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ISBN-10: ISBN-13:

2012

1121539998 9781121539990

Contents

i. Preface 1 ii. Index and Source of Cases 4

Financial Accounting 9 1. Introduction 11 2. The Nature and Purpose of Accounting 12 3. Basic Accounting Concepts: The Balance Sheet 36 4. Basic Accounting Concepts: The Income Statement 60 5. Accounting Records and Systems 90 6. Revenue and Monetary Assets 118 7. Cost of Sales and Inventories 151 8. Long-Lived Nonmonetary Assets and Their Amortization 182 9. Sources of Capital: Debt 230

10. Sources of Capital: Owners’ Equity 266 11. Other Items That Affect Net Income and Owners’ Equity 293 12. The Statement of Cash Flows 325 13. Acquisitions and Consolidated Statements 355 14. Financial Statement Analysis 379 15. Understanding Financial Statements 414

iii

Contents

Management Accounting 449 16. Introduction 451 17. The Nature of Management Accounting 452 18. The Behavior of Costs 470 19. Full Costs and Their Uses 504 20. Additional Aspects of Product Costing Systems 533 21. Standard Costs, Variable Costing Systems, Quality Costs, and Joint Costs 585 22. Production Cost Variance Analyses 620 23. Other Variance Analyses 642 24. Control: The Management Control Environment 664 25. Control: The Management Control Process 696 26. Strategic Planning and Budgeting 725 27. Reporting and Evaluation 787 28. Short-Run Alternative Choice Decisions 821 29. Longer-Run Decisions: Capital Budgeting 854 30. Management Accounting System Design 882 A. Appendixes 907 B. Author Index 909 C. Subject Index 911

iii

Credits

i. Preface: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 1 ii. Index and Source of Cases: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 4

Financial Accounting 9 1. Introduction: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 11 2. The Nature and Purpose of Accounting: Chapter 1 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 12 3. Basic Accounting Concepts: The Balance Sheet: Chapter 2 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 36 4. Basic Accounting Concepts: The Income Statement: Chapter 3 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 60 5. Accounting Records and Systems: Chapter 4 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 90 6. Revenue and Monetary Assets: Chapter 5 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 118 7. Cost of Sales and Inventories: Chapter 6 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 151 8. Long-Lived Nonmonetary Assets and Their Amortization: Chapter 7 from Accounting: Text and Cases, 13th

Edition by Anthony, Hawkins, Merchant, 2011 182 9. Sources of Capital: Debt: Chapter 8 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 230 10. Sources of Capital: Owners’ Equity: Chapter 9 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 266 11. Other Items That Affect Net Income and Owners’ Equity: Chapter 10 from Accounting: Text and Cases, 13th

Edition by Anthony, Hawkins, Merchant, 2011 293 12. The Statement of Cash Flows: Chapter 11 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 325 13. Acquisitions and Consolidated Statements: Chapter 12 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 355 14. Financial Statement Analysis: Chapter 13 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 379 15. Understanding Financial Statements: Chapter 14 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 414

iv

Credits

Management Accounting 449 16. Introduction: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 451 17. The Nature of Management Accounting: Chapter 15 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 452 18. The Behavior of Costs: Chapter 16 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 470 19. Full Costs and Their Uses: Chapter 17 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 504 20. Additional Aspects of Product Costing Systems: Chapter 18 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 533 21. Standard Costs, Variable Costing Systems, Quality Costs, and Joint Costs: Chapter 19 from Accounting: Text

and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 585 22. Production Cost Variance Analyses: Chapter 20 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 620 23. Other Variance Analyses: Chapter 21 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 642 24. Control: The Management Control Environment: Chapter 22 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 664 25. Control: The Management Control Process: Chapter 23 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 696 26. Strategic Planning and Budgeting: Chapter 24 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 725 27. Reporting and Evaluation: Chapter 25 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 787 28. Short-Run Alternative Choice Decisions: Chapter 26 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 821 29. Longer-Run Decisions: Capital Budgeting: Chapter 27 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 854 30. Management Accounting System Design: Chapter 28 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 882 A. Appendixes: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 907 B. Author Index: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 909 C. Subject Index: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 911

iv

Preface An accounting text can be written with an emphasis on either of two viewpoints: (1) what the user of accounting information needs to know about accounting or (2) what the pre- parer of accounting reports needs to know about accounting. This book focuses on the user of accounting information. Because such a person needs to know enough about the prepa- ration of accounting reports to use them intelligently, this text includes the technical material needed for this purpose. The book is aimed primarily, however, at the person who wants to be a knowledgeable user of accounting information. This focus is reinforced in the book’s case studies, which help the student learn that accounting is not a cut-and-dried subject with all of its “answers” clearly indicated by the application of rules.

The focus of the book makes it particularly appropriate for required core courses in accounting, in which many of the students are not planning to take further elective ac- counting courses. We believe that if a core course stresses the more analytical uses of accounting information by managers and outside analysts rather than the procedural details that the practicing accountant needs to know, then those students who do not take further accounting courses will be left with a positive view of the importance of accounting rather than with the negative “bean counter” stereotype. We also feel that a user orientation in the core course actually is likely to generate a greater number of ac- counting majors from the class than if the course is oriented more toward the person who has already decided to major in accounting. Similarly, in our experience the re- quired accounting module in a management development program will generate little participant interest unless the module is oriented toward the nonaccountant user of ac- counting information. In sum, we think the book conveys the fact that accounting is interesting and fun, not dull and tedious.

Specifically, this book is used in at least the following four ways:

1. As an introductory course where most (if not all) of the students have no prior train- ing in accounting. In many schools this introduction comprises two separate courses, one dealing with financial accounting and the other with management accounting. Many schools use this book for both such courses, whereas some use it only for financial accounting (Chapter 1 and Chapters 2–14) or for management accounting (Chapter 1 and Chapters 15–28). It is used in such introductory courses both at the upper undergraduate level and in graduate programs. In addition to its widespread use in schools of business and management, it also is used in introductory accounting courses in some law schools, education schools, and schools of public health.

2. As an elective course that builds on a required introductory course in accounting— particularly where the introductory course had more of a procedural orientation and the elective is intended to be more conceptual, analytical, and user-oriented.

3. As the accounting module in a management development program where the par- ticipants represent a variety of functional and technical backgrounds.

4. As a nontechnical accounting reference book for nonaccountants in business and other organizations.

Many instructors assign or recommend the programmed text Essentials of Accounting,1

either as preliminary to study of the subject (it is often sent in advance to participants in

viii

1 Robert N. Anthony and Leslie K. Breitner, Essentials of Accounting, 10th ed. (Upper Saddle River, NJ: Prentice Hall, 2009). This material is also available in the form of computer software titled Teach Yourself Essentials of Accounting.

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MBA and management development programs) or as a review device. It is a self-study in- troductory treatment of financial accounting, geared to Part 1 of this text.

THE CASES As in previous editions, the cases have been selected because of their interest and edu- cational value as a basis for class discussion. They are not necessarily intended to illustrate either correct or incorrect handling of management problems. Skill in the management use of accounting information can be acquired, we believe, only through experience. Thinking about a case and discussing it in informal discussion groups and in the classroom require the student to do something—to analyze a problem, to weigh various factors involved in it, to make some calculations, to take a position, and so on. In class the student is required to explain her or his point of view, to defend it, to un- derstand and appraise the arguments of colleagues, and to decide what arguments are the strongest. Practice in doing these things helps to increase skill and understanding; in fact, many educators believe that the really important parts of a subject can be learned only by experience of some sort, as opposed to merely hearing or reading about them. Thus, although the case material constitutes less than half the pages in this book, the discussion of these cases is by far the more important part of the educational process. Of course, such discussions contribute to the students’ communication skills as well as to their understanding of accounting.

This edition has a total of 109 cases, 12 of which are new. It is often difficult to judge when to replace an older time-tested case (a “classic” or an “old chestnut”) with which instructors are comfortable with a case of more recent vintage. Each type of case has its advantages. In making changes, we endeavored to strike a balance. We retained some of the best, and most frequently used, older cases while replacing others with some new cases. We hope that these newer cases will become the next generation of classics.

Occasionally, a student or instructor questions our use of small business settings for many of the cases. Such cases often avoid certain complexities at a point when the stu- dent is not yet prepared to deal with them. We also would note that studies have reported that small businesses (those employing fewer than 500 people) represent over 99 per- cent of all U.S. businesses, provide about 50 percent of all private-sector jobs, generate almost 40 percent of the GNP, and contribute two out of three newly created jobs. We therefore feel that exposure to small business cases is beneficial to students, some of whom will one day own a small business while many others will eventually work in such firms or work with them as auditors or consultants. A number of the cases included in the book are copyrighted by the President and Fellows of Harvard College. They are included by express permission. These cases, along with all of the other cases in the book, have been developed solely for class discussion and do not necessarily illustrate effective or ineffective management.

CHANGES IN THE THIRTEENTH EDITION Part 1 reflects Financial Accounting Standards Board pronouncements through early 2010 and the important changes in financial accounting that are expected to occur during the following years. A number of new cases have been added, covering the politics and economics of standard setting, acquisition accounting, contingent liabilities, financial reporting fraud, fair value accounting, lease, revenue recognition, and several other con- temporary accounting controversies and developments. A significant new addition is the inclusion of more International Financial Reporting Standards materials.

Preface ix

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The basic structure of Part 2 remains intact. A discussion of time-driven activity- based costing was added, along with supporting examples and case materials. Other charges provide updated statistics, improved clarity of discussion, and new problems and cases.

ACKNOWLEDGMENTS We are grateful to the many instructors and students who have made suggestions for im- proving this book. Included among those people are our colleagues at the Harvard Busi- ness School and the Marshall School of Business, University of Southern California, as well as the following: Russ Olive, Massachusetts Institute of Technology; Pamela Stuerke, Case Western Reserve University; Marvin Carlson, Southern Methodist University; Alan Lord, Bowling Green State University; and Marc Manalastas, Mary Victoria D. Arce, and Jon Stuart Lim-Vaña, Ateneo de Manila University, the Philippines. We extend our thanks to the reviewers who commented on the twelfth edition, as well as previous editions: Timothy Moffit, Kalamazoo College; Michael Erler and Richard Rogers, Indiana University; Laurie Pant, Suffolk University; Claude Lanfranconi, Richard Ivey School of Business; Thomas Kam and Warren Wee, Hawaii Pacific Uni- versity; Len Weld, Troy State University; Mehmet Kocaculah, University of Southern Indiana; Byron K. Henry, Howard University; Jeffery Kahn, Woodbury University; Pamela Rouse, Butler University; Linda Brown, Saint Ambrose University; Ann L. Watkins, High Point University; Saad Laraqui, Embry-Riddle Aeronautical University; Noel Addy, Mississippi State University; Philip Darcy, Regis University; Frances Lynn Telavera, National University; Patricia Cummins, Troy State University; Reba Cunningham, University of Dallas; Krishagopal Menon, Boston University; Leonardo Rodriguez, Florida International University; Robert Medden, St. Francis Xavier Univer- sity; William S. Hopwood, Florida Atlantic University; Andrew Felo, Pennsylvania State University; David Hurtt and Jack Ruhl, Western Michigan University; Stan Davis, Wake Forest University; Tom Hrubec, Franklin University; Warren Wee, Hawaii Pacific University.

We also would like to thank Beth Woods, Lisa Enfinger, Helen Roybark, and Alice Sineath for their help in accuracy checking the text and Thomas Hrubec of Franklin University for creating PowerPoint® presentations to accompany the text.

Robert N. Anthony David F. Hawkins

Kenneth A. Merchant

x Preface

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xxiii

Index and Source of Cases The 109 cases included in this book are listed below in alphabetical order, together with their authors’ names and the institution with which each author was affiliated at the time the case was written. Cases with no name shown were written by, or under the supervision of, one of the authors of this book. The copyright on all cases is indicated on the first page of each case. No case may be reproduced in any form or by any means without the permission of its copyright holder. Information on requesting permission to reproduce Harvard Business School cases is included on the copyright page of this book. We regret that we are unable to provide permis- sion information for cases not copyrighted by Harvard.

Title Author Accounting at MacCloud Winery Profs. David F. Hawkins, Robert S. Kaplan, and

Gregory S. Miller, Harvard Business School Accounting Fraud at WorldCom Profs. Robert S. Kaplan, Harvard Business School and

David Kiron, Global Research Group. Amerbran Company (A) Prof. James S. Reese, University of Michigan Amerbran Company (B) Prof. James S. Reese, University of Michigan Armco Inc.: Midwestern Steel Division Axeon N.V. Profs. Kenneth A. Merchant, London School of

Economics and Wim A. Van der Stede, University of Southern California

Baldwin Bicycle Company Baron Coburg Prof. W. T. Andrews, Guilford College Behavioral Implications of Airline Depreciation Accounting Policy Choices Bennett Body Company Profs. C. A. Bliss and R. N. Anthony, Harvard

Business School Berkshire Industries PLC Profs. Kenneth A. Merchant, London School of

Economics and Wim A. Van der Stede, University of Southern California

Bill French R. C. Hill and Prof. N. E. Harlan, Harvard Business School

Black Meter Company Body Glove Borealis Profs. Bjorn Jorgensen and Robert S. Kaplan,

Harvard Business School Brisson Company Browning Manufacturing Company Butter Lumber Company

California Creamery, Inc. Profs. Kenneth A. Merchant, London School of Economics and Wim A. Van der Stede, University of Southern California

Campar Industries, Inc. Carter Corporation Copies Express Cotter Company, Inc. Prof. R. F. Vancil, Harvard Business School

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xxiv Index and Source of Cases

Darius Company Delaney Motors Profs. A. Reinstein, University of Detroit and

R. N. Anthony, Harvard Business School Dispensers of California, Inc.

Enager Industries, Inc. Prof. James S. Reece, University of Michigan

Formosa Plastics Group Forner Carpet Company Prof. James S. Reece, University of Michigan Freedom Technology Company

Genmo Corporation Grennell Farm J. Brown and Prof. John K. Shank, Harvard

Business School

Hardin Tool Company Harwood Medical Instruments PLC Hospital Supply, Inc. Prof. Michael W. Maher, University of California, Davis Huron Automotive Company Prof. James S. Reece, University of Michigan

Identify the Industries Jeremy Cott and Profs. Sharon M. McKinnon, Northeastern University, and William J. Bruns Jr., Harvard Business School

Import Distributors, Inc. Prof. James S. Reece, University of Michigan Industrial Electronics, Inc. Innovative Engineering Company Prof. James S. Reece, University of Michigan

Joan Holtz (A) Joan Holtz (B) Joan Holtz (C) Profs. C. B. Nickerson and R. N. Anthony, Harvard

Business School Joan Holtz (D)

Kim Fuller Kim Park Profs. David Hawkins, Gregory S. Miller, and

V. G. Narayaman, Harvard Business School

Landau Company Prof. James S. Reece, University of Michigan Las Ferreterías de México, S.A. de C.V. Profs. Kenneth A. Merchant, London School

of Economics and Wim A. Van der Stede, University of Southern California

Leasing Computers at Persistent Learning Prof. Devin Shanthikumar, Harvard Business School Lewis Corporation Lipman Bottle Company Prof. M. J. Sandretto, Harvard Business School Lone Pine Cafe (A) Lone Pine Cafe (B) Lupton Company Prof. James S. Reece, University of Michigan Lynch’s Chicken Ranch, Inc. Profs. Kenneth A. Merchant and Lesley Porter,

University of Southern California

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Index and Source of Cases xxv

Maynard Company (A) Maynard Company (B) Maxim Integrated Products Medieval Adventures Company Medi-Exam Health Services, Inc. Prof. James S. Reece, University of Michigan Midwest Office Products Prof. Robert S. Kaplan, Harvard Business School Morgan Manufacturing Prof. Julie H. Hertenstein, Northeastern University Music Mart, Inc.

National Association of Accountants Norman Corporation (A) Norman Corporation (B)

Olympic Car Wash Profs. Kenneth A. Merchant, University of Southern California and Wim A. Van der Stede, London School of Economics

Patagonia, Inc. Paul Murray PC Depot Phuket Beach Hotel: Valuing Mutually Profs. Su Han Chan and Ko Wang and Mary Wong,

Exclusive Capital Projects University of Hong Kong Piedmont University Pinetree Motel Profs. James S. Reece, University of Michigan The Politics and Economics of Accounting Karthik Ramanna, Harvard Business School

for Goodwill at Cisco Systems Polymedica Corporation (A) Profs. David F. Hawkins, Harvard Business School, and

Jacob Cohen, INSEAD Precision Worldwide, Inc. Prof. William J. Bruns Jr., Harvard Business School Prestige Telephone Company Prof. William J. Bruns Jr., Harvard Business School Private Fitness LLC Productos Finas Proxim, Inc. Prof. Mark Bradshaw, Harvard Business School Puente Hills Toyota Profs. Kenneth A. Merchant, University of Southern

California, Wim A. Van der Stede, London School of Economics, and Prof. Pieter Jansen, University of Groningen

Quick Lunch Profs. Robert O. Schlaifer and Robert N. Anthony, Harvard Business School

Ribbons an’ Bows, Inc. Rock Creek Golf Club Prof. James S. Reece, University of Michigan

Safety Monitoring Devices, Inc. Prof. Wim A. Van der Stede, London School of Economics Save-Mart Shelter Partnership, Inc. Shuman Automobiles, Inc. A. M. McCosh and Profs. David Hawkins, J. R. Yeager,

and James S. Reece, Harvard Business School

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xxvi Index and Source of Cases

Silic: Choosing Cost or Fair Value Prof. David Hawkins, Harvard Business School, on Adoption of IFRS Vincent Dessain, and Anthony Barron, Harvard

Business School Europe Research Center Silver Appliance Company Prof. James S. Reece, University of Michigan Sinclair Company Sippican Corporation (A) Prof. Robert S. Kaplan, Harvard Business School Sippican Corporation (B) Prof. Robert S. Kaplan, Harvard Business School Springfield National Bank Prof. Ray G. Stephens, The Ohio State University Stafford Press Stern Corporation (A) Prof. James S. Reece, University of Michigan Stern Corporation (B) Prof. James S. Reece, University of Michigan SunAir Boat Builders, Inc. Profs. M. E. Bennett and James S. Reece, Harvard

Business School Supplement to Identify the Industries Prof. Charles M. Williams, Harvard Business School

Tru-Fit Parts, Inc. Prof. James S. Reece, University of Michigan Tokyo AFM Prof. Francois Brochet, Harvard Business School

UPC, Inc.

Waikerie Co-operative Producers, Ltd. Waltham Oil and Lube Center, Inc. Wareham SC Systems, Inc. Woodside Products Prof. James S. Reece, University of Michigan

Xytech, Inc.

Zumwald AG Profs. Kenneth A. Merchant, London School of Economics and Wim A. Van der Stede, University of Southern California

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9

Financial Accounting

1 Part

Financial Accounting

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Chapter1 The Nature and Purpose of Accounting

Chapter

Most of the world’s work is done through organizations—groups of people who work together to accomplish one or more objectives. In doing its work, an organization uses resources—labor, materials, various services, buildings, and equipment. These resources need to be financed, or paid for. To work effectively, the people in an organization need information about the amounts of these resources, the means of financing them, and the results achieved through using them. Parties outside the organization need similar infor- mation to make judgments about the organization. Accounting is a system that provides such information.

Organizations can be classified broadly as either for-profit or nonprofit. As these names suggest, a dominant purpose of organizations in the former category is to earn a profit, whereas organizations in the latter category have other objectives, such as governing, providing social services, and providing education. Accounting is basically similar in both types of organizations.

The Need for Information

In its details, information differs greatly among organizations of various types. But viewed broadly, the information needs of most organizations are similar. We shall out- line and illustrate these general information needs by referring to Varsity Motors, Inc., an automobile dealership.

Varsity Motors seeks to earn a profit by selling new and used automobiles and parts and accessories, and by providing repair service. It is an organization of 52 people headed by Pat Voss, its president. It owns a building that contains the showroom, ser- vice shop, a storeroom for parts and accessories, and office space. It also owns a num- ber of new and used automobiles, which it offers for sale; an inventory of spare parts, accessories, and supplies; and cash in the bank. These are examples of the resources the company needs to conduct its business.

Illustration 1–1 depicts the different types of information that might be useful to people interested in Varsity Motors. As shown in the illustration, information can be either quantitative or nonquantitative. Quantitative information is information that is expressed in numbers. Examples of nonquantitative information are visual impressions,

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Information

Nonquantitative information Quantitative information

Consists of

Accounting information

Nonaccounting information

Consists of

Operating information

Tax accounting

Financial accounting

Management accounting

Consists of

ILLUSTRATION 1–1 Types of Information

Chapter 1 The Nature and Purpose of Accounting 3

conversations, television programs, and newspaper stories. Accounting is primarily concerned with quantitative information.

Accounting is one of several types of quantitative information. Accounting infor- mation is distinguished from the other types in that it usually is expressed in monetary terms. Data on employees’ ages and years of experience are quantitative, but they are not usually considered to be accounting information. The line here is not sharply drawn, however; nonmonetary information is often included in the notes to accounting reports when it will help the reader understand the report. For example, an accounting sales re- port for Varsity Motors would show not only the monetary amount of sales revenue, but also the number of automobiles sold, which is nonmonetary information.

What information is needed about the amounts and financing of the resources used in Varsity Motors and the results achieved by the use of these resources? This infor- mation can be classified into four categories: (1) operating information, (2) financial accounting information, (3) management accounting information, and (4) tax account- ing information. Each is shown in the bottom section of Illustration 1–1.

A considerable amount of operating information is required to conduct an organiza- tion’s day-to-day activities. For example, Varsity Motors’ employees must be paid ex- actly the amounts owed them, and the government requires that records be maintained for each employee showing amounts earned and paid, as well as various deductions. The sales force needs to know what automobiles are available for sale and each one’s cost and selling price. When an automobile is sold, a record must be made of that fact. The person in the stockroom needs to know what parts and accessories are on hand; and if the inventory of a certain part becomes depleted, this fact needs to be known so that an additional quantity can be ordered. Amounts owed by the company’s customers need to be known; and if a customer does not pay a bill on time, this fact needs to be known so that appropriate action can be taken. The company needs to know the amounts it owes to others, when these amounts should be paid, and how much money it has in the bank.

Operating Information

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Operating information constitutes by far the largest quantity of accounting infor- mation. As suggested by the arrows at the bottom of Illustration 1–1, operating infor- mation provides much of the basic data for management accounting, financial accounting, and tax accounting.

Financial accounting information is intended both for managers and also for the use of parties external to the organization, including shareholders (and trustees in nonprofit organizations), banks and other creditors, government agencies, investment advisers, and the general public. Shareholders who have furnished capital to Varsity Motors want information on how well the company is doing. If they should decide to sell their shares, they need information that helps them judge how much their investment is worth. Prospective buyers of these shares need similar information. If the company wants to borrow money, the lender wants information that will show that the company is sound and that there is a high probability that the loan will be repaid.

Only in rare instances can outside parties insist that an organization furnish informa- tion tailor-made to their specifications. In most cases, they must accept the information that the organization chooses to supply. They could not conceivably understand this in- formation without knowing the ground rules that governed its preparation. Moreover, they cannot be expected to learn a new set of ground rules for each organization of in- terest to them, nor can they compare information about two organizations unless both sets of information are prepared according to common ground rules. These ground rules are the subject matter of financial accounting (also called financial reporting).

Varsity Motors’ president, vice president of sales, service manager, and other man- agers do not have the time to examine the details of the operating information. Instead, they rely on summaries of this information. They use these summaries, together with other information, to carry out their management responsibilities. The accounting in- formation specifically prepared to aid managers is called management accounting information. This information is used in three management functions: (1) planning, (2) implementation, and (3) control.

Planning Performed by managers at all levels, in all organizations, planning is the process of de- ciding what actions should be taken in the future. A plan may be made for any segment of the organization or for the entire organization. When Varsity Motors’ service man- ager decides the order in which automobiles will be repaired and which mechanic will work on each of them, the service manager is engaged in planning in the same sense as, but on a smaller scale than, the president when the latter decides to build a new showroom and service facility.

An important form of planning is budgeting. Budgeting is the process of planning the overall activities of the organization for a specified period of time, usually a year. A primary objective of budgeting is to coordinate the separate plans made for various seg- ments of the organization to ensure that these plans harmonize with one another. For example, Varsity’s sales plans and service department capacity plans must be consistent. Also, budgeting helps managers determine whether the coming year’s activities are likely to produce satisfactory results and, if not, what should be done. Even tiny organi- zations find budgeting useful; many persons prepare a budget for their household.

Planning involves making decisions. Decisions are arrived at by (1) recognizing that a problem or an opportunity exists, (2) specifying and ranking the criteria to be used to determine the best solution, (3) identifying alternative ways of addressing the problem or opportunity, (4) analyzing the consequences of each alternative, and (5) comparing

4 Part 1 Financial Accounting

Financial Accounting Information

Management Accounting Information

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Planning Implementation Control

Feedback

Appropriate action

Plan revision

ILLUSTRATION 1–2 Relationship of Management Functions

these consequences to each other and the decision criteria in order to decide which alternative is best. Accounting information is useful especially in the analysis step of the decision-making process.

Implementation Making plans does not itself ensure that managers will implement the plans. In the case of the annual budget, each manager must take actions to provide the human and other re- sources that will be needed to achieve the planned results. Each manager also must make more detailed implementation plans than are encompassed in the budget; specific actions to be taken on a week-to-week and even day-to-day basis must be planned in advance.

The implementation of these very specific plans requires supervision on the part of the manager. Although much of this activity is routine, the manager also must react to events that were not anticipated when the budget was prepared. Indeed, a key manager- ial responsibility is to change previous plans appropriately to adjust for new conditions. If an unexpected situation impacts more than one part of the organization, the managers affected must coordinate their responses, just as their original plans were coordinated.

Control In Varsity Motors most automobile sales are made by salespersons and most service work is done by mechanics. It is not the responsibility of Pat Voss and the other managers to do this work themselves. Rather, it is their responsibility to see that it is done, and done prop- erly, by the employees of the organization. The process they use to ensure that employees perform properly is called control. Accounting information is used in the control process as a means of communication, motivation, attention getting, and appraisal.

As a means of communication, accounting reports (especially budgets) can assist in informing employees about management’s plans and in general about the types of ac- tion management wishes the organization to take. As a means of motivation, account- ing reports can induce members of the organization to act in a way that is consistent with the organization’s overall goals and objectives. As a means of attention getting, accounting information signals that problems may exist that require investigation and possibly action; this process is called feedback. As a means of appraisal, accounting helps show how well managers of the organization have performed, particularly with respect to the budgeted performance of the departments for which they are responsible. This provides a basis for a salary increase, promotion, corrective action of various kinds, or (in extreme cases) dismissal.

The relationship among the management functions of planning, implementation, and control is shown in Illustration 1–2. Chapter 15 will further introduce management accounting and contrast it with financial reporting.

Varsity Motors must file tax returns with the taxing authorities. As we will see later, in the United States for all companies and increasingly around the world for stock- exchange-listed companies, tax accounting rules can differ from financial accounting rules. Varsity Motors therefore must keep separate tax accounting records for tax pur- poses in those areas where it has elected to use different accounting rules for tax accounting and financial accounting.

Chapter 1 The Nature and Purpose of Accounting 5

Tax Accounting Information

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Accounting is related to all of the activities described above, and in all of them the em- phasis is on using accounting information in the process of making decisions. Both managers within an organization and interested outside parties use accounting infor- mation in making decisions that affect the organization. Thus, of the several available definitions of accounting, the one developed by an American Accounting Association committee is perhaps the best because of its focus on accounting as an aid to decision making. This committee defined accounting as the process of identifying, measuring, and communicating economic information to permit informed judgments and deci- sions by users of the information.

The Profession of Accounting

In most organizations the accounting group is the largest staff unit, that is, the largest group other than the “line” activities of production and marketing. The accounting group consists essentially of two types of people: (1) bookkeepers and other data-entry employees who maintain the detailed operating records and (2) staff accountants who decide how items should be reported, prepare the reports, interpret these reports, prepare special analyses, design and operate the systems through which information flows, and ensure that the information is accurate.

All publicly owned companies and many other organizations have their accounting reports audited by an independent public accounting firm. These firms also perform other services for clients. Some of these firms are very large with tens of thousands of employees and hundreds of offices around the world, with annual revenues totaling bil- lions of dollars. They are far larger than any law firm, medical group practice, or other professional firm. At the other extreme, thousands of independent public accountants practice as individuals.

Most independent public accountants are licensed by their state and are designated as Certified Public Accountants (CPAs). The professional organization of CPAs is the American Institute of Certified Public Accountants (AICPA). Many accountants em- ployed by industry belong to the Institute of Management Accountants (IMA). The IMA administers the Certified Management Accountant (CMA) program. Some accountants in industry also are Certified Internal Auditors (CIA). Many college and university ac- counting faculty members belong to the American Accounting Association (AAA).

CPAs that audit public companies are subject to the oversight of the Securities and Ex- change Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB). The SEC was created by the Securities Act of 1934. Its mission is to protect in- vestors; maintain fair, orderly, and efficient securities markets; and facilitate capital for- mation. PCAOB is a five-person board appointed by the SEC to oversee the auditors of public companies in order to protect the interests of investor and further the public inter- est in the preparation of informative, fair, and independent audit reports. PCAOB has the power to set auditing standards and discipline auditors who fail to follow their standards.

Although accounting is a staff function performed by accounting professionals within an organization, the ultimate responsibility for the generation of accounting information—whether financial or managerial—rests with management. Manage- ment’s responsibility for accounting is the reason that one of the top officers of many businesses is the controller. Within the division of top management’s duties, the controller is the person responsible for satisfying other managers’ needs for manage- ment accounting information and for complying with the requirements of financial re- porting and tax accounting. To these ends the controller’s office employs accounting

6 Part 1 Financial Accounting

Definition of Accounting

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professionals in management, financial, and tax accounting. These accountants design, install, and operate the information systems required to generate financial and manage- rial reports and tax returns.

Our Approach to Accounting

Accounting can be approached from either of two directions: from the viewpoint of the accountant or from the viewpoint of the user of accounting information. The former approach emphasizes the concepts and techniques that are involved in collecting, summarizing, and reporting accounting information; the latter emphasizes what the user needs to know about accounting. We focus on the latter approach. The difference between these two approaches is only one of emphasis. Accountants need to know how informa- tion is to be used because they should collect and report information in a form that is most helpful to those who use it. Users need to know what the accountant does; otherwise, they are unlikely to understand the real meaning of the information that is provided.

The approach to accounting taken here is something like that used by an airplane pilot in learning to use flight instruments. The pilot needs to know the meaning of the message conveyed by each of the instruments—for example, that a needle on a certain gauge going above a given point probably means that a certain component is not func- tioning properly. The word probably is used because, for one reason or another, an in- strument may not always give the reading that it is supposed to give. As the user of the instrument, the pilot must realize this and also must understand something of the like- lihood of, and the reason for, these abnormalities. On the other hand, the pilot does not need to know how to design, construct, calibrate, or repair airplane instruments. Specialists are available for these important functions.

Similarly, those who use accounting information must understand what a given ac- counting figure probably means, what its limitations are, and the circumstances in which it may mean something different from the apparent “signal” that it gives. They do not, however, need to know how to design, construct, operate, or check on the accuracy of an accounting system. They can rely on accountants for these important functions.

Readers of this book have already been exposed to a great deal of accounting informa- tion. Cash register or credit card receipts, checks written or (preferably) received, bank statements, merchants’ and utilities’ bills—all these are parts of accounting systems. Newspapers report about the profit (or losses) of a company or an industry, about div- idends, or about money being spent to build new buildings; this information comes from accounting systems. Even before beginning a formal study of the subject, there- fore, the reader has accumulated a number of ideas about accounting.

The trouble is that some of these ideas probably are incorrect. For example, it seems intuitively reasonable that accounting should report what a business is “worth.” But ac- counting does not, in fact, do this, nor does it even attempt to do so. As another example, there is a general notion that the word asset refers to valuable things, good things to have. But the skills and abilities of an organization’s employees are not assets in the account- ing sense, even though they may be a key determinant of the organization’s success.

Thus, as with many other subjects, students of accounting must be wary of precon- ceptions. They will discover that accounting as it really is may be different in impor- tant respects from what they had surmised it to be. They will find that there are sound reasons for these differences, and it is important that they understand these reasons. To achieve such an understanding, users need to know enough about accounting concepts

Chapter 1 The Nature and Purpose of Accounting 7

Preconceptions about Accounting

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and techniques to understand the nature and limitations of the accounting information. They do not, however, need the detailed knowledge that the accountant must have.

We described above four types of accounting information: operating information, financial accounting information, management accounting information, and tax ac- counting information. Since our viewpoint is that of the current and potential users (as opposed to preparers) of accounting information, we shall not describe operating and tax accounting information in any great detail. The book is therefore divided into two approximately equal parts, the first on financial accounting and the second on manage- ment accounting.

The discussion of financial accounting comes first because the structure of financial accounting underlies all accounting. This structure consists of a few basic principles and concepts, a set of relationships among the elements comprising the accounting system, a terminology, and a number of rules and guidelines for the application of the principles and concepts to specific situations. We shall describe the financial account- ing structure in a general way in Chapters 2, 3, and 4; and we shall then go over the same ground again in more detail in Chapters 5 through 14.

The second half of the book discusses the nature and use of management account- ing information. The management of an organization can establish whatever ground rules it wishes for the accounting information collected for its own use. Thus, although the principles of financial accounting are applicable to all organizations, the rules of management accounting are tailor-made to meet the needs of the management of a spe- cific organization.

Nevertheless, a similarity exists in both financial accounting practices and manage- ment accounting practices in most organizations. There are obvious economies in using financial accounting information wherever possible for management accounting pur- poses rather than devising two completely different systems for the two purposes.

The Financial Accounting Framework

Suppose you were asked to keep track of what was going on in an organization in order to provide useful information for management. One way of carrying out this assign- ment would be to write down a narrative of important events in a log similar to that kept by the captain of a ship.

After some experience with your log, you would gradually develop a set of rules to guide your efforts. For example, since it would be impossible to write down every ac- tion of every person in the organization, you would develop rules to guide you in choos- ing between those events that were important enough to record and those that should be omitted. You also would find that your log would be more valuable if you standardized certain terms. People who studied it would then have a clearer understanding of what you meant. Furthermore, if you standardized terms and their definitions, you could turn the job of keeping the log over to someone else and have some assurance that this person’s report of events would convey the same information that you would have con- veyed had you been keeping the log yourself.

In devising these rules of keeping a log, you would necessarily be somewhat arbi- trary. There might be several ways of describing a certain event, all equally good. But in order to have a common basis of understanding, you would select just one of these for use in your recordkeeping system.

8 Part 1 Financial Accounting

Plan of the Book

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All these considerations were actually involved in the development of the accounting process. Accounting has evolved over a period of many centuries, and during this time certain terminology, rules, and conventions have come to be accepted as useful. If you are to understand accounting reports—the end products of an accounting system—you must be familiar with the rules and conventions lying behind these reports.

Accounting is aptly called the language of business. The task of learning accounting, very similar to the task of learning a new language, is complicated by the fact that many words used in accounting mean almost but not quite the same thing as the iden- tical words mean in everyday nonaccounting usage. Accounting is not exactly a foreign language; the problem of learning it is more like that of an American learning to speak English as it is spoken in Great Britain. For example, the grain that Americans call wheat is called corn by the British; and the British use the word maize for what Amer- icans call corn. Unless they are careful, Americans will fail to recognize that some words are used in Great Britain in a different sense from that used in America.

Similarly, some words are used in a different sense in accounting from their collo- quial meanings. For example, accountants often use the term net worth to describe an amount that appears on accounting reports. The commonsense interpretation is that this amount refers to what something is worth, what its value is. However, such an in- terpretation is incorrect, and misunderstandings can arise if the user of an accounting statement does not understand what accountants mean by net worth. (The correct meaning, somewhat technical in nature, will be given in Chapter 2.)

Accounting also resembles a language in that some of its rules are definite, whereas others are not. There are differences of opinion among accountants about how a given event should be reported, just as grammarians differ on many matters of sentence struc- ture, punctuation, and word choice. Nevertheless, just as many practices are clearly poor English, many practices are definitely poor accounting. In the following chapters we describe the elements of good accounting and indicate areas in which there are differ- ences of opinion about what constitutes good practice.

Finally, languages evolve in response to the changing needs of society, and so does accounting. The rules described here are currently in use, but some of them will probably be modified to meet the changing needs of organizations and their constituencies.

The communication and understanding of accounting information may be further com- plicated by the use of different financial statement presentation formats. As far as finan- cial reporting data are concerned, the statement user problems caused by presentational difference has been mitigated by the development and adoption of eXtensible Business Reporting Language (XBRL). XBRL is a digital business language designed to help companies communicate financial statement data internally and externally. XBRL codes every element of a set of financial statements using a simple, universal, plain- language tag. The tag allows companies to consistently communicate financial state- ment data originally prepared in many different forms, and it allows statement users to extract information rapidly and reliably. XBRL does not adjust data for differences in accounting principles. Its principal purpose is to adjust presentational differences. The SEC permits companies to file financial statements using XBRL.

The rules and basic concepts of accounting are commonly referred to as principles. The word principle is here used in the sense of a general law or rule that is to be used as a

Chapter 1 The Nature and Purpose of Accounting 9

Nature of Principles

Accounting as a Language

Different Formats

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guide to action. This means that accounting principles do not prescribe exactly how each event occurring in an organization should be recorded. Consequently, there are many matters in accounting practice that differ from one organization to another. Most of these differences are inevitable because a single detailed set of rules could not conceiv- ably apply to every organization. In part, the differences reflect that, within “generally accepted accounting principles,” management has some latitude in which to express its own ideas about the best way of recording and reporting a specific event.

Readers should realize, therefore, that they cannot know the precise meaning of a number of the items in an accounting report unless they know which of several equally acceptable possibilities has been selected by the person who prepared the report. The meaning intended in a specific situation requires knowledge of the context.

Accounting principles are established by humans. Unlike the principles of physics, chemistry, and the other natural sciences, accounting principles were not deduced from basic axioms, nor can they be verified by observation and experiment. Instead, they have evolved. This evolutionary process is going on constantly; accounting principles are not eternal truths.

The general acceptance of an accounting principle usually depends on how well it meets three criteria: relevance, objectivity, and feasibility. A principle has relevance to the extent that it results in information that is meaningful and useful to those who need to know something about a certain organization. A principle has objectivity to the extent that the resulting information is not influenced by the personal bias or judgment of those who furnish it. Objectivity connotes reliability, trustworthiness. It also con- notes verifiability, which means that there is some way of finding out whether the in- formation is correct. A principle has feasibility to the extent that it can be implemented without undue complexity or cost.

These criteria often conflict with one another. In some cases the most relevant solu- tion may be the least objective and the least feasible. Often, in this situation a less rel- evant but more objective and more feasible solution may be selected.

The development of a new product may have a significant effect on a company’s real value— “miracle” drugs and personal computer chips being spectacular examples. Information about the value of new products is most useful to the investor; it is indeed relevant. But the best esti- mate of the value of a new product is likely to be that made by management, and this is a highly subjective estimate. Accounting therefore does not attempt to record such values. Accounting sacrifices relevance in the interests of objectivity.

The measure of the value of the owners’ interest or equity in a biotechnology firm such as Genentech, Inc., obtained from the stock market quotations (i.e., multiplying the price per share of stock times the number of shares outstanding) is a much more accurate reflec- tion of the true value than the amount listed as owners’ equity that appears in the corpora- tion’s financial statements. The marketplace gave this value as $26.4 billion; the accounting records gave it as $6.8 billion. The difference does not indicate an error in the accounting records. It merely illustrates the fact that accounting does not attempt to report firm mar- ket values.

In developing new principles, the essential problem is to strike the right balance be- tween relevance on the one hand and objectivity and feasibility on the other. Failure to appreciate this problem often leads to unwarranted criticism of accounting principles. It is easy to criticize accounting on the grounds that accounting information is not as relevant as it might be; but the critic often overlooks the fact that proposals to increase

10 Part 1 Financial Accounting

Example

Criteria

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relevance almost always involve a sacrifice of objectivity and feasibility. On balance, such a sacrifice may not be worthwhile.

The foundation of accounting consists of a set of generally accepted accounting principles, or GAAP for short. Currently, these principles are established by the Financial Accounting Standards Board (FASB). Current information about the FASB’s activities can be obtained by accessing the FASB’s website (http://www.fasb.org). The FASB consists of seven members with diverse accounting backgrounds who work full time on developing new or modified principles. The board is supported by a profes- sional staff that does research and prepares a discussion memorandum on each prob- lem that the board addresses. The board acts only after interested parties have been given an opportunity to suggest solutions to problems and to comment on proposed pronouncements. The FASB is a nongovernmental organization.1

It is important to note that the acronym “GAAP” when used in practice (and this text) refers to accounting standards applicable in the United States, where the accept- ability of the FASB pronouncements rests on their general acceptability. In most other countries, the authority of accounting standards is based on laws enacted by the national governing bodies.

Each of the Standards of the FASB deals with a specific topic.2 Collectively, they do not cover all the important topics in accounting. If an authoritative pronouncement has not been made on a given topic, accountants can treat that topic in the way they believe most fairly presents the situation.

Companies are not legally required to adhere to GAAP as established by the FASB. As a practical matter, however, there are strong pressures for them to do so. The accoun- ting reports of most companies are audited by certified public accountants who are members of the American Institute of Certified Public Accountants (AICPA). Although the AICPA (http://www.aicpa.org) does not require its members to force companies to adhere to FASB standards, it does require that if the CPA finds that the company has not followed FASB standards, the difference must be called to public attention. Since companies usually do not like to go counter to the FASB—even though they may feel strongly that the FASB principle is not appropriate in their particular situation—they almost always conform to the FASB pronouncements.

The FASB has established a 14-member group called the Emerging Issues Task Force (EITF). As its name suggests, the EITF publishes guides, referred to as consen- suses, on accounting issues that need to be resolved in a timely manner. Typically, these consensuses are adopted where appropriate by corporations.

Another source of pressure to conform to GAAP is the U.S. Securities and Exchange Commission (SEC). This agency, which exists to protect the interests of in- vestors, has jurisdiction over any corporation with a class of securities listed on a national stock exchange or, if traded over the counter, with 500 or more shareholders and $10 million or more total assets. The SEC requires these companies to file accounting reports prepared in accordance with GAAP. In its Regulation S–X, its

Chapter 1 The Nature and Purpose of Accounting 11

Source of Accounting Principles

1 Financial accounting and reporting standards for state and local governments and government- owned entities, such as colleges and universities, are set by the Government Accounting Standards Board. 2 Authoritative pronouncements consist of Statements and interpretations of the Financial Accounting Standards Board and certain pronouncements of predecessor bodies established by the AICPA. We shall refer to these earlier pronouncements as Accounting Research Bulletins and Opinions.

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Financial Reporting Series Releases, and its Staff Accounting Bulletins, the SEC spells out acceptable accounting principles in more detail than, but generally consis- tent with, the pronouncements of the FASB. Legally, the Securities Exchange Act of 1934 gave the SEC the authority to promulgate GAAP; but over the years, for the most part the SEC has relied on the FASB and its predecessors for carrying out the standard-setting process.

In its past, the AICPA has issued pronouncements called Statements of Position (SOP) for accounting in a number of industries, including finance companies, govern- ment contractors, and real estate investment trusts. Although these pronouncements do not have the force of FASB Standards, organizations have followed them. Recently, the FASB has made it clear that AICPA pronouncements are not GAAP. It has asked the AICPA to cease issuing these pronouncements.

Various regulatory bodies also prescribe accounting rules for the companies they regulate. Among those subjected to such rules are banks and other financial institu- tions, insurance companies, and public utilities. These rules are not necessarily consis- tent with the principles of the FASB, although there has been a tendency in recent years for regulatory agencies to change their accounting rules so that they do conform.

The authority of the FASB and the other agencies discussed so for exists, of course, only in the United States of America. Accounting principles in other countries differ in some respects from American GAAP, but in general there is a basic similarity through- out the world. There is a major effort to codify a set of accounting principles that would apply internationally, and over 40 statements known as International Accounting Stan- dards (IAS) have been published by the International Accounting Standards Commit- tee (IASC)—now reorganized as the International Accounting Standards Board (IASB)—located in London, England. While retaining the name IAS for standards is- sued by its predecessor, standards issued by the IASB (http://www.iasb.org) are known as International Financial Reporting Standards (IFRS).

The IASB does not have the power to enforce its pronouncements. Their adoption by companies and accounting standard setters is voluntary. Neverthless, impressed by the potential value of a global set of accounting principles, the FASB and the IASB have initiated a joint-program to converge GAAP and IFRS. This effort is supported by the SEC, which has proffered a timetable for potential mandatory adoption of IFRS for SEC registered companies beginning in 2014. Currently, over 100 countries have either adopted IFRS in whole or part or are considering IFRS adoption.

Readers of this text can assume, unless noted otherwise, the accounting for a par- ticular transaction or event described in the text is essentially this same under both GAAP and IFRS.

A complete compilation of GAAP—FASB Accounting Standards Codification™— can be found on the FASB website. It is the single official source of authoritative, non- governmental GAAP issued by the FASB. Guidance issued by the SEC is also incor- porated in the site’s materials.

A major controversy in accounting is the extent to which accounting standards should be expressed in the form of broad principles versus detailed rules. IFRS tend to be stated in the form of broad principles. In contrast, much of GAAP tends to be stated in the form of bright-line rules. For example, as you will learn later, under GAAP if a term of a lease is equal to 75 percent of the economic life of the leased property, the lease will be accounted for as a capital lease.3 On the other hand, if the lease term is

12 Part 1 Financial Accounting

3 “Accounting for Leases,” FASB Statement No. 13.

Principles Vs. Rules

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equal to 74 or less percent of the leased property’s economic life, the lease will be ac- counted for as an operating lease. IFRS takes a different approach. It makes the dis- tinction between a capital and an operating lease based on which party—the lessor or the lessee—substantially bears the risks and rewards of owership.4

The distinction between the principle-based and rule-based accounting standards is important. Under a principle-based standards model, the accounting for transactions is more likely to reflect the substance of the transaction. Under a rule-based standards model, the accounting for a transaction is more likely to reflect the form of the trans- action.

As GAAP and IFRS converge, it is anticipated that GAAP will become more prin- ciple based.

Financial Statements

The end product of the financial accounting process is a set of reports that are called financial statements. Generally accepted accounting principles require that three such reports be prepared: (1) a statement of financial position, which is generally referred to as a balance sheet; (2) an income statement; and (3) a statement of cash flows.5 As we examine the details of the financial accounting process, it is important to keep in mind the objective toward which the process is aimed: the preparation of these three finan- cial statements.

Most reports, in any field, can be classified into one of two categories: (1) stock, or status, reports and (2) flow reports. The amount of water in a reservoir at a given mo- ment of time is a measure of stock, whereas the amount of water that moves through the reservoir in a day is a measure of flow. Reports of stocks are always as of a specified instant in time; reports of flow always cover a specified period of time. Reports of stocks are like snapshots; reports of flows are more like motion pictures. One of the accounting reports, the balance sheet, is a report of stocks. It shows information about the resources and obligations of an organization at a specified moment of time. The other two reports, the income statement and the cash flow statement, are reports of flows. They report activities of the organization for a period of time, such as a quarter or a year.

Companies listed on stock exchanges publish annual and quarterly financial reports. These reports can be obtained either directly from the company or from the Securities and Exchange Commission (SEC). Typically, these reports are also available directly from companies through the Internet.

For example, the Coca-Cola Company’s home page (http://www.cocacola.com) contains information about Coca-Cola’s products, history, and financial performance and position. (You might want to access this site to get a sense of a complete set of financial statements. After completing the financial reporting section of this book, you should be able to read and interpret these reports with confidence that you understand them.)6

Chapter 1 The Nature and Purpose of Accounting 13

4 “Leases,” IAS No. 17. 5 Company financial reports also may include other financial displays, such as changes in owners’ equity. This display will be explained in Chapter 10. 6 The home pages of other well-known companies you might want to access are General Electric (http://www.ge.com), Microsoft (http://www.microsoft.com), General Motors (http://www.gm.com), Walmart (http://www.walmart.com), and IBM (http://www.ibm.com).

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Listed company financial reports are also available electronically through the Secu- rities and Exchange Commission’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. All companies registered with the SEC use EDGAR to transmit their required filings to the SEC (http://www.sec.gov).

In this chapter we will give a brief introduction to the balance sheet and income state- ment. The definitions provided should be considered as only working definitions for the purposes of this introductory chapter. The next nine chapters describe more precisely and in greater detail the balance sheet and income statement. We shall defer a descrip- tion of the statement of cash flows until Chapter 11. Because this report is derived from data originally collected for the other two reports, it is inappropriate to defer the discus- sion of the cash flow statement until after the balance sheet and income statement have been thoroughly explained.

Illustration 1–3 presents the December 31, 2010, balance sheet of the Holden Company. (Do not worry if you do not know what all of the account titles mean. They will be dis- cussed in later chapters.)

The Holden balance sheet is a snapshot of the financial position of the company. It has two sides: the left, Assets, and the right, Liabilities and Owners’ Equity. We will give working descriptions of each side. (More precise descriptions will be provided in Chapter 2.)

Assets An entity needs cash, equipment, and other resources in order to operate. These re- sources are its assets. Assets are valuable resources owned by the entity. The left side of the balance sheet shows the amounts of these assets as of a certain date. For example, the amount of Cash that Holden Company owned on December 31, 2010, was $1,449,000.

Assets are resources owned by Holden Company. Its employees, although perhaps its most valuable resource, are not assets in accounting, because the company does not own its employees.

Liabilities and Owners’ Equity The right side of the balance sheet shows the sources that provided the entity’s assets. As the heading indicates, there are two general types of sources, Liabilities and Own- ers’ Equity.

Liabilities are obligations of the entity to outside non owner parties who have fur- nished resources. These parties are generally called creditors because they have ex- tended credit to the entity. As Illustration 1–3 indicates, suppliers have extended credit in the amount of $5,602,000, as indicated by Accounts Payable.

Creditors have a claim against the assets in the amount shown as the liability. For example, a bank has loaned $1,000,000 to Holden Company, and therefore has a claim of this amount, as indicated by Bank Loan Payable.

Because an entity will use its assets to pay off its claims, those claims are against assets. They are claims against all the assets, not any particular assets.

The other source of the funds that an entity uses to acquire its assets is called Owners’ Equity. There are two sources of equity funds: (1) the amount provided di- rectly by equity investors, which is called Total Paid-In Capital; and (2) the amount retained from profits (or earnings), which is called Retained Earnings.

Creditors can sue the entity if the amounts due them are not paid. Equity investors have only a residual claim; that is, if the entity is dissolved, they get whatever is left

14 Part 1 Financial Accounting

The Balance Sheet

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Chapter 1 The Nature and Purpose of Accounting 15

after the liabilities have been paid, which may be nothing. Liabilities therefore are a stronger claim against the assets than equity.

We can describe the right-hand side of the balance sheet in two somewhat different ways: (1) as the amount of funds supplied by creditors and equity investors and (2) as the claims of these parties against the assets. Use whichever way is more meaningful to you.

Dual-Aspect Concept The assets that remain after the liabilities are taken into account will be claimed by the equity investors. If an entity has assets that total $10,000 and liabilities that total $4,000, its owners’ equity must be $6,000.

Because (1) any assets not claimed by creditors will be claimed by equity investors and (2) the total amount of claims (liabilities � owners’ equity) cannot exceed what there is to be claimed, it follows that the total amount of assets will always be equal to the total amount of liabilities plus owners’ equity.

The fact that total assets must equal, or balance, total liabilities plus owners’ equity is why the statement is called a balance sheet. This equality tells nothing about the entity’s financial condition; it always exists unless the accountant has made a mistake.

ILLUSTRATION 1–3 The Balance Sheet

HOLDEN COMPANY Balance Sheet

As of December 31, 2010 (000 omitted)

Assets Liabilities and Owners’ Equity

Current assets: Current liabilities:

Cash $ 1,449 Accounts payable $ 5,602

Marketable securities 246 Bank loan payable 1,000

Accounts receivable, net 9,944 Accrued liabilities 876

Inventories 10,623 Estimated tax liability 1,541

Prepaid expenses 389 Current portion of long-term debt 500_______ _______ Total current assets 22,651 Total current liabilities 9,519_______ _______

Noncurrent assets: Noncurrent liabilities:

Property, plant, equipment Long-term debt, less at cost 26,946 current portion 2,000

Less: Accumulated Deferred income taxes 824_______ depreciation 13,534 Total liabilities 12,343_______ _______

Property, plant, equipment—net 13,412 Owners’ equity:

Investments 1,110 Common stock 1,000

Patents and trademarks 403 Additional paid-in capital 11,256_______ Goodwill 663 Total paid-in capital 12,256_______

Retained earnings 13,640_______ Total owners’ equity 25,896

Total assets $38,239 Total liabilities and owners’ equity $38,239_______ ______________ _______

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This fact leads to what is called the dual-aspect concept. The two aspects that this concept refers to are (1) assets and (2) liabilities plus owners’ equity. The concept states that these two aspects are always equal. (This equality exists even if liabilities are greater than assets. For example, if assets in an unprofitable business were $100,000 and liabilities were $120,000, owners’ equity would be a negative amount of $20,000.)

The dual-aspect concept is 1 of 11 basic accounting concepts we shall describe in Chapters 2 and 3. The dual-aspect concept can be written as an equation:

Assets � Liabilities � Owners’ equity

This equation is fundamental. It governs all accounting. We can write a similar equa- tion in a form that emphasizes the fact that owners’ equity is a residual interest:

Assets � Liabilities � Owners’ equity

For example, if the assets of Violet Company total $19,000 and its liabilities total $3,000, its owners’ equity must total $16,000.

The term net assets is sometimes used instead of owners’ equity. It refers to the fact that owners’ equity is always the difference between assets and liabilities.

Every accounting transaction can be described in terms of its effect on this funda- mental accounting equation. For example, the Violet Company spends $15,000 cash for a new car. The company’s accountant would record a reduction in the asset Cash (�$15,000) and an increase in the asset Cars (�$15,000). After recording this trans- action, the fundamental equation is still in balance. Similarly, if the company had bought the car on credit rather than for cash, the equation would be in balance because the liability Accounts Payable would have increased (�$15,000) and the asset Cars would have increased by a like amount (�$15,000).

The amounts of an entity’s assets and liabilities will change from day to day. Any balance sheet reports the amounts of assets, liabilities, and owners’ equity at one point in time. The balance sheet therefore must be dated. (From here on we shall sometimes use the term 20x1 to refer to the first year, 20x2 for the next year, and so on. Thus, a bal- ance sheet as of December 31 of the first year is dated “as of December 31, 20x1.” It refers to the close of business on that day.)

Returning to Illustration 1–3, if the Holden Company prepared a balance sheet as of the beginning of business the next day, January 1, 2011, it would be the same as the one in Illustration 1–3 because nothing changes between the close of business on one day and the beginning of business on the next day.

Illustration 1–4 shows the Holden Company’s 2010 income statement. The amount added to Retained Earnings as a result of profitable operations during a period is the income of the period. An income statement explains how this income was earned. There is no standard format for an income statement. Illustration 1–4 shows one common format. (The income statement is discussed in greater detail in Chapter 3.)

The basic income statement equation is

Revenues � Expenses � Net income

The first item on this income statement is Sales Revenue, which is the amount of products (i.e., goods and services) sold or delivered to customers during the period.

The item on the second line is labeled Cost of Sales. It reports the cost of the goods or services whose revenue is reported on the first line.

The difference between sales and cost of sales is called gross margin. Thus,

Gross margin � Sales revenue � Cost of sales

16 Part 1 Financial Accounting

The Income Statement

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Chapter 1 The Nature and Purpose of Accounting 17

Operating expenses are subtracted from gross margin, leaving income before taxes. These expenses include costs related to the current period and costs that do not benefit future periods.

The next item in Illustration 1–4, provision for income taxes, is shown separately because it is an especially important expense.

The final item (the bottom line) on an income statement is called net income (or net loss, if expenses were larger than revenues).

Illustration 1–5 is a “package” of financial reports for the Holden Company consisting of two balance sheets and an income statement. (A complete package of financial re- ports also would include a cash flow statement.) The illustration shows how the balance sheet, statement of retained earnings, and income statement relate to each other through the Retained Earnings account.

An income statement is a summary of certain changes in Retained Earnings that have taken place during an accounting period. In other words, an income statement reports cer- tain changes in Retained Earnings that have taken place between two balance sheet dates.

Thus, a useful accounting “report package” consists of a balance sheet at the begin- ning of the accounting period, an income statement for the period, and a balance sheet at the end of the period.

The statement of retained earnings at the bottom of Illustration 1–5 shows that the Retained Earnings on December 31, 2009, was $13,640,000. During 2010 profitable operations resulted in net income of $6,122,000, which increased Retained Earnings by this amount. (Net income is the bottom line on the income statement.) Retained Earnings was decreased by $4,390,000, representing a distribution to the shareholders in the form of dividends. As a result, the total Retained Earnings on December 31, 2010, was $15,372,000 ($13,640,000 � $6,122,000 � $4,390,000).

Dividends are deducted from Retained Earnings because dividends are a distribu- tion of earnings to owners. Dividends are not an expense.

We indicated earlier that financial accounting statements, while also of use to manage- ment, are intended primarily to provide relevant information to parties external to the business. The Financial Accounting Standards Board (FASB) issued a formal state- ment of financial reporting objectives. The entire statement is too lengthy to describe here in detail. We will simply highlight the key objectives. (The numbering is ours, not that of the FASB.)

ILLUSTRATION 1–4 The Income Statement

HOLDEN COMPANY Income Statement For the Year 2010

(000 omitted)

Sales revenue $75,478

Less cost of sales 52,227________ Gross margin 23,251

Less operating expenses 10,785________ Income before taxes 12,466

Provision for income taxes 6,344________ Net income $ 6,122________________

“Package” of Financial Reports

Financial Statement Objectives

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Financial reporting should provide information that

1. Is useful to present and potential investors and creditors in making rational invest- ment and credit decisions.

2. Is comprehensible to those who have a reasonable understanding of business and eco- nomic activities and are willing to study the information with reasonable diligence.

3. Is about the economic resources of an enterprise, the claims to those resources, and the effects of transactions and events that change resources and claims to those resources.

4. Is about an enterprise’s financial performance during a period. 5. Helps users assess the amounts, timing, and uncertainty of prospective cash receipts

from dividends or interest and the proceeds from the sale or redemption of securi- ties or loans.

18 Part 1 Financial Accounting

1ILLUSTRATION 1–5 A “Package” of Accounting Reports

HOLDEN COMPANY (000 OMITTED)

Condensed Balance Sheet Condensed Balance Sheet As of December 31, 2009 As of December 31, 2010

Assets Assets

Current assets $22,651 Current assets $24,062

Buildings and equipment 13,412 Buildings and equipment 14,981

Other assets 2,176 Other assets 3,207________ ________ Total assets $38,239 Total assets $42,250________ ________________ ________

Liabilities and Owners’ Equity Liabilities and Owners’ Equity

Liabilities $12,343 Liabilities $14,622

Owners’ equity: Owners’ equity:

Paid-in capital 12,256 Paid-in capital 12,256

Retained earnings 13,640 Retained earnings 15,372________ ________ Total liabilities and owners’ equity $38,239 Total liabilities and owners’ equity $42,250________ ________________ ________

Income Statement For the Year 2010

Sales revenue $75,478

Less cost of sales 52,127_______ Gross margin 23,351

Less operating expenses 10,885_______ Income before taxes 12,466

Provision for income taxes 6,344_______ Net income, 2010 $ 6,122______________

Statement of Retained Earnings

Retained earnings, 12/31/09 $13,640

Add net income 6,122________ 19,762

Less dividends 4,390________ Retained earnings, 12/31/10 $15,372________________

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Chapter 1 The Nature and Purpose of Accounting 19

Objectives 1 and 2 apply to all financial accounting information. Note that the in- tended users are expected to have attained a reasonable level of sophistication in using the statements; the statements are not prepared for uninformed persons. Objective 3 is related to the balance sheet, objective 4 to the income statement, and objective 5 to the cash flow statement. As the five objectives collectively suggest, financial statements provide information about the past to aid users in making predictions and decisions related to the future financial status and flows of the business.

In July 2002 the U.S. president signed into law the Sarbanes-Oxley Act. It requires chief executives and chief financial officers of public companies to certify that their company’s financial statements filed with the SEC are materially accurate and com- plete, and that in all material respects they present fairly the financial condition and results of operations of the issuer. These certifications subject the signers to potential civil and criminal liability for false certifications.

The Internal Revenue Service (IRS) specifies the ways in which taxable income is calculated for the purpose of assessing income taxes. Because the tax laws’ purposes differ from the objectives of financial reporting, the IRS accounting regulations differ in some respects from GAAP. These differences mean that the amount of pretax in- come or loss shown on the taxpayer’s income statement prepared according to GAAP will probably not be equal to the taxable income or loss shown on the taxpayer’s in- come tax return.7 How GAAP handles this difference will be covered in Chapter 10.

Thus, in the United States, financial accounting, management accounting, and in- come tax accounting are essentially separate processes. GAAP provides the principles for financial accounting; top management for management accounting; and the IRS and Congress for income tax accounting. The underlying operating information that is the basic data for all three processes is the same. The pieces or building blocks of op- erating information simply are put together in different ways for these three different processes. Though differences among the three processes do exist, in practice the sim- ilarities are greater than the differences.

An organization has four types of accounting information: (1) operating information, which has to do with the details of operations; (2) management accounting information, which is used internally for planning, implementation, and control; (3) financial accounting informa- tion, which is used both by management and by external parties; and (4) tax accounting in- formation, which is used to file tax returns with taxing authorities.

Financial accounting is governed by ground rules that in America are referred to as gen- erally accepted accounting principles. Outside the United States, there rules are increasingly most likely to be IFRS, rather than local standards. In either case, these ground rules may be different from what the reader believes them to be, based on previous exposure to account- ing information. There rules attempt to strike a balance between the criterion of relevance on the one hand and the criteria of objectivity and feasibility on the other.

The end products of the financial accounting process are three financial statements: the balance sheet, the income statement, and the cash flow statement. The balance sheet is a

Summary

Sarbanes-Oxley Act

Income Tax Reporting

7 In contrast to the United States, the governments of many countries require a company’s financial accounting and tax accounting to be identical. This is changing. In many countries public companies listed on stock exchanges and, in some cases, unlisted companies are now being allowed or required to use IASB standards in reports to stockholders that differ from the local tax accounting rules.

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20 Part 1 Financial Accounting

report of status or stocks as of a moment of time, whereas the other two statements sum- marize flows over a period of time.

In the United States, calculating taxable income for income tax purposes differs from the process of calculating income for the financial accounting income statement.

The basic accounting equation is

Assets � Liabilities � Owners’ equity

Problems Problem 1–1.

As of December 31, Charles Company had $12,000 in cash, held $95,000 of inventory, and owned other items that originally cost $13,000. Charles Company also had bor- rowed $40,000 from First City Bank. Prepare a balance sheet for Charles Company as of December 31. Be sure to label each item and each column with appropriate terms.

Problem 1–2. Selected balance sheet items are shown for the Microtech Company. Compute the missing amounts for each of the four years. What basic accounting equation did you apply in mak- ing your calculations?

Year 1 Year 2 Year 3 Year 4

Current assets $113,624 $ ? $ 85,124 $ ? Noncurrent assets ? 198,014 162,011 151,021_________ _________ _________ _________ Total assets $524,600 $ ? $ ? $220,111_________ _________ _________ __________________ _________ _________ _________ Current liabilities $ 56,142 $ 40,220 $ ? $ ? Noncurrent liabilities ? ? 60,100 30,222 Paid-in capital 214,155 173,295 170,000 170,000 Retained earnings 13,785 (3,644) 1,452 2,350_________ _________ _________ _________ Total liabilities and

owners’ equity $524,600 $288,456 $ ? $220,111_________ _________ _________ __________________ _________ _________ _________

Problem 1–3. Selected income statement items are shown for Astrotech Company. Compute the missing amounts for each of the four years. What basic accounting equation did you apply in mak- ing your calculations?

(Hint: To estimate the Year 4 missing numbers, compute the typical percentage each ex- pense item is of sales for Years 1 to 3 and apply the percentage figure for each expense item to Year 4’s sales.)

Year 1 Year 2 Year 3 Year 4

Sales $12,011 $ ? $11,545 $10,000 Cost of goods sold 3,011 2,992 ? ?________ ________ ________ ________ Gross margin ? 8,976 8,659 ? Other expenses 6,201 6,429 ? ?________ ________ ________ ________ Profit before taxes 2,799 ? 2,363 ? Tax expense ? 1,019 945 ?________ ________ ________ ________ Net income $ 1,679 $1,528 $ 1,418 ?________ ________ ________ ________________ ________ ________ ________

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Chapter 1 The Nature and Purpose of Accounting 21

Problem 1–4. An analysis of the transactions made by Acme Consulting for the month of July is shown below.

Cash � Accounts � Supplies � Equipment � Accounts � Owners’ Description of Receivable Inventory Payable Equity Transaction

1. �$20,000 �$20,000 Investment 2. �$ 5,000 �$7,000 �$2,000 3. �$ 1,000 �$1,000 4. �$ 4,500 �$ 4,500 Salaries 5. �$ 5,000 �$5,000 �$10,000 Revenues 6. �$ 1,500 �$1,500 7. �$ 1,000 �$1,000 8. �$ 750 �$ 750 Rent 9. �$ 500 �$ 500 Utilities

10. �$ 200 �$ 200 Travel 11. �$ 200 �$ 200

Required: a. Explain each transaction.

b. List the changes in the company’s balance sheet during the month of July.

c. Prepare an income statement for the month (ignore taxes).

d. Explain the changes in the Cash account.

e. Explain why the change in the Cash account and the month’s income are not the same. Problem 1–5.

During the month of June, Bon Voyage Travel recorded the following transactions:

1. Owners invested $25,000 in cash to start the business. They received common stock.

2. The month’s rent of $500 was prepaid in cash.

3. Equipment costing $8,000 was bought on credit.

4. $500 was paid for office supplies.

5. Advertising costing $750 was paid for with cash.

6. Paid $3,000 employee salaries in cash.

7. Earned travel commissions of $10,000 of which $2,000 was received in cash.

8. Paid $5,000 of the $8,000 owed to the equipment supplier.

9. Used $100 of the office supplies.

10. Charged $1,000 of miscellaneous expenses on the corporate credit card.

Required: a. Prepare an analysis of the month’s transactions using the same tabular format as

shown in Problem 1–4 (ignore taxes).

b. Explain how the transactions during the month changed the basic accounting equa- tion (Assets � Liabilities � Owners’ equity) for the company.

c. Prepare an income statement for the month.

d. Explain the changes in the Cash account.

e. Explain why the change in the Cash account and the month’s income are not the same.

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22 Part 1 Financial Accounting

In January 2010, Carmen Diaz, a recent arrival from Cuba, decided to open a small ribbon shop in the Coconut Grove section of Miami, Florida. During the month, she put together a simple business plan, which she took to several relatives whom she believed would be interested in helping her finance the new venture. Two of her cousins agreed to loan the business $10,000 for one year at a 6 percent interest rate. For her part, Carmen agreed to invest $1,000 in the equity of the business.

On March 1, 2010, with the help of an uncle who practiced law, Carmen formally incorporated her busi- ness, which she named “Ribbons an’ Bows.’’ Nor- mally, the uncle would have charged a fee of $600 for handling the legal aspects of a simple incorporation, but, since Carmen was family, he waived the fee.

As soon as the new business was incorporated, Carmen opened a bank account and deposited the cousins’ $10,000 loan and her $1,000 equity contribu- tion. The same day, she signed an agreement to rent store space for $600 per month, paid on the last day of the month. The agreement was for an 18-month period beginning April 1. The agreement called for a prepay- ment of the last two months’ rent, which Carmen paid out of the company bank account at the signing.

Over the next few weeks, Carmen was actively en- gaged in getting ready to open the store for business on April 1. Fortunately for Carmen, the previous ten- ant had left counters and display furniture that Carmen could use at no cost to her. In addition, the landlord agreed to repaint the store at no cost, using colors of Carmen’s choice. For her part, Carmen ordered, re- ceived, and paid for the store’s opening inventory of ribbons and ribbon accessories; acquired for free a simple cash register with credit-card processing capa- bilities from the local credit-card charge processing company after paying a refundable deposit; signed service agreements with the local phone and utility companies; ordered, received, and paid for some store supplies; and placed and paid for advertising an- nouncing the store opening in the April 2 edition of the local paper. In addition, she bought and paid for a used desktop computer with basic business software

already installed to keep track of her business transac- tions and correspondence.

On March 31, before opening for business the next day, Carmen reviewed the activity in the company’s cash bank account. Following the deposit of the loans and equity contribution, the following payments were made.

1. Last two months’ rent $1,200

2. Opening merchandise inventory $3,300

3. Cash register deposit $ 250

4. Store supplies $ 100

5. April 2 edition advertising $ 150

6. Used computer purchase $2,000

After reviewing her cash transaction records, Carmen prepared a list of Ribbons an’ Bows assets and sources of its capital (see Exhibit 1).

EXHIBIT 1 Carmen’s March 31, 2010, Ribbons an’ Bows Assets and Capital Sources List

Sources of Assets Capital

Cash $ 4,000 Inventory 3,300 Supplies 100 Prepaid rent 1,200 Prepaid advertising 150 Computer/ Cousin’s

software 2,000 loan $10,000 Cash register Carmen’s

deposit 250 equity 1,000 $11,000 $11,000

Carmen eventually decided to expand her business by selling custom-designed ribbon table arrangements for weddings and other special events. This decision led to the purchase of a used commercial sewing ma- chine for $1,800 cash on May 1.

Later, at a family Fourth of July celebration, one of Carmen’s cousins reminded her that she had promised to send the cousins a financial report covering the four- month period from March 1 to June 30.

Cases

Case 1–1

Ribbons an’ Bows, Inc.

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Chapter 1 The Nature and Purpose of Accounting 23

The next day, Carmen reviewed the following Ribbons an’ Bows information she had gathered over the last four months.

1. Customers had paid $7,400 cash for ribbons and ac- cessories, but she was still owed $320 for ribbon arrangements for a large wedding delivered to the customer on June 30.

2. A part-time employee had been paid $1,510 but was still owed $90 for work performed during the last week of June.

3. Rent for the three-month period had been paid in cash at the end of each month, as stipulated in the rental agreement.

4. Inventory replenishments costing $2,900 had been delivered and paid for by June 30. Carmen esti- mated the June 30 merchandise inventory on hand had cost $4,100.

5. The small opening office supplies inventory was nearly all gone. She estimated supplies costing $20 had not been used.

Carmen believed that the initial three months of business had been profitable, but she was puzzled by the fact that the cash in the company’s June 30 bank account was $3,390, which was less than the April 1 balance of $4,000.

Carmen also was concerned about how she should reflect the following in her financial report:

1. No interest had been paid on the cousins’ loan.

2. The expenditures made for the desktop computer and its related software and the commercial sewing machine. She believed these expenditures would be beneficial to the business long after June 30. At

the time she purchased the commercial sewing ma- chine, Carmen estimated that it would be used for about five years from its May 1 purchase date, when it would then have to be replaced. Similarly, on March 31, she had estimated the desktop computer and its software would have to be replaced in two years’ time. Carmen believed the sewing machine and the computer along with its software would have no resale value at the end of their useful lives.

3. The free legal work performed by her uncle and the free cash register provided by the local credit-card charge processor.

4. Carmen had not paid herself a salary or dividends during the four months of operations. If cash was available, she anticipated that sometime in July she would pay herself some compensation for the four months spent working in the business. Before start- ing her business, Carmen had worked for $1,300 a month as a cashier in a local grocery store.

Questions

1. How would you report on the three-month opera- tions of Ribbons an’ Bows, Inc., through June 30? Was the company profitable? (Ignore income taxes.) Why did its cash in the bank decline during the three-month operating period?

2. How would you report the financial condition of the business on June 30, 2010?

3. Do you believe Carmen’s first three months of operation could be characterized as “successful’’? Explain your answer.

Case 1–2

Kim Fuller* In the early fall of 2010, Kim Fuller was employed as a district sales engineer for a large chemical firm. During a routine discussion with plant chemists, Fuller learned that the company had developed a use for the recycled material, in pulverized form, made from plastic soft drink bottles. Because the state had mandatory deposits on all beverage bottles, Fuller realized that a ready supply

of this material was available. All that was needed was an organization to tap that bottle supply, grind the bottles, and deliver the pulverized plastic to the chemical comp- any. It was an opportunity Fuller had long awaited—a chance to start a business.

In November 2010, Fuller began checking into the costs involved in setting up a plastic bottle grinding business. A used truck and three trailers were acquired to pick up the empty bottles. Fuller purchased one* © Professor Robert N. Anthony.

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24 Part 1 Financial Accounting

used grinding machine but had to buy a second one new; supplies and parts necessary to run and maintain the machines also were purchased. Fuller also pur- chased a personal computer with the intention of using it to keep company records. These items used $65,000 of the $75,000 Fuller had saved and invested in the company.

A warehouse costing $162,000 was found in an ex- cellent location for the business. Fuller was able to inter- est family members enough in this project that three of them—two sisters and a brother—invested $30,000 each. These funds gave Fuller the $50,000 down pay- ment on the warehouse. The bank approved a mortgage for the balance on the building. In granting the mort- gage, however, the bank official suggested that Fuller start from the beginning with proper accounting records. He said these records would help not only with future bank dealings but also with tax returns and general man- agement of the company. He suggested Fuller find a good accountant to provide assistance from the start, to get things going on the right foot.

Fuller’s neighbor, Marion Zimmer, was an accountant with a local firm. When they sat down to talk about the new business, Fuller explained, “I know little about keep- ing proper records.” Zimmer suggested Fuller should buy an “off-the-shelf ” accounting system software pack- age from a local office supply retailer. Zimmer promised to help Fuller select and install the package as well as learn how to use it. In order to select the right package for Fuller’s needs, Zimmer asked Fuller to list all of the items purchased for the business, all of the debts incurred, and the information Fuller would need to manage the busi- ness. Zimmer explained that not all of this information would be captured by the accounting records and dis- played in financial statements. Based on what Fuller told

Zimmer, Zimmer promised to create files to accommo- date accounting and nonaccounting information that Fuller could access through the company’s personal computer. As Fuller’s first lesson in accounting, Zimmer gave Fuller a brief lecture on the nature of the balance sheet and income statement and suggested Fuller draw up an opening balance sheet for the company.

Confident now that the venture was starting on solid ground, Kim Fuller opened the warehouse, signed contracts with two local bottling companies, and hired two grinding machine workers and a truck driver. By February 2011 the new firm was making regular deliveries to Fuller’s former employer.

Questions

1. What information will Fuller need to manage the business? Classify this information in two cate- gories: accounting information and nonaccounting information.

2. See what you can do to draw up a beginning-of- business list of the assets and liabilities of Fuller’s company making any assumptions you consider useful. How should Fuller go about putting a value on the company’s assets? Using your values, what is the company’s opening owners’ equity?

3. Now that Fuller has started to make sales, what in- formation is needed to determine “profit and loss”? What should be the general construction of a profit and loss analysis for Fuller’s business? How fre- quently should Fuller do such an analysis?

4. What other kinds of changes in assets, liabilities, and owners’ claims will need careful recording and re- porting if Fuller is to keep in control of the business?

Case 1–3

Baron Coburg* Once upon a time many, many years ago, there lived a feudal landlord in a small province of Western Europe. The landlord, Baron Coburg, lived in a castle high on a hill. He was responsible for the well-being of many peasants who occupied the lands surrounding his castle.

Each spring, as the snow began to melt, the Baron would decide how to provide for all his peasants dur- ing the coming year.

One spring, the Baron was thinking about the wheat crop of the coming growing season. “I believe that 30 acres of my land, being worth five bushels of wheat per acre, will produce enough wheat for next winter,” he mused, “but who should do the farming? I believe

* Source: Academic Note “Another Implorable Occurrence,’’ W. T. Andrews, ACCOUNTING HORIZONS, Vol. 9-No.3, April 1974, pp. 369–370. © American Accounting Association.

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Chapter 1 The Nature and Purpose of Accounting 25

I’ll give Ivan and Frederick the responsibility of grow- ing the wheat.” Whereupon Ivan and Frederick were summoned for an audience with Baron Coburg.

“Ivan, you will farm on the 20-acre plot of ground and Frederick will farm the 10-acre plot,” the Baron began. “I will give Ivan 20 bushels of wheat for seed and 20 pounds of fertilizer. (Twenty pounds of fertilizer are worth two bushels of wheat.) Frederick will get 10 bushels of wheat for seed and 10 pounds of fertil- izer. I will give each of you an ox to pull a plow, but you will have to make arrangements with Feyador the Plowmaker for a plow. The oxen, incidentally, are only three years old and have never been used for farming, so they should have a good 10 years of farming ahead of them. Take good care of them because an ox is worth 40 bushels of wheat. Come back next fall and return the oxen and the plows along with your harvest.”

Ivan and Frederick genuflected and withdrew from the Great Hall, taking with them the things provided by the Baron.

The summer came and went, and after the harvest Ivan and Frederick returned to the Great Hall to ac- count to their master for the things given them in the spring. Ivan said, “My Lord, I present you with a slightly used ox, a plow, broken beyond repair, and 223 bushels of wheat. I, unfortunately, owe Feyador the Plowmaker three bushels of wheat for the plow

I got from him last spring. And, as you might expect, I used all the fertilizer and seed you gave me last spring. You will also remember, my Lord, that you took 20 bushels of my harvest for your own personal use.”

Frederick spoke next. “Here, my Lord, is a par- tially used ox, the plow, for which I gave Feyador the Plowmaker 3 bushels of wheat from my harvest, and 105 bushels of wheat. I, too, used all my seed and fer- tilizer last spring. Also, my Lord, you took 30 bushels of wheat several days ago for your own table. I be- lieve the plow is good for two more seasons.”

“You did well,” said the Baron. Blessed with this benediction, the two peasants departed.

After they had taken their leave, the Baron began to contemplate what had happened. “Yes,” he thought, “they did well, but I wonder which one did better?”

Questions

1. For each farm, prepare balance sheets as of the beginning and end of the growing season and an income statement for the season. (Do not be con- cerned that you do not have much understanding of what a balance sheet and income statement are; just use your intuition as best you can.)

2. Which peasant was the better farmer?

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2 Basic Accounting Concepts: The Balance Sheet

Chapter

This chapter describes 5 of the 11 basic concepts from which principles of accounting are derived. Also described, in a preliminary way, are the nature of the balance sheet and the principal categories of items that appear in it. Finally, the chapter shows how amounts that appear in the balance sheet are changed to reflect events that affect an organization’s resources.

The material presented here should be regarded as an overview. Each of the topics introduced will be discussed in more depth in later chapters.

Basic Concepts

Accounting principles are built on a foundation of a few basic concepts. These con- cepts are so basic that most accountants do not consciously think of them; they are re- garded as self-evident. Nonaccountants will not find these concepts to be self-evident, however. Accounting could be constructed on a foundation of quite different concepts; indeed, some accounting theorists argue that certain of the present concepts are wrong and should be changed. Nevertheless, in order to understand accounting as it now ex- ists, one must understand the underlying concepts currently used.

The Financial Accounting Standards Board (FASB) has adopted a number of State- ments of Financial Accounting Concepts. These statements are intended to provide the FASB with explicit conceptual criteria to help resolve future accounting issues, rather than trying to deal with each issue on an ad hoc basis. The concept statements them- selves do not establish generally accepted accounting principles (GAAP). Other groups, including the International Accounting Standards Board, have published state- ments of basic accounting concepts. These publications are similar in many respects to the FASB’s concept statements.

The concepts we shall use in this book, while not identical to those listed by other authors or groups, reflect concepts that are widely accepted and applied in practice by

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accountants in the United States. These 11 concepts are as follows:

1. Money measurement 2. Entity 3. Going concern 4. Cost 5. Dual aspect 6. Accounting period 7. Conservatism 8. Realization 9. Matching

10. Consistency 11. Materiality

The first five are discussed below, and the other six are discussed in Chapter 3.

In financial accounting, a record is made only of information that can be expressed in monetary terms. The advantage of such a record is that money provides a common de- nominator by means of which heterogeneous facts about an entity can be expressed as numbers that can be added and subtracted.

Although it may be a fact that a business owns $30,000 of cash, 6,000 pounds of raw mate- rial, six trucks, 50,000 square feet of building space, and so on, these amounts cannot be added together to produce a meaningful total of what the business owns. Expressing these items in monetary terms—$30,000 of cash, $9,000 of raw material, $150,000 of trucks, and $4,000,000 of buildings—makes such an addition possible. Thus, despite the old cliché about not adding apples and oranges, it is easy to add them if both the apples and the oranges are expressed in terms of their respective monetary values.

Despite its advantage, the money measurement concept imposes a severe limitation on the scope of an accounting report. Accounting does not report the state of the pres- ident’s health, that the sales manager is not on speaking terms with the production manager, that a strike is beginning, or that a competitor has placed a better product on the market. Accounting therefore does not give a complete account of the happenings in an organization or a full picture of its condition. It follows, then, that the reader of an accounting report should not expect to find therein all of the facts, or perhaps even the most important ones, about an organization.

Money is expressed in terms of its value at the time an event is recorded in the ac- counts. Subsequent changes in the purchasing power of money do not affect this amount. Thus, a machine purchased in 2010 for $200,000 and land purchased 20 years earlier for $200,000 are each listed in the 2010 accounting records at $200,000, although the pur- chasing power of the dollar in 2010 was much less than it was 20 years earlier. It is some- times said that accounting assumes that money is an unvarying yardstick of value, but this statement is inaccurate. Accountants know full well that the purchasing power of the dollar changes. They do not, however, attempt to reflect such changes in the accounts.1

1 In countries with high inflation rates, accountants initially record events in terms of their monetary value and then in subsequent periods adjust any remaining balances upward to reflect the changes in the purchasing power of the currency. For example, if the annual inflation rate is 100 percent, land bought for $10,000 at the beginning of the year would be reported at $20,000 one year later ($10,000 * 200 � 100).

The Money Measurement Concept

Example

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Accounts are kept for entities, as distinguished from the persons who are associated with these entities. An entity is any organization or activity for which accounting reports are prepared. Although our examples tend to be drawn from business companies, accounting entities include governments, churches, universities, and other nonbusiness organizations.

In recording events in accounting, the important question is, how do these events affect the entity? How they affect the persons who own, operate, or otherwise are as- sociated with the entity is irrelevant. For example, suppose that the owner of a clothing store removes $100 from the store’s cash register for his or her personal use. The real effect of this event on the owner as a person may be negligible; although the cash has been taken out of the business’s “pocket” and put into the owner’s pocket, in either pocket the cash belongs to the owner. Nevertheless, because of the entity concept, the accounting records show that the business has less cash than it had previously.

It is sometimes difficult to define with precision the entity for which a set of ac- counts is kept. Consider the case of a married couple who own and operate an unin- corporated retail store. In law there is no distinction between the financial affairs of the store and those of its owners. A creditor of the store can sue and, if successful, collect from the owners’ personal resources as well as from the resources of the business. In accounting, by contrast, a set of accounts is kept for the store as a separate business entity, and the events reflected in these accounts must be those of the store. The non- business events that affect the couple must not be included in these accounts. In ac- counting, the business owns the resources of the store, even though the resources are legally owned by the couple, and debts owed by the business are kept separate from personal debts owed by the couple. The expenses of operating the store are kept sepa- rate from the couple’s personal expenses for food, clothing, housing, and the like.

The necessity for making such a distinction between the entity and its owners can create problems. Suppose, for example, that the couple lives on the same premises as the business. How much of the rent, electric bill, and property taxes associated with these premises is properly an expense of the business, and how much is personal ex- pense of the family? Answers to questions like these are often difficult to ascertain, and are indeed somewhat arbitrary.

For a corporation the distinction is often quite easily made. A corporation is a legal entity, separate from the persons who own it, and the accounts of many corporations correspond exactly to the scope of the legal entity. There may be complications, how- ever. In the case of a group of legally separate corporations that are related to one an- other by shareholdings, the whole group may be treated as a single entity for financial reporting purposes, giving rise to what are called consolidated accounting statements. Conversely, within a single corporation, a separate set of accounts may be maintained for each of its principal operating units. For example, General Electric Company main- tains separate accounts for each of its many business units (appliances, lighting, air- craft engines, capital services, and others).

One entity may be part of a larger entity. Thus, a set of accounts may be maintained for an individual elementary school, another set for the whole school district, and still another set for all the schools in a particular state. There even exists a set of accounts, called the national income accounts, for the entire economic activity of the United States. In general, detailed accounting records are maintained for entities at the lowest level in the hierarchy, and reports for higher levels are prepared by summarizing the de- tailed data of these low-level entities.

Unless there is good evidence to the contrary, accounting assumes that an entity is a going concern—that it will continue to operate for an indefinitely long period in the future. The significance of this assumption can be indicated by contrasting it with a

28 Part 1 Financial Accounting

The Going- Concern Concept

The Entity Concept

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possible alternative, namely, that the entity is about to be liquidated. Under the latter assumption, accounting would attempt to measure at all times what the entity’s re- sources are currently worth to potential buyers. Under the going-concern concept, by contrast, there is no need to constantly measure an entity’s worth to potential buyers, and it is not done. Instead, it is assumed that the resources currently available to the entity will be used in its future operations.

At any given moment, a blue jeans manufacturer has jeans in various stages of the produc- tion process. If the business were liquidated today, these partially completed jeans would have little if any value. Accounting does not attempt to value these jeans at what they are currently worth. Instead, accounting assumes that the manufacturing process will be car- ried through to completion, and therefore that the amount for which the partially com- pleted jeans could be sold if the company were liquidated today is irrelevant.

If, however, the accountant has good reason to believe that an entity is going to be liquidated, then its resources would be reported at their liquidation value. Such cir- cumstances are uncommon.

The economic resources of an entity are called its assets. They consist of nonmon- etary assets, such as land, buildings, and machinery, and other similar assets whose cash value is not fixed by contract, and monetary assets, such as money and mar- ketable securities and other similar assets whose cash value is fixed by contract as will be described in Chapter 5. A fundamental concept of accounting, closely related to the going-concern concept, is that an asset is ordinarily entered initially in the accounting records at the price paid to acquire it—at its cost.2 In the case of nonmonetary assets, the cost concept extends to their accounting subsequent to ac- quisition; cost continues to be the basis for all subsequent accounting for the asset. This is not true for most monetary assets. Subsequent to acquisition, they are ac- counted for at their fair value. Fair value is the amount at which an asset could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.

While IFRS favors the cost concept for nonmonetary assets, it does permit as an ac- ceptable alternative treatment the revaluation of land and buildings to their fair value subsequent to their initial recognition at cost.

Nonmonetary Assets Since, for a variety of reasons, the real worth of an asset may change with the passage of time, the accounting measurement of nonmonetary assets does not necessarily—indeed, does not ordinarily—reflect what assets are worth, except at the moment they are acquired. There is therefore a considerable difference between the way in which nonmonetary assets are measured in accounting after their acqui- sition and the everyday, nonaccounting notion that assets are measured at what they are worth.

In accounting, all assets are initially recorded at their cost. (For emphasis, this is also referred to as an asset’s historical cost.) In the case of nonmonetary assets, this amount is ordinarily unaffected by subsequent changes in the value of the asset. By contrast, in ordinary usage, the “value” of an asset usually means the amount for which it currently could be sold.

2 APB Opinion No. 20 requires that donated assets be recorded at their fair value at the date of receipt.

The Cost Concept

Example

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If a business buys a plot of land (a nonmonetary asset), paying $250,000 for it, this asset would be recorded in the accounts of the business at the amount of $250,000. If a year later the land could be sold for $275,000, or if it could be sold for only $220,000, no change would ordinarily be made in the accounting records to reflect this fact.

Thus, the amounts at which nonmonetary assets are shown in an entity’s accounts do not indicate the fair values of these assets. Probably the most common mistake made by uninformed persons reading accounting reports is that of believing there is a close correspondence between the amount at which a nonmonetary asset appears in these re- ports and the fair value of the asset. The amounts reported for land, building, equip- ment, and similar nonmonetary assets have no necessary relationship to what these items are currently worth. In general, it is safe to say that the longer a nonmonetary asset has been owned by an entity, the less likely it is that the amount at which the asset appears on the accounting records corresponds to its current fair value.

To emphasize the distinction between accounting’s cost concept as it is applied to nonmonetary assets and the ordinary meaning of value, the term book value is used for historical cost amounts shown in accounting records.

Rationale for the Cost Concept The cost concept as it is applied to nonmonetary assets provides an excellent illustration of the problem of applying the three basic criteria used to judge the acceptability of an accounting principle discussed in Chapter 1: relevance, objectivity, and feasibility. If the only criterion were relevance, then the application of the cost concept to the accounting for nonmonetary assets subsequent to their acquisition would not be defensible. Clearly, investors and other financial statement users are more interested in what the business and its individual assets are actually worth today than in what the assets cost originally.

The cost concept, by contrast, provides a relatively objective foundation for non- monetary asset accounting. It is not purely objective, as we shall see, for judgments are necessary to apply it. It is much more objective, however, than the alternative of at- tempting to estimate fair values. A market value or current worth concept would be dif- ficult and costly because it would require that the accountant attempt to keep track of the ups and downs through appraisals of the fair value of each nonmonetary asset dur- ing each accounting period. The cost concept leads to a much more feasible system of accounting for nonmonetary assets. As a result, readers of an accounting report must recognize that it is based in part on the cost concept, and they must arrive at their own estimate of current values partly by analyzing the information in the report and partly by using nonaccounting information.

The cost concept does not mean that all nonmonetary assets remain on the account- ing records at their original purchase price for as long as the entity owns them. The cost of a nonmonetary asset that has a long but nevertheless limited life is systematically re- duced over that life by the process called amortization, as discussed in Chapter 7. The purpose of the amortization process is to remove systematically the cost of the asset from the asset accounts and to show it as a cost of operations. Amortization has no nec- essary relationship to changes in market value or in the real worth of the asset.

In summary, adherence to the cost concept when accounting for nonmonetary assets indicates a willingness on the part of the accounting profession to sacrifice some de- gree of relevance in exchange for greater objectivity and greater feasibility.

Monetary Assets Monetary assets are initially recorded at their cost and, in the case of most monetary assets, subsequently accounted for at their fair value. This practice raises an important

30 Part 1 Financial Accounting

Example

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 31

accounting issue: How should the unrealized changes in a monetary asset’s fair value be treated for accounting purposes? As will be explained in later chapters, if a mone- tary asset’s carrying amount is changed at the end of each accounting period to reflect its current fair value, the offsetting adjustment is accounted for in several different ways, depending on the nature of the monetary asset.

Rationale for Fair Value The use of fair value to account for most monetary assets subsequent to their acquisi- tion satisfies the three basic criteria of relevance, objectivity, and feasibility used to judge the acceptability of an accounting principle. Clearly a monetary asset’s fair value is relevant to readers of accounting reports, and the fair value of many monetary assets can readily be determined objectively and at a low cost.

A company has invested surplus cash in 100,000 shares of the common stock of General Electric. On June 12, 2010, the management wants to determine the fair value of its invest- ment. To achieve this objective, the management need only wait until the close of the New York Stock Exchange and then refer to one of several different stock price reporting services. Each of these would show that General Electric’s common stock closed at $30 per share. Then by simple multiplication, the fair value of the investment could be determined to be $3.0 million.

But who knows what a business is worth today? Any estimate of current value is just that—an estimate—and informed people will disagree on what the estimate should be. For example, on the same day, some people believe that the shares of stock of a given company are overpriced and they should therefore sell the stock; others believe that the shares are underpriced and they buy. Furthermore, accounting reports are prepared by an organization’s management. If these reports contained estimates of what the entity is actually worth (including its “goodwill”), these would be management’s estimates. It is quite possible that such estimates would be biased.

Goodwill It follows from the cost concept that if an entity pays nothing for an item it acquires (other than as a donation), this item will usually not appear on the accounting records as an asset. Thus, factors that contribute to the value of a company—such as the knowl- edge and skills that are built up as a business operates, the teamwork that exists within the organization, the importance of a favorable location, the good reputation a com- pany has with its customers, and the trade names developed by the company—do not appear as assets in the accounts of the company.

On some accounting reports, the term goodwill appears. Reasoning from the every- day definition of the word, one might conclude that it represents the accountant’s ap- praisal of what the company’s intellectual capital, market power, name, and reputation are worth. This is not so. Goodwill appears in the accounts of a company only when the company has purchased another company—as discussed in Chapter 12, when one company buys another company and pays more than the fair value of its net assets (the sum of the fair value of individual assets less the sum of the fair value of individual liabilities). The amount by which the purchase price exceeds the fair value of the ac- quired company’s net assets is called goodwill, representing the value of the name, reputation, clientele, or similar intangible resources of the purchased company. Unless a business has actually purchased such intangibles through a business acquisition, however, no item for goodwill is shown in its accounts. If the item does appear, the amount shown initially is the purchase price, even though the management may believe that the real value is considerably higher.

Example

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When Philip Morris Incorporated paid $5.8 billion to acquire the General Foods Corpora- tion, $2.8 billion of the purchase price was allocated to the purchased “goodwill,” which included the value of the General Foods organization and its various brand names (e.g., Jell-O, Good Seasons, Kool-Aid, Maxwell House). This $2.8 billion was recorded in the Philip Morris accounts as goodwill. It had never been recognized as an asset by General Foods.

The economic resources of an entity are called assets. The claims of various parties against these assets are called equities. There are two types of equities: (1) liabilities, which are the claims of creditors (that is, everyone other than the owners of the busi- ness), and (2) owners’ equity, which is the claims of the owners of the business. (Own- ers’ equity for an incorporated business is commonly called shareholders’ equity.) Since all of the assets of a business are claimed by someone (either by its owners or by its creditors) and since the total of these claims cannot exceed the amount of assets to be claimed, it follows that

Assets � Equities

This is the fundamental accounting equation expressed in its general form. It is the formal expression of the dual-aspect concept. As we shall see, all accounting proce- dures are derived from this equation. To reflect the two types of equities, the expanded version of the equation is

Assets � Liabilities � Owners’ equity

Events that affect the numbers in an entity’s accounting records are called transac- tions. Although it is certainly not self-evident to a beginning accounting student, every transaction has a dual impact on the accounting records. Accounting systems are set up to record both of these aspects of a transaction; this is why accounting is called a double-entry system.

To illustrate the dual-aspect concept, suppose that Ms. Jones starts a business and that her first act is to open a bank account in which she deposits $40,000 of her own money. The dual aspect of this transaction is that the business now has an asset, cash, of $40,000, and Ms. Jones, the owner,3 has a claim, also of $40,000, against this asset. In other words,

Assets (cash), $40,000 � Equities (owner’s), $40,000

If, as its next transaction, the business borrowed $15,000 from a bank, the business accounting records would change in two ways: (1) They would show a $15,000 in- crease in cash, making the amount $55,000, and (2) they would show a new claim against the assets, the bank’s claim, in the amount of $15,000. At this point, the ac- counting records of the business would show the following:

Cash $55,000 Owed to bank $15,000

Owner’s equity 40,000_______ _______ Total assets $55,000 Total equities $55,000_______ ______________ _______

32 Part 1 Financial Accounting

3 Recall from the entity concept that the accounts of the business are kept separate from those of Ms. Jones as an individual.

The Dual-Aspect Concept

Example

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 33

To repeat, every transaction recorded in the accounts affects at least two items. There is no conceivable way that a transaction can result in only a single change in the accounts.

The Balance Sheet

The financial position of an accounting entity as of a specified moment in time is shown by a balance sheet. Its more formal name is a statement of financial position. More specifically, the balance sheet reports the assets and equities (liabilities and own- ers’ equity) of the entity at a specified moment in time.4 Because the balance sheet is a snapshot as of an instant in time, it is a status report (rather than a flow report).

A simplified balance sheet for a corporation is shown in Illustration 2–1. Before considering its details, first examine this balance sheet in terms of the basic concepts already described. Note that the amounts are expressed in money and reflect only those

ILLUSTRATION 2–1

GARSDEN CORPORATION Name of entity

Balance Sheet Name of statement

As of December 31, 2010 Moment of time

Assets Liabilities and Shareholders’ Equity

Current assets: Current liabilities:

Cash $ 3,448,891 Accounts payable $ 6,301,442

Marketable securities 246,221 Taxes payable 1,672,000

Accounts receivable 5,954,588 Accrued expenses 640,407

Inventories 12,623,412 Deferred revenues 205,240

Prepaid expenses 377,960 Current portion of

Total current assets $22,651,072 long-term debt 300,000

Total current liabilities $ 9,119,089

Property, plant, and equipment: Long-term debt 3,000,000

Land 642,367 Total liabilities $12,119,089

Buildings and equipment, at cost $26,303,481

Less: Accumulated Shareholders’ equity: depreciation 13,534,069 12,769,412 Paid-in capital $5,000,000

Net property, plant, $13,411,779 Retained earnings 19,116,976 and equipment Total shareholders’ equity $24,116,976

Other assets:

Investments $110,000

Intangible assets 63,214 173,214___________ ____________ ___________ Total assets $36,236,065 Total liabilities and shareholders’ equity $36,236,065___________ ______________________ ___________

4 A balance sheet dated December 31 is implicitly understood to mean “at the close of business on December 31.”

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matters that can be measured in monetary terms. The entity involved is the Garsden Corporation, and the balance sheet pertains to that entity rather than to any of the indi- viduals associated with it. The statement assumes that Garsden Corporation is a going concern. The nonmonetary asset amounts stated are governed by the cost concept. Many of the monetary assets are recorded at their fair value. The dual-aspect concept is evident from the fact that the assets listed on the left-hand side of this balance sheet are equal in total to the liabilities and shareholders’ equity listed on the right-hand side.

Because of the dual-aspect concept, the two sides of the balance sheet necessarily add up to the same total. This equality does not tell anything about the company’s fi- nancial health. The label balance sheet can give the impression that there is something significant about the fact that the two sides balance. This is not so; the two sides always balance.

In the Garsden Corporation balance sheet, assets are listed on the left and equities on the right.5 (Normally, the dollar amounts would be rounded to the nearest thousand dol- lars. We have not done this to emphasize the fact that assets equal equities precisely.)

The balance sheet is the fundamental accounting statement in the sense that every ac- counting transaction can be analyzed in terms of its dual impact on the balance sheet. To understand the information a balance sheet conveys and how economic events affect the balance sheet, the reader must be absolutely clear as to the meaning of its two sides. They can be interpreted in either of two ways, both of which are correct.

Resources and Claims View One interpretation, the resources and claims view, has already been described. The items listed on the asset side are the economic resources of the entity as of the date of the balance sheet. The amounts stated for each asset are recorded in accordance with the basic concepts described above. Liabilities and owners’ equity are claims against the en- tity as of the balance sheet date. Liabilities are the claims of outside parties—amounts that the entity owes to banks, vendors, employees, and other creditors. Owners’ equity shows the claims of the owners.

However, an entity’s owners do not have a claim in the same sense that the creditors do. In the Garsden Corporation illustration, it can be said with assurance that govern- mental taxing authorities had a claim of $1,672,000 as of December 31, 2010—that the corporation owed them $1,672,000, neither more nor less. It is more difficult to inter- pret as a claim the amount shown as shareholders’ equity, $24,116,976. If the corpora- tion were liquidated as of December 31, 2010, if the assets were sold for their book value, and if the creditors were paid the $12,119,089 owed them, then the shareholders would get what was left, which would be $24,116,976. However, these “if ” conditions are obviously unrealistic. According to the going-concern concept, the corporation is not going to be liquidated; and according to the cost concept, the nonmonetary assets are not shown at their liquidation values.

The shareholders’ equity (or owners’ equity) might be worth considerably more or less than $24,116,976. The shareholders’ equity of a healthy, growing company is usu- ally worth considerably more than its “book value”—the amount shown on the balance sheet. On the other hand, if a company is not salable as a going concern and is liqui- dated with the assets being sold piecemeal, the owners’ proceeds are often only a small fraction of the amount stated for shareholders’ equity on the balance sheet. Often when

34 Part 1 Financial Accounting

An Overall View

5 Outside the United States, other balance sheet formats are often used. A common format is to list assets at the top of the page and to list equities beneath them. This format is called the report form. The balance sheet format used by the Garsden Corporation is called the account form.

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a bankrupt company’s assets are liquidated, the proceeds are inadequate to satisfy 100 percent of the creditors’ claims, in which case the owners receive nothing.

The resources and claims view of the balance sheet has some shortcomings. We have already pointed out the difficulty of interpreting shareholders’ equity as a claim. Also, the notion of “claiming” assets is rather legalistic, and has the most meaning if a company is being liquidated in bankruptcy—which is inconsistent with the going- concern concept. Therefore, the second way of interpreting the balance sheet has con- siderable merit. It is described in the next section.

Sources and Uses of Funds View In this alternative view, the left-hand side of the balance sheet is said to show the forms in which the entity has used, or invested, the funds provided to it as of the balance sheet date. These investments have been made in order to help the entity achieve its objectives, which in a business organization include earning a satisfactory profit. The right-hand side shows the sources of the funds that are invested in the assets—it shows how the as- sets were financed. The several liability items describe how much of that financing was obtained from trade creditors (accounts payable), from lenders (long-term debt), and from other creditors. The owners’ equity section shows the financing supplied by the owners. (The two ways in which the owners of a business corporation provide it with funds—paid-in capital and retained earnings—will be explained later in the chapter.)

Thus, with the sources and uses of funds view, the fundamental accounting equation, Assets � Liabilities � Owners’ equity, has this interpretation: Every dollar invested in the entity’s assets was supplied either by the entity’s creditors or by its owners; and every dollar thus supplied is invested in some asset.

Both ways of interpreting the balance sheet are correct. In certain circumstances, the resources and claims view is easier to understand. In analyzing the balance sheet of a going concern, however, the sources and uses of funds view usually provides a more meaningful interpretation.

Although each individual asset or equity—each building, piece of equipment, bank loan, and so on—could conceivably be listed separately on the balance sheet, it is more practicable and more informative to summarize and group related items into classifi- cations or account categories. There is no fixed pattern as to the number of such categories or the amount of detail reported. Rather, the format is governed by manage- ment’s opinion about the most useful way of presenting significant information on the status of the entity.

As in any classification scheme, the categories are defined so that (1) the individual items included in a category resemble one another in significant respects and (2) the items in one category are essentially different from those in all other categories. Al- though the items included in a category are similar to one another, they are not identical.

The category labeled cash usually includes money on deposit in interest-paying accounts as well as money on deposit in checking accounts. These two types of money are similar in that they are both in highly liquid form, but they are not identical because certain restrictions may apply to withdrawals from interest-paying accounts that do not apply to checking accounts.

The balance sheet in Illustration 2–1 gives a minimum amount of detail. The terms used on this balance sheet are common ones, and they are described briefly below. More detailed descriptions are given in Chapters 5 through 9.

Note that the amounts in Illustration 2–1 are rounded to the nearest dollar. Cents are rarely shown; and in a large company, the amounts are usually rounded to thousands or

Account Categories

Example

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even millions of dollars. Although rounding is done in preparing financial statements, the underlying detailed records are maintained to the cent.

We shall now supersede the short definition of assets given in the preceding section by the following more exact statement: Assets are economic resources that are controlled by an entity and whose cost (or fair value) at the time of acquisition could be objec- tively measured. The four key points in this definition are (1) an asset must be acquired in a transaction, (2) an asset must be an economic resource, (3) the resource must be controlled by the entity, and (4) its cost (or fair value) at the time of acquisition must be objectively measurable.

A resource is an economic resource if it provides future benefits to the entity. Re- sources provide future benefits under any of three conditions: (1) They are cash or can be converted to cash, (2) they are goods that are expected to be sold and cash received for them, or (3) they are items expected to be used in future activities that will gener- ate cash inflows to the entity. Thus, economic resources are either cash or items that will eventually result in cash inflows.

Garsden Corporation is a manufacturing company. The cash that it has on deposit in banks is an asset because it is money that can be used to acquire other resources. Amounts owed by customers are assets that when collected will generate cash. The goods Garsden has manufactured and still has on hand are assets because they are expected to be sold. The equipment and other manufacturing facilities it owns are assets because it is expected that they will be used to produce additional goods. However, merchandise that cannot be sold because it is damaged or obsolete is not an asset, even though it is owned by the business, because it will not generate cash.

Control is an accounting concept similar to, but not quite the same as, the legal con- cept of ownership. When a business buys an automobile on an installment loan (e.g., it pays $575 a month for 36 months), the business may not own the car in the legal sense because title to the car does not pass to the buyer until the last installment has been paid. Nevertheless, if the business has the full use of the car, the automobile is regarded as being fully controlled by the business and is an asset. Possession or temporary con- trol is not enough to qualify the item as an asset, however.

Office space leased on an annual basis is not an asset, nor is an automobile or other piece of equipment that is leased for a relatively short time. In both cases, the entity’s control over the use of the item is only temporary. On the other hand, if a business leases a build- ing or an item of equipment for a period of time that equals or almost equals its useful life, such an item is an asset even though the entity does not own it.

The objective measurability test is usually clear-cut, but in some instances it is dif- ficult to apply. If the resource was purchased for cash or for the promise to pay cash, it is an asset. If the resource was manufactured or constructed by the business, then money was paid for the costs of manufacture or construction, and it is an asset. If the resource was acquired by trading in some other asset or by issuing shares of the com- pany’s stock, it is an asset. If the resource was donated and it has future benefit, then the resource is an asset. On the other hand, as already pointed out, a valuable reputa- tion is not an asset if it arose gradually over a period of time rather than being acquired in a transaction at an objectively measurable cost.

On most business balance sheets, assets are listed in decreasing order of their liquidity, that is, in order of the promptness with which they are expected to be converted into cash.6

36 Part 1 Financial Accounting

Assets

Example

Example

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 37

Assets are customarily grouped into categories. Current assets are almost always re- ported in a separate category. All noncurrent assets may be reported together or in var- ious groupings such as “property, plant, and equipment” and “other assets,” as shown on the Garsden Corporation balance sheet.

Current Assets Cash and other assets that are expected to be realized in cash or sold or consumed dur- ing the normal operating cycle of the entity or within one year, whichever is longer, are called current assets. Although the usual time limit is one year, exceptions occur in companies whose normal operating cycle is longer than one year. Tobacco companies and distilleries, for example, include their inventories as current assets even though to- bacco and liquor remain in inventory for an aging process that lasts two years or more.

Cash consists of funds that are readily available for disbursement. Most of these funds are on deposit in interest-paying accounts and checking accounts in banks, and the remainder are in cash registers or petty cash boxes on the entity’s premises.

Marketable securities are investments that are both readily marketable and ex- pected to be converted into cash within a year. These investments are made in order to earn some return on cash that otherwise would be temporarily idle.

Accounts receivable are amounts owed to the entity by its customers. Accounts re- ceivable are reported on the balance sheet as the amount owed less an allowance for that portion that probably will not be collected. (Methods of estimating this “allowance for doubtful accounts” are described in Chapter 5.) Amounts owed the entity by parties other than customers would appear under the heading notes receivable or other re- ceivables rather than as accounts receivable. If the amounts owed to the company are evidenced by written promises to pay, they are listed as notes receivable.

Inventories are the aggregate of those items that are either (1) held for sale in the or- dinary course of business, (2) in process of production for such sale, or (3) soon to be consumed in the production of goods or services that will be available for sale. Note that inventory relates to goods that will be sold in the ordinary course of business. A truck offered for sale by a truck dealer is inventory. A truck used by the dealer to make ser- vice calls is not inventory; it is an item of equipment, which is a noncurrent asset.

Prepaid expenses represent certain assets, usually of an intangible nature, whose usefulness will expire in the near future. An example is an insurance policy. A business pays for insurance protection in advance. Its right to this protection is an asset—an economic resource that will provide future benefits. Since this right will expire within a fairly short period of time, it is a current asset. The amount on the balance sheet is the amount of the unexpired cost of the future benefit.

If on January 1, 2010, Garsden Corporation paid $250,000 for insurance protection for two years, the amount of prepaid insurance expense on the December 31, 2010, balance sheet would be $125,000, which is the cost of the one year of protection then remaining.

Property, Plant, and Equipment This category consists of assets that are tangible and relatively long-lived. The term fixed assets is also used for this category. The entity has acquired these assets in order to use them to produce goods and services that will generate future cash inflows. If such assets are instead held for resale, they are classified as inventory, even though in a sense they are long-lived assets. (They will be long-lived to their purchaser, but they are not expected to be held long term by their seller.)

6 Outside the United States, on some balance sheets, the order is reversed and the least liquid assets are listed first.

Example

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In the balance sheet shown in Illustration 2–1, the first item of property, plant, and equipment is land, which is reported at its cost, $642,367. Land is shown separately be- cause it is not depreciated, as are buildings and equipment. The first amount shown for buildings and equipment, $26,303,481, is the original cost of all the items of tangible long-lived property other than land—the amounts paid to acquire these items. The next item, accumulated depreciation, means that a portion of the original cost of the build- ings and equipment, amounting to $13,534,069, has been written off, allocated as a cost of doing business. Depreciation will be discussed in detail in Chapter 7.

Other Assets Another type of noncurrent asset is investments. These are securities of one company owned by another either in order to control the other company or in anticipation of earning a long-term return from the investment. They are therefore to be distinguished from mar- ketable securities, which are a current asset reflecting the short-term use of excess cash.

Intangible assets include goodwill (briefly described earlier), patents, copyrights, trademarks, franchises, and similar valuable but nonphysical things controlled by the business. They are distinguished from prepaid expenses (intangible current assets) in that they have a longer life span than prepaid expenses.

In general, liabilities are obligations to transfer assets or provide services to outside parties arising from events that have already happened. (A few complicated items that may appear in the liabilities section of the balance sheet do not fit this definition; they will be discussed in later chapters.) Liability obligations exist as a result of past trans- actions or events. Thus, on December 31, wages not yet paid to an employee who worked from December 27 to December 31 are a liability; but that person’s wages to be earned next week (the first week in January) are not a liability as of December 31.7

Liabilities are claims against the entity’s assets. Unless otherwise noted, an indi- vidual liability is not a claim against any specific asset or group of assets. Thus, although accounts payable typically arise from the purchase of items for inventory, ac- counts payable are claims against the assets in general and not specifically against in- ventories. If a liability is a claim against a specific asset, its title indicates that fact, as in a mortgage loan or secured long-term debt.

With minor exceptions, a liability is reported at the amount that would be required to satisfy the obligation as of the balance sheet date.8 For a loan, this includes the principal that is owed as well as any interest earned by the lender but unpaid as of the balance sheet date. (Often this interest payable or “accrued” interest is shown sepa- rately from the principal owed.) Thus, if the December 31 balance sheet showed $100,000 for a loan payable and $1,000 interest payable on that loan, a $101,000 pay- ment to the lender would be required to satisfy the loan liability obligation as of December 31. Note that the total amount needed to satisfy the obligation is reported, not just the portion of that total that is due and payable as of the balance sheet date. The $100,000 loan is a liability even though there may be no principal payment due for another five years.

Current Liabilities Liabilities that are expected to be satisfied or extinguished during the normal operating cycle or within one year, whichever is longer, are called current liabilities.

38 Part 1 Financial Accounting

7 Although, in a sense, employees are not outside parties, in accounting they are considered such to the extent that they are not owners of the entity. Only owners of the entity are inside parties. 8 We shall describe an alternative interpretation of the amount of a liability in Chapter 8.

Liabilities

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 39

Accounts payable represent the claims of suppliers arising from their furnishing goods or services to the entity for which they have not yet been paid. (Such suppliers often are called vendors.) Usually these claims are unsecured. Amounts owed to fi- nancial institutions (which are suppliers of funds rather than of goods or services) are called notes payable or short-term loans (or some other name that describes the na- ture of the debt instrument) rather than accounts payable.

Taxes payable shows the amount that the entity owes government agencies for taxes. It is shown separately from other obligations both because of its size and because the amount owed may not be precisely known as of the date of the balance sheet. Often the liability for federal and state income taxes is shown separately from other tax lia- bilities, such as property taxes.

Accrued expenses represent amounts that have been earned by outside parties but have not yet been paid by the entity. Usually there is no invoice or similar document submitted by the party to whom the money is owed. Interest earned by a lender but not yet paid by the entity is an accrued expense. Another example is the wages and salaries owed to employees for work they have performed but for which they have not yet been paid. The term accrued expenses, although frequently used as a balance sheet category, is not as descriptive as the names used in the detailed records for specific accrued ex- penses, such as interest payable and wages payable.

Deferred revenues (also called unearned revenues) represent the liability that arises because the entity has received advance payment for a service it has agreed to render in the future. An example is unearned subscription revenues, which represent magazine subscription payments received in advance, for which the publishing com- pany agrees to deliver issues of its magazine during some future period.

Current portion of long-term debt represents that part of a long-term loan that is due within the next 12 months. It is reported separately from the noncurrent portion so that current liabilities will give a complete picture of the entity’s short-term obligations.

Other Liabilities Those obligations that do not meet the criteria for being classified as current liabilities are simply called other liabilities. They are also sometimes called noncurrent liabil- ities or long-term debt.

Garsden Corporation has a $3,300,000 loan outstanding. Of this amount, $300,000 is due within the next year and is therefore a current liability. The remaining $3 million is due in some future period (or periods) beyond the next year (i.e., after December 31, 2010) and is thus shown as long-term debt.

The owners’ equity section of the balance sheet shows the amount the owners have in- vested in the entity. The terminology used in this section varies with different forms of organization. In a corporation, the ownership interest is evidenced by shares of stock, and the owners’ equity section of its balance sheet is therefore usually labeled share- holders’ equity or stockholders’ equity.

Paid-In Capital The shareholders’ equity of the Garsden Corporation’s balance sheet is divided into two main categories.9 The first category, called paid-in capital or contributed capital, is the amount the owners have invested directly in the business by purchasing shares of stock as these shares were issued by the corporation. Paid-in capital in most

9 A third section, called other comprehensive income, may be included in the owners’ equity section of some balance sheets. It is discussed in Chapter 10.

Owners’ Equity

Example

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corporations is further subdivided into capital stock and additional paid-in capital. Each share of stock has a stated or “par” value; capital stock shows this value per share times the number of shares outstanding.10 If investors actually paid more to the corpo- ration than the stated value (as is almost always the case) for their shares, the excess is shown separately as additional paid-in capital.

Garsden Corporation has outstanding 1 million shares of common stock with a par value of $1 per share. Investors actually paid into the corporation $5 million for these shares. The balance sheet in Illustration 2–1 could be modified to show:

Paid-in capital:

Common stock at par $1,000,000

Additional paid-in capital 4,000,000

Total paid-in capital $5,000,000

Retained Earnings The second category of shareholders’ equity is labeled retained earnings. The owners’ equity increases through earnings (i.e., the results of profitable operations) and de- creases when earnings are paid out in the form of dividends. Retained earnings is the difference between the total earnings of the entity from its inception to date and the total amount of dividends paid out to its shareholders over its entire life. That is, the difference represents that part of the total earnings that have been retained for use in— reinvested in—the business.11 If the difference is negative, the item usually is labeled deficit rather than retained earnings.

Note that the amount of retained earnings on a given date is the cumulative amount that has been retained in the business from the beginning of the corporation’s existence up to that date. The amount shown for Garsden Corporation means that since the com- pany began operations, the total amount of its earnings reinvested in the business after paying out dividends is $19,116,976.

Note also that the amount of retained earnings does not indicate the form in which the retained earnings have been reinvested. They may be invested in any of the re- sources that appear on the assets side of the balance sheet. (This is true of all liabilities and items of owners’ equity, not just retained earnings.) There is a common miscon- ception that there is some connection between the amount of a company’s retained earnings and the amount of cash it holds. There is no such connection. This should be apparent from the fact that the Garsden Corporation balance sheet shows over $19 mil- lion of retained earnings but only $3.4 million of cash.

Net worth is a synonym for the term owners’ equity that is frequently used in articles and conversation. Net worth can be a misleading term because it implies that the amount indicates what the owners’ interest is “worth,” which, as has been emphasized, is erroneous. For this reason, the use of the term net worth in financial statements is frowned upon.

40 Part 1 Financial Accounting

10 Par value is a dollar amount printed on the face of common stock certificates. It seldom has any significance today. A stockholder who paid less to the issuing company than the par value of the common stock received could be held liable in bankruptcy for the difference between the stock’s par value and the amount paid for it. To guard against this possibility, the par value is set at a nominal amount and the selling price is higher than the par value. 11 Shareholders’ equity also can be affected by events other than the issuance of common stock and the accumulation of earnings and the distribution of these earnings as dividends. Some of these events will be discussed in later chapters.

Example

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 41

Owners’ equity is also sometimes called net assets, since the amount shown for owners’ equity is always equal to assets net of (i.e., minus) liabilities. Similarly, the Financial Accounting Standards Board defines owners’ equity simply as “the residual interest in the assets of an entity that remains after deducting its liabilities.”12 The use of the word residual reflects the fact that in law, owners’ claims rank below creditors’ claims. For the same reason, common stock is sometimes referred to as a “residual security.”

Unincorporated Businesses In unincorporated businesses, different terminology is used in the owners’ equity sec- tion. In a proprietorship—a business owned by one person—the owner’s equity is customarily shown as a single number with a title such as “Lee Jones, capital,” rather than making a distinction between the owner’s initial investment and the accumulated earnings retained in the business.

In a partnership, which is an unincorporated business owned jointly by several per- sons, there is a capital account for each partner. For example:

Jane Davis, capital $75,432

Wayne Smith, capital 75,432

Total partners’ capital $150,864

A proprietorship or partnership balance sheet also may show a reconciliation of the beginning and ending balance in each owner’s capital account. An owner’s capital is in- creased by her or his share of the entity’s earnings during the period and is decreased by the owner’s drawings. (Drawings in an unincorporated firm are analogous to a cor- poration’s dividends.) For example, a proprietorship’s 2010 year-end balance sheet might show the following:

Lee Jones, capital, as of January 1, 2010 $180,000

Add: 2010 earnings 45,000

Deduct: 2010 drawings (40,000)

Lee Jones, capital, as of December 31, 2010 $185,000

The reader may have heard the terms partnership accounting and corporation accounting and thus may have formed the impression that different accounting sys- tems are used for different forms of business organizations. This is not so. The treat- ment of assets and liabilities is generally the same in all forms of business organi- zations: Differences occur principally in the owners’ equity (capital) section, as noted above.13

Having explained the two principal components of owners’ equity in a corporation, we can now expand the fundamental accounting equation to read

Assets � Liabilities � Paid-in capital � Retained earnings

12 FASB, Statement of Financial Accounting Concepts No. 6. 13 Nonbusiness organizations do treat certain items differently than businesses, but these differences are beyond the scope of this book.

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Ratios

In using financial statement information, it often is helpful to express certain impor- tant relationships as ratios or percentages. Some of these ratios will be introduced at appropriate places throughout the book and they will be summarized in Chapter 13. A ratio is simply one number expressed in terms of another. It is found by dividing one number, the base, into the other. Since Garsden Corporation (Illustration 2–1) had cur- rent assets of $22,651,072 and current liabilities of $9,119,089, the ratio of its current assets to its current liabilities is $22,651,072 � $9,119,089, or 2.5 to 1.

The ratio of current assets to current liabilities is called the current ratio. It is an im- portant indication of an entity’s ability to meet its current obligations because if current assets do not exceed current liabilities by a comfortable margin, the entity may be un- able to pay its current bills. This is because most current assets are expected to be con- verted into cash within a year or less, whereas most current liabilities are obligations expected to use cash within a year or less. As a rough rule of thumb, a current ratio of at least 2 to 1 is believed to be desirable in a typical manufacturing company. Garsden’s current ratio of 2.5 to 1 is therefore satisfactory. (The “to 1” part of the ratio is usually not explicitly stated; Garsden’s current ratio is simply 2.5.)

Balance Sheet Changes

At the moment an entity begins, its financial status can be recorded on a balance sheet. From that time on, events occur that change the numbers on this first balance sheet, and the accountant records these transactions in accordance with the concepts given earlier in this chapter. Accounting systems accumulate and summarize these changes as a basis for preparing new balance sheets at prescribed intervals, such as the end of a quarter or a year. Each balance sheet shows the financial condition of the entity as of the date it was prepared, after giving effect to all of these changes.

Although in practice a balance sheet is prepared only at prescribed intervals, in learning the accounting process it is useful to consider the changes one by one. This makes it pos- sible to study the effect of individual events without getting entangled with the mecha- nisms used to record these transactions. The following examples show the effects of a few transactions on the balance sheet. For simplicity, they are assumed to occur on successive days.

Jan. 1 John Smith starts an incorporated CD and tape store called Music Mart, Inc. He does this by depositing $25,000 of his own funds in a bank account that he has opened in the name of the business entity and taking $25,000 of stock certificates in return. He is the sole owner of the corporation. The balance sheet of Music Mart, Inc., will then be as follows:

MUSIC MART Balance Sheet As of January 1

Assets Liabilities and Owner’s Equity

Cash $25,000 Paid-in capital $25,000_______ ______________ _______

42 Part 1 Financial Accounting

Original Capital Contribution

Current Ratio

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 43

Jan. 2 Music Mart borrows $12,500 from a bank; the loan is evidenced by a legal document called a note. This transaction increases the asset, cash, and the business incurs a liability to the bank called notes payable. The balance sheet after this transaction will appear thus:

MUSIC MART Balance Sheet As of January 2

Assets Liabilities and Owner’s Equity

Cash $37,500 Notes payable $12,500

Paid-in capital 25,000_______ _______ Total $37,500 Total $37,500_______ ______________ _______

Jan. 3 The business buys inventory (merchandise it intends to sell) in the amount of $5,000, paying cash. This transaction decreases cash and increases another asset, inventory. The balance sheet will now be as follows:

MUSIC MART Balance Sheet As of January 3

Assets Liabilities and Owner’s Equity

Cash $32,500 Notes payable $12,500

Inventory 5,000 Paid-in capital 25,000_______ _______ Total $37,500 Total $37,500_______ ______________ _______

Jan. 4 For $750 cash, the store sells merchandise that costs $500. The effect of this transaction is to decrease inventory by $500, increase cash by $750, and in- crease owner’s equity by the difference, or $250. The $250 is the profit on this sale. To distinguish it from the paid-in capital portion of owner’s equity, it is recorded as retained earnings. The balance sheet will then look like this:

MUSIC MART Balance Sheet As of January 4

Assets Liabilities and Owner’s Equity

Cash $33,250 Notes payable $12,500

Inventory 4,500 Paid-in capital 25,000

Retained earnings 250_______ _______ Total $37,750 Total $37,750_______ ______________ _______

Bank Loan

Purchase of Merchandise

Sale of Merchandise

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44 Part 1 Financial Accounting

The basic concepts discussed in this chapter may be briefly summarized as follows:

1. Money measurement. Accounting records only those facts that can be expressed in mon- etary terms.

2. Entity. Accounts are kept for entities as distinguished from the persons associated with those entities.

3. Going concern. Accounting assumes that an entity will continue to exist indefinitely and that it is not about to be liquidated.

4. Cost. Nonmonetary and monetary assets are ordinarily entered in the accounts at the amount paid to acquire them. This cost, rather than current fair value, is the basis for subsequent accounting for nonmonetary assets. Most monetary assets are accounted for at fair value following their acquisition.

5. Dual aspect. Every transaction affects at least two items and preserves the fundamental equation: Assets � Liabilities � Owners’ equity.

The balance sheet shows the financial condition of an entity as of a specified moment in time. It consists of two sides. The assets side shows the economic resources controlled by the entity that are expected to provide future benefits to it and that were acquired at ob- jectively measurable amounts. The equities side shows the liabilities, which are obligations of the entity, and the owners’ equity, which is the amount invested by the owners. In a cor- poration, owners’ equity is subdivided into paid-in capital and retained earnings.

Summary

Concluding Comment

At this point, readers should not be alarmed if they do not yet fully understand some of the topics in this chapter. In subsequent chapters, we shall expand considerably on the concepts, categories, and terms introduced here. We shall describe modifications and qualifications to some of the basic concepts, and we shall introduce many addi- tional terms that are used on balance sheets. We shall not, however, discard the basic structure that was introduced in this chapter; it was based on the equation Assets � Liabilities � Owners’ equity. Furthermore, it is important to remember that every ac- counting transaction can be recorded in terms of its effect on the balance sheet. The reader should be able to relate all the new material to this basic structure.

Problems Problem 2–1.

a. If assets equal $95,000 and liabilities equal $40,000, then owners’ equity equals _____.

b. If assets equal $65,000 and owners’ equity equals $40,000, then liabilities equal _____.

c. If current assets equal $25,000, liabilities equal $40,000, and owners’ equity equals $55,000, the noncurrent assets equal _____.

d. If the current ratio is 2.2:1, current assets are $33,000, and noncurrent assets equal $55,000, then owners’ equity is _____. (Assume that all liabilities are current.)

e. What is the current ratio if noncurrent assets equal $60,000, total assets equal $95,000, and owners’ equity equals $70,000? (Assume that all liabilities are current.)

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 45

Problem 2–2. Prepare a balance sheet as of June 30, for the J. L. Gregory Company, using the following data:

Accounts payable $ 241,000 Cash $ 89,000 Accounts receivable 505,000 Equipment (at cost) 761,000 Accrued expenses 107,000 Estimated tax liability 125,000 Accumulated depreciation Inventories 513,000

on buildings 538,000 Investment in the Peerless Accumulated depreciation Company 320,000

on equipment 386,000 Land (at cost) 230,000 Bonds payable 700,000 Marketable securities 379,000 Buildings (at cost) 1,120,000 Notes payable 200,000 Capital stock 1,000,000 Retained earnings ?

Problem 2–3. Indicate the net effect on assets, liabilities, and owners’ equity resulting from each of the following transactions:

1. Capital stock was issued for $100,000 cash. 2. Bonds payable of $25,000 were refunded with capital stock. 3. Depreciation on plant and equipment equaled $8,500 for the year. 4. Inventory was purchased for $15,900 cash. 5. $9,400 worth of inventory was purchased on credit. 6. Inventory costing $4,500 was sold for $7,200 on credit. 7. $3,500 in cash was received for merchandise sold on credit. 8. Dividends of $3,000 were declared. 9. The declared dividends of $3,000 were paid.

10. The company declared a stock split, and replaced each outstanding share with two new shares.

Problem 2–4. D. Carson and F. Leggatt formed a partnership on June 1 to operate a shoe store. Carson contributed $50,000 cash and Leggatt contributed $50,000 worth of shoe inventory. During the month of June, the following transactions took place:

1. Additional shoe inventory was purchased at a cost of $24,000 cash. 2. Total cash sales for the month were $31,000. The inventory that was sold had a cost of

$15,500. 3. Carson withdrew $6,200 of cash drawings. Leggatt withdrew only $3,700 of cash

drawings. 4. The partnership borrowed $50,000 from the Third National Bank. 5. Land and a building were purchased at a cash cost of $25,000 and $50,000,

respectively.

Required: a. Prepare a balance sheet as of June 1.

b. Prepare a reconciliation of the beginning and ending balances for each owner’s cap- ital account.

c. Prepare a balance sheet as of June 30.

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46 Part 1 Financial Accounting

Problem 2–5. The January 1 balance sheet of the Marvin Company, an unincorporated business, is as follows:

MARVIN COMPANY Balance Sheet As of January 1

Assets Liabilities and Owners’ Equity

Cash $25,000 Notes payable $20,000

Inventory 50,000 Capital 55,000_______ _______ Total $75,000 Total $75,000_______ ______________ _______

The following transactions took place in January:

Jan. 4 Merchandise was sold for $12,000 cash that had cost $7,000. 6 To increase inventory, Marvin placed an order with Star Company for mer-

chandise that would cost $7,000. 8 Marvin received the merchandise ordered from Star and agreed to pay the

$7,000 in 30 days. 11 Merchandise costing $1,500 was sold for $2,500 in cash. 16 Merchandise costing $2,000 was sold for $3,400 on 30-day open

account. 26 Marvin paid employees for the month $4,200 in cash. 29 Purchased land for $20,000 in cash. 31 Marvin purchased a two-year insurance policy for $2,800 in cash.

Required:

Describe the impact of each transaction on the balance sheet, and prepare a new balance sheet as of January 31.

Problem 2–6. As of December 31, Brian Company had the following account balances:

Accounts payable $5,000 Long-term investments $1,500 Accounts receivable 7,000 Marketable securities 3,500 Bonds payable 8,000 Plant and equipment 8,500 Cash 2,000 Wages payable 1,500 Current portion of

bonds payable 2,000

Required: a. What was the current ratio?

b. Explain what the current ratio measures.

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 47

Diane Maynard made the following request of a friend:

My bookkeeper has quit, and I need to see the balance sheets of my company. He has left behind a book with the numbers already entered in it. Would you be will- ing to prepare balance sheets for me? Also, any com- ments you care to make about the numbers would be appreciated. The Cash account is healthy, which is a good sign, and he has told me that the net income in June was $19,635.

The book contained a detailed record of transac- tions, and from it the friend was able to copy off the balances at the beginning of the month and at the end of the month as shown in Exhibit 1. Diane Maynard

owned all the stock of Maynard Company. At the end of June, Diane Maynard paid herself an $11,700 divi- dend and used the money to repay her loan from the company.

Questions

1. Prepare balance sheets as of June 1 and as of June 30, in proper format.

2. Make comments about how the financial condition as of the end of June compared with that at the be- ginning of June.

3. Why do retained earnings not increase by the amount of June net income?

4. As of June 30, do you feel that Maynard Company is worth the amount in Shareholder’s Equity, $619,446? Explain.

Cases

Case 2–1

Maynard Company (A)*

* © Professor Robert N. Anthony.

June 1 June 30

Accounts payable $ 8,517 $ 21,315 Accounts receivable 21,798 26,505 Accrued wages payable 1,974 2,202 Accumulated depreciation on building 156,000 157,950 Accumulated depreciation on equipment 5,304 5,928 Bank notes payable 8,385 29,250 Building 585,000 585,000 Capital stock 390,000 390,000 Cash 34,983 66,660 Equipment (at cost) 13,260 36,660 Land 89,700 89,700 Merchandise inventory 29,835 26,520 Note receivable, Diane Maynard 11,700 0 Other noncurrent assets 4,857 5,265 Other noncurrent liabilities 2,451 2,451 Prepaid insurance 3,150 2,826 Retained earnings 221,511 229,446 Supplies on hand 5,559 6,630 Taxes payable 5,700 7,224

EXHIBIT 1 Account Balances

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48 Part 1 Financial Accounting

Case 2–2

Music Mart, Inc.* On a sheet of paper, set up in pencil the balance sheet of Music Mart, Inc., as it appears after the last transac- tion described in the text (January 4), leaving consid- erable space between each item. Record the effect, if any, of the following events on the balance sheet, ei- ther by revising existing figures (cross out, rather than erase) or by adding new items as necessary. At least one of these events does not affect the balance sheet. The basic equation, Assets � Liabilities � Owners’ equity, must be preserved at all times. Errors will be minimized if you make a separate list of the balance sheet items affected by each transaction and the amount (� or �) by which each is to be changed.

After you have recorded these events, prepare a bal- ance sheet in proper form. Assume that all these trans- actions occurred in January and that there were no other transactions in January.

1. The store purchased and received merchandise for inventory for $5,000, agreeing to pay within 30 days.

2. Merchandise costing $1,500 was sold for $2,300, which was received in cash.

3. Merchandise costing $1,700 was sold for $2,620, the customers agreeing to pay $2,620 within 30 days.

4. The store purchased a three-year fire insurance policy for $1,224, paying cash.

5. The store purchased two lots of land of equal size for a total of $24,000. It paid $6,000 in cash and gave a 10-year mortgage for $18,000.

6. The store sold one of the two lots of land for $12,000. It received $3,000 cash, and in addition, the buyer assumed $9,000 of the mortgage; that is, Music Mart, Inc., became no longer responsible for this half.

7. Smith received a bona fide offer of $33,000 for the business; although his equity was then only $26,970, he rejected the offer. It was evident that the store had already acquired goodwill of $6,030.

8. Smith withdrew $1,000 cash from the store’s bank account for his personal use.

9. Smith took merchandise costing $750 from the store’s inventory for his personal use.

10. Smith learned that the individual who purchased the land (No. 6 above) subsequently sold it for $14,000. The lot still owned by Music Mart, Inc., was identical in value with this other plot.

11. The store paid off $6,000 of its note payable (dis- regard interest).

12. Smith sold one-third of the stock he owned in Music Mart, Inc., for $11,000 cash.

13. Merchandise costing $850 was sold for $1,310, which was received in cash.* © Professor Robert N. Anthony.

Case 2–3

Lone Pine Cafe (A)* On March 31, 2010, the partnership that had been or- ganized to operate the Lone Pine Cafe was dissolved under unusual circumstances, and in connection with

its dissolution, preparation of a balance sheet became necessary.

The partnership was formed by Mr. and Mrs. Henry Antoine and Mrs. Sandra Landers, who had become acquainted while working in a Portland, Oregon, restaurant. On November 1, 2009, each of the three partners contributed $16,000 cash to the partnership and agreed to share in the profits proportionally to

* Based on a case decided by the Supreme Court of the State of Oregon (216 P.2d 1005). © Professor Robert N. Anthony, Harvard Business School.

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Chapter 2 Basic Accounting Concepts: The Balance Sheet 49

their contributed capital (i.e., one-third each). The Antoines’ contribution represented practically all of their savings. Mrs. Landers’ payment was the proceeds of her late husband’s insurance policy.

On that day also the partnership signed a one-year lease to the Lone Pine Cafe, located in a nearby recre- ational area. The monthly rent on the cafe was $1,500. This facility attracted the partners in part because there were living accommodations on the floor above the restaurant. One room was occupied by the Antoines and another by Mrs. Landers.

The partners borrowed $21,000 from a local bank and used this plus $35,000 of partnership funds to buy out the previous operator of the cafe. Of this amount, $53,200 was for equipment and $2,800 was for the food and beverages then on hand. The partnership paid $1,428 for local operating licenses, good for one year beginning November 1, and paid $1,400 for a new cash register. The remainder of the $69,000 was de- posited in a checking account.

Shortly after November 1, the partners opened the restaurant. Mr. Antoine was the cook, and Mrs. Antoine and Mrs. Landers waited on customers. Mrs. Antoine also ordered the food, beverages, and supplies, operated the cash register, and was responsible for the checking account.

The restaurant operated throughout the winter sea- son of 2009–2010. It was not very successful. On the morning of March 31, 2010, Mrs. Antoine discovered that Mr. Antoine and Mrs. Landers had disappeared. Mrs. Landers had taken all her possessions, but Mr. Antoine had left behind most of his clothing, presum- ably because he could not remove it without warning Mrs. Antoine. The new cash register and its contents were also missing. No other partnership assets were missing. Mrs. Antoine concluded that the partnership was dissolved. (The court subsequently affirmed that the partnership was dissolved as of March 30.)

Mrs. Antoine decided to continue operating the Lone Pine Cafe. She realized that an accounting would have to be made as of March 30 and called in Donald Simpson, an acquaintance who was knowledgeable about accounting.

In response to Mr. Simpson’s questions, Mrs. Antoine said that the cash register had contained $311 and that the checking account balance was $1,030. Ski instruc- tors who were permitted to charge their meals had run up accounts totaling $870. (These accounts subse- quently were paid in full.) The Lone Pine Cafe owed suppliers amounts totaling $1,583. Mr. Simpson esti- mated that depreciation on the assets amounted to $2,445. Food and beverages on hand were estimated to be worth $2,430. During the period of its operation, the partners drew salaries at agreed-upon amounts, and these payments were up to date. The clothing that Mr. Antoine left behind was estimated to be worth $750. The partnership had also repaid $2,100 of the bank loan.

Mr. Simpson explained that in order to account for the partners’ equity, he would prepare a balance sheet. He would list the items that the partnership owned as of March 30, subtract the amounts that it owed to out- side parties, and the balance would be the equity of the three partners. Each partner would be entitled to one- third of this amount.

Questions

1. Prepare a balance sheet for the Lone Pine Cafe as of November 2, 2009.

2. Prepare a balance sheet as of March 30, 2010.

3. Disregarding the marital complications, do you suppose that the partners would have been able to receive their proportional share of the equity deter- mined in Question 2 if the partnership was dis- solved on March 30, 2010? Why?

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3 Basic Accounting Concepts: The Income Statement

Chapter

Chapter 1 introduced the idea of income. This chapter goes deeper into the measure- ment of income as used in financial accounting and describes the income statement, the financial statement that reports income and its determinants.

In the course of this discussion, we shall explain the last 6 of the 11 basic concepts listed in Chapter 2:

6. Accounting period 7. Conservatism 8. Realization 9. Matching

10. Consistency 11. Materiality

As was the case in Chapter 2, the discussion of topics in this chapter is introductory. Each will be explained in more depth in later chapters.

The Nature of Income

Chapter 2 described the balance sheet, which reports the financial condition of an en- tity as of one moment in time. Chapter 3 describes a second financial statement, the in- come statement, which summarizes the results of operations for a period of time. It is therefore a flow report, as contrasted with the balance sheet, which is a status report. These two financial statements illustrate the only two ways in which any entity— whether it be a business, a human body, or the universe—can be described: (1) in terms of flows through time and (2) in terms of its status or state as of one moment in time.

Flows in a business are continuous. Their essential nature, in many businesses, is in- dicated by the simplified diagram in Illustration 3–1. The business has a pool of cash

Chapter

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Chapter 3 Basic Accounting Concepts: The Income Statement 51

that it has obtained from investors or from past profitable operations. It uses this cash to acquire inventories, either by purchasing goods from others or by producing them it- self. It also incurs other costs. (Accounts payable and various other assets and liability accounts may intervene between the incurrence of these costs and the cash outflow to pay for them.) It sells the goods to customers. The customers either pay cash or agree to pay later, thus creating accounts receivable. When the customer pays, the pool of cash is replenished.

For most types of businesses, the income statement focuses on the section of the flow diagram that is labeled earnings activities—also commonly called the business’s operating activities or simply its operations. The income statement reports the nature and magnitude of these activities for a specified period of time.

Essentially, this report consists of two elements. One reports the inflows (creation) of assets—cash or accounts receivable—that result from the sale of goods and services to customers; these amounts are called revenues. The other reports the outflows (consump- tion) of resources that were required in order to generate these revenues; these amounts are called expenses. Profit (more formally, income) is the amount by which revenues ex- ceed expenses. Since the word income is often used with various qualifying adjectives, the term net income is used to refer to the net excess of all the revenues over all the expenses. Some companies use the term net earnings rather than net income. If total expenses exceed total revenues, the difference is a net loss.

Basic Concepts

Net income for the entire life of an organization is relatively easy to measure. It is simply the difference between the money that comes in and the money that goes out (excluding, of course, money invested by the owners or paid to the owners).

Michael and Judith Lincoln operated a children’s camp for one summer, renting all the nec- essary facilities and equipment. Before the camp opened, they invested $24,000 for food, the initial rental payment, and certain other costs. The camp received $122,400 in fees from parents. At the end of the summer, after all affairs were wound up, the Lincolns had their original $24,000 investment back and $15,237 additional. This $15,237 was the net in- come of the camp business. It was the difference between the revenues they received from

Cash

Inventories Accounts receivable

Collection activities

Earnings activities

Purchasing or production activities

ILLUSTRATION 3–1 Basic Business Financial Flows

The Accounting Period Concept

Example

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52 Part 1 Financial Accounting

parents and the expenses incurred for food, wages, and other costs. The income statement for the business looked like this:

Revenues $122,400

Less expenses:

Food $42,756

Wages 46,935

Rental 12,000

Other costs 5,472

Total expenses 107,163

Net income $ 15,237

Relatively few business ventures have a life of only a few months, as was the case with the Lincolns’ summer camp. Most of them operate for many years. Indeed, in ac- cordance with the going-concern concept, it is usually assumed that the life of a busi- ness is indefinitely long. Management and other interested parties are unwilling to wait until the business has ended before obtaining information on how much income has been earned. They need to know at frequent intervals how things are going.

This need leads to the accounting period concept: Accounting measures activities for a specified interval of time, called the accounting period. For the purpose of report- ing to outsiders, one year is the usual accounting period.1 Most corporate bylaws require an annual report to the shareholders, and income tax reporting is also on an annual basis.

In the majority of businesses, the accounting year, or fiscal year, corresponds to the calendar year; but many businesses use the natural business year instead of the calen- dar year. For example, nearly all department stores end their fiscal year on January 31, which is after the holiday season rush and its repercussions in the form of returns, clearance sales and depleted inventories.

Interim Reports Management needs information more often than once a year. Income statements for management are therefore prepared more frequently. The most common period is a month, but the period may be as short as a week or even a day. The Securities and Exchange Commission (SEC) requires published quarterly income statements from companies over which it has jurisdiction. These reports are called interim reports to distinguish them from the annual reports.2

Businesses are living, ongoing organisms. The act of chopping the continuous stream of business events into time periods is therefore somewhat arbitrary, since busi- ness activities do not stop or change significantly as one accounting period ends and another begins. This fact makes the problem of measuring income for an accounting period the most difficult problem in accounting.

If the Lincolns operated a year-round hotel instead of a summer camp, their income for a year could not be measured simply as the difference between the money taken in and the money paid out. As of the end of the year, some of the guests would not have paid their bills. Yet these unpaid bills are an asset, accounts receivable, that surely increases the “well-offness” of

1 Pacioli, the first author of an accounting text, wrote in 1494: “Books should be closed each year, especially in a partnership, because frequent accounting makes for long friendship.” Luca Pacioli, Summa de Arithmetica Geometria Proportioni et Proportionalita, from the translation by John B. Geijsbeck. 2 Outside the United States, a common practice of companies listed on stock exchanges is to issue semiannual interim statements.

Example

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Chapter 3 Basic Accounting Concepts: The Income Statement 53

the business even though the cash has not yet been received. Conversely, some of the cash paid out may have been for the purchase of an asset, such as the hotel itself, that will bene- fit the business beyond the end of this accounting period. It would be incorrect to conclude that the hotel’s income has been decreased by the amount of such payments.

Relation between Income and Owners’ Equity As explained in Chapters 1 and 2, the net income of an accounting period increases own- ers’ equity. More specifically for a corporation, net income increases retained earnings. In order to understand the implication of this relationship, let us refer to the January 4 transaction of Music Mart, Inc. (page 43). On that day, merchandise costing $500 was sold for $750 cash. Looking first at the effect of this transaction on assets, we note that although inventory decreased by $500, cash increased by $750, so that the total assets in- creased by the difference, $250. From the dual-aspect concept, which states that the total of the assets must always equal the total of the liabilities and owners’ equity, we know that the liabilities and owner’s equity side of the Music Mart, Inc., balance sheet also must have increased by $250. Since no liabilities were affected, the increase must have occurred in owner’s equity. In summary, because assets were sold for more than was paid for them, the owner’s equity increased. Since owner’s equity is made up of paid-in capital and re- tained earnings and since the owner did not contribute more capital, the increase must have been in retained earnings. Such net increases in retained earnings are called income.

In understanding how this income came about, let us consider separately two as- pects of this event: the $750 received from the sale and the $500 decrease in inventory. If we look only at the $750, we see that it is an increase in cash and a corresponding increase in retained earnings. The $500, taken by itself, is a decrease in the asset, in- ventory, and a corresponding decrease in retained earnings. These two aspects illus- trate the only two ways in which earnings activities—that is, operations—can affect retained earnings: They can increase it or they can decrease it.

Revenues and Expenses It follows that revenues and expenses also can be defined in terms of their effect on retained earnings: A revenue is an increase in retained earnings resulting from the operations of the entity, and an expense is a decrease.3

Restating the transactions described above in these terms, there was revenue of $750, expense of $500, and income of $250. The basic equation is

Revenues � Expenses � Net income

This equation clearly indicates that income is a difference. Sometimes the word income is used improperly as a synonym for revenue. This is because the approved definitions as given above are of relatively recent origin and some individuals have not kept up with the latest developments. Also, some nonprofit entities such as churches refer to their “income and outgo” or “income and expenses” rather than to revenues and expenses.

On an income statement, no misunderstanding is caused by such an error because revenues, however labeled, appear at the top and net income at the bottom. But in other contexts confusion can be created. For example, if one reads that Company X had in- come of $1 million, a completely false impression of the size of the company is given if the intended meaning was that Company X had revenues of $1 million.

3 As pointed out in Chapter 2, unincorporated businesses ordinarily do not subdivide owners’ equity into paid-in capital and retained earnings. Nevertheless, conceptually the distinction between changes in owners’ equity related to paid-in capital and those related to retained earnings is both valid and useful in an unincorporated business.

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54 Part 1 Financial Accounting

Income Not the Same as Increase in Cash It is extremely important to understand that the income of a period is associated with changes in retained earnings and that it has no necessary relation to changes in cash dur- ing that period. Income connotes “well-offness”: Roughly speaking, the bigger the in- come is, the better off the owners are. An increase in cash, however, does not necessarily mean that the owners are any better off—that the retained earnings portion of their equity has increased. The increase in cash may merely be offset by a decrease in some other asset or by an increase in a liability, with no effect on retained earnings at all.

Again, reference to the transactions of Music Mart, Inc., may help to clarify this point. When Music Mart borrowed $12,500 from the bank on January 2 (page 43), its increase in cash was exactly matched by an increase in the liability to the bank. There was no change in retained earnings; no income resulted from this transaction. The $12,500 was not revenue; it was the proceeds of a borrowing transaction, whereas rev- enues are related to earnings transactions. Similarly, the purchase of inventory for $5,000 cash on January 3 resulted in a decrease in cash, but there was an exactly cor- responding increase in another asset, inventory. Owner’s equity was not changed. This was an asset purchase transaction, not an earnings transaction.

As we have already seen, the sale for $750 of inventory costing $500 did result in income. But note that the income was $250, whereas cash increased by $750; even here, the income is different from the amount by which the cash increased. In short, although individuals typically measure their personal income by the amount of money they receive, this concept of income is not correct when applied to a business entity.

Managers are human beings. Like most humans, they would like to give a favorable re- port on how well the entity for which they are responsible has performed. Yet, as the Financial Accounting Standards Board says, “prudent reporting based on a healthy skepticism builds confidence in the results and, in the long run, best serves all of the divergent interests [of financial statement users].”4 This long-standing philosophy of prudent reporting leads to the conservatism concept.

This concept is often articulated as a preference for understatement rather than over- statement of net income and net assets when dealing with measurement uncertainties. Thus, if two estimates of some future amount are about equally likely, there is a preference for using the smaller number when measuring assets or revenues, and the larger for liabilities or expenses. For decades, the concept was stated informally as “anticipate no profits but anticipate all losses.”

We state the conservatism concept’s two aspects somewhat more formally:

1. Recognize revenues (increases in retained earnings) only when they are reasonably certain.

2. Recognize expenses (decreases in retained earnings) as soon as they are reasonably possible.

In December 2010 Lynn Jones agrees to buy an automobile from Varsity Motors, Inc., for delivery in January 2011. Although this is good news to Varsity Motors, it is possible that something will go wrong and the sale will not be consummated. Therefore, the conser- vatism concept requires that the revenue not be recorded, that is, recognized, until the au- tomobile is actually delivered. Thus, Varsity Motors does not recognize revenue from this transaction in 2010 because the revenue is not reasonably certain in 2010, even though it is reasonably possible. Rather, if the automobile is actually delivered in 2011, revenue is recognized in 2011.

4 “Qualitative Characteristics of Accounting Information,” FASB Statement of Accounting Concepts No. 2.

The Conservatism Concept

Examples

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Chapter 3 Basic Accounting Concepts: The Income Statement 55

As another example, an uninsured automobile disappears from Varsity Motors’ premises in December 2010. Possibly, it will be recovered; possibly, it has been stolen and is gone for- ever. In the latter case, Varsity Motors’ retained earnings has decreased; the company has incurred an expense. Suppose that Varsity Motors is not reasonably certain that the auto is gone forever until early 2011. Nevertheless, the conservatism concept requires that the ex- pense be recognized in 2010, the year in which it became reasonably possible that there was an expense, rather than in 2011, the year in which the expense became reasonably certain.

As a final example, consider the amount reported as inventory. If late in 2010 an entity learns that the selling price of certain goods in its inventory has declined to less than the cost of these goods, a loss (i.e., an expense) is recognized in 2010, even though in actual fact prices may rise again and the goods may be sold in 2011 at a profit. This is because it is reasonably possible that owners’ equity has been reduced in 2010. (This “lower of cost or market” rule, probably the most well-known application of the conservatism concept, is described in Chapter 6.)

Obviously, in various situations, there are problems in deciding what is meant by such imprecise phrases as about equally likely, reasonably certain, and reasonably possible. For some specific problems, accounting principles give guidance—for example, the in- ventory principle just described. However, as with many accounting matters, judgment is often involved, and there is only a fine line between “prudently” reporting net income and owners’ equity on the one hand and misleadingly understating them on the other.

Application to Revenue Recognition In general, revenue from the sale of goods is recognized in the period in which goods were delivered to customers. Revenue from the performance of services is recognized in the period in which the services were performed. For many events, cash is received at the time of delivery or performance, and this is excellent evidence that the revenue has been earned. This is the case with most supermarkets and for many transactions in other retail stores and service firms. It can happen, however, that the cash is received in either an earlier period or a later period than that in which the revenue is recognized. Examples of each are given below.

Precollected Revenue Magazine publishing companies sell subscriptions that the sub- scriber pays for in advance; the company receives the cash before it renders the service of providing the magazine. Referring to Illustration 3–2, if subscription money is re- ceived this year for magazines to be delivered next year, the revenue belongs in next year. The money received is recognized as an increase in cash, not as revenue for this year, and an offsetting liability is recorded on the balance sheet as of the end of this year. The liability, precollected (or unearned) revenue, represents the company’s obligation to provide its subscribers the future issues of the magazine for which they have already paid. Similarly, rent on property is often received in advance. When this happens, the revenue is properly recognized by the landlord in the period in which the

This year income statement

Last year income statement

Dec. 31

Next year income statement

Balance sheet

Time: Past period

Current period

Future period

Dec. 31

Balance sheet

ILLUSTRATION 3–2

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56 Part 1 Financial Accounting

services of the rented property are provided, not the period in which the rent payment is received. In sum, precollected revenues have been paid to the entity but have not as yet been earned by the entity.

Accounts Receivable The converse of the above situation is illustrated by sales made on credit: The customer agrees to pay for the goods or services sometime after the date on which they are actually received. The revenue is recognized in the period in which the sale is made. If the payment is not due until the following period, an asset—accounts receivable—is shown on the balance sheet as of the end of the current period. When the bill is paid by the customer (i.e., the account receivable is collected), the amount received is not revenue. Rather, it reduces the amount of accounts receivable outstanding and increases cash, leaving retained earnings unchanged. The sale is the earnings transaction that affects retained earnings; collection of the account receivable is the conversion of a noncash asset into cash, which is not an earnings transaction.

The distinction between revenue and receipts is illustrated in the following tabula- tion, which shows various types of sales transactions and classifies the effect of each on cash receipts and sales revenue for “this year”:

This Year

Amount Cash Receipts Sales Revenue

1. Cash sales made this year $200 $200 $200 2. Credit sales made last year;

cash received this year 300 300 0 3. Credit sales made this year;

cash received this year 400 400 400 4. Credit sales made this year;

cash received next year 100 0 100_____ _____ Total $900 $700

In this illustration, this year’s total cash receipts do not equal this year’s total sales rev- enue. The totals would be equal in a given accounting period only if (1) the company made all its sales for cash or (2) the amount of cash collected from credit customers in the accounting period happened by chance to equal the amount of credit sales made during that period.

Accrued Revenue When a bank lends money, it is providing a service to the borrower, namely, the use of the bank’s money. The bank’s charge for this service is called interest, and the amount the bank earns is interest revenue. The bank earns interest revenue on each day that the borrower is permitted to use the money. For some loan transactions, the borrower does not actually pay the interest in the year in which the money was used but rather pays it next year. Even if this interest payment is not made until next year, the bank has earned revenue this year for a loan outstanding during the year. The amount earned but unpaid as of the end of this year is an asset on the bank’s balance sheet called accrued interest revenue or interest receivable. It is similar to an account receivable. In sum, accrued revenue is the reverse of precollected revenue: Accrued revenues have been earned by the entity but have not as yet been paid to the entity.

The conservatism concept suggests the period when revenue should be recognized. An- other concept, the realization concept, indicates the amount of revenue that should be recognized from a given sale.

The Realization Concept

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Realization refers to inflows of cash or claims to cash (e.g., accounts receivable) arising from the sale of goods or services. Thus, if a customer buys $50 worth of items at a grocery store, paying cash, the store realizes $50 from the sale. If a clothing store sells a suit for $300, the purchaser agreeing to pay within 30 days, the store realizes $300 (in receivables) from the sale, provided that the purchaser has a good credit record so that payment is reasonably certain (conservatism concept).

The realization concept states that the amount recognized as revenue is the amount that is reasonably certain to be realized—that is, that customers are reasonably certain to pay. Of course, there is room for differences in judgment as to how certain “reasonably certain” is. However, the concept does clearly allow for the amount of revenue recog- nized to be less than the selling price of the goods and services sold. One obvious situa- tion is the sale of merchandise at a discount—at an amount less than its normal selling price. In such cases, revenue is recorded at the lower amount, not the normal price.

In many instances, the sale of a new car is made at a negotiated price that is lower than the manufacturer’s list (“sticker”) price for the automobile. In these circumstances, revenue is the amount at which the sale is made, rather than the list price. If the list price is $25,000 and the car is actually sold for $23,500, then the revenue is $23,500.

A less obvious situation arises with the sale of merchandise on credit. When a com- pany makes a credit sale, it expects that the customer will pay the bill. Experience may indicate, however, that not all customers do pay their bills. In measuring the revenue for a period, the amount of sales made on credit should be reduced by the estimated amount of credit sales that will never be realized—that is, by the estimated amount of bad debts.

If a store makes credit sales of $100,000 during a period and if experience indicates that 3 percent of credit sales will eventually become bad debts, the amount of revenue for the period is $97,000, not $100,000.

Although conceptually the estimated amount of bad debts is part of the calculation of revenue, in practice this amount is often treated as an expense. Thus, revenue is often reported as $100,000, and there is an expense—bad debt expense—of $3,000. The effect on net income is the same as if the revenue were reported as $97,000.

As noted earlier, the sale of merchandise has two aspects: (1) a revenue aspect, reflect- ing an increase in retained earnings equal to the amount of revenue realized, and (2) an expense aspect, reflecting the decrease in retained earnings because the merchandise (an asset) has left the business. In order to measure correctly this sale’s net effect on re- tained earnings in a period, both of these aspects must be recognized in the same ac- counting period. This leads to the matching concept: When a given event affects both revenues and expenses, the effect on each should be recognized in the same account- ing period.

Usually, the matching concept is applied by first determining the items of revenue to recognize for the period and their amounts (in accordance with the conservatism and realization concepts), and then matching items of cost to these revenues. For example, if goods costing $1,000 are sold for $1,500, it is first determined when the $1,500 is reasonably certain to be realized; then the $1,000 cost of sales is matched with those revenues as an expense, resulting in $500 income from the sale. However, as we shall see in later chapters, in some situations the applicable expenses are identified first, and then revenues are matched to them. Here we shall assume that applicable revenues of a period have been identified; the problem is to determine the costs that match with these revenues. These matched costs are expenses of the period.

The Matching Concept

Example

Example

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58 Part 1 Financial Accounting

Recognition of Expenses

In discussing the period in which an expense is recognized (i.e., recorded), we shall use four terms—cost, expenditure, expense, and disbursement—whose meanings must be kept clear. Although these terms tend to be used interchangeably in everyday conver- sation, in accounting they are not synonyms.

Cost is a monetary measurement of the amount of resources used for some purpose. An expenditure is a decrease in an asset (usually cash) or an increase in a liability (often accounts payable) associated with the incurrence of a cost. The expenditures in an ac- counting period equal the cost of all the goods and services acquired in that period. An expense is an item of cost applicable to the current accounting period. An expense rep- resents resources consumed by the entity’s earnings activities during the current pe- riod. When an expenditure is made, the related cost is either an asset or an expense. If the cost benefits future periods, it is an increase in an asset. If not, it is an expense—a reduction in retained earnings—of the current period.5 A disbursement is the payment of cash. A cash expenditure is a disbursement, but so is any cash payment, such as pay- ing an account payable, repaying a loan, or paying a cash dividend to shareholders.

An item of inventory costing $1,000 is received in March, the vendor is paid in April, and the item is shipped to a customer in May. In March there is a cost of $1,000 (acquisition of a good) and an expenditure of $1,000 (increase in accounts payable). In April there is a dis- bursement of $1,000 (cash payment). In May there is an expense of $1,000 (consumption of inventory).

The matching concept provides one criterion for deciding what costs are expenses in an accounting period: The revenue and expense effects of a given event should be rec- ognized in the same accounting period. There are two other related criteria: (1) Costs associated with activities of the period are expenses of the period and (2) costs that cannot be associated with revenues of future periods are expenses of the current pe- riod. An example of each criterion is given below.

Direct Matching The association of cost of sales with revenues for the same goods or services has already been mentioned. Similarly, if a salesperson is paid a commission, the commission is re- ported as an expense in the same period in which the revenue arising from these sales is recognized. The period in which the commission is recognized as an expense may be different from the period in which the salesperson receives the commission in cash.

Ms. A was paid $2,000 cash in 2010 as a commission on an order she booked late in 2010. However, the goods were not shipped, and thus the sales revenue was not recognized, until early 2011. Thus, the $2,000 is an expense of 2011. Mr. B was paid $1,000 cash in early 2011 as a commission on goods that were shipped in late 2010. The $1,000 is an expense of 2010. Note that, in both cases, the cash disbursement took place in a different period from the period in which the expense was recognized.

Period Costs Some items of expense are associated with a certain accounting period, even though they cannot be traced to any specific revenue transactions occurring in that period. In

Terminology

5 Financial statement users must be alert to the possibility that unscrupulous managers may inflate current profits by deliberately misclassifying expenditures as assets rather than expenses.

Example

Example

Criteria for Expense Recognition

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general, these expenses are the costs of being in business. In a retail store, they include the costs of operating the store during the period, even though these costs cannot be traced directly to the specific merchandise sold. In a manufacturing firm, they include all of the costs that cannot be directly related to the goods being produced and sold. These expenses are called period costs.

If a salesperson is paid a salary rather than a commission as in the previous example, the salary is reported as an expense in the period in which the employee works. The amount of the salary is not affected by the volume of sales, and hence there is no direct relationship between the salary cost and revenue. The salary is one of the costs of operating the business during the period and hence is related only in an indirect way to the revenue of the period.

Costs Not Associated with Future Revenue Even if a cost item is not associated with the operations of a period, it is reported as an expense of that period if it cannot be associated with the revenue of some future period. An item of cost must be either an asset or an expense. For a cost of this period to be an asset, it must, by definition, be expected to provide an economic benefit in some future period. If it does not qualify as an asset by this test, it must be an expense of the cur- rent period. Even if the item of cost benefits the future in some general way, but there is no feasible or objective way of associating these benefits with specific future periods, the item is an expense.

Employee training programs are intended to provide benefits to future periods in that the participants are expected to perform better as a result of the training. The future benefits of this training cannot be objectively measured, however. So training costs are charged as an expense of the current period, rather than being treated as an asset.

Under this general principle, many items of cost are charged as expenses in the cur- rent period even though they have no connection with the revenues of the period or even with the ongoing operations of the period. If assets are destroyed by fire or lost by theft, for example, the amount of the loss is an expense of the current period. In gen- eral, if a cost is incurred and there is no reasonable basis for classifying the cost as an asset, it is reported as an expense.

If during the period an item that once was classified as an asset is found to have a di- minished value for future periods, the asset amount is restated to its new estimated re- coverable value and the amount of the write-off becomes an expense of the period. This can happen, for example, when goods held in inventory are found to have deteriorated, become obsolete, or otherwise become unsalable.

Expenditures take place when an entity acquires goods or services. An expenditure may be made by cash, by incurring a liability (such as an account payable), by the ex- change of another asset (such as a trade-in vehicle), or by some combination of these. As already noted, these expenditures can be either assets or expenses. Over the entire life of an entity, most expenditures become expenses. (The exception would be assets that are liquidated as the business closes down its operations at the end of its life.) In any time segment shorter than the life of an entity, however, there is no necessary cor- respondence between expenses and expenditures.

Late in 2010 $5,000 of fuel oil was purchased for cash. This was an expenditure of $5,000, which was the exchange of cash for another asset. If none of this fuel oil was consumed in 2010, there was no expense in 2010. Rather, the fuel oil was an asset as of the end of 2010. If the fuel oil was consumed in 2011, there was an expense of $5,000 in 2011.

Expenses and Expenditures

Example

Example

Example

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60 Part 1 Financial Accounting

Four types of transactions need to be considered in distinguishing between amounts that are properly considered as expenses of a given accounting period and the expen- ditures made in connection with these items. Focusing on “this year” in Illustration 3–2, these are as follows:

1. Expenditures made this year that are also expenses of this year. 2. Expenditures made prior to this year that become expenses during this year. These

appeared as assets on the balance sheet at the beginning of this year. 3. Expenditures made this year that will become expenses in future years. These will

appear as assets on the balance sheet at the end of this year. 4. Expenses of this year that will be paid for in a future year. On the balance sheet at

the end of this year, these appear as liabilities.

Expenditures That Are Also Expenses This is the simplest and most common type of transaction, and the least troublesome to account for. If an item is acquired during the year, it is an expenditure. If it is con- sumed during the same year, it is an expense of the year. Consumed, as used here, means more precisely that the item provides its intended benefit. For example, raw ma- terials that are converted into goods intended to be sold are not considered to be con- sumed until the goods are sold. At that time, the raw materials cost is a part of the expense, cost of goods sold.

Beginning Assets That Become Expenses On January 1 the balance sheet shows the entity’s assets. Assets are resources that pro- vide future benefits to the entity. The expenditures for the beginning-of-the-period as- sets were made in some earlier period. These expenditures were recorded as assets rather than as expenses because the future benefit test was met when the resources were acquired. During this year, some of these benefits are “released” and “used up” (i.e., some assets are consumed); hence, the expenditures are transformed into expenses. The three principal types of such assets are described below.

First, there are inventories of salable goods. These become expenses when the goods are sold.

Second, there are prepaid expenses (sometimes called deferred charges). These rep- resent services or other assets (usually intangible) purchased prior to this year but whose benefits have not been fully used up when the year begins. They become ex- penses in the year in which the benefits are received—that is, when the services are used or the assets are consumed. Prepaid insurance protection, prepaid lawyers’ re- tainer fees, and prepaid rent are such items.

On December 31, 2010, a company purchased for $90,000 an insurance policy providing three years of protection. The $90,000 appears as an asset on the balance sheet of Decem- ber 31, 2010. In 2011, $30,000 (one-third) becomes an expense and $60,000 remains as an asset on the balance sheet of December 31, 2011. In 2012, $30,000 more becomes an expense and $30,000 remains as an asset on the balance sheet of December 31, 2012. The remaining $30,000 is an expense in 2013.

The third category of assets that will become expenses is long-lived (noncurrent) assets. With the exception of land, assets have a limited useful life; they do not last forever. They are purchased with the expectation that they will be used in the opera- tion of the entity in future periods, and they will become expenses in these future pe- riods. The principle is exactly the same as that of the insurance policy previously mentioned, which also was purchased for the benefit of future periods. An important practical difference between a long-lived asset, such as a building, and an insurance

Example

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Chapter 3 Basic Accounting Concepts: The Income Statement 61

policy, however, is that the life of a building is usually difficult to estimate whereas the life of an insurance policy is known precisely. Thus, estimating what portion of a building’s cost is an expense of a given accounting period is a more difficult task than that of determining the insurance expense of a period. The mechanism used to convert the cost of fixed assets to expense is called depreciation; it is described in Chapter 7.

Expenditures That Are Not Yet Expenses As the preceding examples show, some expenditures made to acquire assets are not ex- penses of this year because the assets’ benefits have not yet been used up as of the year’s end. These include not only the purchase of long-lived assets but also expendi- tures incurred in connection with the production of goods that are to be sold in some future year. Thus, wages and salaries earned by production personnel and all other costs associated with producing goods become part of the cost of the goods produced and remain as an asset, inventory, until the goods are sold. Chapter 6 discusses in more detail the distinction between production costs (also called product costs), which ini- tially are added to inventory amounts, and other operating costs (period costs), which are expenses of the current period.

Expenses Not Yet Paid Some expenses of this year are not paid for by the end of the year. The parties who fur- nished services during the year have a claim against the entity for the amounts owed them. These amounts are therefore liabilities (called accrued expenses) of the entity as of December 31. The liability for wages earned but not yet paid, accrued wages (or wages payable), is an example already mentioned. The cost of using borrowed money during a period is interest expense of that period. If this interest expense has not been paid, the end-of-period balance sheet will show a liability, accrued interest expense (or interest payable). Several other types of obligations have the same characteristic: Although services were rendered prior to the date for which the balance sheet is pre- pared, these services have not yet been paid for. The recognition of these expenses reduces retained earnings; the subsequent payment of the obligation (i.e., the disburse- ment) does not affect retained earnings.

For all obligations of this type, the transaction involved is essentially the same: The expense is recognized in the period in which the services were used, and the obligation that results from these services is shown in the liability section of the balance sheet as of the end of the period.

In the final days of 2010, employee Aneel Prahalad earned $300 that was not paid him by year-end. This is an expense of $300 in 2010, and there is a corresponding liability of $300 (accrued wages) on his employer’s balance sheet as of December 31, 2010. In 2011 when Prahalad is paid, the liability is eliminated and there is a $300 decrease in cash. Accrued wages liability will always occur for an entity whose last payday of the year does not fall on the last day of the year.

In this example, the basic equality, Assets � Liabilities � Owners’ equity, is always maintained. The earning of wages resulted in an expense of $300, which was a decrease in owners’ equity (retained earnings), and there was an equal increase in the liability, accrued wages. Thus, the total of the equities—liabilities and owners’ equity—was un- changed. The payment of the $300 resulted in a decrease in cash and a decrease in the liability, accrued wages, so both assets and liabilities were reduced by $300.

Dividends that a corporation pays to its shareholders are not expenses. Dividends are a distribution of net income rather than an item in the calculation of net income. Cash

Example

Dividends

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62 Part 1 Financial Accounting

dividends reduce the asset, cash, and reduce retained earnings by an equal amount. This is the only common transaction in business entities in which a reduction in re- tained earnings is not an expense. Similarly, in an unincorporated business, owners’ or partners’ drawings are not treated as expenses.

The proper classification of expenditures as either assets or expenses is one of the most difficult problems in accounting. As an aid in this process and as a summary of the pre- ceding discussion, Illustration 3–3 gives a decision diagram that should be helpful. It shows that an entity starts an accounting period with certain assets and that during the pe- riod it makes expenditures. If these costs have not been paid for in cash or by an exchange of another asset, they result in liabilities on the end-of-period balance sheet. In preparing the end-of-period balance sheet and the period’s income statement, the accountant must

Summary of Expense Measurement

Assets as of January 1, 20x9

Assets on balance sheet as of December 31, 20x9

Example: Inventory

Expenditures (costs incurred) during 20x9

(If not paid for in 20x9, then they are liabilities on the December 31,

20x9, balance sheet)

1. Was there a direct

association with the revenues of the

period?

Expenses of 20x9

Example: Cost of goods sold Yes

Yes

No

No

No

Yes

Example: Office expenses

Example: Obsolete merchandise

2. Was there an

association with activities of the period?

3. Can the item be

associated with benefits of future periods?

ILLUSTRATION 3–3 Decision Diagram: Assets and Expenses

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Chapter 3 Basic Accounting Concepts: The Income Statement 63

classify these assets and expenditures either as expenses, which will appear on the income statement, or as assets, which will appear on the end-of-period balance sheet. In order to do this classification, the three questions shown in the diagram must be addressed.

Gains and Losses

Throughout this chapter, revenue, which increases retained earnings, has been associ- ated with the sale of a company’s goods and services. Retained earnings can increase for other reasons. For example, if a company sells marketable securities for more than it paid for them, retained earnings has increased, but this is not sales revenue (unless the company is in the business of selling securities). Technically, such increases in re- tained earnings are called gains, to distinguish them from revenues from the sale of goods and services.

Similarly, decreases in retained earnings (except dividends) for reasons not associ- ated with operations are referred to as losses, and these are sometimes distinguished from expenses. Loss of assets by fire or theft has already been mentioned. Sale of mar- ketable securities at an amount less than was paid for them is another example.

As a practical matter, no sharp distinction is made between sales revenues and gains; they both increase retained earnings. Similarly, expenses and losses both decrease re- tained earnings, so again in practice no sharp distinction is made between them.

The nine concepts that have been described so far in this and the preceding chapter are so broad that in practice there are often several different ways a given event may be recorded. For example, bad debts may be recognized either as a reduction in revenue or as an expense. The consistency concept states that once an entity has decided on one accounting method, it should use the same method for all subsequent events of the same character unless it has a sound reason to change methods. If an entity frequently changed the manner of handling a given class of events in the accounting records—for example, frequently changing between the straight-line method and an accelerated method for depreciating its building—comparison of its financial statements for one period with those of another period would be difficult.

Because of this concept, changes in the method of keeping accounts are not made lightly. If a company changes an accounting method from the method used in the pre- ceding year, the company’s outside auditors must report this in their opinion letter—the auditors’ report that accompanies the annual financial statements distributed to share- holders. (Auditors’ opinion letters will be described more fully in Chapter 14.)

Consistency, as used here, has a narrow meaning. It refers only to consistency over time, not to logical consistency at a given moment of time. For example, long-lived as- sets are recorded at cost, but inventories are recorded at the lower of their cost or mar- ket value. Some people argue that this is inconsistent. Whatever the merits of this argument may be, it does not involve the accounting concept of consistency. This con- cept does not mean that the treatment of different categories of transactions must be consistent with one another, but only that transactions in a given category must be treated consistently from one accounting period to the next.

In law there is a doctrine called de minimis non curat lex, which means that the court will not consider trivial matters. Similarly, the accountant does not attempt to record events so insignificant that the work of recording them is not justified by the usefulness of the results.

The Consistency Concept

The Materiality Concept

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Conceptually, a brand-new pad of paper is an asset of the entity. Every time someone writes on a page of the pad, part of this asset is used up, and retained earnings decreases correspondingly. Theoretically, it would be possible to ascertain the number of partly used pads that are owned by the entity at the end of the accounting period and to show this amount as an asset. But the cost of such an effort would obviously be unwarranted, and no accountant would attempt to do this. Accountants take the simpler, even though less exact, course of action and treat the asset as being used up (expensed) either at the time the pads were purchased or at the time they were issued from supplies inventory to the user.

Unfortunately, there is no agreement on the exact line separating material events from immaterial events. The decision depends on judgment and common sense. It is natural for the beginning student, who does not have an appreciation of the cost of col- lecting accounting information, to expect an accountant to be more meticulous in recording events in the accounts than the practicing accountant actually would be.

The materiality concept is important in the process of determining the expenses and revenue for a given accounting period. Many of the expense items are necessarily esti- mates, and in some cases they are not very close estimates. Beyond a certain point, it is not worthwhile to attempt to refine these estimates.

Telephone bills, although rendered monthly, often do not coincide with a calendar month. It would be possible to analyze each bill and classify all the toll calls according to the month in which they were made. This would be following the matching concept precisely. Few companies bother to do this, however. On the grounds that a procedure to determine the actual expense would not be justified by the accuracy gained, they simply consider the telephone bill as an expense of the month in which the bill is received. Since the amount of the bill is likely to be relatively stable from one month to another, no significant error is introduced.

Materiality is also used in another sense in accounting. The principle of full disclosure requires that all important information about the financial condition and activities of an en- tity must be disclosed in reports prepared for outside parties. In this sense, also, there is no definitive rule that separates material from immaterial information. (This topic is discussed further in Chapter 14.) In sum, the materiality concept states that insignificant events may be disregarded, but there must be full disclosure of all important information.

The question of what is material is important to chief executive and chief financial officers of public companies. The Sarbanes–Oxley Act became law on July 30, 2002. One of its many requirements is that chief executive officers (CEOs) and chief financial officers (CFOs) of companies registered with the Securities and Exchange Commis- sion (SEC) must sign certifications related to the financial data contained in annual and quarterly filings with the SEC.

The certifications requires the CEO and CFO each to certify that the filings are materially accurate and complete, the financial statements and other financial informa- tion included in the filing present in all material respects the financial condition and re- sults of operations of the company, and the issuer’s internal controls do not contain any material weaknesses.

The Income Statement

The accounting report that summarizes the revenues and the expenses of an accounting period is called the income statement (or the profit and loss statement, statement of earnings, or statement of operations). In a technical sense, the income statement is

Example

Example

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subordinate to the balance sheet. This is because it shows in some detail the items that collectively account for most of the period’s net change in only one balance sheet item, retained earnings. (“Most” excludes dividends as well as a few relatively unusual retained earnings changes that are described in later chapters.) Nevertheless, the information on the income statement is regarded by many to be more important than information on the bal- ance sheet. This is because the income statement reports the results of operations and in- dicates reasons for the entity’s profitability (or lack thereof). The importance of the income statement is illustrated by this fact: In situations where accountants in recording an event must choose between a procedure that distorts the balance sheet or one that distorts the income statement, they usually choose not to distort the income statement.

In practice, there is considerable variety in the formats and degree of detail used in income statements. Illustration 3–4 shows an income statement for Garsden Corpora- tion (whose balance sheet was shown in Illustration 2–1). It is representative of the in- come statements published in corporations’ annual reports to their shareholders (with the exception of a few complex items that are discussed in later chapters). Income statements prepared for use by the managers of an entity usually contain more detailed information than that shown in Illustration 3–4.

The heading of the income statement must show (1) the entity to which it relates (Gars- den Corporation), (2) the name of the statement (income statement), and (3) the time period covered (year ended December 31, 2009). The balance sheet in Illustration 2–1 and the income statement in Illustration 3–4 give information for only one year. To provide a basis for comparison, the SEC requires that corporate annual reports contain income statements for the most recent three years and balance sheets as of the end of the most recent two years.

ILLUSTRATION 3–4

GARSDEN CORPORATION Name of entity

Income Statement Name of statement

For the Year Ended December 31, 2010 Time period

Net sales $75,478,221

Cost of sales 52,227,004

Gross margin $23,251,217

Research and development expense 2,158,677

Selling, general, and administrative expenses 8,726,696

Operating income $12,365,844

Other revenues (expenses):

Interest expense (363,000)

Interest and dividend revenues 43,533

Royalty revenues 420,010

Income before income taxes $12,466,387

Provision for income taxes 4,986,555

Net income $ 7,479,832

Earnings per share of common stock $ 6.82

Statement of Retained Earnings Retained earnings at beginning of year $16,027,144

Add: Net income 7,479,832

Deduct: Dividends ($4 per common share) (4,390,000)

Retained earnings at end of year $19,116,976

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66 Part 1 Financial Accounting

Comments about the items listed on this income statement and variations often found in practice are given in the following paragraphs.

An income statement sometimes reports several separate items in the sales revenue section, the net of which is the net sales (or net sales revenue) figure. For example, Garsden’s income statement might have shown

Gross sales $77,157,525

Less: Returns and allowances $ 528,348

Sales discounts 1,150,956

Net sales $75,478,221

Gross sales is the total invoice price of the goods shipped or services rendered during the period. It usually does not include sales taxes or excise taxes that may be charged to the customer. Such taxes are not revenues but rather represent collections that the business makes on behalf of the government. They are a liability owed to the government until paid. Similarly, postage, freight, or other items billed to the customer at cost are not revenues. These items usually do not appear in the sales figure but instead are an offset to the costs the company incurs for them. However, exceptions are made to these rules when it is not feasible to disentangle the revenue and nonrevenue portions of the items in question.

Sales returns and allowances represent the sales value of goods that were returned by customers and allowances that were made to customers because the goods were defective or for some other reason. The amount can be subtracted from the sales figure directly, without showing it as a separate item on the income statement. However, it is often considered as being important enough information to warrant reporting it sepa- rately. Sales discounts are the amount of discounts taken by customers for prompt pay- ment. (These are sometimes called cash discounts.)

Assume that a business offers a 2 percent discount to customers who pay within 10 days from the date of the invoice. The business sells $1,000 of merchandise to a customer (gross sales) who takes advantage of this discount (sales discount). The business receives only $980 cash and records the other $20 as a sales discount.

Trade discounts, which are formulas used in figuring the actual selling price from published catalogs or price lists (e.g., “list less 40 percent”), do not appear in the ac- counting records at all.

Other revenues are revenues earned from activities not associated with the sale of the company’s goods and services. Interest and dividends earned on marketable secu- rities owned by the company are examples. Garsden also had revenues from royalties paid by other companies that Garsden has licensed to use its patented manufacturing process. Although it is preferable to show such peripheral revenues separately from sales revenues, as in Illustration 3–4, many companies add them to net sales and report a total revenue amount.

Because of the matching concept, at the same time that income is increased by the sales value of goods or services sold, it is also decreased by the cost of those goods or ser- vices. Indeed, it would be possible to record only the net increase in retained earnings that results from a sale. However, reporting the separate amounts for sales revenue and the cost of sales provides information useful to both management and outside users of income statements.

The cost of goods or services sold is called the cost of sales. In manufacturing firms and retailing businesses, it is often called the cost of goods sold. In most businesses,

Revenues

Cost of Sales

Example

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the cost of sales amount is associated with a decrease in the asset inventory, which has been consumed in generating the sales revenues. (The principal exception is personal- services businesses such as barber or beauty shops, which have no significant invento- ries.) Procedures for measuring the cost of sales are described in Chapter 6.

The difference between net sales revenue and cost of sales is the gross margin (or gross profit). It is the difference between the revenues generated from selling products (goods or services) and the related product costs. On most income statements, as in Illustration 3–4, this amount appears as a separate item. It does not appear separately on some companies’ income statements but can be calculated as the difference between net sales and cost of sales if the company has disclosed the cost of sales amount.6

The classifications given in Illustration 3–4 are a minimum. In many income state- ments, especially those prepared for internal use, the “selling, general, and administra- tive expense” category is broken down so as to show separately the principal items of which it is composed.

The separate disclosure of research and development expense is a requirement. Formerly, most companies included this expense as part of general and administrative expenses. Because the amount spent on research and development can provide an im- portant clue as to how aggressive the company is in keeping its products and processes up to date, the FASB requires that this amount be reported separately if it is material.

The FASB also requires separate disclosure of the amount of interest expense in a period. In some instances, to be discussed in Chapter 7, the interest expense of a period is not the same as the interest cost incurred during the period.

Many companies’ income statements show an amount for operating income, as in Illustration 3–4. To operating income are added other revenue items, and other ex- penses are subtracted (indicated by parentheses in Illustration 3–4); the result is income before income taxes. A company that shows an operating income amount wants to distinguish the income generated by its primary operating activities from its nonoperating revenues and expenses. Many companies reject this distinction. They say, for example, that interest expense reflects the cost of financing assets used in opera- tions and therefore should not be presented in a way that suggests it is a “nonoperat- ing” item. Nearly all companies report a pretax income amount before subtracting the provision for income taxes (also called income tax expense).

Net income is colloquially referred to as “the bottom line” of the income statement (for ob- vious reasons). The bottom line must be labeled net income or net earnings, with no qual- ification or modification. (If negative, it is labeled net loss.) Net income also is presented on a per-share basis. The calculation of earnings per share is discussed in Chapter 9.

Strictly speaking, the income statement ends with “earnings per share.” Illustration 3–4 goes beyond this to show other changes in retained earnings that have occurred during the period. This final section links the period’s income statement to the beginning-of-the- period and end-of-the-period balance sheets by completing the explanation of the net

Gross Margin

Expenses

Net Income

Statement of Retained Earnings

6 Outside the United States, some companies do not show cost of sales as one item on the income statement. Instead, they list individual expenses by object, such as salaries and wages, usage of goods and services, and interest. In such an income statement, it is impossible to calculate the gross margin because the broad objects (e.g., salaries and wages) intermingle product costs (e.g., factory labor) with period costs (e.g., administrative salaries). The use of this format is rare in the United States. If it is used by a listed company, the SEC requires disclosure of a cost of goods sold figure and gross margin amount in the notes to the financial statements.

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change in retained earnings between those two balance sheet snapshots. For Garsden, this section shows that (1) at the start of 2010, retained earnings was $16,027,144; (2) during 2010, retained earnings was increased by the amount of 2010 net income, $7,479,832, and was decreased by the amount of 2010 dividends, $4,390,000; and thus (3) at the end of 2010, retained earnings was $19,116,976. This calculation, whether shown on a sepa- rate page or included at the bottom of the income statement, is called a statement of retained earnings (or sometimes a reconciliation of retained earnings).7

The balance sheet and income statement are said to articulate because there is a defi- nite relationship between them. More specifically, as shown in the statement of re- tained earnings, the amount of net income reported on the income statement, together with the amount of dividends, explains the change in retained earnings between the two balance sheets prepared as of the beginning and the end of the accounting period. This relationship was shown schematically in Illustration 1–5.

In analyzing an income statement, percentage relationships are often calculated. Usu- ally, the net sales amount is taken as 100 percent. Each income statement item is then expressed as a percentage of net sales. The most important are the gross margin per- centage and the profit margin.

The gross margin percentage is gross margin divided by net sales. For Garsden this is $23,251,217 � $75,478,221 � 30.8 percent. It indicates the average margin obtained on products (goods or services) sold. The percentage varies widely among industries, but companies in the same industry tend to have similar gross margin percentages.

The profit margin is net income divided by net sales. For Garsden this is $7,479,832 � $75,478,221 � 9.9 percent. Profit margins also vary widely among industries. A successful supermarket may have a profit margin of about 1.5 percent, whereas the typical profit margin in healthy manufacturing companies tends to be closer to 8 percent.

Other Concepts of Income

We have described how income is measured and reported in accordance with generally accepted accounting principles (GAAP). Not all income statements are prepared in accordance with these principles, however. Some regulatory bodies require the use of different principles by companies within their jurisdiction. Four other variations of the income concept are described below: cash-basis accounting, income tax accounting, the economic concept of income, and pro forma earnings.

The measurement of income described in this chapter is based on what is called accrual accounting. Central to accrual accounting are the realization concept and the matching concept. Accrual accounting measures income for a period as the difference between the revenues recognized in that period and the expenses that are matched with those revenues. As noted previously, the period’s revenues generally are not the same as the period’s cash receipts from customers, and the period’s expenses generally are not the same as the period’s cash disbursements.

Relation between Balance Sheet and Income Statement

Income Statement Percentages

Accrual versus Cash-Basis Accounting

7 Often the statement of retained earnings is incorporated as a section of a statement of changes in owners’ equity. This larger statement also includes a section showing changes in paid-in capital and a section presenting certain other changes in owners’ equity.

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An alternative way of measuring income is called cash-basis accounting. With this method, sales are not recorded until the period in which they are received in cash. Similarly, costs are subtracted from sales in the period in which they are paid for by cash disbursements. Thus, neither the realization nor matching concept applies in cash-basis accounting.

In practice, “pure” cash-basis accounting is rare. This is because a pure cash-basis approach would require treating the acquisition of inventories as a reduction in profit when the acquisition costs are paid rather than when the inventories are sold. Similarly, costs of acquiring items of plant and equipment would be treated as profit reductions when paid in cash rather than in the later periods when these long-lived items are used. Clearly, such a pure cash-basis approach would result in balance sheets and income statements that would be of limited usefulness. Thus, what is commonly called cash- basis accounting is actually a mixture of cash basis for some items (especially sales and period costs) and accrual basis for other items (especially product costs and long- lived assets). This mixture is also sometimes called modified cash-basis accounting to distinguish it from a pure cash-basis method.

Cash-basis accounting is seen most often in small firms that provide services and therefore do not have significant amounts of inventories. Examples include restaurants, beauty parlors and barber shops, and income tax preparation firms. Since most of these establishments do not extend credit to their customers, cash-basis profit may not differ dramatically from accrual-basis income. Nevertheless, cash-basis accounting is not permitted by GAAP for any type of business entity.8

Most business entities must calculate their taxable income and pay a federal tax (and in some cases, a state or local tax) based on this income. The amounts of revenues and expenses used to determine federal taxable income are usually similar to, but not iden- tical with, amounts measured in accordance with GAAP. The differences are suffi- ciently significant so that it is unwise to rely on income tax regulations as a basis for solving business accounting problems, or vice versa. For example, tax regulations per- mit certain kinds of businesses to report income using the modified cash basis, which, as noted above, is not in accordance with GAAP.

Unless tax rates applicable to the business are expected to increase in the future, a business usually reports in its tax returns the minimum possible amount of taxable in- come in the current year, thus postponing tax payments as much as possible to future years. It does this generally by recognizing expenses as soon as legally possible, but postponing the recognition of revenue for as long as legally possible. Note that this is a process of shifting revenue and expense from one period to another. Over the long run in most businesses, there is little difference between the total expenses and rev- enues computed for tax purposes and the total expenses and revenues computed for financial accounting. The objective of minimizing current taxes is, as the Supreme Court has pointed out, entirely legal and ethical, provided it is done in accordance with the tax regulations. It is also legal and proper under most circumstances to calculate in- come one way for tax purposes and another way for financial accounting purposes (a fact that comes as a surprise to many newcomers to accounting).

Income Tax Accounting

8 Sometimes earnings before interest, taxes, depreciation, and amortization (EBITDA) is referred to as cash earnings. This amount is, however, neither cash earnings nor accrual earnings. The earnings (E) part of EBITDA is accrual based and therefore not cash based and the exclusion of important expense items (ITDA) overstates the operating performance of the company.

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70 Part 1 Financial Accounting

Income tax regulations permit the cost of most fixed assets to be charged as expenses (i.e., depreciated) over a shorter time period than the estimated useful life of these assets and at amounts in the early years that are greater than the cost of the asset benefits consumed in those years (so-called accelerated depreciation). These practices result in higher tax- deductible expenses and correspondingly lower taxable income in the early years of an asset’s life, and therefore encourage businesses to invest in new fixed assets. Most busi- nesses use these practices in calculating their taxable income, but they use different prac- tices for financial accounting.

Although tax regulations are not described in detail in this book, references are made to accounting practices that are or are not consistent with them. The manager learns early the importance of becoming thoroughly familiar with the principal tax rules that affect the business and also the importance of consulting tax experts when unusual sit- uations arise.

Economic theory is not constrained by the practical need of reporting an income amount annually to an entity’s owners or other interested parties. Thus, in economic the- ory, income is defined as the difference between the value of a business at the end of an accounting period and its value at the beginning of the period, after proper adjustments for transactions with owners (i.e., additional paid-in capital and dividends). Both economists and accountants recognize that this economic income cannot be feasibly measured for a given accounting period. Measuring economic income would involve es- timating unrealized changes in value, including changes in the value of such intangibles as a company’s patents and brand names, whereas accounting income focuses on actual transactions that have taken place. Also, economists regard interest on all equities— both interest-bearing liabilities and owners’ equity—as an element of cost. Accountants treat only the interest on borrowings as a cost on the grounds that interest on the use of owners’ capital cannot be objectively measured. Consequently, accounting net income to an economist is a mixture of “true” income and the cost of using shareholders’ capi- tal. To an economist, accounting net income is an attempt to measure the income accru- ing to the entity’s owners; but it is an overstatement of the income earned by the entity itself because the cost of using owners’ funds has not been subtracted.

As an alternative to GAAP-based net income, some companies report a second earn- ings amount known as pro forma earnings. (Pro forma means “As if.”) This amount is net income plus certain unusual or one-time charges, such as restructuring charges and merger-related costs. The exclusion of the unusual charges in the measurement of pro forma earnings is justified on the grounds that shareholders are best served by focus- ing on a company’s core or ongoing earnings capability. In practice, this theory often breaks down since many companies that favor pro forma earnings have recurring un- usual charges. As a result, for these companies, the so-called unusual charges are usual and should be considered part of their core earnings calculation.

Economic Income

Pro Forma Earnings

This chapter described the remaining basic accounting concepts:

6. Accounting period. Accounting measures activities for a specified interval of time. 7. Conservatism. Revenues are recognized only when they are reasonably certain, whereas

expenses are recognized as soon as they are reasonably possible.

8. Realization. The amount recognized as revenue is the amount that customers are rea- sonably certain to pay.

Summary

Example

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9. Matching. When a given event affects both revenues and expenses, the effect on each should be recognized in the same accounting period. Related to the matching concept are two expense recognition criteria: (1) costs associated with activities of the period are expenses of the period and (2) costs that cannot be associated with revenues of future periods are expenses of the current period (costs associated with future periods are assets).

10. Consistency. Once an entity has decided on a certain accounting method, it will use the same method for all subsequent transactions and events of the same character unless it has a sound reason to change methods.

11. Materiality. Insignificant events may be disregarded, but there must be full disclosure of all important information.

The income statement summarizes the revenues and expenses of an entity for an accounting period. The usual accounting period is one year, but many companies prepare interim income statements on a monthly or quarterly basis. The statement of retained earn- ings explains the change in retained earnings between the balance sheets prepared as of the beginning and the end of the period.

Only accrual-basis accounting, which employs the realization and matching concepts, is permitted under GAAP. Income tax accounting regulations differ in some important respects from GAAP, including permitting certain types of businesses to calculate taxable income using modified cash-basis accounting. Economic income is a theoretical concept rather than a practical approach to measuring income.

Problems Problem 3–1.

N. Klein & Company had the following transactions in June. Using the matching concept, decide which of these transactions represented expenses for June.

a. Received orders for goods with prices totaling $25,000; goods to be delivered in July.

b. Paid office staff $9,750 for work performed in June.

c. Products in inventory costing $1,725 were found to be obsolete.

d. Sold goods with a cost of $25,000 in June.

e. Paid $750 for radio advertising in June.

f. Purchased additional inventory for $27,000. Problem 3–2.

The Hosmer Company had June sales of $275,000. The cost of goods sold was $164,000 and other cash expenses were:

Rent $ 3,300 Taxes $ 1,375 Salaries 27,400 Other 50,240

Required: What were the company’s (a) revenues, (b) expenses, and (c) net income in June?

Problem 3–3. What is cost of goods sold for the period, given the following information?

Purchases for the period $78,000 Beginning inventory 27,000 Ending inventory 31,000

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Problem 3–4. Worden Corporation has the following income statement for the year:

Income Statement For the Year Ended December 31

Sales revenues $85,000

Expenses:

Cost of goods sold $45,000

Selling and administrative expenses 25,000

Income taxes 6,000

Total expenses $76,000

Net Income $ 9,000

Required: a. Calculate

(1) Gross margin (in dollars).

(2) Gross margin percentage.

(3) Profit margin percentage.

b. Interpret the results of the above calculations.

Problem 3–5. What expense items are associated with the following transactions? When and how is the income statement affected by each one?

a. Purchased equipment for $40,000 that has a useful life of five years.

b. Purchased land for $135,000.

c. Purchased $7,000 worth of inventory on December 19. On December 27 sold one- half of the inventory for $6,000. On January 8, sold the remainder for $6,200. The company uses the calendar year for its fiscal year.

d. On January 1, subscribed to a magazine for two years. The cost was $72.

Problem 3–6. The Pierson Computer Company purchased a two-year fire insurance policy, paying the $30,000 premium in October 20�5. The policy was dated October 1, 20�5, and expired on September 30, 20�7. With respect to this policy, what were the expenses applicable to 20�5, 20�6, and 20�7, and what was the asset value (prepaid insurance) as of December 31, 20�5, 20�6, and 20�7?

Problem 3–7. QED Electronics Company had the following transactions during April while conducting its television and stereo repair business.

1. A new repair truck was purchased for $19,000.

2. Parts with a cost of $1,600 were received and used during April.

3. Service revenue for the month was $33,400, but only $20,500 was cash sales. Typi- cally, only 95 percent of sales on account are realized.

4. Interest expense on loans outstanding was $880.

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Chapter 3 Basic Accounting Concepts: The Income Statement 73

5. Wage costs for the month totaled $10,000; however, $1,400 of this had not yet been paid to the employees.

6. Parts inventory from the beginning of the month was depleted by $2,100.

7. Utility bills totaling $1,500 were paid. $700 of this amount was associated with March’s operations.

8. Depreciation expense was $2,700.

9. Selling expenses were $1,900.

10. A provision for income taxes was established at $2,800, of which $2,600 had been paid to the federal government.

11. Administrative and miscellaneous expenses were recorded at $4,700.

Required: Prepare a detailed April income statement.

Problem 3–8. Determine the amount of total assets, current assets, and noncurrent assets at the end of the period, given the following data:

Current liabilities, ending balance $ 50,000 Purchases during the period $40,000 Current ratio, ending 1.6:1 Inventory, ending balance $30,000 Owners’ equity, beginning Gross margin percentage 45%

balance $120,000 Profit margin 10% Inventory, beginning balance $ 35,000 Long-term debt, ending

balance $40,000

Diane Maynard was grateful for the balance sheets that her friend prepared [see Case 2–1, Maynard Com- pany (A)]. In going over the numbers, she remarked, “It’s sort of surprising that cash increased by $31,677, but net income was only $19,635. Why was that?”

Her friend replied, “A partial answer to that ques- tion is to look at an income statement for June. I think I can find the data I need to prepare one for you.”

In addition to the data given in the (A) case, her friend found a record of cash receipts and disburse- ments, which is summarized in Exhibit 1. She also learned that all accounts payable were to vendors for

purchase of merchandise inventory and that cost of sales was $39,345 in June.

Questions

1. Prepare an income statement for June in proper format. Explain the derivation of each item on this statement, including cost of sales.

2. Explain why the change in the cash balance was greater than the net income.

3. Explain why the following amounts are incorrect cost of sales amounts for June: (a) $14,715 and (b) $36,030. Under what circumstances would these amounts be correct cost of sales amounts?* © Professor Robert N. Anthony.

Cases

Case 3–1

Maynard Company (B)*

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Cash Receipts and Disbursements Month of June

Cash Receipts Cash Disbursements

Cash sales $44,420 Equipment purchased $23,400 Credit customers 21,798 Other assets purchased 408 Diane Maynard 11,700 Payments on accounts payable 8,517 Bank loan 20,865 Cash purchases of merchandise 14,715

Total receipts $98,783 Cash purchase of supplies 1,671 Dividends 11,700 Wages paid 5,660 Utilities paid 900 Miscellaneous payments 135

Total disbursements $67,106

Reconciliation:

Cash balance, June 1 $ 34,983 Receipts 98,783

Subtotal $133,766 Disbursements 67,106 Cash balance, June 30 $ 66,660

EXHIBIT 1

Case 3–2

Lone Pine Cafe (B)* In addition to preparing the balance sheet described in Lone Pine Cafe (A), Mr. Simpson, the accountant, agreed to prepare an income statement. He said that such a financial statement would show Mrs. Antoine how profitable operations had been, and thus help her to judge whether it was worthwhile to continue operat- ing the restaurant.

In addition to the information given in the (A) case, Mr. Simpson learned that cash received from cus- tomers through March 30 amounted to $43,480 and that cash payments were as follows:

Monthly payments to partners* $23,150 Wages to part-time employees 5,480 Interest 540 Food and beverage suppliers 10,016 Telephone and electricity 3,270 Miscellaneous 255 Rent payments 7,500

*One-third to each partner.

Questions

1. Prepare an income statement for the period of the cafe’s operations through March 30, 2010.

2. What does this income statement tell Mrs. Antoine?* Copyright © Professor Robert N. Anthony.

Case 3–3

Dispensers of California, Inc. Peter Hynes created a working model of a new and im- proved commercial paint spray, which he had patented. The patent had a legal life of 16 years remaining.

Hynes was eager to exploit his patent commer- cially, but he had no funds of his own. Several of Hynes’ friends, who had used prototypes of Hynes’

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Chapter 3 Basic Accounting Concepts: The Income Statement 75

Case 3–4

Pinetree Motel* Mr. and Mrs. Ilyong Kim had purchased the Pinetree Motel in 1998 with their life savings, supplemented by a loan from a close personal friend. The motel con-

sisted of 20 units (i.e., rentable rooms) and was located near a vacation area that was popular during both the summer and winter seasons. The Kims had entered the motel business because Mrs. Kim had long wanted to run a business of her own.* Copyright © by James S. Reece.

paint spray, offered to invest in a new corporation with a capitalization of $200,000 par value capital stock to further develop, manufacture, and market the spray and its related equipment. Before making their invest- ment, the investors asked Hynes to prepare a profit plan projecting the company’s revenues and expenses for the company’s initial year of operation along with an end-of-first-year balance sheet.

Hynes agreed to prepare the requested information incorporating the following projected transactions:

1. In return for signing his patent over to the new company, which was to be called Dispensers of California, Inc., Hynes would receive 60 percent of the company’s capital stock. For their part, the investors would contribute $80,000 cash for a 40 percent interest in the company.

2. Incorporation costs, $2,500.

3. Equipment to be used in assembling the paint spray dispensers, $85,000.

4. Out-of-pocket labor and development costs to re- design the paint spray dispenser to facilitate more efficient assembling, $25,000.

5. Component part purchases, $212,100.

6. Short-term loan from local bank, $30,000. (Loan to be repaid before the end of the year with $500 interest.)

7. Manufacturing payroll, $145,000.

8. Other manufacturing costs (excluding component part costs), $62,000.

9. Selling, general, and administration costs, $63,000.

10. Ending component parts inventory cost, $15,100.

11. Sales, $598,500 (all received in cash.)

12. All incorporation and product redesign costs ex- pensed as incurred.

13. Depreciation, $8,500. (Hynes estimated the useful life of the equipment was 10 years, with no sal- vage value.)

14. Patent cost charged to income over a six-year pe- riod (Hynes anticipated technology developments incorporating digital flow controls would signifi- cantly reduce the current products sales in about six years’ time.)

15. No inventory of unsold or partially completed dis- pensers at year end.

16. Cash dividends, $5,000.

17. Income tax expense, $22,500 (due to be paid dur- ing the next year).

18. All amounts due to employees, suppliers, and oth- ers, except for income taxes, paid in cash. (Hynes made this assumption because he wanted to present a “conservative” balance sheet to the investors.)

Questions

1. How might Hynes and the investors use the profit- plan in managing the business?

2. How might the projected transactions impact the company’s balance sheet? (Think about each trans- action in terms of its impact on both the basic ac- counting equation and specific accounts.)

3. Prepare a profit plan in the form of an income state- ment for the first year of operations.

4. Prepare a balance sheet as of the end of the first year of operations.

5. Hynes made a number of accounting decisions. Do you agree with these decisions?

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76 Part 1 Financial Accounting

Both Mr. and Mrs. Kim felt that they had been suc- cessful. Each year saw a growth in revenue from room rentals. Furthermore, their bank balance had in- creased. They noted that many of their customers re- turned year after year. This was attributed to their lo- cation and their efforts to provide consistently clean rooms and up-to-date furnishings.

The Kims had no formal business training but felt their experience since acquiring the motel had alerted them to the management problems involved. Both Mr. and Mrs. Kim devoted their full time to operating the motel. In addition, they hired part-time help for daily room-cleaning work. They had no dining facilities but had installed vending machines to supplement room rentals. The vending machines posed no inventory or maintenance problems as the vending machine com- pany provided servicing and maintenance.

A frequent guest at Pinetree Motel was Marcus Carter, controller of a large company. Mr. Carter vis- ited a company branch plant near the motel several times a year. As he stayed at the motel during these trips, he became acquainted with the Kims.

In May 2006 Mrs. Kim showed Mr. Carter the cur- rent issue of a motel trade journal that contained oper- ating data for motels with 40 or fewer units for the calendar year 2005. Mrs. Kim commented: “These figures show a profit of 21 percent. Our profit last year was $134,003 on sales of $244,461, or 55 percent. We think 2005 was our best year to date, but we can’t make our figures jibe with those in the magazine, and we wonder if we really are 34 percent ahead of the in- dustry average. Can you help us?”

Mr. Carter was interested and willing to help. He told Mrs. Kim to get the available figures for 2005 so that he could look them over that evening. The princi- pal records the Kims kept to reflect the motel’s finan- cial transactions were a record of receipts taken from the cash register and a checkbook describing cash paid out. In addition, certain rough notations of other ex- penses incurred were available.

That evening Mrs. Kim showed Mr. Carter the cash summary for the year 2005, as given in Exhibit 1. Mr. Carter immediately noted that the difference between receipts and expenditures was $47,903 and asked Mrs. Kim to explain why she had stated the profit was $134,003. Mrs. Kim replied, “Oh, that’s easy. Our drawings aren’t expenses; after all, we are the owners. My husband and I have consistently taken only about $85,000 a year out because we want the rest of the profits to accumulate in the business. As I said, our

bank balance has steadily risen. Furthermore, I have a local accountant make out the annual income tax state- ments so I don’t have to worry about them. That in- come tax stuff is so complicated that I avoid it.”

Mr. Carter worked with the trade journal’s figures (Exhibit 2) and the cash summary (Exhibit 1) that evening and quickly found he needed more informa- tion. He told Mrs. Kim that he was returning to the home office the next morning but would be back in two weeks for another visit to the branch plant. Mean- while, he wanted Mrs. Kim to get together some addi- tional information. Mr. Carter suggested to Mrs. Kim that an important noncash expense was depreciation. Mr. Carter also wanted to know about expenses that had been incurred in 2004 but not paid until 2005. He told Mrs. Kim to check up on wages and salaries, in- surance, advertising, taxes, utilities, and any other items paid in 2005 but applicable to 2004.

In addition, Mr. Carter instructed Mrs. Kim to try to find items of expense properly chargeable to 2005 but not paid by December 31, 2005. Mrs. Kim told Mr. Carter the same types of expenses were involved, that is, wages and salaries, insurance, advertising, taxes,

Receipts

From rooms $236,758 From vending machines 7,703

Total $244,461

Checks Drawn

Owners’ drawings $ 86,100 Wages and salaries 26,305 Paid to laundry 8,800 Replacement of glasses, bed linens,

and towels 1,660 Advertising 2,335 Payroll taxes 2,894 Fuel for heating 12,205 Repairs and maintenance 8,980 Cleaning and other supplies 6,820 Telephone 2,789 Electricity 5,611 Property taxes 9,870 Insurance 11,584 Interest 10,605

Total $196,558

EXHIBIT 1 Cash Register and Checkbook Summary During 2005

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Chargeable in 2004 but paid in January 2005: Wages and salaries $795 Advertising 600 Payroll taxes 84 Fuel for heating 933 Telephone 105 Electricity 360 Property taxes 1,005 Insurance 2,025 Interest 687

Chargeable in 2005 but not paid by December 31, 2005:

Wages and salaries 1,128 Advertising 996 Payroll taxes 126 Fuel for heating 840 Cleaning and other supplies 75 Telephone 153 Electricity 492 Property taxes 1,119 Interest 579

Also, 2005 depreciation charges of $30,280.

Also, 2005 cash receipts included a $1,660 payment from a company that had rented several units during December 2004 for a convention in the nearby city. There were no such uncollected rentals as of December 31, 2005.

EXHIBIT 3 Additional Information about the Business

and percentage composition of each expense for more useful comparison with the journal’s figures.

Questions

1. Prepare a 2005 operating statement for the Pinetree Motel such as the one shown in Exhibit 2 showing dollar amounts and percentages of total revenues.

2. As Mr. Carter, what comments would you make to the Kims regarding the motel’s progress to date?

Case 3–5

National Association of Accountants1,* Each December the incoming members of the board of directors of the National Association of Accountants (NAA) met in joint session with the outgoing board as a 1 Disguised name. * © Professor Robert N. Anthony.

means of smoothing the transition from one administra- tion to another. At the meeting in December 2005, ques- tions were raised about whether the board had adhered to the general policies of the association. The ensuing discussion became quite heated.

and so forth. Also Mr. Carter inquired about income from room rentals. He asked if any of the cash receipts dur- ing 2005 related to rentals during 2004 and if there were any rentals during 2005 that had not been collected.

During the two weeks Mr. Carter was back at the home office, Mrs. Kim checked the records and com- piled the additional information requested by Mr. Carter. The evening Mr. Carter returned to the Pinetree Motel, Mrs. Kim gave him a summary of the information she had gathered (Exhibit 3). With all the additional infor- mation, Mr. Carter constructed a 2005 operating state- ment that matched in form the one appearing in the trade journal. He calculated both the dollar amounts

Revenues: Room rentals 98.7 Other revenue 1.3

Total revenues 100.0 Operating expenses:

Payroll costs 22.5 Administrative and general 4.2 Direct operating expenses 5.9 Fees and commissions 3.3 Advertising and promotion 1.2 Repairs and maintenance 4.8 Utilities 7.5 Total 49.4

Fixed expenses: Property taxes, fees 4.4 Insurance 2.5 Depreciation 12.5 Interest 7.7 Rent 2.8 Total 29.9

Profit (pretax) 20.7

EXHIBIT 2 2005 Operating Data for Motels with 40 or Fewer Units (expressed as percentages of total revenues)

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EXHIBIT 1

Estimated Income Statement Year Ending December 31, 2005

Revenues: Membership dues $287,500 Journal subscriptions 31,000 Publication sales 11,900 Foundation grant 54,000 2000 annual meeting, profit 3,400

Total revenues 387,800

Expenses: Printing and mailing publications 92,400 Committee meeting expense 49,200 Annual meeting advance 10,800 Desktop publishing system 27,000 Administrative salaries and expenses 171,500 Miscellaneous 25,000

Total expenses 375,900 Surplus $ 11,900

NAA was a nonprofit professional association with 3,000 members. The association published two profes- sional journals, arranged an annual meeting and sev- eral regional meetings, appointed committees that developed positions on various topics of interest to the membership, and represented the members before standards-setting bodies.

The operating activities of the association were managed by George Tremble, its executive secretary. Mr. Tremble reported to the board of directors. The board consisted of four officers and seven other mem- bers. Six members of the 2006 board (i.e., the board that assumed responsibility on January 1, 2006) were also on the 2005 board; the other five members were newly elected. The president served a one-year term.

The financial policy of the association was that each year should “stand on its own feet”; that is, ex- penses of the year should approximately equal the rev- enues of the year. If there was a deficit in 2005, this amount would normally be made up by a dues increase in 2006.

At the meeting in December 2005, Mr. Tremble presented an estimated income statement for 2005 (Exhibit 1). Although some of the December transac- tions were necessarily estimated, Mr. Tremble assured the board that the actual totals for the year would closely approximate the numbers shown.

Wilma Fosdick, one of the newly elected board members, raised a question about the foundation grant of $54,000. She questioned whether this item should be counted as revenue. If it were excluded, there was a deficit; and this showed that the 2005 board had, in effect, eaten into reserves and thus made it more difficult to provide the level of service that the members had a right to expect in 2006. This led to detailed questions about items on the income statement, which brought forth the following information from Mr. Tremble.

1. In 2005 NAA received a $54,000 cash grant from the Beckwith Foundation for the purpose of financ- ing a symposium to be held in June 2006. During 2005 approximately $2,700 was spent in prelimi- nary planning for this symposium and was included in Committee Meeting Expenses. When asked why the $54,000 had been recorded as revenue in 2005 rather than in 2006, Mr. Tremble said that the grant was obtained entirely by the initiative and persua- siveness of the 2005 president, so 2005 should be given credit for it. Further, although the grant was intended to finance the symposium, there was no legal requirement that the symposium be held; if for any reason it was not held, the money would be used for the general operations of the association.

2. In early December 2005 the association took deliv- ery of, and paid for, a new desktop publishing sys- tem costing $27,000. This system would greatly simplify the work of preparing membership lists, correspondence, and manuscripts submitted for publication. Except for this new system, the type- writers, desks, and other equipment in the associa- tion office were quite old.

3. Ordinarily, members paid their dues during the first few months of the year. Because of the need to raise cash to finance the purchase of the desktop publish- ing system, the association announced in Septem- ber 2005 that members who paid their 2006 dues before December 15, 2005, would receive a free copy of the book of papers presented at the special symposium to be held in June 2006. The approxi- mate per-copy cost of publishing this book was $16, and it was expected to be sold for $18. Conse- quently, $32,400 of 2006 dues were received by December 15, 2005; they were included in 2005 revenue.

4. In July 2005 the association sent a membership di- rectory to members. Its long-standing practice was to publish such a directory every two years. The

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Chapter 3 Basic Accounting Concepts: The Income Statement 79

cost of preparing and printing this directory was $23,200. Of the 4,000 copies printed, 3,000 were mailed to members in 2005. The remaining 1,000 were held to meet the needs of new members who would join before the next directory came out; they would receive a free copy of the directory when they joined.

5. Members received the association’s journals at no extra cost, as a part of the membership privi- leges. Some libraries and other nonmembers also subscribed to the journals. The $31,000 reported as subscription revenue was the cash received in 2005. Of this amount, about $8,100 was for journals that would be delivered in 2006. Offsetting this was $5,400 of subscription revenue received in 2004 for journals delivered in 2005; this $5,400 had been re- ported as 2004 revenue.

6. The association had advanced $10,800 to the com- mittee responsible for planning the 2005 annual meeting held in late November. This amount was

used for preliminary expenses, and was included as 2005 Committee Meeting Expense. Registration fees at the annual meeting were set so as to cover all convention costs, so that it was expected that the $10,800, plus any profit, would be returned to the association after the committee had finished paying the convention bills. The 2004 convention had re- sulted in a $3,400 profit, but the results of the 2005 convention were not known, although the revenues and expenses were about as anticipated.

Questions

1. Did the association have an excess (revenues greater than expenses) or a deficit (expenses greater than revenues) in 2005?

2. Should the amount of surplus or deficit in 2005 af- fect the decision to change the annual dues for 2006?

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4 Accounting Records and Systems

Chapter

As we emphasized in Chapter 2, each individual accounting transaction can be recorded in terms of its effect on the balance sheet. For example, the Music Mart illustration in Chapter 2 starts with the item “Cash, $25,000” on the January 1 balance sheet and then records the transaction on January 2 involving an increase of $12,500 in cash in effect by erasing the $25,000 and entering the new number, $37,500. Although this procedure was appropriate as an explanatory device, it is not a practical way of handling the many transactions that occur in the actual operations of an organization.

This chapter describes some of the accounting procedures that are used in practice. No new accounting concepts are introduced. The procedures described here provide the mechanical means for making it easier to record and summarize transactions. Al- though most organizations use computer-based accounting systems, we describe the procedures used in a manual system because the basic steps in either type of system are the same and it is easier to visualize these steps in a manual system.

Recordkeeping Fundamentals

We are not concerned here with recordkeeping procedures for the purpose of training bookkeepers. Nevertheless, some knowledge of these procedures is useful for at least two reasons. First, as is the case with many subjects, accounting is something that is best learned by doing—by solving problems. Although any accounting problem can be solved without the aid of the tools discussed in this chapter, using these tools will often speed up the problem-solving process considerably. Second, the debit-and-credit mechanism, which is the principal technique discussed here, provides an analytical framework that is similar in function to and offers the same advantages as the symbols and equations used in algebra.

In all except the smallest companies, the bookkeeping work is done on a computer. However, the computer records much detail about most transactions, and describing this detail would obscure the description of what is going on. Therefore, we focus on what is actually happening by assuming that the records are kept manually.

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Assume that the item “Cash, $10,000” appears on a balance sheet. Subsequent cash transactions can affect this amount in only one of two ways: They can increase it or they can decrease it. Instead of increasing or decreasing the item by erasing the old amount and entering the new amount for each transaction, considerable effort can be saved by collecting all the increases together and all the decreases together and then pe- riodically calculating the net change resulting from all of them. This can be done by adding the sum of the increases to the beginning amount and then subtracting the sum of the decreases. The difference is the new cash balance.

In accounting, the device called an account is used for calculating the net change. The simplest form of account, called a T account, looks like the account shown in Illustration 4–1. Because this account is for a brand-new entity (to be described later in this chapter), its beginning balance is zero.

The saving in effort made possible by T accounts can be seen even from this brief il- lustration. If the balance were changed for each of the eight items listed, four additions and four subtractions would be required. By using the account device, the new balance is obtained by only two additions (to find the 21,200 and 15,750) and one subtraction (21,200 � 15,750).

The accounts maintained for the various items on the balance sheet are called perma- nent (or real) accounts. At the end of each accounting period, the balance of each per- manent account is determined—each account is “balanced.” These balances are the numbers reported in the balance sheet as of the end of the period. The period-ending balance in a permanent account is carried forward into the next accounting period as that period’s beginning balance.

Recall that revenues and expenses are respectively increases and decreases in re- tained earnings arising from the entity’s earnings activities. Although revenue and ex- pense transactions could be entered directly in the Retained Earnings account, this is not done in practice. Entering revenue and expense items directly to Retained Earnings would result in an intermingling of the many specific items that are required to prepare the income statement. All of these items would have to be “sorted out”—classified by income statement categories—if they were intermingled.

To avoid cluttering the Retained Earnings account, a temporary account is estab- lished for each revenue and expense item that will appear on the income statement. Thus, there are temporary accounts for sales revenues, cost of sales, selling expenses, and so on. Revenue and expense transactions are recorded in their respective temporary

The Account

Permanent Accounts and Temporary Accounts

ILLUSTRATION 4–1 Example of a T Account

Cash

(Increases) (Decreases)

Beginning balance –0–

5,000 750

4,000 7,200

200 4,800

12,000 3,000

21,200 15,750

New balance 5,450

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82 Part 1 Financial Accounting

accounts as the period progresses. This procedure creates a “sort as you go” routine for these transactions instead of leaving them to be sorted at the end of the period. For ex- ample, all of the entries to the Sales Revenue account can be added at the end of the pe- riod to arrive at the amount of sales for the income statement. At the end of the ac- counting period, all of the income statement temporary account sums are combined into one net income amount, which is then entered in the Retained Earnings account. Thus, in practice, Retained Earnings has fewer entries made to it than almost any other permanent account. (The process of combining the temporary account sums into one amount for the net change in retained earnings will be illustrated later in the chapter.)

A ledger is a group of accounts. In a manual system, it may be a bound book with the title “general ledger” printed on the cover. Inside are pages, one (or more) for each ac- count. All the accounts of a small business could be maintained in such a book. The ledger is not necessarily a bound book, however. It may consist of a set of loose-leaf pages, or, with computers, a set of impulses on a CD or tape.

The accounts included in a company’s system are listed in a chart of accounts. The list often is arranged according to the items reported on the balance sheet, that is, with Cash at the beginning and Retained Earnings at the end.

For most items, there are detailed accounts, and there may be several levels of this detail. For example, beneath the Cash account, there will be an account for each bank with which the company has deposits and, for each bank, there may be an account for each checking account, money market account, and other cash equivalents. The entries are made only to the accounts in the lowest level in this hierarchy, for example, the checking account at Bank A. In most systems, amounts are automatically added to accounts in the highest levels of the hierarchy when an entry at the lowest level is recorded. For example, a deposit of $1,000 in the checking account of Bank A would be recorded in Checking Account, Bank A; it would also add $1,000 to the Cash Bank A account, and $1,000 to the Cash account.

In developing the chart of accounts, the system designer must anticipate all the in- formation that management might at some time want. If, for example, management wanted to know the respective level of activity of the checking account and the money market account at Bank A, and the system of accounts could not provide this informa- tion, the system would be inadequate. A code number is assigned to each account; this simplifies the task of recording. In a computer-based accounting system, an XBRL tag also may be attached to the account and its underlying components to facilitate extrac- tion on demand and analysis of the data.

Financial information related to sales revenue is often recorded in considerable detail: the item sold, the product line containing that item, the branch that made the sale, and even the responsible salesperson. Accounts are established for each of these possibilities. Conse- quently, many large companies have tens of thousands of accounts.

The accounts for balance sheet and income statement items are often referred to as general ledger accounts, a holdover from the manual system in which these accounts were recorded in a bound book called a ledger.

The left-hand side of any account is arbitrarily called the debit side, and the right-hand side is called the credit side. Amounts entered on the left-hand side are called debits, and amounts entered on the right-hand side are called credits. The verb to debit means to make an entry in the left-hand side of an account, and the verb to credit means to

The Ledger

The Chart of Accounts

Example

Debit and Credit

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Chapter 4 Accounting Records and Systems 83

make an entry in the right-hand side of an account. The words debit and credit have no other meaning in accounting.

In ordinary usage, these words do have other meanings. Credit has a favorable con- notation (such as, “she is a credit to her family”) and debit has an unfavorable conno- tation (such as, “chalk up a debit against him”). In accounting these words do not imply any sort of value judgment; they mean simply “left” and “right.” Debit and credit are usually abbreviated as dr. and cr.1

If each account were considered by itself without regard to its relationship to other accounts, it would make no difference whether increases were recorded on the debit side or on the credit side. In the 15th century, a Franciscan monk, Luca Pacioli, de- scribed a method of arranging accounts so that the dual aspect present in every ac- counting transaction would be expressed by a debit amount and an equal and offsetting credit amount.

This method made possible the following rule, to which there is absolutely no ex- ception: For each transaction, the debit amount (or the sum of all the debit amounts, if there are more than one) must equal the credit amount (or the sum of all the credit amounts). This is why bookkeeping is called double-entry bookkeeping. It follows that the recording of a transaction in which debits do not equal credits is incorrect. For all the accounts combined, the sum of the debit balances must equal the sum of the credit balances; otherwise something has been done incorrectly. Thus, the debit and credit arrangement used in accounting provides a useful means of checking the accuracy with which the transactions have been recorded.

Pacioli based his procedures on the fundamental equation, Assets � Liabilities � Owners’ equity. He arbitrarily decided that asset accounts should increase on the left- hand, or debit, side. That decision immediately led to the rule that asset accounts must decrease on the right-hand, or credit, side. Given those rules for asset accounts, it fol- lowed that (1) in order for debits to equal credits and (2) in order to maintain the fun- damental accounting equation, then the rules for liability and owners’ equity accounts had to be the opposite from those for assets. Liability and owners’ equity accounts increase on the right-hand—credit—side, and they decrease on the left-hand—debit— side. Schematically, these rules are

Assets � Liabilities � Owners’ Equity

Debit Credit Debit Credit Debit Credit

� � � � � �

The rules for recording revenues and expenses are derived from the rules for own- ers’ equity. By definition, a revenue increases owners’ equity (more specifically, re- tained earnings in a corporation), and owners’ equity increases on the credit side. It necessarily follows that revenues are credits. If revenues decrease, such as for a sales return, the decrease in revenues must therefore be a debit.

Expenses are the opposite of revenues in that expenses decrease owners’ equity. Therefore, the rule for expenses must be the following: Expenses are debits. It is also commonly said that an expense account has been charged when it has been debited. If an expense needs to be reversed (such as when returned goods are put back into inventory, thus reversing the cost of sales entry that was made when the goods were originally sold), the decrease in expenses is a credit.

1 The noun debit is derived from the Latin debitur, which means debtor. Credit is derived from the Latin creditor, which means lender. Apparently the dr. and cr. abbreviations came from the first and last letters of these Latin words. In accounting, debit and credit do not mean debtor and creditor.

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84 Part 1 Financial Accounting

Mastering these rules requires practice in using them rather than sheer memoriza- tion. We will therefore begin that practice by introducing you to the accounting process and first recording a simple set of transactions.

The Accounting Process

The next section of the chapter describes the accounting process. It consists of these six steps:

1. The first and most important part of the accounting process is the analysis of transac- tions. This is the process of deciding which account or accounts should be debited, which should be credited, and in what amounts, in order to reflect events in the ac- counting records. This requires both a knowledge of accounting concepts and judgment.

2. Next comes the purely mechanical step of journalizing original entries—recording the results of the transaction analysis in the journal.

3. Posting is the process of recording changes in the ledger accounts exactly as speci- fied by the journal entries. This is also purely mechanical.

4. At the ending of the accounting period, judgment is involved in deciding on the adjusting entries. These are journalized and posted in the same way as original entries.

5. The closing entries are journalized and posted. This is a purely mechanical step. 6. Financial statements are prepared. This requires judgment as to the best arrange-

ment and terminology, but the numbers that are used result from the judgments made in steps 1 and 4.

These six steps are taken sequentially during an accounting period and are repeated in each subsequent period. The steps are therefore commonly referred to as the ac- counting cycle. Illustration 4–2 depicts the accounting cycle schematically. Note that the ending balance sheet account balances from step 6 become the beginning balances for the next repetition of the cycle. Some accountants use a worksheet in the latter steps of the accounting cycle.

1. Analyze transactions

2. Journalize original entries

3. Post journal entries to ledger Ending balance sheet account balances from step 6 become beginning balances for repetition of the cycle in the next accounting period.4. Identify, journalize, and post

adjusting entries

5. Journalize and post closing entries

6. Prepare financial statements

ILLUSTRATION 4–2 The Accounting Cycle

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Chapter 4 Accounting Records and Systems 85

Transaction Analysis

Before it is recorded, a transaction must be analyzed to determine its dual effect on the entity’s accounts. This analysis results in a decision on which account is to be debited and which is to be credited. The result of the transaction analysis must preserve the two basic identities: (1) Assets � Liabilities � Owners’ equity and (2) Debits � Credits. The be- ginner often finds that half of the accounting entry—particularly a change in cash—is relatively obvious, but that the other half—often a change in retained earnings—is less obvious. Our advice is to first record whichever half of the entry is more obvious, whether it is the debit or the credit portion, and then figure out the less obvious half.

Meredith Snelson started Campus Pizzeria, Inc., on August 1. Snelson was the sole owner of the corporation. The following transactions all took place in August. Rev- enue and expense transactions represent summaries of sales and expenses for the entire month; in practice such entries could be made every day. We will present each transaction, analyze it, and show how it would be entered in the accounts. Each trans- action is numbered and its number is shown parenthetically beside the entry in the account. (This is a good practice for the reader to employ when working on similar problems.)

1. On August 1, Snelson invested $5,000 in the business as owner.

Example: Campus Pizzeria, Inc.

Analysis: This transaction increased Cash (a debit). Liabilities were not affected because the $5,000 was not a loan; rather, it was contributed capital. Thus, the owner’s eq- uity account, Paid-In Capital, increased (a credit). This is an equity financing transaction.

Cash

(1) 5,000

Paid-In Capital

(1) 5,000

Analysis: Cash decreased (a credit). The rent has been paid in advance; thus, it is an asset, because the benefits of using the rented space have not yet been received. Prepaid Expenses is increased (a debit). This is an asset acquisition transaction: prepaid rent was acquired in exchange for cash.

Cash

(1) 5,000 (2) 750

Prepaid Expenses

(2) 750

2. On August 1, the firm paid $750 rent for the month of August.

Analysis: This was a debt financing transac- tion. Cash increased (a debit) by the $4,000 proceeds of the loan. The liability, Notes Payable, increased by an equal amount (a credit).

Cash

(1) 5,000 (2) 750 (3) 4,000

Notes Payable

(3) 4,000

3. The firm borrowed $4,000 from a bank on a 9 percent note payable, with in- terest payable quarterly and the principal due in full at the end of two years.

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86 Part 1 Financial Accounting

4. Equipment costing $7,200 was purchased for cash. The expected life of the equipment was 10 years.

Analysis: Cash decreased by $7,200 (a credit). The equipment will provide benefits for several years, so it is an asset. The ac- count Equipment, at Cost, is increased by $7,200 (a debit). This was an asset acquisi- tion transaction: The equipment was ac- quired in exchange for cash.

Cash

(1) 5,000 (2) 750 (3) 4,000 (4) 7,200

Equipment, at Cost

(4) 7,200

Analysis: These items will be used in the fu- ture, so they are an asset. Inventory is in- creased by $800 (a debit). The firm has not yet paid for these items but is obligated to do so at some future time. Thus, the liability, Accounts Payable, is increased by $800 (a credit).

Inventory

(5) 800

Accounts Payable

(5) 800

Analysis: Cash increased by $12,000. This cash increase did not arise from a liability; nor did the owner make an additional invest- ment. The cash was earned by selling pizzas to customers. This is an earnings transaction, which increases retained earnings. Rather than directly increasing Retained Earnings (a credit), we will increase Sales Revenues, a temporary account.

Cash

(1) 5,000 (2) 750 (3) 4,000 (4) 7,200

(6) 12,000

Sales Revenues

(6) 12,000

Analysis: Cash was decreased (a credit) by $3,000. Wages represent labor resources consumed in providing the pizzeria’s services to its customers. This is therefore an earnings transaction that reduces retained earnings. Rather than directly decreasing Retained Earnings (a debit), we will enter the expense in a temporary account, Wage Expense.

Cash

(1) 5,000 (2) 750 (3) 4,000 (4) 7,200

(6) 12,000 (7) 3,000

Wage Expense

(7) 3,000

2 Because this is an introductory example, we are disregarding certain real-world complications such as payroll taxes.

5. An initial inventory of pizza ingredients and boxes was purchased on credit for $800.

6. In August pizza sales were $12,000, all for cash.

7. During August the pizzeria’s employees were paid $3,000 in wages.2

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8. During the month, an additional $5,750 of ingredients and boxes was pur- chased on credit.

Analysis: These items have been removed from Inventory, so that asset account is re- duced (credited). Resources consumed in generating sales revenues are expenses. Again, rather than directly reducing Re- tained Earnings, the $6,000 debit is made to a temporary account, Cost of Sales. This is an earnings transaction.

Inventory

(5) 800 (9) 6,000 (8) 5,750

Cost of Sales

(9) 6,000

Analysis: The bills have not yet been paid, so Accounts Payable is increased by $450 (a credit). This liability is an expenditure for the utilities that were used (consumed) in August’s earnings activities. These resources are thus an expense of August, and are deb- ited to Utilities Expense, a temporary account.

Accounts Payable

(5) 800 (8) 5,750

(10) 450

Utilities Expense

(10) 450

Analysis: Paying bills obviously decreases Cash (a credit). It also reduces the obliga- tion the entity has to its vendors, so Ac- counts Payable is also reduced (a debit).

Cash

(1) 5,000 (2) 750 (3) 4,000 (4) 7,200 (6) 12,000 (7) 3,000

(11) 4,800

Accounts Payable

(11) 4,800 (5) 800 (8) 5,750

(10) 450

Analysis: Except for the amount, this transac- tion is identical to transaction 5 on page 86. Thus, Inventory is increased (debited) and Accounts Payable is increased (credited) by $5,750.

Inventory

(5) 800 (8) 5,750

Accounts Payable

(5) 800 (8) 5,750

9. August sales consumed $6,000 of ingredients and boxes.

10. At the end of the month, bills for various utilities used in August were re- ceived, totaling $450.

11. During the month, $4,800 of accounts payable was paid.

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88 Part 1 Financial Accounting

12. On August 13, the firm catered a party for a fee of $200. Because the cus- tomer was a friend of Snelson, the customer was told that payment could be made later in the month.

13. On August 29, a check was received from Snelson’s friend for the party of August 13.

This completes—for the moment—the August transactions for Campus Pizzeria, Inc.

The transactions we recorded above are called original entries. Such entries are those that obviously need to be made because a check has been written, an invoice has been received, sales have been made, and so on. After recording these original entries, a bal- ance is taken in each account.

An asset account is balanced as illustrated earlier in the chapter for Cash: The entries on each side are added up; then the sum of the credits is subtracted from the sum of the debits to get the new balance. An asset account’s balance is a debit amount. (Asset ac- counts are thus called debit-balance accounts.) The balance in Cash is $5,450. (Be- cause Cash is an asset account, it is understood that the balance is a debit amount.)

Illustration 4–3 shows the formal procedure for ruling and balancing an asset ac- count. This is similar to what was shown in Illustration 4–1, except that there the line “To Balance 5,450” was omitted because we were just introducing the idea of an ac- count. The “To Balance” entry goes with the new “Balance” entry, thus preserving the rule that no debit (here, for the new balance) is made without making an equal credit (here, “To Balance”). The double rules under the two $21,200 totals indicate that all of the information appearing above the double rules has been captured in the new bal- ance that appears below the double rules. The procedure for ruling and balancing a li- ability account is completely analogous to that just described for an asset account.

The formal procedure for the temporary revenue and expense accounts differs slightly from that for the permanent accounts, as will be described below. At this point, all that is necessary is to find the sum of the credits in the Sales Revenues account and the sum of the debits in each expense account (which is trivial here because no expense account had more than one debit).

Analysis: Because services have been ren- dered, revenues have been earned. Thus, increase (credit) the temporary Sales Rev- enues account by $200. Since this was not a cash sale, the asset increased (debited) is Accounts Receivable. This is an earnings transaction.

Sales Revenues

(6) 12,000 (12) 200

Accounts Receivable

(12) 200

Analysis: Payment (collection) of a receiv- able increases Cash (a debit). It also elimi- nates the receivable asset, so Accounts Receivable is decreased by $200 (a credit).

Cash

(1) 5,000 (2) 750 (3) 4,000 (4) 7,200 (6) 12,000 (7) 3,000

(13) 200 (11) 4,800

Accounts Receivable

(12) 200 (13) 200

Balancing Accounts

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After determining the balance of each account, a trial balance is taken. A trial balance is simply a list of the account names and the balances in each account as of a given mo- ment of time, with debit balances shown in one column and credit balances in another column. The preparation of a trial balance serves two principal purposes: (1) It shows whether the equality of debits and credits has been maintained and (2) it provides a convenient summary transcript of the ledger records as a basis for making the adjust- ing and closing entries (described in the next section) that precede the preparation of the period’s financial statements.

Campus Pizzeria’s trial balance is shown in Illustration 4–4. Because Campus Pizzeria was a new entity as of August 1, all the permanent (balance sheet) accounts had a zero beginning balance. As a result, the August 31 balances are based entirely on the 13 entries thus far recorded. In successive accounting periods, the entity’s perma- nent accounts will have nonzero beginning balances. (We suggest that, as practice, the reader verify each amount in Illustration 4–4.)

Although the trial balance shows that total debits equal total credits and thus indi- cates that the integrity of the basic accounting equation has been maintained, it does

Cash

Balance –0– 750

5,000 7,200

4,000 3,000

12,000 4,800

200 To Balance 5,450

21,200 21,200

Balance 5,450

ILLUSTRATION 4–3 Balancing an Account

ILLUSTRATION 4–4 A Trial Balance

CAMPUS PIZZERIA, INC. Trial Balance

As of August 31

Balance

Account Debit Credit

Cash $ 5,450 Accounts receivable –0– Inventory 550 Prepaid expenses 750 Equipment, at cost 7,200 Accounts payable $ 2,200 Notes payable 4,000 Paid-in capital 5,000 Sales revenues 12,200 Cost of sales 6,000 Wage expense 3,000 Utilities expense 450_______ _______

Totals $23,400 $23,400_______ _______________ ________

The Trial Balance

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not prove that errors have not been made. Entries may have been omitted entirely, or they may have been posted to the wrong account. Offsetting errors may have been made, or a transaction may have been analyzed incorrectly. For example, if the debit for the purchase of a piece of equipment were made incorrectly to an expense account rather than correctly to an asset account, the totals of the trial balance would not be affected.

The Adjusting and Closing Process

Most entries to be made in the accounts are original entries. However, some events that affect the accounts are not evidenced by the obvious documents associated with origi- nal entries. The effects of these events are recorded at the end of the accounting period by means of adjusting entries. The purpose of the adjusting entries is to modify ac- count balances so that they will fairly reflect the situation as of the end of the period.

Continuous Transactions Most adjusting entries are made in connection with events that are, in effect, continu- ous transactions. Consider a tankful of fuel oil purchased for $1,000. On the day of de- livery, the $1,000 of fuel oil was an asset. But each day thereafter, some fuel oil was consumed in the furnace, whereupon part of the $1,000 became an expense. Rather than record this consumption daily, a single adjusting entry is made at the end of the accounting period to show how much of the fuel oil is still an asset at that time and how much has become expense during the period. For example, if $600 was consumed and hence became an expense, $400 remains as an asset.

There are two ways of handling these events, both of which give the same result. Under one method, the $1,000 expenditure is originally recorded as an asset, Fuel Oil Inventory, as in the following entry:

Fuel Oil Inventory Accounts Payable

1,000 1,000

At the end of the accounting period, the Fuel Oil Inventory asset account is adjusted by subtracting the cost of fuel oil consumed, thus:

Fuel Expense Fuel Oil Inventory

600 600

Under the other method, the $1,000 expenditure for fuel oil is originally recorded in an expense account (instead of an inventory account). Then the fuel oil remaining at the end of the period is subtracted from expense and shown as a Fuel Oil Inventory asset, thus:

Fuel Oil Inventory Fuel Expense

400 400

Although neither method reflects the correct facts within the period (with the trivial exception that the first method does reflect the facts on the day the oil was delivered), both reflect a correct statement of the facts as of the end of the accounting period. Because accounting focuses on deriving the proper amounts for the statements that

Adjusting Entries

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are prepared at the end of the accounting period, the choice between these methods depends solely on which is more convenient.

Types of Adjusting Entries Events that require adjusting entries essentially relate to the difference between ex- pense and expenditure and between revenue and receipts, discussed in Chapter 3. Four types of such events, together with examples of each, are given below:

1. Recorded costs to be apportioned among two or more accounting periods. The fuel oil transaction given above is one example. Another is a two-year insurance policy costing $1,600, originally recorded as Prepaid Insurance (an asset), $800 of which becomes an expense in the current year:

Insurance Expense Prepaid Insurance

800 800

When an asset is reduced, as prepaid insurance was here, it is said that there has been a write-off of part (or all) of the asset.

2. Unrecorded expenses. These expenses were incurred during the period, but no record of them has yet been made. Example: For $150 of wages earned by an em- ployee during the period but not yet paid to the employee:

Wage Expense Accrued Wages

150 150

3. Recorded revenues to be apportioned among two or more accounting periods. As was the case with recorded costs (insurance example), these amounts were initially recorded in one account and, at the end of the accounting period, must be properly divided between a revenue account and a liability account. For example, rent col- lected during the period and recorded as rent revenue, $600 of which is applicable to the next period and hence is a liability at the end of the current period:

Rent Revenue Unearned Rent Revenue

600 600

4. Unrecorded revenues. These revenues were earned during the period, but no record of them has yet been made. For example, $120 of interest earned by the entity dur- ing the period but not yet received:

Accrued Interest Receivable Interest Revenue

120 120

Depreciation Most long-lived assets give up their benefits to the entity in a continuous stream. Thus, the cost of these assets is continuously being converted to an expense (written off) in the same manner as the current assets—fuel oil and prepaid insurance—that were discussed previously. The item that shows the portion of such long-lived asset costs that has become expense during an accounting period is called depreciation expense. Instead of subtracting the depreciation expense for the period directly from the asset amount—

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instead of crediting depreciation to the account for the asset being depreciated—the credit is made to a separate account, Accumulated Depreciation. The adjusting entry to record the depreciation expense for a period is therefore in the following form:

Accumulated Depreciation Expense Depreciation

2,000 2,000

There is a reason for crediting depreciation to Accumulated Depreciation rather than directly to the asset. Generally accepted accounting principles (GAAP) require sepa- rate disclosure of (1) the original cost of the entity’s depreciable assets and (2) the de- preciation that has been accumulated on these assets from the time they were acquired until the date of the balance sheet. Keeping these two items separate in the accounts fa- cilitates the necessary disclosure, which appears on the balance sheet as follows:

Equipment, at cost $10,000

Less: Accumulated depreciation 2,000

Net equipment $8,000

Accumulated depreciation is called a contra asset account because it is subtracted from some other asset account. Another contra asset account is Allowance for Doubt- ful Accounts, described below.

Other Adjustments Accountants make a variety of other adjusting entries in order to make the accounts re- flect fairly the results of the entity’s operations during the period and its status as of the end of the period. An example, discussed in more detail in Chapter 5, is bad debt ex- pense. This is an adjustment made in order to recognize the likelihood that not all credit customers will pay their bills, and, thus, the Accounts Receivable account may overstate the realizable amount of those bills. An adjusting entry that records the write- off of receivables for the estimated amount of bad debts is as follows:

Allowance for Bad Debt Expense Doubtful Accounts

300 300

On the balance sheet, the accumulated allowance for doubtful accounts is subtracted from accounts receivable, thus:

Accounts receivable, gross $10,000

Less: Allowance for doubtful accounts 300

Net accounts receivable $9,700

A Caution When the student is given a problem involving the preparation of accounting state- ments, the precise nature of the original entries must be described, since the student has no other way of finding out about them. Information about the adjusting entries will

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not necessarily be given, however. Students, like practicing accountants, are expected to be on the lookout for situations that require adjustment.

Campus Pizzeria Adjusting Entries A review of Campus Pizzeria’s trial balance indicates three items that will generate ad- justing entries: the write-off of prepaid expenses (rent), depreciation on the equipment, and accrued interest on the note payable.

14. Adjusting entry for rent expense.

15. Adjusting entry for depreciation expense.

16. Adjusting entry for accrued interest expense (interest payable).

The temporary revenue and expense accounts are actually subdivisions of owners’ eq- uity (retained earnings). At the end of the period, the temporary accounts are closed to Retained Earnings in order to determine the net effect of all the revenue and expense transactions—the net income or loss. Rather than closing each temporary account

Analysis: As of the end of August, the bene- fits from the $750 prepaid rent have all been received. Thus, the asset Prepaid Ex- penses is reduced by $750 (a credit). This rent applied to August operations, so it is an expense of August: debit Rent Expense for $750. This is an earnings transaction.

Prepaid Expenses

(2) 750 (14) 750

Rent Expense

(14) 750

Analysis: The equipment cost $7,200 and is expected to provide benefits for 10 years (120 months). One month’s benefits have now been received, so 1/120 of the origi- nal cost, $60, is debited to Depreciation Expense.3 The corresponding credit is to Accumulated Depreciation, a contra asset account. This is an earnings transaction.

Depreciation Expense

(15) 60

Accumulated Depreciation

(15) 60

Analysis: The bank has earned one month’s interest on the note. The interest rate is 9 percent a year, so one month’s interest on $4,000 will be 3/4 percent, or $30. This amount is debited to Interest Expense. Because the interest has not yet been paid, the credit is to the liability account, Accrued Expenses (or Interest Payable). This is an earnings transaction because the interest is in the nature of “rent” on the borrowed funds used this month.

Interest Expense

(16) 30

Accrued Expenses

(16) 30

Closing Entries

3 This method of charging the cost of an asset to expense in a level stream over the asset’s life is called straight-line depreciation. Other methods will be described in Chapter 7.

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94 Part 1 Financial Accounting

directly to Retained Earnings, however, each is first closed to an intermediate account whose purpose is to summarize the revenue and expense transactions. This account is variously called Income Summary, Profit and Loss, or Expense and Revenue Sum- mary. This account reflects the net income or loss for a given accounting period. In- come Summary is a clearing account that in turn is closed to Retained Earnings to complete the closing process.

The closing process consists of transferring the balance of each temporary account to the clearing account. To close a revenue account, the sum of the credits is found, and then this sum is debited to the revenue account and credited to Income Summary. This gives the revenue account a balance of zero, and transfers its former credit balance to Income Summary. The result is as though the credit balance in the revenue account were “picked up and moved” to the credit side of Income Summary without making any entry. But in an accounting system such informality is not permitted, and the trans- fer of the revenue balance to Income Summary must be accomplished with an equal debit and credit. For Campus Pizzeria, this is done as follows (we use letters to label the closing entries to distinguish them from the original and adjusting entries):

A. Closing the Sales Revenues account.

The double rule intersecting the stem of the T account designates that it has been closed. All the information it contained is now residing, in summary form, in Income Summary. As far as preparing the financial statements is concerned, the Sales Revenue page of the ledger could now be thrown away—that is the sense in which this is a tem- porary account. (Of course, in practice such an accounting record would not be destroyed.)

Closing an expense account is the mirror image of closing a revenue account. There are six expense accounts to be closed (the letters continue the labeling of the closing entries): (B) Cost of Sales, (C) Wage Expense, (D) Utilities Expense, (E) Rent Ex- pense, (F) Depreciation Expense, and (G) Interest Expense.4 Since all of these closing entries are the same in substance, we will illustrate only one of them:

B. Closing the Cost of Sales account.

Explanation: The balance in Sales Rev- enues is a credit of $12,200. A debit of $12,200 will thus give the account a zero balance (i.e., close it). The corresponding credit is to Income Summary.

Sales Revenues

(A) 12,200 (6) 12,000 (12) 200 Balance 12,200

Income Summary

(A) 12,200

Explanation: The balance in Cost of Sales is a debit of $6,000; a credit of $6,000 will thus close this account. The corresponding debit is to Income Summary.

Cost of Sales

(9) 6,000 (B) 6,000

Income Summary

(B) 6,000 (A) 12,200

4 In actual accounting practice, another trial balance would be taken after the adjusting entries were made and before the closing entries commence.

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At this stage, the only accounts remaining open are the permanent accounts (which are always balanced at the end of the period but are never closed) and Income Summary (which is a temporary account). Income Summary is closed in exactly the same manner as other temporary accounts, except that first the debits and credits have to be summed and netted (as in balancing a permanent account). This net amount, which is the period’s income before income taxes, is $1,910 (explained below). It generates one more adjust- ing entry—the entry needed to record the estimated income tax liability arising from the period’s income. Assuming that the applicable income tax rate is 20 percent, the amount of estimated tax liability is $382 ($1,910 * 0.20). This amount is debited to In- come Tax Expense (a temporary account created for recording this final adjusting entry), and is credited to Income Tax Liability. Income Tax Expense is then closed to In- come Summary, which completes the closing of all the expense accounts. (For simplic- ity, we will make the income tax expense debit directly to Income Summary so that we do not have to illustrate creating and closing another expense account that has only one entry made to it.)

To complete the closing process, Income Summary is closed. Its balance is credited (if a net profit) or debited (if a net loss) to Retained Earnings, which can then be bal- anced to complete the balancing of the permanent accounts.

H. Closing the Income Summary account to Retained Earnings.

After the adjusting and closing entries have been made, the period’s financial state- ments can be prepared. The numbers for the income statement can be thought of as coming from either of two equivalent sources: (1) the balances in the temporary ac- counts just prior to their closing or (2) the credit (revenue) and debit (expense) entries to the Income Summary account. Amounts for the balance sheet are the balances in the permanent accounts. In most companies, the accounts reported in the financial state- ments are summaries of more detailed accounts in the ledger.

The August financial statements for Campus Pizzeria, Inc., are shown in Illustration 4–5. Since the accounting period was one month, these are interim statements. It is also im- portant to remember that the August net income and the August 31 retained earnings amounts are the same in this case only because (1) this is the first accounting period for a new entity and (2) the entity did not pay any dividends in this period.

Explanation: After closing all of the tempo- rary accounts (except Income Tax Expense) to Income Summary, the sum of its debits, $10,290, is netted against the sum of its credits, $12,200. This leaves a net credit balance in the account of $1,910, which is the pretax income for August. After the in- come tax adjusting entry for $382 is made, Income Summary is closed by debiting it for $1,528; the corresponding credit is to Retained Earnings. Since this was a new entity as of August 1, Retained Earnings had a zero beginning balance. To complete the process, Retained Earnings is balanced in the same manner as other balance sheet ac- counts. Next month, any profit (or loss) for September will be added to (subtracted from) this $1,528 new beginning balance.

Income Summary

(B) 6,000 (A) 12,200 (C) 3,000 (D) 450 (E) 750 (F) 60 (G) 30_____ _____

10,290 12,200 (17) 382 (H) 1,528

Income Tax Liability

(17) 382

Retained Earnings

Balance –0– To Balance 1,528 (H) 1,528_____ __________ _____

Balance 1,528

Statement Preparation

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96 Part 1 Financial Accounting

In the preceding illustration of the accounting process, we recorded transactions di- rectly in T accounts. In practice, transactions are initially recorded in a journal and then T account entries are made at the end of the period based on the transactions recorded in the journal.

A journal is a chronological record of accounting transactions showing the names of accounts that are to be debited or credited, the amounts of the debits and credits, and any useful supplementary information about the transaction. A journal is analogous to a diary.

The traditional format for writing a journal entry is as follows:

dr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

cr. Paid-In Capital . . . . . . . . . . . . . . . . . 5,000

In practice, the notations dr. and cr. are not used because the accountant distinguishes debits from credits on the basis of the order (debits first) and indentation (credits in- dented) of the accounts. We will use the dr. and cr. in this chapter and Chapter 5 as a reminder to the reader but will follow common practice in subsequent chapters.

Illustration 4–6 shows a journal that records the first few transactions for Campus Pizzeria. With respect to format, note the following: (1) The debit entry is listed first,

ILLUSTRATION 4–5 Financial Statements

CAMPUS PIZZERIA, INC. Balance Sheet

As of August 31

Assets* Liabilities and Owner’s Equity

Cash $ 5,450 Accounts payable $ 2,200 Accounts receivable 0 Notes payable 4,000 Inventory 550 Accrued expenses 30 Prepaid expenses 0 Income tax liability 382_______ _______

Total current assets 6,000 Total liabilities 6,612_______ Equipment, at cost 7,200 Paid-in capital 5,000

Less: Accumulated depreciation 60 Retained earnings 1,528_______ _______ Equipment, net 7,140 Total owner’s equity 6,528_______ _______ Total assets $13,140 Total liabilities and owner’s equity $13,140_______ ______________ _______

Income Statement For the Month of August

Sales revenues $12,200 Cost of sales 6,000_______ Gross margin 6,200 Operating expenses:

Wages $ 3,000 Rent 750 Utilities 450 Depreciation 60 Interest 30 4,290_______ _______

Income before income taxes 1,910 Income tax expense 382_______ Net income $ 1,528______________

* Ordinarily, accounts with zero balances are not shown. Two are included here for completeness, since both did have entries made to them during the period.

The Journal

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(2) the debit amounts appear in the left-hand money column, (3) the account to be cred- ited appears below the debit entry and is indented, and (4) the credit amounts appear in the right-hand money column. “LF” is an abbreviation for ledger folio, which is the page reference to the ledger account where the entry is to be made. This reference is inserted at the time the entry is posted to (i.e., entered in) the appropriate T account in the ledger. Thus, the presence of numbers in the LF column indicates that the entries have been posted to the appropriate T accounts. They also provide an audit trail, a way of tracing the amounts in the ledger back to their sources. In some bookkeeping sys- tems, a brief explanation is written beneath each journal entry.

The journal thus contains explicit instructions on the revenue and expense items to be recorded in the temporary accounts and the changes to be made to the balances in the permanent accounts. No account balance is ever changed except on the basis of a journal entry. The ledger is a device for reclassifying and summarizing, by accounts, information originally listed in chronological order in the journal. Entries are first made in the journal and are later posted to ledger accounts.

Accounting Systems

The simple journals and ledgers described in the preceding pages, together with the rules for using them, constitute an accounting system. But this particular system would not usually be the best system for a given organization. The optimum system is that one that best satisfies the following objectives:

1. To process the information efficiently—at low cost. 2. To obtain reports quickly. 3. To ensure a high degree of accuracy. 4. To minimize the possibility of theft or fraud.

Designing a good accounting system is a specialized job requiring a high degree of skill.

Two objectives of an accounting system stated above—accuracy and protection against theft or fraud—cannot be attained absolutely without conflicting with the other two—speed and economy. An unbeatable system would be prohibitively expensive

ILLUSTRATION 4–6

Journal

Date Accounts LF Debit Credit

Aug. 1 Cash 10 5,000.00 Paid-In Capital 30 5,000.00

1 Prepaid Expenses 14 750.00 Cash 10 750.00

1 Cash 10 4,000.00 Notes Payable 21 4,000.00

2 Equipment 15 7,200.00 Cash 10 7,200.00

2 Inventory 13 800.00 Accounts Payable 20 800.00

Internal Accounting Controls

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98 Part 1 Financial Accounting

and time-consuming. A basic principle of internal accounting control, therefore, is that the system should make it as difficult as is practical for people to be dishonest or careless. Such a principle is based not on a cynical view of people in general but rather on the realistic assumption that a few people will be dishonest or careless if it is easy for them to do so.

Some of the devices used to ensure reasonable accuracy have been touched on al- ready; for example, the idea of verifying one set of figures against another. The idea of divided responsibility is another important one. Whenever feasible, one person should not be responsible for recording all aspects of a transaction, nor should the custodian of assets (e.g., the storekeeper or the cashier) be permitted to do the accounting for these assets. Thus, one person’s work is a check on another’s. Although this does not elimi- nate the possibility that two people will steal through collusion, the likelihood of dis- honesty is greatly reduced.

These brief comments indicate only the nature of the problem of internal ac- counting control, which is a big subject. Furthermore, a book that focuses on ac- counting principles, as this one does, cannot detail the complexities involved in the operation of accounting systems. For example, cash transactions are very easy to an- alyze, whereas some textbooks on auditing contain a dozen pages of questions that should be considered in connection with the internal accounting control of the single item cash.

Computer-Based Accounting Systems

Most organizations do their accounting work by computer. In this section, we give a brief overview of computer-based accounting systems.

As noted above, some steps in the accounting cycle involve judgment, whereas others are primarily mechanical. These mechanical steps are usually referred to as book- keeping. A computer-based system performs some or all of the bookkeeping steps— that is, it records and stores data, performs arithmetic operations on data, sorts and summarizes data, and prepares reports. These functions are described below as inputs, processing, and outputs.

Inputs In some computer systems, data are entered by a data-entry clerk (using a keyboard) who copies them from a paper record such as a sales order or purchase order. In other systems, the computer accepts input data from equipment located at the point of origin. Examples are factory time records; inventory counts, when the person counting uses a handheld recording device; and receiving records, when a similar device is used.

An especially striking and familiar example of direct computer data input is the scanning device used at the supermarket or department store checkout stand. The scan- ner reads a bar code printed on the item (or on a tag attached to the item); this code specifically identifies the item. The computer to which the scanner is connected then uses stored information on each item’s selling price to calculate an itemized list of the amount owed by the customer. A summary of sales revenue, cost of goods sold (also stored for each item in the computer), gross margin by items or categories of items, and the status of inventories is available for use by store managers at any time they desire to access the system.

What a Computer- Based System Does

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The inputs to one business’s computer may be the outputs of the computer of another business. For example, a factory computer may generate purchase orders for parts to be supplied by a vendor. These outputs are transmitted electronically to the vendor, where they become sales order inputs, without a paper purchase order ever being produced. Similarly, a wholesaler’s salesperson may record orders placed by a retail store on a hand- held device; the information is then transmitted to a central computer by the Internet.

Processing Once data are in machine-readable form, the chance for bookkeeping errors is reduced. The computer will not accept an entry in which debits do not equal credits. However, if a human makes an error in selecting the account, or enters the wrong number for both the debit and credit, there will be errors.

Data in machine-readable form can be used in a number of ways. For example, an airline reservation system has a record of the availability of seats in each of several fare categories for every flight the airline will operate over the next several months. Any travel agent connected to the system by a terminal can request information about flight availability and price; the computer can process hundreds of such inquiries every minute. If the agent wishes to book a seat, the computer decreases availability on the flight and sends information to the travel agency’s printer, which prepares a ticket, boarding pass, itinerary, and customer invoice. Computer systems also sort data in ways that may be of interest and use to management.

Outputs Computer-based systems can prepare reports that include either tables of numbers or graphs. These can be generated at regular intervals in a prescribed format or prepared in a form specified by an individual user. In some systems, the user produces cus- tomized reports locally by using a personal computer that can retrieve data from a central computer–based system.

Computer-based accounting systems are usually operated by several interconnected software programs, each of which is called a module. There may be a module for any of the following: sales orders, shipments, and the related accounts receivable (often called an order-entry module); manufacturing costs; purchase orders, inventory, and related ac- counts payable (a purchasing module); payroll and other personnel records; fixed asset acquisitions, location, and depreciation; income taxes; cash; and the general ledger.

Hundreds of software programs are available. Some provide a complete set of mod- ules for a small enterprise for a few hundred dollars; for a larger company, the cost may be several thousand dollars. Some programs are designed for a specific industry (for example, time-intensive professional service businesses such as law, accounting, and architectural firms). These software programs can handle quantitative nonmonetary data as well as monetary data. Manual accounting systems, by contrast, are limited pri- marily to monetary data.

Despite their many advantages, computer-based systems are not without their prob- lems. Although a small company can purchase off-the-shelf software and have its sys- tem up and running in a few days, system development and installation in a larger, more complex organization may take many months and cost millions of dollars. Such systems usually require an outside consultant for their design and implementation. Moreover, technological advances make existing systems obsolete within a few years, and much time and money must be spent to update them. Nevertheless, the advantages of a computer-based system are so great that almost every organization needs one.

Modules

Problems with Computer Systems

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Unlike a manual system, a computer-based system does not leave a paper trail that can be readily audited. The system must therefore rely on the internal controls de- scribed above. In a few spectacular instances, the lack (or circumvention) of such con- trols has resulted in business frauds and resultant failure; but the number of such events is very small relative to the number of computer-based systems in use.

Finally, a computer-based system will not be fully effective until its developers learn to design reports that the system’s users need and can understand. This job of education, for both developers and users, can be substantial. If it is not done properly, the system will spew out reports that no one uses, and the potential users will not appreciate the information that they could receive if only they knew how to ask for it.

The account is a device for collecting information about each item that is to be accounted for. It has two sides: the left-hand, or debit, side and the right-hand, or credit, side. The rules are such that asset and expense accounts increase on the debit side, whereas liabilities, owners’ equity, and revenue accounts increase on the credit side. This maintains both the equation Assets � Liabilities � Owners’ equity and the equation Debits � Credits.

A ledger is a group of accounts. Entries are made to ledger accounts on the basis of in- structions given in a journal, which is a chronological record of transactions.

At the end of an accounting period, adjusting entries are made so that after adjustment the revenue and expense accounts will show the appropriate amounts for the period. These temporary accounts are then closed to the Income Summary account, which in turn is closed to Retained Earnings.

In manual accounting systems, special journals, subsidiary ledgers, and other devices fa- cilitate the process of recording accounting data. A computer-based system performs the same functions more rapidly, and it can provide a variety of useful management reports if it has been designed thoughtfully and its users have been properly trained.

Summary

Problems Problem 4–1. Set up the following in T-account form and determine the ending balances insofar as these

accounts are concerned. (Not all balance sheet accounts are shown.)

Beginning Balances

Account Dr. Cr.

Cash $ 900 Accounts receivable 3,000 Inventory 5,700 Accounts payable $3,600 Note payable 950

Transactions:

1. Purchased inventory on account $2,350

2. Sold goods on account: sales revenues 6,350

Cost of goods sold 4,150

3. Paid vendors 3,400

4. Collected from customers 5,350

5. Paid off note payable 950

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Problem 4–2. Write journal entries for the following transactions that occurred at Woodside Company during May and explain how each would be disclosed in Woodside’s financial statements.

1. The company prepaid $14,340 rent for the period May 1–October 31.

2. Sales discounts and allowances were $34,150.

3. A loan for $3,500 at 12 percent interest continued to be owed to the company by one of its employees, who made no payments related to this loan during May.

4. Depreciation expense was $13,660.

5. Customers paid $2,730 for services they will not receive until sometime in June.

6. The company purchased $172 worth of stamps and used $100 worth of them.

7. The Allowance for Doubtful Accounts was increased by $1,350, reflecting a new esti- mate of uncollectible accounts.

Problem 4–3. Luft Corporation’s accounts had the following beginning balances:

Account Dr. Cr.

Accounts payable $ 3,070 Accounts receivable $ 2,160 Accumulated depreciation 2,800 Allowance for doubtful accounts 70 Cash 1,440 Fixed assets (at cost) 6,200 Inventories 1,730 Note payable (current) 600 Owners’ equity 4,990_______ _______

$11,530 $11,530_______ ______________ _______

During the period, the following transactions occurred:

1. Purchased inventory on account, $1,300.

2. Paid employees, $730.

3. Sold goods for cash, $1,940.

4. Sold goods on credit, $1,810.

5. Overhead and other expenses paid in cash, $900.

6. Collection of accounts receivable, $1,510.

7. Paid certain accounts payable, $1,720.

8. Received cash for revenue applicable to the next period, $650.

9. Increased the current note payable by $200.

10. Physical inventory showed ending balance of $1,750.

11. Depreciation expense, $300.

Required: a. Journalize the transactions.

b. Set up T accounts and post beginning balances and transactions.

c. Determine the cost of goods sold.

d. Prepare an ending balance sheet.

e. Prepare an income statement for the period (ignore taxes).

Chapter 4 Accounting Records and Systems 101

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Problem 4–4. The account balances in the ledger of the Dindorf Company on January 31 (the end of its fiscal year), before adjustments, were as follows:

Debit Balances Credit Balances

Cash and equivalents $ 119,115 Accumulated depreciation Accounts receivable 162,500 on store equipment $ 37,300 Merchandise inventory 700,680 Accounts payable 118,180 Store equipment 215,000 Notes payable 143,000 Supplies inventory 15,475 Common stock 300,000 Prepaid insurance 38,250 Retained earnings 122,375 Selling expense 24,900 Sales revenues 716,935 Sales salaries 105,750 Miscellaneous general expenses 31,000 Sales discounts 6,220 Interest expense 9,300 Social Security tax expense 9,600__________ __________

Total $1,437,790 Total $1,437,790__________ ____________________ __________

The data for the adjustments are

1. Cost of merchandise sold, $302,990.

2. Depreciation on store equipment, $12,750.

3. Supplies inventory, January 31, $5,210. (Purchases of supplies during the year were debited to the Supplies Inventory account.)

4. Expired insurance, $4,660.

5. Interest accrued on notes payable, $3,730.

6. Sales salaries earned but not paid to employees, $3,575.

7. Interest earned on savings accounts, but not recorded, $390.

Required: a. Set up T accounts with the balances given above.

b. Journalize and post adjusting entries, adding other T accounts as necessary.

c. Journalize and post closing entries.

d. Prepare an income statement for the fiscal year and a fiscal year-end balance sheet.

102 Part 1 Financial Accounting

Cases

Case 4–1

PC Depot* PC Depot was a retail store for personal computers and hand-held calculators, selling several national brands in each product line. The store was opened in early September by Barbara Thompson, a young woman previously employed in direct computer sales for a national firm specializing in business computers.

Thompson knew the importance of adequate records. One of her first decisions, therefore, was to hire Chris Jarrard, a local accountant, to set up her bookkeeping system.

Jarrard wrote up the store’s preopening financial transactions in journal form to serve as an example (Exhibit 1). Thompson agreed to write up the remain-

* © Professor Robert N. Anthony.

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Entry Amount Number Account Cr.

(9) Cash sales for September $38,000 (10) Credit sales for September 14,850 (11) Cash received from credit customers 3,614 (12) Bills paid to merchandise suppliers 96,195 (13) New merchandise received on credit from supplier 49,940 (14) Ms. Thompson ascertained the cost of merchandise sold was 38,140 (15) Wages paid to assistant 688 (16) Wages earned but unpaid at the end of September 440 (17) Rent paid for October 1,485 (18) Insurance bill paid for one year (September 1–August 31) 2,310 (19) Bills received, but unpaid, from electric company 226 (20) Purchased sign, paying $660 cash and agreeing to pay the

$1,100 balance by December 31 1,760

Questions

1. Explain the events that probably gave rise to journal entries 1 through 8 of Exhibit 1.

2. Set up a ledger account (in T account form) for each account named in the general journal. Post en- tries 1 through 8 to these accounts, using the entry number as a cross-reference.

3. Analyze the facts listed as 9 through 20, resolving them into their debit and credit elements. Prepare

journal entries and post to the ledger accounts. (Do not prepare closing entries.)

4. Consider any other transactions that should be recorded. Why are these adjusting entries required? Prepare journal entries for them and post to ledger accounts.

5. Prepare closing entries and post to ledger accounts. What new ledger accounts are required? Why?

6. Prepare an income statement for September and a balance sheet as of September 30.

Amount Entry

Number Account Dr. Cr.

(1) Cash 165,000 Bank Loan Payable (15%) 100,000 Proprietor’s Capital 65,000

(2) Rent Expense (September) 1,485 Cash 1,485

(3) Merchandise Inventory 137,500 Accounts Payable 137,500

(4) Furniture and Fixtures (10-year life) 15,500 Cash 15,500

(5) Advertising Expense 1,320 Cash 1,320

(6) Wages Expense 935 Cash 935

(7) Office Supplies Expense 1,100 Cash 1,100

(8) Utilities Expense 275 Cash 275

EXHIBIT 1 General Journal

der of the store’s September financial transactions for Jarrard’s later review.

At the end of September, Thompson had the fol- lowing items to record:

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104 Part 1 Financial Accounting

Case 4–2

Save-Mart* Save-Mart was a retail store. Its account balances on February 28 (the end of its fiscal year), before adjust- ments, were as shown below.

Debit Balances Credit Balances

Cash $ 88,860 Accumulated depreciation on store equipment $ 11,420 Accounts receivable 127,430 Merchandise inventory 903,130 Notes payable 88,500 Store equipment 70,970 Accounts payable 88,970 Supplies inventory 17,480 Common stock 100,000 Prepaid insurance 12,430 Retained earnings 33,500 Selling expense 10,880 Sales 988,700 Sales salaries 47,140 Miscellaneous general expense 18,930 Sales discounts 3,340 Interest expense 7,100 Social Security tax expense 3,400__________ __________

Total $1,311,090 Total $1,311,090__________ ____________________ __________

The data for the adjustments are

1. Cost of merchandise sold, $604,783. 2. Store equipment had a useful life of seven years.

(All equipment was less than seven years old.) 3. Supplies inventory, February 28, $3,877. (Pur-

chases of supplies during the year were debited to the Supplies Inventory account.)

4. Expired insurance, $7,125. 5. The note payable was at an interest rate of 9 per-

cent, payable monthly. It had been outstanding throughout the year.

6. Sales salaries earned but not paid to employees, $2,340.

7. The statement sent by the bank, adjusted for checks outstanding, showed a balance of $88,110. The dif- ference represented bank service charges.

Questions

1. Set up T accounts with the balances given above.

2. Journalize and post adjusting entries, adding other T accounts as necessary.

3. Journalize and post closing entries.

4. Prepare an income statement for the year and a bal- ance sheet as of February 28.

* © Professor Robert N. Anthony.

Case 4–3

Copies Express* Copies Express was incorporated on November 20, 2009, and began operating on January 2, 2010. The

balance sheet as of the beginning of operations is shown in Exhibit 1.

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Chapter 4 Accounting Records and Systems 105

EXHIBIT 1 Copies Express, Inc.

Balance Sheet As of January 2, 2010

Assets

Cash $ 2,000 Supplies 24,400 Building and equipment 300,000 Land 12,000_________

Total $338,400__________________

Liabilities and Owners’ Equity

Accounts payable $ 10,400 Bank loan 24,000 Capital stock 304,000_________

Total $338,400__________________

Cash Receipts and Disbursements: 2010 Cash receipts:

Cash sales $176,450 Collect accounts receivable 64,750_________

Total $241,200__________________ Cash disbursements:

Wages and salaries $ 85,750 Heat, light, power 15,000 Additional supplies 52,600 Selling and administration 28,375 Interest (Note 1) 2,880 Payment—bank loan (12/31) 12,000 Payment—accounts payable 10,400_________

Total $207,005__________________

Note 1. Interest at 12 percent per annum on the bank loan was payable June 30 and December 31 [($24,000 * .12) � $2,880]. Interest payments for 2010 were made when due.

EXHIBIT 2 Copies Express, Inc.

1. At the end of 2010, Copies Express owed $9,875 to suppliers for the purchase of photocopy supplies for which it had not yet paid.

2. The yearly depreciation expense on the buildings and equipment was $15,000. 3. At the end of 2010, Copies Express was owed $11,000 for copying services by customers who had not

yet paid. Copies Express expected that all of these customers would pay within 30 days. 4. An inventory taken of the supplies at year-end revealed that the year’s cost of supplies was $60,250. 5. Income taxes for 2010 were expected to be $11,593. They were unpaid as of December 31, 2010.

EXHIBIT 3 Other Information Relative to Operations

Questions

1. Prepare an income statement for 2010 and a bal- ance sheet as of December 31, 2010.

2. Be prepared to explain the derivation of each num- ber on these financial statements.

In preparing financial statements for the first year of operations, the accountant reviewed the record of cash receipts and cash disbursements for Copies Express. This information appears in Exhibit 2.

In addition, the accountant examined certain other information relative to operations. These additional items appear in Exhibit 3.

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106 Part 1 Financial Accounting

Case 4–4

Waltham Oil and Lube Center, Inc. On April 1 Frank Knight incorporated and capitalized with $40,000 of his savings Waltham Oil and Lube Centers, Inc. On the same day, he signed a lease and op- erating agreement to operate the recently constructed “Waltham Oil and Lube Center,” located in Waltham, Massachusetts. The facility and name were owned by National Oil and Lube Centers, Inc., a nationwide chain of centers offering through local franchisees au- tomobile oil change and lubrication services.

The lease and operating agreement required Knight to deposit $40,000 with National as evidence of his good faith and to pay for certain pre-operating costs in- curred by National on behalf of the Waltham Center. In addition, the lease portion of the agreement called for Knight to pay beginning on May 1 and at the beginning of each month thereafter a flat lease rental payment of $1,500 per month plus $10 payable at the end of each month for every automobile Waltham Center serviced during the month. National was responsible for pay- ment of local property taxes. Knight was responsible for maintaining the facility in good working condi- tion and the payment for all operating expenses. The 12-month lease agreement was automatically renewed unless a 30-day notice of cancellation was given by ei- ther party. The operating portion of the agreement required Knight to purchase all of his oil and lubricat- ing supplies and equipment from National. For its part, National agreed to provide Knight with training mate- rials, operating consulting services, and national advertising support.

During April, Knight ordered for delivery on April 30 office furniture costing $6,000 that had a useful life of 10 years, deposited an additional $10,000 capital in the business’s new checking account, and paid $1,200 for a variety of 12-month insurance coverages begin- ning May 1.

Knight opened the Waltham Center for business on May 1. On the same day, National deducted from Knight’s $40,000 deposit $35,650 for the opening oil and grease inventory ($6,320), uniforms and other op- erating supplies inventory ($4,130), and an equipment purchase down payment ($25,000). The total cost of the equipment was $75,000. In addition, National also deducted the May rental ($1,500) from the deposit. The remaining $4,350 of the deposit was held by

National to apply against any future nonpayment of amounts due National.

The $75,000 worth of grease and oil guns, hy- draulic jacks, and other equipment Knight bought from National was Knight’s to keep. After applying the $25,200 deduction from his deposit toward this cost, Knight owed National $49,800 for the equipment. This balance was financed by giving National a noninterest- bearing note payable on the first of the month at a rate of $830 a month for 60 months.

A National sales representative told Knight the equip- ment was expected to have a useful life of five years. The sales representative also suggested the $75,000 equipment be depreciated on a group basis. That is, Knight would apply a single depreciation method and life to all of the equipment as if it was a single piece of equipment with no salvage value. This method, he ex- plained, would reduce Knight’s bookkeeping costs.

The business got off to a quick start. During the three-month period May through July, Knight and his staff serviced 2,340 cars. In addition to his service business, Knight was able to rent parking spaces to local citizens on a monthly basis between 7 p.m. and 7 a.m. Due to a local ordinance banning overnight street parking, these citizens were required to find off- street parking.

On August 2, Knight decided to assess how well he had done during the first three months of operations. To this end, he gathered the following information:

1. Bank account records showed deposits after March 1 of $108,600. According to notations on the checks, Knight believed $3,300 was generated by parking space rentals. The rest he assumed was oil and lubrication services revenue.

2. Bank account records showed payments for oil and grease inventory purchases from National totaling $8,230; part- and full-time employee payroll, $34,560; utilities, $1,700; miscellaneous expenses, $6,600; lease payment, $26,400; equipment pay- ments, $2,490; and withdrawals by Knight of $4,500.

3. From personal knowledge, Knight knew that on July 31, he was owed $340 by overnight parkers and $730 from local merchants who used Waltham Center to service their delivery trucks. He was also

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Chapter 4 Accounting Records and Systems 107

aware the business owed employees payroll totaling $2,100 and utility companies $350.

4. Based on a physical count, Knight had determined on July 31 that the business had inventory costing $5,290 on hand. On numerous occasions, Knight and his family had serviced their personal cars at Waltham Center.1

As he prepared his assessment, Knight wondered if he should make some provision for possible nonpay- ment of the amounts owed to his business. In addition, he had $400 in checks in his office desk drawer from parking space renters prepaying their August rentals. As of July 31, Knight had not deposited these checks in the business’s bank account.

Questions

1. Prepare journal entries for the period May 1 to July 31.

2. Based on an examination of your journal entries, at the end of July, what is the balance, if any, of the following accounts:

a. Capital

b. Accumulated depreciation

c. Prepaid assets

d. Cash balance

e. Accounts receivable

f. Liabilities

3. Based on an examination of your journal entries, for the three-month period May 1 to July 31, what is the amount of the following:

a. Withdrawals

b. Cost of sales

c. Parking revenues

d. Lease expense

e. Total revenues

4. How should Knight account for the $400 August parking checks? Possible bad debts? Family use of the Waltham Center’s services?

1 The retail value of these services was $450.

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5 Revenue and Monetary Assets

Chapter

This and the next four chapters discuss more thoroughly certain balance sheet and in- come statement items that were treated in an introductory fashion in Chapters 2 and 3. This chapter discusses the two problems in revenue recognition: (1) When—in which accounting period—should revenue be recognized? and (2) How much revenue should be recognized? A closely related matter, the measurement of monetary assets, espe- cially accounts receivable, also is discussed.

Timing of Revenue Recognition

Presumably, most activities in a company are intended to contribute to its profit-seeking objective. These activities may include a fairly long chain of events. Illustration 5–1 depicts this sequence, called the operating cycle, for a typical manufacturing firm. It begins with the purchase of materials and ends with the collection of cash from cus- tomers. (The reader should consider how to modify the diagram for other types of busi- nesses.) In accounting, revenue is recognized at a single point in this cycle. The basic reason for choosing a single point rather than attempting to measure the separate profit contribution of each part of the cycle stems from the criterion of objectivity. There is no objective way of measuring the amount of profit that is earned in each step of the operating cycle.

The conservatism concept and the realization concept, described in Chapter 3, suggest the following revenue recognition criteria: Revenue should be recognized in the earli- est period in which (1) the entity has substantially performed what is required in order to earn income, (2) the amount of income can be reliably measured, and (3) the related assets received can readily be converted to cash or claims for cash. The FASB has com- bined there criteria into a revenue recognition standard that states “revenue should not be recognized until it’s realized or realizable and earned.”1

The criteria are expressed in terms of earning and measuring income rather than revenue because both the revenue and expense components of a transaction need to be

Basic Recognition Criteria

1 “Recognition and Measurement in Financial Statements of Business Enterprises,” FASB Statement of Financial Accounting Concepts No. 5.

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Collect the cash from the customer

Store the product in a warehouse

Ship the product and send the customer an invoice

Convert materials into a finished product

Purchase materials

Customer acknowledges receipt of the item

Inspect the product

Receive an order for the product from a customer

Chapter 5 Revenue and Monetary Assets 109

reliably measurable in order to recognize the revenue. Because of the matching con- cept, both components are recognized in the same period, and thus income is recog- nized. Applications of this general idea to certain types of revenues are summarized in Illustration 5–2 and discussed in more detail below.

The IFRS and GAAP basic revenue recognition standards differ in their wording and underlying theory. IFRS recognizes revenue when the “risks and rewards of own- ership are transferred.” In contrast, GAAP, among other requirements, recognizes rev- enue when it is “earned.” Despite these differences, in most cases the accounting for revenue transaction will be the same under either concept.

IFRS recognizes revenue from the sale of goods when all the following conditions have been satisfied:

• The seller has transferred to the buyer the significant risks and rewards of owership of the goods.

• The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the good sold.

ILLUSTRATION 5–1 The Business Operating Cycle

ILLUSTRATION 5–2 Timing of Revenue Recognition

Revenue Recognition Typical Revenue Event at This Time Recognition Method

1. Sales order received No None 2. Deposit or advance payment received No None 3. Goods produced For certain long-term contracts Percentage of completion 4. Production completed; goods stored For precious metals and certain Production

agricultural products 5. Goods delivered or services provided Usually Delivery 6. Customer pays account receivable Collection is uncertain Installment

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110 Part 1 Financial Accounting

2 “Revenue,” IAS No. 18. 3 ”The Numbers Game,” remarks by Chairman Arthur Levitt, Securities and Exchange Commission, September 28, 1998. 4 Ten Things about Financial Statement Fraud,” Deloitte Forensic Center, 2007.

SEC Response

• The amount of revenue can be measured reliably. • It is probable that the economic benefits associated with the transaction will flow to

the seller. • The costs incurred or to be incurred in respect of the transaction can be measured

reliably.2

The measurement of a period’s income is an approximation because it incorporates estimates of such things as bad debts, future warranty costs, useful lives of fixed assets, and other items. Although generally accepted accounting principles (GAAP) provide guidance that enhances objectivity, the fact inevitably remains that the desire to mea- sure the operating performance of an entity for some relatively short period of time re- sults in an estimate, not a precise determination, of that period’s income. This estimate inevitably involves management judgment, and when companies are experiencing dif- ficulties, ethical issues also may arise. Readers should address this latter consideration when making the accounting and business decisions called for in the case assignments.

Financial statement users should always be aware of the fact that over half of the finan- cial fraud cases identified by the U.S. Securities and Exchange Commission (SEC) in- volve improper revenue recognition. According to former SEC chairman Arthur Levitt:

Companies try to boost revenue by manipulating the recognition of revenue. Think about a bottle of fine wine. You wouldn’t pop the cork on that bottle before it was ready. But some companies are doing this with their revenue—recognizing it before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.3

The most common types of revenue recognition fraud are

• Recording of fictitious revenue. • Recognizing inappropriate amount of revenue from swaps, round-tripping, or barter

arrangements. • Recognition of revenue from sales transactions billed, but not shipped (“bill and

hold”). • Recognition of revenue where there are contingencies associated with the transac-

tion that have not yet been resolved. • Improper accounting for or failure to establish appropriate reserves for rights to re-

funds or exchange, liberal cancellation or refusal rights or liberal or unconditional rights of return granted through undisclosed oral or written side agreements.

• Recognition of revenue when products or services are not delivered, delivery is in- complete, or delivered without customer acceptance.4

Sometimes companies inflate their revenues by “channel stuffing.” This is a business practice whereby a company in order to meet short-term objectives improves its revenues by loading its distribution channels with more product than they are capable of selling in the normal course of business. The inevitable result is that the following period’s

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Chapter 5 Revenue and Monetary Assets 111

revenue growth rates decline as distribution channel attempt to realign their inventories with actual demand. Channel stuffing is not illegal as long as all of the GAAP revenue recognition requirements are met and the company discloses the channel stuffing to investor. If either of these conditions is not met, the SEC will litigate against the offending company and its management.

In accordance with Levitt’s concerns, the SEC issued Staff Accounting Bulletin No. 101 (SAB 101). According to SAB 101, the SEC generally considers revenue to be realized and earned when

1. Persuasive evidence of an order arrangement exists; 2. Delivery of the ordered goods has occurred or services have been rendered; 3. The seller’s price to the buyer is fixed or determinable; and 4. Collectibility of the sale proceeds is reasonably assured.5

Persuasive Evidence Purchase order and sale agreement documentation practices vary widely between cus- tomers, companies, and industries. The SEC appears to be willing to accept these prac- tices as persuasive evidence of an agreement as long as there is some form of written or electronic evidence that a binding final customer purchase authorization, including the terms of sale, is in the hands of the seller before revenue is recognized.

Delivery Typically, revenue is recognized when delivery has occurred and the customer has taken title and assumed the risks and rewards of ownership of the goods specified in the customer’s purchase order or sales agreement. (It is interesting to note in this instance the SEC adopted the IASB revenue recognition standard of “risks and rewards of own- ership,” rather than the FASB standard “earned.”) More specifically,

• Delivery is not considered to have occurred unless the product has been delivered to the customer’s place of business.

• If uncertainty exists about a customer’s acceptance of a product or service, revenue should not be recognized even if the product is delivered or the service performed.

• Revenue should not be recognized until the seller has substantially completed or ful- filled the terms specified in the purchase order or sales agreement.

• In licensing and similar arrangements, delivery does not occur for revenue recogni- tion purposes until the license term begins.

Performance In general, SAB 101 requires substantial performance of the sales arrangement by the seller and acceptance by the customer of the product or services rendered before rev- enue can be recognized. SAB 101 notes:

• A seller should substantially complete or fulfill the terms specified in the sales arrangement.

• After delivery or performance, if uncertainty exists about acceptance, revenue should not be recognized until after acceptance occurs.

5 Securities and Exchange Commission, Staff Accounting Bulletin No. 101.

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Consignment-Type Transactions Products shipped pursuant to a consignment arrangement should not be recorded as revenue since the consignee has not assumed the risks and rewards of ownership. This is a long-standing rule. SAB 101 goes further. It states that if a transaction has the char- acteristics of a consignment arrangement, revenue recognition is precluded even if title to the product has passed to the buyer.

The typical business earns revenue by selling goods or services to customers. The busi- ness has performed substantially what is required in order to earn income when it delivers these goods or provides these services to customers. Thus, the most common approach, called the delivery method, is to recognize the revenue in the period in which goods are delivered or services are provided.

Revenues for goods are not recognized when sales orders are received. Even though in some businesses the amount of income that will be earned can be reliably estimated at that time, there has been no performance until the goods have been de- livered. For services, providing the service is the act of performance. Revenues from renting hotel rooms are recognized each day the room is rented. Revenues from main- tenance contracts are recognized in each month covered by the contract. Revenue from repairing an automobile is recognized when the repairs have been completed (not when the repairs are only partially completed, because the service is to provide a completed repair job).

In the usual situation, the amount of income that will be earned can be reliably estimated when goods are delivered or services provided. The test of the market- place, a price agreed to by the customer minus the appropriate cost of sales, is usu- ally excellent evidence of the amount of income earned. Even though some cus- tomers in the normal course of business may not pay their bills, allowances can be made for this in estimating the amount of revenue. If goods are shipped or services rendered to customers with such poor credit records that part or full collection of the related account receivables is in question, income may be recognized only when all of the costs of the sale are recovered or proportionally as collections or installment payments are received.

When goods are delivered, title usually is transferred from the seller to the buyer, but transfer of title is not a necessary condition for revenue recognition. When goods are sold on the installment credit basis, for example, the buyer does not have a clear title until the installment payments have been completed. (Automobile sales are a com- mon example.) If, however, there is a reasonable certainty that these payments will be made, revenue must be recognized at the time of delivery.6

Consignment Shipments In a consignment shipment, the supplier, or consignor, ships goods to the consignee, who attempts to sell them. The consignor retains title to the goods until they are sold. The consignee can return any unsold goods to the consignor. In these circumstances, performance has not been substantially completed until the goods are sold by the con- signee. Thus, the consignor does not recognize revenue until that time.7 A consignment shipment therefore represents only the movement of the supplier’s asset, inventory,

112 Part 1 Financial Accounting

6 “Omnibus Opinion,” APB Opinion No. 10. 7 “Revenue Recognition When Right of Return Exists,” FASB Statement No. 48. This Statement also describes circumstances when revenue may not be recognized even if title to the goods has passed from the consignor to the consignee.

Delivery Method

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from one place to another. The amount of merchandise out on consignment can be shown by a journal entry, at cost:

dr. Inventory on Consignment . . . . . . . . . . . . 1,000

cr. Merchandise Inventory. . . . . . . . . . . . . 1,000

In the period in which these goods are sold by the consignee, the effect on the ac- counts of the consignor would be as in the following entries:

dr. Cost of Goods Sold . . . . . . . . . . . . . . . . . . 1,000

cr. Inventory on Consignment . . . . . . . . . 1,000

To record the cost of consigned goods sold.

dr. Accounts Receivable . . . . . . . . . . . . . . . . . 1,400

cr. Sales Revenue . . . . . . . . . . . . . . . . . . . 1,400

To record the consignor’s sales value.

Franchises Some companies, called franchisors, sell franchises that permit the franchisee to use a well-known name (e.g., Taco Bell, Days Inn, Avis). The franchisor also may agree to provide advice and other services in return for the franchise fee. A franchisor recog- nizes revenue during the period in which it provides the services, rather than when the fee is received. In particular, a franchisor often receives a large initial fee for which it agrees to provide site selection, personnel training, advice on equipment selection, and other services. It cannot recognize revenue until these services have been provided; normally, this is after the franchisee commences operations.8

High-rise buildings, bridges, aircraft, ships, space exploration hardware, and certain other items involve a design/development and construction/production period that extends over several years. Such projects are performed under contracts in which the customer provides the product specifications. The contract also stipulates either (1) pre- determined amounts the customer must pay at various points during the project, called a fixed-price contract, or (2) some sort of formula that will determine customer payments as a function of actual project costs plus a reasonable profit, called a cost- reimbursement contract.

During each accounting period in which the contractor works on the contract, there has been performance. If there is reasonable assurance of the contract’s profit margin and its ultimate realization, then revenue is appropriately recognized in each such pe- riod. This method of revenue recognition is called the percentage-of-completion method because the amount of revenue is related to the percentage of the total project work that was performed in the period.

GAAP presumes that the percentage-of-completion method will be used to account for long-term contracts. This presumption can be overcome. If the amount of income to be earned on the contract cannot be reliably estimated, then revenue must be recog- nized only when the project has been completed. This is the completed-contract method. Costs incurred on the project are held as an asset, Contract Work in Progress, until the period in which revenue is recognized.9

On a cost-reimbursement contract, the amount of income earned in each period often can be reliably estimated. If the owner agrees to pay cost plus 10 percent and if the

Chapter 5 Revenue and Monetary Assets 113

Percentage-of- Completion Method

8 “Accounting for Franchise Fee Revenue,” FASB Statement No. 45. 9 Long-Term Construction-Type Contracts, ARB No. 45. IFRS has a different approach. When the out- come of a construction contract cannot be estimated reliably, revenue should be recognized only to the extent of contract costs increased that it is probable will be recoverable. Contract costs should be expressed in the period in which they are increased. “Construction Contracts.” IAS No.11.

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114 Part 1 Financial Accounting

work proceeds as planned, the revenue is 110 percent of the costs incurred in the period. A fixed-price contract usually specifies how the satisfactory completion of each phase of the project is to be determined; such points in the project are called milestones. If good project plans exist, the number of milestones reached enables the contractor to reliably estimate the percent complete and hence the revenue earned on the contract.

Illustration 5–3 shows the application of the two long-term contract accounting methods to a three-year project. Note that both methods report the same total project income over the entire three-year period, but only the percentage-of-completion method allocates this total to each of the three years. Also note that the customer pay- ments (cash inflows) are irrelevant in determining the amount of revenue recognized each year under either method.10

For certain grains and other crops, the government sets price supports and assures the farmer that the products can be sold for at least these prices. The minimum amount of income that will be earned therefore can be reliably measured as soon as the crops have been harvested, even though they have not been sold at that time. Furthermore, the farmer’s performance has been substantially completed. In these circumstances, a case can be made for recognizing revenue at the time of harvest. This production method is permitted but not required by generally accepted accounting principles (GAAP). GAAP also permits revenue recognition when gold, silver, and similar pre- cious metals have been produced from the mine, even though the metals have not yet been sold. In recent years, however, fluctuations in the sales value of these metals have been large, and the rationale for the production method is therefore weaker. Relatively few mining companies now use the production method.

Many retail stores sell merchandise on an installment basis, in which the customer pays a certain amount per week or per month. If the customers are good credit risks, then the payments are likely to be received and the store can reliably measure its income at the time the sale is made. In other circumstances, the amount of income that is realized cannot be reliably measured at the time the sale is made, so revenue is not recorded at that time. Instead, revenue is recognized when the installment payments are received.11

Production Method

Installment Method

10 For income tax accounting purposes, most long-term contracts must be accounted for under the percentage-of-completion method. 11 “Omnibus Opinion,” APB Opinion No. 10. This Opinion states that sales revenue should “ordinarily” be recognized when the sale is made and that an installment method is acceptable only when “the circumstances are such that the collection of the sales price is not reasonably assured.”

ILLUSTRATION 5–3 Long-Term Contract Accounting Methods

Completed-Contract Percentage-of-Completion Customer Project Year-End Method MethodPayments Costs Percent

Year Received Incurred Complete Revenues Expenses Income Revenues* Expenses Income

1 $120,000 $160,000 20 $ 0 $ 0 $ 0 $180,000 $160,000 $ 20,000 2 410,000 400,000 70 0 0 0 450,000 400,000 50,000 3 370,000 240,000 100 900,000 800,000 100,000 270,000 240,000 30,000_________ _________ ____ _________ _________ _________ _________ _________ _________

Total $900,000 $800,000 $900,000 $800,000 $100,000 $900,000 $800,000 $100,000_________ ____________________ _________

*This amount for a year is the percent of completion accomplished that year times total project revenues. In this example, 20 percent, 50 percent, and 30 percent of the work was accomplished in years 1, 2, and 3, respectively.

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Chapter 5 Revenue and Monetary Assets 115

In the pure installment method, the installment payment is counted as revenue and a proportional part of the cost of sales is counted as a cost in the same period.

In a more conservative variation, the cost-recovery method, cost of sales is recorded at an amount equal to the installment payment. The result is that no income is reported until the installment payments have recouped the total cost of sales.

The effect of the installment method is to postpone the recognition of revenue and income to later periods as compared with the delivery method.12

A jeweler sells a watch in 2009 for $400, and the customer agrees to make payments totaling $200 in 2005 and $200 in 2010. (The customer would ordinarily pay interest in addition to the payments for the watch itself, but this is a separate revenue item that is disregarded here.) The watch cost the jeweler $220.

Effect on Income Statements

Delivery Method Installment Method

2009 2010 2009 2010 Sales revenue $400 $ 0 $200 $200 Cost of goods sold 220 0 110 110_____ ______ _____ _____ Gross margin $180 $ 0 $ 90 $ 90_____ ______ _____ __________ ______ _____ _____

Real Estate Sales Some developers sell land to customers who make a small down payment and pay the balance of the purchase price over a number of years. In some cases, the buyer later becomes disenchanted with the deal or becomes unable to continue with the pay- ments. Because of the consequent uncertainty about the amount of income that will be realized, three conditions must be met in order for revenue to be recognized: (1) The period of cancellation of the contract with a refund to the buyer has expired; (2) the buyer has made cumulative payments equal to at least 10 percent of the pur- chase price; and (3) the seller has completed improvements (roads, utility connec- tions, and so on) or is making progress on these improvements and is clearly capable of eventually completing them. If the improvements have been completed and the re- ceivable from the buyer is probably collectible, then the full sales price is recognized as revenue, and appropriate costs are matched against the revenue. If the improve- ments are in progress, the percentage-of-completion method is used to recognize the revenue. If there is doubt as to the collectibility of the receivables, the installment method is used. If any of the three above-mentioned criteria for revenue recognition is not met, the seller records any payments received as a liability, deposits on land sales.13

Similar but more complex criteria govern the recognition of revenue on the sale of land for commercial use (office buildings, hotels, and other commercial property) and residential property. The required down payments range from 5 percent to 25 per- cent, depending on the nature of the property, and certain other requirements must be met.14

Example

12 Income tax regulations limit the use of the installment method. 13 “Accounting for Sales of Real Estate,” FASB Statement No. 66. 14 Ibid.

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116 Part 1 Financial Accounting

Bad Debts

Amount of Revenue Recognized

In Chapter 3 we discussed the realization concept, which states that the amount recorded as revenue is the amount that customers are reasonably certain to pay. This concept requires that certain adjustments be made to the gross sales value of the goods or services sold. These adjustments are discussed in this section.

The main source of revenue in many businesses is the sale of goods or services to cus- tomers on credit, or “on account.” These sales may involve a single payment or they may involve a series of payments, as in the installment sales transactions discussed above. They give rise to the sales revenue and also to the asset accounts receivable. These accounts, in turn, give rise to losses when customers do not pay the amounts they owe.

Assume that Essel Company began operations in 2010 and that the company made sales of $262,250, all on credit, during the year. In the interest of simplicity, further assume that no money had been received from customers in 2010. The records made of these transactions would result in accounts receivable of $262,250 and sales revenue of $262,250. It would be correct to report $262,250 as an asset on the balance sheet as of the end of 2010 and $262,250 as sales revenue on the in- come statement for 2010 if, but only if, it is believed that all customers eventually will pay the full amount of their obligations to Essel Company. Unfortunately, some of these customers may never pay their bills. If they do not, their accounts become bad debts.

Consider first the extreme case. A person makes a purchase with no intention of paying for it and in fact does not pay for it. In this case, the company has not actually made a sale at all. No revenue was actually earned, and nothing valuable was added to the asset accounts receivable as a result of this transaction. If this event were recorded as an increase in Sales Revenue and as an increase in Accounts Receivable, both of these accounts would be overstated, and income for the period and owners’ equity at the end of the period also would be overstated.

In the more usual bad debt situation, the customer fully intends to pay but for one reason or another never actually makes payment. The effect is the same as that in the extreme case. Such a sale also is recorded initially by debiting Accounts Receivable and crediting Sales Revenue at the sales value of the customer’s purchase. In these situa- tions, another entry must be made to show that the amount debited to Accounts Receiv- able does not represent the amount of the additional asset and that shareholders’ equity has not in fact increased by the amount of the sale.

Accounting Recognition of Bad Debts When a company makes a sale, the fact that the customer will never pay the bill is, of course, not known; otherwise, the sale would not have been made. Even at the end of the accounting period, the company may not know specifically which of its accounts receivable will never be collected. An estimate of the amount of bad debts can never- theless be made, and the accounting records are adjusted at the end of each account- ing period to reflect this estimate.

One way of making this adjustment is by the direct write-off method. Accounts that are believed to be uncollectible are simply eliminated from the records by subtract- ing the amount of the bad debt from Accounts Receivable and showing the same

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amount as an expense item on the income statement. The entry to accomplish this would be as follows:

dr. Bad Debt Expense. . . . . . . . . . . . . . . . 200

cr. Accounts Receivable. . . . . . . . . . . . 200

The direct write-off method, however, requires that the specific uncollectible accounts be identified, whereas this usually is not possible.

With an alternative procedure, the allowance method, the total amount of un- collectible accounts is estimated. This estimated amount is shown as a deduction from accounts receivable on the balance sheet and as an expense on the income statement. Instead of reducing the accounts receivable amount directly, the estimate often is shown as a separate contra asset number on the balance sheet so that the reader can observe both the total amount owed by customers and that portion of the amount that the com- pany believes will not be collected.15

Accounts Involved The balance sheet contra asset account for Accounts Receivable is called Allowance for Doubtful (or Uncollectible) Accounts. At one time, it was often labeled in the ac- counts Reserve for Bad Debts, but this caused confusion since the word reserve con- notes to many people that a sum of money has been set aside and such is not the case. (Nevertheless, the term bad debt reserve is often still used in everyday conversations.) The Allowance for Doubtful Accounts is in the nature of a decrease in Accounts Re- ceivable for specific, but as yet unknown, customers. The corresponding income state- ment account is called Bad Debt Expense.

Making the Estimate In those situations in which using the direct write-off method is not feasible, any one of several methods may be used to estimate the amount of bad debt expense in an accounting period. The most common method is to estimate bad debt expense as a percentage of credit sales. (The percentage is applied to credit sales since, of course, cash sales do not result in bad debts.) The percentage used depends in part on past experience and in part on management’s judgment as to whether past experience reflects the current situation. The allowance for doubtful accounts should be sufficient at all times to absorb the accounts that prove to be uncollectible. Because business conditions fluctuate, the amount may turn out to be too large in some periods and too small in others. In practice, because of the concept of conservatism, it is common to find that the allowance is too large rather than too small. On the other hand, there have been some cases in which the allowance for doubtful accounts turned out to be woe- fully inadequate.

Aging Accounts Receivable Sometimes different percentages are applied to accounts outstanding for various lengths of time. This requires the preparation of an aging schedule, which is also a useful device for analyzing the quality of the asset accounts receivable. An example for Essel Company is shown in Illustration 5–4.

15 Generally, income tax regulations do not permit use of the allowance method. Rather, the direct write-off method must be used for each specific account that becomes partially or totally worthless.

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118 Part 1 Financial Accounting

The Adjusting Entry Once the amount of the allowance has been determined, it is recorded as one of the adjusting entries made at the end of the accounting period. If Essel Company management estimated the allowance for doubtful accounts on the basis of the above aging schedule, the entry would be

dr. Bad Debt Expense. . . . . . . . . . . . . . . . . 7,132

cr. Allowance for Doubtful Accounts . . . 7,132

The accounts receivable section of the December 31, 2010, balance sheet would then appear as follows:

Accounts receivable $262,250

Less: Allowance for doubtful accounts 7,132

Accounts receivable, net $255,118

The 2010 income statement would show $7,132 of bad debt expense. The contra asset account, Allowance for Doubtful Accounts, usually will have a bal-

ance even before the adjusting entry is made. In these circumstances, the amount re- ported as bad debt expense on the income statement will be different from the amount reported as allowance for doubtful accounts on the balance sheet. (In the Essel Com- pany example just given, this did not occur because the company was organized in 2009, and the above entry was the first one made to Allowance for Doubtful Accounts.)

Write-Off of an Uncollectible Account When a company decides that a specific customer is never going to pay the amount owed, Accounts Receivable is reduced by the amount owed and a corresponding reduc- tion is made in the Allowance for Doubtful Accounts. This entry has no effect on Bad Debt Expense or on income of the period in which the account is written off.

If sometime in 2011 the Essel Company decided that James Johnson was never going to pay his bill of $250, the following entry would be made:

dr Allowance for Doubtful Accounts . . . . . . . 250

cr. Accounts Receivable. . . . . . . . . . . . . . . 250

ILLUSTRATION 5–4 Aging Schedule for Estimating Bad Debts

Estimated Allowance for Status as of Amount Percent Doubtful

December 31, 2010 Outstanding Uncollectible Accounts

Current $207,605 1 $2,076 Overdue:

Less than 1 month 26,003 1 260 1 up to 2 months 10,228 5 511 2 up to 3 months 7,685 10 769 3 up to 6 months 3,876 20 775 6 months and over 6,853 40 2,741_________ _______

Total $262,250 $7,132

Example

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Chapter 5 Revenue and Monetary Assets 119

A balance sheet prepared immediately after this transaction had been recorded (assuming no other changes since December 31, 2010) would appear as follows:

Accounts receivable $262,000

Less: Allowance for doubtful accounts 6,882

Accounts receivable, net $255,118

Note that the net amount of accounts receivable is unchanged by this write-off.

Collection of a Bad Debt Written Off If, by some unexpected stroke of good fortune, James Johnson should subsequently pay all or part of the amount he owed, Cash would be increased (i.e., debited) and a cor- responding credit would be recorded, usually to add back the amount to Allowance for Doubtful Accounts on the balance sheet.

As mentioned in Chapter 3, sales revenue is recorded at not more than the sales value of the actual transaction (realization concept).

Some businesses offer a so-called cash discount to induce customers to pay bills quickly. For example, if a business sells goods on terms of “2/10, net/30,” it permits customers to deduct 2 percent from the invoice amount if they pay within 10 days; oth- erwise, the full amount is due within 30 days.16 The cash discount can be recorded in any of three ways:

1. The discount can be recorded as a reduction from gross sales. 2. The discount can be recorded as an expense of the period. 3. Sales revenue can be initially recorded at the net amount after deduction of the dis-

count. Amounts received from customers who do not take the discount would then be recorded as additional revenue. Thus, a $1,000 sale subject to a 2 percent cash discount would be recorded at the time of sale as

dr. Accounts Receivable . . . . . . . . . . . . . . . . . 980

cr. Sales Revenue . . . . . . . . . . . . . . . . . . . 980

If the discount were not taken by the customer, the entry upon receipt of the cus- tomer’s payment would be

dr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

cr. Discounts Not Taken . . . . . . . . . . . . . . 20

Accounts Receivable . . . . . . . . . . . . . . . 980

Millions of retailers and service establishments who sell on credit have contracted with an outside agency, such as master card or visa, to handle some or all of their accounts receivable.

In these arrangements, at the point of sale, merchants send electronically the sales data and charge to a bank which next day credits the merchant’s account for the sales amount. (From the bank’s point of view, the entry is a credit since it increases the customer’s bank balance, which is a liability of the bank.) The bank arranges to have the charges collected from the customers. So far as the merchant is concerned, this type of

Sales Discounts

Credit Card Sales

16 This is a powerful inducement to pay within 10 days because by forgoing the 2 percent, the customer has the use of the money only for an additional 20 days. Since there are about 18 20-day periods in a year, this amounts to an annual interest rate of 18 � 2 percent � 36 percent.

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120 Part 1 Financial Accounting

Sales Returns and Allowances

Revenue Adjustment versus Expense

transaction is not a credit sale. No accounts receivable appear in the merchant’s ac- counts. The original credit card swipe that is made at the time of purchase is equivalent to the customer writing a check to cover the purchase. The only difference between a credit card sale and a customer payment by check is that, in the former case, the bank deducts a fee for the service of handling the accounts receivable paperwork and assum- ing the risk of bad debts. This fee is in the nature of a sales discount and is recorded as such in the merchant’s accounts thus:

dr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 970

Sales Discount (Credit Cards) . . . . . . . . . . 30

cr. Sales Revenue . . . . . . . . . . . . . . . . . . . 1,000

When customers are dissatisfied with goods or services sold to them, the company may permit them to return the goods for full credit, or it may refund part or all of the sales price. In these circumstances, the amount originally recorded as revenue turns out to be an overstatement of the true amount of the sale. Sales returns and allowances are con- ceptually similar to bad debts.

Some companies treat sales returns and allowances in the same way that they treat bad debt expense. They estimate the percentage of revenues that will eventually result in returns and allowances and set up an account for this amount. The offsetting credit is to a liability account; thus:

dr. Sales Returns and Allowances. . . . . . . . . . . 1,000

cr. Provision for Returns and Allowances. . . 1,000

The Sales Returns and Allowances account is analogous to Bad Debt Expense. The Provision for Returns and Allowances account is analogous to Allowance for Doubtful Accounts, except the former is treated as a liability rather than as a contra asset. When goods are returned or allowances made, Provision for Returns and Allowances is debited; the credit is to the customer’s account receivable or to Cash (if a refund is made).

Other companies do not attempt to estimate the amount of returns and allowances associated with sales revenue of the current period. Instead, they simply debit Sales Returns and Allowances whenever a sales return or allowance occurs, with an offsetting credit to Accounts Receivable (or to Cash, if the returned goods had already been paid for). When this practice is followed, the sales returns and allowances deducted from revenue of a period do not relate to the actual goods included in the sales revenue of that period. The justification for this apparent departure from the matching concept is that the amounts are difficult to estimate in advance, are likely to be relatively constant from one period to the next, and are relatively small. Under these circumstances, the practice is consistent with the materiality concept.

The need for recognizing bad debts, sales discounts, and sales returns and allowances arises because of one aspect of the realization concept—namely, that revenues should be reported at the amount that is reasonably certain to be collected. This concept would seem to require that these amounts be subtracted from gross revenues in order to determine the net revenue of the period. The effect of some of the practices de- scribed above, however, is to report the amounts as expenses rather than as adjust- ments to revenues.

Whether companies report these amounts as expenses or as adjustments to revenues, the effect on income is exactly the same. The difference between the two methods is

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Chapter 5 Revenue and Monetary Assets 121

in the way they affect revenue and gross margin. The consistency concept requires that a company follow the same method from one year to the next; thus, comparisons within a company are not affected by these differences in practice. They may, however, have a significant effect when the income statements of companies that use different methods are being compared.

Following are income statements for Company A, which treats the items of the type dis- cussed in this section as adjustments to revenue, and Company B, which treats them as expenses. Otherwise, the firms are identical.

Income Statements

(000s)

Company A Company B

Amount Percent Amount Percent

Gross sales $1,000 110.0 $1,000 100.0 Less: Sales discounts 20 2.2 0 Bad debts 40 4.5 0 Returns 30 3.3 0

Net sales 910 100.0 1,000 100.0 Cost of sales 600 65.9 600 60.0 Gross margin 310 34.1 400 40.0 Other expenses 210 23.1 210 21.0 Discounts, bad debts, returns 0 90 9.0 Income $ 100 11.0 $ 100 10.0

Note the differences between the two income statements, not only in the dollar amounts of net sales and gross margin but also, more importantly, in the percentages. (In reporting percentage relationships on an income statement, net sales is customarily taken as 100 percent, and the percentages for other items are calculated by dividing each by the amount of net sales.) Various combinations of these alternatives would pro- duce still different amounts and percentages.

Companies usually have an obligation to repair or replace defective goods. This obli- gation arises either because it is an explicit part of the sales contract or because there is an implicit legal doctrine that says that customers have a right to receive satisfactory products. In either case, the obligation is called a warranty.

If it is likely that a material amount of costs will be incurred in future periods in replacing or repairing goods sold in the current period, both the conservatism and matching concepts require that income in the current period be adjusted accord- ingly.17 The amount of the adjustment is usually estimated as a percentage of sales revenue. This adjustment is recorded as an expense with an entry such as the following:

dr. Estimated Warranty Expense . . . . . . . . . . . 2,000

cr. Allowance for Warranties . . . . . . . . . . . . 2,000

Example

Warranty Costs

17 Income tax regulations do not permit recognizing warranty costs until they are actually incurred.

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When costs are incurred in the future in repairing or replacing the goods, Allowance for Warranties, a liability account, is debited, and Cash, Parts Inventory, or some other balance sheet account is credited. Analogous to the write-off of an uncollectible receivable, this warranty repair or replacement transaction affects neither the estimated warranty expense nor the income of the period in which it takes place.

Conceptually, Estimated Warranty Expense is an upward adjustment of Cost of Sales rather than a downward adjustment of Sales Revenue. We nevertheless have included the topic here because the accounting procedures for warranty costs are so similar to those for bad debts and sales returns and allowances. All these adjustments reduce the period’s reported income.

A principal source of revenue to a bank or other lending institution is interest on the money that it lends.18 Industrial and commercial companies also may earn interest revenue. Under the realization concept, the amount of revenue for a period is the amount the lender earned on the money the borrower had available for use during that period. Accounting for this amount depends on whether interest is paid at maturity—that is, when the loan is repaid—or whether it is in effect paid when the money is borrowed. In the latter case, the loan is said to be discounted. Examples of each are given below.

Interest Paid at Maturity. On September 1, 2010, a bank loaned $10,000 for one year at 9 percent interest, the interest and principal to be paid on August 31, 2011. The bank’s entry on September 1, 2010, is

dr. Loans Receivable . . . . . . . . . . . . . . . . . . . . 10,000

cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

On December 31, 2010, an adjusting entry is made to record the fact that interest for one- third of a year, $300, was earned in 2010:

dr. Interest Receivable . . . . . . . . . . . . . . . . . . 300

cr. Interest Revenue . . . . . . . . . . . . . . . . . 300

On August 31, 2011, when the loan is repaid, the entry is

dr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,900

cr. Loans Receivable . . . . . . . . . . . . . . . . . 10,000

Interest Receivable . . . . . . . . . . . . . . . . 300

Interest Revenue. . . . . . . . . . . . . . . . . . 600

Corresponding entries are made on the books of the borrower to record interest expense.

Discounted Loan. On September 1, 2010, a bank loaned $10,000 for one year at 9 percent discounted. The borrower received $10,000 less the $900 prepaid interest, or $9,100.19 On that day, the bank has a liability of $900 because it has not yet performed the service of per- mitting the use of the money. The bank’s entry on September 1, 2010, is

dr. Loans Receivable . . . . . . . . . . . . . . . . . . . . 10,000

cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 9,100

Unearned Interest Revenue. . . . . . . . . . 900

18 In practice, this amount is often called interest income rather than interest revenue. Conceptually, it is revenue. 19 The effective interest rate on this loan is more than 9 percent, since the borrower pays $900 interest for the use of only $9,100 for one year.

Interest Revenue

Example

Example

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Chapter 5 Revenue and Monetary Assets 123

The borrower records a $9,100 increase in Cash, a $900 increase in Prepaid Interest Expense, and a $10,000 increase in Notes Payable.

On December 31, 2010, the bank makes an adjusting entry to record the fact that $300 interest (one-third of a year) was earned in 2010 and is therefore no longer a liability:

dr. Unearned Interest Revenue . . . . . . . . . . . . 300

cr. Interest Revenue . . . . . . . . . . . . . . . . . 300

On August 31, 2011, when the loan is repaid, the entry is

dr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

cr. Loans Receivable . . . . . . . . . . . . . . . . . 10,000

After repayment by the borrower, an adjusting entry is also made by the bank to record the fact that $600 interest (two-thirds of a year) was earned in 2011:

dr. Unearned Interest Revenue . . . . . . . . . . . . 600

cr. Interest Revenue . . . . . . . . . . . . . . . . . 600

Interest Component of a Sale When buyers purchase goods on an installment plan, they pay both for the goods themselves and for the interest that the seller charges on the amount of the unpaid balance. Revenue from the sales value of the goods should be recorded separately from interest revenue. In most sales to consumers, this separation is easy to recognize since federal regulations require that the amount of interest be specified in the sales contract. Although the goods’ sales value may be recognized at the time of the sale (unless the installment method is used), the interest revenue is recognized in the period or periods in which it is earned; that is, it is spread over the life of the install- ment contract.

In some sales agreements, the buyer gives a note promising to pay several months or even years in the future; but the note does not explicitly indicate that an interest charge is involved. Since any rational merchant expects to receive more money for a sale that is not completed for many months in the future than for a cash sale, it is apparent that the amount of the note includes both the sales value of the goods and an interest charge. In recording the transaction, these two components must be shown separately. If the full amount of the note were recognized as revenue in the period in which the transaction took place, revenue for that period would be overstated by the amount of the interest component. The interest implicit in such a transaction is calcu- lated by applying the going rate of interest for transactions of this general type.20 The same principle is used for notes that state a rate of interest significantly below the going rate.

On September 1, 2010, a customer purchased a piece of equipment and gave in payment a note promising to pay $10,000 one year later, with no interest stated. The going rate of interest was 8 percent. The entry on September 1, 2010, would be

dr. Notes Receivable. . . . . . . . . . . . . . . . . . . . 10,000

cr. Sales Revenue . . . . . . . . . . . . . . . . . . . 9,259

Unearned Interest Revenue. . . . . . . . . . 741

20 “Interest on Receivables and Payables,” APB Opinion No. 21, specifies the details as to how the rate of interest is determined. The interest revenue amount is found by using present value techniques de- scribed in Chapter 8, not by discounting the face amount of the note.

Example

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124 Part 1 Financial Accounting

The adjusting entry on December 31, 2010, and the entry recording payment of the note on August 31, 2011, would be similar to those given above for a discounted loan.

Transfer of Financial Assets Companies often sell their financial assets, such as a sale of accounts receivables, to a finance company. In order for a transfer of a financial asset to be accounted for as a sale, the transferor must surrender control of those financial assets to the transferee. If the transfer does not meet this requirement, the two parties to the transaction must account for the transfer as a secured borrowing with a pledge of collateral.21

While the accounting outcome of a transfer of most financial assets governed by IFRS may be the same as under GAAP, the IFRS derecognition (sale) test is different. In order to qualify as a financial asset sale, IAS No. 39 requires the transferor to trans- fer to the transferee substantially all the risks and rewards of ownership of the financial asset.22

Monetary Assets

Monetary assets are money or claims to receive fixed sums of money (e.g., accounts receivable or notes receivable). By contrast, most nonmonetary assets are items that will be used in the future in the production and sale of goods and services. No separate classification for monetary assets appears on the balance sheet. The tradi- tional distinction on the balance sheet is between current assets and noncurrent assets. The reason for calling attention to the distinction between monetary and non- monetary assets is that the concepts governing the amounts at which they appear on the balance sheet subsequent to their initial recognition at cost differ for these two categories.

In general and with the notable exception of inventories (discussed in Chapter 6), non- monetary assets appear on the balance sheet at unexpired cost. When acquired, they were recorded at cost. The amount shown on the balance sheet at any time thereafter is the amount not yet written off as an expense. If a building was acquired in 1995 at a cost of $1 million and if $375,000 of its cost has been written off as depreciation ex- pense in the intervening 15 years, the balance sheet for December 31, 2010, will report the asset amount of this building at $625,000, regardless of its market value at that time.

For monetary assets, the idea of unexpired cost is not appropriate. As we have seen above, the accounts receivable item is reported at its estimated realizable value. This is the effect of the adjustment for the estimated amount of bad debts included in the accounts receivable. Cash, of course, is reported at its face amount, whether on hand or deposited in banks. As indicated in Chapter 2, most other monetary assets are accounted for at their fair value.

21 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” FASB Statement No. 140. 22 “Financial Instruments: Recognition and Measurement,” IAS No. 39.

Difference in Reporting Monetary and Nonmonetary Assets

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Cash consists of funds that are immediately available for disbursement. Cash is usually held in checking accounts on which little or no interest is earned. If an entity has a temporary excess of cash, it may loan the excess to a bank and receive interest on it. The evidence of such a loan is called a certificate of deposit. A certificate of deposit has a maturity date, and a penalty is involved if the entity cashes it prior to that date. Therefore, these funds are not as liquid as cash in a checking account. Some companies include certificates of deposit in the amount reported for cash, whereas other companies disclose separately an amount for these certificates.

The accounts receivable discussed in the preceding section were amounts due from customers. For nonfinancial institutions, these are often called trade receivables. As already explained, financial institutions have loans receivable and interest receivable. Also, an entity may advance funds to employees for various reasons, a principal one being to provide for travel expenses. Such receivables are reported separately from trade receivables in an account with a title such as Due from Employees.

If an entity has a temporary excess of cash, rather than—or in addition to—investing it in certificates of deposit, the entity may invest it in marketable securities. Marketable securities are of several types. Commercial paper is a colloquial name for short-term, interest-bearing promissory notes issued by large companies with high credit ratings and a temporary need for more cash. Treasury bills are short-term obligations of the U.S. Treasury; that is, the investor in a Treasury bill is making a short-term loan to the federal government. Stocks of companies as well as bonds of companies and govern- ment entities are also marketable securities if they are, in fact, marketable—that is, if they can be readily sold.

Most companies report marketable securities as a separate line on the balance sheet, some of them preferring the caption “temporary investments.” Some companies in- clude certificates of deposit in the marketable securities or investments total rather than as a separate item or as a part of cash. Capital stock of other companies held for the purpose of exercising some control over those companies, or stocks and bonds not traded on a securities market, are reported as investments rather than as marketable securities. (Investments are discussed in Chapter 12.)

Security Categories Generally accepted accounting principles set out explicit rules for the balance sheet valuation of marketable securities.23 Application of the rules involves classifying such securities into three categories:

1. Held-to-maturity securities are debt securities that the entity intends to hold to maturity. They are reported on the balance sheet at cost.

2. Trading securities are debt and equity securities that are held for current resale. They are reported at market value, with any unrealized gains or losses of the period

Cash

Receivables

Marketable Securities

23 “Accounting for Certain Investments in Debt and Equity Securities,” FASB Statement No. 115.

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included in the calculation of the period’s income. The entry for an unrealized gain of $5,000 would be

dr. Marketable Securities . . . . . . . . . . . . . . . . 5,000

cr. Gain on Marketable Securities . . . . . . . 5,000

This would increase the period’s pretax income by $5,000. An analogous entry would be made for a loss, which would decrease the period’s reported income.

3. Available-for-sale securities are debt and equity securities that do not fit either of the other two categories. They are reported at market value, and any unrealized gains (or losses) of the period are directly credited (or debited) to an owners’ equity account; that is, the write-up (or write-down) does not “flow through” the income statement as it does in the case of trading securities.

Analysis of Monetary Assets

Some relationships that are helpful in analyzing a company’s monetary assets are de- scribed below. They include the current ratio, the acid-test ratio, days’ cash, and days’ receivables. These ratios will be illustrated using the information given for Franklin Company in Illustration 5–5.

As explained in Chapter 2, the current ratio is

Current ratio � Current assets

� $1,245.1

� 1.03 Current liabilities $1,214.6

The current ratio is the most commonly used of all balance sheet ratios. It is a measure not only of the company’s liquidity but also of the margin of safety that management maintains in order to allow for the inevitable unevenness in the flow of funds through the current asset and current liability accounts. If this flow were absolutely smooth and uniform (so that, for example, money coming in from customers each day exactly equaled that day’s maturing obligations), the requirements for such a safety margin would be small. Since a company rarely can count on such an even flow, it needs a sup- ply of liquid funds to be assured of being able to pay its bills when they come due. The current ratio indicates the size of this buffer.

In interpreting the current ratio, consideration of the proportion of various types of current assets is important. Even if two companies have the same current ratio, a company with a high percentage of its current assets in the form of monetary assets is more liquid than one with a high percentage in inventory. Also, the nature of the business must be considered. For example, a manufacturer that makes high-fashion clothing needs a relatively high current ratio, since there is high risk involved in both this firm’s accounts receivable and its inventory. On the other hand, a metals distrib- utor may safely have a lower current ratio than the clothing manufacturer’s, since the distributor’s primary current asset would be inventories of steel, copper, and alu- minum shapes, which do not become obsolete and whose prices may be increasing because of inflation.

Current Ratio

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Some of the current assets are monetary assets. A ratio that focuses on the relationship of monetary current assets to current liabilities is called the acid-test ratio, or quick ratio. Quick current assets are those current assets that are also monetary assets; they therefore exclude inventories and prepaid items. The formula is

Acid-test ratio � Monetary current assets

� $634.9

� 0.52 Current liabilities $1,214.6

Although cash is a necessary asset, it earns little or no return. Thus, although too little cash is an obvious signal of difficulty, too much cash is a sign that management has not taken advantage of opportunities to put cash to work in, say, marketable securities.

One way to judge how well the company is managing its cash is to calculate roughly how many days’ bills the cash on hand would pay. The first step is to use the income statement to estimate cash expenses: A rough approximation would be to take total ex- penses and subtract noncash expenses such as depreciation. This total is then divided by 365 days to arrive at daily cash needs:

Cash costs per day � $5,348.0

� $14.65 365 days

ILLUSTRATION 5–5 Condensed Financial Statements

FRANKLIN COMPANY Balance Sheet

As of December 31, 2010 (millions)

Assets Current assets:

Cash and temporary investments $ 98.1

Accounts receivable (less allowances) 536.8

Inventories 403.1

Prepaid expenses 207.1________ Total current assets 1,245.1

All other assets 2,992.0________ Total assets $4,237.1________________

Liabilities and Shareholders’ Equity Current liabilities $1,214.6

All other liabilities and stockholders’ equity 3,022.5________ Total liabilities and stockholders’ equity $4,237.1________________

Income Statement For the Year Ended December 31, 2010

(in millions)

Net sales and revenues $6,293.9

Expenses* 5,613.2________ Net income $ 680.7________________

*Includes depreciation expense of $265.2 million.

Days’ Cash

Acid-Test Ratio

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128 Part 1 Financial Accounting

This amount can then be divided into the cash balance to determine approximately the “days’ cash” on hand:

Cash $98.1 Cash costs per day

� $14.65 per day

� 7 days 24

Combining these two steps, the formula for days’ cash is

Cash Days’ cash �

Cash expenses � 365

It must be emphasized that this is a rough approximation. The calculation focuses on routine operating expenses; it does not take account of cash needed for major asset purchases or loan repayments. Thus, a firm might appear to have too much cash on hand because it has just received cash from bonds issued to finance construction of a new facility. On the other hand, firms with good cash management procedures would not let even that cash sit idle; they would invest it in short-term securities for as long as possible, even if that is only one or two days. In companies that manage their cash well, the days’ cash will usually be only a few days. (Some analysts calculate this ratio using cash plus marketable securities in the numerator rather than just “pure” cash. The ratio then indicates short-term liquidity, rather than cash management.)

A calculation similar to that used in days’ cash can be used to see how many days’ worth of sales are represented in accounts receivable (days’ sales outstanding, or DSOs). The formula is

Receivables $536.8 Days’ receivables � Sales � 365 � $6,293.9 � 365 � 31 days

The result is also called the average collection period for the receivables. If available, the amount of sales in the denominator should be credit sales, which is more closely related to receivables than is total sales.

The collection period can be related roughly to the credit terms offered by the com- pany. A rule of thumb is that the collection period should not exceed 11⁄3 times the reg- ular payment period; that is, if the company’s typical terms call for payment in 30 days, it is said that the average collection period should not exceed 40 days. Like all rules of thumb, this one has a great many exceptions. Changes in the ratio may indicate changes in the company’s credit policy or changes in its ability to collect its receivables.

As with other ratios, comparisons should be made with the collection period of other firms in the same industry and also with a firm’s own ratio for previous years. For example, in industries with excess capacity, looser credit policies are sometimes used as a competitive marketing tool, thus increasing the days’ receivables. If a firm’s col- lection period is significantly longer than its competitors’, this may suggest inadequate collection procedures.

24 This result needs to be interpreted in light of the fact that Franklin Company reports cash and highly liquid temporary investments as a single combined amount. For companies that separately re- port cash and marketable securities, basing the calculation on “pure” cash typically will give a result of only two or three days.

Days’ Receivables

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Chapter 5 Revenue and Monetary Assets 129

Problems Problem 5–1.

Below is a schedule of monthly credit sales and collections for Yzerman Company. Assum- ing Yzerman’s cost of goods sold is always 65 percent of sales, calculate how much gross margin Yzerman will report each month (a) if revenues are recognized when the sale is made and (b) if the installment method is used.

Jan. Feb. Mar. Apr. May June

Sales $12,000 $ 8,000 $13,000 $11,000 $ 9,000 $13,500 Collections 11,000 10,000 11,500 10,500 10,500 9,500

Problem 5–2. The Giamatti Construction Company primarily builds houses, and rarely is a house only partially completed as of December 31. However, this year Giamatti is also building a motel, which it started in March and expects to complete next April. The motel calls for a

The aging schedule in Illustration 5–4 also provides useful information in analyzing the quality of the accounts receivable. An increase in the proportion of overdue amounts is a serious danger signal. Although aging schedules frequently are used within corpo- rations, they are not disclosed in corporate annual reports to shareholders.

Summary Although a business earns income continuously, accounting recognizes revenue only in the period in which the entity has performed substantially what is required in order to earn in- come and in which the amount of income can be reliably measured. In the usual case of the sale of goods or services, this is the period in which goods are delivered or services per- formed. If income cannot be reliably measured at this time, as in certain types of installment sales, revenue recognition is postponed. If the earning process takes place over several accounting periods, the percentage-of-completion method recognizes revenue in each of these periods, provided that there is reasonable assurance of the profit margin and its ulti- mate realization.

The realization concept states that the amount of revenue recognized in a period is the amount that is reasonably certain to be collected from customers. Accordingly, the gross sales revenue is reduced by the estimated amount of bad debts that are hidden in credit sales. A corresponding reduction is made in the asset accounts receivable. Similar reduc- tions may be made for warranty costs and for sales returns and allowances.

Monetary assets are money or claims to receive fixed sums of money. Cash, certificates of deposit, and accounts receivable are reported at realizable amounts (which, in the case of cash and certificates of deposit, are the same as the face amount). Marketable debt and eq- uity securities are reported at either cost or current market value, depending on the com- pany’s intentions regarding holding the securities.

The current ratio, the acid-test ratio, days’ cash, and days’ receivables are useful tools in analyzing a company’s monetary assets.

While the basic GAAP and IFRS revenue recognition standards differ, in most cases the revenue accounting outcome is the same.

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fee of $5 million. Expected total costs are $4.25 million, and $2.55 million of these had been incurred as of December 31.

Required: Assume that, excluding the motel project, Giamatti’s income before taxes will be $1.25 mil- lion both this year and next. What will each year’s income before taxes be, including the motel project, (a) if Giamatti uses the completed-contract method and (b) if it uses the percent- age-of-completion method? (Assume actual motel costs in fact turn out to be $4.25 million.) Which method should Giamatti use?

Problem 5–3. Alcon Company decided to write off the $3,000 Wordel Corporation receivable as uncol- lectible. Subsequently, Wordel makes a $950 payment on the account. Prepare journal entries for these two transactions.

Problem 5–4. Huron Corporation operates in an industry that has a high rate of bad debts. On December 31, before any year-end adjustments, the balance in Huron’s Accounts Receivable account was $750,000 and the Allowance for Doubtful Accounts had a balance of $37,500. The year-end balance reported in the statement of financial position for the Allowance for Doubtful Accounts will be based on the aging schedule shown below.

Days Account Outstanding Amount Probability of Collection

Less than 16 $450,000 .99 16 to 30 150,000 .94 31 to 45 75,000 .80 46 to 60 45,000 .65 61 to 75 15,000 .50 Over 75 15,000 .00

Required: a. What is the appropriate balance for the Allowance for Doubtful Accounts on

December 31?

b. Show how accounts receivable would be presented on the balance sheet prepared on December 31.

c. What is the dollar effect of the year-end bad debt adjustment on the before-tax income for the year?

Problem 5–5. Green Lawn Chemical Company sells lawn and garden chemicals through several hundred garden supply stores and department store garden shops. It was Green Lawn’s policy to ship goods to these retailers in late winter on a consignment basis. Periodically, a Green Lawn field representative would count the Green Lawn products on hand at a retailer; based on this count, the previous count, and intervening shipments, it was determined how many items the retailer had sold since the previous count, and the retailer was billed for these goods by Green Lawn.

Required: a. Assume Green Lawn shipped goods costing Green Lawn $8,400 and with a whole-

sale price (i.e., price to the retailer, not the end user) of $12,600 to Carson’s Garden Shop. Prepare journal entries to record this entry (1) on Green Lawn’s books and (2) on Carson’s books.

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b. Later, the field representative’s count indicated that Carson’s had sold some of these goods, totaling $6,720 at retail, $5,040 at wholesale, and $3,360 at Green Lawn’s cost. Prepare journal entries to reflect these sales (1) on Green Lawn’s books and (2) on Carson’s books.

Problem 5–6. Structco Construction Company entered into a long-term construction contract at a fixed contract price of $4,900,000 on September 1, 20x4. Work has proceeded since that time with the following results:

20x4 20x5 20x6

Costs incurred (this year) $ 721,000 $1,190,000 $1,715,000 Cost of work yet to be completed

(at year-end) 3,430,000 2,240,000 525,000 Cash collections (this year) 560,000 1,120,000 1,540,000 Year-end percent complete 20% 50% 95%

Required: Determine the amount of revenues, expenses, and income for 20x4, 20x5, and 20x6 by using the percentage-of-completion method.

Problem 5–7. GRW Company has the following account balances at the end of the year, before adjusting and closing entries. (All numbers are in thousands of dollars.)

Dr. Cr.

Accounts receivable (gross; terms, net 30 days) $ 34,650 Accounts payable $ 38,600 Allowance for doubtful accounts 1,850 Accumulated depreciation 61,600 Cash 23,100 Common stock 231,000 Cost of goods sold 161,700 Depreciation expense 15,400 Goodwill 38,500 Interest payable 25,000 Inventory, beginning 46,200 Long-term debt (required to be repaid at a rate

of $7,700 per year) 192,500 Other expenses 69,300 Plant and equipment, at cost 346,500 Purchases of inventory 184,800 Retained earnings, beginning 46,200 Sales (23% were for cash) 323,400

Required: Calculate and interpret the year-end

a. Quick and current ratios.

b. Number of days’ cash on hand. (Hint: Total expenses minus noncash charges can be used as a proxy for operating cash needed for the year.)

c. Number of days’ worth of sales represented by accounts receivable (i.e., collection period).

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132 Part 1 Financial Accounting

Cases

Case 5–1

Stern Corporation (A)*

On December 31, 2010, before the yearly financial statements were prepared, the controller of the Stern Corporation reviewed certain transactions that affected accounts receivable and the allowance for doubtful ac- counts. The controller first examined the December 31, 2009, balance sheet (Exhibit 1 on page 133). A subse- quent review of the year’s transactions applicable to accounts receivable revealed the items listed below:

1. Sales on account during 2010 amounted to $9,965,575.

2. Payment received on accounts receivable during 2010 totaled $9,685,420.

3. During the year, accounts receivable totaling $26,854 were deemed uncollectible and were written off.

4. Two accounts that had been written off as uncol- lectible in 2009 were collected in 2010. One ac- count for $2,108 was paid in full. A partial payment of $1,566 was made by the Hollowell Company on another account that originally had amounted to $2,486. The controller was reasonably sure this ac- count would be paid in full because reliable reports

were circulating that the trustee in bankruptcy for the Hollowell Company would pay all obligations 100 cents on the dollar.

5. The Allowance for Bad Debts was adjusted to equal 3 percent of the balance in Accounts Receivable at the end of the year.

Questions

1. Analyze the effect of each of these transactions in terms of its effect on Accounts Receivable, Allowance for Doubtful Accounts, and any other account that may be involved, and prepare neces- sary journal entries.

2. Give the correct totals for Accounts Receivable and the Allowance for Doubtful Accounts as of December 31, 2010, after the transactions affecting them had been recorded.

3. Calculate the current ratio, acid-test ratio, and days’ receivables figures as of December 31, 2010. As- sume that amounts for items other than those de- scribed in the case are the same as on December 31, 2009.* Copyright © James S. Reece.

Case 5–2

Grennell Farm*

Early in 2010, Denise Grey was notified by a lawyer that her recently deceased uncle had willed her the owner- ship of a 2,000-acre wheat farm in Iowa. The lawyer asked whether Grey wanted to keep the farm or sell it.

Grey was an assistant vice president in the con- sumer credit department of a large New York bank. Despite the distance between New York and Iowa, Grey was interested in retaining ownership of the farm if she could determine its profitability. During the last 10 years of his life, Jeremiah Grennell had

hired professional managers to run his farm while he remained in semiretirement in Florida.

Keeping the farm as an investment was particularly interesting to Grey for the following reasons:

1. Recent grain deals with foreign countries had begun to increase present farm commodity prices, and many experts believed these prices would re- main high for the next several years.

2. Although the number of small farms had decreased markedly in the last 20 years, Grennell’s use of mechanization and new hybrid seed varieties had proven to be profitable.

* Copyright © by the President and Fellows of Harvard College. Harvard Business School case 198-046.

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Chapter 5 Revenue and Monetary Assets 133

EXHIBIT 1 STERN CORPORATION

Balance Sheet As of December 31, 2009

Assets Current assets:

Cash $ 671,344 Accounts receivable $ 988,257

Less: Allowance for doubtful accounts 29,648 958,609__________ U.S. Treasury securities at cost 274,060 Inventories 1,734,405____________

Total current assets 3,638,418 Other assets:

Investments 412,294 Land 186,563 Building 2,405,259

Less: Accumulated depreciation 663,379 1,741,880__________ Factory machinery 3,425,585

Less: Accumulated depreciation 1,642,358 1,783,227__________ Furniture and fixtures 56,484

Less: Accumulated depreciation 40,400 16,084__________ Automotive equipment 58,298

Less: Accumulated depreciation 37,156 21,142__________ Office machines 42,534

Less: Accumulated depreciation 28,005 14,529__________ Tools 61,294 Patent 56,250 Prepaid expenses 100,190____________

Total assets $8,031,871________________________

Liabilities and Shareholders’ Equity Current liabilities:

Accounts payable $ 510,000 Taxes payable 709,354 Accrued salaries, wages, and interest 141,478 Long-term debt, due within one year 69,300____________

Total current liabilities 1,430,132____________ Noncurrent liabilities:

Long-term debt 1,247,368____________ Shareholders’ equity:

Common stock 2,503,275 Retained earnings 2,851,096____________

Total shareholders’ equity 5,354,371____________ Total liabilities and shareholders’ equity $8,031,871________________________

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134 Part 1 Financial Accounting

3. After some downward movement in the early 2000s, the value of good farmland in Iowa was beginning to appreciate at about 10 percent a year.

Included in the lawyer’s letter were data on revenues and expenses for 2009 and certain information on bal- ance sheet items, which are summarized below:

Beginning inventory 0 bushels 2009 wheat production 210,000 bushels Shipped to grain elevator 180,000 bushels Grain stored at farm at end of 2009 30,000 bushels

2009 Expenses for the Grennell Farm

A. Production costs per bushel: Seed $ 0.053 Fertilizer and chemicals 0.295 Machinery costs, fuel, and repairs 0.107 Part-time labor and other costs 0.058_________

Total production cost per bushel $ 0.513__________________ B. Annual costs not related to the volume

of production: Salaries and wages $ 72,500 Insurance 4,500 Taxesa 32,500 Depreciation 28,500 Other expenses 45,000________

Total costs not related to production volume $183,000__________________

a This figure excludes income taxes since the corporation was taxed as a sole proprietorship.

Prices The average price per bushel that the elevator operator had agreed to pay for wheat shipped to the grain eleva- tor in 2009 was $2.90. The price per bushel at the time of the wheat harvest was $2.80. The closing price per bushel on December 31, 2009, was $3.07.

Accounts Receivable At year-end, the proceeds from 20,000 bushels shipped to the grain elevator had not yet been received from the elevator operator. The average sales price of these 20,000 bushels of wheat had been $2.98 per bushel. There were no uncollected proceeds on December 31, 2009.

Cash The farm had a checking account balance of $7,700 and a money market account balance of $23,200.

Land The original cost of the land was $375,000. It was appraised for estate tax purposes at $1,050 per acre.

Buildings and Machinery Buildings and machinery with an original cost of $412,500 and accumulated depreciation of $300,000 are employed on the farm. The equipment was ap- praised at net book value.

Current Liabilities The farm has notes payable and accounts payable to- taling $33,000.

Owner’s Equity Common stock has a par value of $7,500 plus an addi- tional paid-in capital of $450,000. There was no record of retained earnings. It was known that Jere- miah Grennell withdrew all of the farm’s earnings in the last few years in order to continue the lifestyle to which he had become accustomed in Florida.

Looking over the data on revenues and expenses, Grey discovered that there were no monetary numbers for 2009’s total revenues or ending inventory. The lawyer’s letter explained that there was some doubt in his mind about when revenue for the farm should be recognized and about the appropriate way to value the grain inventory. The lawyer’s understanding was that there are at least three alternative stages in the wheat growing cycle at which revenue could be counted in unaudited statements.

First, the production method could be used. Since wheat has a daily valuation on the Chicago Commodity Exchange, any unsold inventory as of December 31 could be valued at market price very objectively. In this way, revenue can be counted for all wheat produced in a given year, regardless of whether it is sold or not. A decision not to sell this wheat before December 31 is based on speculation about future wheat price increases.

Second, the sales method (also called the delivery method ) could be used. This approach would recognize revenue when the grain is purchased and received from the farm by the grain elevator operator in the neighbor- ing town. In this instance, the owner of the grain eleva- tor had just sold control to a Kansas City company with limited experience in running such a facility. The manager of the Grennell Farm had expressed some concern about selling to an unknown operator.

Third, the collection method could be used. Under this approach, revenue is counted when the cash is

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(Hint: Under the collection method, accounts re- ceivable are zero. Under the production method, ending inventory is zero. Under all three methods, assume beginning retained earnings are zero.)

2. Assume that the Grennell Farm had received a firm offer of $225,000 for 100 acres of the farm that would be used as the site of a new housing devel- opment. This development would have no effect on the use of the remaining acreage as a farm, and Ms. Grey planned to accept it. How would you ac- count in the 2009 financial statements for the eco- nomic gain represented by this appreciation in land values?

3. Should Ms. Grey retain ownership of the farm?

Case 5–3

Joan Holtz (A)*

“Your course unfortunately doesn’t give me the answer to a great many real-life problems,” said Joan Holtz to an accounting professor. “I’ve read the text and lis- tened to you attentively, but every once in a while I run across something that doesn’t seem to fit the rules.”

“Not all of life’s complications can be covered in a first course,” the professor replied. “As is the case with law, medicine, or indeed any of the professions, many matters are dealt with in advanced courses, and others are not settled in any classroom. Nevertheless, some problems that are not specifically discussed can be solved satisfactorily by relating them to principles that you already have learned. Let’s take revenue recogni- tion as a particularly difficult case in point. If you will write down some of the matters about which you are now uncomfortable, I’d be glad to discuss them with you—that is, after you have given some thought as to the most reasonable solution.”

A week later, Holtz returned with the list given below.

1. Electric utility bills. When an electric utility cus- tomer uses electricity, the electric company has earned revenues. It is obviously impossible, how- ever, for the company to read all of its customers’ meters on the evening of December 31. How does the electric company know its revenue for a given year? Explain.

2. Retainer fee. A law firm received a “retainer” of $10,000 on July 1, 2010, from a client. In return, it agreed to furnish general legal advice upon re- quest for one year. In addition, the client would be billed for regular legal services such as represen- tation in litigation. There was no way of knowing how often, or when, the client would request ad- vice, and it was quite possible that no such advice would be requested. How much of the $10,000 should be counted as revenue in 2010? Why?

3. Cruise. Raymond’s, a travel agency, chartered a cruise ship for two weeks beginning January 23, 2011, for $200,000. In return, the ship’s owner agreed to pay all costs of the cruise. In 2010, Raymond’s sold all available space on the ship for $260,000. It incurred $40,000 in selling and other costs in doing so. All the $260,000 was received in cash from passengers in 2011. Raymond’s paid $50,000 as an advance payment to the ship owner in 2011. How much, if any, of the $260,000 was revenue to Raymond’s in 2010? Why? Does the question of whether passengers were entitled to a refund in 2011 if they canceled their reservations make any difference in the answer? Why?

4. Accretion. A nursery owner had one plot of land containing Christmas trees that were four years old on November 1, 2010. The owner had incurred costs of $3 per tree up to that time. A wholesaler offered to buy the trees for $4 each and to pay in* Copyright © Professor Robert N. Anthony.

actually received by the farm from the grain elevator operator. Full collection often took several months be- cause a grain elevator operator might keep wheat for a considerable time in the hope that prices would rise so the elevator company could sell at a higher price than that paid the farmer.

Questions

1. Prepare the 2009 income statement and the related ending balance sheet for the Grennell Farm recog- nizing revenue by the

a. Sales (delivery method).

b. Collection method.

c. Production method.

* Copyright © Professor Robert N. Anthony.

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addition all costs of cutting and bundling, and transporting them to market. The nursery owner declined this offer, deciding that it would be more profitable to let the trees grow for one more year. Only a trivial amount of additional cost would be involved. The price of Christmas trees varies with their height. Should the nursery owner recognize any revenue from these trees in 2010? Why?

5. “Unbilled” receivables. The balance sheet of an architectural firm shows a significant asset labeled Unbilled Receivables. The firm says this represents in-process projects, valued at the rates at which the customers will be charged for the ar- chitects’ time. Why would a firm do this instead of valuing projects in process at their cost, the same as a manufacturing firm would value its in- process inventory? Does it make any difference in the reported owners’ equity for the architectural firm to report such in-process work as receivables rather than as inventory? Why?

6. Premium coupons. A manufacturer of coffee en- closed a premium coupon with each $2.50 (at wholesale) jar of coffee that it sold to retailers. Customers could use this coupon to apply to $0.50 of the price of a new type of instant tea that the manufacturer was introducing and that sold for $2.00 wholesale. The manufacturer reimbursed re- tail stores $0.60 for each such coupon they sub- mitted. (The extra $0.10 was to pay the grocer for coupon handling costs.) Past experience with sim- ilar premium offers indicated that approximately 20 percent of such coupons are eventually re- deemed. At the end of 2010, however, only about 10 percent of the coupons issued in 2010 had been redeemed. In recording the revenues for the com- pany for 2010, what allowance, if any, should be made for these coupons? Why? If an allowance should be made, should it apply to the sales revenue of coffee or to the sales revenue of tea? Why?

7. Traveler’s checks. A bank sells a customer $500 of American Express traveler’s checks, for which the bank collects from the customer $505. (The bank charges a 1 percent fee for this service.) How does the bank record this transaction? How does the transaction affect American Express’s balance sheet?

8. Product repurchase agreement. In December 2010, Manufacturer A sold merchandise to Wholesaler

B. B used this inventory as collateral for a bank loan of $100,000 and sent the $100,000 to A. Manufacturer A agreed to repurchase the goods on or before July 1, 2010, for $112,000, the differ- ence representing interest on the loan and compen- sation for B’s services. Does Manufacturer A have revenue in 2010? Why?

9. Franchises. A national real estate brokerage firm has become highly successful by selling franchises to local real estate brokers. It charges $10,000 for the initial franchise fee and a service fee of 6 per- cent of the broker’s revenue thereafter. For this it permits use of its well-known name and provides a one-week initial training course, a nationwide re- ferral system, and various marketing and manage- ment aids. Currently, the franchise fee accounts for 25 percent of the national firm’s receipts, but it expects that the United States market will be satu- rated within the next three years, and thereafter the firm will have to depend on the service fee and new sources of revenue that it may develop. Should it recognize the $10,000 as revenue in the year in which the franchise agreement is signed? Why? If it does, what will happen to its profits after the market has become saturated? Why?

10. Computer systems. In early 2010, the sales vice president of Tech-Logic reached agreement to de- liver several computer systems with a total price of $570,000 to an organization in one of the newly independent countries established following the dissolution of the former Soviet Union. Tech- Logic management was very excited about this contract. The countries that were part of the for- mer Soviet Union represented a major market that was just opening up for trade, and these countries especially needed the kinds of high-technology products that Tech-Logic sold. Tech-Logic manu- factured and shipped the entire $570,000 order during 2010. Tech-Logic normally recognized rev- enue on the sale of its products when they were shipped. However, Tech-Logic’s controller won- dered whether the same revenue recognition pol- icy should apply to this contract. First, contract law in these countries was evolving and it was hard to know if certain laws existed or what they were. In addition, the controller was uncertain when Tech-Logic would receive the $570,000 in cash. He had heard that in many of these countries it was difficult to obtain currencies needed for foreign

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exchange, although the customer kept assuring Tech-Logic that they would receive cash shortly. The controller pondered whether to recognize the entire $570,000 as revenue in 2010. If not, then when should this revenue be recognized? Why?

Question

Answer the questions raised by Holtz in each of the 10 issues on her list.

Case 5–4

Wareham SC Systems, Inc.*

Soma Desai, the chief financial officer of Wareham SC Systems, Inc., was reviewing the revenue recognition practices of the company’s three divisions. Wareham SC Systems was a capital equipment and testing instru- ment manufacturer and supplier to a variety of highly cyclical electronics-based industries, including the semiconductor industry. Desai undertook the review in anticipation of disclosing in the company’s third quar- ter 2000 Form 10-Q filing with the Securities and Exchange Commission (SEC) the possible impact on the company’s financial statements of the revenue recognition and reporting guidelines set forth in the SEC’s recently issued Staff Accounting Bulletin No 101, “Revenue Recognition in Financial Statements” (SAB 101). SAB 101 had to be adopted no later than the fourth quarter of 2000.

As a test of her own understanding of SAB 101, Desai selected from each of the company’s three divi- sions a limited number of representative sale transac- tions to review.

Wareham SC Systems sales and net income for the last three year was (thousands).

1999 1998 1997

Net Sales $1,790,912 $1,489,151 $1,266,274 Net Income $ 191,694 $ 102,117 $ 127,608

In addition to testing her understanding of SAB 101, Desai wondered what administrative actions she should take to prepare Wareham SC Systems for a suc- cessful adoption of SAB 101.

Revenue Recognition Policy

According to the company’s 1999 annual report, its revenue recognition policy was as follows:

Product revenue is recognized upon shipment. The Company’s products are generally subject to warranty, and the Company provides for such estimated costs when product revenue is recog- nized. The Company recognizes service revenues as the services are provided or ratably over the period of the related contract, as applicable. The Company unbundles service revenue from product sales and installation services and maintenance services based upon amounts charged when such elements are separately sold. For certain contracts, revenue is recognized using the percentage-of- completion accounting method based upon an efforts-expended method.1 In all cases, changes to total estimated costs and anticipated losses, if any, are recognized in the period in which determined.

SAB 101

Under US GAAP guidelines, the general rule govern- ing revenue recognition is:

• Revenue should be recognized when it is earned and realized or realizable.

Because the general rule had been abused by some companies, more specific criteria for revenue recognition were prescribed by the SEC in SAB 101. As a result,

1 The efforts-expended model recognizes revenue from long- term contracts as the work on the contract progresses. Typically, the revenue recognized to date is the percentage the costs to date bear to the contract’s estimated total costs after giving effect to costs to complete based upon the most recent information.

* Copyright © 2003 President and Fellows of Harvard College. Harvard Business School case 110–015.

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revenue was now considered to be earned and realized or realizable when the following conditions were met:

• Persuasive evidence of an order arrangement exists;

• Delivery of the ordered goods has occurred or ser- vices have been rendered;

• The seller’s price to the buyer is fixed or deter- minable; and,

• Collectibility of the sale proceeds is reasonably assured.

Glendale Division: Selected Transactions

Wareham SC System’s Glendale Division was an equip- ment manufacturer whose main product was generally sold in a standard model. The contracts for sale of that model provided for customer acceptance to occur after the equipment was received and tested by the customer. The acceptance provisions stated that if the equipment did not perform to the division’s published specifica- tions, the customer could return the equipment for a full refund or a replacement unit, or could require the divi- sion to repair the equipment so that it performed by ei- ther a formal sign-off by the customer or by the passage of 90 days without a claim under the acceptance provi- sions. Title to the equipment passed upon delivery to the customer. The division did not perform any installation or other services on the equipment it sold. It tested each piece of equipment against the division’s specifications before shipment. Payment was due under the division’s normal payment terms, which was 30 days after cus- tomer acceptance.

In each of the following Glendale Division sales transactions reviewed by Desai, the above facts applied, in addition to those described in each of the Glendale Division sales transactions selected for review.

Onsetcom, Inc. Onsetcom, Inc., a new Glendale Division customer, placed an order for a standard model of the division’s main product. The sales contract included a customer- acceptance clause. It was based on the product meet- ing the division’s published specifications for a stan- dard model. Before shipping the equipment to Onsetcom, the division demonstrated that the equip- ment shipped met the required specifications. There was no reason to believe that the equipment would not operate in the same way in the customer’s facility.

Cataumet Devices, Inc. The Glendale Division entered into a sales arrange- ment with Cataumet Devices, Inc., a new customer, to deliver a version of its standard product modified as necessary to be integrated into the customer’s new as- sembly line while still meeting all of the standard published vendor specifications with regard to perfor- mance. The customer could reject the equipment if it failed to meet the standard published performance specifications or could not be satisfactorily integrated into the new line. The division had never modified its equipment to work on an integrated basis in the type of assembly line the customer had proposed. In re- sponse to the request, the division designed a version of its standard equipment that was modified as be- lieved necessary to operate in the new assembly line. The modified equipment still met all of the standard published performance specifications, and the divi- sion believed the equipment would meet the requested specifications when integrated into the new assembly line. However, the division was unable to replicate the new assembly line conditions in its testing.

Advanced Technology Division: Selected Transactions

Wareham SC System’s Advanced Technology Division developed, manufactured, and sold complex manufac- turing equipment. Desai selected two of the division’s sales transactions involving a similar piece of equip- ment for review. (Although Advanced Technology sold its equipment separately to some customers without installation—meaning a general contractor would in- stall the equipment—the sales transactions selected by Desai involved installation of the equipment by Ad- vanced Technology employees.) The division sold its installation service on a time and materials basis. The uninstalled equipment sold for $19.5 million. In each of the installation contracts, the division’s controller estimated that the fair value of the installation service approximated $500,000.

The division was experienced in the production and in- stallation of the type of equipment involved in each of the two sales arrangements under review and had a history of successfully installing the type of equipment involved.

The division provided a warranty on all equipment sales that guaranteed that the delivered equipment would meet the division’s published specifications and be free of defects in materials and workmanship.

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Title to the equipment passed to the customer upon delivery.

Sandham, Inc. Sandham, Inc. ordered equipment that would be inte- grated into a larger production line that included other manufacturer’s equipment. Advanced Technology had previously developed its own internal specifications for the model and demonstrated that the equipment met those specifications. At Sandham’s request, the contract included a number of customer-specific tech- nical and performance criteria regarding speed, qual- ity, interaction with other equipment, and reliability. Because of the nature of the equipment, the division was unable to demonstrate that the equipment would meet the customer-specific specifications before in- stallation. The contract included a customer-acceptance provision that obligated the division to demonstrate that the installed equipment met all specified criteria before customer acceptance. If customer acceptance was not achieved within 120 days of installation, Sandham could require the division to remove the equipment and refund all payments. Payment terms were 80% due 30 days after delivery, and 20% due 30 days after customer acceptance.

XL Semi, Inc. The Advanced Technology Division also manufac- tured equipment to produce semiconductor wafers. The equipment was complex and sold for prices rang- ing from $500,000 to $10 million per unit. The equip- ment ordered by XL Semi sold for $9 million. The XL Semi order was typical. In the case of semiconductor equipment, the division published the performance specification (often stated in ranges) of its equipment based on results of prototype testing or, for established products, based on previously installed units. The equipment was extensively tested throughout the manufacturing process, which could range from 3 to 12 months, so the division was confident when the ma- chine was shipped that it would ultimately perform in accordance with the customer’s specifications.

Initial customer acceptance usually took place at the division’s facility prior to shipment. Because of the size of the equipment, it was often partially disassem- bled for shipment and reassembled at the customer’s site. The division, to minimize future warranty claims and due to the specialized nature of the equipment, used its own engineers to install and set up its products at the customer’s facility; no other parties had installed

Chapter 5 Revenue and Monetary Assets 139

2 High volume customers bought all of the division’s products, including mechanical testing devices. Prior to the strategy change, distributor’s were limited to selling to low-volume customers.

the divisions equipment in the past. Frequently, although the divisions met its manufacturing and shipping deadlines, the customer would request that the division delay the final installation until a certain phase of the project was completed. The customer then tested and accepted the equipment. Payment of 90% of the total arrangement fee was due upon delivery and the re- maining 10% was due upon final acceptance. The cost of the installation services was approximately 1% to 3% of the total arrangement fee.

Technical Devices Division: Selected Transactions

Wareham SC System’s Technical Devices Division developed, manufactured, and marketed a variety of electrical, electronic, and mechanical testing devices for use in production control, product testing, and re- search laboratory applications. The division used a combination of direct sales by its own sales force and independent distributors to market its products. Typi- cally, the distributor network was used to sell products to low-volume customers, since most high-volume cus- tomers preferred to deal directly with the division.

Unlike Wareham SC System’s other divisions, whose profitability rose and fell with changes in the business cycle, the Technical Devices Division under its current management had steadily increased its prof- its each quarter over a span of 37 consecutive quarters.

New Strategy Only a few days before Desai was scheduled to begin her review of selected sales arrangements, the Technical Devices Division announced a change in its sales strat- egy. The direct marketing and shipment of the divi- sion’s mechanical testing devices to high-volume cus- tomers would end.2 In the future, all of this business would be channeled through the division’s indepen- dent distributors so that the division could free up re- sources to complete in the growing and increasingly more profitable and competitive electronic and electrical testing product markets. While it was not announced, Desai believed the change in sales strategy was moti- vated by a recognition by the division management that demand for mechanical testing devices was declining, uncertain, and increasingly less profitable.

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She also suspected the division anticipated difficulties in reaching the quarter’s profit goals.

As a result of the division’s sales strategy shift, dis- tributors were asked to increase their mechanical test- ing device inventory levels from their current several- weeks sales to as much as two-years sales. Moreover, these purchases had to be made, delivered, and have the title taken by September 30, the day the division closed its third quarter for financial reporting purposes. Dis- tributors that did not comply were told they would lose their Technical Devices Division distributorships.

To help the dealers finance their larger inventories of mechanical testing devices, the division permitted dis- tributors to make five small monthly payments follow- ing delivery with a final balloon payment of roughly 60% of the original amount owed six months after the initial deliveries. The monthly payment schedule was based on the distributor’s expected sell-through of in- ventories. The normal payment terms extended to dis- tributors was 1% upon delivery net 20 days.

While the division had not contractually agreed to take back any excess dealer inventories of mechanical testing devices, the division’s past generous practices of allowing dealer returns of excess inventories led nearly all of the dealers to believe there was little risk to them in the new sales strategy. All but one of its company’s distributors accepted the division’s ultima- tion and payment schedule.

In 1998 the division had recorded a $23 million ex- cess inventory charge, primarily for its excess me- chanical testing instrument inventory.

Ashaban Industries, Ltd. Just as the third quarter of 2000 was to close, the Techni- cal Devices Division delivered, and the Ashaban Indus- tries, Ltd., the customer, accepted a $2 million order for mechanical testing equipment. Ashaban Industries in- tended to use local contractors to install the equipment.

Ashaban Industries was a newly formed private company located in one of the former Soviet Re- publics established during the early 1990’s as indepen- dent countries following the dissolution of the Soviet Union.

Ashaban Industries was a new customer. Is was also the division’s first customer among the now indepen- dent former Soviet Union Republics, which was a mar- ket that some of the division’s top management had long hoped to penetrate.

From the beginning of the negotiations preceding the signing of the Ashaban Industries firm purchase order, some of the division’s top management had con-

cerns about Ashaban Industries’ ability to pay for the order and the division’s ability to collect in the event of nonpayment. They noted that Ashaban and the division had been unable to secure bank, local government or international development agency payment guaran- tees. The concerned senior management also noted that contract law in Ashaban Industries’ home country was evolving and it was hard to know what they were or how they might be interpreted. Later, just before the equipment was shipped, these same concerned man- agers noted that there was increasing unrest in the country and local importers seemed to be having diffi- culty obtaining foreign currency to pay for their for- eign currency denominated imports. Despite these misgivings, based on Ashaban Industries assurances that Wareham SC Systems would be paid, the division accepted the purchase order and shipped the equipment.

Questions

1. What pre SAB 101 revenue recognition policies has Wareham SC Systems adopted? Which of these policies are most likely to be impacted by SAB 101?

2. Why might Soma Desai be concerned about the im- pact of SAB 101 on Wareham SC System’s revenue recognition practice? Be as specific as possible.

3. What revenue recognition accounting is required by the facts of each of the sale transactions reviewed by Soma Desai? Justify your conclusions.

4. International Accounting Standards No. 18 states rev- enue from the sale of goods shall be recognized when all the following conditions have been satisfied:

a. the entity has transferred to the buyer the signif- icant risks and rewards of ownership of the goods;

b. the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

c. the amount of revenue can be measured reliably;

d. it is probably that the economic benefits associ- ated with the transaction will flow to the entity; and

e. the costs incurred or to be incurred in respect of the transaction can be measured reliably.

Would your answer to Question 3 change if you applied IAS No. 18 rather than SAB 101? Explain.

5. What administrative actions should Soma Desai take to prepare Wareham SC Systems for the adop- tion of SAB 101? Be specific.

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6 Cost of Sales and Inventories

Chapter

This chapter describes principles and procedures for measuring cost of sales as reported on the income statement and for the related measurement of inventory on the balance sheet.

We begin with a brief overview of accounting for inventory and cost of sales in three types of companies: merchandising, manufacturing, and service. Next, we describe in detail the procedures in merchandising companies. The procedures in manufacturing companies start with the same steps used in merchandising companies and incorporate additional aspects associated with the manufacturing process. We therefore limit the discussion of manufacturing companies to these additional matters. Service companies also are discussed.

Inventory costs may be accounted for by either the periodic inventory method or the perpetual inventory method; each method is described. The cost of individual units of inventory and of individual goods sold can be measured by any of several methods approved for use in the United States. These include specific identification; average cost; first-in, first-out (FIFO); and last-in, first-out (LIFO). All of these methods are described and compared in the chapter. With the exception of LIFO, all of these meth- ods are also accepted by the International Accounting Standards Board. Inventory turnover, days’ inventory, and gross margin percentage—three ratios used in inventory accounting—also are discussed.

Types of Companies

A single company may conduct merchandising, service, and/or manufacturing activi- ties. For convenience, we shall assume that each company described here conducts only one type. If a company does conduct more than one type of activity, it will use the accounting method appropriate for each type.

Retail stores, wholesalers, distributors, and similar companies that sell tangible goods are merchandising companies.1 A merchandising company sells goods in substantially

1 The word products is often used when goods is intended. For clarity, throughout this book, we use goods for tangible items, services for intangibles, and products for the sum of goods and services. In other words, the outputs of an entity, whether tangible or intangible, are its products.

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the same physical form as that in which it acquires them. Its cost of sales is therefore the acquisition cost of the goods that are sold.2 On the balance sheet, a current asset, Merchandise Inventory, shows the cost of goods that have been acquired but not yet sold as of the balance sheet date.

A manufacturing company converts raw materials and purchased parts into fin- ished goods. Its cost of sales includes the conversion costs as well as the raw material and parts costs of the goods that it sells. A manufacturing company has three types of inventory accounts: Materials, Work in Process, and Finished Goods.

Because both merchandising and manufacturing companies sell tangible goods, their income statements sometimes use the term cost of goods sold rather than cost of sales. We shall use the two terms interchangeably for merchandising and manufactur- ing companies, but use only cost of sales for service organizations.

Service organizations furnish intangible services rather than tangible goods. They include hotels, beauty parlors and other personal services organizations, hospitals and other health care organizations, educational organizations, banks and other finan- cial institutions, and governmental units. Service organizations may have materials inventories—for example, the pipes and fittings of a plumbing company. Professional service firms, such as law, consulting, accounting, and architectural firms, may have intangible inventories consisting of costs that have been incurred on behalf of clients but that have not yet been billed to clients. These inventories, often called jobs in progress or unbilled costs, correspond to work in process inventories in a manufac- turing company. Service organizations do not have finished goods inventories.

In addition to inventory accounts for goods directly involved in the merchandising or manufacturing process, a company may have one or more inventory accounts for sup- plies. Supplies are tangible items that will be consumed in the course of normal oper- ations. Examples include office and janitorial supplies, and lubricants and repair parts for equipment. Supplies are distinguished from merchandise in that they are not sold as such, and they are distinguished from materials in that supplies are not accounted for as an element of the cost of goods manufactured. Paper offered for sale is mer- chandise inventory in a stationery store; paper is materials inventory in a company that manufactures books; and paper intended for use in the office is supplies inventory in any organization. Supplies will not be discussed further in this chapter.

Merchandising Companies

We shall now describe in detail the principles and procedures related to accounting for inventories and cost of goods sold in merchandising companies.

Merchandise is added to inventory at its cost, in accordance with the basic cost con- cept. Cost includes both the cost of acquiring the merchandise and also any expendi- tures made to make the goods ready for sale. Thus, merchandise cost includes not only the invoice cost of the goods purchased but also freight and other shipping costs of bringing the goods to the point of sale and the cost of unpacking the goods and mark- ing prices on them. Since the recordkeeping task of attaching these latter elements of

142 Part 1 Financial Accounting

2 The U.S. tax code requires that the following costs also be included in the cost of inventory: (1) off-site storage and warehousing; (2) purchasing; (3) handling, processing, assembling, and repackaging; and (4) certain general and administrative expenses. Some companies add these costs to the inven- tory cost for financial reporting purposes. This practice is not a requirement of the tax code or gener- ally accepted accounting principles.

Acquisition Cost

Supplies

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cost to individual units of merchandise may be considerable, some or all of them may be excluded from merchandise product costs and reported as general operating ex- penses of the period in which they are incurred.

The purchase cost also is adjusted for returns and allowances and for cash discounts given by the suppliers of the merchandise. As was the case with sales discounts (see Chapter 5), purchase discounts can be accounted for either by recording the pur- chase amount as net of the discount or by recording the purchase amount at the invoice price and recording the discount when it is taken.

In accounting, the word purchase refers not to the placing of a purchase order but rather to the receipt of the merchandise that was ordered. No accounting entry is made when merchandise is ordered. The entry is made only when the merchandise becomes the property of the buyer.3

Think of merchandise inventory as a tank or a reservoir, as in Illustration 6–1. At the beginning of an accounting period there is a certain amount of goods in the reservoir; this is the beginning inventory. During the period, additional merchandise is purchased and added to the reservoir. Also during the period, merchandise sold is withdrawn from the reservoir. At the end of the accounting period, the amount of goods remaining in the reservoir is the ending inventory.

The amount of goods available for sale during the period is the sum of the beginning inventory plus the purchases during the period. This sum is $11,400 in Illustration 6–1. The problem to be discussed in this section, and indeed in most of the chapter, is how to divide the amount of goods available for sale between (1) the ending inventory and (2) cost of goods sold. How much of the $11,400 is still on hand at the end of the period, and how much was sold during the period? This is a significant problem because its res- olution affects both the amount of inventory reported on the balance sheet and (perhaps more important) the amount of profit reported on the income statement for the period.

Chapter 6 Cost of Sales and Inventories 143

Ending inventory

$ ?

Beginning inventory

Inventory reservoir

Available for sale $11,400

Cost of goods sold $ ?

Purchases $7,400

$4,000

ILLUSTRATION 6–1 Merchandise Inventory and Flows

3 Under commercial law, goods in transit usually belong to the buyer as soon as they are delivered to the transportation company if the terms are “FOB shipping point” (if the buyer pays the transporta- tion costs). If the seller pays the transportation costs (“FOB destination”), title does not pass until the goods arrive at the buyer’s warehouse.

The Basic Measurement Problem

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There are two approaches to this problem:

1. We can determine the amount of ending inventory (i.e., the amount in the reservoir at the end of the period) and deduce cost of goods sold by subtracting the ending in- ventory from the goods available for sale. This is the periodic inventory method.

2. We can measure the amount actually delivered to customers and deduce the ending inventory by subtracting cost of goods sold from the goods available for sale. This is the perpetual inventory method.

In the periodic inventory method, a physical count is made of merchandise in the end- ing inventory, and the cost of this inventory is determined. This process is called taking a physical inventory. Assume that the physical inventory shows the cost of the mer- chandise remaining at the end of the period to be $2,000. Cost of goods sold is deduced by subtracting the ending inventory from the amount of goods available for sale; thus:

Beginning inventory $4,000

Plus: Purchases 7,400

Equals: Goods available for sale 11,400

Less: Ending inventory 2,000

Cost of goods sold $9,400____________

The amount of beginning inventory in the above calculation is the amount found by the physical inventory taken at the end of the preceding period. (Recall that in account- ing the end of one period and the beginning of the next period are the same instant in time, even though the dates—say, June 30 and July 1—may make them appear to be different.)

Most companies do not show such a calculation in the cost of goods sold section of the published income statement itself. In contrast, in internal reports to management (as opposed to reports for shareholders), the calculation with additional detail is often presented. For example, if there are freight charges and the return of purchased mer- chandise, the internal income statement might show

Beginning inventory $4,000

Plus: Purchases, gross $7,000

Freight-in 600______

7,600

Less: Purchase returns 200______

Net purchases 7,400______

Goods available for sale 11,400

Less: Ending inventory 2,000______

Cost of goods sold $9,400____________

Accounts When the cost of goods sold is deduced by the method described above, a separate ac- count is established for each element in the calculation. Thus, a Purchases account is established and the invoice cost of merchandise received is debited to this account rather than directly to Merchandise Inventory. Accounts also are established for Freight-In, Purchase Returns, and any other items involved in the calculation.

144 Part 1 Financial Accounting

Periodic Inventory Method

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Rules for debiting and crediting these accounts can be deduced from their relation- ship to other accounts. Since Purchases shows additions to the asset account Mer- chandise Inventory, it increases on the debit side. Purchase Returns is a reduction in Purchases and hence must have the opposite rule; return of goods to suppliers are thus recorded as credits to the Purchase Returns account. The Freight-In account adds to the cost of purchases and therefore increases on the debit side. The rules also can be deduced by thinking of the offsetting part of the transaction. Whenever possible, it is simplest to assume that the other account is Cash. Thus, a cash purchase involves a decrease in Cash, which is a credit; therefore, the entry to Purchases must be a debit.

As of the end of the period, these accounts are closed to Cost of Goods Sold. First, the balance in the Merchandise Inventory account is closed. (Recall that no entries were made to this account during the period, so the amount in the account is the beginning balance.) The entry is

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . 4,000

Merchandise Inventory . . . . . . . . . . . . . . . . . 4,000

Next, the temporary Purchases, Purchase Returns, and Freight-In accounts are closed to Cost of Goods Sold by entries that can be summarized as follows:

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . 7,400

Purchase Returns . . . . . . . . . . . . . . . . . . . . . . . . 200

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Freight-In . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

The new balance (from the physical inventory) is entered in Merchandise Inventory:

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . 2,000

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . 2,000

Finally, Cost of Goods Sold is closed:

Income Summary . . . . . . . . . . . . . . . . . . . . . . . . 9,400

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . 9,400

In the perpetual inventory method, a record is maintained of each item carried in the in- ventory. In a manual system, this record is a card similar to the sample shown in Illustration 6–2. In essence, this record is a subsidiary ledger account, and Merchandise Inventory is its control account. Purchases are entered directly on this record and also deb- ited to Merchandise Inventory; the offsetting credit is to Accounts Payable or Cash. De- liveries of goods to customers are entered on this record and are credited to Merchandise

Chapter 6 Cost of Sales and Inventories 145

Item: Cassette Deck, Model S150

Date Receipts Shipments Balance

Unit Unit Unit Units Cost Total Units Cost Total Units Cost Total

Jan. 2 40 100 4,000 12 32 100 3,200 8 100 800 14 70 100 7,000 78 100 7,800 25 56 100 5,600 22 100 2,200 27 2 100 200 * 20 100 2,000

* This entry is a purchase return to the manufacturer.

ILLUSTRATION 6–2 Perpetual Inventory Card

Perpetual Inventory Method

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Inventory; the offsetting debit is to Cost of Goods Sold. The balance of the inventory record at the end of the period is the amount of that particular item in the ending inven- tory. The sum of the balances for all the items is the ending inventory for the entity.

Assuming for simplicity that a company had only the one item shown in Illustra- tion 6–2, the journal entries for the transactions listed there would be

For purchases:

(1)

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . 7,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . 7,000

For shipments to customers:

(2)

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . 8,800

Merchandise Inventory . . . . . . . . . . . . . . . . . 8,800

For purchase returns:

(3)

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . 200

Merchandise Inventory . . . . . . . . . . . . . . . . . 200

In many perpetual inventory systems, freight-in is not entered on the perpetual in- ventory cards. Instead, it is accumulated in a separate account. Assuming the same $600 freight-in as in the previous example, the closing entry for this account would be

(4)

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . 600

Freight-In . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Cost of Goods Sold is closed to Income Summary, as in the periodic inventory method; that is:

(5)

Income Summary . . . . . . . . . . . . . . . . . . . . . . . . 9,400

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . 9,400

These entries would be posted to ledger accounts as shown below:

Merchandise Inventory Cost of Goods Sold

Balance 4,000 (2) Shipments 8,800 8,800 (5) To Income

(1) Purchases 7,000 (3) Returns 200 (4) Freight-In 600 Summary 9,400

To balance 2,000_______ _______ ______

11,000 11,000 9,400 9,400_______ _______ ______ _____________ _______ ______ ______

Balance 2,000

In the perpetual inventory method, no separate Purchases account is needed; pur- chases are debited directly to Merchandise Inventory.

Both inventory methods match the cost of goods sold with the sales revenue for those same goods. Thus, either method is in accord with the matching concept. Without this matching, the gross margin amount for a period would not be meaningful.

The perpetual inventory method requires that a record be maintained for each item carried in inventory and therefore requires additional recordkeeping. This recordkeeping

146 Part 1 Financial Accounting

Comparison of Periodic and Perpetual Methods

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is not likely to be burdensome for a store offering at most a few hundred, relatively high- cost, items, such as a jewelry or an appliance store. Such recordkeeping may not be worthwhile in stores that stock many low-cost items, such as grocery stores and drug- stores. (A large supermarket may stock 10,000 or more different items.) However, the development of electronic point-of-sale terminals, which have scanners that identify each item sold by reading a bar code on the item’s package, has led many such stores to change to the perpetual inventory method.

The perpetual inventory method has three important advantages. First, the detailed record maintained for each item is useful in deciding when and how much to reorder and in analyzing customer demand for the item. In many stores using point-of-sale ter- minals with scanners, sales data are used as input to computer models that automati- cally prepare orders in a central warehouse to replenish the store’s inventory and in some cases automatically to place orders with suppliers. This helps avoid both stock- outs and excess inventories of the various items carried by the store.

Second, the perpetual inventory record has a built-in check that is not possible with the periodic method. In the latter, the physical inventory at the end of the period is a necessary part of the calculation of cost of goods sold. The difference between the goods available for sale and the goods on hand is assumed to be the cost of goods sold. This assumption is not necessarily correct because some of the goods may have been pilfered, lost, thrown away, or overlooked when the physical inventory was taken. Goods that are not in inventory but were not sold make up the period’s inventory shrinkage. In the perpetual inventory system, an actual count of the goods on hand can be used as a check on the accuracy of the inventory records. Shrinkage thus can be identified separately rather than buried in cost of goods sold.

Third, with a perpetual inventory system, an income statement can be prepared without taking a physical inventory. Thus, an income statement can be prepared every month, with the accuracy of the underlying perpetual inventory records being checked by an annual or semiannual physical inventory.

A store that does not maintain perpetual inventory records can nevertheless prepare reasonably accurate monthly income statements without taking a physical inventory by using the retail method. In this method, purchases are recorded at both their cost and their retail selling price. The gross margin percentage of the goods available for sale is calculated from these records. The complement of this percentage is applied to sales for the month (obtained from sales register records) to find the approximate cost of goods sold.

Assume the following:

At Cost At Retail

Beginning inventory $ 4,000 $ 6,000 Purchases 7,000 10,000_______ ________ Goods available for sale $11,000 $16,000

The gross margin percentage is ($16,000 � $11,000) � $16,000 � 31 percent. The com- plement of this is 100 percent � 31 percent � 69 percent. If sales for the month were $13,000, it is assumed that cost of goods sold was 69 percent of this amount, or $8,970. In applying the retail method in practice, adjustments must be made for markdowns that are made from initial retail prices (e.g., in clearance sales).

Chapter 6 Cost of Sales and Inventories 147

Retail Method

Example

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A variation of this method, the gross profit method, simply applies a “normal” gross margin percentage to the amount of sales in order to arrive at an approximation of cost of goods sold. Records are not kept of the retail value of goods available for sale. With this method, a “normal” margin is determined for each department in the store, and the salesperson or checkout clerk records the department number of each item the customer purchases. A department’s sales for the month are multiplied by the complement of the department’s gross margin percentage to approximate the depart- ment’s cost of goods sold. Some retailers that do not have a computer use these meth- ods to approximate the cost of goods sold without taking a physical inventory.

The retail and gross profit methods are not methods in addition to the periodic and perpetual methods. Rather, they can be viewed as variations of the perpetual method in that cost of goods sold is determined without taking a physical inventory.

Manufacturing Companies

A manufacturing company has as a major function the conversion of raw materials and purchased parts into finished goods. In any company, cost of sales is the total of the acquisition cost plus conversion costs (if any) of the products that are sold.4 The dif- ference between accounting for the cost of sales in a merchandising company and in a manufacturing company arises because the merchandising company usually has no conversion costs.

The measurement of cost of goods sold is therefore more complicated in a manu- facturing company than in a merchandising company. In a manufacturing company, this cost must be obtained by collecting and aggregating the several elements of man- ufacturing cost.

A manufacturing company has three types of inventory accounts. Their names and the nature of their content are as follows:

1. Materials Inventory: Items of material that are to become a part of the ultimately salable goods that result from the manufacturing process. They are costed at acquisi- tion cost, with the same types of adjustments for freight-in and returns as those made in calculating the net purchase cost of merchandise inventory, described above.

2. Work in Process Inventory: Goods that have started through the manufacturing process but have not yet been finished. They are costed as the sum of (1) the mate- rials thus far issued for them plus (2) the conversion costs incurred on these items up to the end of the accounting period.

3. Finished Goods Inventory: Goods that have been manufactured but have not yet been shipped to customers. They are costed at the total cost incurred in manufactur- ing them. This account is essentially the same as Merchandise Inventory in a mer- chandising company, except that the items are recorded at the cost of manufacturing them rather than at their acquisition cost.

There are wide variations in the relative size of the three types of inventories among companies. Those companies with a short production cycle may have so little work in process at the end of the accounting period that they do not have a separate Work in

148 Part 1 Financial Accounting

Inventory Accounts

4 Conversion costs include the cost of labor involved in the manufacture of the goods and other production costs. Other production costs might include depreciation of manufacturing plant and equipment, the cost of manufacturing-related utilities, factory supplies, indirect factory labor, and other production overhead costs, such as factory management and administration costs.

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Process Inventory account. At the end of the period, they charge all manufacturing costs to Finished Goods Inventory (or to Cost of Goods Sold if there is no Finished Goods Inventory account). This process is called back flushing. Companies that pro- duce items to customer order and ship to the customer as soon as the order is com- pleted have little or no finished goods inventory.

A diagram of these accounts and the flow of costs from one to another is shown in Illustration 6–3. Using the periodic inventory method, we shall trace the flow of costs through these accounts. Each step is described by giving the relevant journal entries. The effect on ledger accounts is shown in Illustration 6–4.

In the merchandising company, we established a separate account to show the cal- culation of cost of goods sold. We could use similar accounts in a manufacturing com- pany to show separately the calculation of materials used, cost of goods manufactured, and cost of goods sold. In the following description, however, we have not used these accounts. Instead, we arrive at the amounts by calculations made outside the accounts. There is no substantive difference between the two methods.

During an accounting period, various items of material are issued from a storage area to the production facilities for conversion into goods. The term materials used means the sum of all materials issued during the period. Such materials range in their degree of refinement from truly raw materials, such as crude oil or iron ore, to sophisticated components, such as motors or miniature circuit chips. Traditionally, all such pur- chased items were referred to as raw materials. However, there is nothing very “raw” about a motor or circuit chip. We shall use the term materials inventory to include the entire range of purchased items that are intended to become a part of salable goods dur- ing the production process.

In determining the cost of materials used, the periodic method may be used. That is, the assumption is made that the amount of materials used is the difference between the mate- rials available for use during the period (which is the total of the beginning inventory and the period’s net purchases) and the ending inventory. This assumption does not take into account any waste or spoilage of materials that might have occurred. In practice, waste and

Chapter 6 Cost of Sales and Inventories 149

Ending

Beginning

Materials inventory

Materials used

Purchases

Ending

Beginning

Work in process inventory

Completed goods Plus conversion costs Ending

Beginning

Finished goods inventory

Cost of goods sold

ILLUSTRATION 6–3 Manufacturing Inventories and Flows

Materials Used

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spoilage are either disregarded or collected separately and removed from material costs by crediting Materials Inventory and debiting a separate manufacturing cost account.

We shall make this calculation in the Materials Inventory account. First, the amount of purchases made during the period, which includes $266,000 as the invoice cost of materials received plus $7,000 of freight charges on these materials, is added to Mate- rials Inventory. These amounts would have first been debited to the temporary ac- counts, Purchases and Freight-In, and would have been credited to Accounts Payable. The $273,000 cost is then transferred to Materials Inventory by closing the two tem- porary accounts with this entry:

(1)

Materials Inventory . . . . . . . . . . . . . . . . . . 273,000

Purchases . . . . . . . . . . . . . . . . . . . . . . . 266,000

Freight-In . . . . . . . . . . . . . . . . . . . . . . . 7,000

A physical inventory shows the amount of materials on hand as of the end of the pe- riod to be $163,000. Since $154,000 was on hand at the beginning of the period and $273,000 was added by the above entry, the total amount available was $427,000. By subtracting $163,000 from $427,000, we determine the amount of materials used: $264,000. It is subtracted from Materials Inventory and added to Work in Process In- ventory by the following entry:

(2)

Work in Process Inventory . . . . . . . . . . . . . 264,000

Materials Inventory . . . . . . . . . . . . . . . 264,000

The sum of materials used and conversion costs is the total amount of cost added to Work in Process Inventory during the period. Given the amount in Work in Process Inventory

150 Part 1 Financial Accounting

ILLUSTRATION 6–4 Flow of Costs through Inventories (000 omitted)

Materials Inventory

Balance, Jan. 1 154 264 ➀ Purchases 273

Materials used: 154 � 273 � 163 � 264

Balance, Jan. 31 163 ➁

Work in Process Inventory

Balance, Jan. 1 19 570 Materials used 264 Cost of goods manufactured:

➂ Conversion costs 330 19 � 264 � 330 � 43 � 570 Balance, Jan. 31 43 ➃

Finished Goods Inventory

Balance, Jan. 1 69 573 Goods manufactured 570 Cost of goods sold:

69 � 570 � 66 � 573 Balance, Jan. 31 66 ➄

Cost of Goods Sold

573 573 Income Summary ➅____ ________ ____

Note: Circled numbers correspond to journal entries explained in the text.

Cost of Goods Manufactured

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at the beginning of the period and the amount remaining at the end of the period, the cost of goods manufactured (the goods completed and transferred to Finished Goods In- ventory) can be deduced.

The cost of materials used was added by the preceding entry. Conversion costs in- curred during the period are accumulated in various temporary accounts. For example, if employees directly involved in the conversion process earned $151,000 during the period, this amount would have been debited to a temporary Direct Labor account and credited to Wages Payable. The costs of direct labor and other resources used in the conversion process are added to Work in Process Inventory by closing the temporary accounts, as in the following entry:

(3)

Work in Process Inventory . . . . . . . . . . . . . 330,000

Direct Labor . . . . . . . . . . . . . . . . . . . . . 151,000

Indirect Labor . . . . . . . . . . . . . . . . . . . . 24,000

Factory Heat, Light, and Power . . . . . . 90,000

Factory Supplies Used . . . . . . . . . . . . . 22,000

Factory Insurance and Taxes . . . . . . . . . 8,000

Depreciation, Plant and Equipment . . . 35,000

A physical inventory shows the amount of work in process at the end of the period to be $43,000. Since $19,000 was on hand at the beginning of the period and $264,000 of materials and $330,000 of other manufacturing costs were added by entries 2 and 3, the total amount available was $613,000. By subtracting $43,000 from $613,000, we determine the cost of goods manufactured during the period to be $570,000. This fig- ure is subtracted from Work in Process Inventory and added to Finished Goods Inven- tory by the following entry:

(4)

Finished Goods Inventory . . . . . . . . . . . . . 570,000

Work in Process Inventory . . . . . . . . . . 570,000

Having determined the cost of goods manufactured, the cost of goods sold is found by (1) adding the cost of goods manufactured to the beginning finished goods inventory so as to find the total amount available for sale and then (2) subtracting the ending fin- ished goods inventory. As with the periodic method in a merchandising company, the assumption is that if the merchandise is not in inventory, it has been sold.

A physical inventory shows the amount of finished goods at the end of the period to be $66,000. Since $69,000 was on hand at the beginning of the period and $570,000 of manufactured goods were completed during the period and added to finished goods in- ventory, the total amount available was $639,000. Subtracting $66,000 from $639,000 yields the cost of goods sold: $573,000. It is subtracted from Finished Goods Inventory and recorded as Cost of Goods Sold by the following entry:

(5)

Cost of Goods Sold . . . . . . . . . . . . . . . . . . 573,000

Finished Goods Inventory . . . . . . . . . . . 573,000

The balance in the Cost of Goods Sold account is then closed to Income Summary by the following entry:

(6)

Income Summary . . . . . . . . . . . . . . . . . . . 573,000

Cost of Goods Sold . . . . . . . . . . . . . . . 573,000

Chapter 6 Cost of Sales and Inventories 151

Cost of Goods Sold

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The foregoing entries assumed the use of the periodic inventory method. The same transactions could be accounted for using the perpetual inventory method. In a manufacturing company, the perpetual inventory method is called a product cost- ing system. In such a system, the cost of each product is accumulated as it flows through the production process. The amounts involved in the journal entries are ob- tained directly from the cost records rather than deduced in the manner described above. The mechanisms used for collecting this information are described in Chapters 17–19.

In the accounting process described above, items of cost included in the cost of pro- ducing goods are called product costs. Because these product costs “flow through” in- ventory accounts (see Illustration 6–3), they also are referred to as inventory costs or inventoriable costs. To arrive at gross margin, product costs are matched with, and subtracted from, the sales revenues in the period in which the goods are sold. Other items of cost that are matched with revenue in a given accounting period are called pe- riod costs. They are reported on the income statement of the period under a caption such as “selling, general, and administrative expense.”

In accordance with generally accepted accounting principles, the cost of each product includes (1) materials cost; (2) costs incurred directly in bringing the prod- uct to its existing condition and location, such as direct labor costs; and (3) a fair share of the costs incurred indirectly in bringing the product to its existing condi- tion and location, such as factory management costs.5 These indirect costs are called indirect production costs or production overhead. Collectively, the materi- als, labor, and production overhead costs comprise the full production cost of a product.

Companies differ in their opinions on whether specific items should be treated as product costs or period costs. Some companies include the cost of such support func- tions as production administration, human resource management, industrial engineer- ing, plant protection, and product cost accounting as production overhead and hence as product costs. Other companies include the cost of some or all of these functions as pe- riod costs.6

The way in which a manufacturing company classifies its costs into period costs and product costs can have an important effect on its reported net income. Period costs are expenses in the accounting period in which they are incurred, whereas product costs initially add to the total amount of the entity’s assets. Product costs do not have an im- pact on income until the product has been sold, which may be in a later accounting pe- riod than the period in which the costs were incurred. The larger the inventory in rela- tion to sales, the longer the time interval that elapses between the incurrence of a product cost and its impact on income.7

152 Part 1 Financial Accounting

Product Costs and Period Costs

Product Costing Systems

5 Accounting Research Bulletin No. 43, Chapter 4, Statement 3. 6 Some manufacturing companies follow the tax code rules for costing inventory; others do not. (See footnote 2.) 7 FASB Statement No. 34 requires that interest costs related to items produced as “discrete projects” (such as ships) be treated as product costs. (The accounting procedures for this are the same as for capitalized interest on assets produced for an enterprise’s own use, described in Chapter 7.) “How- ever, interest cost shall not be capitalized for inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis” (FASB Statement No. 34).

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Service Companies

In principle, product costing in service firms is the same as in manufacturing firms. Ap- plication of these principles is described below for three types of service organizations.

Personal services organizations such as barber shops, beauty parlors, and medical and dental practices have no inventories other than supplies inventory. Although these organizations may estimate the average cost of a haircut, a wash and set, or a routine office visit to aid them in pricing these services, these costs do not flow through inventory accounts as do product costs in a merchandising or manufacturing firm. A personal ser- vices organization may identify the labor costs of the people directly providing the service (e.g., a dental hygienist) and supplies costs (X-ray film) as elements of cost of sales, to dis- tinguish them from “office overhead” costs (receptionist, rent, utilities, and so on).

Another category of service organization includes building trade firms (e.g., plumbing and electrical firms) and repair businesses that repair or maintain such items as appliances and automobiles. The inventories of repair parts and building ma- terials carried by these firms are analogous to materials inventories in a manufacturing firm. Thus, the accounting for these inventories is conceptually the same as materials inventory accounting in a manufacturing firm. When materials are issued, they are recorded on some sort of cost sheet for the job. The labor costs of tradespersons or re- pairpersons also are recorded on this sheet, which in effect is a subsidiary work in process inventory record for the job.

The third type of service company, professional service firms such as law and ac- counting firms, has labor product costs but no materials costs. The accounting proce- dures are similar to those for building trade and repair businesses. Each project that the firm works on is given a job number and a subsidiary account is set up for the job. Time spent by professionals on a job, and any related travel costs and long-distance telephone charges, are charged to that job’s account. Collectively, these job costs con- stitute the firm’s work in process inventory, which is the only inventory (other than sup- plies) that such firms have. When a point is reached in the project where the agreement with the client permits these job costs to be billed, a markup is added for office over- head and profit, and the client is billed. The related accounting entries record the revenues—usually called billings—and transfer the costs from the Jobs in Progress account to expense, as in this example:

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . 10,000

Billings (or Revenues) . . . . . . . . . . . . . . . . . . 10,000

Project Expenses . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Jobs in Progress . . . . . . . . . . . . . . . . . . . . . . 4,000

Inventory Costing Methods

One important topic remains to be discussed: the measurement of inventory and cost of goods sold when the per-unit cost of one or more items in inventory changes during the accounting period. The basic problem is that shown in Illustration 6–1: How should the cost of goods available for sale be divided between (1) cost of goods sold and (2) ending inventory? Note that the goods available for sale are assumed to be either sold or still on hand in inventory. It follows that the higher the amount assigned to cost of goods sold, the lower the amount of ending inventory, and vice versa. Several

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acceptable methods of handling this problem exist and the choice of method can have a significant effect on reported income. We shall discuss four widely used methods:8

1. Specific identification. 2. Average cost. 3. First-in, first-out (FIFO). 4. Last-in, first-out (LIFO).

We shall illustrate these methods with an example from a merchandising company, but the same principles apply to a manufacturing company. In our illustration, we as- sume the following for a year:

Units Unit Cost Total Cost

Inventory, January 1 100 $ 8 $ 800 Purchased June 1 60 9 540 Purchased October 1 80 10 800___ _______ ______ Goods available for sale 240 $ 8.917 $2,140 Goods sold during the year 150 ? ?___ _______ ______

Ending inventory 90 ? ?

When there is a means of keeping track of the purchase cost of each item, such as with a code affixed to the item, it is possible to ascertain the actual cost of each item sold. This specific identification method is common practice with certain big-ticket items such as automobiles and with unique items such as paintings, expensive jewelry, and custom-made furniture; and bar codes and scanners are making it feasible with lower- cost items. In many cases, however, when a substantial number of physically similar items are sold, this method can be unsatisfactory because the cost of goods sold de- pends on what specific items happen to be sold. Indeed, a merchant can deliberately manipulate the cost of goods sold by selecting items that have a relatively high cost or a relatively low cost.

In the illustration above, 150 units were sold. If the merchant selected the 100 units with a unit cost of $8 and 50 of the units having a unit cost of $9, the cost of goods sold would be (100 * $8) � (50 * $9) � $1,250. If the 150 units with the highest cost were selected, the cost of goods sold would be (80 * $10) � (60 * $9) � (10 * $8) � $1,420.

With the average cost method, the average cost of the goods available for sale is com- puted, and the units in both cost of goods sold and ending inventory are costed at this average cost. In the periodic inventory method, this average is computed for the whole period. It is a weighted average: Each unit cost is weighted by the number of units with that cost. In the perpetual inventory method, a new average unit cost is sometimes cal- culated after each purchase. In either case, the average cost is representative of the cost of all of the items that were available for sale during the period.

Assuming the periodic inventory method, the 240 units available for sale have a total cost of $2,140; hence, the average cost is $2,140 � 240 � $8.917. The calculations of cost of goods sold and ending inventory are as follows:

154 Part 1 Financial Accounting

Example

Example

Specific Identification Method

Average Cost Method

8 As already noted, LIFO is not permitted under IFRS. Outside of the United States, LIFO is sometimes used where permitted by local accounting standards.

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Units Unit Cost Total*

Cost of goods sold 150 $8.917 $1,338 Ending inventory 90 8.917 802___ ______

Total 240 $2,140___ _________ ______

* Rounded.

Some companies use a predetermined unit cost for all transactions during the pe- riod. This is a standard cost system and is discussed in Chapter 19. It is essentially a variation of the average cost method.

The average cost method gives results that are in between the next two methods to be described, FIFO and LIFO. It is therefore a compromise for those who do not find the arguments for one or the other of these methods to be compelling.

The FIFO method assumes that the oldest goods are sold first and that the most re- cently purchased goods are in the ending inventory. In the illustration, for the 150 units sold, it is assumed that the 100 units in beginning inventory were sold first and that the other 50 units sold were from the purchase made on June 1.

Units Unit Cost Total Cost

Cost of goods sold: From beginning inventory 100 $ 8 $ 800 From purchase of June 1 50 9 450___ ______

Cost of goods sold 150 $1,250____________ Ending inventory:

From purchase of June 1 10 $ 9 $ 90 From purchase of October 1 80 10 800___ ______

Ending inventory 90 $ 890____________

We shall contrast the LIFO and FIFO methods below. For the moment, it is suffi- cient to note that with FIFO (1) cost of goods sold is likely to approximate the physi- cal flow of the goods because most companies sell their oldest merchandise first and (2) the ending inventory approximates the current cost of the goods, since it is costed at the amounts of most recent purchases.

The LIFO method is the opposite of FIFO. Cost of goods sold is based on the cost of the most recent purchases, and ending inventory is costed at the cost of the oldest units available.

Units Unit Cost Total Cost

Cost of goods sold: From purchase of October 1 80 $10 $ 800 From purchase of June 1 60 9 540 From beginning inventory 10 8 80___ ______

Cost of goods sold 150 $1,420____________ Ending inventory:

From beginning inventory 90 $ 8 $ 720____________

Chapter 6 Cost of Sales and Inventories 155

First-In, First- Out Method

Last-In, First- Out Method

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Note that with LIFO (1) cost of goods sold does not reflect the usual physical flow of merchandise and (2) the ending inventory may be costed at amounts prevailing sev- eral years ago, which in an era of rapid inflation are far below current costs.

LIFO Dollar Value Method Originally LIFO was used only by companies whose inventory consisted of fungible products, such as wheat, each unit of which is physically like every other unit. Other companies, however, successfully argued that this was unfair to them. Thus, LIFO may now be used for almost any kind of inventory. It is applied to an inventory of physically unlike items by the so-called LIFO dollar value method. In this method, items whose prices tend to move together are grouped into an inventory pool. For example, a pool may consist of all the items in the inventory of the housewares de- partment in a store. The calculations required to determine cost of goods sold and inventory amounts with this method are beyond the scope of this book. Compared with the unit-by-unit LIFO method, dollar value LIFO saves a considerable amount of recordkeeping effort.

Changes in Inventory In a year when the physical size of the inventory increases above the amount on hand at the beginning of the year, with LIFO the inventory account is increased by the addi- tional quantity valued at the costs existing during that year. During a period of growth, the inventory account will therefore consist of a number of layers, a new layer being added each year. If subsequently the physical inventory should decrease in size, these layers are, in effect, stripped off, taking the most recently added layer first in accor- dance with the basic LIFO rule. This process can have a peculiar effect on the income statement. If inventory is decreased to the extent that several LIFO layers are stripped off, then inventory items will be moving into cost of goods sold at costs established several years previously. If there has been constant inflation during the interim, such a decrease in inventory can result in a significant increase in reported income. Some peo- ple assert that in a recession, some companies deliberately eat into their LIFO invento- ries in order to increase reported income in a lean year. Careful readers of financial statements are not fooled by this practice, since the profit effect of reducing LIFO in- ventories must be disclosed in the notes to the financial statements.

LIFO Reserve Companies that use LIFO for determining their balance sheet valuation of inventory nevertheless keep their detailed inventory records on a FIFO or average cost basis. The inventory amounts on these other bases usually will be higher than the LIFO valuation shown on the balance sheet. At the end of each accounting period, the difference be- tween the LIFO valuation and the FIFO or average cost valuation is determined. (This is a complex calculation that is covered in advanced accounting texts.) This differ- ence is sometimes called the LIFO reserve. The terminology is unfortunate because “reserve” suggests something set aside or saved for some special future purpose. The LIFO reserve is nothing more than the mathematical difference between two in- ventory amounts, one based on LIFO and the other one based on a different method of valuing inventory. LIFO companies disclose their LIFO reserve in the notes for their fi- nancial statement.

The following table summarizes the illustrative results of three of the four methods described above (the specific identification method depends on the specific items selected):

156 Part 1 Financial Accounting

Comparison of Methods

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Cost of Ending Goods Sold Inventory Total

FIFO $1,250 $890 $2,140 Average cost 1,338 802 2,140 LIFO 1,420 720 2,140

All of the methods described are in accordance with generally accepted accounting principles (GAAP) and all are accepted by the Internal Revenue Service (IRS) for calculating taxable income.

Arguments for FIFO A primary conceptual argument for using FIFO is that it matches the costs of the goods that are physically sold with the revenues generated by selling those goods. Also, many companies set selling prices by adding a gross margin to the cost of the actual goods to be sold. Conceptually, such a price results in the company’s recover- ing the funds it had invested in the particular item to be sold, plus a margin to provide for recovery of selling and administrative costs and a reasonable profit. For example, this pricing philosophy is commonly applied in retailing companies such as grocery and department stores.

This brief item from The Wall Street Journal reflects the idea of pricing based on the cost of the goods actually (physically) sold: “Retail coffee prices are being cut by supermarket chains around the nation. The reductions are selective because of lingering high-priced in- ventories; when these are gone, wholesale-price cuts can be passed on to the public.”

Thus, it is argued, if a company’s management thinks of gross margin as the difference between selling prices and the cost of the goods physically sold, then it should use FIFO, which will report this same margin in the company’s income statement.

The other primary argument for FIFO reflects a balance sheet orientation. Many people feel that the amount shown for inventory on the balance sheet should be ap- proximately equal to the current cost of that inventory. The mechanics of FIFO, which assume that the goods in inventory are those most recently acquired, result in an in- ventory valuation that is closer to current costs than would result if LIFO or average cost were used. (This is true irrespective of the rate of inflation.)

Arguments for LIFO Proponents of LIFO also base their primary conceptual argument on the matching concept. They argue that gross margin should reflect the difference between sales revenues, which are necessarily current amounts, and the current cost of the goods sold. Although seldom made explicit, this LIFO matching argument assumes that a company’s management sets selling prices by adding a margin to current costs rather than to historical costs. If this is indeed the case, then the gross margin reported using LIFO will reflect management’s thinking with regard to the nature of gross margin.

It should be pointed out that although this conceptual argument for LIFO involves the notion of the current cost of goods sold, LIFO only approximates these current costs. Generally, current cost of goods sold means the cost of acquiring items identi- cal in type and number to those sold to replenish the inventory immediately after a sale. This is also called replacement cost inventory accounting, or, more jocularly, NIFO

Chapter 6 Cost of Sales and Inventories 157

Example

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(for next-in, first-out). True replacement cost accounting is not permitted by either GAAP or the income tax code.9

While focusing on income statement matching, LIFO proponents downplay the impact of LIFO on balance sheet inventory valuation. Because the base layer of in- ventory is valued forever in terms of price levels prevailing when LIFO was adopted, the LIFO inventory valuation departs further and further from reality as time goes on, thus reflecting neither actual purchase costs nor replacement costs. In periods of pro- longed inflation, this LIFO valuation may be far below current costs, making the in- ventory figure of dubious usefulness. Thus, whereas FIFO leads to a cost of goods sold amount of questionable usefulness and thus casts doubt on the usefulness of the income statement, LIFO casts a similar doubt in the usefulness of the balance sheet amount for inventory and thus on the amounts for current assets, total assets, and owners’ equity.

This problem with LIFO can be mitigated, however. Although the amount reported as inventory on the balance sheet may be unrealistically low, the company must provide the LIFO reserve date in the notes to the financial statements that permits the reader to convert the inventory to a FIFO basis by adding the LIFO reserve to the LIFO inven- tory amount.

Income Tax Considerations FIFO, average cost, and LIFO are all permitted for U.S. income tax calculations— although once a method is chosen, a company cannot change it without seeking per- mission from the Internal Revenue Service (IRS). If a company chooses the LIFO method for tax purposes, it must also use LIFO in its published financial statements. This LIFO conformity rule is the only significant instance in which the IRS requires use of the same accounting method for income tax and “book” (financial reporting) purposes.

In periods of inflation, LIFO results in lower income than FIFO or average costs, and thus results in lower income taxes. If the physical size of inventory remains constant or grows, LIFO reduces taxable income indefinitely. Only if LIFO layers are stripped off in future years might taxable income under LIFO exceed taxable income under FIFO; and even in that case, LIFO will have postponed some income tax payments. These tax advantages of LIFO in periods of rising prices can improve a company’s cash flow and therefore lead many companies to select the LIFO method regardless of the conceptual pros and cons of the various alternatives.

Why Not More LIFO? Since LIFO can improve a company’s after-tax cash flow, why don’t all companies use it for all of their inventories? At least two reasons can be given.

First, although the economy as a whole may be experiencing inflation, the prices of the specific items in a company’s inventory are not necessarily increasing. In some in- stances, particularly in the electronics industry, specific prices fall even while general inflation continues. For example, in 1970 the retail price of a four-function handheld calculator was $395; today, a similar item retails for under $10. Companies whose in- ventory replacement costs are trending downward will report lower taxable income and pay lower taxes by using FIFO rather than LIFO.

158 Part 1 Financial Accounting

9 Replacement cost inventory accounting is used outside the United States in countries with high inflation rates.

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Second, in a company for which LIFO will reduce taxable income and thus lower income tax payments, the company also must report the lower LIFO income to its share- holders because of the LIFO conformity rule. This means that the cash flow improve- ment from LIFO will be accompanied by a decrease in reported earnings per share (relative to cash flows and earnings if FIFO were used). Although academic research studies suggest that the stock market does not penalize a company whose earnings drop because of a change to LIFO, many top managers of U.S. companies have long held the view that lower reported earnings per share are associated with lower stock prices, what- ever the cause of the lower earnings. Thus, in considering LIFO, many managers see a dilemma: Increasing cash flow through lower tax payments is clearly good for the cor- poration, but they believe that the accompanying decrease in reported earnings is bad for the shareholders. Since top management serves at the pleasure of the board of directors and since the board is supposed to protect shareholders’ interests, often the decision is to opt for FIFO and higher reported earnings rather than LIFO and improved cash flows.

Lower of Cost or Market

All the foregoing had to do with measuring the cost of inventory. The LIFO and FIFO methods are alternative ways of measuring cost. The general inventory valuation prin- ciple, deriving from the conservatism concept, is that inventory is reported on the bal- ance sheet at the lower of its cost or its market value.

In the ordinary situation, inventory is reported at its cost. It is reduced below cost (i.e., written down) only when there is evidence that the value of the items, when even- tually sold or otherwise disposed of, will be less than their cost. Such evidence may in- clude physical deterioration, obsolescence, drops in price level, or other causes. When this evidence exists, inventory is stated at market.

Since the goods in inventory have not in fact been sold, their true market value is not ordinarily known and therefore must be estimated. Accounting Research Bulletin (ARB) No. 43 states that this estimate should be the current replacement cost of the item; that is, what it would cost currently to purchase or manufacture the item.10 The ARB further sets upper and lower boundaries on “market”:

1. It should not be higher than the estimated selling price of the item less the costs as- sociated with selling it. This amount is called the net realizable value.

2. It should not be lower than the net realizable value less a normal profit margin.

These principles can be compressed into the following rule: Use historical cost if that cost is lowest; otherwise, use the next-to-lowest of the other three possibilities.

Assume four items with amounts as in the table shown below. The inventory amount to be used for each is starred.

Item

1 2 3 4

a. Historical cost $ 7* $9 $9 $10 b. Current replacement cost 8 8* 7 9 c. Net realizable value (ceiling) 10 9 9 8* d. Net realizable value less profit margin (floor) 9 7 8* 7

Chapter 6 Cost of Sales and Inventories 159

10 Accounting Research Bulletin No. 43, Chapter 4.

Example

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As is true for the rules for marketable securities, which are applied to the individual securities in a portfolio, the rule for inventory is applied to each item in inventory (i.e., each unique part number or product number).

Analysis of Inventory

The ratio most commonly used in analyzing the size of the inventory item is inventory turnover:

Inventory turnover � Cost of goods sold

Inventory

If the cost of goods sold for a year is $1 million and inventory is $250,000, then the inventory turnover is 4.0 times. This is equivalent to saying that the inventory turns over once every three months (quarter of a year).

Some companies calculate this ratio on the basis of the ending inventory, others on the basis of the average inventory. The average may be simply one-half the sum of beginning and ending inventories for the year, or it may be an average of monthly in- ventory levels. The end-of-period basis is more representative of the current state of the inventory if volume is expected to continue at previous levels. The average basis is a better reflection of events that occurred during the period because it measures the amount of inventory that supported the sales activity of that period.

Inventory turnover varies greatly with the nature of the business. It should be high for a store that sells fresh produce; otherwise spoilage is likely to be a problem. A supermar- ket may have an inventory turnover close to 50, a petroleum refinery 20. On the other hand, a jewelry store with a wide selection of expensive and unusual items may not turn its in- ventory as often as once a year, and most art galleries have a turnover much lower than 1.

One also must consider the seasonality of sales. For example, college bookstores have high inventories before the start of each new term, with lower inventories in be- tween. In such entities, an annual calculation of inventory turnover has little meaning, and inventory measured at various seasonal high and low points is of more significance.

Inventory turnover indicates the velocity with which merchandise moves through a business. Turnover may fall either because of inventory buildup in anticipation of in- creased sales or because sales volume has declined, leaving excess merchandise on hand. The first is a favorable event; the second is unfavorable. The turnover number it- self does not indicate which is the cause.

Days’ Inventory The same relationship can be expressed as the number of days’ inventory on hand. If one has already calculated inventory turnover, then days’ inventory is simply 365 � in- ventory turnover. Days’ inventory can be calculated directly as follows:

Inventory $250,000 Days’ inventory �

Cost of goods sold � 365 �

$1,000,000 � 365 � 91 days

Of course, both the inventory turnover and days’ inventory calculations are affected by the company’s inventory costing method. Because, relative to FIFO, the LIFO method results in lower reported inventory value on the balance sheet and higher cost of goods sold, a company using LIFO will have a higher indicated inventory turnover ratio and a lower indicated number of days’ inventory than if it were using FIFO. Such differences must be taken into account when comparing ratios for different entities.

160 Part 1 Financial Accounting

Inventory Turnover

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Chapter 6 Cost of Sales and Inventories 161

One way this problem is resolved is to convert the LIFO data to their FIFO equivalent and use the adjusted data to compute the ratios.

A ratio closely associated with inventory accounting is a company’s gross margin (sales less cost of goods sold) expressed as a percentage of its net sales revenue. Since the gross margin figure is influenced by the cost of goods sold number, different in- ventory accounting methods can lead to different gross margins. The gross margin per- centage is one of several different measures of a company’s profitability. It measures the percentage of each sales dollar a company earns before considering period costs.

Using the cost of goods sold figures from the FIFO and LIFO examples above and assum- ing $2,000 in sales, the FIFO-based gross margin is 37.5 percent ($750 � $2,000); the LIFO-based gross margin is 29 percent ($580 � $2,000).

To compute the gross margin of a LIFO accounting firm on a FIFO basis, the change in the company’s LIFO reserve from the beginning of the accounting period to the end of the period is added to the LIFO-based cost of goods sold if the change is a positive amount. It is deducted if the change is negative. Similarly, to compute the FIFO inven- tory value of a LIFO firm, the LIFO reserve is added to the LIFO inventory value.

Gross Margin Percentage

The objectives of inventory accounting are (1) to match the cost of goods sold, an expense, with the revenue earned from the sale of those goods in an accounting period and (2) to measure the cost of inventory on hand at the end of the period, which is an asset.

A merchandising company has one inventory account. The separation of the cost of the goods available for sale into the amount determined to be cost of goods sold and the amount determined to be ending merchandise inventory can be accomplished by either the periodic inventory method or the perpetual inventory method. In the former, ending inven- tory is obtained by a physical count, and cost of goods sold is obtained by deduction. In the latter, both amounts are obtained directly from inventory records.

A manufacturing company has three inventory accounts: Materials, Work in Process, and Finished Goods. In the periodic inventory method, the amount in each account is determined by taking a physical inventory and then deducing the cost of materials used, the cost of goods manufactured, and the cost of goods sold. In a perpetual inventory system, also called a product costing system, these costs are obtained directly from the accounting records.

Inventory is ordinarily measured at its cost. In a merchandising company, cost is essen- tially the amount expended to acquire the goods. In a manufacturing company, product costs include, in addition to materials costs, the labor cost and other production costs incurred in converting the materials into finished goods. Other operating costs, in either type of company, are called period costs; they are expenses of the current period.

The flow of costs can be measured by any of several methods, including specific identi- fication; average costs; first-in, first-out (FIFO); and last-in, first-out (LIFO). Although the LIFO method usually results in lower income taxes, some companies do not use it because the LIFO conformity rule would result in their reporting lower net income to their share- holders. IFRS does not permit the use of LIFO.

If the market value of an inventory item is below cost, the item is reported at its market value.

Two ratios helpful in analyzing inventories are inventory turnover and days’ inventory. The inventory accounting method adopted by management can influence a company’s

gross margin percentage.

Summary

Example

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Problems Problem 6–1.

In the following table, there appear income statements for four hypothetical companies. Each income statement is missing three numbers; you are to determine these missing num- bers. (Assume taxes are part of “period expenses.”)

Co. W Co. X Co. Y Co. Z

Sales $2,250 $1,800 $1,350 $2,100______ ______ ______ ______ Cost of goods sold:

Beginning inventory 300 225 ? 300 Plus: Purchases 975 ? 850 1,200 Less: Ending inventory 225 300 300 ?______ ______ ______ ______

Cost of goods sold ? 900 ? ?______ ______ ______ ______ Gross margin ? ? ? 750 Period expenses 300 400 150 ?______ ______ ______ ______ Net income (loss) $ ? $ ? $ 150 $ (50)______ ______ ______ ______

Problem 6–2. The Gardner Pharmacy uses the periodic inventory method. In its most recent fiscal year, 2010, Gardner had beginning inventory of $50,000; gross purchases of $167,000; freight-in of $4,000; purchases returned to suppliers totaling $8,000; and ending inventory of $77,500. Make the year-end adjusting and closing entries to reflect the above information in the inventory, cost of goods sold, and income summary accounts. Then, assuming sales of $325,000, other expenses (excluding taxes) of $95,000, and a tax rate of 30 percent, prepare an income statement for the year, including the derivation of the cost of goods sold amount.

Problem 6–3. Gould’s Company, which makes a single product, uses the perpetual inventory method. At the end of each accounting period, a physical inventory is taken to verify the perpetual inventory records. For its most recent accounting period, Gould’s records showed beginning inventory of 673 units; goods added to finished goods inventory during the period, 5,700 units; and sales during the period of 5,800 units. Finally, during the period, 80 units in resalable condi- tion were returned by Gould’s customers. The unit cost was $15 throughout the period.

Required a. Assuming Gould’s sells this item for $23 per unit, prepare summary journal entries

for the period’s purchases, sales, and sales returns.

b. Prepare an income statement down to the gross margin line.

c. Assume that after the entries in part (a) were made, a physical count revealed that ending inventory was actually 610 units. What additional entry is required? How does this affect your income statement?

Problem 6–4. On March 31, the Maple Shop had no alarm clocks on hand. During the next four months, it first purchased 50 clocks for $14 each, and then 75 more for $12 each. During these four months, 100 alarm clocks were sold.

Required What will the July 31 alarm clock inventory amount and the four months’ cost of goods be if the Maple Shop uses the periodic inventory method and (a) average cost; (b) FIFO; (c) LIFO?

162 Part 1 Financial Accounting

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Problem 6–5. Electronic Heaven, Inc., sells electronic merchandise, including a personal computer offered for the first time in September, which retails for $695. Sales of this personal com- puter for the next six-month period (ending February 28) totaled $52,125. Purchase records indicate the following on the amounts purchased and prices paid by Electronic Heaven:

Purchase Date Units Cost per Unit

September 10 12 $370 October 15 20 375 November 2 32 360 December 10 11 350 February 3 10 335

Required a. Prepare a statement for this personal computer showing its gross margin for the six-

month period ending February 28 using the FIFO, average cost, and LIFO inventory methods.

b. What was the gross margin percentage earned on the $52,125 sales of this personal computer? (Hint: The answer depends on the inventory method used.)

c. If all of the purchases and sales of this personal computer were for cash, what was the net pretax cash flow resulting from the purchases and sales of this personal com- puter? Would the use of different inventory methods change the pre-tax cash flow figure you calculated?

d. Assume a tax rate of 30 percent. What would be the net after-tax cash flow using different inventory methods for tax purposes?

Problem 6–6. Marks Manufacturing Company has the following beginning balances:

Materials inventory $100,000 Work in process 370,000 Finished goods 60,000

During the period, the following occurred:

1. Purchased for cash $872,000 worth of raw materials. Delivery charges on these materi- als equaled $22,000.

2. Used $565,000 worth of direct labor in the production process.

3. Used $900,000 worth of materials in the production process.

4. The following costs were incurred:

Indirect labor $27,000 Factory utilities $147,000 Factory supplies used 46,000 Depreciation—manufacturing 46,000 Property taxes and insurance 14,000 Selling and administrative 28,000 Depreciation—factory 54,000

5. Transferred $2,035,000 worth of work in process inventory to finished goods inventory.

6. Sales were $2,600,000.

7. The ending balance in Finished Goods Inventory was $93,000.

Chapter 6 Cost of Sales and Inventories 163

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164 Part 1 Financial Accounting

Required a. Calculate the Ending Materials and Work in Process Inventory balances. (Hint: Refer

to Illustration 6–4.)

b. What was Marks Manufacturing’s gross margin during the period?

Problem 6–7. You are given the following unit cost data for Sun-Power Company:

A B C D

Historical cost $150 $183 $134 $113 Current replacement cost 145 177 126 116 Net realizable value 150 173 134 128 Net realizable value less profit margin 143 165 131 122 Number of units on hand 30 40 20 40

Required Determine the carrying cost of each item, and record the adjusting entry to the inventory account.

Cases

Case 6–1

Browning Manufacturing Company* The management of Browning Manufacturing Com- pany annually prepared a budget of expected financial operations for the ensuing calendar year. The com- pleted budget provided information on all aspects of the coming year’s operations. It included a projected balance sheet as of the end of the year and a projected income statement.

The final preparation of statements was accom- plished only after careful integration of detailed com- putations submitted by each department. This was done to ensure that the operations of all departments were in balance with one another. For example, the fi- nance department needed to base its schedules of loan transactions and of collections and disbursements on numbers that were dependent on manufacturing, pur- chasing, and selling expectations. The level of produc- tion would be geared to the forecasts of the sales department, and purchasing would be geared to the proposed manufacturing schedule.

In short, it was necessary to integrate the estimates of each department and to revise them in terms of the overall effect on operations to arrive at a coordinated

and profitable plan of operations for the coming year. The budget statements ultimately derived from the adjusted estimated transactions would then serve the company as a reliable guide and measure of the com- ing year’s operations.

At the time the 2010 budget was being prepared, in November of 2009, projected 2009 financial state- ments were compiled for use as a comparison with the budgeted figures. These 2009 statements were based on ten months’ actual and two months’ projected trans- actions. They appear as Exhibits 1, 2, and 3.

Below is the summary of expected operations for the budget year 2010 as finally accepted:

1. Sales: All on credit, $2,562,000; sales returns and allowances, $19,200; sales discounts taken by cus- tomers (for prompt payment), $49,200. (The sales figure is net of expected bad debts.)

2. Purchases of goods and services:

a. New assets: i. Purchased for cash: manufacturing plant and

equipment, $144,000; prepaid manufactur- ing taxes and insurance, $78,000.

ii. Purchased on accounts payable: materials, $825,000; supplies, $66,000.

* Copyright © by the President and Fellows of Harvard College. Harvard Business School case 198-047.

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Chapter 6 Cost of Sales and Inventories 165

Assets Current assets:

Cash and marketable securities $ 118,440 Accounts receivable (net of allowance for doubtful accounts) 311,760 Inventories:

Materials $ 110,520 Work in process 172,200 Finished goods 257,040 Supplies 17,280 557,040__________

Prepaid taxes and insurance 66,720___________ Total current assets 1,053,960

Other assets: Manufacturing plant at cost 2,678,400

Less: Accumulated depreciation 907,200 1,771,200____________ ____________ Total Assets $2,825,160________________________

Liabilities and Shareholders’ Equity Current liabilities:

Accounts payable $ 185,760 Notes payable 288,840 Income taxes payable 9,000____________

Total current liabilities $ 483,600

Shareholders’ equity: Capital stock 1,512,000 Retained earnings 829,560 2,341,560____________ ____________

Total Liabilities and Shareholders’ Equity $2,825,160________________________

EXHIBIT 1 Browning Manufacturing Company, Projected Balance Sheet, December 31, 2009

Finished goods inventory, 1/1/09 $ 218,820 Work in process inventory, 1/1/09 $ 137,760 Materials used 663,120 Plus: Factory expenses

Direct manufacturing labor 419,040 Factory overhead:

Indirect manufacturing labor $170,640 Power, heat, and light 116,760 Depreciation of plant 126,600 Social Security taxes 42,120 Taxes and insurance, factory 46,320 Supplies 56,880 559,320__________ _____________

1,779,240 Less: Work in process inventory, 12/31/09 172,200___________

Cost of goods manufactured (i.e., completed) 1,607,040____________ 1,825,320

Less: Finished goods inventory, 12/31/09 257,040____________ Cost of goods sold $1,568,280________________________

EXHIBIT 2 Browning Manufacturing Company, Projected 2009 Statement of Cost of Goods Sold

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b. Services used to convert materials into work in process, all purchased for cash: direct man- ufacturing labor, $492,000; indirect manufac- turing labor, $198,000; social security taxes on labor, $49,200; power, heat, and light, $135,600.

c. Selling and administrative services, purchased for cash: $522,000.

3. Conversion of assets into work in process: This appears as an increase in the cost of work in process and a decrease in the appropriate asset accounts. Depreciation of manufacturing building and equip- ment, $140,400; expiration of prepaid taxes and insurance, $52,800; supplies used in manufactur- ing, $61,200; materials put into process, $811,000.

4. Transfer of work in process to finished goods: This appears as an increase in finished goods and a decrease in work in process. Total cost accumu- lated on goods that have been completed and transferred to finished goods, $1,901,952.

5. Cost of finished goods sold to customers: $1,806,624.

6. Financial transactions:

a. $264,000 borrowed on notes payable to bank.

b. Cash payment to bank of $38,400 for interest on loans.

7. Cash receipts from customers on accounts receiv- able: $2,604,000.

8. Cash payments of liabilities:

a. Payment of accounts payable, $788,400.

b. Payment of 2009 income tax, $9,000.

9. Estimated federal income tax on 2010 income: $58,000, of which $5,800 is estimated to be unpaid as of December 31, 2010.

10. Dividends declared for year and paid in cash: $36,000.

This summary presents the complete cycle of the Browning Manufacturing Company’s budgeted yearly operations from the purchase of goods and services through their various stages of conversion to comple- tion of the finished product to the sale of this product. All costs and cash receipts and disbursements involved in this cycle are presented, including the provision for federal income taxes and the payment of dividends.

The management was particularly interested in the budget’s year-end cash position. The company’s goal was to have a year-end cash balance of approximately $150,000 after paying off at least $350,000 and possi- bly as much as $400,000 of the note payable to the bank (not listed as a transaction in the budget). In addition, the company’s budgeted year-end invest- ment in inventory was of interest to management who had decided to work toward improving the company’s inventory turnover ratio. Management was also aware of the need to maintain its satisfactory trade credit relationship with suppliers.

Questions

1. Prepare a projected statement of cost of goods sold for 2010, a projected income statement for 2010, and a projected balance sheet as of December 31, 2010. (Hint: Set up T accounts corresponding to the 2009

166 Part 1 Financial Accounting

Sales $2,295,600 Less: Sales returns and allowances $17,640

Sales discounts allowed 43,920 61,560_________ ____________ Net sales 2,234,040

Less: Cost of goods sold (per schedule) 1,568,280____________ Gross margin 665,760

Less: Selling and administrative expense 437,160____________ Operating income 228,600

Less: Interest expense 34,080____________ Income before federal and state income tax 194,520

Less: Estimated income tax expense 89,520____________ Net income $ 105,000________________________

EXHIBIT 3 Browning Manufacturing Company, Projected 2009 Income Statement

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balance sheet accounts. Post the budgeted transac- tions to the accounts. Use the inventory T accounts to prepare the projected cost of goods sold statement and the retained earnings T account to prepare the income statement.)

2. Describe the principal differences between the 2010 estimates and the 2009 figures as shown in Exhibits 1, 2, and 3. In what respects is 2010 performance expected to be better than 2009 performance, and in what respects is it expected to be worse?

Chapter 6 Cost of Sales and Inventories 167

Case 6–2

Lewis Corporation* Lewis Corporation had traditionally used the FIFO method of inventory valuation. You are given the infor-

mation shown in Exhibit 1 on transactions during the year affecting Lewis’s inventory account. (The pur- chases are in sequence during the year. The company uses a periodic Inventory method.)

2009

Beginning balance 1,840 cartons @ $20.00 Purchases 600 cartons @ 20.25

800 cartons @ 21.00 400 cartons @ 21.25 200 cartons @ 21.50

Sales 2,820 cartons @ 34.00

2010

Beginning balance 1,020 cartons Purchases 700 cartons @ 21.50

700 cartons @ 21.50 700 cartons @ 22.00

1,000 cartons @ 22.25 Sales 3,080 cartons @ 35.75

2011

Beginning balance 1,040 cartons Purchases 1,000 cartons @ 22.50

700 cartons @ 22.75 700 cartons @ 23.00 700 cartons @ 23.50

Sales 2,950 cartons @ 35.75

EXHIBIT 1 Inventory Transactions 2009–2011

* Copyright © Professor Robert N. Anthony.

3. Does the budget indicate that management will achieve its note payable repayment goal? If not, what do you suggest they do to achieve their mini- mum objective?

4. Does the budget indicate management’s inventory turnover goal will be achieved? If not, what do you suggest they do to improve the company’s inventory turnover?

5. What does the budget indicate might happen to the company’s trade credit standing?

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Questions

1. Calculate the cost of goods sold and year-end inven- tory amounts for 2009, 2010, and 2011 using the (a) FIFO, (b) LIFO, and (c) average cost methods.

2. Lewis Corporation is considering switching from FIFO to LIFO to reduce its income tax expense. Assuming a corporate income tax rate of 40 per- cent, calculate the tax savings this would have made for 2009 to 2011. Would you recommend that Lewis make this change?

3. Dollar sales for 2012 are expected to drop by ap- proximately 8 percent, as a recession in Lewis’s market is forecasted to continue at least through the first three quarters of the year. Total sales are fore- casted to be 2,700 cartons. Lewis will be unable to raise its selling price from the 2011 level of $35.75. However, costs are expected to increase to $24 per

carton for the whole year. Due to these cost/price pressures, the corporation wishes to lower its invest- ment in inventory by holding only the essential inventory of 400 cartons at any time during the year. What is the effect of remaining on FIFO, assuming Lewis had adopted FIFO in 2009? What is the effect of remaining on LIFO, assuming Lewis adopted LIFO in 2009? What method would you recom- mend now?

4. What is the LIFO reserve in 2009? What is the LIFO reserve in 2010? What is the significance of the LIFO reserve number? How much did the LIFO reserve increase in 2010? What is the significance of this increase?

5. Despite continuing inflation in the United States in the 1980s and the early 1990s, many companies continued to use FIFO for all or part of their do- mestic inventories. Why do you believe this was the case?

168 Part 1 Financial Accounting

Case 6–3

Morgan Manufacturing* Charles Crutchfield, manager of manufacturing opera- tions at Morgan Manufacturing, was evaluating the per- formance of the company. Given his position, he was primarily interested in the health of the operating as- pects of the business. At Morgan, the gross margin per- centage was considered to be a key measure of operat- ing performance; other measures considered to provide essential information on the health of business opera- tions were pretax return on sales and pretax return on assets. Crutchfield considered the after-tax versions of these measures less relevant for his purposes because they combined information reflecting the health of op- erations with information reflecting the effectiveness of the tax accounting department, which was not under his control.

From Morgan Manufacturing’s 2010 income state- ments and balance sheets, shown in Exhibit 1, Crutch- field computed Morgan Manufacturing’s gross margin percentage (44.5%), pre-tax return on sales (14.5%), and pre-tax return on assets (13.4%). Crutchfield was

especially interested in comparing his firm’s perfor- mance against that of its major competitor, Westwood, Inc. Crutchfield felt that Morgan had recently made significant productivity improvements over Westwood that would be reflected in the financial statements. When he looked at Westwood’s 2010 financial state- ments (Exhibit 2), he was quite disappointed. Despite the similarities between the two companies based on the three key measures, he concluded that Westwood’s financial performance was better.

Distraught, Crutchfield sought the advice of Edward Drewery, controller. “How can Westwood’s results be better than ours, when I know that our operations are more efficient?” The controller responded, “I’m not sure about the relative efficiency of the two firms’ operations, but I do know that we use a different method to account for inventory than Westwood uses. Have you taken that into account?” “Not really,” replied Crutchfield. “Well, all you need to know,” con- tinued Drewery, “is that we use LIFO; Westwood uses FIFO; and our LIFO reserve was $10 million in 2009 and $70 million in 2010.”* Copyright © Julie H. Hertenstein.

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Chapter 6 Cost of Sales and Inventories 169

Income Statement, for the year ended December 31 2009 2010

Sales $1,500 $2,000 Cost of goods sold 810 1,110______ _______ Gross margin 690 890 Selling, general, and administrative expenses 450 600______ _______ Income before taxes 240 290 Income tax expense 96 116______ _______

Net income $ 144 $ 174______ _____________ _______

Balance Sheet, as of December 31 2009 2010

Cash $ 100 $ 140 Accounts receivable 250 350 Inventory 120 100 Plant, property, and equipment (net) 1,385 1,580______ _______

Total assets $1,855 $2,170______ _____________ _______ Current liabilities $ 250 $ 325 Long-term liabilities 500 675 Common stock 400 400 Retained earnings 705 770______ _______

Total liabilities and owners’ equity $1,855 $2,170______ _____________ _______ LIFO reserve $10 $70

EXHIBIT 1 Morgan Manufacturing Financial Statements ($ millions)

Income Statement, for the year ended December 31 2009 2010

Sales $1,500 $2,000 Cost of goods sold 800 1,100______ _______ Gross margin 700 900 Selling, general, and administrative expenses 450 600______ _______ Income before taxes 250 300 Income tax expense 100 120______ _______

Net income $ 150 $ 180______ _____________ _______

Balance Sheet, as of December 31 2009 2010

Cash $ 100 $ 140 Accounts receivable 250 350 Inventory 140 170 Plant, property, and equipment (net) 1,385 1,580______ _______

Total assets $1,875 $2,240______ _____________ _______ Current liabilities $ 250 $ 330 Long-term liabilities 500 675 Common stock 400 400 Retained earnings 725 835______ _______

Total liabilities and owners’ equity $1,875 $2,240______ _____________ _______

EXHIBIT 2 Westwood, Inc., Financial Statements ($ millions)

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Crutchfield wondered how the reported results could be adjusted so that the comparison could be done on a comparable basis.

Questions

1. What are Westwood’s gross margin percentage, pre-tax return on sales (pre-tax income � sales), and pre-tax return on assets (pre-tax income � total assets)?

2. Which accounts that appear on the income state- ment or balance sheet and the various financial

ratios and measurements incorporating these accounts are affected by the differing choices of inventory accounting method? Explain how the choice of different inventory accounting methods affects one’s ability to directly compare the results of these two companies.

3. Using the information available in the exhibits, make the necessary adjustments to the 2010 results so that you can better compare the performance of the two companies on the three key measures.

4. Which of the two companies do you believe is performing better? Why?

170 Part 1 Financial Accounting

Case 6–4

Joan Holtz (B)* Because an earlier visit with the accounting instructor [see Case 5–3, Joan Holtz (A)] had cleared up some puzzling matters, Joan Holtz decided to prepare a new list of problems as a basis for a second discussion. As before, Holtz knew that the instructor expected that tentative answers to these questions be worked out prior to the meeting. The instructor also wanted Holtz using numbers of her own choosing, to illustrate the is- sues she was raising and her tentative answers with simple numerical illustrations whenever possible. The list follows:

1. Evidently, there are three ways of handling purchase discounts: They can be deducted from the cost of the purchased goods, they can be reported as other income, or purchase discounts not taken can be re- ported as an expense of the period. But isn’t the effect on net income the same under all these meth- ods? If so, why argue about which is preferable?

2. It is said that the perpetual inventory method iden- tifies the amount of inventory shrinkage from pil- ferage, spoilage, and the like, an amount that is not revealed by the periodic inventory method. Having identified this shrinkage amount, however, how should it be recorded in the accounts?

3. People have said that the LIFO method assumes that the goods purchased last are sold first. If this is so, the assumption is clearly unrealistic because companies ordinarily sell their oldest merchandise

first. Can a method based on such an unrealistic assumption be supported, other than as a tax gimmick?

4. A certain automobile dealer bases its selling prices on the actual invoice cost of each automobile. In a given model year, the invoice cost for similar auto- mobiles may be increased once or twice to reflect increased manufacturing costs. Would this automo- bile dealer be wrong if it used the LIFO method? By contrast, a certain hardware dealer changes its selling prices whenever the wholesale price of its goods changes as reported in wholesalers’ price lists. Would this hardware dealer be wrong if it used the FIFO method?

5. Are the following generalizations valid?

a. The difference between LIFO and FIFO is rela- tively small if inventory turnover is relatively high.

b. The average cost method will result in net income that is somewhere between that pro- duced by the LIFO method and that produced by the FIFO method.

c. If prices rise in one year and fall by an equal amount the next year, the total income for the two years is the same under the FIFO method as under the LIFO method.

6. If the LIFO method is used and prices are rising, ending inventory will normally be significantly below prevailing market prices. Therefore, what justification is there for applying the lower-of-cost- or-market rule to LIFO inventories?* Copyright © Professor Robert N. Anthony.

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7. A certain distillery manufactured bourbon whiskey, which it aged in charred, white oak barrels for four years before bottling and selling it. Whiskey was carried in inventory at approximately $1 per gallon, which was the cost of ingredients, labor, and fac- tory overhead of the manufacturing process. Bar- rels, which could not be reused, cost $0.70 per gal- lon. The distillery incurred $0.20 of warehousing costs per gallon per year, including costs involved in moving and testing the barrels. It also incurred $0.10 per gallon of interest costs per year. The costs of barrels, warehousing, and interest were charged directly to expense. If the distillery had consistently earned pretax profit of $600,000 per year on annual production and sale of 1 million gallons, what would happen to profits if it increased production to 1.2 million gallons per year? At what amounts should it carry its whiskey in inventory?

Chapter 6 Cost of Sales and Inventories 171

8. A company produced a “made for TV” movie at a total cost of $1 million. It sold the rights to the initial showing to a network for $1 million, and fully ex- pected to sell the rights for a repeat showing the fol- lowing year for $300,000. It thought that in future years, additional reruns would generate at least another $300,000 of revenue. Disregarding any GAAP dealing with this issue, how much should the company report as cost of sales for the first year? Would the answer be different if in the first year the producing company agreed to pay $100,000 for advertising and promoting the initial showing?

Question

Give your “tentative answers” to the above issues. Illus- trate the issue and your answer whenever possible.

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7 Long-Lived Nonmonetary Assets and Their Amortization

Chapter

Chapters 5 and 6 discussed monetary assets and inventories. Investments are discussed in Chapter 12. This chapter describes other categories of assets. The common charac- teristic of these assets is that they are nonmonetary and have long lives; they provide benefits to the entity for several future years. We describe the accounting principles in- volved in recording the acquisition of these long-lived assets, the conversion of their acquisition costs to expenses, and the disposition of such assets when they no longer provide service. Analytical techniques that give financial statement users a better un- derstanding of a company’s nonmonetary asset accounting decisions and transactions also are discussed.

Nature of Long-Lived Assets

When an entity makes an expenditure, the benefits from the goods or services acquired either are obtained in the current period or are expected to be obtained in future peri- ods. If the benefits are obtained in the current period, the costs of the goods or services are expenses. If benefits are expected in future periods, the costs are assets in the cur- rent period and the expenditures are said to be capitalized. Although inventory and prepaid expenses also are assets because they benefit future periods, the term capital assets is usually taken to mean long-lived assets—assets that provide service for sev- eral future years.

A capital asset can usefully be thought of as a bundle of services. When a company buys a truck that is intended to last for 200,000 miles, it is in effect buying transporta- tion services that will benefit the company over several future years. The cost of these services, that is, the cost of the truck, should be matched with the revenues that are ob- tained from its use in these future periods. The general name for this matching process is amortization, but other names are used for various types of capital assets, as will be described. The portion of the asset’s cost that is charged to a given period is an ex- pense of that period. A capital asset is therefore essentially similar to a prepaid

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insurance policy or other prepaid expense. It is initially recorded as an asset and is con- verted to an expense in one or more future periods. The difference is that the life of most capital assets is longer than that of most prepaid expenses.

Illustration 7–1 uses T accounts to depict how expenditures either are expensed in the current period (period costs) or are capitalized in an asset account and amortized (expensed) in later periods. Note that all costs eventually become expenses, but capital assets’ costs do so over a period of several years, whereas period costs become ex- penses as they are incurred.

Illustration 7–2 lists principal types of long-lived nonmonetary assets and the termi- nology used for the process of amortizing the cost of each type. The principal distinc- tion is between tangible assets and intangible assets. A tangible asset is an asset that has physical substance, such as a building or a machine. An intangible asset, such as patent rights or copyrights, has no physical substance. Many such assets are referred to as intellectual property.

Long-lived tangible assets are usually listed on the balance sheet under the heading “property, plant, and equipment.” The term fixed assets is often used in informal dis- cussion and appears in several balance sheets in this book simply because it is shorter. Property includes land, which ordinarily is not amortized because its useful life is assumed to be indefinitely long. Plant and equipment includes buildings, machinery, office equipment, and other types of long-lived capital assets. The accounting process of converting the original cost of plant and equipment assets to expense is called

ILLUSTRATION 7–1 Expenditures and Expenses

Capitalize

Expense

100

100

100 20

20

Benefits beyond this

period?

Expenditures (costs incurred)

Cash or payables

Asset accounts

Retained earnings

A m

or ti

za ti

on en

tr ie

s (m

ad e

in fu

tu re

p er

io ds

as b

en ef

it s

ar e

re ce

iv ed

)*Y es

N o

* Amortize over five years.

Method of Converting Type of Asset to Expense

Tangible Assets Land Not amortized Plant and equipment Depreciation Natural resources Depletion

Intangible Assets Goodwill Not amortized*

Intangible assets (other than goodwill)—limited life Amortization Intangible assets (other than goodwill)—indefinite life Not amortized*

Leasehold improvements Amortization Deferred charges Amortization Research and development costs Not capitalized

* Subject to periodic impairment test.

ILLUSTRATION 7–2 Types of Long-Lived Assets and Amorti- zation Methods

Types of Long- Lived Assets

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 173

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depreciation. Natural resources such as petroleum and natural gas in the ground are usually reported as a separate category (but not after they have been taken out of the ground and become inventory). The accounting process of converting the cost of these natural resource assets to expense is called depletion.

The several categories of intangible assets will be discussed separately in later sec- tions of this chapter. When intangible assets are converted to expenses, the accounting process has no specific name (as in the case of fixed assets and natural resources); it is just called amortization.

Plant and Equipment: Acquisition

The distinction between expenditures that are capitalized and expenditures that are expensed as period costs is not entirely clear-cut. Some borderline cases are described in the following paragraphs.

Low-Cost Items In accordance with the materiality concept, items that have a low unit cost, such as cal- culators and hand tools, are charged immediately as expenses, even though they may have a long life. Each company sets its own criteria for items that are to be capitalized. Generally, the line is drawn in terms of the cost of an item, which may be anywhere from $25 to $1,000, or even more. Items costing less are expensed.

Nevertheless, the capitalized cost of a new facility may include the cost of the initial outfit of small items that do not individually meet the criteria for capitalization. Exam- ples are the initial outfit of small tools in a factory, the books in a library, and the table- ware and kitchen utensils in a restaurant. When these items are replaced, the cost of the replacement items is charged as an expense, not capitalized.

Betterments Repair and maintenance is work done to keep an asset in good operating condition or to bring it back to good operating condition if it has broken down. Repair and mainte- nance costs are ordinarily period costs; they are not added to the capitalized cost of the asset. A betterment is added to the cost of the asset. The distinction between mainte- nance expenses and betterments is this: Maintenance keeps the asset in good condition but in no better condition than when it was purchased; a betterment makes the asset better than it was when it was purchased or extends its useful life beyond the original estimate of useful life.

In practice, the line between the two is difficult to draw. A new accessory designed to make a machine operate more efficiently or perform new functions is a betterment; an overhaul during which worn-out parts are replaced with new ones is maintenance. In the interest of conservatism, some work that strictly speaking should be considered a betterment is often charged as an expense of the current period.

Replacements Replacements may be either assets or expenses, depending on how the asset unit is defined. The replacement of an entire asset results in the writing off of the old asset and the recording of the new asset. The replacement of a component part of an asset is maintenance expense. For example, a few companies treat a building as a single asset unit, whereas most treat each major component (structure, plumbing, elevators, heating and air-conditioning system) as a separate asset. The replacement of an ele- vator would result in a maintenance charge in the former case and in a new asset in

174 Part 1 Financial Accounting

Distinction between Asset and Expense

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 175

the latter. In general, the broader the definition of the asset unit, the greater will be the amount of costs charged as maintenance and, hence, expensed in the year the replacement parts are installed.

The governing principle is that the cost of an item of property, plant, or equipment in- cludes all expenditures that are necessary to make the asset ready for its intended use. In many cases the amount can be determined easily. For example, the cost of a truck purchased for cash is simply the amount of cash paid. In other cases, the problem is more complicated. The cost of a parcel of land includes the purchase price, broker’s commission, legal fees, and the cost of grading or of tearing down existing structures so as to make the land ready for its intended use. The cost of machinery includes the purchase price, sales tax, transportation costs to where the machinery is to be used, and installation costs.

Despite the principle stated above, many organizations do not capitalize all the costs incurred to make the asset ready to provide service. Some capitalize only the purchase price. They do this both because it is simpler and it also minimizes property taxes, which may be calculated on the basis of the capitalized amount.

Self-Constructed Assets When a company constructs a building or item of equipment for its own use, the amount of capitalized cost includes all the costs incurred in construction. As in the case of product costs, these costs include the materials and labor directly associated with the project, as well as a fair share of the company’s indirect costs incurred during the construction period. The Financial Accounting Standards Board (FASB) requires that these capitalized costs also include interest.1 The amount of interest capitalized is the amount related to borrowings made to finance the project (construction loans) if these are identifiable. If not, the company must estimate the interest cost that could have been avoided if the asset in question had not been constructed. The total amount of interest capitalized cannot exceed the company’s total interest cost for the period. The interest capitalization period ends when the asset is substantially complete and ready for its intended use. If the company contracts with an outside party to build the asset and makes deposits or progress payments to the contractor, then interest costs as- sociated with these funds are included in the capitalized cost.

As is the case with other items of cost, if interest cost is capitalized rather than ex- pensed, this has the effect of increasing the income of the current period and decreas- ing income during the years of the asset’s useful life. This decrease occurs because each year’s depreciation expense for the asset is larger than it would have been had the interest cost not been capitalized.

Noncash Costs In the great majority of cases, a capital asset is acquired for cash or for a note or other obligation whose cash equivalent is easily determined. When some other considera- tion, such as common stock, is given, there may be problems in determining the amount to be capitalized. The general principle is this: First, the fair market value of the consideration given for the asset should be determined; and, second, if it is not feasible to determine this value, then the fair market value of the new capital asset it- self is used. (Special rules apply when one capital asset is traded in as part payment for a new asset, as described in a following section.)

Items Included in Cost

1 “Capitalization of Interest Cost,” FASB Statement No. 34.

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There are a few exceptions to the basic rule that asset acquisitions are recorded in the accounts at cost. If the entity acquires an asset by donation or pays substantially less than the market value of the asset, the asset is recorded at its fair value.2 This happens, for example, when a community donates land or a building in order to induce a com- pany to locate there.

Such exceptions to the general rule are relatively rare, and their rarity emphasizes the importance of the general rule that nonmonetary assets are recorded at cost. Fur- thermore, as will be seen in the next section, increases in market value do not affect the accounting records for capital assets. Competent investors acquire or build apartment houses or shopping centers with the expectation that part of the profit from this invest- ment will be derived from the appreciation of the property. This appreciation may in fact occur year after year, but it is not recorded in the accounts.3

The reason for the supremacy of the cost concept over a system geared to changes in current value is the importance of the basic criterion of objectivity. We may know in a general way that the value of an apartment house is increasing, but there is no objec- tive way of measuring the amount of increase until a sale takes place. When this hap- pens, a new cost is established, and the asset is recorded at this cost in the accounts of the new owner.

In contrast GAAP, IFRS allows property, plant, and equipment, after its initial recognition at cost, to be measured using the cost model (see above) or, if the assets fair value can be measured reliably, the revaluation model. Under the revaluation model, the asset is carried at its revalued amount (fair value) at its date of revaluation less any subsequent accumulated depreciation and subsequent impairment losses. If an asset’s carrying amount is increased as a result of revaluation, the increase is treated as an in- crease in other comprehensive income (an owner’s equity account). Revaluations result- ing in a decrease in an asset’s carrying amount are recorded as a reduction of other comprehensive income to the extent of previously recorded increases. Any excess loss of fair value is charged to income.4

Sometimes an entity acquires in one transaction several capital assets that are to appear in more than one balance sheet category. This is called a basket purchase. The com- pany must divide the basket’s cost between the categories on some reasonable basis. Usually this requires an appraisal of the relative value of each asset included in the bas- ket purchase.

Such a separation is always required when land and a building are purchased in a single transaction; this is because the building will subsequently be depreciated, whereas the land will remain on the books at its cost. A separation also may be neces- sary if the capital assets in the basket have different useful lives, because they will then be depreciated at different rates.

A parcel of land with a building thereon is purchased for $800,000. An appraiser states that the land is worth $90,000 and the building is worth $810,000, a total of $900,000, which is more than the $800,000 cost. Since the appraised value of the land is 10 percent of the total appraised value of the basket, the land is entered in the accounts at 10 percent of the total cost, or $80,000. The building is entered at 90 percent of the cost, or $720,000.

176 Part 1 Financial Accounting

Acquisitions Recorded at Other Than Cost

Basket Purchases

Example

2 “Accounting for Nonmonetary Transactions,” APB Opinion No. 29. 3 “Status of Accounting Research Bulletins,” APB Opinion No. 6, “Property, plant and equipment should not be written up by an entity to reflect appraisal, market or current values which are above cost to the entity.” 4 “Property, Plant and Equipment”, IAS No. 16.

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 177

Note that it would not be correct to use the appraised value of one asset as the amount to be capitalized and to capitalize the other asset at the remainder of the purchase price. Thus, it would not be correct to record the land at $90,000 and the building at $710,000.

Plant and Equipment: Depreciation

Unless otherwise indicated, the discussion of depreciation accounting in this section will relate to financial reporting (i.e., generally accepted accounting principles, or IFRS and GAAP), as distinguished from income tax reporting. Depreciation in finan- cial reporting is based on the matching concept, whereas the tax code essentially elim- inated the matching concept as the basis of income tax depreciation calculations. (De- preciation for income tax purposes is described in a later section.)

With the exception of land, most items of plant and equipment have a limited useful life; that is, they will provide service to the entity over a limited number of future ac- counting periods. A fraction of the cost of the asset is therefore properly chargeable as an expense in each of the accounting periods in which the asset provides service to the entity. The accounting process for this gradual conversion of plant and equipment cap- italized cost into expense is called depreciation.5

Why is depreciation an expense? The answer is that the costs of all goods and ser- vices consumed by an entity during an accounting period are expenses. The cost of insurance protection provided in a year is an expense of that year even though the in- surance premium was paid two or three years previously. Depreciation expense is con- ceptually just like insurance expense. The principal difference is that the fraction of total cost of an item of plant and equipment that is an expense in a given year is diffi- cult to estimate, whereas the fraction of the total cost of an insurance policy that is an expense in a given year can be easily calculated. This difference does not change the fundamental fact that both insurance policies and plant and equipment provide benefits to the entity over a finite number of accounting periods, and a fraction of their original cost therefore must be charged as an expense of each of these periods.

The useful life of a tangible long-lived asset is limited by either deterioration or ob- solescence. Deterioration is the physical process of wearing out. Obsolescence refers to loss of usefulness because of the development of improved equipment or processes, changes in style, or other causes not related to the physical condition of the asset. We will refer to the time until an asset wears out as its physical life, and the time until it becomes obsolete or is expected to be disposed of as its service life. Although the word depreciation is sometimes used as referring only to physical deterioration (“wear and tear”), this usage is incorrect. In many cases, a piece of equipment’s service life is shorter than its physical life; computers are a good example.

The depreciation expense for each accounting period is determined by one of several variations of this general formula:

Depreciation expense � Original cost � Residual value

Service life

5 If the asset is used in the production process, its depreciation is properly chargeable as an item of product cost that is initially added to Work in Process Inventory, then flows through Finished Goods Inventory, and becomes an expense (cost of goods sold) in the period in which the product is sold, as described in Chapter 6. In the interests of simplicity, in this chapter we shall not distinguish between the depreciation that is a product cost and the depreciation that is a period expense.

Judgments Required

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In order to determine the depreciation expense for an accounting period, three judg- ments or estimates must be made for each depreciable asset:

1. The service life of the asset—the number of accounting periods over which the asset will be useful to the entity that owns it.

2. The asset’s residual value at the end of its service life—any amount eventually re- covered through sale, trade-in, or salvage. The net cost of the asset to the entity is its original cost less its residual value. It is this net cost that should be charged as an expense over the asset’s life, not its original cost. In a great many situations, how- ever, the estimated residual value is so small or uncertain that it is disregarded.

3. The method of depreciation—the method that will be used to allocate a fraction of the asset’s net cost to each of the accounting periods in which it is expected to be used.

Managers, not being clairvoyant, cannot know in advance how long the asset will be used or what its residual value will be. Often they have no scientific or strictly logical way of deciding the best depreciation method. The amount of depreciation expense that results from these judgments is therefore an estimate. Because of the arithmetic precision of the calculations that take place after these judgments are made, the inex- act nature of depreciation expense is sometimes overlooked.

The service life of an asset is the period of time over which it is expected to provide service (i.e., benefits) to the entity that controls it. The service life may be shorter than the physical life because of obsolescence or because the entity may plan to dispose of an asset before its physical life ends. For example, although automobiles typically have a useful physical life of about 10 years, many companies trade in their automobiles every two years and buy new ones. In these companies, the service life is two years. If the asset’s service life to a particular entity is clearly less than the asset’s useful physi- cal life, then the estimated residual value of the asset at the end of its service life should be greater than zero.

Estimating the service life of an asset is a difficult problem. Reference to the tax code is not helpful. The tax code uses “cost recovery periods” that generally are shorter than an asset’s useful lives. (For example, a new apartment house has a cost recovery period of 271⁄2 years.) Since GAAP clearly indicates that depreciation is to be based on realistic service lives, companies should make their own estimates of the useful lives of their various categories of depreciable assets for financial reporting purposes rather than relying on income tax lives.

Consider a piece of equipment purchased for $1,000 with an estimated service life of 10 years and estimated residual value of zero. The objective of depreciation account- ing is to charge this net cost of $1,000 as an expense over the 10-year period. How much should be charged as an expense each year?

This question cannot be answered directly by observing the amount of asset value physically consumed in a given year. Physically the equipment continues to be equip- ment; usually, there is no observable indication of its decline in usefulness. Nor can the question be answered in terms of changes in the equipment’s market value during the year, because equipment accounting is concerned with the amortization of cost, not with changes in market values. An indirect approach therefore must be used. Any method that is “systematic and rational” is permitted under GAAP.6 IFRS is more explicit. It requires the depreciation method to reflect the pattern in which the asset’s

178 Part 1 Financial Accounting

Service Life

Depreciation Methods

6 AICPA, Accounting Research Bulletin No. 43, Chap. 9, Sec. C.

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future economic benefits are expected to be consumed.7 Three conceptual ways of looking at the depreciation process are described below, together with the methods that follow from each.

Straight-Line Method One concept views a fixed asset as providing its services in a level stream. That is, the service provided (benefit received) is equal in each year of the asset’s life, just as a three-year insurance policy provides equal insurance protection in each of its three years. This concept leads to the straight-line method, which charges as an expense an equal fraction of the net cost of the asset each year. For a piece of equipment with a cost of $1,000, a zero residual value, and an estimated service life of 10 years, 1⁄10 of $1,000 ($100) is the depreciation expense of the first year, another 1⁄10 is the depreciation expense of the second year, and so on. Expressed another way, the equipment is said to have a depreciation rate of 10 percent per year, the rate being the reciprocal of the estimated service life.

Accelerated Methods A second concept recognizes that the stream of benefits provided by a fixed asset may not be level. Rather, the benefits provided may be greatest in the first year of the asset’s service life and least in the last year. This pattern may occur because the asset’s me- chanical efficiency tends to decline with age, because maintenance costs tend to increase with age, or because of the increasing likelihood that better equipment will become available and make it obsolete. Often, when a facility is not working at capac- ity, it is the older equipment that is not used. It is argued, therefore, that when an asset was purchased, the probability that the earlier periods would benefit more than the later periods was taken into account and that the depreciation method should reflect this. Such a line of reasoning leads to an accelerated method that charges a larger fraction of the cost as an expense of the early years than of the later years.8

Two accelerated depreciation methods, the double-declining-balance method and sum-of-the-years’-digits (or simply years’-digits) method, are described below. The effect of either of these methods is to write off approximately two-thirds of the asset’s cost in the first half of its estimated life, as contrasted with the straight-line method, under which, of course, half the cost is written off in each half of the asset’s estimated life. Thus, if an accelerated method is used, depreciation expense is greater in the early years and less in the later years as compared with the straight-line method.

In a declining-balance method, each year’s depreciation is found by applying a rate to the net book value of the asset as of the beginning of that year. (In the straight-line method, the depreciation rate is applied to original cost net of residual value, not to each year’s net book value.) The net book value of an asset at a point in time is the original acquisition cost less total depreciation accumulated up to that time. With a declining-balance method, the asset’s estimated residual value, if any, has no effect on the annual depreciation charges because residual value is not included in the calcula- tion of an asset’s net book value.

The declining-balance rate is a stated percentage of the straight-line rate. Thus, for an asset with a useful life of 10 years (straight-line rate � 10 percent), 200 percent

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 179

7 “Property, Plant and Equipment,” IAS No. 16. 8 An argument also can be made for an opposite approach: charging a smaller fraction of the cost in the early years and a larger fraction in the later years. This leads to an annuity method. It is rarely used in published financial statements.

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declining balance would use a rate of 20 percent (200 percent * 10 percent). Simi- larly, 150 percent declining balance would use a rate of 15 percent. The 200 percent declining-balance method is also called the double-declining-balance method be- cause the depreciation rate is double the straight-line rate.

After several years, the annual depreciation charge with a declining-balance method will be lower than the annual charge with the straight-line method. The usual practice is to change at that time from declining-balance to straight-line depreciation for the re- mainder of the asset’s life.

In the years’-digits method, also referred to as the sum-of-the-years’ digits method (SYD), the numbers 1, 2, 3, . . ., n are added, where n is the estimated years of useful life. This sum (SYD) can be found by the equation (using 10 years for the example)

SYD � n�n � 1� � 10�10 � 1� � 552 2 The depreciation rate each year is a fraction in which the denominator is the sum of these digits and the numerator is, for the first year, n; for the second year, n � 1; for the third year, n � 2; and so on. Thus, for a 10-year asset, the rate is 10⁄55 the first year, 9⁄55 the second year, 8⁄55 the third year, and so on. As with the straight-line method, the rate is applied to the net cost—cost less residual value—of the asset.

Comparison of Methods Illustration 7–3 shows graphically the way these three methods work out for a piece of equipment costing $1,000 with an estimated service life of 10 years and no residual value.

Units-of-Production Method A third concept of depreciation also treats the asset as consisting of a bundle of service units; but it does not assume that these service units will be provided in a mathematical

180 Part 1 Financial Accounting

0

20

40

60

80

100

120

140

160

180

200

1 2 3 4 5 6 7 8 9 10

Years'-digits

Straight-line

Double-declining-balance

Year

A n

n ua

l d ep

re ci

at io

n (

do ll

ar s)

ILLUSTRATION 7–3 Annual Deprecia- tion Charges for Equipment with Net Cost of $1,000 and 10-Year Service Life

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 181

Choice of a Depreciation Method

time-phased pattern, as is assumed by the straight-line and accelerated methods. Rather, with this concept, a period’s depreciation is related to the number of service units provided by the asset during the period.

This view leads to the units-of-production method, in which the cost of each ser- vice unit is the net cost of the asset divided by the total number of such units. The depreciation charge for a period is then the number of units consumed in that period multiplied by the net cost of one unit. For example, if a truck has an estimated net cost of $60,000 and is expected to give service for 300,000 miles, depreciation would be charged at a rate of 20 cents per mile ($60,000 � 300,000). The depreciation expense in a year in which the truck traveled 50,000 miles would be $10,000.

Later in this chapter, depreciation methods allowed in computing taxable income for the IRS are described. In deciding on a depreciation method for financial reporting purposes, income tax considerations are kept entirely separate. For tax purposes, cor- porations in most instances use the tax code’s accelerated depreciation rules, thereby receiving as quickly as possible the tax savings related to depreciation.

With respect to financial reporting, we have previously indicated that each type of method—straight-line, accelerated, and units-of-production—has its own conceptual basis as to the pattern in which an asset provides its bundle of services. In theory, GAAP allows a choice of methods so that a company can match the method to the pat- tern that an asset follows in that particular company. Strictly speaking, this means that different methods would apply to different types of assets in a given company. How- ever, there is little evidence that companies think about service benefit patterns when selecting depreciation methods for their financial accounting. In most cases, a single method is applied to all of a company’s depreciable assets. The method usually chosen is straight-line.

Accounting for Depreciation

Assume that on January 1, 2010, Trantor Company purchased for $1 million a build- ing with an estimated service life of 40 years and zero residual value. Trantor decided to depreciate this building on a straight-line basis, $25,000 per year. Now consider how to record this depreciation in the financial accounting records.

It would be possible to reduce the asset value by $25,000 a year and to show on the balance sheet only the remaining amount, which at the end of 2010 would be $975,000. However, this is not ordinarily done. Instead, a separate contra-asset account is main- tained for the cumulative amount of depreciation. This account is usually called accumulated depreciation, or it may have some other name such as allowance for de- preciation. GAAP requires disclosure of the amount of accumulated depreciation, ei- ther on the balance sheet or in a note thereto.9 Usually, both the original cost and the accumulated depreciation amounts appear on the balance sheet itself. For Trantor, the figures as of December 31, 2010, would look like this:

Building, at cost $1,000,000

Less: Accumulated depreciation 25,000__________ Building, net $975,000

9 “Disclosure of Depreciable Assets and Depreciation,” APB Opinion No. 12.

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As of December 31, 2011, another year’s depreciation would be added, and the balance sheet would then show

Building at cost $1,000,000

Less: Accumulated depreciation 50,000__________ Building, net $950,000

The foregoing amounts can be interpreted as follows:

Original cost of the building $1,000,000

That portion of the original cost charged as expense for all periods to date 50,000__________

That portion of original cost remaining to be charged as expense of future periods $ 950,000

The $950,000 is the book value of the asset. This is often labeled net book value to distinguish it from original cost, which is called the gross book value. The term book value is intended to highlight the fact that the amount is not an appraisal or mar- ket value.

On the income statement, the expense item is usually labeled depreciation expense. In the income statement for 2010, this item for Trantor Company would be $25,000 (disregarding depreciation on assets other than this building); and $25,000 also would appear in the income statements for 2011, for 2012, and for following years until the building was either disposed of or fully depreciated.

The annual journal entry for depreciation on Trantor’s building, which is one of the adjusting entries, would be as follows:

Depreciation Expense . . . . . . . . . . . . . . . . . . . . 25,000

Accumulated Depreciation . . . . . . . . . . . . . . 25,000

Suppose that in the year 2019 Trantor Company decides that the building is likely to last until 2054, which is longer than the 40 years originally estimated. In theory, Trantor should change the depreciation rate so that the book value remaining in 2019 would be charged off over the newly estimated remaining service life. Because of all the uncertainties and estimates inherent in the depreciation process, however, such changes in the depreciation rate are not always made in practice.

Fully Depreciated Assets Even if Trantor Company should use its building for more than 40 years, depreciation would cease to be accumulated at the end of the 40th year, since by then the total orig- inal cost of the building would have been charged to expense. Until the asset is dis- posed of, it is customary to continue to show the asset on the balance sheet. Thus, as of December 31, 2050, and for as long thereafter as Trantor owned the building, the bal- ance sheet would show the following:

Building, at cost $1,000,000

Less: Accumulated depreciation 1,000,000__________ Building, net $0

182 Part 1 Financial Accounting

Change in Depreciation Rates

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Often, half a year’s depreciation is recorded in the year of acquisition and half a year’s depreciation in the year of disposal, no matter what the actual date of acquisition or disposal is. This half-year convention is justified on the grounds that if the entity is ac- quiring and disposing of assets throughout the year, the inaccuracies in this procedure as regards specific assets will “wash out” over the course of the year. Other companies use an analogous half-quarter or half-month convention.

The amount of the depreciation charged off in the year must be disclosed in the finan- cial statements. In a merchandising company, this can be done by reporting deprecia- tion expense as a separate item on the income statement. In many manufacturing companies, a separate income statement item may not be feasible; this is because de- preciation of production plant and equipment is part of cost of goods sold (product costs), whereas the depreciation of other assets is part of general and administrative ex- penses, which are period costs. In these circumstances, the total amount of deprecia- tion expense is reported in a note accompanying the financial statements. The balance sheet, or a note thereto, must disclose the original cost of major classes of depreciable assets, the amount of accumulated depreciation, and the depreciation method or meth- ods used.

Plant and Equipment: Disposal

Suppose that at the end of 10 years Trantor Company sells its building. At that time 10⁄40 of the original cost, or $250,000, will have been built up in the Accumulated Depreci- ation account, and the net book value of the building will be $750,000. If the building is sold for $750,000 cash, the accounts are charged as follows:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000

Accumulated Depreciation . . . . . . . . . . . . . . . 250,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Since the building is no longer an asset of Trantor, both its original cost and its ac- cumulated depreciation must be removed from the accounts. This is exactly what the preceding entry accomplishes.

If the building were sold for less than $750,000—for $650,000—the $100,000 dif- ference is recorded as a loss, as in the following entry:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650,000

Accumulated Depreciation . . . . . . . . . . . . . . . 250,000

Loss on Sale of Building . . . . . . . . . . . . . . . . . 100,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Note that the effect on the Building and the Accumulated Depreciation accounts is identical with that in the previous illustration: The amounts relating to this building disappear. The loss is a charge to earnings, reflecting the fact that the total depreciation expense recorded for the preceding 10 years was less than what Trantor now knows to have been the actual net cost of the building over that period of time. The actual net cost turns out to have been $350,000, whereas the total depreciation expense charged has amounted to only $250,000.

Since the depreciation expense as originally recorded turns out to have been incor- rect, the Retained Earnings account, which reflects the net of all revenue and expenses to date, is also incorrect. There is therefore some logic in closing the Loss on Sale of

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 183

Partial-Year Depreciation

Disclosure

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Building account directly to Retained Earnings, thus correcting the error contained therein. Nevertheless, the matching concept requires that this loss be shown as an ex- pense on the income statement of the current period. An asset cost amount that no longer benefits future periods is an expense of the current period.

If an asset is sold for more than its book value, the entries are analogous to those de- scribed above. The account Gain on the Sale of Building (or other category of long- lived asset) is credited for the excess of the selling price over net book value. This account (as well as Loss on Sale of . . .) is usually included in “other income” on the income statement, rather than being shown as a separate line item.

Market Values The net book value of an asset usually is not the same as its market value. However, if Trantor’s building was sold at the end of 2015 for $650,000, this was by definition its mar- ket value at that time. Also, the $1 million original cost was presumably its market value on January 1, 2010, when it was acquired. Thus, the first and the last transactions for the building take account of market values. In the intervening periods under the cost model, changes in market values are disregarded in the financial statements and underlying accounting records.

Impaired Assets An exception to this general rule is made in the case of an impaired asset—an asset for which its remaining benefits excluding the cost or benefits of financing activities and income taxes, as measured by the sum of the future cash flows the asset’s use will generate, is less than its net book value. If the entity expects to hold such an impaired asset, it is written down to its fair value. If the entity plans to dispose of an impaired asset, it is valued at the lower of cost or fair value, less the cost of disposal. Any write- down is reported as an element of the period’s income.10 This is analogous to the lower- of-cost-or-market rule for inventories.

On January 1, 20X1, a company paid $1 million for a specialized machine, expecting to use it to produce a specific item for six years. The equipment was depreciated using the straight-line method. By January 20X4 demand for the item had dropped so much that the company expected that the cash flows the item would generate over the remainder of its product life cycle would be less than the equipment’s net book value ($500,000). The equipment was therefore written down to $300,000, its estimated fair value on January 1, 20X4. This write-down reduced 20X4 reported income.

The GAAP impairment test and subsequent measurement of any impairment loss de- scribed above is a two-step process. IFRS’ recognition and measurement of any im- pairment loss is a one-step process. If, and only if, the recoverable amount of an asset accounted for using its cost model is less than its carrying amount, the carrying amount of the asset is reduced to its recoverable amount. Recoverable amount is higher of the assets’ fair value less cost & sell and its value in use. Value in use is the present value of the future cash flows expected to be derived from an asset. Any reduction in the assets carrying amount is an impairment loss, which is a change to earnings.11

184 Part 1 Financial Accounting

Example

10 “Accounting for the Impairment or disposal of Long-Lived Assets,” FASB Statement No. 144. 11 “Impairment of assets,” IAS No. 36. If an asset is measured using the revaluation model, any im- pairment loss is treated as a revaluation decrease in accordance with “Property, Plant and Equip- ment,” IAS No. 16 (see page 176).

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Some items of property and equipment are disposed of by trading them in or exchang- ing them for new assets. When this is done, the value of the old asset is used in calcu- lating the acquisition cost of the new asset. The amount used in this calculation depends on whether or not the asset traded is similar to the new asset. If the trade-in is similar—of the same general type or performing the same function—its value is as- sumed to be its net book value. If the asset traded is dissimilar, its value is its estimated fair value.12

Assume a company trades in two automobiles, each of which originally cost $20,000, of which $15,000 has been depreciated; thus, each has a net book value of $5,000. Each has a fair value of $7,000 as a used car.

The first automobile is traded for another automobile with a list price of $30,000, and $18,000 cash is given to the dealer in addition to the trade-in. In this case, the cost of the new automobile is recorded as $23,000, the sum of the $18,000 cash and the $5,000 net book value of the trade-in.

The second automobile is traded for a piece of equipment that also has a list price of $30,000, and $18,000 cash is given in addition to the trade-in. In this case, the cost of the new equipment is recorded as $25,000—the sum of the $18,000 cash and the $7,000 fair value of the trade-in.

Journal entries for these two transactions are as follows:

1. For an exchange of similar assets:

Automobile (New) . . . . . . . . . . . . . . . . . . . . . . 23,000

Accumulated Depreciation (Automobile) . . . . . . 15,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Automobile (Old) . . . . . . . . . . . . . . . . . . . . . 20,000

2. For other exchanges:

Equipment (New) . . . . . . . . . . . . . . . . . . . . . . . 25,000

Accumulated Depreciation (Automobile) . . . . . . 15,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Automobile (Old) . . . . . . . . . . . . . . . . . . . . . 20,000

Gain on Disposal of Automobile . . . . . . . . . . 2,000

In both cases, the cost and accumulated depreciation of the old asset are removed from the accounts. Also in both cases, the list price of the new asset is disregarded. In the case of an exchange of similar assets, no gain or loss is recognized; in other ex- changes, the gain or loss is recognized. These rules are required for both financial reporting and income tax purposes. (For similar assets, tax regulations use the term like-kind exchange.)

The rationale behind these rules is that an exchange of similar assets does not result in the culmination of an earnings process, whereas an exchange of dissimilar assets does. For example, if a professional football team exchanges the contract of one of its players for cash and the contract of a player from another team, the team’s process of generating earnings is not materially affected. On the other hand, if a farm owner ex- changes a plot of tilled acreage for a new tractor, then the earnings process has ended on that portion of the farm that was exchanged.

The procedures described above related to a single fixed asset, such as one building or one automobile. To find the total depreciation expense for a whole category of assets, this procedure could be repeated for each single asset, and the total depreciation for all

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 185

Exchanges and Trade-Ins

Example

12 “Accounting for Nonmonetary Transactions,” APB Opinion No. 29.

Group Depreciation

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the assets in the category would then be recorded by one journal entry. This is unit depreciation, also called item depreciation.

An alternative procedure is to treat all similar assets (such as all automobiles or all office chairs) as a “pool,” or group, rather than making the calculation for each one separately. The process is called group depreciation. Annual depreciation expense under group depreciation is computed in a manner similar to that described above for an individual asset. If the straight-line method is used, for example, the depreciation rate is applied to the total original cost of the entire group of assets.

If the group method is used, no gain or loss is recognized when an individual asset is sold or otherwise disposed of. Upon disposal, the asset account is credited for the asset’s original cost, as in the entries given above. However, the difference between cost and the sales proceeds is debited or credited to Accumulated Depreciation rather than to a gain or loss account. This procedure assumes that gains on some sales in the group are offset by losses on others. This assumption is reasonable if the group contains a rel- atively large number of similar assets.

A used microcomputer with original cost of $3,000 is disposed of for $400 cash. Assuming group depreciation is used, the journal entry for this transaction is

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Accumulated Depreciation, Microcomputers . . . . . 2,600

Microcomputers . . . . . . . . . . . . . . . . . . . . . . . 3,000

Significance of Depreciation

The amount shown as accumulated depreciation on the balance sheet does not repre- sent the “accumulation” of any tangible thing. It is merely that portion of the deprecia- ble assets’ original cost that already has been matched as expense against revenue.

Occasionally, an entity does set aside money for the specific purpose of purchas- ing new assets, a process sometimes called funding depreciation. This is a financing transaction, which is completely separate from the accounting process of recording depreciation—the operating expense associated with the use of fixed assets. If depreci- ation is funded, cash or securities are set aside in such a way that they cannot be used in the regular operation of the entity (e.g., a special bank account may be created). This practice is not common. It is mentioned here only to emphasize, by contrast, the point that the depreciation process itself is not a means of automatically creating a fund for the replacement of assets.

There is a widespread belief that in some mysterious way depreciation does repre- sent money, specifically, money that can be used to purchase new assets. Sometimes this erroneous belief is reinforced by an entity’s using the term reserve for depreciation to mean accumulated depreciation. Depreciation is not money; the money that the en- tity has is shown by the balance in its Cash account.

This quotation is from a well-known publication: “Most large companies draw much of the cash flow they employ for expanding and modernizing their operations from their depreci- ation reserves.” This statement is not true in anything remotely approaching a literal sense.

A widespread belief that the net book value of assets is related to their real value is equally erroneous.

An auditor’s report included the following statement: “Our inspection of insurance policies in force at the close of the year disclosed that the plant assets on the basis of book values

186 Part 1 Financial Accounting

Example

Example

Example

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were amply protected against fire.” Such a statement has little if any significance. What investors want to know is whether the insurance protection equals the replacement cost of the assets, and this is unlikely to correspond to their book value.

The key to a practical understanding of depreciation is a sentence from Accounting Research Bulletin No. 43: “Depreciation is a process of allocation, not of valuation.”13

Depreciation expense does not represent the shrinkage in assets’ market value during an accounting period. Particularly during periods of inflation, a depreciable asset’s market value may be even higher at the end of the period than it was at the beginning. Neither does the net book value represent the market value of the depreciable assets. Deprecia- tion expense is the systematic allocation of the original cost of an asset to the periods in which the asset provides benefits to the entity. It follows that the net book value of fixed assets reported on the balance sheet represents only that portion of the assets’ original cost that has not yet been charged to expense through this systematic allocation process.

No one really knows how long an asset will last or what its residual value will be at the end of its life. Without this knowledge, each year’s depreciation expense is neces- sarily an estimate, one of several estimates we have now discussed that affect the pe- riod’s reported income.

Income Tax Considerations

Congress uses the income tax laws as a device to encourage corporations to invest in new productive assets. The key mechanism to encourage this capital formation has been depreciation allowances.14

Background An incentive to invest in capital assets is provided in the tax code by allowing the use of accelerated depreciation in calculating taxable income for federal income tax pur- poses. This incentive is further increased by shortening asset lives for tax purposes to periods substantially shorter than the assets’ actual service lives. The tax code calls this specified approach the modified accelerated cost recovery system (MACRS). MACRS provides for a series of asset classes, each class having its own depreciation life (called recovery period in the regulations) and method.15 As with financial accounting declining-balance depreciation calculations, MACRS calculations ignore the estimated residual value of the asset.

Half-Year Convention The tax rules also incorporate the half-year convention. Under this convention, most classes of property acquired or disposed of at any point during the year are assumed to have been acquired or disposed of at the midpoint of that year. Thus, an asset in, say,

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 187

13 AICPA, Accounting Research Bulletin No. 43, Chap. 9, Sec. C. 14 Our description of income tax matters throughout this text is intended to give general principles only. Details are spelled out in thousands of pages of Internal Revenue Service regulations. 15 The tax laws also permit the use of straight-line depreciation over longer (realistic) asset lives. However, it is usually to a company’s benefit to use the accelerated cost-recovery provisions.

Depreciation Allowances

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the five-year class is actually depreciated over six years, with half a year’s depreciation taken in both the first and sixth years and a full year’s taken in each of the intervening four years.

Assume that a machine in the five-year class is acquired at some point in 20X1 for $100,000. This asset would have the following cost recovery schedule, based on the double-declining-balance method for this class and the half-year convention:

Cost Recovery Year Deduction Computation

20X1 $ 20,000 1⁄2 * 40% * $100,000 20X2 32,000 40% * ($100,000 � $20,000) 20X3 19,200 40% * ($80,000 � $32,000) 20X4 11,520 40% * ($48,000 � $19,200) 20X5 11,520 Net book value at end of 20X4 is $17,280; 20X6 5,760 this is allocated to the remaining 11⁄2 years, Total $100,000 using the straight-line method.

As a practical matter, MACRS is a complex combination of a declining-balance method, the half-year convention, and the change to straight-line depreciation for the latter portion of the recovery period that has made income tax depreciation calculations a “look-up” procedure. Instead of doing the calculations as illustrated above, the ac- countant uses an IRS table to look up the percentage of an asset’s cost that can be depre- ciated in each year and applies this percentage to the asset’s original cost. Thus, in the above example for the years 20X1–20X6, the accountant would find in a table the per- centages 20.00, 32.00, 19.20, 11.52, 11.52, and 5.76, and would then multiply each year’s percentage by the $100,000 original cost to arrive at that year’s MACRS depreci- ation charge.

From time to time, the tax laws have permitted a reduction in the year’s income taxes equal to a percentage—often 10 percent—of the cost of any business machinery and equipment (but not buildings) acquired by a company during the year. This is called the investment tax credit (ITC). The credit is a direct reduction in the company’s income tax bill (as contrasted with an item deducted from revenues in arriving at the amount of taxable income). In effect, it is a rebate to the company acquiring a new fixed asset, except the rebate comes from the government rather than from the seller of the asset. For example, if a company acquired a $100,000 machine, it could deduct $10,000 from the federal income tax it would otherwise pay for that year.

Either one of two methods of accounting for the ITC is permitted for financial re- porting purposes. The flow-through method reduces reported income tax expense by the amount of the ITC in the year in which the credit is taken. Conceptually, this method treats the ITC rebate as a tax reduction that is “earned” as a result of acquiring assets that qualify for the ITC.

The deferral method treats the ITC rebate as a reduction in the original cost of the asset (which, of course, is what a true rebate is). The deferral method spreads the tax credit over the years of the asset’s useful life by reducing reported income tax expense in each of those years. Conceptually, the deferral method rejects the notion that the act of acquiring an asset should increase net income, which is the effect of the flow- through method. Rather, the credit is matched with the time periods in which the

188 Part 1 Financial Accounting

Example

Investment Tax Credit

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company is using the asset. Nevertheless, when the ITC was last in effect, almost all large companies used the flow-through method.

The income tax rules also permit special treatment of low-income housing, research expenditures, and restoration of historically important buildings, among other things. These provisions are beyond the scope of this introductory treatment.

A Caution The tax code is subject to frequent change. The rules described above are those in effect as of 2010.16

Natural Resources

Natural resources (such as unextracted coal, oil, other minerals, and gas) are assets of the company that owns the right to extract them. The general principles for measuring the acquisition cost of these wasting assets are the same as those for other tangible as- sets. If purchased, the cost is the purchase price and related acquisition costs. Many companies acquire these assets as a consequence of exploring for them. There are two strongly held views on how these exploration costs should be accounted for, particu- larly for oil and gas companies.

A petroleum company, in a given year, may be exploring in many different loca- tions; it probably will discover oil and gas reserves in only a few of them. Some peo- ple argue that all the exploration costs of a year should be capitalized as the asset value of the reserves that are discovered during the year; this is the full cost method. Others argue that only the costs incurred at locations in which reserves are discovered should be capitalized as the cost of these reserves and that the “dry-hole” costs should be im- mediately expensed; this is the successful efforts method. Both methods are used in practice, with larger companies typically using the successful efforts method.17

A petroleum company explores 10 locations, incurring costs of $10 million at each. It dis- covers oil and gas reserves at three of these locations. If it uses the full cost method, the asset amount of the newly discovered reserves will be recorded as $100 million. If it uses the successful efforts method, the asset amount will be recorded as $30 million and the other $70 million will be charged to expense.

The process of amortizing the cost of natural resources in the accounting periods ben- efited is called depletion. The objective is the same as that for depreciation: to allocate the cost in some systematic manner to the years of the asset’s useful life. The units-of- production method is ordinarily used.

If an oil property cost $250 million and is estimated to contain 50 million barrels of oil, the depletion rate is $5 per barrel. The total depletion for a year in which 8 million barrels of oil were produced would be $40 million.

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 189

16 Remember that many states also levy corporate income taxes; as a result, this book uses a 40 per- cent rate in illustrations. 17 In Statement No. 19, the FASB required the use of the successful efforts method. Subsequently, however, the SEC ruled that either method would continue to be acceptable for SEC filings. This SEC action led the FASB to issue Statement No. 25, which amended Statement No. 19 to permit either method. This reversal by the FASB serves as a reminder that determining GAAP for public companies is formally the SEC’s legislated responsibility, even though in most cases the SEC accepts the FASB’s accounting standards.

Example

Depletion

Example

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For income tax purposes, however, the depletion allowance in certain cases may bear no relation to cost. Rather, in some situations, it is a percentage of revenue. The permitted percentage varies with the type of asset and, like other provisions of the tax law, is subject to change. Percentage depletion is an example of an income tax provision that is inconsis- tent with GAAP. Advocates of the tax law treatment of depletion claim that it stimulates exploration for and development of new supplies of natural resources and is therefore in the national interest.

For timberland, cattle, tobacco, wine, and other agricultural products, the increase in value that arises through the natural process of growth or aging is called accretion. Since accretion does not represent realized revenue, it is ordinarily not recognized in the accounts. However, the costs incurred in the growing or aging process are added to the asset value, just as is done in the case of costs incurred in the manufacture of goods.

Appreciation is also an increase in the value of an asset. It is not the opposite of de- preciation, which is a write-off of cost. Appreciation of assets is recognized in the accounts only under highly unusual circumstances. For example, if a business is pur- chased by a new owner and an appraisal discloses that the current fair value of certain assets is substantially above their book value, in some instances (described below) these assets’ values are written up to their current value. Generally, however, increases in value are recognized in the accounts only when revenue is realized, whereas expira- tion of cost is recognized when it occurs.

Intangible Assets

A business can either acquire long-lived intangibles or develop them internally. The costs of internally developing, maintaining, or restoring intangibles that are not specif- ically identifiable, that have indeterminate lives, or that are inherent in a continuing business and related to the business as a whole, must be expensed as incurred.18 Typi- cally, acquired long-lived intangibles are capitalized.19

Intangibles recognized as long-lived assets fall into three categories: intangible assets with limited useful lives, intangible assets with indefinite useful lives, and goodwill.

Intangible long-lived assets with limited useful lives—such as patents—are usually converted to expenses over a number of accounting periods. The systematic allocation of the costs of these assets to the periods in which they provide benefits is called amortization. (There is no specialized term for the process of amortizing these assets, as there is for fixed assets and natural resources.)

The amortization of limited-useful-life intangible assets is essentially the same process as the depreciation of tangible assets. The method of amortization should reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. However, “if that pattern cannot be reliably determined, a straight-line amortization method shall be used.”20 Also, amortization of an intangible asset is usually credited directly to the asset account rather than being accumulated in a

190 Part 1 Financial Accounting

18 “Goodwill and Other Intangible Assets,” FASB Statement No. 142. 19 “Goodwill and Other Intangible Assets,” FASB Statement No. 142. 20 “Goodwill and Other Intangible Assets,” FASB Statement No. 142.

Accretion and Appreciation

Limited Useful Life

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separate contra asset account, as is the case with accumulated depreciation. Thus, the entry recording one year’s amortization of a five-year nonrenewable license that origi- nally cost $50,000 would be

Amortization Expense . . . . . . . . . . . . . . . . . . . . 10,000

Licenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Intangibles recognized as long-lived assets with indefinite useful lives—such as a re- newable broadcasting license—are not amortized. Rather they are subjected to peri- odic impairment tests. If it is determined that such an intangible asset is impaired, its carrying value is written down to its realizable value and a charge equal to the write- down is made to income. An intangible asset’s useful life is considered to be indefinite if there are no legal, regulatory, contractual, competitive, economic, or other factors that limit its useful life.

When one company buys another company, the purchasing company may pay more for the acquired company than the fair value of its net assets—tangible assets plus recog- nized intangibles, net of any liabilities assumed by the purchaser. The amount by which the purchase price exceeds the fair value of the net assets is recorded as an asset of the acquiring company. Although sometimes reported on the balance sheet with a descrip- tive title such as “excess of acquisition cost over net assets acquired,” the amount is customarily called goodwill.

It is important to note that goodwill arises only as part of a purchase transaction. (More details are given in Chapter 12.) The buying company may be willing to pay more than the fair value of the acquired net assets other than goodwill because the ac- quired company has a strong management team, a favorable reputation in the market- place, superior production methods, or other unidentifiable intangibles.

The acquisition cost of the recognized assets other than goodwill is their fair value at the time of acquisition. Usually, these values are determined by appraisal, but in some cases the net book value of these assets is accepted as being their fair value. If there is evidence that the fair value differs from net book value, either higher or lower, the fair value governs.

Company A acquires all the assets of Company B, giving Company B $1,500,000 cash. Company B has cash of $50,000, accounts receivable that are believed to have a realizable value of $60,000, and acquired assets other than goodwill that are estimated to have a fair value of $1,100,000. The amount of goodwill is calculated as follows:

Total purchase price $1,500,000

Less

Cash acquired $ 50,000

Accounts receivable 60,000

Other acquired assets (estimated) 1,100,000 1,210,000_________ __________ Goodwill $ 290,000

Not Amortized Goodwill cannot be amortized under any circumstances. It must be subjected to an an- nual impairment test. Any write-down due to impairment is charged to income.

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 191

Indefinite Useful Life

Goodwill

Example

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Patents, copyrights, and similar intangible assets with limited useful lives are initially recorded at their cost. If they are purchased, the cost is the amount paid. If a patented invention is developed within the company, however, the costs involved ordinarily are not capitalized. These are considered to be research and development costs, which are discussed separately in a following section.

The cost of intangible assets with limited useful lives is amortized over the useful life of the asset. If the useful life is limited by agreement or by law (e.g., 17 years for a patent), the amortization period cannot be longer. It may be shorter if the company be- lieves that, because of technological advances or other reasons, the practical life will be shorter than the legal life.

Leased property reverts to the owner at the end of the period of the lease. Any im- provements made to the property belong to the owner; the lessee loses the use of them when the leased property is returned. Therefore, the useful life of such improvements corresponds to the period of the lease. The lease agreement may contain renewal op- tions that effectively extend the life beyond the period of the original lease agreement. It follows that although improvements that otherwise meet the criteria for capitaliza- tion are capitalized, the useful life of these improvements is not determined by the physical characteristics of the improvements themselves but rather by the terms of the lease agreement.

A company leases office space and spends $90,000 for remodeling to suit its needs. The lease is for an original period of three years with an option to renew for another three years. The physical life of the improvements is 10 years. The leasehold improvements are amor- tized over a period of six years, or $15,000 a year, if the lessee believes it likely that the lease will be renewed. Otherwise, they are amortized over three years, at $30,000 a year. In any event, they are not amortized over 10 years.

Deferred charges are conceptually the same as prepaid expenses, a current asset dis- cussed in Chapter 2. They are included as long-lived assets only if they have a rela- tively long useful life—that is, if they benefit several future years. Patents, copyrights, and indeed all long-lived assets subject to amortization are deferred charges in the lit- eral sense. However, the term is usually restricted to long-lived intangibles other than those listed in the preceding paragraphs.

Practice varies greatly with respect to these items. Some companies charge them off as expenses as the costs are incurred, even though there is no offsetting revenue. This reflects the conservatism concept. Other companies capitalize them. If capitalized, they are usually amortized over a relatively short period of time, often in the next year, but rarely more than five years.

Research and development (R&D) costs are costs incurred for the purpose of develop- ing new or improved goods, processes, or services. The fruits of R&D efforts can be increased revenues or lower costs. Since these fruits will not be picked until future periods, often five years or more after a research project is started, a good case can be made for capitalizing R&D costs and amortizing them over the periods benefitted. This practice was common at one time, but the FASB no longer permits it. Instead, it requires that R&D costs be treated as period costs—that is, charged off as an expense of the current period.

The reason given by the FASB for its requirement is that by their very nature, the fu- ture benefits to be derived from current R&D efforts are highly uncertain. The efforts

192 Part 1 Financial Accounting

Leasehold Improvements

Example

Deferred Charges

Research and Development Costs

Patents and Copyrights

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that are eventually unsuccessful cannot be identified in advance; otherwise, they would not have been undertaken. Although near the end of the development stage the success of certain projects seems reasonably assured, the FASB has concluded that there is no objective way of distinguishing between these projects and the unsuccessful ones.

The FASB decision is a particularly interesting example of the inherent conflict be- tween certain concepts. Capitalizing R&D costs and then amortizing them over the future periods likely to benefit is consistent with the matching concept. However, it is inconsistent with the criterion that accounting should be reasonably objective, and it is not in accord with the conservatism concept. The FASB decided that the latter consid- erations were more important than the matching concept in this instance.

If a company does R&D work for a customer (i.e., another company or a government agency) and is paid for this work, these payments constitute revenue. The related costs are held as an asset in Work in Process Inventory. They are matched against revenue and therefore are charged as expenses in the period in which the revenue is earned.

IFRS requires expenditures for the research phase of R&D projects to be expensed as incurred. Generally IFRS requires expensing of development expenditures as incurred. However, IFRS requires development costs to be capitalized if they are expected to be recovered from future sales.21

Software Development The costs of developing computer software to be sold, leased, or licensed are a type of R&D cost. These costs must be expensed as incurred up until the point that the tech- nological feasibility of the software product has been established. Technological feasi- bility is established upon completion of a detailed program design or completion of a working model. Thereafter, the costs of bringing the software to market, such as pro- ducing product masters, can be capitalized. Capitalization of such costs ceases when the product is available for release to customers. Annual amortization of such costs is the greater of (1) the straight-line method amount or (2) the amount determined by the ratio of the year’s revenues to the total anticipated revenues for the product. Thus, a product with an estimated market life of four years and with half of its estimated life- time revenues coming in the first year would have half (not one-fourth) of its capital- ized costs amortized in the first year.22

The costs of software developed for internal use are capitalized at the point where a comittment is made to its eventual development. The cost of internally developed soft- ware is amortized over its useful life.

Nonmonetary assets can be analyzed in a variety of ways to gain insights into the asset beyond the amount of the asset’s book value reported on the balance sheet.

The average age of a company’s depreciable assets can be estimated by dividing the asset’s accumulated depreciation balance by the asset’s annual depreciation expense.

A depreciable asset’s depreciation period in years can be estimated by dividing the asset’s gross cost by its related annual depreciation expense.

A company’s annual expenditure for a particular intangible asset can be estimated by adding (an increase in the asset’s balance) or deducting (a decrease in the asset’s bal- ance) to the asset’s related annual amortization expense. The result is the estimated ex- penditure amount.

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 193

21 “Intangible Assets,” IAS No. 38. 22 “Accounting for the Costs of Computer Software,” FASB Statement No. 86.

Analysis of Nonmonetary Assets

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Items of property, plant, and equipment are capitalized at their acquisition cost, which in- cludes all elements of cost involved in making them ready to provide service. Except for land, a portion of this cost (less residual value, if any) is charged as depreciation expense to each of the accounting periods in which the asset provides service. A corresponding reduction is made each period in the net book value of the asset account. Any systematic method may be used for depreciation. The straight-line method is ordinarily used for financial accounting purposes, but declining-balance methods are the basis for the cost recovery deductions al- lowed for income tax purposes.

When an asset is disposed of, its cost and accumulated depreciation are removed from the accounts, and any gain or loss appears on the income statement (unless group depreci- ation is used).

Natural resources are accounted for in the same way as fixed assets, except that the ex- pense item is called depletion rather than depreciation.

Intangible assets also are recorded at cost. In the case of goodwill, this cost is the dif- ference between the price paid for a company and the fair value of the net assets acquired (acquired assets net of any liabilities assumed by the purchaser). If intangible assets have a limited useful life, their cost is amortized over that life. Intangible assets not subject to amortization are periodically tested for impairment. R&D costs are expensed as incurred; exceptions are the costs of developing marketable computer software expected to be recov- ered from future sales, which are capitalized once the product’s technical feasibility is established, and the costs of software developed for internal use, once the commitment is made to develop it.

Accounting for long-lived assets involves making estimates that result in each year’s de- preciation and amortization expense amounts being approximations. Since these amounts affect income in each year of an asset’s life, reported income itself is an estimate. (Similar com- ments apply to the estimates described in earlier chapters for such assets as receivables and in- ventories and for the related expense amounts for bad debts and cost of sales.)

Problems Problem 7–1.

Pemberton Corporation purchased a machine costing $300,000 that had an estimated use- ful life of six years and residual value of $18,000. The machine is expected to produce 3,525,000 units during its useful life, as follows:

Year Units

1 930,000 2 800,000 3 580,000 4 500,000 5 415,000 6 300,000

3,525,000

Required a. What will be each year’s depreciation charge if Pemberton uses the units-of-

production method?

b. Will this give significantly different depreciation charges in each year than the sum- of-the-years’ digits method?

194 Part 1 Financial Accounting

Summary

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 195

Problem 7–2. Higher Company had the following disposals of production equipment during 2006:

Equipment Purchase Original Date of Disposal Useful Depreciation ID Number Date Cost Disposal Proceeds Life Method

301 2/28/98 $70,300 10/03/02 $14,300 10 Straight-line 415 7/03/05 96,000 7/19/02 63,000 5 150% declining-balance 573 6/15/04 94,500 3/21/02 38,000 6 Sum-of-the-years’-digits

Higher’s policy is to charge a full year’s depreciation in the year of purchase if an asset is purchased before July 1. For assets purchased after July 1, only one-half year’s depreciation is charged. During the year of disposal, one-half year’s depreciation is charged if the asset is sold after June 30. No depreciation is charged during the year of disposal if the asset is sold before July 1. In all three cases above, estimated residual value at the time of acquisi- tion was zero.

Required Prepare journal entries to record the above disposals.

Problem 7–3. During the year, Olsen Company traded an automobile plus $8,400 in cash to Barry Company for another automobile. The car Olsen used as a trade-in originally had cost $16,000, of which $14,500 has been depreciated.

Olsen also purchased new office furniture during the year. The list price of the furniture was $9,600. Olsen paid $3,350 cash plus gave the furniture company a used truck. This truck had a net book value of $6,250; it had originally cost $19,860, and had recently been appraised at $5,500.

Required Record the above transactions on Olsen Company’s books.

Problem 7–4. Chipper Company had the following transactions during the year:

1. Land was purchased for $75,000 cash. This land was to be used for a new office build- ing. It was agreed that Chipper Company would pay for the razing of a building cur- rently on the land; this would cost $5,600, to be paid in cash.

2. Chipper Company contracted with Cody Construction to build the new office building. It was agreed that Chipper would pay Cody with 3,000 shares of Chipper common stock, a $16,000 note, and $32,000 in cash. Chipper’s common stock was currently sell- ing for $30 a share.

3. Chipper purchased some office equipment from Northern Office Equipment for $9,600 cash. Mr. Chipper was a close personal friend of the owner of Northern Office Equip- ment, and accordingly was sold this equipment at a price lower than normally would be charged. The prices charged to “normal” customers were as follows:

Desks and chairs $ 8,700 Bookcases 2,200 Filing cabinets 1,100_______

$12,000

Required Prepare journal entries for the above transactions.

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Problem 7–5. Cleanburn Coal Company purchased coal-leasing land that contains 800,000 tons of coal for $21,700,000. Soil tests by geologists cost $35,250 for the purchased land, but tests at other sites that yielded negative results cost $116,250. Clearburn uses the full-cost method for exploration costs (i.e., the company’s total exploration and testing costs are treated as one cost pool for the entire company rather than being associated with any one exploration project). Test permits were issued by the federal government at a cost of $41,000 to Clean- burn. The estimated salvage value of the purchased land will be $2,325,000 once the coal is removed. The coal is expected to be mined within 10 years.

Before mining could begin, the company had to remove trees and undergrowth at a cost of $387,500. In addition, storage facilities and a field office were constructed at a total cost of $271,250. These facilities will last an estimated 25 years but will serve no purpose once the coal is removed; hence, they have no residual value. Machinery that cost $1,162,500 was installed, but its service life is limited to the time required to remove the coal. The buildings will be depreciated on a straight-line basis, while the machinery will be depreci- ated by using the sum-of-the-years’-digits method.

In the first year of operation, Cleanburn mined 30,000 tons of coal; in the second year, 70,000 tons; and in the third year, 75,000 tons.

Required Prepare a schedule showing (a) unit and total depletion and (b) depreciation for the first three years of operation. Assume that the purchase occurred on January 1 and that Clean- burn uses a calendar fiscal year.

Cases

Case 7–1

Stern Corporation (B)*

196 Part 1 Financial Accounting

After the controller of Stern Corporation had ascer- tained the changes in accounts receivable and the al- lowance for doubtful accounts in 2010, a similar analysis was made of property, plant, and equipment and accumulated depreciation accounts. Again the controller examined the December 31, 2009, balance sheet [see Exhibit 1 of Stern Corporation (A), Case 5–1]. Also reviewed were the following company transactions that were found to be applicable to these accounts:

1. On January 2, 2010, one of the factory machines was sold for its book value, $3,866. This machine was recorded on the books at $31,233 with accu- mulated depreciation of $27,367.

2. Tools were carried on the books at cost, and at the end of each year a physical inventory was taken to determine what tools still remained. The account was written down to the extent of the decrease in tools as ascertained by the year-end inventory. At the

end of 2010, it was determined that there had been a decrease in the tool inventory amounting to $7,850.

3. On March 1, 2010, the company sold for $2,336 cash an automobile that was recorded on the books at a cost of $8,354 and had an accumulated depreci- ation of $5,180, giving a net book value of $3,174 as of January 1, 2010. In this and other cases of the sale of long-lived assets during the year, the accu- mulated depreciation and depreciation expense items were both increased by an amount that re- flected the depreciation chargeable for the months in 2010 in which the asset was held prior to the sale, at rates listed in item 7 below.

4. The patent listed on the balance sheet had been pur- chased by the Stern Corporation. The cost of the patent was written off as an expense over the re- mainder of its legal life as of December 31, 2009, the patent’s remaining legal life was five years.

5. On July 1, 2010, a typewriter that had cost $1,027 and had been fully depreciated on December 31, 2009, was sold for $75.* Copyright © James S. Reece.

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6. On October 1, 2010, the company sold a desk for $80. This piece of furniture was recorded on the books at a cost of $490 with an accumulated depre- ciation of $395 as of January 1, 2010.

7. Depreciation was calculated at the following rates:

Buildings 2% Factory machinery 10* Furniture and fixtures 10 Automotive equipment 20 Office machines 10

* Included in the factory machinery cost of $3,425,585 was a machine costing $85,000 that had been fully depreciated on December 31, 2009, and that was still in use.

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 197

Questions

1. In a manner similar to that used in Stern Corporation (A), analyze the effect of each of these transactions on the property, plant, and equipment accounts, ac- cumulated depreciation, and any other accounts that may be involved. Prepare journal entries for these transactions.

2. Give the correct totals for property, plant, and equipment, and the amount of accumulated depre- ciation as of December 31, 2010, after the transac- tions affecting them had been recorded.

Case 7–2

Joan Holtz (C)* Joan Holtz said to the accounting instructor, “The gen- eral principle for arriving at the amount of a fixed asset that is to be capitalized is reasonably clear, but there certainly are a great many problems in applying this principle to specific situations.”

Following are some of the problems Joan Holtz pre- sented:

1. Suppose that the Bruce Manufacturing Company used its own maintenance crew to build an addi- tional wing on its existing factory building. What would be the proper accounting treatment of the following items?

a. Architects’ fees.

b. The cost of snow removal during construction.

c. Cash discounts earned for prompt payment on materials purchased for construction.

d. The cost of building a combined construction office and toolshed that would be torn down once the factory wing had been completed.

e. Interest on money borrowed to f inance con- struction.

f. Local real estate taxes for the period of con- struction on the portion of land to be occupied by the new wing.

g. The cost of mistakes made during construction.

h. The overhead costs of the maintenance depart- ment that include supervision; depreciation on

buildings and equipment of maintenance de- partment shops; heat, light, and power for these shops; and allocations of cost for such items as the cafeteria, medical office, and personnel department.

i. The cost of insurance during construction and the cost of damages or losses on any injuries or losses not covered by insurance.

2. Assume that the Archer Company bought a large piece of land, including the buildings thereon, with the intent of razing the buildings and constructing a combined hotel and office building in their place. The existing buildings consisted of a theater and several stores and small apartment buildings, all in active use at the time of the purchase.

a. What accounting treatment should be accorded that portion of the purchase price considered to be the amount paid for the buildings that are subsequently razed?

b. How should the costs of demolishing the old buildings be treated?

c. Suppose that a single company had owned this large piece of land, including the buildings thereon, and instead of selling to the Archer Company had decided to have the buildings razed and to have a combined hotel and office building constructed on the site for its own ben- efit. In what respect, if any, should the account- ing treatment of the old buildings and the cost of demolishing them differ from your recommen- dations with respect to (a) and (b) above? Why?

* Copyright © by the President and Fellows of Harvard College. Harvard Business School case 198-145.

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3. Midland Manufacturing Company purchased a new machine. It is clear that the invoice price of the new machine should be capitalized, and it also seems reasonable to capitalize the transportation cost to bring the machine to the Midland plant. I’m not so clear, however, on the following items.

a. The new machine is heavier than the old ma- chine it replaced; consequently, the foundation under the machine has had to be strengthened by the installation of additional steel beams. Should this cost be charged to the building, added to the cost of the machine, or expensed? Why?

b. The installation of the machine took longer and was more costly than anticipated. In addition to time spent by the regular maintenance crew on installation, it became necessary to hire an out- side engineer to assist in the installation and in “working out the bugs” to get the machine run- ning properly. His costs included not only his fee but also his transportation, hotel expense, and meals. Moreover, the foreman of the de- partment and the plant superintendent both spent a considerable amount of time assisting in the installation work. Before the new machine was working properly, a large amount of mater- ial had been spoiled during trial runs. How should all of these costs be treated? Why?

c. In addition to the invoice price and transporta- tion, it was necessary to pay a state sales tax on purchasing the machine. Is this part of the ma- chine’s cost? Why?

d. In connection with payment for the new ma- chine, the machine manufacturer was willing to accept the Midland Company’s old machine as partial payment. The amount allowed as a trade- in was larger than the depreciated value at which the old machine was being carried in the books of the Midland Company. Should the difference have been treated as a reduction in the cost of the new machine or a gain on disposal of the old one? Why?

4. A computer manufacturing company sold outright about 25 percent of its products (in terms of dollar volume) and leased 75 percent. On average, a given computer was leased for four years. The cost of leased computers was initially recorded as an asset and was depreciated over four years. The company assisted new customers in installing the computer

198 Part 1 Financial Accounting

and in designing the related systems. These “appli- cations engineering” services were furnished with- out charge, and the company’s cost was reported as part of its marketing expense. Applications engi- neering costs averaged about 5 percent of the sales value of a computer, but about 20 percent of the first-year rental revenue of a leased computer. Re- cently, the company’s installation of computers grew rapidly. Because the applications engineering cost was such a high percentage of lease revenue, reported income did not increase at all. Research and development costs must be expensed as in- curred. Does the same principle apply to applica- tions engineering costs, or could these costs be added to the asset value of leased computers and amortized over the lease period? If so, could other marketing costs related to leased computers be treated in the same way? Why?

5. An electronic component manufacturer announced a new product that would soon be available. This prod- uct, a new generation component, had features highly sought by customers for their next generation of elec- tronics products. To meet the demands of its cus- tomers, many of whom had begun to impose quality standards on suppliers, the electronics component manufacturer would have to achieve a quality standard of 65 ppm, that is, 65 or fewer defective parts per mil- lion parts delivered to the customer.

The equipment intended to produce the new com- ponent at the 65 ppm quality standard was custom- built by the manufacturer. Once the equipment was physically installed in the plant, the company per- formed extensive testing and debugging efforts to en- sure that the components met the required standard. A couple of months after installation, the new equipment was producing components that, while commercially viable, did not quite meet the quality standard. A key customer was eager to purchase the new component for use in its own new product, however. The customer agreed to purchase the component now if the electron- ics component manufacturer would continue to push to meet the quality standard.

Since the new manufacturing equipment was going to begin to generate revenue, the fixed asset accounting manager reviewed the costs capitalized as part of this asset. The costs of the material, labor, and overhead re- quired to fabricate and install the equipment had been capitalized. In addition, the debugging and testing costs incurred to attempt to bring the new manufacturing

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equipment to the 65 ppm quality standard had also been capitalized, as these costs had been required to make the equipment ready for its intended use. The total costs were approximately one-half million dol- lars, and they would be amortized over the asset’s pro- ductive life beginning with production for the eager first customer.

The engineers believed that at least $50,000 of ad- ditional debugging, fine-tuning, and testing would be required for the new equipment to reach the 65 ppm quality standard. Should those costs continue to be capitalized, despite the fact that the equipment was producing components that were sold commercially? Why? If so, once the quality standard was achieved

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 199

and the full cost of the asset was known, should the amount of depreciation for the initial production peri- ods be adjusted? Why? The 65 ppm standard was an extremely tough standard; the engineers who had de- signed the equipment were confident they could achieve it, although a few skeptics had expressed the concern that the standard might never be achieved. What implications, if any, might this have for capital- izing the cost of the asset? Explain.

Question

Answer the questions raised by Holtz in each of the five issues on her list.

Case 7–3

Stafford Press* Stafford Press was founded in 2000 as a one-man job printing firm in a small southwestern town. Shortly after its founding, Lucas Stafford, the owner, decided to concentrate on one specialty line of printing. Be- cause of a high degree of technical proficiency, the company experienced a rapid growth.

However, Stafford Press suffered from a competi- tive disadvantage in that the major market for its specialized output was in a metropolitan area over 300 miles away from the company’s plant. For this rea- son, in 2010, having accumulated some extra cash to finance a move, the owner decided to move nearer his primary market. He also decided to expand and mod- ernize his facilities at the time of the move. After some investigation, an attractive site was found in a suburb of his primary market, and the move was made.

A balance sheet prepared just prior to the move is shown in Exhibit 1. The transactions that arose from this move are described in the following paragraphs:

1. The land at the old site, together with the building thereon, was sold for $149,860 cash.

2. Certain equipment was sold for $35,200 cash. This equipment appeared on the books at a cost of $73,645 less accumulated depreciation of $40,890, for a net book value of $32,755.

3. A new printing press was purchased. The invoice cost of this equipment was $112,110. A 2 percent cash discount was taken by Stafford Press so that only $109,868 was actually paid to the seller. Stafford Press also paid $450 to a trucker to have this equipment delivered. Installation of this equip- ment was made by Stafford Press employees who worked a total of 60 hours. These workers received $15 per hour in wages, but their time was ordinarily charged to printing jobs at $30.50 per hour, the dif- ference representing an allowance for overhead ($12.15) and profit ($3.35).

4. Stafford Press paid $140,000 to purchase land on which the new plant was to be built. A rundown building, which Stafford’s appraiser said had no value, was standing on the plot of land. Stafford Press paid $21,235 to have the old building on the plot of land torn down. In addition, the company paid $13,950 to have permanent drainage facilities installed on the new land.

5. A new composing machine with an invoice cost of $28,030 was purchased. The company paid $20,830 cash and received a trade-in allowance of $7,200 on a used piece of equipment. The used equipment could have been sold outright for not more than $6,050. It had cost $12,000 new, and ac- cumulated depreciation on it was $5,200, making the net book value $6,800.* © Professor Robert N. Anthony.

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6. The company erected a building at the new site for $561,000. Of this amount, $136,000 was paid in cash and $425,000 was borrowed on a mortgage.

7. Trucking and other costs associated with moving equipment from the old location to the new location and installing it were $8,440. In addition, Stafford Press employees worked an estimated 125 hours on that part of the move that related to equipment.

8. During the moving operation, a piece of equipment costing $10,000 was dropped and damaged; $3,220 was spent to repair it. Management believed, how- ever, that the salvage value of this equipment had been reduced by $660 from the original estimate of $1,950 to $1,290. Up until that time, the equipment was being depreciated at $805 per year, represent-

200 Part 1 Financial Accounting

EXHIBIT 1

STAFFORD PRESS Condensed Balance Sheet

(Prior to Move)

Assets Liabilities and Owner’s Equity Current assets:

Cash $395,868 Current liabilities $160,223

Other current assets 251,790 Common stock 400,000

Total current assets $647,658 Retained earnings 358,648

Property and equipment:

Land 34,034

Buildings $350,064

Less: Accumulated depreciation 199,056 151,008

Equipment 265,093

Less: Accumulated depreciation 178,922 86,171

Total assets $918,871 Total liabilities and owner’s equity $918,871_________ __________________ _________

ing a 10 percent rate after deduction of estimated salvage of $1,950. Accumulated depreciation was $3,220.

Questions

1. Analyze the effect of each of these transactions on the items in the balance sheet and income state- ment. For transactions that affect owner’s equity, distinguish between those that affect the net income of the current year and those that do not. In most cases, the results of your analysis can be set forth most clearly in the form of journal entries.

2. Adjust the balance sheet in Exhibit 1 to show the ef- fect of these transactions.

Case 7–4

Silic: Choosing Cost or Fair Value on Adoption of IFRS In June 2002, the Council of Ministers of the European Union approved regulation requiring all companies quoted on European stock exchanges to use, with effect from January 1, 2005, International Financial

Reporting Standards (IFRS) as the basis for their financial statements. Prior to this date, publicly listed companies in France used their domestic accounting standards for financial reporting purposes. Therefore, the transition to IFRS would have a substantial impact on their accounting practices. One company affected by the switch to the new accounting standards was

Copyright © 2007, 2008 President and Fellows of Harvard College Harvard Business School case 108-030.

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Silic, a France-based investment property company. Before the implementation of IFRS, Silic was applying French accounting standards that required its invest- ment properties to be reported using the historical-cost model. However, the introduction of International Ac- counting Standard 40 (IAS 40 Investment Properties) under IFRS would require the company to choose be- tween historical-cost or fair-value accounting to report its investment properties.

Background

Silic (Société Immobilière de Location pour l’Indus- trie et le Commerce) was a major and historical player on the French commercial-property market. It was the first company in France to introduce the concept of business parks—areas of land, typically located close to major highways, railroads and airports, set aside for office space and light industry.

The company’s strategy involved developing and operating business parks in the three largest business areas surrounding Paris. Specifically, the company built, refurbished and rented out office space in the La Défense business district to the west of the city and in the industrial poles located in close proximity to the Charles de Gaulle and Orly airports. Silic also owned

and rented out multipurpose office and light industrial space in business parks located in the outer-lying Paris suburbs of Cergy, Courtaboeuf and Evry.

In the business parks that it managed, Silic also pro- vided associated services and amenities, such as restau- rants, convenience stores, fitness clubs and childcare facilities. In total, the company had over 700 individual tenants, ranging from small and medium-sized compa- nies to major multinationals such as Air France, Alcatel Business Systems, Axa, France Telecom, Danone, LG, Microsoft, Nestle Waters, Peugeot and Xerox.

Silic had been listed on the Paris stock exchange in January 1973 and by 2004 had a largely institutional and relatively stable shareholder community. Groupama, a leading French insurance group, represented the com- pany’s reference shareholder (see Exhibit 1).1

At December 31, 2004, Silic had over €1.5 billion of investment properties valued on its balance sheet, including buildings recorded at over €1.1 billion and land reported at close to €449 million (see Exhibit 2), and was profitable (see Exhibits 3, 4 and 5). The com- pany’s property portfolio consisted of 181 individual

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 201

1 Groupama included Silic in its consolidated financial state- ments using the equity method. In Groupama’s financial statements, land and buildings were reported at this histori- cal cost.

EXHIBIT 1 Silic’s Shareholder Structure at December 31, 2004

Source: Silic

Non-identifiable shareholders

(0.6%)

French retail shareholders

(5.0%)

Non-French shareholders

(14.9%)

Employee shareholders

(0.3%)

Groupama (41.9%)

French institutional shareholders

(37.3%)

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investment properties totaling almost 954,000 m2 of office space (defined as premises where at least 70% of the floor area is occupied by offices) and multi- purpose business space (defined as premises providing

a mix of both office and light-industrial space) (see Exhibit 6). In line with Silic’s development strategy and its focus on both operating and developing busi- ness parks, the company was also constructing new

202 Part 1 Financial Accounting

ASSETS 2004 2003

Goodwill Other intangible assets 512 483 Less amortization and provisions (483) (444)

Net tangible assets 29 39

Tangible fixed assets Land 448,567 364,370 Fixed assets in course of construction 62,008 36,986 Buildings 1,139,063 1,096,824 Other tangible assets 2,181 14,475

1,651,819 1,512,955 Less depreciation and provisions (252,356) (214,080)

Net tangible fixed assets 1,399,463 1,298,875

Net long-term investments 152 162

Total fixed assets 1,399,644 1,299,076

Current assets Debtors 43,398 17,678 Marketable securities 1,524 - Cash 7,009 4,753

Total current assets 51,931 22,431

Total assets 1,451,575 1,321,507

SHAREHOLDERS’ EQUITY AND LIABILITIES

Shareholders’ equity Share capital 69,070 68,777 Share premiums 199,854 272,021 Revaluation surplus 430,967 448,456 Consolidated reserves 142,825 61,278 Other shareholders’ equity (7) (42) Net profit for the year 32,841 38,435

Total shareholders’ equity 875,550 888,925

Provisions for liabilities and charges 1,280 2,154 Liabilities

Bank loans 436,815 291,211 Security deposits 21,508 20,643 Other creditors 116,422 118,574

Total liabilities 574,745 430,428

Total shareholders’ equity and liabilities 1,451,575 1,321,507

Source: Compiled by case writer from Silic annual reports

EXHIBIT 2 Silic’s 2003 and 2004 Balance Sheets (€ thousands)

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office buildings that had been recorded at €62 million. Dominique Schlissinger, Silic’s Chairman and Chief Executive Officer, explained that the company’s

Orly-Rungis site could be expanded by a further million square meters to further consolidate its posi- tion as Europe’s largest business park.

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 203

2004 2003

Rental income 100,242 95,415 Fee income 5,898 4,914 Other services 32,447 31,288

Turnover 138,587 131,617

Fixed assets produced for own use 2,343 1,751 Purchases (36,134) (29,622) Taxes, duties and similar (14,918) (14,592) Staff costs (8,224) (7,704) Other income and expense 10,101 7,387

EBITDA 91,755 88,837

Write-back of provisions and amortization 1,353 828 Charge to amortization, depreciation and provisions (43,536) (42,796)

Operating profit 49,572 48,869

Financial income and expenses (10,995) (11,025)

Consolidated profit on operating activities 38,577 35,844

Exceptional income and expenses (5,274) (2,355) Corporation tax (462) 4,946

Net profit 32,841 38,435

Source: Compiled by case writer from Silic annual reports

EXHIBIT 3 Silic’s 2003 and 2004 Income Statements (€ thousands)

1999 2000 2001 2002 2003a 2004

Balance sheet

Total assets 546,863 577,353 711,915 742,577 1,321,507 1,451,575 Investment properties

Buildings 542,132 565,167 689,007 771,467 1,096,824 1,139,063 Land 79,500 75,729 84,413 84,235 364,670 448,567

Replacement valueb 975,715 1,092,538 1,319,272 1,352,300 1,419,719 1,681,493

Income statement Income 99,695 106,264 116,162 130,047 141,583 152,384 Expenses 59,954 62,467 62,204 79,168 94,714 102,812 Operating profit 43,797 39,741 49,958 50,879 46,869 49,572

(a) Following the adoption of SIIC status in 2003, Silic subjected its investment property portfolio to a one-off revaluation at the fair-value market by external appraisers.

(b) Open market value of investment properties, including any transfer taxes and acquisition-related expenses, as reported in the footnotes

Source: Compiled by case writer from Silic annual reports

EXHIBIT 4 Summary of Silic’s 1999–2004 Financial Data (€ thousands)

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Investment Properties by Type

Type Number

Office buildingsa 96 Multi-purpose business spaceb 85

Total 181

(a) Premises where at least 70% of floor area is occupied by offices (b) Premises providing both office and light-industrial space

Investment Properties by Location

Type Orly-Rungis La Défense Roissy Othera Total

Buildings 85 30 23 43 181 Percentage 46% 17% 13% 24% 100%

(a) Multi-purpose office buildings in the Paris suburbs of Cergy, Courtaboeuf and Evry.

Floor Space by Location

Type Multi-purposea Officesb Otherc Total floor space

Orly-Rungis/Antony 173,889 197,377 68,548 439,814 La Défense 51,931 134,097 3,191 189,219 Roissy 22,263 107,286 1,868 131,417 Evry 30,081 25,909 974 56,964 Courtaboeuf 53,594 40,667 549 94,810 Cergy 40,201 0 0 40,201 Central Paris 0 1,452 0 1,452

Total portfolio 371,959 506,788 75,130 953,877

(a) Premises providing both office and light-industrial space (b) Premises where at least 70% of floor area is occupied by offices (c) Premises used for service or retail operations

Source: Compiled by case writer from Silic annual reports

EXHIBIT 6 Silic’s Investment Properties Portfolio at December 31, 2004

-100,000

-80,000

-60,000

-40,000

-20,000

0

20,000

40,000

60,000

80,000

100,000

1999 2000 2001 2002 2003 2004

EXHIBIT 5 Silic’s 2001–2004 Operating Profits (€ thousands)

Source: Compiled by case writer from Silic annual reports

204 Part 1 Financial Accounting

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French Investment Property Market and Property Values

Since 2001, the French real estate and property man- agement industry had been growing steadily at an average rate of 2.8% per year, reaching a value of €23.8 billion in 2004. Revenues from non-residential properties, including offices and warehouses, ac- counted for over a fifth of the industry’s valuei. France represented Europe’s third largest real estate management and development industry after the United Kingdom and Germany, generating 19.9% of the European industry’s value. The industry was fore- cast to grow by a further 3.7% per year by 2010ii. Other major publicly listed companies in the French real estate management and development industry in- cluded Gecina, Icade, Klépierre, Société Foncière Lyonnaise and Unibail.

With 49 million m2 of office space, the Paris region represented the largest commercial real estate market in Europeiii. Since the 1980s, the commercial property market of Paris and its surrounding region had experi- enced substantial upward and downward movements in the values of properties (see Exhibit 7). By the end of 2004, the commercial property market appeared to be on the cusp of an upswing, with sales prices rising on the year by 1.5%iv.

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 205

EXHIBIT 7 Commercial Property Prices 1979–2003 in Paris and Surrounding Area (€/m2)

The graph represents the evolution of commercial property prices, measured in €/m2, in central Paris, the La Défense business area to the west of the city centre and in the Ile-de-France region surrounding Paris

Source: Banque de France/CB Richard Ellis Bourdaisvi

Accounting for Investment Properties in France

Prior to the introduction of IFRS accounting standards in France, Silic reported its property assets in accor- dance with the French General Accounting Plan at his- torical cost, being either the purchase cost for the properties it had acquired or the cost price of its new construction or redeveloped properties. The company depreciated its office and light industrial buildings on a straight-line basis over an average period of 40 years. Older buildings acquired were depreciated over a period taking into account their average age.

In 2003, Silic adopted SIIC status. Tile SIIC (Sociétés d’Investissements Immobiliers Cotées) tax regime was introduced by the French government in 2003 to create a strong and more efficient domestic real estate market. Inspired by the introduction of real estate investment trusts (REIT) in other countries, the SIIC legislation made real estate companies listed on the French stock exchange eligible for tax exemptions on their rental income and real estate capital gains, provided they distributed 85% of rental earning and 50% of capital gains to shareholders. Companies that elected the new regime had to pay a one-off ‘exit tax’ at a rate of 16.5% of latent capital gains on the build- ings that they held.

0

2,000

4,000

6,000

8,000

10000

12,000

14,000

16,000

19811979 1983 1985 1987 1989 1991 1993 19971995 1999 2001 2003

Paris central business district

La Défense

Ile-de-France

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206 Part 1 Financial Accounting

Investment Property Industry

Serge Grybowski (CEO, Gecina)

Fair value is more indicative of the development of the property .market than the operational

performance of a real estate companyvii

Jean-Michel Gault (CFO, Klépierre)

Fair-value accounting complicates comparisons with historical accounting dataviii

European Public Real Estate Association

Fair-value accounting will enhance uniformity, comparability and transparency of financial reporting by real estate companies. It allows performance benchmarking with direct property market indices.

Real estate companies should therefore account for their property investments based upon the fair-value modelix.

International Accounting Firms and Associations

Rene Ricot (International Federation of Accountants)

Fair value is inevitable. Instability due to using market. values is a problem of the lack of education of market players and not that of accounting.

Françoise Bussac (Ernst & Young)

Fair value is the only single guideline to bring a real transparency in financial statements.

Financial Institution Investors

Federation of French Insurance Companies

Accounts reported at fair value can be deceptive and risk injecting a large dose of subjectivity into financial statements.

Sylvie Mathérat (General Secretary of the French Banking Commission)

The main problem of fair-value accounting is the volatility of earnings

Financial Analysts

Association of French Financial Analysts

The use of fair value can confuse interpretation of a company’s operational results. Fair-value accounting is less reliable, allows greater manipulation of results and introduces volatility.

National Financial Authorities

French National Accounting Council (CNC)

The CNC endorsed neither historical-cost nor fair-value accounting since both methods were authorized under IAS 40.

French financial market regulator (AMF)

Fair-value accounting prevents the manipulation of results by managers by going in and out of the market to make the appearance of results at their will. However, it is better to avoid rushing through too audacious accounting reforms in a period of instability of markets.

Source: Compiled by case writerx

EXHIBIT 8 Comments on Introduction of Fair-Value Accounting in France

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Having chosen to adopt the new SIIC status, Silic followed the recommendations of the French account- ing standards body (Conseil National de la Compt- abilité) and financial market regulator (Autorité des Marchés Financiers) and had its buildings and land revalued by two independent external appraisers on an open-market and building-by-building basis. This one- off, fair-value revaluation had a significant impact on Silic’s 2003 balance sheet. Indeed, the value of the company’s investment properties and land increased from 2002 to 2003 by over €600 million or 70%.

Adoption of International Accounting Standards

The adoption of IFRS in January 2005 would have a number of effects on European property investment companies such as Silic. One major reporting issue re- lated specifically to the International Accounting Stan- dard 40 (IAS 40, Investment Properties). This standard allowed companies to report their investment proper- ties using either a historical-cost model or a fair-value model.

Under the historical-cost model, investment prop- erty would be reported on the balance sheet at cost less accumulated depreciation and any impairment losses. Any changes in fair value would have to be evaluated by external appraisers and reported in the footnotes of annual reports. Companies that initially adopted the historical-cost model could switch to the fair-value model at a later date, if this would result in a more ap- propriate presentation of financial results.

Under the fair-value model, investment property (but not investment properties under construction or building land) would be revalued and reported on the balance sheet at its current market value, with all changes in value reported in the income statement. IAS 40 defined fair value as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s-length transaction. Under the terms of IAS 40, companies adopting the fair- value method could not switch to the historical-cost method.

Although widely used outside of France, the con- cept of fair-value accounting was by and large unknown to the French. It called into question the country’s long-established accounting traditions based on the principles of prudence and an avoidance of a valua- tion of assets which could lead to the disclosure of

overvalued assets in financial statementsv. The imple- mentation of IFRS accounting standards triggered a lively public debate about the strengths and weak- nesses of fair-value accounting versus historical-cost accounting (see Exhibt 8).

In the face of the implementation of IFRS, Dominique Schlissinger noted that Silic faced impor- tant cultural, sectoral and strategic dilemmas. It was against this background that the company’s Board of Directors met on this issue on numerous occasions during 2003 and 2004 to better understand IAS 40. How would the two distinctive accounting models im- pact on Silic’s financial statements? Which method would most transparently reflect Silic’s real value? In short, which method should Silic ultimately adopt on January 1, 2005?

Endnotes i Datamonitor (2006) Real Estate Management &

Development in France – Industry Profile Data- monitor: London, available from Thomson Re- search, <http://research.thomsonib.com/> (accessed 24 September 2007)

ii Datamonitor (2006) Real Estate Management & Development in France – Industry Profile Data- monitor: London, available from Thomson Re- search, <http://research.thomsonib.com> (accessed 24 September 2007)

iii Paris Regional Economic Development Agency (2007) Commercial Property in the Paris Region – 23 Strategic Business Sites Paris Regional Eco- nomic Development Agency: Paris

iv Bank of International Settlements (2004) Annual Report Bank of International Settlements: Basel

v Bertoni, M, and Derosa, B. (2005) ‘Comprehensive Income, Fair Value and Conservatism: A Concep- tual Framework for Reporting Financial Perfor- mance’, paper presented to the 5th International Conference on European Integration, Competition and Cooperation, Lovran, April 22–23, 2005; Richard, J. (2004) ‘The Secret Past of Fair Value: Lessons from History Applied to the French Case’ in Accounting in Europe, Vol. 1, No.1, p95–107; Ricol, R. and Bonnet-Bernard, S. (2003) ‘Fair Value Accounting: An Overworked Issue Over the Past Fifteen Years’ in Revue déconomie financière, 71, p51–56

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 207

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vi Banque de France (2004) Is there a risk of a prop- erty bubble in France? Banque de France: Paris

vii “Les foncières face à un enjeu de communication,” Les Echos, May 13, 2004, available from Factiva, http://www.factiva.com (Accessed September 4, 2007)

viii “Les foncières face à un enjeu de communication,” Les Echos, May 13, 2004, available from Factiva,

http://www.factiva.com (Accessed September 4, 2007)

ix EPRA (2004) Best Practices Policy Recommenda- tions European Public Real Estate Association: Amsterdam

x Richard, J. (2004) ‘The Secret Past of Fair Value: Lessons from History Applied to the French Case’ in Accounting in Europe, Vol. 1, No. 1, p95–107

208 Part 1 Financial Accounting

Case 7–5

Accounting Fraud at WorldCom WorldCom could not have failed as a result of the actions of a limited number of individuals. Rather, there was a broad breakdown of the system of internal controls, corporate governance and individual responsibility, all of which worked together to create a culture in which few persons took responsibility until it was too late.

—Richard Thornburgh, former U.S. attorney general1

On July 21, 2002, WorldCom Group, a telecommuni- cations company with more than $30 billion in rev- enues, $104 billion in assets, and 60,000 employees, filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. Between 1999 and 2002, WorldCom had overstated its pretax income by at least $7 billion, a deliberate miscalculation that was, at the time, the largest in history. The company subsequently wrote down about $82 billion (more than 75%) of its reported assets.2 WorldCom’s stock, once valued at $180 billion, became nearly worthless. Seventeen thousand employees lost their jobs; many left the company with worthless retirement accounts. The company’s bankruptcy also jeopardized service to WorldCom’s 20 million retail customers and on government contracts affecting 80 million Social Security beneficiaries, air traffic control for the Federal Aviation Association, network management

for the Department of Defense, and long-distance services for both houses of Congress and the General Accounting Office.

Background

WorldCom’s origins can be traced to the 1983 breakup of AT&T. Small, regional companies could now gain access to AT&T’s long-distance phone lines at deeply discounted rates.3 LDDS (an acronym for Long Dis- tance Discount Services) began operations in 1984, offering services to local retail and commercial cus- tomers in southern states where well-established long- distance companies, such as MCI and Sprint, had little presence. LDDS, like other of these small regional companies, paid to use or lease facilities belonging to third parties. For example, a call from an LDDS cus- tomer in New Orleans to Dallas might initiate on a local phone company’s line, flow to LDDS’s leased network and then transfer to a Dallas local phone company to be completed. LDDS paid both the New Orleans and Dallas phone company providers for using their local networks, and the telecommunications company whose long-distance network it leased to connect New Orleans to Dallas. These line-cost expenses were a significant cost for all long-distance carriers.

LDDS started with about $650,000 in capital but soon accumulated $1.5 million in debt since it lacked the technical expertise to handle the accounts of large companies that had complex switching systems. The company turned to Bernard J. (Bernie) Ebbers, one of its original nine investors, to run things. Ebbers had

1 Matthew Bakarak, “Reports Detail WorldCom Execs’ Domination,” AP Online, June 9, 2003. 2 WorldCom’s writedown was, at the time, the second largest in U.S. history, surpassed only by the $101 billion writedown taken by AOL Time Warner in 2002.

3 Lynne W. Jeter, Disconnected: deceit and betrayal at World- Com (Hoboken, NJ: John Wiley & Sons, 2003), pp. 17–18.

Copyright © 2004, 2005, 2007 President and Fellows of Harvard College Harvard Business School case 104–071.

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previously been employed as a milkman, bartender, bar bouncer, car salesman, truck driver, garment fac- tory foreman, high school basketball coach, and hote- lier. While he lacked technology experience, Ebbers later joked that his most useful qualification was being “the meanest SOB they could find.”4 Ebbers took less than a year to make the company profitable.

Ebbers focused the young firm on internal growth, acquiring small long-distance companies with limited geographic service areas and consolidating third-tier long-distance carriers with larger market shares. This strategy delivered economies of scale that were critical in the crowded long-distance reselling market. “Because the volume of bandwidth determined the costs, more money could be made by acquiring larger pipes, which lowered per unit costs,” one observer remarked.5

LDDS grew rapidly through acquisitions across the American South and West and expanded internation- ally through acquisitions in Europe and Latin America. In l989, LDDS became a public company through a merger with Advantage Companies, a company that was already trading on Nasdaq. By the end of 1993, LDDS was the fourth-largest long-distance carrier in the United States. After a shareholder vote in May 1995, the company officially became known as WorldCom.

The telecommunications industry evolved rapidly in the 1990s. The industry’s basic market expanded beyond fixed-line transmission of voice and data to include the transport of data packets over fiber-optic cables that could carry voice, data, and video. The Telecommunications Act of 1996 permitted long-distance carriers to compete for local service, transforming the industry’s competitive landscape. Companies scrambled to obtain the capability to pro- vide their customers a single source for all telecom- munications services.

In 1996, WorldCom entered the local service mar- ket by purchasing MFS Communications Company, Inc., for $12.4 billion. MFS’s subsidiary, UUNET, gave WorldCom a substantial international presence and a large ownership stake in the world’s Internet backbone. In 1997, WorldCom used its highly valued stock to outbid British Telephone and GTE (then the nation’s second-largest local phone company) to acquire MCI, the nation’s second-largest long-distance company. The $42 billion price represented, at the time, the largest takeover in U.S. history. By 1998,

WorldCom had become a full-service telecommunica- tions company, able to supply virtually any size busi- ness with a full complement of telecom services. WorldCom’s integrated service packages and its Inter- net strengths gave it an advantage over its major com- petitors, AT&T and Sprint. Analysts hailed Ebbers and Scott Sullivan, the CFO who engineered the MCI merger, as industry leaders.6

In 1999, WorldCom attempted to acquire Sprint, but the U.S. Justice Department, in July 2000, refused to allow the merger on terms that were acceptable to the two companies. The termination of this merger was a significant event in WorldCom’s history. WorldCom executives realized that large-scale mergers were no longer a viable means of expanding the business.a

WorldCom employees noted that after the turndown of the Sprint merger, “Ebbers appeared to lack a strategic sense of direction, and the Company began drifting.”b

Corporate Culture

WorldCom’s growth through acquisitions led to a hodgepodge of people and cultures. One accountant recalled, “We had offices in places we never knew about. We’d get calls from people we didn’t even know existed.” WorldCom’s finance department at the Mississippi corporate headquarters maintained the corporate general ledger, which consolidated informa- tion from the incompatible legacy accounting systems of more than 60 acquired companies. WorldCom’s headquarters for its network operations, which man- aged one of the largest Internet carrier businesses in the world, was based in Texas. The human resources department was in Florida, and the legal department in Washington, D.C.

None of the company’s senior lawyers was lo- cated in Jackson. [Ebbers] did not include the Company’s lawyers in his inner circle and appears to have dealt with them only when he felt it necessary. He let them know his displea- sure with them personally when they gave advice—however Justified—that he did not like. In sum, Ebbers created a culture in which the legal function was less influential and less wel- come than in a healthy corporate environment.c

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 209

4 Jeter, p. 27. 5 Jeter, p. 30.

6 CFO Magazine awarded. Sullivan its CFO Excellence award in 1998; Fortune listed Ebbers as one of its “People to Watch 2001.”

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A former manager added, “Each department had its own rules and management style. Nobody was on the same page. In fact, when I started in 1995, there were no written policies.”7 When Ebbers was told about an internal effort to create a corporate code of conduct, he called the project a “colossal waste of time.”d

WorldCom encouraged “a systemic attitude con- veyed from the top down that employees should not question their superiors, but simply do what they were told.”e Challenges to more senior managers were often met with denigrating personal criticism or threats. In 1999, for example, Buddy Yates, director of World- Com General Accounting, warned Gene Morse, then a senior manager at WorldCom’s Internet division, UUNET, “If you show those damn numbers to the f****ing auditors, I’ll throw you out the window.”8

Ebbers and Sullivan frequently granted compensa- tion beyond the company’s approved salary and bonus guidelines for an employee’s position to reward selected, and presumably loyal, employees, especially those in the financial, accounting, and investor relations de- partments. The company’s human resources depart- ment virtually never objected to such special awards.9

Employees felt that they did not have an indepen- dent outlet for expressing concerns about company policies or behavior. Several were unaware of the exis- tence of an internal audit department, and others, knowing that Internal Audit reported directly to Sullivan, did not believe it was a productive outlet for questioning financial transactions.f

Expense-to-Revenue (E/R) Ratio

In the rapid expansion of the 1990s, WorldCom fo- cused on building revenues and acquiring capacity sufficient to handle expected growth. According to Ebbers, in 1997, “Our goal is not to capture market share or be global. Our goal is to be the No.1 stock on Wall Street.”l0 Revenue growth was a key to increasing the company’s market value.11 The demand for rev- enue growth was “in every brick in every building,”

210 Part 1 Financial Accounting

said one manager.g “The push for revenue encouraged managers to spend whatever was necessary to bring revenue in the door, even if it meant that the long-term costs of a project outweighed short-term gains. . . . As a result, WorldCom entered into long-term fixed rate leases for network capacity in order to meet the antic- ipated increase in customer demand.”h

The leases contained punitive termination provi- sions. Even if capacity were underutilized, WorldCom could avoid lease payments only by paying hefty ter- mination fees. Thus, if customer traffic failed to meet expectations, WorldCom would pay for line capacity that it was not using.

Industry conditions began to deteriorate in 2000 due to heightened competition, overcapacity, and the reduced demand for telecommunications services at the onset of the economic recession and the aftermath of the dot-com bubble collapse. Failing telecommuni- cations companies and new entrants were drastically reducing their prices, and WorldCom was forced to match. The competitive situation put severe pressure on WorldCom’s most important performance indica- tor, the E/R ratio (line-cost expenditures to revenues), closely monitored by analysts and industry observers.

WorldCom’s E/R ratio was about 42% in the first quarter of 2000, and the company struggled to main- tain this percentage in subsequent quarters while fac- ing revenue and pricing pressures and its high com- mitted line costs. Ebbers made a personal, emotional speech to senior staff about how he and other directors would lose everything if the company did not improve its performance.i

As business operations continued to decline, how- ever, CFO Sullivan decided to use accounting entries to achieve targeted performance. Sullivan and his staff used two main accounting tactics: accrual releases in 1999 and 2000, and capitalization of line costs in 2001 and 2002.12

Accrual Releases

WorldCom estimated its line costs monthly. Although bills for line costs were often not received or paid until several months after the costs were incurred, generally

7 Jeter, p. 55. 8 Personal correspondence, Gene Morse. 9 Kay E. Zekany, Lucas W. Braun, and Zachary T. Warder, “Behind Closed Doors at WorldCom: 2001,” Issues in Accounting Education (February 2004): 103. 10 R. Charan, J. Useen, and A. Harrington, “Why Companies Fail,” Fortune (Asia), May 27, 2002, pp. 36–45. 11 Zekany et al., p. 103.

12 The company also used aggressive revenue-recognition methods at the end of each reporting quarter to “close the gap” with Ebbers’s aggressive revenue forecasts; see Zekany et al., pp. 112–114, and Beresford, Katzenbach, and Rogers, Jr., pp. 13–16.

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 211

accepted accounting principles required the company to estimate these expected payments and match this expense with revenues in its income statement. Since the cash for this expense had not yet been paid, the off- setting entry was an accounting accrual to a liability account for the future payment owed to the line owner. When WorldCom paid the bills to the line owner, it re- duced the liability accrual by the amount of the cash payment. If bills came in lower than estimated, the company could reverse (or release) some of the accru- als, with the excess flowing into the income statement as a reduction in line expenses.

Throughout 1999 and 2000, Sullivan told staff to release accrual that he claimed were too high relative to future cash payments. Sullivan apparently told several business unit managers that the MCI merger had created a substantial amount of such overaccruals.

Sullivan directed David Myers (controller) to deal with any resistance from senior managers to the ac- crual releases.

In one instance, Myers asked David Schneeman, acting CFO of UUNET, to release line accruals for his business unit. When Schneeman asked’ for an expla- nation, Myers responded: “No, you need to book the entry.” When Schneeman refused, Myers told him in another e-mail, “I guess the only way I am ‘going to get this booked is to fly to D.C. and book it myself. Book it right now, I can’t wait another minute.”j

Schneeman still refused. Ultimately, staff in the gen- eral accounting department made Myers’s desired changes to the general ledger. (See Exhibit 1 for a par- tial organizational chart.)

In another instance, Myers asked Timothy Schneberger, director of international fixed costs, to

EXHIBIT 1 Partial WorldCom Organizational Chart, 2002

Source: Adapted from Beresford, Katzenbach, and Rogers, “Report of Investigation,” 2003.

Ronald Lomenzo Senior Vice President Financial Operations

Charles Bernacchio Director

International Voice Services

Robert Scesa Director

International Settlements

Timothy Schneberger Director

International Fixed Cost

Sanjeev Sethi Director

Financial Planning

Robert Andereson Manager

Line Cost Budgeting and Planning

Brian Higgins Manager

Capital Reporting

Bernard Ebbers Chief Executive Officer

Scott Sullivan Chief Financial Officer

David Myers Controller

Cynthia Cooper Director

Internal Audit

Gene Morse Manager

Internal Audit Mark Willson

Director Financial Reporting

Ronald Beaumont Chief Operating Officer

WorldCom Group

Thomas Bosley Senior Vice President

U.S. Operations

Louis Prestwood Senior Vice President

Network Financial Management

Jay Slocum Vice President Domestic Telco

Accounting and Planning

Charles Wasserott Director

Domestic Telco Accounting and Planning

Stephanie Scott Vice President

Financial Reporting

Glyn Smith Manager

Internal Audit

Buford “Buddy” Yates, Jr. Director

General Accounting

Troy Normand Director

Legal Equity Reporting

Angela Walter Manager

Legal Entity/Balance Sheet Reporting

Betty Vinson Director

Management Reporting

Daniel Renfroe Manager

Sales/Income Statement Accounting

Mark Abide Director

Property Accounting

Kevin Brumbaugh Manager

Fixed Assets Reporting

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release $370 million in accruals. “Here’s your num- ber,” Myers reportedly told Schneberger, asking him to book the $370 million adjustment. Yates, director of General Accounting, told Schneberger the request was from “the Lord Emperor, God himself, Scott [Sulli- van].” When Schneberger refused to make the entry and also refused to provide the account number to en- able Myers to make the entry, Betty Vinson, a senior manager in General Accounting, obtained the account number from a low-level analyst in Schneberger’s group and had one of her subordinates make the entry.k Employees in the general accounting depart- ment also made accrual releases from some depart- ments without consulting the departments’ senior management. In 2000, General Accounting released $281 million against line costs from accruals in the tax department’s accounts, an entry that the tax group did not learn about until 2001.

Over a seven-quarter period between 1999 and 2000, WorldCom released $3.3 billion worth of accru- als, most at the direct request of Sullivan or Myers. Several business units were left with accruals for fu- ture cash payments that were well below the actual amounts they would have to pay when bills arrived in the next period.

Expense Capitalization

By the first quarter of 200l, so few accruals were left to release that this tactic was no longer available to achieve the targeted E/R ratio.l Revenues, however, continued to decline, and Sullivan, through his lieu- tenants Myers and Yates, urged senior managers to maintain the 42% E/R ratio. Senior staff described this target as “wildly optimistic,” “pure fantasy,” and “im- possible.” One senior executive described the pressure as “unbearable—greater than he had ever’ experienced in his fourteen years with the company.”m

Sullivan devised a creative solution. He had his staff identify the costs of excess network capacity. He reasoned that these costs could be treated as a capital expenditure, rather than as an operating cost, since the contracted excess capacity gave the company an op- portunity to enter the market quickly at some future time when demand was stronger than current levels. An accounting manager in 2000 had raised this possi- bility of treating periodic line costs as a capital expen- diture but had been rebuffed by Yates: “David [Myers] and I have reviewed and discussed your logic of

212 Part 1 Financial Accounting

capitalizing excess capacity and can find no support within the current accounting guidelines that would allow for this accounting treatment.”n

In April 2001, however, Sullivan decided to stop recognizing expenses for unused network capacity.13

He directed Myers and Yates to order managers in the company’s general accounting department to capital- ize $771 million of non-revenue-generating line ex- penses into an asset account, “construction in progress.” The accounting managers were subse- quently told to reverse $227 million of the capitalized amount and to make a $227 million accrual release from ocean-cable liability.

WorldCom’s April 26, 2001 press release and sub- sequent 10-Q quarterly report filed with the U.S. Secu- rities and Exchange Commission (SEC) reported $4.1 billion of line costs and capital expenditures that in- cluded $544 million of capitalized line costs. With $9.8 billion in reported revenues, WorldCom’s line- cost E/R ratio was announced at 42% rather than the 50% it would have been without the reclassification and accrual release.o

General Accounting Department

Betty Vinson, a native of Jackson, Mississippi, joined WorldCom in 1996, when she was 40 years old, as a manager in the international accounting division. She soon developed a reputation as a hardworking, loyal employee who would do “anything you told her” and often voluntarily worked extra hours at night, while at home, and on vacation.14 Her good work soon led to a promotion to senior manager in General Accounting. In October 2000, Vinson and her colleague Troy Nor- mand (another manager in General Accounting) were called into their boss’s office. Their boss, Yates, told them that Myers and Sullivan wanted them to release $828 million of line accruals into the income state- ment. Vinson and Normand were “shocked” by their bosses’ proposal and told Yates that the proposal was “not good accounting.”l5 Yates replied that he was not happy about the transfer either, but after Myers had

13 Sullivan’s rationale, formally described in a two-page white paper, was rejected by the SEC, independent auditors, and WorldCom’s own senior managers. 14 Susan Pulliman, “WorldCom Whistleblowing,” The Wall Street Journal, June 23, 2003. 15 Ibid.

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 213

assured him that it would not happen again, he had agreed to go along. After some debate, Vinson and Normand agreed to make the transfer. When the com- pany publicly reported its third-quarter results, how- ever, Vinson and Normand reconsidered their decision and told Yates that they were planning to resign.

Ebbers heard about the accountants’ concerns and (according to another WorldCom employee) told Myers that the accountants would not be placed in such a difficult position again. A few days later, Sulli- van talked to Vinson and Normand about their resig- nation plans: “Think of us as an aircraft carrier. We have planes in the air. Let’s get the planes landed. Once they are landed, if you still want to leave, then leave. But not while the planes are in the air.”16

Sullivan assured them that they were doing nothing illegal and that he would take full responsibility for their actions. Vinson decided against quitting. She earned more than her husband, and her WorldCom po- sition paid for the family’s insurance benefits. She knew that it would be difficult to find alternative work in the community with comparable compensation. Moreover, while she and Normand had doubts about the accounting transfers, they believed that Sullivan, with his “whiz kid” CFO reputation, probably knew what he was doing.

In April 2001, Vinson and Normand were again placed in a difficult position, except this time the posi- tion was, from Vinson’s perspective, even less defensi- ble. Revenues in the quarter were worse than expected, and Sullivan wanted them to transfer $771 million of line costs into capital expenditures.17 Vinson was again shocked at the request but was reluctant to quit without another job. She knew Myers and Yates had al- ready acquiesced to Sullivan’s request. It was her job to distribute the amount across five capital accounts. She felt trapped but eventually made the entries and backdated them to February 2001.

Vinson continued to make similar entries through- out 2001 but began losing sleep, withdrawing from workers, and losing weight. Each time she hoped it would be the last, yet the pressure continued. In early 2002, she received a raise (to roughly $80,000) and a promotion to director. In April 2002, Yates, Normand,

and Vinson reviewed the first-quarter report, which included $818 million in capitalized line costs. They also learned that achieving Ebbers’s projections would require making similar entries for the remainder of the year. They made a pact to stop making such entries.

Internal Audit

Cynthia Cooper, a strong-willed, 38-year-old, nine- year WorldCom veteran, headed WorldCom’s 24- member internal audit department. Cooper had grown up in Clinton, Mississippi, WorldCom’s headquarters since 1998. Her high school teacher of accounting was the mother of one of her senior auditors. Gene Morse also was working in Internal Audit, as a senior man- ager; he had transferred after Yates threatened him, in October 1999, about speaking to external auditors. In- ternal Audit reported directly to CFO Sullivan for most purposes. It conducted primarily operational au- dits to measure business unit performance and enforce spending controls. Arthur Andersen, WorldCom’s in- dependent auditors, performed the financial audits to assess the reliability and integrity of the publicly re- ported financial information. Andersen reported to the audit committee of the company’s board of directors.18

In August 2001, Cooper began a routine opera- tional audit of WorldCom’s capital expenditures. Sulli- van instructed Myers to restrict the scope of Cooper’s inquiry: “We are not looking for a comprehensive Capex audit but rather very in depth in certain areas and spending.” Cooper’s audit revealed that Corporate had capital expenditures of $2.3 billion. By way of comparison, WorldCom’s operations and technology group, which ran the company’s entire telecommuni- cations network, had capital expenditures of $2.9 bil- lion. Internal Audit requested an explanation of Corporate’s $2.3 billion worth of projects. Cooper’s team received a revised chart indicating that Corporate had only $174 million in expenditures. A footnote

16 Ibid., p. 1. 17 This figure was subsequently reduced to $544 million when Sullivan and Myers found $227 million worth of accruals that could be released for the quarter.

18 This audit was described as operational in nature, with an emphasis on actual spending in the field, capitalization of labor costs, and cash management. Internal Audit focused on operational and not financial statement audits at this time in order to avoid duplicating the work Andersen was doing; one employee told us that Internal Audit also wanted to avoid being seen as digging in Scott Sullivan’s “ back- yard” when the group reported to him. (Beresford, Katzen- bach, and Rogers, Jr., p. 119.)

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reference in this chart indicated that the remainder of the $2.3 billion included a metro lease buyout, line costs, and some corporate-level accruals.

In March 2002, the head of the wireless business unit complained to Cooper about a $400 million ac- crual in his business for expected future cash pay- ments and bad-debt expenses that had been transferred away to pump up company earnings. Both Sullivan and the Arthur Andersen team had supported the trans- fer. Cooper asked one of the Andersen auditors to ex- plain the transfer, but he refused, telling her that he took orders only from Sullivan. Morse recalled: “That was like putting a red flag in front of a bull. She came back to me and said, ‘Go dig.’ ”19

Cooper brought the issue to WorldCom’s audit committee but was told by Sullivan, after the audit committee meeting, to stay away from the wireless business unit. Cooper recalled Sullivan screaming at her in a way she had never been talked to before, by anyone.p

Also in March 2002, SEC investigators sent World- Com a surprise “request for information.’’ The SEC wanted to examine company data to learn how World- Com could be profitable while other telecom compa- nies were reporting large losses.

Cooper decided, unilaterally and without informing Sullivan, to expand Internal Audit’s scope by conduct- ing a financial audit. Cooper asked Morse, who had good computer expertise, to access the company’s computerized journal entries. Such access was granted only with Sullivan’s permission, which they definitely did not have. But Morse, anticipating a need for un- limited access to the company’s financial systems, had previously persuaded a senior manager in WorldCom’s IT department to allow him to use the systems to test new software programs.

The software enabled Morse to find the original journal entry for virtually any expense. Morse worked at night, when his activities were less likely to clog the network.20 By day, Morse examined his downloaded materials in the audit library, a small windowless room. He copied incriminating data onto a CD-ROM so that the company could not subsequently destroy the evidence. Morse, a gregarious father of three, was

214 Part 1 Financial Accounting

so concerned with secrecy that he did not tell his wife what he was doing and instructed her not to touch his briefcase.

The Outside Auditor: Arthur Andersen

WorldCom’s independent external auditor from 1990 to 2002 was Arthur Andersen. Andersen considered WorldCom to be its “flagship” and most “highly cov- eted” client, the firm’s “Crown Jewel.”q Andersen viewed its relationship with WorldCom as long term and wanted to be considered as a committed member of WorldCom’s team. One indicator of its commitment came after the company merged with MCI. Andersen, which had a Mississippi-based team of 10–12 people working full time on WorldCom’s audits, underbilled the company and justified the lower charges as a con- tinuing investment in its WorldCom relationship.

Originally, Andersen did its audit “the old- fashioned way,” testing thousands of details of individ- ual transactions and reviewing and confirming account balances in WorldCom’s general ledger. As World- Com’s operations expanded through mergers and in- creased scope of services, Andersen adopted more ef- ficient and sophisticated audit procedures, based on analytic reviews and risk assessments. The auditors fo- cused on identifying risks and assessing whether the client company had adequate controls in place to miti- gate those risks, for example, for mistakenly or delib- erately misrepresenting financial data. In practice, Andersen reviewed processes, tested systems, and as- sessed whether business unit groups received correct information from the field. Its auditors assumed that the information recorded by General Accounting was valid. It typically requested the same 20 to 30 sched- ules of high-level summaries to review each quarter, including a schedule of topside entries made by Gen- eral Accounting directly to the corporate general ledger after the close of a quarter.r

Andersen also assessed the risk that expenditures for payroll, spare parts, movable parts, and capital pro- jects were being properly recorded and classified as expenses or assets by reviewing the relevant approval process. For line costs, Andersen assessed the risk that line-cost liabilities might be understated or overstated by testing whether the domestic telco accounting group received accurate information from the field. It did not perform comparable tests for the international

19 Susan Pulliman and Deborah Solomon, “Uncooking the Books,” The Wall Street journal, October 30, 2002. 20 In an early effort, Morse attempted to download a large number of transactions from one account and crashed the system, which drew attention to his efforts.

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 215

line-cost group even after WorldCom employees told Andersen’s U.K. audit team about a corporate reversal of $34 million in line-cost accruals after the first quar- ter of 2000.s Andersen focused primarily on the risk that WorldCom revenues would be misstated because of errors or inaccurate records, not by deliberate mis- representation.

Between 1999 and 2001, Andersen’s risk manage- ment software program rated WorldCom as a “high- risk” client for committing fraud, a conclusion that its auditors upgraded to “maximum risk” because of volatility in the telecommunications industry, the com- pany’s active merger and acquisition plans, and its re- liance on a high stock price for acquisitions. The An- dersen concurring partner said at the time of the 1999 risk upgrade, “If this job is not maximum, none are.”t

The engagement manager stated that there were “prob- ably few other engagements where [Andersen] ha[d] a higher risk.”

But the Andersen audit team for WorldCom did not modify its analytic audit approach and continued to audit WorldCom as a “moderate-risk” client. Andersen could have identified the fraudulent topside entries (accrual reversals and capitalized line costs) from a review of the company’s general ledger, its primary transactional accounting record.u WorldCom, how- ever, repeatedly refused Andersen’s request to access the computerized general ledger. Also, Andersen’s an- alytic review procedures, properly performed, should have triggered a search for accounting irregularities when WorldCom’s quarterly financial statements re- ported stable financial ratios during a period of severe decline in the telecommunications industry: “[M]an- agement’s ability to continue to meet aggressive rev- enue growth targets, and maintain a 42% line cost expense-to-revenue ratio, should have raised ques- tions. Instead of wondering how this could be, Ander- sen appeared to have been comforted by the absence of variances. Indeed, this absence led Andersen to con- clude that no follow-up work was required.”v

Myers, Stephanie Scott, and Mark Willson in- structed WorldCom staff about what information could and could not be shared with Andersen. When Andersen auditors asked to speak with Ronald Lomenzo, senior vice president of financial opera- tions, who oversaw international line-cost accruals, the request was refused. One employee commented: “Myers or Stephanie Scott would never permit it to happen.”w In 1998, WorldCom’s treasurer told the person in charge of security for WorldCom’s

computerized consolidation and financial reporting system never to give Andersen access. One employee said that she was specifically instructed not to tell An- dersen that senior management orchestrated adjust- ments to domestic line-cost accruals. Myers told one employee who had continued to talk with Andersen’s U.K. auditors, “Do not have any more meetings with Andersen for any reason. . . . Mark Willson has al- ready told you this once. Don’t make me ask you again.”x

WorldCom also withheld information, altered doc- uments, omitted information from requested materi- als, and transferred millions of dollars in account bal- ances to mislead Andersen. In fact, special monthly revenue reports were prepared for Andersen:

WorldCom provided Andersen with altered MonRevs [monthly revenue reports] that re- moved several of the more transparently prob- lematic revenue items from the Corporate Unal- located schedule, and buried the revenue for these items elsewhere in the report . . . . After the third quarter of 2001, Stephanie Scott became concerned about how Andersen would react to the size of Corporate Unallocated revenue. . . . In the version prepared for Andersen, the Corpo- rate Unallocated revenue items could no longer be identified by name and amount. . . . These items were removed from the Corporate Unallo- cated schedule and subsumed within a sales region’s total/revenue number.y

Andersen rated WorldCom’s compliance with re- quests for information as “fair,” never informing the audit committee about any restrictions on its access to information or personnel.

The Board of Directors

Between 1999 and 2002, nonexecutive members made up more than 50% of WorldCom’s Board of Directors. The board members, most of whom were former own- ers, officers, or directors of companies acquired by WorldCom, included experts in law, finance, and the telecommunications industry (see Exhibit 2). Bert Roberts, Jr., former CEO of MCI, was chairman from 1998 until 2002. His actual role, however, was hon- orary. CEO Ebbers presided over board meetings and determined their agendas.

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The board’s primary interaction with WorldCom matters occurred at regularly scheduled meetings that took place about four to six times a year. With the oc- casional exception of Bobbitt (Audit) and Kellett (Compensation), none of the outside directors had reg- ular communications with Ebbers, Sullivan, or any other WorldCom employee outside of board or com- mittee meetings. Prior to April 2002, the outside direc- tors never met by themselves.

A week prior to board meetings directors received a packet of information that contained an agenda, finan- cial information from the previous quarter, draft min- utes of the previous meeting, investor relations infor- mation such as analyst call summaries, and resolutions to consider at the upcoming meeting. The meetings consisted of a series of short presentations from the chairman of the compensation and stock option com- mittee about officer loans and senior level compensa-

216 Part 1 Financial Accounting

Clifford L. Alexander Jr., 67, joined the board after the merger with MCI in1998. He was previously a mem- ber of the MCI Board.

James C. Allen, 54, became a director in 1998 through the acquisition of Brooks Fiber Properties where he served as the vice chairman and CEO since 1983.

Judith Areen, 56, joined the board after the merger with MCI in 1998. She had previously been a member of the MCI Board. Areen was appointed executive vice president for Law Center Affairs and dean of the Law Center at Georgetown University in 1989.

Carl J. Aycock, 52, was an initial investor in LDDS and a director since 1983. He served as secretary of World- Com from 1987 until 1995.

Ronald R. Beaumont, 52, was COO of WorldCom beginning in 2000 and had previously served both as the president and CEO of WorldCom’s operations and technology unit and as the president of WorldCom Net- work Services, a subsidiary of WorldCom, Inc. Prior to 1996, Beaumont was president and CEO of a sub- sidiary of MFS Communications.

Max E. Bobbitt, 56, became a director in 1992 and served as chairman of the Audit Committee. He was pres- ident and CEO of Metromedia China Corporation from 1996 to 1997 and president and CEO of Asian American Telecommunications Corporation, which was acquired by Metromedia China Corporation in 1997.

Bernard J. Ebbers, 59, was the CEO of WorldCom since 1985 and a board member since 1983.

Francesco Galesi, 70, became a director in 1992. He was the chairman and CEO of the Galesi Group of com- panies, involved in telecommunications and oil and gas exploration and production.

Stiles A. Kellett Jr., 57, became a director in 1981 and served as chairman of the compensation and stock option committee.

Gordon S. Macklin, 72, became a director in 1998 after having served as chairman of White River Corpora- tion, an information services company. He sat on several other boards and had formerly been chairman of Hambrecht and Quist Group and the president of the National Association of Securities Dealers, Inc.

Bert C. Roberts Jr., 58, was the CEO of MCI from 1991 to 1996 and served as chairman of the MCI Board beginning in 1992. He stayed on in this capacity after the WorldCom merger with MCI in1998.

John W. Sidgmore, 50, was the vice chairman of the board and a director at WorldCom beginning in 1996. From 1996 until the MCI merger, he served as COO of WorldCom. He had previously been president and COO of MFS Communications Company, Inc. and an officer of UUNET Technologies, Inc.

Scott D. Sullivan, 39, became a director in 1996 after he was named CFO, treasurer,. and secretary in 1994.

Source; “Annual Report for the Fiscal Year Ended December 31,2000, WorldCom, Inc., March 31, 2001.

EXHIBIT 2 WorldCom Board of Directors, as of 2001

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tion; the chairman of the audit committee;21 the gen- eral counsel, who. discussed legal and regulatory is- sues; CFO Sullivan, who discussed financial issues at a high level of generality for 30 minutes to an hour; and, on occasion, COO Ron Beaumont. This format did not change, even when the board considered large multibillion-dollar deals.22

Sullivan manipulated the information related to capital expenditures and line costs presented to the board. His presentation of total capital spending for the quarter included a breakdown on spending for local, data/long haul, Internet, and international oper- ations and major projects. The board, which was ex- pecting cuts in capital expenditures, received informa- tion that reflected a steady decrease. However, the spending cuts were far greater than they were led to believe. The hundreds of millions of dollars of capital- ized line costs inflated the capital expenditures re- ported to the board (see Table A).

Prior to the meetings, board members received line- cost information from a one-page statement of opera- tions within a 15- to 35-page financial section. On this page, line costs were listed among roughly 10 other line items. In his hour-long PowerPoint presentations, Sullivan had a single slide that made quarterly com- parisons of several budget items, including line costs. The investigative committee concluded:

The Board and the Audit Committee were given information that was both false and plausiblez

[emphasis added] . . . . [Audit Committee] mem- bers do not appear to have been sufficiently fa- miliar and involved with the Company’s internal financial workings, with weaknesses in the Company’s internal control structure, or with its culture. . . . To gain the knowledge necessary to function effectively . . . would have required a

very substantial amount of energy, expertise by at least some of its members, and time— certainly more than the three to five hours a year the Audit Committee met.aa

Ebbers, in addition to his full-time job as World- Com CEO, for which he was generously compen- sated,23 had acquired and was managing several unre- lated businesses, including hotels, real estate ventures, a Canadian cattle ranch, timberlands, a rice farm, a luxury-yacht-building company, an operating marina, a lumber mill, a country club, a trucking company, and a minor league hockey team.bb Ebbers financed the ac- quisitions of many of these businesses by commercial bank loans secured by his personal WorldCom stock. When WorldCom stock began to decline in 2000, Ebbers received margin calls from his bankers. In Sep- tember 2000, the compensation committee began, at Ebbers’s request, to approve loans and guarantees from WorldCom so that Ebbers would not have to sell his stock to meet the margin calls. The full board learned about the loans to Ebbers in November 2000, since the loans needed to be disclosed in the com- pany’s third-quarter l0-Q report. The board ratified and approved the compensation committee’s actions. WorldCom did not receive any collateral from Ebbers or his business interests to secure these loans. Nor did the compensation committee oversee Ebbers’s use of the funds, some of which were used to pay his compa- nies’ operating expenses. By April 29, 2002, the loans and guarantees to Ebbers exceeded $400 million.

According to the investigative committee, World- Com’s board was “distant and detached from the work- ings of the Company.”cc It did not establish processes to encourage employees to contact outside directors about any concerns they might have about accounting entries or operational matters.dd

The Board played far too small a role in the life, direction and culture of the company. The Audit

Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 217

21 A nominating committee, responsible for filling vacancies on the board, met only when vacancies occurred. 22 Committees met separately in hour-long sessions. Special executive sessions discussed mergers and acquisitions.

23 Ebbers was ranked, for several years in a row, as among the highest paid CEOs in the United States.

3Q00 4Q00 lQ0l 2Q01 3Q01 4Q0l 1Q02

As reported to board 2,648 2,418 2,235 2,033 1,786 1,785 1,250 Actual spend, not shown to board 1,691 1,473 1,044 944 462

Source: Beresford, Katzenbach, and Rogers, Jr., p. 282.

TABLE A Report of Capital Expenditures to Board vs. Actual Capital Expenditures (in millions)

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Committee did not engage to the extent neces- sary to Understand and address the financial is- sues presented by this large and extremely com- plex business: its members were not in a position to exercise critical judgment on accounting and reporting issues, or on the non- traditional audit strategy of their outside auditor. The Compensation Committee dispensed extra- ordinarily generous rewards without adequate attention to the incentives they created, and presided over enormous loans to Ebbers that we believe were antithetical to shareholder interests and unjustifiable on any basis.ee

On April 26, 2002, the nonexecutive directors met by themselves, for the first time, to discuss Ebbers’s delay in providing collateral for his loans from the company. The directors, dissatisfied with Ebbers’s lack of strategic vision and his diminished reputation on Wall Street, voted unanimously to ask Ebbers for his resignation. Within three days, the board signed a separation agreement with Ebbers that included a re- structuring of his loans into a five-year note and a promise of a $1.5 million annual payment for life.ff,24

The Endgame

Cooper’s internal audit team, by the beginning of June 2002, had discovered $3 billion in questionable ex- penses, including $500 million in undocumented com- puter expenses. On June 11, Cooper met with Sullivan, who asked her to delay the capital expenditure audit until after the third quarter. Cooper refused. On June 17, Cooper and Glyn Smith, a manager on her team, went to Vinson’s office and asked her to explain sev- eral questionable capital expense accounting entries that Internal Audit had found. Vinson admitted that she had made many of the entries but did not have any support for them. Cooper immediately went to Yates’s office, several feet away, and asked him for an expla- nation. Yates denied knowledge of the entries and referred Cooper to Myers, who acknowledged the

218 Part 1 Financial Accounting

entries and admitted that no accounting standards ex- isted to support them. Myers allegedly said the entries should not have been made, but that once it had started, it was hard to stop.25

On June 20, Cooper and her internal audit team met in Washington, D.C. with the audit committee and disclosed their findings of inappropriate capitalized expenses. When Sullivan could not provide an ade- quate explanation of these transactions, the board told Sullivan and Myers to resign immediately or they would be fired. Myers resigned. Sullivan did not and was promptly fired. On June 25, 2002, WorldCom an- nounced that its profits had been inflated by $3.8 bil- lion over the previous five quarters. Nasdaq immedi- ately halted trading of WorldCom’s stock. Standard & Poor’s lowered its long-term corporate credit rating on WorldCom bonds from B+ to CCC-.

On June 26, the SEC initiated a civil suit of fraud against WorldCom. Attorneys in the U.S. Justice Department launched criminal investigations into the actions of Bernie Ebbers, Scott Sullivan, David Myers, Buford Yates, Betty Vinson, and Troy Normand.

Questions

1. Explain the nature of the accounting fraud.

2. What are the pressures that lead executives and managers to “cook the books?”

3. What is the boundary between earnings smoothing or earnings management and fraudulent reporting?

4. Why were the actions taken by WorldCom man- agers not detected earlier? What management con- trol processes or systems should be in place to deter or detect quickly the types of actions that occurred in WorldCom?

5. Were the external auditors and board of directors blameworthy in this case? Why or why not?

6. Betty Vinson: victim or villain? Should criminal fraud charges have been brough against her? How should employees react when ordered by their em- ployer to do something they do not believe in or feel uncomfortable doing?

24 Subsequently, the corporate monitor and WorldCom’s new management cancelled the $1.5 million annual payment and took control of some of Ebbers’s personal business assets. 25 Pulliman and Solomon.

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Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 219

Endnotes a Dennis R. Beresford, Nicholas de B. Katzenbach,

and C.B. Rogers,. Jr., “Report of Investigation,” Spe- cial Investigative Committee of the Board of Directors of WorldCom, Inc., March 31, 2003, p. 49.

b Ibid.

c Ibid., p. 277.

d Ibid., p. 19.

e Ibid., p. 18.

f Ibid., p. 124.

g Ibid., p. 13.

h Ibid., p. 94.

i Ibid., pp. 94–95.

j Ibid., p. 83.

k Ibid., p. 71.

l Ibid., p. 16.

m Ibid., p. 94.

n Ibid., p. 99.

o Ibid., pp. 105–108.

p Ibid., p. 123.

q Ibid., p. 225.

r Ibid., p. 228.

s Ibid., p. 242.

t Ibid., p. 233.

u Ibid., p. 235.

v Ibid., p. 236.

w Ibid., p. 240.

x Ibid., p. 251.

y Ibid., p. 252.

z Ibid., p. 277.

aa Ibid., p. 286.

bb Ibid., pp. 294–295.

cc Ibid., p. 283.

dd Ibid., p. 290.

ee Ibid., p. 264.

ff Ibid., pp. 309–310.

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8 Sources of Capital: Debt

Chapter

Chapter 8 begins a more detailed description of the liabilities and owners’ equity por- tion of the balance sheet. In this chapter we discuss liabilities and the related interest expense, while Chapter 9 discusses owners’ equity. As mentioned in Chapter 2, liabili- ties and owners’ equity represent the sources of the funds that have been used to finance the entity’s investments in assets.

Identifying the needs for new funds and acquiring these funds are part of the func- tion known as financial management. The financial executives in an organization need to have extensive knowledge about the various means of raising money and the legal and tax rules that relate to financing. Other members of management should have a general understanding of these matters even though they need not be familiar with all the details. This chapter discusses the accounting and financial analysis aspects of lia- bilities at a level that is intended to give the nonfinancial manager a general under- standing of the subject.

In the typical organization, arranging new sources of long-term liabilities is an event that occurs infrequently; but when it does occur, it is likely to have a major im- pact on the financial statements. The appendix to this chapter introduces the concept of present value, a fundamental concept in the balance sheet valuation of liabilities and the measurement of fair value.

Nature of Liabilities

In Chapter 2, liability was defined as an obligation to an outside party arising from a transaction or an event that has already happened. This definition is approximately cor- rect. However, some accounting liabilities are not legally enforceable obligations, and some legal obligations are not liabilities in the accounting meaning of this word.

An estimated allowance for future costs under a warranty agreement is an example of a liability that is not a definite obligation at the time it is set up. When a warranty agreement applies, the liability account Allowances for Warranties is set up by a credit entry in the period in which the revenue is recognized, the offsetting debit being a charge to an expense account such as Estimated Warranty Expense. Later on, when re- pairs or replacements under warranty are made, the liability account will be debited and other balance sheet accounts such as Parts Inventory will be credited.

An example of a legal obligation that is not an accounting liability is an executory contract—a contract in which neither party has as yet performed. Understanding the

Executory Contracts

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nature of such agreements is important, not only in determining accounting liabilities but also in determining revenues and expenses. Five examples follow that illustrate the concept.

1. A sales order is placed for the future delivery of certain goods to the buyer. If the goods are not shipped in the current period, neither party has performed: The buyer has not paid anything and the seller has not shipped the goods. Thus, in accounting the sales order is not recognized—neither party has a liability and no revenue is recognized.

2. A baseball club signs a contract to pay a certain player $1 million per year for five years. The player works in the year in which the contract is signed; in this first year, the player has performed, so the contract is not an executory contract. If the baseball club has not paid all of the $1 million by the end of the first year, it has a liability for the unpaid amount. However, the agreement is currently an executory contract for the other four years; the remaining $4 million obligation is not recorded as a liability (or as anything) in the current year.

3. A law firm signs a contract in which it agrees to provide legal services next year. This is an executory contract in the current year; signing the contract does not constitute performance. This is conceptually the same as the sales order example, except that future provision of services is involved rather than future delivery of goods.

4. A law firm signs a contract in which it agrees to provide legal services next year on an as-needed basis; it receives a $50,000 retainer fee for so agreeing. This is not an executory contract because the client has performed by paying the $50,000. How- ever, because the law firm has not yet performed, it records a liability of $50,000 in the current year; the $50,000 is not yet revenue. The law firm does earn $50,000 rev- enue in the following year, whether or not it is actually called upon by the client to perform any services.

5. The seller of a house receives $10,000 as a nonrefundable deposit from the buyer of the house; subsequently, the would-be buyer decides not to purchase the house after all. This is not an executory contract because the buyer has performed to the extent of $10,000. This $10,000 is a liability to the seller at the time the deposit is made; subsequently, when the buyer does not consummate the purchase, the $10,000 be- comes revenue to the seller.

Important exceptions to the general rule that executory contracts do not create ac- counting liabilities are capital leases, discussed later in this chapter. Lease agreements are executory contracts. The lessor must provide the lessee with “quiet enjoyment” of the leased asset and the lessee must pay future lease payments. In the case of capital leases, the Financial Accounting Standards Board (FASB) decided the substance of the transaction rather than its legal form should dictate the accounting treatment.

A contingency is a set of circumstances involving uncertainty as to possible gain (a gain contingency) or loss (a loss contingency) that will ultimately be resolved when some future event occurs or fails to occur. Gain contingencies usually are not recorded because recording them would mean recognizing revenues before they are reasonably certain, which is not in accord with the conservatism concept. Accounting for loss con- tingencies is more judgmental. Examples of such contingencies include two items pre- viously discussed—collectibility of receivables and future warranty costs—as well as threatened or pending litigation; guarantees of indebtedness to others; risk of damage or loss to property by fire, flood, earthquake, or other hazard; and actual or possible claims and assessments.

Contingencies

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A loss contingency is recognized—recorded—as a liability (with an offsetting debit to an appropriate expense account to record the loss) only if both of the following con- ditions are met:

1. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred.

2. The amount of loss can be reasonably estimated.

If one of the conditions is not met, the contingency must nevertheless be disclosed (but not recognized) if there is at least a reasonable possibility that a loss may have been incurred.1

For example, assume that during the period a lawsuit claiming damages has been filed against a company. If the company concludes that it is probable it will lose the law- suit and if the amount can be reasonably estimated, a liability is recognized. If the amount of the probable loss can be estimated only within a range, the lower end of this range is the amount of the liability. The possible loss above this lower limit is disclosed in notes to the financial statements, but it is not recorded in the accounts.2

A company’s internal auditor discovered that an employee had made errors in calculating the amount of customs duties due on imported merchandise, resulting in underpayments totaling $100,000. The company immediately paid the $100,000 to the government. The penalty would be at the court’s discretion, with a maximum of 10 times the value of the merchandise; in this instance, the maximum penalty could be $30 million. On the other hand, there would be no penalty if the court decided that the error was not willful. Based on the experience of other companies with similar violations, the company decided that the lower limit of the probable range of penalties was $300,000 and recorded this amount as a liability and an expense. It disclosed the possibility of paying up to $30 million in a note accompanying its balance sheet.

A company is said to be “contingently liable” if it has guaranteed payment of a loan made to a third party. But this is not a liability in the accounting sense unless available information indicates that the borrower has defaulted or will probably default.3 The possibility of loss from future earthquakes or other natural catastrophes is not a liabil- ity because the events have not yet happened.

There are often practical difficulties in accounting for contingencies. FASB Statement No. 5 distinguishes among three degrees of uncertainty—probable (“likely to occur”), remote (“slight” chance of occurring), and reasonably possible (“more than remote but less than likely”). In practice, judgment often must be exercised in deciding whether a contingency loss is probable, thus requiring its recognition, or only reasonably possible, thus requiring disclosure of the contingency but not its recognition. Losses that are re- mote need not be disclosed. The company’s reported income for the period is affected by how this judgment is made, which raises the possibility that the judgment may be biased.

As described in Chapter 2, current liabilities are those that are to be satisfied in the near future. One noteworthy aspect of current liabilities is that they often provide funds (financial resources) to the company at no cost. For example, if suppliers permit a

222 Part 1 Financial Accounting

Liabilities as a Source of Funds

1 “Accounting for Contingencies,” FASB Statement No. 5; “Provisions, Contingent Liabilities and Contingent Assets,” IAS No. 37. 2 “Reasonable Estimation of the Amount of a Loss,” FASB Interpretation No. 14. 3 Even though such a guarantee may not create a liability, the nature and amount of the guarantee must be disclosed in a note to the balance sheet. See FASB Statement No. 5 and “Disclosure of Indirect Guarantees of Indebtedness to Others,” FASB Interpretation No. 34.

Example

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company to pay for materials or supplies 30 days after delivery, this credit policy re- sults in an interest-free, 30-day loan to the company. Similarly, unearned subscription revenue prepaid to a magazine publisher is, in effect, an interest-free loan from sub- scribers to the publisher.

With these exceptions, a company pays for the use of the capital that others furnish. Capital obtained from borrowing is called debt capital. Capital obtained from share- holders, either as a direct contribution (paid-in capital) or indirectly as retained earn- ings, is called equity capital. The rest of this chapter deals with debt capital. (Equity capital is dealt with in Chapter 9.)

Debt Capital

The debt instruments that a firm uses to obtain capital can be classified generally as either term loans or bonds. We will describe these instruments in general terms; addi- tional details can be found in texts on financial management.

A business loan repayable according to a specified schedule is a term loan. The lender is usually a bank or an insurance company. Ordinarily a company’s obligation to repay a term loan extends over a period of several years, making the loan a noncurrent liability. However, short-term loans also can be arranged, particularly for businesses with sea- sonal sales patterns that need cash to finance a buildup of inventories prior to the sell- ing season (e.g., toy manufacturers). For major corporations, term loans are a less significant source of debt capital than bonds.

A bond is a certificate promising to pay its holder (1) a specified sum of money at a stated date, called the maturity date, and (2) interest at a stated rate until the maturity date. Although bonds are usually issued in units of $1,000, the price of a bond is usually quoted as a percentage of this face value; thus, a price of 98 means $980. The stated interest rate is usually constant for the life of the bond. However, for some bonds, called variable rate bonds, the rate may be expressed in terms such as “the prime rate plus 2 percent”; the rate thus varies each interest period with that period’s prime rate (the interest rate charged by banks on short-term loans to their best cus- tomers). Bonds may be issued to the general public through the intermediary of an in- vestment banker, or they may be privately placed with an insurance company or other financial institution.

Long-term creditors usually require the borrowing entity to maintain certain mini- mum financial ratios (e.g., current ratio) and to refrain from taking actions that might endanger the safety of the money loaned. These requirements, called covenants, are spelled out in the loan or bond indenture (usually a lengthy document). If any of these covenants is not lived up to, the loan is technically in default, and the creditors can de- mand immediate repayment. In the event of default, however, creditors are more likely to require changes in the management or take other corrective action rather than de- mand immediate repayment.

A mortgage bond (or simply mortgage) is a bond secured by designated pledged assets of the borrower, usually land, buildings, and equipment. Should the firm default on the mortgage, the pledged assets may be sold to repay the mortgage. If the proceeds from the sale of the pledged assets are less than the amount of the mortgage, then the mortgage holder becomes a general creditor for the shortfall. If the bond is not secured by specific assets of the issuing entity, it is referred to as a debenture.

Term Loans

Bonds

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Bond Redemption In an ordinary bond issue, the principal amount is paid in one lump sum at the matu- rity date. This payment is said to redeem the bond. In order to accumulate cash for re- demption, the borrower (bond issuer) may be required to deposit money regularly in an account restricted for this purpose. Bonds that have such a requirement are sinking fund bonds. Sinking funds may be used to redeem bonds at maturity, or to redeem out- standing bonds at regular intervals by buying them in the open market or by redeeming certain bonds that are randomly selected. Bond sinking funds are usually controlled by a trustee, such as a bank; they appear in the “investments” or “other assets” section of the balance sheet.

Serial bonds also are redeemed in installments, the redemption date for each bond in the bond issue being specified on the bond itself. The primary difference between a sinking fund bond and a serial bond is that holders of serial bonds know the date when their bonds will be redeemed, whereas holders of sinking fund bonds do not. The latter may end up holding their bonds to maturity, or their bonds may be randomly selected for redemption by the sinking fund at some earlier time.

A bond also may be callable; the issuing entity may, at its option, call the bonds for redemption before the maturity date. If this is done, the corporation usually must pay a premium for the privilege.

Zero-coupon bonds do not make periodic interest payments. Rather, they are sold at a deep discount from their face value. Over the life of the bond, interest is accrued and added to the bond’s carrying value. At maturity, the bond’s carrying value is equal to its face value.

Other Features of Bonds Some bonds are convertible; they may be exchanged for a specified number of shares of the issuing corporation’s common stock if the bondholder elects to do so. Sinking fund bonds and serial bonds also may be callable, convertible, or both.

Finally, some bonds (and also some term loans) are subordinated. In the event a company goes bankrupt and is liquidated, the claims of the subordinated debtholders are subordinate (i.e., inferior) to the claims of any general or secured creditors. How- ever, subordinated creditors’ claims take precedence over those of the company’s shareholders (equity investors).

Accounting for Bonds

We will now describe how a bond is recorded in the accounts when it is issued, how bond interest expense is recorded while the bond is outstanding, and how the bond’s re- demption is recorded.

To illustrate the entries typically made to record the proceeds from an issue of bonds, assume Mason Corporation issues 100 bonds, each with a par value (also called prin- cipal or face value) of $1,000. The bonds have a stated interest rate, called the coupon rate,4 of 10 percent. This means that the annual interest payment will be 10 percent of

224 Part 1 Financial Accounting

Recording a Bond Issue

4 Before computers were widely used for keeping bondholder records, a bondholder requested each periodic interest payment by mailing in a coupon, printed on sheets attached to the bond certificate, to the bond issuer. That is the origin of the term coupon rate and also of the expression coupon clipper to describe someone with substantial financial investments.

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the par value—in this case, $100 per year.5 The bonds will mature at the end of the 20th year after their issuance. They are not secured by any specific Mason Corporation as- sets. Such a bond would be called a “10 percent, 20-year debenture.” If the corporation received $1,000 for each of these bonds, the following entry would be made:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . 100,000

(In practice the liability account title describes the specific bond issue, with a separate account for each issue. The title is abbreviated here.)

Discount and Premium A fundamental concept in finance is the relationship between risk and return: The higher the risk an investment represents, the higher the return the investor expects to receive from making the investment. For example, if an investor can earn 8 percent in- terest on a $1,000 investment in a federally insured certificate of deposit, the investor will expect a bond to provide more than an 8 percent return because there is some risk that either the bond’s interest payments or its principal redemption will not be received in full by the bondholder. Similarly, if bonds of a given risk are currently providing a 12 percent return to their holders, investors will not be willing to pay $1,000 for a newly issued bond of comparable risk that has only a 10 percent coupon rate. By the same token, they would be willing to pay more than $1,000 for a bond having comparable risk and a 14 percent coupon rate.

There is always some delay between the time a bond’s coupon rate is decided upon and when the bond is actually available to be issued to the public. During this delay the prevailing rate of return on bonds of comparable risk may have changed. For this reason, bonds often are issued for less than their par value—at a discount. This occurs when the prevailing market rate is higher than the bond’s coupon rate. Recall that the bond’s par value is fixed at $1,000, and the annual interest payment is fixed once the coupon rate is set (Interest payment � Par value * Coupon rate). Thus, in order to earn a return higher than the coupon rate, the bondholder must invest less than $1,000 in the bond. Similarly, if prevailing rates are lower than the bond’s coupon rate, bondholders will be willing to invest more than the bond’s par value, and the bond will be issued at a premium.6

If the prevailing rate of interest in the bond market is more than 10 percent for bonds with a risk similar to those issued by Mason Corporation, potential investors will be unwilling to pay $1,000 for a Mason Corporation 10 percent bond. They would be willing to invest an amount such that the $100 annual interest payment on this bond would yield the market rate of interest. Assume that this market rate is 12 percent. The bond would therefore be sold at a price of $851, or at a discount of $149.7

5 In practice, interest payments are usually made in semiannual installments, rather than annually—in this case, $50 every six months. For simplicity, we will usually assume annual payments. 6 Although it is colloquially said that an investor “pays” for a newly issued bond and that corporations “sell” their bonds, a bond is not an asset of the corporation that is sold, as are goods. Rather, bonds are evidence of a contribution of funds—a long-term loan—to the firm by investors. To the investor, the bond is an asset, and it can be sold to another investor. Such an exchange between investors has no impact on the flow of cash into or out of the firm, however. (Similar comments apply to shares of a corporation’s common stock.) 7 The $851 is formally called the present value of the bond; the method of calculating it is described in the appendix to this chapter. The precise present value is $850.61. If the interest were received in $50 semiannual amounts, the present value would be $849.54.

Example

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The words discount and premium carry no connotation of bad or good. They reflect simply a difference between the coupon interest rate for the issue and the going market rate of interest at the time of issuance. The coupon rate is usually quite close to the mar- ket rate as of the date of issue.

From the standpoint of the bond issuer, the discount or premium on a bond is a func- tion only of the interest rates prevailing at the time of issuance of the bonds. Subse- quent changes in the level of interest rates (and hence in bond prices) do not affect the amount recorded in the accounts. To emphasize this fact, the discount or premium recorded by the bond issuer is often called original issue discount or premium.

Issuance Costs The offering of a bond issue to the public is usually undertaken by an investment bank- ing firm that charges the issuer a fee for this service. In addition to this fee, the issuer also incurs printing, legal, and accounting costs in connection with the bond issue. These bond issuance costs are recorded as a deferred charge, which is an asset analo- gous to prepaid expenses. The issuance costs are not subtracted from the bond liability on the balance sheet, nor are they combined with any bond discount or premium.8

Mason Corporation’s bonds, for which investors paid $851 each, also had issue costs to Mason averaging $21 per bond, resulting in a net cash inflow to Mason of $830 per bond. The discount is $149 per bond, not $170 ($149 � $21).

Accounting Entries If the conditions of the preceding examples are assumed, and Mason Corporation re- ceived $83,000 net cash proceeds from the issuance of $100,000 face amount of bonds, the following entry would be made:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,000

Bond Discount . . . . . . . . . . . . . . . . . . . . . . . 14,900

Deferred Charges . . . . . . . . . . . . . . . . . . . . . 2,100

Bonds Payable . . . . . . . . . . . . . . . . . . . . 100,000

By contrast, if prevailing rates for similar bonds had been 9 percent, the bonds would have been issued at a premium of $91 per bond, and the entry would have been

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107,000

Deferred Charges . . . . . . . . . . . . . . . . . . . . . 2,100

Bond Premium . . . . . . . . . . . . . . . . . . . . 9,100

Bonds Payable . . . . . . . . . . . . . . . . . . . . 100,000

Bonds payable are shown in the long-term liabilities section of the balance sheet until one year before they mature, when ordinarily they become current liabilities. The de- scription should give the principal facts about the issue—for example, “10 percent debentures due 2017.” When a bond issue is to be refunded with a new long-term lia- bility, however, it is not shown as a current liability in the year of maturity since it will not require the use of current assets. If the bonds are to be retired in installments (as with serial bonds), the portion to be retired within a year is shown in the current liabil- ities section.

226 Part 1 Financial Accounting

Balance Sheet Presentation

8 “Interest on Receivables and Payables,” APB Opinion No. 21.

Example

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Chapter 8 Sources of Capital: Debt 227

Bond discount or premium is shown on the balance sheet as a direct deduction from, or addition to, the face amount of the bond, as illustrated:

If a Discount: If a Premium:

Bonds payable: Bonds payable:

Face value $100,000 Face value $100,000

Less: Unamortized discount 14,900 Plus: Unamortized premium 9,100________ _________ $ 85,100 $109,100________ _________

The principal amount less unamortized discount (or plus unamortized premium) is called the book value (or net book value) of the bond. It is the basis of calculating the bond’s periodic interest expense, as described below. Note in the above two examples that the initial book value of a bond is equal to the proceeds from its issuance, ignor- ing any issuance costs. The book value less unamortized issuance costs (deferred charges) is called the net carrying amount of the bond.

To the investor, the return on a bond is made up of two components: (1) the periodic cash interest payments and (2) the difference between the bond’s par value (received in cash at redemption) and the amount paid for the bond. The second component is a gain if the bond was purchased at a discount or a loss if purchased at a premium.

From the standpoint of the bond issuer, a bond’s interest expense also has two com- ponents that are the mirror image of the investor’s return components. Bond interest expense is made up of (1) the periodic cash interest payments to the bondholder and (2) amortization of original issue discount or premium. The amount of the issuer’s in- terest expense when related to the initial proceeds from issuing the bond (ignoring is- suance costs) determines the effective rate of interest on the bond. The effective rate is higher than the coupon rate for bonds issued at a discount; the effective rate is lower than the coupon rate for bonds issued at a premium.9 (Calculation of the effective rate is described in the appendix to this chapter.)

Discount/Premium Amortization Bond discount or premium is amortized using the compound interest method, also called the effective interest method or simply the interest method. (This method also is described in the appendix.) Straight-line amortization is not permitted unless the results would not differ materially from those obtained with the interest method.10

With the interest method of amortization, the discount or premium is written off in such a way that each period’s interest expense (as opposed to the cash interest payment) bears a constant ratio to the beginning-of-the-period book value of the bonds over the entire life of the issue. This ratio is the effective interest rate on the bonds. In the Mason example, if the bonds were issued for $851 each, this rate is 12 percent.11

The first year’s interest expense for the 10 percent Mason Corporation bonds that were as- sumed to have been issued for $851 each would be calculated as follows: Interest expense is equal to the book value of the bonds at the start of the year ($85,100) times the effective

9 APB Opinion No. 21 also requires disclosure of this effective rate of interest on the bond. 10 APB Opinion No. 21. 11 Readers checking our numbers with calculators may get slightly different results for our illustrative Mason bonds. Recall (from footnote 7) that the precise present value for a 12 percent return was $850.61 per bond, which we rounded to $851. This rounding changes the precise return to 11.994 percent, but we still use 12 percent.

Bond Interest Expense

Example

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interest rate (12 percent), which equals $10,212. Of this total interest expense for the year, $10,000 is the fixed cash interest payment (based on the bonds’ par value and coupon rate) and the remaining $212 is the amortization of original issue discount. The entry is

Bond Interest Expense . . . . . . . . . . . . . . . . 10,212

Bond Discount . . . . . . . . . . . . . . . . . . . 212

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

This entry reduces the unamortized bond discount by $212 to a new balance of $14,688 ($14,900 � $212). Thus, at the beginning of the second year, the bond’s book value will be $85,312 ($100,000 � $14,688). Next year’s interest expense will be 12 percent of this book value, or $10,237; of this total, $237 is the second year’s discount amortization and $10,000 is the fixed cash interest payment.

Continuing this process for the entire 20 years will completely amortize the original bond discount. Over the 20 years, the bonds’ book value will gradually increase up to the $100,000 par value that must be paid to Mason’s bondholders at maturity. Thus, the effect of bond discount/premium accounting procedures is that (1) when the bond is issued, its book value equals the cash proceeds received by the issuer (ignoring issuance costs) and (2) at maturity, the book value equals the amount of cash that must be paid out to fulfill the bond payable liability obligation. In other words, there is a matching of the cash flows and liability amounts at bond issuance and maturity, which would not be the case without the systematic amortization of discount or premium.

Adjusting Entries If the interest payment date does not coincide with the closing of the company’s books, an adjusting entry is made to record accrued interest expense and the amortization of discount or premium.

Mason Corporation bonds are issued for $851 each on October 1. The first year interest date is September 30 of the following year, and the issue’s fiscal year ends on December 31. The following entries would be made:

1. Adjustment on December 31 to record one-fourth year’s interest accrued since October 1:

Bond Interest Expense . . . . . . . . . . . . . . . . . . . . 2,553

Bond Discount . . . . . . . . . . . . . . . . . . . . . . . 53

Accrued Interest Payable . . . . . . . . . . . . . . . . 2,500

2. Payment of annual interest on September 30; entry to record three-fourths of a year’s interest expense and one year’s payment:

Bond Interest Expense . . . . . . . . . . . . . . . . . . . . 7,659

Accrued Interest Payable . . . . . . . . . . . . . . . . . . . 2,500

Bond Discount . . . . . . . . . . . . . . . . . . . . . . . 159

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Bond issuance costs, which are treated as a deferred charge, usually are amortized using the straight-line method. Thus, for Mason’s bonds, the annual issuance cost amortization would be $105 ($2,100 � 20 years).

Bonds may be retired in total, or they may be retired in installments over a period of years (i.e., as with sinking fund or serial bonds). In either case the retirement is recorded by a debit to Bonds Payable and a credit to Cash (or to a sinking fund that has been set up for this purpose). The bond discount or premium will have been completely amortized by the maturity date, so no additional entry is required for discount or pre- mium at that time.

228 Part 1 Financial Accounting

Retirement of Bonds

Example

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Callable bonds can be paid off before their maturity dates by paying investors more than the bonds’ par value. In periods when interest rates have declined, a company may consider it advantageous to refund a bond issue, that is, to call the old issue and issue a new one with a lower rate of interest. At that point, the company must account for the call premium (the difference between the call price and par value), any other costs of the refunding, and any unamortized issue costs and discount (or premium) on the old bonds.

Recall that the bonds’ face amount, adjusted for unamortized premium or discount and costs of issuance, is called the net carrying amount of the debt to be refunded. The amount paid on refunding, including the call premium and miscellaneous costs of refunding, is called the reacquisition price. The difference between these two amounts must be reported as a separate loss or gain on the income statement for the period in which the refunding takes place.

Suppose that the 100 Mason Corporation bonds are called at the end of five years by pay- ing the call price of the bonds at that time, $1,050 per bond, to each bondholder. Assume that miscellaneous refunding costs are $1,000 in total. Also, much of the bond discount and issuance costs will not have been amortized. The $13,553 of unamortized discount is de- termined using the compound interest method. Unamortized bond issuance costs after five years (one-quarter of the bonds’ scheduled life) would be 3⁄4 * $2,100 � $1,575. The loss is determined as follows:

Reacquisition price ($105,000 � $1,000) $106,000

Net carrying amount:

Face value $100,000

Less: Unamortized discount (13,553)

Less: Unamortized issuance costs (1,575) 84,872________ ________ Loss on retirement of bonds $ 21,128________________

The accounting entry is

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Loss on Retirement of Bonds . . . . . . . . . . . . . . 21,128

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106,000

Bond Discount . . . . . . . . . . . . . . . . . . . . . 13,553

Deferred Charges (Issuance Costs) . . . . . . . 1,575

Leased Assets

In a lease agreement, the owner of property, the lessor, conveys to another party, the lessee, the right to use property, plant, or equipment for a stated period of time. Leases are a form of lessee financing. For many leases, this period of time is short relative to the total life of the asset. Agencies lease—or rent, which is another term for lease— automobiles for a few hours or days, and space in an office building may be leased on an annual basis. These leases are called operating leases. The lease payments are ex- penses of the accounting period to which they apply. The entry to record a period’s operating lease payments of, say, $10,000 is thus

Rental Expense . . . . . . . . . . . . . . . . . . . . . 10,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Refunding a Bond Issue

Example

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Other leases cover a period of time that is substantially equal to the estimated life of the asset, or they contain other provisions that give the lessee almost as many rights to the use of the asset as if the lessee owned it. Such leases are called capital leases or financial leases. Assets acquired under a capital lease are treated as if they had been purchased. The lease obligation is a liability, which is treated in the same manner as long-term debt.

The Financial Accounting Standards Board (FASB) has ruled that a lease is a capital lease if one of the following criteria are met: (1) Ownership is transferred to the lessee at the end of the term of the lease, (2) the lessee has an option to purchase the asset at a “bargain” price, (3) the term of the lease is 75 percent or more of the economic life of the asset, or (4) the present value of the lease payments is 90 percent or more of the fair value of the property (subject to certain detailed adjustments).12 The idea of these criteria is to establish the substance (as opposed to the form) of the lease transaction. Even if only one of the four criteria is met, the transaction is viewed in substance as a sale of the asset to the lessee, with the lessor acting both as a seller of assets and as a finance company. In sum, a capital lease is, in effect, just another name for an asset purchase financial an installment loan.

The lease payments in a capital lease are usually set so that over the life of the lease the lessor will recover (1) the cost of the asset and (2) interest and a profit on the lessor’s capital that is tied up in the asset. The amount debited as the cost of the asset acquired with a capital lease, and the offsetting liability for lease payments, is the smaller of (1) the fair value of the asset or (2) the present value of the stream of mini- mum lease payments required by the lease agreement. Fair value means the cash price that the acquirer of the leased item would have to pay for it if the seller were not pro- viding financing to the acquirer in the form of a lease. The method of calculating the present value of the lease payments is described in the appendix to the chapter. These two amounts are approximately the same in most lease transactions.

The asset amount is depreciated just as would be any item of plant or equipment owned by the organization.13 When lease payments are made to the lessor, part of the payment reduces the liability, and the remainder is interest expense of the period.

A company leases an item of equipment whose useful life is 10 years. Lease payments are $1,558 per year payable at the end of each of the next 10 years. This is a capital lease because the lease term exceeds 75 percent of the asset’s life. The fair value of the equipment is $10,000 (as is the present value of the lease payments). When the equipment is acquired, the entry is

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Capital Lease Obligations . . . . . . . . . . . . . . . 10,000

Assume that the first annual lease payment consists of $900 of interest expense and $658 to reduce the liability. The entry for this payment is as follows:

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . 900

Capital Lease Obligations . . . . . . . . . . . . . . . . . 658

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,558

Also, depreciation on the asset would be charged as an expense each year, just as if the en- tity had bought the asset for cash. Assuming the straight-line method is used, the entry is

Depreciation Expense . . . . . . . . . . . . . . . . . . . . 1,000

Accumulated Depreciation . . . . . . . . . . . . . . 1,000

230 Part 1 Financial Accounting

Capital Leases

12 “Accounting for Leases,” FASB Statement No. 13. 13 If the lease agreement includes an automatic ownership transfer of the leased property to the lesee at the end of the lease or a bargain purchase provision, the lesee depreciates the leased asset over its useful life, otherwise the leased asset is depreciated over the leased term.

Example

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Chapter 8 Sources of Capital: Debt 231

14 “Leases,” IAS No. 17.

At the end of the 10 years, all of the $10,000 asset cost will have been charged to ex- pense via the depreciation mechanism. Also, the capital lease obligation will have been re- duced to zero, and the annual interest expense will have been recognized in each of the 10 years via entries such as the one shown above. Note that once the leased item is acquired and the initial equipment asset and lease obligation liability entry is made, accounting for the leased asset and for the lease obligation are separate, unrelated processes.

Most assets of an entity are legally owned by that entity. Assets acquired by a capi- tal lease are an exception to this general rule. They are legally owned by the lessor, but they are accounted for as if they were owned by the lessee. In this way, the lease obli- gation, which is in substance a long-term loan, is disclosed as a liability.

IFRS refers to “finance leases” and “operating leases,” finance leases are similiar what the FASB refers to as “capital leases.” Under IFRS, a lease agreement that trans- fers substantially all the risks and rewards incidental to ownership of an asset to the lessee is classified as a “finance lease.” The above lease accounting entry discussion applies equally to finance and operating leases.14

A sale and leaseback is a financing transaction whereby the owner of the property sells it and simultaneously leases it back from the buyer. Any losses on the sale are recog- nized in income immediately. Gains on the sale are deferred and in most cases are rec- ognized over the life of the lease.

Other Liabilities

This chapter thus far has focused on debt capital—long-term loans, bonds, and leases. For completeness, two other liabilities will be discussed briefly.

As explained in Chapter 2, current liabilities are obligations that are expected to be sat- isfied either by the use of current assets (usually by cash) or by the creation of other current liabilities within one year or less. The largest current liability for most entities is accounts payable (i.e., amounts owed to suppliers of goods and services). These amounts are recorded based on an invoice (i.e., a bill) from the supplier of the goods or services. Entries to other current liability accounts usually arise from adjusting entries; accrued wages payable, accrued interest payable, and estimated taxes payable are ex- amples that have previously been described.

Another liability section item of significant size for many corporations is deferred in- come taxes. This is a complicated topic and its mechanics are described in Chapter 10. Suffice it to say here that deferred taxes arise when a company uses different ac- counting methods in preparing its corporate income tax return than is used in prepar- ing its financial statements for shareholder reporting purposes. For example, most corporations use straight-line depreciation over an asset’s useful life for shareholder reporting but use the tax law’s accelerated cost recovery provisions for income tax reporting.

Analysis of Capital Structure

The relative amount of a company’s capital that was obtained from various sources is a matter of great importance in analyzing the soundness of the company’s financial

Sale and Leaseback

Current Liabilities

Deferred Taxes

Debt Ratios

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position. In illustrating the ratios intended for this purpose, the following summary of the liabilities and owners’ equity side of a company’s balance sheet will be used:

$ Millions Percent

Current liabilities $1,600 23% Long-term liabilities 1,800 26 Shareholders’ equity 3,600 51______ _____ Total liabilities and owners’ equity $7,000 100%______ ___________ _____

Attention is often focused on the sources of invested capital (also called perma- nent capital): debt capital (long-term liabilities) and equity capital (owners’ equity). From the point of view of the company, debt capital is risky because if bondholders and other creditors are not paid promptly, they can take legal action to obtain payment. Such action can, in extreme cases, force the company into bankruptcy. Equity capital is much less risky to the company because shareholders receive dividends only at the discretion of the directors and the shareholders cannot force bankruptcy.15 Be- cause the shareholders have less certainty of receiving dividends than the bondholders have of receiving interest, investors usually are unwilling to invest in a company’s stock unless they see a reasonable expectation of making a higher return (dividends plus stock price appreciation) than they could obtain as bondholders. Investors would be unwilling to give up the relatively certain prospect of receiving 8 percent or 9 percent interest on bonds, unless the probable, but less certain, return on an equity investment were considerably higher, say, 12 percent or more.

Leverage From the company’s standpoint, the greater the proportion of its invested capital that is obtained from shareholders, the less worry the company has in meeting its fixed oblig- ations. But in return for this lessened worry, the company must expect to pay a higher overall cost of obtaining its capital. Conversely, the more funds that are obtained from bonds, the more the company can use debt funds obtained at relatively low cost in the hopes of earning more on these funds for the shareholders.

The relatively low cost of debt capital arises not only from the fact that investors typ- ically are willing to accept a lower return on bonds than on stocks but also because debt interest (including bond interest payments) is tax deductible to the corporation, whereas dividends are not. Assuming a 40 percent tax rate, for every $1 that a company pays out in interest, it receives a tax saving of $0.40. Thus, its net cost is only 60 percent of the stated interest rate. For example, debt capital obtained from a bond issue with a yield of 10 percent costs the company only about 6 percent. By contrast, if equity investors re- quire a return of 12 percent, the cost of obtaining equity capital is the full 12 percent.

Debt/Equity Ratio A company with a high proportion of long-term debt is said to be highly leveraged. The debt/equity ratio shows the balance that the management of a particular com- pany has struck between these forces of risk versus cost. This is often called simply the debt ratio. It may be calculated in several ways. Debt may be defined as total

232 Part 1 Financial Accounting

15 Note that risk is here viewed from the standpoint of the company. From the viewpoint of investors, the opposite situation prevails. Thus, bondholders have a relatively low risk of not receiving their payments, whereas stockholders have a relatively high risk. Based on this latter perspective, equity capital is called risk capital.

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Chapter 8 Sources of Capital: Debt 233

liabilities, as interest-bearing current liabilities plus noncurrent liabilities, or as only noncurrent liabilities. The user must always be careful to ascertain which method is used in a given situation. Including current liabilities, the debt/equity ratio for the illustrative company is

Total liabilities $3,400 Shareholders’ equity

� $3,600

� 94 percent

Excluding current liabilities, the ratio is

Long-term liabilities $1,800 Shareholders’ equity

� $3,600

� 50 percent

Debt/Capitalization Ratio The mix of debt and equity in the capital structure also may be expressed as the ratio of long-term debt to total invested capital (debt plus equity). This ratio is called the debt/capitalization ratio. For our illustrative company, it is the ratio of $1,800 to $5,400, or 33 percent. Note that this ratio is based on the same data as is the debt/equity ratio; it is just another way of expressing the relationship. (As an analogy, one can say that the female/male ratio in a class is 100 percent, or that females make up 50 percent of the total enrollment in the class.) The debt/capitalization ratio varies widely among industries but is less than 50 percent in the majority of industrial companies.

Another measure of a company’s financial soundness is the times interest earned, or interest coverage ratio. This is the relationship of a company’s income to its interest requirements. The numerator of this ratio is the company’s pretax income before sub- traction of interest expense. Assuming that for our illustrative company this amount was $1,000, and that interest expense was $200, the calculation is

Times interest earned � Pretax income before interest

� $1,000

� 5.0 times Interest expense $200

Organizations such as Standard & Poor’s and Moody’s provide ratings on bonds to indi- cate their probability of going into default. A number of factors are considered in rating a corporation’s bonds, including various financial ratios and evaluation of the prospects of the company’s industry and the company’s market position in that industry. The debt/capitalization ratio and interest coverage ratio are especially important. For ex- ample, the typical industrial company meriting Standard & Poor’s top “AAA” rating might have a debt/capitalization ratio in the preceding three years of about 22 percent and interest coverage of about 17 times. (Standard & Poor’s debt/capitalization ratio definition includes interest-bearing current liabilities, as well as long-term debt.) An AAA rating indicates a company’s capacity to pay interest and repay principal on time is extremely strong.

Times Interest Earned

Bond Ratings

Summary Liabilities and owners’ equity represents the sources of the funds that are invested in the firm’s assets. Liabilities and owners’ equity consists of current liabilities, other liabilities (primarily long-term debt), and owners’ equity. Current liabilities are distin- guished from other liabilities by their payment time horizon (one year or less). Liabil- ities are distinguished from owners’ equity by their nature as obligations to outside parties. Executory contracts are not liabilities (except for capital leases) because neither party

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has performed. Loss contingencies create liabilities only if it is probable that a liability has been incurred and the amount of loss can be reasonably estimated.

The liability arising from the issuance of bonds is shown at its face amount (par value), adjusted for any difference between this face amount and the amount of cash actually paid by investors for the bonds; this difference is recorded as bond premium or discount. Pre- mium or discount is amortized over the life of the issue using the interest method. This amortization plus the periodic cash interest payments equal the bonds’ interest expense of each period. No gain or loss results when a bond is redeemed at maturity, but early retire- ment will lead to such a gain or loss.

If a company has leased equipment but the lease is, in effect, a vehicle to finance the pur- chase of the equipment, then under GAAP this capital lease obligation is reported as a lia- bility. Similarly under IFRS, if the lease agreement transfers substantially all the risks and rewards incidental to ownership to the lease, the lease is classified as a finance lease and reported as a liability. In both cases an offsetting asset is recorded. Other liabilities include current liabilities and deferred income taxes.

Debt/equity ratios and interest coverage indicate the level of risk associated with the amount of a company’s debt capital.

Appendix

Present Value The concept of present value underlies the valuation of many liabilities. The concept is also applied in valuing many monetary assets (which is the nature of most of a bank’s assets). Related to these liability and asset valuations is the interest method, which is used to amortize discount, premium, and the principal amount of all long-term debt, including capital leases. Finally, the present value concept is used in analyzing propos- als to acquire new long-lived assets and to measure the fair value of impaired long- lived assets. These asset acquisition proposals are called capital investment decisions and are described in detail in Chapter 27.

Concept of Present Value

Many people have difficulty understanding the present value concept because it differs from what we were taught as children—that it is a good thing to put money into a piggy bank. We are congratulated when the bank is finally opened and the accumulated coins are counted. Children are taught that it is better to have a given amount of money in the future than to use that money today. More formally, children are taught that a dollar received at some future time is more valuable than a dollar received today.

Business managers think differently, however. They expect a dollar invested today to increase in amount as time passes, because they expect to earn a profit on that investment. It follows that an amount of money available for investment today is more valuable to the manager than an equal amount that will not be available until some future time. Money available today can be invested to earn still more money, whereas money not yet received obviously cannot be invested today. To the manager, therefore, the value of a given amount of money today—its present value—is more than the value of the same amount received at some future time.

234 Part 1 Financial Accounting

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Chapter 8 Sources of Capital: Debt 235

Compound Interest To make the idea of present value more concrete, consider first the idea of compound interest. Suppose we invest $1,000 in a savings account that pays interest of 5 percent compounded annually. (Interest is invariably stated at an annual rate; thus, “5 percent” means 5 percent per year.) Compounded annually means that the interest earned the first year is retained in the account and, along with the initial $1,000, earns interest in the sec- ond year, and so on for future years. If we make no withdrawals from this account, over time the account balance will grow as shown below:

Beginning-of-Year Interest End-of-Year Year Balance Earned* Balance

1 $1,000.00 $50.00 $1,050.00 2 1,050.00 52.50 1,102.50 3 1,102.50 55.13 1,157.63 4 1,157.63 57.88 1,215.51 5 1,215.51 60.78 1,276.29 � � � � � � � �

10 1,551.32 77.57 1,628.89

*Some amounts may appear to be off by 0.01, because the actual calculations were carried to four decimal places and then rounded.

Based on this table, one can make the following statement: “$1,000 invested today at 5 percent interest, compounded annually, will accumulate to $1,628.89 after 10 years.” An equivalent statement is that the future value of $1,000 invested for 10 years at 5 percent interest is $1,628.89.1

Rather than obtaining a future value (FV ) from a table, it can be calculated using the compound interest formula:

FV � p(1 � i)n

where

p � Principal (initial investment) i � Interest rate n � Number of periods

Thus, the future value of $1,000 invested at 5 percent for 10 years is given by

FV � $1,000(1 � 0.05)10 � $1,628.89

Discounting To arrive at present values, we reverse the future value concept. The reverse of interest compounding is called discounting. For example, if the future value of $1,000 at 5 percent

1 Interest may be compounded more frequently than once a year. Interest on savings accounts, for example, may be compounded quarterly, monthly, or even daily. In such a case, both the number of periods and the rate per period must be converted to the period used in compounding. For example, with quarterly compounding, the number of periods is 40 (i.e., 40 quarters in 10 years), and the in- terest rate per quarter would be 1.25 percent (5 percent � 4). Thus, the future value of $1,000 in- vested for 10 years at 5 percent compounded quarterly is $1,000(1.0125)40 � $1,643.62. The results of the formulas given in this chapter are available in published tables and are programmed into many handheld calculators and personal computers.

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interest for 10 years is $1,628.89, then we can also say that the present value of $1,628.89 discounted at 5 percent for 10 years is $1,000. The interest rate (5 percent in the example) in present value problems is commonly referred to as the discount rate. This illustration leads to a more formal def inition of present value:

The present value of an amount that is expected to be received at a specified time in the future is the amount that, if invested today at a designated rate of return, would cumulate to the specified amount.

Thus, assuming a 5 percent rate of return, the present value of $1,628.89 to be received 10 years hence is $1,000, because (as we have illustrated) if $1,000 were invested today at 5 percent, it would cumulate to $1,628.89 after 10 years.

Finding Present Values

The present value (PV ) of an amount p to be received n years hence, discounted at a rate of i, is given by the formula

p PV �

(1 � i )n

Appendix Table A (at the back of the book) is a table of present values that were derived from this formula. The amounts in such a table are expressed as the present value of $1 to be received some number of years hence, discounted at some rate. To find the present value of an amount other than $1, we multiply the amount by the appropriate present value factor from Table A.

To find the PV of $400 to be received 10 years hence, discounted at a rate of 8 percent, we first find the 10 year/8 percent factor from Table A, which is 0.463. Hence, the PV of $400 is $400 * 0.463 � $185.20. This means that $185.20 invested today at a return of 8 per- cent will accumulate to $400 by the end of 10 years.

Inspection of Table A reveals two basic points about present value:

1. Present value decreases as the number of years in the future in which the payment is to be received increases.

2. Present value decreases as the discount rate increases.

Present Value of a Series of Payments

In many business situations, the entity expects to receive a series of annual payments over a period of several years, rather than simply receiving a single amount at some future point. The present value of a series of payments is found by summing the present values of the in- dividual payments. Computational procedures generally assume that each payment in the series is to be received at the end of its respective period rather than in a continuous flow during the period.

Using a 10 percent discount rate, what is the present value of the following series of pay- ments: year 1, $1,000; year 2, $1,500; year 3, $2,000; and year 4, $2,500?

236 Part 1 Financial Accounting

Example

Example

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Chapter 8 Sources of Capital: Debt 237

Solution:

Discount Factor

Present Year Payment (Table A) Value

1 $1,000 0.909 $ 909 2 1,500 0.826 1,239 3 2,000 0.751 1,502 4 2,500 0.683 1,708______

Present value of the series $5,358____________

Equal Payments In many situations, such as the repayment of loans, the series of payments is comprised of equal amounts each period. (Technically, such a series of equal payments is called an annuity.) If the payments are $1,750 per year for four years, then the present value of the series discounted at 10 percent would be

Discount Present Year Payment Factor Value

1 $1,750 0.909 $1,591 2 1,750 0.826 1,446 3 1,750 0.751 1,314 4 1,750 0.683 1,195______

Present value of the series $5,546_____________

Rather than look up discount factors for each year in such a problem, one can use a table such as Appendix Table B (at the back of the book). In that table, the factor shown for four years at 10 percent is 3.170. This number is the same (except for rounding error) as the sum of the individual years’ factors in the previous example: 0.909, 0.826, 0.751, and 0.683; and 3.170 * $1,750 � $5,548. This example illustrates that each factor in Table B was obtained by cumulating the factors for the corresponding year and all preceding years in the same in- terest rate column of Table A. Thus, the present value of a level series can be found in one step using Table B.

The values in Table B also can be used to find the present value of a series of equal pay- ments between any two points in time. The procedure is to subtract the Table B factor for the year preceding the year of the first payment from the factor for the last year of payment.

What is the present value of $1,000 a year to be received in years 6 through 10, assuming a 12 percent discount rate?

Solution:

PV Factor Time Period (Table B)

Years 1–10 5.650 Years 1–5 3.605______ Difference (years 6–10) 2.045

PV � $1,000 * 2.045 � $2,045____________

Example

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Present Values and Liabilities

The amount shown on the balance sheet for a liability such as a loan is often thought of as being the amount the borrower must repay to satisfy the obligation. This is only partly true. Certainly, the borrowing entity must repay the amount borrowed, called the princi- pal in the case of a term loan or bond; and the amount shown on the balance sheet of the borrower is the amount of unpaid principal. However, the borrower’s future payments to satisfy the obligation far exceed the amount of unpaid principal because interest must be paid on the amount of outstanding principal over the life of the loan.

In many cases, the balance sheet liability is properly interpreted as meaning not the dol- lar amount of the principal but rather the present value of the series of future interest pay- ments plus the present value of the future principal payments.

Kinnear Company borrowed $25,000, with interest at 10 percent (i.e., $2,500) to be paid annually and the principal to be repaid in one lump sum at the end of five years. The bal- ance sheet liability would be reported as $25,000. This can be interpreted as the sum of the present values, as follows:

Present Value

Interest, $2,500 * 3.791 (Table B) $ 9,478 Principal, $25,000 * 0.621 (Table A) 15,525________

Total present value $25,003*________________

* Does not add exactly to $25,000 because of rounding.

If the annual repayments are of a constant amount, with each payment including both in- terest and a reduction of principal, Table B can be used to find the amount of these payments.

Kinnear Company borrowed $25,000 with interest at 10 percent to be repaid in equal an- nual amounts at the end of each of the next five years. The present value of this obligation is $25,000. The amount of the annual installments is $6,595. It is found by dividing $25,000 by the 5 year/10 percent factor in Table B, which is 3.791.

Each payment of $6,595 in the above example consists of two components: (1) interest on the amount of principal outstanding during the year and (2) reduction of that principal. These two components of each payment can be calculated as shown in Illustration A8–1, which is called a loan amortization schedule.

238 Part 1 Financial Accounting

(a) (b) (c) (d) (e) Principal Owed Interest Portion Reduction Ending at Beginning Annual of Payment of Principal Principal

Year of Year Payment (a) * 10% (b) � (c) (a) � (d)

1 $25,000 $ 6,595 $2,500 $ 4,095 $20,905 2 20,905 6,595 2,090 4,505 16,400 3 16,400 6,595 1,640 4,955 11,445 4 11,445 6,595 1,145 5,450 5,995 5 5,995 6,595 600 5,995 0_______ ______ _______ Totals $32,975 $7,975 $25,000

* Some numbers may appear to be off by 1 owing to rounding.

ILLUSTRATION A8–1 Loan Amortization Schedule*

Example

Example

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Chapter 8 Sources of Capital: Debt 239

Column c of the schedule shows how much interest expense on this loan Kinnear Com- pany should recognize each year. Column e shows the proper balance sheet valuation of the loan liability as of the end of each year (or, equivalently, as of the beginning of the next year, as shown in column a). The amounts in columns c and d represent the only conceptu- ally correct way to divide each year’s payment between interest expense and principal reduction (amortization). This approach is called the compound interest method (or effective interest method or simply interest method) of debt amortization.

Note how the amounts in column c decrease over time, whereas the amounts in column d increase. Someone not familiar with the compound interest method might assume that each year’s $6,595 payment reflects a principal reduction of $5,000 ($25,000 � 5 years) and inter- est expense of $1,595 ($6,595 � $5,000). Such an assumption is incorrect.

Note also that the compound interest method amounts are calculated such that the inter- est expense is always a constant percentage of the principal outstanding during the year (10 percent in the illustration). This means that Kinnear Company’s interest expense on this loan is a true 10 percent in every year the loan is outstanding and that the true interest rate on the loan over its entire life is 10 percent. This is the same principle mentioned in the chapter text in the illustration of bond discount amortization. The interest expense, the sum of the cash interest costs and the discount amortization on Mason Corporation’s 10 percent bonds issued for $851, will be a constant rate (12 percent) of the book value of the bonds for each of the 20 years they are outstanding, provided that the initial discount is amortized using the compound interest method.

Present Values and Assets

Accounting for interest-bearing receivables and similar monetary assets is the mirror image of accounting for monetary liabilities. For example, in the Kinnear Company loan illustra- tion above, column c in Illustration A8–1 shows how much interest revenue Kinnear’s lender should report each year on this loan. Similarly, column e shows the proper year-end valuation of the loan receivable asset on the lender’s balance sheet. We can therefore con- clude that the amount shown for a loan receivable or similar monetary asset is the present value of the future payments the asset holder will receive in satisfaction of the credit the asset holder has extended to the borrower (Kinnear Company in the illustration).

Calculating Bond Yields

The yield on a bond is the rate of return that the bondholder earns as a result of investing in the bond. The investor’s return is made up of two parts: (1) the bond’s interest payments and (2) any difference between what the investor paid for the bond and the proceeds she or he receives upon selling the bond. This difference is referred to as the investor’s capital gain or loss on the bond. Both the interest stream and future proceeds must be adjusted to present values to be comparable with the current market price.

Current Yield

The yield to maturity on a bond (described below) should not be confused with the current yield, which is the annual interest payment divided by the current price.

If at a given point in time Mason Corporation’s 10 percent bonds were selling on a bond market at a price of 94 (i.e., $940), then the current yield at that time would be $100 � $940 � 10.6 percent.

Example

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Yield to Maturity

The yield on a bond actually is investor-specific because the capital gain (or loss) portion of the yield depends on what a specific investor paid for the bond and how much he or she sells it for. Thus, in calculating a bond’s yield to maturity, it is assumed that (1) the bond will be purchased at the current market price and (2) the bond will then be held until matu- rity. Also, income tax effects are ignored in calculating bond yields. The yield to maturity of a bond is the discount rate that will make the sum of (1) the present value of the series of future interest payments plus (2) the present value of the bond redemption proceeds equal to the current market price of the bond.

Exactly 10 years before their maturity, Mason Corporation 10 percent bonds have a market price of $887. Mason makes the $100 per year interest payments in a lump sum at year-end. The yield to maturity is the discount rate that will make the present value of the 10-year series of future $100 annual interest payments plus the present value of the $1,000 bond re- demption proceeds 10 years hence equal to the bond’s current market price of $887. This rate is 12 percent, which can be demonstrated as follows:

PV of interest stream ($100 * 5.650*) $565 PV of redemption proceeds ($1,000 * 0.322*) 322_____

Sum of PVs (market price) $887__________

* Ten-year/12 percent factors from Tables B and A, respectively.

This 12 percent yield to maturity is also called the effective rate of interest on the bond. The calculation of yield to maturity can be a fairly cumbersome trial-and-error pro-

cedure if present value tables are used. This procedure is programmed into personal com- puters and relatively inexpensive business calculators, which can find the yield in a few seconds.

Bond Prices

A similar calculation can be used to determine the “rational” market price of a bond, given current yields on bonds of similar quality (or risk).

When Mason’s 20-year, 10 percent bonds were issued, the prevailing market interest rate (yield) of similar bonds was 12 percent. The market price of Mason’s bonds should be the price that would result in a yield of 12 percent to a Mason bondholder. This price will be the present value of the 20-year interest stream and the proceeds at maturity (20 years hence):

PV of interest stream ($100 * 7.469*) $747 PV of redemption proceeds ($1,000 * 0.104*) 104_____

Market price for 12% yield $851__________

* Twenty-year/12 percent factors from Tables B and A, respectively.

This $851 is the amount that was given in the text in the Mason Corporation example of 10 percent bonds that were issued at a discount because the prevailing market rate for com- parable bonds was 12 percent.

240 Part 1 Financial Accounting

Example

Example

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Chapter 8 Sources of Capital: Debt 241

Note: The problems may require the use of the present value tables found in the text- book appendix. Handheld calculators may yield slightly different results due to the rounding of factors used in the tables.

Problem 8–1. As a manager in charge of information processing for a fast-growing company, you realize that your current computer will only serve your needs for the next six years. At that time, you will replace it with a more efficient model, which at that time will cost an estimated $750,000. If the anticipated rate of interest is 8 percent for the next six years, how much money should you place in a special investment fund today so that you will have a balance of $750,000 six years from now? (Assume annual compounding and ignore taxes.)

Problem 8–2. In 2010, a compact disc costs $14. If the price of CDs continues to increase at an annual compound rate of 4 percent, how much will a disc cost in 10 years? 25 years? 50 years?

Problem 8–3. For each of the following situations, the present value concept should be applied:

1. Your wealthy aunt has just established a trust fund for you that will accumulate to a total of $100,000 in 12 years. Interest on the trust fund is compounded annually at an 8 per- cent interest rate. How much is in your trust fund today?

2. On January 1, you will purchase a new car. The automobile dealer will allow you to make increasing annual December 31 payments over the following four years. The amounts of these payments are $4,000; $4,500; $5,000; $6,000. On this same January 1, your mother will lend you just enough money to enable you to meet these payments. In- terest rates are expected to be 8 percent for the next five years. Assuming that you can earn annual compounding interest by depositing the loan from your mother in a bank, what is the minimum amount your mother must loan you to enable you to meet the car payments?

3. In settlement of a claim for your recently wrecked car, your insurance company will pay you either a lump sum today or three annual payments of $3,100 starting one year from now. Interest rates are expected to be 6 percent for the next five years. What is the least amount of money that you should be willing to accept today?

4. What is the present value of $3,000 a year to be received in years 3 through 11, assum- ing a 12 percent discount rate?

Problem 8–4. Clearwater Company borrowed $164,440 with interest at 12 percent to be repaid in equal annual amounts at the end of each of the next six years. Prepare a loan amortization sched- ule (i.e., schedule showing principal outstanding after each annual payment) for the repay- ment of this obligation. Round to the nearest whole dollar.

Problem 8–5. How would the following be disclosed on W&H Company’s financial statements? The balance sheet was dated December 31, 2010, and the financial statements were issued February 14, 2011.

1. The Internal Revenue Service has claimed that W&H Company owes $450,000 of addi- tional taxes for the first quarter of 2010; the claim was made in a suit filed on January 25, 2011. W&H Company’s tax adviser estimates that the actual amount that will be paid is between $270,000 and $318,000.

2. On January 15, 2011, a fire destroyed one of W&H Company’s warehouses. The ware- house had a net book value of $2,735,000 on the year-end balance sheet.

Problems

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3. During 2010, a lawsuit was filed against W&H Company that claimed $750,000 in puni- tive damages and $400,000 for personal injury, which the plaintiff alleges occurred when using one of W&H Company’s products. The suit was not settled as of December 31, 2011, but the company’s attorney is convinced insurance would pay 75 percent of any award.

4. In late December, 2010 several dissident shareholders had informed the company that they intended to sue the W&H board of directors for $5,000,000 because the board had rejected a merger offer proposed by a major supplier. The company has indemnified the directors; thus, any judgment against the directors would be paid by the company. W&H Company’s attorney felt any such suit would be without merit.

Problem 8–6. On April 1, 2008, the Texidor Company issued bonds with a face value of $250,000 for $260,000 cash. These bonds paid an annual interest of 8 percent. The interest was paid semiannually on April 1 and October 1. The bonds were to be repaid on April 1, 2018. Record the entries that should be made on the following dates: April 1, 2008; October 1, 2008; December 31, 2008; and April 1, 2009. (Assume for simplicity that the bond pre- mium is to be amortized on a straight-line basis.)

Problem 8–7. During the year, Shor Company issued several series of bonds. For each bond, record the journal entry that must be made upon the issuance date. (Round to the nearest dollar; a cal- culator is needed for 2 and 3.)

1. On March 15, a 20-year, $5,000 par value bond series with annual interest of 9 percent was issued. Three thousand of these bonds were issued at a price of 98. Interest is paid semiannually.

2. On January 20, a series of 15-year, $1,000 par value bonds with annual interest of 8 per- cent was issued at a price giving a current yield to maturity of 6.5 percent. Issuance costs for the 7,000 bonds issued were $250,000. Interest is paid annually.

3. On October 31, a 10-year, $1,000 par value bond series with annual interest of 7 percent was issued at a price to give a current yield to maturity of 8 percent. Interest on the 5,000 bonds issued is paid semiannually.

Problem 8–8. On January 1, 2008, the Evans Company issued callable bonds with a face value of $5,000,000 for $4,750,000 cash. These bonds paid an annual interest of 10 percent payable semiannually on January 2 and July 1. The bonds were to be repaid on January 1, 2018. On January 1, 2013, the bonds were called and redeemed for $5,250,000. Make the journal entries for January 1, 2008, and January 1, 2013. (Assume that the bond discount was being written off on a straight-line basis. Ignore bond issuance and reacquisition costs.)

Problem 8–9. On January 1, 1982, Jackson Corporation issued 4,000 bonds with face value of $1,000 each and a coupon rate of 5 percent. The bonds were purchased by investors at a price of $1,030. Jackson incurred costs of $80,000 in issuing the bonds. On January 1, 2002, which was five years prior to the bond’s maturity date, Jackson redeemed the bonds at a call price of $1,080. Jackson also spent $75,000 in calling the bonds. What accounting entries should Jackson make to reflect this early redemption? (Assume that the bond premium was being written off on a straight-line basis.)

242 Part 1 Financial Accounting

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Until 2010, Norman Corporation, a young manufac- turer of specialty consumer products, had not had its fi- nancial statements audited. It had, however, relied on the auditing firm of Kline & Burrows to prepare its in- come tax returns. Because it was considering borrow- ing on a long-term note and the lender surely would require audited statements, Norman decided to have its 2010 financial statements attested by Kline & Burrows.

Kline & Burrows assigned Jennifer Warshaw to do preliminary work on the engagement, under the direc- tion of Allen Burrows. Norman’s financial vice presi- dent had prepared the preliminary financial statements shown in Exhibit 1. In examining the information on which these financial statements were based, Ms. Warshaw discovered the facts listed below. She referred these to Mr. Burrows.

1. In 2010 a group of female employees sued the com- pany, asserting that their salaries were unjustifiably lower than salaries of men doing comparable work. They asked for back pay of $250,000. A large num- ber of similar suits had been filed in other compa- nies, but results were extremely varied. Norman’s outside counsel thought that the company probably would win the suit but pointed out that the deci- sions thus far were divided, and it was difficult to forecast the outcome. In any event, it was unlikely that the suit would come to trial in 2011. No provi- sion for this loss had been made in the financial statements.

2. The company had a second lawsuit outstanding. It in- volved a customer who was injured by one of the com- pany’s products. The customer asked for $500,000 damages. Based on discussions with the customer’s attorney, Norman’s attorney believed that the suit probably could be settled for $50,000. There was no guarantee of this, of course. On the other hand, if the suit went to trial, Norman might win it. Norman did not carry product liability insurance. Norman re- ported $50,000 as a Reserve for Contingencies, with a corresponding debit to Retained Earnings.

Cases

Case 8–1

Norman Corporation (A)* 3. In 2010 plant maintenance expenditures were

$44,000. Normally, plant maintenance expense was about $60,000 a year, and $60,000 had indeed been budgeted for 2010. Management decided, however, to economize in 2010, even though it was recognized that the amount would probably have to be made up in future years. In view of this, the estimated income statement included an item of $60,000 for plant main- tenance expense, with an offsetting credit of $16,000 to a reserve account included as a noncurrent liability.

4. In early January 2010 the company issued a 5 percent $100,000 bond to one of its stockholders in return for $80,000 cash. The discount of $20,000 arose because the 5 percent interest rate was below the going inter- est rate at the time; the stockholder thought that this arrangement provided a personal income tax advan- tage as compared with an $80,000 bond at the market rate of interest. The company included the $20,000 discount as one of the components of the asset “other deferred charges” on the balance sheet and included the $100,000 as a noncurrent liability. When ques- tioned about this treatment, the financial vice presi- dent said, “I know that other companies may record such a transaction differently, but after all we do owe $100,000. And anyway, what does it matter where the discount appears?”

5. The $20,000 bond discount was reduced by $784 in 2010, and Ms. Warshaw calculated that this was the correct amount of amortization. However, the $784 was included as an item of nonoperating expense on the income statement, rather than being charged directly to Retained Earnings.

6. In connection with the issuance of the $100,000 bond, the company had incurred legal fees amount- ing to $500. These costs were included in nonoper- ating expenses in the income statement because, according to the financial vice president, “issuing bonds is an unusual financial transaction for us, not a routine operating transaction.”

7. On January 2, 2010, the company had leased a new Lincoln Town Car, valued at $35,000, to be used for various official company purposes. After three years* Copyright © Professor Robert N. Anthony.

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of $13,581 annual year-end lease payments, title to the car would pass to Norman, which expected to use the car through at least year-end 2014. The $13,581 lease payment for 2010 was included in operating expenses in the income statement.

244 Part 1 Financial Accounting

Although Mr. Burrows recognized that some of these transactions might affect the provision for in- come taxes, he decided not to consider the possible tax implications until after he had thought through the appropriate financial accounting treatment.

EXHIBIT 1

NORMAN CORPORATION Proposed Income Statement (condensed)

For the Year 2010

Net sales $1,658,130

Cost of sales 1,071,690__________ Gross margin 586,440

Operating expenses 329,100__________ Operating income 257,340

Nonoperating income and expense (net) 9,360__________ Pretax income 247,980

Provision for income taxes 99,300__________ Net income $ 148,680____________________

Proposed Balance Sheet (condensed) As of December 31, 2010

Assets

Current assets:

Cash and short-term investments $ 107,026

Accounts receivable, gross $262,904

Less: Allowance for doubtful accounts 5,250 257,654_________ Inventories 376,006

Prepaid expenses 10,814__________ Total current assets 751,500

Plant and equipment, at cost 310,996

Less: Accumulated depreciation 139,830 171,166_________ Goodwill 101,084

Development costs 124,648

Other deferred charges 166,878__________ Total assets $1,315,276____________________

Liabilities and Shareholders’ Equity

Current liabilities $ 421,770

Noncurrent liabilities 228,704__________ Total liabilities 650,474

Common stock (100,000 shares) 100,000

Capital surplus 82,500

Retained earnings 432,302

Reserve for contingencies 50,000__________ Total liabilities and shareholders’ equity $1,315,276____________________

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Questions

1. How should each of the above seven items be reported in the 2010 income statement and balance sheet?

2. (Optional—requires knowledge of appendix mater- ial.) The bond described in item 4 above has a 15-year maturity date. What is the yield rate to the

investor who paid $80,000 for this bond? Is the $784 discount amortization cited in item 5 indeed the correct first-year amount? (Assume that the $5,000 annual interest payment is made in a lump sum at year-end.)

3. (Optional) If the lease in item 7 is determined to be a capital lease, what is its effective interest rate?

Paul Murray would soon graduate from business school with his MBA. He had accepted a fine job offer. Paul’s wife, Nancy, was an attorney with a local firm specializing in corporate law. Paul and Nancy were ex- pecting their first child a few months after Paul’s grad- uation. With the experience of paying for their own graduate educations fresh in their minds, Paul and Nancy recognized that they would have to plan early to accumulate enough money to send their child through four years of college.

Paul wanted to accumulate a fund equal to four times the first year’s tuition, room, and board by the time his child entered college. Paul and Nancy as- sumed that these fees might increase, perhaps annu- ally, through the four years of college. However, if they invested the funds appropriately, the investments would yield enough to cover the increase in fees through the four years of college.

Ideally, Paul and Nancy wanted their child to be able to choose among an array of public or private col- leges with good academic reputations. A recent news- paper article had indicated that the average tuition, room, and board at private four-year institutions was

about $15,000. They felt that if their child were enter- ing college this coming fall, $18,000 per year for tu- ition, room, and board would provide the range of choice they sought.

Questions

1. In the recent past, college fees had been increasing at about 8 percent per year. Because this rate of in- crease exceeded the general inflation rate, Paul and Nancy felt it would decline to a level closer to measures of general inflation, such as the Con- sumer Price Index. Thus, they decided to assume that college fees would increase 6 percent per year. At this rate, how much will one year of college cost 18 years from this fall?

2. Assume the Murrays want to accumulate a fund equal to four times the first year’s tuition by the end of year 18. Assume further that they make a single payment into this fund at the end of each year, in- cluding the 18th year. How much would they have to contribute to this fund each year, assuming that their investments earn 6 percent per year?

3. How would their annual contributions differ if their investments earned 8 percent? 10 percent? 4 percent?

Case 8–2

Paul Murray*

* Copyright © Professor Robert N. Anthony.

Case 8–3

Joan Holtz (D)* Having recently studied liabilities and the concept of present value, Joan Holtz was interested in discussing with the accounting professor several matters that had recently come to Joan’s attention in the newspaper

and on television. Each of these matters is described below.

1. On a 2010 late-night talk show, a guest described hav- ing found a bond in the attic of his home in a small Missouri town. The bond had been issued in 1883 by the town, apparently to finance a municipal water* Copyright © Professor Robert N. Anthony.

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246 Part 1 Financial Accounting

system. The bond was payable to the bearer (whoever happened to have the bond in his or her possession), rather than to a specifically named individual. The face amount of the bond was $100, and the stated in- terest rate was 10 percent. According to the terms of the bond, it could be redeemed at any future time of the bearer’s choosing for its face value plus accumu- lated compound interest. Joan was anxious to discuss the terms of the bond with has professor and to use her calculator to determine what this bond was worth because only the amount “several million dollars” was mentioned during the show.

2. Joan also had read about “zero-coupon” bonds, which are bonds that pay no interest. Therefore, they are offered at a substantial discount from par value, since the investor’s entire return is the differ- ence between the discounted offering price and the par value. In particular, Joan had read that one com- pany had issued eight-year, zero-coupon bonds at a price of $327 per $1,000 par value. Joan wanted to discuss the following with the accounting profes- sor: (a) Was the yield on these bonds 15 percent, as Joan had calculated? (b) Assuming that bond dis- count amortization is tax deductible by the issuing corporation, that the issuer has a 40 percent income tax rate, and that for tax purposes a straight-line amortization of original discount is permissible, what is the effective or “true” after-tax interest rate to the issuer of this bond? And (c) if, instead of is- suing these zero-coupon bonds, the company had issued 15 percent coupon bonds with issue pro- ceeds of $1,000 per bond (i.e., par value), what would the issuer’s effective after-tax interest rate have been on these alternative bonds?

3. Joan also had read about a new financing gimmick called a “debt-for-equity swap.” The technique works as follows: A company’s bonds are currently trading on the New York Bond Exchange at a sizable discount because their coupon rate is well below current mar- ket interest rates. The company arranges with an in- vestment banking firm to buy up these bonds on the open market. The company then issues new shares of common stock to the investment banker in exchange for the bonds (which are then retired). The shares issued have a value about 4 percent higher than the amount the investment banker has spent acquiring the bonds. Finally, the investment banker sells these shares on the open market, realizing the 4 percent profit. According to the article Joan had read, Exxon

Corporation had swapped 1.4 million common shares valued at $43 million for bonds with a face value of $72 million, thereby realizing a tax-free gain of $29 million. Joan wondered two things about such a trans- action: (a) Why doesn’t the company issue the shares directly and use the proceeds to buy back the bonds on the open market, instead of using an investment banker as an intermediary? And (b) should the gain on such a swap be treated as income for financial re- porting purposes since, in a sense, the company has done nothing of substance to earn it?

4. Joan was aware that major airlines had “frequent flyer” plans, through which a traveler could earn upgrades from coach to first class, or tickets for free travel. Joan wondered how the airlines should ac- count for upgrade and free travel coupons that had been issued to travelers but had not as yet been re- deemed. Were they a liability? If so, how would the amount be determined, and what would be the off- setting debit?

5. Joan had noticed that many retailers, especially those dealing in high-ticket consumer goods like stereos, computers, and VCRs, offered to sell cus- tomers extended warranty contracts when they pur- chased the product. Joan had heard that retailers earned a much higher margin on an extended war- ranty contract than on the product it covered. For example, for a projection TV that cost $2,000, the customer might be offered the option to purchase a three-year warranty contract for $180. The margin on the projection TV might be 8 percent, or $160; the margin on the extended warranty contract might be 75 percent, or $135. Hence, when a customer purchased both the projection TV and the warranty, the margin on the total purchase was $295 or 13.5 percent. The proportion of customers purchasing extended warranty contracts depended on the prod- uct but, because consumers wanted to protect their investment in high-ticket items, the vast majority purchased extended warranty contracts, and the proportion was very predictable.

Joan wondered how to account for this combined purchase. One alternative, which she called Alterna- tive A, was to treat the purchase of the projection TV and the purchase of the warranty contract completely separately. For the projection TV, revenue of $2,000 and cost of goods sold of $1,840 would be recognized immediately. For the three-year warranty, the payment

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received would be treated as deferred revenue, and one-third of the revenue ($60) and one-third of the cost of the service ($15) would be recognized each year for three years. Under this alternative, the accounting would reflect the immediate sale of a low-margin product followed by three years’ sale of a high-margin service.

Joan was not satisfied with this alternative. She fig- ured that the purchase of the projection TV and the ser- vice contract was really a single purchase, not two sep- arate purchases, and thus the margin earned on the sale was really the 13.5 percent combined margin. Using this reasoning, Joan saw two alternative ways to treat the sale. First, all of the revenue from the sale of the projection TV and the three-year warranty ($2,180) as well as all of the cost associated with both ($1,885 � $1,840 � $45) could be recognized immediately (Alternative B). Retailers had reasonably accurate in- formation regarding historical service costs to predict the $45 future service cost. However, if actual service costs differed from those estimated, a subsequent ad- justment could be made.

Another approach (Alternative C) was to defer recognition of some proportion of the revenue until the

warranty period expired. The proportion of the rev- enue to be recognized immediately would depend on the proportion of the costs associated with the product versus the proportion associated with the service con- tract. In this example, $1,840 � $1,885 � 97.6 percent of the revenue (or $2,128) would be recognized imme- diately, with a cost of goods sold of $1,840, and a margin of 13.5 percent; similarly, $45 � $1,885 � 2.4 percent of the revenue (or $52) would be deferred and recognized over the three-year life of the service con- tract, with an associated cost of $15 per year and a margin of 13.5 percent.

Joan wondered from the point of view of manage- ment which alternative provided the most appropriate representation of the profitability of extended war- ranties. She also wondered how the different choices would affect both the balance sheet and the income statement.

Question

Answer the questions raised by Joan Holtz on each of the five issues on her list.

Case 8–4

Leasing Computers at Persistent Learning* Persistent Learning, an early-stage educational soft- ware company, was in the midst of making the largest equipment investment decision in its history. Persis- tent Learning was finally starting to see significant orders for its newly expanded product line, but it was clear that the company’s aging computer systems would not be able to support the increased demand. The entire management team agreed that new systems and more machines were needed. The big decision now was whether to do a “one-dollar-purchase” lease, essentially providing financing for a purchase, or a “fair-market-value” lease, which would be more like a rental agreement. Persistent Learning was under the watchful eye of analysts and customers concerned over its profitability and staying power. The perceptions of its financial performance had suddenly become

extremely important to the company. As a newly pub- lic company, Persistent Learning was faced with not only its biggest single investment decision but also its first major financial reporting and investor relations decision.

Priya Gupta was convinced the financial reporting consequences of Persistent Learning Corporation’s new-computer lease decision would be significant. If she was going to convince the management team, however, she needed to prepare a complete analysis of the effects for their next meeting.

Industry

According to the National Center for Education Statis- tics, there were 123,385 public and private elementary and secondary schools in the U.S. for the 2001–2002 academic year, with the number of schools slowly climbing. Roughly 25% of those schools, enrolling

* Copyright © 2007 President and Fellows of Harvard College. Harvard Business School Case 108–014.

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roughly 10% of K-12 students, were private, meaning that they were funded and run independently of the government. The remaining 75% of the schools were public schools run by government education agencies and publicly elected or appointed boards and funded by federal, state, and local governments.1 School en- rollment was expected to set new records every year from 2006 until 2014, the last year for which the Na- tional Center for Education Statistics had projected enrollment, with almost 55 million students enrolled in 2003 and a projected 56.7 million students for 2014.2 For the 2001–2002 school year, spending by public schools on instructional supplies topped $11 billion, and spending on purchased services was nearly $7 billion, with total per student spending ex- pected to increase in coming years.3 In addition, schools spent heavily on computers, and by the fall of 2002, 99% of public schools had Internet access. Na- tionwide, there was a computer with Internet access for every 4.8 students, and schools were increasingly incorporating computer-based learning. Persistent Learning’s competitors estimated the U.S. public school market for educational software at roughly $600 million–$800 million per year, with continued growth expected for the future.4

Due to the academic year and budgeting cycle, most software purchase decisions were made near the beginning and end of the academic year. This resulted in a high level of cyclicity for order placement and cash collections, with few sales made in December, January, and February. Both the cyclicity and the approval process for large purchases also created extremely long and unpredictable sales cycles for the industry, with companies having to pursue a sale for several months, and sometimes over a year, before any orders were placed.

The industry was marked by diverse competition. Pearson Digital Learning was one example of an edu- cational software division within a larger educational- service and-product company. Pearson’s parent company had over $7 billion in sales and over 30,000 employees. There were also several smaller private companies in the industry. The most comparable com- panies to Persistent Learning, being small and pub- licly traded, were Plato Learning, Scientific Learning Corporation, The American Education Corporation and Renaissance Learning, with sales ranging from less than $10 million to roughly $120 million and with employee counts ranging from round 60 to nearly 1,000.

Persistent Learning’s History

Persistent Learning designed, marketed, and sold edu- cational software and online tools for school students, focusing on computer-related topics such as typing and computer use for younger students and computer programming and Web-page design for more advanced students. Persistent Learning had started in 1998 when the founder, James Bogle, a computer pro- grammer, became frustrated that his children were spending hours at home playing video games on the computer but no time learning computer science top- ics. The company started with a simple program with interactive elements, extensive graphics use, and audio explanations to teach Web design. The first program was marketed to the founder’s local school district. While several companies had entered the educational software market for math, reading, and other core sub- jects, there was almost no competition for computer topics. Within this area the company was able to grow quickly, hiring additional programmers and educa- tional professionals for content development and quickly expanding the product line.

Persistent Learning soon developed a large set of proprietary knowledge for creating and running inter- active tools, lessons with game-like components, and cross-school project competitions. Its systems in- cluded tools to help parents and teachers track student progress. Preliminary data from these tracking tools and some additional research data suggested that Per- sistent Learning’s programs significantly increased student learning, primarily through increasing student involvement, motivation, and particularly the time stu- dents spent on the lessons outside of the classroom.

1 Martha Naomi Alt and Katharin Peter, Private Schools: A Brief Portrait, NCES 2002 1/N 2013, U.S. Department of Education, National Center for Education Statistics, Washington, DC, 2002. 2 The National Center for Education Statistics, a part of the U.S. Department of Education and the Institute of Education Sciences, provides summary statistics and detailed reports on its website, at http://nces.ed.gov. 3 Crecilla Cohen and Frank Johnson, Revenues and Expendi- tures for Public Elementary and Secondary Education: School Year 2001–02 (Washington, DC: U.S. Department of Educa- tion, National Center for Education Statistics, June 2004). 4 Plato Learning 2005 10-K, The American Education Corpo- ration 2005 10-K, Scientific Learning Corporation 2005 10-K.

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Knowing that the core subjects of math, reading, and writing were tied to much larger markets than com- puter topics, Persistent Learning began to slowly ex- pand into those core subject areas, using its unique platform and teaching methods.

During the initial growth period, Persistent Learn- ing financed its growth through venture capital (VC) funding. With the success of its early math and reading/ writing attempts, the company decided to launch a large-scale product-line expansion into these areas. To finance this new project, the company went to public equity markets, completing its initial public offering and listing on NASDAQ in 2004. With both the product- line expansion and its first large-scale nation-wide marketing push under way, the company expected dra- matic growth in the following few years. The company expected to maintain gross margin percentages at roughly the same levels, but with much higher vol- umes. In the short term, research and development as well as sales and marketing expenditures would in- crease disproportionately, but long term the company expected the rates as a percentage of sales to go down. The product-line expansion was expected to improve profit levels within a couple of years.

The Meeting

Both product development and sales and marketing were under high pressure to perform with the planned nationwide launch. Both groups were starting to expe- rience problems with their computer systems that were damaging productivity. The programmers and content developers relied on high-end desktops and test servers for their work, and sales staff needed high-end laptops for demonstrations. Finally, cross-country net- working and increased video content were both key selling points of the new edition, but both of these re- quired newer and faster servers and expanded storage space.

The management team met to discuss all three op- tions for the new computer acquisition: a cash pur- chase, a “fair-market-value” lease, or a “one-dollar- purchase” lease. They concluded the following:

• In order to maintain enough cash for operations, particularly given the new initiatives, the company would have to borrow the full $6.3 million for the computers, at an interest rate of 12%, if it chose to purchase them. While lease rates varied greatly, the leases Persistent Learning were considering

were a slightly cheaper form of financing than other forms of debt. This allowed management to rule out the cash-purchase option. (See Exhibit 1 for Persistent Learning’s 2006 financial state- ments and its most recent projections for 2007, assuming the company made a cash purchase for the new computers.)

• The cash outlay for the one-dollar-purchase lease was slightly higher than for the fair-market-value lease. The one-dollar-purchase lease gave the lessee (Persistent Learning) the option to purchase the computers at the end of the three-year lease term for one dollar each, far below the expected fair mar- ket value at the time. The fair-market-value lease, on the other hand, only allowed the lessee to pur- chase at the fair market value. Because the one- dollar-purchase lease contained this valuable op- tion, the monthly payments were higher. (See Exhibit 1 for the payment schedule for each option.)

• The company intended to use the computers for three years, however if they owned the computers at the end of three years they could sell them or decide to use them for a longer period, depending on conditions at that time.

• Both leases gave the lessee the option to upgrade computers at any time during the lease term, renewing the original three-year lease term from that point in time. The leases also made it easier to acquire additional machines. This flexibility would be valuable if Persistent Learning’s tech- nology needs grew faster than predicted.

• With either lease, the lessor would take responsi- bility for the machines at the end of the lease term if the lessee (Persistent Learning) chose not to purchase. This could save Persistent Learning from having to sell or dispose of the computers itself, a potentially costly and time-consuming process.

Based upon this discussion, the management team was able to rule out the cash purchase but was unable to decide between the fair-market-value and one-dollar- purchase-option leases. Gupta suggested another dimension they should consider:

We met today to discuss the economics of the two options. Since there’s no clear winner from that discussion, I believe we should also con- sider our financial reporting environment. We are a newly public firm, and the market is just

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250 Part 1 Financial Accounting

2007 2004 2005 2006 Projected

ASSETS Current Assets:

Cash and Cash Equivalents $23,319 $11,029 $ 2,616 $ 2,725 Accounts Receivable (net) 10,844 10,678 14,995 20,999 Inventories 1,445 1,362 1,786 2,500 Deferred Tax Asset 0 0 120 700 Prepaid Expenses and Other Current Assets 1,451 1,602 1,908 2,331________ ________ ________ ________ Total Current Assets $37,059 $24,670 $21,425 $29,255

Property and Equipment (net) 2,370 1,720 1,470 5,945________ ________ ________ ________ Deferred Tax Asset $ 6,351 $11,380 $13,193 $12,439

Total Assets $45,780 $37,770 $36,088 $47,638________ ________ ________ ________________ ________ ________ ________

LIABILITIES AND STOCKHOLDERS’ EQUITY Accounts Payable $ 1,219 $ 1,082 $ 1,080 $ 1,302 Accrued Liabilities 3,227 5,487 5,021 6,133 Deferred Revenue 6,888 6,400 8,661 12,125________ ________ ________ ________

Total Current Liabilities $11,335 $12,970 $14,762 $19,560 Long-term deferred revenue 223 189 268 375 Long-term debt 0 0 0 6,300________ ________ ________ ________

Total Liabilities $11,558 $13,158 $15,030 $26,235

Common Stock 2,100 2,100 2,100 2,100 Additional Paid-In Capital 44,100 44,100 44,100 44,100 Accumulated Deficit (11,978) (21,588) (25,141) (24,797)________ ________ ________ ________

Total Stockholders’ Equity $34,222 $24,612 $21,059 $21,403

Total Liabilities and Stockholders’ Equity $45,780 $37,770 $36,088 $47,638________ ________ ________ ________________ ________ ________ ________

EXHIBIT 1 Persistent Learning Financial Statements and Projections Balance Sheet as of December 31, 2006, and Projection for 2007 (in $ thousands)

getting to know us. This year is supposed to be our first positive earnings year and our first year with positive cash from operations. Those are both pretty significant milestones. Plus, even though we’ve forecasted taking on debt again this year, I imagine the market would be pretty happy if we could put that off by one year. All of this is particularly important considering that the VCs and some of out other early invertors are selling off their shares fairly aggressively, so the market is going to be particularly sensitive about our financials.

We made our forecasts assuming we would purchase the machines. And we used the deprecia- tion method that seems most appropriate given our experience with computer assets: straight-line deprecation over three years and a residual value of $1.575 million. We gave earnings guidance based on these assumptions, and when we gave our earnings guidance, we told the market to expect $0.06 per share. But now with the leases, I don’t know what the numbers will look like.

Finally, I checked their financial statement foot- notes, and Scientific Learning, Plato Learning, and

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Chapter 8 Sources of Capital: Debt 251

Renaissance Learning all own their machines5, so the industry analysts and the investors aren’t used to seeing leases in the financials. I’m not sure in- vestors will understand the effect of the leases on our numbers. Basically, I’m concerned about in- vestors thinking that we’ve missed our numbers when it’s just an accounting issue.

Ultimately the group agreed that they needed to figure out exactly what these alternatives would do to their financial statements and how hard it would be for investors to understand. They would meet again the next day to discuss the ultimate decision. Gupta was put in charge of presenting what the financial state- ments would look like under the different options and reporting back to the rest of the management team.

Questions

1. Why has Persistent Learning’s management aban- doned the outright purchase of the equipment and is focusing on leasing the equipment?

2. Which leasing alternative would you choose? Why? (The earnings per share in 2007 will be 5¢ under the “fair market value” lease and under the “one- dollar purchase” lease.)

3. How would the company account for the “fair mar- ket value” lease and the “one-dollar purchase” lease for the computers in each of the three years? Please calculate the dollar amount of each of the journal entries (debits/credits). Assume that the leases are signed on January 1, 2007.

4. The Financial Accounting Standards Board (FASB) is currently reevaluating FASB Statement No. 13, “Accounting for Leases.” They have proposed elim- inating the distinction between capital and operat- ing leases and requiring all leases to be recorded as capital leases. What are the principal arguments for and against the current treatment?

Annually for Three Years At Signing/Purchase (end-of-year)

Fair-value lease $2,197.04 One-dollar-purchase lease 2,497.43 Purchase $6,300

Source: Casewriter.

EXHIBIT 1 Computer Lease or Purchase Pricing Computers to be leased: a combination of high-end laptops, desktops, servers, and storage machines, all with the appropriate peripherals.

These computers are expected to have an economic life of five years. Useful life to the company of purchased computers is currently expected to be three years, but may be extended depending on future conditions. The computers are expected to have a resale value at the end of three years of roughly $1.575 million, with the resale value declining as the computers age.

Effective Interest Rate: 12%

Payment Schedules ($ thousands)

5 Scientific Learning Corporation 2005 10-K, Plato Learning 2005 10-L, and Renaissance Learning 2005 10-K, all avail- able from the SEC Edgar database at http://www.sec.gov.

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252 Part 1 Financial Accounting

Case 8–5

Kim Park* Following her plan to explore interesting accounting questions with her study group, Kim Park prepared a set of short case studies dealing with the recognition and measurement of liabilities. Kim knew from her earlier study group discussions that her fellow students expected prior to the meeting she would prepare tenta- tive answers to the questions she raised. In addition, the study group had encouraged her to illustrate her tentative answers with numerical illustration using case data.

Prior Knowledge

Kim understood from the background readings assigned for her accounting course that Generally Accepted Accounting Principles (GAAP) defined liabilities as:

“[P]robable future sacrifices of economic benefits arising from present obligations of a particular en- tity to transfer assets or provide services to other entities in the future as a result of past transac- tions or events.”1

Kim also knew under International Financial Re- porting Standards liabilities were recognized in the balance sheet when

“[I]t is probable that an outflow of resources em- bodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.”2

Austral Electronics Company

Before Kim went to business school, she had a friend who worked for Austral Electronics Company (“Austral”). As

Kim recalled, during her friend’s time with the com- pany, it had issued a US $1Million equivalent local currency eight-year zero-coupon bond priced to yield 10 percent at maturity.3

Kim had three questions for her study group: How should Austral have accounted for its zero-coupon bond at the issue date? How should the company have ac- counted for the zero-coupon bond at the end of the first year following its issuance? At the end of the third year?

United Airlines, Inc.

Prompted by her observation that different airlines appear to account for their unredeemed frequent flier mileage obligations differently, Kim decided to ask her study group the question—how ought an airline account for its unredeemed frequent flier mile obligations.

To focus the study group discussion, Kim prepared a short description of United Airlines Inc.’s Mileage Plus program. United Airlines (“United”) through its frequent flier rewards program, Mileage Plus, re- warded frequent fliers with mileage credits that could be redeemed for free, discounted or upgraded travel, and non-travel awards. More than 54 million members were enrolled in the program.

United had considerable leeway in changing the Mileage Plus program’s expiration policy, program rules, and program redemption opportunities. For ex- ample, effective December 31, 2007, United an- nounced it was reducing the expiration period for in- active accounts from 36 months to 18 months.

A United subsidiary, UAL Loyalty Services admin- istered much of the Mileage Plus program along with a number of United’s non-core marketing businesses, such as United’s e-commerce activities.

* Copyright © 2009 President and Fellows of Harvard College. Harvard Business School case 110-018.

3 A zero-coupon security makes no periodic interest pay- ments but instead is sold at a deep discount from its face value (US$1 million in the case of the Austral Electronics zero-coupon bond). The buyer of such a bond received the specified rate of return by gradual appreciation of the security, which is redeemed at face value on a specified maturity date. (John Downes and John Elliot Goodman. Dictionary of Financial and Investment Terms. Barron’s Financial Guides).

1 Financial Accounting Standards Board, Statements of Financial Accounting Concepts No. 6, “Elements of Financial Statements.” 2 International Accounting Standards Board, “Framework for the Preparation and Presentation of Financial Statements.”

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At December 31, 2008, the outstanding Mileage Plus frequent flier miles was approximately 478.2 billion miles of which management estimated 362 billion miles would ultimately be redeemed based on certain mileage redemption and expiration pattern assump- tions.

Exhibit 1 presents selected 2008 United operating statistics.

Exhibit 2 shows United’s 2008 mainline operating expenses.

Intel Corporation4

While preparing a term paper on the development of Intel Corporation’s (Intel’s) Pentium chip for her tech- nology innovations course, Kim came across a major accounting issues Intel faced in 1994 when a flaw was

discovered in the company’s 500 Pentium-based PC’s microprocessor chip.5 Microprocessors are the “brains” of computers for both home and business use.

Kim had three questions for her study group: Should Intel have recorded a liability for the potential future costs associated with the chip’s flaw? If so, when should it have recorded the liability? What would be a reasonable estimate of the liability?

Flaw Discovered

Early in the summer of 1994 mathematics professor Dr. Thomas Nicely of Lynchburg College in Virginia discovered inconsistencies in his calculations per- formed on his Pentium-driven PC. Nicely was trying to prove that PCs could do mathematical work hereto- fore only performed on larger systems and thus was in- volved in intense and continuous number crunching far beyond that of a typical user. Nicely discovered the

5 As one example of the flaw, the solution to the following calculation, 4,195,835 – ((4,195,835 / 3,145,727)) � 3,145,727, should be zero, but a computer with a flawed Pentium chip provides an answer of 256. Walter A. Mossberg, “Intel Isn’t Serving Millions Who Bought Its Pentium Campaign,” The Wall Street Journal, December 15, 1994, p. 81.

Revenue passengers (millions) 63 Revenue passenger miles (“RPMs”)a 110,061 Available seat miles (“ASMs”)b 135,861 Passenger lead factorsc 81.0% Yieldd $13.89 Passenger revenue per ASMe $11.29 Operating revenue per ASMf $12.58 Operating expense per ASMg $15.74 Fuel gallons consumed 2,182 Average price per gallon of jet Fuel, 353.90¢

including tax and hedge impact

Source: United Airlines, Inc. 2008 From 10-K a RPMs are the number of miles flown by revenue passengers. (millions) b ASMs are the number of seats available for passengers multiplied by the number of miles those seats are flown. (millions) c Passenger load factor is derived by dividing RPMs by ASMs. d Yield is passenger revenue excluding industry and employee discounted fare per RPM. e PRASM is mainline passenger revenue per ASM. f RASM is operating revenues per ASM. g CASM is operating expenses per ASM.

EXHIBIT 1 United Airlines, Inc. Selected 2008 Mainline Operating Statistics

Aircraft fuel $7,722 Salaries and related costs 4,311 Regional affiliates 3,248 Purchased services 1,375 Aircraft maintenance materials

and outside repairs 1,096 Depreciation and amortization 932 Landing fees and other rent 862 Distribution expenses 710 Aircraft rent 409 Cost of third party sales 272 Goodwill impairment 2,277 Other impairments and 339

special items Other operating expenses 1,079________

Total operating expenses $24,632________________

Source: United Airlines, Inc. 2008 From 10-K

EXHIBIT 2 United Airlines, Inc. 2008 Operating Expenses (millions)

4 This case consists of selected excerpts from “Accounting for the Intel Pentium Chip Flaw” prepared by Professors Gregory S. Miller and V.G. Narayanan. Harvard Business School case 9-101-072.

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division flaw occurred only with rare combinations of numbers, and was not in his software, but in the processor of his Pentium.

The problem arose in the floating-point processing unit of the chip, which handled numbers expressed in scientific notation. At the end of October, Nicely pub- lished a note on the Internet querying other users about the Pentium flaw. A discussion soon emerged at the Internet news group “comp.sys.intel.” The tone quickly changed from a calm discussion of arcane technical tests to flaming accusations and threats aimed at Intel.

On November 7, 1994, an Electrical Engineering Times article by Alexander Wolfe, based on the Inter- net discussions, prompted Intel’s response that it had uncovered the flaw during tests the previous June. However, Intel had run a series of tests and concluded that an error would occur only once every nine billion random calculations, or every 27,000 years for most users. Further, Intel had remedied the problem for the next planned version of the Pentium, but had not in- formed customers who had purchased a flawed proces- sor. Following the article, Intel offered to replace the flawed chips, but only on a limited basis: users first had to demonstrate that the flaw was likely to occur in the work they performed on their computer. The Internet discussion group continued to “flame” the company on-line and eventually attracted the attention of re- porters. On November 22, 1994, CNN broadcasted a story that revealed the chip flaw for the first time to the general public, Intel’s own computer-making cus- tomers, and the rest of the media.

On November 24, the beginning of the Thanks- giving holiday weekend, the front-page of the New York Times Business Section headlined “Flaw undermines the accuracy of Intel’s Pentium.” The Boston Globe car- ried the same story on its front page, and the news con- tinued to unfold over the next month. By November 25 Intel’s stock had dropped two percentage points from its high in late September.

The mounting consumer pressure to fix the Pentium flaw was hitting PC manufacturers as well as Intel. But who would take responsibility for fixing the flaw? Dell, a computer manufacturer, began advertising its Pentium with a built-in computer fix to remedy the la- tent flaw. On November 28, Sequent, a mainframe manufacturer, stopped shipping Pentium machines until a software solution could be installed. On November 30, IBM—a major Intel customer— announced that it would replace the Pentium processor

254 Part 1 Financial Accounting

in any of its machines at the customer’s request. IBM, however, did not have Intel’s support to fulfill such a promise and ran the risk of having to purchase re- placements on its own account.

As the second week of December passed, the media coverage began to abate and Pentium flaw stores lost their front-page status. December Pentium sales con- tinued to increase as planned, but several thousand Pentium owners were calling Intel daily. Intel rallied over a thousand of its employees to respond to these calls and carefully assess whether the users were per- forming functions that would be at risk of engaging the flaw in the floating point unit.

On December 12, 1994, IBM, without prior notice to Intel, dropped a bomb by halting shipments of their Pentium PCs. News coverage and consumer fears re-ignited. IBM claimed that further testing had revealed the bug to be more common that Intel had reported. On certain spreadsheet programs, IBM re- searchers claimed the problematic number combina- tions were not random and occurred much more fre- quently. Calculations for a continuous 15 minutes per day could produce an error once every 24 days. Intel’s stock plummeted $2.50 within an hour of IBM’s announcement.

Cost of Replacement

Clearly, Intel was faced with the prospect of replacing some of the defective chips.

The actual cost of producing the replacement chip and the accompanying heat sinks (the devices that re- lease heat from operating chips) was estimated to be between $50 and $100 per chip. Other replacement costs, which included the actual labor and incidental costs, were estimated to range from $31 to $750 and average over $400 per chip replaced. The amount paid out by Intel depended on what method it used to im- plement the repair. Intel could pay for the entire cost of accessing the unit, the direct labor to replace the flawed chip, and any shipping or transportation costs incurred by customers. Alternatively, Intel could send the replacement chip to the customers, leaving them to decide how to replace the chip. Another possibility was to negotiate with computer manufacturers and sellers to offer discounted or free replacement service to end-user customers. In any case, the end user seek- ing replacement would have to bear some costs. One information technology consultancy estimated that

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“[t]he amount borne by companies in a typical sce- nario will be $289 per system, including administra- tive, labor, and downtime costs.

Other Potential Costs

Intel had other costs to account for as well. It had pro- duced almost eight million flawed chips, so in addition to the six million chips currently in computers it would need to account for the two million chips in inventory.

The potential of lawsuits from consumers, com- puter manufacturers, and shareholders loomed as an imminent threat. The Wall Street Journal reported that “at least 10 suits in three states” accusing Intel of se- curities fraud, false advertising, and violation of con- sumer protection laws, had been filed seeking “hun- dreds of millions of dollars in damages.” Some suits also looked to force Intel to replace the flawed chips. In addition, attorneys general of four states were in the process of filing suits against Intel on the grounds that the company violated unfair-trade-practices laws.

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9 Sources of Capital: Owners’ Equity

Chapter

This chapter continues our more detailed description of the liabilities and owners’ equity portion of the balance sheet. A company obtains its permanent capital (also called invested capital) from two sources: debt and equity. Debt capital consists principally of bonds and long-term loans, as discussed in Chapter 8. This chapter discusses equity capital, the capital supplied by the entity’s owners.

The chapter begins with a discussion of the characteristics of the several legal forms of business organizations—proprietorships, partnerships, and corporations. This is fol- lowed by a description of the accounting for owners’ equity in each form. The primary emphasis is on the ownership interests of a corporation as evidenced by its common and preferred stock. The next section deals with some financial instruments that blur the line between debt and equity. Equity in nonprofit organizations is discussed in the final section.

Forms of Business Organization

The three principal legal forms of business ownership are the sole proprietorship, the partnership, and the corporation.

A business entity owned by an individual is a sole proprietorship. This is a simple form for a business organization. Essentially all that one does to form a proprietorship is to begin selling goods or one’s services. There are no incorporation fees to pay, no special reports to file (except an additional schedule on the proprietor’s personal income tax return), and no co-owners with whom to disagree, to share liability for their actions, or to share the profits of the business. The profits of a proprietorship, whether withdrawn by the proprietor or retained in the firm, are taxed at the proprietor’s personal income tax rate, which may be lower than the corporate tax rate.

On the other hand, sole proprietorships cannot issue stock or bonds, so it is difficult for them to raise large amounts of capital. They can borrow money from banks or individuals, but they cannot obtain outside equity capital because, by definition, in- vestors who provide equity capital have an ownership interest. Moreover, the propri- etor is personally responsible for the entity’s debts. In the event of the firm’s failure,

Sole Proprietorship

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creditors have claims not only against the assets of the proprietorship but also against the personal assets of the proprietor.

A partnership is a business with the same features as a proprietorship, except that it is owned jointly by two or more persons, called the partners. A partnership also is a rel- atively simple and inexpensive kind of organization to form. In a partnership, each partner is personally liable for all debts incurred by the business; in the event of the firm’s failure, each partner’s personal assets are jeopardized. Also, each partner is responsible for the business actions of the other partners. For example, if one partner in an architectural firm makes a mistake in designing a building that ultimately results in a lawsuit, the potential liability extends to all the partners. Each partner pays a personal income tax on his or her share of the partnership’s taxable income whether or not the profits are actually distributed to the partners in cash.

Some partnerships are limited partnerships. They are managed by a general partner, who receives a larger share of the income in exchange for shouldering all potential liability of the partnership. The limited partners provide capital but have little say about operations. Such partnerships are common in oil exploration and real estate investment ventures.

A common variation of the partnership structure is the limited liability company. It may be taxed as a partnership while providing limited liability to its members.

A corporation is a legal entity with essentially perpetual existence. It comes into being under the auspices of a state, which grants it a charter to operate. The corpora- tion is an artificial person in the sense that it is taxed on its net income as an entity, and legal liability accrues to the corporation itself rather than to its owners.

Compared with a proprietorship or a partnership, the corporate form of organization has several disadvantages:

1. There may be significant legal and other fees involved in its formation. 2. The corporation’s activities are limited to those specifically granted in its charter. 3. It is subject to numerous regulations and requirements. 4. It must secure permission from each state in which it wishes to operate. 5. Its income is subject to double taxation. The corporation’s income is taxed, and distri-

butions of any net income to shareholders in the form of dividends are taxed again.1

On the other hand, in addition to its limited liability and indefinite existence, a corpora- tion has the advantage of being able to raise capital from a large number of investors through issuing bonds and stock. Moreover, corporate shareholders can usually liquidate their ownership by selling their shares to others, and organized securities exchanges exist to facilitate such sales. A corporation whose shares are traded on a securities exchange is called a public corporation, in contrast with a private or “tightly held” corporation, whose shares are owned by an individual or by a relatively few indi- viduals and their families. The financial reports and certain other activities of larger public corporations are regulated by the Securities and Exchange Commission (SEC).

While about 80 percent of U.S. business firms are partnerships or proprietorships, they account for only about 10 percent of total business measured in sales. Corpora- tions account for the other 90 percent of total business activity.

Partnership

1 An exception is an S corporation (formerly a Subchapter S corporation). If certain conditions are met, including having no more than 75 shareholders, these firms pay no corporate income tax. Instead, as in a partnership, the owners are taxed on their respective shares of the entity’s taxable income at their personal tax rates.

Corporation

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258 Part 1 Financial Accounting

Accounting for Proprietor’s and Partners’ Equity

Not much more need be said about the owner’s equity accounts in a sole proprietorship than the comments made in Chapter 2. There may be one capital account in which all entries affecting the owner’s equity are recorded. A separate drawing account may be set up for recording periodic withdrawals made by the owner. The drawing account may be closed into the capital account at the end of the accounting period, or it may be kept separate so as to show the owner’s original contribution of capital separate from the effect on owner’s equity of operating transactions.

As far as the ultimate effect is concerned, it is immaterial whether the owner regards withdrawals as salary or as a return of profit. However, if a proprietor wishes to com- pare the proprietorship’s income statement with that of a corporation, a certain part of the owner’s drawings must be viewed as being salary expense and only the remainder as equivalent to corporate dividends. Consistent with this quasi-corporate approach to proprietorship accounting, some proprietorships maintain a separate owner’s equity ac- count that is analogous to Retained Earnings in a corporation. Whatever the format chosen for reporting proprietorship equity, in substance it is the same as owners’ equity in a corporation.

A partnership has an owner’s equity account for each partner. The amounts credited to each account depend on the terms of the partnership agreement. In the absence of a specific agreement, the law assumes that net income is to be divided equally among the partners. This is also common in written partnership agreements. If such is the case, in a three-person partnership the capital account, or the drawing account, of each partner is credited with one-third of net income. It is debited with the actual amount of the partner’s withdrawals.

Partnership agreements also may provide that the partners receive stated salaries and a stated share of residual profits after salaries, or a stated percentage of interest on the capital they have invested and a stated share of residual profits, or a combination of salary and interest. The accounting required in connection with such arrangements depends on the specific terms of the agreement.

The partnership agreement of Jackson and Curtin provided that Jackson (who worked half- time) would receive a salary of $20,000 and Curtin a salary of $40,000; that each would receive 8 percent interest on their invested capital; and that they would share equally in the remainder of net income. In the current year, the average balance in Jackson’s capital account was $30,000 and in Curtin’s was $70,000. The partnership net income (before partners’ salaries) was $80,000.

The amount to be credited to each partner’s equity account would be computed as follows:

Total Jackson Curtin

Salary $60,000 $20,000 $40,000 Interest on capital 8,000 2,400 5,600 Remainder 12,000 6,000 6,000

Total $80,000 $28,400 $51,600

Whatever the partnership arrangement, the law does not regard salaries or interest payments to the partners as being different from any other type of withdrawal, since the partnership is not an entity legally separate from the individual partners. Nevertheless,

Example

Partnership Equity

Proprietorship Equity

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some partnerships prepare income statements that include partners’ salaries as an expense, and balance sheets with equity accounts analogous to Paid-In Capital and Retained Earnings. This enables the partners to compare their statements with those of similar businesses that are incorporated.

Ownership in a Corporation

Ownership in a corporation is evidenced by a stock certificate. This capital stock may be either common or preferred. Each corporation is authorized in its charter to issue a maximum number of shares of each class of stock. Each stock certificate shows how many shares of ownership it represents. Because a corporation’s owners hold stock cer- tificates that indicate their shares of ownership, owners’ equity in a corporation is called shareholders’ equity or stockholders’ equity.

Preferred stock pays a stated dividend, much like the interest payment on bonds. However, the dividend is not a legal liability until it has been declared by the directors, nor is it a tax-deductible expense to the corporation. Preferred stock has preference, or priority, over common as to the receipt of dividends, distribution of assets in the event of liquidation, and other specified matters. Preferred stock may be cumulative or non- cumulative. With cumulative preferred stock, if the corporation is unable to pay the dividend, the unpaid dividends accumulate and must be paid before the firm can resume payment of common stock dividends. The undeclared dividends are not, however, recorded as a liability.

In 2010 Cotting Corporation did not pay the $9 dividend on each share of its $9 cumula- tive preferred stock. Hence, no dividend could be paid on the common stock in 2010. In 2011 holders of Cotting’s common stock cannot be paid any dividend unless $18 is paid on the $9 cumulative preferred (2011’s $9 dividend plus the $9 from 2010).

Preferred stock is usually issued with a face, or par, value of $100 per share. The dividend rate (9 percent in the above example) is analogous to the coupon rate on a bond, although in practice the dividend is usually stated at its dollar amount rather than as a percentage of par value. Also, like bonds, a preferred stock may be convertible into a specified number of shares of common stock; this is called a convertible preferred. Although preferred stock is usually outstanding indefinitely, some issues of preferred stock are redeemable on a specified date or at the holder’s option. These redeemable preferreds are discussed later in this chapter.

If a corporation is liquidated, preferred stockholders are entitled to receive par value for their shares, provided that enough assets exist after all liabilities have been settled. Also, whereas bondholders can force the firm into bankruptcy if an interest payment on the bonds is missed, preferred stockholders have no such re- course if their dividend is not paid. Interest on bonds is an expense, both for finan- cial accounting purposes and for income tax purposes, whereas a dividend on stock, including preferred stock, is not an expense. It is a distribution of owners’ equity. Accounting treatment of preferred stock is substantially the same as for common stock, described below.

Contrary to a common misconception, issuance of bonds is a much larger source of funds for corporations than is issuance of either common or preferred stock. A princi- pal reason for the unpopularity of preferred and common stock is that their dividends are not a deductible expense for income tax purposes, whereas interest on bonds is.

Example

Preferred Stock

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Every corporation has common stock. Common shareholders have a residual interest in profits and assets, below that of all other creditors and preferred stockholders. Com- mon stock may have a par value, or it may be no-par stock. No-par stock usually has a stated value analogous to par value. In the following description, statements about par value apply also to stated value.

The par value of a share of stock2 is usually a nominal amount, such as $1. Whereas par value on a bond or on preferred stock has meaning, par value on a common stock amount is an essentially meaningless amount. Many years ago, shareholders had an obligation to a corporation’s creditors for the difference between the amount paid for the stock and its par value if the shareholders had purchased their shares (when issued by the corporation) at an amount less than par. This is not the case today because most states’ corporation laws forbid issuing stock at a price below its par value. The impor- tant thing to remember about par value is that in isolation it is meaningless and tells us nothing about the proceeds received by the corporation upon issuance of the stock.

The book value of common stock is the total common shareholders’ equity as reported on the balance sheet.3 This section of the balance sheet consists of two parts: (1) the amount invested in the firm by its shareholders, called paid-in capital, and (2) retained earnings. The amount of paid-in capital can be reported as a single amount. Nevertheless, many corporations report this amount in two pieces: (1) the par or stated value of the out- standing shares of capital stock, usually called common stock at par, and (2) the amount by which the proceeds from issuing common stock have exceeded the par value of the shares issued, usually called additional paid-in capital or other paid-in capital. (The Financial Accounting Standards Board suggests the more descriptive but cumbersome title “capital contributed in excess of the par or stated value of shares.”) Generally ac- cepted accounting principles (GAAP) do not require that the two components be sepa- rately reported. The practice started decades ago when par value did mean something, and certain old accounting habits die hard.

Recording a Common Stock Issue To illustrate the issuance of stock, let us consider Kuick Corporation, which received a charter from the state authorizing the issuance of 200,000 shares of $1 par value common stock. If 100,000 shares of this stock were issued at a price of $7 per share and the proceeds were received by Kuick immediately, this financing transaction could be recorded in either of two ways. The most useful way from the standpoint of statement users would be

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000

Common Stock. . . . . . . . . . . . . . . . . . . . 700,000

However, in practice, many corporations may record the transaction this way:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000

Common Stock at Par. . . . . . . . . . . . . . . 100,000 Additional Paid-In Capital . . . . . . . . . . . . 600,000

Issuance Costs The offering of an issue of stock is often handled by an investment banking firm that receives a fee, or “spread,” for this service. Usually the corporation records only the net

Common Stock

2 Henceforth, the word stock unmodified by common or preferred will mean common stock. 3 The book value of a corporation is a term sometimes used to mean the amount of owners’ equity. If a corporation has no preferred stock, then the book value of the corporation equals the book value of its owners’ equity. The book value of a corporation is also called its net assets because book value equals owners’ equity (i.e., owners’ equity equals assets minus liabilities).

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amount received from the investment banker (the amount remitted by shareholders less the banker’s spread).

In addition to this spread, the corporation incurs legal, auditing, and printing costs. These issuance costs are usually also deducted from the amount received from the issue. (The entry would debit Additional Paid-In Capital and credit Cash or Accounts Payable.) Note that because of the spread and other issuance costs, the amount actually remitted by the shareholders is greater than the amount by which paid-in capital (i.e., par value plus additional paid-in capital) increases on the balance sheet. Note also that there is a paid-in capital transaction between the company and its shareholders only when the shares are issued. When a shareholder sells stock to another party, the amounts in the company’s accounts are not affected in any way; the only change is in the company’s detailed record of the identity of its shareholders.

Treasury stock is a corporation’s own stock that has been issued and subsequently reacquired by purchase. The firm may reacquire its shares for a number of reasons: to obtain shares that can be used in the future for acquisitions, bonus plans, exercise of warrants, and conversion of convertible bonds or preferred stocks; to increase the earn- ings per share and therefore the market price of each share; to thwart an attempt by an outsider to accumulate shares in anticipation of a takeover attempt; or to increase the market price of each share of the stock.

Treasury stock is clearly not an “economic resource” of an entity. A corporation cannot own part of itself. Therefore, treasury stock is not an asset, and it has no voting, dividend, or other shareholder rights. Rather, it is reported on the balance sheet as a re- duction in shareholders’ equity—as a reduction in the number and book value of the shares outstanding.

Two methods of accounting for treasury stock are permitted. For a given situation, either method has the same effect on total owners’ equity. With the simpler method, called the cost method, when treasury stock is purchased, the amount debited to Trea- sury Stock (contra equity account) is its reacquisition cost, regardless of its par value. It continues to be shown at this reacquisition cost until it is canceled or reissued, at which time adjustments are made in shareholders’ equity to dispose of any differences between this cost, the paid-in value (i.e., the net proceeds at the time the stock was originally issued), and, in the event of reissuance, the amount then received.4

If treasury shares are reissued, any excess of selling price above cost is credited to a paid-in capital account (such as Paid-In Capital from Treasury Stock Transactions). If treasury stock is sold at a price below its reacquisition cost, the loss may be deducted from the related paid-in capital account if such an account already exists from prior transactions; otherwise the loss is debited to Retained Earnings. Any gain or loss on the resale of treasury stock is not shown on the income statement, nor is it recognized for income tax purposes.5

The remaining owners’ equity account is Retained Earnings. As pointed out in previ- ous chapters, the amount of retained earnings represents the cumulative net income

Treasury Stock

4 An exception occurs if stock is reacquired at an amount significantly in excess of its fair value. This may occur when the company wants to buy out a stockholder who is contemplating an “unfriendly” takeover attempt or who is otherwise viewed by the corporation’s board of directors as being prob- lematical. When such a so-called greenmail transaction takes place, only the fair value of the treasury stock is recorded as the cost of the treasury shares, and the excess of the price paid over the fair value is recorded as an expense. FASB Technical Bulletin No. 85-6. 5 The other permissible method is the par value method. It is more complicated and is described in advanced texts.

Retained Earnings

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of the firm since its beginning, less the total dividends (or drawings, in the case of unincorporated businesses) that have been paid to owners over the entire life of the en- tity. Stated from more of a financial management point of view, retained earnings shows the amount of assets that have been financed by “plowing profits back into the business,” rather than paying all of the company’s net income out as dividends.

Some shareholders do not understand that there is no connection between the amount shown as retained earnings and the corporation’s ability to pay cash dividends to the shareholders. In an attempt to lower these shareholders’ dividend aspiration levels, a corporation may show on its balance sheet an appropriation, or reserve, as a separate item that is subtracted from Retained Earnings. For example, a reserve for future ex- pansion signals to shareholders the corporation’s intention to use internally generated funds (rather than a new bond or stock issue) to finance the acquisition of new assets. Also, if some contingency does not meet the criteria (described in Chapter 8) for recording it as a liability, then a reserve for contingencies may be shown.

None of these reserves represents money, or anything tangible; the assets of a business are reported on the assets side of the balance sheet, not in the shareholders’ equity section. The accounting entry creating the reserve involves a debit to Retained Earnings and a credit to the reserve account. This entry simply moves an amount from one owners’equity account to another. It does not affect any asset account, nor does the reserve represent any- thing more than a segregated portion of Retained Earnings. Because the use of the word reserve tends to be misleading to unsophisticated readers of financial statements (it con- notes something stashed away), such usage fortunately is on the decline.

Dividends are ordinarily paid to shareholders in cash, but they occasionally are paid in other assets. Dividends are debited to Retained Earnings on the date they are declared (i.e., voted) by the board of directors, even though payment is made at a later date. On the date of declaration, the dividends become a legal liability.

If Kuick Corporation declared a $6,000 dividend on December 15 to be paid on January 15 to holders of record as of January 1, the entries would be as follows:

1. Declaration of dividend on December 15:

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Dividends Payable (a liability account) . . . . . . . 6,000

2. Payment of dividend on January 15:

Dividends Payable . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Stock Splits In a stock split, each shareholder receives a multiple of the number of shares previ- ously held. For example, in a two-for-one split, the holder of 100 shares would receive 100 additional shares at no cost, doubling the total held before the split. A stock split merely increases the number of shares of stock outstanding with no change in each shareholder’s proportional interest in the company. Such a split has no effect on the amount of shareholders’ equity; its effect is solely to repackage the evidence of owner- ship in smaller units.

No transfer is made from Retained Earnings to Paid-In Capital when a stock split is effected. However, the par value per share is reduced proportionately; if the stock was

Dividends

Example

Reserves

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$1 par prior to a two-for-one split, it would automatically become $0.50 par after the split. Since the number of outstanding shares doubled and the par value per share halved, the total of Common Stock at Par remains unchanged, as does the amount in Additional Paid-In Capital.

Stock splits are usually effected to reduce the price of a share of stock, thus al- legedly making the stock appealing to a wider range of investors (including those who prefer to trade only in round lots of 100 shares). Theoretically, a stock split should au- tomatically reduce the market price of a share of stock in inverse proportion to the split: A two-for-one split should exactly halve the market price. In practice, however, the price reduction sometimes is less than proportional to the split, indicating that the split may add value in the eyes of shareholders.

Stock Dividends Sometimes a company wants to retain funds in the business to finance expansion, and this precludes paying a cash dividend; yet the company still wants its shareholders to receive a dividend of some kind. Such a company may declare a stock dividend, which increases every shareholder’s number of shares by the same percentage. For example, if a 5 percent stock dividend were declared, the holder of 100 shares would receive 5 more shares at no cost from the corporation (either newly issued or from treasury stock). Since each shareholder’s holdings are increased by the same proportion, every shareholder’s equity in the corporation remains unchanged.

Like a stock split, a stock dividend does increase the number of shares outstanding without changing the corporation’s earnings, its assets, or each shareholder’s propor- tionate equity interest in the company. In theory, therefore, such a dividend should re- duce the market price per share of the stock. For the 5 percent stock dividend example, if the price before the dividend was $10.50 per share, theoretically it should drop to $10 ($10.50 � 105%) after the stock dividend. However, studies indicate that share- holders do perceive a stock dividend as having some value because, in some cases, the price per share does not drop as much as theory would predict.6

To record a stock dividend, Retained Earnings is debited with the fair value of the additional shares issued, with the credit being to the paid-in capital accounts.

If Kuick Corporation declared a 5 percent stock dividend to the holders of its 100,000 out- standing shares (par value of $1) when the market price of a share was $10.50, the entry would be

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . 52,500

Common Stock at Par . . . . . . . . . . . . . . . . . . . 5,000 Additional Paid-In Capital. . . . . . . . . . . . . . . . . 47,500

The $52,500 is the fair value, at $10.50 per share, of the 5,000 additional shares issued as a dividend. The $47,500 is the difference between the $52,500 fair value and the par value of the newly issued shares. Note that the total amount of owners’ equity is not changed by this transaction; there is just a shift of $52,500 out of Retained Earnings and into the paid-in capital accounts.

Stock dividends and splits are similar. They increase the number of shares out- standing without changing the stockholders’ current proportional interests in the com- pany. As can be seen from the above example, accounting treats stock dividends and stock splits differently. The Accounting Principles Board (APB) believed the difference

6 These cases are usually situations where the stock dividend is accompanied by an increase in dividends.

Example

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between a stock dividend and a stock split was a matter of intent. The intent of a stock dividend is to give shareholders “ostensibly separate evidence” of their interests in the firm without having to distribute cash. The intent of a stock split is to reduce the market price of the shares to improve their marketability. The presumption is that any increase in shares smaller than 20 to 25 percent is a stock dividend, not a stock split.7,8

Spin-Offs The stock referred to in the preceding paragraphs is the company’s own stock. If the company owns shares of some other corporation’s stock that it distributes to its share- holders, this distribution is called a spin-off. It is essentially similar to a cash dividend, and it is recorded in the same manner except that the credit is to the Investments asset account rather than to Cash. Most spin-offs are of the stock of a company’s wholly owned subsidiary, as opposed to stock that was being held as an investment.

Warrants The right to purchase shares of common stock at a stated price within a given time period is called a warrant. For example, a warrant could give its holder the right to buy 100 shares of Sterling Company common stock for $25 per share anytime between January 1, 2010, and December 31, 2014. If during this period the market price of Sterling’s common stock rises to $31, the holder of the option can exercise it by paying Sterling $25. The share of stock received can then be sold for $31, so the warrant holder gains $6. Warrants are negotiable; they can be bought and sold. Some companies have warrants that are traded on stock exchanges, just like other corporate securities. In this case the warrant holder can sell the warrant and realize its value without actually exercising it.

Stock Options A stock option is essentially the same as a warrant except that it is not negotiable. Many corporations grant options to certain officers and employees, either to obtain widespread ownership among employees or as a form of compensation.

The fair value–based method is used to account for stock options.9 The fair value–based method requires the issuing corporation to estimate the fair value of the options granted using an option pricing model (described in advanced finance courses). This value is then charged ratably to Salaries Expense over the vesting period of the option. (Vesting means that the option can be exercised even if the employee leaves the company.)

An employee is granted an option to buy 5,000 shares of her company’s common stock at a stated price, and the estimated fair value of this option is $150,000. The option’s vesting period is five years. The company will charge $30,000 per year to Salaries Expense (the offsetting credit is to Paid-In Capital) over each of the next five years to account for this option.

Some corporations have a program of setting aside stock for the benefit of employees as a group (as distinguished from options, which are granted to certain employees as individuals). This is called an employee stock ownership plan (ESOP). Such a plan

7 Accounting Research Bulletin No. 43, Chapter 7B. 8 As a general rule, stock dividends and splits are not taxable to the recipient. 9 “Accounting for Stock-Based Compensation,” FASB Statement No. 123 (revised 2004). “Share-based Payments,” IFRS No. 2.

Warrants and Stock Options

Example

Employee Stock Ownership Plans

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Chapter 9 Sources of Capital: Owners’ Equity 265

ILLUSTRATION 9–1 Presentation of Owners’ Equity

PRESTON COMPANY AND SUBSIDIARIES Consolidated Balance Sheet

At December 31 (millions)

2009 2010

Shareholders’ Equity

Common stock, $.25 par value $ 77.6 $ 77.5

Capital in excess of par value 72.0 69.2

Retained earnings 3,409.4 3,033.9

Treasury stock, at cost (1,653.1) (1,105.0)________ ________

Total shareholders’ equity $1,905.9 $2,075.6

can have important income tax benefits to the corporation. (Contributions to the plan are tax-deductible employee compensation.) The plan’s manager can vote the ESOP’s shares, and the plan receives dividends. The plan is a separate entity whose assets (i.e., the stock that it holds and reinvested dividends) do not appear on the balance sheet of the corporation (just as the accounting records of other shareholders do not appear). However, the ESOP amounts are disclosed in notes to the financial statements.

In sum, the shareholders’ equity section of the balance sheet maintains a distinct separation between capital invested by the shareholders and equity resulting from the retention of earnings in the business. There is a separation between paid-in capital— which in turn is usually subdivided into par value and additional paid-in capital—and retained earnings. If a company has more than one class of stock, a note to the balance sheet provides details on each class. As an example, Illustration 9–1 shows the owners’ equity section of a corporation’s balance sheet.

Earnings per Share

In analyzing the financial statements of a corporation, investors pay particular attention to the amounts called basic and diluted earnings per share. The FASB and IASB require these figures be reported on the income statement and have provided detailed guidelines for making the calculations.10

Basic earnings per share is a measurement of the corporation’s per share perfor- mance over a period of time. It is computed by dividing net income applicable to the common stock (explained below) by the number of shares of common stock outstand- ing. (Recall that treasury stock is not considered to be stock outstanding.)

The 2010 income statement of McLean Corporation showed net income of $7 million. The corporation had 1 million shares of common stock outstanding during 2010. McLean’s basic earnings per share was $7 ($7,000,000 � 1,000,000 shares).

10 “Earnings per Share,” FASB Statement No. 128. “Earnings per Share,” IAS No. 33.

Example

Balance Sheet Presentation

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The various classes of equity stock that a corporation might issue can be divided into one of two categories: (1) senior securities and (2) common stock. Senior securi- ties, usually preferred stock, are those that have a claim on net income ahead of the claim of the common shareholders. The income figure used in the calculation of basic earnings per share is the amount that remains after the claims of the senior securities have been deducted from net income.

Nugent Corporation in 2010 had net income of $7 million. It had outstanding 100,000 shares of $8 preferred stock (i.e., preferred stock whose annual dividend is $8 per share) convertible into 200,000 shares of common stock and 1 million shares of common stock. The preferred stock dividend of $800,000 must be subtracted from net income to arrive at net income applicable to common stock. Nugent’s basic earnings per share was therefore ($7,000,000 � $800,000) � 1,000,000 shares � $6.20 per share.

If the number of shares of common stock outstanding fluctuates within a year, then the weighted-average number of shares outstanding is computed and used to determine basic earnings per share.

Optel Corporation in 2006 had net income of $7 million. On January 1 it had outstanding 1 million shares of common stock. On July 1 it issued an additional 500,000 shares, which were therefore outstanding for half of the year. Its weighted-average number of common shares outstanding was 1,000,000 � (500,000 * 1⁄2) � 1,250,000. Its basic earnings per share was $7,000,000 � 1,250,000 � $5.60.

Diluted earnings per share is another measurement of a corporation’s per share per- formance. It is the amount of earnings for the period applicable to each share of common stock outstanding (basic earnings per share) adjusted to reflect dilution (lower earnings per share) assuming all potentially dilutive common shares were outstanding during the period. Potentially dilutive common stock shares include stock options, warrants, and convertible securities (such as convertible preferred stock and convertible debt). Diluted earnings per share reflects the potential dilution of earnings per share that could occur if these contracts and securities were exercised or converted into common stock. The FASB’s objective in requiring disclosure of diluted earnings per share is to alert financial statement users to this potential dilution. Typically, investors use diluted earnings per share to judge a corporation’s per share performance and to value its common stock.

The diluted earnings per share calculation can be complex. Only two of its commonly used requirements—the if-converted and treasury stock methods—will be covered.

The if-converted method, as its name implies, is used to measure the potential dilu- tive effect on basic earnings per share from convertible securities. It assumes the con- vertible security has been converted. (It is important to remember the securities have not been converted. They are only assumed to be converted for this calculation.)

Nugent Corporation in 2010 had net income of $7 million (see above example). It had out- standing 100,000 shares of $8 preferred stock (i.e., preferred stock whose annual dividend is $8 per share) convertible into 200,000 shares of common stock and 1 million shares of common stock. The preferred stock dividend of $800,000 must be subtracted from net income in the calculation of basic earnings per share to arrive at net income applicable to common stock. Nugent’s basic earnings per share was therefore $6.20 per share [($7,000,000 � $800,000) � 1,000,000 shares].

Since the preferred stock is convertible into common stock, two adjustments must be made to the basic earnings per share calculation to determine Nugent’s diluted earnings per share. First, assuming conversion of the preferred stock, the $800,000 preferred stock dividends that would not have to be paid are added back to the $6,200,000 income applicable to common stock used in the basic earnings per share calculation. Second, again assuming conversion of the preferred stock, the 200,000 shares that would be issued upon

Example

Example

Example

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conversion of the preferred stock are added to the actual 1 million common shares out- standing. Reflecting these two adjustments, Nugent’s diluted earnings per share was $5.83 ($7,000,000 � 1,200,000 shares).

The treasury stock method is used to calculate the potential dilutive effect on basic earnings per share from options and warrants. This method assumes the options or warrants are exercised and the cash received by the corporation is used to purchase its own stock at the average price of the stock during the period. The net of the number of common shares issued when the options or warrants are assumed to be exercised and the assumed number of common shares purchased is added to the denominator of the basic earnings per share calculation to calculate diluted earnings per share.

The average price of the Veba Corporation’s common stock during 2010 was $20 per share. The company had net income of $7 million for 2010. It had stock options for 100,000 com- mon shares issued in 2009 at an exercise price of $10 per share and 1 million shares of common stock outstanding during 2010. Since the stock options are for common stock, their potential dilutive effect on basic earnings per share must be incorporated in the diluted earnings per share figure. First, it is assumed the options are exercised and the cor- poration issued 100,000 common shares and received $1 million. Next, it is assumed the corporation used the $1 million to buy 50,000 ($1 million � $20 per share) of its own com- mon stock. The net effect of these two assumed transactions is a 50,000-share (100,000 shares � 50,000 shares) increase in the outstanding common stock. Veba’s diluted earnings per share was $6.67 ($7 million � 1,050,000 shares).

If-converted and treasury stock–method adjustments enter into the calculation of diluted earnings per share only if the effect on diluted earnings per share is dilutive. That is, the adjustment reduces diluted earnings per share.

During the third quarter of 2010 the average price of the Veba common stock was $5 per share. The company had stock options for 100,000 common shares issued at an exercise price of $10 per share in 2009 and 1 million common shares outstanding during the quarter. For the purpose of calculating dilutive earnings per share, the corporation used the treasury stock method to determine the dilutive effect of the stock options. (The treasury stock and if-converted calculations are made quarterly.) The corporation assumed the stock options were converted at the beginning of the quarter and 100,000 common shares were issued in return for $1 million (100,000 shares * $10 per share). Next, the corpora- tion assumed the $1 million was used to buy 200,000 common shares of the corporation ($1 million � $5 per share). The net result of these two assumed transactions is a reduction of 100,000 common shares in the denominator of the diluted earnings per share calcula- tion (1 million shares � 100,000 shares). This reduction would be antidilutive (i.e., it would increase diluted earnings per share). Therefore, the stock options would not enter into the diluted earnings per share calculation for the third quarter. (They also would not be treated as outstanding during this quarter for the purpose of determining the weighted-average number of dilutive shares outstanding for the year.)

The control number for determining if a potentially dilutive security is dilutive or antidilutive is earnings before discontinued operations, extraordinary items, and the cumulative effect of accounting principle changes.

The Line between Debt and Equity

Chapter 8 described the trade-off between the lower after-tax cost of debt capital (relative to equity capital) and the risk that financial leverage adds to the shareholders’ invest- ment. In general, corporate financial managers favor leverage and the tax-deductible interest associated with debt capital up to a point, but they are concerned about the

Example

Example

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exposure to risk beyond that point. Although they like the lower risk of equity capital, they also realize that equity capital is inherently more expensive than debt capital. Thus, they want as much debt in the capital structure as is practicable without alarming investors by having an excessively high debt/equity (or equivalently, debt/capitalization) ratio.

In recent years, investment banking firms have developed a variety of financial instru- ments that are intended both to suit the needs of various types of investors and also to pro- vide the corporation with securities of different risk characteristics. Some of these instru- ments tend to blur the line between debt and equity, and their existence requires that caution be exercised in using the debt/equity or debt/capitalization ratio to analyze capi- tal structure. Two examples, each previously mentioned in passing, will be described.

A company may issue bonds that pay no interest but whose face value is payable in, say, five years. These are called zero-coupon bonds. They may be issued by a start-up corporation that anticipates having little cash flow in the near future with which to make interest payments. Because there are no interest payments, zero-coupon bonds are sold at a deep discount from their par value. As described in the preceding chap- ter, this discount is determined by finding the present value of the bonds’ future prin- cipal redemption payment at maturity. If investors view the issuing corporation’s prospects as somewhat shaky, they will use a high discount rate in arriving at this present value.

If investors discount a five-year, zero-coupon bond at 14 percent, at the date of issuance they will pay only $519 for each $1,000 par value bond (using Table A, as explained in the appendix to Chapter 8).

Although no cash interest is paid, the annual amortization of the $481 discount is reported as interest expense by the corporation. This noncash interest expense resulting from the discount amortization is tax deductible to the corporation (and, usually, is tax- able interest revenue to the investor). However, the corporation has no cash interest payments to worry about for the five-year period. Thus, a zero-coupon bond meets the traditional definition of a debt security, but its burden may be less onerous to the corporation than that of cumulative preferred stock, which is not debt but whose divi- dends are expected to be declared and paid annually.

Some corporations issue warrants in conjunction with the issuance of bonds, putting an exercise price on the warrants of about 15 to 20 percent above the current market price of the common stock. If the investor expects the firm to prosper and expects this prosperity to be reflected in the market price of the common stock, then the warrant has value. The investor will then accept a correspondingly lower interest rate on the bond, thus reducing the interest cost of the bond to the issuer. Also, some small firms that in- vestors regard as being very risky would not be able to attract investors to their bonds without using warrants as a “sweetener.”

The accounting for debt issued with warrants depends on whether the warrants are detachable (i.e., the warrants can be removed from the debt and used to purchase the issuer’s stock or sold to a third party) or nondetachable (i.e., the debt must be surren- dered to get the issuer’s stock).11 If the warrants are nondetachable, the debt is

Example

Zero-Coupon Bonds

Debt with Warrants

11 “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warranties,” APB Opinion No. 14. The FASB is reconsidering the accounting for hybrid securities that have both debt and equity components.

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accounted for as if it were a convertible debt security. That is, no recognition is given to the equity character of the debt. It is accounted for as regular debt. The Accounting Principles Board adopted this approach in the belief that the debt and equity features could not be separated.

If the warranties are detachable, the proceeds of the offering must be allocated be- tween the debt and warrant based on their relative fair values. The value of a warrant at the time it is issued can be a matter of opinion. If a market for the warrant does not exist, this value sometimes can be approximated by estimating the higher interest rate that would have been required for the bonds if there were no warrants; the warrant’s value is then assumed to be the difference between the present value of the bonds using this higher rate and the actual bond proceeds. Whatever the value is judged to be, the warrants are recorded separately from the bond liability by an entry such as

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000

Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Bond Premium. . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Warrants Outstanding . . . . . . . . . . . . . . . . . . . 4,000

Warrants Outstanding is a shareholders’ equity account.

A corporation may issue preferred stock that not only pays annual dividends but also may be redeemed by the investor on or after a certain date, say five years hence. This redeemable preferred stock may be issued, for example, as part of the payment made to the owner of a small company when it is acquired by a larger one. The redemption price may be considerably higher than its par value. Redeemable preferred stock is evidence of ownership in the company and is therefore an equity security; yet the com- pany’s obligation to pay the redemption price may be fully as certain as that for the re- demption of bonds when they mature, which is a liability. The FASB requires the issuer to classify this security as a liability.12

Equity in Nonprofit Organizations

Nonprofit organizations do not receive equity capital from shareholders; however, they do receive equity capital from contributions. These capital contributions are usually in the form of endowment or contributed “plant.” Endowment consists of contributions whose principal is to be kept intact indefinitely, with the earnings on that principal being available to finance current operations. Contributed plant consists of con- tributed buildings, works of art and other museum objects, or the funds to acquire these or similar assets. Endowment and plant contributions are distinguished from contribu- tions intended for operating purposes, such as contributions to an annual alumni/ alumnae fund; operating contributions are revenues, not contributed capital.

In both for-profit and nonprofit organizations, equity is increased by earning net in- come. In a nonprofit organization, the cumulative net income amount is usually labeled “operating equity” rather than “retained earnings.” Since nonprofit organizations do not pay dividends, their equity does not decrease as does a dividend-paying entity’s equity when it declares a dividend. However, a nonprofit organization’s equity does decrease in any year in which its operations were unprofitable.

12 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” FASB Statement No. 150.

Redeemable Preferred Stock

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270 Part 1 Financial Accounting

This difference in the source of equity funds is the only substantive difference in ac- counting for the two types of organizations. Many other differences are found in prac- tice, but these result from nonprofit accounting traditions and terminology differences rather than from actual differences in substance.

Summary Although the legal forms of organization—proprietorship, partnership, and corporation— differ, all three conceptually have paid-in capital and retained earnings as components of owners’ equity. Most corporations report two separate components of paid-in capital: par value and additional paid-in capital. Neither number is meaningful in isolation; their sum shows the proceeds the corporation received when the stock was issued.

Preferred stock pays a stated dividend, which may be cumulative. Although this divi- dend is analogous to bond interest, it is not a liability. Preferred shareholders have prece- dence over common shareholders in matters of dividend payments and distribution of pro- ceeds of a corporate liquidation.

Treasury stock is stock that a corporation has reacquired by purchase. It is not an asset and is not counted as either paid-in capital or outstanding shares. Ordinarily, it is recorded at its reacquisition cost. Subsequent reissuance of the stock may lead to a reported loss or gain, which is not included in income.

Retained earnings is the cumulative amount of net income an entity has earned since its inception, less the cumulative amount of dividends it has paid to its owners. Stock divi- dends and stock splits do not affect the relative holdings of shareholders nor the total amount of owners’ equity. Creation of a reserve account also does not affect the total of owners’ equity; a reserve is simply a reclassification of a portion of retained earnings. The calculation of basic earnings per share is based on the amount of net income applicable to common stock (net income less preferred stock dividends) and the number of outstanding shares. The diluted earnings per share calculation reflects the potential dilution of basic earnings per share from contracts and securities that may require the issuance of common stock at some time in the future.

Securities such as zero-coupon bonds and redeemable preferreds have blurred the dis- tinction between debt capital and equity capital, and thus complicate the ratio analysis of capital structures.

The nature of nonprofit organizations’ equity capital differs from that of for-profit organi- zations, but otherwise accounting for the two types of entities is substantively similar.

Problems Problem 9–1.

The following information was taken from the balance sheet of Laribee Company (amounts are in thousands of dollars):

Current liabilities* $ 24,480 Long-term debt 73,440 Common stock, par value 61,200 Paid-in capital 15,300 Retained earnings 70,380__________

$244,800____________________

*Includes $6,120 current portion of long-term debt.

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Chapter 9 Sources of Capital: Owners’ Equity 271

Required: a. Calculate the debt/equity and debt/capitalization ratios.

b. What do these ratios measure? Problem 9–2.

During its fiscal year, Morey Corporation had outstanding 600,000 shares of $6.50 pre- ferred stock and 2,000,000 shares of common stock. Morey’s net income for the year was $19,550,000. The company also had granted stock options to employees for 200,000 shares of common stock at $10 per share (exercise price). The average price of the company’s common stock during the fiscal year was $20 per share.

Required: a. Calculate the company’s basic earnings per share.

b. Calculate the company’s diluted earnings per share. Problem 9–3.

The Power Corporation had the following common shares outstanding during the fiscal year: 100,000 during the first quarter of the fiscal year and 300,000 during the balance of the fiscal year. What was the weighted-average number of common shares outstanding dur- ing the fiscal year?

Problem 9–4. Two recent business school graduates, Jane Johns and Lou Schwartz, started a shop called Exports Unlimited on January 1. Their partnership agreement stipulated that each would receive 10 percent on capital contributed and that they would share equally any net income in excess of this 10 percent payment. Jane had contributed $50,000 and Lou, $70,000. They also agreed that Jane, who could devote only part time to the venture, would receive a salary of $15,000, while Lou would receive $40,000. Net income for the first year (after de- ducting both partners’ salaries) was $66,000. What was each partner’s total income (including salaries) from the business?

Problem 9–5. The Owner’s Equity section of the balance sheet of Ovlov Corporation on December 31, 2009, was as follows:

$8.00 preferred stock (40,000 shares, par value $100) $ 4,000,000

Common stock (no par value, 5,000,000 shares issued and outstanding) 21,000,000

Retained earnings 7,000,000____________ Total owner’s equity $32,000,000________________________

The board of directors took the following actions:

December 31, 2010:

1. A 2-for-1 stock split of common stock was declared.

2. 12,000 shares of its outstanding preferred stock were purchased by Ovlov at $114 per share.

January 1, 2011:

1. The preferred dividend of $8.00 was declared.

2. A cash dividend of $.15 a share on common stock outstanding on January 1 was declared.

3. A stock dividend of 1⁄10 of a share was declared on common stock, effective February 1.

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272 Part 1 Financial Accounting

February 1, 2011: The dividends declared in January were paid.

Required: Prepare journal entries to record the transactions.

Problem 9–6. The shareholders’ equity section of Valade Corp.’s balance sheet is:

2010 2009

Preferred stock (8%, $50 par value) $ 300,000 $ 150,000

Common stock ($10 par value, 80,000 shares authorized, 80,000 shares issued, 10,000 shares in treasury) 800,000 650,000

Additional paid-in capital:

Preferred stock 200,000 175,000

Common stock 525,000 300,000

Retained earnings 679,000 505,000

Less: treasury stock 150,000 —_________ _________ Total shareholders’ equity $2,654,000 $1,780,000___________ ______________________ ___________

Required: a. How many shares of common stock were issued during 2010? What was their

average issue price?

b. How many shares of preferred stock were issued during 2010? What was their average issue price?

c. Give the entry for the company’s purchase of treasury stock. What was the average repurchase price?

d. What was the company’s book value at the end of 2009? 2010? Problem 9–7.

Eastman, Inc., incorporated in New Hampshire on April 15, 2007. Since the date of its in- ception, the following transactions occurred:

a. On April 15, 2007, Eastman was authorized to issue 2,000,000 shares of $6 par value common stock.

b. On April 15, 2007, the company issued 100,000 shares of common stock for $15 per share.

c. The company issued and paid a 25 percent stock dividend on December 21, 2007. The market value on that date was $16 per share.

d. On July 1, 2008, Eastman sold 30,000 shares of common for $30.

e. On November 15, 2008, the company repurchased 10,000 shares of stock for $42 per share.

f. On December 15, 2008, Eastman issued 5,000 shares of treasury stock at $46 per share.

g. On February 1, 2009, the stock split 2 for 1.

h. On September 15, 2009, the remaining treasury stock was sold for $35 per share.

i. On December 24, 2009, Eastman declared a cash dividend of $150,000.

j. On January 24, 2010, the cash dividend was paid.

Required: Prepare the necessary journal entries.

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Chapter 9 Sources of Capital: Owners’ Equity 273

Cases

Case 9–1

Xytech, Inc.* Xytech was a high-tech company that had been started by three partners in early 20X0. Their successful prod- uct designs led to rapid growth of the company, with resulting needs for additional capital to support the growth. This case describes the major financing trans- actions entered into by Xytech in its first 10 years of existence. The firm’s earnings history also is given.

You are to write a journal entry for each transaction as it is described. You should be explicit about what noncurrent liability and owners’ equity—that is, in- vested capital—accounts are affected by the transac- tions, but effects on assets (including cash) and current liabilities can be recorded in a single account, “A&CL.”

20X0: The firm began as a partnership on January 10, with the three equal partners, Able, Baker, and Cabot, each contributing $100,000 capital. The ac- countant set up a capital account for each of the three partners. On April 1 the partners arranged with a bank a $100,000, 8 percent, five-year “balloon” note, which meant that only quarterly interest was payable for five years, with the principal due in full as a lump sum at the end of the fifth year. The firm’s net loss for 20X0 was $54,000. A salary for each partner was included in the calculation of net loss; no other payments were made to the partners.

20X1: To help the firm deal with a short-term liq- uidity problem, on April 26, Cabot liquidated some personal securities and loaned the firm the $50,000 proceeds. Cabot expected to be repaid these funds in no more than one year. In October Baker’s ownership interest in the firm was sold out equally to Able and Cabot, with Baker receiving a total of $110,000 in notes and cash from Able and Cabot. The firm had $12,000 net income for the year. Able and Cabot planned to incorporate the firm as of January 1, 20X2. Prepare a statement of invested capital for the partner- ship as of December 31, 20X1.

20X2: The firm was incorporated on January 1, as planned. The articles of incorporation authorized 500 shares of $100 par value common stock, but only 100 shares were issued, 50 each to Able and Cabot. On

March 21 the bank agreed to increase the $100,000 balloon note to $150,000; the $50,000 proceeds were used to repay Cabot’s $50,000 loan. The net income for the year was $26,000.

20X3: In anticipation of a public offering of Xytech, Inc., stock, the firm effected a 1,000-for-1 stock split in November. The year’s net income was $43,000. Calcu- late the 20X3 basic earnings per share amount.

20X4: In January the firm went public. An invest- ment banker sold 100,000 newly issued shares at $7.75 per share. The banker’s fee and other issuance costs amounted to $55,000. The year’s net income (after stock issuance costs) was $68,000. Prepare a statement of in- vested capital as of December 31, 20X4.

20X5: In January the company issued 500 20-year bonds with a face value of $1,000 each and a coupon rate of 6 percent. Although the bonds were issued at par, because of issuance costs the proceeds were only $950 per bond. Part of the proceeds was used to repay the firm’s prior long-term debt. The year’s net income was $85,000.

20X6: In April Able and Cabot each sold 25,000 of their common shares, receiving proceeds of $11 per share. The company earned net income of $111,000. On December 31, the firm declared a dividend of $0.15 per share, payable January 31, 20X7, to holders of record as of January 15. Prepare a statement of invested capital as of December 31, 19X6.

20X7: Feeling that the market was undervaluing the company’s stock, in June the management decided to purchase 20,000 shares on the open market. The pur- chase was effected July 1 at a price of $10 per share. The shares were held as treasury stock, available for possi- ble reissuance. The year’s net income was $152,000. In December, a $0.20 per share dividend was declared, payable the following month. Calculate the year’s earn- ings per share.

20X8: In January the company issued 4,000 shares of convertible cumulative preferred stock with an an- nual dividend rate of $5 per share. Proceeds of the is- suance were $200,000. Each share was convertible upon the holder’s demand into two shares of Xytech com- mon stock. Net income before preferred dividends was* Copyright © Robert N. Anthony.

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declared a 5 percent stock dividend. The market price of the common stock on December 31 was $17 per share. No shares of preferred stock were converted during the year. Calculate the basic and diluted earnings per share for 20X9 and prepare a statement of invested capital as of December 31. What is the company’s debt/capitaliza- tion ratio at year-end?

274 Part 1 Financial Accounting

$186,000. In December, a dividend of $0.25 per com- mon share was declared, payable the following month. Calculate the basic and diluted earnings per share of common stock in 20X8.

20X9: Net income before preferred stock dividends was $252,000. Instead of paying a cash dividend to common stock shareholders, on December 31, the firm

Case 9–2

Innovative Engineering Company* Innovative Engineering Company was founded by two partners, Meredith Gale and Shelley Yeaton, shortly after they had graduated from engineering school. Within five years, the partners had built a thriving business, primarily through the development of a product line of measuring instruments based on the laser principle. Success brought with it the need for new permanent capital. After careful calculation, the partners placed the amount of this need at $1.2 mil- lion. This would replace a term loan that was about to mature and provide for plant expansion and related working capital.

At first, they sought a wealthy investor, or group of investors, who would provide the $1.2 million in return for an interest in the partnership. They soon discovered, however, that although some investors were interested in participating in new ventures, none of them was willing to participate as partner in an industrial company because of the risks to their personal fortunes that were inherent in such an arrangement. Gale and Yeaton therefore planned to incorporate the Innovative Engineering Company, in which they would own all the stock.

After further investigation, they learned that Arbor Capital Corporation, a venture capital firm, might be interested in providing permanent financing. In think- ing about what they should propose to Arbor, their first idea was that Arbor would be asked to provide $1.2 mil- lion, of which $1.1 million would be a long-term loan. For the other $100,000, Arbor would receive 10 percent of the Innovative common stock as a “sweetener.” If Arbor would pay $100,000 for 10 percent of the stock,

this would mean that the 90 percent that would be owned by Gale and Yeaton would have a value of $900,000. Although this was considerably higher than Innovative’s net assets, they thought that this amount was appropriate in view of the profitability of the prod- uct line that they had successfully developed.

A little calculation convinced them, however, that this idea (hereafter, proposal A) was too risky. The re- sulting ratio of debt to equity would be greater than 100 percent, which was considered unsound for an in- dustrial company.

Their next idea was to change the debt/equity ratio by using preferred stock in lieu of most of the debt. Specifically, they thought of a package consisting of $200,000 debt, $900,000 preferred stock, and $100,000 common stock (proposal B). They learned, however, that Arbor Capital Corporation was not inter- ested in accepting preferred stock, even at a dividend that exceeded the interest rate on debt. Thereupon, they approached Arbor with a proposal of $600,000 debt and $600,000 equity (proposal C). For the $600,000 equity, Arbor would receive 6⁄15 (i.e., 40 per- cent) of the common stock.

The Arbor representative was considerably inter- ested in the company and its prospects but explained that Arbor ordinarily did not participate in a major fi- nancing of a relatively new company unless it obtained at least 50 percent equity as part of the deal. They were interested only in a proposal for $300,000 debt and $900,000 for half of the equity (proposal D). The debt/equity ratio in this proposal was attractive, but Gale and Yeaton were not happy about sharing control of the company equally with an outside party.

Before proceeding further, they decided to see if they could locate another venture capital investor who* Copyright © James S. Reece.

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Chapter 9 Sources of Capital: Owners’ Equity 275

might be interested in one of the other proposals. In calculating the implications of these proposals, Gale and Yeaton assumed an interest cost of debt of 8 per- cent, which seemed to be the rate for companies similar to Innovative, and a dividend rate for preferred stock of 10 percent. They assumed, as a best guess, that Innova- tive would earn $300,000 a year after income taxes on operating income but before interest costs and the tax savings thereon. They included their own common stock equity at $900,000.

They also made pessimistic calculations based on income of $100,000 (instead of $300,000) per year and optimistic calculations based on income of $500,000 a year. They realized, of course, that the $100,000 pessimistic calculations were not necessar- ily the minimum amount of income; it was possible that the company would lose money. On the other hand, $500,000 was about the maximum amount of income that could be expected with the plant that could be financed with the $1.2 million. The applic- able income tax rate was 34 percent.

Questions

1. For each of the four proposals, calculate the return on common shareholders’ equity (net income after preferred dividends � common shareholders’ eq- uity) that would be earned under each of the three income assumptions. Round calculations to the nearest $1,000 and 1⁄10 percent.

2. Calculate the pretax earnings and return on its $1.2 million investment to Arbor Capital Corpora- tion under each of the four proposals. Assume that Arbor receives a dividend equal to its portion of common stock ownership times Innovative’s net in- come after preferred dividends (if any); assume a “negative dividend” if Innovative has a net loss.

3. Were the partners correct in rejecting proposals A and B?

4. Comment on the likelihood that Innovative Engi- neering Company could find a more attractive financing proposal than proposal D.

Beginning in late 1997 and continuing into 1998, UPC Inc., a manufacturer of complex circuit boards, raised new debt and equity capital to finance its rapidly growing business. In addition, as part of its management incentive program, the company granted a number of stock options to key employees. All of the previously issued stock options have been exercised.

Statement 128 The Financial Accounting Standards Board’s Statement 128, “Earnings per Share,” became effective for fiscal years beginning after December 15, 1997. As a result, UPC’s 1998 earnings per share disclosures were the company’s first earnings per share figures to be calcu- lated using this new standard. This case describes the effect of the 1997–98 capital and financial incentive transactions on the company’s 1998 annual basic and diluted earnings per share figures.

Capital- and Incentive-Related Transactions UPC’s 1997–98 capital- and incentive-related transac- tions were

(a) In the second quarter of 1997, 600,000 shares of convertible preferred stock were issued for assets in a purchase transaction. The quarterly dividend on each share of the convertible preferred stock was $0.05, payable at the end of the quarter. Each share was convertible into one share of common stock. Holders of 500,000 shares of the convert- ible preferred stock converted their preferred stock into common stock on June 1, 1998.

(b) In the last quarter of 1997, 4 percent convertible debentures with a principal amount of $10,000,000 due in 20 years were sold for cash at $1,000 (par). Interest was payable semiannually on May 1 and November 1. Each $1,000 debenture was convertible into 20 shares of common stock. No debentures were converted in 1997. The entire issue was converted on April 1, 1998, because the issue was called by the company.

Case 9–3

UPC Inc.*

* This case is based on an illustrative example included in Statement of Financial Accounting Standards No. 128.

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(c) Warrants to buy 500,000 shares of common stock at $60 per share for a period of five years were is- sued on January 1, 1998. All outstanding warrants were exercised on September 1, 1998.

(d) Options to buy 1,000,000 shares of common stock at $85 per share for a period of 10 years were

276 Part 1 Financial Accounting

granted to employees on January 1, 1998. No op- tions were exercised during 1998 because the ex- ercise price of the options exceeded the market price of the common stock.

(e) On March 1, 1998, 100,000 shares of common stock were issued for cash.

Selected Financial Data UPC’s 1998 quarterly and annual operating results were

Income (Loss) Before Cumulative Extraordinary Item and Effect of an

1998 Accounting Change Extraordinary Lossa Accounting Changea Net Income (Loss)

First quarter $3,000,000 $3,000,000 Second quarter 4,500,000 4,500,000 Third quarter 500,000 $(2,000,000) (1,500,000) Fourth quarter (500,000) $4,250,000 3,750,000__________ ___________ __________ __________ Full year $7,500,000 $(2,000,000) $4,250,000 $9,750,000__________ ___________ __________ ____________________ ____________ __________ __________

a Net of tax.

The number of shares of UPC’s common stock out- standing at the beginning of 1998 was 3,300,000.

The company’s 1998 tax rate was 40 percent. UPC’s average market prices of common stock for the calendar-year 1998 were as follows:

First quarter $59 Second quarter $70 Third quarter $72 Fourth quarter $72

Full-Year UPC’s 1998 full-year earnings per share computation was

Income before extraordinary item and accounting change $7,500,000

Less: Preferred stock dividends (45,000)___________ Income available to common

stockholders 7,455,000 Extraordinary item (2,000,000) Accounting change 4,250,000___________

Net income available to common stockholders $9,705,000______________________

Fraction Weighted Dates Outstanding Shares Outstanding of Period Average Shares

January 1–February 28 3,300,000 2⁄12 550,000 Issuance of common stock on March 1 100,000_________

March 1–March 31 3,400,000 1⁄ 12 283,333 Conversion of 4% debenture on April 1 200,000_________

April 1–May 31 3,600,000 2⁄ 12 600,000 Conversion of preferred stock on June 1 500,000_________

June 1–August 31 4,100,000 3⁄ 12 1,025,000 Exercise of warrants on September 1 500,000_________

September 1–December 31 4,600,000 4⁄ 12 1,533,333_________ Weighted average shares 3,991,666_________

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Chapter 9 Sources of Capital: Owners’ Equity 277

Income before extraordinary item and accounting change � $7,455,000

� $1.87 3,991,666

Extraordinary item � $(2,000,000)

� $(.50) 3,991,666

Accounting change � $4,250,000

� $1.06 3,991,666

Net income � $9,705,000

� $2.43 3,991,666

Diluted Earnings per Share The equation used by UPC to compute diluted earnings per share was

Diluted earnings per share � Income available to common stockholders � Effect of assumed conversions

Weighted average shares � Dilutive potential common shares

Full Year UPC’s 1998 full-year diluted earnings per share disclosure was

Income before extraordinary item and accounting change $ 1.73

Extraordinary item (0.46) Accounting change 0.97______ Net income $ 2.24____________

These amounts were based on these figures:

Income available to common shareholders $7,455,000a

Plus: Income impact of assumed conversions Preferred stock dividends $45,000 Interest on 4% convertible debentures 60,000_______

Effect of assumed conversions 105,000__________ Income available to common stockholders � assumed conversions 7,560,000

Extraordinary item (2,000,000) Accounting change 4,250,000__________

Net income available to common stockholders � assumed conversions $9,810,000____________________

a See annual basic earnings per share calculations.

Weighted average shares 3,991,666a

Plus: Incremental shares from assumed conversions Warrants 30,768b

Convertible preferred stock 308,333c

4% convertible debentures 50,000d________ Dilutive potential common shares 389,101__________ Adjusted weighted average shares 4,380,767____________________

a See annual basic earnings per share calculations. b (71,429 shares � 3⁄12) � (51,643 shares � 3⁄ 12). c (600,000 shares � 5⁄ 12) � (100,000 shares � 7⁄ 12). d 200,000 shares � 3⁄ 12.

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278 Part 1 Financial Accounting

Case 9–4

Maxim Integrated Products, Inc.

Question

Be prepared to explain the calculations shown above for arriving at the annual income available to common stockholders, weighted average shares,

and the basic and diluted earnings per share amounts disclosed by UPC.

Expensing stock options for financial reporting pur- poses became mandatory for most firms in mid 2005.1

Under the heading “Two Sets of Books,” Investor’s Business Daily reported:

Take Maxim Integrated Products. The chipmaker told analysts August 1 that expensing employee stock options would reduce its earnings per share by about 20% this quarter.

Maxim said expensing options would cut its first-quarter earnings by 7 or 8 cents a share, re- sulting in GAAP EPS of 30 to 31 cents.

Maxim Chief Executive John Gifford said he believes free cash flow and pro forma EPS “will be a truer indication of our performance.”

When pushed by analysts for details on the im- pact of expensing stock options, Gifford said, “I don’t even care . . . I will do whatever they require us to do for GAAP. But I don’t pay any attention to it . . .”

Will Wall Street ignore options?2

The Company Maxim Integrated Products, Inc. (Maxim), incorpo- rated in 1983, is headquartered in Sunnyvale, California. Maxim designs, develops, manufactures, and markets a broad range of linear and mixed-signal integrated circuits, commonly referred to as analog circuits. Maxim also provides a range of high-frequency design processes and capabilities that can be used in custom designs. Maxim is a global company with manufactur- ing facilities in the United States, testing facilities in the Philippines and Thailand, and sales offices through- out the world. Its products are sold to customers in numerous markets, including automotive, communica- tions, consumer, data processing, industrial control, instrumentation, and medical industries.3

The company’s stock is traded on the NASDAQ national market under the symbol MXIM. During fiscal year 2005, the high and low closing prices by quarter for fiscal year 2005 were

1 FASB Statement 123(R) (FAS 123R) required companies to expense the cost of stock options. Management had consid- erable latitude in selecting the method to value stock option grants. Prior to the issuance of FAS 123R, most companies simply disclosed the effect on income of stock option expensing in the financial statement notes. 2 Investor’s Business Daily, September 7, 2005.

3 Maxim Integrated Products, Inc., 2005 Form 10-K. 4 Under the intrinsic value method, no expense was ever rec- ognized for stock options issued with an exercise price equal to the stock’s price at the grant date.

Quarter Ended

June 25, 2005 March 26, 2005 December 25, 2004 September 25, 2004

Fiscal year 2005 High $41.86 $44.40 $44.70 $52.42 Low $36.60 $38.17 $40.87 $39.27

Source: Maxim Integrated Products, Inc., 2005 Form 10-K.

Exhibits 1–4 present selected Maxim financial statement data. These data are from periods when ex- pensing stock options was not mandatory. Like most companies, Maxim used the intrinsic value method to account for stock options.4 The effect on earnings of expensing stock options was a required disclosure.

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June 25, 2005 June 26, 2004 June 28, 2003

Net revenues $1,671,713 $1,439,263 $1,153,219 Cost of goods sold 463,664 433,358 348,264 Gross margin $1,208,049 $1,005,905 $ 804,955

Operating expenses: Research and development $ 328,164 $ 306,320 $ 272,322 Selling, general, and administrative 98,513 93,550 85,597

Total operating expenses $ 426,677 $ 399,870 $ 357,919

Operating income $ 781,372 $ 606,035 $ 447,036 Interest income and other, net 28,265 20,461 15,055__________ __________ __________

Income before provision for income taxes $ 809,637 $ 626,496 $ 462,091 Provision for income taxes 268,800 206,744 152,490

Net income $ 540,837 $ 419,752 $ 309,601

Earnings per share: Basic $ 1.66 $ 1.28 $ 0.96 Diluted $ 1.58 $ 1.20 $ 0.91

Source: Maxim Integrated Products, Inc., 2005 Form 10-K.

EXHIBIT 1

Other Common Stock Additional Accumulated Total

Par Paid-in Retained Comprehensive Stockholders’ Shares Value Capital Earnings (Loss) Income Equity

Balance, June 26, 2004 324,444 $325 $ 80,137 $2,038,820 (6,964) $2,112,318

Components of comprehensive income:

Net income — — — 540,837 — 540,837

Unrealized gain on forward- exchange contracts, net of tax — — — — 795 795

Unrealized loss on available-for-sale investments, net of tax — — — — (361) (361)

Total comprehensive income $ 541,271

Exercises under the Stock Option and Purchase Plans 7,112 7 105,986 — — 105,993

Repurchase of common stock (4,062) (5) (168,452) — — (168,457)

Tax benefit on exercise of nonqualified stock options and disqualifying dispositions under stock plans — — 117,000 — — 117,000

Dividends declared and paid — — — (123,943) — (123,943)

Balance, June 25, 2005 327,494 $327 $134,671 $2,455,714 $(6,530) $2,584,182________ _____ _________ ___________ ________ ____________________ _____ _________ ___________ ________ ____________

Source: Maxim Integrated Products, Inc., 2005 Form 10-K.

MAXIM INTEGRATED PRODUCTS, INC. Consolidated Statements of Income for the Years Ended

June 28, 2003; June 26, 2004; and June 25, 2005 (amounts in thousands, except per share data)

MAXIM INTEGRATED PRODUCTS, INC. 2005 Consolidated Statement of Stockholders’ Equity

(amounts in thousands)

EXHIBIT 2

279

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June 25, 2005 June 26, 2004 June 28, 2003

Cash flows from operating activities:

Net income $540,837 $419,752 $309,601

Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation, amortization, and other 76,849 61,860 61,036

Tax benefit related to stock-based compensation plans 117,000 152,500 113,473

Changes in assets and liabilities:

Accounts receivable 4,813 (70,398) 3,052

Inventories (49,994) 3,407 18,014

Deferred taxes 45,483 23,500 48,404

Income tax refund receivable 668 9,034 41,918

Current assets 946 (7,029) 106

Accounts payable (37,590) 51,815 (3,243)

Income tax payable 13,834 8,439 267

Deferred income on shipments to distributors (2,633) 1,276 (5,601)

All other accrued liabilities (11,153) 41,298 (4,533)__________ ________ ________ Net cash provided by operating activities 699,060 695,454 582,494

Cash flows from investing activities:

Additions to property, plant, and equipment (132,445) (231,618) (84,060)

Other noncurrent assets (308) 2,873 (5,148)

Purchases of available-for-sale securities (1,150,968) (1,002,154) (1,620,085)

Proceeds from sales/maturities of available- for-sale securities 808,885 994,296 1,259,990_________ _________ _________

Net cash used in investing activities (474,836) (236,603) (449,303)

Cash flows from financing activities:

Issuance of common stock 105,993 183,856 83,671

Repurchase of common stock (168,457) (601,244) (153,949)

Dividends paid (123,943) (104,570) (25,879)_________ __________ _________ Net cash used in financing activities (186,407) (521,958) (96,157)

Net increase (decrease) in cash and cash equivalents 37,817 (63,107) 37,034

Cash and cash equivalents:

Beginning of year 147,734 210,841 173,807

End of year $185,551 $147,734 $210,841_________ _________ __________________ _________ _________

Supplemental disclosures of cash flow information:

Cash paid (refunds received), net during the year for:

Income taxes $93,622 $13,275 $(51,562)

Source: Maxim Integrated Products, Inc., 2005 Form 10-K.

EXHIBIT 3

MAXIM INTEGRATED PRODUCTS, INC. Consolidated Statements of Cash Flows for the Years

Ended June 28, 2003, June 26, 2004, and June 25, 2005 (amounts in thousands)

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Chapter 9 Sources of Capital: Owners’ Equity 281

EXHIBIT 4 2005 Stock-Based Compensation Note The company accounts for its stock option and employee stock purchase plans using the intrinsic value method prescribed in Accounting Principles Board’s Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees.” Accordingly, employee and director compensation expense is recognized only for those options whose price is less than fair market value at the measurement date. In addition, the company discloses pro forma information related to its stock plans according to SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by, SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure . . .”

The valuation of options granted in fiscal years 2005, 2004, and 2003 reported below has been estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

Employee Stock Stock Option Plans Participation Plan

2005 2004 2003 2005 2004 2003

Expected option holding period (in years) 4.5 4.8 4.5 1.1 0.5 0.5 Risk-free interest rate 3.3% 2.9% 2.7% 2.5% 1.2% 1.3% Stock price volatility 0.33 0.42 0.43 0.33 0.42 0.43 Dividend yield 1.0% .63% .46% 1.0% .63% .46%

Source: Maxim Integrated Products, Inc., 2005 Form 10-K.

The Black-Scholes option pricing model was developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the company’s options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the estimate of value, in the opinion of management, the existing models do not provide a reliable single measure of the value of the options. The following is a sum- mary of weighted average grant values generated by application of the Black-Scholes model:

Weighted Average Grant Date for the Years Ended

June 25, 2005 June 26, 2004 June 28, 2003

Stock Option Plans $12.08 $15.63 $10.25 Employee Stock Participation Plans $11.99 $11.63 $ 6.23

Source: Maxim Integrated Products, Inc., 2005 Form 10-K.

As required under SFAS 148, the reported net income and earnings per share have been presented to re- flect the impact had the company been required to include the amortization of the Black-Scholes option value as an expense. The adjusted amounts are as follows:

For the Years Ended

June 25, 2005 June 26, 2004 June 28, 2003

Net income—as reported $540,837 $419,752 $309,601 Deduct: Total stock-based employee

compensation expense determined under the fair value method, net of tax 155,904 134,734 139,684

Net income—pro forma $384,933 $285,018 $169,917_________ _________ __________________ _________ _________ Basic earnings per share—pro forma $ 1.18 $ 0.87 $ 0.53 Diluted earnings per share—pro forma $ 1.13 $ 0.82 $ 0.50

Source: Maxim Integrated Products, Inc., 2005 Form 10-K.

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282 Part 1 Financial Accounting

Role of Stock Options At JP Morgan’s Annual Technology Conference, John Gifford stated:

We are the innovative leader in mixed-signal analog in the world. We intend to continue to be. We got here and we will go forward because we have been able to collect and will continue to collect the best engineers in the world. They are world class. If you’re not world class, you cannot do these things I have been talking about.

We cannot hire them out of college. The ones we do hire, it takes five years to train, and there is a huge dropout rate. We need to recruit and continue to recruit and also retain and collect engineers.

Stock options are important to do that. The cost of options to our shareholders is approximately, without taking into account the repurchasing of options by the company, about 4% a year. That is equivalent to—that is paid for if we grow at 25.8% instead of 25%. We do repurchase shares in the past. That has reduced the dilutive effect to less than 2%.

As always, we are completely committed to in- creasing your equity. It is a religion with us because that increases our value and our employees’ value, and we cannot do that without taking care of our cus- tomers. And we know that if we provide security for our people, both of the two things at the top will hap- pen. We are a very competitive group of people, and we intend to be even more important going forward.5

Questions

1. Why are stock options important to the operating effectiveness of companies like Maxim? Are their stock option grants a form of compensation?

2. How might changes in the assumptions Maxim uses in its option pricing model influence the grant date valuations?

3. How would you handle stock option grants in (a) measuring Maxim’s performance and (b) valuing its equity? Do you think Wall Street should ignore options?

4. Gifford suggests free cash flow (cash flow from op- erations less capital investments) as a better indica- tor of Maxim’s performance than net income. Do you agree?

5. Do you believe the tone and substance of Gifford’s statements communicating his view of net income (after expensing stock options) is appropriate for a CEO?

6. Do you believe the requirement to expense stock options will change the way employees are com- pensated? For example, will restricted stock grants and cash bonuses become more popular? How should you account for these alternative forms of compensation?

7. Do you believe the Financial Accounting Standards Board has adopted the best measure of stock option expense?

5 JP Morgan 33rd Annual Technology Conference.

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10 Other Items That Affect Net Income and Owners’ Equity

Chapter

Owners’ equity consists of four components: common stock, preferred stock, retained earnings, and accumulated items that are direct debits or credits to owners’ equity rather than to net income. The preceding chapters discussed the accounting treatment of many transactions that affect owners’ equity either directly or by the process of clos- ing the Net Income account to Retained Earnings. This chapter completes the more de- tailed discussion of income statement and balance sheet items that began in Chapter 5. It discusses the treatment of nonowner transactions that directly change owners’ equity and its disclosure requirements. Also discussed is the accounting for extraordinary items, discontinued operations, accounting changes, accounting errors, foreign currency translation adjustments, and derivatives. How each of these items affects net income and ultimately owners’ equity and its components is covered also.

Total and Other Nonowner Changes in Owners’ Equity

The FASB and IASB require companies to report each accounting period’s total nonowner changes in owners’ equity and to disclose the details of its measurement.1

This figure is the sum of the period’s net income and the changes in the balances of those items that affect owners’ equity directly that do not involve transactions with owners (collectively referred to as other nonowner changes in owners’ equity).2

1 “Reporting Comprehensive Income,” FASB Statement No. 130. “Presentation of Financial Statements,” IAS No. 1. 2 FASB Statement No. 130 and IAS No. 1 refer to the total of this sum as comprehensive income. This caption is misleading. It implies by its name and its elements (net income plus other nonowner changes in owners’ equity) that it is a superior number to net income. This is not the case. Many commentators on the Statement’s exposure draft expressed this view to the FASB, which responded by retaining the term comprehensive income in the final Statement while giving corporations the right to select their own descriptive caption. The caption adopted for this book is one suggested by the FASB as a possible alternative to comprehensive income.

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These items include the accumulated balances of unrealized gains and losses on available-for-sale securities (discussed in Chapter 5), foreign currency–denominated net investment translation adjustments, gains and losses on certain derivatives (these latter two topics are discussed in this chapter), and several other items not discussed in this book.3

Companies have considerable leeway in how they present and label their nonowner changes in owners’ equity disclosures. Illustration 10–1 employs a statement of changes in owners’ equity display to satisfy the FASB’s requirement. As shown in the illustration, the Basel Corporation’s total nonowner changes in owners’ equity is $6,736,000. This figure is the sum of net income ($6,034,000) and unrealized gain on securities, net of reclassification adjustments ($702,000). The reclassification adjustment shown at the bottom of the illustration indicates that the Basel Corporation had unrealized gains on its available-for-sale securities during the period ($802,000). These unrealized gains are

3 For a list of these highly technical additional items, see FASB Statement No. 130.

ILLUSTRATION 10–1 Total and Other Nonowner Changes in Owners’ Equity

BASEL CORPORATION Statement of Changes in Owners’ Equity

Year Ended December 31, 2010 (in thousands)

Total Accumulated Nonowner Other Changes in Nonowner

Owners’ Retained Changes in Common Paid-In Total Equity Earnings Owners’ Equity Stock Capital

Beginning balance $132,457 $ 99,111 $2,502 $10,000 $20,844 Total nonowner changes in owners’ equity

Net income 6,034 $6,034 6,034______ Other nonowner changes in

owners’ equity, net of tax: Unrealized gains on securities,

net of reclassification adjustment (see disclosure below) 702 702______

Other nonowner changes in owners’ equity 702 702______

Total nonowner changes in owners’ equity $6,736____________

Dividends declared on common stock (3,000) (3,000)________ ________ ______ _______ _______ Ending balance $136,193 $102,145 $3,204 $10,000 $20,844________ ________ ______ _______ _______________ ________ ______ _______ _______

Disclosure of reclassification amount: Unrealized holding gains arising

during period $ 802 Less: Reclassification adjustment

for gains included in net income (100)______ Net unrealized gains on securities $ 702____________

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Chapter 10 Other Items That Affect Net Income and Owners’ Equity 285

directly credited to owners’ equity. In addition, the corporation sold some of its securi- ties and realized a gain, some part of which had previously been included as unrealized gains in the beginning accumulated other nonowner changes in equity balance ($2,502,000). To avoid double accounting, the previously recorded unrealized gain re- lated to the sold securities ($100,000) must be deducted (a debit entry) from owners’ equity and included as part of the total realized gain recognized in net income (a credit entry). The owners’ equity section of the Basel Corporation’s balance sheet would re- port only the ending balances of the last four columns of Illustration 10–1.

FASB Statement No. 130 and IAS No. 1 were issued in response to what was per- ceived to be the concerns of some financial statement users about the increasing num- ber of items being taken directly to equity and the effort required to analyze these items. It is difficult to see how FASB Statement No. 130 solves this problem by requiring disclosure of items that were already disclosed and a sum of net income and the changes in the accumulated balances of these items, which has little, if any, analytical or economic significance. It is anticipated that net income, rather than total nonowner changes in owners’ equity, will be used in most situations requiring a bottom- line earnings figure.

Discussed next are four display requirements of the FASB and IASB that do have considerable information value to financial statement users.

Nonoperating Items

To the extent feasible, the income statement should show the results of the year’s nor- mal results from continuing operations separately from those parts of the business that are to be discontinued and special and presumably nonrecurring events that affected net income and retained earnings. This permits the reader to see more clearly the prof- itability of normal ongoing activities. This section describes four types of transactions that are reported separately from the revenues and expenses of recurring operations: ex- traordinary items, discontinued operations, changes in accounting principles, and ad- justments to retained earnings. The first three of these affect net income for the period, whereas the fourth does not. The method of reporting these four types of transactions on a statement of income and retained earnings is shown in Illustration 10–2. (Notes A and B are not given here. They would explain the two items in some detail.)

At one time, companies had considerable latitude in deciding on the types of transac- tions that should be classified as extraordinary. Companies reported a variety of losses as “extraordinary” in the hope that readers would regard them as abnormal and not likely to recur. The publication of APB Opinion No. 30 greatly reduced this discretion.4

Today extraordinary items are rare. APB Opinion No. 30 requires that in order to qualify as an extraordinary item, an

event must satisfy two criteria:

1. The event must be unusual; it should be highly abnormal and unrelated to, or only incidentally related to, the ordinary activities of the entity.

2. The event must occur infrequently; it should be of a type that would not reasonably be expected to recur in the foreseeable future.

Extraordinary Items

4 “Reporting the Results of Operations,” APB Opinion No. 30. See also “Reporting the Results of Operations,” APB Opinion No. 9.

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The words of these criteria do not convey their narrowness as clearly as do the illustra- tions that are used to explain them. The following gains and losses are specifically not extraordinary:

1. Write-down or write-off of accounts receivable, inventory, or intangible assets. 2. Gains or losses from changes in the value of foreign currency. 3. Gains or losses on disposal of a segment of a business (discussed in the next section). 4. Gains or losses from the disposal of fixed assets. 5. Effects of a strike.

Accounting Treatment In those rare cases in which extraordinary gains or losses can be identified, they are re- ported separately on the income statement below “income from continuing opera- tions,” as shown in Illustration 10–2. The amount reported is the net amount after the income tax effect of the item has been taken into account.

If a company had an extraordinary loss of $1 million, its taxable income presumably would be reduced by $1 million. At an income tax rate of 40 percent, its income tax would be reduced by $400,000, and the ultimate effect on net income would therefore be only $600,000.

The IASB took a different approach than that adopted by the IASB to resolve the extraordinary items controversy. The IASB eliminated the concept of extraordinary items and prohibited their presentation in the income statement.5

In recent years, many companies have highlighted in supplemental disclosures what they call pro forma earnings (in contrast to the reported net income figure). Pro forma earnings exclude certain items included in the measurement of net income, such as

ILLUSTRATION 10–2 Separation of Continuing Operations Income from Other Items

BASEL CORPORATION Condensed Statement of Income and Retained Earnings

Year Ended December 31, 2010 (in thousands)

Net sales and other revenue $60,281

Expenses 46,157_______

Income from continuing operations before income taxes 14,124

Provision for income taxes 5,650_______

Income from continuing operations 8,474

Discontinued operations (Note A):

Loss from operations of Division X (less applicable income taxes of $320) $480

Loss on disposal of Division X (less applicable income taxes of $640) 960 (1,440)____

Extraordinary loss (less applicable income taxes of $525) (Note B) (1,000)_______ Net income $ 6,034______________

Example

Pro Forma Earnings

5 “Presentation of Financial Statements,” IAS No. 1.

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Chapter 10 Other Items That Affect Net Income and Owners’ Equity 287

restructuring charges and impairment of goodwill. Sometimes other names are used to describe pro forma earnings. These include “operating earnings” and “recurring earn- ings.” The Securities and Exchange Commission requires that pro forma earnings not be misleading and not exclude recurring items in their calculation. Managements pub- lish pro forma earnings in the belief they are better indicators of their performance and are more useful to investors than their company’s reported net income.

Another type of transaction that, if material, is reported separately on the income state- ment is the gain or loss from the discontinuance of a division or other identifiable segment of the company.6 The transaction must involve a whole business unit, as con- trasted with the disposition of an individual asset or discontinuance of one product in a product line. Discontinuance may occur by abandoning the segment and selling off the remaining assets or by selling the whole segment as a unit to some other company. In the former case, a loss is likely; in the latter case, there may be either a gain or a loss, depending on how attractive the segment is to the other company.

If a loss is expected from discontinuing a segment, the loss is recorded in the period in which the decision to discontinue is made, which may be earlier than the period in which the actual transaction is consummated. Usually, the amount of this loss is an estimate. This estimate may be quite complicated, for it must take into account (1) the estimated revenues and expenses of the discontinued segment during the period in which it continues to be operated by the company; (2) the estimated proceeds of the sale; and (3) the book value of the assets that will be written off when the segment is disposed of. If a gain is expected, it is not recognized until it is realized, which ordi- narily is the disposal date.

Accounting Treatment The amounts related to discontinued operations are reported after their income tax effect has been taken into account. As shown in Illustration 10–2, two amounts are reported:

1. The net income or loss attributable to the operations of the segment until it is sold. 2. The estimated net gain or loss on disposal after taking account of all aspects of the

sale, including the amount received and the write-off of assets that are not sold.

The third type of nonrecurring item reported on the income statement is the effect of a change in accounting principles. Sometimes a change is required by a new FASB or IASB Statement. In most other circumstances, the consistency concept requires that a company use the same accounting principles from one year to the next. But if a company has a sound reason for doing so, it may occasionally shift from one gener- ally accepted principle to another one. For example, several methods of depreciation are acceptable; if a company has a sound reason for doing so, it may shift from one method to another.

Voluntary change in an accounting principle should be accounted for retrospectively and all prior periods should be restated as if the newly adopted accounting policy had al- ways been used, except when retroactive application is impracticable. When the effects of retroactive application of an accounting change for particular prior years are not de- terminable, the cumulative effect on prior years of retroactive application should be recorded directly in opening retained earnings (or other balance sheet caption as appro- priate) of the first year presented on the new basis. When an accounting change is made

Discontinued Operations

Change in Accounting Principles

6 APB Opinion No. 30. “Non-Current Assets Hold for Sale and Discontinued Operations,” IFRS No. 5.

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in other than the first interim period, the change should be reported as if it were adopted at the beginning of the fiscal year.7

Errors are mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time the financial statements were pre- pared. Corrections of errors must be made retrospectively.8

The remainder of this chapter discusses the accounting for personnel costs (which affects net income and ultimately retained earnings), income taxes (which affects both net income and ultimately retained earnings, and the other nonowner changes in own- ers’ equity component of owners’ equity), and foreign currency translation adjust- ments (which affects the other nonowner changes in owners’ equity component of owners’ equity).

Personnel Costs

Personnel costs include wages and salaries earned by employees and other costs related to their services. (Customarily, the word wages refers to the compensation of employees who are paid on a piece-rate, hourly, daily, or weekly basis, whereas the word salaries refers to compensation expressed in longer terms; we use wages to denote either cate- gory.) The effect on the accounting records of earning and paying wages is more com- plicated than merely debiting Wages Expense and crediting Cash. This is because when wages are earned or paid, certain other transactions occur almost automatically.

Employees are rarely paid the gross amount of wages they earn, since from their gross earnings the following must be deducted:

1. An amount representing the employee’s FICA (Federal Insurance Contribution Act) contributions for Social Security and Medicare coverage.

2. An amount withheld from gross earnings to apply toward the employee’s personal state and federal income taxes.

3. Deductions for charitable contributions, savings plans, union dues, and a variety of other items.

None of these deductions represents a cost to the employer. In the case of the tax de- ductions, the employer is acting as a collection agent for the state and federal govern- ments. The withholding of the tax amounts and their subsequent transfer to the gov- ernment does not affect net income or owners’ equity. Rather, the withholding creates a liability, and the subsequent transfer of the taxes to the government pays off this lia- bility. Similarly, the employer is acting as a collection agent in the case of the other de- ductions. The employee is paid the net amount after these deductions have been taken.

When wages are earned, certain other costs are automatically created. The employer must pay a tax equal in amount to the employee’s FICA tax, and the employer also must pay an additional percentage of the employee’s pay for the unemployment insurance tax. The employer’s share of these taxes is an element of cost.

Errors

7 “Accounting Changes and Error Corrections,” FASB Statement No. 154. “Accounting Policies, Changes in Accounting Estimates and Errors,” IAS No. 8. Most accounting estimate changes are applied prospectively. 8 “Accounting Changes and Error Corrections,” FASB Statement No. 154. “Accounting Policies, Changes in Accounting Estimates and Errors,” IAS No. 8.

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Example If an employee with three dependents earned $600 for work in a certain week, and $45.90 for FICA tax contribution and $63.00 for withholding tax was deducted from this $600, the employee’s take-home pay would be $491.10. (Other possible deductions are omitted.) The employer also would incur an expense of $45.90 for FICA and an additional expense of, say, $54 for federal and state unemployment insurance taxes, or a total of $99.90 for em- ployment taxes.

The journal entries for these transactions are as follows:

1. When wages are earned:

Wages Cost9 . . . . . . . . . . . . . . . . . . . . . . . . 600.00

Wages Payable . . . . . . . . . . . . . . . . . . . . 600.00

Employment Tax Cost . . . . . . . . . . . . . . . . . 99.90

FICA Taxes Payable . . . . . . . . . . . . . . . . . 45.90

Unemployment Taxes Payable . . . . . . . . 54.00

2. When the employee is paid:

Wages Payable. . . . . . . . . . . . . . . . . . . . . . . 600.00

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491.10

FICA Taxes Payable . . . . . . . . . . . . . . . . . 45.90

Withholding Taxes Payable . . . . . . . . . . . 63.00

3. When the government is paid:

FICA Taxes Payable (45.90 � 45.90) . . . . . . 91.80

Unemployment Taxes Payable . . . . . . . . . . . 54.00

Withholding Taxes Payable . . . . . . . . . . . . . 63.00

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208.80

In practice, the above entries would be made for all employees as a group. The gov- ernment does require, however, that a record be kept of the amount of FICA tax and withholding tax accumulated for each employee.

In addition to cash wages or salaries, most organizations provide fringe benefits to their employees. Among these are pensions, life insurance, health care, and vacations. Such fringe benefits may amount to as much as 40 percent of payroll. These amounts are costs of the period in which the employee worked, just as are the cash earnings. Accounting for many of these fringe benefits is relatively straightforward. However, that is not the case with pensions.

Payments that employees will receive after they retire are called pensions. Pension costs are typically in the range of 5 to 10 percent of payroll. In some organizations, em- ployees contribute part of their pension cost, and this cost is a payroll deduction that is treated just like the other deductions mentioned above. It does not involve a cost to the organization. The employer’s promise to pay pension benefits is a cost to the employer, just as are other fringe benefits.

In the United States, pension plans are regulated under the Employee Retirement In- come Security Act (ERISA). The provisions of this act are such that, in most cases, pension plans must be funded. This means that the company must make pension plan contributions in cash, stock, or other assets to a bank, insurance company, or other trustee for the pension fund. However, the law does not require that a plan be fully

Pensions

9 As pointed out previously, manufacturing labor costs are a product cost debited to Work in Process Inventory. Other labor costs are period costs debited to Wage and Salary Expense. We use the account Wages Cost here to include either of these.

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funded. That is, at a given point in time, the plan assets do not have to be sufficient to provide all future plan benefits that have already been earned by employees if no fur- ther contributions were made to the plan.

The trustee invests the contributions and pays pension benefits directly to employ- ees after they retire. The pension fund is therefore a separate entity, with its own set of accounts.

Types of Pension Plans There are two general types of pension plans: (1) defined contribution plans and (2) de- fined benefit plans.

In a defined contribution plan, the employer contributes to the pension fund an agreed amount each year for each employee, often determined as a percentage of the employee’s salary. The employee’s pension benefits thus depend on how much has been accumulated (contributions plus gains on the investments of those contributions) for her or him as of the date of retirement. There is no promise about how much those ben- efits (outputs of the plan) will be; the agreement relates only to plan contributions (inputs). Thus, by definition, a defined contribution plan is never underfunded or over- funded. In such plans, the organization’s pension cost for a year is simply the agreed- on contribution. The entry recording this cost is

Pension Cost . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

In a defined benefit plan the employer agrees to contribute to the pension fund an amount large enough so that employees will receive a specified amount of monthly benefits after retirement. This amount depends on the employee’s years of service be- fore retirement, the employee’s average earnings during some period immediately preceding retirement, and possibly other factors. Thus, this plan’s benefits (outputs) are agreed on and the company must determine the amount of contributions (inputs) necessary to provide these benefits.

Pension Cost The determination of the amount of annual pension cost for a defined benefit plan is extremely complicated. FASB Statement No. 8710 is 132 pages long, including 11 pages of definitions. While IAS No. 19 is not as long, it is just as complicated.11 We will pro- vide only a conceptual overview of these matters.

To calculate its pension contribution in a given year, the company must first make a number of estimates: how many years employees will work until they retire; employee turnover; average earnings on which the pension benefits will be calculated; how many years the employee will live after retirement; probable increases in benefit payments due to inflation, new union contracts, or other factors; and the amount that the pension fund will earn on funds invested in it. The pension calculations incorporating these estimates are based on the present value concept.

A company’s pension cost is the sum of a number of elements. The year’s service cost element is the present value of the future benefits employees have earned during the year. The year’s interest cost element is the amount by which the present value of the plan’s beginning-of-the-year obligations are projected to increase during the year.

10 “Employers’ Accounting for Pensions,” FASB Statement No. 87. FASB Statement No. 87 has been amended by a series of subsequent FASB pronouncements including “Employers’ Accounting for Defined Pension Benefit and Other Postretirement Plans,” FASB Statement No. 158. 11 “Employee Benefits,” IAS No. 19.

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Offsetting these two cost elements is the assumed return on plan assets element, which is the gain assumed by management based on the pension asset’s expected return over the long run (assumed return percentage times plan assets).

The fourth element of pension cost relates to the amortization of several other pension-related items. One of these is the prior service cost element. This cost arises if a new pension plan is instituted and it takes into account employees’ service prior to the initiation of the new plan. Prior service cost also can arise if a plan is amended or “sweetened”—the terms are made more generous with the result that the contributions to date are inadequate to meet the amended obligations. Rather than having the cost of such a “sweetening” impact only the year in which the plan is amended, the present value of the added benefits is amortized over the expected service life of the employees affected by the amendment.

The year’s net pension cost is the algebraic sum of the four elements just described: service cost plus interest cost minus assumed return plus amortization. (In some situa- tions, additional elements may be included in the pension cost, but they are not dis- cussed in this book.) Not surprisingly, most companies engage an actuary, a profes- sional who specializes in such matters, to make all of the estimates and calculations that eventually boil down to this one amount for net pension cost.12

Accounting Entries The year’s pension cost for a defined benefit plan is an adjusting entry, analogous to the entry for accrued interest expense payable. If the net pension cost for the year were $500,000, the entry would be

Net Pension Cost . . . . . . . . . . . . . . . . . . . . . 500,000

Accrued Pension Cost (a liability) . . . . . . . 500,000

If a subsequent contribution of $450,000 were made to the plan by the employer, the entry would be

Accrued Pension Cost . . . . . . . . . . . . . . . . . . 450,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000

Note that the remaining $50,000 accrued pension cost liability is related to how much of the employer’s accrued pension cost has not as yet been contributed to the separate pension plan entity. If the employer has contributed more than the amount of its ac- crued pension cost, then the excess is recorded as Prepaid Pension Cost, an asset.

Employers must recognize the funded status of their employee defined benefit plans and other postretirement plans (see below)—measured as the difference between the fair value of plan assets and the benefit obligation—in their balance sheets.

Disclosure In addition to reporting the period’s net pension cost and unfunded plan position, for each of its defined benefit plans, a company must disclose a number of detailed items, such as each of the four components of net pension cost and the elements of the cal- culation of a plan’s funding position. These details are reported in a note to the finan- cial statements. Also, the plan itself must make certain disclosures as an entity.13

12 The FASB uses the term net pension cost rather than net pension expense for the same reason we used Wages Cost rather than Wages Expense in the previous section: Pension costs for manufacturing employees may be capitalized as part of the cost of inventory rather than treated as a period expense. 13 “Accounting and Reporting by Defined Benefit Pension Plans,” FASB Statement No. 35. “Accounting and Reporting by Retirement Benefit Plans,” IAS No. 26.

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Employees often receive other retirement benefits (other postretirement benefits), such as health care and life insurance benefits. The substance of the accounting for these benefits is similar to that for pensions: The total costs that will be incurred by retirees is estimated and a portion of the present value of these costs is charged as an expense in each year that an employee works.14 For health care costs, this requires estimating employees’ needs for postretirement health care services as well as the future cost of such services. These are even more difficult and uncertain estimates than those required for pensions.

For many companies, the requirement to accrue other retirement costs has resulted in a huge obligation for unfunded and unrecognized future nonpension postretirement benefits that employees already had earned.

In some organizations, any vacation and sick leave days that were earned this year but not used this year can be carried forward and used at some future time. If the amount can be reasonably estimated, the cost of these future compensated absences is treated as an expense of the period in which the future absence time is earned. The offsetting credit is to an accrued liability account. When the employee is later compensated, the liability account is debited and Cash is credited.15

Income Taxes

To the beginning accounting student, accounting for income taxes might seem to be straightforward. One might think that all that is involved is calculating the year’s in- come tax liability—the year’s tax bill—and then debiting this amount to Income Tax Expense and crediting it to Income Taxes Liability. (Some companies call the tax expense account Provision for Income Taxes. Also, the liability account may be called Taxes Payable.) Unfortunately, income tax accounting is not so simple. As a result, the tax expense of most corporations is the sum of two components: current income tax expense (this year’s tax bill) and deferred income tax expense (see below).

For most revenue and expense transactions, the amount used in calculating taxable in- come for income tax purposes is the same as the amount used in calculating pre-tax income in the income statement as prepared for shareholders. (The term taxable in- come always means income as reported to the taxing authorities; pretax accounting income, or pretax book income, refers to the amount reported in the income statement that is prepared in accordance with GAAP.) Taxable income and pretax book income are affected in the same way by most revenue and expense transactions. However, most is not the same as all transactions. Those transactions that are not reported in the same way for book and tax purposes cause a difference between pretax book income and taxable income and the carrying amounts of assets and liabilities for book and tax purposes.

A company buys personal computers costing over $15,000 for each for its managers. For tax purposes, it elects to use an accelerated depreciation method to depreciate the com- puters. For financial reporting purposes, it decides to use the straight-line method. As a result, in the first year, the depreciation charge for tax purposes will be higher than the

Compensated Absences

Book-to-Tax Differences

Example

Other Postretirement Benefits

14 “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” FASB Statement No. 106 and FASB Statement No. 158. 15 “Accounting for Compensated Absences,” FASB Statement No. 43.

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depreciation charge for financial reporting purposes. If all other items are accounted for in the same way for tax and financial reporting purposes, the company’s taxable income for this year will be lower than its book pretax income. In addition, at the end of the year, the net carrying amount of the computers (cost less accelerated depreciation charge) on the company’s tax books will be lower than their net carrying amount (cost less straight-line de- preciation charge) on the company’s financial reporting books. (The difference between these two carrying amounts is the cumulative difference between the book and tax depre- ciation charges.)

It is these book-to-tax balance sheet differences that create the complications in accounting for income taxes.

Why the Difference? Before further explaining these complications, we should consider why the difference between taxable income and book income and the tax basis and book value of balance sheet items arises. The answer essentially is that the process of income taxation has little to do with the reporting of financial information to shareholders and other inter- ested outside parties. Income tax laws are formulated, in part, to encourage certain kinds of behavior by taxpayers on the premise that such behavior is good for the econ- omy as a whole. For example, the accelerated depreciation provisions of corporate tax law are intended to encourage investment in fixed assets. By contrast, GAAP is for- mulated to accomplish the objectives of financial reporting (described in Chapter 1), including providing information that is useful to investors and creditors in making rational investment and credit decisions.

As a specific example of the different perspectives of taxation and financial re- porting, consider depreciation. If a corporation acquires an asset that qualifies for accelerated depreciation over six years for tax purposes, the corporation should take advantage of that provision of the law; it should depreciate the asset as rapidly as the law permits. Assuming nonincreasing tax rates over time, the present value of the tax savings associated with reporting a dollar of depreciation expense now is greater than the present value of the savings if the expense is reported in the future. On the other hand, if the corporation believes that the asset will give up its benefits in a level stream over an eight-year period, the depreciation method customarily used in finan- cial reporting is the straight-line method, which, for an eight-year life, would have an annual rate of 12.5 percent. Over the useful life of the asset, this method will provide the appropriate matching of the asset’s original cost with the benefits received from using the asset. Thus, the company would be completely justified in using straight- line depreciation for book purposes while at the same time using accelerated depre- ciation for tax purposes.

Some critics of business like to suggest that there is something cynical or evil about these book versus tax differences. But there is nothing wrong with a corporation’s (or an individual’s) doing everything legally permitted to reduce income taxes. As Supreme Court Justice Learned Hand wrote:16

Over and over again courts have said there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands; taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

16 Commissioner v. Newman.

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Permanent and Temporary Differences There are two important classes of book-to-tax differences. First, the income tax regu- lations prohibit certain deductions from taxable income that are expenses under GAAP, and they permit certain revenue items to be excluded from taxable income. For exam- ple, fines are an expense for book purposes but are not tax deductible, and interest revenue on municipal bonds is income for book purposes but it is not taxable. These ex- ceptions create permanent differences between pretax book income and tax income. The differences are permanent in the sense that they will not reverse or “turn around” in some subsequent year.

In other situations, the income tax regulations permit or require revenues or ex- penses to be recognized in a different period than the recognition method used in financial reporting. For example, the tax law permits certain types of business to use a form of the installment method for recognizing revenues, even though the company may use the sales method for financial reporting. Another example is estimated war- ranty expense; GAAP requires that this be accrued in the period in which the warranted items are sold, whereas the tax law does not permit a deduction until the period in which warranty costs are actually incurred. These book-to-tax accounting recognition differences lead to temporary differences. These differences do reverse or “turn around” in later periods. For example, for a given installment sale contract, the total amount of revenue recognized for book (delivery method) and tax (installment method) purposes is the same over the entire life of the contract, but the amount rec- ognized in any one year for book and tax purposes will differ if the installment contract collections span more than one year.

No special accounting problem arises in the case of permanent differences. For a “tax preference,” such as the municipal bond interest exclusion, the amount reported to shareholders as income tax expense of the current period is simply lower than it would be if the preferential treatment did not exist. Permanent differences lower the effective tax rate that is applied to pretax book income. For an unallowable deduction, such as a fine, the reported income tax expense will be higher than if the expense could also be deducted for tax purposes.

By contrast, temporary differences do create complications in accounting for in- come tax expense. The reason has to do with the matching concept and not mis- leading statement users. The FASB and IASB feel that in each period a company’s financial statements should reflect the tax consequences of all of the events recog- nized in the financial statements that have current tax or taxable temporary differ- ence consequences.17 This means that, ignoring permanent differences and for the purposes of illustrating the FASB and IASB point of view, the amount of reported income tax expense is the amount of tax that would be due if the amount of pretax book income had also been reported to the government as taxable income. (As dis- cussed later, this is not the way deferred taxes are actually measured under GAAP and IFRS.) For example, assuming a 40 percent tax rate, if in some year a corpora- tion reports $1 million pretax income, then it also should report $400,000 income tax expense, irrespective of the amount of the company’s actual tax obligation for that year. The FASB and IASB believe that it would be misleading or confusing to users of the income statement if an amount of income tax expense other than $400,000 were reported when $1 million pretax income is reported and the tax rate is 40 percent.

17 “Accounting for Income Taxes,” FASB Statement No. 109. “Income Taxes,” IAS No. 12.

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Deferred Income Taxes

It might occur to the reader that if Income Tax Expense is debited without regard to the company’s actual tax bill but Cash must be credited based on the payment of that actual bill, then the dual aspect principle of accounting will be violated—less formally, “the books won’t balance.”

Because of temporary differences, in 2010 a corporation reported $1 million pretax income to its shareholders and an income tax expense of $400,000 but only $800,000 taxable in- come to the taxing authorities. Thus, its income tax expense was $400,000, but its actual income taxes were only $320,000 ($800,0000 * .40). Assume that these taxes have been paid (i.e., the taxes have all been credited to Cash; none is still a credit in Taxes Payable). Since an expense reduces Retained Earnings, we can think of these transactions solely in terms of their impact on the balance sheet:

Assets � Liabilities � Owners’ equity

Cash �320,000 Retained Earnings �400,000 (reflecting actual tax (reflecting tax expense used to bill payments) measure book income)

Question: Is the missing $80,000 ($400,000 � $320,000) credit entry a further reduction in assets, or is it an increase in a liability account or an owners’ equity account?

The answer is that the credit entry is an increase in a liability account. In journal entry form, the combined income tax expense and income tax payment transaction is

Income Tax Expense—Current . . . . . . . . . . . 320,000

Income Tax Expense—Deferred . . . . . . . . . . 80,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000

Deferred Income Taxes Liability . . . . . . . . 80,000

FASB Statement No. 109 and IAS No. 12 require that the asset and liability method (also called balance sheet liability method) be used to measure deferred income taxes.

The balance liability sheet method measures deferred income tax expense in two steps. First, the deferred income taxes liability or asset (discussed below) is calcu- lated using the differences between the tax basis (remaining balance for income tax purposes) and book values of the individual taxable items on the corporate report- ing balance sheet. (Remember the example given at the beginning of the income tax discussion.) Next, the deferred income tax expense is calculated. It is the change in the Deferred Income Taxes Liability account for the period. This procedure is demonstrated in Illustrations 10–4, 10–5, and 10–6 using the following $1 million asset example.

The example illustrates temporary differences created by the use of different depre- ciation methods for book and tax purposes, which is the most common source of tim- ing differences in practice. Assume that a company purchased for $1 million a single depreciable asset. For tax purposes, it is depreciated over a five-year period using the years’-digits method (discussed in Chapter 7). For financial reporting purposes, the company depreciates the asset over a five-year period using a straight-line method with zero residual value. There are no other differences between the company’s book and tax accounting. The company’s income for tax and book purposes is $1 million each year, before subtracting depreciation and tax expense. Finally, assume that the applicable tax rate is 40 percent (this includes both federal and state taxes).18

Deferred Tax Measurement

18 For the purpose of this illustration, we will ignore the income tax depreciation rules and methods discussed in Chapter 7.

Example

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Illustration 10–3 shows how the company would calculate its income taxes due to the government in each of the five years. Note how the company’s tax depreciation charge falls each year, leading to higher taxable income and taxes due. If the company reported its taxes due to the government as its tax expense for financial reporting pur- poses, its profit after taxes (net income) would decline each year from $733,300 in 2010 ($1 million � $266,700) to $626,700 in 2014 ($1 million � $373,300) as a consequence of its tax depreciation schedule. Thus, inherent in each year’s net income is a future tax consequence that reduces future net income below the previous year’s figure, making the current net income a misleading indication of future net income. Accounting for de- ferred taxes overcomes this problem by properly matching costs and revenues.

Illustration 10–4 shows the annual calculation of the $1 million asset’s tax basis. The values in the last column are the asset’s tax basis (undepreciated balance for tax purposes).

Illustration 10–5 presents the annual calculation of the $1 million asset’s book value (undepreciated balance for financial reporting purposes).

Illustration 10–6 shows the calculation of the company’s deferred income taxes liabil- ity (step number one) and deferred income tax expense (step number two). Column (3) in Illustration 10–6 is the key column. It shows the temporary differences between the $1 million asset’s book value and tax basis. Using the balance sheet liability method, the deferred income taxes liability is 40 percent (the tax rate) of the values in

Income before Depreciation Taxable Taxes Due Depreciation and Taxes Charge Income (at 40 percent rate)

Year (1) (2)* (3)† (4)‡

2010 $1,000.0 $ 333.3 $ 666.7 $ 266.7 2011 1,000.0 266.7 733.3 293.3 2012 1,000.0 200.0 800.0 320.0 2013 1,000.0 133.3 866.7 346.7 2014 1,000.0 66.7 933.3 373.3________ ________ ________ ________

$5,000.0 $1,000.0 $4,000.0 $1,600.0________ ________ ________ ________________ ________ ________ ________

*Assets’ original depreciable cost times years’-digits rate (5⁄15 in 2010, 4⁄15 in 2011, 3⁄15 in 2012, 2⁄15 in 2013, and 1⁄15 in 2014). †Column (1) less column (2). ‡Column (3) times .4.

ILLUSTRATION 10–3 Calculation of Taxes Due (thousands of dollars)

Original Annual Tax Cumulative Tax Depreciable Cost Depreciation Depreciation Tax Basis

Year (1) (2)* (3)† (4)‡

2010 $1,000 $333.3 $ 333.3 $666.7 2011 1,000 266.7 600.0 400.0 2012 1,000 200.0 800.0 200.0 2013 1,000 133.3 933.3 66.7 2014 1,000 66.7 1,000.0 –0–

*Column (1) times years’-digits rate (5⁄15 in 2010, 4⁄15 in 2011, 3⁄15 in 2012, 2⁄15 in 2013, and 1⁄15 in 2014). †Cumulative sum of column (2). ‡Column (1) less column (3) (year-end balance).

ILLUSTRATION 10–4 Tax Basis Calculation (thousands of dollars)

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Original Annual Tax Cumulative Book Net Book Book Cost Depreciation Depreciation Value

Year (1) (2)* (3)† (4)‡

2010 $1,000.0 $200.0 $ 200.0 $800.0 2011 1,000.0 200.0 400.0 600.0 2012 1,000.0 200.0 600.0 400.0 2013 1,000.0 200.0 800.0 200.0 2014 1,000.0 200.0 1,000.0 –0–

*Column (1) times .2. †Cumulative sum of column (2). ‡Column (1) less column (3) (year-end balance).

ILLUSTRATION 10–5 Net Book Value Calculation (thousands of dollars)

ILLUSTRATION 10–6 Deferred Income Tax Liability and Deferred Income Tax Expense (credit) Calculation: Balance Sheet Method (thousands of dollars)

Deferred Income Net Book Net Book Value Deferred Income Tax Expense

Value Tax Basis Less Tax Basis Taxes Liability (Credit) Year (1)* (2)† (3)‡ (4)§ (5)�

2010 $800.0 $666.7 $133.3 $53.3 $53.3 2011 600.0 400.0 200.0 80.0 26.7 2012 400.0 200.0 200.0 80.0 0.0 2013 200.0 66.7 133.3 53.3 (26.7) 2014 –0– –0– –0– –0– (53.3)

*See Illustration 10–5 Column (4) (year-end balance). †See Illustration 10– 4 Column (4) (year-end balance). ‡Column (1) less column (2). §Column (3) times .4. (Beginning balance assumed to be zero.) Tax rate is 40 percent. �Change in column (4).

this column [see column (4)]. The last column in Illustration 10–6, column (5), shows the annual change in the deferred income taxes liability balance. This change is the de- ferred income tax expense (credit) for the year.

The actual income tax due for 2010 is calculated as in Illustration 10–3 and is recorded in the following journal entry (for 2010):

Income Tax Expense—Current . . . . . . . . . . . 266,700

Income Taxes Payable . . . . . . . . . . . . . . . 266,700

The 2010 income tax expense amount is then adjusted to reflect the income tax that should be matched with pretax accounting income. For 2010, this requires an addition of $53,300 to Income Tax Expense (Illustration 10–6), so the entry is

Income Tax Expense—Deferred . . . . . . . . . . . . 53,300

Deferred Income Taxes Liability . . . . . . . . . . 53,300

After this entry, Income Tax Expense totals $320,000, which is the amount reported on the income statement for 2010.

Accounting Entries

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When the taxes are paid, the entry is19

Income Taxes Payable . . . . . . . . . . . . . . . . . . 266,700

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266,700

Combining all three 2010 entries, the net effect is as shown in this single entry:

Income Tax Expense . . . . . . . . . . . . . . . . . . . 320,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266,700

Deferred Income Taxes Liability . . . . . . . . 53,300

Nature of Deferred Income Taxes Liability Deferred Income Taxes is a liability account. It is shown separately from Income Tax Liability (or Taxes Payable), which is the amount actually owed the government at the time. Deferred Income Taxes is not a liability in the sense that the amount is an obligation owed to the government as of the date of the balance sheet. It is a liability only in the sense of a deferred credit to income. It is an amount that will reduce income tax expense in the years in which the temporary differences between book and tax accounting reverse (the years 2010–14 in Illustration 10–6).

For any year during the five-year period in the above $1 million asset example, the balance in Deferred Income Taxes Liability account can be thought of as an interest- free loan from the government that has resulted from Congress passing a tax law that allows accelerated depreciation for calculating taxable income rather than allowing only straight-line depreciation. For example, the deferred tax liability balance at the end of 2012 means that the company has been able to postpone (or defer) paying in- come taxes of $80,000 ($200,000 * .4) by taking advantage of the tax law’s acceler- ated depreciation provision. This is like having an interest-free $80,000 loan, com- pared with what would be the case if straight-line depreciation had to be used for tax purposes.

Permanent Deferrals As shown in Illustration 10–6, column (4), at the end of the life of the asset, the bal- ance in the Deferred Income Taxes Liability account is zero. This is always the case with respect to a single asset. If, however, we drop the assumption that the company operates with only a single asset and make instead the more realistic assumption that a company acquires additional assets each year, a strange situation develops in the Deferred Income Taxes Liability account.

As long as the company grows in size, the credit balance in Deferred Income Taxes Liability continues to increase. Even if the company stops growing in size, a sizable credit balance remains in the account. This balance remains permanently; there will always be a credit balance in the Deferred Income Taxes Liability account unless the company stops acquiring assets (i.e., it begins to shrink).

Furthermore, since replacement costs of assets increase in periods of inflation, the credit balance will continue to grow even if the physical size of the company remains constant. For these reasons, many companies report a large deferred income taxes lia- bility on their balance sheet. This is not an obligation owed to some outside party, and it is unlikely that the balance in the account ever will be eliminated, or even that it will decrease. The effective permanency of this increasing credit balance has led many companies to argue against deferred tax accounting.

19 In practice, corporations must make estimated payments throughout the year, just as individuals do.

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Deferrals are not necessarily permanent, however. For example, for professional service firms such as architectural and consulting firms, the IRS has generally per- mitted recognizing revenues when clients pay their bills (the collection method), as opposed to when the firm has performed the services for the client. If a firm’s rev- enues are growing, this results in an increasing balance of deferred taxes, because col- lections always lag behind the performance of work. However, if a firm were to cease operations, the full amount of the deferred taxes would come due as the clients for whom work had already been performed sent in their cash payments. (A similar but less extreme effect occurs if the firm’s revenues decrease, rather than the firm com- pletely ceasing operations.) This phenomenon causes the FASB to believe that de- ferred taxes are indeed a liability. The FASB draws an analogy with an item that is clearly a liability—accounts payable. Even though the balance in Accounts Payable increases as a firm grows, there is turnover within the account—that is, old payables are paid (debits) as new ones are recorded (credits). Similarly, the fact that the balance in Deferred Income Taxes Liability is growing (or constant) does not mean that re- versals of old deferrals are not taking place.

Deferred Tax Assets In some circumstances, book-to-tax differences result in a deferred tax asset. For ex- ample, GAAP requires a company to charge estimated future warranty costs as an ex- pense of the period in which the warranted goods are sold, but U.S. tax law does not permit deducting such costs until they actually are incurred. This means that an appli- ance manufacturer with increasing sales (assuming corresponding increasing warranty costs) will show an increasing balance in a deferred income taxes asset account; this happens because (other things being equal) each period’s lower warranty costs on its tax return will result in higher taxable income than its pretax book income. Similarly, a magazine publisher is required for income tax purposes to recognize subscription payments when they are received, whereas GAAP requires that these prepayments be treated as a liability (Deferred Subscription Revenues). With a growing subscription base (or a constant base but increasing subscription prices), the publisher also will ex- perience an increasing balance in a deferred income tax asset account, because each year’s taxable income will be greater than its pretax book income.

Also giving rise to a deferred tax asset are tax-loss carryforwards. These are de- ductions or credits that a company cannot make use of on its current tax return that may be carried forward to reduce taxable income in a future year.

The amount of the deferred tax asset cannot exceed the amount of future tax bene- fits that the company actually expects to receive. If the company believes that “it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized,” a valuation allowance must be established to reduce the nominal amount of the deferred tax asset to its estimated realizable amount.

Recognition of a deferred tax asset (a debit entry) gives rise to a deferred tax credit. The deferred tax credit reduces the income tax expense. For any accounting period, the total deferred tax credit is equal to the change in the recognized deferred tax asset during the period.

Tax Rate Changes The discussion of deferred taxes thus far has assumed that the tax rate would indefi- nitely remain constant. This assumption masked an issue in deferred tax accounting. We will state the issue in the form of two questions: (1) Should the amount of tax

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deferral caused by a temporary difference be based on the tax rate in effect when the difference arose or on the rate expected to be in effect when the difference reverses? (2) If corporate tax rates change, should deferred income taxes assets and liabilities be restated, based on the new rates?

The FASB’s answer to these questions is that new deferrals are entered in the ac- counts based on the tax rates that currently enacted tax laws state will be in effect when the temporary differences will reverse. The balance in a deferred income taxes account is adjusted if a later change in the tax law changes the rates from those that were ex- pected to apply. This adjustment affects reported (book) net income in the year in which the tax rate change is enacted; the adjustment is a component of income tax expense.

A new tax law is passed that reduces the corporate income tax rate from 40 percent to 35 percent. This change requires that the balance in Deferred Income Taxes Liability be re- duced from $680,700, which was calculated based on a 40 percent rate, to $595,613, a reduction of $85,087. The journal entry is

Deferred Income Taxes Liability . . . . . . . . . . 85,087

Income Tax Expense—Deferred . . . . . . . 85,087

Financial Statement Disclosure The FASB requires that deferred tax asset and liability amounts be reported separately; they cannot be combined into a single net asset or net liability amount. Also, deferred tax assets and liabilities must be classified as current or noncurrent based on the clas- sification of the related asset or liability for financial reporting. Thus, for example, a deferred tax liability related to fixed asset depreciation timing differences would be classified as noncurrent because the depreciable asset is noncurrent. On the other hand, a deferred tax liability relating to using the installment method for tax purposes would be classified as current (assuming the related installment receivables were classified as current).

In contrast to GAAP, IFRS does not permit the classification of deferred tax assets and liabilities as current assets and liabilities.20

Foreign Currency Accounting

Changes in the price of a foreign currency vis-à-vis the dollar—that is, fluctuating ex- change rates—cause problems in preparing financial statements involving a foreign subsidiary.21 These problems are foreign currency translation accounting problems. Also, whether or not a company has a foreign subsidiary, the company may engage in transactions with foreign entities; these transactions lead to foreign currency transac- tion accounting problems. Both types of problems are discussed below.

If an American firm buys or sells goods abroad or borrows from, or grants credit to, a foreign entity, the firm may experience a foreign currency transaction gain or loss as a result of exchange rate fluctuations between the date the transaction was entered into and the date cash is transmitted.

Foreign Currency Transactions

20 “Income Taxes,” IAS No. 12. 21 As will be explained in Chapter 12, a subsidiary is an entity controlled by another entity, called its parent. Consolidated financial statements report on the parent and all of its subsidiaries as if they were a single economic entity.

Example

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Shipley Shoe Store received from an Italian manufacturer a shipment of shoes with an in- voice for 50,000 euro (€). On the date the invoice was received and the transaction jour- nalized, the U.S. dollar–euro exchange rate was $1.10 per euro, giving a $55,000 account payable for the shoes received. Thirty days later, when Shipley paid its bill in euro, the exchange rate had increased to $1.30 per euro. Thus, Shipley had to pay $65,000 to buy the required euro, and a currency exchange loss of $10,000 was realized. This would be accounted for as follows:

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . 55,000

Loss on Foreign Exchange . . . . . . . . . . . . . . . . 10,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Note that this transaction loss occurred because the transaction was denominated in a currency other than the dollar. If Shipley had originally agreed to pay $55,000 rather than €50,000 for the shipment, no transaction loss would have occurred.

Transaction gains and losses are included in the calculation of net income for the pe- riod in which the exchange rate changes. This is true whether or not the gain or loss has been realized. For example, if Shipley had still owed the €50,000 as of December 31, 2010, and if at that time the exchange rate was anything other than $1.10 per euro, then Shipley would have recognized a transaction gain or loss in its 2010 income state- ment. If the payment were then made on January 12, 2011, another gain or loss would have been recognized if the exchange rate were different on January 12, 2011, than it was on December 31, 2010.22 The sum of these two recognized transaction gains or losses would equal whatever gain or loss was ultimately realized.

Usually the accounts of a foreign subsidiary are kept in the currency of the country in which the subsidiary operates. In preparing consolidated statements, the American par- ent must translate these foreign currency amounts into dollars (called more generally the reporting currency). Because exchange rates fluctuate, the question arises as to the date or dates that should be used to determine the exchange rates used in this for- eign currency translation process.

FASB Statement No. 52 There are various possible answers to this question, but FASB Statement No. 52 lim- ited the possibilities to two.23 The nature of the subsidiary’s functional currency de- termines which translation method is used. A company’s functional currency is the currency of the primary economic environment in which the company operates.24 If that currency is other than the dollar, the subsidiary’s financial statements are trans- lated into dollars using the net investment, or current rate, method. With this method, the parent’s investment in a foreign subsidiary is considered to be an invest- ment in the subsidiary’s net assets (i.e., assets minus liabilities). Accordingly, all of the

Example

22 “Foreign Currency Translation,” FASB Statement No. 52. “The Effects of Changes in Foreign Currency Exchange Rates,” IAS No. 21. 23 IFRS foreign currency translation standards are similar to FASB Statement No. 52. 24 The salient economic factors management should consider when determining a foreign sub- sidiary’s functional currency are (1) the currency denomination of its cash flows, sale prices, expenses and financings and (2) the degree to which the foreign subsidiary’s activities are integrated with its parent company. For example, if the foreign subsidiary operates primarily in dollars and as an inte- grated extension of its parent, the dollar is its functional currency. IAS No. 21 places emphasis in the functional currency decision on the currency of the economy that determine the pricing of transac- tions, as opposed to the currency in which transactions are denominated.

Foreign Currency Translation Adjustments

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foreign entity’s assets and liabilities are translated at the current exchange rate as of the balance sheet date. All revenue and expense items are translated at the average rate for the period.

The Franco Company, a French subsidiary of its U.S. parent, Americo, Inc., was formed on January 1, 2010. Americo’s initial investment in Franco was $6.5 million, which at the time was equivalent to €5 million because the January 1, 2010, exchange rate was $1.30 per euro. Franco’s 2006 financial statements are shown in Illustration 10–7. All year-end assets and liabilities are translated at the $1.20 per euro exchange rate as of December 31, 2010. All income statement items are translated at the average 2010 exchange rate, which was $1.25 per euro. Franco’s capital stock is translated at the rate in effect when it was con- tributed by Americo, $1.30 per euro. The dollar amount for retained earnings is simply the beginning balance (zero) plus net income ($1.25 million) less dividends (zero).

Collectively, these translation calculations leave the dollar balance sheet’s sum of liabilities and owners’ equity $550,000 greater than the total assets. The negative $550,000 translation adjustment restores the dollar balance sheet’s equality. But this $550,000 downward adjustment can be viewed as more than just a “plug” figure. Since Americo held euro net assets while the value of the euro fell relative to the dollar, Americo sustained a holding loss in the dollar value of this net assets investment. The calculation of this loss is shown at the bottom of Illustration 10–7. The translation loss (or gain) does not appear on the translated income statement. Rather, this amount will be disclosed and accumulated in a separate account in the owners’ equity portion of the translated balance sheet. This account appears as a component of other nonowner changes in owners’ equity, with a name such as “Cumulative foreign currency transla- tion adjustments.” The translated foreign subsidiary’s statements are then consolidated with the parent’s statements, as described in Chapter 12.

If a foreign subsidiary’s functional currency is the dollar, its financial statements are translated into dollars using the remeasurement method (temporal method).25 The objective of the remeasurement method is to report the foreign subsidiary’s financial statement amounts as if its activities were carried out as an integral part of its parent’s operations rather than as a separate entity. This approach is consistent with the charac- teristics of the foreign subsidiary’s operations and financing that determined the dollar is its functional currency. The remeasurement method translates most financial state- ment items using the same exchange rates as the current rate method. There are several exceptions. Long-lived assets and inventories are translated using the exchange rate as of the date the asset was acquired (historical rate). For example, if the € 4,000 Equip- ment (net) balance shown in Illustration 10–7’s December 31, 2010, balance sheet had been acquired on January 1, 2010, and the dollar was the functional currency, it would be translated into dollars using the $1.30 exchange rate (the January 1, 2010, rate). Similarly, the December 31, 2010, €3000 Inventories balance would be translated into dollars using the average exchange rate for its holding period. The expenses related to assets translated at their historical rate are also translated at the same historical rate. For example, the 2010 euro-denominated depreciation expense for the equipment ac- quired on January 1, 2010, would be translated at the same $1.30 exchange rate used to translate the related equipment’s euro balance (not shown on financial statement). The use of historical rates results in the foreign subsidiary’s assets and their related ex- penses being recorded in dollars at the same dollar cost as if they had been originally

25 Under GAAP and IFRS, this method also must be used when the three-year cumulative inflation rate in the foreign subsidiary’s domicile country is approximately 100 percent. See “Financial Report- ing in Hyperinflationary Economics,” IAS No. 29.

Example

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Chapter 10 Other Items That Affect Net Income and Owners’ Equity 303

ILLUSTRATION 10–7 Foreign Statement Translations

FRANCO COMPANY Balance Sheet

As of December 31, 2010 (in thousands except exchange rates)

Exchange Euro Rate Dollars

Assets Cash € 1,000 $1.20 $ 1,200 Receivables 5,000 1.20 6,000 Inventories 3,000 1.20 3,600 Equipment (net) 4,000 1.20 4,800________ _______

€13,000 $15,600________ _______________ _______

Liabilities and Owners’ Equity Liabilities € 7,000 1.20 $ 8,400 Capital stock 5,000 1.30* 6,500 Retained earnings† 1,000 1,250 Accumulated translation adjustment‡ — (550)________ _______

€13,000 $15,600________ _______________ _______

Income Statement For the Year Ended December 21, 2010

(in thousands except exchange rate)

Exchange Euro Rate Dollars

Revenues €20,000 $1.25 $25,000________ Cost of Sales 12,000 1.25 15,000 Other Expenses 7,000 1.25 8,750________ _______ Net Income € 1,000 $ 1,250________ _______________ _______

*Exchange rate as of the date capital stock issued (€ � $1.3). † €1,000 net income added to retained earnings.

‡Calculation of translation loss: Jan. 1, 2010, net assets � €5,000 (Capital stock):

Translated at December 31, 2010, rate � 5,000 * $1.20 � $6,000 Translated at January 1, 2010, rate � 5,000 * $1.30 � $6,500_____

Loss on beginning-of-year net assets ($500) Increment in net assets during 2010 � €1,000:

Translated at December 31, 2010, rate � €1,000 * $1.20 � $1,200 Translated at average 2010 rate � €1,000 * $1.25 � 1,250_____

Loss on incremental net assets ($50)_____ Total loss in dollar value of net assets $(550)__________

acquired by the parent. Unlike the current rate method’s treatment of translation gains and losses, the temporal method requires translation gains or losses (also referred to as remeasurement gains or losses) to be included in the measurement of net income.

Derivatives

A derivative instrument is a financial instrument or other contract that derives its value by direct references to the changes in the values of one or more underlyings. Under- lyings can be the return or yield on another security or contract, a per share price, an

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304 Part 1 Financial Accounting

interest rate, an index of prices, or some other variable. An underlying is not trans- ferred from one party to another at the inception of the contract and may or may not be transferred on maturity of the contract.

You own 100 shares of Example Corporation, which on September 12, 2010, traded for $135 per share. You sell to someone the right to buy your 100 shares at any time during the next six months at a price of $145 per share. The right you sold is a derivative—over the next six months, its value will change by direct reference to the per share price of Example’s stock.26 If the price of an Example share does not go over $145 during the next six months, the buyer of your contract will not exercise the right to obtain your shares. Alternatively, if the price goes over $145, the holder of the right may ask you to deliver the 100 shares or you may keep your shares and pay over to the holder the difference between the current price of the shares and $145.

Derivatives are used by companies both for investment purposes and for hedging their risks from swings in security prices or fluctuations in interest rates, currency rates, or the prices of commodities.

The FASB and IASB require all derivatives held or written by a company to be rec- ognized as assets or liabilities on the company’s balance sheet and to be measured at their fair value. Any unrealized gains or losses on derivatives enter directly into the measurement of current income or owners’ equity, depending on the reason for enter- ing into the derivative contract.27

Pro Forma Earnings

Companies sometimes supplement their GAAP net income announcements with an additional earnings number labeled pro forma earnings.28 The principal characteris- tic of these supplemental numbers is that they exclude certain items included in the measurement of GAAP earnings, such as merger-related charges, nonrecurring items, and goodwill impairment write-offs. These pro forma earnings announcements are not covered by GAAP, but the Securities and Exchange Commission insisted that they not be misleading.

Net Income

The bottom line on the income statement is labeled net income or net earnings (or loss), without any qualifying phrase. The term net income never appears as a label for any other item on the income statement. Note that in Illustration 10–2 the label is “In- come from continuing operations,” not “Net income from continuing operations.”

Example

26 Such contracts as the one described in the example are traded on many of the major exchanges. The $145 is known as the strike or exercise price. This type of contract is called a call option (the buyer has the option to “call” for your 100 shares). The seller of the option is referred to as the writer. You could have bought an option to sell your stock at a specified price within some future period. This is a put option. 27 “Accounting for Derivative Instruments and Hedging Activities,” FASB Statement No. 133. “Financial Instruments: Recognition and Measurement,” IAS No. 39. 28 Other terms used to describe this type of earnings number include core, adjusted, cash, and recurring earnings.

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Net income therefore means the net addition from the income statement to Re- tained Earnings during the accounting period, regardless of whether it arises from ordinary operations or from other events and regardless of whether the transactions entering into its determination are recurring or are highly unusual.

The FASB and IASB require disclosure of a company’s total nonowner changes in owners’ equity (comprehensive income). This is not a particularly helpful disclosure and may be subject to misinterpretation if not correctly described.

A few unusual items are reported on the income statement separately from revenues and expenses of recurring operations. These include extraordinary losses or gains (GAAP only), gain or loss from discontinued operations, and the adjustment that results from changing accounting principles.

In analyzing transactions regarding wages costs, a careful distinction must be made be- tween the amount earned by the employee, the additional cost that the employer incurs for payroll taxes, and the amount collected from employees that is to be transmitted to the gov- ernment. Employee pension and other postretirement benefit costs are costs associated with work done in the current period, although the actual pension payments and provision of other benefits may not begin until many years later. Accounting for defined contribution plans is straightforward, but accounting for defined benefit plans and other postretirement benefits requires complicated estimates and computations.

A period’s income tax expense is the sum of the two tax items: current income taxes and deferred income taxes. The resulting difference between reported income tax expense and the income tax actually payable is recorded in the Deferred Income Taxes Liability or Asset ac- count. This account does not represent an amount due the government; Taxes Payable shows the amount that is currently due.

Foreign currency transaction gains or losses arise from transactions between a domestic company and a foreign entity, where the transaction is denominated in the foreign entity’s currency; they are included in net income. Foreign currency translation gains or losses arise from a domestic parent holding an investment in the net assets of a foreign subsidiary; depending on the functional currency designation they are included in income or directly accumulated in the other nonowner changes in owners’ equity component of the owners’ equity section of the parent’s consolidated balance sheet.

The FASB and IASB require that all derivatives of a company be recognized as assets or liabilities on the company’s balance sheet and be measured at their fair value.

Sometimes companies include in their earnings announcements an amount referred to as “pro forma” earnings. It must not be misleading.

Problems Problem 10–1.

Robin Bradley received a paycheck from her employer in the amount of $776.35. The pay- check stub indicated that in calculating her $776.35 net pay, $139.75 had been withheld for federal income tax, $34.25 for state income tax, and $74.65 for FICA. Assuming that Robin’s employer had to match her share of FICA tax, and in addition had to pay unem- ployment insurance tax of $40.05, prepare journal entries that record these transactions in Robin’s employer’s accounts.

Chapter 10 Other Items That Affect Net Income and Owners’ Equity 305

Summary

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Problem 10–2. Ryan’s Snack Shacks, Inc., had a 2010 pension cost of $85,000. The company’s 2010 cash contribution to the defined pension plan trust was $40,100. Prepare journal entries to record these pension cost and funding transactions.

Problem 10–3. Acton Design Group is an incorporated architectural firm that began operations on January 1, 2007. It reports to its shareholders on the accrual basis, but to the Internal Revenue Service on the cash basis. Following is a schedule of its 2007–2010 revenues, expenses, receipts, and disbursements. For each year shown, calculate the company’s income tax payment and income tax expense (provision for income taxes). Assume that in all four years the effective tax rate was 30 percent.

2007 2008 2009 2010

Revenues $456,000 $696,000 $840,000 $780,000 Expenses 270,000 672,000 798,000 618,000 Receipts 336,000 636,000 894,000 690,000 Disbursements 288,000 528,000 750,000 606,000

Based on your calculations, do you feel the company was wise in using the cash basis for its tax returns? Explain.

Problem 10–4. During 2010, Kirkpatrick Corporation purchased a new electric generator for $2,750,000. The generator is expected to have a five-year useful life and will be disposed of in 2015 without any anticipated residual value. The company uses straight-line depreciation on its income statement. The company will charge $275,000 depreciation in 2010 and 2015 and $550,000 per year in 2011–2014, inclusive. For tax purposes, the generator falls into a spe- cial five-year cost recovery class. The cost recovery percentage rates applicable to the gen- erator are as follows (i.e., 20 percent of the cost is deducted for tax purposes in 2010):

Year Cost Recovery Class Rate

2010 20.0% 2011 32.0 2012 19.2 2013 11.5 2014 11.5 2015 5.8

Kirkpatrick expects its income before depreciation and income taxes to be $1,500,000 per year for years 2010–2015. The combined federal and state income tax rate is 40 percent.

Required: Prepare a schedule showing

a. Each of the six years’ income tax payments, starting in 2010.

b. Each year’s provision for income taxes.

c. The balance in the deferred tax account at the end of each year. (Assume a zero be- ginning balance.)

As you develop your schedule, for each year make a posting to the following T accounts: Cash (for payments), Income Tax Expense, and Deferred Taxes. In what year does the tem- porary difference reverse?

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Problem 10–5. The Smith Corporation disclosed $1.2 million as an unusual loss on its internal income statement this year. The footnotes to the financial statements disclose the following occur- rences this year:

1. Accounts receivable of $85,000 were written off.

2. A loss of $125,000 was incurred when a storage facility in Louisiana was damaged in a hurricane.

3. A loss of $325,000 was incurred when a warehouse in northern New Mexico was dam- aged by a flood.

4. The company lost $365,000 when Smith sold one of its operating divisions.

5. A loss of $300,000 was incurred when a manufacturing facility in Washington state was damaged by an explosive device placed by a disgruntled ex-husband of an employee.

Required: a. Are the items above extraordinary items for external reporting purposes?

Discuss.

b. Show how the extraordinary items section of the income statement should have been reported (the tax rate is 30 percent).

Problem 10–6. Heritage, Ltd., is a U.S. company doing business in 20 countries. Local exchange rates for U.S. $1 at year-end before the introduction of the Euro were

British pound (£) .52 Spanish peseta (PTA) 90.00 Italian lira (�) 1200.00 Australian dollar ($A) 1.25

The company’s records indicate the following transactions for the year:

1. Purchased inventory from Roma Fine Skins in exchange for a note payable of �72,000,000. The exchange rate at that time was �1,250 to $1.

2. While the exchange rate was peseta 100 to $1, sold raw materials to Lopez Trading Company in exchange for a PTA 270,000 note receivable.

3. While the exchange rate was £.5 to $1, sold equipment to U.K. Copies, Ltd., in exchange for an account receivable of £360,000.

4. Purchased from Containers Ltd. (Australia) spare bottles for $A149,500 (Australian). The exchange rate, when the accounts payable was incurred, was $A1.25 (Australian) to $1.

Required: a. What is the U.S. dollar equivalent for the above transactions?

b. Record the transactions in journal entries.

c. If these payables and receivables are outstanding at year-end, would there be an exchange gain or loss for each of the above transactions?

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Cases

Case 10–1

Norman Corporation (B)* In addition to the transactions listed in Norman Cor- poration (A) [Case 8–1], several other matters were re- ferred to Allen Burrows for his opinion as to how they should be reported on the audited 2010 income state- ment and balance sheet.

1. Norman had purchased advertising brochures cost- ing $125,000 in 2010. At the end of 2010, one-fifth of these brochures were on hand; they would be mailed in 2011 to prospective customers who sent in a coupon request for them. As of March 1, 2011, al- most all the brochures had been mailed. Norman had charged $100,000 of the cost of these brochures as an expense in 2010, and showed $25,000 as a de- ferred charge as of December 31, 2010.

2. In 2010 the company had placed magazine adver- tisements, costing $75,000, offering these brochures. The advertisements had appeared in 2010. Because the sales generated by the brochures would not occur until after prospective customers had received the brochures and placed orders, which would primarily be in 2011, Norman had recorded the full $75,000 as a deferred charge on its December 31, 2010, balance sheet.

3. Norman’s long-standing practice was to capitalize the costs of development projects if they were likely to result in successful new products. Upon introduc- tion of the product, these amounts were written off to cost of sales over a five-year period. During 2010, $55,000 had been added to the asset account and $36,000 had been charged off as an expense. Pre- liminary research efforts were charged to expense, so the amount capitalized was an amount that re- lated to products added to Norman’s line. In the ma- jority of instances, these products at least produced some gross profit, and some of them were highly successful.

4. In 2010, the financial vice president decided to cap- italize, as a deferred charge, the costs of the com-

pany’s employee training program, which amounted to $35,000. He had read several books and articles on “human resource accounting” that advocated such treatment because the value of these training programs would certainly benefit operations in fu- ture years.

5. For many years, Norman’s practice had been to set its allowance for doubtful accounts at 2 percent of ac- counts receivable. This amount had been satisfactory. In 2010, however, a customer who owed $19,040 went bankrupt. From inquiries made at local banks, Norman Corporation could obtain no reliable esti- mate of the amount that eventually could be recov- ered. The loss might be negligible, and it might be the entire $19,040. The $19,040 was included as an ac- count receivable on the proposed balance sheet.

6. Norman did not carry fire or theft insurance on its automobiles and trucks. Instead, it followed the practice of self-insurance. It charged $5,000 as an expense in 2010, which was the approximate cost of fire and theft insurance policies, and credited this amount to an insurance reserve, a noncurrent liabil- ity. During 2010, only one charge, for $3,750, was made to this reserve account, representing the cost of repairing a truck that had been stolen and later re- covered. The balance in the reserve account as of January 1, 2010, was $20,900.

7. In 2010, the board of directors voted to sell a park- ing lot that the company had operated for several years. Another company had expressed an interest in buying the lot for approximately $125,000. In 2010, the pretax income generated by this lot was $19,000. The book value of the assets that would be sold was $50,000 as of the end of 2010. Norman did not reflect this transaction in its financial state- ments because no final agreement had been reached with the proposed buyer and because the sale would not take place until well into 2011, even if a final agreement were reached in the near future.

8. During 2010, the president of Norman exercised a stock option and the corporation used treasury

* Copyright © Professor Robert N. Anthony, Harvard Business School.

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stock for this purpose. The treasury stock had been acquired several years earlier at a cost of $10,000 and was carried in the shareholders’ equity section of the balance sheet at this amount. In accordance with the terms of the option agreement, the presi- dent paid $13,000 for it. He immediately sold this stock, however, for $25,000. Norman disregarded the fact that the stock was clearly worth $25,000 and recorded the transaction as

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

Gain on Treasury Stock . . . . . . . . . . 3,000

Treasury Stock . . . . . . . . . 10,000

The $3,000 gain was included as a nonoperating in- come item on the income statement.

9. Norman’s long-standing practice was to declare an annual cash dividend of $50,000 in December and

to pay it in January. When the dividend was paid, the following entry was made:

Retained Earnings . . . . . . . . . 50,000

Cash . . . . . . . . . . . . . . . . . 50,000

Questions

1. What changes in the financial statements [see Nor- man Corporation (A)] is Norman required to make in accordance with generally accepted accounting principles? Ignore income taxes and assume that all the transactions are material.

2. As Mr. Burrows, what additional changes, if any, would you recommend be made in the proposed in- come statement in order to present the results more fairly?

Case 10–2

Silver Appliance Company* Silver Appliance Company operated a large retail ap- pliance store in San Diego. The store sold all sorts of household appliances, plus auto and home sound equipment. The company’s owner, Brian Silver (known by his customers as “Big Brian” because of his rather ample proportions), had for many years been an extremely productive salesman in a San Diego store of the Highland Appliance chain. Having built up a large personal clientele during those years, Mr. Silver felt he could easily shift customers to a new store, were he to open one. In 2003, he did just that, and the store had rapidly achieved an annual sales volume of over $5 million.

In 2006 Mr. Silver decided he could increase the store’s volume, plus earn interest revenue, if he estab- lished an installment credit program to assist cus- tomers in financing their major purchases. The pro- gram was a success, with the amount of installment receivables growing in each successive year (except for 2010).

In early 2011 Mr. Silver decided the firm had out- grown its sole-practitioner accounting firm. He there- fore retained a national public accounting firm to pro-

vide Silver Appliance with various auditing, tax, and consulting services. The accounting firm’s partner as- signed to the Silver account was Suzi Chung. After reviewing Silver’s accounting practices, Ms. Chung met with Mr. Silver to review these practices. Of particular interest to Ms. Chung was the fact that Silver used the typical sale method (formally, the “delivery method”) to recognize sales—and hence cost of sales and gross margin—on all sales, irrespective of whether the sales were for cash, were charged to a Visa or MasterCard account, or were financed on Silver’s installment credit plan. Although she felt this made good sense and was in accord with GAAP for prepar- ing income statements for Mr. Silver’s use, Ms. Chung pointed out that the federal income tax laws permit the use of the installment method of revenue and gross margin recognition on installment plan sales.

With the installment method, the retailer recognizes revenues as installment payments are made and then applies the store’s normal gross margin percentage to these payments to determine the gross margin for tax purposes. For example, suppose a customer bought a $700 refrigerator having a cost of $490; then the gross margin percentage is 30 percent ($210 � $700). If the customer’s first installment payment were $50* Copyright © James S. Reece.

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(ignoring interest), the store would at that time recognize $15 (30% * $50) gross margin for tax purposes.

1 The effect of using this method for calculating taxable in- come is that it delays, relative to the delivery basis, the reporting of gross margin, and hence defers the taxes on that margin until the margin is realized through the customer’s cash installment payments.

After Ms. Chung’s explanation of the installment method, Mr. Silver expressed a definite interest in changing to this method for tax purposes. “However,” he said, “I want to keep using the regular basis for our monthly and annual income statements because I really feel we earn the margin when the customer signs the in- stallment agreement and we deliver the appliances. But before we change, I’d like to see how much we’ve been overpaying in taxes the past few years by not using the installment method.” To address this question, Ms. Chung gathered the data shown in Exhibit 1.

Mr. Silver raised several other questions with Ms. Chung. “I understand in general the impact that this method would have on our tax payments; but it’s not clear to me what the impact would be on our balance sheet, given that I don’t want to change methods on our income statement. I’ve seen an item called ‘de- ferred taxes’ on balance sheets in the annual reports of some companies that I own stock in. I know this is somehow related to using different accounting for shareholder and income tax reporting. Would we have such an account if we make this change? If so, you

will have to explain to me how I should interpret the balance in that account.

“Also, I have a friend who owns an architectural firm that reports on the cash basis for tax purposes. She was telling me the other day that her billings have really dropped this year because of the downturn of local construction activity, and yet she is still having to make tax payments as big as last year’s. Could this happen to us if we change our method for reporting in- stallment sales for tax purposes?

“Finally, it occurs to me that we have already paid taxes on the installment sales profits we recognized in 2010, even though many of those sales have not yet been collected. If we change methods for 2011, are we going to end up paying taxes twice on those uncollected 2010 installment sales—once in 2010 and again in 2011?”

Questions

1. If Silver Appliance Company had used the install- ment method for tax purposes in the years 2006–2010, how different would its tax payments have been in each of those years? What would the year-end balance in deferred taxes have been in each of those years? (Round calculations to the nearest $10.)

2. How would you respond to Mr. Silver’s questions concerning (a) interpretation of the amount of de- ferred taxes, (b) tax payments in a period of declin- ing sales, and (c) double taxation of installment sales made in 2010?

2006 2007 2008 2009 2010

Installment receivables as of December 31 $190.1 $351.9 $526.2 $559.4 $489.1 Pretax profit as reported 332.6 415.3 478.2 492.5 461.3 Gross margin percentage 34.6% 35.1% 34.2% 33.4% 32.2%

Notes: 1. All installment sales contracts were for periods of one year or less. 2. The company’s effective federal income tax rate in each year was approximately 34 percent.

EXHIBIT 1 Installment Sales Data (thousands of dollars)

1 The formal accounting treatment is to recognize $50 of revenues, match with that $35 cost of goods sold, and thus recognize $15 gross margin, as explained in Chapter 5.

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Case 10–3

Freedom Technology Company*

Freedom Technology Company produced various types of household electronic equipment, which it sold primarily through two large retail store chains in the United States. On October 1, 20x1, Freedom estab- lished a wholly owned subsidiary in South Korea, called Freedom-Korea, for the purpose of assembling a small home version of a video arcade game that Freedom had been licensed to produce. The Korean subsidiary sold its output directly to the U.S. retailers that carried the game (as opposed to selling its output to its U.S. parent for resale to U.S. retailers).

Exhibit 1 shows the subsidiary’s condensed balance sheet as of September 30, 20x2 (fiscal year-end) and an income statement for its first year of operations. Freedom’s controller, Marion Rosenblum, asked a member of the accounting staff to translate these state- ments into dollars, following the standards of FASB Statement No. 52.

The accounting staff person assembled the follow- ing information to assist in preparing the two sets of translated statements:

1. The South Korean unit of currency is the won (ab- breviated W). As of October 1, 20x1, the exchange rate was one won � $0.00140; as of September 30, 20x2, the rate was one won � $0.00124.

2. As of October 1, 20x1, Freedom-Korea’s assets were W400 million cash and W600 million fixed assets. No additional fixed assets were acquired during the first year of operations. On average, the year-end inventories had been on hand 11⁄2 months; the exchange rate on August 15, 20x2, was one won � $0.00126.

3. The capital stock of Freedom-Korea had been is- sued to Freedom-Technology on October 1, 20x1; no additional capital stock transactions had taken place during the fiscal year.

EXHIBIT 1

FREEDOM-KOREA Balance Sheet

As of September 30, 20x2 (millions of won)

Assets Liabilities and Owners’ Equity

Cash W 591 Current liabilities W 624

Receivables 1,182

Inventories 552 Capital stock 1,000

Fixed assets 575 Retained earnings 1,276_______ _______

W2,900 W2,900_______ ______________ _______

Income Statement For the Year Ended September 30, 19x2

(millions of won)

Revenues W7,090_______ Cost of sales 4,415

Other expenses 1,399_______ Net income W1,276______________

* Copyright © Professor Robert N. Anthony, Harvard Business School.

Chapter 10 Other Items That Affect Net Income and Owners’ Equity 311

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312 Part 1 Financial Accounting

Questions

1. Prepare translated year-end statements for Free- dom-Korea using the current rate method.

2. Prepare a translated (i.e., measured) year-end state- ment for Freedom-Korea using its temporal method. This method requires any translation gain or loss to be included as an item in the translated income

Case 10–4

Proxim, Inc.*

EXHIBIT 1

PROXIM, INC. Statement of Operations for the Year Ended December 31, 2001

(in thousands, except per share data)

GAAP Pro Forma

Revenue $ 85,536 $85,536 Cost of revenue excluding amortization and provision 49,367 49,367 Amortization of intangible assets 2,832 — Provision for excess and obsolete inventory 50,000 —_________ _______ Gross profit (loss) (16,663) 36,169 Research and development 13,235 13,235 Purchased in-process research and development 1,373 — Selling, general, and administrative 22,057 22,057 Provision for doubtful accounts 4,500 — Restructuring charges 13,585 — Impairment of goodwill and intangible assets 10,372 — Terminated merger costs 2,950 — Patent litigation costs 2,600 — Amortization of goodwill 5,252 —_________ _______ Income (loss) from operations (92,587) 877 Interest income, net 1,905 1,905 Impairment gain (losses) on investments (12,074) — Income (loss) before taxes (102,756) 2,782 Provision for income taxes 5,043 974_________ _______ Net income (loss) ($107,799) $1,808_________ _______ Basic net income (loss) per share ($3.87) $0.06 Diluted net income (loss) per share ($3.87) $0.06

Source: Proxim Inc., 2001 form 10-K.

Julie Cassidy, a financial analyst with a major institu- tional investor, was puzzled by the large number of what appeared to be “nonrecurring” items in Proxim,

Inc.’s 2001 income statement (Exhibit 1). In particular, she was confused as to what income figure or figures she should use to judge the performance of manage- ment and value of the company’s common stock.

Earlier, in mid-January, Proxim had issued a press release announcing its fourth quarter and year-end

*Based on case research previously conducted by Professor Mark Bradshaw, Harvard Business School.

statement. You may treat any such gain or loss as a “plug” figure; that is, you are not expected to calcu- late it in detail.

3. Compare your two sets of translated statements and comment on any differences between them. If the company were permitted a choice as to which method to use, which method do you think they would prefer?

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Chapter 10 Other Items That Affect Net Income and Owners’ Equity 313

2001 financial results. This release indicated fourth quarter revenues were $16.7 million (compared to $33.6 million in the prior year’s fourth quarter) and $85.5 million for the year (compared to $107.5 million for the prior year). Excerpts from the release are in- cluded in Exhibit 2.

Questions

1. Why do you think Proxim has so many “nonrecur- ring”-type charges during 2001?

2. As the management of Proxim, what income figure do you believe best reflects your 2001 performance?

3. What 2001 income figure would you use to calculate Proxim’s 2001 trailing year price-earnings ratio?

4. Should the Securities and Exchange Commission be concerned with any proliferation of pro forma earnings announcements? If you had to write a new Securities and Exchange regulation covering pro forma earnings announcements, what might your regulation require?

5. Should the Financial Accounting Standards Board issue guidance on reporting earnings information. For example, should it define what constitutes acceptable measurements of pro forma earnings? What guidance, if any, do you recommend the Financial Accounting Standards Board issue?

Excluding the provisions and charges discussed below, and the amortization of intangible assets and goodwill in the respective periods, the pro forma loss for the fourth quarter of 2001 was $(1,093,000), or $(0.04) per share, compared to pro forma net income of $4,943,000, or $0.17 per share (diluted) for the fourth quarter of 2000, and pro forma net income for the year ended December 31, 2001, was $1,808,000, or $0.06 per share (diluted), compared to pro forma net income of $14,631,000, or $0.51 per share (diluted) for the year ended December 31, 2000.

Including the provisions and charges discussed below, and the amortization of intangible assets and good- will in the respective periods, the loss for the fourth quarter of 2001 was $(16,002,000), or $(0.53) per share, compared to net income of $1,970,000, or $0.07 per share (diluted) for the fourth quarter of 2000, and the loss for the year ended December 31, 2001, was $(107,799,000), or $(3.87) per share, compared to net in- come of $2,149,000, or $0.07 per share (diluted) for the year ended December 31, 2000.

During the fourth quarter of 2001, the Company recorded a restructuring charge of $12,635,000 related to a reduction in workforce and closing certain facilities. The fourth quarter 2001 restructuring charge includes $1,400,000 related to severance payments and closed facilities lease costs during the quarter, and $11,235,000 related to closed facilities lease commitments, net of estimated future sublease receipts for the closed facilities.

During the fiscal year ended December 31, 2001, the Company recorded the following charges and provi- sions: restructuring charges of $550,000 in the second quarter, $400,000 in the third quarter, and $12,635,000 in the fourth quarter; provisions for excess and obsolete inventory and purchase commitments totaling $44,000,000 in the second quarter and $6,000,000 in the third quarter; increases in the allowance for doubtful accounts of $2,000,000 in the second quarter and $2,500,000 in the third quarter; a charge for purchased in-process research and development related to the acquisition of Card Access, Inc., of $1,373,000 in the third quarter; a charge for the impairment of goodwill and purchased intangible assets of $10,372,000 in the second quarter; a charge for expenses related to a terminated merger of $2,950,000 in the first quarter; a charge for expenses related to patent litigation of $2,600,000 in the first quarter; charges for the impairment of equity investments in five companies of $5,694,000 in the first quarter, $1,000,000 in the second quarter, and $5,380,000 in the third quarter; and a provision for deferred tax assets net of deferred tax liabilities of $5,043,000 in the second quarter.

Source: Business Wire, January 22, 2002.

EXHIBIT 2 Selected Excerpts from Proxim Inc., Q4 and Year-End 2001 Earnings Announcement

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11 The Statement of Cash Flows

Chapter

Our attention thus far has been focused on the analysis of transactions in terms of their effect on the balance sheet and the income statement. In this chapter, we describe the third accounting report that a company must prepare, the statement of cash flows (or cash flow statement).

The discussion of the cash flow statement was deferred to this point because this statement does not affect the way in which transactions are recorded in the accounts. The accounts provide information that is summarized in the balance sheet and the in- come statement. Information used in preparing the cash flow statement is derived from data reported in the other financial statements and therefore does not require any new accounts to be added to the recordkeeping system.

Purpose of the Cash Flow Statement

The income statement focuses on the economic results of the entity’s operating activi- ties during a period. Key concepts in the measurement of the period’s income are rev- enue recognition and the matching of expenses. Revenue is recognized in the period in which the entity performs its revenue-generating tasks (e.g., delivering goods or pro- viding services), irrespective of whether the customer pays cash at that time or agrees to pay later. Expenses measure the resources consumed in generating the period’s rev- enue and in administering the entity during the period, irrespective of when cash was used to pay for those resources. Thus, the period’s income bears no direct relationship to the cash flows associated with the period’s operations. Also, because of its focus on the results of operations, the income statement does not provide information about the entity’s investing or financing activities during the period.

The purpose of the cash flow statement is to provide information about the cash flows associated with the period’s operations and also about the entity’s investing and financ- ing activities during the period. This information is important both to shareholders, part of whose investment return (dividends) is dependent on cash flows, and also to lenders, whose interest payments and principal repayment require the use of cash. The welfare of other constituencies of a company—including its employees, its suppliers, and the local communities that may levy taxes on it—depends to varying degrees on the company’s ability to generate adequate cash flows to fulfill its financial obligations.

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The numbers on the cash flow statement are objective: Cash is cash, and the amounts of cash flows are not influenced by the judgments and estimates that are made in arriv- ing at revenues, expenses, and other accruals.1 Because of this objectivity, many ana- lysts pay considerable attention to the cash flow statement. It must be remembered that despite the judgments and estimates that influence balance sheet and income statement amounts, the numbers in those statements provide better information about an entity’s financial status and operating performance than do cash flow statement numbers.

The activities that the cash flow statement describes can be classified in two categories: (1) activities that generate cash, called sources of cash, and (2) activities that involve spending cash, called uses of cash. Of course, an entity’s operations routinely generate cash (especially from cash sales to customers and collection of customer accounts re- ceivable) and use cash (for most operating expenses, especially the payment of wages and accounts payable). The user of a cash flow statement is interested primarily in the net amount of cash generated by operations rather than in the detailed operating cash inflows and outflows. Thus, rather than separately showing operating cash inflows as sources and outflows as uses, this net amount is shown. Operations ordinarily are a net source of cash; however, operations are a net use of cash if they use more cash than they generate. A net use of cash is common in start-up companies and in companies that are expanding rapidly.

Treating this net of operating inflows and outflows as a single number, here are the following major types of cash sources and uses:

Sources Uses

1. Operations 1. Cash dividends 2. New borrowings 2. Repayment of borrowings 3. New stock issues 3. Repurchase of stock 4. Sale of property, plant, 4. Purchase of property, plant,

and equipment and equipment 5. Sale of other noncurrent assets 5. Purchase of other noncurrent assets

Inspection of the above lists suggests why cash flow statements are felt to be useful. They help the user answer questions such as the following:

• How much cash was provided by the normal, ongoing operations of the company? • In what other ways were significant amounts of cash raised? • Is the company investing enough in new plant and equipment to maintain or in-

crease capacity and to replace old facilities with more efficient ones? • Is the company reinvesting excess cash in productive assets, or is it using the cash

to retire stock? • To what extent are the company’s investments being financed by internally gener-

ated cash and to what extent by borrowing or other external sources? • For the cash obtained externally, what proportion was from debt and what from equity? • Is the company having to borrow cash in order to maintain its cash dividend payments?

Chapter 11 The Statement of Cash Flows 315

Sources and Uses of Cash

1 Despite the objectivity of cash flows, their classification between operating, investing, and financing cash flows can be manipulated by accounting decisions by management. For example, classifying a cost as a noncurrent asset rather than an expense changes the related cash flow to an investing cash flow rather than an operating cash flow.

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Although the cash flow statement cannot provide complete answers to all of these questions, it can at least suggest answers and highlight areas where it would be desir- able to gather more information before deciding, for example, whether to buy, sell, or hold one’s investment in the company’s common stock.

Meaning of Cash Companies using modern cash management techniques invest any temporary excess amounts of cash in highly liquid (i.e., can be readily sold at current market prices), short-term investments (e.g., money market funds and Treasury bills) for periods as short as one or two days. As a result, for purposes of the cash flow statement, cash means the sum of actual cash and these short-term investments; the sum is formally called cash and cash equivalents. The FASB defines cash equivalents as highly liquid investments that are readily convertible to known amounts of cash and that mature in no more than 90 days from the date of the financial statement.2 The IASB has a slightly different definition. It defines cash equivalents as short-term, highly liquid investments that are readily convertible to known amounts of cash that are subject to an insignifi- cant risk of changes in value.3

The Cash Flow Statement

Imagine that you have a checking account in which amounts over some minimum bal- ance, say $1,000, are automatically invested in highly liquid interest-bearing securities. Instead of your account representing just cash, it constitutes the sum of cash and cash equivalents. In your checkbook register, you record all deposits and other increases in the account (debit entries), and you also record all checks written and other with- drawals from the account (credit entries). Now assume that at the end of each year, you wish to prepare a summary of the sources of the items that you deposited in your ac- count and a summary of the various uses you made of the cash in the account. For ex- ample, the sources categories might be wages, investment earnings, and gifts, and the uses categories might be housing costs, other living expenses, recreation/entertain- ment, health care, taxes, and major purchases (such as a new television set or a car). You could first classify each entry in your checkbook register according to one of these categories, and then add the amounts of all of the items in each category and report the totals of the various categories. The end result could reasonably be called a personal cash flow statement.

In substance, the cash flow statement for a business entity is analogous in that it summarizes a myriad of specific cash transactions into a few categories. However, in practice, the information for the statement of cash flows is not taken directly from the Cash and Cash Equivalents accounts but rather is derived from income statement and balance sheet data. This section describes these derivation techniques.

316 Part 1 Financial Accounting

2 “Statement of Cash Flows,” FASB Statement No. 95, as amended by “Statement of Cash Flows— Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale,” FASB Statement No. 102, and “Statement of Cash Flows—Net Reporting of Certain Cash Receipts and Cash Payments and Classification of Cash Flows from Hedging Transactions,” FASB Statement No. 104. 3 “Statement of Cash Flows,” IAS No. 7. Outside the United States, the definition of cash may be different. Users of non-U.S.GAAP cash flow statements should always determine the definition of cash adopted before using the cash flow statement data.

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FASB 95 and IAS No. 7 do not use as many major categories for sources and uses as we listed above. Instead, those 10 types of sources and uses are combined into three major categories: operating activities, investing activities, and financing activities.

Operating activities are defined to be all transactions that are not investing or fi- nancing activities. These transactions include the cash inflows associated with sales revenues and the cash outflows associated with operating expenses, including pay- ments to suppliers of goods or services and payments for wages, interest, and taxes.

Investing activities include acquiring long-lived assets such as property, plant, equipment, and investments in securities that are not cash equivalents; and lending money (i.e., loans receivable). Investing activities also include the opposites of these transactions: disinvesting activities such as disposing of long-lived assets, and collect- ing loans. Note that increases or decreases in accounts receivable and inventory are not treated as investment activities; the changes in these current assets are included in operating activities.

Financing activities include the borrowing of cash (notes payable, mortgages, bonds, and other noncurrent borrowings) and the issuance of equity securities (com- mon or preferred stock). Repayments of borrowings are also financing activities, as are dividend payments to shareholders and the use of cash to repurchase and retire issued stock. Changes in accounts payable, wages payable, interest payable, and taxes payable are not treated as financing activities; they are operating activities.

IAS No. 7 gives managers more flexibility than FASB 95 when it comes to classify interest and dividend cash flows. IAS No. 7 permits, as long as it is done in a consistent manner, interest and dividend cash flows to be classified as either operating, investing, or financing activities depending on the nature of the transaction.

Because the procedures for developing the net cash flow from operations are more complex than those for developing cash flows related to investing and financing activi- ties, we will describe the latter two cash flow statement categories first. The descriptions for all three categories are based on the financial statements shown in Illustrations 11–1 and 11–2 and the resulting statement cash flows shown in Illustration 11–3.

Illustration 11–1 shows that during 2010 investment in plant and equipment (at cost) increased by $350,000 (from $2,000,000 to $2,350,000). This is the net increase in in- vestment during the year: Additional plant and equipment investments minus disposals amounted to a net increase (at cost) of $350,000. From the balance sheet alone one cannot determine whether there was $350,000 of new fixed assets acquired and no disposals or some combination of acquisitions and disposals that amounted to a net in- crease of $350,000. Thus, the preparer of the cash flow statement would need to exam- ine the Plant and Equipment account to make this determination. In this instance it happens that the investment in new equipment was $500,000 and the original cost of equipment disposed of was $150,000, resulting in the $350,000 net increase.

Conceptually, this net amount should be broken down into the portion that repre- sents a cash outflow and the portion that represents a cash inflow, and we do this in the description that follows. However, as a practical matter, flows that are not material in amount are often netted.

If $500,000 cash was paid for the new assets and $20,000 cash received for the old assets, then the cash flow statement would report each of these investing transactions as follows:

Acquisition of plant and equipment $(500,000)

Proceeds from disposals of plant and equipment 20,000

Chapter 11 The Statement of Cash Flows 317

Statement Categories

Investing Activities

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Thus, inflows and outflows related to a specific type of asset are shown as separate gross amounts rather than as a single net amount (i.e., a $480,000 net outflow in the example just given).

A similar approach is applied to the 2010 decrease of $50,000 in investment secu- rities (from $450,000 to $400,000). If that decrease were the result of selling $50,000 of securities (at cost) during the year and receiving $50,000 cash, then one line on the cash flow statement would describe the transactions:

Proceeds from sales of investment securities $50,000

318 Part 1 Financial Accounting

ILLUSTRATION 11–1

FAIRWAY CORPORATION Balance Sheets

As of December 31, 2009, and 2010 (in thousands)

2009 2010 Change

Assets Current assets:

Cash and cash equivalents $ 230 $ 326 $ 96 Accounts receivable 586 673 87 Inventories 610 657 47______ ______ ____

Total current assets 1,426 1,656 230______ ______ ____ Noncurrent assets:

Plant and equipment, at cost 2,000 2,350 350 Accumulated depreciation (1,000) (970) 30______ ______ ____ Plant and equipment, net 1,000 1,380 380 Investment securities 450 400 (50)______ ______ ____

Total noncurrent assets 1,450 1,780 330______ ______ ____ Total assets $2,876 $3,436 $560______ ______ __________ ______ ____ Liabilities and Shareholders’ Equity Current liabilities:

Accounts payable $ 332 $ 388 $ 56 Income taxes payable 9 10 1 Short-term borrowings 147 126 (21)______ ______ ____

Total current liabilities 488 524 36 Long-term debt 500 835 335 Deferred taxes 65 70 5______ ______ ____

Total liabilities 1,053 1,429 376______ ______ ____ Shareholders’ equity:

Common stock ($1 par) 50 60 10 Additional paid-in capital 133 167 34 Retained earnings 1,640 1,780 140______ ______ ____

Total shareholders’ equity 1,823 2,007 184______ ______ ____ Total liabilities and shareholders’ equity $2,876 $3,436 $560______ ______ __________ ______ ____

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On the other hand, if the $50,000 were the net of $75,000 cash inflows from securities sales and $25,000 outflows for purchases, then the cash flow statement would show

Purchases of investment securities $(25,000)

Proceeds from sales of investment securities 75,000

Finally, if the $50,000 net change in investment securities on the balance sheet were different from the associated net cash flow, then the cash flow would be reported. For example, if securities with a balance sheet carrying amount of $50,000 were sold for $53,000, the cash inflow reported would be $53,000, even though the balance sheet In- vestment Securities account decreased by $50,000.

The company’s investing activities are summarized in the middle section of the cash flow statement shown in Illustration 11–3. Note that all of the individual items are sum- marized to arrive at a single net amount of cash flow associated with investing activi- ties, in this case an outflow (use) of $430,000.

During 2010 Fairway Corporation’s short-term borrowings decreased by $21,000 (from $147,000 to $126,000). The underlying records reveal that this was the net effect of $15,000 of new borrowings and $36,000 repayments of old borrowings. Rather than reporting the net amount, the cash flow statement would show

Proceeds of short-term debt $15,000

Payments to settle short-term debt (36,000)

Similarly, analysis of the underlying transactions reveals that the $335,000 increase in long-term debt was the net of $375,000 new borrowings and $40,000 repayments of previous long-term debt. This would be reported as follows:

Proceeds of long-term debt $375,000

Payments on long-term debt (40,000)

Chapter 11 The Statement of Cash Flows 319

ILLUSTRATION 11–2

FAIRWAY CORPORATION Income Statement and Statement of Retained Earnings

For the Year Ended December 31, 2010 (in thousands)

Sales revenues $3,190

Cost of sales 2,290______ Gross margin 900

Expenses:

Depreciation $120

Other expenses 477*

Income taxes 103 700____ ______ Net income $ 200____________

Retained earnings, December 31, 2009 $1,640

Add: 2010 net income 200

Less: Cash dividends (60)______

Retained earnings, December 31, 2010 $1,780____________

* Net of $20,000 gain on disposal of equipment.

Financing Activities

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The $40,000 cash payments are a reduction in the principal of the long-term debt; interest payments are treated as an operating transaction rather than as an investing or financing activity.

Also during 2010, Fairway issued 10,000 additional shares of $1 par value common stock resulting in cash proceeds to the corporation of $44,000. On the balance sheet, this appears as a $10,000 increase in common stock at par and a $34,000 increase in additional paid-in capital. On the cash flow statement, the following line would appear:

Proceeds from issuing common stock $44,000

320 Part 1 Financial Accounting

ILLUSTRATION 11–3

FAIRWAY CORPORATION Statement of Cash Flows

For the Year Ending December 31, 2010 (in thousands)

Net cash flow from operating activities:

Net income $200

Noncash expenses, revenues, gains, and losses included in income:

Depreciation 120

Deferred taxes 5

Increase in accounts receivable (87)

Increase in inventories (47)

Increase in accounts payable 56

Increase in taxes payable 1

Gain on sale of equipment (20)_____

Cash flow from operating activities 228_____

Cash flows from investing activities:

Acquisition of plant and equipment (500)

Proceeds from disposals of plant and equipment 20

Purchase of investment securities (25)

Proceeds from sales of investment securities 75_____

Net cash used by investing activities (430)_____

Cash flows from financing activities:

Proceeds of short-term debt 15

Payments to settle short-term debt (36)

Proceeds of long-term debt 375

Payments on long-term debt (40)

Proceeds from issuing common stock 44

Dividends paid (60)_____

Net cash provided by financing activities 298_____

Net increase (decrease) in cash and cash equivalents 96

Cash and cash equivalents at beginning of year 230_____

Cash and cash equivalents at end of year $326__________

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4 In our view, the FASB’s way of recording this transaction does not adequately capture its substance. In effect, there was a $300,000 financing transaction that momentarily increased cash, representing the note payable proceeds. Then this $300,000 plus another $200,000 cash was used to make the $500,000 investment in the fixed asset. Thus, in substance, there was a $300,000 financing activity inflow and a $500,000 investing activity outflow rather than a $200,000 investing activity outflow.

Finally, FASB 95 treats dividend payments to shareholders as a financing activity. As shown at the bottom of Illustration 11–2, cash dividends amounted to $60,000. This would appear on the cash flow statement thus:

Dividends paid $(60,000)

Note that it is the amount of cash dividends paid during the year, as opposed to the amount of dividends declared for the year, that appears on the cash flow statement. In this instance, the amount paid was the same as the amount declared: $60,000. How- ever, because the dividend declared for the last quarter of the year ordinarily is not paid until early in the following year, it is not unusual for the amount of dividends declared for the year to be different from the amount paid during that year.

The bottom section of the cash flow statement in Illustration 11–3 reports and sum- marizes all of the company’s 2010 financing activities. The net cash flow from these ac- tivities was a $298,000 inflow (source). We emphasize that although the level of detail we have shown is conceptually correct, certain immaterial flows would be netted in practice.

Some significant investing and financing activities do not involve cash flows at all, such as the conversion of a convertible bond into common stock. Certain other invest- ing and financing activities, although affecting cash, do not affect it in the full amount of the investment or financing transaction. For example, if an entity acquires a fixed asset costing $500,000 by making a $200,000 cash payment and giving the seller an equipment note payable for the other $300,000. The cash flow statement report only the $200,000 cash outflow associated with the fixed asset investment transaction.4 How- ever, both the FASB and IASB require disclosure of the $300,000 noncash portion of the transaction in a narrative statement or supplemental schedule.

A transaction involving the conversion of $400,000 face value of bonds into com- mon stock results in no cash inflows or outflows. Thus, it is not reported in the state- ment of cash flows. However, the substance of such a conversion is that stock is issued, resulting in a cash inflow, and then the proceeds of the issuance are used to retire the bonds, an equal and offsetting outflow. FASB 95 and IAS No. 7 require that the conver- sion be reported in a supplemental disclosure, thus: “Additional stock was issued upon conversion of $400,000 of bonds payable.”

As mentioned above, the cash flow statement reports the net cash flow generated by the period’s operations. This net amount can be presented in two ways: the direct method and the indirect, or reconciliation, method.

Direct Method With the direct method of reporting cash flows from operating activities, summaries of operating inflows and outflows are shown and then combined to arrive at the net

Chapter 11 The Statement of Cash Flows 321

Noncash Transactions

Cash Flow from Operating Activities

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cash flow from operations. For Fairway Corporation in 2010, the presentation would appear as follows:

Cash flows from operating activities:

Cash received from customers $3,103,000

Dividends and interest received 19,000__________

Cash provided by operating activities 3,122,000__________

Cash paid to suppliers and employees 2,729,000

Interest paid 67,000

Income taxes paid 98,000__________

Cash disbursed for operating activities 2,894,000__________

Net cash flow from operating activities $ 228,000____________________

FASB 95 “encourages” companies to use the direct method. It results in a straightfor- ward presentation that is intuitively understandable by users with little or no account- ing training. However, it does not suggest why the year’s net operating cash flow ($228,000) differed from the year’s net income ($200,000). However, because one of the FASB’s stated purposes of a statement of cash flows is to help users understand the differences between net income and the associated cash receipts and payments, if the direct method is used, then a reconciliation of net income and net cash flow from oper- ating activities must be provided in a separate schedule.

Indirect Method Because it does not clearly show why the year’s net income differs from the year’s net operating cash flow, the direct method is not the preferred one in practice. Most com- panies prefer a presentation that helps the user understand the reasons for the difference between the period’s net income and the period’s net cash flow from operations—the reconciliation, or indirect, method.

The indirect method is much harder to understand than the direct method. We will first illustrate the presentation and then explain the calculations on which the indirect method is based. The presentation is as shown in the top portion of Illustration 11–3, labeled “Net cash flow from operating activities.”

The approach of the indirect method is to start with the net income amount and ad- just it for differences between revenues (or gains) and operating cash inflows, and for differences between expenses (or losses) and operating cash outflows. For many com- panies, the largest adjustment relates to depreciation.

Depreciation To understand the depreciation adjustment, consider the adjusting entry made to record depreciation expense:

Depreciation Expense . . . . . . . . . . . . . . . . . 120,000

Accumulated Depreciation . . . . . . . . . . 120,000

Note that this entry reduces income by $120,000 but has no effect on Cash. (To affect Cash, the credit would have to be to Cash rather than to Accumulated Depreciation.) Now assume for the moment (contrary to fact) that (1) revenues were equal to operating

322 Part 1 Financial Accounting

Indirect Method Calculations

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cash inflows (Cash was debited whenever Sales Revenues was credited) and (2) total expenses excluding depreciation expense were equal to operating cash outflows (ex- cept for depreciation, Cash was credited whenever an expense account was debited). Then net income would be $120,000 lower than net operating cash flow because $120,000 depreciation expense was subtracted in the calculation of net income, but this $120,000 expense did not reduce Cash. Thus, if we add $120,000 back to the amount of net income, then the resulting amount is the net cash flow from operations. Because of our assumptions, this is the only adjustment needed to take account of revenues that were not also cash inflows and expenses that were not also cash outflows. Note in the Illustration 11–3 reconciliation presentation that $120,000 is added to the net income of $200,000 as one of the adjustments.

Deferred Taxes To understand the adjustment labeled “Deferred taxes,” we must review the nature of the Deferred Income Taxes account. This account will increase (be credited) if the period’s income tax expense is larger than the period’s income tax payments. Note in Illustration 11–1 that the balance in Deferred Taxes increased by $5,000 (from $65,000 to $70,000) during the year. Fairway’s 2010 tax expense was $5,000 larger than its 2010 tax payments. Thus, the amount subtracted for income taxes in preparing Fair- way’s income statement overstated the cash outflows for taxes by $5,000. To adjust the income statement to a cash basis, therefore, requires that this $5,000 overstatement of cash outflows be added back to the net income figure. Note that in the indirect method presentation, $5,000 is added to net income for this adjustment.

Analogously, if the balance in Deferred Income Taxes decreases during the year, then the amount of the decrease must be subtracted from net income. This is because the year’s tax payments were greater than the amount of reported tax expense, and the income statement thus overstates operating cash flows. (An understatement of an out- flow is equivalent to the overstatement of an inflow.)

Accounts Receivable To understand this adjustment, assume all sales are credit sales and recall that the na- ture of the period’s entries to Accounts Receivable is as follows:

Accounts Receivable

Beginning balance Collections (debit to Cash)

Sales revenue Ending balance

Beginning balance of next period

The following equation describes these relationships:

Beginning balance � Sales revenues � Collections � Ending balance

For purposes of developing the operating cash flow amount, the amount of collections is of interest, because this is the amount of cash inflows that resulted from sales. Yet the pe- riod’s net income is calculated based on the amount of revenues, not collections. The nec- essary adjustment can be calculated by a simple rearrangement of the above equation:

Collections � Sales revenues � (Ending balance � Beginning balance)

Thus, if the balance in Accounts Receivable increased during the year, collections can be deduced by subtracting the increase in receivables from sales revenues.

Chapter 11 The Statement of Cash Flows 323

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This was the case with Fairway Corporation in 2010: Collections � $3,190,000 � $87,000 � $3,103,000. (The $87,000 increase in receivables is the difference between the ending balance of $673,000 and the beginning balance of $586,000, as shown in Illustration 11–1.) Note that this result, $3,103,000, is the amount that was reported in the direct method as “Cash received from customers.”5

In a similar manner, it can be demonstrated that a decrease in the amount of accounts receivable during the period should be added to net income because such a decrease means that the period’s cash inflows from customers (i.e., collections) ex- ceeded the amount of sales revenue reported on the income statement.

Inventories The adjustment related to inventories can also be developed by focusing on the T account:

Inventories

Beginning balance Cost of sales

Purchases (credit Ending balance Cash)

Beginning balance of next period

In this case, the equation that is the basis of the adjustment is

Purchases � Cost of sales � (Ending balance � Beginning balance)

If inventories increased during the period, cost of sales understates the cash outflows for purchases, and the inventory increase must therefore be added to cost of sales to deduce the cash outflows. But adding to cost of sales, an expense amount, is equivalent to sub- tracting from net income. Thus, if inventories increased, the amount of the increase is subtracted from net income to adjust income to a cash flow basis. For Fairway Cor- poration, the inventories’ increase during 2010 was $47,000 ($657,000 � $610,000). Thus, $47,000 must be subtracted from 2010 net income to adjust cost of sales from an expense amount to a cash outflow amount.

Similarly, a decrease in inventory would be added to net income, which is equiva- lent to subtracting the amount of the decrease from cost of sales. If inventory decreases during the period, then the cost of sales amount overstates the cash outflows for the pe- riod’s inventory purchases, and this overstatement of outflows must be added back to net income to convert it to an operating cash flow amount.

Accounts Payable The adjustment related to changes in inventory converted the cost of sales expense item to a cash basis on the implicit assumption that all purchases for inventory were made for cash. The adjustment related to Accounts Payable relaxes this assumption and deals at the same time with purchases of resources that are expenses of the period, such as selling expenses, rather than assets. Since, in a sense, Accounts Payable is a mirror image of Accounts Receivable, the payables adjustment is algebraically the opposite of the receivables adjustment. Thus, if the balance in Accounts Payable increases during the period, the amount of the increase is added to net income to reflect the fact that the

324 Part 1 Financial Accounting

5 We have assumed that all sales are made on credit, which is the case with many nonretailing companies. The adjustment procedure is the same if some sales are made for cash. The reader can simply imagine that, for a cash sale, Accounts Receivable is simultaneously debited for the sales revenue and credited for the collection of this revenue.

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period’s expenses overstate the cash outflows for payments to suppliers. If the balance in Accounts Payable declines during the period, then suppliers have been paid more than is reflected in expenses; thus, a decrease in Accounts Payable is subtracted from net income to adjust it to operating cash flows. For Fairway Corporation in 2010, the $56,000 increase in Accounts Payable must be added to net income to adjust it to a cash flow amount.

Similar comments and the same rules apply to other payables related to operations— Interest Payable, Wages Payable, and Taxes Payable. However, there is no adjustment made for Notes Payable because that account relates to financing activities, not operat- ing activities.

Prepaid Expenses Fairway Corporation had no prepaid expenses. If there are prepaid expenses, the ad- justments related to them are the same as for inventories. An increase in the balance in Prepaid Expenses during the period is subtracted from the period’s net income. A de- crease in the balance of Prepaid Expenses is added to net income.

Gains and Losses The final type of adjustment made to net income to convert it to cash flow from opera- tions relates to gains or losses reported on the accrual-basis income statement. Such gains or losses ordinarily are related to the sale or disposal of property, plant, and equipment or of marketable securities. The income statement will report the difference between the proceeds (if any) from the asset’s sale or disposal and the asset’s carrying amount at the time of sale (net book value in the case of fixed assets). If the proceeds exceed the carrying amount, a gain will be reported; if the proceeds are less than the carrying amount, a loss will be reported.

However, from the standpoint of the cash flow statement, the write-off of the asset’s carrying amount is not relevant; the cash outflow associated with that amount occurred in some earlier period when the asset was acquired. Only the cash proceeds from the sale are of concern. Thus, the carrying amount of the asset must be added back to net income, since it was a write-off of a capitalized cost, not a cash outflow. Moreover, any cash proceeds from the asset’s disposal are treated as an investing activity inflow in that section of the cash flow statement. Therefore, if no adjustment was made, the disposal proceeds would get double-counted—once in the operating activities section and again in the investing section. Hence, the cash proceeds must be subtracted from net income to avoid this double-counting. When both adjustments are taken into account—adding back the asset’s carrying amount and subtracting the proceeds—the net effect simply reverses the reported gain or loss.

To illustrate such an adjustment, recall that Fairway Corporation sold a fixed asset in 2010 for $20,000 cash. The original cost of the asset was $150,000, but it was fully depreciated, so its net book value was zero.6 Thus, the sale resulted in a $20,000 gain that would have been recorded by this entry:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Accumulated Depreciation . . . . . . . . . . . . . 150,000

Equipment, at Cost . . . . . . . . . . . . . . . . 150,000

Gain on Disposal of Equipment . . . . . . . 20,000

Chapter 11 The Statement of Cash Flows 325

6 Note in Illustrations 11–1 and 11–2 that Fairway’s accumulated depreciation as of year-end 2009 was $1,000,000 and 2010 depreciation expense was $120,000, a sum of $1,120,000. Yet 2010 year- end accumulated depreciation was $970,000, or $150,000 less than $1,120,000. Thus, the amount of accumulated depreciation associated with the asset disposed of during 2010 was $150,000.

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In this case, because the carrying amount of the asset was zero, the gain and the cash proceeds are the same, $20,000. But recall that the $20,000 proceeds were treated as an inflow in the investing activities section of the cash flow statement. To report this $20,000 also as an inflow from operations would double-count it. Thus, the $20,000 gain must be subtracted in the cash flow from operating activities section to avoid this double-counting.

Book Value Suppose instead that equipment with a net book value of $10,000 had been disposed of with no resultant cash proceeds. In this case, the income statement would have re- ported a $10,000 loss; yet this would not have been associated with a $10,000 cash out- flow. Thus, the adjustment to net income to convert it to net operating cash flow would be to add back the $10,000 loss; otherwise, net income would understate cash outflows and thus understate net cash flow from operating activities.

As a final example, assume that property with a net book value of $10,000 was dis- posed of with cash proceeds of $15,000. The income statement would report a $5,000 gain. Since the sale of long-lived productive assets is treated as an investing activity, the $15,000 cash inflow from the disposal would be reported in that section of the cash flow statement. Thus, this $5,000 gain that is part of net income must be subtracted in the cash flow from operating activities section to preclude (1) double-counting the $15,000 proceeds and (2) counting the write-off of the $10,000 net book value as though it were a cash outflow when it is not.

In sum, the cash flow statement must accurately report the cash inflow (if any) as- sociated with the sale or disposal of long-lived assets, not the difference between cash proceeds and net book value, which is reported in the income statement. Because the cash inflow proceeds are reported in the investing activities section of the statement and the write-off of the carrying amount of the asset does not involve a simultaneous cash outflow, any gain or loss reported in the income statement must be reversed in de- veloping the amount for cash flow from operating activities.

Operating Activities: Summary With the adjustment for gains or losses, the indirect method format for the operating activities section of the cash flow statement is complete. Collectively, the adjustments constitute a reconciliation of net income and net cash generated by operating activities. As seen in Illustration 11–3, the $228,000 net inflow is the same as would have been reported had the direct method been used. (Indeed, some of the adjustment techniques described for the indirect method can be used to obtain the numbers reported by the di- rect method; the direct method simply reports the results of the adjustments rather than showing the adjustments themselves.) Illustration 11–4 is presented as a summary of the adjustments we have described under the indirect method.

The cash flow statement is divided into three major sections: operating, investing, and financing activities. Cash flow from operating activities can be prepared using the di- rect method or the indirect (reconciliation) method. Assuming use of the indirect method, the steps in preparing the statement of cash flows are as follows:

1. Find cash generated by operations by adjusting the net income as reported on the in- come statement using the procedures summarized in Illustration 11–4.

2. Identify any investing activities—for example, acquisition or sale of property, plant, and equipment or marketable securities. Report only the cash outflows associated with acquisitions; any portion of the cost of an acquisition that was financed by a

326 Part 1 Financial Accounting

Summary of the Cash Flow Statement

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Net income + – =

Depreciation expense Increase in deferred taxes Decrease in accounts receivable Decrease in inventories Decrease in prepaid expenses Increase in payables* Loss on disposal

Decrease in deferred taxes Increase in accounts receivable Increase in inventories Increase in prepaid expenses Decrease in payables* Gain on disposal

Net cash flow from operating activities

directly related liability (e.g., a mortgage) must be subtracted in arriving at the cash outflow associated with the acquisition. Report only the cash proceeds from the sale of an asset.

3. Identify any financing activities, such as new borrowings or repayments on existing borrowings, issuance or retirement of stock, and cash dividend payments. If a con- vertible security was converted, do not report it in the cash flow statement, but dis- close it in a supplementary narrative.

4. Sum the subtotals for the three sections of the statement to determine the increase or decrease in cash (and equivalents). This amount is then added to the beginning cash balance to arrive at the ending cash balance, as shown in the bottom portion of Illus- tration 11–3.

Misconceptions about Depreciation

The way in which cash generated by operations is determined in the indirect method can lead to confusion about the nature of depreciation. Hence, this calculation warrants further discussion. Instead of calculating net cash flow from operations by showing cash inflows from customers and other revenue sources and then subtracting cash out- flows for operating costs (the direct method), the starting point in the indirect method (as shown in Illustration 11–3) was the net income figure, to which depreciation was added. This add-back of depreciation was done because depreciation was an expense in Fairway’s accrual-basis income statement that did not represent an outflow of cash during the period. (As was shown by the journal entry to record depreciation expense, depreciation was neither a source nor a use of cash.)

Unfortunately, many people misunderstand the nature of the calculation deriving operating cash flow from net income. They have the misconception that depreciation is a source of cash. Their misunderstanding is compounded by the failure of some com- panies to label the add-back of depreciation as an adjustment needed to convert net in- come to cash generated by operations. Instead, these companies simply list both net income and depreciation under the heading, “cash flow from operations.” This confu- sion is exemplified by statements in the business press such as the following:

Depreciation should not be considered as a part of cash flow that can be used to pay div- idends; rather, it should be considered as a source of funds to replace plant.

This kind of capital expenditure we write off fairly quickly . . . so that it becomes part of the financing. It’s the cash flow.

Chapter 11 The Statement of Cash Flows 327

ILLUSTRATION 11–4 Calculating Operating Cash Flow from Net Income

* Includes accounts payable, wages payable (accrued wages), interest payable (accrued interest expense), and taxes payable; does not include notes payable, short- term borrowings, or current portion of long-term debt.

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The weaker airlines generally leased rather than bought their planes, thus forfeiting the chance to boost cash flow from depreciation. When ticket sales are an airline’s only source of cash, a plunge in bookings can quickly put a carrier out of business.

The loan may be repaid . . . through cash generated from the gradual liquidation of a fixed asset (represented by depreciation) or the earnings of the borrower . . . These two items—depreciation and earnings—constitute cash flow.

These statements are fallacious. Depreciation is not a source of cash. Some people argue that depreciation is a source of cash because depreciation ex-

pense reduces taxable income and hence reduces the cash outflow in payment of taxes. For example, if Fairway Corporation acquires more equipment in 2011, the additional depreciation expense will reduce its 2011 taxable income from what it would be if the equipment were not acquired, and hence will reduce the cash outflow for tax payments. This does not mean, however, that depreciation is a source of cash. The cash transaction is the income tax payment, and depreciation merely enters into the calculation of tax- able income and hence reduces the tax payment. By the same token, Fairway could re- duce its taxes in 2011 by increasing any expense, such as by giving every employee a 25 percent wage increase. Would one then say that increased wages expense is a source of cash?

Since in most companies depreciation is the principal expense item that does not in- volve the use of cash, the sum of net income plus depreciation is often a good approx- imation of the cash generated by operations. (This is presumably what the author of the final quotation had in mind.) This total is often called cash flow earnings. Although depreciation enters into the calculation of this amount, depreciation is not itself a source of cash. The cash is generated by earnings activities, not by an adjusting entry for depreciation. The FASB specifically prohibits reporting an item labeled cash flow income or cash earnings per share.

Preparation of the Cash Flow Statement

Unlike the balance sheet and income statement, which are prepared directly from the firm’s accounts, the cash flow statement is derived analytically from those accounts. This statement explains the changes in the cash and cash equivalents accounts between the beginning and ending balance sheets of the period. Since it is impractical to ana- lyze every transaction recorded in those accounts, we analyze the changes in all other asset accounts, as well as liabilities and owners’ equity, to determine their effect on cash during the period. Therefore, a logical way to prepare a cash flow statement is to identify and analyze the causes of differences between account amounts in the begin- ning and ending balance sheets. This analysis can be done in one of three ways: (1) by directly analyzing differences calculated from the comparative balance sheets, (2) by using a worksheet, or (3) by using T accounts.

The first approach is essentially the same as we have already used in explaining the derivation of amounts shown in Illustration 11–3, based on amounts in Illustra- tion 11–1. The worksheet and T account approaches are not conceptually different but are more methodical and hence reduce the chance of errors. We will demonstrate the worksheet method below.

We emphasize that these descriptions contain no new concepts. The two alternative approaches are merely mechanical devices for arriving at the amounts to be reported on the statement of cash flows.

328 Part 1 Financial Accounting

Cash Flow Earnings

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Illustration 11–5 is the worksheet for preparation of Fairway Corporation’s 2010 cash flow statement. On it have been entered the beginning and ending account balances from Illustration 11–1, and changes in these account balances have been calculated in the final column. We must explain the $96,000 increase in Cash. For each of the other accounts, we will reconstruct the journal entries that caused the changes. Entries that affect the amount of cash will be classified as one of three types: cash from operations, cash from investing activities, and cash from financing activities. Because these classi- fications correspond to the format of the cash flow statement, using them will facilitate its final preparation. The numbers in the entries that follow correspond to those on the completed worksheet in Illustration 11–6.7

Chapter 11 The Statement of Cash Flows 329

ILLUSTRATION 11–5

FAIRWAY CORPORATION Worksheet to Develop the Cash Flow Statement

For the Year Ended December 31, 2010

Analytical Entries Beginning Ending Net Balances Debit Credit Balances Change

Debit-balance accounts:

Cash 230,000 326,000 96,000 dr. Accounts receivable 586,000 673,000 87,000 dr. Inventories 610,000 657,000 47,000 dr. Plant and equipment, at cost 2,000,000 2,350,000 350,000 dr. Accumulated depreciation (1,000,000) (970,000) 30,000 dr. Investment securities 450,000 400,000 50,000 cr

2,876,000 3,436,000 560,000 dr.

Credit-balance accounts: Accounts payable 332,000 388,000 56,000 cr. Income taxes payable 9,000 10,000 1,000 cr. Short-term borrowings 147,000 126,000 21,000 dr. Long-term debt 500,000 835,000 335,000 cr. Deferred taxes 65,000 70,000 5,000 cr. Common stock ($1 par) 50,000 60,000 10,000 cr. Additional paid-in capital 133,000 167,000 34,000 cr. Retained earnings 1,640,000 1,780,000 140,000 cr.

2,876,000 3,436,000 560,000 cr.

Cash from operations: Sources Uses

Cash from investing activities:

Cash from financing activities:

7 Asset balances on Illustration 11–6 are shown as being debit-balance accounts, which is how they are recorded in the company’s general ledger. Similarly, liability and owners’ equity accounts are credit balances. Accumulated depreciation is a credit balance account included among the asset bal- ances as a negative amount.

Cash Flow Worksheet

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330 Part 1 Financial Accounting

ILLUSTRATION 11–6

FAIRWAY CORPORATION Completed Cash Flow Statement Worksheet

For the Year Ended December 31, 2010

Analytical Entries*Beginning Ending Net Balances Debit Credit Balances Change

Debit-balance accounts: Cash 230,000 96,000 326,000 96,000 dr. Accounts receivable 586,000 (7a) 87,000 673,000 87,000 dr. Inventories 610,000 (7b) 47,000 657,000 47,000 dr. Plant and equipment, at cost 2,000,000 (4) 500,000 (5) 150,000 2,350,000 350,000 dr. Accumulated depreciation (1,000,000) (5) 150,000 (3) 120,000 (970,000) 30,000 dr. Investment securities 450,000 (9a) 25,000 (9b) 75,000 400,000 50,000 cr._______________ ________________________________

2,876,000 3,436,000 560,000 dr._______________ _______________________________________________ ________________________________ Credit-balance accounts:

Accounts payable 332,000 (7c) 56,000 388,000 56,000 cr. Income taxes payable 9,000 (7d) 1,000 10,000 1,000 cr. Short-term borrowings 147,000 (10b) 36,000 (10a) 15,000 126,000 21,000 dr. Long-term debt 500,000 (11b) 40,000 (11a) 375,000 835,000 335,000 cr. Deferred taxes 65,000 (8) 5,000 70,000 5,000 cr. Common stock ($1 par) 50,000 (12) 10,000 60,000 10,000 cr. Additional paid-in capital 133,000 (12) 34,000 167,000 34,000 cr. Retained earnings 1,640,000 (2) 60,000 (1) 200,000 1,780,000 140,000 cr.

2,876,000 1,041,000 1,041,000 3,436,000 560,000 cr.

Cash from operations: Sources Uses

Net income (1) 200,000 Depreciation expense (3) 120,000 Gain on disposal (6) 20,000 Increase in accounts receivable (7a) 87,000 Increase in inventories (7b) 47,000 Increase in accounts payable (7c) 56,000 Increase in taxes payable (7d) 1,000 Increase in deferred taxes (8) 5,000

Cash from investing activities: Equipment acquisition (4) 500,000 Proceeds from disposal (6) 20,000 Purchase of securities (9a) 25,000 Sale of securities (9b) 75,000

Cash from financing activities: Dividends paid (2) 60,000 Short-term debt proceeds (10a) 15,000 Short-term debt payments (10b) 36,000 Long-term debt proceeds (11a) 375,000 Long-term debt payments (11b) 40,000 Proceeds from stock issuance (12) 44,000___________________________________ ________________

911,000 815,000 96,000 dr.___________________________________ ___________________________________________________ ________________

* Numbers in parentheses correspond to entries described in the text.

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Retained Earnings A good starting point for the analysis is the $140,000 change in Retained Earnings. Illustration 11–2 showed a condensed version of Fairway’s income statement and a rec- onciliation of the beginning and ending balances of Retained Earnings. From these statements we can see that two things affected the level of retained earnings: net in- come ($200,000), a “source” of cash; and payment of cash dividends ($60,000), a “use” of cash. We thus can record these two entries on the worksheet:

(1)

Cash from Operations. . . . . . . . . . . . . . . . . 200,000

Retained Earnings . . . . . . . . . . . . . . . . . 200,000

(2)

Retained Earnings . . . . . . . . . . . . . . . . . . . . 60,000

Cash from Financing Activities8 . . . . . . 60,000

At this point, note that these two entries result in a net credit to Retained Earnings of $140,000. The last column of the worksheet shows that a change of $140,000 cr. was the amount we needed to explain. Thus, the analysis of the change in Retained Earn- ings is complete.

Plant and Equipment The changes in the plant and equipment balance sheet accounts can be caused by ac- quisition or disposal of fixed assets and by changes in accumulated depreciation. As explained above, depreciation is an expense that is quite properly subtracted in arriv- ing at net income but that, unlike most expenses, does not affect cash. Hence, we must add back the depreciation expense to net income; otherwise, Cash from Operations would be understated. The $120,000 depreciation expense for the period is shown in the income statement in Illustration 11–2. The entry for the worksheet is

(3)

Cash from Operations. . . . . . . . . . . . . . . . . 120,000

Accumulated Depreciation . . . . . . . . . . 120,000

Other company records indicate that $500,000 of new equipment was purchased dur- ing the year. Thus, as another entry we have

(4)

Plant and Equipment, at Cost . . . . . . . . . . . 500,000

Cash from Investing Activities . . . . . . . . 500,000

Entries 3 and 4 do not completely explain the net increase of $350,000 in Plant and Equipment, at Cost, or the net increase of $30,000 in Accumulated Depreciation. (Since Accumulated Depreciation is a contra asset, its changing from $1,000,000 to $970,000 constitutes an increase in assets.) The disposal of a fully depreciated asset, having original cost of $150,000, needs to be included in the analysis:

(5)

Accumulated Depreciation . . . . . . . . . . . . . 150,000

Plant and Equipment, at Cost . . . . . . . . 150,000

Chapter 11 The Statement of Cash Flows 331

Worksheet Entries

8 In the case of the statement of cash flows shown at the bottom of Illustration 11–6, since all three of the major category (operating, investing, and financing) captions are stated in terms of “cash from” (a “source” of cash), a debit cash entry is a “source” of cash and a credit cash entry is a “use” of cash. For example, a credit entry to cash from financing activities is a “use” of cash, which, in this case, is a payment of dividends. Source and use are shown in quotation marks since some of the adjustments do not necessarily represent a movement in the cash account, such as the net income adjustment.

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Entries 3, 4, and 5 now collectively explain the $350,000 increase in Plant and Equip- ment, at Cost, and the $30,000 increase in Accumulated Depreciation.

Note that the write-off transaction in entry 5 does not affect cash flow. However, we also know that there were $20,000 cash proceeds from the disposal, which must be shown as a source in the investing activities section of the cash flow statement. This $20,000 was treated as a gain on the income statement since the net book value of the equipment disposed of was zero. But net income, including this $20,000, has already been reflected as a source of cash from operations in entry 1. Thus, we need to reclassify this $20,000 from an operating activity source to an investing activity source, as with this entry:

(6)

Cash from Investing Activities . . . . . . . . . . . . 20,000

Cash from Operations . . . . . . . . . . . . . . . 20,000

Other Adjustments to Net Income Entries 3 and 6 constitute two of several adjustments that must be made to convert the net income amount, $200,000 in entry 1, to the net cash flow from operations. Illustra- tion 11–4 reminds us of the other adjustments, which are related to changes in receiv- ables, inventories, and payables. These adjustments are made with the following entries:

(7a)

Accounts Receivable . . . . . . . . . . . . . . . . . . . 87,000

Cash from Operations . . . . . . . . . . . . . . . 87,000

(7b)

Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . 47,000

Cash from Operations . . . . . . . . . . . . . . . 47,000

(7c)

Cash from Operations . . . . . . . . . . . . . . . . . 56,000

Accounts Payable . . . . . . . . . . . . . . . . . . 56,000

(7d)

Cash from Operations . . . . . . . . . . . . . . . . . . 1,000

Income Taxes Payable . . . . . . . . . . . . . . . 1,000

Also, the $5,000 increase in deferred taxes, representing income tax expense that did not require a current outflow of cash, leads to this adjustment:

(8)

Cash from Operations . . . . . . . . . . . . . . . . . . 5,000

Deferred Taxes . . . . . . . . . . . . . . . . . . . . 5,000

The analysis has now taken care of all items affecting cash from operations but is incomplete with regard to investing and financing activities.

Investment Securities The one remaining unexplained asset change (other than Cash, which is what we are explaining overall) is the $50,000 decrease in Investment Securities. Underlying records show that this was the net effect of both new investments ($25,000) and secu- rities sales ($75,000). The FASB wants each component reflected separately in the cash flow statement, which will require these entries:

(9a)

Investment Securities . . . . . . . . . . . . . . . . . . 25,000

Cash from Investing Activities . . . . . . . . . 25,000

332 Part 1 Financial Accounting

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(9b)

Cash from Investing Activities . . . . . . . . . . . . 75,000

Investment Securities . . . . . . . . . . . . . . . 75,000

Debt Transactions Short-Term Borrowings and Long-Term Debt both changed during 2010. As with other balance sheet changes, the net amount of a change in debt is explained by reporting both the inflows and outflows contributing to the net change. For Short-Term Borrowings, underlying records reveal that the net decrease of $21,000 is explained by new short-term debt of $15,000 and repayments on earlier short-term debt of $36,000. This leads to the following entries:

(10a)

Cash from Financing Activities . . . . . . . . . . . 15,000

Short-Term Borrowings . . . . . . . . . . . . . . 15,000

(10b)

Short-Term Borrowings . . . . . . . . . . . . . . . . . 36,000

Cash from Financing Activities . . . . . . . 36,000

Similarly, the net increase in Long-Term Debt of $335,000 is explained thus:

(11a)

Cash from Financing Activities . . . . . . . . . . 375,000

Long-Term Debt . . . . . . . . . . . . . . . . . . . 375,000

(11b)

Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . 40,000

Cash from Financing Activities . . . . . . . . 40,000

Paid-In Capital The remaining two account changes to be analyzed are those in Common Stock ($1 par) and Additional Paid-In Capital: that is, total paid-in capital. During the year, 10,000 shares of Fairway Corporation $1 par common stock were issued, for which the firm received $44,000. This financing activity leads to this worksheet entry:

(12)

Cash from Financing Activities . . . . . . . . . . . 44,000

Common Stock ($1 par) . . . . . . . . . . . . . 10,000

Additional Paid-In Capital . . . . . . . . . . . . 34,000

This entry completes the analysis of changes on the worksheet (Illustration 11–6). The change of every noncash account has been explained, and the offsetting entries have been classified as sources of cash (debits in the lower portion of the worksheet) or as uses of cash (credits); and these sources and uses have been further classified as aris- ing from operations, investing activities, or financing activities. As a check, the debits (sources) and credits (uses) below the double line are added and the net change com- pared with the top line of the worksheet. Both changes are $96,000 dr., showing the accuracy of the amounts of the analytical entries.

The actual preparation of the cash flow statement is now straightforward. All of the amounts needed for the statement of cash flows appear on the worksheet in Illustra- tion 11–6. All that is necessary is to put these amounts in the proper format, as shown in Illustration 11–3. We have used the indirect method to develop the amount for cash from operating activities because it is illustrative of usual practice. The direct method

Chapter 11 The Statement of Cash Flows 333

Statement Preparation

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is also permitted; but if it is used, a reconciliation of net income with net cash flow from operations must be presented in a separate schedule.

To prepare a cash flow statement, the following steps are taken:

1. From the company’s balance sheets, enter the beginning and ending balances of each account and the change in each account’s balance on a worksheet (such as in Illustration 11–6).

2. For each account (other than Cash), analyze the nature of the transactions causing the amount of net change and classify the change from each such transaction as either cash from operations, cash from investing activities, or cash from financing activities. This analysis will require reference to the income statement (e.g., to ex- plain the change in Retained Earnings) and, in some cases, to other financial records of the company. Illustration 11–7 summarizes the nature of such transactions and the place where information about them is likely to be found.

3. After the account changes have been analyzed and classified, the debits and credits are totaled and then combined as a check to see that their net amount is equal to the amount of change in Cash.

4. The cash flow statement is prepared directly from the worksheet, using the format shown in Illustration 11–3.

334 Part 1 Financial Accounting

Summary of Preparation Procedures

Item Location on Financial Statements

1. Cash from operations: a. Net income Income statement b. Plus: Depreciation expense Income statement (or note thereto) c. Plus: Amortization of prepaid expense, goodwill, Income statement (or note thereto) or change in

and other intangibles balance sheet item d. Plus: Increase (or Minus: Decrease) in deferred Change in deferred tax liability

income taxes e. Minus: Increase in accounts receivable, inventories; Changes in balance sheet items

Plus: Increase in payables f. Plus: Decrease in accounts receivable, inventories; Changes in balance sheet items

Less: Decrease in payables g. Plus: Loss (or Minus: Gain) on disposal of Income statement

assets (Note 1) 2. Cash from investing activities:

a. Purchase of noncurrent assets Increase in asset account (Note 1), net of related financing

b. Proceeds from asset disposals Decrease in net book value less loss (or plus gain) from income statement (Note 1)

c. Loans made to (or collected from) another entity Change in loans receivable account (Note 2) 3. Cash from financing activities:

a. Borrowings or debt repayments Changes in liability accounts (Note 2) b. Issuance or retirement of stock Changes in paid-in capital accounts (Note 2) c. Cash dividends Retained earnings statement

Notes: 1. The change in the asset account is affected by depreciation, sale of assets, and purchase of assets. The amount of each is reported in a note accompanying the balance

sheet and in detailed accounting records within the organization. 2. Only the net change can be determined from the balance sheet, whereas the FASB requires that any increases and decreases be reported separately. 3. Conversion of bonds and stock (Balance sheet changes). The conversion of bonds or preferred stock to common stock does not affect the total amount of cash flow.

Such transactions are not reported in the statement itself, but are disclosed supplementally.

ILLUSTRATION 11–7 Locating Amounts for a Cash Flow Statement

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Analysis of the Cash Flow Statement

At the outset of this chapter, several questions were mentioned that analysis of the cash flow statement can help answer. In specifying the operating, investing, and financing activities classifications as the basic format for this statement, the FASB and IASB intended to aid in the analysis of the statement’s contents.

For example, for Fairway Corporation, the statement in Illustration 11–3 indicates that operations did not generate enough cash ($228,000) to fund the company’s 2010 in- vesting activities ($430,000). The $202,000 difference was financed through borrow- ings and a common stock issue, which also provided funds for dividend payments and a $96,000 buildup in cash and cash equivalents. Given this relatively large increase in cash (42 percent higher than at the start of the year), the question is raised about why Fairway borrowed the additional $375,000 in long-term debt rather than a lesser amount, or why the $44,000 stock issuance was undertaken. Perhaps the company plans to make some significant investments early in 2011. (Statement analysis often raises as many questions as it answers.)

In addition to the classification of the information into three categories, three specific analytic techniques will now be suggested.

Cash Realization Ratio The cash realization ratio is defined as

Cash generated by operations Net income

This ratio indicates how close net income is to being realized in cash. A ratio higher than one is considered to signal high-quality earnings. The ratio is sometimes called the quality of earnings ratio. It should be used with caution since cash management tactics, such as a slowdown in paying accounts payable, can increase the numerator and the ratio.

Coverage Ratios Two “coverage” ratios, times interest earned and fixed charges coverage, were described in Chapter 8. Both of these ratios would be conceptually sounder if the numerator were based on cash generated by operations rather than on income, because interest, lease payments, and similar fixed charges must be paid by using cash. The amount for cash generated by operations should be adjusted to a pretax, prefixed-charges basis (as was the case when these ratios were based on income in Chapter 8). These coverage ratios will ordinarily be higher when based on operating cash rather than on income because cash generated by operations is usually a larger amount than net income.

Source and Use Percentages Despite the FASB’s prescribed cash flow statement format, some analysts find it useful to reorganize the data into the previously popular sources and uses format, as is done in Illustration 11–8. As shown in that illustration, the amount of total sources of cash can be treated as 100 percent; then each cash flow statement item can be expressed as a per- centage of total sources. For example, internally generated cash provided 30 percent ($228,000 � $757,000) of the total sources; equipment purchases used 66 percent ($500,000 � $757,000) of the total sources; and dividends used another 8 percent.

A ratio used by credit officers in evaluating corporations’ creditworthiness for long- term debt is the ratio of cash generated by operations to total debt (both short- and

Chapter 11 The Statement of Cash Flows 335

Ratios

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long-term debt). For a corporate bond to qualify for the highest credit rating issued by the rating agencies, this ratio must be at least 100 percent (that is, 1 to 1).

“Free” Cash Flow Some analysts calculate the amount of “free” cash flow, which is cash from operations minus three items: (1) cash used by essential investing activities (e.g., fixed asset re- placements necessary to maintain existing capacity); (2) scheduled debt repayments; and (3) normal dividend payments. If positive, the amount indicates cash available to retire additional debt, increase dividends, or invest in new lines of business. If negative, it in- dicates the amount of financing needed just to support current operations and programs.

The purpose of analyzing cash flow statements is not solely to understand what has happened in the past. In addition, this analysis serves as a means of projecting what cash flows may look like in the future.

A projected cash flow statement is an essential device for planning the amount, timing, and character of new financing. These projections are important both to man- agement in anticipating future cash needs and to prospective lenders for appraising a company’s ability to repay debt on the proposed terms. Estimated uses of cash for new plant and equipment, for increased receivables and inventories, for dividends, and for the repayment of debt are made for each of the next several years. Estimates also are made of the cash to be provided by operations. If cash uses exceed cash sources, cash that must be obtained by borrowing or the issuance of new equity securities. If the indicated amount of new cash required is greater than management thinks it is feasi- ble to raise, then the plans for new plant and equipment acquisitions and dividend policies are reexamined so that the uses of cash can be brought into balance with anticipated sources of financing them.

336 Part 1 Financial Accounting

ILLUSTRATION 11–8 Cash Flows Presented in Sources and Uses Format

FAIRWAY CORPORATION Sources and Uses of Cash

For the Year Ended December 31, 2010 (dollars in thousands)

Amount Percent

Sources of Cash Cash generated by operations $228 30.1% Short-term borrowings 15 2.0 Long-term debt 375 49.5 Issuance of common stock 44 5.8 Proceeds from disposal of equipment 20 2.6 Sale of investment securities 75 9.9____ _____

Total sources of cash 757 100.0%____ _____

Uses of Cash Acquisition of plant and equipment $500 66.1% Purchase of investment securities 25 3.3 Dividends paid 60 7.9 Repayment of short-term debt 36 4.8 Repayment of long-term debt 40 5.3____ _____

Total uses of cash 661 87.4%____ _____ Net increase in cash $ 96 12.6%____ _________ _____

Cash Flow Projections

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For shorter-term financial planning, cash flow projections are made for each of the next several months or several quarters. This cash budget is useful in anticipating sea- sonal financing needs; for example, toy manufacturers need short-term financing for in- ventories prior to the major holiday sales season. Similarly, the cash budget will indicate when excess cash will be available to invest in short-term marketable securities.

A statement of cash flows provides information about an entity’s investing and financing activities during the accounting period, as well as showing how much cash was generated by the period’s operations.

The net amount of cash generated by operations is not the same as net income. Some ex- penses (notably depreciation) subtracted in arriving at net income for the period do not use cash. The net amount of cash generated by operations can be derived indirectly from the net income figure by making adjustments for those income statement amounts that were not ac- companied by an equal amount of cash flow. These adjustments take account of changes in accounts receivable, inventories, payables, and deferred taxes. Also, depreciation is added back to net income because it is an expense that does not involve a corresponding use of cash. However, one must not infer from this calculation that depreciation is itself a source of cash, for it definitely is not. The net cash flow from operating activities also can be de- veloped directly from cash receipts and payments related to operations.

The cash flow statement does not include certain financing and investing activities that do not cause a change in cash, such as the purchase of fixed assets with a long-term mortgage note or the conversion of a bond into common stock. However, these noncash transactions are supplementally disclosed in order to give a full picture of investing and financing activities.

Cash flow statements are also prepared prospectively so that an organization can antici- pate both short-term and longer-term needs to raise additional cash through sale of assets, borrowing, or issuing additional shares of stock.

Problems Problem 11–1.

The Bee Company shows the following account amounts:

2009 2010

Sales $8,743,000 $8,337,000 Accounts receivable 12/31 511,000 641,000

Required:

Determine how much cash was generated from sales during 2010. Problem 11–2.

Explain what effect the following transactions would have on cash and how they would be shown in a cash flow statement.

1. A $2,000,000 piece of equipment is purchased with the proceeds of a new 12-month note.

2. Mortgage bonds are retired with $790,000 cash and the proceeds of an issue of 150,000 shares of common stock.

3. $2,000,000 of inventory is purchased on account.

4. A dividend of $0.25 per share is declared on the 750,000 outstanding shares.

5. A piece of machinery is sold for $1,500,000 cash. When originally purchased, it cost Anwat $5,000,000, and currently has $2,500,000 of accumulated depreciation.

Chapter 11 The Statement of Cash Flows 337

Summary

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338 Part 1 Financial Accounting

Problem 11–3. Kids ’n Caboodle, a children’s clothing store, had the following cash receipts and dis- bursements for its first year of operations:

Receipts: Cash sales $155,000 Loan proceeds 21,000_________

Total receipts 176,000__________________ Disbursements

Merchandise purchases (all sold this year) 84,000 Wages 33,000 Rent and lease payments 22,000 Other operating outlays 7,900 Purchase equipment 10,500_________

Total disbursements 157,400_________ Increase in Cash Balance $ 18,600__________________

The store has no accounts receivable (it accepts only cash or bank cards for payment). At year-end, an employee had earned $200, which the store had not yet paid. Also, at year-end, the store had not paid its most recent utilities bills, which totaled $150.

Required:

Prepare a cash flow statement for the year. Problem 11–4.

Lori Crump owns a small trucking operation. The bookkeeper presented Crump with the following income statements and balance sheets for 2010 and 2009.

INCOME STATEMENTS

2010 2009

Revenues $191,400 $182,600 Operating expenses:

Depreciation $26,400 $ 26,400 Fuel 77,000 46,200 Drivers’ salaries 44,000 35,200 Tax and licenses 22,000 17,600 Repairs 30,800 19,800 Miscellaneous 2,200 202,400 1,100 146,300________ _________ ________ _________

Income (Loss) $(11,000) $ 36,300_________ __________________ _________

Balance Sheets

12/31/10 12/31/09

Cash $ 22,000 $ 4,400 Accounts receivable 8,800 26,400 Net fixed assets 198,000 224,400_________ _________

Total Assets $228,800 $255,200_________ __________________ _________ Accounts payable $ 30,800 $ 22,000 Accrued salaries 8,800 5,500 Other accruals 3,300 1,100 Long-term debt 100,100 129,800 Crump, capital 85,800 96,800_________ _________

Total Liabilities and Capital $228,800 $255,200_________ __________________ _________

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Crump does not understand how the company can be $17,600 ahead of last year in terms of cash on hand and yet show an $11,000 loss for the year.

Required:

Prepare a cash flow statement (indirect method) to use in explaining this to Lori Crump. Problem 11–5.

The owner of a small business has asked you to prepare a statement that will show him where his firm’s cash came from and how it was used this year. He gives you the following information based on the Cash account in his general ledger:

Balance at beginning of year $ 3,450 Collection of accounts receivable 34,500 Interest on savings account 345 Sale of old machine 3,105 Cash sales 27,600________

Total 69,000 Payment on vendor accounts $17,250 Cash purchase of supplies 345 Cash purchase of inventory 17,250 Down payment on new truck 3,450 Rent payments 8,625 Utilities 2,070 Interest payment 1,035 Other miscellaneous expenses 1,725 Payment on debt 3,450 Part-time help 6,900 62,100________

Balance at end of year $ 6,900________________

In addition, the following is available from company records:

1. Sales were $61,410 for the year.

2. The Accounts Receivable balance decreased by $690. 3. Cash operating expenses totaled $54,165 (including cost of sales, supplies, rent, utili-

ties, part-time help, and other miscellaneous expenses). 4. Accounts Payable decreased by a net of $2,760 during the year. 5. The Inventory balance remained constant throughout the year. 6. Depreciation of $1,725 was taken this year.

Required:

Prepare a cash flow statement using the direct method.

Cases

Case 11–1

Medieval Adventures Company*

Chapter 11 The Statement of Cash Flows 339

Medieval Adventures Company was founded by Aaron Reinholz to produce a game marketed under the name

“Castles and Unicorns.” Each “Castles and Unicorns” cost the company $35 to produce. In addition to these production costs that varied in direct proportion to volume (so-called variable costs), the company also

* Copyright © Professor Robert N. Anthony, Harvard Business School.

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340 Part 1 Financial Accounting

but did not strictly enforce these credit terms with the result that customers seemed to be taking an additional month to pay. All of the company’s costs were paid in cash in the month in which they were incurred.

Reinholz’s predictions came true. By March, sales had reached 2,000 “Castles and Unicorns,” and 2,500 units were produced in March for April sale. Total profit for the year by March 31 had reached $60,000. In order to get a respite from the increasingly hectic activities of running the business, in mid-April Rein- holz went on a family vacation.

Within the week, the company’s bookkeeper called. Medieval Adventures’ bank balance was almost zero, so necessary materials could not be purchased. Unless Reinholz returned immediately to raise more cash, the entire operation would have to shut down within a few days.

Questions

1. Prepare monthly income statements, balance sheets, and cash budgets based on sales increases of 500 units per month and 30-day advance produc- tion for January through September. When will the company need extra funds? How much will be needed? When can a short-term loan to cover the need be repaid?

2. How is it possible that a company starts with $250,000 in capital and has profitable sales for a period of six months and still ends up with a zero bank balance? Why did Medieval Adventures need money in April? How could this need have been avoided?

3. From your calculations and financial statements for Question 1, derive cash flow statements for the months of March, May, and July from each month’s beginning and ending balance sheets and income statement. Compare these derived cash flow state- ments with the cash budgets prepared directly in Question 1.

incurred $10,000 monthly “being in business” costs (so-called fixed costs) irrespective of the month’s vol- ume. The company sold its product for $55 each.

As of December 31, Reinholz had been producing “Castles and Unicorns” for three months using rented facilities. The balance sheet on that date was as follows:

MEDIEVAL ADVENTURES COMPANY Balance Sheet

As of December 31

Assets

Cash $146,250

Accounts receivable 68,750

Inventory 35,000_________

$250,000__________________

Equities

Common stock $250,000

Retained earnings 0_________

$250,000__________________

Reinholz was very pleased to be operating at a profit in such a short time. December sales had been 750 units, up from 500 in November, enough to report a profit for the month and to eliminate the deficit accu- mulated in October and November. Sales were ex- pected to be 1,000 units in January, and Reinholz’s projections showed sales increases of 500 units per month after that. Thus, by May monthly sales were ex- pected to be 3,000 units. By September that figure would be 5,000 units.

Reinholz was very conscious of developing good sales channel relationships in order to increase sales, so “Castles and Unicorns” deliveries were always prompt. This required production schedules 30 days in advance of predicted sales. For example, Medieval Ad- ventures had produced 1,000 “Castles and Unicorns” in December for January sales, and would produce 1,500 in January for February’s demand. The company billed its customers with stated terms of 30 days net,

Case 11–2

Amerbran Company (A)*

Amerbran Company was a diversified company that sold various consumer products, including food, to-

bacco, distilled products, and personal care products and financial services. Financial statements for the company are shown in Exhibit 1.* Copyright © James S. Reece.

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Chapter 11 The Statement of Cash Flows 341

EXHIBIT 1

AMERBRAN COMPANY Balance Sheets As of December 31, 20x1 and 20x0

(in thousands)

20x1 20x0

Assets Cash $ 28,912 $ 23,952 Accounts receivable 756,152 687,325 Inventories 1,244,912 1,225,402 Prepaid expenses 76,140 77,167__________ __________

Total current assets 2,106,116 2,013,846 Investments 1,116,534 1,058,637__________ __________ Property, plant, and equipment, at cost 1,566,268 1,366,719 Less accumulated depreciation 723,442 645,734__________ __________ Net property, plant, and equipment 842,826 720,985 Goodwill 645,210 577,606 Other assets 115,826 62,374__________ __________

Total assets $4,826,512 $4,433,448__________ ____________________ __________

Liabilities and Shareholders’ Equity Accounts payable $ 271,452 $ 238,377 Short-term debt 430,776 351,112 Accrued expenses payable 922,990 728,262__________ __________

Total current liabilities 1,625,218 1,317,751 Long-term liabilities 880,674 932,828__________ __________

Total liabilities 2,505,892 2,250,579__________ __________ Convertible preferred stock 33,828 42,611 Common stock, at par 322,834 161,417 Additional paid-in capital 53,641 57,072 Treasury stock, at cost (110,948) (102,705) Retained earnings 2,021,265 2,024,474__________ __________

Total shareholders’ equity 2,320,620 2,182,869__________ __________ Total liabilities and shareholders’ equity $4,826,512 $4,433,448__________ ____________________ __________

Income Statement For the year ended December 31, 20x1

(in thousands)

Sales revenues, net $7,622,677___________

Cost of sales 2,803,623

Excise taxes on goods sold 2,887,616___________

Gross margin 1,931,438

Selling, general, and administrative expenses 1,328,107___________

Income before income taxes 603,331

Provision for income taxes 274,558___________

Net income $ 328,773______________________

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The 20x1 financial statements reflect the following transactions (dollar amounts are in thousands):

1. Depreciation and amortization expense was $115,974.

2. Net income included a loss of $66,046 resulting from the write-off of some obsolete equipment. The equipment had not yet been disposed of.

3. Net income included $59,610 from Amerbran’s investment in a subsidiary; none of this income had been received in cash.

4. The year-end balance in Deferred Income Taxes was $17,548 lower than it was at the start of the year.

5. New property, plant, and equipment purchases to- taled $260,075, all paid for with cash. Disposals of fixed assets generated $33,162 cash proceeds.

6. Acquisition of another company that was made for cash resulted in additional depreciable assets of $31,691 and goodwill of $102,030.

7. Cash dividends were paid in the amount of $216,158.

8. The firm declared and issued a 100 percent common stock dividend effective September 10, 20x1; that is, each shareholder received as a dividend a number of shares equal to his or her holdings prior to the divi- dend. The newly issued shares were valued at par in recording this transaction.

9. The firm spent $30,609 to purchase treasury stock on the open market. Some of the shares so acquired were reissued to certain employees as a bonus.

10. The firm increased its short-term debt as indicated on the balance sheet in Exhibit 1. Long-term bor- rowings decreased by $34,606.

Question

Prepare a statement of cash flows for the year 20x1. In order for your statement to show the correct increase in cash ($4,960), you will need to add a “miscellaneous activities” category; this will capture several transac- tions that were not described because they are more complicated than those covered in the text.

342 Part 1 Financial Accounting

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12 Acquisitions and Consolidated Statements

Chapter

Many corporations acquire an ownership interest in other corporations. Depending pri- marily on the percentage of ownership acquired, these investments in other corpora- tions can be accounted for (1) at their fair value, (2) at cost, (3) on an equity basis, or (4) on a consolidated basis. This chapter describes these four methods of accounting.

Because the most difficult problems arise in accounting for consolidated entities, most of the chapter deals with such entities. The chapter also describes the recording of an acquisition of another company—the acquisition method—and the preparation of consolidated financial statements.

Accounting for Investments

If Company A owns securities of Company B, then A is the investor company and B is the investee company. A’s holdings of B’s securities are reported on A’s balance sheet as an asset, Investments.

If the investor company’s holdings constitute less than 20 percent of the common stock of the investee company, and if the stock’s fair value is readily determinable, then FASB 115 (described in Chapter 5) applies. Such stock is treated as an “available-for-sale” equity security and the fair-value method is used: The stock is reported on the balance sheet at fair value with unrealized gains or losses excluded from earnings and entered directly in the owners’ equity account Other Comprehensive Income.1 Dividends re- ceived do not affect the carrying amount of the investment. Rather, they are treated as revenues:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Dividend Revenues . . . . . . . . . . . . . . . . . . . 50,000

These revenues are usually included on the income statement under the caption “other income.”

1 “Accounting for Certain Investments in Debt and Equity Securities,” FASB Statement No. 115. FASB 115 does not apply if the equity method (described later) is used.

Fair-Value Method

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If an investor company owns less than 20 percent of an investee company’s common stock, and the stock’s fair value is not readily determinable, the investment is reported at its cost. Under the cost method, dividends are treated as revenues (a credit entry). The debit entry is to Cash.

If the investing company’s holdings constitute a large enough fraction of the ownership interest in the investee company so that the investing company can significantly influ- ence the actions of the investee, the investment is accounted for by the equity method. Unless the investing company can demonstrate that it does not “exercise significant influence” on the investee company, ownership of 20 percent or more of the investee company’s common stock requires the use of the equity method.2 If the investor company can demonstrate it does not exercise significant influence on the investee com- pany, the investment is accounted for at fair value if the value of the investment is read- ily determinable. If this value is not readily determinable, the investment is accounted for at cost.

The IASB’s equity method standard does not incorporate the FASB’s 20 percent test. Rather it requires that the equity method be used to account for investments in “associ- ates.” An associate is an entity over which the investor has significant influence and is neither a subsidiary nor an interest in a joint venture.3

In the equity method, the investment is initially recorded at its cost. Thereafter, the balance sheet investment amount is increased (debited) to reflect the investing com- pany’s share in the investee’s net income; the offsetting credit is to a revenue account. If a dividend is received from the investee, the balance sheet investment amount is de- creased (credited) and the offsetting debit is to Cash. Thus, in the fair-value and cost methods (described above), the income statement reports dividends; in the equity method, the income statement reports the investing company’s share of the investee’s net income, irrespective of how much of that income is distributed in the form of dividends.

Recording the Acquisition To illustrate the entries made in the equity method, assume that Merkle Company ac- quired 25 percent of the common stock of Pentel Company on January 2, 2010, for $250,000 cash. Merkle Company’s entry for this transaction would be

Investments . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000

Recording Earnings If Pentel Company’s net income for 2010 was $100,000, Merkle Company would in- crease the amount of its investment by its share (25 percent) of this amount, or $25,000. The following entry would be made on December 31, 2010:

Investments . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Investment Revenue . . . . . . . . . . . . . . . . . 25,000

Cost Method

Equity Method

2 “Equity Method for Investments in Common Stock,” APB Opinion No. 18; and “Criteria for Applying the Equity Method of Accounting for Investments in Common Stock,” FASB Interpretation No. 35. 3 “Investments in Associates,” IAS No. 28. A subsidiary is an entity that is controlled by another entity (known as the parent). A joint venture is contractually agreed sharing of control over an economic activity.

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Chapter 12 Acquisitions and Consolidated Statements 345

Dividends If Merkle Company received $10,000 in dividends from Pentel Company during 2010, Merkle would make the following entry:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Investments . . . . . . . . . . . . . . . . . . . . . . . 10,000

Note that this dividend entry reduces the amount of investments on the balance sheet but does not affect the income statement. (Equity method income is usually re- ported as a separate line item on the income statement.)

If an investing company owns more than 50 percent of the stock of another company, it reports on a consolidated basis.4 Such an acquisition is carried on the accounts of the investing company in accordance with the equity method. Consolidated financial statements are prepared by adjusting this account, as will be described in detail later in the chapter.

In summary, the most common methods of reporting an investment encountered in practice are as follows:

Amount of Ownership Method of Reporting

Over 50% Consolidated statements 20–50% Equity method Less than 20% Fair-value or cost method

The IASB’s consolidation standard has a 50 percent plus ownership consolidation test that is similar to the FASB’s quantitative test for consolidation.5 It is anticipated that the IASB will replace its 50 percent plus consolidation test with a requirement that requires consolidation of an entity by a parent when the parent “controls” the entity. The proposed definition of contol of an entity is “the power to direct the activities of an- other entity to generate return for the reporting entity.”6 An investor company under the IASB proposal that has the power to control could consolidate an entity in which it holds a less than 50 percent ownership interest.

Business Combinations

A business combination occurs when two companies are brought together in a single accounting entity. In some cases, an acquiring company dissolves the acquired corpo- ration and incorporates the latter’s assets and liabilities with its own assets and liabili- ties. In other cases, the acquired company continues to exist as a separate corporation. It then becomes a subsidiary of the acquiring company. The acquiring company is its parent.

4 “Consolidation of All Majority-Owned Subsidiaries,” FASB Statement No. 94. FASB 94 is an amend- ment to the basic consolidation standard “Consolidated Financial Statements,” Accounting Research Bulletin No. 51. 5 “Consolidated and Separate Financial Statements,” IAS No. 27. 6 “IASB Exposure Draft,” “Consolidated Financial Statements.”

Consolidated Basis

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Under GAAP and IFRS, the aquisition method must be used to account for the aquisi- tion of another company.7 Prior to the issuance of FASB Statement 141 (2002) and IFRS No. 3 (2004), another accounting method, referred to as the pooling of interests, also was required if the acquisition transaction met certain conditions.8

To illustrate accounting for the pooling and purchase methods, we will use the bal- ance sheets for two hypothetical corporations, shown in Illustration 12–1. We assume that Corporation A plans to acquire on January 1 all 100,000 shares of Corporation B stock and that it will pay for this stock with 200,000 shares of its own stock, which has a market value of $30 per share, a total of $6 million.

The underlying premise of pooling accounting is that there is a “marriage” of the two entities, with the two shareholder groups agreeing to a simple merging of the two firms’ resources, talents, risks, and earnings streams. Accordingly, under pooling treatment, the balance sheets of A and B would simply be added together to arrive at the new consoli- dated balance sheet for A, which is the surviving entity. Any intercorporate obligations involved (for example, a receivable on A’s balance sheet that was due from B) would be eliminated. With this exception, the new enterprise (the A–B combination) is accounted for as the sum of its parts, as shown in the first column of Illustration 12–2.

346 Part 1 Financial Accounting

ILLUSTRATION 12–1

Preacquisition Balance Sheets As of Proposed Date of Acquisition

(in thousands)

Corporation A Corporation B

Assets Cash and marketable securities $ 6,000 $1,000 Accounts receivable 5,000 1,400 Inventories 6,400 1,800_______ _______

Total current assets 17,400 4,200 Plant and equipment (net of

accumulated depreciation) 10,600 2,800_______ _______ Total assets $28,000 $7,000_______ ______________ _______

Liabilities and Shareholders’ Equity Accounts payable $ 6,000 $1,700 Other current liabilities 1,500 300_______ _______

Total current liabilities 7,500 2,000 Long-term debt 8,200 1,600_______ _______

Total liabilities 15,700 3,600_______ _______ Common stock (par plus paid-in capital)* 2,500 700 Retained earnings 9,800 2,700_______ _______

Total shareholders’ equity 12,300 3,400_______ _______ Total liabilities and shareholders’ equity $28,000 $7,000_______ ______________ _______

*Number of shares outstanding 1,000,000 100,000

Accounting as a Pooling

7 “Business Combinations,” FASB Statement No.141 (revised 2007). “Business Combinations,” IFRS No. 3. 8 The pooling of interests method is discussed since those using pre-July 2002 financial statements of U.S. corporations will encounter this method of accounting for business combinations.

Purchase versus Pooling

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Chapter 12 Acquisitions and Consolidated Statements 347

Accounting as a Acquisition

ILLUSTRATION 12–2

CORPORATION A Pro Forma Consolidated Balance Sheets

As of Proposed Date of Acquisition (in thousands)

Pooling Purchase Accounting Accounting

Assets Cash and marketable securities $ 7,000 $ 7,000 Accounts receivable 6,400 6,400 Inventories 8,200 8,200_______ _______

Total current assets 21,600 21,600 Goodwill — 1,500 Plant and equipment (net of accumulated depreciation) 13,400 14,500_______ _______ Total assets $35,000 $37,600_______ ______________ _______

Liabilities and Shareholders’ Equity Accounts payable $ 7,700 $ 7,700 Other current liabilities 1,800 1,800________ ________

Total current liabilities 9,500 9,500 Long-term debt 9,800 9,800________ ________

Total liabilities 19,300 19,300________ ________ Common stock (par plus paid-in capital)* 3,200 8,500 Retained earnings 12,500 9,800________ ________

Total shareholders’ equity 15,700 18,300________ ________ Total liabilities and shareholders’ equity $35,000 $37,600________ ________________ ________

*Number of shares outstanding 1,200,000 1,200,000

The assets and liabilities of the combined firm are carried at the sum of their previ- ous book values. Similarly, the Common Stock and Retained Earnings accounts of the combining firms are simply added to determine the combined firm’s shareholders’ equity. Note that when one compares A’s preacquisition balance sheet in Illustration 12–1 with the pro forma (projected) pooling balance sheet in Illustration 12–2, there is no evidence of the fact that A paid stock worth $6 million for B’s net assets, which had a book value of only $3.4 million (as indicated by its shareholders’ equity). This $2.6 million difference appears nowhere on the balance sheet.

The underlying premise of acquisition accounting is that instead of a marriage of A and B, A is buying the net assets of B.9 A is buying B’s assets and assuming B’s liabilities, the equivalent to buying B’s shareholders’ equity. In accordance with the cost concept, the net assets of B go onto A’s balance sheet at the amount that Corporation A paid for them: $6 million. This treatment involves three steps.

First, B’s tangible assets and those intangible assets that A will have a legal or con- tractual right to and those that are separable and salable (such as patents and licenses) are revalued to their fair value.10 In Illustration 12–2, it is assumed that all of the assets

9 The acquisition method (GAAP terminology) and the acquisition method (IFRS terminology) are similiar in nearly all respects. 10 Fair value is the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties.

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on B’s preacquisition balance sheet were reported at amounts approximately equal to their fair values, except for plant and equipment. Plant and equipment had a book value of $2.8 million but a fair value of $3.9 million, an increase of $1.1 million. Hence, with acquisition accounting, the consolidated plant and equipment account shows $14.5 million ($10.6 million for A’s preacquisition plant and equipment plus the acquired fixed assets of B, newly valued at $3.9 million).

Second, the assumed liabilities must be revalued to their fair value. The illustration assumes the fair value of B’s liabilities assumed by A is equal to their value as reported on B’s balance sheet.

Third, after the revaluation of B’s assets and liabilities, any excess of the purchase price over the net amount of B’s revalued assets and liabilities is shown on the consol- idated balance sheet as an asset called goodwill (also referred to as positive goodwill).11

This amount is $1.5 million, as shown in the second column of Illustration 12–2. It is calculated as follows:

Purchase price $6,000,000

Less: Book value of net assets acquired 3,400,000

2,600,000

Less: Write-up of aquired assets other than goodwill to fair value 1,100,000

Goodwill $1,500,000

Hence, of the $2.6 million excess of the purchase price over the book value of Corpora- tion B (which did not appear under pooling accounting), $1.1 million has been assigned to plant and equipment, and the remaining $1.5 million is shown on the balance sheet as goodwill. Goodwill must not be amortized under any circumstances; rather, it is subject to an annual impairment test.12 (For income tax purposes, so-called Section 197 Intangi- bles, which include goodwill acquired after August 10, 1993, are amortized on a straight- line basis over 15 years; goodwill acquired prior to that date is not tax deductible.)

Intangible assets other than goodwill acquired in a business combination transaction fall into two categories. They have either limited useful lives or indefinite lives. Limited- life intangible assets are amortized over their useful life. Indefinite-life intangible assets are not amortized; rather, they are subjected periodically to an impairment test.

If the purchase price is less than the fair value of the net assets acquired, the cost concept requires that the acquired tangible asset be written down on a pro rata basis by the excess of the fair value over the purchase price. If any excess remains, it is re- cognized as extraordinary gain.

Consolidated Statements

A “company,” as it is thought of by its management, its employees, its competitors, and the general public, may actually consist of a number of different corporations created for various legal, tax, and financial reasons. The existence of a family of corporations is by no means peculiar to big business. A fairly small enterprise may consist of one

348 Part 1 Financial Accounting

11 The preferred caption for this account is “Excess of cost over net assets of acquired companies.” 12 “Goodwill and Other Intangible Assets,” FASB Statement No. 142. “Impairment of Assets,” IAS No. 36. Generally, IFRS allows reversal of previously taken impairment losses when justified by changing circum- stances. Goodwill is an exception. A goodwill impairment loss cannot be reversed in a subsequent period. The IASB believed the reversal is most probably the result of internally generated goodwill, which cannot be recognized.

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Chapter 12 Acquisitions and Consolidated Statements 349

corporation that owns its real estate and buildings, another that primarily handles production, another for marketing activities, and over them all a parent corporation as the locus of management and control. Each of these corporations is a legal entity, and each therefore has its own financial statements. Although the company itself may not be a separate legal entity, it is an important economic entity, and a set of financial state- ments for the whole business enterprise may be more useful than the statements of the separate corporations of which it consists.

Such statements are called consolidated financial statements. They are prepared by first adjusting and then combining the financial statements of the separate corpora- tions. No separate journals or ledgers are kept for the consolidated entity. The adjust- ments are made on worksheets using data from the accounts of the separate corpora- tions. Also, only legal entities are involved in the consolidation process. If an acquired corporation has been dissolved and as a result its assets have come under the legal own- ership of the acquiring company, its assets and liabilities are already reflected in the ac- quiring company’s accounts.

The legal tie that binds the other corporations, or subsidiaries, to the parent is the ownership of their stock. A subsidiary is not consolidated unless more than 50 percent of its voting common stock is owned by the parent. The FASB and IASB require a majority-owned subsidiary be consolidated, irrespective of whether or not its activities are homogeneous with those of its parent. This requirement can lead to confusing consolidated financial statements when unlike entities are consolidated, such as when a finance sub- sidiary and a manufacturing subsidiary are reported as one consolidated entity.

Illustration 12–3 shows the consolidation process in the simplest possible situation, consisting of the parent company and one subsidiary company, named Parent and Sub- sidiary, respectively. Parent owns 100 percent of Subsidiary’s stock; this stock is an

Separate Intercompany Statements Eliminations* Consolidated

Balance Parent Subsidiary Dr. Cr. Sheet

Assets Cash 45,000 12,000 57,000 Accounts receivable 40,000 11,000 (1) 5,000 46,000 Inventory 30,000 15,000 (4) 2,000 43,000 Fixed assets, net 245,000 45,000 290,000 Investment in subsidiary 55,000 — (2) 55,000 —______________________________

415,000 83,000 436,000____________________________ ____________________________________________ _________________

Liabilities and Shareholders’ Equity Accounts payable 20,000 13,000 (1) 5,000 28,000 Other current liabilities 25,000 9,000 34,000 Long-term liabilities 100,000 — 100,000 Capital stock 100,000 40,000 (2) 40,000 100,000 Retained earnings 170,000 21,000 (2) 15,000

(4) 2,000 174,000___________________________ ________________ 415,000 83,000 436,000__________________________ ___________________________________________ _________________

* Parenthetical numbers correspond with text description.

ILLUSTRATION 12–3 Consolidation Worksheet

Basis for Consolidation

Consolidation Procedure

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asset shown on Parent’s balance sheet as Investment in Subsidiary. The investment is recorded at cost. It is assumed here that Parent purchased Subsidiary for $55,000, and this purchase price was equal to Subsidiary’s book value (capital stock plus retained earnings) as of the time of acquisition.

The two companies have been operating for a year. At the end of that year, their sep- arate balance sheets are as summarized in the first two columns of Illustration 12–3. If the two columns were simply added together, the sum of the balance sheet amounts would contain some items that, so far as the consolidated entity is concerned, would be counted twice. To preclude this double counting, adjustments are made in the next two columns; these are explained below. Essentially, these adjustments eliminate the effect of transactions that have occurred between the two corporations as separate legal enti- ties. Since the consolidated financial statements should report only assets owned by the consolidated entity and the liabilities and owners’ equity of parties outside the consol- idated entity, these internal transactions must be eliminated. The consolidated balance sheet that results from these adjustments appears in the last column. The adjustments are as follows:

1. Intercompany Financial Transactions. The consolidated balance sheet must show as accounts receivable and accounts payable only amounts owed by and to parties outside the consolidated business. Therefore, amounts that the companies owe to one another must be eliminated. Assuming that Parent owes Subsidiary $5,000, this amount is eliminated from their respective Accounts Payable and Accounts Receivable accounts. The effect is shown in the following hypothetical journal entry (remember that no journal entries actually are made in the books of either corporation):

Accounts Payable (Parent) . . . . . . . . . . . . . . . . . 5,000

Accounts Receivable (Subsidiary) . . . . . . . . . 5,000

The payment of dividends by the subsidiary to the parent is a financial transaction that has no effect on the consolidated entity. In the separate statements, this was recorded on Parent’s books as a credit to Investment Revenue (which was closed to Parent’s Retained Earnings) and on Subsidiary’s books as a debit to Dividends (which was closed to Subsidiary’s Retained Earnings). Since this transaction ultimately af- fected only the two retained earnings accounts, adding to one account the same amount that was subtracted from the other, the act of combining the two of them automatically eliminates its effect. Therefore, no further adjustment is necessary.

2. Elimination of the Investment. Parent company’s investment in Subsidiary’s stock is strictly an intrafamily matter and must therefore be eliminated from the consoli- dated balance sheet. Because it is assumed that the stock was purchased at book value, the $55,000 cost shown on Parent’s books must have equaled Subsidiary’s capital stock plus retained earnings at the time of purchase. We know that capital stock is $40,000; the difference, $15,000, must therefore be the amount of retained earnings at that time. To eliminate the investment, therefore, the entry is as follows:

Capital Stock (Subsidiary) . . . . . . . . . . . . . . . . . 40,000

Retained Earnings (Subsidiary) . . . . . . . . . . . . . . 15,000

Investment in Subsidiary (Parent) . . . . . . . . . 55,000

The additional $6,000 of retained earnings ($21,000 � $15,000) now shown on Subsidiary’s books has been earned by Subsidiary subsequent to its acquisition by Parent.

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Chapter 12 Acquisitions and Consolidated Statements 351

3. Intercompany Sales. In accordance with the realization concept, the consoli- dated company does not earn revenue until sales are made to the outside world. The revenue, the related costs, and the resulting profit for sales made between companies in the consolidated entity must therefore be eliminated from the con- solidated accounts.

The sales and cost of sales on intercompany transactions are subtracted from the total sales and cost of sales amounts on the consolidated income statement. If this were not done, the amounts would overstate the volume of business done by the con- solidated entity with the outside world. To do this, records must be kept that show the sales revenue and the cost of sales of any sales made within the family.

Subsidiary sold goods costing it $52,000 to Parent for $60,000. Parent then sold these goods to outside customers for $75,000. The consolidated entity’s gross margin on these sales was $23,000 ($75,000 � $52,000). Of this amount, $8,000 ($60,000 � $52,000) appeared on Subsidiary’s income statement and $15,000 ($75,000 � $60,000) appeared on Parent’s income statement. Hence, the consolidated income amount would not be overstated. How- ever, the correct consolidated sales revenue amount is $75,000, not $135,000 ($60,000 � $75,000). Similarly, the correct consolidated cost of sales amount is $52,000, not $112,000. Thus, Subsidiary’s sales and Parent’s cost of sales must be reduced by the $60,000 intercom- pany transfer to avoid double counting:

Sales (Subsidiary) . . . . . . . . . . . . . . . . . . . . . . . 60,000

Cost of Sales (Parent) . . . . . . . . . . . . . . . . . . 60,000

These adjustments would be made on the worksheet for the consolidated income statement. (This worksheet is not illustrated here, but it is similar to the worksheet for the consolidated balance sheet.) Also, as mentioned above, any accounts receivable and payable amounts arising from Subsidiary’s sales to Parent would be eliminated.

4. Intercompany Profit. If goods sold by Subsidiary to Parent have not been sold by Parent to the outside world, these intercompany sales transactions will affect the In- ventory account of the buyer (Parent) and the Retained Earnings account of the seller (Subsidiary). Adjustments to these accounts are required. Assume that, in the preceding example, Parent sold to outside customers only three-fourths of the prod- ucts it acquired from Subsidiary and the other one-fourth remain in Parent’s inven- tory at the end of the year at its cost to Parent of $15,000. The products sold to the outside world present no problem because they have disappeared from inventory and the revenue has been realized. The $15,000 remaining in Parent’s inventory, however, is regarded by Subsidiary as a sale, and the $2,000 gross margin on that amount (one-fourth of Subsidiary gross margin of $8,000) appears in Subsidiary’s Retained Earnings. This portion of the profit must be eliminated from the consoli- dated balance sheet. This is done by reducing Subsidiary’s Retained Earnings and Parent’s Inventory by the amount of the gross margin, as in the following entry:

Retained Earnings (Subsidiary) . . . . . . . . . . . . . 2,000

Inventory (Parent) . . . . . . . . . . . . . . . . . . . . 2,000

(To avoid double-counting, the entry shown in the example—eliminating Sub- sidiary’s $60,000 sales to Parent and Parent’s $60,000 cost of sales—must still be made, even though some of these goods remain in Parent’s inventory.)

The necessary eliminations having been recorded, the amounts for the consolidated balance sheet can now be obtained by carrying each line across the worksheet, as shown in Illustration 12–3.

Example

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In the preceding example, two of the most difficult problems in preparing consoli- dated statements did not arise because of simplifying assumptions that were made. These problems are described below.

In the example it was assumed that Parent purchased Subsidiary’s stock at its book value. But a subsidiary’s stock is often purchased at an amount higher than its book value. As explained earlier, purchase accounting for an acquisition requires that the book value of the acquired identifiable assets be adjusted to show their fair value and that any remaining excess of purchase price over the revalued net assets be shown as an asset called goodwill. In the above illustration, if Parent had paid $70,000 rather than $55,000 for Subsidiary’s stock and if Subsidiary’s assets were found to be recorded at their fair value, there would be goodwill of $15,000, and adjustment 2 (elimination of the investment) would have been

Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Capital Stock (Subsidiary) . . . . . . . . . . . . . . . . . 40,000

Retained Earnings (Subsidiary) . . . . . . . . . . . . . 15,000

Investment in Subsidiary (Parent). . . . . . . . . . 70,000

If Parent had purchased less than 100 percent of Subsidiary’s stock, then there would exist a minority interest—the equity of Subsidiary’s other owners in the acquired entity. On the consolidated balance sheet, this minority interest appears as a separate equity item, in shareholders’ equity.13 For example, if Parent owned 80 percent of Sub- sidiary’s stock, for which it had paid 80 percent of Subsidiary’s book value, or $44,000, adjustment 2 would have been as follows:

Capital Stock (Subsidiary) . . . . . . . . . . . . . . . . . 32,000

Retained Earnings (Subsidiary) . . . . . . . . . . . . . 12,000

Investment in Subsidiary (Parent). . . . . . . . . . 44,000

As this elimination suggests, at the time Parent acquired 80 percent of Subsidiary’s stock, the minority interest amount was $11,000, the sum of the remaining 20 percent of Subsidiary’s capital stock and retained earnings.

After the acquisition, this minority interest would increase by 20 percent of the in- crease in Subsidiary’s retained earnings, after elimination of Subsidiary’s $2,000 profit on sales to Parent. This intercompany profit adjustment is prorated between Parent and the minority shareholders in proportion to their respective ownership. Hence, if Parent owned 80 percent of Subsidiary, on the consolidated balance sheet, the following amounts would appear:

Minority interest $ 11,800

Shareholders’ equity:

Capital stock 100,000

Retained earnings 173,200

352 Part 1 Financial Accounting

Minority Interest

Asset Valuation

13 “Consolidated and Separate Financial Statements,” IAS No. 27. “Noncontrolling Interests in Consolidated Financial Statements,” FASB Statement 160. Under the purchase method, FASB Statement 141R (“Business Combinations”) requires any minority interest remaining in the acquired entity to be valued at its fair value at the acquisition date.

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The amount for minority interest is the net of four items:

20% of Subsidiary capital stock $ 8,000

20% of Subsidiary retained earnings at time of acquisition 3,000

20% of the $6,000 increase in Subsidiary retained earnings since acquisition 1,200

Less 20% of the $2,000 intercompany profit (400)________

Total minority interest $11,800________________

Similarly, the consolidated retained earnings amount, which was $174,000 when we assumed Parent owned 100 percent of Subsidiary, is now $800 less ($173,200), re- flecting the $1,200 minority interest in the $6,000 postacquisition increase in Sub- sidiary’s retained earnings, adjusted downward for the $400 minority interest share of the $2,000 intercompany profit elimination.

Depending primarily on the fraction of stock owned, a corporation reports an investment in other companies (1) at fair value, (2) at cost, (3) on the equity basis, or (4) by the prepara- tion of consolidated financial statements.

Acquisitions of other companies are reported on the basis of their purchase cost. If treated as a purchase, acquisitions often give rise to an asset called goodwill, which is the excess of the acquisition cost over the fair value of the net identifiable assets acquired. Goodwill must not be amortized. It is subjected to an annual impairment test.

Consolidated balance sheets and income statements are prepared by combining the ac- counts of the separate corporations in a corporate family. In combining these accounts, the effects of transactions occurring within the family are eliminated so that the consoli- dated statements reflect only transactions between members of the family and the outside world.

Problems Problem 12–1.

On January 1, Company P purchased 40 percent of the voting stock of Company S for $600,000 cash. Company P exercises significant influence over Company S. During the year, Company S had net income of $300,000 and declared and paid dividends of $100,000. What accounting method should Company P use to record this investment? Why? Show how Company P would account for this investment on January 1, and for the subsequent income and dividends of Company S, using journal entries. Show the explana- tions of the journal entries and your calculations. How would the investment appear on Company P’s books as of December 31?

Problem 12–2. During its fiscal year, Company P purchased 50,000 shares of voting stock of Company S for $1,000,000. Company S has 312,500 shares of voting stock outstanding. Company S had a profit of $156,250 for the current year. Both companies have the same fiscal year. Company S paid dividends of $0.50 per share during the year. What accounting method should be used by Company P to account for this investment and why? Show the journal entries with explanations to record the original investment and make any adjustments nec- essary for Company S’s profits and dividends.

Chapter 12 Acquisitions and Consolidated Statements 353

Summary

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Problem 12–3. XYZ Company had the following transactions related to ABC Company over a two-year period:

Year 1

1. On January 1, XYZ purchased 35 percent ownership of ABC Company for $700,000 cash.

2. ABC Company had net income of $70,000 for the year.

3. At year-end, ABC Company paid its shareholders dividends of $60,000.

Year 2

1. XYZ Company purchased on January 1 an additional 5 percent of ABC Company’s stock for $75,000 cash.

2. ABC Company declared a 10 percent stock dividend.

3. ABC Company had net income of $150,000 for the year.

4. At year-end, ABC Company paid its shareholders dividends of $100,000.

Required: Prepare the journal entries for XYZ Company’s books for the above transactions.

Problem 12–4. Elder Co. acquired for cash all of the outstanding stock of BaBe Co. on December 31 for $870,000. The balance sheets of the two companies just prior to the acquisition were as follows:

Elder BaBe

Current assets $ 1,974,000 $138,000 Net fixed assets 32,814,000 537,600 Other assets 14,412,000 134,400____________ _________

Total assets $49,200,000 $810,000____________ _____________________ _________

Current liabilities $ 3,600,000 $ 42,000 Long-term debt 15,582,000 150,000 Common stock 24,000,000 462,000 Paid-in capital 5,418,000 120,000 Retained earnings 600,000 36,000____________ _________

Total equities $49,200,000 $810,000____________ _____________________ _________

An independent appraiser valued the assets of BaBe Co. as follows:

Market Value

Current assets $150,000 Net fixed assets 555,600 Other assets 134,400

Required: Prepare a consolidated balance sheet as of the acquisition date. Assume that no intercompany transactions have occurred in the past and that Elder will assume BaBe’s liabilities.

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Problem 12–5. Sandvel Company is a wholly owned subsidiary of Pebble, Inc. Each company maintains its own financial statements, but consolidated statements are prepared at the end of each fiscal year. At the end of the present fiscal year, the following items will affect the consolidated statements:

1. During the year, Sandvel sold chemicals to Pebble at a total price of $337,000; Sandvel’s cost of these chemicals was $285,000. Pebble has sold all of these goods to outside customers.

2. Pebble owes Sandvel $73,000 of accounts payable.

3. Sandvel is indebted to Pebble on a long-term loan for $396,000. Pebble realized $32,000 of interest revenue from this long-term loan during the year.

4. As of the beginning of the year, Sandvel was carried at an equity amount of $3.1 million on Pebble’s balance sheet.

Required: Describe the elimination journal entries that would be needed in preparing consolidated statements.

Problem 12–6. After much analysis, Company A, a non-U.S. company, is considering the acquisition of Company B. Under A’s local GAAP, two alternative methods of acquisition accounting are available to the company. It can either buy all of Company B’s stock on the market for a cash outlay of $650,000, or Company A can exchange authorized but unissued Company A shares with a value of $650,000 (currently selling for $50 per share) for all of the out- standing shares of Company B. In either case, Company A will assume Company B’s lia- bilities, and Company B will be preserved as a wholly owned subsidiary. The following data were collected immediately before the acquisition:

Company A Company B

Book Market Book Market Value Value Value Value

Current assets $ 500,000 $ 635,000 $150,000 $175,000 Fixed assets 700,000 840,000 250,000 325,000__________ __________ _________ _________

Totals $1,200,000 $1,475,000 $400,000 $500,000__________ __________ _________ ___________________ __________ _________ _________ Current liabilities $ 250,000 $ 75,000 Long-term liabilities 175,000 50,000 Capital stock, $20 par 400,000 — Capital stock, $10 par — 170,000 Additional paid-in capital 175,000 60,000 Retained earnings 200,000 45,000__________ _________

Totals $1,200,000 $400,000__________ ___________________ _________

Required: a. Present the balance sheet that would result immediately after the acquisition as-

suming a stock exchange is consummated and pooling accounting is to be followed. Use only the facts given and assume no others.

b. Present the balance sheet that would result immediately after the acquisition is consum- mated assuming that the Company B stock is purchased for cash rather than exchanged. Assume that of the $650,000 purchase price, Company A took out a term loan for $550,000 of the total and used $100,000 cash on hand for the remainder.

Chapter 12 Acquisitions and Consolidated Statements 355

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Cases

Case 12–1

Hardin Tool Company*

356 Part 1 Financial Accounting

The management of Pratt Engineering Company had agreed in principle to a proposal from Hardin Tool Com- pany to acquire all its stock in exchange for Hardin secu- rities. The two managements were in general agreement that Hardin would issue 100,000 shares of its authorized but unissued stock in exchange for the 40,000 shares of Pratt common stock. Hardin’s investment banking firm had given an opinion that a new public offering of

100,000 shares of Hardin common stock could be made successfully at $8 per share.

Condensed balance sheets for the two companies, projected to the date of the proposed acquisition, and condensed income statements estimated for the separate organizations are given in Exhibit 1. The income state- ments reflect the best estimate of results of operations if the two firms were not to merge but were to continue to operate as separate companies. There were no intercom- pany receivables or payables, and no intercompany sales or other transactions were contemplated.* Copyright © Professor Robert N. Anthony.

EXHIBIT 1

Condensed Balance Sheets As of the Proposed Acquisition Date

(thousands of dollars)

Hardin Pratt

Assets Current assets $ 432 $246 Plant and equipment 690 312______ _____ Total assets $1,122 $558______ ___________ _____

Liabilities and Equity Current liabilities $ 263 $107 Long-term debt 195 10 Common stock ($1 par) 100 40 Additional paid-in capital 218 94 Retained earnings 346 307______ _____ Total liabilities and equity $1,122 $558______ ___________ _____

Condensed Income Statements For the First Year after Combination

(thousands of dollars)

Sales $2,100 $1,500 Expenses 1,620 1,120______ ______ Income 480 380 Income tax expense 168 133______ ______ Net income $ 312 $ 247______ ____________ ______

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An appraiser had been retained by the two firms and had appraised Pratt’s net assets (assets less liabilities) at $600,000. The difference between this amount and Pratt’s $441,000 book value was wholly attributable to the appraiser’s valuation of Pratt’s plant and equipment.

Although an exchange of common stock was the most frequently talked about way of consummating the merger, one Pratt shareholder inquired about the possibility of a package consisting of 50,000 shares of Hardin common stock and $400,000 of either cumula- tive preferred stock with a 10 percent dividend or debentures with a 10 percent interest rate.

Questions

1. Prepare consolidated balance sheets as of the pro- posed acquisition date, assuming the exchange of

100,000 shares of Hardin common stock on a pur- chase basis.

2. Assuming that in its first year of operations the combined company would achieve the same results of operations as the sum of the two firms’ indepen- dent operations, what would be the combined com- pany’s net income and earnings per share on a pool- ing basis? (Assume plant and equipment life of 10 years, straight-line depreciation, and an income tax rate of 35 percent. Round results—except earn- ings per share—to the nearest thousand dollars.)

3. What would be the combined net income and earn- ings per share under (a) the preferred stock pack- age and (b) the debenture package? Is either of these proposals preferable to the all-common- stock proposal?

Chapter 12 Acquisitions and Consolidated Statements 357

Case 12–2

Carter Corporation* Early in 20x1, Carter Corporation acquired Diroff Corporation. Diroff continued to operate as a Carter subsidiary. At the end of 20x1, the president of Carter asked the company’s public accounting firm to prepare consolidated financial statements. Data from the sepa- rate financial statements of the two corporations are given in Exhibit 1. (For the purpose of this case, these data have been condensed and rounded.)

The following additional information was provided:

1. During 20x1 Diroff delivered and billed to Carter goods amounting to $34,000. Diroff ’s cost for these goods was $25,500. Carter had paid Diroff invoices billed through November 30 that totaled $28,900. All of the Diroff goods were sold to outside cus- tomers in 20x1.

2. Late in December 20x1, Carter took a loan from Diroff for $32,300 cash. The loan was evidently a five-year note. (No interest on this loan was recorded in the accounts of either company be- cause the transaction occurred so near the end of the year.)

The accountant proceeded to prepare consolidated financial statements. In discussing them with the pres- ident, however, the accountant discovered that he had made two assumptions:

1. He had assumed that Carter had acquired 100 per- cent of Diroff ’s stock, whereas, in fact, Carter had acquired only 75 percent.

2. He had assumed that Diroff ’s dividend was in- cluded in Carter’s $37,400 of other income, whereas, in fact, Carter had not received the divi- dend in 20x1 and had made no entry to record the fact that the dividend had been declared and was owed to Carter as of December 31, 20x1.

The accountant thereupon prepared revised consol- idated statements.

After these revised statements had been mailed, the accountant received a telephone call from Carter’s pres- ident: “Sorry, but I was wrong about our sales of Diroff merchandise,” he said. “Carter’s sales were indeed $1,040,400 but only $20,400 was from sales of Diroff products. We discovered that $13,600 of Diroff prod- ucts were in Carter’s inventory as of December 31, 20x1. Don’t bother to prepare new statements, how- ever. Tell me the changes, and I’ll make them on the statements you sent me.”* Copyright © Professor Robert N. Anthony.

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Questions

1. Reconstruct the consolidated financial statements that the accountant originally prepared.

358 Part 1 Financial Accounting

Balance Sheet Data As of December 31, 20x1

Carter Diroff

Assets Cash $ 57,800 $ 20,400 Accounts receivable 110,500 35,700 Inventory 120,700 54,400 Investment in subsidiary 142,800 — Plant (net) 477,700 134,300 Loans receivable — 32,300__________ _________ Total assets $ 909,500 $277,100_________ __________________ _________ Liabilities and Equity Current liabilities $ 88,400 $ 62,900

Noncurrent liabilities 170,000 54,400

Capital stock 255,000 102,000

Retained earnings 396,100 57,800_________ _________ Total liabilities and equity $ 909,500 $277,100_________ __________________ _________

Income Statement Data, 20x1

Sales $1,040,400 $408,000

Cost of sales 816,000 299,200__________ _________ Gross margin 224,400 108,800

Expenses (including income taxes) 234,600 61,200__________ _________ Operating income (loss) (10,200) 47,600

Other income 37,400 —__________ _________ Net income 27,200 47,600 Dividends — 30,600__________ _________ Added to retained earnings $ 27,200 $ 17,000__________ ___________________ _________

EXHIBIT 1 Financial Statement Information

2. Prepare revised consolidated financial statements based on the information that the accountant learned in his first conversation with the president.

Case 12–3

The Politics and Economics of Accounting for Goodwill at Cisco Systems On March 2, 2000, Dennis Powell, vice president and corporate controller for Cisco Systems, appeared before the Senate Committee on Banking, Housing,

and Urban Affairs. Powell was testifying on a recent proposal by the Financial Accounting Standards Board (FASB) to abolish the pooling-of-interests method of accounting for mergers. Powell expressed his opposi- tion to the FASB proposal, arguing that the accounting method firms would be required to use in lieu of

Copyright © 2007 President and Fellows of Harvard College. Harvard Business School case 109–002.

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Chapter 12 Acquisitions and Consolidated Statements 359

pooling (i.e., the purchase method) would “stifle technology development, impede capital formation and slow job creation . . . .”1 The Senate heard from eight other expert witnesses that day; all but one—Ed Jenkins, chairman of the FASB—argued against the proposal to abolish pooling.2

Six months later, by September 2000, Powell had abandoned his support for the pooling method. In leading a group of industry representatives at a meet- ing with members of the FASB, Powell argued for a regime that permitted only the purchase method, pro- vided goodwill recognized under that method be solely subject to impairment testing (rather than amortization as the FASB had proposed).3

Accounting for Mergers: Purchase and Pooling Methods

Until 2001, U.S. generally accepted accounting princi- ples (GAAP) had two methods to account for mergers: the purchase method and the pooling-of-interests method. Under the purchase method, acquired tangible assets, certain acquired intangible assets (e.g., con- tracts, patents, franchises, customer and supplier lists, and favorable leases), and all acquired liabilities were revalued to their current fair values before being added to the acquiring firm’s books. Any excess of the total price paid for the acquisition over the sum of the revalued net assets was added to acquirer’s books as goodwill. In the years following the acquisition, good- will was amortized in the acquirer’s income statement. Further, under the purchase method, the acquiring firm only recognized the acquired firm’s income from the date of the acquisition.

Under the pooling method, the surviving firm in an acquisition simply added the book value of all ac- quired assets and liabilities to its own assets and liabil- ities. There were no asset and liability revaluations and no goodwill was recorded. Accordingly, there was no

goodwill expense associated with pooling transac- tions. Further, under the pooling method, the acquiring firm recognized the acquired firm’s income for the entire fiscal year in which the acquisition occurred. Thus, the balance sheets and income statements of firms doing pooling method acquisitions looked very different from those of firms doing purchase method acquisitions.

Firms were required to use the purchase method un- less they met certain criteria to qualify for pooling ac- counting. The most important of these criteria were (1) that each of the companies in an acquisition was inde- pendent of the other and (2) that the acquiring firm is- sued only common stock (with rights identical to its own outstanding common stock) in consideration for the acquired firm.4

Cisco and the Making of Mergers Accounting

In September 1999, the FASB proposed abolishing the pooling method of accounting for mergers; all firms were asked to use purchase method accounting with amortization required for any, goodwill.5 The vast dif- ference between pooling and purchase method ac- counting, the FASB argued, had led to situations whereby “two transactions that [were] not significantly different [could] be accounted for by methods that pro- duce[d] dramatically different financial statement re- sults.”6 The FASB solicited public comments on its proposal; about 60% of corporate respondents op- posed the idea.7 Cisco was among these opponents, and Powell took a lead role in expressing Cisco’s concerns.

At Cisco, Powell oversaw global financial reporting international tax strategies and implementation, cor- porate procurement, and internal auditing.8 In a December 1999 letter to the FASB, Powell wrote ex- pressing “serious concerns” with the proposed elimi- nation of pooling accounting in favor of the purchase method with goodwill amortization. “While we under- stand that pooling accounting has its critics,” he wrote,1 Prepared statement of Dennis Powell before the Senate

Committee on Banking, Housing, and Urban Affairs (Washington: U.S. Government Printing Office, 2000). 2 Karthik Ramanna, The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting, Journal of Accounting and Economics (forthcoming). 3 Dennis Powell, Business Combination Purchase Account- ing: Goodwill Impairment Test, appendix to the minutes of the September 29, 2000 FASB Board meeting (Norwalk, CT: FASB, 2000).

4 Accounting Principles Board Opinion No. 16: Business Com- binations, (New York: AICPA, 1970). 5 Exposure Draft 201-A: Business Combinations and Intangible Assets, (Norwalk, CT: FASB, 1999). 6 Ibid., p. 34. 7 See footnote 2. 8 Dennis Powell’s biography, www.cisco.com, accessed July 19, 2997.

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360 Part 1 Financial Accounting

“we believe on balance, for equity funded transactions, it is less problematic that the purchase accounting model in representation the economic reality of oper- ating results of the combined entity.”9

Powell’s opposition to the purchase method was based on the idea that goodwill was not an asset.10

“[G]oodwill is simply the amount of purchase price that is left over after allocating value to identifiable as- sets . . .,” he noted. “It has no value on its own; it can’t be borrowed against, sold separately or generate any cash flow.”11

Powell also expressed doubts about the purchase method in general and about goodwill amortization in particular:

The purchase method of accounting was de- signed for accounting for tangible assets that have reliable measurable fair values. However, in the acquisitions of New Economy technology compa- nies, an overwhelming portion of the purchase price is attributable to intangibles. It is this situa- tion that makes the purchase method inadequate. Identifying intangibles is difficult, but determin- ing the fair value of identified intangible assets with some level of consistency or reliability is impossible. . . .12

While Cisco continues to grow our business by combining with similar companies with the same long term strategic goals, our operating results would decrease because of the amortization of goodwill. This decrease in operating results would continue even if the acquisitions we complete were successful resulting in an increase to our market capitalization . . . . Our operating results would not be comparable to companies who develop technology internally.13

Powell concluded his letter to the FASB with a pas- sionate defense of pooling accounting: “We believe the retention of pooling of interests accounting is par- ticularly critical considering the adverse impact its elimination will have on the merger activity in the United States, which in turn will negatively impact the ecosystem that is driving technology development in this country today.”14

Concerns from corporations like Cisco over the FASB proposal to abolish pooling quickly reached Congress. In March and May of 2000, the Senate Bank- ing Committee and the House Finance Subcommittee, respectively, held hearings on the issue. Several of the corporate respondents who had already expressed their opposition to the FASB testified at these hearings.15

Cisco was among them: Powell appeared before both the Senate and House on Cisco’s behalf, reiterating his arguments above. In comments to the House, he added that extant accounting rules for mergers accounting had “for the past 50 years, generated and supported the strongest capital markets in the world.”16

Sometime after the hearings in Congress, two sepa- rate groups of opponents to the FASB proposal met with members of the FASB Board.17 Powell led the second group. This meeting, held in September of 2000, included experts from the American Business Conference, Merrill Lynch, the Technology Network, and United Parcel Service, besides Powell on Cisco’s behalf. Both Powell’s group and the group before it did not discuss retaining pooling accounting at their re- spective meetings. Instead, they proposed an alterna- tive to goodwill amortization under a regime that per- mitted only the purchase method. In the years after an acquisition, they argued for goodwill to be periodi- cally tested for impairment. The impairment test, they proposed, would be based on a comparison of good- will’s recorded book value and an estimate of the cur- rent fair value of goodwill.18

The FASB, after some field testing and an addi- tional round of comment solicitation, accepted the

9 Dennis Powell, Letter of Comment No.: 25A, FASB file refer- ence: 1033–201 (Norwalk, CT: FASB, 1999), p. 2. 10 FASB Concept Statement No. 6 defines “assets” as “prob- able future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” 11 See footnote 9, p. 2. 12 Ibid., p. 3. Note that when Powell was speaking of “iden- tified intangibles,” he was referring to their definition at the time, that is, “intangible assets that can be identified and named.” APB Opinion 16, paragraph 88e, p. 319. The current definition of “identified intangibles” includes any asset that arises from legal rights (regardless of whether those rights are transferable or separable) or any asset that is capable of being separated or divided for sale, rent, and so on (regard- less of whether there is intent to do so). SFAS141, paragraph 39, p. 17. 13 Ibid., pp. 4–5.

14 Ibid., p. 5. 15 See footnote 2. 16 Prepared statement of Dennis Powell before the House Subcommittee on Finance and Hazardous Materials (Washington: U.S. Government Printing Office, 2000). 17 See footnote 2. 18 Trevor Harris, Accounting for Business Combination: A Workable Solution, appendix to the minutes of the May 31, 2000 FASB Board meeting (Norwalk, CT: FASB, 2000); see also footnote 3.

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Chapter 12 Acquisitions and Consolidated Statements 361

goodwill impairment alternative. In June 2001, the FASB formally promulgated new accounting stan- dards that abolished pooling accounting, requiring all firms to use the purchase method, with impairment testing for any acquired goodwill.19

According to the 2001 standards, an acquiring firm must—upon completing the acquisition—allocate any acquired goodwill among its reporting units (a re- porting unit is a segment within the acquiring firm with discrete financial information that is regularly re- viewed by management). If the acquired goodwill rep- resents synergies from a merger, managers are re- quired to disaggregate and allocate those synergies to reporting units based on estimates of how they are ex- pected to be realized. In the years after an acquisition, goodwill must be tested for impairment within the re- porting unit to which it was allocated. The goodwill impairment test in a reporting unit is a two-step proce- dure. In the first step, managers must estimate the cur- rent fair value of the reporting unit (as a whole) and compare it to the unit’s total book value. If the unit’s fair value is greater than the unit’s book value, step two is ignored and no goodwill impairment is recognized. If the unit’s fair value is less than its book value, step two is conducted as follows. Managers calculate the current fair value of the unit’s goodwill as the differ- ence between the estimate of the unit’s total fair value (as calculated in step one) and an estimate of the cur- rent fair value of the unit’s net assets (excluding good- will). The current fair value of goodwill is then com- pared to the goodwill’s book value. The excess (if any) of the goodwill’s book value over its current fair value is the unit’s goodwill impairment.

Managers are not required to disclose the assump- tions that underlie their estimates of goodwill’s fair value (both at the initial stage of allocating goodwill to reporting units and at the subsequent stage of testing for goodwill impairment within units). The goodwill impairment of reporting units (if any) are aggregated and reported at the firm level.

Cisco Systems in the 1990s

Cisco Systems was founded in 1984 by two computer scientists from Stanford University. The company de- veloped technologies that enabled computer networks to communicate with one another. Cisco went public in February 1990 with a market capitalization of about $224 million. By the close of the 1990 fiscal year, Cisco had 251 employees and $69 million in revenues. The 1990s were a period of extraordinary growth for Cisco. As it was a key supplier of computer network- ing technologies, the company’s fortunes grew with the rise of the Internet. By 1999, Cisco employed nearly 21,000 people, had sales of about $12.2 billion, and had a market capitalization of over $235 billion. On March 27, 2000, Cisco briefly became the world’s most valuable company, with a market capitalization of $569 billion.20

Cisco’s growth was fuelled in large part by an ac- quisitions strategy. This strategy was laid out in a 1993 plan put forth by then Chief Technology Officer John Chambers (Chambers became CEO in 1995).21 Cisco made its first acquisition in September 1993. From then through the end of 2000, Cisco acquired 75 other companies at a combined price of over $36 billion. Most of these deals were to acquire key intangibles. As Chambers noted, “Most people forget that in a high-tech acquisition, you really are acquiring only people. . . . At what we pay, $500,000 to $2 million an employee, we are not acquiring current market share. We are acquiring futures.”22 Of the combined purchase price of Cisco’s acquisitions through February 2000, Powell attributed 95% to goodwill and other intangible assets.23

Cisco operations for the quarter ending April 29, 2000, were classified into four broad areas: routers, switches, access, and “other.” Routers and switches each accounted for about $2 billion of the quarter-ending sales, while access and “other” accounted for about $0.6 billion and $0.8 billion, respectively. Unallocated negative sales adjustments were about $0.5 billion.2419 See Statement of Financial Accounting Standards No. 141,

“Business Combinations” (Norwalk, CT: FASB, 2001) and Statement of Financial Accounting Standards No. 142, “Good- will and Other Intangible Assets” (Norwalk, CT: FASB, 2001). The FASB, in collaboration with the International Accounting Standards Board, is in the process of revising the current rules of purchase method accounting in order to harmonize them with international accounting practices. Under the new rules, expected to be released in the third quarter of 2007, the purchase method will be known as the “acquisi- tion method.” See FASB Project Updates: Business Combina- tions, www.fasb.org, accessed August 20,2007.

20 Cisco Systems Corporate Timeline, www.cisco.com, accessed July 19, 2007. 21 “Cisco Systems, Inc.: Acquisition Integration for Manufacturing (A),” HBS Case No. 600–015 (Boston: Harvard Business School Publishing, 2000). 22 John Byrne, “The Corporation of the Future,” BusinessWeek, August 31,1998, quoted from HBS Case No. 600–015. 23 See footnote 1. 24 Cisco Systems Form 10-Q, filed June 13,2000.

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362 Part 1 Financial Accounting

25 “Cisco Systems to Acquire ArrowPoint Communications,” press release, www.cisco.com, accessed July 19, 2007. 26 ArrowPoint Corporate Profile, www.hoovers.com, accessed July 19, 2007. 27 ArrowPoint Communications Form 10-Q, filed May 2, 2000. 28 See footnote 25.

Accounting standards for public companies in the United States were unregulated until the early 1930s. The Securities Acts of 1933 and 1934, promulgated in the wake of the stock market crash of 1929, created the Se- curities and Exchange Commission (SEC) and charged it with the responsibility to set accounting standards. Since the late 1930s, the SEC has relied on private standard-setting bodies to establish accounting rules, reserv- ing for itself the right to veto, amend, and enforce those rules. The first such standard-setting body was the Committee on Accounting Procedure (CAP), in existence from 1938 to 1959. The second was the Accounting Principles Board (APB), in existence from 1959 to 1973. The members of both the CAP and the APB served on a part-time basis. Most members were either public accountants affiliated with audit firms and listed public companies or accounting academics.

In 1973, the FASB replaced the APB as the SEC-designated accounting standard setter for public company finan- cial reports. FASB members serve full time. They are appointed by the FASB’s governing board, the Financial Accounting Foundation (FAF). The FAF was initially charged with both raising (from the private sector) and adminis- tering funds for the FASB. Since the Sarbanes-Oxley Act of 2002, voluntary private-sector funds no longer support FASB activities. Instead, all listed companies are assessed a mandatory tax to pay for the administration of the FASB.

The FASB encourages a collaborative decision-making process on standard-setting. When board members propose a change to accounting standards, they solicit feedback from users and preparers of financial state- ments. This feedback, in the form of letters, testimonials, or presentations, is often incorporated by the FASB in determining the nature of the final standard. The U.S. Congress rarely involves itself directly in the accounting standard-setting process. However, as former FASB chair Dennis Beresford points out, when congressional hear- ings do take place, they are taken “very seriously” by the FASB. Rice University accounting historian Professor Stephen Zeff notes how persistent industry criticisms of the CAP and the APB may have led to their respective demises, suggesting that there is precedent for the dissolution of accounting standard-setting bodies in the face of strong opposition.

Sources: 1. Dennis Beresford, “Congress Looks at Accounting for Business Combinations,” Accounting Horizons (March 2001): 73–86. 2. Facts about FASB, www.fasb.org, accessed August 8, 2007. 3. Financial Accounting Foundation 2006 Annual Report (Norwalk, CT: FAF, 2007). 4. Stephen Zeff, “The Evolution of US GAAP: The Political Forces Behind Professional Standards Part 1,” CPA Journal (January 2005): 18–27.

EXHIBIT 1 Accounting Standard-Setting in the United States

3, 2000, ArrowPoint’s stock opened at $102, giving it a market capitalization of over $3.6 billion; by May 5, ArrowPoint stock closed at $140. In a press release dated May 5, Cisco announced that it would exchange for every outstanding share and option in ArrowPoint 2.1218 shares in Cisco. Based on Cisco’s closing price of $63.625 on May 4, the deal was worth over $5.7 bil- lion (including nearly $1 billion for converted Arrow- Point options).

Cisco announced that it was acquiring ArrowPoint “to provide its customers with a feature-rich, flexible content switching platform.”28 A press release an- nouncing the merger added:

Coupled with Cisco’s Internet infrastructure, ArrowPoint’s products will provide a new level of intelligence that will enable ISPs, Web hosting companies and other customers to create a faster, more reliable Web experience. In addition, ArrowPoint’s solutions strengthen Cisco’s presence

Cisco Systems’ Acquisition of ArrowPoint Communications

On May 5, 2000, one day after Powell testified before the U.S. House, Cisco Systems announced its acquisi- tion of ArrowPoint Communications. ArrowPoint was a Boston-based provider of Internet content switches that help Web hosts optimize and track their website performance.25 The switches allow Web hosts to direct their preferred customers through priority routes and to limit access to their websites based on security or privacy concerns.26

ArrowPoint had only just completed its IPO (April 5, 2000) when the Cisco deal was announced.27 On May

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Chapter 12 Acquisitions and Consolidated Statements 363

in emerging markets that include ASPs (Applica- tion Service Provider), AIPs (Application Infra- structure Provider) and “dot com” companies.29

Cisco stated that after the acquisition the 337- person ArrowPoint group would continue to be led by its CEO, Cheng Wu. ArrowPoint employees would

join Cisco’s Public Carrier IP Group, and Wu would report to a senior vice president at Cisco. Exhibits 2 and 3 detail Cisco’s and ArrowPoint’s most recent bal- ance sheets and income statements before the acquisi- tion announcement.30

29 Ibid.

30 Note: Quarterly income statements are presented because ArrowPoint never released an annual report.

ArrowPoint Cisco Systems Communicationsa

as of April 29, 2000 as of April 30, 2000

Cash and Equivalents 4,653 187 Accounts Receivable, net 1,922 8 Inventory 878 4 Other Current Assets 1,627 –________ _____

Total Current Assets 9,080 199

Investments, net 11,589 – Property, plant, and equipment, net 1,153 6 Goodwill and Other Intangibles, net 3,214 – Other Assets 1,049 1________ _____

Total Assets 26,085 206

Accounts Payable, net 596 4 Other Current Liabilities 4,503 5________ _____

Total Current Liabilities 5,099 9

Other Liabilities 960 35 Preferred Stockb, c – – Common Stockd, e 10,701 222 Retained Earnings 7,624 (60)

Other Comprehensive Incomef 1,701 –________ _____ Total Stockholders’ Equity 20,026 162________ _____

Total Liabilities and Stockholders’ Equity 26,085 206

Source: Cisco Systems and ArrowPoint Communications financial statements and case writer. Note: All figures in millions of U.S. dollars, except as indicated. a The ArrowPoint balance sheet in this exhibit is an estimate of the company’s financial position post-IPQ (ArrowPoint’s only publicly available balance sheet is dated prior to its IPO, completed April 5, 2000). At the IPO, ArrowPoint converted all of its “Preferred Stock” into “Common Stock” and raised $172 million in cash. b For Cisco: no par value; 5 million shares authorized; none issued or outstanding. c For ArrowPoint: $0.01 par value; 699,837 shares authorized; none issued or outstanding. d For Cisco: $0.001 par value; 20 billion shares authorized; 7 billion shares issued and outstanding. e For ArrowPoint: $0.001 par value; 200 million shares authorized; 35 million shares issued and outstanding. f Other comprehensive income is an account accumulating changes in equity from sources other than transactions with owners that do not pass through the income statement.

EXHIBIT 2 Cisco and ArrowPoint Balance Sheets prior to the Merger Announcement

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364 Part 1 Financial Accounting

Questions

1. What is Cisco getting from its acquisition of ArrowPoint? Why does Cisco’s offer price differ from both the book value and the market value of ArrowPoint?

2. (a) Assume Cisco used the purchase method to ac- count for the acquisition of ArrowPoint. Estimate what Cisco’s balance sheet would look like after the acquisition (you will need to allocate the purchase price among acquired net assets; be ready to defend any assumptions you make). What are the acquisi- tion’s income-statement effects on Cisco?

(b) Now assume Cisco used the pooling-of-interest method to account for the acquisition of Arrow- Point. Estimate the acquisition’s balance-sheet and income-statement effects on Cisco?

3. Given your answers above, what is your assessment of the effectiveness of the pooling and purchase methods in reflecting the economics of the acquisi- tion? Do you agree with Dennis Powell that the “purchase method of accounting was designed for accounting for tangible assets?”

4. Why do you think Dennis Powell switched from sup- porting the pooling method to proposing the pur- chase method with goodwill impairment testing?

ArrowPoint Cisco Systems Communications

Quarter ending Quarter ending April 29, 2000 March 31, 2000

Net Sales 4,919 10 Cost of Sales 1,748 4 Selling, General, and Administrative 1,169 9 Research and Development 719 2 Amortization of Intangible Assets 51 – In-process Research and Developmenta 488 – One-time Expenses – – Interest Expenses, net (313) – Other Expenses, net – 3 Provision for Income Taxes 395 –_______ ____

Total Expenses 4,257 18_______ ____ Net Income 662 (8)

Source: Cisco Systems and ArrowPoint Communications financial statements. Note: All figures in millions of U.S. dollars, except as indicated. a In consolidating financials after an acquisition, the in-process research and development of the acquired firm that is considered not to have any alternate use to the acquirer is expensed in the acquirer’s income statement.

EXHIBIT 3 Cisco and ArrowPoint Income Statements prior to the Merger Announcement

Case 12–4

Productos Finas* Recent adoption of International Financial Reporting Standards (IFRS) required “full consolidation” for fi- nancial reporting by Spanish companies. David Ortiz,

president and principal stockholder of Productos Finas, a Spanish operating and holding corporation, was con- cerned about this new law’s impact on his plans for a small public issue of his company’s common stock. Currently, Productos Finas only prepared parent com- pany statements. The cost method was used to account

* Copyright © President and Fellows of Harvard College. Harvard Business School case 106-037.

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Chapter 12 Acquisitions and Consolidated Statements 365

Adjustment and Eliminations Consolidated

Company P Company S Dr. Cr. Statements

Income Statement Sales 1,500 1,800 Cost of sales (900) (1,400)_____ ______

600 400 Depreciation (40) (20) Operating expenses (440) (290)_____ ______ Net income from operations 120 90 Dividend income 24 Minority net income Goodwill _____ ______ Net income 144 90_____ ___________ ______

Retained Earnings Statement Retained earnings, January 1, 2006

Company P 248 Company S 70

Net income (as above) 144 90_____ ______

Dividends: Company P (72) Company S (30)_____ ______

Retained earnings December 31, 2006 320 130_____ ___________ ______

Balance Sheet

Cash 110 150 Accounts receivable (net) 375 410 Inventories 310 75 Plant and equipment 885 200

Less: accumulated depreciation (265) (60) Investment in Company S (at cost) 290 Goodwill _____ ______ Total 1,705 775_____ ___________ ______

Accounts payable 385 345 Minority interest Capital stock:

Company P 1,000 Company S 300

Retained earnings (as above) 320 130_____ ______ Total 1,705 775_____ ___________ ______

EXHIBIT 1 Company P and Subsidiary Company S Working Papers for Consolidated Statements for the Year Ended December 31, 2006 (millions of euros; parentheses indicate deductions)

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366 Part 1 Financial Accounting

for the parent company’s various subsidiaries in these statements.

David Ortiz was unfamiliar with consolidation ac- counting. In order to understand the accounting me- chanics and financial ratio implications of consolidated statements, David Ortiz asked his chief accountant to prepare a short presentation illustrating the preparation of consolidated statements.

ILLUSTRATIVE CASE The chief accountant intended to use the following case example to illustrate consolidation accounting.

Company P purchased 80% of the outstanding cap- ital stock of Company S from individual stockhold- ers for €290 million cash, on January 1, 2002. On this date, the retained earnings of Company S were €30 million.

Company S was primarily, but not exclusively, engaged in marketing goods purchased from Com- pany P. Company S’s purchases from Company P during the year 2006 were €1,200 million. The inventory held by Company S at the beginning or the close of the year did not include any merchan- dise acquired from Company P. On December 31, 2006, the balance due to Company P for intercom- pany purchases was €280 million.

All plant and equipment owned by Company S was acquired for cash from Company P on Janu- ary 1, 2004, and has been depreciated on the basis of its estimated life of 10 years, using the straight- line method without salvage value. In 2004, Company P had recorded a €50 million profit on the sale of these fixed assets to its subsidiary.

A 10% cash dividend was declared and paid by Company S on its outstanding capital stock on July 1, 2006.

Financial statements of Company P and of Com- pany S are presented in vertical form on the accom- panying worksheet (Exhibit 1) to facilitate assembly of information for consolidation statements.

Using this illustrative case and ignoring taxes, the chief accountant intended in his presentation to David Ortiz to:

1. Complete the worksheet and prepare

a. A consolidated income statement.

b. A consolidated retained earnings statement.

c. A consolidated balance sheet.

2. Compare the financial condition of Company P on an unconsolidated basis with that presented by the consolidated statements. His planned comparison in- cluded computation of

a. Working capital (current assets � current liabil- ities).

b. Total assets.

c. Long-term capital.

d. Any other ratios he thought significant.

3. Compare the profitability of Company P on an un- consolidated basis with that shown by the consoli- dated statements.

4. Discuss with David Ortiz the significance of consoli- dated statements to

a. A stockholder of Company P.

b. A minority stockholder of Company S.

To simplify the presentation the chief accountant decided to assume that Company P used the cost method to account on its books for Company S. This was con- sistent with Productos Finas’ present accounting policy. Under IFRS goodwill was not amortized.

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13 Financial Statement Analysis

Chapter

In previous chapters, the principal focus has been on conveying an understanding of the information contained in the three basic financial statements: the balance sheet, the in- come statement, and the cash flow statement. This chapter describes how this information is analyzed, both by parties outside the firm and by the company’s own management.

All analyses of accounting data involve comparisons. An absolute statement, such as “Company X earned $1 million profit,” is by itself not useful. It becomes useful only when the $1 million is compared with something else. The comparison may be quite imprecise and intuitive. For example, if we know that Company X is an industrial giant with tens of thousands of employees, we know intuitively that $1 million profit is a poor showing because we have built up in our minds the impression that such compa- nies should earn much more than that. Or the comparison may be much more formal, explicit, and precise, as is the case when the $1 million profit this year is compared with last year’s profit. In either case, the process of comparison makes the number meaningful.

Business Objectives

Comparisons are essentially intended to shed light on how well a company is achiev- ing its objectives. In order to decide the types of comparisons that are useful, we need first to consider what a business is all about—what its objectives are. Let us say as a generalization that the overall objective of a business is to create value for its share- holders while maintaining a sound financial position.1 Implicit in this statement is the assumption that value creation can be measured. But if a company’s equity securities are not publicly traded and hence the total market valuation of its equity securities can- not be calculated, then shareholder value creation cannot be directly measured. Never- theless, profit and return on investment, which are indicators of value creation, can be measured in all cases. Of course, employee satisfaction, social responsibility, ethical

1 This statement is not necessarily consistent with the profit maximization assumption often made in economics. The techniques in this chapter are equally applicable under a profit maximization assumption, however, so there is no point in arguing here whether the profit maximization assumption is valid and useful. Discussion of this point is deferred until Chapter 26.

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considerations, and other nonmeasurable objectives are also important and must be taken into account whenever possible in appraising the overall success of an enterprise. The measurement of profit has already been discussed; below we briefly discuss return on investment and maintaining a sound financial position.

Return on investment (ROI) is broadly defined as net income divided by investment.2

The term investment is used in three different senses in financial analysis, thus giving three different ROI ratios: return on assets, return on owners’ equity, and return on in- vested capital.

Return on assets (ROA) reflects how much the firm has earned on the investment of all the financial resources committed to the firm. Thus, the ROA measure is appro- priate if one considers the investment in the firm to include current liabilities, long- term liabilities, and owners’ equity, which are the total sources of funds invested in the assets. It is a useful measure if one wants to evaluate how well an enterprise has used its funds, without regard to the relative magnitudes of the sources of those funds (short- term creditors, long-term creditors, bondholders, and shareholders). The ROA ratio often is used by top management to evaluate individual business units within a multi- divisional firm (e.g., the laundry equipment division of a household appliance firm). The division manager has significant influence over the assets used in the division but has little control over how those assets are financed because the division does not arrange its own loans, issue its own bonds or capital stock, or in many cases pay its own bills (current liabilities).

Return on owners’ equity (ROE) reflects how much the firm has earned on the funds invested by the shareholders (either directly or through retained earnings). This ROE ratio is obviously of interest to present or prospective shareholders, and is also of concern to management because this measure is viewed as an important indicator of shareholder value creation. The ratio is not generally of interest to division managers, however, because they are primarily concerned with the efficient use of assets rather than with the relative roles of creditors and shareholders in financing those assets.

The third ROI ratio is return on invested capital (ROIC). Invested capital (also called permanent capital) is equal to noncurrent liabilities plus shareholders’ equity and hence represents the funds entrusted to the firm for relatively long periods of time. ROIC focuses on the use of this permanent capital. It is presumed that the current lia- bilities will fluctuate more or less automatically with changes in current assets and that both will vary with the level of current operations.

Invested capital is also equal to working capital plus noncurrent assets. This equiv- alency points out that the owners and long-term creditors of the firm must in effect fi- nance the plant and equipment, other long-term assets of the firm, and the portion of current assets not financed by current liabilities.

Some firms use ROIC to measure divisional performance, often labeling the ratio return on capital employed (ROCE) or return on net assets (RONA).3 This measure is appropriate for those divisions whose managers have a significant influence on decisions regarding asset acquisitions, purchasing and production schedules (which determine inventory levels), credit policy (accounts receivable), and cash management and also on the level of their divisions’ current liabilities.

368 Part 1 Financial Accounting

Return on Investment

2 As described later, net income may be subject to an adjustment for interest expense when calculating ROI. 3 In this context, the companies are using net assets to mean assets less current liabilities, whereas the formal accounting meaning is assets minus all liabilities.

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In addition to desiring a satisfactory return, investors expect their capital to be pro- tected from more than a normal amount of business risk of capital loss. The return on the shareholders’ investment could be increased if incremental investments in the as- sets for new projects were financed solely by liabilities, provided the return on these in- cremental investments exceeds the interest cost of the added debt. This “financial leverage” policy, however, would increase the shareholders’ risk of losing their invest- ment, because interest charges and principal repayments on the liabilities are fixed obligations and failure to make these payments could throw the company into bank- ruptcy. The degree of risk in a situation can be measured in part by the relative amounts of liabilities and owners’ equity and by the funds available to discharge the liabilities. This analysis also involves the use of ratios.

Many ratios have been described in previous chapters. In this section, these ratios and others are discussed in a sequence intended to facilitate an understanding of the total business. Thus, we shall assume here that one first looks at the firm’s performance in the broadest terms and then works down through various levels of detail in order to identify the significant factors that accounted for the overall results. If the values of the ratios used in this analysis are compared with their values for other time periods, this comparison is called a longitudinal, or trend, analysis.

Dozens of ratios can be computed from a single set of financial statements. Each an- alyst tends to have a set of favorite ratios, selected from those described below and probably from some we do not describe. (Certain ratios that are useful only in a spe- cific industry, such as banking, are not described here.) Although we describe many frequently used ratios, the best analytical procedure is not to compute all of them me- chanically but rather to decide first which ratios might be relevant in the particular type of investigation being made.

Illustration 13–1 shows some of the important ratios and other relationships that aid in the analysis of how satisfactory a company’s performance was.4 These ratios can be grouped into four categories: overall measures, profitability measures, tests of invest- ment utilization, and tests of financial condition. The ratios calculated below are based on the Franklin Company’s financial statements shown in Illustration 13–2. The Franklin Company’s financial statements are typical of these companies with major market shares that produce and sell breakfast cereals and similar products.

Overall Measures

As explained above, return on investment can be calculated in three different ways, de- pending on whether one views investment as being total assets, invested capital, or shareholders’ equity. These ratios are calculated as follows:

Return on assets �

� � 16.6 percent $680.7 � $33.3(.66) ———

$4,237.1

Net income � Interest (1 � Tax rate) ————

Total assets

Chapter 13 Financial Statement Analysis 369

Sound Financial Position

Structure of the Analysis

4 Diagrams analogous to Illustration 13–1 can be drawn to show return on invested capital or return on assets, as alternative ROI measures.

Return on Investment

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