trade) sales.

Fargo Ball Fargo Ball

Company Company Company Company

Data from the current year-end balance sheets Data from the current year’s income statement Assets Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $393,600 $667,500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 36,500 Cost of goods sold . . . . . . . . . . . . . . . . . . . . 290,600 480,000 Accounts receivable, net . . . . . . . . . . . . . . . 77,100 70,500 Interest expense . . . . . . . . . . . . . . . . . . . . . . 5,900 12,300 Current notes receivable (trade) . . . . . . . . 11,600 9,000 Income tax expense . . . . . . . . . . . . . . . . . . . 5,700 12,300 Merchandise inventory . . . . . . . . . . . . . . . . 86,800 82,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 33,850 61,700 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 9,700 10,100 Basic earnings per share . . . . . . . . . . . . . . . . 1.27 2.19 Plant assets, net . . . . . . . . . . . . . . . . . . . . . . 176,900 252,300 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $382,100 $460,400

Beginning-of-year balance sheet data Liabilities and Equity Accounts receivable, net . . . . . . . . . . . . . . . . $ 72,200 $ 73,300 Current liabilities . . . . . . . . . . . . . . . . . . . . . $ 90,500 $ 97,000 Current notes receivable (trade) . . . . . . . . . 0 0 Long-term notes payable . . . . . . . . . . . . . . . 93,000 93,300 Merchandise inventory . . . . . . . . . . . . . . . . . 105,100 80,500 Common stock, $5 par value . . . . . . . . . . . 133,000 141,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . 383,400 443,000 Retained earnings . . . . . . . . . . . . . . . . . . . . 65,600 129,100 Common stock, $5 par value . . . . . . . . . . . . 133,000 141,000 Total liabilities and equity . . . . . . . . . . . . . . $382,100 $460,400 Retained earnings . . . . . . . . . . . . . . . . . . . . . 49,100 109,700

Problem 13-5B Comparative ratio analysis

A1 P3

Summary information from the financial statements of two companies competing in the same industry follows.

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604 Chapter 13 Analysis of Financial Statements

Required

1. For both companies compute the (a) current ratio, (b) acid-test ratio, (c) accounts (including notes) receivable turnover, (d ) inventory turnover, (e) days’ sales in inventory, and ( f ) days’ sales uncollected. Identify the company you consider to be the better short-term credit risk and explain why. Round to one decimal place.

2. For both companies compute the (a) profit margin ratio, (b) total asset turnover, (c) return on total assets, and (d ) return on common stockholders’ equity. Assuming that each company paid cash dividends of $1.50 per share and each company’s stock can be purchased at $25 per share, compute their (e) price- earnings ratios and ( f ) dividend yields. Round to one decimal place, except for part b round to two deci- mals. Identify which company’s stock you would recommend as the better investment and explain why.

Check (1) Fargo: Accounts receivable turnover, 4.9; Inventory turnover, 3.0

(2) Ball: Profit margin, 9.2%; PE, 11.4

Problem 13-6BA

Income statement computations and format

A2

Selected account balances from the adjusted trial balance for Harbor Corp. as of its calendar year-end December 31, 2013, follow.

Debit Credit

a. Accumulated depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400,000 b. Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 c. Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,640,000 d. Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ? e. Loss on hurricane damage (pretax and extraordinary) . . . . . . . . . . . . . . . 64,000 f. Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 g. Other operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328,000 h. Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 i. Loss from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000 j. Gain from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000 k. Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 l. Loss from operating a discontinued segment (pretax) . . . . . . . . . . . . . . . 120,000 m. Depreciation expense—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156,000 n. Correction of overstatement of prior year’s expense (pretax) . . . . . . . . . 48,000 o. Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,040,000 p. Loss on sale of discontinued segment’s assets (pretax) . . . . . . . . . . . . . . . 180,000 q. Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,000

Required

Answer each of the following questions by providing supporting computations. 1. Assume that the company’s income tax rate is 25% for all items. Identify the tax effects and after-tax

amounts of the four items labeled pretax. 2. What is the amount of income from continuing operations before income taxes? What is the amount of

income taxes expense? What is the amount of income from continuing operations? 3. What is the total amount of after-tax income (loss) associated with the discontinued segment? 4. What is the amount of income (loss) before the extraordinary items? 5. What is the amount of net income for the year?

Check (3) $(225,000)

(4) $558,000

(5) $510,000

SERIAL PROBLEM Success Systems

P3

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 13 Use the following selected data from Success Systems’ income statement for the three months ended March 31, 2014, and from its March 31, 2014, balance sheet to complete the requirements below: computer services revenue, $25,160; net sales (of goods), $18,693; total sales and revenue, $43,853; cost of goods sold, $14,052; net income, $18,686; quick assets, $100,205; current assets, $105,209; total assets, $129,909; current liabilities, $875; total liabilities, $875; and total equity, $129,034.

Required

1. Compute the gross margin ratio (both with and without services revenue) and net profit margin ratio (round the percent to one decimal).

2. Compute the current ratio and acid-test ratio (round to one decimal). 3. Compute the debt ratio and equity ratio (round the percent to one decimal). 4. What percent of its assets are current? What percent are long term (round the percent to one decimal)?

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Chapter 13 Analysis of Financial Statements 605

Beyond the Numbers

BTN 13-1 Refer to Polaris financial statements in Appendix A to answer the following. 1. Using fiscal 2009 as the base year, compute trend percents for fiscal years 2009, 2010, and 2011 for

revenues, cost of sales, operating income, non-operating expenses, income taxes, and net income. (Round percents to one decimal.)

2. Compute common-size percents for fiscal years 2010 and 2011 for the following categories of assets: (a) total current assets, (b) property and equipment, net, and (c) goodwill and other intangible assets. (Round percents to one decimal.)

3. Comment on any notable changes across the years for the income statement trends computed in part 1 and the balance sheet percents computed in part 2.

Fast Forward

4. Access Polaris’ financial statements for fiscal years ending after December 31, 2011, from its Website (Polaris.com) or the SEC database (www.sec.gov). Update your work for parts 1, 2, and 3 using the new information accessed.

REPORTING IN ACTION A1 P1 P2

BTN 13-3 As Beacon Company controller, you are responsible for informing the board of directors about its financial activities. At the board meeting, you present the following information.

ETHICS CHALLENGE A1

2013 2012 2011

Sales trend percent . . . . . . . . . . . . . . . . . . 147.0% 135.0% 100.0%

Selling expenses to sales . . . . . . . . . . . . . . 10.1% 14.0% 15.6%

Sales to plant assets ratio . . . . . . . . . . . . . 3.8 to 1 3.6 to 1 3.3 to 1

Current ratio . . . . . . . . . . . . . . . . . . . . . . 2.9 to 1 2.7 to 1 2.4 to 1

Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . 1.1 to 1 1.4 to 1 1.5 to 1

Inventory turnover . . . . . . . . . . . . . . . . . . 7.8 times 9.0 times 10.2 times

Accounts receivable turnover . . . . . . . . . 7.0 times 7.7 times 8.5 times

Total asset turnover . . . . . . . . . . . . . . . . . 2.9 times 2.9 times 3.3 times

Return on total assets . . . . . . . . . . . . . . . 10.4% 11.0% 13.2%

Return on stockholders’ equity. . . . . . . . . 10.7% 11.5% 14.1%

Profit margin ratio . . . . . . . . . . . . . . . . . . . 3.6% 3.8% 4.0%

BTN 13-2 Key figures for Polaris and Arctic Cat follow. COMPARATIVE ANALYSIS C2 P2

Required

1. Compute common-size percents for each of the companies using the data provided. (Round percents to one decimal.)

2. Which company retains a higher portion of cumulative net income in the company? 3. Which company has a higher gross margin ratio on sales? 4. Which company holds a higher percent of its total assets as inventory?

($ thousands) Polaris Arctic Cat

Cash and equivalents . . . . . . . . . . . $ 325,336 $ 14,700

Accounts receivable, net . . . . . . . . . 115,302 23,732

Inventories . . . . . . . . . . . . . . . . . . . 298,042 61,478

Retained earnings . . . . . . . . . . . . . . 321,831 177,493

Cost of sales . . . . . . . . . . . . . . . . . . 1,916,366 363,142

Revenues . . . . . . . . . . . . . . . . . . . . . 2,656,949 464,651

Total assets . . . . . . . . . . . . . . . . . . . 1,228,024 272,906

Polaris

Polaris Arctic Cat

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606 Chapter 13 Analysis of Financial Statements

After the meeting, the company’s CEO holds a press conference with analysts in which she mentions the following ratios.

Required

1. Why do you think the CEO decided to report 4 ratios instead of the 11 prepared? 2. Comment on the possible consequences of the CEO’s reporting of the ratios selected.

2013 2012 2011

Sales trend percent . . . . . . . . . . . . . . 147.0% 135.0% 100.0%

Selling expenses to sales . . . . . . . . . . 10.1% 14.0% 15.6%

Sales to plant assets ratio . . . . . . . . . 3.8 to 1 3.6 to 1 3.3 to 1

Current ratio . . . . . . . . . . . . . . . . . . 2.9 to 1 2.7 to 1 2.4 to 1

BTN 13-4 Each team is to select a different industry, and each team member is to select a different com- pany in that industry and acquire its financial statements. Use those statements to analyze the company, including at least one ratio from each of the four building blocks of analysis. When necessary, use the financial press to determine the market price of its stock. Communicate with teammates via a meeting, e-mail, or telephone to discuss how different companies compare to each other and to industry norms. The team is to prepare a single one-page memorandum reporting on its analysis and the conclusions reached.

COMMUNICATING IN PRACTICE A1 P3

BTN 13-5 Access the February 17, 2012, filing of the December 31, 2011, 10-K report of The Hershey Company (ticker HSY) at www.sec.gov and complete the following requirements.

Required

Compute or identify the following profitability ratios of Hershey for its years ending December 31, 2011, and December 31, 2010. Interpret its profitability using the results obtained for these two years. 1. Profit margin ratio (round the percent to one decimal). 2. Gross profit ratio (round the percent to one decimal). 3. Return on total assets (round the percent to one decimal). (Total assets at year-end 2009 were

$3,675,031,000.) 4. Return on common stockholders’ equity (round the percent to one decimal). (Total shareholders’ eq-

uity at year-end 2009 was $760,339,000.) 5. Basic net income per common share (round to the nearest cent).

TAKING IT TO THE NET P3

BTN 13-7 Assume that David and Tom Gardner of The Motley Fool (Fool.com) have impressed you since you first heard of their rather improbable rise to prominence in financial circles. You learn of a staff opening at The Motley Fool and decide to apply for it. Your resume is successfully screened from the thousands received and you advance to the interview process. You learn that the interview consists of ana- lyzing the following financial facts and answering analysis questions below. (The data are taken from a small merchandiser in outdoor recreational equipment.)

ENTREPRENEURIAL DECISION A1 P1 P2 P3

BTN 13-6 A team approach to learning financial statement analysis is often useful.

Required

1. Each team should write a description of horizontal and vertical analysis that all team members agree with and understand. Illustrate each description with an example.

2. Each member of the team is to select one of the following categories of ratio analysis. Explain what the ratios in that category measure. Choose one ratio from the category selected, present its formula, and explain what it measures.

a. Liquidity and efficiency c. Profitability b. Solvency d. Market prospects 3. Each team member is to present his or her notes from part 2 to teammates. Team members are to con-

firm or correct other teammates’ presentation.

TEAMWORK IN ACTION P1 P2 P3

Hint: Pairing within teams may be nec- essary for part 2. Use as an in-class activity or as an assignment. Consider presentations to the entire class using team rotation with transparencies.

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Required

Use these data to answer each of the following questions with explanations. 1. Is it becoming easier for the company to meet its current liabilities on time and to take advantage of

any available cash discounts? Explain. 2. Is the company collecting its accounts receivable more rapidly? Explain. 3. Is the company’s investment in accounts receivable decreasing? Explain. 4. Is the company’s investment in plant assets increasing? Explain. 5. Is the owner’s investment becoming more profitable? Explain. 6. Did the dollar amount of selling expenses decrease during the three-year period? Explain.

Chapter 13 Analysis of Financial Statements 607

2012 2011 2010

Sales trend percents . . . . . . . . . . . . . . . . . . 137.0% 125.0% 100.0% Selling expenses to sales . . . . . . . . . . . . . . . 9.8% 13.7% 15.3% Sales to plant assets ratio . . . . . . . . . . . . . . 3.5 to 1 3.3 to 1 3.0 to 1 Current ratio . . . . . . . . . . . . . . . . . . . . . . . 2.6 to 1 2.4 to 1 2.1 to 1 Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . 0.8 to 1 1.1 to 1 1.2 to 1 Merchandise inventory turnover . . . . . . . . 7.5 times 8.7 times 9.9 times Accounts receivable turnover . . . . . . . . . . 6.7 times 7.4 times 8.2 times Total asset turnover . . . . . . . . . . . . . . . . . . 2.6 times 2.6 times 3.0 times Return on total assets . . . . . . . . . . . . . . . . 8.8% 9.4% 11.1% Return on equity . . . . . . . . . . . . . . . . . . . . . 9.75% 11.50% 12.25% Profit margin ratio . . . . . . . . . . . . . . . . . . . . 3.3% 3.5% 3.7%

BTN 13-8 You are to devise an investment strategy to enable you to accumulate $1,000,000 by age 65. Start by making some assumptions about your salary. Next compute the percent of your salary that you will be able to save each year. If you will receive any lump-sum monies, include those amounts in your calculations. Historically, stocks have delivered average annual returns of 10–11%. Given this history, you should probably not assume that you will earn above 10% on the money you invest. It is not necessary to specify exactly what types of assets you will buy for your investments; just assume a rate you expect to earn. Use the future value tables in Appendix B to calculate how your savings will grow. Experiment a bit with your figures to see how much less you have to save if you start at, for example, age 25 versus age 35 or 40. (For this assignment, do not include inflation in your calculations.)

HITTING THE ROAD C1 P3

BTN 13-9 KTM (www.KTM.com), which is a leading manufacturer of offroad and street motorcycles, along with Polaris and Arctic Cat, are competitors in the global marketplace. Key figures for KTM follow (in Euro thousands).

Required

1. Compute common-size percents for KTM using the data provided. (Round percents to one decimal.) 2. Compare the results with Polaris and Arctic Cat from BTN 13-2.

GLOBAL DECISION A1

Cash and equivalents . . . . . . . . . . . 14,962 Accounts receivable, net . . . . . . . . . 53,594 Inventories . . . . . . . . . . . . . . . . . . . 113,979 Retained earnings . . . . . . . . . . . . . . 208,987 Cost of sales . . . . . . . . . . . . . . . . . . 371,752 Revenues . . . . . . . . . . . . . . . . . . . . . 526,801 Total assets . . . . . . . . . . . . . . . . . . . 485,775

1. d; ($351,000y$300,000) 3 100 5 117% 2. e; ($86,000 1 $76,000 1 $122,000 1 $12,000)y$124,000 5 2.39 3. c; ($86,000 1 $76,000)y$124,000 5 1.31

4. a; ($124,000 1 $90,000)y$830,000 5 25.78% 5. d; ($300,000 1 $316,000)y$830,000 5 74.22%

ANSWERS TO MULTIPLE CHOICE QUIZ

Polaris KTM

Arctic Cat

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Learning Objectives

CONCEPTUAL

C1 Explain the purpose and nature of, and the role of ethics in, managerial accounting. (p. 610)

C2 Describe accounting concepts useful in classifying costs. (p. 614) C3 Define product and period costs and explain how they impact financial

statements. (p. 616)

C4 Explain how balance sheets and income statements for manufacturing and merchandising companies differ. (p. 619)

C5 Explain manufacturing activities and the flow of manufacturing costs. (p. 622) C6 Describe trends in managerial accounting. (p. 625)

ANALYTICAL

A1 Assess raw materials inventory management using raw materials inventory turnover and days’ sales in raw materials inventory. (p. 628)

PROCEDURAL

P1 Compute cost of goods sold for a manufacturer. (p. 620) P2 Prepare a manufacturing statement and explain its purpose and links to financial

statements. (p. 623)

A Look at This Chapter

We begin our study of managerial accounting by explaining its purpose and describing its major characteristics. We also discuss cost concepts and describe how they help managers gather and orga- nize information for making decisions. The reporting of manufacturing activities is also discussed.

A Look Back

Chapter 13 described the analysis and interpretation of financial statement information. We applied horizontal, vertical, and ratio analyses to better understand company performance and financial condition.

Managerial Accounting Concepts and Principles 14

A Look Ahead

The remaining chapters discuss the types of decisions managers must make and how managerial accounting helps with those decisions. The first of these chap ters, Chap ter 15, considers how we mea sure costs assigned to certain types of projects.

608

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Fun-guys

OAKLAND, CA—Nearing college graduation, Alex Velez and Nikhil Arora spurned the glamor of investment banking for a more down-to-earth calling: urban mushroom farming using coffee grounds. Complete strangers, each was intrigued by the idea of turning waste into food (and wages). “We both fell in love with the idea of using coffee waste and started doing research and brainstorming,” says Nikhil. After researching mushroom- growing techniques and determining there was a demand for their product, the duo wrote up a business plan, set up a mana- gerial accounting system, and began farming. The result is Back to the Roots (backtotheroots.com), a socially conscious com- pany with estimated 2012 revenues of over $5 million. The company’s production process begins with several thou- sand pounds of used coffee grounds that local coffee shops would typically discard. The company’s second key raw material, mushroom seeds, is then added to the coffee grounds. The pas- sage of time and moisture combine with the coffee grounds and mushroom seeds to yield delicious mushrooms in as little as 10 days. Then, the used coffee grounds and mushroom roots are packaged and sold as mulch for landscaping. This simple, sustainable production process “starts with waste and creates delicious food and fertile mulch,” explains Alex. Alex and Nikhil stress that college is the best time to start a new business. Risk is low, and “if the owners are passionate and have a good plan, someone will provide financing to get the busi- ness going,” says Nikhil. In Back to the Roots’ case, $5,000 of start-up financing was provided by a contest for social innovation

sponsored by their college. In addition to passion and seed money, the owners stress that understanding basic managerial principles, product and period costs, manufacturing statements, and cost flow is critical. Managerial accounting information en- ables the owners to monitor and control costs and make good decisions. An understanding of costs and a keen eye for demand led the owners to ask, as Alex explains, “whether we could take this one step more and enable people to grow mushrooms at home.” The company now sells Grow-Your-Own Mushroom Gardens for home use. Alex and Nikhil believe that entrepreneurs fill a void by creating a niche. While financial success depends on monitoring and con- trolling operations to best meet customers’ needs, the owners measure success by more than just profits. “For 2011, we col- lected and diverted over 1 million pounds of coffee grounds from landfill and enabled families to grow over 250,000 pounds of fresh food. In 2012, we’ve already been collecting 40,000 lbs. per week,” exclaims Nikhil. Now, Alex and Nikhil hope to continue to grow their business, while staying focused on sustainability, healthy communities, and green development. Insists Nikhil, “our goal is to show people that you can create a successful company and create a positive impact in the community.”

[Sources: Back to the Roots Website, January 2013; Bloomberg Business Week, http://images.businessweek.com/ss/09/10/1009_entrepreneurs_25_ and_under/4.htm; Whole Foods Market Blog, August 20, 2011; White House Champions of Change blog, August 8, 2011, posted by Ari Matusiak.]

“We didn’t even know what a good mushroom tasted like.“ —NIKHIL ARORA (on right)

Decision Insight

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Chapter Preview

Managerial accounting, like financial accounting, provides infor- mation to help users make better decisions. However, manage- rial accounting and financial accounting differ in important ways, which this chapter explains. This chapter also compares the ac- counting and reporting practices used by manufacturing and mer- chandising companies. A merchandising company sells products with out changing their condition. A manufacturing company buys

raw materials and turns them into finished products for sale to customers. A third type of company earns revenues by providing services rather than products. The skills, tools, and techniques developed for measuring a manufacturing company’s activities apply to service companies as well. The chapter concludes by explaining the flow of manufacturing activities and preparing the manufacturing statement.

Managerial accounting is an activity that provides financial and nonfinancial information to an organization’s managers and other internal decision makers. This section explains the pur pose of managerial accounting (also called management accounting) and compares it with financial accounting. The main purpose of the financial accounting system is to prepare general-purpose financial statements. That information is incomplete for internal decision makers who manage organizations.

Purpose of Managerial Accounting The purpose of both managerial accounting and financial accounting is providing useful infor- mation to decision makers. They do this by collecting, managing, and reporting information in demand by their users. Both areas of accounting also share the common practice of reporting monetary information, although managerial accounting usually includes the reporting of more nonmonetary information. They even report some of the same information. For instance, a com- pany’s financial statements contain information useful for both its managers (insiders) and other persons interested in the company (outsiders). The remainder of this book looks carefully at managerial accounting information, how to gather it, and how managers use it. We consider the concepts and procedures used to determine the costs of products and services as well as topics such as budgeting, break-even analysis, product costing, profit planning, and cost analysis. Information about the costs of products and services is important for many decisions that managers make. These decisions include predict- ing the future costs of a product or service. Predicted costs are used in product pricing, profit- ability analysis, and in deciding whether to make or buy a product or component. More generally, much of managerial accounting involves gathering information about costs for plan- ning and control decisions. Planning is the process of setting goals and making plans to achieve them. Companies for- mulate long-term strategic plans that usually span a 5- to 10-year horizon and then refine them with medium-term and short-term plans. Strategic plans usually set a firm’s long-term direction by developing a road map based on opportunities such as new products, new markets, and capi- tal investments. A strategic plan’s goals and objectives are broadly defined given its long-term

MANAGERIAL ACCOUNTING BASICS

Managerial Accounting Concepts and Principles

Managerial Cost Concepts

• Types of cost classifications • Identification of cost

classifications • Cost concepts for service

companies

Managerial Accounting Basics

• Purpose of managerial accounting • Nature of managerial accounting • Managerial decisions • Fraud and ethics in managerial

accounting

Reporting Manufacturing Activities

• Manufacturer costs • Balance sheet • Income statement • Flow of activities • Manufacturing statement • Managerial accounting trends

C1 Explain the purpose and nature of, and the role of ethics in, managerial accounting.

Point: Nonfinancial information, also called nonmonetary information, includes customer and employee satisfaction data, the percentage of on-time deliveries, and product defect rates.

Point: Costs are important to manag- ers because they impact both the finan- cial position and profitability of a business. Managerial accounting assists in analysis, planning, and control of costs.

610

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Chapter 14 Managerial Accounting Concepts and Principles 611

EXHIBIT 14.1 Planning and Control (including monitoring and feedback)

Monitoring

Feedback

Planning • Strategic aims • Long- & short-term • Annual budgets

Control • Measurement • Evaluation • Oversight

EXHIBIT 14.2 Key Differences between Managerial Accounting and Financial Accounting

Investors, creditors, and other users external to the organization

Assist external users in making investment, credit, and other decisions

Structured and often controlled by GAAP

Often available only after an audit is complete

Focus on historical information with some predictions

Emphasis on whole organization

Monetary information

1. Users and decision makers

2. Purpose of information

3. Flexibility of practice

4. Timeliness of information

5. Time dimension

6. Focus of information

7. Nature of information

Managers, employees, and decision makers internal to the organization

Assist managers in making planning and control decisions

Relatively flexible (no GAAP constraints)

Available quickly without the need to wait for an audit

Many projections and estimates; historical information also presented

Emphasis on an organization’s projects, processes, and subdivisions

Mostly monetary; but also nonmonetary information

Financial Accounting Managerial Accounting

"This company's outlook is good.

I'll buy its stock."

"This department is doing well.

We'll expand its product line."

orientation. Medium- and short-term plans are more operational in nature. They translate the strategic plan into actions. These plans are more concrete and consist of better defined objec- tives and goals. A short-term plan often covers a one-year period that, when translated in monetary terms, is known as a budget. Control is the process of monitoring planning decisions and evaluating an organization’s activities and employees. It includes the measurement and evaluation of actions, processes, and outcomes. Feedback pro vided by the control function allows managers to revise their plans. Mea surement of actions and processes also allows managers to take corrective actions to avoid undesirable outcomes. For example, managers periodically compare actual results with planned results. Exhibit 14.1 portrays the important management functions of planning and control.

Managers use information to plan and control business activities. In later chapters, we explain how managers also use this information to direct and improve business operations.

Nature of Managerial Accounting Managerial accounting has its own special characteristics. To understand these characteristics, we compare managerial accounting to financial accounting; they differ in at least seven impor- tant ways. These differences are summarized in Exhibit 14.2. This section discusses each of these characteristics.

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612 Chapter 14 Managerial Accounting Concepts and Principles

Users and Decision Makers Companies accumulate, process, and report financial ac- counting and managerial accounting information for different groups of decision makers. Finan- cial accounting information is provided primarily to external users including investors, creditors, analysts, and regulators. External users rarely have a major role in managing a company’s daily activities. Managerial accounting information is provided primarily to internal users who are re- sponsible for making and implementing decisions about a company’s business activities.

Purpose of Information Investors, creditors, and other external users of financial ac- counting information must often decide whether to invest in or lend to a company. If they have already done so, they must decide whether to continue owning the company or carrying the loan. Internal decision makers must plan a company’s future. They seek to take advantage of opportuni- ties or to overcome obstacles. They also try to control activities and ensure their effective and ef- ficient implementation. Managerial accounting information helps these internal users make both planning and control decisions.

Flexibility of Practice External users compare companies by using financial reports and need protection against false or misleading information. Accordingly, financial accounting re- lies on accepted principles that are enforced through an extensive set of rules and guidelines, or GAAP. Internal users need managerial accounting information for planning and controlling their company’s activities rather than for external comparisons. They require different types of information depending on the activity. This makes standardizing managerial accounting systems across companies difficult. Instead, managerial accounting systems are flexible. The design of a company’s managerial accounting system depends largely on the nature of the business and the arrangement of its internal operations. Managers can decide for themselves what information they want and how they want it reported. Even within a single company, different managers of- ten design their own systems to meet their special needs. The important question a manager must ask is whether the information being collected and reported is useful for planning, decision making, and control purposes.

Timeliness of Information Formal financial statements reporting past transactions and events are not immediately available to outside parties. Independent certified public accountants often must audit a company’s financial statements before it provides them to external users. Thus, because audits often take several weeks to complete, financial reports to outsiders usually are not available until well after the period-end. However, managers can quickly obtain manage- rial accounting information. External auditors need not review it. Estimates and projections are acceptable. To get information quickly, managers often accept less precision in reports. As an example, an early internal report to management prepared right after the year-end could report net income for the year between $4.2 and $4.8 million. An audited income statement could later show net income for the year at $4.6 million. The internal report is not precise, but its informa- tion can be more useful because it is available earlier.

Internal auditing plays an important role in managerial accounting. Internal auditors evaluate the flow of information not only inside but also outside the company. Managers are responsible for preventing and detecting fraudulent activities in their companies.

Time Dimension To protect external users from false expectations, financial reports deal primarily with results of both past activities and current conditions. While some predictions such as service lives and salvage values of plant assets are necessary, financial accounting avoids pre dictions whenever possible. Managerial accounting regularly includes predictions of condi- tions and events. As an example, one important managerial accounting report is a budget, which predicts revenues, expenses, and other items. If managerial accounting reports were restricted to the past and present, managers would be less able to plan activities and less effective in manag- ing and evaluating current activities.

Focus of Information Companies often organize into divisions and departments, but inves- tors rarely can buy shares in one division or department. Nor do creditors lend money to a compa- ny’s single division or department. Instead, they own shares in or make loans to the entire company. Financial accounting focuses primarily on a company as a whole as depicted in Exhibit 14.3. The focus of managerial accounting is different. While top-level managers are responsible for managing

Point: The Institute of Management Ac- countants issues statements that govern the practice of managerial accounting. Accountants who pass a qualifying exam are awarded the CMA.

Point: Financial statements are usually issued several weeks after the period- end. GAAP requires the reporting of important events that occur while the statements are being prepared. These events are called subsequent events.

Point: Independent auditors test the integrity of managerial accounting records when they are used in preparing financial statements.

Point: It is desirable to accumulate certain information for management reports in a database separate from financial accounting records.

EXHIBIT 14.3 Focus of External Reports

Company Performance

Company Performance

Reports to external users focus on company as a whole

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Chapter 14 Managerial Accounting Concepts and Principles 613

the whole company, most other managers are responsible for much smaller sets of activities. These middle-level and lower-level managers need managerial accounting reports dealing with specific activities, projects, and subdivisions for which they are responsible. For instance, division sales managers are directly responsible only for the results achieved in their divisions. Accordingly, divi- sion sales managers need information about results achieved in their own divisions to improve their performance. This information includes the level of success achieved by each individual, product, or department in each division of the whole company as depicted in Exhibit 14.4.

Nature of Information Both financial and managerial accounting systems report monetary information. Managerial accounting systems also report considerable nonmonetary information. Monetary information is an important part of managerial decisions, and nonmon- etary information plays a crucial role, especially when monetary effects are difficult to measure. Common examples of nonmonetary information are the quality and delivery criteria of purchas- ing decisions.

Managerial Decision Making The previous section emphasized differences between financial and managerial ac- counting, but they are not entirely separate. Similar information is useful to both external and internal users. For instance, information about costs of manufacturing products is useful to all users in making decisions. Also, both financial and manage- rial accounting affect peoples’ actions. For example, Trek’s design of a sales com- pensation plan affects the behavior of its salesforce when selling its manufactured bikes. It also must estimate the dual effects of promotion and sales compensation plans on buying patterns of customers. These estimates impact the equipment pur- chase decisions for manufacturing and can affect the supplier selection criteria es- tablished by purchasing. Thus, financial and managerial accounting systems do more than measure; they also affect people’s decisions and actions.

Fraud and Ethics in Managerial Accounting Fraud, and the role of ethics in reducing fraud, are important factors in running business operations. Fraud involves the use of one’s job for personal gain through the deliberate mis- use of the employer’s assets. Examples include theft of the employer’s cash or other assets, overstating reimbursable expenses, payroll schemes, and financial statement fraud. Three factors must exist for a person to commit fraud: opportunity, pressure, and rationalization. This is known as the fraud triangle. Fraud affects all business and it is costly: A 2010 Report to the Nation from the Association of Certified Fraud Examiners (ACFE) estimates the aver- age U.S. business loses 5% of its annual revenues to fraud. This report also shows that the frequency and average loss from fraud vary by industry; the mining industry has a relatively small number of frauds but a high ($1 million) average loss per fraud. The banking industry has the highest number (16.6%) of the total frauds reported in the current ACFE report. The most common type of fraud, where employees steal or misuse the employer’s resources, results in an average loss of $135,000 per occurrence. For example, in a billing fraud, an em- ployee sets up a bogus supplier. The employee then prepares bills from the supplier and pays these bills from the employer’s checking account. The employee cashes the checks sent to the bogus supplier and uses them for his or her own personal benefit.

Production Manager You invite three friends to a restaurant. When the dinner check arrives, David, a self-employed entrepreneur, picks it up saying, “Here, let me pay. I’ll deduct it as a business expense on my tax return.” Denise, a salesperson, takes the check from David’s hand and says, “I’ll put this on my compa- ny’s credit card. It won’t cost us anything.” Derek, a factory manager for a company, laughs and says, “Neither of you understands. I’ll put this on my company’s credit card and call it overhead on a cost-plus contract my company has with a client.” (A cost-plus contract means the company receives its costs plus a percent of those costs.) Adds Derek, “That way, my company pays for dinner and makes a profit.” Who should pay the bill? Why? ■ [Answer—p. 633]

Decision Ethics

O pp

or tu

ni ty

Rationalization

Financial Pressure

EXHIBIT 14.4 Focus of Internal Reports

Product Performance

Reports to internal users focus on company units and divisions, along with the company as a whole

M in in g

M an

uf ac

tu rin

g

Ba nk

in g

Pr of

. S er

vic es

Re ta

il $0

$400,000

$600,000

$800,000

$1,000,000

$1,200,000

$200,000

0.7%

10.7%

16.6% 2.8% 6.6%

Average Loss per Fraud Case (also shows Percent of All

Fraud Cases in that Industry)

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614 Chapter 14 Managerial Accounting Concepts and Principles

More generally, although there are many types of fraud schemes, all fraud:

● Is done to provide direct or indirect benefit to the employee. ● Violates the employee’s obligations to the employer. ● Costs the employer money or loss of other assets. ● Is hidden from the employer.

Implications for Managerial Accounting Fraud increases a business’s costs. Left undetected, these inflated costs can result in poor pricing decisions, an improper product mix, and faulty performance evaluations. Management can develop accounting systems to closely track costs and identify deviations from expected amounts. In addition, managers rely on an internal control system to monitor and control business activities. An internal control system is the policies and procedures managers use to:

● Urge adherence to company policies. ● Promote efficient operations. ● Ensure reliable accounting. ● Protect assets.

Combating fraud and other dilemmas requires ethics in accounting. Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior. Identify- ing the ethical path can be difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions. The Institute of Management Accountants (IMA), the professional association for man- agement accountants, has issued a code of ethics to help accountants involved in solving ethical dilemmas. The IMA’s Statement of Ethical Professional Practice requires that manage- ment accountants be competent, maintain confidentiality, act with integrity, and communicate information in a fair and credible manner. The IMA provides a “road map” for resolving ethical conflicts. It suggests that an employee follow the company’s policies on how to resolve such conflicts. If the conflict remains unre- solved, an employee should contact the next level of management (such as the immediate supervisor) who is not involved in the ethical conflict.

Point: The IMA also issues the Certi- fied Management Accountant (CMA) and the Certified Financial Manager (CFM) certifications. Employees with the CMA or CFM certifications typically earn higher salaries than those without.

Point: The Sarbanes-Oxley Act requires each issuer of securities to disclose whether it has adopted a code of ethics for its senior officers and the content of that code.

1. Managerial accounting produces information (a) to meet internal users’ needs, (b) to meet a user’s specific needs, (c) often focusing on the future, or (d ) all of these.

2. What is the difference between the intended users of financial and managerial accounting? 3. Do generally accepted accounting principles (GAAP) control and dictate managerial accounting?

Quick Check Answers — p. 634

An organization incurs many different types of costs that are classified differently, de pending on management needs (different costs for different purposes). We can classify costs on the basis of their (1) behavior, (2) traceability, (3) controllability, (4) relevance, and (5) function. This section explains each concept for assigning costs to products and services.

Types of Cost Classifications Classification by Behavior At a basic level, a cost can be classified as fixed or variable. A fixed cost does not change with changes in the volume of activity (within a range of activity known as an activity’s relevant range). For example, straight-line depreciation on equipment is a fixed cost. A variable cost changes in proportion to changes in the volume of activity. Sales com- missions computed as a percent of sales revenue are variable costs. Additional examples of fixed

MANAGERIAL COST CONCEPTS

C2 Describe accounting concepts useful in classifying costs.

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Chapter 14 Managerial Accounting Concepts and Principles 615

and variable costs for a bike manufacturer are provided in Exhibit 14.5. When cost items are com- bined, total cost can be fixed, variable, or mixed. Mixed refers to a combination of fixed and vari- able costs. Equipment rental often includes a fixed cost for some minimum amount and a variable cost based on amount of usage. Classification of costs by behavior is helpful in cost-volume-profit analyses and short-term decision making. We discuss these in Chapters 18 and 23.

EXHIBIT 14.5 Fixed and Variable Costs

Variable Cost: Cost of bicycle tires is variable with the number of bikes

produced—this cost is $15 per pair.

Fixed Cost: Rent for Rocky Mountain Bikes' building is $22,000, and it doesn't change

with the number of bikes produced.

Classification by Traceability A cost is often traced to a cost object, which is a product, process, department, or customer to which costs are assigned. Direct costs are those traceable to a single cost object. For example, if a product is a cost object, its material and labor costs are usually directly traceable. Direct costs for a bicycle, when it is the cost object, include raw materials such as wheels, brakes, chains, and wages and benefits of employees who work directly on making bikes. Indirect costs are those that cannot be easily and cost–beneficially traced to a single cost object. An example of an indirect cost is a maintenance department that benefits two or more departments. Salaries of Rocky Mountain Bikes’ maintenance department employees are consid- ered indirect if the cost object is bicycles. However, these salaries are direct if the cost object is the maintenance department. Exhibit 14.6 identifies examples of both direct and indirect costs for the maintenance department, when the maintenance department is considered the cost object. Classi- fication of costs by traceability is useful for cost allocation. This is discussed in Chapter 22.

EXHIBIT 14.6 Direct and Indirect Costs of a Maintenance Department

Direct Costs (to a Maintenance Department)

• Salaries of maintenance department employees • Equipment purchased by maintenance department

• Materials purchased by maintenance department • Maintenance department equipment depreciation

Indirect Costs (to a Maintenance Department)

• Factory accounting • Factory administration • Factory rent • Factory manager's salary

• Factory light and heat • Factory internal audit • Factory intranet • Insurance on factory

ff

Classification by Controllability A cost can be defined as controllable or not controllable. Whether a cost is controllable or not depends on the employee’s responsibili- ties, as shown in Exhibit 14.7. This is referred to as hierarchical levels in management, or pecking order. For example, investments in machinery are controllable by upper-level managers but not lower-level managers. Many daily operating ex- penses such as overtime often are controllable by lower-level managers. Classification of costs by controllability is especially useful for assigning responsibility to and evaluating managers.

Controls costs of investments in land, buildings, and equipment.

Controls daily expen- ses such as supplies,

maintenance, and overtime.

Senior Manager Supervisor

EXHIBIT 14.7 Controllability of Costs

Entrepreneur You wish to trace as many of your assembly department’s direct costs as possible. You can trace 90% of them in an economical manner. To trace the other 10%, you need sophisticated and costly ac- counting software. Do you purchase this software? ■ [Answer—p. 633]

Decision Maker

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616 Chapter 14 Managerial Accounting Concepts and Principles

Classification by Relevance A cost can be classified by relevance by identifying it as either a sunk cost or an out-of-pocket cost. A sunk cost has already been incurred and cannot be avoided or changed. It is irrelevant to future decisions. One example is the cost of a company’s office equipment previously purchased. An out-of-pocket cost requires a future outlay of cash and is relevant for decision making. Future purchases of equipment involve out-of-pocket costs. A discussion of relevant costs must also consider opportunity costs. An opportunity cost is the potential benefit lost by choosing a specific action from two or more alternatives. One example is a student giving up wages from a job to attend evening classes. Consideration of opportunity cost is important when, for example, an insurance company must decide whether to outsource its payroll function or maintain it internally. This is discussed in Chapter 23.

Classification by Function Another cost classification (for manufacturers) is capitaliza- tion as inventory or to expense as incurred. Costs capitalized as inventory are called product costs, which refer to expenditures necessary and integral to finished products. They include di- rect materials, direct labor, and indirect manufacturing costs called overhead costs. Product costs pertain to activities carried out to manufacture the product. Costs expensed are called period costs, which refer to expenditures identified more with a time period than with finished products. They include selling and general administrative expenses. Period costs pertain to ac- tivities that are not part of the manufacturing process. A distinction between product and period costs is important because period costs are expensed in the income statement and product costs are assigned to inventory on the balance sheet until that inventory is sold. An ability to under- stand and identify product costs and period costs is crucial to using and interpreting a manufac- turing statement described later in this chapter. Exhibit 14.8 shows the different effects of product and period costs. Period costs flow di- rectly to the current income statement as expenses. They are not reported as assets. Product costs are first assigned to inventory. Their final treatment depends on when inventory is sold or disposed of. Product costs assigned to finished goods that are sold in year 2013 are reported on the 2013 income statement as part of cost of goods sold. Product costs assigned to unsold inven- tory are carried forward on the balance sheet at the end of year 2013. If this inventory is sold in year 2014, product costs assigned to it are reported as part of cost of goods sold in that year’s income statement. The difference between period and product costs explains why the year 2013 income state- ment does not report operating expenses related to either factory workers’ wages or depreciation on factory buildings and equipment. Instead, both costs are combined with the cost of raw materials to compute the product cost of finished goods. A portion of these manufacturing costs

Point: Opportunity costs are not recorded by the accounting system.

Point: Only costs of production and purchases are classed as product costs.

C3 Define product and period costs and explain how they impact financial statements.

Operating expenses

Cost of goods sold

Year 2013 Income Statement

Inventory sold in

year 2013

Inventory not sold until

year 2014

* This diagram excludes costs to acquire assets other than inventory.

Product costs

(inventory)

Inventory • Raw materials • Goods in process • Finished goods

December 31, 2013 Balance Sheet

Year 2013 costs

incurred*

Year 2014 Income Statement

Cost of goods sold

Period costs

(expenses)

Inventory sold in

2014

EXHIBIT 14.8 Period and Product Costs in Financial Statements

Point: Product costs are either in the income statement as part of cost of goods sold or in the balance sheet as inventory. Period costs appear only on the income statement under operating expenses. See Exhibit 14.8.

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Chapter 14 Managerial Accounting Concepts and Principles 617

(related to the goods sold) is reported in the year 2013 income statement as part of cost of goods sold. The other portion is reported on the balance sheet at the end of that year as part of inven- tory. The portion assigned to inventory could be included in any or all of raw materials, goods in process, or finished goods inventories. Exhibit 14.9 summarizes typical managerial decisions for various cost classifications.

Point: For a team approach to identify- ing period and product costs, see Team- work in Action in the Beyond the Numbers section.

Identification of Cost Classifications It is important to understand that a cost can be classified using any one (or combination) of the five different means described here. To do this we must understand costs and operations. Spe- cifically, for the five classifications, we must be able to identify the activity for behavior, cost object for traceability, management hierarchical level for controllability, opportunity cost for relevance, and benefit period for function. Factory rent, for instance, can be classified as a prod- uct cost; it is fixed with respect to number of units produced, it is indirect with respect to the product, and it is not controllable by a production supervisor. Potential multiple classifications are shown in Exhibit 14.10 using different cost items incurred in manufacturing mountain bikes. The finished bike is the cost object. Proper allocation of these costs and the managerial deci- sions based on cost data depend on a correct cost classification.

Cost Item By Behavior By Traceability By Function

Bicycle tires . . . . . . . . . . . . . . . . . . . . . . Variable Direct Product

Wages of assembly worker* . . . . . . . . . Variable Direct Product

Advertising . . . . . . . . . . . . . . . . . . . . . . Fixed Indirect Period

Production manager’s salary . . . . . . . . . Fixed Indirect Product

Office depreciation . . . . . . . . . . . . . . . . Fixed Indirect Period

* Although an assembly worker’s wages are classified as variable costs, their actual behavior depends on how workers are paid and whether their wages are based on a union contract (such as piece rate or monthly wages).

EXHIBIT 14.10 Examples of Multiple Cost Classifications

Point: All expenses of service compa- nies are period costs because these companies do not have inventory.

Cost Concepts for Service Companies The cost concepts described are generally applicable to service organizations. For example, consider Southwest Airlines. Its cost of beverages for passengers is a variable cost based on number of passengers. The cost of leasing an aircraft is fixed with respect to number of passengers. We can also trace a flight crew’s salary to a specific flight whereas we likely cannot trace wages for the ground crew to a specific flight. Classification by function (such as product

Costs Classified By Example Managerial Decision

Behavior (variable or fixed) . . . . . . . . . . . . . . . . . . . . . . How many units must we sell to break even? What will profit be if we raise the selling price? Should we add a new line of business?

Traceability (direct or indirect) . . . . . . . . . . . . . . . . . . . How well did our departments perform?

Controllability (controllable or not) . . . . . . . . . . . . . . . How well did our division managers perform?

Relevance (sunk, out-of-pocket, opportunity) . . . . . . . . Should we make or buy a product? Should we keep or replace equipment?

EXHIBIT 14.9 Summary of Cost Classifications and Example Managerial Decisions

Purchase Manager You are evaluating two potential suppliers of seats for the manufacturing of motor- cycles. One supplier (A) quotes a $145 price per seat and ensures 100% quality standards and on-time delivery. The second supplier (B) quotes a $115 price per seat but does not give any written assurances on quality or delivery. You decide to contract with the second supplier (B), saving $30 per seat. Does this decision have opportunity costs? ■ [Answer—p. 634]

Decision Maker

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Companies with manufacturing activities differ from both merchandising and service companies. The main difference between merchandising and manufacturing companies is that merchandisers buy goods ready for sale while manufacturers produce goods from materials and labor. Payless is an example of a merchandising company. It buys and sells shoes without phy s ically changing them. Adidas is primarily a manufacturer of shoes, apparel, and accessories. It purchases materials such as leather, cloth, dye, plastic, rubber, glue, and laces and then uses employees’ labor to convert these materials to products. Southwest Airlines is a service company that transports people and items.

Manufacturer’s Costs Direct Materials Direct materials are tangible components of a finished product. Direct material costs are the expenditures for direct materials that are separately and readily traced through the manufacturing process to finished goods. Examples of direct materials in manufactur-

ing a mountain bike include its tires, seat, frame, pedals, brakes, cables, gears, and handlebars. The chart in the margin shows that direct materials generally make up about 45% of manufacturing costs in today’s products, but this amount varies across industries and companies.

Direct Labor Direct labor refers to the efforts of employees who physically convert materi- als to finished product. Direct labor costs are the wages and salaries for direct labor that are sepa- rately and readily traced through the manufacturing process to finished goods. Examples of direct labor in manufacturing a mountain bike include operators directly involved in converting raw ma- terials into finished products (welding, painting, forming) and assembly workers who attach mate- rials such as tires, seats, pedals, and brakes to the bike frames. Costs of other workers on the assembly line who assist direct laborers are classified as indirect labor costs. Indirect labor re- fers to manufacturing workers’ efforts not linked to specific units or batches of the product.

Factory Overhead Factory overhead consists of all manufacturing costs that are not direct materials or direct labor. Factory overhead costs cannot be separately or readily traced to finished goods. These costs include indirect materials and indirect labor, costs not directly trace- able to the product. Overtime paid to direct laborers is also included in overhead because overtime

REPORTING MANUFACTURING ACTIVITIES

Typical Manufacturing Costs in Today's Products

Direct materials 45%

Direct labor 15%

Factory overhead 40%

Point: Indirect labor costs are part of factory overhead.

Point: Factory overhead is also called manufacturing overhead.

4. Which type of cost behavior increases total costs when volume of activity increases? 5. How could traceability of costs improve managerial decisions?

Quick Check Answers — p. 634

versus period costs) is not relevant to service companies because services are not inventoried. Instead, costs incurred by a service firm are expensed in the reporting period when incurred. Managers in service companies must understand and apply cost concepts. They seek and rely on accurate cost estimates for many decisions. For example, an airline manager must often decide between canceling or rerouting flights. The manager must also be able to estimate costs saved by canceling a flight versus rerouting. Knowledge of fixed costs is equally important. We explain more about the cost requirements for these and other managerial decisions in Chapter 23.

Service Costs

• Beverages and snacks • Cleaning fees • Pilot and copilot salaries • Attendant salaries • Fuel and oil costs • Travel agent fees • Ground crew salaries

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Chapter 14 Managerial Accounting Concepts and Principles 619

is due to delays, interruptions, or constraints not necessarily identifiable to a specific product or batches of product. Factory overhead costs also in- clude maintenance of the mountain bike factory, su- pervision of its employees, repairing manufacturing equipment, factory utilities (water, gas, electricity), production manager’s salary, factory rent, deprecia- tion on factory buildings and equipment, factory in- surance, property taxes on factory buildings and equipment, and factory accounting and legal ser- vices. Factory overhead does not include selling and administrative expenses because they are not incurred in manufacturing products. These expenses are called period costs and are recorded as expenses on the income statement when incurred.

Prime and Conversion Costs Direct mate rial costs and direct labor costs are also called prime costs — expenditures directly associated with the manufacture of finished goods. Direct labor costs and overhead costs are called conversion costs — expenditures incurred in the process of con- verting raw materials to finished goods. Direct labor costs are considered both prime costs and conversion costs. Exhibit 14.11 conveys the relation between prime and conversion costs and their components of direct material, direct labor, and factory overhead. Since manufacturing activities differ from both selling merchandise and providing services, the financial statements differ slightly between these companies. This section considers some of these differences and compares them to accounting for a merchandising or service company. First we use the cost classification concept of traceability to discuss a manufacturer’s costs.

Manufacturer’s Balance Sheet Manufacturers carry several unique assets and usually have three inventories instead of the single inventory that merchandisers carry. Exhibit 14.12 shows three different inventories in the current asset section of the balance sheet for Rocky Mountain Bikes, a manufacturer. The three inventories are raw materials, goods in process, and finished goods.

EXHIBIT 14.12 Balance Sheet for a Manufacturer

Prime costs 5 Direct materials 1 Direct labor. Conversion costs 5 Direct labor 1 Factory overhead.

e Costs

Prime Costs

C on

ve rsi

on

Conversi on

C os

ts

Direct Labor

Direct Material

Factory Overhead

EXHIBIT 14.11 Prime and Conversion Costs and Their Makeup

C4 Explain how balance sheets and income statements for manufacturing and merchandising companies differ.

ROCKY MOUNTAIN BIKES

Balance Sheet

December 31, 2013

Assets

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,000

Accounts receivable, net . . . . . . . . . . . . . . 30,150

Raw materials inventory . . . . . . . . . . . 9,000

Goods in process inventory . . . . . . . . 7,500

Finished goods inventory . . . . . . . . . . 10,300

Factory supplies . . . . . . . . . . . . . . . . . . . . 350

Prepaid insurance . . . . . . . . . . . . . . . . . . . 300

Total current assets . . . . . . . . . . . . . . . . . . 68,600

Plant assets

Small tools, net . . . . . . . . . . . . . . . . . . . . . 1,100

Delivery equipment, net . . . . . . . . . . . . . . 5,000

Office equipment, net . . . . . . . . . . . . . . . . 1,300

Factory machinery, net . . . . . . . . . . . . . . . 65,500

Factory building, net . . . . . . . . . . . . . . . . . 86,700

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Total plant assets, net . . . . . . . . . . . . . . . . . 169,100

Intangible assets (patents), net . . . . . . . . . . . 11,200

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $248,900

Liabilities and Equity

Current liabilities

Accounts payable . . . . . . . . . . . . . . . . $ 14,000

Wages payable . . . . . . . . . . . . . . . . . . 540

Interest payable . . . . . . . . . . . . . . . . . 2,000

Income taxes payable . . . . . . . . . . . . 32,600

Total current liabilities . . . . . . . . . . . . 49,140

Long-term liabilities

Long-term notes payable . . . . . . . . . 50,000

Total liabilities . . . . . . . . . . . . . . . . . . 99,140

Stockholders’ equity

Common stock, $1.2 par . . . . . . . . . 24,000

Paid-in capital . . . . . . . . . . . . . . . . . . 76,000

Retained earnings . . . . . . . . . . . . . . . 49,760

Total stockholders’ equity . . . . . . . . . 149,760

Total liabilities and equity . . . . . . . . . . . $248,900

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620 Chapter 14 Managerial Accounting Concepts and Principles

Raw Materials Inventory Raw materials inventory refers to the goods a company acquires to use in making prod- ucts. It uses raw materials in two ways: directly and indirectly. Most raw materials physically become part of a product and are identified with specific units or batches of a product. Raw materials used directly in a product are called direct materials. Other materials used to support production processes are some- times not as clearly identified with specific units or batches of product. These materials are called indirect materials because they are not clearly identified with specific product units or batches. Items used as indirect materials often appear on a

balance sheet as factory supplies or are included in raw materials. Some direct materials are classified as indirect materials when their costs are low (insignif icant). Examples include screws and nuts used in assembling mountain bikes and staples and glue used in manufacturing shoes. Using the materiality principle, individually tracing the costs of each of these materials and classifying them separately as direct materials does not make much economic sense. For instance, keeping detailed records of the amount of glue used to manufacture one shoe is not cost beneficial.

Goods in Process Inventory Another inventory held by manufacturers is goods in pro- cess inventory, also called work in process inventory. It consists of products in the process of being manufactured but not yet complete. The amount of goods in process inventory depends on the type of production process. If the time required to produce a unit of product is short, the goods in process inventory is likely small; but if weeks or months are needed to produce a unit, the goods in process inventory is usually larger.

Finished Goods Inventory A third inventory owned by a manufacturer is finished goods inventory, which consists of completed products ready for sale. This inventory is similar to merchandise inventory owned by a merchandising company. Manufacturers also often own unique plant assets such as small tools, factory build- ings, factory equipment, and patents to manufacture products. The balance sheet in Exhibit 14.12 shows that Rocky Mountain Bikes owns all of these assets. Some manufacturers invest millions or even billions of dollars in production facilities and patents. Briggs & Stratton’s recent balance sheet shows about $1 billion net investment in land, buildings, machinery, and equipment, much of which involves production facilities. It manufactures more racing engines than any other company in the world.

Balance Sheets for Merchandising and Service Companies The current assets sec- tion of the balance sheet will look different for merchandising and service companies as compared to manufacturing companies. A merchandiser will report only merchandise inventory rather than the three types of inventory reported by a manufacturer. A service company’s balance sheet does not have any inventory held for sale.

Manufacturer’s Income Statement The main difference between the income statement of a manufacturer and that of a merchan- diser involves the items making up cost of goods sold. Exhibit 14.13 compares the compo- nents of cost of goods sold for a manufacturer and a merchandiser. A merchandiser adds cost of goods purchased to beginning merchandise inventory and then subtracts ending merchan- dise inventory to get cost of goods sold. A manufacturer adds cost of goods manufactured to beginning finished goods inventory and then subtracts ending finished goods inventory to get cost of goods sold.

A merchandiser often uses the term merchandise inventory; a manufacturer often uses the term finished goods inventory. A manufacturer’s inventories of raw materials and goods in pro- cess are not included in finished goods because they are not available for sale. A manufacturer also shows cost of goods manufactured instead of cost of goods purchased. This difference

P1 Compute cost of goods sold for a manufacturer.

Raw materials $9,000

Finished goods $10,300

Goods in process $7,500

Inventories of Rocky Mountain Bikes

Point: Reducing the size of inventories saves storage costs and frees money for other uses.

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Chapter 14 Managerial Accounting Concepts and Principles 621

* Cost of goods manufactured is reported in the income statement of Exhibit 14.15.

Merchandising (Tele-Mart) Company

Cost of goods sold Beginning merchandise inventory . . . . . . . . . . $ 14,200 Cost of merchandise purchased . . . . . . . . . . . . 234,150 Goods available for sale . . . . . . . . . . . . . . . . . . . . . 248,350 Less ending merchandise inventory . . . . . . . . . 12,100 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . $236,250

Manufacturing (Rocky Mtn. Bikes) Company

Cost of goods sold Beginning finished goods inventory . . . . . . . . . . . $ 11,200 Cost of goods manufactured* . . . . . . . . . . . . . . . . 170,500 Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . 181,700 Less ending finished goods inventory . . . . . . . . . 10,300 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . $171,400

EXHIBIT 14.14 Cost of Goods Sold for a Merchandiser and Manufacturer

occurs because a manufacturer produces its goods instead of purchasing them ready for sale. We show later in this chapter how to derive cost of goods manufactured from the manufacturing statement. The Cost of Goods Sold sections for both a merchandiser (Tele-Mart) and a manufacturer (Rocky Mountain Bikes) are shown in Exhibit 14.14 to highlight these differences. The remain- ing income statement sections are similar.

EXHIBIT 14.13 Cost of Goods Sold Computation

Merchandiser Manufacturer

Beginning finished goods inventory

Cost of goods manufactured

Ending finished goods inventory

Cost of goods sold

Beginning merchandise inventory

Cost of goods purchased

Ending merchandise inventory

�� �

��

�� �

Although the cost of goods sold computations are similar, the numbers in these computa- tions reflect different activities. A merchandiser’s cost of goods purchased is the cost of buy- ing products to be sold. A manufacturer’s cost of goods manufactured is the sum of direct materials, direct labor, and factory overhead costs incurred in producing products. Next we show a manufacturer’s income statement.

Reporting Performance Exhibit 14.15 shows the income statement for Rocky Moun- tain Bikes. Its operating expenses include sales salaries, office salaries, and depreciation of delivery and office equipment. Operating expenses do not include manufacturing costs such as factory workers’ wages and depreciation of production equipment and the factory buildings. These manufacturing costs are reported as part of cost of goods manufactured and included in cost of goods sold. We explained why and how this is done in the section “Classification by Function.”

Income Statement for Service Company Since a service provider does not make or buy inventory to be sold, it does not report cost of goods manufactured or cost of goods sold. Instead, its operating expenses include all of the costs it incurred in providing its service. South- west Airlines reports large operating expenses for employee pay and benefits, fuel and oil, and depreciation.

Point: Manufacturers treat costs such as depreciation and rent as product costs if they are related to manufacturing.

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622 Chapter 14 Managerial Accounting Concepts and Principles

Flow of Manufacturing Activities To understand manufacturing and its reports, we must first understand the flow of manufactur- ing activities and costs. Exhibit 14.16 shows the flow of manufacturing activities for a manufac- turer. This exhibit has three important sections: materials activity, production activity, and sales activity. We explain each activity in this section.

Materials Activity The far left side of Exhibit 14.16 shows the flow of raw materials. Manufacturers usually start a period with some beginning raw materials inventory carried over from the previous period. The company then acquires additional raw materials in the current period. Adding these purchases to beginning inventory gives total raw ma terials available for use in production. These raw materials are then either used in production in the current period or remain in inventory at the end of the period for use in future periods.

Production Activity The middle section of Exhibit 14.16 describes production activity. Four factors come together in production: beginning goods in process inventory, direct materials,

6. What are the three types of inventory on a manufacturing company’s balance sheet? 7. How does cost of goods sold differ for merchandising versus manufacturing companies?

Quick Check Answers — p. 634

C5 Explain manufacturing activities and the flow of manufacturing costs.

Point: Knowledge of managerial ac- counting provides us a means of mea- suring manufacturing costs and is a sound foundation for studying advanced busi- ness topics.

ROCKY MOUNTAIN BIKES

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $310,000 Cost of goods sold Finished goods inventory, Dec. 31, 2012 . . . . . . . . . . . . . $ 11,200 Cost of goods manufactured . . . . . . . . . . . . . . . . . . . 170,500 Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . 181,700 Less finished goods inventory, Dec. 31, 2013 . . . . . . . . . . 10,300 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171,400 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,600 Operating expenses Selling expenses Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500 Delivery wages expense . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Shipping supplies expense . . . . . . . . . . . . . . . . . . . . . . . 250 Insurance expense — Delivery equipment . . . . . . . . . . 300 Depreciation expense — Delivery equipment . . . . . . . . . 2,100 Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 38,150 General and administrative expenses Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 15,700 Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . 200 Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,550 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . 100 Depreciation expense — Office equipment . . . . . . . . . 200 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Total general and administrative expenses . . . . . . . . . . 21,750 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 59,900 Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . 78,700 Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,600 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 46,100

EXHIBIT 14.15 Income Statement for a Manufacturer

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Chapter 14 Managerial Accounting Concepts and Principles 623

direct labor, and overhead. Beginning goods in process inventory consists of partly assembled products from the previous period. Production activity results in products that are either finished or remain unfinished. The cost of finished products makes up the cost of goods manufactured for the current period. Unfinished products are identified as ending goods in process inventory. The cost of unfinished products consists of direct materials, direct labor, and factory overhead, and is reported on the current period’s balance sheet. The costs of both finished goods manufac- tured and goods in process are product costs.

Sales Activity The company’s sales activity is portrayed in the far right side of Exhibit 14.16. Newly completed units are combined with beginning finished goods inventory to make up total finished goods available for sale in the current period. The cost of finished products sold is reported on the income statement as cost of goods sold. The cost of products not sold is reported on the current period’s balance sheet as ending finished goods inventory.

Manufacturing Statement A company’s manufacturing activities are described in a manufacturing statement, also called the schedule of manufacturing activities or the schedule of cost of goods manufactured. The manufacturing statement summarizes the types and amounts of costs incurred in a company’s manufacturing process. Exhibit 14.17 shows the manufacturing statement for Rocky Mountain Bikes. The statement is divided into four parts: direct materials, direct labor, overhead, and computation of cost of goods manufactured. We describe each of these parts in this section.

1 The manufacturing statement begins by computing direct materials used. We start by adding beginning raw materials inventory of $8,000 to the current period’s purchases of $86,500. This yields $94,500 of total raw materials available for use. A physical count of inven tory shows $9,000 of ending raw materials inventory. This implies a total cost of raw materials used during the period of $85,500 ($94,500 total raw materials available for use 2 $9,000 ending inventory). (Note: All raw materials are direct materials for Rocky Mountain Bikes.)

2 The second part of the manufacturing statement reports direct labor costs. Rocky Mountain Bikes had total direct labor costs of $60,000 for the period. This amount includes payroll taxes and fringe benefits.

EXHIBIT 14.16 Activities and Cost Flows in Manufacturing

Balance Sheet Income Statement Cost of goods sold

Financial Reports

Materials Activity (raw materials)

Production Activity (goods in process)

Sales Activity (finished goods)

Goods in process beginning inventory

Factory overhead used

Direct labor used

Raw materials used

Finished goods beginning inventory

Goods manufactured

Raw materials beginning inventory

Raw materials purchases

Raw materials ending inventory Goods in process ending inventory Finished goods ending inventory

P2 Prepare a manufacturing statement and explain its purpose and links to financial statements.

Point: Direct material and direct labor costs increase with increases in produc- tion volume and are called variable costs. Overhead can be both variable and fixed. When overhead costs vary with produc- tion, they are called variable overhead. When overhead costs don’t vary with production, they are called fixed overhead.

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624 Chapter 14 Managerial Accounting Concepts and Principles

3 The third part of the manufacturing statement reports overhead costs. The statement lists each important factory overhead item and its cost. Total factory overhead cost for the period is $30,000. Some companies report only total factory overhead on the manufacturing state- ment and attach a separate schedule listing individual overhead costs.

4 The final section of the manufacturing statement computes and reports the cost of goods manufactured. (Total manufacturing costs for the period are $175,500 [$85,500 1 $60,000 1 $30,000], the sum of direct materials used and direct labor and overhead costs incurred.) This amount is first added to beginning goods in process inventory. This gives the total goods in process inventory of $178,000 ($175,500 1 $2,500). We then compute the current period’s cost of goods manufactured of $170,500 by taking the $178,000 total goods in process and sub- tracting the $7,500 cost of ending goods in process inventory that consists of direct materi- als, direct labor, and factory overhead. The cost of goods manufactured amount is also called net cost of goods manufactured or cost of goods completed. Exhibit 14.15 shows that this item and amount are listed in the Cost of Goods Sold section of Rocky Mountain Bikes’ income statement and the balance sheet.

A managerial accounting system records costs and reports them in various reports that even- tually determine financial statements. Exhibit 14.18 shows how overhead costs flow through the system: from an initial listing of specific costs, to a section of the manufacturing statement, to the reporting on the income statement and the balance sheet.

Management uses information in the manufacturing statement to plan and control the company’s manufacturing activities. To provide timely information for decision making, the statement is often prepared monthly, weekly, or even daily. In anticipation of release of its much-hyped iPad, Apple grew its inventory of critical components, and its finished goods

Point: Manufacturers sometimes re- port variable and fixed overhead sepa- rately in the manufacturing statement to provide more information to managers about cost behavior.

EXHIBIT 14.17 Manufacturing Statement

ROCKY MOUNTAIN BIKES

Manufacturing Statement

For Year Ended December 31, 2013

Direct materials

Raw materials inventory, Dec. 31, 2012 . . . . . . . . . . . . . $ 8,000

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . . 86,500

Raw materials available for use . . . . . . . . . . . . . . . . . . . . 94,500

Less raw materials inventory, Dec. 31, 2013 . . . . . . . . . 9,000

Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 85,500

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Factory overhead

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600

Repairs — Factory equipment . . . . . . . . . . . . . . . . . . . . . 2,500

Property taxes — Factory building . . . . . . . . . . . . . . . . . 1,900

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Factory insurance expired . . . . . . . . . . . . . . . . . . . . . . . 1,100

Depreciation expense —Small tools . . . . . . . . . . . . . . . 200

Depreciation expense—Factory equipment . . . . . . . . . 3,500

Depreciation expense—Factory building . . . . . . . . . . . 1,800

Amortization expense—Patents . . . . . . . . . . . . . . . . . . 800

Total factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . . 175,500

Add goods in process inventory, Dec. 31, 2012 . . . . . . . . . 2,500

Total cost of goods in process . . . . . . . . . . . . . . . . . . . . . . 178,000

Less goods in process inventory, Dec. 31, 2013 . . . . . . . . . 7,500

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . $170,500

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Chapter 14 Managerial Accounting Concepts and Principles 625

inventory. The manufacturing statement contains information useful to external users but is not a general-purpose finan cial statement. Companies rarely publish the manufacturing statement because managers view this information as proprietary and potentially harmful to them if released to competitors.

EXHIBIT 14.18 Overhead Cost Flows across Accounting Reports

ROCKY MOUNTAIN BIKES Income Statement

For Year Ended December 31, 2013

Sales Cost of goods sold Beg. finished goods Cost of goods manuf. End. finished goods Cost of goods sold Gross profit Expenses Income taxes Net income

$310,000

11,200 170,500

171,400 138,600

$ 46,100

(10,300)

59,900 32,600

ROCKY MOUNTAIN BIKES Balance Sheet–PARTIAL

December 31, 2013

Cash Accounts receivable, net Raw materials inventory Goods in process inventory Finished goods inventory Factory supplies Prepaid insurance Total current assets

$11,000 30,150 9,000 7,500

10,300 350

300 $68,600

ROCKY MOUNTAIN BIKES Manufacturing Statement

For Year Ended December 31, 2013

$ 85,500 60,000 30,000

175,500 2,500

178,000

$170,500

Direct materials Direct labor Factory overhead Total manuf. costs Beg. goods in process Total goods in process End. goods in process Cost of goods manuf.

(7,500)

ROCKY MOUNTAIN BIKES Factory Overhead Costs

For Year Ended December 31, 2013

$ 9,000 6,000

15,000 $30,000

Indirect labor Supervision Other overhead items* Total overhead

*Overhead items are listed in Exhibit 14.17.

8. A manufacturing statement (a) computes cost of goods manufactured for the period, (b) computes cost of goods sold for the period, or (c) reports operating expenses incurred for the period.

9. Are companies required to report a manufacturing statement? 10. How are both beginning and ending goods in process inventories reported on a manufacturing

statement?

Quick Check Answers — p. 634

C6 Describe trends in managerial accounting.

Trends in Managerial Accounting The analytical tools and techniques of managerial accounting have always been useful, and their relevance and importance continue to increase. This is so because of changes in the business environment. This section describes some of these changes and their impact on managerial accounting.

Customer Orientation There is an increased emphasis on customers as the most impor- tant constituent of a business. Customers expect to derive a certain value for the money they spend to buy products and services. Specifically, they expect that their suppliers will offer them the right service (or product) at the right time and the right price. This implies that

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626 Chapter 14 Managerial Accounting Concepts and Principles

companies accept the notion of customer orientation, which means that employees understand the changing needs and wants of their customers and align their management and oper- ating practices accordingly.

Global Economy Our global economy expands competitive boundaries and provides customers more choices. The global economy also produces changes in business activities. One notable case that reflects these changes in customer demand and global competition is auto manufac turing. The top three Japanese auto manufacturers (Honda, Nissan, and Toyota) once controlled

more than 40% of the U.S. auto market. Customers perceived that Japanese auto manufacturers provided value not available from other manufacturers. Many European and North American auto manufacturers responded to this challenge and regained much of the lost market share.

E-Commerce People have become increasingly interconnected via smartphones, text mes- saging, and other electronic applications. Consumers thus expect and demand to be able to buy items electronically, whenever and wherever they want. Many businesses have enhanced their Websites to allow for online transactions. Online sales now make up over 7% of total retail sales.

Service Economy Businesses that provide services, such as telecommunications and health care, constitute an ever-growing part of our economy. In developed economies like the United States, service businesses typically account for over 60% to 70% of total economic activity.

Companies must be alert to these and other factors. Many companies have responded by adopting the lean business model, whose goal is to eliminate waste while “satisfying the cus- tomer” and “providing a positive return” to the company.

Lean Practices Continuous improvement rejects the notions of “good enough” or “ac- ceptable” and challenges employees and managers to continuously experiment with new and improved business practices. This has led companies to adopt practices such as total quality management (TQM) and just-in-time (JIT) manufacturing. The philosophy underlying both practices is continuous improvement; the difference is in the focus. Total quality management focuses on quality improvement and applies this standard to all aspects of business activities. In doing so, managers and employees seek to uncover waste in business activities including accounting activities such as payroll and disbursements. To encour- age an emphasis on quality, the U.S. Congress established the Malcolm Baldrige National Qual- ity Award (MBNQA). Entrants must conduct a thorough analysis and evaluation of their business using guidelines from the Baldrige committee. Ritz Carlton Hotel is a recipient of the Baldrige award in the service category. The company applies a core set of values, collectively called The Gold Standards, to improve customer service.

Just-in-time manufacturing is a system that acquires inventory and produces only when needed. An important aspect of JIT is that compa- nies manufacture products only after they receive an order (a demand- pull system) and then deliver the customer’s requirements on time. This means that processes must be aligned to eliminate any delays and inef- ficiencies including inferior inputs and outputs. Companies must also establish good relations and communications with their suppliers. On the downside, JIT is more susceptible to disruption than traditional sys- tems. As one example, several General Motors plants were temporarily shut down due to a strike at an assembly division; the plants supplied components just in time to the assembly division.

Value Chain The value chain refers to the series of activities that add value to a company’s products or services. Exhibit 14.19 illustrates a possible value chain for a retail cookie company. Companies can use lean practices to increase efficiency and profits.

Point: Goals of a TQM process include reduced waste, better inventory control, fewer defects, and continuous improve- ment. Just-in-time concepts have similar goals.

Point: The time between buying raw materials and selling finished goods is called throughput time.

Im p r o v e m e nt

C ontinuous

Customer Orientation

To tal

Q ua

li ty

M an

ag em

en t Just-in-Tim

e M anufacturing

Copyright © Jerry King. www.artizans.com

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Chapter 14 Managerial Accounting Concepts and Principles 627

Managerial accounting is more flexible than financial accounting and does not follow a set of strict rules. However, many international businesses use the managerial accounting concepts and principles described in this chapter.

Customer Focus Nestlé, one of the world’s leading nutrition and wellness companies, adopts a customer focus and strives to understand its customers’ tastes. For example, Nestlé employees spent three days living with people in Lima, Peru, to understand their motivations, routines, buying habits, and every- day lives. This allowed Nestlé to adjust its products to suit local tastes.

Reporting Manufacturing Activities Nestlé must classify and report costs. In reporting inven- tory, Nestlé includes direct production costs, production overhead, and factory depreciation. A recent Nestlé annual report shows the following:

GLOBAL VIEW

Nestlé managers use this information, along with the more detailed information found in a manufacturing statement, to plan and control manufacturing activities.

Ending Beginning

(in millions of Swiss francs) Inventory Inventory

Raw materials, work in progress, and sundry supplies . . . . . . . . 3,243 3,175

Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,182 4,741

EXHIBIT 14.19 Typical Value Chain (Cookie Retailer)

Acquire raw materials Baking Sales Service

Balanced Scorecard The balanced scorecard aids continuous improvement by augmenting financial measures with information on the “drivers” (indicators) of future financial performance along four dimensions: (1) financial—profitability and risk, (2) customer—value creation and product and service differentiation, (3) internal business processes—business activities that create customer and owner satisfaction, and (4) learning and growth—organizational change, innovation, and growth. ■

Decision Insight

Implications for Managerial Accoun ting Adopting the lean business model can be challenging because to foster its implementation, all systems and procedures that a company follows must be realigned. Managerial accounting has an important role to play by providing accu rate cost and performance information. Com panies must understand the nature and sources of cost and must develop systems that capture costs accurately. Developing such a system is important to measuring the “value” provided to customers. The price that customers pay for acquiring goods and services is an important determinant of value. In turn, the costs a company incurs are key determinants of price. All else being equal, the better a company is at controlling its costs, the better its performance.

Global Lean Toyota Motor Corporation pioneered lean manufacturing, and it has since spread to other manufacturers throughout the world. The goals include improvements in quality, reliability, inventory turn- over, productivity, exports, and—above all—sales and income. ■

Decision Insight

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This ratio reveals how many times a company turns over (uses in production) its raw materials inven- tory during a period. Generally, a high ratio of raw materials inventory turnover is preferred, as long as raw materials inventory levels are adequate to meet demand. To illustrate, Rocky Mountain Bikes reports direct (raw) materials used of $85,500 for a year, with a beginning raw materials inventory of $8,000 and an ending raw materials inventory of $9,000 (see Exhibit 14.17). Raw materials inventory turnover for Rocky Mountain Bikes for that year is computed as in Exhibit 14.21.

628 Chapter 14 Managerial Accounting Concepts and Principles

Days’ Sales in Raw Materials Inventory To further assess raw materials inventory management, a manager can measure the adequacy of raw materi- als inventory to meet production demand. Days’ sales in raw materials inventory reveals how much raw materials inventory is available in terms of the number of days’ sales. It is a measure of how long it takes raw materials to be used in production. It is defined and computed for Rocky Mountain Bikes in Exhibit 14.22.

EXHIBIT 14.21 Raw Materials Inventory Turnover Computed

Raw materials inventory turnover 5 $85,500y[($8,000 1 $9,000)y2] 5 10.06 (rounded).

EXHIBIT 14.22 Days’ Sales in Raw Materials Inventory Turnover

Days’ sales in raw materials inventory 5 Ending raw materials inventoryyRaw materials used 3 365 5 $9,000y$85,500 3 365 5 38.4 days (rounded)

This computation suggests that it will take 38 days for Rocky Mountain Bikes’ raw materials inventory to be used in production. Assuming production needs can be met, companies usually prefer a lower number of days’ sales in raw materials inventory. Just-in-time manufacturing techniques can be useful in lowering days’ sales in raw materials inventory; for example, Dell keeps less than seven days of production needs in raw materials inventory for most of its computer components.

DEMONSTRATION PROBLEM 1: COST BEHAVIOR AND CLASSIFICATION Understanding the classification and assignment of costs is important. Consider a company that manufactures computer chips. It incurs the following costs in manufacturing chips and in operating the company. 1. Plastic board used to mount the chip, $3.50 each. 2. Assembly worker pay of $15 per hour to attach chips to plastic board. 3. Salary for factory maintenance workers who maintain factory equipment. 4. Factory supervisor pay of $55,000 per year to supervise employees. 5. Real estate taxes paid on the factory, $14,500. 6. Real estate taxes paid on the company office, $6,000. 7. Depreciation costs on machinery used by workers, $30,000. 8. Salary paid to the chief financial officer, $95,000. 9. Advertising costs of $7,800 paid to promote products.

A1 Assess raw materials inventory management using raw materials inventory turnover and days’ sales in raw materials inventory.

Managerial accounting information helps business managers perform detailed analyses that are not readily available to external users of accounting information. Inventory management is one example. Using pub- licly available financial statements, an external user can compute the inventory turnover ratio. However, a managerial accountant can go much further.

Raw Materials Inventory Turnover A business manager can assess how effectively a company manages its raw materials inventory by com- puting the raw materials inventory turnover ratio as shown in Exhibit 14.20.

Raw Materials Inventory Turnover and Days’ Sales in Raw Materials Inventory

Decision Analysis

EXHIBIT 14.20 Raw Materials Inventory Turnover

Raw materials inventory turnover 5 Raw materials usedyAverage raw materials inventory

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Chapter 14 Managerial Accounting Concepts and Principles 629

10. Salespersons’ commissions of $0.50 for each assembled chip sold. 11. Management has the option to rent the manufacturing plant to six local hospitals to store medical

records instead of producing and assembling chips. Classify each cost in the following table according to the categories listed in the table header. A cost can be classified under more than one category. For example, the plastic board used to mount chips is classified as a direct material product cost and as a direct unit cost.

DEMONSTRATION PROBLEM 2: REPORTING FOR MANUFACTURERS A manufacturing company’s balance sheet and income statement differ from those for a merchandising or service company.

Required

1. Fill in the [BLANK] descriptors on the partial balance sheets for both the manufacturing company and the merchandising company. Explain why a different presentation is required.

Unit Cost Sunk Opportunity

Period Costs Product Costs Classification Cost Cost

Direct Direct Factory

Material Labor Overhead

Selling and (Prime (Prime and (Conversion

Cost Administrative Cost) Conversion) Cost) Direct Indirect

1. Plastic board used ✔ ✔ to mount the chip, $3.50 each

Unit Cost Sunk Opportunity

Period Costs Product Costs Classification Cost Cost

Direct Direct Factory

Material Labor Overhead

Selling and (Prime (Prime and (Conversion

Cost* Administrative Cost) Conversion) Cost) Direct Indirect

1. ✔ ✔

2. ✔ ✔

3. ✔ ✔

4. ✔ ✔

5. ✔ ✔

6. ✔

7. ✔ ✔ ✔

8. ✔

9. ✔

10. ✔

11. ✔

* Costs 1 through 11 refer to the 11 cost items described at the beginning of the problem.

SOLUTION TO DEMONSTRATION PROBLEM 1

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630 Chapter 14 Managerial Accounting Concepts and Principles

Explanation: A manufacturing company must control and measure three types of inventories: raw materi- als, goods in process, and finished goods. In the sequence of making a product, the raw materials move

2. Fill in the [BLANK] descriptors on the income statements for the manufacturing company and the merchandising company. Explain why a different presentation is required.

ADIDAS GROUP

Partial Balance Sheet

December 31, 2013

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . $10,000

[BLANK] . . . . . . . . . . . . . . . . 8,000

[BLANK] . . . . . . . . . . . . . . . . 5,000

[BLANK] . . . . . . . . . . . . . . . . 7,000

Supplies . . . . . . . . . . . . . . . . . . 500

Prepaid insurance . . . . . . . . . . 500

Total current assets . . . . . . . . . $31,000

Manufacturing Company Merchandising Company

PAYLESS SHOE OUTLET

Partial Balance Sheet

December 31, 2013

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . $ 5,000

[BLANK] . . . . . . . . . . . . . . . . 12,000

Supplies . . . . . . . . . . . . . . . . . . 500

Prepaid insurance . . . . . . . . . . 500

Total current assets . . . . . . . . . $18,000

ADIDAS GROUP

Partial Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000

Cost of goods sold

Finished goods inventory, Dec. 31, 2012 . . . . . . . . . 10,000

[BLANK] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Goods available for sale . . . . . . . . . . . . . . . . . . . . . 130,000

Finished goods inventory, Dec. 31, 2013 . . . . . . . . . (7,000)

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 123,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 77,000

Manufacturing Company Merchandising Company

PAYLESS SHOE OUTLET

Partial Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 190,000

Cost of goods sold

Merchandise inventory, Dec. 31, 2012 . . . . . . . . 8,000

[BLANK] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000

Goods available for sale . . . . . . . . . . . . . . . . . . . 116,000

Merchandise inventory, Dec. 31, 2013 . . . . . . . . (12,000)

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 104,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 86,000

3. A manufacturer’s cost of goods manufactured is the sum of (a) _______, (b) _______, and (c) _______ costs incurred in producing the product.

SOLUTION TO DEMONSTRATION PROBLEM 2 1. Inventories for a manufacturer and for a merchandiser.

ADIDAS GROUP

Partial Balance Sheet

December 31, 2013

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Raw materials inventory . . . . . . . . . . . 8,000

Goods in process inventory . . . . . . . . 5,000

Finished goods inventory . . . . . . . . . . 7,000

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Prepaid insurance . . . . . . . . . . . . . . . . . . . 500

Total current assets . . . . . . . . . . . . . . . . . $31,000

Manufacturing Company Merchandising Company

PAYLESS SHOE OUTLET

Partial Balance Sheet

December 31, 2013

Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Merchandise inventory . . . . . . . . 12,000

Supplies . . . . . . . . . . . . . . . . . . . . . . . 500

Prepaid insurance . . . . . . . . . . . . . . . 500

Total current assets . . . . . . . . . . . . . . $18,000

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Chapter 14 Managerial Accounting Concepts and Principles 631

Explanation: Manufacturing and merchandising companies use different reporting terms. In particular, the terms finished goods and cost of goods manufactured are used to reflect the production of goods, yet the concepts and techniques of reporting cost of goods sold for a manufacturing company and merchandising company are similar. 3. A manufacturer’s cost of goods manufactured is the sum of (a) direct material, (b) direct labor, and

(c) factory overhead costs incurred in producing the product.

into production — called goods in process inventory — and then to finished goods. All raw materials and goods in process inventory at the end of each accounting period are considered current assets. All unsold finished inventory is considered a current asset at the end of each accounting period. The merchandising company must control and measure only one type of inventory, purchased goods. 2. Cost of goods sold for a manufacturer and for a merchandiser.

DEMONSTRATION PROBLEM 3: MANUFACTURING STATEMENT The following account balances and other information are from SUNN Corporation’s accounting rec- ords for year-end December 31, 2013. Use this information to prepare (1) a table listing factory overhead costs, (2) a manufacturing statement (show only the total factory overhead cost), and (3) an income statement.

Goods in process inventory, Dec. 31, 2012 . . . . . . . . . $ 8,000

Goods in process inventory, Dec. 31, 2013 . . . . . . . . . 9,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,400

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . 55,000

Property taxes on factory equipment . . . . . . . . . . . . . 14,000

Raw materials inventory, Dec. 31, 2012 . . . . . . . . . . . . 60,000

Raw materials inventory, Dec. 31, 2013 . . . . . . . . . . . . 78,000

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . 313,000

Repairs expense — Factory equipment . . . . . . . . . . . . . 31,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,630,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 85,000

Amortization expense — Factory Patents . . . . . . . . . . 16,000

Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

Depreciation expense — Office equipment . . . . . . . . . 37,000

Depreciation expense — Factory building . . . . . . . . . . 133,000

Depreciation expense — Factory equipment . . . . . . . . 78,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Factory insurance expired . . . . . . . . . . . . . . . . . . . . . . 62,000

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,000

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000

Finished goods inventory, Dec. 31, 2012 . . . . . . . . . . . . 15,000

Finished goods inventory, Dec. 31, 2013 . . . . . . . . . . . . 12,500

PLANNING THE SOLUTION ● Analyze the account balances and select those that are part of factory overhead costs. ● Arrange these costs in a table that lists factory overhead costs for the year. ● Analyze the remaining costs and select those related to production activity for the year; selected costs

should include the materials and goods in process inventories and direct labor.

ADIDAS GROUP

Partial Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000

Cost of goods sold

Finished goods inventory, Dec. 31, 2012 . . . . . . . . . 10,000

Cost of goods manufactured . . . . . . . . . . . . . . 120,000

Goods available for sale . . . . . . . . . . . . . . . . . . . . . 130,000

Finished goods inventory, Dec. 31, 2013 . . . . . . . . . (7,000)

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 123,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 77,000

Manufacturing Company Merchandising Company

PAYLESS SHOE OUTLET

Partial Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 190,000

Cost of goods sold

Merchandise inventory, Dec. 31, 2012 . . . . . . . . 8,000

Cost of purchases . . . . . . . . . . . . . . . . . . . . . . 108,000

Goods available for sale . . . . . . . . . . . . . . . . . . . 116,000

Merchandise inventory, Dec. 31, 2013 . . . . . . . . (12,000)

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 104,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 86,000

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632 Chapter 14 Managerial Accounting Concepts and Principles

● Prepare a manufacturing statement for the year showing the calculation of the cost of materials used in production, the cost of direct labor, and the total factory overhead cost. When presenting overhead cost on this statement, report only total overhead cost from the table of overhead costs for the year. Show the costs of beginning and ending goods in process inventory to determine cost of goods manufactured.

● Organize the remaining revenue and expense items into the income statement for the year. Combine cost of goods manufactured from the manufacturing statement with the finished goods inventory amounts to compute cost of goods sold for the year.

SOLUTION TO DEMONSTRATION PROBLEM 3

SUNN CORPORATION

Factory Overhead Costs

For Year Ended December 31, 2013

Amortization expense — Factory patents . . . . . . . . . . $ 16,000

Depreciation expense — Factory building . . . . . . . . . . 133,000

Depreciation expense — Factory equipment . . . . . . . . 78,000

Factory insurance expired . . . . . . . . . . . . . . . . . . . . . . 62,000

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,000

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Property taxes on factory equipment . . . . . . . . . . . . . 14,000

Repairs expense — Factory equipment . . . . . . . . . . . . . 31,000

Total factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . $570,000

SUNN CORPORATION

Manufacturing Statement

For Year Ended December 31, 2013

Direct materials

Raw materials inventory, Dec. 31, 2012 . . . . . . . . . . . . . $ 60,000

Raw materials purchase . . . . . . . . . . . . . . . . . . . . . . . . . 313,000

Raw materials available for use . . . . . . . . . . . . . . . . . . . 373,000

Less raw materials inventory, Dec. 31, 2013 . . . . . . . . . 78,000

Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . 295,000

SUNN CORPORATION

Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,630,000

Cost of goods sold

Finished goods inventory, Dec. 31, 2012 . . . . . . . . . . . . . $ 15,000

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . 1,114,000

Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . 1,129,000

Less finished goods inventory, Dec. 31, 2013 . . . . . . . . . 12,500

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,116,500

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513,500

Operating expenses

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000

Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

Depreciation expense—Office equipment . . . . . . . . . . . 37,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 380,000

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . 133,500

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,400

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,100

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570,000

Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . . 1,115,000

Goods in process inventory, Dec. 31, 2012 . . . . . . . . . . . . 8,000

Total cost of goods in process . . . . . . . . . . . . . . . . . . . . . . 1,123,000

Less goods in process inventory, Dec. 31, 2013 . . . . . . . . 9,000

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . $1,114,000

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Chapter 14 Managerial Accounting Concepts and Principles 633

C1 Explain the purpose and nature of, and the role of ethics in, managerial accounting. The purpose of managerial accounting is to provide useful information to management and other internal decision makers. It does this by collecting, managing, and reporting both monetary and nonmonetary information in a manner useful to internal users. Major characteristics of managerial accounting include (1) focus on internal decision makers, (2) emphasis on planning and control, (3) flexibility, (4) timeliness, (5) reliance on forecasts and estimates, (6) focus on segments and projects, and (7) reporting both monetary and nonmonetary information. Ethics are beliefs that distinguish right from wrong. Ethics can be impor- tant in reducing fraud in business operations.

C2 Describe accounting concepts useful in classifying costs. We can classify costs on the basis of their (1) behavior— fixed vs. variable, (2) traceability—direct vs. indirect, (3) control- lability—controllable vs. uncontrollable, (4) relevance—sunk vs. out of pocket, and (5) function—product vs. period. A cost can be classified in more than one way, depending on the purpose for which the cost is being determined. These classifications help us understand cost patterns, analyze performance, and plan operations.

C3 Define product and period costs and explain how they im-pact financial statements. Costs that are capitalized because they are expected to have future value are called product costs; costs that are expensed are called period costs. This classification is im- portant because it affects the amount of costs expensed in the in- come statement and the amount of costs assigned to inventory on the balance sheet. Product costs are commonly made up of direct materials, direct labor, and overhead. Period costs include selling and administrative expenses.

C4 Explain how balance sheets and income statements for manufacturing and merchandising companies differ. The main difference is that manufacturers usually carry three inventories on their balance sheets — raw materials, goods in process, and finished goods — instead of one inventory that merchandisers carry. The main difference between income state- ments of manufacturers and merchandisers is the items making up cost of goods sold. A merchandiser adds beginning merchandise inventory to cost of goods purchased and then subtracts ending merchandise inventory to get cost of goods sold. A manufacturer adds beginning finished goods inventory to cost of goods

Summary manufactured and then subtracts ending finished goods inventory to get cost of goods sold.

C5 Explain manufacturing activities and the flow of manufac-turing costs. Manufacturing activities consist of materials, pro- duction, and sales activities. The materials activity consists of the purchase and issuance of materials to production. The production activity consists of converting materials into finished goods. At this stage in the process, the materials, labor, and overhead costs have been incurred and the manufacturing statement is prepared. The sales activity consists of selling some or all of finished goods available for sale. At this stage, the cost of goods sold is determined.

C6 Describe trends in managerial accounting. Important trends in managerial accounting include an increased focus on satis- fying customers, the impact of a global economy, and the growing presence of e-commerce and service-based businesses. The lean business model, designed to eliminate waste and satisfy customers, can be useful in responding to recent trends. Concepts such as total quality management, just-in-time production, and the value chain often aid in application of the lean business model.

A1 Assess raw materials inventory management using raw materials inventory turnover and days’ sales in raw mate- rials inventory. A high raw materials inventory turnover suggests a business is more effective in managing its raw materials inventory. We use days’ sales in raw materials inventory to assess the likeli- hood of production being delayed due to inadequate levels of raw materials. We prefer a high raw materials inventory turnover ratio and a small number of days’ sales in raw materials inventory, pro- vided that raw materials inventory levels are adequate to keep pro- duction steady.

P1 Compute cost of goods sold for a manufacturer. A manufac-turer adds beginning finished goods inventory to cost of goods manufactured and then subtracts ending finished goods inventory to get cost of goods sold.

P2 Prepare a manufacturing statement and explain its pur-pose and links to financial statements. The manufacturing statement reports computation of cost of goods manufactured for the period. It begins by showing the period’s costs for direct materials, direct labor, and overhead and then adjusts these numbers for the beginning and ending inventories of the goods in process to yield cost of goods manufactured.

Production Manager It appears that all three friends want to pay the bill with someone else’s money. David is using money be- longing to the tax authorities, Denise is taking money from her com- pany, and Derek is defrauding the client. To prevent such practices, companies have internal audit mechanisms. Many companies also adopt ethical codes of conduct to help guide employees. We must recognize that some entertainment expenses are justifiable and even encouraged. For example, the tax law allows certain deductions for

entertainment that have a business purpose. Corporate policies also sometimes allow and encourage reimbursable spending for social ac- tivities, and contracts can include entertainment as allowable costs. Nevertheless, without further details, payment for this bill should be made from personal accounts.

Entrepreneur Tracing all costs directly to cost objects is always desirable, but you need to be able to do so in an eco nomically feasible

Guidance Answers to Decision Maker and Decision Ethics

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634 Chapter 14 Managerial Accounting Concepts and Principles

manner. In this case, you are able to trace 90% of the assembly de- partment’s direct costs. It may not be economical to spend more money on a new software to trace the final 10% of costs. You need to make a cost–benefit trade-off. If the software offers benefits beyond tracing the remaining 10% of the assembly department’s costs, your decision should consider this.

Purchase Manager Opportunity costs relate to the potential quality and delivery benefits given up by not choosing supplier (A).

Selecting supplier (B) might involve future costs of poor-quality seats (inspection, repairs, and returns). Also, potential delivery delays could interrupt work and increase manufacturing costs. Your company could also incur sales losses if the product quality of supplier (B) is low. As purchase manager, you are responsible for these costs and must con- sider them in making your decision.

1. d 2. Financial accounting information is intended for users external

to an organization such as investors, creditors, and government authorities. Managerial accounting focuses on providing infor- mation to managers, officers, and other decision makers within the organization.

3. No, GAAP do not control the practice of managerial account- ing. Unlike external users, the internal users need managerial accounting information for planning and controlling business activities rather than for external comparison. Different types of information are required, depending on the activity. There fore it is difficult to standardize managerial accounting.

4. Variable costs increase when volume of activity increases. 5. By being able to trace costs to cost objects (say, to products

and departments), managers better understand the total costs associated with a cost object. This is useful when managers

consider making changes to the cost object (such as when dropping the product or expanding the department).

6. Raw materials inventory, goods in process inventory, and fin- ished goods inventory.

7. The cost of goods sold for merchandising companies includes all costs of acquiring the merchandise; the cost of goods sold for manufacturing companies includes the three costs of manu- facturing: direct materials, direct labor, and overhead.

8. a 9. No; companies rarely report a manufacturing statement. 10. Beginning goods in process inventory is added to total manu-

facturing costs to yield total goods in process. Ending goods in process inventory is subtracted from total goods in process to yield cost of goods manufactured for the period.

Guidance Answers to Quick Checks

Continuous improvement (p. 626)

Control (p. 611)

Controllable or not controllable cost (p. 615)

Conversion costs (p. 619)

Cost object (p. 615)

Customer orientation (p. 626)

Days’ sales in raw materials inventory (p. 628)

Direct costs (p. 615)

Direct labor (p. 618)

Direct labor costs (p. 618)

Direct materials (p. 618)

Direct material costs (p. 618)

Ethics (p. 614)

Factory overhead (p. 618)

Factory overhead costs (p. 618)

Finished goods inventory (p. 620)

Fixed cost (p. 614)

Goods in process inventory (p. 620)

Indirect costs (p. 615)

Indirect labor (p. 618)

Indirect labor costs (p. 618)

Indirect material (p. 620)

Institute of Management Accountants (IMA) (p. 614)

Internal control system (p. 614)

Just-in-time (JIT) manufacturing (p. 626)

Lean business model (p. 626)

Managerial accounting (p. 610)

Manufacturing statement (p. 623)

Opportunity cost (p. 616)

Out-of-pocket cost (p. 616)

Period costs (p. 616)

Planning (p. 610)

Prime costs (p. 619)

Product costs (p. 616)

Raw materials inventory (p. 620)

Raw materials inventory turnover ratio (p. 628)

Sunk cost (p. 616)

Total quality management (TQM) (p. 626)

Value chain (p. 626)

Variable cost (p. 614)

Key Terms

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Chapter 14 Managerial Accounting Concepts and Principles 635

Icon denotes assignments that involve decision making.

1. Describe the managerial accountant’s role in business plan- ning, control, and decision making.

2. Distinguish between managerial and financial accounting on a. Users and decision makers. b. Purpose of information. c. Flexibility of practice. d. Time dimension. e. Focus of information. f. Nature of information. 3. Identify the usual changes that a company must make

when it adopts a customer orientation. 4. Distinguish between direct labor and indirect labor. 5. Distinguish between (a) factory overhead and (b) selling and

administrative overhead. 6. Distinguish between direct material and indirect material. 7. What product cost is listed as both a prime cost and a conver-

sion cost? 8. Assume that we tour Polaris’ factory where

it makes its products. List three direct costs and three indirect costs that we are likely to see.

9. Should we evaluate a manager’s performance on the basis of controllable or noncontrollable costs? Why?

10. Explain why knowledge of cost behavior is useful in product performance evaluation.

11. Explain why product costs are capitalized but period costs are expensed in the current accounting period.

12. Explain how business activities and inventories for a manufacturing company, a merchandising company, and a ser- vice company differ.

13. Why does managerial accounting often involve working with numerous predictions and estimates?

14. How do an income statement and a balance sheet for a manu- facturing company and a merchandising company differ?

15. Besides inventories, what other assets often appear on manufac- turers’ balance sheets but not on merchandisers’ balance sheets?

16. Why does a manufacturing company require three different in- ventory categories?

17. Manufacturing activities of a company are described in the _______. This statement summarizes the types and amounts of costs incurred in its manufacturing _______.

18. What are the three categories of manufacturing costs? 19. List several examples of factory overhead. 20. List the four components of a manufacturing

statement and provide specific examples of each for Polaris.

Discussion Questions

Finished goods inventory, beginning year . . . . . . . . . $6,000

Finished goods inventory, ending year . . . . . . . . . . . 3,200

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 651 mhhe.com/wildFINMAN5e

4. The three major cost components of manufacturing a product are a. Direct materials, direct labor, and factory overhead. b. Period costs, product costs, and sunk costs. c. Indirect labor, indirect materials, and fixed expenses. d. Variable costs, fixed costs, and period costs. e. Opportunity costs, sunk costs, and direct costs. 5. A company reports the following for the current year.

1. Continuous improvement a. Is used to reduce inventory levels. b. Is applicable only in service businesses. c. Rejects the notion of “good enough.” d. Is used to reduce ordering costs. e. Is applicable only in manufacturing businesses. 2. A direct cost is one that is a. Variable with respect to the cost object. b. Traceable to the cost object. c. Fixed with respect to the cost object. d. Allocated to the cost object. e. A period cost. 3. Costs that are incurred as part of the manufacturing process, but

are not clearly traceable to the specific unit of product or batches of product, are called

a. Period costs. b. Factory overhead. c. Sunk costs. d. Opportunity costs. e. Fixed costs.

Its cost of goods manufactured for the current year is a. $1,500. b. $1,700. c. $7,500. d. $2,800. e. $4,700.

Polaris

Polaris

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636 Chapter 14 Managerial Accounting Concepts and Principles

QUICK STUDY

QS 14-1 Managerial accounting defined

C1

Managerial accounting (choose one) 1. Is directed at reporting aggregate data on the company as a whole. 2. Provides information that is widely available to all interested parties. 3. Must follow generally accepted accounting principles. 4. Provides information to aid management in planning and controlling business activities.

QS 14-2 Managerial accounting versus financial accounting

C1

Identify whether each description most likely applies to managerial or financial accounting. 1. _______ Its primary users are company managers. 2. _______ Its information is often available only after an audit is complete. 3. _______ Its primary focus is on the organization as a whole. 4. _______ Its principles and practices are very flexible. 5. _______ It is directed at external users in making investment, credit, and other decisions.

QS 14-3 Product and period costs

C3

Which of these statements is true regarding product and period costs? 1. Factory maintenance is a product cost and sales commission is a period cost. 2. Sales commission is a product cost and depreciation on factory equipment is a product cost. 3. Sales commission is a product cost and factory rent is a period cost. 4. Factory wages are a product cost and direct material is a period cost.

QS 14-4 Fixed and variable costs

C2

Which of these statements is true regarding fixed and variable costs? 1. Fixed costs stay the same and variable costs increase in total as activity volume increases. 2. Both fixed and variable costs increase as activity volume increases. 3. Both fixed and variable costs stay the same in total as activity volume increases. 4. Fixed costs increase and variable costs decrease in total as activity volume decreases.

QS 14-5 Direct and indirect costs

C2

Verdi Company produces sporting equipment, including leather footballs. Identify each of the following costs as direct or indirect if the cost object is a football produced by Verdi. 1. Electricity used in the production plant. 2. Labor used on the football production line. 3. Salary of manager who supervises the entire plant. 4. Depreciation on equipment used to produce footballs. 5. Leather used to produce footballs.

21. Prepare a proper title for the annual “manu- facturing statement” of Arctic Cat. Does the date match the balance sheet or income statement? Why?

22. Describe the relations among the income statement, the man ufacturing statement, and a detailed listing of factory over- head costs.

23. Define and describe two measures to assess raw materials inventory management.

24. Can management of a company such as Polaris use cycle time and cycle efficiency as useful mea sures of performance? Explain.

25. Access Dell’s annual report (10-K) for the fiscal year ended February 3, 2012, at the SEC’s EDGAR database (SEC.gov) or its Website (Dell.com). From its financial statement notes, iden- tify the titles and amounts of its inventory components.

PolarisArctic Cat

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Chapter 14 Managerial Accounting Concepts and Principles 637

QS 14-6 Inventory reporting for manufacturers C4

Three inventory categories are reported on a manufacturing company’s balance sheet: (a) raw materials, (b) goods in process, and (c) finished goods. Identify the usual order in which these inventory items are reported on the balance sheet. 1. (b)(c)(a) 2. (c)(b)(a) 3. (a)(b)(c) 4. (b)(a)(c)

QS 14-8 Cost of goods sold P1

A company has year-end cost of goods manufactured of $4,000, beginning finished goods inventory of $500, and ending finished goods inventory of $750. Its cost of goods sold is 1. $4,250 2. $4,000 3. $3,750 4. $3,900

QS 14-9 Manufacturing flows identified

C5

Identify the usual sequence of manufacturing activities by filling in the blank (1, 2 or 3) corres ponding to its order: _______ Production activities; _______ sales activities; _______ materials activities.

Finished goods inventory, Dec. 31, 2012 . . . . . . . . . . . . $345,000

Goods in process inventory, Dec. 31, 2012 . . . . . . . . . 83,500

Goods in process inventory, Dec. 31, 2013 . . . . . . . . . 72,300

Cost of goods manufactured, year 2013 . . . . . . . . . . . 918,700

Finished goods inventory, Dec. 31, 2013 . . . . . . . . . . . . 283,600

QS 14-7 Cost of goods sold

P1

Compute cost of goods sold for year 2013 using the following information.

QS 14-12 Direct materials used

C5

Nestlé reports beginning raw materials inventory of 3,243 and ending raw materials inventory of 3,904 (both numbers in millions of Swiss francs). If Nestlé purchased 16,200 (in millions of Swiss francs) of raw materials during the year, what is the amount of raw materials it used during the year?

QS 14-13 Raw materials inventory management A1

Refer to QS 14-12 and compute raw materials inventory turnover and the number of days’ sales in raw materials inventory.

QS 14-11 Lean business concepts

C6

Match each lean business concept with its best description by entering its letter in the blank. 1. _______ Just-in-time manufacturing A. Focuses on quality throughout the production process. 2. _______ Continuous improvements B. Flexible product designs can be modified to accom-

modate customer choices. 3. _______ Customer orientation C. Every manager and employee constantly looks for

ways to improve company operations. 4. _______ Total quality management D. Inventory is acquired or produced only as needed.

Direct materials . . . . . . . . . . . . . . . . . . . . . $190,500

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . 63,150

Factory overhead costs . . . . . . . . . . . . . . . 24,000

Goods in process, Dec. 31, 2012 . . . . . . . . 157,600

Goods in process, Dec. 31, 2013 . . . . . . . . 142,750

QS 14-10 Cost of goods manufactured

P2

Prepare the 2013 manufacturing statement for Briton Company using the following information.

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638 Chapter 14 Managerial Accounting Concepts and Principles

Exercise 14-4 Cost classifications C2

(1) Identify each of the five cost classifications discussed in the chapter. (2) List two purposes of identifying these separate cost classifications.

Exercise 14-5 Cost analysis and classification

C2

Listed here are product costs for the production of soccer balls. (1) Classify each cost (a) as either variable or fixed and (b) as either direct or indirect. (2) What pattern do you see regarding the relation between costs classified by behavior and costs classified by traceability?

Cost by Behavior Cost by Traceability

Product Cost Variable Fixed Direct Indirect

1. Leather covers for soccer balls . . . . . . . . . . . . . ____ ____ ____ ____

2. Annual flat fee paid for office security . . . . . . . . ____ ____ ____ ____ 

3. Coolants for machinery . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

4. Wages of assembly workers . . . . . . . . . . . . . . . . ____ ____ ____ ____

5. Lace to hold leather together . . . . . . . . . . . . . . . ____ ____ ____ ____

6. Taxes on factory . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

7. Machinery depreciation . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

In the following chart, compare financial accounting and managerial accounting by describing how each differs for the items listed. Be specific in your responses.

EXERCISES

Exercise 14-1 Characteristics of financial accounting and managerial accounting

C1

Financial Accounting Managerial Accounting

1. Time dimension . . . . . . . . . . . . . . . . .

2. Users and decision makers . . . . . . . .

3. Timeliness of information . . . . . . . . .

4. Purpose of information . . . . . . . . . . .

5. Nature of information . . . . . . . . . . . .

6. Flexibility of practice . . . . . . . . . . . . .

7. Focus of information . . . . . . . . . . . . .

Exercise 14-3 Sources of accounting information

C1

Both managerial accounting and financial accounting provide useful information to decision makers. Indi- cate in the following chart the most likely source of information for each business decision (a decision can require major input from both sources, in which case both can be marked).

Primary Information Source

Business Decision Managerial Financial

1. Determine amount of dividends to pay stockholders . . . . . . ____ ____

2. Evaluate a purchasing department’s performance . . . . . . . . . ____ ____

3. Report financial performance to board of directors . . . . . . . ____ ____

4. Estimate product cost for a new line of shoes . . . . . . . . . . . ____ ____

5. Plan the budget for next quarter . . . . . . . . . . . . . . . . . . . . . . ____ ____

6. Measure profitability of all individual stores . . . . . . . . . . . . . . ____ ____

7. Prepare financial reports according to GAAP . . . . . . . . . . . . ____ ____

8. Determine location and size for a new plant . . . . . . . . . . . . ____ ____

Exercise 14-2 Planning and control descriptions

C1

Complete the following statements by filling in the blanks. 1. _______ _______ usually covers a period of one year. 2. _______ is the process of monitoring planning decisions and evaluating an organization’s activities

and employees. 3. _______ is the process of setting goals and making plans to achieve them. 4. _______ _______ usually covers a period of 5 to 10 years.

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Chapter 14 Managerial Accounting Concepts and Principles 639

Exercise 14-7 Balance sheet identification and preparation

C4

Current assets for two different companies at calendar year-end 2013 are listed here. One is a manufacturer, Salomon Skis Mfg., and the other, Sun Fresh Foods, is a grocery distribution company. (1) Identify which set of numbers relates to the manufacturer and which to the merchandiser. (2) Prepare the current asset section for each company from this information. Discuss why the current asset section for these two companies is different.

Account Company 1 Company 2

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000 $ 5,000 Raw materials inventory . . . . . . . . . . . — 42,000 Merchandise inventory . . . . . . . . . . . . . 45,000 — Goods in process inventory . . . . . . . . — 30,000 Finished goods inventory . . . . . . . . . . . — 50,000 Accounts receivable, net . . . . . . . . . . . 62,000 75,000 Prepaid expenses . . . . . . . . . . . . . . . . . 1,500 900

Georgia Pacific, a manufacturer, incurs the following costs. (1) Classify each cost as either a product or a period cost. If a product cost, identify it as direct materials, direct labor, or factory overhead, and then as a prime and/or conversion cost. (2) Classify each product cost as either a direct cost or an indirect cost using the product as the cost object.

Product Cost

Prime Conversion

Direct Direct Direct Period Direct Indirect

Cost Material Labor Labor Overhead Cost Cost Cost

1. Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

2. Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

3. Amortization of patents on factory machine . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

4. State and federal income taxes . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

5. Office supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

6. Bad debts expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

7. Small tools used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

8. Payroll taxes for production supervisor . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

9. Accident insurance on factory workers . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

10. Depreciation — Factory building. . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

11. Wages to assembly workers . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

12. Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____ ____ ____ ____

Exercise 14-6 Cost analysis and identification

C3

Exercise 14-8 Cost of goods manufactured and cost of goods sold computation

P1 P2

Using the following data, compute (1) the cost of goods manufactured and (2) the cost of goods sold for both Garcia Company and Culpepper Company.

Garcia Culpepper

Company Company

Beginning finished goods inventory . . . . . . . . . . $12,000 $16,450 Beginning goods in process inventory . . . . . . . . 14,500 19,950 Beginning raw materials inventory . . . . . . . . . . . 7,250 9,000 Rental cost on factory equipment . . . . . . . . . . . 27,000 22,750 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 35,000 Ending finished goods inventory . . . . . . . . . . . . 17,650 13,300 Ending goods in process inventory . . . . . . . . . . 22,000 16,000 Ending raw materials inventory . . . . . . . . . . . . . 5,300 7,200 Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 12,000 Factory supplies used . . . . . . . . . . . . . . . . . . . . . 8,200 3,200 General and administrative expenses . . . . . . . . 21,000 43,000 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,250 7,660 Repairs—Factory equipment . . . . . . . . . . . . . . . 4,780 1,500 Raw materials purchases . . . . . . . . . . . . . . . . . . . 33,000 52,000 Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 46,000 Check Garcia COGS, $91,030

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640 Chapter 14 Managerial Accounting Concepts and Principles

Exercise 14-11 Components of accounting reports

P2

For each of the following accounts for a manufacturing company, place a ✔ in the appropriate column in- dicating that it appears on the balance sheet, the income statement, the manufacturing statement, and/or a detailed listing of factory overhead costs. Assume that the income statement shows the calculation of cost of goods sold and the manufacturing statement shows only the total amount of factory overhead. (An ac- count can appear on more than one report.)

Exercise 14-10 Cost flows in manufacturing

C5

The following chart shows how costs flow through a business as a product is manufactured. Some boxes in the flowchart show cost amounts. Compute the cost amounts for the boxes that contain question marks.

Raw materials purchases $532,000

Beginning raw materials inventory

$145,500

Direct labor used in production

$350,000

Beginning goods in process inventory

$84,500

Finished goods manufactured

$1,593,500

Factory overhead used in production

$750,000

Ending raw materials inventory $175,000

Finished goods available for sale

$1,740,250

Ending finished goods inventory

$139,950

Materials Activity

Production Activity

Sales Activity

Raw materials available for use in production

?$

Direct materials used in production

?$

Total goods in process

?$

Finished goods sold ?$

Beginning finished goods inventory

?$

Ending goods in process inventory

?$

Compute cost of goods sold for each of these two companies for the year ended December 31, 2013.

Viking Retail Log Homes

Manufacturing

$275,000

500,000

115,000

$450,000

375,000

900,000

Merchandise

Beginning inventory

Cost of purchases Cost of goods manufactured Ending inventory

Merchandise Finished goods

Finished goods

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Exercise 14-9 Cost of goods sold computation

P1

Check Viking COGS, $660,000

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Chapter 14 Managerial Accounting Concepts and Principles 641

Use the information in Exercise 14-12 to prepare an income statement for Shanta Company (a man- ufacturer). Assume that its cost of goods manufactured is $534,390.

Exercise 14-13 Income statement preparation

P2

Given the following selected account balances of Shanta Company, prepare its manufacturing statement for the year ended on December 31, 2013. Include a listing of the individual overhead account balances in this statement.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,250,000

Raw materials inventory, Dec. 31, 2012 . . . . . . . . . . . 37,000

Goods in process inventory, Dec. 31, 2012 . . . . . . . 53,900

Finished goods inventory, Dec. 31, 2012 . . . . . . . . . . 62,750

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . 175,600

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000

Factory computer supplies used . . . . . . . . . . . . . . . . . 17,840

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,000

Repairs—Factory equipment . . . . . . . . . . . . . . . . . . . . 5,250

Rent cost of factory building . . . . . . . . . . . . . . . . . . . . 57,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,000

General and administrative expenses . . . . . . . . . . . . . 129,300

Raw materials inventory, Dec. 31, 2013 . . . . . . . . . . . 42,700

Goods in process inventory, Dec. 31, 2013 . . . . . . . 41,500

Finished goods inventory, Dec. 31, 2013 . . . . . . . . . . 67,300

Exercise 14-12 Manufacturing statement preparation

P2

Check Cost of goods manufactured, $534,390

Cash

Accounts receivable Computer supplies used in office Beginning finished goods inventory Beginning goods in process inventory Beginning raw materials inventory

Depreciation expense—Factory building Depreciation expense—Factory equipment Depreciation expense—Office building Depreciation expense—Office equipment Direct labor Ending finished goods inventory Ending goods in process inventory Ending raw materials inventory Factory maintenance wages Computer supplies used in factory Income taxes Insurance on factory building Rent cost on office building Office supplies used Property taxes on factory building Raw materials purchases Sales

Account Balance Sheet

Income Statement

Manufacturing Statement

Overhead Report

4 5 6 7

1 2 3

8 9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

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Following are three separate events affecting the managerial accounting systems for different companies. Match the management concept(s) that the company is likely to adopt for the event identified. There is some overlap in the meaning of customer orientation and total quality management and, therefore, some responses can include more than one concept.

Exercise 14-14 Management concepts

C6

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642 Chapter 14 Managerial Accounting Concepts and Principles

PROBLEM SET A

Problem 14-1A Managerial accounting role

C1

This chapter explained the purpose of managerial accounting in the context of the current business envi- ronment. Review the automobile section of your local newspaper; the Sunday paper is often best. Review advertisements of sport-utility vehicles and identify the manufacturers that offer these products and the factors on which they compete.

Required

Discuss the potential contributions and responsibilities of the managerial accounting professional in help- ing an automobile manufacturer succeed. (Hint: Think about information and estimates that a managerial accountant might provide new entrants into the sport-utility market.)

Customer orientation means that a company’s managers and employees respond to customers’ changing wants and needs. A manufacturer of metal parts has created a customer satisfaction survey that it asks each of its customers to complete. The survey asks about the following factors: (A) product performance; (B) price; (C) lead time; (D) delivery. Each factor is to be rated as unsatisfactory, marginal, average, satisfac- tory, or very satisfied. a. Match the competitive forces 1 through 4 to the factors on the survey. A factor can be matched to

more than one competitive force.

Survey Factor Competitive Force

A. Product performance _______ 1. Time B. Price _______ 2. Quality C. Lead time _______ 3. Cost D. Delivery _______ 4. Flexibility of service

b. How can managers of this company use the information from this customer satisfaction survey to better meet competitive forces and satisfy their customers?

Exercise 14-15 Customer orientation in practice

C6

Event Management Concept

_______ 1. The company starts reporting measures a. Continuous improvement (CI) such as the percent of defective products and the number of units scrapped. b. Total quality management (TQM) _______ 2. The company starts reporting measures on customer complaints and product c. Just-in-time ( JIT) system

returns from customers. _______ 3. The company starts measuring inventory d. Customer orientation (CO)

turnover and discontinues elaborate inventory records. Its new focus is to pull inventory through the system.

Listed below are costs of providing an airline service. Classify each cost as (a) either variable or fixed and (b) as either direct or indirect. Consider the cost object to be a flight.

Exercise 14-16 Cost classifications for a service company

C2 Cost by Behavior Cost by Traceability

Cost Variable Fixed Direct Indirect

1. Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

2. Beverages and snacks . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

3. Regional vice-president salary . . . . . . . . . . . . . ____ ____ ____ ____

4. Depreciation on ground equipment . . . . . . . ____ ____ ____ ____

5. Fuel and oil used in planes . . . . . . . . . . . . . . . ____ ____ ____ ____

6. Flight attendant salaries . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

7. Pilot salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

8. Ground crew wages . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

9. Travel agent salaries . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

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Chapter 14 Managerial Accounting Concepts and Principles 643

Problem 14-4A Cost classification and explanation

C2 C3

Assume that you must make a presentation to the marketing staff explaining the difference between prod- uct and period costs. Your supervisor tells you the marketing staff would also like clarification regarding prime and conversion costs and an explanation of how these terms fit with product and period cost. You are told that many on the staff are unable to classify costs in their merchandising activities.

Required

Prepare a one-page memorandum to your supervisor outlining your presentation to the marketing staff.

Required

1. Classify each cost and its amount as (a) either variable or fixed and (b) either product or period. (The first cost is completed as an example.)

2. Compute the manufacturing cost per drum set.

Analysis Component

3. Assume that 1,200 drum sets are produced in the next year. What do you predict will be the total cost of plastic for the casings and the per unit cost of the plastic for the casings? Explain.

4. Assume that 1,200 drum sets are produced in the next year. What do you predict will be the total cost of property taxes and the per unit cost of the property taxes? Explain.

Check (1) Total variable production cost, $125,000

Listed here are the total costs associated with the 2013 production of 1,000 drum sets manufactured by DrumBeat. The drum sets sell for $500 each.

Problem 14-3A Cost computation, classification, and analysis

C2 C3 Cost by Behavior Cost by Function

Costs Variable Fixed Product Period

1. Plastic for casing—$17,000. . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,000 ____ $17,000 ____

2. Wages of assembly workers—$82,000. . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

3. Property taxes on factory—$5,000 . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

4. Accounting staff salaries — $35,000 . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

5. Drum stands (1,000 stands outsourced)—$26,000 . . . . . . . . ____ ____ ____ ____

6. Rent cost of equipment for sales staff—$10,000 . . . . . . . . . . ____ ____ ____ ____

7. Upper management salaries—$125,000 . . . . . . . . . . . . . . . . . ____ ____ ____ ____

8. Annual flat fee for maintenance service—$10,000 . . . . . . . . . ____ ____ ____ ____

9. Sales commissions—$15 per unit . . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

10. Machinery depreciation, straight-line—$40,000 . . . . . . . . . . . ____ ____ ____ ____

Refer to Decision Maker, Purchase Manager, in this chapter. Assume that you are the motorcycle manu- facturer’s managerial accountant. The purchasing manager asks you about preparing an estimate of the related costs for buying motorcycle seats from supplier (B). She tells you this estimate is needed because unless dollar estimates are attached to nonfinancial factors, such as lost production time, her supervisor will not give it full attention. The manager also shows you the following information.

● Production output is 1,000 motorcycles per year based on 250 production days a year. ● Production time per day is 8 hours at a cost of $2,000 per hour to run the production line. ● Lost production time due to poor quality is 1%. ● Satisfied customers purchase, on average, three motorcycles during a lifetime. ● Satisfied customers recommend the product, on average, to 5 other people. ● Marketing predicts that using seat (B) will result in 5 lost customers per year from repeat business and

referrals. ● Average gross profit per motorcycle is $3,000.

Required

Estimate the costs (including opportunity costs) of buying motorcycle seats from supplier (B). This problem requires that you think creatively and make reasonable estimates; thus there could be more than one correct answer. (Hint: Reread the answer to Decision Maker and compare the cost savings for buying from supplier [B] to the sum of lost customer revenue from repeat business and referrals and the cost of lost production time.)

Problem 14-2A Opportunity cost estimation and application

C1 C2

Check Estimated cost of lost production time, $40,000

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644 Chapter 14 Managerial Accounting Concepts and Principles

Problem 14-7A Manufacturing and income statements; inventory analysis

P2 A1

The following calendar year-end information is taken from the December 31, 2013, adjusted trial balance and other records of DeLeon Company.

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 28,750

Depreciation expense — Office equipment . . . . . . . . . 7,250

Depreciation expense — Selling equipment . . . . . . . . . 8,600

Depreciation expense — Factory equipment . . . . . . . . 33,550

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,600

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . 7,350

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

Inventories

Raw materials, December 31, 2012 . . . . . . . . . . . . . 166,850

Raw materials, December 31, 2013 . . . . . . . . . . . . . 182,000

Goods in process, December 31, 2012 . . . . . . . . . . 15,700

Goods in process, December 31, 2013 . . . . . . . . . . . 19,380

Finished goods, December 31, 2012 . . . . . . . . . . . . . 167,350

Finished goods, December 31, 2013 . . . . . . . . . . . . . 136,490

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 675,480

Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . 233,725

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,875

Miscellaneous production costs . . . . . . . . . . . . . . . . . . 8,425

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 63,000

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . 925,000

Rent expense — Office space . . . . . . . . . . . . . . . . . . . . 22,000

Rent expense — Selling space . . . . . . . . . . . . . . . . . . . . 26,100

Rent expense — Factory building . . . . . . . . . . . . . . . . . 76,800

Maintenance expense — Factory equipment . . . . . . . . 35,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,525,000

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,500

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 392,560

Notaro’s Boot Company makes specialty boots for the rodeo circuit. On December 31, 2012, the company had (a) 300 pairs of boots in finished goods inventory and (b) 1,200 heels at a cost of $8 each in raw ma- terials inventory. During 2013, the company purchased 35,000 additional heels at $8 each and manufac- tured 16,600 pairs of boots.

Required

1. Determine the unit and dollar amounts of raw materials inventory in heels at December 31, 2013.

Analysis Component

2. Write a one-half page memorandum to the production manager explaining why a just-in-time inventory system for heels should be considered. Include the amount of working capital that can be reduced at December 31, 2013, if the ending heel raw material inventory is cut by half.

Problem 14-5A Ending inventory computation and evaluation

C4

Check (1) Ending (heel) inventory, 3,000 units; $24,000

mhhe.com/wildFINMAN5e

Problem 14-6A Inventory computation and reporting

C4 P1

Shown here are annual financial data at December 31, 2013, taken from two different companies.

Sports World Sno-Board

Retail Manufacturing

Beginning inventory

Merchandise . . . . . . . . . . . . . . . . . . . $200,000

Finished goods . . . . . . . . . . . . . . . . . . $500,000

Cost of purchases . . . . . . . . . . . . . . . . . 300,000

Cost of goods manufactured . . . . . . . . 875,000

Ending inventory

Merchandise . . . . . . . . . . . . . . . . . . . 175,000

Finished goods . . . . . . . . . . . . . . . . . . 225,000

Check (1) Sno-Board’s cost of goods sold, $1,150,000

Required

1. Compute the cost of goods sold section of the income statement at December 31, 2013, for each com- pany. Include the proper title and format in the solution.

2. Write a half-page memorandum to your instructor (a) identifying the inventory accounts and (b) de- scribing where each is reported on the income statement and balance sheet for both companies.

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Chapter 14 Managerial Accounting Concepts and Principles 645

Required

1. Prepare the company’s 2013 manufacturing statement. 2. Prepare the company’s 2013 income statement that reports separate categories for (a) selling expenses

and (b) general and administrative expenses.

Analysis Component

3. Compute the (a) inventory turnover, defined as cost of goods sold divided by average inventory, and (b) days’ sales in inventory, defined as 365 times ending inventory divided by cost of goods sold, for both its raw materials inventory and its finished goods inventory. (To compute turnover and days’ sales in inventory for raw materials, use raw materials used rather than cost of goods sold.) Discuss some possible reasons for differences between these ratios for the two types of inventories. Round answers to one decimal place.

Check (1) Cost of goods manufactured, $1,935,650

PROBLEM SET B

Problem 14-1B Managerial accounting role

C1

This chapter described the purpose of managerial accounting in the context of the current business environment. Review the home electronics section of your local newspaper; the Sunday paper is often best. Review advertisements of home electronics and identify the manufacturers that offer these products and the factors on which they compete.

Required

Discuss the potential contributions and responsibilities of the managerial accounting professional in help- ing a home electronics manufacturer succeed. (Hint: Think about information and estimates that a mana- gerial accountant might provide new entrants into the home electronics market.)

Many fast-food restaurants compete on lean business concepts. Match each of the following activities at a fast-food restaurant with the lean business concept it strives to achieve. Some activities might relate to more than one lean business concept. _______ 1. Courteous employees a. Just-in-time (JIT) _______ 2. Food produced to order b. Continuous improvement (CI) _______ 3. Clean tables and floors c. Total quality management (TQM) _______ 4. Orders filled within three minutes _______ 5. Standardized food making processes _______ 6. New product development _______ 7. Customer satisfaction surveys _______ 8. Standardized menus from location to location _______ 9. Drive-through windows _______ 10. Continually changing menus

Problem 14-8A Lean business concepts

C6

Refer to Decision Maker, Purchase Manager, in this chapter. Assume that you are the motorcycle manu- facturer’s managerial accountant. The purchasing manager asks you about preparing an estimate of the related costs for buying motorcycle seats from supplier (B). She tells you this estimate is needed because unless dollar estimates are attached to nonfinancial factors such as lost production time, her supervisor will not give it full attention. The manager also shows you the following information.

● Production output is 1,000 motorcycles per year based on 250 production days a year. ● Production time per day is 8 hours at a cost of $500 per hour to run the production line. ● Lost production time due to poor quality is 1%. ● Satisfied customers purchase, on average, three motorcycles during a lifetime. ● Satisfied customers recommend the product, on average, to four other people. ● Marketing predicts that using seat (B) will result in four lost customers per year from repeat business

and referrals. ● Average gross profit per motorcycle is $4,000.

Problem 14-2B Opportunity cost estimation and application

C1 C2

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646 Chapter 14 Managerial Accounting Concepts and Principles

Problem 14-5B Ending inventory computation and evaluation

C4

Sharp Edges makes specialty skates for the ice skating circuit. On December 31, 2012, the company had (a) 1,500 skates in finished goods inventory and (b) 2,500 blades at a cost of $20 each in raw materials inventory. During 2013, Sharp Edges purchased 45,000 additional blades at $20 each and manufactured 20,750 pairs of skates.

Problem 14-4B Cost classification and explanation

C2 C3

Assume that you must make a presentation to a client explaining the difference between prime and con- version costs. The client makes and sells 200,000 cookies per week. The client tells you that her sales staff also would like a clarification regarding product and period costs. She tells you that most of the staff lack training in managerial accounting.

Required

Prepare a one-page memorandum to your client outlining your planned presentation to her sales staff.

Required

1. Classify each cost and its amount as (a) either variable or fixed and (b) either product or period. (The first cost is completed as an example.)

2. Compute the manufacturing cost per BD.

Analysis Component

3. Assume that 10,000 BDs are produced in the next year. What do you predict will be the total cost of plastic for the BDs and the per unit cost of the plastic for the BDs? Explain.

4. Assume that 10,000 BDs are produced in the next year. What do you predict will be the total cost of factory rent and the per unit cost of the factory rent? Explain.

Listed here are the total costs associated with the 2013 production of 15,000 Blu-ray Discs (BDs) manufac- tured by Nextgen. The BDs sell for $18 each.

Check (2) Total variable production cost, $35,250

Problem 14-3B Cost computation, classification, and analysis

C2 C3 Cost by Behavior Cost by Function

Costs Variable Fixed Product Period

1. Plastic for BDs — $1,500 . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500 $1,500

2. Wages of assembly workers — $30,000 . . . . . . . . . . . . . .

3. Cost of factory rent — $6,750 . . . . . . . . . . . . . . . . . . . . .

4. Systems staff salaries — $15,000 . . . . . . . . . . . . . . . . . . . .

5. Labeling (12,000 outsourced)—$3,750 . . . . . . . . . . . . . .

6. Cost of office equipment rent—$1,050 . . . . . . . . . . . . . .

7. Upper management salaries—$120,000 . . . . . . . . . . . . . .

8. Annual fixed fee for cleaning service—$4,520 . . . . . . . . .

9. Sales commissions—$0.50 per BD . . . . . . . . . . . . . . . . . .

10. Machinery depreciation, straight-line—$18,000 . . . . . . . .

Check Cost of lost gross profit, $16,000

Required

Estimate the costs (including opportunity costs) of buying motorcycle seats from supplier (B). This prob- lem requires that you think creatively and make reasonable estimates; thus there could be more than one correct answer. (Hint: Reread the answer to Decision Maker, and compare the cost savings for buying from supplier [B] to the sum of lost customer revenue from repeat business and referrals and the cost of lost production time.)

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Chapter 14 Managerial Accounting Concepts and Principles 647

Shown here are annual financial data at December 31, 2013, taken from two different companies. Problem 14-6B Inventory computation and reporting

C4 P1

Check (1) Badger cost of goods sold, $200,000

Badger Naima

(Retail) (Manufacturing)

Beginning inventory

Merchandise . . . . . . . . . . . . . . . . . . . $100,000

Finished goods . . . . . . . . . . . . . . . . . $300,000

Cost of purchases . . . . . . . . . . . . . . . . . 250,000

Cost of goods manufactured . . . . . . . . 586,000

Ending inventory

Merchandise . . . . . . . . . . . . . . . . . . . 150,000

Finished goods . . . . . . . . . . . . . . . . . 200,000

Required

1. Compute the cost of goods sold section of the income statement at December 31, 2013, for each com- pany. Include the proper title and format in the solution.

2. Write a half-page memorandum to your instructor (a) identifying the inventory accounts and (b) iden- tifying where each is reported on the income statement and balance sheet for both companies.

Problem 14-7B Manufacturing and income statements; analysis of inventories P2 A1

The following calendar year-end information is taken from the December 31, 2013, adjusted trial balance and other records of Elegant Furniture.

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,250

Depreciation expense—Office equipment . . . . . . . . . . 8,440

Depreciation expense—Selling equipment . . . . . . . . . 10,125

Depreciation expense—Factory equipment . . . . . . . . 35,400

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . 121,500

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . 6,060

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500

Inventories

Raw materials, December 31, 2012 . . . . . . . . . . . . . 40,375

Raw materials, December 31, 2013 . . . . . . . . . . . . . 70,430

Goods in process, December 31, 2012 . . . . . . . . . . 12,500

Goods in process, December 31, 2013 . . . . . . . . . . 14,100

Finished goods, December 31, 2012 . . . . . . . . . . . . . 177,200

Finished goods, December 31, 2013 . . . . . . . . . . . . . 141,750

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 562,500

Income taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . 136,700

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,000

Miscellaneous production costs . . . . . . . . . . . . . . . . . . 8,440

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 70,875

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . 894,375

Rent expense — Office space . . . . . . . . . . . . . . . . . . . . 23,625

Rent expense — Selling space . . . . . . . . . . . . . . . . . . . . 27,000

Rent expense — Factory building . . . . . . . . . . . . . . . . . 93,500

Maintenance expense — Factory equipment . . . . . . . . 30,375

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,375

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 295,300

Required

1. Prepare the company’s 2013 manufacturing statement. 2. Prepare the company’s 2013 income statement that reports separate categories for (a) selling expenses

and (b) general and administrative expenses.

Check (1) Cost of goods manufactured, $1,816,995

Check (1) Ending (blade) inventory, 6,000 units; $120,000

Required

1. Determine the unit and dollar amounts of raw materials inventory in blades at December 31, 2013.

Analysis Component

2. Write a one-half page memorandum to the production manager explaining why a just-in-time inven- tory system for blades should be considered. Include the amount of working capital that can be reduced at December 31, 2013, if the ending blade raw materials inventory is cut in half.

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648 Chapter 14 Managerial Accounting Concepts and Principles

(This serial problem begins in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 14 Adria Lopez, owner of Success Systems, decides to diversify her business by also manufacturing computer workstation furniture.

Required

1. Classify the following manufacturing costs of Success Systems by behavior and traceability.

SERIAL PROBLEM Success Systems

C2 C4 P2

Cost by Behavior Cost by Traceability

Product Costs Variable Fixed Direct Indirect

1. Monthly flat fee to clean workshop . . . . . . . . . ____ ____ ____ ____

2. Laminate coverings for desktops . . . . . . . . . . . ____ ____ ____ ____

3. Taxes on assembly workshop . . . . . . . . . . . . . ____ ____ ____ ____

4. Glue to assemble workstation component parts . . . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

5. Wages of desk assembler . . . . . . . . . . . . . . . . ____ ____ ____ ____

6. Electricity for workshop . . . . . . . . . . . . . . . . . ____ ____ ____ ____

7. Depreciation on tools . . . . . . . . . . . . . . . . . . . ____ ____ ____ ____

Analysis Component

3. Compute the (a) inventory turnover, defined as cost of goods sold divided by average inventory, and (b) days’ sales in inventory, defined as 365 times ending inventory divided by cost of goods sold, for both its raw materials inventory and its finished goods inventory. (To compute turnover and days’ sales in inventory for raw materials, use raw materials used rather than cost of goods sold.) Discuss some possible reasons for differences between these ratios for the two types of inventories. Round answers to one decimal place.

Canon manufactures digital cameras and must compete on lean manufacturing concepts. Match each of the following activities that it engages in with the lean manufacturing concept it strives to achieve. (Some ac- tivities might relate to more than one lean manufacturing concept.) _______ 1. Manufacturing facilities are arranged to reduce

move time and wait time. _______ 2. Canon conducts focus groups to determine new

features that customers want in digital cameras. _______ 3. Canon monitors the market to determine what

features its competitors are offering on digital cameras.

_______ 4. Canon asks production workers for ideas to improve production.

_______ 5. The manufacturing process is standardized and documented.

_______ 6. Cameras are produced in small lots, and only to customer order.

_______ 7. Lenses are received daily based on customer orders.

_______ 8. Customers receive a satisfaction survey with each camera purchased.

_______ 9. Orders received are filled within two business days. _______ 10. Canon works with suppliers to reduce inspection

time of incoming materials.

a. Just-in-time (JIT) b. Continuous improvement (CI) c. Total quality management (TQM)

Problem 14-8B Lean business concepts

C6

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Chapter 14 Managerial Accounting Concepts and Principles 649

BTN 14-1 Managerial accounting is more than recording, maintaining, and reporting financial results. Managerial accountants must provide managers with both financial and nonfinancial information including estimates, projections, and forecasts. An important estimate for Polaris is its reserve for warranty claims, and the company must provide shareholders information on these estimates.

Required

1. Access and read Polaris’s “Product warranties” section of the “Organization and Significant Account- ing Policies” footnote to its financial statements, from Appendix A. What is the warranty period for Polaris’s products? How does management establish and adjust the warranty reserve? What are some of the effects if the company’s actual results differ from its estimates?

2. What is the management accountant’s role in determining those estimates? 3. What are some factors that could impact the warranty accrual in a given year?

Fast Forward

4. Access Polaris’s annual report for a fiscal year ending after December 31, 2011, from either its Web- site [Polaris.com] or the SEC’s EDGAR database [ www.sec.gov ]. Answer the questions in parts (1), (2), and (3) after reading the current “Organization and Significant Accounting Policies”. Identify any major changes.

Beyond the Numbers

REPORTING IN ACTION C1

BTN 14-3 Assume that you are the managerial accountant at Infostore, a manufacturer of hard drives, CDs, and DVDs. Its reporting year-end is December 31. The chief financial officer is concerned about having enough cash to pay the expected income tax bill because of poor cash flow management. On November 15, the purchasing department purchased excess inventory of CD raw materials in anticipa- tion of rapid growth of this product beginning in January. To decrease the company’s tax liability, the chief financial officer tells you to record the purchase of this inventory as part of supplies and expense it in the current year; this would decrease the company’s tax liability by increasing expenses.

ETHICS CHALLENGE C1 C3

BTN 14-2 Both Polaris and Arctic Cat provide warranties on the products they sell. Accurate estimates of these future warranty claims are important. Access the annual report or 10-K for both Polaris (from Appendix A) and Arctic Cat. The Polaris report is for the year ended December 31, 2011, and the Arctic Cat report is for the year ended March 31, 2011.

Required

1. Read the “Product warranties” section of the “Organization and Significant Accounting Policies” foot- note for Polaris. For each of the three years reported, compare the dollar amounts of the annual war- ranty expense and actual warranty claims paid. Is Polaris’ warranty expense higher, lower, or about the same as its warranty claims paid?

2. Read the “Product Warranties” section of the “Summary of Significant Accounting Policies” footnote for Arctic Cat. For each of the three years reported, compare the dollar amounts of the annual warranty expense and actual warranty claims paid. Is Arctic Cat’s warranty expense higher, lower, or about the same as its warranty claims paid?

3. Using the answers from parts (1) and (2), which company made more accurate estimates of warranty costs over the most recent three years?

COMPARATIVE ANALYSIS C2

2. Prepare a manufacturing statement for Success Systems for the month ended January 31, 2014. As- sume the following manufacturing costs:

Direct materials: $2,200 Factory overhead: $490 Direct labor: $900 Beginning goods in process: none (December 31, 2013) Ending goods in process: $540 (January 31, 2014) Beginning finished goods inventory: none (December 31, 2013) Ending finished goods inventory: $350 (January 31, 2014) 3. Prepare the cost of goods sold section of a partial income statement for Success Systems for the month

ended January 31, 2014. Check (3) COGS, $2,700

Polaris

Polaris Arctic Cat

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650 Chapter 14 Managerial Accounting Concepts and Principles

BTN 14-5 Managerial accounting professionals follow a code of ethics. As a member of the Institute of Management Accountants, the managerial accountant must comply with Standards of Ethical Conduct.

Required

1. Identify, print, and read the Statement of Ethical Professional Practice posted at www.IMAnet.org. (Search using “statement of ethical professional practice and select the Ethics Center and Helpline link. Under Ethical Practices, select Learn More.”)

2. What four overarching ethical principles underlie the IMA’s statement? 3. Describe the courses of action the IMA recommends in resolving ethical conflicts.

TAKING IT TO THE NET C1

Required

1. Each team member is to be responsible for computing one of the following amounts. You are not to duplicate your teammates’ work. Get any necessary amounts from teammates. Each member is to ex- plain the computation to the team in preparation for reporting to class.

a. Materials used. d. Total cost of goods in process. b. Factory overhead. e. Cost of goods manufactured. c. Total manufacturing costs.

BTN 14-6 The following calendar-year information is taken from the December 31, 2013, adjusted trial balance and other records of Dahlia Company.

TEAMWORK IN ACTION C5 P2

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,125

Depreciation expense—Office equipment . . . . . . . . . . . 8,750

Depreciation expense—Selling equipment . . . . . . . . . . 10,000

Depreciation expense — Factory equipment . . . . . . . . . 32,500

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122,500

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,750

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,250

Inventories

Raw materials, December 31, 2012 . . . . . . . . . . . . . . 177,500

Raw materials, December 31, 2013 . . . . . . . . . . . . . . . 168,125

Goods in process, December 31, 2012 . . . . . . . . . . . 15,875

Goods in process, December 31, 2013 . . . . . . . . . . . . 14,000

Finished goods, December 31, 2012 . . . . . . . . . . . . . . 164,375

Finished goods, December 31, 2013 . . . . . . . . . . . . . . 129,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 650,750

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Miscellaneous production costs . . . . . . . . . . . . . . . . . . 8,500

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 100,875

Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . 872,500

Rent expense—Office space . . . . . . . . . . . . . . . . . . . . 21,125

Rent expense—Selling space . . . . . . . . . . . . . . . . . . . . 25,750

Rent expense—Factory building . . . . . . . . . . . . . . . . . 79,750

Maintenance expense—Factory equipment . . . . . . . . . 27,875

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,275,000

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 286,250

BTN 14-4 Write a one-page memorandum to a prospective college student about salary expectations for graduates in business. Compare and contrast the expected salaries for accounting (including different subfields such as public, corporate, tax, audit, and so forth), marketing, management, and finance majors. Prepare a graph showing average starting salaries (and those for experienced professionals in those fields if available). To get this information, stop by your school’s career services office; libraries also have this information. The Website JobStar.org (click on Salary Info) also can get you started.

COMMUNICATING IN PRACTICE C6

Required

1. In which account should the purchase of CD raw materials be recorded? 2. How should you respond to this request by the chief financial officer?

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Chapter 14 Managerial Accounting Concepts and Principles 651

Point: Provide teams with transparen- cies and markers for presentation purposes.

BTN 14-7 Alex Velez and Nikhil Arora of Back to the Roots must understand manufacturing costs to effectively operate and succeed as a profitable and efficient business.

Required

1. What are the three main categories of manufacturing costs the owners must monitor and control? Pro- vide examples of each.

2. What are four goals of a total quality management process? How can Back to the Roots use TQM to improve its business activities?

ENTREPRENEURIAL DECISION C1 C2 C6

BTN 14-8 Visit your favorite fast-food restaurant. Observe its business operations.

Required

1. Describe all business activities from the time a customer arrives to the time that customer departs. 2. List all costs you can identify with the separate activities described in part 1. 3. Classify each cost from part 2 as fixed or variable, and explain your classification.

HITTING THE ROAD C1 C2

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

5. Beginning finished goods 1 Cost of goods manufactured (COGM) 2 Ending finished goods 5 Cost of goods sold

$6,000 1 COGM 2 $3,200 5 $7,500 COGM 5 $4,700

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 14-9 Access Piaggio’s Website (www.piaggiogroup.com) and select “Governance” and then se- lect “Company boards.” Read the section dealing with the role of its board of directors.

Required

1. Identify the role of Piaggio’s board of directors. 2. How would management accountants be involved in assisting the board of directors in carrying out

their responsibilities? Explain.

GLOBAL DECISION C1

2. Check your cost of goods manufactured with the instructor. If it is correct, proceed to part (3). 3. Each team member is to be responsible for computing one of the following amounts. You are not to

duplicate your teammates’ work. Get any necessary amounts from teammates. Each member is to ex- plain the computation to the team in preparation for reporting to class.

a. Net sales. d. Total operating expenses. b. Cost of goods sold. e. Net income or loss before taxes. c. Gross profit.

PIAGGIO

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Learning Objectives

CONCEPTUAL

C1 Describe important features of job order production. (p. 654) C2 Explain job cost sheets and how they are used in job order cost accounting.

(p. 656)

ANALYTICAL

A1 Apply job order costing in pricing services. (p. 667)

PROCEDURAL

P1 Describe and record the flow of materials costs in job order cost accounting. (p. 658) P2 Describe and record the flow of labor costs in job order cost accounting. (p. 660) P3 Describe and record the flow of overhead costs in job order cost accounting. (p. 661) P4 Determine adjustments for overapplied and underapplied factory overhead. (p. 666)

A Look at This Chapter

We begin this chapter by describing a cost accounting system. We then explain the procedures used to determine costs using a job order costing system. We conclude with a discussion of over- and underapplied overhead.

A Look Back

Chapter 14 introduced managerial accounting and explained basic cost concepts. We also described the lean business model and the reporting of manufacturing activities, including the manufacturing statement.

Job Order Costing and Analysis 15

A Look Ahead

Chapter 16 focuses on measuring costs in process production companies. We explain process production, describe how to assign costs to processes, and compute and analyze cost per equivalent unit.

652

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Suit Yourself!

COLUMBUS, OH—Watching Italian tailors hand-sew high- quality men’s suits, David Schottenstein decided to start his own men’s clothing store. David’s aspirations were high: Sell custom-made mens’ suits, hand-sewn and made from the finest fabrics, at prices up to 80 percent less than competitor’s clothes. David recalls think- ing, “If I have to crawl around on my hands and knees to measure people’s inseams to get this business started, I’m going to do it.” The result is Astor and Black (AstorandBlack.com), a startup international company with sales in 2010 of over $20 million. David’s employees travel to customers’ homes, offices, and clubs around the world to do personal fittings. Customers select the fabrics, buttons, stitching, and other details, and then tailors hand-sew each suit to exact customer specifications. “I like to pick out my own stuff, and it’s easier than going to a store,” says Malcolm Jenkins, All-Pro NFL cornerback and owner of over 30 Astor and Black suits. David stresses that “customer service and satisfying each customer’s individual needs” are what drive success. David’s business model is based on selling a higher volume of suits than competitors, but at lower margins per suit. This re- quires David to carefully monitor costs. Astor and Black, like other makers of custom products, uses a state-of-the-art job or- der cost accounting system to track costs. Such a system tracks

the cost of materials, labor, and overhead for each suit, enabling David to make quick business decisions regarding costs and selling prices. Job order costing allows entrepreneurs like David to better isolate costs and avoid the run away costs often expe- rienced by startups that fail to use such costing techniques. “We keep our fixed costs low by not stocking inventory,” explains David, “and we use minimal office space as our sales mainly occur in customer’s homes or offices.” David encourages young entrepreneurs to believe in them- selves. “People have great ideas all the time but find all the [wrong] reasons not to do it. You have to be fearless,” says David. In David’s case, that fearlessness began with selling rare cigars and trading stocks as a teenager. “It was bizarre,” says his father Tom. “He was a kid on a mission.” With attention to detail and insights gained from job order costing information, David’s business continues to expand, now offering women’s suits and online tailoring, allowing customers to create a simulated ver- sion of the outfit they want. “Be brazen or you will be done on the day you start,” says David.

[Sources: Astor and Black Website, January 2013; Yourhiddenpotential.co.uk Website, May 8, 2011; The Columbus Dispatch, June 22, 2008; Forbes, May 9, 2011; Smart Business Online, www.sbonline.com, June 2009.]

“Be fearless!” —DAVID SCHOTTENSTEIN

Decision Insight

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Chapter Preview

This chapter introduces a system for assigning costs to the flow of goods through a production process. We then describe the details of a job order cost accounting system. Job order costing is frequently used by manufacturers of custom products or

providers of custom services. Manufac turers that use job order costing typically base it on a perpetual inventory system, which provides a continuous record of materials, goods in process, and finished goods inventories.

This section describes a cost accounting system and job order production and costing.

Cost Accounting System An ever-increasing number of companies use a cost accounting system to generate timely and accurate inventory information. A cost accounting system records manufacturing activities us- ing a perpetual inventory system, which continuously updates records for costs of materials, goods in process, and finished goods inventories. A cost accounting system also provides timely information about inventories and manufacturing costs per unit of product. This is especially helpful for managers’ efforts to control costs and determine selling prices. (A general account- ing system records manufacturing activities using a periodic inventory system. Some compa- nies still use a general accounting system, but its use is declining as competitive forces and customer demands have increased pressures on companies to better manage inventories.) The two basic types of cost accounting systems are job order cost accounting and process cost accounting. We describe job order cost accounting in this chapter. Process cost accounting is explained in the next chapter.

Job Order Production Many companies produce products individually designed to meet the needs of a specific cus- tomer. Each customized product is manufactured separately and its production is called job order production, or job order manufacturing (also called customized production, which is the production of products in response to special orders). Examples of such products include syn- thetic football fields, special-order machines, a factory building, custom jewelry, wedding invi- tations, and artwork. The production activities for a customized product represent a job. Boeing’s aerospace division is one example of a job order production system. Its primary business is twofold: (1) design, develop, and integrate space carriers and (2) provide systems engineering and integration of Department of Defense (DoD) systems. Many of its orders are customized and produced through job order operations. When a job involves producing more than one unit of a custom product, it is often called a job lot. Products produced as job lots could include benches for a church, imprinted T-shirts for a 10K race or company picnic, or advertising signs for a chain of stores. Although these orders

JOB ORDER COST ACCOUNTING

C1 Describe important features of job order production.

Job Order Costing and Analysis

Job Order Cost Flows and Reports

• Materials cost flows and documents

• Labor cost flows and documents

• Overhead cost flows and documents

• Summary of cost flows

Job Order Cost Accounting

• Cost accounting system

• Job order production • Job order costing of

services • Events in job order

costing • Job cost sheet

Adjusting Factory Overhead

• Factory overhead T-account

• Underapplied or overapplied overhead

Point: Cost accounting systems accumulate costs and then assign them to products and services.

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Chapter 15 Job Order Costing and Analysis 655

involve more than one unit, the volume of production is typically low, such as 50 benches, 200 T-shirts, or 100 signs. Another feature of job order production is the diversity, often called heterogeneity, of the products produced. Namely, each customer order is likely to differ from another in some important respect. These variations can be minor or major.

Job Order Costing of Services The principle of customization is equally applicable to both manufacturing and service compa- nies. Most service companies meet customers’ needs by performing a custom service for a specific customer. Examples of such services include an accountant auditing a client’s financial statements, an interior designer remodeling an office, a wedding consultant planning and super- vising a reception, and a lawyer defending a client. Whether the setting is manufacturing or services, job order operations involve meeting the needs of customers by producing or perform- ing custom jobs. We show an example of job order costing for an advertising service in the Decision Analysis section of this chapter.

Events in Job Order Costing The initial event in a normal job order operation is the receipt of a customer order for a custom product. This causes the company to begin work on a job. A less common case occurs when management decides to begin work on a job before it has a signed contract. This is referred to as jobs produced on speculation.

Step 1: Predict the cost to complete the job. This cost depends on the product design prepared by either the customer or the producer.

Step 2: Negotiate price and decide whether to pursue the job. Other than for government or other cost-plus contracts, the selling price is determined by market factors. Producers evaluate the market price, compare it to cost, and determine whether the profit on the job is reasonable. If the profit is not reasonable, the producer would determine a desired target cost. Step 3: Schedule production of the job. This must meet the customer’s needs and fit within the company’s own production constraints. Preparation of this work schedule should consider work- place facilities including equipment, personnel, and supplies. Once this schedule is complete, the producer can place orders for raw materials. Production occurs as materials and labor are applied to the job.

An overview of job order production activity is shown in Exhibit 15.1. This exhibit shows the March production activity of Road Warriors, which installs security devices into cars and trucks. The company converts any vehicle by adding alarms, reinforced exterior, bulletproof glass, and bomb detectors. The company began by catering to high-profile celebrities, but it now caters to anyone who desires added security in a vehicle. Job order production for Road Warriors requires materials, labor, and overhead costs. Recall that direct materials are goods used in manufacturing that are clearly identified with a particular job. Similarly, direct labor is effort devoted to a particular job. Overhead costs support produc- tion of more than one job. Common overhead items are depreciation on factory buildings and equipment, factory supplies, supervision, maintenance, cleaning, and utilities. Exhibit 15.1 shows that materials, labor, and overhead are added to Jobs B15, B16, B17, B18, and B19, which were started during March. Special tires and bulletproof glass are added to Jobs B15 and B16, while Job B17 receives a reinforced exterior and bulletproof glass. Road Warriors completed Jobs B15, B16, and B17 in March and delivered Jobs B15 and B16 to

Point: Some jobs are priced on a cost-plus basis: The customer pays the manufacturer for costs incurred on the job plus a negotiated amount or rate of profit.

Point: Many professional examinations including the CPA and CMA exams require knowledge of job order and process cost accounting.

Custom Design Managers once saw companies as the center of a solar system orbited by suppliers and customers. Now the customer has become the center of the business universe. Nike allows custom orders over the Internet, enabling customers to select materials, colors, and to personalize their shoes with letters and numbers. Soon consumers may be able to personalize almost any product, from cellular phones to ap- pliances to furniture. ■

Decision Insight

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656 Chapter 15 Job Order Costing and Analysis

EXHIBIT 15.1 Job Order Production Activities

Indirect Materials

Indirect Labor

Direct Materials

Direct Labor

Overhead Costs

Completed

Completed

Completed

Delivered

Delivered

Goods in Process Finished Goods Goods Sold

Job B15

Job B16

Job B15

Job B18

Job B16

Job B17 Job B17

Job B15

Job B16

Job B19

Overhead

Labor

Manufacturing Costs

Materials

Job Cost Sheet General ledger accounts usually do not provide the accounting information that managers of job order cost operations need to plan and control production activities. This is so because the needed information often requires more detailed data. Such detailed data are usually stored in subsidiary records controlled by general ledger accounts. Subsidiary records store information about raw materials, overhead costs, jobs in process, finished goods, and other items. This sec- tion describes the use of these records. A major aim of a job order cost accounting system is to determine the cost of producing each job or job lot. In the case of a job lot, the system also aims to compute the cost per unit. The accounting system must include separate records for each job to accomplish this, and it must capture information about costs incurred and charge these costs to each job. A job cost sheet is a separate record maintained for each job. Exhibit 15.2 shows a job cost sheet for an alarm system that Road Warriors produced for a customer. This job cost sheet iden- tifies the customer, the job number assigned, the product, and key dates. Costs incurred on the job are immediately recorded on this sheet. When each job is complete, the supervisor enters the date of completion, records any remarks, and signs the sheet. The job cost sheet in Exhibit 15.2 classifies costs as direct materials, direct labor, or overhead. It shows that a total of $600 in di- rect materials is added to Job B15 on four different dates. It also shows seven entries for direct labor costs that total $1,000. Road Warriors allocates (also termed applies, assigns, or charges) factory overhead costs of $1,600 to this job using an allocation rate of 160% of direct labor cost (160% 3 $1,000) — we discuss overhead allocation later in this chapter.

Cost Flows: During Production While a job is being produced, its accumulated costs are kept in Goods in Process Inventory. The collection of job cost sheets for all jobs in process makes up a subsidiary ledger controlled by the Goods in Process Inventory account in the gen- eral ledger. Managers use job cost sheets to monitor costs incurred to date and to predict and control costs for each job.

C2 Explain job cost sheets and how they are used in job order cost accounting.

Point: Factory overhead consists of costs (other than direct materials and direct labor) that ensure the production activities are carried out.

customers. At the end of March, Jobs B18 and B19 remain in goods in process inventory and Job B17 is in finished goods inventory. Both labor and materials costs are also separated into their direct and indirect components. Their indirect amounts are added to overhead. Total over- head cost is then allocated to the various jobs.

Target Costing Many producers determine a target cost for their jobs. Target cost is determined as follows: Expected selling price 2 Desired profit 5 Target cost. If the projected target cost of the job as determined by job costing is too high, the producer can apply value engineering, which is a  method of determining ways to reduce job cost until the target cost is met. ■

Decision Insight

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Chapter 15 Job Order Costing and Analysis 657

Cost Flows: Job Completion When a job is finished, its job cost sheet is completed and moved from the jobs in process file to the finished jobs file. This latter file acts as a subsidiary ledger controlled by the Finished Goods Inventory account.

Cost Flows: Job Delivery When a finished job is delivered to a customer, the job cost sheet is moved to a permanent file supporting the total cost of goods sold. This permanent file contains records from both current and prior periods. When the job is finished, the company also prepares a journal entry that credits Sales and debits Cash (or Accounts Receivable).

Point: Documents (electronic and paper) are crucial in a job order system, and the job cost sheet is a cornerstone. Understanding it aids in grasping con- cepts of capitalizing product costs and product cost flow.

EXHIBIT 15.2 Job Cost Sheet

Accounting System: Exhibit 15-2

Road Warriors, Los Angeles, California JOB COST SHEET

Date

3/3/2013

3/7/2013

3/9/2013

3/10/2013

3/3/2013

3/4/2013

3/5/2013

3/8/2013

3/9/2013

3/10/2013

3/11/2013

3/11/2013R-4698

R-4705

R-4725

R-4777

L-3393

L-3422

L-3456

L-3479

L-3501

L-3535

L-3559

160% of Direct Labor Cost

100.00

225.00

180.00

95.00

120.00

150.00

180.00

60.00

90.00

240.00

160.00

1,600.00

Requisition Cost Date Time Ticket Cost Date Rate Cost

Direct Materials Direct Labor Overhead

File Edit Maintain Tasks Analysis Options Reports Window Help

Customer’s Name Carroll Connor

Address 1542 High Point Dr.

Job Description Level 1 Alarm System on Ford Expedition

Date promised

REMARKS: SUMMARY:

March 15

Total 600.00

Materials

Labor

Overhead

600.00

1,000.00

1,600.00

Total cost 3,200.00Signed:

City & State Malibu, California

Job No. B15

Date started March 3 Date completed March 11

Total 1,000.00 Total 1,600.00

Completed job on March 11, and shipped to customer on March 15. Met all specifications and requirements.

1. Which of these products is likely to involve job order production? (a) inexpensive watches, (b) racing bikes, (c) bottled soft drinks, or (d ) athletic socks.

2. What is the difference between a job and a job lot? 3. Which of these statements is correct? (a) The collection of job cost sheets for unfinished jobs

makes up a subsidiary ledger controlled by the Goods in Process Inventory account, (b) Job cost sheets are financial statements provided to investors, or (c) A separate job cost sheet is maintained in the general ledger for each job in process.

4. What three costs are normally accumulated on job cost sheets?

Quick Check Answers — p. 671

Management Consultant One of your tasks is to control and manage costs for a consulting company. At the end of a recent month, you find that three consulting jobs were completed and two are 60% com- plete. Each unfinished job is estimated to cost $10,000 and to earn a revenue of $12,000. You are unsure how to recognize goods in process inventory and record costs and revenues. Do you recognize any inven- tory? If so, how much? How much revenue is recorded for unfinished jobs this month? ■ [Answer—p. 671]

Decision Maker

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658 Chapter 15 Job Order Costing and Analysis

Materials Cost Flows and Documents This section focuses on the flow of materials costs and the related docu- ments in a job order cost accounting system. We begin analysis of the flow of materials costs by examining Exhibit 15.3. When materials are first re- ceived from suppliers, the employees count and inspect them and record the items’ quantity and cost on a receiving report. The receiving report

serves as the source document for recording materials received in both a materials ledger card and in the general ledger. In nearly all job order cost systems, materials ledger cards (or files) are perpetual records that are updated each time units are purchased and each time units are is- sued for use in production. To illustrate the purchase of materials, Road Warriors acquired $450 of wiring and related materials on March 4, 2013. This purchase is recorded as follows.

JOB ORDER COST FLOWS AND REPORTS

Materials

P1 Describe and record the flow of materials costs in job order cost accounting.

Point: Some companies certify certain suppliers based on the quality of their materials. Goods received from these suppliers are not always inspected by the purchaser to save costs.

Requisitions

Requisitions

Receiving Reports

600.00

Job B15 Materials Labor Overhead

Job Cost Sheets675.00 225.00

450.00225.00 450.00

Alarm System Wiring Received Issued Balance

Materials Ledger Cards

Direct Cost

Indirect Cost

550.00

Indirect Materials

Factory Overhead Ledger

EXHIBIT 15.3 Materials Cost Flows through Subsidiary Records

Exhibit 15.3 shows that materials can be requisitioned for use either on a specific job (direct materials) or as overhead (indirect materials). Cost of direct materials flows from the materials ledger card to the job cost sheet. The cost of indirect materials flows from the materials ledger card to the Indirect Materials account in the factory overhead ledger, which is a subsidiary led- ger controlled by the Factory Overhead account in the general ledger. Exhibit 15.4 shows a materials ledger card for material received and issued by Road War- riors. The card identifies the item as alarm system wiring and shows the item’s stock num- ber, its location in the storeroom, information about the maximum and minimum quantities that should be available, and the reorder quantity. For example, alarm system wiring is issued

Mar. 4 Raw Materials Inventory—M-347 . . . . . . . . . . . . . . . . . . 450

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 450

To record purchase of materials for production.

Assets 5 Liabilities 1 Equity 1450 1450

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Chapter 15 Job Order Costing and Analysis 659

EXHIBIT 15.4 Materials Ledger Card

Alarm system wiringItem M–347Stock No. Bin 137Location in Storeroom

5 unitsMaximum quantity 1 unitMinimum quantity 2 unitsQuantity to reorder

1 225.00 225.00 C-7117 2 225.00 3 225.00 675.00450.003/4/2013

3/7/2013 21R–4705 225.00225.00 450.00225.00

Date Units Unit Price

Total Price

Receiving Report Number Units

Unit Price

Total Price Units

Unit Price

Total Price

Requi- sition

Number

Received Issued Balance

MATERIALS LEDGER CARD Road Warriors ROAD

WARR IORS

ROAD WARR

IORS

Los Angeles, California

and recorded on March 7, 2013. The job cost sheet in Exhibit 15.2 showed that Job B15 used this wiring. When materials are needed in production, a production manager prepares a materials requi- sition and sends it to the materials manager. The requisition shows the job number, the type of material, the quantity needed, and the signature of the manager authorized to make the requisi- tion. Exhibit 15.5 shows the materials requisition for alarm system wiring for Job B15. To see how this requisition ties to the flow of costs, compare the information on the requisition with the March 7, 2013, data in Exhibits 15.2 and 15.4.

Point: Requisitions are often accumu- lated and recorded in one entry. The frequency of entries depends on the job, the industry, and management procedures.

EXHIBIT 15.5 Materials Requisition

MATERIALS REQUISITION

B15Job No. 3/7/2013Date

M–347Material Stock No. Material Description

1Quantity Requested Requested By

1Quantity Provided

Alarm system wiring

Date Provided

Filled By Material Received By

Remarks

No. R–4705 Road Warriors ROAD

WARR IORS

ROAD WARR

IORS

Los Angeles, California

3/7/2013

The use of alarm system wiring on Job B15 yields the following entry (locate this cost item in the job cost sheet shown in Exhibit 15.2).

Assets 5 Liabilities 1 Equity 1225 2225

Mar. 7 Goods in Process Inventory — Job B15 . . . . . . . . . . . . . . 225

Raw Materials Inventory — M-347 . . . . . . . . . . . . . . 225

To record use of material on Job B15.

Point: Exhibit 15.12 shows this entry.

This entry is posted both to its general ledger accounts and to subsidiary records. Posting to subsidiary records includes a debit to a job cost sheet and a credit to a materials ledger card. (Note: An entry to record use of indirect materials is the same as that for direct materials except the debit is to Factory Overhead. In the subsidiary factory overhead ledger, this entry is posted to Indirect Materials.)

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660 Chapter 15 Job Order Costing and Analysis

Labor Cost Flows and Documents Exhibit 15.6 shows the flow of labor costs from clock cards and the Factory Payroll account to subsidiary records of the job order cost accounting system. Recall that costs in subsidiary records give detailed information needed to manage and control operations.

1,100.00

Indirect Labor

Time Tickets

Time Tickets

Factory Overhead Ledger

Clock Cards

1,000.00

Job B15 Materials Labor Overhead

Job Cost Sheets

Factory Payroll

Direct Cost

Indirect Cost

5,300.00 1,100.00 4,200.00

EXHIBIT 15.6 Labor Cost Flows through Subsidiary Records

Labor

P2 Describe and record the flow of labor costs in job order cost accounting.

The flow of costs in Exhibit 15.6 begins with clock cards. Employees commonly use these cards to record the number of hours worked, and they serve as source documents for entries to record la- bor costs. Clock card data on the number of hours worked is used at the end of each pay period to determine total labor cost. This amount is then debited to the Factory Payroll account, a temporary account containing the total payroll cost (both direct and indirect). Payroll cost is later allocated to both specific jobs and overhead.

According to clock card data, workers earned $1,500 for the week ended March 5. Illustrat- ing the flow of labor costs, the accrual and payment of these wages are recorded as follows.

Point: Many employee fraud schemes involve payroll, including overstated hours on clock cards.

Assets 5 Liabilities 1 Equity 21,500 21,500

Mar. 6 Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

To record the weekly payroll.

To assign labor costs to specific jobs and to overhead, we must know how each employee’s time is used and its costs. Source documents called time tickets usually capture these data. Em- ployees regularly fill out time tickets to report how much time they spent on each job. An em- ployee who works on several jobs during a day completes a separate time ticket for each job. Tickets are also prepared for time charged to overhead as indirect labor. A supervisor signs an employee’s time ticket to confirm its accuracy.

Exhibit 15.7 shows a time ticket reporting the time a Road Warrior employee spent working on Job B15. The employee’s supervisor signed the ticket to confirm its accuracy. The hourly rate and total labor cost are computed after the time ticket is turned in. To see the effect of this time ticket on the job cost sheet, look at the entry dated March 8, 2013, in Exhibit 15.2.

Point: In the accounting equation, we treat accounts such as Factory Payroll and Factory Overhead as temporary accounts, which hold various expenses until they are allocated to balance sheet or income statement accounts.

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Chapter 15 Job Order Costing and Analysis 661

When time tickets report labor used on a specific job, this cost is recorded as direct labor. The following entry records the data from the time ticket in Exhibit 15.7.

EXHIBIT 15.7 Time Ticket

TIME TICKET

TIME AND RATE INFORMATION:

Remarks ................................................. ................................................. ................................................. .................................................

Date .................. 20 .........March 8 13 No. L–3479

Road Warriors ROAD

WARR IORS

ROAD WARR

IORS

Los Angeles, California

Start Time

Employee Name

Finish Time

9:00 12:00

Elapsed Time Hourly Rate

$20.003.0

Total Cost $60.00Approved By ................................

T. Zeller

Employee Number

3969

Job No.

B15

C. Luther

Assets 5 Liabilities 1 Equity 160 160

Mar. 8 Goods in Process Inventory — Job B15 . . . . . . . . . . . . . 60

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

To record direct labor used on Job B15.

EXHIBIT 15.8 Overhead Cost Flows through Subsidiary Records

Factory Overhead 6,720.00550.00

5,070.00 1,100.00

Materials Requisitions

Time Tickets

Vouchers

Adjusting Entries

Indirect Materials

Indirect Labor

Pre-

determined

Overhead

Rate

1,600.00

Job B15 Matls. Labor Ovhd.

Job Cost Sheets

The debit in this entry is posted both to the general ledger account and to the appropriate job cost sheet. (Note: An entry to record indirect labor is the same as for direct labor except that it debits Factory Overhead and credits Factory Payroll. In the subsidiary factory overhead ledger, the debit in this entry is posted to the Indirect Labor account.)

Overhead Cost Flows and Documents Factory overhead (or simply overhead) cost flows are shown in Exhibit 15.8. Factory overhead includes all production costs other than direct materials and direct labor. Two sources of overhead costs are indirect materials and indirect labor. These costs are recorded from requisitions for indirect materi- als and time tickets for indirect labor. Two other sources of overhead are (1) vouchers authorizing payments for items such as supplies or utilities and (2) adjusting entries for costs such as depreciation on factory assets. Factory overhead usually includes many different costs and, thus, a separate account for each is often maintained in a subsidiary factory overhead ledger. This ledger is controlled by the Fac- tory Overhead account in the general ledger. Factory Overhead is a temporary account that ac- cumulates costs until they are allocated to jobs.

Recording Overhead Recall that overhead costs are recorded with debits to the Factory Overhead account and  with credits to other accounts such as Cash, Accounts Payable, and

P3 Describe and record the flow of overhead costs in job order cost accounting.

Overhead

Point: Companies also incur nonmanu- facturing costs, such as advertising, sales- person’s salaries, and depreciation on assets not used in production. These types of costs are not considered overhead, but instead are treated as period costs and charged directly to the income statement. These period costs can be relevant to managers’ pricing decisions.

Point: Exhibit 15.12 shows this entry.

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662 Chapter 15 Job Order Costing and Analysis

Accumulated Depreciation — Equipment. In the subsidiary factory overhead ledger, the debits are posted to their respective accounts such as Depreciation Expense—Equipment, Insurance Expense—Warehouse, or Amortization Expense—Patents. To illustrate the recording of overhead, the following two entries reflect the depreciation of factory equipment and the accrual of utilities, respectively, for the week ended March 6.

Assets 5 Liabilities 1 Equity 2600 2600

Assets 5 Liabilities 1 Equity 1250 2250

Mar. 6 Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Accumulated Depreciation—Equipment . . . . . . . . 600

To record depreciation on factory equipment.

Mar. 6 Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Utilities Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

To record the accrual of factory utilities.

Exhibit 15.8 shows that overhead costs flow from the Factory Overhead account to job cost sheets. Because overhead is made up of costs not directly associated with specific jobs or job lots, we cannot determine the dollar amount incurred on a specific job. We know, however, that overhead costs represent a necessary part of business activities. If a job cost is to include all costs needed to complete the job, some amount of overhead must be included. Given the diffi- culty in determining the overhead amount for a specific job, however, we allocate overhead to individual jobs in some reasonable manner.

Overhead Allocation Bases We generally allocate overhead by linking it to another factor used in production, such as direct labor or machine hours. The factor to which overhead costs are linked is known as the allocation base. A manager must think carefully about how many and which allocation bases to use. This managerial decision influences the accuracy with which overhead costs are allocated to individual jobs. In turn, the cost of individual jobs might impact a manager’s decisions for pricing or performance evaluation. In Exhibit 15.2, overhead is expressed as 160% of direct labor. We then allocate overhead by multiplying 160% by the estimated amount of direct labor on the jobs.

Overhead Allocation Rates We cannot wait until the end of a period to allocate over- head to jobs because perpetual inventory records are part of the job order costing system (demanding up-to-date costs). Instead, we must predict overhead in advance and assign it to jobs so that a job’s total costs can be estimated prior to its completion. This estimated cost is useful for managers in many decisions including setting prices and identifying costs that are out of control. Being able to estimate overhead in advance requires a predetermined overhead rate, also called predetermined overhead allocation (or application) rate. This rate requires an estimate of total overhead cost and an allocation factor such as total direct labor cost before the start of the period. Exhibit 15.9 shows the usual formula for computing a predetermined over- head rate (estimates are commonly based on annual amounts). This rate is used during the pe- riod to allocate overhead to jobs. It is common for companies to use multiple activity (allocation) bases and multiple predetermined overhead rates for different types of products and services.

Point: The predetermined overhead rate is computed at the start of the period and is used throughout the period to allocate overhead to jobs. Predeter- mined overhead rates can be estimated using mathematical equations, statistical analysis, or professional experience.

EXHIBIT 15.9 Predetermined Overhead Allocation Rate Formula

Predetermined overhead rate 5 Estimated

overhead costs 4

Estimated activity base

Recording Allocated Overhead To illustrate, Road Warriors allocates overhead by linking it to direct labor. At the start of the current period, management predicts total direct la- bor costs of $125,000 and total overhead costs of $200,000. Using these estimates, management computes its predetermined overhead rate as 160% of direct labor cost ($200,000 4 $125,000). Specifically, reviewing the job order cost sheet in Exhibit 15.2, we see that $1,000 of direct la- bor went into Job B15. We then use the predetermined overhead rate of 160% to allocate $1,600 (equal to $1,000 3 1.60) of overhead to this job. The entry to record this allocation is

Assets 5 Liabilities 1 Equity 11,600 11,600

Mar. 11 Goods in Process Inventory — Job B15 . . . . . . . . . . . . . . 1,600

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600

To assign overhead to Job B15.

Example: If management predicts total direct labor costs of $100,000 and total overhead costs of $200,000, what is its predetermined overhead rate? Answer: 200% of direct labor cost.

Entries to record indirect materials and indirect labor follow:

Factory Overhead . . . . . . . . . . . $ Raw Materials Inventory . . . . $

Factory Overhead . . . . . . . . . . . $ Factory Payroll . . . . . . . . . . . . $

In the subsidiary factory overhead ledger, these entries are posted to Indirect Materials and Indirect Labor, respectively.

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Chapter 15 Job Order Costing and Analysis 663

Since the allocation rate for overhead is esti mated at the start of a period, the total amount as- signed to jobs during a period rarely equals the amount actually incurred. We explain how this difference is treated later in this chapter.

Summary of Cost Flows We showed journal entries for charging Goods in Process Inventory (Job B15) with the cost of (1) direct materials requisitions, (2) direct labor time tickets, and (3) factory overhead. We made separate entries for each of these costs, but they are usually recorded in one entry. Specifically, materials requisitions are often collected for a day or a week and recorded with a single entry summarizing them. The same is done with labor time tickets. When summary entries are made, supporting schedules of the jobs charged and the types of materials used provide the basis for postings to subsidiary records.

To show all production cost flows for a period and their related entries, we again look at Road Warriors’ activities. Exhibit 15.10 shows costs linked to all of Road Warriors’ produc- tion activities for March. Road Warriors did not have any jobs in process at the beginning of March, but it did apply materials, labor, and overhead costs to five new jobs in March. Jobs B15 and B16 are completed and delivered to customers in March, Job B17 is completed but not de- livered, and Jobs B18 and B19 are still in process. Exhibit 15.10 also shows purchases of raw materials for $2,750, labor costs incurred for $5,300, and overhead costs of $6,720.

Point: Study the flow of manufacturing costs through general ledger accounts and job cost sheets. Use Exhibit 15.11 as reinforcement.

ROAD WARRIORS

Job Order Manufacturing Costs

For Month Ended March 31, 2013

Goods Cost of

Overhead

in Finished Goods

Explanation Materials Labor Incurred Allocated Process Goods Sold

Job B15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 600 $1,000 $1,600 $3,200

Job B16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 800 1,280 2,380

Job B17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 1,100 1,760 $3,360

Job B18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 700 1,120 $1,970

Job B19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 600 960 1,810

Total job costs . . . . . . . . . . . . . . . . . . . . . . . . 1,800 4,200 $6,720 $3,780 $3,360 $5,580

Indirect materials . . . . . . . . . . . . . . . . . . . . . . 550 $ 550

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . 1,100 1,100

Other overhead . . . . . . . . . . . . . . . . . . . . . . . 5,070

Total costs used in production . . . . . . . . . . . . 2,350 $5,300 $6,720

Ending materials inventory . . . . . . . . . . . . . . . 1,400

Materials available . . . . . . . . . . . . . . . . . . . . . 3,750

Less beginning materials inventory . . . . . . . . (1,000)

Materials purchased . . . . . . . . . . . . . . . . . . . . $2,750

EXHIBIT 15.10 Job Order Costs of All Production Activities

The upper part of Exhibit 15.11 shows the flow of these costs through general ledger ac- counts and the end-of-month balances in key subsidiary records. Arrow lines are numbered to show the flows of costs for March. Each numbered cost flow reflects several entries made in March. The lower part of Exhibit 15.11 shows summarized job cost sheets and their status at the end of March. The sum of costs assigned to the jobs in process ($1,970 1 $1,810) equals the

Web Consultant You are working on seven client engagements. Two clients reimburse your firm for ac- tual costs plus a 10% markup. The other five pay a fixed fee for services. Your firm’s costs include overhead allocated at $47 per labor hour. The managing partner of your firm instructs you to record as many labor hours as possible to the two markup engagements by transferring labor hours from the other five. What do you do? ■ [Answer—p. 671]

Decision Ethics

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664 Chapter 15 Job Order Costing and Analysis

$3,780 balance in Goods in Process Inventory shown in Exhibit 15.10. Also, costs assigned to Job B17 equal the $3,360 balance in Finished Goods Inventory. The sum of costs assigned to Jobs B15 and B16 ($3,200 1 $2,380) equals the $5,580 balance in Cost of Goods Sold. Exhibit 15.12 shows each cost flow with a single entry summarizing the actual in dividual entries made in March. Each entry is numbered to link with the arrow lines in Exhibit 15.11.

EXHIBIT 15.11 Job Order Cost Flows and Ending Job Cost Sheets

Materials purchased

Direct materials used

Indirect materials used

Payroll recorded

Direct labor used

Indirect labor used

Other overhead used

Overhead allocated

Finished goods

Goods sold

Raw Materials Inventory*

1,400

1,000 1,800 2,750 550

Other Accounts

Factory Overhead‡

0

550 5,070 6,720 1,100

Goods in Process Inventory*

1,800 6,720 8,940 4,200

Finished Goods Inventory*

8,940 5,580

3,780Factory Payroll‡

5,300

0

3,360

Cost of Goods Sold†

5,580

5,580

1,100 4,200

Goods in Process

Control Control Detail

Finished Goods Delivered Goods

Subsidiary Job Cost Sheets

* The ending balances in the inventory accounts are carried to the balance sheet. † The Cost of Goods Sold balance is carried to the income statement. ‡ Factory Payroll and Factory Overhead are considered temporary accounts; when these costs are allocated to jobs, the balances in these accounts are reduced.

Key:

10

8

10

9

7

6

5

4

3

2

1

2

8

5

9

Matls.

Labor

Ovhd.

Total

Job B19 $ 250

600

960

$1,810

Matls.

Labor

Ovhd.

Total

Job B18 $ 150

700

1,120

$1,970

Matls.

Labor

Ovhd.

Total

Job B17 $ 500

1,100

1,760

$3,360

Matls.

Labor

Ovhd.

Total

Job B15 $ 600

1,000

1,600

$3,200

Matls.

Labor

Ovhd.

Total

Job B16 $ 300

800

1,280

$2,380

1

4

7

6

3

5. In job order cost accounting, which account is debited in recording a raw materials requisition? (a) Raw Materials Inventory, (b) Raw Materials Purchases, (c) Goods in Process Inventory if for a job, or (d ) Goods in Process Inventory if they are indirect materials.

6. What are four sources of information for recording costs in the Factory Overhead account? 7. Why does job order cost accounting require a predetermined overhead rate? 8. What events result in a debit to Factory Payroll? What events result in a credit?

Quick Check Answers — p. 671

Entrepreneur Competitors’ prices on one of your product segments are lower than yours. Of the total product cost used in setting your prices, 53% is overhead allocated using direct labor hours. You believe that product costs are distorted and wonder whether there is a better way to allocate overhead and to set prod- uct price. What do you suggest? ■ [Answer—p. 671]

Decision Maker

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Chapter 15 Job Order Costing and Analysis 665

EXHIBIT 15.12 Entries for Job Order Production Costs*

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . 2,750 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . 2,750 Acquired materials on credit for factory use. Goods in Process Inventory . . . . . . . . . . . . . . . . . 1,800 Raw Materials Inventory . . . . . . . . . . . . . . . . 1,800 To assign costs of direct materials used. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 550 Raw Materials Inventory . . . . . . . . . . . . . . . . 550 To record use of indirect materials. Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,300 Cash (and other accounts) . . . . . . . . . . . . . . 5,300 To record salaries and wages of factory

workers (including various payroll liabilities). Goods in Process Inventory . . . . . . . . . . . . . . . . . 4,200 Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . 4,200 To assign costs of direct labor used.

1

2

3

4

5

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 1,100 Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . 1,100 To record indirect labor costs as overhead. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 5,070 Cash (and other accounts) . . . . . . . . . . . . . . 5,070 To record factory overhead costs such as

insurance, utilities, rent, and depreciation. Goods in Process Inventory . . . . . . . . . . . . . . . . . 6,720 Factory Overhead . . . . . . . . . . . . . . . . . . . . . 6,720 To apply overhead at 160% of direct labor. Finished Goods Inventory . . . . . . . . . . . . . . . . . . . 8,940 Goods in Process Inventory . . . . . . . . . . . . . 8,940 To record completion of Jobs B15, B16, and B17. Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . 5,580 Finished Goods Inventory . . . . . . . . . . . . . . . 5,580 To record sale of Jobs B15 and B16.

6

7

8

9

10

* Exhibit 15.12 provides summary journal entries. Actual overhead is debited to Factory Overhead. Allocated overhead is credited to Factory Overhead.

Refer to the debits in the Factory Overhead account in Exhibit 15.11 (or Exhibit 15.12). The total cost of factory overhead incurred during March is $6,720 ($550 1 $5,070 1 $1,100). The $6,720 exactly equals the amount assigned to goods in process inventory (see 8 ). Therefore, the overhead incurred equals the overhead applied in March. The amount of overhead incurred rarely equals the amount of overhead applied, however, because estimates rarely equal the exact amounts actually incurred. This section explains what we do when too much or too little over- head is applied to jobs.

Factory Overhead T-Account Exhibit 15.13 shows a Factory Overhead T-account. The company applies overhead using a predetermined rate estimated at the beginning of the period. At the end of the period, the com- pany receives bills for its actual overhead costs.

ADJUSTING FACTORY OVERHEAD

EXHIBIT 15.13 Factory Overhead T-account

Factory Overhead

Actual Applied amount amount

Estimated during the periodKnown at end of the period

Exhibit 15.14 shows what to do when actual overhead does not equal applied overhead. When less overhead is applied than is actually incurred, the remaining debit balance in the Factory Overhead account is called underapplied overhead. When the overhead applied in a period exceeds the overhead incurred, the resulting credit balance in the Factory Overhead account is called overapplied overhead. In either case, a journal entry is needed to adjust Factory Over- head and Cost of Goods Sold. Exhibit 15.14 summarizes this entry.

EXHIBIT 15.14 Adjusting Factory Overhead

Factory Overhead

Overhead Costs Balance Is Overhead Is Journal Entry Required

Actual . Applied Debit Underapplied Cost of Goods Sold . . . . . . # Factory Overhead . . . . . #

Actual , Applied Credit Overapplied Factory Overhead . . . . . . . # Cost of Goods Sold . . . . #

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666 Chapter 15 Job Order Costing and Analysis

Underapplied or Overapplied Overhead To illustrate, assume that Road Warriors actually incurred other overhead costs of $5,550 in- stead of the $5,070 shown in Exhibit 15.11. This yields an actual total overhead cost of $7,200 in March. Since the amount of overhead applied was only $6,720, the Factory Overhead account is left with a $480 debit balance as shown in the ledger account in Exhibit 15.15.

EXHIBIT 15.15 Underapplied Overhead in the Factory Overhead Ledger Account

Factory Overhead Acct. No. 540

Date Explanation Debit Credit Balance

Mar. 31 Indirect materials cost 550 550 Dr. 31 Indirect labor cost 1,100 1,650 Dr. 31 Other overhead cost 5,550 7,200 Dr. 31 Overhead costs applied to jobs 6,720 480 Dr.

The $480 debit (increase) to Cost of Goods Sold reduces income by $480. (When the underap- plied (or overapplied) overhead is material, the amount is normally allocated to the Cost of Goods Sold, Finished Goods Inventory, and Goods in Process Inventory accounts. This process is covered in advanced courses.) We treat overapplied overhead at the end of the period in the same way we treat underapplied overhead, except that we debit Factory Overhead and credit Cost of Good Sold for the amount.

Assets 5 Liabilities 1 Equity 2480 1480

Mar. 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480 Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 480 To adjust for underapplied overhead costs.

Porsche AG manufactures high-performance cars. Each car is built ac- cording to individual customer specifications. Customers can use the Internet to place orders for their dream cars. Porsche employs just-in- time inventory techniques to ensure a flexible production process that can respond rapidly to customer orders. For a recent year, Porsche re- ported €33,781 million in costs of materials and €9,038 million in per- sonnel costs, which helped generate €57,081 million in revenue.

GLOBAL VIEW

P4 Determine adjustments for overapplied and underapplied factory overhead.

The $480 debit balance reflects manufacturing costs not assigned to jobs. This means that the balances in Goods in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold do not include all production costs incurred. When the underapplied overhead amount is immaterial, it is allocated (closed) to the Cost of Goods Sold account with the following adjusting entry.

Example: If we do not adjust for underapplied overhead, will net income be overstated or understated? Answer: Overstated.

9. In a job order cost accounting system, why does the Factory Overhead account usually have an overapplied or underapplied balance at period-end?

10. When the Factory Overhead account has a debit balance at period-end, does this reflect overapplied or underapplied overhead?

Quick Check Answers — p. 672

Job Order Learning Many companies invest in their employees, and the demand for executive education is strong. Annual spending on training and education exceeds $20 billion. Annual revenues for providers of execu- tive education continue to rise, with about 40% of revenues coming from custom programs designed for one or a select group of companies. ■

Decision Insight

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Chapter 15 Job Order Costing and Analysis 667

Pricing for Services Decision Analysis

A1 Apply job order costing in pricing services. The chapter described job order costing mainly using a manufacturing setting. However, these concepts and procedures are applicable to a service setting. Consider AdWorld, an advertising agency that develops Web-based ads for small firms. Each of its customers has unique requirements, so costs for each individual job must be tracked separately. AdWorld uses two types of labor: Web designers ($65 per hour) and computer staff ($50 per hour). It also incurs overhead costs that it assigns using two different predetermined overhead allocation rates: $125 per designer hour and $96 per staff hour. For each job, AdWorld must estimate the number of de- signer and staff hours needed. Then total costs pertaining to each job are determined using the procedures in the chapter. (Note: Most service firms have neither the category of materials cost nor inventory.) To illustrate, a manufacturer of golf balls requested a quote from AdWorld for an advertising engage- ment. AdWorld estimates that the job will require 43 designer hours and 61 staff hours, with the following total estimated cost for this job.

Direct Labor

Designers (43 hours 3 $65) . . . . . . . . . . . . . . $ 2,795

Staff (61 hours 3 $50) . . . . . . . . . . . . . . . . . . . 3,050

Total direct labor . . . . . . . . . . . . . . . . . . . . . . . $ 5,845

Overhead

Designer related (43 hours 3 $125) . . . . . . . 5,375

Staff related (61 hours 3 $96) . . . . . . . . . . . . 5,856

Total overhead . . . . . . . . . . . . . . . . . . . . . . . . . 11,231

Total estimated job cost . . . . . . . . . . . . . . . . . $17,076

AdWorld can use this cost information to help determine the price quote for the job (see Decision Maker, Sales Manager, scenario in this chapter).

Another source of information that AdWorld must consider is the market, that is, how much competi- tors will quote for this job. Competitor information is often unavailable; therefore, AdWorld’s managers must use estimates based on their assessment of the competitive environment.

The following information reflects Walczak Company’s job order production activities for May.

DEMONSTRATION PROBLEM — JOB ORDER COSTING

Raw materials purchases . . . . . . . . . . $16,000 Factory payroll cost . . . . . . . . . . . . . . 15,400 Overhead costs incurred Indirect materials . . . . . . . . . . . . . . 5,000 Indirect labor . . . . . . . . . . . . . . . . . 3,500 Other factory overhead . . . . . . . . 9,500

Sales Manager As AdWorld’s sales manager, assume that you estimate costs pertaining to a proposed job as $17,076. Your normal pricing policy is to apply a markup of 18% from total costs. However, you learn that three other agencies are likely to bid for the same job, and that their quotes will range from $16,500 to $22,000. What price should you quote? What factors other than cost must you consider? ■ [Answer—p. 671]

Decision Maker

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668 Chapter 15 Job Order Costing and Analysis

Walczak’s predetermined overhead rate is 150% of direct labor cost. Costs are allocated to the three jobs worked on during May as follows.

Job 401 Job 402 Job 403

In-process balances on April 30 Direct materials . . . . . . . . . . . . . . . . . . . . $3,600 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 1,700 Applied overhead . . . . . . . . . . . . . . . . . . 2,550 Costs during May Direct materials . . . . . . . . . . . . . . . . . . . 3,550 $3,500 $1,400 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 5,100 6,000 800 Applied overhead . . . . . . . . . . . . . . . . . . ? ? ? Status on May 31 . . . . . . . . . . . . . . . . . . . . . Finished (sold) Finished (unsold) In process

Required

1. Determine the total cost of: a. The April 30 inventory of jobs in process. b. Materials used during May. c. Labor used during May. d. Factory overhead incurred and applied during May and the amount of any over- or underapplied

overhead on May 31. e. Each job as of May 31, the May 31 inventories of both goods in process and finished goods, and

the goods sold during May. 2. Prepare summarized journal entries for the month to record: a. Materials purchases (on credit), the factory payroll (paid with cash), indirect materials, indirect

labor, and the other factory overhead (paid with cash). b. Assignment of direct materials, direct labor, and overhead costs to the Goods in Process Inventory

account. (Use separate debit entries for each job.) c. Transfer of each completed job to the Finished Goods Inventory account. d. Cost of goods sold. e. Removal of any underapplied or overapplied overhead from the Factory Overhead account.

(Assume the amount is not material.) 3. Prepare a manufacturing statement for May.

PLANNING THE SOLUTION ● Determine the cost of the April 30 goods in process inventory by totaling the materials, labor, and

applied overhead costs for Job 401. ● Compute the cost of materials used and labor by totaling the amounts assigned to jobs and to

overhead. ● Compute the total overhead incurred by summing the amounts for the three components. Compute the

amount of applied overhead by multiplying the total direct labor cost by the predetermined overhead rate. Compute the underapplied or overapplied amount as the difference between the actual cost and the applied cost.

● Determine the total cost charged to each job by adding the costs incurred in April (if any) to the cost of materials, labor, and overhead applied during May.

● Group the costs of the jobs according to their completion status. ● Record the direct materials costs assigned to the three jobs, using a separate Goods in Process Inventory

account for each job; do the same for the direct labor and the applied overhead. ● Transfer costs of Jobs 401 and 402 from Goods in Process Inventory to Finished Goods. ● Record the costs of Job 401 as cost of goods sold. ● Record the transfer of underapplied overhead from the Factory Overhead account to the Cost of Goods

Sold account. ● On the manufacturing statement, remember to include the beginning and ending goods in process

inventories and to deduct the underapplied overhead.

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Chapter 15 Job Order Costing and Analysis 669

SOLUTION TO DEMONSTRATION PROBLEM 1. Total cost of a. April 30 inventory of b. Materials used during May. jobs in process (Job 401).

Direct materials . . . . . . . . . . $3,600 Direct labor . . . . . . . . . . . . . 1,700 Applied overhead . . . . . . . . 2,550 Total cost . . . . . . . . . . . . . . . $7,850

Direct materials Job 401 . . . . . . . . . . . . . . . . . . $ 3,550 Job 402 . . . . . . . . . . . . . . . . . . 3,500 Job 403 . . . . . . . . . . . . . . . . . . 1,400 Total direct materials . . . . . . . . 8,450 Indirect materials . . . . . . . . . . . 5,000 Total materials used . . . . . . . . . $13,450

Direct labor Job 401 . . . . . . . . . . . . . . . $ 5,100 Job 402 . . . . . . . . . . . . . . . 6,000 Job 403 . . . . . . . . . . . . . . . 800 Total direct labor . . . . . . . . . 11,900 Indirect labor . . . . . . . . . . . . 3,500 Total labor used . . . . . . . . . . $15,400

Actual overhead Indirect materials . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 Other factory overhead . . . . . . . . . . . . . . . . . 9,500 Total actual overhead . . . . . . . . . . . . . . . . . . . . . 18,000 Overhead applied (150% 3 $11,900) . . . . . . . . . 17,850 Underapplied overhead . . . . . . . . . . . . . . . . . . . . $ 150

c. Labor used during May. d. Factory overhead incurred in May.

401 402 403

In-process costs from April Direct materials . . . . . . . . . . . . . . . . $ 3,600 Direct labor . . . . . . . . . . . . . . . . . . . 1,700 Applied overhead* . . . . . . . . . . . . . . 2,550 Cost incurred in May Direct materials . . . . . . . . . . . . . . . . 3,550 $ 3,500 $1,400 Direct labor . . . . . . . . . . . . . . . . . . . 5,100 6,000 800 Applied overhead* . . . . . . . . . . . . . . 7,650 9,000 1,200 Total costs . . . . . . . . . . . . . . . . . . . . . . $24,150 $18,500 $3,400

* Equals 150% of the direct labor cost.

e. Total cost of each job.

Total cost of the May 31 inventory of goods in process (Job 403) 5 $3,400

Total cost of the May 31 inventory of finished goods (Job 402) 5 $18,500

Total cost of goods sold during May (Job 401) 5 $24,150

2. Journal entries. a.

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 To record materials purchases.

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,400 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,400 To record factory payroll.

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . 5,000 To record indirect materials.

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 To record indirect labor.

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 To record other factory overhead.

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670 Chapter 15 Job Order Costing and Analysis

Goods in Process Inventory (Job 401) . . . . . . . . . . . . . . 3,550

Goods in Process Inventory (Job 402) . . . . . . . . . . . . . . 3,500

Goods in Process Inventory (Job 403) . . . . . . . . . . . . . . 1,400

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . 8,450

To assign direct materials to jobs.

Goods in Process Inventory (Job 401) . . . . . . . . . . . . . . 5,100

Goods in Process Inventory (Job 402) . . . . . . . . . . . . . . 6,000

Goods in Process Inventory (Job 403) . . . . . . . . . . . . . . 800

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,900

To assign direct labor to jobs.

Goods in Process Inventory (Job 401) . . . . . . . . . . . . . . 7,650

Goods in Process Inventory (Job 402) . . . . . . . . . . . . . . 9,000

Goods in Process Inventory (Job 403) . . . . . . . . . . . . . . 1,200

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 17,850

To apply overhead to jobs.

b. Assignment of costs to Goods in Process Inventory.

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . . . 42,650

Goods in Process Inventory (Job 401) . . . . . . . . . . 24,150

Goods in Process Inventory (Job 402) . . . . . . . . . . 18,500

To record completion of jobs.

c. Transfer of completed jobs to Finished Goods Inventory.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 150

To assign underapplied overhead.

e.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,150

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . 24,150

To record sale of Job 401.

d.

3.

WALCZAK COMPANY

Manufacturing Statement

For Month Ended May 31

Direct materials . . . . . . . . . . . . . . . . . . . . . $ 8,450

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . 11,900

Factory overhead

Indirect materials . . . . . . . . . . . . . . . . . $5,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . 3,500

Other factory overhead . . . . . . . . . . . . 9,500 18,000

Total production costs . . . . . . . . . . . . . . . 38,350

Add goods in process, April 30 . . . . . . . . . 7,850

Total cost of goods in process . . . . . . . . . 46,200

Less goods in process, May 31 . . . . . . . . . 3,400

Less underapplied overhead . . . . . . . . . . . 150

Cost of goods manufactured . . . . . . . . . . $42,650

Note how underapplied overhead is reported. Overapplied overhead is similarly reported, but is added.

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Chapter 15 Job Order Costing and Analysis 671

C1 Describe important features of job order production. Cer-tain companies called job order manufacturers produce custom-made products for customers. These customized products are produced in response to a customer’s orders. A job order manu- facturer produces products that usually are different and, typically, produced in low volumes. The production systems of job order com- panies are flexible and are not highly standardized.

C2 Explain job cost sheets and how they are used in job order cost accounting. In a job order cost accounting system, the costs of producing each job are accumulated on a separate job cost sheet. Costs of direct materials, direct labor, and overhead are accumulated separately on the job cost sheet and then added to determine the total cost of a job. Job cost sheets for jobs in process, finished jobs, and jobs sold make up subsidiary records controlled by general ledger accounts.

A1 Apply job order costing in pricing services. Job order costing can usefully be applied to a service setting. The resulting job cost estimate can then be used to help determine a price for services.

P1 Describe and record the flow of materials costs in job order cost accounting. Costs of materials flow from re ceiving

Summary reports to materials ledger cards and then to either job cost sheets or the Indirect Materials account in the factory overhead ledger.

P2 Describe and record the flow of labor costs in job or der cost accounting. Costs of labor flow from clock cards to the Factory Payroll account and then to either job cost sheets or the In- direct Labor account in the factory overhead ledger.

P3 Describe and record the flow of overhead costs in job or-der cost accounting. Overhead costs are accumulated in the Factory Overhead account that controls the subsidiary factory over- head ledger. Then, using a predetermined overhead rate, overhead costs are charged to jobs.

P4 Determine adjustments for overapplied and underapplied factory overhead. At the end of each period, the Factory Overhead account usually has a residual debit (underapplied over- head) or credit (overapplied overhead) balance. If the balance is not material, it is transferred to Cost of Goods Sold, but if it is material, it is allocated to Goods in Process Inventory, Finished Goods Inven- tory, and Cost of Goods Sold.

Management Consultant Service companies (such as this consulting firm) do not recognize goods in process inventory or fin- ished goods inventory—an important difference between service and manufacturing companies. For the two jobs that are 60% complete, you could recognize revenues and costs at 60% of the total expected amounts. This means you could recognize revenue of $7,200 (0.60 3 $12,000) and costs of $6,000 (0.60 3 $10,000), yielding net income of $1,200 from each job.

Web Consultant The partner has a monetary incentive to man- age the numbers and assign more costs to the two cost-plus engage- ments. This also would reduce costs on the fixed-price engagements. To act in such a manner is unethical. As a professional and an honest person, it is your responsibility to engage in ethical behavior. You must not comply with the partner’s instructions. If the partner insists you act in an unethical manner, you should report the matter to a higher authority in the organization.

Entrepreneur An inadequate cost system can distort product costs. You should review overhead costs in detail. Once you know the

different cost elements in overhead, you can classify them into groups such as material related, labor related, or machine related. Other groups can also be formed (we discuss this in Chapter 22). Once you have classified overhead items into groups, you can better establish overhead allocation bases and use them to compute prede- termined overhead rates. These multiple rates and bases can then be used to assign overhead costs to products. This will likely improve product pricing.

Sales Manager The price based on AdWorld’s normal pricing policy is $20,150 ($17,076 3 1.18), which is within the price range offered by competitors. One option is to apply normal pricing policy and quote a price of $20,150. On the other hand, assessing the com- petition, particularly in terms of their service quality and other bene- fits they might offer, would be useful. Although price is an input customers use to select suppliers, factors such as quality and timeli- ness (responsiveness) of suppliers are important. Accordingly, your price can reflect such factors.

Guidance Answers to Decision Maker and Decision Ethics

1. b 2. A job is a special order for a custom product. A job lot consists

of a quantity of identical, special-order items. 3. a 4. Three costs normally accumulated on a job cost sheet are direct

materials, direct labor, and factory overhead. 5. c

6. Four sources of factory overhead are materials requisitions, time tickets, vouchers, and adjusting entries.

7. Since a job order cost accounting system uses perpetual inventory records, overhead costs must be assigned to jobs before the end of a period. This requires the use of a predetermined overhead rate.

8. Debits are recorded when wages and salaries of factory employ- ees are paid or accrued. Credits are recorded when direct labor

Guidance Answers to Quick Checks

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672 Chapter 15 Job Order Costing and Analysis

costs are assigned to jobs and when indirect labor costs are transferred to the Factory Overhead account.

9. Overapplied or underapplied overhead usually exists at the end of a period because application of overhead is based on

estimates of overhead and another variable such as direct labor. Estimates rarely equal actual amounts incurred.

10. A debit balance reflects underapplied factory overhead.

Clock card (p. 660)

Cost accounting system (p. 654)

Finished Goods Inventory (p. 657)

General accounting system (p. 654)

Goods in Process Inventory (p. 656)

Job (p. 654)

Job cost sheet (p. 656)

Job lot (p. 654)

Job order cost accounting system (p. 656)

Job order production (p. 654)

Materials ledger card (p. 658)

Materials requisition (p. 659)

Overapplied overhead (p. 665)

Predetermined overhead rate (p. 662)

Target cost (p. 655)

Time ticket (p. 660)

Underapplied overhead (p. 665)

Key Terms

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 689 mhhe.com/wildFINMAN5e

4. A company’s Goods in Process Inventory T-account follows.

The cost of units transferred to Finished Goods inventory is a. $193,000 b. $211,800 c. $185,000 d. $144,600 e. $176,200 5. At the end of its current year, a company learned that its overhead

was underapplied by $1,500 and that this amount is not consid- ered material. Based on this information, the company should

a. Close the $1,500 to Finished Goods Inventory. b. Close the $1,500 to Cost of Goods Sold. c. Carry the $1,500 to the next period. d. Do nothing about the $1,500 because it is not material and

it is likely that overhead will be overapplied by the same amount next year.

e. Carry the $1,500 to the Income Statement as “Other Expense.”

1. A company’s predetermined overhead allocation rate is 150% of its direct labor costs. How much overhead is applied to a job that requires total direct labor costs of $30,000?

a. $15,000 b. $30,000 c. $45,000 d. $60,000 e. $75,000 2. A company’s cost accounting system uses direct labor costs to

apply overhead to goods in process and finished goods invento- ries. Its production costs for the period are: direct materials, $45,000; direct labor, $35,000; and overhead applied, $38,500. What is its predetermined overhead allocation rate?

a. 10% b. 110% c. 86% d. 91% e. 117% 3. A company’s ending inventory of finished goods has a total

cost of $10,000 and consists of 500 units. If the overhead applied to these goods is $4,000, and the predetermined overhead rate is 80% of direct labor costs, how much direct materials cost was incurred in producing these 500 units?

a. $10,000 b. $ 6,000 c. $ 4,000 d. $ 5,000 e. $ 1,000

Beginning balance 9,000

Direct materials 94,200

Direct labor 59,200

Overhead applied 31,600

Ending balance 17,800

? Finished goods

Goods in Process Inventory

1. Why must a company estimate the amount of factory overhead assigned to individual jobs or job lots?

2. The chapter used a percent of labor cost to assign factory overhead to jobs. Identify another factor (or base) a company might reasonably use to assign overhead costs.

Discussion Questions

Icon denotes assignments that involve decision making.

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Chapter 15 Job Order Costing and Analysis 673

3. What information is recorded on a job cost sheet? How do management and employees use job cost sheets?

4. In a job order cost accounting system, what records serve as a subsidiary ledger for Goods in Process Inventory? For Finished Goods Inventory?

5. What journal entry is recorded when a materials manager re- ceives a materials requisition and then issues materials (both direct and indirect) for use in the factory?

6. How does the materials requisition help safeguard a com- pany’s assets?

7. Polaris uses a “time ticket” for some employees. What is the difference between a clock card and a time ticket?

8. What events cause debits to be recorded in the Factory Over- head account? What events cause credits to be recorded in the Factory Overhead account?

9. Piaggio applies overhead to product costs. What account(s) is(are) used to eliminate overapplied

or underapplied overhead from the Factory Overhead account, assuming the amount is not material?

10. Assume that Arctic Cat produces a batch of 1,000 snowmobile helmets. Does it account for this as 1,000 individual jobs or as a job lot? Explain (con- sider costs and benefits).

11. Why must a company prepare a predetermined overhead rate when using job order cost accounting?

12. How would a hospital apply job order costing? Explain. 13. Harley-Davidson manufactures 30 custom-

made, luxury-model motor cycles. Does it account for these motorcycles as 30 individual jobs or as a job lot? Explain.

14. Assume Sprint will install and service a server to link all of a customer’s employees’ smartphones to a cen- tralized company server, for an upfront flat price. How can Sprint use a job order costing system?

Harley- Davidson

Determine which products are most likely to be manufactured as a job and which as a job lot. 1. Hats imprinted with company logo. 4. A 90-foot motor yacht. 2. Little League trophies. 5. Wedding dresses for a chain of stores. 3. A hand-crafted table. 6. A custom-designed home.

QUICK STUDY

QS 15-1 Jobs and job lots C1

QS 15-2 Job cost sheets C2

List the three types of costs that are typically recorded on a job cost sheet. How can managers use job cost sheets?

QS 15-4 Direct materials journal entries

P1

During the current month, a company that uses a job order cost accounting system purchases $50,000 in raw materials for cash. It then uses $12,000 of raw materials indirectly as factory supplies and uses $32,000 of raw materials as direct materials. Prepare entries to record these three transactions.

QS 15-5 Direct labor journal entries P2

During the current month, a company that uses a job order cost accounting system incurred a monthly factory payroll of $180,000, paid in cash. Of this amount, $40,000 is classified as indirect labor and the remainder as direct. Prepare entries to record these transactions.

QS 15-7 Factory overhead rates P3

A company incurred the following manufacturing costs this period: direct labor, $468,000; direct materi- als, $354,000; and factory overhead, $117,000. Compute its overhead cost as a percent of (1) direct labor and (2) direct materials. Express your answers as percents, rounded to the nearest whole number.

QS 15-3 Job cost sheets C2

Clemens Cars’ job cost sheet for job A40 shows that the cost to add security features to a car was $10,500. The car was delivered to the customer, who paid $14,900 in cash for the added features. What journal entries should Clemens record for the completion and delivery of job A40?

QS 15-6 Factory overhead journal entries

P3

During the current month, a company that uses a job order cost accounting system incurred a monthly factory payroll of $175,000, paid in cash. Of this amount, $44,000 is classified as indirect labor and the remainder as direct for the production of Job 65A. Factory overhead is applied at 90% of direct labor. Prepare the entry to apply factory overhead to this job lot.

QS 15-8 Entry for over- or underapplied overhead P4

A company’s Factory Overhead T-account shows total debits of $624,000 and total credits of $646,000 at the end of a period. Prepare the journal entry to close the balance in the Factory Overhead account to Cost of Goods Sold.

Polaris

PIAGGIO

Arctic Cat

Sprint

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674 Chapter 15 Job Order Costing and Analysis

QS 15-11 Pricing services A1

An advertising agency is estimating costs for advertising a music festival. The job will require 200 direct labor hours at a cost of $50 per hour. Overhead costs are applied at a rate of $65 per direct labor hour. What is the total estimated cost for this job?

Exercise 15-3 Documents in job order cost accounting

P1 P2 P3

The left column lists the titles of documents and accounts used in job order cost accounting. The right column presents short descriptions of the purposes of the documents. Match each document in the left column to its numbered description in the right column. A. Time ticket B. Materials ledger card C. Factory Payroll account D. Clock card E. Materials requisition F. Factory Overhead account G. Voucher

1. Shows amount of time an employee works on a job. 2. Temporarily accumulates the cost of incurred overhead

until the cost is assigned to specific jobs. 3. Temporarily accumulates incurred labor costs until they

are assigned to specific jobs or to overhead. 4. Communicates the need for materials to complete a job. 5. Shows only total time an employee works each day. 6. Shows amount approved for payment of an overhead or

other cost. 7. Perpetual inventory record of raw materials received,

used, and available for use.

EXERCISES

Exercise 15-1 Job order production

C1

Match the terms below with their definitions. 1. Cost accounting system 2. Target cost 3. General accounting system 4. Job 5. Job order production 6. Job lot

a. Production of products in response to customer orders. b. A system that records manufacturing costs using a periodic in-

ventory system. c. A system that records manufacturing costs using a perpetual in-

ventory system. d. The expected selling price of a job minus its desired profit. e. Production of more than one unit of a custom product. f. Production activities for a customized product.

QS 15-12 Job order production C1

Refer to this chapter’s Global View. Porsche AG is the manufacturer of the Porsche automobile line. Does Porsche produce in jobs or in job lots? Explain.

QS 15-9 Entry for over- or underapplied overhead P4

A company allocates overhead at a rate of 150% of direct labor cost. Actual overhead cost for the current period is $950,000, and direct labor cost is $600,000. Prepare the entry to close over- or underapplied overhead to cost of goods sold.

QS 15-10 Predetermined overhead rate

P3

At the beginning of a period a company predicts total direct materials costs of $900,000 and total overhead costs of $1,170,000. If the company uses direct materials costs as its activity base to allocate overhead, what is the predetermined overhead rate it should use during the period?

Exercise 15-2 Job cost computation

C2

The following information is from the materials requisitions and time tickets for Job 9-1005 completed by Great Bay Boats. The requisitions are identified by code numbers starting with the letter Q and the time tickets start with W. At the start of the year, management estimated that overhead cost would equal 110% of direct labor cost for each job. Determine the total cost on the job cost sheet for Job 9-1005.

Date Document Amount

7/1/2013 . . . . . . . . . . Q-4698 $1,250

7/1/2013 . . . . . . . . . . W-3393 600

7/5/2013 . . . . . . . . . . Q-4725 1,000

7/5/2013 . . . . . . . . . . W-3479 450

7/10/2013 . . . . . . . . . W-3559 300

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Chapter 15 Job Order Costing and Analysis 675

Exercise 15-4 Analysis of cost flows

C2 P1 P2 P3

As of the end of June, the job cost sheets at Racing Wheels, Inc., show the following total costs accumulated on three custom jobs.

Job 102 Job 103 Job 104

Direct materials . . . . . . . . . $15,000 $33,000 $27,000

Direct labor . . . . . . . . . . . . 8,000 14,200 21,000

Overhead . . . . . . . . . . . . . . 4,000 7,100 10,500

Job 102 was started in production in May and the following costs were assigned to it in May: direct materials, $6,000; direct labor, $1,800; and overhead, $900. Jobs 103 and 104 are started in June. Overhead cost is applied with a predetermined rate based on direct labor cost. Jobs 102 and 103 are finished in June, and Job 104 is expected to be finished in July. No raw materials are used indirectly in June. Using this information, answer the following questions. (Assume this company’s predetermined overhead rate did not change across these months). 1. What is the cost of the raw materials requisitioned in June for each of the three jobs? 2. How much direct labor cost is incurred during June for each of the three jobs? 3. What predetermined overhead rate is used during June? 4. How much total cost is transferred to finished goods during June? Check (4) $81,300

JOB COST SHEET

Customer’s Name Keiser Co. Job No. 13-56

Job Description 5 plasma monitors—61 inch

Overhead

Direct Materials Direct Labor Costs Applied

Date Requisition No. Amount Time-Ticket No. Amount Rate Amount

Mar. 8 4-129 $5,000 T-306 $ 700

Mar. 11 4-142 7,020 T-432 1,250

Mar. 18 4-167 3,330 T-456 1,250

Totals

Exercise 15-5 Overhead rate; costs assigned to jobs

P3

In December 2012, Shire Computer’s management establishes the year 2013 predetermined overhead rate based on direct labor cost. The information used in setting this rate includes estimates that the company will incur $747,500 of overhead costs and $575,000 of direct labor cost in year 2013. During March 2013, Shire began and completed Job No. 13-56. 1. What is the predetermined overhead rate for year 2013? 2. Use the information on the following job cost sheet to determine the total cost of the job. Check (2) $22,710

Exercise 15-6 Analysis of costs assigned to goods in process

P3

Lorenzo Company uses a job order cost accounting system that charges overhead to jobs on the basis of direct material cost. At year-end, the Goods in Process Inventory account shows the following.

ExplanationDate Debit Credit Balance

2013

Dec. 31 31

31 31

Direct materials cost Direct labor cost Overhead costs To finished goods

1,500,000 1,800,000 2,400,000

50,000

1,500,000 300,000 600,000

2,350,000

Accounting System

Goods in Process Inventory Acct. No. 121

File Edit Maintain Tasks Analysis Options Reports Window Help

1. Determine the overhead rate used (based on direct material cost). 2. Only one job remained in the goods in process inventory at December 31, 2013. Its direct materials

cost is $30,000. How much direct labor cost and overhead cost are assigned to it? Check (2) Direct labor cost, $8,000

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676 Chapter 15 Job Order Costing and Analysis

Exercise 15-7 Cost flows in a job order cost system

P1 P2 P3 P4

The following information is available for Lock-Safe Company, which produces special-order security products and uses a job order cost accounting system.

April 30 May 31

Inventories Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $43,000 $ 52,000 Goods in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,200 21,300 Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,000 35,600 Activities and information for May Raw materials purchases (paid with cash) . . . . . . . . . . . . . . . . . . . . . . 210,000 Factory payroll (paid with cash) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345,000 Factory overhead Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Other overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Sales (received in cash) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400,000 Predetermined overhead rate based on direct labor cost . . . . . . . . . . 70%

Compute the following amounts for the month of May. 1. Cost of direct materials used. 4. Cost of goods sold.* 2. Cost of direct labor used. 5. Gross profit. 3. Cost of goods manufactured. 6. Overapplied or underapplied overhead. *Do not consider any underapplied or overapplied overhead.

Check (3) $625,400

Exercise 15-8 Journal entries for materials

P1

Use information in Exercise 15-7 to prepare journal entries for the following events for the month of May. 1. Raw materials purchases for cash. 3. Indirect materials usage. 2. Direct materials usage.

Exercise 15-9 Journal entries for labor

P2

Use information in Exercise 15-7 to prepare journal entries for the following events for the month of May. 1. Factory payroll costs in cash. 3. Indirect labor usage. 2. Direct labor usage.

Exercise 15-10 Journal entries for overhead

P3

Use information in Exercise 15-7 to prepare journal entries for the following events for the month of May. 1. Factory overhead excluding indirect materials and indirect labor (record credit to Other Accounts). 2. Application of overhead to goods in process.

Exercise 15-11 Adjusting factory overhead P4

Refer to information in Exercise 15-7. Prepare the journal entry to allocate (close) overapplied or underapplied overhead to Cost of Goods Sold.

Exercise 15-13 Recording events in job order costing

P1 P2 P3 P4

Using Exhibit 15.12 as a guide, prepare summary journal entries to record the following transactions and events a through h for a company in its first month of operations. a. Raw materials purchased on account, $90,000. b. Direct materials used in production, $36,500. Indirect materials used in production, $19,200. c. Paid cash for factory payroll, $50,000. Of this total, $38,000 is for direct labor and $12,000 is for in-

direct labor. d. Paid cash for other actual overhead costs, $11,475. e. Applied overhead at the rate of 125 percent of direct labor cost.

Exercise 15-12 Adjusting factory overhead

P4

Record the journal entry to close over- or underapplied factory overhead to Cost of Goods Sold for each of the independent cases below.

Marsh Concert Ellis Home

Promotions Builders

Actual indirect materials costs . . . . . . . . $22,000 $ 12,500 Actual indirect labor costs . . . . . . . . . . . 46,000 46,500 Other overhead costs . . . . . . . . . . . . . . . 17,000 47,000 Overhead applied . . . . . . . . . . . . . . . . . . 88,200 105,200

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Chapter 15 Job Order Costing and Analysis 677

Exercise 15-14 Factory overhead computed, applied, and adjusted

P3 P4

In December 2012, Infovision established its predetermined overhead rate for movies produced during year 2013 by using the following cost predictions: overhead costs, $1,680,000, and direct labor costs, $480,000. At year end 2013, the company’s records show that actual overhead costs for the year are $1,652,000. Actual direct labor cost had been assigned to jobs as follows.

Movies completed and released . . . . . . . . . $425,000

Movies still in production . . . . . . . . . . . . . . 50,000

Total actual direct labor cost . . . . . . . . . . . $475,000

1. Determine the predetermined overhead rate for year 2013. 2. Set up a T-account for overhead and enter the overhead costs incurred and the amounts applied to

movies during the year using the predetermined overhead rate. 3. Determine whether overhead is overapplied or underapplied (and the amount) during the year. 4. Prepare the adjusting entry to allocate any over- or underapplied overhead to Cost of Goods Sold.

Check (3) $10,500 overapplied

Exercise 15-15 Factory overhead computed, applied, and adjusted

P3 P4

In December 2012, Cardozo Company established its predetermined overhead rate for jobs produced during year 2013 by using the following cost predictions: overhead costs, $750,000, and direct labor costs, $625,000. At year end 2013, the company’s records show that actual overhead costs for the year are $830,000. Actual direct labor cost had been assigned to jobs as follows.

1. Determine the predetermined overhead rate for year 2013. 2. Set up a T-account for Factory Overhead and enter the overhead costs incurred and the amounts

applied to jobs during the year using the predetermined overhead rate. 3. Determine whether overhead is overapplied or underapplied (and the amount) during the year. 4. Prepare the adjusting entry to allocate any over- or underapplied overhead to Cost of Goods Sold.

Check (3) $8,000 underapplied

Jobs completed and sold . . . . . . . . . . . . . . . . . $513,750

Jobs in finished goods inventory . . . . . . . . . . . 102,750

Jobs in goods in process inventory . . . . . . . . . 68,500

Total actual direct labor cost . . . . . . . . . . . . . $685,000

Exercise 15-16 Overhead rate calculation, allocation, and analysis

P3

Sunrise Company applies factory overhead based on direct labor costs. The company incurred the following costs during 2013: direct materials costs, $650,000; direct labor costs, $3,000,000; and factory overhead costs applied, $1,800,000. 1. Determine the company’s predetermined overhead rate for year 2013. 2. Assuming that the company’s $71,000 ending Goods in Process Inventory account for year 2013 had

$20,000 of direct labor costs, determine the inventory’s direct materials costs. 3. Assuming that the company’s $490,000 ending Finished Goods Inventory account for year 2013 had

$250,000 of direct materials costs, determine the inventory’s direct labor costs and its overhead costs. Check (3) $90,000 overhead costs

Exercise 15-17 Costs allocated to ending inventories

P1 P2 P3

Deschamps Company’s ending Goods in Process Inventory account consists of 5,000 units of partially completed product, and its Finished Goods Inventory account consists of 12,000 units of product. The factory manager determines that Goods in Process Inventory includes direct materials cost of $10 per unit and direct labor cost of $7 per unit. Finished goods are estimated to have $12 of direct materials cost per unit and $9 of direct labor cost per unit. The company established the predetermined overhead rate using the following predictions: estimated direct labor cost, $300,000, and estimated factory overhead, $375,000. The company allocates factory overhead to its goods in process and finished goods inventories based on direct labor cost. During the period, the company incurred these costs: direct materials, $535,000; direct labor, $290,000; and factory overhead applied, $362,500. 1. Determine the predetermined overhead rate. 2. Compute the total cost of the two ending inventories. 3. Compute cost of goods sold for the year (assume no beginning inventories and no underapplied or

overapplied overhead). Check (3) Cost of goods sold,

$671,750

f. Transferred cost of jobs completed to finished goods, $56,800. g. Sold jobs on account for $82,000. The jobs had a cost of $56,800. h. Close underapplied or overapplied overhead to cost of goods sold.

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678 Chapter 15 Job Order Costing and Analysis

Exercise 15-19 Direct materials journal entries

P1

A recent balance sheet for Porsche AG shows beginning raw materials inventory of €83 million and ending raw materials inventory of €85 million. Assume the company purchased raw materials (on account) for €3,108 million during the year. (1) Prepare journal entries to record (a) the purchase of raw materials and (b) the use of raw materials in production. (2) What do you notice about the € amounts in your journal entries?

Exercise 15-18 Cost-based pricing

A1

Hansel Corporation has requested bids from several architects to design its new corporate headquarters. Frey Architects is one of the firms bidding on the job. Frey estimates that the job will require the following direct labor.

File Edit View Insert Format Tools Data Window Help

Architects Staff Clerical

150 300 500

$300 75 20

Frey applies overhead to jobs at 175% of direct labor cost. Frey would like to earn at least $80,000 profit on the architectural job. Based on past experience and market research, it estimates that the competition will bid between $285,000 and $350,000 for the job. 1. What is Frey’s estimated cost of the architectural job? 2. What bid would you suggest that Frey submit?

Check (1) $213,125

Required

1. Determine the total of each production cost incurred for April (direct labor, direct materials, and applied overhead), and the total cost assigned to each job (including the balances from March 31).

2. Prepare journal entries for the month of April to record the following. a. Materials purchases (on credit), factory payroll (paid in cash), and actual overhead costs includ ing

indirect materials and indirect labor. (Factory rent and utilities are paid in cash.) b. Assignment of direct materials, direct labor, and applied overhead costs to the Goods in Process

Inventory. c. Transfer of Jobs 306 and 307 to the Finished Goods Inventory. d. Cost of goods sold for Job 306. e. Revenue from the sale of Job 306. f. Assignment of any underapplied or overapplied overhead to the Cost of Goods Sold account.

(The amount is not material.) 3. Prepare a manufacturing statement for April (use a single line presentation for direct materials and

show the details of overhead cost). 4. Compute gross profit for April. Show how to present the inventories on the April 30 balance sheet.

PROBLEM SET A

Problem 15-1A Production costs computed and recorded; reports prepared

C2 P1 P2 P3 P4

Ciolino Co.’s March 31 inventory of raw materials is $80,000. Raw materials purchases in April are $500,000, and factory payroll cost in April is $363,000. Overhead costs incurred in April are: indirect materials, $50,000; indirect labor, $23,000; factory rent, $32,000; factory utilities, $19,000; and fac tory equipment depreciation, $51,000. The predetermined overhead rate is 50% of direct labor cost. Job 306 is sold for $635,000 cash in April. Costs of the three jobs worked on in April follow.

Job 306 Job 307 Job 308

Balances on March 31

Direct materials . . . . . . . . . . . . $ 29,000 $ 35,000

Direct labor . . . . . . . . . . . . . . . 20,000 18,000

Applied overhead . . . . . . . . . . . 10,000 9,000

Costs during April

Direct materials . . . . . . . . . . . . 135,000 220,000 $100,000

Direct labor . . . . . . . . . . . . . . . 85,000 150,000 105,000

Applied overhead . . . . . . . . . . . ? ? ?

Status on April 30. . . . . . . . . . . . . Finished (sold) Finished (unsold) In process

Check (2f) $5,000 underapplied

(3) Cost of goods manufactured, $828,500

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Chapter 15 Job Order Costing and Analysis 679

Analysis Component

5. The over- or underapplied overhead is closed to Cost of Goods Sold. Discuss how this adjustment impacts business decision making regarding individual jobs or batches of jobs.

Problem 15-2A Source documents, journal entries, overhead, and financial reports

P1 P2 P3 P4

Farina Bay’s computer system generated the following trial balance on December 31, 2013. The company’s manager knows something is wrong with the trial balance because it does not show any balance for Goods in Process Inventory but does show balances for the Factory Payroll and Factory Overhead accounts.

Check (2) $9,200 underapplied overhead

(3) T. B. totals, $736,000

(4) Net income, $85,800

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $102,000

Accounts receivable . . . . . . . . . . . . . . . 75,000

Raw materials inventory . . . . . . . . . . . . 80,000

Goods in process inventory . . . . . . . . . 0

Finished goods inventory . . . . . . . . . . . 15,000

Prepaid rent . . . . . . . . . . . . . . . . . . . . . 3,000

Accounts payable . . . . . . . . . . . . . . . . . $ 17,000

Notes payable . . . . . . . . . . . . . . . . . . . . 25,000

Common stock . . . . . . . . . . . . . . . . . . . 50,000

Retained earnings . . . . . . . . . . . . . . . . . 271,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373,000

Cost of goods sold . . . . . . . . . . . . . . . . 218,000

Factory payroll . . . . . . . . . . . . . . . . . . . 68,000

Factory overhead . . . . . . . . . . . . . . . . . 115,000

Operating expenses . . . . . . . . . . . . . . . 60,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . $736,000 $736,000

After examining various files, the manager identifies the following six source documents that need to be processed to bring the accounting records up to date.

Jobs 402 and 404 are the only units in process at year-end. The predetermined overhead rate is 200% of direct labor cost.

Required

1. Use information on the six source documents to prepare journal entries to assign the following costs. a. Direct materials costs to Goods in Process Inventory. b. Direct labor costs to Goods in Process Inventory. c. Overhead costs to Goods in Process Inventory. d. Indirect materials costs to the Factory Overhead account. e. Indirect labor costs to the Factory Overhead account. 2. Determine the revised balance of the Factory Overhead account after making the entries in part 1. Deter-

mine whether there is any under- or overapplied overhead for the year. Prepare the adjusting entry to al- locate any over- or underapplied overhead to Cost of Goods Sold, assuming the amount is not material.

3. Prepare a revised trial balance. 4. Prepare an income statement for year 2013 and a balance sheet as of December 31, 2013.

Analysis Component

5. Assume that the $5,600 on materials requisition 21-3012 should have been direct materials charged to Job 404. Without providing specific calculations, describe the impact of this error on the income state- ment for 2013 and the balance sheet at December 31, 2013.

Materials requisition 21-3010: $10,200 direct materials to Job 402

Materials requisition 21-3011: $18,600 direct materials to Job 404

Materials requisition 21-3012: $5,600 indirect materials

Labor time ticket 6052: $36,000 direct labor to Job 402

Labor time ticket 6053: $23,800 direct labor to Job 404

Labor time ticket 6054: $8,200 indirect labor

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680 Chapter 15 Job Order Costing and Analysis

Problem 15-3A Source documents, journal entries, and accounts in job order cost accounting

P1 P2 P3

Widmer Watercraft’s predetermined overhead rate for year 2013 is 200% of direct labor. Information on the company’s production activities during May 2013 follows. a. Purchased raw materials on credit, $200,000. b. Paid $126,000 cash for factory wages. c. Paid $15,000 cash to a computer consultant to reprogram factory equipment. d. Materials requisitions record use of the following materials for the month.

Job 136 . . . . . . . . . . . . . . . . . . . . $ 48,000

Job 137 . . . . . . . . . . . . . . . . . . . . 32,000

Job 138 . . . . . . . . . . . . . . . . . . . . 19,200

Job 139 . . . . . . . . . . . . . . . . . . . . 22,400

Job 140 . . . . . . . . . . . . . . . . . . . . 6,400

Total direct materials . . . . . . . . . 128,000

Indirect materials . . . . . . . . . . . . 19,500

Total materials used . . . . . . . . . . $147,500

Job 136 . . . . . . . . . . . . . . . . $ 12,000

Job 137 . . . . . . . . . . . . . . . . 10,500

Job 138 . . . . . . . . . . . . . . . . 37,500

Job 139 . . . . . . . . . . . . . . . . 39,000

Job 140 . . . . . . . . . . . . . . . . 3,000

Total direct labor . . . . . . . . 102,000

Indirect labor . . . . . . . . . . . . 24,000

Total . . . . . . . . . . . . . . . . . . . $126,000

Depreciation of factory building . . . . . . . . . . . $68,000

Depreciation of factory equipment . . . . . . . . 36,500

Expired factory insurance . . . . . . . . . . . . . . . . 10,000

Accrued property taxes payable . . . . . . . . . . . 35,000

Job No. __________

Materials . . . . . . . . . $

Labor . . . . . . . . . . . .

Overhead . . . . . . . .

Total cost . . . . . . . . $

e. Time tickets record use of the following labor for the month.

f. Applied overhead to Jobs 136, 138, and 139. g. Transferred Jobs 136, 138, and 139 to Finished Goods. h. Sold Jobs 136 and 138 on credit at a total price of $525,000. i. The company incurred the following overhead costs during the month (credit Prepaid Insurance for

expired factory insurance).

j. Applied overhead at month-end to the Goods in Process (Jobs 137 and 140) using the predetermined overhead rate of 200% of direct labor cost.

Required

1. Prepare a job cost sheet for each job worked on during the month. Use the following simplified form.

2. Prepare journal entries to record the events and transactions a through j. 3. Set up T-accounts for each of the following general ledger accounts, each of which started the month

with a zero balance: Raw Materials Inventory; Goods in Process Inventory; Finished Goods Inventory;

Check (2f) Cr. Factory Overhead, $177,000

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Chapter 15 Job Order Costing and Analysis 681

Factory Payroll; Factory Overhead; Cost of Goods Sold. Then post the journal entries to these T-accounts and determine the balance of each account.

4. Prepare a report showing the total cost of each job in process and prove that the sum of their costs equals the Goods in Process Inventory account balance. Prepare similar reports for Finished Goods Inventory and Cost of Goods Sold.

Check (4) Finished Goods Inventory, $139,400

mhhe.com/wildFINMAN5e

Problem 15-4A Overhead allocation and adjustment using a predetermined overhead rate

P3 P4

In December 2012, Yerbury Company’s manager estimated next year’s total direct labor cost assuming 50 persons working an average of 2,000 hours each at an average wage rate of $25 per hour. The manager also estimated the following manufacturing overhead costs for year 2013.

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 319,200

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . 240,000

Rent on factory building . . . . . . . . . . . . . . . . . . . . 140,000

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,000

Factory insurance expired . . . . . . . . . . . . . . . . . . . 68,000

Depreciation—Factory equipment . . . . . . . . . . . . 480,000

Repairs expense—Factory equipment . . . . . . . . . 60,000

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . 68,800

Miscellaneous production costs . . . . . . . . . . . . . . 36,000

Total estimated overhead costs . . . . . . . . . . . . . . $1,500,000

Check (1c) 12,800 underapplied

(2) Cr. Factory Overhead $12,800

At the end of 2013, records show the company incurred $1,520,000 of actual overhead costs. It completed and sold five jobs with the following direct labor costs: Job 201, $604,000; Job 202, $563,000; Job 203, $298,000; Job 204, $716,000; and Job 205, $314,000. In addition, Job 206 is in process at the end of 2013 and had been charged $17,000 for direct labor. No jobs were in process at the end of 2012. The company’s predetermined overhead rate is based on direct labor cost.

Required

1. Determine the following. a. Predetermined overhead rate for year 2013. b. Total overhead cost applied to each of the six jobs during year 2013. c. Over- or underapplied overhead at year-end 2013. 2. Assuming that any over- or underapplied overhead is not material, prepare the adjusting entry to

allocate any over- or underapplied overhead to Cost of Goods Sold at the end of year 2013.

Receiving Report No. 426, Material M, 250 units at $250 each.

Receiving Report No. 427, Material R, 90 units at $180 each.

Material M . . . . . . . . 200 units @ $250 5 $50,000

Material R . . . . . . . . 95 units @ 180 5 17,100

Paint . . . . . . . . . . . . . 55 units @ 75 5 4,125

Total cost . . . . . . . . . $71,225

Problem 15-5A Production transactions, subsidiary records, and source documents

P1 P2 P3 P4

Sager Company manufactures variations of its product, a technopress, in response to custom orders from its customers. On May 1, the company had no inventories of goods in process or finished goods but held the following raw materials.

On May 4, the company began working on two technopresses: Job 102 for Worldwide Company and Job 103 for Reuben Company.

Required

Using Exhibit 15.2 as a guide, prepare job cost sheets for jobs 102 and 103. Using Exhibit 15.4 as a guide, prepare materials ledger cards for Material M, Material R, and paint. Enter the beginning raw materials inventory dollar amounts for each of these materials on their respective ledger cards. Then, follow the in- structions in this list of activities. a. Purchased raw materials on credit and recorded the following information from receiving reports and

invoices.

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682 Chapter 15 Job Order Costing and Analysis

Instructions: Record these purchases with a single journal entry. Enter the receiving report informa- tion on the materials ledger cards.

b. Requisitioned the following raw materials for production.

Requisition No. 35, for Job 102, 135 units of Material M.

Requisition No. 36, for Job 102, 72 units of Material R.

Requisition No. 37, for Job 103, 70 units of Material M.

Requisition No. 38, for Job 103, 38 units of Material R.

Requisition No. 39, for 15 units of paint.

Time tickets Nos. 1 to 10 for direct labor on Job 102, $90,000.

Time tickets Nos. 11 to 30 for direct labor on Job 103, $65,000.

Time tickets Nos. 31 to 36 for equipment repairs, $19,250.

Instructions: Enter amounts for direct materials requisitions on the materials ledger cards and the job cost sheets. Enter the indirect material amount on the materials ledger card. Do not record a journal entry at this time.

c. Received the following employee time tickets for work in May.

Instructions: Record direct labor from the time tickets on the job cost sheets. Do not record a journal entry at this time.

d. Paid cash for the following items during the month: factory payroll, $174,250, and miscellaneous overhead items, $102,000.

Instructions: Record these payments with journal entries. e. Finished Job 102 and transferred it to the warehouse. The company assigns overhead to each job

with a predetermined overhead rate equal to 80% of direct labor cost. Instructions: Enter the allocated overhead on the cost sheet for Job 102, fill in the cost summary section

of the cost sheet, and then mark the cost sheet “Finished.” Prepare a journal entry to record the job’s completion and its transfer to Finished Goods.

f. Delivered Job 102 and accepted the customer’s promise to pay $400,000 within 30 days. Instructions: Prepare journal entries to record the sale of Job 102 and the cost of goods sold. g. Applied overhead to Job 103 based on the job’s direct labor to date. Instructions: Enter overhead on the job cost sheet but do not make a journal entry at this time. h. Recorded the total direct and indirect materials costs as reported on all the requisitions for the month. Instructions: Prepare a journal entry to record these costs. i. Recorded the total direct and indirect labor costs as reported on all time tickets for the month. Instructions: Prepare a journal entry to record these costs. j. Recorded the total overhead costs applied to jobs. Instructions: Prepare a journal entry to record the allocation of these overhead costs. k. Compute the balance in the Factory Overhead account as of the end of May.

Check (h) Dr. Goods in Process Inventory, $71,050

Check Balance in Factory Overhead, $1,625 Cr., overapplied

PROBLEM SET B

Problem 15-1B Production costs computed and recorded; reports prepared

C2 P1 P2 P3 P4

Tavella Co.’s August 31 inventory of raw materials is $150,000. Raw materials purchases in September are $400,000, and factory payroll cost in September is $232,000. Overhead costs incurred in September are: indirect materials, $30,000; indirect labor, $14,000; factory rent, $20,000; factory utilities, $12,000; and factory equipment depreciation, $30,000. The predetermined overhead rate is 50% of direct labor cost. Job 114 is sold for $380,000 cash in September. Costs for the three jobs worked on in September follow.

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Chapter 15 Job Order Costing and Analysis 683

Required

1. Determine the total of each production cost incurred for September (direct labor, direct materials, and applied overhead), and the total cost assigned to each job (including the balances from August 31).

2. Prepare journal entries for the month of September to record the following. a. Materials purchases (on credit), factory payroll (paid in cash), and actual overhead costs includ-

ing indirect materials and indirect labor. (Factory rent and utilities are paid in cash.) b. Assignment of direct materials, direct labor, and applied overhead costs to Goods in Process

Inventory. c. Transfer of Jobs 114 and 115 to the Finished Goods Inventory. d. Cost of Job 114 in the Cost of Goods Sold account. e. Revenue from the sale of Job 114. f. Assignment of any underapplied or overapplied overhead to the Cost of Goods Sold account.

(The amount is not material.) 3. Prepare a manufacturing statement for September (use a single line presentation for direct materials

and show the details of overhead cost). 4. Compute gross profit for September. Show how to present the inventories on the September 30 balance

sheet.

Analysis Component

5. The over- or underapplied overhead adjustment is closed to Cost of Goods Sold. Discuss how this adjustment impacts business decision making regarding individual jobs or batches of jobs.

Job 114 Job 115 Job 116

Balances on August 31

Direct materials . . . . . . . . . . . . . . $ 14,000 $ 18,000

Direct labor . . . . . . . . . . . . . . . . . 18,000 16,000

Applied overhead . . . . . . . . . . . . . 9,000 8,000

Costs during September

Direct materials . . . . . . . . . . . . . . 100,000 170,000 $ 80,000

Direct labor . . . . . . . . . . . . . . . . . 30,000 68,000 120,000

Applied overhead . . . . . . . . . . . . . ? ? ?

Status on September 30 . . . . . . . . . Finished (sold) Finished (unsold) In process

Check (2f) $3,000 overapplied

(3) Cost of goods manufactured, $500,000

Problem 15-2B Source documents, journal entries, overhead, and financial reports

P1 P2 P3 P4

Swisher Company’s computer system generated the following trial balance on December 31, 2013. The company’s manager knows that the trial balance is wrong because it does not show any balance for Goods in Process Inventory but does show balances for the Factory Payroll and Factory Overhead accounts.

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,000

Accounts receivable . . . . . . . . . . . . . . . 42,000

Raw materials inventory . . . . . . . . . . . . 26,000

Goods in process inventory . . . . . . . . . 0

Finished goods inventory . . . . . . . . . . . 9,000

Prepaid rent . . . . . . . . . . . . . . . . . . . . . 3,000

Accounts payable . . . . . . . . . . . . . . . . . $ 10,500

Notes payable . . . . . . . . . . . . . . . . . . . . 13,500

Common stock . . . . . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . . . . . 87,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000

Cost of goods sold . . . . . . . . . . . . . . . . 105,000

Factory payroll . . . . . . . . . . . . . . . . . . . 16,000

Factory overhead . . . . . . . . . . . . . . . . . 27,000

Operating expenses . . . . . . . . . . . . . . . 45,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000 $321,000

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684 Chapter 15 Job Order Costing and Analysis

After examining various files, the manager identifies the following six source documents that need to be processed to bring the accounting records up to date.

Materials requisition 94-231: $4,600 direct materials to Job 603 Materials requisition 94-232: $7,600 direct materials to Job 604 Materials requisition 94-233: $2,100 indirect materials Labor time ticket 765: $5,000 direct labor to Job 603 Labor time ticket 766: $8,000 direct labor to Job 604 Labor time ticket 777: $3,000 indirect labor

Jobs 603 and 604 are the only units in process at year-end. The predetermined overhead rate is 200% of direct labor cost.

Required

1. Use information on the six source documents to prepare journal entries to assign the following costs. a. Direct materials costs to Goods in Process Inventory. b. Direct labor costs to Goods in Process Inventory. c. Overhead costs to Goods in Process Inventory. d. Indirect materials costs to the Factory Overhead account. e. Indirect labor costs to the Factory Overhead account. 2. Determine the revised balance of the Factory Overhead account after making the entries in part 1. Deter-

mine whether there is under- or overapplied overhead for the year. Prepare the adjusting entry to allocate any over- or underapplied overhead to Cost of Goods Sold, assuming the amount is not material.

3. Prepare a revised trial balance. 4. Prepare an income statement for year 2013 and a balance sheet as of December 31, 2013.

Analysis Component

5. Assume that the $2,100 indirect materials on materials requisition 94-233 should have been direct materials charged to Job 604. Without providing specific calculations, describe the impact of this error on the income statement for 2013 and the balance sheet at December 31, 2013.

Check (2) $6,100 underapplied overhead

(3) T. B. totals, $321,000

(4) Net income, $23,900

Job 487 . . . . . . . . . . . . . . . . . $ 8,000 Job 488 . . . . . . . . . . . . . . . . . 7,000 Job 489 . . . . . . . . . . . . . . . . . 25,000 Job 490 . . . . . . . . . . . . . . . . . 26,000 Job 491 . . . . . . . . . . . . . . . . . 2,000 Total direct labor . . . . . . . . . 68,000 Indirect labor . . . . . . . . . . . . 16,000 Total . . . . . . . . . . . . . . . . . . . $84,000

Problem 15-3B Source documents, journal entries, and accounts in job order cost accounting

P1 P2 P3

Prescott Company’s predetermined overhead rate is 200% of direct labor. Information on the company’s production activities during September 2013 follows. a. Purchased raw materials on credit, $125,000. b. Paid $84,000 cash for factory wages. c. Paid $11,000 cash for miscellaneous factory overhead costs. d. Materials requisitions record use of the following materials for the month.

Job 487 . . . . . . . . . . . . . . . . . . . . $30,000 Job 488 . . . . . . . . . . . . . . . . . . . . 20,000 Job 489 . . . . . . . . . . . . . . . . . . . . 12,000 Job 490 . . . . . . . . . . . . . . . . . . . . 14,000 Job 491 . . . . . . . . . . . . . . . . . . . . 4,000 Total direct materials . . . . . . . . . 80,000 Indirect materials . . . . . . . . . . . . 12,000 Total materials used . . . . . . . . . . $92,000

e. Time tickets record use of the following labor for the month.

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Chapter 15 Job Order Costing and Analysis 685

f. Allocated overhead to Jobs 487, 489, and 490. g. Transferred Jobs 487, 489, and 490 to Finished Goods. h. Sold Jobs 487 and 489 on credit for a total price of $340,000. i. The company incurred the following overhead costs during the month (credit Prepaid Insurance for

expired factory insurance).

Depreciation of factory building . . . . . . . . . . . $37,000

Depreciation of factory equipment . . . . . . . . 21,000

Expired factory insurance . . . . . . . . . . . . . . . . 7,000

Accrued property taxes payable . . . . . . . . . . . 31,000

Job No. __________

Materials . . . . . . . . . $

Labor . . . . . . . . . . . .

Overhead . . . . . . . .

Total cost . . . . . . . . $

j. Applied overhead at month-end to the Goods in Process (Jobs 488 and 491) using the predetermined overhead rate of 200% of direct labor cost.

Required

1. Prepare a job cost sheet for each job worked on in the month. Use the following simplified form.

2. Prepare journal entries to record the events and transactions a through j. 3. Set up T-accounts for each of the following general ledger accounts, each of which started the month

with a zero balance: Raw Materials Inventory, Goods in Process Inventory, Finished Goods Inventory, Factory Payroll, Factory Overhead, Cost of Goods Sold. Then post the journal entries to these T-accounts and determine the balance of each account.

4. Prepare a report showing the total cost of each job in process and prove that the sum of their costs equals the Goods in Process Inventory account balance. Prepare similar reports for Finished Goods Inventory and Cost of Goods Sold.

Check (2f) Cr. Factory Overhead, $118,000

(3) Finished goods inventory, $92,000 bal.

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,600

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Rent on factory building . . . . . . . . . . . . . . . . . . . . 70,000

Factory utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000

Factory insurance expired . . . . . . . . . . . . . . . . . . 34,000

Depreciation — Factory equipment . . . . . . . . . . . 240,000

Repairs expense — Factory equipment . . . . . . . . . 30,000

Factory supplies used . . . . . . . . . . . . . . . . . . . . . . 34,400

Miscellaneous production costs . . . . . . . . . . . . . . 18,000

Total estimated overhead costs . . . . . . . . . . . . . . $750,000

Problem 15-4B Overhead allocation and adjustment using a predetermined overhead rate

P3 P4

In December 2012, Pavelka Company’s manager estimated next year’s total direct labor cost assuming 50 persons working an average of 2,000 hours each at an average wage rate of $15 per hour. The man- ager also estimated the following manufacturing overhead costs for year 2013.

At the end of 2013, records show the company incurred $725,000 of actual overhead costs. It completed and sold five jobs with the following direct labor costs: Job 625, $354,000; Job 626, $330,000; Job 627, $175,000; Job 628, $420,000; and Job 629, $184,000. In addition, Job 630 is in process at the end of 2013 and had been charged $10,000 for direct labor. No jobs were in process at the end of 2012. The company’s predetermined overhead rate is based on direct labor cost.

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686 Chapter 15 Job Order Costing and Analysis

Required

1. Determine the following. a. Predetermined overhead rate for year 2013. b. Total overhead cost applied to each of the six jobs during year 2013. c. Over- or underapplied overhead at year-end 2013. 2. Assuming that any over- or underapplied overhead is not material, prepare the adjusting entry to

allocate any over- or underapplied overhead to Cost of Goods Sold at the end of year 2013.

Check (1c) $11,500 overapplied

(2) Dr. Factory Overhead, $11,500

Material M . . . . . . . . 120 units @ $200 5 $24,000

Material R . . . . . . . . 80 units @ 160 5 12,800

Paint . . . . . . . . . . . . . 44 units @ 72 5 3,168

Total cost . . . . . . . . . $39,968

Receiving Report No. 20, Material M, 150 units at $200 each.

Receiving Report No. 21, Material R, 70 units at $160 each.

Requisition No. 223, for Job 450, 80 units of Material M.

Requisition No. 224, for Job 450, 60 units of Material R.

Requisition No. 225, for Job 451, 40 units of Material M.

Requisition No. 226, for Job 451, 30 units of Material R.

Requisition No. 227, for 12 units of paint.

Time tickets Nos. 1 to 10 for direct labor on Job 450, $40,000.

Time tickets Nos. 11 to 20 for direct labor on Job 451, $32,000.

Time tickets Nos. 21 to 24 for equipment repairs, $12,000.

Problem 15-5B Production transactions, subsidiary records, and source documents

P1 P2 P3 P4

King Company produces variations of its product, a megatron, in response to custom orders from its cus- tomers. On June 1, the company had no inventories of goods in process or finished goods but held the following raw materials.

On June 3, the company began working on two megatrons: Job 450 for Encinita Company and Job 451 for Fargo, Inc.

Required

Using Exhibit 15.2 as a guide, prepare job cost sheets for jobs 20 and 21. Using Exhibit 15.4 as a guide, prepare materials ledger cards for Material M, Material R, and paint. Enter the beginning raw materials inventory dollar amounts for each of these materials on their respective ledger cards. Then, follow instruc- tions in this list of activities. a. Purchased raw materials on credit and recorded the following information from receiving reports and

invoices.

Instructions: Record these purchases with a single journal entry. Enter the receiving report information on the materials ledger cards.

b. Requisitioned the following raw materials for production.

Instructions: Enter amounts for direct materials requisitions on the materials ledger cards and the job cost sheets. Enter the indirect material amount on the materials ledger card. Do not record a journal entry at this time.

c. Received the following employee time tickets for work in June.

Instructions: Record direct labor from the time tickets on the job cost sheets. Do not record a journal entry at this time.

d. Paid cash for the following items during the month: factory payroll, $84,000, and miscellaneous over- head items, $36,800.

Instructions: Record these payments with journal entries.

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Chapter 15 Job Order Costing and Analysis 687

e. Finished Job 450 and transferred it to the warehouse. The company assigns overhead to each job with a predetermined overhead rate equal to 70% of direct labor cost.

Instructions: Enter the allocated overhead on the cost sheet for Job 450, fill in the cost summary sec- tion of the cost sheet, and then mark the cost sheet “Finished.” Prepare a journal entry to record the job’s completion and its transfer to Finished Goods.

f. Delivered Job 450 and accepted the customer’s promise to pay $290,000 within 30 days. Instructions: Prepare journal entries to record the sale of Job 450 and the cost of goods sold. g. Applied overhead cost to Job 451 based on the job’s direct labor used to date. Instructions: Enter overhead on the job cost sheet but do not make a journal entry at this time. h. Recorded the total direct and indirect materials costs as reported on all the requisitions for the month. Instructions: Prepare a journal entry to record these. i. Recorded the total direct and indirect labor costs as reported on all time tickets for the month. Instructions: Prepare a journal entry to record these costs. j. Recorded the total overhead costs applied to jobs. Instructions: Prepare a journal entry to record the allocation of these overhead costs. k. Compute the balance in the Factory Overhead account as of the end of June.

Check (h) Dr. Goods in Process Inventory, $38,400

Check Balance in Factory Overhead, $736 Cr., overapplied

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 15 The computer workstation furniture manufacturing that Adria Lopez started in January is pro- gressing well. As of the end of June, Success Systems’ job cost sheets show the following total costs accumulated on three furniture jobs.

SERIAL PROBLEM Success Systems

P1 P2 P3

Job 6.02 Job 6.03 Job 6.04

Direct materials . . . . . . . . . $1,500 $3,300 $2,700

Direct labor . . . . . . . . . . . . 800 1,420 2,100

Overhead . . . . . . . . . . . . . . 400 710 1,050

Job 6.02 was started in production in May, and these costs were assigned to it in May: direct materials, $600; direct labor, $180; and overhead, $90. Jobs 6.03 and 6.04 were started in June. Overhead cost is applied with a predetermined rate based on direct labor costs. Jobs 6.02 and 6.03 are finished in June, and Job 6.04 is expected to be finished in July. No raw materials are used indirectly in June. (Assume this company’s predetermined overhead rate did not change over these months).

Required

1. What is the cost of the raw materials used in June for each of the three jobs and in total? 2. How much total direct labor cost is incurred in June? 3. What predetermined overhead rate is used in June? 4. How much cost is transferred to finished goods inventory in June?

Check (1) Total materials, $6,900

(3) 50%

BTN 15-1 Polaris’ financial statements and notes in Appendix A provide evidence of growth potential in its sales.

Required

1. Identify at least two types of costs that will predictably increase as a percent of sales with growth in sales.

2. Explain why you believe the types of costs identified for part 1 will increase, and describe how you might assess Polaris’ success with these costs. (Hint: You might consider the gross margin ratio.)

Beyond the Numbers

REPORTING IN ACTION C1

Polaris

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688 Chapter 15 Job Order Costing and Analysis

Fast Forward

3. Access Polaris’ annual report for a fiscal year ending after December 31, 2011, from its Website [Polaris.com] or the SEC’s EDGAR database [www.sec.gov ]. Review and report its growth in sales along with its cost and income levels (including its gross margin ratio).

BTN 15-3 An accounting professional requires at least two skill sets. The first is to be technically com- petent. Knowing how to capture, manage, and report information is a necessary skill. Second, the ability to assess manager and employee actions and biases for accounting analysis is another skill. For instance, knowing how a person is compensated helps anticipate information biases. Draw on these skills and write a one-half page memo to the financial officer on the following practice of allocating overhead.

Background: Assume that your company sells portable housing to both general contractors and the government. It sells jobs to contractors on a bid basis. A contractor asks for three bids from different manufac- turers. The combination of low bid and high quality wins the job. However, jobs sold to the government are bid on a cost-plus basis. This means price is determined by adding all costs plus a profit based on cost at a specified percent, such as 10%. You observe that the amount of overhead allocated to government jobs is higher than that allocated to contract jobs. These allocations concern you and motivate your memo.

ETHICS CHALLENGE P3

Point: Students could compare responses and discuss differences in concerns with allocating overhead.

BTN 15-4 Assume that you are preparing for a second interview with a manufacturing company. The company is impressed with your credentials but has indicated that it has several qualified applicants. You anticipate that in this second interview, you must show what you offer over other candidates. You learn the company currently uses a periodic inventory system and is not satisfied with the timeliness of its informa- tion and its inventory management. The company manufactures custom-order holiday decorations and dis- play items. To show your abilities, you plan to recommend that it use a cost accounting system.

Required

In preparation for the interview, prepare notes outlining the following: 1. Your cost accounting system recommendation and why it is suitable for this company. 2. A general description of the documents that the proposed cost accounting system requires. 3. How the documents in part 2 facilitate the operation of the cost accounting system.

COMMUNICATING IN PRACTICE C1 C2

Point: Have students present a mock interview, one assuming the role of the president of the company and the other the applicant.

BTN 15-5 Many contractors work on custom jobs that require a job order costing system.

Required

Access the Website AMSI.com and click on Construction Management Software, and then on starbuilder. Prepare a one-page memorandum for the CEO of a construction company provid ing information about the job order costing software this company offers. Would you recommend that the company purchase this software?

TAKING IT TO THE NET C1

BTN 15-2 Manufacturers and merchandisers can apply just-in-time (JIT) to their inventory management. Both Polaris and Arctic Cat want to know the impact of a JIT inventory system for their operating cash flows. Review each company’s statement of cash flows in Appendix A to answer the following.

Required

1. Identify the impact on operating cash flows (increase or decrease) for changes in inventory levels (increase or decrease) for both companies for each of the three most recent years.

2. What impact would a JIT inventory system have on both Polaris’ and Arctic Cat’s operating income? Link the answer to your response for part 1.

3. Would the move to a JIT system have a one-time or recurring impact on operating cash flow?

COMPARATIVE ANALYSIS C1

Polaris Arctic Cat

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BTN 15-6 Consider the activities undertaken by a medical clinic in your area.

Required

1. Do you consider a job order cost accounting system appropriate for the clinic? 2. Identify as many factors as possible to lead you to conclude that it uses a job order system.

TEAMWORK IN ACTION C1

BTN 15-7 Refer to the chapter opener regarding David Schottenstein and his company, Astor and Black. All successful businesses track their costs, and it is especially important for start-up businesses to monitor and control costs.

Required

1. Assume that Astor and Black uses a job order costing system. For the basic cost category of direct materials, explain how a job cost sheet for Astor and Black would differ from a job cost sheet for a service company.

2. For the basic cost categories of direct labor and overhead, provide examples of the types of costs that would fall into each category for Astor and Black.

ENTREPRENEURIAL DECISION C1 C2

BTN 15-8 Job order cost accounting is frequently used by home builders.

Required

1. You (or your team) are to prepare a job cost sheet for a single-family home under construction. List four items of both direct materials and direct labor. Explain how you think overhead should be applied.

2. Contact a builder and compare your job cost sheet to this builder’s job cost sheet. If possible, speak to that company’s accountant. Write your findings in a short report.

HITTING THE ROAD C2 P1 P2 P3

BTN 15-9 KTM and Piaggio are competitors in the global marketplace. KTM’s and Piaggio’s financial statements are in Appendix A.

Required

1. Determine the change in KTM’s and Piaggio’s inventories for the most recent year reported. Then identify the impact on net resources generated by operating activities (increase or decrease) for the change in inventory level (increase or decrease) for KTM and Piaggio for that same year.

2. How would the move to a just-in-time (JIT) system likely impact future operating cash flows and op- erating income?

3. Would a move to a JIT system likely impact KTM more than it would Piaggio? Explain.

GLOBAL DECISION C1

1. c; $30,000 3 150% 5 $45,000 2. b; $38,500y$35,000 5 110% 3. e; Direct materials 1 Direct labor 1 Overhead 5 Total cost; Direct materials 1 ($4,000y.80) 1 $4,000 5 $10,000 Direct materials 5 $1,000

4. e; $9,000 1 $94,200 1 $59,200 1 $31,600 2 Finished goods 5 $17,800 Thus, finished goods 5 $176,200 5. b

ANSWERS TO MULTIPLE CHOICE QUIZ

PIAGGIO KTM

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Learning Objectives

CONCEPTUAL

C1 Explain process operations and the way they differ from job order operations. (p. 692)

C2 Define and compute equivalent units and explain their use in process cost accounting. (p. 699)

C3 Describe accounting for production activity and preparation of a process cost summary using weighted average. (p. 700)

C4 Appendix 16A—Describe accounting for production activity and preparation of a process cost summary using FIFO. (p. 711)

ANALYTICAL

A1 Compare process cost accounting and job order cost accounting. (p. 695) A2 Explain and illustrate a hybrid costing system. (p. 707)

PROCEDURAL

P1 Record the flow of direct materials costs in process cost accounting. (p. 696) P2 Record the flow of direct labor costs in process cost accounting. (p. 697) P3 Record the flow of factory overhead costs in process cost accounting. (p. 697) P4 Record the transfer of completed goods to Finished Goods Inventory and Cost of

Goods Sold. (p. 705)

A Look at This Chapter

This chapter focuses on how to measure and account for costs in process operations. We explain process production, describe how to assign costs to processes, and compute cost per equivalent unit for a process.

A Look Back

Chapter 14 introduced managerial accounting and described cost concepts and the reporting of manufacturing activities. Chapter 15 explained job order costing—an important cost accounting system for customized products and services.

Process Costing and Analysis 16

A Look Ahead

Chapter 17 introduces the activity-based costing (ABC) system, which provides managers with strategic cost information that is not readily available from other costing methods.

690

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Sweet Success

SAN FRANCISCO—After returning from a stint in the Peace Corps, Neal Gottlieb wanted to start the “most Earth-friendly busi- ness I could think of.” Using the $70,000 he saved from delivering newspapers and other boyhood jobs, Neal started Three Twins Ice Cream (ThreeTwinsIceCream.com), a manufacturer and seller of organic ice cream. Business started slowly, with Neal as the lone employee in a single ice cream shop. “I made ice cream in the morning, ran the shop all day, then cleaned up and did pa- perwork at night,” recalls Neal. Working 166 straight days without a day off and recording gross sales of $49 on one cold, rainy Monday, Neal decided he had to expand into the wholesale ice cream business or aban- don his dreams. Neal’s gamble paid off—today Three Twins Ice Cream is certified organic in more ice cream flavors than any ice cream company in the world, and as Neal says, “I’m happy to say I don’t mop floors anymore.” In addition to using only organic ingredients, Neal strives to make his entire operation Earth-friendly. “Everything we give the customer can be composted,” explains Neal. Cups and spoons are made from pressed sugar cane, potatoes, and corn starch. His production strategy adds overhead costs; for exam- ple, spoons cost 4 cents each instead of 1 cent each for plastic spoons. Neal explains that “using organic ingredients isn’t the cheapest option, but it’s the best.” With costly raw materials and overhead costs, Neal must be adept at interpreting product cost reports. Without good cost and production process controls, his income would quickly melt away.

With costly raw materials and overhead costs, Neal relies on process cost summary reports to enable him to monitor and control costs of materials, labor, and overhead in his production processes. Accurate costing is especially useful in companies like Neal’s, where different products require different processes and costs. Traditional flavors like vanilla, chocolate, and straw- berry can be made in large quantities in large production runs, while treats like Peanut Butter Confetti Crunch and The Choco- late Project are made in small quantities. Neal’s recipe is working. Three Twins recently built a 4,200 square foot manufacturing facility to expand its business and reduce costs. Neal’s factory allows him to produce larger quantities of ice cream at lower cost because he now makes his own mix. “We used to pay $15 per gallon for our mix; we can now make mix for less than $7 per gallon,” explains Neal. Neal responded to these cost savings by lowering his selling prices and saw demand for his products grow. From humble beginnings, Three Twins’ sales are growing at almost 100 percent per year. “We want to be a national brand,” says Neal. “We believe we have the potential to find a huge mar- ket.“ Still, Neal advises would-be entrepreneurs to “enjoy what they do, work hard, and give back.”

[Sources: Three Twins Ice Cream Company Website, January 2013; Marin Independent Journal, July 2010; sf.eater.com, April 2010; North Bay Business Journal, April 2010; Napa Valley Register, April 2007]

“Anyone can do it!” —NEAL GOTTLIEB

Decision Insight

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Chapter Preview

The type of product or service a company offers determines its cost accounting system. Job order costing is used to account for custom products and services that meet the demands of a par- ticular customer. Not all products are manufactured in this way; many carry standard designs so that one unit is no different than any other unit. Such a system often produces large numbers of units on a continuous basis, all of which pass through similar

processes. This chapter describes how to use a process cost ac- counting system to account for these types of products. It also explains how costs are accumulated for each process and then assigned to units passing through those processes. This information helps us understand and estimate the cost of each process as well as find ways to reduce costs and improve processes.

Process operations, also called process manufacturing or process production, is the mass pro- duction of products in a continuous flow of steps. This means that products pass through a series of sequential processes. Petroleum refining is a common example of process operations. Crude oil passes through a series of steps before it is processed into different grades of petroleum. Exxon Mobil’s oil activities reflect a process operation. An important characteristic of process operations is the high level of standardization necessary if the system is to produce large vol- umes of products. Process operations also extend to services. Examples include mail sorting in large post offices and order processing in large mail-order firms such as L.L. Bean. The com- mon feature in these service organizations is that operations are performed in a sequential man- ner using a series of standardized processes. Other companies using process operations include:

PROCESS OPERATIONS

C1 Explain process operations and the way they differ from job order operations.

Process Cost Accounting

• Job order versus process cost systems

• Direct and indirect costs

• Accounting for materials costs

• Accounting for labor costs

• Accounting for factory overhead

Process Operations

• Comparing job order and process operations

• Organization of process operations

• GenX Company—an illustration

Equivalent Units of Production (EUP)

• Accounting for goods in process

• Differences between EUP for materials, labor, and overhead

Process Costing Illustration

• Physical flow of units • EUP • Cost per EUP • Cost reconciliation • Process cost summary • Transfers to finished

goods and to cost of goods sold

• Trends in process operations

Company* Product or Service Company Product or Service

Kellogg . . . . . . . . . . . . . . . . . . Cereals Heinz . . . . . . . . . . . Ketchup

Pfizer. . . . . . . . . . . . . . . . . . . . Pharmaceuticals Penn . . . . . . . . . . . . Tennis balls

Proctor & Gamble . . . . . . . . . Household products Hershey . . . . . . . . . Chocolate

Coca-Cola . . . . . . . . . . . . . . . Soft drinks Jiffy Lube . . . . . . . . Oil changes

* For virtual tours of process operations visit PennRacquet.com/factory.html (tennis balls) and Hersheys.com/ads-and-videos/ how-we-make-chocolate.aspx (chocolate).

Each of these examples of products and services involves operations having a series of pro- cesses, or steps. Each process involves a different set of activities. A production operation that processes chemicals, for instance, might include the four steps shown in Exhibit 16.1. Under- standing such processes for companies with process operations is crucial for measuring their costs. Increasingly, process operations use machines and automation to control product quality and reduce manufacturing costs.692

Process Costing and Analysis

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Chapter 16 Process Costing and Analysis 693

Organization of Process Operations In a process operation, each process is identified as a separate production department, worksta- tion, or work center. With the exception of the first process or department, each receives the output from the prior department as a partially processed product. Depending on the nature of the process, a company applies direct labor, overhead, and, perhaps, additional direct materials to move the product toward completion. Only the final process or department in the series pro- duces finished goods ready for sale to customers. Tracking costs for several related departments can seem complex. Yet because process cost- ing procedures are applied to the activity of each department or process separately, we need to consider only one process at a time. This simplifies the procedures. When the output of one department becomes an input to another department, as is the case in sequential processing, we simply transfer the costs associated with those units from the first department into the next. We repeat these steps from department to department until the final process is complete. At that point the accumulated costs are transferred with the product from Goods in Process Inventory to Finished Goods Inventory. The next section illustrates a company with a single process, but the methods illustrated apply to a multiprocess scenario as each de- partment’s costs are handled separately for each department.

Comparing Job Order and Process Operations Job order and process operations can be considered as two ends of a continuum. Important features of both systems are shown in Exhibit 16.2. We often describe job order and process operations with manufacturing examples, but both also apply to service companies. In a job order costing system, the measurement focus is on the individual job or batch. In a process costing system, the measurement focus is on the process itself and the standardized units produced.

Bottling the chemical mix

Packaging the bottles

Mixing the chemicals

Preparing the chemicals

EXHIBIT 16.1 Process Operations: Chemicals

EXHIBIT 16.2 Comparing Job Order and Process Operations

Job Order Operations Process Operations

• Custom orders • Repetitive procedures

• Heterogeneous products • Homogeneous products and services and services

• Low production volume • High production volume

• High product flexibility • Low product flexibility

• Low to medium • High standardization standardization

GenX Company—An Illustration The GenX Company illustrates process operations. It produces Profen®, an over-the-counter pain reliever for athletes. GenX sells Profen to wholesale distributors, who in turn sell it to

Processing Health Many service companies use process departments to perform specific tasks for consumers. Hospitals, for instance, have radiology and physical therapy facilities with special equipment and trained employees. When patients need services, they are processed through departments to receive prescribed care. Service companies need process cost accounting information as much as manufacturers to estimate costs of services, to plan future operations, to control costs, and to determine customer charges. ■

Decision Insight

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694 Chapter 16 Process Costing and Analysis

Production support offices– used by administrative and

maintenance employees who support manufacturing

operations.

Locker rooms–workers change from street

clothes into sanitized uniforms before working

in the factory.

Loading dock (outgoing products)

Front entrance

Employees’ entrance

Loading dock (incoming materials)

Storeroom–materials are received and then

distributed when requisitioned.

Production floor–area where the powder is

processed into tablets.

Warehouse–finished products are stored

before being shipped to wholesalers.

EXHIBIT 16.3 Floor Plan of GenX’s Factory

Point: Electronic monitoring of operations is common in factories.

retailers. Profen is produced by mixing its active ingredient, Profelene, with flavorings and pre- servatives, molding it into Profen tablets, and packaging the tablets. Exhibit 16.3 shows a sum- mary floor plan of the GenX factory, which has five areas. The first step in process manufacturing is to decide when to produce a product. Management determines the types and quantities of materials and labor needed and then schedules the work. Unlike a job order process, where production often begins only after receipt of a custom order, managers of companies with process operations often forecast the demand expected for their products. Based on these plans, production begins. The flowchart in Exhibit 16.4 shows the production steps for GenX. The following sections explain how GenX uses a process cost ac- counting system to compute these costs. Many of the explanations refer to this exhibit and its numbered cost flows 1 through 10 . (Hint: The amounts for the numbered cost flows in Exhibit 16.4 are summarized in Exhibit 16.21. Those amounts are explained in the following pages, but it can help to refer to Exhibit 16.21 as we proceed through the explanations.)

Factory overhead

Goods in

process

Finished goods

Goods sold

Raw materials inventory

Factory payroll

Packaged Profen

Sold Profen

10

In d

ir e c t

la b

o r

In d

ir e c t

m a te

ri a ls

Raw materials

Direct materials

Other overhead

Labor

Direct labor

1 2

3

4

7

6

5

8

Applied overhead

9

EXHIBIT 16.4 Process Operations and Costs: GenX

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Comparing Job Order and Process Cost Accounting Systems Process and job order operations are similar in that both combine materials, labor, and overhead in the process of producing products. They differ in how they are organized and managed. The measurement focus in a job order costing system is on the individual job or batch, whereas in a process costing system, it is on the individual process. Regardless of the measurement focus, we are ultimately interested in determining the cost per unit of product (or service) resulting from either system. Both job order cost accounting systems and process cost accounting systems track direct materials, direct labor, and overhead costs. However, these two accounting systems differ in terms of measuring unit costs. A job order system measures cost per unit upon completion of a job, by dividing the total cost for that job by the number of units in that job. A process costing system measures unit costs at the end of a period (for example, a month) by dividing the total costs for that process by the number of units passing through that process to determine the cost per equivalent unit (defined later in the chapter). Dif ferences in the way these two systems apply materials, labor, and overhead costs are highlighted in Exhibit 16.5.

PROCESS COST ACCOUNTING

Point: The cost object in a job order system is the specific job; the cost object in a process costing system is the process.

Direct and Indirect Costs Like job order operations, process cost accounting systems use the concepts of direct and indi- rect costs. If a cost can be traced to the cost object, it is direct; if it cannot, it is indirect. Materi- als and labor that can be traced to specific processes are assigned to those processes as direct costs. Materials and labor that cannot be traced to a specific process are indirect costs and are assigned to overhead. Some costs classified as overhead in a job order system may be classified as direct costs in process cost accounting. For example, depreciation of a machine used entirely by one process is a direct cost of that process.

EXHIBIT 16.5 Comparing Job Order and Process Cost Accounting Systems

Job order systems

Process systems

Finished goods

Direct materials

Direct labor

Overhead

Job 1

Job 2

Finished goods

Direct materials

Direct labor

Overhead

Process 1

Process 2

Cost of goods sold

Cost of goods sold

A1 Compare process cost accounting and job order cost accounting.

JIT Boon to Process Operations Companies that adopt JIT manufacturing often organize their pro- duction system as a series of sequential processes. One survey found 60% of companies that converted to JIT used process operations; this compares to only 20% before converting to JIT. ■

Decision Insight

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696 Chapter 16 Process Costing and Analysis

Accounting for Materials Costs In Exhibit 16.4, arrow line 1 reflects the arrival of materials at GenX’s factory. These materials include Profelene, flavorings, preservatives, and packaging. They also include supplies for the production support office. GenX uses a perpetual inventory system and makes all purchases on credit. The summary entry for receipts of raw materials in April follows (dates in journal entries numbered 1 through 10 are omitted because they are summary entries, often reflecting two or more transactions or events).

Assets 5 Liabilities 1 Equity 111,095 111,095

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 11,095

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,095

Acquired materials on credit for factory use.

1

Arrow line 2 in Exhibit 16.4 reflects the flow of direct materials to production, where they are used to produce Profen. Most direct materials are physically combined into the finished product; the remaining direct materials include those used and clearly linked with a specific process. The manager of a process usually obtains materials by submitting a materials requisi- tion to the materials storeroom manager. In some situations, materials move continuously from raw materials inventory through the manufacturing process. Pepsi Bottling, for instance, uses a process in which inventory moves con tin uously through the system. In these cases, a materials consumption report summa rizes the materials used by a department during a reporting period and replaces materials requisitions. The entry to record the use of direct materials by GenX’s production department in April follows.

Assets 5 Liabilities 1 Equity 19,900 29,900

Goods in Process Inventory . . . . . . . . . . . . . . . . . . . . . . 9,900

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . 9,900

To assign costs of direct materials used in production.

2

This entry transfers costs from one asset account to another asset account. (When two or more production departments exist, a company uses two or more Goods in Process Inventory accounts to separately accumulate costs incurred by each.) In Exhibit 16.4, the arrow line 3 reflects the flow of indirect materials from the storeroom to factory overhead. These materials are not clearly linked with any specific production process or department but are used to support overall production activity. The following entry records the cost of indirect materials used by GenX in April.

Example: What types of materials might the flow of arrow line ③ in Exhibit 16.4 reflect? Answer: Goggles, gloves, protective clothing, recordkeeping supplies, and cleaning supplies.

Assets 5 Liabilities 1 Equity 21,195 21,195

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,195

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . 1,195

To record indirect materials used in April.

3

After the entries for both direct and indirect materials are posted, the Raw Materials Inventory account appears as shown in Exhibit 16.6. The April 30 balance sheet reports the $4,000 Raw Materials Inventory account as a current asset.

EXHIBIT 16.6 Raw Materials Inventory

Raw Materials Inventory Acct. No. 132

Date Explanation Debit Credit Balance

Mar. 31 Balance 4,000

Apr. 30 Materials purchases 11,095 15,095

30 Direct materials usage 9,900 5,195

30 Indirect materials usage 1,195 4,000

P1 Record the flow of direct materials costs in process cost accounting.

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Time reports from the production department and the production support office triggered this entry. (For simplicity, we do not separately identify withholdings and additional payroll taxes for employ ees.) In a process operation, the direct labor of a production department includes all labor used exclusively by that department. This is the case even if the labor is not applied to the product itself. If a production department in a process operation, for instance, has a full-time manager and a full-time maintenance worker, their salaries are direct labor costs of that process and are not factory overhead. Arrow line 5 in Exhibit 16.4 shows GenX’s use of direct labor in the production depart- ment. The following entry transfers April’s direct labor costs from the Factory Payroll account to the Goods in Process Inventory account.

Accounting for Labor Costs Exhibit 16.4 shows GenX factory payroll costs as reflected in arrow line 4 . Total labor costs of $8,920 are paid in cash and are recorded in the Factory Payroll account.

Assets 5 Liabilities 1 Equity 28,920 28,920

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,920

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,920

To record factory wages for April.

4

Assets 5 Liabilities 1 Equity 15,700 15,700

Goods in Process Inventory . . . . . . . . . . . . . . . . . . . . . . 5,700

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,700

To assign costs of direct labor used in production.

5

Arrow line 6 in Exhibit 16.4 reflects GenX’s indirect labor costs. These employees provide clerical, maintenance, and other services that help produce Profen efficiently. For example, they order materials, deliver them to the factory floor, repair equipment, operate and program computers used in production, keep payroll and other production records, clean up, and move the finished goods to the warehouse. The following entry charges these indirect labor costs to factory overhead.

Assets 5 Liabilities 1 Equity 23,220 13,220

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,220

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,220

To record indirect labor as overhead.

6

After these entries for both direct and indirect labor are posted, the Factory Payroll account ap- pears as shown in Exhibit 16.7. The temporary Factory Payroll account is now closed to another temporary account, Factory Overhead, and is ready to receive entries for May. Next we show how to apply overhead to production and close the temporary Factory Overhead account.

Accounting for Factory Overhead Overhead costs other than indirect materials and indirect labor are reflected by arrow line 7 in Exhibit 16.4. These overhead items include the costs of insuring production assets, renting the factory building, using factory utilities, and depreciating equipment not directly related to a specific process. The following entry records overhead costs for April.

Point: A department’s indirect labor cost might include an allocated portion of the salary of a manager who super- vises two or more departments. Alloca- tion of costs between departments is discussed in a later chapter.

P2 Record the flow of direct labor costs in process cost accounting.

P3 Record the flow of factory overhead costs in process cost accounting.

EXHIBIT 16.7 Factory Payroll

Factory Payroll Acct. No. 530

Date Explanation Debit Credit Balance

Mar. 31 Balance 0

Apr. 30 Total payroll for April 8,920 8,920

30 Direct labor costs 5,700 3,220

30 Indirect labor costs 3,220 0

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698 Chapter 16 Process Costing and Analysis

After this entry is posted, the Factory Overhead account balance is $6,840, comprising indirect materials of $1,195, indirect labor of $3,220, and $2,425 of other overhead. Arrow line 8 in Exhibit 16.4 reflects the application of factory overhead to production. Fac- tory overhead is applied to processes by relating overhead cost to another variable such as direct labor hours or machine hours used. With increasing automation, companies with process opera- tions are more likely to use machine hours to allocate overhead. In some situations, a single alloca- tion basis such as direct labor hours (or a single rate for the entire plant) fails to provide useful allocations. As a result, management can use different rates for different production departments. Based on an analysis of its operations, GenX applies its April overhead at a rate of 120% of di- rect labor cost, as shown in Exhibit 16.8.

Point: The time it takes to process (cycle) products through a process is sometimes used to allocate costs.

EXHIBIT 16.8 Applying Factory Overhead (Production Department)

Overhead applied 5 Direct labor cost 3 Predetermined rate $6,840 5 $5,700 3 120%

GenX records its applied overhead with the following entry.

Assets 5 Liabilities 1 Equity 16,840 16,840

Goods in Process Inventory . . . . . . . . . . . . . . . . . . . . . . 6,840

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 6,840

Allocated overhead costs to production at 120% of direct labor cost.

8

After posting this entry, the Factory Overhead account appears as shown in Exhibit 16.9. For GenX, the amount of overhead applied equals the actual overhead incurred during April. In most cases, using a predetermined overhead rate leaves an overapplied or underapplied balance in the Factory Overhead account. At the end of the period, this overapplied or underapplied bal- ance should be closed to the Cost of Goods Sold account, as described in the job order costing chapter.

EXHIBIT 16.9 Factory Overhead

Factory Overhead Acct. No. 540

Date Explanation Debit Credit Balance

Mar. 31 Balance 0

Apr. 30 Indirect materials usage 1,195 1,195

30 Indirect labor costs 3,220 4,415

30 Other overhead costs 2,425 6,840

30 Applied to production departments 6,840 0

Example: If applied overhead results in a $6,940 credit to the factory over- head account, does it yield an over- or underapplied overhead amount? Answer: $100 overapplied overhead

Assets 5 Liabilities 1 Equity 2180 1645 22,425 2750 2850

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,425

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 180

Utilities Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750

Accumulated Depreciation—Factory Equipment . . . 850

To record overhead items incurred in April.

7

Budget Officer You are working to identify the direct and indirect costs of a new processing department that has several machines. This department’s manager instructs you to classify a majority of the costs as indirect to take advantage of the direct labor-based overhead allocation method so it will be charged a lower amount of overhead (because of its small direct labor cost). This would penalize other departments with higher allocations. It also will cause the performance ratings of managers in these other departments to suffer. What action do you take? ■ [Answer—p. 716]

Decision Ethics

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If a process has a beginning or ending inventory of partially processed units (or both), then the total cost assigned to the process must be allocated to all completed and incomplete units worked on during the period. Therefore, the denominator must measure the entire production activity of the process for the period, called equivalent units of production (or EUP), a phrase that refers to the number of units that could have been started and completed given the cost in- curred during a period. This measure is then used to compute the cost per equivalent unit and to assign costs to finished goods and goods in process inventory. To illustrate, assume that GenX adds (or introduces) 100 units into its process during a period. Suppose at the end of that period, the production supervisor determines that those 100 units are 60% of the way through the process. Therefore, equivalent units of production for that period total 60 EUP (100 units 3 60%). This means that with the resources used to put 100 units 60% of the way through the process, GenX could have started and completed 60 whole units.

Differences in Equivalent Units for Materials, Labor, and Overhead In many processes, the equivalent units of production for direct materials are not the same with respect to direct labor and overhead. To illustrate, consider a five-step process operation shown in Exhibit 16.10.

Total cost assigned to the process (direct materials, direct labor, and overhead)

Total number of units started and finished in the period

Point: For GenX, “units” might refer to individual Profen tablets. For a juice maker, units might refer to gallons.

1. A process operation (a) is another name for a job order operation, (b) does not use the concepts of direct materials or direct labor, or (c) typically produces large quantities of homogeneous products or services.

2. Under what conditions is a process cost accounting system more suitable for measuring production costs than a job order cost accounting system?

3. When direct materials are assigned and used in production, the entry to record their use includes (a) a credit to Goods in Process Inventory, (b) a debit to Goods in Process Inventory, or (c) a debit to Raw Materials Inventory.

4. What are the three cost categories incurred by both job order and process operations? 5. How many Goods in Process Inventory accounts are needed in a process cost system?

Quick Check Answers — p. 716

We explained how materials, labor, and overhead costs for a period are accumulated in the Goods in Process Inventory account, but we have not explained the arrow lines labeled 9 and 10 in Exhibit 16.4. These lines reflect the transfer of products from the production department to fin- ished goods inventory, and from finished goods inventory to cost of goods sold. To determine the costs recorded for these flows, we must first determine the cost per unit of product and then apply this result to the number of units transferred.

Accounting for Goods in Process If a process has no beginning and no ending goods in process inventory, the unit cost of goods transferred out of a process is computed as follows:

EQUIVALENT UNITS OF PRODUCTION

C2 Define and compute equivalent units and explain their use in process cost accounting.

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This exhibit shows that one-third of the direct material cost is added at each of three steps: 1, 2, and 4. One-fifth of the direct labor cost is added at each of the five steps. One-fifth of the over- head also is added at each step because overhead is applied as a percent of direct labor for this company. When units finish step 1, they are one-third complete with respect to direct materials but only one-fifth complete with respect to direct labor and overhead. When they finish step 2, they are two-thirds complete with respect to direct materials but only two-fifths complete with respect to direct labor and overhead. When they finish step 3, they remain two-thirds complete with respect to ma terials but are now three-fifths complete with respect to labor and overhead. When they finish step 4, they are 100% complete with respect to materials (all direct materials have been added) but only four-fifths complete with respect to labor and overhead.

For example, if 300 units of product are started and processed through step 1 of Exhibit 16.10, they are said to be one-third complete with respect to materials. Expressed in terms of equiv- alent finished units, the processing of these 300 units is equal to finishing 100 EUP with re- spect to materials (300 units 3 331⁄3%). However, only one-fifth of direct labor and overhead has been applied to the 300 units at the end of step 1. This means that the equivalent units of production with respect to labor and overhead total 60 EUP (300 units 3 20%).

EXHIBIT 16.10 An Illustrative Five-Step Process Operation

Step 1 Step 2 Step 3 Step 4 Step 5

331/3% of materials

331/3% of materials

20% of labor and overhead

20% of labor and overhead

20% of labor and overhead

20% of labor and overhead

20% of labor and overhead

331/3% of materials

=100% at end of process

=100% at end of process

This section applies process costing concepts and procedures to GenX. This illustration uses the weighted-average method for inventory costs. The FIFO method is illustrated in Appendix 16A. (Assume a weighted-average cost flow for all computations and assign- ments in this chapter unless explicitly stated differently. When using a just-in-time inven- tory  system, different inventory methods yield similar results because inventories are immaterial.) Exhibit 16.11 shows selected information from the production department for the month of April. Accounting for a department’s activity for a period includes four steps involving analy- sis of (1) physical flow, (2) equivalent units, (3) cost per equivalent unit, and (4) cost assign- ment and reconciliation. The next sections describe each step.

PROCESS COSTING ILLUSTRATION

Process Services Customer interaction software is a hot item in customer service processes. Whether in insurance, delivery, or technology services, companies are finding that this software can turn their customer service process into an asset. How does it work? For starters, it cuts time spent on service calls because a customer describes a problem only once. It also yields a database of customer questions and complaints that gives insights into needed improvements. It recognizes incoming phone numbers and accesses previous interactions. ■

Decision Insight

C3 Describe accounting for production activity and preparation of a process cost summary using weighted average.

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Chapter 16 Process Costing and Analysis 701

EXHIBIT 16.11 Production Data

Beginning goods in process inventory (March 31)

Units of product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 units

Percentage of completion—Direct materials . . . . . . . . . . . . . . . . . . 100%

Percentage of completion—Direct labor . . . . . . . . . . . . . . . . . . . . 65%

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,300

Direct labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 600

Factory overhead costs applied (120% of direct labor) . . . . . . . . . $ 720

Activities during the current period (April)

Units started this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 units

Units transferred out (completed) . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,900

Direct labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,700

Factory overhead costs applied (120% of direct labor) . . . . . . . . . $ 6,840

Ending goods in process inventory (April 30)

Units of product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

Percentage of completion—Direct materials . . . . . . . . . . . . . . . . . 100%

Percentage of completion—Direct labor . . . . . . . . . . . . . . . . . . . . . 25%

EXHIBIT 16.12 Physical Flow Reconciliation

Units to Account For Units Accounted For

Beginning goods in Units completed and process inventory . . . . . . . . 30,000 units transferred out . . . . . . . . . . . . . . . . . . 100,000 units

Units started this period . . . . . 90,000 units Ending goods in process inventory. . . . . 20,000 units

Total units to account for . . . . 120,000 units Total units accounted for . . . . . . . . . . . . 120,000 units

reconciled

EXHIBIT 16.13 Equivalent Units of Production— Weighted Average

Direct Direct Factory

Equivalent Units of Production Materials Labor Overhead

Equivalent units completed and transferred out (100,000 3 100%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 EUP 100,000 EUP 100,000 EUP

Equivalent units for ending goods in process

Direct materials (20,000 3 100%) . . . . . . . . . . . . . . . . . . 20,000

Direct labor (20,000 3 25%) . . . . . . . . . . . . . . . . . . . . . 5,000

Factory overhead (20,000 3 25%) . . . . . . . . . . . . . . . . . 5,000

Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . 120,000 EUP 105,000 EUP 105,000 EUP

Step 1: Determine the Physical Flow of Units A physical flow reconciliation is a report that reconciles (1) the physical units started in a period with (2) the physical units completed in that period. A physical flow reconciliation for GenX is shown in Exhibit 16.12 for April.

The weighted-average method does not require us to separately track the units in beginning work in process from those units started this period. Instead, the units are treated as part of a large pool with an average cost per unit.

Step 2: Compute Equivalent Units of Production The second step is to compute equivalent units of production for direct materials, direct labor, and factory overhead for April. Overhead is applied using direct labor as the allocation base for GenX. This also implies that equivalent units are the same for both labor and overhead. GenX used its direct materials, direct labor, and overhead to make finished units of Profen and to begin processing some units that are not yet complete. We must convert the physical units measure to equivalent units based on how each input has been used. Equivalent units are com- puted by multiplying the number of physical units by the percentage of completion for each input—see Exhibit 16.13.

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702 Chapter 16 Process Costing and Analysis

The first row of Exhibit 16.13 reflects units transferred out in April. The production de- partment entirely completed its work on the 100,000 units transferred out. These units have 100% of the materials, labor, and overhead required, or 100,000 equivalent units of each input (100,000 3 100%). The second row references the ending goods in process, and rows three, four, and five break it down by materials, labor, and overhead. For direct materials, the units in ending goods in process inventory (20,000 physical units) include all materials required, so there are 20,000 equivalent units (20,000 3 100%) of materials in the unfinished physical units. Regarding labor, the units in ending goods in process inventory include 25% of the labor required, which implies 5,000 equivalent units of labor (20,000 3 25%). These units are only 25% complete and labor is used uniformly through the process. Overhead is applied on the basis of direct labor for GenX, so equivalent units for overhead are computed identically to labor (20,000 3 25%). The final row reflects the whole units of product that could have been manufactured with the amount of inputs used to create some complete and some incomplete units. For GenX, the amount of inputs used to produce 100,000 complete units and to start 20,000 additional units is equivalent to the amount of direct materials in 120,000 whole units, the amount of direct labor in 105,000 whole units, and the amount of overhead in 105,000 whole units.

Step 3: Compute the Cost per Equivalent Unit Equivalent units of production for each product (from step 2) is used to compute the average cost per equivalent unit. Under the weighted-average method, the computation of EUP does not separate the units in beginning inventory from those started this period; similarly, this method combines the costs of beginning goods in process inventory with the costs incurred in the current period. This process is illustrated in Exhibit 16.14.

For direct materials, the cost averages $0.11 per EUP, computed as the sum of direct materials cost from beginning goods in process inventory ($3,300) and the direct materials cost incurred in April ($9,900), and this sum ($13,200) is then divided by the 120,000 EUP for materials (from step 2). The costs per equivalent unit for labor and overhead are similarly computed. Specifically, direct labor cost averages $0.06 per EUP, computed as the sum of labor cost in beginning goods in process inventory ($600) and the labor costs incurred in April ($5,700), and this sum ($6,300) divided by 105,000 EUP for labor. Overhead costs averages $0.072 per EUP, computed as the sum of overhead cost in the beginning goods in process inventory ($720) and the overhead costs applied in April ($6,840), and this sum ($7,560) divided by 105,000 EUP for overhead.

Step 4: Assign and Reconcile Costs The EUP from step 2 and the cost per EUP from step 3 are used in step 4 to assign costs to (a) units that production completed and transferred to finished goods and (b) units that remain in process. This is illustrated in Exhibit 16.15.

EXHIBIT 16.14 Cost per Equivalent Unit of Production—Weighted Average

Direct Direct Factory

Cost per Equivalent Unit of Production Materials Labor Overhead

Costs of beginning goods in process inventory . . . . . . . $ 3,300 $ 600 $ 720

Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . . . . 9,900 5,700 6,840

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,200 $6,300 $7,560

4 Equivalent units of production (from Step 2) . . . . . . . 120,000 EUP 105,000 EUP 105,000 EUP

5 Cost per equivalent unit of production . . . . . . . . . . . $0.11 per EUP* $0.06 per EUP† $0.072 per EUP‡

*$13,200 4 120,000 EUP †$6,300 4 105,000 EUP ‡$7,560 4 105,000 EUP

Point: Managers can examine changes in monthly costs per equivalent unit to help control the production process. When prices are set in a competitive market, managers can use process cost summary information to determine which costs should be cut to achieve a profit.

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Chapter 16 Process Costing and Analysis 703

EXHIBIT 16.15 Report of Costs Accounted For—Weighted Average

Cost of units completed and transferred out

Direct materials (100,000 EUP 3 $0.11 per EUP) . . . . . . . . . . . $11,000

Direct labor (100,000 EUP 3 $0.06 per EUP) . . . . . . . . . . . . . . . 6,000

Factory overhead (100,000 EUP 3 $0.072 per EUP) . . . . . . . . . 7,200

Cost of units completed this period . . . . . . . . . . . . . . . . . . . . . . . $ 24,200

Cost of ending goods in process inventory

Direct materials (20,000 EUP 3 $0.11 per EUP) . . . . . . . . . . . . 2,200

Direct labor (5,000 EUP 3 $0.06 per EUP) . . . . . . . . . . . . . . . . . 300

Factory overhead (5,000 EUP 3 $0.072 per EUP) . . . . . . . . . . . 360

Cost of ending goods in process inventory . . . . . . . . . . . . . . . . . 2,860

Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,060

Cost of Units Completed and Transferred The 100,000 units completed and trans- ferred to finished goods inventory required 100,000 EUP of direct materials. Thus, we assign $11,000 (100,000 EUP 3 $0.11 per EUP) of direct materials cost to those units. Similarly, those units had received 100,000 EUP of direct labor and 100,000 EUP of factory overhead (recall Exhibit 16.13). Thus, we assign $6,000 (100,000 EUP 3 $0.06 per EUP) of direct labor and $7,200 (100,000 EUP 3 $0.072 per EUP) of overhead to those units. The total cost of the 100,000 completed and transferred units is $24,200 ($11,000 1 $6,000 1 $7,200) and their average cost per unit is $0.242 ($24,200 4 100,000 units).

Cost of Units for Ending Goods in Process There are 20,000 incomplete units in goods in process inventory at period-end. For direct materials, those units have 20,000 EUP of material (from step 2) at a cost of $0.11 per EUP (from step 3), which yields the materials cost of goods in process inventory of $2,200 (20,000 EUP 3 $0.11 per EUP). For direct labor, the in-process units have 25% of the required labor, or 5,000 EUP (from step 2). Using the $0.06 labor cost per EUP (from step 3) we obtain the labor cost of goods in process inventory of $300 (5,000 EUP 3 $0.06 per EUP). For overhead, the in-process units reflect 5,000 EUP (from step 2). Using the $0.072 overhead cost per EUP (from step 3) we obtain overhead costs with in-process inventory of $360 (5,000 EUP 3 $0.072 per EUP). Total cost of goods in pro- cess inventory at period-end is $2,860 ($2,200 1 $300 1 $360). As a check, management verifies that total costs assigned to those units completed and trans- ferred plus the costs of those in process (from Exhibit 16.15) equal the costs incurred by production. Exhibit 16.16 shows the costs incurred by production this period. We then reconcile the costs accounted for in Exhibit 16.15 with the costs to account for in Exhibit 16.16.

EXHIBIT 16.16 Report of Costs to Account For—Weighted Average

Cost of beginning goods in process inventory

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,300

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 $ 4,620

Cost incurred this period

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,700

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,840 22,440

Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,060

At GenX, the production department manager is responsible for $27,060 in costs: $4,620 that is assigned to the goods in process at the start of the period plus $22,440 of materials, labor, and overhead incurred in the period. At period-end, that manager must show where these costs are assigned. The manager for GenX reports that $2,860 are assigned to units in process and $24,200 are assigned to units completed (per Exhibit 16.15). The sum of these amounts equals $27,060. Thus, the total costs to account for equal the total costs accounted for (minor differ- ences can sometimes occur from rounding).

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704 Chapter 16 Process Costing and Analysis

EXHIBIT 16.17 Process Cost Summary

re co

n ci

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Process Cost Summary An important managerial accounting report for a process cost accounting system is the process cost summary (also called production report), which is prepared separately for each process or production department. Three reasons for the sum- mary are to (1) help department managers control and monitor their departments, (2) help factory managers evaluate department managers’ performances, and (3) provide cost infor- mation for financial statements. A process cost summary achieves these purposes by describing the costs charged to each department, reporting the equivalent units of production achieved by each department, and determining the costs assigned to each department’s out- put. For our purposes, it is prepared using a combination of Exhibits 16.13, 16.14, 16.15, and 16.16. The process cost summary for GenX is shown in Exhibit 16.17. The report is divided into three sections. Section 1 lists the total costs charged to the department, including direct mate- rials, direct labor, and overhead costs incurred, as well as the cost of the beginning goods in process inventory. Section 2 describes the equivalent units of production for the department. Equivalent units for materials, labor, and overhead are in separate columns. It also reports direct

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GenX COMPANY

Process Cost Summary (Weighted-Average Method)

For Month Ended April 30, 2013

Costs Charged to Production

Costs of beginning goods in process Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,300 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 $ 4,620 Costs incurred this period Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,700 Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,840 22,440 Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,060

Unit Cost Information

Units to account for: Units accounted for: Beginning goods in process . . . . . . . . . 30,000 Completed and transferred out . . . . . . . . . 100,000 Units started this period . . . . . . . . . . . 90,000 Ending goods in process . . . . . . . . . . . . . . . 20,000 Total units to account for . . . . . . . . . . 120,000 Total units accounted for . . . . . . . . . . . . . . 120,000

Direct Direct Factory

Equivalent Units of Production (EUP) Materials Labor Overhead

Units completed and transferred out . . . . . . . . . . . . . . 100,000 EUP 100,000 EUP 100,000 EUP Units of ending goods in process Direct materials (20,000 3 100%) . . . . . . . . . . . . . . 20,000 Direct labor (20,000 3 25%) . . . . . . . . . . . . . . . . . . 5,000 Factory overhead (20,000 3 25%) . . . . . . . . . . . . . . 5,000 Equivalent units of production . . . . . . . . . . . . . . . . . . . . 120,000 EUP 105,000 EUP 105,000 EUP

Direct Direct Factory

Cost per EUP Materials Labor Overhead

Costs of beginning goods in process . . . . . . . . . . . . . . . $ 3,300 $ 600 $ 720 Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . 9,900 5,700 6,840 Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,200 $6,300 $7,560

4EUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 EUP 105,000 EUP 105,000 EUP Cost per EUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0.11 per EUP $0.06 per EUP $0.072 per EUP

Cost Assignment and Reconciliation

Costs transferred out (cost of goods manufactured) Direct materials (100,000 EUP 3 $0.11 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,000 Direct labor (100,000 EUP 3 $0.06 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Factory overhead (100,000 EUP 3 $0.072 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . 7,200 $ 24,200 Costs of ending goods in process Direct materials (20,000 EUP 3 $0.11 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200 Direct labor (5,000 EUP 3 $0.06 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Factory overhead (5,000 EUP 3 $0.072 per EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . 360 2,860 Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,060

1

3

2

Point: The key report in a job order costing system is a job cost sheet, which reports manufacturing costs per job. A process cost summary reports manufac- turing costs per equivalent unit of a pro- cess or department.

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Chapter 16 Process Costing and Analysis 705

Assets 5 Liabilities 1 Equity 124,200 224,200

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . . . 24,200

Goods in Process Inventory . . . . . . . . . . . . . . . . . . 24,200

To record transfer of completed units.

9

The credit to Goods in Process Inventory reduces that asset balance to reflect that 100,000 units are no longer in production. The cost of these units has been transferred to Finished Goods In- ventory, which is recognized as a $24,200 increase in this asset. After this entry is posted, there remains a balance of $2,860 in the Goods in Process Inventory account, which is the amount com- puted in Step 4 previously. The cost of units transferred from Goods in Process Inventory to Fin- ished Goods Inventory is called the cost of goods manufactured. Exhibit 16.18 reveals the activities in the Goods in Process Inventory account for this period. The ending balance of this ac- count equals the cost assigned to the partially completed units in section 3 of Exhibit 16.17.

EXHIBIT 16.18 Goods in Process Inventory

Goods in Process Inventory Acct. No. 134

Date Explanation Debit Credit Balance

Mar. 31 Balance 4,620

Apr. 30 Direct materials usage 9,900 14,520

30 Direct labor costs incurred 5,700 20,220

30 Factory overhead applied 6,840 27,060

30 Transfer completed product to warehouse 24,200 2,860

Arrow line 10 in Exhibit 16.4 reflects the sale of finished goods. Assume that GenX sold 106,000 units of Profen this period, and that its beginning inventory of finished goods consisted of 26,000 units with a cost of $6,292. Also assume that its ending finished goods inventory con- sists of 20,000 units at a cost of $4,840. Using this information, we can compute its cost of goods sold for April as shown in Exhibit 16.19.

materials, direct labor, and overhead costs per equivalent unit. Section 3 allocates total costs among units worked on in the period. The $24,200 is the total cost of goods transferred out of the department, and the $2,860 is the cost of partially processed ending inventory units. The as- signed costs are then added to show that the total $27,060 cost charged to the department in section 1 is now assigned to the units in section 3 .

Point: We omit the journal entry for sales, but it totals the number of units sold times price per unit. The Accounts Receiv- able (or Cash) account is debited and the Sales Revenue account is credited.

6. Equivalent units are (a) a measure of a production department’s productivity in using direct materials, direct labor, or overhead; (b) units of a product produced by a foreign competitor that are similar to units produced by a domestic company; or (c) generic units of a product similar to brand name units of a product.

7. Interpret the meaning of a department’s equivalent units with respect to direct labor. 8. A department began the period with 8,000 units that were one-fourth complete with respect

to direct labor. It completed 58,000 units, and ended with 6,000 units that were one-third complete with respect to direct labor. What were its direct labor equivalent units for the period using the weighted-average method?

9. A process cost summary for a department has three sections. What information is presented in each of them?

Quick Check Answers — p. 716

Transfers to Finished Goods Inventory and Cost of Goods Sold Arrow line 9 in Exhibit 16.4 reflects the transfer of completed products from production to finished goods inventory. The process cost summary shows that the 100,000 units of finished Profen are assigned a cost of $24,200. The entry to record this transfer follows.

P4 Record the transfer of completed goods to Finished Goods Inventory and Cost of Goods Sold.

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706 Chapter 16 Process Costing and Analysis

Summary of Cost Flows Exhibit 16.21 shows GenX’s manufacturing cost flows for April. Each of these cost flows and the entries to record them have been explained. The flow of costs through the accounts reflects the flow of production activities and products.

EXHIBIT 16.21* Cost Flows through GenX

Materials $11,095

Overhead $6,840

Labor $8,920

Production

Warehouse

Beg. Inv. $ 6,292 FG 24,200 GAFS $30,492

End. Inv. $4,840

Customers COGS

$25,652

$1,195

Beg. GIP $ 4,620 DM 9,900 FOH 6,840 DL 5,700 Total GIP $27,060

End. GIP $2,860

$3,220

$6,840$2,425

$24,200

*Abbreviations: GIP (goods in process); DM (direct materials); DL (direct labor); FOH (factory overhead); FG (finished goods); GAFS (goods available for sale); COGS (cost of goods sold).

$5,700

$9,900

EXHIBIT 16.19 Cost of Goods Sold

Beginning finished goods inventory . . . . . . . . . . . . . . . . $ 6,292

1 Cost of goods manufactured this period . . . . . . . . . 24,200

5 Cost of goods available for sale . . . . . . . . . . . . . . . . $30,492

2 Ending finished goods inventory . . . . . . . . . . . . . . . . 4,840

5 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $25,652

The summary entry to record cost of goods sold for this period follows:

Assets 5 Liabilities 1 Equity 225,652 225,652

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,652

Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . 25,652

To record cost of goods sold for April.

10

The Finished Goods Inventory account now appears as shown in Exhibit 16.20.

EXHIBIT 16.20 Finished Goods Inventory

Finished Goods Inventory Acct. No. 135

Date Explanation Debit Credit Balance

Mar. 31 Balance 6,292

Apr. 30 Transfer in cost of goods manufactured 24,200 30,492

30 Cost of goods sold 25,652 4,840

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Chapter 16 Process Costing and Analysis 707

Trends in Process Operations Some of the recent trends in process operations are discussed in the following paragraphs.

Process Design Management concerns with production efficiency can lead companies to entirely reorganize production processes. For example, instead of producing different types of computers in a series of departments, a separate work center for each computer can be estab- lished in one department. The process cost system is then changed to account for each work center’s costs.

Just-in-Time Production Companies are increasingly adopting just-in-time techniques. With a just-in-time inventory system, inventory levels can be minimal. If raw materials are not ordered or received until needed, a Raw Materials Inventory account might be unnecessary. In- stead, materials cost is immediately debited to the Goods in Process Inventory account. Simi- larly, a Finished Goods Inventory account may not be needed. Instead, cost of finished goods may be immediately debited to the Cost of Goods Sold account.

Automation Advances in technology increasingly enable companies to automate their pro- duction processes. This allows them to reduce direct labor costs. Reflecting this, some compa- nies focus on conversion costs per equivalent unit, which is the combined costs of direct labor and factory overhead per equivalent unit.

Services Service-based businesses are increasingly prevalent. For routine, standardized ser- vices like oil changes and simple tax returns, computing costs based on the process is simpler and more useful than a cost per individual job.

Customer Orientation Focus on customer orientation also leads to improved processes. A manufacturer of control devices improved quality and reduced production time by forming teams to study processes and suggest improvements. An ice cream maker studied customer tastes to develop a more pleasing ice cream texture.

As part of a series of global environmental goals, the international giant Anheuser-Busch InBev set targets to reduce its water usage. The company uses massive amounts of water in beer production and in its cleaning and cooling processes. To meet these goals, the company followed recent trends in pro- cess operations. These included extensive redesign of production processes and the use of advanced technology to increase efficiency at wastewater treatment plants. As a result water usage decreased by almost 37 percent in its global operations.

GLOBAL VIEW

Hybrid Costing System Decision Analysis

A2 Explain and illustrate a hybrid costing system. This chapter explained the process costing system and contrasted it with the job order costing system. Many organizations use a hybrid system that contains features of both process and job order operations. A recent survey of manufacturers revealed that a majority use hybrid systems (also called operation cost systems). To illustrate, consider a car manufacturer’s assembly line. On one hand, the line resembles a process operation in that the assembly steps for each car are nearly identical. On the other hand, the specifications of most cars have several important differences. At the Ford Mustang plant, each car assembled on a given day can be different from the previous car and the next car. This means that the costs of materials (subassemblies or components) for each car can differ. Accordingly, while the conversion costs (direct labor and overhead) can be accounted for using a process costing system, the component costs (direct materials) are accounted for using a job order system (separately for each car or type of car). A hybrid system of processes requires a hybrid costing system to properly cost products or ser vices. In the Ford plant, the assembly costs per car are readily determined using process costing. The costs of

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708 Chapter 16 Process Costing and Analysis

additional components can then be added to the assembly costs to determine each car’s total cost (as in job order costing). To illustrate, consider the following information for a daily assembly process at Ford.

Assembly process costs

Direct materials $10,600,000

Direct labor $5,800,000

Factory overhead $6,200,000

Number of cars assembled 1,000

Costs of three different types of steering wheels $240, $330, $480

Costs of three different types of seats $620, $840, $1,360

The assembly process costs $22,600 per car. Depending on the type of steering wheel and seats the cus- tomer requests, the cost of a car can range from $23,460 to $24,440 (a $980 difference). Today companies are increasingly trying to standardize processes while attempting to meet individual customer needs. To the extent that differences among individual customers’ requests are large, under- standing the costs to satisfy those requests is important. Thus, monitoring and controlling both process and job order costs are important.

Pennsylvania Company produces a product that passes through a single production process. Then com- pleted products are transferred to finished goods in its warehouse. Information related to its manufacturing activities for July follows.

DEMONSTRATION PROBLEM

Raw Materials

Beginning inventory . . . . . . . . . . . . . . . . . . . . . $100,000

Raw materials purchased on credit . . . . . . . . . 211,400

Direct materials used . . . . . . . . . . . . . . . . . . . . (190,000)

Indirect materials used . . . . . . . . . . . . . . . . . . . (51,400)

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . $ 70,000

Factory Payroll

Direct labor incurred . . . . . . . . . . . . . . . . . . . . $ 55,500

Indirect labor incurred . . . . . . . . . . . . . . . . . . . 50,625

Total payroll (paid in cash) . . . . . . . . . . . . . . . . . $106,125

Factory Overhead

Indirect materials used . . . . . . . . . . . . . . . . . . . $ 51,400

Indirect labor used . . . . . . . . . . . . . . . . . . . . . . 50,625

Other overhead costs . . . . . . . . . . . . . . . . . . . . 71,725

Total factory overhead incurred . . . . . . . . . . . . $173,750

Factory Overhead Applied

Overhead applied (200% of direct labor) . . . . . $111,000

Production Department

Beginning goods in process inventory (units) . . . . . . . 5,000

Percentage completed—Materials . . . . . . . . . . . . . 100%

Percentage completed—Labor and overhead . . . . 60%

Beginning goods in process inventory (costs)

Direct materials used . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

Direct labor incurred . . . . . . . . . . . . . . . . . . . . . . . 9,600

Overhead applied (200% of direct labor) . . . . . . . . 19,200

Total costs of beginning goods in process . . . . . . . . $ 48,800

Units started this period . . . . . . . . . . . . . . . . . . . . . . . 20,000 Units completed this period . . . . . . . . . . . . . . . . . . . . 17,000

Ending goods in process inventory (units) . . . . . . . . . 8,000

Percentage completed—Materials . . . . . . . . . . . . . 100%

Percentage completed—Labor and overhead . . . . 20%

Finished Goods Inventory

Beginning finished goods inventory . . . . . . . . . . . . . $ 96,400

Cost transferred in from production . . . . . . . . . . . 321,300

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . (345,050)

Ending finished goods inventory . . . . . . . . . . . . . . . $ 72,650

Entrepreneur You operate a process production company making similar products for three different cus- tomers. One customer demands 100% quality inspection of products at your location before shipping. The added costs of that inspection are spread across all customers, not just the one demanding it. If you charge the added costs to that customer, you could lose that customer and experience a loss. Moreover, your other two customers have agreed to pay 110% of full costs. What actions (if any) do you take? ■ [Answer—p. 716]

Decision Ethics

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Chapter 16 Process Costing and Analysis 709

Required

1. Prepare a physical flow reconciliation for July as illustrated in Exhibit 16.12. 2. Compute the equivalent units of production in July for direct materials, direct labor, and factory overhead. 3. Compute the costs per equivalent units of production in July for direct materials, direct labor, and

factory overhead. 4. Prepare a report of costs accounted for and a report of costs to account for. 5. Prepare summary journal entries to record the transactions and events of July for (a) raw materials

purchases, (b) direct materials usage, (c) indirect materials usage, (d) factory payroll costs, (e) direct labor usage, (f) indirect labor usage, (g) other overhead costs (credit Other Accounts), (h) application of overhead to production, (i) transfer of finished goods from production, and (j) the cost of goods sold.

PLANNING THE SOLUTION ● Track the physical flow to determine the number of units completed in July. ● Compute the equivalent unit of production for direct materials, direct labor, and factory overhead. ● Compute the costs per equivalent unit of production with respect to direct materials, direct labor, and

overhead; and determine the cost per unit for each. ● Compute the total cost of the goods transferred to production by using the equivalent units and unit

costs. Determine (a) the cost of the beginning in-process inventory, (b) the materials, labor, and over- head costs added to the beginning in-process inventory, and (c) the materials, labor, and overhead costs added to the units started and completed in the month.

● Determine the cost of goods sold using balances in finished goods and cost of units completed this period. ● Use the information to record the summary journal entries for July.

SOLUTION TO DEMONSTRATION PROBLEM 1. Physical flow reconciliation.

Units to Account For Units Accounted For

Beginning goods in Units completed and process inventory . . . . . . . . . 5,000 units transferred out . . . . . . . . . . . . . . . . . . . 17,000 units

Units started this period . . . . . . 20,000 units Ending goods in process inventory. . . . . . 8,000 units

Total units to account for . . . . . 25,000 units Total units accounted for . . . . . . . . . . . . . 25,000 units

reconciled

2. Equivalent units of production.

Direct Direct Factory

Equivalent Units of Production Materials Labor Overhead

Equivalent units completed and transferred out . . . . . . . . . 17,000 EUP 17,000 EUP 17,000 EUP

Equivalent units in ending goods in process

Direct materials (8,000 3 100%) . . . . . . . . . . . . . . . . . . . 8,000

Direct labor (8,000 3 20%) . . . . . . . . . . . . . . . . . . . . . . . 1,600

Factory overhead (8,000 3 20%) . . . . . . . . . . . . . . . . . . . 1,600

Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . 25,000 EUP 18,600 EUP 18,600 EUP

3. Costs per equivalent unit of production.

Direct Direct Factory

Costs per Equivalent Unit of Production Materials Labor Overhead

Costs of beginning goods in process . . . . . . . . . . $ 20,000 $ 9,600 $ 19,200

Costs incurred this period . . . . . . . . . . . . . . . . . . 190,000 55,500 111,000*

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000 $65,100 $130,200

4 Equivalent units of production (from part 2) . . 25,000 EUP 18,600 EUP 18,600 EUP

5 Costs per equivalent unit of production . . . . . $8.40 per EUP $3.50 per EUP $7.00 per EUP

*Factory overhead applied

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710 Chapter 16 Process Costing and Analysis

4. Reports of costs accounted for and of costs to account for

Report of Costs Accounted For

Cost of units transferred out (cost of goods manufactured)

Direct materials ($8.40 per EUP 3 17,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . $142,800

Direct labor ($3.50 per EUP 3 17,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . 59,500

Factory overhead ($7.00 per EUP 3 17,000 EUP) . . . . . . . . . . . . . . . . . . . . . . 119,000

Cost of units completed this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 321,300

Cost of ending goods in process inventory

Direct materials ($8.40 per EUP 3 8,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . 67,200

Direct labor ($3.50 per EUP 3 1,600 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600

Factory overhead ($7.00 per EUP 3 1,600 EUP) . . . . . . . . . . . . . . . . . . . . . . . 11,200

Cost of ending goods in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,000

Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $405,300

Report of Costs to Account For

Cost of beginning goods in process inventory

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,600

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200 $ 48,800

Cost incurred this period

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,500

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,000 356,500

Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $405,300

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5. Summary journal entries for the transactions and events in July.

a. Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . 211,400

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . 211,400

To record raw materials purchases.

b. Goods in Process Inventory . . . . . . . . . . . . . . . . . 190,000

Raw Materials Inventory . . . . . . . . . . . . . . . . 190,000

To record direct materials usage.

c. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 51,400

Raw Materials Inventory . . . . . . . . . . . . . . . . 51,400

To record indirect materials usage.

d. Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106,125

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106,125

To record factory payroll costs.

e. Goods in Process Inventory . . . . . . . . . . . . . . . . . 55,500

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . 55,500

To record direct labor usage.

f. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 50,625

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . 50,625

To record indirect labor usage.

g. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 71,725

Other Accounts . . . . . . . . . . . . . . . . . . . . . . . 71,725

To record other overhead costs.

h. Goods in Process Inventory . . . . . . . . . . . . . . . . . 111,000

Factory Overhead . . . . . . . . . . . . . . . . . . . . . 111,000

To record application of overhead.

i. Finished Goods Inventory . . . . . . . . . . . . . . . . . . . 321,300

Goods in Process Inventory . . . . . . . . . . . . . 321,300

To record transfer of finished goods from production.

j. Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . 345,050

Finished Goods Inventory . . . . . . . . . . . . . . . 345,050

To record cost of goods sold.

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APPENDIX

FIFO Method of Process Costing 16A The FIFO method of process costing assigns costs to units assuming a first-in, first-out flow of product. The objectives, concepts, and journal entries (not amounts) are the same as for the weighted-average method, but computation of equivalent units of production and cost assignment are slightly different. Exhibit 16A.11 shows selected information from GenX’s production department for the month of April. Accounting for a department’s activity for a period includes four steps: (1) determine physical flow, (2) compute equivalent units, (3) compute cost per equivalent unit, and (4) determine cost assignment and reconciliation. This appendix describes each of these steps using the FIFO method for process costing.

C4 Appendix 16A—Describe accounting for production activity and preparation of a process cost summary using FIFO.

Step 1: Determine Physical Flow of Units A physical flow reconciliation is a report that reconciles (1) the physical units started in a period with (2) the physical units completed in that period. The physical flow reconciliation for GenX is shown in Exhibit 16A.12 for April.

EXHIBIT 16A.11 Production Data

Beginning goods in process inventory (March 31)

Units of product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 units

Percentage of completion—Direct materials . . . . . . . . . . . . . . . . . 100%

Percentage of completion—Direct labor . . . . . . . . . . . . . . . . . . . . 65%

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,300

Direct labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 600

Factory overhead costs applied (120% of direct labor) . . . . . . . . . $ 720

Activities during the current period (April)

Units started this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 units

Units transferred out (completed) . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Direct materials costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,900

Direct labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,700

Factory overhead costs applied (120% of direct labor) . . . . . . . . . . $ 6,840

Ending goods in process inventory (April 30)

Units of product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

Percentage of completion—Direct materials . . . . . . . . . . . . . . . . . 100%

Percentage of completion—Direct labor . . . . . . . . . . . . . . . . . . . . 25%

EXHIBIT 16A.12 Physical Flow Reconciliation

Units to Account For Units Accounted For

Beginning goods in Units completed and process inventory . . . . . . . . 30,000 units transferred out . . . . . . . . . . . . . . . . . . 100,000 units

Units started this period . . . . . 90,000 units Ending goods in process inventory . . . . 20,000 units

Total units to account for . . . . 120,000 units Total units accounted for . . . . . . . . . . . . 120,000 units

reconciled

FIFO assumes that the 100,000 units transferred to finished goods during April include the 30,000 units from the beginning goods in process inventory. The remaining 70,000 units transferred out are from units started in April. Of the total 90,000 units started in April, 70,000 were completed, leaving 20,000 units unfinished at period-end.

Step 2: Compute Equivalent Units of Production—FIFO GenX used its direct materials, direct labor, and overhead both to make complete units of Profen and to start some units that are not yet complete. We need to convert the physical measure of units to equivalent units based on how much of each input has been used. We do this by multiplying the number of physical units by the percentage of process- ing applied to those units in the current period; this is done for each input (materials, labor, and overhead). The FIFO method accounts for cost flow in a sequential manner—earliest costs are the first to flow out. (This is different from the weighted-average method, which combines prior period costs—those in begin- ning Goods in Process Inventory—with costs incurred in the current period.)

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712 Chapter 16 Process Costing and Analysis

Three distinct groups of units must be considered in determining the equivalent units of production under the FIFO method: (a) units in beginning Goods in Process Inventory that were completed this period, (b) units started and completed this period, and (c) units in ending Goods in Process Inventory. We must determine how much material, labor, and overhead are used for each of these unit groups. These computations are shown in Exhibit 16A.13. The remainder of this section explains these computations.

EXHIBIT 16A.13 Equivalent Units of Production—FIFO

Direct Direct Factory

Equivalent Units of Production Materials Labor Overhead

(a) Equivalent units to complete beginning goods in process Direct materials (30,000 3 0%) . . . . . . . . . . . . . . . . . . . . . . . . . 0 EUP Direct labor (30,000 3 35%) . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500 EUP Factory overhead (30,000 3 35%) . . . . . . . . . . . . . . . . . . . . . . . 10,500 EUP (b) Equivalent units started and completed* . . . . . . . . . . . . . . . . . . . . 70,000 70,000 70,000 (c) Equivalent units in ending goods in process Direct materials (20,000 3 100%) . . . . . . . . . . . . . . . . . . . . . . . 20,000 Direct labor (20,000 3 25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Factory overhead (20,000 3 25%) . . . . . . . . . . . . . . . . . . . . . . . 5,000 Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 EUP 85,500 EUP 85,500 EUP

*Units completed this period . . . . . . . . . . . . . . . . . . . 100,000 units Less units in beginning goods in process . . . . . . . . . 30,000 Units started and completed this period . . . . . . . . . . 70,000 units

(a) Beginning Goods in Process Under FIFO, we assume that production first completes any units started in the prior period. There were 30,000 physical units in beginning goods in process inventory. Those units were 100% complete with respect to direct materials as of the end of the prior period. This means that no materials (0%) are needed in April to complete those 30,000 units. So the equivalent units of materials to complete beginning goods in process are zero (30,000 3 0%)—see first row under row “(a)” in Exhibit 16A.13. The units in process as of April 1 had already been through 65% of production prior to this period and need only go through the remaining 35% of production. The equivalent units of labor to complete the beginning goods in process are 10,500 (30,000 3 35%)—see the second row under row “(a).” This im- plies that the amount of labor required this period to complete the 30,000 units started in the prior period is the amount of labor needed to make 10,500 units, start-to-finish. Finally, overhead is applied based on direct labor costs, so GenX computes equivalent units for overhead as it would for direct labor.

(b) Units Started and Completed This Period After completing any beginning goods in process, FIFO assumes that production begins on newly started units. GenX began work on 90,000 new units this period. Of those units, 20,000 remain incomplete at period-end. This means that 70,000 of the units started in April were completed in April. These complete units have received 100% of materials, labor, and over- head. Exhibit 16A.13 reflects this by including 70,000 equivalent units (70,000 3 100%) of materials, labor, and overhead in its equivalent units of production—see row “(b).”

(c) Ending Goods in Process The 20,000 units started in April that GenX was not able to complete by period-end consumed materials, labor, and overhead. Specifically, those 20,000 units received 100% of materials and, therefore, the equivalent units of materials in ending goods in process inventory are 20,000 (20,000 3 100%)—see the first row under row “(c).” For labor and overhead, the units in ending goods in process were 25% complete in production. This means the equivalent units of labor and overhead for those units are 5,000 (20,000 3 25%) as GenX incurs labor and overhead costs uniformly throughout its produc- tion process. Finally, for each input (direct materials, direct labor, and factory overhead), the equivalent units for each of the unit groups (a), (b), and (c) are added to determine the total equivalent units of pro- duction with respect to each—see the final row in Exhibit 16A.13.

Step 3: Compute Cost per Equivalent Unit—FIFO To compute cost per equivalent unit, we take the product costs (for each of direct materials, direct labor, and factory overhead from Exhibit 16A.11) added in April and divide by the equivalent units of production from step 2. Exhibit 16A.14 illustrates these computations.

EXHIBIT 16A.14 Cost per Equivalent Unit of Production—FIFO

Direct Direct Factory

Cost per Equivalent Unit of Production Materials Labor Overhead

Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . . . . . $9,900 $5,700 $6,840 4 Equivalent units of production (from Step 2) . . . . . . . . . 90,000 EUP 85,500 EUP 85,500 EUP Cost per equivalent unit of production . . . . . . . . . . . . . . . $0.11 per EUP $0.067 per EUP $0.08 per EUP

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Chapter 16 Process Costing and Analysis 713

It is essential to compute costs per equivalent unit for each input because production inputs are added at different times in the process. The FIFO method computes the cost per equivalent unit based solely on this period’s EUP and costs (unlike the weighted-average method, which adds in the costs of the beginning goods in process inventory).

Step 4: Assign and Reconcile Costs The equivalent units determined in step 2 and the cost per equivalent unit computed in step 3 are both used to assign costs (1) to units that the production depart- ment completed and transferred to finished goods and (2) to units that remain in process at period-end. In Exhibit 16A.15, under the section for cost of units transferred out, we see that the cost of units completed in April includes the $4,620 cost carried over from March for work already applied to the 30,000 units that make up beginning Goods in Process Inventory, plus the $1,544 incurred in April to complete those units. This section also includes the $17,990 of cost assigned to the 70,000 units started and completed this period. Thus, the total cost of goods manufactured in April is $24,154 ($4,620 1 $1,544 1 $17,990). The average cost per unit for goods completed in April is $0.242 ($24,154 4 100,000 completed units).

The computation for cost of ending goods in process inventory is in the lower part of Exhibit 16A.15. The cost of units in process includes materials, labor, and overhead costs corresponding to the percentage of these resources applied to those incomplete units in April. That cost of $2,935 ($2,200 1 $335 1 $400) also is the ending balance for the Goods in Process Inventory account. Management verifies that the total costs assigned to units transferred out and units still in process equal the total costs incurred by production. We reconcile the costs accounted for (in Exhibit 16A.15) to the costs that production was charged for as shown in Exhibit 16A.16.

EXHIBIT 16A.15 Report of Costs Accounted For—FIFO

Cost of units transferred out (cost of goods manufactured)

Cost of beginning goods in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,620 Cost to complete beginning goods in process Direct materials ($0.11 per EUP 3 0 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Direct labor ($0.067 per EUP 3 10,500 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . 704 Factory overhead ($0.08 per EUP 3 10,500 EUP) . . . . . . . . . . . . . . . . . . . . . . 840 1,544 Cost of units started and completed this period Direct materials ($0.11 per EUP 3 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . 7,700 Direct labor ($0.067 per EUP 3 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . 4,690 Factory overhead ($0.08 per EUP 3 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . 5,600 17,990 Total cost of units finished this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,154

Cost of ending goods in process inventory

Direct materials ($0.11 per EUP 3 20,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . 2,200 Direct labor ($0.067 per EUP 3 5,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . 335 Factory overhead ($0.08 per EUP 3 5,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . 400 Total cost of ending goods in process inventory . . . . . . . . . . . . . . . . . . . . . . . . 2,935 Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,089

EXHIBIT 16A.16 Report of Costs to Account For—FIFO

Cost of beginning goods in process inventory Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,300 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 $ 4,620 Costs incurred this period Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,700 Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,840 22,440 Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,060

The production manager is responsible for $27,060 in costs: $4,620 that had been assigned to the department’s Goods in Process Inventory as of April 1 plus $22,440 of materials, labor, and overhead costs the department incurred in April. At period-end, the manager must identify where those costs were assigned. The production manager can report that $24,154 of cost was assigned to units completed in April and $2,935 was assigned to units still in process at period-end. The sum of these amounts is $29 dif ferent from the $27,060 total costs in- curred by production due to rounding in step 3—rounding errors are common and not a concern.

The final report is the process cost summary, which summarizes key information from Exhibits 16A.13, 16A.14, 16A.15, and 16A.16. Reasons for the summary are to (1) help managers control and monitor costs, (2) help upper management assess department manager performance, and (3) provide cost information for financial reporting. The process cost summary, using FIFO, for GenX is in Exhibit 16A.17. Section 1 lists

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714 Chapter 16 Process Costing and Analysis

EXHIBIT 16A.17 Process Cost Summary

GenX COMPANY

Process Cost Summary (FIFO Method)

For Month Ended April 30, 2013

Costs charged to production

Costs of beginning goods in process inventory

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,300

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 $ 4,620

Costs incurred this period

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,700

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,840 22,440

Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,060

Unit cost information

Units to account for Units accounted for

Beginning goods in process . . . . . . . . . 30,000 Transferred out . . . . . . . . . . . . . . . . . 100,000

Units started this period . . . . . . . . . . . 90,000 Ending goods in process . . . . . . . . . . 20,000

Total units to account for . . . . . . . . . . 120,000 Total units accounted for . . . . . . . . . 120,000

Direct Direct Factory

Equivalent units of production Materials Labor Overhead

Equivalent units to complete beginning goods in process

Direct materials (30,000 3 0%) . . . . . . . . . . . . . 0 EUP

Direct labor (30,000 3 35%) . . . . . . . . . . . . . . . 10,500 EUP

Factory overhead (30,000 3 35%) . . . . . . . . . . . 10,500 EUP

Equivalent units started and completed . . . . . . . . . 70,000 70,000 70,000

Equivalent units in ending goods in process

Direct materials (20,000 3 100%) . . . . . . . . . . . 20,000

Direct labor (20,000 3 25%) . . . . . . . . . . . . . . . 5,000

Factory overhead (20,000 3 25%) . . . . . . . . . . . 5000

Equivalent units of production . . . . . . . . . . . . . . . . 90,000 EUP 85,500 EUP 85,500 EUP

Direct Direct Factory

Cost per equivalent unit of production Materials Labor Overhead

Costs incurred this period . . . . . . . . . . . . . . . . . . . $9,900 $5,700 $6,840

4 Equivalent units of production . . . . . . . . . . . . . . 90,000 EUP 85,500 EUP 85,500 EUP

Cost per equivalent unit of production . . . . . . . . . $0.11 per EUP $0.067 per EUP $0.08 per EUP

Cost assignment and reconciliation

(cost of units completed and transferred out)

Cost of beginning goods in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,620

Cost to complete beginning goods in process

Direct materials ($0.11 per EUP 3 0 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Direct labor ($0.067 per EUP 3 10,500 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704

Factory overhead ($0.08 per EUP 3 10,500 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . 840 1,544

Cost of units started and completed this period

Direct materials ($0.11 per EUP 3 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,700

Direct labor ($0.067 per EUP 3 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,690

Factory overhead ($0.08 per EUP 3 70,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600 17,990

Total cost of units finished this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,154

Cost of ending goods in process

Direct materials ($0.11 per EUP 3 20,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200

Direct labor ($0.067 per EUP 3 5,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335

Factory overhead ($0.08 per EUP 3 5,000 EUP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Total cost of ending goods in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,935

Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,089*

re co

n ci

le d

*$29 difference due to rounding

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

1

2

3

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Chapter 16 Process Costing and Analysis 715

the total costs charged to the department, including direct materials, direct labor, and overhead costs incurred, as well as the cost of the beginning goods in process inventory. Section 2 describes the equiva- lent units of production for the department. Equivalent units for materials, labor, and overhead are in separate columns. It also reports direct materials, direct labor, and overhead costs per equivalent unit. Section 3 allocates total costs among units worked on in the period.

C1 Explain process operations and the way they differ from job order operations. Process operations produce large quan- tities of similar products or services by passing them through a se- ries of processes, or steps, in production. Like job order operations, they combine direct materials, direct labor, and overhead in the op- erations. Unlike job order operations that assign the responsibility for each job to a manager, process operations assign the responsibil- ity for each process to a manager.

C2 Define and compute equivalent units and explain their use in process cost accounting. Equivalent units of produc- tion measure the activity of a process as the number of units that would be completed in a period if all effort had been applied to units that were started and finished. This measure of production activity is used to compute the cost per equivalent unit and to as- sign costs to finished goods and goods in process inventory. To compute equivalent units, determine the number of units that would have been finished if all materials (or labor or overhead) had been used to produce units that were started and completed during the period. The costs incurred by a process are divided by its equivalent units to yield cost per unit.

C3 Describe accounting for production activity and prepara-tion of a process cost summary using weighted average. A process cost summary reports on the activities of a production pro- cess or department for a period. It describes the costs charged to the department, the equivalent units of production for the department, and the costs assigned to the output. The report aims to (1) help managers control their departments, (2) help factory managers eval- uate department managers’ performances, and (3) provide cost in- formation for financial statements. A process cost summary includes the physical flow of units, equivalent units of production, costs per equivalent unit, and a cost reconciliation. It reports the units and costs to account for during the period and how they were accounted for during the period. In terms of units, the summary includes the beginning goods in process inventory and the units started during the month. These units are accounted for in terms of the goods com- pleted and transferred out, and the ending goods in process inven- tory. With respect to costs, the summary includes materials, labor, and overhead costs assigned to the process during the period. It shows how these costs are assigned to goods completed and trans- ferred out, and to ending goods in process inventory.

C4 Appendix 16A—Describe accounting for production activ-ity and preparation of a process cost summary using FIFO.

Summary The FIFO method for process costing is applied and illustrated to (1) report the physical flow of units, (2) compute the equivalent units of production, (3) compute the cost per equivalent unit of pro- duction, and (4) assign and rec oncile costs.

A1 Compare process cost accounting and job order cost ac-counting. Process and job order manufacturing operations are similar in that both combine materials, labor, and factory overhead to produce products or services. They differ in the way they are or- ganized and managed. In job order operations, the job order cost ac- counting system assigns materials, labor, and overhead to specific jobs. In process operations, the process cost accounting system as- signs materials, labor, and overhead to specific processes. The total costs associated with each process are then divided by the number of units passing through that process to get cost per equivalent unit. The costs per equivalent unit for all processes are added to deter- mine the total cost per unit of a product or service.

A2 Explain and illustrate a hybrid costing system. A hybrid costing system contains features of both job order and pro- cess costing systems. Generally, certain direct materials are ac- counted for by individual products as in job order costing, but direct labor and overhead costs are accounted for similar to pro- cess costing.

P1 Record the flow of direct materials costs in process cost ac-counting. Materials purchased are debited to a Raw Materials Inventory account. As direct materials are issued to processes, they are separately accumulated in a Goods in Process Inventory account for that process.

P2 Record the flow of direct labor costs in process cost account-ing. Direct labor costs are initially debited to the Factory Payroll account. The total amount in it is then assigned to the Goods in Pro- cess Inventory account pertaining to each process.

P3 Record the flow of factory overhead costs in process cost accounting. The different factory overhead items are first ac- cumulated in the Factory Overhead account and are then allocated, using a predetermined overhead rate, to the different processes. The allocated amount is debited to the Goods in Process Inventory account pertaining to each process.

P4 Record the transfer of completed goods to Finished Goods Inventory and Cost of Goods Sold. As units complete the final process and are eventually sold, their accumulated cost is transferred to Finished Goods Inventory and finally to Cost of Goods Sold.

Cost Manager As cost manager for an electronics manufacturer, you apply a process costing system using FIFO. Your company plans to adopt a just-in-time system and eliminate inventories. What is the impact of the use of FIFO (versus the weighted-average method) given these plans? ■ [Answer—p. 716]

Decision Maker

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716 Chapter 16 Process Costing and Analysis

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 735 mhhe.com/wildFINMAN5e

1. Equivalent units of production are equal to a. Physical units that were completed this period from all ef-

fort being applied to them. b. The number of units introduced into the process this period. c. The number of finished units actually completed this period. d. The number of units that could have been started and com-

pleted given the cost incurred. e. The number of units in the process at the end of the period. 2. Recording the cost of raw materials purchased for use in a

process costing system includes a a. Credit to Raw Materials Inventory. b. Debit to Goods in Process Inventory.

c. Debit to Factory Overhead. d. Credit to Factory Overhead. e. Debit to Raw Materials Inventory.

3. The production department started the month with a beginning goods in process inventory of $20,000. During the month, it was assigned the following costs: direct materials, $152,000; direct labor, $45,000; overhead applied at the rate of 40% of direct labor cost. Inventory with a cost of $218,000 was transferred to fin- ished goods. The ending balance of goods in process inventory is

a. $330,000. d. $112,000. b. $ 17,000. e. $118,000. c. $220,000.

Budget Officer By instructing you to classify a majority of costs as indirect, the manager is passing some of his department’s costs to a common overhead pool that other departments will partially ab- sorb. Since overhead costs are allocated on the basis of direct labor for this company and the new department has a relatively low direct labor cost, the new department will be assigned less overhead. Such action suggests unethical behavior by this manager. You must object to such reclassification. If this manager refuses to comply, you must inform someone in a more senior position.

Entrepreneur By spreading the added quality-related costs across three customers, the entrepreneur is probably trying to remain competitive with respect to the customer that demands the 100%

quality inspection. Moreover, the entrepreneur is partly covering the added costs by recovering two-thirds of them from the other two customers who are paying 110% of total costs. This act likely breaches the trust placed by the two customers in this entrepreneur’s application of its costing system. The costing system should be changed, and the entrepreneur should consider renegotiating the pric- ing and/or quality test agreement with this one customer (at the risk of losing this currently loss-producing customer).

Cost Manager Differences between the FIFO and weighted- average methods are greatest when large work in process inventories exist and when costs fluctuate. The method used if inventories are eliminated does not matter; both produce identical costs.

Guidance Answers to Decision Maker and Decision Ethics

1. c 2. When a company produces large quantities of similar products/

services, a process cost system is often more suitable. 3. b 4. The costs are direct materials, direct labor, and overhead. 5. A goods in process inventory account is needed for each produc-

tion department. 6. a 7. Equivalent units with respect to direct labor are the number of

units that would have been produced if all labor had been used on units that were started and finished during the period.

8.

Guidance Answers to Quick Checks

Units completed and transferred out . . . . . . . . . 58,000 EUP

Units of ending goods in process

Direct labor (6,000 3 1y3) . . . . . . . . . . . . . . . 2,000 EUP Units of production . . . . . . . . . . . . . . . . . . . . . . . 60,000 EUP

9. The first section shows the costs charged to the department. The second section describes the equivalent units produced by the department. The third section shows the assignment of total costs to units worked on during the period.

Conversion costs per equivalent unit (p. 707)

Cost of goods manufactured (p. 705)

Equivalent units of production (EUP) (p. 699)

FIFO method (p. 711)

Job order cost accounting system (p. 695)

Materials consumption report (p. 696)

Process cost accounting system (p. 695)

Process cost summary (p. 704)

Process operations (p. 692)

Weighted-average method (p. 702)

Key Terms

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Chapter 16 Process Costing and Analysis 717

4. A company’s beginning work in process inventory consists of 10,000 units that are 20% complete with respect to direct labor costs. A total of 40,000 units are completed this period. There are 15,000 units in goods in process, one-third complete for direct labor, at period-end. The equivalent units of production (EUP) with respect to direct labor at period-end, assuming the weighted-average method, are

a. 45,000 EUP. b. 40,000 EUP. c. 5,000 EUP. d. 37,000 EUP. e. 43,000 EUP.

5. Assume the same information as in question 4. Also assume that beginning work in process had $6,000 in direct labor cost and that $84,000 in direct labor is added during this period. What is the cost per EUP for labor?

a. $0.50 per EUP b. $1.87 per EUP c. $2.00 per EUP d. $2.10 per EUP e. $2.25 per EUP

For each of the following products and services, indicate whether it is most likely produced in a process operation or in a job order operation. 1. Tennis courts 3. Vanilla ice cream

2. Apple juice 4. Luxury cars

QUICK STUDY

QS 16-1 Process vs. job order operations

C1

Icon denotes assignments that involve decision making.

1. What is the main factor for a company in choosing be- tween the job order costing and process costing accounting systems? Give two likely applications of each system.

2. The focus in a job order costing system is the job or batch. Identify the main focus in process costing.

3. Can services be delivered by means of process operations? Support your answer with an example.

4. Are the journal entries that match cost flows to product flows in process costing primarily the same or much different than those in job order costing? Explain.

5. Identify the control document for materials flow when a mate- rials requisition slip is not used.

6. Explain in simple terms the notion of equivalent units of production (EUP). Why is it necessary to use EUP in process costing?

7. What are the two main inventory methods used in process costing? What are the differences between these methods?

8. Why is it possible for direct labor in process operations to include the labor of employees who do not work directly on products or services?

9. Assume that a company produces a single product by pro- cessing it first through a single production department. Direct

labor costs flow through what accounts in this company’s process cost system?

10. After all labor costs for a period are allocated, what balance should remain in the Factory Payroll account?

11. Is it possible to have under- or overapplied overhead costs in a process cost accounting system? Explain.

12. Explain why equivalent units of production for both direct labor and overhead can be the same as, and why they can be different from, equivalent units for direct materials.

13. Companies such as Piaggio apply process op- erations. List the four steps in accounting for production activity in a reporting period (for process operations).

14. Companies such as KTM commonly prepare a pro- cess cost summary. What purposes does a process cost summary serve?

15. Are there situations where Polaris can use process costing? Identify at least one and explain it.

16. Arctic Cat produces snowmobiles with a multiple process production line. Identify and list some of its production processing steps and departments.

Discussion Questions

QS 16-2 Recording costs of direct materials P1

Blanche’s Boxes makes cardboard shipping cartons in a single operation. This period, Blanche purchased $62,000 in raw materials. Its production department requisitioned $50,000 of those materials for use in producing cartons. Prepare journal entries to record its (1) purchase of raw materials and (2) requisition of direct materials.

Polaris

PIAGGIO

KTM

Arctic Cat

A Superscript letter A denotes assignments based on Appendix 16A

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718 Chapter 16 Process Costing and Analysis

QS 16-4 Recording costs of factory overhead

P3

Refer to the information in QS 16-2 and QS 16-3. Blanche’s Boxes requisitioned $9,000 of indirect mate- rials from its raw materials and used $10,000 of indirect labor in its production of boxes. Also, it incurred $156,000 of other factory overhead costs. It applies factory overhead at the rate of 140% of direct labor costs. Prepare journal entries to record its (1) indirect materials requisitioned, (2) indirect labor used in production, (3) other factory overhead costs incurred, and (4) application of overhead to production.

QS 16-5 Recording transfer of costs to finished goods P4

Refer to the information in QS 16-2, QS 16-3, and QS 16-4. Blanche’s Boxes completed 20,000 boxes costing $275,000 and transferred them to finished goods. Prepare its journal entry to record the transfer of the boxes from production to finished goods inventory.

QS 16-7 Computing EUP cost C2

The cost of beginning inventory plus the costs added during the period should equal the cost of units _____________________ plus the cost of _____________________.

QS 16-8 Hybrid costing A2

Explain how a car maintenance and repair garage might use a hybrid costing system.

QS 16-9A

FIFO: Computing equivalent units C4

Refer to QS 16-6 and compute the total equivalent units of production with respect to labor for March using the FIFO inventory method.

QS 16-10 Steps in process costing

C3

Put the four steps in accounting for production activities in the order in which they would occur. a. Determine physical flow of units b. Compute the cost per equivalent unit c. Compute equivalent units of production d. Assign and reconcile costs

QS 16-11 Process cost summary C3

List the headings of the three major sections of a process cost summary. Refer to Exhibit 16.17.

QS 16-6 Weighted average: Computing equivalent units of production

C2

The following refers to units processed in Sunfllower Printing’s binding department in March. Compute the total equivalent units of production with respect to labor for March using the weighted-average inventory method.

Units of Percent of

Product Labor Added

Beginning goods in process . . . . . . . . . . . . 150,000 80%

Goods started . . . . . . . . . . . . . . . . . . . . . . 310,000 100

Goods completed . . . . . . . . . . . . . . . . . . . 340,000 100

Ending goods in process . . . . . . . . . . . . . . 120,000 25

Anheuser-Busch InBev is attempting to reduce its water usage. How could a company manager use a process cost summary to determine if the program to reduce water usage is successful?

QS 16-12 Process cost summary C3

QS 16-3 Recording costs of direct labor

P2

Refer to the information in QS 16-2. Blanche’s Boxes incurred $135,000 in factory payroll costs, of which $125,000 was direct labor. Prepare journal entries to record its (1) total factory payroll incurred and (2) direct labor used in production.

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Chapter 16 Process Costing and Analysis 719

QS 16-13 Process vs. job order costing

A1

Label each statement below as either true (“T”) or false (“F”). 1. The cost per equivalent unit is computed as the total costs of a process divided by the number of

equivalent units passing through that process. 2. Service companies are not able to use process costing. 3. Costs per job are computed in both job order and process costing systems. 4. Job order and process operations both combine materials, labor, and overhead in producing products

or services.

QS 16-15A

FIFO: Computing equivalent units C4

Refer to QS 16-14 and compute the total equivalent units of production with respect to labor for July using the FIFO inventory method.

Match each of the following items A through G with the best numbered description of its purpose. A. Factory Overhead account E. Raw Materials Inventory account B. Process cost summary F. Materials requisition C. Equivalent units of production G. Finished Goods Inventory account D. Goods in Process Inventory account _______ 1. Notifies the materials manager to send materials to a production department. _______ 2. Holds costs of indirect materials, indirect labor, and similar costs until assigned to production.

_______ 3. Holds costs of direct materials, direct labor, and applied overhead until products are transferred from production to finished goods (or another department). _______ 4. Standardizes partially completed units into equivalent completed units. _______ 5. Holds costs of finished products until sold to customers. _______ 6. Describes the activity and output of a production department for a period. _______ 7. Holds costs of materials until they are used in production or as factory overhead.

EXERCISES

Exercise 16-1 Terminology in process cost accounting

C1 A1 P1 P2 P3

Exercise 16-2 Recording costs of materials

P1

Prepare journal entries to record the following production activities. 1. Purchased $80,000 of raw materials on credit. 2. Used $42,000 of direct materials in production. 3. Used $22,500 of indirect materials.

Exercise 16-3 Recording costs of labor

P2

Prepare journal entries to record the following production activities. 1. Incurred total labor cost of $95,000, which is paid in cash. 2. Used $75,000 of direct labor in production. 3. Used $20,000 of indirect labor.

Exercise 16-4 Recording overhead costs

P3

Refer to information in Exercise 16-3. Prepare journal entries to record the following production activities. 1. Paid overhead costs (other than indirect materials and indirect labor) of $38,750. 2. Applied overhead at 110% of direct labor costs.

QS 16-14 Weighted average: Computing equivalent units of production

C2

The following refers to units processed by an ice cream maker in July. Compute the total equivalent units of production with respect to labor for July using the weighted-average inventory method.

Gallons of Percent of

Product Labor Added

Beginning goods in process . . . . . . . . . . . . 320,000 25%

Goods started . . . . . . . . . . . . . . . . . . . . . . 620,000 100

Goods completed . . . . . . . . . . . . . . . . . . . 680,000 100

Ending goods in process . . . . . . . . . . . . . . 240,000 75

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720 Chapter 16 Process Costing and Analysis

Exercise 16-7 Interpretation of journal entries in process cost accounting

P1 P2 P3 P4

The following journal entries are recorded in Kiesha Co.’s process cost accounting system. Kiesha produces apparel and accessories. Overhead is applied to production based on direct labor cost for the period. Prepare a brief explanation (including any overhead rates applied) for each journal entry a through j.

a. Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . 52,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . 52,000

b. Goods in Process Inventory . . . . . . . . . . . . . . . . . 42,000

Raw Materials Inventory . . . . . . . . . . . . . . . . 42,000

c. Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

d. Goods in Process Inventory . . . . . . . . . . . . . . . . . 32,000

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . 32,000

e. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

f. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Raw Materials Inventory . . . . . . . . . . . . . . . . 10,000

g. Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . 6,000

h. Goods in Process Inventory . . . . . . . . . . . . . . . . . 33,600

Factory Overhead . . . . . . . . . . . . . . . . . . . . . 33,600

i. Finished Goods Inventory . . . . . . . . . . . . . . . . . . 88,000

Goods in Process Inventory . . . . . . . . . . . . . 88,000

j. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . 250,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . 100,000

Finished Goods Inventory . . . . . . . . . . . . . . 100,000

During April, the production department of a process manufacturing system completed a number of units of a product and transferred them to finished goods. Of these transferred units, 60,000 were in process in the production department at the beginning of April and 240,000 were started and completed in April. April’s beginning inventory units were 60% complete with respect to materials and 40% complete with respect to labor. At the end of April, 82,000 additional units were in process in the production department and were 80% complete with respect to materials and 30% complete with respect to labor. 1. Compute the number of units transferred to finished goods. 2. Compute the number of equivalent units with respect to both materials used and labor used in the

production department for April using the weighted-average method.

Exercise 16-8 Weighted average: Computing equivalent units of production

C2

Check (2) EUP for materials, 365,600

The production department described in Exercise 16-8 had $850,000 of direct materials and $650,000 of direct labor cost charged to it during April. Also, its beginning inventory included $118,840 of direct materials cost and $47,890 of direct labor. 1. Compute the direct materials cost and the direct labor cost per equivalent unit for the department. 2. Using the weighted-average method, assign April’s costs to the department’s output—specifically, its

units transferred to finished goods and its ending goods in process inventory.

Exercise 16-9 Weighted average: Costs assigned to output and inventories

C2 P4

Check (1) $2.65 per EUP of direct materials

Exercise 16-6 Recording cost flows in a process cost system

P1 P2 P3 P4

Laffer Lumber produces bagged bark for use in landscaping. Production involves packaging bark chips in plastic bags in a bagging department. The following information describes production operations for October.

Direct materials used Direct labor used Predetermined overhead rate (based on direct labor) Goods transferred from bagging to finished goods

Bagging

Department

175% $(595,000)

$ 130,000 $ 522,000

The company’s revenue for the month totaled $950,000 from credit sales, and its cost of goods sold for the month is $540,000. Prepare summary journal entries dated October 31 to record its October production activities for (1) direct material usage, (2) direct labor usage, (3) overhead allocation, (4) goods transfer from production to finished goods, and (5) credit sales.

Check (3) Cr. Factory Overhead, $227,500

Exercise 16-5 Recording cost of completed goods P4

Prepare journal entries to record the following production activities. 1. Transferred completed products with a cost of $135,600 to finished goods inventory. 2. Sold $315,000 of products on credit. Their cost is $175,000.

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Chapter 16 Process Costing and Analysis 721

Exercise 16-10A

FIFO: Computing equivalent units of production C4

Refer to the information in Exercise 16-8 to compute the number of equivalent units with respect to both materials used and labor used in the production department for April using the FIFO method.

Exercise 16-11A

FIFO: Costs assigned to output

C4 P4

Refer to the information in Exercise 16-9 and complete its parts (1) and (2) using the FIFO method. (Round cost per equivalent unit to two decimal places.)

The production department in a process manufacturing system completed 80,000 units of product and transferred them to finished goods during a recent period. Of these units, 24,000 were in process at the beginning of the period. The other 56,000 units were started and completed during the period. At period- end, 16,000 units were in process. Compute the department’s equivalent units of production with respect to direct materials under each of three separate assumptions: 1. All direct materials are added to products when processing begins. 2. Direct materials are added to products evenly throughout the process. Beginning goods in process in-

ventory was 50% complete, and ending goods in process inventory was 75% complete. 3. One-half of direct materials is added to products when the process begins and the other half is

added when the process is 75% complete as to direct labor. Beginning goods in process inventory is 40% complete as to direct labor, and ending goods in process inventory is 60% complete as to direct labor.

Exercise 16-12 Weighted average: Equivalent units computed

C2

Check (3) EUP for materials, 88,000

Exercise 16-13A

FIFO: Equivalent units computed C4

Refer to the information in Exercise 16-12 and complete it for each of the three separate assumptions using the FIFO method for process costing.

Check (3) EUP for materials, 76,000

Exercise 16-14 Flowchart of costs for a process operation P1 P2 P3 P4

The following flowchart shows the August production activity of the Spalding Company. Use the amounts shown on the flowchart to compute the missing four numbers identified by blanks.

Beginning goods

in process

$17,250

Production Direct

labor

$47,250

Factory

overhead

$51,300

Ending goods

in process

$6,000

Warehouse Ending finished

goods inventory

$22,500

Cost of

goods sold

$231,900

Beginning finished

goods inventory

$18,000

Direct

materials

__________(1)

Total costs in process in

production department

__________(2)

Costs transferred

to finished goods

__________(3)

Cost of goods

available for sale

__________(4)

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722 Chapter 16 Process Costing and Analysis

For each of the following products and services, indicate whether it is most likely produced in a process operation or in a job order operation. 1. Beach towels 5. Designed patio 9. Concrete swimming pools 2. Bolts and nuts 6. Door hardware 10. Custom tailored dresses 3. Lawn chairs 7. Cut flower arrangements 11. Grand pianos 4. Headphones 8. House paints 12. Table lamps

Exercise 16-17 Matching of product to cost accounting system

C1

Label each item a through h below as a feature of either a job order or process operation. a. Heterogeneous products and services e. Focus on individual batch b. Custom orders f. Low product standardization c. Low production volume g. Low product flexibility d. Routine, repetitive procedures h. Focus on standardized units

Exercise 16-18 Compare process and job order operations

C1

Exercise 16-19 Hybrid costing system A2

Explain a hybrid costing system. Identify a product or service operation that might well fit a hybrid costing system.

Direct Direct Factory

Equivalent Units of Production Materials Labor Overhead

Units transferred out . . . . . . . . . . . . . . . . . . . . . 32,000 32,000 32,000

Units of ending goods in process . . . . . . . . . . . . 2,500 1,500 1,500

Equivalent units of production . . . . . . . . . . . . . . 34,500 33,500 33,500

Direct Direct Factory

Costs per EUP Materials Labor Overhead

Costs of beginning goods in process . . . . . . . . . $ 18,550 $ 760 $ 1,520

Costs incurred this period . . . . . . . . . . . . . . . . . 357,500 62,890 125,780

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $376,050 $63,650 $127,300

Units in beginning goods in process (all completed during July) . . . . . . . . . . . . . 2,000

Units started this period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,500

Units completed and transferred out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000

Units in ending goods in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Exercise 16-15 Weighted average: Completing a process cost summary

C3

The following partially completed process cost summary describes the July production activities of Ashad Company. Its production output is sent to its warehouse for shipping. All direct materials are added to products when processing begins. Beginning goods in process inventory is 20% complete with respect to direct labor and overhead. Prepare its process cost summary using the weighted-average method.

Exercise 16-16A

FIFO: Completing a process cost summary C3 C4

Refer to the information in Exercise 16-15. Prepare a process cost summary using the FIFO method. (Round cost per equivalent unit calculations to two decimal places.)

Exercise 16-20 Weighted average: Equivalent units computed

C2

ProChem manufactures aspirin in a process operation. Details on production activity follow. Compute the department’s equivalent units of production with respect to direct materials under each of two separate assumptions.

Beginning goods in process . . . . . . . . . 31,500

Goods started . . . . . . . . . . . . . . . . . . . 189,500

Goods completed . . . . . . . . . . . . . . . . 191,500

1. All direct materials are added to products when processing begins. 2. One-half of direct materials is added to products when the process begins and the other half is added

when the process is 75% complete as to direct labor. Beginning goods in process is 20% complete as to direct labor, and ending goods in process inventory is 45% complete as to direct labor.

Check (2) EUP for materials, 206,250

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Chapter 16 Process Costing and Analysis 723

Required

Fill in the blanks labeled a through uu in the following process cost summary.

Exercise 16-22 Weighted average: Process cost summary C3

Hi-Test Company uses the weighted-average method of process costing to assign production costs to its products. Information for September follows. Assume that all materials are added at the beginning of its production process, and that direct labor and factory overhead are added uniformly throughout the process.

Goods in process inventory, September 1 (2,000 units, 100% complete with respect to direct materials, 80% complete with respect to direct labor and overhead; includes $45,000 of direct material cost, $25,600 in direct labor cost, $30,720 overhead cost) . . . . . . . . . . . . $101,320

Units started in April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

Units completed and transferred to finished goods inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000

Goods in process inventory, September 30 ( ____? units, 100% complete with respect to direct materials, 40% complete with respect to direct labor and overhead) . . . . . . . . . . . . . . . . . . . . . . . . . ?

Costs incurred in September

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $155,000

Overhead applied at 120% of direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?

Exercise 16-21A

FIFO: Equivalent units computed C4

Refer to the information in Exercise 16-20 and complete it for each of the two separate assumptions using the FIFO method for process costing.

Check (2) EUP for materials, 190,500

Check (c) $817,320

HI-TEST COMPANY

Process Cost Summary

For Month Ended September 30

Costs Charged to Production

Costs of beginning goods in process

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 45,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,600

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,720 $101,320

Costs incurred this period

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,000

Factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (a) (b)

Total costs to account for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (c)

Unit Cost Information

Units to account for Units accounted for

Beginning goods in process . . . . . . . . . 2,000 Completed and transferred out . . . . . . . . . 23,000

Units started this period . . . . . . . . . . 28,000 Ending goods in process . . . . . . . . . . . . . . . (d)

Total units to account for . . . . . . . . . . (e) Total units accounted for . . . . . . . . . . . . . . (f )

Direct Direct Factory

Equivalent Units of Production (EUP) Materials Labor Overhead

Units completed and transferred out . . . . . . . . . . . . . . . . . . . (g) EUP (h) EUP (i) EUP

Units of ending goods in process

Materials (j) 3 100% (k) EUP

Direct labor (l) 3 40% (m) EUP

Factory overhead (n) 3 40% (o) EUP

Equivalent units of production (EUP) . . . . . . . . . . . . . . . . . . . (p) EUP (q) EUP (r) EUP

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724 Chapter 16 Process Costing and Analysis

PROBLEM SET A

Problem 16-1A Production cost flow and measurement; journal entries

P1 P2 P3 P4

Sierra Company manufactures woven blankets and accounts for product costs using process costing. The following information is available regarding its May inventories.

Beginning Ending

Inventory Inventory

Raw materials inventory . . . . . . . . . . . . $ 60,000 $ 92,500

Goods in process inventory . . . . . . . . . 435,000 515,000

Finished goods inventory . . . . . . . . . . . 633,000 605,000

Raw materials purchases (on credit) . . . . . . . . . . . . . . . . . . . $ 250,000

Factory payroll cost (paid in cash) . . . . . . . . . . . . . . . . . . . . . 1,530,000

Other overhead cost (Other Accounts credited) . . . . . . . . . 87,000

Materials used

Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 157,500

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Labor used

Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 780,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000

Overhead rate as a percent of direct labor . . . . . . . . . . . . . . 115%

Sales (on credit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500,000

The following additional information describes the company’s production activities for May.

Required

1. Compute the cost of (a) products transferred from production to finished goods, and (b) goods sold. 2. Prepare summary journal entries dated May 31 to record the following production activities during

May: (a) raw materials purchases, (b) direct materials usage, (c) indirect materials usage, (d) payroll costs, (e) direct labor costs, (f) indirect labor costs, (g) other overhead costs, (h) overhead applied, (i) goods transferred from production to finished goods, and (j) sale of finished goods.

Check (1b) Cost of goods sold $1,782,500

Check (z) $8.40 per EUP

Direct Direct Factory

Cost per EUP Materials Labor Overhead

Costs of beginning goods in process . . . . . . . . . . . . . . . . . . . $ 45,000 $ 25,600 $30,720

Costs incurred this period . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000 155,000 (s)

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $420,000 $180,600 (t)

4 EUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (u) (v) (w)

Cost per EUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (x) (y) (z)

Cost Assignment and Reconciliation

Costs transferred out Cost/EUP 3 EUP

Direct materials (aa) 3 (bb) (cc)

Direct labor (dd) 3 (ee) (ff)

Factory overhead (gg) 3 (hh) (ii)

Costs of goods completed and transferred out . . . . . . . . . (jj)

Costs of ending goods in process

Direct materials (kk) 3 (ll) (mm)

Direct labor (nn) 3 (oo) (pp)

Factory overhead (qq) 3 (rr) (ss)

Costs of ending goods in process . . . . . . . . . . . . . . . . . . . (tt)

Total costs accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . (uu)

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Chapter 16 Process Costing and Analysis 725

Victory Company uses weighted-average process costing to account for its production costs. Direct labor is added evenly throughout the process. Direct materials are added at the beginning of the process. During November, the company transferred 700,000 units of product to finished goods. At the end of November, the goods in process inventory consists of 180,000 units that are 30% complete with respect to labor. Beginning inventory had $420,000 of direct materials and $139,000 of direct labor cost. The direct material cost added in November is $2,220,000, and the direct labor cost added is $3,254,000.

Required

1. Determine the equivalent units of production with respect to (a) direct labor and (b) direct materials. 2. Compute both the direct labor cost and the direct materials cost per equivalent unit. 3. Compute both direct labor cost and direct materials cost assigned to (a) units completed and trans-

ferred out, and (b) ending goods in process inventory.

Analysis Component

4. The company sells and ships all units to customers as soon as they are completed. Assume that an error is made in determining the percentage of completion for units in ending inventory. Instead of being 30% complete with respect to labor, they are actually 60% complete. Write a one-page memo to the plant manager describing how this error affects its November financial statements.

Beginning goods in process consisted of 60,000 units that were 100% complete with respect to direct materials and 80% complete with respect to direct labor. Of the 700,000 units completed, 60,000 were from beginning goods in process and 640,000 units were started and completed during the period.

Elliott Company produces large quantities of a standardized product. The following information is avail- able for its production activities for March.

Problem 16-3A Weighted average: Journalizing in process costing; equivalent units and costs

C2 P1 P2 P3

Additional information about units and costs of production activities follows.

Raw materials

Beginning inventory . . . . . . . . . . . . . . . . . $ 16,000

Raw materials purchased (on credit) . . . . 250,000

Direct materials used . . . . . . . . . . . . . . . . (168,000)

Indirect materials used . . . . . . . . . . . . . . . (70,000)

Ending inventory . . . . . . . . . . . . . . . . . . . . $ 28,000

Factory payroll

Direct labor used . . . . . . . . . . . . . . . . . . . $199,850

Indirect labor used . . . . . . . . . . . . . . . . . . 45,000

Total payroll cost (paid in cash) . . . . . . . . $244,850

Factory overhead incurred

Indirect materials used . . . . . . . . . . . $ 70,000

Indirect labor used . . . . . . . . . . . . . . 45,000

Other overhead costs . . . . . . . . . . . . 164,790

Total factory overhead incurred . . . . $279,790

Factory overhead applied

(140% of direct labor cost)

Total factory overhead applied . . . . . $279,790

During March, 10,000 units of finished goods are sold for $120 cash each. Cost information regarding finished goods follows.

Beginning finished goods inventory . . . . . . . . . $150,000

Cost transferred in . . . . . . . . . . . . . . . . . . . . . 572,390

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . (592,390)

Ending finished goods inventory . . . . . . . . . . . $130,000

mhhe.com/wildFINMAN5e

Problem 16-2A Weighted average: Cost per equivalent unit; costs assigned to products

C2 C3

Check (2) Direct labor cost per equivalent unit, $4.50

(3b) $783,000

Units Costs

Beginning goods in process inventory . . . . . . . . . . 2,000 Beginning goods in process inventory

Started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Direct materials . . . . . . . . . . . . . . . . . . . . $2,500

Ending goods in process inventory . . . . . . . . . . . 5,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 2,650

Factory overhead . . . . . . . . . . . . . . . . . . . 3,710 $ 8,860 Status of ending goods in process inventory Direct materials added . . . . . . . . . . . . . . . . 168,000

Materials—Percent complete . . . . . . . . . . . . . 100% Direct labor added . . . . . . . . . . . . . . . . . . . 199,850

Labor and overhead—Percent complete . . . . . 35% Overhead applied (140% of direct labor) . . . 279,790

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . $656,500

Ending goods in process inventory . . . . . . . $ 84,110

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726 Chapter 16 Process Costing and Analysis

mhhe.com/wildFINMAN5e

Problem 16-4A Weighted Average: Process cost summary; equivalent units

C2 C3 P4

Fast Co. produces its product through a single processing department. Direct materials are added at the start of production, and direct labor and overhead are added evenly throughout the process. The company uses monthly reporting periods for its weighted-average process cost accounting system. Its Goods in Process Inventory account follows after entries for direct materials, direct labor, and overhead costs for October.

Its beginning goods in process consisted of $59,450 of direct materials, $172,800 of direct labor, and $103,680 of factory overhead. During October, the company started 140,000 units and transferred 150,000 units to finished goods. At the end of the month, the goods in process inventory consisted of 20,000 units that were 80% complete with respect to direct labor and factory overhead.

Required

1. Prepare the company’s process cost summary for October using the weighted-average method. 2. Prepare the journal entry dated October 31 to transfer the cost of the completed units to finished goods

inventory.

Check (1) Costs transferred out to finished goods, $982,500

Goods in Process Inventory Acct. No. 133

Date Explanation Debit Credit Balance

Oct. 1 Balance 335,930

31 Direct materials 102,050 437,980

31 Direct labor 408,200 846,180

31 Applied overhead 244,920 1,091,100

Goods in Process Inventory Acct. No. 133

Date Explanation Debit Credit Balance

May 1 Balance 241,740

31 Direct materials 496,800 738,540

31 Direct labor 1,203,300 1,941,840

31 Applied overhead 962,640 2,904,480

Problem 16-5A Weighted average: Process cost summary, equivalent units, cost estimates

C2 C3 P4

Tamar Co. manufactures a single product in one department. All direct materials are added at the beginning of the manufacturing process. Direct labor and overhead are added evenly throughout the process. The company uses monthly reporting periods for its weighted-average process cost accounting. During May, the company completed and transferred 22,200 units of product to finished goods inventory. Its 3,000 units of beginning goods in process consisted of $19,800 of direct materials, $123,300 of direct labor, and $98,640 of factory overhead. It has 2,400 units (100% complete with respect to direct materials and 80% complete with respect to direct labor and overhead) in process at month-end. After entries to record direct materials, direct labor, and overhead for May, the company’s Goods in Process Inventory account follows.

Required

1. Prepare journal entries dated March 31 to record the following March activities: (a) purchase of raw materials, (b) direct materials usage, (c) indirect materials usage, (d) factory payroll costs, (e) direct labor costs used in production, (f ) indirect labor costs, (g) other overhead costs—credit Other Ac- counts, (h) overhead applied, (i) goods transferred to finished goods, and ( j) sale of finished goods.

2. Prepare a process cost summary report for this company, showing costs charged to production, units cost information, equivalent units of production, cost per EUP, and its cost assignment and reconciliation.

Analysis Component

3. The company provides incentives to its department managers by paying monthly bonuses based on their success in controlling costs per equivalent unit of production. Assume that the production depart- ment underestimates the percentage of completion for units in ending inventory with the result that its equivalent units of production in ending inventory for March are understated. What impact does this error have on the March bonuses paid to the production managers? What impact, if any, does this error have on April bonuses?

Check (2) Cost per equivalent unit: materials, $7.75; labor, $10.80; overhead, $15.12

Required

1. Prepare the company’s process cost summary for May using the weighted-average method. 2. Prepare the journal entry dated May 31 to transfer the cost of completed units to finished goods inventory.

Check (1) EUP for both labor and overhead, 24,120 EUP

(2) Cost transferred out to finished goods, $2,664,000

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Chapter 16 Process Costing and Analysis 727

Analysis Components

3. The cost accounting process depends on numerous estimates. a. Identify two major estimates that determine the cost per equivalent unit. b. In what direction might you anticipate a bias from management for each estimate in part 3a (as-

sume that management compensation is based on maintaining low inventory amounts)? Explain your answer.

Refer to the data in Problem 16-5A. Assume that Tamar uses the FIFO method to account for its process costing system. The following additional information is available:

● Beginning goods in process consisted of 3,000 units that were 100% complete with respect to direct materials and 40% complete with respect to direct labor and overhead.

● Of the 22,200 units completed, 3,000 were from beginning goods in process. The remaining 19,200 were units started and completed during May.

Required

1. Prepare the company’s process cost summary for May using FIFO. 2. Prepare the journal entry dated May 31 to transfer the cost of completed units to finished goods inventory.

Problem 16-6AA

FIFO: Process cost summary; equivalent units; cost estimates

C3 C4 P4

Check (1) EUP for both labor and overhead, 22,920 EUP

(2) Cost transferred out to finished goods, $2,667,840

During May, the production department of a process manufacturing system completed a number of units of a product and transferred them to finished goods. Of these transferred units, 37,500 were in process in the production department at the beginning of May and 150,000 were started and completed in May. May’s beginning inventory units were 60% complete with respect to materials and 40% complete with respect to labor. At the end of May, 51,250 additional units were in process in the production department and were 60% complete with respect to materials and 20% complete with respect to labor. The production department had $505,035 of direct materials and $396,568 of direct labor cost charged to it during May. Its beginning inventory included $74,075 of direct materials cost and $28,493 of direct labor cost. 1. Compute the number of units transferred to finished goods. 2. Compute the number of equivalent units with respect to both materials used and labor used in the

production department for May using the FIFO method. 3. Compute the direct materials cost and the direct labor cost per equivalent unit for the department. 4. Using the FIFO method, assign May’s costs to the units transferred to finished goods and assign costs

to its ending goods in process inventory.

Problem 16-7A FIFO: Costs per equivalent unit; costs assigned to products

C2 C4

Check (2) EUP for materials, 195,750

Refer to the information in Problem 16-2A and complete its parts (1) through (4) using the FIFO method of process costing. Round cost per equivalent unit calculations to two decimal places.

Problem 16-8AA

FIFO: Cost per equivalent unit; costs assigned to products

C2 C3 C4 Check (2) $4.61 direct labor cost

per EUP; $2.71 direct materials cost per EUP

Dengo Co. manufactures a single product in one department. Direct labor and overhead are added evenly throughout the process, while direct materials are added at the beginning of the process. The company uses the FIFO method of process costing. During October, the company completed and transferred 22,200 units to finished goods inventory. Of the units completed, 3,000 were from beginning inventory and the remaining 19,200 were started and completed during the month. Beginning goods in process were 100% complete with respect to direct materials and 40% complete with respect to direct labor and overhead. The company has 2,400 units (100% complete with respect to direct materials and 80% complete with respect to direct labor and overhead) in process at month-end. Information on costs of beginning inventory and costs added during the month follows.

Problem 16-9AA

FIFO: Process cost summary, equivalent units, cost estimates

C2 C3 C4 P4

Cost Raw Materials Direct Labor Overhead

Of beginning inventory . . . . . . . . . . $ 9,900 $ 61,650 $ 49,320

Added during the month . . . . . . . . . 248,400 601,650 481,320

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728 Chapter 16 Process Costing and Analysis

Required

1. Prepare the company’s process cost summary for October using the FIFO method. 2. Prepare the journal entry dated October 31 to transfer the cost of completed units to finished good

inventory.

Analysis Component

3. The company provides incentives to department managers by paying monthly bonuses based on their success in controlling costs per equivalent unit of production. Assume that the production department underestimates the percentage of completion for units in ending inventory with the result that its equivalent units of production for October are understated. What impact does this error have on the October bonuses paid to the production managers? What impact, if any, does this error have on November bonuses?

Check (1) EUP for both labor and overhead, 22,920 EUP

(2) Cost transferred out to finished goods, $1,333,920

Dream Toys Company manufactures video game consoles and accounts for product costs using process costing. The following information is available regarding its June inventories.

PROBLEM SET B

Problem 16-1B Production cost flow and measurement; journal entries

P1 P2 P3 P4

Beginning Ending

Inventory Inventory

Raw materials inventory . . . . . . . . . . . . $ 72,000 $110,000

Goods in process inventory . . . . . . . . . 156,000 250,000

Finished goods inventory . . . . . . . . . . . . 160,000 198,000

Raw materials purchases (on credit) . . . . . . . . . . . . . . . . . . . $200,000

Factory payroll cost (paid in cash) . . . . . . . . . . . . . . . . . . . . . 400,000

Other overhead cost (Other Accounts credited) . . . . . . . . . 170,500

Materials used

Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000

Labor used

Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Overhead rate as a percent of direct labor . . . . . . . . . . . . . . 75%

Sales (on credit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

The following additional information describes the company’s production activities for June.

Required

1. Compute the cost of (a) products transferred from production to finished goods, and (b) goods sold. 2. Prepare journal entries dated June 30 to record the following production activities during June: (a) raw

materials purchases, (b) direct materials usage, (c) indirect materials usage, (d) payroll costs, (e) direct labor costs, (f ) indirect labor costs, (g) other overhead costs, (h) overhead applied, (i) goods trans- ferred from production to finished goods, and ( j) sale of finished goods.

Check (1b) Cost of goods sold, $600,500

Abraham Company uses process costing to account for its production costs. Direct labor is added evenly throughout the process. Direct materials are added at the beginning of the process. During September, the production department transferred 80,000 units of product to finished goods. Beginning goods in process consisted of 2,000 units that were 100% complete with respect to direct materials and 85% complete with respect to direct labor. Of the 40,000 units completed, 2,000 were from beginning goods in process and 78,000 units were started and completed during the period. Beginning goods in process had $58,000 of direct materials and $86,400 of direct labor cost. At the end of September, the goods in process inventory consists of 8,000 units that are 25% complete with respect to labor. The direct materials cost added in September is $712,000, and direct labor cost added is $1,980,000.

Problem 16-2B Weighted average: Cost per equivalent unit; costs assigned to products

C2 C3

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Chapter 16 Process Costing and Analysis 729

Required

1. Determine the equivalent units of production with respect to (a) direct labor and (b) direct materials. 2. Compute both the direct labor cost and the direct materials cost per equivalent unit. 3. Compute both direct labor cost and direct materials cost assigned to (a) units completed and trans-

ferred out, and (b) ending goods in process inventory.

Analysis Component

4. The company sells and ships all units to customers as soon as they are completed. Assume that an er- ror is made in determining the percentage of completion for units in ending inventory. Instead of being 25% complete with respect to labor, they are actually 75% complete. Write a one-page memo to the plant manager describing how this error affects its September financial statements.

Check (2) Direct labor cost per equivalent unit, $25.20

(3b) $120,400

Oslo Company produces large quantities of a standardized product. The following information is available for its production activities for May.

Raw materials

Beginning inventory . . . . . . . . . . . . . . . . . . $ 32,000

Raw materials purchased (on credit) . . . . 221,120

Direct materials used . . . . . . . . . . . . . . . . (197,120)

Indirect materials used . . . . . . . . . . . . . . . (40,560)

Ending inventory . . . . . . . . . . . . . . . . . . . . $ 15,440

Factory payroll

Direct labor used . . . . . . . . . . . . . . . . . . . $123,680

Indirect labor used . . . . . . . . . . . . . . . . . . 36,320

Total payroll cost (paid in cash) . . . . . . . . $160,000

Factory overhead incurred

Indirect materials used . . . . . . . . . . . $ 40,560

Indirect labor used . . . . . . . . . . . . . . 36,320

Other overhead costs . . . . . . . . . . . . 34,432

Total factory overhead incurred . . . . $111,312

Factory overhead applied

(90% of direct labor cost)

Total factory overhead applied . . . . . $111,312

Units Costs

Beginning goods in process inventory . . . . . . . . . . 4,000 Beginning goods in process inventory

Started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 Direct materials . . . . . . . . . . . . . . . . . . . $2,880

Ending goods in process inventory . . . . . . . . . . . . 3,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . 2,820

Factory overhead . . . . . . . . . . . . . . . . . . 2,538 $ 8,238

Status of ending goods in process inventory Direct materials added . . . . . . . . . . . . . . . . 197,120

Materials—Percent complete . . . . . . . . . . . . . . 100% Direct labor added . . . . . . . . . . . . . . . . . . . 123,680

Labor and overhead—Percent complete . . . . . 25% Overhead applied (90% of direct labor) . . . 111,312

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . $440,350

Ending goods in process inventory . . . . . . $ 50,610

Beginning finished goods inventory . . . . . . . . . . . $148,400

Cost transferred in from production . . . . . . . . . 389,740

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . (474,540)

Ending finished goods inventory . . . . . . . . . . . . . $ 63,600

Additional information about units and costs of production activities follows.

During May, 10,000 units of finished goods are sold for $120 cash each. Cost information regarding fin- ished goods follows.

Required

1. Prepare journal entries dated May 31 to record the following May activities: (a) purchase of raw ma- terials, (b) direct materials usage, (c) indirect materials usage, (d) factory payroll costs, (e) direct labor costs used in production, (f ) indirect labor costs, (g) other overhead costs—credit Other Accounts, (h) overhead applied, (i) goods transferred to finished goods, and ( j) sale of finished goods.

2. Prepare a process cost summary report for this company, showing costs charged to production, unit cost information, equivalent units of production, cost per EUP, and its cost assignment and reconciliation.

Check (2) Cost per equivalent unit: materials, $12.50; labor, $9.20; overhead, $8.28

Problem 16-3B Weighted Average: Journalizing in process costing; equivalent units and costs

C2 P1 P2 P3 P4

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730 Chapter 16 Process Costing and Analysis

Analysis Component

3. This company provides incentives to its department managers by paying monthly bonuses based on their success in controlling costs per equivalent unit of production. Assume that production over- estimates the percentage of completion for units in ending inventory with the result that its equivalent units of production in ending inventory for May are overstated. What impact does this error have on bonuses paid to the managers of the production department? What impact, if any, does this error have on these managers’ June bonuses?

Braun Company produces its product through a single processing department. Direct materials are added at the beginning of the process. Direct labor and overhead are added to the product evenly throughout the process. The company uses monthly reporting periods for its weighted-average process cost accounting. Its Goods in Process Inventory account follows after entries for direct materials, di- rect labor, and overhead costs for November.

Problem 16-4B Weighted average: Process cost summary; equivalent units

C2 C3 P4

Goods in Process Inventory Acct. No. 133

Date Explanation Debit Credit Balance

Nov. 1 Balance 21,300

30 Direct materials 116,400 137,700

30 Direct labor 426,800 564,500

30 Applied overhead 640,200 1,204,700

The 7,500 units of beginning goods in process consisted of $6,800 of direct materials, $5,800 of direct labor, and $8,700 of factory overhead. During November, the company finished and transferred 100,000 units of its product to finished goods. At the end of the month, the goods in process inventory consisted of 12,000 units that were 100% complete with respect to direct materials and 25% complete with respect to direct labor and factory overhead.

Required

1. Prepare the company’s process cost summary for November using the weighted-average method. 2. Prepare the journal entry dated November 30 to transfer the cost of the completed units to finished

goods inventory.

Check (1) Cost transferred out to finished goods, $1,160,000

Switch Co. manufactures a single product in one department. Direct labor and overhead are added evenly throughout the process. Direct materials are added as needed. The company uses monthly reporting peri- ods for its weighted-average process cost accounting. During January, Switch completed and transferred 220,000 units of product to finished goods inventory. Its 10,000 units of beginning goods in process con- sisted of $7,500 of direct materials, $14,240 of direct labor, and $35,600 of factory overhead. 40,000 units (50% complete with respect to direct materials and 30% complete with respect to direct labor and over- head) are in process at month-end. After entries for direct materials, direct labor, and overhead for January, the company’s Goods in Process Inventory account follows.

Required

1. Prepare the company’s process cost summary for January using the weighted-average method. 2. Prepare the journal entry dated January 31 to transfer the cost of completed units to finished goods

inventory.

Goods in Process Inventory Acct. No. 133

Date Explanation Debit Credit Balance

Jan. 1 Balance 57,340

31 Direct materials 112,500 169,840

31 Direct labor 176,000 345,840

31 Applied overhead 440,000 785,840

Check (1) EUP for both labor and overhead, 232,000

(2) Cost transferred out to finished goods, $741,400

Problem 16-5B Weighted average: Process cost summary; equivalent units; cost estimates

C2 C3 P4

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Chapter 16 Process Costing and Analysis 731

Analysis Components

3. The cost accounting process depends on several estimates. a. Identify two major estimates that affect the cost per equivalent unit. b. In what direction might you anticipate a bias from management for each estimate in part 3a (as-

sume that management compensation is based on maintaining low inventory amounts)? Explain your answer.

Refer to the information in Problem 16-5B. Assume that Switch uses the FIFO method to account for its process costing system. The following additional information is available.

● Beginning goods in process consists of 10,000 units that were 75% complete with respect to direct materials and 60% complete with respect to direct labor and overhead.

● Of the 220,000 units completed, 10,000 were from beginning goods in process; the remaining 210,000 were units started and completed during January.

Required

1. Prepare the company’s process cost summary for January using FIFO. Round cost per EUP to one- tenth of a cent.

2. Prepare the journal entry dated January 31 to transfer the cost of completed units to finished goods inventory.

Problem 16-6BA

FIFO: Process cost summary; equivalent units; cost estimates

C3 C4 P4

Check (1) Labor and overhead EUP, 226,000

(2) Cost transferred out, $743,554

Refer to the information in Problem 16-2B and complete its parts (1) through (4) using the FIFO method of process costing. Round cost per equivalent unit calculations to two decimal places.

Problem 16-8BA

FIFO: Cost per equivalent unit; costs assigned to products

C2 C3 C4 Check (2) $24.66 direct labor cost

per EUP; $8.28 direct materials cost per EUP

Belda Co. manufactures a single product in one department. Direct labor and overhead are added evenly throughout the process. Direct materials are added as needed. The company uses the FIFO method of process costing. During March, the company completed and transferred 220,000 units to finished goods inventory. Of the units completed, 10,000 were from beginning inventory and the remaining 210,000 were started and completed during the month. Beginning goods in process were 75% complete with respect to direct materials and 60% complete with respect to direct labor and overhead. The company has 40,000 units (50% complete with respect to direct materials and 30% complete with respect to direct labor and

Problem 16-9BA

FIFO: Process cost summary, equivalent units, cost estimates

C2 C3 C4 P4

During May, the production department of a process manufacturing system completed a number of units of a product and transferred them to finished goods. Of these transferred units, 62,500 were in process in the production department at the beginning of May and 175,000 were started and completed in May. May’s beginning inventory units were 40% complete with respect to materials and 80% complete with respect to labor. At the end of May, 76,250 additional units were in process in the production department and were 80% complete with respect to materials and 20% complete with respect to labor. The production department had $683,750 of direct materials and $446,050 of direct labor cost charged to it during May. Its beginning inventory included $99,075 of direct materials cost and $53,493 of direct labor cost. 1. Compute the number of units transferred to finished goods. 2. Compute the number of equivalent units with respect to both materials used and labor used in the

production department for May using the FIFO method. 3. Compute the direct materials cost and the direct labor cost per equivalent unit for the department. 4. Using the FIFO method, assign May’s costs to the units transferred to finished goods and assign costs

to its ending goods in process inventory.

Problem 16-7B FIFO: Costs per equivalent unit; costs assigned to products

C2 C4

Check (2) EUP for materials, 273,500

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732 Chapter 16 Process Costing and Analysis

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.)

SP 16 The computer workstation furniture manufacturing that Adria Lopez started is progressing well. At this point, Adria is using a job order costing system to account for the production costs of this product line. Adria has heard about process costing and is wondering whether process costing might be a better method for her to keep track of and monitor her production costs.

Required

1. What are the features that distinguish job order costing from process costing? 2. Do you believe that Adria should continue to use job order costing or switch to process costing for her

workstation furniture manufacturing? Explain.

SERIAL PROBLEM Success Systems

C1 A1

CP 16 Major League Bat Company manufactures baseball bats. In addition to its goods in process in- ventories, the company maintains inventories of raw materials and finished goods. It uses raw materials as direct materials in production and as indirect materials. Its factory payroll costs include direct labor for production and indirect labor. All materials are added at the beginning of the process, and direct labor and factory overhead are applied uniformly throughout the production process.

Required

You are to maintain records and produce measures of inventories to reflect the July events of this com- pany. Set up the following general ledger accounts and enter the June 30 balances: Raw Materials Inventory, $25,000; Goods in Process Inventory, $8,135 ($2,660 of direct materials, $3,650 of direct labor, and $1,825 of overhead); Finished Goods Inventory, $110,000; Sales, $0; Cost of Goods Sold, $0; Factory Payroll, $0; and Factory Overhead, $0. 1. Prepare journal entries to record the following July transactions and events. a. Purchased raw materials for $125,000 cash (the company uses a perpetual inventory system). b. Used raw materials as follows: direct materials, $52,440; and indirect materials, $10,000. c. Incurred factory payroll cost of $227,250 paid in cash (ignore taxes). d. Assigned factory payroll costs as follows: direct labor, $202,250; and indirect labor, $25,000. e. Incurred additional factory overhead costs of $80,000 paid in cash. f. Allocated factory overhead to production at 50% of direct labor costs.

COMPREHENSIVE PROBLEM

Major League Bat Company Weighted average: Review of Chapters 2, 4, 14, 16

Check (1f) Cr. Factory Overhead, $101,125

Required

1. Prepare the company’s process cost summary for March using the FIFO method. 2. Prepare the journal entry dated March 31 to transfer the cost of completed units to finished good

inventory.

Analysis Component

3. The company provides incentives to department managers by paying monthly bonuses based on their suc- cess in controlling costs per equivalent unit of production. Assume that the production department overes- timates the percentage of completion for units in ending inventory with the result that its equivalent units of production for March are overstated. What impact does this error have on bonuses paid to the managers of the production department? What impact, if any, does this error have on these managers’ April bonuses?

Check (1) EUP for both labor and overhead, 226,000 EUP

(2) Cost transferred out to finished goods, $1,486,960

overhead) in process at month-end. Information on costs of beginning inventory and costs added during the month follows.

Cost Raw Materials Direct Labor Overhead

Of beginning inventory . . . . . . . . . . $ 16,800 $ 27,920 $ 69,800

Added during the month . . . . . . . . . 223,200 352,560 881,400

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Chapter 16 Process Costing and Analysis 733

BTN 16-1 Polaris reports in notes to its financial statements that, in addition to its products sold, it in- cludes the following costs (among others) in cost of sales: customer shipping and handling expenses, warranty expenses, and depreciation expense on assets used in manufacturing.

Required

1. Why do you believe Polaris includes these costs in its cost of sales? 2. What effect does this cost accounting policy for its cost of sales have on Polaris’ financial statements

and any analysis of those statements? Explain.

Fast Forward

3. Access Polaris’ financial statements for the years after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR Website (sec.gov). Review its footnote relating to Organization and Significant Accounting Policies. Has Polaris’ changed its policy with respect to what costs are included in the cost of sales? Explain.

Beyond the Numbers

REPORTING IN ACTION C2

BTN 16-2 Manufacturers such as Polaris and Arctic Cat usually work to maintain a high-quality and low-cost operation. One ratio routinely computed for this assessment is the cost of goods sold divided by total expenses. A decline in this ratio can mean that the company is spending too much on selling and administrative activities. An increase in this ratio beyond a reasonable level can mean that the company is not spending enough on selling activities. (Assume for this analysis that total expenses equal the cost of goods sold plus total operating expenses.)

Required

1. For Polaris and Arctic Cat refer to Appendix A and compute the ratios of cost of goods sold to total expenses for their two most recent fiscal years. (Record answers as percents, rounded to one decimal.)

2. Comment on the similarities or differences in the ratio results across both years between the companies.

COMPARATIVE ANALYSIS C1

3. Using the results from part 2 and the available information, make computations and prepare journal entries to record the following:

g. Total costs transferred to finished goods for July (label this entry g). h. Sale of finished goods costing $265,700 for $625,000 in cash (label this entry h). 4. Post entries from parts 1 and 3 to the ledger accounts set up at the beginning of the problem. 5. Compute the amount of gross profit from the sales in July. (Note: Add any underapplied overhead to, or

deduct any overapplied overhead from, the cost of goods sold. Ignore the corresponding journal entry.)

(3g) $271,150

Units

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 units

Started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 units

Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 units

Beginning inventory

Materials—Percent complete . . . . . . . . . . . . . . . . . . 100%

Labor and overhead—Percent complete . . . . . . . . . 75%

Ending inventory

Materials—Percent complete . . . . . . . . . . . . . . . . . . 100%

Labor and overhead—Percent complete . . . . . . . . . 40%

2. Information about the July inventories follows. Use this information with that from part 1 to prepare a process cost summary, assuming the weighted-average method is used.

Check (2) EUP for overhead, 14,200

Polaris

Polaris Arctic Cat

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734 Chapter 16 Process Costing and Analysis

BTN 16-6 The purpose of this team activity is to ensure that each team member understands process operations and the related accounting entries. Find the activities and flows identified in Exhibit 16.4 with numbers 1 – 10. Pick a member of the team to start by describing activity number 1 in this ex- hibit, then verbalizing the related journal entry, and describing how the amounts in the entry are com- puted. The other members of the team are to agree or disagree; discussion is to continue until all members express understanding. Rotate to the next numbered activity and next team member until all activities and entries have been discussed. If at any point a team member is uncertain about an answer, the team member may pass and get back in the rotation when he or she can contribute to the team’s discussion.

TEAMWORK IN ACTION C1 P1 P2 P3 P4

BTN 16-7 This chapter’s opener featured Neal Gottlieb and his company Three Twins Ice Cream.

Required

1. Neal recently built a large manufacturing facility. Explain how his company’s process cost summary report would differ after his new manufacturing facility is operating.

2. How does holding raw materials inventories increase costs? If the items are not used in production, how can they impact profits? Explain.

3. Suppose Three Twins Ice Cream decides to allow customers to make their own unique ice cream flavors. Why might the company then use a hybrid costing system?

ENTREPRENEURIAL DECISION C3 A2

BTN 16-5 Many companies acquire software to help them monitor and control their costs and as an aid to their accounting systems. One company that supplies such software is proDacapo (prodacapo.com). There are many other such vendors. Access proDacapo’s Website, click on “Prodacapo Process Manage- ment,” and review the information displayed.

Required

How is process management software helpful to businesses? Explain with reference to costs, efficiency, and examples, if possible.

TAKING IT TO THE NET C1

BTN 16-3 Many accounting and accounting-related professionals are skilled in financial analysis, but most are not skilled in manufacturing. This is especially the case for process manufacturing environments (for example, a bottling plant or chemical factory). To provide professional accounting and financial ser- vices, one must understand the industry, product, and processes. We have an ethical responsibility to de- velop this understanding before offering services to clients in these areas.

Required

Write a one-page action plan, in memorandum format, discussing how you would obtain an understanding of key business processes of a company that hires you to provide financial services. The memorandum should specify an industry, a product, and one selected process and should draw on at least one reference, such as a professional journal or industry magazine.

ETHICS CHALLENGE C1

BTN 16-4 You hire a new assistant production manager whose prior experience is with a company that produced goods to order. Your company engages in continuous production of homogeneous prod- ucts that go through various production processes. Your new assistant e-mails you questioning some cost classifications on an internal report—specifically why the costs of some materials that do not actually become part of the finished product, including some labor costs not directly associated with producing the product, are classified as direct costs. Respond to this concern via memorandum.

COMMUNICATING IN PRACTICE A1 C1 P1 P2

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Chapter 16 Process Costing and Analysis 735

1. d 2. e 3. b; $20,000 1 $152,000 1 $45,000 1 $18,000 2 $218,000 5 $17,000

4. a; 40,000 1 (15,000 3 1y3) 5 45,000 EUP 5. c; ($6,000 1 $84,000) 4 45,000 EUP 5 $2 per EUP

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 16-8 In process costing, the process is analyzed first and then a unit measure is computed in the form of equivalent units for direct materials, direct labor, overhead, and all three combined. The same analysis applies to both manufacturing and service processes.

Required

Visit your local U.S. Mail center. Look into the back room, and you will see several ongoing processes. Select one process, such as sorting, and list the costs associated with this process. Your list should include materials, labor, and overhead; be specific. Classify each cost as fixed or variable. At the bottom of your list, outline how overhead should be assigned to your identified process. The following format (with an example) is suggested.

Direct Direct Variable Fixed

Cost Description Material Labor Overhead Cost Cost

Manual sorting . . . . . . . . . . . . . . . . . . . . . . . . X X

Overhead allocation suggestions:

. . .

HITTING THE ROAD C2

Point: The class can compare and dis- cuss the different processes studied and the answers provided.

Required

1. Review the discussion of the importance of the cost of goods sold divided by total expenses ratio in BTN 16-2. Compute the cost of goods sold to total expenses ratio for Piaggio for the two years of data provided. (Record answers as percents, rounded to one decimal.)

2. Comment on the similarities or differences in the ratio results calculated in part 1 and in BTN 16-2 across years and companies. (Record answers as percents, rounded to one decimal.)

(millions of euros) Current Year Prior Year

Cost of goods sold . . . . . . . . . €1,061.9 €1,023.1

Operating expenses . . . . . . . . 349.1 351.2

Total expenses . . . . . . . . . . . . . €1,411.0 €1,374.3

BTN 16-9 Piaggio, Polaris, and Arctic Cat are competitors in the global marketplace. Selected data for Piaggio follow.

GLOBAL DECISION C1

Polaris PIAGGIO

Arctic Cat

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Learning Objectives

CONCEPTUAL

C1 Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity- based costing method. (p. 738)

C2 Explain cost flows for activity-based costing. (p. 743) C3 Describe the four types of activities that cause overhead costs. (p. 750)

ANALYTICAL

A1 Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods. (p. 743)

A2 Identify and assess advantages and disadvantages of activity-based costing. (p. 748)

PROCEDURAL

P1 Allocate overhead costs to products using the plantwide overhead rate method. (p. 739)

P2 Allocate overhead costs to products using the departmental overhead rate method. (p. 740)

P3 Allocate overhead costs to products using activity-based costing. (p. 744)

A Look at This Chapter

This chapter introduces the activity- based costing (ABC) system with the potential for greater accuracy of cost allocations. ABC provides managers with cost information for strategic decisions that is not readily available with other costing methods.

A Look Back

Chapters 15 and 16 described costing systems used by companies to accumulate product costing information for the reporting of inventories and cost of goods sold.

Activity-Based Costing and Analysis 17

A Look Ahead

Chapter 18 discusses the importance of information on both costs and sales behavior for managers in performing cost-volume-profit (CVP) analysis, which is a valuable managerial tool.

736

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Successful Brew

FORT COLLINS, CO—Kim Jordan’s entrepreneurial roots were anything but frothy. “For about eight months, we didn’t pay our- selves,” explains Kim. “We borrowed money from parents and made payroll . . . looking at the bills, we had to decide which to pay.” From those meager beginnings, Kim created New Belgium Brewing Company (NewBelgium.com), which is committed to the Belgian brewing tradition of delicious beers with loads of character. “We did have a set of values, a purpose, and some out- comes that we wanted to achieve,” says Kim. “Four things were important to us: to produce world class Belgium-style beers, to promote beer culture, to be environmental stewards, and to have fun!” To achieve those goals, Kim set up an accounting system to measure, track, summarize, and report on operations. “It is important to have the ability to read financial statements, including product cost reports,” insists Kim. With costly raw ma- terials and overhead costs, understanding product cost reports helps Kim control her operations and make good decisions. “There has to be execution,” explains Kim. That focus on execution includes allocating overhead costs to different beers. In smaller businesses, a single plantwide overhead allocation rate is often sufficient. But as businesses grow and offer more diverse product lines, more sophisticated costing techniques

are often needed. Activity-based costing (ABC) helps managers monitor and control overhead costs and ensure product quality. ABC is especially useful in companies like Kim’s, where different products require different processes and varying levels of over- head. Traditional brews like Blue Paddle and Fat Tire can be made in large quantities in long production runs. Seasonal beers like Snow Day and Somersault, and specialty brews like Cocoa Mole Ale and Prickly Passion, are made in small batches. ABC helps in allocating overhead costs, such as product develop- ment, plant maintenance, and clean-up costs, to different prod- ucts. “Our co-workers [all employees] get to see all of our financials!” Kim explains that this in turn helps shape the prod- uct cost reports for her business, including the control proce- dures applied in the brewery. Kim’s company is riding high with the right accounting sys- tems and controls for long-run success. “Stasis is not an option,” says Kim. “If we’re all in the same place today that we were five years ago, that wouldn’t be very interesting.” Kim smiles and adds, “There’s something wrong if making beer can’t be fun!”

[Sources: NewBelgium Website, January 2013; Entrepreneur, November 2009; 50entrepreneurs.com, March 2010; CNNMoney.com, June 2009; Beverage World, September 2009]

“It’s just following your instincts, knowing the basics, and sticking with what’s important.”

—KIM JORDAN

Decision Insight

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Managerial activities such as product pricing, product mix decisions, and cost control depend on accurate product cost information. Distorted product cost information can result in poor deci- sions. Knowing accurate costs for producing, delivering, and servicing products helps managers set a price to cover product costs and yield a profit. In competitive markets, price is established through the forces of supply and demand. In these situations, managers must understand product costs to assess whether the market price is high enough to justify the cost of entering the market. Disparities between market prices and producer costs give managers insight into their efficiency relative to competitors. Product costs consist of direct materials, direct labor, and overhead (indirect costs). Since the physical components of a product (direct materials) and the work of making a product (direct labor) can be traced to units of output, the assignment of costs of these factors is usually straight- forward. Overhead costs, however, are not directly related to production volume, and therefore cannot be traced to units of product in the same way that direct materials and direct labor can. For example, we can trace the cost of putting tires on a car because we know there is a logical relation between the number of cars produced and the number of tires needed for each car. The cost to heat an automobile manufacturing factory, however, is not readily linked with the num- ber of cars made. Consequently, we must use an allocation system to assign overhead costs such as utilities and factory maintenance. This chapter introduces three methods of overhead alloca- tion: (1) the single plantwide overhead rate method, (2) the departmental overhead rate method, and (3) the activity-based costing method. Exhibit 17.1 summarizes some key features of these three alternative methods. Both the plantwide overhead rate method and the departmental overhead rate method use volume-based measures such as direct labor hours, direct labor dollars, or machine hours to allocate overhead costs to products. These methods differ in that the plantwide method uses a single rate for allo- cating overhead costs, and the departmental rate method uses at least two rates. The departmen- tal method arguably provides more accurate cost allocations than the single rate allocations of the plantwide method. In contrast, activity-based costing focuses on activities and the costs of carrying out activities. Rates based on these activities are then used to assign overhead to prod- ucts in proportion to the amount of activity required to produce them. Activity-based costing typically uses more overhead allocation rates than the plantwide and departmental methods.

ASSIGNING OVERHEAD COSTS

Point: Evidence suggests overhead costs have steadily increased while direct labor costs have steadily decreased as a percentage of total manufacturing costs over recent decades. This puts greater importance on accurate cost allocations.

C1 Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method.

Chapter Preview

Prior chapters described costing systems used to assign costs to product units. This discussion emphasized the valuation of inven- tory and the cost of goods sold. Although the information from these prior costing systems conforms to generally accepted ac-

counting principles (GAAP) for external reporting, it has limita- tions. This chapter introduces the activity-based costing (ABC) system, which is used by managers who desire more accurate product cost information.

Applying Activity- Based Costing

• Step 1 Identify activities and their costs

• Step 2 Trace overhead costs to cost pools

• Step 3 Determine activity rates

• Step 4 Assign overhead costs to cost objects

Assigning Overhead Costs

• Single plantwide overhead rate method

• Multiple departmental overhead rate method

• Activity-based costing rates and method

Assessing Activity- Based Costing

• Advantages of activity-based costing

• Disadvantages of activity-based costing

• Activity-based costing for service providers

• Types of activities

Activity-Based Costing and Analysis

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Chapter 17 Activity-Based Costing and Analysis 739

Applying the Plantwide Overhead Rate Method Under the single plantwide over- head rate method, total budgeted overhead costs are combined into one overhead cost pool. This cost pool is then divided by the chosen allocation base, such as total direct labor hours, to arrive at a single plantwide overhead rate. This rate then is applied to assign costs to all products based on the allocation base such as direct labor hours required to manufacture each product. To illustrate, consider data from KartCo, a go-kart manufacturer that produces both stan- dard and custom go-karts for amusement parks. The standard go-kart is a basic model sold primarily to amusement parks that service county and state fairs. Custom go-karts are produced for theme parks who want unique go-karts that coordinate with their respective themes. Assume that KartCo applies the plantwide overhead rate method and uses direct labor hours (DLH) as its overhead allocation base. KartCo’s budgeted DLH information is in Exhibit 17.3.

Overhead Allocations Overhead Allocation Rates Method Based on Based on

Plantwide rate . . . . . . . . . . . . . . . One rate Volume-based measures such as direct labor hours or machine hours

Departmental rate . . . . . . . . . . . Two or more rates Volume-based measures such as direct labor hours or machine hours

Activity-based costing . . . . . . . . . At least two (but often Activities that drive costs, such as number many) rates of batches of product produced

EXHIBIT 17.1 Overhead Cost Allocation Methods

Overhead Cost

Product 1 Product 2 Product 3

Single Plantwide Overhead Rate

Indirect Costs

Cost Objects

Cost Allocation

Base

EXHIBIT 17.2 Plantwide Overhead Rate Method

Plantwide Overhead Rate Method Cost Flows under Plantwide Overhead Rate Method The first method of allocat- ing overhead costs to products is known as the single plantwide overhead rate method, or simply the plantwide overhead rate method. For this method, the target of the cost assignment, or cost object, is the unit of product—see Exhibit 17.2. The overhead rate is determined using volume- related measures such as direct labor hours, direct labor cost dollars, or machine hours, which are readily available in most manufacturing settings. In some industries, overhead costs are closely related to these volume-related measures. In such cases it is logical to use this method as a basis for assigning indirect manufacturing costs to products.

P1 Allocate overhead costs to products using the plantwide overhead rate method.

EXHIBIT 17.3 KartCo’s Budgeted Direct Labor Hours

Number of Units Direct Labor Hours per Unit Total Direct Labor Hours

Standard go-kart . . . 5,000 15 75,000

Custom go-kart . . . . 1,000 25 25,000

Total . . . . . . . . . . . . . 100,000

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740 Chapter 17 Activity-Based Costing and Analysis

KartCo’s budgeted overhead cost information is in Exhibit 17.4. Its overhead cost consists of indirect labor and factory utilities.

P2 Allocate overhead costs to products using the departmental overhead rate method.

EXHIBIT 17.4 KartCo’s Budgeted Overhead Cost

Indirect labor cost . . . . . . . . . $4,000,000

Factory utilities . . . . . . . . . . . . 800,000

Total overhead cost . . . . . . . . $4,800,000

The single plantwide overhead rate for KartCo is computed as follows.

KartCo uses these per unit overhead costs to compute the total unit cost of each product as follows.

For KartCo, overhead cost is allocated to its two products as follows (on a per unit basis).

During the most recent period, KartCo sold its standard model go-karts for $2,000 and its custom go-karts for $3,500. A recent report from its marketing staff indicates that competitors are selling go-karts similar to KartCo’s standard model for as low as $1,200. KartCo management believes it must be competitive, but management is concerned that meeting this lower price would result in a loss of $270 ($1,200 2 $1,470) on each standard go-kart sold. In the case of its custom go-kart, KartCo has been swamped with orders and is unable to meet demand. Accordingly, management is considering a change in strategy. Some discussion has ensued about dropping its standard model and concentrating on its custom model. Yet man- agement recognizes that its pricing and cost decisions are influenced by its cost allocations. Thus, before making any strategic decisions, management has directed its cost analysts to fur- ther review production costs for both the standard and custom go-kart models. To pursue this analysis, the cost analysts first turned to the departmental rate method.

Departmental Overhead Rate Method Cost Flows under Departmental Overhead Rate Method Many companies have several departments that produce various products and consume overhead resources in substantially different ways. Under such circumstances, use of a single plantwide overhead rate can produce cost assignments that fail to accurately reflect the cost to manufacture a specific product. In these cases, use of multiple overhead rates can result in better overhead cost alloca- tions and improve management decisions. The departmental overhead rate method uses a different overhead rate for each production department. This is usually done through a two-stage assignment process, each with its different

Plantwide 5

Total budgeted 4

Total budgeted direct overhead rate overhead cost labor hours

5 $4,800,000 4 100,000 DLH 5 $48 per DLH

This plantwide overhead rate is then used to allocate overhead cost to products based on the number of direct labor hours required to produce each unit as follows.

Overhead allocated to each product unit 5 Plantwide overhead rate 3 DLH per unit

Standard go-kart: $48 per DLH 3 15 DLH 5 $  720

Custom go-kart: $48 per DLH 3 25 DLH 5 $1,200

Direct Materials Direct Labor Overhead Total Cost per Unit

Standard go-kart . . . . . . . . $400  $350 $ 720 $1,470

Custom go-kart . . . . . . . . . 600 500 1,200 2,300

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Chapter 17 Activity-Based Costing and Analysis 741

Cost Objects

Cost Objects

Cost Allocation

Base

Indirect Costs

First Stage

Second Stage

Overhead Cost

Department A Department B

Product 3Product 2Product 1

Department B Overhead RateDepartment A Overhead Rate

EXHIBIT 17.5 Departmental Overhead Rate Method

Exhibit 17.5 shows that under the departmental overhead rate method, overhead costs are first determined separately for each production department. Next, an overhead rate is computed for each production department to allocate the overhead costs of each department to products passing through that department. The departmental overhead rate method allows each depart- ment to have its own overhead rate and its own allocation base. For example, an assembly department can use direct labor hours to allocate its overhead cost while the machining department can use machine hours as its base.

Applying the Departmental Overhead Rate Method To illustrate the depart- mental overhead rate method, let’s return to KartCo. KartCo has two production departments, the machining department and the assembly department. The first stage requires that KartCo assign its $4,800,000 overhead cost to its two production departments. KartCo determines from an anal- ysis of its indirect labor and factory utilities that $4,200,000 of overhead costs are traceable to its machining department and the remaining $600,000 are traceable to its assembly department. The second stage demands that after overhead costs are assigned to departments, each depart- ment determines an allocation base for its operations. For KartCo, the machining department uses machine hours (MH) as a base for allocating its overhead and the assembly department uses direct labor hours (DLH) as the base for allocating its overhead. Each machine is operated by a person, so that each machine hour also uses one direct labor hour. (With increased automa- tion and the use of robots to perform manufacturing tasks, machine hours can differ from direct labor hours for many companies.) For this stage, the relevant information for KartCo’s machin- ing and assembly departments is in Exhibit 17.6.

Point: In some cases it is difficult for companies to trace overhead costs to distinct departments as some overhead costs can be common to several depart- ments. In these cases, companies must al- locate overhead to departments applying reasonable allocation bases.

EXHIBIT 17.6 Allocation Information for Machining and Assembly Departments

Number

Machining Department Assembly Department

of Units Hours per Unit Total Hours Hours per Unit Total Hours

Standard go-kart . . . . . . 5,000 10 MH per unit 50,000 MH 5 DLH per unit 25,000 DLH

Custom go-kart . . . . . . . 1,000 20 MH per unit 20,000 MH 5 DLH per unit 5,000 DLH

Totals . . . . . . . . . . . . . . . 70,000 MH 30,000 DLH

Each department computes its own overhead rate using the following formula.

Departmental overhead rate 5 Total departmental overhead cost

Total units in departmental allocation base

cost objects (target of cost assignment). In the first stage the departments are the cost objects and in the second stage the products are the cost objects (see Exhibit 17.5).

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742 Chapter 17 Activity-Based Costing and Analysis

The final part of the second stage is to apply overhead costs to each product based on departmental overhead rates. For KartCo, since each standard go-kart requires 10 MH from the machining depart- ment and five DLH from the assembly department, the overhead cost allocated to each standard go- kart is $600 from the machining department (10 MH 3 $60 per MH) and $100 from the assembly department (5 DLH 3 $20 per DLH). The same procedure is applied for its custom go-kart. The al- location of overhead costs to KartCo’s standard and custom go-karts is summarized in Exhibit 17.7.

EXHIBIT 17.7 Overhead Allocation Using Departmental Overhead Rates

Standard Go-Kart Custom Go-Kart

Departmental Overhead Overhead Overhead Rate Hours per Unit Allocated Hours per Unit Allocated

Machining department . . . . . $60 per MH 10 MH per unit $600 20 MH per unit $1,200

Assembly department . . . . . $20 per DLH 5 DLH per unit 100 5 DLH per unit 100

Totals . . . . . . . . . . . . $700 $1,300

Allocated overhead costs vary depending upon the allocation methods used. Exhibit 17.8 sum- marizes and compares the allocated overhead costs for standard and custom go-karts under the single plantwide overhead rate and the departmental overhead rate methods. The overhead cost allocated to each standard go-kart decreased from $720 under the plantwide overhead rate method to $700 under the departmental overhead rate method, whereas overhead cost allocated to each custom go- kart increased from $1,200 to $1,300. These differences occur because the custom go-kart requires more hours in the machining department (20 MH) than the standard go-kart requires (10 MH).

EXHIBIT 17.8 Comparison of Plantwide Overhead Rate and Departmental Overhead Rate Methods

Overhead per Unit Under: Standard Go-Kart Custom Go-Kart

Plantwide overhead rate method . . . . . . . . . . . . $720 $1,200

Departmental overhead rate method . . . . . . . . . $700 $1,300

Compared to the plantwide overhead rate method, the departmental overhead rate method usually results in more accurate overhead allocations. When cost analysts are able to logically trace costs to cost objects, costing accuracy is improved. For KartCo, costs are traced to depart- ments and then assigned to units based on how long they spend in each department. The single plantwide overhead rate of $48 per hour is a combination of the $60 per hour machining depart- ment rate and the $20 per hour assembly department rate. For KartCo, using the multiple departmental overhead rate method yields the following total costs for its products.

Direct Materials Direct Labor Overhead Total Cost per Unit

Standard go-kart . . . . . . . . . . $400 $350 $ 700 $1,450

Custom go-kart . . . . . . . . . . 600 500 1,300 2,400

These costs per unit under the departmental overhead rate method are different from those under the plantwide overhead rate method. Further, this information suggests that KartCo management seri- ously review future production for its standard go-kart product. Specifically, these cost data imply that KartCo cannot make a profit on its standard go-kart if it meets competitors’ $1,200 price.

For KartCo, its departmental overhead rates are computed as follows.

Machining department overhead rate 5 $4,200,000

70,000 MH 5 $60 per MH

Assembly department overhead rate 5 $600,000

30,000 DLH 5 $20 per DLH

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Chapter 17 Activity-Based Costing and Analysis 743

Assessing the Plantwide and Departmental Overhead Rate Methods The plantwide and departmental overhead rate methods have three key advantages: (1) They are based on readily available information, like direct labor hours. (2) They are easy to implement. (3) They are consistent with GAAP and can be used for external reporting needs. Both suffer from an important disadvantage, in that overhead costs are frequently too complex to be ex- plained by one factor like direct labor hours or machine hours. Further, technological advances often lower direct labor costs as a percentage of total manufacturing costs. (In some companies, direct labor cost is such a small part of total cost that it is treated as overhead.) The usefulness of overhead allocations based on the single plantwide overhead rate for manage- rial decisions depends on two critical assumptions: (1) overhead costs change with the allocation base (such as direct labor hours); and (2) all products use overhead costs in the same proportions. The reasonableness of these assumptions varies. For companies that manufacture few products or whose operations are labor-intensive, the single plantwide method can yield reasonably useful information for managerial decisions. However, for companies with many different products or those with products that use overhead costs in very different ways, the assumptions of the single plantwide rate are not reasonable. When overhead costs, like machinery depreciation, bear little if any relation to direct labor hours used, allocating overhead cost using a single plantwide overhead rate based on direct labor hours can distort product cost and lead to poor managerial decisions. De- spite such shortcomings, some companies continue to use the plantwide method for its simplicity. The departmental overhead rate method is more refined than the plantwide overhead rate method, but it too has limitations that can distort product costs. The departmental overhead rate method assumes that different products are similar in volume, complexity, and batch size, and that departmental overhead costs are directly proportional to the department allocation base (such as direct labor hours and machine hours for KartCo). When products differ in batch size and complex- ity, they usually consume different amounts of overhead costs. This is likely the case for KartCo with its high-volume standard model and its low-volume custom model built to customer specifica- tions. In addition, since the departmental overhead rate method still allocates overhead costs based on measures closely related to production volume, it also fails to accurately assign many overhead costs, like machine depreciation or utility costs, that are not driven by production volume. The next section describes the activity-based costing method, which is designed to overcome some of the limitations of the plantwide and departmental overhead rate methods.

A1 Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods.

C2 Explain cost flows for activity-based costing. Activity-Based Costing Rates and Method Cost Flows under Activity-Based Costing Method Activity-based costing (ABC) attempts to more accurately assign overhead costs to the users of overhead by focusing on activities. The basic principle underlying activity-based costing is that an activity, which is a task, operation, or procedure, is what causes costs to be incurred. For example, cutting raw ma- terials consumes labor and machine hours. Likewise, warehousing products consumes resources (costs) such as employee time for driving a forklift, the electricity to power the forklift, and the wear and tear on a forklift. Also, training employees drives costs such as fees or salaries paid to trainers and the training supplies required. Generally, all activities of an organization can be linked to use of resources. An activity cost pool is a collection of costs that are related to the same or similar activity. Pooling costs to determine an activity overhead (pool) rate for all costs incurred by the same activity reduces the number of cost assignments required. There are two basic stages to ABC as shown in Exhibit 17.9. The first stage of ABC cost as- signment is to identify the activities (cost objects) involved in manufacturing products and match those activities with the costs they cause (drive). To reduce the total number of activities

Department Manager Three department managers jointly decide to hire a consulting firm for advice on increasing departmental effectiveness and efficiency. The consulting firm spends 50% of its efforts on department “A” and 25% on each of the other two departments. The manager for department “A” suggests that the three departments equally share the consulting fee. As a manager of one of the other two departments, do you believe equal sharing is fair? ■ [Answer—p. 756]

Decision Ethics

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744 Chapter 17 Activity-Based Costing and Analysis

that must be assigned costs, the homogeneous activities (those caused by the same factor such as cutting metal) are grouped into activity cost pools. The second stage of ABC is to compute an activity rate for each cost pool and then use this rate to allocate overhead costs to products, which are the cost objects of this second stage. ABC is like the departmental method in that it uses more than one overhead rate. It differs from the departmental method in that it focuses on activities rather than departments.

Point: Homogeneous means similar.

Cost Objects

Cost Objects

Cost Allocation

Base

Indirect Costs

First Stage

Second Stage

Overhead Cost

Product 1 Product 2 Product 3

Activity Cost Pool Y

Activity Cost Pool Z

Activity Cost Pool X

Activity Overhead Rate

Activity Overhead Rate

Activity Overhead Rate

EXHIBIT 17.9 Activity-Based Costing Method

1. Which method of cost assignment requires more than one overhead rate? (a) Plantwide overhead rate method (b) Departmental overhead rate method (c) ABC (d) Both b and c.

2. Which method of overhead costing is the most accurate when products use overhead costs in different proportions? (a) Departmental overhead rate method (b) Plantwide overhead rate method.

3. ABC assumes that costs are incurred because of what? (a) Management decisions (b) Activities (c) Financial transactions.

Quick Check Answers — p. 757

Activity-based costing accumulates overhead costs into activity cost pools and then uses activity rates to allocate those costs to products. This involves four steps: (1) identify activities and the costs they cause; (2) group similar activities into activity cost pools; (3) determine an activity rate for each activity cost pool; and (4) allocate overhead costs to products using those activity rates. To illustrate, let’s return to KartCo and apply steps 1 through 4.

Step 1: Identify Activities and the Costs They Cause Step 1 in applying ABC is to identify activities and the costs they cause. This is commonly done through discussions with employees in production departments and through reviews of production activities. The more activities that ABC tracks, the more accurately overhead costs are assigned. However, tracking too many activities makes the system cumbersome and costly to maintain. Con- sequently, we try to reach a balance where it is often necessary to reduce the number of activities tracked by combining similar activities. An activity can also involve several related tasks. The aim of this first step is to understand actions performed in the organization that drive costs.

KartCo has total overhead cost of $4,800,000 consisting of $4,000,000 indirect labor costs and $800,000 factory utilities costs. Details gathered by KartCo about its overhead costs are

APPLYING ACTIVITY-BASED COSTING

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Chapter 17 Activity-Based Costing and Analysis 745

P3 Allocate overhead costs to products using activity- based costing.

EXHIBIT 17.10 KartCo Overhead Cost Details

Activity Indirect Labor Factory Utilities Total Overhead

Machine setup . . . . . . . . . . . . . $ 700,000 — $ 700,000

Machine repair . . . . . . . . . . . . . 1,300,000 — 1,300,000

Factory maintenance . . . . . . . . 800,000 — 800,000

Engineer salaries . . . . . . . . . . . 1,200,000 — 1,200,000

Assembly line power . . . . . . . . — $600,000 600,000

Heating and lighting . . . . . . . . . — 200,000 200,000

Totals . . . . . . . . . . . . . . . . . . . . $4,000,000 $800,000 $4,800,000

shown in Exhibit 17.10. Column totals for indirect labor and factory utilities correspond to amounts in Exhibit 17.4. Activity-based costing provides more detail about the activities and the costs they cause than is provided from traditional costing methods.

Step 2: Trace Overhead Costs to Cost Pools Step 2 in applying ABC is to assign activities and their overhead costs to cost pools. Overhead costs are commonly accumulated by each department in a traditional accounting system. Some of these overhead costs are traced directly to a specific activity cost pool. At KartCo, for ex- ample, the assembly department supervisor’s salary is assigned to its design modification cost pool and its machine repair costs are traced to its setup cost pool. Companies try to trace as many overhead costs to specific activity cost pools as possible to improve costing accuracy.

Recall that a premise of ABC is that operations are a series of activities that cause costs to be incurred. Instead of combining costs from different activities into one plantwide pool or multiple departmental pools, ABC focuses on activities as the cost object in the first step of cost assignment. We are then able to trace costs to a cost object and then combine ac- tivities that are used by products in similar ways to reduce the number of cost allocations. After a review and analysis of its activities, KartCo management assigns its overhead costs into its four activity cost pools as shown in Exhibit 17.11. To assign costs to pools, management looks for costs that are caused by the activities of that pool and activity level. It is crucial that activities in each cost pool be similar and reflect a similar activity level.

Design Modification

Craftsmanship Setup Plant Services

EXHIBIT 17.11 Assigning Overhead to Activity Cost Pools

Activity Pools Activity Cost Pool Cost

Craftsmanship

Assembly line power . . . . . . . . . $ 600,000 $ 600,000

Setup

Machine setup . . . . . . . . . . . . . . 700,000

Machine repair . . . . . . . . . . . . . 1,300,000 2,000,000

Design modification

Engineer salaries . . . . . . . . . . . . 1,200,000 1,200,000

Plant services

Factory maintenance . . . . . . . . 800,000

Heating and lighting . . . . . . . . . 200,000 1,000,000

Total overhead cost . . . . . . . . . . . $4,800,000

Cost Analyst Your employer is exploring the possibility of implementing an activity-based costing system in the plant where you are newly assigned as a cost analyst. Your responsibilities are to identify manufactur- ing acti vities and link them to the costs they drive. You have never worked in this type of manufacturing operation and you are unsure about what activities are performed and their costs. What steps should you pursue to yield a quality report? ■ [Answer—p. 756]

Decision Maker

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746 Chapter 17 Activity-Based Costing and Analysis

Exhibit 17.11 shows that $600,000 of overhead costs are assigned to the craftsmanship cost pool; $2,000,000 to the setup cost pool; $1,200,000 to the design-modification cost pool; and $1,000,000 to the plant services cost pool. This reduces the potential number of overhead rates from six (one for each of its six activities) to four (one for each activity pool).

Step 3: Determine Activity Rates Step 3 is to compute activity rates used to assign overhead costs to final cost objects such as products. Proper determination of activity rates depends on (1) proper identification of the fac- tor that drives the cost in each activity cost pool and (2) proper measures of activities. The factor that drives cost, or activity cost driver, is that activity causing costs in the pool to be incurred. For KartCo’s overhead, craftsmanship costs are mainly driven (caused) by assembling products, setup costs are driven by system repairs and retooling, design-modification costs are driven by new features, and plant service costs are driven by building occupancy. The activity cost driver, a measure of activity level, serves as the allocation base. KartCo uses the following activity drivers and expected activity levels for its activity pools.

In general, cost pool activity rates are computed as:

Activity Pool Activity Driver (# of) Expected Activity Level

Craftsmanship . . . . . . . . . . . . . Direct labor hours 30,000 DLH

Setup . . . . . . . . . . . . . . . . . . . . Batches 200 batches

Design modification . . . . . . . . . Designs 10 design modifications

Plant services . . . . . . . . . . . . . . Square feet 20,000 square feet

Cost pool activity rate 5 Overhead costs assigned to pool 4 Number of activities

Craftsmanship cost pool activity rate 5 $600,000 4 30,000 DLH 5 $20 per DLH

For KartCo, the activity rate for the craftsmanship cost pool is computed as:

The activity rate computations for KartCo are summarized in Exhibit 17.12.

EXHIBIT 17.12 Activity Rates for KartCo

Activity Activity Overhead Costs Number of Activity Rate

Cost Pools Measure Chosen Assigned to Pool Activities

Craftsmanship . . . . . . . . . . DLH $ 600,000 30,000 DLH $20 per DLH

Setup . . . . . . . . . . . . . . . . Batches 2,000,000 200 batches $10,000 per batch

Design modification . . . . Number of designs 1,200,000 10 designs $120,000 per design

Plant services . . . . . . . . . . Square feet 1,000,000 20,000 sq. ft. $50 per sq. ft.

4 5

Step 4: Assign Overhead Costs to Cost Objects Step 4 is to assign overhead costs in each activity cost pool to final cost objects using activity rates. (This is referred to as the second-stage assignment; where steps 1 through 3 make up the first-stage assignment.) To accomplish this, overhead costs in each activity cost pool are allo- cated to product lines based on the level of activity for each product line. After costs in all cost pools are allocated, the costs for each product line are totaled and then divided by the number of units of that product line to arrive at overhead cost per product unit. For KartCo, overhead costs in each pool are allocated to the standard go-karts and the custom go-karts using the activity rates from Exhibit 17.12. The activities used by each product line and the overhead costs allocated to standard and custom go-karts under ABC for KartCo are

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Chapter 17 Activity-Based Costing and Analysis 747

summarized in Exhibit 17.13. To illustrate, of the $600,000 of overhead costs in the craftsman- ship cost pool, $500,000 is allocated to standard go-karts as follows.

Overhead from craftsmanship pool allocated to standard go-kart 5 Activities consumed 3 Activity rate 5 25,000 DLH 3 $20 per DLH 5 $500,000

We know that standard go-karts require 25,000 direct labor hours and the activity rate for craftsman- ship is $20 per direct labor hour. Multiplying the number of direct labor hours by the activity rate yields the craftsmanship costs assigned to standard go-karts. Custom go-karts consumed 5,000 direct labor hours, so we assign $100,000 (5,000 DLH 3 $20 per DLH) to that product line. We similarly allocate overhead to setup, design modification, and plant services pools for each type of go-kart.

EXHIBIT 17.13 Overhead Allocated to Go-Karts for KartCo

Standard Go-Karts Custom Go-Karts

Activities Activity Activity Cost Activities Activity Activity Cost Consumed Rate Allocated Consumed Rate Allocated

Craftsmanship 25,000 DLH $20 per DLH $ 500,000 5,000 DLH $20 per DLH $ 100,000

Setup 40 batches $10,000 per 400,000 160 batches $10,000 per 1,600,000 batch batch

Design 0 designs $120,000 per 0 10 designs $120,000 per 1,200,000 modification design design

Plant services 12,000 sq. ft. $50 per sq. ft. 600,000 8,000 sq. ft. $50 per sq. ft. 400,000

Total cost $1,500,000 $3,300,000

In assigning overhead costs to products, KartCo assigned no design modification costs to stan- dard go-karts because standard go-karts are sold as “off-the-shelf ” items. Overhead cost per unit is computed by dividing total overhead cost allocated to each product line by the number of product units. KartCo’s overhead cost per unit for its standard and custom go-karts is computed and shown in Exhibit 17.14.

Total cost per unit for KartCo using ABC for its two products follows.

EXHIBIT 17.14 Overhead Cost per Unit for Go-Karts Using ABC

(A) (B) (A 4 B) Total Overhead Budgeted Units of Overhead Cost Cost Allocated Production per Unit

Standard go-kart . . . . . . . . $1,500,000 5,000 units $ 300 per unit

Custom go-kart . . . . . . . . . 3,300,000 1,000 units $3,300 per unit

Direct Materials Direct Labor Overhead Total Cost per Unit

Standard go-kart . . . $400 $350 $ 300 $1,050

Custom go-kart . . . . 600 500 3,300 4,400

Assuming that ABC more accurately assigns costs, we now are able to help KartCo’s manage- ment understand how its competitors can sell their standard models at $1,200 and why KartCo is flooded with orders for custom go-karts. Specifically, if the cost to produce a standard go-kart is $1,050, as shown above (and not $1,470 as computed using the plantwide rate or $1,450 computed using departmental rates), a profit of $150 ($1,200 2 $1,050) occurs on each standard unit sold at the competitive $1,200 market price. Further, selling its custom go-kart at $3,500 is a mistake by KartCo management because it is losing $900 ($3,500 2 $4,400) on each custom go-kart sold. That is, KartCo has underpriced its custom go-kart relative to its production costs and competitors’ prices, which explains why the company has more custom orders than it can supply. Overhead allocation per go-kart under the single plantwide rate method, multiple departmen- tal rate method, and ABC is summarized in Exhibit 17.15. Overhead cost allocated to standard

Point: Accurately assigning costs to products is key to setting many product prices. If product costs are inaccurate and result in prices that are too low, the company loses money on each item sold. Likewise, if product prices are improperly set too high, the company loses business to competitors. ABC can be used to more accurately set prices.

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748 Chapter 17 Activity-Based Costing and Analysis

EXHIBIT 17.15 Comparison of Overhead Allocations by Method

Overhead Cost Overhead Cost per Go-Kart

Allocation Method Standard Go-Kart Custom Go-Kart

Plantwide method . . . . . . . . . . . . . . . . . . . . . . . . $720 $1,200

Departmental method . . . . . . . . . . . . . . . . . . . . . 700 1,300

Activity-based costing . . . . . . . . . . . . . . . . . . . . . 300 3,300

go-karts is much less under ABC than under either of the volume-based costing methods. One reason for this difference is the large design modification costs that were spread over all go- karts under both the plantwide rate and the departmental rate methods even though standard go-karts require no engineering modification. When ABC is used, overhead costs commonly shift from standardized, large-volume products to low-volume, customized specialty products that consume disproportionate resources.

Differences between ABC and Multiple Departmental Rates Using ABC differs from using multiple departmental rates in how overhead cost pools are identified and in how over- head cost in each pool is allocated. When using multiple departmental rates, each department is a cost pool, and overhead cost allocated to each department is assigned to products using a volume-based factor (such as direct labor hours or machine hours). This assumes that overhead costs in each department are directly proportional to the volume-based factor. ABC, on the other hand, recognizes that overhead costs are more complex. For example, purchasing costs might make up one activity cost pool (spanning more than one department) that would include activities such as the number of invoices. ABC emphasizes activities and costs of carrying out these activities. Under ABC, only costs related to the same activity are grouped into a cost pool. Therefore, ABC arguably better reflects the complex nature of overhead costs and how these costs are used in making products.

4. What is a cost driver? Provide an example of a typical cost driver. 5. What is an activity driver? Provide an example of a typical activity driver. 6. Traditional volume-based costing methods tend to: (a) overstate the cost of low-volume

products, (b) overstate the cost of high-volume products, or (c) both a and b.

Quick Check Answers — p. 757

While activity-based costing improves the accuracy of overhead cost allocations to products, it too has limitations. This section describes the major advantages and disadvantages of activity- based costing.

Advantages of Activity-Based Costing More Accurate Overhead Cost Allocation Companies have typically used either a plantwide overhead rate or multiple departmental overhead rates because these methods are more straightforward than ABC and are acceptable under GAAP for external reporting. Under these traditional systems, overhead costs are pooled in a few large pools and are spread

ASSESSING ACTIVITY-BASED COSTING

A2 Identify and assess advantages and disadvantages of activity- based costing.

Entrepreneur You are the entrepreneur of a start-up pharmaceutical company. You are assigning over- head to product units based on machine hours in the packaging area. Profits are slim due to increased competition. One of your larger overhead costs is $10,000 for cleaning and sterilization that occurs each time the packaging system is converted from one product to another. These overhead costs average $0.10 per product unit. Can you reduce cleaning and sterilizing costs by reducing the number of units produced? If not, what should you do to control these overhead costs? ■ [Answer—p. 757]

Decision Maker

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Chapter 17 Activity-Based Costing and Analysis 749

Point: ABC can allocate the selling and administrative costs expensed by GAAP to activities; such costs can include mar- keting costs, costs to process orders, and costs to process customer returns.

uniformly across high- and low-volume products. With ABC, overhead costs are grouped into activity pools. There are usually more activity pools under ABC than cost pools under tradi- tional costing, which usually increases costing accuracy. More important is that overhead costs in each ABC pool are caused by a single activity. This means that overhead costs in each activity pool are allocated to products based on the cost of resources consumed by a product (input) rather than on how many units are produced (output). In sum, overhead cost allocation under ABC is more accurate because (1) there are more cost pools, (2) costs in each pool are more similar, and (3) allocation is based on activities that cause overhead costs.

More Effective Overhead Cost Control In traditional costing, overhead costs are usually allocated to products based on either direct labor hours or machine hours. Such allo- cation typically leads management to focus attention on direct labor cost or machine hours. Yet, direct labor or machine hours are often not the cause of overhead costs and often not even linked with these volume-related measures. As we saw with KartCo, design modifications markedly affect its overhead costs. Consequently, a plantwide overhead rate or departmental overhead rate based on direct labor or machine hours can mislead managers, preventing effective control of overhead costs and leading to product mispricing. ABC, on the other hand, can be used to identify activities that can benefit from process improvement. ABC can also help managers effectively control overhead cost by focusing on processes or activities such as batching setups, order processing, and design modifications instead of focusing only on direct labor or machine hours. For KartCo, identification of large design-modification costs would allow managers to work on initiatives to improve this process. Besides controlling overhead costs, KartCo’s better assignment of overhead costs (particularly design-modification costs) for its go-karts helps its managers make better production and pricing decisions.

Focus on Relevant Factors Basing cost assignment on activities is not limited to determin ing product costs, as illustrated by KartCo. ABC can be used to assign costs to any cost object that is of management interest. For instance, a marketing manager often wants to determine the profitability of various market segments. Activity-based costing can be used to accurately assign costs of shipping, advertising, order-taking, and customer service that are un- related to sales and costs of products sold. Such an activity-based analysis can reveal to the marketing department some customers that are better left to the competition if they consume a larger amount of market ing resources than the gross profit generated by sales to those custom- ers. Generally, ABC provides better customer profitability information by including all re- sources consumed to serve a customer. This allows managers to make better pricing decisions on custom orders and to better manage customers by focusing on those that are most profitable.

Better Management of Activities Being competitive requires that managers be able to use resources efficiently. Understanding how costs are incurred is a first step toward controlling costs. One important contribution of ABC is helping managers identify the causes of costs, that is, the activities driving them. Activity-based management (ABM) is an outgrowth of ABC that draws on the link between activities and cost incurrence for better management. Activity-based management can be useful in distinguishing value-added activities, which add value to a product, from non-value-added activities, which do not. For KartCo, its value-added activities include ma- chining, assembly, and the costs of engineering design changes. Its non-value-added activity is machine repair. The way to control a cost requires changing how much of an activity is performed.

The ABC’s of Decisions Business managers must make long-term strategic decisions, day-to-day operating decisions, and decisions on the type of financing the business needs. Survey evidence suggests that manag- ers find ABC more useful in making strategic, operating, and financing decisions than non-ABC methods. ■

Decision Insight

Costing systems and decisions

0 1 2 3 4 5 6

Financial

Strategic

Operational

T y p

e o

f d

e c is

io n

Non-ABC methods ABC method

Average response, 0=Not useful, 6=Extremely useful Source: Stratton et al., Management Accounting Quarterly, 2009

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750 Chapter 17 Activity-Based Costing and Analysis

Costs of Quality A focus on the costs of activities, via ABC and ABM, lends itself to assess- ments of the costs of quality. These costs refer to costs resulting from manufacturing defective products or providing services that do not meet customer expectations. Exhibit 17.16 summarizes the typical costs of quality.

C3 Describe the four types of activities that cause overhead costs.

Prevention and appraisal costs are incurred before a good or service is provided to a customer. The purpose of these costs is to reduce the chance the customer is provided a defective good or service. Prevention activities focus on quality training and improvement programs to ensure qual- ity is built into the product or service. Common appraisal costs include the costs of inspections to ensure that materials and supplies meet specifications and inspections of finished goods. Internal failure costs are incurred after a company has manufactured a defective product but before that product has been delivered to a customer. Internal failure costs include the costs of reworking products, reinspecting reworked products, and scrap. Finally, external failure costs are incurred after a customer has been provided a defective prod- uct or service. Examples of this type of costs include costs of warranty repairs and costs of recall- ing products. A focus on activities and quality costs can lead to higher quality and lower costs.

Disadvantages of Activity-Based Costing Costs to Implement and Maintain ABC Designing and implementing an activity- based costing system requires management commitment and financial resources. For ABC to be effective, a thorough analysis of cost activities must be performed and appropriate cost pools must be determined. Collecting and analyzing cost data are expensive and so is maintaining an ABC system. While technology, such as bar coding, has made it possible for many companies to use ABC, it is still too costly for some. Managers must weigh the cost of implementing and maintain- ing an ABC system against the potential benefits of ABC in light of company circumstances.

Uncertainty with Decisions Remains As with all cost information, managers must in- terpret ABC data with caution in making managerial decisions. In the KartCo case, given the huge design-modification costs for custom go-karts determined under the ABC system, a manager might be tempted to decline some custom go-kart orders to save overhead costs. However, in the short run, some or all of the design-modification costs cannot be saved even if some custom go-kart orders are rejected. Managers must examine carefully the controllability of costs before making decisions.

ABC for Service Providers While we showed how to use ABC in a manufacturing setting, ABC also applies to service pro- viders. The only requirements for ABC are the existence of costs and demand for reliable cost information. A study found that ABC improves health care costing accuracy, enabling improved profitability analysis and decision making. Likewise, First Tennessee National Corporation, a bank, applied ABC and found that 30% of its certificate of deposit (CD) customers provided nearly 90% of its profits from CDs. Further, 30% of the bank’s CD customers were actually los- ing money for the bank. The bank’s management used ABC to correct the problem and increase profits. Laboratories performing medical tests, accounting and law offices, and advertising agencies are other examples of service firms that can benefit from ABC. (Refer to this chapter’s Decision Analysis for an example of applying ABC to assess customer profitability and this chapter’s Demonstration Problem for an example of applying ABC to a law firm.)

Types of Activities Activities causing overhead cost can be separated into four levels of types of activities: (1) unit level activities, (2) batch level activities, (3) product level activities, and (4) facility level ac- tivities. These four activities are described as follows.

EXHIBIT 17.16 Types of Quality Costs

Prevention costs Internal failure costsAppraisal costs External failure costs

–4% 2009

–2%

0%

2%

Retur

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Chapter 17 Activity-Based Costing and Analysis 751

Batch level activities are performed only on each batch or group of units. For example, machine setup is needed only for each batch regardless of the units in that batch, and customer order processing must be performed for each order regardless of the number of units ordered. Batch level costs do not vary with the number of units, but instead with the number of batches.

Unit level activities are performed on each product unit. For example, the machining department needs electricity to power the machinery to produce each unit of product. Unit level costs tend to change with the number of units produced.

Product level activities are performed on each product line and are not affected by either the numbers of units or batches. For example, product design is needed only for each product line. Product level costs do not vary with the number of units or batches produced.

Facility level activities are performed to sustain facility capacity as a whole and are not caused by any specific product. For example, rent and factory maintenance costs are incurred no matter what is being produced. Facility level costs do not vary with what is manufactured, how many batches are produced, or the output quantity.

Activity Levels

In the KartCo example, the craftsmanship pool reflects unit level costs, the setup pool reflects batch level costs, the design-modification pool reflects product level costs, and plant services reflect facility level costs. Additional examples of activities commonly found within each of the four activity levels are shown in the following table. This is not a complete list, but reviewing it can help in understand- ing this hierarchy of production activities. This list also includes common measures used to re- flect the specific activity identified. Knowing this hierarchy can help us simplify and understand activity-based costing.

Activity Level Examples of Activity Activity Driver (Measure)

Unit level Cutting parts Machine hours Assembling components Direct labor hours Printing checks Number of checks

Batch level Calibrating machines Number of batches Receiving shipments Number of orders Sampling product quality Number of lots produced

Product level Designing modifications Change requests Organizing production Engineering hours Controlling inventory Parts per product

Facility level Cleaning workplace Square feet of floors* Providing electricity Kilowatt hours* Providing personnel support Number of employees*

* Facility level costs are not traceable to individual product lines, batches, or units. They are normally assigned to units using a unit-level driver such as direct labor hours or machine hours even though they are caused by another activity.

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752 Chapter 17 Activity-Based Costing and Analysis

7. What are three advantages of ABC over traditional volume-based allocation methods? 8. What is the main advantage of traditional volume-based allocation methods compared to

activity-based costing? How should a manager decide which method to use?

Quick Check Answers — p. 757

Toyota Motor Corporation pioneered lean manufacturing, which focuses on eliminating waste while satisfying customers. Many lean manufacturers embrace lean accounting, which has two key compo- nents. First, the company applies lean thinking to eliminate waste in its accounting process. Second, in- stead of focusing on cost allocation methods such as activity-based costing, the company develops alternative performance measures that better reflect the benefits of manufacturing process changes. Ex- amples include the percentage of products produced without defects, the percentage of ontime deliveries, and the level of sales per employee.

GLOBAL VIEW

Customer ProfitabilityDecision Analysis

Are all customers equal? To help answer this, let’s return to the KartCo case and assume that costs of providing customer support (such as delivery, installation, and warranty work) are related to the distance a technician must travel to provide services. Also assume that, as a result of applying activity-based cost- ing, KartCo plans to sell its standard go-kart for $1,200 per unit. If the annual cost of customer services is expected to be $250,000 and the distance traveled by technicians is 100,000 miles annually, KartCo would want to link the cost of customer services with individual customers to make efficient marketing decisions. Using these data, an activity rate of $2.50 per mile ($250,000/100,000 miles) is computed for assigning customer service costs to individual customers. For KartCo, it would compute a typical customer profit- ability report for one of its customers, Six Flags, as follows.

Customer Profitability Report—Six Flags

Sales (10 standard go-karts 3 $1,200) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000

Less: Product costs

Direct materials (10 go-karts 3 $400 per go-kart) . . . . . . . . . . . . . . . $4,000

Direct labor (10 go-karts 3 $350 per go-kart) . . . . . . . . . . . . . . . . . . . 3,500

Overhead (10 go-karts 3 $300 per go-kart, Exhibit 17.14) . . . . . . . . 3,000 10,500

Product profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Less: Customer service costs (200 miles 3 $2.50 per mile) . . . . . . . . . . . . 500

Customer profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000

Analysis indicates that a total profit margin of $1,000 is generated from this customer. The manage- ment of KartCo can see that if this customer requires service technicians to travel more than 600 miles ($1,500 4 $2.50 per mile), the sale of 10 standard go-karts to this customer would be unprofitable. ABC encourages management to consider all resources consumed to serve a customer, not just manufacturing costs that are the focus of traditional costing methods.

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Chapter 17 Activity-Based Costing and Analysis 753

Silver Law Firm provides litigation and mediation services to a variety of clients. Attorneys keep track of the time they spend on each case, which is used to charge fees to clients at a rate of $300 per hour. A man- agement advisor commented that activity-based costing might prove useful in evaluating the costs of its legal services, and the firm has decided to evaluate its fee structure by comparing ABC to its alternative cost allocations. The following data relate to a typical month at the firm. During a typical month the firm handles seven mediation cases and three litigation cases.

DEMONSTRATION PROBLEM

Required

1. Determine the cost of providing legal services to each type of case using activity-based costing (ABC). 2. Determine the cost of each type of case using a single plantwide rate for nonattorney costs based on

billable hours. 3. Determine the cost of each type of case using multiple departmental overhead rates for the internal

support department (based on number of documents) and external support department (based on bill- able hours).

4. Compare and discuss the costs assigned under each method for management decisions.

PLANNING THE SOLUTION ● Compute pool rates and assign costs to cases using ABC. ● Compute costs for the cases using the volume-based methods and discuss differences between these

costs and the costs computed using ABC.

SOLUTION TO DEMONSTRATION PROBLEM 1. We need to set up activity pools and compute pool rates for ABC. All activities except “occupying

office space” and “heating and lighting” are unit level (meaning they are traceable to the individual cases handled by the law firm). “Preparing documents” and “registering documents” are both driven by the number of documents associated with each case. We can therefore combine these activities and their costs into a single pool, which we call “clerical support.” Similarly, “retaining consultants” and “using services” are related to the number of times the attorneys must go to court (court dates). We combine these activities and their costs into another activity cost pool labeled “litigation support.” The costs associated with occupying office space and the heating and lighting are facility level ac- tivities and are not traceable to individual cases. Yet they are costs that must be covered by fees charged to clients. We assign these costs using a convenient base—in this example we use the number of billable hours, which attorneys record for each client. Providing legal advice is the direct labor for a law firm.

Consumption by

Activity

Total Service Type

Activity Driver Amount Litigation Mediation Cost

Providing legal advice . . . . . . . . . . . . . . . . . Billable hours 200 75 125 $30,000

Overhead costs

Internal support departments

Preparing documents . . . . . . . . . . . . . . Documents 30 16 14 $ 4,000

Occupying office space . . . . . . . . . . . . . Billable hours 200 75 125 1,200

Heating and lighting of office . . . . . . . . . Billable hours 200 75 125 350

External support departments

Registering court documents . . . . . . . . Documents 30 16 14 1,250

Retaining consultants (investigators, psychiatrists) . . . . . . . . Court dates 6 5 1 10,000

Using contract services (couriers, security guards) . . . . . . . . Court dates 6 5 1 5,000

Total overhead costs $21,800

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754 Chapter 17 Activity-Based Costing and Analysis754 Chapter 17 Activity-Based Costing and Analysis

We next determine the cost of providing each type of legal service as shown in the following table. Specifically, the pool rates from above are used to assign costs to each type of service provided by the law firm. Since litigation consumed 75 billable hours of attorney time, we assign $11,250 (75 billable hours 3 $150 per billable hour) of the cost of providing legal advice to this type of case. Mediation required 125 hours of attorney time, so $18,750 (125 billable hours 3 $150 per billable hour) of the cost to provide legal advice is assigned to mediation cases. Clerical support cost $175 per document, so the costs associated with activities in this cost pool are assigned to litigation cases (16 docu- ments 3 $175 per document 5 $2,800) and mediation cases (14 documents 3 $175 per document 5 $2,450). The costs of activities in the litigation support and the facility cost pools are similarly as- signed to the two case types.

We compute the total cost of litigation ($27,131.25) and mediation ($24,668.75) and divide these totals by the number of cases of each type to determine the average cost of each case type: $9,044 for litigation and $3,524 for mediation. This analysis shows that charging clients $300 per billable hour without regard to the type of case results in litigation clients being charged less than the cost to provide that service ($7,500 versus $9,044).

Activity Pool Activity Pool Rate (Pool Cost Activity Pool Cost Cost Driver 4 Activity Driver)

Providing legal advice . . . . . . . . . . . . $30,000 $30,000 200 billable hours $150 per billable hour

Clerical support

Preparing documents . . . . . . . . . . 4,000

Registering documents . . . . . . . . . 1,250 5,250 30 documents $175 per document

Litigation support

Retaining consultants . . . . . . . . . . 10,000

Using services . . . . . . . . . . . . . . . . 5,000 15,000 6 court dates $2,500 per court date

Facility costs

Occupying office space . . . . . . . . . 1,200

Heating and lighting . . . . . . . . . . . 350 1,550 200 billable hours $7.75 per billable hour

2. The cost of each type of case using a single plantwide rate for nonattorney costs (that is, all costs ex- cept for those related to providing legal advice) based on billable hours is as follows.

* (75 billable hours 3 $300 per hour) 4 3 cases † (125 billable hours 3 $300 per hour) 4 7 cases

Pool Rate Litigation Mediation

Providing legal advice . . . . . . $150 per 75 hours $11,250.00 125 hours $18,750.00 billable hour

Clerical support . . . . . . . . . . $175 per 16 docs 2,800.00 14 docs 2,450.00 document

Litigation support . . . . . . . . $2,500 per 5 court dates 12,500.00 1 court date 2,500.00 court date

Facility costs . . . . . . . . . . . . $7.75 per 75 hours 581.25 125 hours 968.75 billable hour

Total cost . . . . . . . . . . . . . . . $27,131.25 $24,668.75

4 Number of cases . . . . . . . 3 cases 7 cases

Average cost per case . . . . . $9,044 $3,524

Average fee per case . . . . . . $7,500* $5,357†

Total overhead cost/ Total billable hours 5 $21,800/200 billable hours 5 $109 per hour

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Chapter 17 Activity-Based Costing and Analysis 755

We then determine the cost of providing each type of legal service as follows.

Litigation Mediation

Providing legal advice . . . . . . . . . . . $150 per billable hour 75 hours $11,250 125 hours $18,750

Overhead (from part 2). . . . . . . . . $109 per billable hour 75 hours 8,175 125 hours 13,625

Total cost . . . . . . . . . . . . . . . . . . . . $19,425 $32,375

4 Number of cases . . . . . . . . . . . . 3 cases 7 cases

Average cost per case . . . . . . . . . . $6,475 $4,625

Average fee per case . . . . . . . . . . . $7,500 $5,357 (from part 1)

3. The cost of each type of case using multiple departmental overhead rates for the internal support de- partment (based on number of documents) and external support department (based on billable hours) is determined as follows.

The departmental overhead rates computed above are used to assign overhead costs to the two types of legal services. For the internal support department we use the overhead rate of $185 per document to assign $2,960 ($185 3 16 documents) to litigation and $2,590 ($185 3 14 documents) to mediation. For the external support department we use the overhead rate of $81.25 per hour to assign $6,093.75 ($81.25 3 75 hours) to litigation and $10,156.25 ($81.25 3 125 hours) to mediation. As shown below, the resulting average costs of litigation cases and mediation cases are $6,768 and $4,499, respectively. Using this method of cost assignment, it appears that the fee of $300 per billable hour is adequate to cover costs associated with each case.

Departmental Departmental Rate Cost Base (Departmental Cost 4 Base)

Internal support departments

Preparing documents . . . . . . . . . $ 4,000

Occupying office space . . . . . . . 1,200

Heating and lighting of office . . . . 350 $ 5,550 30 documents $185 per document

External support departments

Registering documents . . . . . . . 1,250

Retaining consultants . . . . . . . . 10,000

Using contract services . . . . . . . 5,000 16,250 200 billable $81.25 per hour hours

4. A comparison and discussion of the costs assigned under each method follows.

Litigation Mediation

Attorney fees . . . . . . . . . . . . . $150 per billable hour 75 hours $11,250.00 125 hours $18,750.00

Internal support . . . . . . . . . . . $185 per document 16 documents 2,960.00 14 documents 2,590.00

External support . . . . . . . . . . $81.25 per hour 75 hours 6,093.75 125 hours 10,156.25

Total cost . . . . . . . . . . . . . . . . $20,303.75 $31,496.25

4 Number of cases . . . . . . . . 3 cases 7 cases

Average cost per case . . . . . . $6,768 $4,499

Average fee per case . . . . . . . $7,500 $5,357 (from part 1)

Method of Assigning Overhead Costs

Activity-Based Plantwide Departmental Average Cost per Case Costing Overhead Rate Overhead Rates

Litigation cases . . . . . . . . . . . . . . . . . . . $9,044 $6,475 $6,768

Mediation cases . . . . . . . . . . . . . . . . . . 3,524 4,625 4,499

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756 Chapter 17 Activity-Based Costing and Analysis

C1 Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity- based costing method. Overhead costs can be assigned to cost ob- jects using a plantwide rate that combines all overhead costs into a single rate, usually based on direct labor hours, machine hours, or direct labor cost. Multiple departmental overhead rates that include overhead costs traceable to departments are used to allocate over- head based on departmental functions. ABC links overhead costs to activities and assigns overhead based on how much of each activity is required for a product.

C2 Explain cost flows for activity-based costing. With ABC, overhead costs are first traced to the activities that cause them, and then cost pools are formed combining costs caused by the same activity. Overhead rates based on these activities are then used to assign overhead to products in proportion to the amount of activity required to produce them.

C3 Describe the four types of activities that cause overhead costs. The four types of activities that cause overhead costs are: (1) unit level activities, (2) batch level activities, (3) product level activities, and (4) facility level activities. Unit level activities are performed on each unit, batch level activities are performed only on each group of units, and product level activities are performed only on each product line. Facility level activities are performed to sustain facility capacity and are not caused by any specific product. Understanding these types of activities can help in applying activity- based costing.

A1 Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods. A single plantwide overhead rate is a simple way to as- sign overhead cost. A disadvantage is that it can inaccurately assign costs when costs are caused by multiple factors and when different products consume different amounts of inputs. Overhead costing

Summary accuracy is improved by use of multiple departmental rates because differences across departmental functions can be linked to costs in- curred in departments. Yet, accuracy of cost assignment with de- partmental rates suffers from the same problems associated with plantwide rates because activities required for each product are not identified with costs of providing those activities.

A2 Identify and assess advantages and disadvantages of activity-based costing. ABC improves product costing accuracy and draws management attention to relevant factors to con- trol. The cost of constructing and maintaining an ABC system can sometimes outweigh its value.

P1 Allocate overhead costs to products using the plantwide overhead rate method. The plantwide overhead rate equals total budgeted overhead divided by budgeted plant volume, the lat- ter often measured in direct labor hours or machine hours. This rate multiplied by the number of direct labor hours (or machine hours) required for each product provides the overhead assigned to each product.

P2 Allocate overhead costs to products using the departmen-tal overhead rate method. When using multiple departmental rates, overhead cost must first be traced to each department and then divided by the measure of output for that department to yield the de- partmental overhead rate. Overhead is applied to products using this rate as products pass through each department.

P3 Allocate overhead costs to products using activity-based costing. With ABC, overhead costs are matched to activities that cause them. If there is more than one cost with the same activ- ity, these costs are combined into pools. An overhead rate for each pool is determined by dividing total cost for that pool by its activity measure. Overhead costs are assigned to products by multiplying the ABC pool rate by the amount of the activity required for each product.

The departmental and plantwide overhead rate methods assign overhead on the basis of volume-related mea sures (billable hours and document filings). Litigation costs appear profitable under these methods, because the average costs are below the average revenue of $7,500. ABC, however, focuses attention on activities that drive costs. A large part of overhead costs was for consultants and contract services, which were unrelated to the number of cases, but related to the type of cases consuming those re- sources. Using ABC, the costs shift from the high-volume cases (mediation) to the low-volume cases (litigation). When the firm considers the consumption of resources for these cases using ABC, it finds that the fees charged to litigate cases is insufficient (average revenue of $7,500 versus average cost of $9,044). The law firm is charging too little for the complex cases that require litigation.

Department Manager When dividing a bill, common sense suggests fairness. That is, if one department consumes more services than another, we attempt to share the bill in proportion to consump- tion. Equally dividing the bill among the number of departments is fair if each consumed equal services. This same notion applies in assigning costs to products and services. For example, dividing over- head costs by the number of units is fair if all products consumed overhead in equal proportion.

Cost Analyst Before the accounting system can report infor- mation, relevant and accurate data must be collected. One step is to ask questions—it is a good way to leverage others’ experience and knowledge to quickly learn operations. A cost analyst must also un- derstand the manufacturing operation to itemize activities for ABC. Thus, step two might be to tour the manufacturing facility, observing manufacturing operations, asking probing questions, and requesting recommendations from the people who work in those operations. We

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 17 Activity-Based Costing and Analysis 757

Multiple Choice Quiz Answers on p. 775 mhhe.com/wildFINMAN5e

Additional Quiz Questions are available at the book’s Website.

1. In comparison to a traditional cost system, and when there are batch level or product level costs, an activity-based costing system usually:

a. Shifts costs from low-volume to high-volume products. b. Shifts costs from high-volume to low-volume products. c. Shifts costs from standardized to specialized products. d. Shifts costs from specialized to standardized products. 2. Which of the following statements is (are) true? a. An activity-based costing system is generally easier to im-

plement and maintain than a traditional costing system. b. One of the goals of activity-based management is the elim-

ination of waste by allocating costs to products that waste resources.

c. Activity-based costing uses a number of activity cost pools, each of which is allocated to products on the basis of direct labor hours.

d. Activity rates in activity-based costing are computed by di- viding costs from the first-stage allocations by the activity measure for each activity cost pool.

3. All of the following are examples of batch level activities except:

a. Purchase order processing. b. Setting up equipment.

c. Clerical activity associated with processing purchase orders to produce an order for a standard product.

d. Employee recreational facilities. 4. A company has two products: A and B. It uses activity-based

costing and prepares the following analysis showing budgeted cost and activity for each of its three activity cost pools.

Annual production and sales level of Product A is 18,188 units, and the annual production and sales level of Product B is 31,652 units. The approximate overhead cost per unit of Prod- uct B under activity-based costing is:

a. $2.02 b. $5.00 c. $12.87 d. $22.40

Budgeted Budgeted Activity Activity Overhead

Cost Pool Cost Product A Product B Total

Activity 1 $ 80,000 200 800 1,000

Activity 2 58,400 1,000 500 1,500

Activity 3 360,000 600 5,400 6,000

must remember that these employees are the experts who can provide the data we need to implement an activity-based costing system.

Entrepreneur Cleaning and sterilizing costs are not directly re- lated to the volume of product manufactured. Thus, changing the number of units produced does not necessarily reduce these costs. Further, expressing costs of cleaning and sterilizing on a per unit basis

is often misleading for the person responsible for controlling costs. Costs of cleaning and sterilizing are related to changing from one product line to another. Consequently, the way to control those costs is to control the number of times the packing system has to be changed for a different product line. Thus, efficient product scheduling would help reduce those overhead costs and improve profitability.

1. d 2. a 3. b 4. A cost driver is an activity that causes costs to be incurred.

Setup costs, design modifications, and plant services such as maintenance and utilities are examples of typical cost drivers.

5. An activity driver is the measurement used for cost drivers. An example is machine hours.

6. b 7. Three advantages of ABC over traditional methods are: (a) more

accurate product costing; (b) more effective cost control; and (c) focus on relevant factors for decision making.

8. Traditional volume-based methods are easier and less costly to implement and maintain. The choice of accounting method should be made by comparing the costs of alternatives with their benefits.

Guidance Answers to Quick Checks

Activity (p. 743)

Activity-based costing (ABC) (p. 743)

Activity-based management (p. 749)

Activity cost driver (p. 746)

Activity cost pool (p. 743)

Activity overhead (pool) rate (p. 743)

Batch level activities (p. 750)

Cost object (p. 739)

Costs of quality (p. 750)

Facility level activities (p. 750)

Lean accounting (p. 752)

Product level activities (p. 750)

Unit level activities (p. 750)

Value-added activities (p. 749)

Key Terms

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758 Chapter 17 Activity-Based Costing and Analysis

1. Why are overhead costs allocated to products and not traced to products as direct materials and direct labor are?

2. What are three common methods of assigning overhead costs to a product?

3. Why are direct labor hours and machine hours commonly used as the bases for overhead allocation?

4. What are the advantages of using a single plantwide overhead rate?

5. The usefulness of a single plantwide overhead rate is based on two assumptions. What are those assumptions?

6. What is a cost object? 7. Explain why a single plantwide overhead rate can distort

the cost of a particular product. 8. Why are multiple departmental overhead rates more ac-

curate for product costing than a single plantwide overhead rate?

9. In what way are departmental overhead rates similar to a single plantwide overhead rate? How are they different?

10. KTM reports costs in financial statements. If plantwide overhead rates are allowed for reporting costs to external users, why might a company choose to use a more complicated and more expensive method for assigning overhead costs to products?

11. What is the first step in applying activity-based costing? 12. What is an activity cost driver? 13. Arctic Cat’s production requires activities. What

are value-added activities? 14. What are the four activity levels associated with activity-based

costing? Define each. 15. Piaggio is a manufacturer. “Activity-based

costing is only useful for manufacturing companies.” Is this a true statement? Explain.

16. Polaris must assign overhead costs to its products. Activity-based costing is generally con- sidered more accurate than other methods of assigning overhead. If this is so, why do all manufacturing companies not use it?

Discussion Questions

Icon denotes assignments that involve decision making.

KTM

The activity rate under the activity-based costing method for Activity 3 is approximately:

a. $4.00 b. $8.59 c. $18.00 d. $20.00

5. A company uses activity-based costing to determine the costs of its two products: A and B. The budgeted cost and activity for each of the company’s three activity cost pools follow.

Activity Budgeted Budgeted Activity

Cost Pool Cost Product A Product B Total

Activity 1 $19,800 800 300 1,100

Activity 2 16,000 2,200 1,800 4,000

Activity 3 14,000 400 300 700

QUICK STUDY

QS 17-1 Costing terminology

C2

In the blank next to the following terms, place the letter A through D corresponding to the best description of that term. 1. Activity 2. Activity driver 3. Cost object 4. Cost pool

A. Measurement associated with an activity. B. A group of costs that have the same activity drivers. C. Anything to which costs will be assigned. D. A task that causes a cost to be incurred.

QS 17-2 Overhead cost allocation methods

C1

In the blank next to each of the following terms, place the letter A through D that corresponds to the description of that term. Some letters are used more than once. 1. Activity-based costing 2. Plantwide overhead rate method 3. Departmental overhead rate method

A. Uses more than one rate to allocate overhead costs to products.

B. Uses only volume-based measures such as direct labor hours to allocate overhead costs to products.

C. Typically uses the most overhead allocation rates. D. Focuses on the costs of carrying out activities.

Arctic Cat

Polaris

PIAGGIO

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Chapter 17 Activity-Based Costing and Analysis 759

QS 17-3 Advantages of plantwide and departmental rate methods A1

List the three main advantages of the plantwide and departmental overhead rate methods.

QS 17-4 Identify activity levels

C3

Identify each of the following activities as unit level (U), batch level (B), product level (P), or facility level (F) to indicate the way each is incurred with respect to production. 1. Paying real estate taxes on the factory building. 2. Attaching labels to collars of shirts. 3. Redesigning a bicycle seat in response to customer feedback. 4. Cleaning the assembly department. 5. Polishing of gold wedding rings. 6. Mixing of bread dough in a commercial bakery. 7. Sampling cookies to determine quality.

QS 17-5 Compute plantwide overhead rates

P1

Rafner Manufacturing identified the following data in its two production departments.

Assembly Finishing

Manufacturing overhead costs . . . . . . . . . $1,200,000 $600,000

Direct labor hours worked . . . . . . . . . . . 12,000 DLH 20,000 DLH

Machine hours used . . . . . . . . . . . . . . . . . 6,000 MH 16,000 MH

Required

1. What is the company’s single plantwide overhead rate based on direct labor hours? 2. What is the company’s single plantwide overhead rate based on machine hours?

QS 17-6 Compute departmental overhead rates P2

Refer to the information in QS 17-5. What are the company’s departmental overhead rates if the assembly department assigns overhead based on direct labor hours and the finishing department assigns overhead based on machine hours?

QS 17-7 Compute plantwide overhead rates

P1

Xie Company identified the following activities, costs, and activity drivers. The company manufactures two types of go-karts: Deluxe and Basic. Production volume is 10,000 units of the Deluxe model and 30,000 units of the Basic model.

Activity Expected Costs Expected Activity

Handling materials . . . . . . . . . . . . . . . . $625,000 100,000 parts in stock

Inspecting product . . . . . . . . . . . . . . . . 900,000 1,500 batches

Processing purchase orders. . . . . . . . . 105,000 700 orders

Paying suppliers . . . . . . . . . . . . . . . . . . 175,000 500 invoices

Insuring the factory . . . . . . . . . . . . . . . 300,000 40,000 square feet

Designing packaging . . . . . . . . . . . . . . . 375,000 10 models

Required

1. Compute a single plantwide overhead rate assuming that the company assigns overhead based on 125,000 budgeted direct labor hours.

2. Assign overhead costs to each model assuming the Deluxe model requires 25,000 direct labor hours and the Basic model requires 60,000 direct labor hours. What is the overhead cost per unit for each model?

QS 17-8 Compute overhead rates under ABC P3

Refer to the information in QS 17-7. Compute the activity rate for each activity, assuming the company uses activity-based costing.

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760 Chapter 17 Activity-Based Costing and Analysis

QS 17-11 Assigning costs using ABC

P3

Aziz Company sells two types of products, Basic and Deluxe. The company provides technical support for users of its products, at an expected cost of $250,000 per year. The company expects to process 10,000 customer service calls per year.

Required

1. Determine the company’s cost of technical support per customer service call. 2. During the month of January, Aziz received 550 calls for customer service on its Deluxe model, and

250 calls for customer service on its Basic model. Assign technical support costs to each model using activity-based costing (ABC).

QS 17-9 Assigning costs using ABC

P3

Refer to the data in QS 17-7. Assume that the following information is available for the company’s two products.

Deluxe Model Basic Model

Production volume. . . . . . . . . 10,000 units 30,000 units

Parts required . . . . . . . . . . . . 20,000 parts 30,000 parts

Batches made . . . . . . . . . . . . . 250 batches 100 batches

Purchase orders . . . . . . . . . . 50 orders 20 orders

Invoices . . . . . . . . . . . . . . . . . 50 invoices 10 invoices

Space occupied . . . . . . . . . . . 10,000 sq. ft. 7,000 sq. ft.

Models . . . . . . . . . . . . . . . . . . 1 model 1 model

Required

Assign overhead costs to each product model using activity-based costing (ABC). What is the overhead cost per unit of each model?

QS 17-10 Multiple choice overhead questions

A2

1. If management wants the most accurate product cost, which of the following costing methods should be used?

a. Volume-based costing using departmental overhead rates b. Volume-based costing using a plantwide overhead rate c. Normal costing using a plantwide overhead rate d. Activity-based costing 2. Which costing method tends to overstate the cost of high-volume products? a. Traditional volume-based costing c. Job order costing b. Activity-based costing d. Differential costing 3. Disadvantages of activity-based costing include a. It is not acceptable under GAAP c. It can be used in an activity-based management.

for external reporting. d. Both a. and b. b. It can be costly to implement.

QS 17-12 Computing activity rates

P3

A company uses activity-based costing to determine the costs of its three products: A, B, and C. The budgeted cost and cost driver activity for each of the company’s three activity cost pools follow.

Budgeted Activity of Cost Driver

Activity Cost Pool Budgeted Cost Product A Product B Product C

Activity 1 . . . . . . . . . . . . . . . . . $140,000 20,000 9,000 6,000

Activity 2 . . . . . . . . . . . . . . . . . $ 90,000 8,000 15,000 7,000

Activity 3 . . . . . . . . . . . . . . . . . $ 82,000 1,625 1,000 2,500

Compute the activity rates for each of the company’s three activities.

QS 17-13 Activity-based costing and overhead cost allocation P3

The following is taken from Ronda Co.’s internal records of its factory with two operating departments. The cost driver for indirect labor and supplies is direct labor costs, and the cost driver for the remaining overhead items is number of hours of machine use. Compute the total amount of overhead cost allocated to Operating Department 1 using activity-based costing.

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Chapter 17 Activity-Based Costing and Analysis 761

Direct Labor Machine Use Hours

Operating department 1 . . . . . . . . . $18,800 2,000 Operating department 2 . . . . . . . . . 13,200 1,200 Totals . . . . . . . . . . . . . . . . . . . . . . . . $32,000 3,200

Factory overhead costs

Rent and utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,200 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,400 General office expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Depreciation — Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600 Total factory overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,200 Check Dept. 1 allocation, $16,700

Budgeted Activity of Cost Driver

Activity Cost Pool Budgeted Cost Standard Deluxe

Activity 1 . . . . . . . . . . . . . . . . . $93,000 2,500 5,250 Activity 2 . . . . . . . . . . . . . . . . . $92,000 4,500 5,500 Activity 3 . . . . . . . . . . . . . . . . . $87,000 3,000 2,800

QS 17-14 Activity-based costing rates and allocations

P3

A company has two products: standard and deluxe. The company expects to produce 36,375 standard units and 62,240 deluxe units. It uses activity-based costing and has prepared the following analysis showing budgeted cost and cost driver activity for each of its three activity cost pools.

Required

1. What is the overhead cost per unit for the standard units? 2. What is the overhead cost per unit for the deluxe units?

QS 17-15 Costs of quality

A2

A list of activities that generate quality costs is provided below. For each activity, indicate whether it relates to a prevention activity (P), appraisal activity (A), internal failure activity (I), or external failure activity (E). a. Inspecting raw materials b. Training workers in quality techniques c. Collecting data on a manufacturing process d. Overtime labor to rework products

e. Cost of additional materials to rework a product f. Inspecting finished goods inventory g. Scrapping defective goods h. Lost sales due to customer dissatisfaction

QS 17-16 Lean accounting and ABC

A2

Toyota embraces lean techniques, including lean accounting. What are the two key components of lean accounting?

1. When using departmental overhead rates, which of the following cost objects is the first in the cost allocation process?

a. Activities c. Product lines b. Units of product d. Departments 2. Which costing method assumes all products use overhead costs in the same proportions? a. Activity-based costing c. Departmental overhead rate method b. Plantwide overhead rate method d. All cost allocation methods 3. Which of the following would usually not be used in computing plantwide overhead rates? a. Direct labor hours c. Direct labor dollars b. Number of quality inspections d. Machine hours 4. With ABC, overhead costs should be traced to which cost object first? a. Units of product c. Activities b. Departments d. Product batches

EXERCISES

Exercise 17-1 Cost allocation methods

C1

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762 Chapter 17 Activity-Based Costing and Analysis

Exercise 17-2 Cost flows under activity-based costing C2

Explain the two basic stages of cost flows for activity-based costing.

Exercise 17-3 Comparing overhead allocation methods A2

Why is overhead allocation under ABC usually more accurate than either the plantwide overhead allocation method or the departmental overhead allocation method?

Exercise 17-4 Activity classification

C3

Following are activities in providing medical services at Healthsmart Clinic. A. Registering patients E. Ordering medical equipment B. Cleaning beds F. Heating the clinic C. Stocking examination rooms G. Providing security services D. Washing linens H. Filling prescriptions

Required

1. Classify each activity as unit level (U), batch level (B), product level (P), or facility level (F). 2. Identify an activity driver that might be used to measure these activities at the clinic.

Exercise 17-5 Comparing costs under ABC to traditional plantwide overhead rate

P1 P3 A1 A2

Smythe Crystal makes fine tableware in its Ireland factory. The following data are taken from its production plans for the year.

Wine Glasses Commemorative Vases

Expected production . . . . . . . . . . . . . . . 211,000 units 17,000 units

Direct labor hours required . . . . . . . . . 254,000 DLH 16,400 DLH

Machine setups required . . . . . . . . . . . . 200 setups 800 setups

Direct labor costs . . . . . . . . . €5,870,000

Setup costs . . . . . . . . . . . . . . . 630,000

Required

1. Determine the setup cost per unit for the wine glasses and for the commemorative vases if setup costs are assigned using a single plantwide overhead rate based on direct labor hours.

2. Determine setup costs per unit for the wine glasses and for the commemorative vases if the setup costs are assigned based on the number of setups.

3. Which method is better for assigning costs to each product? Explain.

Check (2) Vases, €29.65 per unit

Exercise 17-6 Using the plantwide overhead rate to assess prices P1

Way Cool produces two different models of air conditioners. The company produces the mechanical sys- tems in their components department. The mechanical systems are combined with the housing assembly in its finishing department. The activities, costs, and drivers associated with these two manufacturing pro- cesses and the production support process follow.

Process Activity Overhead Cost Driver Quantity

Components Changeover $ 500,000 Number of batches 800

Machining 279,000 Machine hours 6,000

Setups 225,000 Number of setups 120

$1,004,000

Finishing Welding $ 180,300 Welding hours 3,000

Inspecting 210,000 Number of inspections 700

Rework 75,000 Rework orders 300

$ 465,300

Support Purchasing $ 135,000 Purchase orders 450

Providing space 32,000 Number of units 5,000

Providing utilities 65,000 Number of units 5,000

$ 232,000

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Chapter 17 Activity-Based Costing and Analysis 763

Required

1. Using a plantwide overhead rate based on machine hours, compute the overhead cost per unit for each product line.

2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per unit are $250 for Model 145 and $180 for Model 212.

3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the profit or loss per unit for each model. Comment on the results.

Check (3) Model 212, $(40.26) per unit loss

Model 145 Model 212

Units produced . . . . . . . . . . . . . . . 1,500 3,500 Welding hours . . . . . . . . . . . . . . . . 800 2,200 Batches . . . . . . . . . . . . . . . . . . . . . 400 400 Number of inspections . . . . . . . . . 400 300 Machine hours . . . . . . . . . . . . . . . . 1,800 4,200 Setups . . . . . . . . . . . . . . . . . . . . . . 60 60 Rework orders . . . . . . . . . . . . . . . 160 140 Purchase orders . . . . . . . . . . . . . . 300 150

Additional production information concerning its two product lines follows.

Refer to the information in Exercise 17-6 to answer the following requirements.

Required

1. Determine departmental overhead rates and compute the overhead cost per unit for each product line. Base your overhead assignment for the components department on machine hours. Use welding hours to assign overhead costs to the finishing department. Assign costs to the support department based on number of purchase orders.

2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per unit are $250 for Model 145 and $180 for Model 212.

3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the profit or loss per unit for each model. Comment on the results.

Exercise 17-7 Using departmental overhead rates to assess prices

P2

Check (3) Model 212, $(20.38) per unit loss

Refer to the information in Exercise 17-6 to answer the following requirements.

Required

1. Using ABC, compute the overhead cost per unit for each product line. 2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per

unit are $250 for Model 145 and $180 for Model 212. 3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the

profit or loss per unit for each model. Comment on the results.

Exercise 17-8 Using ABC to assess prices

P3

Check (3) Model 212, $34.88 per unit profit

Exercise 17-9 Plantwide overhead rate

P1

Textra Plastics produces parts for a variety of small machine manufacturers. Most products go through two operations, molding and trimming, before they are ready for packaging. Expected costs and activities for the molding department and for the trimming department for 2013 follow.

Molding Trimming

Direct labor hours . . . . . . . . . 52,000 DLH 48,000 DLH Machine hours . . . . . . . . . . . . 30,500 MH 3,600 MH Overhead costs . . . . . . . . . . . $730,000 $590,000

Data for two special order parts to be manufactured by the company in 2013 follow:

Part A27C Part X82B

Number of units . . . . . . . . . . 9,800 units 54,500 units Machine hours Molding . . . . . . . . . . . . . . . 5,100 MH 1,020 MH Trimming . . . . . . . . . . . . . . 2,600 MH 650 MH Direct labor hours Molding . . . . . . . . . . . . . . . 5,500 DLH 2,150 DLH Trimming . . . . . . . . . . . . . . 700 DLH 3,500 DLH

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764 Chapter 17 Activity-Based Costing and Analysis

Required

1. Compute the plantwide overhead rate using direct labor hours as the base. 2. Determine the overhead cost assigned to each product line using the plantwide rate computed in

requirement 1.

Exercise 17-10 Departmental overhead rates

P2

Refer to the information in Exercise 17-9.

Required

1. Compute a departmental overhead rate for the molding department based on machine hours and a department overhead rate for the trimming department based on direct labor hours.

2. Determine the total overhead cost assigned to each product line using the departmental overhead rates from requirement 2.

3. Determine the overhead cost per unit for each product line using the departmental rate.

Exercise 17-11 Assigning overhead costs using the plantwide rate and departmental rate methods

P1 P2

Laval produces lamps and home lighting fixtures. Its most popular product is a brushed aluminum desk lamp. This lamp is made from components shaped in the fabricating department and assembled in its as- sembly department. Information related to the 35,000 desk lamps produced annually follow.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000

Direct labor

Fabricating department (7,000 DLH 3 $20 per DLH) . . . . . . . . . $140,000

Assembly department (16,000 DLH 3 $29 per DLH) . . . . . . . . . $464,000

Machine hours

Fabricating department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,040 MH

Assembly department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 MH

Expected overhead cost and related data for the two production departments follow.

Fabricating Assembly

Direct labor hours . . . . . . . . . 75,000 DLH 125,000 DLH

Machine hours . . . . . . . . . . . . 80,000 MH 62,500 MH

Overhead cost . . . . . . . . . . . . $300,000 $200,000

Required

1. Determine the plantwide overhead rate for Laval using direct labor hours as a base. 2. Determine the total manufacturing cost per unit for the aluminum desk lamp using the plantwide

overhead rate. 3. Compute departmental overhead rates based on machine hours in the fabricating department and

direct labor hours in the assembly department. 4. Use departmental overhead rates from requirement 3 to determine the total manufacturing cost per

unit for the aluminum desk lamps.

Check (2) $26.90 per unit

Check (4) $27.60 per unit

Exercise 17-12 Using ABC for strategic decisions

P1 P3

Consider the following data for two products of Gitano Manufacturing.

Overhead Cost Product A Product B

Number of units produced . . . . . . . . . . . . . . . . 10,000 units 2,000 units

Direct labor cost (@$24 per DLH) . . . . . . . . . 0.20 DLH per unit 0.25 DLH per unit

Direct materials cost . . . . . . . . . . . . . . . . . . . . . $2 per unit $3 per unit

Activity

Machine setup . . . . . . . . . . . . . . . . . . . . . . . . $121,000

Materials handling . . . . . . . . . . . . . . . . . . . . . 48,000

Quality control . . . . . . . . . . . . . . . . . . . . . . . 80,000

$249,000

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Chapter 17 Activity-Based Costing and Analysis 765

Product A Product B

Number of setups required for production . . . . . . . . . 10 setups 12 setups

Number of parts required . . . . . . . . . . . . . . . . . . . . . . . 1 part/unit 3 parts/unit

Inspection hours required . . . . . . . . . . . . . . . . . . . . . . . 40 hours 210 hours

Required

1. Using direct labor hours as the basis for assigning overhead costs, determine the total production cost per unit for each product line.

2. If the market price for Product A is $20 and the market price for Product B is $60, determine the profit or loss per unit for each product. Comment on the results.

3. Consider the following additional information about these two product lines. If ABC is used for as- signing overhead costs to products, what is the cost per unit for Product A and for Product B?

Check (2) Product B, $26.10 per unit profit

4. Determine the profit or loss per unit for each product. Should this information influence company strategy? Explain.

(4) Product B, ($24.60) per unit loss

Required

1. Using ABC, compute the firm’s activity overhead rates. Form activity cost pools where appropriate. 2. Assign costs to a 9,200 square foot job that requires 450 contact hours, 340 design hours, and 200 days

to complete. Check (2) $150,200

Exercise 17-13 Using ABC in a service company

P3

Cardiff and Delp is an architectural firm that provides services for residential construction projects. The following data pertain to a recent reporting period.

Activities Costs

Design department

Client consultation . . . . . . . . . . . . . . . . . . 1,500 contact hours $270,000

Drawings . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 design hours 115,000

Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 square feet 30,000

Project management department

Supervision . . . . . . . . . . . . . . . . . . . . . . . . 600 days $120,000

Billings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 jobs 10,000

Collections . . . . . . . . . . . . . . . . . . . . . . . . 8 jobs 12,000

Exercise 17-14 Activity-based costing

P3 A2

Glassworks Inc. produces two types of glass shelving, rounded edge and squared edge, on the same production line. For the current period, the company reports the following data.

Rounded Edge Squared Edge Total

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000 $ 43,200 $ 62,200

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,200 23,800 36,000

Overhead (300% of direct labor cost) . . . . . . . . . 36,600 71,400 108,000

Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $67,800 $138,400 $206,200

Quantity produced . . . . . . . . . . . . . . . . . . . . . . . . 10,500 ft. 14,100 ft.

Average cost per ft. (rounded) . . . . . . . . . . . . . . . $ 6.46 $ 9.82

Glassworks’s controller wishes to apply activity-based costing (ABC) to allocate the $108,000 of overhead costs incurred by the two product lines to see whether cost per foot would change markedly from that reported above. She has collected the following information.

Overhead Cost Category (Activity Cost Pool) Cost

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,400

Depreciation of machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,600

Assembly line preparation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000

Total overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,000

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766 Chapter 17 Activity-Based Costing and Analysis

She has also collected the following information about the cost drivers for each category (cost pool) and the amount of each driver used by the two product lines.

Overhead Cost Category Usage

(Activity Cost Pool) Driver Rounded Edge Squared Edge Total

Supervision . . . . . . . . . . . . . . . . . . . . . Direct labor cost($) $12,200 $23,800 $36,000

Depreciation of machinery . . . . . . . . Machine hours 500 hours 1,500 hours 2,000 hours

Assembly line preparation . . . . . . . . . Setups (number) 40 times 210 times 250 times

Required

1. Assign these three overhead cost pools to each of the two products using ABC. 2. Determine average cost per foot for each of the two products using ABC. 3. Compare the average cost per foot under ABC with the average cost per foot under the current method

for each product. Explain why a difference between the two cost allocation methods exists.

Check (2) Rounded edge, $5.19; Squared edge, $10.76

Exercise 17-15 Activity-based costing

P3

Surgery Center is an outpatient surgical clinic that was profitable for many years, but Medicare has cut its reimbursements by as much as 40%. As a result, the clinic wants to better understand its costs. It decides to prepare an activity-based cost analysis, including an estimate of the average cost of both gen- eral surgery and orthopedic surgery. The clinic’s three cost centers and their cost drivers follow.

Cost Center Cost Cost Driver Driver Quantity

Professional salaries . . . . . . . . . . . . . . . . $1,600,000 Professional hours 10,000

Patient services and supplies . . . . . . . . 27,000 Number of patients 600

Building cost . . . . . . . . . . . . . . . . . . . . . 150,000 Square feet 1,500

Service Hours Square Feet* Patients

General surgery . . . . . . . . . . . . 2,500 600 400

Orthopedic surgery . . . . . . . . . 7,500 900 200

* Orthopedic surgery requires more space for patients, supplies, and equipment.

The two main surgical units and their related data follow.

Required

1. Compute the cost per cost driver for each of the three cost centers. 2. Use the results from part 1 to allocate costs from each of the three cost centers to both the general

surgery and the orthopedic surgery units. Compute total cost and average cost per patient for both the general surgery and the orthopedic surgery units.

Check (2) Average cost of general (orthopedic) surgery, $1,195 ($6,495) per patient

The following data are for the two products produced by Tadros Company.PROBLEM SET A

Problem 17-1A Comparing costs using ABC with the plantwide overhead rate

P1 P3 A1 A2

Product A Product B

Direct materials . . . . . . . . . . . . . . . . $15 per unit $24 per unit

Direct labor hours . . . . . . . . . . . . . . 0.3 DLH per unit 1.6 DLH per unit

Machine hours . . . . . . . . . . . . . . . . . 0.1 MH per unit 1.2 MH per unit

Batches . . . . . . . . . . . . . . . . . . . . . . . 125 batches 225 batches

Volume . . . . . . . . . . . . . . . . . . . . . . . 10,000 units 2,000 units

Engineering modifications . . . . . . . . 12 modifications 58 modifications

Number of customers . . . . . . . . . . . 500 customers 400 customers

Market price. . . . . . . . . . . . . . . . . . . $30 per unit $120 per unit

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Chapter 17 Activity-Based Costing and Analysis 767

The company’s direct labor rate is $20 per direct labor hour (DLH). Additional information follows.

Costs Driver

Indirect manufacturing

Engineering support . . . . . . . . . $24,500 Engineering modifications

Electricity . . . . . . . . . . . . . . . . . . 34,000 Machine hours

Setup costs . . . . . . . . . . . . . . . . 52,500 Batches

Nonmanufacturing

Customer service . . . . . . . . . . . 81,000 Number of customers

Required

1. Compute the manufacturing cost per unit using the plantwide overhead rate based on direct labor hours. What is the gross profit per unit?

2. How much gross profit is generated by each customer of Product A using the plantwide overhead rate? How much gross profit is generated by each customer of Product B using the plantwide over- head rate? What is the cost of providing customer service to each customer? What information is provided by this comparison?

3. Determine the manufacturing cost per unit of each product line using ABC. What is the gross profit per unit?

4. How much gross profit is generated by each customer of Product A using ABC? How much gross profit is generated by each customer of Product B using ABC? Is the gross profit per customer adequate?

5. Which method of product costing gives better information to managers of this company? Explain why.

Check (1) Product A, $26.37 per unit cost

(3) Product A, $24.30 per unit cost

Problem 17-2A Assessing impacts of using a plantwide overhead rate versus ABC

A1 A2

Xylon Company manufactures custom-made furniture for its local market and produces a line of home furnishings sold in retail stores across the country. The company uses traditional volume-based methods of assigning direct materials and direct labor to its product lines. Overhead has always been assigned by using a plantwide overhead rate based on direct labor hours. In the past few years, management has seen its line of retail products continue to sell at high volumes, but competition has forced it to lower prices on these items. The prices are declining to a level close to its cost of production.

Meanwhile, its custom-made furniture is in high demand and customers have commented on its favorable (lower) prices compared to its competitors. Management is considering dropping its line of retail products and devoting all of its resources to custom-made furniture.

Required

1. What reasons could explain why competitors are forcing the company to lower prices on its high- volume retail products?

2. Why do you believe the company charges less for custom-order products than its competitors? 3. Does a company’s costing method have any effect on its pricing decisions? Explain. 4. Aside from the differences in volume of output, what production differences do you believe exist

between making custom-order furniture and mass-market furnishings? 5. What information might the company obtain from using ABC that it might not obtain using volume-

based costing methods?

Problem 17-3A Applying activity-based costing

P1 P3 A1 A2 C3

Craft Pro Machining produces machine tools for the construction industry. The following details about overhead costs were taken from its company records.

Production Activity Indirect Labor Indirect Materials Other Overhead

Grinding . . . . . . . . . . . . . . . . . . . . $320,000

Polishing . . . . . . . . . . . . . . . . . . . . $135,000

Product modification . . . . . . . . . . 600,000

Providing power . . . . . . . . . . . . . . $255,000

System calibration . . . . . . . . . . . . 500,000

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768 Chapter 17 Activity-Based Costing and Analysis

Additional information on the drivers for its production activities follows.

Grinding . . . . . . . . . . . . . . . . . . . 13,000 machine hours

Polishing . . . . . . . . . . . . . . . . . . . 13,000 machine hours

Product modification . . . . . . . . . 1,500 engineering hours

Providing power . . . . . . . . . . . . . 17,000 direct labor hours

System calibration . . . . . . . . . . . 400 batches

Required

1. Classify each activity as unit level, batch level, product level, or facility level. 2. Compute the activity overhead rates using ABC. Form cost pools as appropriate. 3. Determine overhead costs to assign to the following jobs using ABC.

Job 3175 Job 4286

Number of units . . . . . . . . . . 200 units 2,500 units

Machine hours . . . . . . . . . . . . 550 MH 5,500 MH

Engineering hours . . . . . . . . . 26 eng. hours 32 eng. hours

Batches . . . . . . . . . . . . . . . . . 30 batches 90 batches

Direct labor hours . . . . . . . . 500 DLH 4,375 DLH

4. What is the overhead cost per unit for Job 3175? What is the overhead cost per unit for Job 4286? 5. If the company used a plantwide overhead rate based on direct labor hours, what is the overhead cost

for each unit of Job 3175? Of Job 4286? 6. Compare the overhead costs per unit computed in requirements 4 and 5 for each job. Which method

more accurately assigns overhead costs?

Check (4) Job 3175, $373.25 per unit

Problem 17-4A Evaluating product line costs and prices using ABC

P3

Bright Day Company produces two beverages, Hi-Voltage and EasySlim. Data about these products follow.

Hi-Voltage EasySlim

Production volume . . . . . . . . 12,500 bottles 180,000 bottles

Liquid materials . . . . . . . . . . . 1,400 gallons 37,000 gallons

Dry materials . . . . . . . . . . . . 620 pounds 12,000 pounds

Bottles . . . . . . . . . . . . . . . . . . 12,500 bottles 180,000 bottles

Labels . . . . . . . . . . . . . . . . . . . 3 labels per bottle 1 label per bottle

Machine setups . . . . . . . . . . . 500 setups 300 setups

Machine hours . . . . . . . . . . . . 200 MH 3,750 MH

Department Driver Cost

Mixing department

Liquid materials . . . . . . . . . . Gallons $ 2,304

Dry materials . . . . . . . . . . . . Pounds 6,941

Utilities . . . . . . . . . . . . . . . . . Machine hours 1,422

Bottling department

Bottles . . . . . . . . . . . . . . . . . Units $77,000

Labeling . . . . . . . . . . . . . . . . Labels per bottle 6,525

Machine setup . . . . . . . . . . . Setups 20,000

Additional data from its two production departments follow.

Required

1. Determine the cost of each product line using ABC. 2. What is the cost per bottle for Hi-Voltage? What is the cost per bottle of EasySlim? (Hint: Your

answer should draw on the total cost for each product line computed in requirement 1.) 3. If Hi-Voltage sells for $3.75 per bottle, how much profit does the company earn per bottle of

Hi-Voltage that it sells? 4. What is the minimum price that the company should set per bottle of EasySlim? Explain.

Check (3) $2.22 profit per bottle

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Chapter 17 Activity-Based Costing and Analysis 769

Problem 17-5A Pricing analysis with ABC and a plantwide overhead rate

A1 A2 P1 P3

Sara’s Salsa Company produces its condiments in two types: Extra Fine for restaurant customers and Family Style for home use. Salsa is prepared in department 1 and packaged in department 2. The activities, overhead costs, and drivers associated with these two manufacturing processes and its production support activities follow.

Additional production information about its two product lines follows.

Extra Fine Family Style

Units produced . . . . . . . . . 20,000 cases 100,000 cases

Batches . . . . . . . . . . . . . . . . 200 batches 400 batches

Machine hours . . . . . . . . . . 500 MH 1,000 MH

Focus groups . . . . . . . . . . . 30 groups 15 groups

Container types . . . . . . . . . 5 containers 3 containers

Production runs . . . . . . . . . 200 runs 200 runs

Process Activity Overhead Cost Driver Quantity

Department 1 Mixing $ 4,500 Machine hours 1,500

Cooking 11,250 Machine hours 1,500

Product testing 112,500 Batches 600

$128,250

Department 2 Machine calibration $250,000 Production runs 400

Labeling 12,000 Cases of output 120,000

Defects 6,000 Cases of output 120,000

$268,000

Support Recipe formulation $ 90,000 Focus groups 45

Heat, lights, and water 27,000 Machine hours 1,500

Materials handling 65,000 Container types 8

$182,000

Required

1. Using a plantwide overhead rate based on cases, compute the overhead cost that is assigned to each case of Extra Fine Salsa and each case of Family Style Salsa.

2. Using the plantwide overhead rate, determine the total cost per unit for the two products if the direct materials and direct labor cost is $6 per case of Extra Fine and $5 per case of Family Style.

3. If the market price of Extra Fine Salsa is $18 per case and the market price of Family Style Salsa is $9 per case, determine the gross profit per case for each product. What might management conclude about each product line?

4. Using ABC, compute the total cost per case for each product type if the direct labor and direct materials cost is $6 per case of Extra Fine and $5 per case of Family Style.

5. If the market price is $18 per case of Extra Fine and $9 per case of Family Style, determine the gross profit per case for each product. How should management interpret the market prices given your computations?

6. Would your pricing analysis be improved if the company used departmental rates based on machine hours in department 1 and number of cases in department 2, instead of ABC? Explain.

Check (2) Cost per case: Extra Fine, $10.82; Family Style, $9.82

(4) Cost per case: Extra Fine, $20.02; Family Style, $7.98

PROBLEM SET B

Problem 17-1B Comparing costs using ABC with the plantwide overhead rate

A1 A2 P1 P3

Wade Company makes two distinct products with the following information available for each.

Standard Deluxe

Direct materials . . . . . . . . . . . . . . . $4 per unit $8 per unit

Direct labor hours . . . . . . . . . . . . . 4 DLH per unit 5 DLH per unit

Machine hours . . . . . . . . . . . . . . . . . 3 MH per unit 3 MH per unit

Batches . . . . . . . . . . . . . . . . . . . . . . 175 batches 75 batches

Volume . . . . . . . . . . . . . . . . . . . . . . . 40,000 units 10,000 units

Engineering modifications . . . . . . . . 50 modifications 25 modifications

Number of customers . . . . . . . . . . . 1,000 customers 1,000 customers

Market price . . . . . . . . . . . . . . . . . . $92 per unit $125 per unit

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770 Chapter 17 Activity-Based Costing and Analysis

The company’s direct labor rate is $20 per direct labor hour (DLH). Additional information follows.

Costs Driver

Indirect manufacturing

Engineering support . . . . . . . . $ 56,250 Engineering modifications

Electricity . . . . . . . . . . . . . . . . . 112,500 Machine hours

Setup costs . . . . . . . . . . . . . . . . 41,250 Batches

Nonmanufacturing

Customer service . . . . . . . . . . 250,000 Number of customers

Required

1. Compute the manufacturing cost per unit using the plantwide overhead rate based on machine hours. What is the gross profit per unit?

2. How much gross profit is generated by each customer of the standard product using the plantwide overhead rate? How much gross profit is generated by each customer of the deluxe product using the plantwide overhead rate? What is the cost of providing customer service to each customer? What information is provided by this comparison?

3. Determine the manufacturing cost per unit of each product line using ABC. What is the gross profit per unit?

4. How much gross profit is generated by each customer of the standard product using ABC? How much gross profit is generated by each customer of the deluxe product using ABC? Is the gross profit per customer adequate?

5. Which method of product costing gives better information to managers of this company? Explain.

Check (1) Gross profit per unit: Standard, $3.80; Deluxe, $12.80

(3) Gross profit per unit: Standard, $4.09; Deluxe, $11.64

Problem 17-2B Assessing impacts of using a plantwide overhead rate versus ABC

A1 A2

Midwest Paper produces cardboard boxes. The boxes require designing, cutting, and printing. (The boxes are shipped flat and customers fold them as necessary.) Midwest has a reputation for providing high- quality products and excellent service to customers, who are major U.S. manufacturers. Costs are assigned to products based on the number of machine hours required to produce them. Three years ago, a new marketing executive was hired. She suggested the company offer custom design and manufacturing services to small specialty manufacturers. These customers required boxes for their products and were eager to have Midwest as a supplier. Within one year Midwest found that it was so busy with orders from small customers, that it had trouble supplying boxes to all its customers on a timely basis. Large, long-time customers began to complain about slow service and several took their business elsewhere. Within another 18 months, Midwest was in financial distress with a backlog of orders to be filled.

Required

1. What do you believe are the major costs of making its boxes? How are those costs related to the vol- ume of boxes produced?

2. How did Midwest’s new customers differ from its previous customers? 3. Would the unit cost to produce a box for new customers be different from the unit cost to produce a

box for its previous customers? Explain. 4. Could Midwest’s fate have been different if it had used ABC for determining the cost of its boxes? 5. What information would have been available with ABC that might have been overlooked using a tra-

ditional volume-based costing method?

Problem 17-3B Applying activity-based costing

P1 P3 A1 A2 C3

Ryan Foods produces gourmet gift baskets that it distributes online as well as from its small retail store. The following details about overhead costs are taken from its records.

Production Activity Indirect Labor Indirect Materials Other Overhead

Wrapping . . . . . . . . . . . . . . . . . . . . . . . $300,000 $200,000

Assembling . . . . . . . . . . . . . . . . . . . . . 400,000

Product design . . . . . . . . . . . . . . . . . . . 180,000

Obtaining business licenses . . . . . . . . . $100,000

Cooking . . . . . . . . . . . . . . . . . . . . . . . . 150,000 120,000

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Chapter 17 Activity-Based Costing and Analysis 771

Additional information on the drivers for its production activities follows.

Wrapping . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Assembling . . . . . . . . . . . . . . . . . . . . . . 20,000 direct labor hours

Product design . . . . . . . . . . . . . . . . . . . 3,000 design hours

Obtaining business licenses . . . . . . . . . 20,000 direct labor hours

Cooking . . . . . . . . . . . . . . . . . . . . . . . . 1,000 batches

Holiday Basket Executive Basket

Number of units . . . . . . . . . . 8,000 units 1,000 units

Direct labor hours . . . . . . . . . 2,000 DLH 500 DLH

Design hours . . . . . . . . . . . . . 40 design hours 40 design hours

Batches . . . . . . . . . . . . . . . . . . 80 batches 200 batches

Required

1. Classify each activity as unit level, batch level, product level, or facility level. 2. Compute the activity overhead rates using ABC. Form cost pools as appropriate. 3. Determine the overhead cost to assign to the following jobs using ABC.

4. What is the overhead cost per unit for the Holiday Basket? What is the overhead cost per unit for the Executive Basket?

5. If the company used a plantwide overhead rate based on direct labor hours, what is the overhead cost for each Holiday Basket unit? What would be the overhead cost for each Executive Basket unit if a single plantwide overhead rate is used?

6. Compare the costs per unit computed in requirements 4 and 5 for each job. Which cost assignment method provides the most accurate cost? Explain.

Check (4) Holiday Basket, $14.25 per unit

(5) Holiday Basket, $18.13 per unit

Fun with Fractions Count Calculus

Production volume . . . . . . . . 150,000 units 10,000 units

Components . . . . . . . . . . . . . 450,000 parts 100,000 parts

Direct labor hours . . . . . . . . 15,000 DLH 2,000 DLH

Packaging materials . . . . . . . . 150,000 boxes 10,000 boxes

Shipping cartons . . . . . . . . . . 100 units per carton 25 units per carton

Machine setups . . . . . . . . . . . 52 setups 52 setups

Machine hours . . . . . . . . . . . . 5,000 MH 2,000 MH

Problem 17-4B Evaluating product line costs and prices using ABC

P3

Mathwerks produces two electronic, handheld educational games: Fun with Fractions and Count Calculus. Data on these products follow.

Additional data from its two production departments follow.

Department Driver Cost

Assembly department

Component cost . . . . . . . . . . . Parts $495,000

Assembly labor . . . . . . . . . . . . . Direct labor hours 244,800

Maintenance . . . . . . . . . . . . . . Machine hours 100,800

Wrapping department

Packaging materials . . . . . . . . . Boxes $460,800

Shipping . . . . . . . . . . . . . . . . . . Cartons 27,360

Machine setup . . . . . . . . . . . . . Setups 187,200

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772 Chapter 17 Activity-Based Costing and Analysis

Required

1. Using ABC, determine the cost of each product line. 2. What is the cost per unit for Fun with Fractions? What is the cost per unit of Count Calculus? 3. If Count Calculus sells for $59.95 per unit, how much profit does the company earn per unit of Count

Calculus sold? 4. What is the minimum price that the company should set per unit of Fun with Fractions? Explain.

Check (3) $32.37 profit per unit

Problem 17-5B Pricing analysis with ABC and a plantwide overhead rate

A1 A2 P1 P3

Tent Pro produces two lines of tents sold to outdoor enthusiasts. The tents are cut to specifications in de- partment A. In department B the tents are sewn and folded. The activities, costs, and drivers associated with these two manufacturing processes and its production support activities follow.

Process Activity Overhead Cost Driver Quantity

Department A Pattern alignment $ 64,400 Batches 560

Cutting 50,430 Machine hours 12,300

Moving product 100,800 Moves 2,400

$215,630

Department B Sewing $327,600 Direct labor hours 4,200

Inspecting 24,000 Inspections 600

Folding 47,880 Units 22,800

$399,480

Support Design $280,000 Modification orders 280

Providing space 51,600 Square feet 8,600

Materials handling 184,000 Square yards 920,000

$515,600

Additional production information on the two lines of tents follows.

Pup Tent Pop-Up Tent

Units produced . . . . . . . . . . . . . . . 15,200 units 7,600 units

Moves . . . . . . . . . . . . . . . . . . . . . . . 800 moves 1,600 moves

Batches . . . . . . . . . . . . . . . . . . . . . . 140 batches 420 batches

Number of inspections . . . . . . . . . 240 inspections 360 inspections

Machine hours . . . . . . . . . . . . . . . . 7,000 MH 5,300 MH

Direct labor hours . . . . . . . . . . . . . 2,600 DLH 1,600 DLH

Modification orders . . . . . . . . . . . . 70 modification orders 210 modification orders

Space occupied . . . . . . . . . . . . . . . 4,300 square feet 4,300 square feet

Material required . . . . . . . . . . . . . . 450,000 square yards 470,000 square yards

Required

1. Using a plantwide overhead rate based on direct labor hours, compute the overhead cost that is assigned to each pup tent and each pop-up tent.

2. Using the plantwide overhead rate, determine the total cost per unit for the two products if the direct materials and direct labor cost is $25 per pup tent and $32 per pop-up tent.

3. If the market price of the pup tent is $65 and the market price of the pop-up tent is $200, determine the gross profit per unit for each tent. What might management conclude about the pup tent?

4. Using ABC, compute the total cost per unit for each tent if the direct labor and direct materials cost is $25 per pup tent and $32 per pop-up tent.

5. If the market price is $65 per pup tent and $200 per pop-up tent, determine the gross profit per unit for each tent. Comment on the results.

6. Would your pricing analysis be improved if the company used, instead of ABC, departmental rates determined using machine hours in Department A and direct labor hours in Department B? Explain.

Check (4) Pup tent, $58.46 per unit cost

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Chapter 17 Activity-Based Costing and Analysis 773

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 17 After reading an article about activity-based costing in a trade journal for the furniture industry, Adria Lopez wondered if it was time to critically analyze overhead costs at Success Systems. In a recent month, Adria found that setup costs, inspection costs, and utility costs made up most of its overhead. Additional information about overhead follows.

SERIAL PROBLEM Success Systems

P3

Activity Cost Driver

Setting up machines . . . . . . . . . . . $20,000 25 batches

Inspecting components . . . . . . . . $ 7,500 5,000 parts

Providing utilities . . . . . . . . . . . . . $10,000 5,000 machine hours

Direct materials . . . . . . . . . . $2,500

Direct labor . . . . . . . . . . . . . $3,500

Batches . . . . . . . . . . . . . . . . . 2 batches

Number of parts . . . . . . . . . 400 parts

Machine hours . . . . . . . . . . . 600 machine hours

Required

1. Classify each of its three overhead activities as unit level, batch level, product level, or facility level. 2. What is the total cost of Job 6.15 if Success Systems applies overhead at 50% of direct labor cost? 3. What is the total cost of Job 6.15 if Success Systems uses activity-based costing? 4. Which approach to assigning overhead gives a better representation of the costs incurred to produce

Job 6.15? Explain.

Overhead has been applied to output at a rate of 50% of direct labor costs. The following data pertain to Job 6.15.

BTN 17-1 Refer to financial statements of Polaris (Polaris.com) and Arctic Cat (arcticcat.com) to answer the following.

Required

1. Identify at least two activities at Polaris and at Arctic Cat that cause costs to be incurred. Do you be- lieve these companies should be concerned about controlling costs of the activities you identified? Explain.

2. Would you classify Polaris and Arctic Cat as service, merchandising, or manufacturing companies? Explain.

3. Is activity-based costing useful for companies such as Polaris and Arctic Cat? Explain.

Beyond the Numbers

REPORTING IN ACTION C3 A2

Polaris Arctic Cat

BTN 17-2 Polaris and Arctic Cat are competitors in the sales of recreational and off-road vehicles. Compare these companies’ income statements and answer the following.

Required

1. Which company has a higher ratio of costs, defined as cost of goods sold plus total operating expenses, to revenues? Use the two most recent years’ income statements from Appendix A. Show your analysis.

2. How might the use of activity-based costing help the less competitive company become more competitive? 3. Polaris sells its vehicles directly to dealers. Assume a dealer is considering opening a new retail store.

What are the activities associated with opening a new retail store?

Polaris Arctic Cat

COMPARATIVE ANALYSIS C2 A2

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774 Chapter 17 Activity-Based Costing and Analysis

BTN 17-3 In conducting interviews and observing factory operations to implement an activity-based cost- ing system, you determine that several activities are unnecessary or redundant. For example, warehouse personnel were inspecting purchased components as they were received at the loading dock. Later that day, the components were inspected again on the shop floor before being installed in the final product. Both of these activities caused costs to be incurred but were not adding value to the product. If you include this ob- servation in your report, one or more employees who perform inspections will likely lose their jobs.

Required

1. As a plant employee, what is your responsibility to report your findings to superiors? 2. Should you attempt to determine if the redundancy is justified? Explain. 3. What is your responsibility to the employees whose jobs will likely be lost by your report? 4. What facts should you consider before making your decision to report or not?

ETHICS CHALLENGE A2 C3

BTN 17-4 The chief executive officer (CEO) of your company recently returned from a luncheon meet- ing where activity-based costing was presented and discussed. Though her background is not in account- ing, she has worked for the company for 15 years and is thoroughly familiar with its operations. Her impression of the presentation about ABC was that it was just another way of dividing up total overhead cost and that the total would still be the same “no matter how you sliced it.”

Required

Write a memorandum to the CEO, no more than one page, explaining how ABC is different from tradi- tional volume-based costing methods. Also, identify its advantages and disadvantages vis-à-vis tradi- tional methods. Be sure it is written to be understandable to someone who is not an accountant.

COMMUNICATING IN PRACTICE A2

BTN 17-5 Accounting professionals that work for private companies often obtain the Certified Manage ment Accountant (CMA) designation to indicate their proficiency in several business areas in addition to manage- rial accounting. The CMA examination is administered by the Institute of Management Accountants (IMA).

Required

Go to the IMA Website (IMAnet.org) and determine which parts of the CMA exam likely cover activity- based costing. A person planning to become a CMA should take what college course work?

TAKING IT TO THE NET A2

BTN 17-6 Observe the operations at your favorite fast-food restaurant.

Required

1. How many people does it take to fill a typical order of sandwich, beverage, and one side-order? 2. Describe the activities involved in its food service process. 3. What costs are related to each activity identified in requirement 2?

TEAMWORK IN ACTION C2 C3

BTN 17-7 New Belgium Brewing Company has expanded its product offerings to include many variet- ies of specialty and seasonal brews. Kim Jordan, CEO of New Belgium Brewing Company, realizes that financial success depends on cost control as well as revenue generation.

Required

1. If New Belgium Brewing Company wanted to expand its product line to include malted energy drinks, what activities would it need to perform that are not required for its current product lines?

2. Related to part 1, should the additional overhead costs related to new product lines be shared by existing product lines? Explain your reasoning.

ENTREPRENEURIAL DECISION C3

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Chapter 17 Activity-Based Costing and Analysis 775

BTN 17-8 Visit and observe the processes of three different fast-food restaurants—these visits can be done as individuals or as teams. The objective of activity-based costing is to accurately assign costs to products and to improve operational efficiency.

Required

1. Individuals (or teams) can be assigned to each of three different fast-food establishments. Make a list of the activities required to process an order of a sandwich, beverage, and one side-order at each restaurant. Record the time required for each process, from placing the order to receiving the completed order.

2. What activities do the three establishments have in common? What activities are different across the establishments?

3. Is the number of activities related to the time required to process an order? Is the number of activities related to the price charged to customers? Explain both.

4. Make recommendations for improving the processes you observe. Would your recommendations in- crease or decrease the cost of operations?

HITTING THE ROAD C2 C3

BTN 17-9 Visit the Websites and review the financial statements for KTM (KTM.com) and Piaggio (piaggio.com). Each of these companies sells street vehicles like motorcycles or scooters in global markets.

Required

1. For KTM in 2011, what are the largest three geographic markets in which it sells products? What is the amount (in millions of euros) of sales in each market?

2. For Piaggio in 2011, what are the largest three geographic markets in which it sells products? What is the amount (in millions of euros) of sales in each market? Hint: EMEA refers to Europe, the Middle East, and Africa. SEA refers to Southeast Asia.

3. How would customer service activities differ across different geographic markets?

GLOBAL DECISION C3

1. b; Under traditional costing methods, overhead costs are allocated to prod- ucts on the basis of some measure of volume such as direct labor hours or machine hours. This results in much of the overhead cost being allocated to high-volume products. In contrast, under activity-based costing, some overhead costs are allocated on the basis of batch level or product level activities. This change in allocation bases results in shifting overhead costs from high-volume products to low-volume products.

2. d; Generally, an activity-based costing system is more difficult to imple- ment and maintain than a traditional costing system (thus answer a is false). Instead of eliminating waste by allocating costs to products that waste resources, activity-based management is a management approach that focuses on managing activities as a means of eliminating waste and reducing delays and defects (thus answer b is false). Instead of using a single allocation base (such as direct labor hours), activity-based costing uses a number of allocation bases for assigning costs to products (thus answer c is false). Answer d is true.

3. d; Batch level activities are activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch. Further, the amount of resources consumed depends on the number of batches rather than on the number of units in the batch. Worker recre- ational facilities relate to the organization as a whole rather than to spe- cific batches and, as such, are not considered to be batch level. On the other hand, purchase order processing, setting up equipment, and the clerical activities described are activities that are performed each time a batch of goods is handled or processed, and, as such, are batch level activities.

4. c;

ANSWERS TO MULTIPLE CHOICE QUIZ

5. d; The activity rate for Activity 3 is determined as follows: Budgeted cost 4 Budgeted activity 5 Activity rate

$14,000 4 700 5 $20

(A) (B) (A 3 B) Activity Rate Overhead (Budgeted overhead Cost cost 4 Budgeted Actual Applied to activity) Activity Production

Activity 1 . . . . ($80,000 4 1,000) 5 $80.00 800 $ 64,000

Activity 2 . . . . ($58,400 4 1,500) 5 $38.93* 500 19,465

Activity 3 . . . . ($360,000 4 6,000) 5 $60.00 5,400 324,000

Total overhead cost per unit for Product B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $407,465

Divided by number of units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 31,652

Overhead cost per unit of Product B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12.87

* rounded

PIAGGIO KTM

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Learning Objectives

CONCEPTUAL

C1 Describe different types of cost behavior in relation to production and sales volume. (p. 778)

C2 Describe several applications of cost-volume-profit analysis. (p. 789)

ANALYTICAL

A1 Compute the contribution margin and describe what it reveals about a company’s cost structure. (p. 785)

A2 Analyze changes in sales using the degree of operating leverage. (p. 795)

PROCEDURAL

P1 Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs. (p. 781)

P2 Compute the break-even point for a single product company. (p. 785) P3 Graph costs and sales for a single product company. (p. 787) P4 Compute the break-even point for a multiproduct company. (p. 793)

A Look at This Chapter

This chapter shows how information on both costs and sales behavior is useful to managers in performing cost- volume-profit analysis. This analysis is an important part of successful management and sound business decisions.

A Look Back

Chapter 17 introduced the activity-based costing (ABC) system, which has the potential for greater accuracy of cost allocations and for providing managers with better cost information for strategic decisions.

Cost Behavior and Cost-Volume-Profit Analysis 18

A Look Ahead

Chapter 19 compares reports prepared under variable costing with those under absorption costing, and it explains how variable costing can improve managerial decisions.

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Sporting Success

GLEN ROCK, NJ—Most quarterbacks in backyard football games have a glaring weakness: They can’t throw good passes. Paul Cunningham, lifelong sports fan and master craftsman, set out to make “an exceptional quality football, slightly smaller than an NFL ball, so that the average person can throw it.” As a re- sult, what started as a side project in his home workshop turned into a full-fledged business, Leather Head Sports (Leather- headsports.com). As Paul notes, “I’ve been able to leave the corporate world and do this full-time.” Paul’s forays began when he crafted leather baseballs for the Major League Baseball Hall of Fame to use in recreating 19th century baseball games. Now, Paul makes leather baseballs, which he sells as Lemon Balls™, along with a line of Leather Head™ footballs and medicine balls. Paul makes every Leather Head™ ball himself. “I want someone to look at my football and see the passion that went into it,” says Paul. Paul stresses that he, like many entrepreneurs, had to learn through a process of trial and error. “Every hide is different, and I tried many different approaches to making a football.” Now, upon receiving an order, Paul begins his production process by grabbing a side of top-quality leather. Using custom-made cut- ting dies, he hand cuts the leather panels. He then sews the leather panels together, inserts a rubber bladder, and laces the ball with rawhide lace. The result is what Paul calls the “official football of collegiate tailgating.”

Operating at a small scale and using expensive, top-quality materials require Paul to understand and control his costs. Suc- cessful entrepreneurs must understand cost behavior to succeed. Identifying fixed and variable costs is key to under- standing break-even points and maintaining the right product mix. Paul’s small but diverse product line has considerably differ- ent selling prices and costs. Contribution margin income state- ments, which separate fixed and variable costs, enable entrepreneurs like Paul to quickly see how changes in selling prices, variable costs, or fixed costs impact profit. Understand- ing contribution margins and cost-volume-profit analyses en- ables small businesses to profit and grow. Paul encourages young entrepreneurs to get out and make it happen. His sights are set on growing his company, possibly by bringing in additional craftsmen. Scaling his business in this way would make understanding how costs relate to volume and profit even more important. “I work hard,” says Paul, “but I love working with my hands and creating things.” Sounds like a perfect pass.

[Sources: Leather Head Sports Website, January 2013; http://www. youtube.com/watch?v=GaL3qxV4UzQ; http://video.foxbusiness.com/ v/1404850982001/investors-consider-adding-fine-art-to-portfoliomix/ ?playlist_id=87185; http://video.foxbusiness.com/v/3972553/]

“Put passion into your work” —PAUL CUNNINGHAM

Decision Insight

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Chapter Preview

This chapter describes different types of costs and shows how changes in a company’s operating volume affect these costs. The chapter also analyzes a company’s costs and sales to explain how different operating strategies affect profit or loss. Managers

use this type of analysis to forecast what will happen if changes are made to costs, sales volume, selling prices, or product mix. They then use these forecasts to select the best business strat- egy for the company.

Planning a company’s future activities and events is crucial to successful management. One of the first steps in planning is to predict the volume of activity, the costs to be incurred, sales to be made, and profit to be received. An important tool to help managers carry out this step is cost- volume-profit (CVP) analysis, which helps them predict how changes in costs and sales levels affect income. In its basic form, CVP analysis involves computing the sales level at which a company neither earns an income nor incurs a loss, called the break-even point. For this reason, this basic form of cost-volume-profit analysis is often called break-even analysis. Managers use variations of CVP analysis to answer questions like:

● What sales volume is needed to earn a target income? ● What is the change in income if selling prices decline and sales volume increases? ● How much does income increase if we install a new machine to reduce labor costs? ● How will income change if we change the sales mix of our products or services?

Consequently, cost-volume-profit analysis is useful in a wide range of business decisions. Conventional cost-volume-profit analysis requires management to classify all costs as either fixed or variable with respect to production or sales volume. The remainder of this section dis- cusses the concepts of fixed and variable cost behavior as they relate to CVP analysis.

IDENTIFYING COST BEHAVIOR

Measuring Cost Behavior

• Scatter diagrams • High-low method • Least-squares

regression • Comparison of cost

estimation methods

Identifying Cost Behavior

• Fixed costs • Variable costs • Mixed costs • Step-wise costs • Curvilinear costs

Using Break-Even Analysis

• Computing contribution margin

• Computing break-even • Computing margin of

safety • Preparing a cost-

volume-profit chart • Assumptions in cost-

volume-profit analysis

Applying Cost-Volume- Profit Analysis

• Computing income from sales and costs

• Computing sales for target income

• Using sensitivity analysis

• Computing multiprod- uct break-even

Cost Behavior and Cost-Volume-Profit Analysis

Point: Profit is another term for income.

Fixed Costs A fixed cost remains unchanged in amount when the volume of activity varies from period to period within a relevant range. For example, $32,000 in monthly rent paid for a factory building remains the same whether the factory operates with a single eight-hour shift or around the clock with three shifts. This means that rent cost is the same each month at any level of output from zero to the plant’s full productive capacity. Notice that while total fixed cost does not change as the level of production

C1 Describe different types of cost behavior in relation to production and sales volume.

No Free Lunch Hardly a week goes by without a company advertising a free product with the purchase of another. Examples are a free printer with a digital camera purchase or a free monitor with a computer purchase. Can these companies break even, let alone earn profits? We are reminded of the no-free-lunch adage, meaning that companies expect profits from the companion or add-on purchase to make up for the free product. ■

Decision Insight

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 779

changes, the fixed cost per unit of output decreases as volume increases. For instance, if 200 units are produced when monthly rent is $32,000, the average rent cost per unit is $160 (computed as $32,000/200 units); and when 100 units are produced, the average rent cost per unit is $320 (computed as $32,000/100 units). When production increases to 1,000 units per month, the average rent cost per unit decreases to $32 (computed as $32,000y1,000 units). The aver- age rent cost decreases to $16 per unit if production increases to 2,000 units per month. Common exam- ples of fixed costs include depreciation, property taxes, office salaries, and many service department costs. When production volume and costs are graphed, units of product are usually plotted on the horizon- tal axis and dollars of cost are plotted on the vertical axis. Fixed costs then are represented as a horizontal line because they remain constant at all levels of production. To illustrate, the top graph in Exhibit 18.1 shows that fixed costs remain at $32,000 at all production levels up to the company’s monthly capacity of 2,000 units of output. The bottom graph in Exhibit 18.1 shows that fixed costs per unit fall as production levels increase. This drop in costs per unit as production levels increase is known as economies of scale. The relevant range for fixed costs in Exhibit 18.1 is 0 to 2,000 units. If the relevant range changes (that is, production capacity extends beyond this range), the amount of fixed costs will likely change.

Example: If the fixed cost line in Exhibit 18.1 is shifted upward, does the total cost line shift up, down, or remain in the same place? Answer: It shifts up by the same amount.

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

10,000

20,000

30,000

40,000

50,000

60,000

$80,000

70,000

Volume (Units)

C o

s t

Monthly Capacity

Variable Costs, $20 per unit

Fixed Costs, $32,000

Total (Mixed) Costs

Relation of Total Fixed

and Variable Costs to Volume EXHIBIT 18.1 Relations of Total and Per-Unit Costs to Volume

Example: If the level of fixed costs in Exhibit 18.1 changes, does the slope of the total cost line change? Answer: No, the slope doesn’t change. The total cost line is simply shifted upward or downward.

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

20

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$200

140

Volume (Units)

C o

s t

p e r

u n

it

Variable Costs per unit

Fixed Costs per unit

Total (Mixed) Costs per unit

Relations of Per-Unit Fixed and Variable Costs to Volume

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780 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Variable Costs A variable cost changes in proportion to changes in volume of activity. The direct materials cost of a product is one example of a variable cost. If one unit of product requires materials costing $20, total materials costs are $200 when 10 units of product are manufactured, $400 for 20 units, $600 for 30 units, and so on. Notice that variable cost per unit remains constant but the total amount of variable cost changes with the level of production. In addition to direct materials, common variable costs include direct labor (if employees are paid per unit), sales commissions, shipping costs, and some overhead costs. When variable costs are plotted on a graph of cost and volume, they appear as a straight line starting at the zero cost level. This straight line is upward (positive) sloping. The line rises as volume of activity increases. A variable cost line using a $20 per unit cost is graphed in Exhibit 18.1. The bottom graph in Exhibit 18.1 shows that variable cost per unit is constant as production levels change.

Mixed Costs A mixed cost includes both fixed and variable cost components. For example, compensation for sales representatives often includes a fixed monthly salary and a variable commission based on sales. Like a fixed cost, a mixed cost is greater than zero when volume is zero; but unlike a fixed cost, it increases steadily in proportion to increases in volume. The mixed cost line in the top graph Exhibit 18.1 starts on the vertical axis at the $32,000 fixed cost point. Thus, at the zero volume level, total (mixed) cost equals the fixed costs. As the activity level increases, the mixed cost line increases at an amount equal to the variable cost per unit. This line is highest when the volume of activity is at 2,000 units (the end point of the relevant range). In CVP analysis, mixed costs are often separated into fixed and variable components. The fixed component is added to other fixed costs, and the variable component is added to other variable costs.

Step-Wise Costs A step-wise cost reflects a step pattern in costs. Salaries of production supervisors often behave in a step-wise manner in that their salaries are fixed within a relevant range of the current pro- duction volume. However, if production volume expands significantly (for example, with the addition of another shift), additional supervisors must be hired. This means that the total cost for supervisory salaries goes up by a lump-sum amount. Similarly, if volume takes another signifi- cant step up, supervisory salaries will increase by another lump sum. This behavior reflects a step-wise cost, also known as a stair-step cost, which is graphed in Exhibit 18.2. See how the step-wise cost line is flat within ranges (steps). Then, when volume significantly changes, it shifts to another level for that range (step).

Point: Fixed costs are constant in total but vary (decline) per unit as more units are produced. Variable costs vary in total but are fixed per unit.

Total Costs

C o

s t

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20,000

30,000

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M C

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Volume (Units)

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s t

Step-Wise Cost

Curvilinear Cost

Monthly Capacity

Relevant RangeEXHIBIT 18.2 Step-Wise and Curvilinear Costs

In a conventional CVP analysis, a step-wise cost is usually treated as either a fixed cost or a variable cost. This treatment involves manager judgment and depends on the width of the range and the expected volume. To illustrate, suppose after the production of every 25 snowboards, an

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 781

operator lubricates the finishing machine. The cost of this lubricant reflects a step-wise pattern. Also, suppose that after the production of every 1,000 units, the snowboard cutting tool is re- placed. Again, this is a step-wise cost. Note that the range of 25 snowboards is much narrower than the range of 1,000 snowboards. Some managers might treat the lubricant cost as a variable cost and the cutting tool cost as a fixed cost.

Curvilinear Costs A variable cost, as explained, is a linear cost; that is, it increases at a constant rate as volume of activity increases. A curvilinear cost, also called a nonlinear cost, increases at a nonconstant rate as volume increases. When graphed, curvilinear costs appear as a curved line. Exhibit 18.2 shows a curvilinear cost beginning at zero when production is zero and then increasing at different rates. An example of a curvilinear cost is total direct labor cost when workers are paid by the hour. At low to medium levels of production, adding more employees allows each of them to special- ize by doing certain tasks repeatedly instead of doing several different tasks. This often yields additional units of output at lower costs. A point is eventually reached at which adding more employees creates inefficiencies. For instance, a large crew demands more time and effort in communicating and coordinating their efforts. While adding employees in this case increases output, the labor cost per unit increases, and the total labor cost goes up at a steeper slope. This pattern is seen in Exhibit 18.2 where the curvilinear cost curve starts at zero, rises, flattens out, and then increases at a faster rate as output nears the maximum.

Point: Computer spreadsheets are important and effective tools for CVP analysis and for analyzing alternative “what-if” strategies.

Point: Cost-volume-profit analysis helped Rod Canion, Jim Harris, and Bill Murto raise start-up capital of $20 million to launch Compaq Com- puter. They showed that break-even vol- umes were attainable within the first year.

1. Which of the following statements is typically true? (a) Variable cost per unit increases as volume increases, (b) fixed cost per unit decreases as volume increases, or (c) a curvilinear cost includes both fixed and variable elements.

2. Describe the behavior of a fixed cost. 3. If cost per unit of activity remains constant (fixed), why is it called a variable cost?

Quick Check Answers — p. 799

Identifying and measuring cost behavior requires careful analysis and judgment. An impor- tant part of this process is to identify costs that can be classified as either fixed or variable, which often requires analysis of past cost behavior. Three methods are commonly used to analyze past costs: scatter diagrams, the high-low method, and least-squares regression. Each method is discussed in this section using the unit and cost data shown in Exhibit 18.3, which

MEASURING COST BEHAVIOR

P1 Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs.

EXHIBIT 18.3 Data for Estimating Cost Behavior

Month Units Produced Total Cost

January . . . . . . . . 27,500 $21,500

February . . . . . . . 17,500 20,500

March . . . . . . . . . 25,000 25,000

April . . . . . . . . . . 35,000 21,500

May . . . . . . . . . . . 47,500 25,500

June . . . . . . . . . . 22,500 18,500

July . . . . . . . . . . . 30,000 23,500

August . . . . . . . . 52,500 28,500

September . . . . . 37,500 26,000

October . . . . . . . 67,500 29,000

November . . . . . 62,500 31,000

December . . . . . 57,500 26,000

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0 0

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10,000

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$40,000

35,000

Volume (Units)

C o

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March Estimated Fixed Cost Component ($16,000)

Estimated Line of Cost Behavior

EXHIBIT 18.4 Scatter Diagram

are taken from a start-up company that uses units produced as the activity base in estimating cost behavior.

Scatter Diagrams Scatter diagrams display past cost and unit data in graphical form. In preparing a scatter dia- gram, units are plotted on the horizontal axis and cost is plotted on the vertical axis. Each individual point on a scatter diagram reflects the cost and number of units for a prior period. In Exhibit 18.4, the prior 12 months’ costs and numbers of units are graphed. Each point reflects total costs incurred and units produced for one of those months. For instance, the point labeled March had units produced of 25,000 and costs of $25,000.

The estimated line of cost behavior is drawn on a scatter diagram to reflect the relation be- tween cost and unit volume. This line best visually “fits” the points in a scatter diagram. Fitting this line demands judgment. The line drawn in Exhibit 18.4 intersects the vertical axis at approximately $16,000, which reflects fixed cost. To compute variable cost per unit, or the slope, we perform three steps. First, we select any two points on the horizontal axis (units), say 0 and 40,000. Second, we draw a vertical line from each of these points to intersect the esti- mated line of cost behavior. The point on the vertical axis (cost) corresponding to the 40,000 units point that intersects the estimated line is roughly $24,000. Similarly, the cost correspond- ing to zero units is $16,000 (the fixed cost point). Third, we compute the slope of the line, or variable cost, as the change in cost divided by the change in units. Exhibit 18.5 shows this computation.

EXHIBIT 18.5 Variable Cost per Unit (Scatter Diagram)

Change in cost

Change in units 5

$24,000 2 $16,000

40,000 2 0 5

$8,000

40,000 5 $0.20 per unit

Variable cost is $0.20 per unit. Thus, the cost equation that management will use to estimate costs for different unit levels is $16,000 plus $0.20 per unit.

High-Low Method The high-low method is a way to estimate the cost equation by graphically connecting the two cost amounts at the highest and lowest unit volumes. In our case, the lowest number of units is 17,500, and the highest is 67,500. The costs corresponding to these unit volumes are $20,500 and $29,000, respectively (see the data in Exhibit 18.3). The estimated line of cost behavior for

Example: In Exhibits 18.4 and 18.5, if units are projected at 30,000, what is the predicted cost? Answer: Approximately $22,000.

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High-Low Line of Cost Behavior

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Volume (Units)

C o

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Estimated Fixed Cost Component ($17,525)

the high-low method is then drawn by connecting these two points on the scatter diagram cor- responding to the lowest and highest unit volumes as follows.

The variable cost per unit is determined as the change in cost divided by the change in units and uses the data from the high and low unit volumes. This results in a slope, or variable cost per unit, of $0.17 as computed in Exhibit 18.6.

EXHIBIT 18.6 Variable Cost per Unit (High-Low Method)

Change in cost

Change in units 5

$29,000 2 $20,500

67,500 2 17,500 5

$8,500

50,000 5 $0.17 per unit

To estimate the fixed cost for the high-low method, we use the knowledge that total cost equals fixed cost plus variable cost per unit times the number of units. Then we pick either the high or low point to determine the fixed cost. This computation is shown in Exhibit 18.7—where we use the high point (67,500 units) in determining the fixed cost of $17,525. Use of the low point (17,500 units) yields the same fixed cost estimate: $20,500 5 Fixed cost 1 ($0.17 per unit 3 17,500), or Fixed cost 5 $17,525.

Point: Note that the high-low method identifies the high and low points of the volume (activity) base, and the costs linked with those extremes—which may not be the highest and lowest costs.

Thus, the cost equation used to estimate costs at different units is $17,525 plus $0.17 per unit. This cost equation differs slightly from that determined from the scatter diagram method. A deficiency of the high-low method is that it ignores all cost points except the highest and lowest. The result is less precision because the high-low method uses the most extreme points rather than the more usual conditions likely to recur.

Least-Squares Regression Least-squares regression is a statistical method for identifying cost behavior. For our pur- poses, we use the cost equation estimated from this method but leave the computational details for more advanced courses. Such computations for least-squares regression are read- ily done using most spreadsheet programs or calculators. We illustrate this using Excel® in Appendix 18A.

EXHIBIT 18.7 Fixed Cost (High-Low Method)

Total cost 5 Fixed cost 1 (Variable cost 3 Units) $29,000 5 Fixed cost 1 ($0.17 per unit 3 67,500 units)

Then, Fixed cost 5 $17,525

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784 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

0 0

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Estimated Fixed Cost Component ($16,947)

Regression Line of Cost Behavior

Comparison of Cost Estimation Methods The three cost estimation methods result in slightly different estimates of fixed and variable costs as summarized in Exhibit 18.8. Estimates from the scatter diagram are based on a visual fit of the cost line and are subject to interpretation. Estimates from the high-low method use only two sets of values corresponding to the lowest and highest unit volumes. Estimates from least-squares regression use a statistical technique and all available data points.

EXHIBIT 18.8 Comparison of Cost Estimation Methods

Estimation Method Fixed Cost Variable Cost

Scatter diagram . . . . . . . . . . . . . . . . $16,000 $0.20 per unit

High-low method . . . . . . . . . . . . . . 17,525 0.17 per unit

Least-squares regression . . . . . . . . . 16,947 0.19 per unit

We must remember that all three methods use past data. Thus, cost estimates resulting from these methods are only as good as the data used for estimation. Managers must establish that the data are reliable in deriving cost estimates for the future. If the data are reliable, the use of more data points, as in the regression or scatter diagram methods, should yield more accurate esti- mates than the high-low method. However, the high-low method is easier to apply than the re- gression method and less subject to interpretation than the scatter diagram approach.

The regression cost equation for the data presented in Exhibit 18.3 is $16,947 plus $0.19 per unit; that is, the fixed cost is estimated as $16,947 and the variable cost at $0.19 per unit. Both costs are reflected in the following graph.

4. Which of the following methods is likely to yield the most precise estimated line of cost behavior? (a) High-low, (b) least-squares regression, or (c) scatter diagram.

5. What is the primary weakness of the high-low method? 6. Using conventional CVP analysis, a mixed cost should be (a) disregarded, (b) treated as a fixed

cost, or (c) separated into fixed and variable components.

Quick Check Answers — p. 799

Break-even analysis is a special case of cost-volume-profit analysis. This section describes break- even analysis by computing the break-even point and preparing a CVP (or break-even) chart.

Contribution Margin and Its Measures We explained how managers classify costs by behavior. This often refers to classifying costs as being fixed or variable with respect to volume of activity. In manufacturing companies, volume

USING BREAK-EVEN ANALYSIS

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 785

of activity usually refers to the number of units produced. We then classify a cost as either fixed or variable, depending on whether total cost changes as the number of units produced changes. Once we separate costs by behavior, we can then compute a product’s contribution margin. Contribution margin per unit, or unit contribution margin, is the amount by which a product’s unit selling price exceeds its total variable cost per unit. This excess amount contributes to cov- ering fixed costs and generating profits on a per unit basis. Exhibit 18.9 shows the contribution margin per unit formula.

A1 Compute the contribution margin and describe what it reveals about a company’s cost structure.

EXHIBIT 18.9 Contribution Margin per Unit

Contribution margin per unit 5 Sales price per unit 2 Total variable cost per unit

EXHIBIT 18.10 Contribution Margin RatioContribution margin ratio 5

Contribution margin per unit

Sales price per unit

The contribution margin ratio, which is the percent of a unit’s selling price that exceeds total unit variable cost, is also useful for business decisions. It can be interpreted as the percent of each sales dollar that remains after deducting the total unit variable cost. Exhibit 18.10 shows the formula for the contribution margin ratio.

To illustrate the use of contribution margin, let’s consider Rydell, which sells footballs for $100 each and incurs variable costs of $70 per football sold. Its fixed costs are $24,000 per month with monthly capacity of 1,800 units (footballs). Rydell’s contribution margin per unit is $30, which is computed as follows.

Selling price per unit . . . . . . . . . . . . . . . . $100

Variable cost per unit . . . . . . . . . . . . . . . 70

Contribution margin per unit . . . . . . . . . $ 30

Its contribution margin ratio is 30%, computed as $30/$100. This reveals that for each unit sold, Rydell has $30 that contributes to covering fixed cost and profit. If we consider sales in dollars, a contribution margin of 30% implies that for each $1 in sales, Rydell has $0.30 that contributes to fixed cost and profit.

Sales Manager You are evaluating orders from two customers but can accept only one of the orders because of your company’s limited capacity. The first order is for 100 units of a product with a contribution margin ratio of 60% and a selling price of $1,000. The second order is for 500 units of a product with a con- tribution margin ratio of 20% and a selling price of $800. The incre mental fixed costs are the same for both orders. Which order do you accept? ■ [Answer—p. 798]

Decision Maker

Computing the Break-Even Point The break-even point is the sales level at which a company neither earns a profit nor incurs a loss. The concept of break-even is applicable to nearly all organizations, activities, and events. One of the most important items of in formation when launching a project is whether it will break even—that is, whether sales will at least cover total costs. The break-even point can be expressed in either units or dollars of sales. To illustrate break-even analysis, let’s again look at Rydell, which sells footballs for $100 per unit and incurs $70 of variable costs per unit sold. Its fixed costs are $24,000 per month. Rydell breaks even for the month when it sells 800 footballs (sales volume of $80,000). We compute this break-even point using the formula in Exhibit 18.11. This formula uses the contribution

P2 Compute the break-even point for a single product company.

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786 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

EXHIBIT 18.11 Formula for Computing Break-Even Sales (in Units)

Break-even point in units 5 Fixed costs

Contribution margin per unit

At a price of $100 per unit, monthly sales of 800 units yield sales dollars of $80,000 (called break-even sales dollars). This $80,000 break-even sales can be computed directly using the formula in Exhibit 18.12.

EXHIBIT 18.12 Formula for Computing Break-Even Sales (in Dollars)

Break-even point in dollars 5 Fixed costs

Contribution margin ratio

Point: Even if a company operates at a level in excess of its break-even point, management may decide to stop operat- ing because it is not earning a reasonable return on investment.

Rydell’s break-even point in dollars is computed as $24,000y0.30, or $80,000 of monthly sales. To verify that Rydell’s break-even point equals $80,000 (or 800 units), we prepare a simplified income statement in Exhibit 18.13. It shows that the $80,000 revenue from sales of 800 units exactly equals the sum of variable and fixed costs.

EXHIBIT 18.13 Contribution Margin Income Statement for Break-Even Sales

RYDELL COMPANY

Contribution Margin Income Statement (at Break-Even)

For Month Ended January 31, 2013

Sales (800 units at $100 each) . . . . . . . . . . . . . . . $80,000

Variable costs (800 units at $70 each) . . . . . . . . . 56,000

Contribution margin . . . . . . . . . . . . . . . . . . . . 24,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

The statement in Exhibit 18.13 is called a contribution margin income statement. It differs in format from a conventional income statement in two ways. First, it separately classifies costs and expenses as variable or fixed. Second, it reports contribution margin (Sales 2 Variable costs). The contribution margin income statement format is used in this chapter’s assignment materials because of its usefulness in CVP analysis.

Computing the Margin of Safety All companies wish to sell more than the break-even number of units. The excess of expected sales over the break-even sales level is called a company’s margin of safety, the amount that sales can drop before the company incurs a loss. It can be expressed in units, dollars, or even as a percent of the predicted level of sales. To illustrate, if Rydell’s expected sales are $100,000, the margin of safety is $20,000 above break-even sales of $80,000. As a percent, the margin of safety is 20% of expected sales as shown in Exhibit 18.14.

Point: A contribution margin income statement is also referred to as a variable costing income statement. This differs from the traditional absorption costing approach where all product costs are as- signed to units sold and to units in ending inventory. Recall that variable costing expenses all fixed product costs. Thus, income for the two approaches differs depending on the level of finished goods inventory; the lower inventory is, the more similar the two approaches are.

EXHIBIT 18.14 Computing Margin of Safety (in Percent)

Margin of safety (in percent) 5 Expected sales 2 Break-even sales

Expected sales

5 $100,000 2 $80,000

$100,000 5 20%

Management must assess whether the margin of safety is adequate in light of factors such as sales variability, competition, consumer tastes, and economic conditions.

margin per unit, which for Rydell is $30 ($100 2 $70). From this we can compute the break- even sales volume as $24,000y$30, or 800 units per month.

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 787

Preparing a Cost-Volume-Profit Chart Exhibit 18.15 is a graph of Rydell’s cost-volume-profit relations. This graph is called a cost- volume-profit (CVP) chart, or a break-even chart or break-even graph. The horizontal axis is the number of units produced and sold and the vertical axis is dollars of sales and costs. The lines in the chart depict both sales and costs at different output levels.

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 0

20,000

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$180,000

Volume (Number of units produced)

D o

ll a

rs

Break-Even Point (sales of 800 units or $80,000)

Loss Area Profit Area

Total Costs

Sales

Sales

Total Costs

Fixed Costs ($24,000)

EXHIBIT 18.15 Cost-Volume-Profit Chart

We follow three steps to prepare a CVP chart, which can also be drawn with computer programs that convert numeric data to graphs:

1. Plot fixed costs on the vertical axis ($24,000 for Rydell). Draw a horizontal line at this level to show that fixed costs remain unchanged regardless of output volume (drawing this fixed cost line is not essential to the chart).

2. Draw the total (variable plus fixed) cost line for a relevant range of volume levels. This line starts at the fixed costs level on the vertical axis because total costs equal fixed costs at zero volume. The slope of the total cost line equals the variable cost per unit ($70). To draw the line, compute the total costs for any volume level, and connect this point with the vertical axis intercept ($24,000). Do not draw this line beyond the productive capacity for the planning period (1,800 units for Rydell).

3. Draw the sales line. Start at the origin (zero units and zero dollars of sales) and make the slope of this line equal to the selling price per unit ($100). To sketch the line, compute dollar sales for any volume level and connect this point with the origin. Do not extend this line beyond the productive capacity. Total sales will be at the highest level at maximum capacity.

The total cost line and the sales line intersect at 800 units in Exhibit 18.15, which is the break- even point—the point where total dollar sales of $80,000 equals the sum of both fixed and vari- able costs ($80,000). On either side of the break-even point, the vertical distance between the sales line and the total cost line at any specific volume reflects the profit or loss expected at that point. At volume levels to the left of the break-even point, this vertical distance is the amount of the expected loss because the total costs line is above the total sales line. At volume levels to the right of the break-even point, the vertical distance represents the expected profit because the total sales line is above the total cost line.

Example: In Exhibit 18.15, the sales line intersects the total cost line at 800 units. At what point would the two lines intersect if selling price is increased by 20% to $120 per unit? Answer: $24,000y($120 2 $70) 5 480 units

Point: CVP analysis is often based on sales volume, using either units sold or dollar sales. Other output measures, such as the number of units produced, can also be used.

P3 Graph costs and sales for a single product company.

Operations Manager As a start-up manufacturer, you wish to identify the behavior of manufacturing costs to develop a production cost budget. You know three methods can be used to identify cost behavior from past data, but past data are unavailable because this is a start-up. What do you do? ■ [Answer—p. 799]

Decision Maker

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788 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Making Assumptions in Cost-Volume-Profit Analysis Cost-volume-profit analysis assumes that relations can normally be expressed as simple lines similar to those in Exhibits 18.4 and 18.15. CVP analysis assumes that selling prices per unit, variable costs per unit, and total fixed costs are all held constant. If the expected costs and sales behavior differ from the assumptions, the results of CVP analysis can be limited. While the be- havior of individual costs and sales may not be perfectly consistent with CVP assumptions, we can still perform useful analyses in spite of these assumptions’ limitations, for reasons we de- scribe next.

Working with Assumptions

Summing costs can offset individual deviations. Deviations from assumptions with indi- vidual costs are often minor when these costs are summed. That is, individual variable cost items may not be perfectly variable, but when we sum these variable costs, their individual deviations can offset each other. This means the assumption of variable cost behavior can be proper for total variable costs. Similarly, an assumption that total fixed costs are constant can be proper even when individual fixed cost items are not exactly constant.

CVP is applied to a relevant range of operations. Sales, variable costs, and fixed costs often are reasonably reflected in straight lines on a graph when the assumptions are applied over a relevant range. The relevant range of operations is the normal operating range for a business. Except for unusually difficult or prosperous times, management typically plans for operations within a range of volume neither close to zero nor at maximum capacity. The relevant range excludes extremely high and low operating levels that are unlikely to occur. The validity of as- suming that a specific cost is fixed or variable is more acceptable when operations are within the relevant range. As shown in Exhibit 18.2, a curvilinear cost can be treated as variable and linear if the relevant range covers volumes where it has a nearly constant slope. If the normal range of activity changes, some costs might need reclassification.

CVP analysis yields estimates. CVP analysis yields approximate answers to questions about costs, volumes, and profits. These answers do not have to be precise because the analysis makes rough estimates about the future. For example, to simplify analysis, we sometimes assume that the production level is the same as the sales level. That is, inventory levels do not change. This often is justified by arguing that CVP analysis provides only approximations. With just-in-time inventory systems, production levels should approximate sales levels, thus CVP estimates should be more accurate. As long as managers understand that CVP analysis gives estimates, it can be a useful tool for starting the planning process. Other qualitative factors also must be considered.

Example: If the selling price declines, what happens to the break-even point? Answer: It increases.

7. Fixed cost divided by the contribution margin ratio yields the (a) break-even point in dollars, (b) contribution margin per unit, or (c) break-even point in units.

8. A company sells a product for $90 per unit with variable costs of $54 per unit. What is the contribution margin ratio?

9. Refer to Quick Check (8). If fixed costs for the period are $90,000, what is the break-even point in dollars?

10. What is a company’s margin of safety? 11. What three basic assumptions are used in CVP analysis?

Quick Check Answers — p. 799

Working with Changes in Estimates Because CVP analysis uses estimates, knowing how changes in those estimates impact break-even is useful. For example, a manager might form three estimates for each of the components of break-even: optimistic, most likely, and pessimistic. Then ranges of break-even points in units can be computed using the formula in Exhibit 18.11.

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 789

To illustrate, assume Rydell’s managers provide the set of estimates in Exhibit 18.16.

Selling Price Variable Cost Total Fixed

per Unit per Unit Costs

Optimistic . . . . . . . . . $105 $68 $21,000

Most likely . . . . . . . . . 100 70 24,000

Pessimistic . . . . . . . . . 95 72 27,000

If, for example, Rydell’s managers believe they can raise the selling price of a football to $105, without any change in unit variable or total fixed costs, then the revised contribution margin per football is $35, and the revised break-even in units follows in Exhibit 18.17.

Repeating this calculation using each of the other eight separate estimates above, and graphing the results, yields the three scatter diagrams in Exhibit 18.18.

These scatter diagrams show how changes in selling prices, variable costs, and fixed costs im- pact break-even. When selling prices can be increased without impacting unit variable costs or total fixed costs, break-even decreases. When competition drives selling prices down, and the company cannot reduce costs, break-even increases. Increases in either variable or fixed costs, if they cannot be passed on to customers via higher selling prices, will increase break-even. If costs can be reduced and selling prices held constant, the break-even decreases.

EXHIBIT 18.16 Alternative Estimates for Break-Even Analysis

Revised break-even point in units

5 $24,000

$35 5 686 units (rounded)

EXHIBIT 18.17 Revised Break-Even in Units

500

800 850 900 950

1,000

750 700 650 600 550

B re

a k

- e

v e

n (

U n

it s )

$94 $96 $98 $100 $102 $104

Price (per Unit)

Impact of Price Changes on

Break-Even in Units

$106 $73$71 $72 740

860

880

840

820

800

780

760

B re

a k

- e

v e

n (

U n

it s )

$67 $68 $69 $70

Variable Cost (per Unit)

Impact of Changes in Variable

Cost on Break-Even in Units

800

850

900

950

750

700

650

600

B re

a k

- e

v e

n (

U n

it s )

$1 5,

00 0

$1 8,

00 0

$2 1,

00 0

$2 4,

00 0

$2 7,

00 0

$3 0,

00 0

Total Dollars of Fixed Costs

Impact of Changes in Fixed

Costs on Break-Even in Units

EXHIBIT 18.18 Scatter Diagrams—Break-Even Points for Alternative Estimates

Point: This analysis changed only one estimate at a time; managers can examine how combinations of changes in estimates will impact break-even.

Managers consider a variety of strategies in planning business operations. Cost-volume-profit analysis is useful in helping managers evaluate the likely effects of these strategies, which is the focus of this section.

Computing Income from Sales and Costs An important question managers often ask is “What is the predicted income from a predicted level of sales?” To answer this, we look at four variables in CVP analysis. These variables and their relations to income (pretax) are shown in Exhibit 18.19. We use these relations to compute expected income from predicted sales and cost levels.

APPLYING COST-VOLUME-PROFIT ANALYSIS

C2 Describe several applications of cost- volume-profit analysis.

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790 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Sales

2 Variable costs

Contribution margin

2 Fixed costs

Income (pretax)

EXHIBIT 18.19 Income Relations in CVP Analysis

To illustrate, let’s assume that Rydell’s management expects to sell 1,500 units in January 2013. What is the amount of income if this sales level is achieved? Following Exhibit 18.19, we compute Rydell’s expected income in Exhibit 18.20.

EXHIBIT 18.20 Computing Expected Pretax Income from Expected Sales

RYDELL COMPANY

Contribution Margin Income Statement

For Month Ended January 31, 2013

Sales (1,500 units at $100 each) . . . . . . . . . . . . . . . $150,000

Variable costs (1,500 units at $70 each) . . . . . . . . . 105,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Income (pretax) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

EXHIBIT 18.21 Computing Expected After-Tax Income from Expected Sales

RYDELL COMPANY

Contribution Margin Income Statement

For Month Ended January 31, 2013

Sales (1,500 units at $100 each) . . . . . . . . . . . . . . . $150,000

Variable costs (1,500 units at $70 each) . . . . . . . . . 105,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Income taxes (25%) . . . . . . . . . . . . . . . . . . . . . . . . . 5,250

Net income (after tax) . . . . . . . . . . . . . . . . . . . . . . $ 15,750

The $21,000 income is pretax. To find the amount of after-tax income from selling 1,500 units, management must apply the proper tax rate. Assume that the tax rate is 25%. Then we can prepare the after-tax income statement shown in Exhibit 18.21. We can also compute pretax income as after-tax income divided by (1 2 tax rate); for Rydell, this is $15,750y(1 2 0.25), or $21,000.

Management then assesses whether this income is an adequate return on assets invested. Management should also consider whether sales and income can be increased by raising or low- ering prices. CVP analysis is a good tool for addressing these kinds of “what-if ” questions.

Computing Sales for a Target Income Many companies’ annual plans are based on certain income targets (sometimes called bud gets). Rydell’s income target for this year is to increase income by 10% over the prior year. When prior year income is known, Rydell easily computes its target income. CVP analysis helps to determine the sales level needed to achieve the target income. Planning for the year is then based on this level. We use the formula shown in Exhibit 18.22 to compute sales for a target after-tax income. To illustrate, Rydell has monthly fixed costs of $24,000 and a 30% contribution margin ratio. As- sume that it sets a target monthly after-tax income of $9,000 when the tax rate is 25%. This means the pretax income is targeted at $12,000 [$9,000y(1 2 0.25)] with a tax expense of $3,000. Using the formula in Exhibit 18.22, we find that $120,000 of sales are needed to produce a $9,000 after-tax income.

"How many units must we sell to earn $50,000?"

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 791

We can also use the contribution margin income statement approach to compute sales for a target income. In step 1, we insert the fixed costs ($24,000) and the desired after tax profit level ($9,000) into a contribution margin income statement, as shown in Exhibit 18.24. To achieve an after tax profit of $9,000, Rydell’s pretax income must be $12,000, computed as $9,000y(1 2 0.25). We insert this as step 2 in the pretax income row in the contribution margin income statement and solve for Rydell’s income taxes ($12,000 2 $9,000), or $3,000. To cover its fixed costs of $24,000 and yield a pretax income of $12,000, Rydell must generate a contribution margin of $36,000 (computed as $24,000 plus $12,000). We enter this in the contribution margin row as step 3. With a contribution margin ratio of 30%, sales must be $120,000, computed as $36,000y0.30, to yield a contribution margin of $36,000. We enter this in the sales row of the contribution margin income statement as step 3 and solve for variable costs of $84,000 (com- puted as $120,000 2 $36,000). At a selling price of $100 per unit, Rydell must sell 1,200 units ($120,000y$100) to earn after tax net income of $9,000.

We can alternatively compute unit sales instead of dollar sales. To do this, we substitute contri- bution margin per unit for the contribution margin ratio in the denominator. This gives the num- ber of units to sell to reach the target after-tax income. Exhibit 18.23 illustrates this for Rydell. The two computations in Exhibits 18.22 and 18.23 are equivalent because sales of 1,200 units at $100 per unit equal $120,000 of sales.

Point: Break-even is a special case of the formulas in Exhibits 18.22 and 18.23; simply set target pretax income to $0 and the formulas reduce to those in Exhibits 18.11 and 18.12.

EXHIBIT 18.22 Computing Sales (Dollars) for a Target After-Tax Income Dollar sales at target after-tax income 5

Fixed costs

1 Target pretax

income Contribution margin ratio

5 $24,000 1 $12,000

30% 5 $120,000

EXHIBIT 18.23 Computing Sales (Units) for a Target After-Tax Income

Unit sales at target after-tax income 5

Fixed costs

1 Target pretax

income Contribution margin per unit

5 $24,000 1 $12,000

$30 5 1,200 units

Supervisor Your team is conducting a cost-volume-profit analysis for a new product. Different sales projections have different incomes. One member suggests picking numbers yielding favorable income be- cause any estimate is “as good as any other.” Another member points to a scatter diagram of 20 months’ production on a comparable product and suggests dropping unfavorable data points for cost estimation. What do you do? ■ [Answer—p. 799]

Decision Ethics

EXHIBIT 18.24 Using the Contribution Margin Income Statement to Find Target Sales

RYDELL COMPANY

Contribution Margin Income Statement

For Month Ended January 31, 2013

Step 1 Step 2 Step 3

Sales . . . . . . . . . . . . . . . . . . . . . . . ? ? $120,000

Variable costs . . . . . . . . . . . . . . . . ? ? 84,000

Contribution margin . . . . . . . . . . ? ? 36,000

Fixed costs . . . . . . . . . . . . . . . . . . 24,000 24,000 24,000

Income (pretax) . . . . . . . . . . . . . . ? 12,000 12,000

Incomes taxes (25%) . . . . . . . . . . ? 3,000 3,000

Net income (after tax) . . . . . . . . . $ 9,000 $ 9,000 $ 9,000

$9,000y(1 2 0.25) $36,000y0.30$24,000 1 $12,000

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792 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

EXHIBIT 18.25 Revising Break-even When Changes Occur

Revised break-even point in dollars

5 Revised fixed costs

Revised contribution margin ratio 5

$30,000

40% 5 $75,000

12. A company has fixed costs of $50,000 and a 25% contribution margin ratio. What dollar sales are necessary to achieve an after-tax net income of $120,000 if the tax rate is 20%? (a) $800,000, (b) $680,000, or (c) $600,000.

13. If a company’s contribution margin ratio decreases from 50% to 25%, what can be said about the unit sales needed to achieve the same target income level?

Quick Check Answers — p. 799

RFID-CVP Companies are increasingly using radio-frequency identi- fication (RFID) tags to control inventory. Affixed to products, RFID tags enable companies to reduce costs of inventory theft and scanning er- rors. Are RFID systems economically feasible? Railroad companies have long used RFID tags on rail cars. While expensive, these tags can be reused thousands of times, thus the cost per tag falls as railroad traf- fic increases. Such economies of scale and other cost savings make RFID a better-than break-even investment for railroad companies. ■

Decision Insight

Example: If fixed costs decline, what happens to the break-even point? Answer: It decreases.

Using Sensitivity Analysis Earlier we showed how changing one of the estimates in a CVP analysis impacts break-even. We can also examine strategies that impact several estimates in the CVP analysis. For instance, we might want to know what happens to income if we automate a currently manual process. We can use CVP analysis to predict income if we can describe how these changes affect a company’s fixed costs, variable costs, selling price, and volume. To illustrate, assume that Rydell Company is looking into buying a new machine that would increase monthly fixed costs from $24,000 to $30,000 but decrease variable costs from $70 per unit to $60 per unit. The machine is used to produce output whose selling price will remain unchanged at $100. This results in increases in both the unit contribution margin and the contribution margin ratio. The revised contribution margin per unit is $40 ($100 2 $60), and the revised contribution margin ratio is 40% of selling price ($40y$100). Using CVP analysis, Rydell’s revised break-even point in dollars would be $75,000 as computed in Exhibit 18.25.

We can also use the contribution margin income statement approach in sensitivity analysis, as we show in Exhibit 18.26. The revised fixed costs and the revised contribution margin ratio can be used to address other issues including computation of (1) expected income for a given sales level and (2) the sales level needed to earn a target income. Once again, we can use sensitivity analysis to generate different sets of revenue and cost estimates that are optimistic, pessimistic, and most likely. Different CVP analyses based on these estimates provide different scenarios that management can analyze and use in planning business strategy.

EXHIBIT 18.26 Using the Contribution Margin Income Statement in Sensitivity Analysis

RYDELL COMPANY

Contribution Margin Income Statement

For Month Ended January 31, 2013

Step 1 Step 2 Step 3

Sales . . . . . . . . . . . . . . . . . . . . . ? ? $75,000

Variable costs . . . . . . . . . . . . . . ? ? 45,000

Contribution margin . . . . . . . . ? 30,000 30,000

Fixed costs . . . . . . . . . . . . . . . . 30,000 30,000 30,000

Income (pretax) . . . . . . . . . . . . $ 0 $ 0 $ 0

$30,000y0.40$30,000 1 $0

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 793

4 units of basic @ $20 per unit . . . . . . . . . . $ 80

2 units of ultra @ $32 per unit . . . . . . . . . . 64

1 unit of budget @ $16 per unit . . . . . . . . . 16

Selling price of a composite unit . . . . . . . . . $160

Point: Selling prices and variable costs are usually expressed in per unit amounts. Fixed costs are usually expressed in total amounts.

Hair-Today’s fixed costs are $192,000 per year, and its variable costs of the three products are basic, $13; ultra, $18.00; and budget, $8.00. Variable costs for a composite unit of these products follow.

4 units of basic @ $13 per unit . . . . . . . . . . . . $ 52

2 units of ultra @ $18 per unit . . . . . . . . . . . . 36

1 unit of budget @ $8 per unit . . . . . . . . . . . . 8

Variable costs of a composite unit . . . . . . . . . $96

Hair-Today’s $64 contribution margin for a composite unit is computed by subtracting the vari- able costs of a composite unit ($96) from its selling price ($160). We then use the contri bution margin to determine Hair-Today’s break-even point in composite units in Exhibit 18.27.

EXHIBIT 18.27 Break-Even Point in Composite Units

Break-even point in composite units 5 Fixed costs

Contribution margin per composite unit

5 $192,000

$64 5 3,000 composite units

P4 Compute the break-even point for a multiproduct company.

Computing a Multiproduct Break-Even Point To this point, we have looked only at cases where the company sells a single product or ser vice. This was to keep the basic CVP analysis simple. However, many companies sell multiple prod- ucts or services, and we can modify the CVP analysis for use in these cases. An important as- sumption in a multiproduct setting is that the sales mix of different products is known and remains constant during the planning period. Sales mix is the ratio (proportion) of the sales volumes for the various products. For instance, if a company normally sells 10,000 footballs, 5,000 softballs, and 4,000 basketballs per month, its sales mix can be expressed as 10:5:4 for footballs, softballs, and basketballs. To apply multiproduct CVP analysis, we can estimate the break-even point by using a composite unit, which consists of a specific number of units of each product in proportion to their expected sales mix. Multiproduct CVP analysis treats this composite unit as a single prod- uct. To illustrate, let’s look at Hair-Today, a styling salon that offers three cuts: basic, ultra, and budget in the ratio of 4 basic units to 2 ultra units to 1 budget unit (expressed as 4:2:1). Manage- ment wants to estimate its break-even point for next year. Unit selling prices for these three cuts are basic, $20; ultra, $32; and budget, $16. Using the 4:2:1 sales mix, the selling price of a com- posite unit of the three products is computed as follows.

Basic: 4 3 3,000 . . . . . . . . 12,000 units

Ultra: 2 3 3,000 . . . . . . . . 6,000 units

Budget: 1 3 3,000 . . . . . . . . 3,000 units

Point: The break-even point in dollars for Exhibit 18.27 is $192,000y($64y$160) 5 $480,000.

This computation implies that Hair-Today breaks even when it sells 3,000 composite units. To determine how many units of each product it must sell to break even, we multiply the number of units of each product in the composite by 3,000 as follows.

Instead of computing contribution margin per composite unit, a company can compute a weighted-average contribution margin. Given the 4:2:1 product mix, basic cuts comprise 57.14% (computed as 4y7) of the company’s haircuts, ultra makes up 28.57% of its business, and budget cuts comprise 14.29%. The weighted-average contribution margin follows in Exhibit 18.28.

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794 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

The company’s break-even point in units is computed in Exhibit 18.29 as follows:

We see that the weighted-average contribution margin method yields 21,000 whole units as the break-even amount, the same total as the composite unit approach. Exhibit 18.30 verifies the results for composite units by showing Hair-Today’s sales and costs at this break-even point using a contribution margin income statement.

Break-even point in units 5 Fixed costs

Weighted-average contribution margin

5 $192,000

$9.143 5 21,000 units

EXHIBIT 18.29 Break-Even in Units using Weighted-Average Contribution Margin

EXHIBIT 18.30 Multiproduct Break-Even Income Statement

HAIR-TODAY

Forecasted Contribution Margin Income Statement (at Break-Even)

Basic Ultra Budget Totals

Sales Basic (12,000 @ $20) . . . . . . . . . . $240,000 Ultra (6,000 @ $32) . . . . . . . . . . . $192,000 Budget (3,000 @ $16) . . . . . . . . . $48,000 Total sales . . . . . . . . . . . . . . . . . . . $480,000 Variable costs Basic (12,000 @ $13) . . . . . . . . . . 156,000 Ultra (6,000 @ $18) . . . . . . . . . . . 108,000 Budget (3,000 @ $8) . . . . . . . . . . 24,000 Total variable costs . . . . . . . . . . . . 288,000 Contribution margin . . . . . . . . . . . . $ 84,000 $ 84,000 $24,000 192,000 Fixed costs . . . . . . . . . . . . . . . . . . . . 192,000 Net income . . . . . . . . . . . . . . . . . . . $ 0

EXHIBIT 18.28 Weighted-Average Contribution Margin

Unit 3 Percentage 5 Weighted unit contribution of contribution

margin sales mix margin

Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7 57.14% $4.000 Ultra . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 28.57 4.000 Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 14.29 1.143 Weighted-average contribution margin . . . . . . . $9.143

Entrepreneur A CVP analysis indicates that your start-up, which markets electronic products, will break even with the current sales mix and price levels. You have a target income in mind. What analysis might you perform to assess the likelihood of achieving this income? ■ [Answer—p. 799]

Decision Maker

A CVP analysis using composite units can be used to answer a variety of planning questions. Once a product mix is set, all answers are based on the assumption that the mix remains con- stant at all relevant sales levels as other factors in the analysis do. We also can vary the sales mix to see what happens under alternative strategies.

Point: Enterprise resource planning (ERP) systems can quickly generate multiproduct break-even analyses.

14. The sales mix of a company’s two products, X and Y, is 2:1. Unit variable costs for both products are $2, and unit sales prices are $5 for X and $4 for Y. What is the contribution margin per composite unit? (a) $5, (b) $10, or (c) $8.

15. What additional assumption about sales mix must be made in doing a conventional CVP analysis for a company that produces and sells more than one product?

Quick Check Answers — p. 799

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 795

Survey evidence shows that many German companies have elaborate and detailed cost accounting sys- tems. Over 90 percent of companies surveyed report their systems focus on contribution margin. This focus helps German companies like Volkswagen control costs and plan their production levels. Recently, Volkswagen announced it expects its Spanish brand Seat to break even within five years. For 2010, the Seat brand lost €311 million on revenue of €5.038 billion (349,000 units).

GLOBAL VIEW

Degree of Operating Leverage Decision Analysis

CVP analysis is especially useful when management begins the planning process and wishes to predict outcomes of alternative strategies. These strategies can involve changes in selling prices, fixed costs, vari- able costs, sales volume, and product mix. Managers are interested in seeing the effects of changes in some or all of these factors. One goal of all managers is to get maximum benefits from their fixed costs. Managers would like to use 100% of their output capacity so that fixed costs are spread over the largest number of units. This would decrease fixed cost per unit and increase income. The extent, or relative size, of fixed costs in the total cost structure is known as operating leverage. Companies having a higher proportion of fixed costs in their total cost structure are said to have higher operating leverage. An example of this is a company that chooses to automate its processes instead of using direct labor, increasing its fixed costs and lowering its variable costs. A useful managerial measure to help assess the effect of changes in the level of sales on income is the degree of operating leverage (DOL) defined in Exhibit 18.31.

EXHIBIT 18.31 Degree of Operating Leverage

DOL 5 Total contribution margin (in dollars)yPretax income

A2 Analyze changes in sales using the degree of operating leverage.

To illustrate, let’s return to Rydell Company. At a sales level of 1,200 units, Rydell’s total contribution margin is $36,000 (1,200 units 3 $30 contribution margin per unit). Its pretax income, after subtracting fixed costs of $24,000, is $12,000 ($36,000 2 $24,000). Rydell’s degree of operating leverage at this sales level is 3.0, computed as contribution margin divided by pretax income ($36,000y$12,000). We then use DOL to measure the effect of changes in the level of sales on pretax income. For instance, suppose Rydell expects sales to increase by 10%. If this increase is within the relevant range of operations, we can expect this 10% increase in sales to result in a 30% increase in pretax income computed as DOL multiplied by the increase in sales (3.0 3 10%). Similar analyses can be done for expected decreases in sales.

Sport Caps Co. manufactures and sells caps for different sporting events. The fixed costs of operating the company are $150,000 per month, and the variable costs for caps are $5 per unit. The caps are sold for $8 per unit. The fixed costs provide a production capacity of up to 100,000 caps per month.

Required

1. Use the formulas in the chapter to compute the following: a. Contribution margin per cap. b. Break-even point in terms of the number of caps produced and sold. c. Amount of net income at 30,000 caps sold per month (ignore taxes). d. Amount of net income at 85,000 caps sold per month (ignore taxes). e. Number of caps to be produced and sold to provide $45,000 of after-tax income, assuming an

income tax rate of 25%.

DEMONSTRATION PROBLEM

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796 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

2. Draw a CVP chart for the company, showing cap output on the horizontal axis. Identify (a) the break- even point and (b) the amount of pretax income when the level of cap production is 70,000. (Omit the fixed cost line.)

3. Use the formulas in the chapter to compute the a. Contribution margin ratio. b. Break-even point in terms of sales dollars. c. Amount of net income at $250,000 of sales per month (ignore taxes). d. Amount of net income at $600,000 of sales per month (ignore taxes). e. Dollars of sales needed to provide $45,000 of after-tax income, assuming an income tax rate of 25%.

PLANNING THE SOLUTION ● Identify the formulas in the chapter for the required items expressed in units and solve them using the

data given in the problem. ● Draw a CVP chart that reflects the facts in the problem. The horizontal axis should plot the volume in

units up to 100,000, and the vertical axis should plot the total dollars up to $800,000. Plot the total cost line as upward sloping, starting at the fixed cost level ($150,000) on the vertical axis and increasing until it reaches $650,000 at the maximum volume of 100,000 units. Verify that the break-even point (where the two lines cross) equals the amount you computed in part 1.

● Identify the formulas in the chapter for the required items expressed in dollars and solve them using the data given in the problem.

SOLUTION TO DEMONSTRATION PROBLEM 1. a. Contribution margin per cap 5 Selling price per unit 2 Variable cost per unit 5 $8 2 $5 5 $3

b. Break-even point in caps 5 Fixed costs

Contribution margin per cap 5

$150,000

$3 5 50,000 caps

c. Net income at 30,000 caps sold 5 (Units 3 Contribution margin per unit) 2 Fixed costs 5 (30,000 3 $3) 2 $150,000 5 $(60,000) loss

d. Net income at 85,000 caps sold 5 (Units 3 Contribution margin per unit) 2 Fixed costs 5 (85,000 3 $3) 2 $150,000 5 $105,000 profit

e. Pretax income 5 $45,000y(1 2 0.25) 5 $60,000 Income taxes 5 $60,000 3 25% 5 $15,000

Units needed for $45,000 income 5 Fixed costs 1 Target pretax income

Contribution margin per cap

5

$150,000 1 $60,000

$3 5 70,000 caps

2. CVP chart.

0 25,000 50,000 75,000 0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

$800,000

Volume (Units)

D o

lla rs

Break-Even Point

100,000

Profit at 70,000 Units

Monthly Capacity

Sales

Total Costs

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 797

3. a. Contribution margin ratio 5 Contribution margin per unit

Selling price per unit 5

$3

$8 5 0.375, or 37.5%

b. Break-even point in dollars 5 Fixed costs

Contribution margin ratio 5

$150,000

37.5% 5 $400,000

c. Net income at sales of $250,000 5 (Sales 3 Contribution margin ratio) 2 Fixed costs 5 ($250,000 3 37.5%) 2 $150,000 5 $(56,250) loss

d. Net income at sales of $600,000 5 (Sales 3 Contribution margin ratio) 2 Fixed costs 5 ($600,000 3 37.5% ) 2 $150,000 5 $75,000 income

e. Dollars of sales to yield

5 Fixed costs 1 Target pretax income

Contribution margin ratio

$45,000 after-tax income

5

$150,000 1 $60,000

37.5% 5 $560,000

APPENDIX

Using Excel to Estimate Least-Squares Regression Microsoft Excel® and other spreadsheet software can be used to perform least-squares regressions to iden- tify cost behavior. In Excel®, the INTERCEPT and SLOPE functions are used. The following screen shot reports the data from Exhibit 18.3 in cells Al through C13 and shows the cell contents to find the intercept (cell B15) and slope (cell B16). Cell B15 uses Excel® to find the intercept from a least-squares regression of total cost (shown as C2:C13 in cell B15) on units produced (shown as B2:B13 in cell B15). Spreadsheet software is useful in understanding cost behavior when many data points (such as monthly total costs and units produced) are available.

18A

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798 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Excel® can also be used to create scatter diagrams such as that in Exhibit 18.4. In contrast to visually drawing a line that “fits” the data, Excel® more precisely fits the regression line. To draw a scatter diagram with a line of fit, follow these steps:

1. Highlight the data cells you wish to diagram; in this example, start from cell C13 and highlight through cell B2.

2. Then select “Insert” and “Scatter” from the drop-down menus. Selecting the chart type in the upper left corner of the choices under Scatter will produce a diagram that looks like that in Exhibit 18.4, without a line of fit.

3. To add a line of fit (also called trend line), select “Layout” and “Trendline” from the drop-down menus. Selecting “Linear Trendline” will produce a diagram that looks like that in Exhibit 18.4, including the line of fit.

C1 Describe different types of cost behavior in relation to pro-duction and sales volume. Cost behavior is described in terms of how its amount changes in relation to changes in volume of activ- ity within a relevant range. Fixed costs remain constant to changes in volume. Total variable costs change in direct proportion to vol- ume changes. Mixed costs display the effects of both fixed and vari- able components. Step-wise costs remain constant over a small volume range, then change by a lump sum and remain constant over another volume range, and so on. Curvilinear costs change in a non- linear relation to volume changes.

C2 Describe several applications of cost-volume-profit analysis. Cost-volume-profit analysis can be used to predict what can happen under alternative strategies concerning sales volume, selling prices, variable costs, or fixed costs. Applications include “what-if” analysis, computing sales for a target income, and break-even analysis.

A1 Compute the contribution margin and describe what it reveals about a company’s cost structure. Contribution mar- gin per unit is a product’s sales price less its total variable costs. Contribution margin ratio is a product’s contribution margin per unit divided by its sales price. Unit contribution margin is the amount received from each sale that contributes to fixed costs and income. The contribution margin ratio reveals what portion of each sales dollar is available as contribution to fixed costs and income.

A2 Analyze changes in sales using the degree of operating leverage. The extent, or relative size, of fixed costs in a company’s total cost structure is known as operating leverage. One tool useful in assessing the effect of changes in sales on income is the degree of operating leverage, or DOL. DOL is the ratio of the contribution margin divided by pretax income. This ratio can be

Summary used to determine the expected percent change in income given a percent change in sales.

P1 Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs. Three dif- ferent methods used to estimate costs are the scatter diagram, the high-low method, and least-squares regression. All three methods use past data to estimate costs. Cost estimates from a scatter diagram are based on a visual fit of the cost line. Estimates from the high-low method are based only on costs corresponding to the lowest and highest sales. The least-squares regression method is a statistical technique and uses all data points.

P2 Compute the break-even point for a single product company. A company’s break-even point for a period is the sales volume at which total revenues equal total costs. To compute a break-even point in terms of sales units, we divide total fixed costs by the con tribution margin per unit. To compute a break-even point in terms of sales dol- lars, divide total fixed costs by the contribution margin ratio.

P3 Graph costs and sales for a single product company. The costs and sales for a company can be graphically illustrated using a CVP chart. In this chart, the horizontal axis represents the number of units sold and the vertical axis represents dollars of sales or costs. Straight lines are used to depict both costs and sales on the CVP chart.

P4 Compute the break-even point for a multiproduct com-pany. CVP analysis can be applied to a multiproduct company by expressing sales volume in terms of composite units. A compos- ite unit consists of a specific number of units of each product in pro- portion to their expected sales mix. Multiproduct CVP analysis treats this composite unit as a single product.

Sales Manager The contribution margin per unit for the first order is $600 (60% of $1,000); the contribution margin per unit for the second order is $160 (20% of $800). You are likely tempted to accept the first order based on its high contribution margin per unit, but you must compute the total contribution margin based on the number of units sold for each order. Total contribution margin is

$60,000 ($600 per unit 3 100 units) and $80,000 ($160 per unit 3 500 units) for the two orders, respectively. The second order provides the largest return in absolute dollars and is the order you would accept. Another factor to consider in your selection is the po- tential for a long-term relationship with these customers including repeat sales and growth.

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 799

Operations Manager Without the availability of past data, none of the three methods described in the chapter can be used to measure cost behavior. Instead, the manager must investigate whether data from similar manufacturers can be accessed. This is likely difficult due to the sensitive nature of such data. In the absence of data, the manager should develop a list of the different production inputs and identify input-output relations. This provides guidance to the manager in measuring cost behavior. After several months, actual cost data will be available for analysis.

Supervisor Your dilemma is whether to go along with the sug- gestions to “manage” the numbers to make the project look like it will achieve sufficient profits. You should not succumb to these suggestions. Many people will likely be affected negatively if you manage the predicted numbers and the project eventually is unprof- itable. Moreover, if it does fail, an investigation would likely reveal

that data in the proposal were “fixed” to make it look good. Proba- bly the only benefit from managing the numbers is the short-term payoff of pleasing those who proposed the product. One way to deal with this dilemma is to prepare several analyses showing re- sults under different assumptions and then let senior management make the decision.

Entrepreneur You must first compute the level of sales required to achieve the desired net income. Then you must conduct sensitivity analysis by varying the price, sales mix, and cost estimates. Results from the sensitivity analysis provide information you can use to assess the possibility of reaching the target sales level. For instance, you might have to pursue aggressive marketing strategies to push the high- margin products, or you might have to cut prices to increase sales and profits, or another strategy might emerge.

Absorption costing (p. 786)

Break-even point (p. 785)

Composite unit (p. 793)

Contribution margin per unit (p. 785)

Contribution margin ratio (p. 785)

Cost-volume-profit (CVP) analysis (p. 778)

Cost-volume-profit (CVP) chart (p. 787)

Curvilinear cost (p. 781)

Degree of operating leverage (DOL) (p. 795)

Estimated line of cost behavior (p. 782)

High-low method (p. 782)

Least-squares regression (p. 783)

Margin of safety (p. 786)

Mixed cost (p. 780)

Operating leverage (p. 795)

Relevant range of operations (p. 788)

Sales mix (p. 793)

Scatter diagram (p. 782)

Step-wise cost (p. 780)

Variable costing income statement (p. 786)

Weighted-average contribution margin (p. 793)

Key Terms

1. b 2. A fixed cost remains unchanged in total amount regardless of

output levels. However, fixed cost per unit declines with in- creased output.

3. Such a cost is considered variable because the total cost changes in proportion to volume changes.

4. b 5. The high-low method ignores all costs and sales (activity base)

volume data points except the costs corresponding to the high- est and lowest (most extreme) sales (activity base) volume.

6. c 7. a 8. ($90 2 $54)y$90 5 40% 9. $90,000y40% 5 $225,000 10. A company’s margin of safety is the excess of the predicted

sales level over its break-even sales level. 11. Three basic CVP assumptions are that (1) selling price per unit is

constant, (2) variable costs per unit are constant, and (3) total fixed costs are constant.

12. a; Two steps are required for explanation: (1) Pretax income 5 $120,000y(1 2 0.20) 5 $150,000

(2)

$50,000 1 $150,000

25% 5 $800,000

13. If the contribution margin ratio decreases from 50% to 25%, unit sales would have to double.

14. c; Selling price of a composite unit: 2 units of X @ $5 per unit . . . . . . . . . . . . . $10 1 unit of Y @ $4 per unit . . . . . . . . . . . . . . 4 Selling price of a composite unit . . . . . . . . $14

Variable costs of a composite unit: 2 units of X @ $2 per unit . . . . . . . . . . . . . $4 1 unit of Y @ $2 per unit . . . . . . . . . . . . . . 2 Variable costs of a composite unit . . . . . . . $6

Therefore, the contribution margin per composite unit is $8.

15. It must be assumed that the sales mix remains unchanged at all sales levels in the relevant range.

Guidance Answers to Quick Checks

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800 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 813 mhhe.com/wildFINMAN5e

1. A company’s only product sells for $150 per unit. Its variable costs per unit are $100, and its fixed costs total $75,000. What is its contribution margin per unit?

a. $50 b. $250 c. $100 d. $150 e. $25

2. Using information from question 1, what is the company’s con- tribution margin ratio?

a. 662⁄3% b. 100% c. 50% d. 0% e. 331⁄3%

3. Using information from question 1, what is the company’s break-even point in units?

a. 500 units b. 750 units

1. What is a variable cost? Identify two variable costs. 2. When output volume increases, do variable costs per unit

in crease, decrease, or stay the same within the relevant range of activity? Explain.

3. When output volume increases, do fixed costs per unit in- crease, decrease, or stay the same within the relevant range of activity? Explain.

4. How is cost-volume-profit analysis useful? 5. How do step-wise costs and curvilinear costs differ? 6. Describe the contribution margin ratio in layperson’s terms. 7. Define and explain the contribution margin ratio. 8. Define and describe contribution margin per unit. 9. In performing CVP analysis for a manufacturing company,

what simplifying assumption is usually made about the volume of production and the volume of sales?

10. What two arguments tend to justify classifying all costs as either fixed or variable even though individual costs might not behave exactly as classified?

11. How does assuming that operating activity occurs within a relevant range affect cost-volume-profit analysis?

12. List three methods to measure cost behavior. 13. How is a scatter diagram used to identify and measure the

behavior of a company’s costs? 14. In cost-volume-profit analysis, what is the estimated profit at

the break-even point?

15. Assume that a straight line on a CVP chart intersects the vertical axis at the level of fixed costs and has a positive slope that rises with each additional unit of volume by the amount of the variable costs per unit. What does this line represent?

16. KTM has both fixed and variable costs. Why are fixed costs depicted as a horizontal line on a CVP chart?

17. Each of two similar companies has sales of $20,000 and total costs of $15,000 for a month. Company A’s total costs include $10,000 of variable costs and $5,000 of fixed costs. If Company B’s total costs include $4,000 of variable costs and $11,000 of fixed costs, which company will enjoy more profit if sales double?

18. _______ of _______ reflects expected sales in excess of the level of break-even sales.

19. Arctic Cat produces snowmobiles for sale. Identify some of the variable and fixed product costs associated with that production.

[Hint: Limit costs to product costs.] 20. Should Polaris use single product or multi-

product break-even analysis? Explain. 21. Piaggio is thinking of expanding sales of

its most popular scooter model by 65%. Should we expect its variable and fixed costs for this model to stay within the relevant range? Explain.

Discussion Questions

Icon denotes assignments that involve decision making.

A Superscript letter A denotes assignments based on Appendix 18A

c. 1,500 units d. 3,000 units e. 1,000 units 4. A company’s forecasted sales are $300,000 and its sales at

break-even are $180,000. Its margin of safety in dollars is a. $180,000. b. $120,000. c. $480,000. d. $60,000. e. $300,000. 5. A product sells for $400 per unit and its variable costs per unit

are $260. The company’s fixed costs are $840,000. If the com- pany desires $70,000 pretax income, what is the required dol- lar sales?

a. $2,400,000 b. $200,000 c. $2,600,000 d. $2,275,000 e. $1,400,000

Polaris

PIAGGIO

Arctic Cat

KTM

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 801

QUICK STUDY

QS 18-1 Cost behavior identification

C1

Listed here are four series of separate costs measured at various volume levels. Examine each series and identify whether it is best described as a fixed, variable, step-wise, or curvilinear cost. (It can help to graph the cost series.)

Volume (Units) Series 1 Series 2 Series 3 Series 4

0 $ 0 $450 $ 800 $100

100 800 450 800 105

200 1,600 450 800 120

300 2,400 450 1,600 145

400 3,200 450 1,600 190

500 4,000 450 2,400 250

600 4,800 450 2,400 320

Determine whether each of the following is best described as a fixed, variable, or mixed cost with respect to product units. 1. Rubber used to manufacture athletic shoes. 2. Maintenance of factory machinery. 3. Packaging expense. 4. Wages of an assembly-line worker paid on

the basis of acceptable units produced.

5. Factory supervisor’s salary. 6. Taxes on factory building. 7. Depreciation expense of warehouse.

QS 18-2 Cost behavior identification

C1

Month Maintenance Hours Maintenance Cost

June. . . . . . . . . . . . . . 9 $5,450

July . . . . . . . . . . . . . . 18 6,900

August . . . . . . . . . . . 12 5,100

September . . . . . . . . 15 6,000

October . . . . . . . . . . 21 6,900

November . . . . . . . . 24 8,100

December . . . . . . . . 6 3,600

The following information is available for a company’s maintenance cost over the last seven months. Using the high-low method, estimate both the fixed and variable components of its maintenance cost.

QS 18-3 Cost behavior estimation— high-low method

P1

QS 18-4 Cost behavior estimation— scatter diagram

P1

0

$12,000

10,000

8,000

6,000

4,000

2,000

M a

in te

n a

n c

e C

o s ts

0 1,000 2,000

Maintenance Hours

3,000 4,000 5,000

This scatter diagram reflects past maintenance hours and their corresponding maintenance costs.

1. Draw an estimated line of cost behavior. 2. Estimate the fixed and variable components of maintenance costs.

Compute and interpret the contribution margin ratio using the following data: sales, $5,000; total variable cost, $3,000.

QS 18-5 Contribution margin ratio

A1

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802 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

QS 18-6 Contribution margin per unit and break-even units P2

SBD Phone Company sells its cordless phone for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. Determine the (1) contribution margin per unit and (2) break-even point in units.

Change Break-even in Units Will

1. Total fixed cost to $190,000 . . . . . . . . __________

2. Variable cost to $34 per unit . . . . . . . . __________

3. Selling price per unit to $80 . . . . . . . . __________

4. Variable cost to $67 per unit . . . . . . . . __________

5. Total fixed cost to $150,000 . . . . . . . . __________

6. Selling price per unit to $120 . . . . . . . __________

QS 18-7 Assumptions in CVP analysis

C2

Refer to the information from QS 18-6. How will the break-even point in units change in response to each of the following independent changes in selling price per unit, variable cost per unit, or total fixed costs? Use I for increase and D for decrease. (It is not necessary to compute new break-even points.)

Refer to QS 18-6. Determine the (1) contribution margin ratio and (2) break-even point in dollars.QS 18-8 Contribution margin ratio and break-even dollars P2

Refer to QS 18-6. Assume that SBD Phone Co. is subject to a 30% income tax rate. Compute the units of product that must be sold to earn after-tax income of $140,000. (Round to the nearest whole unit.)

QS 18-9 CVP analysis and target income

P2

Which one of the following is an assumption that underlies cost-volume-profit analysis? 1. The selling price per unit must change in proportion to the number of units sold. 2. All costs have approximately the same relevant range. 3. For costs classified as variable, the costs per unit of output must change constantly. 4. For costs classified as fixed, the costs per unit of output must remain constant.

QS 18-10 CVP assumptions

C2

A high proportion of Company A’s total costs are variable with respect to units sold; a high proportion of Company B’s total costs are fixed with respect to units sold. Which company is likely to have a higher degree of operating leverage (DOL)? Explain.

QS 18-11 Operating leverage analysis A2

US-Mobile Company manufactures and sells two products, conventional phones and smart phones, in the ratio of 5:3. Fixed costs are $105,000, and the contribution margin per composite unit is $125. What number of both conventional and smart phones is sold at the break-even point?

QS 18-12 Multiproduct break-even P4

Corme Company expects sales of $34 million (400,000 units). The company’s total fixed costs are $17.5 million and its variable costs are $35 per unit. Prepare a CVP chart from this information.

QS 18-13 CVP graph P3

A recent income statement for Volkswagen reports the following (in € millions). Assume 75 percent of the cost of sales and 75 percent of the selling and administrative costs are variable costs, and the remaining 25 percent of each is fixed. Compute the contribution margin (in € millions). (Round computations using percentages to the nearest whole euro.)

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . €126,875

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . 105,431

Selling and administrative expenses . . . . . . . . 15,500

QS 18-14 Contribution margin A1

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 803

EXERCISES

Exercise 18-1 Measurement of cost behavior using a scatter diagram

P1

A company reports the following information about its sales and its cost of sales. Each unit of its product sells for $500. Use these data to prepare a scatter diagram. Draw an estimated line of cost behavior and determine whether the cost appears to be variable, fixed, or mixed.

Period Sales Cost of Sales

1 . . . . . . . . . . . . . . $22,500 $15,150

2 . . . . . . . . . . . . . . 17,250 11,250

3 . . . . . . . . . . . . . . 15,750 10,500

Period Sales Cost of Sales

4 . . . . . . . . . . . . . . 11,250 8,250

5 . . . . . . . . . . . . . . 13,500 9,000

6 . . . . . . . . . . . . . . 18,750 14,250

The left column lists several cost classifications. The right column presents short definitions of those costs. In the blank space beside each of the numbers in the right column, write the letter of the cost best described by the definition. A. Total cost B. Mixed cost C. Variable cost D. Curvilinear cost E. Step-wise cost F. Fixed cost

1. This cost is the combined amount of all the other costs. 2. This cost remains constant over a limited range of volume; when

it reaches the end of its limited range, it changes by a lump sum and remains at that level until it exceeds another limited range.

3. This cost has a component that remains the same over all vol- ume levels and another component that increases in direct pro- portion to increases in volume.

4. This cost increases when volume increases, but the increase is not constant for each unit produced.

5. This cost remains constant over all volume levels within the productive capacity for the planning period.

6. This cost increases in direct proportion to increases in volume; its amount is constant for each unit produced.

Exercise 18-3 Cost behavior defined

C1

Following are five graphs representing various cost behaviors. (1) Identify whether the cost behavior in each graph is mixed, step-wise, fixed, variable, or curvilinear. (2) Identify the graph (by number) that best illustrates each cost behavior: (a) Factory policy requires one supervisor for every 30 factory workers; (b) real estate taxes on factory; (c) electricity charge that includes the standard monthly charge plus a charge for each kilowatt hour; (d) commissions to salespersons; and (e) costs of hourly paid workers that provide substantial gains in effi- ciency when a few workers are added but gradually smaller gains in efficiency when more workers are added.

C o

s ts

Volume VolumeVolume Volume Volume

C o

s ts

C o

s ts

C o

s ts

2.1. 4.3. 5.

C o

s ts

Exercise 18-2 Cost behavior in graphs

C1

Following are five series of costs A through E measured at various volume levels. Examine each series and identify which is fixed, variable, mixed, step-wise, or curvilinear.

File Edit View Insert Format Tools Data Window Help

1 2 3 4 5 6 7

0 400 800

1,200 1,600 2,000 2,400

Volume (Units) $2,500

3,100 3,700 4,300 4,900 5,500 6,100

Series B Series D $5,000

5,000 5,000 5,000 5,000 5,000 5,000

Series ESeries CSeries A 0

3,600 7,200

10,800 14,400 18,000 21,600

$ 0 6,000 6,600 7,200 8,200 9,600

13,500

$ $1,000 1,000 2,000 2,000 3,000 3,000 4,000

Exercise 18-4 Cost behavior identification

C1

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804 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Use the following information about sales and costs to prepare a scatter diagram. Draw a cost line that reflects the behavior displayed by this cost. Determine whether the cost is variable, step-wise, fixed, mixed, or curvilinear.

Period Sales Costs Period Sales Costs

1 . . . . . . . . . . . . . $760 $590 9 . . . . . . . . . . . . . $580 $390

2 . . . . . . . . . . . . . 800 560 10 . . . . . . . . . . . . . 320 240

3 . . . . . . . . . . . . . 200 230 11 . . . . . . . . . . . . . 240 230

4 . . . . . . . . . . . . . 400 400 12 . . . . . . . . . . . . . 720 550

5 . . . . . . . . . . . . . 480 390 13 . . . . . . . . . . . . . 280 260

6 . . . . . . . . . . . . . 620 550 14 . . . . . . . . . . . . . 440 410

7 . . . . . . . . . . . . . 680 590 15 . . . . . . . . . . . . . 380 260

8 . . . . . . . . . . . . . 540 430

Exercise 18-6 Scatter diagram and measurement of cost behavior

P1

Felix & Co. reports the following information about its sales and cost of sales. Draw an estimated line of cost behavior using a scatter diagram, and compute fixed costs and variable costs per unit sold. Then use the high-low method to estimate the fixed and variable components of the cost of sales.

Units Cost of Units Cost of

Period Sold Sales Period Sold Sales

1 . . . . . . . . . . . . . 0 $2,500 6 . . . . . . . . . . . . . 2,000 5,500

2 . . . . . . . . . . . . . 400 3,100 7 . . . . . . . . . . . . . 2,400 6,100

3 . . . . . . . . . . . . . 800 3,700 8 . . . . . . . . . . . . . 2,800 6,700

4 . . . . . . . . . . . . . 1,200 4,300 9 . . . . . . . . . . . . . 3,200 7,300

5 . . . . . . . . . . . . . 1,600 4,900 10 . . . . . . . . . . . . . 3,600 7,900

Exercise 18-7 Cost behavior estimation— scatter diagram and high-low

P1

Refer to the information from Exercise 18-7. Use spreadsheet software to use ordinary least-squares regres- sion to estimate the cost equation, including fixed and variable cost amounts.

Exercise 18-8A

Measurement of cost behavior using regression P1

A jeans maker is designing a new line of jeans called the Slims. The jeans will sell for $205 per pair and cost $164 per pair in variable costs to make. (1) Compute the contribution margin per pair. (2) Compute the contribution margin ratio. (3) Describe what the contribution margin ratio reveals about this new jeans line.

Exercise 18-9 Contribution margin

A2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. (1) Use this information to com- pute the company’s (a) contribution margin, (b) contribution margin ratio, (c) break-even point in units, and (d) break-even point in dollars of sales.

Exercise 18-10 Contribution margin and break-even P2

Refer to the information in Exercise 18-10. Prepare a CVP chart for the company.Exercise 18-11 CVP chart P3

Exercise 18-12 Income reporting and break-even analysis C2

Refer to Exercise 18-10. (1) Prepare a contribution margin income statement for Blanchard Company showing sales, variable costs, and fixed costs at the break-even point. (2) If the company’s fixed costs in- crease by $135,000, what amount of sales (in dollars) is needed to break even? Explain.

Exercise 18-13 Computing sales to achieve target income C2

Blanchard Company management (in Exercise 18-10) targets an annual after-tax income of $810,000. The company is subject to a 20% income tax rate. Assume that fixed costs remain at $562,500. Compute the (1) unit sales to earn the target after-tax net income and (2) dollar sales to earn the target after-tax net income.

Exercise 18-5 Predicting sales and variable costs using contribution margin C2

Bloom Company management predicts that it will incur fixed costs of $160,000 and earn pretax income of $164,000 in the next period. Its expected contribution margin ratio is 25%. Use this information to compute the amounts of (1) total dollar sales and (2) total variable costs.

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 805

Exercise 18-14 Forecasted income statement

C2

Blanchard Company’s sales manager (in Exercise 18-10) predicts that annual sales of the company’s prod- uct will soon reach 40,000 units and its price will increase to $200 per unit. According to the production manager, the variable costs are expected to increase to $140 per unit but fixed costs will remain at $562,500. The income tax rate is 20%. What amounts of pretax and after-tax income can the company expect to earn from these predicted changes? (Hint: Prepare a forecasted contribution margin income statement as in Exhibit 18.21.)

Check Forecasted income, $1,470,000

Exercise 18-15 Predicting unit and dollar sales

C2

Nombre Company management predicts $390,000 of variable costs, $430,000 of fixed costs, and a pretax income of $155,000 in the next period. Management also predicts that the contribution margin per unit will be $9. Use this information to compute the (1) total expected dollar sales for next period and (2) number of units expected to be sold next period.

Exercise 18-16 Computation of variable and fixed costs

C2

Cooper Company expects to sell 200,000 units of its product next year, which would generate total sales of $17 million. Management predicts that pretax net income for next year will be $1,250,000 and that the contribution margin per unit will be $25. Use this information to compute next year’s total expected (a) variable costs and (b) fixed costs.

Exercise 18-18 CVP analysis using weighted- average contribution margin

P4

Refer to the information from Exercise 18-17. Use the information to determine the (1) weighted- average contribution margin, (2) break-even point in units, and (3) number of units of each product that will be sold at the break-even point.

Exercise 18-20 CVP analysis using weighted- average contribution margin

P4

Refer to the information from Exercise 18-19. Use the information to determine the (1) weighted- average contribution margin, (2) break-even point in units, and (3) number of units of each product that will be sold at the break-even point.

Exercise 18-17 CVP analysis using composite units P4

Handy Home sells windows and doors in the ratio of 8:2 (windows:doors). The selling price of each win- dow is $200 and of each door is $500. The variable cost of a window is $125 and of a door is $350. Fixed costs are $900,000. Use this information to determine the (1) selling price per composite unit, (2) variable costs per composite unit, (3) break-even point in composite units, and (4) number of units of each product that will be sold at the break-even point. Check (3) 1,000 composite units

Exercise 18-19 CVP analysis using composite units

P4

R&R Tax Service offers tax and consulting services to individuals and small businesses. Data for fees and costs of three types of tax returns follow. R&R provides services in the ratio of 5:3:2 (easy, moderate, business). Fixed costs total $18,000 for the tax season. Use this information to determine the (1) selling price per composite unit, (2) variable costs per composite unit, (3) break- even point in composite units, and (4) number of units of each product that will be sold at the break-even point.

Fee Variable Cost

Type of Return Charged per Return

Easy (form 1040EZ) . . . . . . . . . . $ 50 $ 30

Moderate (form 1040) . . . . . . . . 125 75

Business . . . . . . . . . . . . . . . . . . . 275 100

Exercise 18-21 Operating leverage computed and applied

A2

Company A is a manufacturer with current sales of $6,000,000 and a 60% contribution margin. Its fixed costs equal $2,600,000. Company B is a consulting firm with current service revenues of $4,500,000 and a 25% contribution margin. Its fixed costs equal $375,000. Compute the degree of operating leverage (DOL) for each company. Identify which company benefits more from a 20% increase in sales and explain why.

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806 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Required

1. Prepare a contribution margin income statement for the company. 2. Compute its contribution margin per unit and its contribution margin ratio.

Analysis Component

3. Interpret the contribution margin and contribution margin ratio from part 2.

The following costs result from the production and sale of 1,000 drum sets manufactured by Tom Thompson Company for the year ended December 31, 2013. The drum sets sell for $500 each. The com- pany has a 25% income tax rate.

Variable production costs

Plastic for casing . . . . . . . . . . . . . . . . . . . . . . . $ 17,000

Wages of assembly workers . . . . . . . . . . . . . . 82,000

Drum stands . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Variable selling costs

Sales commissions . . . . . . . . . . . . . . . . . . . . . . 15,000

Fixed manufacturing costs

Taxes on factory . . . . . . . . . . . . . . . . . . . . . . . 5,000

Factory maintenance . . . . . . . . . . . . . . . . . . . . 10,000

Factory machinery depreciation . . . . . . . . . . . 40,000

Fixed selling and administrative costs

Lease of equipment for sales staff . . . . . . . . . . 10,000

Accounting staff salaries . . . . . . . . . . . . . . . . . 35,000

Administrative management salaries . . . . . . . . 125,000

Xcite Equipment Co. manufactures and markets a number of rope products. Management is considering the future of Product XT, a special rope for hang gliding, that has not been as profitable as planned. Since Product XT is manufactured and marketed independently of the other products, its total costs can be pre- cisely measured. Next year’s plans call for a $200 selling price per 100 yards of XT rope. Its fixed costs for the year are expected to be $270,000, up to a maximum capacity of 700,000 yards of rope. Forecasted variable costs are $140 per 100 yards of XT rope.

Required

1. Estimate Product XT’s break-even point in terms of (a) sales units and (b) sales dollars. 2. Prepare a CVP chart for Product XT like that in Exhibit 18.15. Use 7,000 units (700,000 yards/100

yards) as the maximum number of sales units on the horizontal axis of the graph, and $1,400,000 as the maximum dollar amount on the vertical axis.

3. Prepare a contribution margin income statement showing sales, variable costs, and fixed costs for Product XT at the break-even point.

PROBLEM SET A

Problem 18-1A Contribution margin income statement and contribution margin ratio

A1

Check (1) Net income, $101,250

mhhe.com/wildFINMAN5e

Problem 18-2A CVP analysis and charting

P2 P3

Check (1) Break-even sales, 4,500 units

Problem 18-3A Scatter diagram and cost behavior estimation

P1

Alden Co.’s monthly sales and cost data for its operating activities of the past year follow. Management wants to use these data to predict future fixed and variable costs.

Month Sales Total Cost Month Sales Total Cost

1 . . . . . . . . . . . . . $320,000 $160,000 7 . . . . . . . . . . . . $340,000 $220,000

2 . . . . . . . . . . . . . 160,000 100,000 8 . . . . . . . . . . . . 280,000 160,000

3 . . . . . . . . . . . . . 280,000 220,000 9 . . . . . . . . . . . . 80,000 64,000

4 . . . . . . . . . . . . . 200,000 100,000 10 . . . . . . . . . . . . 160,000 140,000

5 . . . . . . . . . . . . . 300,000 230,000 11 . . . . . . . . . . . . 100,000 100,000

6 . . . . . . . . . . . . . 200,000 120,000 12 . . . . . . . . . . . . 110,000 80,000

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 807

Required

1. Prepare a scatter diagram for these data with sales volume (in $) plotted on the horizontal axis and total cost plotted on the vertical axis.

2. Estimate both the variable costs per sales dollar and the total monthly fixed costs using the high-low method. Draw the total costs line on the scatter diagram in part 1.

3. Use the estimated line of cost behavior and results from part 2 to predict future total costs when sales volume is (a) $200,000 and (b) $300,000.

Check (2) Variable costs, $0.60 per sales dollar; fixed costs, $16,000

Problem 18-4A Break-even analysis; income targeting and forecasting

C2 P2 A1

Astro Co. sold 20,000 units of its only product and incurred a $50,000 loss (ignoring taxes) for the current year as shown here. During a planning session for year 2014’s activities, the production manager notes that variable costs can be reduced 50% by installing a machine that automates several operations. To ob- tain these savings, the company must increase its annual fixed costs by $200,000. The maximum output capacity of the company is 40,000 units per year.

ASTRO COMPANY

Contribution Margin Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Variable costs . . . . . . . . . . . . . . . 800,000

Contribution margin . . . . . . . . . 200,000

Fixed costs . . . . . . . . . . . . . . . . 250,000

Net loss . . . . . . . . . . . . . . . . . . . $ (50,000)

Required

1. Compute the break-even point in dollar sales for year 2013. 2. Compute the predicted break-even point in dollar sales for year 2014 assuming the machine is in-

stalled and there is no change in the unit sales price. 3. Prepare a forecasted contribution margin income statement for 2014 that shows the expected results

with the machine installed. Assume that the unit sales price and the number of units sold will not change, and no income taxes will be due.

4. Compute the sales level required in both dollars and units to earn $140,000 of after-tax income in 2014 with the machine installed and no change in the unit sales price. Assume that the income tax rate is 30%. (Hint: Use the procedures in Exhibits 18.22 and 18.23.) (Round answers to whole dollars or units.)

5. Prepare a forecasted contribution margin income statement that shows the results at the sales level computed in part 4. Assume an income tax rate of 30%.

Check (3) Net income, $150,000

(4) Required sales, $1,083,333 or 21,667 units

Vanna Co. produces and sells two products, T and O. It manufactures these products in separate factories and markets them through different channels. They have no shared costs. This year, the company sold 50,000 units of each product. Sales and costs for each product follow.

Product T Product O

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000 $2,000,000

Variable costs . . . . . . . . . . . . . . . . . . 1,600,000 250,000

Contribution margin . . . . . . . . . . . . 400,000 1,750,000

Fixed costs . . . . . . . . . . . . . . . . . . . . 125,000 1,475,000

Income before taxes . . . . . . . . . . . . 275,000 275,000

Income taxes (32% rate) . . . . . . . . . 88,000 88,000

Net income . . . . . . . . . . . . . . . . . . . $ 187,000 $ 187,000

Problem 18-5A Break-even analysis, different cost structures, and income calculations

C2 A1 P4

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808 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Required

1. Compute the break-even point in dollar sales for each product. (Round the answer to whole dollars.) 2. Assume that the company expects sales of each product to decline to 30,000 units next year with

no change in unit sales price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as just shown with columns for each of the two products (assume a 32% tax rate). Also, assume that any loss before taxes yields a 32% tax savings.

3. Assume that the company expects sales of each product to increase to 60,000 units next year with no change in unit sales price. Prepare forecasted financial results for next year following the format of the contribution margin income statement shown with columns for each of the two products (assume a 32% tax rate).

Analysis Component

4. If sales greatly decrease, which product would experience a greater loss? Explain. 5. Describe some factors that might have created the different cost structures for these two products.

Check (2) After-tax income: T, $78,200; O, $(289,000)

(3) After-tax income: T, $241,400; O, $425,000

This year Bertrand Company sold 40,000 units of its only product for $25 per unit. Manufacturing and selling the product required $200,000 of fixed manufacturing costs and $325,000 of fixed selling and administrative costs. Its per unit variable costs follow.

Problem 18-6A Analysis of price, cost, and volume changes for contribution margin and net income

P2 A1

Check (1) Break-even: Plan 1, $750,000; Plan 2, $700,000

(2) Net income: Plan 1, $122,500; Plan 2, $199,500

Material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8.00

Direct labor (paid on the basis of completed units) . . . . . . . . . . 5.00

Variable overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.00

Variable selling and administrative costs . . . . . . . . . . . . . . . . . . . 0.50

Next year the company will use new material, which will reduce material costs by 50% and direct labor costs by 60% and will not affect product quality or marketability. Management is considering an in- crease in the unit sales price to reduce the number of units sold because the factory’s output is nearing its annual output capacity of 45,000 units. Two plans are being considered. Under plan 1, the company will keep the price at the current level and sell the same volume as last year. This plan will increase income because of the reduced costs from using the new material. Under plan 2, the company will in- crease price by 20%. This plan will decrease unit sales volume by 10%. Under both plans 1 and 2, the total fixed costs and the variable costs per unit for overhead and for selling and administrative costs will remain the same.

Required

1. Compute the break-even point in dollar sales for both (a) plan 1 and (b) plan 2. 2. Prepare a forecasted contribution margin income statement with two columns showing the expected

results of plan 1 and plan 2. The statements should report sales, total variable costs, contribution mar- gin, total fixed costs, income before taxes, income taxes (30% rate), and net income.

Patriot Co. manufactures and sells three products: red, white, and blue. Their unit sales prices are red, $20; white, $35; and blue, $65. The per unit variable costs to manufacture and sell these products are red, $12; white, $22; and blue, $50. Their sales mix is reflected in a ratio of 5:4:2 (red:white:blue). Annual fixed costs shared by all three products are $250,000. One type of raw material has been used to manufacture all three products. The company has developed a new material of equal quality for less cost. The new material would reduce variable costs per unit as follows: red, by $6; white, by $12; and blue, by $10. However, the new material requires new equipment, which will increase annual fixed costs by $50,000. (Round answers to whole composite units.)

Required

1. If the company continues to use the old material, determine its break-even point in both sales units and sales dollars of each individual product.

2. If the company uses the new material, determine its new break-even point in both sales units and sales dollars of each individual product.

Analysis Component

3. What insight does this analysis offer management for long-term planning?

Problem 18-7A Break-even analysis with composite units

P4

Check (1) Old plan break-even, 2,050 composite units (rounded)

(2) New plan break-even, 1,364 composite units (rounded)

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 809

PROBLEM SET B

Problem 18-1B Contribution margin income statement and contribution margin ratio

A1

The following costs result from the production and sale of 12,000 CD sets manufactured by Gilmore Company for the year ended December 31, 2013. The CD sets sell for $18 each. The company has a 25% income tax rate.

Variable manufacturing costs

Plastic for CD sets . . . . . . . . . . . . . . . . . . . . . . $ 1,500

Wages of assembly workers . . . . . . . . . . . . . . . 30,000

Labeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Variable selling costs

Sales commissions . . . . . . . . . . . . . . . . . . . . . . . 6,000

Fixed manufacturing costs

Rent on factory . . . . . . . . . . . . . . . . . . . . . . . . . 6,750

Factory cleaning service . . . . . . . . . . . . . . . . . . 4,520

Factory machinery depreciation . . . . . . . . . . . . 20,000

Fixed selling and administrative costs

Lease of office equipment . . . . . . . . . . . . . . . . . 1,050

Systems staff salaries . . . . . . . . . . . . . . . . . . . . . 15,000

Administrative management salaries . . . . . . . . . 120,000

Required

1. Prepare a contribution margin income statement for the company. 2. Compute its contribution margin per unit and its contribution margin ratio.

Analysis Component

3. Interpret the contribution margin and contribution margin ratio from part 2.

Check (1) Net income, $6,135

Problem 18-2B CVP analysis and charting

P2 P3

Hip-Hop Co. manufactures and markets several products. Management is considering the future of one product, electronic keyboards, that has not been as profitable as planned. Since this product is manufac- tured and marketed independently of the other products, its total costs can be precisely measured. Next year’s plans call for a $350 selling price per unit. The fixed costs for the year are expected to be $42,000, up to a maximum capacity of 700 units. Forecasted variable costs are $210 per unit.

Required

1. Estimate the keyboards’ break-even point in terms of (a) sales units and (b) sales dollars. 2. Prepare a CVP chart for keyboards like that in Exhibit 18.15. Use 700 keyboards as the maximum

number of sales units on the horizontal axis of the graph, and $250,000 as the maximum dollar amount on the vertical axis.

3. Prepare a contribution margin income statement showing sales, variable costs, and fixed costs for keyboards at the break-even point.

Check (1) Break-even sales, 300 units

Problem 18-3B Scatter diagram and cost behavior estimation

P1Month Sales Total Cost Month Sales Total Cost

1 . . . . . . . . . . . . . $195 $ 97 7 . . . . . . . . . . . . $145 $ 93

2 . . . . . . . . . . . . . 125 87 8 . . . . . . . . . . . . 185 105

3 . . . . . . . . . . . . . 105 73 9 . . . . . . . . . . . . 135 85

4 . . . . . . . . . . . . . 155 89 10 . . . . . . . . . . . . 85 58

5 . . . . . . . . . . . . . 95 81 11 . . . . . . . . . . . . 175 95

6 . . . . . . . . . . . . . 215 110 12 . . . . . . . . . . . . 115 79

Kyo Co.’s monthly sales and costs data for its operating activities of the past year follow. Management wants to use these data to predict future fixed and variable costs. (Dollar amounts are in thousands.)

Required

1. Prepare a scatter diagram for these data with sales volume (in $) plotted on the horizontal axis and total costs plotted on the vertical axis.

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810 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

2. Estimate both the variable costs per sales dollar and the total monthly fixed costs using the high-low method. Draw the total costs line on the scatter diagram in part 1.

3. Use the estimated line of cost behavior and results from part 2 to predict future total costs when sales volume is (a) $100 and (b) $170.

Check (2) Variable costs, $0.40 per sales dollar; fixed costs, $24

Problem 18-4B Break-even analysis; income targeting and forecasting

C2 P2 A1

Rivera Co. sold 20,000 units of its only product and incurred a $50,000 loss (ignoring taxes) for the cur- rent year as shown here. During a planning session for year 2014’s activities, the production manager notes that variable costs can be reduced 50% by installing a machine that automates several operations. To obtain these savings, the company must increase its annual fixed costs by $150,000. The maximum output capacity of the company is 40,000 units per year.

RIVERA COMPANY

Contribution Margin Income Statement

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . $750,000

Variable costs . . . . . . . . . . . . . . . 600,000

Contribution margin . . . . . . . . . 150,000

Fixed costs . . . . . . . . . . . . . . . . . 200,000

Net loss . . . . . . . . . . . . . . . . . . . $ (50,000)

Required

1. Compute the break-even point in dollar sales for year 2013. 2. Compute the predicted break-even point in dollar sales for year 2014 assuming the machine is installed

and no change occurs in the unit sales price. (Round the change in variable costs to a whole number.) 3. Prepare a forecasted contribution margin income statement for 2014 that shows the expected results

with the machine installed. Assume that the unit sales price and the number of units sold will not change, and no income taxes will be due.

4. Compute the sales level required in both dollars and units to earn $140,000 of after-tax income in 2014 with the machine installed and no change in the unit sales price. Assume that the income tax rate is 30%. (Hint: Use the procedures in Exhibits 18.22 and 18.23.) (Round sales in dollars to whole dollars and round sales in units to the next whole unit.)

5. Prepare a forecasted contribution margin income statement that shows the results at the sales level computed in part 4. Assume an income tax rate of 30%.

Check (3) Net income, $100,000

(4) Required sales, $916,667 or 24,445 units

Product BB Product TT

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 $800,000

Variable costs . . . . . . . . . . . . . . . . . . 560,000 100,000

Contribution margin . . . . . . . . . . . . 240,000 700,000

Fixed costs . . . . . . . . . . . . . . . . . . . . 100,000 560,000

Income before taxes . . . . . . . . . . . . 140,000 140,000

Income taxes (32% rate) . . . . . . . . . 44,800 44,800

Net income . . . . . . . . . . . . . . . . . . . $ 95,200 $ 95,200

Mingei Co. produces and sells two products, BB and TT. It manufactures these products in separate facto- ries and markets them through different channels. They have no shared costs. This year, the company sold 50,000 units of each product. Sales and costs for each product follow.

Required

1. Compute the break-even point in dollar sales for each product. (Round the answer to the next whole dollar.) 2. Assume that the company expects sales of each product to decline to 33,000 units next year with no

change in the unit sales price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as shown here with columns for each of the two products (assume a 32% tax rate, and that any loss before taxes yields a 32% tax savings).

3. Assume that the company expects sales of each product to increase to 64,000 units next year with no change in the unit sales prices. Prepare forecasted financial results for next year following the format of the contribution margin income statement as shown here with columns for each of the two products (assume a 32% tax rate).

Check (2) After-tax income: BB, $39,712; TT, $(66,640)

(3) After-tax income: BB, $140,896; TT, $228,480

Problem 18-5B Break-even analysis, different cost structures, and income calculations

C2 P4 A1

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 811

Analysis Component

4. If sales greatly increase, which product would experience a greater increase in profit? Explain. 5. Describe some factors that might have created the different cost structures for these two products.

Problem 18-6B Analysis of price, cost, and volume changes for contribution margin and net income

A1 P2

This year Best Company earned a disappointing 5.6% after-tax return on sales (net income/sales) from marketing 100,000 units of its only product. The company buys its product in bulk and repackages it for resale at the price of $20 per unit. Best incurred the following costs this year.

Total variable unit costs . . . . . . . . . . . . . . $800,000

Total variable packaging costs . . . . . . . . . $100,000

Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . $950,000

Income tax rate . . . . . . . . . . . . . . . . . . . . 25%

The marketing manager claims that next year’s results will be the same as this year’s unless some changes are made. The manager predicts the company can increase the number of units sold by 80% if it reduces the selling price by 20% and upgrades the packaging. This change would increase variable packaging costs by 20%. Increased sales would allow the company to take advantage of a 25% quantity purchase discount on the cost of the bulk product. Neither the packaging change nor the volume discount would affect fixed costs, which provide an annual output capacity of 200,000 units.

Required

1. Compute the break-even point in dollar sales under the (a) existing business strategy and (b) new strat- egy that alters both unit sales price and variable costs. (Round answers to the next whole dollar.)

2. Prepare a forecasted contribution margin income statement with two columns showing the expected results of (a) the existing strategy and (b) changing to the new strategy. The statements should report sales, total variable costs (unit and packaging), contribution margin, fixed costs, income before taxes, income taxes, and net income. Also determine the after-tax return on sales for these two strategies.

Check (1) Break-even sales for new strategy, $1,727,273

(2) Net income: Existing strategy, $112,500; new strategy, $475,500

SERIAL PROBLEM Success Systems

P4

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the working papers that accompany the book.)

SP 18 Success Systems sells upscale modular desk units and office chairs in the ratio of 3:2 (desk unit:chair). The selling prices are $1,250 per desk unit and $500 per chair. The variable costs are $750 per desk unit and $250 per chair. Fixed costs are $120,000.

Required

1. Compute the selling price per composite unit. 2. Compute the variable costs per composite unit. 3. Compute the break-even point in composite units. 4. Compute the number of units of each product that would be sold at the break-even point.

Problem 18-7B Break-even analysis with composite units

P4

Milano Co. manufactures and sells three products: product 1, product 2, and product 3. Their unit sales prices are product 1, $40; product 2, $30; and product 3, $20. The per unit variable costs to manufacture and sell these products are product 1, $30; product 2, $15; and product 3, $8. Their sales mix is reflected in a ratio of 6 : 4: 2. Annual fixed costs shared by all three products are $270,000. One type of raw material has been used to manufacture products 1 and 2. The company has developed a new material of equal quality for less cost. The new material would reduce variable costs per unit as follows: product 1 by $10, and product 2, by $5. However, the new material requires new equipment, which will increase annual fixed costs by $50,000.

Required

1. If the company continues to use the old material, determine its break-even point in both sales units and sales dollars of each individual product.

2. If the company uses the new material, determine its new break-even point in both sales units and sales dollars of each individual product.

Analysis Component

3. What insight does this analysis offer management for long-term planning?

Check (1) Old plan break-even, 1,875 composite units (rounded)

(2) New plan break-even, 1,429 composite units (rounded)

Check (3) 60 composite units

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812 Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Beyond the Numbers

BTN 18-1 Polaris offers extended service contracts that provide repair and maintenance coverage over its products. As you complete the following requirements, assume that the Polaris services department uses many of Polaris’s existing resources such as its facilities, repair machinery, and computer systems.

Required

1. Identify several of the variable, mixed, and fixed costs that the Polaris services department is likely to incur in carrying out its services.

2. Assume that Polaris’s services revenues are expected to grow by 25% in the next year. How would we expect the costs identified in part 1 to change, if at all?

3. Based on the answer to part 2, can Polaris use the contribution margin ratio to predict how income will change in response to increases in Polaris’s services revenues?

REPORTING IN ACTION C1

BTN 18-3 Labor costs of an auto repair mechanic are seldom based on actual hours worked. Instead, the amount paid a mechanic is based on an industry average of time estimated to complete a repair job. The re- pair shop bills the customer for the industry average amount of time at the repair center’s billable cost per hour. This means a customer can pay, for example, $120 for two hours of work on a car when the actual time worked was only one hour. Many experienced mechanics can complete repair jobs faster than the industry average. The average data are compiled by engineering studies and surveys conducted in the auto repair busi- ness. Assume that you are asked to complete such a survey for a repair center. The survey calls for objective input, and many questions require detailed cost data and analysis. The mechanics and owners know you have the survey and encourage you to complete it in a way that increases the average billable hours for repair work.

Required

Write a one-page memorandum to the mechanics and owners that describes the direct labor analysis you will undertake in completing this survey.

ETHICS CHALLENGE C1

BTN 18-2 Both Polaris and Arctic Cat sell motorized vehicles, and each of these companies has a dif- ferent product mix.

Required

1. Assume the following data are available for both companies. Compute each company’s break-even point in unit sales. (Each company sells many motorized vehicles at many different selling prices, and each has its own variable costs. This assignment assumes an average selling price per unit and an average cost per item.)

2. If unit sales were to decline, which company would experience the larger decline in operating profit? Explain.

Polaris Arctic Cat

Average selling price per item sold . . . . . . . . . . $10,500 $11,200

Average variable cost per item sold . . . . . . . . . $4,200 $5,100

Total fixed costs ($ in thousands) . . . . . . . . . . . $146,570 $133,570

COMPARATIVE ANALYSIS P2 A2

BTN 18-4 Several important assumptions underlie CVP analysis. Assumptions often help simplify and focus our analysis of sales and costs. A common application of CVP analysis is as a tool to forecast sales, costs, and income.

Required

Assume that you are actively searching for a job. Prepare a one-half page report identifying (1) three as- sumptions relating to your expected revenue (salary) and (2) three assumptions relating to your expected costs for the first year of your new job. Be prepared to discuss your assumptions in class.

COMMUNICATING IN PRACTICE C2

Polaris

Polaris Arctic Cat

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Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis 813

BTN 18-5 Access and review the entrepreneurial information at Business Owner’s Toolkit [Toolkit.com]. Access and review its New Business Cash Needs Checklist under the Start Up menu bar or similar work- sheets related to controls of cash and costs.

Required

Write a one-half page report that describes the information and resources available at the Business Owner’s Toolkit to help the owner of a start-up business to control and monitor its cash flows and costs.

TAKING IT TO THE NET C1

BTN 18-6 A local movie theater owner explains to you that ticket sales on weekends and evenings are strong, but attendance during the weekdays, Monday through Thursday, is poor. The owner proposes to offer a contract to the local grade school to show educational materials at the theater for a set charge per student during school hours. The owner asks your help to prepare a CVP analysis listing the cost and sales projections for the proposal. The owner must propose to the school’s administration a charge per child. At a minimum, the charge per child needs to be sufficient for the theater to break even.

Required

Your team is to prepare two separate lists of questions that enable you to complete a reliable CVP analysis of this situation. One list is to be answered by the school’s administration, the other by the owner of the movie theater.

TEAMWORK IN ACTION C2

BTN 18-7 Leather Head Sports, launched by entrepreneur Paul Cunningham, produces balls for vari- ous sports. Selling prices typically range from $40 per ball to $295 per ball.

Required

1. Identify at least two fixed costs that will not change regardless of how many footballs Leather Head Sports produces.

2. How could overly optimistic sales estimates potentially hurt Paul Cunningham’s business? 3. Explain how cost-volume-profit analysis can help Paul Cunningham manage Leather Head Sports.

ENTREPRENEURIAL DECISION C1 A1

BTN 18-8 Multiproduct break-even analysis is often viewed differently when actually applied in prac- tice. You are to visit a local fast-food restaurant and count the number of items on the menu. To apply multiproduct break-even analysis to the restaurant, similar menu items must often be fit into groups. A reasonable approach is to classify menu items into approximately five groups. We then estimate average selling price and average variable cost to compute average contribution margin. (Hint: For fast-food res- taurants, the highest contribution margin is with its beverages, at about 90%.)

Required

1. Prepare a one-year multiproduct break-even analysis for the restaurant you visit. Begin by establishing groups. Next, estimate each group’s volume and contribution margin. These estimates are necessary to compute each group’s contribution margin. Assume that annual fixed costs in total are $500,000 per year. (Hint: You must develop your own estimates on volume and contribution margin for each group to obtain the break-even point and sales.)

2. Prepare a one-page report on the results of your analysis. Comment on the volume of sales necessary to break even at a fast-food restaurant.

HITTING THE ROAD P4

1. a; $150 2 $100 5 $50 2. e; ($150 2 $100)y$150 5 331⁄3% 3. c; $75,000y$50 CM per unit 5 1,500 units

4. b; $300,000 2 $180,000 5 $120,000 5. c; Contribution margin ratio 5 ($400 2 $260)y$400 5 0.35 Targeted sales 5 ($840,000 1 $70,000)y0.35 5 $2,600,000

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 18-9 Access and review Piaggio’s Website (www.piaggio.com) to answer the following questions.

Required

1. Do you believe that Piaggio’s managers use single product CVP analysis or multiproduct break-even analysis? Explain.

2. How does the addition of a new product line affect Piaggio’s CVP analysis?

GLOBAL DECISION P4

PIAGGIO

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Learning Objectives

CONCEPTUAL

C1 Describe how absorption costing can result in over-production. (p. 823) C2 Explain the role of variable costing in pricing special orders. (p. 825)

ANALYTICAL

A1 Compute and interpret break-even volume in units. (p. 827)

PROCEDURAL

P1 Compute unit cost under both absorption and variable costing. (p. 817) P2 Prepare and analyze an income statement using absorption costing and using variable

costing. (p. 818)

P3 Prepare a contribution margin report. (p. 819) P4 Convert income under variable costing to the absorption cost basis. (p. 823)

A Look at This Chapter

This chapter describes managerial accounting reports that reflect variable costing. It also compares reports prepared under variable costing with those under absorption costing, and it explains how variable costing can improve business decisions.

A Look Back

Chapter 18 looked at cost behavior and its use by managers in performing cost- volume-profit analysis. It also illustrated the application of cost-volume-profit analysis.

Variable Costing and Performance Reporting 19

A Look Ahead

Chapter 20 introduces and describes the budgeting process and its importance to management. It also explains the master budget and its usefulness to the planning of future company activities.

814

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Shoe Biz

NEW YORK—Business recipe: Take one information systems graduate, mix a bit of international flair, add an accountant, and stir. The result is Samanta Shoes (SamantaShoes.com), a start-up shoe manufacturer. Founded by Samanta and Kelvin Joseph, their company is aimed at providing “stylish, comfortable, and affordable” shoes, explains Samanta. “I design every shoe, and nothing less than the best material is used.” In the beginning, Kelvin focused on the accounting and finan- cial side of Samanta Shoes. “The knowledge gained from my years at Ernst & Young LLP [a major accounting firm],” explains Kelvin, “enabled me to be more helpful.” Knowledge of cost ac- counting and the importance of controlling costs remains crucial to Samanta’s success. Both partners stress the importance of attending to variable manufacturing costs, overhead, and product contribution margins to stay afloat. With gross annual sales around $1 million, success is causing their company to evolve, but the partners adhere to a quality-first mentality. “It’s all in the design,” insists Samanta. “[A quality de- sign] allows for more comfort and support.” But quality also ex- tends to style and uniqueness. “Women don’t like other women

having their shoe,” explains Samanta. “We don’t want to dilute our brand by being too mass market.” Kelvin explains that the smallest manufacturing run they can have is 18 pairs of a special line. With small production runs, variable production costs drive decisions regarding product lines and product pricing. Accordingly, a variable costing system, with reports on variable costs, contribution mar- gins, and break-even points, is key. The partners also continue to apply managerial accounting fundamentals. “Our business cannot survive,” says Kelvin, “un- less it is profitable.” They regularly review the accounting results and assess contribution margins, although Kelvin adds, “money does not equal happiness.” Samanta explains, “Live your dreams . . . make a difference . . . give back to your community”— advice that we can all live by. “If you’re not enjoying it,” continues Samanta, “there’s no point to doing it.”

[Sources: Samanta Shoes Website, January 2013; Jet, August 2010; New York Resident, August 2004; Caribbean Vibe, August 2004; Black Enterprise, February 2012; Regine Magazine, Spring 2004; Inc.com, July 2007]

“Be your best, make a difference, and live with passion.” —SAMANTA AND KELVIN JOSEPH

Decision Insight

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Chapter Preview

Product-costing information is crucial for most business deci- sions. This chapter explains and illustrates the concept of vari- able costing. We then compare variable costing to that of absorption costing commonly used for financial reporting. We show that income is different when computed under variable or

absorption costing whenever the number of units produced is different from units sold. We also show how absorption costing can be misleading (though not wrong) and how variable costing can result in better production and pricing decisions.

Product costs consist of direct materials, direct labor, and overhead. Direct materials and direct labor costs are those that can be identified and traced to the product(s). Overhead, which consists of costs such as electricity, equipment depreciation, and supervisor salaries, is not trace- able to the product. Overhead costs must be allocated to products. There are a variety of costing methods for identifying and allocating overhead costs to prod- ucts. A prior chapter focused on how to allocate overhead costs to products. This chapter fo- cuses on what overhead costs are included in product costs. Under the traditional costing approach, all manufacturing costs are assigned to products. Those costs consist of direct materials, direct labor, variable overhead, and fixed overhead. This traditional approach is referred to as absorption costing (also called full costing), which as- sumes that products absorb all costs incurred to produce them. While widely used for external financial reporting (GAAP), this costing method can result in misleading product cost informa- tion for managers’ business decisions. Under variable costing, only costs that change in total with changes in production level are included in product costs. Those consist of direct materials, direct labor, and variable overhead. Fixed overhead does not change with changes in production and, thus, it is excluded from prod- uct costs. Instead, fixed overhead is treated as a period cost, meaning it is expensed in the period when it is incurred. The following diagram compares the absorption and variable costing methods. Under both methods, direct materials, direct labor, and variable overhead are included in product costs. The key difference between the methods lies in their treatment of fixed overhead costs—such costs are included in product costs under absorption costing but included in period expenses under variable costing. Recall that product costs are included in inventory until the goods are sold, at which time they are included in cost of goods sold. Period expenses are reported as expenses immediately in the period in which they are incurred.

INTRODUCING VARIABLE COSTING AND ABSORPTION COSTING

Performance Reporting (Income)

Implications

• When production equals sales • When production exceeds

sales • When production is less than

sales • Income reporting • Converting variable cost

income to absorption cost

Variable Costing and Absorption

Costing

• Absorption costing • Variable costing • Computing unit costs

Comparing Variable Costing and Absorption Costing

• Planning production • Setting prices • Controlling costs • Limitations of variable

costing • Variable costing for service

firms

Variable Costing and Performance Reporting

816

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Chapter 19 Variable Costing and Performance Reporting 817

The diagram above helps us understand when the absorption and variable costing methods will yield different income amounts over a period. In particular, differences in income resulting from the alternative methods will be small when:

● Fixed overhead is small as a percentage of total manufacturing costs. ● Inventory levels are low. As more companies adopt lean techniques, including just-in-time

manufacturing, inventory levels fall. Lower inventory levels reduce differences between absorption and variable costing.

● Inventory turnover is rapid. The more quickly inventory turns over, the more product costs are included in cost of goods sold, relative to the product costs that remain in inventory.

● Period of analysis is long. For example, different costing methods might yield very different income numbers over a quarter or year, but these differences will decrease as income is com- pared over longer periods.

Computing Unit Cost To illustrate the difference between absorption costing and variable costing, let’s consider the product cost data in Exhibit 19.1 from IceAge, a skate manufacturer.

P1 Compute unit cost under both absorption and variable costing.

Product Costs

Absorption Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead Period Expenses

Variable Costing

Product Costs

EXHIBIT 19.1 Summary Product Cost Data

Direct materials cost . . . . . . . . . . . . . . . . . . . . . $4 per unit

Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . 8 per unit

Overhead cost

Variable overhead cost . . . . . . . . . . . . . . . . . . $ 180,000

Fixed overhead cost . . . . . . . . . . . . . . . . . . . . 600,000

Total overhead cost . . . . . . . . . . . . . . . . . . . . . $ 780,000

Expected units produced . . . . . . . . . . . . . . . . . . 60,000 units

Drawing on the product cost data, Exhibit 19.2 shows the product unit cost computations for both absorption and variable costing. For absorption costing, the product unit cost is $25, which consists of $4 in direct materials, $8 in direct labor, $3 in variable overhead ($180,000/60,000 units), and $10 in fixed overhead ($600,000/60,000 units). For variable costing, the product unit cost is $15, which consists of $4 in direct materials, $8 in direct labor, and $3 in variable overhead. Fixed overhead costs of $600,000 are treated as a period cost and are recorded as expense in the period incurred. The difference between the two costing methods is the exclusion of fixed overhead from product costs for variable costing.

EXHIBIT 19.2 Unit Cost Computation

Absorption Costing Variable Costing

Direct materials cost per unit . . . . . . . . . . . . $ 4 $ 4

Direct labor cost per unit . . . . . . . . . . . . . . . 8 8

Overhead cost

Variable overhead cost per unit . . . . . . . . . 3 3

Fixed overhead cost per unit . . . . . . . 10 —

Total product cost per unit . . . . . . . . . . . . . . $25 $15

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818 Chapter 19 Variable Costing and Performance Reporting

1. Which of the following cost elements are included when computing unit cost under absorption costing? a. Direct materials b. Direct labor c. Variable overhead d. Fixed overhead

2. Which of the following cost elements are included when computing unit cost under variable costing? a. Direct materials b. Direct labor c. Variable overhead d. Fixed overhead

Quick Check Answers — p. 831

The prior section illustrated the differences between absorption costing and variable costing in computing unit cost. This section shows the implications of those differences for performance (income) reporting. To illustrate the reporting implications, we return to IceAge Company. Exhibit 19.3 sum- marizes the production cost data for IceAge as well as additional data on nonproduction costs. Assume that IceAge’s variable costs per unit are constant and that its annual fixed costs remain unchanged during the three-year period 2011 through 2013.

PERFORMANCE REPORTING (INCOME) IMPLICATIONS

EXHIBIT 19.3 Summary Cost Information for 2011–2013

Production Costs Nonproduction Costs

Direct materials cost . . $4 per unit Variable selling and administrative expenses . . $2 per unit

Direct labor cost . . . . . $8 per unit Fixed selling and administrative expenses . . . . $200,000 per year

Variable overhead cost . $3 per unit

Fixed overhead cost . . . $600,000 per year

Units Produced Units Sold Units in Ending Inventory

2011 . . . . . . . . 60,000 60,000 0

2012 . . . . . . . . 60,000 40,000 20,000

2013 . . . . . . . . 60,000 80,000 0

The reported sales and production information for IceAge follows. Its sales price was a constant $40 per unit over this time period. We see that the units produced equal those sold for 2011, exceed those sold for 2012, and are less than those sold for 2013.

Drawing on the information above, we next prepare the income statement for IceAge both under absorption costing and under variable costing. Our purpose is to highlight differences between these two costing methods under three different cases: when units produced are equal to, ex- ceed, or are less than units sold.

Units Produced Equal Units Sold Exhibit 19.4 presents the 2011 income statement for both costing methods (2012 and 2013 statements will follow). The income statement under variable costing (on the right) is referred to as the contribution margin income statement. Contribution margin is the excess of sales over variable costs. This margin contributes to covering all fixed costs and earning income. Under

P2 Prepare and analyze an income statement using absorption costing and using variable costing.

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Chapter 19 Variable Costing and Performance Reporting 819

Point: Contribution margin income statements prepared under variable costing are useful in performing cost- volume-profit analyses.

EXHIBIT 19.4 Income for 2011—Quantity Produced Equals Quantity Sold*

ICEAGE COMPANY Income Statement (Variable Costing)

For Year Ended December 31, 2011

Sales† (60,000 3 $40) . . . . . . . $2,400,000

Variable expenses

Variable production costs (60,000 3 $15*) . . . . . . . . $900,000

Variable selling and administrative expenses (60,000 3 $2). . . . 120,000 1,020,000

Contribution margin . . . . . . . . . 1,380,000

Fixed expenses

Fixed overhead . . . . . . . . . . . 600,000

Fixed selling and administrative expense . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2011

Sales† (60,000 3 $40) . . . . . . . . . . . . . . . $2,400,000

Cost of goods sold (60,000 3 $25*) . . . . 1,500,000

Gross margin . . . . . . . . . . . . . . . . . . . . . 900,000

Selling and administrative expenses [$200,000 1 (60,000 3 $2)] . . . . . . . 320,000

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 580,000

* See Exhibit 19.2 for unit cost computation under absorption and under variable costing.

† Units produced equal 60,000; units sold equal 60,000.

T A performance report that excludes fixed expenses and net income is a contribution margin report. Its bottom line is contribution margin.

EXHIBIT 19.5 Production Cost Assignment for 2011

Exhibit 19.4 reveals that reported income is iden tical under absorption costing and variable costing when the number of units produced equals number of the units sold.

Contribution Margin Report A performance report that excludes fixed expenses and net income is known as a contribution margin report. Looking at the variable costing income statement in Exhibit 19.4, a contribution margin report would end with the contribution margin of $1,380,000. However, a contribution margin income statement includes fixed expenses and net income as shown in Exhibit 19.4. Exhibit 19.5 reorganizes the information from Exhibit 19.4 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quan- tity produced equals quantity sold there is no difference in total costs assigned. Yet, there is a difference in what categories receive those costs. Absorption costing assigns $1,500,000 to cost of goods sold compared to $900,000 for variable costing. The $600,000 difference is a period cost for variable costing.

Point: Contribution margin (Sales 2 Variable expenses) is different from gross margin (Sales 2 Cost of sales).

P3 Prepare a contribution margin report.

variable costing, the expenses are grouped according to cost behavior—variable or fixed, and production or nonproduction. Under the traditional format of absorption costing, expenses are grouped according to function.

Cost of Goods Sold Ending Inventory Period Cost 2011 (Expense) (Asset) (Expense) Expense

Absorption Costing

Direct materials . . . . . 60,000 3 $4 $ 240,000 0 3 $4 $ 0 $ 240,000

Direct labor. . . . . . . . . 60,000 3 $8 480,000 0 3 $8 0 480,000

Variable overhead . . . . 60,000 3 $3 180,000 0 3 $3 0 180,000

Fixed overhead . . . . . . 60,000 3 $10 600,000 0 3 $10 0 600,000

Total costs . . . . . . . . . . $1,500,000 $ 0 $1,500,000

Variable Costing

Direct materials . . . . . 60,000 3 $4 $ 240,000 0 3 $4 $ 0 $ 240,000

Direct labor . . . . . . . . 60,000 3 $8 480,000 0 3 $8 0 480,000

Variable overhead . . . . 60,000 3 $3 180,000 0 3 $3 0 180,000

Fixed overhead . . . . . . $600,000 600,000

Total costs . . . . . . . . . . $ 900,000 $ 0 $600,000 $1,500,000

Cost difference . . . . $ 0

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820 Chapter 19 Variable Costing and Performance Reporting

Units Produced Exceed Units Sold Exhibit 19.6 shows absorption costing and variable costing income statements for 2012. In 2012, 60,000 units were produced, which is the same as in 2011. However, only 40,000 units were sold, which means 20,000 units remain in ending inventory. The income statements reveal that for 2012, income is $320,000 under absorption costing. Under variable costing, income is $120,000, which is $200,000 less than under absorption cost- ing. The cause of this $200,000 difference rests with the different treatment of fixed overhead under the two costing methods.

EXHIBIT 19.6 Income for 2012—Quantity Produced Exceeds Quantity Sold*

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2012

Sales† (40,000 3 $40) . . . . . . . . . . . . . . . $1,600,000

Cost of goods sold (40,000 3 $25*) . . . 1,000,000

Gross margin . . . . . . . . . . . . . . . . . . . . . 600,000

Selling and administrative expenses [$200,000 1 (40,000 3 $2)] . . . . . . . 280,000

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 320,000

* See Exhibit 19.2 for unit cost computation under absorption and under variable costing.

† Units produced equal 60,000; units sold equal 40,000.

ICEAGE COMPANY Income Statement (Variable Costing)

For Year Ended December 31, 2012

Sales† (40,000 3 $40) . . . . . . . $1,600,000

Variable expenses

Variable production costs (40,000 3 $15*) . . . . . . . $600,000

Variable selling and administrative expenses (40,000 3 $2). . 80,000 680,000

Contribution margin . . . . . . . . 920,000

Fixed expenses

Fixed overhead . . . . . . . . . . 600,000

Fixed selling and administrative expense . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . $ 120,000

Under variable costing, the entire $600,000 fixed overhead cost is treated as an expense in com- puting 2012 income. Under absorption costing, the fixed overhead cost is allocated to each unit of product at the rate of $10 per unit (from Exhibit 19.2). When production exceeds sales by 20,000 units (60,000 versus 40,000), the $200,000 ($10 3 20,000 units) of fixed overhead cost allocated to these 20,000 units is carried as part of the cost of ending inventory (see Exhibit 19.7). This means that $200,000 of fixed overhead cost incurred in 2012 is not expensed until future periods when it is reported in cost of goods sold as those products are sold. Consequently, income for 2012 under absorption costing is $200,000 higher than income under variable costing. Even though sales (of 40,000 units) and the number of units produced (totaling 60,000) are the same under both costing methods, net income differs greatly due to the treatment of fixed overhead. Exhibit 19.7 reorganizes the information from Exhibit 19.6 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quantity produced exceeds quantity sold there is a difference in total costs assigned. As a result, income under absorption costing is greater than under variable costing because of the greater fixed over- head cost allocated to ending inventory (asset) under absorption costing. Those cost differences extend to cost of goods sold, ending inventory, and period costs.

Manufacturing Margin Some managers compute manufacturing margin (also called production margin), which is sales less variable pro- duction costs. Some managers also require that internal income state- ments show this amount to highlight variable product costs on income. The contribution margin section of IceAge’s variable costing income statement would appear as follows (compare this to Exhibit 19.4).

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400,000 Variable production costs . . . . . . . . . . 900,000 Manufacturing margin . . . . . . . . . . . . . 1,500,000 Variable selling & admin. exp. . . . . . . . . . 120,000

Contribution margin . . . . . . . . . . . . . . $1,380,000 ■

Decision Insight

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Chapter 19 Variable Costing and Performance Reporting 821

Cost of Goods Sold Ending Inventory Period Cost 2012 (Expense) (Asset) (Expense) Expense

Absorption Costing

Direct materials . . . . 40,000 3 $4 $ 160,000 20,000 3 $4 $ 80,000 $ 160,000

Direct labor . . . . . . . 40,000 3 $8 320,000 20,000 3 $8 160,000 320,000

Variable overhead . . 40,000 3 $3 120,000 20,000 3 $3 60,000 120,000

Fixed overhead. . . . . 40,000 3 $10 400,000 20,000 3 $10 200,000 400,000

Total costs . . . . . . . . $1,000,000 $500,000 $1,000,000

Variable Costing

Direct materials . . . . 40,000 3 $4 $ 160,000 20,000 3 $4 $ 80,000 $ 160,000

Direct labor . . . . . . . 40,000 3 $8 320,000 20,000 3 $8 160,000 320,000

Variable overhead . . 40,000 3 $3 120,000 20,000 3 $3 60,000 120,000

Fixed overhead. . . . . $600,000 600,000

Total costs . . . . . . . . $ 600,000 $300,000 $600,000 $1,200,000

Cost difference . . . $ (200,000)

EXHIBIT 19.7 Production Cost Assignment for 2012

Units Produced Are Less Than Units Sold Exhibit 19.8 shows absorption costing and variable costing income statements for 2013. In 2013, IceAge produced 20,000 fewer units than it sold. Production equaled 60,000 units, but units sold were 80,000. This means IceAge sold all that it produced during the period, and it sold all of its beginning finished goods inventory. IceAge’s income statements reveal that in- come is $840,000 under absorption costing, but it is $1,040,000 under variable costing. The cause of this $200,000 difference lies with the treatment of fixed overhead. Beginning inventory in 2013 under absorption costing included $200,000 of fixed overhead cost incurred in 2012, which is assigned to cost of goods sold in 2013 under absorption costing.

Point: IceAge can sell more units than it produced in 2013 because of inventory carried over from 2012.

Exhibit 19.9 reorganizes the information from Exhibit 19.8 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quantity produced is less than quantity sold there is a difference in total costs assigned. Specifically, ending inventory in 2012 under absorption costing was $500,000 (20,000 units 3 $25) whereas it was only $300,000 (20,000 units 3 $15) under variable costing—see Exhibit 19.7. Consequently, when that inventory is sold in 2013, the 2013 income under absorption cost- ing is $200,000 less than the income under variable costing. That inventory cost difference flows through cost of goods sold and then to income.

EXHIBIT 19.8 Income for 2013—Quantity Produced Is Less Than Quantity Sold*

ICEAGE COMPANY Income Statement (Variable Costing)

For Year Ended December 31, 2013

Sales† (80,000 3 $40) . . . . . $3,200,000

Variable expenses

Variable production costs (80,000 3 $15*) . . . . . $1,200,000

Variable selling and administrative expenses (80,000 3 $2) . . . . . . . 160,000 1,360,000

Contribution margin . . . . . . 1,840,000

Fixed expenses

Fixed overhead . . . . . . . . 600,000

Fixed selling and admin- istrative expense . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . $1,040,000

* See Exhibit 19.2 for unit cost computation under absorption and under variable costing.

† Units produced equal 60,000; units sold equal 80,000.

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2013

Sales† (80,000 3 $40) . . . . . . . . . . . . . . . $3,200,000

Cost of goods sold (80,000 3 $25*). . . 2,000,000

Gross margin . . . . . . . . . . . . . . . . . . . . . 1,200,000

Selling and administrative expenses [$200,000 1 (80,000 3 $2)] . . . . . . . 360,000

Net income . . . . . . . . . . . . . . . . . . . . . . . $ 840,000

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822 Chapter 19 Variable Costing and Performance Reporting

Summarizing Income Reporting Income reported under both variable costing and absorption costing for the years 2011 through 2013 for IceAge is summarized in Exhibit 19.10. We see that the differences in income are due to timing, as total income is $1,740,000 for this time period for both methods. Further, income under absorption costing and that under variable costing will be different whenever the quantity produced and the quantity sold are different. Specifically, income under absorption costing is higher when more units are produced relative to units sold and is lower when fewer units are produced than are sold.

EXHIBIT 19.10 Summary of Income Reporting

Units Units Income under Income under Produced Sold Absorption Costing Variable Costing Differences

2011 . . . . . . . . . 60,000 60,000 $ 580,000 $ 580,000 $ 0

2012 . . . . . . . . . 60,000 40,000 320,000 120,000 200,000

2013 . . . . . . . . . 60,000 80,000 840,000 1,040,000 (200,000)

Totals . . . . . . . . 180,000 180,000 $1,740,000 $1,740,000 $ 0

Cost of Goods Sold Ending Inventory Period Cost 2013 (Expense) (Asset) (Expense) Expense

Absorption Costing

Direct materials . . . . . 80,000 3 $4 $ 320,000 0 3 $4 $ 0 $ 320,000

Direct labor . . . . . . . . 80,000 3 $8 640,000 0 3 $8 0 640,000

Variable overhead . . . 80,000 3 $3 240,000 0 3 $3 0 240,000

Fixed overhead . . . . . 80,000 3 $10 800,000 0 3 $10 0 800,000

Total costs . . . . . . . . . $2,000,000 $ 0 $2,000,000

Variable Costing

Direct materials . . . . . 80,000 3 $4 $ 320,000 0 3 $4 $ 0 $ 320,000

Direct labor . . . . . . . . 80,000 3 $8 640,000 0 3 $8 0 640,000

Variable overhead . . . 80,000 3 $3 240,000 0 3 $3 0 240,000

Fixed overhead . . . . . $600,000 600,000

Total costs . . . . . . . . . $1,200,000 $ 0 $600,000 $1,800,000

Cost difference . . . $ 200,000

EXHIBIT 19.9 Production Cost Assignment for 2013

Our illustration using IceAge had the total number of units produced over 2011–2013 exactly equal to the number of units sold over that period. This meant that the difference between ab- sorption costing income and variable costing income for the total three-year period is zero. In reality, it is unusual for production and sales quantities to exactly equal each other over such a short period of time. This means that we normally continue to see differences in income for these two methods extending over several years.

3. Which of the following statements is true when units produced exceed units sold? a. Variable costing income exceeds absorption costing income. b. Variable costing income equals absorption costing income. c. Variable costing income is less than absorption costing income.

4. Which of the following statements is true when units produced are less than units sold? a. Variable costing income exceeds absorption costing income. b. Variable costing income equals absorption costing income. c. Variable costing income is less than absorption costing income.

Quick Check Answers — p. 831

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Chapter 19 Variable Costing and Performance Reporting 823

Converting Income under Variable Costing to Absorption Costing Companies commonly use variable costing for internal reporting and business decisions, and use absorption costing for external reporting and tax reporting. For companies concerned about the cost of maintaining two costing systems, it is comforting to know that we can readily con- vert reports under variable costing to that using absorption costing. Income under variable costing is restated to that under absorption costing by adding the fixed production cost in ending inventory and subtracting the fixed production cost in beginning inventory, as follows.

P4 Convert income under variable costing to the absorption cost basis.

Income under 5

Income under 1

Fixed production cost 2

Fixed production cost absorption costing variable costing in ending inventory in beginning inventory

Using IceAge’s data, in 2012, absorption costing income was $200,000 higher than variable costing income. The $200,000 difference was because the fixed overhead cost incurred in 2012 was allocated to the 20,000 units of ending inventory under absorption costing (and not ex- pensed in 2012 under absorption costing). On the other hand, the $200,000 fixed overhead costs (along with all other fixed costs) were expensed in 2012 under variable costing. Exhibit 19.11 shows the computations for restating income under the two costing methods. To restate variable costing income to absorption costing income for 2012, we must add back the fixed overhead cost deferred in (ending) inventory. Similarly, to restate variable costing in- come to absorption costing income for 2013, we must deduct the fixed overhead cost recog- nized from (beginning) inventory, which was incurred in 2012, but expensed in the 2013 cost of goods sold when the inventory was sold.

EXHIBIT 19.11 Converting Variable Costing Income to Absorption Costing Income

2011 2012 2013

Variable costing income (Exhibit 19.10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $580,000 $120,000 $1,040,000

Add: Fixed overhead cost deferred in ending inventory (20,000 3 $10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 200,000 0

Less: Fixed overhead cost recognized from beginning inventory (20,000 3 $10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 (200,000)

Absorption costing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $580,000 $320,000 $ 840,000

This section discusses how absorption costing can lead to undesirable production and pricing decisions and how variable costing can result in better business decisions.

Planning Production Production planning is an important managerial function. Producing too much leads to excess inven- tory, which in turn leads to higher storage and financing costs, and to greater risk of product obsoles- cence. On the other hand, producing too little can lead to lost sales and customer dissatisfaction. Production levels should be based on reliable sales forecasts. However, overproduction and inventory buildup can occur because of how managers are evaluated and rewarded. For instance, many companies link manager bonuses to income computed under absorption costing because this is how income is reported to shareholders (per GAAP). To illustrate how a reward system can lead to overproduction under absorption costing, let’s use IceAge’s 2011 data with one change: assume that its manager decides to produce 100,000 units instead of 60,000. Since only 60,000 units are sold, the 40,000 units of excess production will be stored in ending finished goods inventory. The left side of Exhibit 19.12 shows the unit cost when 60,000 units are produced (same as Exhibit 19.2). The right side shows unit cost when 100,000 units are produced. The ex- hibit is prepared under absorption costing for 2011.

COMPARING VARIABLE COSTING AND ABSORPTION COSTING

C1 Describe how absorption costing can result in overproduction.

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824 Chapter 19 Variable Costing and Performance Reporting

EXHIBIT 19.12 Unit Cost under Absorption Costing for Different Production Levels

Total production cost per unit is $4 less when 100,000 units are produced. Specifically, cost per unit is $21 when 100,000 units are produced versus $25 per unit at 60,000 units. The reason for this difference is because the company is spreading the $600,000 fixed overhead cost over more units when 100,000 units are produced than when 60,000 are produced. The difference in cost per unit impacts performance reporting. Exhibit 19.13 presents the 2011 income statement under absorption costing for the two alternative production levels.

Common sense suggests that because the company’s variable cost per unit, total fixed costs, and sales are identical in both cases, merely producing more units and creating excess ending inventory should not increase income. Yet, as we see in Exhibit 19.13, income under absorption costing is 41% greater if management produces 40,000 more units than necessary and builds up ending inventory. The reason is that $240,000 of fixed overhead (40,000 units 3 $6) is assigned to ending inventory instead of being expensed as cost of goods sold in 2011. This shows that under absorption costing, a manager can report increased income merely by producing more and disregarding whether the excess units can be sold or not. Manager bonuses are tied to income computed under absorption costing for many compa- nies. Accordingly, these managers may be enticed to increase production that increases income and their bonuses. This incentive problem encourages inventory buildup, which leads to in- creased costs in storage, financing, and obsolescence. If the excess inventory is never sold, it will be disposed of at a loss. The manager incentive problem can be avoided when income is measured using variable costing. To illustrate, Exhibit 19.14 reports income under variable costing for the same pro- duction levels used in Exhibit 19.13. This demonstrates that managers cannot increase income under variable costing by merely increasing production without increasing sales.

Why is income under absorption costing affected by the production level when that for variable costing is not? The answer lies in the different treatment of fixed overhead costs for the two methods. Under absorption costing, fixed overhead per unit is lower when 100,000 units are pro- duced than when 60,000 units are produced, and then fixed overhead cost is allocated to more units—recall Exhibit 19.12. If those excess units produced are not sold, the fixed overhead cost allocated to those units is not expensed until a future period when those units are sold.

Point: The 41% income increase is computed as:

$820,000 2 $580,000

$580,000 5 0.41

EXHIBIT 19.13 Income under Absorption Costing for Different Production Levels

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2011 [60,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . . . . . . . . . . . . . . . $2,400,000

Cost of goods sold (60,000 3 $25) . . . . . . 1,500,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . 900,000

Selling and administrative expenses

Variable (60,000 3 $2) . . . . $120,000

Fixed . . . . . . . . . . . . . . . . . 200,000 320,000

Net income . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2011 [100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . . . . . . . . . . . . . . . $2,400,000

Cost of goods sold (60,000 3 $21) . . . . . 1,260,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . 1,140,000

Selling and administrative expenses

Variable (60,000 3 $2). . . $120,000

Fixed . . . . . . . . . . . . . . . . 200,000 320,000

Net income . . . . . . . . . . . . $ 820,000

Absorption Costing Absorption Costing When 60,000 Units Are Produced When 100,000 Units Are Produced

Direct materials cost . . . . . . . . . . . . $ 4 per unit Direct materials cost . . . . . . . . . . . . . . $ 4 per unit

Direct labor cost . . . . . . . . . . . . . . . . 8 per unit Direct labor cost . . . . . . . . . . . . . . . . . 8 per unit

Variable overhead cost . . . . . . . . . . . 3 per unit Variable overhead cost . . . . . . . . . . . . . 3 per unit

Total variable cost . . . . . . . . . . . . . . . 15 per unit Total variable cost . . . . . . . . . . . . . . . . 15 per unit

Fixed overhead Fixed overhead ($600,000/60,000 units) . . . . . . . . 10 per unit ($600,000/100,000 units) . . . . . . . . . 6 per unit

Total product cost . . . . . . . . . . . . . . . $25 per unit Total product cost . . . . . . . . . . . . . . . . $21 per unit

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Chapter 19 Variable Costing and Performance Reporting 825

EXHIBIT 19.14 Income under Variable Costing for Different Production Levels

ICEAGE COMPANY Income Statement (Variable Costing)

For Year Ended December 31, 2011 [60,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . . . . . . . . $2,400,000

Variable expenses

Variable production costs (60,000 3 $15) . . . . . . . . . . $900,000

Variable selling and administrative expenses (60,000 3 $2) . . . . . . . . . . . 120,000 1,020,000

Contribution margin . . . . . . . . . . 1,380,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . 600,000

Fixed selling and administrative expense . . . . . . . . . . . . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Variable Costing)

For Year Ended December 31, 2011 [100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . $2,400,000

Variable expenses

Variable production costs (60,000 3 $15) . . . $900,000

Variable selling and administrative expenses (60,000 3 $2) . . . . 120,000 1,020,000

Contribution margin . . . 1,380,000

Fixed expenses

Fixed overhead . . . . . 600,000

Fixed selling and administrative expense . . . . . . . . . 200,000 800,000

Net income . . . . . . . . . . $ 580,000

Reported income under variable costing, on the other hand, is not affected by production level changes because all fixed production costs are expensed in the year when incurred. Under variable costing, companies increase reported income by selling more units—it is not possible to increase income just by producing more units and creating excess inventory.

Point: A per unit cost that is constant at all production levels is a variable cost per unit.

Setting Prices Setting prices for products and services is one of the more complex and important managerial decisions. Although many factors impact pricing, cost is a crucial factor. Cost information from both absorption costing and variable costing can aid managers in pricing. Over the long run, price must be high enough to cover all costs, including variable costs and fixed costs, and still provide an acceptable return to owners. For this purpose, absorption cost information is useful because it reflects the full costs that sales must exceed for the company to be profitable. Over the short run, however, fixed production costs such as the cost to maintain plant capac- ity do not change with changes in production levels. With excess capacity, increases in produc- tion level would increase variable production costs, but not fixed costs. This implies that while managers try to maintain the long-run price on existing orders, which covers all production costs, managers should accept special orders provided the special order price exceeds vari- able cost. To illustrate, let’s return to the data of IceAge Company. Recall that its variable production cost per unit is $15 and its total production cost per unit is $25 (at production level of 60,000 units). Assume that it receives a special order for 1,000 pairs of skates at an offer price of $22 per pair from a foreign skating school. This special order will not affect IceAge’s regular sales and its plant has excess capacity to fill the order. Drawing on absorption costing information, we observe that cost is $25 per unit and that the special order price is $22 per unit. These data would suggest that management reject the order as it would lose $3,000, computed as 1,000 units at $3 loss per pair ($22 2 $25).

C2 Explain the role of variable costing in pricing special orders.

Production Manager Your company produces and sells MP3 players. Due to competition, your company projects sales to be 35% less than last year. In a recent meeting, the CEO expressed concern that top execu- tives may not receive bonuses because of the expected sales decrease. The controller suggests that if the company continues to produce as many units as last year, reported income might achieve the level for bo- nuses to be paid. Should your company produce excess inventory to maintain income? What ethical issues arise? ■ [Answer—p. 831]

Decision Ethics

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826 Chapter 19 Variable Costing and Performance Reporting

However, closer analysis suggests that this order should be accepted. This is because the $22 order price exceeds the $15 variable cost of the product. Specifically, Exhibit 19.15 reveals that the incremental revenue from accepting the order is $22,000 (1,000 units at $22 per unit), whereas the incremental production cost of the order is $15,000 (1,000 units at $15 per unit) and the incremental variable selling and administrative cost is $2,000 (1,000 units at $2 per unit). Thus, both its contribution margin and net income would increase by $5,000 from accepting the order. Variable costing reveals this profitable opportunity while absorption costing hides it.

EXHIBIT 19.15 Computing Incremental Income for a Special Order

Rejecting Special Order Accepting Special Order

Incremental sales . . . . . . . . . $ 0 Incremental sales (1,000 3 $22) . . . . . . . . . . . . . . . . . . . . . . $22,000

Incremental costs . . . . . . . . 0 Incremental costs

Variable production cost (1,000 3 $15) . . . . . . . . . . . . . . 15,000

Variable selling and admin. expense (1,000 3 $2) . . . . . . . 2,000

Incremental income . . . . . . $ 0 Incremental income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Point: Use of relevant costs in special order and other managerial decisions is covered more extensively in a later chapter.

The reason for increased income from accepting the special order lies in the different behavior of variable and fixed production costs. We see that if the order is rejected, only variable costs are saved. Fixed costs, on the other hand, do not change in the short run regardless of rejecting or accepting this order. Since incremental revenue from the order exceeds incremental costs (only variable cost in this case), accepting the special order increases company income.

Controlling Costs Every company strives to control costs to be competitive. An effective cost control practice is to hold managers responsible only for their controllable costs. A cost is controllable if a manager has the power to determine or at least markedly affect the amount incurred. Uncontrollable costs are not within the manager’s control or influence. For example, direct materials cost is controllable by a production supervisor. On the other hand, costs related to production capacity are not controllable by that supervisor as that supervisor does not have authority to change fac- tory size or add new machinery. Generally, variable production costs and fixed production costs are controlled at different levels of management. Similarly, variable selling and administrative costs are usually controlled at a level of management different from that which controls fixed selling and administrative costs. Under absorption costing, both variable production costs and fixed production costs are in- cluded in product cost. This makes it difficult to evaluate the effectiveness of cost control by different levels of managers. Variable costing separates the variable costs from fixed costs and, therefore, makes it easier to identify and assign control over costs. Decisions to change a company’s fixed costs are usually assigned to higher-level managers. This is different from most variable costs that are assigned to lower-level managers and supervisors. When we separately report variable and fixed cost elements, as is done with an income statement in the contribution format, it highlights the impact of each cost element for income. This makes it easier for us to identify problem areas and to take cost control mea- sures by appropriate levels of management. This approach is also useful in evaluating the performance of managers of different segments within a company.

Point: Fixed overhead costs won’t in- crease when these additional units are sold because the company already has the capacity.

Internal Auditor Your company uses absorption costing for preparing its GAAP-based income statement and balance sheet. Management is disappointed because its external auditors are requiring it to write off an inventory amount because it exceeds what the company could reasonably sell in the foreseeable future. Why would management produce more than it sells? Why would management be disappointed about the write-off? ■ [Answer—p. 831]

Decision Maker

Limitations of Reports Using Variable Costing An important generally accepted accounting principle is that of matching. Most managers inter- pret the matching principle as expensing all manufacturing costs, both variable and fixed, in the

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Chapter 19 Variable Costing and Performance Reporting 827

period when the related product is sold rather than when costs are incurred. Thus, and despite the many useful applications and insights provided by variable cost reports, absorption costing is the only acceptable basis for external reporting under both U.S. GAAP and IFRS. Also, as we discussed, top executives are often awarded bonuses based on income computed using absorp- tion costing. For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of 1986. These realities con- tribute to the widespread use of absorption costing by companies.

Variable Costing for Service Firms Although most of this chapter’s examples used data for a manufacturer, variable costing also applies to service companies. Since service companies do not produce inventory, the differences in income from absorption and variable costing shown for a manufacturer do not apply. Still, a focus on variable costs can be useful in managerial decisions for service firms. One example is “special order” pricing for airlines when they sell tickets a day or so before a flight at deeply discounted prices. Provided the discounted price exceeds variable costs, such sales increase contribution margin and net income.

5. Why is information under variable costing useful in making short-run pricing decisions when idle capacity exits?

6. Discuss the usefulness of absorption costing versus variable costing in controlling costs. 7. What are the limitations of variable costing?

Quick Check Answers — p. 831

Break-Even Analysis Decision Analysis

The previous chapter discussed cost-volume-profit (CVP) analysis for making managerial decisions. However, if the income statement is prepared under absorption costing, the data needed for CVP analysis are not readily available. Accordingly, substantial effort is required to go back to the account- ing records and reclassify the cost data to obtain information necessary for conducting CVP analysis. On the other hand, if the income statement is prepared using the contribution format, the data needed for CVP analysis are readily available. To illustrate, we can draw on IceAge’s contribution margin income statement from Exhibit 19.4 (reproduced below) to readily compute its contribution margin per unit and its break-even volume in units.

A1 Compute and interpret break-even volume in units.

U.S. multinational companies must change their business processes when moving their operations to international locations. These changes can impact the company’s cost structure. For example, both McDonald’s and Yum Brands offer delivery services in major inter- national cities like Beijing (China) and Seoul (South Korea). Cities like these are heavily populated and real estate costs are high. These factors discourage the building of drive-through facilities, which would in- crease fixed overhead costs. Fixed overhead costs also fall as these companies process more orders over the Internet and thus build fewer call centers. As fixed overhead costs decrease, the difference in net in- come that would result from applying variable costing versus absorp- tion costing also decreases.

Source: “Asia Delivers for McDonald’s,” The Wall Street Journal, December 13, 2011.

GLOBAL VIEW

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828 Chapter 19 Variable Costing and Performance Reporting

We compute and report the company’s contribution margin per unit and its components in the far right columns of the exhibit above. Recall that contribution margin per unit is defined as follows.

Contribution margin per unit 5 Sales price per unit 2 Variable cost per unit

5 $40 2 $17 5 $23

The above report shows that its variable cost per unit consists of $15 in variable production costs and $2 in variable selling and administrative costs. We also see that the company’s total fixed costs of $800,000 is the sum of $600,000 in fixed overhead cost and $200,000 in fixed selling and administrative cost. From this information we can compute the company’s break-even volume in units as follows.

Break-even volume in units 5 Total fixed costs

Contribution margin per unit 5

$800,000

$23 5 34,783 units (rounded)

This finding implies that the company must produce and sell 34,783 units to break even (zero in- come). Sales less than that amount would yield a net loss and sales above that amount would yield net income.

ICEAGE COMPANY Income Statement (Variable Costing)

For Year Ended December 31, 2011 Dollars Per Unit

Sales (60,000 3 $40) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400,000 $40

Variable expenses

Variable production costs (60,000 3 $15) . . . . . . . . . . . . . . . . . . . $900,000 $15

Variable selling and administrative expenses (60,000 3 $2) . . . . . . . . 120,000 1,020,000 2 17

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,380,000 $23

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Fixed selling and administrative expense . . . . . . . . . . . . . . . . . . . . 200,000 800,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 580,000

Navaroli Company began operations on January 5, 2012. Cost and sales information for its first two calendar years of operations are summarized below.

DEMONSTRATION PROBLEM

Manufacturing costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . $80 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120 per unit

Factory overhead costs for the year

Variable overhead . . . . . . . . . . . . . . . . . . . . . . $30 per unit

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . $14,000,000

Nonmanufacturing costs

Variable selling and administrative . . . . . . . . . . . $10 per unit

Fixed selling and administrative . . . . . . . . . . . . . $ 8,000,000

Production and sales data

Units produced, 2012 . . . . . . . . . . . . . . . . . . . . . 200,000 units

Units sold, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 units

Units in ending inventory, 2012 . . . . . . . . . . . . . 60,000 units

Units produced, 2013 . . . . . . . . . . . . . . . . . . . . . 80,000 units

Units sold, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 units

Units in ending inventory, 2013 . . . . . . . . . . . . . 0 units

Sales price per unit . . . . . . . . . . . . . . . . . . . . . . $600 per unit

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Chapter 19 Variable Costing and Performance Reporting 829

Required

1. Prepare an income statement for the company for 2012 under absorption costing. 2. Prepare an income statement for the company for 2012 under variable costing. 3. Explain the source(s) of the difference in reported income for 2012 under the two costing methods. 4. Prepare an income statement for the company for 2013 under absorption costing. 5. Prepare an income statement for the company for 2013 under variable costing. 6. Prepare a schedule to convert variable costing income to absorption costing income for the years 2012

and 2013. Use the format in Exhibit 19.11.

PLANNING THE SOLUTION ● Set up a table to compute the unit cost under the two costing methods (refer to Exhibit 19.2). ● Prepare an income statement under both of the two costing methods (refer to Exhibit 19.6). ● Consider differences in the treatment of fixed production costs for the income statement to answer

requirements 3 and 6.

SOLUTION TO DEMONSTRATION PROBLEM Before the income statement for 2012 is prepared, unit costs for 2012 are computed under the two costing methods as follows.

Absorption Costing Variable Costing

Direct materials per unit . . . . . . . . . . . . . . $ 80 $ 80

Direct labor per unit . . . . . . . . . . . . . . . . . 120 120

Overhead per unit

Variable overhead per unit . . . . . . . . . . 30 30

Fixed overhead per unit* . . . . . . . . . . . 70 —

Total production cost per unit . . . . . . . . . $300 $230

* Fixed overhead per unit 5 $14,000,000 4 200,000 units 5 $70 per unit.

1. Absorption costing income statement for 2012.

NAVAROLI COMPANY Income Statement

For Year Ended December 31, 2012

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000

Cost of goods sold (140,000 3 $300) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000,000

Selling and administrative expenses ($1,400,000 1 $8,000,000) . . . . . . . . . 9,400,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,600,000

2. Variable costing income statement for 2012.

NAVAROLI COMPANY Income Statement (Contribution Format)

For Year Ended December 31, 2012

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000

Variable expenses

Variable production costs (140,000 3 $230) . . . . . . . . . $32,200,000

Variable selling and administrative costs . . . . . . . . . . . . . 1,400,000 33,600,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,400,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000,000

Fixed selling and administrative . . . . . . . . . . . . . . . . . . . 8,000,000 22,000,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000

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830 Chapter 19 Variable Costing and Performance Reporting

3. Income under absorption costing is $4,200,000 more than that under variable costing even though sales are identical for each. This difference is due to the different treatment of fixed overhead cost. Under variable costing, the entire $14,000,000 of fixed overhead is expensed on the 2012 income statement. However, un- der absorption costing, $70 of fixed overhead cost is allocated to each of the 200,000 units produced. Since there were 60,000 units unsold at year-end, $4,200,000 (60,000 units 3 $70 per unit) of fixed overhead cost allocated to these units will be carried on its balance sheet in ending inventory. Consequently, reported income under absorption costing is $4,200,000 higher than variable costing income for the current period.

Before the income statement for 2013 is prepared, unit costs are computed under the two costing methods as follows.

* Fixed overhead per unit 5 $14,000,000y80,000 units 5 $175 per unit.

Absorption Costing Variable Costing

Direct materials per unit . . . . . . . . . . . . . . $ 80 $ 80

Direct labor per unit . . . . . . . . . . . . . . . . . 120 120

Overhead per unit

Variable overhead per unit . . . . . . . . . . 30 30

Fixed overhead per unit* . . . . . . . . . . . 175

Total production cost per unit . . . . . . . . . $405 $230

4. Absorption costing income statement for 2013.

NAVAROLI COMPANY Income Statement

For Year Ended December 31, 2013

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000

Cost of goods sold

From beginning inventory (60,000 3 $300) . . . . . . . . . . . . . . . . . . . . . . . $18,000,000

Produced during the year (80,000 3 $405) . . . . . . . . . . . . . . . . . . . . . . . 32,400,000 50,400,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,600,000

Selling and administrative expenses ($1,400,000 1 $8,000,000) . . . . . . . . . 9,400,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,200,000

5. Variable costing income statement for 2013.

NAVAROLI COMPANY Income Statement (Contribution Format)

For Year Ended December 31, 2013

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000

Variable expenses

Variable production costs (140,000 3 $230) . . . . . . . . . $32,200,000

Variable selling and administrative costs . . . . . . . . . . . . . 1,400,000 33,600,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,400,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000,000

Fixed selling and administrative . . . . . . . . . . . . . . . . . . . 8,000,000 22,000,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000

6. Conversion of variable costing income to absorption costing income.

2012 2013

Variable costing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000 $28,400,000

Add: Fixed overhead cost deferred in ending inventory (60,000 3 $70) . . . . . . . . . . . . . . 4,200,000 0

Less: Fixed overhead cost recognized from beginning inventory (60,000 3 $70) . . . . . . . . . 0 (4,200,000)

Absorption costing income . . . . . . . . . . . . . . . . . . . . . . . . . $32,600,000 $24,200,000

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Chapter 19 Variable Costing and Performance Reporting 831

C1 Describe how absorption costing can result in over- production. Under absorption costing, fixed overhead costs are allocated to all units including both units sold and units in ending in- ventory. Consequently, expenses associated with the fixed overhead allocated to ending inventory are deferred to a future period. As a re- sult, the larger ending inventory is, the more overhead cost is de- ferred to the future, and the greater current period income is.

C2 Explain the role of variable costing in pricing special orders. Over the short run, fixed production costs such as cost of maintaining plant capacity do not change with changes in produc- tion levels. When there is excess capacity, increases in production levels would only increase variable costs. Thus, managers should accept special orders as long as the order price is greater than the variable cost. This is because accepting the special order would in- crease only variable costs.

A1 Compute and interpret break-even volume in units. Break-even volume in units is defined as total fixed costs divided by contribution margin per unit. The result gives managers a unit goal to achieve breakeven; if the goal is surpassed, the company earns income.

P1 Compute unit cost under both absorption and variable costing. Absorption cost per unit includes direct materials, direct labor, and all overhead, whereas variable cost per unit in- cludes direct materials, direct labor, and only variable overhead.

Summary P2 Prepare and analyze an income statement using absorption costing and using variable costing. The variable costing in- come statement differs from the absorption costing income statement in that it classifies expenses based on cost behavior rather than func- tion. Instead of gross margin, the variable costing income statement shows contribution margin. This contribution margin format focuses attention on the relation between costs and sales that is not evident from the absorption costing format. Under absorption costing, some fixed overhead cost is allocated to ending inventory and is carried on the balance sheet to the next period. However, all fixed costs are ex- pensed in the period incurred under variable costing. Consequently, absorption costing income is generally greater than variable costing income if units produced exceed units sold, and conversely.

P3 Prepare a contribution margin report. Under variable costing, the total variable costs are first deducted from sales to arrive at contribution margin. Variable costs and contribution margin are also shown as ratios (after dividing by dollar sales).

P4 Convert income under variable costing to the absorption cost basis. Variable costing income can be adjusted to absorp- tion costing income by adding the fixed cost allocated to ending in- ventory and subtracting the fixed cost previously allocated to beginning inventory.

Production Manager Under absorption costing, fixed produc- tion costs are spread over all units produced. Thus, fixed cost for each unit would be lower if more units are produced because the fixed cost is spread over more units. This means the company can increase income by producing excess units even if sales remain con- stant. With sales lagging, producing excess inventory leads to in- creased financing cost and inventory obsolescence. Also, producing excess inventory to meet income levels for bonuses harms company owners and is unethical. You must discuss this with the appropriate managers.

Internal Auditor If manager bonuses are tied to income, they would have incentives to increase income for personal gain. If absorp- tion costing is used to determine income, management can reduce cur- rent period expenses (and raise income) with over-production, which shifts fixed production costs to future periods. This decision fails to consider whether there is a viable market for all units that are produced. If there is not, an auditor can conclude that the inventory does not have “future economic value” and pressure management to write it off. Such a write-off reduces income by the cost of the excess inventory.

Guidance Answers to Decision Maker and Decision Ethics

1. a, b, c, and d; Direct materials, direct labor, variable overhead, and fixed overhead.

2. a, b, and c; Direct materials, direct labor, and variable overhead. 3. c; see Exhibit 19.6 4. a; see Exhibit 19.8 5. This is because only the variable cost will be avoided if a spe-

cial order is rejected, as fixed cost does not change with changes to short-run sales. This means a company is better off taking an order provided the order price exceeds variable cost.

6. Variable costs and fixed costs are typically influenced by deci- sions at different managerial levels. Since reports under variable costing separate variable costs from fixed costs, variable costing makes it easier to identify and control these cost elements.

7. Variable costing is not accepted for external reporting and in- come tax purposes—only absorption costing is acceptable for those purposes.

Guidance Answers to Quick Checks

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832 Chapter 19 Variable Costing and Performance Reporting

Absorption costing (also called full costing) (p. 816)

Contribution format (p. 826)

Contribution margin income statement (p. 818)

Contribution margin report (p. 819)

Controllable costs (p. 826)

Fixed overhead cost deferred in inventory (p. 823)

Fixed overhead cost recognized from inventory (p. 823)

Uncontrollable costs (p. 826)

Variable costing (also called direct or marginal costing) (p. 816)

Key Terms

1. What costs are normally included as part of product costs under the method of variable costing?

2. What costs are normally included as part of product costs under the method of absorption costing?

3. When units produced exceed units sold for a reporting period, would income under variable costing be greater than, equal to, or less than income under absorption costing? Explain.

4. Describe how the following items are computed: a. Gross margin, and b. Contribution margin

5. How can absorption costing lead to incorrect short-run pricing decisions?

6. What conditions must exist to achieve accurate short-run pric- ing decisions using variable costing?

7. Describe the usefulness of variable costing for controlling company costs.

8. Describe how use of absorption costing in determining income can lead to over-production and a buildup of inventory. Explain how variable costing can avoid this same problem.

9. What are the major limitations of variable costing? 10. Polaris uses variable costing for several business

decisions. How can variable costing income statements be converted to absorption costing?

11. Explain how contribution margin analysis is useful for managerial decisions and performance evaluations.

Discussion Questions

Icon denotes assignments that involve decision making.

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 845 mhhe.com/wildFINMAN5e

Answer questions 1 and 2 using the following company data.

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $3 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $5 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . $3 per unit

Variable selling and administrative . . . . . . . . . $1 per unit

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . $3,000

Fixed selling and administrative . . . . . . . . . . . $1,000

1. Product cost per unit under absorption costing is: a. $11 b. $12 c. $14 d. $15 e. $16 2. Product cost per unit under variable costing is: a. $11 b. $12 c. $14 d. $15 e. $16

3. Under variable costing, which costs are included in product cost? a. All variable product costs, including direct materials, direct

labor, and variable overhead. b. All variable and fixed allocations of product costs, including

direct materials, direct labor, and both variable and fixed overhead.

c. All variable product costs except for variable overhead. d. All variable and fixed allocations of product costs, except

for both variable and fixed overhead. 4. The difference between unit product cost under absorption

costing as compared to that under variable costing is: a. Direct materials and direct labor. b. Fixed and variable portions of overhead. c. Fixed overhead only. d. Variable overhead only. 5. When production exceeds sales, which of the following is true? a. No change occurs to inventories for either absorption cost-

ing or variable costing methods. b. Use of absorption costing produces a higher net income

than the use of variable costing. c. Use of absorption costing produces a lower net income than

the use of variable costing. d. Use of absorption costing causes inventory value to decrease

more than it would through the use of variable costing.

Polaris

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Chapter 19 Variable Costing and Performance Reporting 833

Under absorption costing a company had the following per unit costs when 10,000 units were produced. QUICK STUDY

QS 19-1 Absorption costing and over-production

C1

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2

Direct material . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . 4

Total variable cost . . . . . . . . . . . . . . . . . . . . . . . . . 9

Fixed overhead ($50,000/10,000 units) . . . . . . . . 5

Total production cost per unit . . . . . . . . . . . . . . . $14

Required

1. Compute the company’s total production cost per unit if 12,500 units had been produced. 2. Why might a manager of a company using absorption costing produce more units than can currently

be sold?

QS 19-5 Computing unit cost under variable costing P1

Refer to Vijay Company’s data in QS 19-4. Compute its production cost per unit under variable costing.

QS 19-7 Absorption costing income statement P2

Refer to information in QS 19-6. Prepare an income statement under absorption costing.

QS 19-4 Computing unit cost under absorption costing

P1

Vijay Company reports the following information regarding its production costs. Compute its production cost per unit under absorption costing.

Direct materials . . . . . . . . . . . . . . . . . . . $10 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . $20 per unit

Overhead costs for the year

Variable overhead . . . . . . . . . . . . . . . . $10 per unit

Fixed overhead . . . . . . . . . . . . . . . . . . $160,000

Units produced . . . . . . . . . . . . . . . . . . . 20,000 units

QS 19-6 Variable costing income statement

P2

Aces Inc., a manufacturer of tennis rackets, began operations this year. The company produced 6,000 rackets and sold 4,900. Each racket was sold at a price of $90. Fixed overhead costs are $78,000 and fixed selling and administrative costs are $65,200. The company also reports the following per unit costs for the year:

Variable production costs . . . . . . . . . . . . . . . . . . . . . . . $25.00

Variable selling and administrative expenses . . . . . . . . . 2.00

Prepare an income statement under variable costing.

12. KTM’s managers rely on reports of variable costs. How can variable costing reports prepared using the contribution margin format help managers in com- puting break-even volume in units?

13. Assume that Arctic Cat has received a special order from a retailer for 100 specially outfitted

snowmobiles. This is a one-time order, which will not require any additional capacity or fixed costs. What should Arctic Cat con- sider when determining a selling price for these snowmobiles?

14. How can Piaggio use variable costing to help better understand its operations and to make better pricing decisions?

PIAGGIO Arctic Cat

KTM

QS 19-2 Computing manufacturing margin P3

D’Souza Company sold 10,000 units of its product at a price of $80 per unit. Total variable cost is $50 per unit, consisting of $40 in variable production cost and $10 in variable selling and administrative cost. Compute the manufacturing (production) margin for the company under variable costing.

QS 19-3 Computing contribution margin

P3

Refer to the information for D’Souza Company in QS 19-2. Compute the contribution margin.

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834 Chapter 19 Variable Costing and Performance Reporting

QS 19-9 Production level, variable costing, and gross margin P2 P3

Refer to the information about Ramort Company in QS 19-8. Would the answer to the question in QS 19-8 change if the company uses variable costing? Explain.

QS 19-14 Converting variable costing income to absorption costing income P4

Mortech had net income of $250,000 based on variable costing. Beginning and ending inventories were 50,000 units and 48,000 units, respectively. Assume the fixed overhead per unit was $0.75 for both the beginning and ending inventory. What is net income under absorption costing?

QS 19-10 Special order pricing

C2

Li Company produces a product that sells for $84 per unit. A customer contacts Li and offers to purchase 2,000 units of its product at a price of $68 per unit. Variable production costs with this order would be $30 per unit, and variable selling expenses would be $18 per unit. Assuming that this special order would not require any additional fixed costs, and that Li has sufficient capacity to produce the product without affecting regular sales, explain to Li’s management why it might be a good decision to accept this special order.

QS 19-8 Production level, absorption costing, and gross margin

P3

Ramort Company reports the following cost data for its single product. The company regularly sells 20,000 units of its product at a price of $60 per unit. If Ramort doubles its production to 40,000 units while sales remain at the current 20,000 unit level, by how much would the company’s gross margin increase or decrease under absorption costing?

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $10 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . $12 per unit

Overhead costs for the year

Variable overhead . . . . . . . . . . . . . . . . . . . . . $3 per unit

Fixed overhead per year . . . . . . . . . . . . . . . $40,000

Normal production level (in units) . . . . . . . . . 20,000 units

QS 19-12 Converting variable costing income to absorption costing

P4

Diaz Company reports the following variable costing income statement for its single product. This company’s sales totaled 50,000 units, but its production was 80,000 units. It had no beginning finished goods inventory for the current period.

DIAZ COMPANY Income Statement (Variable Costing)

Sales (50,000 units 3 $60 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000

Variable expenses

Variable manufacturing expense (50,000 units 3 $28 per unit) . . . . . . . . . . . . 1,400,000

Variable selling and admin. expense (50,000 units 3 $5 per unit) . . . . . . . . . . . 250,000

Total variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,650,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,350,000

Fixed expenses

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Fixed selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000

Total fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 870,000

1. Convert this company’s variable costing income statement to an absorption costing income statement. 2. Explain the difference in income between the variable costing and absorption costing income statement.

QS 19-13 Converting variable costing income to absorption costing income P4

Ming Company had net income of $772,200 based on variable costing. Beginning and ending inventories were 7,800 units and 5,200 units, respectively. Assume the fixed overhead per unit was $3.00 for both the beginning and ending inventory. What is net income under absorption costing?

QS 19-11 Break-even volume in units A1

Assume a company sells a given product for $85 per unit. How many units must be sold to break even if variable selling costs are $27 per unit, variable production costs are $23 per unit, and total fixed costs are $700,000?

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Chapter 19 Variable Costing and Performance Reporting 835

Trio Company reports the following information for the current year, which is its first year of operations. EXERCISES

Exercise 19-1 Computing unit and inventory costs under absorption costing and variable costing

P1

Exercise 19-3 Converting absorption costing income to variable costing income

P2 P4

Kenzi Kayaking, a manufacturer of kayaks, began operations this year. During this first year, the company produced 1,050 kayaks and sold 800 at a price of $1,050 each. At the current year-end, the company re- ported the following income statement information using absorption costing.

Sales (800 3 $1,050) . . . . . . . . . . . . . . . . . . . . . $840,000

Cost of goods sold (800 3 $500) . . . . . . . . . . 400,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000

Selling and administrative expenses . . . . . . . . . 230,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000

Additional Information

a. Production cost per kayak totals $500, which consists of $400 in variable production cost and $100 in fixed production cost—the latter amount is based on $105,000 of fixed production costs allocated to the 1,050 kayaks produced.

b. The $230,000 in selling and administrative expense consists of $75,000 that is variable and $155,000 that is fixed.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16 per unit

Overhead costs for the year

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 per year

Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 per year

Units produced this year . . . . . . . . . . . . . . . . . . . . . . 20,000 units

Units sold this year . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 units

Ending finished goods inventory in units . . . . . . . . . 6,000 units

1. Compute the cost per unit of finished goods using absorption costing. 2. Compute the cost per unit of finished goods using variable costing. 3. Determine the cost of ending finished goods inventory using absorption costing. 4. Determine the cost of ending finished goods inventory using variable costing.

Check (1) Absorption cost per unit, $43; (2) Variable cost per unit, $35

Production costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $40 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $60 per unit

Overhead costs for the year

Variable overhead . . . . . . . . . . . . . . . . . . . . $3,000,000

Fixed overhead . . . . . . . . . . . . . . . . . . . . . $7,000,000

Nonproduction costs for the year

Variable selling and administrative . . . . . . . . . $ 770,000

Fixed selling and administrative . . . . . . . . . . . $4,250,000

Production and sales for the year

Units produced . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 units

Sales price per unit . . . . . . . . . . . . . . . . . . . . $350 per unit

Exercise 19-2 Income reporting under absorption costing and variable costing

P2

Sims Company, a manufacturer of in-home decorative fountains, began operations on September 1 of the current year. Its cost and sales information for this year follows.

Check (1) Variable costing income, $3,380,000; (2) Absorption costing income, $5,480,000

1. Prepare an income statement for the company using variable costing. 2. Prepare an income statement for the company using absorption costing. 3. Under what circumstance(s) is reported income identical under both absorption costing and variable

costing?

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836 Chapter 19 Variable Costing and Performance Reporting

Exercise 19-6 Income reporting under absorption costing and variable costing

P2 P4

Oak Mart, a producer of solid oak tables, reports the following data from its current year operations, which is its second year of business.

Sales price per unit . . . . . . . . . . . . . . . . . . . . . . $320 per unit

Units produced this year . . . . . . . . . . . . . . . . . . 115,000 units

Units sold this year . . . . . . . . . . . . . . . . . . . . . . 118,000 units

Units in beginning-year inventory . . . . . . . . . . . 3,000 units

Beginning inventory costs

Variable (3,000 units 3 $135) . . . . . . . . . . . . $405,000

Fixed (3,000 units 3 $80) . . . . . . . . . . . . . . . 240,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $645,000

Production costs this year

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $40 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $62 per unit

Overhead costs this year

Variable overhead . . . . . . . . . . . . . . . . . . . . $3,220,000

Fixed overhead . . . . . . . . . . . . . . . . . . . . . $7,400,000

Nonproduction costs this year

Variable selling and administrative . . . . . . . . . $1,416,000

Fixed selling and administrative . . . . . . . . . . 4,600,000

1. Prepare the current year income statement for the company using variable costing. 2. Prepare the current year income statement for the company using absorption costing. 3. Explain any difference between the two income numbers under the two costing methods in parts 1 and 2.

Check (1) Variable costing income, $8,989,000; (2) Absorption costing income, $8,749,000

Check (1) Variable costing income, $185,000

Required

1. Prepare an income statement for the current year under variable costing. 2. Explain the difference in income between the variable costing and absorption costing income statement.

Exercise 19-4 Break-even volume in units

A1

Rey Company’s single product sells at a price of $216 per unit. Cost data for its single product follows. Compute this company’s break-even volume in units.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $20 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . $28 per unit

Overhead costs

Variable overhead . . . . . . . . . . . . . . . . . . . . . $ 6 per unit

Fixed overhead per year . . . . . . . . . . . . . . . $160,000 per year

Selling and administrative expenses

Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18 per unit

Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 per year

Exercise 19-5 Converting variable costing income to absorption costing income P2 P4

Hayek Furnaces prepares the income statement under variable costing for its managerial reports, and it prepares the income statement under absorption costing for external reporting. For its first month of opera- tions, 375 furnaces were produced and 225 were sold; this left 150 furnaces in ending inventory. The income statement information under variable costing follows.

Sales (225 3 $1,600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000

Variable production cost (225 3 $625) . . . . . . . . . . . . . . . . . . . . . . . . 140,625

Variable selling and administrative expenses (225 3 $65) . . . . . . . . . . 14,625

Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204,750

Fixed overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,250

Fixed selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . 75,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 73,500

Check (1) Absorption costing income, $96,000

1. Prepare this company’s income statement for its first month of operations under absorption costing. 2. Explain the difference in income between the variable costing and absorption costing income statement.

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Chapter 19 Variable Costing and Performance Reporting 837

Exercise 19-9 Unit costs and income statement under absorption costing and variable costing

P1 P2

Cool Sky Company reports the following costing data on its product for its first year of operations. During this first year, the company produced 44,000 units and sold 36,000 units at a price of $140 per unit.

Production costs

Direct materials per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . $60

Direct labor per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22

Variable overhead per unit . . . . . . . . . . . . . . . . . . . . . . . . . . $8

Fixed overhead for the year . . . . . . . . . . . . . . . . . . . . . . . . . $528,000

Selling and administrative cost

Variable selling and administrative cost per unit . . . . . . . . . $11

Fixed selling and administrative cost per year . . . . . . . . . . . $105,000

1. Assume that this company uses absorption costing. a. Determine its unit product cost. b. Prepare its income statement for the year under absorption costing. 2. Assume that this company uses variable costing. a. Determine its unit product cost. b. Prepare its income statement for the year under variable costing.

Check (1a) Absorption cost per unit, $102

(2a) Variable cost per unit, $90

Exercise 19-7 Variable costing for services

C2

MidCoast Airlines provides charter airplane services. In October this year, the company was operating at 60% of its capacity when it received a bid from the local community college. The college was organizing a Washington, D.C., trip for its international student group. The college only budgeted $30,000 for roundtrip airfare. MidCoast Airlines normally charges between $50,000 and $60,000 for such ser vice given the number of travelers. MidCoast determined its cost for the roundtrip flight to Washington to be $44,000, which consists of the following:

Although the manager at MidCoast supports the college’s educational efforts, she could not justify accept- ing the $30,000 bid for the trip given the projected $14,000 loss. Still, she decides to consult with you, an independent financial consultant. Do you believe the airline should accept the bid from the college? Prepare a memorandum, with supporting computations, explaining why or why not.

Variable cost . . . . . . . . $15,000

Fixed cost . . . . . . . . . . 29,000

Total cost . . . . . . . . . . . $44,000

Exercise 19-8 Contribution margin format income statement P3

Polarix is a retailer of ATVs (all terrain vehicles) and accessories. An income statement for its Consumer ATV Department for the current year follows. ATVs sell, on average, for $3,800. Variable selling expenses are $270 each. The remaining selling expenses are fixed. Administrative expenses are 40% variable and 60% fixed. The company does not manufacture its own ATVs; it purchases them from a supplier for $1,830 each.

POLARIX Income Statement—Consumer ATV Department

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $646,000

Cost of goods sold . . . . . . . . . . . . . . . 311,100

Gross margin . . . . . . . . . . . . . . . . . . . . 334,900

Operating expenses

Selling expenses . . . . . . . . . . . . . . . . $135,000

Administrative expenses . . . . . . . . . 59,500 194,500

Net income . . . . . . . . . . . . . . . . . . . . . $140,400

Required

1. Prepare an income statement for this current year using the contribution margin format. 2. For each ATV sold during this year, what is the contribution toward covering fixed expenses and earn-

ing income? Check (2) $1,560

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838 Chapter 19 Variable Costing and Performance Reporting

Additional Information

a. Sales and production data for these first two years follow.

2012 2013

Units produced . . . . . . . . 30,000 30,000 Units sold . . . . . . . . . . . . . 20,000 40,000

Exercise 19-11 Variable costing and contribution margin statement

P3

Tee-Pro has three types of costs: t-shirt cost, factory rent cost, and utilities cost. This company sells its shirts for $16.50 each. Management has prepared the following estimated cost information for next month under two different sales levels.

At 10,000 Shirts At 12,000 Shirts

T-shirt cost . . . . . . . . . . . $80,000 $96,000 Rent cost . . . . . . . . . . . . 6,000 6,000 Utilities cost . . . . . . . . . 8,400 9,900

Required

1. Compute what the company should expect for total variable cost if 11,000 shirts are sold next month. (Hint: Use the high-low method to separate shirt and utilities costs into their variable and fixed components.)

2. Prepare its contribution margin statement for a monthly sales volume of 12,000 jackets. Check (2) Contribution margin, $93,000

Exercise 19-10 Absorption costing and over-production

C1

Jacquie Inc. reports the following annual cost data for its single product.

If Jacquie increases its production to 80,000 units, while sales remain at the current 60,000 unit level, by how much would the company’s gross margin increase or decrease under absorption costing? Assume the company has idle capacity to double current production.

Normal production and sales level . . . . . . . . . 60,000 units Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56.00 per unit Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $9.00 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . $6.50 per unit Variable overhead . . . . . . . . . . . . . . . . . . . . . . $11.00 per unit Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . $720,000 in total

Exercise 19-12 Analyzing income growth

P2

A recent annual report for McDonald’s reports the following operating income for its United States and APMEA (Asia-Pacific, Middle East, and Africa) geographic segments:

Required

1. Is operating income growing faster in the United States or in the APMEA segment? Explain. 2. Is the difference in operating income growth due to the use of different costing methods (absorption or

variable costing) in the U.S. and APMEA segments? Explain.

In $ millions 2011 2010 2009

United States . . . . . . . . . $3,666 $3,446 $3,232 APMEA . . . . . . . . . . . . . . 1,526 1,200 989

PROBLEM SET A

Problem 19-1A Variable costing income statement and conversion to absorption costing income (two consecutive years)

P2 P4

Dowell Company produces a single product. Its income statement under absorption costing for its first two years of operation follow.

2012 2013

Sales ($46 per unit) . . . . . . . . . . . . . . . . . . . . . . $920,000 $1,840,000 Cost of goods sold ($31 per unit) . . . . . . . . . . 620,000 1,240,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 600,000 Selling and administrative expenses . . . . . . . . . 290,000 340,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000 $ 260,000

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Chapter 19 Variable Costing and Performance Reporting 839

Sales (80,000 units 3 $50 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000

Cost of goods sold

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Cost of goods manufactured (100,000 units 3 $30 per unit) . . . . . . . . . 3,000,000

Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000

Ending inventory (20,000 3 $30) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,070,000

b. Variable cost per unit and total fixed costs are unchanged during 2012 and 2013. The company’s $31 per unit product cost consists of the following.

Problem 19-2A CVP analysis, absorption costing, and variable costing

A1

Refer to information about Dowell Company in Problem 19-1A. In the company’s planning documents, Kyra Dowell, the company’s president, reports that the break-even volume (in units) for the company is 24,000 units. This break-even point is computed as follows.

Break-even volume 5 Total fixed cost

Contribution margin per unit 5

$540,000

$22.50 5 24,000 units

Total fixed cost consists of $300,000 in fixed production cost and $240,000 in fixed selling and admin- istrative expenses. The contribution margin per unit of $22.50 is computed by deducting the $23.50 variable cost per unit (which consists of $21 in variable production cost and $2.50 in variable selling and administrative cost) from the $46 sales price per unit. In 2012, the company sold 20,000 units, which was below break-even, and Kyra was concerned that the company’s income statement would show a net loss. To her surprise, the company’s 2012 income statement revealed a net income of $10,000 as shown in Problem 19-1A.

Required

Prepare a one-half-page memorandum to the president explaining how the company could report net income when it sold less than its break-even volume in units.

Problem 19-3A Variable costing income statement and conversion to absorption costing income

P2 P4

Trez Company began operations this year. During this first year, the company produced 100,000 units and sold 80,000 units. The absorption costing income statement for its first year of operations follows.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Fixed overhead ($300,000/30,000 units) . . . . . . . . 10

Total product cost per unit . . . . . . . . . . . . . . . . . . . $31

Check (1) 2012 net loss, $(90,000)

2012 2013

Variable selling and administrative ($2.50 per unit) . . . . . . . $ 50,000 $100,000

Fixed selling and administrative . . . . . . . . . . . . . . . . . . . . . . . 240,000 240,000

Total selling and administrative . . . . . . . . . . . . . . . . . . . . . . . $290,000 $340,000

c. Selling and administrative expenses consist of the following.

Required

1. Prepare income statements for the company for each of its first two years under variable costing. 2. Explain any difference between the absorption costing income and the variable costing income for

these two years.

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840 Chapter 19 Variable Costing and Performance Reporting

Problem 19-4A Variable cost analysis for a services company

C2

Grand Garden is a luxury hotel with 150 suites. Its regular suite rate is $250 per night per suite. The hotel’s cost per night is $140 per suite and consists of the following.

Variable direct labor and materials cost . . . . . . . . . . . . . . . . . . $ 30

Fixed cost [($6,022,500/150 suites) 4 365 days] . . . . . . . . . . 110

Total cost per night per suite . . . . . . . . . . . . . . . . . . . . . . . . . . . $140

The hotel manager received an offer to hold the local Bikers’ Club annual meeting at the hotel in March, which is the hotel’s low season with an occupancy rate of under 50%. The Bikers’ Club would reserve 50 suites for three nights if the hotel could offer a 50% discount, or a rate of $125 per night. The hotel manager is inclined to reject the offer because the cost per suite per night is $140. The manager believes that if 50 suites are offered at the rate of $125 per night for three nights, the hotel would lose $2,250, computed as ($125 2 $140) 3 50 suites 3 3 nights.

Required

Prepare an analysis of this offer for the hotel manager. Explain (with supporting computations) whether the offer from the Bikers’ Club should be accepted or rejected.

Check $14,250 contribution margin

Additional Information

a. Selling and administrative expenses consist of $350,000 in annual fixed expenses and $2.25 per unit in variable selling and administrative expenses.

b. The company’s product cost of $30 per unit is computed as follows.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . $2 per unit

Fixed overhead ($900,000/100,000 units) . . . . . . . . $9 per unit

Required

1. Prepare an income statement for the company under variable costing. 2. Explain any difference between the income under variable costing (from part 1) and the income

reported above.

Check (1) Variable costing income, $890,000

Problem 19-5A Income reporting, absorption costing, and managerial ethics

C1 P2

Blazer Chemical produces and sells an ice-melting granular used on roadways and sidewalks in winter. It annually produces and sells about 100 tons of its granular. In its nine-year history, the company has never reported a net loss. However, because of this year’s unusually mild winter, projected demand for its prod- uct is only 60 tons. Based on its predicted production and sales of 60 tons, the company pro jects the fol- lowing income statement (under absorption costing).

Sales (60 tons at $21,000 per ton) . . . . . . . . . . . . . . . . . . . . . $1,260,000

Cost of goods sold (60 tons at $16,000 per ton) . . . . . . . . . 960,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . 318,600

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (18,600)

Its product cost information follows and consists mainly of fixed cost because of its automated production process requiring expensive equipment.

Variable direct labor and material costs per ton . . . . . . . . . $ 3,500

Fixed cost per ton ($750,000 4 60 tons) . . . . . . . . . . . . . . . 12,500

Total product cost per ton . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000

Selling and administrative expenses consist of variable selling and administrative expenses of $310 per ton and fixed selling and administrative expenses of $300,000 per year. The company’s president is con- cerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported. The operations manager mentions that since the company has large storage capacity, it can report a net

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Chapter 19 Variable Costing and Performance Reporting 841

Check (1) $281,400 absorption costing income

income by keeping its production at the usual 100-ton level even though it expects to sell only 60 tons. The president was puzzled by the suggestion that the company can report income by producing more without increasing sales.

Required

1. Can the company report a net income by increasing production to 100 tons and storing the excess production in inventory? Your explanation should include an income statement (using absorption cost- ing) based on production of 100 tons and sales of 60 tons.

2. Should the company produce 100 tons given that projected demand is 60 tons? Explain, and also refer to any ethical implications of such a managerial decision.

Azule Company produces a single product. Its income statement under absorption costing for its first two years of operation follow.

PROBLEM SET B

Problem 19-1B Variable costing income statement and conversion to absorption costing income (two consecutive years)

P2 P4

2012 2013

Sales ($35 per unit) . . . . . . . . . . . . . . . . . . . . . $1,925,000 $2,275,000

Cost of goods sold ($26 per unit) . . . . . . . . . 1,430,000 1,690,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . 495,000 585,000

Selling and administrative expenses . . . . . . . . 465,000 495,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 90,000

2012 2013

Units produced . . . . . . . . 60,000 60,000

Units sold . . . . . . . . . . . . . 55,000 65,000

Additional Information

a. Sales and production data for these first two years follow:

b. Its variable cost per unit and total fixed costs are unchanged during 2012 and 2013. Its $26 per unit product cost consists of the following.

2012 2013

Variable selling and administrative ($3 per unit) . . . . . . . . . . $165,000 $195,000

Fixed selling and administrative . . . . . . . . . . . . . . . . . . . . . . . 300,000 300,000

Total selling and administrative . . . . . . . . . . . . . . . . . . . . . . . $465,000 $495,000

Check (1) 2012 net loss, $(10,000)

Required

1. Prepare this company’s income statements under variable costing for each of its first two years. 2. Explain any difference between the absorption costing income and the variable costing income for

these two years.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Fixed overhead ($480,000/60,000 units) . . . . . . . . . 8

Total product cost per unit . . . . . . . . . . . . . . . . . . . $26

c. Its selling and administrative expenses consist of the following.

Problem 19-2B CVP analysis, absorption costing, and variable costing

A1

Refer to information about Azule Company in Problem 19-1B. In the company’s planning documents, Roberta Azule, the company president, reports that the company’s break-even volume in unit sales is 55,715 units. This break-even point is computed as follows.

Break-even volume 5 Total fixed cost

Contribution margin per unit 5

$780,000

$14 5 55,715 units (rounded)

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842 Chapter 19 Variable Costing and Performance Reporting

Problem 19-4B Variable cost analysis for a services company

C2

Empire Plaza Hotel is a luxury hotel with 400 rooms. Its regular room rate is $300 per night per room. The hotel’s cost is $165 per night per room and consists of the following.

The hotel manager received an offer to hold the Junior States of America (JSA) convention at the hotel in February, which is the hotel’s low season with an occupancy rate of under 45%. JSA would reserve 100 rooms for four nights if the hotel could offer a 50% discount, or a rate of $150 per night. The hotel manager is inclined to reject the offer because the cost per room per night is $165. The manager believes that if 100 rooms are offered at the rate of $150 per night for four nights, the hotel would lose $6,000, computed as ($150 2 $165) 3 100 rooms 3 4 nights.

Required

Prepare an analysis of this offer for the hotel manager. Explain (with supporting computations) whether the offer from JSA should be accepted or rejected.

Check (1) Variable costing income, $350,000

Check Contribution margin, $44,000

Variable direct labor and materials cost . . . . . . . . . . . . . . . . . $ 40

Fixed cost [($18,250,000/400 rooms) 4 365 days] . . . . . . . . . 125

Total cost per night per room . . . . . . . . . . . . . . . . . . . . . . . . . $165

Problem 19-3B Variable costing income statement and conversion to absorption costing income

P2 P4

E’Lonte Company began operations this year. During this first year, the company produced 300,000 units and sold 250,000 units. Its income statement under absorption costing for its first year of operations follows.

Sales (250,000 units 3 $18 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,500,000

Cost of goods sold

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Cost of goods manufactured (300,000 units 3 $7.50 per unit) . . . . . . . 2,250,000

Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,250,000

Ending inventory (50,000 3 $7.50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,875,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 425,000

Additional Information

a. Selling and administrative expenses consist of $1,200,000 in annual fixed expenses and $4 per unit in variable selling and administrative expenses.

b. The company’s product cost of $7.50 per unit is computed as follows.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.00 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.40 per unit

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.60 per unit

Fixed overhead ($450,000/300,000 units) . . . . . . . . . . $1.50 per unit

Required

1. Prepare the company’s income statement under variable costing. 2. Explain any difference between the company’s income under variable costing (from part 1) and the

income reported above.

Total fixed cost consists of $480,000 in fixed production cost and $300,000 in fixed selling and administrative expenses. The contribution margin per unit of $14 is computed by deducting the $21 variable cost per unit (which consists of $18 in variable production cost and $3 in variable selling and administrative cost) from the $35 sales price per unit. In 2012, it sold 55,000 units, which was below break-even, and Roberta was concerned that the company’s income statement would show a net loss. To her surprise, the company’s 2012 income statement revealed a net income of $30,000 as shown in Problem 19-1B.

Required

Prepare a one-half-page memorandum to the president explaining how the company could report net in- come when it sold less than its break-even volume in units.

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Chapter 19 Variable Costing and Performance Reporting 843

Sales (250,000 lbs at $8 per lb.) . . . . . . . . . . . . . . . . . . . . . . . $ 2,000,000

Cost of goods sold (250,000 lbs at $6.80 per lb.) . . . . . . . . . 1,700,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . 450,000

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (150,000)

Its product cost information follows and consists mainly of fixed production cost because of its automated production process requiring expensive equipment.

Variable direct labor and materials costs per lb. . . . . . . . . . . . . . . $2.00

Fixed production cost per lb ($1,200,000/250,000 lbs.) . . . . . . . . 4.80

Total product cost per lb. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6.80

Problem 19-5B Income reporting, absorption costing, and managerial ethics

C1 P2

Chem-Melt produces and sells an ice-melting granular used on roadways and sidewalks in winter. The company annually produces and sells about 300,000 lbs of its granular. In its ten-year history, the com- pany has never reported a net loss. Because of this year’s unusually mild winter, projected demand for its product is only 250,000 lbs. Based on its predicted production and sales of 250,000 lbs, the company projects the following income statement under absorption costing.

The company’s selling and administrative expenses are all fixed. The president is concerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported. The controller sug- gests that since the company has large storage capacity, it can report a net income by keeping its production at the usual 300,000 lbs level even though it expects to sell only 250,000 lbs. The president was puzzled by the suggestion that the company can report a profit by producing more without increasing sales.

Required

1. Can the company report a net income by increasing production to 300,000 lbs and storing the excess production in inventory? Your explanation should include an income statement (using absorption cost- ing) based on production of 300,000 lbs and sales of 250,000 lbs.

2. Should the company produce 300,000 lbs given that projected demand is 250,000 lbs? Explain, and also refer to any ethical implications of such a managerial decision.

Check (1) $50,000 absorption income

SERIAL PROBLEM Success Systems

P2 P4

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 19 Adria Lopez expects sales of her line of computer workstation furniture to equal 300 workstations (at a sales price of $3,000) for 2014. The workstations’ manufacturing costs include the following.

Direct materials . . . . . . . . . . . $800 per unit

Direct labor . . . . . . . . . . . . . . $400 per unit

Variable overhead . . . . . . . . . . $100 per unit

Fixed overhead . . . . . . . . . . . . $24,000 per year

Variable selling expenses . . . . . . . . . $50 per unit

Fixed selling expenses . . . . . . . . . . . $4,000 per year

The selling expenses related to these workstations follow.

Adria is considering how many workstations to produce in 2014. She is confident that she will be able to sell any workstations in her 2014 ending inventory during 2015. However, Adria does not want to overpro- duce as she does not have sufficient storage space for many more workstations.

Required

1. Compute Success Systems’ absorption costing income assuming a. 300 workstations are produced. b. 320 workstations are produced.

[continued on next page]

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844 Chapter 19 Variable Costing and Performance Reporting

2. Compute Success Systems’ variable costing income assuming a. 300 workstations are produced. b. 320 workstations are produced. 3. Explain to Adria any differences in the income figures determined in parts 1 and 2. How should Adria

use the information from parts 1 and 2 to help make production decisions?

BTN 19-1 Polaris’s ending inventory amounts (in $ millions) are shown below:

Beyond the Numbers

REPORTING IN ACTION P2

COMPARATIVE ANALYSIS P2

BTN 19-2 Polaris offers its dealers financing plans while Arctic Cat currently relies on outside compa- nies to provide its dealers’ financing. Assume Arctic Cat is considering starting its own finance unit to provide financing directly to its dealers.

Required

1. What are some of the costs that Arctic Cat should consider when deciding whether to offer financing services to its dealers? Are these costs different from what Polaris must consider when offering addi- tional new financing services? Explain.

2. Would variable or absorption costing be more useful to Arctic Cat in analyzing whether its new financ- ing service is profitable? Explain.

ETHICS CHALLENGE P2

BTN 19-3 FDP Company produces a variety of home security products. Gary Price, the company’s presi- dent, is concerned with the fourth quarter market demand for the company’s products. Unless something is done in the last two months of the year, the company is likely to miss its earnings expectation of Wall Street analysts. Price still remembers when FDP’s earnings were below analysts’ expectation by two cents a share three years ago, and the company’s share price fell 19% the day earnings were announced. In a recent meet- ing, Price told his top management that something must be done quickly. One proposal by the marketing vice president was to give a deep discount to the company’s major customers to increase the company’s sales in the fourth quarter. The company controller pointed out that while the discount could increase sales, it may not help the bottom line; to the contrary, it could lower income. The controller said, “Since we have enough stor- age capacity, we might simply increase our production in the fourth quarter to increase our reported profit.”

Required

1. Gary Price is not sure how the increase in production without a corresponding increase in sales could help boost the company’s income. Explain to Price how reported income varies with respect to production level.

2. Is there an ethical concern in this situation? If so, which parties are affected? Explain.

BTN 19-4 Mertz Chemical has three divisions. Its consumer product division faces strong competition from companies overseas. During its recent teleconference, Ryan Peterson, the consumer product division manager, reported that his division’s sales for the current year were below its break-even point. However, when the division’s annual reports were received, Billie Mertz, the company president, was surprised that the consumer product division actually reported a profit of $264,000. How could this be possible?

Required

Assume that you work in the corporate controller’s office. Write a one-half-page memorandum to the president explaining how the division can report income even if its sales are below the break-even point.

COMMUNICATING IN PRACTICE A1

Polaris

Polaris

2011 2010 2009

$298.04 $235.93 $179.32

Required

1. Assume Polaris uses variable costing for some of its internal reports. For each of the years 2011 and 2010, would net income based on variable costing be higher, lower, or no different from net income based on absorption costing? Explain.

2. Assume Polaris is considering implementing a just-in-time (JIT) inventory system. Would a JIT sys- tem increase, decrease, or have no effect on differences in net income between absorption costing and variable costing? Explain.

Arctic Cat

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Chapter 19 Variable Costing and Performance Reporting 845

BTN 19-5 This chapter discussed the variable costing method and how to use variable costing informa- tion to make various business decisions. We also can find several Websites on variable costing and its business applications.

Required

1. Review the Website of Value Based Management at ValueBasedManagement.net. Identify and print the site page on the topic of variable costing (valuebasedmanagement.net/methods_variable_costing.html).

2. What other phrases are used in practice for variable costing? 3. According to this Website, what are the consequences of variable costing for profit calculation?

TAKING IT TO THE NET P2

1. c; $14, computed as $3 1 $5 1 $3 1 ($3,000/1,000 units). 2. a; $11, computed as $3 1 $5 1 $3 (consisting of all variable product

costs).

3. a 4. c 5. b

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 19-6 This chapter identified many decision contexts in which variable costing information is more relevant than absorption costing. However, absorption costing is still used by many companies and re- mains the only acceptable basis for external (and tax) reporting.

Required

Break into teams and identify at least one specific decision context in which absorption costing information is more relevant than variable costing. Be prepared to discuss your answers in class.

TEAMWORK IN ACTION P4

BTN 19-7 Samanta Shoes, which was launched by entrepreneurs Samanta and Kelvin Joseph, produces high-quality shoes in unique styles and limited quantities. Selling prices for a pair of Samanta shoes can range from $100 per pair to $350 per pair.

Required

1. Based on information in this chapter’s opener, identify at least four examples of the types of costs that likely explain the wide range of shoe selling prices.

2. The founders of Samanta Shoes use variable costing in their business decisions. If Samanta Shoes used absorption costing, would you expect the company’s income to be more, less than, or about the same as its income measured under variable costing? Explain.

ENTREPRENEURIAL DECISION P4

BTN 19-8 Visit a local hotel and observe its daily operating activities. The costs associated with some of its activities are variable while others are fixed with respect to occupancy levels.

Required

1. List cost items that are likely variable for the hotel. 2. List cost items that are likely fixed for the hotel. 3. Compare the fixed cost items with variable cost items. Rank costs within each category based on your

perception of which ones you believe are the larger. 4. Based on your observations and the answers to parts 1 through 3, explain why many hotels offer dis-

counts as high as 50% or more during their low occupancy season.

HITTING THE ROAD C2

BTN 19-9 Assume that KTM (KTM.com) is considering offering financing services for its dealers. However, instead of developing the division internally, KTM is considering buying a company that al- ready offers such services.

Required

Would absorption or variable costing be most useful to KTM in evaluating whether to acquire an existing business that provides dealer financing services similar to those offered by Polaris? Explain.

GLOBAL DECISION P2

Polaris KTM

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Learning Objectives

CONCEPTUAL

C1 Describe the importance and benefits of budgeting and the process of budget administration. (p. 848)

C2 Describe a master budget and the process of preparing it. (p. 852)

ANALYTICAL

A1 Analyze expense planning using activity-based budgeting. (p. 862)

PROCEDURAL

P1 Prepare each component of a master budget and link each to the budgeting process. (p. 854)

P2 Link both operating and capital expenditures budgets to budgeted financial statements. (p. 858)

P3 Appendix 20A—Prepare production and manufacturing budgets. (p. 863)

A Look at This Chapter

This chapter explains the importance of budgeting and describes the master budget and its preparation. It also discusses the value of the master budget to the planning of future business activities.

A Look Back

Chapter 19 compared reports prepared under variable costing with those under absorption costing, and it explained how variable costing can improve managerial decisions.

Master Budgets and Performance Planning 20

A Look Ahead

Chapter 21 focuses on flexible budgets, standard costs, and variance reporting. It explains the usefulness of these procedures and reports for business decisions.

846

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Fresh Profits

CHICAGO, IL—Matthew Corrin was tired of eating typical lunch fare. Stuck in a greasy deli, Matthew realized “the service and food was lackluster. I needed an alternative.” The then 22-year- old budding entrepreneur set off to build a restaurant based on fresh, healthy foods served in an environmentally sustaining en- vironment. Today, Matthew’s company, Freshii (Freshii.com), has over 60 stores across several countries. Matthew admits he was “totally naïve. Restaurants are one of the hardest businesses. A thousand things have to go right every day.” Unfortunately, many things did go wrong at the beginning. “The first day we ran out of food at lunch. We ordered more but ran out again on the second day,” recalls Matt. Making accurate sales forecasts is one of the most important, but most difficult, parts of preparing business budgets. Sales forecasts are espe- cially challenging for new businesses. Through hard work and help from his girlfriend (now wife), Matthew’s business broke sales records every day for its first six months. “Those first days were a turning point for me. I realized if I could get through that, I could survive anything” says Matthew. Matthew learned his business by doing “whatever needed to be done.” “This isn’t rocket science,” he says, “just hard work.” In addition to learning the nuances of the restaurant business, Matthew had to learn budgeting and cost concepts. As Matthew explains, the perishability of food items is a key variable. Food

costs can vary due to weather, supply disruptions, and other fac- tors. Matthew updates his budgets frequently to factor in chang- ing costs and customer tastes. Matthew advises young entrepreneurs to “go for it.” “Some might say starting a restaurant with no previous food or retail experience wasn’t the smartest move. But, isn’t that the entre- preneurial spirit, to just jump in and figure it out on the fly?” As his company continues to grow, the budgeting process and master budgets become even more important. Budgets help formalize plans and goals, and help direct and monitor employ- ees. Matthew also uses budgeted income statements to deter- mine how changes in the cost of food, labor, and overhead will impact his bottom line. While linking budgeted data to budgeted financial state- ments and using that information to control costs is important, Matthew stresses “you have to execute every day and generate a buzz.” From humble beginnings, Freshii has over 400 new lo- cations in development, forecasted sales of $50 million, and, in Matthew’s words, “a vision to be the Starbucks of the fresh food business.” Bold and fresh.

[Sources: Freshii Website, January 2013; Inc.com, March 16, 2011, and June 27, 2011; Canada Restaurant News, January 31, 2011; Under30ceo. com, October 25, 2010.]

”Talk is cheap . . . execution sets you apart” —MATTHEW CORRIN

Decision Insight

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Chapter Preview

Management seeks to turn its strategies into action plans. These action plans include financial details that are compiled in a mas- ter budget. The budgeting process serves several purposes, in- cluding motivating employees and communicating with them. The budget process also helps coordinate a company’s activities toward common goals and is useful in evaluating results and

management performance. This chapter explains how to prepare a master budget and use it as a formal plan of a company’s future activities. The ability to prepare this type of plan is of enormous help in starting and operating a company. Such planning gives managers a glimpse into the future, and it can help translate ideas into actions.

Strategic Budgeting Most companies prepare long-term strategic plans spanning 5 to 10 years. They then fine-tune them in preparing medium-term and short-term plans. Strategic plans usually set a company’s long-term direction. They provide a road map for the future about potential opportunities such as new products, markets, and investments. The strategic plan can be inexact, given its long- term focus. Medium- and short-term plans are more operational and translate strategic plans into actions. These action plans are fairly concrete and consist of defined objectives and goals. Short-term financial plans are called budgets and typically cover a one-year period. A budget is a formal statement of a company’s future plans. It is usually expressed in monetary terms because the economic or financial aspects of the business are the primary factors driving man- agement’s decisions. All managers should be involved in budgeting, the process of planning

future business actions and expressing them as formal plans. Man- agers who plan carefully and formalize plans in a budgeting process increase the likelihood of both personal and company success. (Although most firms prepare annual budgets, it is not unusual for organizations to prepare three-year and five-year budgets that are revised at least annually.)

The relevant focus of a budgetary analysis is the future. Manage- ment must focus on future transactions and events and the opportu- nities available. A focus on the future is important because the pressures of daily operating problems often divert management’s attention and take precedence over planning. A good budgeting sys- tem counteracts this tendency by formalizing the planning process and demanding relevant input. Budgeting makes planning an ex- plicit management responsibility.

Benchmarking Budgets The control function requires management to evaluate (benchmark) business operations against some norm. Evaluation involves comparing actual results against one of two usual alternatives: (1) past performance or (2) expected performance.

BUDGET PROCESS

C1 Describe the importance and benefits of budgeting and the process of budget administration.

Budget Administration

• Budget committee • Budget reporting • Budget timing

Budget Process

• Strategic budgeting • Benchmarking budgets • Budgeting and human behavior • Budgeting as a management tool • Budgeting communication

Master Budget

• Master budget components • Operating budgets • Capital expenditures budget • Financial budgets

Master Budgets and Performance Planning

Companies Performing Annual Budgeting

Yes 91% No* 9%

*Most of the 9% have eliminated annual budgeting in favor of rolling or continual budgeting.

848

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Chapter 20 Master Budgets and Performance Planning 849

An evaluation assists management in identifying problems and taking corrective actions if necessary. Evaluation using expected, or budgeted, performance is potentially superior to using past performance to decide whether actual results trigger a need for corrective actions. This is so because past performance fails to consider several changes that can affect current and future activities. Changes in economic conditions, shifts in competitive advantages within the industry, new product developments, increased or decreased advertising, and other factors reduce the usefulness of comparisons with past results. In hi-tech industries, for instance, increasing com- petition, technological advances, and other innovations often reduce the usefulness of perfor- mance comparisons across years. Budgeted performance is computed after careful analysis and research that attempts to an- ticipate and adjust for changes in important company, industry, and economic factors. There- fore, budgets usually provide management an effective control and monitoring system.

Budgeting and Human Behavior Budgeting provides standards for evaluating performance and can affect the attitudes of em- ployees evaluated by them. It can be used to create a positive effect on employees’ attitudes, but it can also create negative effects if not properly applied. Budgeted levels of performance, for instance, must be realistic to avoid discouraging employees. Personnel who will be evaluated should be consulted and involved in preparing the budget to increase their commitment to meet- ing it. Performance evaluations must allow the affected employees to explain the reasons for apparent performance deficiencies. The budgeting process has three important guidelines: (1) Employees affected by a budget should be consulted when it is prepared ( participatory budgeting), (2) goals reflected in a bud- get should be attainable, and (3) evaluations should be made carefully with opportunities to explain any failures. Budgeting can be a positive motivating force when these guidelines are followed. Budgeted performance levels can provide goals for employees to attain or even ex- ceed as they carry out their responsibilities. This is especially important in organizations that consider the annual budget a “sacred” document. Managers must also be aware of potential negative outcomes of budgeting. Under participa- tory budgeting, some employees might understate sales budgets and overstate expense budgets to allow them a cushion, or budgetary slack, to aid in meeting targets. For some businesses, pressure to meet budgeted results might lead employees to engage in unethical behavior or com- mit fraud. Finally, some employees might always spend their budgeted amounts, even on un- necessary items, to ensure their budgets aren’t reduced for the next period.

Point: The practice of involving employees in the budgeting process is known as participatory budgeting.

Budgeting as a Management Tool An important management objective in large companies is to ensure that activities of all depart- ments contribute to meeting the company’s overall goals. This requires coordination. Budgeting helps to achieve this coordination. We describe later in this chapter that a company’s budget, or operating plan, is based on its objectives. This operating plan starts with the sales budget, which drives all other budgets including production, materials, labor, and overhead. The budgeting process coordinates the activities of these various departments to meet the company’s overall goals.

Budgeting Communication Managers of small companies can adequately explain business plans directly to employees through conversations and other informal communications. However, conversations can create uncertainty and confusion if not supported by clear documentation of the plans. A written

Example: Assume a company’s sales force receives a bonus when sales exceed the budgeted amount. How would this arrangement affect the participatory sales forecasts? Answer: Sales reps may understate their budgeted sales.

Budget Staffer Your company’s earnings for the current period will be far below the budgeted amount reported in the press. One of your superiors, who is aware of the upcoming earnings shortfall, has accepted a management position with a competitor. This superior is selling her shares of the company. What are your ethical concerns, if any? ■ [Answer—p. 870]

Decision Ethics

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850 Chapter 20 Master Budgets and Performance Planning

Budget Committee The task of preparing a budget should not be the sole responsibility of any one department. Similarly, the budget should not be simply handed down as top management’s final word. Instead, budget figures and budget estimates developed through a bottom-up process

usually are more useful. This includes, for instance, involv ing the sales department in preparing sales estimates. Likewise, the production department should have initial responsibility for preparing its own expense budget. Without active em- ployee involvement in preparing budget figures, there is a risk these employees will feel that the numbers fail to reflect their special problems and needs.

Most budgets should be developed by a bottom-up pro- cess, but the budgeting system requires central guidance. This guidance is supplied by a budget committee of depart- ment heads and other executives responsible for seeing that budgeted amounts are realistic and coordinated. If a de-

partment submits initial budget figures not reflecting efficient performance, the budget com- mittee should return them with explanatory comments on how to improve them. Then the originating department must either adjust its proposals or explain why they are acceptable. Communication between the originating department and the budget committee should con- tinue as needed to ensure that both parties accept the budget as reasonable, attainable, and desirable. The concept of continuous improvement applies to budgeting as well as production. For example, one of the world’s largest energy companies streamlined its monthly budget report from a one-inch-thick stack of monthly control reports to a tidy, two-page flash report on monthly earnings and key production statistics. The key to this efficiency gain was the integra- tion of new budgeting and cost allocation processes with its strategic planning process. Its con- troller explained the new role of the finance department with respect to the budgetary control process as follows: “there’s less of an attitude that finance’s job is to control. People really have come to see that our job is to help attain business objectives.”

Budget Reporting The budget period usually coincides with the accounting period. Most companies prepare at least an annual budget, which reflects the objectives for the next year. To provide specific guidance, the annual budget usually is separated into quarterly or monthly budgets. These short- term budgets allow management to periodically evaluate performance and take needed correc- tive action. Managers can compare actual results to budgeted amounts in a report such as that shown in Exhibit 20.1. This report shows actual amounts, budgeted amounts, and their differences. A dif- ference is called a variance. Management examines variances, particularly large ones, to identify areas for improvement and corrective action.

BUDGET ADMINISTRATION

Point: In a large company, developing a budget through a bottom-up process can involve hundreds of employees and take several weeks to finalize.

HOCKEY DEN Cash Budget

October 2013–December 2013

October November December

Beginning cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 20,000 $ 22,272

Cash receipts from customers (Exhibit 22.12) . . . . . . . . . 82,000 92,000 104,000

Total cash available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,000 112,000 126,272

Cash disbursements

Payments for merchandise (Exhibit 22.13) . . . . . . . . . . 58,200 49,200 80,400

Sales commissions (Exhibit 22.9) . . . . . . . . . . . . . . . . . 10,000 8,000 14,000

Salaries

Sales (Exhibit 22.9) . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000 2,000

Administrative (Exhibit 22.10) . . . . . . . . . . . . . . . . . . 4,500 4,500 4,500

Income taxes payable (Exhibit 22.5) . . . . . . . . . . . . . . . 20,000

Dividends ($150,000 3 2%) . . . . . . . . . . . . . . . . . . . . . 3,000

Interest on bank loan

000,01$( rebotcO 3 1%)* . . . . . . . . . . . . . . . . . . . . 100

008,22$( rebmevoN 3 1%) . . . . . . . . . . . . . . . . . . . 228

Purchase of equipment . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Total cash disbursements . . . . . . . . . . . . . . . . . . . . . . . . 94,800 66,928 125,900

Preliminary cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,200 $ 45,072 $ 372

Loan activity

Additional loan from bank . . . . . . . . . . . . . . . . . . . . . . . . . 12,800 19,628

Repayment of loan to bank . . . . . . . . . . . . . . . . . . . . . . . . 22,800

Ending cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 22,272 $ 20,000

Loan balance, end of month . . . . . . . . . . . . . . . . . . . . . . . $ 22,800 $ 0 $ 19,628

* Beginning loan balance from Exhibit 22.5

budget is preferred and can inform employees in all types of organizations about management’s plans. The budget can also communicate management’s specific action plans for the employees in the budget period.

Budgets Exposed When companies go public and their securities trade on an organized stock exchange, management usually develops specific future plans and budgets. For this purpose, companies often develop detailed six- to twelve-month budgets and less-detailed budgets spanning two to five years. ■

Decision Insight

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Chapter 20 Master Budgets and Performance Planning 851

Budget Timing The time period required for the annual budgeting process can vary considerably. For example, budgeting for 2014 can begin as early as January 2013 or as late as December 2013. Large, complex or- ganizations usually require a longer time to prepare their budgets than do smaller organizations. This is so because considerable ef- fort is required to coordinate the different units (departments) within large organizations.

Many companies apply continuous budgeting by preparing rolling budgets. As each monthly or quarterly budget period goes by, these companies revise their entire set of bud gets for the months or quarters remaining and add new monthly or quarterly budgets to replace the ones that have lapsed. At any point in time, monthly or quarterly budgets are available for the next 12 months or four quarters. Exhibit 20.2 shows rolling budgets prepared at the end of five consecutive

Companies Using Rolling Budgets

No 55% Yes 45%

EXHIBIT 20.1 Comparing Actual Performance with Budgeted Performance

ECCENTRIC MUSIC Income Statement with Variances from Budget

For Month Ended April 30, 2013

Actual Budget Variance

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,500 $57,150 $13,350

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,350 39,100 12,250

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,150 18,050 11,100

Operating expenses

Selling expenses

Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,250 6,000 1250

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 800 1100

Store supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 500 150

Depreciation — Store equipment . . . . . . . . . . . . . . . . 1,600 1,600

Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 9,300 8,900 1400

General and administrative expenses

Office salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000

Office supplies used . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 150 115

Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100 1,100

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 200

Depreciation — Office equipment . . . . . . . . . . . . . . . . 100 100

Total general and administrative expenses . . . . . . . . . 3,565 3,550 115

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 12,865 12,450 1415

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,285 $ 5,600 $ 1685

Example: Assume that you must explain variances to top management. Which variances in Exhibit 20.1 would you research and why? Answer: Sales and cost of goods sold — due to their large variances.

EXHIBIT 20.2 Rolling Budgets

2013 2014 Calendar Years and Quarters

B u

d g

e t

P re

p a

ra ti

o n

D a

te

December 2012

March 2013

June 2013

September 2013

December 2013

First

Quarter

Third

Quarter

Fourth

Quarter

First

Quarter

Second

Quarter

Second

Quarter

Third

Quarter

Fourth

Quarter

Second

Quarter

Third

Quarter

Fourth

Quarter

First

Quarter

First

Quarter

Second

Quarter

Third

Quarter

Fourth

Quarter

Fourth

Quarter

First

Quarter

Second

Quarter

Third

Quarter

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852 Chapter 20 Master Budgets and Performance Planning

periods. The first set (at top) is prepared in December 2012 and covers the four calendar quar- ters of 2013. In March 2013, the company prepares another rolling budget for the next four quarters through March 2014. This same process is repeated every three months. As a result, management is continuously planning ahead. Exhibit 20.2 reflects an annual budget composed of four quarters prepared four times per year using the most recent information available. For example, the budget for the fourth quarter of 2013 is prepared in December 2012 and revised in March, June, and September of 2013. When continuous budgeting is not used, the fourth-quarter budget is nine months old and perhaps out of date when applied.

June AUGUSTMarch

Normal monitoring of budgeted activities.

Prepare final budget. Present to board of directors.

July Departments provide

budgeted sales, spending, and operating

August Assist with

budget requests.

Negotiate final budgeted amounts with departments.

September Input, analyze, and

summarize data.

1. What are the major benefits of budgeting? 2. What is the main responsibility of the budget committee? 3. What is the usual time period covered by a budget? 4. What are rolling budgets?

Quick Check Answers — p. 870

A master budget is a formal, comprehensive plan for a company’s future. It contains several individual budgets that are linked with each other to form a coordinated plan.

Master Budget Components The master budget typically includes individual budgets for sales, purchases, production, various expenses, capital expenditures, and cash. Managers often express the expected finan- cial results of these planned activities with both a budgeted income statement for the budget period and a budgeted balance sheet for the end of the budget period. The usual number and types of budgets included in a master budget depend on the company’s size and complexity. A master budget should include, at a minimum, the budgets listed in Exhibit 20.3. In addition to these individual budgets, managers often include supporting calculations and additional tables with the master budget. Some budgets require the input of other budgets. For example, the merchandise purchases budget cannot be prepared until the sales budget has been prepared because the number of units

MASTER BUDGET

C2 Describe a master budget and the process of preparing it.

Budget Calendar Many companies use long-range operating budgets. For large companies, three groups usually deter- mine or influence the budgets: creditors, directors, and management. All three are interested in the companies’ future cash flows and earnings. The annual budget process often begins six months or more before the budget is due to the board of directors. A typical budget calendar, shown here, provides insight into the budget process during a typical calendar year. ■

Decision Insight

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Chapter 20 Master Budgets and Performance Planning 853

to be purchased depends on how many units are expected to be sold. As a result, we often must sequentially prepare budgets within the master budget. A typical sequence for a master budget consists of the five steps in Exhibit 20.4. Any stage in this budgeting process might reveal undesirable outcomes, so changes often must be made to prior budgets by repeating the previous steps. For instance, an early version of the cash budget could show an insufficient amount of cash unless cash outlays are reduced. This could yield a reduction in planned equipment purchases. A preliminary budgeted balance sheet could also reveal too much debt from an ambitious capital expenditures budget. Findings such as these often result in revised plans and budgets.

Operating budgets ● Sales budget ● For merchandisers add: Merchandise purchases budget (units to be purchased) ● For manufacturers add: Production budget (units to be produced)

Manufacturing budget (manufacturing costs) ● Selling expense budget ● General and administrative expense budget Capital expenditures budget (expenditures for plant assets) Financial budgets ● Cash budget (cash receipts and disbursements) ● Budgeted income statement ● Budgeted balance sheet

EXHIBIT 20.3 Basic Components of a Master Budget

EXHIBIT 20.4 Master Budget Sequence

Develop production

or purchases budget

Prepare sales

budget

Operating Budgets

Prepare manufacturing,

selling, and general and administrative expense budgets

Consolidate operating and capital expenditures budgets into financial budgets:

Cash budget Budgeted income statement Budgeted balance sheet

• •

Financial Budgets

Sta tem

ent Sta

tem entStat

eme nt

Stat eme

ntHOCKEY DENCash BudgetOctober 2013–December 2013 October November DecemberBeginning cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 20,000 $ 22,272Cash receipts from customers (Exhibit 22.12) . . . . . . . . . 82,000 92,000 104,000Total cash available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,000 112,000 126,272Cash disbursements Payments for merchandise (Exhibit 22.13) . . . . . . . . . . 58,200 49,200 80,400 Sales commissions (Exhibit 22.9) . . . . . . . . . . . . . . . . . 10,000 8,000 14,000 Salaries Sales (Exhibit 22.9) . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000 2,000

Administrative (Exhibit 22.10) . . . . . . . . . . . . . . . . . . 4,500 4,500 4,500

Income taxes payable (Exhibit 22.5) . . . . . . . . . . . . . . . 20,000

Dividends ($150,000 3 2%) . . . . . . . . . . . . . . . . . . . . . 3,000

Interest on bank loan

000,01$( rebotcO 3 1%)* . . . . . . . . . . . . . . . . . . . . 100

008,22$( rebmevoN 3 1%) . . . . . . . . . . . . . . . . . . . 228

Purchase of equipment . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Total cash disbursements . . . . . . . . . . . . . . . . . . . . . . . . 94,800 66,928 125,900

Preliminary cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,200 $ 45,072 $ 372

Loan activity

Additional loan from bank . . . . . . . . . . . . . . . . . . . . . . . . . 12,800 19,628

Repayment of loan to bank . . . . . . . . . . . . . . . . . . . . . . . . 22,800

Ending cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 22,272 $ 20,000

Loan balance, end of month . . . . . . . . . . . . . . . . . . . . . . . $ 22,800 $ 0 $ 19,628

* Beginning loan balance from Exhibit 22.5

Prepare capital

expenditures budget

Capital Expenditures Budget

The remainder of this section explains how Hockey Den (HD), a retailer of youth hockey sticks, prepares its master budget. Its master budget includes operating, capital expenditures, and cash budgets for each month in each quarter. It also includes a budgeted income statement for each quarter and a budgeted balance sheet as of the last day of each quarter. We show how HD prepares budgets for October, November, and December 2013. Exhibit 20.5 presents HD’s balance sheet at the start of this budgeting period, which we often refer to as we prepare the component budgets.

Incentive Pay Budgets are important in determining managers’ pay. A recent survey shows that 82% of large companies tie managers’ bonus payments to beating budget goals. For these companies, bonus pay- ments are frequently more than 20% of total manager pay. ■

Decision Insight

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854 Chapter 20 Master Budgets and Performance Planning

EXHIBIT 20.5 Balance Sheet Prior to the Budgeting Periods

HOCKEY DEN Balance Sheet

September 30, 2013

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000

Inventory (900 units @ $60) . . . . . . . . . . . . . . . . . . . 54,000

Equipment* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000

Less accumulated depreciation . . . . . . . . . . . . . . . . . 36,000 164,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000

Liabilities and Equity

Liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,200

Income taxes payable (due 10/31/2013) . . . . . . . . 20,000

Note payable to bank . . . . . . . . . . . . . . . . . . . . . . . 10,000 $ 88,200

Stockholders’ equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 41,800 191,800

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . $280,000

* Equipment is depreciated on a straight-line basis over 10 years (salvage value is $20,000).

Operating Budgets This section explains HD’s preparation of operating budgets. Its operating budgets consist of the sales budget, merchandise purchases budget, selling expense budget, and general and ad- ministrative expense budget. HD does not prepare production and manufacturing budgets because it is a merchandiser. (The preparation of production budgets and manufacturing budgets is described in Appendix 20A.)

Sales Budget The first step in preparing the master budget is planning the sales budget, which shows the planned sales units and the expected dollars from these sales. The sales budget is the starting point in the budgeting process because plans for most departments are linked to sales.

The sales budget should emerge from a careful analysis of forecasted economic and market conditions, business capacity, proposed selling expenses (such as advertising), and predictions of unit sales. A company’s sales personnel are usually asked to develop predictions of sales for each territory and department because people normally feel a greater commitment to goals they help set. Another advantage to this participatory budgeting approach is that it draws on knowl- edge and experience of people involved in the activity. To illustrate, in September 2013, HD sold 700 hockey sticks at $100 per unit. After considering sales predictions and market conditions, HD prepares its sales budget for the next quarter (three months) plus one extra month (see Exhibit 20.6). The sales budget includes

P1 Prepare each component of a master budget and link each to the budgeting process.

HOCKEY DEN Monthly Sales Budget

October 2013 – January 2014

Budgeted Budgeted Budgeted Unit Sales Unit Price Total Sales

September 2013 (actual) . . . . . . . . . 700 $100 $ 70,000

October 2013 . . . . . . . . . . . . . . . . . 1,000 $100 $100,000

November 2013 . . . . . . . . . . . . . . . . 800 100 80,000

December 2013 . . . . . . . . . . . . . . . . 1,400 100 140,000

Totals for the quarter . . . . . . . . . . . 3,200 100 $320,000

January 2014 . . . . . . . . . . . . . . . . . . 900 100 $ 90,000

EXHIBIT 20.6 Sales Budget for Planned Unit and Dollar Sales

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Chapter 20 Master Budgets and Performance Planning 855

January 2014 because the purchasing department relies on estimated January sales to decide on December 2013 inventory purchases. The sales budget in Exhibit 20.6 includes forecasts of both unit sales and unit prices. Some sales budgets are expressed only in total sales dollars, but most are more detailed. Management finds it useful to know budgeted units and unit prices for many different products, regions, departments, and sales representatives.

EXHIBIT 20.7 General Formula for a Merchandise Purchases Budget

Budgeted ending

inventory

Budgeted cost of sales for the period

Budgeted beginning inventory

Inventory to be

purchased 5 1 2

Merchandise Purchases Budget Companies use various methods to help managers make inventory purchasing decisions. These methods recognize that the number of units added to inventory depends on budgeted sales volume. Whether a company manufactures or purchases the product it sells, budgeted future sales volume is the primary factor in most inventory man- agement decisions. A company must also consider its inven tory system and other factors that we discuss next.

Just-in-time inventory systems. Managers of just-in-time (JIT) inventory systems use sales budgets for short periods (often as few as one or two days) to order just enough merchandise or materials to satisfy the immediate sales demand. This keeps the amount of inventory to a mini- mum (or zero in an ideal situation). A JIT system minimizes the costs of maintaining inventory, but it is practical only if customers are content to order in advance or if managers can accurately determine short-term sales demand. Suppliers also must be able and willing to ship small quan- tities regularly and promptly.

Safety stock inventory systems. Market conditions and manufacturing processes for some products do not allow use of a just-in-time system. Companies in these cases maintain sufficient inventory to reduce the risk and cost of running short. This practice requires enough purchases to satisfy the budgeted sales amounts and to maintain a safety stock, a quantity of inventory that provides protection against lost sales caused by unfulfilled demands from customers or delays in shipments from suppliers.

Merchandise purchases budget preparation. A merchandiser usually expresses a mer- chandise purchases budget in both units and dollars. Exhibit 20.7 shows the general layout for this budget in equation form. If this formula is expressed in units and only one product is in- volved, we can compute the number of dollars of inventory to be purchased for the budget by multiplying the units to be purchased by the cost per unit.

Point: Accurate estimates of future sales are crucial in a JIT system.

To illustrate, after assessing the cost of keeping inventory along with the risk and cost of in- ventory shortages, HD decided that the number of units in its inventory at each month-end should equal 90% of next month’s predicted sales. For example, inventory at the end of October should equal 90% of budgeted November sales, and the November ending inventory should equal 90% of budgeted December sales, and so on. Also, HD’s suppliers expect the September 2013 per unit cost of $60 to remain unchanged through January 2014. This information along with knowledge of 900 units in inventory at September 30 (see Exhibit 20.5) allows the com- pany to prepare the merchandise purchases budget shown in Exhibit 20.8. The first three lines of HD’s merchandise purchases budget determine the required ending inventories (in units). Budgeted unit sales are then added to the desired ending inventory to give the required units of available merchandise. We then subtract beginning inventory to

Example: Assume Hockey Den adopts a JIT system in purchasing merchandise. How will its sales budget differ from its merchandise purchases budget? Answer: The two budgets will be similar because future inventory should be near zero.

Entrepreneur You run a start-up that manufactures designer clothes. Business is seasonal, and fash- ions and designs quickly change. How do you prepare reliable annual sales budgets? ■ [Answer—p. 870]

Decision Maker

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856 Chapter 20 Master Budgets and Performance Planning

EXHIBIT 20.8 Merchandise Purchases Budget

HOCKEY DEN Merchandise Purchases Budget October 2013 – December 2013

October November December

Next month’s budgeted sales (units) . . . . . . . . . . . . 800 1,400 900

Ratio of inventory to future sales . . . . . . . . . . . . . . . 3 90% 3 90% 3 90%

Budgeted ending inventory (units) . . . . . . . . . . . . . . 720 1,260 810

Add budgeted sales (units) . . . . . . . . . . . . . . . . . . . . 1,000 800 1,400

Required units of available merchandise . . . . . . . . . . 1,720 2,060 2,210

Deduct beginning inventory (units) . . . . . . . . . . . . . 900 720 1,260

Units to be purchased . . . . . . . . . . . . . . . . . . . . . . . . 820 1,340 950

Budgeted cost per unit . . . . . . . . . . . . . . . . . . . . . . . $ 60 $ 60 $ 60

Budgeted cost of merchandise purchases . . . . . . . . . $49,200 $80,400 $57,000

Example: If ending inventory in Exhibit 20.8 is required to equal 80% of next month’s predicted sales, how many units must be purchased each month? Answer: Budgeted ending inventory: Oct. 5 640 units; Nov. 5 1,120 units; Dec. 5 720 units. Required purchases: Oct. 5 740 units; Nov. 5 1,280 units; Dec. 5 1,000 units.

determine the budgeted number of units to be purchased. The last line is the budgeted cost of the purchases, computed by multiplying the number of units to be purchased by the predicted cost per unit. We already indicated that some budgeting systems describe only the total dollars of bud- geted sales. Likewise, a system can express a merchandise purchases budget only in terms of the total cost of merchandise to be purchased, omitting the number of units to be purchased. This method assumes a constant relation between sales and cost of goods sold. HD, for in- stance, might assume the expected cost of goods sold to be 60% of sales, computed from the budgeted unit cost of $60 and the budgeted sales price of $100. However, it still must consider the effects of changes in beginning and ending inventories in determining the amounts to be purchased.

Selling Expense Budget The selling expense budget is a plan listing the types and amounts of selling expenses expected during the budget period. Its initial responsibility usually rests with the vice president of marketing or an equivalent sales manager. The selling expense budget is normally created to provide sufficient selling expenses to meet sales goals reflected in the sales budget. Predicted selling expenses are based on both the sales budget and the experi- ence of previous periods. After some or all of the master budget is prepared, management might decide that projected sales volume is inadequate. If so, subsequent adjustments in the sales bud- get can require corresponding adjustments in the selling expense budget.

To illustrate, HD’s selling expense budget is in Exhibit 20.9. The firm’s selling expenses consist of commissions paid to sales personnel and a $2,000 monthly salary paid to the sales manager. Sales commissions equal 10% of total sales and are paid in the month sales occur. Sales commissions are variable with respect to sales volume, but the sales manager’s salary is fixed. No advertising expenses are budgeted for this particular quarter.

Example: If sales commissions in Exhibit 20.9 are increased, which budgets are affected? Answer: Selling expenses budget, cash budget, and budgeted income statement.

EXHIBIT 20.9 Selling Expense Budget

HOCKEY DEN Selling Expense Budget

October 2013–December 2013

October November December Totals

Budgeted sales . . . . . . . . . . . . . . . . . $100,000 $80,000 $140,000 $320,000

Sales commission percent . . . . . . . . 3 10% 3 10% 3 10% 3 10%

Sales commissions . . . . . . . . . . . . . . 10,000 8,000 14,000 32,000

Salary for sales manager . . . . . . . . . 2,000 2,000 2,000 6,000

Total selling expenses . . . . . . . . . . . $ 12,000 $10,000 $ 16,000 $ 38,000

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Chapter 20 Master Budgets and Performance Planning 857

EXHIBIT 20.10 General and Administrative Expense Budget

HOCKEY DEN General and Administrative Expense Budget

October 2013–December 2013

October November December Totals

Administrative salaries . . . . . . . . . . . . . . . . . . . . . . . . . $4,500 $4,500 $4,500 $13,500

Depreciation of equipment . . . . . . . . . . . . . . . . . . . . . 1,500 1,500 1,500 4,500

Total general and administrative expenses . . . . . . . . . $6,000 $6,000 $6,000 $18,000

Example: In Exhibit 20.10, how would a rental agreement of $5,000 per month plus 1% of sales affect the general and administrative expense budget? (Budgeted sales are in Exhibit 20.6.) Answer: Rent expense: Oct. 5 $6,000; Nov. 5 $5,800; Dec. 5 $6,400; Total 5 $18,200; Revised total general and administrative expenses: Oct. 5 $12,000; Nov. 5 $11,800; Dec. 5 $12,400; Total 5 $36,200.

General and Administrative Expense Budget The general and administrative expense budget plans the predicted operating expenses not included in the selling expenses budget. General and administrative expenses can be either variable or fixed with respect to sales volume. The office manager responsible for general administration often is responsible for preparing the initial general and administrative expense budget. Exhibit 20.10 shows HD’s general and administrative expense budget. It includes salaries of $54,000 per year, or $4,500 per month (paid each month when they are earned). Using information in Exhibit 20.5, the depreciation on equipment is computed as $18,000 per year [($200,000 2 $20,000)y10 years], or $1,500 per month ($18,000y12 months).

5. What is a master budget? 6. A master budget (a) always includes a manufacturing budget specifying the units to be

produced; (b) is prepared with a process starting with the operating budgets and continues with the capital expenditures budget and then financial budgets; or (c) is prepared with a process ending with the sales budget.

7. What are the three primary categories of budgets in the master budget? 8. In preparing monthly budgets for the third quarter, a company budgeted sales of 120 units for

July and 140 units for August. Management wants each month’s ending inventory to be 60% of next month’s sales. The June 30 inventory consists of 50 units. How many units of product for July acquisition should the merchandise purchases budget specify for the third quarter? (a) 84, (b) 120, (c) 154, or (d ) 204.

9. How do the operating budgets for merchandisers and manufacturers differ? 10. How does a just-in-time inventory system differ from a safety stock system?

Quick Check Answers — p. 870

Interest expense and income tax expense are often classified as general and administrative expenses in published income statements but normally cannot be planned at this stage of the budgeting process. The prediction of interest expense follows the preparation of the cash budget and the decisions regarding debt. The predicted income tax expense depends on the budgeted amount of pretax income. Both interest and income taxes are usually beyond the control of the office manager. As a result, they are not used in comparison to the budget to evaluate that person’s performance.

No Biz Like Snow Biz Ski resorts’ costs of making snow are in the millions of dollars for equipment alone. Snowmaking involves spraying droplets of water into the air, causing them to freeze and come down as snow. Making snow can cost more than $2,000 an hour. Snowmaking accounts for 40 to 50 percent of the operating budgets for many ski resorts. ■

Decision Insight

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858 Chapter 20 Master Budgets and Performance Planning

Capital Expenditures Budget The capital expenditures budget lists dollar amounts to be both received from plant asset disposals and spent to purchase additional plant assets to carry out the budgeted business activities. It is usually prepared after the operating budgets. Since a company’s plant assets determine its productive capacity, this budget is usually affected by long-range plans for the business. Yet the process of preparing a sales or purchases budget can reveal that the company requires more (or less) capacity, which implies more (or less) plant assets. Capital budgeting is the process of evaluating and planning for capital (plant asset) expenditures. This is an important management task because these expenditures often involve long-run commit- ments of large amounts, affect predicted cash flows, and impact future debt and equity financing. This means that the capital expenditures budget is often linked with management’s evaluation of the company’s ability to take on more debt. We describe capital budgeting in Chapter 24. Hockey Den does not anticipate disposal of any plant assets through December 2013, but it does plan to acquire additional equipment for $25,000 cash near the end of December 2013. This is the only budgeted capital expenditure from October 2013 through January 2014. Thus, no sepa- rate budget is shown. Hockey Den’s cash budget will reflect this $25,000 planned expenditure.

Financial Budgets After preparing its operating and capital expenditures budgets, a company uses information from these budgets to prepare at least three financial budgets: the cash budget, budgeted income statement, and budgeted balance sheet.

Cash Budget After developing budgets for sales, merchandise purchases, expenses, and capital expenditures, the next step is to prepare the cash budget, which shows expected cash in- flows and outflows during the budget period. It is especially important to maintain a cash balance necessary to meet ongoing obligations. By preparing a cash budget, management can prearrange loans to cover anticipated cash shortages before they are needed. A cash budget also helps man- agement avoid a cash balance that is too large. Too much cash is undesirable because it earns a relatively low (if any) return. Exhibit 20.11 shows the general formula for the cash budget.

Budgeted cash

receipts

Budgeted cash

disbursements

Preliminary cash

balance

Repay loans, buy securities

Loan Activity

Adequate

Too low

Increase short-term

loans

Beginning cash

balance 1 2 5

EXHIBIT 20.11 General Formula for Cash Budget

When preparing a cash budget, we add expected cash receipts to the beginning cash balance and deduct expected cash disbursements. If the expected (preliminary) ending cash balance is too low, additional cash requirements appear in the budget as planned increases from short-term loans. If the expected ending cash balance exceeds the desired balance, the excess is used to repay loans or to acquire short-term investments. Information for preparing the cash budget is mainly taken from the operating and capital expenditures budgets.

Cash Receipts from Sales To illustrate, Exhibit 20.12 presents HD’s budgeted cash receipts.

P2 Link both operating and capital expenditures budgets to budgeted financial statements.

EXHIBIT 20.12 Computing Budgeted Cash Receipts

September October November December

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70,000 $100,000 $80,000 $140,000

Less ending accounts receivable (60%) . . . . . . . . . . 42,000 60,000 48,000 84,000

Cash receipts from

Cash sales (40% of sales) . . . . . . . . . . . . . . . . . . . 40,000 32,000 56,000

Collections of prior month’s receivables . . . . . . 42,000 60,000 48,000

Total cash receipts . . . . . . . . . . . . . . . . . . . . . . . . $ 82,000 $92,000 $104,000

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Chapter 20 Master Budgets and Performance Planning 859

We begin with reference to HD’s budgeted sales (Exhibit 20.6). Analysis of past sales indi- cates that 40% of the firm’s sales are for cash. The remaining 60% are credit sales; these cus- tomers are expected to pay in full in the month following the sales. We now can compute the budgeted cash receipts from customers as shown in Exhibit 20.12. October’s budgeted cash re- ceipts consist of $40,000 from expected cash sales ($100,000 3 40%) plus the anticipated col- lection of $42,000 of accounts receivable from the end of September.

Cash Disbursements for Merchandise Next, we see that HD’s merchandise purchases are entirely on account. It makes full payment during the month following its purchases. Therefore, cash disbursements for purchases can be computed from the September 30, 2013, balance sheet (Exhibit 20.5), for October disbursements, and the merchandise purchases budget (Exhibit 20.8), for November and December disbursements. This is shown in Exhibit 20.13.

The schedule above can be modified for alternative payment timing. For example, if Hockey Den paid for 20% of its purchases in the month of purchase, and paid the remaining 80% of a month’s purchases in the following month, its cash disbursements in December would equal $75,720, computed as (20% 3 $57,000) plus (80% 3 $80,400). Exhibit 20.14 shows the full cash budget for Hockey Den, beginning with information on bud- geted cash receipts from Exhibit 20.13 and budgeted cash purchases for merchandise from Exhibit 20.13. Next we discuss HD’s other cash disbursements and loan activity on its cash budget.

EXHIBIT 20.13 Computing Cash Disbursements for Purchases

October November December

Purchases (from Exhibit 20.8) . . . . . . . . . . . . . . . . $49,200 $80,400 $57,000

Cash disbursements for

Current month purchases (0%) . . . . . . . . . . . . . 0 0 0

Prior month purchases (100%) . . . . . . . . . . . . . 58,200* 49,200 80,400

Total cash disbursements for purchases . . . . . . $58,200 $49,200 $80,400

*From September 30 balance sheet (Exhibit 20.5)

EXHIBIT 20.14 Cash Budget

HOCKEY DEN Cash Budget

October 2013–December 2013

October November December

Beginning cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 20,000 $ 22,272

Cash receipts from customers (Exhibit 20.12) . . . . . . . . . 82,000 92,000 104,000

Total cash available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,000 112,000 126,272

Cash disbursements

Payments for merchandise (Exhibit 20.13) . . . . . . . . . . 58,200 49,200 80,400

Sales commissions (Exhibit 20.9) . . . . . . . . . . . . . . . . . 10,000 8,000 14,000

Salaries

Sales (Exhibit 20.9) . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000 2,000

Administrative (Exhibit 20.10) . . . . . . . . . . . . . . . . . . 4,500 4,500 4,500

Income taxes payable (Exhibit 20.5) . . . . . . . . . . . . . . . 20,000

Dividends ($150,000 3 2%) . . . . . . . . . . . . . . . . . . . . . 3,000

Interest on bank loan

October ($10,000 3 1%)* . . . . . . . . . . . . . . . . . . . . 100

November ($22,800 3 1%) . . . . . . . . . . . . . . . . . . . 228

Purchase of equipment . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Total cash disbursements . . . . . . . . . . . . . . . . . . . . . . . . 94,800 66,928 125,900

Preliminary cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,200 $ 45,072 $ 372

Loan activity

Additional loan from bank . . . . . . . . . . . . . . . . . . . . . . . . . 12,800 19,628

Repayment of loan to bank . . . . . . . . . . . . . . . . . . . . . . . . 22,800

Ending cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 22,272 $ 20,000

Loan balance, end of month . . . . . . . . . . . . . . . . . . . . . . . $ 22,800 $ 0 $ 19,628

Example: If the minimum ending cash balance in Exhibit 20.14 is changed to $25,000 for each month, what is the pro- jected loan balance at Dec. 31, 2013? Answer: Loan balance, Oct. 31. . . . . . . $27,800 November interest . . . . . . . . 278 November payment . . . . . . . . 25,022 Loan balance, Nov. 30 . . . . . . 2,778 December interest . . . . . . . . 28 Additional loan in Dec. . . . . . 21,928 Loan balance, Dec. 31. . . . . . . $24,706

* Beginning loan balance from Exhibit 20.5

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860 Chapter 20 Master Budgets and Performance Planning

The monthly budgeted cash disbursements for sales commissions and salaries are taken from the selling expense budget (Exhibit 20.9) and the general and administrative expense budget (Exhibit 20.10). The cash budget is unaffected by depreciation as reported in the general and administrative expenses budget.

Cash Disbursements for Other Items Income taxes are due and payable in October as shown in the September 30, 2013, balance sheet (Exhibit 20.5). The cash budget in Exhibit 20.14 shows this $20,000 expected payment in October. Predicted income tax expense for the quarter ending December 31 is 40% of net income and is due in January 2014. It is therefore not reported in the October – December 2013 cash budget but in the budgeted income statement as income tax ex- pense and on the budgeted balance sheet as income tax liability. Hockey Den also pays a cash dividend equal to 2% of the par value of common stock in the second month of each quarter. The cash budget in Exhibit 20.14 shows a November payment of $3,000 for this purpose (2% of $150,000; see Exhibit 20.5).

Loan Activity Analyzing Hockey Den’s loan activity is necessary in computing its budgeted cash disbursements for interest. Hockey Den has an agreement with its bank that promises ad- ditional loans at each month-end, if necessary, to keep a minimum cash balance of $20,000. If the cash balance exceeds $20,000 at a month-end, HD uses the excess to repay loans. Interest is paid at each month-end at the rate of 1% of the beginning balance of these loans. For October, this payment is 1% of the $10,000 amount reported in the balance sheet of Exhibit 20.5. For November, HD expects to pay interest of $228, computed as 1% of the $22,800 expected loan balance at October 31. No interest is budgeted for December because the company expects to repay the loans in full at the end of November. Exhibit 20.14 shows that the October 31 cash balance declines to $7,200 (before any loan- related activity). This amount is less than the $20,000 minimum. Hockey Den will bring this balance up to the minimum by borrowing $12,800 with a short-term note. At the end of November, the budget shows an expected cash balance of $45,072 before any loan activity. This means that HD expects to repay $22,800 of debt. The equipment purchase budgeted for December reduces the expected cash balance to $372, far below the $20,000 minimum. The company expects to borrow $19,628 in that month to reach the minimum desired ending balance.

Budgeted Income Statement One of the final steps in preparing the master budget is to summarize the income effects. The budgeted income statement is a managerial accounting report showing predicted amounts of sales and expenses for the budget period. Information needed for preparing a budgeted income statement is primar ily taken from already prepared budgets. The volume of information summarized in the budgeted income statement is so large for some companies that they often use spreadsheets to accumulate the budgeted transactions and classify them by their effects on income. We condense HD’s budgeted income statement and show it in Exhibit 20.15. All information in this exhibit is taken from earlier budgets. Also, we now can predict the amount of income tax expense for the quarter, computed as 40% of the budgeted pretax income. This amount is included in the cash budget and/or the budgeted bal- ance sheet as necessary.

Budgeted Balance Sheet The final step in preparing the master budget is sum marizing the company’s financial position. The budgeted balance sheet shows predicted amounts for the

Point: Lenders often require potential borrowers to provide cash budgets, bud- geted income statements, and budgeted balance sheets, as well as data on past performance.

Cash Cushion Why do some companies maintain a minimum cash balance when the budget shows extra cash is not needed? For example, iPhone sales have pushed Apple’s cash and investments balance to over $97 billion. For Apple’s CEO Tim Cook the cushion provides “flexibility and security,” important in navigating uncertain economic times. ■

Decision Insight

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Chapter 20 Master Budgets and Performance Planning 861

1 An eight-column spreadsheet, or work sheet, can be used to prepare a budgeted balance sheet (and income state ment). The first two columns show the ending balance sheet amounts from the period prior to the budget period. The budgeted transactions and adjustments are entered in the third and fourth columns in the same manner as adjustments are entered on an ordinary work sheet. After all budgeted transactions and adjustments have been entered, the amounts in the first two columns are combined with the budget amounts in the third and fourth columns and sorted to the proper Income Statement (fifth and sixth columns) and Balance Sheet columns (seventh and eighth columns). Amounts in these col- umns are used to prepare the budgeted income statement and balance sheet.

company’s assets, liabilities, and equity as of the end of the budget period. HD’s budgeted bal- ance sheet in Exhibit 20.16 is prepared using information from the other budgets. The sources of amounts are reported in the notes to the budgeted balance sheet.1

HOCKEY DEN Budgeted Income Statement

For Three Months Ended December 31, 2013

Sales (Exhibit 20.6, 3,200 units @ $100) . . . . . . . . . . . . . $320,000 Cost of goods sold (3,200 units @ $60) . . . . . . . . . . . . . 192,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,000 Operating expenses Sales commissions (Exhibit 20.9) . . . . . . . . . . . . . . . . . $32,000 Sales salaries (Exhibit 20.9) . . . . . . . . . . . . . . . . . . . . . . 6,000 Administrative salaries (Exhibit 20.10) . . . . . . . . . . . . . 13,500 Depreciation on equipment (Exhibit 20.10) . . . . . . . . . 4,500 Interest expense (Exhibit 20.14) . . . . . . . . . . . . . . . . . 328 56,328 Income before income taxes . . . . . . . . . . . . . . . . . . . . . . 71,672 Income tax expense ($71,672 3 40%) . . . . . . . . . . . . . . . 28,669 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 43,003

EXHIBIT 20.15 Budgeted Income Statement

EXHIBIT 20.16 Budgeted Balance Sheet

HOCKEY DEN Budgeted Balance Sheet

December 31, 2013

Assets

Casha . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 Accounts receivableb . . . . . . . . . . . . . . . . . 84,000 Inventoryc . . . . . . . . . . . . . . . . . . . . . . . . . . 48,600 Equipmentd . . . . . . . . . . . . . . . . . . . . . . . . . $225,000 Less accumulated depreciatione . . . . . . . . . 40,500 184,500 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $337,100

Liabilities and Equity

Liabilities Accounts payablef . . . . . . . . . . . . . . . . . . $ 57,000 Income taxes payableg . . . . . . . . . . . . . . 28,669 Bank loan payableh . . . . . . . . . . . . . . . . . 19,628 $105,297 Stockholders’ equity Common stocki . . . . . . . . . . . . . . . . . . . 150,000 Retained earningsj . . . . . . . . . . . . . . . . . 81,803 231,803 Total liabilities and equity . . . . . . . . . . . . . . $337,100

a Ending balance for December from the cash budget in Exhibit 20.14. b 60% of $140,000 sales budgeted for December from the sales budget in Exhibit 20.6. c 810 units in budgeted December ending inventory at the budgeted cost of $60 per unit (from the purchases budget in Exhibit 20.8). d September 30 balance of $200,000 from the beginning balance sheet in Exhibit 20.5 plus $25,000 cost of new equipment from the cash

budget in Exhibit 20.14. e September 30 balance of $36,000 from the beginning balance sheet in Exhibit 20.5 plus $4,500 expense from the general and administrative

expense budget in Exhibit 20.10. f Budgeted cost of purchases for December from the purchases budget in Exhibit 20.8. g Income tax expense from the budgeted income statement for the fourth quarter in Exhibit 20.15. h Budgeted December 31 balance from the cash budget in Exhibit 20.14. i Unchanged from the beginning balance sheet in Exhibit 20.5. j September 30 balance of $41,800 from the beginning balance sheet in Exhibit 20.5 plus budgeted net income of $43,003 from the budgeted income statement in Exhibit 20.15 minus budgeted cash dividends of $3,000 from the cash budget in Exhibit 20.14.

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862 Chapter 20 Master Budgets and Performance Planning

Royal Phillips Electronics of the Netherlands is a diversified company. Preparing budgets and evaluating progress helps the company achieve its goals. In a recent annual report the company reports that it budgets sales to grow at a faster pace than overall economic growth. Based on this sales target, company managers prepare detailed operating, capital expenditure, and financial budgets. Budgeted and actual results of companies that do global business are impacted by changes in foreign currency exchange rates. While most of Royal Phillips’ cash disbursements are in euros, the company’s sales are in euros, U.S. dollars, Chinese yuan, Brazilian real, and other currencies. Forecasting future ex- change rates and their impact on sales budgets is difficult. In addition, global economic and political un- certainties add to budgeting challenges.

GLOBAL VIEW

11. In preparing a budgeted balance sheet, (a) plant assets are determined by analyzing the capital expenditures budget and the balance sheet from the beginning of the budget period, (b) liabilities are determined by analyzing the general and administrative expense budget, or (c) retained earnings are determined from information contained in the cash budget and the balance sheet from the beginning of the budget period.

12. What sequence is followed in preparing the budgets that constitute the master budget?

Quick Check Answers — p. 870

Activity-Based BudgetingDecision Analysis

Activity-based budgeting (ABB) is a budget system based on expected activities. Knowledge of expected activities and their levels for the budget period enables management to plan for resources required to per- form the activities. To illustrate, we consider the budget of a company’s accounting department. Tradi- tional budgeting systems list items such as salaries, supplies, equipment, and utilities. Such an itemized budget informs management of the use of the funds budgeted (for example, salaries), but management cannot assess the basis for increases or decreases in budgeted amounts as compared to prior periods. Accordingly, management often makes across-the-board cuts or increases. In contrast, ABB requires management to list activities performed by, say, the accounting department such as auditing, tax reporting, financial reporting, and cost accounting. Exhibit 20.17 contrasts a traditional budget with an activity-based

A1 Analyze expense planning using activity-based budgeting.

EXHIBIT 20.17 Activity-Based Budgeting versus Traditional Budgeting (for an accounting department)

Activity-Based Budget Traditional Budget

Auditing . . . . . . . . . . . . . . . . . . . . . . . $ 58,000 Salaries . . . . . . . . . . . . . . . . . . . . $152,000

Tax reporting . . . . . . . . . . . . . . . . . . . 71,000 Supplies . . . . . . . . . . . . . . . . . . . 22,000

Financial reporting . . . . . . . . . . . . . . . 63,000 Depreciation . . . . . . . . . . . . . . . 36,000

Cost accounting . . . . . . . . . . . . . . . . 32,000 Utilities . . . . . . . . . . . . . . . . . . . 14,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . $224,000 Total . . . . . . . . . . . . . . . . . . . . . . $224,000

Strategic Planning Most companies allocate dollars based on budgets submitted by department managers. These managers verify the numbers and monitor the budget. Managers must re- member, however, that a budget is judged by its success in help- ing achieve the company’s mission. One analogy is that a hiker must know the route to properly plan a hike and monitor hiking progress. ■

Decision Insight

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Chapter 20 Master Budgets and Performance Planning 863

Wild Wood Company’s management asks you to prepare its master budget using the following informa- tion. The budget is to cover the months of April, May, and June of 2013.

DEMONSTRATION PROBLEM

WILD WOOD COMPANY Balance Sheet March 31, 2013

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . 175,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,000

Total current assets . . . . . . . . . . . . . . . . . . . . 351,000

Equipment, gross . . . . . . . . . . . . . . . . . . . . . . 480,000

Accumulated depreciation . . . . . . . . . . . . . . . (90,000)

Equipment, net . . . . . . . . . . . . . . . . . . . . . . . . 390,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $741,000

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . $156,000

Short-term notes payable . . . . . . . . . 12,000

Total current liabilities . . . . . . . . . . . 168,000

Long-term note payable . . . . . . . . . . 200,000

Total liabilities . . . . . . . . . . . . . . . . . . 368,000

Common stock . . . . . . . . . . . . . . . . . 235,000

Retained earnings . . . . . . . . . . . . . . . 138,000

Total stockholders’ equity . . . . . . . . 373,000

Total liabilities and equity . . . . . . . . . $741,000

Additional Information

a. Sales for March total 10,000 units. Each month’s sales are expected to exceed the prior month’s results by 5%. The product’s selling price is $25 per unit.

b. Company policy calls for a given month’s ending inventory to equal 80% of the next month’s expected unit sales. The March 31 inventory is 8,400 units, which complies with the policy. The purchase price is $15 per unit.

c. Sales representatives’ commissions are 12.5% of sales and are paid in the month of the sales. The sales manager’s monthly salary will be $3,500 in April and $4,000 per month thereafter.

d. Monthly general and administrative expenses include $8,000 administrative salaries, $5,000 depreciation, and 0.9% monthly interest on the long-term note payable.

e. The company expects 30% of sales to be for cash and the remaining 70% on credit. Receivables are collected in full in the month following the sale (none is collected in the month of the sale).

f. All merchandise purchases are on credit, and no payables arise from any other transactions. One month’s purchases are fully paid in the next month.

g. The minimum ending cash balance for all months is $50,000. If necessary, the company borrows enough cash using a short-term note to reach the minimum. Short-term notes require an interest payment of 1% at each month-end (before any repayment). If the ending cash balance exceeds the minimum, the excess will be applied to repaying the short-term notes payable balance.

h. Dividends of $100,000 are to be declared and paid in May.

budget for a company’s accounting department. An understanding of the resources required to perform the activities, the costs associated with these resources, and the way resource use changes with changes in activity levels allows management to better assess how expenses will change to accommodate changes in activity levels. Moreover, by knowing the relation between activities and costs, management can attempt to reduce costs by eliminating nonvalue-added activities.

Environmental Manager You hold the new position of environmental control manager for a chemical company. You are asked to develop a budget for your job and identify job responsibilities. How do you proceed? ■ [Answer—p. 870]

Decision Maker

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864 Chapter 20 Master Budgets and Performance Planning

i. No cash payments for income taxes are to be made during the second calendar quarter. Income taxes will be assessed at 35% in the quarter.

j. Equipment purchases of $55,000 are scheduled for June.

Required

Prepare the following budgets and other financial information as required: 1. Sales budget, including budgeted sales for July. 2. Purchases budget, the budgeted cost of goods sold for each month and quarter, and the cost of the

June 30 budgeted inventory. 3. Selling expense budget. 4. General and administrative expense budget. 5. Expected cash receipts from customers and the expected June 30 balance of accounts receivable. 6. Expected cash payments for purchases and the expected June 30 balance of accounts payable. 7. Cash budget. 8. Budgeted income statement. 9. Budgeted statement of retained earnings. 10. Budgeted balance sheet.

PLANNING THE SOLUTION ● The sales budget shows expected sales for each month in the quarter. Start by multiplying March

sales by 105% and then do the same for the remaining months. July’s sales are needed for the purchases budget. To complete the budget, multiply the expected unit sales by the selling price of $25 per unit.

● Use these results and the 80% inventory policy to budget the size of ending inventory for April, May, and June. Add the budgeted sales to these numbers and subtract the actual or expected beginning inven- tory for each month. The result is the number of units to be purchased each month. Multiply these numbers by the per unit cost of $15. Find the budgeted cost of goods sold by multiplying the unit sales in each month by the $15 cost per unit. Compute the cost of the June 30 ending inventory by multiply- ing the expected units available at that date by the $15 cost per unit.

● The selling expense budget has only two items. Find the amount of the sales representatives’ commis- sions by multiplying the expected dollar sales in each month by the 12.5% commission rate. Then in- clude the sales manager’s salary of $3,500 in April and $4,000 in May and June.

● The general and administrative expense budget should show three items. Administrative salaries are fixed at $8,000 per month, and depreciation is $5,000 per month. Budget the monthly interest expense on the long-term note by multiplying its $200,000 balance by the 0.9% monthly interest rate.

● Determine the amounts of cash sales in each month by multiplying the budgeted sales by 30%. Add to this amount the credit sales of the prior month (computed as 70% of prior month’s sales). April’s cash receipts from collecting receivables equals the March 31 balance of $175,000. The expected June 30 accounts receivable balance equals 70% of June’s total budgeted sales.

● Determine expected cash payments on accounts payable for each month by making them equal to the merchandise purchases in the prior month. The payments for April equal the March 31 balance of ac- counts payable shown on the beginning balance sheet. The June 30 balance of accounts payable equals merchandise purchases for June.

● Prepare the cash budget by combining the given information and the amounts of cash receipts and cash payments on account that you computed. Complete the cash budget for each month by either borrowing enough to raise the preliminary balance to the minimum or paying off short-term debt as much as the balance allows without falling below the minimum. Show the ending balance of the short-term note in the budget.

● Prepare the budgeted income statement by combining the budgeted items for all three months. Deter- mine the income before income taxes and multiply it by the 35% rate to find the quarter’s income tax expense.

● The budgeted statement of retained earnings should show the March 31 balance plus the quarter’s net income minus the quarter’s dividends.

● The budgeted balance sheet includes updated balances for all items that appear in the beginning balance sheet and an additional liability for unpaid income taxes. Amounts for all asset, liability, and equity ac- counts can be found either in the budgets, other calculations, or by adding amounts found there to the beginning balances.

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Chapter 20 Master Budgets and Performance Planning 865

SOLUTION TO DEMONSTRATION PROBLEM 1. Sales budget

April May June July

Prior period’s unit sales . . . . . . . . . 10,000 10,500 11,025 11,576

Plus 5% growth . . . . . . . . . . . . . . . 500 525 551 579

Projected unit sales . . . . . . . . . . . . 10,500 11,025 11,576 12,155

April May June Quarter

Projected unit sales . . . . . . . . . . . . 10,500 11,025 11,576

Selling price per unit . . . . . . . . . . . 3 $25 3 $25 3 $25

Projected sales . . . . . . . . . . . . . . . . $262,500 $275,625 $289,400 $827,525

2. Purchases budget

April May June Quarter

Next period’s unit sales (part 1) . . . . . . . . . . 11,025 11,576 12,155

Ending inventory percent . . . . . . . . . . . . . . . . 3 80% 3 80% 3 80%

Desired ending inventory . . . . . . . . . . . . . . . . 8,820 9,261 9,724

Current period’s unit sales (part 1) . . . . . . . . 10,500 11,025 11,576

Units to be available . . . . . . . . . . . . . . . . . . . . 19,320 20,286 21,300

Less beginning inventory . . . . . . . . . . . . . . . . . 8,400 8,820 9,261

Units to be purchased . . . . . . . . . . . . . . . . . . 10,920 11,466 12,039

Budgeted cost per unit . . . . . . . . . . . . . . . . . . 3 $15 3 $15 3 $15

Projected purchases . . . . . . . . . . . . . . . . . . . . $163,800 $171,990 $180,585 $516,375

Budgeted cost of goods sold

April May June Quarter

This period’s unit sales (part 1) . . . . . . . . . 10,500 11,025 11,576

Budgeted cost per unit . . . . . . . . . . . . . . . . 3 $15 3 $15 3 $15

Projected cost of goods sold . . . . . . . . . . . $157,500 $165,375 $173,640 $496,515

Units (part 2) . . . . . . . . . 9,724

Cost per unit . . . . . . . . . 3 $15

Total . . . . . . . . . . . . . . . . $145,860

Budgeted inventory for June 30

3. Selling expense budget

April May June Quarter

Budgeted sales (part 1) . . . . . . . . . . . . . . . . $262,500 $275,625 $289,400 $827,525

Commission percent . . . . . . . . . . . . . . . . . . 3 12.5% 3 12.5% 3 12.5% 3 12.5%

Sales commissions . . . . . . . . . . . . . . . . . . . . 32,813 34,453 36,175 103,441

Manager’s salary . . . . . . . . . . . . . . . . . . . . . 3,500 4,000 4,000 11,500

Projected selling expenses . . . . . . . . . . . . . $ 36,313 $ 38,453 $ 40,175 $114,941

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866 Chapter 20 Master Budgets and Performance Planning

4. General and administrative expense budget

April May June Quarter

Administrative salaries . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000 $ 8,000 $ 8,000 $24,000

Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,000 5,000 15,000

Interest on long-term note payable (0.9% 3 $200,000) . . . . . . . . . . . . . . . . . . . . 1,800 1,800 1,800 5,400

Projected expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,800 $14,800 $14,800 $44,400

April May June Quarter

Budgeted sales (part 1) . . . . . . . . . . . . . . . . . . . . . . . . . $262,500 $275,625 $289,400

Ending accounts receivable (70%) . . . . . . . . . . . . . . . . $183,750 $192,938 $202,580

Cash receipts

Cash sales (30% of budgeted sales) . . . . . . . . . . . . . $ 78,750 $ 82,687 $ 86,820 $248,257

Collections of prior month’s receivables . . . . . . . . . 175,000 183,750 192,938 551,688

Total cash to be collected . . . . . . . . . . . . . . . . . . . . . . . $253,750 $266,437 $279,758 $799,945

5. Expected cash receipts from customers

April May June Quarter

Cash payments (equal to prior month’s purchases) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $156,000 $163,800 $171,990 $491,790

Expected June 30 balance of accounts payable ( June purchases) . . . . . . . . . . . . . . . . . . . . . . $180,585

6. Expected cash payments to suppliers

April May June

Beginning cash balance . . . . . . . . . . . . . . . . . . . . . $ 50,000 $ 89,517 $ 50,000

Cash receipts (part 5) . . . . . . . . . . . . . . . . . . . . . . 253,750 266,437 279,758

Total cash available . . . . . . . . . . . . . . . . . . . . . . . . 303,750 355,954 329,758

Cash payments

Payments for merchandise (part 6) . . . . . . . . . 156,000 163,800 171,990

Sales commissions (part 3) . . . . . . . . . . . . . . . . 32,813 34,453 36,175

Salaries

Sales (part 3) . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 4,000 4,000

Administrative (part 4) . . . . . . . . . . . . . . . . . 8,000 8,000 8,000

Interest on long-term note (part 4) . . . . . . . . . 1,800 1,800 1,800

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Equipment purchase . . . . . . . . . . . . . . . . . . . . . 55,000

Interest on short-term notes

April ($12,000 3 1.0%) . . . . . . . . . . . . . . . . . 120

June ($6,099 3 1.0%) . . . . . . . . . . . . . . . . . . 61

Total cash payments . . . . . . . . . . . . . . . . . . . . . 202,233 312,053 277,026

Preliminary balance . . . . . . . . . . . . . . . . . . . . . . 101,517 43,901 52,732

Loan activity

Additional loan . . . . . . . . . . . . . . . . . . . . . . . . . 6,099

Loan repayment . . . . . . . . . . . . . . . . . . . . . . . . (12,000) (2,732)

Ending cash balance . . . . . . . . . . . . . . . . . . . . . $ 89,517 $ 50,000 $ 50,000

Ending short-term notes . . . . . . . . . . . . . . . . . $ 0 $ 6,099 $ 3,367

7. Cash budget

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Chapter 20 Master Budgets and Performance Planning 867

8. WILD WOOD COMPANY

Budgeted Income Statement For Quarter Ended June 30, 2013

Sales (part 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $827,525

Cost of goods sold (part 2) . . . . . . . . . . . . . . . . . . . 496,515

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331,010

Operating expenses

Sales commissions (part 3) . . . . . . . . . . . . . . . . . . $103,441

Sales salaries (part 3) . . . . . . . . . . . . . . . . . . . . . . 11,500

Administrative salaries (part 4) . . . . . . . . . . . . . . . 24,000

Depreciation (part 4) . . . . . . . . . . . . . . . . . . . . . . 15,000

Interest on long-term note (part 4) . . . . . . . . . . . 5,400

Interest on short-term notes (part 7) . . . . . . . . . 181

Total operating expenses . . . . . . . . . . . . . . . . . . . . . 159,522

Income before income taxes . . . . . . . . . . . . . . . . . . 171,488

Income taxes (35%) . . . . . . . . . . . . . . . . . . . . . . . . . 60,021

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $111,467

WILD WOOD COMPANY Budgeted Statement of Retained Earnings

For Quarter Ended June 30, 2013

Beginning retained earnings (given) . . . . . . . . . $138,000

Net income (part 8) . . . . . . . . . . . . . . . . . . . . 111,467

249,467

Less cash dividends (given) . . . . . . . . . . . . . . . 100,000

Ending retained earnings . . . . . . . . . . . . . . . . . $149,467

9.

WILD WOOD COMPANY Budgeted Balance Sheet

June 30, 2013

Assets

Cash (part 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000

Accounts receivable (part 5) . . . . . . . . . . . . . . . . . . . . . . . . . . 202,580

Inventory (part 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145,860

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398,440

Equipment (given plus purchase) . . . . . . . . . . . . . . . . . . . . . . . $535,000

Less accumulated depreciation (given plus expense) . . . . . . . . 105,000 430,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $828,440

Liabilities and Equity

Accounts payable (part 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $180,585

Short-term notes payable (part 7) . . . . . . . . . . . . . . . . . . . . . . 3,367

Income taxes payable (part 8) . . . . . . . . . . . . . . . . . . . . . . . . . 60,021

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243,973

Long-term note payable (given) . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443,973

Common stock (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235,000

Retained earnings (part 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149,467

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384,467

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $828,440

10.

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868 Chapter 20 Master Budgets and Performance Planning

APPENDIX

Production and Manufacturing Budgets Unlike a merchandising company, a manufacturer must prepare a production budget instead of a mer- chandise purchases budget. A production budget, which shows the number of units to be produced each month, is similar to merchandise purchases budgets except that the number of units to be purchased each month (as shown in Exhibit 20.8) is replaced by the number of units to be manufactured each month. A production budget does not show costs; it is always expressed in units of product. Exhibit 20A.1 shows the production budget for Toronto Sticks Company (TSC), a manufacturer of hockey sticks. TSC is an ex- clusive supplier of hockey sticks to Hockey Den, meaning that TSC uses HD’s budgeted sales figures (Exhibit 20.6) to determine its production and manufacturing budgets.

20A P3 Prepare production and manufacturing

budgets.

A manufacturing budget shows the budgeted costs for direct materials, direct labor, and overhead. It is based on the budgeted production volume from the production budget. The manufacturing budget for most companies consists of three individual budgets: direct materials budget, direct labor budget, and overhead budget. Exhibits 20A.2–20A.4 show these three manufacturing budgets for TSC. These budgets yield the total expected cost of goods to be manufactured in the budget period. The direct materials budget is driven by the budgeted materials needed to satisfy each month’s production requirement. To this we must add the desired ending inventory requirements. The desired ending inventory of direct materials as shown in Exhibit 20A.2 is 50% of next month’s budgeted materials requirements of wood. For instance, in October 2013, an ending inventory of 335 units of ma- terial is desired (50% of November’s 670 units). The desired ending inventory for December 2013 is 225 units, computed from the direct material requirement of 450 units for a production level of 900 units in January 2014. The total materials requirements are computed by adding the desired ending inventory figures to that month’s budgeted production material requirements. For October 2013, the total materials requirement is 745 units (335 1 410). From the total materials requirement, we then subtract the units of

TSC Production Budget

October 2013 – December 2013

October November December

Next period’s budgeted sales (units) . . . . . . . . . . . . . . 800 1,400 900

Ratio of inventory to future sales . . . . . . . . . . . . . . . . 3 90% 3 90% 3 90%

Budgeted ending inventory (units) . . . . . . . . . . . . . . . 720 1,260 810

Add budgeted sales for the period (units) . . . . . . . . . . 1,000 800 1,400

Required units of available production . . . . . . . . . . . . 1,720 2,060 2,210

Deduct beginning inventory (units) . . . . . . . . . . . . . . . (900) (720) (1,260)

Units to be produced . . . . . . . . . . . . . . . . . . . . . . . . . 820 1,340 950

EXHIBIT 20A.1 Production Budget

TSC Direct Materials Budget

October 2013 – December 2013

October November December

Budget production (units) . . . . . . . . . . . . . . . . . . . . 820 1,340 950

Materials requirements per unit . . . . . . . . . . . . . . . 3 0.5 3 0.5 3 0.5

Materials needed for production (units) . . . . . . . . . 410 670 475

Add budgeted ending inventory (units) . . . . . . . . . . 335 237.5 225

Total materials requirements (units) . . . . . . . . . . . . 745 907.5 700

Deduct beginning inventory (units) . . . . . . . . . . . . . (205) (335) (237.5)

Materials to be purchased (units) . . . . . . . . . . . . . . 540 572.5 462.5

Material price per unit . . . . . . . . . . . . . . . . . . . . . . . $ 20 $ 20 $ 20

Total cost of direct materials purchases . . . . . . . . . $10,800 $11,450 $9,250

EXHIBIT 20A.2 Direct Materials Budget

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Chapter 20 Master Budgets and Performance Planning 869

materials available in beginning inventory. For October 2013, the materials available from September 2013 are computed as 50% of October’s materials requirements to satisfy production, or 205 units (50% of 410). Therefore, direct materials purchases in October 2013 are budgeted at 540 units (745 2 205). See Exhibit 20A.2. TSC’s direct labor budget is shown in Exhibit 20A.3. About 15 minutes of labor time is required to produce one unit. Labor is paid at the rate of $12 per hour. Budgeted labor hours are computed by multi- plying the budgeted production level for each month by one-quarter (0.25) of an hour. Direct labor cost is then computed by multiplying budgeted labor hours by the labor rate of $12 per hour.

TSC Direct Labor Budget

October 2013 – December 2013

October November December

Budgeted production (units) . . . . . . . . . . . . . . . 820 1,340 950

Labor requirements per unit (hours) . . . . . . . . 3 0.25 3 0.25 3 0.25

Total labor hours needed . . . . . . . . . . . . . . . . . 205 335 237.5

Labor rate (per hour) . . . . . . . . . . . . . . . . . . . . $ 12 $ 12 $ 12

Labor dollars . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,460 $4,020 $2,850

EXHIBIT 20A.3 Direct Labor Budget

EXHIBIT 20A.4 Factory Overhead Budget

TSC Factory Overhead Budget

October 2013 – December 2013

October November December

Budgeted production (units) . . . . . . . . . . . . . . . 820 1,340 950

Variable factory overhead rate . . . . . . . . . . . . . 3 $2.50 3 $2.50 3 $2.50

Budgeted variable overhead . . . . . . . . . . . . . . . 2,050 3,350 2,375

Budgeted fixed overhead . . . . . . . . . . . . . . . . . . 1,500 1,500 1,500

Budgeted total overhead . . . . . . . . . . . . . . . . . . $3,550 $4,850 $3,875

TSC’s factory overhead budget is shown in Exhibit 20A.4. The variable portion of overhead is as- signed at the rate of $2.50 per unit of production. The fixed portion stays constant at $1,500 per month. The budget in Exhibit 20A.4 is in condensed form; most overhead budgets are more detailed, listing each overhead cost item. We explain these more detailed overhead budgets in the next chapter.

C1 Describe the importance and benefits of budgeting and the process of budget administration. Planning is a management responsibility of critical importance to business success. Budgeting is the process management uses to formalize its plans. Budgeting promotes management analysis and focuses its attention on the fu- ture. Budgeting also provides a basis for evaluating performance, serves as a source of motivation, is a means of coordinating activities, and communicates management’s plans and instructions to employees. Budgeting is a detailed activity that requires administra- tion. At least three aspects are important: budget committee, budget reporting, and budget timing. A budget committee oversees the bud- get preparation. The budget period pertains to the time period for which the budget is prepared such as a year or month.

C2 Describe a master budget and the process of preparing it. A master budget is a formal overall plan for a company. It consists of plans for business operations and capital expenditures, plus the fi- nancial results of those activities. The budgeting process begins with a

Summary sales budget. Based on expected sales volume, companies can budget purchases, selling expenses, and administrative expenses. Next, the capital expenditures budget is prepared, followed by the cash budget and budgeted financial statements. Manufacturers also must budget production quantities, materials purchases, labor costs, and overhead.

A1 Analyze expense planning using activity-based budgeting. Activity-based budgeting requires management to identify ac- tivities performed by departments, plan necessary activity levels, identify resources required to perform these activities, and budget the resources.

P1 Prepare each component of a master budget and link each to the budgeting process. The term master budget refers to a collection of individual component budgets. Each component bud- get is designed to guide persons responsible for activities covered by that component. A master budget must reflect the components of a company and their interaction in pursuit of company goals.

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870 Chapter 20 Master Budgets and Performance Planning

P2 Link both operating and capital expenditures budgets to budgeted financial statements. The operating budgets, capi- tal expenditures budget, and cash budget contain much of the infor- mation to prepare a budgeted income statement for the budget period and a budgeted balance sheet at the end of the budget period. Budgeted financial statements show the expected financial conse- quences of the planned activities described in the budgets.

P3 Prepare production and manufacturing budgets. A manufacturer must prepare a production budget instead of a purchases budget. A manufacturing budget shows the budgeted production costs for direct materials, direct labor, and overhead.

Budget Staffer Your superior’s actions appear unethical be- cause she is using private information for personal gain. As a budget staffer, you are low in the company’s hierarchical structure and prob- ably unable to confront this superior directly. You should inform an individual with a position of authority within the organization about your concerns.

Entrepreneur You must deal with two issues. First, because fashions and designs frequently change, you cannot heavily rely on previous budgets. As a result, you must carefully analyze the market to understand what designs are in vogue. This will help you plan the product mix and estimate demand. The second issue is the budgeting

period. An annual sales budget may be unreliable because tastes can quickly change. Your best bet might be to prepare monthly and quar- terly sales budgets that you continuously monitor and revise.

Environmental Manager You are unlikely to have data on this new position to use in preparing your budget. In this situation, you can use activity-based budgeting. This requires developing a list of activities to conduct, the resources required to perform these activi- ties, and the expenses associated with these resources. You should challenge yourself to be absolutely certain that the listed activities are necessary and that the listed resources are required.

Guidance Answers to Decision Maker and Decision Ethics

1. Major benefits include promoting a focus on the future; provid- ing a basis for evaluating performance; providing a source of motivation; coordinating the departments of a business; and communicating plans and instructions.

2. The budget committee’s responsibility is to provide guidance to ensure that budget figures are realistic and coordinated.

3. Budget periods usually coincide with accounting periods and therefore cover a month, quarter, or a year. Budgets can also be prepared for longer time periods, such as five years.

4. Rolling budgets are budgets that are periodically revised in the ongoing process of continuous budgeting.

5. A master budget is a comprehensive or overall plan for the com- pany that is generally expressed in monetary terms.

6. b 7. The master budget includes operating budgets, the capital ex-

penditures budget, and financial budgets.

8. c; Computed as (60% 3 140) 1 120 2 50 5 154. 9. Merchandisers prepare merchandise purchases budgets; manu-

facturers prepare production and manufacturing budgets. 10. A just-in-time system keeps the level of inventory to a mini-

mum and orders merchandise or materials to meet immediate sales demand. A safety stock system maintains an inventory that is large enough to meet sales demands plus an amount to satisfy unexpected sales demands and an amount to cover delayed shipments from suppliers.

11. a 12. (a) Operating budgets (such as sales, selling expense, and ad-

ministrative budgets), (b) capital expenditures budget, (c) finan- cial budgets: cash budget, budgeted income statement, and budgeted balance sheet.

Guidance Answers to Quick Checks

Activity-based budgeting (ABB) (p. 862)

Budget (p. 848)

Budgeted balance sheet (p. 860)

Budgeted income statement (p. 860)

Budgeting (p. 848)

Capital expenditures budget (p. 858)

Cash budget (p. 858)

Continuous budgeting (p. 851)

General and administrative expense budget (p. 857)

Manufacturing budget (p. 868)

Master budget (p. 852)

Merchandise purchases budget (p. 855)

Production budget (p. 868)

Rolling budgets (p. 851)

Safety stock (p. 855)

Sales budget (p. 854)

Selling expense budget (p. 856)

Key Terms

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Chapter 20 Master Budgets and Performance Planning 871

Multiple Choice Quiz Answers on p. 893 mhhe.com/wildFINMAN5e

Additional Quiz Questions are available at the book’s Website.

1. A plan that reports the units or costs of merchandise to be pur- chased by a merchandising company during the budget period is called a

a. Capital expenditures budget. b. Cash budget. c. Merchandise purchases budget. d. Selling expenses budget. e. Sales budget. 2. A hardware store has budgeted sales of $36,000 for its power

tool department in July. Management wants to have $7,000 in power tool inventory at the end of July. Its beginning inventory of power tools is expected to be $6,000. What is the budgeted dollar amount of merchandise purchases?

a. $36,000 b. $43,000 c. $42,000 d. $35,000 e. $37,000 3. A store has the following budgeted sales for the next five months.

a. $240,000 b. $225,000 c. $ 60,000 d. $165,000 e. $220,000 4. A plan that shows the expected cash inflows and cash outflows

during the budget period, including receipts from loans needed to maintain a minimum cash balance and repayments of such loans, is called

a. A rolling budget. b. An income statement. c. A balance sheet. d. A cash budget. e. An operating budget. 5.A The following sales are predicted for a company’s next four

months.

Cash sales are 25% of total sales and all credit sales are expected to be collected in the month following the sale. The total amount of cash expected to be received from customers in September is

Each month’s ending inventory of finished goods should be 30% of the next month’s sales. At September 1, the finished goods inventory is 140 units. The budgeted production of units for October is

a. 572 units. b. 560 units. c. 548 units. d. 600 units. e. 180 units.

September October November December

Unit sales . . 480 560 600 480

May . . . . . . . . . . . . . $210,000

June . . . . . . . . . . . . . 186,000

July . . . . . . . . . . . . . . 180,000

August . . . . . . . . . . . 220,000

September . . . . . . . . 240,000

1. Identify at least three roles that budgeting plays in helping managers control and monitor a business.

2. What two common benchmarks can be used to evaluate actual performance? Which of the two is generally more useful?

3. What is the benefit of continuous budgeting? 4. Identify three usual time horizons for short-term planning and

budgets. 5. Why should each department participate in preparing its

own budget? 6. How does budgeting help management coordinate and

plan business activities? 7. Why is the sales budget so important to the budgeting

process? 8. What is a selling expense budget? What is a capital expendi-

tures budget? 9. Budgeting promotes good decision making by requiring

managers to conduct ______ and by focusing their attention on the ______.

10. Piaggio prepares a cash budget. What is a cash budget? Why must operating budgets and the capital expenditures budget be prepared before the cash budget?

11. KTM regularly uses budgets. What is the difference between a production budget and a manufacturing budget?

12. Would a manager of an Apple retail store partici- pate more in budgeting than a manager at the corporate offices? Explain.

13. Does the manager of a Arctic Cat distribu- tion center participate in long-term budgeting? Explain.

14. Assume that Polaris’ snowmobile division is charged with preparing a master budget. Iden- tify the participants—for example, the sales manager for the sales budget—and describe the information each person pro- vides in preparing the master budget.

Discussion Questions

Icon denotes assignments that involve decision making.

A Superscript letter A denotes assignments based on Appendix 20A, relating to production, direct materials, direct labor, and factory overhead budgets.

Apple

Polaris

Arctic Cat

PIAGGIO

KTM

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872 Chapter 20 Master Budgets and Performance Planning

QUICK STUDY

QS 20-1 Components of a master budget

C2

Which one of the following sets of items are all necessary components of the master budget? 1. Operating budgets, historical income statement, and budgeted balance sheet. 2. Prior sales reports, capital expenditures budget, and financial budgets. 3. Sales budget, operating budgets, and historical financial budgets.

4. Operating budgets, financial budgets, and capital expenditures budget.

QS 20-3 Merchandising: Purchases budget P1

Montel Company’s July sales budget calls for sales of $600,000. The store expects to begin July with $50,000 of inventory and to end the month with $40,000 of inventory. Gross margin is typically 40% of sales. Determine the budgeted cost of merchandise purchases for July.

QS 20-5 Computing budgeted accounts receivable

P2

Lighthouse Company anticipates total sales for June and July of $420,000 and $398,000, respectively. Cash sales are normally 60% of total sales. Of the credit sales, 20% are collected in the same month as the sale, 70% are collected during the first month after the sale, and the remaining 10% are collected in the second month. Determine the amount of accounts receivable reported on the company’s budgeted balance sheet as of July 31.

QS 20-6 Cash budget

P1

Use the following information to prepare a cash budget for the month ended on March 31 for Gado Merchandising Company. The budget should show expected cash receipts and cash disbursements for the month of March and the balance expected on March 31. a. Beginning cash balance on March 1, $72,000. b. Cash receipts from sales, $300,000. c. Budgeted cash disbursements for purchases, $140,000. d. Budgeted cash disbursements for salaries, $80,000. e. Other budgeted cash expenses, $45,000. f. Cash repayment of bank loan, $20,000.

QS 20-8A

Manufacturing: Production budget P3

Forrest Company manufactures watches and has a JIT policy that ending inventory must equal 10% of the next month’s sales. It estimates that October’s actual ending inventory will consist of 40,000 watches. November and December sales are estimated to be 400,000 and 350,000 watches, respectively. Compute the number of watches to be produced that would appear on the company’s production budget for the month of November.

QS 20-9A

Manufacturing: Factory overhead budget P3

Refer to information from QS 20-8. Forrest Company assigns variable overhead at the rate of $1.50 per unit of production. Fixed overhead equals $4,600,000 per month. Prepare a factory overhead budget for November.

QS 20-10 Sales budget P1

Grace sells miniature digital cameras for $250 each. 1,000 units were sold in May, and it forecasts 4% growth in unit sales each month. Determine (a) the number of camera sales and (b) the dollar amount of camera sales for the month of June.

QS 20-2 Budget motivation C1

The motivation of employees is one goal of budgeting. Identify three guidelines that organizations should follow if budgeting is to serve effectively as a source of motivation for employees.

QS 20-4 Budgeting process C1

Good management includes good budgeting. (1) Explain why the bottom-up approach to budgeting is considered a more successful management technique than a top-down approach. (2) Provide an example of implementation of the bottom-up approach to budgeting.

QS 20-7 Activity-based budgeting

A1

Activity-based budgeting is a budget system based on expected activities. (1) Describe activity-based budgeting, and explain its preparation of budgets. (2) How does activity-based budgeting differ from traditional budgeting?

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Chapter 20 Master Budgets and Performance Planning 873

QS 20-11 Selling expense budget P1

Refer to information from QS 20-10. Grace pays a sales manager a monthly salary of $6,000 and a commission of 8% of camera sales (in dollars). Prepare a selling expense budget for the month of June.

QS 20-12 Cash budget P1

Refer to information from QS 20-10. Assume 60% of Grace’s sales are for cash. The remaining 40% are credit sales; these customers pay in the month following the sale. Compute the budgeted cash receipts for June.

QS 20-14 Cash receipts P1

The Candle Shoppe reports the following sales forecast: August, $150,000; September, $170,000. Cash sales are normally 40% of total sales and all credit sales are expected to be collected in the month following the date of sale. Prepare a schedule of cash receipts for September.

QS 20-15 Cash receipts P1

Wells Company reports the following sales forecast: September, $55,000; October, $66,000; and November, $80,000. All sales are on account. Collections of credit sales are received as follows: 20% in the month of sale, 70% in the first month after sale, and 10% in the second month after sale. Prepare a schedule of cash receipts for November.

QS 20-16 Merchandising: Cash disbursements for merchandise

P1

Gordands purchased $600,000 of merchandise in August and expects to purchase $720,000 in September. Merchandise purchases are paid as follows: 25% in the month of purchase and 75% in the following month. Compute cash disbursements for merchandise for September.

QS 20-17 Merchandising: Cash disbursements for merchandise

P1

Meyer Co. forecasts merchandise purchases of $15,800 in January, $18,600 in February, and $20,200 in March; 40% of purchases are paid in the month of purchase and 60% are paid in the following month. At December 31 of the prior year, the balance of Accounts Payable (for December purchases) is $22,000. Prepare a schedule of cash disbursements for merchandise for each of the months of January, February, and March.

QS 20-18 Merchandising: Computing purchases

P1

Raider-X Company forecasts sales of 18,000 units for April. Beginning inventory is 3,000 units. The desired ending inventory is 30% higher than the beginning inventory. How many units should Raider-X purchase in April?

QS 20-19 Merchandising: Computing purchases

P1

Lexi Company forecasts unit sales of 1,040,000 in April, 1,220,000 in May, 980,000 in June, and 1,020,000 in July. Beginning inventory on April 1 is 280,000 units, and the company wants to have 30% of next month’s sales in inventory at the end of each month. Prepare a merchandise purchases budget for the months of April, May, and June.

QS 20-13 Budgeted financial statements

P2

Following are selected accounts for a company. For each account, indicate whether it will appear on a budgeted income statement (BIS) or a budgeted balance sheet (BBS). If an item will not appear on either budgeted financial statement, label it NA.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . ________

Office salaries paid . . . . . . . . . . . . . . . . ________

Accumulated depreciation . . . . . . . . . . ________

Amortization expense . . . . . . . . . . . . . ________

Interest paid on note payable . . . . . . . ________

Cash dividends paid . . . . . . . . . . . . . . . ________

Bank loan owed . . . . . . . . . . . . . . . . . . ________

Cost of goods sold. . . . . . . . . . . . . . . . ________

QS 20-20A

Manufacturing: Production budget

P3

Champ, Inc. predicts the following sales in units for the coming three months:

May June July

Sales in units . . . . . . . . 180 200 240

Each month’s ending inventory of finished units should be 60% of the next month’s sales. The April 30 finished goods inventory is 50 units. Compute Champ’s budgeted production (in units) for May.

QS 20-21A

Manufacturing: Direct materials budget P3

Zortek Corp. budgets production of 400 units in January and 200 units in February. Each finished unit requires five pounds of raw material Z, which costs $2 per pound. Each month’s ending inventory of raw materials should be 40% of the following month’s budgeted production. The January 1 raw materials inventory has 130 pounds of Z. Prepare a direct materials budget for January.

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874 Chapter 20 Master Budgets and Performance Planning

QS 20-22A

Manufacturing: Direct labor budget P3

Tora Co. plans to produce 1,020 units in July. Each unit requires two hours of direct labor. The direct labor rate is $20 per hour. Prepare a direct labor budget for July.

QS 20-24 Cash receipts budget P1

Refer to information in QS 20-23. In addition, sales are 40% cash and 60% on credit. All credit sales are collected in the month following the sale. The January 1 balance in accounts receivable is $15,000. Prepare a schedule of budgeted cash receipts for January, February, and March.

QS 20-25 Selling expense budget P1

Refer to information in QS 20-23. In addition, sales commissions are 10% of sales and the company pays a sales manager a salary of $6,000 per month. Sales commissions and salaries are paid in the month incurred. Prepare a selling expense budget for January, February, and March.

January February March April

Sales in units . . . . . . . . 1,200 2,000 1,600 1,400

QS 20-23 Sales budget P1

Scora, Inc., is preparing its master budget for the quarter ending March 31. It sells a single product for $50 per unit. Budgeted sales for the next four months follow. Prepare a sales budget for the months of January, February, and March.

QS 20-26 Budgeted loan activity

P1

Messers Company is preparing a cash budget for February. The company has $20,000 cash at the beginning of February and anticipates $75,000 in cash receipts and $100,250 in cash disbursements during February. What amount, if any, must the company borrow during February to maintain a $5,000 cash balance? The company has no loans outstanding on February 1.

Check January ending cash balance, $30,000

Exercise 20-2 Merchandising: Preparation of purchases budgets (for three periods)

P1

Walker Company prepares monthly budgets. The current budget plans for a September ending inventory of 30,000 units. Company policy is to end each month with merchandise inventory equal to a specified percent of budgeted sales for the following month. Budgeted sales and merchandise purchases for the three most recent months follow. (1) Prepare the merchandise purchases budget for the months of July, August, and September. (2) Compute the ratio of ending inventory to the next month’s sales for each budget prepared in part 1. (3) How many units are budgeted for sale in October?

QS 20-27 Operating budgets

P1

Royal Phillips Electronics of the Netherlands reports sales of €25,400 million for a recent year. Assume that the company expects sales growth of 3 percent for the next year. Also assume that selling expenses are typically 20 percent of sales, while general and administrative expenses are 4 percent of sales.

Required

1. Compute budgeted sales for the next year. 2. Assume budgeted sales for next year is €26,000 million, and then compute budgeted selling expenses

and budgeted general and administrative expenses for the next year.

Cash Receipts Cash Disbursements

January . . . . . . . . . . $525,000 $475,000

February . . . . . . . . . 400,000 350,000

March . . . . . . . . . . . 450,000 525,000

EXERCISES

Exercise 20-1 Preparation of cash budgets (for three periods)

P1

Kayak Co. budgeted the following cash receipts (excluding cash receipts from loans received) and cash disbursements (excluding cash disbursements for loan and interest payments) for the first three months of next year.

According to a credit agreement with the company’s bank, Kayak promises to have a minimum cash balance of $30,000 at each month-end. In return, the bank has agreed that the company can borrow up to $150,000 at an annual interest rate of 12%, paid on the last day of each month. The interest is computed based on the beginning balance of the loan for the month. The company has a cash balance of $30,000 and a loan bal- ance of $60,000 at January 1. Prepare monthly cash budgets for each of the first three months of next year.

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Chapter 20 Master Budgets and Performance Planning 875

Exercise 20-3 Merchandising: Preparation of a cash budget

P1

Use the following information to prepare the July cash budget for Acco Co. It should show expected cash receipts and cash disbursements for the month and the cash balance expected on July 31. a. Beginning cash balance on July 1: $50,000. b. Cash receipts from sales: 30% is collected in the month of sale, 50% in the next month, and 20% in the

second month after sale (uncollectible accounts are negligible and can be ignored). Sales amounts are: May (actual), $1,720,000; June (actual), $1,200,000; and July (budgeted), $1,400,000.

c. Payments on merchandise purchases: 60% in the month of purchase and 40% in the month following purchase. Purchases amounts are: June (actual), $700,000; and July (budgeted), $750,000.

d. Budgeted cash disbursements for salaries in July: $275,000. e. Budgeted depreciation expense for July: $36,000. f. Other cash expenses budgeted for July: $200,000. g. Accrued income taxes due in July: $80,000. h. Bank loan interest due in July: $6,600.

Check Ending cash balance, $122,400

Exercise 20-4 Merchandising: Preparing a budgeted income statement and balance sheet

P2

Use the information in Exercise 20-3 and the following additional information to prepare a budgeted in- come statement for the month of July and a budgeted balance sheet for July 31. a. Cost of goods sold is 55% of sales. b. Inventory at the end of June is $80,000 and at the end of July is $60,000. c. Salaries payable on June 30 are $50,000 and are expected to be $60,000 on July 31. d. The equipment account balance is $1,600,000 on July 31. On June 30, the accumulated depreciation

on equipment is $280,000. e. The $6,600 cash payment of interest represents the 1% monthly expense on a bank loan of $660,000. f. Income taxes payable on July 31 are $30,720, and the income tax rate applicable to the company is

30%. g. The only other balance sheet accounts are: Common Stock, with a balance of $600,000 on June 30;

and Retained Earnings, with a balance of $964,000 on June 30. Check Net income, $71,680; Total assets, $2,686,400

Exercise 20-5 Merchandising: Computing budgeted cash payments for purchases

P1

Hardy Company’s cost of goods sold is consistently 60% of sales. The company plans to carry ending merchandise inventory for each month equal to 20% of the next month’s budgeted cost of good sold. All merchandise is purchased on credit, and 50% of the purchases made during a month is paid for in that month. Another 35% is paid for during the first month after purchase, and the remaining 15% is paid for during the second month after purchase. Expected sales are: August (actual), $325,000; September (actual), $320,000; October (estimated), $250,000; November (estimated), $310,000. Use this information to deter- mine October’s expected cash payments for purchases. (Hint: Use the layout of Exhibit 20.8, but revised for the facts given here.)

Check Budgeted purchases: August, $194,400; October, $157,200

Exercise 20-6 Merchandising: Computing budgeted purchases and costs of goods sold

P1

Quick Dollar Company purchases all merchandise on credit. It recently budgeted the following month-end accounts payable balances and merchandise inventory balances. Cash payments on accounts payable dur- ing each month are expected to be: May, $1,600,000; June, $1,490,000; July, $1,425,000; and August, $1,495,000. Use the available information to compute the budgeted amounts of (1) merchandise purchases for June, July, and August and (2) cost of goods sold for June, July, and August.

Check June purchases, $1,540,000; June cost of goods sold, $1,390,000

Accounts Payable Merchandise Inventory

May 31 . . . . . . . . . . . $150,000 $250,000

June 30 . . . . . . . . . . . 200,000 400,000

July 31 . . . . . . . . . . . . 235,000 300,000

August 31 . . . . . . . . . 195,000 330,000

Sales (Units) Purchases (Units)

July . . . . . . . . . . . . . . 180,000 200,250

August . . . . . . . . . . . 315,000 308,250

September . . . . . . . . 270,000 259,500

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876 Chapter 20 Master Budgets and Performance Planning

Exercise 20-7 Merchandising: Computing budgeted accounts payable and purchases—sales forecast in dollars

P1 P2

Big Sound, a merchandising company specializing in home computer speakers, budgets its monthly cost of goods sold to equal 70% of sales. Its inventory policy calls for ending inventory in each month to equal 20% of the next month’s budgeted cost of goods sold. All purchases are on credit, and 25% of the purchases in a month is paid for in the same month. Another 60% is paid for during the first month after purchase, and the remaining 15% is paid for in the second month after purchase. The following sales budgets are set: July, $350,000; August, $290,000; September, $320,000; October, $275,000; and November, $265,000. Compute the following: (1) budgeted merchandise purchases for July, August, September, and October; (2) budgeted payments on accounts payable for September and October; and (3) budgeted ending balances of accounts payable for September and October. (Hint: For part 1, refer to Exhibits 20.7 and 20.8 for guidance, but note that budgeted sales are in dollars for this assignment.)

Check July purchases, $236,600; Sept. payments on accts. pay., $214,235

Exercise 20-8A

Manufacturing: Preparing production budgets (for two periods) P3

Electro Company manufactures an innovative automobile transmission for electric cars. Management pre- dicts that ending inventory for the first quarter will be 75,000 units. The following unit sales of the trans- missions are expected during the rest of the year: second quarter, 450,000 units; third quarter, 525,000 units; and fourth quarter, 475,000 units. Company policy calls for the ending inventory of a quarter to equal 20% of the next quarter’s budgeted sales. Prepare a production budget for both the second and third quar- ters that shows the number of transmissions to manufacture.

Check Second quarter production, 480,000 units

Exercise 20-9A

Manufacturing: Direct materials budget

P3

Refer to information from Exercise 20-8. Each transmission requires 0.80 pounds of a key raw material. Electro Company aims to end each quarter with an ending inventory of direct materials equal to 50% of next quarter’s budgeted materials requirements. Direct materials cost $170 per unit. Prepare a direct materials budget for the second quarter.

Exercise 20-10A

Manufacturing: Direct labor budget P3

Refer to information from Exercise 20-8. Each transmission requires 4 direct labor hours, at a cost of $12 per hour. Prepare a direct labor budget for the second quarter.

Exercise 20-12 Budgeted cash receipts

P1

Jasper Company has sales on account and sales for cash. Specifically, 70% of its sales are on account and 30% are for cash. Credit sales are collected in full in the month following the sale. The company forecasts sales of $525,000 for April, $535,000 for May, and $560,000 for June. The beginning balance of Accounts Receivable is $400,000 on April 1. Prepare a schedule of budgeted cash receipts for April, May, and June.

Exercise 20-11 Merchandising: Budgeted cash disbursements

P1

Hector Company reports the following:

July August September

Sales . . . . . . . . . . . . $50,000 $72,000 $66,000

Purchases . . . . . . . . 14,400 19,200 21,600

Payments for purchases are made in the month after purchase. Selling expenses are 10% of sales, adminis- trative expenses are 8% of sales, and both are paid in the month of sale. Rent expense of $7,400 is paid monthly. Depreciation expense is $2,300 per month. Prepare a schedule of budgeted cash disbursements for August and September.

Exercise 20-13 Cash budget

P1

Karim Corp. requires a minimum $8,000 cash balance. If necessary, loans are taken to meet this requirement at a cost of 1% interest per month (paid monthly). Any excess cash is used to repay loans at month-end. The cash balance on July 1 is $8,400 and the company has no outstanding loans. Forecasted cash receipts (other than for loans received) and forecasted cash payments (other than for loan or interest payments) are:

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Chapter 20 Master Budgets and Performance Planning 877

Prepare a cash budget for July, August, and September. Round interest payments to the nearest whole dollar.

July August September

Cash receipts . . . . . . . . . . . . . $20,000 $26,000 $40,000

Cash disbursements . . . . . . . . 28,000 30,000 22,000

October November December

Cash receipts . . . . . . . . . . . . . . $110,000 $80,000 $100,000

Cash disbursements . . . . . . . . 120,000 75,000 80,000

Exercise 20-14 Cash budget

P1

Foyert Corp. requires a minimum $30,000 cash balance. If necessary, loans are taken to meet this require- ment at a cost of 1% interest per month (paid monthly). Any excess cash is used to repay loans at month- end. The cash balance on October 1 is $30,000 and the company has an outstanding loan of $10,000. Forecasted cash receipts (other than for loans received) and forecasted cash payments (other than for loan or interest payments) follow. Prepare a cash budget for October, November, and December. Round interest payments to the nearest whole dollar.

April May June

Budgeted sales . . . . . . . . . . . . . . . . . . . . $32,000 $40,000 $24,000

Budgeted cash payments for merchandise . . . . . . . . . . . . . . . . . . . . 20,200 16,800 17,200

Exercise 20-15 Merchandising: Cash budget

P1

Castor, Inc. is preparing its master budget for the quarter ended June 30. Budgeted sales and cash payments for merchandise for the next three months follow:

Sales are 50% cash and 50% on credit. All credit sales are collected in the month following the sale. The March 30 balance sheet includes balances of $12,000 in cash, $12,000 in accounts receivable, $11,000 in accounts payable, and a $2,000 balance in loans payable. A minimum cash balance of $12,000 is required. Loans are obtained at the end of any month when a cash shortage occurs. Interest is 1% per month based on the beginning of the month loan balance and is paid at each month-end. If an excess balance of cash exists, loans are repaid at the end of the month. Operating expenses are paid in the month incurred and consist of sales commissions (10% of sales), shipping (2% of sales), office salaries ($5,000 per month) and rent ($3,000 per month). Prepare a cash budget for each of the months of April, May, and June (round all dollar amounts to the nearest whole dollar).

July August September

Budgeted sales . . . . . . . . . . . . . . . . . . . . $64,000 $80,000 $48,000

Budgeted cash payments for merchandise . . . . . . . . . . . . . . . . . . . . 40,400 33,600 34,400

Exercise 20-16 Merchandising: Cash budget

P1

Kelsey is preparing its master budget for the quarter ended September 30. Budgeted sales and cash pay- ments for merchandise for the next three months follow:

Sales are 20% cash and 80% on credit. All credit sales are collected in the month following the sale. The June 30 balance sheet includes balances of $15,000 in cash; $45,000 in accounts receivable; $4,500 in accounts payable; and a $5,000 balance in loans payable. A minimum cash balance of $15,000 is re- quired. Loans are obtained at the end of any month when a cash shortage occurs. Interest is 1% per month based on the beginning of the month loan balance and is paid at each month-end. If an excess bal- ance of cash exists, loans are repaid at the end of the month. Operating expenses are paid in the month incurred and consist of sales commissions (10% of sales), office salaries ($4,000 per month), and rent ($6,500 per month). (1) Prepare a cash receipts budget for July, August, and September. (2) Prepare a cash budget for each of the months of July, August, and September. (Round all dollar amounts to the nearest whole dollar.)

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878 Chapter 20 Master Budgets and Performance Planning

Commissions . . . . . . . . . 8% of sales

Rent . . . . . . . . . . . . . . . . $14,000 per month

Advertising . . . . . . . . . . 15% of sales

Office salaries . . . . . . . . $75,000 per month

Depreciation . . . . . . . . . $40,000 per month

Interest . . . . . . . . . . . . . 15% annually on a $250,000 note payable

Tax rate. . . . . . . . . . . . . . 30%

Exercise 20-18 Merchandising: Budgeted income statement

P2

Fortune, Inc., is preparing its master budget for the first quarter. The company sells a single product at a price of $25 per unit. Sales (in units) are forecasted at 45,000 for January, 55,000 for February, and 50,000 for March. Cost of goods sold is $14 per unit. Other expense information for the first quarter follows. Pre- pare a budgeted income statement for this first quarter.

Exercise 20-19A

Manufacturing: Direct labor budget

P3

The production budget for Manner Company shows units to be produced as follows: July, 620; August, 680; September, 540. Each unit produced requires two hours of direct labor. The direct labor rate is cur- rently $20 per hour but is predicted to be $21 per hour in September. Prepare a direct labor budget for the months July, August, and September.

Exercise 20-21A

Manufacturing: Direct materials budget P3

Refer to the information in Exercise 20-20. In addition, assume each finished unit requires five pounds of raw materials and the company wants to end each month with raw materials inventory equal to 30% of next month’s production needs. Beginning raw materials inventory for April was 663 pounds. Prepare a direct materials budget for April, May, and June.

Exercise 20-20A

Manufacturing: Production budget

P3

Hospitable Co. provides the following sales forecast for the next four months:

April May June July

Sales (units) . . . . . . . . 500 580 540 620

The company wants to end each month with ending finished goods inventory equal to 25% of next month’s sales. Finished goods inventory on April 1 is 190 units. Assume July’s budgeted production is 540 units. Prepare a production budget for the months of April, May, and June.

Exercise 20-17 Merchandising: Budgeted balance sheet

P2

The following information is available for Zetrov Company: a. The cash budget for March shows an ending bank loan of $10,000 and an ending cash balance of

$50,000. b. The sales budget for March indicates sales of $140,000. Accounts receivable are expected to be 70%

of the current-month sales. c. The merchandise purchases budget indicates that $89,000 in merchandise will be purchased on ac-

count in March. Purchases on account are paid 100% in the month following the purchase. Ending inventory for March is predicted to be 600 units at a cost of $35 each.

d. The budgeted income statement for March shows net income of $48,000. Depreciation expense of $1,000 and $26,000 in income tax expense were used in computing net income for March. Accrued taxes will be paid in April.

e. The balance sheet for February shows equipment of $84,000 with accumulated depreciation of $46,000, common stock of $25,000, and ending retained earnings of $8,000. There are no changes budgeted in the equipment or common stock accounts.

Prepare a budgeted balance sheet for March.

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Chapter 20 Master Budgets and Performance Planning 879

Exercise 20-22 Master budget definitions

C2

Match the definitions 1 through 9 with the term or phrase a through i. A. Budget B. Merchandise purchases

budget C. Cash budget D. Safety stock E. Budgeted income statement F. General and administrative

expense budget G. Sales budget H. Master budget I. Budgeted balance sheet

1. A comprehensive business plan that includes specific plans for expected sales, the units of product to be produced, the merchandise or materials to be purchased, the expenses to be incurred, the long-term assets to be purchased, and the amounts of cash to be borrowed or loans to be repaid, as well as a budgeted income statement and balance sheet.

2. A quantity of inventory or materials over the minimum to reduce the risk of running short.

3. A plan showing the units of goods to be sold and the sales to be derived; the usual starting point in the budgeting process.

4. An accounting report that presents predicted amounts of the company’s revenues and expenses for the budgeting period.

5. An accounting report that presents predicted amounts of the company’s assets, liabilities, and equity balances at the end of the budget period.

6. A plan that shows the units or costs of merchandise to be purchased by a merchandising company during the budget period.

7. A formal statement of a company’s future plans, usually expressed in monetary terms.

8. A plan that shows predicted operating expenses not in- cluded in the selling expenses budget.

9. A plan that shows the expected cash inflows and cash out- flows during the budget period, including receipts from any loans needed to maintain a minimum cash balance and repayments of such loans.

Exercise 20-23 Budget consequences C1

Participatory budgeting can sometimes lead to negative consequences. Identify three potential negative outcomes that can arise from participatory budgeting.

Data entry . . . . . . . . . 2,200 hours

Auditing . . . . . . . . . . . 4,800 hours

Tax . . . . . . . . . . . . . . . 4,300 hours

Consulting . . . . . . . . . 750 hours

Exercise 20-24 Activity-based budgeting

A1

Render Co. CPA is preparing activity-based budgets for 2013. The partners expect the firm to generate bill- able hours for the year as follows:

The company pays $10 per hour to data-entry clerks, $40 per hour to audit personnel, $50 per hour to tax personnel, and $50 per hour to consulting personnel. Prepare a schedule of budgeted labor costs for 2013 using activity-based budgeting.

Direct materials . . . . . . . . . . Each unit requires 0.60 pounds of a key raw material, priced at $175 per pound. The company plans to end each quarter with an ending inventory of materials equal to 50% of next quarter’s budgeted materials requirements.

Direct labor . . . . . . . . . . . . . Each finished unit requires 4 direct labor hours, at a cost of $9 per hour.

Variable overhead . . . . . . . . Applied at the rate of $11 per direct labor hour.

Fixed overhead . . . . . . . . . . Budgeted at $450,000 per quarter

Exercise 20-25 Manufacturing: Direct materials budget

P3

Rida, Inc., a manufacturer in a seasonal industry, is preparing its direct materials budget for the second quarter. It forecasts sales of 225,000 units in the second quarter and 262,500 units in the third quarter. It also plans production of 52,500 units for the third quarter. Based on this information, the company plans to produce 240,000 units in the second quarter. Other information is as follows:

Prepare a direct materials budget for the second quarter.

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880 Chapter 20 Master Budgets and Performance Planning

Exercise 20-26 Manufacturing: Direct labor and factory overhead budgets

P3

Refer to Exercise 20-25. For the second quarter, prepare (1) a direct labor budget and (2) a factory overhead budget.

Exercise 20-27 Manufacturing: Direct materials budget

P3

Rad Co. provides the following sales forecast and production budget for the next four months:

April May June July

Sales (units) . . . . . . . . . . . . . . . . . . . . . . 500 580 530 600

Budgeted production (units) . . . . . . . . . 442 570 544 540

The company plans for finished goods inventory of 120 units at the end of June. In addition, each finished unit requires five pounds of raw materials and the company wants to end each month with raw materials inventory equal to 30% of next month’s production needs. Beginning raw materials inventory for April was 663 pounds. Each finished unit requires 0.50 hours of direct labor at the rate of $16 per hour. The company budgets variable overhead at the rate of $20 per direct labor hour and budgets fixed overhead of $8,000 per month. Prepare a raw materials budget for April, May, and June.

Exercise 20-28 Manufacturing: Direct labor and factory overhead budgets

P3

Refer to Exercise 20-27. For April, May, and June, prepare (1) a direct labor budget and (2) a factory over- head budget.

Keggler’s Supply is a merchandiser of three different products. The company’s February 28 inventories are footwear, 20,000 units; sports equipment, 80,000 units; and apparel, 50,000 units. Management be- lieves that excessive inventories have accumulated for all three products. As a result, a new policy dictates that ending inventory in any month should equal 30% of the expected unit sales for the following month. Expected sales in units for March, April, May, and June follow.

PROBLEM SET A

Problem 20-1A Merchandising: Preparation and analysis of purchases budgets

C2 P1 Budgeted Sales in Units

March April May June

Footwear . . . . . . . . . . . . . . . 15,000 25,000 32,000 35,000

Sports equipment . . . . . . . . 70,000 90,000 95,000 90,000

Apparel . . . . . . . . . . . . . . . . 40,000 38,000 37,000 25,000mhhe.com/wildFINMAN5e

Required

1. Prepare a merchandise purchases budget (in units) for each product for each of the months of March, April, and May.

Analysis Component

2. The purchases budgets in part 1 should reflect fewer purchases of all three products in March com- pared to those in April and May. What factor caused fewer purchases to be planned? Suggest business conditions that would cause this factor to both occur and impact the company in this way.

Check (I) March budgeted purchases Footwear, 2,500; Sports equip., 17,000; Apparel, 1,400

mhhe.com/wildFINMAN5e

Problem 20-2A Merchandising: Preparation of cash budgets (for three periods)

C2 P2

During the last week of August, Oneida Company’s owner approaches the bank for an $100,000 loan to be made on September 2 and repaid on November 30 with annual interest of 12%, for an interest cost of $3,000. The owner plans to increase the store’s inventory by $80,000 during September and needs the loan to pay for inventory acquisitions. The bank’s loan officer needs more information about Oneida’s ability to repay the loan and asks the owner to forecast the store’s November 30 cash position. On September 1, Oneida is expected to have a $5,000 cash balance, $148,000 of accounts receivable, and $125,000 of ac- counts payable. Its budgeted sales, merchandise purchases, and various cash disbursements for the next three months follow.

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Chapter 20 Master Budgets and Performance Planning 881

* Operations began in August; August sales were $215,000 and purchases were $125,000.

File Edit View Insert Format Tools Data Window Help

1 2 3 4 5 6 7 8 9

Budgeted Figures* September October November

Sales ........................................... Merchandise purchases .............. Cash disbursements Payroll ...................................... Rent ......................................... Other cash expenses .............. Repayment of bank loan ......... Interest on the bank loan .........

$250,000 240,000

20,000 10,000 35,000

$375,000 225,000

22,000 10,000 30,000

$400,000 200,000

24,000 10,000 20,000

100,000 3,000

The budgeted September merchandise purchases include the inventory increase. All sales are on account. The company predicts that 25% of credit sales is collected in the month of the sale, 45% in the month following the sale, 20% in the second month, 9% in the third, and the remainder is uncollectible. Applying these percents to the August credit sales, for example, shows that $96,750 of the $215,000 will be collected in September, $43,000 in October, and $19,350 in November. All merchandise is purchased on credit; 80% of the balance is paid in the month following a purchase, and the remaining 20% is paid in the second month. For example, of the $125,000 August purchases, $100,000 will be paid in September and $25,000 in October.

Required

Prepare a cash budget for September, October, and November for Oneida Company. Show supporting calculations as needed.

Check Budgeted cash balance: September, $99,250; October, $69,500; November, $22,600

Problem 20-3A Merchandising: Preparation and analysis of cash budgets with supporting inventory and purchases budgets

C2 P2

Aztec Company sells its product for $180 per unit. Its actual and projected sales follow.

Units Dollars

April (actual) . . . . . . . . . . . . . 4,000 $ 720,000

May (actual) . . . . . . . . . . . . . . 2,000 360,000

June (budgeted) . . . . . . . . . . . 6,000 1,080,000

July (budgeted) . . . . . . . . . . . . 5,000 900,000

August (budgeted) . . . . . . . . . 3,800 684,000

All sales are on credit. Recent experience shows that 20% of credit sales is collected in the month of the sale, 50% in the month after the sale, 28% in the second month after the sale, and 2% proves to be un- collectible. The product’s purchase price is $110 per unit. All purchases are payable within 12 days. Thus, 60% of purchases made in a month is paid in that month and the other 40% is paid in the next month. The company has a policy to maintain an ending monthly inventory of 20% of the next month’s unit sales plus a safety stock of 100 units. The April 30 and May 31 actual inventory levels are consistent with this policy. Selling and administrative expenses for the year are $1,320,000 and are paid evenly throughout the year in cash. The company’s minimum cash balance at month-end is $100,000. This minimum is maintained, if necessary, by borrowing cash from the bank. If the balance exceeds $100,000, the company repays as much of the loan as it can without going below the minimum. This type of loan carries an annual 12% interest rate. On May 31, the loan balance is $25,000, and the com- pany’s cash balance is $100,000. (Round amounts to the nearest dollar.)

Required

1. Prepare a table that shows the computation of cash collections of its credit sales (accounts receivable) in each of the months of June and July.

2. Prepare a table that shows the computation of budgeted ending inventories (in units) for April, May, June, and July.

3. Prepare the merchandise purchases budget for May, June, and July. Report calculations in units and then show the dollar amount of purchases for each month.

4. Prepare a table showing the computation of cash payments on product purchases for June and July. 5. Prepare a cash budget for June and July, including any loan activity and interest expense. Compute the

loan balance at the end of each month.

Check (1) Cash collections: June, $597,600; July, $820,800

(3) Budgeted purchases: May, $308,000; June, $638,000

(5) Budgeted ending loan balance: June, $43,650; July, $0

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882 Chapter 20 Master Budgets and Performance Planning

MERLINE COMPANY Income Statement

For Month Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,250,000

Cost of goods sold . . . . . . . . . . . . . . . 1,125,000

Gross profit . . . . . . . . . . . . . . . . . . . . . 1,125,000

Expenses

Sales commissions (10%) . . . . . . . . 225,000

Advertising . . . . . . . . . . . . . . . . . . . 250,000

Store rent . . . . . . . . . . . . . . . . . . . . 30,000

Administrative salaries . . . . . . . . . . 45,000

Depreciation . . . . . . . . . . . . . . . . . . 50,000

Other expenses . . . . . . . . . . . . . . . 10,000

Total expenses . . . . . . . . . . . . . . . . . 610,000

Net income . . . . . . . . . . . . . . . . . . . . . $ 515,000

Merline, a one-product mail-order firm, buys its product for $75 per unit and sells it for $150 per unit. The sales staff receives a 10% commission on the sale of each unit. Its December income statement follows.

Management expects December’s results to be repeated in January, February, and March of 2014 without any changes in strategy. Management, however, has an alternative plan. It believes that unit sales will in- crease at a rate of 10% each month for the next three months (beginning with January) if the item’s selling price is reduced to $125 per unit and advertising expenses are increased by 15% and remain at that level for all three months. The cost of its product will remain at $75 per unit, the sales staff will continue to earn a 10% commission, and the remaining expenses will stay the same.

Required

1. Prepare budgeted income statements for each of the months of January, February, and March that show the expected results from implementing the proposed changes. Use a three-column format, with one column for each month.

Analysis Component

2. Use the budgeted income statements from part 1 to recommend whether management should implement the proposed changes. Explain.

Problem 20-4A Merchandising: Preparation and analysis of budgeted income statements

C2 P2

Check (1) Budgeted net income: January, $196,250; February, $258,125; March, $326,187

Analysis Component

6. Refer to your answer to part 5. Aztec’s cash budget indicates the company will need to borrow more than $18,000 in June. Suggest some reasons that knowing this information in May would be helpful to management.

Problem 20-5A Merchandising: Preparation of a complete master budget

C2 P1 P2

Near the end of 2013, the management of Dimsdale Sports Co., a merchandising company, prepared the following estimated balance sheet for December 31, 2013.

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . $ 36,000

Accounts receivable . . . . . . . . . . . 525,000

Inventory . . . . . . . . . . . . . . . . . . . . 150,000

Total current assets . . . . . . . . . . . . $ 711,000

Equipment . . . . . . . . . . . . . . . . . . . 540,000

Less accumulated depreciation . . . 67,500

Equipment, net . . . . . . . . . . . . . . 472,500

Total assets . . . . . . . . . . . . . . . . . . $1,183,500

DIMSDALE SPORTS COMPANY Estimated Balance Sheet

December 31, 2013

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . $360,000

Bank loan payable . . . . . . . . . . . . . 15,000

Taxes payable (due 3/15/2014) . . . 90,000

Total liabilities . . . . . . . . . . . . . . . . $465,000

Common stock . . . . . . . . . . . . . . . 472,500

Retained earnings . . . . . . . . . . . . . 246,000

Total stockholders’ equity . . . . . . 718,500

Total liabilities and equity . . . . . . . $1,183,500

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Chapter 20 Master Budgets and Performance Planning 883

To prepare a master budget for January, February, and March of 2014, management gathers the following information. a. Dimsdale Sports’ single product is purchased for $30 per unit and resold for $55 per unit. The ex-

pected inventory level of 5,000 units on December 31, 2013, is more than management’s desired level for 2014, which is 20% of the next month’s expected sales (in units). Expected sales are: January, 7,000 units; February, 9,000 units; March, 11,000 units; and April, 10,000 units.

b. Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 60% is collected in the first month after the month of sale and 40% in the second month after the month of sale. For the December 31, 2013, accounts receivable balance, $125,000 is collected in January and the remaining $400,000 is collected in February.

c. Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the December 31, 2013, accounts payable balance, $80,000 is paid in January and the remaining $280,000 is paid in February.

d. Sales commissions equal to 20% of sales are paid each month. Sales salaries (excluding commissions) are $60,000 per year.

e. General and administrative salaries are $144,000 per year. Maintenance expense equals $2,000 per month and is paid in cash.

f. Equipment reported in the December 31, 2013, balance sheet was purchased in January 2013. It is be- ing depreciated over eight years under the straight-line method with no salvage value. The following amounts for new equipment purchases are planned in the coming quarter: January, $36,000; February, $96,000; and March, $28,800. This equipment will be depreciated under the straight-line method over eight years with no salvage value. A full month’s depreciation is taken for the month in which equip- ment is purchased.

g. The company plans to acquire land at the end of March at a cost of $150,000, which will be paid with cash on the last day of the month.

h. Dimsdale Sports has a working arrangement with its bank to obtain additional loans as needed. The interest rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full payments on these loans can be made on the last day of the month. The company has agreed to maintain a minimum ending cash balance of $25,000 in each month.

i. The income tax rate for the company is 40%. Income taxes on the first quarter’s income will not be paid until April 15.

Required

Prepare a master budget for each of the first three months of 2014; include the following component budgets (show supporting calculations as needed, and round amounts to the nearest dollar): 1. Monthly sales budgets (showing both budgeted unit sales and dollar sales). 2. Monthly merchandise purchases budgets. 3. Monthly selling expense budgets. 4. Monthly general and administrative expense budgets. 5. Monthly capital expenditures budgets. 6. Monthly cash budgets. 7. Budgeted income statement for the entire first quarter (not for each month). 8. Budgeted balance sheet as of March 31, 2014.

Check (2) Budgeted purchases: January, $114,000; February, $282,000 (3) Budgeted selling expenses: January, $82,000; February, $104,000

(6) Ending cash bal.: January, $30,100; February, $210,300

(8) Budgeted total assets at March 31, $1,568,650

Black Diamond Company produces snow skis. Each ski requires 2 pounds of carbon fiber. The company’s management predicts that 5,000 skis and 6,000 pounds of carbon fiber will be in inventory on June 30 of the current year and that 150,000 skis will be sold during the next (third) quarter. A set of two skis sells for $300. Management wants to end the third quarter with 3,500 skis and 4,000 pounds of carbon fiber in inventory. Carbon fiber can be purchased for $15 per pound. Each ski requires 0.5 hours of direct labor at $20 per hour. Variable overhead is applied at the rate of $8 per direct labor hour. The company budgets fixed overhead of $1,782,000 for the quarter.

Required

1. Prepare the third-quarter production budget for skis. 2. Prepare the third-quarter direct materials (carbon fiber) budget; include the dollar cost of purchases.

Problem 20-6AA

Manufacturing: Preparing production and manufacturing budgets

C2 P3

Check (1) Units manuf., 148,500; (2) Cost of carbon fiber purchases, $4,425,000

[continued on next page]

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884 Chapter 20 Master Budgets and Performance Planning

The management of Zigby Manufacturing prepared the following estimated balance sheet for March, 2013:Problem 20-7A Manufacturing: Preparation of a complete master budget

C2 P1 P2 P3

To prepare a master budget for April, May, and June of 2013, management gathers the following information: a. Sales for March total 20,500 units. Forecasted sales in units are as follows: April, 20,500; May, 19,500;

June, 20,000; July, 20,500. Sales of 240,000 units are forecasted for the entire year. The product’s sell- ing price is $23.85 per unit and its total product cost is $19.85 per unit.

b. Company policy calls for a given month’s ending raw materials inventory to equal 50% of the next month’s materials requirements. The March 31 raw materials inventory is 4,925 units, which complies with the policy. The expected June 30 ending raw materials inventory is 4,000 units. Raw materials cost $20 per unit. Each finished unit requires 0.50 units of raw materials.

c. Company policy calls for a given month’s ending finished goods inventory to equal 80% of the next month’s expected unit sales. The March 31 finished goods inventory is 16,400 units, which complies with the policy.

d. Each finished unit requires 0.50 hours of direct labor at a rate of $15 per hour. e. Overhead is allocated based on direct labor hours. The predetermined variable overhead rate is

$2.70 per direct labor hour. Depreciation of $20,000 per month is treated as fixed factory overhead.

f. Sales representatives’ commissions are 8% of sales and are paid in the month of the sales. The sales manager’s monthly salary is $3,000 per month.

g. Monthly general and administrative expenses include $12,000 administrative salaries and 0.9% monthly interest on the long-term note payable.

h. The company expects 30% of sales to be for cash and the remaining 70% on credit. Receivables are collected in full in the month following the sale (none is collected in the month of the sale).

i. All raw materials purchases are on credit, and no payables arise from any other transactions. One month’s raw materials purchases are fully paid in the next month.

j. The minimum ending cash balance for all months is $40,000. If necessary, the company borrows enough cash using a short-term note to reach the minimum. Short-term notes require an interest payment of 1% at each month-end (before any repayment). If the ending cash balance exceeds the minimum, the excess will be applied to repaying the short-term notes payable balance.

k. Dividends of $10,000 are to be declared and paid in May. l. No cash payments for income taxes are to be made during the second calendar quarter. Income tax will

be assessed at 35% in the quarter and paid in the third calendar quarter. m. Equipment purchases of $130,000 are budgeted for the last day of June.

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000

Accounts receivable . . . . . . . . . . . . . . 342,248

Raw materials inventory . . . . . . . . . . . 98,500

Finished goods inventory . . . . . . . . . . 325,540

Total current assets . . . . . . . . . . . . . 806,288

Equipment, gross . . . . . . . . . . . . . . . . . 600,000

Accumulated depreciation . . . . . . . . . (150,000)

Equipment, net . . . . . . . . . . . . . . . . 450,000

Total assets . . . . . . . . . . . . . . . . . . . . . $1,256,288

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . $ 200,500

Short-term notes payable . . . . . . . . . 12,000

Total current liabilities . . . . . . . . . . 212,500

Long-term note payable . . . . . . . . . . 500,000

Total liabilities . . . . . . . . . . . . . . . . 712,500

Common stock . . . . . . . . . . . . . . . . . 335,000

Retained earnings . . . . . . . . . . . . . . . 208,788

Total stockholders’ equity . . . . . . . 543,788

Total liabilities and equity . . . . . . . . . $1,256,288

ZIGBY MANUFACTURING Estimated Balance Sheet

March 31, 2013

3. Prepare the direct labor budget for the third quarter. 4. Prepare the factory overhead budget for the third quarter.

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Chapter 20 Master Budgets and Performance Planning 885

Budgeted Sales in Units

April May June July

Water skis . . . . . . . . . 70,000 90,000 130,000 100,000

Tow ropes . . . . . . . . . 100,000 90,000 110,000 100,000

Life jackets . . . . . . . . . 160,000 190,000 200,000 120,000

PROBLEM SET B

Problem 20-1B Merchandising: Preparation and analysis of purchases budgets

C2 P1

H20 Sports Company is a merchandiser of three different products. The company’s March 31 inventories are water skis, 40,000 units; tow ropes, 90,000 units; and life jackets, 150,000 units. Management believes that excessive inventories have accumulated for all three products. As a result, a new policy dictates that ending inventory in any month should equal 10% of the expected unit sales for the following month. Expected sales in units for April, May, June, and July follow.

Required

1. Prepare a merchandise purchases budget (in units) for each product for each of the months of April, May, and June.

Analysis Component

2. The purchases budgets in part 1 should reflect fewer purchases of all three products in April com- pared to those in May and June. What factor caused fewer purchases to be planned? Suggest business conditions that would cause this factor to both occur and affect the company as it has.

Check (1) April budgeted purchases: Water skis, 39,000; Tow ropes, 19,000; Life jackets, 29,000

Problem 20-2B Merchandising: Preparation of cash budgets (for three periods)

C2 P2

During the last week of March, Sony Stereo’s owner approaches the bank for a $80,000 loan to be made on April 1 and repaid on June 30 with annual interest of 12%, for an interest cost of $2,400. The owner plans to increase the store’s inventory by $60,000 in April and needs the loan to pay for inventory acquisitions. The bank’s loan officer needs more information about Sony Stereo’s ability to repay the loan and asks the owner to forecast the store’s June 30 cash position. On April 1, Sony Stereo is expected to have a $3,000 cash balance, $135,000 of accounts receivable, and $100,000 of accounts

Required

Prepare the following budgets and other financial information as required. All budgets and other finan- cial information should be prepared for the second calendar quarter, except as otherwise noted below. Round calculations up to the nearest whole dollar, except for the amount of cash sales, which should be rounded down to the nearest whole dollar.: 1. Sales budget. 2. Production budget. 3. Raw materials budget. 4. Direct labor budget. 5. Factory overhead budget. 6. Selling expense budget. 7. General and administrative expense budget. 8. Cash budget. 9. Budgeted income statement for the entire first quarter (not for each month separately). 10. Budgeted statement of retained earnings. 11. Budgeted balance sheet as of the end of the second calendar quarter.

Check (2) Units to produce: April, 19,700; May, 19,900 (3) Cost of raw materials purchases, April, $198,000 (5) Total overhead cost, May, $46,865

(8) Ending cash balance: April, $83,346; May, $124,295

(10) Budgeted total assets, June 30: $1,299,440

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886 Chapter 20 Master Budgets and Performance Planning

payable. Its budgeted sales, merchandise purchases, and various cash disbursements for the next three months follow.

The budgeted April merchandise purchases include the inventory increase. All sales are on account. The company predicts that 25% of credit sales is collected in the month of the sale, 45% in the month fol lowing the sale, 20% in the second month, 9% in the third, and the remainder is uncollectible. Applying these percents to the March credit sales, for example, shows that $81,000 of the $180,000 will be collected in April, $36,000 in May, and $16,200 in June. All merchandise is purchased on credit; 80% of the balance is paid in the month following a purchase and the remaining 20% is paid in the second month. For exam- ple, of the $100,000 March purchases, $80,000 will be paid in April and $20,000 in May.

Required

Prepare a cash budget for April, May, and June for Sony Stereo. Show supporting calculations as needed.

File Edit View Insert Format Tools Data Window Help

1 2 3 4 5 6 7 8 9

Budgeted Figures* April May June

Sales ........................................... Merchandise purchases .............. Cash disbursements Payroll ..................................... Rent ......................................... Other cash expenses .............. Repayment of bank loan ......... Interest on the bank loan.........

*Operations began in March; March sales were $180,000 and purchases were $100,000.

$220,000 210,000

16,000 6,000

64,000

$300,000 180,000

17,000 6,000 8,000

$380,000 220,000

18,000 6,000 7,000

80,000 2,400

Check Budgeted cash balance: April, $53,000; May, $44,000; June, $34,800

Problem 20-3B Merchandising: Preparation and analysis of cash budgets with supporting inventory and purchases budgets

C2 P2

Connick Company sells its product for $22 per unit. Its actual and projected sales follow.

Units Dollars

January (actual) . . . . . . . . . . 18,000 $396,000

February (actual) . . . . . . . . . 22,500 495,000

March (budgeted) . . . . . . . . 19,000 418,000

April (budgeted) . . . . . . . . . 18,750 412,500

May (budgeted) . . . . . . . . . . 21,000 462,000

All sales are on credit. Recent experience shows that 40% of credit sales is collected in the month of the sale, 35% in the month after the sale, 23% in the second month after the sale, and 2% proves to be uncollectible. The product’s purchase price is $12 per unit. All purchases are payable within 21 days. Thus, 30% of pur- chases made in a month is paid in that month and the other 70% is paid in the next month. The company has a policy to maintain an ending monthly inventory of 20% of the next month’s unit sales plus a safety stock of 100 units. The January 31 and February 28 actual inventory levels are consistent with this policy. Selling and administrative expenses for the year are $1,920,000 and are paid evenly throughout the year in cash. The company’s minimum cash balance for month-end is $50,000. This minimum is maintained, if necessary, by borrowing cash from the bank. If the balance exceeds $50,000, the company repays as much of the loan as it can without going below the minimum. This type of loan carries an annual 12% interest rate. At February 28, the loan balance is $12,000, and the company’s cash balance is $50,000.

Required

1. Prepare a table that shows the computation of cash collections of its credit sales (accounts receivable) in each of the months of March and April.

2. Prepare a table showing the computations of budgeted ending inventories (units) for January, February, March, and April.

3. Prepare the merchandise purchases budget for February, March, and April. Report calculations in units and then show the dollar amount of purchases for each month.

4. Prepare a table showing the computation of cash payments on product purchases for March and April. 5. Prepare a cash budget for March and April, including any loan activity and interest expense. Compute

the loan balance at the end of each month.

Check (1) Cash collections: March, $431,530; April, $425,150

(3) Budgeted purchases: February, $261,600; March, $227,400

(5) Ending cash balance: March, $58,070, April, $94,920

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Chapter 20 Master Budgets and Performance Planning 887

Analysis Component

6. Refer to your answer to part 5. Connick’s cash budget indicates whether the company must borrow additional funds at the end of March. Suggest some reasons that knowing the loan needs in advance would be helpful to management.

Problem 20-4B Merchandising: Preparation and analysis of budgeted income statements

C2 P2

Comp-Media buys its product for $60 and sells it for $130 per unit. The sales staff receives a 10% com- mission on the sale of each unit. Its June income statement follows.

COMP-MEDIA COMPANY Income Statement

For Month Ended June 30, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300,000

Cost of goods sold . . . . . . . . . . . . . . . 600,000

Gross profit . . . . . . . . . . . . . . . . . . . . . 700,000

Expenses

Sales commissions (10%) . . . . . . . . 130,000

Advertising . . . . . . . . . . . . . . . . . . . 200,000

Store rent . . . . . . . . . . . . . . . . . . . . 24,000

Administrative salaries . . . . . . . . . . 40,000

Depreciation . . . . . . . . . . . . . . . . . . 50,000

Other expenses . . . . . . . . . . . . . . . 12,000

Total expenses . . . . . . . . . . . . . . . . . 456,000

Net income . . . . . . . . . . . . . . . . . . . . . $ 244,000

Management expects June’s results to be repeated in July, August, and September without any changes in strategy. Management, however, has another plan. It believes that unit sales will increase at a rate of 10% each month for the next three months (beginning with July) if the item’s selling price is reduced to $115 per unit and advertising expenses are increased by 25% and remain at that level for all three months. The cost of its product will remain at $60 per unit, the sales staff will continue to earn a 10% commis- sion, and the remaining expenses will stay the same.

Required

1. Prepare budgeted income statements for each of the months of July, August, and September that show the expected results from implementing the proposed changes. Use a three-column format, with one column for each month.

Analysis Component

2. Use the budgeted income statements from part 1 to recommend whether management should imple- ment the proposed plan. Explain.

Check Budgeted net income: July, $102,500; August, $150,350; September, $202,985

Problem 20-5B Merchandising: Preparation of a complete master budget

C2 P1 P2

Near the end of 2013, the management of Isle Corp., a merchandising company, prepared the following estimated balance sheet for December 31, 2013.

ISLE CORPORATION Estimated Balance Sheet

December 31, 2013

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . $ 36,000

Accounts receivable . . . . . . . . . . . 525,000

Inventory . . . . . . . . . . . . . . . . . . . . 150,000

Total current assets . . . . . . . . . . . . $ 711,000

Equipment . . . . . . . . . . . . . . . . . . . 540,000

Less accumulated depreciation . . . 67,500

Equipment, net . . . . . . . . . . . . . . 472,500

Total assets . . . . . . . . . . . . . . . . . . $1,183,500

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . $360,000

Bank loan payable . . . . . . . . . . . . . 15,000

Taxes payable (due 3/15/2014) . . . 90,000

Total liabilities . . . . . . . . . . . . . . . . $ 465,000

Common stock . . . . . . . . . . . . . . . 472,500

Retained earnings . . . . . . . . . . . . . 246,000

Total stockholders’ equity . . . . . . 718,500

Total liabilities and equity . . . . . . . $1,183,500

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888 Chapter 20 Master Budgets and Performance Planning

To prepare a master budget for January, February, and March of 2014, management gathers the following information. a. Isle Corp.’s single product is purchased for $30 per unit and resold for $45 per unit. The expected

inventory level of 5,000 units on December 31, 2013, is more than management’s desired level for 2014, which is 25% of the next month’s expected sales (in units). Expected sales are: January, 6,000 units; February, 8,000 units; March, 10,000 units; and April, 9,000 units.

b. Cash sales and credit sales represent 25% and 75%, respectively, of total sales. Of the credit sales, 60% is collected in the first month after the month of sale and 40% in the second month after the month of sale. For the $525,000 accounts receivable balance at December 31, 2013, $315,000 is collected in January 2014 and the remaining $210,000 is collected in February 2014.

c. Merchandise purchases are paid for as follows: 20% in the first month after the month of purchase and 80% in the second month after the month of purchase. For the $360,000 accounts payable bal- ance at December 31, 2013, $72,000 is paid in January 2014 and the remaining $288,000 is paid in February 2014.

d. Sales commissions equal to 20% of sales are paid each month. Sales salaries (excluding commissions) are $90,000 per year.

e. General and administrative salaries are $144,000 per year. Maintenance expense equals $3,000 per month and is paid in cash.

f. Equipment reported in the December 31, 2013, balance sheet was purchased in January 2013. It is being depreciated over 8 years under the straight-line method with no salvage value. The follow- ing amounts for new equipment purchases are planned in the coming quarter: January, $72,000; February, $96,000; and March, $28,800. This equipment will be depreciated using the straight-line method over 8 years with no salvage value. A full month’s depreciation is taken for the month in which equipment is purchased.

g. The company plans to acquire land at the end of March at a cost of $150,000, which will be paid with cash on the last day of the month.

h. Isle Corp. has a working arrangement with its bank to obtain additional loans as needed. The interest rate is 12% per year, and interest is paid at each month-end based on the beginning balance. Partial or full payments on these loans can be made on the last day of the month. Isle has agreed to maintain a minimum ending cash balance of $36,000 in each month.

i. The income tax rate for the company is 40%. Income taxes on the first quarter’s income will not be paid until April 15.

Required

Prepare a master budget for each of the first three months of 2014; include the following component bud- gets (show supporting calculations as needed, and round amounts to the nearest dollar): 1. Monthly sales budgets (showing both budgeted unit sales and dollar sales). 2. Monthly merchandise purchases budgets. 3. Monthly selling expense budgets. 4. Monthly general and administrative expense budgets. 5. Monthly capital expenditures budgets. 6. Monthly cash budgets. 7. Budgeted income statement for the entire first quarter (not for each month). 8. Budgeted balance sheet as of March 31, 2014.

Check (2) Budgeted purchases: January, $90,000; February, $255,000; (3) Budgeted selling expenses: January, $61,500; February, $79,500

(6) Ending cash bal.: January, $182,500; February, $107,850

Problem 20-6BA

Manufacturing: Preparing production and manufacturing budgets

C2 P3

NSA Company produces baseball bats. Each bat requires 3 pounds of aluminum alloy. Management pre- dicts that 8,000 bats and 15,000 pounds of aluminum alloy will be in inventory on March 31 of the current year and that 250,000 bats will be sold during this year’s second quarter. Bats sell for $80 each. Management wants to end the second quarter with 6,000 finished bats and 12,000 pounds of aluminum alloy in inventory. Aluminum alloy can be purchased for $4 per pound. Each bat requires 0.5 hours of di- rect labor at $18 per hour. Variable overhead is applied at the rate of $12 per direct labor hour. The com- pany budgets fixed overhead of $1,776,000 for the quarter.

(8) Budgeted total assets at March 31, $1,346,875

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Chapter 20 Master Budgets and Performance Planning 889

Check (1) Units manuf., 248,000; (2) Cost of materials purchases, $2,964,000

The management of Nabar Manufacturing prepared the following estimated balance sheet for June, 2013:

Problem 20-7B Manufacturing: Preparation of a complete master budget

C2 P1 P2 P3

To prepare a master budget for July, August, and September of 2013, management gathers the following information: a. Sales were 20,000 units in June. Forecasted sales in units are as follows: July, 21,000; August, 19,000;

September, 20,000; October, 24,000. The product’s selling price is $17 per unit and its total product cost is $14.35 per unit.

b. Company policy calls for a given month’s ending finished goods inventory to equal 70% of the next month’s expected unit sales. The June 30 finished goods inventory is 16,800 units, which does not comply with the policy.

c. Company policy calls for a given month’s ending raw materials inventory to equal 20% of the next month’s materials requirements. The June 30 raw materials inventory is 4,375 units (which also fails to meet the policy). The budgeted September 30 raw materials inventory is 1,980 units. Raw materials cost $8 per unit. Each finished unit requires 0.50 units of raw materials.

d. Each finished unit requires 0.50 hours of direct labor at a rate of $16 per hour. e. Overhead is allocated based on direct labor hours. The predetermined variable overhead rate is $1.35

per direct labor hour. Depreciation of $20,000 per month is treated as fixed factory overhead. f. Monthly general and administrative expenses include $9,000 administrative salaries and 0.9% monthly

interest on the long-term note payable. g. Sales representatives’ commissions are 10% of sales and are paid in the month of the sales. The sales

manager’s monthly salary is $3,500 per month. h. The company expects 30% of sales to be for cash and the remaining 70% on credit. Receivables are

collected in full in the month following the sale (none is collected in the month of the sale). i. All raw materials purchases are on credit, and no payables arise from any other transactions. One

month’s raw materials purchases are fully paid in the next month. j. Dividends of $20,000 are to be declared and paid in August.

Required

1. Prepare the second-quarter production budget for bats. 2. Prepare the second-quarter direct materials (aluminum alloy) budget; include the dollar cost of

purchases. 3. Prepare the direct labor budget for the second quarter. 4. Prepare the factory overhead budget for the second quarter.

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000

Accounts receivable . . . . . . . . . . . . . . 249,900

Raw materials inventory . . . . . . . . . . . 35,000

Finished goods inventory . . . . . . . . . . 241,080

Total current assets . . . . . . . . . . . . . 565,980

Equipment, gross . . . . . . . . . . . . . . . . . 720,000

Accumulated depreciation . . . . . . . . . (240,000)

Equipment, net . . . . . . . . . . . . . . . . 480,000

Total assets . . . . . . . . . . . . . . . . . . . . . $1,045,980

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . $ 51,400

Income taxes payable . . . . . . . . . . . . . 10,000

Short-term notes payable . . . . . . . . . 24,000

Total current liabilities . . . . . . . . . . 85,400

Long-term note payable . . . . . . . . . . 300,000

Total liabilities . . . . . . . . . . . . . . . . 385,400

Common stock . . . . . . . . . . . . . . . . . 600,000

Retained earnings . . . . . . . . . . . . . . . 60,580

Total stockholders’ equity . . . . . . . 660,580

Total liabilities and equity . . . . . . . . . $1,045,980

NABAR MANUFACTURING Estimated Balance Sheet

June 30, 2013

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890 Chapter 20 Master Budgets and Performance Planning

k. Income taxes payable at June 30 will be paid in July. Income tax expense will be assessed at 35% in the quarter and paid in October.

l. Equipment purchases of $100,000 are budgeted for the last day of September. m. The minimum ending cash balance for all months is $40,000. If necessary, the company borrows

enough cash using a short-term note to reach the minimum. Short-term notes require an interest pay- ment of 1% at each month-end (before any repayment). If the ending cash balance exceeds the mini- mum, the excess will be applied to repaying the short-term notes payable balance.

Required

Prepare the following budgets and other financial information as required. All budgets and other finan- cial information should be prepared for the second calendar quarter, except as otherwise noted below. Round calculations to the nearest whole dollar: 1. Sales budget. 2. Production budget. 3. Raw materials budget. 4. Direct labor budget. 5. Factory overhead budget. 6. Selling expense budget. 7. General and administrative expense budget. 8. Cash budget. 9. Budgeted income statement for the entire quarter (not for each month separately). 10. Budgeted statement of retained earnings for the quarter. 11. Budgeted balance sheet as of September 30, 2013.

SUCCESS SYSTEMS Segment Income Statement*

For Quarter Ended March 31, 2014

Sales† . . . . . . . . . . . . . . . . . . . . . . . . . . $180,000

Cost of goods sold‡ . . . . . . . . . . . . . . . 115,000

Gross profit . . . . . . . . . . . . . . . . . . . . . 65,000

Expenses

Sales commissions (10%) . . . . . . . . . . . 18,000

Advertising expenses . . . . . . . . . . . . . . 9,000

Other fixed expenses. . . . . . . . . . . . . . 18,000

Total expenses . . . . . . . . . . . . . . . . . . . 45,000

Net income . . . . . . . . . . . . . . . . . . . . . $ 20,000

* Reflects revenue and expense activity only related to the computer furniture segment. † Revenue: (120 desks 3 $1,250) 1 (60 chairs 3 $500) 5 $150,000 1 $30,000 5 $180,000 ‡ Cost of goods sold: (120 desks 3 $750) 1 (60 chairs 3 $250) 1 $10,000 5 $115,000

Check (2) Units to produce: July, 17,500; August, 19,700 (3) Cost of raw materials purchases, July, $50,760 (5) Total overhead cost, August, $46,595

(8) Ending cash balance: July, $96,835; August, $141,180

(10) Budgeted total assets, Sept. 30: $1,054,920

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 20 Adria Lopez expects second quarter 2014 sales of her new line of computer furniture to be the same as the first quarter’s sales (reported below) without any changes in strategy. Monthly sales averaged 40 desk units (sales price of $1,250) and 20 chairs (sales price of $500).

SERIAL PROBLEM Success Systems

P2

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Chapter 20 Master Budgets and Performance Planning 891

Adria Lopez believes that sales will increase each month for the next three months (April, 48 desks, 32 chairs; May, 52 desks, 35 chairs; June, 56 desks, 38 chairs) if selling prices are reduced to $1,150 for desks and $450 for chairs, and advertising expenses are increased by 10% and remain at that level for all three months. The products’ variable cost will remain at $750 for desks and $250 for chairs. The sales staff will continue to earn a 10% commission, the fixed manufacturing costs per month will remain at $10,000 and other fixed expenses will remain at $6,000 per month.

Required

1. Prepare budgeted income statements for each of the months of April, May, and June that show the expected results from implementing the proposed changes. Use a three-column format, with one col- umn for each month.

2. Use the budgeted income statements from part 1 to recommend whether Adria Lopez should imple- ment the proposed changes. Explain.

Check (1) Budgeted income (loss): April, $(660); May, $945

Beyond the Numbers

BTN 20-1 Financial statements often serve as a starting point in formulating budgets. Review Polaris’ financial statements to determine its cash paid for acquisitions of property and equipment in the current year and the budgeted cash needed for such acquisitions in the next year.

Required

1. Which financial statement reports the amount of cash paid for acquisitions of property and equipment? Explain where on the statement this information is reported.

2. Indicate the amount of cash (a) paid for acquisitions of property and equipment in the year ended December 31, 2011, and (b) to be paid (budgeted for) next year under the assumption that annual ac- quisitions of property and equipment equal 40% of the prior year’s net income.

Fast Forward

3. Access Polaris’ financial statements for a year ending after December 31, 2011, from either its Website [Polaris.com] or the SEC’s EDGAR database [www.sec.gov ]. Compare your answer for part 2 with actual cash paid for acquisitions of property and equipment for that fiscal year. Com- pute the error, if any, in your estimate. Speculate as to why cash paid for acquisitions of property and equipment was higher or lower than your estimate.

REPORTING IN ACTION P2

BTN 20-2 One source of cash savings for a company is improved management of inventory. To il- lustrate, assume that Polaris and Arctic Cat both have $1,000,000 per month in sales of one model of snowmobiles in Canada, and both forecast this level of sales per month for the next 24 months. Also assume that both Polaris and Arctic Cat have a 20% contribution margin, their fixed costs are equal, and that cost of goods sold is the only variable cost. Assume that the main difference between Polaris and Arctic Cat is the distribution system. Polaris uses a just-in-time system and requires ending inven- tory of only 10% of next month’s sales in inventory at each month-end. However, Arctic Cat is build- ing an improved distribution system and currently requires 30% of next month’s sales in inventory at each month-end.

Required

1. Compute the amount by which Arctic Cat can reduce its inventory level if it can match Polaris’ system of maintaining an inventory equal to 10% of next month’s sales. (Hint: Focus on the facts given and only on the Canadian market.)

2. Explain how the analysis in part 1 that shows ending inventory levels for both the 30% and 10% re- quired inventory policies can help justify a just-in-time inventory system. Assume a 15% interest cost for resources that are tied up in ending inventory.

COMPARATIVE ANALYSIS P2

Polaris

Polaris Arctic Cat

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892 Chapter 20 Master Budgets and Performance Planning

BTN 20-3 Both the budget process and budgets themselves can impact management actions, both posi- tively and negatively. For instance, a common practice among not-for-profit organizations and government agencies is for management to spend any amounts remaining in a budget at the end of the budget period, a practice often called “use it or lose it.’’ The view is that if a department manager does not spend the budgeted amount, top management will reduce next year’s budget by the amount not spent. To avoid los- ing budget dollars, department managers often spend all budgeted amounts regardless of the value added to products or services. All of us pay for the costs associated with this budget system.

Required

Write a one-half page report to a local not-for-profit organization or government agency offering a solu- tion to the “use it or lose it” budgeting problem.

ETHICS CHALLENGE C1

BTN 20-4 The sales budget is usually the first and most crucial of the component budgets in a master budget because all other budgets usually rely on it for planning purposes.

Required

Assume that your company’s sales staff provides information on expected sales and selling prices for items making up the sales budget. Prepare a one-page memorandum to your supervisor outlining concerns with the sales staff’s input in the sales budget when its compensation is at least partly tied to these budgets. More gen- erally, explain the importance of assessing any potential bias in information provided to the budget process.

COMMUNICATING IN PRACTICE C2

BTN 20-5 Access information on e-budgets through The Manage Mentor: http://www.themanagementor.com/kuniverse/kmailers_universe/finance_kmailers/cfa/budgeting2.htm Read the information provided.

Required

1. Assume the role of a senior manager in a large, multidivision company. What are the benefits of using e-budgets?

2. As a senior manager, what concerns do you have with the concept and application of e-budgets?

TAKING IT TO THE NET C1

BTN 20-6 Your team is to prepare a budget report outlining the costs of attending college (full- time) for the next two semesters (30 hours) or three quarters (45 hours). This budget’s focus is solely on attending college; do not include personal items in the team’s budget. Your budget must include tuition, books, sup- plies, club fees, food, housing, and all costs associated with travel to and from college. This budgeting exercise is similar to the initial phase in activity-based budgeting. Include a list of any assumptions you use in completing the budget. Be prepared to present your budget in class.

TEAMWORK IN ACTION A1

BTN 20-7 Freshii sells fresh foods with a focus on healthy fare. Company founder Matthew Corrin stresses the importance of planning and budgeting for business success.

Required

1. How can budgeting help Matthew Corrin efficiently develop and operate his business? 2. Why would sales forecasts and purchases budgets be particularly important for a business like

Freshii?

ENTREPRENEURIAL DECISION C1

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Chapter 20 Master Budgets and Performance Planning 893

BTN 20-9 Access KTM’s income statement (in Appendix A) for the business year 2011.

Required

1. Is KTM’s infrastructure and administration expense budget likely to be an important budget in its master budgeting process? Explain.

2. Identify three types of expenses that would be reported as infrastructure and administration expenses on KTM’s income statement.

3. Who likely has the initial responsibility for KTM’s infrastructure and administration expense budget? Explain.

GLOBAL DECISION P1

1. c 2. e; Budgeted purchases 5 $36,000 1 $7,000 2 $6,000 5 $37,000 3. b; Cash collected 5 25% of September sales 1 75% of August sales 5

(0.25 3 $240,000) 1 (0.75 3 $220,000) 5 $225,000

4. d 5. a; 560 units 1 (0.30 3 600 units) 2 (0.30 3 560 units) 5 572 units

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 20-8 To help understand the factors impacting a sales budget, you are to visit three businesses with the same ownership or franchise membership. Record the selling prices of two identical products at each location, such as regular and premium gas sold at Chevron stations. You are likely to find a difference in prices for at least one of the three locations you visit.

Required

1. Identify at least three external factors that must be considered when setting the sales budget. (Note: There is a difference between internal and external factors that impact the sales budget.)

2. What factors might explain any differences identified in the prices of the businesses you visited?

HITTING THE ROAD C2 P1

KTM

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Learning Objectives

CONCEPTUAL

C1 Define standard costs and explain how standard cost information is useful for management by exception. (p. 901)

C2 Describe variances and what they reveal about performance. (p. 903)

ANALYTICAL

A1 Analyze changes in sales from expected amounts. (p. 911)

PROCEDURAL

P1 Prepare a flexible budget and interpret a flexible budget performance report. (p. 898)

P2 Compute materials and labor variances. (p. 904) P3 Compute overhead variances.(p. 908) P4 Appendix 21A—Prepare journal entries for standard costs and account for price and

quantity variances. (p. 918)

A Look at This Chapter

This chapter describes flexible budgets, variance analysis, and standard costs. It explains how each is used for purposes of better controlling and monitoring of business activities.

A Look Back

Chapter 20 explained the master budget and its component budgets as well as their usefulness for planning and monitoring company activities.

Flexible Budgets and Standard Costs 21

A Look Ahead

Chapter 22 describes managerial reports useful in measuring performance and directing a company’s activities. It describes responsibility accounting, measuring departmental performance, allocating common costs across departments, and transfer pricing. It also explains financial and nonfinancial performance measures used to evaluate investment center performance.

894

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Whoosh!

BOULDER, CO—Self-described “ski bum” Jordan Grano wanted a pair of skis that could handle more than one ski season. Frustrated by the quality and performance of “off-the-rack” skis, Jordan began researching how to build better skis. The result is Folsom Custom Skis (folsomskis.com), the company he founded in 2007. In addition to building custom skis to precise customer specifications, the company also builds “semi-custom” skis which allow customers fewer choices. Master Builder and current company President Mike McCabe says customers can “take their favorite skis and alter them to suit their needs and wants. We come up with a finished ski built exactly to customer specifications.” The company’s manufactur- ing process demands precision. “Design elements like ski turn radius, camber, and taper interact in complex ways and require careful measurement,” says Mike. The result is a better-quality and more durable ski as Mike, a professional skier, can attest to. “I was hired to break a set of skis. I failed.” Manufacturers like Folsom Custom Skis must control materi- als, labor, and overhead costs. Determining standard costs helps. For example, Mike estimates it takes 12 hours to go from design to a complete ski. “We make them as fast as we can but we don’t cut corners; we make sure we put an equal amount of time into every one of our skis,” explains Mike. Putting too much time into a ski could waste the company’s productive capacity,

but putting too little time into a ski could result in an inferior product. Attention to variances from standards can keep the manufacturing process on track. The company uses only the highest quality poplar and bam- boo in their skis. Here too, Mike analyzes materials price and quantity variances to control costs. Mike stresses the impor- tance of “having precise specifications and controls to detect problems; we don’t use any material that does not meet our re- quirements.” Unfavorable materials price variances could result from rising raw materials prices, which could cause the company to consider alternative suppliers or raising prices. At an average price of about $1,300 per pair, the company reports revenue of about $300,000 per year. While currently op- erating at about a break-even level, Mike hopes to double the company’s output and ultimately make profits. The use of flexi- ble budgets, reflecting cost estimates at different production levels, can be useful in making business decisions. While atten- tion to budgeting, standards, and variances is important, Mike encourages entrepreneurs to “build a business on something you feel passionate about.”

[Sources: Folsom Custom Skis website, January 2013; Boulder County Business Report, November 13, 2009; Skiing mag (www.skinet.com), July 2009.]

”Skiing is not just a sport, it’s a life-long choice.” —MIKE McCABE

Decision Insight

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Chapter Preview

Budgeting helps organize and formalize management’s planning activities. This chapter extends the study of budgeting to look more closely at the use of budgets to evaluate performance. Evaluations are important for controlling and monitoring business

activities. This chapter also describes and illustrates the use of standard costs and variance analyses. These mana gerial tools are useful for both evaluating and controlling organizations and for the planning of future activities.

This section introduces fixed budgets and fixed budget performance reports. It then introduces flexible budgets and flexible budget performance reports and illustrates their advantages.

Section 1—Flexible Budgets

A master budget reflects management’s planned objectives for a future period. The preparation of a master budget is based on a predicted level of activity such as sales volume for the budget period. This section discusses the effects on the usefulness of budget reports when the actual level of activity differs from the predicted level.

Budgetary Control and Reporting Budgetary control refers to management’s use of budgets to monitor and control a company’s operations. This includes using budgets to see that planned objectives are met. Budget reports contain relevant information that compares actual results to planned activities. This comparison is motivated by a need to both monitor performance and control activities. Budget reports are sometimes viewed as progress reports, or report cards, on management’s performance in achiev- ing planned objectives. These reports can be prepared at any time and for any period. Three common periods for a budget report are a month, quarter, and year. The budgetary control process involves at least four steps: (1) develop the budget from planned objectives, (2) compare actual results to budgeted amounts and analyze any differences, (3) take corrective and strategic actions, and (4) establish new planned objectives and prepare a new budget. Exhibit 21.1 shows this continual process of budgetary control. Budget reports and

BUDGETARY PROCESS

Point: Budget reports are often used to determine bonuses of managers.

EXHIBIT 21.1 Process of Budgetary Control

OPTEL Fixed Budget Performance Report For Month Ended January 31, 2013

Fixed Actual Budget Results Variances*

Sales (in units) . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 12,000

Sales (in dollars) . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $125,000 $25,000 F

Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 10,000 13,000 3,000 U

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 20,000 5,000 U

Overhead

Factory supplies . . . . . . . . . . . . . . . . . . . . . . 2,000 2,100 100 U

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,000 1,000 U

Depreciation — machinery . . . . . . . . . . . . . . 8,000 8,000 0

Supervisory salaries . . . . . . . . . . . . . . . . . . . 11,000 11,000 0

Selling expenses

Sales commissions . . . . . . . . . . . . . . . . . . . . . . 9,000 10,800 1,800 U

Shipping expenses . . . . . . . . . . . . . . . . . . . . . . 4,000 4,300 300 U

General and administrative expenses

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,200 200 U

Insurance expenses . . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U

Depreciation — office equipment . . . . . . . . . . . 7,000 7,000 0

Administrative salaries . . . . . . . . . . . . . . . . . . . 13,000 13,000 0

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . 88,000 99,600 11,600 U

Income from operations . . . . . . . . . . . . . . . . . . . $ 12,000 $ 25,400 $13,400 F

* F 5 Favorable variance; U 5 Unfavorable variance.

Flexible Budget Reports

• Purpose • Preparation • Flexible budget

performance report

Budgetary Process

• Control and reporting

• Fixed budget performance report

• Budget reports for evaluation

Materials and Labor Standards

• Identifying standard costs

• Setting standard costs

Cost Variances

• Analysis • Computation • Computing

materials and labor variances

Overhead Standards and Variances

• Setting overhead standards

• Predicting activity levels

• Computing overhead variances

Flexible Budgets Standard Costs

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Chapter 21 Flexible Budgets and Standard Costs 897

related documents are effective tools for managers to obtain the greatest benefits from this bud- getary process.

Fixed Budget Performance Report In a fixed budgetary control system, the master budget is based on a single prediction for sales volume or other activity level. The budgeted amount for each cost essentially assumes that a specific (or fixed ) amount of sales will occur. A fixed budget, also called a static budget, is based on a single predicted amount of sales or other measure of activity. One benefit of a budget is its usefulness in comparing actual results with planned activities. In- formation useful for analysis is often presented for comparison in a performance report. As shown in Exhibit 21.2, a fixed budget performance report for Optel compares actual results for January 2013 with the results expected under its fixed budget that predicted 10,000 (composite) units of sales. Optel manufactures inexpensive eyeglasses, frames, contact lens, and related supplies. For this report, its production volume equals sales volume (its inventory level did not change).

This type of performance report designates differences between budgeted and actual results as variances. We see the letters F and U located beside the numbers in the third number column of this report. Their meanings are as follows:

F 5  Favorable variance When compared to budget, the actual cost or revenue contributes to a higher income. That is, actual revenue is higher than budgeted revenue, or actual cost is lower than budgeted cost.

U 5  Unfavorable variance When compared to budget, the actual cost or revenue contributes to a lower income; actual revenue is lower than budgeted revenue, or actual cost is higher than budgeted cost.

This convention is common in practice and is used throughout this chapter.

OPTEL Fixed Budget Performance Report For Month Ended January 31, 2013

Fixed Actual Budget Results Variances*

Sales (in units) . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 12,000

Sales (in dollars) . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $125,000 $25,000 F

Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 10,000 13,000 3,000 U

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 20,000 5,000 U

Overhead

Factory supplies . . . . . . . . . . . . . . . . . . . . . . 2,000 2,100 100 U

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,000 1,000 U

Depreciation — machinery . . . . . . . . . . . . . . 8,000 8,000 0

Supervisory salaries . . . . . . . . . . . . . . . . . . . 11,000 11,000 0

Selling expenses

Sales commissions . . . . . . . . . . . . . . . . . . . . . . 9,000 10,800 1,800 U

Shipping expenses . . . . . . . . . . . . . . . . . . . . . . 4,000 4,300 300 U

General and administrative expenses

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,200 200 U

Insurance expenses . . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U

Depreciation — office equipment . . . . . . . . . . . 7,000 7,000 0

Administrative salaries . . . . . . . . . . . . . . . . . . . 13,000 13,000 0

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . 88,000 99,600 11,600 U

Income from operations . . . . . . . . . . . . . . . . . . . $ 12,000 $ 25,400 $13,400 F

EXHIBIT 21.2 Fixed Budget Performance Report

* F 5 Favorable variance; U 5 Unfavorable variance.

Example: How is it that the favorable sales variance in Exhibit 21.2 is linked with so many unfavorable cost and expense variances? Answer: Costs have increased with the increase in sales.

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898 Chapter 21 Flexible Budgets and Standard Costs

Budget Reports for Evaluation A primary use of budget reports is as a tool for management to monitor and control operations. Evaluation by Optel management is likely to focus on a variety of questions that might include these:

● Why is actual income from operations $13,400 higher than budgeted? ● Are amounts paid for each expense item too high? ● Is manufacturing using too much direct material? ● Is manufacturing using too much direct labor?

The performance report in Exhibit 21.2 provides little help in answering these questions because actual sales volume is 2,000 units higher than budgeted. A manager does not know if this higher level of sales activity is the cause of variations in total dollar sales and expenses or if other factors have influenced these amounts. This inability of fixed budget reports to adjust for changes in activ- ity levels is a major limitation of a fixed budget performance report. That is, it fails to show whether actual costs are out of line due to a change in actual sales volume or some other factor.

Purpose of Flexible Budgets To help address limitations with the fixed budget performance report, particularly from the effects of changes in sales volume, management can use a flexible budget. A flexible budget, also called a variable budget, is a report based on predicted amounts of revenues and expenses corresponding to the actual level of output. Flexible budgets are useful both before and after the period’s activities are complete. A flexible budget prepared before the period is often based on several levels of activity. Bud- gets for those different levels can provide a “what-if ” look at operations. The different levels often include both a best case and worst case scenario. This allows management to make adjust- ments to avoid or lessen the effects of the worst case scenario. A flexible budget prepared after the period helps management evaluate past performance. It is especially useful for such an evaluation because it reflects budgeted revenues and costs based on the actual level of activity. Thus, comparisons of actual results with budgeted performance are more likely to identify the causes of any differences. This can help managers focus attention on real problem areas and implement corrective actions. This is in contrast to a fixed budget, whose primary purpose is to assist managers in planning future activities and whose numbers are based on a single predicted amount of budgeted sales or production.

Preparation of Flexible Budgets A flexible budget is designed to reveal the effects of volume of activity on revenues and costs. To prepare a flexible budget, management relies on the distinctions between fixed and variable costs. Recall that the cost per unit of activity remains constant for variable costs so that the total amount of a variable cost changes in direct proportion to a change in activity level. The total amount of fixed cost remains unchanged regardless of changes in the level of activity within a relevant (normal) operating range. (Assume that costs can be reasonably classified as variable or fixed within a relevant range.)

FLEXIBLE BUDGET REPORTS

P1 Prepare a flexible budget and interpret a flexible budget performance report.

Point: A flexible budget yields an “apples to apples” comparison because budgeted activity levels are the same as the actual.

Cruise Control Budget reporting and evaluation are used at service providers such as Royal Carribbean Cruises Ltd. It regu- larly prepares performance plans and budget requests for its fleet of cruise ships, which describe performance goals, measure out- comes, and analyze variances. ■

Decision Insight

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Chapter 21 Flexible Budgets and Standard Costs 899

When we create the numbers constituting a flexible budget, we express each variable cost as either a constant amount per unit of sales or as a percent of a sales dollar. In the case of a fixed cost, we express its budgeted amount as the total amount expected to occur at any sales volume within the relevant range. Exhibit 21.3 shows a set of flexible budgets for Optel for January 2013. Seven of its ex penses are classified as variable costs. Its remaining five expenses are fixed costs. These classifications result from management’s investigation of each expense. Variable and fixed expense categories are not the same for every company, and we must avoid drawing conclusions from specific cases. For example, depending on the nature of a company’s operations, office supplies expense can be either fixed or variable with respect to sales.

Point: The usefulness of a flexible budget depends on valid classification of variable and fixed costs. Some costs are mixed and must be analyzed to deter- mine their variable and fixed portions.

The layout for the flexible budgets in Exhibit 21.3 follows a contribution margin format— beginning with sales followed by variable costs and then fixed costs. Both the expected indi- vidual and total variable costs are reported and then subtracted from sales. The difference between sales and variable costs equals contribution margin. The expected amounts of fixed costs are listed next, followed by the expected income from operations before taxes. The first and second number columns of Exhibit 21.3 show the flexible budget amounts for variable costs per unit and each fixed cost for any volume of sales in the relevant range. The third, fourth, and fifth columns show the flexible budget amounts computed for three different sales volumes. For instance, the third column’s flexible budget is based on 10,000 units. These num- bers are the same as those in the fixed budget of Exhibit 21.2 because the expected volumes are the same for these two budgets. Recall that Optel’s actual sales volume for January is 12,000 units. This sales volume is 2,000 units more than the 10,000 units originally predicted in the master budget. When differ- ences between actual and predicted volume arise, the usefulness of a flexible budget is apparent. For instance, compare the flexible budget for 10,000 units in the third column (which is the same as the fixed budget in Exhibit 21.2) with the flexible budget for 12,000 units in the fourth

Example: Using Exhibit 21.3, what is the budgeted income from operations for unit sales of (a) 11,000 and (b) 13,000? Answers: $17,200 for unit sales of 11,000; $27,600 for unit sales of 13,000.

Point: Flexible budgeting allows a bud- get to be prepared at the actual output level. Performance reports are then pre- pared comparing the flexible budget to actual revenues and costs.

OPTEL Flexible Budgets

For Month Ended January 31, 2013

Flexible Budget Flexible Budget for Unit Variable Total Sales of Amount Fixed per Unit Cost 10,000 12,000 14,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10.00 $100,000 $120,000 $140,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . 1.00 10,000 12,000 14,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . 1.50 15,000 18,000 21,000

Factory supplies . . . . . . . . . . . . . . . . . . . . . . . 0.20 2,000 2,400 2,800

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.30 3,000 3,600 4,200

Sales commissions . . . . . . . . . . . . . . . . . . . . . 0.90 9,000 10,800 12,600

Shipping expenses . . . . . . . . . . . . . . . . . . . . . 0.40 4,000 4,800 5,600

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . 0.50 5,000 6,000 7,000

Total variable costs . . . . . . . . . . . . . . . . . . . . 4.80 48,000 57,600 67,200

Contribution margin . . . . . . . . . . . . . . . . . . . . . $ 5.20 $ 52,000 $ 62,400 $ 72,800

Fixed costs

Depreciation—machinery . . . . . . . . . . . . . . $ 8,000 8,000 8,000 8,000

Supervisory salaries . . . . . . . . . . . . . . . . . . . . 11,000 11,000 11,000 11,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . 1,000 1,000 1,000 1,000

Depreciation—office equipment . . . . . . . . . 7,000 7,000 7,000 7,000

Administrative salaries . . . . . . . . . . . . . . . . . . 13,000 13,000 13,000 13,000

Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . $40,000 40,000 40,000 40,000

Income from operations . . . . . . . . . . . . . . . . . . $ 12,000 $ 22,400 $ 32,800

EXHIBIT 21.3 Flexible Budgets

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900 Chapter 21 Flexible Budgets and Standard Costs

column. The higher levels for both sales and variable costs reflect nothing more than the increase in sales activity. Any budget analysis comparing actual with planned results that ignores this information is less useful to management. To illustrate, when we evaluate Optel’s performance, we need to prepare a flexible budget showing actual and budgeted values at 12,000 units. As part of a complete profitability analysis, managers could compare the actual income of $25,400 (from Exhibit 21.2) with the $22,400 income expected at the actual sales volume of 12,000 units (from Exhibit 21.3). This results in a total favorable income variance of $3,000 to be explained and interpreted. This variance is markedly lower from the $13,400 favorable variance identified in Exhibit 21.2 using a fixed budget, but still suggests good performance. After receiving the flexible budget based on Janu- ary’s actual volume, management must determine what caused this $3,000 difference. The next section describes a flexible budget performance report that provides guidance in this analysis.

Flexible Budget Performance Report A flexible budget performance report lists differences between actual performance and bud- geted performance based on actual sales volume or other activity level. This report helps direct management’s attention to those costs or revenues that differ substantially from budgeted amounts. Exhibit 21.4 shows Optel’s flexible budget performance report for January. We pre- pare this report after the actual volume is known to be 12,000 units. This report shows a $5,000 favorable variance in total dollar sales. Because actual and budgeted volumes are both 12,000 units, the $5,000 sales variance must have resulted from a higher than expected selling price.

EXHIBIT 21.4 Flexible Budget Performance Report

OPTEL Flexible Budget Performance Report

For Month Ended January 31, 2013

Flexible Actual Budget Results Variances*

Sales (12,000 units) . . . . . . . . . . . . . . . . . . . . . . $120,000 $125,000 $5,000 F

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . 12,000 13,000 1,000 U

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 20,000 2,000 U

Factory supplies . . . . . . . . . . . . . . . . . . . . . . 2,400 2,100 300 F

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 4,000 400 U

Sales commissions . . . . . . . . . . . . . . . . . . . . 10,800 10,800 0

Shipping expenses . . . . . . . . . . . . . . . . . . . . 4,800 4,300 500 F

Office supplies . . . . . . . . . . . . . . . . . . . . . . . 6,000 5,200 800 F

Total variable costs . . . . . . . . . . . . . . . . . . . . 57,600 59,400 1,800 U

Contribution margin . . . . . . . . . . . . . . . . . . . . 62,400 65,600 3,200 F

Fixed costs

Depreciation—machinery . . . . . . . . . . . . . . 8,000 8,000 0

Supervisory salaries . . . . . . . . . . . . . . . . . . . 11,000 11,000 0

Insurance expense . . . . . . . . . . . . . . . . . . . . 1,000 1,200 200 U

Depreciation—office equipment . . . . . . . . . 7,000 7,000 0

Administrative salaries . . . . . . . . . . . . . . . . . 13,000 13,000 0

Total fixed costs . . . . . . . . . . . . . . . . . . . . . . 40,000 40,200 200 U

Income from operations . . . . . . . . . . . . . . . . . $ 22,400 $ 25,400 $ 3,000 F

* F 5 Favorable variance; U 5 Unfavorable variance.

Entrepreneur The heads of both the strategic consulting and tax consulting divisions of your financial services firm complain to you about the unfavorable variances on their performance reports. “We worked on more consulting assignments than planned. It’s not surprising our costs are higher than expected. To top it off, this report characterizes our work as poor!” How do you respond? ■ [Answer—p. 920]

Decision Maker

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Chapter 21 Flexible Budgets and Standard Costs 901

Actual average price per unit (rounded to cents) . . . . . . . . . $125,000y12,000 5 $10.42 Budgeted price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000y12,000 5 10.00 Favorable sales variance per unit . . . . . . . . . . . . . . . . . . . . . . $5,000y12,000 5 $ 0.42

The other variances in Exhibit 21.4 also direct management’s attention to areas where corrective actions can help control Optel’s operations. Each expense variance is analyzed as the sales vari- ance was. We can think of each expense as the joint result of using a given number of units of input and paying a specific price per unit of input. Optel’s expense variances total $2,000 unfa- vorable, suggesting poor control of some costs, particularly direct materials and direct labor.

Each variance in Exhibit 21.4 is due in part to a difference between actual price per unit of input and budgeted price per unit of input. This is a price variance. Each variance also can be due in part to a difference between actual quantity of input used and budgeted quan- tity of input. This is a quantity variance. We explain more about this breakdown, known as variance analysis, next in the standard costs section of this chapter.

1. A flexible budget (a) shows fixed costs as constant amounts of cost per unit of activity, (b) shows variable costs as constant amounts of cost per unit of activity, or (c) is prepared based on one expected amount of budgeted sales or production.

2. What is the initial step in preparing a flexible budget? 3. What is the main difference between a fixed and a flexible budget? 4. What is the contribution margin?

Quick Check Answers — p. 921

Standard costs are preset costs for delivering a product or service under normal conditions. These costs are established by personnel, engineering, and accounting studies using past experi- ences and data. Management uses these costs to assess the reasonableness of actual costs in- curred for producing the product or providing the service. When actual costs vary from standard costs, management follows up to identify potential problems and take corrective actions. Man- agement by exception means that managers focus attention on the most significant differences between actual costs and standard costs and give less attention to areas where performance is reasonably close to standard. Management by exception is especially useful when directed at controllable items, enabling top management to affect the actions of lower-level managers re- sponsible for the company’s revenues and costs. Standard costs are often used in preparing budgets because they are the anticipated costs in- curred under normal conditions. Terms such as standard materials cost, standard labor cost, and standard overhead cost are often used to refer to amounts budgeted for direct materials, direct labor, and overhead. While many managers use standard costs to investigate manufacturing costs, standard costs can also help control nonmanufacturing costs. Companies providing services instead of prod- ucts can also benefit from the use of standard costs. For example, while quality medical service is paramount, efficiency in providing that service is also important to medical professionals. The use of budgeting and standard costing is touted as an effective means to control and monitor medical costs, especially overhead.

Section 2—Standard Costs

C1 Define standard costs and explain how standard cost information is useful for management by exception.

Further analysis of the facts surrounding this $5,000 sales variance reveals a favorable sales variance per unit of nearly $0.42 as shown here:

Point: Business practice often uses the word budget when speaking of total amounts and standard when discussing per unit amounts.

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902 Chapter 21 Flexible Budgets and Standard Costs

Example: What factors might be con- sidered when deciding whether to revise standard costs? Answer: Changes in the processes and/or resources needed to carry out the processes.

Setting Standard Costs To illustrate the setting of a standard cost, we consider a professional league baseball bat manufactured by ProBat. Its engineers have determined that manufacturing one bat requires 0.90 kg. of high-grade wood. They also expect some loss of material as part of the process be- cause of inefficiencies and waste. This results in adding an allowance of 0.10 kg., making the standard requirement 1.0 kg. of wood for each bat. The 0.90 kg. portion is called an ideal standard; it is the quantity of material required if the process is 100% efficient without any loss or waste. Reality suggests that some loss of material usually occurs with any process. The standard of 1.0 kg. is known as the practical standard, the quantity of material required under normal application of the process. High-grade wood can be purchased at a standard price of $25 per kg. The purchasing depart- ment sets this price as the expected price for the budget period. To determine this price, the pur- chasing department considers factors such as the quality of materials, future economic conditions, supply factors (shortages and excesses), and any available discounts. The engineers also decide that two hours of labor time (after including allowances) are required to manufacture a bat. The wage rate is $20 per hour (better than average skilled labor is required). ProBat assigns all over- head at the rate of $10 per labor hour. The standard costs of direct materials, direct labor, and overhead for one bat are shown in Exhibit 21.5 in what is called a standard cost card. These cost amounts are then used to prepare manufac tur ing budgets for a budgeted level of production.

This section explains how to set materials and labor standards and how to prepare a standard cost card.

Identifying Standard Costs Managerial accountants, engineers, personnel administrators, and other managers combine their efforts to set standard costs. To identify standards for direct labor costs, we can conduct time and motion studies for each labor operation in the process of providing a product or service. From these studies, management can learn the best way to perform the operation and then set the standard labor time required for the operation under normal conditions. Similarly, standards for materials are set by studying the quantity, grade, and cost of each material used. Standards for overhead costs are explained later in the chapter.

Regardless of the care used in setting standard costs and in revising them as conditions change, actual costs frequently differ from standard costs, often as a result of one or more factors. For instance, the actual quantity of material used can differ from the standard, or the price paid per unit of material can differ from the standard. Quantity and price differences from standard amounts can also occur for labor. That is, the actual labor time and actual labor rate can vary from what was expected. The same analysis applies to overhead costs.

MATERIALS AND LABOR STANDARDS

Point: Companies promoting continu- ous improvement strive to achieve ideal standards by eliminating inefficiencies and waste.

Internal Auditor You discover a manager who always spends exactly what is budgeted. About 30% of her budget is spent just before the period-end. She admits to spending what is budgeted, whether or not it is needed. She offers three reasons: (1) she doesn’t want her budget cut, (2) “management by exception” focuses on budget deviations; and (3) she believes the money is budgeted to be spent. What action do you take? ■ [Answer—p. 920]

Decision Ethics

Cruis’n Standards The Corvette consists of hundreds of parts for which engineers set standards. Various types of labor are also involved in its production, including machining, assembly, painting, and welding, and standards are set for each. Actual results are periodically compared with standards to assess performance. ■

Decision Insight

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Chapter 21 Flexible Budgets and Standard Costs 903

EXHIBIT 21.5 Standard Cost Card

Direct materials (wood)

Direct labor

Overhead

1 kg. @ $25 per kg.

2 hours @ $20 per hour

2 labor hours @ $10 per hour

$25

40

20

Production factor Cost factor Total

REMARKS:

Based on standard costs of direct materials, direct labor, and overhead for a single ProBat

SUMMARY:

Total

Materials

Labor

Overhead

Total cost

$25

40

20

$85

$85

STANDARD COST CARD

A cost variance, also simply called a variance, is the difference between actual and standard costs. A cost variance can be favorable or unfavorable. A variance from standard cost is considered favorable if actual cost is less than standard cost. It is considered unfavorable if actual cost is more than standard cost.1 This section discusses variance analysis.

Cost Variance Analysis Variances are usually identified in performance reports. When a variance occurs, management wants to determine the factors causing it. This often involves analysis, evaluation, and explana- tion. The results of these efforts should enable management to assign responsibility for the vari- ance and then to take actions to correct the situation. To illustrate, ProBat’s standard materials cost for producing 500 bats is $12,500. Assume that its actual materials cost for those 500 bats is $13,000. The $500 unfavorable variance raises questions that call for answers that, in turn, can lead to changes to correct the situation and eliminate this variance in the next period. A performance report often identifies the existence of a problem, but we must follow up with further investigation to see what can be done to improve future performance. Exhibit 21.6 shows the flow of events in the effective management of variance analysis. It shows four steps: (1) preparing a standard cost performance report, (2) computing and analyz- ing variances, (3) identifying questions and their explanations, and (4) taking corrective and strategic actions. These variance analysis steps are interrelated and are frequently applied in good organizations.

COST VARIANCES

C2 Describe variances and what they reveal about performance.

1 Short-term favorable variances can sometimes lead to long-term unfavorable variances. For instance, if management spends less than the budgeted amount on maintenance or insurance, the performance report would show a favorable variance. Cutting these expenses can lead to major losses in the long run if machinery wears out prematurely or insur- ance coverage proves inadequate.

Cumulative Pay (Excludes Current Period)

Current Period Gross Pay FUTA

Pay Hours

Gross Pay

Pay Type

SIT

FIT

SUTA

Kathleen

Anthony

Nichole

Zoey

Gracie

Totals

Employee

$108,300.00

6,800.00

15,000.00

6,500.00

5,000.00

141,600.00

Regular Overtime

Regular Overtime

Regular Overtime

Salary

Salary

0

4

74

8

80

80

---

---

388.00

21.00

22.00

2,380.00

90.00

25.00

100.00

110.00

80.00

300.00 $2,000.00

20.00

0.00

740.00

500.00

$7,000.00

FICA-SS_EE FICA-Med_EE

FICA-SS_ER FICA-Med_ER

EE-Ben_Plan Withholding ER-Ben_Plan Withholding

EXHIBIT 21.6 Variance Analysis

Cost Variance Computation Management needs information about the factors causing a cost variance, but first it must prop- erly compute the variance. In its most simple form, a cost variance (CV) is computed as the difference between actual cost (AC) and standard cost (SC) as shown in Exhibit 21.7.

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904 Chapter 21 Flexible Budgets and Standard Costs

EXHIBIT 21.7 Cost Variance Formulas

Cost Variance (CV) 5 Actual Cost (AC) 2 Standard Cost (SC)

where:

Actual Cost (AC) 5 Actual Quantity (AQ) 3 Actual Price (AP)

Standard Cost (SC) 5 Standard Quantity (SQ) 3 Standard Price (SP)

EXHIBIT 21.8 Price Variance and Quantity Variance Formulas

Actual Cost Standard Cost AQ 3 AP SQ 3 SP AQ 3 SP

Price Variance (AQ 3 AP) 2 (AQ 3 SP)

Cost Variance

Quantity Variance (AQ 3 SP) 2 (SQ 3 SP)

A cost variance is further defined by its components. Actual quantity (AQ) is the input (material or labor) used to manufacture the quantity of output. Standard quantity (SQ) is the expected input for the quantity of output. Actual price (AP) is the amount paid to acquire the input (mate- rial or labor), and standard price (SP) is the expected price. Two main factors cause a cost variance: (1) the difference between actual price and standard price results in a price (or rate) variance and (2) the difference between actual quantity and standard quantity results in a quantity (or usage or efficiency) variance. To assess the impacts of these two factors in a cost variance, we use the formulas in Exhibit 21.8.

Point: Price and quantity variances for direct labor are nearly always referred to as rate and efficiency variances, respectively.

In computing a price variance, the quantity (actual) is held constant. In computing a quantity variance, the price (standard) is held constant. The cost variance, or total variance, is the sum of the price and quantity variances. These formulas identify the sources of the cost variance. Man- agers sometimes find it useful to apply an alternative (but equivalent) computation for the price and quantity variances as shown in Exhibit 21.9.

EXHIBIT 21.9 Alternative Price Variance and Quantity Variance Formulas

Price Variance (PV) 5 [Actual Price (AP) 2 Standard Price (SP)] 3 Actual Quantity (AQ) Quantity Variance (QV) 5 [Actual Quantity (AQ) 2 Standard Quantity (SQ)] 3 Standard Price (SP)

Direct materials (0.5 lb. per unit at $20 per lb.) . . . . . . . . . $10.00

Direct labor (1 hr. per unit at $8 per hr.) . . . . . . . . . . . . . . 8.00

Total standard direct cost per unit . . . . . . . . . . . . . . . . . . . . $18.00

Materials Cost Variances During May 2013, G-Max budgeted to produce 4,000 clubheads (units). It actually produced only 3,500 units. It used 1,800 pounds of direct materials (titanium) costing $21.00 per pound, meaning its total materials cost was $37,800. This information allows us to compute both actual and standard direct materials costs for G-Max’s 3,500 units and its direct materials cost variance as follows:

Actual cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 lbs. @ $21.00 per lb. 5 $37,800

Standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 lbs. @ $20.00 per lb. 5 35,000

Direct materials cost variance (unfavorable) . . . . . . . . 5 $ 2,800

The results from applying the formulas in Exhibits 21.8 and 21.9 are identical.

Computing Materials and Labor Variances We illustrate the computation of the materials and labor cost variances using data from G-Max, a company that makes specialty golf equipment and accessories for individual customers. This company has set the following standard quantities and costs for materials and labor per unit for one of its hand-crafted golf clubheads:

P2 Compute materials and labor variances.

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Chapter 21 Flexible Budgets and Standard Costs 905

To better isolate the causes of this $2,800 unfavorable total direct materials cost variance, the materials price and quantity variances for these G-Max clubheads are computed and shown in Exhibit 21.10.

The $1,800 unfavorable price variance results from paying $1 more per unit than the standard price, computed as 1,800 lbs. 3 $1. The $1,000 unfavorable quantity variance is due to using 50 lbs. more materials than the standard quantity, computed as 50 lbs. 3 $20. The total direct materials variance is $2,800 and it is unfavorable. This information allows management to ask the responsible individuals for explanations and corrective actions. The purchasing department is usually responsible for the price paid for materials. Responsi- bility for explaining the price variance in this case rests with the purchasing manager if a price higher than standard caused the variance. The production department is usually responsible for the amount of material used and in this case is responsible for explaining why the process used more than the standard amount of materials. Variance analysis presents challenges. For instance, the production department could have used more than the standard amount of material because its quality did not meet specifications and led to excessive waste. In this case, the purchasing manager is responsible for explaining why inferior ma- terials were acquired. However, the production manager is responsible for explaining what happened if analysis shows that waste was due to inefficiencies, not poor quality material. In evaluating price variances, managers must recognize that a favorable price vari- ance can indicate a problem with poor product quality. Redhook Ale, a micro brewery in the Pacific Northwest, can probably save 10% to 15% in material prices by buying six-row barley malt instead of the better two-row from Washington’s Yakima valley. Attention to quality, however, has helped Redhook Ale increase its sales. Redhook’s purchasing activities are judged on both the quality of the materials and the purchase price variance.

Labor Cost Variances Labor cost for a specific product or service depends on the num- ber of hours worked (quantity) and the wage rate paid to employees (price). When actual amounts for a task differ from standard, the labor cost variance can be divided into a rate (price) variance and an efficiency (quantity) variance. To illustrate, G-Max’s direct labor standard for 3,500 units of its hand-crafted clubheads is one hour per unit, or 3,500 hours at $8 per hour. Since only 3,400 hours at $8.30 per hour were actually used to complete the units, the actual and standard labor costs are

Example: Identify at least two factors that might have caused the unfavorable quantity variance and the unfavorable price variance in Exhibit 21.10. Answer: Poor quality materials or untrained workers for the former; poor price negotiation or higher-quality materials for the latter.

Actual cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400 hrs. @ $8.30 per hr. 5 $28,220

Standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 hrs. @ $8.00 per hr. 5 28,000

Direct labor cost variance (unfavorable) . . . . . . . . 5 $ 220

This analysis shows that actual cost is merely $220 over the standard and suggests no im mediate concern. Computing both the labor rate and efficiency variances reveals a different picture, however, as shown in Exhibit 21.11.

EXHIBIT 21.10 Materials Price and Quantity Variances*

Actual Cost Standard Cost AQ 3 AP

1,800 lbs. 3 $21.00 $37,800

SQ 3 SP 1,750 lbs. 3 $20.00

$35,000

AQ 3 SP 1,800 lbs. 3 $20.00

$36,000

$1,800 U $1,000 U

$2,800 U

Quantity Variance $36,000 2 $35,000

Total Direct Materials Variance $1,800 1 $1,000

Price Variance $37,800 2 $36,000

*AQ is actual quantity; AP is actual price; SP is standard price; SQ is standard quantity allowed for actual output.

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906 Chapter 21 Flexible Budgets and Standard Costs

The analysis in Exhibit 21.11 shows that an $800 favorable efficiency variance results from using 100 fewer direct labor hours than standard for the units produced, but this favorable vari- ance is more than offset by a wage rate that is $0.30 per hour higher than standard. The personnel administrator or the production manager needs to explain why the wage rate is higher than ex- pected. The production manager should also explain how the labor hours were reduced. If this experience can be repeated and transferred to other departments, more savings are possible. One possible explanation of these labor rate and efficiency variances is the use of workers with different skill levels. If this is the reason, senior management must discuss the implications with the production manager who has the responsibility to assign workers to tasks with the ap- propriate skill level. In this case, an investigation might show that higher-skilled workers were used to produce 3,500 units of hand-crafted clubheads. As a result, fewer labor hours might be required for the work, but the wage rate paid these workers is higher than standard because of their greater skills. The effect of this strategy is a higher than standard total cost, which would require actions to remedy the situation or adjust the standard.

Example: Compute the rate variance and the efficiency variance for Exhibit 21.11 if 3,700 actual hours are used at an actual price of $7.50 per hour. Answer: $1,850 favorable labor rate variance and $1,600 unfavorable labor efficiency variance.

5. A standard cost (a) changes in direct proportion to changes in the level of activity, (b) is an amount incurred at the actual level of production for the period, or (c) is an amount incurred under normal conditions to provide a product or service.

6. What is a cost variance? 7. The following information is available for York Company.

Actual direct labor hours per unit . . . . . . . . . . . . . . 2.5 hours

Standard direct labor hours per unit . . . . . . . . . . . . 2.0 hours

Actual production (units) . . . . . . . . . . . . . . . . . . . . . 2,500 units

Budgeted production (units) . . . . . . . . . . . . . . . . . . 3,000 units

Actual rate per hour . . . . . . . . . . . . . . . . . . . . . . . . $3.10

Standard rate per hour . . . . . . . . . . . . . . . . . . . . . . $3.00

The labor efficiency variance is (a) $3,750 U, (b) $3,750 F, or (c) $3,875 U. 8. Refer to Quick Check 7; the labor rate variance is (a) $625 F or (b) $625 U. 9. If a materials quantity variance is favorable and a materials price variance is unfavorable, can

the total materials cost variance be favorable?

Quick Check Answers — p. 921

Production Manager You receive the manufacturing variance report for June and discover a large unfavorable labor efficiency (quantity) variance. What factors do you investigate to identify its possible causes? ■ [Answer—p. 920]

Decision Maker

EXHIBIT 21.11 Labor Rate and Efficiency Variances*

Actual Cost Standard Cost AH 3 AR

3,400 hrs. 3 $8.30 $28,220

SH 3 SR 3,500 hrs. 3 $8.00

$28,000

AH 3 SR 3,400 hrs. 3 $8.00

$27,200

$1,020 U $800 F

$220 U

Efficiency Variance $27,200 2 $28,000

Total Direct Labor Variance $1,020 2 $800

Rate Variance $28,220 2 $27,200

* AH is actual direct labor hours: AR is actual wage rate; SH is standard direct labor hours allowed for actual output; SR is standard wage rate.

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Chapter 21 Flexible Budgets and Standard Costs 907

When standard costs are used, a predetermined overhead rate is used to assign standard overhead costs to products or services produced. This predetermined rate is often based on some overhead allocation base (such as standard labor cost, standard labor hours, or standard machine hours).

Setting Overhead Standards Standard overhead costs are the amounts expected to occur at a certain activity level. Unlike di- rect materials and direct labor, overhead includes fixed costs and variable costs. This results in the average overhead cost per unit changing as the predicted volume changes. Since standard costs are also budgeted costs, they must be established before the reporting period begins. Stan- dard overhead costs are therefore average per unit costs based on the predicted activity level. To establish the standard overhead cost rate, management uses the same cost structure it used to construct a flexible budget at the end of a period. This cost structure identifies the different overhead cost components and classifies them as variable or fixed. To get the standard overhead rate, man- agement selects a level of activity (volume) and predicts total overhead cost. It then divides this total by the allocation base to get the standard rate. Standard direct labor hours expected to be used to produce the predicted volume is a common allocation base and is used in this section. To illustrate, Exhibit 21.12 shows the overhead cost struc- ture  used to develop G-Max’s flexible overhead budgets for May 2013. The predetermined standard overhead rate for May is set before the month begins. The first two number columns list the per unit amounts of variable costs and the monthly amounts of fixed costs. The four right-most columns show the costs ex- pected to occur at four different levels of production activity. The predetermined overhead rate per labor hour is smaller as volume of activity increases because total fixed costs remain constant.

OVERHEAD STANDARDS AND VARIANCES

Point: With increased automation, machine hours are frequently used in applying overhead instead of labor hours.

EXHIBIT 21.12 Flexible Overhead Budgets

G-MAX Flexible Overhead Budgets

For Month Ended May 31, 2013

Flexible Budget

Variable Total Amount Fixed

Flexible Budget at Capacity Level of

per Unit Cost 70% 80% 90% 100%

Production (in units) . . . . . . . . . . . . . . 1 unit 3,500 4,000 4,500 5,000

Factory overhead

Variable costs

Indirect labor . . . . . . . . . . . . . . . . $0.40/unit $1,400 $1,600 $1,800 $2,000

Indirect materials . . . . . . . . . . . . 0.30/unit 1,050 1,200 1,350 1,500

Power and lights . . . . . . . . . . . . . 0.20/unit 700 800 900 1,000

Maintenance . . . . . . . . . . . . . . . . 0.10/unit 350 400 450 500

Total variable overhead costs . . . . $1.00/unit 3,500 4,000 4,500 5,000

Fixed costs (per month)

Building rent . . . . . . . . . . . . . . . . $1,000 1,000 1,000 1,000 1,000

Depreciation—machinery . . . . . . 1,200 1,200 1,200 1,200 1,200

Supervisory salaries . . . . . . . . . . . 1,800 1,800 1,800 1,800 1,800

Total fixed overhead costs . . . . . . $4,000 4,000 4,000 4,000 4,000

Total factory overhead . . . . . . . . . . $7,500 $8,000 $8,500 $9,000

Standard direct labor hours 1 hr./unit . . 3,500 hrs. 4,000 hrs. 4,500 hrs. 5,000 hrs.

Predetermined overhead rate per standard direct labor hour . . . . . . . $ 2.14 $ 2.00 $ 1.89 $ 1.80

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908 Chapter 21 Flexible Budgets and Standard Costs

Predicting Activity Levels When choosing the predicted activity level, management considers many factors. The level can be set as high as 100% of capacity, but this is rare. Factors causing the activity level to be less than full capacity include difficulties in scheduling work, equipment under repair or mainte- nance, and insufficient product demand. Good long-run management practices often call for some plant capacity in excess of current operating needs to allow for special opportunities and demand changes. G-Max managers predicted an 80% activity level for May, or a production volume of 4,000 clubheads. At this volume, they budget $8,000 as the May total overhead. This choice implies a $2 per unit (labor hour) average overhead cost ($8,000y4,000 units). Since G-Max has a stan- dard of one direct labor hour per unit, the predetermined standard overhead rate for May is $2 per standard direct labor hour. The variable overhead rate remains constant at $1 per direct labor hour regardless of the budgeted production level. The fixed overhead rate changes according to the budgeted production volume. For instance, for the predicted level of 4,000 units of produc- tion, the fixed rate is $1 per hour ($4,000 fixed costsy4,000 units). For a production level of 5,000 units, however, the fixed rate is $0.80 per hour ($4,000 fixed costs/5,000 units).

Point: Variable costs per unit remain constant, but fixed costs per unit decline with increases in volume. This means the average total overhead cost per unit declines with increases in volume.

Computing Overhead Cost Variances When standard costs are used, the cost accounting system applies overhead to the good units produced using the predetermined standard overhead rate. At period-end, the difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance (total overhead variance), which is defined in Exhibit 21.13.EXHIBIT 21.13

Overhead Cost Variance

Overhead cost variance (OCV) 5 Actual overhead incurred (AOI) 2 Standard overhead applied (SOA)

The standard overhead applied is based on the predetermined overhead rate (at the predicted activity level) and the standard number of hours that should have been used, based on the actual production. To illustrate, G-Max produced 3,500 units during the month, which should have used 3,500 direct labor hours. From Exhibit 21.12, G-Max’s predetermined overhead rate at the predicted capacity level of 4,000 units was $2.00 per direct labor hour, so the standard overhead applied is $7,000 (computed as 3,500 direct labor hours 3 $2.00). Additional data from cost reports show that the actual overhead cost incurred in the month is $7,650. G-Max’s total over- head variance is thus $650, computed as:

P3 Compute overhead variances.

Measuring Up In the spirit of continuous improvement, competitors compare their processes and per- formance standards against benchmarks established by industry leaders. Those that use benchmarking include Jiffy Lube, All Tune and Lube, and Speedee Oil Change and Tune-Up. ■

Decision Insight

Actual total overhead (given) . . . . . . . . . . . . . . . . . . . . . . . . $7,650

Standard overhead applied (3,500 DLH 3 $2.00) . . . . . . . . 7,000

Total overhead variance (unfavorable). . . . . . . . . . . . . . . . . . $ 650

This variance is unfavorable, as G-Max’s actual overhead was higher than it should have been based on budgeted amounts.

Controllable and Volume Variances To help identify factors causing the overhead cost variance, managers analyze this variance separately for controllable and volume variances, as illustrated in Exhibit 21.14. The results provide information useful for taking strategic actions to improve company performance.

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Chapter 21 Flexible Budgets and Standard Costs 909

The controllable variance is the difference between actual overhead costs incurred and the budgeted overhead costs based on a flexible budget. The controllable variance is so named be- cause it refers to activities usually under management control. A volume variance occurs when there is a difference between the actual volume of production and the standard volume of pro- duction. The volume variance is based solely on fixed overhead. The budgeted fixed overhead amount is the same regardless of the volume of production (within the relevant range). The ap- plied fixed overhead is based, however, on the standard direct labor hours allowed for the actual volume of production, using the flexible budget. When a company operates at a capacity level different from what it expected, the volume variance will differ from zero. We next compute the controllable and volume variances for G-Max. Returning to the G-Max data, the flexible budget in Exhibit 21.12 shows budgeted factory overhead of $7,500 at the production volume of 3,500 units during the month. The controllable variance is then computed as:

Controllable Variance Actual total overhead incurred–Budgeted total overhead

Volume Variance Budgeted fixed overhead –Applied fixed overhead

Total Overhead Variance Actual total overhead incurred–Standard total overhead applied

EXHIBIT 21.14 Framework for Understanding Total Overhead Variance

Controllable Variance

Actual total overhead (given) . . . . . . . . . . . . . . . . . . . . . . $7,650

Applied total overhead (from flexible budget) . . . . . . . . . 7,500

Controllable variance (unfavorable) . . . . . . . . . . . . . . . . . $ 150

Volume Variance

Budgeted fixed overhead (at predicted capacity) . . . . . $4,000

Applied fixed overhead (3,500 DLH 3 $1.00) . . . . . . . 3,500

Volume variance (unfavorable) . . . . . . . . . . . . . . . . . . . $ 500

We then compute the volume variance. G-Max’s budgeted fixed overhead at the predicted capacity level for the month was $4,000. Recall from Exhibit 21.12 that G-Max’s predetermined fixed over- head at the predicted capacity level of 4,000 units was $1 per hour. Thus, G-Max’s applied fixed overhead was $3,500, computed as 3,500 direct labor hours 3 $1.00 per unit. G-Max’s volume variance is then computed as:

Analyzing Controllable and Volume Variances How should the top management of G-Max interpret the unfavorable controllable and volume variances? An unfavorable vol- ume variance means that the company did not reach its predicted operating level. In this case, 80% of manufacturing capacity was budgeted but only 70% was used. Management needs to know why the actual level of production differs from the expected level. The main purpose of the volume variance is to identify what portion of the total overhead variance is caused by failing to meet the expected production level. Often the reasons for failing to meet this ex- pected production level are due to factors, for example customer demand, that are beyond employees’ control. This information permits management to focus on explanations for the controllable variance, as we discuss next.

Overhead Variance Reports To help management isolate the reasons for the $150 unfavorable controllable variance, an overhead variance report can be prepared. A complete overhead variance report provides managers information about specific overhead costs and how they differ from budgeted amounts. Exhibit 21.15 shows G-Max’s overhead variance report for May. It reveals that (1) fixed costs and maintenance costs were incurred as expected, (2) costs for indirect labor and power and lights were higher than expected, and (3)  indirect materials cost was less than expected.

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910 Chapter 21 Flexible Budgets and Standard Costs

EXHIBIT 21.15 Overhead Variance Report

G-MAX Overhead Variance Report

For Month Ended May 31, 2013

Volume Variance

Expected production level . . . . . . . . . . . . . 80% of capacity

Production level achieved . . . . . . . . . . . . . . 70% of capacity

Volume variance . . . . . . . . . . . . . . . . . . . . . $500 (unfavorable)

Flexible Actual Controllable Variance Budget Results Variances*

Variable overhead costs

Indirect labor . . . . . . . . . . . . . . . . . . . . . $1,400 $1,525 $125 U

Indirect materials . . . . . . . . . . . . . . . . . . 1,050 1,025 25 F

Power and lights . . . . . . . . . . . . . . . . . . . 700 750 50 U

Maintenance . . . . . . . . . . . . . . . . . . . . . . 350 350 0

Total variable overhead costs . . . . . . . . . 3,500 3,650 150 U

Fixed overhead costs

Building rent . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000 0

Depreciation—machinery . . . . . . . . . . . 1,200 1,200 0

Supervisory salaries . . . . . . . . . . . . . . . . 1,800 1,800 0

Total fixed overhead costs . . . . . . . . . . . 4,000 4,000 0

Total overhead costs . . . . . . . . . . . . . . . . . $7,500 $7,650 $150 U

* F 5 Favorable variance; U 5 Unfavorable variance.

10. Under what conditions is an overhead volume variance considered favorable? 11. To use management by exception, a company (a) need not study fixed overhead variances,

(b) should compute variances from flexible budget amounts to allow management to focus its attention on significant differences between actual and budgeted results, or (c) should analyze only variances for direct materials and direct labor.

Quick Check Answers — p. 921

BMW, a German automobile manufacturer, uses concepts of standard costing and variance analysis. Pro- duction begins with huge rolls of steel and aluminum, which are then cut and pressed by large machines. Material must meet high quality standards, and the company sets standards for each of its machine opera- tions. In the Assembly department, highly-trained employees complete the assembly of the painted car chassis, often to customer specifications. Again, BMW sets standards for how much labor should be used and monitors its employee performance. The company then computes and analyzes materials price and quantity variances and labor rate and efficiency variances and takes action as needed.

GLOBAL VIEW

The total controllable variance amount ($150 unfavorable) is also readily available from Exhibit 21.15. The overhead variance report shows the total volume variance as $500 unfavor- able (shown at the top) and the $150 unfavorable controllable variance (reported at the bottom right). The sum of the controllable variance and the volume variance equals the total overhead variance of $650 unfavorable. Appendix 21A describes an expanded analysis of overhead variances.

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Using this information, we compute both the sales price variance and the sales volume variance as shown in Exhibit 21.16. The total sales price variance is $850 unfavorable, and the total sales volume variance is $1,000 unfavorable. Neither total variance implies anything positive about these two products. However, further analysis of these total sales variances reveals that both the sales price and sales volume variances for Excel golf balls are favorable, meaning that both the unfavorable total sales price variance and the unfavorable total sales volume variance are due to the Big Bert driver.

Chapter 21 Flexible Budgets and Standard Costs 911

Budgeted Actual

Sales of Excel golf balls (units) . . . . . . . . . . . 1,000 units 1,100 units

Sales price per Excel golf ball . . . . . . . . . . . . $10 $10.50

Sales of Big Bert® drivers (units) . . . . . . . . . 150 units 140 units

Sales price per Big Bert® driver . . . . . . . . . . $200 $190

Managers use sales variances for planning and control purposes. The sales variance information is used to plan future actions to avoid unfavorable variances. G-Max sold 90 total combined units (both balls and drivers) more than planned, but these 90 units were not sold in the proportion budgeted. G-Max sold fewer than the budgeted quantity of the higher-priced driver, which contributed to the unfavorable total sales variances. Managers use such detail to question what caused the company to sell more golf balls and fewer drivers. Managers also use this information to evaluate and even reward their salespeo- ple. Extra compensation is paid to salespeople who contribute to a higher profit margin. Finally, with multiple products, the sales volume variance can be separated into a sales mix variance and a sales quan- tity variance. The sales mix variance is the difference between the actual and budgeted sales mix of the products. The sales quantity variance is the difference between the total actual and total budgeted quan- tity of units sold.

Sales Variances Decision Analysis

This chapter explained the computation and analysis of cost variances. A similar variance analysis can be applied to sales. To illustrate, consider the following sales data from G-Max for two of its golf products, Excel golf balls and Big Bert® drivers.

A1 Analyze changes in sales from expected amounts.

Sales Manager The current performance report reveals a large favorable sales volume variance but an unfavorable sales price variance. You did not expect to see a large increase in sales volume. What steps do you take to analyze this situation? ■ [Answer—p. 920]

Decision Maker

EXHIBIT 21.16 Computing Sales Variances*

Excel Golf Balls Actual Results AS 3 AP

(1,000 3 $10)

(1,100 3 $10.50)

(1,100 3 $10)

Sales dollars (balls) $11,550 $11,000 $10,000

$1,000 F$550 F

Big Bert® Drivers (150 3 $200)

(140 3 $200)

(140 3 $190)

Sales dollars (drivers) $26,600 $28,000 $30,000

Total $850 U $1,000 U

$2,000 U$1,400 U

Sales Volume Variance

Sales Volume Variance

Sales Price Variance

Sales Price Variance

Fixed BudgetFlexible Budget BS 3 BPAS 3 BP

* AS 5 actual sales units; AP 5 actual sales price; BP 5 budgeted sales price; BS 5 budgeted sales units (fixed budget).

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912 Chapter 21 Flexible Budgets and Standard Costs

Budget Actual (25,000 units) (27,000 units)

Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5.00 per unit $5.23 per unit

Variable costs (per unit)

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . 1.24 per unit 1.12 per unit

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.50 per unit 1.40 per unit

Factory supplies* . . . . . . . . . . . . . . . . . . . . . . . . 0.25 per unit 0.37 per unit

Utilities* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.50 per unit 0.60 per unit

Selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.40 per unit 0.34 per unit

Fixed costs (per month)

Depreciation — machinery* . . . . . . . . . . . . . . . . $3,750 $3,710

Depreciation — building* . . . . . . . . . . . . . . . . . . 2,500 2,500

General liability insurance . . . . . . . . . . . . . . . . . 1,200 1,250

Property taxes on office equipment . . . . . . . . . 500 485

Other administrative expense . . . . . . . . . . . . . . 750 900

* Indicates factory overhead item; $0.75 per unit or $3 per direct labor hour for variable overhead, and $0.25 per unit or $1 per direct labor hour for fixed overhead.

Standard costs based on expected output of 25,000 units

Actual costs incurred to produce 27,000 units

Standard costs based on expected output of 27,000 units

Per Unit Quantity Total of Output to Be Used Cost

Direct materials, 4 oz. @ $0.31/oz. . . . . . . . . . . $1.24/unit 100,000 oz. $31,000

Direct labor, 0.25 hrs. @ $6.00/hr. . . . . . . . . . . 1.50/unit 6,250 hrs. 37,500

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.00/unit 25,000

Per Unit Quantity Total of Output Used Cost

Direct materials, 4 oz. @ $0.28/oz. . . . . . . . . . . $1.12/unit 108,000 oz. $30,240

Direct labor, 0.20 hrs. @ $7.00/hr. . . . . . . . . . . 1.40/unit 5,400 hrs. 37,800

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.20/unit 32,400

Per Unit Quantity Total of Output to Be Used Cost

Direct materials, 4 oz. @ $0.31/oz. . . . . . . . . . . $1.24/unit 108,000 oz. $33,480

Direct labor, 0.25 hrs. @ $6.00/hr. . . . . . . . . . . 1.50/unit 6,750 hrs. 40,500

Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,500

Pacific Company provides the following information about its budgeted and actual results for June 2013. Although the expected June volume was 25,000 units produced and sold, the company actually produced and sold 27,000 units as detailed here:

DEMONSTRATION PROBLEM

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Chapter 21 Flexible Budgets and Standard Costs 913

Required

1. Prepare June flexible budgets showing expected sales, costs, and net income assuming 20,000, 25,000, and 30,000 units of output produced and sold.

2. Prepare a flexible budget performance report that compares actual results with the amounts budgeted if the actual volume had been expected.

3. Apply variance analysis for direct materials and direct labor. 4. Compute the total overhead variance, and the controllable and volume variances. 5. Compute spending and efficiency variances for overhead. (Refer to Appendix 21A.) 6. Prepare journal entries to record standard costs, and price and quantity variances, for direct materials,

direct labor, and factory overhead. (Refer to Appendix 21A.)

PLANNING THE SOLUTION ● Prepare a table showing the expected results at the three specified levels of output. Compute the vari-

able costs by multiplying the per unit variable costs by the expected volumes. Include fixed costs at the given amounts. Combine the amounts in the table to show total variable costs, contribution margin, total fixed costs, and income from operations.

● Prepare a table showing the actual results and the amounts that should be incurred at 27,000 units. Show any differences in the third column and label them with an F for favorable if they increase income or a U for unfavorable if they decrease income.

● Using the chapter’s format, compute these total variances and the individual variances requested: ● Total materials variance (including the direct materials quantity variance and the direct materials

price variance). ● Total direct labor variance (including the direct labor efficiency variance and rate variance). ● Total overhead variance (including both controllable and volume overhead variances and their com-

ponent variances).

SOLUTION TO DEMONSTRATION PROBLEM 1.

PACIFIC COMPANY Flexible Budgets

For Month Ended June 30, 2013

Flexible Flexible Flexible

Flexible Budget Budget Budget Budget

Variable Total for Unit for Unit for Unit Amount Fixed Sales of Sales of Sales of per Unit Cost 20,000 25,000 30,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5.00 $100,000 $125,000 $150,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . 1.24 24,800 31,000 37,200

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . 1.50 30,000 37,500 45,000

Factory supplies . . . . . . . . . . . . . . . . . . . . 0.25 5,000 6,250 7,500

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.50 10,000 12,500 15,000

Selling costs . . . . . . . . . . . . . . . . . . . . . . . . 0.40 8,000 10,000 12,000

Total variable costs . . . . . . . . . . . . . . . . . . 3.89 77,800 97,250 116,700

Contribution margin . . . . . . . . . . . . . . . . . . . $1.11 22,200 27,750 33,300

Fixed costs

Depreciation—machinery . . . . . . . . . . . . . $3,750 3,750 3,750 3,750

Depreciation—building . . . . . . . . . . . . . . . 2,500 2,500 2,500 2,500

General liability insurance . . . . . . . . . . . . . 1,200 1,200 1,200 1,200

Property taxes on office equipment . . . . . 500 500 500 500

Other administrative expense . . . . . . . . . 750 750 750 750

Total fixed costs . . . . . . . . . . . . . . . . . . . . . $8,700 8,700 8,700 8,700

Income from operations . . . . . . . . . . . . . . . . $ 13,500 $ 19,050 $ 24,600

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914 Chapter 21 Flexible Budgets and Standard Costs

Materials cost variances

Actual cost . . . . . . . . . . . . 108,000 oz. @ $0.28 $30,240

Standard cost . . . . . . . . . . 108,000 oz. @ $0.31 33,480

Direct materials cost variance (favorable) . . . . . . . $ 3,240

Price and quantity variances (based on formulas in Exhibit 21.10):

Standard Cost

$0$3,240 F

$3,240 F

AQ 3 AP 108,000 oz. 3 $0.28

$30,240

AQ 3 SP 108,000 oz. 3 $0.31

$33,480

SQ 3 SP 108,000 oz. 3 $0.31

$33,480

Actual Cost

Price Variance Quantity Variance

Total Direct Materials Variance

Labor cost variances

Actual cost . . . . . . . . . . . . 5,400 hrs. @ $7.00 $37,800

Standard cost . . . . . . . . . . 6,750 hrs. @ $6.00 40,500

Direct labor cost variance (favorable) . . . . . . . . . . $ 2,700

Rate and efficiency variances (based on formulas in Exhibit 21.11): Standard Cost

AH 3 AR 5,400 hrs. 3 $7

$37,800

AH 3 SR 5,400 hrs. 3 $6

$32,400

SH 3 SR 6,750 hrs. 3 $6

$40,500

$8,100 F$5,400 U

$2,700 F

Actual Cost

Total Direct Labor Variance

Rate Variance Efficiency Variance

3. Variance analysis of materials and labor costs.

PACIFIC COMPANY Flexible Budget Performance Report

For Month Ended June 30, 2013

Flexible Actual Budget Results Variance*

Sales (27,000 units) . . . . . . . . . . . . . . . . . . . . . . . . $135,000 $141,210 $6,210 F Variable costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 33,480 30,240 3,240 F Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,500 37,800 2,700 F Factory supplies . . . . . . . . . . . . . . . . . . . . . . . . 6,750 9,990 3,240 U Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500 16,200 2,700 U Selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,800 9,180 1,620 F Total variable costs . . . . . . . . . . . . . . . . . . . . . . 105,030 103,410 1,620 F Contribution margin . . . . . . . . . . . . . . . . . . . . . . . 29,970 37,800 7,830 F Fixed costs Depreciation—machinery . . . . . . . . . . . . . . . . . 3,750 3,710 40 F Depreciation—building . . . . . . . . . . . . . . . . . . . 2,500 2,500 0 General liability insurance . . . . . . . . . . . . . . . . . 1,200 1,250 50 U Property taxes on office equipment . . . . . . . . . 500 485 15 F Other administrative expense . . . . . . . . . . . . . 750 900 150 U Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . 8,700 8,845 145 U Income from operations . . . . . . . . . . . . . . . . . . . . $ 21,270 $ 28,955 $7,685 F

* F 5 Favorable variance; U 5 Unfavorable variance.

2.

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Chapter 21 Flexible Budgets and Standard Costs 915

Overhead cost variances

Total overhead cost incurred . . . . . 27,000 units @ $1.20 $32,400

Total overhead applied . . . . . . . . . . 27,000 units @ $1.00 27,000

Overhead cost variance (unfavorable) . . . . . . . . . . . . . . . . . $ 5,400

$32,400

26,500

$ 5,900

Controllable variance

Actual overhead (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Applied overhead (from flexible budget for 27,000 units) . . . .

Controllable variance (unfavorable) . . . . . . . . . . . . . . . . . . . . .

$ 6,250

6,750

$ 500

Volume variance

Budgeted fixed overhead (at predicted capacity) . . . . . . . . . . .

Applied fixed overhead (6,750 3 $1.00) . . . . . . . . . . . . . . . . .

Volume variance (favorable) . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4. Total, controllable, and volume variances for overhead.

5. Variable and fixed overhead spending and efficiency variances.

Variable overhead variance (factory supplies and utilities)

Variable overhead cost incurred . . . . . . ($9,990 1 $16,200)

Variable overhead cost applied . . . . . . . 6,750 hrs. @ $3/hr. 20,250

Variable overhead cost variance (unfavorable) . . . . . . . . . . . . . $ 5,940

Spending and efficiency variances (based on formulas in Exhibit 21A.2):

AH 3 AVR

$26,190

AH 3 SVR 5,400 3 $3

$16,200

SH 3 SVR 6,750 3 $3

$20,250

$4,050 F$9,990 U

$5,940 U

Applied OverheadActual Overhead

Spending Variance Efficiency Variance

Total Variable Overhead Variance

$26,190

Fixed overhead (depreciation on machinery and building)

Fixed overhead cost incurred . . . . . . . . ($3,710 1 $2,500)

Fixed overhead cost applied . . . . . . . . . 6,750 hrs. @ $1/hr. 6,750

Fixed overhead cost variance (favorable) . . . . . . . . . . . . . . . . . $ 540

Spending and volume variances (based on formulas in Exhibit 21A.2):

Actual Overhead Budgeted Overhead

We can also compute

Controllable variance: $5,900 U (both spending variances plus efficiency variance)

Volume variance: 500 F (identified as above)

6,750 3 $1 $6,750$6,250$6,210

$500 F$40 F

$540 F

Spending Variance Volume Variance

Total Fixed Overhead Variance

Applied Overhead

$ 6,210

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916 Chapter 21 Flexible Budgets and Standard Costs

6. Goods in Process Inventory . . . . . . . . . . . . . . . . . . 33,480

Direct Materials Price Variance . . . . . . . . . . . . . . 3,240

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . 30,240

Goods in Process Inventory . . . . . . . . . . . . . . . . . . 40,500

Direct Labor Rate Variance . . . . . . . . . . . . . . . . . . . 5,400

Direct Labor Efficiency Variance . . . . . . . . . . . . . 8,100

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,800

Goods in Process Inventory* . . . . . . . . . . . . . . . . . 27,000

Variable Overhead Spending Variance . . . . . . . . . . . 9,990

Variable Overhead Efficiency Variance . . . . . . . . . 4,050

Fixed Overhead Spending Variance . . . . . . . . . . . 40

Fixed Overhead Volume Variance . . . . . . . . . . . . 500

Factory Overhead†. . . . . . . . . . . . . . . . . . . . . . . . 32,400

* $20,250 1 $6,750 †$26,190 1 $6,210

APPENDIX

Expanded Overhead Variances and Standard Cost Accounting System

Expanded Overhead Variances Similar to analysis of direct materials and direct labor, overhead variances can be more completely analyzed. Exhibit 21A.1 shows an expanded framework for under- standing these component overhead variances. This framework uses classifications of overhead costs as

either variable or fixed. A spending variance occurs when management pays an amount different than the standard price to acquire an item. For instance, the actual wage rate paid to indirect labor might be higher than the standard rate. Similarly, actual su- pervisory salaries might be different than expected. Spending variances such as these cause manage- ment to investigate the reasons that the amount paid differs from the standard. Both variable and fixed overhead costs can yield their own spending vari- ances. Analyzing variable overhead includes com- puting an efficiency variance, which occurs when standard direct labor hours (the allocation base) ex- pected for actual production differ from the actual direct labor hours used. This efficiency variance reflects on the cost-effectiveness in using the over- head allocation base (such as direct labor).

Exhibit 21A.1 shows that we can combine the variable overhead spending variance, the fixed over- head spending variance, and the variable overhead efficiency variance to get the controllable variance.

Computing Variable and Fixed Overhead Cost Variances To illustrate the computation of more detailed overhead cost variances, we return to the G-Max data. We know that G-Max produced 3,500 units when 4,000 units were budgeted. Additional data from cost reports show that the actual overhead cost incurred is $7,650 (the variable portion of $3,650 and the fixed portion of $4,000). Recall from Exhibit 21.12 that each unit requires 1 hour of direct labor, that variable overhead is applied at a rate of $1.00 per direct labor hour, and that the pre determined fixed overhead rate is $1.00 per direct labor hour. Using this information, we can compute overhead variances for both variable and fixed overhead as follows:

21A

EXHIBIT 21A.1 Expanded Framework for Total Overhead Variance

Controllable Variance

Fixed Overhead Variance

Variable Overhead Variance

Total Overhead Variance

Spending Variance

Volume Variance

Spending Variance

Efficiency Variance

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Chapter 21 Flexible Budgets and Standard Costs 917

Actual variable overhead (given) . . . . . . . . . . . . . . . . . . $3,650

Applied variable overhead (3,500 3 $1.00) . . . . . . . . . 3,500

Variable overhead variance (unfavorable) . . . . . . . . . . . $ 150

Actual fixed overhead (given) . . . . . . . . . . . . . . . . . . . . $4,000

Applied fixed overhead (3,500 3 $1.00) . . . . . . . . . . . 3,500

Fixed overhead variance (unfavorable) . . . . . . . . . . . . . $ 500

EXHIBIT 21A.2 Variable and Fixed Overhead Variances

* AH actual direct labor hours; AVR actual variable overhead rate; SH standard direct labor hours; SVR standard variable overhead rate.

† SH 5 standard direct labor hours; SF R 5 standard fixed overhead rate.

Actual Overhead Applied Overhead AH 3 AVR SH 3 SVRAH 3 SVR

Variable Overhead Variance*

Spending Variance (AH 3 AVR) 2 (AH 3 SVR)

Efficiency Variance (AH 3 SVR) 2 (SH 3 SVR)

Variable Overhead Variance

Actual Overhead (Given)

Budgeted Overhead (From Budget)

Applied Overhead (SH 3 SFR)

Fixed Overhead Variance†

Spending Variance Actual 2 Budgeted

Volume Variance Budgeted 2 Applied

Fixed Overhead Variance

Management should seek to determine the causes of these unfavorable variances and take corrective ac- tion. To help better isolate the causes of these variances, more detailed overhead variances can be used, as shown in the next section.

Expanded Overhead Variance Formulas Exhibit 21A.2 shows formulas to use in computing detailed over- head variances that can better identify reasons for variable and fixed overhead variances.

EXHIBIT 21A.3 Computing Variable Overhead Cost Variances

Actual Overhead Applied Overhead AH 3 AVR

Given $3,650

SH 3 SVR 3,500 hrs. 3 $1.00

$3,500

AH 3 SVR 3,400 hrs. 3 $1.00

$3,400

$250 U $100 F

$150 U

Spending Variance $3,650 2 $3,400

Efficiency Variance $3,400 2 $3,500

Variable Overhead Variance $250 2 $100

Variable Overhead Cost Variances Using these formulas, Exhibit 21A.3 offers insight into the causes of G-Max’s $150 unfavorable variable overhead cost variance. Recall that G-Max applies overhead based on direct labor hours as the allocation base. We know that it used 3,400 direct labor hours to produce 3,500 units. This compares favorably to the standard requirement of 3,500 direct labor hours at one labor hour per unit. At a standard variable overhead rate of $1.00 per direct labor hour, this should have resulted in variable overhead costs of $3,400 (middle column of Exhibit 21A.3).

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918 Chapter 21 Flexible Budgets and Standard Costs

G-Max’s cost records, however, report actual variable overhead of $3,650, or $250 higher than expected. This means G-Max has an unfavorable variable overhead spending variance of $250 ($3,650 2 $3,400). On the other hand, G-Max used 100 fewer labor hours than expected to make 3,500 units, and its actual variable overhead is lower than its applied variable overhead. Thus, G-Max has a favorable variable overhead efficiency variance of $100 ($3,400 2 $3,500).

Fixed Overhead Cost Variances Exhibit 21A.4 provides insight into the causes of G-Max’s $500 unfavorable fixed overhead variance. G-Max reports that it incurred $4,000 in actual fixed overhead; this amount equals the budgeted fixed overhead for May at the expected production level of 4,000 units (see Exhibit 21.12). Thus, the fixed overhead spending variance is zero, suggesting good control of fixed overhead costs. G-Max’s budgeted fixed overhead application rate is $1 per hour ($4,000y4,000 direct labor hours), but the actual production level is only 3,500 units. Using this information, we can compute the fixed overhead volume variance shown in Exhibit 21A.4. The applied fixed overhead is computed by multiplying 3,500 standard hours allowed for the actual production by the $1 fixed overhead allocation rate. The volume variance of $500 occurs because 500 fewer units are produced than budgeted; namely, 80% of the manufacturing capacity is budgeted but only 70% is used.

EXHIBIT 21A.4 Computing Fixed Overhead Cost Variances

Actual Overhead Applied Overhead Given $4,000

Budgeted Overhead Given $4,000

3,500 hrs. 3 $1.00 $3,500

$0 $500 U

$500 U

Spending Variance $4,000 – $4,000

Volume Variance $4,000 – $3,500

Fixed Overhead Variance $0 – $500

Standard Cost Accounting System We have shown how companies use standard costs in management reports. Most standard cost systems also record these costs and variances in accounts. This practice simplifies recordkeeping and helps in preparing reports. Although we do not need knowledge of standard cost accounting practices to understand standard costs and their use, we must know how to inter- pret the accounts in which standard costs and variances are recorded. The entries in this section briefly illustrate the important aspects of this process for G-Max’s standard costs and variances for May. The first of these entries records standard materials cost incurred in May in the Goods in Process In- ventory account. This part of the entry is similar to the usual accounting entry, but the amount of the debit equals the standard cost ($35,000) instead of the actual cost ($37,800). This entry credits Raw Materials Inventory for actual cost. The difference between standard and actual direct materials costs is recorded with debits to two separate materials variance accounts (recall Exhibit 21.10). Both the materials price and quantity variances are recorded as debits because they reflect additional costs higher than the standard cost (if actual costs were less than the standard, they are recorded as credits). This treatment (debit) re- flects their unfavorable effect because they represent higher costs and lower income.

P4 Prepare journal entries for standard costs and account for price and quantity variances.

Assets 5 Liabilities 1 Equity 135,000 21,000 237,800 21,800

May 31 Goods in Process Inventory . . . . . . . . . . . . . . . . . . . . . . 35,000

Direct Materials Price Variance* . . . . . . . . . . . . . . 1,800

Direct Materials Quantity Variance . . . . . . . . . . . . 1,000

Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . 37,800

To charge production for standard quantity of materials used (1,750 lbs.) at the standard price ($20 per lb.), and to record material price and material quantity variances.

* Many companies record the materials price variance when materials are purchased. For simplicity, we record both the materials price and quantity variances when materials are issued to production.

The second entry debits Goods in Process Inventory for the standard labor cost of the goods manufac- tured during May ($28,000). Actual labor cost ($28,220) is recorded with a credit to the Factory Payroll

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Chapter 21 Flexible Budgets and Standard Costs 919

account. The difference between standard and actual labor costs is explained by two variances (see Exhibit 21.11). The direct labor rate variance is unfavorable and is debited to that account. The direct labor effi- ciency variance is favorable and that account is credited. The direct labor efficiency variance is favorable because it represents a lower cost and a higher net income.

The entry to assign standard predetermined overhead to the cost of goods manufactured must debit the $7,000 predetermined amount to the Goods in Process Inventory account. Actual overhead costs of $7,650 were debited to Factory Overhead during the period (entries not shown here). Thus, when Factory Over- head is applied to Goods in Process Inventory, the actual amount is credited to the Factory Overhead ac- count. To account for the difference between actual and standard overhead costs, the entry includes a $250 debit to the Variable Overhead Spending Variance, a $100 credit to the Variable Overhead Efficiency Vari- ance, and a $500 debit to the Volume Variance (recall Exhibits 21A.3 and 21A.4). An alternative (simpler) approach is to record the difference with a $150 debit to the Controllable Variance account and a $500 debit to the Volume Variance account (recall from Exhibit 21A.1 that controllable variance is the sum of both variable overhead variances and the fixed overhead spending variance).

Assets 5 Liabilities 1 Equity 17,000 17,650 2 250 2 500 1 100

May 31 Goods in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Volume Variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Variable Overhead Spending Variance . . . . . . . . . . . . . . 250

Variable Overhead Efficiency Variance . . . . . . . . . . 100

Factory Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,650

To apply overhead at the standard rate of $2 per standard direct labor hour (3,500 hours), and to record overhead variances.

Assets 5 Liabilities 1 Equity 128,000 128,220

2 1,020 1 800

May 31 Goods in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000

Direct Labor Rate Variance . . . . . . . . . . . . . . . . . . . . . . . . . 1,020

Direct Labor Efficiency Variance . . . . . . . . . . . . . . . . . 800

Factory Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,220

To charge production with 3,500 standard hours of direct labor at the standard $8 per hour rate, and to record the labor rate and efficiency variances.

The balances of these different variance accounts accumulate until the end of the accounting period. As a result, the unfavorable variances of some months can offset the favorable variances of other months. These ending variance account balances, which reflect results of the period’s various transactions and events, are closed at period-end. If the amounts are immaterial, they are added to or subtracted from the balance of the Cost of Goods Sold account. This process is similar to that shown in the job order costing chapter for eliminating an underapplied or overapplied balance in the Factory Overhead account. (Note: These variance balances, which represent differences between actual and standard costs, must be added to or subtracted from the materials, labor, and overhead costs recorded. In this way, the recorded costs equal the actual costs incurred in the period; a company must use actual costs in external financial statements prepared in accordance with generally accepted accounting principles.)

Point: If variances are material they can be allocated between Goods in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. This closing process is explained in advanced courses.

12. A company uses a standard cost accounting system. Prepare the journal entry to record these direct materials variances:

Direct materials cost actually incurred. . . . . . . . . . . . . . . . . . $73,200

Direct materials quantity variance (favorable) . . . . . . . . . . . . 3,800

Direct materials price variance (unfavorable) . . . . . . . . . . . . 1,300

13. If standard costs are recorded in the manufacturing accounts, how are recorded variances treated at the end of an accounting period?

Quick Check Answers — p. 921

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920 Chapter 21 Flexible Budgets and Standard Costs

C1 Define standard costs and explain how standard cost infor-mation is useful for management by exception. Standard costs are the normal costs that should be incurred to produce a product or perform a service. They should be based on a careful examination of the processes used to produce a product or perform a service as well as the quantities and prices that should be incurred in carrying out those processes. On a performance report, standard costs (which are flexible budget amounts) are compared to actual costs, and the differences are presented as variances. Standard cost accounting provides management information about costs that differ from budgeted (expected) amounts. Performance reports disclose the costs or areas of operations that have significant variances from budgeted amounts. This allows managers to focus attention on the exceptions and less attention on areas proceeding normally.

C2 Describe variances and what they reveal about perfor-mance. Management can use variances to monitor and control activities. Total cost variances can be broken into price and quantity variances to direct management’s attention to those responsible for quantities used and prices paid.

A1 Analyze changes in sales from expected amounts. Actual sales can differ from budgeted sales, and managers can investigate this difference by computing both the sales price and sales volume vari- ances. The sales price variance refers to that portion of total variance resulting from a difference between actual and budgeted selling prices. The sales volume variance refers to that portion of total variance re- sulting from a difference between actual and budgeted sales quantities.

P1 Prepare a flexible budget and interpret a flexible budget performance report. A flexible budget expresses variable costs in per unit terms so that it can be used to develop budgeted amounts for any volume level within the relevant range. Thus, man- agers compute bud geted amounts for evaluation after a period for the volume that actually occurred. To prepare a flexible budget, we express each variable cost as a constant amount per unit of sales (or as a percent of sales dollars). In contrast, the budgeted amount

Summary of each fixed cost is expressed as a total amount expected to occur at any sales volume within the relevant range. The flexible budget is then determined using these computations and amounts for fixed and variable costs at the expected sales volume.

P2 Compute materials and labor variances. Materials and labor variances are due to differences between the actual costs incurred and the budgeted costs. The price (or rate) variance is computed by comparing the actual cost with the flexible budget amount that should have been incurred to acquire the actual quantity of resources. The quantity (or efficiency) variance is computed by comparing the flexible budget amount that should have been incurred to acquire the actual quantity of resources with the flexible budget amount that should have been incurred to acquire the standard quantity of resources.

P3 Compute overhead variances. Overhead variances are due to differences between the actual overhead costs incurred and the overhead applied to production. An overhead spending variance arises when the actual amount incurred differs from the budgeted amount of overhead. An overhead efficiency (or volume) variance arises when the flexible overhead budget amount differs from the overhead ap- plied to production. It is important to realize that overhead is assigned using an overhead allocation base, meaning that an efficiency vari- ance (in the case of variable overhead) is a result of the overhead ap- plication base being used more or less efficiently than planned.

P4A Prepare journal entries for standard costs and account for price and quantity variances. When a company records stan- dard costs in its accounts, the standard costs of materials, labor, and overhead are debited to the Goods in Process Inventory account. Based on an analysis of the material, labor, and overhead costs, each quantity variance, price variance, volume variance, and controllable variance is recorded in a separate account. At period-end, if the variances are material, they are allocated among the balances of the Goods in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. If they are not material, they are simply debited or credited to the Cost of Goods Sold account.

Entrepreneur From the complaints, this performance report ap- pears to compare actual results with a fixed budget. This comparison is useful in determining whether the amount of work actually performed was more or less than planned, but it is not useful in determining whether the divisions were more or less efficient than planned. If the two consulting divisions worked on more assignments than expected, some costs will certainly increase. Therefore, you should prepare a flexible budget using the actual number of consulting assignments and then compare actual performance to the flexible budget.

Internal Auditor Although the manager’s actions might not be unethical, this action is undesirable. The internal auditor should report this behavior, possibly recommending that for the purchase of such discretionary items, the manager must provide budgetary requests using an activity-based budgeting process. The internal auditor would then be given full authority to verify this budget request.

Production Manager As production manager, you should in- vestigate the causes for any labor-related variances although you may not be responsible for them. An unfavorable labor efficiency variance occurs because more labor hours than standard were used during the period. There are at least three possible reasons for this: (1) materials quality could be poor, resulting in more labor consumption due to rework; (2) unplanned interruptions (strike, breakdowns, accidents) could have occurred during the period; and (3) a different labor mix might have occurred for a strategic reason such as to expedite orders. This new labor mix could have consisted of a larger proportion of untrained labor, which resulted in more labor hours.

Sales Manager The unfavorable sales price variance suggests that actual prices were lower than budgeted prices. As the sales man- ager, you want to know the reasons for a lower than expected price. Perhaps your salespeople lowered the price of certain products by offering quantity discounts. You then might want to know what

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 21 Flexible Budgets and Standard Costs 921

prompted them to offer the quantity dis counts (perhaps competitors were offering discounts). You want to break the sales volume vari- ance into both the sales mix and sales quantity variances. You could

find that although the sales quantity variance is favorable, the sales mix variance is not. Then you need to investigate why the actual sales mix differs from the budgeted sales mix.

1. b 2. The first step is classifying each cost as variable or fixed. 3. A fixed budget is prepared using an expected volume of sales or

production. A flexible budget is prepared using the actual vol- ume of activity.

4. The contribution margin equals sales less variable costs. 5. c 6. It is the difference between actual cost and standard cost. 7. a; Total actual hours: 2,500 3 2.5 5 6,250 Total standard hours: 2,500 3 2.0 5 5,000 Efficiency variance 5 (6,250 2 5,000) 3 $3.00 5 $3,750 U

8. b; Rate variance 5 ($3.10 2 $3.00) 3 6,250 5 $625 U

9. Yes, this will occur when the materials quantity variance is more than the materials price variance.

10. The overhead volume variance is favorable when the actual op- erating level is higher than the expected level.

11. b 12.

13. If the variances are material, they should be prorated among the Goods in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. If they are not material, they can be closed to Cost of Goods Sold.

Guidance Answers to Quick Checks

Goods in Process Inventory . . . . . . . . . . . . . 75,700

Direct Materials Price Variance . . . . . . . . . . . 1,300

Direct Materials Quantity Variance . . . . . . 3,800

Raw Materials Inventory . . . . . . . . . . . . . . 73,200

Benchmarking (p. 908)

Budget report (p. 896)

Budgetary control (p. 896)

Controllable variance (p. 909)

Cost variance (p. 903)

Efficiency variance (p. 916)

Favorable variance (p. 897)

Fixed budget (p. 897)

Fixed budget performance report (p. 897)

Flexible budget (p. 898)

Flexible budget performance report (p. 900)

Management by exception (p. 901)

Overhead cost variance (p. 908)

Price variance (p. 901)

Quantity variance (p. 901)

Spending variance (p. 916)

Standard costs (p. 901)

Unfavorable variance (p. 897)

Variance analysis (p. 901)

Volume variance (p. 909)

Key Terms

Multiple Choice Quiz Answers on p. 939 mhhe.com/wildFINMAN5e

Additional Quiz Questions are available at the book’s Website.

1. A company predicts its production and sales will be 24,000 units. At that level of activity, its fixed costs are budgeted at $300,000, and its variable costs are budgeted at $246,000. If its activity level declines to 20,000 units, what will be its fixed costs and its variable costs?

a. Fixed, $300,000; variable, $246,000 b. Fixed, $250,000; variable, $205,000 c. Fixed, $300,000; variable, $205,000 d. Fixed, $250,000; variable, $246,000 e. Fixed, $300,000; variable, $300,000 2. Using the following information about a single product com-

pany, compute its total actual cost of direct materials used. • Direct materials standard cost: 5 lbs. 3 $2 per lb. 5 $10. • Total direct materials cost variance: $15,000 unfavorable. • Actual direct materials used: 300,000 lbs. • Actual units produced: 60,000 units.

a. $585,000 b. $600,000 c. $300,000 d. $315,000 e. $615,000 3. A company uses four hours of direct labor to produce a product

unit. The standard direct labor cost is $20 per hour. This period the company produced 20,000 units and used 84,160 hours of direct labor at a total cost of $1,599,040. What is its labor rate variance for the period?

a. $83,200 F b. $84,160 U c. $84,160 F d. $83,200 U e. $ 960 F

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922 Chapter 21 Flexible Budgets and Standard Costs

1. What limits the usefulness to managers of fixed budget performance reports?

2. Identify the main purpose of a flexible budget for managers. 3. Prepare a flexible budget performance report title (in proper

form) for Spalding Company for the calendar year 2013. Why is a proper title important for this or any report?

4. What type of analysis does a flexible budget performance report help management perform?

5. In what sense can a variable cost be considered constant? 6. What department is usually responsible for a direct labor

rate variance? What department is usually responsible for a di- rect labor efficiency variance? Explain.

7. What is a price variance? What is a quantity variance? 8. What is the purpose of using standard costs? 9. KTM monitors its fixed overhead. In an analysis of

fixed overhead cost variances, what is the volume variance?

10. What is the predetermined standard overhead rate? How is it computed?

11. In general, variance analysis is said to provide information about _________ and _________ variances.

12. Polaris monitors its overhead. In an analysis of overhead cost variances, what is the controlla- ble variance and what causes it?

13. What are the relations among standard costs, flexible budgets, variance analysis, and management by exception?

14. How can the manager of snowmobile sales at Arctic Cat use flexible budgets to enhance performance?

15. Is it possible for a retail store such as Apple to use variances in analyzing its operating performance? Explain.

16. Assume that Piaggio is budgeted to oper- ate at 80% of capacity but actually operates at 75% of capacity. What effect will the 5% deviation have on its controllable variance? Its volume variance?

Discussion Questions

A Superscript letter A denotes assignments based on Appendix 21A.

Icon denotes assignments that involve decision making.

Apple

4. A company’s standard for a unit of its single product is $6 per unit in variable overhead (4 hours 3 $1.50 per hour). Actual data for the period show variable overhead costs of $150,000 and produc- tion of 24,000 units. Its total variable overhead cost variance is

a. $ 6,000 F. b. $ 6,000 U. c. $114,000 U. d. $114,000 F. e. $ 0.

5. A company’s standard for a unit of its single product is $4 per unit in fixed overhead ($24,000 total/6,000 units bud- geted). Actual data for the period show total actual fixed overhead of $24,100 and production of 4,800 units. Its volume variance is

a. $4,800 U. b. $4,800 F. c. $ 100 U. d. $ 100 F. e. $4,900 U.

QS 21-4 Management by exception

C1

Managers use management by exception for control purposes. (1) Describe the concept of management by exception. (2) Explain how standard costs help managers apply this concept to monitor and control costs.

QUICK STUDY

QS 21-1 Flexible budget performance report

P1

Beech Company sold 105,000 units of its product in May. For the level of production achieved in May, the budgeted amounts were: sales, $1,300,000; variable costs, $750,000; and fixed costs, $300,000. The following actual financial results are available for May. Prepare a flexible budget performance report for May.

Sales (105,000 units) . . . . . . . . . $1,275,000

Variable costs . . . . . . . . . . . . . . . 712,500

Fixed costs . . . . . . . . . . . . . . . . . 300,000

QS 21-2 Standard cost card C1

BatCo makes metal baseball bats. Each bat requires 1 kg. of aluminum at $18 per kg. and 0.25 direct labor hours at $20 per hour. Overhead is assigned at the rate of $40 per labor hour. What amounts would appear on a standard cost card for BatCo?

QS 21-3 Cost variances C2

Refer to information in QS 21-2. Assume the actual cost to manufacture one metal bat was $40. Compute the cost variance and classify it as favorable or unfavorable.

Polaris

Arctic Cat

PIAGGIO

KTM

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Chapter 21 Flexible Budgets and Standard Costs 923

QS 21-5 Materials cost variances P2

Juan Company’s output for the current period was assigned a $150,000 standard direct materials cost. The direct materials variances included a $12,000 favorable price variance and a $2,000 favorable quantity variance. What is the actual total direct materials cost for the current period?

QS 21-6 Labor cost variances P2

Frontera Company’s output for the current period results in a $20,000 unfavorable direct labor rate variance and a $10,000 unfavorable direct labor efficiency variance. Production for the current period was assigned an $400,000 standard direct labor cost. What is the actual total direct labor cost for the current period?

QS 21-7 Materials cost variances P2

For the current period, Kayenta Company’s manufacturing operations yield a $4,000 unfavorable price variance on its direct materials usage. The actual price per pound of material is $78; the standard price is $77.50. How many pounds of material are used in the current period?

QS 21-8 Overhead cost variances P3

Alvarez Company’s output for the current period yields a $20,000 favorable overhead volume variance and a $60,400 unfavorable overhead controllable variance. Standard overhead charged to production for the period is $225,000. What is the actual total overhead cost incurred for the period?

QS 21-9A

Preparing overhead entries P4 Refer to the information in QS 21-8. Alvarez records standard costs in its accounts. Prepare the journal entry to charge overhead costs to the Goods in Process Inventory account and to record any variances.

Actual machine hours used . . . . . . . . . . . . . . . . . . . . . 4,700 hours

Standard machine hours . . . . . . . . . . . . . . . . . . . . . . . 5,000 hours

Actual variable overhead rate per hour . . . . . . . . . . . $4.15

Standard variable overhead rate per hour . . . . . . . . . $4.00

QS 21-10 Total overhead cost variance

P3

Mosaic Company applies overhead using machine hours and reports the following information. Compute the total variable overhead cost variance.

QS 21-11A

Overhead spending and efficiency variances P3

Refer to the information from QS 21-10. Compute the variable overhead spending variance and the variable overhead efficiency variance.

QS 21-12 Computing sales price and volume variances A1

Farad, Inc. specializes in selling used SUVs. During the first six months of 2013, the dealership sold 50 trucks at an average price of $9,000 each. The budget for the first six months of 2013 was to sell 45 trucks at an average price of $9,500 each. Compute the dealership’s sales price variance and sales volume variance for the first six months of 2013.

QS 21-13 Flexible budget P1

Based on predicted production of 24,000 units, a company anticipates $300,000 of fixed costs and $246,000 of variable costs. If the company actually produces 20,000 units, what are the flexible budget amounts of fixed and variable costs?

QS 21-15 Flexible budget performance report P1

Refer to information in QS 21-14. Assume that actual sales are $480,000, actual variable costs for the year are $112,000, and actual fixed costs for the year are $145,000. Prepare a flexible budget performance report for the year.

QS 21-14 Flexible budget

P1

Brodrick Company expects to produce 20,000 units for the year ending December 31. A flexible budget for 20,000 units of production reflects sales of $400,000; variable costs of $80,000; and fixed costs of $150,000. If the company instead produces and sells 26,000 units for the year, calculate the expected level of income from operations.

QS 21-16 Materials variances

P2

Tercer reports the following on one of its products. Compute the direct materials price and quantity variances.

Direct materials standard (4 lbs. @ $2/lb.) . . . . . . . . $8 per finished unit

Actual direct materials used . . . . . . . . . . . . . . . . . . . . 300,000 lbs.

Actual finished units produced . . . . . . . . . . . . . . . . . . 60,000 units

Actual cost of direct materials used . . . . . . . . . . . . . . $535,000

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924 Chapter 21 Flexible Budgets and Standard Costs

QS 21-18 Controllable overhead variance

P3

Fogel Co. expects to produce 116,000 units for the year. The company’s flexible budget for 116,000 units of production shows variable overhead costs of $162,400 and fixed overhead costs of $124,000. For the year, the company incurred actual overhead costs of $262,800 while producing 110,000 units. Compute the controllable overhead variance.

QS 21-20 Volume variance P3

Refer to information in QS 21-19. Compute the overhead volume variance for November.

QS 21-17 Direct labor variances

P2

The following information describes a company’s usage of direct labor in a recent period. Compute the direct labor rate and efficiency variances for the period.

Actual direct labor hours used . . . . . . . . . . . . . . . . . . . . . . 65,000 Actual direct labor rate per hour . . . . . . . . . . . . . . . . . . . . $15 Standard direct labor rate per hour . . . . . . . . . . . . . . . . . . $14 Standard direct labor hours for units produced . . . . . . . . . 67,000

QS 21-19 Controllable overhead variance

P3

AirPro Corp. reports the following for November. Compute the controllable overhead variance for November.

Actual total factory overhead incurred . . . . . . . . . . . . . . . . . . . $28,175 Standard factory overhead: Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3.10 per unit produced Fixed overhead ($12,000/12,000 predicted units to be produced) . . . . . . . $1 per unit Predicted units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 units Actual units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,800 units

Exercise 21-2 Preparation of flexible budgets

P1

Tempo Company’s fixed budget for the first quarter of calendar year 2013 reveals the following. Prepare flexible budgets following the format of Exhibit 21.3 that show variable costs per unit, fixed costs, and three different flexible budgets for sales volumes of 6,000, 7,000, and 8,000 units.

Sales (7,000 units) . . . . . . . . . . . . . . . . . . . $2,800,000 Cost of goods sold Direct materials . . . . . . . . . . . . . . . . . . $280,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . 490,000 Production supplies . . . . . . . . . . . . . . . 175,000 Plant manager salary . . . . . . . . . . . . . . . 65,000 1,010,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . 1,790,000 Selling expenses Sales commissions . . . . . . . . . . . . . . . . . 140,000 Packaging . . . . . . . . . . . . . . . . . . . . . . . . 154,000 Advertising . . . . . . . . . . . . . . . . . . . . . . 125,000 419,000 Administrative expenses Administrative salaries . . . . . . . . . . . . . 85,000 Depreciation—office equip. . . . . . . . . . 35,000 Insurance . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Office rent . . . . . . . . . . . . . . . . . . . . . . . 36,000 176,000 Income from operations . . . . . . . . . . . . . . $1,195,000Check Income (at 6,000 units),

$972,000

QS 21-21 Sales variances A1

In a recent year, BMW sold 216,944 of its 1 Series cars. Assume the company expected to sell 225,944 of these cars during the year. Also assume the budgeted sales price for each car was $30,000, and the actual sales price for each car was $30,200. Compute the sales price variance and the sales volume variance.

EXERCISES

Exercise 21-1 Classification of costs as fixed or variable

P1

JPAK Company manufactures and sells mountain bikes. It normally operates eight hours a day, five days a week. Using this information, classify each of the following costs as fixed or variable. If additional infor- mation would affect your decision, describe the information. a. Bike frames e. Bike tires i. Office supplies b. Screws for assembly f. Gas used for heating j. Depreciation on tools c. Repair expense for tools g. Incoming shipping expenses k. Management salaries d. Direct labor h. Taxes on property

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Chapter 21 Flexible Budgets and Standard Costs 925

Exercise 21-4 Preparation of a flexible budget performance report

P1

Bay City Company’s fixed budget performance report for July follows. The $647,500 budgeted expenses include $487,500 variable expenses and $160,000 fixed expenses. Actual expenses include $158,000 fixed expenses. Prepare a flexible budget performance report that shows any variances between budgeted results and actual results. List fixed and variable expenses separately.

Fixed Budget Actual Results Variances

Sales (in units) . . . . . . . . . . . . . . . . . 7,500 7,200

Sales (in dollars) . . . . . . . . . . . . . . . $750,000 $737,000 $13,000 U

Total expenses . . . . . . . . . . . . . . . . 647,500 641,000 6,500 F

Income from operations . . . . . . . . . $102,500 $ 96,000 $ 6,500 U Check Income variance, $4,000 F

After evaluating Null Company’s manufacturing process, management decides to establish standards of 3 hours of direct labor per unit of product and $15 per hour for the labor rate. During October, the company uses 16,250 hours of direct labor at a $247,000 total cost to produce 5,600 units of product. In November, the company uses 22,000 hours of direct labor at a $335,500 total cost to produce 6,000 units of product. (1) Compute the rate variance, the efficiency variance, and the total direct labor cost variance for each of these two months. (2) Interpret the October direct labor variances.

Exercise 21-5 Computation and interpretation of labor variances P2

Check (1) October rate variance, $3,250 U

Exercise 21-3 Preparation of a flexible budget performance report

P1

Solitaire Company’s fixed budget performance report for June follows. The $315,000 budgeted expenses include $294,000 variable expenses and $21,000 fixed expenses. Actual expenses include $27,000 fixed expenses. Prepare a flexible budget performance report showing any variances between budgeted and ac- tual results. List fixed and variable expenses separately.

Fixed Budget Actual Results Variances

Sales (in units) . . . . . . . . . . . . . . . . . 8,400 10,800

Sales (in dollars) . . . . . . . . . . . . . . . $420,000 $540,000 $120,000 F

Total expenses . . . . . . . . . . . . . . . . 315,000 378,000 63,000 U

Income from operations . . . . . . . . . $105,000 $162,000 $ 57,000 F Check Income variance, $21,000 F

Sedona Company set the following standard costs for one unit of its product for 2013. Exercise 21-6 Computation of total variable and fixed overhead variances

P3 Direct material (20 Ibs. @ $2.50 per Ib.) . . . . . . . . . . . . . . . . . . . $ 50.00

Direct labor (10 hrs. @ $8.00 per hr.) . . . . . . . . . . . . . . . . . . . . . 80.00

Factory variable overhead (10 hrs. @ $4.00 per hr.) . . . . . . . . . . 40.00

Factory fixed overhead (10 hrs. @ $1.60 per hr.) . . . . . . . . . . . . 16.00

Standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $186.00

The $5.60 ($4.00 1 $1.60) total overhead rate per direct labor hour is based on an expected operating level equal to 75% of the factory’s capacity of 50,000 units per month. The following monthly flexible budget information is also available.

70% 80%

Operating Levels (% of capacity)

Budgeted output (units)

1

2

3

4

5

6 7

8

Budgeted labor (standard hours)

Budgeted overhead (dollars) Variable overhead

Fixed overhead

Total overhead

75%

File Edit View Insert Format Tools Data Window Help

35,000 350,000

$1,400,000

600,000

$2,000,000

37,500

$2,100,000

600,000

$1,500,000

375,000

$1,600,000

40,000 400,000

$2,200,000

600,000

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926 Chapter 21 Flexible Budgets and Standard Costs

During the current month, the company operated at 70% of capacity, employees worked 340,000 hours, and the following actual overhead costs were incurred.

Variable overhead costs . . . . . . . . $1,375,000

Fixed overhead costs . . . . . . . . . . 628,600

Total overhead costs . . . . . . . . . . . $2,003,600

(1) Show how the company computed its predetermined overhead application rate per hour for total overhead, variable overhead, and fixed overhead. (2) Compute the total variable and total fixed overhead variances.

Check (2) Variable overhead cost variance, $25,000 F

Exercise 21-7A

Computation and interpretation of overhead spending, efficiency, and volume variances P3

Refer to the information from Exercise 21-6. Compute and interpret the following. 1. Variable overhead spending and efficiency variances. 2. Fixed overhead spending and volume variances. 3. Controllable variance.

Check (1) Variable overhead: Spending, $15,000 U; Efficiency, $40,000 F

Exercise 21-8 Computation and interpretation of materials variances P2

Hart Company made 3,000 bookshelves using 22,000 board feet of wood costing $266,200. The company’s direct materials standards for one bookshelf are 8 board feet of wood at $12 per board foot. (1) Compute the direct materials variances incurred in manufacturing these bookshelves. (2) Interpret the direct materials variances.

Check Price variance, $2,200 U

Refer to Exercise 21-8. Hart Company records standard costs in its accounts and its material variances in separate accounts when it assigns materials costs to the Goods in Process Inventory account. (1) Show the journal entry that both charges the direct materials costs to the Goods in Process Inventory account and records the materials variances in their proper accounts. (2) Assume that Hart’s material variances are the only variances accumulated in the accounting period and that they are immaterial. Prepare the adjusting journal entry to close the variance accounts at period-end. (3) Identify the vari- ance that should be investigated according to the management by exception concept. Explain.

Exercise 21-9A

Materials variances recorded and closed

P4

Check (2) Cr. to Cost of Goods Sold, $21,800

World Company expects to operate at 80% of its productive capacity of 50,000 units per month. At this planned level, the company expects to use 25,000 standard hours of direct labor. Overhead is allocated to products using a predetermined standard rate based on direct labor hours. At the 80% capacity level, the total budgeted cost includes $50,000 fixed overhead cost and $275,000 variable overhead cost. In the cur- rent month, the company incurred $305,000 actual overhead and 22,000 actual labor hours while producing 35,000 units. (1) Compute the overhead application rate for total overhead. (2) Compute the total overhead variance.

Exercise 21-10 Computation of total overhead rate and total overhead variance

P3

Check (1) Variable overhead rate, $11.00 per hour

Refer to the information from Exercise 21-10. Compute the (1) overhead volume variance and (2) overhead controllable variance.

Exercise 21-11 Computation of volume and controllable overhead variances

P3 Check (2) $14,375 U

Comp Wiz sells computers. During May 2013, it sold 350 computers at a $1,200 average price each. The May 2013 fixed budget included sales of 365 computers at an average price of $1,100 each. (1) Compute the sales price variance and the sales volume variance for May 2013. (2) Interpret the findings.

Exercise 21-12 Computing and interpreting sales variances

A1

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Chapter 21 Flexible Budgets and Standard Costs 927

Exercise 21-13 Standard costs

C1

Match the terms labeled a through e with their correct definition labeled 1 through 5. a. Standard cost card b. Management by

exception c. Standard cost d. Ideal standard e. Practical standard

1. Quantity of input required under normal conditions. 2. Quantity of input required if a production process is 100% efficient. 3. Managing by focusing on large differences from standard costs. 4. Record that accumulates standard cost information. 5. Preset cost for delivering a product or service under normal conditions.

Exercise 21-14 Cost variances

C2

Presented below are terms preceded by letters a through j and a list of definitions 1 through 10. Enter the letter of the term with the definition, using the space preceding the definition. a. Fixed budget b. Standard costs c. Price variance d. Quantity variance e. Volume variance f. Controllable variance g. Cost variance h. Flexible budget i. Variance analysis j. Management by

exception

1. The difference between actual and budgeted sales or cost caused by the difference between the actual price per unit and the bud- geted price per unit.

2. A planning budget based on a single predicted amount of sales or production volume; unsuitable for evaluations if the actual volume differs from the predicted volume.

3. Preset costs for delivering a product, component, or service un- der normal conditions.

4. A process of examining the differences between actual and bud- geted sales or costs and describing them in terms of the amounts that resulted from price and quantity differences.

5. The difference between the total budgeted overhead cost and the overhead cost that was allocated to products using the predeter- mined fixed overhead rate.

6. A budget prepared based on predicted amounts of revenues and expenses corresponding to the actual level of output.

7. The difference between actual and budgeted cost caused by the difference between the actual quantity and the budgeted quantity.

8. The combination of both overhead spending variances (variable and fixed) and the variable overhead efficiency variance.

9. A management process to focus on significant variances and give less attention to areas where performance is close to the standard.

10. The difference between actual cost and standard cost, made up of a price variance and a quantity variance.

Resset Co. provides the following results of April’s operations: F indicates favorable and U indicates unfavorable. Applying the management by exception approach, which of the variances are of greatest concern? Why?

Exercise 21-15 Analyzing variances

C1

Direct materials price variance . . . . . . . . . . . . . $ 300 F

Direct materials quantity variance . . . . . . . . . . . 3,000 U

Direct labor rate variance . . . . . . . . . . . . . . . . . 100 U

Direct labor efficiency variance . . . . . . . . . . . . . 2,200 F

Controllable overhead variance . . . . . . . . . . . . . 400 U

Fixed overhead volume variance . . . . . . . . . . . . 500 F

The following information describes production activities of Mercer Manufacturing for the year: Exercise 21-16 Direct materials and direct labor variances

P2 Actual raw materials used . . . . . . . . . 16,000 lbs. at $4.05 per lb.

Actual factory payroll . . . . . . . . . . . . . 5,545 hours for a total of $105,355

Actual units produced . . . . . . . . . . . . 30,000

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928 Chapter 21 Flexible Budgets and Standard Costs

The predetermined overhead rate is based on a planned operating volume of 80% of the productive capac- ity of 60,000 units per quarter. The following flexible budget information is available.

PROBLEM SET A

Problem 21-1A Computation of materials, labor, and overhead variances

P2 P3

Trico Company set the following standard unit costs for its single product.

Direct materials (30 Ibs. @ $4 per Ib.) . . . . . . . . . . . . . . . . . $120.00

Direct labor (5 hrs. @ $14 per hr.) . . . . . . . . . . . . . . . . . . . . 70.00

Factory overhead — variable (5 hrs. @ $8 per hr.) . . . . . . . . 40.00

Factory overhead — fixed (5 hrs. @ $10 per hr.) . . . . . . . . . 50.00

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280.00

Operating Levels

70% 80% 90%

Production in units . . . . . . . . . . . . . . . . 42,000 48,000 54,000

Standard direct labor hours . . . . . . . . . 210,000 240,000 270,000

Budgeted overhead

Fixed factory overhead . . . . . . . . . . . $2,400,000 $2,400,000 $2,400,000

Variable factory overhead . . . . . . . . . $1,680,000 $1,920,000 $2,160,000

During the current quarter, the company operated at 90% of capacity and produced 54,000 units of product; actual direct labor totaled 265,000 hours. Units produced were assigned the following standard costs:

Direct materials (1,620,000 Ibs. @ $4 per Ib.) . . . . . . . . . $ 6,480,000

Direct labor (270,000 hrs. @ $14 per hr.) . . . . . . . . . . . . 3,780,000

Factory overhead (270,000 hrs. @ $18 per hr.) . . . . . . . . 4,860,000

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,120,000

Direct materials (1,615,000 Ibs. @ $4.10) . . . . . . . . . . . . $ 6,621,500

Direct labor (265,000 hrs. @ $13.75) . . . . . . . . . . . . . . . 3,643,750

Fixed factory overhead costs . . . . . . . . . . . . . . . . . . . . . . 2,350,000

Variable factory overhead costs . . . . . . . . . . . . . . . . . . . . 2,200,000

Total actual costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,815,250

Actual costs incurred during the current quarter follow:

Required

1. Compute the direct materials cost variance, including its price and quantity variances. 2. Compute the direct labor variance, including its rate and efficiency variances. 3. Compute the overhead controllable and volume variances.

Check (1) Materials variances: Price, $161,500 U; Quantity, $20,000 F. (2) Labor variances: Rate, $66,250 F; Efficiency, $70,000 F

Problem 21-2AA

Expanded overhead variances

P3

Refer to information in Problem 21-1A.

Required

Compute these variances: (a) variable overhead spending and efficiency, (b) fixed overhead spending and vol- ume, and (c) total overhead controllable.

Budgeted standards for each unit produced are 0.50 pounds of raw material at $4.00 per pound and 10 minutes of direct labor at $20 per hour. (1) Compute the direct materials price and quantity variances. (2) Compute the direct labor rate and efficiency variances. Indicate whether each variance is favorable or unfavorable.

mhhe.com/wildFINMAN5e

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Chapter 21 Flexible Budgets and Standard Costs 929

PHOENIX COMPANY Fixed Budget Report

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000 Cost of goods sold Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $975,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000 Machinery repairs (variable cost) . . . . . . . . . . 60,000 Depreciation—plant equipment . . . . . . . . . . . 300,000 Utilities ($45,000 is variable) . . . . . . . . . . . . . 195,000 Plant management salaries . . . . . . . . . . . . . . . 200,000 1,955,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,045,000 Selling expenses Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000 Sales salary (fixed annual amount) . . . . . . . . . 250,000 430,000 General and administrative expenses Advertising expense . . . . . . . . . . . . . . . . . . . . 125,000 Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,000 Entertainment expense . . . . . . . . . . . . . . . . . . 90,000 456,000 Income from operations . . . . . . . . . . . . . . . . . . . $ 159,000

Problem 21-3A Preparation and analysis of a flexible budget P1

Phoenix Company’s 2013 master budget included the following fixed budget report. It is based on an ex- pected production and sales volume of 15,000 units.

Required

1. Classify all items listed in the fixed budget as variable or fixed. Also determine their amounts per unit or their amounts for the year, as appropriate.

2. Prepare flexible budgets (see Exhibit 21.3) for the company at sales volumes of 14,000 and 16,000 units. 3. The company’s business conditions are improving. One possible result is a sales volume of

approximately 18,000 units. The company president is confident that this volume is within the relevant range of existing capacity. How much would operating income increase over the 2013 budgeted amount of $159,000 if this level is reached without increasing capacity?

4. An unfavorable change in business is remotely possible; in this case, production and sales volume for 2013 could fall to 12,000 units. How much income (or loss) from operations would occur if sales vol- ume falls to this level?

Check (2) Budgeted income at 16,000 units, $260,000

(4) Potential operating loss, $(144,000)

Problem 21-4A Preparation and analysis of a flexible budget performance report

P1 P2 A1

Refer to the information in Problem 21-3A. Phoenix Company’s actual income statement for 2013 follows.

PHOENIX COMPANY Statement of Income from Operations

For Year Ended December 31, 2013

Sales (18,000 units) . . . . . . . . . . . . . . . . . . . . . . . $3,648,000 Cost of goods sold Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $1,185,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 278,000 Machinery repairs (variable cost) . . . . . . . . . . 63,000 Depreciation — plant equipment . . . . . . . . . . 300,000 Utilities (fixed cost is $147,500) . . . . . . . . . . . 200,500 Plant management salaries . . . . . . . . . . . . . . . . 210,000 2,236,500 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,411,500 Selling expenses Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,500 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118,500 Sales salary (annual) . . . . . . . . . . . . . . . . . . . . . 268,000 474,000 General and administrative expenses Advertising expense . . . . . . . . . . . . . . . . . . . . 132,000 Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,000 Entertainment expense . . . . . . . . . . . . . . . . . . 93,500 466,500 Income from operations . . . . . . . . . . . . . . . . . . . $ 471,000

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930 Chapter 21 Flexible Budgets and Standard Costs

Required

1. Prepare a flexible budget performance report for 2013.

Analysis Component

2. Analyze and interpret both the (a) sales variance and (b) direct materials variance.

The company incurred the following actual costs when it operated at 75% of capacity in October.

Direct materials (91,000 Ibs. @ $5.10 per lb.) . . . . . . . . . $ 464,100

Direct labor (30,500 hrs. @ $17.25 per hr.) . . . . . . . . . . 526,125

Overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,250

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177,750

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000

Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Depreciation—building . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Depreciation—machinery . . . . . . . . . . . . . . . . . . . . . . . 75,000

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89,000 560,500

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,550,725

Overhead Budget (75% Capacity)

Variable overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . $ 45,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . 180,000

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Repairs and maintenance . . . . . . . . . . . . 90,000

Total variable overhead costs . . . . . . . . . $360,000

Fixed overhead costs

Depreciation—building . . . . . . . . . . . . . . 24,000

Depreciation—machinery . . . . . . . . . . . 80,000

Taxes and insurance . . . . . . . . . . . . . . . . . 12,000

Supervision . . . . . . . . . . . . . . . . . . . . . . . 79,000

Total fixed overhead costs . . . . . . . . . . . . 195,000

Total overhead costs . . . . . . . . . . . . . . . . . . $555,000

Check (1) Variances: Fixed costs, $36,000 U; Income, $9,000 F

Problem 21-5A Flexible budget preparation; computation of materials, labor, and overhead variances; and overhead variance report

P1 P2 P3 C2

Antuan Company set the following standard costs for one unit of its product.

Direct materials (6 Ibs. @ $5 per Ib.) . . . . . . . . . $ 30

Direct labor (2 hrs. @ $17 per hr.) . . . . . . . . . . 34

Overhead (2 hrs. @ $18.50 per hr.) . . . . . . . . . . 37

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . $101

The predetermined overhead rate ($18.50 per direct labor hour) is based on an expected volume of 75% of the factory’s capacity of 20,000 units per month. Following are the company’s budgeted overhead costs per month at the 75% level.

Required

1. Examine the monthly overhead budget to (a) determine the costs per unit for each variable overhead item and its total per unit costs, and (b) identify the total fixed costs per month.

2. Prepare flexible overhead budgets (as in Exhibit 21.12) for October showing the amounts of each vari- able and fixed cost at the 65%, 75%, and 85% capacity levels.

3. Compute the direct materials cost variance, including its price and quantity variances.

Check (2) Budgeted total overhead at 13,000 units, $507,000.

(3) Materials variances: Price, $9,100 U; Quantity, $5,000 U

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Chapter 21 Flexible Budgets and Standard Costs 931

4. Compute the direct labor cost variance, including its rate and efficiency variances. 5. Prepare a detailed overhead variance report (as in Exhibit 21.15) that shows the variances for indi-

vidual items of overhead.

(4) Labor variances: Rate, $7,625 U; Efficiency, $8,500 U

Problem 21-6AA

Materials, labor, and overhead variances; overhead variance report

C2 P2 P3

Kegler Company has set the following standard costs per unit for the product it manufactures.

The predetermined overhead rate is based on a planned operating volume of 80% of the productive capacity of 10,000 units per month. The following flexible budget information is available.

During May, the company operated at 90% of capacity and produced 9,000 units, incurring the following actual costs.

Direct materials (138,000 Ibs. @ $3.75 per Ib.) . . . . . . . . $ 517,500

Direct labor (31,000 hrs. @ $15.10 per hr.) . . . . . . . . . . 468,100

Overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,500

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,750

Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Rent of factory building . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Depreciation—machinery . . . . . . . . . . . . . . . . . . . . . . . 10,000

Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 99,250

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,084,850

Operating Levels

70% 80% 90%

Production in units . . . . . . . . . . . . . . . . . . 7,000 8,000 9,000

Standard direct labor hours . . . . . . . . . . . 21,000 24,000 27,000

Budgeted overhead

Variable overhead costs

Indirect materials . . . . . . . . . . . . . . . . $13,125 $ 15,000 $16,875

Indirect labor . . . . . . . . . . . . . . . . . . . 21,000 24,000 27,000

Power . . . . . . . . . . . . . . . . . . . . . . . . . 5,250 6,000 6,750

Maintenance . . . . . . . . . . . . . . . . . . . . 2,625 3,000 3,375

Total variable costs . . . . . . . . . . . . . . 42,000 48,000 54,000

Fixed overhead costs

Rent of factory building . . . . . . . . . . 15,000 15,000 15,000

Depreciation—machinery . . . . . . . . 10,000 10,000 10,000

Supervisory salaries . . . . . . . . . . . . . 19,400 19,400 19,400

Total fixed costs . . . . . . . . . . . . . . . . . 44,400 44,400 44,400

Total overhead costs . . . . . . . . . . . . . . . $86,400 $92,400 $98,400

Required

1. Compute the direct materials variance, including its price and quantity variances. 2. Compute the direct labor variance, including its rate and efficiency variances.

Check (1) Materials variances: Price, $34,500 F; Quantity, $12,000 U (2) Labor variances: Rate, $3,100 U; Efficiency, $60,000 U

Direct materials (15 Ibs. @ $4 per Ib.). . . . . . . . . . . $ 60.00

Direct labor (3 hrs. @ $15 per hr.) . . . . . . . . . . . . 45.00

Overhead (3 hrs. @ $3.85 per hr.) . . . . . . . . . . . . . 11.55

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . $116.55

[continued on next page]

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932 Chapter 21 Flexible Budgets and Standard Costs

3. Compute these variances: (a) variable overhead spending and efficiency, (b) fixed overhead spending and volume, and (c) total overhead controllable.

4. Prepare a detailed overhead variance report (as in Exhibit 21.15) that shows the variances for indi- vidual items of overhead.

Problem 21-7AA

Materials, labor, and overhead variances recorded and analyzed

C1 P4

Boss Company’s standard cost accounting system recorded this information from its December operations.

Standard direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Direct materials quantity variance (unfavorable) . . . . . . . . 3,000

Direct materials price variance (favorable) . . . . . . . . . . . . . 500

Actual direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000

Direct labor efficiency variance (favorable) . . . . . . . . . . . . . 7,000

Direct labor rate variance (unfavorable) . . . . . . . . . . . . . . . 1,200

Actual overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000

Volume variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . . 12,000

Controllable variance (unfavorable) . . . . . . . . . . . . . . . . . . . 9,000

Required

1. Prepare December 31 journal entries to record the company’s costs and variances for the month. (Do not prepare the journal entry to close the variances.)

Analysis Component

2. Identify the areas that would attract the attention of a manager who uses management by exception. Explain what action(s) the manager should consider.

Check (1) Dr. Goods in Process Inventory (for overhead), $354,000

PROBLEM SET B

Problem 21-1B Computation of materials, labor, and overhead variances

P2 P3

Kryll Company set the following standard unit costs for its single product.

During the current quarter, the company operated at 70% of capacity and produced 42,000 units of product; direct labor hours worked were 250,000. Units produced were assigned the following standard costs:

Direct materials (1,050,000 Ibs. @ $4 per Ib.) . . . . . . . . . . . $4,200,000

Direct labor (252,000 hrs. @ $8 per hr.) . . . . . . . . . . . . . . . 2,016,000

Factory overhead (252,000 hrs. @ $12 per hr.) . . . . . . . . . . 3,024,000

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,240,000

Direct materials (25 Ibs. @ $4 per Ib.) . . . . . . . . . . . . . . . . . . . $100.00

Direct labor (6 hrs. @ $8 per hr.) . . . . . . . . . . . . . . . . . . . . . . . 48.00

Factory overhead—variable (6 hrs. @ $5 per hr.) . . . . . . . . . . 30.00

Factory overhead—fixed (6 hrs. @ $7 per hr.) . . . . . . . . . . . . 42.00

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $220.00

The predetermined overhead rate is based on a planned operating volume of 80% of the productive capacity of 60,000 units per quarter. The following flexible budget information is available.

Operating Levels

70% 80% 90%

Production in units . . . . . . . . . . . . . . . . 42,000 48,000 54,000

Standard direct labor hours . . . . . . . . . 252,000 288,000 324,000

Budgeted overhead

Fixed factory overhead . . . . . . . . . . . $2,016,000 $2,016,000 $2,016,000

Variable factory overhead . . . . . . . . . 1,260,000 1,440,000 1,620,000

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Chapter 21 Flexible Budgets and Standard Costs 933

Actual costs incurred during the current quarter follow:

Direct materials (1,000,000 Ibs. @ $4.25). . . . . . . . . . $4,250,000

Direct labor (250,000 hrs. @ $7.75) . . . . . . . . . . . . . . 1,937,500

Fixed factory overhead costs . . . . . . . . . . . . . . . . . . . 1,960,000

Variable factory overhead costs . . . . . . . . . . . . . . . . . 1,200,000

Total actual costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,347,500

Check (1) Materials variances: Price, $250,000 U; Quantity, $200,000 F (2) Labor variances: Rate, $62,500 F; Efficiency, $16,000 F

Required

1. Compute the direct materials cost variance, including its price and quantity variances. 2. Compute the direct labor variance, including its rate and efficiency variances. 3. Compute the total overhead controllable and volume variances.

Problem 21-2BA

Expanded overhead variances

P3

Refer to information in Problem 21-1B.

Required

Compute these variances: (a) variable overhead spending and efficiency, (b) fixed overhead spending and volume, and (c) total overhead controllable.

Problem 21-3B Preparation and analysis of a flexible budget P1 A1

Tohono Company’s 2013 master budget included the following fixed budget report. It is based on an expected production and sales volume of 20,000 units.

TOHONO COMPANY Fixed Budget Report

For Year Ended December 31, 2013

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000

Cost of goods sold

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $1,200,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 260,000

Machinery repairs (variable cost) . . . . . . . . . . 57,000

Depreciation — machinery . . . . . . . . . . . . . . . 250,000

Utilities (25% is variable cost) . . . . . . . . . . . . 200,000

Plant manager salaries . . . . . . . . . . . . . . . . . . . 140,000 2,107,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 893,000

Selling expenses

Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116,000

Sales salary (fixed annual amount) . . . . . . . . . 160,000 356,000

General and administrative expenses

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . 81,000

Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,000

Entertainment expense . . . . . . . . . . . . . . . . . . 90,000 412,000

Income from operations . . . . . . . . . . . . . . . . . . . $ 125,000

Required

1. Classify all items listed in the fixed budget as variable or fixed. Also determine their amounts per unit or their amounts for the year, as appropriate.

2. Prepare flexible budgets (see Exhibit 21.3) for the company at sales volumes of 18,000 and 24,000 units. 3. The company’s business conditions are improving. One possible result is a sales volume of

approximately 28,000 units. The company president is confident that this volume is within the relevant range of existing capacity. How much would operating income increase over the 2013 budgeted amount of $125,000 if this level is reached without increasing capacity?

4. An unfavorable change in business is remotely possible; in this case, production and sales volume for 2013 could fall to 14,000 units. How much income (or loss) from operations would occur if sales vol- ume falls to this level?

Check (2) Budgeted income at 24,000 units, $372,400

(4) Potential operating loss, $(246,100)

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934 Chapter 21 Flexible Budgets and Standard Costs

Problem 21-4B Preparation and analysis of a flexible budget performance report

P1 A1

Refer to the information in Problem 21-3B. Tohono Company’s actual income statement for 2013 follows.

TOHONO COMPANY Statement of Income from Operations

For Year Ended December 31, 2013

Sales (24,000 units) . . . . . . . . . . . . . . . . . . . . . . . $3,648,000 Cost of goods sold Direct materials . . . . . . . . . . . . . . . . . . . . . . . $1,400,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,000 Machinery repairs (variable cost) . . . . . . . . . . 60,000 Depreciation—machinery . . . . . . . . . . . . . . . 250,000 Utilities (variable cost, $64,000) . . . . . . . . . . . 218,000 Plant manager salaries . . . . . . . . . . . . . . . . . . . 155,000 2,443,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,205,000 Selling expenses Packaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,000 Sales salary (annual) . . . . . . . . . . . . . . . . . . . . 162,000 376,000 General and administrative expenses Advertising expense . . . . . . . . . . . . . . . . . . . . 104,000 Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232,000 Entertainment expense . . . . . . . . . . . . . . . . . . 100,000 436,000 Income from operations . . . . . . . . . . . . . . . . . . . $ 393,000

Required

1. Prepare a flexible budget performance report for 2013.

Analysis Component

2. Analyze and interpret both the (a) sales variance and (b) direct materials variance.

Check (1) Variances: Fixed costs, $45,000 U; Income, $20,600 F

Problem 21-5B Flexible budget preparation; computation of materials, labor, and overhead variances; and overhead variance report

P1 P2 P3 C2

Suncoast Company set the following standard costs for one unit of its product.

Direct materials (4.5 lb. @ $6 per kg.) . . . . . . . . . $27

Direct labor (1.5 hrs. @ $12 per hr.) . . . . . . . . . . 18

Overhead (1.5 hrs. @ $16 per hr.) . . . . . . . . . . . . 24

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . $69

The predetermined overhead rate ($16.00 per direct labor hour) is based on an expected volume of 75% of the factory’s capacity of 20,000 units per month. Following are the company’s budgeted overhead costs per month at the 75% level.

Overhead Budget (75% Capacity)

Variable overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . $22,500

Indirect labor . . . . . . . . . . . . . . . . . . . . . . 90,000

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500

Repairs and maintenance . . . . . . . . . . . . 45,000

Total variable overhead costs . . . . . . . . . $180,000

Fixed overhead costs

Depreciation—building . . . . . . . . . . . . . . 24,000

Depreciation—machinery . . . . . . . . . . . . 72,000

Taxes and insurance . . . . . . . . . . . . . . . . 18,000

Supervision . . . . . . . . . . . . . . . . . . . . . . . 66,000

Total fixed overhead costs . . . . . . . . . . . . 180,000

Total overhead costs . . . . . . . . . . . . . . . . . . $360,000

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Chapter 21 Flexible Budgets and Standard Costs 935

The company incurred the following actual costs when it operated at 75% of capacity in December.

Direct materials (69,000 lbs. @ $6.10) . . . . . . . . . $ 420,900

Direct labor (22,800 hrs. @ $12.30) . . . . . . . . . . . 280,440

Overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . $21,600

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,260

Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,100

Repairs and maintenance . . . . . . . . . . . . . . . . . . . 46,800

Depreciation—building . . . . . . . . . . . . . . . . . . . . 24,000

Depreciation — machinery . . . . . . . . . . . . . . . . . . 75,000

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . 16,500

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,000 355,260

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,056,600

Required

1. Examine the monthly overhead budget to (a) determine the costs per unit for each variable overhead item and its total per unit costs, and (b) identify the total fixed costs per month.

2. Prepare flexible overhead budgets (as in Exhibit 21.12) for December showing the amounts of each variable and fixed cost at the 65%, 75%, and 85% capacity levels.

3. Compute the direct materials cost variance, including its price and quantity variances. 4. Compute the direct labor cost variance, including its rate and efficiency variances. 5. Prepare a detailed overhead variance report (as in Exhibit 21.15) that shows the variances for indi-

vidual items of overhead.

Check (2) Budgeted total overhead at 17,000 units, $384,000

(3) Materials variances: Price, $6,900 U; Quantity, $9,000 U

(4) Labor variances: Rate, $6,840 U; Efficiency, $3,600 U

Problem 21-6BA

Materials, labor, and overhead variances; overhead variance report

C2 P2 P3

Guadelupe Company has set the following standard costs per unit for the product it manufactures.

The predetermined overhead rate is based on a planned operating volume of 80% of the productive capacity of 10,000 units per month. The following flexible budget information is available.

Direct materials (10 lbs. @ $3.00 per lb.) . . . . . . . . . $30.00

Direct labor (4 hr. @ $6 per hr.) . . . . . . . . . . . . . . 24.00

Overhead (4 hr. @ $2.50 per hr.) . . . . . . . . . . . . . 10.00

Total standard cost . . . . . . . . . . . . . . . . . . . . . . . . . $64.00

Operating Levels

70% 80% 90%

Production in units . . . . . . . . . . . . . . . . . . 7,000 8,000 9,000

Standard direct labor hours . . . . . . . . . . . 28,000 32,000 36,000

Budgeted overhead

Variable overhead costs

Indirect materials . . . . . . . . . . . . . . . $ 8,750 $10,000 $11,250

Indirect labor . . . . . . . . . . . . . . . . . . 14,000 16,000 18,000

Power . . . . . . . . . . . . . . . . . . . . . . . . 3,500 4,000 4,500

Maintenance . . . . . . . . . . . . . . . . . . . 1,750 2,000 2,250

Total variable costs . . . . . . . . . . . . . . 28,000 32,000 36,000

Fixed overhead costs

Rent of factory building . . . . . . . . . . 12,000 12,000 12,000

Depreciation—machinery . . . . . . . . 20,000 20,000 20,000

Taxes and insurance . . . . . . . . . . . . . . 2,400 2,400 2,400

Supervisory salaries . . . . . . . . . . . . . 13,600 13,600 13,600

Total fixed costs . . . . . . . . . . . . . . . . . 48,000 48,000 48,000

Total overhead costs . . . . . . . . . . . . . . . $76,000 $80,000 $84,000

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936 Chapter 21 Flexible Budgets and Standard Costs

During March, the company operated at 90% of capacity and produced 9,000 units, incurring the following actual costs.

Direct materials (92,000 lbs. @ 2.95 per lb.) . . . . . . . . . . . $ 271,400

Direct labor (37,600 hrs. @ $6.05 per hr.) . . . . . . . . . . . . 227,480

Overhead costs

Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Power. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Rent of factory building . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Depreciation—machinery . . . . . . . . . . . . . . . . . . . . . . . 19,200

Taxes and insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 81,700

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $580,580

Required

1. Compute the direct materials cost variance, including its price and quantity variances. 2. Compute the direct labor variance, including its rate and efficiency variances. 3. Compute these variances: (a) variable overhead spending and efficiency, (b) fixed overhead spending

and volume, and (c) total overhead controllable. 4. Prepare a detailed overhead variance report (as in Exhibit 21.15) that shows the variances for indi-

vidual items of overhead.

Check (1) Materials variances: Price, $4,600 F; Quantity, $6,000 U (2) Labor variances: Rate, $1,880 U; Efficiency, $9,600 U

SERIAL PROBLEM Success Systems

P1

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the working papers that accompany the book.)

SP 21 Success Systems’ second quarter 2014 fixed budget performance report for its computer furniture operations follows. The $156,000 budgeted expenses include $108,000 in variable expenses for desks and $18,000 in variable expenses for chairs, as well as $30,000 fixed expenses. The actual expenses include

Problem 21-7BA

Materials, labor, and overhead variances recorded and analyzed

C1 P4

Kenya Company’s standard cost accounting system recorded this information from its June operations.

Standard direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . $130,000

Direct materials quantity variance (favorable) . . . . . . . . . 5,000

Direct materials price variance (favorable) . . . . . . . . . . . . 1,500

Actual direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Direct labor efficiency variance (favorable) . . . . . . . . . . . . 3,000

Direct labor rate variance (unfavorable) . . . . . . . . . . . . . . 500

Actual overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Volume variance (unfavorable) . . . . . . . . . . . . . . . . . . . . . . 12,000

Controllable variance (unfavorable) . . . . . . . . . . . . . . . . . . 8,000

Required

1. Prepare journal entries dated June 30 to record the company’s costs and variances for the month. (Do not prepare the journal entry to close the variances.)

Analysis Component

2. Identify the areas that would attract the attention of a manager who uses management by exception. Describe what action(s) the manager should consider.

Check (1) Dr. Goods in Process Inventory (for overhead), $230,000

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Chapter 21 Flexible Budgets and Standard Costs 937

$31,000 fixed expenses. Prepare a flexible budget performance report that shows any variances between budgeted results and actual results. List fixed and variable expenses separately.

Check Variances: Fixed expenses, $1,000 U

Fixed Budget Actual Results Variances

Desk sales (in units) . . . . . . . . . . . . . 144 150

Chair sales (in units) . . . . . . . . . . . . 72 80

Desk sales (in dollars) . . . . . . . . . . . $180,000 $186,000 $6,000 F

Chair sales (in dollars) . . . . . . . . . . . $ 36,000 $ 41,200 $5,200 F

Total expenses . . . . . . . . . . . . . . . . . $156,000 $163,880 $7,880 U

Income from operations . . . . . . . . . $ 60,000 $ 63,320 $3,320 F

BTN 21-1 Analysis of flexible budgets and standard costs emphasizes the importance of a similar unit of measure for meaningful comparisons and evaluations. When Polaris compiles its financial reports in compliance with GAAP, it applies the same unit of measurement, U.S. dollars, for most mea sures of busi- ness operations. One issue for Polaris is how best to adjust account values for its subsidiaries that compile financial reports in currencies other than the U.S. dollar.

Required

1. Read Polaris’s Note 1 in Appendix A and identify the financial statement where it reports the annual adjustment (remeasurement) for foreign currency translation.

2. Translating financial statements requires the use of a currency exchange rate. For each of the following three financial statement items, explain the exchange rate the company would apply to translate into U.S. dollars.

a. Cash b. Sales revenue c. Property, plant and equipment

Beyond the Numbers

REPORTING IN ACTION C1

BTN 21-3 Setting materials, labor, and overhead standards is challenging. If standards are set too low, companies might purchase inferior products and employees might not work to their full potential. If stan- dards are set too high, companies could be unable to offer a quality product at a profitable rate and em- ployees could be overworked. The ethical challenge is to set a high but reasonable standard. Assume that as a manager, you are asked to set the standard materials price and quantity for the new 1,000 CKB Mega- Max chip, a technically advanced product. To properly set the price and quantity standards, you assemble a team of specialists to provide input.

Required

Identify four types of specialists that you would assemble to provide information to help set the materials price and quantity standards. Briefly explain why you chose each individual.

ETHICS CHALLENGE C1

BTN 21-2 The usefulness of budgets, variances, and related analyses often depends on the accuracy of management’s estimates of future sales activity.

Required

1. Identify and record the prior three years’ sales (in dollars) for Polaris and for Arctic Cat using their financial statements in Appendix A.

2. Using the data in part 1, predict both companies’ sales activity for the next two to three years. (If possible, compare your predictions to actual sales figures for those years.)

COMPARATIVE ANALYSIS A1

Polaris

Polaris Arctic Cat

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938 Chapter 21 Flexible Budgets and Standard Costs

BTN 21-4 The reason we use the words favorable and unfavorable when evaluating variances is made clear when we look at the closing of accounts. To see this, consider that (1) all variance accounts are closed at the end of each period (temporary accounts), (2) a favorable variance is always a credit balance, and (3) an unfavorable variance is always a debit balance. Write a one-half page memorandum to your instructor with three parts that answer the three following requirements. (Assume that variance accounts are closed to Cost of Goods Sold.)

Required

1. Does Cost of Goods Sold increase or decrease when closing a favorable variance? Does gross margin increase or decrease when a favorable variance is closed to Cost of Goods Sold? Explain.

2. Does Cost of Goods Sold increase or decrease when closing an unfavorable variance? Does gross margin increase or decrease when an unfavorable variance is closed to Cost of Goods Sold? Explain.

3. Explain the meaning of a favorable variance and an unfavorable variance.

COMMUNICATING IN PRACTICE P4 C2

BTN 21-6 Many service industries link labor rate and time (quantity) standards with their processes. One example is the standard time to board an aircraft. The reason time plays such an important role in the service industry is that it is viewed as a competitive advantage: best service in the shortest amount of time. Although the labor rate component is difficult to observe, the time component of a service delivery standard is often readily apparent—for example, “Lunch will be served in less than five minutes, or it is free.”

Required

Break into teams and select two service industries for your analysis. Identify and describe all the time ele- ments each industry uses to create a competitive advantage.

TEAMWORK IN ACTION C2

BTN 21-5 Access iSixSigma’s Website (iSixSigma.com) to search for and read information about benchmarking to complete the following requirements. (Hint: Look in the “dictionary” link.)

Required

1. Write a one-paragraph explanation (in layperson’s terms) of benchmarking. 2. How does standard costing relate to benchmarking?

TAKING IT TO THE NET C1

BTN 21-7 Folsom Custom Skis, as discussed in the chapter opener, uses a costing system with standard costs for direct materials, direct labor, and overhead costs. Two comments frequently are mentioned in relation to standard costing and variance analysis: “Variances are not explanations” and “Management’s goal is not to minimize variances.”

Required

Write a short memo to Mike McCabe, Folsom Custom Skis’ President, (no more than 1 page) interpreting these two comments in the context of his business.

ENTREPRENEURIAL DECISION C1 C2

BTN 21-8 Training employees to use standard amounts of materials in production is common. Typically large companies invest in this training but small organizations do not. One can observe these different practices in a trip to two different pizza businesses. Visit both a local pizza business and a national pizza chain business and then complete the following.

Required

1. Observe and record the number of raw material items used to make a typical cheese pizza. Also ob- serve how the person making the pizza applies each item when preparing the pizza.

2. Record any differences in how items are applied between the two businesses. 3. Estimate which business is more profitable from your observations. Explain.

HITTING THE ROAD C1

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Chapter 21 Flexible Budgets and Standard Costs 939

BTN 21-9 Access the annual report of Piaggio (at www.piaggio.com) for the year ended December 31, 2011. The usefulness of its budgets, variances, and related analyses depends on the accuracy of manage- ment’s estimates of future sales activity.

Required

1. Identify and record the prior two years’ sales (in € thousands) for Piaggio from its income statement. 2. Using the data in part 1, predict sales activity for Piaggio for the next two years. Explain your predic-

tion process.

GLOBAL DECISION A1

1. c; Fixed costs remain at $300,000; Variable costs 5 ($246,000/24,000 units) 3 20,000 units 5 $205,000.

2. e; Budgeted direct materials 1 Unfavorable variance 5 Actual cost of direct materials used; or, 60,000 units 3 $10 per unit 5 $600,000 1 $15,000 U 5 $615,000.

3. c; (AH 3 AR) 2 (AH 3 SR) 5 $1,599,040 – (84,160 hours 3 $20 per hour) 5 $84,160 F.

4. b; Actual variable overhead 2 Variable overhead applied to production 5 Variable overhead cost variance; or $150,000 2 (96,000 hours 3 $1.50 per hour) 5 $6,000 U.

5. a; Budgeted fixed overhead 2 Fixed overhead applied to production 5 Volume variance; or $24,000 2 (4,800 units 3 $4 per unit) 5 $4,800 U.

ANSWERS TO MULTIPLE CHOICE QUIZ

PIAGGIO

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Learning Objectives

CONCEPTUAL

C1 Distinguish between direct and indirect expenses and identify bases for allocating indirect expenses to departments. (p. 945)

C2 Appendix 22A—Explain transfer pricing and methods to set transfer prices. (p. 961)

C3 Appendix 22B—Describe allocation of joint costs across products. (p. 962)

ANALYTICAL

A1 Analyze investment centers using return on assets and residual income. (p. 953) A2 Analyze investment centers using profit margin and investment turnover. (p. 954) A3 Analyze investment centers using the balanced scorecard. (p. 955) A4 Compute cycle time and cycle efficiency, and explain their importance to production

management. (p. 957)

PROCEDURAL

P1 Prepare a responsibility report for a cost center. (p. 944) P2 Allocate indirect expenses to departments (p. 946) P3 Prepare departmental income statements and contribution reports. (p. 947)

A Look at This Chapter

This chapter describes responsibility accounting, measuring departmental performance, allocating common costs across departments, and transfer pricing. It also explains financial and nonfinancial performance measures used to evaluate investment center performance.

A Look Back

Chapter 21 discussed flexible budgets, variance analysis, and standard costs. It explained how management uses each to control and monitor business activities.

Performance Measurement and Responsibility Accounting 22

A Look Ahead

Chapter 23 explains several tools and procedures used in making and evaluating short-term managerial decisions.

940

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Go Blue!

PHILADELPHIA, PA—Brian Linton has a passion for oceans. Growing up in Singapore, Brian spent time scuba diving and tend- ing to his 30 fish tanks. Traveling the world enabled Brian to see the “good, the bad, and the ugly of oceans and waterways.” Combining his love of the water with an entrepreneurial spirit, Brian started his company United By Blue (UnitedByBlue.com), an apparel and jewelry company that removes one pound of trash in oceans and waterways for every product sold. As Brian notes, the company’s unique business model was driven by “a quest for concrete ways to contribute to real and significant conservation efforts.” Building off Brian’s college experiences selling jewelry he im- ported from Thailand, United By Blue sells men’s and women’s clothing, bags, and jewelry. The company uses organic cotton and creative designs to make products that elicit a fun vibe as- sociated with oceans and harbor villages. Offering a diverse prod- uct line requires Brian to pay attention to cost management and departmental profits. The Sand Shack, a product in the compa- ny’s jewelry department, “is a line of jewelry with chunky tur- quoise stones that generates much of the profits the company runs on,” says Brian. His managers monitor direct, indirect, and controllable costs; allocate indirect costs to departments; and “measure return on investment (ROI),” explains Brian. While focusing on controlling costs, United By Blue also strives to remove plastic from its packaging. “The number one material we collect during cleanups is plastic debris. We try to eliminate as

much plastic as we can from our supply chain,” says Brian. Apparel tags are made from biodegradable substances, infused with flower seeds. T-shirts are packaged in banana fiber paper. “We use things that go back to the earth in a very natural way and actually grow life.” While these materials are more costly than plastic, they better fit the company’s philosophy and, Brian believes, help gen- erate new business. “We have customers that double their orders the next season because of the cleanups,” Brian notes. As United By Blue continues to grow, Brian focuses on finan- cial and nonfinancial performance measures. Revenues were $330,000 in 2010, and were projected to exceed $800,000 in 2011. A focus on departmental contribution margins enables the company to operate efficiently to finance future growth. Like- wise, more revenues mean the company collects more trash, over 80,000 pounds by the end of 2011 and a goal of over a mil- lion pounds by the end of 2012. As company founder and chief trash collector, this nonfinancial indicator measures progress to- ward Brian’s vision of “doing the most good possible.” Brian encourages young entrepreneurs to “leave a positive impact on this world” by focusing on what you love. “My heart is in the ocean, so whatever I am doing is going to be in that realm. Whatever your passion is, leave that positive impact.”

[Sources: United By Blue Website, January 2013; Bloomberg Business- week, January 9, 2012; MO.com interview, http://www.mo.com/ brian-linton-united-by-blue; Philadelphia Magazine, July 2011; PRweb.com, January 2012.]

”Do the dirty work yourself.” —BRIAN LINTON

Decision Insight

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Chapter Preview

This chapter describes how to measure performance when organi- zations are split into separate departments. It discusses responsi- bility accounting and how to allocate indirect costs of shared items such as utilities, advertising, and rent. This knowledge helps

managers better measure and evaluate departmental perfor- mance. The chapter also introduces additional managerial account- ing reports useful in managing a company’s activities and explains how and why management divides companies into departments.

Companies are divided into departments, also called subunits, when they are too large to be managed effectively as a single unit. The use of departments creates a need for performance measures to evaluate department performance. A responsibility accounting system can be set up to control costs and expenses and evaluate department managers’ performance by assigning costs and expenses to the managers responsible for controlling them. This chapter introduces responsibility accounting and departmental performance measures.

Motivation for Departmentalization Many companies are so large and complex that they are broken into separate divisions for efficiency and/or effectiveness purposes. Divisions then are usually organized into separate departments. When a company is departmentalized, each department is often placed under the direction of a manager. As a company grows, management often divides departments into new departments so that responsibilities for a department’s activities do not overwhelm the manag- er’s ability to oversee and control them. A company also creates departments to take advantage of the skills of individual managers. Departments are broadly classified as either operating or service departments. Operating departments perform an organization’s main functions. For example, an account- ing firm’s main functions usually include auditing, tax, and advisory services. Similarly, the production and selling departments of a manufacturing firm perform its main functions and serve as operating departments. Service departments provide support to an organization’s oper- ating departments. Examples of service departments are payroll, human resource management, accounting, and executive management. Service departments do not engage in activities that generate revenues, yet their support is crucial for the operating departments’ success.

Departmental Evaluation When a company is divided into departments, managers need to know how each department is performing. The accounting system must supply information about resources used and outputs achieved by each department. This requires a system to measure and accumulate revenue and expense information for each department whenever possible.

RESPONSIBILITY ACCOUNTING

Cost Centers

• Responsibility accounting system

• Evaluating cost center performance

Responsibility Accounting

• Motivation for departmentalization

• Departmental evaluation

• Controllable versus uncontrollable costs

Profit Centers

• Direct and indirect expenses

• Allocation of indirect expenses

• Departmental income statements

• Departmental contri- bution to overhead

Investment Centers

• Financial performance measures

• Nonfinancial perfor- mance measures

• Transfer pricing

Performance Measurement and Responsibility Accounting

942

Point: Responsibility accounting is sometimes referred to as departmental accounting.

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Chapter 22 Performance Measurement and Responsibility Accounting 943

Departmental information is rarely distributed publicly because of its potential usefulness to competitors. Information about departments is prepared for internal managers to help control operations, appraise performance, allocate resources, and plan strategy. If a department is highly profitable, management may decide to expand its operations, or if a department is performing poorly, information about revenues or expenses can suggest useful changes.

More companies are emphasizing customer satisfaction as a main responsibility of many depart- ments. This has led to changes in the measures reported. Increasingly, financial mea surements are being supplemented with quality and customer satisfaction indexes. Motorola, for instance, uses two key measures: the number of defective parts per million parts produced and the percent of or- ders delivered on time to customers. (Note that some departments have only “internal customers.”)

Financial information used to evaluate a department depends on whether it is evaluated as a profit center, cost center, or investment center. A profit center incurs costs and generates reve- nues; selling departments are often evaluated as profit centers. A cost center incurs costs without directly generating revenues. An investment center incurs costs and generates revenues, and is responsible for effectively using center assets. The manufacturing departments of a manufacturer and its service departments such as accounting, advertising, and purchasing, are all cost centers.

Evaluating managers’ performance depends on whether they are responsible for profit centers, cost centers, or investment centers. Profit center managers are judged on their abilities to gener- ate revenues in excess of the department’s costs. They are assumed to influence both revenue generation and cost incurrence. Cost center managers are judged on their abilities to control costs by keeping them within a satisfactory range under an assumption that only they influence costs. Investment center managers are evaluated on their use of center assets to generate income.

Controllable versus Uncontrollable Costs We often evaluate a manager’s performance using responsibility accounting reports that describe a department’s activities in terms of controllable costs.1 A cost is controllable if a manager has the power to determine or at least significantly affect the amount incurred. Uncontrollable costs are not within the manager’s control or influence. For example, department managers often have little or no control over depreciation expense because they cannot affect the amount of equip- ment assigned to their departments. Also, department managers rarely control their own sala- ries. However, they can control or influence items such as the cost of supplies used in their department. When evaluating managers’ performances, we should use data reflecting their departments’ outputs along with their controllable costs and expenses. Distinguishing between controllable and uncontrollable costs depends on the particular man- ager and time period under analysis. For example, the cost of property insurance is usually not controllable at the department manager’s level but by the executive responsible for obtaining the company’s insurance coverage. Likewise, this executive might not control costs resulting from insurance policies already in force. However, when a policy expires, this executive can renegoti- ate a replacement policy and then controls these costs. Therefore, all costs are controllable at some management level if the time period is sufficiently long. We must use good judgment in identifying controllable costs.

Point: Selling departments are often treated as revenue centers; their managers are responsible for maximizing sales revenues.

1. Service departments (a) manufacture products, (b) make sales directly to customers, (c) produce revenues, (d ) assist operating departments.

2. Explain the difference between a cost center and a profit center. Cite an example of each. 3. Performance reports to evaluate managers should [select a, b or c] (a) include data about

controllable expenses, (b) compare actual results with budgeted levels, or (c) both (a) and (b).

Quick Check Answers — p. 965

1 The terms cost and expense are often used interchangeably in managerial accounting, but they are not necessarily the same. Cost often refers to the monetary outlay to acquire some resource that can have present and future benefit. Expense usually refers to an expired cost. That is, as the benefit of a resource expires, a portion of its cost is written off as an expense.

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944 Chapter 22 Performance Measurement and Responsibility Accounting

Responsibility Accounting System A responsibility accounting system uses the concept of controllable costs to assign managers the responsibility for costs and expenses under their control. Prior to each reporting period, a com- pany prepares plans that identify costs and expenses under each manager’s control. These re- sponsibility accounting budgets are typically based on the flexible budgeting approach we

showed in Chapter 21. To ensure the cooperation of man- agers and the reasonableness of budgets, managers should be involved in preparing their budgets.

A responsibility accounting system also involves performance reports. A responsibility accounting per- formance report accumulates and reports costs and expenses that a manager is responsible for and their bud- geted amounts. Management’s analysis of differences be- tween budgeted amounts and actual costs and expenses often results in corrective or strategic managerial actions. Upper-level management uses perfor mance reports to evaluate the effectiveness of lower-level managers in controlling costs and expenses and keeping them within budgeted amounts.

A responsibility accounting system recognizes that control over costs and expenses belongs to several levels of management. We illustrate this by considering the or- ganization chart in Exhibit 22.1. The lines in this chart connecting the managerial positions reflect channels of authority. For example, the four department managers of this consulting firm (benchmarking, cost management, outsourcing, and service) are responsible for controllable costs and expenses incurred in their departments, but these same costs are subject to the overall control of the vice president (VP) for operational consulting. Similarly, this VP’s costs are subject to the control of the executive

vice president (EVP) for operations, the president, and, ultimately, the board of directors. At lower levels, managers have limited responsibility and relatively little control over costs

and expenses. Performance reports for low-level management typically cover few controllable costs. Responsibility and control broaden for higher-level managers; therefore, their reports span a wider range of costs. However, reports to higher-level managers seldom contain the de- tails reported to their subordinates but are summarized for two reasons: (1) lower-level manag- ers are often responsible for these detailed costs and (2) detailed reports can obscure broader, more important issues facing a company.

Evaluating Cost Center Performance Exhibit 22.2 shows summarized performance reports for the three management levels identified in Exhibit 22.1. Exhibit 22.2 shows that costs under the control of the benchmarking department manager are totaled and included among controllable costs of the VP for operational consulting. Also, costs under the control of the VP are totaled and included among controllable costs of the EVP for operations. In this way, a responsibility accounting system provides relevant informa- tion for each management level. Technological advances increase our ability to produce vast amounts of information that of- ten exceed our ability to use it. Good managers select relevant data for planning and controlling the areas under their responsibility. A good responsibility accounting system makes every effort to provide relevant information to the right person (the one who controls the cost) at the right time (before a cost is out of control).

COST CENTERS

P1 Prepare a responsibility accounting report for a cost center

Board of Directors

President

Executive Vice President

Operations

Executive Vice President

Finance

Executive Vice President

Marketing

Vice President Strategic

Consulting

Vice President Operational Consulting

Manager Cost

Management Department

Manager Outsourcing Department

Manager Service

Department

Manager Benchmarking

Department

EXHIBIT 22.1 Organizational Responsibility Chart

Point: Responsibility accounting does not place blame. Instead, responsibility accounting is used to identify opportuni- ties for improving performance.

Point: Responsibility accounting usually divides a company into subunits, or responsibility centers. A center manager is evaluated on how well the center per- forms, as reported in responsibility ac- counting reports.

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Chapter 22 Performance Measurement and Responsibility Accounting 945

When departments are organized as profit centers, responsibility accounting focuses on how well each department controlled costs and generated revenues. This leads to departmental income statements as a common way to report profit center performance. When a company computes departmental profits, it confronts some accounting challenges that involve allocating expenses across its operating departments. We next illustrate these allocations and departmental income statement reporting.

Direct and Indirect Expenses Direct expenses are costs readily traced to a department because they are incurred for that de- partment’s sole benefit. They require no allocation across departments. For example, the salary of an employee who works in only one department is a direct expense of that one department. Direct expenses are often, but not always, controllable costs. Indirect expenses are costs that are incurred for the joint benefit of more than one depart- ment and cannot be readily traced to only one department. For example, if two or more depart- ments share a single building, all enjoy the benefits of the expenses for rent, heat, and light. Indirect expenses are allocated across departments benefiting from them when we need infor- mation about departmental profits. Ideally, we allocate indirect expenses by using a cause- effect relation. When we cannot identify cause-effect relations, we allocate each indirect expense on a

PROFIT CENTERS

Point: Utility expense has elements of both direct and indirect expenses.

C1 Distinguish between direct and indirect expenses and identify bases for allocating indirect expenses to departments.

Executive Vice President, Operations For July

Budgeted

Amount

Actual

Amount

Over (Under)

Budget Controllable Costs

Salaries, VPs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Quality control costs . . . . . . . . . . . . . . . . . . . . . . . Office costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operational consulting . . . . . . . . . . . . . . . . . . Strategic consulting . . . . . . . . . . . . . . . . . . . . . . . .

$ 80,000 21,000 29,500

276,700

390,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 797,200

$ 80,000 22,400 28,800

279,500

380,600

$ 791,300

Vice President, Operational Consulting

Controllable Costs

Salaries, department managers . . . . . . . . . . . . . . . $ 75,000 $ 78,000 $ 3,000 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,600 10,600 0 Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,800 6,300 (500) Benchmarking department . . . . . . . . . . . . . . 79,600 79,900 300 Cost management department . . . . . . . . . . . . . . . 61,500 60,200 (1,300) Outsourcing department . . . . . . . . . . . . . . . . . . . . 24,300 24,700 400 Service department . . . . . . . . . . . . . . . . . . . . . . . . 18,900 19,800 900

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $276,700 $279,500 $2,800

For July

Budgeted

Amount

Actual

Amount

Over (Under)

Budget

For July

Budgeted

Amount

Actual

Amount

Over (Under)

Budget

$ 0 1,400 (700)

2,800

(9,400)

$ (5,900)

Manager, Benchmarking Department

Controllable Costs

Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,600 $ 52,500 $ 900 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 7,800 (200) Other controllable costs . . . . . . . . . . . . . . . . . . . 20,000 19,600 (400) Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 79,600 $ 79,900 $ 300

EXHIBIT 22.2 Responsibility Accounting Performance Reports for Cost Centers

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946 Chapter 22 Performance Measurement and Responsibility Accounting

basis approximating the relative benefit each department receives. Measuring the benefit for each department from an indirect expense can be difficult. Indirect expenses are typically con- sidered uncontrollable costs when evaluating a department manager’s performance.

Illustration of Indirect Expense Allocation To illustrate how to allocate an indi- rect expense, we consider a retail store that purchases janitorial services from an outside com- pany. Management allocates this cost across the store’s three departments according to the floor space each occupies. Costs of janitorial services for a recent month are $300. Exhibit 22.3 shows the square feet of floor space each department occupies. The store computes the percent of total square feet allotted to each department and uses it to allocate the $300 cost.

EXHIBIT 22.3 Indirect Expense Allocation

Square Percent Allocated

Department Feet of Total Cost

Jewelry . . . . . . . . . . . . . . . . 2,400 60% $180

Watch repair . . . . . . . . . . . 600 15 45

China and silver . . . . . . . . . 1,000 25 75

Totals . . . . . . . . . . . . . . . . . 4,000 100% $300

Specifically, because the jewelry department occupies 60% of the floor space, 60% of the total $300 cost is assigned to it. The same procedure is applied to the other departments. When the allocation process is complete, these and other allocated costs are deducted from the gross profit for each department to determine net income for each. One consideration in allocating costs is to motivate managers and employees to behave as desired. As a result, a cost incurred in one department might be best allocated to other departments when one of the other departments caused the cost.

Allocation of Indirect Expenses This section describes how to identify the bases used to allocate indirect expenses across departments. No standard rule identifies the best basis because expense allocation involves several factors, and the relative importance of these factors varies across departments and organizations. Judgment is required, and people do not always agree. Employee morale suf- fers when allocations are perceived as unfair. Thus, it is important to carefully design and explain the allocation of service department costs. In our discussion, note the parallels be- tween activity-based costing and the departmental expense allocation procedures described here.

Wages and Salaries Employee wages and salaries can be either direct or indirect ex- penses. If their time is spent entirely in one department, their wages are direct expenses of that department. However, if employees work for the benefit of more than one department, their wages are indirect expenses and must be allocated across the departments benefited. An em- ployee’s contribution to a department usually depends on the number of hours worked in con- tributing to that department. Thus, a reasonable basis for allocating employee wages and salaries is the relative amount of time spent in each department. In the case of a super visor who man- ages more than one department, recording the time spent in each department may not always be practical. Instead, a company can allocate the supervisor’s salary to departments on the basis of the number of employees in each department — a reasonable basis if a supervisor’s main task is managing people. Another basis of allocation is on sales across departments, also a reasonable basis if a supervisor’s job reflects on departmental sales.

Rent and Related Expenses Rent expense for a building is reasonably allocated to a department on the basis of floor space it occupies. Location can often make some floor space

Point: Some companies ask supervi- sors to estimate time spent supervising specific departments for purposes of expense allocation.

P2 Allocate indirect expenses to departments.

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Chapter 22 Performance Measurement and Responsibility Accounting 947

more valuable than other space. Thus, the allocation method can charge departments that oc- cupy more valuable space a higher expense per square foot. Ground floor retail space, for in- stance, is often more valuable than basement or upper-floor space because all customers pass departments near the entrance but fewer go beyond the first floor. When no precise mea sures of floor space values exist, basing allocations on data such as customer traffic and real estate assessments is helpful. When a company owns its building, its expenses for depreciation, taxes, insurance, and other related building expenses are allocated like rent expense.

Advertising Expenses Effective advertising of a department’s products increases its sales and customer traffic. Moreover, advertising products for some departments usually helps other departments’ sales because customers also often buy unadvertised products. Thus, many stores treat advertising as an indirect expense allocated on the basis of each department’s pro- portion of total sales. For example, a department with 10% of a store’s total sales is assigned 10% of advertising expense. Another method is to analyze each advertisement to compute the Web/newspaper space or TV/radio time devoted to the products of a department and charge that department for the proportional costs of advertisements. Management must consider whether this more detailed and costly method is justified.

Equipment and Machinery Depreciation Depreciation on equipment and machin- ery used only in one department is a direct expense of that department. Depreciation on equip- ment and machinery used by more than one department is an indirect expense to be allocated across departments. Accounting for each department’s depreciation expense requires a company to keep records showing which departments use specific assets. The number of hours that a de- partment uses equipment and machinery is a reasonable basis for allocating depreciation.

Utilities Expenses Utilities expenses such as heating and lighting are usually allocated on the basis of floor space occupied by departments. This practice assumes their use is uniform across departments. When this is not so, a more involved allocation can be necessary, although there is often a trade-off between the usefulness of more precise allocations and the effort to compute them. Manufacturers often allocate electricity cost to departments on the basis of the horsepower of equipment located in each department.

Service Department Expenses To generate revenues, operating departments require support services provided by departments such as personnel, payroll, advertising, and purchas- ing. Such service departments are typically evaluated as cost centers because they do not pro- duce revenues. (Evaluating them as profit centers requires the use of a system that “charges” user departments a price that then serves as the “revenue” generated by service departments.) A departmental accounting system can accumulate and report costs incurred directly by each service department for this purpose. The system then allocates a service department’s expenses to operating departments benefiting from them. Exhibit 22.4 shows some commonly used bases for allocating service department expenses to operating departments.

Point: When a service department “charges” its user departments within a company, a transfer pricing system must be set up to determine the “revenue” from its services provided.

EXHIBIT 22.4 Bases for Allocating Service Department Expenses

Service Department Common Allocation Bases

Office expenses . . . . . . . . . . . . . . . Number of employees or sales in each department

Personnel expenses . . . . . . . . . . . . Number of employees in each department

Payroll expenses . . . . . . . . . . . . . . Number of employees in each department

Advertising expenses . . . . . . . . . . Sales or amount of advertising charged directly to each department

Purchasing costs . . . . . . . . . . . . . . Dollar amounts of purchases or number of purchase orders processed

Cleaning expenses . . . . . . . . . . . . Square feet of floor space occupied

Maintenance expenses . . . . . . . . . Square feet of floor space occupied

P3 Prepare departmental income statements and contribution reports.

Departmental Income Statements An income statement can be prepared for each operating department once expenses have been assigned to it. Its expenses include both direct expenses and its share of indirect expenses. For this purpose, compiling all expenses incurred in service departments before assigning them to

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948 Chapter 22 Performance Measurement and Responsibility Accounting

2 In some cases we allocate a service department’s expenses to other service departments when they use its ser vices. For example, expenses of a payroll office benefit all service and operating departments and can be assigned to all departments. Nearly all examples and assignment materials in this book allocate service expenses only to operating departments for simplicity.

Step 1: Step 1 accumulates revenues and direct expenses in departmental accounts for each department. As cost centers, the service departments do not generate revenues. Direct expenses include salaries, wages, and other expenses that each department incurs but does not share with any other department.

Step 2: Step 2 allocates indirect company expenses across all service and operating depart- ments. Indirect expenses can include items such as depreciation, rent, advertising, and any other expenses that cannot be directly assigned to a department. Indirect expenses are recorded in company accounts, an allocation base is identified for each expense, and costs are allocated us- ing a departmental expense allocation spreadsheet described next.

Step 3: Step 3 allocates service department expenses to operating departments. Service depart- ment expenses are not allocated to other service departments.2 Exhibit 22.6 reflects the allocation of service department expenses using the allocation base(s). All of the direct and indirect expenses of service departments are allocated to operating departments.

Computations for both steps 2 and 3 are commonly made using a departmental expense alloca- tion spreadsheet as shown in Exhibit 22.6. The first two sections of this spreadsheet list direct expenses and indirect expenses by department. The third section lists the service department expenses and their allocations to operating departments. The allocation bases are identified in the second column, and total expense amounts are reported in the third column.

Point: We sometimes allocate service department costs across other service departments before allocating them to operating departments. This “step-wise” process is in advanced courses.

operating departments is useful. We illustrate the steps to prepare departmental income statements using A-1 Hardware and its five de partments. Two of them (office and purchasing) are service departments and the other three (hardware, housewares, and appliances) are operating (selling) departments. Allocating costs to operating departments and preparing departmental income statements involves four steps.

Step 1: Accumulating revenues and direct expenses by department.

Step 2: Allocating indirect expenses across departments.

Step 3: Allocating ser vice department expenses to operating departments.

Step 4: Preparing departmental income statements.

Exhibit 22.5 summarizes the steps in preparing departmental performance reports for cost cen- ters and profit centers. A-1 Hardware’s service departments (general office and purchasing) are cost centers, so their performance will be based on how well they controlled total service de- partment expenses. The company’s operating departments (hardware, housewares, and appli- ances) are profit centers, and their performance will be based on how well they generated departmental net income.

Service Departments (cost centers) Operating Departments (profit centers)Servicee DDDeepp

General office

osst ceenters)arrtmmmenntn s (ccco

e PurchasingPurchasingGeneral office Purchasing

parttmennts

Housewares

Opeeraating DDep ters)(proofit cennt

HardwareHardware AppliancesAppliancesAppliancesHousewaresHardware

Departmental revenues

– Departmental direct expenses

– Allocated company indirect expenses

– Allocated service department expenses

� Departmental net income

Departmental direct expenses

� Allocated company indirect expenses

� Total service department expenses

EXHIBIT 22.5 Departmental Performance Reporting

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Chapter 22 Performance Measurement and Responsibility Accounting 949

EXHIBIT 22.6 Departmental Expense Allocation Spreadsheet

Appli- ances Dept.

House- wares Dept.

Hard- ware Dept.

Purchas- ing

Dept.

31, 2013

(9,700) ( )

Second (step 2), the four indirect expenses of rent, utilities, advertising, and insurance are allocated to all departments using the allocation bases identified. For example, consider rent allocation. Exhibit 22.7 lists the five departments’ square footage of space occupied.

EXHIBIT 22.7 Departments’ Allocation Bases

Floor Space Value of Insured Number of

Department (Square Feet) Assets ($) Sales ($) Purchase Orders

General office . . . . . . . . . 1,500 $ 38,000 __

Purchasing . . . . . . . . . . . . 1,500 19,000 __*

Hardware . . . . . . . . . . . . 4,050 85,500 $119,500 394

Housewares . . . . . . . . . . 2,700 57,000 71,700 267

Appliances . . . . . . . . . . . 2,250 38,000 47,800 324

Total . . . . . . . . . . . . . . . . 12,000 $237,500 $239,000 985

* Purchasing department tracks purchase orders by department.

The two service departments (office and purchasing) occupy 25% of the total space (3,000 sq. feet/ 12,000 sq. feet). However, they are located near the back of the building, which is of lower value than space near the front that is occupied by operating departments. Management esti- mates that space near the back accounts for $1,200 of the total rent expense of $12,000. Exhibit 22.8 shows how we allocate the $1,200 rent expense between these two service departments in proportion to their square footage. Exhibit 22.8 shows a simple rule for cost

EXHIBIT 22.8 Allocating Indirect (Rent) Expense to Service Departments

Square Percent Allocated

Department Feet of Total Cost

General office . . . . . . . . 1,500 50.0% $ 600

Purchasing . . . . . . . . . . . 1,500 50.0 600

Totals . . . . . . . . . . . . . . . 3,000 100.0% $1,200

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950 Chapter 22 Performance Measurement and Responsibility Accounting

allocations: Allocated cost 5 Percentage of allocation base 3 Total cost. We then allocate the re- maining $10,800 of rent expense to the three operating departments as shown in Exhibit 22.9.

EXHIBIT 22.9 Allocating Indirect (Rent) Expense to Operating Departments

Square Percent Allocated

Department Feet of Total Cost

Hardware . . . . . . . . . . . . 4,050 45.0% $ 4,860

Housewares . . . . . . . . . . 2,700 30.0 3,240

Appliances . . . . . . . . . . . 2,250 25.0 2,700

Totals . . . . . . . . . . . . . . . 9,000 100.0% $10,800

EXHIBIT 22.10 Allocating Indirect (Utilities) Expense to All Departments

Square Percent Allocated

Department Feet of Total Cost

General office . . . . . . . . 1,500 12.50% $ 300

Purchasing . . . . . . . . . . . 1,500 12.50 300

Hardware . . . . . . . . . . . . 4,050 33.75 810

Housewares . . . . . . . . . . 2,700 22.50 540

Appliances . . . . . . . . . . . 2,250 18.75 450

Totals . . . . . . . . . . . . . . . 12,000 100.00% $2,400

EXHIBIT 22.11 Allocating Indirect (Advertising) Expense to Operating Departments

Percent Allocated

Department Sales of Total Cost

Hardware . . . . . . . . . . . . $119,500 50.0% $ 500

Housewares . . . . . . . . . . 71,700 30.0 300

Appliances . . . . . . . . . . . 47,800 20.0 200

Totals . . . . . . . . . . . . . . . $239,000 100.0% $1,000

EXHIBIT 22.12 Allocating Indirect (Insurance) Expense to All Departments

Value of Percent Allocated

Department Insured Assets of Total Cost

General office . . . . . . . . . $ 38,000 16.0% $ 400

Purchasing . . . . . . . . . . . . 19,000 8.0 200

Hardware . . . . . . . . . . . . 85,500 36.0 900

Housewares . . . . . . . . . . 57,000 24.0 600

Appliances . . . . . . . . . . . 38,000 16.0 400

Total . . . . . . . . . . . . . . . . $237,500 100.0% $2,500

Exhibit 22.11 shows the allocation of $1,000 of advertising expense to the three operating departments on the basis of sales dollars. We exclude service departments from this alloca- tion because they do not generate sales.

To complete step 2 we allocate insurance expense to each service and operating department as shown in Exhibit 22.12.

We continue step 2 by allocating the $2,400 of utilities expense to all departments based on the square footage occupied as shown in Exhibit 22.10.

Third (step 3), total expenses of the two service departments are allocated to the three operating departments as shown in Exhibits 22.13 and 22.14.

Percent Allocated

Department Sales of Total Cost

Hardware . . . . . . . . . . . . $119,500 50.0% $ 7,650

Housewares . . . . . . . . . . 71,700 30.0 4,590

Appliances . . . . . . . . . . . . 47,800 20.0 3,060

Total . . . . . . . . . . . . . . . . $239,000 100.0% $15,300

EXHIBIT 22.13 Allocating Service Department (General Office) Expenses to Operating Departments

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Chapter 22 Performance Measurement and Responsibility Accounting 951

EXHIBIT 22.14 Allocating Service Department (Purchasing) Expenses to Operating Departments

Number of Percent Allocated

Department Purchase Orders of Total Cost

Hardware . . . . . . . . . . . . 394 40.00% $3,880

Housewares . . . . . . . . . . 267 27.11 2,630

Appliances . . . . . . . . . . . . 324 32.89 3,190

Total . . . . . . . . . . . . . . . . 985 100.00% $9,700

Step 4: The departmental expense allocation spreadsheet can now be used to prepare perfor- mance reports for the company’s service and operating departments. The general office and purchasing departments are cost centers, and their managers will be evaluated on their control of costs. Actual amounts of service department expenses can be compared to budgeted amounts to help assess cost center manager performance. Amounts in the operating department columns are used to prepare departmental income statements as shown in Exhibit 22.15. This exhibit uses the spreadsheet for its operating ex- penses; information on sales and cost of goods sold comes from departmental records.

Example: If the $15,300 general office expenses in Exhibit 22.6 are allocated equally across departments, what is net income for the hardware department and for the combined company? Answer: Hardware income, $13,350; combined income, $19,000.

EXHIBIT 22.15 Departmental Income Statements (Operating Departments)

A-1 HARDWARE

Departmental Income Statements

For Year Ended December 31, 2013

Hardware Housewares Appliances

Department Department Department Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,500 $71,700 $47,800 $239,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 73,800 43,800 30,200 147,800

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,700 27,900 17,600 91,200

Operating expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . 15,600 7,000 7,800 30,400

Depreciation expense — Equipment . . . . . . 400 100 200 700

Supplies expense . . . . . . . . . . . . . . . . . . . . . 300 200 100 600

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . 4,860 3,240 2,700 10,800

Utilities expense . . . . . . . . . . . . . . . . . . . . . 810 540 450 1,800

Advertising expense . . . . . . . . . . . . . . . . . . 500 300 200 1,000

Insurance expense . . . . . . . . . . . . . . . . . . . . 900 600 400 1,900

Share of general office expenses . . . . . . . . 7,650 4,590 3,060 15,300

Share of purchasing expenses . . . . . . . . . . . 3,880 2,630 3,190 9,700

Total operating expenses . . . . . . . . . . . . . . 34,900 19,200 18,100 72,200

Net income (loss) . . . . . . . . . . . . . . . . . . . . $ 10,800 $ 8,700 $ (500) $ 19,000

Direct expenses

Allocated service department expenses

Allocated indirect expenses

Departmental Contribution to Overhead Data from departmental income statements are not always best for evaluating each profit center’s performance, especially when indirect expenses are a large portion of total expenses and when weaknesses in assumptions and decisions in allocating indirect expenses can mark- edly affect net income. Also, operating department managers might have no control over the level of service department services they use. In these and other cases, we might better evaluate profit center performance using the departmental contribution to overhead, which is a report of the amount of sales less direct expenses.3 (We can also examine cost center performance by focusing on control of direct expenses.)

3 A department’s contribution is said to be “to overhead” because of the practice of considering all indirect expenses as overhead. Thus, the excess of a department’s sales over direct expenses is a contribution toward at least a portion of its total overhead.

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The upper half of Exhibit 22.16 shows a departmental (profit center) contribution to overhead as part of an expanded income statement. This format is common when reporting departmental contributions to overhead. Using the information in Exhibits 22.15 and 22.16, we can evaluate the profitability of the three profit centers. For instance, let’s compare the performance of the appliances department as described in these two exhibits. Exhibit 22.15 shows a $500 net loss resulting from this department’s operations, but Exhibit 22.16 shows a $9,500 positive contribu- tion to overhead, which is 19.9% of the appliance department’s sales. The contribution of the appliances department is not as large as that of the other selling departments, but a $9,500 con- tribution to overhead is better than a $500 loss. This tells us that the appliances department is not a money loser. On the contrary, it is contributing $9,500 toward defraying total indirect expenses of $40,500.

Point: Net income is the same in Exhibits 22.15 and 22.16. The method of reporting indirect expenses in Exhibit 22.16 does not change total net income but does identify each operating department’s contribution to overhead and net income.

EXHIBIT 22.16 Departmental Contribution to Overhead

A-1 HARDWARE

Income Statement Showing Departmental Contribution to Overhead

For Year Ended December 31, 2013

Hardware Housewares Appliances

Department Department Department Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,500 $ 71,700 $47,800 $239,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 73,800 43,800 30,200 147,800

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,700 27,900 17,600 91,200

Direct expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . 15,600 7,000 7,800 30,400

Depreciation expense — Equipment . . . . . . 400 100 200 700

Supplies expense . . . . . . . . . . . . . . . . . . . . . 300 200 100 600

Total direct expenses . . . . . . . . . . . . . . . . . . 16,300 7,300 8,100 31,700

Departmental contributions

to overhead . . . . . . . . . . . . . . . . . . . . . . . . $ 29,400 $20,600 $ 9,500 $ 59,500

Indirect expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . 10,800

Utilities expense . . . . . . . . . . . . . . . . . . . . . 1,800

Advertising expense . . . . . . . . . . . . . . . . . . . 1,000

Insurance expense . . . . . . . . . . . . . . . . . . . . 1,900

General office department expense . . . . . . 15,300

Purchasing department expense . . . . . . . . . 9,700

Total indirect expenses . . . . . . . . . . . . . . . . 40,500

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,000

Contribution as percent of sales . . . . . . . . . . 24.6% 28.7% 19.9% 24.9%

4. If a company has two operating (selling) departments (shoes and hats) and two service departments (payroll and advertising), which of the following statements is correct? (a) Wages incurred in the payroll department are direct expenses of the shoe department, (b) Wages incurred in the payroll department are indirect expenses of the operating departments, or (c) Advertising department expenses are allocated to the other three departments.

5. Which of the following bases can be used to allocate supervisors’ salaries across operating departments? (a) Hours spent in each department, (b) number of employees in each department, (c) sales achieved in each department, or (d) any of the above, depending on which information is most relevant and accessible.

6. What three steps are used to allocate expenses to operating departments? 7. An income statement showing departmental contribution to overhead, (a) subtracts indirect

expenses from each department’s revenues, (b) subtracts only direct expenses from each department’s revenues, or (c) shows net income for each department.

Quick Check Answers — p. 965

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Chapter 22 Performance Measurement and Responsibility Accounting 953

This section introduces both financial and nonfinancial measures of investment center performance.

Financial Performance Evaluation Measures Investment center managers are typically evaluated using performance measures that combine income and assets. Consider the following data for ZTel, a company which operates two divisions: LCD and S-Phone. The LCD division manufactures liquid crystal display (LCD) touch-screen monitors and sells them for use in computers, cellular phones, and other products. The S-Phone division sells smartphones, mobile phones that also function as personal comput- ers, MP3 players, cameras, and global positioning satellite (GPS) systems. Exhibit 22.17 shows current year income and assets for those divisions.

EVALUATING INVESTMENT CENTER PERFORMANCE

A1 Analyze investment centers using return on assets and residual income.

Investment Center Return on (Assets) Investment One measure to evaluate division performance is the investment center return on total assets, commonly called return on investment (ROI) or return on assets (ROA). This measure is computed as follows:

Return on investment 5 Investment center net income

Investment center average invested assets

The return on investment for the LCD division is 21% (rounded), computed as $526,500/ $2,500,000. The S-Phone division’s return on investment is 23% (rounded), computed as $417,600/$1,850,000. Though the LCD division earned more dollars of net income, it was less efficient in using its assets to generate income compared to the S-Phone division.

Investment Center Residual Income Another way to evaluate division performance is to compute investment center residual income, which is computed as follows:

EXHIBIT 22.17 Investment Center Income and Assets

LCD S-Phone

Net income . . . . . . . . . . . . . . . . . . $ 526,500 $ 417,600

Average invested assets . . . . . . . . . 2,500,000 1,850,000

Residual income 5

Investment center 2

Target investment center net income net income

Assume ZTel’s top management sets target net income at 8% of divisional assets. For an invest- ment center, this hurdle rate is typically the cost of obtaining financing. Applying this hurdle rate using the data from Exhibit 22.17 yields the residual income for ZTel’s divisions in Exhibit 22.18.

EXHIBIT 22.18 Investment Center Residual Income

LCD S-Phone

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $526,500 $417,600

Less: Target net income

$2,500,000 3 8% . . . . . . . . . . . . . . . . . . . . . 200,000

$1,850,000 3 8% . . . . . . . . . . . . . . . . . . . . . 148,000

Investment center residual income . . . . . . . . . $326,500 $269,600

Unlike return on assets, residual income is expressed in dollars. The LCD division outperformed the S-Phone division on the basis of residual income. However, this result is due in part to the LCD division having a larger asset base than the S-Phone division.

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954 Chapter 22 Performance Measurement and Responsibility Accounting

Point: Economic Value Added (EVA®), developed and trademarked by Stern, Stewart, and Co., is an approach to address issues in computing residual income. This method uses a variety of adjustments to compute income, assets, and the hurdle rate.

Using residual income to evaluate division performance encourages division managers to accept all opportunities that return more than the target net income, thus increasing company value. For example, the S-Phone division might not want to accept a new customer that will provide a 15% return on investment, since that will reduce the S-Phone division’s overall return on investment (23% as shown above). However, the S-Phone division should accept this oppor- tunity because the new customer would increase residual income by providing net income above the target net income.

Issues in Computing Return on (Assets) Investment and Residual Income

Evaluations of investment center performance using return on assets and residual income can be impacted by how a company answers the questions below:

1. How do you compute average invested assets? It is common to compute the average by adding the year’s beginning amount of invested assets to the year’s ending amount of in- vested assets, and dividing that sum by 2. Averages based on monthly or quarterly asset amounts are also acceptable.

2. How do you measure invested assets? It is common to measure invested assets using their net book values. For example, depreciable assets would be measured at their cost minus accumulated depreciation. As net book value declines over a depreciable asset’s useful life, the result is that return on assets and residual income would increase over that asset’s life. This might cause managers not to invest in new assets. In addition, in measuring in- vested assets, companies commonly exclude assets that are not used in generating invest- ment center net income such as land held for resale.

3. How do you measure investment center income? It is common to exclude both interest expense and tax expense from investment center income. Interest expense reflects a com- pany’s financing decisions, and tax expense is typically considered outside the control of an investment center manager. Excluding interest and taxes in these calculations enables more meaningful comparisons of return on assets and residual income across investment centers and companies.

In-the-Money Executive pay is often linked to performance measures. Bonus payments are often based on exceeding a target return on investment or certain balanced scorecard indicators. Stock awards, such as stock options and restricted stock, reward executives when their company’s stock price rises. The goal of bonus plans and stock awards is to encourage executives to make decisions that increase company perfor- mance and value. ■

Decision Insight

Investment Center Profit Margin and Investment Turnover We can further examine investment center (division) performance by splitting return on investment into profit margin and investment turnover as follows

A2 Analyze investment centers using profit margin and investment turnover.

Return on investment 5 Profit margin 3 Investment turnover

Investment center net income Investment center average assets

5 Investment center net income

Investment center sales 3

Investment center sales Investment center average assets

Profit margin measures the income earned per dollar of sales. Investment turnover measures how efficiently an investment center generates sales from its invested assets. Profit margin is expressed as a percent, while investment turnover is interpreted as the number of times as- sets were converted into sales. Higher profit margin and higher investment turnover indicate better performance. To illustrate, consider Best Buy which reports in Exhibit 22.19 results for two divisions (segments): Domestic and International.

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Chapter 22 Performance Measurement and Responsibility Accounting 955

EXHIBIT 22.19 Best Buy Division Sales, Income, and Assets

($ millions) Domestic International

Sales . . . . . . . . . . . . . . . . . . . . . . . . $37,186 $13,086

Net income . . . . . . . . . . . . . . . . . . 2,031 83

Average invested assets . . . . . . . . 10,021 8,055

Profit margin and investment turnover for its Domestic and International divisions are computed and shown in Exhibit 22.20:

EXHIBIT 22.20 Best Buy Division Profit Margin and Investment Turnover

($ millions) Domestic International

Profit Margin

$2,031y$37,186 . . . . . . . . . . 5.55% $83y$13,086 . . . . . . . . . . . . 0.6% Investment Turnover

$37,186y$10,021 . . . . . . . . . 3.71 $13,086y$8,055 . . . . . . . . . . 1.62 Return on Investment

5.55% 3 3.71 . . . . . . . . . . . . 20.59%

0.6% 3 1.62 . . . . . . . . . . . . . 1.01%

Best Buy’s Domestic division generates 5.55 cents of profit per $1 of sales, while its Interna- tional division generates less than 1 cent of profit per dollar of sales. Its Domestic division also uses its assets more efficiently; its investment turnover of 3.71 is over twice that of its International division’s 1.62. Alternatively, if Best Buy’s Domestic division instead had sales of $40 billion, net income of $3 billion, and average invested assets of $4 billion, its profit margin, investment turnover, and return on assets would be 7.5%, 4%, and 30%, respectively. Top man- agement can use profit margin and investment turnover to evaluate the performance of division managers. The measures can also aid management when considering further investment in its divisions. As a result of both a much higher profit margin and a more rapid investment turnover, the Domestic division’s return on investment (20.59%) is much greater than that of the Interna- tional division (0.97%).

Division Manager You manage a division in a highly competitive industry. You will receive a cash bonus if your division achieves an ROI above 12%. Your division’s profit margin is 7%, equal to the industry average, and your division’s investment turnover is 1.5. What actions can you take to increase your chance of receiving the bonus? ■ [Answer—p. 965]

Decision Maker

8. A division reports sales of $50,000, income of $2,000, and average invested assets of $10,000. Compute the division’s (a) profit margin, (b) investment turnover, and (c) return on investment.

Quick Check Answers — p. 965

Nonfinancial Performance Evaluation Measures Evaluating performance solely on financial measures such as return on investment or residual income has limitations. For example, some investment center managers might forgo profitable opportunities to keep their return on investment high. Also, residual income is less useful when comparing investment centers of different size. And, both return on investment and residual in- come can encourage managers to focus too heavily on short-term financial goals. In response to these limitations, companies consider nonfinancial measures. For example, a delivery company such as FedEx might track the percentage of on-time deliveries. The percentage

A3 Analyze investment centers using the balanced scorecard.

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956 Chapter 22 Performance Measurement and Responsibility Accounting

EXHIBIT 22.21 Balanced Scorecard Performance Indicators

$0 2012 2006 2009 2004

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

400 600 1,200

Quality Management Training Financial Results

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 0706

Va lu

e of

$ 1

In ve

st ed

08 09

• Defect rates

• Cycle time

• Product costs

• Labor hours per order

• Production days with- out an accident

• Employee satisfaction

• Employee turnover

• $ spent on training

• # of new products

• # of patents

• $ spent on research

Internal ProcessCustomer Innovation/Learning Financial

• Customer satisfaction rating

• # of new customers acquired

• % of on-time deliveries

• % of sales from new products

• Time to fill orders

% of sales returned

• Net income

• ROI

• Sales growth

• Cash flow

• Residual income

• Stock price•

Point: One survey indicates that nearly 60% of global companies use some form of a balanced scorecard.

After selecting key performance indicators, companies collect data on each indicator and compare actual amounts to expected amounts to assess performance. For example, a company might have a goal of filling 98% of customer orders within two hours. Balanced scorecard re- ports are often presented in graphs or tables that can be updated frequently. Such timely infor- mation aids division managers in their decisions, and can be used by top management to evaluate division manager performance. Exhibit 22.22 is an example of balanced scorecard reporting on the customer perspective for an Internet retailer. This scorecard reports for example that the retailer is getting 62% of its potential customers successfully through the checkout process, and that 2.2% of all orders are returned. The color of the arrows in the right-most column reveals whether the company is exceeding its goal (green), barely meeting the goal (yellow), or not meeting the goal (red). The direction of the arrows reveals any trend in performance: an upward arrow indicates improvement, a downward arrow indicates declining performance, and an arrow pointing sideways indicates no change. A

of defective tennis balls manufactured can be used to assess performance of Penn’s production managers. Walmart’s credit card screens commonly ask customers at check-out whether the cashier was friendly or the store was clean. This kind of information can help division managers run their divisions and help top management evaluate division manager performance.

Balanced Scorecard The balanced scorecard is a system of performance measures, in- cluding nonfinancial measures, used to assess company and division manager performance. The balanced scorecard requires managers to think of their company from four perspectives:

1. Customer: What do customers think of us? 2. Internal processes: Which of our operations are critical to meeting customer needs? 3. Innovation and learning: How can we improve? 4. Financial: What do our owners think of us?

The balanced scorecard collects information on several key performance indicators within each of the four perspectives. These key indicators vary across companies. Exhibit 22.21 lists com- mon performance measures.

EXHIBIT 22.22 Balanced Scorecard Reporting: Internet Retailer Checkout success

Orders returned

Customer satisfaction rating

Number of customer complaints

62%

2.2%

9.5

142

ActualCustomer Perspective Goal

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Chapter 22 Performance Measurement and Responsibility Accounting 957

review of these arrows’ color and direction suggests the retailer is meeting or exceeding its goals on checkout success, orders returned, and customer satisfaction. Further, checkout success and customer satisfaction are improving. The red arrow shows the company has received more cus- tomer complaints than was hoped for; however, the number of customer complaints is declining. A manager would combine this information with similar information on the internal process, in- novation and learning, and financial perspectives to get an overall view of division performance.

Center Manager Your center’s usual return on total assets is 19%. You are considering two new invest- ments for your center. The first requires a $250,000 average investment and is expected to yield annual net income of $50,000. The second requires a $1 million average investment with an expected annual net in- come of $175,000. Do you pursue either? ■ [Answer—p. 965]

Decision Maker

L’Oreal is an international cosmetics company incorporated in France. With multiple brands and opera- tions in over 100 countries, the company uses concepts of departmental accounting and controllable costs to evaluate performance. For example, its 2010 annual report shows the following for the major divisions in its Cosmetics branch:

GLOBAL VIEW

For L’Oreal, nonallocated costs include costs that are not controllable by division managers, including fundamental research and development and costs of service operations like insurance and banking. Exclud- ing noncontrollable costs enables L’Oreal to prepare more meaningful division performance evaluations.

Cycle Time and Cycle Efficiency Decision Analysis

Manufacturing companies commonly use nonfinancial measures to evaluate the performance of their pro- duction processes. For example, as lean manufacturing practices help companies move toward just-in- time manufacturing, it is important for these companies to reduce the time to manufacture their products and to improve manufacturing efficiency. One metric that measures that time element is cycle time (CT). A definition of cycle time is in Exhibit 22.23.

A4 Compute cycle time and cycle efficiency, and explain their importance to production management.

EXHIBIT 22.23 Cycle Time

Cycle time 5 Process time 1 Inspection time 1 Move time 1 Wait time

Process time is the time spent producing the product. Inspection time is the time spent inspecting (1) raw materials when received, (2) goods in process while in production, and (3) finished goods prior to shipment. Move time is the time spent moving (1) raw materials from storage to production and (2) goods in process from one factory location to another factory location. Wait time is the time that an order or job sits with no production applied to it; this can be due to order delays, bottlenecks in production, and poor scheduling.

Division Operating Profit (€ millions)

Consumer products . . . . . . . . . . €1,765

Professional products . . . . . . . . . 552

Luxury products . . . . . . . . . . . . . 791

Active cosmetics . . . . . . . . . . . . . 277 €3,385

Nonallocated costs . . . . . . . . . . . (513)

Cosmetics branch total . . . . . . . €2,872 Similar to “Net income” in Exhibit 22.16

Similar to “Departmental contributions to overhead” in Exhibit 22.16

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Process time is considered value-added time because it is the only activity in cycle time that adds value to the product from the customer’s perspective. The other three time activities are considered non- value-added time because they add no value to the customer. Companies strive to reduce non-value-added time to improve cycle efficiency (CE). Cycle efficiency is the ratio of value-added time to total cycle time—see Exhibit 22.24.

958 Chapter 22 Performance Measurement and Responsibility Accounting

To illustrate, assume that Rocky Mountain Bikes receives and produces an order for 500 Tracker® moun- tain bikes. Assume that the following times were measured during production of this order.

In this case, cycle time is 6.0 days, computed as 1.8 days 1 0.5 days 1 0.7 days 1 3.0 days. Also, cycle efficiency is 0.3, or 30%, computed as 1.8 days divided by 6.0 days. This means that Rocky Mountain Bikes spends 30% of its time working on the product (value-added time). The other 70% is spent on non- value-added activities. If a company has a CE of 1, it means that its time is spent entirely on value-added activities. If the CE is low, the company should evaluate its production process to see if it can identify ways to reduce non- value-added activities. The 30% CE for Rocky Mountain Bikes is low and its management should look for ways to reduce non-value-added activities.

Process time... 1.8 days Inspection time... 0.5 days Move time... 0.7 days Wait time... 3.0 days

EXHIBIT 22.24 Cycle Efficiency Cycle efficiency 5

Value-added time Cycle time

Management requests departmental income statements for Hacker’s Haven, a computer store that has five departments. Three are operating departments (hardware, software, and repairs) and two are service depart- ments (general office and purchasing).

DEMONSTRATION PROBLEM

General

Office Purchasing Hardware Software Repairs

Sales . . . . . . . . . . . . . . . . . . . . — — $960,000 $600,000 $840,000

Cost of goods sold . . . . . . . . — — 500,000 300,000 200,000

Direct expenses

Payroll . . . . . . . . . . . . . . . . $60,000 $45,000 80,000 25,000 325,000

Depreciation . . . . . . . . . . . 6,000 7,200 33,000 4,200 9,600

Supplies . . . . . . . . . . . . . . . 15,000 10,000 10,000 2,000 25,000

Indirect Expense Total Cost Allocation Basis

Rent . . . . . . . . . . . . . . . . . . . . . . $150,000 Square footage occupied

Utilities . . . . . . . . . . . . . . . . . . . 50,000 Square footage occupied

Advertising . . . . . . . . . . . . . . . . 125,000 Dollars of sales

Insurance . . . . . . . . . . . . . . . . . . 30,000 Value of assets insured

Service departments

General office . . . . . . . . . . . . ? Number of employees

Purchasing . . . . . . . . . . . . . . . ? Dollars of cost of goods sold

The departments incur several indirect expenses. To prepare departmental income statements, the indirect expenses must be allocated across the five departments. Then the expenses of the two service departments must be allocated to the three operating departments. Total cost amounts and the allocation bases for each indirect expense follow.

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Chapter 22 Performance Measurement and Responsibility Accounting 959

The following additional information is needed for indirect expense allocations.

Square Insured Cost of

Department Feet Sales Assets Employees Goods Sold

General office . . . . . . . . 500 $ 60,000

Purchasing . . . . . . . . . . . 500 72,000

Hardware . . . . . . . . . . . . 4,000 $ 960,000 330,000 5 $ 500,000

Software . . . . . . . . . . . . . 3,000 600,000 42,000 5 300,000

Repairs . . . . . . . . . . . . . . 2,000 840,000 96,000 10 200,000

Totals . . . . . . . . . . . . . . . 10,000 $2,400,000 $600,000 20 $1,000,000

Required

1. Prepare a departmental expense allocation spreadsheet for Hacker’s Haven. 2. Prepare a departmental income statement reporting net income for each operating department and for

all operating departments combined.

PLANNING THE SOLUTION ● Set up and complete four tables to allocate the indirect expenses — one each for rent, utilities, advertis-

ing, and insurance. ● Allocate the departments’ indirect expenses using a spreadsheet like the one in Exhibit 22.6. Enter the

given amounts of the direct expenses for each department. Then enter the allocated amounts of the in- direct expenses that you computed.

● Complete two tables for allocating the general office and purchasing department costs to the three operating departments. Enter these amounts on the spreadsheet and determine the total expenses allocated to the three operating departments.

● Prepare departmental income statements like the one in Exhibit 22.15. Show sales, cost of goods sold, gross profit, individual expenses, and net income for each of the three operating departments and for the combined company.

SOLUTION TO DEMONSTRATION PROBLEM Allocations of the four indirect expenses across the five departments.

Square Percent Allocated

Rent Feet of Total Cost

General office . . . . . . . . 500 5.0% $ 7,500

Purchasing . . . . . . . . . . . 500 5.0 7,500

Hardware . . . . . . . . . . . . 4,000 40.0 60,000

Software . . . . . . . . . . . . 3,000 30.0 45,000

Repairs . . . . . . . . . . . . . . 2,000 20.0 30,000

Totals . . . . . . . . . . . . . . . 10,000 100.0% $150,000

Square Percent Allocated

Utilities Feet of Total Cost

General office . . . . . . . . 500 5.0% $ 2,500

Purchasing . . . . . . . . . . . 500 5.0 2,500

Hardware . . . . . . . . . . . . 4,000 40.0 20,000

Software . . . . . . . . . . . . 3,000 30.0 15,000

Repairs . . . . . . . . . . . . . . 2,000 20.0 10,000

Totals . . . . . . . . . . . . . . . 10,000 100.0% $50,000

Sales Percent Allocated

Advertising Dollars of Total Cost

Hardware . . . . . . . . . . . $ 960,000 40.0% $ 50,000

Software . . . . . . . . . . . . 600,000 25.0 31,250

Repairs . . . . . . . . . . . . . 840,000 35.0 43,750

Totals . . . . . . . . . . . . . . $2,400,000 100.0% $125,000

Assets Percent Allocated

Insurance Insured of Total Cost

General office . . . . . . . . $ 60,000 10.0% $ 3,000

Purchasing . . . . . . . . . . . 72,000 12.0 3,600

Hardware . . . . . . . . . . . 330,000 55.0 16,500

Software . . . . . . . . . . . . 42,000 7.0 2,100

Repairs . . . . . . . . . . . . . . 96,000 16.0 4,800

Totals . . . . . . . . . . . . . . . $600,000 100.0% $30,000

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960 Chapter 22 Performance Measurement and Responsibility Accounting

1. Allocations of service department expenses to the three operating departments.

General Office Percent Allocated

Allocations to Employees of Total Cost

Hardware . . . . . . . . . . . . . . 5 25.0% $23,500

Software . . . . . . . . . . . . . . . 5 25.0 23,500

Repairs . . . . . . . . . . . . . . . . 10 50.0 47,000

Totals . . . . . . . . . . . . . . . . . 20 100.0% $94,000

Purchasing Cost of Percent Allocated

Allocations to Goods Sold of Total Cost

Hardware . . . . . . . . . . . . . . $ 500,000 50.0% $37,900

Software . . . . . . . . . . . . . . . 300,000 30.0 22,740

Repairs . . . . . . . . . . . . . . . . 200,000 20.0 15,160

Totals . . . . . . . . . . . . . . . . . $1,000,000 100.0% $75,800

HACKER’S HAVEN

Departmental Expense Allocations

For Year Ended December 31, 2013

Expense General

Allocation Account Office Purchasing Hardware Software Repairs

Base Balance Dept. Dept. Dept. Dept. Dept.

Direct Expenses

Payroll. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 535,000 $ 60,000 $ 45,000 $ 80,000 $ 25,000 $ 325,000

Depreciation . . . . . . . . . . . . . . . . . . . . . . . . 60,000 6,000 7,200 33,000 4,200 9,600

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,000 15,000 10,000 10,000 2,000 25,000

Indirect Expenses

Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Square ft. 150,000 7,500 7,500 60,000 45,000 30,000

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Square ft. 50,000 2,500 2,500 20,000 15,000 10,000

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . Sales 125,000 — — 50,000 31,250 43,750

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . Assets 30,000 3,000 3,600 16,500 2,100 4,800

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . 1,012,000 94,000 75,800 269,500 124,550 448,150

Service Department Expenses

General office . . . . . . . . . . . . . . . . . . . . . . . Employees (94,000) 23,500 23,500 47,000

Purchasing . . . . . . . . . . . . . . . . . . . . . . . . . . Goods sold (75,800) 37,900 22,740 15,160

Total expenses allocated to operating departments . . . . . . . . . . . . . . $1,012,000 $ 0 $ 0 $330,900 $170,790 $510,310

HACKER’S HAVEN

Departmental Income Statements

For Year Ended December 31, 2013

Hardware Software Repairs Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $ 960,000 $ 600,000 $ 840,000 $2,400,000

Cost of goods sold . . . . . . . . . . . . . 500,000 300,000 200,000 1,000,000

Gross profit . . . . . . . . . . . . . . . . . . . 460,000 300,000 640,000 1,400,000

Expenses

Payroll . . . . . . . . . . . . . . . . . . . . . 80,000 25,000 325,000 430,000

Depreciation . . . . . . . . . . . . . . . . 33,000 4,200 9,600 46,800

Supplies . . . . . . . . . . . . . . . . . . . . 10,000 2,000 25,000 37,000

Rent . . . . . . . . . . . . . . . . . . . . . . . 60,000 45,000 30,000 135,000

Utilities . . . . . . . . . . . . . . . . . . . . 20,000 15,000 10,000 45,000

Advertising . . . . . . . . . . . . . . . . . . 50,000 31,250 43,750 125,000

Insurance . . . . . . . . . . . . . . . . . . . 16,500 2,100 4,800 23,400

Share of general office . . . . . . . . 23,500 23,500 47,000 94,000

Share of purchasing . . . . . . . . . . . 37,900 22,740 15,160 75,800

Total expenses . . . . . . . . . . . . . . . 330,900 170,790 510,310 1,012,000

Net income . . . . . . . . . . . . . . . . . $129,100 $129,210 $129,690 $ 388,000

2. Departmental income statements for Hacker’s Haven.

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Chapter 22 Performance Measurement and Responsibility Accounting 961

APPENDIX

Transfer Pricing 22A C2 Explain transfer pricing and methods to set transfer

prices.

Divisions in decentralized companies sometimes do business with one another. For example, a separate division of Harley-Davidson manufactures its plastic and fiberglass parts used in the company’s motor- cycles. Anheuser-Busch’s metal container division makes cans and lids used in its brewing operations, and also sells cans and lids to soft-drink companies. A division of Prince produces strings used in tennis rackets made by Prince and other manufacturers. Determining the price that should be used to record transfers between divisions in the same company is the focus of this appendix. Because these transactions are transfers within the same company, the price to record them is called the transfer price. In decentralized organizations, division managers have input on or decide those prices. Transfer prices can be used in cost, profit, and investment centers. Since these transfers are not with customers outside the company, the transfer price has no direct impact on the com- pany’s overall profits. However, transfer prices can impact performance evaluations and, if set incorrectly, lead to bad decisions.

Alternative Transfer Prices Exhibit 22A.1 reports data on the LCD division of ZTel. LCD man- ufactures liquid crystal display (LCD) touch-screen monitors for use in ZTel’s S-Phone division’s smart- phones, which sell for $400 each. The monitors can also be used in other products. So, LCD can sell its monitors to buyers other than S-Phone. Likewise, the S-Phone division can purchase monitors from sup- pliers other than LCD.

Point: Transfer pricing can impact com- pany profits when divisions are located in countries with different tax rates; this is covered in advanced courses.

Exhibit 22A.1 reveals the range of transfer prices for transfers of monitors from LCD to S-Phone. The manager of LCD wants to report a division profit; thus, this manager will not accept a transfer price less than $40 (variable manufacturing cost per unit) because doing so would cause the division to lose money on each monitor transferred. The LCD manager will only consider transfer prices of $40 or more. On the other hand, the S-Phone division manager also wants to report a division profit. Thus, this manager will not pay more than $80 per monitor because similar monitors can be bought from outside suppliers at that price. The S-Phone manager will only consider transfer prices of $80 or less. As any transfer price between $40 and $80 per monitor is possible, how does ZTel determine the transfer price? The answer depends in part on whether the LCD division has excess capacity to manufacture monitors.

EXHIBIT 22A.1 LCD Division Manufacturing Information—Monitors

$40 Variable Manufacturing Cost per Unit

$0

$80 Market Price per Unit

I won’t pay more than the $80 market price to buy this from LCD.

My department loses money if the transfer price is less

than $40 per monitor.

LCD Manager

Negotiation Range

S-Phone Manager

Production capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units

Selling price per unit to outside customers . . . . . . . . . $80

Variable manufacturing costs per unit . . . . . . . . . . . . . $40

Fixed manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . $2,000,000

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962 Chapter 22 Performance Measurement and Responsibility Accounting

No Excess Capacity Assume the LCD division can sell every monitor it produces, and thus is producing 100,000 units. In that case, a market-based transfer price of $80 per monitor is preferred. At that price, the LCD division manager is willing to either transfer monitors to S-Phone or sell to outside customers. The S-Phone manager cannot buy monitors for less than $80 from outside suppliers, so the $80 price is acceptable. Further, with a transfer price of $80 per monitor, top management of ZTel is indifferent to S-Phone buying from LCD or buying similar-quality monitors from outside suppliers. With no excess capacity, the LCD manager will not accept a transfer price less than $80 per monitor. For example, suppose the S-Phone manager suggests a transfer price of $70 per monitor. At that price the LCD manager incurs an unnecessary opportunity cost of $10 per monitor (computed as $80 market price minus $70 transfer price). This would lower the LCD division’s income and hurt its performance evaluation.

Excess Capacity Assume that the LCD division has excess capacity. For example, the LCD division might currently be producing only 80,000 units. Because LCD has $2,000,000 of fixed manufacturing costs, both LCD and the top management of ZTel prefer that S-Phone purchases its monitors from LCD. For example, if S-Phone purchases its monitors from an outside supplier at the market price of $80 each, LCD manufactures no units. Then, LCD reports a division loss equal to its fixed costs, and ZTel overall reports a lower net income as its costs are higher. Consequently, with excess capacity, LCD should accept any transfer price of $40 per unit or greater and S-Phone should purchase monitors from LCD. This will allow LCD to recover some (or all) of its fixed costs and increase ZTel’s overall profits. For example, if a transfer price of $50 per monitor is used, the S-Phone manager is pleased to buy from LCD, since that price is below the market price of $80. For each monitor transferred from LCD to S-Phone at $50, the LCD division receives a contribution margin of $10 (computed as $50 transfer price less $40 variable cost) to contribute towards recovering its fixed costs. This form of transfer pricing is called cost-based transfer pricing. Under this approach the transfer price might be based on variable costs, total costs, or variable costs plus a markup. Determining the transfer price under excess capacity is complex and is cov- ered in advanced courses.

Additional Issues in Transfer Pricing Several additional issues arise in determining transfer prices which include the following:

● No market price exists. Sometimes there is no market price for the product being transferred. The product might be a key component that requires additional conversion costs at the next stage and is not easily replicated by an outside company. For example, there is no market for a console for a Nissan Maxima and there is no substitute console Nissan can use in assembling a Maxima. In this case a market-based transfer price cannot be used.

● Cost control. To provide incentives for cost control, transfer prices might be based on standard, rather than actual costs. For example, if a transfer price of actual variable costs plus a markup of $20 per unit is used in the case above, LCD has no incentive to control its costs.

● Division managers’ negotiation. With excess capacity, division managers will often negotiate a trans- fer price that lies between the variable cost per unit and the market price per unit. In this case, the nego- tiated transfer price and resulting departmental performance reports reflect, in part, the negotiating skills of the respective division managers. This might not be best for overall company performance.

● Nonfinancial factors. Factors such as quality control, reduced lead times, and impact on employee morale can be important factors in determining transfer prices.

Transfer Pricing Approaches Used by Companies

Negotiated 17%

Market 37%

Cost 46%

Most manufacturing processes involve joint costs, which refer to costs incurred to produce or purchase two or more products at the same time. A joint cost is like an indirect expense in the sense that more than one cost object share it. For example, a sawmill company incurs a joint cost when it buys logs that it cuts into lumber as shown in Exhibit 22B.1. The joint cost includes the logs (raw material) and its cutting (conversion) into boards classified as Clear, Select, No. 1 Common, No. 2 Com mon, No. 3 Common, and other types of lumber and by-products. When a joint cost is incurred, a question arises as to whether to allocate it to different products result- ing from it. The answer is that when management wishes to estimate the costs of individual products, joint

C3 Describe allocation of joint costs across products.

APPENDIX

22B Joint Costs and Their Allocation

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Chapter 22 Performance Measurement and Responsibility Accounting 963

costs are included and must be allocated to these joint products. However, when manage- ment needs information to help decide whether to sell a product at a certain point in the production process or to process it further, the joint costs are ignored.

Financial statements prepared according to GAAP must assign joint costs to prod- ucts. To do this, management must decide how to allocate joint costs across products benefiting from these costs. If some prod- ucts are sold and others remain in inventory, allocating joint costs involves assigning costs to both cost of goods sold and ending inventory. The two usual methods to allocate joint costs are the (1) physical basis and (2) the value basis. The physical basis typically involves allocating joint cost using physical characteristics such as the ratio of pounds, cubic feet, or gallons of each joint product to the total pounds, cubic feet, or gallons of all joint products flowing from the cost. This method is not preferred because the resulting cost allocations do not reflect the relative market values the joint cost generates. The preferred approach is the value basis, which allocates joint cost in proportion to the sales value of the output produced by the process at the “split-off point”; see Exhibit 22B.1.

Physical Basis Allocation of Joint Cost To illustrate the physical basis of allocating a joint cost, we con- sider a sawmill that bought logs for $30,000. When cut, these logs produce 100,000 board feet of lumber in the grades and amounts shown in Exhibit 22B.2. The logs produce 20,000 board feet of No. 3 Common lumber, which is 20% of the total. With physical allocation, the No. 3 Common lumber is assigned 20% of the $30,000 cost of the logs, or $6,000 ($30,000 3 20%). Because this low-grade lumber sells for $4,000, this allocation gives a $2,000 loss from its production and sale. The physical basis for allocating joint costs does not reflect the extra value flowing into some products or the inferior value flowing into others. That is, the portion of a log that produces Clear and Select grade lumber is worth more than the portion used to produce the three grades of common lumber, but the physical basis fails to reflect this.

EXHIBIT 22B.1 Joint Products from Logs

Joint Products

Joint Cost

Split-off Point

Clear

Select

No. 1 Common

No. 3 Common

No. 2 Common

Cutting of Logs

EXHIBIT 22B.2 Allocating Joint Costs on a Physical Basis

Board Feet Percent Allocated Sales Gross

Grade of Lumber Produced of Total Cost Value Profit

Clear and Select . . . . . . . . . . . . 10,000 10.0% $ 3,000 $12,000 $ 9,000

No. 1 Common . . . . . . . . . . . . 30,000 30.0 9,000 18,000 9,000

No. 2 Common . . . . . . . . . . . . 40,000 40.0 12,000 16,000 4,000

No. 3 Common . . . . . . . . . . . . 20,000 20.0 6,000 4,000 (2,000)

Totals . . . . . . . . . . . . . . . . . . . . 100,000 100.0% $30,000 $50,000 $20,000

Value Basis Allocation of Joint Cost Exhibit 22B.3 illustrates the value basis method of allocation. It determines the percents of the total costs allocated to each grade by the ratio of each grade’s sales value to the total sales value of $50,000 (sales value is the unit selling price multiplied by the number of units produced). The Clear and Select lumber grades receive 24% of the total cost ($12,000y$50,000) instead of the 10% portion using a physical basis. The No. 3 Common lumber receives only 8% of the total cost, or $2,400, which is much less than the $6,000 assigned to it using the physical basis.

EXHIBIT 22B.3 Allocating Joint Costs on a Value Basis

Sales Percent Allocated Gross

Grade of Lumber Value of Total Cost Profit

Clear and Select . . . . . . . . . . . $12,000 24.0% $ 7,200 $ 4,800

No. 1 Common . . . . . . . . . . . . 18,000 36.0 10,800 7,200

No. 2 Common . . . . . . . . . . . . 16,000 32.0 9,600 6,400

No. 3 Common . . . . . . . . . . . . 4,000 8.0 2,400 1,600

Totals . . . . . . . . . . . . . . . . . . . . $50,000 100.0% $30,000 $20,000

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964 Chapter 22 Performance Measurement and Responsibility Accounting

An outcome of value basis allocation is that each grade produces exactly the same 40% gross profit at the split-off point. This 40% rate equals the gross profit rate from selling all the lumber made from the $30,000 logs for a combined price of $50,000.

Example: Refer to Exhibit 22B.3. If the sales value of Clear and Select lumber is changed to $10,000, what is the revised ratio of the market value of No. 1 Common to the total? Answer: $18,000y$48,000 5 37.5%

9. A company produces three products, B1, B2, and B3. The joint cost incurred for the current month for these products is $180,000. The following data relate to this month’s production:

Product Units Produced Unit Sales Value

B1 96,000 $3.00 B2 64,000 6.00 B3 32,000 9.00

The amount of joint cost allocated to product B3 using the value basis allocation is (a) $30,000, (b) $54,000, or (c) $90,000.

Quick Check Answers — p. 965

C1 Distinguish between direct and indirect expenses and identify bases for allocating indirect expenses to departments. Direct expenses are traced to a specific department and are incurred for the sole benefit of that department. Indirect expenses benefit more than one department. Indirect expenses are allocated to departments when com- puting departmental net income. Ideally, we allocate indirect expenses by using a cause-effect relation for the allocation base. When a cause- effect relation is not identifiable, each indirect expense is allocated on a basis reflecting the relative benefit received by each department.

C2 Explain transfer pricing and methods to set transfer prices. Transfer prices are used to record transfers of items between divisions of the same company. Transfer prices can be based on costs or market prices, or can be negotiated by division managers.

C3 Describe allocation of joint costs across products. A joint cost refers to costs incurred to produce or purchase two or more products at the same time. When income statements are pre- pared, joint costs are usually allocated to the resulting joint products using either a physical or value basis.

A1 Analyze investment centers using return on assets and re-sidual income. A financial measure often used to evaluate an investment center manager is the investment center return on total assets, also called return on investment. This measure is computed as the center’s net income divided by the center’s average total as- sets. Residual income, computed as investment center net income minus a target net income is an alternative financial measure of investment center performance.

A2 Analyze investment centers using profit margin and invest-ment turnover. Return on investment can also be computed as profit margin times investment turnover. Profit margin (equal to net income/sales) measures the income earned per dollar of sales and investment turnover (equal to sales/assets) measures how efficiently a division uses its assets.

A3 A balanced scorecard uses a combination of financial and nonfinancial measures to evaluate performance. Customer, internal process, and innovation and learning are the three primary perspectives of nonfinancial measures used in balanced scorecards.

Summary A4 Compute cycle time and cycle efficiency, and explain their importance to production management. It is important for companies to reduce the time to produce their products and to improve manufacturing efficiency. One measure of that time is cycle time (CT), defined as Process time 1 Inspection time 1 Move time 1 Wait time. Process time is value-added time; the others are non- value-added time. Cycle efficiency (CE) is the ratio of value-added time to total cycle time. If CE is low, management should evaluate its production process to see if it can reduce non-value-added activities.

P1 Prepare a responsibility report for a cost center. Responsi-bility accounting systems provide information for evaluating the performance of department managers. A responsibility account- ing system’s performance reports for evaluating department manag- ers should include only the expenses (and revenues) that each manager controls.

P2 Allocate indirect expenses to departments. Indirect ex-penses include items like depreciation, rent, advertising, and other expenses that cannot be assigned directly to departments. Indi- rect expenses are recorded in company accounts, an allocation base is identified for each expense, and costs are allocated to depart- ments. Departmental expense allocation spreadsheets are often used in allocating indirect expenses to departments.

P3 Prepare departmental income statements and contribution reports. Each profit center (department) is assigned its ex- penses to yield its own income statement. These costs include its di- rect expenses and its share of indirect expenses. The departmental income statement lists its revenues and costs of goods sold to deter- mine gross profit. Its operating expenses (direct expenses and its indirect expenses allocated to the department) are deducted from gross profit to yield departmental net income. The departmental contribution report is similar to the departmental income statement in terms of computing the gross profit for each department. Then the direct operating expenses for each department are deducted from gross profit to determine the contribution generated by each depart- ment. Indirect operating expenses are deducted in total from the company’s combined contribution.

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Chapter 22 Performance Measurement and Responsibility Accounting 965

Multiple Choice Quiz Answers on p. 983 mhhe.com/wildFINMAN5e

Additional Quiz Questions are available at the book’s Website.

1. A retailer has three departments—housewares, appliances, and clothing—and buys advertising that benefits all departments. Ad- vertising expense is $150,000 for the year, and departmental sales for the year follow: housewares, $356,250; appliances, $641,250; clothing, $427,500. How much advertising expense is allocated to appliances if allocation is based on departmental sales?

a. $37,500 b. $67,500 c. $45,000 d. $150,000 e. $641,250

Division Manager Your division’s ROI without further action is 10.5% (equal to 7% 3 1.5). In a highly competitive industry, it is dif- ficult to increase profit margins by raising prices. Your division might be better able to control its costs to increase its profit margin. In ad- dition, you might engage in a marketing program to increase sales without increasing your division’s invested assets. Investment turn- over and thus ROI will increase if the marketing campaign attracts customers.

Center Manager We must first realize that the two investment opportunities are not comparable on the basis of absolute dollars of

in come or on assets. For instance, the second investment provides a higher income in absolute dollars but requires a higher investment. Accordingly, we need to compute return on total assets for each alternative: (1) $50,000 4 $250,000 5 20%, and (2) $175,000 4 $1 million 5 17.5%. Alternative 1 has the higher return and is preferred over alternative 2. Do you pursue one, both, or neither? Because alternative 1’s return is higher than the center’s usual return of 19%, it should be pursued, assuming its risks are acceptable. Also, since alternative 1 requires a small investment, top management is likely to be more agreeable to pursuing it. Alternative 2’s return is lower than the usual 19% and is not likely to be acceptable.

Guidance Answers to Decision Maker and Decision Ethics

1. d 2. A cost center, such as a service department, incurs costs without

directly generating revenues. A profit center, such as a product division, incurs costs but also generates revenues.

3. c 4. b 5. d

6. (1) Assign the direct expenses to each department. (2) Allocate indirect expenses to all departments. (3) Allocate the service department expenses to the operating departments.

7. b 8. a) $2,000y50,000 5 4%; b) $50,000y10,000 5 5; $2,000y10,000

5 20%. 9. b; $180,000 3 ([32,000 3 $9]y[96,000 3 $3 1 64,000 3 $6 1 32,000 3 $9]) 5 $54,000.

Guidance Answers to Quick Checks

Balanced scorecard (p. 956)

Controllable costs (p. 943)

Cost-based transfer pricing (p. 962)

Cost center (p. 943)

Cycle efficiency (p. 958)

Cycle Time (CT) (p. 957)

Departmental contribution to overhead (p. 951)

Departmental income statements (p. 945)

Direct expenses (p. 945)

Hurdle rate (p. 953)

Indirect expenses (p. 945)

Investment center (p. 943)

Investment center residual income (p. 953)

Investment center return on total assets (p. 953)

Investment turnover (p. 954)

Joint cost (p. 962)

Market-based transfer price (p. 962)

Negotiated transfer price (p. 962)

Non-value-added time (p. 958)

Profit center (p. 943)

Profit margin (p. 954)

Responsibility accounting budget (p. 944)

Responsibility accounting performance report (p. 944)

Responsibility accounting system (p. 942)

Transfer price (p. 961)

Uncontrollable costs (p. 943)

Value-added time (p. 958)

Key Terms

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966 Chapter 22 Performance Measurement and Responsibility Accounting

1. Why are many companies divided into departments? 2. What is the difference between operating departments and ser-

vice departments? 3. What are controllable costs? 4. Controllable and uncontrollable costs must be identified with a

particular _____ and a definite _____ period. 5. Why should managers be closely involved in preparing

their responsibility accounting budgets? 6. What are two main goals in managerial accounting for re-

porting on and analyzing departments? 7. Is it possible to evaluate a cost center’s profitability?

Explain. 8. What is the difference between direct and indirect expenses? 9. Suggest a reasonable basis for allocating each of the following

indirect expenses to departments: (a) salary of a supervisor who manages several departments, (b) rent, (c) heat, (d) electricity for lighting, (e) janitorial services, (f ) advertising, (g) expired insur- ance on equipment, and (h) property taxes on equipment.

10. Piaggio has many departments. How is a de- partment’s contribution to overhead measured?

11. KTM aims to give its managers timely cost re- ports. In responsibility accounting, who receives timely cost reports and specific cost information? Explain.

12.A What is a transfer price? Under what conditions is a market- based transfer price most likely to be used?

13.B What is a joint cost? How are joint costs usually allocated among the products produced from them?

14.B Give two examples of products with joint costs. 15. Each retail store of Apple has several depart-

ments. Why is it useful for its management to (a) col- lect accounting information about each department and (b) treat each department as a profit center?

16. Polaris delivers its products to locations around the world. List three controllable and three uncontrollable costs for its delivery department.

17. Define and describe cycle time and identify the compo- nents of cycle time.

18. Explain the difference between value-added time and non- value-added time.

19. Define and describe cycle efficiency. 20. Can management of a company such as

Arctic Cat use cycle time and cycle efficiency as useful mea sures of performance? Explain.

Discussion Questions

A(B) Superscript letter A (B) denotes assignments based on Appendix 22A (22B).

Icon denotes assignments that involve decision making.

Apple

2. Indirect expenses a. Cannot be readily traced to one department. b. Are allocated to departments based on the relative benefit

each department receives. c. Are the same as uncontrollable expenses. d. a, b, and c above are all true. e. a and b above are true. 3. A division reports the information below. What is the divi-

sion’s investment (asset) turnover?

a. 37.5% b. 15.0 c. 2.5 d. 2.67 e. 4.0 4. A company operates three retail departments as profit centers,

and the following information is available for each. Which department has the largest dollar amount of departmental

a. Department Y, $ 55,000 b. Department Z, $125,000 c. Department X, $500,000 d. Department Z, $200,000 e. Department X, $ 60,000 5. Using the data in question 4, Department X’s contribution to

overhead as a percentage of sales is a. 20% b. 30% c. 12% d. 48% e. 32%

contribution to overhead and what is the dollar amount contributed?

Allocated

Cost of Direct Indirect

Department Sales Goods Sold Expenses Expenses

X . . . . $500,000 $350,000 $50,000 $40,000

Y . . . . 200,000 75,000 20,000 50,000

Z . . . . 350,000 150,000 75,000 10,000

Sales . . . . . . . . . . . . . . . . . $500,000

Income . . . . . . . . . . . . . . . 75,000

Average assets . . . . . . . . . 200,000

PIAGGIO

KTM

Polaris

Arctic Cat

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Chapter 22 Performance Measurement and Responsibility Accounting 967

QUICK STUDY

QS 22-1 Allocation and measurement terms

C1

In each blank next to the following terms, place the identifying letter of its best description. 1. Cost center 2. Investment center 3. Departmental accounting

system

4. Operating department 5. Profit center 6. Responsibility accounting

system 7. Service department

A. Incurs costs without directly yielding revenues. B. Provides information used to evaluate the performance

of a department. C. Holds manager responsible for revenues, costs, and

investments. D. Engages directly in manufacturing or in making sales

directly to customers. E. Does not directly manufacture products but contributes

to profitability of the entire company. F. Incurs costs and also generates revenues. G. Provides information used to evaluate the performance

of a department manager.

For each of the following types of indirect expenses and service department expenses, identify one allocation basis that could be used to distribute it to the departments indicated. 1. Computer service expenses of production scheduling for operating departments. 2. General office department expenses of the operating departments. 3. Maintenance department expenses of the operating departments. 4. Electric utility expenses of all departments.

QS 22-2 Basis for cost allocation

C1

QS 22-3 Responsibility accounting terms

C1

In each blank next to the following terms, place the identifying letter of its best description. 1. Indirect expenses A. Costs not within a manager’s control or influence 2. Controllable costs B. Costs that can be readily traced to a department 3. Direct expenses C. Cost that a manager has the ability to affect 4. Uncontrollable costs D. Costs incurred for the joint benefit of more than one department

Dept. A Dept. B Dept. C

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $53,000 $180,000 $84,000

Cost of goods sold . . . . . . . . . . . . . . 34,185 103,700 49,560

Gross profit . . . . . . . . . . . . . . . . . . . . 18,815 76,300 34,440

Total direct expenses . . . . . . . . . . . . 3,660 37,060 7,386

Contribution to overhead . . . . . . . . $ $ $

Contribution percent . . . . . . . . . . . . % % %

QS 22-4 Departmental contribution to overhead

P3

Use the information in the following table to compute each department’s contribution to overhead (both in dollars and as a percent). Which department contributes the largest dollar amount to total overhead? Which contributes the highest percent (as a percent of sales)? Round percents to one decimal.

QS 22-6 Computing residual income A1

Refer to information in QS 22-5. Assume a target income of 12% of average invested assets. Compute residual income for each division.

QS 22-5 Computing investment center return on assets

A1

Compute return on assets for each of the divisions below (each is an investment center). Comment on the relative performance of each investment center.

Investment Center Net Income Average Assets Return on Assets

Cameras and camcorders . . . . . . . . . . . $4,500,000 $20,000,000 _________

Phones and communications . . . . . . . . . 1,500,000 12,500,000 _________

Computers and accessories . . . . . . . . . 800,000 10,000,000 _________

QS 22-7 Computing profit margin and investment turnover A2

A company’s shipping division (an investment center) has sales of $2,420,000, net income of $516,000, and average invested assets of $2,250,000. Compute the division’s profit margin and investment turnover.

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968 Chapter 22 Performance Measurement and Responsibility Accounting

QS 22-9 Performance measures— balanced scorecard

A3

Classify each of the performance measures below into the most likely balanced scorecard perspective it relates to. Label your answers using C (customer), P (internal process), I (innovation and growth), or F (financial). 1. Customer wait time 2. Number of days of employee absences 3. Profit margin 4. Number of new products introduced 5. Change in market share 6. Employee training sessions attended 7. Length of time raw materials are in inventory 8. Customer satisfaction index

QS 22-8 Performance measures

A1 A2

Fill in the blanks in the schedule below for two separate investment centers A and B. Round answers to the nearest whole percent.

Investment Center

A B

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $________ $10,400,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 352,000 $_________ Average invested assets . . . . . . . . . . . . . . $1,400,000 $_________ Profit margin . . . . . . . . . . . . . . . . . . . . . . . 8% _________% Investment turnover . . . . . . . . . . . . . . . . . ________ 1.5 Return on (assets) investment . . . . . . . . . ________% 12%

Assume Walt Disney uses a balanced scorecard and sets a target of 90% occupancy in its resorts. Using Exhibit 22.22 as a guide, show how the company’s performance on hotel occupancy would appear on a balanced scorecard report.

East Coast West Coast

Current year Prior year Current year Prior year

Hotel occupancy rates . . . . . . . . 89% 86% 92% 93%

QS 22-10 Performance measures— balanced scorecard

A3

Walt Disney reports the following information for its two Parks and Resorts divisions.

QS 22-11A

Determining transfer prices without excess capacity

C2

The Windshield division of Fast Car Co. makes windshields for use in Fast Car’s Assembly division. The Windshield division incurs variable costs of $200 per windshield and has capacity to make 500,000 windshields per year. The market price is $450 per windshield. The Windshield division incurs total fixed costs of $3,000,000 per year. If the Windshield division is operating at full capacity, what transfer price should be used on transfers between the Windshield and Assembly divisions? Explain.

QS 22-12A

Determining transfer prices with excess capacity C2

Refer to information in QS 22-11. If the Windshield division has excess capacity, what is the range of possible transfer prices that could be used on transfers between the Windshield and Assembly divisions? Explain.

QS 22-13B

Joint cost allocation

C3

A company purchases a 10,020 square foot commercial building for $325,000 and spends an additional $50,000 to divide the space into two separate rental units and prepare it for rent. Unit A, which has the desirable location on the corner and contains 3,340 square feet, will be rented for $1.00 per square foot. Unit B contains 6,680 square feet and will be rented for $0.75 per square foot. How much of the joint cost should be assigned to Unit B using the value basis of allocation?

QS 22-14 Rent expense allocated to departments

P2

Car Mart pays $130,000 rent each year for its two-story building. The space in this building is occupied by five departments as specified here.

Paint department . . . . . . . . . . . . 1,440 square feet of first-floor space Engine department . . . . . . . . . . . 3,360 square feet of first-floor space Window department . . . . . . . . . 2,016 square feet of second-floor space Electrical department . . . . . . . . . 960 square feet of second-floor space Accessory department . . . . . . . . 1,824 square feet of second-floor space

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Chapter 22 Performance Measurement and Responsibility Accounting 969

The company allocates 65% of total rent expense to the first floor and 35% to the second floor, and then allocates rent expense for each floor to the departments occupying that floor on the basis of space occupied. Determine the rent expense to be allocated to each department. (Round percents to the nearest one-tenth and dollar amounts to the nearest whole dollar.)

Check Allocated to Paint Dept., $25,350

For a recent year L’Oreal reported operating profit of €3,385 (in millions) for its Cosmetics division. Total assets were €12,888 at the beginning of the year and €13,099 (in millions) at the end of the year. Compute return on investment for the year. State your answer as a percent, rounded to one decimal.

QS 22-15 Return on investment A1

EXERCISES

Exercise 22-1 Departmental expense allocations

P2

Woh Che Co. has four departments: materials, personnel, manufacturing, and packaging. In a recent month, the four departments incurred three shared indirect expenses. The amounts of these indirect expenses and the bases used to allocate them follow.

Indirect Expense Cost Allocation Base

Supervision . . . . . . . . . . . . . . $ 82,500 Number of employees Utilities . . . . . . . . . . . . . . . . . 50,000 Square feet occupied Insurance . . . . . . . . . . . . . . . . 22,500 Value of assets in use Total . . . . . . . . . . . . . . . . . . . . $155,000

Departmental data for the company’s recent reporting period follow.

Department Employees Square Feet Asset Values

Materials . . . . . . . . . . . . 27 25,000 $ 6,000 Personnel . . . . . . . . . . . . 9 5,000 1,200 Manufacturing . . . . . . . . 63 55,000 37,800 Packaging . . . . . . . . . . . . 51 15,000 15,000 Total . . . . . . . . . . . . . . . 150 100,000 $60,000

(1) Use this information to allocate each of the three indirect expenses across the four departments. (2) Prepare a summary table that reports the indirect expenses assigned to each of the four departments.

Check (2) Total of $29,600 assigned to Materials Dept.

Process time . . . . . . . . . 15 minutes Inspection time . . . . . . . 2 minutes Move time . . . . . . . . . . . 6.4 minutes Wait time . . . . . . . . . . . 36.6 minutes

QS 22-16 Manufacturing cycle time and efficiency

A4

Compute and interpret (a) manufacturing cycle time and (b) manufacturing cycle efficiency using the following information from a manufacturing company.

QS 22-17 Allocating costs to departments

P1

Macee Department Store has three departments, and it conducts advertising campaigns that benefit all departments. Advertising costs are $100,000 this year, and departmental sales for this year follows. How much advertising cost is allocated to each department if the allocation is based on departmental sales?

Department Sales

Department 1 . . . . . . . . $220,000 Department 2 . . . . . . . . 400,000 Department 3 . . . . . . . . 180,000

QS 22-18 Allocating costs to departments

P1

Mervon Company has two operating departments: Mixing and Bottling. Mixing has 300 employees and occupies 22,000 square feet. Bottling has 200 employees and occupies 18,000 square feet. Indirect factory costs for the current period follow: Administrative, $160,000; and Maintenance, $200,000. Administrative costs are allocated to operating departments based on the number of workers. Determine the administrative cost allocated to each operating department.

QS 22-19 Allocating costs to departments

P1

Refer to the information in QS 22-18. If the maintenance costs are allocated to operating departments based on square footage, determine the amount of maintenance costs allocated to each operating department.

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970 Chapter 22 Performance Measurement and Responsibility Accounting

Revenues

Sales of parts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 72,000

Sales of services . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000 $177,000

Costs and expenses

Cost of parts sold . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Building depreciation . . . . . . . . . . . . . . . . . . . . . . . 9,300

Income taxes allocated to department . . . . . . . . . 8,700

Interest on long-term debt . . . . . . . . . . . . . . . . . . 7,500

Manager’s salary . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Payroll taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,900

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400

Wages (hourly) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

Total costs and expenses . . . . . . . . . . . . . . . . . . . . 111,900

Departmental net income . . . . . . . . . . . . . . . . . . . . . $ 65,100

Exercise 22-4 Departmental expense allocation spreadsheet

P2

Marathon Running Shop has two service departments (advertising and administration) and two operating departments (shoes and clothing). During 2013, the departments had the following direct expenses and occupied the following amount of floor space.

Department Direct Expenses Square Feet

Advertising . . . . . . . . . . $ 18,000 1,120

Administrative . . . . . . . . 25,000 1,400

Shoes . . . . . . . . . . . . . . . 103,000 7,140

Clothing . . . . . . . . . . . . . 15,000 4,340

Exercise 22-3 Departmental contribution report

P3

Below are departmental income statements for a guitar manufacturer. The manufacturer is considering dropping its electric guitar department since it has a net loss. The company classifies advertising, rent, and utilities expenses as indirect. (1) Prepare a departmental contribution report that shows each department’s contribution to overhead. (2) Based on contribution to overhead, should the electric guitar department be eliminated?

WHOLESALE GUITARS

Departmental Income Statements

For Year Ended December 31, 2013

Acoustic Electric

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $111,500 $105,500

Cost of goods sold . . . . . . . . . . . . . . . . . . . . 55,675 66,750

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . 56,825 38,750

Operating expenses

Advertising expense . . . . . . . . . . . . . . . . . . 8,075 6,250

Depreciation expense-equipment . . . . . . . 10,150 9,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . 17,300 13,500

Supplies expense . . . . . . . . . . . . . . . . . . . . 2,030 1,700

Rent expense . . . . . . . . . . . . . . . . . . . . . . . 6,105 5,950

Utilities expense. . . . . . . . . . . . . . . . . . . . . 3,045 2,550

Total operating expenses . . . . . . . . . . . . . . . . 46,705 38,950

Net income (loss) . . . . . . . . . . . . . . . . . . . $ 10,120 ($200)

Maryanne Dinardo manages an auto dealership’s service department. The recent month’s income state- ment for his department follows. (1) Analyze the items on the income statement and identify those that definitely should be included on a performance report used to evaluate Dinardo’s performance. List them and explain why you chose them. (2) List and explain the items that should definitely be excluded. (3) List the items that are not definitely included or excluded and explain why they fall into that category.

Exercise 22-2 Managerial performance evaluation

P1

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Chapter 22 Performance Measurement and Responsibility Accounting 971

The advertising department developed and distributed 120 advertisements during the year. Of these, 90 promoted shoes and 30 promoted clothing. The store sold $350,000 of merchandise during the year. Of this amount, $273,000 is from the shoes department, and $77,000 is from the clothing department. The utilities expense of $64,000 is an indirect expense to all departments. Prepare a departmental expense allocation spreadsheet for Marathon Running Shop. The spreadsheet should assign (1) direct expenses to each of the four departments, (2) the $64,000 of utilities expense to the four departments on the basis of floor space occupied, (3) the advertising department’s expenses to the two operating departments on the basis of the number of ads placed that promoted a department’s products, and (4) the administrative department’s expenses to the two operating departments based on the amount of sales. Provide supporting computations for the expense allocations.

Check Total expenses allocated to Shoes Dept., $177,472

Exercise 22-5 Service department expenses allocated to operating departments P2

The following is a partially completed lower section of a departmental expense allocation spreadsheet for Cozy Bookstore. It reports the total amounts of direct and indirect expenses allocated to its five departments. Complete the spreadsheet by allocating the expenses of the two service departments (advertising and purchasing) to the three operating departments.

Service department expenses

Total expenses allocated to

Total department expenses..........

Advertising department............. Purchasing department.............

operating departments..............

Allocation of Expenses to Departments

$698,000

?

$24,000

$ 0

?

$34,000

$ 0

?

$425,000

? ?

?

$90,000

? ?

?

$125,000

? ?

?

Sales Purch. orders

Advertising Dept.

Allocation Base

Expense Account Balance

Purchasing Dept.

Books Dept.

Magazines Dept.

Newspapers Dept.

Advertising and purchasing department expenses are allocated to operating departments on the basis of dollar sales and purchase orders, respectively. Information about the allocation bases for the three operating departments follows.

Check Total expenses allocated to Books Dept., $452,820

Department Sales Purchase Orders

Books . . . . . . . . . . . . . . . $495,000 516

Magazines . . . . . . . . . . . . 198,000 360

Newspapers . . . . . . . . . . 207,000 324

Total . . . . . . . . . . . . . . . . $900,000 1,200

Exercise 22-6 Indirect payroll expense allocated to departments

P2

Jessica Porter works in both the jewelry department and the hosiery department of a retail store. Porter assists customers in both departments and arranges and stocks merchandise in both departments. The store allocates Porter’s $30,000 annual wages between the two departments based on a sample of the time worked in the two departments. The sample is obtained from a diary of hours worked that Porter kept in a randomly chosen two-week period. The diary showed the following hours and activities spent in the two departments. Allocate Porter’s annual wages between the two departments.

Check Assign $7,500 to Hosiery

Selling in jewelry department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 hours

Arranging and stocking merchandise in jewelry department . . . . . . . . . . . . . . . . . . . . . . . . . 6 hours

Selling in hosiery department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 hours

Arranging and stocking merchandise in hosiery department . . . . . . . . . . . . . . . . . . . . . . . . 7 hours

Idle time spent waiting for a customer to enter one of the selling departments . . . . . . . . 4 hours

You must prepare a return on investment analysis for the regional manager of Fast & Great Burgers. This growing chain is trying to decide which outlet of two alternatives to open. The first location (A) requires a $1,000,000 investment and is expected to yield annual net income of $160,000. The second location (B) requires a $600,000 investment and is expected to yield annual net income of $108,000. Compute the return on investment for each Fast & Great Burgers alternative and then make your recommendation in a one-half page memorandum to the regional manager. (The chain currently generates an 18% return on total assets.)

Exercise 22-7 Investment center analysis

A1

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972 Chapter 22 Performance Measurement and Responsibility Accounting

Exercise 22-8 Computing return on assets and residual income; investing decision

A1

Megamart, a retailer of consumer goods, provides the following information on two of its departments (each considered an investment center).

Net Average

Investment Center Sales Income Invested Assets

Electronics . . . . . . . . . . . . . . . . . . $40,000,000 $2,880,000 $16,000,000

Sporting goods . . . . . . . . . . . . . . . 20,000,000 2,040,000 12,000,000

(1) Compute return on investment for each department. Using return on investment, which department is most efficient at using assets to generate returns for the company? (2) Assume a target income level of 12% of average invested assets. Compute residual income for each department. Which department gener- ated the most residual income for the company? (3) Assume the Electronics department is presented with a new investment opportunity that will yield a 15% return on assets. Should the new investment opportunity be accepted? Explain.

Exercise 22-9 Computing margin and turnover; department efficiency A2

Refer to information in Exercise 22-8. Compute profit margin and investment turnover for each depart- ment. Which department generates the most net income per dollar of sales? Which department is most efficient at generating sales from average invested assets?

Exercise 22-11A

Determining transfer prices

C2

The Trailer department of Baxter Bicycles makes bike trailers that attach to bicycles and can carry children or cargo. The trailers have a retail price of $200 each. Each trailer incurs $80 of variable manufacturing costs. The Trailer department has capacity for 40,000 trailers per year, and incurs fixed costs of $1,000,000 per year.

Required

1. Assume the Assembly division of Baxter Bicycles wants to buy 15,000 trailers per year from the Trailer division. If the Trailer division can sell all of the trailers it manufactures to outside customers, what price should be used on transfers between Baxter Bicycle’s divisions? Explain.

2. Assume the Trailer division currently only sells 20,000 trailers to outside customers, and the Assem- bly division wants to buy 15,000 trailers per year from the Trailer division. What is the range of ac- ceptable prices that could be used on transfers between Baxter Bicycle’s divisions? Explain.

3. Assume transfer prices of either $80 per trailer or $140 per trailer are being considered. Comment on the preferred transfer prices from the perspectives of the Trailer division manager, the Assembly division manager, and the top management of Baxter Bicycles.

Exercise 22-10 Performance measures— balanced scorecard

A3

USA Airlines uses the following performance measures. Classify each of the performance measures be- low into the most likely balanced scorecard perspective it relates to. Label your answers using C (cus- tomer), P (internal process), I (innovation and growth), or F (financial). 1. Cash flow from operations 2. Number of reports of mishandled or lost baggage 3. Percentage of on-time departures 4. On-time flight percentage 5. Percentage of ground crew trained 6. Return on investment 7. Market value 8. Accidents or safety incidents per mile flown 9. Customer complaints

10. Flight attendant training sessions attended 11. Time airplane is on ground between flights 12. Airplane miles per gallon of fuel 13. Revenue per seat 14. Cost of leasing airplanes

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Chapter 22 Performance Measurement and Responsibility Accounting 973

Exercise 22-13 B

Joint product costs assigned

C3

Pirate Seafood Company purchases lobsters and processes them into tails and flakes. It sells the lobster tails for $21 per pound and the flakes for $14 per pound. On average, 100 pounds of lobster are processed into 52 pounds of tails and 22 pounds of flakes, with 26 pounds of waste. Assume that the company purchased 2,400 pounds of lobster for $4.50 per pound and processed the lobsters with an additional labor cost of $1,800. No materials or labor costs are assigned to the waste. If 1,096 pounds of tails and 324 pounds of flakes are sold, what is (1) the allocated cost of the sold items and (2) the allocated cost of the ending inventory? The company allocates joint costs on a value basis. (Round the dollar cost per pound to the nearest thousandth.)

Check (2) Inventory cost, $2,268

Heart & Home Properties is developing a subdivision that includes 600 home lots. The 450 lots in the Canyon section are below a ridge and do not have views of the neighboring canyons and hills; the 150 lots in the Hilltop section offer unobstructed views. The expected selling price for each Canyon lot is $55,000 and for each Hilltop lot is $110,000. The developer acquired the land for $4,000,000 and spent another $3,500,000 on street and utilities improvements. Assign the joint land and improvement costs to the lots using the value basis of allocation and determine the average cost per lot.

Exercise 22-12B

Joint real estate costs assigned

C3

Check Total Hilltop cost, $3,000,000

1. Compute profit margin for each division. State your answers as percents, rounded to two decimal places. Which L’Oreal division has the highest profit margin?

2. Compute investment turnover for each division. Round your answers to two decimal places. Which L’Oreal division has the best investment turnover?

Exercise 22-14 Profit margin and investment turnover

A2

L’Oreal reports the following for a recent year for the major divisions in its Cosmetics branch.

Total Assets Total Assets

(€ millions) Sales Income End of Year Beginning of Year

Professional products . . . . . . . . € 2,717 € 552 € 2,624 € 2,516

Consumer products . . . . . . . . . 9,530 1,765 5,994 5,496

Luxury products . . . . . . . . . . . . 4,507 791 3,651 4,059

Active cosmetics . . . . . . . . . . . . 1,386 278 830 817

Total . . . . . . . . . . . . . . . . . . . . . . €18,140 €3,386 €13,099 €12,888

National Bank has several departments that occupy both floors of a two-story building. The depart mental accounting system has a single account, Building Occupancy Cost, in its ledger. The types and amounts of occupancy costs recorded in this account for the current period follow.

PROBLEM SET A

Problem 22-1A Allocation of building occupancy costs to departments

P2 Depreciation—Building . . . . . . . . . . . . . $18,000

Interest—Building mortgage . . . . . . . . . 27,000

Taxes—Building and land . . . . . . . . . . . 9,000

Gas (heating) expense . . . . . . . . . . . . . . 3,000

Lighting expense . . . . . . . . . . . . . . . . . . 3,000

Maintenance expense . . . . . . . . . . . . . . 6,000

Total occupancy cost . . . . . . . . . . . . . . $66,000

mhhe.com/wildFINMAN5e

The building has 4,000 square feet on each floor. In prior periods, the accounting manager merely divided the $66,000 occupancy cost by 8,000 square feet to find an average cost of $8.25 per square foot and then charged each department a building occupancy cost equal to this rate times the number of square feet that it occupied. Diane Linder manages a first-floor department that occupies 1,000 square feet, and Juan Chiro manages a second-floor department that occupies 1,800 square feet of floor space. In discussing the departmental reports, the second-floor manager questions whether using the same rate per square foot for all departments makes sense because the first-floor space is more valuable. This manager also references a recent real estate study of average local rental costs for similar space that shows first-floor space worth $30 per square foot and second- floor space worth $20 per square foot (excluding costs for heating, lighting, and maintenance).

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974 Chapter 22 Performance Measurement and Responsibility Accounting

Problem 22-3A Responsibility accounting performance reports; controllable and budgeted costs P1

Billie Whitehorse, the plant manager of Travel Free’s Indiana plant, is responsible for all of that plant’s costs other than her own salary. The plant has two operating departments and one service department. The camper and trailer operating departments manufacture different products and have their own managers. The office de- partment, which Whitehorse also manages, provides services equally to the two operating departments. A budget is prepared for each operating department and the office department. The company’s responsibility ac- counting system must assemble information to present budgeted and actual costs in performance reports for each operating department manager and the plant manager. Each performance report includes only those costs

Problem 22-2A Departmental income statements; forecasts

P3

Williams Company began operations in January 2013 with two operating (selling) departments and one service (office) department. Its departmental income statements follow.

WILLIAMS COMPANY

Departmental Income Statements

For Year Ended December 31, 2013

Clock Mirror Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $130,000 $55,000 $185,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 63,700 34,100 97,800

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,300 20,900 87,200

Direct expenses

Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 7,000 27,000

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200 500 1,700

Store supplies used . . . . . . . . . . . . . . . . . . . . . . . 900 400 1,300

Depreciation — Equipment . . . . . . . . . . . . . . . . . 1,500 300 1,800

Total direct expenses . . . . . . . . . . . . . . . . . . . . . . 23,600 8,200 31,800

Allocated expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,020 3,780 10,800

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . 2,600 1,400 4,000

Share of office department expenses . . . . . . . . . 10,500 4,500 15,000

Total allocated expenses . . . . . . . . . . . . . . . . . . . 20,120 9,680 29,800

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,720 17,880 61,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,580 $ 3,020 $ 25,600

mhhe.com/wildFINMAN5e

Williams plans to open a third department in January 2014 that will sell paintings. Management predicts that the new department will generate $50,000 in sales with a 55% gross profit margin and will require the fol- lowing direct expenses: sales salaries, $8,000; advertising, $800; store supplies, $500; and equipment depre- ciation, $200. It will fit the new department into the current rented space by taking some square footage from the other two departments. When opened the new painting department will fill one-fifth of the space pres- ently used by the clock department and one-fourth used by the mirror department. Management does not predict any increase in utilities costs, which are allocated to the departments in proportion to occupied space (or rent expense). The company allocates office department expenses to the operating departments in propor- tion to their sales. It expects the painting department to increase total office department expenses by $7,000. Since the painting department will bring new customers into the store, management expects sales in both the clock and mirror departments to increase by 8%. No changes for those departments’ gross profit percents or their direct expenses are expected except for store supplies used, which will increase in proportion to sales.

Required

Prepare departmental income statements that show the company’s predicted results of operations for cal- endar year 2014 for the three operating (selling) departments and their combined totals. (Round percents to the nearest one-tenth and dollar amounts to the nearest whole dollar.)

Check 2014 forecasted combined net income (sales), $43,472 ($249,800)

Required

1. Allocate occupancy costs to the Linder and Chiro departments using the current allocation method. 2. Allocate the depreciation, interest, and taxes occupancy costs to the Linder and Chiro departments in

proportion to the relative market values of the floor space. Allocate the heating, lighting, and mainte- nance costs to the Linder and Chiro departments in proportion to the square feet occupied (ignoring floor space market values).

Analysis Component

3. Which allocation method would you prefer if you were a manager of a second-floor department? Explain.

Check (1) Total allocated to Linder and Chiro, $23,100 (2) Total occupancy cost to Linder, $9,600

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Chapter 22 Performance Measurement and Responsibility Accounting 975

Budget Actual

Campers Trailers Combined Campers Trailers Combined

Raw materials . . . . . . . . . . . . . $195,000 $275,000 $ 470,000 $194,200 $273,200 $ 467,400

Employee wages . . . . . . . . . . . 104,000 205,000 309,000 106,600 206,400 313,000

Dept. manager salary . . . . . . . 43,000 52,000 95,000 44,000 53,500 97,500

Supplies used . . . . . . . . . . . . . . 33,000 90,000 123,000 31,700 91,600 123,300

Depreciation—Equip. . . . . . . . 60,000 125,000 185,000 60,000 125,000 185,000

Utilities . . . . . . . . . . . . . . . . . . . 3,600 5,400 9,000 3,300 5,000 8,300

Building rent . . . . . . . . . . . . . . 5,700 9,300 15,000 5,300 8,700 14,000

Office department costs . . . . . 68,750 68,750 137,500 67,550 67,550 135,100

Totals . . . . . . . . . . . . . . . . . . . . $513,050 $830,450 $1,343,500 $512,650 $830,950 $1,343,600

Budget Actual

Plant manager salary . . . . . . . . . $ 80,000 $ 82,000

Other office salaries . . . . . . . . . 32,500 30,100

Other office costs . . . . . . . . . . . 25,000 23,000

Totals . . . . . . . . . . . . . . . . . . . . . $137,500 $135,100

The office department’s annual budget and its actual costs follow.

Required

1. Prepare responsibility accounting performance reports like those in Exhibit 22.2 that list costs con- trolled by the following:

a. Manager of the camper department. b. Manager of the trailer department. c. Manager of the Indiana plant. In each report, include the budgeted and actual costs and show the amount that each actual cost is over

or under the budgeted amount.

Analysis Component

2. Did the plant manager or the operating department managers better manage costs? Explain.

Check (1a) $500 total over budget

(1c) Indiana plant controllable costs, $1,900 total under budget

that a particular operating department manager can control: raw materials, wages, supplies used, and equipment depreciation. The plant manager is responsible for the department managers’ salaries, utilities, building rent, office salaries other than her own, and other office costs plus all costs controlled by the two operating depart- ment managers. The annual departmental budgets and actual costs for the two operating departments follow.

GEORGIA ORCHARDS

Income Statement

For Year Ended December 31, 2013

No. 1 No. 2 No. 3 Combined

Sales (by grade)

No. 1: 300,000 Ibs. @ $1.50/lb . . . . . . . . . . . . . . . . $450,000

No. 2: 300,000 Ibs. @ $1.00/lb . . . . . . . . . . . . . . . . $300,000

No. 3: 750,000 Ibs. @ $0.25/lb . . . . . . . . . . . . . . . . $ 187,500

Total sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $937,500

Costs

Tree pruning and care @ $0.30/Ib . . . . . . . . . . . . . 90,000 90,000 225,000 405,000

Picking, sorting, and grading @ $0.15/Ib . . . . . . . . . 45,000 45,000 112,500 202,500

Delivery costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 15,000 37,500 67,500

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 150,000 375,000 675,000

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $150,000 $(187,500) $262,500

Georgia Orchards produced a good crop of peaches this year. After preparing the following income state- ment, the company believes it should have given its No. 3 peaches to charity and saved its efforts.

Problem 22-4AB

Allocation of joint costs

C3

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976 Chapter 22 Performance Measurement and Responsibility Accounting

In preparing this statement, the company allocated joint costs among the grades on a physical basis as an equal amount per pound. The company’s delivery cost records show that $30,000 of the $67,500 relates to crating the No. 1 and No. 2 peaches and hauling them to the buyer. The remaining $37,500 of delivery costs is for crating the No. 3 peaches and hauling them to the cannery.

Required

1. Prepare reports showing cost allocations on a sales value basis to the three grades of peaches. Separate the delivery costs into the amounts directly identifiable with each grade. Then allocate any shared de- livery costs on the basis of the relative sales value of each grade.

2. Using your answers to part 1, prepare an income statement using the joint costs allocated on a sales value basis.

Analysis Component

3. Do you think delivery costs fit the definition of a joint cost? Explain.

Check (1) $129,600 tree pruning and care costs allocated to No. 2

(2) Net income from No. 1 & No. 2 peaches, $140,400 & $93,600

Problem 22-5A Manufacturing cycle time and efficiency

A4

Oakwood Company produces maple bookcases to customer order. It received an order from a customer to produce 5,000 bookcases. The following information is available for the production of the bookcases.

Process time . . . . . . . . . . 6.0 days Inspection time . . . . . . . . 0.8 days Move time . . . . . . . . . . . . 3.2 days Wait time . . . . . . . . . . . . 5.0 days

Required

1. Compute the company’s manufacturing cycle time. 2. Compute the company’s manufacturing cycle efficiency. Interpret your answer.

Analysis Component

3. Assume that Oakwood wishes to increase its manufacturing cycle efficiency to 0.75. What are some ways that it can accomplish this?

Check (2) Manufacturing cycle efficiency, 0.40

Indirect costs are allocated as follows: salaries on the basis of sales; insurance and depreciation on the basis of square footage; and office expenses on the basis of number of employees. Additional information about the departments follows.

The company also incurred the following indirect costs.

Salaries . . . . . . . . . . . . . . . . $36,000 Insurance . . . . . . . . . . . . . . 6,000 Depreciation . . . . . . . . . . . 15,000 Office expenses . . . . . . . . . 50,000

Vortex Company operates a retail store with two departments. Information about those departments follows.Problem 22-6A Departmental contribution to income

P1 Department A Department B

Sales . . . . . . . . . . . . . . . . . . . . . $800,000 $450,000 Cost of goods sold . . . . . . . . . 497,000 291,000 Direct expenses Salaries . . . . . . . . . . . . . . . . . 125,000 88,000 Insurance . . . . . . . . . . . . . . . 20,000 10,000 Utilities . . . . . . . . . . . . . . . . . 24,000 14,000 Depreciation . . . . . . . . . . . . 21,000 12,000 Maintenance . . . . . . . . . . . . . 7,000 5,000

Department Square footage Number of employees

A . . . . . . . . . 28,000 75 B . . . . . . . . . 12,000 50

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Chapter 22 Performance Measurement and Responsibility Accounting 977

Required

1. For each department, determine the departmental contribution to overhead and the departmental net income.

2. Should Department B be eliminated? Explain.

Check (1) Dept. A net income, $38,260

PROBLEM SET B

Problem 22-1B Allocation of building occupancy costs to departments

P2

Harmon’s has several departments that occupy all floors of a two-story building that includes a basement floor. Harmon rented this building under a long-term lease negotiated when rental rates were low. The departmental accounting system has a single account, Building Occupancy Cost, in its ledger. The types and amounts of occupancy costs recorded in this account for the current period follow.

Building rent . . . . . . . . . . . . . . . $400,000 Lighting expense . . . . . . . . . . . . 25,000 Cleaning expense . . . . . . . . . . . 40,000 Total occupancy cost . . . . . . . . $465,000

The building has 7,500 square feet on each of the upper two floors but only 5,000 square feet in the base- ment. In prior periods, the accounting manager merely divided the $465,000 occupancy cost by 20,000 square feet to find an average cost of $23.25 per square foot and then charged each department a building occupancy cost equal to this rate times the number of square feet that it occupies. Jordan Style manages a department that occupies 2,000 square feet of basement floor space. In discuss- ing the departmental reports with other managers, she questions whether using the same rate per square foot for all departments makes sense because different floor space has different values. Style checked a recent real estate report of average local rental costs for similar space that shows first-floor space worth $40 per square foot, second-floor space worth $20 per square foot, and basement space worth $10 per square foot (excluding costs for lighting and cleaning).

Required

1. Allocate occupancy costs to Style’s department using the current allocation method. 2. Allocate the building rent cost to Style’s department in proportion to the relative market value of the

floor space. Allocate to Style’s department the lighting and cleaning costs in proportion to the square feet occupied (ignoring floor space market values). Then, compute the total occupancy cost allocated to Style’s department.

Analysis Component

3. Which allocation method would you prefer if you were a manager of a basement department?

Check Total costs allocated to Style’s Dept., (1) $46,500; (2) Total occupancy cost to Style $22,500

Bonanza Entertainment began operations in January 2013 with two operating (selling) departments and one service (office) department. Its departmental income statements follow.

Problem 22-2B Departmental income statements; forecasts P3

BONANZA ENTERTAINMENT

Departmental Income Statements

For Year Ended December 31, 2013

Movies Video Games Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 $200,000 $800,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 154,000 574,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 46,000 226,000 Direct expenses Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000 15,000 52,000 Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500 6,000 18,500 Store supplies used . . . . . . . . . . . . . . . . . . . . . . . 4,000 1,000 5,000 Depreciation—Equipment . . . . . . . . . . . . . . . . . 4,500 3,000 7,500 Total direct expenses . . . . . . . . . . . . . . . . . . . . . . 58,000 25,000 83,000 Allocated expenses Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,000 9,000 50,000 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . 7,380 1,620 9,000 Share of office department expenses . . . . . . . . . 56,250 18,750 75,000 Total allocated expenses . . . . . . . . . . . . . . . . . . . 104,630 29,370 134,000 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162,630 54,370 217,000 Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,370 $ (8,370) $ 9,000

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978 Chapter 22 Performance Measurement and Responsibility Accounting

The company plans to open a third department in January 2014 that will sell compact discs. Management predicts that the new department will generate $300,000 in sales with a 35% gross profit margin and will require the following direct expenses: sales salaries, $18,000; advertising, $10,000; store supplies, $2,000; and equipment depreciation, $1,200. The company will fit the new department into the current rented space by taking some square footage from the other two departments. When opened, the new compact disc de- partment will fill one-fourth of the space presently used by the movie department and one-third of the space used by the video game department. Management does not predict any increase in utilities costs, which are allocated to the departments in proportion to occupied space (or rent expense). The company allocates of- fice department expenses to the operating departments in proportion to their sales. It expects the compact disc department to increase total office department expenses by $10,000. Since the compact disc depart- ment will bring new customers into the store, management expects sales in both the movie and video game departments to increase by 8%. No changes for those departments’ gross profit percents or for their direct expenses are expected, except for store supplies used, which will increase in proportion to sales.

Required

Prepare departmental income statements that show the company’s predicted results of operations for cal- endar year 2014 for the three operating (selling) departments and their combined totals. (Round percents to the nearest one-tenth and dollar amounts to the nearest whole dollar.)

Check 2014 forecasted movies net income (sales), $52,450 ($648,000)

Britney Brown, the plant manager of LMN Co.’s Chicago plant, is responsible for all of that plant’s costs other than her own salary. The plant has two operating departments and one service department. The refrigerator and dishwasher operating departments manufacture different products and have their own managers. The office department, which Brown also manages, provides services equally to the two operat- ing departments. A monthly budget is prepared for each operating department and the office department. The company’s responsibility accounting system must assemble information to present budgeted and ac- tual costs in performance reports for each operating department manager and the plant manager. Each performance report includes only those costs that a particular operating department manager can control: raw materials, wages, supplies used, and equipment depreciation. The plant manager is responsible for the department managers’ salaries, utilities, building rent, office salaries other than her own, and other office costs plus all costs controlled by the two operating department managers. The April departmental budgets and actual costs for the two operating departments follow.

Problem 22-3B Responsibility accounting performance reports; controllable and budgeted costs

P1

The office department’s budget and its actual costs for April follow.

Budget Actual

Refrigerators Dishwashers Combined Refrigerators Dishwashers Combined

Raw materials . . . . . . . . . . . . . . . . . $400,000 $200,000 $ 600,000 $385,000 $202,000 $ 587,000

Employee wages . . . . . . . . . . . . . . . 170,000 80,000 250,000 174,700 81,500 256,200

Dept. manager salary . . . . . . . . . . . 55,000 49,000 104,000 55,000 46,500 101,500

Supplies used . . . . . . . . . . . . . . . . . . 15,000 9,000 24,000 14,000 9,700 23,700

Depreciation — Equip. . . . . . . . . . . . 53,000 37,000 90,000 53,000 37,000 90,000

Utilities . . . . . . . . . . . . . . . . . . . . . . . 30,000 18,000 48,000 34,500 20,700 55,200

Building rent . . . . . . . . . . . . . . . . . . 63,000 17,000 80,000 65,800 16,500 82,300

Office department costs . . . . . . . . . 70,500 70,500 141,000 75,000 75,000 150,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . $856,500 $480,500 $1,337,000 $857,000 $488,900 $1,345,900

Budget Actual

Plant manager salary . . . . . . . . . $ 80,000 $ 85,000

Other office salaries . . . . . . . . . 40,000 35,200

Other office costs . . . . . . . . . . . 21,000 29,800

Totals . . . . . . . . . . . . . . . . . . . . . $141,000 $150,000

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Chapter 22 Performance Measurement and Responsibility Accounting 979

Required

1. Prepare responsibility accounting performance reports like those in Exhibit 22.2 that list costs con- trolled by the following:

a. Manager of the refrigerator department. b. Manager of the dishwasher department. c. Manager of the Chicago plant. In each report, include the budgeted and actual costs for the month and show the amount by which each

actual cost is over or under the budgeted amount.

Analysis Component

2. Did the plant manager or the operating department managers better manage costs? Explain.

Check (1a) $11,300 total under budget

(1c) Chicago plant controllable costs, $3,900 total over budget

Rita and Rick Redding own and operate a tomato grove. After preparing the following income statement, Rita believes they should have offered the No. 3 tomatoes to the public for free and saved themselves time and money.

Problem 22-4BB

Allocation of joint costs

C3

RITA AND RICK REDDING

Income Statement

For Year Ended December 31, 2013

No. 1 No. 2 No. 3 Combined

Sales (by grade)

No. 1: 500,000 Ibs. @ $1.80/lb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900,000

No. 2: 400,000 Ibs. @ $1.25/lb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000

No. 3: 100,000 Ibs. @ $0.40/lb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000

Total sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,440,000

Costs

Land preparation, seeding, and cultivating @ $0.70/Ib . . . . . . . . . 350,000 280,000 70,000 700,000

Harvesting, sorting, and grading @ $0.04/Ib . . . . . . . . . . . . . . . . . . . 20,000 16,000 4,000 40,000

Delivery costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 7,000 3,000 20,000

Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 303,000 77,000 760,000

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $520,000 $197,000 $(37,000) $ 680,000

In preparing this statement, Rita and Rick allocated joint costs among the grades on a physical basis as an equal amount per pound. Also, their delivery cost records show that $17,000 of the $20,000 relates to crat- ing the No. 1 and No. 2 tomatoes and hauling them to the buyer. The remaining $3,000 of delivery costs is for crating the No. 3 tomatoes and hauling them to the cannery.

Required

1. Prepare reports showing cost allocations on a sales value basis to the three grades of tomatoes. Sepa- rate the delivery costs into the amounts directly identifiable with each grade. Then allocate any shared delivery costs on the basis of the relative sales value of each grade. (Round percents to the nearest one- tenth and dollar amounts to the nearest whole dollar.)

2. Using your answers to part 1, prepare an income statement using the joint costs allocated on a sales value basis.

Analysis Component

3. Do you think delivery costs fit the definition of a joint cost? Explain.

Check (1) $1,120 harvesting, sorting and grading costs allocated to No. 3

(2) Net income from No. 1 & No. 2 tomatoes, $426,569 & $237,151

Process time . . . . . . . . . . 16.0 hours

Inspection time . . . . . . . . 3.5 hours

Move time . . . . . . . . . . . . 9.0 hours

Wait time . . . . . . . . . . . . 21.5 hours

Best Ink produces ink-jet printers for personal computers. It received an order for 500 printers from a customer. The following information is available for this order.

Problem 22-5B Manufacturing cycle time and efficiency

A4

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980 Chapter 22 Performance Measurement and Responsibility Accounting

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 22 Adria Lopez’s two departments, computer consulting services and computer workstation furni- ture manufacturing, have each been profitable. Adria has heard of the balanced scorecard and wants you to provide details on how it could be used to measure performance of her departments.

Required

1. Explain the four performance perspectives included in a balanced scorecard. 2. For each of the four performance perspectives included in a balanced scorecard, provide examples of

measures Adria could use to measure performance of her departments.

SERIAL PROBLEM Success Systems

A3

Required

1. Compute the company’s manufacturing cycle time. 2. Compute the company’s manufacturing cycle efficiency. Interpret your answer.

Analysis Component

3. Assume that Best Ink wishes to increase its manufacturing cycle efficiency to 0.80. What are some ways that it can accomplish this?

The company also incurred the following indirect costs.

Indirect costs are allocated as follows: advertising on the basis of sales; salaries on the basis of number of employees; and office expenses on the basis of square footage. Additional information about the departments follows.

Department Square footage Number of employees

Videos . . . . . . . . 5,000 3

Music . . . . . . . . . 3,000 2

Advertising . . . . . . . . . . . . $15,000

Salaries . . . . . . . . . . . . . . . . 27,000

Office expenses . . . . . . . . 3,200

Sadar Company operates a store with two departments: videos and music. Information about those departments follows.

Problem 22-6B Departmental contribution to income

P1 Videos Department Music Department

Sales . . . . . . . . . . . . . . . . . . . . . $370,500 $279,500

Cost of goods sold . . . . . . . . . 320,000 175,000

Direct expenses

Salaries . . . . . . . . . . . . . . . . . 35,000 25,000

Maintenance . . . . . . . . . . . . 12,000 10,000

Utilities . . . . . . . . . . . . . . . . 5,000 4,500

Insurance . . . . . . . . . . . . . . . 4,200 3,700

Check (1) Music dept. net income, $42,850

Required

1. For each department, determine the departmental contribution to overhead and the departmental net income.

2. Should the video department be eliminated? Explain.

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Chapter 22 Performance Measurement and Responsibility Accounting 981

BTN 22-3 Senior Security Co. offers a range of security services for senior citizens. Each type of ser- vice is considered within a separate department. Mary Pincus, the overall manager, is compensated partly on the basis of departmental performance by staying within the quarterly cost budget. She often revises operations to make sure departments stay within budget. Says Pincus, “I will not go over budget even if it means slightly compromising the level and quality of service. These are minor compromises that don’t significantly affect my clients, at least in the short term.”

Required

1. Is there an ethical concern in this situation? If so, which parties are affected? Explain. 2. Can Mary Pincus take action to eliminate or reduce any ethical concerns? Explain. 3. What is Senior Security’s ethical responsibility in offering professional services?

ETHICS CHALLENGE P3

Beyond the Numbers

BTN 22-1 Review Polaris’s income statement in Appendix A and identify its revenues for the years ended December 31, 2011, December 31, 2010, and December 31, 2009. For the year ended December 31, 2011, Polaris reports the following product revenue mix. (Assume that its product revenue mix is the same for each of the three years reported when answering the requirements.)

Required

1. Compute the amount of revenue from each of its product lines for the years ended December 31, 2011, December 31, 2010, and December 31, 2009.

2. If Polaris wishes to evaluate each of its product lines, how can it allocate its operating expenses to each of them to determine each product line’s profitability?

Fast Forward

3. Access Polaris’s annual report for a fiscal year ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (sec.gov). Compute its revenues for its product lines for the most recent year(s). Compare those results to those from part 1. How has its product mix changed?

Off-Road Vehicles Snowmobiles On-Road Vehicles Parts, Garments, & Accessories

69% 11% 5% 15%

REPORTING IN ACTION C1

Polaris

BTN 22-2 Polaris and Arctic Cat compete in several on-road and off-road motorized vehicle categories. Sales, income, and asset information is provided for each company below.

(in thousands) Polaris Arctic Cat

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,656,949 $464,651

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 227,575 13,007

Invested assets, beginning of year . . . . . . . . . 1,061,647 246,084

Invested assets, end of year . . . . . . . . . . . . . . 1,228,024 272,906

COMPARATIVE ANALYSIS A2 Polaris Arctic Cat

Required

1. Compute profit margin for each company. 2. Compute investment turnover for each company.

Analysis Component

3. Using your answers to the questions above, compare the companies’ performance during the most recent year.

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982 Chapter 22 Performance Measurement and Responsibility Accounting

BTN 22-7 Brian Linton’s company, United By Blue, sells jewelry and apparel. His company’s plans call for continued expansion into other types of products.

Required

1. How can United By Blue use departmental income statements to assist in understanding and control- ling operations?

2. Are departmental income statements always the best measure of a department’s performance? Explain.

3. Provide examples of nonfinancial performace indicators United By Blue might use as part of a bal- anced scorecard system of performance evaluation.

ENTREPRENEURIAL DECISION P3

BTN 22-6 Polaris, and Arctic Cat compete across the world in several markets.

Required

1. Design a three-tier responsibility accounting organizational chart assuming that you have available internal information for both companies. Use Exhibit 22.1 as an example. The goal of this assignment is to design a reporting framework for the companies; numbers are not required. Limit your reporting framework to sales activity only.

2. Explain why it is important to have similar performance reports when comparing performance within a company (and across different companies). Be specific in your response.

TEAMWORK IN ACTION P1

Polaris Arctic Cat

BTN 22-4 Improvement Station is a national home improvement chain with more than 100 stores throughout the country. The manager of each store receives a salary plus a bonus equal to a percent of the store’s net income for the reporting period. The following net income calculation is on the Denver store manager’s performance report for the recent monthly period.

COMMUNICATING IN PRACTICE P2

Sales . . . . . . . . . . . . . . . . . . . . . . . . $2,500,000

Cost of goods sold . . . . . . . . . . . . 800,000

Wages expense . . . . . . . . . . . . . . . 500,000

Utilities expense . . . . . . . . . . . . . . 200,000

Home office expense . . . . . . . . . . 75,000

Net income . . . . . . . . . . . . . . . . . . $ 925,000

Manager’s bonus (0.5%) . . . . . . . . $ 4,625

In previous periods, the bonus had also been 0.5%, but the performance report had not included any charges for the home office expense, which is now assigned to each store as a percent of its sales.

Required

Assume that you are the national office manager. Write a one-half page memorandum to your store man- agers explaining why home office expense is in the new performance report.

BTN 22-5 This chapter described and used spreadsheets to prepare various managerial reports (see Exhibit 22-6). You can download from Websites various tutorials showing how spreadsheets are used in managerial accounting and other business applications.

Required

1. Link to the Website Lacher.com. Select “Excel Examples.” Identify and list three tutorials for review. 2. Describe in a one-half page memorandum to your instructor how the applications described in each

tutorial are helpful in business and managerial decision making.

TAKING IT TO THE NET P2

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Chapter 22 Performance Measurement and Responsibility Accounting 983

BTN 22-8 Visit a local movie theater and check out both its concession area and its showing areas. The manager of a theater must confront questions such as:

● How much return do we earn on concessions? ● What types of movies generate the greatest sales? ● What types of movies generate the greatest net income?

Required

Assume that you are the new accounting manager for a 16-screen movie theater. You are to set up a responsibility accounting reporting framework for the theater. 1. Recommend how to segment the different departments of a movie theater for responsibility

reporting. 2. Propose an expense allocation system for heat, rent, insurance, and maintenance costs of the theater.

HITTING THE ROAD C1 P1

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; [$641,250/($356,250 1 $641,250 1 $427,500)] 3 $150,000 5 $67,500 2. d; 3. c; $500,000/200,000 5 2.5 4. b;

5. a; $100,000/$500,000 5 20%

Department Department Department

X Y Z

Sales . . . . . . . . . . . . . . . . . . . . . $500,000 $200,000 $350,000

Cost of goods sold . . . . . . . . . 350,000 75,000 150,000

Gross profit . . . . . . . . . . . . . . . 150,000 125,000 200,000

Direct expenses . . . . . . . . . . . . 50,000 20,000 75,000

Departmental contribution . . . . . . . . . . . . . $100,000 $105,000 $125,000

Required

1. Compute the percentage growth in net sales for each product line from fiscal year 2010 to 2011. Round percents to one decimal.

2. Which product line’s net sales grew the fastest? 3. Which segment was the most profitable? 4. How can Piaggio’s managers use this information?

BTN 22-9 Selected product data from Piaggio (www.piaggio.com) follow.

Net Sales

Gross Margin Product Segment for

Year Ended (millions) December 31, 2011 December 31, 2010 December 31, 2011 December 31, 2010

Two-wheeler vehicles. . . . . . . . . . . . €1,025.3 €988.1 €337.1 €330.7

Commercial vehicles . . . . . . . . . . . . 491.1 497.3 117.5 131.6

GLOBAL DECISION P3

PIAGGIO

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Learning Objectives

CONCEPTUAL

C1 Describe the importance of relevant costs for short-term decisions. (p. 986)

ANALYTICAL

A1 Evaluate short-term managerial decisions using relevant costs. (p. 987) A2 Determine product selling price based on total costs. (p. 994)

PROCEDURAL

P1 Identify relevant costs and apply them to managerial decisions. (p. 988) A Look at This Chapter

This chapter explains several tools and procedures useful for making and evaluating short-term managerial decisions. It also describes how to assess the consequences of such decisions.

A Look Back

Chapter 22 focused on responsibility accounting and performance measurement. We identified several reports useful in measuring and analyzing the activities of a company, its departments, and its managers.

Relevant Costing for Managerial Decisions 23

984

A Look Ahead

Chapter 24 focuses on capital budgeting decisions. It explains and illustrates several methods that help identify projects with the higher return on investment.

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Sweet Success

LOS ANGELES—Noticing long lines and an inadequate supply of sweets to satisfy his high school friends’ cravings, Charlie Fyffe began making brownies and selling them at school. His brownies were an instant hit, and as his clientele and passion for baking grew, so did his desire to start his own business. “I started Charlie’s Brownies (CharliesBrownies.com) because sweets make people happy and baking is a fun industry,” ex- plains Charlie. “I developed a quality original recipe and started selling brownies in simple cake boxes. Staying simple and con- sistent opened the door to a viable business.” After six months of professional baking classes to sharpen his skills, Charlie turned to the business side. “I had a lot to learn,” admits Charlie. “I read entrepreneurial books and did in- ternships to learn how to run a business. Becoming an entrepre- neur was hard work, but it allows me a life of freedom outside the cubicle and the opportunity to pursue my dreams and vi- sions.” Charlie had to learn how to use accounting information to make important business decisions. For example, attention to contribution margins enables Charlie to decide if adding new product lines, like vegan and gluten-free brownies, would increase profits. Focusing on contribution margins, his own and his competition’s, also helps Charlie decide whether to eliminate certain products because they are not profitable. Charlie applies high standards to his production process. Un- like some companies that can rework substandard materials into a viable product, Charlie explains that “raw materials that don’t

meet our standards never enter the baking process.” Further, al- though expensive, exotic ingredients like “Chardonnay-infused sea salts create a pop and that undeniable urge to eat another brownie. It isn’t heavy, and you want another one.” Charlie has also managed to control overhead costs by doing much of the baking, marketing, and delivery himself. “I do whatever it takes to get the job done” he says. “There is never a dull moment!” Much of Charlie’s Brownies business is done online. To meet Charlie’s goal of developing the company into a “nationwide and global Brownie Experience,” he must focus on relevant costs to help him make good decisions. Determining the optimal sales mix requires Charlie to understand product contribution margins. Charlie also explains that “we need to upgrade our space and add to our capacity.” The decision to keep or replace equipment is common in growing businesses, and assessing relevant costs helps Charlie with this and other key managerial decisions. Charlie advises young entrepreneurs to follow their passion. “Hang out with other overachievers and young entrepreneurs to stay one step ahead,” he says. “Stay focused, work hard, and seek guidance from other successful business people.” Sounds like a recipe for success.

[Sources: Charlie’s Brownies Website, January 2013; JaredSurnamer.com, August 2011; PopularFinesse.tumblr.com, October 2011; Twentity.com, February 2011.]

“Put all of your love into your product.” —CHARLIE FYFFE

Decision Insight

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Chapter Preview

Making business decisions involves choosing between alterna- tive courses of action. Many factors affect business decisions, yet analysis typically focuses on finding the alternative that of- fers the highest return on investment or the greatest reduction

in costs. In all situations, managers can reach a sounder deci- sion if they identify the consequences of alternative choices in financial terms. This chapter explains several methods of analy- sis that can help managers make short-term business decisions.

986

Decisions and Information

• Decision making • Relevant costs

Decision Scenarios

• Additional business • Make or buy • Scrap or rework • Sell or process • Sales mix selection • Segment elimination • Keep or replace

Relevant Costing for Managerial Decisions

This section explains how managers make decisions and the information relevant to those decisions.

Decision Making Managerial decision making involves five steps: (1) define the decision task, (2) identify alternative courses of action, (3) collect relevant information and evaluate each alternative, (4) select the preferred course of action, and (5) analyze and assess decisions made. These five steps are illustrated in Exhibit 23.1.

DECISIONS AND INFORMATION

EXHIBIT 23.1 Managerial Decision Making

Define Task and Goal

Identify Alternative Actions

Select Course of Action

Collect Relevant Information

Analyze and Assess Decision

$0 2011 2010 2009 2008 2007

Ratio

15%

0.0%

30%

45%

Task and Goal Millions

$200 $300 $400 $500 $600 $700

$900 $800

Alternative 1

400 600

Alternative 2

C1 Describe the importance of relevant costs for short- term decisions.

Both managerial and financial accounting information play an important role in most manage- ment decisions. The accounting system is expected to provide primarily financial information such as performance reports and budget analyses for decision making. Nonfinancial information is also relevant, however; it includes information on environmental effects, political sensitivi- ties, and social responsibility.

Relevant Costs Most financial measures of revenues and costs from accounting systems are based on historical costs. Although historical costs are important and useful for many tasks such as product pricing and the control and monitoring of business activities, we sometimes find that an analysis of relevant costs, or avoidable costs, is especially useful. Three types of costs are pertinent to our discussion of relevant costs: sunk costs, out-of-pocket costs, and opportunity costs.

This chapter focuses on methods that use accounting information to make important managerial decisions. Most of these cases involve short-term decisions. This differs from methods used for longer-term managerial decisions that are described in the next chapter.

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Chapter 23 Relevant Costing for Managerial Decisions 987

A sunk cost arises from a past decision and cannot be avoided or changed; it is irrelevant to future decisions. An example is the cost of computer equipment previously purchased by a com- pany. Most of a company’s allocated costs, including fixed overhead items such as depreciation and administrative expenses, are sunk costs. An out-of-pocket cost requires a future outlay of cash and is relevant for current and future decision making. These costs are usually the direct result of management’s decisions. For in- stance, future purchases of computer equipment involve out-of-pocket costs. Depreciation and amortization are allocations of the original cost of plant and intangible assets. They are sunk costs, not out-of-pocket costs. An opportunity cost is the potential benefit lost by taking a specific action when two or more alternative choices are available. An example is a student giving up wages from a job to attend summer school. Companies continually must choose from alternative courses of action. For in- stance, a company making standardized products might be approached by a customer to supply a special (nonstandard) product. A decision to accept or reject the special order must consider not only the profit to be made from the special order but also the profit given up by devoting time and resources to this order instead of pursuing an alternative project. The profit given up is an oppor- tunity cost. Consideration of opportunity costs is important. The implications extend to internal resource allocation decisions. For instance, a computer manufacturer must decide between inter- nally manufacturing a chip versus buying it externally. In another case, management of a multi- divisional company must decide whether to continue operating or close a particular division. Besides relevant costs, management must also consider the relevant benefits associated with a decision. Relevant benefits refer to the additional or incremental revenue generated by selecting a particular course of action over another. For instance, a student must decide the relevant benefits of taking one course over another. In sum, both relevant costs and relevant benefits are crucial to managerial decision making.

Point: Opportunity costs are not entered in accounting records. This does not reduce their relevance for managerial decisions.

"Sunk costs are not relevant to my decision."

"I must consider out-of-pocket and opportunity costs."

Managers experience many different scenarios that require analyzing alternative actions and making a decision. We describe several different types of decision scenarios in this section. We set these tasks in the context of FasTrac, an exercise supplies and equipment manufacturer intro- duced earlier. We treat each of these decision tasks as separate from each other.

Additional Business FasTrac is operating at its normal level of 80% of full capacity. At this level, it produces and sells approximately 100,000 units of product annually. Its per unit and annual total sales and costs are shown in Exhibit 23.2.

MANAGERIAL DECISION SCENARIOS

A1 Evaluate short-term managerial decisions using relevant costs.

EXHIBIT 23.2 Selected Operating Income Data

Per Unit Annual Total

Sales (100,000 units) . . . . . . . . . . . . $10.00 $1,000,000

Direct materials . . . . . . . . . . . . . . . . (3.50) (350,000)

Direct labor . . . . . . . . . . . . . . . . . . . (2.20) (220,000)

Overhead . . . . . . . . . . . . . . . . . . . . . (1.10) (110,000)

Selling expenses . . . . . . . . . . . . . . . . (1.40) (140,000)

Administrative expenses . . . . . . . . . (0.80) (80,000)

Total costs and expenses . . . . . . . . . (9.00) (900,000)

Operating income . . . . . . . . . . . . . . $ 1.00 $ 100,000

A current buyer of FasTrac’s products wants to purchase additional units of its product and export them to another country. This buyer offers to buy 10,000 units of the product at $8.50 per unit, or $1.50 less than the current price. The offer price is low, but FasTrac is considering the proposal because this sale would be several times larger than any single previous sale and it would use idle capacity. Also, the units will be exported, so this new business will not affect current sales.

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988 Chapter 23 Relevant Costing for Managerial Decisions

EXHIBIT 23.3 Analysis of Additional Business Using Historical Costs

Per Unit Total

Sales (10,000 additional units) . . . . . . . . . $ 8.50 $ 85,000

Total costs and expenses . . . . . . . . . . . . . (9.00) (90,000)

Operating loss . . . . . . . . . . . . . . . . . . . . . $(0.50) $ (5,000)

To correctly make its decision, FasTrac must analyze the costs of this new business in a dif- ferent manner. The following information regarding the order is available:

● Manufacturing 10,000 additional units requires direct materials of $3.50 per unit and direct labor of $2.20 per unit (same as for all other units).

● Manufacturing 10,000 additional units adds $5,000 of incremental overhead costs for power, packaging, and indirect labor (all variable costs).

● Incremental commissions and selling expenses from this sale of 10,000 additional units would be $2,000 (all variable costs).

● Incremental administrative expenses of $1,000 for clerical efforts are needed (all fixed costs) with the sale of 10,000 additional units.

We use this information, as shown in Exhibit 23.4 to assess how accepting this new business will affect FasTrac’s income.

To determine whether to accept or reject this order, management needs to know whether ac- cepting the offer will increase net income. The analysis in Exhibit 23.3 shows that if manage- ment relies incorrectly on per unit historical costs, it would reject the sale because the selling price ($8.50) per unit is less than the total costs per unit ($9.00), and it thus yields a loss. However, historical costs are not relevant to this decision. Instead, the relevant costs are the ad- ditional costs, called incremental costs. These costs, also called differential costs, are the additional costs incurred if a company pursues a certain course of action. FasTrac’s incremental costs are those related to the added volume that this new order would bring.

EXHIBIT 23.4 Analysis of Additional Business Using Relevant Costs

Additional Current Business Business Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $ 85,000 $1,000,000 $1,085,000

Direct materials . . . . . . . . . . . . . . . . (35,000) (350,000) (385,000)

Direct labor . . . . . . . . . . . . . . . . . . . (22,000) (220,000) (242,000)

Overhead . . . . . . . . . . . . . . . . . . . . . (5,000) (110,000) (115,000)

Selling expenses . . . . . . . . . . . . . . . . (2,000) (140,000) (142,000)

Administrative expense . . . . . . . . . . (1,000) (80,000) (81,000)

Total costs and expenses . . . . . . . . . (65,000) (900,000) (965,000)

Operating income . . . . . . . . . . . . . . $ 20,000 $ 100,000 $ 120,000

Example: Exhibit 23.4 uses quantita- tive information. Suggest some qualitative factors to be considered when deciding whether to accept this project. Answer: (1) Impact on relationships with other customers and (2) Improved relationship with customer buying additional units.

The analysis of relevant costs in Exhibit 23.4 suggests that the additional business be accepted. It would provide $85,000 of added revenue while incurring only $65,000 of added costs. This would yield $20,000 of additional pretax income, or a pretax profit margin of 23.5%. More gener- ally, FasTrac would increase its income with any price that exceeded $6.50 per unit ($65,000 in- cremental costy10,000 additional units). The key point is that management must not blindly use historical costs, especially allocated overhead costs. Instead, the accounting system needs to pro- vide information about the incremental costs to be incurred if the additional business is accepted.

Other Factors An analysis of the incremental costs pertaining to the additional volume is always relevant for this type of decision. We must proceed cautiously, however, when the addi- tional volume approaches or exceeds the factory’s existing available capacity. If the additional volume requires the company to expand its capacity by obtaining more equipment, more space, or more personnel, the incremental costs could quickly exceed the incremental revenue. Another

P1 Identify relevant costs and apply them to managerial decisions.

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Chapter 23 Relevant Costing for Managerial Decisions 989

cautionary note is the effect on existing sales. All new units of the extra business will be sold outside FasTrac’s normal domestic sales channels. If accepting additional business would cause existing sales to decline, this information must be included in our analysis. The contribution margin lost from a decline in sales is an opportunity cost.

Make or Buy The managerial decision to make or buy a component for one of its current products is common and depends on incremental costs. To illustrate, FasTrac has excess productive capacity it can use to manufacture Part 417, a component of the main product it sells. The part is currently purchased and delivered to the plant at a cost of $1.20 per unit. FasTrac estimates that making Part 417 would cost $0.45 for direct materials, $0.50 for direct labor, and an undetermined amount for overhead. The task is to determine how much overhead to add to these costs so we can decide whether to make or buy Part 417. If FasTrac’s normal predetermined overhead application rate is 100% of direct labor cost, we might be tempted to conclude that overhead cost is $0.50 per unit, computed as 100% of the $0.50 direct labor cost. We would then mistakenly conclude that total cost is $1.45 per unit ($0.45 of materials 1 $0.50 of labor 1 $0.50 of overhead). A wrong decision in this case would be to con- clude that the company is better off buying the part at $1.20 each than making it for $1.45 each. Instead, as we explained earlier, only incremental overhead costs are relevant in this situa- tion. Thus, we must compute an incremental overhead rate. Incremental overhead costs might include, for example, additional power for operating machines, extra supplies, added cleanup costs, materials handling, and quality control. We can prepare a per unit analysis in this case as shown in Exhibit 23.5.

Partner You are a partner in a small accounting firm that specializes in keeping the books and preparing taxes for clients. A local restaurant is interested in obtaining these services from your firm. Identify factors that are relevant in deciding whether to accept the engagement. ■ [Answer—p. 998]

Decision Maker

EXHIBIT 23.5 Make or Buy Analysis

Make Buy

Direct materials . . . . . . . . . . . . . . . . . . $0.45 —

Direct labor . . . . . . . . . . . . . . . . . . . . . 0.50 —

Overhead costs . . . . . . . . . . . . . . . . [?] —

Purchase price . . . . . . . . . . . . . . . . . . . — $ 1.20

Total incremental costs . . . . . . . . . $0.95 1 [?] $1.20

We can see that if incremental overhead costs are less than $0.25 per unit, ($1.20 2 $0.95) the total cost of making the component is less than the purchase price of $1.20 and FasTrac should make the part. FasTrac’s decision rule in this case is that any amount of overhead less than $0.25 per unit yields a total cost for Part 417 that is less than the $1.20 purchase price. FasTrac must consider several nonfinancial factors in the make or buy decision, includ- ing product quality, timeliness of delivery (especially in a just-in-time setting), reactions of customers and suppliers, and other intangibles such as employee morale and workload. It must also consider whether making the part requires incremental fixed costs to expand plant capacity. When these added factors are considered, small cost differences may not matter.

Make or Buy IT Companies apply make or buy decisions to their services. Many now outsource their information technology activities. Information technology companies provide infrastruc- ture and services to enable businesses to focus on their key ac- tivities. It is argued that outsourcing saves money and streamlines operations, and without the headaches. ■

Decision Insight

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990 Chapter 23 Relevant Costing for Managerial Decisions

Scrap or Rework Managers often must make a decision on whether to scrap or rework products in process. Re- member that costs already incurred in manufacturing the units of a product that do not meet quality standards are sunk costs that have been incurred and cannot be changed. Sunk costs are irrelevant in any decision on whether to sell the substandard units as scrap or to rework them to meet quality standards.

To illustrate, assume that FasTrac has 10,000 defective units of a product that have already cost $1 per unit to manufacture. These units can be sold as is (as scrap) for $0.40 each, or they can be reworked for $0.80 per unit and then sold for their full price of $1.50 each. Should FasTrac sell the units as scrap or rework them? To make this decision, management must recognize that the already incurred manufacturing costs of $1 per unit are sunk (unavoidable). These costs are entirely irrelevant to the decision. In addition, we must be certain that all costs of reworking defects, including interfering with normal operations, are accounted for in our analysis. For instance, reworking the defects means that FasTrac is unable to manufacture 10,000 new units with an incremental cost of $1 per unit and a selling price of $1.50 per unit, meaning it incurs an opportunity cost equal to the lost $5,000 net return from making and selling 10,000 new units. This opportunity cost is the differ- ence between the $15,000 revenue (10,000 units 3 $1.50) from selling these new units and their $10,000 manufacturing costs (10,000 units 3 $1). Our analysis is reflected in Exhibit 23.6.

EXHIBIT 23.6 Scrap or Rework Analysis

Scrap Rework

Sale of scrapped/reworked units (10,000 units) . . . . . . . . . . . . . . . . . . . . $ 4,000 $ 15,000

Less out-of-pocket costs to rework defects ($0.80 per unit) . . . . . . . . . (8,000)

Less opportunity cost of not making new units . . . . . . . . . . . . . . (5,000)

Incremental net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000 $ 2,000

The analysis yields a $2,000 difference in favor of scrapping the defects, yielding a total incre- mental net income of $4,000. If we had failed to include the opportunity costs of $5,000, the rework option would have shown an income of $7,000 instead of $2,000, mistakenly making reworking appear more favorable than scrapping.

1. A company receives a special order for 200 units that requires stamping the buyer’s name on each unit, yielding an additional fixed cost of $400 to its normal costs. Without the order, the company is operating at 75% of capacity and produces 7,500 units of product at the following costs:

Direct materials . . . . . . . . . . . . . . . . . . . . . . $37,500

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Overhead (30% variable) . . . . . . . . . . . . . . . 20,000

Selling expenses (60% variable) . . . . . . . . . . 25,000

The special order will not affect normal unit sales and will not increase fixed overhead and selling expenses. Variable selling expenses on the special order are reduced to one-half the normal amount. The price per unit necessary to earn $1,000 on this order is (a) $14.80, (b) $15.80, (c) $19.80, (d) $20.80, or (e) $21.80.

2. What are the incremental costs of accepting additional business?

Quick Check Answers — p. 998

Sell or Process The managerial decision to sell partially completed products as is or to process them further for sale depends significantly on relevant costs. To illustrate, suppose that FasTrac has 40,000 units of partially finished Product Q. It has already spent $0.75 per unit to manufacture these 40,000 units

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at a $30,000 total cost. FasTrac can sell the 40,000 units to another manufacturer as raw material for $50,000. Alternatively, it can process them further and produce finished products X, Y, and Z at an incremental cost of $2 per unit. The added processing yields the products and revenues shown in Exhibit 23.7. FasTrac must decide whether the added revenues from selling finished products X, Y, and Z exceed the costs of finishing them.

EXHIBIT 23.7 Revenues from Processing Further

Product Price Units Revenues

Product X . . . . . . . . . $4.00 10,000 $ 40,000

Product Y . . . . . . . . . . 6.00 22,000 132,000

Product Z . . . . . . . . . 8.00 6,000 48,000

Spoilage . . . . . . . . . . . — 2,000 0

Totals . . . . . . . . . . . . . 40,000 $220,000

Exhibit 23.8 shows the two-step analysis for this decision. First, FasTrac computes its incremental revenue from further processing Q into products X, Y, and Z. This amount is the dif- ference between the $220,000 revenue from the further processed products and the $50,000 FasTrac will give up by not selling Q as is (a $50,000 opportunity cost). Second, FasTrac com- putes its incremental costs from further processing Q into X, Y, and Z. This amount is $80,000 (40,000 units 3 $2 incremental cost). The analysis shows that FasTrac can earn incremental net income of $90,000 from a decision to further process Q. (Notice that the earlier incurred $30,000 manufacturing cost for the 40,000 units of Product Q does not appear in Exhibit 23.8 because it is a sunk cost and as such is irrelevant to the decision.)

Example: Does the decision change if incremental costs in Exhibit 23.8 increase to $4 per unit and the opportunity cost increases to $95,000? Answer: Yes. There is now an incremental net loss of $35,000.

EXHIBIT 23.8 Sell or Process Analysis

Revenue if processed . . . . . . . . . . . . . . . $220,000

Revenue if sold as is . . . . . . . . . . . . . . . . (50,000)

Incremental revenue . . . . . . . . . . . . . . . 170,000

Incremental cost to process . . . . . . . . . (80,000)

Incremental net income . . . . . . . . . $ 90,000

3. A company has already incurred a $1,000 cost in partially producing its four products. Their selling prices when partially and fully processed follow with additional costs necessary to finish these partially processed units:

Unfinished Finished Further Product Selling Price Selling Price Processing Costs

Alpha . . . . . . . . . . . . . . $300 $600 $150

Beta . . . . . . . . . . . . . . . 450 900 300

Gamma. . . . . . . . . . . . . 275 425 125

Delta . . . . . . . . . . . . . . 150 210 75

Which product(s) should not be processed further, (a) Alpha, (b) Beta, (c) Gamma, or (d) Delta? 4. Under what conditions is a sunk cost relevant to decision making?

Quick Check Answers — p. 998

Sales Mix Selection When a company sells a mix of products, some are likely to be more profitable than others. Management is often wise to concentrate sales efforts on more profitable products. If produc- tion facilities or other factors are limited, an increase in the production and sale of one prod- uct usually requires reducing the production and sale of others. In this case, management must identify the most profitable combination, or sales mix of products. To identify the best sales mix, management must know the contribution margin of each product, the facilities required to produce each product, any constraints on these facilities, and its markets.

Point: A method called linear program- ming is useful for finding the optimal sales mix for several products subject to many market and production constraints. This method is described in advanced courses.

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992 Chapter 23 Relevant Costing for Managerial Decisions

To illustrate, assume that FasTrac makes and sells two products, A and B. The same ma- chines are used to produce both products. A and B have the following selling prices and variable costs per unit:

Product A Product B

Selling price per unit . . . . . . . . . . . . . . . . $5.00 $7.50

Variable costs per unit . . . . . . . . . . . . . . 3.50 5.50

Contribution margin per unit . . . . . . . . . $1.50 $2.00

The variable costs are included in the analysis because they are the incremental costs of produc- ing these products within the existing capacity of 100,000 machine hours per month. We con- sider three separate cases.

Demand Is Unlimited and Products Use Same Inputs Assume that (1) each prod- uct requires 1 machine hour per unit for production and (2) the demand for these products is un- limited. Under these conditions, FasTrac should produce as much of Product B as it can because of its larger contribution margin of $2 per unit. At full capacity, FasTrac would produce $200,000 of total contribution margin per month, computed as $2 per unit times 100,000 machine hours.

Demand Is Unlimited and Products Use Different Inputs Assume that (1) Product A requires 1 machine hour per unit, (2) Product B requires 2 machine hours per unit, and (3) the demand for these products is unlimited. Under these conditions, FasTrac should produce as much of Product A as it can because it has a contribution margin of $1.50 per machine hour compared with only $1 per machine hour for Product B. Exhibit 23.9 shows the relevant analysis.

EXHIBIT 23.9 Sales Mix Analysis

Product A Product B

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5.00 $ 7.50

Variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.50 5.50

Contribution margin per unit . . . . . . . . . . . . . . . . . . . . . $ 1.50 $ 2.00

Machine hours per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.0 2.0

Contribution margin per machine hour . . . . . . . . . $1.50 $1.00

At its full capacity of 100,000 machine hours, FasTrac would produce 100,000 units of Product A, yielding $150,000 of total contribution margin per month. In contrast, if it uses all 100,000 hours to produce Product B, only 50,000 units would be produced yielding a contribution mar- gin of $100,000. These results suggest that when a company faces unlimited demand and lim- ited capacity, only the most profitable product per input should be manufactured.

Demand Is Limited and Products Use Different Inputs The need for a mix of different products arises when market demand is not sufficient to allow a company to sell all that it produces. For instance, assume that (1) Product A requires 1 machine hour per unit, (2) Product B requires 2 machine hours per unit, and (3) the market for Product A is limited to 80,000 units. Under these conditions, FasTrac should produce no more than 80,000 units of Product A. This would leave another 20,000 machine hours of capacity for making Product B. FasTrac should use this spare capacity to produce 10,000 units of Product B. This sales mix would maximize FasTrac’s total contribution margin per month at an amount of $140,000. In this case, the com- pany first produces its most profitable product, up to the point of total demand (or its capacity constraint). It then uses remaining capacity to produce its next most profitable product.

Example: If Product B’s variable costs per unit increase to $6, Product A’s vari- able costs per unit decrease to $3, and the same machine hours per unit are used, which product should FasTrac pro- duce? Answer: Product A. Its contribution margin of $2 per machine hour is higher than B’s $.75 per machine hour.

Companies such as Gap, Abercrombie & Fitch, and American Eagle must continuously monitor and manage the sales mix of their product lists. Selling their products in hundreds of countries and territories fur- ther complicates their decision process. The contribution margin of each product is crucial to their product mix strategies. ■

Decision Insight

Point: FasTrac might consider buying another machine to reduce the constraint on production. A strategy designed to reduce the impact of constraints or bottlenecks, on production, is called the theory of constraints.

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Segment Elimination When a segment such as a department or division is performing poorly, management must consider eliminating it. Segment information on either net income (loss) or its contribution to overhead is not sufficient for this decision. Instead, we must look at the segment’s avoidable expenses and unavoidable expenses. Avoidable expenses, also called escapable expenses, are amounts the company would not incur if it eliminated the segment. Unavoidable expenses, also called inescapable expenses, are amounts that would continue even if the segment is eliminated. To illustrate, FasTrac considers eliminating its treadmill division because its $48,300 total expenses are higher than its $47,800 sales. Classification of this division’s operating expenses into avoidable or unavoidable expenses is shown in Exhibit 23.10.

Avoidable Unavoidable Total Expenses Expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 30,000 —

Direct expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 7,900 7,900 —

Depreciation expense—Equipment . . . . . . . . . . 200 — $ 200

Indirect expenses

Rent and utilities expense . . . . . . . . . . . . . . . . . . 3,150 — 3,150

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . 400 400 —

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . 400 300 100

Service department costs

Share of office department expenses . . . . . . . . . 3,060 2,200 860

Share of purchasing expenses . . . . . . . . . . . . . . . 3,190 1,000 2,190

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $48,300 $41,800 $6,500

EXHIBIT 23.10 Classification of Segment Operating Expenses for Analysis

FasTrac’s analysis shows that it can avoid $41,800 expenses if it eliminates the treadmill di- vision. Because this division’s sales are $47,800, eliminating it will cause FasTrac to lose $6,000 of income. Our decision rule is that a segment is a candidate for elimination if its reve- nues are less than its avoidable expenses. Avoidable expenses can be viewed as the costs to generate this segment’s revenues. When considering elimination of a segment, we must assess its impact on other segments. A segment could be unprofitable on its own, but it might still contribute to other segments’ reve- nues and profits. It is possible then to continue a segment even when its revenues are less than its avoidable expenses. Similarly, a profitable segment might be discontinued if its space, assets, or staff can be more profitably used by expanding existing segments or by creating new ones. Our decision to keep or eliminate a segment requires a more complex analysis than simply look- ing at a segment’s performance report. Such reports provide useful information, but they do not provide all the information necessary for this decision.

Keep or Replace Equipment Businesses periodically must decide whether to keep using equipment or replace it. Advances in technology typically mean newer equipment can operate more efficiently and at lower cost than older equipment. In making the decision to keep or replace equipment, managers must decide whether the reduction in variable manufacturing costs with the new equipment over its useful life is greater than the net purchase price of the equipment. In this setting, the net purchase price of the equipment is its total cost minus any trade-in allowance or cash receipt for the old equipment. For example, FasTrac has a piece of manufacturing equipment with a book value (cost minus accumulated depreciation) of $20,000 and a remaining useful life of four years. At the end of four years the equipment will have a salvage value of zero. The market value of the equipment is currently $25,000. FasTrac can purchase a new machine for $100,000 and receive $25,000 in return for trading in its old machine. The new machine will reduce FasTrac’s variable manufacturing costs by $18,000 per year over the four-year life of the new machine. FasTrac’s incremental analysis is shown in Exhibit 23.11.

Example: How can insurance be classified as either avoidable or unavoid- able? Answer: Depends on whether the assets insured can be removed and the premiums canceled.

Example: Give an example of a segment that a company might profitably use to attract customers even though it might incur a loss. Answer: Warranty and post-sales services.

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994 Chapter 23 Relevant Costing for Managerial Decisions

EXHIBIT 23.11 Keep or Replace Analysis

Increase or (Decrease) in Net Income

Cost to buy new machine . . . . . . . . . . . . . . . . . . . . . . $(100,000)

Cash received to trade in old machine . . . . . . . . . . . . 25,000

Reduction in variable manufacturing costs* . . . . . . . . 72,000

Total increase (decrease) in net income . . . . . . . . . . . $ (3,000)

*18,000 3 4 years

The analysis in Exhibit 23.11 shows that FasTrac should not replace the old equipment with this newer version as it will decrease income by $3,000. Note, the book value of the old equipment ($20,000) is not relevant to this analysis. Book value is a sunk cost, and it cannot be changed regardless of whether FasTrac keeps or replaces this equipment.

Qualitative Decision Factors Managers must consider qualitative factors in making managerial decisions. Consider a decision on whether to buy a component from an outside supplier or continue to make it. Several qualita- tive decision factors must be considered. For example, the quality, delivery, and reputation of the proposed supplier are important. The effects from deciding not to make the component can in- clude potential layoffs and impaired worker morale. Consider another situation in which a com- pany is considering a one-time sale to a new customer at a special low price. Qualitative factors to consider in this situation include the effects of a low price on the company’s image and the threat that regular customers might demand a similar price. The company must also consider whether this customer is really a one-time customer. If not, can it continue to offer this low price in the long run? Clearly, management cannot rely solely on financial data to make such decisions.

5. What is the difference between avoidable and unavoidable expenses? 6. A segment is a candidate for elimination if (a) its revenues are less than its avoidable

expenses, (b) it has a net loss, (c) its unavoidable expenses are higher than its revenues.

Quick Check Answers — p. 998

Setting Product PriceDecision Analysis

Relevant costs are useful to management in determining prices for special short-term decisions. But longer run pricing decisions of management need to cover both variable and fixed costs, and yield a profit. There are several methods to help management in setting prices. The cost-plus methods are probably the most common, where management adds a markup to cost to reach a target price. We will describe the total cost method, where management sets price equal to the product’s total costs plus a desired profit on the product. This is a four-step process:

1. Determine total costs.

A2 Determine product selling price based on total costs.

Total costs 5 Production (direct materials, Nonproduction (selling and direct labor, and overhead)

1 administrative) costs

2. Determine total cost per unit.

Total cost per unit 5 Total costs 4 Total units expected to be produced and sold

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Chapter 23 Relevant Costing for Managerial Decisions 995

3. Determine the dollar markup per unit.

Markup per unit 5 Total cost per unit 3 Markup percentage

where Markup percentage 5 Desired profityTotal costs 4. Determine selling price per unit.

Selling price per unit 5 Total cost per unit 1 Markup per unit

To illustrate, consider a company that produces MP3 players. The company desires a 20% return on its assets of $1,000,000, and it expects to produce and sell 10,000 players. The following additional company information is available:

Variable costs (per unit)

Production costs . . . . . . . . . . . . . $ 44

Nonproduction costs . . . . . . . . . 6

Fixed costs (in dollars)

Overhead. . . . . . . . . . . . . . . . . . . $140,000

Nonproduction . . . . . . . . . . . . . . 60,000

We apply our four-step process to determine price.

1. Total costs 5 Production costs 1 Nonproduction costs 5 [($44 3 10,000 units) 1 $140,000] 1 [($6 3 10,000 units) 1 $60,000] 5 $700,000 2. Total cost per unit 5 Total costsyTotal units expected to be produced and sold 5 $700,000y10,000 5 $70 3. Markup per unit 5 Total cost per unit 3 (Desired profityTotal costs) 5 $70 3 [(20% 3 $1,000,000)y$700,000] 5 $20 4. Selling price per unit 5 Total cost per unit 1 Markup per unit 5 $70 1 $20 5 $90

To verify that our price yields the $200,000 desired profit (20% 3 $1,000,000), we compute the following simplified income statement using the information above.

Sales ($90 3 10,000) . . . . . . . . . . . . . . . . . $900,000

Expenses

Variable ($50 3 10,000) . . . . . . . . . . . . . 500,000

Fixed ($140,000 1 $60,000) . . . . . . . . . 200,000

Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000

Companies use cost-plus pricing as a starting point for determining selling prices. Many factors determine price, including consumer preferences and competition.

Determine the appropriate action in each of the following managerial decision situations. 1. Packer Company is operating at 80% of its manufacturing capacity of 100,000 product units per year.

A chain store has offered to buy an additional 10,000 units at $22 each and sell them to customers so as not to compete with Packer Company. The following data are available.

DEMONSTRATION PROBLEM

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Proceeds of selling as scrap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500

Additional cost of melting down defective parts . . . . . . . . . . . . . . . . . . . . . . . 400

Cost of purchases avoided by using recycled metal from defects . . . . . . . . . . 4,800

Cost to rework 500 defective parts

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Incremental overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750

Cost to produce 500 new parts

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Incremental overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Selling price per good unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

The required volume of output to produce the part will not require any incremental fixed overhead. Incremental variable overhead cost will be $17 per unit. Should the company make or buy this part?

3. Gold Company’s manufacturing process causes a relatively large number of defective parts to be pro- duced. The defective parts can be (a) sold for scrap, (b) melted to recover the recycled metal for reuse, or (c) reworked to be good units. Reworking defective parts reduces the output of other good units because no excess capacity exists. Each unit reworked means that one new unit cannot be produced. The following information reflects 500 defective parts currently available.

Should the company melt the parts, sell them as scrap, or rework them?

PLANNING THE SOLUTION ● Determine whether Packer Company should accept the additional business by finding the incremental

costs of materials, labor, and overhead that will be incurred if the order is accepted. Omit fixed costs that the order will not increase. If the incremental revenue exceeds the incremental cost, accept the order.

● Determine whether Green Company should make or buy the component by finding the incremental cost of making each unit. If the incremental cost exceeds the purchase price, the component should be pur- chased. If the incremental cost is less than the purchase price, make the component.

● Determine whether Gold Company should sell the defective parts, melt them down and recycle the metal, or rework them. To compare the three choices, examine all costs incurred and benefits received

In producing 10,000 additional units, fixed overhead costs would remain at their current level but in- cremental variable overhead costs of $3 per unit would be incurred. Should the company accept or reject this order?

2. Green Company uses Part JR3 in manufacturing its products. It has always purchased this part from a supplier for $40 each. It recently upgraded its own manufacturing capabilities and has enough excess capacity (including trained workers) to begin manufacturing Part JR3 instead of buying it. The com- pany prepares the following cost projections of making the part, assuming that overhead is allocated to the part at the normal predetermined rate of 200% of direct labor cost.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Overhead (fixed and variable) (200% of direct labor) . . . . . . . . . 30

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56

Costs at 80% Capacity Per Unit Total

Direct materials . . . . . . . . . . . . . . . . . . . $ 8.00 $ 640,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . 7.00 560,000

Overhead (fixed and variable) . . . . . . . . 12.50 1,000,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27.50 $2,200,000

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Direct materials . . . . . . . . . . . . . . . $ 8.00

Direct labor . . . . . . . . . . . . . . . . . . . 7.00

Variable overhead (given) . . . . . . . . 3.00

Total incremental cost . . . . . . . . . . $18.00

Direct materials . . . . . . . . . . . . . $11.00

Direct labor . . . . . . . . . . . . . . . . . 15.00

Variable overhead . . . . . . . . . . . . 17.00

Total incremental cost . . . . . . . . $43.00

2. For this make or buy decision, the analysis must not include the $13 nonincremental overhead per unit ($30 2 $17). When only the $17 incremental overhead is included, the relevant unit cost of manufac- turing the part is shown in the following table. It would be better to continue buying the part for $40 instead of making it for $43.

Sell Melt and Rework Incremental Cost to Produce 500 Marketable Units as Is Recycle Units

Direct materials

New materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 $6,000

Recycled metal materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,800)

Net materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Melting costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Total direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 1,600

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,000 $1,500

Incremental overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200 3,200 1,750

Cost to produce 500 marketable units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,200 9,800 3,250

Less proceeds of selling defects as scrap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,500)

Opportunity costs* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,800

Net cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,700 $9,800 $9,050

* The $5,800 opportunity cost is the lost contribution margin from not being able to produce and sell 500 units because of reworking, computed as ($40 2 [$14,200/500 units]) 3 500 units.

3. The goal of this scrap or rework decision is to identify the alternative that produces the greatest net benefit to the company. To compare the alternatives, we determine the net cost of obtaining 500 mar- ketable units as follows:

from the alternatives in working with the 500 defective units versus the production of 500 new units. For the scrapping alternative, include the costs of producing 500 new units and subtract the $2,500 proceeds from selling the old ones. For the melting alternative, include the costs of melting the defec- tive units, add the net cost of new materials in excess over those obtained from recycling, and add the direct labor and overhead costs. For the reworking alternative, add the costs of direct labor and incre- mental overhead. Select the alternative that has the lowest cost. The cost assigned to the 500 defective units is sunk and not relevant in choosing among the three alternatives.

SOLUTION TO DEMONSTRATION PROBLEM 1. This decision involves accepting additional business. Since current unit costs are $27.50, it appears

initially as if the offer to sell for $22 should be rejected, but the $27.50 cost includes fixed costs. When the analysis includes only incremental costs, the per unit cost is as shown in the following table. The offer should be accepted because it will produce $4 of additional profit per unit (computed as $22 price less $18 incremental cost), which yields a total profit of $40,000 for the 10,000 additional units.

The incremental cost of 500 marketable parts is smallest if the defects are reworked.

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998 Chapter 23 Relevant Costing for Managerial Decisions

C1 Describe the importance of relevant costs for short-term decisions. A company must rely on relevant costs pertaining to alternative courses of action rather than historical costs. Out- of-pocket expenses and opportunity costs are relevant because these are avoidable; sunk costs are irrelevant because they result from past decisions and are therefore unavoidable. Managers must also consider the relevant benefits associated with alterna- tive decisions.

A1 Evaluate short-term managerial decisions using relevant costs. Relevant costs are useful in making decisions such as to accept additional business, make or buy, and sell as is or process further. For example, the relevant factors in deciding whether to

Summary produce and sell additional units of product are incremental costs and incremental revenues from the additional volume.

A2 Determine product selling price based on total costs. Product selling price is estimated using total production and nonproduction costs plus a markup. Price is set to yield manage- ment’s desired profit for the company.

P1 Identify relevant costs and apply them to managerial deci-sions. Several illustrations apply relevant costs to managerial decisions, such as whether to accept additional business; make or buy; scrap or rework products; sell products or process them further; or eliminate a segment and how to select the best sales mix.

Partner You should identify the differences between existing cli- ents and this potential client. A key difference is that the restaurant business has additional inventory components (groceries, vegetables, meats, etc.) and is likely to have a higher proportion of depreciable assets. These differences imply that the partner must spend more

hours auditing the records and understanding the business, regula- tions, and standards that pertain to the restaurant business. Such dif- ferences suggest that the partner must use a different “formula” for quoting a price to this potential client vis-à-vis current clients.

Guidance Answer to Decision Maker

1. e; Variable costs per unit for this order of 200 units follow:

Direct materials ($37,500y7,500) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5.00 Direct labor ($60,000y7,500) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.00 Variable overhead [(0.30 3 $20,000)y7,500] . . . . . . . . . . . . . . . . . . . . 0.80 Variable selling expenses [(0.60 3 $25,000 3 0.5)y7,500] . . . . . . . . . 1.00 Total variable costs per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14.80

Cost to produce special order: (200 3 $14.80) 1 $400 5 $3,360. Price per unit to earn $1,000: ($3,360 1 $1,000)y200 5 $21.80. 2. They are the additional (new) costs of accepting new business.

3. d;

4. A sunk cost is never relevant because it results from a past deci- sion and is already incurred.

5. Avoidable expenses are ones a company will not incur by elimi- nating a segment; unavoidable expenses will continue even after a segment is eliminated.

6. a

Guidance Answers to Quick Checks

Incremental benefits Incremental costs

Alpha $300 ($600 2 $300) . $150 (given)

Beta $450 ($900 2 $450) . $300 (given)

Gamma $150 ($425 2 $275) . $125 (given)

Delta $ 60 ($210 2 $150) , $ 75 (given)

Avoidable expense (p. 993)

Incremental cost (p. 988)

Markup (p. 994)

Relevant benefits (p. 987)

Total cost method (p. 994)

Unavoidable expense (p. 993)

Key Terms

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Chapter 23 Relevant Costing for Managerial Decisions 999

Icon denotes assignments that involve decision making.

1. Identify the five steps involved in the managerial decision- making process.

2. Is nonfinancial information ever useful in managerial decision making?

3. What is a relevant cost? Identify the two types of relevant costs.

4. Why are sunk costs irrelevant in deciding whether to sell a product in its present condition or to make it into a new product through additional processing?

5. Arctic Cat has many types of costs. What is an out-of-pocket cost? What is an opportunity cost? Are opportunity costs recorded in the accounting records?

6. Piaggio must confront sunk costs. Why are sunk costs irrelevant in deciding whether to sell a product in its present condition or to make it into a new product through additional processing?

7. Identify some qualitative factors that should be considered when making managerial decisions.

8. Identify the incremental costs incurred by Apple for shipping one additional iPod from a warehouse to a retail store along with the store’s normal order of 75 iPods.

9. KTM is considering eliminating one of its stores in a large U.S. city. What are some factors that it should consider in making this decision?

10. Assume that Polaris manufactures and sells 60,000 units of a product at $11,000 per unit in domestic markets. It costs $6,000 per unit to manufacture ($4,000 variable cost per unit, $2,000 fixed cost per unit). Can you describe a situation under which the company is willing to sell an additional 8,000 units of the product in an international market at $5,000 per unit?

Discussion Questions

Apple

PIAGGIO

KTM

Arctic Cat Polaris

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 1013 mhhe.com/wildFINMAN5e

regular customers. Production costs are $13.50 per unit, which includes $9 of variable costs. To produce the special order, the company must incur additional fixed costs of $5,000. Should the company accept the special order?

a. Yes, because incremental revenue exceeds incremental costs. b. No, because incremental costs exceed incremental revenue. c. No, because the units are being sold for $5 less than the

regular price. d. Yes, because incremental costs exceed incremental revenue. e. No, because incremental cost exceeds $15 per unit when

total costs are considered. 4. A cost that cannot be changed because it arises from a past

decision and is irrelevant to future decisions is a. An uncontrollable cost. b. An out-of-pocket cost. c. A sunk cost. d. An opportunity cost. e. An incremental cost. 5. The potential benefit of one alternative that is lost by choosing

another is known as a. An alternative cost. b. A sunk cost. c. A differential cost. d. An opportunity cost. e. An out-of-pocket cost.

1. A company inadvertently produced 3,000 defective MP3 play- ers. The players cost $12 each to produce. A recycler offers to purchase the defective players as they are for $8 each. The pro- duction manager reports that the defects can be corrected for $10 each, enabling them to be sold at their regular market price of $19 each. The company should:

a. Correct the defect and sell them at the regular price. b. Sell the players to the recycler for $8 each. c. Sell 2,000 to the recycler and repair the rest. d. Sell 1,000 to the recycler and repair the rest. e. Throw the players away. 2. A company’s productive capacity is limited to 480,000 ma-

chine hours. Product X requires 10 machine hours to produce; and Product Y requires 2 machine hours to produce. Product X sells for $32 per unit and has variable costs of $12 per unit; Product Y sells for $24 per unit and has variable costs of $10 per unit. Assuming that the company can sell as many of either product as it produces, it should:

a. Produce X and Y in the ratio of 57% and 43%. b. Produce X and Y in the ratio of 83% X and 17% Y. c. Produce equal amounts of Product X and Product Y. d. Produce only Product X. e. Produce only Product Y. 3. A company receives a special one-time order for 3,000 units of

its product at $15 per unit. The company has excess capacity and it currently produces and sells the units at $20 each to its

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1000 Chapter 23 Relevant Costing for Managerial Decisions

QS 23-5 Relevant costs

C1

Label each of the following statements as either true (“T”) or false (“F”). 1. Relevant costs are also known as unavoidable costs. 2. Incremental costs are also known as differential costs. 3. An out-of-pocket cost requires a current and/or future outlay of cash. 4. An opportunity cost is the potential benefit that is lost by taking a specific action when two or more

alternative choices are available. 5. A sunk cost will change with a future course of action.

QS 23-6 Analysis of incremental costs

A1 P1

Kando Company incurs a $9 per unit cost for Product A, which it currently manufactures and sells for $13.50 per unit. Instead of manufacturing and selling this product, the company can purchase Product B for $5 per unit and sell it for $12 per unit. If it does so, unit sales would remain unchanged and $5 of the $9 per unit costs assigned to Product A would be eliminated. Should the company continue to manufacture Product A or purchase Product B for resale?

QS 23-7 Selection of sales mix

A1

Excel Memory Company can sell all units of computer memory X and Y that it can produce, but it has limited production capacity. It can produce two units of X per hour or three units of Y per hour, and it has 4,000 production hours available. Contribution margin is $5 for product X and $4 for product Y. What is the most profitable sales mix for this company?

QS 23-8 Sell or process decision

A1 P1

Holmes Company produces a product that can either be sold as is or processed further. Holmes has already spent $50,000 to produce 1,250 units that can be sold now for $67,500 to another manufacturer. Alternatively, Holmes can process the units further at an incremental cost of $250 per unit. If Holmes processes further, the units can be sold for $375 each. Compute the incremental income if Holmes processes further.

QUICK STUDY

QS 23-1 Identification of relevant costs

P1

Helix Company has been approached by a new customer to provide 2,000 units of its regular product at a special price of $6 per unit. The regular selling price of the product is $8 per unit. Helix is operating at 75% of its capacity of 10,000 units. Identify whether the following costs are relevant to Helix’s decision as to whether to accept the order at the special selling price. No additional fixed manu facturing overhead will be incurred because of this order. The only additional selling expense on this order will be a $0.50 per unit shipping cost. There will be no additional administrative expenses because of this order. Place an X in the appropriate column to identify whether the cost is relevant or irrelevant to accepting this order.

QS 23-2 Analysis of relevant costs A1

Refer to the data in QS 23-1. Based on financial considerations alone, should Helix accept this order at the special price? Explain.

QS 23-3 Identification of relevant nonfinancial factors P1

Refer to QS 23-1 and QS 23-2. What nonfinancial factors should Helix consider before accepting this

order? Explain.

QS 23-4 Sell or process

P1 A1

Garcia Company has 10,000 units of its product that were produced last year at a total cost of $150,000. The units were damaged in a rain storm because the warehouse where they were stored developed a leak in the roof. Garcia can sell the units as is for $2 each or it can repair the units at a total cost of $18,000 and then sell them for $5 each. Should Garcia sell the units as is or repair them and then sell them? Explain.

Item Relevant Not relevant

a. Selling price of $6.00 per unit

b. Direct materials cost of $1.00 per unit

c. Direct labor of $2.00 per unit

d. Variable manufacturing overhead of $1.50 per unit

e. Fixed manufacturing overhead of $0.75 per unit

f. Regular selling expenses of $1.25 per unit

g. Additional selling expenses of $0.50 per unit

h. Administrative expenses of $0.60 per unit

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Chapter 23 Relevant Costing for Managerial Decisions 1001

QS 23-10 Decision to accept additional business

A1 P1

Radar Company sells bikes for $300 each. The company currently sells 3,750 bikes per year and could make as many as 5,000 bikes per year. The bikes cost $225 each to make; $150 in variable costs per bike and $75 of fixed costs per bike. Radar received an offer from a potential customer who wants to buy 750 bikes for $250 each. Incremental fixed costs to make this order are $50,000. No other costs will change if this order is accepted. Compute Radar’s additional income (ignore taxes) if it accepts this order.

QS 23-12 Keep or replace decision

A1 P1

Rory Company has a machine with a book value of $75,000 and a remaining five-year useful life. A new machine is available at a cost of $112,500, and Rory can also receive $60,000 for trading in its old machine. The new machine will reduce variable manufacturing costs by $12,000 per year over its five-year useful life. Should the machine be replaced?

QS 23-11 Segment elimination

A1 P1

A guitar manufacturer is considering eliminating its electric guitar division because its $76,000 expenses are higher than its $72,000 sales. The company reports the following expenses for this division. Should the division be eliminated?

Avoidable Expenses Unavoidable Expenses

Cost of goods sold . . . . . . . . . . . . . . $56,000

Direct expenses . . . . . . . . . . . . . . . . 9,250 $1,250

Indirect expenses . . . . . . . . . . . . . . . 470 1,600

Service department costs . . . . . . . . . 6,000 1,430

QS 23-9 Scrap or rework

A1 P1

Signal mistakenly produced 10,000 defective cell phones. The phones cost $60 each to produce. A salvage company will buy the defective phones as they are for $30 each. It would cost Signal $80 per phone to rework the phones. If the phones are reworked, Signal could sell them for $110 each. Compute the incremental net income from reworking the phones.

EXERCISES

Exercise 23-1 Relevant costs

C1

Fill in each of the blanks below with the correct term. 1. A arises from a past decision and cannot be avoided or changed; it is irrelevant to future

decisions. 2. refer to the incremental revenue generated from taking one particular action over another. 3. Relevant costs are also known as . 4. An requires a future outlay of cash and is relevant for current and future decision making. 5. An is the potential benefit lost by taking a specific action when two or more alternative

choices are available.

Exercise 23-2 Keep or replace

A1 P1

Xinhong Company is considering replacing one of its manufacturing machines. The machine has a book value of $45,000 and a remaining useful life of 5 years, at which time its salvage value will be zero. It has a current market value of $52,000. Variable manufacturing costs are $36,000 per year for this machine. Infor- mation on two alternative replacement machines follows. Should Xinhong keep or replace its manufacturing machine? If the machine should be replaced, which alternative new machine should Xinhong purchase?

Alternative A Alternative B

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000 $125,000

Variable manufacturing costs per year. . . . . . . . . 19,000 15,000

Exercise 23-3 Scrap or rework

A1 P1

A company must decide between scrapping or reworking units that do not pass inspection. The company has 22,000 defective units that cost $6 per unit to manufacture. The units can be sold as is for $2.50 each, or they can be reworked for $4.50 each and then sold for the full price of $8.50 each. If the units are sold as is, the company will have to build 22,000 replacement units at a cost of $6 each, and sell them at the full price of $8.50 each. (1) What is the incremental income from selling the units as scrap? (2) What is the incremental income from reworking and selling the units? (3) Should the company sell the units as scrap or rework them?

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1002 Chapter 23 Relevant Costing for Managerial Decisions

Farrow Co. expects to sell 150,000 units of its product in the next period with the following results.

Sales (150,000 units) . . . . . . . . . . . . . . $2,250,000

Costs and expenses

Direct materials . . . . . . . . . . . . . . . . 300,000

Direct labor . . . . . . . . . . . . . . . . . . . 600,000

Overhead . . . . . . . . . . . . . . . . . . . . . 150,000

Selling expenses . . . . . . . . . . . . . . . . 225,000

Administrative expenses . . . . . . . . . 385,500

Total costs and expenses . . . . . . . . . . . 1,660,500

Net income . . . . . . . . . . . . . . . . . . . . . $ 589,500

Exercise 23-4 Decision to accept additional business or not

A1 P1

Exercise 23-5 Decision to accept new business or not

P1 A1

Goshford Company produces a single product and has capacity to produce 100,000 units per month. Costs to produce its current sales of 80,000 units follow. The regular selling price of the product is $100 per unit. Management is approached by a new customer who wants to purchase 20,000 units of the product for $75 per unit. If the order is accepted, there will be no additional fixed manufacturing overhead, and no additional fixed selling and administrative expenses. The customer is not in the company’s regular selling territory, so there will be a $5 per unit shipping expense in addition to the regular variable selling and administrative expenses.

Required

1. Determine whether management should accept or reject the new business. 2. What nonfinancial factors should management consider when deciding whether to take this order?

Check (1) Additional volume effect on net income, $370,000

Costs at Per Unit 80,000 Units

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12.50 $1,000,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.00 1,200,000

Variable manufacturing overhead . . . . . . . . . . . . . . . . . 10.00 800,000

Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . 17.50 1,400,000

Variable selling and administrative expenses . . . . . . . . 14.00 1,120,000

Fixed selling and administrative expenses . . . . . . . . . . 13.00 1,040,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $82.00 $6,560,000

The company has an opportunity to sell 15,000 additional units at $12 per unit. The additional sales would not affect its current expected sales. Direct materials and labor costs per unit would be the same for the ad- ditional units as they are for the regular units. However, the additional volume would create the following incremental costs: (1) total overhead would increase by 15% and (2) administrative expenses would in- crease by $64,500. Prepare an analysis to determine whether the company should accept or reject the offer to sell additional units at the reduced price of $12 per unit.Check Income increase, $3,000

Exercise 23-6 Make or buy decision

A1

Gilberto Company currently manufactures one of its crucial parts at a cost of $4.45 per unit. This cost is based on a normal production rate of 65,000 units per year. Variable costs are $1.95 per unit, fixed costs related to making this part are $65,000 per year, and allocated fixed costs are $58,500 per year. Allocated fixed costs are unavoidable whether the company makes or buys the part. Gilberto is considering buying the part from a supplier for a quoted price of $3.50 per unit guaranteed for a three-year period. Should the company continue to manufacture the part, or should it buy the part from the outside supplier? Support your answer with analyses.

Check $35,750 increased costs to buy

Gelb Company currently manufactures 40,000 units of a key component for its manufacturing process at a cost of $4.45 per unit. Variable costs are $1.95 per unit, fixed costs related to making this component are $65,000 per year, and allocated fixed costs are $58,500 per year. The allocated fixed costs are unavoidable whether the company makes or buys this component. The company is considering buying this component from a supplier for $3.50 per unit. Should it continue to manufacture the component, or should it buy this component from the outside supplier? Support your decision with analysis of the data provided.

Exercise 23-7 Make or buy decision P1 A1

Check Increased cost to make, $3,000

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Chapter 23 Relevant Costing for Managerial Decisions 1003

Exercise 23-9 Sell or rework decision

P1 A1

Varto Company has 7,000 units of its sole product in inventory that it produced last year at a cost of $22 each. This year’s model is superior to last year’s and the 7,000 units cannot be sold at last year’s regular sell- ing price of $35 each. Varto has two alternatives for these items: (1) they can be sold to a wholesaler for $8 each, or (2) they can be reworked at a cost of $125,000 and then sold for $25 each. Prepare an analysis to determine whether Varto should sell the products as is or rework them and then sell them.

Check Incremental net income of reworking, $(6,000)

Exercise 23-8 Sell or process decision

A1

Cobe Company has already manufactured 28,000 units of Product A at a cost of $28 per unit. The 28,000 units can be sold at this stage for $700,000. Alternatively, the units can be further processed at a $420,000 total additional cost and be converted into 5,600 units of Product B and 11,200 units of Product C. Per unit selling price for Product B is $105 and for Product C is $70. Prepare an analysis that shows whether the 28,000 units of Product A should be processed further or not.

Suresh Co. expects its five departments to yield the following income for next year.

Sales

Expenses

Avoidable

Unavoidable

Total expenses

Net income (loss)

Dept. N Dept. O Dept. P Dept. T

$63,000 $35,000

9,800

51,800

61,600

36,400

12,600

49,000

$(14,000)

$56,000

22,400

4,200

26,600

$29,400

$42,000

14,000

29,400

43,400

28,000

37,800

9,800

47,600

(19,600)

Dept. M

$

1,400$ (1,400)$ $

File Edit View Insert Format Tools Data Window Help

Recompute and prepare the departmental income statements (including a combined total column) for the company under each of the following separate scenarios: Management (1) does not eliminate any depart- ment, (2) eliminates departments with expected net losses, and (3) eliminates departments with sales dol- lars that are less than avoidable expenses. Explain your answers to parts 2 and 3.

Exercise 23-10 Analysis of income effects from eliminating departments

A1

Check Total income (loss) (2) $(21,000), (3) $7,000

Marinette Company makes several products, including canoes. The company has been experiencing losses from its canoe segment and is considering dropping that product line. The following information is available regarding its canoe segment. Should management discontinue the manufacturing of canoes? Support your decision.

Exercise 23-11 Income analysis of eliminating departments

A1

Check Income impact if canoe segment dropped, $(175,000)

MARINETTE COMPANY Income Statement—Canoe Segment

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000

Variable costs

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $450,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Variable overhead . . . . . . . . . . . . . . . . . . . . . . 300,000

Variable selling and administrative . . . . . . . . . 200,000

Total variable costs . . . . . . . . . . . . . . . . . . . . . . 1,450,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . 550,000

Fixed costs

Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000

Indirect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . 675,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (125,000)

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1004 Chapter 23 Relevant Costing for Managerial Decisions

Exercise 23-12 Sales mix determination and analysis

A1

Colt Company owns a machine that can produce two specialized products. Production time for Product TLX is two units per hour and for Product MTV is five units per hour. The machine’s capacity is 2,750 hours per year. Both products are sold to a single customer who has agreed to buy all of the company’s output up to a maximum of 4,700 units of Product TLX and 2,500 units of Product MTV. Selling prices and variable costs per unit to produce the products follow. Determine (1) the company’s most profitable sales mix and (2) the contribution margin that results from that sales mix.

Product TLX Product MTV

Selling price per unit . . . . . . . . . . $15.00 $9.50

Variable costs per unit . . . . . . . . . 4.80 5.50 Check (2) $55,940

Exercise 23-13 Sales mix

A1

Childress Company produces three products, K1, S5, and G9. Each product uses the same type of direct material. K1 uses 4 pounds of the material, S5 uses 3 pounds of the material, and G9 uses 6 pounds of the material. Demand for all products is strong, but only 50,000 pounds of material are available. Information about the selling price per unit and variable cost per unit of each product follows. Orders for which product should be produced and filled first, then second, and then third? Support your answer.

Check K1 contribution margin per pound, $16

K1 S5 G9

Selling price . . . . . . . . . . $160 $112 $210

Variable costs . . . . . . . . 96 85 144

mhhe.com/wildFINMAN5e

Direct materials . . . . . . . . . . . . . . . . $576,000

Direct labor . . . . . . . . . . . . . . . . . . . 144,000

Overhead . . . . . . . . . . . . . . . . . . . . . 320,000

Selling expenses . . . . . . . . . . . . . . . . 150,000

Administrative expenses . . . . . . . . . 100,000

Total costs and expenses . . . . . . . . . $1,290,000

A new wholesaler has offered to buy 50,000 packages for $5.20 each. These markers would be marketed under the wholesaler’s name and would not affect Jones Products’ sales through its normal channels. A study of the costs of this additional business reveals the following:

● Direct materials costs are 100% variable. ● Per unit direct labor costs for the additional units would be 50% higher than normal because their pro-

duction would require overtime pay at one-and-one-half times the usual labor rate. ● 25% of the normal annual overhead costs are fixed at any production level from 350,000 to 500,000

units. The remaining 75% of the annual overhead cost is variable with volume. ● Accepting the new business would involve no additional selling expenses. ● Accepting the new business would increase administrative expenses by a $5,000 fixed amount.

Required

Prepare a three-column comparative income statement that shows the following: 1. Annual operating income without the special order (column 1). 2. Annual operating income received from the new business only (column 2). 3. Combined annual operating income from normal business and the new business (column 3).

PROBLEM SET A

Problem 23-1A Analysis of income effects of additional business

A1 P1

Jones Products manufactures and sells to wholesalers approximately 400,000 packages per year of under- water markers at $6 per package. Annual costs for the production and sale of this quantity are shown in the table.

Check Operating income: (1) $1,110,000

(2) $126,000

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Chapter 23 Relevant Costing for Managerial Decisions 1005

Problem 23-2A Analysis of income effects of additional business

P1 A1

Calla Company produces skateboards that sell for $50 per unit. The company currently has the capacity to produce 90,000 skateboards per year, but is selling 80,000 skateboards per year. Annual costs for 80,000 skateboards follow.

Direct materials . . . . . . . . . . . . . . . . $ 800,000

Direct labor . . . . . . . . . . . . . . . . . . . 640,000

Overhead . . . . . . . . . . . . . . . . . . . . . 960,000

Selling expenses . . . . . . . . . . . . . . . . 560,000

Administrative expenses . . . . . . . . . 480,000

Total costs and expenses . . . . . . . . . $3,440,000

A new retail store has offered to buy 10,000 of its skateboards for $45 per unit. The store is in a different market from Calla’s regular customers and it would not affect regular sales. A study of its costs in antici- pation of this additional business reveals the following:

● Direct materials and direct labor are 100% variable. ● Thirty percent of overhead is fixed at any production level from 80,000 units to 90,000 units; the re-

maining 70% of annual overhead costs are variable with respect to volume. ● Selling expenses are 60% variable with respect to number of units sold, and the other 40% of selling

expenses are fixed. ● There will be an additional $2 per unit selling expense for this order. ● Administrative expenses would increase by a $1,000 fixed amount.

Required

1. Prepare a three-column comparative income statement that reports the following: a. Annual income without the special order. b. Annual income from the special order. c. Combined annual income from normal business and the new business. 2. Should Calla accept this order? What nonfinancial factors should Calla consider? Explain.

Analysis Component

3. Assume that the new customer wants to buy 15,000 units instead of 10,000 units—it will only buy 15,000 units or none and will not take a partial order. Without any computations, how does this change your answer for part 2?

Check (1b) Added income from order, $123,000

Problem 23-3A Make or buy

P1 A1

Haver Company currently produces component RX5 for its sole product. The current cost per unit to manufacture the required 50,000 units of RX5 follows.

Direct materials . . . . . . . . . . . $ 5.00

Direct labor . . . . . . . . . . . . . . 8.00

Overhead . . . . . . . . . . . . . . . . 9.00

Total cost per unit . . . . . . . . . $22.00

Direct materials and direct labor are 100% variable. Overhead is 80% fixed. An outside supplier has of- fered to supply the 50,000 units of RX5 for $18.00 per unit.

Required

1. Determine whether the company should make or buy the RX5. 2. What factors beside cost must management consider when deciding whether to make or buy RX5?

Check (1) Incremental cost to make RX5, $740,000

Problem 23-4A Sell or process

P1 A1

Harold Manufacturing produces denim clothing. This year, it produced 5,000 denim jackets at a manufac- turing cost of $45 each. These jackets were damaged in the warehouse during storage. Management inves- tigated the matter and identified three alternatives for these jackets. 1. Jackets can be sold to a second-hand clothing shop for $6 each. 2. Jackets can be disassembled at a cost of $32,000 and sold to a recycler for $12 each.

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1006 Chapter 23 Relevant Costing for Managerial Decisions

ELEGANT DECOR COMPANY Departmental Income Statements For Year Ended December 31, 2013

Dept. 100 Dept. 200 Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $436,000 $290,000 $726,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 262,000 207,000 469,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174,000 83,000 257,000

Operating expenses

Direct expenses

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 12,000 29,000

Store supplies used . . . . . . . . . . . . . . . . . . . 4,000 3,800 7,800

Depreciation — Store equipment . . . . . . . . . 5,000 3,300 8,300

Total direct expenses . . . . . . . . . . . . . . . . . . 26,000 19,100 45,100

[continued on next page]

Elegant Decor Company’s management is trying to decide whether to eliminate Department 200, which has produced losses or low profits for several years. The company’s 2013 departmental income statement shows the following.

Problem 23-6A Analysis of possible elimination of a department

A1

Edgerron Company is able to produce two products, G and B, with the same machine in its factory. The following information is available.

Product G Product B

Selling price per unit . . . . . . . . . . . . . . . . . . . $120 $160

Variable costs per unit . . . . . . . . . . . . . . . . . . 40 90

Contribution margin per unit . . . . . . . . . . . . $ 80 $ 70

Machine hours to produce 1 unit . . . . . . . . . 0.4 hours 1.0 hours

Maximum unit sales per month . . . . . . . . . . . 600 units 200 units

The company presently operates the machine for a single eight-hour shift for 22 working days each month. Management is thinking about operating the machine for two shifts, which will increase its productivity by another eight hours per day for 22 days per month. This change would require $15,000 additional fixed costs per month.

Required

1. Determine the contribution margin per machine hour that each product generates. 2. How many units of Product G and Product B should the company produce if it continues to operate

with only one shift? How much total contribution margin does this mix produce each month? 3. If the company adds another shift, how many units of Product G and Product B should it produce?

How much total contribution margin would this mix produce each month? Should the company add the new shift? Explain.

4. Suppose that the company determines that it can increase Product G’s maximum sales to 700 units per month by spending $12,000 per month in marketing efforts. Should the company pursue this strategy and the double shift? Explain.

Check Units of Product G: (2) 440

(3) 600

(4) 700

Problem 23-5A Analysis of sales mix strategies

A1

3. Jackets can be reworked and turned into good jackets. However, with the damage, management estimates it will be able to assemble the good parts of the 5,000 jackets into only 3,000 jackets. The remaining pieces of fabric will be discarded. The cost of reworking the jackets will be $102,000, but the jackets can then be sold for their regular price of $45 each.

Required

Which alternative should Harold choose? Show analysis for each alternative. Check Incremental income for alternative 2, $28,000

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Chapter 23 Relevant Costing for Managerial Decisions 1007

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Allocated expenses Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . 65,000 39,000 104,000

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . 9,440 4,720 14,160

Bad debts expense . . . . . . . . . . . . . . . . . . . 9,900 8,100 18,000

Office salary . . . . . . . . . . . . . . . . . . . . . . . . 18,720 12,480 31,200

Insurance expense . . . . . . . . . . . . . . . . . . . 2,000 1,100 3,100

Miscellaneous office expenses . . . . . . . . . . 2,400 1,600 4,000

Total allocated expenses . . . . . . . . . . . . . . . 107,460 67,000 174,460

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 133,460 86,100 219,560

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . $ 40,540 $ (3,100) $ 37,440

In analyzing whether to eliminate Department 200, management considers the following: a. The company has one office worker who earns $600 per week, or $31,200 per year, and four sales-

clerks who each earn $500 per week, or $26,000 per year for each salesclerk. b. The full salaries of two salesclerks are charged to Department 100. The full salary of one salesclerk is

charged to Department 200. The salary of the fourth clerk, who works half-time in both departments, is divided evenly between the two departments.

c. Eliminating Department 200 would avoid the sales salaries and the office salary currently allocated to it. However, management prefers another plan. Two salesclerks have indicated that they will be quit- ting soon. Management believes that their work can be done by the other two clerks if the one office worker works in sales half-time. Eliminating Department 200 will allow this shift of duties. If this change is implemented, half the office worker’s salary would be reported as sales salaries and half would be reported as office salary.

d. The store building is rented under a long-term lease that cannot be changed. Therefore, Department 100 will use the space and equipment currently used by Department 200.

e. Closing Department 200 will eliminate its expenses for advertising, bad debts, and store supplies; 70% of the insurance expense allocated to it to cover its merchandise inventory; and 25% of the mis- cellaneous office expenses presently allocated to it.

Required

1. Prepare a three-column report that lists items and amounts for (a) the company’s total expenses (including cost of goods sold) — in column 1, (b) the expenses that would be eliminated by closing Department 200 — in column 2, and (c) the expenses that will continue — in column 3.

2. Prepare a forecasted annual income statement for the company reflecting the elimination of Depart- ment 200 assuming that it will not affect Department 100’s sales and gross profit. The statement should reflect the reassignment of the office worker to one-half time as a salesclerk.

Analysis Component

3. Reconcile the company’s combined net income with the forecasted net income assuming that Depart- ment 200 is eliminated (list both items and amounts). Analyze the reconciliation and explain why you think the department should or should not be eliminated.

Check (1) Total expenses: (a) $688,560, (b) $284,070

(2) Forecasted net income without Department 200, $31,510

PROBLEM SET B

Problem 23-1B Analysis of income effects of additional business

A1 P1

Windmire Company manufactures and sells to local wholesalers approximately 300,000 units per month at a sales price of $4 per unit. Monthly costs for the production and sale of this quantity follow.

Direct materials . . . . . . . . . . . . . . . . $384,000

Direct labor . . . . . . . . . . . . . . . . . . . 96,000

Overhead . . . . . . . . . . . . . . . . . . . . . 288,000

Selling expenses . . . . . . . . . . . . . . . . 120,000

Administrative expenses . . . . . . . . . 80,000

Total costs and expenses . . . . . . . . . $968,000

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1008 Chapter 23 Relevant Costing for Managerial Decisions

A new out-of-state distributor has offered to buy 50,000 units next month for $3.44 each. These units would be marketed in other states and would not affect Windtrax’s sales through its normal channels. A study of the costs of this new business reveals the following:

● Direct materials costs are 100% variable. ● Per unit direct labor costs for the additional units would be 50% higher than normal because their pro-

duction would require overtime pay at one and one half times their normal rate to meet the distributor’s deadline.

● Twenty-five percent of the normal annual overhead costs are fixed at any production level from 250,000 to 400,000 units. The remaining 75% is variable with volume.

● Accepting the new business would involve no additional selling expenses. ● Accepting the new business would increase administrative expenses by a $4,000 fixed amount.

Required

Prepare a three-column comparative income statement that shows the following: 1. Monthly operating income without the special order (column 1). 2. Monthly operating income received from the new business only (column 2). 3. Combined monthly operating income from normal business and the new business (column 3).

Check Operating income: (1) $232,000, (2) $44,000

Problem 23-2B Analysis of income effects of additional business

P1 A1

Mervin Company produces circuit boards that sell for $8 per unit. It currently has capacity to produce 600,000 circuit boards per year, but is selling 550,000 boards per year. Annual costs for the 550,000 circuit boards follow.

Direct materials . . . . . . . . . . . . . . . . $ 825,000

Direct labor . . . . . . . . . . . . . . . . . . . 1,100,000

Overhead . . . . . . . . . . . . . . . . . . . . . 1,375,000

Selling expenses . . . . . . . . . . . . . . . . 275,000

Administrative expenses . . . . . . . . . 550,000

Total costs and expenses . . . . . . . . . $4,125,000

An overseas customer has offered to buy 50,000 circuit boards for $6 per unit. The customer is in a differ- ent market from its regular customers and would not affect regular sales. A study of its costs in anticipa- tion of this additional business reveals the following:

● Direct materials and direct labor are 100% variable. ● Twenty percent of overhead is fixed at any production level from 550,000 units to 600,000 units; the

remaining 80% of annual overhead costs are variable with respect to volume. ● Selling expenses are 40% variable with respect to number of units sold, and the other 60% of selling

expenses are fixed. ● There will be an additional $0.20 per unit selling expense for this order. ● Administrative expenses would increase by a $700 fixed amount.

Required

1. Prepare a three-column comparative income statement that reports the following: a. Annual income without the special order. b. Annual income from the special order. c. Combined annual income from normal business and the new business. 2. Should management accept the order? What nonfinancial factors should Mervin consider? Explain.

Analysis Component

3. Assume that the new customer wants to buy 100,000 units instead of 50,000 units—it will only buy 100,000 units or none and will not take a partial order. Without any computations, how does this change your answer in part 2?

Check (1b) Additional income from order, $4,300

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Chapter 23 Relevant Costing for Managerial Decisions 1009

Problem 23-3B Make or buy

P1 A1

Alto Company currently produces component TH1 for its sole product. The current cost per unit to manufac- ture its required 400,000 units of TH1 follows.

Direct materials . . . . . . . . . . . $1.20

Direct labor . . . . . . . . . . . . . . 1.50

Overhead . . . . . . . . . . . . . . . . 6.00

Total cost per unit . . . . . . . . . $8.70

Direct materials and direct labor are 100% variable. Overhead is 75% fixed. An outside supplier has of- fered to supply the 400,000 units of TH1 for $4 per unit.

Required

1. Determine whether management should make or buy the TH1. 2. What factors besides cost must management consider when deciding whether to make or buy TH1?

Check (1) Incremental cost to make TH1, $1,680,000

Problem 23-4B Sell or process

P1 A1

Micron Manufacturing produces electronic equipment. This year, it produced 7,500 oscilloscopes at a manufacturing cost of $300 each. These oscilloscopes were damaged in the warehouse during storage and, while usable, cannot be sold at their regular selling price of $500 each. Management has investigated the matter and has identified three alternatives for these oscilloscopes. 1. They can be sold to a wholesaler for $75 each. 2. They can be disassembled at a cost of $400,000 and the parts sold to a recycler for $130 each. 3. They can be reworked and turned into good units. The cost of reworking the units will be $3,200,000,

after which the units can be sold at their regular price of $500 each.

Required

Which alternative should management pursue? Show analysis for each alternative. Check Incremental income for alternative 2, $575,000

Problem 23-5B Analysis of sales mix strategies

A1

Sung Company is able to produce two products, R and T, with the same machine in its factory. The following information is available.

Product R Product T

Selling price per unit . . . . . . . . . . . . . . . . . . . $60 $80

Variable costs per unit . . . . . . . . . . . . . . . . . . 20 45

Contribution margin per unit . . . . . . . . . . . . $40 $35

Machine hours to produce 1 unit . . . . . . . . . 0.4 hours 1.0 hours

Maximum unit sales per month . . . . . . . . . . . 550 units 175 units

The company presently operates the machine for a single eight-hour shift for 22 working days each month. Management is thinking about operating the machine for two shifts, which will increase its productivity by another eight hours per day for 22 days per month. This change would require $3,250 additional fixed costs per month.

Required

1. Determine the contribution margin per machine hour that each product generates. 2. How many units of Product R and Product T should the company produce if it continues to operate

with only one shift? How much total contribution margin does this mix produce each month? 3. If the company adds another shift, how many units of Product R and Product T should it produce?

How much total contribution margin would this mix produce each month? Should the company add the new shift? Explain.

4. Suppose that the company determines that it can increase Product R’s maximum sales to 675 units per month by spending $4,500 per month in marketing efforts. Should the company pursue this strategy and the double shift? Explain.

Check Units of Product R: (2) 440

(3) 550

(4) 675

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1010 Chapter 23 Relevant Costing for Managerial Decisions

In analyzing whether to eliminate Department Z, management considers the following items: a. The company has one office worker who earns $500 per week or $26,000 per year and four sales-

clerks who each earn $450 per week or $23,400 per year for each salesclerk. b. The full salaries of three salesclerks are charged to Department A. The full salary of one salesclerk is

charged to Department Z. c. Eliminating Department Z would avoid the sales salaries and the office salary currently allocated to

it. However, management prefers another plan. Two salesclerks have indicated that they will be quitting soon. Management believes that their work can be done by the two remaining clerks if the one office worker works in sales half-time. Eliminating Department Z will allow this shift of duties. If this change is implemented, half the office worker’s salary would be reported as sales salaries and half would be reported as office salary.

d. The store building is rented under a long-term lease that cannot be changed. Therefore, Department A will use the space and equipment currently used by Department Z.

e. Closing Department Z will eliminate its expenses for advertising, bad debts, and store supplies; 65% of the insurance expense allocated to it to cover its merchandise inventory; and 30% of the miscella- neous office expenses presently allocated to it.

Required

1. Prepare a three-column report that lists items and amounts for (a) the company’s total expenses (including cost of goods sold) — in column 1, (b) the expenses that would be eliminated by closing Department Z — in column 2, and (c) the expenses that will continue — in column 3.

2. Prepare a forecasted annual income statement for the company reflecting the elimination of Depart- ment Z assuming that it will not affect Department A’s sales and gross profit. The statement should reflect the reassignment of the office worker to one-half time as a salesclerk.

Analysis Component

3. Reconcile the company’s combined net income with the forecasted net income assuming that Depart- ment Z is eliminated (list both items and amounts). Analyze the reconciliation and explain why you think the department should or should not be eliminated.

Esme Company’s management is trying to decide whether to eliminate Department Z, which has produced low profits or losses for several years. The company’s 2013 departmental income statement shows the following.

ESME COMPANY Departmental Income Statements For Year Ended December 31, 2013

Dept. A Dept. Z Combined

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $700,000 $175,000 $875,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 461,300 125,100 586,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238,700 49,900 288,600

Operating expenses

Direct expenses

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000 3,000 30,000

Store supplies used . . . . . . . . . . . . . . . . . . . 5,600 1,400 7,000

Depreciation — Store equipment . . . . . . . . 14,000 7,000 21,000

Total direct expenses . . . . . . . . . . . . . . . . . . 46,600 11,400 58,000

Allocated expenses

Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . 70,200 23,400 93,600

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . 22,080 5,520 27,600

Bad debts expense . . . . . . . . . . . . . . . . . . . 21,000 4,000 25,000

Office salary . . . . . . . . . . . . . . . . . . . . . . . . 20,800 5,200 26,000

Insurance expense . . . . . . . . . . . . . . . . . . . . 4,200 1,400 5,600

Miscellaneous office expenses . . . . . . . . . . 1,700 2,500 4,200

Total allocated expenses . . . . . . . . . . . . . . . 139,980 42,020 182,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 186,580 53,420 240,000

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . $ 52,120 $ (3,520) $ 48,600

Problem 23-6B Analysis of possible elimination of a department

A1

Check (1) Total expenses: (a) $826,400, (b) $181,960

(2) Forecasted net income without Department Z, $55,560

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Chapter 23 Relevant Costing for Managerial Decisions 1011

BTN 23-1 Revenues for three of Polaris’ four segments for the year ending December 31, 2011 are re- ported below. Assume that Polaris reports operating expenses for each of its segments for that same year below.

Beyond the Numbers

REPORTING IN ACTION A1

Polaris

BTN 23-2 Polaris and Arctic Cat sell several different products; most are profitable but some are not. Teams of employees in each company make advertising, investment, and product mix decisions. A certain portion of advertising for both companies is on a local basis to a target audience.

Required

1. Contact the local newspaper and ask the approximate cost of ad space (for example, cost of one page or one-half page of advertising) for a company’s product or group of products (such as Polaris ATVs).

2. Estimate how many products this advertisement must sell to justify its cost. Begin by taking the prod- uct’s sales price advertised for each company and assume a 20% contribution margin.

3. Prepare a one-half page memorandum explaining the importance of effective advertising when making a product mix decision. Be prepared to present your ideas in class.

COMPARATIVE ANALYSIS A1

Polaris Arctic Cat

SERIAL PROBLEM Success Systems

P1 A1

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 23 Adria Lopez has found that her line of computer desks and chairs has become very popular and she is finding it hard to keep up with demand. She knows that she cannot fill all of her orders for both items, so she decides she must determine the optimal sales mix given the resources she has available. Information about the desks and chairs follows.

Adria has determined that she only has 1,015 direct labor hours available for the next quarter and wants to optimize her contribution margin given the limited number of direct labor hours available.

Required

Determine the optimal sales mix and the contribution margin the business will earn at that sales mix.

Desks Chairs

Selling price per unit . . . . . . . . . . . . . . . . . . . . . $1,125 $375

Variable costs per unit . . . . . . . . . . . . . . . . . . . 500 200

Contribution margin per unit . . . . . . . . . . . . . . $ 625 $175

Direct labor hours per unit . . . . . . . . . . . . . . . 5 hours 4 hours

Expected demand for next quarter . . . . . . . . . 175 desks 50 chairs

Required

1. Compute operating income for each segment. 2. If the results in part 1 are typical, what segments, if any, might Polaris decide to eliminate?

$ millions Off-road Snow On-road

Revenues . . . . . . . . . . . . . . . . . . $1,823 $280 $146

Operating expenses . . . . . . . . . 1,586 294 140

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1012 Chapter 23 Relevant Costing for Managerial Decisions

BTN 23-3 Bert Asiago, a salesperson for Convertco, received an order from a potential new customer for 50,000 units of Convertco’s single product at a price $25 below its regular selling price of $65. Asiago knows that Convertco has the capacity to produce this order without affecting regular sales. He has spoken to Convertco’s controller, Bia Morgan, who has informed Asiago that at the $40 selling price, Convertco will not be covering its variable costs of $42 for the product, and she recommends the order not be accepted. Asiago knows that variable costs include his sales commission of $4 per unit. If he accepts a $2 per unit commission, the sale will produce a contribution margin of zero. Asiago is eager to get the new customer because he be- lieves that this could lead to the new customer becoming a regular customer.

Required

1. Determine the contribution margin per unit on the order as determined by the controller. 2. Determine the contribution margin per unit on the order as determined by Asiago if he takes the lower

commission. 3. Do you recommend Convertco accept the special order? What factors must management consider?

ETHICS CHALLENGE P1 A1

BTN 23-4 Assume that you work for Greeble’s Department Store, and your manager requests that you outline the pros and cons of discontinuing its hardware department. That department appears to be gener- ating losses, and your manager believes that discontinuing it will increase overall store profits.

Required

Prepare a memorandum to your manager outlining what Greeble’s management should consider when trying to decide whether to discontinue its hardware department.

COMMUNICATING IN PRACTICE P1

BTN 23-5 Many companies must determine whether to internally produce their component parts or to outsource them. Further, some companies now outsource key components or business processes to international providers. Access the Website BizBrim.com and review the available information on business process outsourcing.

Required

1. What types of processes are commonly outsourced, according to Bizbrim? 2. What are some of the benefits listed for business process outsourcing?

TAKING IT TO THE NET A1

BTN 23-6 Break into teams and identify costs that an airline such as Delta Airlines would incur on a flight from Green Bay to Minneapolis. (1) Identify the individual costs as variable or fixed. (2) Assume that Delta is trying to decide whether to drop this flight because it seems to be unprofitable. Determine which costs are likely to be saved if the flight is dropped. Set up your answer in the following format.

TEAMWORK IN ACTION P1

Cost Variable or Fixed Cost Saved if Flight Is Dropped Rationale

ENTREPRENEURIAL DECISION A1

BTN 23-7 Charlie Fyffe of Charlie’s Brownies makes brownies and other sweets. Charlie must decide on the best sales mix for his products. Assume that his company has a capacity of 400 hours of processing time available each month and it makes two types of brownies, Deluxe and Premium. Information on these foods follows.

Deluxe Premium

Selling price per carton . . . . . . . . . . . . . . . . . $70 $90

Variable costs per carton . . . . . . . . . . . . . . . $40 $50

Processing minutes per carton . . . . . . . . . . . 60 minutes 120 minutes

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Chapter 23 Relevant Costing for Managerial Decisions 1013

Required

1. Assume the markets for both cartons of brownies are unlimited. How many Deluxe cartons and how many Premium cartons should the company make each month? Explain. How much total contribution margin does this mix produce each month?

2. Assume the market for the Deluxe carton is limited to 60 cartons per month, with no market limit for the Premium cartons. How many Deluxe cartons and how many Premium cartons should the company make each month? Explain. How much total contribution margin does this mix produce each month?

BTN 23-8 Restaurants are often adding and removing menu items. Visit a restaurant and identify a new food item. Make a list of costs that the restaurant must consider when deciding whether to add that new item. Also, make a list of nonfinancial factors that the restaurant must consider when adding that item.

HITTING THE ROAD P3

1. a; Reworking provides incremental revenue of $11 per unit ($19 2 $8); and, it costs $10 to rework them. The company is better off by $1 per unit when it reworks these products and sells them at the regular price.

2. e; Product X has a $2 contribution margin per machine hour [($32 2 $12)/ 10 MH]; Product Y has a $7 contribution margin per machine hour [($24 2 $10)/2 MH]. It should produce as much of Product Y as possible.

3. a; Total revenue from the special order 5 3,000 units 3 $15 per unit 5 $45,000; and, Total costs for the special order 5 (3,000 units 3 $9 per unit) 1 $5,000 5 $32,000. Net income from the special order 5 $45,000 2 $32,000 5 $13,000. Thus, yes, it should accept the order.

4. c 5. d

ANSWERS TO MULTIPLE CHOICE QUIZ

BTN 23-9 Access KTM’s 2011 annual report dated December 31, 2011, from its Website www.KTM.com. Identify and read the section in the Group Status Report—2011, section 12, regarding Sustainability.

Required

KTM reports that they developed a special KTM motorcyle logistics system on reusable metal plates. This special system eliminates additional packaging materials. These sustainability efforts are costly. Why would a company like KTM pursue these costly efforts?

GLOBAL DECISION C1

KTM

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Learning Objectives

CONCEPTUAL

C1 Describe the selection of a hurdle rate for an investment. (p. 1020)

ANALYTICAL

A1 Analyze a capital investment project using break-even time. (p. 1026)

PROCEDURAL

P1 Compute payback period and describe its use. (p. 1017) P2 Compute accounting rate of return and explain its use. (p. 1019) P3 Compute net present value and describe its use. (p. 1021) P4 Compute internal rate of return and explain its use. (p. 1023)

A Look at This Chapter

This chapter focuses on evaluating capital budgeting decisions. Several methods are described and illustrated that help managers identify projects with the greater return on investment.

A Look Back

Chapter 23 described several procedures useful for making and evaluating short- term managerial decisions. It also assessed the consequences of such decisions.

Capital Budgeting and Investment Analysis 24

1014

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Wow Factor

SAN DIEGO—“I have been battling greasy fingers and keyboard crumbs,” complained gamer Keith Mullin. “I thought ‘there has to be a better way!’” So, Keith-the-gamer morphed into Keith- the- entrepreneur. In 2008, Keith set up what he calls his “ga- rage startup” and introduced Gamer Grub® (GamerGrub. com), which is performance snack food for gamers. “I got tired of wiping my hands on my jeans,” laughs Keith. “And, I like to multi-task.” Success, however, requires Keith to monitor and minimize costs. “I made the first Gamer Grub prototypes in my mom’s kitchen,” explains Keith. He eventually set up an accounting sys- tem to track costs and match them with revenues. But, Keith says, it is a constant struggle as his business has been tripling in revenues each month. He explains that properly applying capital budgeting methods and acting on that information has helped in his success. However, admits Keith, “it is more of a collabora- tive effort.” To date, Keith has successfully controlled his costs while monitoring both revenues and customer needs. “You need to be in front of your customer, watch them taste it, watch them understand what you’re doing,” says Keith. “You have to be out

there . . . we have given out at least 16,000 samples!” Keith adds that he applies capital budgeting methods such as net present value and internal rate of return. These methods en- able Keith to expand his capacity and enter new markets that deliver high returns. He also relies on analyses from these methods to assess which snacks have positive returns and which investments in production operations to make. But, what keeps him going, admits Keith, is knowing that he offers “different ways to snack while you’re computer gaming or multi-tasking.” Keith is on a mission. What motivates him, explains Keith, is the “Wow! If you get that ‘Wow’ reaction, that’s a really good thing.” To make that happen, he tracks the accounting numbers to be sure his “Wow food” is a money-making venture. “Gamer Grub allows gamers to consume healthy, game-enhancing snacks,” insists Keith. “Without greasy fingers or keyboard crumbs!”

[Sources: GamerGrub Website, January 2013; Entrepreneur, October 2009; Business Wire, September 2008; MGC Website, January 2010]

“Be in front of your customer . . . [and] have a little bit of an edge.” —KEITH MULLIN (far left)

Decision Insight

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Chapter Preview

Management must assess alternative long-term strategies and investments, and then decide which assets to acquire or sell to achieve company objectives. This analysis process is called capital budgeting, which is one of the more challenging, risky, and important

tasks that management undertakes. This task requires predictions and estimates, and management’s capital budgeting decisions im- pact the company for years. This chapter explains and illustrates sev- eral methods to aid management in the capital budgeting decisions.

1016

Present Value Methods

• Net present value • Internal rate of return • Comparison of methods

Non-present Value Methods

• Payback period • Accounting rate

of return

Capital Budgeting and Investment Analysis

Point: The nature of capital spending has changed with the business environ- ment. Budgets for information technol- ogy have increased from about 25% of corporate capital spending 20 years ago to an estimated 35% today.

The capital expenditures budget is management’s plan for acquiring and selling plant assets. Capital budgeting is the process of analyzing alternative long-term investments and deciding which assets to acquire or sell. These decisions can involve developing a new product or pro- cess, buying a new machine or a new building, or acquiring an entire company. An objective for these decisions is to earn a satisfactory return on investment. Capital budgeting decisions require careful analysis because they are usually the most diffi- cult and risky decisions that managers make. These decisions are difficult because they require predicting events that will not occur until well into the future. Many of these predictions are tentative and potentially unreliable. Specifically, a capital budgeting decision is risky because (1) the outcome is uncertain, (2) large amounts of money are usually involved, (3) the invest- ment involves a long-term commitment, and (4) the decision could be difficult or impossible to reverse, no matter how poor it turns out to be. Risk is especially high for investments in technol- ogy due to innovations and uncertainty. Managers use several methods to evaluate capital budgeting decisions. Nearly all of these methods involve predicting cash inflows and cash outflows of proposed investments, assessing the risk of and returns on those flows, and then choosing the investments to make. Manage- ment often restates future cash flows in terms of their present value. This approach applies the time value of money: A dollar today is worth more than a dollar tomorrow. Similarly, a dollar tomorrow is worth less than a dollar today. The process of restating future cash flows in terms of their present value is called discounting. The time value of money is important when evalu- ating capital investments, but managers sometimes apply evaluation methods that ignore pres- ent value. This section describes four methods for comparing alternative investments.

INTRODUCTION TO CAPITAL BUDGETING

All investments, whether they involve the purchase of a machine or another long-term asset, are expected to produce net cash flows. Net cash flow is cash inflows minus cash outflows. Some- times managers perform simple analyses of the financial feasibility of an invest ment’s net cash flow without using the time value of money. This section explains two of the most common methods in this category: (1) payback period and (2) accounting rate of return.

Payback Period An investment’s payback period (PBP) is the expected time period to recover the initial investment amount. Managers prefer investing in assets with shorter payback periods to reduce the risk of an unprofitable investment over the long run. Acquiring assets with short payback

METHODS NOT USING TIME VALUE OF MONEY

M et

ho ds

N OT

usi ng Time Value of M

oney

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Chapter 24 Capital Budgeting and Investment Analysis 1017

P1 Compute payback period and describe its use.

EXHIBIT 24.1 Cash Flow Analysis

FASTRAC Cash Flow Analysis—Machinery Investment

January 15, 2013

Expected Expected Accrual Net Cash Income Flow

Annual sales of new product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 $30,000

Deduct annual expenses

Cost of materials, labor, and overhead (except depreciation) . . . . . . . . . 15,500 15,500

Depreciation—Machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Additional selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . 9,500 9,500

Annual pretax accrual income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 900

Annual net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,100

Annual net cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,100

The amount of net cash flow from the machinery is computed by subtracting expected cash outflows from expected cash inflows. The cash flows column of Exhibit 24.1 excludes all noncash revenues and expenses. Depreciation is FasTrac’s only noncash item. Alternatively, managers can adjust the projected net income for revenue and expense items that do not affect cash flows. For FasTrac, this means taking the $2,100 net income and adding back the $2,000 depreciation. The formula for computing the payback period of an investment that yields even net cash flows is in Exhibit 24.2.

Point: Annual net cash flow in Exhibit 24.1 equals net income plus depreciation (a noncash expense).

EXHIBIT 24.2 Payback Period Formula with Even Cash Flows

Payback period 5 Cost of investment

Annual net cash flow

periods reduces a company’s risk from potentially inaccurate long-term predictions of future cash flows.

Computing Payback Period with Even Cash Flows To illustrate use of the payback period for an investment with even cash flows, we look at data from FasTrac, a manu- facturer of exercise equipment and supplies. (Even cash flows are cash flows that are the same each and every year; uneven cash flows are cash flows that are not all equal in amount.) FasTrac is considering several different capital investments, one of which is to purchase a machine to use in manufacturing a new product. This machine costs $16,000 and is expected to have an eight-year life with no salvage value. Management predicts this machine will produce 1,000 units of product each year and that the new product will be sold for $30 per unit. Exhibit 24.1 shows the expected annual net cash flows for this asset over its life as well as the expected annual revenues and ex- penses (including depreciation and income taxes) from investing in the machine.

Payback period 5 $16,000

$4,100 5 3.9 years

The payback period reflects the amount of time for the investment to generate enough net cash flow to return (or pay back) the cash initially invested to purchase it. FasTrac’s payback period for this machine is just under four years:

Example: If an alternative machine (with different technology) yields a payback period of 3.5 years, which one does a manager choose? Answer: The alternative (3.5 is less than 3.9).

The initial investment is fully recovered in 3.9 years, or just before reaching the halfway point of this machine’s useful life of eight years.

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1018 Chapter 24 Capital Budgeting and Investment Analysis

EXHIBIT 24.3 Payback Period Calculation with Uneven Cash Flows

Period* Expected Net Cash Flows Cumulative Net Cash Flows

Year 0 . . . . . . . . . . $(16,000) $(16,000)

Year 1 . . . . . . . . . . 3,000 (13,000)

Year 2 . . . . . . . . . . 4,000 (9,000)

Year 3 . . . . . . . . . . . 4,000 (5,000)

Year 4 . . . . . . . . . . 4,000 (1,000)

Year 5 . . . . . . . . . . 5,000 4,000

Year 6 . . . . . . . . . . 3,000 7,000

Year 7 . . . . . . . . . . 2,000 9,000

Year 8 . . . . . . . . . . 2,000 11,000

Payback period 5 4.2 years

* All cash inflows and outflows occur uniformly during the year.

Computing Payback Period with Uneven Cash Flows Computing the payback period in the prior section assumed even net cash flows. What happens if the net cash flows are uneven? In this case, the payback period is computed using the cumulative total of net cash flows. The word cumulative refers to the addition of each period’s net cash flows as we progress through time. To illustrate, consider data for another investment that FasTrac is considering. This machine is predicted to generate uneven net cash flows over the next eight years. The rel- evant data and payback period computation are shown in Exhibit 24.3.

Example: Find the payback period in Exhibit 24.3 if net cash flows for the first 4 years are: Year 1 5 $6,000; Year 2 5 $5,000; Year 3 5 $4,000; Year 4 5 $3,000. Answer: 3.33 years

Year 0 refers to the period of initial investment in which the $16,000 cash outflow occurs at the end of year 0 to acquire the machinery. By the end of year 1, the cumulative net cash flow is reduced to $(13,000), computed as the $(16,000) initial cash outflow plus year 1’s $3,000 cash inflow. This process continues throughout the asset’s life. The cumulative net cash flow amount changes from negative to positive in year 5. Specifically, at the end of year 4, the cumulative net cash flow is $(1,000). As soon as FasTrac receives net cash inflow of $1,000 during the fifth year, it has fully recovered the investment. If we assume that cash flows are received uniformly within each year, receipt of the $1,000 occurs about one-fifth of the way through the year. This is computed as $1,000 divided by year 5’s total net cash flow of $5,000, or 0.20. This yields a payback period of 4.2 years, computed as 4 years plus 0.20 of year 5.

Using the Payback Period Companies desire a short payback period to increase return and reduce risk. The more quickly a company receives cash, the sooner it is available for other uses and the less time it is at risk of loss. A shorter payback period also improves the company’s ability to respond to unanticipated changes and lowers its risk of having to keep an unprofitable investment. Payback period should never be the only consideration in evaluating investments. This is so because it ignores at least two important factors. First, it fails to reflect differences in the timing of net cash flows within the payback period. In Exhibit 24.3, FasTrac’s net cash flows in the first five years were $3,000, $4,000, $4,000, $4,000, and $5,000. If another investment had predicted cash flows of $9,000, $3,000, $2,000, $1,800, and $1,000 in these five years, its payback period would also be 4.2 years, but this second alternative could be more desirable because it provides

e-Payback Health-care providers are increasingly using electronic systems to improve their operations. With e-charting, doctor’s orders and notes are saved electronically. Such systems allow for more person- alized care plans, more efficient staffing, and reduced costs. Invest- ments in such systems must be evaluated on the basis of payback periods and other financial measures. ■

Decision Insight

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Chapter 24 Capital Budgeting and Investment Analysis 1019

cash more quickly. The second important factor is that the payback period ignores all cash flows after the point where its costs are fully recovered. For example, one investment might pay back its cost in 3 years but stop producing cash after 4 years. A second investment might require 5 years to pay back its cost yet continue to produce net cash flows for another 15 years. A focus on only the payback period would mistakenly lead management to choose the first investment over the second.

1. Capital budgeting is (a) concerned with analyzing alternative sources of capital, including debt and equity, (b) an important activity for companies when considering what assets to acquire or sell, or (c) best done by intuitive assessments of the value of assets and their usefulness.

2. Why are capital budgeting decisions often difficult? 3. A company is considering purchasing equipment costing $75,000. Future annual net cash

flows from this equipment are $30,000, $25,000, $15,000, $10,000, and $5,000. The payback period is (a) 4 years, (b) 3.5 years, or (c) 3 years.

4. If depreciation is an expense, why is it added back to an investment’s net income to compute the net cash flow from that investment?

5. If two investments have the same payback period, are they equally desirable? Explain.

Quick Check Answers — p. 1030

Accounting Rate of Return The accounting rate of return, also called return on average investment, is computed by divid- ing a project’s after-tax net income by the average amount invested in it. To illustrate, we return to FasTrac’s $16,000 machinery investment described in Exhibit 24.1. We first compute (1) the after-tax net income and (2) the average amount invested. The $2,100 after-tax net income is already available from Exhibit 24.1. If a company uses straight-line depreciation, we can find the average amount invested by us- ing the formula in Exhibit 24.4. Because FasTrac uses straight-line depreciation, its average amount invested for the eight years equals the sum of the book value at the beginning of the asset’s investment period and the book value at the end of its investment period, divided by 2, as shown in Exhibit 24.4.

P2 Compute accounting rate of return and explain its use.

Point: Amount invested includes all costs that must be incurred to get the asset in its location and ready for use.

EXHIBIT 24.4 Computing Average Amount Invested under Straight-Line Depreciation

Annual average investment 5 Beginning book value 1 Ending book value

2

5 $16,000 1 $0

2 5 $8,000

(straight-line case only)

If an investment has a salvage value, the average amount invested when using straight-line de- preciation is computed as (Beginning book value 1 Salvage value)y2. If a company uses a depreciation method other than straight-line, the calculation of aver- age book value is more complicated. In this case, the book value of the asset is computed for each year of its life. The general formula for the annual average investment is shown in Exhibit 24.5.

Annual average investment 5 Sum of individual years’ average book values

Number of years of the planned investment

EXHIBIT 24.5 General Formula for Average Amount Invested(general case)

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1020 Chapter 24 Capital Budgeting and Investment Analysis

This yields an accounting rate of return of 26.25% ($2,100y$8,000). FasTrac management must decide whether a 26.25% accounting rate of return is satisfactory. To make this decision, we must factor in the investment’s risk. For instance, we cannot say an investment with a 26.25% return is preferred over one with a lower return unless we consider any differences in risk. Thus, an investment’s return is satisfactory or unsatisfactory only when it is related to returns from other investments with similar lives and risk. When accounting rate of return is used to choose among capital investments, the one with the least risk, the shortest payback period, and the highest return for the longest time period is often identified as the best. However, use of accounting rate of return to evaluate investment opportuni- ties is limited because it bases the amount invested on book values (not predicted market values) in future periods. Accounting rate of return is also limited when an asset’s net incomes are ex- pected to vary from year to year. This requires computing the rate using average annual net in- comes, yet this accounting rate of return fails to distinguish between two investments with the same average annual net income but different amounts of income in early years versus later years or different levels of income variability.

6. The following data relate to a company’s decision on whether to purchase a machine:

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $180,000

Salvage value . . . . . . . . . . . . . . . . . . . . . . . 15,000

Annual after-tax net income . . . . . . . . . . . 40,000

The machine’s accounting rate of return, assuming the even receipt of its net cash flows dur- ing the year and use of straight-line depreciation, is (a) 22%, (b) 41%, or (c) 21%.

7. Is a 15% accounting rate of return for a machine a good rate?

Quick Check Answers — p. 1030

This section describes two methods that help managers with capital budgeting decisions and that use the time value of money: (1) net present value and (2) internal rate of return. (To apply these methods, you need a basic understanding of the concept of present value. An expanded explanation of present value concepts is in Appendix B near the end of the book. You can use the present value tables at the end of Appendix B to solve many of this chapter’s assignments that use the time value of money.)

Net Present Value Net present value analysis applies the time value of money to future cash inflows and cash out- flows so management can evaluate a project’s benefits and costs at one point in time. Specifi- cally, net present value (NPV) is computed by discounting the future net cash flows from the investment at the project’s required rate of return and then subtracting the initial amount in- vested. A company’s required return, often called its hurdle rate, is typically its cost of capital, which is the rate the company must pay to its long-term creditors and shareholders. To illustrate, let’s return to FasTrac’s proposed machinery purchase described in Exhibit 24.1. Does this machine provide a satisfactory return while recovering the amount invested? Recall that the machine requires a $16,000 investment and is expected to provide $4,100 annual net cash inflows for the next eight years. If we assume that net cash flows from this machine are received at each year-end and that FasTrac requires a 12% annual return, net present value can be computed as in Exhibit 24.7.

METHODS USING TIME VALUE OF MONEY

Methods using Time Value of Money

Accounting rate of return 5 Annual after-tax net income Annual average investment

EXHIBIT 24.6 Accounting Rate of Return Formula

Once we determine the after-tax net income and the average amount invested, the account ing rate of return on the investment can be computed from the annual after-tax net income divided by the average amount invested, as shown in Exhibit 24.6.

C1 Describe the selection of a hurdle rate for an investment.

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Chapter 24 Capital Budgeting and Investment Analysis 1021

EXHIBIT 24.7 Net Present Value Calculation with Equal Cash Flows

Present Value Present Value of Net Cash Flows* of 1 at 12%† Net Cash Flows

Year 1 . . . . . . . . . . . . . . . . . . . . . $ 4,100 0.8929 $ 3,661

Year 2 . . . . . . . . . . . . . . . . . . . . . 4,100 0.7972 3,269

Year 3 . . . . . . . . . . . . . . . . . . . . . 4,100 0.7118 2,918

Year 4 . . . . . . . . . . . . . . . . . . . . . 4,100 0.6355 2,606

Year 5 . . . . . . . . . . . . . . . . . . . . . 4,100 0.5674 2,326

Year 6 . . . . . . . . . . . . . . . . . . . . . 4,100 0.5066 2,077

Year 7 . . . . . . . . . . . . . . . . . . . . . 4,100 0.4523 1,854

Year 8 . . . . . . . . . . . . . . . . . . . . . 4,100 0.4039 1,656

Totals . . . . . . . . . . . . . . . . . . . . . $32,800 20,367

Amount invested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (16,000)

Net present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,367

* Cash flows occur at the end of each year. † Present value of 1 factors are taken from Table B.1 in Appendix B.

Accept

project

Reject

project

Present

value

of net

cash

flows

($)

Amount

invested

($)

If ≥ $0

If < $0

Net

present

value

($)

P3 Compute net present value and describe its use. The first number column of Exhibit 24.7 shows the annual net cash flows. Present value of 1 factors, also called discount factors, are shown in the second column. Taken from Table B.1 in Appendix B, they assume that net cash flows are received at each year-end. (To simplify present value computations and for assignment material at the end of this chapter, we as- sume that net cash flows are received at each year-end.) Annual net cash flows from the first column of Exhibit 24.7 are multiplied by the discount factors in the second column to give present values shown in the third column. The last three lines of this exhibit show the final NPV computations. The asset’s $16,000 initial cost is deducted from the $20,367 total pres- ent value of all future net cash flows to give this asset’s NPV of $4,367. The machine is thus expected to (1) recover its cost, (2) provide a 12% compounded return, and (3) generate $4,367 above cost. We summarize this analysis by saying the present value of this machine’s future net cash flows to FasTrac exceeds the $16,000 investment by $4,367.

Net Present Value Decision Rule The decision rule in applying NPV is as follows: When an asset’s expected cash flows are discounted at the required rate and yield a positive net present value, the asset should be acquired. This decision rule is reflected in the graphic below. When comparing several investment opportunities of about the same cost and same risk, we prefer the one with the highest positive net present value.

Point: The assumption of end-of-year cash flows simplifies computations and is common in practice.

Example: What is the net present value in Exhibit 24.7 if a 10% return is required? Answer: $5,873

Cost of capital by industry

E-commerce

2%0% 4% 6% 8% 10% 12%

Computers

Apparel

Advertising

Simplifying Computations The computations in Exhibit 24.7 use separate present value of 1 factors for each of the eight years. Each year’s net cash flow is multiplied by its present value of 1 factor to determine its present value. The individual present values for each of the eight net cash flows are added to give the asset’s total present value. This computation can be simplified in two ways if annual net cash flows are equal in amount. A series of cash flows of equal dollar amount is called an annuity. One way is to add the eight annual present value of 1 factors for a total of 4.9676 and multiply this amount by the annual $4,100 net cash flow to get the $20,367 total present value of net cash flows.1 A second simplification is to use a calculator

Example: Why does the net present value of an investment increase when a lower discount rate is used? Answer: The present value of net cash flows increases.

1 We can simplify this computation using Table B.3, which gives the present value of 1 to be received periodically for a number of periods. To determine the present value of these eight annual receipts discounted at 12%, go down the 12% column of Table B.3 to the factor on the eighth line. This cumulative discount factor, also known as an annuity factor, is 4.9676. We then compute the $20,367 present value for these eight annual $4,100 receipts, computed as 4.9676 3 $4,100.

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1022 Chapter 24 Capital Budgeting and Investment Analysis

EXHIBIT 24.8 Net Present Value Calculation with Uneven Cash Flows

Present

Present Value of Net Cash Flows

Value of Net Cash Flows

A B C 1 at 10% A B C

Year 1 . . . . . . . . . . . . . . . . $ 5,000 $ 8,000 $ 1,000 0.9091 $ 4,546 $ 7,273 $ 909

Year 2 . . . . . . . . . . . . . . . . 5,000 5,000 5,000 0.8264 4,132 4,132 4,132

Year 3 . . . . . . . . . . . . . . . . 5,000 2,000 9,000 0.7513 3,757 1,503 6,762

Totals . . . . . . . . . . . . . . . . $15,000 $15,000 $15,000 12,435 12,908 11,803

Amount invested . . . . . . . (12,000) (12,000) (12,000)

Net present value . . . . $ 435 $ 908 $ (197)

Uneven Cash Flows Net present value analysis can also be applied when net cash flows are uneven (unequal). To illustrate, assume that FasTrac can choose only one capital investment from among projects A, B, and C. Each project requires the same $12,000 initial investment. Future net cash flows for each project are shown in the first three number columns of Exhibit 24.8.

Example: If 12% is the required return in Exhibit 24.8, which project is preferred? Answer: Project B. Net present values are: A 5 $10; B 5 $553; C 5 $(715).

The three projects in Exhibit 24.8 have the same expected total net cash flows of $15,000. Proj- ect A is expected to produce equal amounts of $5,000 each year. Project B is expected to pro- duce a larger amount in the first year. Project C is expected to produce a larger amount in the third year. The fourth column of Exhibit 24.8 shows the present value of 1 factors from Table B.1 assuming 10% required return. Computations in the right-most columns show that Project A has a $435 positive NPV. Proj- ect B has the largest NPV of $908 because it brings in cash more quickly. Project C has a $(197) negative NPV because its larger cash inflows are delayed. If FasTrac requires a 10% return, it should reject Project C because its NPV implies a return under 10%. If only one project can be accepted, project B appears best because it yields the highest NPV.

Salvage Value FasTrac predicted the $16,000 machine to have zero salvage value at the end of its useful life (recall Exhibit 24.1). In many cases, assets are expected to have salvage values. If so, this amount is an additional net cash inflow received at the end of the final year of the asset’s life. All other computations remain the same. For example, the net present value of the $16,000 investment that yields $4,100 of net cash flows for eight years is $4,367, as shown in Exhibit 24.7. If that machine is expected to have a $1,500 salvage value at the end of its eight- year life, the present value of this salvage amount is $606 (computed as $1,500 3 0.4039). The net present value of the machine, including the present value of its expected salvage amount, is $4,973 (computed as $4,367 1 $606).

Accelerated Depreciation Depreciation computations also affect net present value analysis. FasTrac computes depreciation using the straight-line method. Accelerated deprecia- tion is also commonly used, especially for income tax reports. Accelerated depreciation pro- duces larger depreciation deductions in the early years of an asset’s life and smaller deductions in later years. This pattern results in smaller income tax payments in early years and larger pay- ments in later years. Accelerated depreciation does not change the basics of a present value analysis, but it can change the result. Using accelerated depreciation for tax reporting affects the NPV of an asset’s cash flows because it produces larger net cash inflows in the early years

Example: Will the rankings of Projects A, B, and C change with the use of differ- ent discount rates, assuming the same rate is used for all projects? Answer: No; only the NPV amounts will change.

with compound interest functions or a spreadsheet program. We show how to use Excel func- tions to compute net present value in this chapter’s Appendix. Whatever procedure you use, it is important to understand the concepts behind these computations.

Systems Manager Top management adopts a policy requiring purchases in excess of $5,000 to be submitted with cash flow projections to the cost analyst for capital budget approval. As systems manager, you want to upgrade your computers at a $25,000 cost. You consider submitting several orders all under $5,000 to avoid the approval process. You believe the computers will increase profits and wish to avoid a delay. What do you do? ■ [Answer—p. 1030]

Decision Ethics

Point: Projects with higher cash flows in earlier years generally yield higher net present values.

Point: Tax savings from depreciation is called: depreciation tax shield.

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Chapter 24 Capital Budgeting and Investment Analysis 1023

of the asset’s life and smaller ones in later years. Being able to use accelerated depreciation for tax reporting always makes an investment more desirable because early cash flows are more valuable than later ones.

Use of Net Present Value In deciding whether to proceed with a capital investment project, we approve the proposal if the NPV is positive but reject it if the NPV is negative. When considering several projects of similar investment amounts and risk levels, we can compare the different projects’ NPVs and rank them on the basis of their NPVs. However, if the amount in- vested differs substantially across projects, the NPV is of limited value for comparison pur- poses. One means to compare projects, especially when a company cannot fund all positive net present value projects, is to use the profitability index, which is computed as:

Example: When is it appropriate to use different discount rates for different projects? Answer: When risk levels are different.

Profitability index 5 Net present value of cash flows

Investment

A higher profitability index suggests a more desirable project. To illustrate, suppose that Proj- ect X requires a $1 million investment and provides a $100,000 NPV. Project Y requires an in- vestment of only $100,000 and returns a $75,000 NPV. Ranking on the basis of NPV puts Project X ahead of Y, yet X’s profitability index is only 0.10 ($100,000/$1,000,000) whereas Y’s profitability index is 0.75. We must also remember that when reviewing projects with different risks, we computed the NPV of individual projects using different discount rates. The higher the risk, the higher the discount rate.

Inflation Large price-level increases should be considered in NPV analyses. Hurdle rates should already include inflation forecasts. Net cash flows can be adjusted for inflation by using future value computations. For example, if the expected net cash inflow in year 1 is $4,100 and 5% inflation is expected, then the expected net cash inflow in year 2 is $4,305, computed as $4,100 3 1.05 (1.05 is the future value of $1 (Table B.2) for 1 period with a 5% rate).

Internal Rate of Return Another means to evaluate capital investments is to use the internal rate of return (IRR), which equals the rate that yields an NPV of zero for an investment. This means that if we com- pute the total present value of a project’s net cash flows using the IRR as the discount rate and then subtract the initial investment from this total present value, we get a zero NPV. To illustrate, we use the data for FasTrac’s Project A from Exhibit 24.8 to compute its IRR. Exhibit 24.9 shows the two-step process in computing IRR.

P4 Compute internal rate of return and explain its use.

EXHIBIT 24.9 Computing Internal Rate of Return (with even cash flows)

Step 1: Compute the present value factor for the investment project.

Present value factor 5

Amount invested Net cash flows

5 $12,000

$5,000 5 2.4000

Step 2: Identify the discount rate (IRR) yielding the present value factor

Search Table B.3 for a present value factor of 2.4000 in the three-year row (equal- ing the 3-year project duration). The 12% discount rate yields a present value factor of 2.4018. This implies that the IRR is approximately 12%.*

* Since the present value factor of 2.4000 is not exactly equal to the 12% factor of 2.4018, we can more precisely estimate the IRR as follows:

Discount rate Present Value Factor from Table B.3

12% 2.4018 15% 2.2832 0.1186 5 difference

Then, IRR 5 12% 1 c (15% 2 12% ) 3 2.4018 2 2.4000 0.1186

d 5 12.05%

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1024 Chapter 24 Capital Budgeting and Investment Analysis

When cash flows are equal, as with Project A, we compute the present value factor (as shown in Exhibit 24.9) by dividing the initial investment by its annual net cash flows. We then use an an- nuity table to determine the discount rate equal to this present value factor. For FasTrac’s Project A, we look across the three-period row of Table B.3 and find that the discount rate correspond- ing to the present value factor of 2.4000 roughly equals the 2.4018 value for the 12% rate. This row is reproduced here:

Discount Rate

Periods 1% 5% 10% 12% 15%

3 . . . . . . . . . . . . 2.9410 2.7232 2.4869 2.4018 2.2832

Present Value of an Annuity of 1 for Three Periods

The 12% rate is the Project’s IRR. A more precise IRR estimate can be computed following the procedure shown in the note to Exhibit 24.9. Spreadsheet software and calculators can also com- pute this IRR. We show how to use an Excel function to compute IRR in this chapter’s appendix.

Uneven Cash Flows If net cash flows are uneven, we must use trial and error to compute the IRR. We do this by selecting any reasonable discount rate and computing the NPV. If the amount is positive (negative), we recompute the NPV using a higher (lower) discount rate. We continue these steps until we reach a point where two consecutive computations result in NPVs having different signs (positive and negative). Because the NPV is zero using IRR, we know that the IRR lies between these two discount rates. We can then estimate its value. Spreadsheet programs and calculators can also do these computations.

Use of Internal Rate of Return When we use the IRR to evaluate a project, we com- pare it to a predetermined hurdle rate, which is a minimum acceptable rate of return and is applied as follows:

Accept

project

Reject

project

Internal

rate of

return

(%)

Hurdle

rate

(%)

If ≥ 0%

If < 0%

Top management selects the hurdle rate to use in evaluating capital investments. Financial formu- las aid in this selection, but the choice of a minimum rate is subjective and left to management. For projects financed from borrowed funds, the hurdle rate must exceed the interest rate paid on these funds. The return on an investment must cover its interest and provide an additional profit to re- ward the company for its risk. For instance, if money is borrowed at 10%, an average risk invest- ment often requires an after-tax return of 15% (or 5% above the borrowing rate). Remember that lower-risk investments require a lower rate of return compared with higher-risk investments. If the project is internally financed, the hurdle rate is often based on actual returns from com- parable projects. If the IRR is higher than the hurdle rate, the project is accepted. Multiple proj- ects are often ranked by the extent to which their IRR exceeds the hurdle rate. The hurdle rate

Example: How does management evaluate the risk of an investment? Answer: It must assess the uncertainty of future cash flows.

CEO-IRR A survey reported that 41% of top managers would reject a project with an internal rate of return above the cost of capital if the project would cause the firm to miss its earnings forecast. The roles of benchmarks and manager compensation plans must be considered in capital budgeting decisions. ■

Decision Insight

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Chapter 24 Capital Budgeting and Investment Analysis 1025

EXHIBIT 24.10 Comparing Capital Budgeting Methods

Accounting Rate Net Present Internal Rate Payback Period of Return Value of Return

Measurement basis ● Cash flows ● Accrual income ● Cash flows ● Cash flows

● Profitability ● Profitability

Measurement unit ● Years ● Percent ● Dollars ● Percent

Strengths ● Easy to understand ● Easy to understand ● Reflects time value ● Reflects time value of money of money

● Allows comparison ● Allows comparison ● Reflects varying risks ● Allows comparisons of projects of projects over project’s life of dissimilar projects

Limitations ● Ignores time ● Ignores time value ● Difficult to compare ● Ignores varying risks value of money of money dissimilar projects over life of project

● Ignores cash flows ● Ignores annual rates after payback period over life of project

Comparison of Capital Budgeting Methods We explained four methods that managers use to evaluate capital investment projects. How do these methods compare with each other? Exhibit 24.10 addresses that question. Neither the payback period nor the accounting rate of return considers the time value of money. On the other hand, both the net present value and the internal rate of return do.

for individual projects is often different, depending on the risk involved. IRR is not subject to the limitations of NPV when comparing projects with different amounts invested because the IRR is expressed as a percent rather than as an absolute dollar value in NPV.

The payback period is probably the simplest method. It gives managers an estimate of how soon they will recover their initial investment. Managers sometimes use this method when they have limited cash to invest and a number of projects to choose from. The accounting rate of return yields a percent measure computed using accrual income instead of cash flows. The ac- counting rate of return is an average rate for the entire investment period. Net present value considers all estimated net cash flows for the project’s expected life. It can be applied to even and uneven cash flows and can reflect changes in the level of risk over a project’s life. Since it yields a dollar measure, comparing projects of unequal sizes is more difficult. The profitability index, based on each project’s net present value, can be used in this case. The internal rate of return considers all cash flows from a project. It is readily computed when the cash flows are even but requires some trial and error or use of a computer estimation when cash flows are un- even. Because the IRR is a percent mea sure, it is readily used to compare projects with different investment amounts. However, IRR does not reflect changes in risk over a project’s life.

And the Winner Is . . . How do we choose among the methods for evaluating capital investments? Man- agement surveys consistently show the internal rate of return (IRR) as the most popular method followed by the payback period and net present value (NPV). Few companies use the ac counting rate of return (ARR), but nearly all use more than one method. ■

Decision Insight

Company Usage of Capital Budgeting Methods

40%20% 30%10%0%

ARR

NPV

Payback

IRR

Other

Entrepreneur You are developing a new product and you use a 12% discount rate to compute its NPV. Your banker, from whom you hope to obtain a loan, expresses concern that your discount rate is too low. How do you respond? ■ [Answer—p. 1030]

Decision Maker

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1026 Chapter 24 Capital Budgeting and Investment Analysis

Siemens AG is a global electrical engineering and electronics company headquartered in Germany. Re- cently, the company announced plans to invest £80 million to build a wind turbine plant in the United Kingdom. Net present value analyses support such decisions. In this case, Siemens foresees strong future cash flows based on increased demand for clean sources of energy, like wind power.

GLOBAL VIEW

Break-Even TimeDecision Analysis

The first section of this chapter explained several methods to evaluate capital investments. Break-even time of an investment project is a variation of the payback period method that overcomes the limitation of not using the time value of money. Break-even time (BET) is a time-based measure used to evaluate a capital investment’s acceptability. Its computation yields a measure of expected time, reflecting the time period until the present value of the net cash flows from an investment equals the initial cost of the investment. In basic terms, break-even time is computed by restating future cash flows in terms of present values and then determining the payback period using these present values. To illustrate, we return to the FasTrac case described in Exhibit 24.1 involving a $16,000 investment in machinery. The annual net cash flows from this investment are projected at $4,100 for eight years. Exhibit 24.11 shows the computation of break-even time for this investment decision.

A1 Analyze a capital invest-ment project using break-even time.

8. A company can invest in only one of two projects, A or B. Each project requires a $20,000 investment and is expected to generate end-of-period, annual cash flows as follows:

Year 1 Year 2 Year 3 Total

Project A . . . . . . . . . $12,000 $8,500 $4,000 $24,500

Project B . . . . . . . . . 4,500 8,500 13,000 26,000

Assuming a discount rate of 10%, which project has the higher net present value?

9. Two investment alternatives are expected to generate annual cash flows with the same net present value (assuming the same discount rate applied to each). Using this information, can you conclude that the two alternatives are equally desirable?

10. When two investment alternatives have the same total expected cash flows but differ in the timing of those flows, which method of evaluating those investments is superior, (a) accounting rate of return or (b) net present value?

Quick Check Answers — p. 1031

EXHIBIT 24.11 Break-Even Time Analysis*

Present Value Present Value Cumulative Present Year Cash Flows of 1 at 10% of Cash Flows Value of Cash Flows

0 . . . . . . . . . $(16,000) 1.0000 $(16,000) $(16,000)

1 . . . . . . . . . 4,100 0.9091 3,727 (12,273)

2 . . . . . . . . . 4,100 0.8264 3,388 (8,885)

3 . . . . . . . . . 4,100 0.7513 3,080 (5,805)

4 . . . . . . . . . 4,100 0.6830 2,800 (3,005)

5 . . . . . . . . . 4,100 0.6209 2,546 (459)

6 . . . . . . . . . 4,100 0.5645 2,314 1,855

7 . . . . . . . . . 4,100 0.5132 2,104 3,959

8 . . . . . . . . . 4,100 0.4665 1,913 5,872

* The time of analysis is the start of year 1 (same as end of year 0). All cash flows occur at the end of each year.

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Chapter 24 Capital Budgeting and Investment Analysis 1027

The right-most column of this exhibit shows that break-even time is between 5 and 6 years, or about 5.2 years—also see margin graph (where the line crosses the zero point). This is the time the project takes to break even after considering the time value of money (recall that the payback period computed without considering the time value of money was 3.9 years). We interpret this as cash flows earned after 5.2 years contribute to a positive net present value that, in this case, eventually amounts to $5,872.

Break-even time is a useful measure for managers because it identifies the point in time when they can expect the cash flows to begin to yield net positive returns. Managers expect a positive net present value from an investment if break-even time is less than the investment’s estimated life. The method al- lows managers to compare and rank alternative investments, giving the project with the shortest break-even time the highest rank.

0 1 2 3 4 5 76 8 –$16,000

–$12,000

–$8,000

–$4,000

$0

$4,000

$8,000

Cumulative Present Value of Cash Flows

Investment Manager Management asks you, the investment manager, to evaluate three alternative investments. Investment recovery time is crucial because cash is scarce. The time value of money is also important. Which capital budgeting method(s) do you use to assess the investments? ■ [Answer—p. 1030]

Decision Maker

White Company can invest in one of two projects, TD1 or TD2. Each project requires an initial investment of $101,250 and produces the year-end cash inflows shown in the following table.

DEMONSTRATION PROBLEM

Net Cash Flows

TD1 TD2

Year 1 . . . . . . . . . $ 20,000 $ 40,000 Year 2 . . . . . . . . . 30,000 40,000 Year 3 . . . . . . . . . 70,000 40,000 Totals . . . . . . . . . $120,000 $120,000

Required

1. Compute the payback period for both projects. Which project has the shortest payback period? 2. Assume that the company requires a 10% return from its investments. Compute the net present value

of each project. 3. Drawing on your answers to parts 1 and 2, determine which project, if any, should be chosen. 4. Compute the internal rate of return for project TD2. Based on its internal rate of return, should project

TD2 be chosen?

PLANNING THE SOLUTION ● Compute the payback period for the series of unequal cash flows (Project TD1) and for the series of

equal cash flows (Project TD2). ● Compute White Company’s net present value of each investment using a 10% discount rate. ● Use the payback and net present value rules to determine which project, if any, should be selected. ● Compute the internal rate of return for the series of equal cash flows (Project TD2) and determine

whether that internal rate of return is greater than the company’s 10% discount rate.

SOLUTION TO DEMONSTRATION PROBLEM 1. The payback period for a project with a series of equal cash flows is computed as follows:

Payback period 5 Cost of investment

Annual net cash flow

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1028 Chapter 24 Capital Budgeting and Investment Analysis

For project TD2, the payback period equals 2.53 (rounded), computed as $101,250/$40,000. This means that the company expects to recover its investment in Project TD2 after approximately two and one-half years of its three-year life.

Next, determining the payback period for a series of unequal cash flows (as in Project TD1) re- quires us to compute the cumulative net cash flows from the project at the end of each year. Assuming the cash outflow for Project TD1 occurs at the end of year 0, and cash inflows occur continuously over years 1, 2, and 3, the payback period calculation follows.

2. TD1: Present Value Present Value of Net Cash Flows of 1 at 10% Net Cash Flows

Year 1 . . . . . . . . . . . . . . . . . . . . . $ 20,000 0.9091 $ 18,182

Year 2 . . . . . . . . . . . . . . . . . . . . . 30,000 0.8264 24,792

Year 3 . . . . . . . . . . . . . . . . . . . . . 70,000 0.7513 52,591

Totals . . . . . . . . . . . . . . . . . . . . . $120,000 95,565

Amount invested . . . . . . . . . . . . (101,250)

Net present value . . . . . . . . . $ (5,685)

The cumulative net cash flow for Project TD1 changes from negative to positive in year 3. As cash flows are received continuously, the point at which the company has recovered its investment into year 3 is 0.27 (rounded), computed as $18,750/$70,000. This means that the payback period for TD1 is 2.27 years, computed as 2 years plus 0.27 of year 3.

Expected Net Cumulative Net Period Cash Flows Cash Flows

0 . . . . . . . . $(101,250) $(101,250)

1 . . . . . . . . 20,000 (81,250)

2 . . . . . . . . 30,000 (51,250)

3 . . . . . . . . 70,000 18,750

TD1:

TD2: Present Value Present Value of Net Cash Flows of 1 at 10% Net Cash Flows

Year 1 . . . . . . . . . . . . . . . . . . . . . $ 40,000 0.9091 $ 36,364

Year 2 . . . . . . . . . . . . . . . . . . . . . 40,000 0.8264 33,056

Year 3 . . . . . . . . . . . . . . . . . . . . . 40,000 0.7513 30,052

Totals . . . . . . . . . . . . . . . . . . . . . $120,000 99,472

Amount invested . . . . . . . . . . . . (101,250)

Net present value . . . . . . . . . $ (1,778)

3. White Company should not invest in either project. Both are expected to yield a negative net present value, and it should invest only in positive net present value projects. Although the company expects to recover its investment from both projects before the end of these projects’ useful lives, the projects are not acceptable after considering the time value of money.

4. To compute Project TD2’s internal rate of return, we first compute a present value factor as follows:

Present value factor 5 Amount invested

Net cash flow 5 $101,250y$40,000 5 2.5313 (rounded)

Then, we search Table B.3 for the discount rate that corresponds to the present value factor of 2.5313 for three periods. From Table B.3, this discount rate is 9%. Project TD2’s internal rate of return of 9% is below this company’s hurdle rate of 10%. Thus, Project TD2 should not be chosen.

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Chapter 24 Capital Budgeting and Investment Analysis 1029

APPENDIX

Using Excel to Compute Net Present Value and Internal Rate of Return 24A Computing present values and internal rates of return for projects with uneven cash flows is tedious and error prone. These calculations can be performed simply and accurately by using functions built into Excel. Many calculators and other types of spreadsheet software can perform them too. To illustrate, con- sider FasTrac, a company that is considering investing in a new machine with the expected cash flows shown in the following spreadsheet. Cash outflows are entered as negative numbers, and cash inflows are entered as positive numbers. Assume FasTrac requires a 12% annual return, entered as 0.12 in cell C1.

To compute the net present value of this project, the following is entered into cell C13:

5NPV(C1,C4:C11)1C2.

This instructs Excel to use its NPV function to compute the present value of the cash flows in cells C4 through C11, using the discount rate in cell C1, and then add the amount of the (negative) initial in- vestment. For this stream of cash flows and a discount rate of 12%, the net present value is $1,326.03. To compute the internal rate of return for this project, the following is entered into cell C15:

5IRR(C2:C11).

This instructs Excel to use its IRR function to compute the internal rate of return of the cash flows in cells C2 through C11. By default, Excel starts with a guess of 10%, and then uses trial and error to find the IRR. The IRR equals 14% for this project.

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1030 Chapter 24 Capital Budgeting and Investment Analysis

C1 Describe the selection of a hurdle rate for an investment. Top management should select the hurdle (discount) rate to use in evaluating capital investments. The required hurdle rate should be at least higher than the interest rate on money borrowed because the return on investment must cover the interest and provide an additional profit to reward the company for risk. A company must rely on relevant costs pertaining to alternative courses of action rather than historical costs. Out-of-pocket expenses and opportunity costs are relevant because these are avoidable; sunk costs are irrelevant because they result from past decisions and are therefore unavoidable. Managers must also consider the relevant benefits associated with alternative decisions.

A1 Analyze a capital investment project using break-even time. Break-even time (BET) is a method for evaluating capital investments by restating future cash flows in terms of their present values (discounting the cash flows) and then calculating the payback period using these present values of cash flows.

P1 Compute payback period and describe its use. One way to compare potential investments is to compute and compare their payback periods. The payback period is an estimate of the expected time before the cumulative net cash inflow from the investment equals its initial cost. A payback period analysis fails to reflect risk of the cash flows, differences in the timing of cash flows within the payback period, and cash flows that occur after the payback period.

Summary P2 Compute accounting rate of return and explain its use. A project’s accounting rate of return is computed by dividing the expected annual after-tax net income by the average amount of in- vestment in the project. When the net cash flows are received evenly throughout each period and straight-line depreciation is used, the average investment is computed as the average of the investment’s initial book value and its salvage value.

P3 Compute net present value and describe its use. An invest-ment’s net present value is determined by predicting the future cash flows it is expected to generate, discounting them at a rate that represents an acceptable return, and then by subtracting the invest- ment’s initial cost from the sum of the present values. This tech- nique can deal with any pattern of expected cash flows and applies a superior concept of return on investment.

P4 Compute internal rate of return and explain its use. The in-ternal rate of return (IRR) is the discount rate that results in a zero net present value. When the cash flows are equal, we can com- pute the present value factor corresponding to the IRR by dividing the initial investment by the annual cash flows. We then use the an- nuity tables to determine the discount rate corresponding to this present value factor.

Systems Manager Your dilemma is whether to abide by rules designed to prevent abuse or to bend them to acquire an investment that you believe will benefit the firm. You should not pursue the latter action because breaking up the order into small components is dis- honest and there are consequences of being caught at a later stage. Develop a proposal for the entire package and then do all you can to expedite its processing, particularly by pointing out its benefits. When faced with controls that are not working, there is rarely a rea- son to overcome its shortcomings by dishonesty. A direct assault on those limitations is more sensible and ethical.

Entrepreneur The banker is probably concerned because new products are risky and should therefore be evaluated using a higher

rate of return. You should conduct a thorough technical analysis and obtain detailed market data and information about any similar prod- ucts available in the market. These factors might provide sufficient information to support the use of a lower return. You must convince yourself that the risk level is consistent with the discount rate used. You should also be confident that your company has the capacity and the resources to handle the new product.

Investment Manager You should probably focus on either the payback period or break-even time because both the time value of money and recovery time are important. Break-even time method is superior because it accounts for the time value of money, which is an important consideration in this decision.

Guidance Answers to Decision Maker and Decision Ethics

1. b 2. A capital budgeting decision is difficult because (1) the out-

come is uncertain, (2) large amounts of money are usually in- volved, (3) a long-term commitment is required, and (4) the decision could be difficult or impossible to reverse.

3. b 4. Depreciation expense is subtracted from revenues in computing

net income but does not use cash and should be added back to net income to compute net cash flows.

5. Not necessarily. One investment can continue to generate cash flows beyond the payback period for a longer time period than the other. The timing of their cash flows within the payback period also can differ.

6. b; Annual average investment 5 ($180,000 1 $15,000)y2 5 $97,500 Accounting rate of return 5 $40,000y$97,500 5 41% 7. For this determination, we need to compare it to the returns ex-

pected from alternative investments with similar risk.

Guidance Answers to Quick Checks

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Chapter 24 Capital Budgeting and Investment Analysis 1031

Multiple Choice Quiz Answers on p. 1042 mhhe.com/wildFINMAN5e

Additional Quiz Questions are available at the book’s Website.

1. The minimum acceptable rate of return for an investment deci- sion is called the

a. Hurdle rate of return. b. Payback rate of return. c. Internal rate of return. d. Average rate of return. e. Maximum rate of return. 2. A corporation is considering the purchase of new equipment

costing $90,000. The projected after-tax annual net income from the equipment is $3,600, after deducting $30,000 depre- ciation. Assume that revenue is to be received at each year-end, and the machine has a useful life of three years with zero salvage value. Management requires a 12% return on its in vestments. What is the net present value of this machine?

a. $ 60,444 b. $ 80,700 c. $(88,560) d. $ 90,000 e. $ (9,300) 3. A disadvantage of using the payback period to compare invest-

ment alternatives is that it a. Ignores cash flows beyond the payback period. b. Cannot be used to compare alternatives with different ini-

tial investments.

c. Cannot be used when cash flows are not uniform. d. Involves the time value of money. e. Cannot be used if a company records depreciation. 4. A company is considering the purchase of equipment for

$270,000. Projected annual cash inflow from this equipment is $61,200 per year. The payback period is:

a. 0.2 years b. 5.0 years 5. A company buys a machine for $180,000 that has an expected

life of nine years and no salvage value. The company expects an annual net income (after taxes of 30%) of $8,550. What is the accounting rate of return?

a. 4.75% b. 42.75% c. 2.85% d. 9.50% e. 6.65%

8. Project A has the higher net present value as follows: 9. No, the information is too limited to draw that conclusion. For example, one investment could be riskier than the other, or one could require a substantially larger initial investment.

10. b

Project A Project B

Present Present Present Value Value Value Net of Net Net of Net of 1 Cash Cash Cash Cash

Year at 10% Flows Flows Flows Flows

1 0.9091 $12,000 $10,909 $ 4,500 $ 4,091

2 0.8264 8,500 7,024 8,500 7,024

3 0.7513 4,000 3,005 13,000 9,767

Totals $24,500 $20,938 $26,000 $20,882

Amount invested (20,000) (20,000)

Net present value $ 938 $ 882

Accounting rate of return (p. 1019)

Annuity (p. 1021)

Break-even time (BET) (p. 1026)

Capital budgeting (p. 1016)

Cost of capital (p. 1020)

Hurdle rate (p. 1024)

Internal rate of return (IRR) (p. 1023)

Net present value (NPV) (p. 1020)

Payback period (PBP) (p. 1016)

Profitability index (p. 1023)

Key Terms

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1032 Chapter 24 Capital Budgeting and Investment Analysis

1. Capital budgeting decisions require careful analysis because they are generally the ________ ________ and ________ decisions that management faces.

2. What is capital budgeting? 3. Identify four reasons that capital budgeting decisions by

managers are risky. 4. Identify two disadvantages of using the payback period for

comparing investments. 5. Why is an investment more attractive to management if it

has a shorter payback period? 6. What is the average amount invested in a machine during its

predicted five-year life if it costs $200,000 and has a $20,000 salvage value? Assume that net income is received evenly throughout each year and straight-line depreciation is used.

7. If the present value of the expected net cash flows from a machine, discounted at 10%, exceeds the amount to be in- vested, what can you say about the investment’s expected rate of return? What can you say about the expected rate of return if the present value of the net cash flows, discounted at 10%, is less than the investment amount?

8. Why is the present value of $100 that you expect to receive one year from today worth less than $100 received today? What is

the present value of $100 that you expect to receive one year from today, discounted at 12%?

9. Why should managers set the required rate of return higher than the rate at which money can be borrowed when making a typical capital budgeting decision?

10. Polaris managers must select depreciation methods. Why does the use of the accelerated de- preciation method (instead of straight line) for income tax re- porting increase an investment’s value?

11. The management of Piaggio is planning to in- vest in a new companywide computerized in- ventory tracking system. What makes this potential investment risky?

12. The management of Arctic Cat is planning to acquire new equipment to manufacture snowmo- biles. What are some of the costs and benefits that would be included in Arctic Cat’s analysis?

13. KTM is considering expanding a store. Iden- tify three methods management can use to evaluate whether to expand.

Discussion Questions

Icon denotes assignments that involve decision making.

PIAGGIO

KTM

Polaris

Arctic Cat

QUICK STUDY

QS 24-1 Payback period P1

Freeman Brothers Co. is considering an investment that requires immediate payment of $27,000 and provides expected cash inflows of $9,000 annually for four years. What is the investment’s payback period?

QS 24-2 Analyzing payback periods P1

Park Company is considering two alternative investments. The payback period is 3.5 years for investment A and 4 years for investment B. (1) If management relies on the payback period, which investment is preferred? (2) Why might Park’s analysis of these two alternatives lead to the selection of B over A?

QS 24-3 Computation of accounting rate of return P2

Peng Company is considering an investment expected to generate an average net income after taxes of $1,950 for three years. The investment costs $45,000 and has an estimated $6,000 salvage value. Compute the accounting rate of return for this investment; assume the company uses straight-line depreciation. Hint: Use the formula in Exhibit 24.5 when computing the average annual investment.

QS 24-4 Computation of net present value P3

If Quail Company invests $50,000 today, it can expect to receive $10,000 at the end of each year for the next seven years, plus an extra $6,000 at the end of the seventh year. What is the net present value of this investment assuming a required 10% return on investments?

QS 24-5 Profitability index

P3

Yokam Company is considering two alternative projects. Project 1 requires an initial investment of $400,000 and has a net present value of cash flows of $1,100,000. Project 2 requires an initial investment of $3,500,000 and has a net present value of cash flows of $2,500,000. Compute the profitability index for each project. Based on the profitability index, which project should the company prefer? Explain.

QS 24-6 Internal rate of return P4

A company is considering investing in a new machine that requires a cash payment of $47,946 today. The machine will generate annual cash flows of $21,000 for the next three years. What is the internal rate of return if the company buys this machine?

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Chapter 24 Capital Budgeting and Investment Analysis 1033

QS 24-7 Net present value analysis P3

Tinto Company is planning to invest in a project at a cost of $135,000. This project has the following expected cash flows over its three-year life: Year 1, $45,000; Year 2, $52,000; and Year 3, $78,000. Management requires a 10% rate of return on its investments. Compute the net present value of this investment.

QS 24-8 Computation of break-even time

A1

Heels, a shoe manufacturer, is evaluating the costs and benefits of new equipment that would custom fit each pair of athletic shoes. The customer would have his or her foot scanned by digital computer equipment; this information would be used to cut the raw materials to provide the customer a perfect fit. The new equipment costs $90,000 and is expected to generate an additional $35,000 in cash flows for five years. A bank will make a $90,000 loan to the company at a 10% interest rate for this equipment’s purchase. Use the following table to determine the break-even time for this equipment. (Round the present value of cash flows to the nearest dollar.)

Present Value Present Value Cumulative Present Value Year Cash Flows* of 1 at 10% of Cash Flows of Cash Flows

0 $(90,000) 1.0000

1 35,000 0.9091

2 35,000 0.8264

3 35,000 0.7513

4 35,000 0.6830

5 35,000 0.6209

* All cash flows occur at year-end.

QS 24-9 Capital budgeting methods

P1 P3

Siemens AG invests €80 million to build a manufacturing plant to build wind turbines. The company predicts net cash flows of €16 million per year for the next 8 years. Assume the company requires an 8% rate of return from its investments. (1) What is the payback period of this investment? (2) What is the net present value of this investment?

EXERCISES

Exercise 24-1 Payback period computation; uneven cash flows P1

Beyer Company is considering the purchase of an asset for $180,000. It is expected to produce the follow- ing net cash flows. The cash flows occur evenly throughout each year. Compute the payback period for this investment (round years to two decimals).

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Net cash flows $60,000 $40,000 $70,000 $125,000 $35,000 $330,000 Check 3.08 years

A machine can be purchased for $150,000 and used for 5 years, yielding the following net incomes. In project- ing net incomes, double-declining balance depreciation is applied, using a 5-year life and a zero salvage value. Compute the machine’s payback period (ignore taxes). (Round the payback period to three decimals.)

Exercise 24-2 Payback period computation; declining-balance depreciation

P1

Check 2.265 years

Year 1 Year 2 Year 3 Year 4 Year 5

Net incomes . . . . . . . . $10,000 $25,000 $50,000 $37,500 $100,000

Exercise 24-3 Payback period computation; even cash flows

P1

Compute the payback period for each of these two separate investments (round the payback period to two decimals): a. A new operating system for an existing machine is expected to cost $520,000 and have a useful life

of six years. The system yields an incremental after-tax income of $150,000 each year after de- ducting its straight-line depreciation. The predicted salvage value of the system is $10,000.

b. A machine costs $380,000, has a $20,000 salvage value, is expected to last eight years, and will generate an after-tax income of $60,000 per year after straight-line depreciation.

Exercise 24-4 Accounting rate of return P2

A machine costs $700,000 and is expected to yield an after-tax net income of $52,000 each year. Management predicts this machine has a 10-year service life and a $100,000 salvage value, and it uses straight-line depreciation. Compute this machine’s accounting rate of return.

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1034 Chapter 24 Capital Budgeting and Investment Analysis

Exercise 24-6 Computing net present value P3

After evaluating the risk of the investment described in Exercise 24-5, B2B Co. concludes that it must earn at least a 8% return on this investment. Compute the net present value of this investment. (Round the net present value to the nearest dollar.)

Check (1) 5.39 years (2) 20.42%

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $225,000

Costs

Materials, labor, and overhead (except depreciation) . . . . . . . . . 120,000

Depreciation on new equipment . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . 22,500

Total costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,500

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,500

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,750

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,750

Exercise 24-5 Payback period and accounting rate of return on investment

P1 P2

B2B Co. is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost $360,000 with a 6-year life and no salvage value. It will be depreciated on a straight-line basis. The company expects to sell 144,000 units of the equipment’s product each year. The expected annual income related to this equipment follows. Compute the (1) payback period and (2) accounting rate of return for this equipment.

Exercise 24-9A

Using Excel to compute IRR P4 Refer to the information in Exercise 24-8. Create an Excel spreadsheet to compute the internal rate of return for each of the projects. Round the percentage return to two decimals.

Project A Project B

Initial investment . . . . . . . . . . . . . . . . . . . . . . $(160,000) $(105,000)

Expected net cash flows in year:

1 . . . . . . . . . . . . . . . . . . . . . . 40,000 32,000

2 . . . . . . . . . . . . . . . . . . . . . . 56,000 50,000

3 . . . . . . . . . . . . . . . . . . . . . . 80,295 66,000

4 . . . . . . . . . . . . . . . . . . . . . . 90,400 72,000

5 . . . . . . . . . . . . . . . . . . . . . . 65,000 24,000

Exercise 24-8 NPV and profitability index P3

Following is information on two alternative investments being considered by Jolee Company. The company requires a 10% return from its investments.

For each alternative project compute the (a) net present value, and (b) profitability index. If the company can only select one project, which should it choose? Explain.

Exercise 24-7 Computation and interpretation of net present value and internal rate of return

P3 P4

Phoenix Company can invest in each of three cheese-making projects: C1, C2, and C3. Each project requires an initial investment of $228,000 and would yield the following annual cash flows.

(1) Assuming that the company requires a 12% return from its investments, use net present value to determine which projects, if any, should be acquired. (2) Using the answer from part 1, explain whether the internal rate of return is higher or lower than 12% for project C2. (3) Compute the internal rate of return for project C2.Check (3) IRR 5 13%

C1 C2 C3

Year 1 . . . . . . . . . $ 12,000 $ 96,000 $180,000

Year 2 . . . . . . . . 108,000 96,000 60,000

Year 3 . . . . . . . . 168,000 96,000 48,000

Totals . . . . . . . . . $288,000 $288,000 $288,000

This chapter explained two methods to evaluate investments using recovery time, the payback period and break-even time (BET). Refer to QS 24-8 and (1) compute the recovery time for both the payback period and break-even time, (2) discuss the advantage(s) of break-even time over the payback period, and (3) list two conditions under which payback period and break-even time are similar.

Exercise 24-10 Comparison of payback and BET

P1 A1

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Chapter 24 Capital Budgeting and Investment Analysis 1035

Project Y Project Z

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000 $280,000

Expenses

Direct materials . . . . . . . . . . . . . . . . . . . . . . . 49,000 35,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 42,000

Overhead including depreciation . . . . . . . . . . 126,000 126,000

Selling and administrative expenses . . . . . . . . 25,000 25,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000 228,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 52,000

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . 24,000 15,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 56,000 $ 36,400

Problem 24-2A Analysis and computation of payback period, accounting rate of return, and net present value

P1 P2 P3

Most Company has an opportunity to invest in one of two new projects. Project Y requires a $350,000 investment for new machinery with a four-year life and no salvage value. Project Z requires a $350,000 investment for new machinery with a three-year life and no salvage value. The two projects yield the fol- lowing predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

mhhe.com/wildFINMAN5e

PROBLEM SET A

Problem 24-1A Computation of payback period, accounting rate of return, and net present value

P1 P2 P3

Factor Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $480,000 cost with an expected four-year life and a $20,000 salvage value. All sales are for cash, and all costs are out of pocket except for depreciation on the new machine. Additional information includes the following.

Expected annual sales of new product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,840,000

Expected annual costs of new product

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672,000

Overhead excluding straight-line depreciation on new machine . . . . . . . . . 336,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30%

Required

1. Compute straight-line depreciation for each year of this new machine’s life. (Round depreciation amounts to the nearest dollar.)

2. Determine expected net income and net cash flow for each year of this machine’s life. (Round answers to the nearest dollar.)

3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year. (Round the payback period to two decimals.)

4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year. (Round the percentage return to two decimals.)

5. Compute the net present value for this machine using a discount rate of 7% and assuming that cash flows occur at each year-end. (Hint: Salvage value is a cash inflow at the end of the asset’s life. Round the net present value to the nearest dollar.)

Check (4) 21.56%

(5) $107,356

Required

1. Compute each project’s annual expected net cash flows. (Round the net cash flows to the nearest dollar.) 2. Determine each project’s payback period. (Round the payback period to two decimals.) 3. Compute each project’s accounting rate of return. (Round the percentage return to one decimal.) 4. Determine each project’s net present value using 8% as the discount rate. For part 4 only, assume that

cash flows occur at each year-end. (Round the net present value to the nearest dollar.)

Analysis Component

5. Identify the project you would recommend to management and explain your choice.

Check For Project Y: (2) 2.44 years, (3) 32%

(4) $125,286

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1036 Chapter 24 Capital Budgeting and Investment Analysis

Problem 24-3A Computation of cash flows and net present values with alternative depreciation methods

P3

Manning Corporation is considering a new project requiring a $90,000 investment in test equipment with no salvage value. The project would produce $66,000 of pretax income before depreciation at the end of each of the next six years. The company’s income tax rate is 40%. In compiling its tax return and computing its income tax payments, the company can choose between the two alternative depreciation schedules shown in the table.

Straight-Line MACRS Depreciation Depreciation*

Year 1 . . . . . . . . . $ 9,000 $18,000

Year 2 . . . . . . . . . 18,000 28,800

Year 3 . . . . . . . . . 18,000 17,280

Year 4 . . . . . . . . . 18,000 10,368

Year 5 . . . . . . . . . 18,000 10,368

Year 6 . . . . . . . . . 9,000 5,184

Totals . . . . . . . . . $90,000 $90,000

* The modified accelerated cost recovery system (MACRS) for depreciation is discussed in Chapter 8.

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) straight-line de- preciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

2. Prepare a five-column table that reports amounts (assuming use of MACRS depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) MACRS deprecia- tion expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the in- come amount before depreciation minus the income taxes. (Round answers to the nearest dollar.)

3. Compute the net present value of the investment if straight-line depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

4. Compute the net present value of the investment if MACRS depreciation is used. Use 10% as the dis- count rate. (Round the net present value to the nearest dollar.)

Analysis Component

5. Explain why the MACRS depreciation method increases this project’s net present value.

Check Net present value: (3) $108,518

(4) $110,303

Problem 24-4A Computing net present value of alternate investments

P3

Interstate Manufacturing is considering either replacing one of its old machines with a new machine or having the old machine overhauled. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.

Alternative 1: Keep the old machine and have it overhauled. If the old machine is overhauled, it will be kept for another five years and then sold for its salvage value.

Cost of old machine . . . . . . . . . . . . . . . . . . . . . . . . . . . $112,000

Cost of overhaul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Annual expected revenues generated . . . . . . . . . . . . . 95,000

Annual cash operating costs after overhaul . . . . . . . . . 42,000

Salvage value of old machine in 5 years . . . . . . . . . . . . 15,000

Alternative 2: Sell the old machine and buy a new one. The new machine is more efficient and will yield substantial operating cost savings with more product being produced and sold.

Cost of new machine . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Salvage value of old machine now . . . . . . . . . . . . . . 29,000

Annual expected revenues generated . . . . . . . . . . . 100,000

Annual cash operating costs . . . . . . . . . . . . . . . . . . . 32,000

Salvage value of new machine in 5 years . . . . . . . . . 20,000

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Chapter 24 Capital Budgeting and Investment Analysis 1037

Required

1. Determine the net present value of alternative 1. 2. Determine the net present value of alternative 2. 3. Which alternative do you recommend that management select? Explain.

Check (1) Net present value of Alternative 1, $60,226

Problem 24-5A Payback period, break-even time, and net present value

P1 A1

Sentinel Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $250,000 and will yield the following expected cash flows. Management requires investments to have a payback period of three years, and it requires a 10% return on investments.

Period Cash Flow

1 . . . . . . . . . . . $ 47,000 2 . . . . . . . . . . . 52,000 3 . . . . . . . . . . . 75,000 4 . . . . . . . . . . . 94,000 5 . . . . . . . . . . . 125,000

Required

1. Determine the payback period for this investment. (Round the answer to one decimal.) 2. Determine the break-even time for this investment. (Round the answer to one decimal.) 3. Determine the net present value for this investment.

Analysis Component

4. Should management invest in this project? Explain.

Check (1) Payback period, 3.8 years

Problem 24-6A Payback period, break-even time, and net present value

P1 A1

Lenitnes Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $250,000 and will yield the following expected cash flows. Management requires investments to have a payback period of three years, and it requires a 10% return on its investments.

Period Cash Flow

1 . . . . . . . . . . . $125,000 2 . . . . . . . . . . . 94,000 3 . . . . . . . . . . . 75,000 4 . . . . . . . . . . . 52,000 5 . . . . . . . . . . . 47,000

Required

1. Determine the payback period for this investment. (Round the answer to one decimal.)

2. Determine the break-even time for this investment. (Round the answer to one decimal.)

3. Determine the net present value for this investment.

Analysis component

4. Should management invest in this project? Explain. 5. Compare your answers for parts 1 through 4 with those for Problem 24-5A. What are the causes of the

differences in results and your conclusions?

Check (1) Payback period, 2.4 years

PROBLEM SET B

Problem 24-1B Computation of payback period, accounting rate of return, and net present value

P1 P2 P3

Cortino Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $300,000 cost with an expected four-year life and a $20,000 salvage value. All sales are for cash and all costs are out of pocket, except for depreciation on the new machine. Additional information includes the following.

Expected annual sales of new product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,150,000 Expected annual costs of new product Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 Overhead excluding straight-line depreciation on new machine . . . . . . . . . 210,000 Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30%

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1038 Chapter 24 Capital Budgeting and Investment Analysis

Required

1. Compute straight-line depreciation for each year of this new machine’s life. (Round depreciation amounts to the nearest dollar.)

2. Determine expected net income and net cash flow for each year of this machine’s life. (Round answers to the nearest dollar.)

3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year. (Round the payback period to two decimals.)

4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year. (Round the percentage return to two decimals.)

5. Compute the net present value for this machine using a discount rate of 7% and assuming that cash flows occur at each year-end. (Hint: Salvage value is a cash inflow at the end of the asset’s life.)

Check (4) 21.88%

(5) $70,915

Aikman Company has an opportunity to invest in one of two projects. Project A requires a $240,000 investment for new machinery with a four-year life and no salvage value. Project B also requires a $240,000 investment for new machinery with a three-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

Project A Project B

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000 $200,000

Expenses

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . 35,000 25,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 30,000

Overhead including depreciation . . . . . . . . . . 90,000 90,000

Selling and administrative expenses . . . . . . . . 18,000 18,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 193,000 163,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,000 37,000

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . 17,100 11,100

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,900 $ 25,900

Check For Project A: (2) 2.4 years

(3) 33.3%

(4) $90,879

Required

1. Compute each project’s annual expected net cash flows. (Round net cash flows to the nearest dollar.) 2. Determine each project’s payback period. (Round the payback period to two decimals.) 3. Compute each project’s accounting rate of return. (Round the percentage return to one decimal.) 4. Determine each project’s net present value using 8% as the discount rate. For part 4 only, assume that

cash flows occur at each year-end. (Round net present values to the nearest dollar.)

Analysis Component

5. Identify the project you would recommend to management and explain your choice.

Problem 24-2B Analysis and computation of payback period, accounting rate of return, and net present value

P1 P2 P3

Straight-Line MACRS Depreciation Depreciation*

Year 1 . . . . . . $ 3,000 $ 6,000

Year 2 . . . . . 6,000 9,600

Year 3 . . . . . 6,000 5,760

Year 4 . . . . . 6,000 3,456

Year 5 . . . . . 6,000 3,456

Year 6 . . . . . 3,000 1,728

Totals . . . . . . $30,000 $30,000

* The modified accelerated cost recovery system (MACRS) for depreciation is discussed in Chapter 8.

Grossman Corporation is considering a new project requiring a $30,000 investment in an asset having no sal- vage value. The project would produce $12,000 of pretax income before depreciation at the end of each of the next six years. The company’s income tax rate is 40%. In compiling its tax return and computing its income tax payments, the company can choose between two alternative depreciation schedules as shown in the table.

Problem 24-3B Computation of cash flows and net present values with alternative depreciation methods

P3

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Chapter 24 Capital Budgeting and Investment Analysis 1039

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following items for each of the six years: (a) pretax income before depreciation, (b) straight-line de- preciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

2. Prepare a five-column table that reports amounts (assuming use of MACRS depreciation) for each of the following items for each of the six years: (a) income before depreciation, (b) MACRS depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

3. Compute the net present value of the investment if straight-line depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

4. Compute the net present value of the investment if MACRS depreciation is used. Use 10% as the dis- count rate. (Round the net present value to the nearest dollar.)

Analysis Component

5. Explain why the MACRS depreciation method increases the net present value of this project.

Check Net present value: (3) $10,041

(4) $10,635

Problem 24-4B Computing net present value of alternate investments

P3

Archer Foods has a freezer that is in need of repair and is considering whether to replace the old freezer with a new freezer or have the old freezer extensively repaired. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.

Alternative 1: Keep the old freezer and have it repaired. If the old freezer is repaired, it will be kept for another 8 years and then sold for its salvage value.

Alternative 2: Sell the old freezer and buy a new one. The new freezer is larger than the old one and will allow the company to expand its product offerings, thereby generating more revenues. Also, it is more energy efficient and will yield substantial operating cost savings.

Cost of old freezer . . . . . . . . . . . . . . . . . . . . . . . . . . $75,000

Cost of repair . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Annual expected revenues generated . . . . . . . . . . . 63,000

Annual cash operating costs after repair . . . . . . . . . 55,000

Salvage value of old freezer in 8 years . . . . . . . . . . . 3,000

Cost of new freezer . . . . . . . . . . . . . . . . . . . . . . . . $150,000

Salvage value of old freezer now . . . . . . . . . . . . . . 5,000

Annual expected revenues generated . . . . . . . . . . 68,000

Annual cash operating costs . . . . . . . . . . . . . . . . . . 30,000

Salvage value of new freezer in 8 years . . . . . . . . . 8,000

Required

1. Determine the net present value of alternative 1. 2. Determine the net present value of alternative 2. 3. Which alternative do you recommend that management select? Explain.

Check (1) Net present value of Alternative 1, $(5,921)

Problem 24-5B Payback period, break-even time, and net present value

P1 A1

Aster Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $800,000 and yield the following expected cash flows. Management requires investments to have a payback period of two years, and it requires a 10% return on its investments.

Period Cash Flow

1 . . . . . . . . . . . $300,000

2 . . . . . . . . . . . 350,000

3 . . . . . . . . . . . 400,000

4 . . . . . . . . . . . 450,000

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1040 Chapter 24 Capital Budgeting and Investment Analysis

Required

1. Determine the payback period for this investment. 2. Determine the break-even time for this investment. 3. Determine the net present value for this investment.

Analysis Component

4. Should management invest in this project? Explain.

Check (1) Payback period, 2.4 years

Problem 24-6B Payback period, break-even time, and net present value

P1 A1

Retsa Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of $800,000 and will yield the following expected cash flows. Management re- quires investments to have a payback period of two years, and it requires a 10% return on its investments.

Period Cash Flow

1 . . . . . . . . . . . $450,000

2 . . . . . . . . . . . 400,000

3 . . . . . . . . . . . 350,000

4 . . . . . . . . . . . 300,000

Required

1. Determine the payback period for this investment. (Round the answer to one decimal.) 2. Determine the break-even time for this investment. (Round the answer to one decimal.) 3. Determine the net present value for this investment.

Analysis Component

4. Should management invest in this project? Explain. 5. Compare your answers for parts 1 through 4 with those for Problem 24-5B. What are the causes of the

differences in results and your conclusions?

Check (1) Payback period, 1.9 years

SERIAL PROBLEM Success Systems

P1 P2

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 24 Adria Lopez is considering the purchase of equipment for Success Systems that would allow the company to add a new product to its computer furniture line. The equipment is expected to cost $300,000 and to have a six-year life and no salvage value. It will be depreciated on a straight-line basis. Success Systems expects to sell 100 units of the equipment’s product each year. The expected annual income re- lated to this equipment follows.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,000

Costs

Materials, labor, and overhead (except depreciation) . . . . . . . . . 200,000

Depreciation on new equipment . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . 37,500

Total costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287,500

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,500

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,250

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 61,250

Required

Compute the (1) payback period and (2) accounting rate of return for this equipment. (Record answers as percents, rounded to one decimal.)

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Chapter 24 Capital Budgeting and Investment Analysis 1041

BTN 24-1 Assume Polaris invested $2.12 million to expand its manufacturing capacity. Assume that these assets have a ten-year life, and that Polaris requires a 10% internal rate of return on these assets.

Required

1. What is the amount of annual cash flows that Polaris must earn from these projects to have a 10% in- ternal rate of return? (Hint: Identify the 10-period, 10% factor from the present value of an annuity table, and then divide $2.12 million by this factor to get the annual cash flows necessary.)

Fast Forward

2. Access Polaris’s financial statements for fiscal years ended after December 31, 2011, from its Website (Polaris.com) or the SEC’s Website (sec.gov).

a. Determine the amount that Polaris invested in capital assets for the most recent year. (Hint: Refer to the statement of cash flows.)

b. Assume a 10-year life and a 10% internal rate of return. What is the amount of cash flows that Polaris must earn on these new projects?

Beyond the Numbers

REPORTING IN ACTION P3

BTN 24-2 Assume that Arctic Cat invests $2.42 million in capital expenditures, including $1.08 mil- lion related to manufacturing capacity. Assume that these projects have a seven-year life and that man- agement requires a 15% internal rate of return on those projects.

Required

1. What is the amount of annual cash flows that Arctic Cat must earn from those expenditures to achieve a 15% internal rate of return? (Hint: Identify the 7-period, 15% factor from the present value of an an- nuity table and then divide $1.08 million by the factor to get the annual cash flows required.)

2. BTN 24-1 must be completed to answer part 2. How does your answer to part 1 compare to Polaris’s required cash flows determined in BTN 24-1? What does this imply about each company’s cash flow requirements for these types of projects?

COMPARATIVE ANALYSIS P3 P4

Polaris Arctic Cat

Polaris

BTN 24-3 A consultant commented that “too often the numbers look good but feel bad.” This comment often stems from estimation error common to capital budgeting proposals that relate to future cash flows. Three reasons for this error often exist. First, reliably predicting cash flows several years into the future is very difficult. Second, the present value of cash flows many years into the future (say, beyond 10 years) is often very small. Third, it is difficult for personal biases and expectations not to unduly influence present value computations.

Required

1. Compute the present value of $100 to be received in 10 years assuming a 12% discount rate. 2. Why is understanding the three reasons mentioned for estimation errors important when evaluating

investment projects? Link this response to your answer for part 1.

ETHICS CHALLENGE P3

BTN 24-4 Payback period, accounting rate of return, net present value, and internal rate of return are common methods to evaluate capital investment opportunities. Assume that your manager asks you to iden- tify the type of measurement basis and unit that each method offers and to list the advantages and disadvan- tages of each. Present your response in memorandum format of less than one page.

COMMUNICATING IN PRACTICE P1 P2 P3 P4

BTN 24-5 Capital budgeting is an important topic and there are Websites designed to help people understand the methods available. Access TeachMeFinance.com’s capital budgeting web page (teachmefinance.com/capitalbudgeting.html). This web page contains an example of a capital budget- ing case involving a $15,000 initial cash outflow.

Required

Compute the payback period and the net present value (assuming a 10% required rate of return) of the following investment—assume that its cash flows occur at year-end. Compared to the example case at the

TAKING IT TO THE NET P1 P3

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1042 Chapter 24 Capital Budgeting and Investment Analysis

BTN 24-6 Break into teams and identify four reasons that an international airline such as Southwest or Delta would invest in a project when its direct analysis using both payback period and net present value indicate it to be a poor investment. (Hint: Think about qualitative factors.) Provide an example of an in- vestment project supporting your answer.

TEAMWORK IN ACTION P1 P3

BTN 24-7 Read the chapter opener about Keith Mullin and his company, Gamer Grub. Keith is consid- ering building a new, larger warehousing center to make his business more efficient and reduce costs. He expects that an efficient warehouse could reduce his costs by 20%.

Required

1. What are some of the management tools that Keith can use to evaluate whether the new warehousing center will be a good investment?

2. What information does he need to use the tools that are identified in your answer to part 1? 3. What are some of the advantages and disadvantages of each tool identified in your answer to part 1?

ENTREPRENEURIAL DECISION P1 P2 P3 P4

BTN 24-8 Visit or call a local auto dealership and inquire about leasing a car. Ask about the down pay- ment and the required monthly payments. You will likely find the salesperson does not discuss the cost to purchase this car but focuses on the affordability of the monthly payments. This chapter gives you the tools to compute the cost of this car using the lease payment schedule in present dollars and to estimate the profit from leasing for an auto dealership.

Required

1. Compare the cost of leasing the car to buying it in present dollars using the information from the dealership you contact. (Assume you will make a final payment at the end of the lease and then own the car.)

2. Is it more costly to lease or buy the car? Support your answer with computations.

HITTING THE ROAD P3

BTN 24-9 Piaggio’s annual report includes information about its debt and interest rates. One statement in its annual report reveals that Piaggio recently issued 10-year bonds with a market return of about 6.5%.

Required

Explain how Piaggio would use that 6.5% rate to evaluate its investments in capital projects.

GLOBAL DECISION C1

Year Cash Flow

0 . . . . . . . . . . $(15,000)

1 . . . . . . . . . . 1,000

2 . . . . . . . . . . 2,000

3 . . . . . . . . . . 3,000

4 . . . . . . . . . . 6,000

5 . . . . . . . . . . 7,000

Website, the larger cash inflows in the example below occur in the later years of the project’s life. Is this investment acceptable based on the application of these two capital budgeting methods? Explain.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. a 2. e;

3. a 4. c; Payback 5 $270,000/$61,200 per year 5 4.4 years. 5. d; Accounting rate of return = $8,550/[($180,000 1 $0)/2] 5 9.5%.

Present Value Present of an Annuity Value of Net Cash Flow of 1 at 12% Cash Flows

Years 1–3 . . . . . . . . . . . $3,600 1 $30,000 2.4018 $ 80,700

Amount invested . . . . . (90,000)

Net present value . . . . $ (9,300)

PIAGGIO

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Financial Statement Information

A-1

This appendix includes financial information for (1) Polaris, (2) Arctic Cat, (3) KTM, and (4) Piaggio. Polaris is a manufacturer of ATVs, snowmobiles, motorcycles and electric vehicles; it competes with Arctic Cat in the United States and globally. KTM and Piaggio also compete with Polaris and Arctic Cat, and are two of Europe’s leading manufacturers of two-, three-, and four-wheel vehicles. The information in this Appendix is taken from their annual 10-K reports (or annual reports for KTM and Piaggio) filed with the SEC or other regulatory agency. An annual report is a summary of a company’s financial results for the year along with its current financial condition and future plans. This report is directed to external users of financial information, but it also affects the actions and decisions of internal users. A company often uses an annual report to showcase itself and its products. Many annual reports in- clude photos, diagrams, and illustrations related to the company. The primary objective of annual reports, however, is the financial section, which communicates much information about a company, with most data drawn from the accounting information system. The layout of an annual report’s financial section is fairly established and typically includes the following:

● Letter to Shareholders ● Financial History and Highlights ● Management Discussion and Analysis ● Management’s Report on Financial Statements and on Internal Controls ● Report of Independent Accountants (Auditor’s Report) and on Internal Controls ● Financial Statements ● Notes to Financial Statements ● List of Directors and Officers

This appendix provides the financial statements for Polaris (plus selected notes), Arctic Cat, KTM, and Piaggio. The appendix is organized as follows:

● Polaris A-2 through A-9 ● Arctic Cat A-10 through A-13 ● KTM A-14 through A-17 ● Piaggio A-18 through A-21

Many assignments at the end of each chapter refer to information in this appendix. We encourage readers to spend time with these assignments; they are especially useful in showing the relevance and diversity of financial accounting and reporting.

Special note: The SEC maintains the EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database at www.SEC.gov for U.S. filers. The Form 10-K is the annual report form for most companies. It pro- vides electronically accessible information. The Form 10-KSB is the annual report form filed by small businesses. It requires slightly less information than the Form 10-K. One of these forms must be filed within 90 days after the company’s fiscal year-end. (Forms 10-K405, 10-KT, 10-KT405, and 10-KSB405 are slight variations of the usual form due to certain regulations or rules.)

KTM

Polaris Arctic Cat

PIAGGIO

A Appendix

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A-2 Appendix A Financial Statement Information PO

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Shares outstanding, common stock, additional paid-in-capital, retained earnings and per share data have been adjusted to give effect to the two-for-one stock split declared on July 20, 2011, paid on

September 12, 2011 to shareholders of record on September 2, 2011.

2011 2010

ASSETS Current Assets:

Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 325,336 $ 393,927 Trade receivables, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,302 89,294 Inventories, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298,042 235,927 Prepaid expenses and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,608 21,628 Income taxes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,723 — Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77,665 67,369

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 878,676 808,145 Property and Equipment:

Land, buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123,771 118,831 Equipment and tooling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524,382 488,562

648,153 607,393 Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (434,375) (423,382)

Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213,778 184,011 Investments in finance affiliate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,251 37,169 Investments in other affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 1,009 Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,601 — Goodwill and other intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77,718 31,313

Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,228,024 $1,061,647

LIABILITIES AND SHAREHOLDERS’ EQUITY Current Liabilities:

Current portion of long-term borrowings under credit agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — $ 100,000 Current portion of capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,653 — Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146,743 113,248 Accrued expenses:

Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187,671 126,781 Warranties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,355 32,651 Sales promotions and incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81,228 75,494 Dealer holdback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76,512 79,688 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,730 53,744

Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639 2,604 Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615,531 584,210

Long term income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,837 5,509 Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 937 Capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 — Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 727,968 690,656 Shareholders’ Equity:

Preferred stock $0.01 par value, 20,000 shares authorized, no shares issued and outstanding . . . . . . . . . — — Common stock $0.01 par value, 160,000 shares authorized, 68,430 and 68,468 shares issued and

outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684 685 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165,518 79,239 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,831 285,169 Accumulated other comprehensive income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,023 5,898

Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,056 370,991 Total Liabilities and Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,228,024 $1,061,647

POLARIS INDUSTRIES INC. CONSOLIDATED BALANCE SHEETS

December 31 (In thousands, except per share data)

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Appendix A Financial Statement Information A-3

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Shares outstanding and per share data have been adjusted to give effect to the two-for-one stock split declared on July 20, 2011, paid on September 12, 2011 to shareholders of record on September 2, 2011.

2011 2010 2009

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,656,949 $1,991,139 $1,565,887 Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,916,366 1,460,926 1,172,668

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 740,583 530,213 393,219 Operating expenses:

Selling and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,725 142,353 111,137 Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,631 84,940 62,999 General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,395 99,055 71,184

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414,751 326,348 245,320 Income from financial services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,092 16,856 17,071

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349,924 220,721 164,970 Non-operating expense (income):

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,987 2,680 4,111 (Gain) loss on securities available for sale . . . . . . . . . . . . . . . . . . . . — (825) 8,952 Other expense (income), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (689) 325 733

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 346,626 218,541 151,174 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119,051 71,403 50,157

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 227,575 $ 147,138 $ 101,017

Basic net income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3.31 $ 2.20 $ 1.56

Diluted net income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3.20 $ 2.14 $ 1.53

Weighted average shares outstanding: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,792 66,900 64,798 Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,057 68,765 66,148

POLARIS INDUSTRIES INC. CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)For the Years Ended December 31

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A-4 Appendix A Financial Statement Information PO

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Shares outstanding, common stock, additional paid-in-capital, retained earnings and per share data have been adjusted to give effect to the two-for-one stock split declared on July 20, 2011, paid on

September 12, 2011 to shareholders of record on September 2, 2011.

Number of Shares

Common Stock

Additional Paid-

In Capital Retained Earnings

Accumulated Other Comprehensive Income (Loss) Total

Balance, December 31, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,984 $650 — $ 140,234 $ (3,857) $ 137,027 Employee stock compensation . . . . . . . . . . . . . . . . . . . . . . . . 62 1 10,225 10,226 Proceeds from stock issuances under employee plans . . . . . . 472 4 4,729 4,733 Tax effect of exercise of stock options . . . . . . . . . . . . . . . . . . (410) (410) Cash dividends declared ($0.78 per share) . . . . . . . . . . . . . . . (50,177) (50,177) Repurchase and retirement of common shares . . . . . . . . . . . . (222) (2) (4,554) (4,556) Comprehensive income:

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,017 Foreign currency translation adjustments, net of tax of $69 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

Reclassification of unrealized loss on available for sale securities to the income statement, net of tax of $2,277 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,675

Unrealized loss on available for sale securities, net of tax benefit of $230 . . . . . . . . . . . . . . . . . . . . . . . . . . . (382)

Unrealized gain on derivative instruments, net of tax of $165 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

Total comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . 107,698

Balance, December 31, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,296 653 9,990 191,074 2,824 204,541 Employee stock compensation . . . . . . . . . . . . . . . . . . . . . . . . 308 3 18,049 18,052 Proceeds from stock issuances under employee plans . . . . . . 4,066 41 68,064 68,105 Tax effect of exercise of stock options . . . . . . . . . . . . . . . . . . 10,610 10,610 Cash dividends declared ($0.80 per share) . . . . . . . . . . . . . . . (53,043) (53,043) Repurchase and retirement of common shares . . . . . . . . . . . . (1,202) (12) (27,474) (27,486) Comprehensive income:

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,138 Foreign currency translation adjustments, net of tax of $222 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,131

Unrealized gain on available for sale securities, net of tax benefit of $230 . . . . . . . . . . . . . . . . . . . . . . . . . . . 382

Unrealized loss on derivative instruments, net of tax benefit of $256 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (439)

Total comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . 150,212

Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,468 685 79,239 285,169 5,898 370,991 Employee stock compensation . . . . . . . . . . . . . . . . . . . . . . . . 290 3 20,545 20,548 Proceeds from stock issuances under employee plans . . . . . . 2,280 22 45,632 45,654 Tax effect of exercise of stock options . . . . . . . . . . . . . . . . . . 23,120 23,120 Cash dividends declared ($0.90 per share) . . . . . . . . . . . . . . . (61,585) (61,585) Repurchase and retirement of common shares . . . . . . . . . . . . (2,608) (26) (3,018) (129,328) (132,372) Comprehensive income:

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227,575 Foreign currency translation adjustments, net of tax benefit of $6,782 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,554

Unrealized gain/(loss) on derivative instruments, net of tax of $2,125 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,571

Total comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . 233,700

Balance, December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,430 $684 $165,518 $ 321,831 $12,023 $ 500,056

(In thousands, except per share data)

POLARIS INDUSTRIES INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’

EQUITY AND COMPREHENSIVE INCOME

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Appendix A Financial Statement Information A-5

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POLARIS INDUSTRIES INC. CONSOLIDATED STATEMENTS OF CASH FLOWS

Impact of currency exchange rates on cash balances . . . . . . . . . . . . . . . . . . . . . (2,460) — —

Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . (68,591) 253,687 113,113

Net cash used for financing activities . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . (227,516) (1,814) (50,410)

. . . . . . . — (825) 8,952(Gain) loss on securities available for sale . . . . . . . . . . . . . . . . . .

2011 2010 2009

Operating Activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 227,575 $147,138 $ 101,017 Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,390 66,519 64,593 Noncash compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,548 18,052 10,226 Noncash income from financial services . . . . . . . . . . . . . . . . . . . . . . . . . . (4,444) (4,574) (4,021) Noncash expense from other affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 1,376 382 Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (16,946) (16,888) 13,573 Tax effect of share-based compensation exercises . . . . . . . . . . . . . . . . . . . (23,120) (10,610) 410 Changes in current operating items:

Trade receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (23,115) 1,111 8,192 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (49,973) (56,612) 42,997 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,232 37,580 (40,329) Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,668 107,363 (24,759) Income taxes payable/receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,343) 7,033 7,325 Prepaid expenses and others, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,075) 956 4,643

Net cash provided by operating activities . . . . . . . . . . . . . . . . . . 302,530 297,619 193,201

Investing Activities: Purchase of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (84,484) (55,718) (43,932) Investments in finance affiliate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,588) (9,173) (3,007) Distributions from finance affiliate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,950 17,910 17,261 Investment in other affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000) — — Proceeds from sale of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 876 9,061 — Acquisition of businesses, net of cash acquired . . . . . . . . . . . . . . . . . . . . . (51,899) (4,738) —

Net cash used for investment activities . . . . . . . . . . . . . . . . . . . . (141,145) (42,118) (29,678)

Financing Activities: Borrowings under credit agreement / senior notes . . . . . . . . . . . . . . . . . . . 100,000 — 364,000 Repayments under credit agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (202,333) — (364,000) Repurchase and retirement of common shares . . . . . . . . . . . . . . . . . . . . . . (132,372) (27,486) (4,556) Cash dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (61,585) (53,043) (50,177) Tax effect of proceeds from share-based compensation exercises . . . . . . . 23,120 10,610 (410) Proceeds from stock issuances under employee plans . . . . . . . . . . . . . . . . 45,654 68,105 4,733

Cash and cash equivalents at beginning of period . . . . . . . . . . . . . . . . . . . . . . . 393,927 140,240 27,127

Cash and cash equivalents at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 325,336 $393,927 $ 140,240

Supplemental Cash Flow Information: Interest paid on debt borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,350 $ 2,813 $ 3,966

Income taxes paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 132,088 $ 81,142 $ 29,039

For the Year Ended December 31 (In thousands)

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A-6 Appendix A Financial Statement Information PO

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Note 1. Organization and Significant Accounting Policies Polaris Industries Inc. (“Polaris” or the “Company”) a Minnesota corporation, and its subsidiaries, are engaged in the design, engi- neering, manufacturing and marketing of innovative, high-quality, high-performance Off-Road Vehicles (“ORV”), Snowmobiles, and On-Road Vehicles, including motorcycles and Small Electric Vehicles. Polaris products, together with related parts, garments and accessories are sold worldwide through a network of deal- ers, distributors and its subsidiaries located in the United States, Canada, France, the United Kingdom, Australia, Norway, Sweden, Germany, Spain, China, India and Brazil.

Basis of presentation: The accompanying consolidated financial statements include the accounts of Polaris and its wholly-owned subsidiaries. All inter-company transactions and balances have been eliminated in consolidation. Income from financial services is reported as a component of operating income to better reflect income from ongoing operations, of which financial services has a significant impact.

During the 2011 third quarter, the Board of Directors declared a two-for-one split of the Company’s outstanding shares of Com- mon Stock. On September 12, 2011, Polaris shareholders received one additional share of Common Stock for each share they held of record at the close of business on September 2, 2011. All amounts, including shares and per share information, have been adjusted to give effect to the two-for-one stock split.

Investment in finance affiliate: The caption Investment in finance affiliate in the consolidated balance sheets represents Polaris’ 50 percent equity interest in Polaris Acceptance, a partnership agree- ment between GE Commercial Distribution Finance Corpora- tion (“GECDF”) and one of Polaris’ wholly-owned subsidiaries. Polaris Acceptance provides floor plan financing to Polaris dealers in the United States. Polaris’ investment in Polaris Acceptance is accounted for under the equity method, and is recorded as invest- ments in finance affiliate in the consolidated balance sheets.

Investment in other affiliates: The caption Investments in other affiliates in the consolidated balance sheets for the period ended December 31, 2011 represents the Company’s October 2011 investment in Brammo, Inc., a privately held manufacturer of elec- tric motorcycles. This investment represents a minority interest in Brammo and is accounted for under the cost method.

(Gain) Loss on Securities Available for Sale: The net gain of $825,000 in 2010 on securities available for sale resulted from a $1,594,000 gain on the sale of our remaining investment in KTM during the 2010 third quarter offset by a related non-cash impair- ment charge of $769,000 during the 2010 second quarter. In the first quarter 2009, we recorded a non-cash impairment charge on securities held for sales of $8,952,000 from the decline in the fair value of the KTM shares owned by Polaris as of March 31, 2009, when it was determined that the decline in the fair value of the KTM shares owned by the Company was other than temporary.

Use of estimates: The preparation of financial statements in confor- mity with accounting principles generally accepted in the United

States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial state- ments and the reported amounts of revenues and expenses during the reporting period. Ultimate results could differ from those estimates.

Cash equivalents: Polaris considers all highly liquid investments purchased with an original maturity of 90 days or less to be cash equivalents. Cash equivalents are stated at cost, which approxi- mates fair value. Such investments consist principally of money market mutual funds.

Allowance for doubtful accounts: Polaris’ financial exposure to collection of accounts receivable is limited due to its agreements with certain finance companies. For receivables not serviced through these finance companies, the Company provides a reserve for doubtful accounts based on historical rates and trends. This reserve is adjusted periodically as information about specific ac- counts becomes available.

Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market. The major components of inventories are as follows (in thousands):

December 31 2011 2010

Raw materials and purchased components . . . . $ 61,296 $ 35,580 Service parts, garments and accessories . . . . . . 77,437 60,813 Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . 175,252 155,744 Less: reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . (15,943) (16,210) Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $298,042 $235,927

Property and equipment: Property and equipment is stated at cost. Depreciation is provided using the straight-line method over the estimated useful life of the respective assets, ranging from 10–40 years for buildings and improvements and from 1–7 years for equipment and tooling. Fully depreciated tooling is eliminated from the accounting records annually.

Research and Development Expenses: Polaris records research and development expenses in the period in which they are incurred as a component of operating expenses. In the years ended Decem- ber 31, 2011, 2010, and 2009, Polaris incurred $105,631,000, $84,940,000, and $62,999,000, respectively.

Advertising Expenses: Polaris records advertising expenses as a component of selling and marketing expenses in the period in which they are incurred. In the years ended December 31, 2011, 2010, and 2009, Polaris incurred $48,877,000, $40,833,000 and $37,433,000, respectively.

Shipping and Handling Costs: Polaris records shipping and han- dling costs as a component of cost of sales at the time the product is shipped.

Product warranties: Polaris provides a limited warranty for its ORVs for a period of six months and for a period of one year for its snowmobiles and motorcycles and a two year period for SEVs. Polaris provides longer warranties in certain geographical markets as determined by local regulations and market conditions and may provide longer warranties related to certain promotional programs.

POLARIS INDUSTRIES INC. SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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Appendix A Financial Statement Information A-7

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Polaris’ standard warranties require the Company or its dealers to repair or replace defective products during such warranty periods at no cost to the consumer. The warranty reserve is established at the time of sale to the dealer or distributor based on management’s best estimate using historical rates and trends. Adjustments to the warranty reserve are made from time to time as actual claims be- come known in order to properly estimate the amounts necessary to

The carrying amounts of the Company’s long-term debt approxi- mates its fair vale as December 31, 2011 and 2010.

Note 4. Goodwill and Other Intangible Assets

Goodwill and other intangible assets: ASC Topic 350 prohibits the amortization of goodwill and intangible assets with indefinite useful lives. Topic 350 requires that these assets be reviewed for impairment at least annually. An impairment charge for goodwill is recognized only when the estimated fair value of a reporting unit, including goodwill, is less than its carrying amount. The results of the analyses indicated that no goodwill or intangible impairment existed. In ac- cordance with Topic 350, the Company will continue to complete an

settle future and existing claims on products sold as of the balance sheet date. Factors that could have an impact on the warranty accrual in any given year include the following: improved manufacturing quality, shifts in product mix, changes in warranty coverage periods, snowfall and its impact on snowmobile usage, product recalls and any significant changes in sales volume. The activity in the warranty reserve during the years presented is as follows (in thousands):

Sales promotions and incentives: Polaris provides for estimated sales promotion and incentive expenses, which are recognized as a reduction to sales, at the time of sale to the dealer or dis- tributor. Polaris recorded accrued liabilities of $81,228,000 and $75,494,000 related to various sales promotions and incentive pro- grams as of December 31, 2011 and 2010, respectively.

Dealer holdback programs: Dealer holdback represents a portion of the invoiced sales price that is expected to be subsequently re- turned to the dealer or distributor as a sales incentive upon the ulti- mate retail sale of the product. Polaris recorded accrued liabilities of $76,512,000 and $79,688,000, for dealer holdback programs in the consolidated balance sheets as of December 31, 2011 and 2010, respectively.

Foreign currency translation: The functional currency for each of the Polaris foreign subsidiaries is their respective local currencies. The assets and liabilities in all Polaris foreign entities are trans- lated at the foreign exchange rate in effect at the balance sheet date. Translation gains and losses are reflected as a component of Accumulated other comprehensive income in the sharehold- ers’ equity section of the accompanying consolidated balance sheets. Revenues and expenses in all of Polaris’ foreign entities are translated at the average foreign exchange rate in effect for each month of the quarter. Transaction gains and losses includ- ing intercompany transactions denominated in a currency other

than the functional currency of the entity involved are included in “Other income (expense), net” on our Consolidated statements of income. The net Accumulated other comprehensive income related to translation gains and losses was a net gain of $9,545,000 and $6,991,000 at December 31, 2011 and 2010, respectively.

Revenue recognition: Revenues are recognized at the time of ship- ment to the dealer or distributor or other customers. Product re- turns, whether in the normal course of business or resulting from repossession under its customer financing program, have not been material. Polaris sponsors certain sales incentive programs and ac- crues liabilities for estimated sales promotion expenses and esti- mated holdback amounts that are recognized as reductions to sales when products are sold to the dealer or distributor customer.

Comprehensive income: Components of comprehensive income include net income, foreign currency translation adjustments, un- realized gains or losses on derivative instruments, and unrealized gains or losses on securities held for sale, net of tax. The Company has chosen to disclose comprehensive income in the accompany- ing consolidated statements of shareholders’ equity and compre- hensive income.

Note 3. Financing

The following summarizes activity under Polaris’ credit arrange- ments (dollars in thousands):

impairment analysis on an annual basis. Goodwill and other intangible assets, net, consist of $44,668,000 and $28,354,000 of goodwill and $33,050,000 and $2,959,000 of intangible assets, net of accumulated amortization, for the periods ended December 31, 2011 and Decem- ber 31, 2010, respectively. Amortization expense for intangible assets during 2011 and 2010 was $1,018,000 and $188,000, respectively.

Note 9. Commitments and Contingencies

Product liability: Polaris is subject to product liability claims in the normal course of business. Polaris is currently self-insured for all product liability claims. The estimated costs resulting from any losses are charged to operating expenses when it is probable a loss

For the Year Ended December 31 2011 2010 2009

Balance at beginning of year . . . . . . . . . . . . . . . . . . . . . . $ 32,651 $ 25,520 $ 28,631 Additions to warranty reserve through acquisitions . . . . 2,727 — — Additions charged to expense . . . . . . . . . . . . . . . . . . . . . 46,217 43,721 40,977 Warranty claims paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . (37,240) (36,590) (44,088) Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,355 $ 32,651 $ 25,520

2011 2010 2009

Total borrowings at December 31, . . . . . . . . . . . . . . $100,000 $200,000 $200,000 Average outstanding borrowings during year . . . . . $133,800 $200,000 $268,100 Maximum outstanding borrowings during year. . . . $200,000 $200,000 $345,000 Interest rate at December 31 . . . . . . . . . . . . . . . . . . 4.40% 0.65% 0.79%

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A-8 Appendix A Financial Statement Information PO

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has been incurred and the amount of the loss is reasonably determin- able. The Company utilizes historical trends and actuarial analysis tools, along with an analysis of current claims, to assist in determin- ing the appropriate loss reserve levels. At December 31, 2011, the Company had an accrual of $16,861,000 for the probable payment of pending claims related to product liability litigation associated with Polaris products. This accrual is included as a component of Other Accrued expenses in the accompanying consolidated balance sheets.

Leases: Polaris leases buildings and equipment under non-can- celable operating leases. Total rent expense under all operating lease agreements was $9,184,000, $5,553,000 and $4,999,000 for 2011, 2010 and 2009, respectively. Future minimum annual lease payments under capital and operating leases with non-cancelable terms in excess of one year as of December 31, 2011, including payments for the Monterrey, Mexico facility operating lease were as follows (in thousands):

Note 12. Segment Reporting

Polaris has reviewed ASC Topic 280 and determined that the Com- pany meets the aggregation criteria outlined since the Company’s segments have similar (1) economic characteristics, (2) product

and services, (3) production processes, (4) customers, (5) distri- bution channels, and (6) regulatory environments. Therefore, the Company reports as a single reportable business segment. The fol- lowing data relates to Polaris’ foreign operations:

Lease Obligations Capital Leases Operating Leases

2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,653 $ 7,184 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,190 5,845 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,444 4,857 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 701 3,899 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 3,460 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 11,644 Total future minimum lease obligation . . . . $7,253 $36,889

For the Year Ended December 31 (In thousands) 2011 2010 2009

Canadian subsidiary: Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $368,487 $279,309 $239,240 Identifiable assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,008 42,936 35,462 Other foreign countries: Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $424,363 $305,864 $252,419 Identifiable assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252,519 145,528 97,771

2009: Deducted from asset accounts—Allowance for doubtful accounts receivable . . . . . . . . . . . . . $6,098 $5,741 — $(2,246) $9,593

2010: Deducted from asset accounts—Allowance for doubtful accounts receivable . . . . . . . . . . . . . $9,593 $1,599 — $(4,823) $6,369

2011: Deducted from asset accounts—Allowance for doubtful accounts receivable . . . . . . . . . . . . . $6,369 $ 25 $532 $(2,453) $4,473

2009: Deducted from asset accounts—Allowance for obsolete inventory . . . . . . . . . . . . . . . . . . . . . $17,216 $6,400 — $(8,023) $15,593

2010: Deducted from asset accounts—Allowance for obsolete inventory . . . . . . . . . . . . . . . . . . . . . $15,593 $5,840 — $(5,223) $16,210

2011: Deducted from asset accounts—Allowance for obsolete inventory . . . . . . . . . . . . . . . . . . . . . $16,210 $4,611 $725 $(5,603) $15,943

(2) Inventory disposals, net of recoveries

(1) Uncollectible accounts receivable written off, net of recoveries.

Inventory Reserve

POLARIS INDUSTRIES INC. SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

Allowance for Doubtful Accounts

Balance at Beginning of

Period

Additions Charged to Costs and Expenses

Additions Through

Acquisition Other Changes Add (Deduct)(1)

Balance at End of Period

(In thousands)

2

1

1

1

2

2

1

2

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For the Years Ended December 31,

(Dollars in millions, except per-share data) 2011 2010 2009 2008 2007 2006

Statement of Operations Data Sales Data:

Total sales . . . . . . . . . . . . . . . . . . . . . . $2,656.9 $1,991.1 $1,565.9 $1,948.3 $1,780.0 $1,656.5 Percent change from prior year . . . . . . . . . . . . . . . . . . . . . 33% 27% -20% 9% 7% -11%

Sales mix by product: Off-Road Vehicles . . . . . . . . . . . 69% 69% 65% 67% 67% 67% Snowmobiles . . . . . . . . . . . . . . . 11% 10% 12% 10% 10% 10% On-Road Vehicles . . . . . . . . . . . 5% 4% 3% 5% 6% 7% Parts, Garments and Accessories . . . . . . . . . . . . . . . 15% 17% 20% 18% 17% 16%

Operating Expense Data: Total operating expenses . . . . . . . . . . $ 414.7 $ 326.3 $ 245.3 $ 284.1 $ 262.3 $ 238.4

Percent of sales . . . . . . . . . . . . . . 15.6% 16.4% 15.7% 14.6% 14.7% 14.4%

Net Income Data: Net income from continuing operations . . . . . . . . . . . . . . . . . . . . $ 227.6 $ 147.1 $ 101.0 $ 117.4 $ 112.6 $ 112.8

Percent of sales . . . . . . . . . . . . . . . . . . 8.6% 7.4% 6.5% 6.0% 6.3% 6.8% Diluted net income per share from continuing operations . . . . . . . . . . . $ 3.20 $ 2.14 $ 1.53 $ 1.75 $ 1.55 $ 1.36

Net income . . . . . . . . . . . . . . . . . . . . . $ 227.6 $ 147.1 $ 101.0 $ 117.4 $ 111.7 $ 107.0 Diluted net income per share . . . . . . . $ 3.20 $ 2.14 $ 1.53 $ 1.75 $ 1.54 $ 1.29

Cash Flow Data: Cash flow provided by continuing operations . . . . . . . . . . . . . . . . . . . . . . . . $ 302.5 $ 297.9 $ 193.2 $ 176.2 $ 213.2 $ 152.8

Purchase of property and equipment for continuing operations . . . . . . . . . . . . . . . 84.5 55.7 43.9 76.6 63.7 52.6

Repurchase and retirement of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132.4 27.5 4.6 107.2 103.1 307.6

Cash dividends to shareholders . . . . . . . . . 61.6 53.0 50.2 49.6 47.7 50.2 Cash dividends per share . . . . . . . . . . . . . . $ 0.90 $ 0.80 $ 0.78 $ 0.76 $ 0.68 $ 0.62

Balance Sheet Data (at end of year): Cash and cash equivalents . . . . . . . . . . . . . $ 325.3 $ 393.9 $ 140.2 $ 27.2 $ 63.3 $ 19.6 Current assets . . . . . . . . . . . . . . . . . . . . . . . 878.7 808.1 491.5 443.6 447.6 393.0 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . 1,228.0 1,061.6 763.7 751.1 769.9 778.8 Current liabilities . . . . . . . . . . . . . . . . . . . . 615.5 584.2 343.1 404.8 388.2 361.4 Long-term debt . . . . . . . . . . . . . . . . . . . . . . 104.6 100.0 200.0 200.0 200.0 250.0 Shareholders’ equity . . . . . . . . . . . . . . . . . . 500.1 371.0 204.5 137.0 173.0 167.4

Operating Income Data: Total operating income . . . . . . . . . . . $ 349.9 $ 220.7 $ 165.0 $ 182.8 $ 176.0 $ 168.1

Percent of sales . . . . . . . . . . . . . . 13.2% 11.1% 10.5% 9.4% 9.9% 10.1%

Gross Profit Data: Total gross profit . . . . . . . . . . . . . . . . $ 740.6 $ 530.2 $ 393.2 $ 445.7 $ 393.0 $ 359.4

Percent of sales . . . . . . . . . . . . . . 27.9% 26.6% 25.1% 22.9% 22.1% 21.7%

POLARIS INDUSTRIES INC.

Selected Financial Data

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CONSOLIDATED BALANCE SHEETS

2011 2010

ASSETS Current Assets Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,700,000 $ 31,811,000 Short term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,413,000 39,251,000 Accounts receivable, less allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,732,000 29,227,000 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,478,000 81,361,000 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,048,000 4,384,000 Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,669,000 14,981,000

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232,040,000 201,015,000

Property and Equipment Machinery, equipment and tooling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,189,000 185,023,000 Land, building and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,924,000 28,937,000

224,113,000 213,960,000 Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184,883,000 170,644,000

39,230,000 43,316,000 Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,636,000 1,753,000

$272,906,000 $246,084,000

LIABILITIES AND SHAREHOLDERS’ EQUITY Current Liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 41,666,000 $ 37,303,000 Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,398,000 35,042,000 Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,380,000 2,975,000

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,444,000 75,320,000

Deferred Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,426,000 3,425,000

Commitments and Contingencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — —

Shareholders’ Equity Preferred stock, par value $1.00; 2,050,000 shares authorized; none issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — —

Preferred stock—Series A Junior Participating, par value $1.00; 450,000 shares authorized; none issued . . . . . . . . . . . . . . . . . . . . . . . . . . —

Common stock, par value $.01; 37,440,000 shares authorized; shares issued and outstanding: 12,199,271 in 2011 and 12,125,985 in 2010 . . 122,000 121,000

Class B common stock, par value $.01; 7,560,000 shares authorized; shares issued and outstanding: 6,102,000 in 2011 and 2010 . . . . . . . . . 61,000 61,000

Additional paid-in-capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,280,000 5,053,000 Accumulated other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,920,000) (2,382,000) Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177,493,000 164,486,000

Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183,036,000 167,339,000

$272,906,000 $246,084,000

March 31

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Appendix A Financial Statement Information A-11

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Net earnings (loss) per share Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.71 $ 0.10 $ (0.53)

Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.70 $ 0.10 $ (0.53)

Weighted average share outstanding Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,232,000 18,220,000 18,070,000

Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,539,000 18,291,000 18,070,000

2011 2010 2009

Net sales Snowmobile & ATV units . . . . . . . . . . . . . . . . . . . . . . . . . . $363,015,000 $350,871,000 $454,589,000 Parts, garments, & accessories . . . . . . . . . . . . . . . . . . . . . . 101,636,000 99,857,000 109,024,000

Total net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464,651,000 450,728,000 563,613,000

Cost of goods sold Snowmobile & ATV units . . . . . . . . . . . . . . . . . . . . . . . . . . 302,783,000 309,217,000 411,776,000 Parts, garments, & accessories . . . . . . . . . . . . . . . . . . . . . . 60,359,000 58,275,000 68,665,000

Total cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . 363,142,000 367,492,000 480,441,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,509,000 83,236,000 83,172,000 Operating expenses

Selling & marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,540,000 33,929,000 43,971,000 Research & development . . . . . . . . . . . . . . . . . . . . . . . . . . 15,029,000 12,926,000 18,404,000 General & administrative . . . . . . . . . . . . . . . . . . . . . . . . . . 34,805,000 35,045,000 33,904,000 Goodwill impairment charge . . . . . . . . . . . . . . . . . . . . . . . — — 1,750,000

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 83,374,000 81,900,000 98,029,000

Operating profit (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,135,000 1,336,000 (14,857,000) Other income (expense)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107,000 12,000 117,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,000) (250,000) (1,015,000)

Total other income (expense) . . . . . . . . . . . . . . . . . . . . . . . 96,000 (238,000) (898,000)

Earnings (loss) before incomes taxes . . . . . . . . . . . . . . . . . . . . . 18,231,000 1,098,000 (15,755,000) Income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,224,000 (777,000) (6,247,000)

Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,007,000 $ 1,875,000 $ (9,508,000)

ARCTIC CAT INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

Years ended March 31

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A-12 Appendix A Financial Statement Information

ARCTIC CAT INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years ended March 31,

Common Stock Class B

Common Stock AdditionalPaid-in Capital

Accumulated Other

Comprehensive Income (Loss)

Retained Earnings TotalShares Amount Shares Amount

Balances at March 31, 2008 . . . 11,833,485 $118,000 6,102,000 $61,000 $ — $ 4,768,000 $175,915,000 $180,862,000 Restricted stock awards . . . . . 163,500 2,000 — — (2,000) — — — Restricted stock forfeited . . . . (9,500) — — — — — — — Stock based compensation expense . . . . . . . . . . . . . . . — — — — 2,570,000 — — 2,570,000

Comprehensive loss:

Net loss . . . . . . . . . . . . . . . — — — — — — (9,508,000) (9,508,000) Unrealized loss on derivative instruments, net of tax . . . . . . . . . . . . — — — — — (133,000) — (133,000)

Foreign currency adjustment . . . . . . . . . . . — — — — — (5,147,000) — (5,147,000)

Total comprehensive loss . . . (14,788,000) Dividends ($.21 per share) . . — — — — — — (3,796,000) (3,796,000)

Balances at March 31, 2009 . . . 11,987,485 120,000 6,102,000 61,000 2,568,000 (512,000) 162,611,000 164,848,000 Restricted stock awards . . . . . 140,500 1,000 — — (1,000) — — — Restricted stock forfeited . . . . (2,000) — — — — — — — Stock based compensation expense . . . . . . . . . . . . . . . — — — — 2,486,000 — — 2,486,000

Comprehensive income: Net earnings . . . . . . . . . . . . — — — — — — 1,875,000 1,875,000 Unrealized gain on derivative instruments, net of tax . . . . . . . . . . . . — — — — — 244,000 — 244,000

Foreign currency adjustment . . . . . . . . . . . — — — — — (2,114,000) — (2,114,000)

Total comprehensive income . . . . . . . . . . . . . . . . 5,000

Balances at March 31, 2010 . . . 12,125,985 121,000 6,102,000 61,000 5,053,000 (2,382,000) 164,486,000 167,339,000 Exercise of stock options . . . . 184,869 2,000 — — 726,000 — — 728,000 Tax benefits from stock options exercised . . . . . . . . — — — — 745,000 — — 745,000

Repurchase of common stock . . . . . . . . . . . . . . . . . . (183,953) (2,000) — — (2,417,000) — — (2,419,000)

Restricted stock awards . . . . . 78,500 1,000 — — (1,000) — — — Restricted stock forfeited . . . . (6,130) — — — — — — — Stock based compensation expense . . . . . . . . . . . . . . . — — — — 3,174,000 — — 3,174,000

Comprehensive income: Net earnings . . . . . . . . . . . . — — — — — — 13,007,000 13,007,000 Unrealized loss on derivative instruments, net of tax . . . . . . . . . . . . — — — — — (1,147,000) — (1,147,000)

Foreign currency adjustment . . . . . . . . . . . — — — — — 1,609,000 — 1,609,000

Total comprehensive income . . . . . . . . . . . . . . . . 13,469,000

Balances at March 31, 2011 . . 12,199,271 $122,000 6,102,000 $61,000 $ 7,280,000 $(1,920,000) $177,493,000 $183,036,000

A R

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IC C

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Appendix A Financial Statement Information A-13

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ARCTIC CAT INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended March 31 2011 2010 2009

Cash flows from operating activities Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,007,000 $ 1,875,000 $ (9,508,000) Adjustments to reconcile net earnings to net cash provided by (used in) operating activities Depreciation and amortization . . . . . . . . . . . . . . . . . 15,816,000 22,779,000 28,981,000 Loss on the disposal of assets . . . . . . . . . . . . . . . . . . . 105,000 144,000 252,000 Impairment of goodwill . . . . . . . . . . . . . . . . . . . . . . . — — 1,750,000 Deferred income taxes benefit . . . . . . . . . . . . . . . . . . (3,194,000) (3,577,000) (6,379,000) Stock based compensation expense . . . . . . . . . . . . . . 3,174,000 2,486,000 2,570,000 Changes in operating assets and liabilities

Trading securities . . . . . . . . . . . . . . . . . . . . . . . . (71,162,000) (39,082,000) 24,837,000 Accounts receivable, less allowances . . . . . . . . . 5,543,000 9,400,000 (437,000) Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,587,000 40,003,000 2,798,000 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . 345,000 205,000 (1,246,000) Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . 2,879,000 (7,668,000) (29,615,000) Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . 9,238,000 (585,000) (3,392,000) Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,461,000) 3,335,000 8,980,000

Net cash provided by (used in) operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,123,000) 29,315,000 19,591,000

Cash flows from investing activities Purchases of property and equipment . . . . . . . . . . . . . . . (11,761,000) (6,540,000) (14,226,000) Proceeds from the sale of assets . . . . . . . . . . . . . . . . . . . . . 87,000 — —

Net cash used in investing activities . . . . . . . . . . (11,674,000) (6,540,000) (14,226,000)

Cash flows from financing activities Checks written in excess of bank balance . . . . . . . . . . . . . — 221,000 — Proceeds from short-term borrowings . . . . . . . . . . . . . . . 1,012,000 73,429,000 227,230,000 Payments on short-term borrowings . . . . . . . . . . . . . . . . . (1,012,000) (73,429,000) (227,230,000) Proceeds from issuance of common stock . . . . . . . . . . . . . 728,000 — — Tax benefit from stock option exercises . . . . . . . . . . . . . . 745,000 — — Repurchase of common stock . . . . . . . . . . . . . . . . . . . . . . . (2,419,000) — — Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — (3,796,000)

Net cash provided by (used in) financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (946,000) 221,000 (3,796,000)

Effect of exchange rate changes on cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632,000 (2,429,000) (382,000)

Net increase (decrease) in cash and cash equivalents . . . . . . . (17,111,000) 20,567,000 1,187,000 Cash and cash equivalents at beginning of year . . . . . . . . . . . . 31,811,000 11,244,000 10,057,000

Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . $ 14,700,000 $ 31,811,000 $ 11,244,000

Supplemental disclosure of cash payments for: Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,179,000 $ 1,935,000 $ 409,000 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,000 $ 250,000 $ 987,000

Supplemental disclosure of non-cash investing and financing activities:

As of March 31, 2011 and 2010, the unrealized gain (loss) on derivative instruments, net of tax was ($1,147,000) and $244,000.

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KTM POWER SPORTS AG CONSOLIDATED INCOME STATEMENT

FOR BUSINESS YEAR 2011

KTM POWER SPORTS AG CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

FOR BUSINESS YEAR 2011

(In thousands of Euro) 2011

Net result of the business year 20,818

Currency conversion 107

Valuation of cash flow hedges 11,393

Deferred tax on the valuation of cash flow hedges (2,848)

Other income 8,652

TOTAL INCOME 29,470

Thereof net result to owners 29,371

Thereof net result to non-controlling shareholders 99

(In thousands of Euro) 2011

Net sales 526,801

Cost of goods sold (371,752)

Gross margin 155,049

Selling and sport-activity expenses (71,952)

R&D expenses (23,099)

Infrastructure and administration expenses (20,870)

Other operating expenses (9,206)

Other operating Income 1,088

Operating result 31,009

Interest income 768

Interest expenses (9,693)

Other financial and participation result (2,975)

Pre-tax result 19,109

Tax on income and earnings 1,709

NET RESULT 20,818

Thereof net result to owners 20,719

Thereof net result to non-controlling shareholders 99

EARNINGS PER SHARE (EUR)

Basic 2.003

Diluted 1.968

A-14 Appendix A Financial Statement Information

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Appendix A Financial Statement Information A-15

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KTM POWER SPORTS AG CONSOLIDATED BALANCE SHEET

AS AT DECEMBER 31

(In thousands of Euro) 12/31/2011 12/31/2010

SHORT-TERM ASSETS

Liquid assets 14,962 8,946

Accounts receivable 2 trade to third parties 49,924 53,087

Accounts receivable 2 trade to affiliated companies 1,443 1,040

Accounts receivable 2 trade to associated companies 2,227 3,130

Inventory 113,979 108,910

Prepayments 1,649 1,169

Other short-term assets 9,701 7,231

193,885 183,513 LONG-TERM ASSETS

Financial fixed assets 7,458 6,222

Tangible fixed assets 84,256 63,204

Goodwill 78,793 78,492

Intangible fixed assets 118,202 110,118

Deferred taxes 3,132 3,725

Other long-term assets 49 51

291,890 261,812

ASSETS 485,775 445,325

(In thousands of Euro) 12/31/2011 12/31/2010

SHORT-TERM LIABILITIES

Bank loans 5,415 14,061

Accounts payable 2 trade to third parties 54,578 37,725

Accounts payable 2 trade to affiliated companies 11,062 7,979

Accounts payable 2 trade to associated companies 2,600 2,895

Provisions 4,238 3,993

Liabilities 2 corporate tax 1,470 33

Prepayments 735 1,614

Other short-term liabilities 29,256 33,926

109,353 102,226

LONG-TERM LIABILITIES

Interest-bearing loans 132,898 129,957

Liabilities for personnel 7,699 6,479

Liabilities from deferred taxes 14,560 15,851

Liabilities to affiliated companies 0 13,021

Other long-term liabilities 1,490 1,005

156,648 166,313

SHAREHOLDER’S EQUITY

Share capital 10,509 10,109

Reserves including retained earnings 208,987 166,593

Non-controlling shares 279 84

219,775 176,786

EQUITY AND LIABILITIES 485,775 445,325

ASSETS

EQUITY AND LIABILITIES

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A-16 Appendix A Financial Statement Information K

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KTM POWER SPORTS AG CONSOLIDATED CASH FLOW STATEMENT

FOR BUSINESS YEAR 2011

(In thousands of Euro) 2011 CONSOLIDATED CASH FLOW FROM OPERATING ACTIVITIES 1(2) Profit (loss) of the business year 20,818

1(2) Profit (loss) of non-controlling shareholders (99)

1(2) Depreciation (write-up) of fixed assets 33,368

1(2) Depreciation (write-up) to financial assets 118

1(2) Deferred taxes (3,352)

2 Results from consolidation not affecting income (649)

2 Results from companies validated at-equity not affecting income (657)

1(2) Addition (disposal) of liabilities for personnel 1,432

2(1) Profit (loss) from the sale of fixed assets (59)

Consolidated cash flow from earnings 50,919

2(1) Increase (decrease) in inventories including prepayments (5,069)

2(1) Increase (decrease) in accounts receiveable 2 trade, prepayments, other short- and longterm assets 831

2(1) Increase (decrease) in accounts receivable 2 trade from affiliated companies 43O

2(1) Increase (decrease) in accounts receivable 2 trade from associated companies 903

(1)2 Increase (decrease) in accounts payable 2 trade, prepayments and other short-term and long-term liabilities 16,346

(1)2 Increase (decrease) in accounts payable 2 trade from affiliated companies 3,083

(1)2 Increase (decrease) in accounts payable 2 trade from associated companies (295)

(1)2 Increase (decrease) from corporate taxes, deferred taxes and other provisions 3,201

19,429

Cash flow from operating activities 70,348

CONSOLIDATED CASH FLOW FROM INVESTMENT ACTIVITIES 2 Investments in fixed assets (outflow of funds for investments) (37,705)

2 Investments in financial assets (697)

(1)2 Changes from first/final consolidation 273

1 Disposal of fixed assets (inflow of funds from sales: book value 1 profit (2 loss) from the disposal of fixed assets) 871

(1)2 Currency rate differences from fixed assets (13)

Consolidated cash flow from investment activities (37,271)

CONSOLIDATED CASH FLOW FROM FINANCING ACTIVITIES (1)2 Currency rate differences 33

1 Capital increase 1,095

(1)2 Increase (decrease) of short-term bank loans (8,646)

(1)2 Change in liabilities to affiliated and associated companies (259)

(1)2 Increase (decrease) in long-term interest bearing loans (19,479)

1(2) Changes in non-controlling interests 196

1(2) Change deconsolidation Cost Plus subsidiaries O

Consolidated cash flow from financing activities (27,060)

CONSOLIDATED CASH FLOW 1(2) Consolidated cash flow from operating activities 70,348

1(2) Consolidated cash flow from investment activities (37,271)

1(2) Consolidated cash flow from financing activities (27,060)

Change in the liquidity of the group 6,017

1 Starting cash and cash equivalents of the group 8,946

CASH AND CASH EQUIVALENTS OF THE GROUP AS AT DECEMBER 31 14,962 Consisting of cash in hand. cheques, cash at bank and term deposits 14,962

Interest paid 10,052

Taxes paid 547

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Appendix A Financial Statement Information A-17

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KTM POWER SPORTS AG DEVELOPMENT OF THE GROUP’S EQUITY CAPITAL

FOR BUSINESS YEAR 2011

Nominal Reserves Revaluation Cash flow Currency Total Shares Total capital incl. net result reserve hedge translation of non- share for the reserve adjustments controlling capital business Interests (In thousands of Euro) year

As at December 31, 2010 10,109 163,106 17,235 (13,648) (100) 176,702 84 176,786

Currency conversion 0 0 0 0 105 105 0 105

Financial instruments 0 0 0 8,545 0 8,545 0 8,545

Profit and loss directly recognized in equity 0 0 0 8,545 105 8,650 0 8,650

Result of the business year 0 20,719 0 0 0 20,719 99 20,819

Total profit and loss recognized in equity 0 20,719 0 8,545 105 29,369 99 29,469

Capital increase 400 13,600 0 0 0 14,000 0 14,000

Cost of capital increase 0 (480) 0 0 0 (480) 0 (480)

Change in non-controlling

interests 0 (96) 0 0 0 (96) 96 0

AS AT DECEMBER 31, 2011 10,509 196,849 17,235 (5,103) 5 219,495 279 219,775

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A-18 Appendix A Financial Statement Information

2011 2010

Net revenues 1,516,463

Cost for materials 904,060

Cost for services and leases and rentals 266,484

Employee costs 247,600

Depreciation of property, plant and equipment 35,219

Amortisation of intangible assets 59,794

Other operating income 122,562

Other operating costs 20,323

Operating income 105,545

Income/(loss) from investments 2,481

Financial income 4,087

Borrowing Costs 31,853

Net exchange gains/(losses) (932)

Earnings before tax 79,328

Taxation for the period 32,305

Earnings from continuing activities 47,023

Assets held for disposal:

Profits or losses arising from assets held for disposal

Net Income (Loss) for the period 47,023

Attributable to:

Shareholders of the Parent Company 47,053

Non-controlling interests (30)

Earnings per share (figures in €) 0.126

Diluted earnings per share (figures in €) 0.126

1,485,351

881,075

258,358

240,115

35,879

50,127

121,128

29,821

111,104

5,252

2,891

33,905

(1,518)

83,824

40,983

42,841

42,841

42,811

30

0.113

0.112

For Year Ended December 31 (In thousands of Euro)

Piaggio Group Consolidated Income Statement

Profit (loss) for the period (A) 47,023 42,841

Effective portion of profits (losses) on cash flow hedges (1,283) (354)

Profit (loss) deriving from the translation of financial statements of foreign companies denominated in foreign currency

(11,262) 3,060

(12,545) 2,706

34,478 45,547

34,533 45,531

(55) 16

Total Other Profits (and losses) for the period (B)

Total Profit (loss) for the period (A + B)

Attributable to:

Shareholders of the Parent Company

Non-controlling interests

2011 2010

Piaggio Group Consolidated Statement of Comprehensive Income

For Year Ended December 31 (In thousands of Euro)

PI A

G G

IO

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Appendix A Financial Statement Information A-19

Piaggio Group Consolidated Statement of Financial Position

As of December 31 (In thousands of Euro) 2011 2010

652,622 256,759

194 334 967

46,294

12,655 969,825

90,421 23,300 44,200

240,066 23,051

154,859 575,897

1,545,722

441,277

1,613 442,890

371,048 88

16,993 32,338 58,636

3,361 4,202

486,666

156,800 352,627 19,290 69,503 17,946

616,166

1,545,722

Assets

Non-current assets

Intangible assets 649,420 Property, plant and equipment 274,871 Investment property Investments 2,482 Other financial assets 11,836 Long-term tax receivables 976 Deferred tax assets 55,726 Trade receivables Other receivables 15,165 Total non-current assets 1,010,476

Assets held for sale

Current assets

Trade receivables 65,560 Other receivables 28,028 Short-term tax receivables 27,245 Inventories 236,988 Other financial assets 0 Cash and cash equivalents 151,887 Total current assets 509,708

Total assets 1,520,184

Shareholders’ equity and liabilities

Shareholders’ equity

Share capital and reserves attributable to the shareholders of the Parent Company

445,036

Share capital and reserves attributable to non-controlling interests 1,182 Total shareholders’ equity 446,218

Non-current liabilities

Financial liabilities falling due after one year 329,200 Trade payables 235 Other long-term provisions 12,429 Deferred tax liabilities 32,735 Retirement funds and employee benefits 46,603 Tax payables 2,539 Other long-term payables 5,948 Total non-current liabilities 429,689

Current liabilities

Financial liabilities falling due within one year 170,261 Trade payables 375,263 Tax payables 20,920 Other short-term payables 64,718 Current portion of other long-term provisions 13,115 Total current liabilities 644,277

Total shareholders’ equity and liabilities 1,520,184

PI A

G G

IO

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A-20 Appendix A Financial Statement Information

Operating activities

Consolidated net income 47,053 Allocation of profit to non-controlling interests (30) Taxation for the period 32,305 Depreciation of property, plant and equipment 35,219 Amortisation of intangible assets 59,794 Non-monetary costs for stock options 771 Allocations for risks and retirement funds and employee benefits 21,134 Write-downs / (Reversals) (1,192) Losses / (Gains) on the disposal of property, plants and equipment (6,012) Losses / (Gains) on the disposal of intangible assets 0 Financial income (3,910) Dividend income (193) Borrowing Costs 25,558 Income from public grants (3,492) Portion of earnings of affiliated companies 0 Change in working capital:

(Increase)/Decrease in trade receivables 24,861 (Increase)/Decrease in other receivables (18,740) (Increase)/Decrease in inventories 3,078 Increase/(Decrease) in trade payables 22,783 Increase/(Decrease) in other payables 8,636 Increase/(Decrease) in provisions for risks (21,782) Increase/(Decrease) in retirement funds and employee benefits (20,795) Other changes 5,265 Cash generated from operating activities 210,311

Interest paid (22,825) Taxes paid (31,862) Cash flow from operating activities (A) 155,624

Investment activities

Investment in property, plant and equipment (61,790) Sale price, or repayment value, of property, plant and equipment 6,542 Investment in intangible assets (64,300) Sale price, or repayment value, of intangible assets 122 Purchase of financial assets 0 Sale price of financial assets 23,051 Collected interests 11,666 Cash flow from investment activities (B) (84,709)

Financing activities

Exercise of stock options 2,843 Purchase of treasury shares (9,080) Outflow for dividends paid (25,684) Loans received 71,400 Outflow for repayment of loans (112,727) Financing received for leases 227 Repayment of finance leases (850) Cash flow from funding activities (C) (73,871)

Increase / (Decrease) in cash and cash equivalents (A+B+C) (2,956) Opening balance 154,758

Exchange differences Closing balance 151,802

42,811 30

40,983 35,879 50,127

2,650 29,243

1,755 (2,240)

0 (2,891)

(12) 29,744 (4,164)

45

12,743 (1,157) 12,430 6,640

(12,347) (26,974) (13,028) (43,774) 158,493

(23,178) (12,774) 122,541

(37,132) 3,823

(59,063) 261

(23,051) 4,127 2,360

(108,675)

(3,344) (25,765) 37,652

(65,174) 0

(758) (57,389)

(43,523)

198,281

154,758

Piaggio Group Consolidated Cash Flow Statement

PI A

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e a ed pa es (Section E)

e a ed pa es (Section E)2011 2010For Year Ended December 31 (In thousands of Euro)

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Appendix A Financial Statement Information A-21

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Learning Objectives

CONCEPTUAL

C1 Describe the earning of interest and the concepts of present and future values. (p. B-1)

PROCEDURAL

P1 Apply present value concepts to a single amount by using interest tables. (p. B-3) P2 Apply future value concepts to a single amount by using interest tables. (p. B-4) P3 Apply present value concepts to an annuity by using interest tables. (p. B-5) P4 Apply future value concepts to an annuity by using interest tables. (p. B-6)

Time Value of Money B Appendix

B

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B-1

Appendix Preview

The concepts of present and future values are important to mod- ern business, including the preparation and analysis of financial statements. The purpose of this appendix is to explain, illustrate,

and compute present and future values. This appendix applies these concepts with reference to both business and everyday activities.

Time Value of Money

Value of a Single Amount

• Present value of a single amount

• Future value of a single amount

Present and Future Value Concepts

• Time is money • Concept of interest

Value of an Annuity

• Present value of an annuity

• Future value of an annuity

The old saying “Time is money” reflects the notion that as time passes, the values of our assets and liabilities change. This change is due to interest, which is a borrower’s payment to the owner of an asset for its use. The most common example of interest is a savings account asset. As we keep a balance of cash in the account, it earns interest that the financial institution pays us. An example of a liability is a car loan. As we carry the balance of the loan, we accumulate interest costs on it. We must ultimately repay this loan with interest. Present and future value computations enable us to measure or estimate the interest compo- nent of holding assets or liabilities over time. The present value computation is important when we want to know the value of future-day assets today. The future value computation is important when we want to know the value of present-day assets at a future date. The first section focuses on the present value of a single amount. The second section focuses on the future value of a single amount. Then both the present and future values of a series of amounts (called an annu- ity) are defined and explained.

C1 Describe the earning of interest and the concepts of present and future values.

PRESENT AND FUTURE VALUE CONCEPTS

We graphically express the present value, called p, of a single future amount, called f, that is received or paid at a future date in Exhibit B.1.

PRESENT VALUE OF A SINGLE AMOUNT

EXHIBIT B.1 Present Value of a Single Amount Diagram

f Time

p ↑ ↑

Today Future

⎯→

Working for Lotto Winnings Lottery winners often never work again. Kenny Dukes, a recent Georgia lottery winner, doesn’t have that option. He is serving parole for burglary charges, and Georgia requires its parolees to be employed (or in school). For his lottery winnings, Dukes had to choose between $31 million in 30 annual payments or $16 million in one lump sum ($10.6 million after-tax); he chose the latter. ■

Decision Insight

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B-2 Appendix B Time Value of Money

To illustrate present value concepts, assume that we need $220 one period from today. We want to know how much we must invest now, for one period, at an interest rate of 10% to provide for this $220. For this illustration, the p, or present value, is the unknown amount — the specifics are shown graphically as follows:

Conceptually, we know p must be less than $220. This is obvious from the answer to this ques- tion: Would we rather have $220 today or $220 at some future date? If we had $220 today, we could invest it and see it grow to something more than $220 in the future. Therefore, we would prefer the $220 today. This means that if we were promised $220 in the future, we would take less than $220 today. But how much less? To answer that question, we compute an estimate of the present value of the $220 to be received one period from now using the formula in Exhibit B.2 as follows:

p 5 f

(1 1 i)n 5

$220

(1 1 0.10)1 5 $200

We interpret this result to say that given an interest rate of 10%, we are indifferent between $200 today or $220 at the end of one period. We can also use this formula to compute the present value for any number of periods. To il- lustrate, consider a payment of $242 at the end of two periods at 10% interest. The present value of this $242 to be received two periods from now is computed as follows:

p 5 f

(1 1 i)n 5

$242

(1 1 0.10)2 5 $200

Together, these results tell us we are indifferent between $200 today, or $220 one period from today, or $242 two periods from today given a 10% interest rate per period.

The number of periods (n) in the present value formula does not have to be expressed in years. Any period of time such as a day, a month, a quarter, or a year can be used. Whatever period is used, the interest rate (i) must be compounded for the same period. This means that if a situation expresses n in months and i equals 12% per year, then i is transformed into interest earned per month (or 1%). In this case, interest is said to be compounded monthly. A present value table helps us with present value computations. It gives us present values (factors) for a variety of both interest rates (i) and periods (n). Each present value in a present value table assumes that the future value ( f ) equals 1. When the future value ( f ) is different from 1, we simply multiply the present value (p) from the table by that future value to give us the estimate. The formula used to construct a table of present values for a single future amount of 1 is shown in Exhibit B.3.

p 5 1

(1 1 i)n

EXHIBIT B.3 Present Value of 1 Formula

The formula to compute the present value of a single amount is shown in Exhibit B.2, where p 5 present value; f 5 future value; i 5 rate of interest per period; and n 5 number of periods. (Interest is also called the discount, and an interest rate is also called the discount rate.)

EXHIBIT B.2 Present Value of a Single Amount Formula

p 5 f

(1 1 i)n

f 5 $220 (i 5 0.10)

p 5 ? ⎯→

I will pay your allowance at the end

of the month. Do you want to wait or receive its present value today?

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Appendix B Time Value of Money B-3

P1 Apply present value concepts to a single amount by using interest tables.

This formula is identical to that in Exhibit B.2 except that f equals 1. Table B.1 at the end of this appendix is such a present value table. It is often called a present value of 1 table. A present value table involves three factors: p, i, and n. Knowing two of these three factors allows us to compute the third. (A fourth is f, but as already explained, we need only multiply the 1 used in the formula by f.) To illustrate the use of a present value table, consider three cases.

Case 1 (solve for p when knowing i and n). To show how we use a present value table, let’s look again at how we estimate the present value of $220 (the f value) at the end of one period (n 5 1) where the interest rate (i) is 10%. To solve this case, we go to the present value table (Table B.1) and look in the row for 1 period and in the column for 10% interest. Here we find a present value (p) of 0.9091 based on a future value of 1. This means, for instance, that $1 to be received one period from today at 10% interest is worth $0.9091 today. Since the future value in this case is not $1 but $220, we multiply the 0.9091 by $220 to get an answer of $200.

Case 2 (solve for n when knowing p and i). To illustrate, assume a $100,000 future value ( f ) that is worth $13,000 today (p) using an interest rate of 12% (i) but where n is unknown. In par- ticular, we want to know how many periods (n) there are between the present value and the future value. To put this in context, it would fit a situation in which we want to retire with $100,000 but currently have only $13,000 that is earning a 12% return and we will be unable to save any addi- tional money. How long will it be before we can retire? To answer this, we go to Table B.1 and look in the 12% interest column. Here we find a column of present values (p) based on a future value of 1. To use the present value table for this solution, we must divide $13,000 (p) by $100,000 ( f ), which equals 0.1300. This is necessary because a present value table defines f equal to 1, and p as a fraction of 1. We look for a value nearest to 0.1300 (p), which we find in the row for 18 periods (n). This means that the present value of $100,000 at the end of 18 periods at 12% interest is $13,000; alternatively stated, we must work 18 more years.

Case 3 (solve for i when knowing p and n). In this case, we have, say, a $120,000 future value ( f ) worth $60,000 today ( p) when there are nine periods (n) between the present and future values, but the interest rate is unknown. As an example, suppose we want to retire with $120,000, but we have only $60,000 and we will be unable to save any additional money, yet we hope to retire in nine years. What interest rate must we earn to retire with $120,000 in nine years? To answer this, we go to the present value table (Table B.1) and look in the row for nine periods. To use the present value table, we must divide $60,000 ( p) by $120,000 ( f ), which equals 0.5000. Recall that this step is neces sary because a present value table defines f equal to 1 and p as a fraction of 1. We look for a value in the row for nine periods that is near- est to 0.5000 ( p), which we find in the column for 8% interest (i). This means that the present value of $120,000 at the end of nine periods at 8% interest is $60,000 or, in our example, we must earn 8% annual interest to retire in nine years.

1. A company is considering an investment expected to yield $70,000 after six years. If this company demands an 8% return, how much is it willing to pay for this investment?

Quick Check Answer — p. B-7

We must modify the formula for the present value of a single amount to obtain the formula for the future value of a single amount. In particular, we multiply both sides of the equation in Exhibit B.2 by (1 1 i)n to get the result shown in Exhibit B.4.

FUTURE VALUE OF A SINGLE AMOUNT

EXHIBIT B.4 Future Value of a Single Amount Formula

f 5 p 3 (1 1 i)n

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B-4 Appendix B Time Value of Money

The future value ( f ) is defined in terms of p, i, and n. We can use this formula to determine that $200 ( p) invested for 1 (n) period at an interest rate of 10% (i) yields a future value of $220 as follows:

P2 Apply future value concepts to a single amount by using interest tables.

f 5 p 3 (1 1 i)n

5 $200 3 (1 1 0.10)1

5 $220

This formula can also be used to compute the future value of an amount for any number of periods into the future. To illustrate, assume that $200 is invested for three periods at 10%. The future value of this $200 is $266.20, computed as follows:

f 5 p 3 (1 1 i)n

5 $200 3 (1 1 0.10)3

5 $266.20

A future value table makes it easier for us to compute future values ( f ) for many different combinations of interest rates (i) and time periods (n). Each future value in a future value table assumes the present value ( p) is 1. As with a present value table, if the future amount is some- thing other than 1, we simply multiply our answer by that amount. The formula used to con- struct a table of future values (factors) for a single amount of 1 is in Exhibit B.5.

EXHIBIT B.5 Future Value of 1 Formula

f 5 (1 1 i)n

Table B.2 at the end of this appendix shows a table of future values for a current amount of 1. This type of table is called a future value of 1 table. There are some important relations between Tables B.1 and B.2. In Table B.2, for the row where n 5 0, the future value is 1 for each interest rate. This is so because no interest is earned when time does not pass. We also see that Tables B.1 and B.2 report the same information but in a different manner. In particular, one table is simply the inverse of the other. To illustrate this inverse relation, let’s say we invest $100 for a period of five years at 12% per year. How much do we expect to have after five years? We can answer this question using Table B.2 by finding the future value ( f ) of 1, for five periods from now, compounded at 12%. From that table we find f 5 1.7623. If we start with $100, the amount it accumulates to after five years is $176.23 ($100 3 1.7623). We can alterna- tively use Table B.1. Here we find that the present value ( p) of 1, discounted five periods at 12%, is 0.5674. Recall the inverse relation between present value and future value. This means that p 5 1yf (or equivalently, f 5 1yp). We can compute the future value of $100 invested for five periods at 12% as follows: f 5 $100 3 (1y0.5674) 5 $176.24 (which equals the $176.23 just computed, except for a 1 cent rounding difference). A future value table involves three factors: f, i, and n. Knowing two of these three factors al- lows us to compute the third. To illustrate, consider these three possible cases.

Case 1 (solve for f when knowing i and n). Our preceding example fits this case. We found that $100 invested for five periods at 12% interest accumulates to $176.24.

Case 2 (solve for n when knowing f and i). In this case, we have, say, $2,000 ( p) and we want to know how many periods (n) it will take to accumulate to $3,000 ( f ) at 7% (i) interest. To answer this, we go to the future value table (Table B.2) and look in the 7% interest column. Here we find a column of future values ( f ) based on a present value of 1. To use a future value table, we must divide $3,000 ( f ) by $2,000 ( p), which equals 1.500. This is necessary because a future value table defines p equal to 1, and f as a multiple of 1. We look for a value nearest to 1.50 ( f ), which we find in the row for six periods (n). This means that $2,000 invested for six periods at 7% interest accumulates to $3,000.

Case 3 (solve for i when knowing f and n). In this case, we have, say, $2,001 ( p), and in nine years (n) we want to have $4,000 ( f ). What rate of interest must we earn to accomplish this? To answer that, we go to Table B.2 and search in the row for nine periods. To use a future value ta- ble, we must divide $4,000 ( f ) by $2,001 ( p), which equals 1.9990. Recall that this is necessary

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Appendix B Time Value of Money B-5

because a future value table defines p equal to 1 and f as a multiple of 1. We look for a value near- est to 1.9990 ( f ), which we find in the column for 8% interest (i). This means that $2,001 in- vested for nine periods at 8% interest accumulates to $4,000.

2. Assume that you win a $150,000 cash sweepstakes. You decide to deposit this cash in an account earning 8% annual interest, and you plan to quit your job when the account equals $555,000. How many years will it be before you can quit working?

Quick Check Answer — p. B-7

An annuity is a series of equal payments occurring at equal intervals. One example is a series of three annual payments of $100 each. An ordinary annuity is defined as equal end-of-period pay- ments at equal intervals. An ordinary annuity of $100 for three periods and its present value ( p) are illustrated in Exhibit B.6.

PRESENT VALUE OF AN ANNUITY

P3 Apply present value concepts to an annuity by using interest tables.

One way to compute the present value of an ordinary annuity is to find the present value of each payment using our present value formula from Exhibit B.3. We then add each of the three present values. To illustrate, let’s look at three $100 payments at the end of each of the next three periods with an interest rate of 15%. Our present value computations are

p 5 $100

(1 1 0.15)1 1

$100

(1 1 0.15)2 1

$100

(1 1 0.15)3 5 $228.32

This computation is identical to computing the present value of each payment (from Table B.1) and taking their sum or, alternatively, adding the values from Table B.1 for each of the three payments and multiplying their sum by the $100 annuity payment. A more direct way is to use a present value of annuity table. Table B.3 at the end of this appendix is one such table. This table is called a present value of an annuity of 1 table. If we look at Table B.3 where n 5 3 and i 5 15%, we see the present value is 2.2832. This means that the present value of an annuity of 1 for three periods, with a 15% interest rate, equals 2.2832. A present value of an annuity formula is used to construct Table B.3. It can also be con- structed by adding the amounts in a present value of 1 table. To illustrate, we use Tables B.1 and B.3 to confirm this relation for the prior example:

From Table B.1 From Table B.3

i 5 15%, n 5 1 . . . . . . . . 0.8696

i 5 15%, n 5 2 . . . . . . . . 0.7561

i 5 15%, n 5 3 . . . . . . . . 0.6575

Total . . . . . . . . . . . . . . . . 2.2832 i 5 15%, n 5 3 . . . . . . . . 2.2832

We can also use business calculators or spreadsheet programs to find the present value of an annuity.

EXHIBIT B.6 Present Value of an Ordinary Annuity Diagram

$100 $100 $100 • • • • Time p ↑ ↑ ↑ ↑

Today Future (n 5 1) Future (n 5 2) Future (n 5 3)

⎯→

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B-6 Appendix B Time Value of Money

3. A company is considering an investment paying $10,000 every six months for three years. The first payment would be received in six months. If this company requires an 8% annual return, what is the maximum amount it is willing to pay for this investment?

Quick Check Answer — p. B-7

The future value of an ordinary annuity is the accumulated value of each annuity payment with interest as of the date of the final payment. To illustrate, let’s consider the earlier annuity of three annual payments of $100. Exhibit B.7 shows the point in time for the future value ( f ). The first payment is made two periods prior to the point when future value is determined, and the final payment occurs on the future value date.

FUTURE VALUE OF AN ANNUITY

One way to compute the future value of an annuity is to use the formula to find the future value of each payment and add them. If we assume an interest rate of 15%, our calculation is

f 5 $100 3 (1 1 0.15)2 1 $100 3 (1 1 0.15)1 1 $100 3 (1 1 0.15)0 5 $347.25

From Table B.2 From Table B.4

i 5 15%, n 5 0 . . . . . . . . 1.0000

i 5 15%, n 5 1 . . . . . . . . 1.1500

i 5 15%, n 5 2 . . . . . . . . 1.3225

Total . . . . . . . . . . . . . . . . 3.4725 i 5 15%, n 5 3 . . . . . . . . 3.4725

Note that the future value in Table B.2 is 1.0000 when n 5 0, but the future value in Table B.4 is 1.0000 when n 5 1. Is this a contradiction? No. When n 5 0 in Table B.2, the future value is determined on the date when a single payment occurs. This means that no interest is earned

EXHIBIT B.7 Future Value of an Ordinary Annuity Diagram

$100 $100 $100 • • • • Time

f ↑ ↑ ↑ ↑

Today Future (n 5 1) Future (n 5 2) Future (n 5 3)

⎯→

This is identical to using Table B.2 and summing the future values of each payment, or adding the future values of the three payments of 1 and multiplying the sum by $100. A more direct way is to use a table showing future values of annuities. Such a table is called a future value of an annuity of 1 table. Table B.4 at the end of this appendix is one such table. Note that in Table B.4 when n 5 1, the future values equal 1 ( f 5 1) for all rates of interest. This is so because such an annuity consists of only one payment and the future value is deter- mined on the date of that payment — no time passes between the payment and its future value. The future value of an annuity formula is used to construct Table B.4. We can also construct it by adding the amounts from a future value of 1 table. To illustrate, we use Tables B.2 and B.4 to confirm this relation for the prior example:

P4 Apply future value concepts to an annuity by using interest tables.

Blessed Winnings “I don’t have good luck—I’m blessed,” proclaimed Andrew “Jack” Whittaker, 55, a sewage treatment contractor, after winning the largest ever undivided jackpot in a U.S. lottery. Whittaker had to choose between $315 million in 30 annual installments or $170 million in one lump sum ($112 million after-tax). ■

Decision Insight

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Appendix B Time Value of Money B-7

because no time has passed, and the future value equals the payment. Table B.4 describes an- nuities with equal payments occurring at the end of each period. When n 5 1, the annuity has one payment, and its future value equals 1 on the date of its final and only payment. Again, no time passes between the payment and its future value date.

4. A company invests $45,000 per year for five years at 12% annual interest. Compute the value of this annuity investment at the end of five years.

Quick Check Answer — p. B-7

C1 Describe the earning of interest and the concepts of present and future values. Interest is payment by a borrower to the owner of an asset for its use. Present and future value computations are a way for us to estimate the interest component of holding assets or liabilities over a period of time.

P1 Apply present value concepts to a single amount by using interest tables. The present value of a single amount received at a future date is the amount that can be invested now at the speci- fied interest rate to yield that future value.

P2 Apply future value concepts to a single amount by using interest tables. The future value of a single amount invested

Summary at a specified rate of interest is the amount that would accumulate by the future date.

P3 Apply present value concepts to an annuity by using interest tables. The present value of an annuity is the amount that can be invested now at the specified interest rate to yield that series of equal periodic payments.

P4 Apply future value concepts to an annuity by using interest tables. The future value of an annuity invested at a specific rate of interest is the amount that would accumulate by the date of the final payment.

1. $70,000 3 0.6302 5 $44,114 (use Table B.1, i 5 8%, n 5 6). 2. $555,000y$150,000 5 3.7000; Table B.2 shows this value is

not achieved until after 17 years at 8% interest.

3. $10,000 3 5.2421 5 $52,421 (use Table B.3, i 5 4%, n 5 6). 4. $45,000 3 6.3528 5 $285,876 (use Table B.4, i 5 12%,

n 5 5).

Guidance Answers to Quick Checks

QS B-2 Interest rate on an investment P1

Ken Francis is offered the possibility of investing $2,745 today and in return to receive $10,000 after 15 years. What is the annual rate of interest for this investment? (Use Table B.1.)

QS B-3 Number of periods of an investment P1

Megan Brink is offered the possibility of investing $6,651 today at 6% interest per year in a desire to accumulate $10,000. How many years must Brink wait to accumulate $10,000? (Use Table B.1.)

QS B-4 Present value of an amount P1

Flaherty is considering an investment that, if paid for immediately, is expected to return $140,000 five years from now. If Flaherty demands a 9% return, how much is she willing to pay for this investment?

QS B-5 Future value of an amount P2

CII, Inc., invests $630,000 in a project expected to earn a 12% annual rate of return. The earnings will be reinvested in the project each year until the entire investment is liquidated 10 years later. What will the cash proceeds be when the project is liquidated?

Assume that you must make future value estimates using the future value of 1 table (Table B.2). Which interest rate column do you use when working with the following rates? 1. 8% annual rate, compounded quarterly 3. 6% annual rate, compounded semiannually 2. 12% annual rate, compounded annually 4. 12% annual rate, compounded monthly

QUICK STUDY

QS B-1 Identifying interest rates in tables

C1

QS B-6 Present value of an annuity P3

Beene Distributing is considering a project that will return $150,000 annually at the end of each year for the next six years. If Beene demands an annual return of 7% and pays for the project immediately, how much is it willing to pay for the project?

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B-8 Appendix B Time Value of Money

Exercise B-2 Interest rate on an investment P2

Ed Summers expects to invest $10,000 for 25 years, after which he wants to receive $108,347. What rate of interest must Summers earn? (Use Table B.2.)

Exercise B-4 Number of periods of an investment P3

Keith Riggins expects an investment of $82,014 to return $10,000 annually for several years. If Riggins earns a return of 10%, how many annual payments will he receive? (Use Table B.3.)

Exercise B-6 Number of periods of an investment P4

Kate Beckwith expects to invest $10,000 annually that will earn 8%. How many annual investments must Beckwith make to accumulate $303,243 on the date of the last investment? (Use Table B.4.)

Exercise B-8 Present value of bonds

P1 P3

Spiller Corp. plans to issue 10%, 15-year, $500,000 par value bonds payable that pay interest semiannually on June 30 and December 31. The bonds are dated December 31, 2013, and are issued on that date. If the market rate of interest for the bonds is 8% on the date of issue, what will be the total cash proceeds from the bond issue?

Exercise B-11 Present value of an amount P1

On January 1, 2013, a company agrees to pay $20,000 in three years. If the annual interest rate is 10%, determine how much cash the company can borrow with this agreement.

Exercise B-3 Interest rate on an investment P3

Jones expects an immediate investment of $57,466 to return $10,000 annually for eight years, with the first payment to be received one year from now. What rate of interest must Jones earn? (Use Table B.3.)

Exercise B-5 Interest rate on an investment P4

Algoe expects to invest $1,000 annually for 40 years to yield an accumulated value of $154,762 on the date of the last investment. For this to occur, what rate of interest must Algoe earn? (Use Table B.4.)

Exercise B-7 Present value of an annuity P3

Sam Weber finances a new automobile by paying $6,500 cash and agreeing to make 40 monthly payments of $500 each, the first payment to be made one month after the purchase. The loan bears interest at an annual rate of 12%. What is the cost of the automobile?

Exercise B-9 Present value of an amount P1

McAdams Company expects to earn 10% per year on an investment that will pay $606,773 six years from now. Use Table B.1 to compute the present value of this investment. (Round the amount to the nearest dollar.)

Exercise B-10 Present value of an amount and of an annuity P1 P3

Compute the amount that can be borrowed under each of the following circumstances: 1. A promise to repay $90,000 seven years from now at an interest rate of 6%. 2. An agreement made on February 1, 2013, to make three separate payments of $20,000 on February 1

of 2014, 2015, and 2016. The annual interest rate is 10%.

QS B-7 Future value of an annuity P4

Claire Fitch is planning to begin an individual retirement program in which she will invest $1,500 at the end of each year. Fitch plans to retire after making 30 annual investments in the program earning a return of 10%. What is the value of the program on the date of the last payment (30 years from the present)?

Bill Thompson expects to invest $10,000 at 12% and, at the end of a certain period, receive $96,463. How many years will it be before Thompson receives the payment? (Use Table B.2.)

EXERCISES

Exercise B-1 Number of periods of an investment P2

Exercise B-12 Practical applications of the time value of money

P1 P2 P3 P4

a. How much would you have to deposit today if you wanted to have $60,000 in 4 years? Annual interest rate is 9%.

b. Assume that you are saving up for a trip around the world when you graduate in 2 years. If you can earn 8% on your investments, how much would you have to deposit today to have $15,000 when you graduate?

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Appendix B Time Value of Money B-9

Exercise B-13 Present values of annuities

P3

C&H Ski Club recently borrowed money and agrees to pay it back with a series of six annual payments of $5,000 each. C&H subsequently borrows more money and agrees to pay it back with a series of four annual payments of $7,500 each. The annual interest rate for both loans is 6%. 1. Use Table B.1 to find the present value of these two separate annuities. (Round amounts to the nearest

dollar.) 2. Use Table B.3 to find the present value of these two separate annuities. (Round amounts to the nearest

dollar.)

Exercise B-14 Present value with semiannual compounding

C1 P3

Otto Co. borrows money on April 30, 2013, by promising to make four payments of $13,000 each on November 1, 2013; May 1, 2014; November 1, 2014; and May 1, 2015. 1. How much money is Otto able to borrow if the interest rate is 8%, compounded semiannually? 2. How much money is Otto able to borrow if the interest rate is 12%, compounded semiannually? 3. How much money is Otto able to borrow if the interest rate is 16%, compounded semiannually?

Exercise B-15 Future value of an amount P2

Mark Welsch deposits $7,200 in an account that earns interest at an annual rate of 8%, compounded quarterly. The $7,200 plus earned interest must remain in the account 10 years before it can be withdrawn. How much money will be in the account at the end of 10 years?

Exercise B-16 Future value of an annuity P4

Kelly Malone plans to have $50 withheld from her monthly paycheck and deposited in a savings account that earns 12% annually, compounded monthly. If Malone continues with her plan for two and one-half years, how much will be accumulated in the account on the date of the last deposit?

Exercise B-17 Future value of an amount plus an annuity P2 P4

Starr Company decides to establish a fund that it will use 10 years from now to replace an aging production facility. The company will make a $100,000 initial contribution to the fund and plans to make quarterly contributions of $50,000 beginning in three months. The fund earns 12%, compounded quarterly. What will be the value of the fund 10 years from now?

Exercise B-18 Future value of an amount P2

Catten, Inc., invests $163,170 today earning 7% per year for nine years. Use Table B.2 to compute the future value of the investment nine years from now. (Round the amount to the nearest dollar.)

Exercise B-19 Using present and future value tables

C1 P1 P2 P3 P4

For each of the following situations, identify (1) the case as either (a) a present or a future value and (b) a single amount or an annuity, (2) the table you would use in your computations (but do not solve the problem), and (3) the interest rate and time periods you would use. a. You need to accumulate $10,000 for a trip you wish to take in four years. You are able to earn 8%

compounded semiannually on your savings. You plan to make only one deposit and let the money ac- cumulate for four years. How would you determine the amount of the one-time deposit?

b. Assume the same facts as in part (a) except that you will make semiannual deposits to your savings account.

c. You want to retire after working 40 years with savings in excess of $1,000,000. You expect to save $4,000 a year for 40 years and earn an annual rate of interest of 8%. Will you be able to retire with more than $1,000,000 in 40 years? Explain.

d. A sweepstakes agency names you a grand prize winner. You can take $225,000 immediately or elect to receive annual installments of $30,000 for 20 years. You can earn 10% annually on any investments you make. Which prize do you choose to receive?

c. Would you rather have $463 now or $1,000 ten years from now? Assume that you can earn 9% on your investments.

d. Assume that a college parking sticker today costs $90. If the cost of parking is increasing at the rate of 5% per year, how much will the college parking sticker cost in 8 years?

e. Assume that the average price of a new home is $158,500. If new homes are increasing at a rate of 10% per year, how much will a new home cost in 8 years?

f. An investment will pay you $10,000 in 10 years, and it will also pay you $400 at the end of each of the next 10 years (years 1 thru 10). If the annual interest rate is 6%, how much would you be willing to pay today for this type of investment?

g. A college student is reported in the newspaper as having won $10,000,000 in the Kansas State Lottery. However, as is often the custom with lotteries, she does not actually receive the entire $10 million now. Instead she will receive $500,000 at the end of the year for each of the next 20 years. If the annual interest rate is 6%, what is the present value (today’s amount) that she won? (Ignore taxes.)

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B-10 Appendix B Time Value of Money

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.8929 0.8696 2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.7972 0.7561 3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7118 0.6575 4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6355 0.5718 5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5674 0.4972 6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5066 0.4323 7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4523 0.3759 8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4039 0.3269 9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3606 0.2843 10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3220 0.2472 11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.2875 0.2149 12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2567 0.1869 13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2292 0.1625 14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2046 0.1413 15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.1827 0.1229 16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1631 0.1069 17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1456 0.0929 18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1300 0.0808 19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1161 0.0703 20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1037 0.0611 25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0588 0.0304 30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0334 0.0151 35 0.7059 0.5000 0.3554 0.2534 0.1813 0.1301 0.0937 0.0676 0.0490 0.0356 0.0189 0.0075 40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0107 0.0037

TABLE B.1 Present Value of 1

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000 1.1200 1.1500 2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100 1.2544 1.3225 3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310 1.4049 1.5209 4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641 1.5735 1.7490 5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105 1.7623 2.0114 6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716 1.9738 2.3131 7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487 2.2107 2.6600 8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436 2.4760 3.0590 9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579 2.7731 3.5179 10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937 3.1058 4.0456 11 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531 3.4785 4.6524 12 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384 3.8960 5.3503 13 1.1381 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523 4.3635 6.1528 14 1.1495 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975 4.8871 7.0757 15 1.1610 1.3459 1.5580 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772 5.4736 8.1371 16 1.1726 1.3728 1.6047 1.8730 2.1829 2.5404 2.9522 3.4259 3.9703 4.5950 6.1304 9.3576 17 1.1843 1.4002 1.6528 1.9479 2.2920 2.6928 3.1588 3.7000 4.3276 5.0545 6.8660 10.7613 18 1.1961 1.4282 1.7024 2.0258 2.4066 2.8543 3.3799 3.9960 4.7171 5.5599 7.6900 12.3755 19 1.2081 1.4568 1.7535 2.1068 2.5270 3.0256 3.6165 4.3157 5.1417 6.1159 8.6128 14.2318 20 1.2202 1.4859 1.8061 2.1911 2.6533 3.2071 3.8697 4.6610 5.6044 6.7275 9.6463 16.3665 25 1.2824 1.6406 2.0938 2.6658 3.3864 4.2919 5.4274 6.8485 8.6231 10.8347 17.0001 32.9190 30 1.3478 1.8114 2.4273 3.2434 4.3219 5.7435 7.6123 10.0627 13.2677 17.4494 29.9599 66.2118 35 1.4166 1.9999 2.8139 3.9461 5.5160 7.6861 10.6766 14.7853 20.4140 28.1024 52.7996 133.1755 40 1.4889 2.2080 3.2620 4.8010 7.0400 10.2857 14.9745 21.7245 31.4094 45.2593 93.0510 267.8635

TABLE B.2 Future Value of 1

f 5 (1 1 i)n

p 5 1y(1 1 i)n

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Appendix B Time Value of Money B-11

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.8929 0.8696 2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.6901 1.6257 3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4018 2.2832 4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.0373 2.8550 5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6048 3.3522 6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.1114 3.7845 7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.5638 4.1604 8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 4.9676 4.4873 9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.3282 4.7716 10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.6502 5.0188 11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 5.9377 5.2337 12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.1944 5.4206 13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.4235 5.5831 14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.6282 5.7245 15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 6.8109 5.8474 16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 6.9740 5.9542 17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.1196 6.0472 18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.2497 6.1280 19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.3658 6.1982 20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.4694 6.2593 25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 7.8431 6.4641 30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.0552 6.5660 35 29.4086 24.9986 21.4872 18.6646 16.3742 14.4982 12.9477 11.6546 10.5668 9.6442 8.1755 6.6166 40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.2438 6.6418

TABLE B.3 Present Value of an Annuity of 1

p 5 c 1 2 1 (1 1 i)n

d yi

Rate

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 2 2.0100 2.0200 2.0300 2.0400 2.0500 2.0600 2.0700 2.0800 2.0900 2.1000 2.1200 2.1500 3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.3100 3.3744 3.4725 4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.6410 4.7793 4.9934 5 5.1010 5.2040 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051 6.3528 6.7424 6 6.1520 6.3081 6.4684 6.6330 6.8019 6.9753 7.1533 7.3359 7.5233 7.7156 8.1152 8.7537 7 7.2135 7.4343 7.6625 7.8983 8.1420 8.3938 8.6540 8.9228 9.2004 9.4872 10.0890 11.0668 8 8.2857 8.5830 8.8923 9.2142 9.5491 9.8975 10.2598 10.6366 11.0285 11.4359 12.2997 13.7268 9 9.3685 9.7546 10.1591 10.5828 11.0266 11.4913 11.9780 12.4876 13.0210 13.5795 14.7757 16.7858 10 10.4622 10.9497 11.4639 12.0061 12.5779 13.1808 13.8164 14.4866 15.1929 15.9374 17.5487 20.3037 11 11.5668 12.1687 12.8078 13.4864 14.2068 14.9716 15.7836 16.6455 17.5603 18.5312 20.6546 24.3493 12 12.6825 13.4121 14.1920 15.0258 15.9171 16.8699 17.8885 18.9771 20.1407 21.3843 24.1331 29.0017 13 13.8093 14.6803 15.6178 16.6268 17.7130 18.8821 20.1406 21.4953 22.9534 24.5227 28.0291 34.3519 14 14.9474 15.9739 17.0863 18.2919 19.5986 21.0151 22.5505 24.2149 26.0192 27.9750 32.3926 40.5047 15 16.0969 17.2934 18.5989 20.0236 21.5786 23.2760 25.1290 27.1521 29.3609 31.7725 37.2797 47.5804 16 17.2579 18.6393 20.1569 21.8245 23.6575 25.6725 27.8881 30.3243 33.0034 35.9497 42.7533 55.7175 17 18.4304 20.0121 21.7616 23.6975 25.8404 28.2129 30.8402 33.7502 36.9737 40.5447 48.8837 65.0751 18 19.6147 21.4123 23.4144 25.6454 28.1324 30.9057 33.9990 37.4502 41.3013 45.5992 55.7497 75.8364 19 20.8109 22.8406 25.1169 27.6712 30.5390 33.7600 37.3790 41.4463 46.0185 51.1591 63.4397 88.2118 20 22.0190 24.2974 26.8704 29.7781 33.0660 36.7856 40.9955 45.7620 51.1601 57.2750 72.0524 102.4436 25 28.2432 32.0303 36.4593 41.6459 47.7271 54.8645 63.2490 73.1059 84.7009 98.3471 133.3339 212.7930 30 34.7849 40.5681 47.5754 56.0849 66.4388 79.0582 94.4608 113.2832 136.3075 164.4940 241.3327 434.7451 35 41.6603 49.9945 60.4621 73.6522 90.3203 111.4348 138.2369 172.3168 215.7108 271.0244 431.6635 881.1702 40 48.8864 60.4020 75.4013 95.0255 120.7998 154.7620 199.6351 259.0565 337.8824 442.5926 767.0914 1,779.0903

TABLE B.4 Future Value of an Annuity of 1

f 5 [(1 1 i)n 2 1]yi

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Learning Objectives

CONCEPTUAL

C1 Distinguish between debt and equity securities and between short-term and long-term investments. (p. C-2)

C2 Describe how to report equity securities with controlling influence. (p. C-9) C3 Appendix C-A—Explain foreign exchange rates and record transactions listed in a

foreign currency. (p. C-16)

ANALYTICAL

A1 Compute and analyze the components of return on total assets. (p. C-11)

PROCEDURAL

P1 Account for trading securities. (p. C-5)

P2 Account for held-to-maturity securities. (p. C-6) P3 Account for available-for-sale securities. (p. C-6) P4 Account for equity securities with significant influence. (p. C-8)

A Look at This Appendix

This appendix focuses on investments in securities. We explain how to identify, account for, and report investments in both debt and equity securities. We also explain accounting for transactions listed in a foreign currency.

Investments and International Operations C

C

Appendix

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100 Million Dollar Investment

NEW YORK—“We were relatively new in our high school and we just wanted a better way to get to know our classmates,” admits Catherine Cook. “We started brainstorming a general idea of what we wanted: superlatives, profiles, classes, groups . . . and myYearbook was born!” Catherine, along with her brother Dave, launched myYearbook aimed at teenagers and young adults. “If you think about Facebook as where you go to connect with people you know,” explains Catherine, “myYearbook is where you go to connect with people you want to know.” In 2011, myYearbook was the top site for teenagers, accord- ing to the online tracking company comScore, with over 33 mil- lion users. Catherine says myYearbook employed more than 100 workers at offices in New York and New Hope, Pennsylvania. She admits, however, that “it is really hard to keep up with the site along with my school work.” The next big step according to Catherine was to take myYear- book to a global audience. “The dream we’ve had for some time now,” she says, “is to become a global brand.” This step required Catherine to extend her business into international operations and to deal with intercorporate investments. “I am committed to focus on what we do best,” she says, “to make myYearbook the number one site to meet new people.”

This broad goal has led to business challenges, involving both investments and international operations. “I want to grow myYear- book as far as I can,” insists Catherine. That drive led her into dis- cussions with Quepasa.com, a social network whose users are based mainly in Latin America. Explains Catherine, “With Quepasa, we could end up the leader in social discovery!” However, to make this happen, she had to study their international operations, includ- ing their financials and accounting disclosures. Catherine explored various investment deals that she could set up with Quepasa, which required her to learn about accounting for investments. Catherine recently finalized her investment in Quepasa, which involved a merger of their two operations, whereby she and her brother received $18 million in cash and $82 million in stock. Combined, myYearbook.com and Quepasa.com, now re- branded under the name Meet Me Inc. (MeetMe.com), have more than 70 million registered users. Catherine aims to launch translated versions of games, social applications, and mobile platform. “I’m working hard at coming up with interesting and fun features for our members,” she said. “I’ll be in the office every day working on a full pipeline of new features.”

[Sources: MeetMe Website, January 2013; The Star-Ledger, July 2011; New Jersey Monthly Magazine, August 2011; Smart Business Network, February 2012]

“Never be scared of asking for advice.” —CATHERINE COOK

Decision Insight

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Appendix Preview

This appendix’s main focus is investments in securities. Many companies have investments, and many of these are in the form of debt and equity securities issued by other companies. We describe investments in these securities and how to account

for  them. An increasing number of companies also invest in international operations. We explain how to account for and report international transactions listed in foreign currencies.

Investments and International Operations

Noninfluential Investments

• Trading securities • Held-to-maturity

securities • Available-for-sale

securities

Basics of Investments

• Motivation for investments

• Short-term versus long-term

• Classification and reporting

• Accounting basics

Influential Investments

• Securities with significant influence

• Securities with controlling influence

• Accounting summary

This section describes the motivation for investments, the distinction between short- and long- term investments, and the different classes of investments.

Motivation for Investments Companies make investments for at least three reasons. First, companies transfer excess cash into investments to produce higher income. Second, some entities, such as mutual funds and pension funds, are set up to produce income from investments. Third, companies make invest- ments for strate gic reasons. Examples are invest ments in competitors, suppliers, and even cus-

tomers. Exhibit C.1 shows short-term (S-T) and long-term (L-T) investments as a percent of total assets for several companies.

Short-Term Investments Cash equiva- lents are investments that are both readily con- verted to known amounts of cash and mature within three months. Many investments, how- ever, mature between 3 and 12 months. These investments are short-term investments, also called temporary investments and marketable

securities. Specifically, short-term invest ments are securities that (1) management intends to convert to cash within one year or the operating cycle, whichever is longer, and (2) are readily convertible to cash. Short-term investments are reported under current assets and serve a purpose similar to cash equivalents.

Long-Term Investments Long-term investments in securities are defined as those se- curities that are not readily convertible to cash or are not intended to be converted into cash in the short term. Long-term investments can also include funds earmarked for a special purpose, such as bond sinking funds and investments in land or other assets not used in the company’s operations. Long-term investments are reported in the noncurrent section of the balance sheet, often in its own separate line titled Long-Term Investments.

Debt Securities versus Equity Securities Investments in securities can include both debt and equity securities. Debt securities reflect a creditor relationship such as investments in

BASICS OF INVESTMENTS

C1 Distinguish between debt and equity securities and between short-term and long-term investments.

EXHIBIT C.1 Investments of Selected Companies

Percent of total assets 50%0%

Pfizer

Coca-Cola

Starbucks

Microsoft S-T 40%

S-T 12.5%

S-T 12%

S-T 1.5%

L-T 10%

L-T 5%

L-T 6.5%

L-T 9%

C-2

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Appendix C Investments and International Operations C-3

notes, bonds, and certificates of deposit; they are issued by governments, companies, and individu- als. Equity securities reflect an owner relationship such as shares of stock issued by companies.

Classification and Reporting Accounting for investments in securities depends on three factors: (1) security type, either debt or equity, (2) the company’s intent to hold the security either short term or long term, and (3) the company’s (investor’s) percent ownership in the other company’s (investee’s) equity securities. Exhibit C.2 identifies five classes of securities using these three factors. It describes each of these five classes of securities and the standard reporting required under each class.

EXHIBIT C.2 Investments in Securities

Debt Securities: Accounting Basics This section explains the accounting basics for debt securities, including that for acquisition, disposition, and any interest.

Acquisition. Debt securities are recorded at cost when purchased. To illus- trate, assume that Music City paid $29,500 plus a $500 brokerage fee on September 1, 2012, to buy Dell’s 7%, two-year bonds payable with a $30,000 par value. The bonds pay interest semiannually on August 31 and February 28. Music City intends to hold the bonds until they mature on August 31, 2014; consequently, they are classified as held-to-maturity (HTM) securities. The entry to record this purchase follows. (If the maturity of the securities was short term, and management’s intent was to hold them until they mature, then they would be classified as Short-Term Investments—HTM.)

Interest earned. Interest revenue for investments in debt securities is recorded when earned. To illustrate, on December 31, 2012, at the end of its accounting period, Music City accrues interest receivable as follows.

Assets 5 Liabilities 1 Equity 130,000 230,000

2012

Sept. 1 Long-Term Investments—HTM (Dell) . . . . . . . . . . . . . . 30,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Purchased bonds to be held to maturity.

Assets 5 Liabilities 1 Equity 1700 1700

Dec. 31 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Accrued interest earned ($30,000 3 7% 3 4⁄12).

The $700 reflects 4y6 of the semiannual cash receipt of interest — the portion Music City earned as of December 31. Relevant sections of Music City’s financial statements at December 31, 2012, are shown in Exhibit C.3.

Reporting

Class

a Holding less than 20% of voting stock (equity securities only). b Holding 20% or more, but not more than 50%, of voting stock. c Holding more than 50% of voting stock.

* Unrealized gains and losses reported on the income statement.

Unrealized gains and losses reported in the equity section of the balance sheet and in comprehensive income.**

Fair Value* Amortized Cost Fair Value** Equity Method Consolidation

Held-to-Maturity

[Debt securities intended to be held until

maturity]

Available-for-Sale

[Debt and noninfluential equitya securities]

Significant Influence

[Equity securities with significant influenceb]

Controlling Influence

[Equity securities with controlling influencec]

Trading

[Debt and noninfluential equitya securities that are actively traded]

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C-4 Appendix C Investments and International Operations

EXHIBIT C.3 Financial Statement Presentation of Debt Securities

On the income statement for year 2012:

Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 700

On the December 31, 2012, balance sheet:

Long-term investments—Held-to-maturity securities (at amortized cost) . . . . . . . . . $30,000

On February 28, 2013, Music City records receipt of semiannual interest.

Assets 5 Liabilities 1 Equity 11,050 1350

2700

Feb. 28 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . 700

Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

Received six months’ interest on Dell bonds.

Assets 5 Liabilities 1 Equity 130,000 230,000

2014

Aug. 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Long-Term Investments—HTM (Dell) . . . . . . . . . . . 30,000

Received cash from matured bonds.

Assets 5 Liabilities 1 Equity 145,000 12,000 243,000

Dec. 20 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Long-Term Investments—AFS (Intex) . . . . . . . . . . 43,000

Gain on Sale of Long-Term Investments . . . . . . . . . 2,000

Sold 500 Intex shares ($86,000 3 500y1,000).

Assets 5 Liabilities 1 Equity 186,000 286,000

Oct. 10 Long-Term Investments—AFS (Intex) . . . . . . . . . . . . . . 86,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,000

Purchased 1,000 shares of Intex.

Assets 5 Liabilities 1 Equity 11,720 11,720

Nov. 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,720

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 1,720

Received dividend of $1.72 per share.

The cost of a debt security can be either higher or lower than its maturity value. When the in- vestment is long term, the difference between cost and maturity value is amortized over the re- maining life of the security. We assume for ease of computations that the cost of a long-term debt security equals its maturity value.

Equity Securities: Accounting Basics This section explains the accounting basics for equity securities, including that for acquisition, dividends, and disposition.

Acquisition. Equity securities are recorded at cost when acquired, including commissions or brokerage fees paid. To illustrate, assume that Music City purchases 1,000 shares of Intex com- mon stock at par value for $86,000 on October 10, 2012. It records this purchase of available- for-sale (AFS) securities as follows.

Example: What is cost per share? Answer: Cost per share is the total cost of acquisition, including broker fees, divided by number of shares acquired.

Disposition. When the bonds mature, the proceeds (not including the interest entry) are recorded as:

Dividend earned. Any cash dividends received are credited to Dividend Revenue and reported in the income statement. To illustrate, on November 2, Music City receives a $1,720 quarterly cash dividend on the Intex shares, which it records as:

Disposition. When the securities are sold, sale proceeds are compared with the cost, and any gain or loss is recorded. To illustrate, on December 20, Music City sells 500 of the Intex shares for $45,000 cash and records this sale as:

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Appendix C Investments and International Operations C-5

Companies must value and report most noninfluential investments at fair value. The exact reporting requirements depend on whether the investments are classified as (1) trading, (2) held- to-maturity, or (3) available-for-sale.

Trading Securities Trading securities are debt and equity securities that the company intends to actively manage and trade for profit. Frequent purchases and sales are expected and are made to earn profits on short-term price changes. Trading securities are always reported as current assets.

Valuing and reporting trading securities. The entire portfolio of trading securities is re- ported at its fair value; this requires a “fair value adjustment” from the cost of the portfolio. The term portfolio refers to a group of securities. Any unrealized gain (or loss) from a change in the fair value of the portfolio of trading securities is reported on the income statement. Most users believe accounting reports are more useful when changes in fair value for trading securities are reported in income. To illustrate, TechCom’s portfolio of trading securities had a total cost of $11,500 and a fair value of $13,000 on December 31, 2012, the first year it held trading securities. The difference between the $11,500 cost and the $13,000 fair value reflects a $1,500 gain. It is an unrealized gain because it is not yet confirmed by actual sales. The fair value adjustment for trading securi- ties is recorded with an adjusting entry at the end of each period to equal the difference between the portfolio’s cost and its fair value. TechCom records this gain as follows.

REPORTING OF NON INFLUENTIALNON INFLUENTIAL INVESTMENTS

P1 Account for trading securities.

Point: ‘Fair Value Adjustment—Trading’ is a permanent account, shown as a deduction or addition to ‘Short-Term Investments—Trading.’

Point: ‘Unrealized gain (or loss)’ refers to a change in fair value that is not yet realized through actual sale.

Assets 5 Liabilities 1 Equity 11,500 11,500

Dec. 31 Fair Value Adjustment—Trading . . . . . . . . . . . . . . . . . . . 1,500

Unrealized Gain—Income . . . . . . . . . . . . . . . . . . . . 1,500

To reflect an unrealized gain in fair values of trading securities.

Selling trading securities. When individual trading securities are sold, the difference between the net proceeds (sale price less fees) and the cost of the individual trading securities that are sold is recognized as a gain or a loss. Any prior period fair value adjustment to the portfolio is not used to compute the gain or loss from sale of individual trading securities. For example, if TechCom sold some of its trading securities that had cost $1,000 for $1,200 cash on January 9, 2013, it would record the following.

The Unrealized Gain (or Loss) is reported in the Other Revenues and Gains (or Expenses and Losses) section on the income statement. Unrealized Gain (or Loss) — Income is a temporary account that is closed to Income Summary at the end of each period. Fair Value Adjustment— Trading is a permanent account, which adjusts the reported value of the trading securities port- folio from its prior period fair value to the current period fair value. The total cost of the trading securities portfolio is maintained in one account, and the fair value adjustment is recorded in a separate account. For example, TechCom’s investment in trading securities is reported in the current assets section of its balance sheet as follows.

Example: If TechCom’s trading securities have a cost of $14,800 and a fair value of $16,100 at Dec. 31, 2013, its adjusting entry is Unrealized Loss—Income . . . . . 200 Fair Value Adj.—Trading . . . . . 200 This is computed as: $1,500 Beg. Dr. bal. 1 $200 Cr. 5 $1,300 End. Dr. bal.

Point: Reporting securities at fair value is referred to as mark-to-market accounting.

Current Assets

Short-term investments—Trading (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . $11,500

Fair Value adjustment—Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Short-term investments—Trading (at fair value) . . . . . . . . . . . . . . . . . . . . . $13,000

or simply

Short-term investments—Trading (at fair value; cost is $11,500) . . . . . . . $13,000

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C-6 Appendix C Investments and International Operations

Assets 5 Liabilities 1 Equity 11,550 11,550

Dec. 31 Fair Value Adjustment—Available-for-Sale (LT) . . . . . . . 1,550

Unrealized Gain—Equity . . . . . . . . . . . . . . . . . . . . . 1,550

To record adjustment to fair value of available-for-sale securities.

EXHIBIT C.4 Cost and Fair Value of Available-for-Sale Securities

Cost Fair Value Unrealized Gain (Loss)

Improv bonds . . . . . . . . . . . . . . . . . . . . . . . $30,000 $29,050 $ (950)

Intex common stock, 500 shares . . . . . . . . 43,000 45,500 2,500

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $73,000 $74,550 $1,550

Assets 5 Liabilities 1 Equity 11,200 1200 21,000

Jan. 9 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Short-Term Investments—Trading . . . . . . . . . . . . . 1,000

Gain on Sale of Short-Term Investments . . . . . . . . 200

Sold trading securities costing $1,000 for $1,200 cash.

A gain is reported in the Other Revenues and Gains section on the income statement, whereas a loss is shown in Other Expenses and Losses. When the period-end fair value adjustment for the portfolio of trading securities is computed, it excludes the cost and fair value of any secu- rities sold.

Held-to-Maturity Securities Held-to-maturity (HTM) securities are debt securities a company intends and is able to hold until maturity. They are reported in current assets if their maturity dates are within one year or the operating cycle, whichever is longer. HTM securities are reported in long-term assets when the maturity dates extend beyond one year or the operating cycle, whichever is longer. All HTM securities are recorded at cost when purchased, and interest revenue is recorded when earned.

The portfolio of HTM securities is usually reported at (amortized) cost, which is explained in advanced courses. There is no fair value adjustment to the portfolio of HTM securities — neither to the short-term nor long-term portfolios. The basics of accounting for HTM securities were described earlier in this appendix.

P2 Account for held-to- maturity securities.

Point: Only debt securities can be classified as held-to-maturity; equity securities have no maturity date.

P3 Account for available-for-sale securities.

Example: If fair value in Exhibit C.4 is $70,000 (instead of $74,550), what entry is made? Answer: Unreal. Loss—Equity . . . . 3,000 Fair Value Adj.—AFS. . . 3,000

Available-for-Sale Securities Available-for-sale (AFS) securities are debt and equity securities not classified as trading or held-to-maturity securities. AFS securities are purchased to yield interest, dividends, or in- creases in fair value. They are not actively managed like trading securities. If the intent is to sell AFS securities within the longer of one year or operating cycle, they are classified as short- term investments. Otherwise, they are classified as long-term.

Valuing and reporting available-for-sale securities. As with trading securities, companies adjust the cost of the portfolio of AFS securities to reflect changes in fair value. This is done with a fair value adjustment to its total portfolio cost. However, any unrealized gain or loss for the portfolio of AFS securities is not reported on the income statement. Instead, it is reported in the equity section of the balance sheet (and is part of comprehensive income, explained later). To illustrate, assume that Music City had no prior period investments in available-for-sale secu- rities other than those purchased in the current period. Exhibit C.4 shows both the cost and fair value of those investments on December 31, 2012, the end of its reporting period.

The year-end adjusting entry to record the fair value of these investments follows.

Money Manager You expect interest rates to sharply fall within a few weeks and remain at this lower rate. What is your strategy for holding investments in fixed-rate bonds and notes? ■ [Answer—p. C-19]

Decision Maker

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Appendix C Investments and International Operations C-7

Point: Income can be window-dressed upward by selling AFS securities with unrealized gains; income is reduced by selling those with unrealized losses.

Let’s extend this illustration and assume that at the end of its next calendar year (December 31, 2013), Music City’s portfolio of long-term AFS securities has an $81,000 cost and an $82,000 fair value. It records the adjustment to fair value as follows.

EXHIBIT C.5 Balance Sheet Presentation of Available-for-Sale Securities

Assets

Long-term investments — Available-for-sale (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $73,000

Fair value adjustment— Available-for-sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,550

Long-term investments — Available-for-sale (at fair value) . . . . . . . . . . . . . . . . . . . . . . . . . $74,550

or simply

Long-term investments — Available-for-sale (at fair value; cost is $73,000) . . . . . . . . . . . . $74,550

Equity

. . . consists of usual equity accounts . . .

Add unrealized gain on available-for-sale securities* . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,550

* Often included under the caption Accumulated Other Comprehensive Income.

R ec

o nc

ile d

Exhibit C.5 shows the December 31, 2012, balance sheet presentation — it assumes these invest- ments are long term, but they can also be short term. It is also common to combine the cost of invest- ments with the balance in the Fair Value Adjustment account and report the net as a single amount.

Point: ‘Unrealized Loss — Equity’ and ‘Unrealized Gain — Equity’ are permanent (balance sheet) equity accounts.

Example: If cost is $83,000 and fair value is $82,000 at Dec. 31, 2013, it re- cords the following adjustment: Unreal. Gain—Equity . . . . . 1,550 Unreal. Loss—Equity . . . . . 1,000 Fair Value Adj.—AFS . . 2,550

Assets 5 Liabilities 1 Equity 2550 2550

Dec. 31 Unrealized Gain — Equity . . . . . . . . . . . . . . . . . . . . . . . . 550

Fair Value Adjustment — Available-for-Sale (LT). . . . . 550

To record adjustment to fair value of available-for-sale securities.

Amounts reconcile.

Bal. 12/31/12 1,550

Bal. 12/31/13 1,000

Adj. 12/31/13 550

Fair Value Adjustment—Available-for-Sale (LT)

Adj. 12/31/13 550 Bal. 12/31/12 1,550

Bal. 12/31/13 1,000

Unrealized Gain—Equity

The effects of the 2012 and 2013 securities transactions are reflected in the following T-accounts.

Alert Both U.S. GAAP (and IFRS) permit companies to use fair value in reporting financial assets (referred to as the fair value option). This option allows companies to report any financial asset at fair value and recognize value changes in income. This method was previously reserved only for trading securities, but is now an option for available-for-sale and held-to-maturity securities (and other ‘financial assets and liabilities’ such as accounts and notes receivable, accounts and notes payable, and bonds). U.S. standards also set a 3-level system to determine fair value: —Level 1: Use quoted market values —Level 2: Use observable values from related assets or liabilities —Level 3: Use unobservable values from estimates or assumptions To date, a fairly small set of companies has chosen to broadly apply the fair value option—but, we continue to monitor its use …

Point: ‘Fair Value Adjustment — Available-for-Sale’ is a permanent account, shown as a deduction or addition to the Investment account.

Selling available-for-sale securities. Accounting for the sale of individual AFS securities is identical to that described for the sale of trading securities. When individual AFS securities are sold, the difference between the cost of the individual securities sold and the net proceeds (sale price less fees) is recognized as a gain or loss.

1. How are short-term held-to-maturity securities reported (valued) on the balance sheet? 2. How are trading securities reported (valued) on the balance sheet? 3. Where are unrealized gains and losses on available-for-sale securities reported? 4. Where are unrealized gains and losses on trading securities reported? 5. Does the Fair Value Adjustment account have a normal balance?

Quick Check Answers — p. C-19

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C-8 Appendix C Investments and International Operations

Investment in Securities with Significant Influence A long-term investment classified as equity securities with significant influence implies that the investor can exert significant influence over the investee. An investor that owns 20% or more (but not more than 50%) of a company’s voting stock is usually presumed to have a significant influence over the investee. In some cases, however, the 20% test of significant influence is over- ruled by other, more persuasive, evidence. This evidence can either lower the 20% requirement or increase it. The equity method of accounting and reporting is used for long-term investments in equity securities with significant influence, which is explained in this section. Long-term investments in equity securities with significant influence are recorded at cost when acquired. To illustrate, Micron Co. records the purchase of 3,000 shares (30%) of Star Co. common stock at a total cost of $70,650 on January 1, 2012, as follows.

REPORTING OF INFLUENTIALINFLUENTIAL INVESTMENTS

P4 Account for equity securities with significant influence.

Assets 5 Liabilities 1 Equity 170,650 270,650

Jan. 1 Long-Term Investments — Star . . . . . . . . . . . . . . . . . . . . 70,650

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,650

To record purchase of 3,000 Star shares.

Assets 5 Liabilities 1 Equity 16,000 16,000

Dec. 31 Long-Term Investments — Star . . . . . . . . . . . . . . . . . . . . 6,000

Earnings from Long-Term Investment . . . . . . . . . . . 6,000

To record 30% equity in investee earnings.

Assets 5 Liabilities 1 Equity 13,000 23,000

Jan. 9 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Long-Term Investments—Star . . . . . . . . . . . . . . . . 3,000

To record share of dividend paid by Star.

The investee’s (Star) earnings increase both its net assets and the claim of the investor (Micron) on the investee’s net assets. Thus, when the investee reports its earnings, the investor records its share of those earnings in its investment account. To illustrate, assume that Star reports net in- come of $20,000 for 2012. Micron then records its 30% share of those earnings as follows.

The book value of an investment under the equity method equals the cost of the investment plus (minus) the investor’s equity in the undistributed (distributed ) earnings of the investee. Once Micron records these transactions, its Long-Term Investments account appears as in Exhibit C.6.

The debit reflects the increase in Micron’s equity in Star. The credit reflects 30% of Star’s net in- come. Earnings from Long-Term Investment is a temporary account (closed to Income Summary at each period-end) and is reported on the investor’s (Micron’s) income statement. If the investee in- curs a net loss instead of a net income, the investor records its share of the loss and reduces (credits) its investment account. The investor closes this earnings or loss account to Income Summary. The receipt of cash dividends is not revenue under the equity method because the investor has already recorded its share of the investee’s earnings. Instead, cash dividends received by an in- vestor from an investee are viewed as a conversion of one asset to another; that is, dividends reduce the balance of the investment account. To illustrate, Star declares and pays $10,000 in cash dividends on its common stock. Micron records its 30% share of these dividends received on January 9, 2013, as:

EXHIBIT C.6 Investment in Star Common Stock (Ledger Account)

1/ 1/2012 Investment acquisition 70,650

12/31/2012 Share of earnings 6,000

12/31/2012 Balance 76,650

1/ 9/2013 Share of dividend 3,000

1/ 9/2013 Balance 73,650

Long-Term Investment—Star

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Appendix C Investments and International Operations C-9

Micron’s account balance on January 9, 2013, for its investment in Star is $73,650. This is the investment’s cost plus Micron’s equity in Star’s earnings since its purchase less Micron’s equity in Star’s cash dividends since its purchase. When an investment in equity securities is sold, the gain or loss is computed by comparing proceeds from the sale with the book value of the investment on the date of sale. If Micron sells its Star stock for $80,000 on January 10, 2013, it records the sale as:

Assets 5 Liabilities 1 Equity 180,000 16,350 273,650

Jan. 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Long-Term Investments—Star . . . . . . . . . . . . . . . . 73,650

Gain on Sale of Investment . . . . . . . . . . . . . . . . . . . 6,350

Sold 3,000 shares of stock for $80,000.

Point: Security prices are sometimes listed in fractions. For example, a debt security with a price of 2214 is the same as $22.25.

Accounting Summary for Investments in Securities Exhibit C.8 summarizes the standard accounting for investments in securities. Recall that many investment securities are classified as either short term or long term depending on management’s intent and ability to convert them in the future. Understanding the accounting for these investments enables us to draw better conclusions from financial statements in making business decisions.

Investment in Securities with Controlling Influence A long-term investment classified as equity securities with controlling influence implies that the investor can exert a controlling influence over the investee. An investor who owns more than 50% of a company’s voting stock has control over the investee. This investor can dominate all other shareholders in electing the corporation’s board of directors and has control over the in- vestee’s management. In some cases, controlling influence can extend to situations of less than 50% ownership. Exhibit C.7 sum- marizes the accounting for invest- ments in equity securities based on an investor’s ownership in the stock.

The equity method with con- solidation is used to account for long-term investments in equity securities with controlling influ- ence. The investor reports consolidated financial statements when owning such securities. The controlling investor is called the parent, and the investee is called the subsidiary. Many compa- nies are parents with subsidiaries. Examples are (1) Gap, Inc., the parent of Gap, Old Navy, and Banana Republic; and (2) Brunswick, the parent of Mercury Marine, Sea Ray, and U.S. Marine. A company owning all the outstanding stock of a subsidiary can, if it desires, take over the sub- sidiary’s assets, retire the subsidiary’s stock, and merge the subsidiary into the parent. However, there often are financial, legal, and tax advantages if a business operates as a parent controlling one or more subsidiaries. When a company operates as a parent with subsidiaries, each entity maintains separate accounting records. From a legal viewpoint, the parent and each subsidiary are separate entities with all rights, duties, and responsibilities of individual companies. Consolidated financial statements show the financial position, results of operations, and cash flows of all entities under the parent’s control, including all subsidiaries. These statements are prepared as if the business were organized as one entity. The parent uses the equity method in its accounts, but the investment account is not reported on the parent’s financial statements. Instead, the individual assets and liabilities of the parent and its subsidiaries are combined on one balance sheet. Their revenues and expenses also are combined on one income statement, and their cash flows are combined on one statement of cash flows. The procedures for preparing consolidated financial statements are in advanced courses.

EXHIBIT C.7 Accounting for Equity Investments by Percent of OwnershipEquity Method with

Consolidation (50%1)

Equity Method (20%–50%)

Fair Value Method (Under 20%)

C2 Describe how to report equity securities with controlling influence.

IFRS Unlike U.S. GAAP, IFRS requires uniform accounting policies be used throughout the group of consolidated subsidiaries. Also, unlike U.S. GAAP, IFRS offers no detailed guidance on valuation procedures. ■

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C-10 Appendix C Investments and International Operations

EXHIBIT C.8 Accounting for Investments in Securities

Classification Accounting

Short-Term Investment in Securities

Held-to-maturity (debt) securities . . . . . . . . . . . . . . . . Cost (without any discount or premium amortization)

Trading (debt and equity) securities . . . . . . . . . . . . . . . Fair value (with fair value adjustment to income)

Available-for-sale (debt and equity) securities . . . . . . . Fair value (with fair value adjustment to equity)

Long-Term Investment in Securities

Held-to-maturity (debt) securities . . . . . . . . . . . . . . . . Cost (with any discount or premium amortization)

Available-for-sale (debt and equity) securities . . . . . . . Fair value (with fair value adjustment to equity)

Equity securities with significant influence . . . . . . . . . Equity method

Equity securities with controlling influence . . . . . . . . . Equity method (with consolidation)

Comprehensive Income Comprehensive income is defined as all changes in equity during a period except those from owners’ investments and dividends. Specifically, comprehen- sive income is computed by adding or subtracting other comprehensive income to net income:

Net income . . . . . . . . . . . . . . . . . . . . . . . $ #

Other comprehensive income . . . . . . . . #

Comprehensive income . . . . . . . . . . . . . $ #

6. Give at least two examples of assets classified as long-term investments. 7. What are the requirements for an equity security to be listed as a long-term investment? 8. Identify similarities and differences in accounting for long-term investments in debt securities

that are held-to-maturity versus those available-for-sale.

9. What are the three possible classifications of long-term equity investments? Describe the criteria for each class and the method used to account for each.

Quick Check Answers — p. C-19

Other comprehensive income

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,818

Foreign currency conversion . . . . . . . . . . . . . . . . . . . 107

Valuation of cash flow hedges, net of tax . . . . . . . . . 8,545

Other comprehensive income . . . . . . . . . . . . . . . . . 8,652

Total comprehensive income . . . . . . . . . . . . . . . 29,470

Point: Some users believe that since AFS securities are not actively traded, reporting fair value changes in income would unnecessarily increase income variability and decrease usefulness.

Other comprehensive income includes unrealized gains and losses on available-for-sale securi- ties, foreign currency translation adjustments, and certain pension adjustments. (Accumulated other comprehensive income is defined as the cumulative impact of other comprehensive income.) Comprehensive income is reported in financial statements in one of two ways (which reflects new FASB guidance as of 2012):

1. On a separate statement of comprehensive income that immediately follows the income statement.

2. On the lower section of the income statement (as a single continuous statement of income and comprehensive income).

Option 1 is the most common. KTM, for example, reports a statement of comprehensive income following its income statement in Appendix A near the end of the book (Piaggio also applies this same presentation in Appendix A). Following is an abbreviated version of the KTM statement us- ing language more common for U.S. GAAP:

KTM

Option 2 adds the components of other comprehensive income to net income on the bottom of the income statement to compute a continuous statement of income and comprehensive income. There is no difference in the numbers; it is simply a matter of how those numbers are presented. A third option, which is no longer acceptable, was to include the components of other comprehensive in- come and its total along with the total of comprehensive income in the statement of equity. Polaris and Arctic Cat show examples of this presentation, which is no longer acceptable for future years.

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Appendix C Investments and International Operations C-11

This section discusses similarities and differences for the accounting and reporting of investments when financial statements are prepared under U.S. GAAP vis-à-vis IFRS.

Accounting for Noninfluential Securities The accounting for noninfluential securities is broadly similar between U.S. GAAP and IFRS. Trading securities are accounted for using fair values with unrealized gains and losses reported in net income as fair values change. Available-for-sale securi- ties are accounted for using fair values with unrealized gains and losses reported in other comprehen- sive income as fair values change (and later in net income when realized). Held-to-maturity securities are accounted for using amortized cost. Similarly, companies have the option under both systems to apply the fair value option for available-for-sale and held-to-maturity securities. Also, both systems review held-to-maturity securities for impairment. There are some differences in terminology under IFRS: (1) trading securities are commonly referred to as financial assets at fair value through profit and loss, and (2) available-for-sale securities are commonly referred to as available-for-sale financial as- sets. NOKIA reports the following categories for noninfluential securities: (1) Financial assets at fair value through profit or loss, consisting of financial assets held for trading and financial assets designated upon initial recognition as at fair value through profit or loss, (2) Available-for-sale financial assets, which are measured at fair value.

Accounting for Influential Securities The accounting for influential securities is broadly similar across U.S. GAAP and IFRS. Specifically, under the equity method, the share of investee’s net income is reported in the investor’s income in the same period the investee earns that income; also, the investment account equals the acquisition cost plus the share of investee income less the share of in- vestee dividends (minus amortization of excess on purchase price above fair value of identifiable, limited- life assets). Under the consolidation method, investee and investor revenues and expenses are combined, absent intercompany transactions, and subtracting noncontrolling interests. Also, nonintercompany assets and liabilities are similarly combined (eliminating the need for an investment account), and noncontrol- ling interests are subtracted from equity. There are some differences in terminology: (1) U.S. GAAP companies commonly refer to earnings from long-term investments as equity in earnings of affiliates whereas IFRS companies commonly use equity in earnings of associated (or associate) companies, (2) U.S. GAAP companies commonly refer to noncontrolling interests in consolidated subsidiaries as minority interests whereas IFRS companies commonly use noncontrolling interests.

GLOBAL VIEW

Components of Return on Total Assets Decision Analysis

A1 Compute and analyze the components of return on total assets.

A company’s return on total assets (or simply return on assets) is important in assessing financial performance. The return on total assets can be separated into two components, profit margin and total asset turnover, for additional analyses. Exhibit C.9 shows how these two components determine return on total assets.

EXHIBIT C.9 Components of Return on Total Assets

Return on total assets 5 Profit margin 3 Total asset turnover

Net income Average total assets

5

Net income Net sales

3

Net sales Average total assets

Profit margin reflects the percent of net income in each dollar of net sales. Total asset turnover reflects a company’s ability to produce net sales from total assets. All companies desire a high return on total assets. By considering these two components, we can often discover strengths and weaknesses not revealed by return on total assets alone. This improves our ability to assess future performance and company strategy.

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C-12 Appendix C Investments and International Operations

To illustrate, consider return on total assets and its components for Gap Inc. in Exhibit C.10.

EXHIBIT C.10 Gap’s Components of Return on Total Assets

Fiscal Year Return on Total Assets 5 Profit Margin 3 Total Asset Turnover

2012 11.5% 5 5.7% 3 2.01

2011 16.0* 5 8.2 3 1.95

2010 14.1* 5 7.7 3 1.83

2009 12.6 5 6.66 3 1.89

2008 10.2* 5 5.28 3 1.92

* Differences due to rounding.

2011 2010 2009 0.0%

2012

1.55

1.95

1.90

1.85

1.80

1.75

1.70

1.65

1.60

Return and Margin

Total Asset Turnover

10.0%

8.0%

6.0%

4.0%

18.0%

16.0%

2.0%

12.0%

14.0%

2.05

2.00

Return on Total Assets Total Asset TurnoverProfit Margin

At least three findings emerge. First, Gap’s return on total assets improved from 10.2% in 2008 to 11.5% in 2012. Second, total asset turnover has slightly improved over this period, from 1.92 to 2.01. Third, Gap’s profit margin steadily increased over this period, from 2008’s level of 5.28%. These components reveal the dual role of profit margin and total asset turnover in determining return on total assets. They also reveal that the driver of Gap’s recent improvement in return on total assets is not total asset turnover but profit margin. Generally, if a company is to maintain or improve its return on total assets, it must meet any decline in either profit margin or total asset turnover with an increase in the other. If not, return on assets will decline. Companies consider these components in planning strategies. A component analysis can also reveal where a company is weak and where changes are needed, especially in a competitor analysis. If asset turnover is lower than the industry norm, for instance, a company should focus on raising asset turnover at least to the norm. The same applies to profit margin.

Garden Company completes the following selected transactions related to its short-term investments during 2013.

May 8 Purchased 300 shares of FedEx stock as a short-term investment in available-for-sale securities at $40 per share plus $975 in broker fees.

Sept. 2 Sold 100 shares of its investment in FedEx stock at $47 per share and held the remaining 200 shares; broker’s commission was $225.

Oct. 2 Purchased 400 shares of Ajay stock for $60 per share plus $1,600 in commissions. The stock is held as a short-term investment in available-for-sale securities.

Required

1. Prepare journal entries for the above transactions of Garden Company for 2013. 2. Prepare an adjusting journal entry as of December 31, 2013, if the fair values of the equity securities

held by Garden Company are $48 per share for FedEx and $55 per share for Ajay. (Year 2013 is the first year Garden Company acquired short-term investments.)

SOLUTION TO DEMONSTRATION PROBLEM—1 1.

DEMONSTRATION PROBLEM—1

May 8 Short-Term Investments — AFS (FedEx) . . . . . . . . . . . . . 12,975

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,975

Purchased 300 shares of FedEx stock (300 3 $40) 1 $975.

[continued on next page]

Retailer You are an entrepreneur and owner of a retail sporting goods store. The store’s recent annual perfor- mance reveals (industry norms in parentheses): return on total assets 5 11% (11.2%); profit margin 5 4.4% (3.5%); and total asset turnover 5 2.5 (3.2). What does your analysis of these figures reveal? ■ [Answer—p. C-19]

Decision Maker

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Appendix C Investments and International Operations C-13

2. Computation of unrealized gain or loss follows.

[continued from previous page]

Sept. 2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,475

Gain on Sale of Short-Term Investment . . . . . . . . . 150

Short-Term Investments—AFS (FedEx) . . . . . . . . . 4,325

Sold 100 shares of FedEx for $47 per share less a $225 commission. The original cost is ($12,975 3 100y300). Oct. 2 Short-Term Investments — AFS (Ajay) . . . . . . . . . . . . . . 25,600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,600

Purchased 400 shares of Ajay for $60 per share plus $1,600 in commissions.

Short-Term Fair Investments in Cost Value Total Unrealized

Available-for-Sale per Total per Fair Gain Securities Shares Share Cost Share Value (Loss)

FedEx . . . . . . . . . . . . . . . . . . . . 200 $43.25 $ 8,650 $48.00 $ 9,600

Ajay . . . . . . . . . . . . . . . . . . . . . 400 64.00 25,600 55.00 22,000

Totals . . . . . . . . . . . . . . . . . . . . $34,250 $31,600 $(2,650)

Dec. 31 Unrealized Loss — Equity . . . . . . . . . . . . . . . . . . . . . . . . . 2,650

Fair Value Adjustment — Available-for-Sale (ST) . . . . 2,650

To reflect an unrealized loss in fair values of available-for-sale securities.

The adjusting entry follows:

The following transactions relate to Brown Company’s long-term investments during 2012 and 2013. Brown did not own any long-term investments prior to 2012. Show (1) the appropriate journal entries and (2) the relevant portions of each year’s balance sheet and income statement that reflect these transactions for both 2012 and 2013.

2012

Sept. 9 Purchased 1,000 shares of Packard, Inc., common stock for $80,000 cash. These shares repre- sent 30% of Packard’s outstanding shares.

Oct. 2 Purchased 2,000 shares of AT&T common stock for $60,000 cash as a long-term investment. These shares represent less than a 1% ownership in AT&T.

17 Purchased as a long-term investment 1,000 shares of Apple Computer common stock for $40,000 cash. These shares are less than 1% of Apple’s outstanding shares.

Nov. 1 Received $5,000 cash dividend from Packard. 30 Received $3,000 cash dividend from AT&T. Dec. 15 Received $1,400 cash dividend from Apple. 31 Packard’s net income for this year is $70,000. 31 Fair values for the investments in equity securities are Packard, $84,000; AT&T, $48,000; and

Apple Computer, $45,000. 31 For preparing financial statements, note the following post-closing account balances: Common

Stock, $500,000, and Retained Earnings, $350,000.

2013

Jan. 1 Sold Packard, Inc., shares for $108,000 cash. May 30 Received $3,100 cash dividend from AT&T. June 15 Received $1,600 cash dividend from Apple.

DEMONSTRATION PROBLEM—2

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C-14 Appendix C Investments and International Operations

Aug. 17 Sold the AT&T stock for $52,000 cash. 19 Purchased 2,000 shares of Coca-Cola common stock for $50,000 cash as a long-term invest-

ment. The stock represents less than a 5% ownership in Coca-Cola. Dec. 15 Received $1,800 cash dividend from Apple. 31 Fair values of the investments in equity securities are Apple, $39,000, and Coca-Cola, $48,000. 31 For preparing financial statements, note the following post-closing account balances: Common

Stock, $500,000, and Retained Earnings, $410,000.

PLANNING THE SOLUTION ● Account for the investment in Packard under the equity method. ● Account for the investments in AT&T, Apple, and Coca-Cola as long-term investments in available-for-

sale securities. ● Prepare the information for the two years’ balance sheets by including the relevant asset and equity

accounts, and the two years’ income statements by identifying the relevant revenues, earnings, gains, and losses.

SOLUTION TO DEMONSTRATION PROBLEM—2 1. Journal entries for 2012.

Sept. 9 Long-Term Investments — Packard . . . . . . . . . . . . . . . . . 80,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Acquired 1,000 shares, representing a 30% equity in Packard.

Oct. 2 Long-Term Investments — AFS (AT&T) . . . . . . . . . . . . . 60,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Acquired 2,000 shares as a long-term investment in available-for-sale securities.

Oct. 17 Long-Term Investments — AFS (Apple) . . . . . . . . . . . . . . 40,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Acquired 1,000 shares as a long-term investment in available-for-sale securities.

Nov. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Long-Term Investments — Packard . . . . . . . . . . . . . 5,000

Received dividend from Packard.

Nov. 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Received dividend from AT&T.

Dec. 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Received dividend from Apple.

Dec. 31 Long-Term Investments — Packard . . . . . . . . . . . . . . . . . 21,000

Earnings from Investment (Packard) . . . . . . . . . . . . 21,000

To record 30% share of Packard’s annual earnings of $70,000.

Dec. 31 Unrealized Loss—Equity . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Fair Value Adjustment — Available-for-Sale (LT)* . . . 7,000

To record change in fair value of long-term available-for-sale securities.

* Fair value adjustment computations:

Fair Unrealized Cost Value Gain (Loss)

AT&T $ 60,000 $48,000 $(12,000)

Apple 40,000 45,000 5,000

Total $100,000 $93,000 $ (7,000)

Required balance of the Fair Value Adjustment — Available-for-Sale (LT) account (credit) . . . . . . . . . . . . $(7,000)

Existing balance . . . . . . . . . . . . . . . . . 0

Necessary adjustment (credit) . . . . . . $(7,000)

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Appendix C Investments and International Operations C-15

2. The December 31, 2012, selected balance sheet items appear as follows.

Dividend revenue . . . . . . . . . . . . . . $ 4,400

Earnings from investment . . . . . . . . 21,000

Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000

Long-Term Investments — Packard . . . . . . . . . . . . . 96,000

Gain on Sale of Long-Term Investments . . . . . . . . . 12,000

Sold 1,000 shares for cash.

May 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,100

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 3,100

Received dividend from AT&T.

June 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600

Received dividend from Apple.

Aug. 17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000

Loss on Sale of Long-Term Investments . . . . . . . . . . . . . 8,000

Long-Term Investments—AFS (AT&T) . . . . . . . . . . 60,000

Sold 2,000 shares for cash.

Aug. 19 Long-Term Investments — AFS (Coca-Cola) . . . . . . . . . . 50,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Acquired 2,000 shares as a long-term investment in available-for-sale securities.

Dec. 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Dividend Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Received dividend from Apple.

Dec. 31 Fair Value Adjustment — Available-for-Sale (LT)* . . . . . . . 4,000

Unrealized Loss — Equity . . . . . . . . . . . . . . . . . . . . 4,000

To record change in fair value of long-term available-for-sale securities.

* Fair value adjustment computations:

The relevant income statement items for the year ended December 31, 2012, follow.

1. Journal entries for 2013.

Assets

Long-term investments

Available-for-sale securities (at fair value; cost is $100,000) . . . . . . . . $ 93,000

Investment in equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000

Total long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189,000

Stockholders’ Equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000

Unrealized loss—Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,000)

Fair Unrealized Cost Value Gain (Loss)

Apple $40,000 $39,000 $(1,000)

Coca-Cola 50,000 48,000 (2,000)

Total $90,000 $87,000 $(3,000)

Required balance of the Fair Value Adjustment — Available-for-Sale (LT) account (credit) . . . . . . . . . . . . $(3,000)

Existing balance (credit) . . . . . . . . . . . (7,000)

Necessary adjustment (debit) . . . . . . . $ 4,000

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C-16 Appendix C Investments and International Operations

2. The December 31, 2013, balance sheet items appear as follows.

Assets

Long-term investments

Available-for-sale securities (at fair value; cost is $90,000) . . . . . . . $ 87,000

Stockholders’ Equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410,000

Unrealized loss — Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000)

Dividend revenue . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,500

Gain on sale of long-term investments . . . . . . . . . . 12,000

Loss on sale of long-term investments . . . . . . . . . . (8,000)

The relevant income statement items for the year ended December 31, 2013, follow.

APPENDIX

Investments in International Operations Many entities from small entrepreneurs to large corporations conduct business internationally. Some enti- ties’ operations occur in so many different countries that the companies are called multinationals. Many

of us think of Coca-Cola and McDonald’s, for example, as primarily U.S. companies, but most of their sales occur outside the United States. Exhibit C-A.1 shows the percent of international sales and income for selected U.S. companies. Managing and accounting for multinationals pre sent challenges. This section describes some of these challenges and how to account for and report these activities.

Two major accounting challenges that arise when companies have international operations relate to transactions that involve more than one currency. The first is to account for sales and purchases listed in a foreign currency. The sec- ond is to prepare consolidated financial state-

ments with international subsidiaries. For ease in this discussion, we use companies with a U.S. base of operations and assume the need to prepare financial statements in U.S. dollars. This means the reporting currency of these companies is the U.S. dollar.

Exchange Rates between Currencies Markets for the purchase and sale of foreign currencies exist all over the world. In these markets, U.S. dollars can be exchanged for Canadian dollars, British pounds, Japanese yen, Euros, or any other legal currencies. The price of one currency stated in terms of another cur- rency is called a foreign exchange rate. Exhibit C-A.2 lists recent exchange rates for selected currencies. The exchange rate for British pounds and U.S. dollars is $1.8980, meaning 1 British pound could be pur- chased for $1.8980. On that same day, the exchange rate between Mexican pesos and U.S. dollars is $0.0925, or 1 Mexican peso can be purchased for $0.0925. Exchange rates fluctuate due to changing economic and political conditions, including the supply and demand for currencies and expectations about future events.

C-A

Point: Transactions listed or stated in a foreign currency are said to be denominated in that currency.

EXHIBIT C-A.1 International Sales and Income as a Percent of Their Totals

International Sales International Income

Percent of respective totals 1007550250

McDonald's

3M

Nike

68% 57%

66% 74%

50% 54%

C3 Explain foreign exchange rates and record transactions listed in a foreign currency.

Point: To convert currency, see XE.com

Greek Haircut Investors in government debt securities in the Euro- zone must be careful of the heightened default risk associated with secu- rities issued by certain Eurozone member nations. For example, in 2012, buyers of certain Greek bonds were repaid only 30% of principal because of the government’s inability to honor its full obligation on the bonds. ■

Decision Insight

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Appendix C Investments and International Operations C-17

EXHIBIT C-A.2 Foreign Exchange Rates for Selected Currencies*

Price in Price in Source (unit) $U.S. Source (unit) $U.S.

Britain (pound) . . . . . . . . $1.8980 Canada (dollar) . . . . . . . . $0.9793

Mexico (peso) . . . . . . . . . 0.0925 Japan (yen) . . . . . . . . . . . . 0.0090

Taiwan (dollar) . . . . . . . . 0.0305 Europe (Euro) . . . . . . . . . 1.2920

* Rates will vary over time based on economic, political, and other changes.

Sales and Purchases Listed in a Foreign Currency When a U.S. company makes a credit sale to an international customer, accounting for the sale and the account receivable is straightforward if sales terms require the international customer’s payment in U.S. dollars. If sale terms require (or allow) payment in a foreign currency, however, the U.S. company must account for the sale and the account receivable in a different manner.

Sales in a Foreign Currency To illustrate, consider the case of the U.S.-based manufacturer Boston Com- pany, which makes credit sales to London Outfitters, a British retail company. A sale occurs on December 12, 2012, for a price of £10,000 with payment due on February 10, 2013. Boston Company keeps its account- ing records in U.S. dollars. To record the sale, Boston Company must translate the sales price from pounds to dollars. This is done using the exchange rate on the date of the sale. Assuming the exchange rate on December 12, 2012, is $1.80, Boston records this sale as follows.

Assets 5 Liabilities 1 Equity 118,000 118,000

Dec. 12 Accounts Receivable — London Outfitters . . . . . . . . . . . 18,000

Sales* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

To record a sale at £10,000, when the exchange rate equals $1.80. * (£10,000 3 $1.80y£)

Assets 5 Liabilities 1 Equity 1400 1400

Dec. 31 Accounts Receivable — London Outfitters . . . . . . . . . . . 400

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . 400

To record the increased value of the British pound for the receivable.

When Boston Company prepares its annual financial statements on December 31, 2012, the current exchange rate is $1.84. Thus, the current dollar value of Boston Company’s receivable is $18,400 (£10,000 3 $1.84y£). This amount is $400 higher than the amount recorded on December 12. Accounting principles require a receivable to be reported in the balance sheet at its current dollar value. Thus, Boston Company must make the following entry to record the increase in the dollar value of this receivable at year-end.

Point: Foreign exchange gains are credits, and foreign exchange losses are debits.

On February 10, 2013, Boston Company receives London Outfitters’ payment of £10,000. It imme- diately exchanges the pounds for U.S. dollars. On this date, the exchange rate for pounds is $1.78. Thus, Boston Company receives only $17,800 (£10,000 3 $1.78y£). It records the cash receipt and the loss associated with the decline in the exchange rate as follows.

Assets 5 Liabilities 1 Equity 117,800 2600 218,400

Feb. 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,800

Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Accounts Receivable — London Outfitters . . . . . . . 18,400

Received foreign currency payment of an account and converted it into dollars.

Gains and losses from foreign exchange transactions are accumulated in the Foreign Exchange Gain (or Loss) account. After year-end adjustments, the balance in the Foreign Exchange Gain (or Loss) ac- count is reported on the income statement and closed to the Income Summary account.

Purchases in a Foreign Currency Accounting for credit purchases from an international seller is similar to the case of a credit sale to an international customer. In particular, if the U.S. company is required to make payment in a foreign currency, the account payable must be translated into dollars before the U.S. company can record it. If the exchange rate is different when preparing financial statements and when paying for the purchase, the U.S. company must recognize a foreign exchange gain or loss at those dates. To illustrate, assume NC Imports, a U.S. company, purchases products costing €20,000 (euros) from

Example: Assume that a U.S. company makes a credit purchase from a British company for £10,000 when the exchange rate is $1.62. At the balance sheet date, this rate is $1.72. Does this imply a gain or loss for the U.S. company? Answer: A loss.

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C-18 Appendix C Investments and International Operations

Hamburg Brewing on January 15, when the exchange rate is $1.20 per euro. NC records this transaction as follows.

Assets 5 Liabilities 1 Equity 124,000 124,000

Jan. 15 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Accounts Payable—Hamburg Brewing . . . . . . . . . . 24,000

To record a €20,000 purchase when exchange rate is $1.20 (€20,000 3 $1.20y€)

NC Imports makes payment in full on February 14 when the exchange rate is $1.25 per euro, which is recorded as follows.

Assets 5 Liabilities 1 Equity 225,000 224,000 21,000

Feb. 14 Accounts Payable—Hamburg Brewing . . . . . . . . . . . . . . 24,000

Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

To record cash payment towards €20,000 account when exchange rate is $1.25 (€20,000 3 $1.25y€).

Consolidated Statements with International Subsidiaries A second challenge in ac- counting for international operations involves preparing consolidated financial statements when the parent company has one or more international subsidiaries. Consider a U.S.-based company that owns a controlling interest in a French subsidiary. The reporting currency of the U.S. parent is the dollar. The French subsidiary maintains its financial records in euros. Before preparing consolidated statements, the parent must translate financial statements of the French company into U.S. dollars. After this translation is complete (including that for accounting differences), it prepares consolidated statements the same as for domestic subsidiaries. Procedures for translating an international subsidiary’s account balances depend on the nature of the subsid- iary’s operations. The process requires the parent company to select appropriate foreign exchange rates and to apply those rates to the foreign subsidiary’s account balances. This is described in advanced courses.

Global: A weaker U.S. dollar often increases global sales for U.S. companies.

C1 Distinguish between debt and equity securities and between short-term and long-term investments. Debt securities reflect a creditor relationship and include investments in notes, bonds, and certificates of deposit. Equity securities reflect an owner relationship and include shares of stock issued by other companies. Short-term investments in securities are current assets that meet two criteria: (1) They are expected to be converted into cash within one year or the current operating cycle of the business, whichever is longer and (2) they are readily convertible to cash, or marketable. All other investments in securities are long-term. Long-term investments also include assets not used in operations and those held for special purposes, such as land for expansion. Investments in securities are classified into one of five groups: (1) trading securities, which are always short-term, (2) debt securi-

Summary ties held-to-maturity, (3) debt and equity securities available-for- sale, (4) equity securities in which an investor has a significant influence over the investee, and (5) equity securities in which an investor has a controlling influence over the investee.

C2 Describe how to report equity securities with controlling influence. If an investor owns more than 50% of another company’s voting stock and controls the investee, the investor’s financial reports are prepared on a consolidated basis. These reports are prepared as if the company were organized as one entity.

C3A Explain foreign exchange rates and record transactions listed in a foreign currency. A foreign exchange rate is the price of one currency stated in terms of another. An entity with trans- actions in a foreign currency when the exchange rate changes

Global Greenback What do changes in foreign exchange rates mean? A decline in the price of the U.S. dollar against other currencies usually yields increased international sales for U.S. companies, without hiking prices or cutting costs, and puts them on a stronger competitive footing abroad. At home, they can raise prices without fear that foreign rivals will undercut them. ■

Decision Insight

Entrepreneur Assume that Ben and Jerry’s purchases milk from dairies in both the U.S. and Canada. The price of the Canadian dollar in terms of the U.S. dollar jumps from US$0.70 to US$0.80. Is the ice cream maker now more or less likely to buy milk from Canadian or U.S. suppliers? ■ [Answer—p. C-19]

Decision Maker

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Appendix C Investments and International Operations C-19

between the transaction dates and their settlement will experience exchange gains or losses. When a company makes a credit sale to a foreign customer and sales terms call for payment in a foreign cur- rency, the company must translate the foreign currency into dollars to record the receivable. If the exchange rate changes before pay- ment is re ceived, exchange gains or losses are recognized in the year they occur. The same treat ment is used when a company makes a credit purchase from a foreign supplier and is required to make payment in a foreign currency.

A1 Compute and analyze the components of return on total assets. Return on total assets has two components: profit margin and total asset turnover. A decline in one component must be met with an increase in another if return on assets is to be main- tained. Component analysis is helpful in assessing company performance compared to that of competitors and its own past.

P1 Account for trading securities. Investments are initially recorded at cost, and any dividend or interest from these investments is recorded in the income statement. Investments classified as trading securities are reported at fair value. Un- realized gains and losses on trading securities are reported in income. When investments are sold, the difference between the

net proceeds from the sale and the cost of the securities is recog- nized as a gain or loss.

P2 Account for held-to-maturity securities. Debt securities held-to-maturity are reported at cost when purchased. Interest revenue is recorded as it accrues. The cost of long-term held-to-maturity securities is adjusted for the amortization of any difference between cost and maturity value.

P3 Account for available-for-sale securities. Debt and equity securities available-for-sale are recorded at cost when pur- chased. Available-for-sale securities are reported at their fair values on the balance sheet with unrealized gains or losses shown in the equity section. Gains and losses realized on the sale of these invest- ments are reported in the income statement.

P4 Account for equity securities with significant influence. The equity method is used when an investor has a signifi cant influ- ence over an investee. This usually exists when an investor owns 20% or more of the investee’s voting stock but not more than 50%. The eq- uity method means an investor records its share of investee earnings with a debit to the investment account and a credit to a revenue ac- count. Dividends received reduce the investment account balance.

Money Manager If you have investments in fixed-rate bonds and notes when interest rates fall, the value of your investments increases. This is so because the bonds and notes you hold continue to pay the same (high) rate while the market is demanding a new lower interest rate. Your strategy is to continue holding your in vestments in bonds and notes, and, potentially, to increase these holdings through additional purchases.

Retailer Your store’s return on assets is 11%, which is similar to the industry norm of 11.2%. However, disaggregation of return on assets reveals that your store’s profit margin of 4.4% is much higher than the norm of 3.5%, but your total asset turnover of 2.5 is much lower than the norm of 3.2. These results suggest that, as compared with competitors, you are less efficient in using assets. You need to

focus on increasing sales or reducing assets. You might consider reducing prices to increase sales, provided such a strategy does not reduce your return on assets. For instance, you could reduce your profit margin to 4% to increase sales. If total asset turnover increases to more than 2.75 when profit margin is lowered to 4%, your overall return on assets is improved.

Entrepreneur You are now less likely to buy Canadian milk products because it takes more U.S. money to buy a Canadian dollar (and milk). For instance, the purchase of milk from a Canadian dairy with a $1,000 (Canadian dollars) price would have cost the U.S. company $700 (U.S. dollars, computed as C$1,000 3 US$0.70) be- fore the rate change, and $800 (US dollars, computed as C$1,000 3 US$0.80) after the rate change.

Guidance Answers to Decision Maker

1. Short-term held-to-maturity securities are reported at cost. 2. Trading securities are reported at fair value. 3. The equity section of the balance sheet (and in comprehensive

income). 4. The income statement. 5. The Fair Value Adjustment account does not have a normal bal-

ance. Its balance is a function of market values for securities which move up or down. The balance of this valuation account is determined by market conditions.

6. Long-term investments include (1) long-term funds earmarked for a special purpose, (2) debt and equity securities that do not meet current asset requirements, and (3) long-term assets not used in the regular operations of the business.

7. An equity investment is classified as long term if it is not mar- ketable or, if marketable, it is not held as an available source of cash to meet the needs of current operations.

8. Debt securities held-to-maturity and debt securities available- for-sale are both recorded at cost. Also, interest on both is accrued as earned. However, only long-term securities held- to- maturity require amortization of the difference between cost and maturity value. In addition, only securities available-for- sale require a period-end adjustment to fair value.

9. Long-term equity investments are placed in one of three catego- ries and accounted for as follows: (a) available-for-sale (nonin- fluential, less than 20% of outstanding stock) — fair value; (b) significant influence (20% to 50% of outstanding stock) — equity method; and (c) controlling influence (holding more than 50% of outstanding stock) — equity method with consolidation.

Guidance Answers to Quick Checks

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C-20 Appendix C Investments and International Operations

Multiple Choice Quiz Answers on p. C-35 mhhe.com/wildFINMAN5e

c. Credit to Cash for $17,500. d. Debit to Long-Term Investments for $17,500. e. Debit to Cash for $50,000. 4. A company has net income of $300,000, net sales of $2,500,000,

and total assets of $2,000,000. Its return on total assets equals: a. 6.7% b. 12.0% c. 8.3% d. 80.0% e. 15.0% 5. A company had net income of $80,000, net sales of $600,000,

and total assets of $400,000. Its profit margin and total asset turnover are:

1. A company purchased $30,000 of 5% bonds for investment purposes on May 1. The bonds pay interest on February 1 and August 1. The amount of interest revenue accrued at December 31 (the company’s year-end) is:

a. $1,500 b. $1,375 c. $1,000 d. $625 e. $300 2. Earlier this period, Amadeus Co. purchased its only available-for-

sale investment in the stock of Bach Co. for $83,000. The period-end fair value of this stock is $84,500. Amadeus records a:

a. Credit to Unrealized Gain—Equity for $1,500. b. Debit to Unrealized Loss—Equity for $1,500. c. Debit to Investment Revenue for $1,500. d. Credit to Fair Value Adjustment—Available-for-Sale for

$3,500. e. Credit to Cash for $1,500. 3. Mozart Co. owns 35% of Melody Inc. Melody pays $50,000 in

cash dividends to its shareholders for the period. Mozart’s entry to record the Melody dividend includes a:

a. Credit to Investment Revenue for $50,000. b. Credit to Long-Term Investments for $17,500.

Profit Margin Total Asset Turnover

a. 1.5% 13.3

b. 13.3% 1.5

c. 13.3% 0.7

d. 7.0% 13.3

e. 10.0% 26.7

Available-for-sale (AFS) securities (p. C-6)

Comprehensive income (p. C-10)

Consolidated financial statements (p. C-9)

Equity method (p. C-8)

Equity securities with controlling influence (p. C-9)

Equity securities with significant influence (p. C-8)

Foreign exchange rate (p. C-16)

Held-to-maturity (HTM) securities (p. C-6)

Long-term investments (p. C-2)

Multinational (p. C-16)

Other comprehensive income (p. C-10)

Parent (p. C-9)

Return on total assets (p. C-11)

Short-term investments (p. C-2)

Subsidiary (p. C-9)

Trading securities (p. C-5)

Unrealized gain (loss) (p. C-5)

Key Terms

A Superscript A denotes assignments based on Appendix C-A.

Icon denotes assignments that involve decision making.

1. Under what two conditions should investments be classified as current assets?

2. On a balance sheet, what valuation must be reported for short-term investments in trading securities?

3. If a short-term investment in available-for-sale securities costs $10,000 and is sold for $12,000, how should the difference between these two amounts be recorded?

4. Identify the three classes of noninfluential and two classes of influential investments in securities.

5. Under what conditions should investments be classified as cur- rent assets? As long-term assets?

6. For investments in available-for-sale securities, how are unreal- ized (holding) gains and losses reported?

7. If a company purchases its only long-term investments in available-for-sale debt securities this period and their fair value is below cost at the balance sheet date, what entry is re- quired to recognize this unrealized loss?

Discussion Questions

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Appendix C Investments and International Operations C-21

8. On a balance sheet, what valuation must be reported for debt securities classified as available-for-sale?

9. Under what circumstances are long-term investments in debt securities reported at cost and adjusted for amortization of any difference between cost and maturity value?

10. In accounting for investments in equity securities, when should the equity method be used?

11. Under what circumstances does a company prepare consoli- dated financial statements?

12.A What are two major challenges in accounting for interna- tional operations?

13.A Assume a U.S. company makes a credit sale to a foreign customer that is required to make payment in its foreign cur- rency. In the current period, the exchange rate is $1.40 on the date of the sale and is $1.30 on the date the customer pays the receivable. Will the U.S. company record an exchange gain or loss?

14.A If a U.S. company makes a credit sale to a foreign customer required to make payment in U.S. dollars, can the U.S. company have an exchange gain or loss on this sale?

15. Refer to Polaris’ statement of changes in shareholders’ equity in Appendix A. What is the amount of foreign currency translation adjustment for the year ended December 31, 2011? Is this adjustment an unrealized gain or an unrealized loss?

16. Refer to Arctic Cat’s statement of stockholders’ equity. What was the amount of its fiscal 2011 un- realized gain or loss on derivative instruments?

17. Refer to the balance sheet of KTM in Appendix A. How can you tell that KTM uses the consoli- dated method of accounting?

18. Refer to the financial statements of Piaggio in Appendix A. Com pute its return on total as- sets for the year ended December 31, 2011.

On April 18, Riley Co. made a short-term investment in 300 common shares of XLT Co. The purchase price is $42 per share and the broker’s fee is $250. The intent is to actively manage these shares for profit. On May 30, Riley Co. receives $1 per share from XLT in dividends. Prepare the April 18 and May 30 journal entries to record these transactions.

QUICK STUDY

QS C-1 Short-term equity investments

P1

QS C-3 Available-for-sale securities

P3

Prepare Hertog Company’s journal entries to reflect the following transactions for the current year.

May 7 Purchases 200 shares of Kraft stock as a short-term investment in available-for-sale securities at a cost of $50 per share plus $300 in broker fees.

June 6 Sells 200 shares of its investment in Kraft stock at $56 per share. The broker’s commission on this sale is $150.

QS C-2 Available-for-sale securities

P3

Journ Co. purchased short-term investments in available-for-sale securities at a cost of $50,000 on November 25, 2013. At December 31, 2013, these securities had a fair value of $47,000. This is the first and only time the company has purchased such securities. 1. Prepare the December 31, 2013, year-end adjusting entry for the securities’ portfolio. 2. For each account in the entry for part 1, explain how it is reported in financial statements. 3. Prepare the April 6, 2014, entry when Journ sells one-half of these securities for $26,000.

QS C-4 Available-for-sale securities

P3

Hiker Company completes the following transactions during the current year.

May 9 Purchases 200 shares of Higo stock as a short-term investment in available-for-sale securities at a cost of $25 per share plus $150 in broker fees.

June 2 Sells 100 shares of its investment in Higo stock at $28 per share. The broker’s commission on this sale is $90.

Dec. 31 The closing market price (fair value) of the Higo stock is $23 per share.

Prepare the May 9 and June 2 journal entries and the December 31 adjusting entry. This is the first and only time the company purchased such securities.

QS C-5 Identifying long-term investments

C1

Which of the following statements are true of long-term investments? a. They are held as an investment of cash available for current operations. b. They can include funds earmarked for a special purpose, such as bond sinking funds. c. They can include investments in trading securities. [continued on next page]

Polaris

Arctic Cat

KTM

PIAGGIO

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C-22 Appendix C Investments and International Operations

QS C-8 Recording equity securities

P3

On May 20, 2013, Montero Co. paid $1,000,000 to acquire 25,000 common shares (10%) of ORD Corp. as a long-term investment. On August 5, 2014, Montero sold one-half of these shares for $625,000. What valuation method should be used to account for this stock investment? Prepare entries to record both the acquisition and the sale of these shares.

QS C-9 Equity method transactions

P4

Assume the same facts as in QS C-8 except that the stock acquired represents 40% of ORD Corp.’s outstanding stock. Also assume that ORD Corp. paid a $100,000 dividend on November 1, 2013, and reported a net income of $700,000 for 2013. Prepare the entries to record (a) the receipt of the dividend and (b) the December 31, 2013, year-end adjustment required for the investment account.

QS C-14A

Foreign currency transactions

C3

A U.S. company sells a product to a British company with the transaction listed in British pounds. On the date of the sale, the transaction total of $14,500 is billed as £10,000, reflecting an exchange rate of 1.45 (that is, $1.45 per pound). Prepare the entry to record (1) the sale and (2) the receipt of payment in pounds when the exchange rate is 1.35.

QS C-15A

Foreign currency transactions

C3

On March 1, 2013, a U.S. company made a credit sale requiring payment in 30 days from a Malaysian company, Hamac Sdn. Bhd., in 20,000 Malaysian ringgits. Assuming the exchange rate between Malaysian ringgits and U.S. dollars is $0.4538 on March 1 and $0.4899 on March 31, prepare the entries to record the sale on March 1 and the cash receipt on March 31.

QS C-10 Recording fair value adjustment for securities

P3

During the current year, Reed Consulting Group acquired long-term available-for-sale securities at a $70,000 cost. At its December 31 year-end, these securities had a fair value of $58,000. This is the first and only time the company purchased such securities. 1. Prepare the necessary year-end adjusting entry related to these securities. 2. Explain how each account used in part 1 is reported in the financial statements.

QS C-13 Component return on total assets A1

Return on total assets can be separated into two important components. 1. Write the formula to separate the return on total assets into its two basic components. 2. Explain how these components of the return on total assets are helpful to financial statement users for

business decisions.

QS C-12 Return on total assets A1

The return on total assets is the focus of analysts, creditors, and other users of financial statements. 1. How is the return on total assets computed? 2. What does this important ratio reflect?

d. They can include debt securities held-to-maturity. e. They are always easily sold and therefore qualify as being marketable. f. They can include debt and equity securities available-for-sale. g. They can include bonds and stocks not intended to serve as a ready source of cash.

QS C-6 Describing investments in securities

C1 C2

Complete the following descriptions by filling in the blanks. 1. Equity securities giving an investor significant influence are accounted for using the . 2. Available-for-sale debt securities are reported on the balance sheet at . 3. Trading securities are classified as assets. 4. Accrual of interest on bonds held as long-term investments requires a credit to . 5. The controlling investor (more than 50% ownership) is called the , and the investee company

is called the .

QS C-7 Debt securities transactions

P2

On February 1, 2013, Garzon purchased 6% bonds issued by PBS Utilities at a cost of $40,000, which is their par value. The bonds pay interest semiannually on July 31 and January 31. For 2013, prepare entries to record Garzon’s July 31 receipt of interest and its December 31 year-end interest accrual.

QS C-11 Equity securities with controlling influence

C2

Complete the following descriptions by filling in the blanks. 1. The controlling investor is called the , and the investee is called the . 2. A long-term investment classified as equity securities with controlling influence implies that the inves-

tor can exert a influence over the investee.

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Appendix C Investments and International Operations C-23

QS C-16 International accounting for investments

P1

The Carrefour Group reports the following description of its trading securities (titled “financial assets reported at fair value in the income statement”).

These are financial assets held by the Group in order to make a short-term profit on the sale. These assets are valued at their fair value with variations in value recognized in the income statement.

Note 10 to Carrefour’s 2010 financial statements reports €7 million in unrealized gains for 2010 and €26 million in unrealized losses for 2010, both included in the fair value of those financial assets held for trading. What amount of these unrealized gains and unrealized losses, if any, are reported in its 2010 income statement? Explain.

Exercise C-2 Accounting for short-term held- to-maturity securities P2

Prepare journal entries to record the following transactions involving the short-term securities investments of Natura Co., all of which occurred during year 2013. a. On June 15, paid $1,000,000 cash to purchase Remedy’s 90-day short-term debt securities ($1,000,000

principal), dated June 15, that pay 10% interest (categorized as held-to-maturity securities). b. On September 16, received a check from Remedy in payment of the principal and 90 days’ interest on

the debt securities purchased in transaction a.

Exercise C-3 Accounting for short-term available-for-sale securities

P3

Prepare journal entries to record the following transactions involving the short-term securities investments of Krum Co., all of which occurred during year 2013. a. On August 1, paid $450,000 cash to purchase Houtte’s 9% debt securities ($450,000 principal), dated

July 30, 2013, and maturing January 30, 2014 (categorized as available-for-sale securities). b. On October 30, received a check from Houtte for 90 days’ interest on the debt securities purchased in

transaction a.

Exercise C-4 Debt and equity securities and short- and long-term investments

C1

Complete the following descriptions by filling in the blanks. 1. Debt securities reflect a relationship such as investments in notes, bonds, and certificates of

deposit. 2. Equity securities reflect an relationship such as shares of stock issued by companies. 3. Short-term investments are securities that (1) management intends to convert to cash within

or the whichever is longer, and (2) are readily convertible to . 4. Long-term investments in securities are defined as those securities that are convertible to

cash or are to be converted into cash in the short term.

Exercise C-5 Equity securities with controlling influence

C2

Complete the following descriptions by filling in the blanks. 1. Consolidated show the financial position, results of operations, and cash flows of all

entities under the parent’s control, including all subsidiaries. 2. The equity method with is used to account for long-term investments in equity securities with

controlling influence.

Exercise C-6 Accounting for trading securities

P1

Brooks Co. purchases various investments in trading securities at a cost of $66,000 on December 27, 2013. (This is its first and only purchase of such securities.) At December 31, 2013, these securities had a fair value of $72,000. 1. Prepare the December 31, 2013, year-end adjusting entry for the trading securities’ portfolio. 2. Explain how each account in the entry of part 1 is reported in financial statements. 3. Prepare the January 3, 2014, entry when Brooks sells a portion of its trading securities (that had origi-

nally cost $33,000) for $35,000. Check (3) Gain, $2,000

Prepare journal entries to record the following transactions involving the short-term securities investments of Duke Co., all of which occurred during year 2013. a. On March 22, purchased 1,000 shares of RIP Company stock at $10 per share plus a $80 brokerage

fee. These shares are categorized as trading securities. b. On September 1, received a $1.00 per share cash dividend on the RIP Company stock purchased in

transaction a. c. On October 8, sold 500 shares of RIP Co. stock for $15 per share, less a $50 brokerage fee.

EXERCISES

Exercise C-1 Accounting for short-term trading securities

P1 (c) Dr. Cash $7,450

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C-24 Appendix C Investments and International Operations

Exercise C-8 Transactions in short-term and long-term investments

P1 P2 P3

Prepare journal entries to record the following transactions involving both the short-term and long-term investments of Cancun Corp., all of which occurred during calendar year 2013. Use the account Short-Term Investments for any transactions that you determine are short term. a. On February 15, paid $160,000 cash to purchase American General’s 90-day short-term notes at par,

which are dated February 15 and pay 10% interest (classified as held-to-maturity). b. On March 22, bought 700 shares of Fran Industries common stock at $51 cash per share plus a $150

brokerage fee (classified as long-term available-for-sale securities). c. On May 15, received a check from American General in payment of the principal and 90 days’ interest

on the notes purchased in transaction a. d. On July 30, paid $100,000 cash to purchase MP3 Electronics’ 8% notes at par, dated July 30, 2013,

and maturing on January 30, 2014 (classified as trading securities). e. On September 1, received a $1.00 per share cash dividend on the Fran Industries common stock pur-

chased in transaction b. f. On October 8, sold 350 shares of Fran Industries common stock for $64 cash per share, less a $125

brokerage fee. g. On October 30, received a check from MP3 Electronics for three months’ interest on the notes pur-

chased in transaction d.

Exercise C-7 Adjusting available-for-sale securities to fair value

P3

On December 31, 2013, Reggit Company held the following short-term investments in its portfolio of available-for-sale securities. Reggit had no short-term investments in its prior accounting periods. Pre- pare the December 31, 2013, adjusting entry to report these investments at fair value.

Cost Fair Value

Verrizano Corporation bonds payable . . . . . . . . . . $89,600 $91,600

Preble Corporation notes payable . . . . . . . . . . . . . 70,600 62,900

Lucerne Company common stock . . . . . . . . . . . . . 86,500 83,100 Check Unrealized loss, $9,100

Exercise C-9 Fair value adjustment to available-for-sale securities

P3

On December 31, 2013, Lujack Co. held the following short-term available-for-sale securities.

Lujack had no short-term investments prior to the current period. Prepare the December 31, 2013, year-end adjusting entry to record the fair value adjustment for these securities.

Cost Fair Value

Nintendo Co. common stock . . . . . . . . . . . . . $44,450 $48,900

Atlantic bonds payable . . . . . . . . . . . . . . . . . . 49,000 47,000

Kellogg Co. notes payable . . . . . . . . . . . . . . . . 25,000 23,200

McDonald’s Corp. common stock . . . . . . . . . 46,300 44,800

Exercise C-10 Fair value adjustment to available-for-sale securities

P3

Prescrip Co. began operations in 2012. The cost and fair values for its long-term investments portfolio in available-for-sale securities are shown below. Prepare Prescrip’s December 31, 2013, adjusting entry to reflect any necessary fair value adjustment for these investments.

Cost Fair Value

December 31, 2012 . . . . . . . . . $120,483 $118,556

December 31, 2013 . . . . . . . . . 60,120 90,271

Exercise C-11 Multiyear fair value adjustments to available-for-sale securities

P3

Ticker Services began operations in 2011 and maintains long-term investments in available- for-sale securi- ties. The year-end cost and fair values for its portfolio of these investments follow. Prepare journal entries to record each year-end fair value adjustment for these securities.

Cost Fair Value

December 31, 2011 . . . . . . . . . . . . $372,000 $360,860

December 31, 2012 . . . . . . . . . . . . 428,500 455,800

December 31, 2013 . . . . . . . . . . . . 600,200 700,500

December 31, 2014 . . . . . . . . . . . . 876,900 780,200

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Appendix C Investments and International Operations C-25

Exercise C-12 Classifying investments in securities; recording fair values

C1 P2 P3 P4

Information regarding Carperk Company’s individual investments in securities during its calendar-year 2013, along with the December 31, 2013, fair values, follows. a. Investment in Brava Company bonds: $420,500 cost, $457,000 fair value. Carperk intends to hold

these bonds until they mature in 2018. b. Investment in Baybridge common stock: 29,500 shares; $362,450 cost; $391,375 fair value. Carperk

owns 32% of Baybridge’s voting stock and has a significant influence over Baybridge. c. Investment in Buffa common stock: 12,000 shares; $165,500 cost; $178,000 fair value. This invest-

ment amounts to 3% of Buffa’s outstanding shares, and Carperk’s goal with this investment is to earn dividends over the next few years.

d. Investment in Newton common stock: 3,500 shares; $90,300 cost; $88,625 fair value. Carperk’s goal with this investment is to reap an increase in fair value of the stock over the next three to five years. Newton has 30,000 common shares outstanding.

e. Investment in Farmers common stock: 16,300 shares; $100,860 cost; $111,210 fair value. This stock is marketable and is held as an investment of cash available for operations.

Required

1. Identify whether each investment should be classified as a short-term or long-term investment. For each long-term investment, indicate in which of the long-term investment classifications it should be placed.

2. Prepare a journal entry dated December 31, 2013, to record the fair value adjustment of the long-term investments in available-for-sale securities. Carperk had no long-term investments prior to year 2013. Check (2) Unrealized gain, $10,825

Exercise C-13 Securities transactions; equity method

P4

Prepare journal entries to record the following transactions and events of Kodax Company.

2013

Jan. 2 Purchased 30,000 shares of Grecco Co. common stock for $408,000 cash plus a broker’s fee of $3,000 cash. Bushtex has 90,000 shares of common stock outstanding and its policies will be significantly influenced by Kodax.

Sept. 1 Grecco declared and paid a cash dividend of $1.50 per share. Dec. 31 Grecco announced that net income for the year is $486,900.

2014

June 1 Grecco declared and paid a cash dividend of $2.10 per share. Dec. 31 Grecco announced that net income for the year is $702,750. Dec. 31 Kodax sold 10,000 shares of Grecco for $320,000 cash.

Exercise C-14 Return on total assets

A1

The following information is available from the financial statements of Regae Industries. Compute Regae’s return on total assets for 2013 and 2014. (Round returns to one-tenth of a percent.) Comment on the com- pany’s efficiency in using its assets in 2013 and 2014.

2012 2013 2014

$340,000$210,000

30,200 38,400 60,300

$770,000Total assets, December 31

Net income

Exercise C-15A

Foreign currency transactions

C3

Leigh of New York sells its products to customers in the United States and the United Kingdom. On December 16, 2013, Leigh sold merchandise on credit to Bronson Ltd. of London at a price of 17,000 pounds. The exchange rate on that day for £1 was $1.4583. On December 31, 2013, when Leigh pre- pared its financial statements, the rate was £1 for $1.4382. Bronson paid its bill in full on January 15, 2014, at which time the exchange rate was £1 for $1.4482. Leigh immediately exchanged the 17,000 pounds for U.S. dollars. Prepare Leigh’s journal entries on December 16, December 31, and January 15 (round to the nearest dollar).

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C-26 Appendix C Investments and International Operations

Exercise C-16A

Computing foreign exchange gains and losses on receivables

C3

On May 8, 2013, Jett Company (a U.S. company) made a credit sale to Lopez (a Mexican company). The terms of the sale required Lopez to pay 800,000 pesos on February 10, 2014. Jett prepares quarterly financial statements on March 31, June 30, September 30, and December 31. The exchange rates for pesos during the time the receivable is outstanding follow.

May 8, 2013 . . . . . . . . . . . . . . . . $0.1323

June 30, 2013 . . . . . . . . . . . . . . . 0.1352

September 30, 2013 . . . . . . . . . 0.1368

December 31, 2013. . . . . . . . . . 0.1335

February 10, 2014 . . . . . . . . . . . 0.1386

Compute the foreign exchange gain or loss that Jett should report on each of its quarterly income state- ments for the last three quarters of 2013 and the first quarter of 2014. Also compute the amount reported on Jett’s balance sheets at the end of each of its last three quarters of 2013.

Exercise C-17 International accounting for investments

P3

The Carrefour Group reports the following description of its financial assets available-for-sale.

Assets available for sale are . . . valued at fair value. Unrealized . . . gains or losses are recorded as shareholders’ equity until they are sold.

Note 10 to Carrefour’s 2010 financial statements reports €18 million in net unrealized losses (net of unreal- ized gains) for 2010, which is included in the fair value of its available-for-sale securities reported on the balance sheet. 1. What amount of the €18 million net unrealized losses, if any, is reported in its 2010 income state-

ment? Explain. 2. If the €18 million net unrealized losses are not reported in the income statement, in which statement

are they reported, if any? Explain.

Check (2) Dr. Fair Value Adjustment—Trading $985

PROBLEM SET A

Problem C-1A Recording transactions and fair value adjustments for trading securities

P1

Carlsville Company, which began operations in 2013, invests its idle cash in trading securities. The fol- lowing transactions are from its short-term investments in its trading securities.

2013

Jan. 20 Purchased 800 shares of Ford Motor Co. at $26 per share plus a $125 commission. Feb. 9 Purchased 2,200 shares of Lucent at $44.25 per share plus a $578 commission. Oct. 12 Purchased 750 shares of Z-Seven at $7.50 per share plus a $200 commission.

2014

Apr. 15 Sold 800 shares of Ford Motor Co. at $29 per share less a $285 commission. July 5 Sold 750 shares of Z-Seven at $10.25 per share less a $102.50 commission. July 22 Purchased 1,600 shares of Hunt Corp. at $30 per share plus a $444 commission. Aug. 19 Purchased 1,800 shares of Donna Karan at $18.25 per share plus a $290 commission.

2015

Feb. 27 Purchased 3,400 shares of HCA at $34 per share plus a $420 commission. Mar. 3 Sold 1,600 shares of Hunt at $25 per share less a $250 commission. June 21 Sold 2,200 shares of Lucent at $42 per share less a $420 commission. June 30 Purchased 1,200 shares of Black & Decker at $47.50 per share plus a $595 commission. Nov. 1 Sold 1,800 shares of Donna Karan at $18.25 per share less a $309 commission.

Required

1. Prepare journal entries to record these short-term investment activities for the years shown. (Ignore any year-end adjusting entries.)

2. On December 31, 2015, prepare the adjusting entry to record any necessary fair value adjustment for the portfolio of trading securities when HCA’s share price is $36 and Black & Decker’s share price is $43.50. (Assume the Fair Value Adjustment—Trading account had an unadjusted balance of zero.)

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Appendix C Investments and International Operations C-27

Problem C-2A Recording, adjusting, and reporting short-term available- for-sale securities

P3

Rose Company had no short-term investments prior to year 2013. It had the following transactions involv- ing short-term investments in available-for-sale securities during 2013.

Apr. 16 Purchased 4,000 shares of Gem Co. stock at $24.25 per share plus a $180 brokerage fee. May 1 Paid $100,000 to buy 90-day U.S. Treasury bills (debt securities): $100,000 principal amount,

6% interest, securities dated May 1. July 7 Purchased 2,000 shares of PepsiCo stock at $49.25 per share plus a $175 brokerage fee. 20 Purchased 1,000 shares of Xerox stock at $16.75 per share plus a $205 brokerage fee. Aug. 3 Received a check for principal and accrued interest on the U.S. Treasury bills that matured on

July 29. 15 Received an $0.85 per share cash dividend on the Gem Co. stock. 28 Sold 2,000 shares of Gem Co. stock at $30 per share less a $225 brokerage fee. Oct. 1 Received a $1.90 per share cash dividend on the PepsiCo shares. Dec. 15 Received a $1.05 per share cash dividend on the remaining Gem Co. shares. 31 Received a $1.30 per share cash dividend on the PepsiCo shares.

Required

1. Prepare journal entries to record the preceding transactions and events. 2. Prepare a table to compare the year-end cost and fair values of Rose’s short-term investments in avail-

able-for-sale securities. The year-end fair values per share are: Gem Co., $26.50; PepsiCo, $46.50; and Xerox, $13.75.

3. Prepare an adjusting entry, if necessary, to record the year-end fair value adjustment for the portfolio of short-term investments in available-for-sale securities.

Analysis Component

4. Explain the balance sheet presentation of the fair value adjustment for Rose’s short-term investments. 5. How do these short-term investments affect Rose’s (a) income statement for year 2013 and (b) the

equity section of its balance sheet at year-end 2013?

Check (2) Cost 5 $164,220

(3) Dr. Unrealized Loss— Equity $4,470

Problem C-3A Recording, adjusting, and reporting long-term available-for-sale securities

P3

Grass Security, which began operations in 2013, invests in long-term available-for-sale securities. Following is a series of transactions and events determining its long-term investment activity.

2013

Jan. 20 Purchased 1,000 shares of Johnson & Johnson at $20.50 per share plus a $240 commission. Feb. 9 Purchased 1,200 shares of Sony at $46.20 per share plus a $225 commission. June 12 Purchased 1,500 shares of Mattel at $27.00 per share plus an $195 commission. Dec. 31 Per share fair values for stocks in the portfolio are Johnson & Johnson, $21.50; Mattel, $30.90;

Sony, $38.

2014

Apr. 15 Sold 1,000 shares of Johnson & Johnson at $23.50 per share less a $525 commission. July 5 Sold 1,500 shares of Mattel at $23.90 per share less a $235 commission. July 22 Purchased 600 shares of Sara Lee at $22.50 per share plus a $480 commission. Aug. 19 Purchased 900 shares of Eastman Kodak at $17 per share plus a $198 commission. Dec. 31 Per share fair values for stocks in the portfolio are: Kodak, $19.25; Sara Lee, $20.00; Sony,

$35.00.

2015

Feb. 27 Purchased 2,400 shares of Microsoft at $67.00 per share plus a $525 commission. June 21 Sold 1,200 shares of Sony at $48.00 per share less a $880 commission. June 30 Purchased 1,400 shares of Black & Decker at $36.00 per share plus a $435 commission. Aug. 3 Sold 600 shares of Sara Lee at $16.25 per share less a $435 commission. Nov. 1 Sold 900 shares of Eastman Kodak at $22.75 per share less a $625 commission. Dec. 31 Per share fair values for stocks in the portfolio are: Black & Decker, $39.00; Microsoft, $69.00.

Required

1. Prepare journal entries to record these transactions and events and any year-end fair value adjustments to the portfolio of long-term available-for-sale securities.

[continued on next page]

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C-28 Appendix C Investments and International Operations

2. Prepare a table that summarizes the (a) total cost, (b) total fair value adjustment, and (c) total fair value of the portfolio of long-term available-for-sale securities at each year-end.

3. Prepare a table that summarizes (a) the realized gains and losses and (b) the unrealized gains or losses for the portfolio of long-term available-for-sale securities at each year-end.

Check (2b) Fair Value Adjustment bal.: 12/31/13, $(3,650); 12/31/14; $(13,818)

(3b) Unrealized Gain at 12/31/2015, $8,040

Problem C-4A Long-term investment transactions; unrealized and realized gains and losses

C2 P3 P4

Stoll Co.’s long-term available-for-sale portfolio at December 31, 2012, consists of the following.

Available-for-Sale Securities Cost Fair Value

40,000 shares of Company A common stock . . . . . . . . . $535,300 $490,000

7,000 shares of Company B common stock . . . . . . . . . . 159,380 154,000

17,500 shares of Company C common stock . . . . . . . . . 662,750 640,938

Stoll enters into the following long-term investment transactions during year 2013.

Jan. 29 Sold 3,500 shares of Company B common stock for $79,188 less a brokerage fee of $1,500. Apr. 17 Purchased 10,000 shares of Company W common stock for $197,500 plus a brokerage fee of

$2,400. The shares represent a 30% ownership in Company W. July 6 Purchased 4,500 shares of Company X common stock for $126,562 plus a brokerage fee of

$1,750. The shares represent a 10% ownership in Company X. Aug. 22 Purchased 50,000 shares of Company Y common stock for $375,000 plus a brokerage fee of

$1,200. The shares represent a 51% ownership in Company Y. Nov. 13 Purchased 8,500 shares of Company Z common stock for $267,900 plus a brokerage fee of

$2,450. The shares represent a 5% ownership in Company Z. Dec. 9 Sold 40,000 shares of Company A common stock for $515,000 less a brokerage fee of $4,100.

The fair values of its investments at December 31, 2013, are: B, $81,375; C, $610,312; W, $191,250; X, $118,125; Y, $531,250; and Z, $278,800.

Required

1. Determine the amount Stoll should report on its December 31, 2013, balance sheet for its long-term investments in available-for-sale securities.

2. Prepare any necessary December 31, 2013, adjusting entry to record the fair value adjustment for the long-term investments in available-for-sale securities.

3. What amount of gains or losses on transactions relating to long-term investments in available-for-sale securities should Stoll report on its December 31, 2013, income statement?

Check (2) Cr. Unrealized Loss— Equity, $20,002

Problem C-5A Accounting for long-term investments in securities; with and without significant influence

P3 P4

Selk Steel Co., which began operations on January 4, 2013, had the following subsequent transactions and events in its long-term investments.

2013

Jan. 5 Selk purchased 60,000 shares (20% of total) of Kildaire’s common stock for $1,560,000. Oct. 23 Kildaire declared and paid a cash dividend of $3.20 per share. Dec. 31 Kildaire’s net income for 2013 is $1,164,000, and the fair value of its stock at December 31 is

$30.00 per share.

2014

Oct. 15 Kildaire declared and paid a cash dividend of $2.60 per share. Dec. 31 Kildaire’s net income for 2014 is $1,476,000, and the fair value of its stock at December 31 is

$32.00 per share.

2015

Jan. 2 Selk sold all of its investment in Kildaire for $1,894,000 cash.

Part 1 Assume that Selk has a significant influence over Kildaire with its 20% share of stock.

Required

1. Prepare journal entries to record these transactions and events for Selk. 2. Compute the carrying (book) value per share of Selk’s investment in Kildaire common stock as

reflected in the investment account on January 1, 2015. 3. Compute the net increase or decrease in Selk’s equity from January 5, 2013, through January 2, 2015,

resulting from its investment in Kildaire.

Check (2) Carrying value per share, $29

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Appendix C Investments and International Operations C-29

Part 2 Assume that although Selk owns 20% of Kildaire’s outstanding stock, circumstances indicate that it does not have a significant influence over the investee and that it is classified as an available-for-sale security investment.

Required

1. Prepare journal entries to record the preceding transactions and events for Selk. Also prepare an entry dated January 2, 2015, to remove any balance related to the fair value adjustment.

2. Compute the cost per share of Selk’s investment in Kildaire common stock as reflected in the investment account on January 1, 2015.

3. Compute the net increase or decrease in Selk’s equity from January 5, 2013, through January 2, 2015, resulting from its investment in Kildaire.

(1) 1/2/2015 Dr. Unrealized Gain—Equity $360,000

(3) Net increase, $682,000

Problem C-6AA

Foreign currency transactions

C3

Doering Company, a U.S. corporation with customers in several foreign countries, had the following selected transactions for 2013 and 2014.

2013

Apr. 8 Sold merchandise to Salinas & Sons of Mexico for $5,938 cash. The exchange rate for pesos is $0.1043 on this day.

July 21 Sold merchandise on credit to Sumito Corp. in Japan. The price of 1.5 million yen is to be paid 120 days from the date of sale. The exchange rate for yen is $0.0094 on this day.

Oct. 14 Sold merchandise for 19,000 pounds to Smithers Ltd. of Great Britain, payment in full to be received in 90 days. The exchange rate for pounds is $1.4566 on this day.

Nov. 18 Received Sumito’s payment in yen for its July 21 purchase and immediately exchanged the yen for dollars. The exchange rate for yen is $0.0092 on this day.

Dec. 20 Sold merchandise for 17,000 ringgits to Hamid Albar of Malaysia, payment in full to be received in 30 days. On this day, the exchange rate for ringgits is $0.4501.

Dec. 31 Recorded adjusting entries to recognize exchange gains or losses on Doering’s annual financial statements. Rates for exchanging foreign currencies on this day follow.

Pesos (Mexico) . . . . . . . . . . $0.1055

Yen (Japan) . . . . . . . . . . . . . . 0.0093

Pounds (Britain) . . . . . . . . . 1.4620

Ringgits (Malaysia) . . . . . . . . 0.4456

Check (2) 2013 total foreign exchange loss, $274

2014

Jan. 12 Received full payment in pounds from Smithers for the October 14 sale and immediately exchanged the pounds for dollars. The exchange rate for pounds is $1.4699 on this day.

Jan. 19 Received Hamid Albar’s full payment in ringgits for the December 20 sale and immediately exchanged the ringgits for dollars. The exchange rate for ringgits is $0.4420 on this day.

Required

1. Prepare journal entries for the Doering transactions and adjusting entries (round amounts to the nearest dollar).

2. Compute the foreign exchange gain or loss to be reported on Doering’s 2013 income statement.

Analysis Component

3. What actions might Doering consider to reduce its risk of foreign exchange gains or losses?

PROBLEM SET B

Problem C-1B Recording transactions and fair value adjustments for trading securities P1

Harris Company, which began operations in 2013, invests its idle cash in trading securities. The following transactions relate to its short-term investments in its trading securities.

2013

Mar. 10 Purchased 2,400 shares of AOL at $59.15 per share plus a $1,545 commission. May 7 Purchased 5,000 shares of MTV at $36.25 per share plus a $2,855 commission. Sept. 1 Purchased 1,200 shares of UPS at $57.25 per share plus a $1,250 commission.

2014

Apr. 26 Sold 5,000 shares of MTV at $34.50 per share less a $2,050 commission. Apr. 27 Sold 1,200 shares of UPS at $60.50 per share less an $1,788 commission.

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C-30 Appendix C Investments and International Operations

June 2 Purchased 3,600 shares of SPW at $172 per share plus a $3,250 commission. June 14 Purchased 900 shares of Walmart at $50.25 per share plus a $1,082 commission.

2015

Jan. 28 Purchased 2,000 shares of PepsiCo at $43 per share plus a $2,890 commission. Jan. 31 Sold 3,600 shares of SPW at $168 per share less a $2,040 commission. Aug. 22 Sold 2,400 shares of AOL at $56.75 per share less a $2,480 commission. Sept. 3 Purchased 1,500 shares of Vodaphone at $40.50 per share plus an $1,680 commission. Oct. 9 Sold 900 shares of Walmart at $53.75 per share less a $1,220 commission.

Required

1. Prepare journal entries to record these short-term investment activities for the years shown. (Ignore any year-end adjusting entries.)

2. On December 31, 2015, prepare the adjusting entry to record any necessary fair value adjustment for the portfolio of trading securities when PepsiCo’s share price is $41 and Vodaphone’s share price is $37. (Assume the Fair Value Adjustment—Trading account had an unadjusted balance of zero.)

Check (2) Cr. Fair Value Adjustment—Trading $13,820

Problem C-2B Recording, adjusting, and reporting short-term available- for-sale securities

P3

Slip Systems had no short-term investments prior to 2013. It had the following transactions involving short-term investments in available-for-sale securities during 2013.

Feb. 6 Purchased 3,400 shares of Nokia stock at $41.25 per share plus a $3,000 brokerage fee. 15 Paid $20,000 to buy six-month U.S. Treasury bills (debt securities): $20,000 principal amount,

6% interest, securities dated February 15. Apr. 7 Purchased 1,200 shares of Dell Co. stock at $39.50 per share plus a $1,255 brokerage fee. June 2 Purchased 2,500 shares of Merck stock at $72.50 per share plus a $2,890 brokerage fee. 30 Received a $0.19 per share cash dividend on the Nokia shares. Aug. 11 Sold 850 shares of Nokia stock at $46 per share less a $1,050 brokerage fee. 16 Received a check for principal and accrued interest on the U.S. Treasury bills purchased

February 15. 24 Received a $0.10 per share cash dividend on the Dell shares. Nov. 9 Received a $0.20 per share cash dividend on the remaining Nokia shares. Dec. 18 Received a $0.15 per share cash dividend on the Dell shares.

Required

1. Prepare journal entries to record the preceding transactions and events. 2. Prepare a table to compare the year-end cost and fair values of the short-term investments in

available-for-sale securities. The year-end fair values per share are: Nokia, $40.25; Dell, $40.50; and Merck, $59.

3. Prepare an adjusting entry, if necessary, to record the year-end fair value adjustment for the portfolio of short-term investments in available-for-sale securities.

Analysis Component

4. Explain the balance sheet presentation of the fair value adjustment to Slip’s short-term investments. 5. How do these short-term investments affect (a) its income statement for year 2013 and (b) the equity

section of its balance sheet at the 2013 year-end?

Check (2) Cost 5 $340,232

(3) Dr. Unrealized Loss— Equity, $41,494

Problem C-3B Recording, adjusting, and reporting long-term available- for-sale securities

P3

Paris Enterprises, which began operations in 2013, invests in long-term available-for-sale securities. Following is a series of transactions and events involving its long-term investment activity.

2013

Mar. 10 Purchased 1,200 shares of Apple at $25.50 per share plus $800 commission. Apr. 7 Purchased 2,500 shares of Ford at $22.50 per share plus $1,033 commission. Sept. 1 Purchased 600 shares of Polaroid at $47.00 per share plus $890 commission. Dec. 31 Per share fair values for stocks in the portfolio are: Apple, $27.50; Ford, $21.00; Polaroid, $49.00.

2014

Apr. 26 Sold 2,500 shares of Ford at $20.50 per share less a $1,207 commission. June 2 Purchased 1,800 shares of Duracell at $19.25 per share plus a $1,050 commission. June 14 Purchased 1,200 shares of Sears at $21 per share plus a $280 commission. Nov. 27 Sold 600 shares of Polaroid at $51 per share less a $845 commission. Dec. 31 Per share fair values for stocks in the portfolio are: Apple, $29.00; Duracell, $18.00; Sears, $23.00.

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Appendix C Investments and International Operations C-31

2015

Jan. 28 Purchased 1,000 shares of Coca-Cola Co. at $40 per share plus a $1,480 commission. Aug. 22 Sold 1,200 shares of Apple at $21.50 per share less a $1,850 commission. Sept. 3 Purchased 3,000 shares of Motorola at $28 per share plus a $780 commission. Oct. 9 Sold 1,200 shares of Sears at $24.00 per share less a $599 commission. Oct. 31 Sold 1,800 shares of Duracell at $15.00 per share less a $898 commission. Dec. 31 Per share fair values for stocks in the portfolio are: Coca-Cola, $48.00; Motorola, $24.00.

Required

1. Prepare journal entries to record these transactions and events and any year-end fair value adjustments to the portfolio of long-term available-for-sale securities.

2. Prepare a table that summarizes the (a) total cost, (b) total fair value adjustment, and (c) total fair value for the portfolio of long-term available-for-sale securities at each year-end.

3. Prepare a table that summarizes (a) the realized gains and losses and (b) the unrealized gains or losses for the portfolio of long-term available-for-sale securities at each year-end.

Check (2b) Fair Value Adjustment bal.: 12/31/13, ($2,873); 12/31/14, $2,220

(3b) Unrealized Loss at 12/31/2015, $6,260

Problem C-4B Long-term investment transactions; unrealized and realized gains and losses

C2 P3 P4

Troyer’s long-term available-for-sale portfolio at December 31, 2012, consists of the following.

Available-for-Sale Securities Cost Fair Value

27,500 shares of Company R common stock . . . . . . . . . $559,125 $599,063

8,500 shares of Company S common stock . . . . . . . . . . . 308,380 293,250

11,000 shares of Company T common stock . . . . . . . . . . 147,295 151,800

Troyer enters into the following long-term investment transactions during year 2013.

Jan. 13 Sold 2,125 shares of Company S stock for $72,250 less a brokerage fee of $1,195. Mar. 24 Purchased 15,500 shares of Company U common stock for $282,875 plus a brokerage fee of

$1,980. The shares represent a 62% ownership interest in Company U. Apr. 5 Purchased 42,500 shares of Company V common stock for $133,875 plus a brokerage fee of

$1,125. The shares represent a 10% ownership in Company V. Sept. 2 Sold 11,000 shares of Company T common stock for $156,750 less a brokerage fee of $2,700. Sept. 27 Purchased 2,500 shares of Company W common stock for $50,500 plus a brokerage fee of

$1,050. The shares represent a 25% ownership interest in Company W. Oct. 30 Purchased 5,000 shares of Company X common stock for $48,750 plus a brokerage fee of

$1,170. The shares represent a 13% ownership interest in Company X.

The fair values of its investments at December 31, 2013, are: R, $568,125; S, $210,375; U, $272,800; V, $134,938; W, $54,689; and X, $45,625.

Required

1. Determine the amount Troyer should report on its December 31, 2013, balance sheet for its long-term investments in available-for-sale securities.

2. Prepare any necessary December 31, 2013, adjusting entry to record the fair value adjustment of the long-term investments in available-for-sale securities.

3. What amount of gains or losses on transactions relating to long-term investments in available-for-sale securities should Troyer report on its December 31, 2013, income statement?

Check (2) Dr. Unrealized Loss— Equity, $16,267; Cr. Fair Value Adjustment—AFS (LT), $45,580

Problem C-5B Accounting for long-term investments in securities; with and without significant influence

P3 P4

Brinkley Company, which began operations on January 3, 2013, had the following subsequent transac- tions and events in its long-term investments.

2013

Jan. 5 Brinkley purchased 20,000 shares (25% of total) of Bloch’s common stock for $200,500. Aug. 1 Bloch declared and paid a cash dividend of $1.05 per share. Dec. 31 Bloch’s net income for 2013 is $82,000, and the fair value of its stock is $11.90 per share.

2014

Aug. 1 Bloch declared and paid a cash dividend of $1.35 per share. Dec. 31 Bloch’s net income for 2014 is $78,000, and the fair value of its stock is $13.65 per share.

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C-32 Appendix C Investments and International Operations

2015

Jan. 8 Brinkley sold all of its investment in Bloch for $375,000 cash.

Part 1 Assume that Brinkley has a significant influence over Bloch with its 25% share.

Required

1. Prepare journal entries to record these transactions and events for Brinkley. 2. Compute the carrying (book) value per share of Brinkley’s investment in Bloch common stock as

reflected in the investment account on January 7, 2015. 3. Compute the net increase or decrease in Brinkley’s equity from January 5, 2013, through January 8,

2015, resulting from its investment in Bloch.

Part 2 Assume that although Brinkley owns 25% of Bloch’s outstanding stock, circumstances indicate that it does not have a significant influence over the investee and that it is classified as an available-for-sale security investment.

Required

1. Prepare journal entries to record these transactions and events for Brinkley. Also prepare an entry dated January 8, 2015, to remove any balance related to the fair value adjustment.

2. Compute the cost per share of Brinkley’s investment in Bloch common stock as reflected in the investment account on January 7, 2015.

3. Compute the net increase or decrease in Brinkley’s equity from January 5, 2013, through January 8, 2015, resulting from its investment in Bloch.

Check (2) Carrying value per share, $9.63

(1) 1/8/2015 Dr. Unrealized Gain—Equity $72,500

(3) Net increase, $222,500

Problem C-6BA

Foreign currency transactions

C3

Datamix, a U.S. corporation with customers in several foreign countries, had the following selected trans- actions for 2013 and 2014.

2013

May 26 Sold merchandise for 6.5 million yen to Fuji Company of Japan, payment in full to be received in 60 days. On this day, the exchange rate for yen is $0.0093.

June 1 Sold merchandise to Fordham Ltd. of Great Britain for $64,800 cash. The exchange rate for pounds is $1.4498 on this day.

July 25 Received Fuji’s payment in yen for its May 26 purchase and immediately exchanged the yen for dollars. The exchange rate for yen is $0.0092 on this day.

Oct. 15 Sold merchandise on credit to Martinez Brothers of Mexico. The price of 378,000 pesos is to be paid 90 days from the date of sale. On this day, the exchange rate for pesos is $0.1020.

Dec. 6 Sold merchandise for 250,000 yuans to Chi-Ying Company of China, payment in full to be received in 30 days. The exchange rate for yuans is $0.1439 on this day.

Dec. 31 Recorded adjusting entries to recognize exchange gains or losses on Datamix’s annual financial statements. Rates of exchanging foreign currencies on this day follow.

Yen ( Japan) . . . . . . . . . . . . $0.0094

Pounds (Britain) . . . . . . . . 1.4580

Pesos (Mexico) . . . . . . . . . 0.1060

Yuans (China) . . . . . . . . . . 0.1450

2014

Jan. 5 Received Chi-Ying’s full payment in yuans for the December 6 sale and immediately exchanged the yuans for dollars. The exchange rate for yuans is $0.1580 on this day.

Jan. 13 Received full payment in pesos from Martinez for the October 15 sale and immediately exchanged the pesos for dollars. The exchange rate for pesos is $0.1039 on this day.

Required

1. Prepare journal entries for the Datamix transactions and adjusting entries. 2. Compute the foreign exchange gain or loss to be reported on Datamix’s 2013 income statement.

Analysis Component

3. What actions might Datamix consider to reduce its risk of foreign exchange gains or losses?

Check (2) 2013 total foreign exchange gain, $1,137

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Appendix C Investments and International Operations C-33

SERIAL PROBLEM Success Systems

P1

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP C While reviewing the March 31, 2014, balance sheet of Success Systems, Adria Lopez notes that the business has built a large cash balance of $77,845. Its most recent bank money market statement shows that the funds are earning an annualized return of 0.75%. Adria Lopez decides to make several in- vestments with the desire to earn a higher return on the idle cash balance. Accordingly, in April 2014, Success Systems makes the following investments in trading securities:

April 16 Purchases 400 shares of Johnson & Johnson stock at $50 per share plus $300 commission. April 30 Purchases 200 shares of Starbucks Corporation at $22 per share plus $250 commission.

On June 30, 2014, the per share market price (fair value) of the Johnson & Johnson shares is $55 and the Starbucks shares is $19.

Required

1. Prepare journal entries to record the April purchases of trading securities by Success Systems. 2. On June 30, 2014, prepare the adjusting entry to record any necessary fair value adjustment to its port-

folio of trading securities.

Beyond the Numbers

BTN C-1 Refer to Polaris’ financial statements in Appendix A to answer the following. 1. Are Polaris’ financial statements consolidated? How can you tell? 2. What is Polaris’ comprehensive income for the year ended December 31, 2011? 3. Does Polaris have any foreign operations? How can you tell? 4. Compute Polaris’ return on total assets for the year ended December 31, 2011.

Fast Forward

5. Access Polaris’ annual report for a fiscal year ending after December 31, 2011, from either its Website (Polaris.com) or the SEC’s database (www.sec.gov). Recompute Polaris’ return on total assets for the years subsequent to December 31, 2011.

REPORTING IN ACTION C3 A1

BTN C-2 Key figures for Polaris and Arctic Cat follow. COMPARATIVE ANALYSIS A1

Required

1. Compute return on total assets for Polaris and Arctic Cat for the two most recent years. 2. Separate the return on total assets computed in part 1 into its components for both companies and both

years according to the formula in Exhibit C.9. 3. Which company has the highest total return on assets? The highest profit margin? The highest total

asset turnover? What does this comparative analysis reveal? (Assume an industry average of 10.0% for return on assets.)

Polaris Arctic Cat

Current 1 Year 2 Years Current 1 Year 2 Years ($ thousands) Year Prior Prior Year Prior Prior

Net income . . . . . . . . . $ 227,575 $ 147,138 $ 101,017 $ 13,007 $ 1,875 ($9,508)

Net sales . . . . . . . . . . . 2,656,949 1,991,139 1,565,887 464,651 450,728 563,613

Total assets . . . . . . . . . 1,228,024 1,061,647 763,653 272,906 246,084 251,165

ETHICS CHALLENGE P2 P3

BTN C-3 Kasey Hartman is the controller for Wholemart Company, which has numerous long-term investments in debt securities. Wholemart’s investments are mainly in 5-year bonds. Hartman is preparing its year-end financial statements. In accounting for long-term debt securities, she knows that each long- term investment must be designated as a held-to-maturity or an available-for-sale security. Interest rates

Polaris

Polaris Arctic Cat

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C-34 Appendix C Investments and International Operations

rose sharply this past year causing the portfolio’s fair value to substantially decline. The company does not intend to hold the bonds for the entire 5 years. Hartman also earns a bonus each year, which is computed as a percent of net income.

Required

1. Will Hartman’s bonus depend in any way on the classification of the debt securities? Explain. 2. What criteria must Hartman use to classify the securities as held-to-maturity or available-for-sale? 3. Is there likely any company oversight of Hartman’s classification of the securities? Explain.

BTN C-4 Assume that you are Jolee Company’s accountant. Company owner Mary Jolee has reviewed the 2013 financial statements you prepared and questions the $6,000 loss reported on the sale of its investment in Kemper Co. common stock. Jolee acquired 50,000 shares of Kemper’s common stock on December 31, 2011, at a cost of $500,000. This stock purchase represented a 40% interest in Kemper. The 2012 income statement reported that earnings from all investments were $126,000. On January 3, 2013, Jolee Company sold the Kemper stock for $575,000. Kemper did not pay any dividends during 2012 but reported a net income of $202,500 for that year. Mary Jolee believes that because the Kemper stock purchase price was $500,000 and was sold for $575,000, the 2013 income statement should report a $75,000 gain on the sale.

Required

Draft a one-half page memorandum to Mary Jolee explaining why the $6,000 loss on sale of Kemper stock is correctly reported.

COMMUNICATING IN PRACTICE P4

BTN C-5 Access the July 28, 2011, 10-K filing (for year-end June 30, 2011) of Microsoft (MSFT) at www.sec.gov. Review its note 4, “Investments.”

Required

1. How does the “cost-basis” total amount for its investments as of June 30, 2011, compare to the prior year-end amount?

2. Identify at least eight types of short-term investments held by Microsoft as of June 30, 2011. 3. What were Microsoft’s unrealized gains and its unrealized losses from its investments for 2011? 4. Was the cost or fair value (“recorded basis”) of the investments higher as of June 30, 2011?

TAKING IT TO THE NET C1

BTN C-6 Each team member is to become an expert on a specific classification of long-term invest- ments. This expertise will be used to facilitate other teammates’ understanding of the concepts and proce- dures relevent to the classification chosen. 1. Each team member must select an area for expertise by choosing one of the following classifications

of long-term investments. a. Held-to-maturity debt securities b. Available-for-sale debt and equity securities c. Equity securities with significant influence d. Equity securities with controlling influence 2. Learning teams are to disburse and expert teams are to be formed. Expert teams are made up of those

who select the same area of expertise. The instructor will identify the location where each expert team will meet.

3. Expert teams will collaborate to develop a presentation based on the following requirements. Students must write the presentation in a format they can show to their learning teams in part (4).

Requirements for Expert Presentation

a. Write a transaction for the acquisition of this type of investment security. The transaction description is to include all necessary data to reflect the chosen classification.

b. Prepare the journal entry to record the acquisition. [Note: The expert team on equity securities with controlling influence will substitute requirements

(d ) and (e) with a discussion of the reporting of these investments.]

TEAMWORK IN ACTION C1 C2 P1 P2 P3 P4

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Appendix C Investments and International Operations C-35

c. Identify information necessary to complete the end-of-period adjustment for this investment. d. Assuming that this is the only investment owned, prepare any necessary year-end entries. e. Present the relevant balance sheet section(s). 4. Re-form learning teams. In rotation, experts are to present to their teams the presentations they

developed in part 3. Experts are to encourage and respond to questions.

ENTREPRENEURIAL DECISION C3

BTN C-7A Refer to the opening feature in this appendix about Catherine and David Cook and their com- pany, myYearbook (now rebranded as MeetMe). Assume that they must acquire the Japanese rights to certain games and social applications that will then be produced for presentation on MeetMe’s U.S. site. Assume MeetMe acquires those rights on January 1, 2013, from a Japanese distributor and agrees to pay 12,000,000 yen per year for those rights. Quarterly payments are due March 31, June 30, September 30, and December 31 each year. On January 1, 2013, the yen is worth $0.00891.

Required

1. Prepare the journal entry to record the Internet rights purchased on January 1, 2013. 2. Prepare the journal entries to record the payments on March 31, June 30, September 30, and December 31,

2013. The value of the yen on those dates follows.

March 31 . . . . . . . . . . . . $0.00893

June 30 . . . . . . . . . . . . . 0.00901

September 30 . . . . . . . . 0.00902

December 31 . . . . . . . . 0.00897

3. How can MeetMe protect itself from unanticipated gains and losses from currency translation if all of the payments are specified to be paid in yen?

BTN C-8A Assume that you are planning a spring break trip to Europe. Identify three locations where you can find exchange rates for the dollar relative to the Euro or other currencies.

HITTING THE ROAD C3

Piaggio (Euro thousands) Polaris Arctic Cat

Current One Year Two Years Current Prior Current Prior Key Figure Year Prior Prior Year Year Year Year

Net income . . . . . . . . . . . . . . € 47,053 € 42,811 € 46,031 — — — —

Net sales . . . . . . . . . . . . . . . . 1,516,463 1,485,351 1,486,882 — — — —

Total assets . . . . . . . . . . . . . . 1,520,184 1,545,722 1,564,820 — — — —

Profit margin . . . . . . . . . . . . . ? ? — 8.6% 7.4% 2.8% 0.416%

Total asset turnover . . . . . . . ? ? — 2.31 2.18 1.79 1.81

BTN C-9 Piaggio, Polaris, and Arctic Cat are competitors in the global marketplace. Following are selected data from each company.

GLOBAL DECISION A1

Required

1. Compute Piaggio’s return on total assets, and its components of profit margin and total asset turnover, for the most recent two years using the data provided.

2. Which of these three companies has the highest return on total assets? Highest profit margin? Highest total asset turnover? Interpret these results for the (a) current year and (b) prior year.

1. d; $30,000 3 5% 3 5y12 5 $625 2. a; Unrealized gain 5 $84,500 2 $83,000 5 $1,500 3. b; $50,000 3 35% 5 $17,500

4. e; $300,000y$2,000,000 5 15% 5. b; Profit margin 5 $80,000y$600,000 5 13.3%

Total asset turnover 5 $600,000y$400,000 5 1.5

ANSWERS TO MULTIPLE CHOICE QUIZ

Polaris Arctic Cat

PIAGGIO

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Accounting for Partnerships

D-1

Appendix

Learning Objectives

CONCEPTUAL

C1 Identify characteristics of partnerships and similar organizations. (p. D-2)

ANALYTICAL

A1 Compute partner return on equity and use it to evaluate partnership performance. (p. D-14)

PROCEDURAL

P1 Prepare entries for partnership formation. (p. D-5) P2 Allocate and record income and loss among partners. (p. D-5) P3 Account for the admission and withdrawal of partners. (p. D-8) P4 Prepare entries for partnership liquidation. (p. D-11)

D D A Look at This Appendix

This appendix explains the partnership form of organization. Important partnership characteristics are described along with the accounting concepts and procedures for its most fundamental transactions.

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Appendix Preview

The three basic types of business organizations are proprietorships, partnerships, and corporations. Partnerships are similar to proprietor- ships, except they have more than one owner. This appendix explains partnerships and looks at several variations of them such as limited

partnerships, limited liability partnerships, S corporations, and limited liability companies. Understanding the advantages and disadvan- tages of the partnership form of business organization is important for making informed business decisions.

Accounting for Partnerships

Basic Partnership Accounting

• Organizing a partnership

• Dividing income or loss

• Partnership financial statements

Partnership Organization

• Characteristics • Organizations with

partnership characteristics

• Choice of business form

Partner Admission and Withdrawal

• Admission of partner • Withdrawal of partner • Death of partner

Partnership Liquidation

• No capital deficiency • Capital deficiency

A partnership is an unincorporated association of two or more people to pursue a business for profit as co-owners. Many businesses are organized as partnerships. They are especially com- mon in small retail and service businesses. Many professional practitioners, including physi- cians, lawyers, investors, and accountants, also organize their practices as partnerships.

Characteristics of Partnerships Partnerships are an important type of organization because they offer certain advantages with their unique characteristics. We describe these characteristics in this section.

Voluntary Association A partnership is a voluntary association between partners. Join- ing a partnership increases the risk to one’s personal financial position. Some courts have ruled that partnerships are created by the actions of individuals even when there is no express agree- ment to form one. Omar Soliman and Nick Friedman are partners who voluntarily created the company College Hunks Hauling Junk.

Partnership Agreement Forming a partnership requires that two or more legally com- petent people (who are of age and of sound mental capacity) agree to be partners. Their agree- ment becomes a partnership contract, also called articles of copartnership. Although it should be in writing, the contract is binding even if it is only expressed verbally. Partnership agree- ments normally include details of the partners’ (1) names and contributions, (2) rights and duties, (3) sharing of income and losses, (4) withdrawal arrangement, (5) dispute procedures, (6) admission and withdrawal of partners, and (7) rights and duties in the event a partner dies.

Limited Life The life of a partnership is limited. Death, bankruptcy, or any event taking away the ability of a partner to enter into or fulfill a contract ends a partnership. Any one of the partners can also terminate a partnership at will.

Taxation A partnership is not subject to taxes on its income. The income or loss of a part- nership is allocated to the partners according to the partnership agreement, and it is included in determining the taxable income for each partner’s tax return. Partnership income or loss is allocated each year whether or not cash is distributed to partners.

Mutual Agency Mutual agency implies that each partner is a fully authorized agent of the partnership. As its agent, a partner can commit or bind the partnership to any contract within the scope of the partnership business. For instance, a partner in a merchandising business can sign contracts binding the partnership to buy merchandise, lease a store building, borrow money, or hire

PARTNERSHIP FORM OF ORGANIZATION

C1 Identify characteristics of partnerships and similar organizations.

Point: When a new partner is admitted, all parties usually must agree to the admission.

Point: The end of a partnership is referred to as its dissolution.

Point: Partners are taxed on their share of partnership income, not on their withdrawals. Partners receive a “K-1” form each year showing their share of income they must report on their personal tax return.

D-2

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Appendix D Accounting for Partnerships D-3

employees. These activities are all within the scope of a merchandising firm. A partner in a law firm, acting alone, however, cannot bind the other partners to a contract to buy snowboards for resale or rent an apartment for parties. These actions are outside the normal scope of a law firm’s business. Partners also can agree to limit the power of any one or more of the partners to negotiate contracts for the partnership. This agreement is binding on the partners and on outsiders who know it exists. It is not binding on outsiders who do not know it exists. Outsiders unaware of the agree- ment have the right to assume each partner has normal agency powers for the partnership. Mutual agency exposes partners to the risk of unwise actions by any one partner.

Unlimited Liability Unlimited liability implies that each partner can be called on to pay a partnership’s debts. When a partnership cannot pay its debts, creditors usually can apply their claims to partners’ personal assets. If a partner does not have enough assets to meet his or her share of the partnership debt, the creditors can apply their claims to the assets of the other part- ners. A partnership in which all partners have mutual agency and unlimited liability is called a general partnership. Mutual agency and unlimited liability are two main reasons that most general partnerships have only a few members.

Co-Ownership of Property Partnership assets are owned jointly by all partners. Any investment by a partner becomes the joint property of all partners. Partners have a claim on partnership assets based on their capital account and the partnership contract.

Organizations with Partnership Characteristics Organizations exist that combine certain characteristics of partnerships with other forms of organizations. We discuss several of these forms in this section.

Limited Partnerships Some individuals who want to invest in a partnership are unwilling to accept the risk of unlimited liability. Their needs can be met with a limited partnership. This type of organization is identified in its name with the words “Limited Partnership” or “Ltd.” or “LP.” A limited partnership has two classes of partners, general and limited. At least one partner must be a general partner, who assumes management duties and unlimited liability for the debts of the partnership. The limited partners have no personal liability beyond the amounts they invest in the partnership. Limited partners have no active role except as specified in the partnership agreement. A limited partnership agreement often specifies unique procedures for allocating income and losses between general and limited partners. The accounting procedures are similar for both limited and general partnerships.

Limited Liability Partnerships Most states allow individuals to form a limited liability partnership. This is identified in its name with the words “Limited Liability Partnership” or by “LLP.” This type of partnership is designed to protect innocent partners from malpractice or negligence claims resulting from the acts of another partner. When a partner provides service resulting in a malpractice claim, that partner has personal liability for the claim. The remaining partners who were not responsible for the actions resulting in the claim are not personally liable for it. However, most states hold all partners personally liable for other partnership debts. Accounting for a limited liability partnership is the same as for a general partnership.

Point: The majority of states adhere to the Uniform Partnership Act for the basic rules of partnership formation, operation, and dissolution.

Point: Limited life, mutual agency, and unlimited liability are disadvantages of a partnership.

Point: Many accounting, law, consulting, and architectural firms are set up as LLPs.

The Signing Ceremony

ABC Co. Ltd.

between

XYZ Pvt. LtdXYZ Pvt. Ltd

Pencil Pushing Partners Most states allow any business to form as a lim- ited liability partnership (LLP); however, some states only allow approved pro- fessional service companies to form them. Of the four largest CPA firms in the United States (KPMG, Deloitte, PricewaterhouseCoopers, and Ernst & Young), all are set up as LLPs. ■

Decision Insight

S Corporations Certain corporations with 100 or fewer stockholders can elect to be treated as a partnership for income tax purposes. These corporations are called Sub-Chapter S or simply S corporations. This distinguishes them from other corporations, called Sub-Chapter C or

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D-4 Appendix D Accounting for Partnerships

simply C corporations. S corporations provide stockholders the same limited liability feature that C corporations do. The advantage of an S corporation is that it does not pay income taxes. If stockholders work for an S corporation, their salaries are treated as expenses of the corpora- tion. The remaining income or loss of the corporation is allocated to stockholders for inclusion on their personal tax returns. Except for C corporations having to account for income tax ex- penses and liabilities, the accounting procedures are the same for both S and C corporations.

Limited Liability Companies A relatively new form of business organization is the limited liability company. The names of these businesses usually include the words “Limited Liability Company” or an abbreviation such as “LLC” or “LC.” This form of business has certain features similar to a corporation and others similar to a limited partnership. The owners, who are called members, are protected with the same limited liability feature as owners of corporations. While limited part- ners cannot actively participate in the management of a limited part- nership, the members of a limited liability company can assume an active management role. A limited liability company usually has a limited life. For income tax purposes, a limited liability company is typically treated as a partnership. This treatment depends on factors such as whether the members’ equity interests are freely transferable and whether the company has continuity of life. A limited liability company’s accounting system is designed to help management com- ply with the dictates of the articles of organization and company regu- lations adopted by its members. The accounting system also must provide information to support the company’s compliance with state and federal laws, including taxation. The company College Hunks Hauling Junk is an LLC.

Choosing a Business Form Choosing the proper business form is crucial. Many factors should be considered, including taxes, liability risk, tax and fiscal year-end, ownership structure, estate planning, business risks, and earnings and property distributions. The following table summarizes several important char- acteristics of business organizations:

Proprietorship Partnership LLP LLC S Corp. Corporation

Business entity . . . . . . . . . Yes Yes Yes Yes Yes Yes

Legal entity . . . . . . . . . . . . No No No Yes Yes Yes

Limited liability . . . . . . . . . No No Limited* Yes Yes Yes

Business taxed . . . . . . . . . . No No No No No Yes

One owner allowed . . . . . Yes No No Yes Yes Yes

* A partner’s personal liability for LLP debts is limited. Most LLPs carry insurance to protect against malpractice.

Point: The Small Business Administra- tion provides suggestions and informa- tion on setting up the proper form for your organization—see SBA.gov.

We must remember that this table is a summary, not a detailed list. Many details underlie each of these business forms, and several details differ across states. Also, state and federal laws change, and a body of law is still developing around LLCs. Business owners should look at these details and consider unique business arrangements such as organizing various parts of their businesses in different forms.

Point: The majority of proprietorships and partnerships that are organized today are set up as LLCs.

Point: Accounting for LLCs is similar to that for partnerships (and proprietor- ships). One difference is that Owner (Partner), Capital is usually called Mem- bers, Capital for LLCs.

Global: Forms of business organizations allowed vary by country.

1. A partnership is terminated in the event (a) a partnership agreement is not in writing, (b) a partner dies, (c) a partner exercises mutual agency.

2. What does the term unlimited liability mean when applied to a general partnership? 3. Which of the following forms of organization do not provide limited liability to all of its

owners? (a) S corporation, (b) limited liability company, (c) limited partnership.

Quick Check Answers — p. D-17

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Appendix D Accounting for Partnerships D-5

Since ownership rights in a partnership are divided among partners, partnership accounting

● Uses a capital account for each partner. ● Uses a withdrawals account for each partner. ● Allocates net income or loss to partners according to the partnership agreement.

This section describes partnership accounting for organizing a partnership, distributing income and loss, and preparing financial statements.

Organizing a Partnership When partners invest in a partnership, their capital accounts are credited for the invested amounts. Partners can invest both assets and liabilities. Each partner’s investment is recorded at  an agreed-on value, normally the market values of the contributed assets and liabilities at the date of contribution. To illustrate, Kayla Zayn and Hector Perez organize a partnership on January 11 called BOARDS that offers year-round facilities for skateboarding and snowboarding. Zayn’s initial net investment in BOARDS is $30,000, made up of cash ($7,000), boarding fa- cilities ($33,000), and a note payable reflecting a bank loan for the new business ($10,000). Perez’s initial investment is cash of $10,000. These amounts are the values agreed on by both partners. The entries to record these investments follow.

BASIC PARTNERSHIP ACCOUNTING

P1 Prepare entries for partner-ship formation.

Zayn’s Investment

Jan. 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Boarding facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

To record the investment of Zayn.

Assets 5 Liabilities 1 Equity 17,000 110,000 130,000 133,000

Perez’s Investment

Jan. 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

To record the investment of Perez.

Assets 5 Liabilities 1 Equity 110,000 110,000

In accounting for a partnership, the following additional relations hold true: (1) Partners’ with- drawals are debited to their own separate withdrawals accounts. (2) Partners’ capital accounts are credited (or debited) for their shares of net income (or net loss) when closing the accounts at the end of a period. (3) Each partner’s withdrawals account is closed to that partner’s capital account. Separate capital and withdrawals accounts are kept for each partner.

Point: Both equity and cash are reduced when a partner withdraws cash from a partnership.

P2 Allocate and record income and loss among partners.

Dividing Income or Loss Partners are not employees of the partnership but are its owners. If partners devote their time and services to their partnership, they are understood to do so for profit, not for salary. This means there are no salaries to partners that are reported as expenses on the partnership income statement. However, when net income or loss of a partnership is allocated among partners, the partners can agree to allocate “salary allowances” reflecting the relative value of services

Broadway Partners Big River Productions is a partnership that owns the rights to the play Big River. The play is performed on tour and periodically on Broadway. For a recent year-end, its Partners’ Capital was approximately $300,000, and it was distributed in its entirety to the partners. ■

Decision Insight

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D-6 Appendix D Accounting for Partnerships

provided. Partners also can agree to allocate “interest allowances” based on the amount in- vested. For instance, since Zayn contributes three times the investment of Perez, it is only fair that this be considered when allocating income between them. Like salary allowances, these interest allowances are not expenses on the income statement. Partners can agree to any method of dividing income or loss. In the absence of an agreement, the law says that the partners share income or loss of a partnership equally. If partners agree on how to share income but say nothing about losses, they share losses the same way they share income. Three common methods to divide income or loss use (1) a stated ratio basis, (2) the ratio of capital balances, or (3) salary and interest allowances and any remainder according to a fixed ratio. We explain each of these methods in this section.

Allocation on Stated Ratios The stated ratio (also called the income-and-loss-sharing ra- tio, the profit and loss ratio, or the P&L ratio) method of allocating partnership income or loss gives each partner a fraction of the total. Partners must agree on the fractional share each receives. To il- lustrate, assume the partnership agreement of K. Zayn and H. Perez says Zayn receives two-thirds and Perez one-third of partnership income and loss. If their partnership’s net income is $60,000, it is allocated to the partners when the Income Summary account is closed as follows.

Point: Partners can agree on a ratio to divide income and another ratio to divide a loss.

Point: The fractional basis can be stated as a proportion, ratio, or per- cent. For example, a 3:2 basis is the same as 3⁄5 and 2⁄5, or 60% and 40%.

Point: To determine the percent of income received by each partner, divide an individual partner’s share by total net income.

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

To allocate income and close Income Summary.

Assets 5 Liabilities 1 Equity 260,000 140,000 120,000

Allocation on Capital Balances The capital balances method of allocating partner- ship income or loss assigns an amount based on the ratio of each partner’s relative capital bal- ance. If Zayn and Perez agree to share income and loss on the ratio of their beginning capital balances — Zayn’s $30,000 and Perez’s $10,000 — Zayn receives three-fourths of any income or loss ($30,000y$40,000) and Perez receives one-fourth ($10,000y$40,000). The journal entry follows the same format as that using stated ratios (see the preceding entries).

Allocation on Services, Capital, and Stated Ratios The services, capital, and stated ratio method of allocating partnership income or loss recognizes that service and capital contributions of partners often are not equal. Salary allowances can make up for differences in service contributions. Interest allowances can make up for unequal capital contributions. Also, the allocation of income and loss can include both salary and interest allowances. To illustrate, assume that the partnership agreement of K. Zayn and H. Perez reflects differences in service and capital contributions as follows: (1) annual salary allowances of $36,000 to Zayn and $24,000 to Perez, (2) annual interest allowances of 10% of a partner’s beginning-year capital balance, and (3) equal share of any remaining balance of income or loss. These salaries and in- terest allowances are not reported as expenses on the income statement. They are simply a means of dividing partnership income or loss. The remainder of this section provides two illus- trations using this three-point allocation agreement.

Illustration when income exceeds allowance. If BOARDS has first-year net income of $70,000, and Zayn and Perez apply the three-point partnership agreement described in the prior paragraph, income is allocated as shown in Exhibit D.1. Zayn gets $42,000 and Perez gets $28,000 of the $70,000 total.

Illustration when allowances exceed income. The sharing agreement between Zayn and Perez must be followed even if net income is less than the total of the allowances. For example, if BOARDS’ first-year net income is $50,000 instead of $70,000, it is allocated to the partners as shown in Exhibit D.2. Computations for salaries and interest are identical to those in Exhibit D.1. However, when we apply the total allowances against income, the balance of income is negative. This $(14,000) negative balance is allocated equally to the partners per their sharing agreement. This means that a negative $(7,000) is allocated to each partner. In this case, Zayn ends up with $32,000 and Perez with $18,000. If BOARDS had experienced a net loss, Zayn and Perez would share it in the same manner as the $50,000 income. The only difference is that they would have begun with a negative amount because of the loss. Specifically, the partners would still have been

Point: When allowances exceed income, the amount of this negative balance often is referred to as a shar- ing agreement loss or deficit.

Point: Check to make sure the sum of the dollar amounts allocated to each partner equals net income or loss.

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Appendix D Accounting for Partnerships D-7

allocated their salary and interest allowances, further adding to the negative balance of the loss. This total negative balance after salary and interest allowances would have been allocated equally between the partners. These allocations would have been applied against the positive numbers from any allowances to determine each partner’s share of the loss.

Point: When a loss occurs, it is possible for a specific partner’s capital to increase (when closing income summary) if that partner’s allowance is in excess of his or her share of the negative balance. This implies that decreases to the capital balances of other partners exceed the partnership’s loss amount.

Partnership Financial Statements Partnership financial statements are similar to those of other organizations. The statement of partners’ equity, also called statement of partners’ capital, is one exception. It shows each part- ner’s beginning capital balance, additional investments, allocated income or loss, withdrawals, and ending capital balance. To illustrate, Exhibit D.3 shows the statement of partners’ equity for BOARDS prepared using the sharing agreement of Exhibit D.1. Recall that BOARDS’ income was $70,000; also, assume that Zayn withdrew $20,000 and Perez $12,000 at year-end.

EXHIBIT D.1 Dividing Income When Income Exceeds Allowances

Zayn Perez Total

Net income . . . . . . . . . . . . . . . . . . . . $70,000

Salary allowances

Zayn . . . . . . . . . . . . . . . . . . . . . . . $ 36,000

Perez . . . . . . . . . . . . . . . . . . . . . . . $ 24,000

Interest allowances

Zayn (10% 3 $30,000) . . . . . . . . . 3,000

Perez (10% 3 $10,000) . . . . . . . . 1,000

Total salaries and interest . . . . . . . . . 39,000 25,000 64,000

Balance of income . . . . . . . . . . . . 6,000

Balance allocated equally

Zayn . . . . . . . . . . . . . . . . . . . . . . . 3,000

Perez . . . . . . . . . . . . . . . . . . . . . . . 3,000

Total allocated . . . . . . . . . . . . . . . . 6,000

Balance of income . . . . . . . . . . . . $ 0

Income of each partner . . . . . . . . . . $42,000 $28,000

← ←

EXHIBIT D.2 Dividing Income When Allowances Exceed Income

Zayn Perez Total

Net income . . . . . . . . . . . . . . . . . . . . $50,000

Salary allowances

Zayn . . . . . . . . . . . . . . . . . . . . . . . $ 36,000

Perez . . . . . . . . . . . . . . . . . . . . . . . $ 24,000

Interest allowances

Zayn (10% 3 $30,000) . . . . . . . . . 3,000

Perez (10% 3 $10,000) . . . . . . . . 1,000

Total salaries and interest . . . . . . . . . 39,000 25,000 64,000

Balance of income . . . . . . . . . . . . (14,000)

Balance allocated equally

Zayn . . . . . . . . . . . . . . . . . . . . . . . (7,000)

Perez . . . . . . . . . . . . . . . . . . . . . . . (7,000)

Total allocated . . . . . . . . . . . . . . . . (14,000)

Balance of income . . . . . . . . . . . . $ 0

Income of each partner . . . . . . . . . . $32,000 $18,000

← ←

4. Denzel and Shantell form a partnership by contributing $70,000 and $35,000, respectively. They agree to an interest allowance equal to 10% of each partner’s capital balance at the beginning of the year, with the remaining income shared equally. Allocate first-year income of $40,000 to each partner.

Quick Check Answer — p. D-17

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D-8 Appendix D Accounting for Partnerships

EXHIBIT D.3 Statement of Partners’ Equity

BOARDS Statement of Partners’ Equity

For Year Ended December 31, 2013

Zayn Perez Total

Beginning capital balances . . . . . . . . . . $ 0 $ 0 $ 0

Plus

Investments by owners . . . . . . . . . . 30,000 10,000 40,000

Net income

Salary allowances . . . . . . . . . . . . $36,000 $24,000

Interest allowances . . . . . . . . . . . 3,000 1,000

Balance allocated . . . . . . . . . . . . 3,000 3,000

Total net income . . . . . . . . . . . . . 42,000 28,000 70,000

72,000 38,000 110,000

Less partners’ withdrawals . . . . . . . . . (20,000) (12,000) (32,000)

Ending capital balances . . . . . . . . . $52,000 $26,000 $78,000

The equity section of the balance sheet of a partnership usually shows the separate capital account balance of each partner. In the case of BOARDS, both K. Zayn, Capital, and H. Perez, Capital, are listed in the equity section along with their balances of $52,000 and $26,000, respectively.

A partnership is based on a contract between individuals. When a partner is admitted or with- draws, the present partnership ends. Still, the business can continue to operate as a new part- nership consisting of the remaining partners. This section considers how to account for the admission and withdrawal of partners.

Admission of a Partner A new partner is admitted in one of two ways: by purchasing an interest from one or more cur- rent partners or by investing cash or other assets in the partnership.

Purchase of Partnership Interest The purchase of partnership interest is a personal transaction between one or more current partners and the new partner. To become a partner, the current partners must accept the purchaser. Accounting for the purchase of partnership interest involves reallocating current partners’ capital to reflect the transaction. To illustrate, at the end of BOARDS’ first year, H. Perez sells one-half of his partnership interest to Tyrell Rasheed for $18,000. This means that Perez gives up a $13,000 recorded interest ($26,000 3 1y2) in the partnership (see the ending capital balance in Exhibit D.3). The partnership records this January 4 transaction as follows.

ADMISSION AND WITHDRAWAL OF PARTNERS

P3 Account for the admission and withdrawal of partners.

Jan. 4 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

To record admission of Rasheed by purchase.

Assets 5 Liabilities 1 Equity 213,000 113,000

Double Draw Partnerships sometimes use two accounts to reflect a partner’s withdrawal of cash from a partnership. For example, a “Drawing” account might be used for regular withdrawals such as for a monthly salary allowance. A second “Withdrawals” account might be used for infrequent or personal draws such as to help pay for a daughter/son’s wedding or a lake home. ■

Decision Insight

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Appendix D Accounting for Partnerships D-9

After this entry is posted, BOARDS’ equity shows K. Zayn, Capital; H. Perez, Capital; and T. Rasheed, Capital, and their respective balances of $52,000, $13,000, and $13,000. Two aspects of this transaction are important. First, the partnership does not record the $18,000 Rasheed paid Perez. The partnership’s assets, liabilities, and total equity are unaffected by this transaction among partners. Second, Zayn and Perez must agree that Rasheed is to become a part- ner. If they agree to accept Rasheed, a new partnership is formed and a new contract with a new income-and-loss-sharing agreement is prepared. If Zayn or Perez refuses to accept Rasheed as a partner, then (under the Uniform Partnership Act) Rasheed gets Perez’s sold share of partnership income and loss. If the partnership is liquidated, Rasheed gets Perez’s sold share of partnership assets. Rasheed gets no voice in managing the company unless Rasheed is admitted as a partner.

Investing Assets in a Partnership Admitting a partner by accepting assets is a trans- action between the new partner and the partnership. The invested assets become partnership property. To illustrate, if Zayn (with a $52,000 interest) and Perez (with a $26,000 interest) agree to accept Rasheed as a partner in BOARDS after an investment of $22,000 cash, this is recorded as follows.

Point: Partners’ withdrawals are not constrained by the partnership’s annual income or loss.

Jan. 4 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

To record admission of Rasheed by investment.

Assets 5 Liabilities 1 Equity 122,000 122,000

After this entry is posted, both assets (cash) and equity (T. Rasheed, Capital) increase by $22,000. Rasheed now has a 22% equity in the assets of the business, computed as $22,000 di- vided by the entire partnership equity ($52,000 1 $26,000 1 $22,000). Rasheed does not nec- essarily have a right to 22% of income. Dividing income and loss is a separate matter on which partners must agree.

Bonus to old partners. When the current value of a partnership is greater than the recorded amounts of equity, the partners usually require a new partner to pay a bonus for the privilege of joining. To illustrate, assume that Zayn and Perez agree to accept Rasheed as a partner with a 25% interest in BOARDS if Rasheed invests $42,000. Recall that the partnership’s accounting records show that Zayn’s recorded equity in the business is $52,000 and Perez’s recorded equity is $26,000 (see Exhibit D.3). Rasheed’s equity is determined as follows.

Equities of existing partners ($52,000 1 $26,000) . . . . . . . $ 78,000

Investment of new partner . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000

Total partnership equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000

Equity of Rasheed (25% 3 $120,000) . . . . . . . . . . . . . . . . . . $ 30,000 ↓

Although Rasheed invests $42,000, the equity attributed to Rasheed in the new partnership is only $30,000. The $12,000 difference is called a bonus and is allocated to existing partners (Zayn and Perez) according to their income-and-loss-sharing agreement. A bonus is shared in this way because it is viewed as reflecting a higher value of the partnership that is not yet re- flected in income. The entry to record this transaction follows.

Jan. 4 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000

T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

K. Zayn, Capital ($12,000 3 1⁄2) . . . . . . . . . . . . . . . 6,000

H. Perez, Capital ($12,000 3 1⁄2) . . . . . . . . . . . . . . . 6,000

To record admission of Rasheed and bonus.

Assets 5 Liabilities 1 Equity 142,000 130,000

16,000 16,000

Bonus to new partner. Alternatively, existing partners can grant a bonus to a new partner. This usually occurs when they need additional cash or the new partner has exceptional talents. The bonus to the new partner is in the form of a larger share of equity than the amount invested. To illustrate, assume that Zayn and Perez agree to accept Rasheed as a partner with a

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D-10 Appendix D Accounting for Partnerships

25% interest in the partnership, but they require Rasheed to invest only $18,000. Rasheed’s equity is determined as follows.

Jan. 4 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

K. Zayn, Capital ($6,000 3 1⁄2) . . . . . . . . . . . . . . . . . . . . 3,000

H. Perez, Capital ($6,000 3 1⁄2) . . . . . . . . . . . . . . . . . . . . 3,000

T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

To record Rasheed’s admission and bonus.

Assets 5 Liabilities 1 Equity 118,000 23,000

23,000 124,000

Oct. 31 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000

To record withdrawal of Perez from partnership with no bonus.

Assets 5 Liabilities 1 Equity 238,000 238,000

Oct. 31 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000

K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

To record withdrawal of Perez and bonus to remaining partners.

Assets 5 Liabilities 1 Equity 234,000 238,000

12,000 12,000

Equities of existing partners ($52,000 1 $26,000) . . . . . . . . . $78,000

Investment of new partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Total partnership equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $96,000

Equity of Rasheed (25% 3 $96,000) . . . . . . . . . . . . . . . . . . . . . $24,000 ↓

The old partners contribute the $6,000 bonus (computed as $24,000 minus $18,000) to Rasheed according to their income-and-loss-sharing ratio. Moreover, Rasheed’s 25% equity does not necessarily entitle Rasheed to 25% of future income or loss. This is a separate matter for agree- ment by the partners. The entry to record the admission and investment of Rasheed is

Withdrawal of a Partner A partner generally withdraws from a partnership in one of two ways. (1) First, the withdraw- ing partner can sell his or her interest to another person who pays for it in cash or other assets. For this, we need only debit the withdrawing partner’s capital account and credit the new part- ner’s capital account. (2) The second case is when cash or other assets of the partnership are distributed to the withdrawing partner in settlement of his or her interest. To illustrate these cases, assume that Perez withdraws from the partnership of BOARDS in some future period. The partnership shows the following capital balances at the date of Perez’s withdrawal: K. Zayn, $84,000; H. Perez, $38,000; and T. Rasheed, $38,000. The partners (Zayn, Perez, and Rasheed) share income and loss equally. Accounting for Perez’s withdrawal depends on whether a bonus is paid. We describe three possibilities.

No Bonus If Perez withdraws and takes cash equal to Perez’s capital balance, the entry is

Perez can take any combination of assets to which the partners agree to settle Perez’s equity. Perez’s withdrawal creates a new partnership between the remaining partners. A new partner- ship contract and a new income-and-loss-sharing agreement are required.

Bonus to Remaining Partners A withdrawing partner is sometimes willing to take less than the recorded value of his or her equity to get out of the partnership or because the recorded value is overstated. Whatever the reason, when this occurs, the withdrawing partner in effect gives the remaining partners a bonus equal to the equity left behind. The remaining partners share this unwithdrawn equity according to their income-and-loss-sharing ratio. To illustrate, if Perez with- draws and agrees to take $34,000 cash in settlement of Perez’s capital balance, the entry is

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Appendix D Accounting for Partnerships D-11

Perez withdrew $4,000 less than Perez’s recorded equity of $38,000. This $4,000 is divided between Zayn and Rasheed according to their income-and-loss-sharing ratio.

Bonus to Withdrawing Partner A withdrawing partner may be able to receive more than his or her recorded equity for at least two reasons. First, the recorded equity may be under- stated. Second, the remaining partners may agree to remove this partner by giving assets of greater value than this partner’s recorded equity. In either case, the withdrawing partner receives a bonus. The remaining partners reduce their equity by the amount of this bonus according to their income-and-loss-sharing ratio. To illustrate, if Perez withdraws and receives $40,000 cash in settlement of Perez’s capital balance, the entry is

Falcon Cable Communications set up a partnership withdrawal agreement. Falcon owns and operates cable television systems and had two managing general partners. The partnership agreement stated that either partner “can offer to sell to the other partner the offering part- ner’s entire partnership interest . . . for a negotiated price. If the partner receiving such an offer rejects it, the offering partner may elect to cause [the partnership] . . . to be liquidated and dissolved.”

Death of a Partner A partner’s death dissolves a partnership. A deceased partner’s estate is entitled to receive his or her equity. The partnership contract should contain provisions for settlement in this case. These provisions usually require (1) closing the books to determine income or loss since the end of the previous period and (2) determining and recording current market values for both assets and liabilities. The remaining partners and the deceased partner’s estate then must agree to a settle- ment of the deceased partner’s equity. This can involve selling the equity to remaining partners or to an outsider, or it can involve withdrawing assets.

When a partnership is liquidated, its business ends and three concluding steps are required.

1. Record the sale of noncash assets for cash, and any gain or loss from liquidation is allo- cated to partners using their income-and-loss-sharing agreement.

2. Pay or settle all partner liabilities. 3. Distribute any remaining cash to partners based on their capital balances.

Partnership liquidation usually falls into one of two cases, as described in this section.

LIQUIDATION OF A PARTNERSHIP

Oct. 31 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000

K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

To record Perez’s withdrawal from partnership with a bonus to Perez.

Assets 5 Liabilities 1 Equity 240,000 238,000

21,000 21,000

P4 Prepare entries for partnership liquidation.

Financial Planner You are hired by the two remaining partners of a three-member partnership after the third partner’s death. The partnership agreement states that a deceased partner’s estate is entitled to a  “share of partnership assets equal to the partner’s relative equity balance” (partners’ equity balances are equal). The estate argues that it is entitled to one-third of the current value of partnership assets. The remaining partners say the distribution should use asset book values, which are 75% of current value. They also point to partnership liabilities, which equal 40% of total asset book value and 30% of current value. How would you resolve this situation? ■ [Answer—p. D-17]

Decision Ethics

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D-12 Appendix D Accounting for Partnerships

No Capital Deficiency No capital deficiency means that all partners have a zero or credit balance in their capital ac- counts for final distribution of cash. To illustrate, assume that Zayn, Perez, and Rasheed operate their partnership in BOARDS for several years, sharing income and loss equally. The partners then decide to liquidate. On the liquidation date, the current period’s income or loss is trans- ferred to the partners’ capital accounts according to the sharing agreement. After that transfer, assume the partners’ recorded account balances (immediately prior to liquidation) are:

Cash . . . . . . . $178,000 Land . . . . . . . . 40,000

Accounts payable . . . . . . . $20,000 K. Zayn, Capital . . . . . . . . 70,000

H. Perez, Capital . . . . . . . . . $66,000 T. Rasheed, Capital . . . . . . . 62,000

We apply three steps for liquidation. 1 The partnership sells its noncash assets, and any losses or gains from liquidation are shared among partners according to their income-and-loss-sharing agreement (equal for these partners). Assume that BOARDS sells its noncash assets consisting of $40,000 in land for $46,000 cash, yielding a net gain of $6,000. In a liquidation, gains or losses usu- ally result from the sale of noncash assets, which are called losses and gains from liquidation. The entry to sell its assets for $46,000 follows.

Jan. 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Gain from Liquidation . . . . . . . . . . . . . . . . . . . . . . . 6,000 Sold noncash assets at a gain.

Jan. 15 Gain from Liquidation . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 To allocate liquidation gain to partners.

Allocation of the gain from liquidation per the partners’ income-and-loss-sharing agreement follows.

2 The partnership pays its liabilities, and any losses or gains from liquidation of liabilities are shared among partners according to their income-and-loss-sharing agreement. BOARDS’ only liability is $20,000 in accounts payable, and no gain or loss occurred.

3 Any remaining cash is divided among the partners according to their capital account balances. The entry to record the final distribution of cash to partners follows.

Jan. 15 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 To pay claims of creditors.

Assets 5 Liabilities 1 Equity 220,000 220,000

K. Zayn

Bal. 70,000 (2) 2,000

Bal. 72,000

H. Perez, Capital

Bal. 66,000 (2) 2,000

Bal. 68,000

T. Rasheed, Capital

Bal. 62,000 (2) 2,000

Bal. 64,000

Cash

Bal. 178,000 (3) 20,000 (1) 46,000

Bal. 204,000

After step 2, we have the following capital balances along with the remaining cash balance.

It is important to remember that the final cash payment is distributed to partners according to their capital account balances, whereas gains and losses from liquidation are allocated accord- ing to the income-and-loss-sharing ratio. The following statement of liquidation summarizes the three steps in this section.

Assets 5 Liabilities 1 Equity 2204,000 272,000

268,000 264,000

Jan. 15 K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000 T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204,000 To distribute remaining cash to partners.

Assets 5 Liabilities 1 Equity 240,000 16,000 146,000

Assets 5 Liabilities 1 Equity 26,000 12,000 12,000 12,000

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Appendix D Accounting for Partnerships D-13

Capital Deficiency Capital deficiency means that at least one partner has a debit balance in his or her capital account at the point of final cash distribution (during step 3 as explained in the prior section). This can arise from liquidation losses, excessive withdrawals before liquidation, or recurring losses in prior periods. A partner with a capital deficiency must, if possible, cover the deficit by paying cash into the partnership. To illustrate, assume that Zayn, Perez, and Rasheed operate their partnership in BOARDS for several years, sharing income and losses equally. The partners then decide to liquidate. Immedi- ately prior to the final distribution of cash, the partners’ recorded capital balances are Zayn, $19,000; Perez, $8,000; and Rasheed, $(3,000). Rasheed’s capital deficiency means that Rasheed owes the partnership $3,000. Both Zayn and Perez have a legal claim against Rasheed’s personal assets. The final distribution of cash in this case depends on how this capital deficiency is handled. Two possibilities exist: the partner pays the deficiency or the partner cannot pay the deficiency.

Partner Pays Deficiency Rasheed is obligated to pay $3,000 into the partnership to cover the deficiency. If Rasheed is willing and able to pay, the entry to record receipt of pay- ment from Rasheed follows.

Jan. 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 To record payment of deficiency by Rasheed.

Assets 5 Liabilities 1 Equity 13,000 13,000

Jan. 15 K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000 To distribute remaining cash to partners.

Assets 5 Liabilities 1 Equity 227,000 219,000

28,000

Jan. 15 K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 T. Rasheed, Capital . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 To transfer Rasheed deficiency to Zayn and Perez.

Assets 5 Liabilities 1 Equity 21,500 21,500 13,000

Jan. 15 K. Zayn, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 H. Perez, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 To distribute remaining cash to partners.

Assets 5 Liabilities 1 Equity 224,000 217,500

26,500

After the $3,000 payment, the partners’ capital balances are Zayn, $19,000; Perez, $8,000; and Rasheed, $0. The entry to record the final cash distributions to partners is

Partner Cannot Pay Deficiency The remaining partners with credit balances absorb any partner’s unpaid deficiency according to their income-and-loss-sharing ratio. To illustrate, if Rasheed is unable to pay the $3,000 deficiency, Zayn and Perez absorb it. Since they share income and loss equally, Zayn and Perez each absorb $1,500 of the deficiency. This is recorded as follows.

After Zayn and Perez absorb Rasheed’s deficiency, the capital accounts of the partners are Zayn, $17,500; Perez, $6,500; and Rasheed, $0. The entry to record the final cash distribution to the partners is

Rasheed’s inability to cover this deficiency does not relieve Rasheed of the liability. If Rasheed becomes able to pay at a future date, Zayn and Perez can each collect $1,500 from Rasheed.

Noncash 5

K. Zayn, H. Perez, T. Rasheed, Statement of Liquidation Cash Assets Liabilities Capital Capital Capital

Balances prior to liquidation. . . . $178,000 $ 40,000 $ 20,000 $ 70,000 $66,000 $62,000 1 Sale of noncash assets . . . . . . . . 46,000 (40,000) 2,000 2,000 2,000 2 Payment of liabilities . . . . . . . . . (20,000) (20,000) 0 0 0 Balances for distribution . . . . . . 204,000 $ 0 $ 0 72,000 68,000 64,000 3 Distribution of cash to partners (204,000) (72,000) (68,000) (64,000) $ 0 $ 0 $ 0 $ 0

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D-14 Appendix D Accounting for Partnerships

Partner Return on EquityDecision Analysis

A1 Compute partner return on equity and use it to evaluate partnership performance.

An important role of partnership financial statements is to aid current and potential partners in evaluating partnership success compared with other opportunities. One measure of this success is the partner return on equity ratio:

Partner return on equity 5 Partner net income

Average partner equity

This measure is separately computed for each partner. To illustrate, Exhibit D.4 reports selected data from  the Boston Celtics LP. The return on equity for the total partnership is computed as $216y[($85 1 $253)y2] 5 127.8%. However, return on equity is quite different across the partners. For example, the Boston Celtics LP I partner return on equity is computed as $44y[($122 1 $166)y2] 5 30.6%, whereas the Celtics LP partner return on equity is computed as $111y[($270 1 $333)y2] 5 36.8%. Partner return on equity provides each partner an assessment of its return on its equity invested in the partnership. A specific partner often uses this return to decide whether additional investment or withdrawal of re- sources is best for that partner. Exhibit D.4 reveals that the year shown produced good returns for all partners (the Boston Celtics LP II return is not computed because its average equity is negative due to an unusual and large distribution in the prior year).

EXHIBIT D.4 Selected Data from Boston Celtics LP

Boston Celtics Boston Celtics ($ thousands) Total* LP I LP II Celtics LP

Beginning-year balance . . . . . . . . . . . . . $ 85 $122 $(307) $270

Net income (loss) for year . . . . . . . . . . 216 44 61 111

Cash distribution . . . . . . . . . . . . . . . . . (48) — — (48)

Ending-year balance . . . . . . . . . . . . . . . $253 $166 $(246) $333

Partner return on equity . . . . . . . . 127.8% 30.6% n.a. 36.8%

* Totals may not add up due to rounding.

Partnership accounting according to U.S. GAAP is similar, but not identical, to that under IFRS. This section discusses broad differences in partnership accounting, organization, admission, withdrawal, and liquidation. Both U.S. GAAP and IFRS include broad and similar guidance for partnership accounting. Further, partnership organization is similar worldwide; however, different legal and tax systems dictate different implications and motivations for how a partnership is effectively set up. The accounting for partnership admission, withdrawal, and liquidation is likewise similar worldwide. Specifically, procedures for admission, withdrawal, and liquidation depend on the partnership agreements constructed by all parties involved. However, different legal and tax systems impact those agreements and their implications to the parties.

GLOBAL VIEW

The following transactions and events affect the partners’ capital accounts in several successive partner- ships. Prepare a table with six columns, one for each of the five partners along with a total column to show the effects of the following events on the five partners’ capital accounts.

Part 1

4/13/2011 Ries and Bax create R&B Company. Each invests $10,000, and they agree to share income and losses equally.

12/31/2011 R&B Co. earns $15,000 in income for its first year. Ries withdraws $4,000 from the partner- ship, and Bax withdraws $7,000.

1/1/2012 Royce is made a partner in RB&R Company after contributing $12,000 cash. The partners agree that a 10% interest allowance will be given on each partner’s beginning-year capital

DEMONSTRATION PROBLEM

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Appendix D Accounting for Partnerships D-15

balance. In addition, Bax and Royce are to receive $5,000 salary allowances. The remainder of the income or loss is to be divided evenly.

12/31/2012 The partnership’s income for the year is $40,000, and withdrawals at year-end are Ries, $5,000; Bax, $12,500; and Royce, $11,000.

1/1/2013 Ries sells her interest for $20,000 to Murdock, whom Bax and Royce accept as a partner in the new BR&M Co. Income or loss is to be shared equally after Bax and Royce receive $25,000 salary allowances.

12/31/2013 The partnership’s income for the year is $35,000, and year-end withdrawals are Bax, $2,500, and Royce, $2,000.

1/1/2014 Elway is admitted as a partner after investing $60,000 cash in the new Elway & Associates partnership. He is given a 50% interest in capital after the other partners transfer $3,000 to his account from each of theirs. A 20% interest allowance (on the beginning-year capital balances) will be used in sharing any income or loss, there will be no salary allowances, and Elway will receive 40% of the remaining balance — the other three partners will each get 20%.

12/31/2014 Elway & Associates earns $127,600 in income for the year, and year-end withdrawals are Bax, $25,000; Royce, $27,000; Murdock, $15,000; and Elway, $40,000.

1/1/2015 Elway buys out Bax and Royce for the balances of their capital accounts after a revaluation of the partnership assets. The revaluation gain is $50,000, which is divided in using a 1:1:1:2 ratio (Bax:Royce:Murdock:Elway). Elway pays the others from personal funds. Murdock and Elway will share income on a 1:9 ratio.

2/28/2015 The partnership earns $10,000 of income since the beginning of the year. Murdock retires and receives partnership cash equal to her capital balance. Elway takes possession of the partnership assets in his own name, and the partnership is dissolved.

Part 2

Journalize the events affecting the partnership for the year ended December 31, 2012.

PLANNING THE SOLUTION ● Evaluate each transaction’s effects on the capital accounts of the partners. ● Each time a new partner is admitted or a partner withdraws, allocate any bonus based on the income-or-loss-

sharing agreement. ● Each time a new partner is admitted or a partner withdraws, allocate subsequent net income or loss in

accordance with the new partnership agreement. ● Prepare entries to (1) record Royce’s initial investment; (2) record the allocation of interest, salaries,

and remainder; (3) show the cash withdrawals from the partnership; and (4) close the withdrawal ac- counts on December 31, 2012.

SOLUTION TO DEMONSTRATION PROBLEM Part 1

[continued on next page]

Event Ries Bax Royce Murdock Elway Total

4/13/2011

Initial investment . . . . . . . . . . $10,000 $10,000 $ 20,000

12/31/2011

Income (equal) . . . . . . . . . . . 7,500 7,500 15,000

Withdrawals . . . . . . . . . . . . . (4,000) (7,000) (11,000)

Ending balance . . . . . . . . . . . . $13,500 $10,500 $ 24,000

1/1/2012

New investment . . . . . . . . . . $12,000 $ 12,000

12/31/2012

10% interest . . . . . . . . . . . . . 1,350 1,050 1,200 3,600

Salaries . . . . . . . . . . . . . . . . . 5,000 5,000 10,000

Remainder (equal) . . . . . . . . . 8,800 8,800 8,800 26,400

Withdrawals . . . . . . . . . . . . . (5,000) (12,500) (11,000) (28,500)

Ending balance . . . . . . . . . . . . $18,650 $12,850 $16,000 $ 47,500

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D-16 Appendix D Accounting for Partnerships

Event Ries Bax Royce Murdock Elway Total

1/1/2013

Transfer interest . . . . . . . . . . (18,650) $18,650 $ 0

12/31/2013

Salaries . . . . . . . . . . . . . . . . . 25,000 25,000 50,000

Remainder (equal) . . . . . . . . . (5,000) (5,000) (5,000) (15,000)

Withdrawals . . . . . . . . . . . . . (2,500) (2,000) (4,500)

Ending balance . . . . . . . . . . . . $ 0 $30,350 $34,000 $13,650 $ 78,000

1/1/2014

New investment . . . . . . . . . . $ 60,000 60,000

Bonuses to Elway . . . . . . . . . (3,000) (3,000) (3,000) 9,000 0

Adjusted balance . . . . . . . . . . $27,350 $31,000 $10,650 $ 69,000 $138,000

12/31/2014

20% interest . . . . . . . . . . . . . . 5,470 6,200 2,130 13,800 27,600

Remainder (1:1:1:2) . . . . . . . . 20,000 20,000 20,000 40,000 100,000

Withdrawals . . . . . . . . . . . . . . (25,000) (27,000) (15,000) (40,000) (107,000)

Ending balance . . . . . . . . . . . . $27,820 $30,200 $17,780 $ 82,800 $158,600

1/1/2015

Gain (1:1:1:2) . . . . . . . . . . . . . 10,000 10,000 10,000 20,000 50,000

Adjusted balance . . . . . . . . . . $37,820 $40,200 $27,780 $102,800 $208,600

Transfer interests . . . . . . . . . . (37,820) (40,200) 78,020 0

Adjusted balance . . . . . . . . . . $ 0 $ 0 $27,780 $180,820 $208,600

2/28/2015

Income (1:9) . . . . . . . . . . . . . . 1,000 9,000 10,000

Adjusted balance . . . . . . . . . . $28,780 $189,820 $218,600

Settlements . . . . . . . . . . . . . . (28,780) (189,820) (218,600)

Final balance . . . . . . . . . . . . . . $ 0 $ 0 $ 0

[continued from previous page]

2012

Jan. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Royce, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

To record investment of Royce.

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Ries, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,150

Bax, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,850

Royce, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

To allocate interest, salaries, and remainders.

Dec. 31 Ries, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Bax, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500

Royce, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,500

To record cash withdrawals by partners.

Dec. 31 Ries, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Bax, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500

Royce, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

Ries, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Bax, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500

Royce, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

To close withdrawal accounts.

Part 2

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Appendix D Accounting for Partnerships D-17

C corporation (p. D-4)

General partner (p. D-3)

General partnership (p. D-3)

Limited liability company (LLC) (p. D-4)

Limited liability partnership (p. D-3)

Limited partners (p. D-3)

Limited partnership (p. D-3)

Mutual agency (p. D-2)

Partner return on equity (p. D-14)

Partnership (p. D-2)

Partnership contract (p. D-2)

Partnership liquidation (p. D-11)

S corporation (p. D-3)

Statement of partners’ equity (p. D-7)

Unlimited liability (p. D-3)

Key Terms

C1 Identify characteristics of partnerships and similar organizations. Partnerships are voluntary associations, involve partnership agreements, have limited life, are not subject to income tax, include mutual agency, and have unlimited liability. Organiza- tions that combine selected characteristics of partnerships and cor- porations include limited partnerships, limited liability partnerships, S corporations, and limited liability companies.

A1 Compute partner return on equity and use it to evaluate partnership performance. Partner return on equity provides each partner an assessment of his or her return on equity invested in the partnership.

P1 Prepare entries for partnership formation. A partner’s ini-tial investment is recorded at the market value of the assets contributed to the partnership.

P2 Allocate and record income and loss among partners. A partnership agreement should specify how to allocate partner- ship income or loss among partners. Allocation can be based on a stated ratio, capital balances, or salary and interest allowances to

Summary compensate partners for differences in their service and capital contributions.

P3 Account for the admission and withdrawal of partners. When a new partner buys a partnership interest directly from one or more existing partners, the amount of cash paid from one partner to another does not affect the partnership total recorded eq- uity. When a new partner purchases equity by investing additional assets in the partnership, the new partner’s investment can yield a bonus either to existing partners or to the new partner. The entry to record a withdrawal can involve payment from either (1) the exist- ing partners’ personal assets or (2) partnership assets. The latter can yield a bonus to either the withdrawing or remaining partners.

P4 Prepare entries for partnership liquidation. When a partnership is liquidated, losses and gains from selling partnership assets are allocated to the partners according to their income-and-loss-sharing ratio. If a partner’s capital account has a deficiency that the partner cannot pay, the other partners share the deficit according to their relative income-and-loss-sharing ratio.

Financial Planner The partnership agreement apparently fails to mention liabilities or use the term net assets. To give the estate one- third of total assets is not fair to the remaining partners because if the partner had lived and the partners had decided to liquidate, the liabili- ties would need to be paid out of assets before any liquidation. Also, a

settlement based on the deceased partner’s recorded equity would fail to recognize excess of current value over book value. This value in- crease would be realized if the partnership were liquidated. A fair set- tlement would seem to be a payment to the estate for the balance of the deceased partner’s equity based on the current value of net assets.

Guidance Answers to Decision Ethics

1. (b) 2. Unlimited liability means that the creditors of a partnership re-

quire each partner to be personally responsible for all partnership debts.

3. (c)

4.

Guidance Answers to Quick Checks

Denzel Shantell Total

Net income . . . . . . . . . . . . . . . . . $ 40,000

Interest allowance (10%) . . . . . . $ 7,000 $ 3,500 10,500

Balance of income . . . . . . . . . $29,500

Balance allocated equally . . . . . . 14,750 14,750 29,500

Balance of income . . . . . . . . . . . . $ 0

Income of partners . . . . . . . . $21,750 $18,250

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D-18 Appendix D Accounting for Partnerships

1. If a partnership contract does not state the period of time the partnership is to exist, when does the partnership end?

2. What does the term mutual agency mean when applied to a partnership?

3. How does a general partnership differ from a limited partnership? 4. Can partners limit the right of a partner to commit their

partnership to contracts? Would such an agreement be binding (a) on the partners and (b) on outsiders?

5. Assume that Amey and Lacey are partners. Lacey dies, and her son claims the right to take his mother’s place in the part- nership. Does he have this right? Why or why not?

6. Assume that the Barnes and Ardmore partnership agree- ment provides for a two-third/one-third sharing of income but says nothing about losses. The first year of partnership opera- tion resulted in a loss, and Barnes argues that the loss should be shared equally because the partnership agreement said noth- ing about sharing losses. Is Barnes correct? Explain.

7. Allocation of partnership income among the partners appears on what financial statement?

8. What does the term unlimited liability mean when it is applied to partnership members?

9. George, Burton, and Dillman have been partners for three years. The partnership is being dissolved. George is leaving the firm, but Burton and Dillman plan to carry on the business. In the final settlement, George places a $75,000 salary claim against the partnership. He contends that he has a claim for a salary of $25,000 for each year because he devoted all of his time for three years to the affairs of the partnership. Is his claim valid? Why or why not?

10. Kay, Kat, and Kim are partners. In a liquidation, Kay’s share of partnership losses exceeds her capital account balance. Moreover, she is unable to meet the deficit from her personal assets, and her partners shared the excess losses. Does this re- lieve Kay of liability?

11. After all partnership assets have been converted to cash and all liabilities paid, the remaining cash should equal the sum of the balances of the partners’ capital accounts. Why?

12. Assume a partner withdraws from a partnership and receives assets of greater value than the book value of his equity. Should the remaining partners share the resulting reduction in their eq- uities in the ratio of their relative capital balances or according to their income-and-loss-sharing ratio?

Discussion Questions

Icon denotes assignments that involve decision making.

Multiple Choice Quiz Answers on p. D-27 mhhe.com/wildFINMAN5e

with any remaining income or loss divided equally. If net in- come for its initial year is $270,000, then Jamison’s and Blue’s respective shares are

a. $135,000; $135,000. b. $154,286; $115,714. c. $120,000; $150,000. d. $185,000; $85,000. e. $85,000; $185,000. 4. Hansen and Fleming are partners and share equally in income or

loss. Hansen’s current capital balance in the partnership is $125,000 and Fleming’s is $124,000. Hansen and Fleming agree to accept Black with a 20% interest. Black invests $75,000 in the partnership. The bonus granted to Hansen and Fleming equals

a. $13,000 each. b. $5,100 each. c. $4,000 each. d. $5,285 to Hansen; $4,915 to Fleming. e. $0; Hansen and Fleming grant a bonus to Black. 5. Mee Su is a partner in Hartford Partners, LLC. Her partnership

capital balance at the beginning of the current year was $110,000, and her ending balance was $124,000. Her share of the partner- ship income is $10,500. What is her partner return on equity?

a. 8.97% b. 1060.00% c. 9.54% d. 1047.00% e. 8.47%

1. Stokely and Leder are forming a partnership. Stokely invests a building that has a market value of $250,000; and the part- nership assumes responsibility for a $50,000 note secured by a mortgage on that building. Leder invests $100,000 cash. For the partnership, the amounts recorded for the building and for Stokely’s Capital account are these:

a. Building, $250,000; Stokely, Capital, $250,000. b. Building, $200,000; Stokely, Capital, $200,000. c. Building, $200,000; Stokely, Capital, $100,000. d. Building, $200,000; Stokely, Capital, $250,000. e. Building, $250,000; Stokely, Capital, $200,000. 2. Katherine, Alliah, and Paulina form a partnership. Katherine

contributes $150,000, Alliah contributes $150,000, and Paulina contributes $100,000. Their partnership agreement calls for the income or loss division to be based on the ratio of capital invested. If the partnership reports income of $90,000 for its first year of operations, what amount of income is credited to Paulina’s capital account?

a. $22,500 b. $25,000 c. $45,000 d. $30,000 e. $90,000 3. Jamison and Blue form a partnership with capital contributions

of $600,000 and $800,000, respectively. Their partnership agreement calls for Jamison to receive $120,000 per year in salary. Also, each partner is to receive an interest allowance equal to 10% of the partner’s beginning capital contributions,

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Appendix D Accounting for Partnerships D-19

QS D-6 Admission of a partner

P3

Jules and Johnson are partners, each with $40,000 in their partnership capital accounts. Kwon is admitted to the partnership by investing $40,000 cash. Make the entry to show Kwon’s admission to the partnership.

QS D-7 Liquidation of partnership

P4

The Field, Brown & Snow partnership was begun with investments by the partners as follows: Field, $131,250; Brown, $165,000; and Snow, $153,750. The operations did not go well, and the partners eventu- ally decided to liquidate the partnership, sharing all losses equally. On May 31, after all assets were con- verted to cash and all creditors were paid, only $45,000 in partnership cash remained. 1. Compute the capital account balance of each partner after the liquidation of assets and the payment of

creditors. 2. Assume that any partner with a deficit agrees to pay cash to the partnership to cover the deficit.

Present the journal entries on May 31 to record (a) the cash receipt from the deficient partner(s) and (b) the final disbursement of cash to the partners.

3. Assume that any partner with a deficit is not able to reimburse the partnership. Present journal entries (a) to transfer the deficit of any deficient partners to the other partners and (b) to record the final disbursement of cash to the partners.

Check (1) Field, $(3,750)

QS D-4 Liability in limited partnerships

P1

Fancher organized a limited partnership and is the only general partner. Carley invested $20,000 in the partnership and was admitted as a limited partner with the understanding that she would receive 10% of the profits. After two unprofitable years, the partnership ceased doing business. At that point, partnership liabilities were $85,000 larger than partnership assets. How much money can the partnership’s creditors obtain from Carley’s personal assets to satisfy the unpaid partnership debts?

QS D-8 Partner return on equity

A1

Howe and Duley’s company is organized as a partnership. At the prior year-end, partnership equity totaled $150,000 ($100,000 from Howe and $50,000 from Duley). For the current year, partnership net income is $24,990 ($20,040 allocated to Howe and $4,950 allocated to Duley), and year-end total partnership equity is $200,000 ($140,000 from Howe and $60,000 from Duley). Compute the total partnership return on equity and the individual partner return on equity ratios.

Amy and Lester are partners in operating a store. Without consulting Amy, Lester enters into a contract to purchase merchandise for the store. Amy contends that she did not authorize the order and refuses to pay for it. The vendor sues the partners for the contract price of the merchandise. (a) Must the partnership pay for the merchandise? Why? (b) Does your answer differ if Amy and Lester are partners in a public accounting firm? Explain.

QUICK STUDY

QS D-1 Partnership liability

C1

QS D-2 Partnership income allocation

P2

Ann Stolton and Susie Bright are partners in a business they started two years ago. The partnership agreement states that Stolton should receive a salary allowance of $15,000 and that Bright should receive a $20,000 salary allowance. Any remaining income or loss is to be shared equally. Determine each partner’s share of the current year’s net income of $52,000.

QS D-3 Partnership income allocation

P2

Blake and Matthew are partners who agree that Blake will receive a $100,000 salary allowance and that any remaining income or loss will be shared equally. If Matthew’s capital account is credited for $2,000 as his share of the net income in a given period, how much net income did the partnership earn in that period?

QS D-5 Partner admission through purchase of interest

P3

Stein agrees to pay Choi and Amal $10,000 each for a one-third (331⁄3%) interest in the Choi and Amal partnership. Immediately prior to Stein’s admission, each partner had a $30,000 capital balance. Make the journal entry to record Stein’s purchase of the partners’ interest.

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D-20 Appendix D Accounting for Partnerships

Characteristic Application to General Partnerships

1. Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2. Owners’ liability . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3. Legal status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4. Tax status of income . . . . . . . . . . . . . . . . . . . . . . .

5. Owners’ authority . . . . . . . . . . . . . . . . . . . . . . . . . .

6. Ease of formation . . . . . . . . . . . . . . . . . . . . . . . . . .

7. Transferability of ownership . . . . . . . . . . . . . . . . . .

8. Ability to raise large amounts of capital . . . . . . . .

Exercise D-4 Journalizing partnership formation

P2

Angela Moss and Autumn Barber organize a partnership on January 1. Moss’s initial net investment is $75,000, consisting of cash ($17,500), equipment ($82,500), and a note payable reflecting a bank loan for the new business ($25,000). Barber’s initial investment is cash of $31,250. These amounts are the values agreed on by both partners. Prepare journal entries to record (1) Moss’s investment and (2) Barber’s investment.

Exercise D-5 Income allocation in a partnership

P2

Kramer and Knox began a partnership by investing $60,000 and $80,000, respectively. During its first year, the partnership earned $160,000. Prepare calculations showing how the $160,000 income should be allo- cated to the partners under each of the following three separate plans for sharing income and loss: (1) the partners failed to agree on a method to share income; (2) the partners agreed to share income and loss in proportion to their initial investments (round amounts to the nearest dollar); and (3) the partners agreed to share income by granting a $50,000 per year salary allowance to Kramer, a $40,000 per year salary allow- ance to Knox, 10% interest on their initial capital investments, and the remaining balance shared equally.Check Plan 3, Kramer, $84,000

EXERCISES

Exercise D-1 Characteristics of partnerships

C1

Next to the following list of eight characteristics of business organizations, enter a brief description of how each characteristic applies to general partnerships.

Exercise D-2 Forms of organization

C1

For each of the following separate cases, recommend a form of business organization. With each recom- mendation, explain how business income would be taxed if the owners adopt the form of organization rec- ommended. Also list several advantages that the owners will enjoy from the form of business organization that you recommend. a. Sharif, Henry and Korb are recent college graduates in computer science. They want to start a Website

development company. They all have college debts and currently do not own any substantial computer equipment needed to get the company started.

b. Dr. Ward and Dr. Liu are recent graduates from medical residency programs. Both are family practice physicians and would like to open a clinic in an underserved rural area. Although neither has any funds to bring to the new venture, an investor has expressed interest in making a loan to provide start- up funds for their practice.

c. Munson has been out of school for about five years and has become quite knowledgeable about the resi- dential real estate market. He would like to organize a company that buys and sells real estate. Munson believes he has the expertise to manage the company but needs funds to invest in residential property.

Exercise D-3 Journalizing partnership transactions

P2

On March 1, 2013, Eckert and Kelley formed a partnership. Eckert contributed $82,500 cash and Kelley contributed land valued at $60,000 and a building valued at $100,000. The partnership also assumed responsibility for Kelley’s $92,500 long-term note payable associated with the land and building. The partners agreed to share income as follows: Eckert is to receive an annual salary allowance of $25,000, both are to receive an annual interest allowance of 10% of their beginning-year capital investment, and any remaining income or loss is to be shared equally. On October 20, 2013, Eckert withdrew $34,000 cash and Kelley withdrew $20,000 cash. After the adjusting and closing entries are made to the revenue and expense accounts at December 31, 2013, the Income Summary account had a credit balance of $90,000. 1. Prepare journal entries to record (a) the partners’ initial capital investments, (b) their cash withdraw-

als, and (c) the December 31 closing of both the Withdrawals and Income Summary accounts. 2. Determine the balances of the partners’ capital accounts as of December 31, 2013.Check (2) Kelley, $79,250

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Appendix D Accounting for Partnerships D-21

Exercise D-9 Sale of partnership interest

P3

The partners in the Biz Partnership have agreed that partner Mandy may sell her $100,000 equity in the partnership to Brittney, for which Brittney will pay Mandy $85,000. Present the partnership’s journal entry to record the sale of Mandy’s interest to Brittney on September 30.

Exercise D-11 Liquidation of limited partnership

P4

Assume that the Turner, Roth, and Lowe partnership of Exercise D-10 is a limited partnership. Turner and Roth are general partners and Lowe is a limited partner. How much of the remaining $28,000 liability should be paid by each partner? (Round amounts to the nearest dollar.)

Exercise D-6 Income allocation in a partnership

P2

Assume that the partners of Exercise D-5 agreed to share net income and loss by granting annual salary allowances of $50,000 to Kramer and $40,000 to Knox, 10% interest allowances on their investments, and any remaining balance shared equally. 1. Determine the partners’ shares of Kramer and Knox given a first-year net income of $98,800. 2. Determine the partners’ shares of Kramer and Knox given a first-year net loss of $16,800. Check (2) Kramer, $(4,400)

Exercise D-10 Liquidation of partnership

P4

Turner, Roth, and Lowe are partners who share income and loss in a 1:4:5 ratio. After lengthy disagreements among the partners and several unprofitable periods, the partners decide to liquidate the partnership. Im- mediately before liquidation, the partnership balance sheet shows total assets, $126,000; total liabilities, $78,000; Turner, Capital, $2,500; Roth, Capital, $14,000; and Lowe, Capital, $31,500. The cash proceeds from selling the assets were sufficient to repay all but $28,000 to the creditors. (a) Calculate the loss from selling the assets. (b) Allocate the loss to the partners. (c) Determine how much of the remaining liability should be paid by each partner.

Check (b) Lowe, Capital after allocation, $(6,500)

Exercise D-12 Partner return on equity

A1

Rugged Sports Enterprises LP is organized as a limited partnership consisting of two individual partners: Hockey LP and Football LP. Both partners separately operate a minor league hockey team and a semipro football team. Compute partner return on equity for each limited partnership (and the total) for the year ended June 30, 2013, using the following selected data on partner capital balances from Rugged Sports Enterprises LP.

Hockey LP Football LP Total

Balance at 6/30/2012 . . . . . . . . . $189,000 $ 758,000 $ 947,000

Annual net income . . . . . . . . . . 22,208 445,473 468,032

Cash distribution . . . . . . . . . . . — (50,000) (50,000)

Balance at 6/30/2013 . . . . . . . . . $211,134 $1,153,898 $1,365,032

Exercise D-7 Admission of new partner

P3

The Struter Partnership has total partners’ equity of $510,000, which is made up of Main, Capital, $400,000, and Frist, Capital, $110,000. The partners share net income and loss in a ratio of 80% to Main and 20% to Frist. On November 1, Madison is admitted to the partnership and given a 15% interest in equity and a 15% share in any income and loss. Prepare the journal entry to record the admission of Madison under each of the following separate assumptions: Madison invests cash of (1) $90,000; (2) $120,000; and (3) $80,000.

Exercise D-8 Retirement of partner

P3

Hunter, Folgers, and Tulip have been partners while sharing net income and loss in a 5:3:2 ratio. On January 31, the date Tulip retires from the partnership, the equities of the partners are Hunter, $150,000; Folgers, $90,000; and Tulip, $60,000. Present journal entries to record Tulip’s retirement under each of the following separate assumptions: Tulip is paid for her equity using partnership cash of (1) $60,000; (2) $80,000; and (3) $30,000.

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D-22 Appendix D Accounting for Partnerships

Check (3) Thomas, Capital, $97,800

PROBLEM SET A

Problem D-1A Allocating partnership income

P2

Kara Ries, Tammy Bax, and Joe Thomas invested $80,000, $112,000, and $128,000, respectively, in a partnership. During its first calendar year, the firm earned $249,000.

Required

Prepare the entry to close the firm’s Income Summary account as of its December 31 year-end and to al- locate the $249,000 net income to the partners under each of the following separate assumptions: The partners (1) have no agreement on the method of sharing income and loss; (2) agreed to share income and loss in the ratio of their beginning capital investments; and (3) agreed to share income and loss by provid- ing annual salary allowances of $66,000 to Ries, $56,000 to Bax, and $80,000 to Thomas; granting 10% interest on the partners’ beginning capital investments; and sharing the remainder equally.

Problem D-2A Allocating partnership income and loss; sequential years

P2

Irene Watts and John Lyon are forming a partnership to which Watts will devote one-half time and Lyon will devote full time. They have discussed the following alternative plans for sharing income and loss: (a) in the ratio of their initial capital investments, which they have agreed will be $42,000 for Watts and $63,000 for Lyon; (b) in proportion to the time devoted to the business; (c) a salary allowance of $6,000 per month to Lyon and the balance in accordance with the ratio of their initial capital investments; or (d ) a salary allowance of $6,000 per month to Lyon, 10% interest on their initial capital investments, and the balance shared equally. The partners expect the business to perform as follows: year 1, $36,000 net loss; year 2, $90,000 net income; and year 3, $150,000 net income.

Required

Prepare three tables with the following column headings.

Income (Loss) Year

Sharing Plan Calculations Watts Lyon

Complete the tables, one for each of the first three years, by showing how to allocate partnership income or loss to the partners under each of the four plans being considered. (Round answers to the nearest whole dollar.)

Check Plan d, year 1, Lyon’s share, $19,050

Check (2) Barb, Ending Capital, $449,600

Problem D-3A Partnership income allocation, statement of partners’ equity, and closing entries

P2

Bill Beck, Bruce Beck, and Barb Beck formed the BBB Partnership by making capital contributions of $67,500, $262,500, and $420,000, respectively. They predict annual partnership net income of $450,000 and are considering the following alternative plans of sharing income and loss: (a) equally; (b) in the ratio of their initial capital investments; or (c) salary allowances of $80,000 to Bill, $60,000 to Bruce, and $90,000 to Barb; interest allowances of 10% on their initial capital investments; and the balance shared as follows: 20% to Bill, 40% to Bruce, and 40% to Barb..

Required

1. Prepare a table with the following column headings.

Income (Loss) Sharing Plan Calculations Bill Bruce Barb Total

Use the table to show how to distribute net income of $450,000 for the calendar year under each of the alternative plans being considered. (Round answers to the nearest whole dollar.)

2. Prepare a statement of partners’ equity showing the allocation of income to the partners assuming they agree to use plan (c), that income earned is $209,000, and that Bill, Bruce, and Barb withdraw $34,000, $48,000, and $64,000, respectively, at year-end.

3. Prepare the December 31 journal entry to close Income Summary assuming they agree to use plan (c) and that net income is $209,000. Also close the withdrawals accounts.

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Appendix D Accounting for Partnerships D-23

Problem D-4A Partner withdrawal and admission

P3

Part 1. Meir, Benson, and Lau are partners and share income and loss in a 3:2:5 ratio. The partnership’s capital balances are as follows: Meir, $168,000; Benson, $138,000; and Lau, $294,000. Benson decides to withdraw from the partnership, and the partners agree to not have the assets revalued upon Benson’s retirement. Prepare journal entries to record Benson’s February 1 withdrawal from the partnership under each of the following separate assumptions: Benson (a) sells her interest to North for $160,000 after Meir and Lau approve the entry of North as a partner; (b) gives her interest to a son-in-law, Schmidt, and thereafter Meir and Lau accept Schmidt as a partner; (c) is paid $138,000 in partnership cash for her equity; (d ) is paid $214,000 in partnership cash for her equity; and (e) is paid $30,000 in partnership cash plus equipment recorded on the partnership books at $70,000 less its accumulated depreciation of $23,200.

Part 2. Assume that Benson does not retire from the partnership described in Part 1. Instead, Rhode is admitted to the partnership on February 1 with a 25% equity. Prepare journal entries to record Rhode’s entry into the partnership under each of the following separate assumptions: Rhode invests (a) $200,000; (b) $145,000; and (c) $262,000.

Check (1e) Cr. Lau, Capital, $38,250

(2c) Cr. Benson, Capital, $9,300

Problem D-2B Allocating partnership income and loss; sequential years

P2

Maria Bell and J.R. Green are forming a partnership to which Bell will devote one-third time and Green will devote full time. They have discussed the following alternative plans for sharing income and loss: (a) in the ratio of their initial capital investments, which they have agreed will be $104,000 for Bell and $156,000 for Green; (b) in proportion to the time devoted to the business; (c) a salary allowance of $4,000 per month to Green and the balance in accordance with the ratio of their initial capital investments; or

Problem D-5A Liquidation of a partnership

P4

Kendra, Cogley, and Mei share income and loss in a 3:2:1 ratio. The partners have decided to liquidate their partnership. On the day of liquidation their balance sheet appears as follows.

KENDRA, COGLEY, AND MEI Balance Sheet

May 31

Assets Liabilities and Equity

Cash . . . . . . . . . . . . . $180,800 Accounts payable . . . . . . . . . . . . . . . $245,500

Inventory . . . . . . . . . . 537,200 Kendra, Capital . . . . . . . . . . . . . . . . . 93,000

Cogley, Capital . . . . . . . . . . . . . . . . . 212,500

Mei, Capital . . . . . . . . . . . . . . . . . . . . 167,000

Total assets . . . . . . . . $718,000 Total liabilities and equity . . . . . . . . . $718,000

Required

Prepare journal entries for (a) the sale of inventory, (b) the allocation of its gain or loss, (c) the payment of liabilities at book value, and (d ) the distribution of cash in each of the following separate cases: Inventory is sold for (1) $600,000; (2) $500,000; (3) $320,000 and any partners with capital deficits pay in the amount of their deficits; and (4) $250,000 and the partners have no assets other than those invested in the partnership. (Round to the nearest dollar.)

Check (4) Cash distribution: Mei, $102,266

Mark Albin, Roland Peters and Sam Ramsey invested $164,000, $98,400 and $65,600, respectively, in a partnership. During its first calendar year, the firm earned $270,000.

Required

Prepare the entry to close the firm’s Income Summary account as of its December 31 year-end and to al- locate the $270,000 net income to the partners under each of the following separate assumptions. (Round answers to whole dollars.) The partners (1) have no agreement on the method of sharing income and loss; (2) agreed to share income and loss in the ratio of their beginning capital investments; and (3) agreed to share income and loss by providing annual salary allowances of $96,000 to Albin, $72,000 to Peters, and $50,000 to Ramsey; granting 10% interest on the partners’ beginning capital investments; and sharing the remainder equally.

PROBLEM SET B

Problem D-1B Allocating partnership income

P2

Check (3) Ramsey, Capital, $62,960

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D-24 Appendix D Accounting for Partnerships

(d ) a salary allowance of $4,000 per month to Green, 10% interest on their initial capital investments, and the balance shared equally. The partners expect the business to perform as follows: year 1, $36,000 net loss; year 2, $76,000 net income; and year 3, $188,000 net income.

Required

Prepare three tables with the following column headings.

Income (Loss) Year

Sharing Plan Calculations Bell Green

Complete the tables, one for each of the first three years, by showing how to allocate partnership income or loss to the partners under each of the four plans being considered. (Round answers to the nearest whole dollar.)

Check Plan d, year 1, Green’s share, $8,600

Problem D-3B Partnership income allocation, statement of partners’ equity, and closing entries

P2

Sally Cook, Lin Xi, and Ken Schwartz formed the CXS Partnership by making capital contributions of $144,000, $216,000, and $120,000, respectively. They predict annual partnership net income of $240,000 and are considering the following alternative plans of sharing income and loss: (a) equally; (b) in the ratio of their initial capital investments; or (c) salary allowances of $40,000 to Cook, $30,000 to Xi, and $80,000 to Schwartz; interest allowances of 12% on their initial capital investments; and the balance shared equally.

Required

1. Prepare a table with the following column headings.

Income (Loss) Sharing Plan Calculations Cook Xi Schwartz Total

Use the table to show how to distribute net income of $240,000 for the calendar year under each of the alternative plans being considered. (Round answers to the nearest whole dollar.)

2. Prepare a statement of partners’ equity showing the allocation of income to the partners assuming they agree to use plan (c), that income earned is $87,600, and that Cook, Xi, and Schwartz withdraw $18,000, $38,000, and $24,000, respectively, at year-end.

3. Prepare the December 31 journal entry to close Income Summary assuming they agree to use plan (c) and that net income is $87,600. Also close the withdrawals accounts.

Check (2) Schwartz, Ending Capital, $150,400

Problem D-4B Partner withdrawal and admission

P3

Part 1. Gibbs, Cook, and Chan are partners and share income and loss in a 5:1:4 ratio. The partnership’s capital balances are as follows: Gibbs, $606,000; Cook, $148,000; and Chan, $446,000. Gibbs decides to withdraw from the partnership, and the partners agree not to have the assets revalued upon Gibbs’s retire- ment. Prepare journal entries to record Gibbs’s April 30 withdrawal from the partnership under each of the following separate assumptions: Gibbs (a) sells her interest to Brady for $250,000 after Cook and Chan approve the entry of Brady as a partner; (b) gives her interest to a daughter-in-law, Cannon, and thereafter Cook and Chan accept Cannon as a partner; (c) is paid $606,000 in partnership cash for her equity; (d ) is paid $350,000 in partnership cash for her equity; and (e) is paid $200,000 in partnership cash plus manu- facturing equipment recorded on the partnership books at $538,000 less its accumulated depreciation of $336,000.

Part 2. Assume that Gibbs does not retire from the partnership described in Part 1. Instead, Chip is admitted to the partnership on April 30 with a 20% equity. Prepare journal entries to record the entry of Brise under each of the following separate assumptions: Chip invests (a) $300,000; (b) $196,000; and (c) $426,000.

Check (1e) Cr. Chan, Capital, $163,200

Check (2c) Cr. Cook, Capital, $10,080

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Appendix D Accounting for Partnerships D-25

Problem D-5B Liquidation of a partnership

P4

Lasure, Ramirez, and Toney, who share income and loss in a 2:1:2 ratio, plan to liquidate their partnership. At liquidation, their balance sheet appears as follows.

LASURE, RAMIREZ, AND TONEY Balance Sheet

January 18

Assets Liabilities and Equity

Cash . . . . . . . . . . . . . $348,600 Accounts payable . . . . . . . . . . . . . . . $342,600

Equipment . . . . . . . . . 617,200 Lasure, Capital . . . . . . . . . . . . . . . . . 300,400

Ramirez, Capital . . . . . . . . . . . . . . . . 195,800

Toney, Capital . . . . . . . . . . . . . . . . . . 127,000

Total assets . . . . . . . . $965,800 Total liabilities and equity . . . . . . . . . $965,800

Required

Prepare journal entries for (a) the sale of equipment, (b) the allocation of its gain or loss, (c) the payment of liabilities at book value, and (d ) the distribution of cash in each of the following separate cases: Equipment is sold for (1) $650,000; (2) $530,000; (3) $200,000 and any partners with capital deficits pay in the amount of their deficits; and (4) $150,000 and the partners have no assets other than those invested in the partnership. (Round amounts to the nearest dollar.)

Check (4) Cash distribution: Lasure, $73,600

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP D At the start of 2014, Adria Lopez is considering adding a partner to her business. She envisions the new partner taking the lead in generating sales of both services and merchandise for Success Systems. A. Lopez’s equity in Success Systems as of January 1, 2014, is reflected in the following capital balance.

SERIAL PROBLEM Success Systems

P3

A. Lopez, Capital. . . . . . . . . . $90,148

Required

1. A. Lopez is evaluating whether the prospective partner should be an equal partner with respect to capital investment and profit sharing (1:1) or whether the agreement should be 4:1 with Lopez retain- ing four-fifths interest with rights to four-fifths of the net income or loss. What factors should she consider in deciding which partnership agreement to offer?

2. Prepare the January 1, 2014, journal entry(ies) necessary to admit a new partner to Success Systems through the purchase of a partnership interest for each of the following two separate cases: (a) 1:1 sharing agreement and (b) 4:1 sharing agreement.

3. Prepare the January 1, 2014, journal entry(ies) required to admit a new partner if the new partner in- vests cash of $22,537.

4. After posting the entry in part 3, what would be the new partner’s equity percentage?

BTN D-1 Take a step back in time and imagine Polaris in its infancy as a company. The year is 1954.

Required

1. Read the history of Polaris at www.Polaris.com. Identify the founder of the company. 2. Assume that Polaris was originally organized as a partnership. Polaris’s income statement in Appendix

A varies in several key ways from what it would look like for a partnership. Identify at least two ways in which a corporate income statement differs from a partnership income statement.

3. Compare the Polaris balance sheet in Appendix A to what a partnership balance sheet would have shown. Identify and explain any account differences we would anticipate.

Beyond the Numbers

REPORTING IN ACTION C1

Polaris

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D-26 Appendix D Accounting for Partnerships

BTN D-2 Over the years Polaris and Arctic Cat have evolved into large corporations. Today it is diffi- cult to imagine them as fledgling start-ups. Research each company’s history online.

Required

1. Which company is older? 2. In what years did each company have its first public offering of stock? 3. Which stock exchange is each company listed under?

COMPARATIVE ANALYSIS C1

BTN D-3 Doctors Mobey, Oak, and Chesterfield have been in a group practice for several years. Mobey and Oak are family practice physicians, and Chesterfield is a general surgeon. Chesterfield receives many referrals for surgery from his family practice partners. Upon the partnership’s original formation, the three doctors agreed to a two-part formula to share income. Every month each doctor receives a salary allowance of $3,000. Additional income is divided according to a percent of patient charges the doctors generate for the month. In the current month, Mobey generated 10% of the billings, Oak 30%, and Chesterfield 60%. The group’s income for this month is $50,000. Chesterfield has expressed dissatisfaction with the income- sharing formula and asks that income be split entirely on patient charge percents.

Required

1. Compute the income allocation for the current month using the original agreement. 2. Compute the income allocation for the current month using Chesterfield’s proposed agreement. 3. Identify the ethical components of this partnership decision for the doctors.

ETHICS CHALLENGE P2

BTN D-4 Assume that you are studying for an upcoming accounting exam with a good friend. Your friend says that she has a solid understanding of general partnerships but is less sure that she understands organizations that combine certain characteristics of partnerships with other forms of business organiza- tion. You offer to make some study notes for your friend to help her learn about limited partnerships, limited liability partnerships, S corporations, and limited liability companies. Prepare a one-page set of well-organized, complete study notes on these four forms of business organization.

COMMUNICATING IN PRACTICE C1

BTN D-5 Access the March 14, 2011, filing of the December 31, 2010, 10-K of America First Tax Exempt Investors LP. This company deals with tax-exempt mortgage revenue bonds that, among other things, finance student housing properties. 1. Locate its December 31, 2010, balance sheet and list the account titles reported in the equity section

of the balance sheet. 2. Locate its statement of partners’ capital and comprehensive income (loss). How many units of limited

partnership (known as “beneficial unit certificate holders”) are outstanding at December 31, 2010? 3. What is the partnership’s largest asset and its amount at December 31, 2010?

TAKING IT TO THE NET P1 P2

BTN D-6 This activity requires teamwork to reinforce understanding of accounting for partnerships.

Required

1. Assume that Baker, Warner, and Rice form the BWR Partnership by making capital contributions of $200,000, $300,000, and $500,000, respectively. BWR predicts annual partnership net income of $450,000. The partners are considering various plans for sharing income and loss. Assign a different team member to compute how the projected $450,000 income would be shared under each of the fol- lowing separate plans:

a. Shared equally. b. In the ratio of the partners’ initial capital investments. c. Salary allowances of $50,000 to Baker, $60,000 to Warner, and $70,000 to Rice, with the remain-

ing balance shared equally. d. Interest allowances of 10% on the partners’ initial capital investments, with the remaining balance

shared equally.

TEAMWORK IN ACTION P2

Polaris Arctic Cat

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Appendix D Accounting for Partnerships D-27

2. In sequence, each member is to present his or her income-sharing calculations with the team. 3. As a team, identify and discuss at least one other possible way that income could be shared.

BTN D-7 Omar Soliman and Nick Friedman are founding partners of their company, College Hunks Hauling Junk LLC. Assume that Omar and Nick decide to expand their business with the help of general partners.

Required

1. What details should Omar, Nick, and their future partners specify in the general partnership agreements?

2. What advantages should Omar, Nick, and their future partners be aware of with respect to orga nizing as a general partnership?

3. What disadvantages should Omar, Nick, and their future partners be aware of with respect to organiz- ing as a general partnership?

ENTREPRENEURIAL DECISION C1

BTN D-8 Access KTM’s Website (www.KTM.com) and research the company’s history (profile). 1. When did the company go public? 2. What stock exchange is the company listed under? 3. What are the companies that are part of KTM?

GLOBAL DECISION C1

1. e; Capital 5 $250,000 2 $50,000 2. a; $90,000 3 [$100,000y($150,000 1 $150,000 1 $100,000)]

5 $22,500

3. d;

4. b; Total partnership equity 5 $125,000 1 $124,000 1 $75,000 5 $324,000

Equity of Black 5 $324,000 3 20% 5 $64,800 Bonus to old partners 5 $75,000 2 $64,800 5 $10,200, split equally 5. a; $10,500y[($110,000 1 $124,000)y2] 5 8.97%

ANSWERS TO MULTIPLE CHOICE QUIZ

Jamison Blue Total

Net income . . . . . . . . . . . . . . . . . . $ 270,000

Salary allowance . . . . . . . . . . . . . . . $120,000 (120,000)

Interest allowance . . . . . . . . . . . . . 60,000 $80,000 (140,000)

Balance of income . . . . . . . . . . . . . 10,000

Balance divided equally . . . . . . . . . 5,000 5,000 (10,000)

Totals . . . . . . . . . . . . . . . . . . . . . . . $185,000 $85,000 $ 0

KTM

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Learning Objectives

CONCEPTUAL

C1 Identify the principles and components of accounting information systems. (p. E-1) C2 Explain the goals and uses of special journals. (p. E-4) C3 Describe the use of controlling accounts and subsidiary ledgers. (p. E-5)

ANALYTICAL

A1 Compute segment return on assets and use it to evaluate segment performance. (p. E-18)

PROCEDURAL

P1 Journalize and post transactions using special journals. (p. E-7) P2 Prepare and prove the accuracy of subsidiary ledgers. (p. E-8) P3 Journalize and post transactions using special journals in a periodic inventory

system. (p. E-25)

A Look at This Appendix

This appendix emphasizes accounting information systems. We describe fundamental system principles, the system’s components, use of special journals and subsidiary ledgers, and technology-based systems.

Accounting with Special Journals E

E

Appendix

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Appendix Preview

With increases in the number and complexity of business activi- ties, the demands placed on accounting information systems increase. Accounting information systems must meet this chal- lenge in an efficient and effective manner. In this appendix, we learn about fundamental principles guiding information systems, and we study components making up these systems. We also

explain procedures that use special journals and subsidiary ledgers to make accounting information systems more efficient. An understanding of the details of accounting reports makes us better decision makers when using financial information, and it improves our ability to analyze and interpret financial statements.

Accounting information systems collect and process data from transactions and events, orga- n ize them in useful reports, and communicate results to decision makers. With the increasing complexity of business and the growing need for information, accounting information systems are more important than ever. All decision makers need to have a basic knowledge of how accounting information systems work. This knowledge gives decision makers a competitive edge as they gain a better understanding of informa- tion constraints, measurement limitations, and poten- tial applications. It allows them to make more informed decisions and to better balance the risks and returns of different strategies. This section explains five basic principles of account ing information systems, shown in Exhibit E.1.

Control Principle Managers need to control and monitor business activi- ties. The control principle prescribes that an account- ing information system have internal controls. Internal controls are methods and procedures allowing man- agers to control and monitor business activities. They include policies to direct operations toward common goals, procedures to ensure reliable financial reports, safeguards to protect company assets, and methods to achieve compliance with laws and regulations.

Relevance Principle Decision makers need relevant information to make informed decisions. The relevance principle prescribes that an accounting information system report useful, understandable, timely, and pertinent information for effective decision making. The system must be designed to capture data that make a difference in decisions. To ensure this, we must consider all decision makers when identifying relevant information for disclosure.

C1 Identify the principles and components of accounting information systems.

FUNDAMENTAL SYSTEM PRINCIPLES

EXHIBIT E.1 System Principles

Control

RelevanceCost-Benefit Principle

CompatibilityFlexibility

System Principles

Point: Hackers stole 45 million debit and credit card numbers from T. J. Maxx. The security breach is estimated to have cost the company $100 per card or $4.5 billion.

E-1

System Components

• Source documents • Input devices • Processors • Storage • Output devices

System Principles

• Control • Relevance • Compatibility • Flexibility • Cost-Benefit

Special Journals

• Subsidiary ledgers • Sales journal • Cash receipts journal • Purchases journal • Cash disbursements

journal

System Technology

• Computers • Data processing • Networks • Enterprise resource

planning (ERP)

Accounting with Special Journals

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E-2 Appendix E Accounting with Special Journals

Compatibility Principle Accounting information systems must be consistent with the aims of a company. The compatibility principle prescribes that an accounting information system conform with a com pany’s activities, personnel, and structure. It also must adapt to a company’s unique characteristics. The system must not be intrusive but must work in harmony with and be driven by company goals. Most start-up entrepreneurs require only a simple information system. Starbucks, on the other hand, demands both a merchandising and a manufacturing information system able to assemble data from its global operations.

Flexibility Principle Accounting information systems must be able to adjust to changes. The flexibility principle prescribes that an accounting information system be able to adapt to changes in the company, business environment, and needs of decisions makers. Technological advances, competitive pressures, consumer tastes, regulations, and company activities constantly evolve. A system must be designed to adapt to these changes.

Cost-Benefit Principle The cost-benefit principle prescribes that the benefits from an activity in an accounting in- formation system outweigh the costs of that activity. The costs and benefits of an activity such as producing a specific report will impact the decisions of both external and internal users. Decisions regarding other systems principles (control, relevance, compatibility, and flexibility) are also affected by the cost-benefit principle.

Point: Law requires that all employers destroy credit-check and other employee records before tossing them. A cross-cut shredder is the tool of choice.

Accounting information systems consist of people, records, methods, and equipment. The systems are designed to capture information about a company’s transactions and to provide output including financial, managerial, and tax reports. All accounting information systems have these same goals, and thus share some basic components. These components apply whether or not a system is heavily computerized, yet the components of computerized systems usually provide more accuracy, speed, efficiency, and convenience than those of manual systems. The five basic components of accounting systems are source documents, input devices, information processors, information storage, and output devices. Exhibit E.2 shows these components as a series of steps, yet we know that much two-way communication occurs be- tween many of these components. We briefly describe each of these key components in this section.

COMPONENTS OF ACCOUNTING SYSTEMS

EXHIBIT E.2 Accounting System Components

Output

Devices

Source

Document

Input

Devices

Information

Processor

Information

Storage

Cloud

Storage

Digitals Are Forever E-communications have helped bring down many employees, including the former CEO of Boeing. To comply with Sarbanes-Oxley, more and more companies now archive and monitor e-mails, instant messages, blog postings, and Net -based phone calls. Using natural-language software, com- panies sift through digital communications in milliseconds, checking for trade secrets, bad language, porn, and pirated files. Also, employers should draft policies for employee use and access to electronic media to preserve company property interest and access rights to electronic data. ■

Decision Insight

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c o

S Y S T E M P R I N C I P L E S

t - b e n e f i t

p a

e

o

e x i b i l i t yf

n t r o l

l e v a n c e

t a b i i t yl

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Appendix E Accounting with Special Journals E-3

Source Documents We introduced source documents in Chapters 1 and 2 and explained their importance for both business transactions and information collection. Source documents provide the basic information processed by an accounting system. Examples of source documents include bank statements and checks, invoices from suppliers, billings to customers, cash register files, and employee earnings records. Source documents can be paper, although they increasingly are taking the form of elec- tronic files and Web communications. A growing number of companies are sending documents directly from their systems to their customers’ and suppliers’ systems. The Web is playing a major role in this transformation from paper-based to paperless systems. Accurate source documents are crucial to accounting information systems. Input of faulty or incomplete information seriously impairs the reliability and relevance of the information system. We commonly refer to this as “garbage in, garbage out.” Information systems are set up with attention on control procedures to limit the possibility of entering faulty data in the system.

Input Devices Input devices capture information from source documents and enable its transfer to the system’s information processing component. These devices often involve converting data on source doc- uments from written or electronic form to a form usable for the system. Journal entries, both electronic and paper based, are a type of input device. Keyboards, scanners, and modems are some of the most common input devices in practice today. For example, bar code readers cap- ture code numbers and transfer them to the organization’s computer for processing. Moreover, a scanner can capture writing samples and other input directly from source documents. Cell phone cameras also can serve as input devices via bar codes. Controls are used to ensure that only authorized individuals input data to the system. Con- trols increase the system’s reliability and allow information to be traced back to its source.

Information Processors Information processors are systems that interpret, transform, and summarize information for use in analysis and reporting. An important part of an information processor in accounting systems is professional judgment. Accounting principles are never so structured that they limit the need for professional judgment. Other parts of an information processor include journals, ledgers, working papers, and posting procedures. Each assists in transforming raw data to useful information. Increasingly, computer technology (both computing hardware and software) is assisting man- ual information processors. This assistance is freeing accounting professionals to take on in- creased analysis, interpretive, and managerial roles. Web-based application service providers (ASPs) offer another type of information processor.

Information Storage Information storage is the accounting system component that keeps data in a form accessible to information processors. After being input and processed, data are stored for use in future analyses and reports. The database must be accessible to preparers of periodic financial reports. Auditors rely on this database when they audit both financial statements and a company’s con- trols. Companies also maintain files of source documents.

Older systems consisted almost exclusively of paper documents, but most modern systems depend on electronic storage devices or, increasingly, cloud storage. Advances in information

Point: Understanding a manual accounting system is useful in understanding an electronic system.

Point: BusinessWeek reported that 75% of all e-mail traffic is spam.

Point: Well-designed accounting soft- ware includes a report generator that allows accountants to design and customize internal reports.

Siri Exposure Siri (Speech Interpretation and Recognition Inter- face) is an intelligent personal assistant and knowledge navigator that works as an application for Apple’s iOS. The latest iPhones in- clude Siri, including its voice recognition capabilities. Companies should ask: Siri, do we have adequate controls for inputs to our sys- tem via voice recognition? ■

Decision Insight

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E-4 Appendix E Accounting with Special Journals

storage enable accounting systems to increasingly store more detailed data. This means managers have more data to access and work with in planning and controlling business activities. Informa- tion storage can be online, meaning that data can be accessed whenever, and from wherever, it is needed. Off-line storage means access often requires assistance and authorization. Information storage is increasingly augmented by Web sources such as SEC databases, benchmarking services, and financial and product markets. Also, audit technology allows external auditors 365-day real- time access to client records from remote locations.

1. Identify the five primary components of an accounting information system. 2. What is the aim of information processors in an accounting system? 3. How are data in the information storage component of an accounting system used?

Quick Check Answers — p. E-27

This section describes the underlying records of accounting information systems. Designed cor- rectly, these records support efficiency in processing transactions and events. They are part of all systems in various forms and are increasingly electronic. Even in technologically advanced systems, a basic understanding of the records we describe in this section aids in using, interpret- ing, and applying accounting information. It also improves our knowledge of computer-based systems. Remember that all accounting systems have common purposes and internal workings whether or not they depend on technology. (Popular accounting software that utilizes special journals includes Great Plains and QuickBooks.)

SPECIAL JOURNALS IN ACCOUNTING

C2 Explain the goals and uses of special journals.

Virtual Output A screenless computer display, called virtual retinal display (VRD), scans rows of pixels directly onto the user’s retina by means of a laser. VRDs can simulate three-dimensional virtual worlds, including 3D financial graphics. ■

Decision Insight

Output Devices Output devices are the means to take information out of an accounting system and make it available to users. Common output devices are printers, monitors, projectors, and Web com- munications. Output devices provide users a variety of items including graphics, analysis re- ports, bills to customers, checks to suppliers, employee paychecks, financial statements, and internal reports. When requests for output occur, an information processor takes the needed data from a database and prepares the necessary report, which is then sent to an output device. A special type of output is an electronic funds transfer (EFT). One example is the transfer of payroll from the company’s bank account to its employees’ bank accounts. This requires an interface to allow a company’s accounting system to send payroll data directly to the bank’s accounting system. This interface can involve a company recording its payroll data in an en- crypted zip file and forwarding it to the bank. The bank then uses this output to transfer wages earned to employees’ accounts.

Point: The SEC database now allows searchable data fields in required company filings. The software that facilitates this capability is XBRL (eXtensible Business Reporting Language).

Accountant Your client requests advice in purchasing software for its accounting system. You have been offered a 10% commission by a software company for each purchase of its system by one of your clients. Does this commission arrangement affect your evaluation of software? Do you tell your client about the commission arrangement? ■ [Answer—p. E-27]

Decision Ethics

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Appendix E Accounting with Special Journals E-5

This section focuses on special journals and subsidiary ledgers that are an important part of accounting systems. We describe how special journals are used to capture transactions, and we explain how subsidiary ledgers are set up to capture details of accounts. This section uses a perpetual inventory system, and the special journals are set up using this system. We include a note at the bottom of each of the special journals explaining the change required if a company uses a periodic system.

Basics of Special Journals A general journal is an all-purpose journal in which we can record any transaction. Use of a general journal for all transactions is usually more costly for a business and is a less effective control procedure. Moreover, for less technologically advanced systems, use of a general journal requires that each debit and each credit entered be individually posted to its respective ledger account. To enhance internal control and reduce costs, transactions are organized into common groups. A special journal is used to record and post transactions of similar type. Most transac- tions of a merchandiser, for instance, can be categorized into the journals shown in Exhibit E.3. This section assumes the use of these four special journals along with the general journal. The general journal continues to be used for transactions not covered by special journals and for adjusting, closing, and correcting entries. We show in the following discussion that special jour- nals are efficient tools in helping journalize and post transactions. This is done, for instance, by accumulating debits and credits of similar transactions, which allows posting of amounts as column totals rather than as individual amounts. The advantage of this system increases as the number of transactions increases. Special journals allow an efficient division of labor, which is also an effective control procedure.

Point: A specific transaction is recorded in only one journal.

Point: Companies can use as many special journals as necessary given their unique business activities.

EXHIBIT E.3 Using Special Journals with a General Journal

Sales Journals

For recording credit sales

Reference Date Description Account Tax Debt Credt

^D: Delete ^N: Insert F5: Balance F6: Post F7: Inclusive F8: List F9: Process F10: Setup

Sales Journal

Cash Disburement Journal

For recording cash payments

Forte Company Programs Payroll Utilities View Help

Current Month: Cash Disbursements Cash Receipts General Journal

Current Journal Monthly Balance:

Employee Account Number Amount DescriptionVendorCheck DateCheck Number

Delete After Fact Check General Check Vendor Check Close

Cash Disbursements Journal

Cash Receipts Journal

File View Manage Tools Settings Help

Date Rec.No. GST Commissions SundryAccount and Comment

Help Configure cancel Enter

Category Accounts : Revenue/Commissions

Revenue Other RevenueSundry Accounts :

Comment:

Amount GST Receipt

Cash Receipts Journal

For recording cash receipts

Date

General Journal

General Journal

For transactions not in special journals

Date

Amount Transactions Account Description

Explanation

New Del

Account Description Amount

Increase Decrease

Purchases Journal

Purchase Journal Navigator Reporting Suite Help and Support

Customers Quotes Order Entry Invoicing Activities Vendors Purchasing Inventory Financials Manual Setup Exit

ABC Industrial Supply

PO# Required Comments Vendor Order# PO Total

For recording credit purchases

Print Return

It is important to note that special journals and subsidiary ledgers are designed in a manner that is best suited for each business. The most likely candidates for special journal status are recurring transactions—for many businesses those are sales, cash receipts, purchases, and cash disburse- ments. However, good systems design for a business could involve collapsing sales and cash re- ceipts in one journal, or purchases and cash disbursements in another. It could also involve adding more special journals or additional subsidiary ledgers for other recurring transactions. This design decision extends to journal and ledger format. That is, the selection on number of columns, col- umn headings, and so forth is based on what is best suited for each business. Thus, read the follow- ing sections as one example of a common systems design, but not the only design. (Proprietary software is internally developed by companies to meet system needs not met by off-the-shelf accounting software.)

Subsidiary Ledgers To understand special journals, it is necessary to understand the workings of a subsidiary ledger, which is a list of individual accounts with a common characteristic. A subsidiary ledger contains detailed information on specific accounts in the general ledger. Information systems often include several subsidiary ledgers. Two of the most important are:

● Accounts receivable ledger—stores transaction data of individual customers. ● Accounts payable ledger—stores transaction data of individual suppliers.

Individual accounts in subsidiary ledgers are often arranged alphabetically, which is the ap- proach taken here. We describe accounts receivable and accounts payable ledgers in this section. Our discussion of special journals uses these ledgers.

C3 Describe the use of controlling accounts and subsidiary ledgers.

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E-6 Appendix E Accounting with Special Journals

Accounts Receivable Ledger When we recorded credit sales in prior chapters, we deb- ited (increased) Accounts Receivable. When a company has more than one credit customer, the accounts receivable records must show how much each customer purchased, paid, and has yet to pay. This information is collected by keeping a separate account receivable for each credit cus- tomer. A separate account for each customer could be kept in the general ledger with the other financial statement accounts, but this is uncommon. Instead, the general ledger usually has a single Accounts Receivable account, and a subsidiary ledger is set up to keep a separate account for each customer. This subsidiary ledger is called the accounts receivable ledger (also called accounts receivable subsidiary ledger or customers ledger), and it can exist in electronic or paper form. Exhibit E.4 shows the relation between the Accounts Receivable account and its individual accounts in the subsidiary ledger. After all items are posted, the balance in the Accounts Receiv- able account must equal the sum of all balances of its customers’ accounts. The Accounts Re- ceivable account is said to control the accounts receivable ledger and is called a controlling account. Since the accounts receivable ledger is a supplementary record controlled by an ac- count in the general ledger, it is called a subsidiary ledger.

Point: When a general ledger account has a subsidiary ledger, any transaction that impacts one of them also impacts the other—some refer to this as general and subsidiary ledgers kept in tandem.

Accounts Payable Ledger There are other controlling accounts and subsidiary ledgers. We know, for example, that many companies buy on credit from several suppliers. This means that companies must keep a separate account for each supplier by keeping an Accounts Payable controlling account in the general ledger and a separate account for each supplier (creditor) in an accounts payable ledger (also called accounts payable subsidiary ledger or creditors ledger).

Other Subsidiary Ledgers Subsidiary ledgers are common for several other accounts. A company with many classes of equipment, for example, might keep only one Equipment account in its general ledger, but its Equipment account would control a subsidiary ledger in which each class of equipment is recorded in a separate account. Similar treatment is common for invest- ments, inventory, and any accounts needing separate detailed records. Genmar Holdings, which manufactures boats by Champion, Glastron, Four Winns, and Larson, reports sales information by product line in its report. Yet its accounting system keeps much more detailed sales records. Genmar Holdings, for instance, sells hundreds of different products and must be able to analyze the sales performance of each. This detail can be captured by many different general ledger sales accounts but is instead captured by using supplementary records that function like subsidiary ledgers. Overall, subsidiary ledgers are applied in many different ways to ensure that the account- ing system captures sufficient details to support analyses that decision makers need. At least four benefits derive from subsidiary ledgers:

1. Removal of excessive details, and detailed accounts, from the general ledger. 2. Up-to-date information readily available on specific customers and suppliers. 3. Aid in error identification for specific accounts. 4. Potential efficiencies in recordkeeping through division of labor in posting.

EXHIBIT E.4 Accounts Receivable Controlling Account and Its Subsidiary Ledger

General Ledger

Active Accounts

General Ledger Accounts

Liability Equity Cost/Sales Expense Other Inc. Other ExpenseIncome Account Level Type ActiveCRDRDescription

Asset

Active Accounts

General Ledger Accounts

Liability Equity Cost/Sales Expense Other Inc. Other ExpenseIncome Account Level Type ActiveCRDRDescription

Asset

Used for preparing financial statements

General Ledger Accounts

Accounts Receivable controlling account

Accounts Receivable Subsidiary Ledger

Used for preparing bills sent to customers

Receivable controlling account

One account for each customer

Frank Booth Controlling account balance = Sum of subsidiary account

balances Point: A control account refers to any general ledger account that summarizes subsidiary ledger data.

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Appendix E Accounting with Special Journals E-7

Sales Journal A typical sales journal is used to record sales of inventory on credit. Sales of inventory for cash are not recorded in a sales journal but in a cash receipts journal. Sales of noninventory assets on credit are recorded in the general journal.

Journalizing Credit sale transactions are recorded with information about each sale entered separately in a sales journal. This information is often taken from a copy of the sales ticket or invoice prepared at the time of sale. The top portion of Exhibit E.5 shows a typical sales journal from a merchandiser. It has columns for recording the date, customer’s name, invoice number, posting reference, and the retail and cost amounts of each credit sale. The sales journal in this exhibit is called a columnar journal, which is any journal with more than one column. Each transaction recorded in the sales journal yields an entry in the “Accounts Receivable Dr., Sales Cr.” column. We usually need only one column for these two accounts. (An exception is when managers need more information about taxes, returns, and other sales details.) Each transaction in the sales journal also yields an entry in the “Cost of Goods Sold Dr., Inventory Cr.” column. This entry reflects the perpetual inventory system of tracking costs with each sale. To illustrate, on February 2, this company sold merchandise on account to Jason Henry for $450. The invoice number is 307, and the cost of this merchandise is $315. This information is

Point: Each transaction in the sales journal includes a debit to accounts receivable and a credit to sales.

P1 Journalize and post transactions using special journals.

File Edit Maintain Tasks Analysis Options Reports Window Help

Sales Journal

Date Account Debited

Invoice Number PR

Accounts Receivable Dr. Sales Cr.

Cost of Goods Sold Dr. Inventory Cr.

Page 3

Feb. 2

7 13 15 22 25 28 28 Totals

Albert Co. Frank Booth

Jason Henry

Albert Co. Kam Moore Paul Roth Jason Henry

307

308 309 310 311 312 313

315

355 260 150 155

95 170

1,500

(502/119)

450

500 350 200 225 175 250

2,150 (106/413)

Customer Name

Date PR Debit

Frank Booth

Credit Balance Feb. 25 S3 175 175

Customer Name

Date PR Debit

Kam Moore

Credit Balance Feb. 13 S3 350 350

Customer Name

Date PR Debit

Paul Roth

Credit Balance Feb. 15 S3 200 200

Customer Name

PRDate Debit

Albert Co.

Credit Balance

28 S3

S3 500 500

750250

Feb. 7

Customer Name

Date PR Debit

Jason Henry

Credit Balance

S3

S3 450 450

675225

Feb. 2 22

Accounts Receivable Ledger

No. 502

Date PR Debit Accounts Receivable No. 106

Credit Balance S3 2,150

No. 413

Date PR Debit Sales

Credit Balance S3 2,150

Date PR Debit Credit Balance S3 1,500

General Ledger

No. 119

Date PR Debit Balance

Feb. 28

Feb. 28

Feb. 28

28 S3

bal.

2,150

2,150

1,500

15,700

14,200

Credit

1,500

Cost of Goods Sold

Inventory

Totals are posted at the end of the period to General Ledger accounts.

Customer accounts are in a subsidiary ledger and the financial

statement accounts are in the General Ledger.

Individual line item amounts in the Accounts Receivable Dr. and Sales Cr. column are posted immediately

to the subsidiary ledger.

*The Sales Journal in a periodic system would exclude the column on the far right titled “Cost of Goods Sold Dr., Inventory Cr.”

Feb. 1

EXHIBIT E.5 Sales Journal with Posting*

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E-8 Appendix E Accounting with Special Journals

captured on one line in the sales journal. No further explanations or entries are necessary, saving time and effort. Moreover, this sales journal is consistent with most inventory systems that use bar codes to record both sales and costs with each sale transaction. Note that the Posting Refer- ence (PR) column is not used when entering transactions but instead is used when posting.

Posting A sales journal is posted as reflected in the arrow lines of Exhibit E.5. Two types of posting can be identified: (1) posting to the subsidiary ledger(s) and (2) posting to the general ledger.

Posting to subsidiary ledger. Individual transactions in the sales journal are posted regularly (typically concurrently) to customer accounts in the accounts receivable ledger. These postings keep customer accounts up-to-date, which is important for the person granting credit to custom- ers. When sales recorded in the sales journal are individually posted to customer accounts in the accounts receivable ledger, check marks are entered in the sales journal’s PR column. Check marks are used rather than account numbers because customer accounts usually are arranged alphabetically in the accounts receivable ledger. Note that posting debits to Accounts Receiv- able twice—once to Accounts Receivable and once to the customer’s subsidiary account—does not violate the accounting equation of debits equal credits. The equality of debits and credits is always maintained in the general ledger.

Posting to general ledger. The sales journal’s account columns are totaled at the end of each period (the month of February in this case). For the “sales” column, the $2,150 total is debited to Accounts Receivable and credited to Sales in the general ledger (see Exhibit E.5). For the “cost” column, the $1,500 total is debited to Cost of Goods Sold and credited to Inventory in the general ledger. When totals are posted to accounts in the general ledger, the account numbers are entered below the column total in the sales journal for t racking. For example, we enter (106/413) below the total in the sales column after this amount is posted to account number 106 (Accounts Receivable) and account number 413 (Sales). A company identifies in the PR column of its subsidiary ledgers the journal and page number from which an amount is taken. We identify a journal by using an initial. Items posted from the sales journal carry the initial S before their journal page numbers in a PR column. Likewise, items from the cash receipts journal carry the initial R; items from the cash disbursements jour- nal carry the initial D; items from the p_ urchases journal carry the initial P; and items from the g_eneral journal carry the initial G.

Proving the Ledgers Account balances in the general ledger and subsidiary ledgers are periodically proved (or reviewed) for accuracy after posting. To do this we first prepare a trial balance of the general ledger to confirm that debits equal credits. Second, we test a subsidiary ledger by prepar ing a schedule of individual accounts and amounts. A schedule of accounts receivable lists each customer and the balance owed. If this total equals the balance of the Ac- counts Receivable controlling account, the accounts in the accounts receivable ledger are as- sumed correct. Exhibit E.6 shows a schedule of accounts receivable drawn from the accounts receivable ledger of Exhibit E.5. (Accountants may use the expression “tie out” when checking whether the balance of the accounts receivable control account matches the total balance on the subsidiary listing of accounts receivable.)

Additional Issues We consider three additional issues with the sales journal: (1) recording sales taxes, (2) recording sales returns and allowances, and (3) using actual sales invoices as a journal.

Point: In accounting, the word schedule generally means a list.

Point: Continuously updated customer accounts provide timely information for customer inquiries on those accounts and on current amounts owed.

Point: PR column is only checked after the amount(s) is posted.

Point: Postings are automatic in a computerized system.

P2 Prepare and prove the accuracy of subsidiary ledgers.

Schedule of Accounts Receivable February 28

Albert Co. . . . . . . . . . . . . . . . . . . . . . $ 750

Frank Booth . . . . . . . . . . . . . . . . . . . 175

Jason Henry . . . . . . . . . . . . . . . . . . . 675

Kam Moore . . . . . . . . . . . . . . . . . . . 350

Paul Roth . . . . . . . . . . . . . . . . . . . . . 200

Total accounts receivable . . . . . . . . . $2,150

EXHIBIT E.6 Schedule of Accounts Receivable

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Appendix E Accounting with Special Journals E-9

Sales taxes. Governmental agencies such as cities and states often require sellers to collect sales taxes from customers and to periodically send these taxes to the appropriate agency. When using a columnar sales journal, we can keep a record of taxes collected by adding a Sales Taxes Payable column as follows.

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Sales Journal Page 3

Date Account Debited

Invoice Number PR

Accounts Receivable Dr.

Sales Taxes Payable Cr. Sales Cr.

Cost of Goods Sold Dr. Inventory Cr.

Dec. 1 Favre Co. 7-1698 103 3 100 75

Individual amounts in the Accounts Receivable column would continue to be posted immedi- ately to customer accounts in the accounts receivable ledger. Individual amounts in the Sales Taxes Payable and Sales columns are not posted. Column totals would continue to be posted as usual. (A company that collects sales taxes on its cash sales can also use a Sales Taxes Payable column in its cash receipts journal.)

Sales returns and allowances. A company with only a few sales returns and allowances can record them in a general journal with an entry such as the following:

May 17 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . 414 175

Accounts Receivable—Ray Ball . . . . . . . . . . . . . . 106/✓ 175

Customer returned merchandise.

Assets 5 Liabilities 1 Equity 2175 2175

The debit in this entry is posted to the Sales Returns and Allowances account (no. 414). The credit is posted to both the Accounts Receivable controlling account (no. 106) and to the cus- tomer’s account. When we enter the account number and the check mark, 106/✓, in the PR col- umn on the credit line, this means both the Accounts Receivable controlling account in the general ledger and the Ray Ball account in the accounts receivable ledger are credited for $175. [Note: If the returned goods can be resold to another customer, the company would debit (increase) the Inventory account and credit (decrease) the Cost of Goods Sold account. If the re- turned goods are defective (worthless), the company could simply leave their costs in the Cost of Goods Sold account (see Chapter 4).] A company with a large number of sales returns and allow- ances can save time by recording them in a separate sales returns and allowances journal.

Sales invoices as a sales journal. To save costs, some small companies avoid using a sales journal for credit sales and instead post each sales invoice amount directly to the customer’s account in the accounts receivable ledger. They then put copies of invoices in a file. At the end of the period, they total all invoices for that period and make a general journal entry to debit Accounts Receivable and credit Sales for the total amount. The file of invoice copies acts as a sales journal. This is called direct posting of sales invoices.

4. When special journals are used, where are cash payments by check recorded? 5. How does a columnar journal save posting time and effort? 6. How do debits and credits remain equal when credit sales are posted twice (once to

Accounts Receivable and once to the customer’s subsidiary account)?

7. How do we identify the journal from which an amount in a ledger account was posted? 8. How are sales taxes recorded in the context of special journals? 9. What is direct posting of sales invoices?

Quick Check Answers — pp. E-27–E-28

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E-10 Appendix E Accounting with Special Journals

Cash Receipts Journal A cash receipts journal is typically used to record all receipts of cash. Exhibit E.7 shows one common form of the cash receipts journal.

Journalizing and Posting Cash receipts can be separated into one of three types: (1) cash from credit customers in payment of their accounts, (2) cash from cash sales, and (3) cash from other sources. The cash receipts journal in Exhibit E.7 has a separate credit column for each of

*The Cash Receipts Journal in a periodic system would exclude the column on the far right titled “Cost of Goods Sold Dr., Inventory Cr.”

Date Explanation PR Cash Dr.

Sales Discount

Dr. Sales Cr.

Accounts Receivable

Cr.

Other Accounts

Cr.

Cost of Goods Sold Dr.

Inventory Cr.Account Credited

Feb. 7 12 14 17 20 21 22 23 25 28 28

Sales Jason Henry Sales

Sales

Sales

Kam Moore

Albert Co. Notes Payable

Interest revenue

Paul Roth

Totals

Cash sales

Cash sales

Cash sales

Invoice, 2/2

Invoice, 2/13 Invoice, 2/15

Invoice, 2/7 Note to bank Cash sales Bank account 409

245

✓ ✓ ✗

✗ 4,450

4,225 19,770

441

490 750

250 343 196

3,925

4,700

(101) (415)

9

7 4

10

30 1,500

450

500

200 350

(106)

4,450

4,225 17,300

3,925

4,700

(413)

1,000

250

750

(✗)

3,400

12,550 3,050

(502/119)

2,950

3,150

Accounts Receivable Ledger

Customer Name

Date PR Debit

Frank Booth

Credit Balance Feb. 25 S3 175 175

Customer Name

Date PR Debit

Albert Co.

Credit Balance

500

Feb. 7

17 28

R2

S3

S3

500

250

500

0 250

Customer Name Jason Henry

Date PR Debit Credit Balance Feb. 2

12 R2

S3 450

450

22 S3 225

450

0

225

Customer Name

Date PR Debit

Kam Moore

Credit Balance Feb. 13

23 R2

S3 350

350

350

0

Customer Name

Date PR Debit

Paul Roth

Credit Balance Feb. 15

25 R2

S3 200 200

0200

Date PR Debit

Cash No. 101

Credit Balance Feb. 28 R2 19,770 19,770

Date PR Debit

Notes Payable No. 245

Credit Balance Feb. 20 R2 750 750

Date PR Debit

Interest Revenue No. 409

Credit Balance Feb. 22 R2 250 250

Date PR Debit

Sales Discounts No. 415

Credit Balance Feb. 28 R2 30 30

Date PR Debit

Accounts Receivable No. 106

Credit Balance Feb. 28

28

S3 2,150

1,500 650

2,150

Date PR Debit

Inventory No. 119

Credit Balance bal.

R2

Date PR Debit

Sales No. 413

Credit Balance Feb. 28

28

S3 2,150

17,300 19,450

2,150

R2

Date PR Debit

No. 502

Credit Balance Feb. 28

28

Feb. 1

28

28

S3

R2

1,500

12,550

15,700

1,650

14,200

S3 1,500

12,550

1,500

14,050R2

General Ledger

Column totals are posted at the end of the period.

Individual line item amounts in the Other Accounts Cr. column and

the Accounts Receivable Cr. column are posted immediately.

Cost of Goods Sold

Page 2

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Cash Receipts Journal

EXHIBIT E.7 Cash Receipts Journal with Posting*

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Appendix E Accounting with Special Journals E-11

these three sources. We describe how to journalize transactions from each of these three sources. (An Explanation column is included in the cash receipts journal to identify the source.)

Cash from credit customers. Journalizing. To record cash received in payment of a cus- tomer’s account, the customer’s name is first entered in the Account Credited column—see transactions dated February 12, 17, 23, and 25. Then the amounts debited to both Cash and the Sales Discount (if any) are entered in their respective columns, and the amount credited to the customer’s account is entered in the Accounts Receivable Cr. column. Posting. Individual amounts in the Accounts Receivable Cr. column are posted immediately to customer accounts in the subsidiary accounts receivable ledger. The $1,500 column total is posted at the end of the period (month in this case) as a credit to the Accounts Receivable con- trolling account in the general ledger.

Cash sales. Journalizing. The amount for each cash sale is entered in the Cash Dr. column and the Sales Cr. column. The February 7, 14, 21, and 28 transactions are examples. (Cash sales are usually journalized daily or at point of sale, but are journalized weekly in Exhibit E.7 for brevity.) Each cash sale also yields an entry to Cost of Goods Sold Dr. and Inventory Cr. for the cost of merchandise—see the far right column. Posting. For cash sales, we place an x in the PR column to indicate that its amount is not in- dividually posted. We do post the $17,300 Sales Cr. total and the $12,550 total from the “cost” column.

Cash from other sources. Journalizing. Examples of cash from other sources are money bor- rowed from a bank, cash interest received on account, and cash sale of noninventory assets. The transactions of February 20 and 22 are illustrative. The Other Accounts Cr. column is used for these transactions. Posting. Amounts from these transactions are immediately posted to their general ledger accounts and the PR column identifies those accounts.

Footing, Crossfooting, and Posting To be sure that total debits and credits in a co- lumnar journal are equal, we often crossfoot column totals before posting them. To foot a col- umn of numbers is to add it. To crossfoot in this case is to add the Debit column totals, then add the Credit column totals, and compare the two sums for equality. Footing and crossfooting of the numbers in Exhibit E.7 result in the report in Exhibit E.8.

Point: Each transaction in the cash receipts journal involves a debit to Cash. Credit accounts will vary.

Point: Some software packages put cash sales in the sales journal.

Example: Record in the cash receipts journal a $700 cash sale of land when the land carries a $700 original cost. Answer: Debit the Cash column for $700, and credit the Other Accounts column for $700 (the account credited is Land).

Point: Subsidiary ledgers and their controlling accounts are in balance only after all posting is complete.

At the end of the period, after crossfooting the journal to confirm that debits equal credits, the total amounts from the columns of the cash receipts journal are posted to their general ledger accounts. The Other Accounts Cr. column total is not posted because the individual amounts are directly posted to their general ledger accounts. We place an x below the Other Accounts Cr. column to indicate that this column total is not posted. The account numbers for the column totals that are posted are entered in parentheses below each column. (Note: Posting items im- mediately from the Other Accounts Cr. column with a delayed posting of their offsetting items in the Cash column total causes the general ledger to be out of balance during the period. Post- ing the Cash Dr. column total at the end of the period corrects this imbalance in the general ledger before the trial balance and financial statements are prepared.)

Debit Columns Credit Columns

Cash Dr. . . . . . . . . . . . . . . . . . . . . . $19,770 Accounts Receivable Cr. . . . . . . . . . $ 1,500

Sales Discounts Dr. . . . . . . . . . . . . 30 Sales Cr. . . . . . . . . . . . . . . . . . . . . . 17,300

Cost of Goods Sold Dr. . . . . . . . . . 12,550 Other Accounts Cr. . . . . . . . . . . . . 1,000

Inventory Cr. . . . . . . . . . . . . . . . . . 12,550

Total . . . . . . . . . . . . . . . . . . . . . . . . $32,350 Total . . . . . . . . . . . . . . . . . . . . . . . . $32,350

EXHIBIT E.8 Footing and Crossfooting Journal Totals

Entrepreneur You want to know how promptly customers are paying their bills. This information can help you decide whether to extend credit and to plan your cash payments. Where do you find this information? ■ [Answer—p. E-27]

Decision Maker

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E-12 Appendix E Accounting with Special Journals

Purchases Journal A purchases journal is typically used to record all credit purchases, including those for inven- tory. Purchases for cash are recorded in the Cash Disbursements Journal.

Journalizing Entries in the purchases journal in Exhibit E.9 reflect purchase invoices or other source documents. We use the invoice date and terms to compute the date when payment for each purchase is due. The Accounts Payable Cr. column is used to record the amounts owed to each creditor. Inventory purchases are recorded in the Inventory Dr. column. To illustrate, inventory costing $200 is purchased from Ace Manufacturing on February 5. The creditor’s name (Ace) is entered in the Account column, the invoice date is entered in the Date of Invoice column, the purchase terms are entered in the Terms column, and the $200 amount is entered in the Accounts Payable Cr. and the Inventory Dr. columns. When a purchase involves an amount recorded in the Other Accounts Dr. column, we use the Account column to identify the general ledger account debited. For example, the February 28

transaction involves

purchases of inventory, office supplies, and store supplies from ITT. The journal has no column for store supplies, so the Other Accounts Dr. column is used. In this case, Store Supplies is en- tered in the Account column along with the creditor’s name (ITT). This purchases journal also includes a separate column for credit purchases of office supplies. A separate column such as this is useful when several transactions involve debits to the same account. Each company uses its own judgment in deciding on the number of separate columns necessary.

Posting The amounts in the Accounts Payable Cr. column are immediately posted to indi- vidual creditor accounts in the accounts payable subsidiary ledger. Individual amounts in the Other Accounts Dr. column are immediately posted to their general ledger accounts. At the end

Point: The number of special journals and the design of each are based on a company’s specific needs.

Point: Each transaction in the pur- chases journal has a credit to Accounts Payable. Debit accounts will vary.

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Inventory Dr.

Office Supplies Dr.

Other Accounts Dr.Date Account

Date of Invoice Terms PR

Accounts Payable Cr.

Feb. 3 5

13 20 25 28 28

Horning Supply Co. Ace Mfg. Co. Wynet & Co. Smite Co. Ace Mfg. Co. Store Supplies/ITT Co. Totals

2/2 2/5

2/10 2/18 2/24 2/28

2/10, n/30 2/10, n/30 2/10, n/30 2/10, n/30

n/30

n/30

125/✓

350 200 150 300 100 225

(201) 1,325

275 200 150 300 100 125

(119) 1,150 100

(124)

75

25

(✗)

75 75

Company Name

Date PR Debit

Horning Supply Company

Credit Balance Feb. 3 P1 350 350

Company Name

Date PR Debit

ITT Company

Credit Balance Feb. 28 P1 225 225

Company Name

Date PR Debit

Smite Company

Credit Balance Feb. 20 P1 300300

Company Name

Date PR Debit

Wynet and Company

Credit Balance Feb. 13 P1 150150

Company Name

Date PR Debit

Ace Mfg. Company

Credit Balance Feb. 5

25 P1

P1 200 200

300100

Accounts Payable Ledger

No. 201

Date PR Debit

Inventory No. 119

Credit Balance Feb. 1

28 S3

R2 P1

28 28

bal.

1,150

1,500

12,550

15,700

14,200

1,650

2,800

No. 125

Date PR Debit

Store Supplies

Credit Balance Feb. 28 P1 75 75

Date PR Debit Credit Balance Feb. 28 P1 1,325 1,325

General Ledger

Accounts Payable

No. 124

Date PR Debit Credit Balance Feb. 28 P1 100 100

Office Supplies

Individual amounts in the Other Accounts Dr. column and the Accounts Payable Cr. column

are posted immediately.

Column totals, except for Other Accounts Dr. column, are

posted at the end of the period.

*The Purchases Journal in a periodic system replaces “Inventory Dr.” with “Purchases Dr.”

Purchases Journal Page 1

EXHIBIT E.9 Purchases Journal with Posting*

Point: The Other Accounts Dr. column allows the purchases journal to be used for any purchase on credit.

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Appendix E Accounting with Special Journals E-13

of the period, all column totals except the Other Accounts Dr. column are posted to their general ledger accounts.

Proving the Ledger Accounts payable balances in the subsidiary ledger can be periodi- cally proved after posting. We prove the subsidiary ledger by preparing a schedule of accounts payable, which is a list of accounts from the accounts payable ledger with their balances and the total. If this total of the individual balances equals the balance of the Accounts Payable con- trolling account, the accounts in the accounts payable ledger are assumed correct. Exhibit E.10 shows a schedule of accounts payable drawn from the accounts payable ledger of Exhibit E.9. (This schedule can be done after any posting; for example, we could prepare another schedule of accounts payable after the postings in Exhibit E.11.)

EXHIBIT E.10 Schedule of Accounts Payable

Schedule of Accounts Payable February 28

Ace Mfg. Company . . . . . . . . . . . . . . $ 300

Horning Supply Company . . . . . . . . . 350

ITT Company . . . . . . . . . . . . . . . . . . 225

Smite Company . . . . . . . . . . . . . . . . . 300

Wynet & Company . . . . . . . . . . . . . . 150

Total accounts payable . . . . . . . . . . . . $1,325

Point: The balance in the Accounts Payable controlling account must equal the sum of the individual account bal- ances in the accounts payable subsidiary ledger after posting.

Point: Each transaction in the cash disbursements journal involves a credit to Cash. The debit accounts will vary.

Cash Disbursements Journal A cash disbursements journal, also called a cash payments journal, is typically used to record all cash payments.

Journalizing The cash disbursements journal shown in Exhibit E.11 illustrates repetitive entries to the Cash Cr. column of this journal (reflecting cash payments). Also note the frequent credits to Inventory (which reflect purchase discounts) and the debits to Accounts Payable. For example, on February 15, the company pays Ace on account (credit terms of 2y10, ny30—see February 5 transaction in Exhibit E.9). Since payment occurs in the discount period, the com- pany pays $196 ($200 invoice less $4 discount). The $4 discount is credited to Inventory. Note that when this company purchases inventory for cash, it is recorded using the Other Accounts Dr. column and the Cash Cr. column as illustrated in the February 3 and 12 transactions. Gener- ally, the Other Accounts column is used to record cash payments on items for which no column exists. For example, on February 15, the company pays salaries expense of $250. The title of the account debited (Salaries Expense) is entered in the Account Debited column.

The cash disbursements journal has a column titled Ck. No. (check number). For control over cash disbursements, all payments except for those of small amounts are made by check. Checks should be prenumbered and each check’s number entered in the journal in numerical order in the column headed Ck. No. This makes it possible to scan the numbers in the column for omitted checks. When a cash disbursements journal has a column for check numbers, it is sometimes called a check register.

Posting Individual amounts in the Other Accounts Dr. column of a cash disbursements journal are immediately posted to their general ledger accounts. Individual amounts in the Accounts Payable Dr. column are also immediately posted to creditors’ accounts in the sub- sidiary Accounts Payable ledger. At the end of the period, we crossfoot column totals and post the Accounts Payable Dr. column total to the Accounts Payable controlling account. Also, the Inventory Cr. column total is posted to the Inventory account, and the Cash Cr. column total is posted to the Cash account.

Controller You wish to analyze your company’s cash payments to suppliers and its purchases discounts. Where do you find this information? ■ [Answer—p. E-27]

Decision Maker

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E-14 Appendix E Accounting with Special Journals

Cash Disbursements Journal

Date Ck. No. Payee Account Debited PR Other

Accounts Dr. Accounts Payable Dr.

Page 2

Cash Cr. Inventory Cr.

20 28 28

Feb. 3 12

15 15

109 110

105 106

108 107

Wynet & Co. Smite Co. Totals

L. & N. Railroad East Sales Co.

Jerry Hale Ace Mfg. Co.

Wynet & Co. Smite Co.

Inventory Inventory

Salaries Expense Ace Mfg. Co.

119 119

622 ✓

294 927

(101)

147

15 25

250 196

13 (119)

4

3 6

250

290 (✗)

15 25

300 650

(201)

200

150

General Ledger

Date PR Debit Credit Balance Feb. 28

28 D2

R2 19,770 19,770

18,843927

Date PR Debit Credit Balance Feb. 28

28 D2

P1 1,325 1,325

675650

No. 622

Date PR Debit Credit Balance Feb. 15 D2 250 250

Salaries Expense

Date PR Debit

Inventory

Cash

No. 119

Accounts Payable No. 201

No. 101

Credit Balance Feb. 1

3

12

28

28

28

28

D2

D2

S3

R2

P1

D2

bal.

13

1,500

12,550

15

25

1,150

15,700

15,715

15,740

14,240

1,690

2,840 2,827

Company Name

Date PR Debit

Horning Supply Company

Credit Balance Feb. 3 P1 350 350

Company Name

Date PR Debit

ITT Company

Credit Balance Feb. 28 P1 225 225

Accounts Payable Ledger

Company Name

Date PR Debit

Ace Mfg. Company

Credit Balance Feb. 5

15 25 P1

D2

P1 200

100

200

0 100

200

Company Name

Date PR Debit

Smite Company

Credit Balance Feb. 20

28 P1 D2

300 300

300 0

Date PR Debit Credit Balance P1 D2

Feb. 13 20

150

0

150

150

Company Name Wynet & Company

Individual amounts in the Other Accounts Dr. column and the Accounts Payable Dr. column

are posted immediately.

Column totals, except for Other Accounts column, are posted

at the end of the period.

*The Cash Disbursements Journal in a periodic system replaces “Inventory Cr.” with “Purchases Discounts Cr.”

File Edit Maintain Tasks Analysis Options Reports Window Help

EXHIBIT E.11 Cash Disbursements Journal with Posting*

General Journal Transactions When special journals are used, we still need a general journal for adjusting, closing, and any other transactions for which no special journal has been set up. Examples of these other transactions might include purchases returns and allowances, purchases of plant assets by issuing a note payable, sales returns if a sales returns and allowances journal is not used, and receipt of a note receivable from a customer. We described the recording of transactions in a general journal in Chapters 2 and 3.

10. What are the normal recording and posting procedures when using special journals and controlling accounts with subsidiary ledgers?

11. What is the process for posting to a subsidiary ledger and its controlling account? 12. How do we prove the accuracy of account balances in the general ledger and subsidiary

ledgers after posting?

13. Why does a company need a general journal when using special journals for sales, purchases, cash receipts, and cash disbursements?

Quick Check Answers — p. E-28

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Appendix E Accounting with Special Journals E-15

TECHNOLOGY-BASED ACCOUNTING SYSTEMS

Data Processing in Accounting Accounting systems differ with regard to how input is entered and processed. Online processing enters and processes data as soon as source documents are available. This means that databases are immediately updated. Batch processing accumulates source docu ments for a period of time and then processes them all at once such as daily, weekly, or monthly. The advantage of online processing is timeliness. This often requires additional costs related to both software and hard- ware requirements. Companies such as Intuit (Intuit.com) are making online processing of ac- counting data a reality for many businesses. The advantage of batch processing is that it requires only periodic updating of databases. Records used to send bills to customers, for instance, might require updating only once a month. The disadvantage of batch processing is the lack of updated databases for management to use when making business decisions. (Businesses and individuals can now deposit checks into bank accounts using scanners with capabilities of reading amounts, ensuring that each item passes a specified image quality standard, and reducing the risk that the scanned image is a duplicate of a previously scanned check.)

Computer Networks in Accounting Networking, or linking computers with each other, can create information advantages (and cost efficiencies). Computer networks are links among computers giving different users and different computers access to common databases, programs, and hardware. Many college

Middleware is software allowing different computer programs in a company or across companies to work together. It allows transfer of purchase orders, invoices, and other electronic documents between accounting systems. For example, suppliers can monitor inventory levels of their buyers for production and shipping purposes. ■

Decision Insight

Accounting information systems are supported with technology, which can range from simple calculators to advanced computerized systems. Since technology is increasingly important in accounting information systems, we discuss the impact of computer technology, how data pro- cessing works with accounting data, and the role of computer networks.

Computer Technology in Accounting Computer technology provides accuracy, speed, efficiency, and convenience in performing account- ing tasks. A program can be written, for instance, to process customers’ merchandise orders. Multi- purpose off-the-shelf software applications exist for a variety of business operations. These include familiar accounting programs such as Sage 50 Complete Accounting (formerly known as Peachtree®) and QuickBooks®. Off-the-shelf programs are designed to be user friendly and menu driven, and many operate more efficiently as integrated systems. In an integrated system, actions taken in one part of the system automatically affect related parts. When a credit sale is recorded in an integrated system, for instance, several parts of the system are automatically updated, such as posting.

Computer technology can dramatically reduce the time and effort devoted to recordkeeping. Less effort spent on recordkeeping means more time for accounting professionals to concentrate on analysis and managerial decision making. These advances have created a greater demand for accounting pro- fessionals who understand financial reports and can draw insights and infor mation from mountains of processed data. Accoun ting professionals have expertise in determining relevant and reliable information for decision making. They also can assess the effects of transactions and events on a company and its financial statements. (The IRS allows individuals to enter tax info online and receive free processing of such returns.)

Point: Companies that have reported missing or stolen employee data such as Social Security numbers include Time Warner, Polo Ralph Lauren, Lexis/Nexis, ChoicePoint, and DSW Shoes.

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E-16 Appendix E Accounting with Special Journals

computer labs, for instance, are networked. A small computer network is called a local area network (LAN); it links machines with hard-wire hookups. Large computer networks extending over long distances often rely on modem or wireless communication. Demand for information sometimes requires advanced networks such as the systems Federal Express and UPS use to track packages and bill customers and the system Walmart uses to monitor inventory levels in its stores. These networks include many computers and satellite com- munications to gather information and to provide ready access to its databases from all locations.

Enterprise Resource Planning Software Enterprise resource planning (ERP) software includes the programs that manage a company’s vital operations. They extend from order taking to manufacturing to accounting. (Your college likely relies on ERP software to track its budget and student records information.) When working properly, these integrated programs can speed decision making, identify costs for reduction, and give managers control over operations with the click of a mouse. For many managers, ERP soft- ware allows them to scrutinize business, identify where inventories are piling up, and see what plants are most efficient. The software is designed to link every part of a company’s operations. This software allowed Butterball, one of America’s leading poultry brands, to reduce costs, en- able rapid acquisitions, realize return on IT investment, and drive business improvements.

ERP has several suppliers. SAP leads the mar- ket, with Oracle, which gobbled up PeopleSoft and J. D. Edwards, a distant second (AMR Re- search). SAP software is used by more than half of the world’s 500 largest companies. It links ordering, inventory, production, purchasing, plan- ning, tracking, and human resources. A transac- tion or event triggers an immediate chain reaction of events throughout the enterprise. It is making companies more efficient and profitable. Tasty Baking Company, a leading U.S. producer of snack cakes and other baked goods, uses SAP

solutions to access real-time information, gain greater efficiencies, plan and respond to business needs, and achieve measurable results. ERP is pushing into cyberspace and customer relationship management (CRM). Now compa- nies can share data with customers and suppliers. Applesauce maker Mott’s is using SAP so that distributors can check the status of orders and place them over the Net, and the Coca-Cola Com- pany uses it to ship soda on time. ERP is also increasingly used by small business. One-third of Oracle’s sales in North America are to companies with less than $500 million in annual revenue. Worldwide, small and midsize companies are 25% to 30% of Oracle’s sales. For example, NetSuite’s accounting services to small and medium businesses are powered by Oracle’s system. Jeff Johanson, director of channel operations of SAP’s practice for small and midsize businesses asserts that: “Small and medium businesses don’t have different needs from larger companies, but they generally can’t afford customized solutions.”

Total ERP Market: About $30 Billion

SAP 35%

Oracle Applications

21%

Microsoft Dynamics

6% Sage Group

8%

Other 23%

Infor (SSA) 7%

A new generation of accounting support is available. With the touch of a key, users can create real-time inventory reports showing all payments, charges, and credit limits at any point in the accounting cycle. Many services also include “alert signals” notifying the company when, for example, a large order exceeds a cus- tomer’s credit limit or when purchases need to be made or when a bank balance is running low. These alerts occur via e-mail, fax, PDA, or phone. ■

Decision Insight

Cloud Computing Cloud computing is the delivery of computing as a service rather than a product. Many argue that its introduction will revolutionize information systems applications. Cloud computing uses applications via the Web instead of installing them on individual computers. This means that companies lease, rather than purchase, those applications, which also means that the user does

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Appendix E Accounting with Special Journals E-17

Special Journals Accounting systems for recording sales, purchases, cash receipts, and cash dis- bursements are similar worldwide. Although the exact structure of special journals is unique to each com- pany, the basic structure is identical. Companies desire to apply accounting in an efficient manner. Accordingly, systems that employ special journals are applied worldwide.

not need to update applications as that is the job of the computing service provider. Thus, as tax laws change or when rates are revised, the service provider takes on that responsibility (and cost). When a company transfers computing applications to a provider, there is much less risk if a user’s computers crash or are stolen. Further, many users and their clients can access the same ap- plications and share data. Accountants, lawyers, and analysts can similarly access data for quicker and easier processing and analysis. For example, all invoices could be offloaded to a Web-based bill management system, where documentation, disbursement, and record keeping could all be handled in the cloud. However, the user does lose control over the data and is dependent on the provider’s control system. Today, many companies are exploring cloud computing and often begin with applications that are independent of other systems so that if problems arise, they are concen- trated within that application only. Examples are training programs and workflow systems. Fur- ther, many argue that the gains of cloud computing are great for small and medium-sized companies, which do not have large IT departments or require unique information systems. Cloud computing has enormous potential for greater efficiency and effectiveness with informa- tion systems applications. The future will reveal whether or not that potential will be achieved. Cloud computing has the potential to improve controls due to data centralization and the enhanced security from providers who can spread that cost over many customers. Still, some users worry about exposure to sensitive data. Users should consider the following factors when looking at pro- viders of cloud computing:

● Provider’s knowledge of the user’s business. ● Security of the provider’s cloud, including firewalls. ● Provider’s history, reputation, and references. ● Service level agreement for hardware and software. ● Provider’s cloud compatibility with user’s system.

The internal control system ensures that all the information needed to achieve the objectives set for the internal control system is made available to those responsible in an appropriate and timely manner. Controls are carried out with the aid of the IT applications, thus reducing the incidence of process risks.

14. Identify an advantage of an integrated computer-based accounting system. 15. What advantages do computer systems offer over manual systems? 16. Identify an advantage of computer networks. 17. Describe ERP software and its potential advantages to businesses.

Quick Check Answers — E-28

This section discusses similarities and differences between U.S. GAAP and IFRS regarding system principles and components, and special journals.

System Principles and Components Both U.S. GAAP and IFRS aim for high-quality financial reporting. That aim implies that sound information system principles and components are applied worldwide. However, while system principles and components are fundamentally similar across the globe, culture and other realities often mean different emphases are placed on the mix of system controls. BMW provides the following description of its system controls:

GLOBAL VIEW

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Segment Return on AssetsDecision Analysis

E-18 Appendix E Accounting with Special Journals

The trend in Callaway’s segment return on assets is up-and-down for its golf club segment, and similarly mixed for its golf balls segment. Importantly, its golf clubs segment makes up a much greater portion of its operations; for example, 2010 income of $39,176 from golf clubs make up 94% of its total income of $41,735 from both segments. 2011 was a poor year for Callaway as both segments reported losses, which meant its returns for 2011 were not applicable (n.a.) for analysis. Still, those negative returns must return to positive levels as losses are not sustainable in the long run. Callaway should continue its emphasis on its golf club seg- ment vis-a-vis its golf balls segment given the greater returns and larger total income from that segment. Analysis can also be extended to geographical segments and any other segments that companies report.

Good accounting information systems collect financial data for a company’s various segments. A segment refers to a part of a company that is separately identified by its products or services, or by the geographic market it serves. Callaway Golf Company reports that it operates in two business segments: (1) golf clubs and (2) golf balls. Users of financial statements are especially interested in segment information to better understand a company’s activities because segments often vary on profitability, risk, and growth.

Companies must report segment infor mation, including their sales, operating income, identifiable as- sets, capital expenditures, and depreciation. However, managers are reluctant to release information that can harm competitive position. Exhibit E.12 shows survey results on the number of companies with dif- ferent (reported) segments.

A1 Compute segment return on assets and use it to evaluate segment performance.

EXHIBIT E.12 Companies Reporting Operations by Types of Segments*

*Total exceeds 100% because companies can report more than one segment.

Geographic

200 40 60

Industry

Major Customers

Export Sales

43%

59%

28%

27%

One measure of success for business segments is the segment return on assets ratio defined as follows.

Segment return on assets 5 Segment operating income

Segment average assets

This ratio reflects on the profitability of a segment. Exhibit E.13 shows the segments’ operating income, average assets, and return on assets for Callaway Golf Company.

EXHIBIT E.13 Callaway Golf’s Segment Return on Assets

2011 2010 2009 2008

($ thousands) Clubs Balls Clubs Balls Clubs Balls Clubs Balls

Operating income . . . . . . . . . $ (3,899) $(12,655) $ 39,176 $ 2,559 $ 34,502 $ (9,427) $134,018 $ 6,903

Average assets . . . . . . . . . . . . $423,538 $ 107,214 $422,419 $125,972 $418,003 $138,326 $421,261 $143,793

Segment return on assets . . . n.a. n.a. 9% 2% 8% n.a. 32% 5%

* A segment’s operating income is usually measured as pretax income, and assets is usually measured as identifiable assets.

Golf Segment*

Banker A soccer equipment merchandiser requests a loan from you to expand operations. Its net income is $220,000, reflecting a 10% increase over the prior year. You ask about segment results. The owner reports that $160,000 of net income is from Cuban operations, reflecting a 60% increase over the prior year. The remaining $60,000 of net income is from U.S. operations, reflecting a 40% decrease. Does this segment information impact your loan decision? ■ [Answer—p. E-27]

Decision Maker

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Appendix E Accounting with Special Journals E-19

Pepper Company completed the following selected transactions and events during March of this year. (Terms of all credit sales for the company are 2y10, ny30.)

Mar. 4 Sold merchandise on credit to Jennifer Nelson, Invoice No. 954, for $16,800 (cost is $12,200). 6 Purchased $1,220 of office supplies on credit from Mack Company. Invoice dated March 3,

terms ny30. 6 Sold merchandise on credit to Dennie Hoskins, Invoice No. 955, for $10,200 (cost is $8,100). 11 Purchased $52,600 of merchandise, invoice dated March 6, terms 2y10, ny30, from Defore

Industries. 12 Borrowed $26,000 cash by giving Commerce Bank a long-term promissory note payable. 14 Received cash payment from Jennifer Nelson for the March 4 sale less the discount (Invoice

No. 954). 16 Received a $200 credit memorandum from Defore Industries for unsatisfactory merchandise

Pepper purchased on March 11 and later returned. 16 Received cash payment from Dennie Hoskins for the March 6 sale less the discount (Invoice

No. 955). 18 Purchased $22,850 of store equipment on credit from Schmidt Supply, invoice dated March 15,

terms ny30. 20 Sold merchandise on credit to Marjorie Allen, Invoice No. 956, for $5,600 (cost is $3,800). 21 Sent Defore Industries Check No. 516 in payment of its March 6 dated invoice less the return

and the discount. 22 Purchased $41,625 of merchandise, invoice dated March 18, terms 2y10, ny30, from Welch

Company. 26 Issued a $600 credit memorandum to Marjorie Allen for defective merchandise Pepper sold on

March 20 and Allen later returned. 31 Issued Check No. 517, payable to Payroll, in payment of $15,900 sales salaries for the month.

Cashed the check and paid the employees. 31 Cash sales for the month are $134,680 (cost is $67,340). (Cash sales are recorded daily but are

recorded only once here to reduce repetitive entries.)

Required

1. Open the following selected general ledger accounts: Cash (101), Accounts Receivable (106) Inventory (119), Office Supplies (124), Store Equipment (165), Accounts Payable (201), Long-Term Notes Pay- able (251), Sales (413), Sales Returns and Allowances (414), Sales Discounts (415), Cost of Goods Sold (502), and Sales Salaries Expense (621). Open the following accounts receivable ledger accounts: Marjorie Allen, Dennie Hoskins, and Jennifer Nelson. Open the following accounts payable ledger accounts: Defore Industries, Mack Company, Schmidt Supply, and Welch Company.

2. Enter the transactions using a sales journal, a purchases journal, a cash receipts journal, a cash dis- bursements journal, and a general journal similar to the ones illustrated in this appendix. Regularly post to the individual customer and creditor accounts. Also, post any amounts that should be posted as individual amounts to general ledger accounts. Foot and crossfoot the journals and make the month- end postings. Pepper Co. uses the perpetual inventory system.

3. Prepare a trial balance for the selected general ledger accounts in part 1 and prove the accuracy of subsidiary ledgers by preparing schedules of accounts receivable and accounts payable.

PLANNING THE SOLUTION ● Set up the required general ledger, the subsidiary ledger accounts, and the five required journals as

illustrated in this appendix. ● Read and analyze each transaction and decide in which special journal (or general journal) the transac-

tion is recorded. ● Record each transaction in the proper journal (and post the appropriate individual amounts). ● Once you have recorded all transactions, total the journal columns. Post from each journal to the

appropriate ledger accounts. ● Prepare a trial balance to prove the equality of the debit and credit balances in your general ledger. ● Prepare schedules of accounts receivable and accounts payable. Compare the totals of these schedules

to the Accounts Receivable and Accounts Payable controlling account balances, making sure that they agree.

DEMONSTRATION PROBLEM—PERPETUAL SYSTEM

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E-20 Appendix E Accounting with Special Journals

SOLUTION TO DEMONSTRATION PROBLEM—PERPETUAL SYSTEM

Sales Journal Page 2

Date Account Debited

Invoice Number PR

Cost of Goods Sold Dr. Inventory Cr.

Mar. 4

6

20

31

Jennifer Nelson

Dennie Hoskins

Marjorie Allen

Totals

954

955

956

Accounts Receivable Dr. Sales Cr.

12,200

8,100

3,800

24,100

(502/119)

16,800

10,200

5,600

32,600

(106/413)

251 ✓ ✓ x

Note to bank Invoice 954, 3/4 Invoice 955, 3/6 Cash sales

L.T. Notes Payable Jennifer Nelson Dennie Hoskins Sales Totals

Mar. 12 14 16 31 31

Date Explanation PR Cash Dr.

Sales Discount

Dr. Sales Cr.

Accounts Receivable

Cr.

Other Accounts

Cr.

Cost of Goods Sold Dr.

Inventory Cr.Account Credited

16,800 10,200

27,000

(106)

134,680 134,680

(413)

Cash Receipts Journal Page 3

26,000 16,464 9,996

134,680 187,140

(101)

336 204

(415)

540

26,000

26,000

(x)

67,340 67,340

(502/119)

Purchases Journal Page 3

Inventory Dr. Office

Supplies Dr. Other

Accounts Dr.Date Account Date of Invoice Terms PR

Accounts Payable Cr.

Mar. 6 11 18 22 31

Office Supplies/Mack Co Defore Industries

Welch Company Totals

Store Equipment/Schmidt Supp

3/3 3/6

3/15 3/18

n/30

n/30 2/10, n/30

2/10, n/30

165/✓

1,220 52,600 22,850 41,625

118,295 (201)

52,600

41,625

(119) 94,225

1,220

(124) 1,220

22,850

(x) 22,850

Inventory Cr.Date Ck. No. Payee Account Debited PR Cash Cr. Other

Accounts Dr. Accounts

Payable Dr. Mar. 21

31 31

516 517

Defore Industries Payroll Totals

Defore Industries Sales Salaries Expense 621

✓ 51,352 15,900 67,252

(101)

1,048

(119) 1,048

15,900

(x) 15,900

52,400

(201) 52,400

Cash Disbursements Journal Page 3

General Journal Page 2

Mar. 16 Accounts Payable — Defore Industries . . . . . . . . . . . . . . 201/✓ 200

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 200

To record credit memorandum received.

26 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 414 600

Accounts Receivable — Marjorie Allen . . . . . . . . . . . 106/✓ 600

To record credit memorandum issued.

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Appendix E Accounting with Special Journals E-21

Accounts Receivable Ledger

Marjorie Allen

Date PR Debit Credit Balance

Mar. 20 S2 5,600 5,600

26 G2 600 5,000

Dennie Hoskins

Date PR Debit Credit Balance

Mar. 6 S2 10,200 10,200

16 R3 10,200 0

Jennifer Nelson

Date PR Debit Credit Balance

Mar. 4 S2 16,800 16,800

14 R3 16,800 0

Accounts Payable Ledger

Defore Industries

Date PR Debit Credit Balance

Mar. 11 P3 52,600 52,600

16 G2 200 52,400

21 D3 52,400 0

Mack Company

Date PR Debit Credit Balance

Mar. 6 P3 1,220 1,220

Schmidt Supply

Date PR Debit Credit Balance

Mar. 18 P3 22,850 22,850

Welch Company

Date PR Debit Credit Balance

Mar. 22 P3 41,625 41,625

Long-Term Notes Payable Acct. No. 251

Date PR Debit Credit Balance

Mar. 12 R3 26,000 26,000

Sales Acct. No. 413

Date PR Debit Credit Balance

Mar. 31 S2 32,600 32,600

31 R3 134,680 167,280

Sales Returns and Allowances Acct. No. 414

Date PR Debit Credit Balance

Mar. 26 G2 600 600

Sales Discounts Acct. No. 415

Date PR Debit Credit Balance

Mar. 31 R3 540 540

Cost of Goods Sold Acct. No. 502

Date PR Debit Credit Balance

Mar. 31 R3 67,340 67,340

31 S2 24,100 91,440

Sales Salaries Expense Acct. No. 621

Date PR Debit Credit Balance

Mar. 31 D3 15,900 15,900

Cash Acct. No. 101

Date PR Debit Credit Balance

Mar. 31 R3 187,140 187,140

31 D3 67,252 119,888

Accounts Receivable Acct. No. 106

Date PR Debit Credit Balance

Mar. 26 G2 600 (600)

31 S2 32,600 32,000

31 R3 27,000 5,000

Inventory Acct. No. 119

Date PR Debit Credit Balance

Mar. 16 G2 200 (200)

21 D3 1,048 (1,248)

31 P3 94,225 92,977

31 S2 24,100 68,877

31 R3 67,340 1,537

Office Supplies Acct. No. 124

Date PR Debit Credit Balance

Mar. 31 P3 1,220 1,220

Store Equipment Acct. No. 165

Date PR Debit Credit Balance

Mar. 18 P3 22,850 22,850

Accounts Payable Acct. No. 201

Date PR Debit Credit Balance

Mar. 16 G2 200 (200)

31 P3 118,295 118,095

31 D3 52,400 65,695

General Ledger (Partial Listing)

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E-22 Appendix E Accounting with Special Journals

PEPPER COMPANY Trial Balance (partial)

March 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,888

Accounts receivable . . . . . . . . . . . . . . . 5,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . 1,537

Office supplies . . . . . . . . . . . . . . . . . . . . 1,220

Store equipment . . . . . . . . . . . . . . . . . . 22,850

Accounts payable . . . . . . . . . . . . . . . . . $ 65,695

Long-term notes payable . . . . . . . . . . . 26,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167,280

Sales returns and allowances . . . . . . . . 600

Sales discounts . . . . . . . . . . . . . . . . . . . 540

Cost of goods sold . . . . . . . . . . . . . . . . 91,440

Sales salaries expense . . . . . . . . . . . . . . 15,900

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . $258,975 $258,975

PEPPER COMPANY Schedule of Accounts Receivable

March 31

Marjorie Allen . . . . . . . . . . . . . . . . . $5,000

Total accounts receivable . . . . . . . . $5,000

reconciled

PEPPER COMPANY Schedule of Accounts Payable

March 31

Mack Company . . . . . . . . . . . . . . $ 1,220

Schmidt Supply . . . . . . . . . . . . . . 22,850

Welch Company . . . . . . . . . . . . . 41,625

Total accounts payable . . . . . . . . $65,695

reconciled

Pepper Company completed the following selected transactions and events during March of this year. (Terms of all credit sales for the company are 2y10, ny30.)

Mar. 4 Sold merchandise on credit to Jennifer Nelson, Invoice No. 954, for $16,800 (cost is $12,200). 6 Purchased $1,220 of office supplies on credit from Mack Company. Invoice dated March 3,

terms ny30. 6 Sold merchandise on credit to Dennie Hoskins, Invoice No. 955, for $10,200 (cost is $8,100). 11 Purchased $52,600 of merchandise, invoice dated March 6, terms 2y10, ny30, from Defore

Industries. 12 Borrowed $26,000 cash by giving Commerce Bank a long-term promissory note payable. 14 Received cash payment from Jennifer Nelson for the March 4 sale less the discount (Invoice No. 954). 16 Received a $200 credit memorandum from Defore Industries for unsatisfactory merchandise

Pepper purchased on March 11 and later returned. 16 Received cash payment from Dennie Hoskins for the March 6 sale less the discount (Invoice

No. 955). 18 Purchased $22,850 of store equipment on credit from Schmidt Supply, invoice dated March 15,

terms ny30. 20 Sold merchandise on credit to Marjorie Allen, Invoice No. 956, for $5,600 (cost is $3,800). 21 Sent Defore Industries Check No. 516 in payment of its March 6 dated invoice less the return

and the discount. 22 Purchased $41,625 of merchandise, invoice dated March 18, terms 2y10, ny30, from Welch Company. 26 Issued a $600 credit memorandum to Marjorie Allen for defective merchandise Pepper sold on

March 20 and Allen later returned. 31 Issued Check No. 517, payable to Payroll, in payment of $15,900 sales salaries for the month.

Cashed the check and paid the employees. 31 Cash sales for the month are $134,680 (cost is $67,340). (Cash sales are recorded daily but are

recorded only once here to reduce repetitive entries.)

DEMONSTRATION PROBLEM—PERIODIC SYSTEM

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Appendix E Accounting with Special Journals E-23

Required

1. Open the following selected general ledger accounts: Cash (101), Accounts Receivable (106), Office Sup- plies (124), Store Equipment (165), Accounts Payable (201), Long-Term Notes Payable (251), Sales (413), Sales Returns and Allowances (414), Sales Discounts (415), Purchases (505), Purchases Returns and Allow- ances (506), Purchases Discounts (507), and Sales Salaries Expense (621). Open the following accounts receivable ledger accounts: Marjorie Allen, Dennie Hoskins, and Jennifer Nelson. Open the following ac- counts payable ledger accounts: Defore Industries, Mack Company, Schmidt Supply, and Welch Company.

2. Enter the transactions using a sales journal, a purchases journal, a cash receipts journal, a cash dis- bursements journal, and a general journal similar to the ones illustrated in Appendix E-A. Regularly post to the individual customer and creditor accounts. Also, post any amounts that should be posted as individual amounts to general ledger accounts. Foot and crossfoot the journals and make the month- end postings. Pepper Co. uses the periodic inventory system in this problem.

3. Prepare a trial balance for the selected general ledger accounts in part 1 and prove the accuracy of subsidiary ledgers by preparing schedules of accounts receivable and accounts payable.

SOLUTION TO DEMONSTRATION PROBLEM—PERIODIC SYSTEM

251 ✓ ✓ x

Note to bank Invoice 954, 3/4 Invoice 955, 3/6 Cash sales

L.T. Notes Payable Jennifer Nelson Dennie Hoskins Sales Totals

Mar. 12 14 16 31 31

Date Explanation PR Cash Dr.

Sales Discount

Dr. Sales Cr.

Accounts Receivable

Cr.

Other Accounts

Cr.Account Credited

336 204

(415)

Cash Receipts Journal

26,000 16,464 9,996

134,680 187,140

(101)

540

16,800 10,200

27,000

(106)

134,680 134,680

(413)

26,000

26,000

(x)

Page 3

Sales Journal

Date Account Debited Invoice Number PR Accounts Receivable Dr.

Sales Cr. Mar. 4

6 20 31

Jennifer Nelson Dennie Hoskins Marjorie Allen Totals

954 955 956

16,800 10,200

5,600 32,600

(106/413)

Page 2

Purchases Journal Page 3

Purchases Dr.

Office Supplies Dr.

Other Accounts Dr.Date Account

Date of Invoice Terms PR

Accounts Payable Cr.

165/✓

n/30 2/10, n/30

n/30 2/10, n/30

3/3 3/6

3/15 3/18

Office Supplies/Mack Co Defore Industries

Welch Company Totals

Store Equipment/Schmidt Supp

Mar. 6 11 18 22 31

(201)

1,220 52,600 22,850 41,625

118,295 (x)(505)

52,600

41,625 94,225

1,220

(124) 1,220

22,850

22,850

Cash Disbursements Journal

Purchases Discount Cr.Date Ck. No. Payee Account Debited PR Cash Cr.

Other Accounts Dr.

Accounts Payable Dr.

Mar. 21 31 31

516 517

Defore Industries Payroll Totals

Defore Industries Sales Salaries Expense 621

✓ 51,352 15,900 67,252

(101)

1,048

(507)

1,048 15,900

(x) 15,900

52,400

(201)

52,400

Page 3

General Journal Page 2

Mar. 16 Accounts Payable — Defore Industries . . . . . . . . . . . . . 201/✓ 200

Purchases Returns and Allowances . . . . . . . . . . . . 506 200

To record credit memorandum received.

26 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . 414 600

Accounts Receivable — Marjorie Allen . . . . . . . . . . 106/✓ 600

To record credit memorandum issued.

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E-24 Appendix E Accounting with Special Journals

Accounts Receivable Ledger

Marjorie Allen

Date PR Debit Credit Balance

Mar. 20 S2 5,600 5,600

26 G2 600 5,000

Dennie Hoskins

Date PR Debit Credit Balance

Mar. 6 S2 10,200 10,200

16 R3 10,200 0

Jennifer Nelson

Date PR Debit Credit Balance

Mar. 4 S2 16,800 16,800

14 R3 16,800 0

Accounts Payable Ledger

Defore Industries

Date PR Debit Credit Balance

Mar. 11 P3 52,600 52,600

16 G2 200 52,400

21 D3 52,400 0

Mack Company

Date PR Debit Credit Balance

Mar. 6 P3 1,220 1,220

Schmidt Supply

Date PR Debit Credit Balance

Mar. 18 P3 22,850 22,850

Welch Company

Date PR Debit Credit Balance

Mar. 22 P3 41,625 41,625

Cash Acct. No. 101

Date PR Debit Credit Balance

Mar. 31 R3 187,140 187,140

31 D3 67,252 119,888

Accounts Receivable Acct. No. 106

Date PR Debit Credit Balance

Mar. 26 G2 600 (600)

31 S2 32,600 32,000

31 R3 27,000 5,000

Office Supplies Acct. No. 124

Date PR Debit Credit Balance

Mar. 31 P3 1,220 1,220

Store Equipment Acct. No. 165

Date PR Debit Credit Balance

Mar. 18 P3 22,850 22,850

Accounts Payable Acct. No. 201

Date PR Debit Credit Balance

Mar. 16 G2 200 (200)

31 P3 118,295 118,095

31 D3 52,400 65,695

Long-Term Notes Payable Acct. No. 251

Date PR Debit Credit Balance

Mar. 12 R3 26,000 26,000

Sales Acct. No. 413

Date PR Debit Credit Balance

Mar. 31 S2 32,600 32,600

31 R3 134,680 167,280

Sales Returns and Allowances Acct. No. 414

Date PR Debit Credit Balance

Mar. 26 G2 600 600

Sales Discounts Acct. No. 415

Date PR Debit Credit Balance

Mar. 31 R3 540 540

Purchases Acct. No. 505

Date PR Debit Credit Balance

Mar. 31 P3 94,225 94,225

Purchases Returns and Allowances Acct. No. 506

Date PR Debit Credit Balance

Mar. 16 G2 200 200

Purchases Discounts Acct. No. 507

Date PR Debit Credit Balance

Mar. 31 D3 1,048 1,048

Sales Salaries Expense Acct. No. 621

Date PR Debit Credit Balance

Mar. 31 D3 15,900 15,900

General Ledger (Partial Listing)

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Appendix E Accounting with Special Journals E-25

PEPPER COMPANY Schedule of Accounts Receivable

March 31

Marjorie Allen . . . . . . . . . . . . . . . . $5,000

Total accounts receivable . . . . . . . $5,000

PEPPER COMPANY Trial Balance (partial)

March 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119,888

Accounts receivable . . . . . . . . . . . . . . . . . . . 5,000

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . 1,220

Store equipment . . . . . . . . . . . . . . . . . . . . . . 22,850

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 65,695

Long-term notes payable . . . . . . . . . . . . . . . 26,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167,280

Sales returns and allowances . . . . . . . . . . . . 600

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . 540

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,225

Purchases returns and allowances . . . . . . . . 200

Purchases discounts . . . . . . . . . . . . . . . . . . . 1,048

Sales salaries expense . . . . . . . . . . . . . . . . . . 15,900

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $260,223 $260,223

PEPPER COMPANY Schedule of Accounts Payable

March 31

Mack Company . . . . . . . . . . . . . . $ 1,220

Schmidt Supply . . . . . . . . . . . . . . 22,850

Welch Company . . . . . . . . . . . . . 41,625

Total accounts payable . . . . . . . . $65,695

APPENDIX

Special Journals under a Periodic System E-A This appendix describes special journals under a periodic inventory system. Each journal is slightly impacted. The sales journal and the cash receipts journal both require one less column (namely that of Cost of Goods Sold Dr., Inventory Cr.). The Purchases Journal replaces the Inventory Dr. column with a Purchases Dr. column in a periodic system. The cash disbursements journal replaces the In- ventory Cr. column with a Purchases Discounts Cr. column in a periodic system. These changes are illustrated.

Sales Journal The sales journal using the periodic inventory system is shown in Exhibit E-A.1. The difference in the sales journal between the perpetual and periodic system is the exclusion of the column to record cost of goods sold and inventory amounts for each sale. The periodic system does not record the increase in cost of goods sold and the decrease in inventory at the time of each sale.

EXHIBIT E-A.1 Sales Journal—Periodic System

Sales Journal

Date Account Debited

Invoice Number PR

Accounts Receivable Dr. Sales Cr.

Feb. 2

13 15 22 25 28 28

7 Jason Henry

Kam Moore Paul Roth Jason Henry Frank Booth Albert Co. Total

Albert Co. 307

309 310 311 312 313

308 ✓

450 500 350 200 225 175 250

2,150 (106/413)

Page 3

Cash Receipts Journal The cash receipts journal using the periodic system is shown in Exhibit E-A.2. Note the absence of the column on the far right side to record debits to Cost of Goods

P3 Journalize and post transactions using special journals in a periodic inventory system.

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E-26 Appendix E Accounting with Special Journals

Sold and credits to Inventory for the cost of merchandise sold (seen under the perpetual system). Con- sistent with the cash receipts journal shown in Exhibit E.7, we show only the weekly (summary) cash sale entries.EXHIBIT E-A.2

Cash Receipts Journal— Periodic System

Date Explanation PR Cash Dr. Sales

Discount Dr. Sales Cr. Accounts

Receivable Cr. Other

Accounts Cr.Account Credited

Cash Receipts Journal

Jason Henry Sales Albert Co. Notes Payable Sales Interest revenue Kam Moore Paul Roth Sales Totals

Sales ✓

x

x

x

245

409

x

3,925

4,700

4,225

4,450

17,300

9

10

7 4

30

450

500

350 200

1,500

441 3,925

490 750

4,700 250 343 196

4,225

4,450

19,770

Invoice 307, 2/2 Cash sales Invoice 308, 2/7 Note to bank Cash sales Bank account Invoice 309, 2/13

Cash sales Invoice 310, 2/15

Cash salesFeb. 7 12 14 17 20 21 22 23 25 28 28

750

250

(x)(413)(106)(415)(101)

1,000

Page 2

Purchases Journal The purchases journal using the periodic system is shown in Exhibit E-A.3. This journal under a perpetual system included an Inventory column where the periodic system now has a Purchases column.

EXHIBIT E-A.3 Purchases Journal — Periodic System

Purchases Journal

Purchases Dr.

Office Supplies Dr.

Other Accounts Dr.Date Account

Date of Invoice Terms PR

Accounts Payable Cr.

125/✓

n/30

n/30

2/10, n/30 2/10, n/30 2/10, n/30 2/10, n/30

2/2 2/5

2/10 2/18 2/24 2/28

Horning Supply Co. Ace Mfg. Co.

Smite Co. Ace Mfg. Co. Store Supplies/ITT Co. Totals

Wynet and Co.

Feb. 3 5

13 20 25 28 28

(201)

350 200 150 300 100 225

1,325 (505)

275 200 150 300 100 125

1,150 (124)

75

25 100

(x)

75 75

Page 1

Cash Disbursements Journal The cash disbursements journal using a periodic system is shown in Exhibit E-A.4. This journal under the perpetual system included an Inventory column where the peri- odic system now has the Purchases Discounts column.

EXHIBIT E-A.4 Cash Disbursements Journal — Periodic System

Cash Disbursements Journal Page 2

Purchases Discounts Cr.Date Ck. No. Payee Account Debited PR Cash Cr.

Other Accounts Dr.

Accounts Payable Dr.

Feb. 3 12 15 15 20 28 28

105 106 107 108 109 110

505 ✓

622 ✓

505L. and N. Railroad East Sales Co. Ace Mfg. Co. Jerry Hale Wynet and Co. Smite Co. Totals

Purchases Purchases Ace Mfg. Co. Salaries Expense Wynet and Co. Smite Co.

25 196 250 147 294

(101)

15

927

(x)

25

250

290

15

200

150 300

(201)

650

4

3 6

(507) 13

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Appendix E Accounting with Special Journals E-27

C1 Identify the principles and components of accounting information systems. Accounting information systems are governed by five fundamental principles: control, relevance, com- patibility, flexibility, and cost-benefit. The five basic components of an accounting information system are source documents, input de- vices, information processors, information storage, and output de- vices.

C2 Explain the goals and uses of special journals. Special jour-nals are used for recording transactions of similar type, each meant to cover one kind of transaction. Four of the most common special journals are the sales journal, cash receipts journal, pur- chases journal, and cash disbursements journal. Special journals are efficient and cost-effective tools in the journalizing and posting processes.

C3 Describe the use of controlling accounts and subsidiary ledgers. A general ledger keeps controlling accounts such as Accounts Receivable and Accounts Payable, but details on individ- ual accounts making up the controlling account are kept in subsid- iary ledgers (such as an accounts receivable ledger). The balance in a controlling account must equal the sum of its subsidiary account balances after posting is complete.

A1 Compute segment return on assets and use it to evaluate segment performance. A business segment is a part of a company that is separately identified by its products or services or by the geographic market it serves. Analysis of a company’s segments is aided by the segment return on assets (segment operating income divided by segment average assets).

Summary P1 Journalize and post transactions using special journals. Each special journal is devoted to similar kinds of transac- tions. Transactions are journalized on one line of a special journal, with columns devoted to specific accounts, dates, names, posting references, explanations, and other necessary information. Posting is threefold: (1) individual amounts in the Other Accounts column are posted to their general ledger accounts on a regular (daily) basis, (2) individual amounts in a column whose total is not posted to a controlling account at the end of a period (month) are posted regularly (daily) to their general ledger accounts, and (3) total amounts for all columns except the Other Accounts column are posted at the end of a period (month) to their column’s account title in the general ledger.

P2 Prepare and prove the accuracy of subsidiary ledgers. Account balances in the general ledger and its subsidiary led- gers are tested for accuracy after posting is complete. This proce- dure is twofold: (1) prepare a trial balance of the general ledger to confirm that debits equal credits and (2) prepare a schedule to con- firm that the controlling account’s balance equals the subsidiary ledger’s balance.

P3A Journalize and post transactions using special journals in a periodic inventory system. Transactions are journalized and posted using special journals in a periodic system. The methods are similar to those in a perpetual system; the primary difference is that both cost of goods sold and inventory are not adjusted at the time of each sale. This usually results in the deletion (or renaming) of one or more columns devoted to these accounts in each special journal.

Accountant The main issue is whether commissions have an actual or perceived impact on the integrity and objectivity of your advice. You probably should not accept a commission arrangement (the AICPA Code of Ethics prohibits it when you perform the audit or a review). In any event, you should tell the client of your commission arrangement. Also, you need to seriously examine the merits of agreeing to a commission arrangement when you are in a position to exploit it.

Entrepreneur The accounts receivable ledger has much of the information you need. It lists detailed information for each customer’s account, including the amounts, dates for transactions, and dates of payments. It can be reorganized into an “aging schedule” to show how long customers wait before paying their bills.

Controller Much of the information you need is in the accounts pay- able ledger. It contains information for each supplier, the amounts due, and when payments are made. This subsidiary ledger along with infor- mation on credit terms should enable you to conduct your analyses.

Banker This merchandiser’s segment information is likely to greatly impact your loan decision. The risks associated with the com- pany’s two sources of net income are quite different. While net in- come is up by 10%, U.S. operations are performing poorly and Cuban operations are subject to many uncertainties. These uncertain- ties depend on political events, legal issues, business relationships, Cuban economic conditions, and a host of other risks. Overall, net income results suggested a low-risk loan opportunity, but the seg- ment information reveals a high-risk situation.

Guidance Answers to Decision Maker and Decision Ethics

1. The five components are source documents, input devices, information processors, information storage, and output devices.

2. Information processors interpret, transform, and summarize the recorded accounting information so that it can be used in analy- sis, interpretation, and decision making.

3. Data saved in information storage are used to prepare periodic financial reports and special-purpose internal reports as well as source documentation for auditors.

4. All cash payments by check are recorded in the cash disburse- ments journal.

Guidance Answers to Quick Checks

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E-28 Appendix E Accounting with Special Journals

Multiple Choice Quiz Answers on p. E-45 mhhe.com/wildFINMAN5e

1. The sales journal is used to record a. Credit sales b. Cash sales c. Cash receipts d. Cash purchases e. Credit purchases 2. The purchases journal is used to record a. Credit sales b. Cash sales c. Cash receipts

d. Cash purchases e. Credit purchases 3. The ledger that contains the financial statement accounts of a

company is the a. General journal b. Column balance journal c. Special ledger d. General ledger e. Special journal

Accounting information systems (p. E-1)

Accounts payable ledger (p. E-6)

Accounts receivable ledger (p. E-6)

Batch processing (p. E-15)

Cash disbursements journal (p. E-13)

Cash receipts journal (p. E-10)

Check register (p. E-13)

Columnar journal (p. E-7)

Compatibility principle (p. E-2)

Components of accounting systems (p. E-2)

Computer network (p. E-15)

Control principle (p. E-1)

Controlling account (p. E-6)

Cost-benefit principle (p. E-2)

Enterprise resource planning (ERP) software (p. E-16)

Flexibility principle (p. E-2)

General journal (p. E-5)

Information processor (p. E-3)

Information storage (p. E-3)

Input device (p. E-3)

Internal controls (p. E-1) Online processing (p. E-15) Output devices (p. E-4) Purchases journal (p. E-12) Relevance principle (p. E-1) Sales journal (p. E-7) Schedule of accounts payable (p. E-13) Schedule of accounts receivable (p. E-8) Segment return on assets (p. E-18) Special journal (p. E-5) Subsidiary ledger (p. E-5)

Key Terms

5. Columnar journals allow us to accumulate repetitive debits and credits and post them as column totals rather than as individual amounts from each entry.

6. The equality of debits and credits is kept within the general ledger. The subsidiary ledger keeps the customer’s individual account and is used only for supplementary information.

7. An initial and the page number of the journal from which the amount was posted are entered in the PR column next to the amount.

8. A separate column for Sales Taxes Payable can be included in both the cash receipts journal and the sales journal.

9. This refers to a procedure of using copies of sales invoices as a sales journal. Each invoice amount is posted directly to the cus- tomer’s account. All invoices are totaled at period-end for post- ing to the general ledger accounts.

10. The normal recording and posting procedures are threefold. First, transactions are entered in a special journal if applicable. Second, individual amounts are posted to any subsidiary ledger accounts. Third, column totals are posted to general ledger ac- counts if not already individually posted.

11. Controlling accounts are debited periodically for an amount or amounts equal to the sum of their respective debits in the sub- sidiary ledgers (equals journal column totals), and they are

credited periodically for an amount or amounts equal to the sum of their respective credits in the subsidiary ledgers (from jour- nal column totals).

12. Tests for accuracy of account balances in the general ledger and subsidiary ledgers are twofold. First, we prepare a trial balance of the general ledger to confirm that debits equal credits. Sec- ond, we prove the subsidiary ledgers by preparing schedules of accounts receivable and accounts payable.

13. The general journal is still needed for adjusting, closing, and correcting entries and for special transactions such as sales re- turns, purchases returns, and certain asset purchases.

14. Integrated systems can save time and minimize errors. This is so because actions taken in one part of the system automatically affect and update related parts.

15. Computer systems offer increased accuracy, speed, efficiency, and convenience.

16. Computer networks can create advantages by linking comput- ers, and giving different users and different computers access to common databases, programs, and hardware.

17. ERP software involves integrated programs, from order taking to manufacturing to accounting. It can speed decision making, help identify costs for reduction, and aid managers in control- ling operations.

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Appendix E Accounting with Special Journals E-29

Icon denotes assignments that involve decision making.

1. What are five basic components of an accounting system? 2. What are source documents? Give two examples. 3. What are the five fundamental principles of accounting infor-

mation systems? 4. What is the purpose of an input device? Give examples of input

devices for computer systems. 5. What is the difference between data that are stored off-line and

data that are stored online? 6. What purpose is served by the output devices of an accounting

system? 7. When special journals are used, they are usually used to record

each of four different types of transactions. What are these four types of transactions?

8. What notations are entered into the Posting Reference column of a ledger account?

9. When a general journal entry is used to record sales re- turns, the credit of the entry must be posted twice. Does this cause the trial balance to be out of balance? Explain.

10. Describe the procedures involving the use of copies of a com- pany’s sales invoices as a sales journal.

11. Credits to customer accounts and credits to Other Accounts are individually posted from a cash receipts journal such as the one in Exhibit E.7. Why not put both types of credits in the same column and save journal space?

12. Why should sales to and receipts of cash from credit cus- tomers be recorded and posted immediately?

13. Locate the annual report note that discusses Polaris’s operations by segments in Appendix A. In what segment does it predominantly operate?

14. Does the income statement of Arctic Cat in Appendix A indicate the net income earned by its business segments? If so, list them.

15. Locate the note that discusses KTM’s segments from its 2011 annual report on its Website. What three reportable segments does KTM have?

16. Does the balance sheet of Piaggio in Ap- pendix A indicate the identifiable assets owned by its business segments? If so, list them.

Discussion Questions

Arctic Cat

Polaris

KTM

PIAGGIO

4. A subsidiary ledger that contains a separate account for each supplier (creditor) to the company is the

a. Controlling account b. Accounts payable ledger c. Accounts receivable ledger d. General ledger e. Special journal

5. Enterprise resource planning software a. Refers to programs that help manage company operations. b. Is another name for spreadsheet programs. c. Uses batch processing of business information. d. Is substantially declining in use. e. Is another name for database programs.

QUICK STUDY

QS E-1 Accounting information system principles

C1

For account titles and numbers, use the Chart of Accounts at the end of the book.

Enter the letter of each system principle in the blank next to its best description. A. Control principle D. Flexibility principle B. Relevance principle E. Cost-benefit principle C. Compatibility principle 1. The principle prescribes the accounting information system to help monitor activities. 2. The principle prescribes the accounting information system to adapt to the unique character-

istics of the company. 3. The principle prescribes the accounting information system to change in response to techno-

logical advances and competitive pressures. 4. The principle that affects all other accounting information system principles. 5. The principle prescribes the accounting information system to provide timely information for

effective decision making.

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E-30 Appendix E Accounting with Special Journals

QS E-2 Accounting information system

C1

Fill in the blanks to complete the following descriptions. 1. With processing, source documents are accumulated for a period and then processed all at the

same time, such as once a day, week, or month. 2. A computer allows different computer users to share access to data and programs. 3. A is an input device that captures writing and other input directly from source documents. 4. software comprises programs that help manage a company’s vital operations,

from manufacturing to accounting.

Wilcox Electronics uses a sales journal, a purchases journal, a cash receipts journal, a cash dis bursements journal, and a general journal as illustrated in this appendix. Wilcox recently completed the following trans- actions a through h. Identify the journal in which each transaction should be recorded. a. Sold merchandise on credit. e. Sold merchandise for cash. b. Purchased shop supplies on credit. f. Purchased merchandise on credit. c. Paid an employee’s salary in cash. g. Purchased inventory for cash. d. Borrowed cash from the bank. h. Paid cash to a creditor.

QS E-4 Identifying the special journal of entry

C2

QS E-3 Accounting information system components

C1

Identify the most likely role in an accounting system played by each of the numbered items 1 through 12 by assigning a letter from the list A through E on the left. A. Source documents B. Input devices C. Information processors D. Information storage E. Output devices

1. Computer keyboard 2. Computer printer 3. Computer monitor 4. MP3 player 5. Bank statement 6. Computer software 7. Bar code reader 8. Digital camera 9. Invoice from a supplier 10. Zip drive 11. Computer scanner 12. Filing cabinet

QS E-6 Controlling accounts and subsidiary ledgers

C3

Following is information from Fredrickson Company for its initial month of business. (1) Identify the balances listed in the accounts receivable subsidiary ledger. (2) Identify the accounts receivable balance listed in the general ledger at month’s end.

Credit Sales Cash Collections

Jan. 10 Stern Company . . . . . . . . . . . $4,000 Jan. 20 Stern Company . . . . . . . . . . . . $2,000

19 Diaz Brothers . . . . . . . . . . . . . 1,600 28 Diaz Brothers . . . . . . . . . . . . . 1,600

23 Rex Company . . . . . . . . . . . . . 2,500 31 Rex Company . . . . . . . . . . . . . 1,300

QS E-5 Entries in the general journal

C2

Biloxi Gifts uses a sales journal, a purchases journal, a cash receipts journal, a cash disbursements journal, and a general journal as illustrated in this appendix. Journalize its November transactions that should be recorded in the general journal. For those not recorded in the general journal, identify the special journal where each should be recorded.

Nov. 2 The company purchased $2,600 of merchandise on credit from the Midland Co., terms 2y10, ny30. 12 The owner, T. Biloxi, contributed an automobile worth $17,000 to the company in exchange for

common stock. 16 The company sold $1,200 of merchandise (cost is $800) on credit to K. Myer, terms ny30. 19 K. Myer returned $175 of (worthless) merchandise to the company originally purchased on

November 16 (assume the cost of this merchandise is left in cost of goods sold).

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Appendix E Accounting with Special Journals E-31

QS E-7 Purchases journal—perpetual

P1

Peachtree Company uses a sales journal, a purchases journal, a cash receipts journal, a cash disbursements journal, and a general journal. The following transactions occur in the month of May.

May 1 Purchased $10,100 of merchandise on credit from Krause, Inc., terms ny30. 8 Sold merchandise costing $900 on credit to G. Seles for $1,500 subject to a $30 sales discount

if paid by the end of the month. 14 Purchased $240 of store supplies from Chang Company on credit, terms ny30. 17 Purchased $260 of office supplies on credit from Monder Company, terms ny30. 24 Sold merchandise costing $400 to D. Air for $650 cash. 28 Purchased store supplies from Porter’s for $90 cash. 29 Paid Krause, Inc., $10,100 cash for the merchandise purchased on May 1.

Prepare headings for a purchases journal like the one in Exhibit E.9. Journalize the May transactions that should be recorded in the purchases journal.

QS E-8 Identifying journal of entry C2

Refer to QS E-7 and for each of the May transactions identify the journal in which it would be recorded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash disbursements journal, and general journal as illustrated in this appendix.

QS E-9 Accounts receivable ledger; posting from sales journal

P2

Warton Company posts its sales invoices directly and then binds them into a Sales Journal. The company had the following credit sales to these customers during July.

July 2 Mary Mack . . . . . . . . . . . . . $ 8,600

8 Eric Horner . . . . . . . . . . . . 11,100

10 Troy Wilson . . . . . . . . . . . . 13,400

14 Hong Jiang . . . . . . . . . . . . . 20,500

20 Troy Wilson . . . . . . . . . . . . 11,200

29 Mary Mack . . . . . . . . . . . . . 7,300

Total credit sales . . . . . . . . $72,100

Required

1. Open an accounts receivable subsidiary ledger having a T-account for each customer. Post the invoices to the subsidiary ledger.

2. Open an Accounts Receivable controlling T-account and a Sales T-account to reflect general ledger accounts. Post the end-of-month total from the sales journal to these accounts.

3. Prepare a schedule of accounts receivable and prove that its total equals the Accounts Receivable con- trolling account balance.

Apple reports the following operating income (and average assets in parentheses) in a recent year for each of its geographic segments—$ millions: Americas, $13,538 ($3,308); Europe, $11,528 ($2,456); and Japan, $2,481 ($898). Apple also reports the following sales (only) by product segments: iPhone, $47,057; iPad, $20,358; iPod, $7,453; Desktops, $6,439; Portables, $15,344; Other, $11,598. Compute Apple’s return on assets for each of its geographic segments, and assess the relative performance of these segments. Compute the percentage of total sales for each of its five product segments.

QS E-10 Analyzing segment reports

A1

Apple

Nestlé, a Switzerland-based company, uses a sales journal, a purchases journal, a cash receipts journal, a cash disbursements journal, and a general journal in a manner similar to that explained in this appendix. Journalize the following summary transactions of Nestlé transactions that should be recorded in the general journal. For those not recorded in the general journal, identify only the special journal where each should be recorded. (All amounts in millions of Swiss franc, CHF.) 1. Assume Nestlé purchased CHF 17,000 of merchandise on credit from the suppliers. 2. Assume Nestlé sold CHF 94,000 of merchandise (cost is CHF 42,300) on credit to customers. 3. Assume a key customer returned CHF 2,400 of (worthless) merchandise to Nestlé (assume the cost of

this merchandise is left in cost of goods sold).

QS E-11 International accounting and special journals

C2

Prepare headings for a purchases journal like the one in Exhibit E-A.3. Journalize the May transactions from QS E-7 that should be recorded in the purchases journal assuming the periodic inventory system is used.

QS E-12A

Purchases journal—periodic P3

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E-32 Appendix E Accounting with Special Journals

Exercise E-2 Identifying journal of entry C2

Refer to Exercise E-1 and for each of the May transactions identify the journal in which it would be recorded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash disburse- ments journal, and general journal as illustrated in this appendix.

Exercise E-4 Identifying journal of entry C2

Refer to Exercise E-3 and for each of the November transactions identify the journal in which it would be recorded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash disburse- ments journal, and general journal as illustrated in this appendix.

Exercise E-3 Cash receipts journal—perpetual

P1

Ali Co. uses a sales journal, a purchases journal, a cash receipts journal, a cash disbursements journal, and a general journal. The following transactions occur in the month of November.

Nov. 3 The company purchased $3,200 of merchandise on credit from Hart Co., terms ny20. 7 The company sold merchandise costing $840 on credit to J. Than for $1,000, subject to an

$20 sales discount if paid by the end of the month. 9 The company borrowed $3,750 cash by signing a note payable to the bank. 13 J. Ali, the owner, contributed $5,000 cash to the company in exchange for common stock. 18 The company sold merchandise costing $250 to B. Cox for $330 cash. 22 The company paid Hart Co. $3,200 cash for the merchandise purchased on November 3. 27 The company received $980 cash from J. Than in payment of the November 7 purchase. 30 The company paid salaries of $1,650 in cash.

Prepare headings for a cash receipts journal like the one in Exhibit E.7. Journalize the November transac- tions that should be recorded in the cash receipts journal.

For account titles and numbers, use the Chart of Accounts at the end of the book.

Finer Company uses a sales journal, a purchases journal, a cash receipts journal, a cash disbursements jour- nal, and a general journal. The following transactions occur in the month of May.

May 2 Sold merchandise costing $300 to B. Facer for $450 cash, invoice no. 5703. 5 Purchased $2,400 of merchandise on credit from Marchant Corp. 7 Sold merchandise costing $800 to J. Dryer for $1,250, terms 2y10, ny30, invoice no. 5704. 8 Borrowed $9,000 cash by signing a note payable to the bank. 12 Sold merchandise costing $200 to R. Lamb for $340, terms ny30, invoice no. 5705. 16 Received $1,225 cash from J. Dryer to pay for the purchase of May 7. 19 Sold used store equipment for $900 cash to Golf, Inc. 25 Sold merchandise costing $500 to T. Taylor for $750, terms ny30, invoice no. 5706.

Prepare headings for a sales journal like the one in Exhibit E.5. Journalize the May transactions that should be recorded in this sales journal.

EXERCISES

Exercise E-1 Sales journal—perpetual

P1

Credit Purchases Cash Paid

Jan. 9 Bailey Company . . . . . . . . . . . $14,000 Jan. 19 Bailey Company . . . . . . . . . . . $10,100

18 Johnson Brothers . . . . . . . . . . 6,600 27 Johnson Brothers . . . . . . . . . . 6,600

22 Preston Company . . . . . . . . . 6,200 31 Preston Company . . . . . . . . . . 5,400

Exercise E-5 Controlling accounts and subsidiary ledgers

C3

Following is information from Jesper Company for its initial month of business. (1) Identify the balances listed in the accounts payable subsidiary ledger. (2) Identify the accounts payable balance listed in the gen- eral ledger at month’s end.

Exercise E-6 Cash disbursements journal—perpetual

P1

Marx Supply uses a sales journal, a purchases journal, a cash receipts journal, a cash disbursements journal, and a general journal. The following transactions occur in the month of April.

Apr. 3 Purchased merchandise for $2,950 on credit from Seth, Inc., terms 2y10, ny30. 9 Issued check no. 210 to Kitt Corp. to buy store supplies for $650. 12 Sold merchandise costing $500 on credit to C. Myrs for $770, terms ny30. 17 Issued check no. 211 for $1,400 to pay off a note payable to City Bank. 20 Purchased merchandise for $4,500 on credit from Lite, terms 2y10, ny30.

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Appendix E Accounting with Special Journals E-33

Exercise E-7 Identifying journal of entry C2

Refer to Exercise E-6 and for each of the April transactions identify the journal in which it would be re- corded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash disburse- ments journal, and general journal as illustrated in this appendix.

Post Pharmacy uses the following journals: sales journal, purchases journal, cash receipts journal, cash disbursements journal, and general journal. On June 5, Post purchased merchandise priced at $14,000, subject to credit terms of 2y10, ny30. On June 14, the pharmacy paid the net amount due for the merchan- dise. In journalizing the payment, the pharmacy debited Accounts Payable for $14,000 but failed to record the cash discount on the purchases. Cash was properly credited for the actual $13,720 paid. (a) In what journals would the June 5 and the June 14 transactions be recorded? (b) What procedure is likely to dis- cover the error in journalizing the June 14 transaction?

Exercise E-9 Special journal transactions and error discovery

P1

Exercise E-8 Purchases journal and error identification

P1

A company that records credit purchases in a purchases journal and records purchases returns in a general journal made the following errors. Indicate when each error should be discovered. 1. Made an addition error in totaling the Office Supplies column of the purchases journal. 2. Made an addition error in determining the balance of a creditor’s subsidiary account. 3. Posted a purchases return to the Accounts Payable account and to the creditor’s subsidiary account but

did not post the purchases return to the Inventory account. 4. Correctly recorded a $8,000 purchase in the purchases journal but posted it to the creditor’s subsidiary

account as a $800 purchase. 5. Posted a purchases return to the Inventory account and to the Accounts Payable account but did not

post to the creditor’s subsidiary account.

28 Issued check no. 212 to Lite to pay the amount due for the purchase of April 20, less the discount. 29 Paid salary of $1,800 to B. Dock by issuing check no. 213. 30 Issued check no. 214 to Seth, Inc., to pay the amount due for the purchase of April 3.

Prepare headings for a cash disbursements journal like the one in Exhibit E.11. Journalize the April transac- tions that should be recorded in the cash disbursements journal.

Exercise E-10 Posting to subsidiary ledger accounts; preparing a schedule of accounts receivable

P2

At the end of May, the sales journal of Mountain View appears as follows.

Mountain View also recorded the return of defective merchandise with the following entry.

May 20 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 350

Accounts Receivable—Anna Page . . . . . . . . . . . . . . 350

Customer returned (worthless) merchandise.

Sales Journal

Date Account Debited

Invoice Number PR

Cost of Goods Sold Dr. Inventory Cr.

Accounts Receivable Dr. Sales Cr.

May 6 10 17 25 31

Aaron Reckers Sara Reed Anna Page Sara Reed Totals

190 191 192 193

3,880 2,940 1,850 1,340

10,010

3,120 2,325 1,480 1,075 8,000

Page 2

Required

1. Open an accounts receivable subsidiary ledger that has a T-account for each customer listed in the sales journal. Post to the customer accounts the entries in the sales journal and any portion of the gen- eral journal entry that affects a customer’s account.

2. Open a general ledger that has T-accounts for Accounts Receivable, Inventory, Sales, Sales Returns and Allowances, and Cost of Goods Sold. Post the sales journal and any portion of the general journal entry that affects these accounts.

3. Prepare a schedule of accounts receivable and prove that its total equals the balance in the Accounts Receivable controlling account.

Check (3) Ending Accounts Receivable, $9,660

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E-34 Appendix E Accounting with Special Journals

Refer to Exhibit E.13 and complete the segment return on assets table for Teton Company (round ratios to three decimals, or one decimal if shown in percent form). Analyze your findings and identify the segment with the highest, and that with the lowest, segment return on assets.

Exercise E-11 Computing and analyzing segment return on assets

A1

Prepare headings for a sales journal like the one in Exhibit E-A.1. Journalize the May transactions shown in Exercise E-1 that should be recorded in the sales journal assuming that the periodic inventory system is used.

Exercise E-12A

Sales journal—periodic P3

Prepare headings for a cash receipts journal like the one in Exhibit E-A.2. Journalize the November transactions shown in Exercise E-3 that should be recorded in the cash receipts journal assuming that the periodic inventory system is used.

Exercise E-13A

Cash receipts journal—periodic

P3

Prepare headings for a cash disbursements journal like the one in Exhibit E-A.4. Journalize the April transactions from Exercise E-6 that should be recorded in the cash disbursements journal assuming that the periodic inventory system is used.

Exercise E-14A

Cash disbursements journal—periodic P3

Segment Operating Segment Assets Segment Return Income (in $ mil.) (in $ mil.) on Assets

Segment 2013 2012 2013 2012 2013

Specialty

Skiing Group . . . . . . . . . . . . . $ 72 $ 68 $ 591 $450

Skating Group . . . . . . . . . . . . 19 16 63 52

Specialty Footwear . . . . . . . . 32 29 165 146

Other Specialty . . . . . . . . . . . 21 14 47 34

Subtotal . . . . . . . . . . . . . . . . . 144 127 866 682

General Merchandise

South America . . . . . . . . . . . . 42 46 315 284

United States . . . . . . . . . . . . . 17 18 62 45

Europe . . . . . . . . . . . . . . . . . . 15 13 24 22

Subtotal . . . . . . . . . . . . . . . . . 74 77 401 351

Total . . . . . . . . . . . . . . . . . . . . . . $218 $204 $1,267 $1,033Check Europe segment return, 65.2%

For account titles and numbers, use the Chart of Accounts at the end of the book.

Wiset Company completes these transactions during April of the current year (the terms of all its credit sales are 2y10, ny30).

Apr. 2 Purchased $14,300 of merchandise on credit from Noth Company, invoice dated April 2, terms 2y10, ny60.

3 Sold merchandise on credit to Page Alistair, Invoice No. 760, for $4,000 (cost is $3,000). 3 Purchased $1,480 of office supplies on credit from Custer, Inc. Invoice dated April 2, terms

ny10 EOM. 4 Issued Check No. 587 to World View for advertising expense, $899. 5 Sold merchandise on credit to Paula Kohr, Invoice No. 761, for $8,000 (cost is $6,500). 6 Received an $80 credit memorandum from Custer, Inc., for the return of some of the office sup-

plies received on April 3. 9 Purchased $12,125 of store equipment on credit from Hal’s Supply, invoice dated April 9,

terms ny10 EOM. 11 Sold merchandise on credit to Nic Nelson, Invoice No 762, for $10,500 (cost is $7,000). 12 Issued Check No. 588 to Noth Company in payment of its April 2 invoice, less the discount. 13 Received payment from Page Alistair for the April 3 sale, less the discount. 13 Sold $5,100 of merchandise on credit to Page Alistair (cost is $3,600), Invoice No. 763. 14 Received payment from Paula Kohr for the April 5 sale, less the discount. 16 Issued Check No. 589, payable to Payroll, in payment of sales salaries expense for the first half

of the month, $10,750. Cashed the check and paid employees.

PROBLEM SET A

Problem E-1A Special journals, subsidiary ledgers, and schedule of accounts receivable—perpetual

C3 P1 P2

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Appendix E Accounting with Special Journals E-35

Check Trial balance totals, $434,285

Problem E-2A Special journals, subsidiary ledgers, and schedule of accounts payable—perpetual

C3 P1 P2

The April transactions of Wiset Company are described in Problem E-1A.

Required

1. Prepare a general journal, a purchases journal like that in Exhibit E.9, and a cash disbursements jour- nal like that in Exhibit E.11. Number all journal pages as page 3. Review the April transactions of Wiset Company and enter those transactions that should be journalized in the general journal, the pur- chases journal, or the cash disbursements journal. Ignore any transactions that should be journalized in a sales journal or cash receipts journal.

2. Open the following general ledger accounts: Cash, Inventory, Office Supplies, Store Supplies, Store Equipment, Accounts Payable, Long-Term Notes Payable, Common Stock, Retained Earnings, Sales Salaries Expense, and Advertising Expense. Enter the March 31 balances of Cash ($85,000), Inventory ($125,000), Long-Term Notes Payable ($110,000), Common Stock ($20,000), and Retained Earnings ($80,000). Also open accounts payable subsidiary ledger accounts for Hal’s Supply, Noth Company, Grant Company, and Custer, Inc.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month-end postings.

4. Prepare a trial balance of the general ledger and a schedule of accounts payable. Check Trial balance totals, $235,730

16 Cash sales for the first half of the month are $52,840 (cost is $35,880). (Cash sales are recorded daily from cash register data but are recorded only twice in this problem to reduce repetitive entries.)

17 Purchased $13,750 of merchandise on credit from Grant Company, invoice dated April 17, terms 2y10, ny30.

18 Borrowed $60,000 cash from First State Bank by signing a long-term note payable. 20 Received payment from Nic Nelson for the April 11 sale, less the discount. 20 Purchased $830 of store supplies on credit from Hal’s Supply, invoice dated April 19, terms

ny10 EOM. 23 Received a $750 credit memorandum from Grant Company for the return of defective merchan-

dise received on April 17. 23 Received payment from Page Alistair for the April 13 sale, less the discount. 25 Purchased $11,375 of merchandise on credit from Noth Company, invoice dated April 24, terms

2y10, ny60. 26 Issued Check No. 590 to Grant Company in payment of its April 17 invoice, less the return and

the discount. 27 Sold $3,170 of merchandise on credit to Paula Kohr, Invoice No. 764 (cost is $2,520). 27 Sold $6,700 of merchandise on credit to Nic Nelson, Invoice No. 765 (cost is $4,305). 30 Issued Check No. 591, payable to Payroll, in payment of the sales salaries expense for the last

half of the month, $10,750. 30 Cash sales for the last half of the month are $73,975 (cost is $58,900).

Required

1. Prepare a sales journal like that in Exhibit E.5 and a cash receipts journal like that in Exhibit E.7. Number both journal pages as page 3. Then review the transactions of Wiset Company and enter those that should be journalized in the sales journal and those that should be journalized in the cash receipts journal. Ignore any transactions that should be journalized in a purchases journal, a cash disburse- ments journal, or a general journal.

2. Open the following general ledger accounts: Cash, Accounts Receivable, Inventory, Long-Term Notes Payable, Common Stock, Retained Earnings, Sales, Sales Discounts, and Cost of Goods Sold. Enter the March 31 balances for Cash ($85,000), Inventory ($125,000), Long-Term Notes Payable ($110,000), Common Stock ($20,000), and Retained Earnings ($80,000). Also open accounts re- ceivable subsidiary ledger accounts for Paula Kohr, Page Alistair, and Nic Nelson.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month-end postings.

4. Prepare a trial balance of the general ledger and prove the accuracy of the subsidiary ledger by preparing a schedule of accounts receivable.

Analysis Component

5. Assume that the total for the schedule of Accounts Receivable does not equal the balance of the controlling account in the general ledger. Describe steps you would take to discover the error(s).

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E-36 Appendix E Accounting with Special Journals

Church Company completes these transactions and events during March of the current year (terms for all its credit sales are 2y10, ny30).

Mar. 1 Purchased $43,600 of merchandise from Van Industries, invoice dated March 1, terms 2y15, ny30. 2 Sold merchandise on credit to Min Cho, Invoice No. 854, for $16,800 (cost is $8,400). 3 Purchased $1,230 of office supplies on credit from Gabel Company, invoice dated March 3,

terms ny10 EOM. 3 Sold merchandise on credit to Linda Witt, Invoice No. 855, for $10,200 (cost is $5,800). 6 Borrowed $82,000 cash from Federal Bank by signing a long-term note payable. 9 Purchased $21,850 of office equipment on credit from Spell Supply, invoice dated March 9,

terms ny10 EOM. 10 Sold merchandise on credit to Jovita Albany, Invoice No. 856, for $5,600 (cost is $2,900). 12 Received payment from Min Cho for the March 2 sale less the discount. 13 Sent Van Industries Check No. 416 in payment of the March 1 invoice less the discount. 13 Received payment from Linda Witt for the March 3 sale less the discount. 14 Purchased $32,625 of merchandise from the CD Company, invoice dated March 13,

terms 2y10, ny30. 15 Issued Check No. 417, payable to Payroll, in payment of sales salaries expense for the first half

of the month, $18,300. Cashed the check and paid the employees. 15 Cash sales for the first half of the month are $34,680 (cost is $20,210). (Cash sales are recorded

daily, but are recorded only twice here to reduce repetitive entries.) 16 Purchased $1,770 of store supplies on credit from Gabel Company, invoice dated March 16,

terms ny10 EOM. 17 Received a $2,425 credit memorandum from CD Company for the return of unsatisfactory mer-

chandise purchased on March 14. 19 Received a $630 credit memorandum from Spell Supply for office equipment received on

March 9 and returned for credit. 20 Received payment from Jovita Albany for the sale of March 10 less the discount. 23 Issued Check No. 418 to CD Company in payment of the invoice of March 13 less the

March 17 return and the discount. 27 Sold merchandise on credit to Jovita Albany, Invoice No. 857, for $14,910 (cost is $7,220). 28 Sold merchandise on credit to Linda Witt, Invoice No. 858, for $4,315 (cost is $3,280). 31 Issued Check No. 419, payable to Payroll, in payment of sales salaries expense for the last half

of the month, $18,300. Cashed the check and paid the employees. 31 Cash sales for the last half of the month are $30,180 (cost is $16,820). 31 Verify that amounts impacting customer and creditor accounts were posted and that any

amounts that should have been posted as individual amounts to the general ledger accounts were posted. Foot and crossfoot the journals and make the month-end postings.

Required

1. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory (March 1 beg. bal. is $10,000); Office Supplies; Store Supplies; Office Equipment; Accounts Payable; Long-Term Notes Payable; Common Stock (March 1 beg. bal. is $3,000), and Retained Earnings (March 1 beg. bal. is $7,000); Sales; Sales Discounts; Cost of Goods Sold; and Sales Salaries Expense. Open the following accounts receivable subsidiary ledger accounts: Jovita Albany, Min Cho, and Linda Witt. Open the following accounts payable subsidiary ledger accounts: Gabel Company, Van Industries, Spell Supply, and CD Company.

2. Enter these transactions in a sales journal like Exhibit E.5, a purchases journal like Exhibit E.9, a cash receipts journal like Exhibit E.7, a cash disbursements journal like Exhibit E.11, or a general journal. Number all journal pages as page 2.

3. Prepare a trial balance of the general ledger and prove the accuracy of the subsidiary ledgers by pre- paring schedules of both accounts receivable and accounts payable.

Problem E-3A Special journals, subsidiary ledgers, trial balance—perpetual

C3 P1 P2

mhhe.com/wildFINMAN5e

Check Trial balance totals, $232,905

Assume that Wiset Co. in Problem E-1A uses the periodic inventory system.

Required

1. Prepare headings for a sales journal like the one in Exhibit E-A.1. Prepare headings for a cash receipts journal like the one in Exhibit E-A.2. Journalize the April transactions shown in Problem E-1A that should be recorded in the sales journal and the cash receipts journal assuming the periodic inventory system is used.

Problem E-4AA

Special journals, subsidiary ledgers, and schedule of accounts receivable—periodic C3 P2 P3

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Appendix E Accounting with Special Journals E-37

2. Open the general ledger accounts with balances as shown in Problem E-1A (do not open a Cost of  Goods Sold ledger account). Also open accounts receivable subsidiary ledger accounts for Page Alistair, Paula Kohr, and Nic Nelson. Under the periodic system, an Inventory account exists but is inactive until its balance is updated to the correct inventory balance at year-end. In this problem, the Inventory account remains inactive but must be included to correctly complete the trial balance.

3. Complete parts 3, 4, and 5 of Problem E-1A using the results of parts 1 and 2 of this problem. Check Trial balance totals, $434,285

Problem E-6AA

Special journals, subsidiary ledgers, trial balance—periodic

C3 P2 P3

Assume that Church Company in Problem E-3A uses the periodic inventory system.

Required

1. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory (March 1 beg. bal. is $10,000); Office Supplies; Store Supplies; Office Equipment; Accounts Payable; Long-Term Notes Payable; Common Stock (March 1 beg. bal. is $3,000), and Retained Earnings (March 1 beg. bal. is $7,000); Sales; Sales Discounts; Purchases; Purchases Returns and Allowances; Purchases Discounts; and Sales Salaries Expense. Open the following accounts receivable subsidiary ledger accounts: Jovita Albany, Min Cho, and Linda Witt. Open the following accounts payable subsidiary ledger accounts: Gabel Company, Van Industries, Spell Supply, and CD Company.

2. Enter the transactions from Problem E-3A in a sales journal like that in Exhibit E-A.1, a purchases journal like that in Exhibit E-A.3, a cash receipts journal like that in Exhibit E-A.2, a cash disbursements journal like that in Exhibit E-A.4, or a general journal. Number journal pages as page 2.

3. Prepare a trial balance of the general ledger and prove the accuracy of the subsidiary ledgers by pre- paring schedules of both accounts receivable and accounts payable.

mhhe.com/wildFINMAN5e

For account titles and numbers, use the Chart of Accounts at the end of the book.

Acorn Industries completes these transactions during July of the current year (the terms of all its credit sales are 2y10, ny30).

July 1 Purchased $6,500 of merchandise on credit from Teton Company, invoice dated June 30, terms 2y10, ny30.

3 Issued Check No. 300 to The Weekly for advertising expense, $625. 5 Sold merchandise on credit to Kim Nettle, Invoice No. 918, for $19,200 (cost is $10,500). 6 Sold merchandise on credit to Ruth Blake, Invoice No. 919, for $7,500 (cost is $4,300). 7 Purchased $1,250 of store supplies on credit from Plaine, Inc., invoice dated July 7, terms

ny10 EOM. 8 Received a $250 credit memorandum from Plaine, Inc., for the return of store supplies received

on July 7.

PROBLEM SET B

Problem E-1B Special journals, subsidiary ledgers, schedule of accounts receivable—perpetual

C3 P1 P2

Problem E-5AA

Special journals, subsidiary ledgers, and schedule of accounts payable—periodic

C3 P2 P3

Refer to Problem E-1A and assume that Wiset Co. uses the periodic inventory system.

Required

1. Prepare a general journal, a purchases journal like that in Exhibit E-A.3, and a cash disbursements journal like that in Exhibit E-A.4. Number all journal pages as page 3. Review the April transac- tions of Wiset Company (Problem E-1A) and enter those transactions that should be journalized in the general journal, the purchases journal, or the cash disbursements journal. Ignore any transac- tion that should be journalized in a sales journal or cash receipts journal.

2. Open the following general ledger accounts: Cash, Inventory, Office Supplies, Store Supplies, Store Equipment, Accounts Payable, Long-Term Notes Payable, Common Stock, Retained Earnings, Purchases, Purchases Returns and Allowances, Purchases Discounts, Sales Salaries Expense, and Advertising Expense. Enter the March 31 balances of Cash ($85,000), Inventory ($125,000), Long- Term Notes Payable ($110,000), Common Stock ($20,000), and Retained Earnings ($80,000). Also open accounts payable subsidiary ledger accounts for Hal’s Supply, Noth Company, Grant Company, and Custer, Inc.

3. Complete parts 3 and 4 of Problem E-2A using the results of parts 1 and 2 of this problem. Check Trial balance totals, $237,026

Check Trial balance totals, $236,806

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E-38 Appendix E Accounting with Special Journals

9 Purchased $38,220 of store equipment on credit from Charm’s Supply, invoice dated July 8, terms ny10 EOM.

10 Issued Check No. 301 to Teton Company in payment of its June 30 invoice, less the discount. 13 Sold merchandise on credit to Ashton Moore, Invoice No. 920, for $8,550 (cost is $5,230). 14 Sold merchandise on credit to Kim Nettle, Invoice No. 921, for $5,100 (cost is $3,800). 15 Received payment from Kim Nettle for the July 5 sale, less the discount. 15 Issued Check No. 302, payable to Payroll, in payment of sales salaries expense for the first half

of the month, $31,850. Cashed the check and paid employees. 15 Cash sales for the first half of the month are $118,350 (cost is $76,330). (Cash sales are recorded

daily using data from the cash registers but are recorded only twice in this problem to reduce repetitive entries.)

16 Received payment from Ruth Blake for the July 6 sale, less the discount. 17 Purchased $7,200 of merchandise on credit from Drake Company, invoice dated July 17, terms

2y10, ny30. 20 Purchased $650 of office supplies on credit from Charm’s Supply, invoice dated July 19, terms

ny10 EOM. 21 Borrowed $15,000 cash from College Bank by signing a long-term note payable. 23 Received payment from Ashton Moore for the July 13 sale, less the discount. 24 Received payment from Kim Nettle for the July 14 sale, less the discount. 24 Received a $2,400 credit memorandum from Drake Company for the return of defective mer-

chandise received on July 17. 26 Purchased $9,770 of merchandise on credit from Teton Company, invoice dated July 26, terms

2y10, ny30. 27 Issued Check No. 303 to Drake Company in payment of its July 17 invoice, less the return and

the discount. 29 Sold merchandise on credit to Ruth Blake, Invoice No. 922, for $17,500 (cost is $10,850). 30 Sold merchandise on credit to Ashton Moore, Invoice No. 923, for $16,820 (cost is $9,840). 31 Issued Check No. 304, payable to Payroll, in payment of the sales salaries expense for the last

half of the month, $31,850. 31 Cash sales for the last half of the month are $80,244 (cost is $53,855).

Required

1. Prepare a sales journal like that in Exhibit E.5 and a cash receipts journal like that in Exhibit E.7. Number both journals as page 3. Then review the transactions of Acorn Industries and enter those transactions that should be journalized in the sales journal and those that should be journalized in the cash receipts journal. Ignore any transactions that should be journalized in a purchases journal, a cash disbursements journal, or a general journal.

2. Open the following general ledger accounts: Cash, Accounts Receivable, Inventory, Long-Term Notes Payable, Common Stock, Retained Earnings, Sales, Sales Discounts, and Cost of Goods Sold. Enter the June 30 balances for Cash ($100,000), Inventory ($200,000), Long-Term Notes Payable ($200,000), Common Stock ($10,000), and Retained Earnings ($90,000). Also open accounts receivable subsidiary ledger accounts for Kim Nettle, Ashton Moore, and Ruth Blake.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month- end postings.

4. Prepare a trial balance of the general ledger and prove the accuracy of the subsidiary ledger by prepar- ing a schedule of accounts receivable.

Analysis Component

5. Assume that the total for the schedule of Accounts Receivable does not equal the balance of the controlling account in the general ledger. Describe steps you would take to discover the error(s).

Check Trial balance totals, $588,264

Problem E-2B Special journals, subsidiary ledgers, and schedule of accounts payable—perpetual

C3 P1 P2

The July transactions of Acorn Industries are described in Problem E-1B.

Required

1. Prepare a general journal, a purchases journal like that in Exhibit E.9, and a cash disbursements jour- nal like that in Exhibit E.11. Number all journal pages as page 3. Review the July transactions of Acorn Industries and enter those transactions that should be journalized in the general journal, the

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Appendix E Accounting with Special Journals E-39

purchases journal, or the cash disbursements journal. Ignore any transactions that should be journal- ized in a sales journal or cash receipts journal.

2. Open the following general ledger accounts: Cash, Inventory, Office Supplies, Store Supplies, Store Equipment, Accounts Payable, Long-Term Notes Payable, Common Stock, Retained Earnings, Sales Salaries Expense, and Advertising Expense. Enter the June 30 balances of Cash ($100,000), Inventory ($200,000), Long-Term Notes Payable ($200,000), Common Stock ($10,000), and Retained Earnings ($90,000). Also open accounts payable subsidiary ledger accounts for Charm’s Supply, Teton Company, Drake Company, and Plaine, Inc.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month-end postings.

4. Prepare a trial balance of the general ledger and a schedule of accounts payable. Check Trial balance totals, $349,640

Problem E-3B Special journals, subsidiary ledgers, trial balance—perpetual

C3 P2 P3

Grassley Company completes these transactions during November of the current year (terms for all its credit sales are 2y10, ny30).

Nov. 1 Purchased $5,058 of office equipment on credit from Brun Supply, invoice dated November 1, terms ny10 EOM.

2 Borrowed $88,500 cash from Wisconsin Bank by signing a long-term note payable. 4 Purchased $33,500 of merchandise from BLR Industries, invoice dated November 3, terms

2y10, ny30. 5 Purchased $1,040 of store supplies on credit from Grebe Company, invoice dated November 5,

terms ny10 EOM. 8 Sold merchandise on credit to Cyd Rounder, Invoice No. 439, for $6,550 (cost is $3,910). 10 Sold merchandise on credit to Carlos Mantel, Invoice No. 440, for $13,500 (cost is $8,500). 11 Purchased $2,557 of merchandise from Lo Company, invoice dated November 10, terms 2y10,

ny30. 12 Sent BLR Industries Check No. 633 in payment of its November 3 invoice less the discount. 15 Issued Check No. 634, payable to Payroll, in payment of sales salaries expense for the first half

of the month, $6,585. Cashed the check and paid the employees. 15 Cash sales for the first half of the month are $18,170 (cost is $9,000). (Cash sales are recorded

daily but are recorded only twice in this problem to reduce repetitive entries.) 15 Sold merchandise on credit to Tori Tripp, Invoice No. 441, for $5,250 (cost is $2,450). 16 Purchased $459 of office supplies on credit from Grebe Company, invoice dated November 16,

terms ny10 EOM. 17 Received a $557 credit memorandum from Lo Company for the return of unsatisfactory mer-

chandise purchased on November 11. 18 Received payment from Cyd Rounder for the November 8 sale less the discount. 19 Received payment from Carlos Mantel for the November 10 sale less the discount. 19 Issued Check No. 635 to Lo Company in payment of its invoice of November 10 less the

return and the discount. 22 Sold merchandise on credit to Carlos Mantel, Invoice No. 442, for $3,695 (cost is $2,060). 24 Sold merchandise on credit to Tori Tripp, Invoice No. 443, for $4,280 (cost is $2,130). 25 Received payment from Tori Tripp for the sale of November 15 less the discount. 26 Received a $922 credit memorandum from Brun Supply for the return of office equipment pur-

chased on November 1. 30 Issued Check No. 636, payable to Payroll, in payment of sales salaries expense for the last half

of the month, $6,585. Cashed the check and paid the employees. 30 Cash sales for the last half of the month are $16,703 (cost is $10,200). 30 Verify that amounts impacting customer and creditor accounts were posted and that any

amounts that should have been posted as individual amounts to the general ledger accounts were posted. Foot and crossfoot the journals and make the month-end postings.

Required

1. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory (November 1 beg. bal. is $40,000); Office Supplies; Store Supplies; Office Equipment; Accounts Payable; Long-Term Notes Pay- able; Common Stock (Nov. 1 beg. bal. is $10,000), and Retained Earnings (Nov. 1 beg. bal. is $30,000); Sales; Sales Discounts; Cost of Goods Sold; and Sales Salaries Expense. Open the following accounts receivable subsidiary ledger accounts: Carlos Mantel, Tori Tripp, and Cyd Rounder. Open the following accounts pay- able subsidiary ledger accounts: Grebe Company, BLR Industries, Brun Supply, and Lo Company.

[continued on next page]

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E-40 Appendix E Accounting with Special Journals

Problem E-4BA

Special journals, subsidiary ledgers, and schedule of accounts receivable—periodic

C3 P2 P3

Assume that Acorn Industries in Problem E-1B uses the periodic inventory system.

Required

1. Prepare headings for a sales journal like the one in Exhibit E-A.1. Prepare headings for a cash receipts journal like the one in Exhibit E-A.2. Journalize the July transactions shown in Problem E-1B that should be recorded in the sales journal and the cash receipts journal assuming the periodic inventory system is used.

2. Open the general ledger accounts with balances as shown in Problem E-1B (do not open a Cost of Goods Sold ledger account). Also open accounts receivable subsidiary ledger accounts for Ruth Blake, Ashton Moore, and Kim Nettle. Under the periodic system, an Inventory account exists but is inactive until its balance is updated to the correct inventory balance at year-end. In this prob- lem, the Inventory account remains inactive but must be included to correctly complete the trial balance.

3. Complete parts 3, 4, and 5 of Problem E-1B using the results of parts 1 and 2 of this problem.Check Trial balance totals, $588,264

Problem E-5BA

Special journals, subsidiary ledgers, and schedule of accounts payable—periodic

C3 P2 P3

Refer to Problem E-1B and assume that Acorn uses the periodic inventory system.

Required

1. Prepare a general journal, a purchases journal like that in Exhibit E-A.3, and a cash disbursements journal like that in Exhibit E-A.4. Number all journal pages as page 3. Review the July transactions of Acorn Company (Problem E-1B) and enter those transactions that should be journalized in the general journal, the purchases journal, or the cash disbursements journal. Ignore any transaction that should be journalized in a sales journal or cash receipts journal.

2. Open the following general ledger accounts: Cash, Inventory, Office Supplies, Store Supplies, Store Equipment, Accounts Payable, Long-Term Notes Payable, Common Stock, Retained Earnings, Pur- chases, Purchases Returns and Allowances, Purchases Discounts, Sales Salaries Expense, and Adver- tising Expense. Enter the June 30 balances of Cash ($100,000), Inventory ($200,000), Long-Term Notes Payable ($200,000), Common Stock ($10,000), and Retained Earnings ($90,000). Also open accounts payable subsidiary ledger accounts for Teton Company, Plaine, Inc., Charm’s Supply, and Drake Company.

3. Complete parts 3 and 4 of Problem E-2B using the results of parts 1 and 2 of this problem.Check Trial balance totals, $352,266

Problem E-6BA

Special journals, subsidiary ledgers, trial balance—periodic

C3 P2 P3

Assume that Grassley Company in Problem E-3B uses the periodic inventory system.

Required

1. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory (November 1 beg. bal. is $40,000); Office Supplies; Store Supplies; Office Equipment; Accounts Payable; Long-Term Notes Payable; Common Stock (Nov. 1 beg. bal. is $10,000), and Retained Earnings (Nov. 1 beg. bal. is $30,000); Sales; Sales Discounts; Purchases; Purchases Returns and Allowances; Purchases Dis- counts; and Sales Salaries Expense. Open the following accounts receivable subsidiary ledger ac- counts: Carlos Mantel, Tori Tripp, and Cyd Rounder. Open the following accounts payable subsidiary ledger accounts: Grebe Company, BLR Industries, Brun Supply, and Lo Company.

2. Enter the transactions from Problem E-3B in a sales journal like that in Exhibit E-A.1, a pur- chases journal like that in Exhibit E-A.3, a cash receipts journal like that in Exhibit E-A.2, a cash disbursements journal like that in Exhibit E-A.4, or a general journal. Number journal pages as page 2.

2. Enter these transactions in a sales journal like that in Exhibit E.5, a purchases journal like that in Ex- hibit E.9, a cash receipts journal like that in Exhibit E.7, a cash disbursements journal like that in Exhibit E.11, or a general journal. Number all journal pages as page 2.

3. Prepare a trial balance of the general ledger and prove the accuracy of the subsidiary ledgers by pre- paring schedules of both accounts receivable and accounts payable.

Check Trial balance totals, $202,283

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Appendix E Accounting with Special Journals E-41

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP E Assume that Adria Lopez expands Success Systems’ accounting system to include special journals.

Required

1. Locate the transactions related to January through March 2014 for Success Systems in Chapter 4. 2. Enter the Success Systems transactions for January through March in a sales journal like that in

Exhibit E.5 (insert “n/a” in the Invoice column), a cash receipts journal like that in Exhibit E.7, a purchases journal like that in Exhibit E.9 (use Computer Supplies heading instead of Office Sup- plies), and a cash disbursements journal like that in Exhibit E.11 (insert “n/a” in the Check Num- ber column), or a general journal. Number journal pages as page 2. If the transaction does not specify the name of the payee, state “not specified” in the Payee column of the cash disburse- ments journal.

3. The transactions on the following dates should be journalized in the general journal: January 5, 11, 20, 24, and 29 (no entry required) and March 24. Do not record and post the adjusting entries for the end of March.

SERIAL PROBLEM Success Systems P1

Check Trial balance totals, $203,5503. Prepare a trial balance of the general ledger and prove the accuracy of the subsidiary ledgers by pre- paring schedules of both accounts receivable and accounts payable.

BTN E-1 Refer to Polaris’s financial statements in Appendix A to answer the following. 1. Identify the note that reports on Polaris’s business segments. 2. Describe the focus and activities of each of Polaris’s business segments.

Fast Forward

3. Access Polaris’s annual report for fiscal years ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Has Polaris changed its reporting pol- icy regarding segment information? Explain.

Beyond the Numbers

REPORTING IN ACTION A1

Polaris

BTN E-2 Key figures for Polaris and Arctic Cat follow ($ thousands).

Current Year One Year Prior Two Years Prior

Segment Segment Segment Segment Segment Segment Arctic Cat Segment Revenue Assets Revenue Assets Revenue Assets

Domestic . . . . . . . . . . . . . . . . . $218,560 $271,163 $215,460 $244,020 $292,295 $248,625

International . . . . . . . . . . . . . . . 246,091 1,743 235,268 2,064 271,318 2,540

Current Year One Year Prior Two Years Prior

Segment Segment Segment Segment Segment Segment Polaris Segment Revenue Assets Revenue Assets Revenue Assets

Domestic . . . . . . . . . . . . . . . . . . $1,864,099 $957,497 $1,405,966 $873,183 $1,074,228 $630,420

International . . . . . . . . . . . . . . . . 792,850 270,527 585,173 188,464 491,659 133,233

COMPARATIVE ANALYSIS A1

Polaris Arctic Cat

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E-42 Appendix E Accounting with Special Journals

Required

1. Compute the ratio of segment revenue divided by segment assets for each of the segments of Polaris and Arctic Cat for each of the two most recent years shown. (We do not compute the segment return on assets as these companies did not report their segment income.)

2. Interpret and comment on your results of part 1.

BTN E-3 Erica Gray, CPA, is a sole practitioner. She has been practicing as an auditor for 10 years. Recently a long-standing audit client asked Gray to design and implement an integrated computer-based accounting information system. The fees associated with this additional engagement with the client are very attractive. However, Gray wonders if she can remain objective on subsequent audits in her evaluation of the client’s accounting system and its records if she was responsible for its design and implementation. Gray knows that professional auditing standards require her to remain independent in fact and appearance from her auditing clients.

Required

1. What do you believe auditing standards are mainly concerned with when they require indepen dence in fact? In appearance?

2. Why is it important that auditors remain independent of their clients? 3. Do you think Gray can accept this engagement and remain independent? Justify your response.

ETHICS CHALLENGE C1

BTN E-4 Your friend, Wendy Geiger, owns a small retail store that sells candies and nuts. Geiger ac- quires her goods from a few select vendors. She generally makes purchase orders by phone and on credit. Sales are primarily for cash. Geiger keeps her own manual accounting system using a general journal and a general ledger. At the end of each business day, she records one summary entry for cash sales. Geiger recently began offering items in creative gift packages. This has increased sales substantially, and she is now receiving orders from corporate and other clients who order large quantities and prefer to buy on credit. As a result of increased credit transactions in both purchases and sales, keeping the accounting rec- ords has become extremely time consuming. Geiger wants to continue to maintain her own manual system and calls you for advice. Write a memo to her advising how she might modify her current manual account- ing system to accommodate the expanded business activities. Geiger is accustomed to checking her ledger by using a trial balance. Your memo should explain the advantages of what you propose and of any other verification techniques you recommend.

COMMUNICATING IN PRACTICE C2 C3

BTN E-5 Access the March 13, 2012, filing of the fiscal 2012 10-K report for Dell (ticker DELL) at www.sec.gov. Read its Note 14 that details Dell’s segment information and answer the following. 1. Dell’s operations are divided among which four global business segments? 2. In fiscal year 2012, which segment had the largest dollar amount of operating income? Which had the

largest amount of assets? 3. Compute the return on assets for each segment for fiscal year 2012. Use operating income and average

total assets by segment for your calculation. Which segment has the highest return on assets? 4. For what product groups does Dell provide segment data? What percent of Dell’s net revenue is earned

by each product group?

TAKING IT TO THE NET A1

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Appendix E Accounting with Special Journals E-43

BTN E-6 Each member of the team is to assume responsibility for one of the following tasks: a. Journalizing in the purchases journal. b. Journalizing in the cash disbursements journal. c. Maintaining and verifying the Accounts Payable ledger. d. Journalizing in the sales journal and the general journal. e. Journalizing in the cash receipts journal. f. Maintaining and verifying the Accounts Receivable ledger. The team should abide by the following procedures in carrying out responsibilities.

Required

1. After tasks a – f are assigned, each team member is to quickly read the list of transactions in Prob- lem E-3A, identifying with initials the journal in which each transaction is to be recorded. Upon completion, the team leader is to read transaction dates, and the appropriate team member is to vocalize responsibility. Any disagreement between teammates must be resolved.

2. Journalize and continually update subsidiary ledgers. Journal recorders should alert teammates assigned to subsidiary ledgers when an entry must be posted to their subsidiary.

3. Team members responsible for tasks a, b, d, and e are to summarize and prove journals; members responsible for tasks c and f are to prepare both payables and receivables schedules.

4. The team leader is to take charge of the general ledger, rotating team members to obtain amounts to be posted. The person responsible for a journal must complete posting references in that journal. Other team members should verify the accuracy of account balance computations. To avoid any abnormal account balances, post in the following order: P, S, G, R, D. (Note: Posting any necessary individual general ledger amounts is also done at this time.)

5. The team leader is to read out general ledger account balances while another team member fills in the trial balance form. Concurrently, one member should keep a running balance of debit account bal- ance totals and another credit account balance totals. Verify the final total of the trial balance and the schedules. If necessary, the team must resolve any errors. Turn in the trial balance and schedules to the instructor.

TEAMWORK IN ACTION C3 P1 P2

BTN E-7 Access and refer to the December 31, 2011, annual report for KTM at www.KTM.com.

Required

1. Identify its ‘Enclosure to the Notes to the Financial Statements’ (Segment Information) to its financial statements and locate its information relating to KTM’s operating and reportable segments. List its three segments.

2. What accounting information does it disclose for each segment? (Answers need only list titles for the accounting line items, not numbers, disclosed for each segment.)

3. Does KTM have a dominant segment (from a financial perspective)? Explain.

GLOBAL DECISION A1

KTM

1. a 2. e 3. d

4. b 5. a

ANSWERS TO MULTIPLE CHOICE QUIZ

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Absorption costing Costing method that assigns both variable and fixed costs to products. (pp. 786 & 816)

Accelerated depreciation method Method that produces larger depre- ciation charges in the early years of an asset’s life and smaller charges in its later years. (p. 342)

Account Record within an accounting system in which increases and decreases are entered and stored in a specific asset, liability, equity, rev- enue, or expense. (p. 53)

Account balance Difference between total debits and total credits (including the beginning balance) for an account. (p. 60)

Account form balance sheet Balance sheet that lists assets on the left side and liabilities and equity on the right. (p. 68)

Account payable Liability created by buying goods or services on credit; backed by the buyer’s general credit standing.

Accounting Information and measurement system that identifies, re- cords, and communicates relevant information about a company’s busi- ness activities. (p. 4)

Accounting cycle Recurring steps performed each accounting period, starting with analyzing transactions and continuing through the post- closing trial balance (or reversing entries). (p. 116)

Accounting equation Equality involving a company’s assets, liabilities, and equity; Assets 5 Liabilities 1 Equity; also called balance sheet equation. (p. 15)

Accounting information system People, records, and methods that col- lect and process data from transactions and events, organize them in use- ful forms, and communicate results to decision makers. (p. E-2)

Accounting period Length of time covered by financial statements; also called reporting period. (p. 98)

Accounting rate of return Rate used to evaluate the acceptability of an investment; equals the after-tax periodic income from a project divided by the average investment in the asset; also called rate of return on aver- age investment. (p. 1019)

Accounts payable ledger Subsidiary ledger listing individual creditor (supplier) accounts.

Accounts receivable Amounts due from customers for credit sales; backed by the customer’s general credit standing. (p. 302)

Accounts receivable ledger Subsidiary ledger listing individual cus- tomer accounts. (p. E-7)

Accounts receivable turnover Measure of both the quality and liquid- ity of accounts receivable; indicates how often receivables are received and collected during the period; computed by dividing net sales by aver- age accounts receivable. (p. 317)

Accrual basis accounting Accounting system that recognizes revenues when earned and expenses when incurred; the basis for GAAP. (p. 99)

Accrued expenses Costs incurred in a period that are both unpaid and unrecorded; adjusting entries for recording accrued expenses involve in- creasing expenses and increasing liabilities. (p. 105)

Accrued revenues Revenues earned in a period that are both unrecorded and not yet received in cash (or other assets); adjusting entries for recording accrued revenues involve increasing assets and increasing revenues. (p. 107)

Accumulated depreciation Cumulative sum of all depreciation expense recorded for an asset. (p. 100)

Acid-test ratio Ratio used to assess a company’s ability to settle its current debts with its most liquid assets; defined as quick assets (cash, short-term investments, and current receivables) divided by current liabilities. (p. 178)

Activity An event that causes the consumption of overhead resources in an entity. (p. 743)

Activity-based budgeting (ABB) Budget system based on expected ac- tivities. (p. 862)

Activity-based costing (ABC) Cost allocation method that focuses on activities performed; traces costs to activities and then assigns them to cost objects. (pp. 9 & 743)

Activity cost driver Variable that causes an activity’s cost to go up or down; a causal factor. (pp. 12 & 746)

Activity cost pool Temporary account that accumulates costs a com- pany incurs to support an activity. (pp. 9 & 743)

Adjusted trial balance List of accounts and balances prepared after period-end adjustments are recorded and posted. (p. 110)

Adjusting entry Journal entry at the end of an accounting period to bring an asset or liability account to its proper amount and update the related expense or revenue account. (p. 101)

Aging of accounts receivable Process of classifying accounts receiv- able by how long they are past due for purposes of estimating uncollect- ible accounts. (p. 310)

Allowance for Doubtful Accounts Contra asset account with a balance approximating uncollectible accounts receivable; also called Allowance for Uncollectible Accounts. (p. 307)

Allowance method Procedure that (a) estimates and matches bad debts expense with its sales for the period and/or (b) reports accounts receiv- able at estimated realizable value. (p. 307)

Amortization Process of allocating the cost of an intangible asset to expense over its estimated useful life. (p. 351)

Annual financial statements Financial statements covering a one-year period; often based on a calendar year, but any consecutive 12-month (or 52-week) period is acceptable. (p. 98)

G

Glossary

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Bearer bonds Bonds made payable to whoever holds them (the bearer); also called unregistered bonds. (p. 436)

Benchmarking Practice of comparing and analyzing company financial performance or position with other companies or standards. (p. 908)

Betterments Expenditures to make a plant asset more efficient or pro- ductive; also called improvements. (p. 347)

Bond Written promise to pay the bond’s par (or face) value and interest at a stated contract rate; often issued in denominations of $1,000. (p. 422)

Bond certificate Document containing bond specifics such as issuer’s name, bond par value, contract interest rate, and maturity date. (p. 424)

Bond indenture Contract between the bond issuer and the bondholders; identifies the parties’ rights and obligations. (p. 424)

Book value Asset’s acquisition costs less its accumulated depreciation (or depletion, or amortization); also sometimes used synonymously as the carrying value of an account. (pp. 104 & 341)

Book value per common share Recorded amount of equity appli- cable to common shares divided by the number of common shares outstanding. (p. 486)

Book value per preferred share Equity applicable to preferred shares (equals its call price [or par value if it is not callable] plus any cumula- tive dividends in arrears) divided by the number of preferred shares outstanding. (p. 486)

Bookkeeping (See recordkeeping.)

Break-even point Output level at which sales equals fixed plus variable costs; where income equals zero. (p. 785)

Break-even time (BET) Time-based measurement used to evaluate the acceptability of an investment; equals the time expected to pass before the present value of the net cash flows from an investment equals its ini- tial cost. (p. 1026)

Budget Formal statement of future plans, usually expressed in monetary terms. (p. 848)

Budget report Report comparing actual results to planned objectives; sometimes used as a progress report. (p. 896)

Budgetary control Management use of budgets to monitor and control company operations. (p. 896)

Budgeted balance sheet Accounting report that presents predicted amounts of the company’s assets, liabilities, and equity balances as of the end of the budget period. (p. 860)

Budgeted income statement Accounting report that presents predicted amounts of the company’s revenues and expenses for the budget period. (p. 860)

Budgeting Process of planning future business actions and expressing them as formal plans. (p. 848)

Business An organization of one or more individuals selling products and/or services for profit.

Business entity assumption Principle that requires a business to be ac- counted for separately from its owner(s) and from any other entity. (p. 12)

Business segment Part of a company that can be separately identified by the products or services that it provides or by the geographic markets that it serves; also called segment. (p. 588)

Annual report Summary of a company’s financial results for the year with its current financial condition and future plans; directed to external users of financial information. (p. A-1)

Annuity Series of equal payments at equal intervals. (pp. 441 & 1021)

Appropriated retained earnings Retained earnings separately reported to inform stockholders of funding needs. (p. 482)

Asset book value (See book value.)

Assets Resources a business owns or controls that are expected to pro- vide current and future benefits to the business. (p. 15)

Audit Analysis and report of an organization’s accounting system, its records, and its reports using various tests. (p. 13)

Auditors Individuals hired to review financial reports and information systems. Internal auditors of a company are employed to assess and evaluate its system of internal controls, including the resulting reports. External auditors are independent of a company and are hired to assess and evaluate the “fairness” of financial statements (or to perform other contracted financial services). (p. 13)

Authorized stock Total amount of stock that a corporation’s charter au- thorizes it to issue. (p. 469)

Available-for-sale (AFS) securities Investments in debt and equity se- curities that are not classified as trading securities or held-to-maturity securities. (p. C-6)

Average cost See weighted average.

Avoidable expense Expense (or cost) that is relevant for decision mak- ing; expense that is not incurred if a department, product, or service is eliminated. (p. 993)

Bad debts Accounts of customers who do not pay what they have prom- ised to pay; an expense of selling on credit; also called uncollectible ac- counts. (p. 306)

Balance column account Account with debit and credit columns for recording entries and another column for showing the balance of the ac- count after each entry. (p. 60)

Balance sheet Financial statement that lists types and dollar amounts of assets, liabilities, and equity at a specific date. (p. 20)

Balance sheet equation (See accounting equation.)

Balanced scorecard A system of performance measurement that col- lects information on several key performance indicators within each of four perspectives: customer, internal processes, innovation and learning, and financial. (p. 956)

Bank reconciliation Report that explains the difference between the book (company) balance of cash and the cash balance reported on the bank statement. (p. 273)

Bank statement Bank report on the depositor’s beginning and ending cash balances, and a listing of its changes, for a period. (p. 272)

Basic earnings per share Net income less any preferred dividends and then divided by weighted-average common shares outstanding. (p. 485)

Batch level activities Activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch; the amount of resources used depends on the number of batches run rather than on the number of units in the batch. (p. 750)

Batch processing Accumulating source documents for a period of time and then processing them all at once such as once a day, week, or month. (p. E-16)

Glossary G-1

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G-2 Glossary

Change in an accounting estimate Change in an accounting estimate that results from new information, subsequent developments, or improved judgment that impacts current and future periods. (pp. 345 & 483)

Chart of accounts List of accounts used by a company; includes an identification number for each account. (p. 54)

Check Document signed by a depositor instructing the bank to pay a specified amount to a designated recipient. (p. 271)

Check register Another name for a cash disbursements journal when the journal has a column for check numbers. (pp. 282 & E-14)

Classified balance sheet Balance sheet that presents assets and liabili- ties in relevant subgroups, including current and noncurrent classifica- tions. (p. 117)

Clock card Source document used to record the number of hours an employee works and to determine the total labor cost for each pay pe- riod. (p. 660)

Closing entries Entries recorded at the end of each accounting period to transfer end-of-period balances in revenue, gain, expense, loss, and with- drawal (dividend for a corporation) accounts to the capital account (to retained earnings for a corporation). (p. 112)

Closing process Necessary end-of-period steps to prepare the accounts for recording the transactions of the next period. (p. 112)

Columnar journal Journal with more than one column. (p. E-8)

Committee of Sponsoring Organizations (COSO) Committee of Spon- soring Organizations of the Treadway Commission (or COSO) is a joint ini- tiative of five private sector organizations and is dedicated to providing thought leadership through the development of frameworks and guidance on enterprise risk management, internal control, and fraud deterrence. (p. 259)

Common stock Corporation’s basic ownership share; also generically called capital stock. (pp. 13 & 468)

Common-size financial statement Statement that expresses each amount as a percent of a base amount. In the balance sheet, total assets is usually the base and is expressed as 100%. In the income statement, net sales is usually the base. (p. 571)

Comparative financial statement Statement with data for two or more successive periods placed in side-by-side columns, often with changes shown in dollar amounts and percents. (p. 566)

Compatibility principle Information system principle that prescribes an accounting system to conform with a company’s activities, personnel, and structure. (p. E-3)

Complex capital structure Capital structure that includes outstanding rights or options to purchase common stock, or securities that are con- vertible into common stock. (p. 485)

Components of accounting systems Five basic components of ac- counting systems are source documents, input devices, information pro- cessors, information storage, and output devices. (p. E-3)

Composite unit Generic unit consisting of a specific number of units of each product; unit comprised in proportion to the expected sales mix of its products. (p. 793)

Compound journal entry Journal entry that affects at least three accounts. (p. 63)

Comprehensive income Net change in equity for a period, excluding owner investments and distributions. (p. C-10)

Computer hardware Physical equipment in a computerized accounting information system.

C corporation Corporation that does not qualify for nor elect to be treated as a proprietorship or partnership for income tax purposes and therefore is subject to income taxes; also called C corp. (p. 12)

Call price Amount that must be paid to call and retire a callable pre- ferred stock or a callable bond. (p. 479)

Callable bonds Bonds that give the issuer the option to retire them at a stated amount prior to maturity. (p. 436)

Callable preferred stock Preferred stock that the issuing corporation, at its option, may retire by paying the call price plus any dividends in ar- rears. (p. 479)

Canceled checks Checks that the bank has paid and deducted from the depositor’s account. (p. 272)

Capital budgeting Process of analyzing alternative investments and de- ciding which assets to acquire or sell. (p. 1016)

Capital expenditures Additional costs of plant assets that provide ma- terial benefits extending beyond the current period; also called balance sheet expenditures. (p. 346)

Capital expenditures budget Plan that lists dollar amounts to be both received from disposal of plant assets and spent to purchase plant assets. (p. 858)

Capital leases Long-term leases in which the lessor transfers substan- tially all risk and rewards of ownership to the lessee. (p. 446)

Capital stock General term referring to a corporation’s stock used in obtaining capital (owner financing). (p. 469)

Capitalize Record the cost as part of a permanent account and allocate it over later periods.

Carrying (book) value of bonds Net amount at which bonds are re- ported on the balance sheet; equals the par value of the bonds less any unamortized discount or plus any unamortized premium; also called car- rying amount or book value. (p. 426)

Cash Includes currency, coins, and amounts on deposit in bank check- ing or savings accounts. (p. 263)

Cash basis accounting Accounting system that recognizes revenues when cash is received and records expenses when cash is paid. (p. 99)

Cash budget Plan that shows expected cash inflows and outflows dur- ing the budget period, including receipts from loans needed to maintain a minimum cash balance and repayments of such loans. (p. 266)

Cash disbursements journal Special journal normally used to record all payments of cash; also called cash payments journal. (p. E-14)

Cash discount Reduction in the price of merchandise granted by a seller to a buyer when payment is made within the discount period. (p. 165)

Cash equivalents Short-term, investment assets that are readily convert- ible to a known cash amount or sufficiently close to their maturity date (usually within 90 days) so that market value is not sensitive to interest rate changes. (p. 264)

Cash flow on total assets Ratio of operating cash flows to average total assets; not sensitive to income recognition and measurement; partly re- flects earnings quality. (p. 528)

Cash Over and Short Income statement account used to record cash overages and cash shortages arising from errors in cash receipts or pay- ments. (p. 265)

Cash receipts journal Special journal normally used to record all re- ceipts of cash. (p. E-11)

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Control Process of monitoring planning decisions and evaluating the organization’s activities and employees. (p. 611)

Control principle Information system principle that prescribes an ac- counting system to aid managers in controlling and monitoring business activities. (p. E-2)

Controllable costs Costs that a manager has the power to control or at least strongly influence. (pp. 615, 826 & 943)

Controllable variance Combination of both overhead spending variances (variable and fixed) and the variable overhead efficiency variance. (p. 909)

Controlling account General ledger account, the balance of which (after posting) equals the sum of the balances in its related subsidiary ledger. (p. E-7)

Conversion costs Expenditures incurred in converting raw materials to finished goods; includes direct labor costs and overhead costs. (p. 619)

Conversion costs per equivalent unit The combined costs of direct labor and factory overhead per equivalent unit. (p. 707)

Convertible bonds Bonds that bondholders can exchange for a set num- ber of the issuer’s shares. (p. 436)

Convertible preferred stock Preferred stock with an option to ex- change it for common stock at a specified rate. (p. 478)

Copyright Right giving the owner the exclusive privilege to publish and sell musical, literary, or artistic work during the creator’s life plus 70 years. (p. 352)

Corporation Business that is a separate legal entity under state or federal laws with owners called shareholders or stockholders. (pp. 12 & 466)

Cost All normal and reasonable expenditures necessary to get an asset in place and ready for its intended use. (pp. 337 & 339)

Cost accounting system Accounting system for manufacturing activi- ties based on the perpetual inventory system. (p. 654)

Cost-based transfer pricing A transfer pricing system based on the cost of goods or services being transferred across divisions within the same company. (p. 962)

Cost-benefit constraint The notion that the benefit of a disclosure ex- ceeds the cost of that disclosure. (p. 13)

Cost-benefit principle Information system principle that prescribes the benefits from an activity in an accounting system to outweigh the costs of that activity. (pp. 262 & E-3)

Cost center Department that incurs costs but generates no revenues; common example is the accounting or legal department. (p. 943)

Cost object Product, process, department, or customer to which costs are assigned. (pp. 615 & 739)

Cost of capital Rate the company must pay to its long-term creditors and shareholders. (p. 1020)

Cost of goods available for sale Consists of beginning inventory plus net purchases of a period.

Cost of goods manufactured Total manufacturing costs (direct materi- als, direct labor, and factory overhead) for the period plus beginning goods in process less ending goods in process; also called net cost of goods manufactured and cost of goods completed. (p. 705)

Cost of goods sold Cost of inventory sold to customers during a period; also called cost of sales. (p. 162)

Costs of quality Costs resulting from manufacturing defective products or providing services that do not meet customer expectations. (p. 750)

Computer network Linkage giving different users and different com- puters access to common databases and programs. (p. E-16)

Computer software Programs that direct operations of computer hardware.

Conceptual framework The basic concepts that underlie the prepara- tion and presentation of financial statements for external users; can serve as a guide in developing future standards and to resolve accounting is- sues that are not addressed directly in current standards using the defini- tions, recognition criteria, and measurement concepts for assets, liabilities, revenues, and expenses. (p. 10)

Conservatism constraint Principle that prescribes the less optimistic estimate when two estimates are about equally likely. (p. 220)

Consignee Receiver of goods owned by another who holds them for purposes of selling them for the owner. (p. 210)

Consignor Owner of goods who ships them to another party who will sell them for the owner. (p. 210)

Consistency concept Principle that prescribes use of the same account- ing method(s) over time so that financial statements are comparable across periods. (p. 219)

Consolidated financial statements Financial statements that show all (combined) activities under the parent’s control, including those of any subsidiaries. (p. C-9)

Contingent liability Obligation to make a future payment if, and only if, an uncertain future event occurs. (p. 390)

Continuous budgeting Practice of preparing budgets for a selected number of future periods and revising those budgets as each period is completed. (p. 851)

Continuous improvement Concept requiring every manager and em- ployee continually to look to improve operations. (p. 626)

Contra account Account linked with another account and having an op- posite normal balance; reported as a subtraction from the other account’s balance. (p. 103)

Contract rate Interest rate specified in a bond indenture (or note); mul- tiplied by the par value to determine the interest paid each period; also called coupon rate, stated rate, or nominal rate. (p. 425)

Contributed capital Total amount of cash and other assets received from stockholders in exchange for stock; also called paid-in capital. (p. 15)

Contributed capital in excess of par value Difference between the par value of stock and its issue price when issued at a price above par.

Contribution format An income statement format that is geared to cost behavior in that costs are separated into variable and fixed categories rather than being separated according to the functions of production, sales, and administration. (p. 826)

Contribution margin Sales revenue less total variable costs. (p. 785)

Contribution margin income statement Income statement that sepa- rates variable and fixed costs; highlights the contribution margin, which is sales less variable expenses. (p. 818)

Contribution margin per unit Amount that the sale of one unit con- tributes toward recovering fixed costs and earning profit; defined as sales price per unit minus variable expense per unit. (p. 785)

Contribution margin ratio Product’s contribution margin divided by its sale price. (p. 785)

Contribution margin report Product’s contribution margin divided by its sale price. (p. 819)

Glossary G-3

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Days’ sales in raw materials inventory Measure of how much raw ma- terials inventory is available in terms of the number of days’ sales; defined as Ending raw materials inventory divided by Raw materials used and that quotient multiplied by 365 days. (p. 628)

Days’ sales uncollected Measure of the liquidity of receivables com- puted by dividing the current balance of receivables by the annual credit (or net) sales and then multiplying by 365; also called days’ sales in re- ceivables. (p. 277)

Debit Recorded on the left side; an entry that increases asset and expense accounts, and decreases liability, revenue, and most equity accounts; abbreviated Dr. (p. 57)

Debit memorandum Notification that the sender has debited the recipi- ent’s account in the sender’s records. (p. 166)

Debt ratio Ratio of total liabilities to total assets; used to reflect risk associated with a company’s debts. (p. 71)

Debt-to-equity ratio Defined as total liabilities divided by total equity; shows the proportion of a company financed by non-owners (creditors) in comparison with that financed by owners. (p. 437)

Debtors Individuals or organizations that owe money. (p. 51)

Declining-balance method Method that determines depreciation charge for the period by multiplying a depreciation rate (often twice the straight- line rate) by the asset’s beginning-period book value. (p. 342)

Deferred income tax liability Corporation income taxes that are de- ferred until future years because of temporary differences between GAAP and tax rules. (p. 402)

Degree of operating leverage (DOL) Ratio of contribution margin di- vided by pretax income; used to assess the effect on income of changes in sales. (p. 795)

Departmental accounting system Accounting system that provides in- formation useful in evaluating the profitability or cost effectiveness of a department.

Departmental contribution to overhead Amount by which a depart- ment’s revenues exceed its direct expenses. (p. 951)

Depletion Process of allocating the cost of natural resources to periods when they are consumed and sold. (p. 350)

Departmental income statements Income statements prepared for each operating department within a decentralized organization. (p. 945)

Deposit ticket Lists items such as currency, coins, and checks deposited and their corresponding dollar amounts. (p. 271)

Deposits in transit Deposits recorded by the company but not yet re- corded by its bank. (p. 274)

Depreciable cost Cost of a plant asset less its salvage value. (p. 340)

Depreciation Expense created by allocating the cost of plant and equip- ment to periods in which they are used; represents the expense of using the asset. (pp. 103 & 339)

Diluted earnings per share Earnings per share calculation that requires dilutive securities be added to the denominator of the basic EPS calcula- tion. (p. 485)

Dilutive securities Securities having the potential to increase common shares outstanding; examples are options, rights, convertible bonds, and convertible preferred stock. (p. 485)

Direct costs Costs incurred for the benefit of one specific cost object. (p. 615)

Cost principle Accounting principle that prescribes financial statement information to be based on actual costs incurred in business transac- tions. (p. 11)

Cost variance Difference between the actual incurred cost and the stan- dard cost. (p. 903)

Cost-volume-profit (CVP) analysis Planning method that includes pre- dicting the volume of activity, the costs incurred, sales earned, and prof- its received. (p. 778)

Cost-volume-profit (CVP) chart Graphic representation of cost- volume-profit relations. (p. 787)

Coupon bonds Bonds with interest coupons attached to their certifi- cates; bondholders detach coupons when they mature and present them to a bank or broker for collection. (p. 436)

Credit Recorded on the right side; an entry that decreases asset and ex- pense accounts, and increases liability, revenue, and most equity ac- counts; abbreviated Cr. (p. 57)

Credit memorandum Notification that the sender has credited the re- cipient’s account in the sender’s records. (p. 171)

Credit period Time period that can pass before a customer’s payment is due. (p. 165)

Credit terms Description of the amounts and timing of payments that a buyer (debtor) agrees to make in the future. (p. 165)

Creditors Individuals or organizations entitled to receive payments. (p. 54)

Cumulative preferred stock Preferred stock on which undeclared divi- dends accumulate until paid; common stockholders cannot receive divi- dends until cumulative dividends are paid. (p. 477)

Current assets Cash and other assets expected to be sold, collected, or used within one year or the company’s operating cycle, whichever is longer. (p. 118)

Current liabilities Obligations due to be paid or settled within one year or the company’s operating cycle, whichever is longer. (pp. 119 & 379)

Current portion of long-term debt Portion of long-term debt due within one year or the operating cycle, whichever is longer; reported un- der current liabilities. (p. 387)

Current ratio Ratio used to evaluate a company’s ability to pay its short-term obligations, calculated by dividing current assets by current liabilities. (p. 121)

Curvilinear cost Cost that changes with volume but not at a constant rate. (p. 781)

Customer orientation Company position that its managers and employ- ees be in tune with the changing wants and needs of consumers. (p. 626)

Cycle efficiency (CE) A measure of production efficiency, which is de- fined as value-added (process) time divided by total cycle time. (p. 958)

Cycle time (CT) A measure of the time to produce a product or service, which is the sum of process time, inspection time, move time, and wait time; also called throughput time. (p. 957)

Date of declaration Date the directors vote to pay a dividend. (p. 473)

Date of payment Date the corporation makes the dividend payment. (p. 473)

Date of record Date directors specify for identifying stockholders to receive dividends. (p. 473)

Days’ sales in inventory Estimate of number of days needed to convert inventory into receivables or cash; equals ending inventory divided by cost of goods sold and then multiplied by 365; also called days’ stock on hand. (p. 223)

G-4 Glossary

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by multiplying the balance of the liability at the beginning of the period by the bond market rate at issuance; also called interest method. (p. 442)

Efficiency Company’s productivity in using its assets; usually measured relative to how much revenue a certain level of assets generates. (p. 565)

Efficiency variance Difference between the actual quantity of an input and the standard quantity of that input. (p. 916)

Electronic funds transfer (EFT) Use of electronic communication to transfer cash from one party to another. (p. 271)

Employee benefits Additional compensation paid to or on behalf of em- ployees, such as premiums for medical, dental, life, and disability insur- ance, and contributions to pension plans. (p. 387)

Employee earnings report Record of an employee’s net pay, gross pay, deductions, and year-to-date payroll information. (p. 398)

Enterprise resource planning (ERP) software Programs that manage a company’s vital operations, which range from order taking to produc- tion to accounting. (p. E-17)

Entity Organization that, for accounting purposes, is separate from other organizations and individuals.

EOM Abbreviation for end of month; used to describe credit terms for credit transactions. (p. 165)

Equity Owner’s claim on the assets of a business; equals the residual interest in an entity’s assets after deducting liabilities; also called net assets. (p. 15)

Equity method Accounting method used for long-term investments when the investor has “significant influence” over the investee. (p. C-8)

Equity ratio Portion of total assets provided by equity, computed as to- tal equity divided by total assets. (p. 579)

Equity securities with controlling influence Long-term investment when the investor is able to exert controlling influence over the investee; investors owning 50% or more of voting stock are presumed to exert controlling influence. (p. C-9)

Equity securities with significant influence Long-term investment when the investor is able to exert significant influence over the investee; investors owning 20 percent or more (but less than 50 percent) of voting stock are presumed to exert significant influence. (p. C-8)

Equivalent units of production (EUP) Number of units that would be completed if all effort during a period had been applied to units that were started and finished. (p. 699)

Estimated liability Obligation of an uncertain amount that can be rea- sonably estimated. (p. 387)

Estimated line of cost behavior Line drawn on a graph to visually fit the relation between cost and sales. (p. 782)

Ethics Codes of conduct by which actions are judged as right or wrong, fair or unfair, honest or dishonest. (pp. 7 & 614)

Events Happenings that both affect an organization’s financial position and can be reliably measured. (p. 16)

Expanded accounting equation Assets 5 Liabilities 1 Equity; Equity equals [Owner capital 2 Owner withdrawals 1 Revenues 2 Expenses] for a noncorporation; Equity equals [Contributed capital 1 Retained earnings 1 Revenues 2 Expenses] for a corporation where dividends are subtracted from retained earnings. (p. 15)

Expense recognition (or matching) principle (See matching principle.)

Expenses Outflows or using up of assets as part of operations of a busi- ness to generate sales. (p. 15)

Direct expenses Expenses traced to a specific department (object) that are incurred for the sole benefit of that department. (p. 945)

Direct labor Efforts of employees who physically convert materials to finished product. (p. 618)

Direct labor costs Wages and salaries for direct labor that are separately and readily traced through the production process to finished goods. (p. 618)

Direct material Raw material that physically becomes part of the product and is clearly identified with specific products or batches of product. (p. 618)

Direct material costs Expenditures for direct material that are sepa- rately and readily traced through the production process to finished goods. (p. 618)

Direct method Presentation of net cash from operating activities for the statement of cash flows that lists major operating cash receipts less major operating cash payments. (p. 516)

Direct write-off method Method that records the loss from an uncol- lectible account receivable at the time it is determined to be uncollect- ible; no attempt is made to estimate bad debts. (p. 306)

Discount on bonds payable Difference between a bond’s par value and its lower issue price or carrying value; occurs when the contract rate is less than the market rate. (p. 425)

Discount on note payable Difference between the face value of a note payable and the (lesser) amount borrowed; reflects the added interest to be paid on the note over its life.

Discount on stock Difference between the par value of stock and its is- sue price when issued at a price below par value. (p. 471)

Discount period Time period in which a cash discount is available and the buyer can make a reduced payment. (p. 165)

Discount rate Expected rate of return on investments; also called cost of capital, hurdle rate, or required rate of return. (p. B-2)

Discounts lost Expenses resulting from not taking advantage of cash discounts on purchases. (p. 283)

Dividend in arrears Unpaid dividend on cumulative preferred stock; must be paid before any regular dividends on preferred stock and before any dividends on common stock. (p. 477)

Dividend yield Ratio of the annual amount of cash dividends distributed to common shareholders relative to the common stock’s market value (price). (p. 486)

Dividends Corporation’s distributions of assets to its owners. (p. 15)

Dodd-Frank Wall Street Reform and Consumer Protection Act (p. 14)

Double-declining-balance (DDB) depreciation Depreciation equals be- ginning book value multiplied by 2 times the straight-line rate. (p. 342)

Double-entry accounting Accounting system in which each transaction af- fects at least two accounts and has at least one debit and one credit. (p. 57)

Double taxation Corporate income is taxed and then its later distribu- tion through dividends is normally taxed again for shareholders. (p. 13)

Earnings (See net income.)

Earnings per share (EPS) Amount of income earned by each share of a company’s outstanding common stock; also called net income per share. (p. 485)

Effective interest method Allocates interest expense over the bond life to yield a constant rate of interest; interest expense for a period is found

Glossary G-5

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Finished goods inventory Account that controls the finished goods files, which acts as a subsidiary ledger (of the Inventory account) in which the costs of finished goods that are ready for sale are recorded. (pp. 620 & 657)

First-in, first-out (FIFO) Method to assign cost to inventory that as- sumes items are sold in the order acquired; earliest items purchased are the first sold. (pp. 215 & 711)

Fiscal year Consecutive 12-month (or 52-week) period chosen as the organization’s annual accounting period. (p. 99)

Fixed budget Planning budget based on a single predicted amount of volume; unsuitable for evaluations if the actual volume differs from pre- dicted volume. (p. 897)

Fixed budget performance report Report that compares actual reve- nues and costs with fixed budgeted amounts and identifies the differ- ences as favorable or unfavorable variances. (p. 897)

Fixed cost Cost that does not change with changes in the volume of ac- tivity. (p. 614)

Fixed overhead cost deferred in inventory The portion of the fixed man- ufacturing overhead cost of a period that goes into inventory under the ab- sorption costing method as a result of production exceeding sales. (p. 823)

Fixed overhead cost recognized from inventory The portion of the fixed manufacturing overhead cost of a prior period that becomes an ex- pense of the current period under the absorption costing method as a re- sult of sales exceeding production. (p. 823)

Flexibility principle Information system principle that prescribes an ac- counting system be able to adapt to changes in the company, its opera- tions, and needs of decision makers. (p. E-3)

Flexible budget Budget prepared (using actual volume) once a period is complete that helps managers evaluate past performance; uses fixed and variable costs in determining total costs. (p. 898)

Flexible budget performance report Report that compares actual rev- enues and costs with their variable budgeted amounts based on actual sales volume (or other level of activity) and identifies the differences as variances. (p. 900)

FOB Abbreviation for free on board; the point when ownership of goods passes to the buyer; FOB shipping point (or factory) means the buyer pays shipping costs and accepts ownership of goods when the seller transfers goods to carrier; FOB destination means the seller pays shipping costs and buyer accepts ownership of goods at the buyer’s place of business. (p. 167)

Foreign exchange rate Price of one currency stated in terms of another currency. (p. C-16)

Form 940 IRS form used to report an employer’s federal unemployment taxes (FUTA) on an annual filing basis. (p. 395)

Form 941 IRS form filed to report FICA taxes owed and remitted. (p. 395)

Form 10-K (or 10-KSB) Annual report form filed with SEC by busi- nesses (small businesses) with publicly traded securities. (p. A-1)

Form W-2 Annual report by an employer to each employee showing the employee’s wages subject to FICA and federal income taxes along with amounts withheld. (p. 397)

Form W-4 Withholding allowance certificate, filed with the employer, identifying the number of withholding allowances claimed. (p. 400)

Franchises Privileges granted by a company or government to sell a product or service under specified conditions. (p. 353)

Full disclosure principle Principle that prescribes financial statements (including notes) to report all relevant information about an entity’s op- erations and financial condition. (p. 11)

External transactions Exchanges of economic value between one en- tity and another entity. (p. 16)

External users Persons using accounting information who are not di- rectly involved in running the organization. (p. 5)

Extraordinary gains or losses Gains or losses reported separately from continuing operations because they are both unusual and infrequent. (p. 588)

Extraordinary repairs Major repairs that extend the useful life of a plant asset beyond prior expectations; treated as a capital expenditure. (p. 347)

Facility level activities Activities that relate to overall production and can- not be traced to specific products; cost associated with these activities per- tain to a plant’s general manufacturing process. (p. 750)

Factory overhead Factory activities supporting the production process that are not direct material or direct labor; also called overhead and man- ufacturing overhead. (p. 618)

Factory overhead costs Expenditures for factory overhead that cannot be separately or readily traced to finished goods; also called overhead costs. (p. 618)

Fair value option Fair Value Option (FVO) refers to an option to mea- sure eligible items at fair value; eligible items include financial assets, such as HTM, AFS, and equity method investments, and financial liabil- ities. FVO is applied “instrument by instrument” and is elected when the eligible item is “first recognized”; once FVO is elected the decision is “irrevocable.” When FVO is elected, it is measured at “fair value” and unrealized gains and losses are recognized in earnings. (p. 435)

Favorable variance Difference in actual revenues or expenses from the budgeted amount that contributes to a higher income. (p. 897)

Federal depository bank Bank authorized to accept deposits of amounts payable to the federal government. (p. 395)

Federal Insurance Contributions Act (FICA) Taxes Taxes assessed on both employers and employees; for Social Security and Medicare pro- grams. (p. 384)

Federal Unemployment Taxes (FUTA) Payroll taxes on employers as- sessed by the federal government to support its unemployment insurance program. (p. 386)

FIFO method (See first-in, first-out.)

Financial accounting Area of accounting aimed mainly at serving ex- ternal users. (p. 5)

Financial Accounting Standards Board (FASB) Independent group of full-time members responsible for setting accounting rules. (p. 9)

Financial leverage Earning a higher return on equity by paying divi- dends on preferred stock or interest on debt at a rate lower than the return earned with the assets from issuing preferred stock or debt; also called trading on the equity. (p. 479)

Financial reporting Process of communicating information relevant to investors, creditors, and others in making investment, credit, and busi- ness decisions. (p. 565)

Financial statement analysis Application of analytical tools to general- purpose financial statements and related data for making business deci- sions. (p. 564)

Financial statements Includes the balance sheet, income statement, state- ment of owner’s (or stockholders’) equity, and statement of cash flows. (p. 5)

Financing activities Transactions with owners and creditors that in- clude obtaining cash from issuing debt, repaying amounts borrowed, and obtaining cash from or distributing cash to owners. (p. 512)

G-6 Glossary

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Inadequacy Condition in which the capacity of plant assets is too small to meet the company’s production demands. (p. 339)

Income (See net income.) (p. 15)

Income statement Financial statement that subtracts expenses from revenues to yield a net income or loss over a specified period of time; also includes any gains or losses. (p. 20)

Income summary Temporary account used only in the closing process to which the balances of revenue and expense accounts (including any gains or losses) are transferred; its balance is transferred to the capital account (or retained earnings for a corporation). (p. 113)

Incremental cost Additional cost incurred only if a company pursues a specific course of action. (p. 988)

Indefinite life Asset life that is not limited by legal, regulatory, contrac- tual, competitive, economic, or other factors. (p. 351)

Indirect costs Costs incurred for the benefit of more than one cost object. (p. 615)

Indirect expenses Expenses incurred for the joint benefit of more than one department (or cost object). (p. 945)

Indirect labor Efforts of production employees who do not work specifi- cally on converting direct materials into finished products and who are not clearly identified with specific units or batches of product. (p. 618)

Indirect labor costs Labor costs that cannot be physically traced to pro- duction of a product or service; included as part of overhead. (p. 618)

Indirect material Material used to support the production process but not clearly identified with products or batches of product. (p. 620)

Indirect method Presentation that reports net income and then adjusts it by adding and subtracting items to yield net cash from operating activi- ties on the statement of cash flows. (p. 516)

Information processor Component of an accounting system that inter- prets, transforms, and summarizes information for use in analysis and reporting. (p. E-4)

Information storage Component of an accounting system that keeps data in a form accessible to information processors.

Infrequent gain or loss Gain or loss not expected to recur given the operating environment of the business. (p. 588)

Input device Means of capturing information from source documents that enables its transfer to information processors. (p. E-4)

Installment note Liability requiring a series of periodic payments to the lender. (p. 433)

Institute of Management Accountants (IMA) A professional associa- tion of management accountants. (p. 614)

Intangible assets Long-term assets (resources) used to produce or sell products or services; usually lack physical form and have uncertain ben- efits. (pp. 119 & 351)

Interest Charge for using money (or other assets) loaned from one en- tity to another. (p. 312)

Interim financial statements Financial statements covering periods of less than one year; usually based on one-, three-, or six-month peri- ods. (pp. 98 & 234)

Interim statements (See interim financial statements.)

Internal controls or Internal control system All policies and procedures used to protect assets, ensure reliable accounting, promote efficient opera- tions, and urge adherence to company policies. (pp. 258, 614 & E-2)

GAAP (See generally accepted accounting principles.)

General accounting system Accounting system for manufacturing ac- tivities based on the periodic inventory system. (p. 654)

General and administrative expenses Expenses that support the oper- ating activities of a business. (p. 175)

General and administrative expense budget Plan that shows predicted operating expenses not included in the selling expenses budget. (p. 857)

General journal All-purpose journal for recording the debits and cred- its of transactions and events. (pp. 58 & E-6)

General ledger (See ledger.) (p. 53)

General partner Partner who assumes unlimited liability for the debts of the partnership; responsible for partnership management.

General partnership Partnership in which all partners have mutual agency and unlimited liability for partnership debts.

Generally accepted accounting principles (GAAP) Rules that specify acceptable accounting practices. (p. 9)

Generally accepted auditing standards (GAAS) Rules that specify acceptable auditing practices.

General-purpose financial statements Statements published periodi- cally for use by a variety of interested parties; includes the income state- ment, balance sheet, statement of owner’s equity (or statement of retained earnings for a corporation), statement of cash flows, and notes to these statements. (p. 565)

Going-concern assumption Principle that prescribes financial statements to reflect the assumption that the business will continue operating. (p. 12)

Goods in process inventory Account in which costs are accumulated for products that are in the process of being produced but are not yet complete; also called work in process inventory. (pp. 620 & 656)

Goodwill Amount by which a company’s (or a segment’s) value exceeds the value of its individual assets less its liabilities. (p. 353)

Gross margin (See gross profit.)

Gross margin ratio Gross margin (net sales minus cost of goods sold) divided by net sales; also called gross profit ratio. (p. 178)

Gross method Method of recording purchases at the full invoice price without deducting any cash discounts. (p. 283)

Gross pay Total compensation earned by an employee. (p. 383)

Gross profit Net sales minus cost of goods sold; also called gross mar- gin. (pp. 162 & 163)

Gross profit method Procedure to estimate inventory by using the past gross profit rate to estimate cost of goods sold, which is then subtracted from the cost of goods available for sale. (p. 235)

Held-to-maturity (HTM) securities Debt securities that a company has the intent and ability to hold until they mature. (p. C-6)

High-low method Procedure that yields an estimated line of cost behav- ior by graphically connecting costs associated with the highest and low- est sales volume. (p. 782)

Horizontal analysis Comparison of a company’s financial condition and performance across time. (p. 566)

Hurdle rate Minimum acceptable rate of return (set by management) for an investment. (pp. 953 & 1024)

Impairment Diminishment of an asset value. (pp. 346 & 352)

Imprest system Method to account for petty cash; maintains a constant balance in the fund, which equals cash plus petty cash receipts. (p. 268)

Glossary G-7

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Known liabilities Obligations of a company with little uncertainty; set by agreements, contracts, or laws; also called definitely determinable li- abilities. (p. 380)

Land improvements Assets that increase the benefits of land, have a limited useful life, and are depreciated. (p. 338)

Large stock dividend Stock dividend that is more than 25% of the pre- viously outstanding shares. (p. 474)

Last-in, first-out (LIFO) Method for assigning cost to inventory that assumes costs for the most recent items purchased are sold first and charged to cost of goods sold. (p. 215)

Lean accounting System designed to eliminate waste in the account- ing process and better reflect the benefits of lean manufacturing tech- niques. (p. 752)

Lean business model Practice of eliminating waste while meeting cus- tomer needs and yielding positive company returns. (p. 626)

Lease Contract specifying the rental of property. (pp. 353 & 446)

Leasehold Rights the lessor grants to the lessee under the terms of a lease. (p. 353)

Leasehold improvements Alterations or improvements to leased prop- erty such as partitions and storefronts. (p. 354)

Least-squares regression Statistical method for deriving an estimated line of cost behavior that is more precise than the high-low method and the scatter diagram. (p. 783)

Ledger Record containing all accounts (with amounts) for a business; also called general ledger. (p. 51)

Lessee Party to a lease who secures the right to possess and use the property from another party (the lessor). (p. 353)

Lessor Party to a lease who grants another party (the lessee) the right to possess and use its property. (p. 353)

Liabilities Creditors’ claims on an organization’s assets; involves a probable future payment of assets, products, or services that a company is obligated to make due to past transactions or events. (p. 15)

Licenses (See franchises.)

Limited liability Owner can lose no more than the amount invested. (p. 12)

Limited liability company Organization form that combines select fea- tures of a corporation and a limited partnership; provides limited liability to its members (owners), is free of business tax, and allows members to actively participate in management. (p. D-4)

Limited liability partnership Partnership in which a partner is not per- sonally liable for malpractice or negligence unless that partner is respon- sible for providing the service that resulted in the claim. (p. D-3)

Limited life (See useful life.)

Limited partners Partners who have no personal liability for partner- ship debts beyond the amounts they invested in the partnership. (p. 483)

Limited partnership Partnership that has two classes of partners, lim- ited partners and general partners. (p. D-3)

Liquid assets Resources such as cash that are easily converted into other assets or used to pay for goods, services, or liabilities. (p. 263)

Liquidating cash dividend Distribution of assets that returns part of the original investment to stockholders; deducted from contributed capital accounts. (p. 474)

Liquidation Process of going out of business; involves selling assets, paying liabilities, and distributing remainder to owners.

Internal rate of return (IRR) Rate used to evaluate the acceptability of an investment; equals the rate that yields a net present value of zero for an investment. (p. 1023)

Internal transactions Activities within an organization that can affect the accounting equation. (p. 16)

Internal users Persons using accounting information who are directly involved in managing the organization. (p. 6)

International Accounting Standards Board (IASB) Group that identi- fies preferred accounting practices and encourages global acceptance; issues International Financial Reporting Standards (IFRS). (p. 9)

International Financial Reporting Standards (IFRS) Set of interna- tional accounting standards explaining how types of transactions and events are reported in financial statements; IFRS are issued by the Inter- national Accounting Standards Board (p. 9)

Inventory Goods a company owns and expects to sell in its normal op- erations. (p. 163)

Inventory turnover Number of times a company’s average inventory is sold during a period; computed by dividing cost of goods sold by average inventory; also called merchandise turnover. (p. 223)

Investing activities Transactions that involve purchasing and selling of long-term assets, includes making and collecting notes receivable and investments in other than cash equivalents. (p. 512)

Investment center Center of which a manager is responsible for reve- nues, costs, and asset investments. (p. 943)

Investment center residual income The net income an investment cen- ter earns above a target return on average invested assets. (p. 953)

Investment center return on total assets Center net income divided by average total assets for the center. (p. 953)

Investment turnover The efficiency with which a company generates sales from its available assets; computed as sales divided by average in- vested assets. (p. 954)

Invoice Itemized record of goods prepared by the vendor that lists the customer’s name, items sold, sales prices, and terms of sale. (p. 281)

Invoice approval Document containing a checklist of steps necessary for approving the recording and payment of an invoice; also called check authorization. (p. 281)

Job Production of a customized product or service. (p. 654)

Job cost sheet Separate record maintained for each job. (p. 656)

Job lot Production of more than one unit of a customized product or service. (p. 654)

Job order cost accounting system Cost accounting system to deter- mine the cost of producing each job or job lot. (pp. 656 & 695)

Job order production Production of special-order products; also called customized production. (p. 654)

Joint cost Cost incurred to produce or purchase two or more products at the same time. (p. 962)

Journal Record in which transactions are entered before they are posted to ledger accounts; also called book of original entry. (p. 58)

Journalizing Process of recording transactions in a journal. (p. 58)

Just-in-time (JIT) manufacturing Process of acquiring or producing inventory only when needed. (p. 626)

G-8 Glossary

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Materials ledger card Perpetual record updated each time units are purchased or issued for production use. (p. 658)

Materials requisition Source document production managers use to re- quest materials for production; used to assign materials costs to specific jobs or overhead. (p. 659)

Maturity date of a note Date when a note’s principal and interest are due. (p. 312)

Measurement principle Principle that prescribes financial statement information, and its underlying transactions and events, be based on rel- evant measures of valuation; also called the cost principle. (p. 11)

Merchandise (See merchandise inventory.) (p. 162)

Merchandise inventory Goods that a company owns and expects to sell to customers; also called merchandise or inventory. (p. 163)

Merchandise purchases budget Plan that shows the units or costs of merchandise to be purchased by a merchandising company during the budget period. (p. 855)

Merchandiser Entity that earns net income by buying and selling mer- chandise. (p. 162)

Merit rating Rating assigned to an employer by a state based on the employer’s record of employment. (p. 386)

Minimum legal capital Amount of assets defined by law that stock- holders must (potentially) invest in a corporation; usually defined as par value of the stock; intended to protect creditors. (p. 469)

Mixed cost Cost that behaves like a combination of fixed and variable costs. (p. 780)

Modified Accelerated Cost Recovery System (MACRS) Depreciation system required by federal income tax law. (p. 344)

Monetary unit assumption Principle that assumes transactions and events can be expressed in money units. (p. 12)

Mortgage Legal loan agreement that protects a lender by giving the lender the right to be paid from the cash proceeds from the sale of a bor- rower’s assets identified in the mortgage. (p. 434)

Multinational Company that operates in several countries. (p. C-16)

Multiple-step income statement Income statement format that shows subtotals between sales and net income, categorizes expenses, and often reports the details of net sales and expenses. (p. 175)

Mutual agency Legal relationship among partners whereby each part- ner is an agent of the partnership and is able to bind the partnership to contracts within the scope of the partnership’s business. (p. 466)

Natural business year Twelve-month period that ends when a compa- ny’s sales activities are at their lowest point. (p. 99)

Natural resources Assets physically consumed when used; examples are timber, mineral deposits, and oil and gas fields; also called wasting assets. (p. 350)

Negotiated transfer price A system where division managers negotiate to determine the price to use to record transfers of goods or services across divisions within the same company. (p. 962)

Net assets (See equity.)

Net income Amount earned after subtracting all expenses necessary for and matched with sales for a period; also called income, profit, or earn- ings. (p. 15)

Net loss Excess of expenses over revenues for a period. (p. 15)

Liquidity Availability of resources to meet short-term cash require- ments. (pp. 263 & 565)

List price Catalog (full) price of an item before any trade discount is deducted. (p. 164)

Long-term investments Long-term assets not used in operating activi- ties such as notes receivable and investments in stocks and bonds. (pp. 119, 379 & C-2)

Long-term liabilities Obligations not due to be paid within one year or the operating cycle, whichever is longer. (p. 119)

Lower of cost or market (LCM) Required method to report inventory at market replacement cost when that market cost is lower than recorded cost. (p. 219)

Maker of the note Entity who signs a note and promises to pay it at maturity. (p. 312)

Management by exception Management process to focus on signifi- cant variances and give less attention to areas where performance is close to the standard. (p. 901)

Managerial accounting Area of accounting aimed mainly at serving the decision-making needs of internal users; also called management ac- counting. (pp. 6 & 610)

Manufacturer Company that uses labor and operating assets to convert raw materials to finished goods. (p. 16)

Manufacturing budget Plan that shows the predicted costs for direct materials, direct labor, and overhead to be incurred in manufacturing units in the production budget. (p. 868)

Manufacturing statement Report that summarizes the types and amounts of costs incurred in a company’s production process for a pe- riod; also called cost of goods manufacturing statement. (p. 623)

Marginal costing (p. 816)

Margin of safety Excess of expected sales over the level of break-even sales. (p. 786)

Market-based transfer price A transfer pricing system based on the market price of the goods or services being transferred across divisions within the same company. (p. 962)

Market prospects Expectations (both good and bad) about a company’s fu- ture performance as assessed by users and other interested parties. (p. 565)

Market rate Interest rate that borrowers are willing to pay and lenders are willing to accept for a specific lending agreement given the borrow- ers’ risk level. (p. 425)

Market value per share Price at which stock is bought or sold. (p. 469)

Master budget Comprehensive business plan that includes specific plans for expected sales, product units to be produced, merchandise (or materials) to be purchased, expenses to be incurred, plant assets to be purchased, and amounts of cash to be borrowed or loans to be repaid, as well as a budgeted income statement and balance sheet. (p. 852)

Matching (or expense recognition) principle Prescribes expenses to be reported in the same period as the revenues that were earned as a result of the expenses. (pp. 11, 100 & 306)

Materiality constraint Prescribes that accounting for items that signifi- cantly impact financial statement and any inferences from them adhere strictly to GAAP. (pp. 13 & 306)

Materials consumption report Document that summarizes the materi- als a department uses during a reporting period; replaces materials requi- sitions. (p. 696)

Glossary G-9

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Organization expenses (costs) Costs such as legal fees and promoter fees to bring an entity into existence. (p. 467)

Other comprehensive income (See comprehensive income.)

Out-of-pocket cost Cost incurred or avoided as a result of manage- ment’s decisions. (p. 616)

Output devices Means by which information is taken out of the ac- counting system and made available for use. (p. E-5)

Outsourcing Manager decision to buy a product or service from another entity; part of a make-or-buy decision; also called make or buy.

Outstanding checks Checks written and recorded by the depositor but not yet paid by the bank at the bank statement date. (p. 274)

Outstanding stock Corporation’s stock held by its shareholders. (p. 469)

Overapplied overhead Amount by which the overhead applied to pro- duction in a period using the predetermined overhead rate exceeds the actual overhead incurred in a period. (p. 665)

Overhead cost variance Difference between the total overhead cost ap- plied to products and the total overhead cost actually incurred. (p. 908)

Owner, Capital Account showing the owner’s claim on company as- sets; equals owner investments plus net income (or less net losses) minus owner withdrawals since the company’s inception; also referred to as equity. (p. 15)

Owner investment Assets put into the business by the owner. (p. 15)

Owner’s equity (See equity.)

Owner, Withdrawals Account used to record asset distributions to the owner. (See also withdrawals.) (p. 15)

Paid-in capital (See contributed capital.)

Paid-in capital in excess of par value Amount received from issuance of stock that is in excess of the stock’s par value. (p. 471)

Par value Value assigned a share of stock by the corporate charter when the stock is authorized. (p. 469)

Par value of a bond Amount the bond issuer agrees to pay at maturity and the amount on which cash interest payments are based; also called face amount or face value of a bond. (p. 422)

Par value stock Class of stock assigned a par value by the corporate charter. (p. 469)

Parent Company that owns a controlling interest in a corporation (re- quires more than 50% of voting stock). (p. C-9)

Participating preferred stock Preferred stock that shares with common stockholders any dividends paid in excess of the percent stated on pre- ferred stock. (p. 478)

Partner return on equity Partner net income divided by average part- ner equity for the period. (p. D-4)

Partnership Unincorporated association of two or more persons to pur- sue a business for profit as co-owners. (pp. 12 & D-2)

Partnership contract Agreement among partners that sets terms under which the affairs of the partnership are conducted; also called articles of partnership.

Partnership liquidation Dissolution of a partnership by (1) selling noncash assets and allocating any gain or loss according to partners’ income-and-loss ratio, (2) paying liabilities, and (3) distributing any remaining cash according to partners’ capital balances. (p. D-11)

Net method Method of recording purchases at the full invoice price less any cash discounts. (p. 283)

Net pay Gross pay less all deductions; also called take-home pay. (p. 384)

Net present value (NPV) Dollar estimate of an asset’s value that is used to evaluate the acceptability of an investment; computed by discounting future cash flows from the investment at a satisfactory rate and then sub- tracting the initial cost of the investment. (p. 1020)

Net realizable value Expected selling price (value) of an item minus the cost of making the sale. (p. 210)

Noncumulative preferred stock Preferred stock on which the right to receive dividends is lost for any period when dividends are not de- clared. (p. 477)

Noninterest-bearing note Note with no stated (contract) rate of inter- est; interest is implicitly included in the note’s face value.

Nonparticipating preferred stock Preferred stock on which dividends are limited to a maximum amount each year. (p. 478)

No-par value stock Stock class that has not been assigned a par (or stated) value by the corporate charter. (p. 469)

Nonsufficient funds (NSF) check Maker’s bank account has insuffi- cient money to pay the check; also called hot check. (p. 274)

Non-value-added time The portion of cycle time that is not directed at producing a product or service; equals the sum of inspection time, move time, and wait time. (p. 958)

Not controllable costs Costs that a manager does not have the power to control or strongly influence. (p. 615)

Note (See promissory note.)

Note payable Liability expressed by a written promise to pay a definite sum of money on demand or on a specific future date(s). (p. 52)

Note receivable Asset consisting of a written promise to receive a defi- nite sum of money on demand or on a specific future date(s). (p. 51)

Objectivity Concept that prescribes independent, unbiased evidence to support financial statement information. (p. 11)

Obsolescence Condition in which, because of new inventions and im- provements, a plant asset can no longer be used to produce goods or services with a competitive advantage. (p. 339)

Off-balance-sheet financing Acquisition of assets by agreeing to liabil- ities not reported on the balance sheet. (p. 447)

Online processing Approach to inputting data from source documents as soon as the information is available. (p. E-16)

Operating activities Activities that involve the production or purchase of merchandise and the sale of goods or services to customers, including expenditures related to administering the business. (p. 511)

Operating cycle Normal time between paying cash for merchandise or employee services and receiving cash from customers. (p. 117)

Operating leases Short-term (or cancelable) leases in which the lessor retains risks and rewards of ownership. (p. 446)

Operating leverage Extent, or relative size, of fixed costs in the total cost structure. (p. 795)

Opportunity cost Potential benefit lost by choosing a specific action from two or more alternatives. (p. 616)

Ordinary repairs Repairs to keep a plant asset in normal, good operat- ing condition; treated as a revenue expenditure and immediately expensed. (p. 347)

G-10 Glossary

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Preemptive right Stockholders’ right to maintain their proportionate interest in a corporation with any additional shares issued. (p. 468)

Preferred stock Stock with a priority status over common stockholders in one or more ways, such as paying dividends or distributing assets. (p. 476)

Premium on bonds Difference between a bond’s par value and its higher carrying value; occurs when the contract rate is higher than the market rate; also called bond premium. (p. 428)

Premium on stock (See contributed capital in excess of par value.) (p. 471)

Prepaid expenses Items paid for in advance of receiving their benefits; classified as assets. (p. 101)

Price-earnings (PE) ratio Ratio of a company’s current market value per share to its earnings per share; also called price-to-earnings. (p. 485)

Price variance Difference between actual and budgeted revenue or cost caused by the difference between the actual price per unit and the bud- geted price per unit. (p. 901)

Prime costs Expenditures directly identified with the production of fin- ished goods; include direct materials costs and direct labor costs. (p. 619)

Principal of a note Amount that the signer of a note agrees to pay back when it matures, not including interest. (p. 312)

Principles of internal control Principles prescribing management to establish responsibility, maintain records, insure assets, separate record- keeping from custody of assets, divide responsibility for related transac- tions, apply technological controls, and perform reviews. (p. 259)

Prior period adjustment Correction of an error in a prior year that is reported in the statement of retained earnings (or statement of stockhold- ers’ equity) net of any income tax effects. (p. 483)

Pro forma financial statements Statements that show the effects of proposed transactions and events as if they had occurred. (p. 128)

Process cost accounting system System of assigning direct materials, direct labor, and overhead to specific processes; total costs associated with each process are then divided by the number of units passing through that process to determine the cost per equivalent unit. (p. 695)

Process cost summary Report of costs charged to a department, its equivalent units of production achieved, and the costs assigned to its output. (p. 704)

Process operations Processing of products in a continuous (sequential) flow of steps; also called process manufacturing or process produc- tion. (p. 692)

Product costs Costs that are capitalized as inventory because they pro- duce benefits expected to have future value; include direct materials, direct labor, and overhead. (p. 616)

Product level activities Activities that relate to specific products that must be carried out regardless of how many units are produced and sold or batches run. (p. 750)

Production budget Plan that shows the units to be produced each period. (p. 868)

Profit (See net income.)

Profit center Business unit that incurs costs and generates revenues. (p. 943)

Profit margin Ratio of a company’s net income to its net sales; the percent of income in each dollar of revenue; also called net profit margin. (pp. 121 & 954)

Profitability Company’s ability to generate an adequate return on in- vested capital. (p. 565)

Profitability index A measure of the relation between the expected ben- efits of a project and its investment, computed as the present value of

Patent Exclusive right granted to its owner to produce and sell an item or to use a process for 17 years. (p. 352)

Payback period (PBP) Time-based measurement used to evaluate the acceptability of an investment; equals the time expected to pass before an investment’s net cash flows equal its initial cost. (p. 1016)

Payee of the note Entity to whom a note is made payable. (p. 312)

Payroll bank account Bank account used solely for paying employees; each pay period an amount equal to the total employees’ net pay is de- posited in it and the payroll checks are drawn on it. (p. 400)

Payroll deductions Amounts withheld from an employee’s gross pay; also called withholdings. (p. 384)

Payroll register Record for a pay period that shows the pay period dates, regular and overtime hours worked, gross pay, net pay, and deduc- tions. (p. 397)

Pension plan Contractual agreement between an employer and its em- ployees for the employer to provide benefits to employees after they re- tire; expensed when incurred. (p. 448)

Period costs Expenditures identified more with a time period than with finished products costs; includes selling and general administrative ex- penses. (p. 616)

Periodic inventory system Method that records the cost of inventory purchased but does not continuously track the quantity available or sold to customers; records are updated at the end of each period to reflect the physical count and costs of goods available. (p. 164)

Permanent accounts Accounts that reflect activities related to one or more future periods; balance sheet accounts whose balances are not closed; also called real accounts. (p. 112)

Perpetual inventory system Method that maintains continuous records of the cost of inventory available and the cost of goods sold. (p. 164)

Petty cash Small amount of cash in a fund to pay minor expenses; ac- counted for using an imprest system. (p. 268)

Planning Process of setting goals and preparing to achieve them. (p. 610)

Plant asset age Plant asset age is an approximation of the age of plant assets, which is estimated by dividing accumulated depreciation by de- preciation expense. (p. 355)

Plant assets Tangible long-lived assets used to produce or sell products and services; also called property, plant and equipment (PP&E) or fixed assets. (pp. 103 & 336)

Pledged assets to secured liabilities Ratio of the book value of a com- pany’s pledged assets to the book value of its secured liabilities. (p. 703)

Post-closing trial balance List of permanent accounts and their bal- ances from the ledger after all closing entries are journalized and posted. (p. 114)

Posting Process of transferring journal entry information to the ledger; computerized systems automate this process. (p. 58)

Posting reference (PR) column A column in journals in which indi- vidual ledger account numbers are entered when entries are posted to those ledger accounts. (p. 60)

Predetermined overhead rate Rate established prior to the beginning of a period that relates estimated overhead to another variable, such as estimated direct labor, and is used to assign overhead cost to produc- tion. (p. 662)

Glossary G-11

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Responsibility accounting system System that provides information that management can use to evaluate the performance of a department’s manager. (p. 942)

Restricted retained earnings Retained earnings not available for divi- dends because of legal or contractual limitations. (p. 482)

Retail inventory method Method for estimating ending inventory based on the ratio of the amount of goods for sale at cost to the amount of goods for sale at retail. (p. 234)

Retailer Intermediary that buys products from manufacturers or whole- salers and sells them to consumers. (p. 162)

Retained earnings Cumulative income less cumulative losses and divi- dends. (pp. 15 & 470)

Retained earnings deficit Debit (abnormal) balance in Retained Earn- ings; occurs when cumulative losses and dividends exceed cumulative income; also called accumulated deficit. (p. 473)

Return Monies received from an investment; often in percent form. (p. 27)

Return on assets (See return on total assets.)

Return on equity Ratio of net income to average equity for the period.

Return on total assets Ratio reflecting operating efficiency; defined as net income divided by average total assets for the period; also called re- turn on assets or return on investment. (pp. 24 & C-11)

Revenue expenditures Expenditures reported on the current income statement as an expense because they do not provide benefits in future periods. (p. 346)

Revenue recognition principle The principle prescribing that revenue is recognized when earned. (p. 11)

Revenues Gross increase in equity from a company’s business activities that earn income; also called sales. (p. 15)

Reverse stock split Occurs when a corporation calls in its stock and re- places each share with less than one new share; increases both market value per share and any par or stated value per share. (p. 476)

Reversing entries Optional entries recorded at the beginning of a period that prepare the accounts for the usual journal entries as if adjusting en- tries had not occurred in the prior period. (p. 129)

Risk Uncertainty about an expected return. (p. 27)

Rolling budget New set of budgets a firm adds for the next period (with revisions) to replace the ones that have lapsed. (p. 851)

S corporation Corporation that meets special tax qualifications so as to be treated like a partnership for income tax purposes. (p. D-3)

Safety stock Quantity of inventory or materials over the minimum needed to satisfy budgeted demand. (p. 855)

Sales (See revenues.)

Sales budget Plan showing the units of goods to be sold or services to be provided; the starting point in the budgeting process for most depart- ments. (p. 854)

Sales discount Term used by a seller to describe a cash discount granted to buyers who pay within the discount period. (p. 165)

Sales journal Journal normally used to record sales of goods on credit.

Sales mix Ratio of sales volumes for the various products sold by a company. (p. 793)

expected future cash flows from the investment divided by the cost of the investment; a higher value indicates a more desirable investment, and a value below 1 indicates an unacceptable project. (p. 1023)

Promissory note (or note) Written promise to pay a specified amount either on demand or at a definite future date; is a note receivable for the lender but a note payable for the lendee. (p. 312)

Proprietorship (See sole proprietorship.)

Proxy Legal document giving a stockholder’s agent the power to exer- cise the stockholder’s voting rights. (p. 467)

Purchase discount Term used by a purchaser to describe a cash discount granted to the purchaser for paying within the discount period. (p. 165)

Purchase order Document used by the purchasing department to place an order with a seller (vendor). (p. 280)

Purchase requisition Document listing merchandise needed by a de- partment and requesting it be purchased. (p. 280)

Purchases journal Journal normally used to record all purchases on credit. (p. E-13)

Quantity variance Difference between actual and budgeted revenue or cost caused by the difference between the actual number of units and the budgeted number of units. (p. 901)

Ratio analysis Determination of key relations between financial state- ment items as reflected in numerical measures. (p. 566)

Raw materials inventory Goods a company acquires to use in making products. (p. 620)

Raw materials inventory turnover ratio Measure of how many times a company turns over (uses in production) its raw materials inventory during a period; defined as Raw materials used divided by Average raw materials inventory. (p. 628)

Realizable value Expected proceeds from converting an asset into cash. (p. 307)

Receiving report Form used to report that ordered goods are received and to describe their quantity and condition. (p. 281)

Recordkeeping Part of accounting that involves recording transactions and events, either manually or electronically; also called bookkeeping. (p. 4)

Registered bonds Bonds owned by investors whose names and ad- dresses are recorded by the issuer; interest payments are made to the registered owners. (p. 436)

Relevance principle Information system principle prescribing that its reports be useful, understandable, timely, and pertinent for decision mak- ing. (p. E-2)

Relevant benefits Additional or incremental revenue generated by se- lecting a particular course of action over another. (p. 987)

Relevant range of operations Company’s normal operating range; ex- cludes extremely high and low volumes not likely to occur. (p. 788)

Report form balance sheet Balance sheet that lists accounts vertically in the order of assets, liabilities, and equity. (p. 22)

Responsibility accounting budget Report of expected costs and ex- penses under a manager’s control. (p. 944)

Responsibility accounting performance report Responsibility report that compares actual costs and expenses for a department with budgeted amounts. (p. 944)

G-12 Glossary

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Simple capital structure Capital structure that consists of only com- mon stock and nonconvertible preferred stock; consists of no dilutive securities. (p. 485)

Single-step income statement Income statement format that includes cost of goods sold as an expense and shows only one subtotal for total expenses. (p. 176)

Sinking fund bonds Bonds that require the issuer to make deposits to a separate account; bondholders are repaid at maturity from that ac- count. (p. 436)

Small stock dividend Stock dividend that is 25% or less of a corpora- tion’s previously outstanding shares. (p. 474)

Social responsibility Being accountable for the impact that one’s ac- tions might have on society. (p. 8)

Sole proprietorship Business owned by one person that is not orga- nized as a corporation; also called proprietorship. (p. 12)

Solvency Company’s long-run financial viability and its ability to cover long-term obligations. (p. 565)

Source documents Source of information for accounting entries that can be in either paper or electronic form; also called business papers. (p. 52)

Special journal Any journal used for recording and posting transactions of a similar type. (p. E-6)

Specific identification Method for assigning cost to inventory when the purchase cost of each item in inventory is identified and used to compute cost of inventory. (pp. 213 & 230)

Spending variance Difference between the actual price of an item and its standard price. (p. 916)

Spreadsheet Computer program that organizes data by means of formu- las and format; also called electronic work sheet. (pp. 123 & 532)

Standard costs Costs that should be incurred under normal conditions to produce a product or component or to perform a service. (p. 901)

State Unemployment Taxes (SUTA) State payroll taxes on employers to support its unemployment programs. (p. 386)

Stated value stock No-par stock assigned a stated value per share; this amount is recorded in the stock account when the stock is issued. (p. 470)

Statement of cash flows A financial statement that lists cash inflows (receipts) and cash outflows (payments) during a period; arranged by operating, investing, and financing. (pp. 20 & 510)

Statement of owner’s equity Report of changes in equity over a period; adjusted for increases (owner investment and net income) and for de- creases (withdrawals and net loss). (p. 20)

Statement of partners’ equity Financial statement that shows total capital balances at the beginning of the period, any additional investment by partners, the income or loss of the period, the partners’ withdrawals, and the partners’ ending capital balances; also called statement of part- ners’ capital. (p. D-7)

Statement of retained earnings Report of changes in retained earnings over a period; adjusted for increases (net income), for decreases (divi- dends and net loss), and for any prior period adjustment. (p. 20)

Statement of stockholders’ equity Financial statement that lists the be- ginning and ending balances of each major equity account and describes all changes in those accounts. (p. 483)

Salvage value Estimate of amount to be recovered at the end of an as- set’s useful life; also called residual value or scrap value. (p. 339)

Sarbanes-Oxley Act (SOX) Created the Public Company Accounting Oversight Board, regulates analyst conflicts, imposes corporate gover- nance requirements, enhances accounting and control disclosures, im- pacts insider transactions and executive loans, establishes new types of criminal conduct, and expands penalties for violations of federal securi- ties laws. (pp. 13 & 258)

Scatter diagram Graph used to display data about past cost behavior and sales as points on a diagram. (p. 782)

Schedule of accounts payable List of the balances of all accounts in the accounts payable ledger and their totals. (p. E-14)

Schedule of accounts receivable List of the balances of all accounts in the accounts receivable ledger and their totals. (p. E-9)

Section 404 (of SOX) Section 404 of SOX requires management and the external auditor to report on the adequacy of the company’s internal control on financial reporting, which is the most costly aspect of SOX for companies to implement as documenting and testing important financial manual and automated controls require enormous efforts. Section 404 also requires management to produce an “internal control report” as part of each annual SEC report that affirms “the responsibility of manage- ment for establishing and maintaining an adequate internal control struc- ture and procedures for financial reporting.” (p. 259)

Secured bonds Bonds that have specific assets of the issuer pledged as collateral. (p. 436)

Securities and Exchange Commission (SEC) Federal agency Con- gress has charged to set reporting rules for organizations that sell owner- ship shares to the public. (p. 9)

Segment return on assets Segment operating income divided by seg- ment average (identifiable) assets for the period.

Selling expense budget Plan that lists the types and amounts of selling expenses expected in the budget period. (p. 856)

Selling expenses Expenses of promoting sales, such as displaying and advertising merchandise, making sales, and delivering goods to customers. (p. 175)

Serial bonds Bonds consisting of separate amounts that mature at dif- ferent dates. (p. 436)

Service company Organization that provides services instead of tangi- ble products.

Shareholders Owners of a corporation; also called stockholders. (p. 13)

Shares Equity of a corporation divided into ownership units; also called stock. (p. 13)

Short-term investments Debt and equity securities that management expects to convert to cash within the next 3 to 12 months (or the operat- ing cycle if longer); also called temporary investments or marketable se- curities. (p. C-2)

Short-term note payable Current obligation in the form of a written promissory note. (p. 381)

Shrinkage Inventory losses that occur as a result of theft or deteriora- tion. (p. 172)

Signature card Includes the signatures of each person authorized to sign checks on the bank account. (p. 271)

Glossary G-13

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Times interest earned Ratio of income before interest expense (and any income taxes) divided by interest expense; reflects risk of covering inter- est commitments when income varies. (p. 392)

Total asset turnover Measure of a company’s ability to use its assets to gen- erate sales; computed by dividing net sales by average total assets. (p. 355)

Total quality management (TQM) Concept calling for all managers and employees at all stages of operations to strive toward higher stan- dards and reduce number of defects. (p. 626)

Trade discount Reduction from a list or catalog price that can vary for wholesalers, retailers, and consumers. (p. 164)

Trademark or trade (brand) name Symbol, name, phrase, or jingle identified with a company, product, or service. (p. 353)

Trading on the equity (See financial leverage.)

Trading securities Investments in debt and equity securities that the company intends to actively trade for profit. (p. C-5)

Transfer price The price used to record transfers of goods or services across divisions within the same company. (p. 961)

Transaction Exchange of economic consideration affecting an entity’s financial position that can be reliably measured. (p. 16)

Treasury stock Corporation’s own stock that it reacquired and still holds. (p. 480)

Trial balance List of accounts and their balances at a point in time; total debit balances equal total credit balances. (p. 67)

Unadjusted trial balance List of accounts and balances prepared be- fore accounting adjustments are recorded and posted. (p. 110)

Unavoidable expense Expense (or cost) that is not relevant for business decisions; an expense that would continue even if a department, product, or service is eliminated. (p. 993)

Unclassified balance sheet Balance sheet that broadly groups assets, liabilities, and equity accounts. (p. 117)

Uncontrollable costs Costs that a manager does not have the power to determine or strongly influence. (pp. 826 & 943)

Underapplied overhead Amount by which overhead incurred in a pe- riod exceeds the overhead applied to that period’s production using the predetermined overhead rate. (p. 665)

Unearned revenue Liability created when customers pay in advance for products or services; earned when the products or services are later deliv- ered. (pp. 55 & 104)

Unfavorable variance Difference in revenues or costs, when the actual amount is compared to the budgeted amount, that contributes to a lower income. (p. 897)

Unit contribution margin Amount a product’s unit selling price ex- ceeds its total unit variable cost. (p. 785)

Unit level activities Activities that arise as a result of the total volume of goods and services that are produced, and that are performed each time a unit is produced (p. 750)

Units-of-production depreciation Method that charges a varying amount to depreciation expense for each period of an asset’s useful life depending on its usage. (p. 341)

Unlimited liability Legal relationship among general partners that makes each of them responsible for partnership debts if the other part- ners are unable to pay their shares. (p. D-3)

Unrealized gain (loss) Gain (loss) not yet realized by an actual transac- tion or event such as a sale. (p. C-5)

Unsecured bonds Bonds backed only by the issuer’s credit standing; al- most always riskier than secured bonds; also called debentures. (p. 436)

Statements of Financial Accounting Standards (SFAS) FASB publi- cations that establish U.S. GAAP.

Step-wise cost Cost that remains fixed over limited ranges of volumes but changes by a lump sum when volume changes occur outside these limited ranges. (p. 780)

Stock (See shares) (p. 13)

Stock dividend Corporation’s distribution of its own stock to its stock- holders without the receipt of any payment. (p. 474)

Stock options Rights to purchase common stock at a fixed price over a specified period of time. (p. 483)

Stock split Occurs when a corporation calls in its stock and replaces each share with more than one new share; decreases both the market value per share and any par or stated value per share. (p. 476)

Stock subscription Investor’s contractual commitment to purchase unissued shares at future dates and prices.

Stockholders (See shareholders.) (p. 13)

Stockholders’ equity A corporation’s equity; also called shareholders’ equity or corporate capital. (p. 470)

Straight-line depreciation Method that allocates an equal portion of the depreciable cost of plant asset (cost minus salvage) to each account- ing period in its useful life. (pp. 103 & 341)

Straight-line bond amortization Method allocating an equal amount of bond interest expense to each period of the bond life. (p. 426)

Subsidiary Entity controlled by another entity (parent) in which the parent owns more than 50% of the subsidiary’s voting stock. (p. C-9)

Subsidiary ledger List of individual subaccounts and amounts with a common characteristic; linked to a controlling account in the general ledger. (p. E-6)

Sunk cost Cost already incurred and cannot be avoided or changed. (p. 616)

Supplementary records Information outside the usual accounting re- cords; also called supplemental records. (p. 168)

Supply chain Linkages of services or goods extending from suppliers, to the company itself, and on to customers.

T-account Tool used to show the effects of transactions and events on individual accounts. (p. 57)

Target cost Maximum allowable cost for a product or service; defined as expected selling price less the desired profit. (p. 655)

Temporary accounts Accounts used to record revenues, expenses, and withdrawals (dividends for a corporation); they are closed at the end of each period; also called nominal accounts. (p. 112)

Term bonds Bonds scheduled for payment (maturity) at a single speci- fied date. (p. 436)

Throughput time (See cycle time.)

Time period assumption Assumption that an organization’s activities can be divided into specific time periods such as months, quarters, or years. (pp. 12 & 98)

Time ticket Source document used to report the time an employee spent working on a job or on overhead activities and then to determine the amount of direct labor to charge to the job or the amount of indirect labor to charge to overhead. (p. 660)

G-14 Glossary

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Voucher Internal file used to store documents and information to con- trol cash disbursements and to ensure that a transaction is properly autho- rized and recorded. (p. 267)

Voucher register Journal (referred to as book of original entry) in which all vouchers are recorded after they have been approved. (p. 282)

Voucher system Procedures and approvals designed to control cash dis- bursements and acceptance of obligations. (p. 266)

Wage bracket withholding table Table of the amounts of income tax withheld from employees’ wages. (p. 400)

Warranty Agreement that obligates the seller to correct or replace a product or service when it fails to perform properly within a specified period. (p. 388)

Weighted average Method for assigning inventory cost to sales; the cost of available-for-sale units is divided by the number of units available to determine per unit cost prior to each sale that is then multiplied by the units sold to yield the cost of that sale. (pp. 216, 232 & 702)

Weighted-average contribution margin The contribution margin per composite unit for a company that provides multiple goods or services; also called contribution margin per composite unit. (p. 793)

Weighted-average method (See weighted average.)

Wholesaler Intermediary that buys products from manufacturers or other wholesalers and sells them to retailers or other wholesalers. (p. 162)

Work sheet Spreadsheet used to draft an unadjusted trial balance, adjusting entries, adjusted trial balance, and financial state- ments. (p. 123)

Working capital Current assets minus current liabilities at a point in time. (p. 575)

Working papers Analyses and other informal reports prepared by ac- countants and managers when organizing information for formal reports and financial statements. (p. 127)

Unusual gain or loss Gain or loss that is abnormal or unrelated to the company’s ordinary activities and environment. (p. 588)

Useful life Length of time an asset will be productively used in the opera- tions of a business; also called service life or limited life. (pp. 339 & 351)

Value-added activities Activities that add to the value of a product or service (p. 749)

Value-added time The portion of cycle time that is directed at produc- ing a product or service; equals process time. (p. 958)

Value chain Sequential activities that add value to an entity’s products or services; includes design, production, marketing, distribution, and ser- vice. (p. 626)

Variable cost Cost that changes in proportion to changes in the activity output volume. (p. 614)

Variable costing A costing method that includes only variable manufactur- ing costs—direct materials, direct labor, and variable manufacturing over- head—in unit product costs; also called direct or marginal costing (p. 816)

Variable costing income statement An income statement in which costs are classified as variable or fixed; also called contribution margin income statement. (p. 786)

Variance analysis Process of examining differences between actual and budgeted revenues or costs and describing them in terms of price and quantity differences. (p. 901)

Vendee Buyer of goods or services. (p. 281)

Vendor Seller of goods or services. (p. 280)

Vertical analysis Evaluation of each financial statement item or group of items in terms of a specific base amount. (p. 566)

Volume variance Difference between two dollar amounts of fixed over- head cost; one amount is the total budgeted overhead cost, and the other is the overhead cost allocated to products using the predetermined fixed overhead rate. (p. 909)

Glossary G-15

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Credits

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Chapter 24 Page 1024 Robert Kirk/ Getty Images Page 1018 Tetra Images/ Getty Images Page 1015 Courtesy of Gamer Grub

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Credits CR-1

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Accounts payable ledger, 382 Accounts receivable, 301, 30 2– 311, 320

adjustments for changes in, 51 8– 519 aging of, 31 0– 311, 320 analyzing and recording, 53 estimating

by aging of receivables method, 31 0– 311, 320 percent of receivables method, 309 percent of sales method, 30 8– 309, 320 summary of methods, 311

ratio analysis accounts receivable turnover ratio, 31 7– 318,

318 n, 320, 321, 577, 588 days’ sales uncollected ratio, 27 7– 278,

28 4– 285, 57 7– 578, 588 recognizing, 30 2– 305

credit card sales, 30 4– 305 installment sales, 305 sales on credit, 30 2– 304

transaction analysis, 18 valuation of

by allowance method, 30 7– 308 by direct write-off method, 306 global view of, 316 realizable value, 307

Accounts receivable ledger, 303 Accounts receivable turnover ratio, 31 7– 318, 318 n

in analysis of financial statements, 577, 588 in estimating bad debts, 320, 321

Account titles, 55, 55 n, 59, 378 Accretion liability accounts, 428 Accrual basis accounting, 99, 131 Accrued assets. See Accrued revenues Accrued expenses, 55, 55 n, 101, 10 5– 107, 379

future payment of, 107 interest expense, 107 links to financial statements, 109 payroll expenses and liabilities, 385 salaries expense, 106

Accrued revenues, 101, 107 future receipt of, 108 interest revenue, 108 links to financial statements, 109 from sales promotions, 108, 132 services revenue, 10 7– 108

Accumulated deficit, 473 Accumulated depletion, 350 Accumulated Depreciation account, 10 3– 104, 346 Accumulated other comprehensive income, C - 10 Acid-test (quick) ratio, 17 8– 179,

57 6– 577, 588 demonstration of, 18 1– 182 in making credit decisions, 178, 188

Acquisition of securities, C - 3, C - 4

ABB (activity-based budgeting), 86 2– 863, 869, 870 Abbott-Langer.com, 7 ABC. See Activity-based costing (ABC) Abercrombie & Fitch, 302, 482, 992 Ability to service debt, 122, 132, 429 ABM (activity-based management), 749 Abnormal balance, 61 Abnormal credit balance, 131 Absorption costing, 786, 816

break-even analysis and, 82 7– 828 computing unit cost under ( See Unit cost(s)) demonstration of, 82 8– 830 expenses grouped by function under, 819 global view of, 827 manager bonuses tied to sales, 825, 831 performance (income) reporting implications,

81 8– 823 converting income from variable costing,

823, 831 difference in cost per unit and, 82 3– 825 summary of income reporting, 821, 822 units produced equal units sold, 81 8– 819 units produced exceed units sold, 820, 821 units sold exceed units produced, 821, 822

role in overproduction, 826, 831 variable costing compared, 82 3– 827

controlling costs, 826 limitations of variable costing reports, 82 6– 827 production planning, 82 3– 825 setting prices, 82 5– 826 variable costing for service firms, 827

Accelerated depreciation, 102 2– 1023 Accelerated depreciation method(s), 34 2– 343, 344 Account(s), 5 3– 56, 76

asset accounts, 5 3– 54 chart of, 22, 56, 76 equity accounts, 5 5– 56 liability accounts, 5 4– 55 numbering system for, 56

Account analysis, 519, 535 Account balance, 57 Account form of balance sheet, 22, 70 Accounting, 2– 28

defined, 4 financial statements ( See Financial statement(s)) fundamentals of, 7– 14 global view of ( See Global view of

accounting principles) importance of, 4– 7, 28 transaction analysis in ( See Transaction analysis)

Accounting assumptions, 1 2– 13 . See also Accounting principles

business entity assumption, 12, 466 going-concern assumption, 12, 345

monetary unit assumption, 12 time period (periodicity) assumption, 12, 98, 100

Accounting books, 52 Accounting cycle, 11 6– 117

classified balance sheet, 11 7– 119 closing process, 11 2– 117 for merchandisers, 17 2– 174 reversing entries ( See Reversing entries ) steps in, 131 work sheet as tool ( See Work sheet )

Accounting distribution, 282 Accounting equation, 15, 28

business activities and, 2 7– 28 expanded, 15 in transaction analysis, 1 6– 20 in transaction processing, 65, 66

Accounting errors. See Errors Accounting information, 434, 61 2– 613 Accounting information systems, 60, 61 Accounting period, 6 8– 69, 9 8– 99, 164, 183 Accounting principles . See also

Accounting assumptions changes in, sustainable income and, 58 9– 590 cost-benefit principle, 262 cost principle, 11, 104, 337, 360 full-disclosure principle ( See Full-

disclosure principle ) GAAP ( See Generally accepted

accounting principles ) general and specific, 1 0– 11 global view of, 22 on inventory costing methods, 219 matching principle ( See Matching principle ) materiality principle, 620 measurement principle, 11 realization principle, 316 revenue recognition principle, 11, 55, 63, 100,

105, 107 Accounting rate of return (ARR), 101 9– 1020,

1025, 1030 Accounting-related professions, 6– 7 Accounting scandals, 13 Accounting software, 615 . See also Software;

specific programs analyzing cash account and, 514, 515 for payroll, 398

Accounting year, 6 8– 69 Accounts payable, 54

adjustments for changes in, 520 analysis of, 54, 53 6– 537 creditor requires notes to replace, 382 as known liabilities, 380 recording, 54 transaction analysis, 1 8– 19, 63

Note: Page numbers followed by n indicate material in footnotes; defined terms and the page number on which the definition appears are shown in boldface.

IND

Index

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Index IND-1

demonstrations of effective interest method, 43 9– 440 straight-line amortization, 43 8– 439

intangible assets, 35 2– 354, 358 securities reported at amortized cost, C - 6

Analysis period, 567 Analyst services, 564 “Angel” investors, 468 Anheuser-Busch, 961 Anheuser-Busch InBev, 707 Annual budget, 852 Annual Federal Unemployment Tax Return (Form

940), 395 Annual financial statements, 98 Annual interest rate, 442 Annual report(s), A - 1 Annual Statement Studies (The Risk Management

Association), 24 Annuity(ies), 44 1– 442, 1021, B - 7

computing, 1021, 1021 n ordinary annuity, B - 7

future value of, B - 6 – B - 7 present value of, B - 5

Annuity factor, 1021 n AOL Time Warner, 13 Apple, Inc., 4, 15, 317, 345, 379, 469, 483, 484,

624, 860, C - 14, C - 15 Appraisal costs, 750 Appropriated retained earnings, 48 2– 483 Arctic Cat, 4, 55 n, 69, 176, 564, C - 10

analysis of financial statements, 570, 574, 57 5– 590 consolidated financial statements (examples),

A - 10 – A - 13 balance sheet, A - 10 statement of cash flows, A - 13 statement of operations, A - 11 statement of shareholders’ equity, A - 12

Arm’s-length transactions, 316 Arora, Nikhail, 609 ARR (accounting rate of return), 101 9– 1020,

1025, 1030 ashanddans.com, 97 ash&dans, 97 Asset(s), 15, 2 7– 28, 33 4– 360

agricultural, 222 average invested assets, 954 components of, 573, 574, 576 custody of, 260 intangible ( See Intangible assets ) long-term ( See Long-term assets) natural resources, 35 0– 351, 358, 360 notes receivable as, 313 plant assets ( See Plant asset(s) ) prepaid accounts, 54 ratio analysis of ( See Ratio analysis ) sale of, 538

Asset accounts, 5 3– 54, 115 Asset book value. See Book value of assets Asset management, 2 7– 28, 264 Asset revaluations (IFRS), 355 Association of Certified Fraud Examiners, 260,

262, 613 Assumptions

cost flow assumptions, 212, 213, 222 in CVP analysis, 78 8– 789

Astor and Black, 653 ATMs (automated teller machines), 260, 271, 272

end-of-period adjustment for interest on note payable, 383 for interest on note receivable, 31 4– 315 for warranty liabilities, 389

fair value adjustment – trading securities, C - 5 for interest on notes receivable, 31 4– 315, 320 keying adjustments, 128, 129 for merchandisers, 172, 173, 174, 188

periodic inventory system, 18 4– 186, 185 n periodic v s . perpetual system, 184, 185 n perpetual inventory system, 172, 174

for prepaid accounts, 5 3– 54 for prepaid expenses, 10 1– 104 for prepaid revenues, 126, 127, 132 preparing, 123, 131 reversing entries ( See Reversing entries ) as source of overhead, 661 for straight-line depreciation, 340 for unrealized gain (loss), C - 13

Adjusting entry method, 186 n Advance sales, 11 Advertising expenses, 947, 950, A - 6 Aeropostale, 162 AFS securities. See Available-for-

sale securities After-tax income targets, 79 0– 791,

794, 799 Aging of accounts receivable, 31 0– 311, 320 Aging schedule, 310 Agricultural assets, 222 A-1 Hardware, 948 AICPA (American Institute of Certified Public

Accountants), 8 Alcoa, 350 Allocation base(s)

in departmental expense allocation, 946, 948, 949, 964

effects on overhead costs, 743 in job order cost accounting, 662 overhead allocation base, 662, 73 9– 740

Allowance(s), 902 Allowance for Doubtful Accounts, 307, 309

adjustments to, 311, 321 downward trend in, 316, 321 note regarding, A - 6

Allowance method, 30 7– 308, 320 recording bad debts expense, 307 recovering bad debts, 308 writing off bad debts, 30 7– 308

All Tune and Lube, 908 Altria Group, 485, 486 Amazon.com, 261, 474, 485, 486 American Eagle, 992 American Exchange, 423 American Express, 304, 308, 511 American Greetings, 469 American Institute of Certified Public Accountants

(AICPA), 8 Amortization, 351

of bond discount, 426 effective interest method, 44 2– 443, 448 straight-line method, 42 6– 427, 448

of bond premium effective interest method, 44 3– 444, 448 rounding in, 429 straight-line method, 42 9– 430, 448

change in method, 590

Activity(ies), 210, 617, 743 focus on, 738 homogeneous, grouped into cost pools, 744 identification of, 74 4– 745, 75 6– 757 predicting levels of, 908 types of, 75 0– 751, 756

Activity-based budgeting (ABB), 86 2– 863, 869, 870

Activity-based costing (ABC), 73 6– 756 application of, 74 4– 748

assigning costs to cost objects, 74 6– 748 determining activity rates, 746 identifying activities and costs, 74 4– 745,

75 6– 757 reducing costs, 748, 749, 757 tracing costs to cost pools, 74 5– 746

assessment of, 74 8– 751 advantages, 74 8– 750, 756 disadvantages, 750, 756 for service providers, 750 types of activities and, 75 0– 751, 756

defined, 743 demonstration problem, 75 3– 754 global view of, 752 overhead cost assignment, 73 8– 744

ABC rates and method, 74 3– 744 departmental overhead rate method,

74 0– 743 plantwide overhead rate method, 73 9– 740

Activity-based management (ABM), 749 Activity cost driver, 746 Activity cost pool, 743 Activity overhead (pool) rate, 743 Activity rates, determining, 746 Actual cost (AC), 903 Actual price (AP), 904 Actual quantity (AQ), 904 Additional business decision, 82 5– 826, 831,

98 7– 989, 99 5– 996, 997, 998 Additions, 347 Adelphia Communications, 13 adidas, 340, 428, 429, 430, 443, 445, 446,

618, 630 Adjusted bank balance, 275 Adjusted book balance, 275 Adjusted trial balance, 110, 111

demonstration of, 17 9– 182 in financial statement preparation, 11 0– 112 preparing from work sheet, 128, 129, 131

Adjusting accounts, 10 0– 110 accrued expenses, 10 5– 107 demonstration of, 12 2– 123 framework of, 10 0– 101 global view of, 120 links to financial statements, 109, 131 unearned (deferred) revenues, 10 4– 105

Adjusting entries, 101 for accrued expenses, 106, 107 for accrued revenues, 108 for accrued tax expense, 395 AFS securities, C - 6 for bad debts expense, 311 from bank reconciliation, 27 5– 276 for deferred revenues, 105 demonstration of, 123 for depreciation on factory assets, 662 effects on financial statements, 109, 123

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IND-2 Index

BET (break-even time), 102 6– 1027, 1030 Betterments, 347 Billing fraud, 613 BizChair.com, 335 Blue chips, 565 BMW, 910 BMX, 487, 491 Boanson, Jacqueline, 262 Board of directors, 5, 12, 467 Bond(s), 422

advantages of, 42 2– 423 amortization of discount (premium) ( See

Amortization ) assigning ratings to, 446, 449 basics of, 42 2– 424

financing, 42 2– 423, 448 issuing procedures, 424, 424 n trading, 423

debenture bonds, 436, 437, 449 debt features, 436, 448 default risk on, C - 16 disadvantages of, 423 global view of, 435 interpreting bond quotes, 423 issuances, 423, 42 4– 431

accruing bond interest expense, 44 5– 446, 448

contract v s . market rate, 425 at discount, 42 5– 427 between interest dates, 44 4– 446 at par, 42 4– 425 at premium, 42 8– 430 pricing, 430

junk bonds, 432 municipal (“munis”), 436 present values of bonds and notes,

44 0– 442, 448 annuities, 44 1– 442 compounding periods shorter than one year,

430, 442 present value concepts, 440 present value tables, 441, B - 10

retirement, 44 8– 449 by conversion, 432 demonstration, 440 at maturity, 431 before maturity, 43 1– 432

return and risk on, 27 Bond certificate, 424 Bond indenture, 424 Bonding of employees, 259 Bond rating services, 427, 446, 449 Bonuses

under absorption costing, 823, 824, 825, 831 bonus plans, 219, 236, 388, 402 budgets tied to, 853 linked to performance measures, 954

Bookkeeping, 4 Book of final entry, 61 Book of original entry, 61 Book value of assets, 104, 341

computing ARR, 1019 goodwill, 353 investments, 954, C - 8 keep or replace decision, 993, 994 sale of assets, 349 zero (fully depreciated), 348

effects of plant asset valuation, 337 examples of, A - 2, A - 10, A - 15, A - 19 global view of, 177 IFRS reporting on, 120 items reported in, 345, 350, 351 links to other financial statements, 69 long-term investments, C - 15, C - 16 for manufacturer, 61 9– 620, 625, 633

compared to other industries, 620, 633 finished goods inventory, 619, 620 goods in process inventory, 619, 620 raw materials inventory, 619, 620

for merchandiser, 173 notes payable reported on, 382 preferred stock issuance shown on, 477 preparation of

for point in time, 21 from trial balance, 69, 70, 110, 111, 125 from work sheet, 861 n

stockholders’ equity section, 488 unreported liabilities, 431 use in making credit decisions, 70, 76

Balance sheet expenditures, 346 Balance sheet methods, 309 Banana Republic, C - 9 Bank(s), 271, 272, 433 Bank account, 271 Banker’s rule (36 0 - day year), 107, 313, 382 Banking activities, 27 0– 276

bank reconciliation, 27 3– 276, 27 8– 279, 285 bank statement, 27 2– 273, 274 basic services, 27 0– 271, 272 borrowing, 38 2– 383, 394 collection of funds, 274 global view of, 277 online services, 271 payroll bank account, 400

Bank of America, 511 Bank reconciliation, 27 3– 276, 285

adjusting entries prepared from, 27 5– 276 demonstration of, 27 8– 279 illustrated, 27 4– 275 purpose of, 27 3– 274

Bank statement, 27 2– 273, 274 Bar code readers, 211 Bare Escentuals, 168 Bargain purchase option, 447 n barleyandbirch.com, 421 barley & birch, 421 Barnes & Noble, 188 Base amount, 571 Base period, 567, 569 Basic earnings per share, 485, 583 Basket purchase, 338 Baskin-Robbins, 383 Batch level activities, 750, 751 Bearer bonds, 436 Bear market, 580 Behavior, classification by, 61 4– 615, 617 Belnick, Sean, 335 Ben and Jerry’s, C - 18 Benchmark(s), 1024 Benchmarking, 908 Benchmarking budgets, 84 8– 849 Benefit period, 617 Berkshire Hathaway, 476 Best Buy, 302, 381, 389, 95 4– 955

AT&T, C - 14, C - 15 Audit, 13, 14, 612 Auditors, 13

external (independent) auditors, 5, 612 observation of inventory taking, 211 regular independent review by, 260 reports by, 261 review of voucher system, 282 Sarbanes-Oxley requirements for, 258

Authorized stock, 469 Automated teller machines (ATMs), 260, 271, 272 Automation, 707 Available-for-sale (AFS) securities, C - 3, C - 6, C - 19

accounting summary for, C - 10 fair value option for, C - 7 global view of, C - 11 note regarding, A - 6 selling, C - 7 valuing and reporting, C - 6 – C - 7

Average collection period, 318 n, 578 Average cost, 216, 217, 232 Average days’ sales uncollected, 318 n Average invested assets, 954 Average values, 567 Avia, 444, 445 Avoidable costs, 98 6– 987 Avoidable expenses, 993

Baby bond, 424 n Back to the Roots, 609 backtotheroots.com, 609 Bad debts, 306

aging schedule for, 310 allowance for uncollectibles, 311, 316, 321 allowance method of accounting for, 30 7– 308, 320

recording expense, 307 recovering bad debts, 308 writing off bad debts, 30 7– 308

direct write-off method of accounting for, 306, 307, 320

estimating, 320 accounts receivable turnover and, 577 by aging of receivables method, 31 0– 311, 320 demonstration of, 320 percent of receivables method, 309 percent of sales method, 30 8– 309, 320 summary of methods, 311

recording bad debts expense, 307 recovering, 306 writing off, 308, 588

Balance column accounts, 6 0– 61 Balanced scorecard, 627, 95 6– 957, 964 Balance per bank, 275 Balance per book, 275 Balance sheet, 20, 21, 22

account form and report form, 22 budgeted, 853, 86 0– 861, 861 n, 867, 870 classified ( See Classified balance sheet ) common-size, 571 comparative

horizontal analysis of, 56 7– 568, 586, 587 in preparing statement of cash flows, 516,

525, 526 demonstration of, 25, 26, 75 effects of inventory errors, 222 effects of merchandise inventory costing, 218

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Index IND-3

using Excel ® to compute, 1029 using in managerial decisions, 1023

payback period method, 101 6– 1019, 1025, 1030 computing with even cash flows, 1017 computing with uneven cash flows, 1018 demonstration of, 102 7– 1028 disadvantages of, 101 8– 1019 using in managerial decisions, 101 8– 1019

popularity of methods, 1025 time value of money

methods not using, 101 6– 1020 methods using, 102 0– 1025 tables used in, B - 10, B - 11

Capital expenditures, 346, 360 . See also Plant asset(s)

asset acquisition, 336 betterments, 347 extraordinary repairs, 347 impact on financial statements, 346, 361

Capital expenditures budget, 853, 858 Capital-intensive companies, 336, 355 Capitalization policy, 347 Capital leases, 353, 447 n, 447 Capital stock, 46 9– 470 . See also Common stock Capital structure, 485 n, 579 Careers in accounting, 6– 7 CarMax, 338 Carrying (book) value of bonds, 426 Cash, 26 3– 264, 284

converting receivables to, 31 5– 316, 320 custody separated from recordkeeping, 265 oversupply of, 858 payment of cash dividend, 19

Cash accounts, 53, 514, 515, 516 Cash basis accounting, 99 Cash budget, 266, 853, 85 8– 860, 866

cash receipts from sales, 85 8– 859, 866 disbursements for merchandise, 85 9– 860 disbursements for other items, 860 loan activity and, 860

Cash controls, 26 3– 270 cash, cash equivalents, and liquidity, 26 3– 264 cash disbursements ( See Cash disbursements) cash management, 264 cash receipts, 26 4– 266, 285 days’ sales uncollected ratio, 27 7– 278,

28 4– 285, 57 7– 578, 588 for entrepreneurs, 257 global view of, 277 voucher system as, 26 6– 267

Cash coverage of debt ratio, 529, 583 n Cash coverage of growth ratio, 529, 583 n Cash disbursements

control of, 26 6– 270, 285 cash budget, 266 petty cash ( See Petty cash fund) purchase discounts, 28 3– 284 voucher system, 26 6– 267, 28 0– 283

future payment of accrued expenses, 107 for merchandise and other items, 85 9– 860 operating cash payments ( See Operating cash

payments) transaction analysis, 1 7– 19, 62, 65

Cash discount, 165 Cash dividends, 491

accounting for, 473, 473 n deficits and, 47 3– 474

as management tool, 849 strategic budgeting, 848

Budget reports, 896, 898 Buildings, 54, 338, 351, 357 Buildings accounts, 54 Bulk purchase, 338 Bull market, 580 Business activities

accounting equation and, 2 7– 28 financing activities ( See Financing activities) investing activities ( See Investing activities) operating activities, 28, 511, 539

Business entities corporation ( See Corporation(s) ) partnership, 12, 467 proprietorship ( See Sole proprietorship )

Business entity assumption, 12, 466 Business segments, 588

notes regarding, 573, A - 8 segment elimination decision, 993

BusinessWeek magazine, 13, 100, 223, 389 Business year, 6 8– 69, 99 Bylaws, corporate, 467

Calculators, 430, 102 1– 1022, B - 5 Calendar-year companies, 69 Callable bonds, 436 Callable preferred stock, 479 Callaway Golf Company, 302, 352 Call option, 431 Call premium, 431 Call price, 479 Cameron, Andrew, 262 Canceled checks, 272 Canion, Rod, 781 Capital

contributed, 470, 48 1– 482 corporate ( See Stockholders’ equity ) ease of accumulation, 466, 479 minimum legal capital, 469 simple (complex) capital structure,

485 n, 579 working capital, 57 5– 576

Capital budgeting, 858, 101 4– 1030 accounting rate of return method, 101 9– 1020,

1025, 1030 break-even time method, 102 6– 1027, 1030 comparison of methods, 1025 defined, 1016 demonstration problem, 102 7– 1028 entrepreneurship, 1015 internal rate of return method, 102 3– 1025, 1030

demonstration of, 1027 with uneven cash flows, 1024 using Excel ® to compute, 1029 using in managerial decisions, 102 4– 1025

net present value method, 102 0– 1023, 1025, 1030 accelerated depreciation and, 102 2– 1023 decision rule for, 1021 demonstration of, 1027 global view of, 1026 inflation and, 1023, B - 10 salvage value and, 1022 simplified computations, 1021 n,

102 1– 1022, B - 11 uneven cash flows and, 1022

Book (carrying) value of bonds, 426 Book value per common share, 486, 487, 491 Book value per preferred share, 486, 487 Borrowing, 576

long-term, 21, 22 short-term, 38 2– 383, 394

Boston Beer, 336, 355, 383 Boston Celtics, 104, 390 Bot-Networking, 262 Bottom-line figure, 514 Bottom line items, 177 Bottom-up process, budgeting as, 850 Bowl America, 379 Brand (trade) names, 353 Braun, Ryan, 263 Break-even analysis, 78 4– 789

absorption v s . variable costing and, 82 7– 828 computing break-even point, 78 5– 786 computing margin of safety, 786 contribution margin, 78 4– 785 contribution margin income statement, 82 7– 828 CVP analysis as, 778 preparing CVP chart, 787, 796

Break-even chart, 787, 796 Break-even point, 778, 78 5– 786, 798

in composite units, 793, 794 demonstration of, 796, 797 multiproduct, computing, 79 3– 794, 798 revised, 789

Break-even sales dollars, 786 Break-even time (BET), 102 6– 1027, 1030 Break-even volume, in units, 828, 831 Briggs & Stratton, 620 Bristol-Myers Squibb, 13 Brokers, 565 Brunswick, 347, C - 9 The Buckle, 220 Budget, 848 . See also specific kinds of budgets Budget administration, 85 0– 852, 869 Budgetary analysis, 848 Budgetary control, 896 Budgetary slack, 849 Budget calendar, 852 Budget committee, 850 Budgeted balance sheet, 853, 86 0– 861, 861 n,

867, 870 Budgeted income statement, 853, 860, 861, 861 n,

867, 870 Budgeted statement of retained earnings,

867, 870 Budgeting, 848, 869

activity-based (ABB), 86 2– 863, 869, 870 as bottom-up process, 850 capital budgeting ( See Capital budgeting ) communication in, 84 9– 850 continuous, 85 1– 852 participatory, 849, 854 strategic, 848

Budget process flexible budgets, 89 6– 898

budget reports for evaluation, 897, 898 control and reporting, 89 6– 897 fixed budget performance report, 897

master budgets, 84 8– 850, 869 benchmarking budgets, 84 8– 849 communication in, 84 9– 850 human behavior and, 849

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IND-4 Index

Commitments, A - 7 – A - 8 Committee of Sponsoring Organizations (COSO),

259, 260 Common-size analysis. See Vertical analysis Common-size financial statements,

57 1– 572, 573 Common-size graphical analysis, 57 3– 574 Common-size percents, 571 Common stock, 13, 15, 468, 47 0– 472, 490, 491 .

See also Preferred stock book value per share, 48 6– 487 classes of, 469 demonstration, 48 7– 489 dividends on ( See Dividend(s) ) equity analysis of transactions, 526 global view of, 484 issuance

initial public offering, 467, 469 for noncash assets, 472 no-par value stock, 471 par value stock, 47 0– 471 stated value stock, 472

return on common stockholders’ equity, 581, 588 Common Stock account, 55 Common Stock Dividend Distributable

account, 475 Communicating business activities, 4 Communication, in budgeting, 84 9– 850 Companies

capital-intensive, 336, 355 comparisons, 565, 570, 574, 908 corporations ( See Corporation(s) ) entrepreneurship ( See Entrepreneurship) partnerships, 12, 467 public companies, 25 8– 259, 850 service companies ( See Service businesses) sole proprietorships, 12, 467

Compaq Computer, 781 Comparative financial statements, 566

balance sheets horizontal analysis of, 56 7– 568, 586, 587 in preparing statement of cash flows, 516,

525, 526 horizontal analysis of, 56 6– 569

comparative balance sheets, 56 7– 568, 586 comparative income statements, 569, 58 6– 587 computation of dollar and percent changes,

567, 567 n Comparative income statements, 569, 58 6– 587 Compensated absences, 388 Compensating control, 261, 285 Compensation plans, 14, 954, 1024 Competitive markets, 738 Complex capital structure, 485 n Composite unit, 793 Compounding, 440

compounding periods, B - 2, B - 3, B - 4, B - 10 semiannual, 430, 442

Compound journal entries, 63, 65, 276 Comprehensive income, C - 10

from AFS securities, C - 6 note regarding, A - 7 statements of (examples), A - 14, A - 18

Computerized accounting systems, 60, 61 Computer viruses, 261 Conceptual framework of accounting, 1 0– 13 Condemnation of property, 588

Certified public accountants (CPAs), 6– 7 CFA (certified forensic accountant), 7 CFE (certified fraud examiner), 7 cfenet.com, 260 CFM (Certified Financial Manager), 614 CFOs (chief financial officers), 7 Chairman of the board of directors, 467 Change analysis, 567, 567 n Change fund, 265 Change in accounting estimate, 345, 483,

58 9– 590 Charlie’s Brownies, 985 CharliesBrownies.com, 985 Chart of accounts, 22, 56, 76, 259 Chawan, Jay, 815 Check(s), 267, 271, 272

canceled, 272 NSF checks, 274, 27 5– 276 for payroll, 398, 399 payroll check, 398, 399

Check authorization, 281 “Checker” mobile payment system, 305 Check fraud, 274 Check kiting, 274 Check printing, 275 Check protectors, 260 Check register, 282 CHEESEBOY, 257 CheeseBoy.com, 257 Chevrolet Corvette, 902 Chief executive officer (CEO), 467 Chief financial officers (CFOs), 7 Chief operating officer (COO), 467 Chien, Misa, 51 CIA (certified internal auditor), 7 Classified balance sheet, 11 7– 119,

131, 176 categories in, 11 8– 119 classification structure, 117 global view of, 177

“Clawback,” 14 Clock cards, 660 Closely held corporations, 466 Closing entries, 112, 131, 188

demonstration of, 181 periodic system, 185 n, 18 5– 186 perpetual system, 173, 174 recording in work sheet, 11 2– 114

Closing entry method, 186 n Closing process, 11 2– 117

accounting cycle and, 11 6– 117 classified balance sheet and, 11 7– 119 reversing entries in, 117, 12 9– 131,

132, 171 temporary and permanent accounts, 112

CMA (certificate in management accounting), 7 CMA (Certified Management Accountant), 614 Coach, 162 Coca-Cola Company, 54, 222, 353, 566, 692, C - 2,

C - 14, C - 16 Codes of ethics, 7, 8 Cold Stone Creamery, 383 Collateral agreements, 436 Collection of funds by banks, 274 Collusion, 260, 262, 266 Columbia Sportswear, 379 Commercial substance of exchange, 35 8– 359

Cash dividends—Cont. demonstration, 490 liquidating cash dividend, 474

Cash equivalents, 263, 264, 284 cash flows from, 511 note regarding, A - 6 as short-term investments, C - 2

Cash flow(s) analysis of, 514, 527, 540 from bond issuance, 428 in computing payback period, 1017 domestic v s . international, 526 from financing activities, 52 5– 527, 528, 534, 540

equity analysis, 526 noncurrent liability accounts, 525 proving cash balances, 527 ratio analysis ( See Cash flow ratios) reporting, global issues in, 527 in statement of cash flows, 21, 22 three-stage analysis, 525

free cash flows, 528 future cash flows from bonds, 426 from investing activities, 21, 22, 528, 534, 540

analysis of, 52 3– 524 global issues in reporting, 527

misclassification of, 512 monitoring, 512 from operating activities ( See Operating cash flows) positive and negative, 513 predicting, 1016

Cash flow on total assets ratio, 52 8– 529, 540, 583 n Cash flow ratios

cash coverage of debt, 529, 583 n cash coverage of growth, 529, 583 n cash flow on total assets, 52 8– 529, 540, 583 n operating cash flow to sales, 529

Cash inflows, 511 Cash outflows, 511 Cash over and short, 26 5– 266, 270 Cash payments. See Cash disbursements Cash purchases, 16, 17, 61, 62, 64 Cash receipts

from accounts receivable, 18, 63 from customers, 26 4– 266, 53 5– 536 operating cash receipts, 53 5– 536 from sales, 305, 85 8– 859, 866

Cash registers, 53, 260, 264, 266 Cash sales, 17 Catalina Marketing, 10 Catalog price, 164 Catastrophe (“act of God”), 588, 589, 591 CB (certified bookkeeper), 7 CE (cycle efficiency), 958, 964 Cedar Fair, 437 Center for Women’s Business Research, 54 CEO (chief executive officer), 467 Ceridian Connection, 387 Certificate in management accounting (CMA), 7 Certified bookkeeper (CB), 7 Certified Financial Manager (CFM), 614 Certified forensic accountant (CFA), 7 Certified fraud examiner (CFE), 7 Certified Fraud Examiners, Association of, 259,

262, 613 Certified internal auditor (CIA), 7 Certified Management Accountant (CMA), 614 Certified payroll professional (CPP), 7

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Index IND-5

Cost assignment and reconciliation under absorption v s . variable costing, 82 0– 822 FIFO method of process costing, 71 3– 715 process costing illustration, 70 2– 705

ending goods in process, 703 process cost summary, 70 4– 705 units completed and transferred, 703

Cost-based transfer pricing, 962 Cost basis, 359 Cost behavior, expenses grouped by, 81 8– 819 Cost-benefit constraint, 13, 211, 306, 347 Cost-benefit principle, 262 Cost centers, 943, 944, 945 Costco, 164, 302 Cost control, 962 Cost equation, 783 Cost flow(s)

under ABC method, 74 3– 744, 756 under departmental overhead rate method,

74 0– 741 inventory cost flow assumptions, 212,

213, 222 in job order cost accounting, 65 6– 657, 671

labor cost flows, 66 0– 661 materials cost flows, 65 8– 659 overhead cost flows, 66 1– 663, 715 summary of, 66 3– 664

for merchandisers, 163, 172, 188 under plantwide overhead rate method, 739

Cost flow summary, 706 Cost method, 48 0– 481 Cost object(s), 615, 617, 739, 74 6– 748 Cost of capital, 1020 Cost of goods available for sale, 213, 225 Cost of goods manufactured, 62 3– 625, 630, 631,

70 5– 706 Cost of goods sold, 162, 715

budgeted, 865 for manufacturer, 633 for merchandiser, 621, 631 as operating expense, 53 6– 537 under periodic inventory system, 184, 186, 214,

215, 225 shown in income statement, 173 summary entry for, 706

Cost per equivalent unit, 702, 707, 709, 71 2– 713 Cost-plus basis jobs, 655 Cost-plus contracts, 613 Cost-plus price setting, 99 4– 995 Cost pools

activity cost pool, 743 activity rates, 746 assigning costs to, 74 4– 745 tracing overhead costs to, 74 5– 746

Cost principle, 11, 104, 337, 360 Costs accounted for, 703, 710, 713 Costs charged to production, 70 4– 705 Costs of quality, 750 Costs to account for, 703, 710, 713 Cost to be depreciated, 340 Cost-to-retail ratio, 234 Cost variance(s), 903 n, 90 3– 906

analysis of, 903, 914, 915 computation of, 90 3– 904 demonstration of, 914, 915 labor cost variances, 90 5– 906, 920 materials cost variances, 90 4– 905

Conversion costs, 619 Conversion costs per equivalent unit, 707 Convertible bonds, 436 Convertible preferred stock,

47 8– 479, 484 COO (chief operating officer), 467 Cook, Ashley, 97 Cook, Catherine, C - 1 Cook, Dave, C - 1 Cook, Tim, 860 Cooper, Karen, 377 Copyrights, 352, 353 Copyright Term Extension Act (CTEA), 353 Corporate bonds, 27 Corporate capital. See Stockholders’ equity Corporate income taxes. See Income taxes Corporation(s), 1 2– 13, 2 8– 29, 46 4– 491

capital structure of, 485 n, 579 common stock ( See Common stock ) core values of, 626 defined, 12, 466 demonstration problems, 48 7– 489, 490 entrepreneurship, 465 equity reporting, 48 2– 484

global view of, 484 statement of retained earnings ( See Statement

of retained earnings ) statement of stockholders’ equity, 483, 484,

A - 4, A - 12, A - 17, A - 21 stock options, 48 3– 484

form of organization, 46 6– 470 capital stock basics, 46 9– 470 characteristics, 46 6– 467, 490 disadvantages, 467 organization and management, 467 stockholders, 468

preferred stock ( See Preferred stock ) treasury stock ( See Treasury stock )

Corrin, Matthew, 847 COSO (Committee of Sponsoring Organizations),

259, 260 Cost(s), 337, 339

allocation of, 337, 357, 96 3– 964 behavior of, identifying, 77 8– 781, 798 classification of, 61 4– 617

by behavior, 61 4– 615 by controllability, 615 demonstration of, 62 8– 629 by function, 61 6– 617 by relevance, 616 by traceability, 615

controllable and uncontrollable, 826 expenses contrasted, 943 n to implement and maintain ABC, 750 of intangible assets, 35 1– 352, 360 of inventory ( See Inventory(ies) ) managerial cost concepts, 61 4– 618 for manufacturer, 61 8– 619 of plant assets, 339

buildings, 338 demonstration, 357 determination of, 33 7– 338 land improvements, 338 lump-sum purchases, 338 machinery and equipment, 338

recognized in sales, 169 Cost accounting system, 654

Congress, U.S., 626 Conservatism constraint, 13, 220 Consignee, 210 Consignor, 210 Consistency concept, 219, 58 9– 590 Consolidated financial statements, C - 9, C - 18

balance sheets, A - 2, A - 10, A - 15, A - 19 income statements, A - 3, A - 14, A - 18 statements of cash flow, A - 5, A - 13, A - 16, A - 20 statements of comprehensive income, A - 14, A - 18 statements of operations, A - 11 statements of shareholders’ equity, A - 4, A - 12,

A - 17, A - 21 Consolidation method, C - 3, C - 11 Contingent liabilities, 39 0– 391, 402

accounting for (conditions determining), 390 disclosure of, 390, 394 IFRS on, 380 notes regarding, 390, A - 7 – A - 8 reasonably possible, 39 0– 391 uncertainties, 37 9– 380

Contingent valuation, 391 Continuing operations, 588 Continuous budgeting, 85 1– 852 Continuous improvement, 626, 850, 902 Continuous life of corporations, 466 Contra accounts, 103, 104

contra asset accounts, 10 3– 104, 307, 346 contra equity accounts, 55 contra purchases accounts, 183 contra revenue accounts, 170

Contract rate on bonds, 425, 426 Contractual restrictions, 482 Contributed capital, 470, 48 1– 482 Contributed capital, 15 Contribution format, 826 Contribution margin, 962, 992

in CVP analysis, 78 4– 785, 793, 794, 795 in variable v s . absorption costing, 81 8– 819

Contribution margin budget format, 899 Contribution margin income statement, 786,

81 8– 819 in break-even analysis, 82 7– 828 in cost-volume-profit (CVP) analysis, 791, 792, 794 differences in cost per unit and, 824 units produced are less than units sold, 821, 822 units produced equal units sold, 81 8– 819 units produced exceed units sold, 820, 821

Contribution margin per unit, 785 in break-even analysis, 828 in CVP analysis, 78 4– 785, 79 3– 796, 798

Contribution margin ratio, 785, 797, 798 Contribution margin report, 819, 831 Contributors to nonprofit organizations, 5 Control, 611 . See also Internal control(s)

budgetary control, 896, 898 of cash ( See Cash controls) of corporation by board of directors, 467

Controllability, classification by, 615, 617 Controllable costs, 615, 826, 943, 943 n Controllable variances, 90 8– 909, 910, 915 Controlling accounts, 211, 303 Controlling influence, C - 3, C - 18 “Convenience” financial statements, 572 Convergence process, 9– 10, 23, 7 0– 71 Converse, 72, 340, 432 Conversion, 432

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IND-6 Index

DDB (double-declining-balance) depreciation, 342, 343

Dealer holdback programs, A - 7 Debenture bonds, 436, 437, 449 Debit(s), 57 n, 57, 59, 65, 76 Debit balance, 57, 311 Debit card(s), 304 Debit memorandum(a), 166, 27 2– 273, 274, 275 Debt guarantees, 390 Debtors, 53, 382 Debt ratio, 7 1– 72, 76, 579, 588 Debt securities

accounting basics, C - 3 – C - 4 available-for-sale securities, A - 6, C - 3, C - 6 – C - 7,

C - 10, C - 11, C - 19 classification of, C - 3, C - 18 held-to-maturity securities, C - 3, C - 6, C - 7, C - 10,

C - 11, C - 19 motivation for investment, C - 2 – C - 3 trading securities, C - 3, C - 5 – C - 6, C - 10, C - 11

Debt-to-equity ratio, 43 6– 437, 448, 449, 579, 588 Decision making

analyzing cash flows in, 514, 540 analyzing cash sources and uses, 528 credit decisions, 70, 76, 178, 188 decision to accept credit cards, 305, 320 direct costs and, 615 ethics of ( See Ethics ) managerial ( See Managerial decisions) role of statement of cash flows in, 51 0– 511 using managerial accounting, 613

Decision rule, 1021 Declining-balance depreciation, 34 2– 343,

344, 360 Defective merchandise, 167, 171 Deferrals

expenses ( See Prepaid expenses ) income tax liabilities, 40 1– 402 revenues ( See Unearned revenue(s) )

Deferred income tax asset, 402 Deferred income tax liability, 40 1– 402 Defined benefit pension plan, 448 Defined contribution pension plan, 448 Definitely determinable liabilities.

See Known liabilities Degree of operating leverage (DOL), 795, 798 Dell, Inc., 24, 317, 628 Deloitte, 7 Delta Air Lines, 347 Deltic Timber, 342 Demand, 992 Demand deposits, 263 Demand-pull system, 626 Department(s), 942 Departmental contribution to overhead, 951 n,

95 1– 952 Departmental evaluation, 94 2– 943 Departmental expense allocation

allocation of indirect expenses, 94 5– 947, 964 departmental contribution to overhead, 951 n,

95 1– 952 direct and indirect expenses, 94 5– 946, 964

Departmental expense allocation spreadsheet, 94 8– 949, 95 9– 960

Departmental income statements, 945, 94 7– 951, 948 n, 964

accumulating revenues and expenses, 948

Current liabilities, 37 6– 402 changes in, 52 0– 521 characteristics of, 37 8– 380 classification of, 379 contingent liabilities

accounting for (conditions determining), 390 disclosure of, 390, 394 IFRS on, 380 notes regarding, 390, A - 7 – A - 8 reasonably possible, 39 0– 391 uncertainties, 37 9– 380

defined, 119, 379 demonstration of, 39 3– 395 entrepreneurship, 377 estimated, 38 7– 389, 402

bonus plans, 388 global view of, 392 health and pension benefits, 387 multi-period, 389 vacation benefits, 388 warranty liabilities, 38 8– 389

global view of, 39 1– 392 known liabilities, 38 0– 387, 402

accounts payable ( See Accounts payable) global view of, 391 multi-period, 38 6– 387 payroll ( See Payroll liabilities) sales taxes payable, 38 0– 381, 381 n short-term notes payable, 38 1– 383 unearned revenues, 381

Current portion of long-term debt, 387 Current ratio, 12 1– 122, 131, 379

ability to meet loan payments and, 122, 132 in analysis of financial statements,

57 5– 576, 588 Curvilinear costs, 781, 788 Customer(s), 6, 53, 170, 30 2– 303, 655 Customer lists, 354 Customer orientation, 62 5– 626, 627, 707 Customer profitability, 749, 752 Customer satisfaction, 943, 956, 957 Customer service, 700 Customers ledger, 382 Customized production, 65 4– 655 Custom products, 666, 739, 740, 74 6– 747 CVP analysis. See Cost-volume-profit

(CVP) analysis CVP (cost-volume-profit) chart, 787, 796 Cybercrime.gov, 262 Cybersleuthing, 267 Cycle efficiency (CE), 958, 964 Cycle time (CT), 698, 95 7– 958, 964

Dale Jarrett Racing Adventure, 345 Dankner, Danielle, 97 Data entry errors, 261 Date of declaration, 473 Date of payment, 473, 475 Date of record, 473 Days’ cash expense coverage ratio, 264, 583 n Days’ sales in inventory ratio, 22 3– 224,

236, 578 Days’ sales in raw materials inventory, 628, 633 Days’ sales in receivables ratio, 27 7– 278 Days’ sales uncollected ratio, 27 7– 278, 28 4– 285,

57 7– 578, 588

Cost-volume-profit (CVP) analysis, 77 6– 798 application of, 78 9– 794, 798

computing income from sales and costs, 78 9– 790

computing sales for target income, 79 0– 791, 796, 797

ethical issues, 791, 799 multiproduct break-even point, 79 3– 794, 798 sensitivity analysis, 792

break-even analysis used in, 78 4– 789 computing break-even point, 78 5– 786 computing margin of safety, 786 contribution margin, 78 4– 785 preparing CVP chart, 787, 796

contribution margin income statement in, 819 defined, 778 demonstration of, 79 5– 797 entrepreneurship, 777 identifying cost behavior, 77 8– 781

fixed costs, 77 8– 779 mixed costs, 780 step-wise costs, 78 0– 781 variable costs, 778, 779, 780

making assumptions in, 78 8– 789 measuring cost behavior, 78 1– 784

comparison of methods, 784 least-squares regression, 78 3– 784,

79 7– 798 scatter diagrams ( See Scatter diagrams )

for start-up companies, 787, 799 use of Excel ® in , 78 3– 784, 79 7– 798

Cost-volume-profit (CVP) chart, 787, 796 Counterfeit checks, 274 Coupon bonds, 436 Coupon rate on bonds, 425 CPAs (certified public accountants), 6– 7 CPP (certified payroll professional), 7 Crackers (criminal hackers), 262 Credit(s), 57 n, 57, 59, 65, 76 Credit approval, 307 Credit balance, 57 Credit card(s), 304, 305, 308, 320 Credit card association fees, 304 Credit card number theft, 261, 262 Credit card sales, 30 4– 305 Credit memorandum, 171, 272 Creditor(s), 54, 382, 436 Creditor financing, 27 Creditors ledger, 372 Credit period, 165 Credit purchases, 17, 62 Credit risk ratio, 317, 583 n Credit sales, 53, 30 2– 304

in foreign currency, C - 17 net, in accounts receivable turnover, 317 posting, 303 receivables, 301 services and facilities, 18

Credit terms, 165 CT (cycle time), 698, 95 7– 958, 964 CTEA (Copyright Term Extension Act), 353 Cumulative preferred stock, 47 7– 478 Cumulative total of net cash flows, 1018 Cunningham, Paul, 777 Currency counters, 260 Currency translation. See Foreign currency translation Current assets, 11 8– 119, 51 8– 520, 576, 620

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Index IND-7

DOL (degree of operating leverage), 795, 798 Dollar changes, 567 Domini Social Index (DSI), 8 Domino’s Pizza, 379 Dorsey, Jack, 3 Double-declining-balance (DDB) depreciation,

342, 343 Double-declining-balance depreciation

schedule, 343 Double-entry accounting, 5 7– 58, 64, 76 Double taxation of corporations, 13, 2 8– 29, 467 Dow Chemical Company, 424 “Drivers” of future financial performance, 627 DSI (Domini Social Index), 8 Dukes, Kenny, B - 1 Dun & Bradstreet, 24, 355, 564, 566 Dunkin’ Donuts, 383

Earnings. See Net income Earnings per share (EPS), 485, 491

basic, 485 diluted, 485 n sustainable income, 589

Earnings quality, 171, 529 Earnings statement. See Income statement Eastman Kodak Company, C - 3 eBay, 261, 336 Ebbers, Bernard, 9, 267 E-cash, 516 ECG (electrocardiogram), 260 E-charting, 1018 Echostar, 10 E-commerce, 26 1– 262, 626 Economic Value Added (EVA ® ), 954 Economies of scale, 779, 792 EDGAR (Electronic Data Gathering, Analysis, and

Retrieval) database, 16, A - 1 Effective interest method (amortization), 44 2– 444

demonstration of, 43 9– 440 discount on bonds payable, 44 2– 443, 448 premium on bonds, 44 3– 444, 448

Efficiency, 565, 575 Efficiency variance(s), 90 4– 906, 915, 916, 919, 920 EFT (electronic funds transfer), 271, 305, 400 Electrocardiogram (ECG), 260 Electronic Data Gathering, Analysis, and Retrieval

(EDGAR) database, 16, A - 1 Electronic Data Systems, 10 Electronic funds transfer (EFT), 271, 305, 400 Electronic monitoring of operations, 694 Elements of financial accounting, 10 Emerging markets, C - 16 Employee(s), 5, 946

bonded, 259 fraud committed by, 260 illegal acts by ( See Fraud; Illegal acts) payroll deductions for ( See Payroll deductions ) payroll records of, 398, 399 as users of financial information, 5

Employee benefits, 387, 388 Employee earnings report, 398, 399 Employer payroll tax liabilities, 38 5– 386, 402

FICA tax, 385 FUTA and SUTA, 386 recording, 386 summary of, 400

Direct labor hours (DLH), 73 9– 740, 741 Direct labor variances, 919 Direct material(s), 618, 620 Direct materials budget, 86 8– 869 Direct materials costs, 618, 631, 715, 738

cost per equivalent unit, 702 equivalent units of production, 700 in job order costing, 655, 656 in process cost accounting system, 695, 696 shown in manufacturing statement, 623, 624 units finished and transferred, 703

Direct materials variances, 918 Direct method of reporting cash flows, 51 6– 517, 518

operating cash flows, 53 5– 539, 540 indirect method compared, 51 6– 517, 518 operating activities section format, 539 operating cash payments, 53 6– 539 operating cash receipts, 53 5– 536 summary of adjustments for, 539

Direct stock sale, 469 Direct write-off method, 306, 307, 320 Discount(s) . See also Interest

cash discounts, 165, 166, 166 n, 167, 188 purchase discounts ( See Purchase discount(s) ) sales discounts, 165, 170, 184 trade discounts, 164

Discounting, 1016 Discount on bonds payable, 42 5– 427

amortizing, 42 6– 427, 44 2– 443, 448 issuance, 425 present value of, 430

Discount on stock, 471 Discount period, 165 Discount rate(s), 1021, 1023, 1025, 1030, B - 2 Discounts Lost account, 283 Discover, 308 Dishonored note, 314, 320 Disposal of assets

debt securities, C - 4 equity securities, C - 4 plant assets, 337

by discarding, 348, 357, 360 by exchange, 35 8– 359, 360 salvage value and, 339 by selling, 34 8– 349, 360, 519, 522

Distributed earnings, C - 8 Dividend(s), 15, 55, 47 3– 476

cash dividends, 473 n, 47 3– 474, 490 declaration of, 526 on equity securities, C - 4 global view of, 484 payment of cash dividend, 19 on preferred stock, 47 7– 478, 478 n, 485 right of stockholders to receive, 468 in stock ( See Stock dividends ) stock splits, 476, 491

Dividend allocation table, 489 Dividend in arrears, 477, 478 Dividends account, 55, 114 Dividend yield ratio, 486, 491, 582 DLH (direct labor hours), 73 9– 740, 741 Documentation

in job order cost system, 656, 657, 65 8– 663, 671 source documents ( See Source documents ) in voucher system ( See Voucher system )

Dodd-Frank Wall Street Reform and Consumer Protection Act, 14

allocation of service department expenses, 948 n, 94 8– 951

demonstration of, 95 8– 960 preparation of, 951 spreadsheet used in, 94 8– 949

Departmentalization, 942 Departmental overhead rate method, 738, 739,

74 0– 743, 756 ABC compared to, 748 application of, 74 1– 742 assessment of, 743, 756 cost flows under, 74 0– 741 demonstration of, 753, 755 plantwide method compared, 742, 743,

75 5– 756 Depletion, 35 0– 351, 590 Deposits in transit, 274 Deposit ticket, 271 Depreciable basis, 104 Depreciable cost, 340, 345 Depreciation, 103, 33 9– 346

accelerated, 102 2– 1023 adjusting entries for, 662 change in estimates for, 345 change in method, 590 decision ethics, 346, 360 demonstration of, 357 disposal of plant assets and, 348 factors in computing, 339 methods, 34 0– 344, 360

comparison of, 34 3– 344 declining-balance method, 342, 343, 344, 360 double-declining-balance method, 342, 343 popularity of various methods, 344 straight-line method, 103, 34 0– 344, 360, 1019 for tax reporting, 344, 40 1– 402, 102 2– 1023 units-of-production method, 34 1– 344, 350,

351, 360 partial-year, 344, 360 as prepaid expense, 10 3– 104 reporting, 34 5– 346 up-to-date, 348, 357

Depreciation expense, 521, 524, 538, 947 Depreciation per unit, 342 Depreciation schedules, 104, 132, 341,

342, 343 Depreciation tax shield, 1022 Diamond Foods, Inc., 100 Differential costs, 988 Diluted earnings per share, 485 n Dilutive securities, 485 n Direct costs, 615

decision making and, 615 ethical dilemmas, 708, 716 labor costs ( See Direct labor costs ) materials ( See Direct materials costs ) in process cost accounting, 695

Direct expenses, 945, 948, 964 Direct labor, 618 Direct labor budget, 869 Direct labor costs, 618, 631, 715, 738

cost per equivalent unit, 702 equivalent units of production, 700 in process cost accounting systems, 695, 697 shown in manufacturing statement,

623, 624 units finished and transferred, 703

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IND-8 Index

in managerial accounting, 61 3– 614, 633 use of principles and scruples, 10

Eubank, Chelsea, 161 EUP. See Equivalent units of production European Union, C - 16 EVA ® (Economic Value Added), 954 Even cash flows, 1017, 1023 Events, 16 Everson, Mark W., 385 Excel ® software

in computing IRR, 1024, 1029 in computing NPV, 1022, 1029 in least-squares regression, 78 3– 784, 79 7– 798

Exemption from withholding, 384 Expanded accounting equation, 15 Expanded income statement, 952 Expanded overhead variances, 91 6– 918

computing variable and fixed variances, 91 6– 917 fixed overhead cost variances, 917, 918 formulas for, 917 variable overhead cost variances, 91 7– 918

Expenditure planning, 264 Expense accounts, 56, 114, 115

closing to Income Summary, 113 recording prepaid expenses in, 12 5– 126, 13 1– 132

Expense recognition principle. See Matching principle

Expenses, 15, 56 accrued ( See Accrued expenses ) accumulating, 948 asset-related, 337 avoidable and unavoidable, 993 costs contrasted, 943 n direct and indirect, 94 5– 946, 948, 964 early recording of, 100 fixed or variable, 392 general and administrative, 175 joint relation with sales, 571 miscellaneous, 26 5– 266 notes regarding, A - 6 operating expenses, 175 organization expenses, 467 payment of, in cash, 1 7– 18, 62, 65 prepaid ( See Prepaid expenses ) selling expenses, 175

Explanation of transactions, 59, 60 Export sales, 315 Expropriation of property, 588 External audit, 14 External auditors, 5 External failure costs, 750 External transactions, 16 External users of accounting information, 5– 6, 9,

510, 564, 611, 612 Extraordinary gains and losses, 588 Extraordinary repairs, 347 ExxonMobil, 692

Facebook, Inc., 3, 99, 467 Face-recognition software, 260 Face value of note payable, 382 Facility level activities, 750, 751 Factor, 315 Factoring fee, 315 Factory overhead, 61 8– 619, 656, 66 5– 666 Factory overhead budget, 869

Equivalent units of production (EUP), 69 9– 700, 715

cost per equivalent unit, 702, 707, 709, 71 2– 713 demonstration, 709 differences in equivalent units, 69 9– 700 FIFO method

cost per equivalent unit, 71 2– 713 equivalent units of production, 71 1– 712

goods in process, 699 process costing illustration, 70 1– 702 in process cost summary, 70 4– 705 weighted-average method, 70 1– 702

Ernst & Young, 7, 10 Errors

correction of adjusting entries for, 276 in bank statements, 272, 273, 274 in preparing trial balance, 6 7– 68, 68 n

data entry errors, 261 effects of inventory errors, 22 0– 222,

228, 236 human error, 262, 265 in petty cash system, 269 transposition errors, 68 n

Error testing, 274 Escapable expenses, 993 Estimate(s)

acceptable in managerial accounting, 612 changes in, 345, 483, 58 9– 590, 789 of cost behavior in CVP analysis, 78 1– 784 from CVP analysis, 788 for depreciation, 339, 341 inventory estimation methods, 23 4– 235 note regarding use of, A - 6 in sensitivity analysis, 792

Estimated liabilities, 38 7– 389, 402 bonus plans, 388 global view of, 392 health and pension benefits, 387 multi-period, 389 vacation benefits, 388 warranty liabilities, 38 8– 389

Estimated line of cost behavior, 782 Ethical hackers, 262 Ethics, 7– 8, 28, 614

codes of ethics, 7, 8 decision ethics

application of CVP analysis, 791, 799 budget deviations, 902, 920 budgeting, 849, 870 capital budgeting, 1022, 1030 cash register receipts, 53, 76 cost allocation, 698, 716 cost-plus contracts, 613 depreciation, 346, 360 direct and indirect costs, 708, 716 favorable cash discounts, 167, 188 forms of business organization, 13,

2 8– 29 manager bonuses tied to sales, 825, 831 methods of allocating costs, 743, 756 overhead allocation, 663, 671 payroll taxes, 386, 402 pressure to pursue fraudulent accounting,

109, 132 guidelines for decisions, 8 impact of SOX regulations, 14

Employer’s Quarterly Federal Tax Return (Form 941), 395, 396

Encryption, 261, 262 Ending goods in process, 703, 712, 713 Ending inventory, 22 1– 222 End of month (EOM), 165 Enron, 9, 12, 13, 14 Entrepreneurship

activity-based costing, 737 capital budgeting, 1015 cash controls, 257 cash flow monitoring, 509 cost-volume-profit (CVP) analysis, 777 current liabilities and payroll, 377 financial statement(s), 3, 97 financial statement analysis, 563 flexible budgets, 895 international operations, C - 1 inventories and costs, 209 job order cost accounting, 653 liability monitoring, 421 long-term assets, 335 managerial accounting, 609 managerial decisions, 985 master budgets, 847 merchandisers, 161 performance measurement, 941 process cost accounting, 691 receivables, 301 transaction analysis, 51 variable costing, 815 women-owned businesses, 51, 54, 97, 161, 377,

421, 737, C - 1 Environmental controls, 356, 361 Environmental damages, 391 Environmental issues, 707 EOM (end of month), 165 EPS. See Earnings per share Equal total payments, 433 Equipment, 17, 54, 338, 351, A - 6 Equipment accounts, 54 Equity, 15, 28, 55

analysis of, 526 in classified balance sheet, 119 decreased by expenses, 56 minority interest included in, 579 reporting, 48 2– 484

global view of, 484 statement of retained earnings ( See Statement

of retained earnings ) stockholders’ equity ( See Statement of

stockholders’ equity ) stock options, 48 3– 484

stockholders’ equity ( See Stockholders’ equity )

Equity accounts, 5 5– 56, 115 Equity in earnings of affiliates, C - 11 Equity in earnings of associated

companies, C - 11 Equity method, C - 3, C - 8 – C - 9, C - 11 Equity method with consolidation, C - 9 Equity ratio, 579 Equity securities, C - 2, C - 3, C - 4, C - 18 Equity securities with controlling influence, C - 3,

C - 9, C - 18 Equity securities with significant influence, C - 3,

C - 8 – C - 9, C - 19

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Index IND-9

Financial statement preparation, 97, 111 from adjusted trial balance, 11 0– 112, 12 4– 125, 131 balance sheet ( See Balance sheet ) income statement ( See Income statement ) for merchandisers, 173 periodic inventory system, 186 statement of cash flows ( See Statement of

cash flows ) from transactions, 76 from trial balance, 67, 6 8– 70, 110, 111 from work sheet, 128

Financing activities, 27, 28, 512, 540 accounting equation and, 27 cash flows from, 52 5– 527, 528, 534, 540

ratio analysis ( See Cash flow ratios) in statement of cash flows, 21, 22

Fingerprint identification, 260 Finished goods inventory, 619, 620, 631, 656, 657,

670, 694, 70 5– 706, 715 Firewalls, 26 1– 262 First-in, first-out (FIFO), 215, 576

periodic inventory system, 231, 236 demonstration, 228 financial statement effects, 23 3– 234

perpetual inventory system, 212, 215, 236 cost flow assumptions, 212, 213 demonstration, 22 5– 226 financial statement effects, 218

First Industrial Realty, 306 First-stage assignment, in ABC method, 74 4– 746 First Tennessee National Corporation, 750 Fiscal year, 6 8– 69, 99 Fitch, 427 Fixed assets. See Plant asset(s) Fixed budget, 897 Fixed budget performance report, 897 Fixed costs, 614, 615

in CVP chart, 787, 796 in flexible budgets, 898, 899 identifying cost behavior, 77 8– 779 step-wise costs treated as, 78 0– 781

Fixed costs per unit, 779, 783 Fixed expenses, 392, 819, 820, 821 Fixed overhead

under absorption v s . variable costing, 820, 824

decision to accept new business and, 82 5– 826

treatment of costs, 82 4– 825 overhead cost variances and, 909

Fixed overhead cost deferred in (ending) inventory, 823

Fixed overhead cost recognized from (beginning) inventory, 823

Fixed overhead cost variances, 917, 918 Fixed overhead rate, 908 Fixed variances, 91 6– 917 Fleming, 162 Flexibility of practice, 611, 612 Flexible budget(s), 89 6– 901, 920

budgetary process, 89 6– 898 budget reports for evaluation, 897, 898 control and reporting, 89 6– 897 fixed budget performance report, 897

defined, 898 demonstration of, 913 entrepreneurship, 895

Financial calculators, 430, 102 1– 1022, B - 5 Financial leverage, 7 1– 72, 422, 479, 579 Financial management, 27 Financial measures of investment center

performance, 95 3– 955, 964, 965 Financial regulation, 584 Financial reporting, 565 Financial statement(s), 2 0– 22, 28

balance sheet ( See Balance sheet ) comparability of, 99 demonstration of, 2 4– 27 examples of, A - 2 – A - 21

Arctic Cat, A - 10 – A - 13 KTM, A - 14 – A - 17 Piaggio, A - 18 – A - 21 Polaris, A - 2 – A - 9

formats of, 21, 70, 17 4– 176 classified balance sheet, 176 multiple-step income statement, 17 5– 176,

18 0– 181, 188 single-step income statement, 176, 181, 188

GAAP v s . IFRS on, 71 global view of, 2 2– 23 income statement ( See Income statement ) interim statements, 234 links among, 21, 68, 69, 109 links to adjusting entries, 109 preparation of ( See Financial statement

preparation) presentation basis of, A - 6 pro forma statements, 128 statement of cash flows ( See Statement of

cash flows ) statement of retained earnings ( See Statement

of retained earnings ) Financial statement analysis, 56 2– 590

analysis reporting, 58 4– 585 basics of, 56 4– 566

building blocks of, 56 4– 565, 590 information for analysis, 565 purpose of, 564 standards for comparisons, 566, 590 tools of analysis, 566

“convenience” statements, 572 defined, 564 demonstrations, 58 5– 588 entrepreneurship, 563 horizontal analysis, 563, 56 6– 571, 590

comparative statements, 56 6– 569 global view of, 584 trend analysis, 56 9– 571

ratio analysis ( See Ratio analysis; individual ratios ) sustainable income and, 58 8– 590 vertical analysis, 563, 566, 57 1– 574, 590

common-size graphics, 57 3– 574 common-size income statements, 572, 573 global view of, 584

Financial statement analysis report, 58 4– 585, 590 Financial statement effects

of adjusting entries, 109, 123 of cost classification, 346 of inventory errors, 21 8– 220, 226, 236 of merchandise inventory costing

demonstrations, 228, 229 periodic inventory system, 23 3– 234 perpetual inventory system, 21 8– 219

of straight-line depreciation, 341

Factory overhead costs, 616, 61 8– 619, 624, 625, 631 flow of, 715 in process cost accounting, 695, 69 7– 698

Factory overhead ledger, 658, 660 Fair value, 354 Fair value adjustment, C - 5 Fair value option, 435, C - 3, C - 7, C - 10 Faithful Fish, 161 FaithfulFish.com, 161 Fannie Mae, 13, 120 FASB. See Financial Accounting Standards

Board (FASB) FASB.org, 10 Fasciana, Sal, 301 Fastow, Andrew, 9 Favorable cash discounts, 166, 166 n, 167, 188 Favorable purchase discounts, 166, 166 n Favorable variances, 897, 903 n FDIC (Federal Deposit Insurance Corporation), 579 Federal Deposit Insurance Corporation (FDIC), 579 Federal depository banks, 395 Federal Express (FedEx), 955 Federal income taxes. See Income taxes Federal Insurance Contributions Act (FICA), 395 Federal Insurance Contributions Act (FICA)

taxes, 384, 385 Federal Trade Commission (FTC), 267 Federal Unemployment Taxes (FUTA), 386 Federated Department Stores, 510 Fencing stolen assets, 263 Feverish Ice Cream, 209 FeverishIceCream.com, 209 F&F (furniture and fixtures), 119 FICA (Federal Insurance Contributions Act), 395 FICA (Federal Insurance Contributions Act)

taxes, 384, 385 Fictitious employee fraud, 387 FIFO method of process costing, 71 1– 715

assigning and reconciling costs, 71 3– 715 change to weighted-average method, 715, 716 cost per equivalent unit, 71 2– 713 equivalent units of production, 71 1– 712

beginning goods in process, 712 ending goods in process, 712 units started and completed, 712

physical flow of units, 711 Fila, 340, 425, 426, 430, 442 Finance.Google.com, 16 Finance leases, 435 Finance.Yahoo.com, 16 Financial accounting, 5– 6, 61 1– 613 Financial Accounting Standards Board (FASB),

9, 10 proposed rules for revenue recognition, 120 on reward programs, 381 on statement of cash flows, 512, 517, 539 Statements of Financial Accounting Standards

No. 153, “Exchanges of Nonmonetary Assets,” 358

Financial assets at fair value through profit and loss, C - 11

Financial budgets, 85 8– 862 budgeted balance sheet, 853, 86 0– 861, 861 n, 870 budgeted income statement, 853, 860, 861,

861 n, 867, 870 cash budget ( See Cash budget ) in master budget, 853

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IND-10 Index

General rights of stockholders, 468 Gift card sales, 381 “Gilts,” 424 Global Crossing, 13 Global economy, 626 Global view of accounting principles

absorption v s . variable costing and, 827 accounting controls and assurance, 71 accounting principles, 22 adjusting accounts, 120 analyzing and recording transactions, 7 0– 71 banking activities, 277 bonds and notes, 435 cash controls, 277 cash flow reporting, 527 dividends, 484 fair value option, 435 financial statements, 2 2– 23, 71, 177, 584 “gilts,” 424 influential securities, C - 11 internal controls, 276 lean accounting, 752 leases and pensions, 435 liabilities, 391, 392 in managerial accounting

budgets, 862 contribution margin, 795 customer orientation, 627 foreign currency exchange rates, 862 job order cost accounting, 666 manufacturing activity reporting, 627 net present value, 1026 performance evaluation, 957 process cost accounting, 707 standard costs and variances, 910

merchandise inventory costing, 22 2– 223 merchandise purchases and sales, 177 noninfluential securities, C - 11 plant assets, accounting for, 35 4– 355 receivables, 316 status of IFRS, 23 stock, 484 transaction analysis, 22 treasury stock, 484

Going-concern assumption, 12, 345 The Gold Standards, 626 Goods in process inventory, 620, 631, 656, 670

beginning goods in process (FIFO method), 712 ending goods in process, 703, 712, 713 equivalent units of production and, 699 for manufacturer, 619, 620

Goods in transit, 210 Goods on consignment, 210 Goods sold, 656 Goodwill, 352, 353, A - 7 Google, 264, 353, 476 Gottlieb, Neal, 691 Governance systems, 14 Government investigations, 391 Government officials, 5 Government regulation of corporations, 467 Grano, Jordan, 895 Grant Thornton, 10 Graphical analysis

of break-even time, 1027 common-size graphics, 57 3– 574 CVP chart, 787, 796, 798

Freshii, 847 Freshii.com, 847 Fringe benefits, 448 FTC (Federal Trade Commission), 267 ftc.gov/bcp/consumer.shtm, 261 Full costing. See Absorption costing Full-disclosure principle, 11, 314

contingent liabilities, 390 dividends in arrears, 478 merchandise inventory costing

methods, 219 noncash investing and financing, 513 warranties, 388, 389

Fully depreciated plant assets, 348 Function, classification by, 61 6– 617 Furniture and fixtures (F&F), 119 FUTA (Federal Unemployment Taxes), 386 Future value(s)

computation of, 1023, B - 10 formula for, B - 3, B - 6 of ordinary annuity, B - 6 – B - 7, B - 10, B - 11 of single amount, B - 3 – B - 5, B - 7, B - 10 solving for, B - 4

Future value tables, B - 10, B - 11 future value of annuity of 1 table,

B - 6, B - 11 future value of $1 table, 1023, B - 4, B - 10

Fyffe, Charlie, 985

GAAP. See Generally accepted accounting principles

Gains . See also Losses from disposal of business segments, 588 on disposal of plant assets, 349 exchange with commercial substance, 359 extraordinary, infrequent, or unusual, 588 on retirement of debt, 519, 522, 53 8– 539 on securities available for sale, A - 6 unrealized, C - 5, C - 13

Gamer Grub, 1015 GamerGrub.com, 1015 Gannett Co., Inc., 104 Gap Inc., 99, 522, 992, C - 9, C - 12 Gardner, David, 563 Gardner, Tom, 563 Garza, Mary E., 511 Gateway Distributors, 306 General accounting system, 654 General and administrative expense budget,

857, 866 General and administrative expenses, 175 General journal, 5 8– 59, 7 3– 74 General ledger, 53, 56, 115, 303 Generally accepted accounting principles

(GAAP), 9, 28 on absorption costing, 827 acceptable overhead costing methods, 748 fair value option for securities, C - 7 on joint cost allocation, 963 on methods of reporting cash flows, 539 as rules-based system, 120 on statement of cash flows, 527 terminology of investments, C - 11

General Motors, 626 General principles of accounting, 1 0– 11 General-purpose financial statements, 5, 565

Flexible budget—Cont. flexible budget reports, 89 8– 901

flexible budget performance report, 90 0– 901, 914, 920

preparation of flexible budgets, 89 8– 900 purpose of flexible budgets, 898

Flexible budget performance report, 90 0– 901, 914, 920

Flexible budget reports, 89 8– 901 flexible budget performance report, 90 0– 901,

914, 920 preparation of flexible budgets, 89 8– 900 purpose of flexible budgets, 898

Floating an issue, 424 n Floor-space, 94 6– 947, 94 9– 950 Flow of manufacturing activities, 62 2– 623 FOB (free on board) point, 16 7– 168, 210 Folsom Custom Skis, 895 folsomskis.com, 895 Fool.com, 563 Ford Motor Company, 223, 305, 388, 390,

70 7– 708 Foreign currency translation, 272

budgeting and, 862 exchange rates, C - 16, C - 17, C - 18, C - 19 note regarding, A - 7 purchases in foreign currency, C - 17 – C - 18, C - 19 ratio analysis and, 577 sales in foreign currency, C - 17 weakness in U.S. dollar and, C - 18

Foreign exchange rates, 862, C - 16, C - 17, C - 18, C - 19

Forgery, 274 Form 940, 395 Form 941, 395, 396 Form 1 0– K, 16, A - 1 Form 1 0– KSB, A - 1 Form 1 0– Q, 16 Form W-2, 397, 398, 399 Form W-4, 385, 400, 402 FranchiseFoundations.com, 383 Franchises, 353, 383, 393, 402 Franklin, Benjamin, 440 Fraud, 217, 267

characteristics of, 61 3– 614 check fraud, 274 cost of, 260 encryption of e-cash and, 516 fraudulent accounting, 109, 132 Internet fraud, 261 knowledge of, 276 managerial accounting and, 614 merchant fraud losses, 308 payroll fraud, 387, 660 “pump ‘n dump,” 484 triple-threat of, 262 unreported liabilities, 431 warning signs of, 270

Fraud prevention, 8– 9, 217 Fraud survey, 120 Fraud triangle, 8– 9 Free cash flows, 528, 583 n Free on board (FOB) point, 16 7– 168, 210 Free product with purchase, 778 Freight-in, 168 Freight-out, 168 Fremont General, 10

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Index IND-11

for merchandisers, 173 multiple-step, 17 5– 176, 18 0– 181, 188 prepared from trial balance, 69, 110, 111, 124 in preparing statement of cash flows, 516 single-step, 176, 181, 188 variable costing income statement, 786

Income statement expenditures, 346 Income statement method, 30 8– 309, 320 Income Summary account, 113, 114, 173 Income taxes, 467, 527

computing, 398, 400 depreciation tax shield, 1022 effects of inventory costing methods, 21 8– 219, 236 employee income taxes, 38 4– 385 income tax liabilities, 40 1– 402 taxes payable, 521, 538

Income tax expense, 857, 860, 954 Incorporation, 467 Incorporators, 467 Incremental costs, 98 8– 989, 997 Incremental overhead rate, 989 Incremental revenue, 987 Indefinite life of intangible asset, 351, 352 Index number, 569 Index number trend analysis, 56 9– 571 Indirect costs, 615, 695, 697, 708, 716 Indirect expenses, 94 5– 946

allocation of, 94 6– 947, 964 advertising expenses, 947 depreciation, 947 illustrated, 946 rent and related expenses, 94 6– 947 service department expenses, 947 utilities expenses, 947 wages and salaries, 946

direct expenses contrasted, 964 Indirect labor, 618 Indirect labor costs, 618, 695, 697 Indirect materials, 620, 695, 696 Indirect method of reporting cash flows, 51 6– 517,

518, 540 application of (adjustments), 51 7– 522

changes in current liabilities, 52 0– 521 changes in noncash current assets, 51 8– 520 nonoperating items, 52 1– 522 operating items not providing or using cash, 521

illustration of, 517, 518 operating cash flows, 51 6– 517, 518 spreadsheet used in, 53 2– 534 summary of adjustments, 522

Indirect stock sale, 469 Individual-item approach to LCM, 220 Industry comparisons, 566, 571, 62 0– 621 Industry Norms and Key Ratios (Dun & Bradstreet), 24 Industry practices constraint, 13 Inescapable expenses, 993 Inflation, 1023, B - 10 Influential investments, C - 8 – C - 10

accounting summary for, C - 9 – C - 10 global view of, C - 11 securities with controlling influence, C - 9 securities with significant influence, C - 3,

C - 8 – C - 9, C - 19 Information technology services, 989 Infrequent gain or loss, 588 Initial public offering (IPO), 467, 469 Input(s), 992

IASB (International Accounting Standards Board), 9, 10

IASB.org.uk, 10 IBM, 24, 423 Ideal standard, 902 Identification of business activities, 4 IFRS. See International Financial Reporting

Standards (IFRS) IFRS.com, 10 IFRS Foundation Monitoring Board, 9 Illegal acts

accounting scandals, 13 collusion, 260, 262, 266 fencing stolen assets, 263 forgery, 274 fraud ( See Fraud) increased e-commerce and, 26 1– 262 manipulation of accounting information, 434 observation of, 71 shoplifting by employees, 172 violations of SOX, 258

IMA (Institute of Management Accountants), 612, 614

ImClone, 14 Impairment of asset value, 346, 352,

352, 354 Impersonation online, 261 Implied annual interest rate, 166, 166 n Imprest system, 268 Inadequacy, 339 Incentive-based compensation, 14 Income, 15

under absorption v s . variable costing, 822, 823 comprehensive, A - 7, C - 6, C - 10 computing from sales and costs, 78 9– 790 global view of operating income, 177 for merchandisers, 16 2– 163 net ( See Net income ) operating cash flows contrasted, 522 target income, computing sales for, 79 0– 791,

796, 797 Income statement, 20, 21

under absorption v s . variable costing, 81 8– 823 demonstration of, 82 9– 830 units produced equal units sold, 81 8– 819 units produced exceed units sold, 820, 821 units sold exceed units produced, 821, 822

all-inclusive, 58 8– 590 budgeted income statement, 853, 860, 861,

861 n, 867, 870 common-size, 572, 573 comparative, 569, 58 6– 587 contribution margin format ( See Contribution

margin income statement ) demonstration of, 25, 26, 75 departmental ( See Departmental income

statements ) effects of allocating plant asset costs, 337 effects of inventory costing, 218 effects of inventory errors, 22 0– 222 examples of, A - 3, A - 11, A - 14, A - 18 expanded, 952 global view of, 177 items shown in, 173, 17 5– 176, C - 10 links to other financial statements, 69 long-term investments, C - 15, C - 16 for manufacturer, 62 0– 622, 625

high-low method, 78 2– 783, 784, 798 line graphs, 570 margin graph, 1027 pie charts, 573 scatter diagrams ( See Scatter diagrams ) trend analysis, 570 of variable and step-wise costs, 780

Green, Jennifer, 51 Green Bay Packers, 11, 210 Green Mountain Coffee Roasters, 171 Gross margin, 16 2– 163, 178 Gross margin ratio, 17 8– 179, 18 1– 182, 188 Gross method of recording purchases, 166, 283, 284 Gross pay, 38 3– 384 Gross profit, 16 2– 163

merchandise inventory costing and, 228 periodic inventory system, 186 shown in income statement, 173, 175

Gross profit method, 235, 236 Gross profit ratio, 17 8– 179, 18 1– 182, 188 Groupon, 465 Groupon.com, 465 Group purchase, 338 Guidelines (rules of thumb), 566 Guy Brown, 815 GuyBrown.com, 815

Hackers, 26 1– 262 Halliburton, 13 Harley-Davidson, 306, 379, 476, 522, 961 Harris, Jim, 781 Hasbro, 277 Hatcher, Felicia, 209 Health insurance benefits, 387 Heinz, 692 Held-to-maturity (HTM) securities, C - 6, C - 19

accounting summary for, C - 10 acquisition of, C - 3 fair value option for, C - 7 global view of, C - 11

Hershey Foods, 340, 692 Heterogeneity, 655 Hewlett-Packard, 24 Hierarchical levels of management, 615 High-low method, 78 2– 783, 784, 798 Historical cost(s), 988 Historical cost principle, 11 The Home Depot, 164, 188, 234, 380, 446, 447, 483 Honda, 626 Honored note, 314, 320 Horizontal analysis, 563, 56 6– 571, 590

comparative statements, 56 6– 569 comparative balance sheets, 56 7– 568, 586, 587 comparative income statements, 569, 58 6– 587 computation of dollar and percent changes,

567, 567 n demonstration, 58 6– 587

global view of, 584 trend analysis, 56 9– 571

Hostile takeovers, 478 n HTM securities. See Held-to-maturity securities Human behavior, 849 Human error, 262, 265 Hurdle rate, 953, 1024, 1030 Hybrid costing system, 70 7– 708, 715 Hybrid inventory system, 168

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IND-12 Index

costing (generally), 21 1– 219 cost flow assumptions, 212, 213, 222 determining costs, 211 global view of, 22 2– 223 illustration of, 213 turnover ratios and, 223

costing (periodic system), 22 9– 234 demonstration of, 22 8– 229 financial statement effects, 23 3– 234 specific identification, 23 0– 231 weighted average, 229, 23 2– 234, 236

costing (perpetual system), 213 consistency concept, 219 demonstration of, 22 4– 228 financial statement effects, 21 8– 219 first-in, first-out (FIFO) ( See First-in, first-

out (FIFO) ) last-in, first-out (LIFO) ( See Last-in,

first-out (LIFO) ) specific identification, 212, 21 3– 214 tax effects, 21 8– 219 weighted average, 212, 21 6– 217, 218, 227, 236

effects of errors, 236 balance sheet effects, 222 demonstration, 228 income statement effects, 22 0– 222

estimation methods, 23 4– 235 gross profit method, 235, 236 retail inventory method, 234, 235

global view of, 22 2– 223 income components of, 188 for manufacturer

demonstration of, 63 0– 631 finished goods inventory, 619, 620 goods in process inventory, 619, 620 raw materials inventory, 619, 620

for merchandiser ending inventory, 22 1– 222 inventory systems, 16 3– 164 reporting, 163, 218, 222

merchandising cost flows, 172 note regarding, A - 6 physical count of, 183 process costing illustration, 70 0– 707 ratio analysis of

days’ sales in inventory, 22 3– 224, 236, 578 inventory turnover, 223, 224, 236, 577, 588

shown in income statement, 173 valuation of, 21 9– 222

effects of inventory errors, 22 0– 222 at lower of cost or market, 21 9– 220, 222, 236

write-downs of, 588 Inventory control, 792 Inventory counters, 211 Inventory management, 22 3– 224 Inventory relation, 220 Inventory subsidiary ledger, 211 Inventory tickets, 211 Inventory turnover, 588 Inventory turnover ratio, 22 3– 224, 236,

577, 588 Invested assets, 954 Investing activities, 512, 523, 540

accounting equation and, 2 7– 28 cash flows from, 21, 22, 528, 534, 540

global issues in reporting, 527 other asset analysis, 524

Internal failure costs, 750 Internal rate of return (IRR), 102 3– 1025, 1030

with uneven cash flows, 1024 using Excel ® to compute, 1029 using in managerial decisions, 102 4– 1025

Internal Revenue Service (IRS), 5, 68, 384, 385 absorption costing acceptable to, 827 on amortization of goodwill, 353 IRS withholding tables, 385 required forms

Annual Federal Unemployment Tax Return (Form 940), 395

Employer’s Quarterly Federal Tax Return (Form 941), 395, 396

Wage and Tax Statement (Form W-2), 397, 398, 399

Withholding Allowance Certificate (Form W-4), 385, 400, 402

Internal transactions, 16 Internal users of accounting information, 6, 9, 510,

564, 611, 612 International Accounting Standards Board

(IASB), 9, 10 International Financial Reporting Standards

(IFRS), 9– 10 on absorption costing, 827 on accounting for plant assets, 35 4– 355 on adjusting accounts, 120 conceptual framework for, 10 convergence with U.S. standards, 9– 10, 23 differences from U.S. GAAP ( See Global view

of accounting principles) effective interest method of amortizing bonds, 444 on explanatory notes, 60 fair value option for securities, C - 7 individual-item approach to LCM, 220 internal controls and, 277 LIFO not permitted under, 219, 222 on methods of reporting cash flows, 539 on preferred stock, 479, 484 as principles-based system, 22, 120 on recording contingent liabilities, 380 on restructuring costs, 389 on statement of cash flows, 527 terminology of investments, C - 11 on transaction analysis, 7 0– 71 uniform accounting for consolidated

subsidiaries, C - 9 International operations, C - 16 – C - 18

business processes and, 827 consolidated financial statements for, C - 18 foreign exchange rates, 862, C - 16, C - 17,

C - 18, C - 19 purchases in foreign currency, C - 17 – C - 18 sales in foreign currency, C - 17

Internet fraud, 261 Intracompany comparisons, 565, 570 Intracompetitor comparisons, 566 Inventoriable costs, 164 Inventory(ies), 119, 163, 20 8– 236 . See also

Periodic inventory system; Perpetual inventory system

adjustments for changes in, 51 9– 520 basic concepts, 21 0– 211

determining costs of, 211, 222, 236 determining items in, 210, 222, 236 internal controls and physical count, 211

Inspection time, 957 Installment accounts receivable, 305 Installment notes, 43 3– 434, 434 n, 438, 448 Installment sales, 305 Institute of Management Accountants (IMA),

612, 614 Insurance, 5 3– 54, 10 1– 102, 387, 391 Insurance expense, 950, 993 Intangible assets, 54, 119, 35 1– 354

cost determination and amortization, 35 1– 352, 360 global view of, 355 limited life of, 351, 352 notes regarding, 355, A - 7 types of, 35 2– 354

copyrights, 352, 353 franchises and licenses, 353 goodwill, 352, 353, A - 7 leasehold improvements, 354 leaseholds, 35 3– 354 patents, 352, 358 software, covenants, customer lists, 354 trademarks and trade names, 353

Intercompany comparisons, 574, 908 Interest, 312

on bonds, 423, 429 computation of, 313 on notes payable, 38 2– 383 on notes receivable, 313, 31 4– 315 present and future values, B - 1, B - 7 solving for, B - 3, B - 4 – B - 5, B - 10

Interest expense accrued, 107, 44 5– 446, 448 classification of, 857 computing on notes payable, 382 in computing return on total assets, 581 excluded from investment center income, 954 times interest earned ratio, 392, 393, 395, 402

Interest payable, 519, 52 0– 521, 538 Interest rates, 166, 166 n, 442, 1024, C - 6, C - 19 Interest revenue, 108, 275, C - 3 – C - 4 Interim financial statements, 98, 100, 234 Intermediary(ies), 162 Internal auditing, 611, 612 Internal control(s), 25 8– 263, 284

banking activities as ( See Banking activities) bar code scanners, 211 compensating control, 261, 285 control of cash ( See Cash controls) control procedures, 276 demonstrations of

bank reconciliation, 27 8– 279 petty cash fund, 27 9– 280

in fraud prevention, 9 GAAP v s . IFRS on, 71 global view of, 27 6– 277 inventory safeguards, 217 limitations of, 262 in physical count of inventory, 211 principles of, 25 9– 260, 261 purpose of, 25 8– 259, 276 RFID tags, 170, 260 safeguarding long-term assets, 351 SOX requirements ( See Sarbanes-Oxley

Act (SOX) ) technological, 260, 26 1– 262

Internal control report, 259 Internal control system(s), 258, 614

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Index IND-13

KTM, 4, 176, 527, 564, C - 10 analysis of financial statements, 570, 574,

57 5– 590 consolidated financial statements (examples),

A - 14 – A - 17 balance sheet, A - 15 income statement, A - 14 statement of cash flows, A - 16 statement of comprehensive income, A - 14 statement of shareholders’ equity, A - 17

Kyocera, 168

Labor, 712 Labor contracts, 384, 527, 540 Labor cost(s)

direct ( See Direct labor costs ) indirect, 618, 695, 697 in job order costing, 655, 656 in process cost accounting, 695, 697 standard, 901 variance analysis of, 914

Labor cost flows and documents, 66 0– 661, 671 Labor cost variances, 90 5– 906, 920 Labor strikes, 588 Labor unions, 5, 311, 321 Land, 54, 33 7– 338, 339 Land accounts, 54 Land improvements, 338, 357 Large stock dividend, 474, 47 5– 476 Last-in, first-out (LIFO), 215, 576

LIFO conformity rule, 219 not permitted under IFRS, 219, 222 periodic inventory system, 232, 236

demonstration, 229 financial statement effects, 23 3– 234

perpetual inventory system, 212, 21 5– 216, 236 cost flow assumptions, 212, 213 demonstration, 226 financial statement effects, 218

Latham, William, 815 LCM. See Lower of cost or market Lean accounting, 752 Lean business model, 626, 627 Lean manufacturing, 752 Lean practices, 626 Lease(s), 353, 446, 448

global view of, 435 lease liabilities, 44 6– 447, 448

capital leases, 353, 447, 447 n operating leases, 446

note regarding contingencies, A - 8 subleases, 354

Leasehold, 35 3– 354 Leasehold improvements, 354 Least-squares regression, 78 3– 784, 79 7– 798 Leather Head Sports, 777 Leatherheadsports.com, 777 Lebed, Jonathan, 484 Ledger(s), 53, 56, 76

general ledger, 53, 56, 115, 303 subsidiary ledgers ( See Subsidiary ledgers)

Legal claims, 390 Legislation . See also specific laws

tax laws, differences from GAAP, 40 1– 402 withholdings required under, 384

Legislators, 5

Job order cost accounting, 65 2– 671 adjusting factory overhead, 66 5– 666 basics of, 65 4– 657

cost accounting system, 654 events in job order costing, 65 5– 656 job cost sheet, 656, 657 job order production, 65 4– 655

demonstration of, 66 7– 670 entrepreneurship, 653 global view of, 666 job order cost flows and reports,

65 8– 665, 671 labor cost flows, 66 0– 661 materials cost flows, 65 8– 659 overhead cost flows, 66 1– 663 summary of cost flows, 66 3– 664

pricing for services, 667 process cost accounting compared, 715

Job order cost accounting system, 656, 695 Job order operations, 693, 695, 715 Job order production, 65 4– 655, 671 John Deere, 214, 231, 302 Joint costs, 96 2– 964 Jordan, Kim, 737 Journal, 58 Journal entries

adjusting entries ( See Adjusting entries ) closing entries ( See Closing entries ) compound, 63, 65, 276 for cost variances, 916, 920 demonstrations, 7 3– 74, 182, 319 explanation of transactions, 59 in job order cost accounting

allocating production costs, 664, 665 demonstration, 66 9– 670 for indirect labor, 661 materials requisitions, 658, 659

long-term investments, C - 14, C - 15 reversing entries ( See Reversing entries ) short-term investments, C - 12 – C - 13 steps in posting, 60, 61 stock transactions, 488, 489 summary entries, 706, 710

Journalizing transactions, 5 8– 60, 76 JP Morgan, 308 Junk bonds, 432 Just-in-time (JIT) inventory systems, 178, 264,

788, 855 Just-in-time (JIT) manufacturing, 626 Just-in-time (JIT) production, 707

Keep or replace decision, 99 3– 994 The Kellogg Company, 99, 692 Keying adjustments, 128, 129 Key performance indicators, 956 Kforce.com, 7 Known liabilities, 38 0– 387, 402

accounts payable ( See Accounts payable) global view of, 391 multi-period, 38 6– 387 payroll ( See Payroll liabilities) sales taxes payable, 38 0– 381, 381 n short-term notes payable, 38 1– 383 unearned revenues, 381

KPMG, 7, 120, 177, 217, 351, 387 K2Sports, 118, 119

reconstruction analysis, 52 3– 524 three-stage analysis, 523

InvestingInBonds.com, 430 Investment(s), 16, C – C - 19

basics of, C - 2 – C - 4 classification and reporting, C - 3 debt securities, C - 3 – C - 4 equity securities, C - 4 motivation, C - 2 – C - 3

capital budgeting ( See Capital budgeting ) demonstration of, C - 12 – C - 16 entrepreneurship, C - 1 evaluation of

ARR, 101 9– 1020, 1025, 1030 book value per common share, 487, 491 IRR, 102 3– 1025, 1029, 1030 payback period, 101 6– 1019, 1025, 1030

influential, reporting, C - 8 – C - 10 accounting summary for, C - 9 – C - 10 global view of, C - 11 securities with controlling influence, C - 9 securities with significant influence, C - 3,

C - 8 – C - 9, C - 19 in international operations, C - 16 – C - 18 long-term, 119, 512, C - 2, C - 13 – C - 16 noninfluential, reporting, C - 5 – C - 7

available-for-sale securities, C - 6 – C - 7 fair value adjustment, C - 5 global view of, C - 11 held-to-maturity securities, C - 6 trading securities, C - 5 – C - 6

notes regarding, A - 6 short-term, 264, 512, C - 2, C - 12 – C - 13

Investment center(s), 943 Investment center performance, 95 3– 957, 964

financial measures, 95 3– 955 income measurement, 954 nonfinancial measures, 95 5– 957

Investment center residual income, 95 3– 954, 964

Investment center return on total assets, 953, 955, 964

Investment grade bonds, 427 Investment turnover, 95 4– 955, 964 Investors, 5 Investor’s Business Daily, 565, 582 Invoice(s), 164, 281, 282

false or misleading, 177 sales invoice, 53, 259, 281

Invoice approval, 28 1– 282 Inwald, Michael, 257 iPad, 305 IPO (initial public offering), 467, 469 IRR. See Internal rate of return (IRR) IRS. See Internal Revenue Service

JCPenney, 178, 179, 304 Jenkins, Malcolm, 653 Jiffy Lube, 692, 908 JIT (just-in-time) inventory systems, 178, 264,

788, 855 JIT (just-in-time) manufacturing, 626 JIT (just-in-time) production, 707 Job(s), 654, 655 Job cost sheet, 656, 657, 658, 660, 661, 671 Job lot, 654

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IND-14 Index

hierarchical levels of, 615, 617 responsibility accounting and, 905, 906

Management by exception, 901, 902 Management Discussion and Analysis (MD&A),

27, 261, 565 Management override, 262 Management report on controls, 261 Manager(s), 6, 943, 944, 96 1– 962 Managerial accounting, 60 8– 633

basics of, 61 0– 614, 633 decision making, 613 fraud and ethics in, 61 3– 614, 633 nature of, 61 1– 613 purpose, 61 0– 611

cost classifications, 61 4– 617, 633 by behavior, 61 4– 615 by controllability, 615 cost identification, 617 by function, 61 6– 617 by relevance, 616 for service companies, 61 7– 618 by traceability, 615

decision making and ( See Managerial decisions) defined, 6, 610 global view of, 627 manufacturing activity reporting, 61 8– 627, 633

balance sheet, 61 9– 620, 625, 633 costs, 616, 61 8– 619, 624, 625 demonstration of, 61 1– 631 flow of activities, 62 2– 623 global view of, 627 income statement, 62 0– 622, 625 manufacturing statement, 616, 62 3– 625, 63 1– 632

trends in, 62 5– 627, 633 Managerial activities, 738 Managerial decisions, 613, 98 6– 994

ABC used in decision making, 749, 750 in accounting for inventory, 212 decision scenarios, 98 7– 994

additional business decision, 82 5– 826, 831, 98 7– 989, 99 5– 996, 997, 998

keep or replace decision, 99 3– 994 make or buy decision, 989, 996, 997 qualitative factors in, 994 sales mix selection decision, 99 1– 992 scrap or rework decision, 990, 996, 997 segment elimination decision, 993 sell or process decision, 99 0– 991

demonstration of, 99 5– 997 entrepreneurship, 985 IRR used in, 102 4– 1025 NPV used in, 1023 payback period used in, 101 8– 1019 relevant costs in, 98 6– 987, 998 steps in making, 986 using customer profitability analysis, 752

Mandatory vacation policy, 259 Manual accounting systems, 60, 61 Manufacturers, 16

account titles for, 55 n budgeting for, 86 8– 869 hierarchy of production activities, 751 manufacturing budget, 853, 86 8– 869, 870 production budget, 853, 868, 870

Manufacturer’s balance sheet, 61 9– 620, 625 compared to other industries, 620, 633 finished goods inventory, 619, 620

Long-term assets, 335, 351 change in accounting estimates, 590 intangible ( See Intangible assets ) investments, 119, 512, C - 2, C - 13 – C - 16 natural resources, 35 0– 351, 358, 360 plant assets ( See Plant asset(s) ) in statement of cash flows, 21, 22

Long-term debt, A - 7 Long-term investments, 119, 512, C - 2, C - 13 – C - 16 Long-term (noncancelable) leases, 447, 447 n Long-term liabilities, 119, 379, 402,

42 0– 449 bonds ( See Bond(s) ) debt features, 436, 448 debt-to-equity ratio and, 43 6– 437, 448 demonstration of, 43 7– 440 global view of, 435 lease liabilities, 44 6– 447, 448

capital leases, 353, 447, 447 n operating leases, 446

notes payable, 43 2– 434, 449 debt features, 436, 448 global view of, 435 installment notes, 43 3– 434, 434 n, 448 mortgage notes and bonds, 434 present values of, 44 0– 442

pension liabilities, 448 L’Oreal, 957 Los Angeles Lakers, 56 Losses . See also Gains

on disposal of assets, 348, 349, 519, 522, 538 on disposal of business segments, 588 exchange with commercial substance, 35 8– 359 extraordinary or infrequent, 588, 589, 591 insurance losses, 391 merchant fraud losses, 308 net loss, 15, 128, 129 note regarding, A - 6 other expenses and losses, 175, 176 unrealized, C - 5, C - 13

Lotteries, B - 1, B - 6 Lower of cost or market (LCM), 219, 222

applied to individual items, 220 computation and application of, 21 9– 220, 236

Lowes, 164 Loyalty (reward) programs, 381 LP (limited partnership), 12 Lump-sum purchases, 338

Machine hours, 741, 907 Machinery, 338, 351, 357 MACRS (Modified Accelerated Cost Recovery

System), 344 Macy’s, 99, 510 Madoff, Bernard, 9 Madoff Investment Securities, 9 Magazine subscriptions, 386 Major League Baseball (MLB), 263, 388, 777 Make or buy decision, 989, 996, 997 Maker of check, 271, 272 Maker of note, 312 Malcolm Baldrige National Quality Award

(MBNQA), 626 Management

budgeting as tool of, 849 budget reports and, 896

Lenders, 5 Lenovo, 24 Lessee, 353, 446 Lessor, 353, 446 Liabilities, 15, 28, 54, 37 6– 402

accrued ( See Accrued expenses ) classification of

current ( See Current liabilities ) long-term ( See Long-term liabilities )

contingent ( See Contingent liabilities ) demonstration of, 39 3– 395 entrepreneurship, 421 estimated ( See Estimated liabilities ) global view of, 39 1– 392 improper classification of, 379 income tax liabilities, 40 1– 402 known ( See Known liabilities ) note regarding recognition of, 391 notes payable as, 313 payment of, 264 payroll liabilities

employee deductions, 38 3– 385 employer payroll tax liabilities, 38 5– 386,

400, 402 uncertainty in, 37 9– 380 unreported, 431 vacation pay, 106

Liability accounts, 5 4– 55, 115 Licenses, 353 LIFO conformity rule, 219 Limited Brands, Inc., 188 Limited liability, 466 Limited liability company (LLC), 12 Limited liability partnership (LLP), 12 Limited life of intangible asset, 351, 352 Limited partnership (LP), 12 Linear programming, 991 Line graph, 570 Linton, Brian, 941 Liquid assets, 263, 264 Liquidating cash dividend, 474 Liquidity, 178, 263, 28 4– 285, 565, 575 Liquidity and efficiency ratios, 23, 57 5– 578, 588

accounts receivable turnover, 31 7– 318, 318 n, 320, 321, 577, 588

acid-test (quick) ratio, 17 8– 179, 18 1– 182, 188, 57 6– 577, 588

composition of current assets and, 576 current ratio, 12 1– 122, 131, 132, 379,

57 5– 576, 588 days’ sales in inventory, 22 3– 224, 236, 578 days’ sales uncollected, 27 7– 278, 28 4– 285,

57 7– 578, 588 inventory turnover, 22 3– 224, 236, 577, 588 summary of, 583 total asset turnover, 355, 356, 360, 361, 578,

580, 588, C - 11 – C - 12, C - 19 turnover rate of assets and, 576 type of business and, 576 working capital, 57 5– 576

Liquidity of receivables, 317 List price, 164 L.L. Bean, 692 LLC (limited liability company), 12 LLP (limited liability partnership), 12 Loan activity, 860 Lock box system, 266

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Index IND-15

defined, 162 demonstrations, 17 9– 182 entrepreneurs, 161 financial statements for, 173, 17 9– 182 global view of, 177 income reporting for, 16 2– 163 inventory reporting for, 163 inventory systems, 16 3– 164

periodic system ( See Periodic inventory system )

perpetual system ( See Perpetual inventory system )

manufacturers different from, 618 merchandise purchases budget, 853, 85 5– 856 operating cycle, 163 ratio analysis for, 17 8– 179 supply chain management, 170 work sheet for, 187

Merchandise sales, 16 9– 171, 188 under periodic inventory system, 184 returns and allowances, 17 0– 171 sales discounts, 170

Merchandising cost flows, 163, 172, 188 Mercury Marine, C - 9 Merit rating, 386 MGM Mirage, 379 Miami Heat, 56 Mickey Mouse Protection Act, 353 Microsoft Corporation, C - 2 Microwave Satellite Technologies, 306 Milwaukee Brewers, 263 Minimum cash balance, 860 Minimum legal capital, 469 Minority interests, C - 11 Miscellaneous expenses, 26 5– 266 Miscellaneous revenues, 26 5– 266 Mixed costs, 615, 780 MLB (Major League Baseball), 263,

388, 777 Modified Accelerated Cost Recovery System

(MACRS), 344 Molson Coors, 355 Monetary unit assumption, 12 Monetizing business, 3 Money market funds, 264 Monster Worldwide, Inc., 469 Moody’s, 427, 446, 564, 566 Mortgage, 434 Mortgage bonds, 434 Mortgage contract, 434 Mortgage notes, 434 Motivation for investments, C - 2 – C - 3 The Motley Fool, 563 Motorola, 943 Move time, 957 Mukherji, Ashoke (“Bappa”), 815 Mullin, Keith, 1015 Multinationals, C - 16 Multi-period liabilities, 38 6– 387, 389 Multiple-step income statement, 17 5– 176,

18 0– 181, 188 Multiproduct break-even point, 79 3– 794, 798 Municipal bonds (“munis”), 436 Murto, Bill, 781 Mutual agency, 466 Mycoskie, Blake, 509 myYearbook, C - 1

Matching principle, 11, 100, 306 absorption costing and, 82 6– 827 in merchandise inventory costing, 21 1– 212 recording accrued interest on note, 383 warranties, 388, 389

Materiality, 919 Materiality constraint, 13, 211, 306, 347 Materiality principle, 620 Materials, 712 Materials activity, 622, 623 Materials consumption report, 696 Materials cost(s)

direct ( See Direct materials costs ) in process cost accounting, 695, 696 standard, 901 variance analysis of, 914

Materials cost flows and documents, 65 8– 659, 671

Materials cost variances, 90 4– 905, 920 Materials ledger cards, 65 8– 659 Materials requisitions, 658, 659, 661, 663, 696 Mattel, 277 Maturity date of bond, 422, 43 1– 432 Maturity date of note, 312, 313, 320 MBNA, 308 MBNQA (Malcolm Baldrige National Quality

Award), 626 McCabe, Mike, 895 McDonald’s, 336, 353, 383, 827, C - 16 McGraw-Hill, C - 9 MCI, 267 MD&A (Management’s Discussion and Analysis),

27, 261, 565 Measurement principle, 11 Median values, 567, 567 n Medicare benefits, 384 Medicare taxes, 384 MeetMe.com, C - 1 Meet Me Inc., C - 1 Memo line of check, 271, 272 Men’s Wearhouse, 381 Merchandise, 119, 162

computing cash paid for, 53 6– 537 purchasing ( See Merchandise purchases) selling ( See Merchandise sales)

Merchandise inventory. See Inventory(ies) Merchandise inventory turnover ratio, 22 3– 224,

236, 577, 588 Merchandise purchases, 188

computing total cost of, 180 global view of, 177 under periodic system, 183 under perpetual system, 16 4– 168, 188 purchase discounts ( See Purchase discount(s) ) returns and allowances, 16 6– 167 trade discounts, 164 transportation costs, 16 7– 168

Merchandise purchases budget, 853, 85 5– 856, 865

Merchandisers, 16, 16 0– 188 accounting for purchases

( See Merchandise purchases) accounting for sales ( See Merchandise sales) account titles for, 55 n activities of, 210 adjusting entries for ( See Adjusting entries ) completing accounting cycle for, 17 2– 174

goods in process inventory, 619, 620 raw materials inventory, 619, 620

Manufacturer’s costs, 61 8– 619 direct labor, 618 direct materials, 618 factory overhead, 616, 61 8– 619, 624, 625 prime and conversion costs, 619

Manufacturer’s income statement, 62 0– 622, 625 performance reporting, 621, 622 service company statement compared, 621

Manufacturing budget, 853, 86 8– 869, 870 Manufacturing margin, 820 Manufacturing overhead, 618 Manufacturing statement, 62 3– 625, 633, 670

cost classifications in, 616 demonstration of, 63 1– 632

Margin of safety, 786 Marketable securities. See Short-term investments Market-based transfer price, 962 Market price, 962 Market prospects, 565 Market prospects ratios, 23, 58 1– 582

dividend yield ratio, 486, 491, 582 price-earnings ratio, 485, 486, 491, 582 summary of, 583

Market rate on bonds, 425, 426 Market value(s), 338 Market value per share, 469 Mark-to-market accounting, C - 5 Markup, 667, 994, 995 Markup engagements, 663 Marlboro, 353 Mason, Andrew, 465 Master budgets, 84 6– 870

activity-based budgeting, 86 2– 863, 869, 870

budget administration, 85 0– 852 budget committee, 850 reporting, 850, 851 timing, 85 1– 852

budget process, 84 8– 850, 869 benchmarking budgets, 84 8– 849 communication in, 84 9– 850 human behavior and, 849 as management tool, 849 strategic budgeting, 848

capital expenditures budget, 853, 858 components of, 85 2– 853, 854 defined, 852 demonstration of, 86 3– 867 entrepreneurship, 847 financial budgets, 853, 85 8– 862

budgeted balance sheet, 86 0– 861, 861 n, 870 budgeted income statement, 853, 860, 861,

861 n, 867, 870 cash budget ( See Cash budget )

global view of, 862 manufacturing budget, 853, 86 8– 869, 870 operating budgets, 85 4– 857, 870

general and administrative expense budget, 857, 866

merchandise purchases budget, 85 5– 856 sales budget, 85 4– 855 selling expense budget, 856, 865

production budget, 853, 868, 870 sequence of preparation, 853

MasterCard, 304, 308

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IND-16 Index

research and development expenses, A - 6 retail inventory method, 234 revenue recognition, A - 7 sales promotions and incentives, A - 7 segment reporting, A - 8 shipping and handling costs, A - 6 significant accounting policies, A - 6 – A - 7 on use of LCM, 220 valuation and qualifying accounts, A - 8

NPV. See Net present value (NPV) NSF (nonsufficient funds) checks, 274,

27 5– 276 NVCA (National Venture Capital Association), 468 NVCA.org, 468 NYSE (New York Stock Exchange), 467, 581

Objectives of accounting, 10 Objectivity, 11 Obsolescence, 339 Off-balance-sheet accounting, 431 Off-balance-sheet financing, 447 n, 584 Office equipment, 54 Office supplies, 54 Old Navy, C - 9 1- 80 0- FLOWERS.COM, 16 7– 168 Online banking services, 271 Operating activities, 28, 511

accounting equation and, 28 cash flows from ( See Operating cash flows)

Operating budgets, 85 4– 857, 870 general and administrative expense budget,

857, 866 in master budget, 853 merchandise purchases budget, 853,

85 5– 856, 865 sales budget, 85 4– 855 selling expense budget, 856, 865

Operating cash flows, 21, 22, 51 1– 512, 51 6– 522, 534, 540

analyzing, 528 classes of, 535 direct method of reporting, 53 5– 539, 540

illustration of, 515 indirect method compared, 51 6– 517, 518 operating activities section format, 539 operating cash payments, 53 6– 539 operating cash receipts, 53 5– 536 summary of adjustments for, 539

global issues in reporting, 527 income contrasted, 522 indirect method of reporting

application of (adjustments), 51 7– 522 demonstration of, 53 0– 531 direct method compared, 51 6– 517, 518 spreadsheet used in, 53 2– 534 summary of adjustments, 522

Operating cash flow to sales ratio, 529 Operating cash payments, 53 6– 539

additional expenses, gains, and losses, 53 8– 539 for interest and income taxes, 538 for merchandise, 53 6– 537 for wages and operating expenses, 537, 537 n, 538

Operating cash receipts, 53 5– 536 Operating cycle, 117, 163 Operating departments, 942, 948 n, 950, 951 Operating expenses, 175

Noncurrent liability accounts, 525 Nonfinancial criteria, 95 5– 958, 962, 994 Nonfinancial information, 610 Noninfluential investments, C - 5 – C - 7

AFS securities ( See Available-for-sale (AFS) securities )

fair value adjustment, C - 5 global view of, C - 11 HTM securities ( See Held-to-maturity

(HTM) securities ) trading securities, C - 3, C - 5 – C - 6, C - 10, C - 11

Nonlinear costs, 781 Nonmanufacturing costs, 661 Nonmonetary information, 613 Nonoperating activities, 17 5– 176 Nonoperating items, 52 1– 522 Nonowner financing, 27 Nonparticipating preferred stock, 478 Nonsufficient funds (NSF) checks, 274, 27 5– 276 Non-value-added activities, 749 Non-value-added time, 958 No-par value stock, 469, 471 Normal balance, 57, 61 Nortel Networks, 10, 13 Northrop Grumman, 347 Notes payable, 54, 312

analyzing and recording, 54 long-term ( See Long-term liabilities ) as multi-period known liabilities, 38 6– 387 negotiability of, 381 short-term ( See Short-term notes payable )

Notes receivable, 301, 31 2– 315, 320 analyzing and recording, 53 collection of, 275 computing maturity and interest, 31 2– 313, 320 recognizing, 31 3– 314, 316 sale of, as contingent liability, 390 valuing and settling, 31 4– 315, 320

Notes to financial statements, A - 6 – A - 9 accounting for plant assets, 354 advertising expenses, A - 6 allowance for doubtful accounts, 316, A - 6 bonds and notes, 435 cash equivalents, A - 6 commitments and contingencies

contingent liabilities, 390 lease contingency, A - 8 product liability, A - 7 – A - 8

comprehensive income, A - 7 dealer holdback programs, A - 7 depreciation methods, 342 on direct write-off method, 306 estimates, use of, A - 6 foreign currency translation, A - 7 (gain) loss on securities available for

sale, A - 6 goodwill, A - 7 intangible assets, 355, A - 7 inventories, 223, A - 6 investments in affiliates, A - 6 long-term debt, A - 7 mortgage notes payable, 434 pledging receivables, 316 presentation basis of statements, A - 6 product warranties, A - 6 – A - 7 property and equipment, A - 6 recognition of liabilities, 391

National Football League (NFL), 11 National Retail Federation, 105 National Venture Capital Association (NVCA), 468 Natural business year, 99 Natural resources, 350

cost determination and depletion, 35 0– 351, 358, 360

plant assets used in extracting, 351 Navistar, 10 Negative NPV, 1022 Negotiated transfer price, 962 Neiman Marcus, 381 Nestlé, 627 Net amount. See Book value of assets Net assets, 15 Net book value, 954 Net cash flows, 514, 540, 1018 Net change in cash, 527 Net income, 15

computing, 796, 797 computing in work sheet, 128, 129 factory overhead adjustment and, 666 measured using accrual accounting, 536 shown in income statement, 175 in statement of cash flows, 534

Net loss, 15, 128, 129 Net method of recording purchases, 283, 284, 285 Net pay, 384 Net present value (NPV), 102 0– 1023, 1025, 1030

accelerated depreciation and, 102 2– 1023 decision rule for, 1021 global view of, 1026 inflation and, 1023, B - 10 salvage value and, 1022 simplified computations, 1021 n, 102 1– 1022, B - 11 uneven cash flows and, 1022 using Excel ® to compute, 1029 using in managerial decisions, 1023

Net realizable value, 210, 222 Net working capital, 57 5– 576 New Belgium Brewing Company, 737 NewBelgium.com, 737 New England Patriots, 11 New Frontier Energy, 306 New York Exchange, 423 New York Giants, 11, 55 New York Stock Exchange (NYSE), 467, 581 NFL (National Football League), 11 Nike, 353, 52 8– 529, 655, C - 16 Nissan, 626, 962 “No-free-lunch” adage, 778 Nokia, 223, 276, 354, 355, 391, 392, 435, C - 11 Nominal accounts. See Temporary accounts Nom Nom Truck, 51, 54 NomNomTruck.com, 51 Noncalendar-year companies, 69 Noncash accounts, 51 5– 516 Noncash assets, 472 Noncash charges, 517 Noncash credits, 517 Noncash investing and financing, 513, 540 Noncompete covenants, 354 Non-controllable costs, 615 Noncontrolling interests, C - 11 Noncumulative preferred stock, 47 7– 478, 485 Noncurrent assets, 52 3– 524 Noncurrent investments, 119

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Index IND-17

FUTA and SUTA, 386 recording, 386 summary of, 400

employer tax liabilities, 38 5– 386 Payroll register, 397 n, 39 7– 398 PBP. See Payback period (PBP) PCAOB (Public Company Accounting Oversight

Board), 258 Pearson, Derick, 209 Pecking order, 615 Penn Racquet, 692, 956 Pension plans, 387, 435, 448 Pension recipients, 448 Pepsi Bottling, 696 PepsiCo, 566 PE (price-earnings) ratio, 485, 486, 491, 582 Percent changes, 567 Percent of receivables method, 309 Percent of sales method, 30 8– 309, 320 Performance evaluation, 94 0– 964

cost center performance, 944, 945 cycle time and cycle efficiency in, 95 7– 958, 964 demonstration of, 95 8– 960 entrepreneurship, 941 global view of, 957 investment centers, 95 3– 957 responsibility accounting, 94 2– 952, 943 n using budgeted performance, 849

Performance reporting, 621, 622 variable costing v s . absorption costing, 81 8– 823

converting income to absorption costing, 823, 831

difference in cost per unit and, 82 3– 825 summary of income reporting, 821, 822 units produced equal units sold, 81 8– 819 units produced exceed units sold, 820, 821 units sold exceed units produced, 821, 822

Period costs, 616, 633, 661 Periodic inventory system, 164, 18 3– 186, 188

adjusting and closing entries, 18 4– 186, 185 n control of purchase discounts, 284 cost of goods sold, 184, 186, 214, 215, 225 financial statement preparation, 186 hybrid system, 168 inventory costing under, 22 9– 234

demonstration of, 22 8– 229 financial statement effects, 23 3– 234 first-in, first-out (FIFO), 228, 231, 23 3– 234, 236 last-in, first-out (LIFO), 229, 232, 23 3– 234, 236 specific identification, 229, 23 0– 231, 236 weighted average, 229, 23 2– 234, 236

purchase discounts, 284 recording transactions, 18 3– 184 sales discounts, 184

Periodicity assumption, 12, 98, 100 Period of note, 31 2– 313 Period of time, 21, 68 Permanent accounts, 112, 113, C - 5, C - 7 Perpetual inventory system, 164

control of purchase discounts, 28 3– 284 hybrid system, 168 inventory costing under

consistency concept, 219 demonstration of, 22 4– 228 financial statement effects, 21 8– 219 first-in, first-out (FIFO) ( See First-in,

first-out (FIFO) )

Overhead variance reports, 90 9– 910 Overproduction, reward systems linked to, 823,

824, 831 Over-the-counter cash receipts, 26 4– 266 Overtime, 61 8– 619 Owner financing, 27 Ownership rights in corporations, 466 Ownership transfer, 16 7– 168

Pacioli, Luca, 64 Paid absences, 388 Paid-in capital, 470, 48 1– 482 Paid-in capital in excess of par value, 472 Pandora Media, 471 Parent(s), C - 9 Partial-year depreciation, 344, 360 Participating preferred stock, 478 n, 478 Participatory budgeting, 849, 854 Partner(s), 12 Partnership(s), 12, 467 Par value, 469, 477 Par value method, 480 Par value of bond, 422, 42 4– 425 Par value stock, 469, 47 0– 471 Past performance, 898 Patent(s), 352, 358 Patent Office, U.S., 353 Payables, 15 Payback period (PBP), 101 6– 1019, 1025, 1030

computing with even cash flows, 1017 computing with uneven cash flows, 1018 using in managerial decisions, 101 8– 1019

Payee of check, 271, 272 Payee of note, 312 Payless Shoe Outlet, 618, 630 Payments, 539 Payout ratio, 486, 583 n PayPal, 308 Payroll, 39 5– 400

procedures, 402 computing federal income taxes, 398, 400 payroll bank account, 400 who pays what taxes, 400

records, 39 7– 398, 402 employee earnings report, 398, 399 payroll check, 398, 399 payroll register, 397 n, 39 7– 398

reporting, 39 5– 397, 402 Form 940, 395 Form 941, 395, 396 Form W-2, 397, 398, 399

Payroll bank account, 400 Payroll check, 398, 399 Payroll deductions, 38 3– 385, 402

defined, 384 FICA taxes, 384 Form W-4, 385, 400, 402 income taxes, 38 4– 385 recording, 385 summary of, 400 voluntary deductions, 385

Payroll fraud, 387, 660 Payroll liabilities, 38 3– 386, 402

employee deductions ( See Payroll deductions ) employer payroll liabilities, 38 5– 386, 402

FICA tax, 385

Operating income, 175, 177 Operating leases, 446 Operating leverage, 795 Operations, plant assets used in, 336, 339 Opportunity costs, 616, 617, 962, 987, 990 Opportunity for fraud, 8, 262 Ordinary annuity

future value of, B - 6 – B - 7, B - 10, B - 11 present value of, B - 5, B - 7, B - 10, B - 11

Ordinary repairs, 347 Organizational responsibility chart, 944 Organization expenses, 467 Organization Expenses account, 467 Other comprehensive income, C - 10 Other expenses and losses, 175, 176 Other revenues and gains, 17 5– 176 Out-of-pocket costs, 616, 987 Outstanding checks, 274 Outstanding stock, 469 Overapplied overhead, 665, 666, 671 Overfunded pension plan, 448 Overhead allocation base, 662, 73 9– 740 Overhead cost(s)

in ABC method assigning to cost objects, 74 6– 748 more accurate allocation of, 74 8– 749 more effective control of, 749 tracing to cost pools, 74 5– 746

allocation of, 663, 664, 666, 671, 738 of buildings, 338 cost per equivalent unit, 702 in departmental method, 742 equivalent units of production, 700 in job order costing, 655, 656 reducing, 748, 749, 757 standard, 901 units finished and transferred, 703

Overhead cost assignment (ABC), 73 8– 744 departmental overhead rate method, 738, 739,

74 0– 743 ABC compared to, 748, 75 5– 756 application of, 74 1– 742 assessment of, 743 cost flows under, 74 0– 741

plantwide overhead rate method, 738 application of, 73 9– 740 assessment of, 743 cost flows under, 739

rates and method, 74 3– 744 Overhead cost flows and documents, 66 1– 663,

671, 715 allocation bases, 662, 73 9– 740 allocation rates, 662 recording allocated overhead, 66 2– 663 recording overhead, 66 1– 662

Overhead cost variance(s), 90 8– 910, 920 controllable and volume variances, 90 8– 909 overhead variance reports, 90 9– 910 variance analysis, 909

Overhead rates fixed or variable, 908 incremental, 989 predetermined, 662, 907, 908

Overhead standards and variances, 90 7– 910 computing overhead cost variances, 90 8– 910 predicting activity levels, 908 setting overhead standards, 907

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IND-18 Index

callable, 479 convertible, 47 8– 479 dividend preference of

cumulative or noncumulative, 47 7– 478, 485 participating or nonparticipating, 478, 478 n

global view of, 484 IFRS on, 479, 484 issuance, 477, 479

Premium, 471 Premium on bonds, 428

amortizing, 42 8– 430, 448 effective interest method, 43 9– 440,

44 3– 444, 448 issuance, 425 present value of, 430 straight-line method, 42 9– 430, 448

Premium on stock, 469, 471 Prepaid accounts, 5 3– 54 Prepaid expenses, 53, 100, 10 1– 104

adjusting entries for depreciation, 10 3– 104 insurance, 10 1– 102 other expenses, 102 supplies, 102

adjustments for changes in, 520 alternative accounting for, 12 5– 126, 13 1– 132 analysis of, 537, 537 n, 538 author signing fees, 103, 132 links to financial statements, 109 transaction analysis, 64

Presentation issues, note regarding, A - 6 Present value(s)

of bonds and notes, 44 0– 442, 448 annuities, 44 1– 442 compounding periods shorter than one year,

430, 442 present value concepts, 430, 440 present value tables, 441

formula for, B - 2, B - 5 of ordinary annuity, B - 5, B - 7, B - 10, B - 11 present value tables, B - 10, B - 11 of single amount, B - 1 – B - 3, B - 7, B - 10 solving for, B - 3, B - 10

Present value concepts, 430, 435, 440, 449 Present value factors, 1023 Present value tables, 430, B - 10, B - 11

application of, 441 present value of annuity of 1 table, B - 11 present value of 1 table, B - 10

Pressure for fraud, 8, 262 Prevention costs, 750 Price-earnings (PE) ratio, 485, 486, 491, 582 Price setting

absorption v s . variable costing, 82 5– 826 methods for, 99 4– 995

Price variances, 901, 904, 905 PricewaterhouseCoopers, 7 Prime costs, 619 Prince, 961 Principal of note, 312, 382, 433 Principles-based accounting, 22, 120 Principles of internal control, 25 9– 260

custody of assets, 260 established responsibilities, 259 global view of, 276 insurance and bonding, 259 recordkeeping, 259

lump-sum purchases, 338 machinery and equipment, 338

demonstration of, 35 6– 358 depreciation of ( See Depreciation ) disposal of, 337

by discarding, 348, 357, 360 by exchange, 35 8– 359, 360 salvage value and, 339 by selling, 34 8– 349, 360, 519, 522

global view of, 35 4– 355 natural resources reported under, 350 note regarding, A - 6 reconstruction analysis of, 52 3– 524 salvage value of, 339, 349, 1019, 1022 total asset turnover ratio, 355, 356, 361 used in extracting natural resources, 351 useful life of, 336, 339, 340, 345, 349, 355

Plant asset age, 355, 583 n Plant asset subsidiary ledger, 345 Plant asset useful life ratio, 583 n Plantwide overhead rate method, 738, 756

application of, 73 9– 740 assessment of, 743, 756 cost flows under, 739 demonstration of, 753, 75 4– 755 departmental method compared, 742, 743,

75 5– 756 Pledging receivables, 31 5– 316 P&L (profit and loss) statement.

See Income statement Point in time, 21, 68 Point-of-sale systems, 259, 266 Poison pill, 478 n Polaris.com, 16, 565 Polaris Industries, Inc., 4, 16, 55 n, 69, 70,

222, 564, 565, C - 10 analysis of financial statements, 56 5– 570, 574,

57 5– 590 comparative balance sheets, 568 trend analysis, 56 9– 570 vertical analysis, 57 1– 574

consolidated financial statements (examples), A - 2 – A - 9

balance sheet, A - 2 income statement, A - 3 notes to financial statements (selected),

A - 6 – A - 8 selected financial data, A - 9 statement of cash flows, A - 5 statement of shareholders’ equity, A - 4

reportable segments, 573 Porsche AG, 666 Post-closing trial balance, 11 4– 116, 131 Posting reference (PR) column, 60 Posting transactions, 58, 76

credit sales, 303 demonstration of, 74 steps in, 60, 61 write-offs of bad debts, 308

Post-sales services, 993 Practical standard, 902 PR (posting reference) column, 60 Predetermined overhead rate, 662, 907, 908 Preemptive right, 468 Preferred stock, 47 6– 479, 490 . See

also Common stock book value per preferred share, 486, 487

Perpetual inventory system—Cont. inventory costing under—Cont.

last-in, first-out (LIFO) ( See Last-in, first-out (LIFO) )

specific identification, 212, 21 3– 214, 218, 227, 236

tax effects, 21 8– 219 weighted average, 212, 217, 218,

227, 236 job order cost accounting, 654 for merchandisers

accounting for purchases, 16 4– 168 accounting for sales, 16 9– 171 adjusting entries, 172, 174 closing entries, 173, 174 completing accounting cycle, 17 2– 174 Merchandise Inventory account, 167, 168 work sheet, 187

Personal financial specialist (PFS), 7 Personal identification scanners, 260 Petty cash fund, 266, 26 8– 270, 285

cash over and short, 270 demonstration of, 27 9– 280 illustrated, 26 8– 269 increasing or decreasing, 26 9– 270 operation of, 268 surprise counts of, 267

Petty cashier, 268 Petty cash receipt, 268 Pfizer, 302, 692, C - 2 PFS (personal financial specialist), 7 Pharma-Bio Serve, 306 Pharming, 262 Phishing, 262 Physical count of inventory, 183, 211 Physical flow of goods, 212 Physical flow of units, 701 Physical flow reconciliation, 701, 709, 711 Piaggio, 4, 2 2– 23, 55 n, 120, 177, 484, 527, 564,

584, C - 10 consolidated financial statements (examples),

A - 18 – A - 21 balance sheet, A - 19 income statement, A - 18 statement of cash flows, A - 20 statement of shareholders’ equity, A - 21 statements of comprehensive

income, A - 18 Pie charts, 573 Plan administrator, 448 Plan assets (pension plans), 448 Plank, Kevin, 301 Planning, 27, 28, 61 0– 611, 862, 911 Plant and equipment. See Plant asset(s) Plant asset(s), 103, 33 6– 349

additional expenditures for, 34 6– 347

betterments, 347 extraordinary repairs, 347 ordinary repairs, 347

capital expenditures budget and, 858 in classified balance sheet, 119 cost determination for

buildings, 338 demonstration, 357 land, 33 7– 338 land improvements, 338

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Index IND-19

Qualitative characteristics of accounting, 10 Qualitative decision factors, 994 Quality, costs of, 750 Quality of receivables, 317 Quantity variances, 901, 904, 905, 906, 920 Quepasa.com, C - 1 Quick ratio. See Acid-test ratio Qwest Communications, 13

Radio-frequency identification (RFID) tags, 170, 260, 792

Raju, Ramalinga, 9 Rand Medical Billing, 306 Rate variance, 904, 905 Ratio analysis, 48 5– 487, 563, 566, 57 4– 583, 590

areas of, 23 cash flow ratios

cash coverage of debt, 529, 583 n cash coverage of growth, 529, 583 n cash flow on total assets ratio, 52 8– 529,

540, 583 n operating cash flow to sales, 529

credit risk ratio, 583 n days’ cash expense coverage, 264, 583 n days’ sales in raw materials inventory, 628, 633 days’ sales in receivables, 27 7– 278 global view of, 584 improper classification of liabilities and, 379 investment center return on total assets, 953,

955, 964 liquidity and efficiency ratios, 23, 57 5– 578, 588

accounts receivable turnover, 31 7– 318, 318 n, 320, 321, 577, 588

acid-test (quick) ratio, 17 8– 179, 18 1– 182, 188, 57 6– 577, 588

composition of current assets and, 576 current ratio, 12 1– 122, 131, 132, 379,

57 5– 576, 588 days’ sales in inventory, 22 3– 224, 236, 578 days’ sales uncollected, 27 7– 278, 28 4– 285,

57 7– 578, 588 inventory turnover, 223, 224, 236, 577, 588 summary of, 583 total asset turnover, 355, 356, 360, 361, 578,

580, 588, C - 11 – C - 12, C - 19 turnover rate of assets and, 576 type of business and, 576 working capital, 57 5– 576

market prospects ratios, 23, 58 1– 582 dividend yield ratio, 486, 491, 582 price-earnings ratio, 485, 486, 491, 582 summary of, 583

profitability ratios, 23, 58 0– 581, 588 basic earnings per share, 485, 583 book value per common share, 486, 487, 491 book value per share, 48 6– 487 earnings per share, 485, 485 n, 491, 589 gross margin ratio, 17 8– 179, 18 1– 182, 188 profit margin ratio, 121, 131, 580, 588,

C - 11 – C - 12, C - 19 return on assets (ROA), 24, 27, 28, 29, 953,

955, 964 return on common stockholders’ equity, 581, 588 return on total assets, 58 0– 581, 588, 953, 957,

965, C - 11 – C - 12, C - 19 summary of, 583

Profitability ratios, 23, 58 0– 581, 588 basic earnings per share, 485, 583 book value per common share, 486, 487, 491 book value per share, 48 6– 487 earnings per share, 485, 485 n, 491, 589 gross margin ratio, 17 8– 179, 18 1– 182, 188 profit margin, 121, 131, 580, 588, C - 11 – C - 12, C - 19 return on assets (ROA), 24, 27, 28, 29, 953,

955, 964 return on common stockholders’ equity, 581, 588 return on total assets, 58 0– 581, 588, 953, 957,

965, C - 11 – C - 12, C - 19 summary of, 583

Profit and loss (P&L) statement. See Income statement

Profit centers, 943, 94 5– 952 allocation of indirect expenses, 94 6– 947 departmental contribution to overhead, 951 n,

95 1– 952 departmental income statements, 94 7– 951, 948 n direct and indirect expenses, 94 5– 946

Profit margin, 95 4– 955, 964 Profit margin ratio, 121, 131, 580, 588,

C - 11 – C - 12, C - 19 Pro forma financial statements, 128 Projections, 612 Promissory note, 53, 312, 382 Promoters, 467, 472 Promotions liability account, 386 Property, plant and equipment. See Plant asset(s) Proprietorship. See Sole proprietorship Proving balances, 67 Proxy, 467 Public accounting, 6 Public companies, 25 8– 259, 850 Public Company Accounting Oversight Board

(PCAOB), 258 Publicly held corporations, 466 Public sale of stock, 466 Purchase discount(s), 16 5– 166, 166 n

control of ( See Voucher system ) favorable, 166, 166 n, 167, 188 periodic inventory system, 284 perpetual inventory system, 28 3– 284 recording in periodic system, 183 taking advantage of, 166, 188

Purchase invoice, 281 Purchase order, 280, 281, 282 Purchase requisition, 267, 280, 282 Purchase returns and allowances, 166, 167, 183 Purchases

in cash, 16, 17, 61, 62, 64 on credit, 17, 62 in foreign currency, C - 17 – C - 18, C - 19 lump-sum purchases, 338 by merchandisers, 188

computing total cost of, 180 discounts on ( See Purchase discount(s) ) global view of, 177 under periodic system, 183 under perpetual system, 16 4– 168, 188 returns and allowances, 16 6– 167 trade discounts, 164 transportation costs, 16 7– 168

recording by gross method, 166, 283, 284 by net method, 283, 284, 285

regular reviews, 260 separation of duties, 260, 261 technological controls, 260, 26 1– 262

Pringles, 100 Prior period adjustments, 483 Private accounting, 6 Privately held corporations, 466 Process cost accounting, 654, 69 0– 715

demonstration of, 70 8– 710 entrepreneurship, 691 equivalent units of production, 69 9– 700

cost per equivalent unit, 702, 709, 71 2– 713 differences in equivalent units, 69 9– 700 goods in process, 699 process costing illustration, 70 1– 702

FIFO method, 71 1– 715 assigning and reconciling costs, 71 3– 715 change to weighted-average method, 715, 716 cost per equivalent unit, 71 2– 713 equivalent units of production, 71 1– 712 physical flow of units, 711

global view of, 707 hybrid costing system, 70 7– 708 process cost accounting system, 69 5– 698 process costing illustration, 70 0– 707

assigning and reconciling costs, 70 2– 705 cost of goods manufactured, 70 5– 706 cost per equivalent unit, 702 equivalent units of production, 70 1– 702 physical flow of units, 701

process operations, 69 2– 694 illustration of, 69 3– 694 job order operations compared, 693 organization of, 693

Process cost accounting system, 69 5– 698 direct and indirect costs, 695 factory overhead costs, 695, 69 7– 698 labor costs, 695, 697 materials costs, 695, 696

Process cost summary, 70 4– 705, 713, 714, 715 Process design, 707 Processes (steps), 692 Process improvement, 749 Processing errors, 261 Processing transactions, 261 Process operations, 69 2– 694, 715

illustration of steps in, 69 3– 694 job order operations compared, 693, 695, 715 organization of, 693 trends in, 707

Process time, 957, 958 Procter & Gamble, 692 Product costs, 616, 623, 633, 738 Production activities, 62 2– 623, 65 5– 656, 751 Production budget, 853, 868, 870 Production departments, 693, 698 Production margin, 820 Production planning, 82 3– 825 Production report, 70 4– 705 Product level activities, 750, 751 Product liability contingency, A - 7 – A - 8 Product protection plans, 389 Product warranties, A - 6 – A - 7 Profit. See Net income Profitability, 565, 580 Profitability analysis, 900 Profitability index, 1023, 1025

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IND-20 Index

departmental evaluation, 94 2– 943 departmentalization, 942 profit centers in, 94 5– 952

allocation of indirect expenses, 94 6– 947 departmental contribution to overhead, 951 n,

95 1– 952 departmental income statements,

94 7– 951, 948 n direct and indirect expenses, 94 5– 946

Re-stocking fees, 171 Restricted retained earnings, 482 Retailer, 162 Retail inventory method, 234, 235, 236 Retained earnings, 15, 470, 490, 526

appropriated, 48 2– 483 budgeted statement of, 867, 870 restricted, 482 statement of, 48 2– 483

Retained earnings account, 114, 173 Retained earnings deficit, 473 Retirement of debt

bonds, 43 1– 432, 440, 44 8– 449 gain on, 519, 522, 53 8– 539 stock, 482, 491

Retrospective application, 58 9– 590 Return, 27, 28 Return and risk analysis, 27, 28 Return on assets (ROA), 24, 27, 28, 953

investment center return on total assets, 953, 955, 964

uses of, 24, 29 Return on average investment, 101 9– 1020, 1025, 1030 Return on common stockholders’ equity, 581, 588 Return on equity, 422 Return on investment. See Return on assets Return on sales. See Profit margin ratio Return on total assets ratio, 58 0– 581, 588, 953,

957, 965, C - 11 – C - 12, C - 19 Revenue(s), 15

accrued ( See Accrued revenues ) accumulating, 948 early recording of, 100 increase in equity and, 55 incremental, 987 interest revenue, 108, 275, C - 3 – C - 4 miscellaneous, 26 5– 266 other revenues and gains, 17 5– 176 prepaid, alternative accounting for, 12 6– 127, 132 received in sales, 169 unearned ( See Unearned revenue(s) ) for unfinished jobs, 657, 671

Revenue accounts, 55, 114, 115 closing to Income Summary, 113 recording prepaid revenues in, 12 6– 127, 132

Revenue expenditures, 346, 347, 360 Revenue recognition, 11, 120, A - 7 Revenue recognition principle, 11, 55, 63, 100,

105, 107 Reverse stock split, 476 Reversing entries, 12 9– 131, 132, 171

accounting with, 117, 130, 131 accounting without, 130

Reward (loyalty) programs, 381 RFID tags, 170, 260, 792 Rights of stockholders, 468, 481 Rihanna, 381 Ripken, Cal, Jr., 388

Recordkeeping, 4 abbreviations in, 57, 57 n internal control and, 259, 260, 263 numbered accounts in, 5 6– 57 separated from custody of cash, 265

Records testing, 261 Recoverable amount, 354 Redemption value, 479 Redhook Ale, 905 Reebok, 340 Registered bonds, 436 Regression cost equation, 784 Regulators, 5 Related-party transactions, 584 Relative market values, 338 Relevance, classification by, 616, 617 Relevant benefits, 987 Relevant costs, 98 6– 987, 998, 1030 Relevant range, 614, 779, 780, 787, 796 Relevant range of operations, 787 Remittance advice, 271, 272 Rent, 18, 53, 102 Rent expense, 94 6– 947, 94 9– 950 Replacement cost, 218, 219, 222, 236 Report form of balance sheet, 22, 70 Reporting

auditors’ reports, 261 balanced scorecard, 627, 95 6– 957, 964 in budget administration, 850, 851 depreciation, 34 5– 346 equity ( See Equity ) flexible budgets, 89 8– 901, 914, 920 under GAAP ( See Generally accepted

accounting principles ) global issues, 527, 627 under IFRS ( See International Financial

Reporting Standards ) manufacturing activities

balance sheet, 61 9– 620, 625, 633 income statement, 62 0– 622, 625 manufacturing statement, 616, 62 3– 625,

63 1– 632, 633, 670 performance reporting, 621, 622

merchandising activities, 16 2– 163 payroll reporting, 39 5– 397, 398, 399, 402 performance reporting ( See Performance

reporting) tax reporting

absorption costing used for, 823 accelerated depreciation, 102 2– 1023 MACRS, 344 payroll, 39 5– 399 temporary differences, 40 1– 402

timing of, 9 8– 100, 131 Reporting currency, C - 16 Reporting period, 6 8– 69, 9 8– 99, 164, 183 Report to the Nation (ACFE, 2010), 613 Research and development expenses, A - 6 Residual equity, 15 Residual interest, 55 Responsibilities for internal control, 259 Responsibility accounting budgets, 944 Responsibility accounting performance reports,

944, 945, 964 Responsibility accounting system, 94 2– 943

controllable v s . uncontrollable costs, 943, 943 n cost centers in, 944, 945

Ratio analysis—Cont. raw materials inventory turnover, 628, 633 solvency ratios, 23, 57 9– 580, 588

debt ratio, 7 1– 72, 76, 579, 588 debt-to-equity ratio, 43 6– 437, 448, 449,

79, 588 equity ratio, 579 summary of, 583 times interest earned ratio, 392, 393, 395,

402, 57 9– 580, 588 summary of ratios, 582, 583

Rationalization, 8 Rationalization of fraud, 262 Raw materials, 622, 623 Raw materials inventory, 619, 620, 628 Raw materials inventory turnover ratio,

628, 633 Real (permanent) accounts, 112, 113, C - 7 Realizable value, 307 Realization principle, 316 “Reasonableness” criterion, 571 Receipts

adjustments to, 539 in cash ( See Cash receipts)

Receivables, 15, 30 0– 320 accounts ( See Accounts receivable ) collection of, 264 days’ sales in receivables ratio, 27 7– 278 demonstration of, 31 8– 320 disposal of, 31 5– 316, 320 global view of, 316 installment sales and, 305 notes receivable, 301, 31 2– 315, 320

analyzing and recording, 53 collection of, 275 computing maturity and interest, 31 2– 313, 320 recognizing, 31 3– 314, 316 sale of, as contingent liability, 390 valuing and settling, 31 4– 315, 320

quality and liquidity of, 317 write-offs of, 588

Receiving report, 281, 282 Recognition and measurement, 10

of accounts receivable, 30 2– 305, 316 notes receivable, 31 3– 314, 316 revenue recognition, 11, 100

Reconstruction analysis, 52 3– 524 Recording business activities, 4 Recording transactions

allocated overhead, 66 2– 663 asset accounts, 5 3– 54 bad debts expense, 307 employer payroll taxes, 386 equity accounts, 5 5– 56 expense accounts, 56 global issues, 7 0– 71 goodwill not recorded, 353 journalizing, 5 8– 60, 76 liability accounts, 5 4– 55 merchandise transactions, 18 3– 184 notes receivable, 31 4– 315, 320 overhead, 66 1– 662 partial-year depreciation, 344 payroll liabilities, 386 under periodic inventory system, 18 3– 184 revenue accounts, 55 use of accounts in, 76

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Index IND-21

Shares. See Stock Shipping and handling costs, A - 6 Shoplifting, 172 Short selling, 582, 585 Short-term investments, 264, 512, C - 2, C - 12 – C - 13 Short-term liabilities. See Current liabilities Short-term notes payable, 38 1– 383, 402

to borrow from bank, 38 2– 383, 394 end-of-period interest adjustment, 383 to extend credit period, 382, 394

Short-term planning, 610, 611 Short-term receivables, 577 Shrinkage, 172, 234 Siemens AG, 1026 Signature card, 271 Significant accounting policies, A - 6 – A - 7 Significant influence, C - 3, C - 8 – C - 9, C - 19 Simple capital structure, 485 n Single plantwide overhead rate method. See

Plantwide overhead rate method Single-step income statement, 176, 181, 188 Sinking fund bonds, 436 Six Flags, 379 Skechers, 72 Small businesses, 8 Small stock dividend, 474, 475 SmartIT Staffing, 377 SmartIT-Staffing.com, 377 Smitley, Kyle, 421 Snowmaking costs, 857 Social responsibility, 8 Social Security Administration (SSA), 397 Social Security benefits, 384 Social Security taxes, 384 Software . See also Accounting software;

specific programs customer interaction software, 700 face-recognition software, 260 as intangible asset, 354

Sole proprietorship, 12 closing process for ( See Closing process) lack of government regulation, 467 unlimited liability of, 12

Solvency, 565 Solvency ratios, 23, 57 9– 580, 588

debt ratio, 7 1– 72, 76, 579, 588 debt-to-equity ratio, 43 6– 437, 448, 449,

579, 588 equity ratio, 579 summary of, 583 times interest earned ratio, 392, 393, 395, 402,

57 9– 580, 588 Source documents, 5 2– 53, 101

invoices, 177, 281, 282 purchase invoice, 164 sales invoice, 53, 259, 281

receiving reports, 658 in voucher system ( See Voucher system )

Southwest Airlines, 617, 618, 621 SOX. See Sarbanes-Oxley Act (SOX) Special journals. See Subsidiary ledgers Special orders, 82 5– 826, 827, 831 Specific identification, 213, 230

periodic inventory system, 229, 23 0– 231, 236 perpetual inventory system, 212, 21 3– 214, 218,

227, 236 Specific principles of accounting, 1 0– 11

Scatter diagrams, 782, 783, 784 for changes in estimates, 789 creating with Excel ® , 798 manipulation of, 791, 799

Schedule of accounts receivable, 303 Schedule of cost of goods manufactured, 62 3– 625 Schedule of manufacturing activities, 62 3– 625 Schottenstein, David, 653 S corporations, 13 Scrap or rework decision, 990, 996, 997 Sea Ray, C - 9 Sears, 304 Seasonal businesses, 855, 870 Seasonal variations in sales, 99 SEC. See Securities and Exchange

Commission (SEC) sec.gov/investor/pubs/cyberfraud.htm, 261 Second-stage assignment, in ABC method, 74 6– 748 Section 404 (of SOX), 259 Secured bonds, 436 Securities and Exchange Commission (SEC), 9

annual reports filed with, A - 1 bond registration requirements, 424 n EDGAR database, 16, A - 1 financial statements filed with, 111 fines paid to, for accounting fraud, 267 Form 1 0– K requirements, 565 required to pay some whistle-blowers, 14

Segment elimination decision, 993 Segment reporting, A - 8 Selling and administrative costs, 749 Selling departments, 943 Selling expense budget, 856, 865 Selling expenses, 175 Selling price, 164, 99 4– 995 Sell or process decision, 99 0– 991 Semiannual compounding, 430, 442 Sensitivity analysis, 792 Separate legal entity, 466 Separation of duties, 211, 260, 261, 263 Serial bonds, 436 Service businesses, 16

account titles for, 55 n activity-based costing for, 750

application of, 752 demonstration of, 75 3– 756

analyst services, 564 bond rating services, 427, 446, 449 budget reporting and evaluation, 898 cost concepts for, 61 7– 618 cost of sales in, 162 current ratios of, 576 job order cost accounting for, 657, 667, 671 manufacturing activities different from, 618 process cost accounting for, 693 process operations in, 692, 707 variable costing for, 827

Service charges/fees, 272, 274 Service department(s), 942 Service department expenses, 947, 948 n, 94 8– 951 Service economy, 626 Service life of plant asset, 336, 339, 340, 345,

349, 355 Services, 17, 18, 53 Services revenue, 10 7– 108 Shareholders. See Stockholder(s) Shareholders’ equity. See Stockholders’ equity

Risk, 27, 28, 1016, 1020 The Risk Management Association, 24 Ritz-Carlton Hotel, 626 ROA. See Return on assets (ROA) Robbery prevention, 265 Rodgers, Aaron, 210 Rogue insiders, 262 ROI. See Return on assets (ROA) Rolling budgets, 85 1– 852 Rounding, 70, 429 Royal Caribbean Cruises Ltd., 898 Royal Phillips Electronics, 862 Rules-based accounting, 22, 120

Safety stock, 855 Safety stock inventory systems, 855 Salaries, 7, 62, 106, 384, 394, 946 Sales

on account ( See Credit sales) cash sales, 17 computing for target income, 79 0– 791,

796, 797 cost of ( See Cost of goods sold ) credit cards, 30 4– 305, 308, 320 expenses allocated on proportion of, 947 in foreign currency, C - 17 gift card sales, 381 internal control and, 259 joint relation with expenses, 571 of merchandise, accounting for, 16 9– 171, 188

under periodic inventory system, 184 returns and allowances, 17 0– 171 sales discounts, 170

under perpetual inventory system, 16 9– 171

seasonal variations in, 99 Sales activity, 623, 795, 89 9– 900 Sales allowances, 170, 171 Sales budget, 853, 85 4– 855, 865 Sales commissions, 61 4– 615, 856, 860 Sales discount(s), 165, 170, 184 Sales invoices, 53, 259, 281 Sales mix, 793, 991, 992 Sales mix selection, 99 1– 992 Sales mix variance, 911 Sales on account, 53, 30 2– 304 Sales price variance, 911, 920 Sales promotions and incentives, 108, 132, 435,

449, A - 7 Sales quantity variance, 911 Sales returns, 17 0– 171, 184 Sales taxes, 38 0– 381, 381 n Sales volume, 787 Sales volume variance, 911, 920 Salvage value of asset, 339

annual review of, 349 in computing ARR, 1019 net present value and, 1022

Sam’s Club, 164 Sarbanes-Oxley Act (SOX), 1 3– 14, 25 8– 259, 614

code of ethics mandated by, 7 exemption from Section 404(b) of, 14 filing requirements of, 111 internal control report mandated by, 259 Section 404 requirements, 259

Satyam Computers, 9

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IND-22 Index

Statutory restrictions on retained earnings, 482 Step-wise costs, 780 Stern, Stewart, and Co., 954 Stock, 13

capital stock, 13, 46 9– 470 common stock ( See Common stock ) direct or indirect sale of, 469 dividends on ( See Dividend(s) ) interpretation of stock quotes, 470 no-par value stock, 469, 471 par value stock, 469, 47 0– 471 percent ownership in, C - 9 preferred stock ( See Preferred stock ) redemption value of, 479 retirement of debt, 482, 491 treasury stock ( See Treasury stock )

Stock awards, 954 Stock buyback. See Treasury stock Stock dividends, 474, 491

accounting for, 47 4– 476 reasons for, 474 value of stock and, 476, 491

Stockholder(s), 5, 13, 466, 468 limited liability of, 466 registrar and transfer agents, 468 rights of, 468 stock certificate and transfer, 468

Stockholders’ equity, 55, 470 after declaring stock dividend, 475 book value per share, 48 6– 487 common stock

book value per share, 48 6– 487 classes of, 469 demonstration, 48 7– 489 equity analysis of transactions, 526 global view of, 484 issuance, 47 0– 471, 472 return on common stockholders’ equity,

581, 588 dividends

cash dividends, 473 n, 47 3– 474, 490 declaration of, 526 global view of, 484 stock dividends, 47 4– 476, 491 stock splits, 476, 491

preferred stock, 47 6– 479, 490 book value per preferred share, 486, 487 callable, 479 convertible, 47 8– 479 dividend preference of, 47 7– 478, 478 n, 485 global view of, 484 IFRS on, 479, 484 issuance, 477, 479

reporting, 48 2– 484 global view of, 484 statement of retained earnings ( See Statement

of retained earnings ) statement of stockholders’ equity, 483, 484,

A - 4, A - 12, A - 17, A - 21 stock options, 48 3– 484

Stock liquidation, 469 Stock markets, 466 Stock options, 48 3– 484 Stock quotes, 470 Stock splits, 476, 491 Stone, Biz, 3 Store supplies, 54

demonstration, 52 9– 532 demonstration of, 25, 26 direct method of reporting, 53 5– 539, 540

demonstration of, 532 illustration of, 515 indirect method compared, 51 6– 517, 518 operating activities section format, 539 operating cash payments, 53 6– 539 operating cash receipts, 53 5– 536 summary of adjustments for, 539

entrepreneurship, 509 examples of, A - 5, A - 13, A - 16, A - 20 financing cash flows, 52 5– 527, 528, 534, 540

equity analysis, 526 global view of, 527 noncurrent liability analysis, 525 proving cash balances, 527 ratio analysis ( See Cash flow ratios) three-stage analysis, 525

global view of, 527 indirect method of reporting, 51 6– 517, 540

application of, 51 7– 522 demonstration of, 53 0– 531 direct method compared, 51 6– 517, 518 illustration of, 517, 518 spreadsheet used in, 53 2– 534 summary of adjustments, 522

investing cash flows, 21, 22, 52 3– 524, 528, 534, 540

global view of, 527 other asset analysis, 524 reconstruction analysis, 52 3– 524 three-stage analysis, 523

operating cash flows, 51 6– 522 application of indirect method, 51 7– 522 global view of, 527 indirect and direct reporting methods,

51 6– 517, 518 spreadsheet preparation of, 53 2– 533 summary of adjustments for indirect

method, 522 preparation of, 51 4– 516, 540

analyzing cash account, 51 4– 515 analyzing noncash accounts, 51 5– 516 information needed, 516 proving cash balances, 527

spreadsheet preparation of, 53 2– 534 analysis of changes, 534 indirect method, 53 2– 533

use in evaluating company, 527, 540 Statement of comprehensive income, A - 14, A - 18, C - 10 Statement of earnings, 398, 399 Statement of financial position. See Balance sheet Statement of operations. See Income statement Statement of retained earnings, 20, 21, 48 2– 483

demonstration of, 25, 26, 75 links to other financial statements, 69 for merchandiser, 173 prepared from trial balance, 6 9– 70, 111, 125

Statement of stockholders’ equity, 483 equity reporting, 483, 484 examples of, A - 4, A - 12, A - 17, A - 21

Statements of Financial Accounting Standards No. 153, “Exchanges of Nonmonetary Assets – an amendment of APB Opinion No. 29,” 358

State Unemployment Taxes (SUTA), 386, 395 Static budget, 897

Specific rights of stockholders, 468 Speedee Oil Change and Tune-Up, 908 Spending variance, 916, 917, 918 S&P 500 index, 8 Sports Illustrated magazine, 386 “Spread,” 424 Spreadsheet(s) . See also Work sheet

in financial statement analysis, 567 in preparing budgeted balance sheet, 861 n in preparing statement of cash flows, 53 2– 534 spreadsheet programs, B - 5 as tools for CVP analysis, 781

SSA (Social Security Administration), 397 Stair-step costs, 780 Standard cost(s), 90 1– 910, 920

cost variances, 903 n, 90 3– 906 analysis of, 903, 914, 915 computation of, 90 3– 904 cost variance analysis, 903, 914, 915 demonstration of, 914, 915 labor cost variances, 90 5– 906, 920 materials cost variances, 90 4– 905 overhead cost variance ( See Overhead

cost variance(s) ) demonstration of, 91 2– 916 ethical dilemma, 902, 920 expanded overhead variances, 91 6– 918

computing variable and fixed variances, 91 6– 917

fixed overhead cost variances, 917, 918 formulas for, 917 variable overhead cost variances, 91 7– 918

global view of, 910 identifying, 902 materials and labor standards, 902, 918 overhead standards and variances, 90 7– 910

computing overhead cost variances, 90 8– 910 predicting activity levels, 908 setting overhead standards, 907

sales variances, 911 setting, 902, 903 standard cost accounting system, 91 8– 919

Standard cost card, 902, 903 Standard labor cost, 901 Standard materials cost, 901 Standard overhead cost, 901, 907 Standard overhead rate, 907, 908 Standard & Poor’s, 427, 564, 566 Standard price (SP), 904 Standard products, 739, 740, 74 6– 747 Standard quantity (SQ), 904 Staples, 173 Starbucks, 33 7– 338, 483, 522, C - 2 Start-up money, 468 Stated rate on bonds, 425 Stated value stock, 470, 472 Statement of cash flows, 21, 22, 50 8– 540

basics of, 51 0– 516 classification of, 51 1– 512 format, 51 3– 514 importance of, 51 0– 511 measurement of, 511 noncash investing and financing, 513, 540 preparation of, 51 4– 516 purpose, 510

cash sources and uses, 528 defined, 20, 510

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Index IND-23

Total asset turnover ratio, 355, 356, 360, 361 in financial statement analysis, 578, 580, 588 investments and, C - 11 – C - 12, C - 19

Total cost method, 99 4– 995 Total overhead variance, 90 8– 909, 915 Total quality management (TQM), 626 Toyota Motor Corporation, 626, 627, 752 Toys “R” Us, 223 TQM (total quality management), 626 Traceability, classification by, 615, 617 Trade discounts, 164 Trade-in allowance, 358 Trademarks, 353 Trade names, 353 Trade payables. See Accounts payable Trading on the equity, 422, 479 Trading securities, C - 3, C - 5 – C - 6

accounting summary for, C - 10 global view of, C - 11 selling, C - 5 – C - 6 valuing and reporting, C - 5

Transaction(s), 52, 76 Transaction analysis, 1 5– 20, 5 0– 76

accounting equation and, 15, 28 analyzing and recording process, 5 2– 56 cash purchases, 16, 17, 61, 62, 64 cash receipts, 18, 63 credit purchases, 17, 62 demonstration of, 7 2– 76 GAAP v s . IFRS on, 7 0– 71 global view of, 22, 7 0– 71 investment by owner, 16, 61 payment of accounts payable, 1 8– 19, 63 payment of cash dividend, 19, 63 payment of expenses in cash, 1 7– 18, 62, 65 prepaid expenses, 64 processing ( See Transaction processing) provision of services for cash, 17, 62, 64 recording transactions

( See Recording transactions) summary of transactions, 1 9– 20 trial balance, 6 7– 70 unearned revenues, 64

Transaction processing, 5 6– 66, 76 accounting equation analysis, 65, 66 debits and credits, 57, 57 n double-entry accounting, 5 7– 58 illustration of, 6 1– 65 journalizing and posting, 5 8– 61 ledger and chart of accounts, 5 6– 57

Transfer prices, 96 1– 962, 964 Transfer pricing system, 947, 96 1– 962 Transportation costs, 16 7– 168 Transportation-in, 168, 18 3– 184 Transportation-out, 168 Transposition errors, 68 n Treasurer of company, 264 Treasury bills, U.S., 264 Treasury bonds, U.S., 27 Treasury stock, 48 0– 482, 491

global view of, 484 purchasing, 48 0– 481 reissuing, 48 1– 482 retiring, 482

Trek, 613 Trend analysis, 56 9– 571 Trial and error, 1024

potential tax assessments, 391 sales taxes payable, 38 0– 381, 381 n tax deductible interest on bonds, 422 Wage and Tax Statement (Form W-2), 397,

398, 399 Tax Reform Act of 1986, 827 Tax reporting

absorption costing used for, 823, 827 accelerated depreciation, 102 2– 1023 MACRS used for, 344 payroll, 39 5– 399 temporary differences, 40 1– 402

Technological innovation in accounting, 4– 5 automation, 707 data overload and, 944 in internal control, 260, 26 1– 262

Technology-based accounting systems, 60, 61 Temporary accounts, 112, C - 8

closing to Income Summary, 173 for merchandise transactions, 18 3– 184 work sheet used in closing, 113, 114 zero balances of, 113

Temporary differences, 40 1– 402 Temporary investments. See

Short-term investments Tennessee Small Business Development

Centers, 815 Term bonds, 436 Theft, 172, 265

collusion in, 266 credit card number theft, 261, 262

Third-party credit cards, 304, 305, 320 36 0 - day year (bankers’ rule), 107,

313, 382 3M, C - 16 Three-stage analysis, 523, 525 Three Twins Ice Cream, 691 Throughput time, 626 TIBCO Software, 434 Ticker prices, 582 TicketMaster, 4 Ticket revenues, 55, 104 Time clocks, 260 Time deposits, 263 Time dimension of managerial accounting,

611, 612 Timeliness of information, 611, 612 Time period assumption, 12, 98, 100, 131 Times interest earned ratio, 392, 393, 395, 402,

57 9– 580, 588 Time tickets, 66 0– 661, 663 Time value of money, B - 10, B - 11, B -– B - 7

in capital budgeting, 1027, 1030 methods not using, 101 6– 1020 methods using, 102 0– 1025 tables used in, B - 10, B - 11

concepts, B - 1, B - 7 future values ( See Future value(s)) present values ( See Present value(s))

Timing in budget administration, 85 1– 852 of cash disbursements, 85 9– 860

TOMS, 509 TOMS.com, 509 Tootsie Roll, 339, 340 Top line items, 177

Straight-line bond amortization, 351, 426 demonstration of, 43 8– 439 discount on bonds payable, 42 6– 427, 448 premium on bonds payable, 42 9– 430, 448

Straight-line depreciation, 103, 34 0– 344, 360, 1019 Straight-line depreciation rate, 341 Straight-line depreciation schedule, 341 Strategic budgeting, 848 Strategic management, 28 Strategic plans, 61 0– 611 Sub-Chapter S corporations, 13 Subleases, 354 Subordinated debentures, 436 Subscriptions revenues, 104 Subsidiaries, C - 9 Subsidiary ledgers

accounts payable ledger, 382 accounts receivable ledger, 303 factory overhead ledger, 658, 660 inventory ledger, 211 notes payable not detailed in, 382 other ledgers, 303 plant asset ledger, 345

Sub Surface Waste Management, 306 Subunits (departments), 942 Sunk costs, 616, 987, 990, 991, 994 Sunoco, 391 SuperValu, 162, 302 Supplementary records, 168, 18 0– 182, 303 Suppliers, 6 Supplies, 16, 17, 54, 102 Supplies accounts, 54 Sustainable income, 58 8– 590

changes in accounting principles and, 58 9– 590 continuing operations, 588 discontinued segments, 588 earnings per share, 589 extraordinary items, 58 8– 589

SUTA (State Unemployment Taxes), 386, 395 SYSCO, 162, 302

Table of accounts, 25 T-accounts, 57, 58, 65, 66

in account analysis, 519, 524 for adjusting entries, 101, 105, 123 in analyzing cash flows, 53 5– 536 balance column accounts contrasted, 60 factory overhead account, 665

Take-home pay, 384 Talbots, 381 Target (stores), 99, 162, 235, 304, 470 Target, in budgeting, 853 Target cost, 655, 656 Tax accounting, 6 Taxation . See also Tax reporting

Annual Federal Unemployment Tax Return (Form 940), 395

corporate income tax ( See Income taxes) double taxation of corporations, 13, 2 8– 29, 467 Employer’s Quarterly Federal Tax Return (Form

941), 395, 396 inventory costing methods and, 21 8– 219, 236 IRS ( See Internal Revenue Service) payroll

employee deductions, 38 4– 385 employer liabilities, 38 5– 386, 402

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IND-24 Index

performance (income) reporting implications, 81 8– 823

converting income to absorption costing, 823, 831 differences in cost per unit and, 82 3– 825 summary of income reporting, 821, 822 units produced equal units sold, 81 8– 819 units produced exceed units sold, 820, 821 units sold exceed units produced, 821, 822

Variable costing income statement, 786 Variable expenses, 392 Variable interest entities (VIEs), 431 Variable overhead cost variances, 915, 91 7– 918 Variable overhead rate, 908 Variance(s), 920

in budget reporting, 850, 851 controllable, 90 8– 909, 910, 915 cost variances, 903 n, 90 3– 906

analysis of, 903, 914, 915 computation of, 90 3– 904 demonstration of, 914, 915 labor cost variances, 90 5– 906, 920 materials cost variances, 90 4– 905 overhead cost variance ( See Overhead

cost variance(s) ) efficiency variances, 90 4– 906, 915, 916, 919, 920 expanded overhead variances, 91 6– 918 favorable and unfavorable, 897, 900, 903 n, 920 price variances, 901, 904, 905 quantity variances, 901, 904, 905, 906, 920 sales variances, 911, 920 spending variance, 916, 917, 918 variable, computing, 91 6– 917

Variance analysis, 901, 903, 905 Vazquez, Maria Teresa (“Tera”), 815 Velez, Alexandro, 609 Vendee, 281 Vendor, 280, 380 Venture capitalists, 468 Vertical analysis, 563, 566, 590

common-size graphics, 57 3– 574 common-size statements, 57 1– 572, 573 global view of, 584

VIEs (variable interest entities), 431 VISA, 304, 308 Volkswagen Group, 177, 795 Volume, 779 Volume-based measures, 738, 739 Volume variances, 90 8– 909, 915 Voluntary payroll deductions, 385 Voters, 5 Voting rights, 468 Voucher, 267, 282, 283, 661 Voucher register, 282 Voucher system, 266, 28 0– 283, 285

as cash control, 26 6– 267 invoice, 281, 282 invoice approval, 28 1– 282 purchase order, 280, 281, 282 purchase requisition, 280, 282 receiving report, 281, 282 voucher, 282, 283

Wage and Tax Statement (Form W-2), 397, 398, 399 Wage bracket withholding table, 400 Wages, 62, 384, 946 Wait time, 957

Unusual gain or loss, 588 UPC codes, 164 Upper Deck, 210 Up-to-date depreciation, 348, 357 Usage variance, 904 Useful life of asset, 339, 345, 355

annual review of, 349 depreciation, 340 keep or replace decision, 993 of patents, 352 used in operations, 336, 339

Utilities expenses, 945, 947, 950

Vacation benefits, 388 Vacation pay, 106 Vacation policies, 259 Valuation

of accounts receivable by allowance method, 30 7– 308 by direct write-off method, 306 global view of, 316 realizable value, 307

of assets balance sheet effects, 337 book value ( See Book value of assets) fair value of financial assets, C - 11 impairment of asset value, 346, 352, 354 revaluations (IFRS), 355 salvage value, 339, 349, 1019, 1022

contingent valuation, 391 of inventories, 21 9– 222

effects of inventory errors, 22 0– 222 at lower of cost or market, 21 9– 220,

222, 236 note regarding, A - 8 of notes receivable, 320

dishonored note, 314 end-of-period interest adjustment, 31 4– 315 honored note, 314

Value-added activities, 749 Value-added time, 958 Value chain, 626, 627 Value engineering, 656 Variable budgets. See Flexible budget(s) Variable cost(s), 614, 615, 779

assumptions about behavior of, 788 in CVP analysis, 778, 779, 780 in flexible budgets, 898, 899 of manufacturing, 993 per unit, 779, 783, 825, 899 sales commissions as, 61 4– 615 step-wise costs treated as, 78 0– 781

Variable costing, 816 absorption costing compared, 81 6– 817,

82 3– 827 controlling costs, 826 limitations of variable costing reports,

82 6– 827 production planning, 82 3– 825 setting prices, 82 5– 826 variable costing for service firms, 827

break-even analysis and, 82 7– 828 computing unit cost under ( See Unit cost(s)) demonstration problem, 82 8– 830 entrepreneurship, 815 global view of, 827

Trial balance, 6 7– 70, 76 adjusted ( See Adjusted trial balance ) demonstration of, 75 post-closing, 11 4– 116 preparation of, 6 7– 68 in preparing financial statements, 67, 6 8– 70

balance sheet, 69, 70, 111 income statement, 69, 111 presentation issues, 70 statement of retained earnings, 6 9– 70, 111

unadjusted, 67, 110 Truth-in-Lending Act, 434 Turnover rate of assets, 576 Twitter, 3, 16 Tyco International, 13, 14 Type of business, 576 Typo-Squatting, 262

Unadjusted financial statements, 68 Unadjusted trial balance, 67, 110, 128, 129 Unavoidable expenses, 993 Uncertainty in liabilities, 37 9– 380, 391 Unclassified balance sheet, 117 Uncollectible accounts. See Bad debts Uncontrollable costs, 826, 943 Underapplied overhead, 665, 666, 671 Under Armour, 301 UnderArmour.com, 301 Underfunded pension plan, 448 Underwriters, 424 n Undistributed earnings, C - 8 Unearned revenue(s), 55, 100, 104

adjusting accounts, 10 4– 105 analyzing and recording, 55, 55 n as known liabilities, 381 links to financial statements, 109 subscriptions revenue, 386

Uneven cash flows, 1017 computing internal rate of return with, 1024 computing payback period with, 1018 net present value and, 1022

Unfavorable variances, 897, 900, 920 Unit contribution margin, 78 4– 785, 793 Unit cost(s), 212

in setting product price, 994, 995 for variable v s . absorption costing, 817, 824

computing, 831 demonstration of, 830 differences in, income reporting and, 82 3– 825

United By Blue, 941 UnitedByBlue.com, 941 U.S. Marine, C -9 U.S. Treasury bills, 264 U.S. Treasury bonds, 27 Unit level activities, 750, 751 Unit sales, 791 Units of input, 901 Units of product, 868, 899 Units-of-production depreciation, 34 1– 344, 350,

351, 360 Units-of-production depreciation schedule, 342 Unlimited liability, 12 Unrealized gain (loss), C - 5, C - 13 Unregistered bonds, 436 Unsecured bonds, 436 Unusual and infrequent items, 431

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Index IND-25

post-closing trial balance and, 11 4– 116 recording closing entries in, 11 2– 114 steps in using, 12 7– 128, 129

Workstations, 693 WorldCom, 9, 13, 14, 120, 267 Write-downs of inventory value, 222, 588 Write-offs of receivables, 588 W. T. Grant Co., 511 www.AICPA.org, 7 www.fraud.org, 261 www.investors.com, 565 www.IRS.gov, 344, 384, 385 www.SEC.gov, 345, A - 1 www.SEC.gov/edgar.shtml, 16 www.SSA.gov, 384

xe.com, 12 Xerox, 13, 120

YouTube, 353 Yum Brands, 827

Zero balances, 113 Zuckerberg, Mark, 467

WeMarket4U.net/FatFoe, 267 WeMarket4U.net/SundaeStation, 267 Weyerhaeuser, 350 “What-if” scenarios, 898 Whistle-blowers, 14 White-hat hackers, 262 Whiteman Air Force Base, 347 Whittaker, Andrew (“Jack”), B - 6 Whole Foods Market, Inc., 223 Wholesaler, 162 Williams, Evan, 3 Wi-Phishing, 262 Withholding allowance(s), 384, 398, 400 Withholding Allowance Certificate (Form W-4),

385, 400, 402 Withholdings. See Payroll deductions Women-owned businesses, 51, 54, 161 Work centers, 693 Working capital, 57 5– 576 Working papers, 127 Work sheet, 127 . See also Spreadsheet(s)

adjusted trial balance prepared from, 128, 129, 131 applications of, 128, 132 balance sheet prepared from, 861 n benefits of, 127 closing temporary accounts, 113, 114 perpetual inventory system, 187

Wall Street, 581 The Wall Street Journal, 469, 582 Walmart, 99, 162, 188, 266, 336 Walt Disney Company, 100, 353 Walton, Sam, 266 Warranty(ies), 388, 402

computing warranty expense, 394 note regarding, A - 6 – A - 7 warranty liabilities, 38 8– 389

Warranty services, 993 Waste elimination, 626 Wasting assets, 35 0– 351, 358, 360 Web sites, 16, 565 Weighted average (WA), 21 6– 217, 232

cost flow assumptions, 212, 213 periodic inventory system, 229, 23 2– 234, 236 perpetual inventory system, 217, 218, 227, 236

Weighted-average contribution margin, 793, 794

Weighted-average method, 702 change from FIFO method to, 715, 716 process costing illustration, 70 0– 707

assigning and reconciling costs, 70 2– 705 cost of goods manufactured, 70 5– 706 cost per equivalent unit, 702 equivalent units of production, 70 1– 702 physical flow of units, 701

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Following is a typical chart of accounts, which is used in several assignments. Every company has its own unique accounts and numbering system.

Assets Current Assets

101 Cash 102 Petty cash 103 Cash equivalents 104 Short-term investments 105 Fair value adjustment, _______ securities (S-T) 106 Accounts receivable 107 Allowance for doubtful accounts 108 Legal fees receivable 109 Interest receivable 110 Rent receivable 111 Notes receivable 119 Merchandise inventory 120 __________ inventory 121 __________ inventory 124 Office supplies 125 Store supplies 126 _______ supplies 128 Prepaid insurance 129 Prepaid interest 131 Prepaid rent 132 Raw materials inventory 133 Goods in process inventory, _______ 134 Goods in process inventory, _______ 135 Finished goods inventory

Long-Term Investments

141 Long-term investments 142 Fair value adjustment, _______ securities (L-T) 144 Investment in _______ 145 Bond sinking fund

Plant Assets

151 Automobiles 152 Accumulated depreciation — Automobiles 153 Trucks 154 Accumulated depreciation — Trucks 155 Boats 156 Accumulated depreciation — Boats 157 Professional library 158 Accumulated depreciation — Professional

library 159 Law library 160 Accumulated depreciation — Law library 161 Furniture 162 Accumulated depreciation — Furniture 163 Office equipment 164 Accumulated depreciation — Office equipment 165 Store equipment

166 Accumulated depreciation — Store equipment 167 _______ equipment 168 Accumulated depreciation — _______

equipment 169 Machinery 170 Accumulated depreciation — Machinery 173 Building _______ 174 Accumulated depreciation — Building _______ 175 Building _______ 176 Accumulated depreciation — Building _______ 179 Land improvements _______ 180 Accumulated depreciation — Land

improvements _______ 181 Land improvements _______ 182 Accumulated depreciation — Land

improvements _______ 183 Land

Natural Resources

185 Mineral deposit 186 Accumulated depletion — Mineral deposit

Intangible Assets

191 Patents 192 Leasehold 193 Franchise 194 Copyrights 195 Leasehold improvements 196 Licenses 197 Accumulated amortization— _______

Liabilities Current Liabilities

201 Accounts payable 202 Insurance payable 203 Interest payable 204 Legal fees payable 207 Office salaries payable 208 Rent payable 209 Salaries payable 210 Wages payable 211 Accrued payroll payable 214 Estimated warranty liability 215 Income taxes payable 216 Common dividend payable 217 Preferred dividend payable 218 State unemployment taxes payable 219 Employee federal income taxes payable 221 Employee medical insurance payable

222 Employee retirement program payable 223 Employee union dues payable 224 Federal unemployment taxes payable 225 FICA taxes payable 226 Estimated vacation pay liability

Unearned Revenues

230 Unearned consulting fees 231 Unearned legal fees 232 Unearned property management fees 233 Unearned _______ fees 234 Unearned _______ fees 235 Unearned janitorial revenue 236 Unearned _______ revenue 238 Unearned rent

Notes Payable

240 Short-term notes payable 241 Discount on short-term notes payable 245 Notes payable 251 Long-term notes payable 252 Discount on long-term notes payable

Long-Term Liabilities

253 Long-term lease liability 255 Bonds payable 256 Discount on bonds payable 257 Premium on bonds payable 258 Deferred income tax liability

Equity Owner’s Equity

301 ______________, Capital 302 ______________, Withdrawals 303 ______________, Capital 304 ______________, Withdrawals 305 ______________, Capital 306 ______________, Withdrawals

Paid-In Capital

307 Common stock, $ _______ par value 308 Common stock, no-par value 309 Common stock, $ _______ stated value 310 Common stock dividend distributable 311 Paid-in capital in excess of par value,

Common stock

Chart of Accounts

CA

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Chart of Accounts CA-1

312 Paid-in capital in excess of stated value, No-par common stock

313 Paid-in capital from retirement of common stock 314 Paid-in capital, Treasury stock 315 Preferred stock 316 Paid-in capital in excess of par value,

Preferred stock

Retained Earnings

318 Retained earnings 319 Cash dividends (or Dividends) 320 Stock dividends

Other Equity Accounts

321 Treasury stock, Common 322 Unrealized gain — Equity 323 Unrealized loss — Equity

Revenues 401 ______________ fees earned 402 ______________ fees earned 403 ______________ services revenue 404 ______________ services revenue 405 Commissions earned 406 Rent revenue (or Rent earned) 407 Dividends revenue (or Dividend earned) 408 Earnings from investment in _______ 409 Interest revenue (or Interest earned) 410 Sinking fund earnings 413 Sales 414 Sales returns and allowances 415 Sales discounts

Cost of Sales Cost of Goods Sold

502 Cost of goods sold 505 Purchases 506 Purchases returns and allowances 507 Purchases discounts 508 Transportation-in

Manufacturing

520 Raw materials purchases 521 Freight-in on raw materials 530 Factory payroll 531 Direct labor 540 Factory overhead 541 Indirect materials 542 Indirect labor 543 Factory insurance expired 544 Factory supervision 545 Factory supplies used 546 Factory utilities 547 Miscellaneous production costs 548 Property taxes on factory building 549 Property taxes on factory equipment 550 Rent on factory building 551 Repairs, factory equipment 552 Small tools written off 560 Depreciation of factory equipment 561 Depreciation of factory building

Standard Cost Variance

580 Direct material quantity variance 581 Direct material price variance 582 Direct labor quantity variance 583 Direct labor price variance 584 Factory overhead volume variance 585 Factory overhead controllable variance

Expenses Amortization, Depletion, and Depreciation

601 Amortization expense — _______ 602 Amortization expense — _______ 603 Depletion expense — _______ 604 Depreciation expense — Boats 605 Depreciation expense — Automobiles 606 Depreciation expense — Building _______ 607 Depreciation expense — Building _______ 608 Depreciation expense — Land

improvements _______ 609 Depreciation expense — Land

improvements _______ 610 Depreciation expense — Law library 611 Depreciation expense — Trucks 612 Depreciation expense — _______ equipment 613 Depreciation expense — _______ equipment 614 Depreciation expense — _______ 615 Depreciation expense — _______

Employee-Related Expenses

620 Office salaries expense 621 Sales salaries expense 622 Salaries expense 623 _______ wages expense 624 Employees’ benefits expense 625 Payroll taxes expense

Financial Expenses

630 Cash over and short 631 Discounts lost 632 Factoring fee expense 633 Interest expense

Insurance Expenses

635 Insurance expense — Delivery equipment 636 Insurance expense — Office equipment 637 Insurance expense — _______

Rental Expenses

640 Rent expense 641 Rent expense — Office space 642 Rent expense — Selling space 643 Press rental expense 644 Truck rental expense 645 _______ rental expense

Supplies Expenses

650 Office supplies expense 651 Store supplies expense 652 _______ supplies expense 653 _______ supplies expense

Miscellaneous Expenses

655 Advertising expense 656 Bad debts expense 657 Blueprinting expense 658 Boat expense 659 Collection expense 661 Concessions expense 662 Credit card expense 663 Delivery expense 664 Dumping expense 667 Equipment expense 668 Food and drinks expense 671 Gas and oil expense 672 General and administrative expense 673 Janitorial expense 674 Legal fees expense 676 Mileage expense 677 Miscellaneous expenses 678 Mower and tools expense 679 Operating expense 680 Organization expense 681 Permits expense 682 Postage expense 683 Property taxes expense 684 Repairs expense — _______ 685 Repairs expense — _______ 687 Selling expense 688 Telephone expense 689 Travel and entertainment expense 690 Utilities expense 691 Warranty expense 695 Income taxes expense

Gains and Losses 701 Gain on retirement of bonds 702 Gain on sale of machinery 703 Gain on sale of investments 704 Gain on sale of trucks 705 Gain on _______ 706 Foreign exchange gain or loss 801 Loss on disposal of machinery 802 Loss on exchange of equipment 803 Loss on exchange of _______ 804 Loss on sale of notes 805 Loss on retirement of bonds 806 Loss on sale of investments 807 Loss on sale of machinery 808 Loss on _______ 809 Unrealized gain — Income 810 Unrealized loss — Income 811 Impairment gain 812 Impairment loss

Clearing Accounts 901 Income summary 902 Manufacturing summary

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ISBN: 0-07-8025605 Author: Wild Title: Financial and Managerial Accounting, 5/e

Back endsheets Color: Black and Cyan Pages: 8, 5

SELECTED TRANSACTIONS AND RELATIONS ① Merchandising Transactions Summary ② Merchandising Cost Flows

Merchandising Transactions Merchandising Entries Dr. Cr.

Purchasing merchandise for • Merchandise Inventory . . . . . . . . . . . . . . . . # resale. Cash or Accounts Payable . . . . . . . . . . . # Paying freight costs on • Merchandise Inventory . . . . . . . . . . . . . . . . # purchases; FOB shipping point. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Purchases Paying within discount period. • Accounts Payable . . . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Recording purchase returns or • Cash or Accounts Payable . . . . . . . . . . . . . # allowances. Merchandise Inventory . . . . . . . . . . . . . # Selling merchandise. • Cash or Accounts Receivable . . . . . . . . . . # Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # • Cost of Goods Sold. . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . . . # Receiving payment within • Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # discount period. Sales Discounts . . . . . . . . . . . . . . . . . . . . . . #

Sales Accounts Receivable . . . . . . . . . . . . . . . . #

Granting sales returns or • Sales Returns and Allowances. . . . . . . . . . . # allowances. Cash or Accounts Receivable . . . . . . . . # • Merchandise Inventory . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . # Paying freight costs on sales; • Delivery Expense . . . . . . . . . . . . . . . . . . . . # FOB destination. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Merchandising Events Adjusting and Closing Entries

Adjusting due to shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . # Adjusting (occurs when recorded amount Merchandise Inventory . . . . . . . . . . . . . . # larger than physical inventory). Closing temporary accounts Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # with credit balances. Income Summary . . . . . . . . . . . . . . . . . . # Closing temporary accounts Income Summary . . . . . . . . . . . . . . . . . . . . . . #

Closing with debit balances. Sales Returns and Allowances . . . . . . . . #

Sales Discounts . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . # Delivery Expense . . . . . . . . . . . . . . . . . . # “Other Expenses” . . . . . . . . . . . . . . . . . #

⎫ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎭ ⎫ ⎬ ⎭

④ Bad Debts Estimation

Stock Transactions Stock Entries Dr. Cr.

Issue par value common stock at par Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Common Stock . . . . . . . . . . . . . . . . # Issue par value common stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Common Stock . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Par Value, Common Stock . . . . . # Issue no-par value common stock Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (no-par stock recorded at amount received). Common Stock . . . . . . . . . . . . . . . . # Issue stated value common stock at stated value Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (stated stock recorded at stated value). Common stock . . . . . . . . . . . . . . . . # Issue stated value common stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (stated stock recorded at stated value). Common stock . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Stated Value, Common Stock . . . . # Issue par value preferred stock at par Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Preferred Stock . . . . . . . . . . . . . . . . # Issue par value preferred stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Preferred Stock . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Par Value, Preferred Stock . . . . . # Reacquire its own common stock Treasury Stock, Common . . . . . . . . . . . # (treasury stock recorded at cost). Cash . . . . . . . . . . . . . . . . . . . . . . . . . # Reissue its treasury stock at cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost). Treasury Stock, Common . . . . . . . # Reissue its treasury stock above cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost). Treasury Stock, Common . . . . . . . . # Paid-In Capital, Treasury . . . . . . . . . # Reissue its treasury stock below cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost; if paid-in capital Paid-In Capital, Treasury . . . . . . . . . . . . . # is insufficient to cover amount below cost, Retained Earnings (if necessary) . . . . . . . # retained earnings is debited for remainder). Treasury Stock, Common . . . . . . . #

⑥ Stock Transactions Summary

Issue Common Stock

Issue Preferred Stock

Reacquire Common Stock

Reissue Common Stock

Type of Dividend

Account Cash Stock Stock Affected Dividend Dividend Split

Cash . . . . . . . . . . . . . Decrease — — Common Stock . . . . — Increase — Retained Earnings . . Decrease Decrease —

⑦ Dividend Transactions

t

t

Beginning inventory

From supplier

Net cost of purchases

Ending inventory

P e ri

o d

2 P

e ri

o d

1

To Balance Sheet

To Income Statemen

To Balance Sheet

Beginning inventory

Net cost of purchases

Ending inventory

Cost of goods sold

To Income Statemen Cost of

goods sold

Merchandise available for sale

Merchandise available for sale

From supplier

③ Credit Terms and Amounts

Amount Due

Due: Invoice priceDue: Invoice price minus discount*

*Discount refers to a purchase discount for a buyer and a sales discount for a seller.

Discount* period

Credit period

Date of invoice

Credit Terms

Time

Income Statement Focus

Percent of Sales [Emphasis on Matching]

Sales × Rate = Bad Debts Expense

or

or

Allowance for Doubtful Accounts

× Rate = Accounts

Receivable Allowance

for Doubtful Accounts

Accounts Receivable

(by Age)

Rates (by Age)

Bad Debts Estimation

Balance Sheet Focus

Percent of Receivables [Emphasis on Realizable Value]

Aging of Receivables [Emphasis on Realizable Value]

⑤ Bond Valuation

Bond Sets Market Sets Bond Price Determined

Contract rate > Market rate Bond sells at Premium

Contract rate = Market rate Bond sells at Par

Contract rate < Market rate Bond sells at Discount Bo

nd

Contract rate Market rate

⎫⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭ ⎫ ⎬ ⎭

* The term Consolidated often precedes or follows these statement titles to reflect the combination of different entities, such as a parent company and its subsidiaries.

Balance Sheet Statement of Financial Position Statement of Financial Condition

Income Statement Statement of Income Operating Statement Statement of Operations Statement of Operating Activity Earnings Statement Statement of Earnings Profit and Loss (P&L) Statement

Statement of Statement of Cash Flow Cash Flows Cash Flows Statement

Statement of Changes in Cash Position Statement of Changes in Financial Position

Statement of

Statement of Changes in Owner’s Equity

Stockholders’ Equity

Statement of Changes in Owner’s Capital

Statement of Shareholders’ Equity Statement of Changes in Shareholders’ Equity Statement of Stockholders’ Equity and

Comprehensive Income

Statement of Changes in Capital Accounts

The same financial statement sometimes receives different titles. Following are some of the more common aliases.*

⑧ A Rose by Any Other Name

wiL25605_ep.indd Page 1 10/12/12 7:35 AM user-f502wiL25605_ep.indd Page 1 10/12/12 7:35 AM user-f502 /208/MH01865/wiL25605_disk1of1/0078025605/wiL25605_pagefiles/208/MH01865/wiL25605_disk1of1/0078025605/wiL25605_pagefiles

ISBN: 0-07-8025605 Author: Wild Title: Financial and Managerial Accounting, 5/e

Back endsheets Color: Black and Cyan Pages: 8, 5

SELECTED TRANSACTIONS AND RELATIONS ① Merchandising Transactions Summary ② Merchandising Cost Flows

Merchandising Transactions Merchandising Entries Dr. Cr.

Purchasing merchandise for • Merchandise Inventory . . . . . . . . . . . . . . . . # resale. Cash or Accounts Payable . . . . . . . . . . . # Paying freight costs on • Merchandise Inventory . . . . . . . . . . . . . . . . # purchases; FOB shipping point. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Purchases Paying within discount period. • Accounts Payable . . . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Recording purchase returns or • Cash or Accounts Payable . . . . . . . . . . . . . # allowances. Merchandise Inventory . . . . . . . . . . . . . # Selling merchandise. • Cash or Accounts Receivable . . . . . . . . . . # Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # • Cost of Goods Sold. . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . . . # Receiving payment within • Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # discount period. Sales Discounts . . . . . . . . . . . . . . . . . . . . . . #

Sales Accounts Receivable . . . . . . . . . . . . . . . . #

Granting sales returns or • Sales Returns and Allowances. . . . . . . . . . . # allowances. Cash or Accounts Receivable . . . . . . . . # • Merchandise Inventory . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . # Paying freight costs on sales; • Delivery Expense . . . . . . . . . . . . . . . . . . . . # FOB destination. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Merchandising Events Adjusting and Closing Entries

Adjusting due to shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . # Adjusting (occurs when recorded amount Merchandise Inventory . . . . . . . . . . . . . . # larger than physical inventory). Closing temporary accounts Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # with credit balances. Income Summary . . . . . . . . . . . . . . . . . . # Closing temporary accounts Income Summary . . . . . . . . . . . . . . . . . . . . . . #

Closing with debit balances. Sales Returns and Allowances . . . . . . . . #

Sales Discounts . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . # Delivery Expense . . . . . . . . . . . . . . . . . . # “Other Expenses” . . . . . . . . . . . . . . . . . #

⎫ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎭ ⎫ ⎬ ⎭

④ Bad Debts Estimation

Stock Transactions Stock Entries Dr. Cr.

Issue par value common stock at par Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Common Stock . . . . . . . . . . . . . . . . # Issue par value common stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Common Stock . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Par Value, Common Stock . . . . . # Issue no-par value common stock Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (no-par stock recorded at amount received). Common Stock . . . . . . . . . . . . . . . . # Issue stated value common stock at stated value Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (stated stock recorded at stated value). Common stock . . . . . . . . . . . . . . . . # Issue stated value common stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (stated stock recorded at stated value). Common stock . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Stated Value, Common Stock . . . . # Issue par value preferred stock at par Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Preferred Stock . . . . . . . . . . . . . . . . # Issue par value preferred stock at premium Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (par stock recorded at par). Preferred Stock . . . . . . . . . . . . . . . . # Paid-In Capital in Excess of Par Value, Preferred Stock . . . . . # Reacquire its own common stock Treasury Stock, Common . . . . . . . . . . . # (treasury stock recorded at cost). Cash . . . . . . . . . . . . . . . . . . . . . . . . . # Reissue its treasury stock at cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost). Treasury Stock, Common . . . . . . . # Reissue its treasury stock above cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost). Treasury Stock, Common . . . . . . . . # Paid-In Capital, Treasury . . . . . . . . . # Reissue its treasury stock below cost Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # (treasury stock removed at cost; if paid-in capital Paid-In Capital, Treasury . . . . . . . . . . . . . # is insufficient to cover amount below cost, Retained Earnings (if necessary) . . . . . . . # retained earnings is debited for remainder). Treasury Stock, Common . . . . . . . #

⑥ Stock Transactions Summary

Issue Common Stock

Issue Preferred Stock

Reacquire Common Stock

Reissue Common Stock

Type of Dividend

Account Cash Stock Stock Affected Dividend Dividend Split

Cash . . . . . . . . . . . . . Decrease — — Common Stock . . . . — Increase — Retained Earnings . . Decrease Decrease —

⑦ Dividend Transactions

t

t

Beginning inventory

From supplier

Net cost of purchases

Ending inventory

P e ri

o d

2 P

e ri

o d

1

To Balance Sheet

To Income Statemen

To Balance Sheet

Beginning inventory

Net cost of purchases

Ending inventory

Cost of goods sold

To Income Statemen Cost of

goods sold

Merchandise available for sale

Merchandise available for sale

From supplier

③ Credit Terms and Amounts

Amount Due

Due: Invoice priceDue: Invoice price minus discount*

*Discount refers to a purchase discount for a buyer and a sales discount for a seller.

Discount* period

Credit period

Date of invoice

Credit Terms

Time

Income Statement Focus

Percent of Sales [Emphasis on Matching]

Sales × Rate = Bad Debts Expense

or

or

Allowance for Doubtful Accounts

× Rate = Accounts

Receivable Allowance

for Doubtful Accounts

Accounts Receivable

(by Age)

Rates (by Age)

Bad Debts Estimation

Balance Sheet Focus

Percent of Receivables [Emphasis on Realizable Value]

Aging of Receivables [Emphasis on Realizable Value]

⑤ Bond Valuation

Bond Sets Market Sets Bond Price Determined

Contract rate > Market rate Bond sells at Premium

Contract rate = Market rate Bond sells at Par

Contract rate < Market rate Bond sells at Discount Bo

nd

Contract rate Market rate

⎫⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

⎫⎪ ⎪ ⎬ ⎪ ⎪ ⎭

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭ ⎫ ⎬ ⎭

* The term Consolidated often precedes or follows these statement titles to reflect the combination of different entities, such as a parent company and its subsidiaries.

Balance Sheet Statement of Financial Position Statement of Financial Condition

Income Statement Statement of Income Operating Statement Statement of Operations Statement of Operating Activity Earnings Statement Statement of Earnings Profit and Loss (P&L) Statement

Statement of Statement of Cash Flow Cash Flows Cash Flows Statement

Statement of Changes in Cash Position Statement of Changes in Financial Position

Statement of

Statement of Changes in Owner’s Equity

Stockholders’ Equity

Statement of Changes in Owner’s Capital

Statement of Shareholders’ Equity Statement of Changes in Shareholders’ Equity Statement of Stockholders’ Equity and

Comprehensive Income

Statement of Changes in Capital Accounts

The same financial statement sometimes receives different titles. Following are some of the more common aliases.*

⑧ A Rose by Any Other Name

wiL25605_ep.indd Page 1 10/12/12 7:35 AM user-f502wiL25605_ep.indd Page 1 10/12/12 7:35 AM user-f502 /208/MH01865/wiL25605_disk1of1/0078025605/wiL25605_pagefiles/208/MH01865/wiL25605_disk1of1/0078025605/wiL25605_pagefiles

ISBN: 0-07-8025605 Author: Wild Title: Financial and Managerial Accounting, 5/e

Back endsheets Color: Black and Cyan Pages: 6, 7

FINANCIAL REPORTS

Balance Sheet Date

ASSETS Current assets Examples: Cash, Cash equivalents, Short-term investments, Accounts receivable, Current portion of notes . . . . . . . . . . . . . . . . . . . $ # receivable, Inventory, Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . # Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Long-term investments Examples: Investment in stock, Investment in bonds, . . . . . . . . . . . . . . # Land for expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Plant assets Examples: Equipment, Machinery, Buildings, Land . . . . . . . . . . . . . . . . . # Total plant assets, net of depreciation . . . . . . . . . . . . . . . . . . . . . . . . . # Intangible assets Examples: Patent, Trademark, Copyright, License, Goodwill . . . . . . . . # Total intangible assets, net of amortization . . . . . . . . . . . . . . . . . . . . . . # Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # LIABILITIES AND EQUITY Current liabilities Examples: Accounts payable, Wages payable, Salaries . . . . . . . . . . . . . . $ # payable, Current notes payable, Taxes payable, . . . . . . . . . . . . . . . . # Interest payable, Unearned revenues . . . . . . . . . . . . . . . . . . . . . . . . . # Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Long-term liabilities Examples: Notes payable, Bonds payable, Lease liability . . . . . . . . . . . . # Total long-term liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Paid-in capital in excess of par or stated value . . . . . . . . . . . . . . . . . . . # Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Less treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (#) Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Income Statement* For period Ended date

Net sales (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cost of goods sold (cost of sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Gross margin (gross profit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Operating expenses Examples: Depreciation, salaries, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # wages, rent, utilities, interest, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # amortization, advertising, taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Nonoperating gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Net income (net profit or earnings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

* A typical chart of accounts is at the end of the book and classifies all accounts by financial statement categories.

†Indirect Method: Cash Flows from Operating Activities

Cash flows from operating activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Add: Decreases in noncash current assets . . . . . . . . . . . . . . . . . . . . . . . . $ # Increases in current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Expenses with no cash outflows (examples: depreciation, and amortization of both intangibles and bond discounts) . . . . . # Nonoperating losses (examples: losses from asset sales and from debt retirements) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # #

Less: Increases in noncash current assets . . . . . . . . . . . . . . . . . . . . . . . . . # Decreases in current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Revenues with no cash inflows (examples: amortization of bond premiums) . . . . . . . . . . . . . . . . . . . . . . . . . # Nonoperating gains (examples: gains from asset sales and from debt retirements) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # # Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . $ #

Installment Notes Payment Table Payments

Period Debit Debit Credit Ending Beginning Interest Notes Ending Date Balance Expense 1 Payable 5 Cash Balance

# # # # # # . . . . . .. . . . . .. . . . . .

Statement of Cash Flows For period Ended date

Cash flows from operating activities [Prepared using the indirect (see below)† or direct method] Net cash provided (used) by operating activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cash flows from investing activities [List of individual investing inflows and outflows] Net cash provided (used) by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Cash flows from financing activities [List of individual financing inflows and outflows] Net cash provided (used) by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cash (and equivalents) balance at beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . # Cash (and equivalents) balance at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Attach separate schedule or note disclosure of “Noncash investing and financing transactions.”

Discount Bond Amortization (Straight-Line) Table†

Semiannual Period-End Unamortized Bond Discount* Bond Carrying Value**

Bond life-start . . . . . . . . . . . . . . $ # $ # . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond life-end . . . . . . . . . . . . . . . 0 par

† Bond carrying value is adjusted to par and its amortized discount to zero over the bond life (note: unamortized bond discount plus carrying value equals par).

* Equals total bond discount less its accumulated amortization. ** Equals bond par value less its unamortized bond discount.

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Premium Bond Amortization (Straight-Line) Table†

Semiannual Period-End Unamortized Bond Premium* Bond Carrying Value**

Bond life-start . . . . . . . . . . . . . . $ # $ # . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond life-end . . . . . . . . . . . . . . . 0 par

† Bond carrying value is adjusted to par and its amortized premium to zero over the bond life (note: carrying value less unamortized bond premium equals par).

* Equals total bond premium less its accumulated amortization. ** Equals bond par value plus its unamortized bond premium.

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Effective Interest Amortization Table for Bonds with Semiannual Interest Payment

Semiannual Cash Bond Discount Unamortized Interest Interest Interest or Premium Discount or Carrying Period-End PaidA ExpenseB AmortizationC PremiumD ValueE

# # # # # # . . . . . .. . . . . .. . . . . .

APar value multiplied by the semiannual contract rate. BPrior period’s carrying value multiplied by the semiannual market rate. CThe difference between interest paid and bond interest expense. DPrior period’s unamortized discount or premium less the current period’s discount or premium amortization. EPar value less unamortized discount or plus unamortized premium.

Book balance . . . . . . . . . . . . . . . . . . . . $# Add: Unrecorded bank credit memoranda . . . . . . . . . . . . . . $# Book errors understating the balance. . . . . . . . . . . . . . . $# $# Less: Unrecorded bank debit memoranda . . . . . . . . . . . . . . $# Book errors overstating the balance. . . . . . . . . . . . . . . $# Adjusted book balance . . . . . . . . . . $#

Bank statement balance. . . . . . . . . . . $# Add: Unrecorded deposits. . . . . . . . #

Bank errors understating the balance . . . . . . . . . . . . . # # Less: Outstanding checks . . . . . . . . . #

Bank errors overstating the balance . . . . . . . . . . . . . # Adjusted bank balance. . . . . . . . . $#

Bank Reconciliation Date

Balances are equal (reconciled)

Statement of Retained Earnings For period Ended date

Retained earnings, beginning . . . . . . . . . . . . $ # Add: Net income . . . . . . . . . . . . . . . . . . . . . # # Less: Dividends declared . . . . . . . . . . . . . . . # Retained earnings, ending . . . . . . . . . . . . . . $ #

Statement of Stockholders’ Equity†

For period Ended date Common Capital in Retained Treasury Stock Excess of Par Earnings Stock Total

Balances, beginning. . . . . . . . . . . $ # $ # $ # $ # $ # Net income . . . . . . . . . . . . . . . . Cash dividends . . . . . . . . . . . . . . Stock issuance . . . . . . . . . . . . . . Treasury stock purchase . . . . . . Treasury stock reissuance. . . . . Other . . . . . . . . . . . . . . . . . . . . . Balances, ending . . . . . . . . . . . . . $ # $ # $ # $ # $ #

† Additional columns and account titles commonly include number of shares, preferred stock, unrealized gains and losses on available-for-sale securities, foreign currency translation, and comprehensive income.

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FUNDAMENTALS ① Accounting Equation

Assets 5 Liabilities 1 Equity

↑ ↓ ↓ ↑ ↓ ↑ Debit for Credit for Debit for Credit for Debit for Credit for increases decreases decreases increases decreases increases

⑦ Inventory Costing Methods

• Specific identification • Weighted-average • First-in, first-out (FIFO) • Last-in, first-out (LIFO)

⑧ Depreciation and Depletion

Straight-line: Cost 2 Salvage value

Useful life in periods 3 Periods expired

Units-of-production:

Cost 2 Salvage value

Useful life in units 3 Units produced

Declining-balance: Rate* 3 Beginning-of-period book value *Rate is often double the straight-line rate, or 2 3 (1yUseful life)

Depletion: Cost 2 Salvage value

Total capacity in units 3 Units extracted

⑨ Interest Computation Interest 5 Principal (face) 3 Rate 3 Time

⑩ Accounting for Investment Securities

④ 4-Step Closing Process 1. Transfer revenue and gain account balances to Income Summary. 2. Transfer expense and loss account balances to Income Summary. 3. Transfer Income Summary balance to Retained Earnings. 4. Transfer Dividends balance to Retained Earnings.

ANALYSES ① Liquidity and Efficiency

Current ratio 5 Current assets

Current liabilities pp. 117 & 575

Working capital 5 Current assets 2 Current liabilities p. 575

Acid-test ratio 5 Cash 1 Short-term investments 1 Current receivables

Current liabilities pp. 178 & 576

Accounts receivable turnover 5 Net sales

Average accounts receivable, net pp. 317 & 577

Credit risk ratio 5 Allowance for doubtful accounts

Accounts receivable, net p. 317

Inventory turnover 5 Cost of goods sold

Average inventory

pp. 223 & 577

Days’ sales uncollected 5 Accounts receivable, net

Net sales 3 365*

p. 577

Days’ sales in inventory 5 Ending inventory

Cost of goods sold 3 365*

pp. 223 & 578

Total asset turnover 5 Net sales

Average total assets pp. 355 & 578

Plant asset useful life 5 Plant asset cost

Depreciation expense p. 355

Plant asset age 5 Accumulated depreciation

Depreciation expense p. 355

Days’ cash expense coverage 5 Cash and cash equivalents

Average daily cash expenses p. 264

*360 days is also commonly used.

② Solvency

Debt ratio 5 Total liabilities

Total assets

Equity ratio 5 Total equity

Total assets pp. 69 & 583

Debt-to-equity 5 Total liabilities

Total equity pp. 437 & 579

Times interest earned 5 Income before interest expense and income taxes

Interest expense pp. 392 & 580

Cash coverage of growth 5

Cash flow from operations

Cash outflow for plant assets p. 529

Cash coverage of debt 5 Cash flow from operations

Total noncurrent liabilities p. 529

③ Profitability

Profit margin ratio 5 Net income

Net sales p. 117

Gross margin ratio 5 Net sales 2 Cost of goods sold

Net sales p. 178

Return on total assets 5 Net income

Average total assets pp. 580 & 953

5 Profit margin ratio 3 Total asset turnover p. 581

Return on common stockholders’ equity 5 Net income 2 Preferred dividends

Average common stockholders’ equity p. 581

Book value per common share 5 Stockholders’ equity applicable to common shares

Number of common shares outstanding p. 486

Basic earnings per share 5 Net income 2 Preferred dividends

Weighted-average common shares outstanding p. 485

Cash flow on total assets 5 Cash flow from operations

Average total assets p. 528

Payout ratio 5 Cash dividends declared on common stock

Net income p. 486

④ Market

Price-earnings ratio 5 Market value (price) per share

Earnings per share p. 485

Dividend yield 5 Annual cash dividends per share

Market price per share

pp. 486 & 582

Residual income 5 Net income 2 Target net income

⑤ Accounting Concepts

Characteristics Assumptions Principles Constraints

Relevance Business entity Measurement (historical cost) Cost-benefit Reliability Going concern Revenue recognition Materiality Comparability Monetary unit Expense recognition Industry practice Consistency Periodicity Full disclosure Conservatism

⑥ Ownership of Inventory

Ownership Transfers Transportation Costs When Goods Passed To Paid By

FOB Shipping Point . . . . . . . . . . . Carrier Buyer FOB Destination . . . . . . . . . . . . . Buyer Seller

Type Adjusting Entry

Prepaid Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Expense Cr. Asset* Unearned Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Liability Cr. Revenue Accrued Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Expense Cr. Liability Accrued Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Asset Cr. Revenue

*For depreciation, credit Accumulated Depreciation (contra asset).

③ Adjustments and Entries

Classification* Accounting

Short-Term Investment in Securities Held-to-maturity (debt) securities . . . . . . . . . . . . Cost (without any discount or premium amortization) Trading (debt and equity) securities. . . . . . . . . . . Fair value (with fair value adjustment to income) Available-for-sale (debt and equity) securities . . . Fair value (with fair value adjustment to equity) Long-Term Investment in Securities Held-to-maturity (debt) securities . . . . . . . . . . . . Cost (with any discount or premium amortization) Available-for-sale (debt and equity) securities . . . Fair value (with fair value adjustment to equity) Equity securities with significant influence . . . . . . Equity method Equity securities with controlling influence . . . . . Equity method (with consolidation)

*A fair value option allows companies to report HTM and AFS securities much like trading securities.

Contributed Capital* Retained Earnings

Common Stock Dividends Revenues Expenses

Dr. for Cr. for Dr. for Cr. for Dr. for Cr. for Dr. for Cr. for decreases increases increases decreases decreases increases increases decreases

Indicates normal balance. *Includes common stock and any preferred stock.

② Accounting Cycle

2. Journalize

10. Reverse (Optional)

1. Analyze transactions

Accounting Cycle

3. Post

4. Prepare unadjusted

trial balance

5. Adjust

6. Prepare adjusted

trial balance

9. Prepare post-

closing trial balance

7. Prepare statements

8. Close

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wiL25605_ep.indd Page 2 10/12/12 7:35 AM user-f502wiL25605_ep.indd Page 2 10/12/12 7:35 AM user-f502 /208/MH01865/wiL25605_disk1of1/0078025605/wiL25605_pagefiles/208/MH01865/wiL25605_disk1of1/0078025605/wiL25605_pagefiles

ISBN: 0-07-8025605 Author: Wild Title: Financial and Managerial Accounting, 5/e

Back endsheets Color: Black and Cyan Pages: 6, 7

FINANCIAL REPORTS

Balance Sheet Date

ASSETS Current assets Examples: Cash, Cash equivalents, Short-term investments, Accounts receivable, Current portion of notes . . . . . . . . . . . . . . . . . . . $ # receivable, Inventory, Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . # Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Long-term investments Examples: Investment in stock, Investment in bonds, . . . . . . . . . . . . . . # Land for expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Plant assets Examples: Equipment, Machinery, Buildings, Land . . . . . . . . . . . . . . . . . # Total plant assets, net of depreciation . . . . . . . . . . . . . . . . . . . . . . . . . # Intangible assets Examples: Patent, Trademark, Copyright, License, Goodwill . . . . . . . . # Total intangible assets, net of amortization . . . . . . . . . . . . . . . . . . . . . . # Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # LIABILITIES AND EQUITY Current liabilities Examples: Accounts payable, Wages payable, Salaries . . . . . . . . . . . . . . $ # payable, Current notes payable, Taxes payable, . . . . . . . . . . . . . . . . # Interest payable, Unearned revenues . . . . . . . . . . . . . . . . . . . . . . . . . # Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Long-term liabilities Examples: Notes payable, Bonds payable, Lease liability . . . . . . . . . . . . # Total long-term liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Paid-in capital in excess of par or stated value . . . . . . . . . . . . . . . . . . . # Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Less treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (#) Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Income Statement* For period Ended date

Net sales (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cost of goods sold (cost of sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Gross margin (gross profit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Operating expenses Examples: Depreciation, salaries, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # wages, rent, utilities, interest, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # amortization, advertising, taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Nonoperating gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Net income (net profit or earnings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

* A typical chart of accounts is at the end of the book and classifies all accounts by financial statement categories.

†Indirect Method: Cash Flows from Operating Activities

Cash flows from operating activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Add: Decreases in noncash current assets . . . . . . . . . . . . . . . . . . . . . . . . $ # Increases in current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Expenses with no cash outflows (examples: depreciation, and amortization of both intangibles and bond discounts) . . . . . # Nonoperating losses (examples: losses from asset sales and from debt retirements) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # #

Less: Increases in noncash current assets . . . . . . . . . . . . . . . . . . . . . . . . . # Decreases in current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Revenues with no cash inflows (examples: amortization of bond premiums) . . . . . . . . . . . . . . . . . . . . . . . . . # Nonoperating gains (examples: gains from asset sales and from debt retirements) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # # Net cash provided (used) by operating activities . . . . . . . . . . . . . . . . . . . $ #

Installment Notes Payment Table Payments

Period Debit Debit Credit Ending Beginning Interest Notes Ending Date Balance Expense 1 Payable 5 Cash Balance

# # # # # # . . . . . .. . . . . .. . . . . .

Statement of Cash Flows For period Ended date

Cash flows from operating activities [Prepared using the indirect (see below)† or direct method] Net cash provided (used) by operating activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cash flows from investing activities [List of individual investing inflows and outflows] Net cash provided (used) by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Cash flows from financing activities [List of individual financing inflows and outflows] Net cash provided (used) by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Cash (and equivalents) balance at beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . # Cash (and equivalents) balance at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Attach separate schedule or note disclosure of “Noncash investing and financing transactions.”

Discount Bond Amortization (Straight-Line) Table†

Semiannual Period-End Unamortized Bond Discount* Bond Carrying Value**

Bond life-start . . . . . . . . . . . . . . $ # $ # . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond life-end . . . . . . . . . . . . . . . 0 par

† Bond carrying value is adjusted to par and its amortized discount to zero over the bond life (note: unamortized bond discount plus carrying value equals par).

* Equals total bond discount less its accumulated amortization. ** Equals bond par value less its unamortized bond discount.

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Premium Bond Amortization (Straight-Line) Table†

Semiannual Period-End Unamortized Bond Premium* Bond Carrying Value**

Bond life-start . . . . . . . . . . . . . . $ # $ # . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bond life-end . . . . . . . . . . . . . . . 0 par

† Bond carrying value is adjusted to par and its amortized premium to zero over the bond life (note: carrying value less unamortized bond premium equals par).

* Equals total bond premium less its accumulated amortization. ** Equals bond par value plus its unamortized bond premium.

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Effective Interest Amortization Table for Bonds with Semiannual Interest Payment

Semiannual Cash Bond Discount Unamortized Interest Interest Interest or Premium Discount or Carrying Period-End PaidA ExpenseB AmortizationC PremiumD ValueE

# # # # # # . . . . . .. . . . . .. . . . . .

APar value multiplied by the semiannual contract rate. BPrior period’s carrying value multiplied by the semiannual market rate. CThe difference between interest paid and bond interest expense. DPrior period’s unamortized discount or premium less the current period’s discount or premium amortization. EPar value less unamortized discount or plus unamortized premium.

Book balance . . . . . . . . . . . . . . . . . . . . $# Add: Unrecorded bank credit memoranda . . . . . . . . . . . . . . $# Book errors understating the balance. . . . . . . . . . . . . . . $# $# Less: Unrecorded bank debit memoranda . . . . . . . . . . . . . . $# Book errors overstating the balance. . . . . . . . . . . . . . . $# Adjusted book balance . . . . . . . . . . $#

Bank statement balance. . . . . . . . . . . $# Add: Unrecorded deposits. . . . . . . . #

Bank errors understating the balance . . . . . . . . . . . . . # # Less: Outstanding checks . . . . . . . . . #

Bank errors overstating the balance . . . . . . . . . . . . . # Adjusted bank balance. . . . . . . . . $#

Bank Reconciliation Date

Balances are equal (reconciled)

Statement of Retained Earnings For period Ended date

Retained earnings, beginning . . . . . . . . . . . . $ # Add: Net income . . . . . . . . . . . . . . . . . . . . . # # Less: Dividends declared . . . . . . . . . . . . . . . # Retained earnings, ending . . . . . . . . . . . . . . $ #

Statement of Stockholders’ Equity†

For period Ended date Common Capital in Retained Treasury Stock Excess of Par Earnings Stock Total

Balances, beginning. . . . . . . . . . . $ # $ # $ # $ # $ # Net income . . . . . . . . . . . . . . . . Cash dividends . . . . . . . . . . . . . . Stock issuance . . . . . . . . . . . . . . Treasury stock purchase . . . . . . Treasury stock reissuance. . . . . Other . . . . . . . . . . . . . . . . . . . . . Balances, ending . . . . . . . . . . . . . $ # $ # $ # $ # $ #

† Additional columns and account titles commonly include number of shares, preferred stock, unrealized gains and losses on available-for-sale securities, foreign currency translation, and comprehensive income.

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FUNDAMENTALS ① Accounting Equation

Assets 5 Liabilities 1 Equity

↑ ↓ ↓ ↑ ↓ ↑ Debit for Credit for Debit for Credit for Debit for Credit for increases decreases decreases increases decreases increases

⑦ Inventory Costing Methods

• Specific identification • Weighted-average • First-in, first-out (FIFO) • Last-in, first-out (LIFO)

⑧ Depreciation and Depletion

Straight-line: Cost 2 Salvage value

Useful life in periods 3 Periods expired

Units-of-production:

Cost 2 Salvage value

Useful life in units 3 Units produced

Declining-balance: Rate* 3 Beginning-of-period book value *Rate is often double the straight-line rate, or 2 3 (1yUseful life)

Depletion: Cost 2 Salvage value

Total capacity in units 3 Units extracted

⑨ Interest Computation Interest 5 Principal (face) 3 Rate 3 Time

⑩ Accounting for Investment Securities

④ 4-Step Closing Process 1. Transfer revenue and gain account balances to Income Summary. 2. Transfer expense and loss account balances to Income Summary. 3. Transfer Income Summary balance to Retained Earnings. 4. Transfer Dividends balance to Retained Earnings.

ANALYSES ① Liquidity and Efficiency

Current ratio 5 Current assets

Current liabilities pp. 117 & 575

Working capital 5 Current assets 2 Current liabilities p. 575

Acid-test ratio 5 Cash 1 Short-term investments 1 Current receivables

Current liabilities pp. 178 & 576

Accounts receivable turnover 5 Net sales

Average accounts receivable, net pp. 317 & 577

Credit risk ratio 5 Allowance for doubtful accounts

Accounts receivable, net p. 317

Inventory turnover 5 Cost of goods sold

Average inventory

pp. 223 & 577

Days’ sales uncollected 5 Accounts receivable, net

Net sales 3 365*

p. 577

Days’ sales in inventory 5 Ending inventory

Cost of goods sold 3 365*

pp. 223 & 578

Total asset turnover 5 Net sales

Average total assets pp. 355 & 578

Plant asset useful life 5 Plant asset cost

Depreciation expense p. 355

Plant asset age 5 Accumulated depreciation

Depreciation expense p. 355

Days’ cash expense coverage 5 Cash and cash equivalents

Average daily cash expenses p. 264

*360 days is also commonly used.

② Solvency

Debt ratio 5 Total liabilities

Total assets

Equity ratio 5 Total equity

Total assets pp. 69 & 583

Debt-to-equity 5 Total liabilities

Total equity pp. 437 & 579

Times interest earned 5 Income before interest expense and income taxes

Interest expense pp. 392 & 580

Cash coverage of growth 5

Cash flow from operations

Cash outflow for plant assets p. 529

Cash coverage of debt 5 Cash flow from operations

Total noncurrent liabilities p. 529

③ Profitability

Profit margin ratio 5 Net income

Net sales p. 117

Gross margin ratio 5 Net sales 2 Cost of goods sold

Net sales p. 178

Return on total assets 5 Net income

Average total assets pp. 580 & 953

5 Profit margin ratio 3 Total asset turnover p. 581

Return on common stockholders’ equity 5 Net income 2 Preferred dividends

Average common stockholders’ equity p. 581

Book value per common share 5 Stockholders’ equity applicable to common shares

Number of common shares outstanding p. 486

Basic earnings per share 5 Net income 2 Preferred dividends

Weighted-average common shares outstanding p. 485

Cash flow on total assets 5 Cash flow from operations

Average total assets p. 528

Payout ratio 5 Cash dividends declared on common stock

Net income p. 486

④ Market

Price-earnings ratio 5 Market value (price) per share

Earnings per share p. 485

Dividend yield 5 Annual cash dividends per share

Market price per share

pp. 486 & 582

Residual income 5 Net income 2 Target net income

⑤ Accounting Concepts

Characteristics Assumptions Principles Constraints

Relevance Business entity Measurement (historical cost) Cost-benefit Reliability Going concern Revenue recognition Materiality Comparability Monetary unit Expense recognition Industry practice Consistency Periodicity Full disclosure Conservatism

⑥ Ownership of Inventory

Ownership Transfers Transportation Costs When Goods Passed To Paid By

FOB Shipping Point . . . . . . . . . . . Carrier Buyer FOB Destination . . . . . . . . . . . . . Buyer Seller

Type Adjusting Entry

Prepaid Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Expense Cr. Asset* Unearned Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Liability Cr. Revenue Accrued Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Expense Cr. Liability Accrued Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. Asset Cr. Revenue

*For depreciation, credit Accumulated Depreciation (contra asset).

③ Adjustments and Entries

Classification* Accounting

Short-Term Investment in Securities Held-to-maturity (debt) securities . . . . . . . . . . . . Cost (without any discount or premium amortization) Trading (debt and equity) securities. . . . . . . . . . . Fair value (with fair value adjustment to income) Available-for-sale (debt and equity) securities . . . Fair value (with fair value adjustment to equity) Long-Term Investment in Securities Held-to-maturity (debt) securities . . . . . . . . . . . . Cost (with any discount or premium amortization) Available-for-sale (debt and equity) securities . . . Fair value (with fair value adjustment to equity) Equity securities with significant influence . . . . . . Equity method Equity securities with controlling influence . . . . . Equity method (with consolidation)

*A fair value option allows companies to report HTM and AFS securities much like trading securities.

Contributed Capital* Retained Earnings

Common Stock Dividends Revenues Expenses

Dr. for Cr. for Dr. for Cr. for Dr. for Cr. for Dr. for Cr. for decreases increases increases decreases decreases increases increases decreases

Indicates normal balance. *Includes common stock and any preferred stock.

② Accounting Cycle

2. Journalize

10. Reverse (Optional)

1. Analyze transactions

Accounting Cycle

3. Post

4. Prepare unadjusted

trial balance

5. Adjust

6. Prepare adjusted

trial balance

9. Prepare post-

closing trial balance

7. Prepare statements

8. Close

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

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① Cost Types Variable costs: Total cost changes in proportion to volume of activity Fixed costs: Total cost does not change in proportion to volume of activity Mixed costs: Cost consists of both a variable and a fixed element

② Cost Sources Direct materials: Raw materials costs directly linked to finished product Direct labor: Employee costs directly linked to finished product Overhead: Costs indirectly linked to finished product

③ Costing Systems Job order costing: Costs assigned to each unique unit or batch of units Process costing: Costs assigned to similar products that are mass-produced in a continuous manner

④ Costing Ratios

Contribution margin ratio 5 (Net sales 2 Variable costs)yNet sales Predetermined overhead rate 5 Estimated overhead costsy Estimated activity base Break-even point in units 5 Total fixed costsyContribution margin per unit

⑤ Planning and Control Metrics Cost variance 5 Actual cost 2 Standard (budgeted) cost Sales (revenue) variance 5 Actual sales 2 Standard (budgeted) sales

⑥ Capital Budgeting Payback period 5 Time expected to recover investment cost Accounting rate of return 5 Expected annual net incomeyAverage annual investment Net present value (NPV) 5 Present value of future cash flows 2 Investment cost NPV rule: 1. Compute net present value (NPV in $) 2. If NPV $ 0, then accept project; If NPV , 0, then reject project Internal rate 1. Compute internal rate of return (IRR in %) of return rule: 2. If IRR $ hurdle rate, accept project; If IRR , hurdle rate, reject project

⑦ Costing Terminology Relevant range: Organization’s normal range of operating activity. Direct cost: Cost incurred for the benefit of one cost object. Indirect cost: Cost incurred for the benefit of more than one cost object. Product cost: Cost that is necessary and integral to finished products. Period cost: Cost identified more with a time period than with finished products. Overhead cost: Cost not separately or directly traceable to a cost object. Relevant cost: Cost that is pertinent to a decision. Opportunity cost: Benefit lost by choosing an action from two or more alternatives. Sunk cost: Cost already incurred that cannot be avoided or changed. Standard cost: Cost computed using standard price and standard quantity. Budget: Formal statement of an organization’s future plans. Break-even point: Sales level at which an organization earns zero profit. Incremental cost: Cost incurred only if the organization undertakes a certain action. Transfer price: Price on transactions between divisions within a company.

⑧ Standard Cost Variances

Total materials variance

5

Materials price

variance   1  

Materials quantity variance

Total labor variance

5

Labor (rate)

variance   1  

Labor efficiency (quantity) variance

Total overhead variance

5

Overhead controllable

variance   1  

Fixed overhead volume variance

Overhead controllable 5 Actual total 2 Applied total overhead variance overhead from flexible budget

Fixed overhead volume 5 Budgeted fixed 2 Applied fixed variance overhead overhead

Variable overhead variance 5 Variable overhead 1 Variable overhead spending variance efficiency variance

Fixed overhead variance 5 Fixed overhead 1 Fixed overhead spending variance volume variance

Materials price variance 5 [AQ 3 AP] 2 [AQ 3 SP]

Materials quantity variance 5 [AQ 3 SP] 2 [SQ 3 SP]

Labor (rate) variance 5 [AH 3 AR] 2 [AH 3 SR]

Labor efficiency (quantity) variance 5 [AH 3 SR] 2 [SH 3 SR]

Variable overhead spending variance 5 [AH 3 AVR] 2 [AH 3 SVR]

Variable overhead efficiency variance 5 [AH 3 SVR] 2 [SH 3 SVR]

Fixed overhead spending variance 5 Actual fixed overhead 2 Budgeted fixed overhead

where AQ is actual q_uantity of materials; AP is actual p_rice of materials; AH is actual hours of la- bor; AR is actual rate of wages; AVR is actual variable rate of overhead; SQ is standard q_uantity of materials; SP is standard p_rice of materials; SH is standard hours of labor; SR is standard rate of wages; SVR is standard variable rate of overhead.

⑨ Sales Variances

Sales price variance 5 [AS 3 AP] 2 [AS 3 BP]

Sales volume variance 5 [AS 3 BP] 2 [BS 3 BP]

where AS 5 actual sales units; AP 5 actual sales price; BP 5 budgeted sales price; BS 5 budgeted sales units (fixed budget)

⎫ ⎪ ⎬ ⎪ ⎭

5 Total overhead variance

Contribution Margin Income Statement For period Ended date

Net sales (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Contribution margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Manufacturing Statement For period Ended date

Direct materials Raw materials inventory, Beginning . . . . . . . . . . . . . . . . . $ # Raw materials purchases . . . . . . . . . . . . . . . . . . . . . . . . . # Raw materials available for use . . . . . . . . . . . . . . . . . . . . # Raw materials inventory, Ending . . . . . . . . . . . . . . . . . . . (#) Direct materials used . . . . . . . . . . . . . . . . . . . . . . . . . . . # Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Overhead costs Total overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . # Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . . . . . . # Add goods in process inventory, Beginning . . . . . . . . . . . . . # Total cost of goods in process . . . . . . . . . . . . . . . . . . . . . . # Deduct goods in process inventory, Ending . . . . . . . . . . . . (#) Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . $ #

Flexible Budget For period Ended date

Flexible Budget Flexible Budget

Variable for Unit Amount Fixed Sales of per Unit Cost #

Sales (revenues) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # $ # Variable costs Examples: Direct materials, Direct labor, Other variable costs . . . . . . . . . . . . . . . . . . . . . . . . # # Total variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . # # Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # # Fixed costs Examples: Depreciation, Manager . . . . . . . . . . . . . . . . $ # # salaries, Administrative salaries . . . . . . . . . . . . . . . . # # Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ # # Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . $ #

Budget Performance Report* For period Ended date

Actual Budget Performance Variances†

Sales: In units . . . . . . . . . . . . . . . . . . . . . . . . . # #

In dollars. . . . . . . . . . . . . . . . . . . . . . . . $ # $ # $ # F or U Cost of sales Direct costs . . . . . . . . . . . . . . . . . . . . . . . . # # # F or U Indirect costs . . . . . . . . . . . . . . . . . . . . . . # # # F or U Selling expenses Examples: Commissions . . . . . . . . . . . . . . # # # F or U Shipping expenses. . . . . . . . . . . # # # F or U General and administrative expenses Examples: Administrative salaries . . . . . . . # # # F or U Total expenses . . . . . . . . . . . . . . . . . . . . . . . $ # $ # $ # F or U Income from operations . . . . . . . . . . . . . . . . $ # $ # $ # F or U

† F 5 Favorable variance; U 5 Unfavorable variance. * Applies to both flexible and fixed budgets.

Prepare sales

budget

Develop production

or purchases budget

Consolidate operating and capital expenditures budgets into financial budgets: • Cash budget • Budgeted income

statement • Budgeted balance

sheet

Prepare manufacturing,

selling, and general and administrative expense budgets

Prepare capital

expenditures budget

Operating Budgets Capital Expenditures Budget

Financial Budgets

Master Budget Sequence

MANAGERIAL ANALYSES AND REPORTS

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Financial & managerial Accounting

John J. Wild

Ken W. Shaw

Barbara Chiappetta

5th edition

information for decisions

5th edition

fin a n c ia l &

m a n a g er ia l

a c c o u n t in g

Wild Shaw

chiappetta

9 7 8 0 0 7 8 0 2 5 6 0 0

9 0 0 0 0

www.mhhe.com

ISBN 978-0-07-802560-0 MHID 0-07-802560-5

E A N

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  • Cover Page
  • connect
  • Title Page
  • Copyright Page
  • Adapting to the Needs of Today's Students
  • About the Authors
  • Letter to the reader
  • Adapting to the Needs of Today's Students!
  • Adapting to the Needs of Today's Students!
  • Adapting to the Needs of Today's Instructors
  • How Can Text-Related Web Resources Enrich My Course?
  • CourseSmart
  • Innovative Textbook Features
  • Bring Accounting To Life
  • Outstanding Assignment Material
  • Helps Students Master Key Concepts
  • Enhancements in This Edition
  • For Better Learning
  • Instructor Supplements
  • Student Supplements
  • Assurance of Learning Ready
  • Acknowledgments
  • Brief Contents
  • Table of Content
  • 1 Introducing Accounting in Business
    • Importance of Accounting
      • Users of Accounting Information
      • Opportunities in Accounting
    • Fundamentals of Accounting
      • Ethics—A Key Concept
      • Fraud Triangle
      • Generally Accepted Accounting Principles
      • International Standards
      • Conceptual Framework and Convergence
      • Sarbanes–Oxley (SOX)
      • Dodd-Frank
    • Transaction Analysis and the Accounting Equation
      • Accounting Equation
      • Transaction Analysis
      • Summary of Transactions
    • Financial Statements
      • Income Statement
      • Statement of Retained Earnings
      • Balance Sheet
      • Statement of Cash Flows
    • Global View
    • Decision Analysis—Return on Assets
    • Appendix 1A Return and Risk Analysis
    • Appendix 1B Business Activities and the Accounting Equation
  • 2 Analyzing and Recording Transactions
    • Analyzing and Recording Process
      • Source Documents
      • The Account and Its Analysis
    • Analyzing and Processing Transactions
      • Ledger and Chart of Accounts
      • Debits and Credits
      • Double-Entry Accounting
      • Journalizing and Posting Transactions
      • Analyzing Transactions—An Illustration
      • Accounting Equation Analysis
    • Trial Balance
      • Preparing a Trial Balance
      • Using a Trial Balance to Prepare Financial Statements
    • Global View
    • Decision Analysis—Debt Ratio
  • 3 Adjusting Accounts and Preparing Financial Statements
    • Timing and Reporting
      • The Accounting Period
      • Accrual Basis versus Cash Basis
      • Recognizing Revenues and Expenses
    • Adjusting Accounts
      • Frameworks for Adjustments
      • Prepaid (Deferred) Expenses
      • Unearned (Deferred) Revenues
      • Accrued Expenses
      • Accrued Revenues
      • Links to Financial Statements
      • Adjusted Trial Balance
    • Preparing Financial Statements
    • Closing Process
      • Temporary and Permanent Accounts
      • Recording Closing Entries
      • Post-Closing Trial Balance
      • Accounting Cycle
    • Classified Balance Sheet
      • Classification Structure
      • Classification Categories
    • Global View
    • Decision Analysis—Profit Margin and Current Ratio
    • Appendix 3A Alternative Accounting for Prepayments
    • Appendix 3B Work Sheet as a Tool
    • Appendix 3C Reversing Entries
  • 4 Accounting for Merchandising Operations
    • Merchandising Activities
      • Reporting Income for a Merchandiser
      • Reporting Inventory for a Merchandiser
      • Operating Cycle for a Merchandiser
      • Inventory Systems
    • Accounting for Merchandise Purchases
      • Purchase Discounts
      • Purchase Returns and Allowances
      • Transportation Costs and Ownership Transfer
    • Accounting for Merchandise Sales
      • Sales of Merchandise
      • Sales Discounts
      • Sales Returns and Allowances
    • Completing the Accounting Cycle
      • Adjusting Entries for Merchandisers
      • Preparing Financial Statements
      • Closing Entries for Merchandisers
      • Summary of Merchandising Entries
    • Financial Statement Formats
      • Multiple-Step Income Statement
      • Single-Step Income Statement
      • Classified Balance Sheet
    • Global View
    • Decision Analysis—Acid-Test and Gross Margin Ratios
    • Appendix 4A Periodic Inventory System
    • Appendix 4B Work Sheet—Perpetual System
  • 5 Inventories and Cost of Sales
    • Inventory Basics
      • Determining Inventory Items
      • Determining Inventory Costs
      • Internal Controls and Taking a Physical Count
    • Inventory Costing under a Perpetual System
      • Inventory Cost Flow Assumptions
      • Inventory Costing Illustration
      • Specific Identification
      • First-In, First-Out
      • Last-In, First-Out
      • Weighted Average
      • Financial Statement Effects of Costing Methods
      • Consistency in Using Costing Methods
    • Valuing Inventory at LCM and the Effects of Inventory Errors
      • Lower of Cost or Market
      • Financial Statement Effects of Inventory Errors
    • Global View
    • Decision Analysis—Inventory Turnover and Days’ Sales in Inventory
    • Appendix 5A Inventory Costing under a Periodic System
    • Appendix 5B Inventory Estimation Methods
  • 6 Cash and Internal Controls
    • Internal Control
      • Purpose of Internal Control
      • Principles of Internal Control
      • Technology and Internal Control
      • Limitations of Internal Control
    • Control of Cash
      • Cash, Cash Equivalents, and Liquidity
      • Cash Management
      • Control of Cash Receipts
      • Control of Cash Disbursements
    • Banking Activities as Controls
      • Basic Bank Services
      • Bank Statement
      • Bank Reconciliation
    • Global View
    • Decision Analysis—Days’ Sales Uncollected
    • Appendix 6A Documentation and Verification
    • Appendix 6B Control of Purchase Discounts
  • 7 Accounts and Notes Receivable
    • Accounts Receivable
      • Recognizing Accounts Receivable
      • Valuing Accounts Receivable—Direct Write-Off Method
      • Valuing Accounts Receivable—Allowance Method
      • Estimating Bad Debts—Percent of Sales Method
      • Estimating Bad Debts—Percent of Receivables Method
      • Estimating Bad Debts—Aging of Receivables Method
    • Notes Receivable
      • Computing Maturity and Interest
      • Recognizing Notes Receivable
      • Valuing and Settling Notes
    • Disposal of Receivables
      • Selling Receivables
      • Pledging Receivables
    • Global View
    • Decision Analysis—Accounts Receivable Turnover
  • 8 Long-Term Assets
    • SECTION 1—PLANT ASSETS
    • Cost Determination
      • Land
      • Land Improvements
      • Buildings
      • Machinery and Equipment
      • Lump-Sum Purchase
    • Depreciation
      • Factors in Computing Depreciation
      • Depreciation Methods
      • Partial-Year Depreciation
      • Change in Estimates for Depreciation
      • Reporting Depreciation
    • Additional Expenditures
      • Ordinary Repairs 347
      • Betterments and Extraordinary Repairs
    • Disposals of Plant Assets
      • Discarding Plant Assets
      • Selling Plant Assets
    • SECTION 2—NATURAL RESOURCES
      • Cost Determination and Depletion
      • Plant Assets Used in Extracting
    • SECTION 3—INTANGIBLE ASSETS
      • Cost Determination and Amortization
      • Types of Intangibles
    • Global View
    • Decision Analysis—Total Asset Turnover
    • Appendix 8A Exchanging Plant Assets
  • 9 Current Liabilities
    • Characteristics of Liabilities
      • Defining Liabilities
      • Classifying Liabilities
      • Uncertainty in Liabilities
    • Known Liabilities
      • Accounts Payable
      • Sales Taxes Payable
      • Unearned Revenues
      • Short-Term Notes Payable
      • Payroll Liabilities
      • Multi-Period Known Liabilities
    • Estimated Liabilities
      • Health and Pension Benefits
      • Vacation Benefits
      • Bonus Plans
      • Warranty Liabilities
      • Multi-Period Estimated Liabilities
    • Contingent Liabilities
      • Accounting for Contingent Liabilities
      • Reasonably Possible Contingent Liabilities
      • Uncertainties that Are Not Contingencies
    • Global View
    • Decision Analysis—Times Interest Earned Ratio
    • Appendix 9A Paroll Reports, Records, and Procedures
    • Appendix 9B Corporate Income Taxes
  • 10 Long-Term Liabilities
    • Basics of Bonds
      • Bond Financing
      • Bond Trading
      • Bond-Issuing Procedures
    • Bond Issuances
      • Issuing Bonds at Par
      • Bond Discount or Premium
      • Issuing Bonds at a Discount
      • Issuing Bonds at a Premium
      • Bond Pricing
    • Bond Retirement
      • Bond Retirement at Maturity
      • Bond Retirement before Maturity
      • Bond Retirement by Conversion
    • Long-Term Notes Payable
      • Installment Notes
      • Mortgage Notes and Bonds
    • Global View
    • Decision Analysis—Debt Features and the Debt-to- Equity Ratio
    • Appendix 10A Present Values of Bonds and Notes
    • Appendix 10B Effective Interest Amortization
    • Appendix 10C Issuing Bonds between Interest Dates
    • Appendix 10D Leases and Pensions
  • 11 Corporate Reporting and Analysis
    • Corporate Form of Organization
      • Characteristics of Corporations
      • Corporate Organization and Management
      • Stockholders of Corporations
      • Basics of Capital Stock
    • Common Stock
      • Issuing Par Value Stock
      • Issuing No-Par Value Stock
      • Issuing Stated Value Stock
      • Issuing Stock for Noncash Assets
    • Dividends
      • Cash Dividends
      • Stock Dividends
      • Stock Splits
    • Preferred Stock
      • Issuance of Preferred Stock
      • Dividend Preference of Preferred Stock
      • Convertible Preferred Stock
      • Callable Preferred Stock
      • Reasons for Issuing Preferred Stock
    • Treasury Stock
      • Purchasing Treasury Stock
      • Reissuing Treasury Stock
      • Retiring Stock
    • Reporting of Equity
      • Statement of Retained Earnings
      • Statement of Stockholders’ Equity
      • Reporting Stock Options
    • Global View
    • Decision Analysis—Earnings per Share, Price- Earnings Ratio, Dividend Yield, and Book Value per Share
  • 12 Reporting Cash Flows
    • Basics of Cash Flow Reporting
      • Purpose of the Statement of Cash Flows
      • Importance of Cash Flows
      • Measurement of Cash Flows
      • Classification of Cash Flows
      • Noncash Investing and Financing
      • Format of the Statement of Cash Flows
      • Preparing the Statement of Cash Flows
    • Cash Flows from Operating
      • Indirect and Direct Methods of Reporting
      • Application of the Indirect Method of Reporting
      • Summary of Adjustments for Indirect Method
    • Cash Flows from InvestingCash Flows from Investing
      • Three-Stage Process of Analysis
      • Analysis of Noncurrent Assets
      • Analysis of Other Assets
    • Cash Flows from Financing
      • Three-Stage Process of Analysis
      • Analysis of Noncurrent Liabilities
      • Analysis of Equity
      • Proving Cash Balances
    • Global View
    • Decision Analysis—Cash Flow Analysis
    • Appendix 12A Spreadsheet Preparation of the Statement of Cash Flows
    • Appendix 12B Direct Method of Reporting Operating Cash Flows
  • 13 Analysis of Financial Statements
    • Basics of Analysis
      • Purpose of Analysis
      • Building Blocks of Analysis
      • Information for Analysis
      • Standards for Comparisons
      • Tools of Analysis
    • Horizontal Analysis
      • Comparative Statements
      • Trend Analysis
    • Vertical Analysis
      • Common-Size Statements
      • Common-Size Graphics
    • Ratio Analysis
      • Liquidity and Efficiency
      • Solvency
      • Profitability
      • Market Prospects
      • Summary of Ratios
    • Global View
    • Decision Analysis—Analysis Reporting
    • Appendix 13A Sustainable Income
  • 14 Managerial Accounting Concepts and Principles
    • Managerial Accounting Basics
      • Purpose of Managerial Accounting
      • Nature of Managerial Accounting
      • Managerial Decision Making
      • Fraud and Ethics in Managerial Accounting
    • Managerial Cost Concepts
      • Types of Cost Classifications
      • Identification of Cost Classifications
      • Cost Concepts for Service Companies
    • Reporting Manufacturing Activities
      • Manufacturer’s Costs
      • Manufacturer’s Balance Sheet
      • Manufacturer’s Income Statement
      • Flow of Manufacturing Activities
      • Manufacturing Statement
      • Trends in Managerial Accounting
    • Global View
    • Decision Analysis—Raw Materials Inventory Turnover and Days’ Sales of Raw Materials Inventory
  • 15 Job Order Costing and Analysis
    • Job Order Cost Accounting
      • Cost Accounting System
      • Job Order Production
      • Job Order Costing of Services
      • Events in Job Order Costing
      • Job Cost Sheet
    • Job Order Cost Flows and Reports
      • Materials Cost Flows and Documents
      • Labor Cost Flows and Documents
      • Overhead Cost Flows and Documents
      • Summary of Cost Flows
    • Adjusting Factory Overhead
      • Factory Overhead T-Account
      • Underapplied or Overapplied Overhead
    • Global View
    • Decision Analysis—Pricing for Services
  • 16 Costing and Analysis
    • Process Operations
      • Comparing Job Order and Process Operations
      • Organization of Process Operations
      • GenX Company—An Illustration
    • Process Cost Accounting
      • Comparing Job Order and Process Cost Accounting Systems
      • Direct and Indirect Costs
      • Accounting for Materials Costs
      • Accounting for Labor Costs
      • Accounting for Factory Overhead
    • Equivalent Units of Production
      • Accounting for Goods in Process
      • Differences in Equivalent Units for Materials, Labor, and Overhead
    • Process Costing Illustration
      • Step 1: Determine the Physical Flow of Units
      • Step 2: Compute Equivalent Units of Production
      • Step 3: Compute the Cost per Equivalent Unit
      • Step 4: Assign and Reconcile Costs
      • Transfers to Finished Goods Inventory and Cost of Goods Sold
      • Trends in Process Operations
    • Global View
    • Decision Analysis—Hybrid Costing System
    • Appendix 16A FIFO Method of Process Costing
  • 17 Activity-Based Costing and Analysis
    • Assigning Overhead Costs
      • Plantwide Overhead Rate Method
      • Departmental Overhead Rate Method
      • Activity-Based Costing Rates and Method
    • Applying Activity-Based Costing
      • Step 1: Identify Activities and the Costs They Cause
      • Step 2: Trace Overhead Costs to Cost Pools
      • Step 3: Determine Activity Rates
      • Step 4: Assign Overhead Costs to Cost Objects
    • Assessing Activity-Based Costing
      • Advantages of Activity-Based Costing
      • Disadvantages of Activity-Based Costing
      • ABC for Service Providers
      • Types of Activities
    • Global View
    • Decision Analysis—Customer Profitability
  • 18 Cost Behavior and Cost-Volume- Profit Analysis
    • Identifying Cost Behavior
      • Fixed Costs
      • Variable Costs
      • Mixed Costs
      • Step-Wise Costs
      • Curvilinear Costs
    • Measuring Cost Behavior
      • Scatter Diagrams
      • High-Low Method
      • Least-Squares Regression
      • Comparison of Cost Estimation Methods
    • Using Break-Even Analysis
      • Contribution Margin and Its Measures
      • Computing the Break-Even Point
      • Computing the Margin of Safety
      • Preparing a Cost-Volume-Profit Chart
      • Making Assumptions in Cost-Volume-Profit Analysis
    • Applying Cost-Volume-Profit Analysis
      • Computing Income from Sales and Costs
      • Computing Sales for a Target Income
      • Using Sensitivity Analysis
      • Computing a Multiproduct Break-Even Point
    • Global View
    • Decision Analysis—Degree of Operating Leverage
    • Appendix 18A Using Excel to Estimate Least-Squares Regression
  • 19 Variable Costing and Performance Reporting
    • Introducing Variable Costing and Absorption Costing
      • Computing Unit Cost
    • Performance Reporting (Income) Implications
      • Units Produced Equal Units Sold
      • Units Produced Exceed Units Sold
      • Units Produced Are Less Than Units Sold
      • Summarizing Income Reporting
      • Converting Income under Variable Costing to Absorption Costing
    • Comparing Variable Costing and Absorption Costing
      • Planning Production
      • Setting Prices
      • Controlling Costs
      • Limitations of Reports Using Variable Costing
      • Variable Costing for Service Firms
    • Global View
    • Decision Analysis—Break-Even Analysis
  • 20 Master Budgets and Performance Planning
    • Budget Process
      • Strategic Budgeting
      • Benchmarking Budgets
      • Budgeting and Human Behavior
      • Budgeting as a Management Tool
      • Budgeting Communication
    • Budget Administration
      • Budget Committee
      • Budget Reporting
      • Budget Timing
    • Master Budget
      • Master Budget Components
      • Operating Budgets
      • Capital Expenditures Budget
      • Financial Budgets
    • Global View
    • Decision Analysis—Activity-Based Budgeting
    • Appendix 20A Production and Manufacturing Budgets
  • 21 Flexible Budgets and
    • SECTION 1—FLEXIBLE BUDGETS
      • Budgetary Process
        • Budgetary Control and Reporting
        • Fixed Budget Performance Report
        • Budget Reports for Evaluation
    • Flexible Budget Reports
      • Purpose of Flexible Budgets
      • Preparation of Flexible Budgets
      • Flexible Budget Performance Report
    • SECTION 2—STANDARD COSTS
    • Materials and Labor Standards
      • Identifying Standard Costs
      • Setting Standard Costs
    • Cost Variances
      • Cost Variance Analysis
      • Cost Variance Computation
      • Computing Materials and Labor Variances
    • Overhead Standards and Variances
      • Setting Overhead Standards
      • Predicting Activity Levels
      • Computing Overhead Cost Variances
    • Global View
    • Decision Analysis—Sales Variances
    • Appendix 21A: Expanded Overhead Variances and Standard Cost Accounting System
  • 22 Performance Measurement and Responsibility Accounting
    • Responsibility Accounting
      • Motivation for Departmentalization
      • Departmental Evaluation
      • Controllable versus Uncontrollable Costs
    • Cost Centers
      • Responsibility Accounting System
      • Evaluating Cost Center Performance
    • Profit Center
      • Direct and Indirect Expenses
      • Allocation of Indirect Expenses
      • Departmental Income Statements
      • Departmental Contribution to Overhead
    • Evaluating Investment Center Performance
      • Financial Performance Evaluation Measures
      • Nonfinancial Performance Evaluation Measures
    • Global View
    • Decision Analysis—Cycle Time and Cycle Efficiency
    • Appendix 22A Transfer Pricing
    • Appendix 22B Joint Costs and Their Allocation
  • 23 Relevant Costing for Managerial Decisions
    • Decisions and Information
      • Decision Making
      • Relevant Costs
    • Managerial Decision Scenarios
      • Additional Business
      • Make or Buy
      • Scrap or Rework
      • Sell or Process
      • Sales Mix Selection
      • Segment Elimination
      • Keep or Replace Equipment
      • Qualitative Decision Factors
    • Decision Analysis—Setting Product Price
  • 24 Capital Budgeting and Investment Analysis
    • Introduction to Capital Budgeting
    • Methods Not Using Time Value of Money
      • Payback Period
      • Accounting Rate of Return
    • Methods Using Time Value of Money
      • Net Present Value
      • Internal Rate of Return
      • Comparison of Capital Budgeting Methods
    • Global View
    • Decision Analysis—Break-Even Time
    • Appendix 24A Using Excel to Compute Net Present Value and Internal Rate of Return
  • Appendix A Financial Statement Information
  • Appendix A Polaris
  • Appendix A Arctic Cat
  • Appendix A KTM
  • Appendix A Piaggio
  • Appendix B Time Value of Money
  • Appendix C Investments and International Operations
  • * Appendix D Accounting for Partnerships
  • * Appendix E Accounting with Special Journals
  • Glossary
  • Credits
  • Index
  • Chart of Accounts
  • Back Cover