Week 1 assignment

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Fundamental Accounting Principles

24th edition

John J. Wild University of Wisconsin at Madison

Ken W. Shaw University of Missouri at Columbia

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To my students and family, especially Kimberly, Jonathan, Stephanie, and Trevor. To my wife Linda and children Erin, Emily, and Jacob.

FUNDAMENTAL ACCOUNTING PRINCIPLES, TWENTY-FOURTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2017, 2015, and 2013. 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 McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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

This book is printed on acid-free paper.

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ISBN 978-1-259-91696-0 (combined bound edition) MHID 1-259-91696-0 (combined bound edition) ISBN 978-1-260-15855-7 (combined loose-leaf edition) MHID 1-260-15855-1 (combined loose-leaf edition) ISBN 978-1-260-15860-1 (principles bound edition, chapters 1-17) MHID 1-260-15860-8 (principles bound edition, chapters 1-17) ISBN 978-1-260-15861-8 (principles loose-leaf edition, chapters 1-17) MHID 1-260-15861-6 (principles loose-leaf edition, chapters 1-17)

Executive Portfolio Manager: Steve Schuetz Product Developers: Michael McCormick, Christina Sanders Marketing Manager: Michelle Williams Content Project Managers: Lori Koetters, Brian Nacik Buyer: Sandy Ludovissy Design: Debra Kubiak Content Licensing Specialist: Melissa Homer Cover Image: Bicyclist: ©Mezzotint/Shutterstock; Statistics icons: ©A-spring/Shutterstock; Background image: ©Vector work/Shutterstock

Compositor: Aptara®, Inc.

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

Library of Congress Cataloging-in-Publication Data

Names: Wild, John J., author. | Shaw, Ken W., author. Title: Fundamental accounting principles / John J. Wild, University of  Wisconsin at Madison, Ken W. Shaw, University of Missouri at Columbia. Description: 24th edition. | Dubuque, IA : McGraw-Hill Education, [2018] |  Revised edition of Fundamental accounting principles, [2017] Identifiers: LCCN 2018016853 | ISBN 9781259916960 (alk. paper) | ISBN  1259916960 (alk. paper) | ISBN 9781260158601 (alk. paper) | ISBN  1260158608 (alk. paper) Subjects: LCSH: Accounting. Classification: LCC HF5636 .W675 2018 | DDC 657—dc23 LC record available at https://lccn.loc.gov/2018016853     The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.     mheducation.com/highered

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About the Authors

Courtesy of John J. Wild

JOHN J. WILD is a distinguished professor 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.

John teaches accounting courses at both the undergraduate and graduate levels. He has received numerous teaching honors, including the Mabel W. Chipman Excellence-in- Teaching Award and the departmental Excellence-in-Teaching Award, and he is a two-time recipient of the Teaching Excellence Award from 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. John has received several research honors, 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.

John 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. John is author of Financial Accounting, Managerial Accounting, Financial and Managerial Accounting, and College Accounting, all published by McGraw- Hill Education.

John’s 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; Accounting Horizons; and other journals. He is past associate editor of Contemporary Accounting Research and has served on several editorial boards including The Accounting Review and the Journal of Accounting and Public Policy.

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

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Using Learning Science and Data Analytics

Courtesy of Ken W. Shaw

KEN W. SHAW is an associate professor of accounting and the KPMG/Joseph A. Silvoso Distinguished Professor of Accounting at the University of Missouri. He previously was on the faculty at the University of Maryland at College Park. He has also taught in international programs at the University of Bergamo (Italy) and the University of Alicante (Spain). 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.

Ken teaches accounting at the undergraduate and graduate levels. He has received numerous School of Accountancy, College of Business, and university-level teaching awards. He was voted the “Most Influential Professor” by four 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.

Ken 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. Ken’s research appears in the Journal of Accounting Research; The Accounting Review; 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; Journal of Business Research; and Research in Accounting Regulation. Ken is co-author of Financial and Managerial Accounting, Managerial Accounting, and College Accounting, all published by McGraw-Hill Education.

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

Author Letter

We use data to make decisions and maximize performance. Like the mountain biker on the cover who uses data to track his progress, we used student performance data to identify content areas that can be made more direct, concise, and systematic.

Learning science reveals that students do not read large chunks of text, so we streamlined this edition to present it in a more focused, succinct, blocked format to improve student learning and retention. Our new edition delivers the same content in 115

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fewer pages. Visual aids and numerous videos offer additional learning aids. New summary Cheat Sheets conclude each chapter to visually reinforce key concepts and procedures.

Our new edition has over 1,500 videos to engage students and improve outcomes:

Concept Overview Videos—cover each chapter’s learning objectives with multimedia presentations that include Knowledge Checks to engage students and assess comprehension. Need-to-Know Demos—walk-through demonstrations of key procedures and analysis to ensure success with assignments and tests. Guided Examples (Hints)—step-by-step walk-through of assignments that mimic Quick Studies, Exercises, and General Ledger.

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Difference Makers in Teaching . . . Learning Science Learning analytics show that students learn better when material is broken into “blocks” of content. Each chapter opens with a visual preview. Learning objective numbers highlight the location of related content. Each “block” of content concludes with a Need- to-Know (NTK) to aid and reinforce student learning. Visual aids and concise, bullet-point discussions further help students learn.

New Revenue Recognition

Wild uses the popular gross method for merchandising transactions (net method is covered in an appendix). The gross method is widely used in practice and best for student success. Adjusting entries for new revenue recognition rules are included in an appendix. Assignments are clearly marked and separated. Wild is GAAP compliant.

Up-to-Date This book reflects changes in accounting for revenue recognition, investments, leases,

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and extraordinary items. It is important that students learn GAAP accounting.

Less Is More Wild has markedly fewer pages than competing books covering the same material.

The text is to the point and uses visuals to aid student learning. Bullet-point discussions and active writing aids learning. The 24th edition has 115 fewer pages than the 23rd edition—a 10% reduction!

Visual Learning

Learning analytics tell us today’s students do not read large blocks of text. Wild has adapted to student needs by having informative visual aids throughout. Many visuals and exhibits are new to this edition.

Videos

A growing number of students now learn accounting online. Wild offers over 1,500 videos designed to increase student engagement and improve outcomes. Hundreds of hint videos or Guided Examples provide a narrated, animated, step-by- step walk-through of select exercises similar to those assigned. These short presentations, which can be turned on or off by instructors, provide reinforcement when students need it most. (Exercise PowerPoints are available for instructors.) Concept Overview Videos cover each chapter’s learning objectives with narrated, animated presentations that frequently assess comprehension. Wild has concept overview presentations covering 228 Learning Objectives broken down into over 700 videos.

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Need-to-Know Demos Need-to-Know demonstrations are located at key junctures in each chapter. These demonstrations pose questions about the material just presented—content that students “need to know” to learn accounting. Accompanying solutions walk students through key procedures and analysis necessary to be successful with homework and test materials. Need-to-Know demonstrations are supplemented with narrated, animated, step-by-step walk-through videos led by an instructor and available via Connect.

Comprehensive Need-to-Know Comprehensive Need-to-Knows are problems that draw on material from the entire chapter. They include a complete solution, allowing students to review the entire problem-solving process and achieve success.

Driving Decisions Whether we prepare, analyze, or apply accounting information, one skill remains essential: decision making. To help develop good decision-making habits and to show the relevance of accounting, we use a learning framework.

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Decision Insight provides context for business decisions. Decision Ethics and Decision Maker are role-playing scenarios that show the relevance of accounting. Decision Analysis provides key tools to assess company performance.

Accounting Analytics New to this edition, Accounting Analysis assignments have students evaluate the most current financial statements from Apple, Google, and Samsung. Students compute key metrics and compare performance between companies and industry. These assignments are auto-gradable in Connect and are included after Problem Set B in the text.

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Keep It Real Research shows that students learn best when using current data from real companies. Wild uses the most current data from real companies for assignments, examples, and analysis in the text. See Chapter 17 for use of real data.

Cheat Sheets New to this edition, Cheat Sheets are provided at the end of each chapter. Cheat Sheets are roughly one page in length and include key procedures, concepts, journal entries, and formulas.

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Doing What’s Right Companies increasingly issue sustainability reports, and accountants are being asked to prepare, analyze, and audit them. Wild includes brief sections in the managerial chapters. This material focuses on the importance of sustainability within the context of accounting, including standards from the Sustainability Accounting Standards Board (SASB). Sustainability assignments cover chapter material with a social responsibility twist.

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SUPERIOR ASSIGNMENTS Connect 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 immediate feedback.

Wild has auto-gradable and algorithmic assignments; most focus on one learning objective and are targeted at introductory students. 90% of Wild’s Quick Study, Exercise, and Problem Set A assignments are available in Connect with algorithmic options. Over 210 assignments new to this edition—all available in Connect with algorithmic options. Nearly all are Quick Studies (brief exercises) and Exercises.

NEW! Concept Overview Videos Concept Overview Videos teach each chapter’s learning objectives through an engaging multimedia presentation. These learning tools enhance the text through video, audio, and checkpoint questions that can be graded—ensuring students complete and comprehend the material. Concept Overview Videos harness the power of technology to appeal to all learning styles and are ideal in all class formats. The Concept Overview Videos replace the previous edition’s Interactive Presentations.

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General Ledger Problems General Ledger Problems offer students the ability to record financial transactions and see how these transactions flow into financial statements. Easy minimal-scroll navigation, instant “Check My Work” feedback, and fully integrated hyperlinking across tabs show how inputted data affects each stage of the accounting process. General Ledger Problems expose students to general ledger software similar to that in practice, without the expense and hassle of downloading additional software. Algorithmic versions are available. All are auto-gradable.

Applying Excel Applying Excel enables students to work select chapter problems or examples in Excel. These problems are assignable in Connect and give students instant feedback as they work through the problem in Excel. Accompanying Excel videos teach students how to use Excel and the primary functions needed to complete the assignment. Short assessments can be assigned to test student comprehension of key Excel skills.

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Excel Simulations Simulated Excel Questions, assignable within Connect, allow students to practice their Excel skills—such as basic formulas and formatting—within the context of accounting. These questions feature animated, narrated Help and Show Me tutorials (when enabled), as well as automatic feedback and grading for both students and professors. These questions differ from Applying Excel in that students work in a simulated version of Excel. Downloading the Excel application is not required to complete Simulated Excel Questions.

Guided Examples The Guided Examples (Hints) in Connect provide a narrated, animated, step-by-step walk- through of most Quick Studies, Exercises, and General Ledger Problems similar to those assigned. These short presentations can be turned on or off by instructors and provide reinforcement when students need it most.

Exercise Presentations Animated PowerPoints, created from text assignments, enable instructors to be fully prepared for in-class demonstrations. Instructors also can use these with Tegrity (in Connect) to record online lectures.

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Content Revisions Enhance Learning Instructors and students guided this edition’s revisions. Revisions include

New Cheat Sheets at each chapter-end visually reinforce key chapter concepts. More concise text covering the same content. New 24th edition has 115 fewer pages than 23rd edition. Over 210 new assignments—all available in Connect with algorithmic options. Gross method is used for merchandising transactions, reflecting practice—adjusting entries for new revenue recognition rules are set in an appendix. Many new Need-to-Know (NTK) demos and accompanying videos to reinforce learning. Revised the Investments chapter for the new standard. New assignments that focus on financial statement preparation. Many new and revised General Ledger and Excel assignments. New Accounting Analysis assignments—all available in Connect— using real-world data from Apple, Google, and Samsung. Updated videos for each learning objective in new Concept Overview Video format.

Chapter 1 Updated opener—Apple and entrepreneurial assignment. Updated salary info for accountants. Revised business entity section along with adding LLC. Updated section on FASB objectives and accounting constraints. New layout for introducing the expanded accounting equation. New layout for introducing financial statements. Updated Apple numbers for NTK 1-5. New Cheat Sheet reinforces chapter content. Updated return on assets analysis using Nike and Under Armour. Added a new Exercise assignment and Quick Study assignment. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 2 NEW opener—Fitbit and entrepreneurial assignment. New visual for process to get from transactions to financial statements. New layout on four types of accounts that determine equity. Improved presentation of “Double-Entry System” section.

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Updated Apple data for NTK 2-4. Updated debt ratio analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added three new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 3 NEW opener—Urban One and entrepreneurial assignment. Revised learning objectives and chapter preview—each type of adjusting entry is assigned its own learning objective. Updated “Recognizing Revenues and Expenses” section. New streamlined “Framework for Adjustments” section. Continued emphasis of 3-step adjusting process. Enhanced Exhibit 3.12 on summary of adjustments. Updated profit margin analysis using Visa and Mastercard. Improved layouts for Exhibits 3A.1 through 3A.5. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 4 NEW opener—Snapchat and entrepreneurial assignment. New Decision Insight on women in accounting. Shortened discussion of closing entries. Exhibit 4.5 color-coded all adjustments. Enhanced Exhibit 4.7 on steps of accounting cycle with images. Streamlined section on classified balance sheet. Updated current ratio analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 5 NEW opener—Build-A-Bear and entrepreneurial assignment. Updated introduction for servicers vs. merchandisers using Liberty Tax and Nordstrom. Revised NTK 5-1 covers basics of merchandising. Reorganized “Purchases” section to aid learning. New Decision Insight on growing number of returns for businesses.

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Enhanced entries on payment of purchases within discount period vs. after discount period. Improved discussion of entries for sales with discounts vs. sales without discounts. Color-coded Exhibit 5.12 highlights different merchandising transactions. Updated acid-test ratio and gross margin analysis using Nike and Under Armour. Appendix 5B explains adjusting entries for future sales discounts, returns, and allowances. Appendix 5C covers the net method. Appendix 5D moved to online only. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 6 NEW opener—Shake Shack and entrepreneurial assignment. New Ethical Risk on the alleged fraud of Homex. Simplified introduction to inventory costing. Shortened explanation for specific identification. Enhanced layout to explain effects of inventory errors across years. Updated inventory turnover and days’ sales in inventory analysis using Costco and Walmart. Added colored arrow lines to Exhibits 6A.3 and 6A.4 to show cost flows from purchases to sales. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 7 Updated opener—Box and entrepreneurial assignment. Revised learning objectives and chapter preview—each type of journal is assigned its own learning objective. New Decision Insight on financial impact of Pokémon Go for Nintendo. Streamlined presentation of system principles and system components. Enhanced “Basics of Special Journals” and “Subsidiary Ledgers” sections to improve learning. New simplified designs for Exhibits 7.5, 7.7, 7.9, and 7.11 to improve student comprehension. Removed discussion of sales tax and postponed it to the current liabilities chapter. New section on Data Analytics and Data Visualization. New days’ payable outstanding analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added five new Quick Studies.

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Added three new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 8 NEW opener—Care.com and entrepreneurial assignment. New COSO framework to guide internal control, including COSO cube. New discussion of internal control failure at Amazon that cost customers $150 million. Simplified bank statement for learning. Revised “Bank Reconciliation” section to separate bank balance adjustments and book balance adjustments. New summary image on adjustments for bank balance and for book balance. Removed collection expenses and NSF fees—most are immaterial and covered in advanced courses. Updated days’ sales uncollected analysis using Starbucks and Jack in the Box. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added eight new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 9 NEW opener—Facebook and entrepreneurial assignment. Updated company data in Exhibit 9.1. Streamlined direct write-off method. Enhanced Exhibit 9.6 showing allowances set aside for future bad debts along with journal entries. New calendar graphic added as learning aid with Exhibit 9.12. New Excel demo to compute maturity dates. Updated accounts receivable analysis using Visa and Mastercard. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 10 NEW opener—New Glarus Brewery and entrepreneurial assignment. Updated company data in Exhibit 10.1. Added entry with Exhibit 10.3 and Exhibit 10.4. Simplified “Partial-Year Depreciation” section. Added margin table to Exhibit 10.14 as a learning aid. New Decision Insight box on extraordinary repairs to SpaceX’s reusable orbital rocket. New simple introduction to finance leases and operating leases for the new standard.

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Updated asset turnover analysis using Starbucks and Jack in the Box. Simplified Appendix 10A by postponing exchanges without commercial substance to advanced courses. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added one new Exercise. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 11 NEW opener—Pandora and entrepreneurial assignment. Updated data in Exhibit 11.2. Streamlined “Short-Term Notes Payable” section. Simplified explanation of FICA taxes. Updated payroll tax rates and explanations. Revised NTK 11-4. New W-4 form added to Appendix 11A. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 12 Updated opener—Scholly and entrepreneurial assignment. Streamlined partnership characteristics and types of organizations. Simplified graphic on business entity characteristics. Enhanced partnership formation example to emphasize partner investments are recorded at market value. Revised NTK 12-1. Shortened “Partner Withdrawal” section. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 13 NEW opener—Yelp and entrepreneurial assignment. New Decision Insight on bots investing in stocks based on erroneous news. New AT&T stock quote explanation. New graphic visually depicting cash dividend dates.

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New table summarizing differences between small stock dividends, large stock dividends, and stock splits. Updated Apple statement of equity in Exhibit 13.10. Updated PE ratio and dividend yield using Amazon, Altria, Visa, and Mastercard. Simplified book value per share explanation and computations. New Cheat Sheet reinforces chapter content. Added six new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 14 NEW opener—e.l.f. Cosmetics and entrepreneurial assignment. Updated IBM bond quote data. Simplified numbers in Exhibit 14.7. Simplified Exhibit 14.10 on premium bonds. Simplified numbers in Exhibit 14.11. Bond pricing moved to Appendix 14A. Simplified Exhibit 14.12 for teaching the note amortization schedule. Updated debt-to-equity analysis using Nike and Under Armour. New Excel computations for bond pricing in Appendix 14A. Simplified numbers in Exhibits 14B.1 and 14B.2. Revised Appendix 14C for new standard on finance leases and operating leases. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added four new Exercises. Added four new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 15 Updated opener—Echoing Green and entrepreneurial assignment. New learning objective P4 for new category of stock investments. Revised and simplified Exhibit 15.2 for new standard on investments. Reorganized text to first explain debt securities and then stock securities. Revised trading and available-for-sale securities to cover only debt securities given the new standard. New section on stock investments with insignificant influence. New Exhibit 15.6 to describe accounting for equity securities by ownership level. Updated component-returns analysis using Costco and Walmart. Investments in international operations set online as Appendix 15A. New Cheat Sheet reinforces chapter content. Added three new Quick Studies.

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Added four new Exercises. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 16 NEW opener—Vera Bradley and entrepreneurial assignment. New box on Tesla’s cash outflows and growing market value. Slightly revised infographics on cash flows from operating, investing, and financing. Streamlined sections on analyzing the cash account and noncash accounts. New presentation to aid learning of indirect adjustments to income. Simplified T-accounts to reconstruct cash flows. Simplified reconstruction entries to help compute cash flows. Updated cash flow on total assets analysis using Nike and Under Armour. New Cheat Sheet reinforces chapter content. Added ten new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 17 Updated opener—Morgan Stanley and entrepreneurial assignment. Updated data for all analyses of Apple using horizontal, vertical, and ratio analysis. Updated comparative analysis using Google and Samsung. Streamlined section on ratio analysis. Streamlined the “Analysis Reporting” section. Shortened Appendix 17A. New Cheat Sheet reinforces chapter content. Added eight new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 18 NEW opener—MoringaConnect and entrepreneurial assignment. Added discussion on role of managerial accounting for nonaccounting and nonbusiness majors. Added equation boxes for total manufacturing costs and cost of goods manufactured. New margin exhibit showing product and period cost flows. Added lists of common selling and administrative expenses. Updated and edited several exhibits for clarity. New Cheat Sheet reinforces chapter content. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global

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Analysis.

Chapter 19 NEW opener—HoopSwagg and entrepreneurial assignment. Revised discussions of manufacturing costs and link between job cost sheets and general ledger. Added graphic linking job cost sheets and general ledger accounts. Enhanced exhibit of 4-step overhead process. Added formula for computing applied overhead. New short discussion of cost-plus pricing. Added margin T-accounts and calculations for clarity. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 20 NEW opener—Azucar Ice Cream and entrepreneurial assignment. Revised discussion comparing process and job order costing systems. Added cost flow graphic. New margin graphic illustrating EUP. Revised discussion of weighted-average versus FIFO method of process costing. Revised discussion of using the process cost summary. New graphic on FIFO goods flow. Added margin T-accounts and calculations for clarity. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 21 NEW opener—Ellis Island Tropical Tea and entrepreneurial assignment. Added margin graphs of fixed, variable, and mixed costs. New Excel steps to create a line chart. Moved details of creating scatter plot to Appendix 21A, with Excel steps. Revised discussion of scatter plots. Moved details of creating a CVP chart to Appendix 21C, with Excel steps. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 22 NEW opener—Misfit Juicery and entrepreneurial assignment.

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Added T-accounts and steps to exhibit margins. Added numbered steps to several exhibits. Expanded discussion of cost of goods sold budgeting. New exhibit for calculation of cash paid for interest. Expanded discussion with bulleted list on use of a master budget. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added one new Exercise. New assignment on CMA exam budgeting coverage. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 23 NEW opener—Away and entrepreneurial assignment. Added graph to flexible budget exhibit. Revised discussion of flexible budget. New exhibit and discussion of computing total cost variance. Edited discussion of direct materials cost variance. Edited discussion of evaluating labor variances. Edited discussion of overhead variance reports. New exhibit for summary of variances. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 24 NEW opener—Jibu and entrepreneurial assignment. Updated Walt Disney ROI example. New Decision Analysis on cash conversion cycle. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 25 NEW opener—Solugen and entrepreneurial assignment. Organized decision scenarios into three types: production, capacity, and pricing. Expanded discussion of product pricing. Added other pricing methods: value-based, auction-based, and dynamic. New Decision Analysis on time and materials pricing of services. New Decision Insight on blockchain technology.

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New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 26 NEW opener—Fellow Robots and entrepreneurial assignment. New discussion of postaudit of investment decisions. Added example of investment in robotics. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Appendix A New financial statements for Apple, Google, and Samsung.

Appendix B New Decision Maker on postponed retail pricing. Continued Excel demos for PV and FV of lump sums. Continued Excel demos for PV and FV of annuities.

Appendix C New Cheat Sheet reinforces appendix content.

Appendix D NEW appendix on lean principles and accounting. Describes lean business principles. Measures production efficiency. Illustrates how to account for product costs using lean accounting. New: 13 Discussion Questions, 14 Quick Studies, 14 Exercises, and 3 Problems.

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Acknowledgments John J. Wild, Ken W. Shaw, and McGraw-Hill Education recognize the following instructors for their valuable feedback and involvement in the development of Fundamental Accounting Principles. We are thankful for their suggestions, counsel, and encouragement. Darlene Adkins, University of Tennessee–Martin Peter Aghimien, Indiana University South Bend Janice Akao, Butler Community College Nathan Akins, Chattahoochee Technical College John Alpers, Tennessee Wesleyan University Sekhar Anantharaman, Indiana University of Pennsylvania Karen Andrews, Lewis-Clark State College Chandra D. Arthur, Cuyahoga Community College Steven Ault, Montana State University Victoria Badura, Metropolitan Community College Felicia Baldwin, City College of Chicago Reb Beatty, Anne Arundel Community College Robert Beebe, Morrisville State College George Henry Bernard, Seminole State College of Florida Cynthia Bird, Tidewater Community College, Virginia Beach Pascal Bizarro, Bowling Green State University Amy Bohrer, Tidewater Community College, Virginia Beach John Bosco, North Shore Community College Nicholas Bosco, Suffolk County Community College Jerold K. Braun, Daytona State College Doug Brown, Forsyth Technical Community College Tracy L. Bundy, University of Louisiana at Lafayette Marci Butterfield, University of Utah Ann Capion, Scott Community College Amy Cardillo, Metropolitan State University of Denver Anne Cardozo, Broward College Crystal Carlson-Myer, Indian River State College Julie Chasse, Des Moines Area Community College Patricia Chow, Grossmont College Maria Coclin, Community College of Rhode Island Michael Cohen, Lewis-Clark State College Jerilyn Collins, Herzing University Scott Collins, Penn State University, University Park

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William Conner, Tidewater Community College Erin Cornelsen, University of South Dakota Mariah Dar, John Tyler Community College Nichole Dauenhauer, Lakeland Community College Donna DeMilia, Grand Canyon University Tiffany DeRoy, University of South Alabama Susan Dickey, Motlow State Community College Erin Dischler, Milwaukee Area Technical College–West Allis Holly Dixon, State College of Florida Vicky Dominguez, College of Southern Nevada David Doyon, Southern New Hampshire University Chester Drake, Central Texas College Christopher Eller, Appalachian State University Cynthia Elliott, Southwest Tennessee Community College–Macon Kim Everett, East Carolina University Corinne Frad, Eastern Iowa Community College Krystal Gabel, Southeast Community College Harry Gallatin, Indiana State University Rena Galloway, State Fair Community College Rick Gaumer, University of Wisconsin–Green Bay Tammy Gerszewski, University of North Dakota Pradeep Ghimire, Rappahannock Community College Marc Giullian, Montana State University, Bozeman Nelson Gomez, Miami Dade College–Kendall Robert Goodwin, University of Tampa Steve G. Green, U.S. Air Force Academy Darryl Greene, Muskegon Community College Lisa Hadley, Southwest Tennessee Community College–Macon Penny Hahn, KCTCS Henderson Community College Yoon Han, Bemidji State University Becky Hancock, El Paso Community College Amie Haun, University of Tennessee–Chattanooga Michelle Hays, Kalamazoo Valley Community College Rhonda Henderson, Olive Harvey College Lora Hines, John A. Logan College Rob Hochschild, Ivy Tech Community College of Indiana–South Bend John Hoover, Volunteer State Community College Roberta Humphrey, Southeast Missouri State University Carley Hunzeker, Metro Community College, Elkhorn Kay Jackson, Tarrant County College South

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Elizabeth Jennison, Saddleback College Mary Jepperson, Saint John’s University Vicki Jobst, Benedictine University Odessa Jordan, Calhoun Community College Susan Juckett, Victoria College Amanda Kaari, Central Georgia Technical College Ramadevi Kannan, Owens Community College Jan Klaus, University of North Texas Aaron P. Knape, The University of New Orleans Cedric Knott, Henry Ford Community College Robin Knowles, Texas A&M International University Kimberly Kochanny, Central Piedmont Community College Sergey Komissarov, University of Wisconsin–La Crosse Stephanie Lareau Kroeger, Ocean County College Joseph Krupka, Lander University Tara Laken, Joliet Junior College Suzanne Lay, Colorado Mesa University Brian Lazarus, Baltimore City Community College Kevin Leifer, Long Island University, CW Post Campus Harold Levine, Los Angeles Valley College Yuebing Liu, University of Tampa Philip Lee Little, Coastal Carolina University Delores Loedel, Miracosta College Rebecca Lohmann, Southeast Missouri State University Ming Lu, Santa Monica Community College Annette C. Maddox, Georgia Highlands College Natasha Maddox, KCTCS Maysville Community and Technical College Rich Mandau, Piedmont Technical College Robert Maxwell, College of the Canyons Karen McCarron, Georgia Gwinnett College Michael McDonald, College of Southern Neveda Gwendolyn McFadden-Wade, North Carolina A&T University Allison McLeod, University of North Texas Kate McNeil, Johnson County Community College Jane Medling, Saddleback College Heidi H. Meier, Cleveland State University Tammy Metzke, Milwaukee Area Technical College Jeanine Metzler, Northampton Community College Michelle Meyer, Joliet Junior College Pam Meyer, University of Louisiana at Lafayette

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Deanne Michaelson, Pellissippi State Community College Susan Miller, County College of Morris Carmen Morgan, Oregon Tech Karen Satterfield Mozingo, Pitt Community College Haris Mujahid, South Seattle College Andrea Murowski, Brookdale Community College Jaclynn Myers, Sinclair Community College Micki Nickla, Ivy Tech Community College of Indiana–Gary Dan O’Brien, Madison College–Truax Jamie O’Brien, South Dakota State University Grace Odediran, Union County College Ashley Parker, Grand Canyon University Pamela Parker, NOVA Community College Alexandria Margaret Parrish, John Tyler Community College Reed Peoples, Austin Community College Rachel Pernia, Essex County College Brandis Phillips, North Carolina A&T University Debbie Porter, Tidewater Community College–Virginia Beach M. Jeff Quinlan, Madison Area Technical College James E. Racic, Lakeland Community College Ronald de Ramon, Rockland Community College Robert J. Rankin, Texas A&M University–Commerce Robert Rebman, Benedictine University Jenny Resnick, Santa Monica Community College DeAnn Ricketts, York Technical College Renee Rigoni, Monroe Community College Kevin Rosenberg, Southeastern Community College David Rosser, University of Texas at Arlington Michael J. Rusek, Eastern Gateway Community College Alfredo Salas, El Paso Community College Carolyn Satz, Tidewater Community College–Chesapeake Kathy Saxton, Bryant & Stratton College Wilson Seda, Lehman College–CUNY Perry Sellers, Lonestar College–North Harris James Shimko, Ferris State University Philip Slater, Forsyth Technical Community College Clayton Smith, Columbia College Chicago Patricia Smith, DePaul University Jane Stam, Onondaga Community College Natalie Strouse, Notre Dame College

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Many talented educators and professionals have worked hard to create the materials for this product, and for their efforts, we’re grateful. We extend a special thank you to our contributing and technology supplement authors, who have worked so diligently to support this product.

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efforts.

John J. Wild Ken W. Shaw

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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 A B C

Brief Contents  Accounting in Business 2

 Analyzing and Recording Transactions 44

 Adjusting Accounts for Financial Statements 84

 Completing the Accounting Cycle 128

 Accounting for Merchandising Operations 166

 Inventories and Cost of Sales 214

 Accounting Information Systems 258

 Cash, Fraud, and Internal Control 290

 Accounting for Receivables 326

 Plant Assets, Natural Resources, and Intangibles 358

 Current Liabilities and Payroll Accounting 396

 Accounting for Partnerships 436

 Accounting for Corporations 464

 Long-Term Liabilities 500

 Investments 536

 Reporting the Statement of Cash Flows 568

 Analysis of Financial Statements 612

 Managerial Accounting Concepts and Principles 650

 Job Order Costing 686

 Process Costing 726

 Cost-Volume-Profit Analysis 772

 Master Budgets and Planning 814

 Flexible Budgets and Standard Costs 864

 Performance Measurement and Responsibility Accounting 912

 Relevant Costing for Managerial Decisions 956

 Capital Budgeting and Investment Analysis 990

 Financial Statement Information A1

 Time Value of Money B

 Activity-Based Costing C

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D CA BR

 Lean Principles and Accounting D-1

 Chart of Accounts CA

 Brief Review BR-1

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Contents Preface iv

1 Accounting in Business 2 Importance of Accounting 3

Users of Accounting Information 4 Opportunities in Accounting 4

Fundamentals of Accounting 6 Ethics—A Key Concept 6 Generally Accepted Accounting Principles 7 Conceptual Framework 7

Business Transactions and Accounting 9 Accounting Equation 10 Transaction Analysis 11 Summary of Transactions 14

Communicating with Users 15 Income Statement 15 Statement of Owner’s Equity 17 Balance Sheet 17 Statement of Cash Flows 17

Decision Analysis—Return on Assets 18 Appendix 1A Return and Risk 21 Appendix 1B Business Activities 22

2 Analyzing and Recording Transactions 44 Basis of Financial Statements 45

Source Documents 45 The “Account” Underlying Financial Statements 45 Ledger and Chart of Accounts 48

Double-Entry Accounting 49 Debits and Credits 49 Double-Entry System 49

Analyzing and Processing Transactions 51 Journalizing and Posting Transactions 51 Processing Transactions—An Example 52 Summarizing Transactions in a Ledger 57

Trial Balance 58

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Preparing a Trial Balance 58 Financial Statements Prepared from Trial Balance 59

Decision Analysis—Debt Ratio 62

3 Adjusting Accounts for Financial Statements 84 Timing and Reporting 85

The Accounting Period 85 Accrual Basis versus Cash Basis 86 Recognizing Revenues and Expenses 86 Framework for Adjustments 87

Deferral of Expense 87 Prepaid Insurance 87 Supplies 88 Other Prepaid Expenses 89 Depreciation 89

Deferral of Revenue 91 Unearned Consulting Revenue 92

Accrued Expense 93 Accrued Salaries Expense 93 Accrued Interest Expense 94 Future Cash Payment of Accrued Expenses 94

Accrued Revenue 95 Accrued Services Revenue 96 Accrued Interest Revenue 96 Future Cash Receipt of Accrued Revenues 96 Links to Financial Statements 97

Trial Balance and Financial Statements 98 Adjusted Trial Balance 98 Preparing Financial Statements 99

Decision Analysis—Profit Margin 101 Appendix 3A Alternative Accounting for Prepayments 104

4 Completing the Accounting Cycle 128 Work Sheet as a Tool 129

Benefits of a Work Sheet (Spreadsheet) 129 Use of a Work Sheet 129 Work Sheet Applications and Analysis 130

Closing Process 133 Temporary and Permanent Accounts 134 Recording Closing Entries 134

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Post-Closing Trial Balance 137 Accounting Cycle 137 Classified Balance Sheet 138

Classification Structure 138 Classification Categories 139

Decision Analysis—Current Ratio 141 Appendix 4A Reversing Entries 143

5 Accounting for Merchandising Operations 166 Merchandising Activities 167

Reporting Income for a Merchandiser 167 Reporting Inventory for a Merchandiser 168 Operating Cycle for a Merchandiser 168 Inventory Systems 168

Accounting for Merchandise Purchases 169 Purchases without Cash Discounts 169 Purchases with Cash Discounts 169 Purchases with Returns and Allowances 171 Purchases and Transportation Costs 172

Accounting for Merchandise Sales 174 Sales without Cash Discounts 174 Sales with Cash Discounts 175 Sales with Returns and Allowances 175

Adjusting and Closing for Merchandisers 177 Adjusting Entries for Merchandisers 177 Preparing Financial Statements 178 Closing Entries for Merchandisers 178 Summary of Merchandising Entries 179

More on Financial Statement Formats 177 Multiple-Step Income Statement 180 Single-Step Income Statement 181 Classified Balance Sheet 182

Decision Analysis—Acid-Test and Gross Margin Ratios 183 Appendix 5A Periodic Inventory System 187 Appendix 5B Adjusting Entries under New Revenue Recognition Rules 191 Appendix 5C Net Method for Inventory 192

6 Inventories and Cost of Sales 214 Inventory Basics 215

Determining Inventory Items 215

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Determining Inventory Costs 216 Internal Controls and Taking a Physical Count 216

Inventory Costing under a Perpetual System 217 Inventory Cost Flow Assumptions 217 Inventory Costing Illustration 218 Specific Identification 218 First-In, First-Out 219 Last-In, First-Out 219 Weighted Average 220 Financial Statement Effects of Costing Methods 221 Tax Effects of Costing Methods 222

Valuing Inventory at LCM and the Effects of Inventory Errors 224 Lower of Cost or Market 224 Financial Statement Effects of Inventory Errors 225

Decision Analysis—Inventory Turnover and Days’ Sales in Inventory 227 Appendix 6A Inventory Costing under a Periodic System 233 Appendix 6B Inventory Estimation Methods 238

7 Accounting Information Systems 258 System Principles 259 System Components 260 Special Journals and Subsidiary Ledgers 261

Basics of Special Journals 261 Subsidiary Ledgers 261

Sales Journal 263 Cash Receipts Journal 265 Purchases Journal 267 Cash Payments (Disbursements) Journal 268

General Journal Transactions 269 Technology-Based Accounting Systems 270

Technology in Accounting 270 Data Processing in Accounting 270 Computer Networks in Accounting 270 Enterprise Resource Planning Software 271 Data Analytics and Data Visualization 271 Cloud Computing 271

Decision Analysis—Days’ Payable Outstanding 271

8 Cash, Fraud, and Internal Control 290 Fraud and Internal Control 291

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Purpose of Internal Control 291 Principles of Internal Control 292 Technology, Fraud, and Internal Control 293 Limitations of Internal Control 293

Control of Cash 294 Cash, Cash Equivalents, and Liquidity 294 Cash Management 295 Control of Cash Receipts 295 Control of Cash Payments 297

Banking Activities as Controls 301 Basic Bank Services 301 Bank Statement 302 Bank Reconciliation 303

Decision Analysis—Days’ Sales Uncollected 306 Appendix 8A Documentation and Verification 308

9 Accounting for Receivables 326 Valuing Accounts Receivable 327 Direct Write-Off Method 330 Allowance Method 331 Estimating Bad Debts 334

Percent of Sales Method 334 Percent of Receivables Method 334 Aging of Receivables Method 335

Notes Receivable 337 Computing Maturity and Interest 338 Recording Notes Receivable 339 Valuing and Settling Notes 339 Disposal of Receivables 341

Decision Analysis—Accounts Receivable Turnover 341

10 Plant Assets, Natural Resources, and Intangibles 358 SECTION 1—PLANT ASSETS 359 Cost Determination 360

Machinery and Equipment 360 Buildings 360 Land Improvements 360 Land 360 Lump-Sum Purchase 361

Depreciation 361

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Factors in Computing Depreciation 361 Depreciation Methods 362 Partial-Year Depreciation 365 Change in Estimates 366 Reporting Depreciation 366

Additional Expenditures 367 Ordinary Repairs 368 Betterments and Extraordinary Repairs 368

Disposals of Plant Assets 368 Discarding Plant Assets 369 Selling Plant Assets 369

SECTION 2—NATURAL RESOURCES 371 Cost Determination and Depletion 371 Plant Assets Tied into Extracting 372

SECTION 3—INTANGIBLE ASSETS 373 Cost Determination and Amortization 373 Types of Intangibles 373

Decision Analysis—Total Asset Turnover 376 Appendix 10A Exchanging Plant Assets 379

11 Current Liabilities and Payroll Accounting 396 Known Liabilities 397

Characteristics of Liabilities 397 Examples of Known Liabilities 398 Accounts Payable 399 Sales Taxes Payable 399 Unearned Revenues 399 Short-Term Notes Payable 399

Payroll Liabilities 402 Employee Payroll and Deductions 402 Employer Payroll Taxes 403 Internal Control of Payroll 404 Multi-Period Known Liabilities 404

Estimated Liabilities 405 Health and Pension Benefits 405 Vacation Benefits 406 Bonus Plans 406 Warranty Liabilities 406 Multi-Period Estimated Liabilities 407

Contingent Liabilities 408

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Accounting for Contingent Liabilities 408 Applying Rules of Contingent Liabilities 409 Uncertainties That Are Not Contingencies 409

Decision Analysis—Times Interest Earned Ratio 409 Appendix 11A Payroll Reports, Records, and Procedures 412 Appendix 11B Corporate Income Taxes 417

12 Accounting for Partnerships 436 Partnership Formation 437

Characteristics of Partnerships 437 Organizations with Partnership Characteristics 438 Choosing a Business Form 438 Accounting for Partnership Formation 438

Dividing Partnership Income or Loss 439 Partnership Financial Statements 441

Partner Admission 442 Purchase of Partnership Interest 442 Investing Assets in a Partnership 443

Partner Withdrawal 444 No Bonus 444 Bonus to Remaining Partners 445 Bonus to Withdrawing Partner 445 Death of a Partner 445

Liquidation of a Partnership 446 No Capital Deficiency 446 Capital Deficiency 448

Decision Analysis—Partner Return on Equity 449

13 Accounting for Corporations 464 Corporate Form of Organization 465

Corporate Advantages 465 Corporate Disadvantages 465 Corporate Organization and Management 466 Corporate Stockholders 466 Corporate Stock 467

Common Stock 468 Issuing Par Value Stock 468 Issuing No-Par Value Stock 469 Issuing Stated Value Stock 469 Issuing Stock for Noncash Assets 469

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Dividends 471 Cash Dividends 470 Stock Dividends 471 Stock Splits 473 Financial Statement Effects of Dividends and Splits 473

Preferred Stock 474 Issuance of Preferred Stock 474 Dividend Preference of Preferred Stock 475 Reasons for Issuing Preferred Stock 475

Treasury Stock 477 Purchasing Treasury Stock 477 Reissuing Treasury Stock 477

Reporting of Equity 479 Statement of Retained Earnings 479 Statement of Stockholders’ Equity 480

Decision Analysis—Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per Share 480

14 Long-Term Liabilities 500 Basics of Bonds 501

Bond Financing 501 Bond Issuing 502 Bond Trading 502

Par Bonds 502 Discount Bonds 503

Bond Discount or Premium 503 Issuing Bonds at a Discount 504

Premium Bonds 506 Issuing Bonds at a Premium 506 Bond Retirement 508

Long-Term Notes Payable 510 Installment Notes 510 Mortgage Notes and Bonds 511

Decision Analysis—Debt Features and the Debt-to-Equity Ratio 512 Appendix 14A Bond Pricing 515 Appendix 14B Effective Interest Amortization 517 Appendix 14C Leases and Pensions 518

15 Investments 536 Basics of Investments 537

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Purposes and Types of Investments 537 Classification and Reporting 538

Debt Investments 538 Debt Investments—Basics 538

Debt Investments—Trading 539 Debt Investments—Held-to-Maturity 540 Debt Investments—Available-for-Sale 541 Equity Investments 543 Equity Investments—Insignificant Influence, Under 20% 543 Equity Investments—Significant Influence, 20% to 50% 545 Equity Investments—Controlling Influence, More Than 50% 547 Accounting Summary for Debt and Equity Investments 548 Decision Analysis—Components of Return on Total Assets 549

16 Reporting the Statement of Cash Flows 568 Basics of Cash Flow Reporting 569

Purpose of the Statement of Cash Flows 569 Importance of Cash Flows 569 Measurement of Cash Flows 569 Classification of Cash Flows 570 Noncash Investing and Financing 571 Format of the Statement of Cash Flows 571 Preparing the Statement of Cash Flows 572

Cash Flows from Operating 573 Indirect and Direct Methods of Reporting 573 Applying the Indirect Method 573 Summary of Adjustments for Indirect Method 576

Cash Flows from Investing 577 Three-Step Analysis 577 Analyzing Noncurrent Assets 577

Cash Flows from Financing 579 Three-Step Analysis 579 Analyzing Noncurrent Liabilities 579 Analyzing Equity 580 Proving Cash Balances 580

Summary Using T-Accounts 582 Decision Analysis—Cash Flow Analysis 583 Appendix 16A Spreadsheet Preparation of the Statement of Cash Flows 586 Appendix 16B Direct Method of Reporting Operating Cash Flows 588

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17 Analysis of Financial Statements 612 Basics of Analysis 613

Purpose of Analysis 613 Building Blocks of Analysis 613 Information for Analysis 614 Standards for Comparisons 614 Tools of Analysis 614

Horizontal Analysis 614 Comparative Statements 614 Trend Analysis 617

Vertical Analysis 618 Common-Size Statements 618 Common-Size Graphics 620

Ratio Analysis 622 Liquidity and Efficiency 622 Solvency 624 Profitability 625 Market Prospects 626 Summary of Ratios 627

Decision Analysis—Analysis Reporting 628 Appendix 17A Sustainable Income 631

18 Managerial Accounting Concepts and Principles 650 Managerial Accounting Basics 651

Purpose of Managerial Accounting 651 Nature of Managerial Accounting 652 Fraud and Ethics in Managerial Accounting 653 Career Paths 654

Managerial Cost Concepts 655 Types of Cost Classifications 655 Identification of Cost Classifications 657 Cost Concepts for Service Companies 657

Managerial Reporting 658 Manufacturing Costs 658 Nonmanufacturing Costs 658 Prime and Conversion Costs 659 Costs and the Balance Sheet 659 Costs and the Income Statement 659

Cost Flows and Cost of Goods Manufactured 662

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Flow of Manufacturing Activities 662 Schedule of Cost of Goods Manufactured 663 Trends in Managerial Accounting 666

Decision Analysis—Raw Materials Inventory Turnover and Days’ Sales in Raw Materials Inventory 668

19 Job Order Costing 686 Job Order Costing 687

Cost Accounting System 687 Job Order Production 687 Job Order vs. Process Operations 688 Production Activities in Job Order Costing 688 Cost Flows 689 Job Cost Sheet 689

Materials and Labor Cost 690 Materials Cost Flows and Documents 690 Labor Cost Flows and Documents 693

Overhead Cost 694 Set Predetermined Overhead Rate 695 Apply Estimated Overhead 695 Record Actual Overhead 697 Summary of Cost Flows 698 Using Job Cost Sheets for Managerial Decisions 699 Schedule of Cost of Goods Manufactured 700

Adjusting Overhead 701 Factory Overhead Account 701 Adjust Underapplied or Overapplied Overhead 701 Job Order Costing of Services 702

Decision Analysis—Pricing for Services 703

20 Process Costing 726 Process Operations 727

Organization of Process Operations 727 Comparing Process and Job Order Costing Systems 728 Equivalent Units of Production 729

Process Costing Illustration 730 Overview of GenX Company’s Process Operation 730 Pre-Step: Collect Production and Cost Data 731 Step 1: Determine Physical Flow of Units 732 Step 2: Compute Equivalent Units of Production 732 Step 3: Compute Cost per Equivalent Unit 733

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Step 4: Assign and Reconcile Costs 733 Process Cost Summary 735

Accounting for Process Costing 736 Accounting for Materials Costs 737 Accounting for Labor Costs 738 Accounting for Factory Overhead 739 Accounting for Transfers 740 Trends in Process Operations 742

Decision Analysis—Hybrid Costing System 743 Appendix 20A FIFO Method of Process Costing 747

21 Cost-Volume-Profit Analysis 772 Identifying Cost Behavior 773

Fixed Costs 774 Variable Costs 774 Graphing Fixed and Variable Costs against Volume 774 Mixed Costs 774 Step-wise Costs 775 Curvilinear Costs 776

Measuring Cost Behavior 777 Scatter Diagram 777 High-Low Method 778 Regression 778 Comparing Cost Estimation Methods 778

Contribution Margin and Break-Even Analysis 779 Contribution Margin and Its Measures 779 Break-Even Point 780 Cost-Volume-Profit Chart 782 Changes in Estimates 782

Applying Cost-Volume-Profit Analysis 783 Margin of Safety 783 Computing Income from Sales and Costs 784 Computing Sales for a Target Income 785 Evaluating Strategies 786 Sales Mix and Break-Even 787 Assumptions in Cost-Volume-Profit Analysis 789

Decision Analysis—Degree of Operating Leverage 790 Appendix 21A Using Excel for Cost Estimation 792 Appendix 21B Variable Costing and Performance Reporting 793

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Appendix 21C Preparing a CVP Chart 796

22 Master Budgets and Planning 814 Budget Process and Administration 815

Budgeting Process 815 Benefits of Budgeting 816 Budgeting and Human Behavior 816 Budget Reporting and Timing 817 Master Budget Components 817

Operating Budgets 818 Sales Budget 818 Production Budget 818 Direct Materials Budget 820 Direct Labor Budget 821 Factory Overhead Budget 822 Selling Expense Budget 823 General and Administrative Expense Budget 824

Investing and Financing Budgets 825 Capital Expenditures Budget 825 Cash Budget 825

Budgeted Financial Statements 829 Budgeted Income Statement 829 Budgeted Balance Sheet 830 Using the Master Budget 830 Budgeting for Service Companies 830

Decision Analysis—Activity-Based Budgeting 831 Appendix 22A Merchandise Purchases Budget 839

23 Flexible Budgets and Standard Costs 864 Fixed and Flexible Budgets 865

Fixed Budget Reports 866 Budget Reports for Evaluation 867 Flexible Budget Reports 867

Standard Costing 871 Standard Costs 871 Setting Standard Costs 871 Cost Variance Analysis 872

Materials and Labor Variances 874 Materials Variances 874 Labor Variances 876

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Overhead Standards and Variances 877 Flexible Overhead Budgets 877 Standard Overhead Rate 877 Computing Overhead Cost Variances 879 Standard Costing—Management Considerations 882

Decision Analysis—Sales Variances 883 Appendix 23A Expanded Overhead Variances and Standard Cost Accounting System 888

24 Performance Measurement and Responsibility Accounting 912 Responsibility Accounting 913

Performance Evaluation 913 Controllable versus Uncontrollable Costs 914 Responsibility Accounting for Cost Centers 914

Profit Centers 916 Direct and Indirect Expenses 916 Expense Allocations 917 Departmental Income Statements 918 Departmental Contribution to Overhead 921

Investment Centers 922 Return-on-Investment and Residual Income 922 Investment Center Profit Margin and Investment Turnover 924

Nonfinancial Performance Evaluation Measures 925 Balanced Scorecard 925 Transfer Pricing 927

Decision Analysis—Cash Conversion Cycle 928 Appendix 24A Cost Allocations 931 Appendix 24B Transfer Pricing 933 Appendix 24C Joint Costs and Their Allocation 934

25 Relevant Costing for Managerial Decisions 956 Decisions and Information 957

Decision Making 957 Relevant Costs and Benefits 958

Production Decisions 958 Make or Buy 959 Sell or Process Further 960 Sales Mix Selection When Resources Are Constrained 961

Capacity Decisions 963 Segment Elimination 963

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Appendix A

Appendix B Appendix C Appendix D Index Chart of Accounts Brief Review

Keep or Replace Equipment 964 Pricing Decisions 965

Normal Pricing 965 Special Offers 967

Decision Analysis—Time and Materials Pricing 969

26 Capital Budgeting and Investment Analysis 990 Capital Budgeting 991

Capital Budgeting Process 991 Capital Investment Cash Flows 992

Methods Not Using Time Value of Money 992 Payback Period 992 Accounting Rate of Return 995

Methods Using Time Value of Money 996 Net Present Value 996 Internal Rate of Return 1000 Comparison of Capital Budgeting Methods 1002 Postaudit 1002

Decision Analysis—Break-Even Time 1004 Appendix 26A Using Excel to Compute Net Present Value and Internal Rate of Return 1006

 Financial Statement Information A-1  Apple A-2  Google A-10  Samsung A-14  Time Value of Money B  Activity-Based Costing C  Lean Principles and Accounting D-1  IND-1

 CA  Managerial Analyses and Reports BR-1  Financial Reports and Tables BR-2  Selected Transactions and Relations BR-3  Fundamentals and Analyses BR-4

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Education and ©Dizzle52/Getty Images

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C1 C2

C3 C4

Page 2

1 Accounting in Business

Chapter Preview is organized by “blocks” of key content and learning objectives followed by Need-To-Know (NTK) guided video examples

Chapter Preview

ACCOUNTING USES

Purpose of accounting Accounting information users Opportunities in accounting

NTK 1-1

ETHICS AND ACCOUNTING

Ethics Generally accepted accounting principles Conceptual framework

NTK 1-2

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A1

P1

P2

A2

C1 C2 C3 C4

C5

A1 A2 A3

P1

TRANSACTION ANALYSIS

Accounting equation and its components Expanded accounting equation Transaction analysis—Illustrated

NTK 1-3 , 1-4

FINANCIAL STATEMENTS

Income statement Statement of owner’s equity Balance sheet Statement of cash flows Financial analysis

NTK 1-5

Learning Objectives are classified as conceptual, analytical, or procedural

Learning Objectives

CONCEPTUAL

Explain the purpose and importance of accounting. Identify users and uses of, and opportunities in, accounting. Explain why ethics are crucial to accounting. Explain generally accepted accounting principles and define and apply several accounting principles. Appendix 1B—Identify and describe the three major activities of organizations.

ANALYTICAL

Define and interpret the accounting equation and each of its components. Compute and interpret return on assets. Appendix 1A—Explain the relation between return and risk.

PROCEDURAL

Analyze business transactions using the accounting equation.

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P2

Page 3

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

Big Apple

“We ran the business . . . with just a few hundred bucks” —STEVE WOZNIAK CUPERTINO, CA—“When I designed the Apple stuff,” says Steve Wozniak, “I never thought in my life I would have enough money to fly to Hawaii or make a down payment on a house.” But some dreams do come true. Woz, along with Steve Jobs and Ron Wayne, founded Apple (Apple.com) when Woz was 25 and Jobs was 21.

©Miguel Medina/AFP/Getty Images

The young entrepreneurs faced challenges, including how to read and interpret accounting data. They also needed to finance the company, which they did by selling Woz’s HP calculator and Jobs’s Volkswagen van. The $1,300 raised helped them purchase the equipment Woz used to build the first Apple computer.

In setting up their company, the owners chose between a partnership and a corporation. They decided on a partnership that included Ron as a third partner with 10% ownership. Days later, Ron withdrew when he considered the unlimited liability of a partnership. He sold his 10% share to Woz and Jobs for $800. Within nine months, Woz and Jobs converted Apple to a corporation.

As Apple grew, Woz and Jobs had to learn more accounting, along with details of preparing and interpreting financial statements. Important questions involving transaction analysis and financial reporting arose, and the owners took care to do things right. “Everything we did,” asserts Woz, “we were setting the tone for the world.”

Woz and Jobs focused their accounting system to provide information for Apple’s business decisions. Today, Woz believes that Apple is key to the language of technology, just as accounting is the language of business. In retrospect, Woz says, “Every dream I have ever had in life has come true ten times over.”

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Page 4

Sources: Apple website, January 2019; Woz.org, January 2019; Apple 2016 Sustainability Report, April 2016; Greenbiz, October 2014; iWoz: From Computer Geek to Cult Icon, W.W. Norton & Co., 2006; Founders at Work, Apress, 2007

Decision Feature launches each chapter showing the relevance of accounting for a real entrepreneur; Entrepreneurial Decision assignment returns to this feature with a mini- case

IMPORTANCE OF ACCOUNTING

C1_______ Explain the purpose and importance of accounting.

Why is accounting so popular on campus? Why are there so many openings for accounting jobs? Why is accounting so important to companies? The answer is that we live in an information age in which accounting information impacts us all.

Accounting is an information and measurement system that identifies, records, and communicates an organization’s business activities. Exhibit 1.1 shows these accounting functions.

EXHIBIT 1.1 Accounting Functions

Our most common contact with accounting is through credit checks, checking accounts, tax forms, and payroll. These experiences focus on recordkeeping, or bookkeeping, which is the recording of transactions and events. This is just one part of accounting. Accounting also includes analysis and interpretation of information. Point: Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting.

Technology plays a major role in accounting. Technology reduces the time, effort, and cost of recordkeeping while improving accuracy. As technology makes more information available, the demand for accounting knowledge increases. Consulting, planning, and other financial services are closely linked to accounting.

Users of Accounting Information

C2_______

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

Accounting is called the language of business because it communicates data that help people make better decisions. People using accounting information are divided into two groups: external users and internal users. Financial accounting focuses on the needs of external users, and managerial accounting focuses on the needs of internal users.

External Users External users of accounting information do not directly run the organization and have limited access to its accounting information. These users get accounting information from general-purpose financial statements. Following is a partial list of external users and decisions they make with accounting information.

Lenders (creditors) loan money or other resources to an organization. Banks, savings and loans, and mortgage companies are lenders. Lenders use information to assess if an organization will repay its loans. Shareholders (investors) are the owners of a corporation. They use accounting reports to decide whether to buy, hold, or sell stock. Boards of directors oversee organizations. Directors use accounting information to evaluate the performance of executive management. External (independent) auditors examine financial statements to verify that they are prepared according to generally accepted accounting principles. Nonmanagerial and nonexecutive employees and labor unions use external information to bargain for better wages. Regulators have legal authority over certain activities of organizations. For example, the Internal Revenue Service (IRS) requires accounting reports for computing taxes. Voters and government officials use information to evaluate government performance. Contributors to nonprofits use information to evaluate the use and impact of donations. Suppliers use information to analyze a customer before extending credit. Customers use financial reports to assess the stability of potential suppliers.

Internal Users Internal users of accounting information directly manage the organization. Internal reports are designed for the unique needs of managerial or executive employees, such as the chief executive officer (CEO). Following is a partial list of internal users and decisions they make with accounting information.

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Purchasing managers need to know what, when, and how much to purchase. Human resource managers need information about employees’ payroll, benefits, and performance. Production managers use information to monitor costs and ensure quality. Distribution managers need reports for timely and accurate delivery of products and services. Marketing managers use reports to target consumers, set prices, and monitor consumer needs. Service managers use reports to provide better service to customers. Research and development managers use information on projected costs and revenues of innovations.

Opportunities in Accounting Accounting has four areas of opportunities: financial, managerial, taxation, and accounting- related. Exhibit 1.2 lists selected opportunities in each area.

EXHIBIT 1.2 Accounting Opportunities

Point: The largest accounting firms are EY, KPMG, PwC, and Deloitte. Point: Higher education yields higher pay:

EXHIBIT 1.3 Accounting Jobs by Area

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Exhibit 1.3 shows that the majority of opportunities are in private accounting, which are employees working for businesses. Public accounting involves accounting services such as auditing and taxation. Opportunities also exist in government and not-for-profit agencies, including business regulation and law enforcement.

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, pass an exam, and be ethical. 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), certified fraud examiner (CFE), and certified forensic accountant (CrFA).

Accounting specialists are in demand. Exhibit 1.4 reports average annual salaries for several accounting positions. Salaries vary based on location, company size, and other factors.

EXHIBIT 1.4 Accounting Salaries

NEED-TO-KNOWs highlight key procedures and concepts in learning accounting

NEED-TO-KNOW 1-1

Accounting Users C1 C2

Identify the following users of accounting information as either an (a) external or (b) internal user.

1. _____ Regulator

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2. _____ CEO 3. _____ Shareholder 4. _____ Marketing manager 5. _____ Executive employee 6. _____ External auditor 7. _____ Production manager 8. _____ Nonexecutive employee 9. _____ Bank lender

Solution

1. a 2. b 3. a 4. b 5. b 6. a 7. b 8. a 9. a.

Do More: QS 1-1, QS 1-2, E 1-1, E 1-2, E 1-3

FUNDAMENTALS OF ACCOUNTING

Ethics—A Key Concept

C3_______ Explain why ethics are crucial to accounting.

For information to be useful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that separate right from wrong. They are accepted standards of good and bad behavior. Point: A Code of Conduct is available at AICPA.org.

Accountants face ethical choices as they prepare financial reports. These choices can affect the salaries and bonuses paid to workers. They even can affect the success of products and services. Misleading information can lead to a bad decision that harms workers and the business. There is an old saying: Good ethics are good business. Exhibit 1.5 gives a three- step process for making ethical decisions.

EXHIBIT 1.5 Ethical Decision Making

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Fraud Triangle: Ethics under Attack The fraud triangle shows that three factors push a person to commit fraud.

Opportunity. A person must be able to commit fraud with a low risk of getting caught. Pressure, or incentive. A person must feel pressure or have incentive to commit fraud. Rationalization, or attitude. A person justifies fraud or does not see its criminal nature.

The key to stopping fraud is to focus on prevention. It is less expensive and more effective to prevent fraud from happening than it is to detect it.

To prevent fraud, companies set up internal controls. Internal controls are procedures to protect assets, ensure reliable accounting, promote efficiency, and uphold company policies. Examples are good records, physical controls (locks), and independent reviews.

Enforcing Ethics In response to major accounting scandals, like those at Enron and WorldCom, Congress passed the Sarbanes-Oxley Act, also called SOX, to help stop financial abuses. SOX requires documentation and verification of internal controls and emphasizes effective internal controls. Management must issue a report stating that internal controls are effective. Auditors verify the effectiveness of internal controls. Ignoring SOX can lead to penalties and criminal prosecution of executives. CEOs and CFOs who knowingly sign off on bogus accounting reports risk millions of dollars in fines and years in prison. Point: An audit examines whether financial statements are prepared using GAAP. Point: SOX requires a business that sells stock to disclose a code of ethics for its executives.

Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank, has two important provisions.

Clawback Mandates recovery (clawback) of excessive pay. Whistleblower SEC pays whistleblowers 10% to 30% of sanctions exceeding $1 million.

Ethical Risk boxes highlight ethical issues from practice

Ethical Risk

Ethics Pay The $100 million mark in total payments made by the SEC to whistleblowers was recently surpassed. Since the SEC began awarding whistleblowers a percentage of money from sanctions, over 14,000 tips have been reported. Many of the tips come from accountants. ■

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Generally Accepted Accounting Principles

C4_______ Explain generally accepted accounting principles and define and apply several accounting principles.

Financial accounting is governed by concepts and rules known as generally accepted accounting principles (GAAP). GAAP wants information to have relevance and faithful representation. Relevant information affects decisions of users. Faithful representation means information accurately reflects the business results. Point: CPAs who audit financial statements must disclose if they do not comply with GAAP.

The Financial Accounting Standards Board (FASB) is given the task of setting GAAP from the Securities and Exchange Commission (SEC). The SEC is a U.S. government agency that oversees proper use of GAAP by companies that sell stock and debt to the public.

International Standards Our global economy demands comparability in accounting reports. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. These standards are similar to, but sometimes different from, U.S. GAAP. The FASB and IASB are working to reduce differences between U.S. GAAP and IFRS.

Conceptual Framework The FASB conceptual framework in Exhibit 1.6 consists of the following.

Objectives—to provide information useful to investors, creditors, and others. Qualitative characteristics—to require information that has relevance and faithful representation. Elements—to define items in financial statements. Recognition and measurement—to set criteria for an item to be recognized as an element; and how to measure it.

EXHIBIT 1.6 Conceptual Framework

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Principles, Assumptions, and Constraint There are two types of accounting principles (and assumptions). General principles are the assumptions, concepts, and guidelines for preparing financial statements; these are shown in purple font in Exhibit 1.7, along with key assumptions in red font. Specific principles are detailed rules used in reporting business transactions and events; they are described as we encounter them.

EXHIBIT 1.7 Building Blocks for GAAP

Accounting Principles There are four general principles.

Measurement principle (cost principle) Accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured by the 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 received. Information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence. Later chapters cover adjustments to market and introduce fair value. Point: A company pays $500 for equipment. The cost principle requires it be recorded at $500. It makes no difference if the owner thinks this equipment is worth $700.

Revenue recognition principle Revenue is recognized (1) when goods or services are provided to customers and (2) at the amount expected to be received from the customer. Revenue (sales) is the amount received from selling products and services.

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Page 8 The amount received is usually in cash, but it also can be a customer’s promise to pay at a future date, called credit sales. (To recognize means to record it.) Example: A lawn service bills a customer $800 on June 1 for two months of mowing (June and July). The customer pays the bill on July 1. When is revenue recorded? Answer: It is recorded over time as it is earned; record $400 revenue for June and $400 for July.

Expense recognition principle (matching principle) A company records the expenses it incurred to generate the revenue reported. An example is rent costs of office space. Example: Credit cards are used to pay $200 in gas for a lawn service during June and July. The cards are paid in August. When is expense recorded? Answer: If revenue is earned over time, record $100 expense in June and $100 in July.

Full disclosure principle A company reports the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.

Decision Insight

Measurement and Recognition Revenues for the Seattle Seahawks, Atlanta Falcons, Green Bay Packers, and other professional football teams include ticket sales, television broadcasts, concessions, and advertising. Revenues from ticket sales are earned when the NFL team plays each game. Advance ticket sales are not revenues; instead, they are 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. ■

©Shane Roper/CSM/REX/Shutterstock

Accounting Assumptions There are four accounting assumptions.

Going-concern assumption Accounting information presumes that the business will continue operating instead of being closed or sold. This means, for example, that property is reported at cost instead of liquidation value. Monetary unit assumption Transactions and events are expressed in monetary, or money, units. Examples of monetary units are the U.S. dollar and the Mexican peso. Time period assumption The life of a company can be divided into time periods, such as months and years, and useful reports can be prepared for those periods. Business entity assumption A business is accounted for separately from other business entities and its owner. Exhibit 1.8 describes four common business entities.

EXHIBIT 1.8 Attributes of Businesses

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*When a corporation issues only one class of stock, it is called common stock (or capital stock).

Accounting Constraint The cost-benefit constraint, or cost constraint, says that information disclosed by an entity must have benefits to the user that are greater than the costs of providing it. Materiality, or the ability of information to influence decisions, is also sometimes mentioned as a constraint. Conservatism and industry practices are sometimes listed as well. Point: Proprietorships, partnerships, and LLCs are managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who hire managers to run the business.

Decision Ethics boxes are role-playing exercises that stress ethics in accounting

Decision Ethics

Entrepreneur You and a friend develop a new design for ice skates that improves speed. You plan to form a business to manufacture and sell the skates. You and your friend want to minimize taxes, but your big concern is potential lawsuits from customers who might be injured on these skates. What form of organization do you set up? ■ Answer: You should probably form an LLC. An LLC helps protect personal property from lawsuits directed at the business. Also, an LLC is not subject to an additional business income tax. You also must examine the ethical and social aspects of starting a business where injuries are expected.

Point: Double taxation means that (1) the corporation income is taxed and (2) any dividends to owners are taxed as part of the owners’ personal income.

NEED-TO-KNOW 1-2

Accounting Guidance C3 C4

Part 1: Identify each of the following terms/phrases as either an accounting (a) principle, (b) assumption, or (c) constraint.

1. ______ Cost-benefit 2. ______ Measurement

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3. ______ Business entity 4. ______ Going-concern 5. ______ Full disclosure 6. ______ Time period 7. ______ Expense recognition 8. ______ Revenue recognition

Solution

1. c 2. a 3. b 4. b 5. a 6. b 7. a 8. a Part 2: Complete the following table with either a yes or a no regarding the attributes of a partnership, corporation, and LLC.

Solution

a. no b. no c. no d. no e. yes f. yes g. yes h. yes i. no j. yes k. yes l. yes

Do More: QS 1-3, QS 1-4, QS 1-5, QS 1-6, E 1-4, E 1-5, E 1-6, E 1-7

BUSINESS TRANSACTIONS AND ACCOUNTING

A1_______ Define and interpret the accounting equation and each of its components.

Accounting shows two basic aspects of a company: what it owns and what it owes. Assets are resources a company owns or controls. The claims on a company’s assets—what it owes— are separated into owner (equity) and nonowner (liability) claims. Together, liabilities and equity are the source of funds to acquire assets.

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 instruments for a rock band, and land for a vegetable grower. Assets include cash, supplies, equipment, land, and accounts receivable. A receivable is an asset that promises a future inflow of resources. A company that provides a service or product on credit has an account receivable from that customer. Point: “On credit” and “on account” mean cash is paid at a future date.

Liabilities Liabilities are creditors’ claims on assets. These claims are obligations to provide assets, products, or services to others. A payable is a liability that promises a future

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outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes (loans) payable to banks, and taxes payable.

Equity Equity is the owner’s claim on assets and is equal to assets minus liabilities. Equity is also called net assets or residual equity.

Accounting Equation The relation of assets, liabilities, and equity is shown in the following accounting equation. The accounting equation applies to all transactions and events, to all companies and organizations, and to all points in time.

We can break down equity to get the expanded accounting equation.

Point: This equation can be rearranged. Example: Assets − Liabilities = Equity

We see that equity increases from owner investments and from revenues. It decreases from withdrawals and from expenses. Equity consists of four parts.

Decision Insight

Big Data The SEC keeps an online database called EDGAR (sec.gov/edgar) that has accounting information for thousands of companies, such as Columbia Sportswear, 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.Yahoo.com offers online data and analysis. ■

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©Greg Epperson/Shutterstock

NEED-TO-KNOW 1-3

Accounting Equation A1

Part 1: Use the accounting equation to compute the missing financial statement amounts.

Solution

a. $120 b. $400 Part 2: Use the expanded accounting equation to compute the missing financial statement amounts.

Solution

a. $65 b. $10

Do More: QS 1-7, QS 1-8, E 1-8, E 1-9

Transaction Analysis

P1_______ Analyze business transactions using the accounting equation.

Business activities are described in terms of transactions and events. External transactions are exchanges of value between two entities, which cause changes in the accounting equation. An example is the sale of the AppleCare Protection Plan by Apple. Internal transactions are exchanges within an entity, which may or may not affect the accounting equation. An

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example is Target’s use of its supplies, which are reported as expenses when used. Events are 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 fires that destroy assets and create losses.

This section uses the accounting equation to analyze 11 transactions and events of FastForward, a start-up consulting (service) business, in its first month of operations. Remember that after each transaction and event, assets always equal liabilities plus equity.

Real company names are in bold magenta

Transaction 1: Investment by Owner On December 1, Chas Taylor forms a consulting business named FastForward and set up as a proprietorship. FastForward evaluates the performance of footwear and accessories. Taylor owns and manages the business, which will publish online reviews and consult with clubs, athletes, and others who purchase Nike and Adidas products.

Taylor 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, cash (an asset) and owner’s equity each equals $30,000. Equity is increased by the owner’s investment, which is included in the column titled C. Taylor, Capital. The effect of this transaction on FastForward is shown in the accounting equation as follows (we label the equity entries).

Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of Nike and Adidas 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 simply 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.

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Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to acquire 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 future benefits from testing footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance.

Transaction 4: Purchase Supplies on Credit Taylor decides more supplies of footwear and accessories are needed. These additional supplies cost $7,100, but 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 supplies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount.

Example: If FastForward pays $500 cash in Transaction 4, how does this partial payment affect the liability to CalTech? Answer: The liability to CalTech is reduced to $6,600 and the cash balance is reduced to $1,000.

Transaction 5: Provide Services for Cash FastForward plans to earn revenues by selling online ad space and consulting with clients about footwear and accessories. It earns net income only if its revenues are greater than its expenses. In its first job, FastForward provides consulting services and immediately collects $4,200 cash. The accounting equation reflects this increase in cash of $4,200 and in equity of $4,200. This increase in equity is

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shown in the far right column under Revenues because the cash received is earned by providing consulting services.

Point: Revenue recognition principle requires that revenue is recognized when work is performed.

Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 to rent its facilities. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is shown in the following accounting equation as Transaction 6. FastForward also pays the biweekly $700 salary of the company’s only employee. This is shown in the accounting equation as Transaction 7. Both Transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, not assets, because their benefits are used in December (they have no future benefits after December). The accounting equation shows that both transactions reduce cash and equity. The far right column shows these decreases as Expenses.

Point: Expense recognition principle requires that expenses are recognized when the revenue they help generate is recorded.

Transaction 8: Provide Services and Facilities for Credit FastForward provides consulting services of $1,600 and rents its test facilities for an additional $300 to Adidas on credit. Adidas is billed for the $1,900 total. This transaction creates a new asset, called accounts receivable, from Adidas. Accounts receivable is increased instead of cash because the payment has not yet been received. Equity is increased from the two revenue components shown in the Revenues column of the accounting equation.

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Point: Transaction 8, like 5, records revenue when work is performed, not necessarily when cash is received.

Transaction 9: Receipt of Cash from Accounts Receivable The client in Transaction 8 (Adidas) pays $1,900 to FastForward 10 days after it is billed for consulting 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 performed the services in Transaction 8, not when the cash is collected.

Point: Transaction 9 involved no added client work, so no added revenue is recorded. Point: Receipt of cash is not always a revenue.

Transaction 10: Payment of Accounts Payable FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (Transaction 4), leaving $6,200 unpaid. 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 uses these supplies).

Transaction 11: Withdrawal of Cash by Owner The owner of FastForward withdraws $200 cash for personal use. Withdrawals (decreases in equity) are not reported as expenses because they do not help earn revenue. Because withdrawals are not expenses, they are not used in computing net income.

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Summary of Transactions Exhibit 1.9 shows the effects of these 11 transactions of FastForward using the accounting equation. Assets equal liabilities plus equity after each transaction.

EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation

NEED-TO-KNOW 1-4

Transaction Analysis P1

Assume Tata Company began operations on January 1 and completed the following transactions during its first month of operations. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Equipment; Accounts Payable; J. Tata, Capital; J. Tata, Withdrawals; Revenues; and Expenses.

Solution

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Do More: QS 1-10, QS 1-11, E 1-10, E 1-11, E 1-13

COMMUNICATING WITH USERS

P2_______ Identify and prepare basic financial statements and explain how they interrelate.

Financial statements are prepared in the order below using the 11 transactions of FastForward. (These statements are unadjusted—we explain this in Chapters 2 and 3.) The four financial statements and their purposes follow.

Income Statement FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is 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. Rent and salary expenses are from Transactions 6 and 7. Expenses are the costs to generate the revenues reported. Net income occurs when revenues exceed expenses. A net loss occurs when expenses exceed revenues. Net income (or loss) is

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Page 16 shown at the bottom of the statement and is the amount reported in December. Owner’s investments and withdrawals are not part of income.

Key Terms are in bold and defined again in the glossary

Point: Net income is sometimes called earnings or profit.

EXHIBIT 1.10 Financial Statements and Their Links

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Point: A statement’s heading identifies the company, the statement title, and the date or time period. Point: Arrow lines show how the statements are linked. ➀ Net income is used to compute equity. ➁ Owner capital is used to prepare the balance sheet. ➂ Cash from the balance sheet is used to reconcile the statement of cash flows.

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

Point: A single ruled line means an addition or subtraction. Final totals are double underlined. Negative amounts may or may not be in parentheses.

Statement of Owner’s Equity

©Pavel1964/Shutterstock

The statement of owner’s equity reports how equity changes over the reporting period. This statement shows beginning capital, events that increase it (owner investments and net income), and events that decrease it (withdrawals and net loss). Ending capital is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of owner’s equity 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 a beginning balance equal to the prior period’s ending balance (such as from November 30). FastForward’s statement shows the $4,400 of net income for the period, which links the income statement to the statement of owner’s equity (see line ➀). The statement also reports the $200 cash withdrawal and FastForward’s end-of- period capital balance.

Balance Sheet FastForward’s balance sheet is the third report in Exhibit 1.10. This statement shows FastForward’s financial position at the end of business day on December 31. The left side of the balance 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 ➁ shows the link between the ending balance of the statement of owner’s equity and the equity balance on the balance sheet. (This presentation of the balance 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 at the bottom. Both are acceptable.) As always, the accounting equation balances: Assets of $40,400 = Liabilities of $6,200 + Equity of $34,200.

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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 subtraction. Net cash provided by operating activities for December is $1,000. The second section reports 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 long-term borrowing and repaying of cash from lenders and the cash investments from, and withdrawals by, the owner. FastForward reports $30,000 from the owner’s initial investment and a $200 cash withdrawal. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows an increased cash balance of $4,800. The ending balance is also $4,800 as it started with no cash—see line ➂. 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.

NEED-TO-KNOW 1-5

Financial Statements P2

Prepare the (a) income statement, (b) statement of owner’s equity, and (c) balance sheet for Apple using the following condensed data from its fiscal year ended September 30, 2017 ($ in millions).

Solution ($ in millions)

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Do More: QS 1-12, QS 1-13, QS 1-14, E 1-15, E 1-16, E 1-17

Decision Analysis (a section at the end of each chapter) covers ratios for decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 17

Decision Analysis Return on Assets

A2_______ Compute and interpret return on assets.

We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 17 has a ratio listing with definitions and groupings by area. When analyzing ratios, we use a company’s prior-year ratios and competitor ratios to identify good, bad, or average performance.

This chapter presents a profitability measure: return on assets. Return on assets is

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useful in evaluating management, analyzing and forecasting profits, and planning activities. Return on assets (ROA), also called return on investment (ROI), is defined in Exhibit 1.11.

EXHIBIT 1.11 Return on Assets

Net income is from the annual income statement, and average total assets is computed by adding the beginning and ending amounts for that same period and dividing by 2. Nike reports total net income of $4,240 million for the current year. At the beginning of the current year its total assets are $21,396 million, and at the end of the current year they total $23,259 million. Nike’s return on assets for the current year is:

Is a 19.0% return on assets good or bad for Nike? To help answer this question, we compare (benchmark) Nike’s return with its prior performance and the return of its competitor, Under Armour. Nike shows a stable pattern of good returns that reflects effective use of assets. Nike has outperformed Under Armour in each of the last three years. Its management performed well based on Nike’s return on assets.

EXHIBIT 1.12 Nike and Under Armour Returns

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

Decision Maker

Business Owner You own a 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 14% return on its assets. The industry return for competitors of this manufacturer is 9%. Do you purchase this manufacturer? ■ Answer: The 14% return on assets for the manufacturer exceeds the 9% industry return. This is positive for a potential purchase. Also, this purchase is an opportunity to spread your risk over two businesses. Still, you should hesitate to purchase a business whose 14% return is lower than your current 21% return. You might better direct efforts to increase investment in your resort if it can earn more than the 14% alternative.

Comprehensive Need-to-Know is a review of key chapter content; the Planning the Solution section offers strategies in solving it

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NEED-TO-KNOW 1-6 COMPREHENSIVE

Transaction Analysis, Statement Preparation, and Return on Assets

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

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; Accounts Payable; J. Worthy, Capital; J. Worthy, Withdrawals; Revenues; and Expenses. Show the effects of each transaction using the accounting equation.

2. Prepare an income statement for August. 3. Prepare a statement of owner’s equity 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 owner’s equity. 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.

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Page 20 Calculate return on assets by dividing net income by average assets.

SOLUTION

1.

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

APPENDIX

Return and Risk A3_______ Explain the relation between return and risk.

This appendix covers return and risk analysis. 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 2%. We also could invest in a company’s stock, or even start our own business. How do we decide among these 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 investments 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). If we buy a share of eBay or any other company, we might get a large return. However, we have no guarantee of any return; there is even the risk of loss.

Exhibit 1A.1 shows recent returns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds have a low expected return, but they also have low risk because they are backed by the U.S. government. High-risk corporate bonds have a much larger potential return but have much higher risk.

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

The trade-off between return and risk is a normal 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.

APPENDIX

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1BBusiness Activities C5_______ Identify and describe the three major activities of organizations.

This appendix explains how the accounting equation is linked to business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning is defining an organization’s ideas, goals, and actions. Point: Investing (assets) and financing (liabilities plus equity) totals are always equal.

Financing Financing activities provide the resources organizations use to pay for assets such as land, buildings, and equipment. 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 loaned by creditors (lenders).

Investing Investing activities are the acquiring and disposing of assets that an organization uses to buy and sell its products or services. Some organizations require land and factories to operate. Others need only an office. Invested amounts are referred to as assets. Creditor and owner financing hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This yields the accounting equation: Assets = Liabilities + 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. Exhibit 1B.1 summarizes business activities. Planning is part of each activity and gives them meaning and focus. Investing (assets) and financing (liabilities and equity) are opposite each other because they always are equal. Operating activities are below to show that they are the result of investing and financing.

EXHIBIT 1B.1 Activities of Organizations

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Summary: Cheat Sheet

ACCOUNTING USES

External users: Do not directly run the organization and have limited access to its accounting information. Examples are lenders, shareholders, boards of directors, external auditors, nonexecutive employees, labor unions, regulators, voters, donors, suppliers, and customers. Internal users: Directly manage organization operations. Examples are the CEO and other executives, research and development managers, purchasing managers, production managers, and other managerial-level employees. Private accounting: Accounting employees working for businesses. Public accounting: Offering audit, tax, and accounting services to others.

ETHICS AND ACCOUNTING

Fraud triangle: Factors that push a person to commit fraud. Opportunity: Must be able to commit fraud with a low risk of getting caught. Pressure, or incentive: Must feel pressure or have incentive to commit fraud. Rationalization, or attitude: Justifies fraud or does not see its criminal nature.

Common business entities:

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SYSTEM OF ACCOUNTS

Assets: Resources a company owns or controls that are expected to yield future benefits. Liabilities: Creditors’ claims on assets. These are obligations to provide assets, products, or services to others. Equity: Owner’s claim on assets. It consists of:

TRANSACTION ANALYSIS

Accounting equation: Applies to all transactions and events, to all companies and organizations, and to all points in time.

Summary of transactions:

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Transaction 1: Investment by owner Transaction 2: Purchase supplies for cash Transaction 3: Purchase equipment for cash Transaction 4: Purchase supplies on credit Transaction 5: Provide services for cash Transactions 6 and 7: Payment of expenses in cash Transaction 8: Provide services and facilities for credit Transaction 9: Receipt of cash from accounts receivable Transaction 10: Payment of accounts payable Transaction 11: Withdrawal of cash by owner

FINANCIAL STATEMENTS

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A list of key terms concludes each chapter (a complete glossary is also available)

Key Terms

Accounting 3 Accounting equation 10 Assets 9 Audit 6 Auditors 6 Balance sheet 15 Bookkeeping 3 Business entity assumption 8 Common stock 8 Conceptual framework 7 Corporation 8 Cost-benefit constraint 8 Cost constraint 8 Cost principle 7 Dodd-Frank Wall Street Reform and Consumer Protection Act 6 Double taxation 9 Equity 9 Ethics 6 Events 11 Expanded accounting equation 10 Expense recognition principle 8 Expenses 10 External transactions 11 External users 4 Financial accounting 4 Financial Accounting Standards Board (FASB) 7 Full disclosure principle 8 Generally accepted accounting principles (GAAP) 7 Going-concern assumption 8 Income statement 15 Internal controls 6 Internal transactions 11 Internal users 4 International Accounting Standards Board (IASB) 7 International Financial Reporting Standards (IFRS) 7 Liabilities 9

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Limited liability company (LLC) 8 Managerial accounting 4 Matching principle 8 Measurement principle 7 Members 8 Monetary unit assumption 8 Net income 15 Net loss 15 Owner, Capital 10 Owner investments 10 Owner, Withdrawals 10 Partnership 8 Proprietorship 8 Recordkeeping 3 Return 21 Return on assets (ROA) 18 Revenue recognition principle 7 Revenues 10 Risk 21 Sarbanes-Oxley Act 6 Securities and Exchange Commission (SEC) 7 Shareholders 8 Shares 8 Sole proprietorship 8 Statement of cash flows 15 Statement of owner’s equity 15 Stock 8 Stockholders 8 Time period assumption 8

Multiple Choice Quiz

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

a. $50,000. b. $400,000. c. $450,000. d. $475,000.

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Page 24e. $500,000. 2. On December 30 of the current year, KPMG signs a $150,000

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

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.

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.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; $450,000 is the actual cost incurred. 2. b; revenue is recorded when services are provided.

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3. d;

Change in equity = $100,000 – $35,000 = $65,000 4. a 5. a

A(B) Superscript letter A (B) denotes assignments based on Appendix 1A (1B).

Icon denotes assignments that involve decision making.

Discussion Questions

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 addition to preparing

tax returns? 13. What does the concept of objectivity imply for information reported in

financial statements? 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 assumption justifies this treatment?

15. Why is the revenue recognition principle needed? What does it demand? 16. Describe the four basic forms of business organization and their key

attributes. 17. Define (a) assets, (b) liabilities, (c) equity, and (d) net assets. 18. What events or transactions change equity?

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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 owner’s equity? 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 Google in Appendix A near

the end of the text. To what level of significance are dollar amounts rounded? What time period does its income statement cover?

33. Access the SEC EDGAR database (SEC.gov) and retrieve Apple’s 2017 10-K (filed November 3, 2017). Identify its auditor. What responsibility does its independent auditor claim regarding Apple’s financial statements?

Quick Study exercises offer a brief check of key points

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

QUICK STUDY

QS 1-1 Understanding accounting C1 Choose the term or phrase below that best completes each statement.

a. Accounting b. Identifying c. Recording d. Communicating e. Governmental f. Technology

g. Language of business h. Recordkeeping (bookkeeping)

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1. _____

2. _____ 3. _____

_____ a. _____ b. _____ c. _____ d. _____ e. _____ f. _____ g. _____ h. _____ i. _____ j. _____ k. _____ l.

_____ 1. _____ 2. _____ 3.

_____ 4. _____ 5. _____ 6.

reduces the time, effort, and cost of recordkeeping while improving clerical accuracy.

requires that we input, measure, and log transactions and events. is the recording of transactions and events, either manually or

electronically.

QS 1-2 Identifying accounting users C2 Identify the following users as either external users (E) or internal users (I).

Customers Suppliers External auditors Business press Managers District attorney Shareholders Lenders

Controllers FBI and IRS Consumer group Directors

QS 1-3 Identifying ethical risks C3 The fraud triangle asserts that the following three factors must exist for a person to commit fraud.

A. Opportunity B. Pressure C. Rationalization

Identify the fraud risk factor (A, B, or C) in each of the following situations.

The business has no cameras or security devices at its warehouse. Managers are expected to grow business or be fired. A worker sees other employees regularly take inventory for personal

use. No one matches the cash in the register to receipts when shifts end. Officers are told to show rising income or risk layoffs. A worker feels that fellow employees are not honest.

This icon highlights ethics-related assignments

QS 1-4 Identifying principles, assumptions, and constraints C4

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_____ 1. _____ 2. _____ 3. _____ 4.

_____ 1.

_____ 2.

_____ 3.

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Identify each of the following terms or phrases as an accounting (a) principle, (b) assumption, or (c) constraint.

Full disclosure Time period Going-concern Revenue recognition

QS 1-5 Identifying attributes of businesses C4 Complete the following table with either a yes or no regarding the attributes of a proprietorship, partnership, corporation, and limited liability company (LLC).

QS 1-6 Identifying accounting principles and assumptions C4 Identify the letter for the principle or assumption from A through F in the blank space next to each numbered situation that it best explains or justifies.

A. General accounting principle B. Measurement (cost) principle C. Business entity assumption D. Revenue recognition principle E. Expense recognition (matching) principle F. Going-concern assumption

In December of this year, Chavez Landscaping received a customer’s order and cash prepayment to install sod at a house that would not be ready for installation until March of next year. Chavez should record the revenue from the customer order in March of next year, not in December of this year.

If $51,000 cash is paid to buy land, the land is reported on the buyer’s balance sheet at $51,000.

Mike Derr owns both Sailing Passions and Dockside Digs. In preparing financial statements for Dockside Digs, Mike makes sure that the expense transactions of Sailing Passions are kept separate from Dockside Digs’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?

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This icon highlights assignments that enhance decision-making skills

QS 1-8 Applying the accounting equation A1

1. Use the accounting equation to compute the missing financial statement amounts (a), (b), and (c).

2. Use the expanded accounting equation to compute the missing financial statement amounts (a) and (b).

QS 1-9 Identifying and computing assets, liabilities, and equity A1

Use Google’s December 31, 2017, financial statements, in Appendix A near the end of the text, to answer the following.

a. Identify the amounts (in $ millions) of its 2017 (1) assets, (2) liabilities, and (3) equity.

b. Using amounts from part a, verify that Assets = Liabilities + Equity.

QS 1-10 Identifying effects of transactions using accounting equation— Revenues and Expenses P1 Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation (identify each revenue and expense type, such as commissions revenue or rent expense).

a. The company completed consulting work for a client and immediately collected $5,500 cash earned.

b. The company completed commission work for a client and sent a bill for $4,000 to be received within 30 days.

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_____ a. _____ b. _____ c. _____ d. _____ e. _____ f. _____ g. _____ h.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6.

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c. The company paid an assistant $1,400 cash as wages for the period. d. The company collected $1,000 cash as a partial payment for the amount owed

by the client in transaction b. e. The company paid $700 cash for this period’s cleaning services.

QS 1-11 Identifying effects of transactions using accounting equation—Assets and Liabilities P1 Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation.

a. The owner (Alex Carr) invested $15,000 cash in the company. b. The company purchased supplies for $500 cash. c. The owner (Alex Carr) invested $10,000 of equipment in the company. d. The company purchased $200 of additional supplies on credit. e. The company purchased land for $9,000 cash.

QS 1-12 Identifying items with financial statements P2 Indicate in which financial statement each item would most likely appear: income statement (I), balance sheet (B), or statement of cash flows (CF).

Assets Cash from operating activities Equipment Expenses Liabilities Net decrease (or increase) in cash Revenues Total liabilities and equity

QS 1-13 Identifying income and equity accounts P2 Classify each of the following items as revenues (R), expenses (EX), or withdrawals (W).

Cost of sales Service revenue Wages expense Owner withdrawal Rent expense Rental revenue

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_____ 7. _____ 8.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6.

_____ 1.

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Insurance expense Consulting revenue

QS 1-14 Identifying assets, liabilities, and equity P2 Classify each of the following items as assets (A), liabilities (L), or equity (EQ).

Land Owner, Capital Equipment Accounts payable Accounts receivable Supplies

QS 1-15 Preparing an income statement P2 On December 31, Hawkin’s records show the following accounts. Use this information to prepare a December income statement for Hawkin.

QS 1-16 Computing and interpreting return on assets A2 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 an 11.0% return on assets).

QS 1-17 Identifying and computing assets, liabilities, and equity A1

Use Samsung’s December 31, 2017, financial statements in Appendix A near the end of the text to answer the following.

a. Identify the amounts (in millions of Korean won) of Samsung’s 2017 (1) assets, (2) liabilities, and (3) equity.

b. Using amounts from part a, verify that Assets = Liabilities + Equity.

EXERCISES

Exercise 1-1 Classifying activities reflected in the accounting system C1 Classify the following activities as part of the identifying (I), recording (R), or communicating (C) aspects of accounting.

Analyzing and interpreting reports.

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_____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ 1. _____ 2. _____ 3.

Presenting financial information. Keeping a log of service costs. Measuring the costs of a product. Preparing financial statements. Acquiring knowledge of revenue transactions. Observing transactions and events. Registering cash sales of products sold.

Exercise 1-2 Identifying accounting users and uses C2 Part A. Identify the following questions as most likely to be asked by an internal (I) or an external (E) user of accounting information.

Which inventory items are out of stock? Should we make a five-year loan to that business? What are the costs of our product’s ingredients? Should we buy, hold, or sell a company’s stock? Should we spend additional money for redesign of our product? Which firm reports the highest sales and income? What are the costs of our service to customers?

Part B. Identify the following users as either an internal (I) or an external (E) user.

Research and development executive Human resources executive Politician Shareholder Distribution manager Creditor Production supervisor Purchasing manager

Exercise 1-3 Describing accounting responsibilities C2 Many accounting professionals work in one of the following three areas.

A. Financial accounting B. Managerial accounting C. Tax accounting

Identify the area of accounting that is most involved in each of the following responsibilities.

Internal auditing External auditing Cost accounting

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_____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ 1. _____ 2.

_____ 3. _____ 4. _____ 5.

_____ 1. _____ 2.

_____ 3. Page 29

Budgeting Enforcing tax laws Planning transactions to minimize taxes Preparing external financial statements Analyzing external financial reports

Exercise 1-4 Learning the language of business C1 C2 C3 Match each of the numbered descriptions 1 through 5 with the term or phrase it best reflects. Indicate your answer by writing the letter A through H for the term or phrase in the blank provided.

A. Audit B. GAAP C. Ethics D. FASB E. SEC F. Public accountants G. Net income H. IASB

An assessment of whether financial statements follow GAAP. Amount a business earns in excess of all expenses and costs

associated with its sales and revenues. A group that sets accounting principles in the United States. Accounting professionals who provide services to many clients. Principles that determine whether an action is right or wrong.

Exercise 1-5 Identifying ethical terminology C3 Match each of the numbered descriptions 1 through 7 with the term or phrase it best reflects. Indicate your answer by writing the letter A through G for the term or phrase in the blank provided.

A. Ethics B. Fraud triangle C. Prevention D. Internal controls E. Sarbanes-Oxley Act F. Audit G. Dodd-Frank Act

Requires the SEC to pay whistleblowers. Examines whether financial statements are prepared using GAAP; it

does not ensure absolute accuracy of the statements. Requires documentation and verification of internal

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_____ 4.

_____ 5. _____ 6.

_____ 7.

_____ a.

_____ b.

_____ c.

_____ d.

_____ e.

_____ f.

_____ g. _____ h.

_____ 1.

controls and increases emphasis on internal control effectiveness. Procedures set up to protect company property and equipment,

ensure reliable accounting, promote efficiency, and encourage adherence to policies.

A less expensive and more effective means to stop fraud. Three factors push a person to commit fraud: opportunity, pressure,

and rationalization. Beliefs that distinguish right from wrong.

Exercise 1-6 Distinguishing business organizations C4 The following describe several different business organizations. Determine whether each description best refers to a sole proprietorship (SP), partnership (P), corporation (C), or limited liability company (LLC).

Micah and Nancy own Financial Services, which pays a business income tax. Micah and Nancy do not have personal responsibility for the debts of Financial Services.

Riley and Kay own Speedy Packages, a courier service. Both are personally liable for the debts of the business.

IBC Services does not have separate legal existence apart from the one person who owns it.

Trent Company is owned by Trent Malone, who is personally liable for the company’s debts.

Ownership of Zander Company is divided into 1,000 shares of stock. The company pays a business income tax.

Physio Products does not pay income taxes and has one owner. The owner has unlimited liability for business debt.

AJ Company pays a business income tax and has two owners. Jeffy Auto is a separate legal entity from its owner, but it does not

pay a business income tax.

Exercise 1-7 Identifying accounting principles and assumptions C4 Enter the letter A through H for the principle or assumption in the blank space next to each numbered description that it best reflects.

A. General accounting principle B. Measurement (cost) principle C. Business entity assumption D. Revenue recognition principle E. Specific accounting principle F. Expense recognition (matching) principle G. Going-concern assumption H. Full disclosure principle

A company reports details behind financial statements that would

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_____ 2.

_____ 3.

_____ 4.

_____ 5. _____ 6. _____ 7. _____ 8.

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impact users’ decisions. Financial statements reflect the assumption that the business

continues operating. A company records the expenses incurred to generate the revenues

reported. Concepts, assumptions, and guidelines for preparing financial

statements. Each business is accounted for separately from its owner or owners. Revenue is recorded when products and services are delivered. Detailed rules used in reporting events and transactions. Information is based on actual costs incurred in transactions.

Exercise 1-8 Using the accounting equation A1 Determine the missing amount from each of the separate situations a, b, and c below.

Exercise 1-9 Using the accounting equation A1 Answer the following questions. Hint: Use the accounting equation.

a. 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 year-end?

b. Office Store has assets equal to $123,000 and liabilities equal to $47,000 at year-end. What is the equity for Office Store at year-end?

c. At the beginning of the year, Quaker Company’s liabilities equal $70,000. During the year, assets increase 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 1-10 Analysis using the accounting equation P1 Zen began a new consulting firm on January 5. Following is a financial summary, including balances, for each of the company’s first five transactions (using the accounting equation form).

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Identify the explanation from a through j below that best describes each transaction 1 through 5 above and enter it in the blank space in front of each numbered transaction.

a. The company purchased office furniture for $8,000 cash. b. The company received $40,000 cash from a bank loan. c. The owner invested $1,000 cash in the business. d. The owner invested $40,000 cash in the business. e. The company purchased office supplies for $3,000 by paying $2,000 cash and

putting $1,000 on credit. f. The company billed a customer $6,000 for services provided.

g. The company purchased office furniture worth $8,000 on credit. h. The company provided services for $1,000 cash. i. The company sold office supplies for $3,000 and received $2,000 cash and

$1,000 on credit. j. The company provided services for $6,000 cash.

Exercise 1-11 Identifying effects of transactions on the accounting equation P1 The following table shows the effects of transactions 1 through 5 on the assets, liabilities, and equity of Mulan’s Boutique.

Identify the explanation from a through j below that best describes each transaction 1 through 5 and enter it in the blank space in front of each numbered transaction.

a. The company purchased $1,000 of office supplies on credit. b. The company collected $1,900 cash from an account receivable. c. The company sold land for $4,000 cash. d. The owner withdrew $1,000 cash from the business.

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_____ a. _____ b. _____ c. _____ d. _____ e. _____ f.

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e. The company purchased office supplies for $1,000 cash. f. The company purchased land for $4,000 cash.

g. The company billed a client $1,900 for services provided. h. The company paid $1,000 cash toward an account payable. i. The owner invested $1,900 cash in the business. j. The company sold office supplies for $1,900 on credit.

Exercise 1-12 Identifying effects of transactions on the accounting equation P1 For each transaction a through f, identify its impact on the accounting equation (select from 1 through 5 below).

The company pays cash toward an account payable. The company purchases equipment on credit. The owner invests cash in the business. The owner withdraws cash from the business. The company purchases supplies for cash. The company provides services for cash.

1. Decreases an asset and decreases equity. 2. Increases an asset and increases a liability. 3. Decreases an asset and decreases a liability. 4. Increases an asset and decreases an asset. 5. Increases an asset and increases equity.

Exercise 1-13 Identifying effects of transactions using the accounting equation P1 Ming Chen began a professional practice on June 1 and plans to prepare financial statements at the end of each month. During June, Ming Chen (the owner) completed these transactions.

a. Owner invested $60,000 cash in the company along with equipment that had a $15,000 market value.

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 transaction e.

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i. The company paid $10,000 cash to settle the liability created in transaction c. j. Owner withdrew $1,000 cash from the company for personal use.

Required Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of the transactions on individual items of the accounting equation. Show new balances after each transaction. Check Ending balances: Cash, $46,000; Expenses, $4,500

Exercise 1-14 Analyzing return on assets A2 Swiss Group reports net income of $40,000 for 2019. At the beginning of 2019, Swiss Group had $200,000 in assets. By the end of 2019, assets had grown to $300,000. What is Swiss Group’s 2019 return on assets? How would you assess its performance if competitors average an 11% return on assets?

Exercise 1-15 Preparing an income statement P2 On October 1, Ebony Ernst organized Ernst Consulting; on October 3, the owner contributed $84,000 in assets to launch the business. On October 31, the company’s records show the following items and amounts. Use this information to prepare an October income statement for the business.

Check Net income, $2,110

Exercise 1-16 Preparing a statement of owner’s equity P2 Use the information in Exercise 1-15 to prepare an October statement of owner’s equity for Ernst Consulting.

Exercise 1-17 Preparing a balance sheet P2 Use the information in Exercise 1-15 to prepare an October 31 balance sheet for Ernst Consulting. Hint: The solution to Exercise 1-16 can help.

Exercise 1-18 Preparing a statement of cash flows P2 Use the information in Exercise 1-15 to prepare an October 31 statement of cash flows for Ernst Consulting. Assume the following additional information.

a. The owner’s initial investment consists of $38,000 cash and $46,000 in land. b. The company’s $18,000 equipment purchase is paid in cash.

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_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ a. _____ b. _____ c. _____ d. _____ e.

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 1-19 Identifying sections of the statement of cash flows P2 Indicate the section (O, I, or F) where transactions 1 through 8 would appear on the statement of cash flows.

O. Cash flows from operating activity F. Cash flows from financing activity I. Cash flows from investing activity

Cash purchase of equipment Cash withdrawal by owner Cash paid for advertising Cash paid for wages Cash paid on account payable to supplier Cash received from clients Cash paid for rent Cash investment by owner

Exercise 1-20 Preparing an income statement for a company P2 Ford Motor Company, one of the world’s largest automakers, reports the following income statement accounts for the year ended December 31 ($ in millions). Use this information to prepare Ford’s income statement for the year ended December 31.

Exercise 1-21B Identifying business activities C5 Match each transaction a through e to one of the following activities of an organization: financing activity (F), investing activity (I), or operating activity (O).

An owner contributes cash to the business. An organization borrows money from a bank. An organization advertises a new product. An organization sells some of its land. An organization purchases equipment.

Exercise 1-22 Preparing an income statement for a company P2 BMW Group, one of Europe’s largest manufacturers, reports the following income statement accounts for the year ended December 31 (euros in millions). Use this

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information to prepare BMW’s income statement for the year ended December 31.

Exercise 1-23 Using the accounting equation A1

Answer the following questions. Hint: Use the accounting equation.

a. On January 1, Lumia Company’s liabilities are $60,000 and its equity is $40,000. On January 3, Lumia purchases and installs solar panel assets costing $10,000. For the panels, Lumia pays $4,000 cash and promises to pay the remaining $6,000 in six months. What is the total of Lumia’s assets after the solar panel purchase?

b. On March 1, ABX Company’s assets are $100,000 and its liabilities are $30,000. On March 5, ABX is fined $15,000 for failing emission standards. ABX immediately pays the fine in cash. After the fine is paid, what is the amount of equity for ABX?

c. On August 1, Lola Company’s assets are $30,000 and its liabilities are $10,000. On August 4, Lola issues a sustainability report following SASB guidelines. Investors react positively to this report. On August 5, a new investor contributes $3,000 cash and $7,000 in equipment in exchange for Lola stock. After the investment, what is the amount of equity for Lola?

This icon highlights sustainability-related assignments

PROBLEM SET A

Problem Set B, located at the end of Problem Set A, is provided for each problem to reinforce the learning process

Problem 1-1A Identifying effects of transactions on financial statements A1 P1 Identify how each of the following separate transactions 1 through 10 affects financial statements. For increases, place a “+” and the dollar amount in the column or columns. For decreases, place a “−” and the dollar amount in the column or columns. Some cells may contain both an increase (+) and a decrease (−) along with dollar amounts. The first transaction is completed as an example.

Required

a. 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.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

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Problem 1-2A Computing missing information using accounting knowledge A1 P1 The following financial statement information is from five separate companies.

Required

1. Answer the following questions about Company A. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019?

Check (1b) $41,500

2. Answer the following questions about Company B. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is net income for year 2019?

(2c) $1,600

3. Compute the amount of assets for Company C on December 31, 2019. (3) $55,875

4. Compute the amount of owner investments for Company D during year 2019. 5. Compute the amount of liabilities for Company E on December 31, 2018.

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Problem 1-3A Preparing an income statement P2 As of December 31, 2019, Armani Company’s financial records show the following items and amounts.

Required Prepare the 2019 year-end income statement for Armani Company. Check Net income, $15,000

Problem 1-4A Preparing a statement of owner’s equity P2 Use the information in Problem 1-3A to prepare a year-end statement of owner’s equity for Armani Company. Note: The owner invested a total of $1,000 cash during the year.

Problem 1-5A Preparing a balance sheet P2 Use the information in Problem 1-3A to prepare a year-end balance sheet for Armani Company.

Problem 1-6A Preparing a statement of cash flows P2 Following is selected financial information of Kia Company for the year ended December 31, 2019.

Required Prepare the 2019 year-end statement of cash flows for Kia Company. Check Cash balance, Dec. 31, 2019, $3,500

Problem 1-7A Analyzing transactions and preparing financial statements P1 P2 Gabi Gram started The Gram Co., a new business that began operations on May 1. The Gram Co. completed the following transactions during its first month of operations.

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1. Create the following table similar to the one in Exhibit 1.9.

Enter the effects of each transaction on the accounts of the accounting equation by recording dollar 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. Check (1) Ending balances: Cash, $42,780; Expenses, $5,030

2. Prepare the income statement and the statement of owner’s equity for the month of May, and the balance sheet as of May 31. (2) Net income, $6,070; Total assets, $44,750

3. Prepare the statement of cash flows for the month of May.

Problem 1-8A Analyzing effects of transactions P1 A1 Lita Lopez started Biz Consulting, a new business, and completed the following transactions during its first year of operations.

a. Lita Lopez invested $70,000 cash and office equipment valued at $10,000 in the company.

b. The company purchased an office suite for $40,000 cash. 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 a $4,000 cash fee.

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h. Lita Lopez withdrew $3,275 cash from the company for personal use. 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 the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $14,525; Expenses, $2,300; Accounts Payable, $2,200

2. Determine the company’s net income. (2) Net income, $4,500

Problem 1-9A Analyzing transactions and preparing financial statements C4 P1 P2 Sanyu Sony started a new business and completed these transactions during December.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $59,180; Accounts Payable, $8,550

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2. Prepare the income statement and the statement of owner’s equity for the current month, and the balance sheet as of the end of the month. (2) Net income, $4,160; Total assets, $76,760

3. Prepare the statement of cash flows for the current month.

Analysis Component

4. Assume that the owner investment transaction on December 1 was $49,000 cash instead of $65,000 and that Sony Electric obtained another $16,000 in cash by borrowing it from a bank. Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

Problem 1-10A Determining expenses, liabilities, equity, and return on assets A1 A2 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?

Check (3) $410,000

4. What is the average total amount of liabilities plus equity for Kyzera? (4) $250,000

Problem 1-11A Computing and interpreting return on assets A2 Coca-Cola and PepsiCo both produce and market beverages that are direct competitors. Key financial figures for these businesses for a recent year follow.

Required

1. Compute return on assets for (a) Coca-Cola and (b) PepsiCo. Check (1a) 11.3%; (1b) 9.2%

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

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_____ a. _____ b. _____ c. _____ d.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

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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 1-12AA Identifying risk and return A3 All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” is most risky and “4” is least risky.

Lowest-risk corporate bond Medium-risk corporate bond Company stock in a start-up U.S. government Treasury bond

Problem 1-13AB Describing business activities C5 A start-up company often engages in the following transactions during 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

Owner investing in business Purchasing a building Purchasing land Borrowing cash from a bank Purchasing equipment Selling and distributing products Paying for advertising Paying employee wages

Problem 1-14AB Describing business activities C5 An organization undertakes various activities in pursuit of business success. Identify an organization’s three major business activities, and describe each activity.

PROBLEM SET B

Problem 1-1B Identifying effects of transactions on financial statements A1 P1 Identify how each of the following separate transactions 1 through 10 affects financial statements. For increases, place a “+” and the dollar amount in the column or columns. For decreases, place a “−” and the dollar amount in the column or columns. Some cells may contain both an increase (+) and a decrease (−) along with

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dollar amounts. The first transaction is completed as an example.

Required

a. 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.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

Problem 1-2B Computing missing information using accounting knowledge A1 P1 The following financial statement information is from five separate companies.

Required

1. Answer the following questions about Company V. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the net income or loss for the year 2019?

Check (1b) $23,000

2. Answer the following questions about Company W. a. What is the amount of equity on December 31, 2018?

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b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019?

(2c) $22,000

3. Compute the amount of owner investments for Company X during 2019. 4. Compute the amount of assets for Company Y on December 31, 2019.

(4) $135,100

5. Compute the amount of liabilities for Company Z on December 31, 2018.

Problem 1-3B Preparing an income statement P2 As of December 31, 2019, Audi Company’s financial records show the following items and amounts.

Required Prepare the 2019 year-end income statement for Audi Company. Check Net income, $3,000

Problem 1-4B Preparing a statement of owner’s equity P2 Use the information in Problem 1-3B to prepare a year-end statement of owner’s equity for Audi Company. Hint: The owner invested $200 cash during the year.

Problem 1-5B Preparing a balance sheet P2 Use the information in Problem 1-3B to prepare a year-end balance sheet for Audi Company.

Problem 1-6B Preparing a statement of cash flows P2 Selected financial information of Banji Company for the year ended December 31, 2019, follows.

Required Prepare the 2019 year-end statement of cash flows for Banji Company.

Problem 1-7B Analyzing transactions and preparing financial statements P1 P2 Nina Niko launched a new business, Niko’s Maintenance Co., that began operations on June 1. The following transactions were completed by the company during that first month.

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1. Create the following table similar to the one in Exhibit 1.9.

Enter the effects of each transaction on the accounts of the accounting equation by recording dollar 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. Check (1) Ending balances: Cash, $130,060; Expenses, $9,790

2. Prepare the income statement and the statement of owner’s equity for the month of June, and the balance sheet as of June 30. (2) Net income, $7,135; Total assets, $133,135

3. Prepare the statement of cash flows for the month of June.

Problem 1-8B Analyzing effects of transactions P1 A1 Neva Nadal started a new business, Nadal Computing, and completed the following transactions during its first year of operations.

a. Neva Nadal invested $90,000 cash and office equipment valued at $10,000 in the company.

b. The company purchased an office suite for $50,000 cash. c. The company purchased office equipment for $25,000 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 $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.

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h. Neva Nadal withdrew $11,500 cash from the company for personal use. 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 the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $5,350; Expenses, $3,250; Accounts Payable, $2,200

2. Determine the company’s net income. (2) Net income, $3,550

Problem 1-9B Analyzing transactions and preparing financial statements C4 P1 P2 Rivera Roofing Company, owned by Reyna Rivera, began operations in July and completed these transactions during that first month of operations.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $87,545; Accounts Payable, $7,100

2. Prepare the income statement and the statement of owner’s equity for the month of July, and the balance sheet as of July 31. (2) Net income, $18,245; Total assets, $103,545

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3. Prepare the statement of cash flows for the month of July.

Analysis Component

4. Assume that the $5,000 purchase of roofing equipment on July 3 was financed from an owner investment of another $5,000 cash in the business (instead of the purchase conditions described in the transaction above). Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

Problem 1-10B Determining expenses, liabilities, equity, and return on assets A1 A2 Ski-Doo Company manufactures, markets, and sells snowmobiles and snowmobile equipment and accessories. The average total assets for Ski-Doo is $3,000,000. In its most recent year, Ski-Doo reported net income of $201,000 on revenues of $1,400,000.

Required

1. What is Ski-Doo Company’s return on assets? 2. Does return on assets seem satisfactory for Ski-Doo given that its competitors

average a 9.5% return on assets? 3. What are the total expenses for Ski-Doo Company in its most recent year?

Check (3) $1,199,000

4. What is the average total amount of liabilities plus equity for Ski-Doo Company? (4) $3,000,000

Problem 1-11B Computing and interpreting return on assets A2 AT&T and Verizon produce and market telecommunications products and are competitors. Key financial figures for these businesses for a recent year follow.

Required

1. Compute return on assets for (a) AT&T and (b) Verizon. Check (1a) 1.6%; (1b) 4.5%

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

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_____ a. _____ b. _____ c. _____ d.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

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provided.)

Problem 1-12BA Identifying risk and return A3 All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” reflects the highest expected return and “4” the lowest expected return.

Low-risk corporate bond Stock of a successful company Money stored in a fireproof vault U.S. Treasury bond

Problem 1-13BB Describing business 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

Providing client services Obtaining a bank loan Purchasing machinery Research for its products Supervising workers Owner investing in business Renting office space Paying utilities expenses

Problem 1-14BB Describing business activities C5 Identify in outline format the three major business activities of an organization. For each of these activities, identify at least two specific transactions or events normally undertaken by the business’s owners or its managers.

Serial Problem starts here and continues throughout the text

SERIAL PROBLEM

Business Solutions C4 P1

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©Alexander Image/Shutterstock

SP 1 On October 1, 2019, Santana Rey launched a computer services company, Business Solutions, that is organized as a proprietorship and provides consulting services, computer system installations, and custom program development.

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; S. Rey, Capital; S. Rey, Withdrawals; Revenues; and Expenses. Then use additions and subtractions within the table to show the dollar effects for each of the following October transactions for Business Solutions on the individual items of the accounting equation. Show new balances after each transaction.

Check Ending balances: Cash, $42,772; Revenues, $11,408; Expenses, $3,408

GENERAL LEDGER PROBLEM

Accounting professionals apply many technology tools to aid them in their everyday tasks and decision making. The General Ledger tool in Connect automates several

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of the procedural steps in the accounting cycle so the accounting professional can focus on the impacts of each transaction on the full set of financial statements. Chapter 2 is the first chapter to use this tool in helping students see the advantages of technology and, in particular, the power of the General Ledger tool in accounting practice, including financial analysis and “what-if” scenarios.

Accounting Analysis (AA) is a section aimed to refine company analysis, comparative analysis, and global analysis skills; Accounting Analysis assignments are available in Connect.

Accounting Analysis

COMPANY ANALYSIS A1 A2

AA 1-1 Key financial figures for Apple’s two most recent fiscal years follow.

Required

1. What is the total amount of assets invested in Apple in the current year? 2. What is Apple’s return on assets for the current year? 3. How much are total expenses for Apple for the current year? 4. Is Apple’s current-year return on assets better or worse than competitors’

average of 10% return?

COMPARATIVE ANALYSIS A1 A2

AA 1-2 Key comparative figures ($ millions) for both Apple and Google follow.

Required

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1. What is the total amount of assets invested for the current year in (a) Apple and (b) Google?

2. What is the current-year return on assets for (a) Apple and (b) Google? 3. How much are current-year expenses for (a) Apple and (b) Google? 4. Is the current-year return on assets better than the 10% return of competitors

for (a) Apple and (b) Google? 5. Relying only on return on assets, would we invest in Google or Apple?

Note: Reference to Google throughout the text refers to Alphabet Inc., as Google is a wholly owned subsidiary of Alphabet.

GLOBAL ANALYSIS A1 A2

AA 1-3 Samsung is a leading global manufacturer that competes with Apple and Google. Key financial figures for Samsung follow.

*Figures prepared in accordance with International Financial Reporting Standards as adopted by the Republic of Korea.

Required

1. What is the return on assets for Samsung in the (a) current year and (b) prior year?

2. Does Samsung’s return on assets exhibit a favorable or unfavorable trend? 3. Is Samsung’s current-year return on assets better or worse than that for (a)

Apple and (b) Google?

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.

Beyond the Numbers

ETHICS CHALLENGE C3 C4

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BTN 1-1 Tana Thorne works in a public accounting firm and hopes to eventually be a partner. The management of Allnet Company invites Thorne to prepare a bid to audit Allnet’s financial statements. In discussing 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.

COMMUNICATING IN PRACTICE C2 C4

BTN 1-2 Refer to this chapter’s opening feature about Apple. Assume that the owners, sometime during their first five years of business, desire to expand their computer product services to meet business demand regarding computing services. They eventually decide to meet with their banker to discuss a loan to allow Apple to expand and offer computing services.

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 business organization for Apple.

TAKING IT TO THE NET A2

BTN 1-3 Visit the EDGAR database at SEC.gov. Access the Form 10-K report of Rocky Mountain Chocolate Factory (ticker: RMCF) filed on May 23, 2017, covering its 2017 fiscal year.

Required

1. Item 6 of the 10-K report provides comparative financial highlights of RMCF for the years 2013–2017. 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.

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TEAMWORK IN ACTION C1

BTN 1-4 Teamwork is important in today’s business world. Successful teams schedule convenient meetings, maintain regular communications, and cooperate with and support their members. This assignment 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, LinkedIn pages, and/or e-mail addresses of your teammates.

ENTREPRENEURIAL DECISION A1 A2

BTN 1-5 Refer to this chapter’s opening feature about Apple. Assume that the owners decide to open a new company with an innovative mobile app devoted to microblogging for accountants and those learning accounting. This new company will be called AccountApp.

Required

1. AccountApp obtains a $500,000 loan and the two owners contribute $250,000 in total from their own savings in exchange for ownership of 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. Check (2) 10.7%

HITTING THE ROAD C4

BTN 1-6 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 networking. If you do not know the owner, you should call ahead to introduce yourself and explain your position 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

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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.

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw- Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

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C1 C2 C3

C4

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2 Analyzing and Recording Transactions

Chapter Preview

SYSTEM OF ACCOUNTS

Using financial statements Source documents Types of accounts General ledger

NTK 2-1

DEBITS AND CREDITS

T-account Debits and credits Normal balance

NTK 2-2

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P1 A1

P2

P3 A2

C1 C2 C3 C4

A1 A2

P1 P2

RECORDING TRANSACTIONS

Journalizing and posting Processing transactions—Examples

NTK 2-3

TRIAL BALANCE

Trial balance preparation and use Error identification

NTK 2-4

FINANCIAL STATEMENTS

Financial statement preparation Debt ratio

NTK 2-5

Learning Objectives

CONCEPTUAL

Explain the steps in processing transactions and the role of source documents. Describe an account and its use in recording transactions. Describe a ledger and a chart of accounts. Define debits and credits and explain double-entry accounting.

ANALYTICAL

Analyze the impact of transactions on accounts and financial statements. Compute the debt ratio and describe its use in analyzing financial condition.

PROCEDURAL

Record transactions in a journal and post entries to a ledger. Prepare and explain the use of a trial balance.

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Prepare financial statements from business transactions.

Have a Fit

“I’m always confident” —JAMES PARK SAN FRANCISCO—James Park and Eric Friedman created a wooden box with a circuit

board inside. James recalls that to fix an antenna, he “literally took a piece of foam and put it on the circuit board.” Their device could be used to track fitness activity, such as steps taken. The device James and Eric built would later be known as a Fitbit (Fitbit.com).

©Daniel Boczarski/Getty Images for Fitbit

As Fitbit grew, the co-founders struggled to track sales and expenses. “It was pretty challenging,” recalls James. “I would just try to use the weekend to see if I could catch up.” James and Eric knew that having reliable accounting data would help “manage the ups and downs of running a company.”

To address this concern, the co-founders took action. They set up recordkeeping processes, transaction analysis, control procedures, and financial statement reporting. “You need to see the data,” insists James.

With accounting data, James says he “can uncover insights that weren’t possible or very practical before . . . and enable the discovery of new insights and trends.”

Eric offers the following advice to aspiring entrepreneurs unsure of how to unlock the potential of accounting data: “Get your hands dirty and do it yourself. You learn more that way.”

Sources: Fitbit website, January 2019; Wareable.com, September 2016; Business Wire, November 2015; Fortune, July 2015; Marketing Land, March 2015; Fast Company, March 2014

BASIS OF FINANCIAL STATEMENTS

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C1_______ Explain the steps in processing transactions and the role of source documents.

Business transactions and events are the starting points of financial statements. The process to go from transactions and events to financial statements includes the following.

Identify each transaction and event from source documents. Analyze each transaction and event using the accounting equation. Record relevant transactions and events in a journal. Post journal information to ledger accounts. Prepare and analyze the trial balance and financial statements.

Source Documents Source documents identify and describe transactions and events entering the accounting system. They can be in hard copy or electronic form. Examples are sales receipts, checks, purchase orders, bills from suppliers, payroll records, and bank statements. For example, cash registers record each sale on a tape or electronic file. This record is a source document for recording sales in the accounting system. Source documents are objective and reliable evidence about transactions and events and their amounts. Point: Accounting records also are called accounting books or the books.

The “Account” Underlying Financial Statements

C2_______ Describe an account and its use in recording transactions.

An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense. The general ledger, or simply ledger, is a record of all accounts used by a company. The ledger is often in electronic form. While most companies’ ledgers have similar accounts, a company often uses one or more unique accounts to match its type of operations. An unclassified balance sheet broadly groups accounts into assets, liabilities, and equity. Exhibit 2.1 shows common asset, liability, and equity accounts.

EXHIBIT 2.1 Accounts Organized by the Accounting Equation

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Asset Accounts Assets are resources owned or controlled by a company. Resources have expected future benefits. Most accounting systems include (at a minimum) separate accounts for the assets described here.

Cash A Cash account shows a company’s cash balance. All increases and decreases in cash are recorded in the Cash account. It includes money and any funds that a bank accepts for deposit (coins, checks, money orders, and checking account balances).

Accounts Receivable Accounts receivable are held by a seller and are promises of payment from customers to sellers. Accounts receivable are increased by credit sales or sales on account (or on credit). They are decreased by customer payments. We record all increases and decreases in receivables in the Accounts Receivable account. When there are multiple customers, separate records are kept for each, titled Accounts Receivable—‘Customer Name’. Point: Customers and others who owe a company are debtors.

Note Receivable A note receivable, or promissory note, is a written promise of another entity to pay a specific sum of money on a specified future date to the holder of the note; the holder has an asset recorded in a Note (or Notes) Receivable account. Point: A note receivable is different than an account receivable because it comes from a formal contract called a promissory note. A note receivable usually requires interest, whereas an account receivable does not.

Prepaid Accounts Prepaid accounts (or prepaid expenses) are assets from prepayments of future expenses (expenses expected to be incurred in future accounting periods). When the expenses are later incurred, the amounts in prepaid accounts are transferred to expense accounts. Common examples of prepaid accounts are prepaid insurance, prepaid rent, and prepaid services. Prepaid accounts expire with the passage of time (such as with rent) or through use (such as with prepaid meal plans). When financial statements are prepared, (1) all expired and used prepaid accounts are recorded as expenses and (2) all unexpired and unused prepaid accounts are recorded as assets (reflecting future benefits). Chapter 3 covers prepaid accounts in detail. Point: At the beginning of the term, a prepaid college parking pass is an asset that allows a student to park on campus. Benefits of the parking pass expire as the term progresses. At term-end, prepaid parking (asset) equals zero as it has been entirely recorded as parking expense.

Supplies Accounts Supplies are assets until they are used. When they are used up, their costs are reported as expenses. Unused supplies are recorded in a Supplies asset account. Supplies often are grouped by purpose—for example, office supplies and store supplies. Office supplies include paper and pens. Store supplies include packaging and cleaning

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materials.

Equipment Accounts Equipment is an asset. When equipment is used and wears down, its cost is gradually reported as an expense (called depreciation). Equipment often is grouped by its purpose—for example, office equipment and store equipment. Office equipment includes computers and desks. The Store Equipment account includes counters and cash registers.

Buildings Accounts Buildings such as stores, offices, warehouses, and factories are assets because they provide expected future benefits. When a building is used and wears down, its cost is reported as an expense (called depreciation). When several buildings are owned, separate accounts are sometimes kept for each of them. Point: Some assets are called intangible because they do not have physical existence. Coca-Cola reports billions in intangible assets.

Land The cost of land is recorded in a Land account. The cost of buildings located on the land is separately recorded in building accounts.

Decision Insight

©Rob Kim/Getty Images

Women Entrepreneurs Sara Blakely (in photo), the billionaire entrepreneur/owner of SPANX, has promised to donate half of her wealth to charity. The Center for Women’s Business Research reports the following for women-owned businesses.

They total more than 11 million and employ nearly 20 million workers. They generate $2.5 trillion in annual sales and tend to embrace technology.

They are philanthropic—70% of owners volunteer at least once per month. ■

Liability Accounts Liabilities are obligations to transfer assets or provide products or services to others. They are claims (by creditors) against assets. Creditors are individuals and organizations that have rights to receive payments from a company. Common liability accounts are described here.

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Accounts Payable Accounts payable are promises to pay later. Payables can come from purchases of merchandise-for-resale, supplies, equipment, and services. We record all increases and decreases in payables in the Accounts Payable account. When there are multiple suppliers, separate records are kept for each, titled Accounts Payable—‘Supplier Name’. Point: Accounts payable also are called trade payables.

Note Payable A note payable is a written promissory note to pay a future amount. It is recorded as either a short-term note payable or a long-term note payable, depending on when it must be repaid. We explain short- and long-term classification in the next two chapters. Point: A note payable is different than an account payable because it comes from a formal contract called a promissory note and requires interest.

Unearned Revenue Accounts Unearned revenue is 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 seller records this receipt as unearned revenue. Examples of unearned revenue include magazine subscriptions collected in advance by a publisher, rent collected in advance by a landlord, and season ticket sales by sports teams. The seller would record these in liability accounts such as Unearned Subscriptions and Unearned Rent. When products and services are later delivered, the earned portion of the unearned revenue is transferred to revenue accounts such as Subscription Fees Revenue and Rent Revenue.1

Point: Two words that almost always identify liability accounts: “payable,” meaning liabilities that must be paid, and “unearned,” meaning liabilities that must be fulfilled.

Accrued Liabilities Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. These often are recorded in separate liability accounts by the same title. If they are not a large amount, one or more ledger accounts can be added and reported as a single amount on the balance sheet. (Financial statements often report totals of several ledger accounts.)

Decision Insight

©Mike Zarrilli/Getty Images

Unearned Revenue The Dallas Cowboys, Atlanta Falcons, New England Patriots, and most NFL teams have over $100 million in advance ticket sales in Unearned Revenue. When a team plays its home games, it settles this liability to its ticket holders and then transfers the amount earned to Ticket Revenue. Teams in other major sports such as the National Women’s Soccer League and the Women’s National Basketball Association also have unearned revenue. ■

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Equity Accounts The owner’s claim on a company’s assets is called equity or owner’s equity. Equity is the owner’s residual interest in the assets of a business after subtracting liabilities. Equity is impacted by four types of accounts.

We show this in Exhibit 2.2 by expanding the accounting equation. We also organize assets and liabilities into subgroups that have similar attributes. An important subgroup for both assets and liabilities is the current items. Current items are expected to be either collected or owed within the next year. The next chapter explains this. At this point, know that a classified balance sheet groups accounts into classifications (such as land and buildings into Plant Assets) and it reports current assets before noncurrent assets and current liabilities before noncurrent liabilities.

EXHIBIT 2.2 Accounts Classified by the Expanded Accounting Equation

Owner Capital When an owner invests in a company, it increases both assets and equity. The increase to equity is recorded in the account titled Owner, Capital (where the owner’s name is inserted in place of “Owner”). C. Taylor, Capital is used for FastForward. Owner investments are recorded in this account.

Owner Withdrawals When an owner withdraws assets for personal use, it decreases both company assets and total equity. The decrease to equity is recorded in an account titled Owner, Withdrawals. C. Taylor, Withdrawals is used for FastForward. Withdrawals are not expenses of the business; they are simply the opposite of owner investments. Point: Owner, Withdrawals account is a contra equity account because it reduces the normal balance of equity.

Revenue Accounts Amounts received from sales of products and services to customers are recorded in revenue accounts, which increase equity. Examples of revenue accounts are Sales, Commissions Earned, Professional Fees Earned, Rent Revenue, and Interest Revenue. Revenues always increase equity.

Expense Accounts Amounts used for costs of providing products and services are recorded in expense accounts, which decrease equity. Examples of expense accounts are

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Advertising Expense, Salaries Expense, Rent Expense, Utilities Expense, and Insurance Expense. Expenses always decrease equity. A variety of revenues and expenses are in the chart of accounts at the end of this book. (Different companies use different account titles to describe the same thing. For example, some use Interest Revenue instead of Interest Earned.)

Decision Insight

Sporting Accounts The Cleveland Cavaliers, Boston Celtics, Golden State Warriors, and other NBA teams have revenue accounts that include Ticket Sales, Broadcast Fees, and Advertising Revenues. Expense accounts include Player Salaries, NBA Franchise Costs, and Promotional Costs. ■

Ledger and Chart of Accounts

C3_______ Describe a ledger and a chart of accounts.

The collection of all accounts and their balances is called a ledger (or general ledger). A company’s size and diversity of operations affect the number of accounts needed. A small company can have as few as 20 accounts; a large company can require thousands. The chart of accounts is a list of all ledger accounts and has an identification number assigned to each account. Exhibit 2.3 shows a common numbering system of accounts for a smaller business.

EXHIBIT 2.3 Typical Chart of Accounts for a Smaller Business

These account numbers have a three-digit code that is useful in recordkeeping. In this example, the first digit of asset accounts is a 1, the first digit of liability accounts is a 2, and so on. The second and third digits relate to the accounts’ subcategories. Exhibit 2.4 shows a partial chart of accounts for FastForward.

EXHIBIT 2.4 Partial Chart of Accounts for FastForward

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1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

NEED-TO-KNOW 2-1

Classifying Accounts C1 C2 C3

Classify each of the following accounts as either an asset (A), liability (L), or equity (EQ) account.

Prepaid Rent Owner, Capital Note Receivable Accounts Payable Accounts Receivable Equipment Interest Payable Unearned Revenue Land Prepaid Insurance Wages Payable Rent Payable

Solution

1. A 2. EQ 3. A 4. L 5. A 6. A 7. L 8. L 9. A 10. A 11. L 12. L

Do More: QS 2-2, QS 2-3

DOUBLE-ENTRY ACCOUNTING

Debits and Credits

C4_______ Define debits and credits and explain double-entry accounting.

A T-account represents a ledger account and is used to show the effects of transactions. Its name comes from its shape like the letter T. The layout of a T-account is shown in Exhibit 2.5.

EXHIBIT 2.5 The T-Account

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The left side of an account is called the debit side, or Dr. The right side is called the credit side, or Cr. 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. The term debit or credit, by itself, does not mean increase or decrease. Whether a debit or a credit is an increase or decrease depends on the account.

The difference between total debits and total credits for an account, including any beginning balance, is the account balance. When total debits exceed total credits, the account has a debit balance. It has a credit balance when total credits exceed total debits. When total debits equal total credits, the account has a zero balance. Point: Dr. and Cr. come from 18th-century English where terms debitor and creditor were used instead of debit and credit. Dr. and Cr. use the first and last letters of these terms, just as we still do for Saint (St.) and Doctor (Dr.).

Double-Entry System

Double-entry accounting demands the accounting equation remain in balance, which means that for each transaction:

At least two accounts are involved, with at least one debit and one credit. Total amount debited must equal total amount credited.

This means total debits must equal total credits for all entries, and total debit account balances in the ledger must equal total credit account balances. The system for recording debits and credits follows the accounting equation—see Exhibit 2.6.

EXHIBIT 2.6 Debits and Credits in the Accounting Equation

Point: Debit and credit are accounting directions for left and right.

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Net increases or decreases on one side have equal net effects on the other side. For example, a net increase in assets must include an equal net increase on the liabilities and equity side. Some transactions affect only one side of the equation, such as acquiring a land asset by giving up a cash asset, but their net effect on this one side is zero.

The left side is the normal balance side for assets; 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 and liabilities and equity are on the right. Point: Assets are on the left-hand side of the equation and thus increase on the left. Liabilities and equity are on the right-hand side of the equation and thus increase on the right.

Equity increases from revenues and owner investments and it decreases from expenses and owner withdrawals. We see this by expanding the accounting equation to include debits and credits in double-entry form, as shown in Exhibit 2.7.

EXHIBIT 2.7 Debit and Credit Effects for Component Accounts

Increases (credits) to owner’s capital and revenues increase equity; increases (debits) to withdrawals and expenses decrease equity. The normal balance of each account is the side where increases are recorded.

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 (debits) in its Cash account are $36,100, and the total decreases (credits) are $31,300. Total debits exceed total credits by $4,800, resulting in its ending debit balance of $4,800. Point: DrEAD means debit (Dr) is the normal balance side for Expense, Asset, and Drawing accounts; credit the others.

EXHIBIT 2.8 Computing the Balance for a T-Account

Point: The ending balance is on the side with the larger dollar amount. Also, a plus (+) and minus (−) are not used in a T-account.

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________ 1. ________ 2. ________ 3. ________ 4. ________ 5. ________ 6. ________ 7. ________ 8. ________ 9. ________10. ________11. ________12.

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NEED-TO-KNOW 2-2

Normal Account Balance C4

Identify the normal balance (debit [Dr] or credit [Cr]) for each of the following accounts.

Prepaid Rent Owner, Capital Note Receivable Accounts Payable Accounts Receivable Equipment Interest Payable Unearned Revenue Land Prepaid Insurance Owner, Withdrawals Utilities Expense

Solution

1. Dr. 2. Cr. 3. Dr. 4. Cr. 5. Dr. 6. Dr. 7. Cr. 8. Cr. 9. Dr. 10. Dr. 11. Dr. 12. Dr.

Do More: QS 2-4, QS 2-5, QS 2-7, E 2-4

ANALYZING AND PROCESSING TRANSACTIONS This section explains the analyzing, recording, and posting of transactions.

Journalizing and Posting Transactions

P1_______ Record transactions in a journal and post entries to a ledger.

The four steps of processing transactions are shown in Exhibit 2.9. Steps 1 and 2— transaction analysis and the accounting equation—already were covered. This section focuses on steps 3 and 4. Step 3 is to record each transaction chronologically in a journal. A journal is a complete record of each transaction in one place. It also shows debits and credits for each transaction. Recording transactions in a journal is called journalizing. Step 4 is to transfer (or post) entries from the journal to the ledger. Transferring journal entry information to the

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ⓐ

ⓑ

ⓒ

ⓓ

ledger is called posting.

EXHIBIT 2.9 Steps in Processing Transactions

Journalizing Transactions Journalizing transactions requires an understanding of a journal. While companies can use various journals, every company uses a general journal. It can be used to record any transaction. Exhibit 2.10 shows how the first two transactions of FastForward are recorded in a general journal.

EXHIBIT 2.10 Partial General Journal for FastForward

To record entries in a general journal, apply these steps; refer to Exhibit 2.10.

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.

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.

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 separate them from debited accounts.

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 a journal entry explanation—it should be short yet describe why an entry is made.

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.

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Balance Column Account T-accounts are simple and show how the accounting process works. However, actual accounting systems need more structure and therefore use a different formatting of T-accounts, called balance column accounts, shown in Exhibit 2.11.

EXHIBIT 2.11 Cash Account in Balance Column Format

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. FastForward’s Cash account in Exhibit 2.11 is debited on December 1 for the $30,000 owner investment, yielding 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 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.

The heading of the Balance column does not show whether it is a debit or credit balance. Instead, an account is assumed to have a normal balance. Unusual events can sometimes temporarily create an abnormal balance. An abnormal balance is 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 often is identified by setting it in brackets or entering it in red. A zero balance is shown by writing zero or a dash in the Balance column. Point: Explanations are included in ledger accounts only for unusual transactions or events.

Posting Journal Entries Step 4 of processing transactions is to post journal entries to ledger accounts. All entries are posted to the ledger before financial statements are prepared so that account balances are up-to-date. When entries 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 four parts to posting a journal entry. First, identify the ledger account(s) that is debited in the entry. Next, 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. (G shows it came from the general journal.) Second, enter the ledger account number in the PR column of the journal. Parts C and D 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. Point: Posting is automatic with accounting software. Point: The fundamental concepts of a manual system are identical to those of a computerized information system.

EXHIBIT 2.12 Posting an Entry to the Ledger

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Step 1 Step 2 Step 3 Step 4

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Processing Transactions—An Example

A1_______ Analyze the impact of transactions on accounts and financial statements.

We use FastForward to show how double-entry accounting is used in analyzing and processing transactions. Analysis of each transaction follows the four steps of Exhibit 2.9.

Identify the transaction and any source documents.

Analyze the transaction using the accounting equation.

Record the transaction in journal entry form applying double-entry accounting.

Post the entry (for simplicity, we use T-accounts to represent ledger accounts).

Study each transaction before moving to the next. The first 11 transactions are from Chapter 1, and we analyze five additional December transactions of FastForward (numbered 12 through 16). Point: In Need-To-Know 2-5, we show how to use balance column accounts for the ledger.

1. Receive Investment by Owner

2. Purchase Supplies for Cash

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3. Purchase Equipment for Cash

4. Purchase Supplies on Credit

5. Provide Services for Cash

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6. Payment of Expense in Cash

7. Payment of Expense in Cash

Point: Salary usually refers to compensation of a fixed amount for a given time period. Wages is compensation based on time worked.

8. Provide Consulting and Rental Services on Credit

Point: The revenue recognition principle requires revenue to be recognized when the company provides products and services to a customer. This is not necessarily the same time that the customer pays.

Point: Transaction 8 is a compound journal entry, which is an entry that affects three or more accounts. The rule that total debits equal total credits continues.

9. Receipt of Cash on Account

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11. Withdrawal of Cash by Owner

Point: Owner withdrawals always decrease equity.

12. Receipt of Cash for Future Services

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Point: “Unearned” accounts are liabilities that must be fulfilled.

13. Pay Cash for Future Insurance Coverage

14. Purchase Supplies for Cash

Point: Luca Pacioli, a 15th-century monk and famous mathematician, was the first to devise double-entry accounting.

15. Payment of Expense in Cash

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16. Payment of Expense in Cash

Summarizing Transactions in a Ledger Exhibit 2.13 shows the ledger accounts (in T-account form) of FastForward after all 16 transactions are recorded and posted and the balances computed. The accounts are grouped into three columns following the accounting equation: assets, liabilities, and equity.

Totals for the three columns obey the accounting equation: Assets equal $42,395 ($4,275 + $0 + $9,720 + $2,400 + $26,000). Liabilities equal $9,200 ($6,200 + $3,000). Equity equals $33,195 ($30,000 − $200 + $5,800 + $300 − $1,400 − $1,000 − $305). These obey the accounting equation: $42,395 = $9,200 + $33,195.

Capital, withdrawals, revenue, and expense accounts reflect transactions that change equity. Revenue and expense account balances are reported in the income statement.

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EXHIBIT 2.13 Ledger for FastForward (in T-Account Form)

NEED-TO-KNOW 2-3

Recording Transactions P1 A1

Assume Tata Company began operations on January 1 and completed the following

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transactions during its first month of operations. For each transaction, (a) analyze the transaction using the accounting equation, (b) record the transaction in journal entry form, and (c) post the entry using T-accounts to represent ledger accounts. Tata Company has the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Accounts Receivable (106); Equipment (167); Accounts Payable (201); J. Tata, Capital (301); J. Tata, Withdrawals (302); Services Revenue (403); and Wages Expense (601).

Solution

Jan. 1 Receive Investment by Owner

Jan. 5 Purchase Equipment on Credit

Jan. 14 Provide Services on Credit

Do More: QS 2-6, E 2-7, E 2-9, E 2-11, E 2-12

TRIAL BALANCE

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P2_______ Prepare and explain the use of a trial balance.

A trial balance is a list of all ledger accounts and their balances at a point in time. Exhibit 2.14 shows the trial balance for FastForward after its 16 entries are posted to the ledger. (This is an unadjusted trial balance. Chapter 3 explains adjustments.)

Preparing a Trial Balance Preparing a trial balance has three steps.

1. List each account title and its amount (from the 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).

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 will be equal when a debit or credit of a correct amount is made to a wrong account. Another error not identified with a trial balance is when equal debits and credits of an incorrect amount are entered.

EXHIBIT 2.14 Trial Balance (Unadjusted)

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Point: A trial balance is not a financial statement but a tool for checking equality of debits and credits in the ledger.

Searching for Errors If the trial balance does not balance (when its columns are not equal), the error(s) must be found and corrected. An efficient way to search for an error is to check the journalizing, posting, and trial balance preparation in reverse order. Step 1 is to verify that the trial balance columns are correctly added. If step 1 does not 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. 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. Example: If a credit to Unearned Revenue was incorrectly posted to the Revenue ledger account, would the ledger still balance? Answer: The ledger would balance, but liabilities would be understated, equity would be overstated, and income would be overstated.

Ethical Risk

Accounting Quality Recording valid and accurate transactions enhances the quality of financial statements. Roughly 30% of employees in IT report observing misconduct such as falsifying accounting data. They also report increased incidences of such misconduct in recent years. Source: KPMG.■

Financial Statements Prepared from Trial Balance

P3_______ Prepare financial statements from business transactions.

Financial Statements across Time How financial statements are linked in time is shown in Exhibit 2.15. A balance sheet reports an organization’s financial position at a point in time. The income statement, statement of owner’s equity, and statement of cash flows report financial performance over a period of time. The three statements in the middle column of Exhibit 2.15 explain how financial position changes from the beginning to the end of a reporting period.

EXHIBIT 2.15 Links between Financial Statements across Time

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A one-year (annual) reporting period is common, as are semiannual, quarterly, and monthly periods. The one-year reporting period is called the accounting, or fiscal, year. Businesses whose accounting year begins on January 1 and ends on December 31 are called calendar-year companies.

Financial Statement Preparation This section shows how to prepare financial statements from the trial balance. (These are unadjusted statements. Chapter 3 explains adjustments.) We prepare these statements in the following order.

1 Income Statement An income statement reports revenues earned minus expenses incurred over a period of time. FastForward’s income statement for December is shown at the top right side of Exhibit 2.16. Information about revenues and expenses is taken from the trial balance on the left side. Net income of $3,395 is the bottom line for the income statement. Owner investments and withdrawals are not part of income. Point: An income statement also is called an earnings statement, a statement of operations, or a P&L (profit and loss) statement. A balance sheet also is called a statement of financial position.

2 Statement of Owner’s Equity The statement of owner’s equity reports how equity changes over the reporting period. FastForward’s statement of owner’s equity is the second report in Exhibit 2.16. It shows the $30,000 owner investment, the $3,395 of net income, the $200 withdrawal, and the $33,195 end-of-period (capital) balance. (The beginning balance in the statement of owner’s equity is rarely zero, except in the first period of operations. The beginning balance in January 2020 is $33,195, which is December 2019’s ending balance.) Point: Revenues and expenses are not reported in detail in the statement of owner’s equity. Instead, their effects are reflected through net income.

3 Balance Sheet The balance sheet reports the financial position of a company at a point in time. FastForward’s balance sheet is the third report in Exhibit 2.16. This statement shows financial condition at the close of business on December 31. The left side of the balance sheet lists its assets: cash, supplies, prepaid insurance, 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 capital balance of $33,195. Note the link between the ending balance of the statement of owner’s equity and the capital balance. (This presentation of the balance 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.)

EXHIBIT 2.16 Financial Statements Prepared from Trial Balance

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Point: A statement’s heading lists the 3 W’s: Who—name of organization, What—name of statement, When—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.

Presentation Issues Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports such as trial balances. We usually put dollar signs beside only the first and last numbers in a column. Apple’s financial statements in Appendix A show this. Companies commonly round amounts in reports to the nearest dollar, or even to a higher level. Apple, like many large companies, rounds its financial statement amounts to the nearest million. This decision is based on the impact of rounding for users’ decisions.

Decision Maker

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Entrepreneur You open a wholesale business selling entertainment equipment to retail outlets. Most of your customers want to buy on credit. How can you use the balance sheets of customers to decide which ones to extend credit to? ■ Answer: We use the accounting equation (Assets = Liabilities + Equity) to identify risky customers to whom we would 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 be to extend credit. A low equity means the business already has many creditor claims to it.

NEED-TO-KNOW 2-4

Preparing Trial Balance P2

Prepare a trial balance for Apple using the following condensed data from its recent fiscal year ended September 30 ($ in millions).

Solution ($ in millions)

Do More: E 2-8, E 2-10

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Decision Analysis Debt Ratio

A2_______ Compute the debt ratio and describe its use in analyzing financial condition.

It is important to 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 relatively large portion of its assets with liabilities is said to have higher financial leverage. Higher financial leverage means greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). One measure of the risk associated with liabilities is the debt ratio as defined in Exhibit 2.17.

EXHIBIT 2.17 Debt Ratio

Costco’s total liabilities, total assets, and debt ratio for the past three years are shown in Exhibit 2.18. Costco’s debt ratio ranges from a low of 0.63 to a high of 0.70. Its ratio exceeds Walmart’s in each of the last three years, suggesting a higher than average risk from financial leverage. So, is financial leverage good or bad for Costco? The answer: If Costco is making more money with this debt than it is paying the lenders, then it is successfully borrowing money to make more money. A company’s use of debt can turn unprofitable quickly if its return from that money drops below the rate it is paying lenders.

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

Decision Maker

Investor You consider buying stock in Converse. As part of your analysis, you compute the company’s debt ratio for 2017, 2018, and 2019 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 averages 0.40.) ■ Answer: The debt ratio suggests that Converse’s stock is of higher risk than normal and that this risk is rising. The average industry ratio of 0.40 supports this conclusion. The 2019 debt ratio for Converse is twice the industry norm. Also, a debt ratio approaching 1.0 indicates little to no equity.

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NEED-TO-KNOW 2-5 COMPREHENSIVE

Journalizing and Posting Transactions, Statement Preparation, and Debt Ratio

This problem extends Need-To-Know 1-6 from Chapter 1: Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month.

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); Accounts Payable (201); J. Worthy, Capital (301); J. Worthy, Withdrawals (302); Haircutting Services Revenue (403); Wages Expense (623); and Rent Expense (640). Prepare general journal entries for the transactions.

2. Post the journal entries from part 1 to the ledger accounts. 3. Prepare a trial balance as of August 31. 4. Prepare an income statement for August. 5. Prepare a statement of owner’s equity 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 have 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

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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 owner’s equity. 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

1. General journal entries.

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Page 642. Post journal entries from part 1 to the ledger accounts (in balance column format).

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Page 653. Prepare a trial balance from the ledger—see how it feeds the financial statements.

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7.

Summary: Cheat Sheet

SYSTEM OF ACCOUNTS

Asset Accounts Cash: A company’s cash balance. Accounts receivable: Held by a seller; promises of payment from customers to sellers. Accounts receivable are increased by credit sales; often phrased as sales on account or on credit.

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Note receivable: Held by a lender; a borrower’s written promise to pay the lender a specific sum of money on a specified future date. Prepaid accounts (or expenses): Assets that arise from prepayment of future expenses. Examples are prepaid insurance and prepaid rent. More assets: Supplies, equipment, buildings, and land. Liability Accounts Accounts payable: Held by a buyer; a buyer’s promise to pay a seller later for goods or services received. More generally, payables arise from purchases of merchandise for resale, supplies, services, and other items. Note payable: Held by a borrower; a written promissory note to pay a future amount at a future date. Unearned revenue: A liability to be settled in the future when a company delivers its products or services. When a customer pays in advance for products or services (before revenue is earned), the seller records this receipt as unearned revenue. Accrued liabilities: Amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. Equity Accounts Owner capital: When an owner invests in a company, it increases both assets and equity. Owner withdrawals: When an owner withdraws assets for personal use, it decreases both company assets and total equity. Revenue: Amounts received from sales of products and services to customers. Revenue increases equity. Expenses: Costs of providing products and services. Expenses decrease equity.

DEBITS AND CREDITS

The left side of an account is called the debit side, or Dr. The right side is called the credit side, or Cr. Double-entry accounting transaction rules:

At least two accounts are involved, with at least one debit and one credit. Total amount debited must equal total amount credited.

Debits and credits in accounting equation:

Net increases or decreases on one side have equal net effects on the other side. Left side is the normal balance side for assets. Right side is the normal balance side for liabilities and equity.

RECORDING TRANSACTIONS

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Receive investment by owner:

Purchase supplies for cash:

Purchase equipment for cash:

Purchase supplies on credit:

Provide services for cash:

Payment of expenses in cash:

Provide consulting and rental services on credit:

Receipt of cash on account:

Partial payment of accounts payable:

Withdrawal of cash by owner:

Receipt of cash for future services:

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Pay cash for future insurance coverage:

FINANCIAL STATEMENTS

Key Terms

Account (45) Account balance (49) Balance column account (51) Chart of accounts (48) Compound journal entry (54) Credit (49) Creditors (47) Debit (49)

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Debt ratio (62) Debtors (46) Double-entry accounting (49) General journal (51) General ledger (45) Journal (51) Journalizing (51) Ledger (45) Posting (51) Posting reference (PR) column (51) Source documents (45) T-account (49) Trial balance (58) Unearned revenue (47)

Multiple Choice Quiz

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 capital 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 Accounts Payable for $2,500.

3. Liang Shue contributed $250,000 cash and land worth $500,000 to open his new business, Shue Consulting. Which of the following journal entries does Shue Consulting make to record this transaction?

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4. A trial balance prepared at year-end shows total credits exceed 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, liabilities 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%

ANSWERS TO MULTIPLE CHOICE QUIZ

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 L. Shue,

Capital for $750,000. 4. d 5. e; Debt ratio = $400,000/$1,000,000 = 40%

Icon denotes assignments that involve decision making.

Discussion Questions

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 entries? Are the

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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 accounts, 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 Apple balance sheet in Appendix A. Identify three

accounts on its balance sheet that carry debit balances and three accounts on its balance sheet that carry credit balances.

17. Review the Google balance sheet in Appendix A. Identify an asset with the word receivable in its account title and a liability with the word payable in its account title.

18. Review the Samsung balance sheet in Appendix A. Identify three current liabilities and three noncurrent liabilities in its balance sheet.

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 receipt b. Trial balance c. Balance sheet d. Prepaid insurance account e. Invoice from supplier f. Company revenue account

g. Income statement h. Bank statement i. Telephone bill

QS 2-2 Identifying financial statement accounts C2

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Classify each of the following accounts as an asset (A), liability (L), or equity (EQ) account.

a. Cash b. Prepaid Rent c. Office Supplies d. Prepaid Insurance e. Office Equipment f. Owner, Capital

g. Accounts Payable h. Unearned Rent Revenue i. Owner, Withdrawals

QS 2-3 Reading a chart of accounts C3 A chart of accounts is a list of all ledger accounts and an identification number for each. One example of a chart of accounts is near the end of the book on pages CA and CA-1. Using that chart, identify the following accounts as either an asset (A), liability (L), equity (EQ), revenue (R), or expense (E) account, along with its identification number.

a. Advertising Expense b. Rent Revenue c. Rent Receivable d. Machinery e. Accounts Payable f. Furniture

g. Notes Payable h. Owner, Capital i. Utilities Expense

QS 2-4 Identifying normal balance C4 Identify the normal balance (debit or credit) for each of the following accounts.

a. Fees Earned (Revenues) b. Office Supplies c. Owner, Withdrawals d. Wages Expense e. Accounts Receivable f. Prepaid Rent

g. Wages Payable h. Building i. Owner, Capital

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QS 2-5 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. Interest Payable b. Service Revenue c. Salaries Expense d. Accounts Receivable e. Owner, Capital f. Prepaid Insurance

g. Buildings h. Interest Revenue i. Owner, Withdrawals j. Unearned Revenue

k. Accounts Payable l. Land

QS 2-6 Analyzing transactions and preparing journal entries P1 For each transaction, (1) analyze the transaction using the accounting equation, (2) record the transaction in journal entry form, and (3) post the entry using T-accounts to represent ledger accounts. Use the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Accounts Receivable (106); Office Supplies (124); Trucks (153); Equipment (167); Accounts Payable (201); Unearned Landscaping Revenue (236); D. Tyler, Capital (301); D. Tyler, Withdrawals (302); Landscaping Revenue (403); Wages Expense (601), and Landscaping Expense (696).

a. On May 15, DeShawn Tyler opens a landscaping company called Elegant Lawns by investing $7,000 in cash along with equipment having a $3,000 value.

b. On May 21, Elegant Lawns purchases office supplies on credit for $500. c. On May 25, Elegant Lawns receives $4,000 cash for performing landscaping

services. d. On May 30, Elegant Lawns receives $1,000 cash in advance of providing

landscaping services to a customer.

QS 2-7 Analyzing debit or credit by account A1 Identify whether a debit or credit results in the indicated change for each of the following accounts.

a. To increase Land b. To decrease Cash c. To increase Fees Earned (Revenues) d. To increase Salaries Expense e. To decrease Unearned Revenue

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f. To decrease Prepaid Rent g. To increase Notes Payable h. To decrease Accounts Receivable i. To increase Owner, Capital j. To increase Store Equipment

QS 2-8 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 was 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 was 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 (Revenues) in a journal entry was 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 2-9 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 owner’s equity, and B for balance sheet.

a. Services Revenue b. Interest Payable c. Accounts Receivable d. Salaries Expense e. Equipment f. Prepaid Insurance

g. Buildings h. Rental Revenue i. Owner Withdrawals j. Office Supplies

k. Interest Expense l. Insurance Expense

QS 2-10 Computing T-account balance C4

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Determine the ending balance of each of the following T-accounts.

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_____ a. _____ b. _____ c. _____ d.

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QS 2-11 Preparing journal entries P1

Prepare general journal entries for the following transactions of Green Energy Company. Use the following (partial) chart of accounts: Cash; Accounts Receivable; Supplies; Accounts Payable; Consulting Revenue; and Utilities Expense.

QS 2-12 Preparing an income statement P3 Liu Zhang operates Lawson Consulting, which began operations on June 1. On June 30, the company’s records show the following selected accounts and amounts for the month of June. Prepare a June income statement for the business.

QS 2-13 Preparing a statement of owner’s equity P3 Use the information in QS 2-12 to prepare a June statement of owner’s equity for Lawson Consulting. The owner’s capital account balance at June 1 was $0, and the owner invested $10,000 cash in the company on June 2.

QS 2-14 Preparing a balance sheet P3 Use the information in QS 2-12 and QS 2-13 to prepare a June 30 balance sheet for Lawson Consulting. Hint: Compute the owner’s capital account balance as of June 30.

QS 2-15 Computing and using the debt ratio A2 In a recent year’s financial statements, Home Depot reported the following: Total liabilities = $38,633 million and Total assets = $42,966 million. Compute and interpret Home Depot’s debt ratio (assume competitors average a 60.0% debt ratio).

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.

Prepare and analyze the trial balance. Analyze each transaction from source documents. Record relevant transactions in a journal. Post journal information to ledger accounts.

Exercise 2-2 Identifying and classifying accounts C2

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Enter the number for the item that best completes each of the descriptions below.

1. Asset 2. Equity 3. Account 4. Liability 5. Three

a. Balance sheet accounts are arranged into ___________ general categories. b. Owner, Capital and Owner, Withdrawals are examples of __________

accounts. c. Accounts Payable and Note Payable are examples of __________ accounts. d. Accounts Receivable, Prepaid Accounts, Supplies, and Land are examples of

____________ accounts. e. A(n) ________________ is a record of increases and decreases in a specific

asset, liability, equity, revenue, or expense item.

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 3. Journal 4. Account 5. Source document

a. A(n) ___________ of accounts is a list of all accounts a company uses, not including account balances.

b. The ___________ is a record containing all accounts used by a company, including account balances.

c. A(n) ___________ describes transactions entering an accounting system, such as a purchase order.

d. Increases and decreases in a specific asset, liability, equity, revenue, or expense are recorded in a(n) ___________.

e. A(n) ___________ has a complete record of every transaction recorded.

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. Land b. Cash c. Legal Expense

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d. Prepaid Insurance e. Accounts Receivable f. Owner, Withdrawals

g. License Fee Revenue h. Unearned Revenue i. Fees Earned j. Equipment

k. Notes Payable l. Owner, Capital

Exercise 2-5 Analyzing effects of a compound entry 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) equipment worth $80,000, and (3) to assume responsibility for a $28,000 note payable related to the equipment. For this transaction, (a) analyze the transaction using the accounting equation, (b) record the transaction in journal entry form, and (c) post the entry using T-accounts to represent ledger accounts. Use the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Supplies (124); Equipment (167); Accounts Payable (201); Note Payable (245); Owner, Capital (301); and Revenue (404).

Exercise 2-6 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 Receivable 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 disbursements. The October 31 Cash balance was $18,600. Determine how much cash the company had at the close of business on September 30.

Exercise 2-7 Preparing general journal entries P1 Prepare general journal entries for the following transactions of a new company called Pose-for-Pics. Use the following (partial) chart of accounts: Cash; Office Supplies; Prepaid Insurance; Photography Equipment; M. Harris, Capital; Photography Fees Earned; and Utilities Expense.

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Exercise 2-8 Preparing T-accounts (ledger) and a trial balance P2 Use the information in Exercise 2-7 to prepare a trial balance for Pose-for-Pics. Begin by opening these T-accounts: Cash; Office Supplies; Prepaid Insurance; Photography Equipment; M. Harris, Capital; Photography Fees Earned; and Utilities Expense. Then, (1) post the general journal entries to these T-accounts (which will serve as the ledger) and (2) prepare the August 31 trial balance.

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 following accounts: Cash; Accounts Receivable; Office Supplies; Office Equipment; Accounts Payable; K. Spade, Capital; K. Spade, Withdrawals; Fees Earned; and Rent Expense. Use the letters beside each transaction to identify entries. After recording the transactions, post them to T-accounts, which serve 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. 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. Kacy Spade withdrew $10,000 cash from the company for personal use.

Check Cash ending balance, $94,850

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 as its report date.

Exercise 2-11 Analyzing and journalizing transactions involving cash payments P1

1. Prepare general journal entries for the following transactions of Valdez Services.

a. The company paid $2,000 cash for payment on a 6-month-old account payable for office supplies.

b. The company paid $1,200 cash for the just completed two-week salary

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_______

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of the receptionist. c. The company paid $39,000 cash for equipment purchased. d. The company paid $800 cash for this month’s utilities. e. The owner (B. Valdez) withdrew $4,500 cash from the company for

personal use. 2. Transactions a, c, and e did not result in an expense. Match each transaction

(a, c, and e) with one of the following reasons for not recording an expense. This transaction is a distribution of cash to the owner. Even though equity decreased, that decrease did not occur in the

process of providing goods or services to customers. This transaction decreased cash in settlement of a previously existing liability (equity did not change). Supplies expense is

recorded when assets are used, not necessarily when cash is paid. This transaction involves the purchase of an asset. The form of the company’s assets changed, but total assets did not (and

neither did equity).

Exercise 2-12 Analyzing and journalizing transactions involving receipt of cash P1

1. Prepare general journal entries for the following transactions of Valdez Services.

a. Brina Valdez invested $20,000 cash in the company. b. The company provided services to a client and immediately received

$900 cash. c. The company received $10,000 cash from a client in payment for

services to be provided next year. d. The company received $3,500 cash from a client in partial payment of

accounts receivable. e. The company borrowed $5,000 cash from the bank by signing a note

payable. 2. Transactions a, c, d, and e did not yield revenue. Match each transaction (a, c,

d, and e) with one of the following reasons for not recording revenue. This transaction changed the form of an asset from a receivable to cash. Total assets were not increased (revenue was

recognized when the services were originally provided). This transaction brought in cash (increased assets), and it also increased a liability by the same amount (represented by the

signing of a note to repay the amount). This transaction brought in cash, but this is an owner investment. This transaction brought in cash, but it created a liability to provide services to the client in the next year.

Exercise 2-13 Entering transactions into T-accounts A1

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Fill in each of the following T-accounts for Belle Co.’s seven transactions listed here. The T-accounts represent Belle Co.’s general ledger. Code each entry with transaction number 1 through 7 (in order) for reference.

1. D. Belle created a new business and invested $6,000 cash, $7,600 of equipment, and $12,000 in web servers.

2. The company paid $4,800 cash in advance for prepaid insurance coverage. 3. The company purchased $900 of supplies on account. 4. The company paid $800 cash for selling expenses. 5. The company received $4,500 cash for services provided. 6. The company paid $900 cash toward accounts payable. 7. The company paid $3,400 cash for equipment.

Exercise 2-14 Preparing general journal entries P1 Use information from Exercise 2-13 to prepare the general journal entries for Belle Co.’s first seven transactions.

Exercise 2-15 Computing net income A1 A sole proprietorship had the following assets and liabilities at the beginning and end of this year.

Determine net income or net loss for the business during the year for each of the following separate cases.

a. Owner made no investments in the business, and no withdrawals were made during the year.

b. Owner made no investments in the business, but the owner withdrew $1,250 cash per month for personal use.

c. Owner made no withdrawals during the year, but the owner did invest an additional $55,000 cash.

d. Owner withdrew $1,250 cash per month for personal use, and the owner invested an additional $35,000 cash.

Exercise 2-16 Preparing an income statement C3 P3 Carmen Camry operates a consulting firm called Help Today, which began

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operations on August 1. On August 31, the company’s records show the following selected accounts and amounts for the month of August. Use this information to prepare an August income statement for the business.

Check Net income, $10,470

Exercise 2-17 Preparing a statement of owner’s equity P3 Use the information in Exercise 2-16 to prepare an August statement of owner’s equity for Help Today. The owner’s capital account balance at August 1 was $0, and the owner invested $102,000 cash in the company on August 2.

Exercise 2-18 Preparing a balance sheet P3 Use the information in Exercise 2-16 to prepare an August 31 balance sheet for Help Today. Hint: Compute the owner’s capital account balance as of August 31.

Exercise 2-19 Analyzing changes in a company’s equity P3 Compute the missing amount for each of the following separate companies in columns B through E.

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.

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Exercise 2-21 Analyzing a trial balance error P1 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 an $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. (1) Answer each of the following questions and (2) compute the dollar amount of any misstatement for parts a through d.

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?

Exercise 2-22 Calculating and interpreting the debt ratio A2

a. Compute the debt ratio for each of the three companies. b. Which company has the most financial leverage?

Exercise 2-23 Preparing journal entries P1

Prepare general journal entries for the following transactions of Sustain Company.

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Use the following (partial) chart of accounts: Cash; Prepaid Insurance; Accounts Receivable; Furniture; Accounts Payable; Unearned Revenue; Fees Earned; and T. James, Capital.

PROBLEM SET A

Problem 2-1A Preparing and posting journal entries; preparing a trial balance C3 C4 A1 P1 P2 Karla Tanner opened a web consulting business called Linkworks and completed the following transactions in its first month of operations.

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); K. Tanner, Capital (301); K. Tanner, Withdrawals (302); Services Revenue (403); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting. Check (2) Ending balances: Cash, $59,465; Accounts Receivable, $4,490; Accounts Payable, $600

3. Prepare a trial balance as of April 30. (3) Total debits, $119,490

Problem 2-2A 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.

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a. Jenna Aracel, the owner, invested $100,000 cash, office equipment with a value of $5,000, and $60,000 of drafting equipment to launch the company.

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. Jenna Aracel withdrew $9,480 cash from the company for personal use. 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 column 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); J. Aracel, Capital (301); J. Aracel, Withdrawals (302); 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. Check (2) Ending balances: Cash, $22,945; Accounts Receivable, $29,000; Accounts Payable, $1,333

3. Prepare a trial balance as of the end of June. (3) Trial balance totals, $261,733

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Problem 2-3A Preparing and posting journal entries; preparing a trial balance C3 C4 A1 P1 P2 Denzel Brooks opened a web consulting business called Venture Consultants and completed the following transactions in March.

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 column format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); D. Brooks, Capital (301); D. Brooks, Withdrawals (302); 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. Check (2) Ending balances: Cash, $136,700; Accounts Receivable, $7,820; Accounts Payable, $600

3. Prepare a trial balance as of the end of March. (3) Total debits, $187,920

Problem 2-4A 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 a new sole proprietorship 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. 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.

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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. Venedict withdrew $2,800 cash from the company for personal use.

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); H. Venedict, Capital (301); H. Venedict, Withdrawals (302); 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. Check (2) Ending balances: Cash, $12,665; Office Equipment, $50,900

3. Prepare a trial balance as of the end of September. (3) Trial balance totals, $291,350

Problem 2-5A 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, 2018 and 2019.

Required

1. Prepare balance sheets for the business as of December 31, 2018 and 2019. Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.

2. Compute net income for 2019 by comparing total equity amounts for these two years and using the following information: During 2019, the owner invested $35,000 additional cash in the business and withdrew $19,000 cash

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for personal use. Check (2) Net income, $6,000

3. Compute the 2019 year-end debt ratio (in percent and rounded to one decimal). (3) Debt ratio, 19.5%

Problem 2-6A Analyzing account balances and reconstructing transactions C1 C3 A1 P2 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. Check (1) Trial balance totals, $66,900

2. The following seven transactions produced the account balances shown above.

a. Y. Min invested $18,000 cash in the business. b. Paid $7,540 cash for monthly rent expense for May. c. Paid $4,600 cash in advance for the annual insurance premium

beginning the next period. d. Purchased office supplies for $890 cash. e. Purchased $12,900 of office equipment on credit (with accounts

payable). f. Received $36,000 cash for engineering services provided in May.

g. Y. Min withdrew $3,370 cash for personal use. (2) Ending Cash balance, $37,600

Prepare a Cash T-account, enter the cash effects (if any) of each transaction, and compute the ending Cash balance. Code each entry in the T-account with one of the transaction codes a through g.

Problem 2-7A Preparing an income statement, statement of owner’s equity, and balance sheet P3 Angela Lopez owns and manages a consulting firm called Metrix, which began operations on March 1. On March 31, Metrix shows the following selected accounts and amounts for the month of March.

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Required

1. Prepare a March income statement for the business. 2. Prepare a March statement of owner’s equity. The owner’s capital account

balance at March 1 was $0, and the owner invested $11,600 cash in the company on March 2.

3. Prepare a March 31 balance sheet. Hint: Use the owner’s capital account balance calculated in part 2.

PROBLEM SET B

Problem 2-1B Preparing and posting journal entries; preparing a trial balance C3 C4 A1 P1 P2 Humble Management Services opened for business and completed these transactions in September.

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); H. Humble, Capital (301); H. Humble, Withdrawals (302); Services Revenue (401); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting. Check (2) Ending balances: Cash, $21,520; Accounts Receivable, $9,800; Accounts Payable, $550

3. Prepare a trial balance as of the end of September. (3) Total debits, $74,330

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Problem 2-2B Preparing and posting journal entries; preparing a trial balance C3 C4 A1 P1 P2 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.

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 completed 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. B. Grechus withdrew $6,230 cash from the company for personal use. 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.

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); Prepaid Insurance (108); Office Equipment (163); Computer Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); B. Grechus, Capital (301); B. Grechus, Withdrawals (302); Fees Earned (402); Wages Expense (601); Computer Rental Expense (602); Advertising Expense (603); and Repairs Expense

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(604). Post the journal entries from part 1 to the accounts and enter the balance after each posting. Check (2) Ending balances: Cash, $17,262; Accounts Receivable, $9,350; Accounts Payable, $580

3. Prepare a trial balance as of the end of April. (3) Trial balance totals, $141,080

Problem 2-3B Preparing and posting journal entries; preparing a trial balance C3 C4 A1 P1 P2 Zucker Management Services opened for business and completed these transactions in November.

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); M. Zucker, Capital (301); M. Zucker, Withdrawals (302); 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. Check (2) Ending balances: Cash, $23,069; Accounts Receivable, $6,750; Accounts Payable, $249

3. Prepare a trial balance as of the end of November. (3) Total debits, $60,599

Problem 2-4B Recording transactions; posting to ledger; preparing a trial balance C3 A1 P1 P2 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.

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.

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d. A. Nuncio invested his personal automobile in the company. 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. A. Nuncio withdrew $1,100 cash from the company for personal use.

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); A. Nuncio, Capital (301); A. Nuncio, Withdrawals (302); 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. Check (2) Ending balances: Cash, $17,860; Office Equipment, $15,600

3. Prepare a trial balance as of the end of June. (3) Trial balance totals, $95,100

Problem 2-5B 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, 2018 and 2019.

Required

1. Prepare balance sheets for the business as of December 31, 2018 and 2019. Hint: Report only total equity on the balance sheet and remember that total

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equity equals the difference between assets and liabilities. 2. Compute net income for 2019 by comparing total equity amounts for these

two years and using the following information: During 2019, the owner invested $5,000 additional cash in the business and withdrew $3,000 cash for personal use. Check (2) Net income, $11,000

3. Compute the December 31, 2019, debt ratio (in percent and rounded to one decimal). (3) Debt ratio, 63.6%

Problem 2-6B 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.

Required

1. Prepare a trial balance for this business as of the end of April. Check (1) Trial balance totals, $47,650

2. The following seven transactions produced the account balances shown above.

a. Gould invested $15,000 cash in the business. b. Paid $1,800 cash in advance for next month’s rent expense. c. Paid $7,650 cash for miscellaneous expenses. d. Purchased office supplies for $750 cash. e. Purchased $12,250 of office equipment on credit (with accounts

payable). f. Received $20,400 cash for consulting services provided in April.

g. Gould withdrew $5,200 cash for personal use.

Prepare a Cash T-account, enter the cash effects (if any) of each transaction, and compute the ending Cash balance. Code each entry in the T-account with one of the transaction codes a through g. (2) Ending Cash balance, $20,000

Problem 2-7B Preparing an income statement, statement of owner’s equity, and balance sheet P3 Victoria Rivera owns and manages a consulting firm called Prisek, which began operations on July 1. On July 31, the company’s records show the following selected accounts and amounts for the month of July.

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Required

1. Prepare a July income statement for the business. 2. Prepare a July statement of owner’s equity. The owner’s capital account

balance at July 1 was $0, and the owner invested $34,800 cash in the company on July 2.

3. Prepare a July 31 balance sheet. Hint: Use the owner’s capital account balance calculated in part 2.

SERIAL PROBLEM

Business Solutions 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.

©Alexander Image/Shutterstock RF

SP 2 On October 1, 2019, Santana Rey launched a computer services company called Business Solutions, which provides consulting services, computer system installations, and custom program development. Rey adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2019. The company’s initial chart of accounts follows.

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Required

1. Prepare journal entries to record each of the following transactions for Business Solutions.

2. Open ledger accounts (in balance column format) and post the journal entries from part 1 to them. Check (2) Cash, Nov. 30 bal., $38,264

3. Prepare a trial balance as of the end of November. (3) Trial bal. totals, $98,659

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GENERAL LEDGER PROBLEM

Using transactions from the following assignments along with the General Ledger tool, prepare journal entries for each transaction and identify the financial statement impact of each entry. The financial statements are automatically generated based on the journal entries recorded. GL 2-1 Transactions from the FastForward illustration in this chapter GL 2-2 Based on Exercise 2-9 GL 2-3 Based on Exercise 2-12 GL 2-4 Based on Problem 2-1A Using transactions from the following assignments, record journal entries, create financial statements, and assess the impact of each transaction on financial statements. GL 2-5 Based on Problem 2-2A GL 2-6 Based on Problem 2-3A GL 2-7 Based on Problem 2-4A GL 2-8 Based on the Serial Problem SP 2

Accounting Analysis

COMPANY ANALYSIS A1 A2

AA 2-1 Refer to Apple’s financial statements in Appendix A for the following questions.

Required

1. What amount of total liabilities does Apple report for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016?

2. What amount of total assets does it report for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016?

3. Compute its debt ratio for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016. (Report ratio in percent and round it to one decimal.)

4. In which fiscal year did it employ more financial leverage: September 30, 2017, or September 24, 2016? Explain.

COMPARATIVE ANALYSIS A1 A2

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AA 2-2 Key comparative figures for Apple and Google follow.

1. What is the debt ratio for Apple in the current year and for the prior year? 2. What is the debt ratio for Google in the current year and for the prior year? 3. Which of the two companies has the higher degree of financial leverage in the

current year?

GLOBAL ANALYSIS A2

AA 2-3 Key comparative figures for Apple, Google, and Samsung follow.

Required

1. Compute Samsung’s debt ratio for the current year and prior year. 2. Is Samsung on a trend toward increased or decreased financial leverage? 3. Looking at the current-year debt ratio, is Samsung a more risky or less risky

investment than (a) Apple and (b) Google?

Beyond the Numbers

ETHICS CHALLENGE C1

BTN 2-1 Assume that you are a cashier and your manager requires that you immediately enter each sale when it occurs. Recently, lunch hour traffic has increased and the assistant manager asks you to avoid delays by taking customers’

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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, customers will be happy and the register record will always match the cash amount when the manager arrives at three o’clock. The advantages to the process proposed by the assistant manager include improved customer service, fewer delays, and less work for you. The disadvantage is that the assistant manager could steal cash by simply recording less sales than the cash received and then pocketing the excess cash. You decide to reject her suggestion without the manager’s approval and to confront her on the ethics of her suggestion.

Required Propose and evaluate two other courses of action you might consider, and explain why.

COMMUNICATING IN PRACTICE C1 C2 A1 P3

BTN 2-2 Lila Corentine is an aspiring entrepreneur and your friend. She is having difficulty understanding 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.

TAKING IT TO THE NET A1

BTN 2-3 Access EDGAR online (SEC.gov) and locate the 2016 10-K report of Amazon.com (ticker: AMZN) filed on February 10, 2017. Review its financial statements reported for years ended 2016, 2015, and 2014 to answer the following questions.

Required

1. What are the amounts of Amazon’s net income or net loss reported for each of these three years?

2. Do Amazon’s operating activities provide cash or use cash for each of these three years? Hint: See the statement of cash flows.

3. If Amazon has 2016 net income of $2,371 million and 2016 operating cash flows of $16,443 million, how is it possible that its cash balance at December 31, 2016, increases by only $3,444 million relative to its balance at December 31, 2015?

TEAMWORK IN ACTION C1 C2 C4 A1

BTN 2-4 The expanded accounting equation consists of assets, liabilities, capital, withdrawals, revenues, and expenses. It can be used to reveal insights into changes in a company’s financial position.

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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) capital, (d) withdrawals, (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.

ENTREPRENEURIAL DECISION A1 A2 P3

BTN 2-5 Assume that James Park and Eric Friedman of Fitbit plan on expanding their business to accommodate more product lines. They are considering financing 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 James and Eric should consider when trying to decide on the method for financing their expansion.

ENTREPRENEURIAL DECISION A1 A2 P3

BTN 2-6 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 that Martin prepare a balance sheet and key financial ratios. Martin has not kept formal records but is able to provide the following accounts and their amounts as of December 31.

*The total equity amount reflects all owner investments, withdrawals, revenues, and expenses

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as of December 31.

Required

1. Prepare a balance sheet as of December 31 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?

HITTING THE ROAD C1

BTN 2-7 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 printouts to your report). Alternatively, you may want to search the web for the required information. One suitable website is CareerOneStop (CareerOneStop.org). For documentation, 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 most to you, the reason for its appeal, and its requirements.

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw- Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

1 In practice, account titles vary. Subscription Fees Revenue is sometimes called Subscription Fees, Subscription Fees Earned, or Earned Subscription Fees. Rent Revenue is sometimes called Rent Earned, Rental Revenue, or Earned Rent Revenue. Titles can differ even within the same industry. Product sales are called net sales at Apple, revenues at Google, and revenue at Samsung. Revenues or fees is commonly used with service businesses, and net sales or sales is used with product businesses.

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C1

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3 Adjusting Accounts for Financial Statements

Chapter Preview

DEFERRAL OF EXPENSE

Timing Accrual vs. cash 3-Step process Framework Examples

NTK 3-1

DEFERRAL OF REVENUE

Framework Examples

NTK 3-2

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P3

P4

P5 P6

A1

NTK 3-5

C1

A1

P1 P2 P3 P4

ACCRUED EXPENSE

Framework Examples

NTK 3-3

ACCRUED REVENUE

Framework Examples Summary

NTK 3-4

REPORTING AND ANALYSIS

Adjusted trial balance Financial statements

Profit margin

Learning Objectives

CONCEPTUAL

Explain the importance of periodic reporting and the role of accrual accounting.

ANALYTICAL

Compute profit margin and describe its use in analyzing company performance.

PROCEDURAL

Prepare adjusting entries for deferral of expenses. Prepare adjusting entries for deferral of revenues. Prepare adjusting entries for accrued expenses. Prepare adjusting entries for accrued revenues.

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P5 P6 P7

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Explain and prepare an adjusted trial balance. Prepare financial statements from an adjusted trial balance. Appendix 3A—Explain the alternatives in accounting for prepaids.

©Johnny Nunez/WireImage/Getty Images

Making Airwaves

“Great success comes through service” —CATHY HUGHES SILVER SPRING, MD—At 16, Cathy Hughes was pregnant and booted out of the house by her mother. “I was in shock,” recalls Cathy, “but I was determined not to allow me or my child to become a statistic.”

Cathy clung to her dream of running her own business. Even while “sleeping in a sleeping bag and washing up in a public bathroom,” Cathy pursued her dream and built Urban One (Urban1.com).

Times were tough, but Cathy set up an accounting system to capture data to help her make good decisions. She “stayed focused on not losing the company.” Her insight into accounting adjustments and transaction analysis helped her distinguish accrual income from cash flows. Cathy insisted that “the accountant regularly send her the monthly financial statements.”

Cathy explains that she learned about the deferral and accrual of revenues and expenses as her business grew. This knowledge gave her an advantage in taking strategic actions. Urban One eventually became the largest African American owned and operated broadcast company. Cathy tells entrepreneurs “to translate your ideas into a formal business plan . . . as no one will invest in your business without one.” She adds: “Accurate accounting is crucial to providing investor comfort.”

Sources: Urban One website, January 2019; Huffington Post, August 2012

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TIMING AND REPORTING

The Accounting Period

C1_______ Explain the importance of periodic reporting and the role of accrual accounting.

“Apple announces annual income of . . .”

The value of information is linked to its timeliness. Useful information must reach decision makers frequently. To provide timely information, accounting systems prepare reports at regular intervals. 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 reporting, 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.

EXHIBIT 3.1 Accounting Periods

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©Vixit/Shutterstock

The annual reporting period is not always a calendar year ending on December 31. An organization can use a fiscal year consisting of any 12 consecutive months or 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 use the calendar year as their fiscal year. Facebook uses calendar-year reporting. Companies that have seasonal variations in sales often use a natural business year end, which is when sales are at their lowest level for the year. The natural business year for retailers such as Target and Dick’s Sporting Goods ends around January 31, after the holidays.

Accrual Basis versus Cash Basis After external transactions and events are recorded, several accounts require adjustments before their balances appear in financial statements. This is needed because internal transactions and events are not yet recorded.

Accrual basis accounting records revenues when services and products are delivered and records expenses when incurred (matched with revenues). Cash basis accounting records revenues when cash is received and records expenses when cash is paid. Cash basis income is cash receipts minus cash payments.

Most agree that accrual accounting better reflects business performance than cash basis accounting. Accrual accounting also increases the comparability of financial statements from period to period.

Accrual Basis To compare these two systems, let’s consider FastForward’s Prepaid Insurance account. FastForward paid $2,400 for 24 months of insurance coverage that began on December 1, 2019. Accrual accounting requires that $100 of insurance expense be reported each month, from December 2019 through November 2021. (This means expenses are $100 in 2019, $1,200 in 2020, and $1,100 in 2021.) Exhibit 3.2 shows this allocation of insurance cost across the three years. Any unexpired premium is reported as a Prepaid Insurance asset on the accrual basis balance sheet.

EXHIBIT 3.2 Accrual Accounting for Allocating Prepaid Insurance to Expense

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Point: Annual income statements for Exhibit 3.2 follow:

Cash Basis A cash basis income statement for December 2019 reports insurance expense of $2,400, as shown in Exhibit 3.3. The cash basis income statements for years 2020 and 2021 report no insurance expense. The cash basis balance sheet never reports a prepaid insurance asset because it is immediately expensed. Also, cash basis income for 2019–2021 does not match the cost of insurance with the insurance benefits received for those years and months.

EXHIBIT 3.3 Cash Accounting for Allocating Prepaid Insurance to Expense

Point: Annual income statements for Exhibit 3.3 follow:

Recognizing Revenues and Expenses We divide a company’s activities into time periods, but not all activities are complete when financial statements are prepared. Thus, adjustments are required to get proper account balances. We use two principles in the adjusting process: revenue recognition and expense recognition.

Revenue recognition principle requires that revenue be recorded when goods or services are provided to customers and at an amount expected to be received from customers. Adjustments ensure revenue is recognized (reported) in the time period when those services and products are provided. Point: Recording revenue early overstates current-period income; recording it late understates current-period income.

Expense recognition (or matching) principle requires that expenses be recorded in the same accounting period as the revenues that are recognized as a result of those expenses. Point: Recording expense early understates current-period income; recording it late overstates current-period income.

Ethical Risk 201

Ethical Risk

Clawbacks from Accounting Fraud Former executives at Saba Software, a cloud-based talent management system, were charged with accounting fraud by the SEC for falsifying revenue to boost income. This alleged overstatement of income led to a payback of millions of dollars to the company by the former CEO and former CFO. See SEC release 2015-28. ■

©Marco Marchi/Getty Images

Framework for Adjustments Four types of adjustments exist for transactions and events that extend over more than one period.

Adjustments are made using a 3-step process, as shown in Exhibit 3.4.

EXHIBIT 3.4 Three-Step Process for Adjusting Entries

Each adjusting entry made at the end of an accounting period reflects a transaction or event that is not yet recorded. An adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never the Cash account).

DEFERRAL OF EXPENSE

P1_______ Prepare adjusting entries for deferral of expenses.

Prepaid expenses, or deferred expenses, are assets paid for in advance of receiving their benefits. When these assets are used, those advance payments become expenses.

Framework Adjusting entries for prepaid expenses increase expenses and decrease assets, as shown in the T-accounts of Exhibit 3.5. This adjustment shows the using up of prepaid expenses. To demonstrate accounting for prepaid expenses, we look at prepaid insurance, supplies, and depreciation. In each case we decrease an asset (balance sheet)

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account and increase an expense (income statement) account.

EXHIBIT 3.5 Adjusting for Prepaid Expenses (decrease an asset and record an expense)

Prepaid Insurance Prepaid insurance expires with time. We use our three-step process.

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, 2019. Step 2: As time passes, 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, 2019. This expense is $100, or 1/24 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.

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 adjustment on or before December 31 would

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Understate expenses by $100 for the December income statement. Overstate prepaid insurance (assets) by $100 in the December 31 balance sheet.

The following highlights the adjustment for prepaid insurance.

Supplies We count supplies at period-end and make an adjusting entry.

Step 1: FastForward purchased $9,720 of supplies in December, some of which were used during that same month. When financial statements are prepared at December 31, the cost of supplies used during December is expensed. Step 2: When FastForward computes (physically counts) 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.

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

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Understate expenses by $1,050 for the December income statement. Overstate supplies by $1,050 in the December 31 balance sheet.

The following highlights the adjustment for supplies.

Other Prepaid Expenses Other prepaid expenses, such as Prepaid Rent and Prepaid Advertising, are accounted for exactly as insurance and supplies are.

Some prepaid expenses are both paid for and fully used up within a single period. One example is when a company pays monthly rent on the first day of each month. In this case, we record the cash paid with a debit to Rent Expense instead of an asset account.

Decision Maker

Investor A publisher signs an Olympic skier to write a book. The company pays the skier $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.” How does this affect your analysis? ■ Answer: Prepaid expenses are assets paid for in advance of receiving their benefits–they are expensed as they are used up. 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).

©Don Hammond/ Design Pics

Depreciation A special category of prepaid expenses is plant assets, which are long-term tangible assets used to produce and sell products and services. Plant assets provide benefits for more than one period. Examples of plant assets are buildings, machines, vehicles, and fixtures. All plant assets (excluding land) eventually wear out or become less useful. The costs of plant assets are gradually reported as expenses in the income statement over the assets’ useful lives (benefit periods). Depreciation is the allocation of 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. Point: Plant assets are also called Plant & Equipment or Property, Plant & Equipment (PP&E). Point: Depreciation does not necessarily measure decline in market value. Point: An asset’s expected value at the end of its useful life is called salvage value.

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Step 1: 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 five years and to be worth about $8,000 at the end of five years. This means the net cost of this equipment over its useful life is $18,000 ($26,000 − $8,000). FastForward depreciates it using 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 60 months (5 years) in the asset’s useful life gives a monthly cost of $300 ($18,000⁄60). Step 3: The adjusting entry to record monthly depreciation expense, along with T-account postings, follows.

Explanation After posting the adjustment, the Equipment account ($26,000) minus its Accumulated Depreciation ($300) account equals the $25,700 net cost. The $300 balance in the Depreciation Expense account is reported in the December income statement. Not making the adjustment at December 31 would

Understate expenses by $300 for the December income statement. Overstate assets by $300 in the December 31 balance sheet.

The following highlights the adjustment for depreciation.

Accumulated Depreciation is a separate contra account. A contra account is an account linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance. FastForward’s contra account of Accumulated Depreciation—Equipment is subtracted from the Equipment account in the balance sheet. Point: Accumulated Depreciation has a normal credit balance; it decreases the asset’s reported value.

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The Accumulated Depreciation contra account includes total depreciation expense for all prior periods for which the asset was used. To demonstrate, on February 28, 2020, after three months of adjusting entries, the Equipment and Accumulated Depreciation accounts appear as in Exhibit 3.6. The $900 balance in the Accumulated Depreciation account is subtracted from its related $26,000 asset cost. The difference ($25,100) between these two balances is called book value, or net amount, which is the asset’s costs minus its accumulated depreciation. Point: The net cost of equipment is also called depreciable basis.

EXHIBIT 3.6 Accounts after Three Months of Depreciation Adjustments

These account balances are reported in the assets section of the February 28 balance sheet in Exhibit 3.7. This presentation shows the full cost of assets and accumulated depreciation.

EXHIBIT 3.7 Equipment and Accumulated Depreciation on February 28 Balance Sheet

NEED-TO-KNOW 3-1

Prepaid Expenses P1

For each separate case below, follow the three-step process for adjusting the prepaid asset account at December 31. Assume no other adjusting entries are made during the year.

1. Prepaid Insurance. The Prepaid Insurance account has a $5,000 debit balance to start the year, and no insurance payments were made during the year. A review of insurance policies shows that $1,000 of unexpired insurance remains at its December 31 year-end.

2. Prepaid Rent. On October 1 of the current year, the company prepaid $12,000 for one year of rent for facilities being occupied from that day forward. The company debited Prepaid Rent and credited Cash for $12,000. December 31

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year-end statements must be prepared. 3. Supplies. The Supplies account has a $1,000 debit balance to start the year.

Supplies of $2,000 were purchased during the current year and debited to the Supplies account. A December 31 physical count shows $500 of supplies remaining.

4. Accumulated Depreciation. The company has only one fixed asset (equipment) that it purchased at the start of this year. That asset had cost $38,000, had an estimated life of 10 years, and is expected to be valued at $8,000 at the end of the 10-year life. December 31 year-end statements must be prepared.

Solution

1. Step 1: Prepaid Insurance equals $5,000 (before adjustment) Step 2: Prepaid Insurance should equal $1,000 (the unexpired part) Step 3: Adjusting entry to get from step 1 to step 2

2. Step 1: Prepaid Rent equals $12,000 (before adjustment) Step 2: Prepaid Rent should equal $9,000 (the unexpired part)* Step 3: Adjusting entry to get from step 1 to step 2

3. Step 1: Supplies equal $3,000 (from $1,000 + $2,000; before adjustment)? Step 2: Supplies should equal $500 (what’s left) Step 3: Adjusting entry to get from step 1 to step 2*

4. Step 1: Accumulated Depreciation equals $0 (before adjustment) Step 2: Accumulated Depreciation should equal $3,000 (after current-period depreciation of $3,000)* Step 3: Adjusting entry to get from step 1 to step 2

Do More: QS 3-5, QS 3-6, QS 3-7, QS 3-8, QS 3-9

DEFERRAL OF REVENUE

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P2_______ Prepare adjusting entries for deferral of revenues.

Unearned revenue is cash received in advance of providing products and services. Unearned revenues, or deferred revenues, are liabilities. When cash is accepted, an obligation to provide products or services is accepted.

Framework As products or services are provided, the liability decreases, and the unearned revenues become earned revenues. Adjusting entries for unearned revenue decrease the unearned revenue (balance sheet) account and increase the revenue (income statement) account, as shown in Exhibit 3.8.

EXHIBIT 3.8 Adjusting for Unearned Revenues (decrease a liability and record revenue)

Point: To defer is to postpone. We postpone reporting amounts received as revenues until the product or service is provided.

Unearned revenues are common in sporting and concert events. When the Boston Celtics receive cash from advance ticket sales, they record it in an unearned revenue account called Deferred Game Revenues. The Celtics record revenue as games are played.

Unearned Consulting Revenue FastForward has unearned revenues. The company agreed on December 26 to provide consulting services to a client for 60 days for a fixed fee of $3,000. 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

This advance payment increases cash and creates a liability to do consulting work over the next 60 days (5 days this year and 55 days next year).

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Step 2: As time passes, FastForward earns this payment through consulting. By December 31, it has provided five days’ service and earned 5⁄60 of the $3,000 unearned revenue. This amounts to $250 ($3,000 × 5⁄60). The revenue recognition principle requires that $250 of unearned revenue 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

Understates revenue by $250 in the December income statement. Overstates unearned revenue by $250 on the December 31 balance sheet.

The following highlights the adjustment for unearned revenue.

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NEED-TO-KNOW 3-2

Unearned Revenues P2

For each separate case below, follow the three-step process for adjusting the unearned revenue liability account at December 31. Assume no other adjusting entries are made during the year.

a. Unearned Rent Revenue. The company collected $24,000 rent in advance on September 1, debiting Cash and crediting Unearned Rent Revenue. The tenant was paying 12 months’ rent in advance and moved in on September 1.

b. Unearned Services Revenue. The company charges $100 per month to spray a house for insects. A customer paid $600 on November 1 in advance for six treatments, which was recorded with a debit to Cash and a credit to Unearned Services Revenue. At year-end, the company has applied two treatments for the customer.

Solution

a. Step 1: Unearned Rent Revenue equals $24,000 (before adjustment) Step 2: Unearned Rent Revenue should equal $16,000 (current-period earned revenue is $8,000*) Step 3: Adjusting entry to get from step 1 to step 2

b. Step 1: Unearned Services Revenue equals $600 (before adjustment) Step 2: Unearned Services Revenue should equal $400 (current-period earned revenue is $200*) Step 3: Adjusting entry to get from step 1 to step 2

Do More: QS 3-10, QS 3-11

ACCRUED EXPENSE

P3_______ Prepare adjusting entries for accrued expenses.

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Accrued expenses are costs that are incurred in a period that are both unpaid and unrecorded. Accrued expenses are reported on the income statement for the period when incurred.

Framework Adjusting entries for recording accrued expenses increase the expense (income statement) account and increase a liability (balance sheet) account, as shown in Exhibit 3.9. This adjustment recognizes expenses incurred in a period but not yet paid. Common examples of accrued expenses are salaries, interest, rent, and taxes. We use salaries and interest to show how to adjust accounts for accrued expenses.

EXHIBIT 3.9 Adjusting for Accrued Expenses (increase a liability and record an expense)

Point: Accrued expenses are also called accrued liabilities.

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 on Wednesday, December 31, yet this salary cost has not been paid or recorded. FastForward must report the added expense and liability for unpaid salary from December 29, 30, and 31.

EXHIBIT 3.10 Salary Accrual and Paydays

Step 3: The adjusting entry for accrued salaries, along with T-account postings, follows.

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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

Understates salaries expense by $210 in the December income statement. Understates salaries payable by $210 on the December 31 balance sheet.

The following highlights the adjustment for salaries incurred.

Accrued Interest Expense

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Companies accrue interest expense on notes payable (loans) and other long-term liabilities at the end of a period. Interest expense is incurred as time passes. 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 × Annual interest rate × Fraction of year since last payment

If a company has a $6,000 loan from a bank at 5% annual interest, then 30 days’ accrued interest expense is $25—computed as $6,000 × 0.05 × 30⁄360. The adjusting entry debits

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Interest Expense for $25 and credits Interest Payable for $25. Point: Interest computations use a 360-day year, called the bankers’ rule.

Future Cash Payment of Accrued Expenses Accrued expenses at the end of one accounting period result in cash payment in a future period(s). Recall that FastForward recorded accrued salaries of $210. On January 9, the first payday of the next period, the following entry settles the accrued liability (salaries payable) and records salaries expense for seven days of work in January.

The $210 debit is the payment of the liability for the three days’ salary accrued on December 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.

NEED-TO-KNOW 3-3

Accrued Expenses P3

For each separate case below, follow the three-step process for adjusting the accrued expense account at December 31. Assume no other adjusting entries are made during the year.

a. Salaries Payable. At year-end, salaries expense of $5,000 has been incurred by the company but is not yet paid to employees.

b. Interest Payable. At its December 31 year-end, the company holds a mortgage payable that has incurred $1,000 in annual interest that is neither recorded nor paid. The company intends to pay the interest on January 3 of the next year.

Solution

a. Step 1: Salaries Payable equals $0 (before adjustment) Step 2: Salaries Payable should equal $5,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

b. Step 1: Interest Payable equals $0 (before adjustment) Step 2: Interest Payable should equal $1,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

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Do More: QS 3-12, QS 3-13

ACCRUED REVENUE

P4_______ Prepare adjusting entries for accrued revenues.

Accrued revenues are 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 after 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.

Framework The adjusting entries for accrued revenues increase a revenue (income statement) account and increase an asset (balance sheet) account, as shown in Exhibit 3.11. Accrued revenues usually come from services, products, interest, and rent. We use service fees and interest to show how to adjust for accrued revenues.

EXHIBIT 3.11 Adjusting for Accrued Revenues (increase an asset and record revenue)

Point: Accrued revenues are also called accrued assets.

Accrued Services Revenue Accrued revenues are recorded when 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 or the seller has not yet billed the buyer. FastForward provides an example.

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Step 1: In the second week of December, FastForward agreed to provide 30 days of consulting services to a fitness club for a fixed fee of $2,700 (or $90 per day). FastForward will provide services from December 12 through January 10, or 30 days of service. The club agrees to pay FastForward $2,700 on January 10 when the service is complete. Step 2: At December 31, 20 days of services have already been provided. Because 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 × 20⁄30). The revenue recognition principle requires FastForward to report the $1,800 on the December income statement. The balance sheet reports that the club owes FastForward $1,800. Step 3: The adjusting entry for accrued services, along with T-account postings, follows.

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

Understates consulting revenue by $1,800 in the December income statement. Understates accounts receivable by $1,800 on the December 31 balance sheet.

The following highlights the adjustment for accrued revenue.

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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 If a company is holding notes 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, debit Interest Receivable (asset) and credit Interest Revenue.

Future Cash Receipt of Accrued Revenues Accrued revenues at the end of one accounting period result in cash receipts in a future period(s). 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 record revenue earned in January. The $2,700 debit is the cash received. The $1,800 credit is the removal of the receivable, and the $900 credit is revenue earned in January.

Decision Maker

Loan Officer The owner of a home theater store applies for a business loan. The store’s financial statements reveal large increases in current-year revenues and income. 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: While increased revenues and income are fine, your concern is with collectibility of these promotional sales. If the store sold products to customers with poor records of paying bills, then collectibility of these sales is low. Your analysis must assess this possibility and estimate losses.

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NEED-TO-KNOW 3-4

Accrued Revenues P4

For each separate case below, follow the three-step process for adjusting the accrued revenue account at December 31. Assume no other adjusting entries are made during the year.

a. Accounts Receivable. At year-end, the company has completed services of $1,000 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, $500 of interest earned from its investments in government bonds.

Solution

a. Step 1: Accounts Receivable equals $0 (before adjustment) Step 2: Accounts Receivable should equal $1,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

b. Step 1: Interest Receivable equals $0 (before adjustment) Step 2: Interest Receivable should equal $500 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Do More: QS 3-3, QS 3-14

Links to Financial Statements Exhibit 3.12 summarizes the four adjustments. Each adjusting entry affects one or more income statement (revenue or expense) accounts and one or more balance sheet (asset or liability) accounts, but never the Cash account.

EXHIBIT 3.12 Summary of Adjustments and Financial Statement Links

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Page 98Information for some adjustments is not available until 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 December utility bill on January 10. When it receives the bill, the company records the expense and the payable as of December 31. The income statement and balance sheet include these adjustments even though amounts were not known at period-end.

Decision Ethics

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 follow these instructions. What do you do? ■ Answer: You should probably form an LLC. An LLC helps protect personal property from lawsuits directed at the business. Also, an LLC is not subject to an additional business income tax. You also must examine the ethical and social aspects of starting a business where injuries are expected.

TRIAL BALANCE AND FINANCIAL STATEMENTS

Adjusted Trial Balance

P5_______ Explain and prepare an adjusted trial balance.

An unadjusted trial balance is a list of accounts and balances before adjustments are recorded. An adjusted trial balance is a list of accounts and balances 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, 2019. The order of accounts in the trial balance usually matches the order in the chart of accounts. Several new accounts usually arise from adjusting entries.

EXHIBIT 3.13 Unadjusted and Adjusted Trial Balances

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Each adjustment (see middle columns) has a letter that links it to an adjusting entry explained earlier. Each amount in the Adjusted Trial Balance columns is computed by taking that account’s amount from the Unadjusted Trial Balance columns and adding or subtracting any adjustment(s). To demonstrate, Supplies has a $9,720 Dr. balance in the unadjusted columns. Subtracting the $1,050 Cr. amount shown in the Adjustments columns equals 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.

Preparing Financial Statements

P6_______ Prepare financial statements from an adjusted trial balance.

We can prepare financial statements directly from information in the adjusted trial balance. Exhibit 3.14 shows how revenue and expense balances are transferred from the adjusted trial balance to the income statement (red lines). The net income and withdrawals amounts are then used to prepare the statement of owner’s equity (black lines). Asset and liability balances are then transferred to the balance sheet (blue lines). The ending capital is determined on the statement of owner’s equity and transferred to the balance sheet (green lines).

EXHIBIT 3.14 Preparing Financial Statements (Adjusted Trial Balance from Exhibit 3.13)

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Page 100We prepare financial statements in the following order: (1) income statement, (2) statement of owner’s equity, and (3) balance sheet. This order makes sense because the balance sheet uses information from the statement of owner’s equity, 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.

NEED-TO-KNOW 3-5

Preparing Financial Statements from a Trial Balance P6

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Use the following adjusted trial balance of Magic Company to prepare its December 31 year-end (1) income statement, (2) statement of owner’s equity, and (3) balance sheet (unclassified). The Magic, Capital account balance was $75,000 on December 31 of the prior year.

Do More: QS 3-19, E 3-10, P 3-5

Decision Analysis Profit Margin

A1_______ Compute profit margin and describe its use in analyzing company performance.

A useful measure of a company’s operating results is the ratio of its net income to

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net sales. This ratio is called profit margin, or return on sales, and is computed as in Exhibit 3.15. This ratio shows the percent of profit in each dollar of sales.

EXHIBIT 3.15 Profit Margin

Visa’s profit margins are shown in Exhibit 3.16. Visa’s profit margin is superior to Mastercard’s in each of the last three years. For Mastercard to improve its profit margin, it must either reduce expenses, or increase revenues at a relatively greater amount than expenses.

EXHIBIT 3.16 Analysis Using Profit Margin

Decision Maker

CFO Your health care equipment company consistently reports a 9% profit margin, which is similar to that of competitors. The treasurer argues that profit margin can be increased to 20% if the company cuts marketing expenses. Do you cut those expenses? ■ Answer: The 14% return on assets for the manufacturer exceeds the 9% industry return. This is positive for a potential purchase. Also, this purchase is an opportunity to spread your risk over two businesses. Still, you should hesitate to purchase a business whose 14% return is lower than your current 21% return. You might better direct efforts to increase investment in your resort if it can earn more than the 14% alternative.

NEED-TO-KNOW 3-6 COMPREHENSIVE 1

Preparing Year-End Accounting Adjustments

The following information relates to Fanning’s Electronics on December 31, 2019. The company, which uses the calendar year as its annual reporting period, initially records prepaid and unearned items in balance 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, 2019, falls on a Monday, but the employees will not be paid their wages until Friday, January 4, 2020.

b. Eighteen months earlier, on July 1, 2018, the company purchased equipment that cost $20,000. Its useful life is predicted to be five years, at which time the equipment is expected to be worthless (zero salvage value).

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c. On October 1, 2019, 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, 2019, the company purchased a 12-month insurance policy for $1,800. The transaction was recorded with an $1,800 debit to Prepaid Insurance.

e. On December 29, 2019, the company completed a $7,000 service that has not been billed or recorded as of December 31, 2019.

Required

1. Prepare any necessary adjusting entries on December 31, 2019, 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. Determine 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 2019 income statement and the December 31, 2019, balance sheet. Use up (down) arrows to indicate an increase (decrease) in the Effect columns.

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.

SOLUTION

1. Adjusting journal entries.

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2. T-accounts for adjusting journal entries a through e.

3. Financial statement effects of adjusting journal entries.

NEED-TO-KNOW 3-7 COMPREHENSIVE 2

Preparing Financial Statements from Adjusted Account Balances

Use the following year-end adjusted trial balance to answer questions

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1–3.

1. Prepare the annual income statement from the adjusted trial balance of Choi Company.

Answer:

2. Prepare a statement of owner’s equity from the adjusted trial balance of Choi Company. Choi’s capital account balance of $40,340 consists of a $30,340 balance from the prior year-end, plus a $10,000 owner investment during the current year.

Answer:

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3A

3. Prepare a balance sheet (unclassified) from the adjusted trial balance of Choi Company.

Answer:

APPENDIX

Alternative Accounting for Prepayments P7_______ Explain the alternatives in accounting for prepaids.

This appendix explains alternative accounting for deferred expenses and deferred

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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 transfer the cost of the unused portions from expense accounts to prepaid expense (asset) accounts. The financial statements are identical under either method, but the adjusting entries are different. To demonstrate the differences between these two methods, let’s look at FastForward’s cash payment on December 1 for 24 months of insurance coverage beginning on December 1. FastForward recorded that payment with a debit to an asset account, but it could have recorded a debit to an expense account. These alternatives are shown in Exhibit 3A.1.

EXHIBIT 3A.1 Alternative Initial Entries for Prepaid Expenses

At the end of its accounting period on December 31, insurance protection for one month has expired. This means $100 ($2,400⁄24) 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.

EXHIBIT 3A.2 Adjusting Entry for Prepaid Expenses for the Two Alternatives

When these entries are posted, we see in Exhibit 3A.3 that the two methods give identical results.

EXHIBIT 3A.3 Account Balances under Two Alternatives for Recording Prepaid Expenses

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RECORDING PREPAYMENT OF REVENUES IN REVENUE ACCOUNTS 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 transfer the unearned portions from revenue accounts to unearned revenue (liability) accounts. The adjusting entries are different for these two alternatives, but the financial statements are identical. To demonstrate the 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.

EXHIBIT 3A.4 Alternative Initial Entries for Unearned Revenues

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.

EXHIBIT 3A.5 Adjusting Entry for Unearned Revenues for the Two Alternatives

After adjusting entries are posted, the two alternatives give identical results, as shown in Exhibit 3A.6.

EXHIBIT 3A.6 Account Balances under Two Alternatives for Recording Unearned Revenues

Summary: Cheat Sheet

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DEFERRAL OF EXPENSE

Prepaid expenses: Assets paid for in advance of receiving their benefits. When these assets are used, the advance payments become expenses. Prepaid insurance expires:

Supplies are used up:

Depreciation of assets:

Accumulated depreciation: A separate contra account. A contra account is an account linked with another account. It has an opposite normal balance and is a subtraction from that other account’s balance.

DEFERRAL OF REVENUE

Unearned revenue: Cash received in advance of providing products and services. When cash is accepted, the company has a liability to provide products or services. Record unearned revenue (cash received in advance):

Reduce unearned revenue (products or services are provided):

ACCRUED EXPENSE

Accrued expenses: Costs incurred in a period that are both unpaid and unrecorded. They are reported on the income statement for the period when incurred. Salaries expense owed but not yet paid:

Accrued interest formula:

Payment of accrued expenses:

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ACCRUED REVENUE

Accrued revenues: Revenues earned in a period that are both unrecorded and not yet received in cash. Revenue earned but not received in cash:

Receipt of accrued revenue:

REPORTING AND ANALYSIS

Unadjusted trial balance: A list of ledger accounts and balances before adjustments are recorded. Adjusted trial balance: A list of accounts and balances after adjusting entries have been recorded and posted to the ledger. Preparing financial statements from adjusted trial balance:

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Key Terms

Accounting period (85) Accrual basis accounting (86) Accrued expenses (93) Accrued revenues (95) Accumulated depreciation (90) Adjusted trial balance (98) Adjusting entry (87) Annual financial statements (85) Book value (90) Cash basis accounting (86) Contra account (90)

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Depreciation (89) Expense recognition (or matching) principle (87) Fiscal year (85) Interim financial statements (85) Natural business year (86) Plant assets (89) Prepaid expenses (87) Profit margin (101) Revenue recognition principle (87) Straight-line depreciation method (89) Time period assumption (85) Unadjusted trial balance (98) Unearned revenues (91)

Multiple Choice Quiz

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 of the current year, 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 current year ended December 31?

a. $4,000 b. $8,000 c. $12,000 d. $20,000 e. $24,000

4. On November 1, Stockton Co. receives $3,600 cash from Hans Co. for

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consulting services to be provided evenly over the period November 1 to April 30—at which time Stockton credits $3,600 to Unearned Consulting Fees. The adjusting entry on December 31 (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%

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; the forgotten adjusting entry is: dr. Wages Expense, cr. Wages Payable. 2. c; Supplies used = $450 − $125 = $325 3. b; Insurance expense = $24,000 × (8⁄24) = $8,000; adjusting entry is: dr.

Insurance Expense for $8,000, cr. Prepaid Insurance for $8,000. 4. a; Consulting fees earned = $3,600 × (2⁄6) = $1,200; adjusting entry is: dr.

Unearned Consulting Fees for $1,200, cr. Consulting Fees Earned for $1,200.

5. e; Profit margin = $15,000⁄$300,000 = 5%

A Superscript letter A denotes assignments based on Appendix 3A.

Icon denotes assignments that involve decision making.

Discussion Questions

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 corresponds to its natural business year instead of the calendar year?

4. What is a prepaid expense and where is it reported in the financial statements?

5. What type of assets requires adjusting entries to record depreciation?

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6. What contra account is used when recording and reporting the effects of depreciation? Why is it used?

7. What is an accrued revenue? Give an example. 8. 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?

9. Review Apple’s balance sheet in Appendix A. Identify one asset account that requires 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.)

10. Review Google’s balance sheet in Appendix A. Identify the amount for property and equipment. What adjusting entry is necessary (no numbers required) for this account when preparing financial statements?

11. Assume Samsung has unearned revenue. What is unearned revenue and where is it reported in financial statements?

12. Refer to Samsung’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?

QUICK STUDY

QS 3-1 Periodic reporting C1 Choose from the following list of terms and phrases to best complete the statements below.

a. Fiscal year b. Timeliness c. Accrual basis accounting d. Annual financial statements e. Cash basis accounting f. Time period assumption

1. _______ presumes that an organization’s activities can be divided into specific time periods.

2. Financial reports covering a one-year period are known as _______. 3. A(n) _______ consists of any 12 consecutive months. 4. _______ records revenues when services are provided and records expenses

when incurred. 5. The value of information is often linked to its _______.

QS 3-2 Computing accrual and cash income C1

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_______ a.

_______ b. _______ c. _______ d. _______ e.

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In its first year of operations, Roma Company reports the following.

Earned revenues of $45,000 ($37,000 cash received from customers). Incurred expenses of $25,500 ($20,250 cash paid toward them). Prepaid $6,750 cash for costs that will not be expensed until next year.

Compute Roma’s first-year net income under the cash basis and the accrual basis of accounting.

QS 3-3 Identifying accounting adjustments P1 P2 P3 P4 Classify the following adjusting entries as involving prepaid expenses (PE), unearned revenues (UR), accrued expenses (AE), or accrued revenues (AR).

To record revenue earned that was previously received as cash in advance.

To record wages expense incurred but not yet paid (nor recorded). To record revenue earned but not yet billed (nor recorded). To record expiration of prepaid insurance. To record annual depreciation expense.

QS 3-4 Concepts of adjusting entries P1 P2 P3 P4 During the year, a company 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.

For each of the adjusting entries (1), (2), and (3), indicate the account to be debited and the account to be credited—from a through i below.

a. Prepaid Insurance b. Cash c. Salaries Payable d. Unearned Services Revenue e. Salaries Expense f. Services Revenue

g. Accounts Receivable h. Accounts Payable i. Depreciation Expense

QS 3-5 Prepaid (deferred) expenses adjustments P1 For each separate case below, follow the three-step process for adjusting the prepaid asset account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year.

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a. Prepaid Insurance. The Prepaid Insurance account has a $4,700 debit balance to start the year. A review of insurance policies 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 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 two years of rent for facilities being occupied that day. The company debited Prepaid Rent and credited Cash for $24,000.

QS 3-6 Prepaid (deferred) expenses adjustments P1 For each separate case below, follow the three-step process for adjusting the Supplies asset account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 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 3-7 Adjusting prepaid (deferred) expenses P1 For each separate case, record the necessary adjusting entry.

a. On July 1, Lopez 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. Prepare the year-end adjusting entry to reflect expiration of the insurance as of December 31.

b. Zim Company has a Supplies account balance of $5,000 at the beginning of the year. During the year, it purchases $2,000 of supplies. As of December 31, a physical count of supplies 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.

QS 3-8 Accumulated depreciation adjustments P1 For each separate case below, follow the three-step process for adjusting the Accumulated Depreciation account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year.

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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 expense 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 five years, and is expected to have zero value at the end of the five 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 seven years, and is expected to be valued at $4,000 at the end of the seven years.

QS 3-9 Adjusting for depreciation P1 For each separate case, record an adjusting entry (if necessary).

a. Barga Company purchases $20,000 of equipment on January 1. 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.

b. Welch Company purchases $10,000 of land on January 1. The land is expected to last forever. What depreciation adjustment, if any, should be made with respect to the Land account as of December 31?

QS 3-10 Unearned (deferred) revenues adjustments P2 For each separate case below, follow the three-step process for adjusting the unearned revenue liability account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 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, debiting Cash and crediting Unearned Rent Revenue. The tenant was paying 12 months’ rent in advance and occupancy began November 1.

b. Unearned Services Revenue. The company charges $75 per insect treatment. 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 treatments 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 3-11 Adjusting for unearned (deferred) revenues P2

For each separate case, record the necessary adjusting entry.

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a. Tao Co. receives $10,000 cash in advance for four months of evenly planned legal services beginning on October 1. Tao records it by debiting Cash and crediting Unearned Revenue both for $10,000. It is now December 31, and Tao has provided legal services as planned. What adjusting entry should Tao make to account for the work performed from October 1 through December 31?

b. 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. It sends Contest News to each of these subscribers every month from July through December. Assuming no changes in subscribers, prepare the year-end journal entry that Caden must make as of December 31 to adjust the Subscription Revenue account and the Unearned Subscription Revenue account.

QS 3-12 Accrued expenses adjustments P3 For each separate case below, follow the three-step process for adjusting the accrued expense account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 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 incurred $875 in annual interest that is neither recorded nor paid. The company intends to pay the interest on January 7 of the next year.

QS 3-13 Accruing salaries P3 Molly Mocha 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.) The coffee shop adjusts its books monthly, if needed, to show salaries earned but unpaid at month-end. The student works the last week of July, which is Monday, July 28, through Friday, August 1. If the student earns $100 per day, what adjusting entry must the coffee shop make on July 31 to correctly record accrued salaries expense for July?

QS 3-14 Accrued revenues adjustments P4 For each separate case below, follow the three-step process for adjusting the accrued revenue account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year.

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a. Accounts Receivable. At year-end, the L. Cole 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 bills customers when jobs are complete. The work for one job has been completed, and the customer has been billed $1,300 but has not yet paid.

QS 3-15 Recording and analyzing adjusting entries P1 P2 P3 P4 Adjusting entries affect at least one balance sheet account and at least one income statement account. For the entries below, identify the account to be debited and the account to be credited from the following accounts: Cash; Accounts Receivable; Prepaid Insurance; Equipment; Accumulated Depreciation; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Insurance Expense; and Depreciation Expense. 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.

QS 3-16 Determining effects of adjusting entries P1 P3

In making adjusting entries at the end of its accounting period, Chao Consulting mistakenly forgot to record:

1. $3,200 of insurance coverage that had expired (this $3,200 cost had been initially debited to the Prepaid Insurance account).

2. $2,000 of accrued salaries expense.

As a result of these two oversights, the financial statements for the reporting period will [choose one]:

a. Understate assets by $3,200. b. Understate expenses by $5,200. c. Understate net income by $2,000. d. Overstate liabilities by $2,000.

QS 3-17 Preparing an adjusted trial balance P5 Following are unadjusted balances along with year-end adjustments for Quinlan Company. Complete the adjusted trial balance by entering the adjusted balance for each of the following accounts.

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QS 3-18 Analyzing profit margin A1

Damita 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 3-19 Preparing financial statements P6 The adjusted trial balance for Zahurak Company follows. Use the adjusted trial balance to prepare the December 31 year-end (a) income statement, (b) statement of owner’s equity, and (c) balance sheet. The E. Happ, Capital account balance was $65,500 on December 31 of the prior year.

Check Net income, $17,800

QS 3-20 Adjusting for unearned (deferred) revenues P2

For each separate case, record an adjusting entry (if necessary).

a. Lonzo Co. receives $3,000 cash in advance for six months of sustainable recycling services on September 1 and records it by debiting Cash and crediting Unearned Revenue for $3,000. Lonzo provides sustainable recycling services monthly as promised. Prepare the December 31 year-end adjusting entry that Lonzo records for the work performed from September 1 through December 31.

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b. Tío launched a two-week promotion ending March 31 for its digital magazine, Sustainability Today. This one-time promotion allows subscribers to pay $20 up front and receive 12 monthly issues from April through the following March. For this promotion, Tío debits Cash and credits Unearned Subscription Revenue for the amount received. Tío has 300 new subscribers as of April 1, and it sends Sustainability Today to each of them monthly from April through March. Prepare the December 31 year-end entry that Tío records to adjust the Subscription Revenue and the Unearned Subscription Revenue accounts.

QS 3-21A Preparing adjusting entries P7 Garcia Company had the following selected transactions during the year. (A partial chart of accounts follows: Cash; Accounts Receivable; Prepaid Insurance; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Insurance Expense; Depreciation Expense.)

a. Record journal entries for these transactions assuming Garcia follows the usual practice of recording a prepayment of an expense in an asset account and recording a prepayment of revenue received in a liability account.

b. Record journal entries for these transactions assuming Garcia follows the alternative practice of recording a prepayment of an expense in an expense account and recording a prepayment of revenue received in a revenue account.

QS 3-22A Preparing adjusting entries P7 Cal Consulting follows the practice that prepayments are debited to expense when paid, and unearned revenues are credited to revenue when cash is received. Given this company’s accounting practices, which one 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 of $500 and a credit to Unearned Consulting Fees of $500.

b. Unpaid salaries of $400 are recorded with a debit to Prepaid Salaries of $400 and a credit to Salaries Expense of $400.

c. Office supplies purchased for the period were $1,000. The cost of unused office supplies of $650 is recorded with a debit to Supplies Expense of $650 and a credit to Office Supplies of $650.

d. Earned but unbilled (and unrecorded) consulting fees for the period were $1,200, which are recorded with a debit to Unearned Consulting Fees of $1,200 and a credit to Consulting Fees Earned of $1,200.

EXERCISES

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Exercise 3-1 Determining assets and expenses for accrual and cash accounting C1 On March 1, 2017, a company paid an $18,000 premium on a 36-month insurance policy for coverage beginning on that date. Refer to that policy and fill in the blanks in the following table.

Check 2019 insurance expense: Accrual, $6,000; Cash, $0. Dec. 31, 2019, asset: Accrual, $1,000; Cash, $0.

Exercise 3-2 Classifying adjusting entries P1 P2 P3 P4 In the blank space beside each adjusting entry, enter the letter of the explanation A through F that most closely describes the entry.

A. To record this period’s depreciation expense. B. To record accrued salaries expense. C. To record this period’s use of a prepaid expense. D. To record accrued interest revenue. E. To record accrued interest expense. F. To record the earning of previously unearned income.

Exercise 3-3 Adjusting and paying accrued wages P3 Pablo Management has five employees, each of whom earns $250 per day. They are paid on Fridays for work completed Monday through Friday of the same week. Near year-end, the five employees worked Monday, December 31, and Wednesday through Friday, January 2, 3, and 4. New Year’s Day (January 1) was an unpaid holiday.

a. Prepare the year-end adjusting entry for wages expense. b. Prepare the journal entry to record payment of the employees’ wages on

Friday, January 4.

Exercise 3-4 Determining cost flows through accounts P1 Determine the missing amounts in each of these four separate situations a through d.

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Exercise 3-5 Adjusting and paying accrued expenses P3 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. The subsequent entry during May to record payment of the accrued expenses.

Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Salaries Payable; Interest Payable; Legal Services Payable; Unearned Revenue; Revenue; Salaries Expense; Interest Expense; Legal Services Expense; and Depreciation Expense.

a. On April 1, the company hired an attorney for a flat monthly fee of $3,500. Payment for April legal services was made by the company on May 12.

b. As of April 30, $3,000 of interest expense has accrued on a note payable. The full interest payment of $9,000 on the note is due on May 20.

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 a Tuesday, 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 3-6 Preparing adjusting entries P1 P2 P3 Prepare adjusting journal entries for the year ended (date of) December 31 for each of these separate situations. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Supplies; Prepaid Insurance; Prepaid Rent; Equipment; Accumulated Depreciation—Equipment; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Supplies Expense; Insurance Expense; Rent Expense; and Depreciation Expense—Equipment.

a. Depreciation on the company’s equipment for the year is computed to be $18,000.

b. The Prepaid Insurance account had a $6,000 debit balance at December 31 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 Supplies account had a $700 debit balance at the beginning of the year; and $3,480 of supplies were purchased during the year. The December 31 physical count showed $300 of supplies available. Check (c) Dr. Supplies Expense, $3,880

d. Two-thirds of the work related to $15,000 of cash received in

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advance was performed this period. e. The Prepaid Rent account had a $6,800 debit balance at December 31 before

adjusting for the costs of expired prepaid rent. An analysis of the rental agreement showed that $5,800 of prepaid rent had expired. (e) Dr. Rent Expense, $5,800

f. Wage expenses of $3,200 have been incurred but are not paid as of December 31.

Exercise 3-7 Preparing adjusting entries P1 P3 P4 For each of the following separate cases, prepare adjusting entries required of financial statements for the year ended (date of) December 31. Entries can draw from the following partial chart of accounts: Cash; Interest Receivable; Supplies; Prepaid Insurance; Equipment; Accumulated Depreciation—Equipment; Wages Payable; Interest Payable; Unearned Revenue; Interest Revenue; Wages Expense; Supplies Expense; Insurance Expense; Interest Expense; and Depreciation Expense —Equipment.

a. Wages of $8,000 are earned by workers but not paid as of December 31. b. Depreciation on the company’s equipment for the year is $18,000. c. The Supplies account had a $240 debit balance at the beginning of the year.

During the year, $5,200 of supplies are purchased. A physical count of supplies at December 31 shows $440 of supplies available. Check (d) Dr. Insurance Expense, $2,800

d. The Prepaid Insurance account had a $4,000 balance at the beginning of the year. An analysis of insurance policies shows that $1,200 of unexpired insurance benefits remain at December 31.

e. The company has earned (but not recorded) $1,050 of interest revenue for the year ended December 31. The interest payment will be received 10 days after the year-end on January 10. (e) Cr. Interest Revenue, $1,050

f. The company has a bank loan and has incurred (but not recorded) interest expense of $2,500 for the year ended December 31. The company will pay the interest five days after the year-end on January 5.

Exercise 3-8 Analyzing and preparing adjusting entries P5

Following are two income statements for Alexis Co. for the year ended December 31. The left number column is prepared before adjusting entries are recorded, and the right column is prepared after adjusting entries. Analyze the statements and prepare the seven adjusting entries a through g that likely were recorded. Hint: The entry for a refers to fees that have been earned but not yet billed. None of the entries involve cash.

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Exercise 3-9 Preparing adjusting entries—accrued revenues and expenses P3 P4 Prepare year-end adjusting journal entries for M&R Company as of December 31 for each of the following separate cases. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Interest Receivable; Equipment; Wages Payable; Salary Payable; Interest Payable; Lawn Services Payable; Unearned Revenue; Revenue; Interest Revenue; Wages Expense; Salary Expense; Supplies Expense; Lawn Services Expense; and Interest Expense.

a. M&R Company provided $2,000 in services to customers in December. Those customers are expected to pay the company sometime in January following the company’s year-end.

b. Wage expenses of $1,000 have been incurred but are not paid as of December 31.

c. M&R Company has a $5,000 bank loan and has incurred (but not recorded) 8% interest expense of $400 for the year ended December 31. The company will pay the $400 interest in cash on January 2 following the company’s year- end.

d. M&R Company hired a firm that provided lawn services during December for $500. M&R will pay for December lawn services on January 15 following the company’s year-end.

e. M&R Company has earned $200 in interest revenue from investments for the year ended December 31. The interest revenue will be received on January 15 following the company’s year-end.

f. Salary expenses of $900 have been earned by supervisors but not paid as of December 31.

Exercise 3-10 Preparing financial statements from a trial balance P6

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Following are the accounts and balances from the adjusted trial balance of Stark Company. Prepare the (1) income statement and (2) statement of owner’s equity for the year ended December 31 and (3) balance sheet at December 31. The Stark, Capital account balance was $24,800 on December 31 of the prior year.

Exercise 3-11 Computing and interpreting profit margin A1

Use the following information to compute profit margin for each separate company a through e. Which of the five companies is the most profitable according to the profit margin ratio? Interpret the profit margin ratio for company c.

Exercise 3-12A Adjusting for prepaids recorded as expenses and unearned revenues recorded as revenues P7 Ricardo Construction began operations on December 1. In setting up its accounting procedures, the company 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 entries as of its December 31 period-end for items e through g. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Interest Receivable; Supplies; Prepaid Insurance; Unearned Remodeling Fees; Remodeling Fees Earned; Supplies Expense; Insurance Expense; and Interest Expense.

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. f. An analysis of insurance policies in effect on December 31 shows that $340

of insurance coverage had expired. Check (f) Cr. Insurance Expense, $1,200

g. As of December 31, only one remodeling project has been worked on and

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completed. The $5,570 fee for this project had been received in advance and recorded as remodeling fees earned. (g) Dr. Remodeling Fees Earned, $11,130

Exercise 3-13A Recording and reporting revenues received in advance P7 Costanza Company experienced the following events and transactions during July. The company has the following partial chart of accounts: Cash; Accounts Receivable; Unearned Fees; and Fees Earned.

a. Prepare journal entries (including any adjusting entries as of the July 31 month-end) 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 July 31 month-end) to record these events using the alternative 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.

Check (c) $10,500 Fees Earned—following part b

Exercise 3-14 Preparing adjusting entries P1 P2 P3 P4

For each of the following separate cases, prepare the required December 31 year- end adjusting entries. Entries can draw from this partial chart of accounts: Interest Receivable; Prepaid Insurance; Accumulated Depreciation—Equipment; Wages Payable; Unearned Revenue; Consulting Revenue; Interest Revenue; Wages Expense; Insurance Expense; Interest Expense; and Depreciation Expense— Equipment.

a. Depreciation on the company’s wind turbine equipment for the year is $5,000. b. The Prepaid Insurance account for the solar panels had a $2,000 debit balance

at December 31 before adjusting for the costs of any expired coverage. Analysis of prepaid insurance shows that $600 of unexpired insurance coverage remains at year-end.

c. The company received $3,000 cash in advance for sustainability consulting work. As of December 31, one-third of the sustainability consulting work had been performed.

d. As of December 31, $1,200 in wages expense for the organic produce workers have been incurred but not yet paid.

e. As of December 31, the company has earned, but not yet recorded, $400 of

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interest revenue from investments in socially responsible bonds. The interest revenue is expected to be received on January 12.

PROBLEM SET A

Problem 3-1A Identifying adjusting entries with explanations P1 P2 P3 P4 For journal entries 1 through 12, 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. 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.

Problem 3-2A Preparing adjusting and subsequent journal entries P1 P2 P3 P4 Arnez Company’s annual accounting period ends on December 31, 2019. The following information concerns the adjusting entries to be recorded as of that date. Entries can draw from the following partial chart of accounts: Cash; Rent Receivable; Office Supplies; Prepaid Insurance; Building; Accumulated Depreciation—Building; Salaries Payable; Unearned Rent; Rent Earned; Salaries Expense; Office Supplies Expense; Insurance Expense; and Depreciation Expense— Building.

a. The Office Supplies account started the year with a $4,000 balance. During 2019, the company purchased supplies for $13,400, which was added to the Office Supplies account. The inventory of supplies available at December 31, 2019, totaled $2,554.

b. An analysis of the company’s insurance policies provided the following facts. 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.)

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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, 2019, 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, 2020.

d. The company purchased a building on January 1, 2019. 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 tenant at $3,000 per month, starting on November 1, 2019. 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, 2019. 2. Prepare journal entries to record the first subsequent cash transaction in 2020

for parts c and e.

Check (1b) Dr. Insurance Expense, $7,120 (1d) Dr. Depreciation Expense, $30,500

Problem 3-3A Preparing adjusting entries, adjusted trial balance, and financial statements P1 P2 P3 P4 P6 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 follows, along with descriptions of items a through h that require adjusting entries on December 31. Additional Information

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.

c. Annual depreciation on the equipment is $13,200.

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d. Annual depreciation on the professional library is $7,200. e. On September 1, WTI agreed to do five courses for a client for $2,500 each.

Two courses will start immediately and finish before the end of the year. Three courses will not begin until next year. The client paid $12,500 cash in advance for all five courses on September 1, and WTI credited Unearned Training Fees.

f. On October 15, WTI agreed to teach a four-month class (beginning immediately) for an executive with payment due at the end of the class. At December 31, $7,500 of the tuition has been earned by WTI.

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.

Required

1. Prepare T-accounts (representing the ledger) with balances from the unadjusted trial balance. Check (2e) Cr. Training Fees Earned, $5,000

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. (2f) Cr. Tuition Fees Earned, $7,500

3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance.

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(3) Adj. trial balance totals, $345,700

4. Prepare Wells Technical Institute’s income statement and statement of owner’s equity for the year and prepare its balance sheet as of December 31. The T. Wells, Capital account balance was $90,000 on December 31 of the prior year. (4) Net income, $49,600

Problem 3-4A Interpreting unadjusted and adjusted trial balances, and preparing financial statements P1 P2 P3 P4 P5 P6

A six-column table for JKL Company follows. The first two columns contain the unadjusted trial balance for the company as of July 31. 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 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 provide a short description of each.

Preparation Component

2. Use the information in the adjusted trial balance to prepare the company’s (a) income statement and its statement of owner’s equity for the year ended July 31 [Note: J. Logan, Capital at July 31 of the prior year was $40,000, and the current-year withdrawals were $5,000] and (b) the balance sheet as of July 31.

Check (2) Net income, $4,960; Total assets, $124,960

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Problem 3-5A Preparing financial statements from the adjusted trial balance and computing profit margin P6 A1 The adjusted trial balance for Chiara Company as of December 31 follows.

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Required

1. Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31; (b) the statement of owner’s equity for the year ended December 31 [Note: R. Chiara, Capital at December 31 of the prior year was $255,800]; and (c) the balance sheet as of December 31.

Check (1) Total assets, $600,000

2. Compute the profit margin for the year (use total revenues as the denominator).

Problem 3-6AA Recording prepaid expenses and unearned revenues P7 Gomez Co. had the following transactions in the last two months of its year ended December 31. Entries can draw from the following partial chart of accounts: Cash; Prepaid Insurance; Prepaid Advertising; Prepaid Consulting Fees; Unearned Service Fees; Services Fees Earned; Insurance Expense; Advertising Expense; and Consulting Fees Expense.

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Required

1. Prepare entries for these transactions under the method that initially records prepaid expenses as assets and records unearned revenues as liabilities. Also prepare adjusting entries at the end of the year.

2. Prepare entries for these transactions under the method that initially records prepaid expenses as expenses and records unearned revenues as revenues. Also prepare adjusting entries at the end of the year.

Analysis Component

3. Explain why the alternative sets of entries in requirements 1 and 2 do not result in different financial statement amounts.

PROBLEM SET B

Problem 3-1B Identifying adjusting entries with explanations P1 P2 P3 P4 For each of the following journal entries 1 through 12, 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.

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Problem 3-2B Preparing adjusting and subsequent journal entries P1 P2 P3 P4 Natsu Company’s annual accounting period ends on October 31, 2019. The following information concerns the adjusting entries that need to be recorded as of that date. Entries can draw from the following partial chart of accounts: Cash; Rent Receivable; Office Supplies; Prepaid Insurance; Building; Accumulated Depreciation—Building; Salaries Payable; Unearned Rent; Rent Earned; Salaries Expense; Office Supplies Expense; Insurance Expense; and Depreciation Expense— Building.

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 supplies available at October 31, 2019, totaled $800.

b. An analysis of the company’s insurance policies provided the following facts. 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.)

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, 2019, 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, 2019.

d. The company purchased a building on November 1, 2016, 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. Because 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, 2019. 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.

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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 Check (1b) Dr. Insurance Expense, $4,730 (1d) Dr. Depreciation Expense, $5,400

1. Use the information to prepare adjusting entries as of October 31, 2019. 2. Prepare journal entries to record the first subsequent cash transaction in

November 2019 for parts c and e.

Problem 3-3B Preparing adjusting entries, adjusted trial balance, and financial statements P1 P2 P3 P4 P6 Following is the unadjusted trial balance for Alonzo Institute as of December 31. 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.

Additional Information

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

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available at year-end. 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 two-month course

(starting immediately) for a client. The contract calls for a $14,300 monthly fee, and the client paid the two months’ fees in advance. When the cash was received, the Unearned Training Fees account was credited.

f. On October 15, the Institute agreed to teach a four-month class (beginning immediately) to an executive with payment due at the end of the class. At December 31, $5,750 of the tuition has been earned by the Institute.

g. The Institute’s only employee is paid weekly. As of the end of the year, three days’ salaries have accrued 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. Check (2e) Cr. Training Fees Earned, $28,600

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. (2f ) Cr. Tuition Fees Earned, $5,750

3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance. (3) Adj. trial balance totals, $344,600

4. Prepare the company’s income statement and statement of owner’s equity for the year, and prepare its balance sheet as of December 31. The C. Alonzo, Capital account balance was $71,500 on December 31 of the prior year. (4) Net income, $54,200;

Problem 3-4B Interpreting unadjusted and adjusted trial balances, and preparing financial statements P1 P2 P3 P4 P5 P6 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, and the last two columns contain the adjusted trial balance as of the same date.

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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 provide a short description of each.

Preparation Component

2. Use the information in the adjusted trial balance to prepare this company’s (a) income statement and its statement of owner’s equity for the year ended December 31 [Note: Z. Yan, Capital at December 31 of the prior year was $80,200, and the current-year withdrawals were $20,000] and (b) the balance sheet as of December 31.

Check (2) Net income, $9,110; Total assets, $222,260

Problem 3-5B Preparing financial statements from the adjusted trial balance and computing profit margin P6 A1 The adjusted trial balance for Speedy Courier as of December 31 follows.

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Required

1. Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31; (b) the statement of owner’s equity for the year ended December 31 [Note: L. Horace, Capital at Dec. 31 of the prior year was $125,000]; and (c) the balance sheet as of December 31.

2. Compute the profit margin for the year (use total revenues as the denominator).

Check (1) Total assets, $663,000

Problem 3-6BA Recording prepaid expenses and unearned revenues P7 Tremor Co. had the following transactions in the last two months of its fiscal year ended May 31. Entries can draw from the following partial chart of accounts: Cash; Prepaid Insurance; Prepaid Advertising; Prepaid Consulting Fees; Unearned Service Fees; Service Fees Earned; Insurance Expense; Advertising Expense; and Consulting Fees Expense.

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1. Prepare entries for these transactions under the method that initially records prepaid expenses and unearned revenues in balance sheet accounts. Also prepare adjusting entries at its May 31 fiscal year-end.

2. Prepare entries for these transactions under the method that initially records prepaid expenses and unearned revenues in income statement accounts. Also prepare adjusting entries at its May 31 fiscal year-end.

Analysis Component

3. Explain why the alternative sets of entries in parts 1 and 2 do not result in different financial statement amounts.

SERIAL PROBLEM

Business Solutions P1 P2 P3 P4 P5 P6 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 still begin at this point.

©Alexander Image/ Shutterstock

SP 3 After the success of the company’s first two months, Santana Rey continues to operate Business Solutions. (Transactions for the first two months are described in the Chapter 2 serial problem.) The November 30, 2019, unadjusted trial balance

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of Business Solutions (reflecting its transactions for October and November of 2019) follows.

Business Solutions had the following transactions and events in December 2019.

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

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$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 have expired.

Required

1. Prepare journal entries to record each of the December transactions and events for Business Solutions. 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, 2019. Check (3) Adjusted trial balance totals, $109,034

4. Prepare an income statement for the three months ended December 31, 2019. 5. Prepare a statement of owner’s equity for the three months ended December

31, 2019. 6. Prepare a balance sheet as of December 31, 2019.

(6) Total assets, $83,460

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect allows students to immediately see the financial statements as of a specific date. Each of the following questions begins with an unadjusted trial balance. Using transactions from the following assignment, prepare the necessary adjustments and determine the impact each adjustment has on net income. The financial statements are automatically populated. GL 3-1 Based on the FastForward illustration in this chapter Using transactions from the following assignments, prepare the necessary adjustments, create the financial statements, and determine the impact each adjustment has on net income. GL 3-2 Based on Problem 3-3A GL 3-3 Extension of Problem 2-1A GL 3-4 Extension of Problem 2-2A GL 3-5 Based on Serial Problem SP 3

Accounting Analysis

COMPANY ANALYSIS A1

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AA 3-1 Use Apple’s financial statements in Appendix A to answer the following.

1. Compute Apple’s profit margin for fiscal years ended (a) September 30, 2017, and (b) September 24, 2016.

2. Is Apple’s profit margin on a favorable or unfavorable trend? 3. In 2017, did Apple’s profit margin outperform or underperform the industry

(assumed) average of 12%?

COMPARATIVE ANALYSIS A1

AA 3-2 Key figures for the recent two years of both Apple and Google follow.

Required

1. Compute profit margins for (a) Apple and (b) Google for the two years of data reported above.

2. In the current year, which company is more successful on the basis of profit margin?

GLOBAL ANALYSIS A1

AA 3-3 Key comparative figures for Samsung, Apple, and Google follow.

Required

1. Compute profit margin for Samsung, Apple, and Google.

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2. Which company has the highest profit margin?

Beyond the Numbers

ETHICS CHALLENGE C1 P1

BTN 3-1 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

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 contra 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.

COMMUNICATING IN PRACTICE A1

BTN 3-2 The class should be divided into teams. Teams are to select an industry (such as automobile manufacturing, airlines, defense contractors), and each team member is to select a different company in that industry. Each team member is to acquire the annual report of the company selected. Annual reports can be downloaded from company websites or from the SEC’s EDGAR database (SEC.gov).

Required

1. Use the annual report to compute the return on assets, debt ratio, and profit margin.

2. Communicate with team members via a meeting, e-mail, or telephone to discuss the meaning of the ratios, how different companies compare to each other, and the industry norm. The team must prepare a single memo reporting the ratios for each company and identifying the conclusions or consensus of opinion reached during the team’s discussion. The memo is to be copied and distributed to the instructor and all classmates.

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TAKING IT TO THE NET A1

BTN 3-3 Access EDGAR online (SEC.gov) and locate the 10-K report of The Gap, Inc. (ticker: GPS), filed on March 20, 2017. Review its financial statements reported for the year ended January 28, 2017, to answer the following questions.

Required

1. What are Gap’s main brands? 2. When is Gap’s fiscal year-end? 3. What is Gap’s net sales for the period ended January 28, 2017? 4. What is Gap’s net income for the period ended January 28, 2017? 5. Compute Gap’s profit margin for the year ended January 28, 2017. 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.

TEAMWORK IN ACTION P1 P2 P3 P4

BTN 3-4 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.

ENTREPRENEURIAL DECISION P2

BTN 3-5 Review the opening feature of this chapter dealing with Urban One and its entrepreneurial owner, Cathy Hughes.

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Required

1. Assume that Urban One sells a $300 gift certificate to a customer, collecting the $300 cash in advance. Prepare the journal entry for (a) collection of the cash for delivery of the gift certificate to the customer and (b) revenue from the subsequent delivery of merchandise when the gift certificate is used.

2. How can keeping less inventory help to improve Urban One’s profit margin? 3. Cathy Hughes understands that many companies carry considerable

inventory, and she is thinking of carrying additional inventory of merchandise for sale. Cathy desires your advice on the pros and cons of carrying such inventory. Provide at least one reason for, and one reason against, carrying additional inventory.

HITTING THE ROAD C1

BTN 3-6 Visit the website of a major company that interests you. Use the “Investor Relations” link at the website to obtain the toll-free telephone number of the Investor Relations Department. Call the company, ask to speak to Investor Relations, and request a copy of the company’s most recent annual report (a company will sometimes send a prepackaged investor packet, which includes the annual report plus other relevant information). You should receive the requested report within one to two weeks. Once you have received your report, use it throughout the term to see how the principles you are learning in class are being applied in practice.

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw- Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

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P1

C1 P2 P3 C2

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4 Completing the Accounting Cycle

Chapter Preview

WORK SHEET

Benefits of a work sheet Preparing a work sheet Applying a work sheet

NTK 4-1

CLOSING PROCESS

Temporary accounts Closing entries Post-closing trial balance Accounting cycle

NTK 4-2

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C3 A1

C1 C2 C3

A1

P1 P2 P3 P4

CLASSIFIED BALANCE SHEET

Classified balance sheet—Structure and categories Current ratio

NTK 4-3

Learning Objectives

CONCEPTUAL

Explain why temporary accounts are closed each period. Identify steps in the accounting cycle. Explain and prepare a classified balance sheet.

ANALYTICAL

Compute the current ratio and describe what it reveals about a company’s financial condition.

PROCEDURAL

Prepare a work sheet and explain its usefulness. Describe and prepare closing entries. Explain and prepare a post-closing trial balance. Appendix 4A—Prepare reversing entries and explain their purpose.

©J. Emilio Flores/Corbis via Getty Images

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Snap!

“Creativity creates value” —EVAN SPIEGEL VENICE, CA—Evan Spiegel met his future co-founder Bobby Murphy in college. “We weren’t cool,” recalls Bobby, “so we tried to build things to be cool!” One of their cool projects was an app that could send messages that disappeared after a few seconds. This app would later be called Snapchat (Snapchat.com).

The first headquarters of Snapchat was the home of Evan’s dad. However, within a matter of months, their app had over a million users.

As Snapchat grew, Evan and Bobby knew an effective accounting system was key to attracting investors. “One of the things I did underestimate,” admits Evan, “was how much more important communication becomes [when seeking investors].”

Investors wanted to know revenues, costs, assets, and liabilities for Snapchat. “You really need to explain . . . how your business works,” insists Evan.

To communicate “the Snap story,” the entrepreneurs learned how to use work sheets and create classified financial statements. This included learning the accounting cycle. With accounting reports in hand, Evan and Bobby were able to secure additional financing. Exclaims Evan: “That was the greatest feeling of all time!”

Sources: Snapchat website, January 2019; Vanity Fair, October 2017; LA Times, March 2017; Forbes, January 2014

WORK SHEET AS A TOOL

Benefits of a Work Sheet (Spreadsheet) A work sheet is a document that is used internally by companies to help with adjusting and closing accounts and with preparing financial statements. It is an internal accounting aid and is not a substitute for journals, ledgers, or financial statements. A work sheet:

P1_______ Prepare a work sheet and explain its usefulness.

Helps in preparing financial statements. Reduces the risk of errors when working with many accounts and adjustments. Links accounts and adjustments to financial statements. Shows the effects of proposed or “what-if” transactions.

Decision Insight

Women in Charge In a recent survey, it was reported that women make up roughly 50% of managers and senior managers at accounting firms. Further, women also make up about half of all supervisors and senior staff. If the current trend continues, women will soon hold the majority of manager and senior staff

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positions in accounting. Source: AICPA ■

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Use of a Work Sheet When a work sheet is used to prepare financial statements, it is constructed at the end of a period before the adjusting process. The complete work sheet includes 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 (including the statement of owner’s equity). To describe and interpret the work sheet, we use the information from FastForward. Preparing the work sheet has five steps.

Step 1. Enter Unadjusted Trial Balance

Refer to Exhibit 4.1—green section. The first step in preparing a work sheet is to list the title of every account and its account number that appears on its financial statements. This includes all accounts in the ledger plus any new ones from adjusting entries. The unadjusted balance for each account is then entered in the correct Debit or Credit column of the unadjusted trial balance columns. The totals of these two columns must be equal. The light green section of Exhibit 4.1 shows FastForward’s work sheet after completing this first step (dark green rows show accounts that arise because of the adjustments). Sometimes an account can require more than one adjustment, such as for Consulting Revenue. The additional adjustment can be added to a blank line below (as in Exhibit 4.1), squeezed on one line, or combined into one adjustment amount.

Step 2. Enter Adjustments Exhibit 4.1—yellow section. The second step is to enter adjustments in the Adjustments columns. The adjustments shown are the same ones shown in Exhibit 3.13. An identifying letter links the debit and credit of each adjustment. This is called keying the adjustments. After preparing a work sheet, adjustments must still be entered in the journal and posted to the ledger. The Adjustments columns provide the information for adjusting entries in the journal.

Step 3. Prepare Adjusted Trial Balance Exhibit 4.1—blue section. 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

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Adjusted Trial Balance columns confirm debits and credits are equal.

Step 4. Sort Adjusted Trial Balance Amounts to Financial Statements Exhibit 4.1—orange section. This step involves sorting account balances from the adjusted trial balance to their proper financial statement columns. Expenses go to the Income Statement Debit column and revenues to the Income Statement Credit column. Assets and withdrawals go to the Balance Sheet & Statement of Owner’s Equity Debit column. Liabilities and owner’s capital go to the Balance Sheet & Statement of Owner’s Equity Credit column.

Step 5. Total Statement Columns, Compute Income or Loss, and Balance Columns Exhibit 4.1—purple section. Each financial statement column (from step 4) is totaled. The difference between the Debit and Credit column 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 & Statement of Owner’s Equity Credit column. Adding net income to the last Credit column means that it is to be added to owner’s capital. If a loss occurs, it is added to the Debit column. This means that it is to be subtracted from owner’s capital. The ending balance of owner’s capital does not appear in the last two columns as a single amount, but it is computed in the statement of owner’s equity using these account balances. When net income or net loss is added to the proper Balance Sheet & Statement of Owner’s Equity column, the totals of the last two columns must balance. If they do not, one or more errors have occurred.

EXHIBIT 4.1 Work Sheet with Five-Step Process for Completion

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Decision Maker

Entrepreneur You make a printout of the electronic work sheet used to prepare financial statements. There is no depreciation adjustment, yet you own a large amount of equipment. Does the absence of depreciation adjustment concern you? ■ Answer: Yes, you are concerned about the absence of a depreciation adjustment. Equipment does depreciate, and financial statements must recognize this occurrence. Its absence suggests an error (there is also the possibility that equipment is fully depreciated).

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Work Sheet Applications and Analysis A work sheet does not substitute for financial statements. It is a tool we use to help prepare financial statements. FastForward’s financial statements are shown in Exhibit 4.2. Its income statement amounts are taken from the Income Statement columns of the work sheet. Amounts for its balance sheet and its statement of owner’s equity are taken from the Balance Sheet & Statement of Owner’s Equity columns of the work sheet.

EXHIBIT 4.2 Financial Statements Prepared from 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 had occurred.

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NEED-TO-KNOW 4-1

Work Sheet P1

The following 10-column work sheet contains the year-end unadjusted trial balance for Magic Company as of December 31. Complete the work sheet by entering the necessary adjustments, computing the adjusted account balances, extending the adjusted balances into the appropriate financial statement columns, and entering the amount of net income for the period. Note: The Magic, Capital account balance was $75,000 at December 31 of the prior year.

1. Prepare and complete the work sheet, starting with the unadjusted trial balance and including adjustments based on the following.

a. The company has earned $9,000 in fees that were not received or recorded at year-end.

b. The company incurred $2,000 in salary expense that was not yet recorded or paid at year-end. Hint: Assume it records salary not yet paid as part of accounts payable.

c. The long-term note payable was issued on December 31 this year. Thus, no interest has yet accrued on this loan.

2. Use information from the completed work sheet in part 1 to prepare adjusting journal entries.

3. Prepare the income statement and the statement of owner’s equity for the year ended December 31 and the unclassified balance sheet at December 31.

Part 1 Solution

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Part 2 Solution

Part 3 Solution

Do More: QS 4-1, QS 4-2, QS 4-3, QS 4-4, E 4-1, E 4-2, E 4-3

CLOSING PROCESS

C1_______ Explain why temporary accounts are closed each period.

The closing process occurs at the end of an accounting period after financial statements are completed. In the closing process we (1) identify accounts for closing, (2) record and post the

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closing entries, and (3) prepare a post-closing trial balance. The closing process has two purposes. First, it resets revenue, expense, and withdrawals account balances to zero at the end of each period (which updates the owner’s capital account for inclusion on the balance sheet). This is done so that these accounts can properly measure income and withdrawals for the next period. Second, it helps summarize a period’s revenues and expenses. This section explains the closing process.

Temporary and Permanent Accounts

Temporary accounts relate to one accounting period. They include all income statement accounts, the owner withdrawals 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 accounts report on activities related to one or more future accounting periods. They include asset, liability, and owner capital accounts (all balance sheet accounts). Permanent accounts are not closed each period and carry their ending balance into future periods.

Recording Closing Entries Closing entries transfer the end-of-period balances in revenue, expense, and withdrawals accounts to the permanent capital account. Closing entries are necessary at the end of each period after financial statements are prepared because

Revenue, expense, and withdrawals accounts must begin each period with zero balances. Owner’s capital must reflect prior periods’ revenues, expenses, and withdrawals.

Point: If Apple did not make closing entries, prior-year revenue from iPhone sales would be included with current-year revenue.

An income statement reports revenues and expenses for a specific accounting period. Owner withdrawals are also for a specific accounting period. Because revenue, expense, and withdrawals accounts record information separately for each period, they must start each period with zero balances.

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P2_______ Describe and prepare closing entries.

Exhibit 4.3 uses the adjusted account balances of FastForward (from the Adjusted Trial Balance columns of Exhibit 4.1 or from the left side of Exhibit 4.4) to show the four steps to close its temporary accounts.

EXHIBIT 4.3 Four-Step Closing Process

Point: C. Taylor, Capital is the only permanent account in Exhibit 4.3—meaning it is not closed, but it does have income Summary closed to it.

1 2 To close revenue and expense accounts, we transfer their balances to Income Summary. Income Summary is a temporary account only used for the closing process that contains a credit for total revenues (and gains) and a debit for total expenses (and losses).

3 The Income Summary balance, which equals net income or net loss, is transferred to the capital account.

4 The withdrawals account balance is transferred to the capital account. After closing entries are posted, the revenue, expense, withdrawals, and Income Summary accounts have zero balances and are said to be closed or cleared.

Exhibit 4.4 shows the four closing journal entries to apply the closing process of Exhibit 4.3.

EXHIBIT 4.4 Preparing Closing Entries

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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 is step 1 in Exhibit 4.4. The $8,150 credit entry to Income Summary equals total revenues for the period. This leaves revenue accounts with zero balances, and they are now ready to record revenues for next 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 record expenses for next period. This second closing entry for FastForward is step 2 in Exhibit 4.4.

Step 3: Close Income Summary to Owner’s Capital After steps 1 and 2, the balance of Income Summary equals December 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 the capital account. This entry closes the Income Summary account—see step 3 in Exhibit 4.4. (If a net loss occurred because expenses exceeded revenues, the third entry is reversed: debit Owner, Capital and credit Income Summary.)

Step 4: Close Withdrawals Account to Owner’s Capital The fourth closing entry transfers any debit balance in the withdrawals account to the owner’s capital account— see step 4 in Exhibit 4.4. This entry gives the withdrawals account a zero balance, and the account is now ready to record next period’s withdrawals.

Exhibit 4.5shows the entire ledger of FastForward as of December 31 after adjusting and closing entries are posted. The temporary accounts (revenues, expenses, and withdrawals) have ending balances equal to zero.

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EXHIBIT 4.5 General Ledger after the Closing Process for FastForward

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Post-Closing Trial Balance

P3_______ Explain and prepare a post-closing trial balance.

A post-closing trial balance is a list of permanent accounts and their balances after all

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closing entries. It lists the balances for all accounts not closed. A post-closing trial balance verifies that (1) total debits equal total credits for permanent accounts and (2) all temporary accounts have zero balances. FastForward’s post-closing trial balance is in Exhibit 4.6 and often is the last step in the accounting process.

EXHIBIT 4.6 Post-Closing Trial Balance

Point: C. Taylor, Capital is computed as $30,000 + $3,785 − $200. Point: Only balance sheet (permanent) accounts are on a post-closing trial balance.

Decision Maker

Staff Accountant A friend shows you the post-closing trial balance she is working on. You review the statement and see a line item for rent expense. How do you know that an error exists? ■ Answer: This error is apparent in a post-closing trial balance because Rent Expense is a temporary account. Post-closing trial balances only contain permanent accounts.

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NEED-TO-KNOW 4-2

Closing Entries P2

Use the adjusted trial balance solution for Magic Company from Need-To-Know 4-1 to

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prepare its closing entries—the accounts are also listed here for convenience.

Solution

Do More: QS 4-6, E 4-6, E 4-7, E 4-8, E 4-9

ACCOUNTING CYCLE

C2_______ Identify steps in the accounting cycle.

The accounting cycle is the steps in preparing financial statements. It is called a cycle because the steps are repeated each reporting period. Exhibit 4.7 shows the 10 steps in the cycle. Steps 1 through 3 occur regularly as a company enters into transactions. Steps 4 through 9 are done at the end of a period. Reversing entries in step 10 are optional and are explained in Appendix 4A.

EXHIBIT 4.7 Steps in the Accounting Cycle*

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CLASSIFIED BALANCE SHEET

C3_______ Explain and prepare a classified balance sheet.

This section describes a classified balance sheet. An unclassified balance sheet broadly groups accounts into assets, liabilities, and equity. One example is FastForward’s balance sheet in Exhibit 4.2. A classified balance sheet organizes assets and liabilities into subgroups.

Classification Structure A classified balance sheet typically contains the categories in Exhibit 4.8 (there is no required layout). An important classification is the separation between current and noncurrent for both assets and liabilities. Current items are 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

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cash is received from the sale of goods and services. Most operating cycles are less than one year, which means most companies use a one-year period to classify current and noncurrent items. To make it easy, assume an operating cycle of one year, unless we say otherwise.

EXHIBIT 4.8 Typical Categories in a Classified Balance Sheet

A balance sheet lists current assets before noncurrent assets and current liabilities before noncurrent liabilities. Current assets and current liabilities are listed in order of how quickly they will be converted to, or paid in, cash.

Classification Categories

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The balance sheet for Snowboarding Components in Exhibit 4.9 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. Jarden, a producer of snowboards, reported a balance sheet with five asset classes: current assets; property, plant, and equipment; goodwill; intangibles; and other assets.

EXHIBIT 4.9 Example of a Classified Balance Sheet

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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 longer. Examples are cash, short-term investments, accounts receivable, short-term notes receivable, goods for sale (called merchandise or inventory), and prepaid expenses. Point: Current is also called short-term, and noncurrent is also called long-term.

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Long-Term Investments Long-term (or noncurrent) investments include notes receivable and investments in stocks and bonds 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

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to produce or sell products and services. Examples are equipment, machinery, buildings, and land that are used to produce or sell products and services. Plant assets are normally listed in order by how quickly they can be converted to cash. Point: Plant assets are also called fixed assets; property, plant and equipment (PP&E); or long-lived assets.

Intangible Assets Intangible assets are long-term assets that benefit business operations but lack physical form. Examples are patents, trademarks, copyrights, franchises, and goodwill. Their value comes from the privileges or rights granted to or held by the owner.

Current Liabilities Current liabilities are liabilities due to be paid or settled within one year or the operating cycle, whichever is longer. They usually are settled by paying out cash. Current liabilities 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 products or services are to be provided within one year or the operating cycle, whichever is longer.

Long-Term Liabilities Long-term liabilities are liabilities 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. Point: Only assets and liabilities (not equity) are classified as current or noncurrent.

Equity Equity is the owner’s claim on assets. For a proprietorship, this claim is reported in the equity section with an owner’s capital account.

NEED-TO-KNOW 4-3

Classified Balance Sheet C3

Use the adjusted trial balance solution for Magic Company from Need-To-Know 4-1 to prepare its classified balance sheet as of December 31—the accounts are also listed here for convenience. Note: The Magic, Capital account balance was $75,000 at December 31 of the prior year.

Solution

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*Computed as $75,000 beginning balance + $15,000 net income (from NTK 4-1) − $20,000 withdrawals.

Do More: QS 4-9, E 4-12, P 4-3

Decision Analysis Current Ratio

A1_______ Compute the current ratio and describe what it reveals about a company’s financial condition.

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 and due date. The current ratio is one measure of a company’s ability to pay its short-term obligations. It is defined in Exhibit 4.10.

EXHIBIT 4.10 Current Ratio

Costco’s current ratio for each of the last three years is in Exhibit 4.11. A current ratio of over 1.0 means that current obligations can be covered with current assets. For the recent two years, Costco’s current ratio was slightly below 1.0. This means Costco could face challenges in covering liabilities. Although Costco has a better ratio than Walmart in each of the last three years, management must continue to monitor current assets and liabilities.

EXHIBIT 4.11 Analysis Using Current Ratio

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Decision Maker

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Analyst You are analyzing a dirt bike company’s ability to meet upcoming loan payments. You compute its current ratio as 1.2. You 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: A current ratio of 1.2 suggests that current assets are sufficient to cover current liabilities. Removing the past-due receivable reduces the current ratio to 0.7. You conclude that the company will have difficulty meeting its loan payments.

NEED-TO-KNOW 4-4 COMPREHENSIVE

Completing a Work Sheet, Recording Closing Entries, and Preparing Financial Statements

The partial work sheet of Midtown Repair Company at December 31 follows.

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1. Complete the work sheet by extending the adjusted trial balance totals to the appropriate financial statement columns.

2. Prepare closing entries for Midtown Repair Company. 3. Set up the Income Summary and the C. Trout, Capital accounts in the

general ledger (in balance column format) and post the closing entries to these accounts.

4. Determine the balance of the C. Trout, Capital account to be reported on the December 31 current-year balance sheet.

5. Prepare an income statement and a statement of owner’s equity for the year-ended December 31. Prepare a classified balance sheet as of December 31. The balance in C. Trout, Capital on December 31 of the prior year was $178,500.

PLANNING THE SOLUTION

Extend the adjusted trial balance account balances to the correct financial statement columns. Prepare entries to close the revenue accounts to Income Summary, to close the expense accounts to Income Summary, to close Income Summary to the capital account, and to close the withdrawals account to the capital account. Post the first and second closing entries to the Income Summary account. Verify that the Income Summary balance agrees with net income shown on the work sheet. Post the third and fourth closing entries to the capital account. Use the work sheet’s two right-most columns and your answer in part 4 to prepare the classified balance sheet.

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SOLUTION

1. Completing the work sheet.

2. Closing entries.

3. Set up the Income Summary and the capital ledger accounts and post the closing entries.

4. The final capital balance of $163,600 (from part 3) will be reported on the December 31 current-year balance sheet. The final capital balance reflects

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the increase from net income and the decrease from owner’s withdrawals. 5.

APPENDIX

Reversing Entries P4_______ Prepare reversing entries and explain their purpose.

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. Reversing entries simplify recordkeeping. Exhibit 4A.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, 2020, 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.

EXHIBIT 4A.1 Reversing Entries for an Accrued Expense

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Accounting without Reversing Entries The path down the left side of Exhibit 4A.1 is described in the chapter. To summarize, 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 because the payable has been settled.

Accounting with Reversing Entries The right side of Exhibit 4A.1

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shows reversing entries. A reversing entry is the exact opposite of an adjusting entry. For FastForward, the Salaries Payable liability account is debited for $210, meaning that this account now has a zero balance after the entry is posted on January 1. The Salaries Payable account temporarily understates the liability, but this is not a problem because 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 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 4A.1). The zero balance in the Salaries Payable account is now correct. The lower section of Exhibit 4A.1 shows that the expense and liability accounts have exactly the same balances whether reversing entries are used or not. Point: Adjusting entries that create new asset or liability accounts likely require reversing.

Summary: Cheat Sheet

WORK SHEET

Work sheet: Used to help with adjusting and closing accounts and with preparing financial statements. Steps in Preparing Worksheets

1. Enter unadjusted trial balance—list every account that appears on financial statements and their balances.

2. Enter adjustments—enter the period-end adjustments. 3. Prepare adjusted trial balance—combine the unadjusted balances and

adjustments for each account. 4. Sort adjusted trial balance amounts to financial statements—

5. Total statement columns, compute income or loss, and balance columns—if income statement Credit total exceeds Debit total, there is net income. If Debit total exceeds Credit total, there is a net loss. Net income (loss) is then entered in the Balance Sheet & Statement of Owner’s Equity Credit (Debit) column.

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CLOSING PROCESS

Closing process: Occurs at period-end after financial statements have been prepared. Resets revenue, expense, and withdrawals balances to zero. Temporary accounts: Closed at period-end. They consist of revenue, expense, withdrawals, and Income Summary. Permanent accounts: Not closed at period-end. They consist of asset, liability, and owner capital (all balance sheet accounts). Income Summary: A temporary account only used for the closing process that has a credit for total revenues and a debit for total expenses.

Closing Process Journal Entries by Step

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Post-closing trial balance: A list of permanent accounts (assets, liabilities, equity) and their balances after all closing entries.

CLASSIFIED BALANCE SHEET

Classified balance sheet: Organizes assets and liabilities into meaningful subgroups. Current vs. long-term classification: Current items are to be collected or owed within one year. Long-term items are expected after one year. Current assets: Assets to be sold, collected, or used within one year. Examples are cash, short-term investments, accounts receivable, short-term notes receivable, merchandise, inventory, and prepaid expenses. Long-term investments: Assets to be held for more than one year. Examples are notes receivable, long-term investments in stock and bonds, and land held for future expansion. Plant assets: Tangible assets used to produce or sell products and services. Examples are equipment, machinery, buildings, and land used in operations. Intangible assets: Long-term assets that lack physical form. Examples are patents, trademarks, copyrights, franchises, and goodwill. Current liabilities: Liabilities to be paid or settled within one year. Examples are accounts payable, wages payable, taxes payable, interest payable, unearned revenues, and current portions of notes or long-term debt. Long-term liabilities: Liabilities not due within one year. Examples are notes payable, mortgages payable, bonds payable, and lease obligations. Equity: The owner’s claim on assets. For a proprietorship, this is the owner’s capital account. Common Layout of Classified Balance Sheet

Key Terms

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Accounting cycle (137) Classified balance sheet (138) Closing entries (134) Closing process (133) Current assets (139) Current liabilities (140) Current ratio (141) Income Summary (134) Intangible assets (140) Long-term investments (139) Long-term liabilities (140) Operating cycle (139) Permanent accounts (134) Post-closing trial balance (137) Pro forma financial statements (130) Reversing entries (143) Temporary accounts (134) Unclassified balance sheet (138) Work sheet (129)

Multiple Choice Quiz

1. G. Venda, owner of Venda Services, withdrew $25,000 from the business during the current year. The entry to close the withdrawals account at the end of the year is:

2. The following information is available for the R. Kandamil Company before closing the accounts. After all of the closing entries are made, what will be the balance in the R. Kandamil, Capital account?

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a. $360,000 b. $250,000 c. $160,000 d. $150,000 e. $60,000

3. Which of the following errors would cause the Balance Sheet and Statement of Owner’s Equity columns of a work sheet to be out of balance?

a. Entering a revenue amount in the Balance Sheet and Statement of Owner’s Equity Debit column.

b. Entering a liability amount in the Balance Sheet and Statement of Owner’s Equity Credit column.

c. Entering an expense amount in the Balance Sheet and Statement of Owner’s Equity Debit column.

d. Entering an asset amount in the Income Statement Debit column. e. Entering a liability amount in the Income Statement Credit column.

4. The temporary account used only in the closing process to hold the amounts of revenues and expenses before the net difference is added or subtracted from the owner’s capital account is called the

a. Closing account. b. Nominal account. c. Income Summary account. d. Balance Column account. e. Contra account.

5. 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

ANSWERS TO MULTIPLE CHOICE QUIZ

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

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1. 2.

3. 4. 5.

6. 7.

8. 9.

10. 11.

13A.

14.

15.

16.

17.

12A.

_____ a.

A Superscript letter A denotes assignments based on Appendix 4A.

Icon denotes assignments that involve decision making.

Discussion Questions

What are the steps in recording closing entries? What accounts are affected by closing entries? What accounts are not

affected? What two purposes are accomplished by recording closing entries?

What is the purpose of the Income Summary account? Explain whether an error has occurred if a post-closing trial balance

includes a Depreciation Expense account. What tasks are aided by a work sheet? Why are the debit and credit entries in the Adjustments columns of the

work sheet identified with letters? What is a company’s operating cycle? What classes of assets and liabilities are shown on a typical classified

balance sheet? How is unearned revenue classified on the balance sheet? What are the characteristics of plant assets? How do reversing entries simplify recordkeeping? 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?

Refer to Apple’s most recent balance sheet in Appendix A. What five main noncurrent asset categories are used on its classified balance sheet?

Refer to Samsung’s most recent balance sheet in Appendix A. Identify and list its 10 current assets.

Refer to Google’s most recent balance sheet in Appendix A. Identify the six accounts listed as current liabilities.

Refer to Samsung’s financial statements in Appendix A. What journal entry was likely recorded as of December 31, 2017, to close its Income Summary account?

QUICK STUDY

QS 4-1 Ordering work sheet steps P1 List the following steps in preparing a work sheet in their proper order.

Total the statement columns, compute net income (loss), and complete the work sheet.

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_____ b. _____ c. _____ d. _____ e.

_____ a. _____ b. _____ c. _____ d. _____ e. _____ f. _____ g. _____ h. _____ i.

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Extend adjusted balances to appropriate financial statement columns. Prepare an unadjusted trial balance on the work sheet. Prepare an adjusted trial balance on the work sheet. Enter adjustments data on the work sheet.

QS 4-2 Preparing a work sheet P1 In the blank space beside each account, enter the code for the financial statement column (IS or BS) where a normal account balance is extended. Use IS for the Income Statement column or BS for the Balance Sheet and Statement of Owner’s Equity column.

Equipment Owner, Withdrawals Prepaid Rent Depreciation Expense Accounts Receivable Insurance Expense Supplies Rent Expense

Cash

QS 4-3 Computing ending capital balance using work sheet information P1 The following selected information is taken from the work sheet for Warton Company at its December 31 year-end. Determine the amount for B. Warton, Capital, that should be reported on its current December 31 year-end balance sheet. Note: The B. Warton, Capital account balance was $72,000 on December 31 of the prior year.

QS 4-4 Preparing a partial work sheet P1 The ledger of Claudell Company includes the following unadjusted normal balances: Prepaid Rent $1,000, Services Revenue $55,600, and Wages Expense $5,000. Adjustments are required for (a) prepaid rent expired $200; (b) accrued services revenue $900; and (c) accrued wages expense $700. Prepare a 10-column worksheet with six rows for the following accounts: Prepaid Rent, Services Revenue, Wages Expense, Accounts Receivable, Wages Payable, and Rent

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_____ a. _____ b. _____ c. _____ d. _____ e. _____ f.

_____ a. _____ b. _____ c.

Expense. Enter the unadjusted balances and the necessary adjustments on the work sheet and complete the work sheet for these accounts.

QS 4-5 Explaining temporary and permanent accounts C1 Choose from the following list of terms/phrases to best complete the statements below.

a. Temporary b. Permanent c. One or more d. One e. Zero balances f. Income Summary

1. _____ accounts generally consist of all balance sheet accounts, and these accounts are not closed.

2. Permanent accounts report on activities related to _____ future accounting periods, and they carry their ending balances into the next period.

3. Temporary accounts accumulate data related to _____ accounting period. 4. _____ accounts include all income statement accounts, the withdrawals

account, and the Income Summary account.

QS 4-6 Preparing closing entries from the ledger P2 The ledger of Mai Company includes the following accounts with normal balances as of December 31: D. Mai, Capital $9,000; D. Mai, Withdrawals $800; Services Revenue $13,000; Wages Expense $8,400; and Rent Expense $1,600. Prepare its December 31 closing entries.

QS 4-7 Identifying post-closing accounts P3 Identify which of the following accounts would be included in a post-closing trial balance.

Accounts Receivable Salaries Expense Goodwill Land Income Tax Expense Salaries Payable

QS 4-8 Identifying the accounting cycle C2 List the following steps of the accounting cycle in their proper order.

Posting the journal entries. Journalizing and posting adjusting entries. Preparing the adjusted trial balance.

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_____ d. _____ e. _____ f. _____ g. _____ h. _____ i.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

Journalizing and posting closing entries. Analyzing transactions and events. Preparing the financial statements. Preparing the unadjusted trial balance. Journalizing transactions and events.

Preparing the post-closing trial balance.

QS 4-9 Classifying balance sheet items C3 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

For each of the following items, select the letter that identifies the balance sheet category where the item typically would best appear.

Land held for future expansion Notes payable (due in five years) Accounts receivable Trademarks Accounts payable Store equipment Wages payable Cash

QS 4-10 Preparing financial statements C2 Use the following adjusted trial balance of Sierra Company to prepare its (1) income statement and (2) statement of owner’s equity for the year ended December 31. The H. Sierra, Capital account balance was $10,500 on December 31 of the prior year.

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Page 149QS 4-11 Preparing a classified balance sheet C3 Use the information in the adjusted trial balance reported in QS 4-10 to prepare Sierra Company’s classified balance sheet as of December 31.

QS 4-12 Identifying current accounts and computing the current ratio A1 Compute Chavez Company’s current ratio using the following information.

QS 4-13A Reversing entries P4 On December 31, Yates Co. prepared an adjusting entry for $12,000 of earned but unrecorded Consulting Revenue. On January 16, Yates received $26,700 cash as payment in full for consulting work it provided that began on December 18 and ended on January 16. The company uses reversing entries.

a. Prepare the December 31 adjusting entry. b. Prepare the January 1 reversing entry. c. Prepare the January 16 cash receipt entry.

EXERCISES

Exercise 4-1 Extending adjusted account balances on a work sheet P1 These 16 accounts are from the Adjusted Trial Balance columns of a company’s work sheet. In the blank space beside each account, enter the letter of the financial statement column (A, B, C, or D) where a normal account balance is extended.

A. Debit column for the Income Statement columns. B. Credit column for the Income Statement columns. C. Debit column for the Balance Sheet and Statement of Owner’s Equity

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_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8. _____ 9. _____ 10. _____ 11. _____ 12. _____ 13. _____ 14. _____ 15. _____ 16.

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columns. D. Credit column for the Balance Sheet and Statement of Owner’s Equity

columns.

Interest Revenue Machinery Owner, Withdrawals Depreciation Expense Accounts Payable Service Fees Revenue Owner, Capital Interest Expense Accounts Receivable

Accumulated Depreciation Office Supplies Insurance Expense Interest Receivable Cash Rent Expense Wages Payable

Exercise 4-2 Extending accounts in a work sheet P1 The Adjusted Trial Balance columns of a 10-column work sheet for Planta Company follow. Complete the work sheet by extending the account balances into the appropriate financial statement columns and by entering the amount of net income for the reporting period.

Check Net income, $17,800

Exercise 4-3 Preparing adjusting entries from a work sheet P1 Use the following information from the Adjustments columns of a 10-column work sheet to prepare the necessary adjusting journal entries (a) through (e).

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Exercise 4-4 Preparing unadjusted and adjusted trial balances, including the adjustments P1 The following data are taken from the unadjusted trial balance of the Westcott Company at December 31. Each account carries a normal balance. Set up a 10- column work sheet to answer the requirements.

1. Enter the accounts in proper order and enter their balances in the correct Debit or Credit column of the Unadjusted Trial Balance columns of the 10-column work sheet.

2. Use the following adjustment information to complete the Adjustments columns of the work sheet from part 1.

a. Depreciation on equipment, $3 b. Accrued salaries, $6 c. The $12 of unearned revenue has been earned d. Supplies available at December 31, $15 e. Expired insurance, $15

3. Extend the balances in the Adjusted Trial Balance columns of the work sheet to the proper financial statement columns. Compute totals for those columns, including net income.

Exercise 4-5 Computing Income Summary and ending capital balance from closing entries C1 P2 Capri Company began the current period with a $20,000 credit balance in the K. Capri, Capital account. At the end of the period, the company’s adjusted account balances include the following temporary accounts with normal balances.

1. After closing the revenue and expense accounts, what is the balance of the Income Summary account?

2. After all closing entries are journalized and posted, what is the balance of the

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K. Capri, Capital account?

Exercise 4-6 Completing the Income Statement columns and preparing closing entries P1 P2 These Income Statement columns from a 10-column work sheet are for Brown’s Bike Rental Company. (1) Determine the amount that should be entered on the net income line of the work sheet. (2) Prepare the company’s closing entries. The owner, H. Brown, did not make any withdrawals this period.

Check Net income, $25,600

Exercise 4-7 Preparing a work sheet and recording closing entries P1 P2 The following unadjusted trial balance contains the accounts and balances of Dylan Delivery Company as of December 31.

1. Use the following information about the company’s adjustments to complete a 10-column work sheet.

a. Unrecorded depreciation on the trucks at the end of the year is $40,000. b. The total amount of accrued interest expense at year-end is $6,000. c. The cost of unused office supplies still available at year-end is $2,000.

2. Prepare the year-end closing entries for this company and determine the capital amount to be reported on its year-end balance sheet. Note: The S. Dylan, Capital account balance was $307,000 on December 31 of the prior year.

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Check Adj. trial balance totals, $820,000; Net income, $39,000

Exercise 4-8 Preparing and posting closing entries P2 Use the May 31 fiscal year-end information from the following ledger accounts (assume that all accounts have normal balances) to prepare closing journal entries and then post those entries to ledger accounts.

Check M. Muncel, Capital (ending balance), $46,200

Exercise 4-9 Preparing closing entries and a post-closing trial balance P2 P3 The following adjusted trial balance contains the accounts and year-end balances of Cruz Company as of December 31. (1) Prepare the December 31 closing entries for Cruz Company. Assume the account number for Income Summary is 901. (2) Prepare the December 31 post-closing trial balance for Cruz Company. Note: The A. Cruz, Capital account balance was $47,600 on December 31 of the prior year.

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Check (2) A. Cruz, Capital (ending), $51,500; Total debits, $59,000

Exercise 4-10 Entering data for closing entries and a post-closing trial balance P2 P3 The adjusted trial balance for Salon Marketing Co. follows. Complete the four right- most columns of the table by (1) entering information for the four closing entries (keyed 1 through 4) in the middle columns and (2) completing the post-closing trial balance columns.

Exercise 4-11 Preparing financial statements C3 Use the following adjusted year-end trial balance at December 31 of Wilson Trucking Company to prepare the (1) income statement and (2) statement of owner’s equity for the year ended December 31. The K. Wilson, Capital account balance was $175,000 at December 31 of the prior year.

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Check Total assets, $249,500

Exercise 4-12 Preparing a classified balance sheet C3 Use the information in the adjusted trial balance reported in Exercise 4-11 to prepare Wilson Trucking Company’s classified balance sheet as of December 31.

Exercise 4-13 Computing the current ratio A1 Use the information in the adjusted trial balance reported in Exercise 4-11 to compute the current ratio as of the balance sheet date (round the ratio to two decimals). Interpret the current ratio for the Wilson Trucking Company. Assume that the industry average for the current ratio is 1.5.

Exercise 4-14 Preparing closing entries P2 Following are Nintendo’s revenue and expense accounts for a recent March 31 fiscal year-end (yen in millions). Prepare the company’s closing entries for its revenues and its expenses.

Exercise 4-15 Computing and analyzing the current ratio A1 Calculate the current ratio for each of the following companies (round the ratio to two decimals). Identify the company with the strongest liquidity position. (These companies are competitors in the same industry.)

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Exercise 4-16A Preparing reversing entries P4 Hawk Company records prepaid assets and unearned revenues in balance sheet accounts. The following information was used to prepare adjusting entries for the company as of August 31, the end of the company’s fiscal year.

a. The company has earned $6,000 in service fees that were not yet recorded at period-end.

b. The expired portion of prepaid insurance is $3,700. c. The company has earned $2,900 of its Unearned Service Fees account

balance. d. Depreciation expense for office equipment is $3,300. e. Employees have earned but have not been paid salaries of $3,400.

Prepare any necessary reversing entries for the accounting adjustments a through e assuming that the company uses reversing entries in its accounting system.

Exercise 4-17A Preparing reversing entries P4 The following two events occurred for Trey Co. on October 31, 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.

PROBLEM SET A

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Problem 4-1A Applying the accounting cycle C2 P2 P3 On April 1, Jiro Nozomi created a new travel agency, Adventure Travel. The following transactions occurred during the company’s first month.

The company’s chart of accounts follows.

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

4. Use the following information to journalize and post adjusting entries for the month:

a. Prepaid insurance of $133 has expired this month. (4a) Dr. Insurance Expense, $133

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 owner’s equity for the month of April and the balance sheet at April 30. (5) Net income, $2,197; Total assets, $51,117

6. Prepare journal entries to close the temporary accounts and post these entries to the ledger.

7. Prepare a post-closing trial balance. (7) P-C trial balance totals, $51,617

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Problem 4-2A Preparing a work sheet, adjusting and closing entries, and financial statements C3 P1 P2 The following unadjusted trial balance is for Ace Construction Co. as of the end of its 2019 fiscal year. The June 30, 2018, credit balance of the owner’s capital account was $53,660, and the owner invested $35,000 cash in the company during the 2019 fiscal year.

Required

1. Prepare and complete a 10-column work sheet for fiscal year 2019, starting with the unadjusted trial balance and including adjustments based on these additional facts.

a. The supplies available at the end of fiscal year 2019 had a cost of $3,300.

b. The cost of expired insurance for the fiscal year is $3,800. c. Annual depreciation on equipment is $8,400. d. The June utilities expense of $650 is not included in the unadjusted trial

balance because the bill arrived after the trial balance was prepared. The $650 amount owed needs to be recorded.

e. The company’s employees have earned $1,800 of accrued and unpaid wages at fiscal year-end.

f. The rent expense incurred and not yet paid or recorded at fiscal year- end is $500.

g. Additional property taxes of $1,000 have been assessed for this fiscal

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year but have not been paid or recorded in the accounts. h. The $250 accrued interest for June on the long-term notes payable has

not yet been paid or recorded. 2. Using information from the completed 10-column work sheet in part 1,

journalize the adjusting entries and the closing entries. 3. Prepare the income statement and the statement of owner’s equity for the year

ended June 30 and the classified balance sheet at June 30, 2019. Check (3) Net income, $30,890; Total assets, $122,550; Current liabilities, $11,000

Problem 4-3A Determining balance sheet classifications C3 In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classification. 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

1. Long-term investment in stock 2. Depreciation expense—Building 3. Prepaid rent (2 months of rent) 4. Interest receivable 5. Taxes payable (due in 5 weeks) 6. Automobiles 7. Notes payable (due in 3 years) 8. Accounts payable 9. Cash

10. Owner, Capital 11. Unearned services revenue 12. Accumulated depreciation—Trucks 13. Prepaid insurance (expires in 5 months) 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

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Problem 4-4A Preparing closing entries, financial statements, and ratios C3 A1 P2 The adjusted trial balance for Tybalt Construction as of December 31, 2019, follows. O. Tybalt invested $5,000 cash in the business during year 2019 (the December 31, 2018, credit balance of the O. Tybalt, Capital account was $121,400).

Required

1. Prepare the income statement and the statement of owner’s equity for calendar-year 2019 and the classified balance sheet at December 31, 2019. Check (1) Total assets (12/31/2019), $218,100; Net income, $4,300

2. Prepare the necessary closing entries at December 31, 2019.

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3. Use the information in the financial statements to compute these ratios: (a) return on assets (total assets at December 31, 2018, 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 4-5A Preparing trial balances, closing entries, and financial statements C3 P2 P3 The adjusted trial balance of Karise Repairs on December 31 follows.

Required

1. Prepare an income statement and a statement of owner’s equity for the year and a classified balance sheet at December 31. Note: The C. Karise, Capital account balance was $33,000 on December 31 of the prior year. Check (1) Ending capital balance, $47,750; Net income, $30,750

2. Enter the adjusted trial balance in the first two columns of a six-column table. Use columns three and four for closing entry information and the last two columns for a post-closing trial balance. Insert an Income Summary account as the last item in the trial balance. (2) P-C trial balance totals, $67,350

3. Enter closing entry information in the six-column table and prepare journal entries for it.

Problem 4-6AA Preparing adjusting, reversing, and next period entries P4 The following six-column table for Hawkeye Ranges includes the unadjusted trial

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balance as of December 31.

Required

1. Complete the six-column table by entering adjustments that reflect the following information.

a. As of December 31, employees had earned $1,200 of unpaid and unrecorded salaries. The next payday is January 4, at which time $1,500 of salaries will be paid.

b. The cost of supplies still available at December 31 is $3,000. c. The notes payable require an interest payment to be made every three

months. The amount of unrecorded accrued interest at December 31 is $1,875. The next interest payment, at an amount of $2,250, is due on January 15.

d. Analysis of the Unearned Member Fees account shows $5,800 remaining unearned at December 31.

e. In addition to the member fees included in the revenue account balance, the company has earned another $9,300 in unrecorded fees that will be collected on January 31. The company is also expected to collect $10,000 on that same day for new fees earned in January.

f. Depreciation expense for the year is $15,000.

Check (1) Adjusted trial balance totals, $239,625

2. Prepare journal entries for the adjustments entered in the six-column table for part 1.

3. Prepare journal entries to reverse the effects of the adjusting entries that involve accruals.

4. Prepare journal entries to record the cash payments and cash collections described for January.

PROBLEM SET B

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Problem 4-1B Applying the accounting cycle C2 P2 P3 On July 1, Lula Plume created a new self-storage business, Safe Storage Co. The following transactions occurred during the company’s first month.

The company’s chart of accounts follows:

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. Check (3) Unadj. trial balance totals, $189,800

4. Use the following information to journalize and post adjusting entries for the month:

a. Prepaid insurance of $400 has expired this month. (4a) Dr. Insurance Expense, $400

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 owner’s equity for the month of July and the balance sheet at July 31. (5) Net income, $2,725; Total assets, $180,825

6. Prepare journal entries to close the temporary accounts and post these entries to the ledger.

7. Prepare a post-closing trial balance. (7) P-C trial balance totals, $182,325

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Problem 4-2B Preparing a work sheet, adjusting and closing entries, and financial statements C3 P1 P2 The following unadjusted trial balance is for Power Demolition Company as of the end of its April 30, 2019, fiscal year. The April 30, 2018, credit balance of the owner’s capital account was $46,900, and the owner invested $40,000 cash in the company during the 2019 fiscal year.

Required

1. Prepare and complete a 10-column work sheet for fiscal year 2019, starting with the unadjusted trial balance and including adjustments based on these additional facts.

a. The supplies available at the end of fiscal year 2019 had a cost of $7,900.

b. The cost of expired insurance for the fiscal year is $10,600. c. Annual depreciation on equipment is $7,000. d. The April utilities expense of $800 is not included in the unadjusted

trial balance because the bill arrived after the trial balance was prepared. The $800 amount owed needs to be recorded.

e. The company’s employees have earned $2,000 of accrued and unpaid wages at fiscal year-end.

f. The rent expense incurred and not yet paid or recorded at fiscal year- end is $3,000.

g. Additional property taxes of $550 have been assessed for this fiscal year but have not been paid or recorded in the accounts.

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h. The $300 accrued interest for April on the long-term notes payable has not yet been paid or recorded.

2. Using information from the completed 10-column work sheet in part 1, journalize the adjusting entries and the closing entries.

3. Prepare the income statement and the statement of owner’s equity for the year ended April 30 and the classified balance sheet at April 30, 2019. Check (3) Net income, $77,550; Total assets, $195,900; Current liabilities, $13,450

Problem 4-3B Determining balance sheet classifications C3 In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classification. 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

1. Commissions earned 2. Interest receivable 3. Long-term investment in stock 4. Prepaid insurance (4 months of rent) 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 (due in 11 weeks) 14. Owner, Capital 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

Problem 4-4B Preparing closing entries, financial statements, and ratios C3 A1

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P2 The adjusted trial balance for Anara Co. as of December 31, 2019, follows. P. Anara invested $40,000 cash in the business during year 2019. (The December 31, 2018, credit balance of the P. Anara, Capital account was $52,800.)

Required

1. Prepare the income statement and the statement of owner’s equity for calendar-year 2019 and the classified balance sheet at December 31, 2019. Check (1) Total assets (12/31/2019), $164,700; Net income, $28,890

2. Prepare the necessary closing entries at December 31, 2019. 3. Use the information in the financial statements to calculate these

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ratios: (a) return on assets (total assets at December 31, 2018, 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.

Problem 4-5B Preparing trial balances, closing entries, and financial statements C3 P2 P3 Santo Company’s adjusted trial balance on December 31 follows.

Required

1. Prepare an income statement and a statement of owner’s equity for the year and a classified balance sheet at December 31. Note: The P. Santo, Capital account balance was $35,650 on December 31 of the prior year. Check (1) Ending capital balance, $39,590

2. Enter the adjusted trial balance in the first two columns of a six-column table. Use the middle two columns for closing entry information and the last two columns for a post-closing trial balance. Insert an Income Summary account (No. 901) as the last item in the trial balance. (2) P-C trial balance totals, $51,790

3. Enter closing entry information in the six-column table and prepare journal entries for it.

Problem 4-6BA Preparing adjusting, reversing, and next period entries P4 The following six-column table for Solutions Co. includes the unadjusted trial balance as of December 31.

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Page 162Required

1. Complete the six-column table by entering adjustments that reflect the following information:

a. As of December 31, employees had earned $400 of unpaid and unrecorded wages. The next payday is January 4, at which time $1,200 in wages will be paid.

b. The cost of supplies still available at December 31 is $3,450. c. The notes payable require an interest payment to be made every three

months. The amount of unrecorded accrued interest at December 31 is $800. The next interest payment, at an amount of $900, is due on January 15.

d. Analysis of the unearned rental fees shows that $3,200 remains unearned at December 31.

e. In addition to the machinery rental fees included in the revenue account balance, the company has earned another $2,450 in unrecorded fees that will be collected on January 31. The company is also expected to collect $5,400 on that same day for new fees earned in January.

f. Depreciation expense for the year is $3,800. Check (1) Adjusted trial balance totals, $111,300

2. Prepare journal entries for the adjustments entered in the six-column table for part 1.

3. Prepare journal entries to reverse the effects of the adjusting entries that involve accruals.

4. Prepare journal entries to record the cash payments and cash collections described for January.

SERIAL PROBLEM

Business Solutions P2 P3

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© Alexander Image/Shutterstock

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. SP 4 The December 31, 2019, adjusted trial balance of Business Solutions (reflecting its transactions from October through December of 2019) follows.

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Required

1. Record and post the necessary closing entries as of December 31, 2019. 2. Prepare a post-closing trial balance as of December 31, 2019.

Check Post-closing trial balance totals, $85,110

GENERAL LEDGER PROBLEM

The following General Ledger assignments focus on transactions related to the closing process. For each of the following questions, prepare the required closing entries, create the income statement and the classified balance sheet, and then indicate which accounts appear on the post-closing trial balance. Three options exist for displaying the trial balance: unadjusted, adjusted, or post-closing. GL 4-1 Transactions from the FastForward illustration in this chapter GL 4-2 Based on Problem 4-1A GL 4-3 Based on Problem 4-2A GL 4-4 Based on Problem 4-6A GL 4-5 Based on Serial Problem SP 4

Accounting Analysis

COMPANY ANALYSIS C1 P2

AA 4-1 Refer to Apple’s financial statements in Appendix A to answer the following.

1. For the fiscal year ended September 30, 2017, what amount is credited to Income Summary to summarize its revenues earned?

2. For the fiscal year ended September 30, 2017, what amount is debited to Income Summary to summarize its expenses incurred?

3. For the fiscal year ended September 30, 2017, what is the balance of its Income Summary account before it is closed?

COMPARATIVE ANALYSIS A1

AA 4-2 Key figures for the recent two years of both Apple and Google follow.

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Required

1. Compute current ratios for (a) Apple and (b) Google for the two years reported above.

2. In the current year, which company has the better ability to pay short-term obligations according to the current ratio?

3. Do (a) Apple’s and (b) Google’s current ratios underperform or outperform the industry (assumed) average ratio of 2.0?

GLOBAL ANALYSIS A1

AA 4-3 The following selected information is available from Samsung’s financial statements.

Required

1. Compute Samsung’s current ratio for both the current year and the prior year. 2. In the current year, did Samsung's current ratio improve or worsen versus the

prior year?

Beyond the Numbers

ETHICS CHALLENGE C2

BTN 4-1 On January 20, 2019, Tamira Nelson, the accountant for Picton Enterprises, is feeling pressure to complete the annual financial statements. The company president has said he needs up-to-date financial statements to share with the bank on January 21 at a dinner meeting that has been called to discuss Picton’s obtaining loan financing for a special building project. Tamira knows that she will not be able to gather all the needed information in the next 24 hours to prepare the entire set of adjusting entries. Those entries must be posted before the financial statements accurately portray the company’s performance and financial position for the fiscal period ended December 31, 2018. Tamira ultimately decides to estimate several expense accruals at the last minute. When deciding on

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estimates for the expenses, she uses low estimates because she does not want to make the financial statements look worse than they are. Tamira finishes the financial statements before the deadline and gives them to the president without mentioning that several account balances are estimates that she provided.

Required

1. Identify several courses of action that Tamira could have taken instead of the one she took.

2. If you were in Tamira’s situation, what would you have done? Briefly justify your response.

COMMUNICATING IN PRACTICE C1 P2

BTN 4-2 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 the capital account. Hint: Think about what would happen if the scoreboard were not cleared before the start of a new game.

TAKING IT TO THE NET A1

BTN 4-3 Access Motley Fool’s discussion of the current ratio at Fool.com/investing/beginning/how-to-value-stocks-how-to-read-a-balance-sheet- cu.aspx. (If the page has changed, search that site for the article “How to Read a Balance Sheet: Current and Quick Ratios.”)

Required

1. What level for the current ratio is generally regarded as sufficient to meet near-term operating needs?

2. Once you have calculated the current ratio for a company, what should you compare it against?

3. What are the implications for a company that has a current ratio that is too high?

TEAMWORK IN ACTION P1 P2 P3

BTN 4-4 The unadjusted trial balance and information for the accounting adjustments of Noseworthy Investigators follow. Each team member involved in this project is to assume one of the four responsibilities listed. After completing each of these responsibilities, the team should work together to prove the accounting equation utilizing information from teammates (1 and 4). If your equation does not balance, you are to work as a team to resolve the error. The team’s goal is to

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complete the task as quickly and accurately as possible.

Additional Year-End Information

a. Insurance that expired in the current period amounts to $2,200. b. Equipment depreciation for the period is $4,000. c. Unused supplies total $5,000 at period-end. d. Services in the amount of $800 have been provided but have not been billed

or collected.

Responsibilities for Individual Team Members

1. Determine the accounts and adjusted balances to be extended to the Balance Sheet columns of the work sheet for Noseworthy. Also determine total assets and total liabilities.

2. Determine the adjusted revenue account balance and prepare the entry to close this account.

3. Determine the adjusted account balances for expenses and prepare the entry to close these accounts.

4. Prepare T-accounts for both D. Noseworthy, Capital (reflecting the unadjusted trial balance amount) and Income Summary. Ask teammates assigned to parts 2 and 3 for the postings for Income Summary. Using that information, prepare and post both the third and fourth closing entries. Provide the team with the ending capital account balance.

5. The entire team should prove the accounting equation using post-closing balances.

ENTREPRENEURIAL DECISION A1 C3 P2

BTN 4-5 Review this chapter’s opening feature involving Evan and Bobby and Snapchat.

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1. Explain how a classified balance sheet can help Evan and Bobby know what bills are due when and whether they have the resources to pay those bills.

2. Why is it important for Evan and Bobby to match costs and revenues in a specific time period? How do closing entries help them in this regard?

3. What objectives are met when Evan and Bobby apply closing procedures each fiscal year-end?

HITTING THE ROAD C2

BTN 4-6 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?

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw- Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

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C1 C2

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5 Accounting for Merchandising Operations

Chapter Preview

MERCHANDISING ACTIVITIES

Income and inventory for merchandisers Operating cycle Inventory cost flows

NTK 5-1

MERCHANDISING PURCHASES

Accounting for: Purchases discounts Purchases returns and allowances Transportation costs

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P2

P3 P4 A1 A2

C1

C2

A1 A2

P1

P2

NTK 5-2

MERCHANDISING SALES

Accounting for: Sales of merchandise Sales discounts Sales returns and allowances

NTK 5-3

MERCHANDISER REPORTING

Adjusting and closing Multiple-step and single-step income statements Acid-test analysis Gross margin analysis

NTK 5-4 , 5-5

Learning Objectives

CONCEPTUAL

Describe merchandising activities and identify income components for a merchandising company. Identify and explain the inventory asset and cost flows of a merchandising company.

ANALYTICAL

Compute the acid-test ratio and explain its use to assess liquidity. Compute the gross margin ratio and explain its use to assess profitability.

PROCEDURAL

Analyze and record transactions for merchandise purchases using a perpetual system. Analyze and record transactions for merchandise sales using a perpetual system.

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P3 P4 P5

P6

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Prepare adjustments and close accounts for a merchandising company. Define and prepare multiple-step and single-step income statements. Appendix 5A—Record and compare merchandising transactions using both periodic and perpetual inventory systems. Appendix 5B—Prepare adjustments for discounts, returns, and allowances per revenue recognition rules. Appendix 5C—Record and compare merchandising transactions using the gross method and net method.

©Monty Brinton/CBS via Getty Images

Bear Up

“Understand what matters” —MAXINE CLARK ST. LOUIS—“When I graduated from college,” explains Maxine Clark, “I felt the retail world had lost its spark. I wanted to be more creative.” Maxine was determined to start a business that would be different. Then she went shopping with the young daughter of a friend. “When we couldn’t find anything new, Katie picked up a Beanie Baby and said we could make one,” recalls Maxine. “Her words gave me the idea to create a company that would allow people to create their own customized stuffed animals.” Build-A-Bear Workshop (BuildaBear.com) was born!

“I did some research and began putting together a plan,” says Maxine. The Build-A-Bear Workshops were an instant success.

As her company grew, Maxine says accounting data on her merchandising operations fell

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short. “We can’t give up!” was her view. In response, Maxine set up an accounting system to measure, track, summarize, and report on merchandising transactions, especially purchases.

Maxine computerized the accounting system, prepared monthly financial statements per store, developed annual budgets, and tracked all bank accounts and payables.

Build-A-Bear’s successful use of accounting data has made Maxine a self-made woman. She insists, however, it is not about the financial rewards. “We’re a family business,” explains Maxine. “It’s important to set an example for children by being a company that does good things and cares about the well-being of others.”

Sources: Build-A-Bear website, January 2019; Fortune, March 2012; LEADERS, April 2011; CSRwire, August 2008

MERCHANDISING ACTIVITIES

C1_______ Describe merchandising activities and identify income components for a merchandising company.

Previous chapters covered accounting for service companies. A merchandising company’s activities differ from those of a service company. Merchandise refers to products, also called goods, that a company buys to resell. A merchandiser earns net income by buying and selling merchandise. Merchandisers are wholesalers or retailers. A wholesaler buys products from manufacturers and sells them to retailers. A retailer buys products from manufacturers or wholesalers and sells them to consumers.

Reporting Income for a Merchandiser Net income for a merchandiser equals revenues from selling merchandise minus both the cost of merchandise sold and other expenses—see Exhibit 5.1. Revenue from selling merchandise is called sales, and the expense of buying and preparing merchandise is called cost of goods sold. (Some service companies use the term sales instead of revenues; cost of goods sold is also called cost of sales.)

EXHIBIT 5.1 Computing Income for a Merchandising Company versus a Service Company

Point: SuperValu and SYSCO are wholesalers. Target and Walmart are retailers.

The income statements for a service company, Liberty Tax, and for a merchandiser, Nordstrom, are in Exhibit 5.2. We see that the merchandiser, Nordstrom, reports cost of goods sold, which is not reported by the service company. The merchandiser

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also reports gross profit, or gross margin, which is net sales minus cost of goods sold.

EXHIBIT 5.2 Income Statement for a Service Company and a Merchandising Company

Reporting Inventory for a Merchandiser

C2_______ Identify and explain the inventory asset and cost flows of a merchandising company.

A merchandiser’s balance sheet has 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. Inventory cost includes the cost to buy the goods, ship them to the store, and make them ready for sale.

Operating Cycle for a Merchandiser

EXHIBIT 5.3 Merchandiser’s Operating Cycle

Exhibit 5.3 shows an operating cycle for a merchandiser with credit sales. The cycle moves from (a) cash purchases of merchandise to (b) inventory for sale to (c) credit sales to (d) accounts receivable to (e) receipt of cash. 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 stores are usually from two to eight weeks. Companies try to keep their operating cycles short because assets tied up in inventory and receivables are not productive. Cash sales shorten operating cycles.

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Inventory Systems Exhibit 5.4 shows that a company’s merchandise available for sale consists of what it begins with (beginning inventory) and what it purchases (net purchases). The merchandise available for sale is either sold (cost of goods sold) or kept for future sales (ending inventory).

EXHIBIT 5.4 Merchandiser’s Cost Flow for a Single Time Period

Point: Merchandise avail. for sale: MAS = EI + COGS, which can be rewritten as MAS − EI = COGS or MAS − COGS = EI.

Companies account for inventory in one of two ways: perpetual system or periodic system.

Perpetual inventory system updates accounting records for each purchase and each sale of inventory. Periodic inventory system updates accounting records for purchases and sales of inventory only at the end of a period.

Technology has dramatically increased the use of the perpetual system. It gives managers immediate access to information on sales and inventory levels, which allows them to strategically react and increase 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.)

NEED-TO-KNOW 5-1

Merchandise Accounts and Computations C1 C2

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Use the following information (in random order) from a merchandising company and from a service company to complete the requirements. Hint: Not all information may be necessary for the solutions.

1. For the merchandiser only, compute (a) Goods available for sale, (b) cost of goods sold, and (c) gross profit.

2. Compute net income for each company.

Solution

2. Computation of net income for each company.

Do More: QS 5-3, E 5-1, E 5-2

ACCOUNTING FOR MERCHANDISE PURCHASES

P1_______ Analyze and record transactions for merchandise purchases using a perpetual system.

This section explains how we record purchases under different purchase terms.

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Purchases without Cash Discounts Z-Mart records a $500 cash purchase of merchandise on November 2 as follows.

If these goods are instead purchased on credit, and no discounts are offered for early payment, Z-Mart makes the same entry except that Accounts Payable is credited instead of Cash. Point: Costs recorded in Merchandise Inventory are called inventoriable costs.

Decision Insight

Trade Discounts When a manufacturer or wholesaler prepares a catalog of items for sale, each item has a list price, or catalog price. However, an item’s selling price equals list price minus a percent called a trade discount. A wholesaler buying in large quantities gets a larger discount than a retailer buying in small quantities. A buyer records the net amount of list price minus trade discount. If a supplier of Z-Mart lists an item at $625 and gives Z-Mart a 20% trade discount, Z-Mart’s purchase price is $500, computed as $625 − (20% × $625). ■

Point: Trade discounts are not journalized; purchases are recorded based on the invoice amount.

Purchases with Cash Discounts The purchase of goods on credit requires credit terms. Credit terms include the amounts and timing of payments from a buyer to a seller. To demonstrate, when sellers require payment within 10 days after the end of the month (EOM) of the invoice date, credit terms are “n/10 EOM.” When sellers require payment within 30 days after the invoice date, credit terms are “n/30,” meaning net 30 days.

Credit Terms Exhibit 5.5 explains credit terms. The amount of time allowed before full payment is due is the credit period. Sellers can grant a cash discount to encourage buyers to pay earlier. A buyer views a cash discount as a purchases discount. A seller views a cash discount as a sales discount. Any cash discounts are described on the invoice. For example, credit terms of “2/10, n/60” 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 is only for the discount period.

EXHIBIT 5.5 Credit Terms

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Invoice On November 2, Z-Mart purchases $500 of merchandise on credit with terms of 2/10, n/30. The invoice for this purchase is shown in Exhibit 5.6. This is a purchase invoice for Z-Mart (buyer) and a 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.

EXHIBIT 5.6 Invoice

Point: The invoice date sets the discount and credit periods.

Gross Method Z-Mart purchases $500 of merchandise on credit terms of 2/10, n/30. The November 2 invoice offers a 2% discount if paid within 10 days; if not, Z-Mart must pay the full amount within 30 days. The buyer has two options.

The $490 equals the $500 invoice minus $10 discount (computed as $500 × 2%). On the purchase date, we do not know if payment will occur within the discount

period. The gross method records the purchase at its gross (full) invoice amount. For Z-Mart, the purchase of $500 of merchandise with terms of 2/10, n/30 is recorded at $500. The gross

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method is used here because it is (1) used more in practice, (2) easier to apply, and (3) less costly.

Purchases on Credit Z-Mart’s entry to record the November 2 purchase of $500 of merchandise on credit follows. (For recording, it can help to add the name to the payable, such as Accounts Payable—Trex.)

Point: Appendix 5A repeats journal entries a through g using the periodic system.

Payment within Discount Period Good cash management means that invoices are not paid until the last day of the discount or credit period. This is because the buyer can use that money until payment is required. If Z-Mart pays the amount due on (or before) November 12, the entry is

The Merchandise Inventory account equals the $490 net cost of purchases after these entries, and the Accounts Payable account has a zero balance.

Payment after Discount Period If the invoice is paid after November 12, the discount is lost. If Z-Mart pays the gross (full) amount due on December 2 (the n/30 due date), the entry is

Purchases with Returns and Allowances Purchases returns are merchandise a buyer purchases but then returns. Purchases allowances refer to a seller granting a price reduction (allowance) to a buyer of defective or unacceptable merchandise. Point: When a buyer returns or takes an allowance on merchandise, the buyer issues a debit memorandum. This informs the seller of a debit made to the seller’s account payable in the buyer’s records.

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Purchases Allowances On November 5, Z-Mart (buyer) agrees to a $30 allowance from Trex for defective merchandise (assume allowance is $30 whether paid within the discount period or not). Z-Mart’s entry to update Merchandise Inventory and record the allowance follows. Z-Mart’s allowance for defective merchandise reduces its account payable to the seller. If cash is refunded, Cash is debited instead of Accounts Payable.

Purchases Returns Returns of inventory are recorded at the amount charged for that inventory. On June 1, Z-Mart purchases $250 of merchandise with terms 2/10, n/60—see entries below. On June 3, Z-Mart returns $50 of those goods. When Z-Mart pays on June 11, it takes the 2% discount only on the $200 remaining balance ($250 − $50). When goods are returned, a buyer takes a discount on only the remaining balance. This means the discount is $4 (computed as $200 × 2%) and the cash payment is $196 (computed as $200 − $4). Point: Credit terms apply to both partial and full payments.

These T-accounts show the final $196 in inventory, the zero balance in Accounts Payable, and the $196 cash payment.

Decision Insight 339

Decision Insight

What’s Your Policy? Return policies are a competitive advantage for businesses. REI offers a 1-year return policy on nearly every product it sells. Amazon picks up returned items at your door. On the other hand, some stores like Best Buy allow only 14 days to return products. ■

Purchases and Transportation Costs

©Michael DeYoung/Blend Images

The buyer and seller must agree on who is responsible for paying freight (shipping) costs and who has the risk of loss during transit. This is 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.

Exhibit 5.7 covers two alternative points of transfer.

1. FOB shipping point means the buyer accepts ownership when the goods depart the seller’s place of business. The buyer pays shipping costs and has the risk of loss in transit. The goods are part of the buyer’s inventory when they are in transit because ownership has transferred to the buyer. 1-800-Flowers.com, a floral merchandiser, uses 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 pays shipping charges and has the risk of loss in transit. The seller does not record revenue until the goods arrive at the destination.

EXHIBIT 5.7 Ownership Transfer and Transportation Costs

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Point: When the party not responsible for shipping pays shipping cost, it either bills the other party responsible or adjusts its account payable or account receivable with the other party. Freight payments are not applied in computing discounts.

When a buyer is responsible for paying transportation costs, the payment is made to a carrier or directly to the seller. The cost principle requires that transportation costs of a buyer (often called transportation-in or freight-in) be part of the cost of merchandise inventory. Z-Mart’s entry to record a $75 freight charge from UPS for merchandise purchased FOB shipping point is Point: If we place an order online and receive free shipping, we have terms FOB destination.

When a seller is responsible for paying shipping costs, it records these costs in a Delivery Expense account. Delivery expense, also called transportation-out or freight-out, is reported as a selling expense in the seller’s income statement. Point: INcoming freight costs are charged to INventory. When inventory EXits, freight costs are charged to EXpense.

Itemized Costs of Purchases In summary, purchases are recorded as debits to Merchandise Inventory (or Inventory). Purchases discounts, returns, and allowances are credited to (subtracted from) Merchandise Inventory. Transportation-in is debited (added) to Merchandise Inventory. Z-Mart’s itemized costs of merchandise purchases for the year are in Exhibit 5.8.

EXHIBIT 5.8 Itemized Costs of Merchandise Purchases

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Oct. 1

3 7

11

31

The accounting system described here does not provide separate records (accounts) for total purchases, total purchases discounts, total purchases returns and allowances, and total transportation-in. Many companies collect this information in supplementary records to evaluate these costs. Supplementary records, or supplemental records, refer to information outside the usual ledger accounts. Point: Some companies have separate accounts for purchases 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.

Decision Ethics

Payables Manager As a new accounts payable manager, you are being trained by the outgoing manager. 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 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.” Do you continue this policy? ■ Answer: One point of view is that the late payment policy is unethical. A deliberate plan to make late payments means the company lies when it pretends to make payment within the discount period. Another view is that the late payment policy is acceptable. Some believe attempts to take discounts through late payments are accepted as “price negotiation.

NEED-TO-KNOW 5-2

Merchandise Purchases P1

Prepare journal entries to record each of the following purchases transactions of a merchandising company. Assume a perpetual inventory system using the gross method for recording purchases.

Purchased $1,000 of goods. Terms of the sale are 4/10, n/30, and FOB shipping point; the invoice is dated October 1. Paid $30 cash for freight charges from UPS for the October 1 purchase. Returned $50 of the $1,000 of goods from the October 1 purchase and

received full credit. Paid the amount due from the October 1 purchase (less the return on

October 7). Assume the October 11 payment was never made. Instead, payment of the

amount due, less the return on October 7, occurred on October 31.

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Solution

Do More: QS 5-5, QS 5-6, QS 5-7, E 5-3, E 5-5

ACCOUNTING FOR MERCHANDISE SALES

P2_______ Analyze and record transactions for merchandise sales using a perpetual system.

Merchandising companies must account for sales, sales discounts, sales returns and allowances, and cost of goods sold. Z-Mart has these items in its gross profit computation— see Exhibit 5.9. This shows that customers paid $314,700 for merchandise that cost Z-Mart $230,400, yielding a gross profit of $84,300.

EXHIBIT 5.9 Gross Profit Computation

The perpetual accounting system requires that each sales transaction for a merchandiser, whether for cash or on credit, has two entries: one for revenue and one for cost.

1. Revenue received (and asset increased) from the customer. 2. Cost of goods sold incurred (and asset decreased) to the customer.

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Sales without Cash Discounts

Revenue Side: Inflow of Assets Z-Mart sold $1,000 of merchandise on credit terms n/60 on November 12. The revenue part of this transaction is recorded as follows. This entry shows 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, debit Cash instead of Accounts Receivable.

Cost Side: Outflow of Assets The cost side of each sale requires that Merchandise Inventory decrease by that item’s cost. The cost of the merchandise Z-Mart sold on November 12 is $300, and the entry to record the cost part of this transaction follows.

Decision Insight

©Polaris/Newscom

Future Demands Large merchandising companies, such as Amazon, bombard suppliers with demands. These include discounts for bar coding and technology support systems and fines for shipping errors. Merchandisers’ goals are to reduce inventories, shorten lead times, and eliminate errors. Colleges offer programs in supply chain management and logistics to train future employees to help merchandisers meet such goals. ■

Sales with Cash Discounts Offering discounts on credit sales benefits a seller through earlier cash receipts and reduced collection efforts. We use the gross method, which records sales at the full amount and records sales discounts if, and when, they are taken. The gross method requires a period-end adjusting entry to estimate future sales discounts. (The net method records sales at the net amount, which assumes all discounts are taken. This method requires an adjusting entry to

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estimate future discounts lost. See Appendix 5C.)

Sales on Credit Z-Mart makes a credit sale for $1,000 on November 12 with terms of 2/10, n/45 (cost of the merchandise sold is $300). The entries to record this sale follow.

Buyer Pays within Discount Period One option is for the buyer to pay $980 within the 10-day discount period ending November 22. The $20 sales discount is computed as $1,000 × 2%. If the customer pays on (or before) November 22, Z-Mart records the cash receipt as follows. Sales Discounts is a contra revenue account, meaning the Sales Discounts account is subtracted from the Sales account when computing net sales. The Sales Discounts account has a normal debit balance because it is subtracted from Sales, which has a normal credit balance.

Buyer Pays after Discount Period The customer’s second option is to wait 45 days until December 27 (or at least until after the discount period) and then pay $1,000. Z- Mart records that cash receipt as

Sales with Returns and Allowances If a customer is unhappy with a purchase, many sellers allow the customer to either return the merchandise for a full refund (sales return) or keep the merchandise along with a partial

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refund (sales allowance). Most sellers can reliably estimate returns and allowances (abbreviated R&A).

Buyer Returns Goods—Revenue Side When a buyer returns goods, it impacts the seller’s revenue and cost sides. When a return occurs, the seller debits Sales Returns and Allowances, a contra revenue account to Sales. Assume that a customer returns merchandise on November 26 that sold for $15 and cost $9; the revenue-side returns entry is

Buyer Returns Goods—Cost Side When a return occurs, the seller must reduce the cost of sales. Continuing the example where the returned items sold for $15 and cost $9, the cost-side entry depends on whether the goods are defective.

Returned Goods Not Defective If the merchandise returned is not defective and can be resold, there is a cost-side entry. The seller adds the cost of the returned goods back to inventory and reduces cost of goods sold as follows. This entry reverses the cost-side entry of November 12 for only $9 of goods returned.

Returned Goods Are Defective If the merchandise returned is defective, the returned inventory is recorded at its estimated value, not its cost. The following entry assumes the returned goods costing $9 are defective and are worth $2.

Buyer Granted Allowances If a buyer is not satisfied with the goods, the seller might offer a price reduction for the buyer to keep the goods. There is no cost-side entry in this case as the inventory is not returned. On the revenue side, the seller debits Sales Returns and Allowances and credits Cash or Accounts Receivable depending on what’s agreed. Assume that $40 of merchandise previously sold is defective, but the buyer keeps it because the seller offers a $10 price reduction paid in cash to the buyer. The seller records this allowance as follows.

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June 1

7

11

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If the seller has not yet collected cash for the sale, the seller could credit the buyer’s account. For example, instead of the seller sending $10 cash to the buyer in the entry above, the seller can credit Accounts Receivable for $10. Point: When a seller accepts returns or grants an allowance, the seller issues a credit memorandum. This informs the buyer of a credit made to the buyer’s account in the seller’s records.

NEED-TO-KNOW 5-3

Merchandise Sales P2

Prepare journal entries to record each of the following sales transactions of a merchandising company. Assume a perpetual inventory system and use of the gross method (beginning inventory equals $9,000).

Sold 50 units of merchandise to a customer for $150 per unit under credit terms of 2/10, n/30, FOB shipping point, and the invoice is dated June 1. The 50 units of merchandise had cost $100 per unit.

The customer returns 2 units purchased on June 1 because those units did not fit its needs. The seller restores those units to its inventory (as they are not defective) and credits Accounts Receivable from the customer.

The seller receives the balance due from the June 1 sale to the customer less returns and allowances.

The customer discovers that 10 units have minor damage but keeps them because the seller sends a $50 cash payment allowance to compensate.

Solution

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Do More: QS 5-8, E 5-4, E 5-6, E 5-7

ADJUSTING AND CLOSING FOR MERCHANDISERS Exhibit 5.10 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.

EXHIBIT 5.10 Merchandising Cost Flow in the Accounting Cycle

Adjusting Entries for Merchandisers

P3_______ Prepare adjustments and close accounts for a merchandising company.

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Each of the steps in the accounting cycle described in the prior chapter applies to a merchandiser. We expand upon three steps of the accounting cycle for a merchandiser— adjustments, statement preparation, and closing.

Inventory Shrinkage—Adjusting Entry A merchandiser using a perpetual inventory system makes an adjustment to Merchandise Inventory for any loss of merchandise, including theft and deterioration. Shrinkage is the loss of inventory, and it is computed by comparing a physical count of inventory with recorded amounts.

Z-Mart’s Merchandise Inventory account at the end of the year has a balance of $21,250, but a physical count shows only $21,000 of inventory exists. The adjusting entry to record this $250 shrinkage is

Sales Discounts, Returns, and Allowances—Adjusting Entries Revenue recognition rules require sales to be reported at the amount expected to be received. This means that period-end adjusting entries are commonly made for

Expected sales discounts. Expected returns and allowances (revenue side). Expected returns and allowances (cost side).

These three adjustments produce three new accounts: Allowance for Sales Discounts, Sales Refund Payable, and Inventory Returns Estimated. Appendix 5B covers these accounts and the adjusting entries.

Preparing Financial Statements The financial statements of a merchandiser are similar to those for a service company described in prior chapters. The income statement mainly differs by the addition of cost of goods sold and gross profit. Net sales is affected by discounts, returns, and allowances, and some additional expenses such as delivery expense and loss from defective merchandise. The balance sheet differs by the addition of merchandise inventory as part of current assets. (Appendix 5B explains inventory returns estimated as part of current assets and sales refund payable as part of current liabilities.) The statement of owner’s equity is unchanged.

Closing Entries for Merchandisers Closing entries are similar for service companies and merchandising companies. The difference is that we close some new temporary accounts that come from merchandising activities. Z-Mart has temporary accounts unique to merchandisers: Sales (of goods), Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. The third and fourth closing entries are identical for a merchandiser and a service company. The differences are in red in the closing entries of Exhibit 5.11. Sales, having a normal credit balance, is debited in Step 1. Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold, having normal debit balances, are credited in Step 2.

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EXHIBIT 5.11 Closing Entries for a Merchandiser

Summary of Merchandising Entries Exhibit 5.12 summarizes the adjusting and closing entries of a merchandiser (using a perpetual inventory system).

EXHIBIT 5.12 Summary of Key Merchandising Entries (using perpetual system and gross method)

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NEED-TO-KNOW 5-4

Recording Shrinkage and Closing Entries P3

A merchandising company’s ledger on May 31, its fiscal year-end, includes the following accounts that have normal balances (it uses the perpetual inventory system). A physical count of its May 31 year-end inventory reveals that the cost of the merchandise inventory still available is $656. (a) Prepare the entry to record any inventory shrinkage. (b) Prepare the four closing entries as of May 31.

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Solution

a.

b.

Do More: QS 5-9, QS 5-10, E 5-10, E 5-12, P 5-4

MORE ON FINANCIAL STATEMENT FORMATS

P4_______ Define and prepare multiple-step and single-step income statements.

This section covers two income statement formats: multiple-step and single-step. The classified balance sheet of a merchandiser also is covered.

Multiple-Step Income Statement A multiple-step income statement details net sales and expenses and reports subtotals for various types of items. Exhibit 5.13 shows a multiple-step income statement. The statement has three main parts: (1) gross profit, which is net sales minus cost of goods sold; (2) income from operations, which is gross profit minus operating expenses; and (3) net income, which is income from operations plus or minus nonoperating items.

EXHIBIT 5.13 Multiple-Step Income Statement

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Point: Z-Mart did not have any nonoperating activities. Exhibit 5.13 includes some for illustrative purposes.

Operating expenses are separated into two sections. Selling expenses are the expenses of 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 resources, and finance. 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 expenses.

Nonoperating activities consist of other expenses, revenues, losses, and gains that are unrelated to a company’s operations. Other revenues and gains commonly include interest revenue, dividend revenue, rent revenue, and gains from asset disposals. Other expenses and losses commonly include interest expense, losses from asset disposals, and casualty losses. When there are no reportable nonoperating activities, its income from operations is simply labeled net income. Example: Sometimes interest revenue and interest expense are netted and reported on the income statement as Interest, net.

Single-Step Income Statement A single-step income statement is shown in Exhibit 5.14. It lists cost of goods sold as another expense and shows only one subtotal for total expenses. Expenses are grouped

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into few, if any, categories. Many companies use formats that combine features of both single- and multiple-step statements. Management chooses the format that best informs users.

EXHIBIT 5.14 Single-Step Income Statement

Point: Net income is identical under the single-step and multiple-step formats.

Classified Balance Sheet The classified balance sheet reports merchandise inventory as a current asset, usually after accounts receivable, according to how quickly they can be converted to cash. Inventory is converted less quickly to cash than accounts receivable because inventory first must be sold before cash can be received. Exhibit 5.15 shows the current asset section of Z-Mart’s classified balance sheet (other sections are similar to the previous chapter).

EXHIBIT 5.15 Classified Balance Sheet (partial) of a Merchandiser

Ethical Risk

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Shenanigans Accurate invoices are important to both sellers and buyers. Merchandisers use invoices to make sure they receive full payment for products provided. To achieve this, controls are set up. Still, failures occur. A survey reports that 30% of employees in sales and marketing witnessed false or misleading invoices sent to customers. Another 29% observed employees violating contract terms with customers (KPMG). ■

NEED-TO-KNOW 5-5

Multiple- and Single-Step Income Statements P4

Taret’s adjusted trial balance on April 30, its fiscal year-end, is shown here (accounts in random order). (a) Prepare a multiple-step income statement that begins with gross sales and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. (b) Prepare a single-step income statement that begins with net sales and includes these expense categories: cost of goods sold, selling expenses, and general and administrative expenses.

Solution

a. Multiple-step income statement.

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b. Single-step income statement.

Do More: QS 5-11, E 5-11, E 5-15, P 5-3

Decision Analysis Acid-Test and Gross Margin Ratios

Acid-Test Ratio

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A1_______ Compute the acid-test ratio and explain its use to assess liquidity.

One measure of a merchandiser’s ability to pay its current liabilities (referred to as its liquidity) is the acid-test ratio. 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 5.16. 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.

EXHIBIT 5.16 Acid-Test (Quick) Ratio

Nike’s acid-test ratio implies that it has enough quick assets to cover current liabilities. It is also on par with its competitor, Under Armour. Nike’s current ratio suggests it has more than enough current assets to cover current liabilities. Analysts might argue that Nike could invest some current assets in more productive assets. 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. Less than 1.0 raises liquidity concerns unless a company can get enough cash from sales or if liabilities are not due until late in the next period. Exhibit 5.17 shows both the acid-test and current ratios of Nike and under Armour for three recent years.

EXHIBIT 5.17 Acid-Test and Current Ratios for Nike and Under Armour

Point: Successful use of a just-in-time inventory system can narrow the gap between the acid-test ratio and the current ratio.

Decision Maker

Supplier A retailer requests to purchase supplies on credit from your company. You have no prior experience 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: A current ratio of 2.1 suggests sufficient current assets to cover current liabilities. An acid-test ratio of 0.5 suggests, however, that quick assets can cover only about one-half of current liabilities. The retailer depends on money from sales of inventory to pay current liabilities. If sales decline, the likelihood that this retailer will default on its payments increases. You probably do not extend credit.

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Gross Margin Ratio

A2_______ Compute the gross margin ratio and explain its use to assess profitability.

Without enough gross profit, a merchandiser can fail. The gross margin ratio helps understand this link. It differs from the profit margin ratio in that it excludes all costs except cost of goods sold. The gross margin ratio (or gross profit ratio) is defined as gross margin (net sales minus cost of goods sold) divided by net sales— see Exhibit 5.18.

EXHIBIT 5.18 Gross Margin Ratio

Exhibit 5.19 shows the gross margin ratio of Nike for three recent years. For Nike, each $1 of sales in the current year yielded about 44.6¢ in gross margin to cover all expenses and still produce a net income. This 44.6¢ margin is down from 46.2¢ in the prior year. This decrease is unfavorable.

EXHIBIT 5.19 Nike’s Gross Margin Ratio

Decision Maker

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: Your company’s net profit margin is about equal to the industry average. However, gross margin shows that your company is paying far more in cost of goods sold or receiving far less in sales price than competitors. You should try to find the problem with cost of goods sold, sales, or both.

NEED-TO-KNOW 5-6 COMPREHENSIVE 1

Single- and Multiple-Step Income Statements, Closing Entries, and Analysis Using Acid-Test and Gross Margin

Use the following adjusted trial balance and additional information to complete

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the requirements.

KC Antiques’s supplementary records for the year reveal the following itemized costs for merchandising activities.

Required

1. Use the supplementary records to compute the total cost of merchandise purchases for the year.

2. Prepare a multiple-step income statement for the year. (Beginning inventory was $70,100.)

3. Prepare a single-step income statement for the year. 4. Prepare closing entries for KC Antiques at December 31. 5. Compute the acid-test ratio and the gross margin ratio. Explain the

meaning of each ratio and interpret them for KC Antiques.

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PLANNING THE SOLUTION

Compute the total cost of merchandise purchases for the year. 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 Summary account. The second closing entry credits all temporary accounts with debit balances. The third entry closes the Income Summary account to the Capital account, and the fourth entry closes the Withdrawals account to the Capital 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

1.

2. Multiple-step income statement.

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3. Single-step income statement.

4.

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May 4

6

KC Antiques has a healthy acid-test ratio of 1.82. This means it has $1.82 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 − $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.

NEED-TO-KNOW 5-7 COMPREHENSIVE 2

Recording merchandising transactions—both seller and buyer

Prepare journal entries for the following transactions for both the seller (BMX) and buyer (Sanuk).

BMX sold $1,500 of merchandise on account to Sanuk, terms FOB shipping point, n/45, invoice dated May 4. The cost of the merchandise was $900. Sanuk paid transportation charges of $30 on the May 4 purchase from BMX.

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8

10

16

18 21

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5A

BMX sold $1,000 of merchandise on account to Sanuk, terms FOB destination, n/15, invoice dated May 8. The cost of the merchandise was $700. This sale permitted returns for 30 days. BMX paid transportation costs of $50 for delivery of merchandise sold to Sanuk on May 8. 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. BMX received payment from Sanuk for the May 8 purchase. BMX sold $2,400 of merchandise on account to Sanuk, terms FOB shipping point, 2/10, n/EOM. The cost of the merchandise was $1,440. This sale permitted returns for 90 days. BMX received payment from Sanuk for the May 21 purchase, less discount.

Solution

APPENDIX

Periodic Inventory System A periodic inventory system requires updating the inventory account only at the end of a period. During the period, the Merchandise Inventory balance remains

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unchanged and 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, it takes a physical count of inventory to get ending inventory. The cost of goods sold is then computed as cost of merchandise available for sale minus ending inventory.

P5_______ Record and compare merchandising transactions using both periodic and perpetual inventory systems.

Recording Merchandise Purchases Under a periodic system, the purchases, purchases returns and allowances, purchases discounts, and transportation-in transactions are recorded in separate temporary accounts. At period-end, each of these temporary accounts is closed, which updates the Merchandise Inventory account. To demonstrate, journal entries under the periodic inventory system are shown for the most common transactions (codes a through d link these transactions to those in the chapter). For comparison, perpetual system journal entries are shown to the right of each periodic entry. Differences are highlighted.

Credit Purchases with Cash Discounts The periodic system uses a temporary Purchases account that accumulates the cost of all purchase transactions during each period. The Purchases account has a normal debit balance, as it increases the cost of merchandise available for sale. Z-Mart’s November 2 entry to record the purchase of merchandise for $500 on credit with terms of 2/10, n/30 is (a)

Payment of Purchases The periodic system uses a temporary Purchases Discounts account that accumulates discounts taken during the period. If payment for transaction a is made within the discount period, the entry is (b1)

If payment for transaction a is made after the discount period expires, the entry is (b2)

Purchases Allowances The buyer and seller agree to a $30 purchases allowance

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for defective goods (whether paid within the discount period or not). In the periodic system, the temporary Purchases Returns and Allowances account accumulates the cost of all returns and allowances during a period. The buyer records the $30 allowance as Point: Purchases Discounts and Purchases Returns and Allowances are contra purchases accounts and have normal credit balances, as they both decrease the cost of merchandise available for sale.

(c1)

Purchases Returns The buyer returns $50 of merchandise within the discount period. The entry is (c2)

Transportation-In The buyer paid a $75 freight charge to transport goods with terms FOB destination. In the periodic system, this cost is recorded in a temporary Transportation-In account, which has a normal debit balance as it increases the cost of merchandise available for sale. (d)

Recording Merchandise Sales Journal entries under the periodic system are shown for the most common transactions (codes e through h link these transactions to those in the chapter). Perpetual system entries are shown to the right of each periodic entry. Differences are highlighted.

Credit Sales and Receipt of Payments Both the periodic and perpetual systems record sales entries similarly, using the gross method. The same holds for entries related to payment of receivables from sales both during and after the discount period. However, under the periodic system, the cost of goods sold is not recorded at the time of each sale (whereas it is under the perpetual system). The entry to record $1,000 in credit sales (costing $300) is

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Returns Received by Seller A customer returned merchandise for a cash refund. The goods sell for $15 and cost $9. (Recall: The periodic system records only the revenue effect, not the cost effect, for sales transactions.) The entry for the seller to take back the return is

Allowances Granted by Seller A customer is given an allowance in transaction f of $10 cash. The entry is identical under the periodic and perpetual systems. The seller records this allowance as

Recording Adjusting Entries Shrinkage—Adjusting Entry Adjusting (and closing) entries for the two systems are in Exhibit 5A.1. The $250 shrinkage is only recorded under the perpetual system—see entry z in Exhibit 5A.1. Shrinkage in cost of goods is unknown using a periodic system because inventory is not continually updated and therefore cannot be compared to the physical count.

EXHIBIT 5A.1 Comparison of Adjusting and Closing Entries—Periodic and Perpetual

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Expected Sales Discounts—Adjusting Entry Both the periodic and perpetual methods make a period-end adjusting entry under the gross method to estimate the $50 sales discounts arising from current-period sales that are likely to be taken in future periods. Z-Mart made the period-end adjusting entry g in Exhibit 5A.1 for expected sales discounts.

Expected Returns and Allowances—Adjusting Entry Both the periodic and perpetual inventory systems estimate returns and allowances arising from current- period sales that will occur in future periods. The adjusting entry for both systems is identical for the sales side, but slightly different for the cost side. The period-end entries h1 and h2 in Exhibit 5A.1 are used to record the updates to expected sales refunds of $900 and the cost side of $300. Under both systems, the seller sets up a Sales Refund Payable account, which is a current liability reflecting the amount expected to be refunded to customers, and an Inventory Returns Estimated account, which is a current asset reflecting the inventory estimated to be returned.

Recording Closing Entries Periodic and perpetual inventory systems have slight differences in closing entries. The period-end Merchandise Inventory balance (unadjusted) is $19,000 under the periodic system. Because the periodic system does not update the Merchandise Inventory balance during the period, the $19,000 amount is the beginning inventory. A physical count of inventory taken at the end of the period reveals $21,000 of merchandise available. The adjusting and closing entries for the two systems are in Exhibit 5A.1. Recording the periodic inventory balance is a two-step process. The ending inventory balance of $21,000 is entered by debiting the inventory account in the first closing entry. The beginning inventory balance of $19,000 is deleted by crediting the inventory account in the second closing entry.1

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5B

By updating Merchandise Inventory and closing Purchases, Purchases Discounts, Purchases Returns and Allowances, and Transportation-In, the periodic system transfers the cost of sales amount to Income Summary. Review the periodic side of Exhibit 5A.1 and see that the red items affect Income Summary as follows.

This $230,400 effect on Income Summary is the cost of goods sold amount (which is equal to cost of goods sold reported in a perpetual inventory system). 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 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 periodic system are similar to those for a service company described in prior chapters. The income statement 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 system follows. The balance sheet mainly differs by the inclusion of merchandise inventory, inventory returns estimated, allowance for sales discounts, and sales refund payable. Visit the Additional Student Resource section of the Connect ebook to view sample chart of accounts for periodic and perpetual systems.

APPENDIX

Adjusting Entries under New Revenue Recognition Rules P6_______

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Prepare adjustments for discounts, returns, and allowances per revenue recognition rules.

Expected Sales Discounts—Adjusting Entry New revenue recognition rules require sales to be reported at the amount expected to be received. This means that a period-end adjusting entry is made to estimate sales discounts for current-period sales that are expected to be taken in future periods. To demonstrate, assume Z-Mart has the following unadjusted balances.

Of the $11,250 of receivables, $2,500 of them are within the 2% discount period for which we expect buyers to take $50 in future-period discounts (computed as $2,500 × 2%) arising from this period’s sales. The adjusting entry for the $50 update to Allowance for Sales Discounts is

Allowance for Sales Discounts is a contra asset account and is reported on the balance sheet as a reduction to the Accounts Receivable asset account. The Allowance for Sales Discounts account has a normal credit balance because it reduces Accounts Receivable, which has a normal debit balance. This adjusting entry results in both accounts receivable and sales being reported at expected amounts.*

Expected Returns and Allowances—Adjusting Entries To avoid overstatement of sales and cost of sales, sellers estimate sales returns and allowances in the period of the sale. Estimating returns and allowances requires companies to maintain the following two balance sheet accounts that are set up with adjusting entries. Two adjusting entries are made: one for the revenue side and one for the cost side.

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Revenue Side for Expected R&A When returns and allowances are expected, a seller sets up a Sales Refund Payable account, which is a current liability showing the amount expected to be refunded to customers. Assume that on December 31 the company estimates future sales refunds to be $1,200. Assume also that the unadjusted balance in Sales Refund Payable is a $300 credit. The adjusting entry for the $900 update to Sales Refund Payable follows. The Sales Refund Payable account is updated only during the adjusting entry process. Its balance remains unchanged during the period when actual returns and allowances are recorded.

*This entry uses our three-step adjusting process: Step 1: Current bal. is $300 credit for Sales Refund Payable. Step 2: Current bal. should be $1,200 credit for Sales Refund Payable. Step 3: Record entry to get from step 1 to step 2.

Point: If estimates of returns and allowances prove too high or too low, we adjust future estimates accordingly.

Cost Side for Expected R&A On the cost side, some inventory is expected to be returned, which means that cost of goods sold recorded at the time of sale is overstated due to expected returns. A seller sets up an Inventory Returns Estimated account, which is a current asset showing the inventory estimated to be returned. Extending the example above, assume that the company estimates future inventory returns to be $500 (which is the cost side of the $1,200 expected returns and allowances above). Assume also that the (beginning) unadjusted balance in Inventory Returns Estimated is a $200 debit. The adjusting entry for the $300 update to expected returns follows. The Inventory Returns Estimated account is updated only during the adjusting entry process. Its balance remains unchanged during the period when actual returns and allowances are recorded.

*This entry uses our three-step adjusting process: Step 1: Current bal. is $200 debit for Inventory Returns Estimated. Step 2: Current bal. should be $500 debit for Inventory Returns Estimated. Step 3: Record entry to get from step 1 to step 2.

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5C

NEED-TO-KNOW 5-8

Estimating Discounts, Returns, and Allowances P6

At the current year-end, a company shows the following unadjusted balances for selected accounts.

a. After an analysis of future sales discounts, the company estimates that the Allowance for Sales Discounts account should have a $275 credit balance. Prepare the current year-end adjusting journal entry for future sales discounts.

b. After an analysis of future sales returns and allowances, the company estimates that the Sales Refund Payable account should have an $870 credit balance (revenue side).

c. After an analysis of future inventory returns, the company estimates that the Inventory Returns Estimated account should have a $500 debit balance (cost side).

Solution

Do More: QS 5-19, QS 5-20, E 5-20, E 5-21, E 5-22

APPENDIX

Net Method for Inventory P7_______ Record and compare merchandising transactions using the gross method and net method.

The net method records an invoice at its net amount (net of any cash discount). The

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gross method, covered earlier in the chapter, initially records an invoice at its gross (full) amount. This appendix records merchandising transactions using the net method. Differences with the gross method are highlighted.

When invoices are recorded at net amounts, any cash discounts are deducted from the balance of the Merchandise Inventory account when initially recorded. This assumes that all cash discounts will be taken. If any discounts are later lost, they are recorded in a Discounts Lost expense account reported on the income statement.

Perpetual Inventory System

PURCHASES—Perpetual A company purchases merchandise on November 2 at a $500 invoice price ($490 net) with terms of 2/10, n/30. Its November 2 entries under the gross and net methods are

If the invoice is paid on (or before) November 12 within the discount period, it records

If the invoice is paid after the discount period, it records

SALES—Perpetual A company sells merchandise on November 2 at a $500 invoice price ($490 net) with terms of 2/10, n/30. The goods cost $200. Its November 2 entries are

If cash is received on (or before) November 12 within the discount period, it records

If cash is received after the discount period, it records

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5D

Periodic Inventory System

PURCHASES—Periodic Under the periodic system, the balance of the Merchandise Inventory account remains unchanged during the period and is updated at period-end. During the period, three accounts are used to record purchases of inventory: Purchases; Purchases Discounts; and Purchases Returns and Allowances. The entries below are identical to the perpetual system except that Merchandise Inventory is substituted for each of the three purchases accounts.

To demonstrate, we apply the periodic system to purchases transactions. On November 2, a buyer purchases goods ($500 gross; $490 net) with terms of 2/10, n/30. Its November 2 entries under the gross and net methods are

If the invoice is paid on (or before) November 12 within the discount period, it records

If the invoice is paid after the discount period, it records

SALES—Periodic For sales transactions, the perpetual and periodic entries are identical except that under the periodic system the cost-side entries are not made at the time of each sale nor for any subsequent returns. Instead, the cost of goods sold is computed at period-end based on a physical count of inventory. This entry is shown in Exhibit 5A.1.

APPENDIX

Work Sheet—Perpetual System This appendix along with assignments is available online.

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Summary: Cheat Sheet

MERCHANDISING ACTIVITIES

Merchandise: Goods a company buys to resell. Cost of goods sold: Costs of merchandise sold. Gross profit (gross margin): Net sales minus cost of goods sold. Computing net income (service company vs. merchandiser):

Inventory: Costs of merchandise owned, but not yet sold. It is a current asset on the balance sheet. Merchandise Cost Flows:

Perpetual inventory system: Updates accounting records for each purchase and each sale of inventory. Periodic inventory system: Updates accounting records for purchases and sales of inventory only at the end of a period.

MERCHANDISING PURCHASES

Cash discount: A purchases discount on the price paid by the buyer; or, a sales discount on amount received for the seller. Credit terms example: “2/10, n/60” means full payment is due within 60 days, but the buyer can deduct 2% of the invoice amount if payment is made

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within 10 days. Gross method: Initially record purchases at gross (full) invoice amounts.

Purchasing Merchandise for Resale Entries:

Transportation Costs and Ownership Transfer Rules:

MERCHANDISING SALES

Sales Discounts: A contra revenue account, meaning Sales Discounts is subtracted from Sales when computing net sales. Customer Merchandise Returns Entries:

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If goods are defective, Inventory is debited for estimated value. A loss is recorded for the difference between cost of merchandise and estimated value.

Sales allowance: A price reduction agreed to with the buyer if they are unsatisfied with the goods.

MERCHANDISER REPORTING

Inventory shrinkage: An adjusting entry to account for the loss of inventory due to theft or deterioration. It is computed by comparing a physical count of inventory with recorded amounts.

Closing Entries: Differences between merchandisers and service companies in red.

Steps 3 and 4: Same entries as those for service companies. Multiple-step income statement: Three parts: (1) gross profit; (2) income from operations, which is gross profit minus operating expenses; and (3) net income, which is income from operations plus or minus nonoperating items.

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Operating expenses: Separated into selling expenses and general & administrative expenses. Selling expenses: Expenses of advertising merchandise, making sales, and delivering goods to customers. General & administrative expenses: Expenses that support a company’s overall operations, including accounting and human resources. Nonoperating activities: Consist of expenses, revenues, losses, and gains that are unrelated to a company’s main operations.

Multiple-Step Income Statement Example

†Must list all individual expenses and amounts—see Exhibit 5.13 (not done here for brevity).

Single-Step Income Statement Example

*Must list all individual expenses and amounts—see Exhibit 5.14 (not done here for brevity).

Key Terms

Acid-test ratio (183) Allowance for Sales Discounts (191) Cash discount (170) Cost of goods sold (167) Credit memorandum (176) Credit period (170) Credit terms (169) Debit memorandum (171) Discount period (170)

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Discounts Lost (192) EOM (169) FOB (172) General and administrative expenses (180) Gross margin (168) Gross margin ratio (183) Gross method (171, 192) Gross profit (168) Inventory (168) Inventory Returns Estimated (190) List price (169) Merchandise (167) Merchandise inventory (168) Merchandiser (167) Multiple-step income statement (180) Net method (175, 192) Periodic inventory system (168) Perpetual inventory system (168) Purchases discount (170) Retailer (167) Sales discount (170) Sales Refund Payable (190) Sales Returns and Allowances (175) Selling expenses (180) Shrinkage (177) Single-step income statement (181) Supplementary records (173) Trade discount (169) Wholesaler (167)

Multiple Choice Quiz

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).

2. A company purchased $4,500 of merchandise on May 1 with terms of 2/10,

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n/30. On May 6, it returned $250 of that merchandise. 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 cost of goods sold is $459,000, and its net income is $74,250. Its gross margin ratio equals

a. 32%. b. 68%. c. 47%. d. 11%. e. 34%.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; Gross profit = $550,000 − $193,000 = $357,000 2. d; ($4,500 − $250) × (100% − 2%) = $4,165 3. b; Net sales = $75,000 + $320,000 − $13,700 − $6,000 = $375,300 4. b; Acid-test ratio = $37,500/$50,000 = 0.75 5. a; Gross margin ratio = ($675,000 − $459,000)/$675,000 = 32%

A(B,C) Superscript letter A, B, or C denotes assignments based on Appendix 5A, 5B, or 5C.

Icon denotes assignments that involve decision making.

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Discussion Questions

1. What items appear in financial statements of merchandising 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 for purchases. 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 purchases discount? 8. Why would a company’s manager be concerned about the quantity of its

purchases 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 Apple’s balance sheet and income statement in

Appendix A. What does the company title its inventory account? Does the company present a detailed calculation of its cost of goods sold?

12. Refer to Google’s income statement in Appendix A. What title does it use for cost of goods sold?

13. Refer to Samsung’s income statement in Appendix A. What does Samsung title its cost of goods sold account?

14. Refer to Samsung’s income statement 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?

QUICK STUDY

QS 5-1 Applying merchandising terms C1 P1 Enter the letter for each term in the blank space beside the definition that it most closely matches.

A. Sales discount B. Credit period

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_____ 1. _____ 2. _____ 3.

_____ 4.

_____ 5.

_____ 6. _____ 7. _____ 8.

C. Discount period D. FOB destination E. FOB shipping point F. Gross profit G. Merchandise inventory H. Purchases discount

Goods a company owns and expects to sell to its customers. Time period that can pass before a customer’s full payment is due. Seller’s description of a cash discount granted to buyers in return for

early payment. Ownership of goods is transferred when the seller delivers goods to

the carrier. Purchaser’s description of a cash discount received from a supplier

of goods. Difference between net sales and the cost of goods sold. Time period in which a cash discount is available. Ownership of goods is transferred when delivered to the buyer’s

place of business.

QS 5-2 Identifying inventory costs C2 Costs of $5,000 were incurred to acquire goods and make them ready for sale. The goods were shipped to the buyer (FOB shipping point) for a cost of $200. Additional necessary costs of $400 were incurred to acquire the goods. No other incentives or discounts were available. What is the buyer’s total cost of merchandise inventory?

a. $5,000 b. $5,200 c. $5,400 d. $5,600

QS 5-3 Merchandise accounts and computations C2 Use the following information (in random order) from a merchandising company and from a service company. Hint: Not all information may be necessary for the solutions.

a. For the merchandiser only, compute (1) goods available for sale, (2) cost of goods sold, and (3) gross profit.

b. Compute net income for each company.

381

Nov. 5

7

15

Aug. 1

11

Sep. 15

29

Apr. 1

4

8

11

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QS 5-4 Computing net invoice amounts P1 Compute the amount to be paid for each of the four separate invoices assuming that all invoices are paid within the discount period.

QS 5-5 Recording purchases, returns, and discounts taken P1 Prepare journal entries to record each of the following transactions of a merchandising company. The company uses a perpetual inventory system and the gross method.

Purchased 600 units of product at a cost of $10 per unit. Terms of the sale are 2/10, n/60; the invoice is dated November 5. Returned 25 defective units from the November 5 purchase and received full credit. Paid the amount due from the November 5 purchase, minus the return on November 7.

QS 5-6 Recording purchases and discounts taken P1 Prepare journal entries to record each of the following transactions. The company records purchases using the gross method and a perpetual inventory system.

Purchased merchandise with an invoice price of $60,000 and credit terms of 3/10, n/30. Paid supplier the amount owed from the August 1 purchase.

QS 5-7 Recording purchases and discounts missed P1 Prepare journal entries to record each of the following transactions. The company records purchases using the gross method and a perpetual inventory system.

Purchased merchandise with an invoice price of $35,000 and credit terms of 2/5, n/15. Paid supplier the amount owed on the September 15 purchase.

QS 5-8 Recording sales, returns, and discounts taken P2 Prepare journal entries to record each of the following sales transactions of a merchandising company. The company uses a perpetual inventory system and the gross method.

Sold merchandise for $3,000, with credit terms n⁄30; invoice dated April 1. The cost of the merchandise is $1,800. The customer in the April 1 sale returned $300 of merchandise for full credit. The merchandise, which had cost $180, is returned to inventory. Sold merchandise for $1,000, with credit terms of 1/10, n/30; invoice dated April 8. Cost of the merchandise is $700. Received payment for the amount due from the April 1 sale less the return on April 4.

382

_____ 1.

_____ 2. _____ 3. _____ 4.

QS 5-9 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).

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.

QS 5-10 Closing entries P3 Refer to QS 5-9 and prepare journal entries to close the balances in temporary revenue and expense accounts. Remember to consider the entry for shrinkage from QS 5-9.

QS 5-11 Multiple-step income statement P4 For each item below, indicate whether the statement describes a multiple-step income statement or a single-step income statement.

a. Multiple-step income statement b. Single-step income statement

Commonly reports detailed computations of net sales and other costs and expenses.

Statement limited to two main categories (revenues and expenses). Reports gross profit on a separate line. Separates income from operations from the other revenues and gains.

QS 5-12 Preparing a multiple-step income statement P4 Save-the-Earth Co. reports the following income statement accounts for the year ended December 31. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Categorize the following accounts as selling expenses: Sales Staff Salaries and Advertising Expense. Categorize the remaining expenses as general and administrative.

QS 5-13 Preparing a classified balance sheet for a merchandiser P4 Clear Water Co. reports the following balance sheet accounts as of December 31.

383

_____ a. _____ b. _____ c.

_____ d. _____ e.

Page 199

Prepare a classified balance sheet.

QS 5-14 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.

QS 5-15 Computing and analyzing gross margin ratio A2 Compute net sales, gross profit, and the gross margin ratio for each of the four separate companies. Interpret the gross margin ratio for Carrier.

QS 5-16A Contrasting periodic and perpetual systems P5 Identify whether each description best applies to a periodic or a perpetual inventory system.

Updates the inventory account only at period-end. Requires an adjusting entry to record inventory shrinkage. Returns immediately affect the account balance of Merchandise

Inventory. Records cost of goods sold each time a sales transaction occurs. Provides more timely information to managers.

QS 5-17A Recording purchases, returns, and discounts—periodic & gross methods P5 Refer to QS 5-5 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the gross method and a periodic inventory system.

QS 5-18A Recording sales, returns, and discounts—periodic & gross methods P5 Refer to QS 5-8 and prepare journal entries to record each of the merchandising

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Oct. 1

6

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transactions assuming that the company records purchases using the gross method and a periodic inventory system.

QS 5-19B Recording estimates of future discounts P6 ProBuilder has the following June 30 fiscal-year-end unadjusted balances: Allowance for Sales Discounts, $0; and Accounts Receivable, $10,000. Of the $10,000 of receivables, $2,000 are within a 3% discount period, meaning that it expects buyers to take $60 in future discounts arising from this period’s sales.

a. Prepare the June 30 fiscal-year-end adjusting journal entry for future sales discounts.

b. Assume the same facts above and that there is a $10 fiscal-year-end unadjusted credit balance in the Allowance for Sales Discounts. Prepare the June 30 fiscal-year-end adjusting journal entry for future sales discounts.

QS 5-20B Recording estimates of future returns P6 ProBuilder reports merchandise sales of $50,000 and cost of merchandise sales of $20,000 in its first year of operations ending June 30. It makes fiscal-year-end adjusting entries for estimated future returns and allowances equal to 2% of sales, or $1,000, and 2% of cost of sales, or $400.

a. Prepare the June 30 fiscal-year-end adjusting journal entry for future returns and allowances related to sales.

b. Prepare the June 30 fiscal-year-end adjusting journal entry for future returns and allowances related to cost of sales.

QS 5-21C Recording purchases, returns, and discounts—net & perpetual methods P7 Refer to QS 5-5 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the net method and a perpetual inventory system.

QS 5-22C Recording sales, returns, and discounts—net & perpetual methods P7 Refer to QS 5-8 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the net method and a perpetual inventory system.

QS 5-23 Sales transactions P2

Prepare journal entries to record each of the following sales transactions of EcoMart Merchandising. EcoMart uses a perpetual inventory system and the gross method.

Sold fair trade merchandise for $1,500, with credit terms n/30, invoice dated October 1. The cost of the merchandise is $900. The customer in the October 1 sale returned $150 of fair trade merchandise for full credit. The merchandise, which had cost $90, is returned to inventory.

385

9

11

______a. ______b. ______c. ______d. ______e.

Apr. 2

3 4

17

18

21

28

Sold recycled leather merchandise for $700, with credit terms of 1/10, n/30, invoice dated October 9. Cost of the merchandise is $450. Received payment for the amount due from the October 1 sale less the return on October 6.

EXERCISES

Exercise 5-1 Computing revenues, expenses, and income C1 C2 Fill in the blanks in the following separate income statements a through e. Identify any negative amount by putting it in parentheses.

Exercise 5-2 Operating cycle for merchandiser C2 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.

Prepare merchandise for sale. Collect cash from customers on account. Make credit sales to customers. Purchase merchandise. Monitor and service accounts receivable.

Exercise 5-3 Recording purchases, purchases returns, and purchases allowances P1 Prepare journal entries to record the following transactions for a retail store. The company uses a perpetual inventory system and the gross method.

Purchased $4,600 of merchandise from Lyon Company with credit terms of 2/15, n/60, invoice dated April 2, and FOB shipping point. Paid $300 cash for shipping charges on the April 2 purchase. Returned to Lyon Company unacceptable merchandise that had an invoice price of $600. Sent a check to Lyon Company for the April 2 purchase, net of the discount and the returned merchandise. Purchased $8,500 of merchandise from Frist Corp. with credit terms of 1/10, n/30, invoice dated April 18, and FOB destination. After negotiations, received from Frist a $500 allowance toward the $8,500 owed on the April 18 purchase. Sent check to Frist paying for the April 18 purchase, net of the

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May 3

5

7

8

15

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allowance and the discount.

Check Apr. 28, Cr. Cash, $7,920

Exercise 5-4 Recording sales, sales returns, and sales allowances P2 Allied Merchandisers was organized on May 1. Macy Co. is a major customer (buyer) of Allied (seller) products. Prepare journal entries to record the following transactions for Allied assuming it uses a perpetual inventory system and the gross method.

Allied made its first and only purchase of inventory for the period on May 3 for 2,000 units at a price of $10 cash per unit (for a total cost of $20,000). Allied sold 1,500 of the units in inventory for $14 per unit (invoice total: $21,000) to Macy Co. under credit terms 2/10, n/60. The goods cost Allied $15,000. Macy returns 125 units because they did not fit the customer’s needs (invoice amount: $1,750). Allied restores the units, which cost $1,250, to its inventory. Macy discovers that 200 units are scuffed but are still of use and, therefore, keeps the units. Allied gives a price reduction (allowance) and credits Macy’s accounts receivable for $300 to compensate for the damage. Allied receives payment from Macy for the amount owed on the May 5 purchase; payment is net of returns, allowances, and any cash discount.

Exercise 5-5 Recording purchases, purchases returns, and purchases allowances P1 Refer to Exercise 5-4 and prepare journal entries for Macy Co. to record each of the May transactions. Macy is a retailer that uses the gross method and a perpetual inventory system; it purchases these units for resale.

Exercise 5-6 Recording sales, purchases, and cash discounts—buyer and seller P1 P2 Santa Fe Retailing purchased merchandise “as is” (with no returns) from Mesa Wholesalers with credit terms of 3/10, n/60 and an invoice price of $24,000. The merchandise had cost Mesa $16,000. Assume that both buyer and seller use a perpetual inventory system and the gross method.

1. Prepare entries that the buyer records for the (a) purchase, (b) cash payment within the discount period, and (c) cash payment after the discount period.

2. Prepare entries that the seller records for the (a) sale, (b) cash collection within the discount period, and (c) cash collection after the discount period.

Exercise 5-7 Recording sales, purchases, shipping, and returns—buyer and seller P1 P2 Sydney Retailing (buyer) and Troy Wholesalers (seller) enter into the following transactions. Both Sydney and Troy use a perpetual inventory system and the gross method.

387

May 11

12

20

Nov. 1

5 7

10

13

16

Sydney accepts delivery of $40,000 of merchandise it purchases for resale from Troy: invoice dated May 11, terms 3/10, n/90, FOB shipping point. The goods cost Troy $30,000. Sydney pays $345 cash to Express Shipping for delivery charges on the merchandise. Sydney returns $1,400 of the $40,000 of goods to Troy, who receives them the same day and restores them to its inventory. The returned goods had cost Troy $1,050. Sydney pays Troy for the amount owed. Troy receives the cash immediately.

1. Prepare journal entries that Sydney Retailing (buyer) records for these three transactions.

2. Prepare journal entries that Troy Wholesalers (seller) records for these three transactions.

Check (1) May 20, Cr. Cash, $37,442

Exercise 5-8 Inventory and cost of sales transactions in T-accounts P1 P2 The following summarizes Tesla’s merchandising activities for the year. Set up T- accounts for Merchandise Inventory and for Cost of Goods Sold. Enter each line item into one of the two T-accounts and compute the T-account balances.

Check Ending Merch. Inventory, $20,000

Exercise 5-9 Recording purchases, sales, returns, and shipping P1 P2 Prepare journal entries for the following merchandising transactions of Dollar Store assuming it uses a perpetual inventory system and the gross method.

Dollar Store purchases merchandise for $1,500 on terms of 2/5, n/30, FOB shipping point, invoice dated November 1. Dollar Store pays cash for the November 1 purchase. Dollar Store discovers and returns $200 of defective merchandise purchased on November 1, and paid for on November 5, for a cash refund. Dollar Store pays $90 cash for transportation costs for the November 1 purchase. Dollar Store sells merchandise for $1,600 with terms n/30. The cost of the merchandise is $800. Merchandise is returned to the Dollar Store from the November 13 transaction. The returned items are priced at $160 and cost $80; the items were not damaged and were returned to inventory.

Exercise 5-10 Preparing adjusting and closing entries for a merchandiser P3

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The following list includes selected permanent accounts and all of the temporary accounts from the December 31 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.

Check Dr. $84,500 to close Income Summary

Additional Information

Accrued and unpaid sales salaries amount to $1,700. Prepaid selling expenses of $3,000 have expired. A physical count of year-end merchandise inventory is taken to determine shrinkage and shows $28,700 of goods still available.

Exercise 5-11 Net sales computation for multiple-step income statement P4 A company reports the following sales-related information. Compute and prepare the net sales portion only of this company’s multiple-step income statement.

Exercise 5-12 Impacts of inventory error on key accounts P3 A retailer completed a physical count of ending merchandise inventory. When counting inventory, employees did not include $3,000 of incoming goods shipped by a supplier on December 31 under FOB shipping point. These goods had been recorded in Merchandise Inventory, but they were not included in the physical count because they were in transit. This means shrinkage was incorrectly overstated by $3,000. Compute the amount of overstatement or understatement for each of the following amounts for this period.

a. Ending inventory b. Total assets c. Net income d. Total equity

Exercise 5-13 Physical count error and profits A2 Refer to the information in Exercise 5-12 and indicate whether the failure to include in-transit inventory as part of the physical count results in an overstatement, understatement, or no effect on the following ratios.

a. Gross margin ratio b. Profit margin ratio

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c. Acid-test ratio d. Current ratio

Exercise 5-14 Computing and analyzing acid-test and current ratios A1 Compute the current ratio and acid-test ratio for each of the following separate cases. (Round ratios to two decimals.) Which company situation is in the best position to meet short-term obligations? Explain.

Exercise 5-15 Preparing a multiple-step income statement P4 Fit-for-Life Foods reports the following income statement accounts for the year ended December 31. Prepare a multiple-step income statement that includes separate categories for net sales; cost of goods sold; selling expenses; general and administrative expenses; and other revenues, gains, expenses, and losses. Categorize the following accounts as selling expenses: Sales Staff Wages, Rent Expense— Selling Space, TV Advertising Expense, and Sales Commission Expense. Categorize the remaining expenses as general and administrative.

Exercise 5-16 Preparing a classified balance sheet for a merchandiser P4 Adams Co. reports the following balance sheet accounts as of December 31. Prepare a classified balance sheet.

Exercise 5-17A Recording purchases, returns, and allowances— periodic P5 Refer to Exercise 5-3 and prepare journal entries to record each of the merchandising transactions assuming that the buyer uses the periodic inventory system and the gross method.

390

Exercise 5-18A Recording sales, purchases, and discounts: buyer and seller— periodic P5 Refer to Exercise 5-6 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system and the gross method are used by both the buyer and the seller.

Exercise 5-19A Recording sales, purchases, shipping, and returns: buyer and seller—periodic P5 Refer to Exercise 5-7 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system and the gross method are used by both the buyer and the seller.

Exercise 5-20B Recording estimates of future discounts P6 Med Labs has the following December 31 year-end unadjusted balances: Allowance for Sales Discounts, $0; and Accounts Receivable, $5,000. Of the $5,000 of receivables, $1,000 are within a 2% discount period, meaning that it expects buyers to take $20 in future-period discounts arising from this period's sales.

a. Prepare the December 31 year-end adjusting journal entry for future sales discounts.

b. Assume the same facts above and that there is a $5 year-end unadjusted credit balance in Allowance for Sales Discounts. Prepare the December 31 year-end adjusting journal entry for future sales discounts.

c. Is Allowance for Sales Discounts a contra asset or a contra liability account?

Exercise 5-21B Recording estimates of future returns P6 Chico Company allows its customers to return merchandise within 30 days of purchase.

At December 31, the end of its first year of operations, Chico estimates future-period merchandise returns of $60,000 (cost of $22,500) related to its current-year sales. A few days later, on January 3, a customer returns merchandise with a selling price of $2,000 for a cash refund; the returned merchandise cost $750 and is returned to inventory as it is not defective.

a. Prepare the December 31 year-end adjusting journal entry for estimated future sales returns and allowances (revenue side).

b. Prepare the December 31 year-end adjusting journal entry for estimated future inventory returns and allowances (cost side).

c. Prepare the January 3 journal entries to record the merchandise returned.

Exercise 5-22B Recording estimates of future returns P6 Lopez Company reports unadjusted first-year merchandise sales of $100,000 and cost of merchandise sales of $30,000.

a. Compute gross profit (using the unadjusted numbers above).

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Oct. 2

10

17

27 31

Mar. 3

4 5

18

19

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b. The company expects future returns and allowances equal to 5% of sales and 5% of cost of sales.

1. Prepare the year-end adjusting entry to record the sales expected to be refunded.

2. Prepare the year-end adjusting entry to record the cost side of sales returns and allowances.

3. Recompute gross profit using the adjusted numbers from parts 1 and 2. c. Is Sales Refund Payable an asset, liability, or equity account? d. Is Inventory Returns Estimated an asset, liability, or equity account?

Exercise 5-23C Recording sales, purchases, shipping, and returns: buyer and seller—perpetual and net method P7 Refer to Exercise 5-7 and prepare journal entries to record each of the merchandising transactions assuming that the perpetual inventory system and the net method are used by both the buyer and the seller.

Exercise 5-24C Recording purchases, sales, returns, and discounts: buyer and seller—perpetual and both net & gross methods P7 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.

Purchased merchandise at a $3,000 price ($2,940 net), invoice dated October 2, terms 2/10, n/30. Returned $500 ($490 net) of merchandise purchased on October 2 and debited its account payable for that amount. Purchased merchandise at a $5,400 price ($5,292 net), invoice dated October 17, terms 2/10, n/30. Paid for the merchandise purchased on October 17, less the discount. Paid for the merchandise purchased on October 2.

Exercise 5-25 Purchasing transactions P1

Prepare journal entries to record the following transactions of Recycled Fashion retail store. Recycled Fashion uses a perpetual inventory system and the gross method.

Purchased $1,150 of merchandise made from recycled material from GreenWorld Company with credit terms of 2/15, n/60, invoice dated March 3, and FOB shipping point. Paid $75 cash for shipping charges on the March 3 purchase. Returned to GreenWorld unacceptable merchandise that had an invoice price of $150. Paid GreenWorld for the March 3 purchase, net of the discount and the returned merchandise. Purchased $425 of fair trade merchandise from PeopleFirst Corp. with credit terms of 1/10, n/30, invoice dated March 19, and FOB

392

21

29

destination. After negotiations, received from PeopleFirst a $25 allowance (for scuffed merchandise) toward the $425 owed on the March 19 purchase. Sent check to PeopleFirst paying for the March 19 purchase, net of the allowance and the discount.

PROBLEM SET A

Problem 5-1A Preparing journal entries for merchandising activities—perpetual system P1 P2 Prepare journal entries to record the following merchandising transactions of Cabela’s, which uses the perpetual inventory system and the gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on July 1 in Accounts Payable—Boden.

Check July 12, Dr. Cash, $882 July 16, Cr. Cash, $5,940 July 24, Cr. Cash, $1,960 July 30, Dr. Cash, $1,078

Problem 5-2A Preparing journal entries for merchandising activities—perpetual system P1 P2 Prepare journal entries to record the following merchandising transactions of Lowe’s, which uses the perpetual inventory system and the gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on August 1 in Accounts Payable—Aron.

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Check Aug. 9, Dr. Delivery Expense, $125 Aug. 18, Cr. Cash, $4,950 Aug. 29, Dr. Cash, $4,300

Problem 5-3A Computing merchandising amounts and formatting income statements C2 P4 Valley Company’s adjusted trial balance on August 31, its fiscal year-end, follows. It categorizes the following accounts as selling expenses: Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Beginning merchandise inventory was $25,400. Supplementary records of merchandising activities for the year ended August 31 reveal the following itemized

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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.

Check (2) $90,100

3. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. (3) Gross profit, $136,850; Net income, $49,850

4. Prepare a single-step income statement that includes these expense categories: cost of goods sold, selling expenses, and general and administrative expenses. (4) Total expenses, $161,500

Problem 5-4A Preparing closing entries and interpreting information about discounts and returns C2 P3 Use the data for Valley Company in Problem 5-3A to complete the following requirement. Required Prepare closing entries as of August 31 (the perpetual inventory system is used).

Problem 5-5A Preparing adjusting entries and income statements; computing gross margin, acid-test, and current ratios P3 P4 A1 A2 The following unadjusted trial balance is prepared at fiscal year-end for Nelson Company. Nelson Company uses a perpetual inventory system. It categorizes the following accounts as selling expenses: Depreciation Expense—Store Equipment, Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

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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 the year ended January 31 that begins with gross sales and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Check (2) Gross profit, $67,750

3. Prepare a single-step income statement for the year ended January 31. (3) Total expenses, $106,775; Net income, $975

4. Compute the current ratio, acid-test ratio, and gross margin ratio as of January 31. (Round ratios to two decimals.)

PROBLEM SET B

Problem 5-1B Preparing journal entries for merchandising activities— perpetual system P1 P2

396

Prepare journal entries to record the following merchandising transactions of IKEA, which uses the perpetual inventory system and gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on May 2 in Accounts Payable—Havel.

Problem 5-2B Preparing journal entries for merchandising activities—perpetual system P1 P2 Prepare journal entries to record the following merchandising transactions of Menards, which applies the perpetual inventory system and gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on July 3 in Accounts Payable—OLB.

Problem 5-3B Computing merchandising amounts and formatting income

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statements C1 C2 P4 Barkley Company’s adjusted trial balance on March 31, its fiscal year-end, follows. It categorizes the following accounts as selling expenses: Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Beginning merchandise inventory was $37,500. Supplementary records of merchandising activities for the year ended March 31 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.

Check (2) $134,600

3. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. (3) Gross profit, $191,175; Net income, $55,175

4. Prepare a single-step income statement that includes these expense categories: cost of goods sold, selling expenses, and general and administrative expenses. (4) Total expenses, $251,600

Problem 5-4B Preparing closing entries and interpreting information about discounts and returns C2 P3 Use the data for Barkley Company in Problem 5-3B to complete the following requirement. Required Prepare closing entries as of March 31 (the perpetual inventory system is used).

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Problem 5-5B Preparing adjusting entries and income statements; computing gross margin, acid-test, and current ratios A1 A2 P3 P4 The following unadjusted trial balance is prepared at fiscal year-end for Foster Products Company. Foster Products Company uses a perpetual inventory system. It categorizes the following accounts as selling expenses: Depreciation Expense— Store Equipment, Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

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 the year ended October 31 that begins with gross sales and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Check (2) Gross profit, $142,600

399

3. Prepare a single-step income statement for the year ended October 31. (3) Total expenses, $197,100; Net income, $24,000

4. Compute the current ratio, acid-test ratio, and gross margin ratio as of October 31. (Round ratios to two decimals.)

SERIAL PROBLEM

Business Solutions P1 P2 P3 P4 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. SP 5 Santana Rey created Business Solutions on October 1, 2019. 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, 2019. Santana Rey 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.

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©Alexander Image/Shutterstock

In response to requests from customers, S. Rey will begin selling computer software. The company will extend credit terms of 1/10, n/30, 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. Its transactions for January through March follow.

401

Page 210The following additional facts are available for preparing adjustments on March 31 prior to financial statement preparation.

a. The March 31 amount of computer supplies still available totals $2,005. b. Prepaid insurance coverage of $555 expired during this three-month period. c. Lyn Addie has not been paid for seven days of work at the rate of $125 per

day. d. Prepaid rent of $2,475 expired during this three-month period.

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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, 2019. Check (2) Ending balances at March 31: Cash, $68,057; Sales, $19,240

3. Prepare a 6-column work sheet (similar to the one shown in Exhibit 3.13) 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. (3) Unadj. TB totals, $151,557; Adj. TB totals, $154,082

4. Prepare an income statement (from the adjusted trial balance in part 3) for the three months ended March 31, 2020. (a) Use a single-step format. List all expenses without differentiating between selling expenses and general and administrative expenses. (b) Use a multiple-step format that begins with gross sales (service revenues plus gross product sales) and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Categorize the following accounts as selling expenses: wages expense, mileage expense, and advertising expense. Categorize the remaining expenses as general and administrative. (4) Net income, $18,833

5. Prepare a statement of owner’s equity (from the adjusted trial balance in part 3) for the three months ended March 31, 2020. (5) S. Rey, Capital (at March 31), $119,393

6. Prepare a classified balance sheet (from the adjusted trial balance) as of March 31, 2020. (6) Total assets, $120,268

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so that the accounting professional can focus on the impacts of each transaction on the various financial reports. The following General Ledger questions highlight the operating cycle of a merchandising company. In each case, the trial balance is automatically updated from the journal entries recorded. GL 5-1 Based on Problem 5-1A GL 5-2 Based on Problem 5-2A GL 5-3 Based on Problem 5-5A

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Accounting Analysis

COMPANY ANALYSIS A1

AA 5-1 Refer to Apple’s 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 September 30, 2017.

2. Compute the current ratio and acid-test ratio as of September 30, 2017, and September 24, 2016.

3. Does Apple’s 2017 current ratio outperform or underperform the (assumed) industry average of 1.5?

4. Does Apple’s 2017 acid-test ratio outperform or underperform the (assumed) industry average of 1.0?

COMPARATIVE ANALYSIS A2

AA 5-2 Key comparative figures for Apple and Google follow.

Required

1. Compute the 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 for the current year?

3. Do (a) Apple’s and (b) Google’s current-year gross margins underperform or outperform the industry (assumed) average of 35.0%?

4. Are (a) Apple’s and (b) Google’s current-year gross margins on a favorable or unfavorable trend?

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GLOBAL ANALYSIS A2 P4

AA 5-3 Key comparative figures for Samsung, Apple, and Google follow.

Required

1. Compute the gross margin ratio for each of the three companies. 2. Is Samsung’s gross margin ratio better or worse than (a) Apple’s ratio? (b)

Google’s? 3. Do (a) Apple, (b) Google, and (c) Samsung use single-step or multiple-step

income statements?

Beyond the Numbers

ETHICS CHALLENGE C1 P2

BTN 5-1 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?

COMMUNICATING IN PRACTICE C2 P3 P5

BTN 5-2 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

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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.

TAKING IT TO THE NET A2 C1

BTN 5-3 Access the SEC’s EDGAR database (SEC.gov) and obtain the March 21, 2017, filing of its fiscal 2017 10-K report (for year ended January 28, 2017) 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.

TEAMWORK IN ACTION C1 C2

BTN 5-4 Official Brands’s general ledger and supplementary records at the end of its current period reveal the following.

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 b. Total cost of merchandise purchases c. Cost of goods sold d. Gross profit e. Net income

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.

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ENTREPRENEURIAL DECISION C1 C2 P1

BTN 5-5 Refer to the opening feature about Build-A-Bear Workshop and its founder Maxine Clark. Assume the business reports current annual sales at approximately $1 million and prepares the following income statement.

Assume the business sells to individuals and retailers, ranging from small shops to large chains. Assume that they currently offer credit terms of 1/15, n/60, and ship FOB destination. To improve their cash flow, they are considering changing credit terms to 3/10, n/30. In addition, they propose to change shipping terms to FOB shipping point. They expect 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. They also expect 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, 2019, based on the proposal.

2. Based on the forecasted income statement alone (from your part 1 solution), do you recommend that the business implement the new sales policies? Explain.

3. What else should the business consider before deciding whether to implement the new policies? Explain.

HITTING THE ROAD C1 P2

BTN 5-6 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 merchandising 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. Point: This activity complements the Ethics Challenge assignment.

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and

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©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw- Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

1 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 5A.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. *Next Period Adjustment The Allowance for Sales Discounts balance remains unchanged during a period except for the period-end adjusting entry. At next period-end, assume that Z- Mart computes an $80 balance for the Allowance for Sales Discounts. Using our three-step adjusting process we get: Step 1: Current bal. is $50 credit in Allowance for Sales Discounts. Step 2: Current bal. should be $80 credit in Allowance for Sales Discounts. Step 3: Record entry to get from step 1 to step 2. Sales Discounts 30 Allowance for Sales Discounts 30

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C1 C2

P1

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6 Inventories and Cost of Sales

Chapter Preview

INVENTORY BASICS

Determining inventory items Determining inventory costs Control of inventory Physical count

NTK 6-1

INVENTORY COSTING

Cost flow assumptions: Specific identification First-in, first-out Last-in, first-out Weighted average Effects on financial statements

NTK 6-2

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P2 A2 A3 P3 P4

C1 C2

A1 A2 A3

P1

P2 P3

P4

INVENTORY VALUATION, ERRORS, AND ANALYSIS

Lower of cost or market Effects of inventory errors Inventory management Appendix: Periodic system Appendix: Inventory estimation

NTK 6-3 , 6-4

Learning Objectives

CONCEPTUAL

Identify the items making up merchandise inventory. Identify the costs of merchandise inventory.

ANALYTICAL

Analyze the effects of inventory methods for both financial and tax reporting. Analyze the effects of inventory errors on current and future financial statements. Assess inventory management using both inventory turnover and days’ sales in inventory.

PROCEDURAL

Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average. Compute the lower of cost or market amount of inventory. Appendix 6A—Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average. Appendix 6B—Apply both the retail inventory and gross profit methods to estimate inventory.

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©Monica Schipper/Getty Images for NYCWFF

Shake It Up

“Show guests you care” —DANNY MEYER NEW YORK—Danny Meyer opened his first Shake Shack (ShakeShack.com) restaurant in Madison Square Park. The first Shake Shack was a hot dog stand! While much has changed since the first Shack, Danny’s commitment to high-quality ingredients has not.

“We call it fine-casual,” explains Danny. “Shake Shack . . . is proving that people don’t want to go backwards in terms of how their food was sourced, how it was cooked.”

Managing this “modern-day roadside burger stand” was not easy. Danny’s Shack grew from “$5,000 worth of hamburgers” to “$30,000-plus” of hamburgers per day. Danny needed an accounting system to track everything.

“The thinking back then was, to have a successful restaurant, the owner had to be there 24/7,” says Danny. To expand Shake Shack, that had to change. Danny put in an inventory system for each of his Shacks. “Great companies,” insists Danny, “figured [inventory] out.”

To ensure fresh sourced ingredients were available at the Shacks, Danny set up an inventory tracking system. He prepared and read inventory reports and applied inventory management tools. His inventory system tracks all transactions, and he regularly reviews accounting data in making key decisions.

“You need to get your ducks in a line,” asserts Danny. This means that Shake Shack must successfully manage its inventory, even as growth continues.

To be successful, Danny insists that “the numbers add up.” Once your financial house is in order, explains Danny, “you need to take more risk.” He adds, “The best start-ups are businesses that find a unique way to solve problems for people—sometimes problems that people didn’t even know they had.”

Sources: Shake Shack website, January 2019; Fool.com, December 2016; Eater.com, September 2016;

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Inc.com, May 2015

INVENTORY BASICS

Determining Inventory Items

C1_______ Identify the items making up merchandise inventory.

Merchandise inventory includes all goods that a company owns and holds for sale. This is true regardless of where the goods are located when inventory is counted. Special attention is directed at goods in transit, goods on consignment, and goods that are damaged or obsolete.

Goods in Transit Does a buyer’s inventory include goods in transit from a supplier? If ownership has passed to the buyer, the goods are included in the buyer’s inventory. We determine this by reviewing shipping terms.

FOB shipping point—goods are included in buyer’s inventory once they are shipped. FOB destination—goods are included in buyer’s inventory after arrival 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 consignor owns the consigned goods and reports them in its inventory. For example, Upper Deck pays sports celebrities such as Russell Wilson of the Seattle Seahawks to sign memorabilia, which are offered to card shops on consignment. Upper Deck, the consignor, reports these items in its inventory until sold. The consignee never reports consigned goods in inventory.

Goods Damaged or Obsolete Damaged, obsolete (out-of-date), and deteriorated goods are not reported in inventory if they cannot be sold. If these goods can be sold at a lower price, they are included in inventory at net realizable value. Net realizable value is sales price minus the cost of making the sale. A loss is recorded when the damage or obsolescence occurs.

Ethical Risk

Eyes in the Sky One of the largest builders, Homex, was accused of faking the construction and sale of 100,000 homes. How were they caught? When the SEC used satellite imagery to confirm the existence of homes, they found nothing but bare soil. SEC 2017-60 ■

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©Aleksandar Georgiev/Getty Images

Determining Inventory Costs

C2_______ Identify the costs of merchandise inventory.

Merchandise inventory includes costs to bring an item to a salable condition and location. Inventory costs include invoice cost minus any discount, plus any other costs. Other costs include shipping, storage, import duties, and insurance. The expense recognition principle says that inventory costs are expensed as cost of goods sold when inventory is sold.

Internal Controls and Taking a Physical Count Events can cause the Inventory account balance to be different than 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. This physical count is used to adjust the Inventory account balance to the actual inventory available. Fraud: Auditors observe employees as they count inventory. Auditors also take their own count to ensure accuracy.

Decision Insight

In Control A company applies internal controls when taking a physical count of inventory that usually include the following to minimize fraud and to increase reliability.

Prenumbered inventory tickets are distributed to counters—each ticket must be accounted for. Counters of inventory are assigned and do not include those responsible for inventory. Counters confirm the existence, amount, and condition of inventory. A second count is taken by a different counter.

A manager confirms all inventories are ticketed once, and only once. ■

Point: The Inventory account has subsidiary ledgers that contain a separate record (units and costs) for each separate product.

NEED-TO-KNOW 6-1

Inventory Items and Costs C1 C2

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1. A master carver of wooden birds operates her business out of a garage. At the end of the current period, the carver has 17 units (carvings) in her garage, 3 of which were damaged by water and cannot be sold. She also has another 5 units in her truck, ready to deliver per a customer order, terms FOB destination, and another 11 units out on consignment at retail stores. How many units does she include in the business’s period-end inventory?

2. A distributor of artistic iron-based fixtures acquires a piece for $1,000, terms FOB shipping point. Additional costs in obtaining it and offering it for sale include $150 for transportation-in, $300 for import duties, $100 for insurance during shipment, $200 for advertising, a $50 voluntary gratuity to the delivery person, $75 for enhanced store lighting, and $250 for sales staff salaries. For computing inventory, what cost is assigned to this artistic piece?

Solutions

1.

2.

Page 217Do More: QS 6-1, QS 6-2, QS 6-23, E 6-1, E 6-2

INVENTORY COSTING UNDER A PERPETUAL SYSTEM

When identical items are purchased at different costs, we must decide which amounts to record in cost of goods sold and which amounts remain in inventory. Four methods are used to assign costs to inventory and to cost of goods sold: (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted average. Exhibit 6.1 shows the frequency in use of these methods.

EXHIBIT 6.1 Frequency in Use of Inventory Methods

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Each method has a pattern for how costs flow through inventory. The cost flow assumption does not have to match the actual physical flow of goods. For example, Kroger’s grocery chain sells food first-in, first-out, meaning they sell the oldest food in inventory first. However, Kroger can use last-in, first-out to assign costs to food sold. With the exception of specific identification, the physical flow and cost flow do not have to be the same.

Inventory Cost Flow Assumptions To show inventory cost flow assumptions, 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 6.2 shows the flow of costs to either cost of goods sold on the income statement or inventory reported on the balance sheet for FIFO, LIFO, and weighted average. Point: Cost of goods sold is abbreviated COGS.

EXHIBIT 6.2 Cost Flow Assumptions

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(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. Point: Recall inventory cost flow.

(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 + $65 + $70)/3. 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 impact gross profit and inventory numbers. Exhibit 6.2 shows that gross profit ranges from $30 to $55 due to the cost flow assumption.

The following sections on inventory costing use the perpetual system. Appendix 6A uses the periodic system. An instructor can choose to cover either one or both systems. If the perpetual system is skipped, then read Appendix 6A and return to the “Valuing Inventory at LCM and the Effects of Inventory Errors” section.

Inventory Costing Illustration

P1_______ Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average.

This section demonstrates inventory costing methods. We use information from Trekking, a sporting goods store. Among its products, Trekking sells one type of mountain bike whose sales are directed at resorts that provide inexpensive bikes for guest use. 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 6.3. It ends August with 12 bikes in inventory.

EXHIBIT 6.3 Purchases and Sales of Goods

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©Michael DeYoung/Blend Images

Trekking uses the perpetual inventory system, which means that its Merchandise Inventory account is updated for each purchase and sale of inventory. (Appendix 6A describes the assignment of costs to inventory using a periodic system.) Regardless of what inventory method 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 matched with a specific purchase and invoice, we can use specific identification or SI to assign costs. We also need sales records that identify exactly which items were sold and when. Trekking’s internal documents show the following specific unit sales.

EXHIBIT 6.4 Specific Identification Computations

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Point: Specific identification is common for custom-made inventory. Examples include jewelers and fashion designers.

Trekking’s cost of goods sold reported on the income statement is $4,582, and ending inventory reported on the balance sheet is $1,408. The following graphic shows this flow of costs.

First-In, First-Out First-in, first-out (FIFO) 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. Exhibit 6.5 starts with beginning inventory of 10 bikes at $91 each.

EXHIBIT 6.5 FIFO Computations—Perpetual System

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August 3

August 14

August 17

August 30

Purchased 15 bikes costing $106 each for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500.

Sold 20 bikes—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.

Purchased 20 bikes costing $115 each, and on August 28, purchased another 10 bikes costing $119 each, for a total of 35 bikes costing $4,020 in inventory.

Sold 23 bikes—applying FIFO, the first 5 bikes sold cost $106 each and the next 18 sold cost $115 each, for a total of $2,600. This leaves 12 bikes costing $1,420 in ending inventory.

Point: “Goods Purchased” column is identical for all methods.

Trekking’s cost of goods sold reported on its income statement is $4,570 ($1,970 + $2,600), and its ending inventory reported on the balance sheet is $1,420.

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August 17

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Point: 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.

Last-In, First-Out Last-in, first-out (LIFO) 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. Exhibit 6.6 starts with beginning inventory of 10 bikes at $91 each.

EXHIBIT 6.6 LIFO Computations—Perpetual System

Purchased 15 bikes costing $106 each for $1,590. Inventory now consists of 10 bikes at $91 each and 15 bikes at $106 each, for a total of $2,500.

Sold 20 bikes—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 of $2,045. This leaves 5 bikes costing $91 each, or $455, in inventory.

Purchased 20 bikes costing $115 each, and on August 28, purchased another 10 bikes costing $119 each, for a total of 35 bikes costing $3,945 in inventory.

Sold 23 bikes—applying LIFO, the first 10 bikes sold are from the most recent purchase costing $119 each, and the next 13 sold are from the next most recent purchase costing $115 each, for a total of $2,685. This leaves 12 bikes costing $1,260 in ending inventory.

Trekking’s cost of goods sold reported on the income statement is $4,730 ($2,045 +

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$2,685), and its ending inventory reported on the balance sheet is $1,260.

Weighted Average Weighted averageor WA (also called average cost) requires that we use the weighted average cost per unit of inventory at the time of each sale.

Exhibit 6.7 starts with beginning inventory of 10 bikes at $91 each.

EXHIBIT 6.7 Weighted Average Computations—Perpetual System

Purchased 15 bikes costing $106 each 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 $2,500/(10 bikes + 15 bikes).

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August 17

August 30

Page 221Sold 20 bikes—applying WA, the 20 sold are assigned the $100 average cost, for a total of $2,000. This leaves 5 bikes with an average cost of $100 each, or $500, in inventory.

Purchased 20 bikes costing $2,300, and on August 28, purchased another 10 bikes costing $1,190, 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 $3,990/35 bikes.

Sold 23 bikes—applying WA, the 23 sold are assigned the $114 average cost, for a total of $2,622. This leaves 12 bikes costing $1,368 in ending inventory.

Trekking’s cost of goods sold reported on the income statement is $4,622 ($2,000 + $2,622), and its ending inventory reported on the balance sheet is $1,368.

Point: WA perpetual applied at each sale date.

Ethical Risk

Kickbacks and Invoice Fraud Inventory safeguards include restricted access, use of authorized requisitions, and security measures. Proper accounting includes matching inventory received with purchase order terms and quality requirements, preventing misstatements, and controlling access to records. A study reports that 35% of employees in purchasing and procurement observed improper kickbacks or gifts from suppliers. ■

Financial Statement Effects of Costing Methods

A1_______ Analyze the effects of inventory methods for both financial and tax reporting.

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, the methods assign different cost amounts. We show these differences in Exhibit 6.8 using Trekking’s data.

EXHIBIT 6.8 Financial Statement Effects of Inventory Costing Methods

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Rising Costs When purchase costs regularly rise, as in Trekking’s case, the following occurs.

FIFO reports the lowest cost of goods sold—yielding the highest gross profit and net income. LIFO reports the highest cost of goods sold—yielding the lowest gross profit and net income. Weighted average yields results between FIFO and LIFO.

Falling Costs 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. LIFO gives the lowest cost of goods sold—yielding the highest gross profit and income.

Method Advantages Each method offers advantages.

FIFO—inventory on the balance sheet approximates its current cost; it also follows the actual flow of goods for most businesses. LIFO—cost of goods sold on the income statement approximates its current cost; it also better matches current costs with revenues. Weighted average—smooths out erratic changes in costs. Specific identification—matches the costs of items with the revenues they generate.

Point: LIFO inventory is often less than the inventory’s replacement cost because LIFO inventory is valued using the oldest inventory purchase costs.

Tax Effects of Costing Methods Inventory costs affect net income and have potential tax effects. Exhibit 6.8 shows that Trekking gains a temporary tax advantage by using LIFO because it has less income to be

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taxed. Many companies use LIFO for this reason. The IRS requires that when LIFO is used for tax reporting, it also must be used for financial reporting—called LIFO conformity rule.

Decision Ethics

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. As 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: 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 believe you have earned and deserve. Your best decision is to tell your superior about the tax savings with LIFO. You should discuss your bonus plan and how this is likely to hurt you unfairly.

NEED-TO-KNOW 6-2

Perpetual SI, FIFO, LIFO, and WA P1

A company reported the following December purchase and sales data for its only product.

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) FIFO, (c) LIFO, and (d) weighted average. (Round per unit costs and inventory amounts to cents.) For specific identification, ending inventory consists of 10 units, where 8 are from the December 30 purchase and 2 are from the December 8 purchase. Specific units sales follow.

Sold 2 units costing $3.00 each and 6 units costing $4.50 each. Total cost = $33.00. Sold 3 units costing $3.00 each, 2 units costing $4.50 each, and 13 units

costing $5.00 each. Total cost = $83.00.

Solutions

a. Specific identification: Ending inventory—eight units from December 30 purchase and two units from December 8 purchase.

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b. FIFO—Perpetual.

OR “short-cut” FIFO—Perpetual.

c. LIFO—Perpetual.

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d. Weighted Average—Perpetual.

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Do More: QS 6-3, QS 6-4, QS 6-5, QS 6-6, QS 6-10, QS 6-11, QS 6-12, E 6-3

VALUING INVENTORY AT LCM AND THE EFFECTS OF INVENTORY ERRORS

This section covers how market value and inventory errors impact financial statements.

Lower of Cost or Market

P2_______ Compute the lower of cost or market amount of inventory.

After companies apply one of four costing methods (FIFO, LIFO, weighted average, or specific identification), inventory is reviewed to ensure it is reported at the lower of cost or market (LCM).

Computing the Lower of Cost or Market Market in the term LCM is replacement cost for LIFO, but net realizable value for the other three methods—advanced courses cover specifics. A decline in market value means a loss of value in inventory. When market value is lower than cost of inventory, a loss is recorded. When market value is higher than cost of inventory, no adjustment is made. Point: LCM applied to each individual item always yields the lowest inventory.

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. With the increasing use of technology and inventory tracking, companies increasingly apply LCM to each individual item separately. Accordingly, we show that method only; advanced courses cover other methods. To demonstrate LCM, we apply it to the ending inventory of a motorsports retailer in Exhibit 6.9.

EXHIBIT 6.9 Lower of Cost or Market Computations

For Roadster, $140,000 is the lower of the $170,000 cost and the $140,000 market. For Sprint, $50,000 is the lower of the $50,000 cost and the $60,000 market. This yields a $190,000 reported inventory, computed from $140,000 for Roadster plus $50,000 for Sprint.

Recording the Lower of Cost or Market Inventory is adjusted downward when total “LCM applied to items” is less than total cost of inventory. To demonstrate, if LCM is applied in Exhibit 6.9, the Merchandise Inventory account must be adjusted from the $220,000 recorded cost down to the $190,000 LCM amount as follows.

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NEED-TO-KNOW 6-3

LCM Method P2

A company has the following products in its ending inventory, along with cost and market values. (a) Compute the lower of cost or market for its inventory when applied separately to each product. (b) If the market amount is less than the recorded cost of the inventory, then record the December 31 LCM adjustment to the Merchandise Inventory account.

Solution

a.

b.

Do More: QS 6-19, E 6-10

Financial Statement Effects of Inventory Errors

A2_______ Analyze the effects of inventory errors on current and future financial statements.

An inventory error causes misstatements in cost of goods sold, gross profit, net income,

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current assets, and equity. It also causes misstatements in the next period’s statements because ending inventory of one period is the beginning inventory of the next. As we consider financial statement effects, we recall the following inventory relation.

Income Statement Effects Exhibit 6.10 shows the effects of inventory errors in the current and next period’s income statements.

EXHIBIT 6.10 Effects of Inventory Errors on the Income Statement

Row 1, Year 1. Understating ending inventory overstates cost of goods sold. This is because we subtract a smaller ending inventory in computing cost of goods sold. A higher cost of goods sold yields a lower income. Row 1, Year 2. Understated ending inventory for Year 1 becomes an understated beginning inventory for Year 2. If beginning inventory is understated, cost of goods sold is understated (because we are starting with a smaller amount). A lower cost of goods sold yields a higher income. Row 2, Year 1. Overstating ending inventory understates cost of goods sold. A lower cost of goods sold yields a higher income. Row 2, Year 2. Overstated ending inventory for Year 1 becomes an overstated beginning inventory for Year 2. If beginning inventory is overstated, cost of goods sold is overstated. A higher cost of goods sold yields a lower income.

Inventory Error Example Consider an inventory error for a company with $100,000 in sales for each of Year 1, Year 2, and Year 3. If this company has a steady $20,000 inventory level and makes $60,000 in purchases in each year, its cost of goods sold is $60,000 and its gross profit is $40,000.

Year 1 Understated Inventory: Year 1 Impact Assume the company makes an error in

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computing its Year 1 ending inventory and reports $16,000 instead of the correct amount of $20,000. The effects of this error are in Exhibit 6.11. The $4,000 understatement of Year 1 ending inventory causes a $4,000 overstatement in Year 1 cost of goods sold and a $4,000 understatement in both gross profit and net income for Year 1.

EXHIBIT 6.11 Effects of Inventory Errors on Three Periods’ Income Statements

Example: If Year 1 ending inventory in Exhibit 6.11 is overstated by $3,000, cost of goods sold is understated by $3,000 in Year 1 and overstated by $3,000 in Year 2. Net income is overstated in Year 1 and understated in Year 2. Assets and equity are overstated in Year 1.

Year 1 Understated Inventory: Year 2 Impact The Year 1 understated ending inventory becomes the Year 2 understated beginning inventory. This error causes an understatement in Year 2 cost of goods sold and a $4,000 overstatement in both gross profit and net income for Year 2.

Year 1 Understated Inventory: Year 3 Impact The Year 1 ending inventory error affects only that period and the next. It does not affect Year 3 results or any period thereafter.

Balance Sheet Effects Understating ending inventory 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 6.12 shows the effects of inventory errors on the current period’s balance sheet amounts.

EXHIBIT 6.12 Effects of Inventory Errors on Current Period’s Balance Sheet

NEED-TO-KNOW 6-4

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Effects of Inventory Errors A2

A company had $10,000 of sales, and purchased merchandise costing $7,000 in each of Year 1, Year 2, and Year 3. It also maintained a $2,000 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 1 that caused its Year 1 ending inventory to appear on its statements as $1,600 rather than the correct $2,000. (a) Determine the correct amount of the company’s gross profit in each of Year 1, Year 2, and Year 3. (b) Prepare comparative income statements as in Exhibit 6.11 to show the effect of this error on the company’s cost of goods sold and gross profit for each of Year 1, Year 2, and Year 3.

Solution

a. Correct gross profit = $10,000 − $7,000 = $3,000 (for each year). b. Cost of goods sold and gross profit figures follow.

Do More: QS 6-20, E 6-12

Decision Analysis Inventory Turnover and Days’ Sales in Inventory

Inventory Turnover

A3_______ Assess inventory management using both inventory turnover and days’ sales in inventory.

Inventory turnover, also called merchandise inventory turnover, is defined in Exhibit 6.13. Inventory turnover tells how many times a company turns over (sells) its inventory in a period. It is used to assess whether management is doing a good job controlling the amount of inventory. A low ratio means the company may have more inventory than it needs. A very high ratio means inventory might be too low.

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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 if inventory is adequate to meet demand.

EXHIBIT 6.13 Inventory Turnover

Point: Low inventory turnover can reveal obsolescence. Point: Inventory turnover is higher and days’ sales in inventory is lower for industries such as foods.

Days’ Sales in Inventory

Days’ sales in inventory is a ratio that shows how much inventory is available in terms of the number of days’ sales. It can be interpreted as the number of days one can sell from existing inventory if no new items are purchased. This ratio reveals the buffer against out-of-stock inventory and is useful in evaluating how quickly inventory is being sold. It is defined in Exhibit 6.14. Days’ sales in inventory uses ending inventory, whereas inventory turnover uses average inventory.

EXHIBIT 6.14 Days’ Sales in Inventory

Analysis of Inventory Management

Merchandisers must plan and control inventory purchases and sales. Costco’s inventory at the end of the current year was $9,834 million. This inventory was 57% of its current assets and 27% of its total assets. We apply the analysis tools in this section to Costco and Walmart, as shown in Exhibit 6.15.

EXHIBIT 6.15 Inventory Turnover and Days’ Sales in Inventory for Costco and Walmart

Costco’s current year inventory turnover of 11.9 times means that it turns over its inventory 11.9 times per year. Costco’s inventory turnover exceeded Walmart’s turnover in each of the last three years. This is a positive for Costco, as we prefer

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inventory turnover to be high provided inventory is not out of stock and the company is not losing customers. Days’ sales in inventory of 32.1 days means that Costco is carrying 32.1 days of sales in inventory. This inventory buffer seems sufficient. As long as Costco is not at risk of running out of stock, it prefers its assets not be tied up in inventory. Point: Take care when comparing turnover ratios across companies that use different costing methods (such as FIFO and LIFO).

Decision Maker

Entrepreneur Your retail store has 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: Your inventory turnover is higher than the norm, whereas days’ sales in inventory approximates the norm. Because your turnover is already 14% better than average, you should probably direct attention to days’ sales in inventory. You should see if you can reduce the level of inventory while maintaining service to customers. Given your higher turnover, you should be able to hold less inventory.

NEED-TO-KNOW 6-5 COMPREHENSIVE 1

Perpetual Method: Computing Inventory Using LIFO, FIFO, WA, and SI; Financial Statement Impacts; and Inventory Errors

Craig Company buys and sells one product. Its beginning inventory, purchases, and sales during calendar-year 2019 follow.

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. Compute the cost of goods available for sale. 2. Apply the four methods of inventory costing (FIFO, LIFO, weighted

average, and specific identification) to compute 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

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1.

balance sheet for each of the four methods. 4. In preparing financial statements for year 2019, 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 2019’s income from the error. Also determine the effect of this error on year 2020’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 purchase 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 6.5). Prepare a perpetual LIFO table starting with beginning inventory and showing how inventory changes after each purchase and after each sale (see Exhibit 6.6). Make a table of purchases and sales recalculating the average cost of inventory prior to each sale to arrive at the weighted average cost of ending inventory. Total the average costs associated with each sale to determine cost of goods sold (see Exhibit 6.7). Prepare a table showing the computation of cost of goods sold and ending inventory using the specific identification method (see Exhibit 6.4). Compare the year-end 2019 inventory amounts under FIFO and LIFO to determine the misstatement of year 2019 income that results from using LIFO. The errors for years 2019 and 2020 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 were adopted.

SOLUTION

Cost of goods available for sale (this amount is the same for all methods).

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2a. Page 230

FIFO perpetual method.

Note: 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 approach 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 ending inventory first]

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2b.

2c.

[FIFO Alternate No. 2: Computing cost of goods sold first]

LIFO perpetual method.

Weighted average perpetual method.

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3.

Specific identification method.

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4. Mistakenly using LIFO when FIFO should have been used overstates cost of goods sold in year 2019 by $1,400, which is the difference between the FIFO and LIFO amounts of ending inventory. It understates income in 2019 by $1,400. In year 2020, income is overstated by $1,400 because of the understatement in beginning inventory.

5. Analysis of the effects of alternative inventory methods.

NEED-TO-KNOW 6-6 COMPREHENSIVE 2

Periodic Method: Computing Inventory Using LIFO, FIFO, WA, and SI; Financial Statement Impacts; and Inventory Errors

Craig Company buys and sells one product. Its beginning inventory, purchases, and sales during calendar-year 2019 follow.

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. Compute the cost of goods available for sale. 2. Apply the four methods of inventory costing (FIFO, LIFO, weighted

average, and specific identification) to compute 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 2019, the financial officer was instructed to use FIFO but failed to do so and instead computed cost of

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2a.

goods sold according to LIFO. Determine the impact of the error on year 2019’s income. Also determine the effect of this error on year 2020’s income. Assume no income taxes.

PLANNING THE SOLUTION

Compute cost of goods available for sale by multiplying the units of beginning inventory and each purchase by their unit costs to determine the total cost of goods available for sale. Prepare a periodic FIFO computation starting with cost of units available and subtracting FIFO ending inventory amounts to obtain FIFO cost of goods sold (see Exhibit 6A.3). Prepare a periodic LIFO computation starting with cost of units available and subtracting LIFO ending inventory amounts to obtain LIFO cost of goods sold (see Exhibit 6A.4). Compute weighted average ending inventory and cost of goods sold using the three-step process illustrated in Exhibits 6A.5a and 6A.5b. Prepare a table showing the computation of cost of goods sold and ending inventory using the specific identification method (see Exhibit 6A.2). Compare the year-end 2019 inventory amounts under FIFO and LIFO to determine the misstatement of year 2019 income that results from using LIFO. The errors for years 2019 and 2020 are equal in amount but opposite in effect.

SOLUTION

1. Cost of goods available for sale (this amount is the same for all methods).

FIFO periodic method.

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2b.

Page 2332c.

2d.

LIFO periodic method.

Weighted average periodic method.

Specific identification method.

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4.

3.

6A

Mistakenly using LIFO, when FIFO should have been used, overstates cost of goods sold in year 2019 by $2,450, which is the difference

between the FIFO and LIFO amounts of ending inventory. It understates income in 2019 by $2,450. In year 2020, income is overstated by $2,450 because of the understatement in beginning inventory.

APPENDIX

Inventory Costing under a Periodic System P3_______ Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average.

This section demonstrates inventory costing methods. We use information from Trekking, a sporting goods store. Among its many products, Trekking sells one type of mountain bike whose sales are directed at resorts that provide inexpensive bikes for guest use. 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 6A.1. It ends August with 12 bikes remaining in inventory.

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EXHIBIT 6A.1 Purchases and Sales of Goods

Trekking uses the periodic inventory system, which means that its Merchandise Inventory account is updated at the end of each period (monthly for Trekking) to reflect purchases and sales. Regardless of what inventory method is used, cost of goods available for sale must be allocated between cost of goods sold and ending inventory. (Many companies use the periodic system for tracking costs [not so much for sales]. Reasons include the use of standard costs by some companies and dollar-value LIFO by others. Also, the methods of specific identification and FIFO, used by a majority of companies, give the same result under the periodic and the perpetual systems.)

Specific Identification When each item in inventory can be matched with a specific purchase and invoice, we can use specific identification or SI to assign costs. We also need sales records that identify exactly which items were sold and when. Trekking’s internal documents show the following specific unit sales.

EXHIBIT 6A.2 Specific Identification Computations

Trekking’s cost of goods sold reported on the income statement is $4,582, and ending inventory reported on the balance sheet is $1,408. The following graphic shows these cost flows. Point: Specific identification is common for custom-made inventory. Examples include jewelers and fashion designers.

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Point: SI yields identical results under both periodic and perpetual.

First-In, First-Out First-in, first-out (FIFO) 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.

Exhibit 6A.3 starts with $5,990 in total units available for sale. Applying FIFO, the 12 units in ending inventory are reported at the cost of the most recent 12 purchases. Reviewing purchases in reverse order, we assign costs to the 12 bikes in ending inventory as follows: $119 cost to 10 bikes and $115 cost to 2 bikes. This yields $1,420 in ending inventory. We subtract this $1,420 in ending inventory from $5,990 in cost of goods available to get $4,570 in cost of goods sold. Point: For FIFO, COGS and ending inventory are the same for periodic and perpetual.

EXHIBIT 6A.3 FIFO Computations—Periodic System

Last-In, First-Out Last-in, first-out (LIFO) assumes that the most recent purchases are sold first. These more recent costs are charged to goods sold, and the costs of the earliest purchases are assigned to inventory. Point: 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.

Exhibit 6A.4 starts with $5,990 in total units available for sale. Applying LIFO, the 12 units in ending inventory are reported at the cost of the earliest 12 purchases. Reviewing the earliest purchases in order, we assign costs to the 12 bikes in ending

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inventory as follows: $91 cost to 10 bikes and $106 cost to 2 bikes. This yields $1,122 in ending inventory. We 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 6A.4 LIFO Computations—Periodic System

Weighted Average Weighted average or WA (also called average 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 has three steps. The first two steps are shown in Exhibit 6A.5a. Step 1 in Exhibit 6A.5a multiplies the per unit cost for beginning inventory and each purchase by the number of units (from Exhibit 6A.1). Step 2 adds these amounts and divides by the total number of units available for sale to find the weighted average cost per unit.

EXHIBIT 6A.5A Weighted Average Cost per Unit

Step 3 uses the weighted average cost per unit to assign costs to ending inventory and to cost of goods sold, as shown in Exhibit 6A.5b.

EXHIBIT 6A.5B Weighted Average Computations—Periodic

Trekking’s ending inventory reported on the balance sheet is $1,307, and its cost of

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goods sold reported on the income statement is $4,683.

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, the methods assign different cost amounts. We show these differences in Exhibit 6A.6 using Trekking’s data.

EXHIBIT 6A.6 Financial Statement Effects of Inventory Costing Methods

Rising Costs When purchase costs regularly rise, as in Trekking’s case, the following occurs.

FIFO reports the lowest cost of goods sold—yielding the highest gross profit and net income. LIFO reports the highest cost of goods sold—yielding the lowest gross profit and net income. Weighted average yields results between FIFO and LIFO.

Falling Costs 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. LIFO gives the lowest cost of goods sold—yielding the highest gross profit and income.

Method Advantages Each method offers advantages.

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FIFO—inventory on the balance sheet approximates its current cost; it also follows the actual flow of goods for most businesses. LIFO—cost of goods sold on the income statement approximates its current cost; it also better matches current costs with revenues. Weighted average—smooths out erratic changes in costs. Specific identification—matches the costs of items with the revenues they generate.

Point: LIFO inventory is often less than the inventory’s replacement cost because LIFO inventory is valued using the oldest inventory purchase costs.

NEED-TO-KNOW 6-7

Periodic SI, FIFO, LIFO, and WA P3

A company reported the following December purchases and sales data for its only product.

The company uses a periodic inventory system. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) FIFO, (c) LIFO, and (d) weighted average. (Round per unit costs and inventory amounts to cents.) For specific identification, ending inventory consists of 10 units, where 8 are from the December 30 purchase and 2 are from the December 8 purchase.

Solution

a. Specific identification: Ending inventory—eight units from December 30 purchase and two units from December 8 purchase.

b. FIFO—Periodic.

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6B

c. LIFO—Periodic.

d. WA—Periodic.

Do More: QS 6-7, QS 6-8, QS 6-9, QS 6-14, QS 6-15, QS 6-16, QS 6-17, E 6-5

APPENDIX

Inventory Estimation Methods P4_______ Apply both the retail inventory and gross profit methods to estimate inventory.

Inventory sometimes is estimated for two reasons. First, companies often report interim financial statements (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 companies 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 process of taking a physical inventory, some companies use the retail inventory method to estimate cost of goods sold and ending inventory.

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 already explained how

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to compute the cost of inventory. The retail amount of inventory is measured using selling prices of inventory items. We also need to know the net amount of goods purchased (minus returns, allowances, and discounts) in the period, both at cost and at retail. The amount of net sales at retail also is needed. The process is shown in Exhibit 6B.1.

EXHIBIT 6B.1 Retail Inventory Method of Inventory Estimation

The reasoning behind the retail inventory method is that if we can get a good estimate of the cost-to-retail ratio, we can multiply ending inventory at retail by this ratio to estimate ending inventory at cost. Exhibit 6B.2 shows how these steps are applied to estimate ending inventory. First, we find that $100,000 of goods (at retail selling prices) were available for sale. A total of $70,000 of these goods were sold, leaving $30,000 (retail value) of merchandise in ending inventory. Second, the cost of these goods is 60% of the $100,000 retail value. Third, because cost for these goods is 60% of retail, the estimated cost of ending inventory is $18,000.

EXHIBIT 6B.2 Estimated Inventory Using the Retail Inventory Method

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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 used when inventory is destroyed, lost, or stolen. 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 subtracted from cost of goods available for sale to estimate the ending inventory at cost. These two steps are shown in Exhibit 6B.3.

EXHIBIT 6B.3 Gross Profit Method of Inventory Estimation

To demonstrate, assume that a company’s inventory is destroyed by fire in March. When the fire occurs, the company’s accounts show the following balances for January through March: Net Sales, $30,000; Beginning Inventory, $12,000 (at January 1); 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 6B.4 how this 70% is used to estimate lost inventory of $11,500.

EXHIBIT 6B.4 Estimated Inventory Using the Gross Profit Method

NEED-TO-KNOW 6-8

Retail Inventory Estimation P4

Using the retail method and the following data, estimate the cost of ending inventory.

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Solution

Estimated ending inventory (at cost) is $327,000. It is computed as follows.

Do More: QS 6-22, E 6-16, E 6-17, P 6-9

Summary: Cheat Sheet

INVENTORY BASICS

FOB shipping point: Goods are included in buyer’s inventory once they are shipped. FOB destination: Goods are included in buyer’s inventory after arrival at their destination. Consignee: Never reports consigned goods in inventory; stays in consignor’s inventory until sold. Merchandise inventory: Includes any necessary costs to make an item ready for sale. Examples—shipping, storage, import fees, and insurance.

INVENTORY COSTING

FIFO: Earliest units purchased are the first to be reported as cost of goods sold. LIFO: Latest units purchased are the first to be reported as cost of goods sold. Weighted average: The weighted average cost per unit (formula below) of inventory at the time of each sale is reported as cost of goods sold.

Specific identification: Each unit is assigned a cost, and when that unit is sold, its cost is reported as cost of goods sold. Cost Flow Assumptions Example

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Financial Statement Effects Rising Costs—FIFO reports lowest cost of goods sold and highest net income. LIFO reports highest cost of goods sold and lowest income. Weighted average reports results in between LIFO and FIFO. Falling Costs—FIFO reports highest cost of goods sold and lowest net income. LIFO reports lowest cost of goods sold and highest income.

INVENTORY VALUATION, ERRORS, & ANALYSIS

Lower of cost or market (LCM): When market value of inventory is lower than its cost, a loss is recorded. When market value is higher than cost of inventory, no adjustment is made. LCM Example (applied to individual items separately)

Roadster: $140,000 is the lower of the $170,000 cost and $140,000 market. Sprint: $50,000 is the lower of the $50,000 cost and $60,000 market. LCM: Results in a $190,000 reported inventory. LCM Journal Entry: To get from $220,000 reported inventory to the $190,000 LCM inventory, make the following entry.

Effects of Overstated or Understated Inventory for Income Statement

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1.

Effects of Overstated or Understated Inventory for Balance Sheet

Key Terms

Average cost (220, 235) Consignee (215) Consignor (215) Days’ sales in inventory (227) First-in, first-out (FIFO) (219, 234) Gross profit method (239) Interim financial statements (238) Inventory turnover (227) Last-in, first-out (LIFO) (219, 235) Lower of cost or market (LCM) (224) Net realizable value (216) Retail inventory method (238) Specific identification (SI) (218, 234) Weighted average (WA) (220, 235)

Multiple Choice Quiz

Use the following information from Marvel Company for the month of July to answer questions 1 through 4.

Perpetual: Assume that Marvel uses a perpetual FIFO inventory system. What is the dollar value of its ending inventory?

a. $2,940

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2.

3.

4.A

i)

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b. $2,685

c. $2,625

d. $2,852

e. $2,705

Perpetual: Assume that Marvel uses a perpetual LIFO inventory system. What is the dollar value of its ending inventory?

a. $2,940

b. $2,685

c. $2,625

d. $2,852

e. $2,705

Perpetual and Periodic: Assume that Marvel uses a specific identification inventory system. Its ending inventory consists of 20 units from beginning inventory, 40 units from the July 3 purchase, and 45 units from the July 15 purchase. What is the dollar value of its ending inventory?

a. $2,940

b. $2,685

c. $2,625

d. $2,852

e. $2,840

Periodic: Assume that Marvel uses a periodic FIFO inventory system. What is the dollar value of its ending inventory? a. $2,940

b. $2,685

c. $2,625

d. $2,852

e. $2,705

Periodic: A company reports the following beginning inventory and purchases, and it ends the period with 30 units in inventory.

Compute ending inventory using the FIFO periodic system. a. $400

b. $1,460

c. $1,360

d. $300

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ii)

6.

1.

2.

Compute cost of goods sold using the LIFO periodic system. a. $400

b. $1,460

c. $1,360

d. $300

A company has cost of goods sold of $85,000 and ending inventory of $18,000. Its days’ sales in inventory equals

a. 49.32 days.

b. 0.21 day.

c. 4.72 days.

d. 77.29 days.

e. 1,723.61 days.

ANSWERS TO MULTIPLE CHOICE QUIZ

a; FIFO perpetual

b; LIFO perpetual

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3.

4.

5.

6.

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e; Specific identification (perpetual and periodic are identical for specific identification)—Ending inventory computation follows.

a; FIFO periodic. Ending inventory computation: 105 units @ $28 each = $2,940. (Hint: FIFO periodic inventory computation is identical to the FIFO perpetual inventory computation.)

i) a; FIFO periodic inventory = (20 × $14) + (10 × $12) = $400 ii) b; LIFO periodic cost of goods sold = (20 × $14) + (40 × $12) + (70 × $10) = $1,460

d; Days’ sales in inventory = (Ending inventory/Cost of goods sold) × 365 = ($18,000/$85,000) × 365 = 77.29 days

A(B) Superscript letter A or B denotes assignments based on Appendix 6A or 6B.

Icon denotes assignments that involve decision making.

Discussion Questions

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. If costs are declining, will the LIFO or FIFO method of inventory valuation yield the lower cost of goods sold? Why?

4. If inventory errors are said to correct themselves, why are accounting users concerned when such errors are made?

5. Explain the following statement: “Inventory errors correct themselves.” 6. What is the meaning of market as it is used in determining the lower of cost or

market for inventory? 7. What factors contribute to (or cause) inventory shrinkage? 8. B When preparing interim financial statements, what two methods can

companies utilize to estimate cost of goods sold and ending inventory? 9. Refer to Apple’s financial statements in Appendix A. On

September 30, 2017, what percent of current assets is represented by inventory?

10. Refer to Apple’s financial statements in Appendix A and compute its cost of goods available for sale for the year ended September 30, 2017.

11. Refer to Samsung’s financial statements in Appendix A. Compute its cost of

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goods available for sale for the year ended December 31, 2017.

12. Refer to Samsung’s financial statements in Appendix A. What percent of its current assets is inventory as of December 31, 2017 and 2016?

QUICK STUDY

QS 6-1 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 looks over her inventory and finds that she has

1,300 units (products) in her basement, 20 of which were damaged by water and cannot be sold. 350 units in her van, ready to deliver per a customer order, terms FOB destination. 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?

QS 6-2 Inventory costs C2 A car dealer acquires a used car for $14,000, with terms FOB shipping point. Compute total inventory costs assigned to the used car if additional costs include

$250 for transportation-in. $300 for shipping insurance. $900 for car import duties. $150 for advertising. $1,250 for sales staff salaries. $180 for trimming shrubs.

QS 6-3 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. Compute 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 6-4 Perpetual: Inventory costing with FIFO P1 A company reports the following beginning inventory and two purchases for the month of January. On January 26, the company sells 350 units. Ending inventory at January 31 totals 150 units.

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Required Assume the perpetual 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 6-5 Perpetual: Inventory costing with LIFO P1 Refer to the information in QS 6-4 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 6-6 Perpetual: Inventory costing with weighted average P1 Refer to the information in QS 6-4 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.)

QS 6-7A Periodic: Inventory costing with FIFO P3 Refer to the information in QS 6-4 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 6-8A Periodic: Inventory costing with LIFO P3 Refer to the information in QS 6-4 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 6-9A Periodic: Inventory costing with weighted average P3 Refer to the information in QS 6-4 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 6-10 Perpetual: Assigning costs with FIFO P1 Trey Monson starts a merchandising business on December 1 and enters into the following three inventory purchases. Also, on December 15, Monson sells 15 units for $20 each.

Required

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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 6-11 Perpetual: Inventory costing with LIFO P1 Refer to the information in QS 6-10 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 6-12 Perpetual: Inventory costing with weighted average P1 Refer to the information in QS 6-10 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.)

QS 6-13 Perpetual: Inventory costing with specific identification P1 Refer to the information in QS 6-10 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 6-14A Periodic: Inventory costing with FIFO P3 Refer to the information in QS 6-10 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 6-15A Periodic: Inventory costing with LIFO P3 Refer to the information in QS 6-10 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 6-16A Periodic: Inventory costing with weighted average P3 Refer to the information in QS 6-10 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 6-17A Periodic: Inventory costing with specific identification P3 Refer to the information in QS 6-10 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.)

QS 6-18 Contrasting inventory costing methods A1 Identify the inventory costing method (SI, FIFO, LIFO, or WA) best described by each of the following separate statements. Assume a period of increasing costs.

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_____ 1. _____ 2. _____ 3.

_____ 4. _____ 5.

Results in the highest cost of goods sold. Yields the highest net income. Has the lowest tax expense because of reporting the lowest net

income. Better matches current costs with revenues. Precisely matches the costs of items with the revenues they generate.

QS 6-19 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.

QS 6-20 Inventory errors A2 In taking a physical inventory at the end of Year 1, Grant Company forgot to count certain units and understated ending inventory by $10,000. Determine how this error affects each of the following.

a. Year 1 cost of goods sold b. Year 1 net income c. Year 2 cost of goods sold d. Year 2 net income

QS 6-21 Analyzing inventory A3 Endor Company begins the year with $140,000 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 there are 365 days in the year.

QS 6-22B Estimating inventories—gross profit method P4 Confucius Bookstore’s inventory is destroyed by a fire on September 5. The following data for the current year are available from the accounting records. Estimate the cost of the inventory destroyed.

QS 6-23 Inventory costs C2

A solar panel dealer acquires a used panel for $9,000, with terms FOB shipping

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point. Compute total inventory costs assigned to the used panel if additional costs include

$1,500 for sales staff salaries. $135 for shipping insurance. $280 for transportation-in by train. $550 for used panel restoration. $110 for online advertising. $300 for lawn care.

EXERCISES

Exercise 6-1 Inventory ownership C1

1. At year-end, Barr Co. had shipped $12,500 of merchandise FOB destination to Lee Co. Which company should include the $12,500 of merchandise in transit as part of its year-end inventory?

2. Parris Company has shipped $20,000 of goods to Harlow Co., and Harlow Co. has arranged to sell the goods for Parris. Identify the consignor and the consignee. Which company should include any unsold goods as part of its inventory?

Exercise 6-2 Inventory costs C2 Walberg Associates, antique dealers, purchased goods for $75,000. Terms of the purchase were FOB shipping point, and the cost of transporting the goods to Walberg Associates’s 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 inventory.

Exercise 6-3 Perpetual: Inventory costing methods P1 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,

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and 15 are from beginning inventory. Check Ending inventory: LIFO, $930; WA, $918

Exercise 6-4 Perpetual: Income effects of inventory methods A1 Use the data in Exercise 6-3 to prepare comparative income statements for the month of January for Laker Company similar to those shown in Exhibit 6.8 for the four inventory methods. Assume expenses are $1,250 and 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 above, between, or below that

using FIFO and LIFO? 3. If costs were rising instead of falling, which method would yield the highest

net income?

Exercise 6-5A Periodic: Inventory costing P3 Refer to the information in Exercise 6-3 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.) 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.

Exercise 6-6A Periodic: Income effects of inventory methods P3 A1 Use the data and results from Exercise 6-5 to prepare comparative income statements for the month of January for the company similar to those shown in Exhibit 6.8 for the four inventory methods. Assume expenses are $1,250 and 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 above, between, or below that

using FIFO and LIFO? 3. If costs were rising instead of falling, which method would yield the highest

net income?

Exercise 6-7 Perpetual: Inventory costing methods—FIFO and LIFO P1 Hemming Co. reported the following current-year purchases and sales for its only product.

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Page 246Required 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. (c) Compute the gross margin for each method. (Round amounts to cents.) Check Ending inventory: LIFO, $4,150

Exercise 6-8 Specific identification P1 Refer to the information in Exercise 6-7. 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, compute (a) the cost of goods sold and (b) the gross profit. (Round amounts to cents.)

Exercise 6-9A Periodic: Inventory costing P3 Refer to the information in Exercise 6-7 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. (c) Compute the gross margin for each method.

Exercise 6-10 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.

Check LCM = $7,394

Exercise 6-11 Comparing LIFO numbers to FIFO numbers; ratio analysis A1 A3 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.

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Check (1) FIFO: Current ratio, 1.5; Inventory turnover, 3.8 times

1. Compute its current ratio, inventory turnover, and days’ sales in inventory for Year 2 using (a) LIFO numbers and (b) FIFO numbers. (Round answers to one decimal.)

2. Comment on and interpret the results of part 1.

Exercise 6-12 Analyzing inventory errors A2 Vibrant Company had $850,000 of sales in each of Year 1, Year 2, and Year 3, 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 1 that caused its Year 1 ending 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 Year 1, Year 2, and Year 3.

2. Prepare comparative income statements as in Exhibit 6.11 to show the effect of this error on the company’s cost of goods sold and gross profit for each of Year 1, Year 2, and Year 3.

Exercise 6-13 Inventory turnover and days’ sales in inventory A3 Use the following information for Palmer Co. to compute inventory turnover for Year 3 and Year 2, and its days’ sales in inventory at December 31, Year 3 and Year 2. (Round answers to one decimal.) Comment on Palmer’s efficiency in using its assets to increase sales from Year 2 to Year 3.

Exercise 6-14A Periodic: Cost flow assumptions P3 Lopez Company 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.) (e) Which method yields the highest net income?

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Check Inventory; LIFO, $313.50; FIFO, $435.00

Exercise 6-15A Periodic: Cost flow assumptions P3 Flora’s Gifts reported the following current-month 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.) (e) Which method yields the lowest net income?

Check Inventory: LIFO, $180.00; FIFO, $131.40

Exercise 6-16B Estimating ending inventory—retail method P4 Dakota Company had net sales (at retail) of $260,000. The following additional information is available from its records. Use the retail inventory method to estimate Dakota’s year-end inventory at cost.

Check End. inventory at cost, $35,860

Exercise 6-17B Estimating ending inventory—gross profit method P4 On January 1, JKR Shop had $225,000 of beginning 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.

Exercise 6-18 Perpetual inventory costing P1

Tree Seedlings has the following current-year purchases and sales for its only

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product.

Required The company uses a perpetual inventory system. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. (c) Compute the gross margin for each method.

Exercise 6-19A Periodic inventory costing P3

Refer to the information in Exercise 6-18 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. (c) Compute the gross margin for each method.

PROBLEM SET A

Problem 6-1A Perpetual: Alternative cost flows P1 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.)

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.)

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Check (3) Ending inventory: FIFO, $14,800; LIFO, $13,680; WA, $14,352

4. Compute gross profit earned by the company for each of the four costing methods in part 3. (4) LIFO gross profit, $17,980

Problem 6-2AA Periodic: Alternative cost flows P3 Refer to the information in Problem 6-1A 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.

Problem 6-3A Perpetual: Alternative cost flows P1 Montoure Company uses a perpetual inventory system. It entered into the following calendar-year 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.)

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.) Check (3) Ending inventory: FIFO, $18,400; LIFO, $18,000; WA, $17,760

4. Compute gross profit earned by the company for each of the four costing methods in part 3. (4) LIFO gross profit, $45,800

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Analysis Component

5. The company’s manager earns a bonus based on a percent of gross profit. Which method of inventory costing produces the highest bonus for the manager?

Problem 6-4AA Periodic: Alternative cost flows P3 Refer to the information in Problem 6-3A 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. The company’s manager earns a bonus based on a percentage of gross profit. Which method of inventory costing produces the highest bonus for the manager?

Problem 6-5A Lower of cost or market P2 A physical inventory of Liverpool Company taken at December 31 reveals the following.

Required

1. Compute the lower of cost or market for the inventory applied separately to each item. Check (1) $273,054

2. If the market amount is less than the recorded cost of the inventory, then record the LCM adjustment to the Merchandise Inventory account.

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Problem 6-6A 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: Year 1 ending inventory is understated by $56,000 and Year 2 ending inventory 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: Year 1, $286,000; Year 2, $209,000; Year 3, $261,000

2. What is the total error in combined net income for the three-year period resulting from the inventory errors? Explain.

Problem 6-7AA Periodic: Alternative cost flows P3 Seminole Co. began the year with 23,000 units of product in its January 1 inventory costing $15 each. It made four purchases of its product during the year as follows. The company uses a periodic inventory system. On December 31, a physical count reveals that 40,000 units of its product remain in inventory.

Required

1. Compute the number and total cost of the units available for sale during the year.

2. Compute the amounts assigned to 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

Problem 6-8AA Periodic: Income comparisons and cost flows A1 P3 QP Corp. sold 4,000 units of its product at $50 per unit during the year and incurred

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operating expenses of $5 per unit in selling the units. It began the year with 700 units in inventory and made successive purchases of its product as follows.

Required

1. Prepare comparative income statements similar to Exhibit 6.8 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%. Check (1) Net income: FIFO, $61,200; LIFO, $57,180; WA, $59,196

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 continuing trend of increasing costs.

Problem 6-9AB Retail inventory method P4 The records of Alaska Company provide the following information for the year ended December 31.

Required

1. Use the retail inventory method to estimate the company’s year-end inventory at cost. Check (1) Inventory, $924,182 cost

2. A year-end physical inventory at retail prices yields a total inventory of $1,686,900. Prepare a calculation showing the company’s loss from shrinkage at cost and at retail. (2) Inventory shortage at cost, $36,873

Problem 6-10AB 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 following information for the first

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quarter is available from its records.

Required Use the gross profit method to estimate the company’s first-quarter ending inventory. Check Estimated ending inventory, $449,805

PROBLEM SET B

Problem 6-1B Perpetual: Alternative cost flows P1 Ming 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.)

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.) Check (3) Ending inventory: FIFO, $24,000; LIFO, $15,000; WA, $20,000

4. Compute gross profit earned by the company for each of the four costing methods in part 3. (4) LIFO gross profit, $549,500

Problem 6-2BA Periodic: Alternative cost flows P3 Refer to the information in Problem 6-1B and assume the periodic inventory system is used.

Required

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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 6-3B Perpetual: Alternative cost flows P1 Aloha Company uses a perpetual inventory system. It entered into the following calendar-year 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.) Check (3) Ending inventory: FIFO, $88,800; LIFO, $62,500; WA, $75,600

4. Compute gross profit earned by the company for each of the four costing methods in part 3. (4) LIFO gross profit, $449,200

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 6-4BA Periodic: Alternative cost flows P3 Refer to the information in Problem 6-3B and assume the periodic inventory system is used.

Required

1. Compute cost of goods available for sale and the number of units available for

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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 inventory costing will the manager likely prefer?

Problem 6-5B Lower of cost or market P2 A physical inventory of Office Necessities Company taken at December 31 reveals the following.

Required

1. Compute the lower of cost or market for the inventory applied separately to each item. Check (1) $580,054

2. If the market amount is less than the recorded cost of the inventory, then record the LCM adjustment to the Merchandise Inventory account.

Problem 6-6B 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: Year 1 ending inventory is overstated by $18,000 and Year 2 ending inventory is understated by $26,000.

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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: Year 1, $157,800; Year 2, $256,270; Year 3, $158,910

2. What is the total error in combined net income for the three-year period resulting from the inventory errors? Explain.

Problem 6-7BA Periodic: Alternative cost flows P3 Seneca Co. began the year with 6,500 units of product in its January 1 inventory costing $35 each. It made four purchases of its product during the year as follows. The company uses a periodic inventory system. On December 31, a physical count reveals that 8,500 units of its product remain in inventory.

Required

1. Compute the number and total cost of the units available for sale during the year.

2. Compute the amounts assigned to 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, $1,328,700; LIFO, $1,266,500; WA, $1,294,800

Problem 6-8BA Periodic: Income comparisons and cost flows A1 P3 Shepard Company sold 4,000 units of its product at $100 per unit during the year 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.

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Required

1. Prepare comparative income statements similar to Exhibit 6.8 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%. Check (1) Net income: LIFO, $52,896; FIFO, $57,000; WA, $55,200

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 continuing trend of increasing costs.

Problem 6-9BB Retail inventory method P4 The records of Macklin Co. provide the following information for the year ended December 31.

Required

1. Use the retail inventory method to estimate the company’s year-end inventory. Check (1) Inventory, $66,555 cost

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. (2) Inventory shortage at cost, $12,251.25

Problem 6-10BB 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.

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Required Use the gross profit method to estimate the company’s first-quarter ending inventory. Check Est. ending inventory, $619,892

SERIAL PROBLEM

Business Solutions P2 A3 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.

©Alexander Image/ Shutterstock

SP 6 Part A Santana Rey of Business Solutions is evaluating her inventory to determine whether it must be adjusted based on lower of cost or market rules. Business Solutions has three different types of software in its inventory, and the following information is available for each.

Required Compute the lower of cost or market for ending inventory assuming Rey applies the

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lower of cost or market rule to each product in inventory. Must Rey adjust the reported inventory value? Explain. Part B Selected accounts and balances for the three months ended March 31, 2020, for Business Solutions follow.

Required

1. Compute inventory turnover and days’ sales in inventory for the three months ended March 31, 2020.

2. Assess the company’s performance if competitors average 15 times for inventory turnover and 25 days for days’ sales in inventory.

Accounting Analysis

COMPANY ANALYSIS C2 A3

AA 6-1 Use Apple’s financial statements in Appendix A to answer the following.

Required

1. What amount of inventories did Apple report as a current asset (a) on September 30, 2017? (b) On September 24, 2016?

2. Inventories make up what percent of total assets (a) on September 30, 2017? (b) On September 24, 2016?

3. Assuming Apple has enough inventory to meet demand, does Apple prefer inventory to be a lower or higher percentage of total assets?

4. Compute (a) inventory turnover for fiscal year ended September 30, 2017, and (b) days’ sales in inventory as of September 30, 2017.

COMPARATIVE ANALYSIS A3

AA 6-2 Comparative figures for Apple and Google follow.

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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. In the current year, does (a) Apple’s and (b) Google’s inventory turnover underperform or outperform the industry (assumed) average of 15?

GLOBAL ANALYSIS A3

AA 6-3 Key figures for Samsung follow.

Required

1. Compute Samsung’s (a) inventory turnover and (b) days’ sales in inventory for the most recent two years.

2. Is Samsung’s inventory turnover on a favorable or unfavorable trend? 3. In the current year, does Samsung’s inventory turnover underperform or

outperform the industry (assumed) average of 15?

Beyond the Numbers

ETHICS CHALLENGE A1

BTN 6-1 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

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the 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 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.

COMMUNICATING IN PRACTICE A1

BTN 6-2 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 latter 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 increasing 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 that Ms. Gish adopt.

TAKING IT TO THE NET A3

BTN 6-3 Access the September 30, 2017, 10-K report for Apple, Inc. (ticker: AAPL), filed on November 3, 2017, from the EDGAR filings at SEC.gov.

Required

1. What products are manufactured by Apple? 2. What inventory method does Apple use? Hint: See Note 1 to its financial

statements. 3. Compute its gross margin and gross margin ratio for the 2017 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 30, 2017. Comment on your computations—assume an industry average of 15 for inventory turnover and 9 for days’ sales in inventory.

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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.

BTN 6-4 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 presentation 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.

The company transacted sales on the following dates at a $350 per unit sales price.

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 balances 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

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presentation developed in part 3. Experts are to encourage and respond to questions.

ENTREPRENEURIAL DECISION A3

BTN 6-5 Review the chapter’s opening feature highlighting Danny Meyer and Shake Shack. Assume that the business consistently maintains an inventory level of $30,000, meaning that its average and ending inventory levels are the same. Also assume its annual cost of sales is $120,000. To cut costs, the business proposes to slash inventory to a constant level of $15,000 with no impact on cost of sales. The business plans 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 conditions and (b) proposed conditions.

2. Evaluate and comment on the merits of the proposal given your analysis for part 1. Identify any concerns you might have about the proposal.

HITTING THE ROAD C1 C2

BTN 6-6 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 also might inquire as to what the store’s inventory turnover is and how often physical inventory is taken.

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw- Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

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7 Accounting Information Systems

Chapter Preview

ACCOUNTING SYSTEM AND JOURNAL BASICS

Principles Components Journals Controlling accounts Subsidiary ledgers Accounts receivable ledger Accounts payable ledger

NTK 7-1 , 7-2

SALES JOURNAL

Journalizing Posting Proving Returns and allowances

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P2

P3

P4

C1 C2

A1

NTK 7-3

CASH RECEIPTS JOURNAL

Journalizing Posting Footing and cross footing

NTK 7-4

PURCHASES JOURNAL

Journalizing Posting Proving

NTK 7-5

CASH PAYMENTS JOURNAL

Journalizing Posting General journal transactions

NTK 7-6

Learning Objectives

CONCEPTUAL

Identify the principles and components of accounting information systems. Explain special journals, controlling accounts, and subsidiary ledgers.

ANALYTICAL

Compute days’ payable outstanding and explain its use in assessing payments to

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suppliers.

PROCEDURAL

Journalize and post transactions using a sales journal. Journalize and post transactions using a cash receipts journal. Journalize and post transactions using a purchases journal. Journalize and post transactions using a cash payments journal.

©Radius Images/Alamy Stock Photo

Thinking Out of the Box

“Execute like there’s no tomorrow, strategize like there will be” —AARON LEVIE LOS ALTOS, CA—Aaron Levie, Dylan Smith, Jeff Queisser, and Sam Ghods met in high school. “[Aaron] was a magician, and I was very much a hard core nerd,” recalls Jeff. Beyond magic and nerdiness, the four friends were interested in information systems. The four friends launched Box (Box.com), a cloud storage solution.

An immediate concern was how to obtain money to get started. “A couple of 19- and 20- year-olds starting a business isn’t that old school,” admits Dylan. Then a surprise occurred. As a result of a cold e-mail to Mark Cuban, the Shark Tank TV star, the founders received an investment of $350,000.

As the number of businesses and individuals using their service skyrocketed, the owners realized they needed to get their accounting system in order. This included setting up internal controls to guard against errors and fraud and creating special journals and accounting

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ledgers. Aaron insists that reliable accounting “platforms not only offer agility and productivity, but also an opportunity for better security.”

Box maintains special journals for sales, cash receipts, purchases, and cash payments. Because Box has many customers paying to use its services, Box has subsidiary accounts receivable ledgers for each customer. It also has subsidiary accounts payable ledgers.

The larger message of Box according to Aaron is, “Take the stodgiest, oldest, slowest moving industry you can find … and build amazing software for it.”

Sources: Box website, January 2019; Yahoo Finance, January 2016; Inc., October 2012; BBC, May 2013; TechRepublic, March 2014; CrunchBase.com, 2016

SYSTEM PRINCIPLES

C1_______ Identify the principles and components of accounting information systems.

Accounting information systems collect and process data from transactions and events, organize them in reports, and communicate results to decision makers. Accounting systems help users make more informed decisions and better understand the risks and returns of different strategies. Five principles of accounting information systems are shown in Exhibit 7.1.

EXHIBIT 7.1 System Principles

Control Principle The control principle prescribes that an accounting information system have internal controls. Internal controls are procedures that help managers control and monitor business activities. They include policies to protect company assets and ensure compliance with laws and regulations.

Relevance Principle The relevance principle prescribes that an accounting information system report useful, understandable, and timely information for decision making.

Compatibility Principle The compatibility principle prescribes that an accounting information system conform with a company’s activities, personnel, and structure.

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Flexibility Principle The flexibility principle prescribes that an accounting information system be able to adapt to changes in the company, business environment, and needs of decision makers. Technological advances, competitive pressures, consumer tastes, regulations, and company activities constantly evolve. A system must be designed to adapt to these changes.

Cost-Benefit Principle The cost-benefit principle prescribes that the benefits from an activity in an accounting information system outweigh the costs of that activity. For example, the benefits of producing a specific report must outweigh the costs of time and effort to produce that report. Decisions regarding other system principles (control, relevance, compatibility, and flexibility) are also affected by the cost-benefit principle.

Decision Insight

System’s Fine Print Nintendo’s stock increased greatly after the huge success of Pokémon Go. However, few investors read Nintendo’s disclosures that said it owned less than one-third of the company that developed the app. When investors realized this, the stock dropped 17%, representing over $6 billion in value. ■

©Eric Audras/Getty Images

SYSTEM COMPONENTS The five components of accounting systems are source documents, input devices, information processors, information storage, and output devices. These components apply whether a system is computerized or manual. Exhibit 7.2 shows these components.

EXHIBIT 7.2 Accounting System Components

Point: Computerized systems provide more accuracy and speed than manual.

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Source Documents Source documents provide the information processed by an accounting system. Examples include bank statements and checks, invoices from suppliers, customer bills, sales receipts, and employee earnings records. Accurate source documents are crucial to accounting information systems. Input of wrong information damages the reliability of the information system. Point: Control procedures limit the possibility of entering wrong data.

Input Devices Input devices take information from source documents and transfer it to information processing. These devices convert data on source documents to a form usable by the system. Journal entries are a type of input device. Keyboards and scanners are the most common input devices in business. Point: Controls ensure that only authorized individuals input data into the system.

©Amble Design/Shutterstock

Information Processors Information processors summarize information for use in analysis and reporting. An information processor includes journals, ledgers, working papers, and posting procedures. Each assists in transforming raw data to useful information.

Information Storage Information storage keeps data accessible to information processors. After being input and processed, data are stored for use in future analyses and reports. Auditors rely on this database when they audit both financial statements and a company’s controls. Modern systems depend increasingly on cloud storage.

Output Devices Output devices make accounting information available to users. Common output devices are printers, monitors, and smartphones. Output devices provide users a variety of items including customer bills, financial statements, and internal reports.

NEED-TO-KNOW 7-1

System Principles and Components C1

Match each of the numbered descriptions with the principle, component, or descriptor that it best reflects. Indicate your answer by entering the letter A through J in the blank

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_______ 2. _______ 3. _______ 4.

_______ 5. _______ 6.

_______ 7.

_______ 8.

_______ 9.

_______ 10.

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provided.

A. Control principle B. Relevance principle C. Compatibility principle D. Flexibility principle E. Cost-benefit principle F. Source documents G. Input devices H. Information processors I. Information storage

J. Output devices

Capture information from source documents and transfer to information processing.

Keeps data accessible to information processors. Systems that summarize information for use. Means to take information out of an accounting system and make it

available to users. Provide the information processed by the accounting system. Prescribes that benefits from an activity in a system outweigh the

costs. Prescribes that a system be adaptable to changes in the company,

environment, and user needs. Prescribes that a system conform with a company’s activities,

personnel, and structure. Prescribes that a system report useful, understandable, and timely

information. Prescribes that a system have internal controls.

Solution

1. G 2. I 3. H 4. J 5. F 6. E 7. D 8. C 9. B 10. A

Do More: QS 7-1, QS 7-2

SPECIAL JOURNALS AND SUBSIDIARY LEDGERS

C2_______ Explain special journals, controlling accounts, and subsidiary ledgers.

This chapter covers special journals using a perpetual inventory system.

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Basics of Special Journals A general journal is an all-purpose journal in which we can record any transaction. To enhance internal control and reduce costs, transactions are organized into common groups. A special journal is used to record and post transactions of similar type. Special journals accumulate debits and credits of similar transactions and post amounts as column totals instead of individual amounts. The general journal is used for transactions not covered by special journals and for adjusting, closing, and correcting entries. Most transactions of a merchandiser are categorized into the journals shown in Exhibit 7.3. Special journals allow an efficient division of labor, which is also an effective control procedure.

EXHIBIT 7.3 Using Special Journals with a General Journal

Point: Companies use as many special journals as necessary. Point: A specific transaction is recorded in only one journal.

Special journals are different for different types of businesses. A business creates special journals for its most common transactions, such as sales, cash receipts, purchases, and cash payments (or disbursements). The following sections give one example of a common systems design, but other designs are possible.

Subsidiary Ledgers A subsidiary ledger is a list of individual accounts with a common characteristic. A subsidiary ledger has detailed information on specific accounts in the general ledger. Two of the most important are:

Accounts receivable ledger—stores transaction data of individual customers. Accounts payable ledger—stores transaction data of individual suppliers.

Accounts Receivable Ledger When a company has more than one credit customer, the accounts receivable records must show how much each customer purchased, paid, and has yet to pay. A subsidiary ledger, called the accounts receivable ledger, is set up to keep a separate account for each customer. The general ledger usually has a single Accounts Receivable account that equals the total of its subsidiary ledgers.

The left side of Exhibit 7.4 shows the relation between the Accounts Receivable account in the general ledger and its individual accounts in the subsidiary ledger. After all items are posted, the balance in the Accounts Receivable account must equal the total of all balances of its customers’ accounts. The Accounts Receivable account is said to control the accounts receivable ledger and is called a controlling account.

EXHIBIT 7.4 Controlling Accounts and Subsidiary Ledgers

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Point: When a general ledger account has a subsidiary ledger, any transaction that impacts one of them also impacts the other.

Accounts Payable Ledger Companies buy on credit from several suppliers and keep a separate account for each supplier by having an Accounts Payable controlling account in the general ledger and a separate account for each supplier (creditor) in an accounts payable ledger—see the right side of Exhibit 7.4. Point: A control account is any general ledger account that summarizes subsidiary ledger data.

Other Subsidiary Ledgers Subsidiary ledgers are used for several other accounts. For example, a company might keep only one Equipment account in its general ledger, but its equipment subsidiary ledger could record each type of equipment in a separate account. Subsidiary ledgers have at least two benefits: (1) removal of excessive details from the general ledger and (2) up-to-date information available on specific customers, suppliers, and other items.

NEED-TO-KNOW 7-2

Journals and Ledgers C2

Match each of the numbered descriptions with the term, title, or phrase that it best reflects. Indicate your answer by entering the letter A through J in the blank provided.

A. General journal B. Special journal C. Subsidiary ledger D. Accounts receivable ledger E. Accounts payable ledger F. Controlling account G. Sales journal H. Cash receipts journal I. Purchases journal

J. Cash payments journal

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_______ 1. _______ 2. _______ 3. _______ 4. _______ 5. _______ 6. _______ 7. _______ 8.

_______ 9. _______ 10.

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Used to record all cash payments. Used to record all credit purchases. Used to record all receipts of cash. Used to record sales of inventory on credit. Stores transaction data of individual customers. Stores transaction data of individual suppliers. Account that is said to control a specific subsidiary ledger. Contains detailed information on a specific account from the

general ledger. Used to record and post transactions of similar type. All-purpose journal in which any transaction can be recorded.

Solution

1. J 2. I 3. H 4. G 5. D 6. E 7. F 8. C 9. B 10. A

Do More: QS 7-3, QS 7-4, E 7-5

SALES JOURNAL

P1_______ Journalize and post transactions using a sales journal.

A sales journal is used to record sales of inventory on credit. Sales of inventory for cash are recorded in a cash receipts journal. Sales of noninventory assets on credit are recorded in the general journal.

Journalizing Each sale on credit is recorded separately in a sales journal. Information about each sale is taken from the sales receipt or invoice. The top part of Exhibit 7.5 shows a sales journal from a merchandiser. It has columns for recording the date, customer’s name, invoice number, posting reference, and the sales and cost amounts of each credit sale.

EXHIBIT 7.5 Sales Journal with Posting

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Point: The sales journal in Exhibit 7.5 is called a columnar journal, which is any journal with more than one column.

Each transaction recorded in the sales journal yields an entry in the Accounts Receivable Dr., Sales Cr. column. We use one column for these two accounts. Each transaction in the sales journal yields an entry in the Cost of Goods Sold Dr., Inventory Cr. column. To demonstrate, on February 2, the company sold merchandise on credit to Jason Henry for $450. The invoice number is 307, and the cost of this merchandise is $315. This information is shown on one line in the sales journal. The Posting Reference (PR) column is not used when entering transactions but instead is used when posting.

Posting Posting from a sales journal is shown in the arrow lines of Exhibit 7.5. There are two types of posting: (1) posting to the subsidiary ledger(s) and (2) posting to the general ledger.

Posting to Subsidiary Ledger Transactions in the sales journal are posted to customer accounts in the accounts receivable ledger to keep customer accounts up to date. When sales recorded in the sales journal are individually posted to customer accounts in the accounts receivable ledger, check marks are entered in the sales journal’s PR column. Check marks are used rather than account numbers because customer accounts are arranged alphabetically in the accounts receivable ledger. The equality of debits and credits is always maintained in the general ledger. Point: The $2,150 total of the five customer accounts equals the balance in the Accounts Receivable control account.

Posting to General Ledger The sales journal’s account columns are totaled at the

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end of each period (the month of February in this case). For the “sales” column, the $2,150 total is debited to Accounts Receivable and credited to Sales in the general ledger (see Exhibit 7.5). For the “cost” column, the $1,500 total is debited to Cost of Goods Sold and credited to Inventory in the general ledger. When totals are posted to accounts in the general ledger, the account numbers are entered below the column total in the sales journal for tracking. For example, we enter (106/413) below the total in the sales column after this amount is posted to account number 106 (Accounts Receivable) and account number 413 (Sales). Point: Postings are automatic in a computerized system.

The PR column of subsidiary ledgers shows the journal and page number from which an amount is taken. Items posted from the sales journal have the initial S before their journal page numbers in a PR column. The cash receipts journal uses R; the cash payments or disbursements journal uses D; the purchases journal uses P; and the general journal uses G.

Proving the Ledgers Account balances in the general ledger and subsidiary ledgers are proved (reviewed) for accuracy after posting. To do this, we first prepare a trial balance of the general ledger to confirm that debits equal credits. Second, we use a subsidiary ledger to prepare a schedule of individual accounts and amounts. A schedule of accounts receivable lists each customer and the balance owed. If this total equals the balance of the Accounts Receivable controlling account, the accounts in the accounts receivable ledger are assumed correct. Exhibit 7.6 shows a schedule of accounts receivable that uses the accounts receivable ledger from Exhibit 7.5.

EXHIBIT 7.6 Schedule of Accounts Receivable

Point: In accounting, schedule generally means a list.

Sales Returns and Allowances A company with few sales returns and allowances can record them in a general journal with the following entry.

The debit is posted to the Sales Returns and Allowances account (no. 414). The credit is posted to both the Accounts Receivable controlling account (no. 106) and to the customer’s account. The 106/✓ in the PR column means both the Accounts Receivable controlling account in the general ledger and the Ray Ball account in the accounts receivable ledger are

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credited for $175.

NEED-TO-KNOW 7-3

Sales Journal P1

Prepare a sales journal like the one in Exhibit 7.5 and then record the following sales transactions.

Solution

Do More: QS 7-6, QS 7-12, E 7-1, E 7-12

CASH RECEIPTS JOURNAL

P2_______ Journalize and post transactions using a cash receipts journal.

A cash receipts journal is used to record all receipts of cash (all transactions that include a debit to Cash). Cash receipts are separated into three types: (1) cash from credit customers in payment of their accounts, (2) cash from cash sales, and (3) cash from other sources. The cash receipts journal in Exhibit 7.7 has a separate credit column for each of these three types.

EXHIBIT 7.7 Cash Receipts Journal with Posting

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Point: The $650 total of the five customer accounts equals the balance in Accounts Receivable control account.

Cash from Credit Customers Journalizing To record cash received in payment of a customer’s account, the customer’s name is first entered in the Account Credited column— see transactions dated February 12, 17, 23, and 25. Then the amounts debited to both Cash and Sales Discount (if any) are entered in their columns, and the amount credited to the customer’s account is entered in the Accounts Receivable Cr. column.

Posting Individual amounts in the Accounts Receivable Cr. column are posted immediately to customer accounts in the subsidiary accounts receivable ledger. The $1,500 column total is posted at the end of the period (month in this case) as a credit to the Accounts Receivable controlling account in the general ledger.

Cash Sales Journalizing Each cash sale is entered in the Cash Dr. column and the Sales Cr. column. The February 7, 14, 21, and 28 transactions are examples. Each cash sale also yields an entry to Cost of Goods Sold Dr. and Inventory Cr. for the cost of merchandise—see the far right column. Example: Record in the cash receipts journal a $700 cash sale of land when the land carries a $700

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original cost. Answer: Debit the Cash column for $700, and credit the Other Accounts column for $700 (the account credited is Land).

Posting For cash sales, an x in the PR column means that its amount is not individually posted. We do post the $17,300 Sales Cr. total and the $12,550 total from the “cost” column.

Cash from Other Sources Journalizing Examples of cash from other sources are money borrowed from a bank, cash interest received, and cash sale of noninventory assets. The February 20 and 22 transactions are examples. The Other Accounts Cr. column is used for these transactions.

Posting These transactions are immediately posted to their general ledger accounts.

Footing, Crossfooting, and Posting To be sure that total debits and credits in a journal are equal, we crossfoot column totals before posting them. To foot a column of numbers is to add it. To crossfoot in this case is to add the Debit column totals, then add the Credit column totals, and verify that the Debit and Credit column totals are equal. Footing and crossfooting of the numbers in Exhibit 7.7 result in the report in Exhibit 7.8.

EXHIBIT 7.8 Footing and Crossfooting Journal Totals

Point: Subsidiary ledgers and their controlling accounts are in balance only after all posting is complete.

At the end of the period, the total amounts from the columns of the cash receipts journal are posted to their general ledger accounts. The Other Accounts Cr. column total is not posted because the individual amounts are directly posted to their general ledger accounts. An x below the Other Accounts Cr. column indicates this column total is not posted. The account numbers for the column totals that are posted are entered in parentheses below each column.

Decision Maker

Entrepreneur You want to know how quickly customers are paying their bills. Where do you find this information? ■ Answer: The accounts receivable ledger lists detailed information for each customer’s account, including the amounts, dates of transactions, and dates of payments. It shows how long customers wait before paying their bills.

NEED-TO-KNOW 7-4

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Cash Receipts Journal P2

Prepare a cash receipts journal like the one in Exhibit 7.7 and then record the following cash receipts transactions.

Solution

Do More: QS 7-7, E 7-3, P 7-2

PURCHASES JOURNAL

P3_______ Journalize and post transactions using a purchases journal.

A purchases journal is used to record all credit purchases, including those for inventory. Purchases using cash are recorded in the cash payments journal.

Journalizing The Accounts Payable Cr. column in Exhibit 7.9 is used to record the amounts owed to each creditor. Inventory purchases are recorded using the Inventory Dr. column. Point: The $1,325 total of the five vendor accounts equals the balance in the Accounts Payable control account.

EXHIBIT 7.9 Purchases Journal with Posting

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To demonstrate, inventory costing $200 is purchased from Ace Manufacturing on February 5. The creditor’s name (Ace) is entered in the Account column, the invoice date is entered in the Date of Invoice column, the purchase terms are entered in the Terms column, and the $200 amount is entered in the Accounts Payable Cr. and the Inventory Dr. columns. When a purchase has an amount recorded in the Other Accounts Dr. column, the Account column shows the general ledger account debited. For example, the February 28 transaction has purchases of inventory, office supplies, and store supplies from ITT. The journal has no column for store supplies, so the Other Accounts Dr. column is used. In this case, Store Supplies is entered in the Account column along with the creditor’s name (ITT). This purchases journal also includes a separate column for credit purchases of office supplies. Each company decides what separate columns are necessary. Point: Each transaction in the purchases journal has a credit to Accounts Payable. Debit accounts will vary.

Point: The Other Accounts Dr. column allows the purchases journal to be used for any purchase on credit.

Posting The amounts in the Accounts Payable Cr. column are immediately posted to individual creditor accounts in the accounts payable subsidiary ledger. Individual amounts in the Other Accounts Dr. column are immediately posted to their general ledger accounts. At the end of the period, all column totals except the Other Accounts Dr. column are posted to their general ledger accounts.

Proving the Ledger Accounts payable balances in the subsidiary ledger are proved after posting. We prove the subsidiary ledger by preparing a schedule of accounts payable, which is a list of accounts from the accounts payable ledger with their balances and the total. If the total of the individual balances equals the balance of the Accounts Payable controlling

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account, the accounts in the accounts payable ledger are assumed correct. Exhibit 7.10 shows a schedule of accounts payable drawn from the accounts payable ledger of Exhibit 7.9.

EXHIBIT 7.10 Schedule of Accounts Payable

Point: The balance in the Accounts Payable controlling account must equal the total of the individual account balances in the accounts payable subsidiary ledger after posting.

NEED-TO-KNOW 7-5

Purchases Journal P3

Prepare a purchases journal like the one in Exhibit 7.9 and then record the following purchases transactions.

Solution

Do More: QS 7-8, E 7-6, E 7-10

CASH PAYMENTS (DISBURSEMENTS) JOURNAL

P4_______ Journalize and post transactions using a cash payments journal.

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A cash payments journal, or cash disbursements journal, is used to record all cash payments (all transactions with a credit to Cash).

Journalizing The cash payments journal in Exhibit 7.11 shows entries reflecting cash payments. Credits to Inventory reflect purchase discounts. For example, on February 15, the company pays Ace on account (credit terms of 2/10, n/30—see February 5 transaction in Exhibit 7.9). Because payment occurs in the discount period, the company pays $196 ($200 invoice less $4 discount). The $4 discount is credited to Inventory.

EXHIBIT 7.11 Cash Payments Journal with Posting

When a company purchases inventory for cash, it is recorded using the Other Accounts Dr. column and the Cash Cr. column as shown in the February 3 and 12 transactions. Generally, the Other Accounts column is used to record cash payments on items for which no column exists. For example, on February 15, the company pays salaries expense of $250. The amount is recorded using the Other Accounts Dr. column, and the title of the account debited (Salaries Expense) is entered in the Account Debited column. Point: The $675 total of the five vendor accounts equals the balance in the Accounts Payable control account.

The cash payments journal has a column titled Ck. No. (check number). The identifying number of the paper or electronic check (or ACH) is entered in this column. Point: When a cash payments journal has a column for check numbers, it is sometimes called a check register.

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Posting Individual amounts in the Other Accounts Dr. column of a cash payments journal are immediately posted to their general ledger accounts. Individual amounts in the Accounts Payable Dr. column are also immediately posted to creditors’ accounts in the subsidiary accounts payable ledger. At the end of the period, we post the Accounts Payable Dr. column total to the Accounts Payable controlling account. Also, the Inventory Cr. column total is posted to the Inventory account, and the Cash Cr. column total is posted to the Cash account.

General Journal Transactions When special journals are used, we still need a general journal for adjusting, closing, and any other transactions for which no special journal has been set up. Examples of these other transactions might include purchases returns and allowances, purchases of plant assets by issuing a note payable, sales returns if a sales returns and allowances journal is not used, and receipt of a note receivable from a customer.

Decision Maker

Controller You want to analyze your company’s cash payments to suppliers and its purchases discounts. Where do you find this information? ■ Answer: The accounts payable ledger contains information for each supplier, the amounts due, and when payments are made. This subsidiary ledger, along with information on credit terms, provides the data for analyses.

NEED-TO-KNOW 7-6

Cash Payments Journal P4

Prepare a cash payments journal like the one in Exhibit 7.11 and then record the following cash payments transactions.

Solution

Do More: QS 7-10, E 7-7, P 7-3

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TECHNOLOGY-BASED ACCOUNTING SYSTEMS

Technology in Accounting Technology provides accuracy and speed in performing accounting tasks. Accounting programs such as Sage 50 (formerly Peachtree®) and QuickBooks® can do a number of accounting tasks for a variety of different businesses. Off-the-shelf programs are menu driven, and many operate more efficiently as integrated systems. In an integrated system, actions taken in one part of the system automatically affect related parts. When a credit sale is recorded in an integrated system, for example, several parts of the system are automatically updated, such as posting.

Less effort spent on recordkeeping means more time for accountants to concentrate on analysis and managerial decision making. Technology has created a greater demand for accountants who understand financial reports and can draw insights from accounting data.

Decision Insight

Middleware is software that allows different computer programs in a company or across companies to work together. It allows transfer of purchase orders, invoices, and other electronic documents between accounting systems. For example, suppliers can monitor their buyers’ inventory levels for production and shipping purposes. ■

©Chain45154/Getty Images

Data Processing in Accounting Accounting systems are different in how input is entered and processed.

Online processing enters and processes data as soon as source documents are available. This means that databases are immediately updated. Batch processing accumulates source documents for a period of time and then processes them all at once such as daily, weekly, or monthly.

The advantage of online processing is timeliness. The advantage of batch processing is that it requires only periodic updating of databases. The disadvantage of batch processing is the lack of up-to-date information for managers.

Computer Networks in Accounting Networking, or linking computers with each other, can create information advantages (and cost efficiencies). Computer networks are links among computers giving users access to common databases, programs, and hardware. The network setups by UPS and FedEx allow

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Enterprise Resource Planning Software

Enterprise resource planning (ERP) software includes the programs that manage a company’s operations. They extend from order taking to manufacturing to accounting. ERP can help speed decision making, identify costs for reduction, and give managers control over operations. For many managers, ERP allows them to scrutinize the business, identify where inventories are piling up, and see what plants are most efficient.

Several companies offer ERP software. SAP leads the market, with Oracle a distant second (AMR Research). SAP is used by more than half of the world’s 500 largest companies.

ERP is increasingly used by small business. One-third of Oracle’s sales in North America are to companies with less than $500 million in annual revenue.

Data Analytics and Data Visualization Data analytics is a process of analyzing data to identify meaningful relations and trends. In accounting, data analytics helps individuals make informed business decisions. Dr Pepper Snapple Group uses data analytics to send accounting information to its sales route staff via an app in real time. Staff can then make data driven decisions on what sales and promotions to offer retailers. Data analytics also tracks their progress relative to projections.

Data visualization is a graphical presentation of data to help people understand its significance. Software is used to create meaningful visuals that inform key decision makers. Tableau is the most popular data visualization software. NASA uses data visualization to depict its plans and five-year budget in a graphic titled Funding the Final Frontier. This graphic shows the budget breakdown for space exploration, science, space operations, and other activities.

Cloud Computing

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Cloud computing is the delivery of computing as a service rather than a product. Cloud computing uses applications via the web instead of installing them on individual computers. This means that companies lease, rather than purchase, those applications.

When a company uses cloud computing, users and their clients can access the same applications and share data. Accountants and analysts can similarly access data for quicker and easier processing and analysis. For example, all invoices could be offloaded to a web- based bill management system, where documentation, payments, and recordkeeping could all be handled in the cloud.

Decision Analysis Days’ Payable Outstanding

A1_______ Compute days’ payable outstanding and explain its use in assessing payments to suppliers.

Days’ payable outstanding is the average length of time that payables are deferred until payment is made. Delaying payment allows the buyer to increase available cash. However, excessive delays can hurt the buyer’s relationship with the seller. Days’ payable outstanding (DPO) is defined in Exhibit 7.12. Cost of goods sold is in the denominator because payables relate to the purchase of goods, which are recorded at cost.

EXHIBIT 7.12 Days’ Payable Outstanding (DPO)

We compute DPO in Exhibit 7.13 for Costco and Walmart. Costco’s DPO is less than Walmart’s in each of the last three years. This means that, on average, Walmart takes longer to pay its suppliers. Many investors view this as positive because it suggests that Walmart is negotiating better terms with its suppliers that allow Walmart to defer payment. However, if DPO is excessively large relative to its peers, investors worry that a company will hurt its relationship with suppliers by paying later than its peers. In managing DPO, companies wish to maximize available cash (using a higher DPO) while not hurting supplier relations.

EXHIBIT 7.13 Days’ Payable Outstanding for Two Competitors

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Decision Maker

Analyst A company under analysis has a days’ payable outstanding (DPO) of 15 days. The industry norm is 32 days and this company’s usual credit terms are n/30. What is your assessment of DPO? ■ Answer: DPO is less than the norm and lower than the usual credit period. This suggests that the company can further delay payments to suppliers (and increase its level of available cash) and not hurt its relationship with suppliers.

NEED-TO-KNOW 7-7 COMPREHENSIVE

Using Special Journals for Recording Transactions; Preparing a Trial Balance and Subsidiary Ledgers for Receivables and Payables

Pepper Company completed the following selected transactions and events during March of this year. (Terms of all credit sales for the company are 2/10, n/30.)

Required

1. Open the following selected general ledger accounts: Cash (101), Accounts Receivable (106), Inventory (119), Office Supplies (124), Store Equipment (165), Accounts Payable (201), Long-Term Notes Payable (251), Sales (413), Sales Returns and Allowances (414), Sales Discounts

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(415), Cost of Goods Sold (502), and Sales Salaries Expense (621). Open the following accounts receivable ledger accounts: Marjorie Allen, Dennie Hoskins, and Jennifer Nelson. Open the following accounts payable ledger accounts: Defore Industries, Mack Company, Schmidt Supply, and Welch Company.

2. Enter the transactions using a sales journal, a purchases journal, a cash receipts journal, a cash payments journal, and a general journal. Regularly post to the individual customer and creditor accounts. Also, post any amounts that should be posted as individual amounts to general ledger accounts. Foot and crossfoot the journals and make the month-end postings. Pepper Co. uses the perpetual inventory system.

3. Prepare a trial balance for the selected general ledger accounts in part 1 and prove the accuracy of subsidiary ledgers by preparing schedules of accounts receivable and accounts payable.

PLANNING THE SOLUTION

Set up the required general ledger, the subsidiary ledger accounts, and the five required journals. Read and analyze each transaction and decide in which special journal (or general journal) the transaction is recorded. Record each transaction in the correct journal (and post the appropriate individual amounts). Once you have recorded all transactions, total the journal columns. Post from each journal to the correct ledger accounts. Prepare a trial balance to prove the debit and credit balances are equal in your general ledger. Prepare schedules of accounts receivable and accounts payable. Compare the totals of these schedules to the Accounts Receivable and Accounts Payable controlling account balances.

SOLUTION

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Summary: Cheat Sheet

ACCOUNTING SYSTEM & JOURNAL BASICS

Control principle: A system has internal controls, which are procedures that help managers control a business. Relevance principle: Accounting info is useful and timely. Compatibility principle: System conforms to company structure. Flexibility principle: System adapts to internal/external changes. Cost-benefit principle: Benefits from an activity outweigh the costs. Source documents: Information processed by the system. Input devices: Transfer info from source documents to processing. Information processors: Summarize info for use in reporting. Information storage: Keeps data accessible. Output devices: Make info available to users.

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General journal: All-purpose journal for adjusting, closing, and any other transactions for which there is no special journal. Transactions include sales of noninventory assets on credit, purchases returns and allowances, purchases of plant assets by issuing a note payable, sales returns and allowances, and receipt of a note receivable. Special journal: Used to record and post transactions of similar type. Subsidiary ledger: A list of individual accounts detailing a specific account in the general ledger.

SALES JOURNAL

Sales journal: Used to record sales of inventory on credit.

Schedule of accounts receivable: Lists each customer and the balance owed. Used to prove that the Accounts Receivable controlling account and the total of individual accounts in subsidiary ledger are equal. Sales returns and allowances: Record them in a general journal with the following entry.

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CASH RECEIPTS JOURNAL

Cash receipts journal: Used to record all receipts of cash, including (1) cash from credit customers in payment of their accounts—as well as discounts, (2) cash from cash sales, and (3) cash from all other sources.

Footing and crossfooting: To be sure that total debits and credits in a journal are equal, we crossfoot column totals. To foot a column of numbers is to add it. To crossfoot is to check if debit and credit column totals are equal.

PURCHASES JOURNAL

Purchases journal: Used to record all credit purchases, including those for inventory and supplies.

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Schedule of accounts payable: Lists each creditor’s accounts payable and the balance owed. Used to prove that the Accounts Payable controlling account and the total of individual accounts in subsidiary ledger are equal.

CASH PAYMENTS JOURNAL

Cash payments journal: Used to record all cash payments, including cash payments for inventory, salaries, and accounts payable—minus discounts.

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Key Terms

Accounting information system (259) Accounts payable ledger (262) Accounts receivable ledger (262) Batch processing (270) Cash payments journal (268) Cash receipts journal (265) Check register (269) Columnar journal (263) Compatibility principle (259) Components of accounting systems (260) Computer network (270) Control principle (259) Controlling account (262)

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Cost-benefit principle (259) Data analytics 271 Data visualization 271 Days’ payable outstanding (DPO) 271 Enterprise resource planning (ERP) software (271) Flexibility principle (259) General journal (261) Information processor (260) Information storage (260) Input device (260) Internal controls (259) Online processing (270) Output devices (260) Purchases journal (267) Relevance principle (259) Sales journal (263) Schedule of accounts payable (268) Schedule of accounts receivable (264) Special journal (261) Subsidiary ledger (261)

Multiple Choice Quiz

1. The sales journal is used to record a. Credit sales. b. Cash sales. c. Cash receipts. d. Cash purchases. e. Credit purchases.

2. The purchases journal is used to record a. Credit sales. b. Cash sales. c. Cash receipts. d. Cash purchases. e. Credit purchases.

3. The ledger that contains the financial statement accounts of a company is the a. General journal. b. Column balance journal. c. Special ledger.

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d. General ledger. e. Special journal.

4. A subsidiary ledger that contains a separate account for each supplier (creditor) to the company is the

a. Controlling account. b. Accounts payable ledger. c. Accounts receivable ledger. d. General ledger. e. Special journal.

5. Enterprise resource planning software a. Refers to programs that help manage company operations. b. Is another name for spreadsheet programs. c. Uses batch processing of business information. d. Is substantially declining in use. e. Is another name for database programs.

ANSWERS TO MULTIPLE CHOICE QUIZ

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

Icon denotes assignments that involve decision making.

Discussion Questions

1. What are five basic components of an accounting system? 2. What are source documents? Give two examples. 3. What are the five fundamental principles of accounting information systems? 4. What is the purpose of an input device? Give examples of input devices for

computer systems. 5. What purpose is served by the output devices of an accounting system? 6. When special journals are used, they are usually used to record each of four

different types of transactions. What are these four types of transactions? 7. What notations are entered into the Posting Reference column of a ledger

account? 8. When a general journal entry is used to record sales returns, the credit of

the entry must be posted twice. Does this cause the trial balance to be out of balance? Explain.

9. Credits to customer accounts and credits to Other Accounts are individually

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_______ 1. _______ 2. _______ 3. _______ 4. _______ 5. _______ 6. _______ 7. _______ 8. _______ 9. _______ 10.

posted from a cash receipts journal such as the one in Exhibit 7.7. Why not put both types of credits in the same column and save journal space?

10. Why should sales to and receipts of cash from credit customers be recorded and posted immediately?

11. Apple’s balance sheet reports 2017 accounts receivable total of $17,932 million, computed as $17,874 million plus its $58 million allowance. What is Apple’s total of its schedule of accounts receivable?

12. Locate Google’s balance sheet in Appendix A. What is the total of Google’s 2017 accounts payable? What is the total of its schedule of accounts payable?

13. Refer to Appendix A and locate Apple’s balance sheet. What is the total of Apple’s 2017 accounts payable? What is the total of its schedule of accounts payable?

QUICK STUDY

QS 7-1 Accounting information system components C1 Identify each item 1 through 10 with the system component A through E that it is best associated with.

A. Source documents B. Input devices C. Information processors D. Information storage E. Output devices

Computer keyboard Printer Monitor Bank statement Ledger software Cloud storage Journal software Invoice from supplier Computer scanner Filing cabinet

QS 7-2 Accounting information system principles C1 Enter the letter of each system principle in the blank next to its best description.

A. Control principle B. Relevance principle C. Compatibility principle

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_______ 1. _______ 2.

_______ 3.

_______ 4. _______ 5.

_______ a. _______ b. _______ c. _______ d. _______ e. _______ f.

_______ a. _______ b. _______ c. _______ d. _______ e.

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D. Flexibility principle E. Cost-benefit principle

The accounting information system helps monitor activities. The accounting information system conforms to the company’s

business activities. The accounting information system changes in response to

technological advances and competitive pressures. Affects all other accounting information system principles. The accounting information system provides timely information

for effective decision making.

QS 7-3 Identifying general and subsidiary ledgers C2 For each account, indicate whether it appears in the general ledger or the subsidiary ledger.

Accounts Receivable—Martin Interest Expense Prepaid Rent Accounts Payable—Julie Notes Payable

Store Supplies

QS 7-4 Controlling accounts and subsidiary ledgers C2 Following is information from Fredrickson Company for its first month of business.

1. Identify the balances listed in the accounts receivable subsidiary ledger. 2. Identify the Accounts Receivable balance listed in the general ledger at

month’s end.

QS 7-5 Identifying the special journal of entry P1 P2 P3 P4 Wilcox Electronics uses sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Identify the journal in which each transaction should be recorded.

Sold merchandise on credit. Purchased shop supplies on credit. Paid an employee’s salary in cash. Borrowed cash from the bank. Sold merchandise for cash.

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_______ f. _______ g. _______ h.

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Purchased merchandise on credit. Purchased inventory for cash. Paid cash to a creditor.

QS 7-6 Sales journal P1 Caesar Company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a sales journal like the one in Exhibit 7.5. Journalize the following transactions that should be recorded in the sales journal.

QS 7-7 Cash receipts journal P2 Li Company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a cash receipts journal like the one in Exhibit 7.7. Journalize the following transactions that should be recorded in the cash receipts journal.

QS 7-8 Purchases journal P3 Peachtree Company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a purchases journal like the one in Exhibit 7.9. Journalize the following transactions that should be recorded in the purchases journal.

QS 7-9 Identifying journal of entry P1 P2 P3 P4 Refer to QS 7-8 and for each of the transactions identify the journal in which it would be recorded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal.

QS 7-10 Cash payments journal P4 Greenleaf Company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a cash payments journal like the one in Exhibit 7.11. Journalize the following transactions that should be recorded in the cash payments journal.

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QS 7-11 Entries in the general journal P1 P2 P3 P4 Biloxi Gifts uses sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Journalize its transactions that should be recorded in the general journal. For those not recorded in the general journal, identify the special journal where each should be recorded.

QS 7-12 Accounts receivable ledger; posting to accounts P1 Warton Company posts individual sales to the accounts receivable subsidiary ledger immediately. At the end of each month, Warton posts the end-of-month totals to the general ledger.

1. Open an accounts receivable subsidiary ledger with a T-account for each customer. Post the amounts to the subsidiary ledger.

2. Open an Accounts Receivable controlling T-account and a Sales T-account to reflect general ledger accounts. Post the end-of-month total to these accounts.

3. Prepare a schedule of accounts receivable and prove (confirm) that its total equals the Accounts Receivable controlling account balance.

QS 7-13 Days’ payable outstanding A1 Wentz Co. made it a priority to negotiate better credit terms with its suppliers so it could defer payments longer. (a) Use the following information for Wentz Co. to compute days’ payable outstanding for Year 1 and Year 2. (b) Does Wentz Co. appear to have negotiated better credit terms in Year 2 than in Year 1?

EXERCISES

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Exercise 7-1 Sales journal P1 Finer Company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a sales journal like the one in Exhibit 7.5. Journalize the following transactions that should be recorded in the sales journal.

Exercise 7-2 Identifying journal of entry P1 P2 P3 P4 Refer to Exercise 7-1 and for each of the transactions identify the journal in which it would be recorded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal.

Exercise 7-3 Cash receipts journal P2 Ali Co. uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a cash receipts journal like the one in Exhibit 7.7. Journalize the following transactions that should be recorded in the cash receipts journal.

Exercise 7-4 Identifying journal of entry P1 P2 P3 P4 Refer to Exercise 7-3 and for each of the transactions identify the journal in which it would be recorded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal.

Exercise 7-5 Controlling accounts and subsidiary ledgers C2 Following is information from Jesper Company for its first month of business.

1. Identify the balances listed in the accounts payable subsidiary ledger. 2. Identify the Accounts Payable balance listed in the general ledger at month’s

end.

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Exercise 7-6 Purchases journal P3 Gomez Company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a purchases journal like the one in Exhibit 7.9. Journalize the following transactions that should be recorded in the purchases journal.

Exercise 7-7 Cash payments journal P4 Marx Supply uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Prepare a cash payments journal like the one in Exhibit 7.11. Journalize the following transactions that should be recorded in the cash payments journal.

Exercise 7-8 Identifying journal of entry P1 P2 P3 P4 Refer to Exercise 7-7 and for each of the transactions identify the journal in which it would be recorded. Assume the company uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal.

Exercise 7-9 Entries in general journal P1 P2 P3 P4 Smith Auto uses a sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. Journalize its transactions that should be recorded in the general journal. For those not recorded in the general journal, identify the special journal where each should be recorded.

Exercise 7-10 Purchases journal and error identification P3 A company that records credit purchases in a purchases journal and records purchases returns in a general journal made the following errors. Enter A, B, or C indicating when each error should be discovered.

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______ 1.

______ 2.

______ 3.

______ 4.

______ 5.

A. When preparing the schedule of accounts payable. B. When crossfooting the purchases journal. C. When preparing the trial balance.

Made an addition error in totaling the Office Supplies column of the purchases journal.

Made an addition error in determining the balance of a creditor’s subsidiary account.

Posted a purchases return to the Accounts Payable account and to the creditor’s subsidiary account but did not post the purchases return to the Inventory account.

Correctly recorded an $8,000 purchase in the purchases journal but posted it to the creditor’s subsidiary account as an $800 purchase.

Posted a purchases return to the Inventory account and to the Accounts Payable account but did not post to the creditor’s subsidiary account.

Exercise 7-11 Special journal transactions and error discovery P4 Post Pharmacy uses the following journals: sales journal, purchases journal, cash receipts journal, cash payments journal, and general journal. The following two transactions were processed.

In journalizing the June 14 payment, the pharmacy debited Accounts Payable for $14,000 but failed to record the cash discount on the purchase. Cash was properly credited for the actual $13,720 paid.

a. In what journals would the June 5 and the June 14 transactions be recorded? b. What procedure is likely to discover the error in journalizing the June 14

transaction?

Exercise 7-12 Posting to subsidiary ledger accounts; preparing a schedule of accounts receivable P1 At the end of May, the sales journal of Mountain View appears as follows.

Mountain View also recorded an allowance (price reduction) given to Anna Page with the following entry.

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1. Open an accounts receivable subsidiary ledger that has a T-account for each customer listed in the sales journal. Post to the customer accounts the entries in the sales journal and any portion of the general journal entry that affects a customer’s account.

2. Open a general ledger that has T-accounts for Accounts Receivable, Inventory, Sales, Sales Returns and Allowances, and Cost of Goods Sold. Post the sales journal and any portion of the general journal entry that affects these accounts.

3. Prepare a schedule of accounts receivable and prove (confirm) that its total equals the balance in the Accounts Receivable controlling account. Check (3) Ending Accounts Receivable, $9,660

Exercise 7-13 Days’ payable outstanding A1 The following companies are competitors in the same industry and have many of the same suppliers. (a) Calculate days’ payable outstanding for each of the following companies (round to one decimal). (b) Assuming each company has positive relations with its suppliers, which company has likely negotiated the best credit terms?

PROBLEM SET A

Problem 7-1A Special journals, subsidiary ledgers, trial balance P1 P2 P3 P4 Church Company completes these transactions and events during March of the current year (terms for all its credit sales are 2/10, n/30).

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Required

1. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory (March 1 beg. bal. is $10,000); Office Supplies; Store Supplies; Office Equipment; Accounts Payable; Long-Term Notes Payable; Z. Church, Capital (March 1 beg. bal. is $10,000); Sales; Sales Discounts; Cost of Goods Sold; and Sales Salaries Expense. Open the following accounts receivable subsidiary ledger accounts: Jovita Albany, Min Cho, and Linda Witt. Open the following accounts payable subsidiary ledger accounts: Gabel Company, Van Industries, Spell Supply, and CD Company.

2. Enter these transactions in a sales journal, purchases journal, cash receipts journal, cash payments journal, or general journal. Number all journal pages as page 2.

3. (a) Prepare a trial balance of the general ledger. (b) Prove the accuracy of the subsidiary ledgers by preparing schedules of both accounts receivable and accounts payable. Check Trial balance totals, $232,905

Problem 7-2A Special journals, subsidiary ledgers, and schedule of accounts receivable P1 P2 Wiset Company completes these transactions during April of the current year (the terms of all its credit sales are 2/10, n/30).

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Required

1. Prepare a sales journal and cash receipts journal. Number both journal pages as page 3. Enter the transactions of Wiset Company that should be journalized in the sales journal and those that should be journalized in the cash receipts journal. Ignore transactions that should be journalized in a purchases journal, cash payments journal, or general journal.

2. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory; Long-Term Notes Payable; B. Wiset, Capital; Sales; Sales Discounts; and Cost of Goods Sold. Enter the March 31 balances for Cash ($85,000), Inventory ($125,000), Long-Term Notes Payable ($110,000), and B. Wiset, Capital ($100,000). Also open accounts receivable subsidiary ledger accounts for Paula Kohr, Page Alistair, and Nic Nelson.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month-end postings.

4. (a) Prepare a trial balance of the general ledger accounts opened as required for part 2. (b) Prove the accuracy of the subsidiary ledger by preparing a schedule of accounts receivable. Check Trial balance totals, $434,285

Problem 7-3A Special journals, subsidiary ledgers, and schedule of

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accounts payable P3 P4 The April transactions of Wiset Company are described in Problem 7-2A.

Required

1. Prepare a general journal, purchases journal, and cash payments journal. Number all journal pages as page 3. Enter the transactions of Wiset Company that should be journalized in the general journal, purchases journal, or cash payments journal. Ignore transactions that should be journalized in a sales journal or cash receipts journal.

2. Open the following general ledger accounts: Cash; Inventory; Office Supplies; Store Supplies; Store Equipment; Accounts Payable; Long-Term Notes Payable; B. Wiset, Capital; Sales Salaries Expense; and Advertising Expense. Enter the March 31 balances of Cash ($85,000), Inventory ($125,000), Long-Term Notes Payable ($110,000), and B. Wiset, Capital ($100,000). Also open accounts payable subsidiary ledger accounts for Hal’s Supply, Noth Company, Grant Company, and Custer, Inc.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month-end postings.

4. (a) Prepare a trial balance of the general ledger accounts opened as required for part 2. (b) Prepare a schedule of accounts payable. Check Trial balance totals, $235,730

PROBLEM SET B

Problem 7-1B Special journals, subsidiary ledgers, trial balance P1 P2 P3 P4 Grassley Company completes these transactions during November of the current year (terms for all its credit sales are 2/10, n/30).

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Required

1. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory (Nov. 1 beg. bal. is $40,000); Office Supplies; Store Supplies; Office Equipment; Accounts Payable; Long-Term Notes Payable; C. Grassley, Capital (Nov. 1 beg. bal. is $40,000); Sales; Sales Discounts; Cost of Goods Sold; and Sales Salaries Expense. Open the following accounts receivable subsidiary ledger accounts: Carlos Mantel, Tori Tripp, and Cyd Rounder. Open the following accounts payable subsidiary ledger accounts: Grebe Company, BLR Industries, Brun Supply, and Lo Company.

2. Enter these transactions in a sales journal, purchases journal, cash receipts journal, cash payments journal, or general journal. Number all journal pages as page 2.

3. (a) Prepare a trial balance of the general ledger. (b) Prove the accuracy of the subsidiary ledgers by preparing schedules of both accounts receivable and accounts payable. Check Trial balance totals, $202,283

Problem 7-2B Special journals, subsidiary ledgers, schedule of accounts receivable P1 P2 Acorn Industries completes these transactions during July of the current year (the

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terms of all its credit sales are 2/10, n/30).

Required

1. Prepare a sales journal and cash receipts journal. Number both journals as page 3. Enter the transactions of Acorn Industries that should be journalized in the sales journal and those that should be journalized in the cash receipts journal. Ignore transactions that should be journalized in a purchases journal, cash payments journal, or general journal.

2. Open the following general ledger accounts: Cash; Accounts Receivable; Inventory; Long-Term Notes Payable; R. Acorn, Capital; Sales; Sales Discounts; and Cost of Goods Sold. Enter the June 30 balances for Cash ($100,000), Inventory ($200,000), Long-Term Notes Payable ($200,000), and R. Acorn, Capital ($100,000). Also open accounts receivable subsidiary ledger accounts for Kim Nettle, Ashton Moore, and Ruth Blake.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month-end postings.

4. (a) Prepare a trial balance of the general ledger accounts opened as required for part 2. (b) Prove the accuracy of the subsidiary ledger by preparing a schedule of accounts receivable. Check Trial balance totals, $588,264

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Problem 7-3B Special journals, subsidiary ledgers, and schedule of accounts payable P3 P4 The July transactions of Acorn Industries are described in Problem 7-2B.

Required

1. Prepare a general journal, purchases journal, and cash payments journal. Number all journal pages as page 3. Enter the transactions of Acorn Industries that should be journalized in the general journal, purchases journal, or cash payments journal. Ignore transactions that should be journalized in a sales journal or cash receipts journal.

2. Open the following general ledger accounts: Cash; Inventory; Office Supplies; Store Supplies; Store Equipment; Accounts Payable; Long-Term Notes Payable; R. Acorn, Capital; Sales Salaries Expense; and Advertising Expense. Enter the June 30 balances of Cash ($100,000), Inventory ($200,000), Long-Term Notes Payable ($200,000), and R. Acorn, Capital ($100,000). Also open accounts payable subsidiary ledger accounts for Charm’s Supply, Teton Company, Drake Company, and Plaine, Inc.

3. Verify that amounts that should be posted as individual amounts from the journals have been posted. (Such items are immediately posted.) Foot and crossfoot the journals and make the month-end postings.

4. (a) Prepare a trial balance of the general ledger accounts opened as required for part 2. (b) Prepare a schedule of accounts payable. Check Trial balance totals, $349,640

SERIAL PROBLEM

Business Solutions P1 P2 P3 P4 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.

©Alexander Image/Shutterstock

SP 7 Assume that Santana Rey expands Business Solutions’s system to include special journals.

Required

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1. Locate the transactions related to January through March 2020 for Business Solutions in Chapter 5.

2. Enter the Business Solutions transactions for January through March in a sales journal (insert “n/a” in the Invoice column), cash receipts journal, purchases journal (use Computer Supplies heading instead of Office Supplies), cash payments journal (insert “n/a” in the Check Number column), or general journal. Number journal pages as page 2. If the transaction does not specify the name of the payee, state “not specified” in the Payee column of the cash payments journal.

3. The transactions on the following dates should be journalized in the general journal: January 5, 11, 20, and 24 and March 24. Do not record and post the adjusting entries for the end of March.

COMPREHENSIVE PROBLEM

Using Special Journals to Record and Post Transactions; Preparing Adjusting and Closing Entries; Preparing a Trial Balance and Financial Statements; Completing Subsidiary Ledgers for Receivables and Payables This Comprehensive Problem requires account balances from the April month-end, which are available in Connect or in the Working Papers. Assume it is Monday, May 1, the first business day of the month, and you have just been hired as the accountant for Colo Company, which operates with monthly accounting periods. All of the company’s accounting work is completed through the end of April, and its ledgers show April 30 balances. During your first month on the job, the company experiences the following transactions and events (terms for all its credit sales are 2/10, n/30 unless stated differently).

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1. Enter these transactions in a sales journal, purchases journal, cash receipts journal, cash payments journal, or general journal (number all journal pages as page 2). Post when instructed to do so. Assume a perpetual inventory system.

2. Prepare a trial balance in the Trial Balance columns of the work sheet provided. Complete the work sheet using the following information for accounting adjustments.

a. Expired insurance, $553. b. Ending store supplies inventory, $2,632.

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c. Ending office supplies inventory, $504. d. Depreciation of store equipment, $567. e. Depreciation of office equipment, $329.

Check (2) Unadjusted trial balance totals, $545,020; Adjustments column totals, $2,407

Prepare and post adjusting and closing entries. 3. Prepare a May multiple-step income statement, a May statement of owner’s

equity, and a May 31 classified balance sheet. (3) Net income, $31,647; Total assets, $385,791

4. (a) Prepare a post-closing trial balance. (b) Prove the accuracy of subsidiary ledgers by preparing schedules of both accounts receivable and accounts payable.

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so that the accounting professional can focus on the impacts of each transaction on the various financial reports. GL 7-1 General Ledger assignment GL 7-1, based on Problem 7-1A, highlights the relation between the subidiary ledgers and the control accounts. Prepare journal entries for a merchandiser, both purchase and sale transactions.

Accounting Analysis

COMPANY ANALYSIS A1

AA 7-1 Refer to Apple’s financial statements in Appendix A.

1. What amount of accounts payable did Apple report on (a) September 30, 2017? (b) On September 24, 2016?

2. Compute days’ payable outstanding for fiscal year ended (a) September 30, 2017, and (b) September 24, 2016.

3. Does Apple appear to be taking more or less time to pay its suppliers in fiscal year 2017 versus 2016?

COMPARATIVE ANALYSIS A1

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AA 7-2 Key figures for Apple and Google follow.

Required

1. Compute days’ payable outstanding for each company for the most recent two years.

2. For the current year, which company took more time to pay its suppliers?

GLOBAL ANALYSIS A1

AA 7-3 Key figures for Samsung and Google follow.

Required

1. Compute Samsung’s days’ payable outstanding for the most recent two years. 2. Assuming Samsung is not at risk of damaging its relationships with suppliers,

does it prefer days’ payable outstanding to increase or decrease? 3. For the current year, did Samsung or Google take more time to pay its

suppliers (based on days’ payable outstanding)?

Beyond the Numbers

ETHICS CHALLENGE C1

BTN 7-1 Erica Gray, CPA, is a sole practitioner. She has been practicing as an auditor for 10 years. Recently a long-standing audit client asked Gray to design and implement an integrated computer-based accounting information system. The fees associated with this additional engagement with the client are very attractive. However, Gray wonders if she can remain objective on subsequent audits in her evaluation of the client’s accounting system and its records if she was responsible

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for its design and implementation. Gray knows that professional auditing standards require her to remain independent in fact and appearance from her auditing clients.

Required

1. What do you believe auditing standards are mainly concerned with when they require independence in fact? In appearance?

2. Why is it important that auditors remain independent of their clients? 3. Do you think Gray can accept this engagement and remain independent?

Justify your response.

COMMUNICATING IN PRACTICE C2

BTN 7-2 Your friend, Wendy Geiger, owns a small retail store that sells candies and nuts. Geiger acquires her goods from a few select vendors. She generally makes purchase orders by phone and on credit. Sales are primarily for cash. Geiger keeps her own manual accounting system using a general journal and a general ledger. At the end of each business day, she records one summary entry for cash sales. Geiger recently began offering items in creative gift packages. This has increased sales substantially, and she is now receiving orders from corporate and other clients who order large quantities and prefer to buy on credit. As a result of increased credit transactions in both purchases and sales, keeping the accounting records has become extremely time-consuming. Geiger wants to continue to maintain her own manual system and calls you for advice. Write a memo to her advising how she might modify her current manual accounting system to accommodate the expanded business activities. Geiger is accustomed to checking her ledger by using a trial balance. Your memo should explain the advantages of what you propose and of any other verification techniques you recommend.

TAKING IT TO THE NET A1

BTN 7-3 Access the December 15, 2017, filing of the fiscal 2017 10-K/A report for HP (ticker: HPQ) at SEC.gov. Read its Note 2, which details HP’s segment information, and answer the following.

1. HP’s operations are divided among which three business segments? 2. In fiscal year 2017, which segment had the largest dollar amount of operating

income (titled “Earnings (loss) from continuing operations”)? Which segment had the largest amount of assets?

3. Compute the return on assets for each segment for fiscal year 2017. Use operating income and average total assets by segment for your calculation. Which segment has the highest return on assets?

TEAMWORK IN ACTION P1 P2 P3 P4

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BTN 7-4 Each member of the team is to assume responsibility for one of the following tasks.

a. Journalizing in the purchases journal. b. Journalizing in the cash payments journal. c. Maintaining and verifying the accounts payable ledger. d. Journalizing in the sales journal and the general journal. e. Journalizing in the cash receipts journal. f. Maintaining and verifying the accounts receivable ledger.

The team should abide by the following procedures in carrying out responsibilities.

Required

1. After tasks a through f are assigned, each team member is to quickly read the list of transactions in Problem 7-1A, identifying with initials the journal in which each transaction is to be recorded. Upon completion, the team leader is to read transaction dates, and the appropriate team member is to vocalize responsibility. Any disagreement between teammates must be resolved.

2. Journalize and continually update subsidiary ledgers. Journal recorders should alert teammates assigned to subsidiary ledgers when an entry must be posted to their subsidiary ledger.

3. Team members responsible for tasks a, b, d, and e are to summarize and prove journals; members responsible for tasks c and f are to prepare both payables and receivables schedules.

4. The team leader is to take charge of the general ledger, rotating team members to obtain amounts to be posted. The person responsible for a journal must complete posting references in that journal. Other team members should verify the accuracy of account balance computations. To avoid any abnormal account balances, post in the following order: P, S, G, R, D. (Note: Posting any necessary individual general ledger amounts is also done at this time.)

5. The team leader is to read out general ledger account balances while another team member fills in the trial balance form. Concurrently, one member should keep a running balance of debit account balance totals and another credit account balance totals. Verify the final total of the trial balance and the schedules. If necessary, the team must resolve any errors. Turn in the trial balance and schedules to the instructor.

ENTREPRENEURIAL DECISION P1

BTN 7-5 Refer to the chapter’s opening feature about Aaron, Dylan, Jeff, and Sam and their company, Box. Their company deals with the cloud storage needs of numerous suppliers and customers.

Required

1. Identify the special journals that Box would be likely to use in its operations. Also identify any subsidiary ledgers that it would likely use.

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2. Box hopes to double yearly sales within five years from its current $10 million annual assumed amount. Also assume that its sales growth projections are as follows.

Estimate Box’s projected sales for each year (round to the nearest dollar). If this pattern of sales growth holds, will Box achieve its goal of doubling sales in five years?

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8 Cash, Fraud, and Internal Control

Chapter Preview

FRAUD AND INTERNAL CONTROL

Purpose and principles of controls Technology and controls Limitations of controls

NTK 8-1

CONTROL OF CASH

Definition and reporting of cash Control of cash receipts and cash payments

NTK 8-2

TOOLS OF CONTROL AND ANALYSIS

Control of petty cash

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P3 A1

C1 C2

A1

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Bank reconciliation as a control tool Assessing liquidity

NTK 8-3 , 8-4

Learning Objectives

CONCEPTUAL

Define internal control and identify its purpose and principles. Define cash and cash equivalents and explain how to report them.

ANALYTICAL

Compute the days’ sales uncollected ratio and use it to assess liquidity.

PROCEDURAL

Apply internal control to cash receipts and payments. Explain and record petty cash fund transactions. Prepare a bank reconciliation. Appendix 8A—Describe use of documentation and verification to control cash payments.

©Jin Lee/Bloomberg via Getty Images

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Taking Care of Business

“Take the risks” —SHEILA MARCELO WALTHAM, MA—Sheila Marcelo was in college when her first child was born. “We had to scramble for child care throughout our college years,” recalls Sheila. “It was harder than it should have been.”

The struggle to find child care led Sheila to start Care.com (Care.com). Care.com matches caregivers with families online.

A key part of Care.com’s business is its internal control systems. Sheila explains that controls are important to Care.com’s future, to the integrity of its systems, and to the trust of its members. Her controls extend to monitoring transactions and safeguarding its assets and members.

Sheila insists that controls raise productivity, cut expenses, reduce fraud, and enhance the member experience. “People fear finance [and accounting] courses,” admits Sheila. “[But] if you want to be an entrepreneur,” declares Sheila, “don’t underestimate the value of skills learned in those classes.”

Sheila offers two suggestions for pursuing a business. First, “don’t worry about how you’re being perceived . . . about fitting into the mold.” Second, “to grow in leadership, you have to be a narcissist.” Adds Sheila, “Focus on yourself, understand yourself, take time for yourself. It will make you a better leader.”

Sources: Care.com website, January 2019; EAK, October 2016; Business Insider, March 2014; Boston Globe, August 2014; Bloomberg, September 2012

FRAUD AND INTERNAL CONTROL

Purpose of Internal Control

C1_______ Define internal control and identify its purpose and principles.

Managers or owners of small businesses often control the entire operation. They know if the business is actually receiving the assets and services it paid for. Most companies, however, cannot maintain personal supervision and must rely on internal controls.

©Wright Studio/Shutterstock

Internal Control System Managers use an internal control system to monitor and

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control business activities. An internal control system is policies and procedures used to

Protect assets. Ensure reliable accounting. Promote efficient operations. Uphold company policies.

Managers use internal control systems to prevent avoidable losses, plan operations, and monitor company and employee performance. For example, internal controls for UnitedHealth Group protect patient records and privacy.

Sarbanes-Oxley Act (SOX) Sarbanes-Oxley Act (SOX) requires managers and auditors of companies whose stock is traded on an exchange (called public companies) to document and verify internal controls. Following are some of the requirements.

The company must have effective internal controls. Auditors must evaluate internal controls. Violators receive harsh penalties—up to 25 years in prison with fines. Auditors’ work is overseen by the Public Company Accounting Oversight Board (PCAOB).

Committee of Sponsoring Organizations (COSO) Committee of Sponsoring Organizations (COSO) lists five ingredients of internal control that add to the quality of accounting information.

Control environment—company structure, ethics, and integrity for internal control. Risk assessment—identify, analyze, and manage risk factors. Control activities—policies and procedures to reduce risk of loss. Information & communication—reports to internal and external parties. Monitoring—regular review of internal control effectiveness.

Principles of Internal Control

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Internal control varies from company to company, but 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.

Establish Responsibilities Responsibility for a task should be clearly established and assigned to one person. When a problem occurs in a company where responsibility is not established, determining who is at fault is difficult. For example, if two salesclerks share the same cash register and cash is missing, neither clerk can be held accountable. To prevent this problem, a company can use separate cash drawers for each clerk. Point: Many companies have a mandatory 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.

Maintain Adequate Records Good recordkeeping helps protect assets and helps managers monitor company activities. When there are detailed records of equipment, for example, 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 used. Preprinted forms are also part of good internal control. When sales slips are properly designed, employees can record information efficiently with fewer errors. When sales slips are prenumbered, each slip is the responsibility of one salesperson, preventing the salesperson from stealing cash by making a sale and destroying the sales slip. Computerized point-of-sale systems achieve the same control results.

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Courtesy of Commercial Collection Agency Association of the Commercial Law League of America

Insure Assets and Bond Key Employees Assets should be insured against losses, and employees handling lots of cash and easily transferable assets should be bonded. An employee is bonded when a company purchases an insurance policy, or a bond, against theft by that employee. Bonding discourages theft because bonded employees know the bonding company will pursue reported theft.

Separate Recordkeeping from Custody of Assets A person who controls or has access to an asset must not have access to 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. Point: ACFE estimates that employee fraud costs more than $150,000 per incident.

Divide Responsibility for Related Transactions Responsibility for a transaction should be divided between two or more individuals or departments. This ensures the work of one person acts as a check on the other to prevent fraud and errors. This principle, called separation of duties, does not mean duplication of work. For example, when a company orders inventory, the task should be split among several employees. One employee submits a request to purchase inventory, a second employee approves the request, a third employee makes the payment, and a fourth employee records the transaction.

Apply Technological Controls Cash registers, time clocks, and ID scanners are examples of devices that can improve internal control. A cash register with a locked-in tape or electronic file makes a record of each cash sale. A time clock records the exact hours worked by an employee. ID scanners limit access to authorized individuals.

Perform Regular and Independent Reviews Regular reviews of internal controls help ensure that procedures are followed. These reviews are preferably done by auditors not directly involved in the activities. Auditors evaluate the efficiency and effectiveness of internal controls. Many companies pay for audits by independent auditors. These auditors test the company’s financial records and evaluate the effectiveness of internal controls.

Decision Maker 540

Decision Maker

Entrepreneur As owner of a start-up surfboard company, you hire a systems analyst. The analyst sees that your company employs only two workers. She says that as owner you must serve as a compensating control. What does the analyst mean? ■ Answer: Transaction authorization, recording, and asset custody are ideally handled by three employees. Many small businesses do not employ three workers. In such cases, an owner must make sure that the lack of separation of duties does not result in fraud.

©EpicStockMedia/iStockphoto/ Getty Images

Technology, Fraud, and Internal Control Principles of internal control are relevant no matter what the technological state of the accounting system, from manual to fully automated. Technology allows us quicker access to information and improves managers’ abilities to monitor and control business activities. This section describes technological impacts we must be alert to.

Reduced Processing Errors Technology reduces, but does not eliminate, errors in processing information. Less human involvement can cause data entry errors to go undiscovered. Also, errors in software can produce consistent but inaccurate processing of transactions. Point: Internal control failure reduces confidence in financial statements.

More Extensive Testing of Records When accounting records are kept manually, only small samples of data are usually checked for accuracy. When data are accessible using technology, large samples or even the entire database can be tested quickly.

New Evidence of Processing Technology makes it possible to record additional transaction details not possible with manual systems. For example, a system can record who made the entry, the date and time, the source of the entry, and so on. 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. Point: To assess a company’s internal controls, review the auditor’s report, management report on controls (if available), management discussion and analysis, and financial press.

Separation of Duties A company with few employees risks losing separation of duties. For example, the person who designs the information system should not operate it. The company also must separate control over programs and files from the activities related to cash receipts and payments. For example, a computer operator should not control check- writing activities.

Increased E-Commerce Amazon and eBay are examples of successful e-commerce

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companies. All e-commerce transactions involve at least three risks: (1) credit card number theft, (2) computer viruses, and (3) impersonation or identity theft. Companies use technological internal controls to combat these risks.

Decision Insight

Butterfingers Internal control failures can cost a company and its customers millions. Amazon learned the hard way when its web services failed. This failure led hundreds of websites to slow down. Reports say this failure cost companies in the S&P 500 index $150 million. The culprit? A typo in Amazon’s code. ■

Limitations of Internal Control

Internal controls have limitations from (1) human error or fraud and (2) the cost-benefit principle.

Human error occurs from carelessness, misjudgment, or confusion. Human fraud is intentionally defeating internal controls, such as management override, for personal gain. Human fraud is driven by the triple threat of fraud.

Opportunity—internal control weaknesses in a business. Pressure—financial, family, and societal stresses to succeed. Rationalization—employees justifying fraudulent behavior.

The cost-benefit principle says that the costs of internal controls must not exceed their benefits. Analysis of costs and benefits considers all factors, including morale. For example, most companies have a legal right to read employees’ e-mails but rarely do unless there is evidence of potential harm.

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_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8. _____ 9. _____ 10. _____ 11. _____ 12. _____ 13. _____ 14.

NEED-TO-KNOW 8-1

Internal Controls C1

Identify each of the following as a (a) purpose of an internal control system, (b) principle of internal control, or (c) limitation of internal control.

Protect assets Establish responsibilities Human error Maintain adequate records Apply technological controls Ensure reliable accounting Insure assets and bond key employees Human fraud Separate recordkeeping from custody of assets

Divide responsibility for related transactions Cost-benefit principle Promote efficient operations Perform regular and independent reviews Uphold company policies

Solution

1. a 2. b 3. c 4. b 5. b 6. a 7. b 8. c 9. b 10. b 11. c 12. a 13. b 14. a

Do More: QS 8-1, E 8-1, E 8-2, E 8-3, P 8-1

CONTROL OF CASH

C2_______ Define cash and cash equivalents and explain how to report them.

Cash is easily hidden and moved. Internal controls protect cash and meet three guidelines.

1. Handling cash is separate from recordkeeping of cash. 2. Cash receipts are promptly deposited in a bank. 3. Cash payments are made by check or electronic funds transfer (EFT).

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 hide this action. The second guideline uses immediate deposits of all cash receipts to produce an independent record of the

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cash received. It also reduces the chance of cash theft (or loss). The third guideline uses payments by check to develop an independent record of cash payments. It also reduces the risk of cash theft (or loss).

Cash, Cash Equivalents, and Liquidity

Liquidity refers to a company’s ability to pay for its current liabilities. Cash and similar assets are called liquid assets because they can be readily used to pay for liabilities.

Cash includes currency, coins, and deposits in bank accounts. Cash also includes items that can be deposited in these accounts such as customer checks, cashier’s checks, certified checks, and money orders. Cash equivalents are short-term, highly liquid investment assets meeting two criteria: (1) readily convertible to a known cash amount and (2) close enough to their due date so that their market value will not greatly change. Only investments within three months of their due date usually meet these criteria. Cash equivalents are short-term investments such as U.S. Treasury bills. Most companies combine cash equivalents with cash on the balance sheet. Point: The most liquid assets are usually reported first on a balance sheet; the least liquid assets are reported last.

Point: Companies invest idle cash in cash equivalents to increase income.

Cash Management A common reason companies fail is inability to manage cash. Companies must plan both cash receipts and cash payments. Goals of cash management are to

1. Plan cash receipts to meet cash payments when due. 2. Keep a minimum level of cash necessary to operate.

The treasurer is responsible for cash management. Effective cash management involves applying the following cash management strategies.

Encourage collection of receivables. The quicker customers and others pay the company, the quicker it can use the money. Some companies offer discounts for quicker payments. Delay payment of liabilities. The more delayed a company is in paying others, the more time it has to use the money. Companies regularly wait to pay bills until the last day allowed. Keep only necessary assets. Acquiring expensive and rarely used assets can cause cash shortages. Some companies lease warehouses or rent equipment to avoid large up- front payments. Plan expenditures. Companies must look at seasonal and business cycles to plan

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expenditures when money is available. Invest excess cash. Excess cash earns no return and should be invested in productive assets like factories. Excess cash from seasonal cycles can be placed in a short-term investment for interest.

Control of Cash Receipts

P1_______ Apply internal control to cash receipts and payments.

Internal control of cash receipts ensures that cash received is properly recorded and deposited. Cash receipts arise from transactions such as cash sales, collections of customer accounts, receipts of interest, bank loans, sales of assets, and owner investments. This section explains internal control over two types of cash receipts: over-the-counter and by mail.

Over-the-Counter Cash Receipts Over-the-counter cash sales should be recorded on a cash register after each sale, and customers should get a receipt. Cash registers should hold a permanent, locked-in record of each transaction. The register is often linked with the accounting system. Less advanced registers record each transaction on a paper tape or electronic file locked inside the register. Point: Many businesses have signs that read: If you receive no receipt, your purchase is free! This helps ensure that clerks ring up all transactions on registers.

Custody over cash should be separate from recordkeeping. The clerk who has access to cash in the register should not have access to its 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 record 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 with the cash receipts reported by the cashier. This record is used 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 steal cash without the difference being noticed (see the following diagram).

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Cash Over and Short 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. 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

Alternatively, 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

Because 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. A debit balance reflects an expense. It is reported on the income statement as part of selling, general, and administrative expenses. (Because the amount is usually small, it is often reported as part of miscellaneous expenses—or as part of miscellaneous revenues if it has a credit balance.)

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Cash Receipts by Mail Two people are assigned the task of opening the mail. In this case, theft of cash receipts by mail requires collusion between these two employees. The person(s) opening the mail enters a list (in triplicate) of money received. This list has each sender’s name, the amount, and an explanation of why the money was sent. The first copy is sent with the money to the cashier. A second copy is sent to the recordkeeper. A third copy is kept by the person(s) who opened the mail. The cashier deposits the money in a bank, and the recordkeeper records the amounts received.

This process is good internal control because the bank’s record of cash deposited must agree with the records from each of the three. If the mail person(s) does not report all receipts correctly, customers will question their account balances. If the cashier does not deposit all the cash, the bank balance does not agree with the recordkeeper’s cash balance. The recordkeeper does not have access to cash and has no opportunity to steal cash. This system makes errors and fraud highly unlikely. The exception is employee collusion.

Decision Insight

Cash Register Insight Walmart uses a network of information links with its point-of-sale cash registers to coordinate sales, purchases, and distribution. Its stores ring up tens of thousands of separate sales on heavy days. By using cash register information, the company can fix pricing mistakes quickly and capitalize on sales trends. ■

©Ambie Design/Shutterstock

Control of Cash Payments Control of cash payments is important as most large thefts occur from payment of fictitious invoices. One key to controlling cash payments is to require all payments to be made by check. The only exception is small payments made from petty cash. Another key is to deny access to accounting records to anyone other than the owner who has the authority to sign checks. A small-business owner often signs checks and knows that the items being paid for are actually received. Large businesses cannot maintain personal supervision and must rely on internal controls described here, including the voucher system and petty cash system.

Cash Budget Projected cash receipts and cash payments are summarized in a cash budget. If there is enough cash for operations, companies wish to minimize the cash they hold because of its risk of theft and its low return versus other assets.

Voucher System of Control A voucher system is a set of procedures and approvals designed to control cash payments and the acceptance of liabilities that consist of

Verifying, approving, and recording liabilities for cash payment.

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Issuing checks for payment of verified, approved, and recorded liabilities.

A voucher system’s control over cash payments begins when a company incurs a liability that will result in cash payment. The system only allows authorized departments and individuals to incur liabilities and limits the type of liabilities. In a large retail store, for example, only a purchasing department is authorized to incur liabilities for inventory. Purchasing, receiving, and paying for merchandise are divided among several departments (or individuals). These departments include the one requesting 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 8.1 shows how documents are accumulated in a voucher, which is an internal document (or file) used to collect information to control cash payments and to ensure that a transaction is properly recorded. This specific example begins with a purchase requisition and ends with issuing a check.

EXHIBIT 8.1 Document Flow in a Voucher System

Point: A purchase requisition is a request to purchase merchandise.

A voucher system should be applied to all payments (except those using petty cash). When a company receives a monthly telephone bill, it should review the charges, prepare a voucher (file), and insert the bill. This transaction is then recorded. If the amount is due, a check is issued. If not, the voucher is filed for payment on its due date. Without records, an employee could collude with a supplier to get more than one payment, payment for excessive amounts, or payment for goods and services not received. A voucher system helps prevent such frauds.

Ethical Risk

Cash Fraud The Association of Certified Fraud Examiners (ACFE) reports that 87% of fraud is from asset theft. Of those asset thefts, a few stand out—in both frequency and median loss. Namely, cash is most frequently stolen through billing (22%) and theft (20%), followed by expense reimbursements (14%), skimming (12%), check tampering (11%), and payroll (9%). Interestingly, the average loss per incident is greatest for check tampering ($158,000) and billing ($100,000). Source: “Report to the Nations,” ACFE. ■

NEED-TO-KNOW 8-2

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_____ 1.

_____ 2. _____ 3.

_____ 4.

_____ 5.

Control of Cash Receipts and Payments P1 C2

Which of the following statements are true regarding the control of cash receipts and cash payments?

Over-the-counter cash sales should be recorded on a cash register after each sale.

Custody over cash should be separate from the recordkeeping of cash. For control of cash receipts that arrive through the mail, two people

should be present for opening that mail. One key to controlling cash payments is to require that no expenditures

be made by check; instead, all expenditures should be made from petty cash. A voucher system of control should be applied only to purchases of

inventory and never to other expenditures.

Solution

1. True 2. True 3. True 4. False 5. False

Do More: QS 8-2, QS 8-4, QS 8-5, E 8-4, E 8-5, E 8-6, E 8-7

P2_______ Explain and record petty cash fund transactions.

Petty Cash System of Control To avoid writing checks for small amounts, a company sets up a petty cash system. Petty cash payments are small payments for items such as shipping fees, minor repairs, and low-cost supplies.

Operating a Petty Cash Fund A petty cash fund requires estimating the amount of small payments 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. The check is cashed and given to an employee called the petty cashier or petty cash custodian. The petty cashier keeps this cash safe, makes payments from the fund, and keeps records of it in a secure petty cashbox.

When a cash payment is made, the person receiving payment signs a prenumbered petty cash receipt, also called petty cash ticket—see Exhibit 8.2. The petty cash receipt is then placed in the petty cashbox with the remaining money. Under this system, the total of all receipts plus the remaining cash equals the total fund amount. A $100 petty cash fund, for example, 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).

EXHIBIT 8.2 Petty Cash Receipt

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The petty cash fund is reimbursed when it is nearing zero and at the end of an accounting period. The petty cashier sorts the paid receipts by the type of expense or account and then totals the receipts. The petty cashier gives 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. 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. Point: Companies use surprise petty cash counts for verification.

Illustrating a Petty Cash Fund Assume Z-Mart sets up a petty cash fund on November 1. A $75 check is drawn, cashed, and the proceeds given to the petty cashier. The entry to record the setup of this petty cash fund is

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.

Next, assume that Z-Mart’s petty cashier makes several November payments from petty cash. On November 27, after making a $46.50 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 8.3.

EXHIBIT 8.3 Petty Cash Payments Report

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Point: This report also can include receipt number and names of those who approved and received cash payment (see Need-To-Know 8-3).

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. 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.

Increasing or Decreasing a Petty Cash Fund A decision to increase or decrease a petty cash fund is often made when reimbursing it. Assume Z-Mart decides to increase its petty cash fund from $75 to $100 on November 27 when it reimburses the fund. The entries required are to (1) reimburse the fund as usual (see the preceding November 27 entry) and (2) increase the fund amount as follows.

Instead, if it decreases the petty cash fund from $75 to $55 on November 27, the entry is

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 equal 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.)

Following is the June 1 entry to reimburse a $200 petty cash fund when its payments report shows $178 in miscellaneous expenses and only $15 cash remains.

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Ethical Risk

Get Clued In There are clues to fraudulent activities. Clues 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. Clues from employees include (1) lifestyle change—could be embezzlement, (2) too close with suppliers—could signal fraudulent transactions, and (3) refusal to leave job, even for vacations—could conceal fraudulent activities. ■

NEED-TO-KNOW 8-3

Petty Cash System P2

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 payments report, which follows.

Required

1. Identify four internal control weaknesses from the petty cash payments 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?

After reimbursement?

Solution

1. Four internal control weaknesses that are apparent from the payments report

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include a. Petty cash Receipt No. 14 is missing. This raises questions about the petty

cashier’s management of the fund. b. The $19 cash balance means that $131 has been withdrawn ($150 − $19 =

$131). However, the total amount of the petty cash receipts is only $120 ($29 + $18 + $32 + $41). The fund is $11 short of cash ($131 − $120 = $11). Management should investigate.

c. The petty cashier (Eminem) did not sign petty cash Receipt No. 16. This could have been a mistake on his part or he might not have authorized the payment.

d. Petty cash Receipt No. 15 does not say which account to charge. Management should check with C. Carlsberg and the petty cashier (Eminem) about the transaction. Without further information, debit Miscellaneous Expense.

2. Petty cash general journal entries. a. Entry to establish the petty cash fund.

b. Entry to reimburse the fund.

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.

Do More: QS 8-6, E 8-8, E 8-9, E 8-10, P 8-2, P 8-3

BANKING ACTIVITIES AS CONTROLS

Basic Bank Services Banks safeguard cash and provide detailed records of cash transactions. They provide services and documents that help control cash, which is the focus of this section.

Bank Account, Deposit, and Check A bank account is used to deposit money for safekeeping and helps control withdrawals. Persons authorized to write checks on the account must sign a signature card, which the bank uses to verify signatures. Point: Firms often have multiple bank accounts for different needs and for specific transactions such as payroll.

Each bank deposit has a deposit ticket, which lists items such as currency, coins, and checks deposited along with amounts. The bank gives the customer a receipt as proof of the

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deposit. Exhibit 8.4 shows a deposit ticket.

EXHIBIT 8.4 Deposit Ticket

To withdraw money, the depositor can use a check, which is a document telling the bank to pay a specified amount to a designated recipient. A check involves three parties: a maker who signs the check, a payee who is the recipient, and a bank (or payer) on which the check is drawn. The bank provides the depositor the checks. Exhibit 8.5 shows one type of check. It has an optional remittance advice explaining the payment. The memo line is used for an explanation.

EXHIBIT 8.5 Check with Remittance Advice

Electronic Funds Transfer Electronic funds transfer (EFT) is the electronic transfer of cash from one party to another. Companies are increasingly using EFT because of its convenience and low cost. Payroll, rent, utilities, insurance, and interest payments are usually done by EFT. The bank statement lists cash withdrawals by EFT with the checks and

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Page 302other deductions. Cash receipts by EFT are listed with deposits and other additions.

Bank Statement Usually once a month, the bank sends a bank statement showing the account activity. Different banks use different formats for their bank statements, but all of them include the following. Point: Good control is to send a copy of the bank statement directly to a party without access to cash or recordkeeping.

1. Beginning-of-period account balance. 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 account balance.

Exhibit 8.6 shows one type of bank statement. Part A of Exhibit 8.6 summarizes changes in the account. B lists paid checks along with other debits. C lists deposits and credits to the account.

EXHIBIT 8.6 Bank Statement

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Point: Debit memos (DM) from the bank produce credits on the depositor’s books. Credit memos (CM) from the bank produce debits on the depositor’s books.

Canceled checks are checks the bank has paid and deducted from the customer’s account. We say such checks cleared the bank. Other usual deductions on a bank statement include (1) bank service fees, (2) checks deposited that are uncollectible, (3) corrections of previous errors, (4) withdrawals through automated teller machines (ATMs), and (5) payments arranged in advance by a depositor. A debit memorandum notifies a depositor of a deduction. Point: Your checking account is a liability from the bank’s perspective (but an asset from yours). When you make a deposit, they “credit your account.” Credits increase the bank’s liability to you. When you write a check or use your debit card, the bank decreases its liability to you; they “debit your account.” Debits decrease the bank’s liability to you.

Increases to the depositor’s account include amounts the bank collects on behalf of the depositor and the corrections of previous errors. A credit memorandum notifies the depositor of all increases. Banks that pay interest on checking accounts credit interest earned to the depositor’s account each period. In Exhibit 8.6, the bank credits $8 of interest to the account.

Bank Reconciliation

P3_______

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+

−

±

+

−

±

Prepare a bank reconciliation.

The balance of a checking account on the bank statement rarely equals the depositor’s book balance (from its records). This is due to information that one party has that the other does not. We must therefore verify the accuracy of both the depositor’s records and the bank’s records. To do this, we prepare a bank reconciliation to explain differences between the checking account balance in the depositor’s records and the balance on the bank statement. The following explains bank and book adjustments. Point: Books refer to accounting records.

Bank Balance Adjustments

Deposits in transit (or outstanding deposits). Deposits in transit are deposits made and recorded in the depositor’s books but not yet listed on the bank statement. For example, companies can make deposits (in the night depository) 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 not listed on the bank statement. Point: The person preparing the bank reconciliation should not be responsible for processing cash receipts, managing checks, or maintaining cash records.

Outstanding checks. Outstanding checks are checks written by the depositor, subtracted on the depositor’s books, and sent to the payees but not yet turned in for payment at the bank statement date. Bank errors. Any errors made by the bank are accounted for in the reconciliation. To

find errors, we (a) compare deposits on the bank statement with deposits in the accounting records and (b) compare canceled checks on the bank statement with checks recorded in the accounting records.

Book Balance Adjustments

Interest earned and unrecorded cash receipts. Banks sometimes collect notes for depositors. Banks also receive electronic funds transfers to the depositor’s account. When a bank collects an item, it is added to the depositor’s account, less any service fee. The bank statement also includes any interest earned. Point: Businesses with few employees often allow recordkeepers to both write checks and keep the general ledger. If this is done, the owner must do the bank reconciliation.

Bank fees and NSF checks. A company sometimes deposits another party’s check that is uncollectible. This check is called a nonsufficient funds (NSF) check. The bank initially credits (increases) the depositor’s account for the check. When the check is uncollectible, the bank debits (reduces) the depositor’s account for that check. The bank may charge the depositor a fee for processing an uncollectible check. Other bank charges include printing new checks and service fees. Book errors. Any errors made by the depositor in the company books are accounted

for in the reconciliation. To find errors, we use the same procedures described in the “Bank errors” section above.

Adjustments Summary Following is a summary of bank and book adjustments. Each of these items has already been recorded by either the bank or the company, but not both.

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1 2

3

4 5

6

7

8

Page 304 Bank Reconciliation Demonstration In preparing the bank reconciliation, refer to Exhibit 8.7 and steps 1 through 8 .

Enter VideoBuster’s bank balance of $2,050 taken from the bank statement. Add any unrecorded deposits and bank errors that understate the bank balance to the

bank balance. VideoBuster’s $145 deposit in the bank’s night depository on October 31 is not listed on its bank statement. Point: Outstanding checks are identified 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.

Subtract any outstanding checks and bank errors that overstate the bank balance 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. Enter VideoBuster’s cash account book balance of $1,405 taken from its accounting

records. Add any unrecorded cash receipts, interest earned, and errors understating the book

balance to the book balance. VideoBuster’s bank statement shows the bank collected a note receivable and increased VideoBuster’s account for $485. The bank statement also shows $8 for interest earned that was not yet recorded on the books.

Subtract any unrecorded bank fees, NSF checks, and errors overstating the book balance from the book balance. Deductions on VideoBuster’s bank statement that are not yet recorded include (a) a $23 charge for check printing and (b) an NSF check for $30. (The NSF check is dated October 16 and was in the book balance.)

Compute the adjusted book balance.

EXHIBIT 8.7 Bank Reconciliation

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Verify that the two adjusted balances from steps 4 and 8 are equal (reconciled).

Adjusting Entries from a Bank Reconciliation A bank reconciliation often finds unrecorded items that need recording by the company. In VideoBuster’s reconciliation, the adjusted balance of $1,845 is the correct balance as of October 31. But the company’s accounting records show a $1,405 balance. We make adjusting entries so that the book balance equals the adjusted balance. Only items impacting the book balance need entries. Exhibit 8.7 shows that four entries are required.

Collection of Note The first entry is to record collection of a note receivable by the bank.

Interest Earned

The second entry records interest earned.

Check Printing The third entry records expenses for the check printing charge.

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NSF Check The fourth entry records the NSF check that is returned as uncollectible. The check was from T. Woods in payment of his account. The bank deducted $30 total from VideoBuster’s account. This means the entry must reverse the effects of the original entry when the check was received. Point: The company will try to collect the $30 from the customer.

After these four entries are recorded, the book balance of cash is adjusted to the correct amount of $1,845 (the adjusted book balance). The Cash T-account to the side shows the computation, where entries match the steps in Exhibit 8.7.

Point: Need-To-Know 8-4 shows an adjusting entry for an error correction.

©Redpixel.pl/Shutterstock

Ethical Risk

Cause for Alarm The Association of Certified Fraud Examiners (ACFE) reports that the primary factor contributing to fraud is the lack of internal controls (30%), followed by the override of existing controls (19%), lack of management review (18%), poor tone at the top (10%), and lack of competent oversight (8%). These findings highlight the importance of internal controls over cash. Source: “Report to the Nations,” ACFE. ■

NEED-TO-KNOW 8-4

Bank Reconciliation P3

The following information is available to reconcile Gucci’s book balance of cash with its bank statement cash balance as of December 31.

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a. The December 31 cash balance according to the accounting records is $1,610, and the bank statement cash balance for that date is $1,900.

b. Gucci’s December 31 daily cash receipts of $800 were placed in the bank’s night depository on December 31 but do not appear on the December 31 bank statement.

c. Gucci’s comparison of canceled checks with its books shows three checks outstanding: No. 6242 for $200, No. 6273 for $400, and No. 6282 for $100.

d. When the December checks are compared with entries in the accounting records, it is found that Check No. 6267 had been correctly drawn (taken from the bank) for $340 to pay for office supplies but was erroneously entered in the accounting records as $430.

e. The bank statement shows the bank collected a note receivable and increased Gucci’s account for $470. Gucci had not recorded this transaction before receiving the statement.

f. The bank statement included an NSF check for $150 received from Prada Inc. in payment of its account. It also included a $20 charge for check printing. Gucci had not recorded these transactions before receiving the statement.

Required

1. Prepare the bank reconciliation for this company as of December 31. 2. Prepare the journal entries to make Gucci’s book balance of cash equal to the

reconciled cash balance as of December 31.

Solutions

Part 1

Part 2

Do More: QS 8-7, QS 8-8, QS 8-9, E 8-11, E 8-12, E 8-13, E 8-14, P 8-4, P 8-5

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Decision Analysis Days’ Sales Uncollected

A1_______ Compute the days’ sales uncollected ratio and use it to assess liquidity.

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, which is defined in Exhibit 8.8.

EXHIBIT 8.8 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. It is used to determine if cash is being collected quickly enough to pay upcoming obligations. Days’ sales uncollected are shown for Starbucks and Jack in the Box in Exhibit 8.9.

EXHIBIT 8.9 Analysis Using Days’ Sales Uncollected

Days’ sales uncollected for Starbucks is 14.2 days for the current year, computed as ($870/$22,387) × 365 days. This means it takes 14.2 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 Starbucks, we compare it to Jack in the Box. We see that Starbucks’s 14.2 days’ sales uncollected is better than Jack in the Box’s 16.2 days’ sales uncollected for the current year. Starbucks took less time to collect its receivables. The less time money is tied up in receivables, the better.

Decision Maker

Sales Representative The sales staff are told to help reduce days’ sales uncollected for cash management purposes. What can you, a salesperson, do to reduce days’ sales

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uncollected? ■ Answer: A salesperson can (1) push cash sales over credit, (2) identify customers most delayed in their payments and require earlier payments or cash sales, and (3) eliminate credit sales to customers that never pay.

NEED-TO-KNOW 8-5 COMPREHENSIVE

Preparing Bank Reconciliation and Adjusting Entries

Prepare a bank reconciliation for Jamboree Enterprises for the month ended November 30. The following information is available as of November 30.

a. On November 30, the company’s book balance of cash is $16,380, 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 (taken from the bank) 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. The bank statement says that the bank collected a $30,000 note and $900 of interest was earned. These transactions were not recorded by Jamboree prior to receiving the statement.

g. The bank statement 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 (as in Exhibit 8.7). Examine each item a through h to determine whether it affects the book or the bank balance and whether it should be added or subtracted. 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

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8A

Required Adjusting Entries for Jamboree

APPENDIX

Documentation and Verification This appendix covers the documents of a voucher system of control.

P4_______ Describe use of documentation and verification to control cash payments.

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 requested to be purchased—see Exhibit 8A.1. Two copies of the purchase requisition are sent to the purchasing 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 a third copy.

EXHIBIT 8A.1 Purchase Requisition

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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 merchandise at the stated price and terms—see Exhibit 8A.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 vendor as a purchase request 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 of the purchase; copy 4 to the receiving department without order quantity so it can compare with goods received and provide an independent count of goods received; and copy 5 kept on file by the purchasing department.

EXHIBIT 8A.2 Purchase Order

Point: This appendix shows one example of a common voucher system design, but not the only design.

Point: Shipping terms and credit terms are shown on the 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

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Page 309 also a bill sent to the buyer from the supplier. From the vendor’s point of view, it is a sales invoice. The buyer, or vendee, treats it as a purchase invoice. The invoice is sent to the buyer’s accounting department, where it is placed in the voucher. (Refer back to Exhibit 5.6, which shows Z-Mart’s purchase invoice.)

Receiving Report Many companies have a receiving 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 report, which is used within the company to notify that ordered goods have been received and to describe the quantities and condition of the goods. One copy is sent to accounting and placed in the voucher. Copies also are sent to the requesting department and the purchasing department to notify them that the goods have arrived. The receiving department keeps 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 payment. In approving an invoice for payment, it checks and compares information across all documents. To verify this information and to ensure that no step is missing, it often uses an invoice approval, also called check authorization—see Exhibit 8A.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 8A.3 Invoice Approval

As each step in the checklist is approved, the person initials the invoice approval and records the current date. Final approval means the following steps have occurred. 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.

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.

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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.

Point: Auditors, when auditing inventory, check a sampling of purchases by reviewing the purchase order, receiving report, and invoice.

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 recording an obligation. A voucher also contains approval for paying the obligation on an appropriate date.

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 on the left-hand side of Exhibit 8A.4, and that for the outside is on the right-hand side. This information is taken from the invoice and the supporting 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.

EXHIBIT 8A.4 A Voucher

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 signatures are forged.

Summary: Cheat Sheet

FRAUD AND INTERNAL CONTROL

Principles of Internal Control

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Establish responsibilities: Responsibility for a task should be assigned to one person. If responsibility is not established, determining who is at fault is difficult. Maintain adequate records: Good recordkeeping helps protect assets and helps managers monitor company activities. Insure assets and bond key employees: Assets should be insured and employees handling cash and easily transferable assets should be bonded. Separate recordkeeping from custody of assets: An employee who has access to an asset must not have access to that asset’s accounting records. Divide responsibility for related transactions: Responsibility for a transaction should be divided between two or more individuals or departments. One person’s work is a check on the others to prevent errors. This is not duplication of work. Apply technological controls: Use technology such as ID scanners to protect assets and improve control. Perform regular and independent reviews: Regular reviews of internal controls should be performed by outside reviewers, preferably auditors.

CONTROL OF CASH

Cash account: Includes currency, coins, checks, and deposits in bank accounts. Cash equivalents: Short-term, liquid investment assets meeting two criteria: (1) convertible to a known cash amount and (2) close to their due date, usually within 3 months. An example is a U.S. Treasury bill. Cash management strategies: (a) Encourage early collection of receivables, (b) delay payment of liabilities, (c) keep only necessary assets, (d) plan expenditures, and (e) invest excess cash. Over-the-Counter Cash Receipt Control Procedures

Sales are recorded on a cash register after each sale and customers are given a receipt. Cash registers hold a locked-in record of each transaction and often are linked with the accounting system. Custody over cash is separate from recordkeeping. The clerk who has access to cash in the register cannot access accounting records. The recordkeeper cannot access the cash.

Cash Over and Short Journal Entries If cash received is more than recorded cash sales:

If cash received is less than recorded cash sales:

Cash Receipts by Mail Control Procedures

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Two people are tasked with opening mail. Theft of cash would require collusion between these two employees. A list (in triplicate) is kept of each sender’s name, the amount, and an explanation of why money was sent. The first copy is sent with the money to the cashier. A second copy is sent to the recordkeeper. The employees who opened the mail keep the third copy. The cashier deposits the money in a bank, and the recordkeeper records amounts received. No employee has access to both accounting records and cash.

Cash Payment Control Procedures

Require all payments to be made by check or EFT. The only exception is small payments made from petty cash. Deny access to records to employees who can sign checks (other than the owner).

Voucher system: Set of procedures to control cash payments. Applied to all payments.

TOOLS OF CONTROL AND ANALYSIS

Petty cash: System of control used for small payments. Entry to set up a petty cash fund:

Reimburse and record expenses for petty cash:

Increasing a petty cash fund (after reimbursement):

Decreasing a petty cash fund (after reimbursement):

Petty cash fund has unexplained shortage:

Canceled checks: Checks the bank has paid and deducted from the customer’s account.

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Bank reconciliation adjustments:

Adjusting Entries from Bank Reconciliation—Examples Collection of note:

Interest earned:

Bank fees:

NSF checks:

Key Terms

Bank reconciliation (303) Bank statement (302) Canceled checks (302) Cash (295) Cash equivalents (295) Cash Over and Short (296) Check (301) Check register (310) Committee of Sponsoring Organizations (COSO) (291) Credit memorandum (303) Days’ sales uncollected (306) Debit memorandum (303) Deposit ticket (301) Deposits in transit (303) Electronic funds transfer (EFT) (301) Internal control system (291) Invoice (308)

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Invoice approval (309) Liquid assets (294) Liquidity (294) Outstanding checks (303) Petty cash (298) Principles of internal control (292) Purchase order (308) Purchase requisition (308) Receiving report (309) Sarbanes-Oxley Act (SOX) (291) Signature card (301) Vendee (308) Vendor (308) Voucher (297) Voucher register (310) Voucher system (297)

Multiple Choice Quiz

1. The following information is available for Hapley Co. 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 $320 note was collected by the bank and deposited in Hapley’s account in November. 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.

2. Using the information from question 1, what is the reconciled balance on Hapley’s November 30 bank reconciliation?

a. $2,052 b. $1,895

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c. $1,742 d. $2,201 e. $1,184

3. A company needs to replenish its $500 petty cash fund. Its petty cashbox 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.

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.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. a; recognizes cash collection of note by bank. 2. a; the bank reconciliation follows.

3. e; The entry follows.

4. d; ($6,720⁄$84,000) × 365 = 29.2 days

A Superscript letter A denotes assignments based on Appendix 8A.

Icon denotes assignments that involve decision making.

Discussion Questions

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_____ 1.

_____ 2.

_____ 3.

1. List the seven broad principles of internal control. 2. Internal control procedures are important in every business, but at what

stage in the development of a business do they become especially critical? 3. Why should responsibility for related transactions be divided 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—inventory, building, accounts receivable, or

cash—is most liquid? Which is least liquid? 8. What is a petty cash receipt? Who should sign it? 9. Why should cash receipts be deposited on the day of receipt?

10. Apple’s statement of cash flows in Appendix A describes changes in cash and cash equivalents for the year ended September 30, 2017. What total amount is provided (used) by investing activities? What amount is provided (used) by financing activities?

11. Refer to Google’s financial statements in Appendix A. Identify Google’s net earnings (income) for the year ended December 31, 2017. Is its net earnings equal to the change in cash and cash equivalents for the year? Explain the difference between net earnings and the change in cash and cash equivalents.

12. Refer to Samsung’s balance sheet in Appendix A. How does its cash (titled “Cash and cash equivalents”) compare with its other current assets (in both amount and percent) as of December 31, 2017? Compare and assess its cash at December 31, 2017, with its cash at December 31, 2016.

13. Samsung’s statement of cash flows in Appendix A reports the change in cash and equivalents for the year ended December 31, 2017. Identify the cash generated (or used) by operating activities, by investing activities, and by financing activities.

QUICK STUDY

QS 8-1 Internal control objectives C1 Indicate which statements are true and which are false.

Separation of recordkeeping for assets from the custody over assets helps reduce fraud.

The primary objective of internal control procedures is to safeguard the business against theft from government agencies.

Internal control procedures should be designed to protect assets from waste and theft.

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_____ a. _____ b. _____ c. _____ d.

_____ 1.

_____ 2.

_____ 3.

_____ a.

_____ b.

_____ c.

_____ d.

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Separating the responsibility for a transaction between two or more individuals or departments will not help prevent someone from creating a fictitious invoice and paying the money to himself.

QS 8-2 COSO internal control components C1 COSO lists five components of internal control: control environment, risk assessment, control activities, information and communication, and monitoring. Indicate the COSO component that matches with each of the following internal control activities.

Independent review of controls Executives’ strong ethics Reporting of control effectiveness Analyses of fraud risk factors

QS 8-3 Cash and equivalents C2 Choose from the following list of terms and phrases to best complete the following statements.

a. Cash b. Cash equivalents c. Outstanding check d. Liquidity e. Cash over and short f. Voucher system

The _______ category includes currency, coins, and deposits in bank accounts.

The term _______ refers to a company’s ability to pay for its current liabilities.

The _______ category includes short-term, highly liquid investment assets that are readily convertible to a known cash amount and sufficiently close to their due dates so that their market value will not greatly change.

QS 8-4 Internal control for cash P1 Identify each of the following statements as either true or false.

A guideline for safeguarding cash is that all cash receipts be deposited monthly or yearly.

A voucher system of control is a control system exclusively for cash receipts.

A guideline for safeguarding cash is to separate the duties of those who have custody of cash from those who keep cash records.

Separation of duties eliminates the possibility of collusion to steal an asset and hide the theft from the records.

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_____ a. _____ b. _____ c. _____ d.

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QS 8-5 Cash Over and Short P1 Record the journal entry for Sales and for Cash Over and Short for each of the following separate situations.

a. The cash register’s record shows $420 of cash sales, but the count of cash in the register is $430.

b. The cash register’s record shows $980 of cash sales, but the count of cash in the register is $972.

QS 8-6 Petty cash accounting P2

1. Brooks Agency set up a petty cash fund for $150. At the end of the current period, the fund contained $28 and had the following receipts: entertainment, $70; postage, $30; and printing, $22. Prepare 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 from the following that cause a Petty Cash account to be credited in a journal entry.

Fund amount is being reduced. Fund amount is being increased. Fund is being eliminated. Fund is being established.

QS 8-7 Bank reconciliation P3 For a through g, indicate whether its amount (1) affects the bank or book side of a bank reconciliation, (2) is an addition or a subtraction in a bank reconciliation, and (3) requires an adjusting journal entry.

QS 8-8 Bank reconciliation P3 Nolan Company’s Cash account shows a $22,352 debit balance and its bank statement shows $21,332 on deposit at the close of business on June 30. Prepare a bank reconciliation using the following information.

a. Outstanding checks as of June 30 total $3,713. b. The June 30 bank statement lists $41 in bank service charges; 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 as $99.

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_____ a. _____ b. _____ c. _____ d.

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 company’s cash in the bank. The company has not yet recorded interest earned.

QS 8-9 Bank reconciliation P3

Organic Food Co.’s Cash account shows a $5,500 debit balance and its bank statement shows $5,160 on deposit at the close of business on August 31. Prepare a bank reconciliation using the following information.

a. August 31 cash receipts of $1,240 were placed in the bank’s night depository after banking hours and were not recorded on the August 31 bank statement.

b. The bank statement shows a $120 NSF check from a customer; the company has not yet recorded this NSF check.

c. Outstanding checks as of August 31 total $1,120. d. In reviewing the bank statement, an $80 check written by Organic Fruits was

mistakenly drawn against Organic Food’s account. e. The August 31 bank statement lists $20 in bank service charges; the company

has not yet recorded the cost of these services.

QS 8-10 Days’ sales uncollected A1 The following annual account balances are from Armour Sports at December 31.

a. What is the change in the number of days’ sales uncollected between Year 1 and Year 2? (Round the number of days to one decimal.)

b. From the analysis in part a, is the company’s collection of receivables improving?

QS 8-11A Documents in a voucher system P4 Management uses a voucher system to help control and monitor cash payments. Which one or more of the four documents listed below are prepared as part of a voucher system of control?

Purchase order Outstanding check Invoice Voucher

EXERCISES

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Exercise 8-1 Analyzing internal control C1 Identify the internal control principle that was violated in each of the following separate situations.

a. The recordkeeper left town after the owner discovered a large sum of money had disappeared. An audit found that the recordkeeper had written and signed several checks made payable to his fiancée and recorded the checks as salaries expense.

b. An employee was put in charge of handling cash. That employee later stole cash from the business. The company incurred an uninsured loss of $184,000.

c. There is $500 in cash missing from a cash register drawer. Three salesclerks shared the cash register drawer, so the owner cannot determine who is at fault.

Exercise 8-2 Applying internal control principles C1 Whole Fruits Market took the following actions to improve internal controls. For each of the following actions, identify the internal control principle the company followed.

a. Prohibit the recordkeeper from having control over cash. b. Purchased an insurance (bonding) policy against losses from theft by a

cashier. c. Each cashier is designated a specific cash drawer and is solely responsible for

cash in that drawer. d. Detailed records of inventory are kept to ensure items lost or stolen do not go

unnoticed. e. Digital time clocks are used to register which employees are at work at what

times. f. External auditors are regularly hired to evaluate internal controls.

Exercise 8-3 Internal control strengths and weaknesses C1 Determine whether each procedure described below is an internal control strength or weakness; then identify the internal control principle violated or followed for each procedure.

1. The same employee requests, records, and makes payment for purchases of inventory.

2. The company saves money by having employees involved in operations perform the only review of internal controls.

3. Time is saved by not updating records for use of supplies. 4. The recordkeeper is not allowed to write checks or initiate EFTs. 5. Each salesclerk is in charge of her own cash drawer.

Exercise 8-4 Cash management strategies C2 Determine whether each policy below is good or bad cash management; then identify the cash management strategy violated or followed for each policy.

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1. Bills are paid as soon as they are received. 2. Cash receipts and cash payments are regularly planned and reviewed. 3. Excess cash is put in checking accounts, earning no interest income. 4. Customers are regularly allowed to pay after due dates without concern. 5. Rarely used equipment is rented rather than purchased.

Exercise 8-5 Cash and cash equivalents C2 Specter Co. combines cash and cash equivalents on the balance sheet. Using the following information, determine the amount reported on the year-end balance sheet for cash and cash equivalents.

$3,000 cash deposit in checking account. $20,000 bond investment due in 20 years. $5,000 U.S. Treasury bill due in 1 month. $200, 3-year loan to an employee. $1,000 of currency and coins. $500 of accounts receivable.

Exercise 8-6 Control of cash receipts P1 Determine whether each cash receipts procedure is an internal control strength or weakness.

1. If a salesclerk makes an error in recording a cash sale, she can access the register’s electronic record to correct the transaction.

2. All sales transactions, even those for less than $1, are recorded on a cash register.

3. Two employees are tasked with opening mail that contains cash receipts. 4. One of the two employees tasked with opening mail is also the recordkeeper

for the business. 5. The supervisor has access to both cash and the accounting records. 6. Receipts are given to customers only for sales that are above $20.

Exercise 8-7 Voucher system and control of cash payments P1 Determine whether each cash payment procedure is an internal control strength or weakness.

1. A voucher system is used for all payments of liabilities. 2. The owner of a small business has authority to write and sign checks. 3. When the owner is out of town, the recordkeeper is in charge of signing

checks. 4. To save time, all departments are allowed to incur liabilities. 5. Payments over $100 are made by check. 6. Requesting and receiving merchandise are handled by the same department.

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Exercise 8-8 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 8-9 Petty cash fund with an overage P2

EcoMart establishes a $1,050 petty cash fund on May 2. On May 30, the fund shows $326 in cash along with receipts for the following expenditures: transportation-in, $120; postage expenses, $369; and miscellaneous expenses, $240. The petty cashier could not account for a $5 overage in the fund. The company uses the perpetual system in accounting for merchandise inventory.

Prepare the (1) May 2 entry to establish the fund, (2) May 30 entry to reimburse the fund [Hint: Credit Cash Over and Short for $5 and credit Cash for $724], and (3) June 1 entry to increase the fund to $1,200.

Exercise 8-10 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 & $250

Exercise 8-11 Bank reconciliation and adjusting entries P3 Prepare a table with the following headings for a monthly bank reconciliation dated September 30.

Indicate whether each item should be added to or deducted from the book or bank balance and whether it should or should not appear on the September 30 reconciliation. For items that add or deduct from the book balance column, place a Dr. or Cr. after the “Add” or “Deduct” to show the accounting impact on Cash.

1. NSF check from a customer is shown on the bank statement but not yet recorded by the company.

2. Interest earned on the September cash balance in the bank is not yet recorded by the company.

3. Deposit made on September 5 and processed by the bank on September 6.

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4. Checks written by another depositor but mistakenly charged against this company’s account.

5. Bank service charge for September is not yet recorded by the company. 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. A note receivable is collected by the bank for the company, but it is 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. Bank fees for check printing are not yet recorded by the company.

Exercise 8-12 Bank reconciliation P3 Del Gato Clinic’s Cash account shows an $11,589 debit balance and its bank statement shows $10,555 on deposit at the close of business on June 30. Prepare its bank reconciliation using the following information.

a. Outstanding checks as of June 30 total $1,829. b. The June 30 bank statement lists a $16 bank service charge. 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 8-13 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 8-12.

Exercise 8-14 Bank reconciliation P3 Wright Company’s Cash account shows a $27,500 debit balance and its bank statement shows $25,800 on deposit at the close of business on May 31. Prepare its bank reconciliation using the following information.

a. The May 31 bank statement lists $100 in bank service charges; 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. The bank statement shows a $600 NSF check from a customer; the company

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has not yet recorded this NSF check. Check Reconciled bal., $26,800

Exercise 8-15 Liquid assets and accounts receivable A1 Barga Co.’s net sales for Year 1 and Year 2 are $730,000 and $1,095,000, respectively. Its year-end balances of accounts receivable follow: Year 1, $65,000; and Year 2, $123,000.

a. Compute its days’ sales uncollected at the end of each year. Round the number of days to one decimal.

b. Did days’ sales uncollected improve or worsen in Year 2 versus Year 1?

Exercise 8-16 A Documents in a voucher system P4 Match each document in a voucher system with its description.

PROBLEM SET A

Problem 8-1A Analyzing internal control C1 Following are five separate cases involving internal control issues.

a. Chi Han receives all incoming customer cash receipts for her employer and posts the customer payments to their respective accounts.

b. At Tico Company, Julia and Trevor alternate lunch hours. Julia is the petty cash custodian, but if someone needs petty cash when she is at lunch, Trevor fills in as custodian.

c. Nori Nozumi posts all patient charges and payments at the Hopeville Medical Clinic. Each night Nori backs up the computerized accounting system but does not password lock her computer.

d. Ben Shales prides himself on hiring quality workers who require little supervision. As office manager, Ben gives his employees full discretion over their tasks and for years has seen no reason to perform independent reviews of their work.

e. Carla Farah’s manager has told her to reduce costs. Carla decides to raise the deductible on the plant’s property insurance from $5,000 to $10,000. This

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cuts the property insurance premium in half. In a related move, she decides that bonding the plant’s employees is a waste of money because the company has not experienced any losses due to employee theft. Carla saves the entire amount of the bonding insurance premium by dropping the bonding insurance.

Required

1. For each case, identify the principle(s) of internal control that is violated. 2. Recommend what should be done to adhere to principles of internal control in

each case.

Problem 8-2A Establishing, reimbursing, and adjusting 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).

Required Prepare journal entries 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. Check Cr. to Cash: May 15, $237.85; May 16, $200.00

Problem 8-3A Establishing, reimbursing, and increasing petty cash P2 Nakashima Gallery had the following petty cash transactions in February of the current year. Nakashima uses the perpetual system to account for merchandise inventory.

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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 expense, postage expense, merchandise inventory (for transportation-in), and office supplies expense.

3. Prepare the journal entries for part 2 to both (a) reimburse and (b) increase the fund amount. Check Cash credit: (3a) $279.58; (3b) $100.00

Problem 8-4A Preparing a bank reconciliation and recording 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.

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, Check No. 3065 for $382, and Check No. 3069 for $2,281 are outstanding checks as of July 31.

c. Check No. 3056 for July rent expense was correctly written and drawn for $1,270 but was erroneously entered in the accounting records as $1,250.

d. The July bank statement shows the bank collected $7,955 cash on a note for Branch. Branch had not recorded this event before receiving the statement.

e. The bank statement shows an $805 NSF check. The check had been received from a customer, Evan Shaw. Branch has not yet recorded this check as NSF.

f. The July statement shows a $25 bank service charge. It has not yet been recorded in miscellaneous expenses 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. 2. Prepare the journal entries necessary to make the company’s book balance of

cash equal to the reconciled cash balance as of July 31.

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Page 319Check (1) Reconciled balance, $34,602; (2) Cr. Notes Receivable, $8,000

Problem 8-5A Preparing a bank reconciliation and recording 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 and No. 5893 for $494. Check No. 5893 was still outstanding as of September 30. The following information is available for its September 30 reconciliation.

From Chavez Company’s Accounting Records

Additional Information (a) Check No. 5904 is correctly drawn for $2,090 to pay

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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. (b) 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. (c) The credit memorandum (CM) is from the collection of a $1,485 note for Chavez Company by the bank. The collection is not yet recorded.

Required

1. Prepare the September 30 bank reconciliation for this company. 2. Prepare journal entries to adjust the book balance of cash to the reconciled

balance. Check (1) Reconciled balance, $18,271; (2) Cr. Notes Receivable, $1,485

PROBLEM SET B

Problem 8-1B Analyzing internal control C1 Following are five separate cases involving internal control issues.

a. Tywin Company keeps very poor records of its equipment. Instead, the company asserts its employees are honest and would never steal from the company.

b. Marker Theater has a computerized order-taking system for its tickets. The system is backed up once a year.

c. Sutton Company has two employees handling acquisitions of inventory. One employee places purchase orders and pays vendors. The second employee receives the merchandise.

d. The owner of Super Pharmacy uses a check software/printer to prepare checks, making it difficult for anyone to alter the amount of a check. The check software/printer, which is not password protected, is on the owner’s desk in an office that contains company checks and is normally unlocked.

e. To ensure the company retreat would not be cut, the manager of Lavina Company decided to save money by canceling the external audit of internal controls.

Required

1. For each case, identify the principle(s) of internal control that is violated. 2. Recommend what should be done to adhere to principles of internal control in

each case.

Problem 8-2B Establishing, reimbursing, and adjusting petty cash P2 Moya Co. establishes a petty cash fund for payments of small amounts. The following transactions involving the petty cash fund occurred in January (the last month of the company’s fiscal year).

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Required 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. Check Cr. to Cash: Jan. 14, $87.72; Jan. 31 (total), $232.65

Problem 8-3B Establishing, reimbursing, and increasing petty cash P2 Blues Music Center had the following petty cash transactions in March of the current year. Blues uses the perpetual system to account for merchandise inventory.

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 expense, postage expense, merchandise inventory (for transportation-in), and office supplies expense. Check (2) Total expenses, $189.47

3. Prepare the journal entries for part 2 to both (a) reimburse and (b) increase the fund amount. (3a & 3b) Total Cr. to Cash, $238.47

Problem 8-4B Preparing a bank reconciliation and recording adjustments P3

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The following information is available to reconcile Severino Co.’s book balance of cash with its bank statement cash balance as of December 31.

a. The December 31 cash balance according to the accounting records is $32,878.30, and the bank statement cash balance for that date is $46,822.40.

b. Check No. 1242 for $410.40, Check No. 1273 for $4,589.30, and Check No. 1282 for $400 are outstanding checks as of December 31.

c. 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. The bank statement shows a $762.50 NSF check received from a customer, Titus Industries, in payment of its account. The statement also shows a $99 bank fee in miscellaneous expenses for check printing. Severino had not yet recorded these transactions.

e. The bank statement shows that the bank collected $18,980 cash on a note receivable for the company. 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. Check (1) Reconciled balance, $51,005.80;

2. Prepare the journal entries necessary to make the company’s book balance of cash equal to the reconciled cash balance as of December 31. (2) Cr. Notes Receivable, $18,980.00

Problem 8-5B Preparing a bank reconciliation and recording adjustments P3 Shamara Systems most recently reconciled its bank balance on April 30 and reported two checks outstanding at that time, No. 1771 for $781 and No. 1780 for $1,425.90. Check No. 1780 was still outstanding as of May 31. The following information is available for its May 31 reconciliation.

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From Shamara Systems’s Accounting Records

Additional Information (a) 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. (b) 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 recorded its return. (c) The credit memorandum (CM) is from a $7,350 note that the bank collected for the company. The collection has not yet been recorded.

Required

1. Prepare the May 31 bank reconciliation for Shamara Systems.

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Check (1) Reconciled balance, $22,071.50;

2. Prepare journal entries to adjust the book balance of cash to the reconciled balance. (2) Cr. Notes Receivable, $7,350.00

SERIAL PROBLEM

Business Solutions P3 This serial problem began in Chapter 1 and continues through most of the book. If previous chapter segments were not completed, the serial problem can begin at this point.

©Alexander Image/ Shutterstock

SP 8 Santana Rey receives the March bank statement for Business Solutions on April 11, 2020. The March 31 bank statement shows an ending cash balance of $67,566. The general ledger Cash account, No. 101, shows an ending cash balance per books of $68,057 as of March 31 (prior to any reconciliation). A comparison of the bank statement with the general ledger Cash account, No. 101, reveals the following.

a. The bank erroneously cleared a $500 check against the company account in March that S. Rey did not issue. The check was actually issued by Business Systems.

b. On March 25, the bank statement lists a $50 charge for a safety deposit box. Santana has not yet recorded this expense.

c. On March 26, the bank statement lists a $102 charge for printed checks that Business Solutions ordered from the bank. Santana has not yet recorded this expense.

d. On March 31, the bank statement lists $33 interest earned on Business Solutions’s checking account for the month of March. Santana has not yet recorded this revenue.

e. S. Rey notices that the check she issued for $128 on March 31, 2020, has not yet cleared the bank.

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f. S. Rey verifies that all deposits made in March do appear on the March bank statement.

Required

1. Prepare a bank reconciliation for Business Solutions for the month ended March 31, 2020. Check (1) Adj. bank bal., $67,938

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 March.

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so that the financial professional can focus on the impacts of each transaction on the various financial reports. GL 8-1 General Ledger assignment GL 8-1, based on Problem 8-2A, focuses on transactions related to the petty cash fund and highlights the impact each transaction has on net income, if any. Prepare the journal entries related to the petty cash fund and assess the impact of each transaction on the company’s net income, if any.

Accounting Analysis

COMPANY ANALYSIS C2 A1

AA 8-1 Use Apple’s financial statements in Appendix A to answer the following.

1. Identify the total amount of cash and cash equivalents for fiscal years ended (a) September 30, 2017, and (b) September 24, 2016.

2. Compute cash and cash equivalents as a percent (rounded to one decimal) of total current assets, total current liabilities, total shareholders’ equity, and total assets at fiscal year-end for both 2017 and 2016.

3. Compute the percent change (rounded to one decimal) between the beginning and ending year amounts of cash and cash equivalents for fiscal years ended (a) September 30, 2017, and (b) September 24, 2016.

4. Compute the days’ sales uncollected (rounded to one decimal) as of (a) September 30, 2017, and (b) September 24, 2016.

5. Does Apple’s collection of receivables show a favorable or unfavorable change?

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COMPARATIVE ANALYSIS A1

AA 8-2 Key comparative figures for Apple and Google follow.

Required

1. Compute days’ sales uncollected (rounded to one decimal) for (a) Apple and (b) Google for the current and prior years.

2. Which company had more success collecting receivables?

GLOBAL ANALYSIS C2 A1

AA 8-3 Key figures for Samsung follow.

Required

1. Compute cash and cash equivalents as a percent (rounded to one decimal) of total current assets, total assets, total current liabilities, and total shareholders’ equity for both years.

2. Compute the percentage change (rounded to one decimal) between the current year and prior year cash balances.

3. Compute the days’ sales uncollected (rounded to one decimal) at the end of both the (a) current year and (b) prior year.

4. Does Samsung’s collection of receivables show a favorable or unfavorable change?

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Beyond the Numbers

ETHICS CHALLENGE C1

BTN 8-1 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 recordkeeper, 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.

COMMUNICATING IN PRACTICE P4

BTN 8-2 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 purchase discounts in the future. Provide a response in memorandum form. Hint: It will help to review the recording of purchase discounts in Appendix 5C.

TAKING IT TO THE NET C1 P1

BTN 8-3 Visit the Association of Certified Fraud Examiners website and open the “2016 Report to the Nations” (s3-us-west-2.amazonaws.com/acfepublic/2016- report-to-the-nations.pdf). Read the two-page Executive Summary and fill in the following blanks.

1. The median loss for all cases in our study was ______, with ______ of cases

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causing losses of $1 million or more. 2. The typical organization loses ______ of revenues in a given year as a result

of fraud. 3. The median duration—the amount of time from when the fraud commenced

until it was detected—for the fraud cases reported to us was ______. 4. Asset misappropriation was by far the most common form of occupational

fraud, occurring in more than ______ of cases, but causing the smallest median loss of ______.

5. Financial statement fraud was on the other end of the spectrum, occurring in less than 10% of cases but causing a median loss of ______. Corruption cases fell in the middle, with ______ of cases and a median loss of ______.

6. The most common detection method in our study was ______ (39.1% of cases).

7. Approximately ______ of the cases reported to us targeted privately held or publicly owned companies. These for-profit organizations suffered the largest median losses among the types of organizations analyzed, at ______ and ______, respectively.

TEAMWORK IN ACTION C1

BTN 8-4 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 prepared to share controls identified by the team that have not been shared by another team’s spokesperson.

ENTREPRENEURIAL DECISION C1 P1

BTN 8-5 Review the opening feature of this chapter that highlights Sheila Marcelo and her company Care.com. Her company plans to open a kiosk in the Ferry Building in San Francisco to sell Care.com shirts, hats, and other merchandise. Other retail outlets and expansion plans may be in the works.

Required

1. List the seven principles of internal control and explain how a retail outlet might implement each of the principles in its store.

2. Do you believe that a retail outlet will need to add controls to the business as it expands? Explain.

HITTING THE ROAD C1

BTN 8-6 Visit an area of your college that serves the student community with either products or services. Some examples are food services, libraries, and bookstores. Identify and describe between four and eight internal controls being implemented.

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