Wk7 DQ - Financial Management
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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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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.
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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
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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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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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The end result is content that better prepares students for
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based, interactive adaptive learning tools that provide an
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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
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"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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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
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* 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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Contents xxix
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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Contents xxxi
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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xxxii Contents
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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xxxiv Contents
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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Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10
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DSEFX S&P 500
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$12,932 S&P 500
$12,398 DSEFX
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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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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Hawaiian Islands Puerto Rico (to U.S.)
Canary Islands
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COSTA RICA
PANAMA
BELIZE JAMAICA
CUBA
BAHAMAS
HAITI
DOMINICAN REPUBLIC
TRINIDAD AND TOBAGO
AFGHANISTAN
TAJIKISTAN
K AZAKHSTAN
KYRGYZSTAN
INDIA
NEPAL
PAKISTAN
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YEMEN
IR AQ IR AN
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JORDAN
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KUWAIT
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BOTSWANA
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ZAMBIA
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TOGO
BURKINA FASO
IVORY COAST
BENINLIBERIA
SIERRA LEONE
MALIMAURITANIA
NIGER
NIGERIA CENTRAL
AFRICAN REP.
WESTERN SAHARA
SENEGAL GAMBIA
CAPE VERDE
GUINEA-BISSAU
LIBYA ALGERIA
TUNISIA
PORTUGAL SPAIN
UNITED KINGDOM
IRELAND
NORWAY FINLAND
GEORGIA
ARMENIA
AZERBAIJAN
GUYANA SURINAME
FRENCH GUIANA
CHINA
BHUTAN
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Bratislava Vienna
Prague
Amsterdam
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Warsaw
Oslo Stockholm
London Kiev
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Lisbon Madrid
Helsinki
Dublin
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New York
San Francisco
Chicago
Montreal
Denver
Los Angeles
Havana
Dallas
Miami
Atlanta
Seattle
Anchorage
Lima
Rio De Janeiro
São Paulo
Honolulu
Cape Town
Kinshasa
Lagos
Baghdad
Tehran
New Delhi
Bangkok
Shanghai
Sydney
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
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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
W979 7 Che
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Antig o, WI
5440 9
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Date Num
ber
11/2 /11
4657 -2
P.O. Dat
e Sale
spe rson
Term s
Frei ght
Ship
Sub Tota
l 1,20
0
1,20 0
Ship ping
Tax
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INVO ICE
CH0 15
SD0 99
Cha lleng
er X 7
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490
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10/30 /11
#141 2/10,
n/30 FOB
Desti nation
Via Fe dEx
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6052 1
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
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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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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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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).
G lo
b a l a
cc o u n ts
( in
m il.
)
JP M
o rg
a n
D is
co ve
r
M B
N A
A m
e ri ca
n E
xp re
ss
P a yP
a l
M a st
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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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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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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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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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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
