Week 3 & 4 Discussion 1 & 2

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Chapter 6 Cash and Internal Control

Chapter Introduction

Module 1 Accounting and Controlling for Cash Cash Equivalents and the Statement of Cash Flows

Control Over Cash Cash Management

Reading a Bank Statement

The Bank Reconciliation

The Need for Adjustments to the Records

Establishing a Petty Cash Fund

Module 2 Internal Control The Sarbanes-Oxley Act of 2002

The Control Environment

The Accounting System

Internal Control Procedures Limitations on Internal Control

Computerized Business Documents and Internal Control Control Over Cash Receipts

The Role of Computerized Business Documents in Controlling Cash Disbursements

Chapter Review Accounts Highlighted

Key Terms Quiz

Review Problem

Exercises

Multi-Concept Exercise

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Problems

Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

© 2020 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means - graphic, electronic, or mechanical, or in any other manner - without the written permission of the copyright holder.

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Chapter Introduction

Making Business Decisions

robert harrison/Alamy

Regal Entertainment Group

Regal Entertainment Group is the largest movie theatre company in the United States, with revenues topping $3.1 billion in 2015. At the end of that year, it operated 572 theatres in 42 states, as well as in Guam, Saipan, American Samoa, and the District of Columbia. Approximately 217 million attendees filled Regal's seats in its theatres during the 2015 fiscal year!

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Regal Entertainment relies on a steady flow of cash to run smoothly. Cash is needed to pay its distributors for films, to buy concessions, and to expand its ever-growing chain of theatres. Cash flows into the theatres continuously in the form of concession and ticket revenues. It is no wonder that 65% of the company's total current assets are in the form of cash and cash equivalents, as shown here.

Because cash is such a liquid asset, control over it is crucial to a company's long-term success. This chapter looks at the accounting for cash and cash equivalents and at the ways companies maintain effective control over all valuable assets, including cash.

Source: Regal Entertainment Group, Form 10-K for the fiscal year ended December 31, 2015.

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LO 1 - Identify and describe the various forms of cash reported on a balance sheet.

Chapter 6: Cash and Internal Control: Module 1 Accounting and Controlling for Cash Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 1 Accounting and Controlling for Cash Cash takes many forms. Coin and currency on hand and cash on deposit in the form of checking and savings accounts are the most obvious forms of cash. Also included in cash are checks, including undeposited checks from customers as well as cashier checks and certified checks. The key to the classification of an amount as cash is that it be readily available to pay debts. Technically, a bank has the legal right to demand that a customer notify it before making withdrawals from savings accounts, or time deposits, as they are often called. Because this right is rarely exercised, however, savings accounts are normally classified as cash. In contrast, a certificate of deposit has a specific maturity date and carries a penalty for early withdrawal and therefore is not included in cash.

Connect to the Real World 6-1

Panera Bread: Reading the Statement of Cash Flows

Refer to the company's statement of cash flows, for 2015 as included in Appendix C. Did its cash and cash equivalents increase or decrease during the most recent year? Summarize the changes in cash and cash equivalents for the year using the framework shown in Exhibit 6-1.

Example 6-1

Determining the Amount of Cash and Cash Equivalents

Given the following items, what amount should be reported on the balance sheet as Cash and cash equivalents?

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Cash and cash equivalents would be reported as $28,850 ($2,000 + $4,500 + $1,500 + $12,000 + $8,000 + $850).

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Chapter 6: Cash and Internal Control Cash Equivalents and the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Cash Equivalents and the Statement of Cash Flows

The first item on Regal Entertainment's balance sheet in the chapter opener is Cash and cash equivalents. Examples of items normally classified as cash equivalents are commercial paper issued by corporations, Treasury bills issued by the federal government, and money market funds offered by financial institutions. According to U.S. GAAP, classification as a cash equivalent (An investment that is readily convertible to a known amount of cash and has an original maturity to the investor of three months or less.) is limited to those investments that are readily convertible to known amounts of cash and that have an original maturity to the investor of three months or less. According to that definition, a six-month bank certificate of deposit would not be classified as a cash equivalent. The IFRS definition of cash equivalents is very similar to that used by U.S. GAAP.

A summary of the major categories appearing on Regal Entertainment's statement of cash flows is shown in Exhibit 6-1. Note the direct tie between this statement and the balance sheet. When the net increase in cash and cash equivalents of $72.5 million is added to the beginning balance in cash and cash equivalents of $147.1 million, the result is the ending balance of $219.6 million. Recall that this is the same balance in cash and cash equivalents as shown on the partial balance sheet in the chapter opener.

Exhibit 6-1

Cash and Cash Equivalents on the Balance Sheet and the Statement of Cash Flows for Regal Entertainment

Source: Regal Entertainment Group, Form 10-K for the fiscal year ended December 31, 2015.

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LO 2 - Describe the various techniques that companies use to control cash.

Control Over Cash Because cash is universally accepted as a medium of exchange, control over it is critical to the smooth functioning of any business, no matter how large or small.

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Cash Management

In addition to the need to guard against theft and other abuses related to the physical custody of cash, management of this asset is also important. Regal Entertainment must constantly be sure that it has neither too little nor too much cash on hand. The need to have enough cash on hand is obvious: suppliers, employees, taxing agencies, banks, and all other creditors must be paid on time. It is equally important that a company not maintain cash on hand and on deposit in checking accounts beyond the minimal amount necessary to support ongoing operations since cash is essentially a nonearning asset. The potential return from investing idle cash in various forms of marketable securities dictates that companies carefully monitor cash on hand at all times.

An important tool in cash management, the cash flows statement, is discussed in detail in Chapter 12. Cash budgets, which are also critical to cash management, are discussed in management accounting and business finance texts. Companies often use two other cash control features: bank reconciliations and petty cash funds. Before turning to those control devices, we need to review the basic features of a bank statement.

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Reading a Bank Statement

Two fundamental principles of internal control are applicable to cash:

1. All cash receipts should be deposited intact daily.

2. All cash payments should be made by check.

Checking accounts at banks are critical in this regard. These accounts allow a company to carefully monitor and control cash receipts and cash payments. Control is aided further by the monthly bank statement (A detailed list, provided by the bank, of all activity for a particular account during the month.) . This statement provides a detailed list of all activity for a particular account during the month. The example of a typical bank statement shown in Exhibit 6-2 indicates the activity in one of the cash accounts maintained by Mickey's Marathon Sports at Mt. Etna State Bank.

Exhibit 6-2

Bank Statement

It is important to understand the route a check takes after it is written. Assume that Mickey's writes a check on its account at Mt. Etna State Bank. Mickey's mails the check to one of its suppliers, Keese Corp., which deposits the check in its account at Second City Bank. At this

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Study Tip

Review your own bank statement to see the similarities and differences between it and the one illustrated here. Also look on the reverse side of your statement for the form of a reconciliation the bank provides. It may or may not be the same format illustrated in Example 6-2.

point, Second City presents the check to Mt. Etna for payment, and Mt. Etna reduces the balance in Mickey's account accordingly. The canceled check has now “cleared” the banking system.

The following types of items appear on Mickey's bank statement:

Canceled checks—Mickey's checks that cleared the bank during the month of June are listed with the corresponding check number and the date paid. Some of these checks may have been written by Mickey's in a previous month but were not presented for payment to the bank until June. Also, during June Mickey's may have written some checks that do not yet appear on the bank statement because they have not been presented for payment. A check written by a company but not yet presented to the bank for payment is called an outstanding check (A check written by a company but not yet presented to the bank for payment.) .

Deposits—Most companies deposit all checks, coins, and currency on a daily basis; this is in keeping with an internal control principle that all cash receipts should be deposited in their entirety. For the sake of brevity, we have limited to four the number of deposits that Mickey's made during the month. Mickey's also may have made a deposit on the last day or two of the month, and this deposit may not yet be reflected on the bank statement. This type of deposit is called a deposit in transit (A deposit recorded on the books but not yet reflected on the bank statement.) .

NSF check—NSF stands for “not sufficient funds.” The NSF check listed on the bank statement on June 13 is a customer's check that Mickey's recorded on its books, deposited, and thus included in its Cash account. When Mt. Etna State Bank learned that the customer did not have sufficient funds on hand in its bank account to cover the check, the bank deducted the amount from Mickey's account. Mickey's needs to contact its customer to collect the amount due. Ideally, the customer will issue a new check once it has sufficient funds in its accounts.

Service charge—The most common bank service charges are monthly activity fees and fees charged for new checks, for the rental of a lockbox in which to store valuable company documents, and for the collection of customer notes by the bank.

Customer note and interest—It is often convenient to have customers pay amounts owed to a company directly to that company's bank. The bank simply acts as a collection

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agency for the company.

Interest earned—Most checking accounts pay interest on the average daily balance in the account. Rates paid on checking accounts are usually significantly less than could be earned on most other forms of investment.

Example 6-2

Preparing a Bank Reconciliation

A bank reconciliation for Mickey's Marathon Sports is shown below.

The following are explanations for the various items on the reconciliation.

1. The balance per bank statement of $3,308.59 is taken from the June statement as shown in Exhibit 6-2.

2. Mickey's records showed a deposit for $642.30 made on June 30 that is not reflected on the bank statement. The deposit in transit is listed as an addition to the bank statement balance.

3. The accounting records indicate three checks written but not yet reflected on the bank statement. The three outstanding checks are as follows:

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496 $ 79.89

501 $213.20

502 $424.75

Outstanding checks are the opposite of deposits in transit and therefore are deducted from the bank statement balance.

4. The adjusted balance of $3,233.05 is found by adding the deposit in transit and deducting the outstanding checks from the bank statement balance.

5. The $2,895.82 book balance on June 30 is taken from the company's records as of that date.

6. According to the bank statement, $550 was added to the account on June 26 for the collection of a note with interest. We assume that the repayment of the note accounted for $500 of this amount and that the other $50 was for interest. The bank statement notifies Mickey's that the note with interest has been collected. Therefore, Mickey's must add $550 to the book balance.

7. An entry on June 30 on the bank statement shows an increase of $15.45 for interest earned on the bank account during June. This amount is added to the book balance.

8. A review of the canceled checks returned with the bank statement detected an error that Mickey's made. The company records indicated that check 498 was recorded incorrectly as $471.25; the check was actually written for $417.25 and reflected as such on the bank statement. This error, referred to as a transposition error, resulted from transposing the 7 and the 1 in recording the check in the books. The error is the difference between the amount of $471.25 recorded and the amount of $417.25 that should have been recorded, or $54.00. Because Mickey's recorded the cash payment at too large an amount, $54.00 must be added back to the book balance.

9. In addition to canceled checks, three other deductions appear on the bank statement. Each of these must be deducted from the book balance:

a. A customer's NSF check for $245.72 (see June 13 entry on bank statement)

b. A $16.50 fee charged by the bank to collect the customer's note discussed in (6) (see June 26 entry on bank statement)

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c. A service fee of $20.00 charged by the bank for rental of a lockbox (see June 23 entry on bank statement)

10. The additions of $619.45 and deductions of $282.22 resulted in an adjusted cash balance of $3,233.05. Note that this adjusted balance agrees with the adjusted bank statement balance on the bank reconciliation [see (4)]. Thus, all differences between the two balances have been explained.

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The Bank Reconciliation

A bank reconciliation (A form used by the accountant to reconcile or resolve any differences between the balance shown on the bank statement for a particular account with the balance shown in the accounting records.) should be prepared for each individual bank account as soon as the bank statement is received. Ideally, the reconciliation should be performed or thoroughly reviewed by someone independent of custody, record-keeping, and authorization responsibilities relating to cash. As the name implies, the purpose of a bank reconciliation is to reconcile, or resolve, any differences between the bank's recorded balance and the balance that appears on the company's books. Differences between the two amounts are investigated, and necessary adjustments are made. The following steps are used in preparing a bank reconciliation:

1. Trace deposits listed on the bank statement to the books. Any deposits recorded on the books but not yet shown on the bank statement are deposits in transit. Prepare a list of the deposits in transit.

2. Arrange the canceled checks in numerical order and trace each of them to the books. Any checks recorded on the books but not yet listed on the bank statement are outstanding. Prepare a list of the outstanding checks.

3. List all items, other than deposits, shown as additions on the bank statement, such as interest paid by the bank and amounts collected by the bank from one of the company's customers. When the bank pays interest or collects an amount owed to a company, the bank increases its liability to the company on its own books. These items are called credit memoranda (Additions on a bank statement for such items as interest paid on the account and notes collected by the bank for the customer.) . Prepare a list of credit memoranda.

4. List all amounts, other than canceled checks, shown as subtractions on the bank statement, such as any NSF checks and service charges. When a company deposits money in a bank, a liability is created on the books of the bank. This liability is reduced for items such as NSF checks and service charges. These items are called debit memoranda (Deductions on a bank statement for items such as NSF checks and various service charges.) . Prepare a list of debit memoranda.

5. Identify any errors made by the bank or by the company in recording cash transactions.

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Companies use a number of different formats in preparing bank reconciliations. For example, some companies take the balance shown on the bank statement and reconcile this amount to the balance shown on the books. Another approach, which will be illustrated for Mickey's, involves reconciling the bank balance and the book balance to an adjusted balance, rather than one to the other. The advantage of this second approach is that it yields the correct balance and makes it easy for the company to make any necessary adjustments to its books.

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Chapter 6: Cash and Internal Control The Need for Adjustments to the Records Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

The Need for Adjustments to the Records

After it completes the bank reconciliation, Mickey's must prepare a number of adjustments to its records. In fact, all of the information for these adjustments will be from one section of the bank reconciliation. Are the additions and deductions made to the bank balance or the ones made to the book balance the basis for the adjustments? The additions and deductions to the Cash account on the books should be the basis for the adjustments because these are items that Mickey's was unaware of before receiving the bank statement. Conversely, the additions and deductions to the bank's balance (i.e., the deposits in transit and the outstanding checks) are items that Mickey's has already recorded on its books.

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Chapter 6: Cash and Internal Control Establishing a Petty Cash Fund Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Establishing a Petty Cash Fund

Most businesses make an exception to the rule that all disbursements should be made by check. For minor expenditures, they use a petty cash fund (Money kept on hand for making minor disbursements in coin and currency rather than by writing checks.) , which consists of coin and currency kept on hand to make minor disbursements. The necessary steps in setting up and maintaining a petty cash fund are as follows:

1. A check is written for a lump-sum amount, such as $100 or $500. The check is cashed, and the coin and currency are entrusted to a petty cash custodian.

2. A journal entry is made to record the establishment of the fund.

3. Upon presentation of the necessary documentation, employees receive minor disbursements from the fund. In essence, cash is traded from the fund in exchange for a receipt.

4. Periodically, the fund is replenished by writing and cashing a check in the amount necessary to bring the fund back to its original balance.

5. At the time the fund is replenished, an adjustment is made to record its replenishment and to recognize the various expenses incurred.

The use of this fund is normally warranted on the basis of cost versus benefits. That is, the benefits in time saved in making minor disbursements from cash are thought to outweigh the cost associated with the risk of loss from decreased control over cash disbursements. The fund also serves a practical purpose for certain expenditures, such as taxi fares and postage, that often must be paid in cash.

Module 1

Test Yourself

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Question

1. Why does the purchase of an item classified as a cash equivalent not appear on the statement of cash flows as an investing activity?

2. Different formats for bank reconciliations are possible. What is the format for a bank reconciliation in which a service charge for a lockbox is added to the balance per the bank statement? Explain your answer.

Apply

1. For the following items, indicate whether each should be included (I) or excluded (E) from the line item titled Cash and cash equivalents on the balance sheet.

Certificate of deposit maturing in 60 days

Checking account

Certificate of deposit maturing in six months

Savings account

Shares of GM stock

Petty cash

Corporate bonds maturing in 30 days

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Certified check

2. Using Y for yes and N for no, indicate whether each of the following items should or should not be included with cash and cash equivalents on the balance sheet.

Cash in a checking account

Coin and currency in a cash register drawer

A six-month certificate of deposit

Postage stamps

An amount owed by an employee for a travel advance

A three-month Treasury bill

Cash in a money market account

3. Indicate whether each of the following items is an adjustment to the balance per books (BK) or to the balance per bank statement (BS) on a reconciliation that adjusts the bank balance and the bank statement to the correct balance.

Customer's NSF check

Service charge for a lockbox

Outstanding checks

Interest earned on an account for the month

Check written on the account but recorded on the books at the wrong amount

Deposits in transit

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LO 3 - Explain the importance of internal control to a business and the significance of the Sarbanes-Oxley Act of 2002.

Module 2 Internal Control An employee of a large auto parts warehouse routinely takes spare parts home for personal use. A payroll clerk writes and signs two checks for an employee and then splits the amount of the second check with the worker. Through human error, an invoice is paid for merchandise never received from the supplier. These cases all point to a deficiency in a company's internal control system. An internal control system (Policies and procedures necessary to ensure the safeguarding of an entity's assets, the reliability of its accounting records, and the accomplishment of overall company objectives.) consists of the policies and procedures necessary to ensure the safeguarding of an entity's assets, the reliability of its accounting records, and the accomplishment of its overall objectives.

Three assets are especially critical to the operation of merchandising companies: cash, accounts receivable, and inventory. Activities related to those three assets compose the operating cycle of a business. Cash is used to buy inventory; the inventory is eventually sold; and assuming a sale on credit, the account receivable from the customer is collected. After looking at the government's response to huge lapses in internal control by major U.S. companies, we turn to the ways in which a company attempts to control the assets at its disposal.

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Chapter 6: Cash and Internal Control The Sarbanes-Oxley Act of 2002 Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

The Sarbanes-Oxley Act of 2002

As briefly described in Chapter 1, the Sarbanes-Oxley Act (An act of Congress in 2002 intended to bring reform to corporate accountability and stewardship in the wake of a number of major corporate scandals.) of 2002 (or SOX) was a direct response to the numerous corporate scandals that surfaced in the first few years of the new millennium. High-profile cases involving questionable accounting practices by companies such as Enron and WorldCom caused the federal government to step in and attempt to restore the public's confidence in the financial reporting system. SOX's various provisions are far- reaching, including provisions designed to ensure the independence of a company's auditors. For example, external auditors can no longer provide bookkeeping, human resource, information system design, and brokerage services for clients that they audit.

Another major part of SOX, Section 404, deals with a company's internal control system. Section 404 requires the annual report to include an internal control report (A report required by Section 404 of the Sarbanes-Oxley Act to be included in a company's annual report in which management assesses the effectiveness of the internal control structure.) in which management is required to:

1. State its responsibility to establish and maintain an adequate internal control structure and procedures for financial reporting.

2. Assess the effectiveness of its internal control structure and procedures for financial reporting.

Regal Entertainment's Report on Internal Control over Financial Reporting is shown in Exhibit 6-3. The first paragraph states management's responsibility for its system of internal control, and the second paragraph indicates that management believes internal control over financial reporting is effective.

Exhibit 6-3

Management Report on Internal Control—Regal Entertainment

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Source: Regal Entertainment Group, Form 10-K for the fiscal year ended December 31, 2015.

Another important provision in SOX is that a company's outside auditors must issue a report on their assessment of the company's internal control. The statement in the last paragraph in Exhibit 6-3 calls attention to this report. KPMG is Regal Entertainment's independent auditor, and its report is shown in Exhibit 6-4. Note the reference in the second paragraph to the Public Company Accounting Oversight Board (PCAOB) (The five-member body created by the Sarbanes-Oxley Act that was given the authority to set auditing standards in the United States.) . The PCAOB is the five-member body created by SOX that was given authority to set auditing standards in the United States. The last sentence in KPMG's report also contains the important statement that, in its opinion, Regal Entertainment has maintained effective internal control over financial reporting.

Exhibit 6-4

Auditors' Report—Regal Entertainment

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Source: Regal Entertainment Group, Form 10-K for the fiscal year ended December 31, 2015.

The top of the independent auditors' report in Exhibit 6-4 states that it is directed to the board of directors and stockholders of Regal Entertainment. The board of directors (A group composed of key officers of a corporation and outside members responsible for general oversight of the affairs of the entity.) usually consists of key officers of the corporation as well as a number of directors whom it does not directly employ. Another key provision in SOX requires that the audit committee be made up entirely of outside directors. The audit committee (A board of directors subset that acts as a direct contact between the stockholders and the independent accounting firm.) is a subset of the board of directors that provides direct contact between stockholders and the independent accounting firm.

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Stockholders and others affected by the scandals thought that top management of these organizations should have taken more responsibility for the accuracy of the information presented in the financial statements. SOX places this responsibility directly in the hands of the CEO (chief executive officer) and the CFO (chief financial officer). Now, the CEO and the CFO must certify that the information in the financial statements fairly presents the financial condition and results of operations of the company.

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The Control Environment

Management's operating style will have a major impact on the effectiveness of various policies. An autocratic style, in which a few key officers tightly control operations, will result in an environment different from that of a decentralized organization, in which departments have more freedom to make decisions. Personnel policies and practices form another factor in the internal control of a business. An appropriate system for hiring competent employees and firing incompetent ones is crucial to an efficient operation. After all, no internal control system will work very well if employees who are dishonest or poorly trained are on the payroll. On the other hand, too few people doing too many tasks defeats the purpose of an internal control system. Finally, the effectiveness of internal control in a business is influenced by the board of directors, particularly its audit committee.

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The Accounting System

Internal controls are important to all businesses, regardless of the degree of automation of the accounting system. An accounting system (Methods and records used to accurately report an entity's transactions and to maintain accountability for its assets and liabilities.) consists of all of the methods and records used to report an entity's transactions accurately and to maintain accountability for its assets and liabilities. An integral part of all accounting systems is the use of a journal to record transactions. However, refinements may be made to the basic components of the system. For example, most companies use specialized journals to record recurring transactions, such as sales of merchandise on credit.

An accounting system can be completely manual, fully computerized, or as is often the case, a mixture of the two. It must be capable of handling the volume and complexity of transactions entered into by a business.

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LO 4 - Describe the basic internal control procedures.

Internal Control Procedures Management establishes policies and procedures on a number of different levels to ensure that corporate objectives will be met. Some procedures are formalized in writing, while others may not be written. Certain administrative controls (Procedures concerned with efficient operation of the business and adherence to managerial policies.) within a company are more concerned with the efficient operation of the business and adherence to managerial policies than with the accurate reporting of financial information. For example, a company policy that requires all prospective employees to be interviewed by the personnel department is an administrative control. Other accounting controls (Procedures concerned with safeguarding the assets or the reliability of the financial statements.) primarily concern safeguarding assets and ensuring the reliability of the financial statements. Some of the most important internal control procedures are as follows:

Proper authorizations

Segregation of duties

Independent verification

Safeguarding of assets and records

Independent review and appraisal

Design and use of business documents

Proper Authorizations

Management grants specific departments the authority to perform various activities. Along with the authority comes responsibility. Most large organizations give the authority to hire new employees to the personnel department. Management authorizes the purchasing department to order goods and services for the company and the credit department to establish specific policies for granting credit to customers. By specifically authorizing certain individuals to carry out specific tasks for the business, management is able to hold those same people accountable for the outcome of their actions.

The authorizations for some transactions are general in nature; others are specific. For example, a cashier authorizes the sale of a book in a bookstore by ringing up the

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transaction (a general authorization). However, the bookstore manager's approval may be required before a book can be returned (a specific authorization).

Segregation of Duties

What might happen if one employee is given the authority to prepare checks and to sign them? What might happen if a single employee is allowed to order inventory and receive it from the shipper? Or what if the cashier at a checkout stand records the daily receipts in the journal? If the employee in each of these situations is honest and never makes mistakes, nothing bad will happen. However, if the employee is dishonest or makes errors, the company can experience losses. Without segregation of duties, an employee is able not only to perpetrate a fraud but also to conceal it. A good system of internal control requires that the physical custody of assets be separated from the accounting for those same assets.

Like most internal control principles, the concept of segregation of duties is an ideal that is not always attainable. Many smaller businesses do not have adequate personnel to achieve complete segregation of key functions. In certain instances, these businesses need to rely on the direct involvement of the owners and on independent verification.

Independent Verification

Independent verification means the work of one department should act as a check on the work of another. For example, the physical count of the inventory in a perpetual inventory system provides such a check. The accounting department maintains the general ledger card for inventory and updates it as sales and purchases are made. The physical count of the inventory by an independent department acts as the check on the work of the accounting department.

Or consider the bank reconciliation shown earlier in the chapter. The reconciliation of a company's bank account with the bank statement by someone not responsible for either the physical custody of cash or the cash records acts as an independent check on the work of these parties.

Safeguarding of Assets and Records

Adequate safeguards must be in place to protect assets and the accounting records from losses of various kinds. Cash registers, safes, and lockboxes are important safeguards for cash. Secured storage areas with limited access are essential for the safekeeping of inventory. Protection of the accounting records against misuse is equally important. Access to a computerized accounting record should be limited to those employees authorized to prepare journal entries. This can be done with the use of a personal identification number and a password to access the system.

Independent Review and Appraisal

A well-designed system of internal control provides for periodic review and appraisal of the accounting system as well as the people operating it. The group primarily responsible for

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review and appraisal of the system is the internal audit staff (The department responsible for monitoring and evaluating the internal control system.) . Most large corporations have a full-time staff of internal auditors. They provide management with periodic reports on the effectiveness of the control system and the efficiency of operations.

The primary concern of the independent public accountants (or external auditors) is whether the financial statements have been presented fairly. Internal auditors focus more on the efficiency with which the organization is run. They are responsible for periodically reviewing both accounting and administrative controls. The internal audit staff also helps to ensure that the company's policies and procedures are followed.

Design and Use of Business Documents

Business documents are the crucial link between economic transactions entered into by an entity and the accounting record of those events. They are often called source documents and may be generated by computer or completed manually. The source document for the recognition of the expense of an employee's wages is the time card. The source documents for a sale include the sales order, the sales invoice, and the related shipping document. Business documents must be designed to capture all relevant information about an economic event and to ensure that related transactions are properly classified.

Business documents must be properly controlled. For example, a key feature for documents is a sequential numbering system just like you have for your personal checks. This system results in a complete accounting for all documents in the series and negates the opportunity for an employee to misdirect one. Another key feature of well-designed business documents is the use of multiple copies. The various departments involved in a particular activity, such as sales or purchasing, are kept informed of the status of outstanding orders through the use of copies of documents.

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Chapter 6: Cash and Internal Control Limitations on Internal Control Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Limitations on Internal Control

No system of internal control is totally foolproof. An entity's size affects the degree of control that it can obtain. In general, large organizations are able to devote a substantial amount of resources to safeguarding assets and records. Because the installation and maintenance of controls can be costly, an internal audit staff is a luxury that many small businesses cannot afford. The mere segregation of duties can result in added costs if two employees must be involved in a task previously performed by only one.

Segregation of duties can be effective in preventing collusion, but no system of internal control can ensure that it will not happen. It does no good to have one employee count the cash at the end of the day and another to record it if the two act in concert to steal from the company. Rotation of duties can help lessen the likelihood of such problems. An employee is less likely to collude with someone to steal if the assignment is a temporary one. Another control feature, a system of authorizations, is meaningless if management continually overrides or fails to support it.

Human errors can weaken a system of internal control. Misunderstood instructions, carelessness, fatigue, and distraction can all lead to errors. A well-designed internal control system should result in the best possible people being hired to perform the various tasks.

Connect to the Real World 6-2

Panera Bread: Reading the Management's Report

Refer Appendix C for Management's Report on Internal Control over Financial Reporting for Panera Bread. Where does management discuss limitations on internal control? Why are there risks in making any projections about the effectiveness of controls in the future?

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LO 5 - Describe the various documents used in recording purchases and their role in controlling cash disbursements.

Chapter 6: Cash and Internal Control Computerized Business Documents and Internal Control Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Computerized Business Documents and Internal Control In addition to separating the custodianship of cash from its recording in the accounts, two other fundamental principles apply to its control. First, all cash receipts should be deposited intact in the bank on a daily basis. Intact means that no disbursements should be made from the cash received from customers. Second, all cash disbursements should be made by check. Using sequentially numbered checks results in a clear record of all disbursements. The only exception to this rule is the use of a petty cash fund to make cash disbursements for minor expenditures such as postage stamps and repairs.

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Control Over Cash Receipts

Most merchandisers receive checks and currency from customers in two ways: (1) cash received over the counter from cash sales and (2) cash received in the mail from credit sales. Each type of cash receipt poses its own control problems.

Cash Received Over the Counter

Several control mechanisms are used to handle these cash receipts.

First, cash registers allow the customer to see the display, which deters the salesclerk from ringing up a sale for less than the amount received from the customer and pocketing the difference.

A locked-in cash register tape is another control feature. At various times during the day, an employee other than the clerk unlocks the register, removes the tape, and forwards it to the accounting department. At the end of the shift, the salesclerk remits the coin and currency from the register to a central cashier. Any difference between the amount of cash remitted to the cashier and the amount on the tape submitted to the accounting department is investigated.

Finally, prenumbered customer receipts, prepared in duplicate, are a useful control mechanism. The customer is given a copy, and the salesclerk retains another. The salesclerk is accountable for all numbers in a specific series of receipts and must be able to explain any differences between the amount of cash remitted to the cashier and the amount collected per the receipts.

Cash Received in the Mail

Most customers send checks rather than currency through the mail. Any form of cash received in the mail from customers should be applied to their account balances. The customer wants assurance that the account is appropriately reduced for the amount of the payment. The company must be assured that all cash received is deposited in the bank and that the account receivable is reduced accordingly.

To achieve a reasonable degree of control, two employees should be present when the mail is opened.

1. The first employee opens the mail in the presence of the second employee, counts the money received, and prepares a control list of the amount received on that particular day.

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2. The second employee takes the original list and the cash to the cashier, who makes the bank deposit.

3. One copy of the list is forwarded to the accounting department to be used as the basis for recording the increase in Cash and the decrease in Accounts Receivable.

4. The other copy is retained by one of the two people who opens the mail.

5. A comparison of the list to the bank deposit slip is a timely way to detect receipts that do not make it to the bank.

6. Because the two employees acting in concert could circumvent the control process, rotation of duties is important.

Monthly customer statements act as an additional control device for customer payments received in the mail. Assume that the two employees responsible for opening the mail and remitting checks to the cashier decide to pocket a check received from a customer. Because the check is not remitted to the cashier, the accounting department will not be notified to reduce the customer's account for the payment. The monthly statement, however, should alert the customer to the problem. At this point, the customer should ask the company to investigate the discrepancy. As evidence of its payment on account, the customer will be able to point to a canceled check—which was cashed by the unscrupulous employees.

The use of customer statements as a control device will be effective only if the employees responsible for the custody of cash received through the mail, for record keeping, and for authorization of adjustments to customers' accounts are not allowed to prepare and mail statements to customers. Employees allowed to do so are in a position to alter customers' statements.

Cash Discrepancies

Discrepancies occur occasionally due to theft by dishonest employees and to human error. For example, if a salesclerk intentionally or unintentionally gives the wrong amount of change, the amount remitted to the cashier will not agree with the cash register tape. Any material differences should be investigated.

Of particular significance are recurring differences between the amount remitted by any one cashier and the amount on the cash register tape.

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Chapter 6: Cash and Internal Control The Role of Computerized Business Documents in Controlling Cash Disbursements Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

The Role of Computerized Business Documents in Controlling Cash Disbursements

A company makes cash payments to purchase merchandise and supplies, to pay operating expenditures, and to cover payroll expenses. We will concentrate on the disbursement of cash to purchase goods for resale, focusing particularly on the role of business documents in the process. Suppliers must be paid on time so that companies can continue to make goods available for resale to customers.

The following example begins with a requisition for merchandise by Mickey's Marathon Sports, continues through the receipt of the goods, and concludes with the eventual payment to the supplier. The entire process is summarized in Exhibit 6-5.

Exhibit 6-5

Document Flow for the Purchasing Function

Purchase Requisition

The shoe department at Mickey's Marathon Sports reviews its stock weekly to determine if any items need replenishing. On the basis of its needs, the supervisor of the shoe department fills out the purchase requisition form (A form a department uses to initiate a request to order merchandise.) shown in Exhibit 6-6 above. The form indicates the supplier or vendor, Fleet Foot.

Exhibit 6-6

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Purchase Requisition

The purchasing department makes the final decision on a vendor. The purchasing department is thus held accountable for acquiring the goods at the lowest price, given certain standards for merchandise quality. Mickey's assigns a separate item number to each of the thousands of individual items of merchandise it stocks. Note that the requisition also indicates the vendor's number for each item. The unit of measure for each item is indicated in the quantity column. For example, “24 PR” means 24 pairs of shoes. The original and a copy of the purchase requisition are sent to the purchasing department. The shoe department keeps one copy for its records.

Purchase Order

A computer-generated purchase order (A form sent by the purchasing department to the supplier.) for Mickey's is shown in Exhibit 6-7. Purchase orders are usually prenumbered, and a company should periodically investigate any missing numbers. The purchasing department uses its copy of the purchase requisition as a basis for preparing the purchase order. An employee in the purchasing department keys in the relevant information from the purchase requisition and adds the unit cost for each item gathered from the vendor's price guide. The software program generates a purchase order, as shown in Exhibit 6-7. You should trace all of the information for at least one of the three items ordered from the purchase requisition to the purchase order.

Exhibit 6-7

Computer-Generated Purchase Order

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The system generates the original purchase order and three copies. As indicated in Exhibit 6-5, the original is sent to the supplier after a supervisor in the purchasing department approves it. One copy is sent to the accounting department, where it will be matched with the original requisition. A second copy is sent to the shoe department as confirmation of its request for the items. The purchasing department keeps the third copy for its records.

A purchase order is not the basis for recording a purchase and a liability. Legally, the order is merely an offer by the company to purchase goods from the supplier.

Invoice

When Fleet Foot ships the merchandise, it also mails an invoice to Mickey's, requesting payment according to the agreed-upon terms, in this case 2/10, net 30. This means that the customer (Mickey's) receives a 2% discount by paying within 10 days of purchase; if not, the full amount is due within 30 days of purchase. The invoice (A form sent by the seller to the buyer as evidence of a sale. Alternate term: Purchase invoice, Sales invoice.) may be mailed separately or included with the shipment of merchandise. Fleet Foot, the seller, calls this document a sales invoice; it is the basis for recording a sale and an account receivable. Mickey's, the buyer, calls the same document a purchase invoice, which is the basis for recording a purchase and an account payable. The invoice that Fleet Foot sent to Mickey's accounting department is shown in Exhibit 6-8.

Exhibit 6-8

Invoice

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Receiving Report

The accounting department receives the invoice for the three items ordered. Within a few days before or after the receipt of the invoice, the merchandise arrives at Mickey's warehouse. As soon as the items are unpacked, the receiving department inspects and counts them. The same software used to generate the purchase order also generates a receiving report, as shown in Exhibit 6-9.

Exhibit 6-9

Computer-Generated Receiving Report

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Mickey's uses a blind receiving report (A form used by the receiving department to account for the quantity and condition of merchandise received from a supplier.) . The column for the quantity received is left blank and is filled in by the receiving department. Rather than simply being able to indicate that the number ordered was received, an employee must count the pairs of shoes to determine that the number ordered is actually received.

The accounting system generates an original receiving report and three copies. The receiving department keeps one copy for its records and sends the original to the accounting department. One copy is sent to the purchasing department to be matched with the purchase order, and the other copy is sent to the shoe department as verification that the items it originally requested have been received.

Invoice Approval Form

Mickey's accounting department has copies of the purchase requisition from the shoe department, the purchase order from the purchasing department, the invoice from the supplier, and the receiving report from the warehouse. The accounting department uses an invoice approval form (A form the accounting department uses before making payment to document the accuracy of all information about a purchase. Alternate term: Voucher.) to document the accuracy of the information on each of these other forms. The invoice approval form for Mickey's Marathon Sports is shown in Exhibit 6-10. Some businesses do not use a separate invoice approval form, but simply note approval directly on the invoice.

Exhibit 6-10

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Invoice Approval Form

The invoice is compared to the purchase requisition to ensure that the company is billed for goods that it requested. A comparison of the invoice with the purchase order ensures that the goods were in fact ordered. Finally, the receiving report is compared with the invoice to verify that all goods for which the company is being billed were received. An accounting department employee must also verify the mathematical accuracy of the amounts that appear on the invoice. The date the invoice must be paid to take advantage of the discount is noted so that the finance department will be sure to send the check by this date. At this point, the accounting department prepares the journal entry to increase the inventory and accounts payable accounts. The invoice approval form and the invoice are then sent to the finance department. Some businesses call the invoice approval form a voucher, which is used for all expenditures, not just for purchases of merchandise.

Check with Remittance Advice

Mickey's finance department is responsible for issuing checks. This results from the need to segregate custody of cash (the signed check) from record keeping (the updating of the ledger). Upon receipt of the invoice approval form from the accounting department, a clerk in the finance department processes a check with a remittance advice attached, as shown in Exhibit 6-11. Before the check is signed, the documents referred to on the invoice approval form are reviewed and canceled to prevent reuse. The clerk then forwards the check to one of the company officers authorized to sign checks. According to one of Mickey's internal control policies, only the treasurer and the assistant treasurer are

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authorized to sign checks. Both officers must sign check amounts above a specified dollar limit. To maintain separation of duties, the finance department should mail the check. The remittance advice informs the supplier as to the nature of the payment.

Exhibit 6-11

Check with Remittance Advice

Module 2

Test Yourself

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Question

1. What circumstances led to the passage of the Sarbanes-Oxley Act in 2002?

2. An order clerk fills out a purchase requisition for an expensive item of inventory and the receiving report when the merchandise arrives. The clerk takes the inventory home, then sends the invoice to the accounting department so that the supplier will be paid. What basic internal control procedure could have prevented this misuse of company assets?

3. What two basic procedures are essential to an effective system of internal control over cash?

4. What is the purpose of comparing a purchase invoice with a purchase order? of comparing a receiving report with a purchase invoice?

Apply

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1. Provide answers to each of the following questions.

a. Who is responsible for establishing and maintaining an adequate internal control structure for a company?

b. Who provides an independent opinion as to whether management has maintained effective internal control over financial reporting?

c. To whom should the independent auditors' report be directed?

d. Which committee of the board of directors provides direct contact between stockholders and the independent accounting firm?

2. List the internal control procedures discussed in the text.

3. Number each of the following documents to indicate the order in which each document would be used.

Purchase order

Invoice approval form

Check and remittance advice

Purchase requisition

Invoice

Receiving report

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Chapter Review

Accounts Highlighted

Account Titles Where It Appears

In What Section Cited on

Cash and Cash Equivalents Balance Sheet Current Assets 289

Petty Cash Fund Balance Sheet Current Assets 294

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Chapter 7 Receivables and Investments

Chapter Introduction

Module 1 Accounting for Accounts Receivable The Use of a Subsidiary Ledger

The Valuation of Accounts Receivable

Two Methods to Account for Bad Debts

Two Approaches to the Allowance Method of Accounting for Bad Debts

The Accounts Receivable Turnover Ratio

Module 2 Accounting for Notes Receivable Important Terms Connected with Promissory Notes

Accelerating the Inflow of Cash from Sales Credit Card Sales

Discounting Notes Receivable

Module 3 Accounting for Investments Investments in Highly Liquid Financial Instruments

Investments in Stocks and Bonds

Valuing and Reporting Investments on the Financial Statements

Module 4 How Liquid Assets Affect the Statement of Cash Flows

Chapter Review Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Multi-Concept Exercises

Problems

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Multi-Concept Problem

Alternate Problems

Alternate Multi-Concept Problem

Decision Cases

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Chapter Introduction

Making Business Decisions

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iStockphoto.com/Hocus Focus

Apple Inc.

iPhones, iPads, iTunes, and iPods—these brand names have set Apple Inc. apart in the highly competitive tech world. For 40 years, the California-based company has been at the forefront in developing products that have revolutionized the way we work and play. The company that Steve Jobs made famous has seen sales skyrocket over this stretch, topping $233 billion in fiscal 2015.

Apple makes many of its sales—whether laptops, tablets, or phones—on credit. The resulting receivables must be collected to add cash to its balance sheet. As you know from personal experience, idle cash does not earn a very good return and so Apple invests its idle cash in various marketable securities. It should come as no surprise that the three largest current assets on Apple's recent partial balance sheet, shown here, are its cash and cash equivalents, marketable securities, and accounts receivable.

In the Current assets portion of the Consolidated Balance Sheet for Apple, the lines for Cash and cash equivalents, Short-term marketable securities, and Accounts receivable are highlighted. For Cash and cash equivalents, the amount $13,844 appears in the column for September 27, 2014; and the amount $14,259 appears in the column for September 28, 2013. For Short-term marketable securities, the amounts are $11,233 and $26,287, respectively. For Accounts receivable, the amounts are $17,460 and $13,102, respectively. A comment box pointing to these highlighted rows with a blue arrow states, “Apple's three most important liquid assets.”

Source: Apple Inc., Form 10-K, For the Fiscal Year Ended September 26, 2015.

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LO 1 - Explain how to account for accounts receivable, including bad debts.

Chapter 7: Receivables and Investments: Module 1 Accounting for Accounts Receivable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 1 Accounting for Accounts Receivable The most common type of receivables is accounts receivable (A receivable arising from the sale of goods or services with a verbal promise to pay.) , which arise from the sale of goods or services to customers with a verbal promise to pay within a specified period of time. Accounts receivable do not bear interest. Apple or any other company prefers to make all sales for cash, because selling on credit causes two problems: it slows down the inflow of cash to the company, and it raises the possibility that the customer may not pay its bill on time or possibly ever. To remain competitive, however, Apple and most other businesses must sell their products and services on credit.

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Chapter 7: Receivables and Investments The Use of a Subsidiary Ledger Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

The Use of a Subsidiary Ledger

Assume that Apple sells $25,000 of hardware to a school. The sale results in the recognition of an asset and revenue. The transaction can be identified and analyzed as follows:

How Will I Use Accounting?

If you start up your own company it is very likely you will extend credit to your customers. Financial statements are the starting point in evaluating the credit- worthiness of a potential customer. They tell you about the company's liquidity, its profitability and how it uses its cash. Granting credit always involves some degree of risk, but only after reading the financials are you able to make an informed decision.

It is important for control purposes that Apple keep a record of each sale and include that amount on a periodic statement or bill sent to the customer. What if a company has a hundred or a thousand different customers? The mechanism that companies use to track the balance owed by each customer is called a subsidiary ledger (The detail for a number of individual items that collectively make up a single general ledger account.) .

A subsidiary ledger contains the necessary detail on items that collectively make up a single general ledger account, called the control account (The general ledger account that is supported by a subsidiary ledger.) . This detail is shown in the following example for accounts receivable:

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In theory, any one of the accounts in the general ledger could be supported by a subsidiary ledger. In addition to Accounts Receivable, two other common accounts supported by subsidiary ledgers are Plant and Equipment and Accounts Payable. An accounts payable subsidiary ledger contains a separate account for each of the suppliers or vendors from which a company purchases inventory. A plant and equipment subsidiary ledger consists of individual accounts, along with their balances, for each of the various long-term tangible assets the company owns.

A subsidiary ledger does not take the place of the control account in the general ledger. Instead, at any point in time, the balances of the accounts that make up the subsidiary ledger should total to the single balance in the related control account. The remainder of this chapter will illustrate the use of only the control account. However, whenever a specific customer's account is increased or decreased, the name of the customer will be noted next to the control account.

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Chapter 7: Receivables and Investments The Valuation of Accounts Receivable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

The Valuation of Accounts Receivable

Apple's 2015 Form 10-K revealed the following receivables on the balance sheet:

Connect to the Real World 7-1

Apple: Reading the Balance Sheet

Refer to Apple's partial balance sheet as presented in the chapter opener. By what amount did accounts receivable increase or decrease during 2015? How significant are accounts receivable to the amount of total current assets at the end of 2015?

Apple does not sell its products under the assumption that any particular customer will not pay its bill. In fact, the credit department of a business is responsible for performing a credit check on all potential customers before granting them credit. Apple's management knows, however, that not all customers will be able to pay their accounts when due.

The reduction in Apple's receivables for an allowance is how most companies deal with bad debts in their accounting records. Bad debts are unpaid customer accounts that are uncollectible. Some companies describe the allowance as the allowance for doubtful accounts or the allowance for uncollectible accounts. Using the end of 2015 as an example, Apple believes that the net recoverable amount of its receivables is $16,849 million even though the gross amount of receivables is $82 million higher than this amount. The company has reduced the gross receivables for an amount it believes is necessary to reflect the asset on the books at the net recoverable amount or net realizable value (The amount a company expects to collect on an account receivable. Alternate term: net recoverable amount) .

Chapter 7: Receivables and Investments The Valuation of Accounts Receivable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Chapter 7: Receivables and Investments Two Methods to Account for Bad Debts Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Two Methods to Account for Bad Debts

Example 7-1

Using the Direct Write-Off Method for Bad Debts

Assume that Roberts Corp. makes a $500 sale to Dexter Inc. on November 10, 2017, with credit terms of 2/10, n/60. The effect of the transaction can be identified and analyzed as follows:

Assume further that Dexter is unable to pay within 60 days. After pursuing the account for four months into 2018, the credit department of Roberts informs the accounting department that it has given up on collecting the $500 from Dexter and advises that the account be written off. To do so, the accounting department makes an adjustment. The effect of the adjustment can be identified and analyzed as follows:

This approach to accounting for bad debts, called the direct write-off method (The recognition of bad debts expense at the point an account is written off as uncollectible.) , has some deficiencies.

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What about Roberts' balance sheet at the end of 2017? By ignoring the possibility that not all of its outstanding accounts receivable will be collected, Roberts is overstating the value of this asset at December 31, 2017.

What about the income statement for 2017? By ignoring the possibility of bad debts on sales made during 2017, Roberts has violated the matching principle. This principle requires that all costs associated with making sales in a period be matched with the sales of that period. Roberts has overstated net income for 2017 by ignoring bad debts as expense. The problem is one of timing: even though any one particular account may not prove to be uncollectible until a later period (e.g., the Dexter account), the cost associated with making sales on credit (bad debts) should be recognized in the period of sale.

Accountants use the allowance method (A method of estimating bad debts on the basis of either the net credit sales of the period or the accounts receivable at the end of the period.) to overcome the deficiencies of the direct write-off method. They estimate the amount of bad debts before these debts actually occur.

Example 7-2

Using the Allowance Method for Bad Debts

Assume that Roberts' total sales during 2017 amount to $600,000 and that at the end of the year, the outstanding accounts receivable total $250,000. Also, assume that Roberts estimates that 1% of the sales of the period, or $6,000, will prove to be uncollectible. Under the allowance method, Roberts makes an adjustment at the end of 2017. The effect of the adjustment can be identified and analyzed as follows:

Bad Debts Expense recognizes the cost associated with the reduction in value of Accounts Receivable. The cost is charged to the income statement in the form of Bad Debts Expense. A contra-asset account is used to reduce the asset to its net

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Study Tip

Note the similarities between the Allowance for Doubtful Accounts contra account and another contra account, Accumulated Depreciation. Both are used to reduce an asset account to a lower carrying or book value.

realizable value. This is accomplished by crediting an allowance account, Allowance for Doubtful Accounts (A contra-asset account used to reduce accounts receivable to its net realizable value. Alternate term: Allowance for uncollectible accounts.) .

Roberts presents accounts receivable on its December 31, 2017, balance sheet as follows:

Assume, as we did earlier, that Dexter's $500 account is written off on May 1, 2018. Under the allowance method, the following entry is recorded:

To summarize, whether the direct write- off method or the allowance method is used, the adjustment to write off a specific customer's account reduces Accounts Receivable. It is the other side of the adjustment that differs between the two methods:

Under the direct write-off method, an expense is increased.

Under the allowance method, the allowance account is reduced.

Chapter 7: Receivables and Investments Two Methods to Account for Bad Debts Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Chapter 7: Receivables and Investments Two Approaches to the Allowance Method of Accounting for Bad Debts Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Two Approaches to the Allowance Method of Accounting for Bad Debts

Because the allowance method results in a better matching, accounting standards require it rather than the direct write-off method unless bad debts are immaterial in amount. Accountants use one of two variations of the allowance method to estimate bad debts. One approach emphasizes matching bad debts expense with revenue on the income statement and bases bad debts on a percentage of the sales of the period. This was the method illustrated earlier for Roberts Corp. The other approach emphasizes the net realizable amount (value) of accounts receivable on the balance sheet and bases bad debts on a percentage of the accounts receivable balance at the end of the period.

Percentage of Net Credit Sales Approach

If a company has been in business for enough years, it may be able to use the past relationship between bad debts and net credit sales to predict bad debt amounts. Net means that credit sales have been adjusted for sales discounts and returns and allowances.

Example 7-3

Using the Percentage of Net Credit Sales Approach

Assume that the accounting records for Bosco Corp. reveal the following:

Although the exact percentage varied slightly over the five-year period, the average percentage of bad debts to net credit sales is very close to 2%

. Bosco needs to determine whether this estimate is realistic for the current period. For example, are current economic conditions considerably different from those in prior years? Has the company made sales to any new customers with significantly different credit terms? If the answers to these types of questions are yes, Bosco should consider adjusting the 2% experience rate to estimate future bad debts. Assuming that it uses the 2% rate and that its net

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credit sales during 2017 are $2,340,000, Bosco makes an adjustment of 0.02 × $2,340,000, or $46,800 that can be identified and analyzed as follows:

Thus, Bosco matches bad debts expense of $46,800 with sales revenue of $2,340,000.

Percentage of Accounts Receivable Approach

Some companies believe that they can more accurately estimate bad debts by relating them to the balance in the Accounts Receivable account at the end of the period rather than to the sales of the period.

Example 7-4

Using the Percentage of Accounts Receivable Approach

Assume that the records for Cougar Corp. reveal the following:

The ratio of bad debts to the ending balance in Accounts Receivable over the past five years is $32,330/$4,038,000, or approximately 0.008 (0.8%). Assuming balances in Accounts Receivable and Allowance for Doubtful Accounts on December 31, 2017, of $865,000 and $2,100, respectively, Cougar makes an adjustment that can be identified and analyzed as follows:

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The adjustment of $4,820 results in a balance in Allowance for Doubtful Accounts of $6,920, which is 0.8% of the Accounts Receivable balance of $865,000. The net realizable value of Accounts Receivable is determined as follows:

Note the one major difference between this approach and the percentage of sales approach:

Under the percentage of net credit sales approach, the balance in the allowance account is ignored and the bad debts expense is simply a percentage of the sales of the period.

Under the percentage of accounts receivable approach, however, the balance in the allowance account must be considered.

Connect to the Real World 7-2

Apple: Reading the Balance Sheet

Refer to the excerpt from Apple's balance sheet in the chapter opener. Compute for each of the two year-ends the amount of accounts receivable before deducting the balance in the allowance account. Did this amount increase or decrease during 2015? Did the allowance account increase or decrease during 2015? What would cause the allowance account to increase or decrease in any one year?

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Aging of Accounts Receivable

Some companies use a refinement of the percentage of accounts receivable approach to estimate bad debts. This variation considers the length of time that the receivables have been outstanding. The older an account receivable is, the less likely it is to be collected. An aging schedule (A form used to categorize the various individual accounts receivable according to the length of time each has been outstanding.) categorizes the various accounts by length of time outstanding. A partial aging schedule is shown in Exhibit 7-1. We assume that the company's policy is to allow 30 days for payment of an outstanding account. After that time, the account is past due. An alphabetical list of customers appears in the first column, with the balance in each account shown in the appropriate column to the right. The dotted lines after A. Matt's account indicate that many more accounts appear in the records; only a few have been included to show the format of the schedule.

Exhibit 7-1

Aging Schedule

Example 7-5

Using an Aging Schedule to Estimate Bad Debts

The totals on the aging schedule are used as the basis for estimating bad debts, as shown below.

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The estimated percentage of uncollectibles increases as the period of time the accounts have been outstanding lengthens. If we assume that Allowance for Doubtful Accounts has a balance of $1,230 before adjustment, an adjustment is made that can be identified and analyzed as follows:

The net realizable value of accounts receivable would be determined as follows:

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LO 2 - Explain how information about sales and receivables can be combined to evaluate how efficient a company is in collecting its receivables.

Chapter 7: Receivables and Investments The Accounts Receivable Turnover Ratio Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

The Accounts Receivable Turnover Ratio Managers, investors, and creditors are keenly interested in how well a company manages its accounts receivable. One simple measure is to compare a company's sales to its accounts receivable. The result is the accounts receivable turnover ratio (A measure of the number of times accounts receivable are collected during the period.) :

Example 7-6

Computing the Accounts Receivable Turnover Ratio

Assume that a company has sales on credit of $10 million and an average accounts receivable of $1 million. This means it turns over its accounts receivable $10 million/$1 million, or ten times per year. If we assume 360 days in a year, that is once every 360/10, or 36 days. An observer would compare that figure with historical figures to see if the company is experiencing slower or faster collections. A comparison also could be made to other companies in the same industry. If receivables are turning over too slowly, the company's credit department may not be operating effectively; therefore, the company is missing opportunities with the cash that isn't available. On the other hand, a turnover rate that is too fast might mean that the company's credit policies are too stringent and that sales are being lost as a result.

Making Business Decisions

Apple

Analyzing the Accounts Receivable Rate of Collection

Managers, investors, and creditors must be able to assess how well a company manages its accounts receivable. Each dollar of sales on credit produces a dollar of

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accounts receivable. And the quicker each dollar of receivables can be collected, the sooner the money will be available for other purposes. Use the following models to help you in your role as a banker to decide whether to lend money to Apple Inc.

A.The Ratio Analysis Model

1. Formulate the Question

How many times a year does the company turn over its accounts receivable?

2. Gather the Information from the Financial Statements

To calculate a company's accounts receivable turnover ratio, it is essential to know its net credit sales and the average balance in accounts receivable:

Net credit sales: From the income statement

Average accounts receivable: From the balance sheet at the end of the two most recent years

3. Calculate the Ratio

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4. Compare the Ratio with Other Ratios

Ratios are of no use in a vacuum. It is necessary to compare them with prior years and with competitors.

Accounts Receivable Turnover Ratio

Apple Inc. Hewlett-Packard

Year Ended Year Ended Year Ended Year Ended

September 26, 2015

September 27, 2014

October 31, 2015

October 31, 2014

13.6 times 12.0 times 7.6 times 7.5 times

5. Interpret the Ratios

In fiscal year 2015, Apple Inc. turned over its accounts receivable an average of 13.6 times. This is faster than the turnover in the prior year, and the turnover for both years is quicker than the ratios for its competitor, Hewlett-Packard. An alternative way to look at a company's efficiency in managing its accounts receivable is to calculate the number of days, on average, that accounts receivables are outstanding. This measure is called number of days' sales in receivables (A measure of how long it takes to collect receivables.) and is calculated as follows for Apple Inc. in 2015, assuming 360 days in a year:

This measure tells us that it took Apple Inc. 26 days or less than a month on average to collect its accounts receivable.

B.The Business Decision Model

1. Formulate the Question

If you were a banker, would you loan money to Apple Inc.?

2. Gather Information from the Financial Statements and Other Sources

This information will come from a variety of sources, not limited to but including:

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The balance sheet provides information about liquidity, the income statement regarding profitability, and the statement of cash flows on inflows and outflows of cash.

The outlook for the computer industry, including consumer trends, foreign markets, labor issues, and other factors.

The outlook for the economy in general.

Alternative uses for the money.

3. Analyze the Information Gathered

Compare Apple Inc.'s accounts receivable turnover ratio in (A) above with Hewlett-Packard as well as with industry averages.

Look at trends over time in the accounts receivable turnover ratios.

Look at trends in net income over time as an indication of the ability to control expenses other than cost of goods sold.

Review projections for the economy and the industry.

4. Make the Decision

Taking into account all of the various sources of information, decide either to

Loan money to Apple Inc. or

Find an alternative use for the money

5. Monitor Your Decision

If you decide to make the loan, you will need to monitor it periodically. During the time the loan is outstanding, you will want to assess the company's continuing liquidity as well as other factors you considered before making the loan.

Module 1

Test Yourself

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Question

1. Why do accountants prefer the allowance method of accounting for bad debts?

2. When bad debts are estimated, why is the balance in the Allowance for Doubtful Accounts considered when the percentage of receivables approach is used, but not when the percentage of sales approach is used?

3. When computing the accounts receivable turnover ratio, why is the average of accounts receivable for the period used in the denominator of the ratio?

Apply

1. Badger recorded $500,000 of net sales for the year of which 2% is estimated to be uncollectible. Identify and analyze the adjustment required at the end of the year to record bad debts.

2. Brown Corp. ended the year with balances in Accounts Receivable of $60,000 and in Allowance for Doubtful Accounts of $800 (balance before adjustment). Net sales for the year amounted to $200,000. Identify and analyze the effect of the adjustment at the end of the year assuming the following:

a. Estimated percentage of net sales uncollectible is 1%.

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b. Estimated percentage of year-end accounts receivable uncollectible is 4%.

3. Hawkeye recorded sales of $240,000 for the year. Accounts receivable amounted to $40,000 at the beginning of the year and $20,000 at the end of the year. Compute the company's accounts receivable turnover for the year.

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LO 3 - Explain how to account for interest- bearing notes receivable.

Chapter 7: Receivables and Investments: Module 2 Accounting for Notes Receivable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 2 Accounting for Notes Receivable A promissory note (A written promise to repay a definite sum of money on demand or at a fixed or determinable date in the future.) is a written promise to repay a definite sum of money on demand or at a fixed or determinable date in the future. The party that agrees to repay money is the maker (The party that agrees to repay the money for a promissory note at some future date.) of the note, and the party that receives money in the future is the payee (The party that will receive the money from a promissory note at some future date.) . A company that holds a promissory note received from another company has an asset, called a note receivable (An asset resulting from the acceptance of a promissory note from another company.) . The company that makes or gives a promissory note to another company has a liability, a note payable (A liability resulting from the signing of a promissory note.) . Over the life of the note, the maker incurs interest expense on its note payable and the payee earns interest revenue on its note receivable. The following summarizes this relationship:

Party Recognizes on Balances Sheet

Recognizes on Income Statement

Maker Note payable Interest expense

Payee Note receivable Interest revenue

Promissory notes are used for a variety of purposes. Banks normally require a company to sign a promissory note to borrow money. Promissory notes are often used in the sale of consumer durables with relatively high purchase prices, such as appliances and

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automobiles. At times, a promissory note is issued to replace an existing overdue account receivable.

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Chapter 7: Receivables and Investments Important Terms Connected with Promissory Notes Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Important Terms Connected with Promissory Notes

It is important to understand the following terms when dealing with promissory notes:

Principal—the amount of cash received, or the fair value of the products or services received, by the maker when a promissory note is issued.

Maturity date—the date the promissory note is due.

Term—the length of time a note is outstanding, that is, the period of time between the date it is issued and the date it matures.

Maturity value—the amount of cash the maker is to pay the payee on the maturity date of the note.

Interest—the difference between the principal amount of the note and its maturity value.

Example 7-7

Accounting for a Note Receivable

Assume that on December 13, 2017, High Tec sells a computer to Baker Corp. at an invoice price of $15,000. Because Baker is short of cash, it gives High Tec a 90-day, 12% promissory note. The total amount of interest due on the maturity date is determined as follows:

The effect of the receipt of the note by High Tec can be identified and analyzed as follows:

If we assume that December 31 is the end of High Tec's accounting year, an adjustment is needed to recognize interest earned but not yet received. It is required

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when a company uses the accrual basis of accounting. How many days of interest have been earned during December? In computing interest, it is normal practice to count the day a note matures but not the day it is signed. Thus, in the example, interest would be earned for 18 days (December 14 to December 31) during 2017 and for 72 days in 2018:

The amount of interest earned during 2017 is $15,000 × 0.12 × 18/360, or $90. An adjustment is made on December 31 to record interest earned during 2017. The effect of the adjustment can be identified and analyzed as follows:

On March 13, 2018, High Tec collects the principal amount of the note and interest from Baker. The effect of the transaction can be identified and analyzed as follows:

This adjustment removes the amount of $15,000 originally recorded in the Notes Receivable account. It also increases Interest Revenue for the interest earned during the 72 days in 2018 that the note was outstanding. The calculation of interest earned during 2018 is as follows:

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The adjustment decreases Interest Receivable by $90 to remove this account from the records now that the note has been collected. Finally, it increases Cash by $15,450, which represents the principal amount of the note, $15,000, plus interest of $450 for 90 days.

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LO 4 - Explain various techniques that companies use to accelerate the inflow of cash from sales.

Chapter 7: Receivables and Investments Accelerating the Inflow of Cash from Sales Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Accelerating the Inflow of Cash from Sales Earlier in the chapter, we pointed out that credit sales slow down the inflow of cash to the company and create the potential for bad debts. To remain competitive, most businesses find it necessary to grant credit to customers. Companies have found it possible, however, to circumvent the problems inherent in credit sales.

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Credit Card Sales

Most retail establishments as well as many service businesses accept one or more major credit cards. Among the most common cards are MasterCard , VISA , and American Express . Most merchants find that they must honor at least one or more of these credit cards to remain competitive. In return for a fee, the merchant passes the responsibility for collection on to the credit card company. Thus, the credit card issuer assumes the risk of nonpayment. The basic relationships among the three parties—the customer, the merchant, and the credit company—are illustrated in Exhibit 7-2.

Exhibit 7-2

Basic Relationships Among Parties with Credit Card Sales

Example 7-8

Accounting for Credit Card Sales

Assume that Joe Smith buys an iPad in an Apple store and charges the $500 cost to his VISA card. When Joe is presented with the bill, he is asked to sign the

® ®

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salesperson's iPhone and then a copy of the receipt is emailed to Joe. The store uses the receipt as the basis for recording its sales of the day and sends a copy to VISA for payment. VISA uses the receipt it gets for two purposes: to reimburse Apple $475 (keeping $25, or 5% of the original sale, as a collection fee) and to include Joe Smith's $500 purchase on the monthly bill it mails him.

Assume that total credit card sales on June 5 amount to $8,000. The effect of the transaction can be identified and analyzed as follows:

Assume that Apple remits the credit card receipts to VISA once a week and that the total sales for the week ending June 11 amount to $50,000. Further assume that on June 13, VISA pays the amount due to Apple after deducting a 5% collection fee. The effect of the transaction can be identified and analyzed as follows:

Some credit cards, such as MasterCard and VISA, allow a merchant to present receipts directly for deposit in a bank account, in much the same way the merchant deposits checks, coins, and currency. Obviously, this type of arrangement is even more advantageous for the merchant because the funds are available as soon as the receipts are added to the bank account. Assume that on July 9, Apple presents VISA credit card receipts to its bank for payment in the amount of $20,000 and that the collection charge is 4%. The effect of the collection can be identified and analyzed as follows:

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Chapter 7: Receivables and Investments Discounting Notes Receivable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Discounting Notes Receivable

Promissory notes are negotiable, which means that they can be endorsed and given to someone else for collection. In other words, a company can sign the back of a note (just as it would a check), sell it to a bank, and receive cash before the note's maturity date. This process, called discounting (The process of selling a promissory note.) , is another way for companies to speed the collection of cash from receivables.

When a note is discounted at a bank, it is normally done “with recourse.” This means that if the original customer fails to pay the bank the total amount due on the maturity date of the note, the company that transferred the note to the bank is liable for the full amount. Because there is uncertainty as to whether the company will have to make good on any particular note that it discounts at the bank, a contingent liability exists from the time the note is discounted until its maturity date. The accounting profession has adopted guidelines to decide whether a particular uncertainty requires that the company record a contingent liability on its balance sheet. Under these guidelines, the contingency created by the discounting of a note with recourse is not recorded as a liability. However, a note in the financial statements is used to inform the reader of the existing uncertainty.

Module 2

Test Yourself

Question

1. What is the distinction between an account receivable and a note receivable?

2. Why does the discounting of a note receivable with recourse result in a contingent liability? Should the liability be reported on the balance sheet?

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Explain.

Apply

1. On November 1, 2017, Gopher received a $50,000, 6%, 90-day promissory note. Identify and analyze the adjustment required on December 31, the end of the company's fiscal year.

2. On July 20, Wolverine presents credit card receipts to its bank in the amount of $10,000; the collection charge is 4%. Identify and analyze the transaction on Wolverine's books on July 20, the date of deposit.

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LO 5 - Explain the accounting for and disclosure of various types of investments that companies make.

Chapter 7: Receivables and Investments: Module 3 Accounting for Investments Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 3 Accounting for Investments Some corporations have excess cash during certain times of the year and invest this idle cash in various highly liquid financial instruments such as certificates of deposit and money market funds. Chapter 6 pointed out that these investments are included with cash and are called cash equivalents when they have an original maturity to the investor of three months or less. Otherwise, they are accounted for as short-term investments.

Some companies invest in the stocks and bonds of other corporations as well as bonds issued by various government agencies. Securities issued by corporations as a form of ownership in the business, such as common stock and preferred stock, are called equity securities (Securities issued by corporations as a form of ownership in the business. Alternate term: Stocks.) . Because these securities are a form of ownership, they do not have a maturity date. As we will see later, investments in equity securities can be classified as either current or long term depending on the company's intent. Alternatively, securities issued by corporations and governmental bodies as a form of borrowing are called debt securities (Securities issued by corporations and governmental bodies as a form of borrowing. Alternate term: Bonds.) and often take the form of bonds. The term of a bond can be relatively short, such as five years, or much longer, such as 20 or 30 years. Regardless of the term, classification as a current or noncurrent asset by the investor depends on whether it plans to sell or redeem the debt securities within the next year.

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Chapter 7: Receivables and Investments Investments in Highly Liquid Financial Instruments Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Investments in Highly Liquid Financial Instruments

The seasonal nature of most businesses leads to a potential cash shortage during certain times of the year and an excess of cash during other times. Companies typically deal with cash shortages by borrowing on a short-term basis either from a bank in the form of notes or from other entities in the form of commercial paper. The maturities of the bank notes or the commercial paper generally range from 30 days to six months. These same companies use various financial instruments as a way to invest excess cash during other times of the year. The most common type of highly liquid financial instrument is a certificate of deposit (CD).

Example 7-9

Accounting for an Investment in a Certificate of Deposit

On October 2, 2017, Creston Corp. invests $100,000 of excess cash in a 120-day CD. The CD matures on January 30, 2018, at which time Creston receives the $100,000 and interest at an annual rate of 6%. The effect of the transaction to record the purchase of the CD can be identified and analyzed as follows:

December 31 is the end of Creston's fiscal year, so an adjustment is needed on this date to record interest earned during 2017 even though no cash will be received until the CD matures in 2018. The effect of the adjustment can be identified and analyzed as follows:

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The basic formula to compute interest is as follows:

Because interest rates are normally stated on an annual basis, time is interpreted to mean the fraction of a year that the investment is outstanding. The amount of interest is based on the principal or amount invested ($100,000) times the rate of interest (6%) times the fraction of a year the CD was outstanding in 2016

. To simplify interest calculations, it is easiest to assume 360 days in a year. With the availability of computers to do the work, however, most businesses now use 365 days in a year to calculate interest. Throughout this book, we assume 360 days in a year to allow us to focus on concepts rather than detailed calculations. Thus, in this example, the fraction of a year that the CD is outstanding during 2017 is 90/360.

The effect of the receipt of the principal amount of the CD of $100,000 and interest for 120 days can be identified and analyzed as follows:

This results in the removal of both the CD and the interest receivable from the records and recognizes $500 in interest earned during the first 30 days of 2018:

. Exhibit 7-3 below summarizes the calculation of interest in each of the two accounting periods.

Exhibit 7-3

Interest Calculation

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Chapter 7: Receivables and Investments Investments in Stocks and Bonds Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Investments in Stocks and Bonds

Corporations frequently invest in the debt securities (bonds) and equity securities of other businesses. The company that invests is the investor, and the company whose stocks or bonds are purchased is the investee.

No Significant Influence

In some cases, companies may invest excess funds in stocks and bonds over the short run. In other cases, stocks and bonds are purchased as a way to invest cash over the long run. Often, these types of investments are made in anticipation of a need for cash at some distant point in the future. For example, a company may invest today in a combination of stocks and bonds because it will need cash ten years from now to build a new plant. The investor may be interested primarily in periodic income in the form of interest and dividends, in appreciation in the value of the securities, or in some combination of the two.

Significant Influence

Sometimes a company buys a relatively large percentage of the common stock of the investee in order to secure significant influence over this company's policies. For example, a company might buy 30% of the common stock of a supplier of its raw materials to ensure a steady source of inventory. When an investor is able to secure influence over the investee, the equity method of accounting is used. According to current accounting standards, this method is appropriate when an investor owns at least 20% of the common stock of the investee.

Control

A corporation may buy stock in another company with the purpose of obtaining control over the other entity. Normally, this requires an investment in excess of 50% of the common stock of the investee. When an investor owns more than half the stock of another company, accountants normally prepare a set of consolidated financial statements. This involves combining the financial statements of the individual entities into a single set of statements. An investor with an interest of more than 50% in another company is called the parent, and the investee in these situations is called the subsidiary.

The following chart summarizes the accounting by an investor for investments in the common stock of another company:

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The remainder of this section will discuss how companies account for investments that do not give them significant influence over the other company.

Example 7-10

Accounting for an Investment in Bonds

On January 1, 2017, ABC issues $10,000,000 of bonds that will mature in ten years. Assume that Atlantic buys $100,000 of these bonds at face value, which is the amount that will be repaid to the investor when the bonds mature. In many instances, bonds are purchased at an amount more or less than face value. However, the discussion here will be limited to the simpler case in which bonds are purchased for face value. The bonds pay 10% interest semiannually on June 30 and December 31. Atlantic will receive 5% of $100,000, or $5,000, on each of those dates. The transaction on Atlantic's books to record the purchase can be identified and analyzed as follows:

On June 30, Atlantic must record the receipt of semiannual interest. The transaction on this date can be identified and analyzed as follows:

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Income was recognized when interest was received. If interest is not received at the end of an accounting period, a company should accrue interest earned but not yet received.

Before the maturity date, Atlantic needs cash and decides to sell the bonds. Any difference between the proceeds received from the sale of the bonds and the amount paid for the bonds is recognized as either a gain or a loss. On July 1, 2017, Atlantic sells all of its ABC bonds at 99. The amount of cash received is 0.99 × $100,000, or $99,000. The effect of the sale of the bonds can be identified and analyzed as follows:

The $1,000 loss on the sale of the bonds is the excess of the amount paid for the purchase of the bonds of $100,000 over the cash proceeds from the sale of $99,000. The loss is reported in the Other Income and Expenses section on the 2017 income statement.

Example 7-11

Accounting for an Investment in Stock

All investments in stock are recorded initially at cost, including any brokerage fees, commissions, or other fees paid to acquire the shares. On February 1, 2017, Dexter Corp. pays $50,000 for shares of Stuart common stock and another $1,000 in commissions. The effect of the purchase of the stock can be identified and analyzed as follows:

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Many companies attempt to pay dividends every year as a signal of overall financial strength and profitability. On March 31, 2017, Dexter received dividends of $500 from Stuart. The dividends received are recognized as income in a transaction that can be identified and analyzed as follows:

Unlike interest on a bond or note, dividends do not accrue over time. In fact, a company has no legal obligation to pay dividends until its board of directors declares them. Up to that point, the investor has no guarantee that dividends will ever be paid.

Dexter sells the Stuart stock on May 20, 2017, for $53,000. In this case, Dexter recognizes a gain for the excess of the cash proceeds, $53,000, over the amount recorded on the books, $51,000. The effect of the sale of the stock can be identified and analyzed as follows:

The gain is classified on the income statement as other income.

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Chapter 7: Receivables and Investments Valuing and Reporting Investments on the Financial Statements Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Valuing and Reporting Investments on the Financial Statements

Investments in other companies' bonds and stocks are reported on a company's balance sheet as assets. Whether the investments are reported as current assets or noncurrent assets depends on the company's intent. If the company intends to sell the investments within the next year, they are normally classified as current assets. All other investments are classified on the balance sheet as noncurrent.

In addition to the question of where investments are reported at the end of the period, another issue is their valuation. For example, you know that accounts receivable are reported at net realizable value. How should an investment in the bonds or stock of another company be reported on a year-end balance sheet? Investments are generally reported on the balance sheet at their fair value. However, the question still remains as to when any gains or losses from recognizing the changes in the fair value of investments should be recorded on the income statement. The accounting rules in this area are somewhat complex and thus are usually covered in advanced accounting courses.

Module 3

Test Yourself

Question

1. On December 31, Stockton Inc. invests idle cash in two different certificates of deposit. The first is an 8%, 90-day CD, and the second has an interest rate of 9% and matures in 120 days. How is each of these CDs classified on the December 31 balance sheet?

2. Stanzel Corp. purchased 1,000 shares of Canby Company common stock. What will determine whether the shares are classified as current assets or noncurrent assets?

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Apply

1. Indicate whether each of the following events will result in an increase (I), will result in a decrease (D), or will have no effect (NE) on net income for the period.

a. Stock held as an investment is sold for more than its carrying value.

b. Interest is recognized on bonds held as an investment.

c. Stock held as an investment is sold for less than its carrying value.

d. Bonds held as an investment are redeemed on their maturity date at face value.

e. Stock is purchased and a commission is paid to a broker.

2. On March 5, Spartan sold stock in another company for $12,300. Spartan bought the stock on February 14 for $10,100. Identify and analyze the transaction on Spartan's books on March 5.

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LO 6 - Explain the effects of transactions involving liquid assets on the statement of cash flows.

Chapter 7: Receivables and Investments: Module 4 How Liquid Assets Affect the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 4 How Liquid Assets Affect the Statement of Cash Flows As was discussed in Chapter 6, cash equivalents are combined with cash on the balance sheet. These items are very near maturity and do not present any significant risk of collectibility. Because of this, any purchases or redemptions of cash equivalents are not considered significant activities to be reported on a statement of cash flows.

The purchase and sale of investments are considered significant activities and therefore are reported on the statement of cash flows. Cash flows from purchases, sales, and maturities of investments are usually classified as investing activities. The following excerpt from Apple's 2015 statement of cash flows in its Form 10-K illustrates the reporting for these activities (all amounts in millions of dollars):

The collection of accounts receivable and notes receivable generates cash for a business and affects the Operating Activities section of the statement of cash flows. Most companies use the indirect method of reporting cash flows and begin the statement of cash flows with the net income of the period. Net income includes the sales revenue for the period. Therefore, a decrease in accounts receivable or notes receivable during the period indicates that the company collected more cash than it recorded in sales revenue. Thus, a decrease in accounts receivable or notes receivable must be added back to net income because more cash was collected than is reflected in the sales revenue number.

Alternatively, an increase in accounts receivable or notes receivable indicates that the company recorded more sales revenue than cash collected during the period. Therefore, an increase in accounts receivable or notes receivable requires a deduction from the net income of the period to arrive at cash flow from operating activities. The following excerpt from Apple's 2015 statement of cash flows in its Form 10-K illustrates how it reports the

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change in accounts receivable on its statement of cash flows (all amounts in millions of dollars). A decrease in accounts receivable in the most recent year is added back to net income:

These adjustments as well as the cash flows from buying and selling investments are summarized in Exhibit 7-4.

Exhibit 7-4

How Investments and Receivables Affect the Statement of Cash Flows

Module 4

Test Yourself

Question

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1. How are purchases of investments classified and reported on the statement of cash flows?

2. In what section of the statement of cash flows are changes in accounts receivable reported when the indirect method is used to prepare the statement?

Apply

Wildcat started the year with $25,000 in accounts receivable and ended the year with $40,000 in the account. Describe how information regarding the company's accounts receivable should be reflected on its statement of cash flows, assuming the use of the indirect method.

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LO 6 - Explain the effects of transactions involving liquid assets on the statement of cash flows.

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change in accounts receivable on its statement of cash flows (all amounts in millions of dollars). A decrease in accounts receivable in the most recent year is added back to net income:

These adjustments as well as the cash flows from buying and selling investments are summarized in Exhibit 7-4.

Exhibit 7-4

How Investments and Receivables Affect the Statement of Cash Flows

Module 4

Test Yourself

Question

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1. How are purchases of investments classified and reported on the statement of cash flows?

2. In what section of the statement of cash flows are changes in accounts receivable reported when the indirect method is used to prepare the statement?

Apply

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Chapter Review

Ratio Review

*Average accounts receivable can be estimated using the following calculation:

**Usually assume 360 days unless some other number is a better estimate of the number of days in the period.

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Chapter Review

Accounts Highlighted

Account Titles Where It Appears

In What Section Page Number

Accounts Receivable Balance Sheet Current Assets The Use of a Subsidiary Ledger

Allowance for Doubtful Accounts

Balance Sheet Current Assets Example 7-2

Bad Debts Expense Income Statement

Operating Expenses

Example 7-2

Notes Receivable Balance Sheet Current or Noncurrent Assets

Example 7-7

Interest Receivable Balance Sheet Current Assets Example 7-7

Interest Revenue Income Statement

Other Income Example 7-7

Short-Term Investments Balance Sheet Current Assets Example 7-9

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Chapter Contents Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter 8 Operating Assets: Property, Plant, and Equipment, and Intangibles

Chapter Introduction

Module 1 Acquisition of Operating Assets

Acquisition of Property, Plant, and Equipment

Module 2 Depreciation and Disposal of Operating Assets

Capital versus Revenue Expenditures Environmental Aspects of Operating Assets

Disposal of Property, Plant, and Equipment IFRS and Property, Plant, and Equipment

Module 3 Intangible Assets Balance Sheet Presentation

Acquisition Cost of Intangible Assets

Amortization of Intangibles

IFRS and Intangible Assets

Module 4 Cash Flow and Analysis Issues

Analyzing Long-Term Assets for Average Life and Asset Turnover

Chapter Review Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Multi-Concept Exercises

Problems

Multi-Concept Problems

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Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

Integrative Problem

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Chapter Introduction Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Introduction

A three-column diagram contains the headings Modules; Learning Objectives; and Why Is This Chapter Important? For Module 1: Acquisition of Operating Assets, the learning objectives are LO1 Understand balance sheet disclosures for operating assets; and LO2 Determine the acquisition cost of an operating asset; LO3 Explain how to calculate the acquisition cost of assets purchased for a lump sum; and LO4 Describe the impact of capitalizing interest as part of the acquisition cost of an asset. The third column contains one bullet point: •You need to know how operating assets appear on the balance sheet and how a company accounts for the acquisition of assets. (See pp. 370–371.) For Module 2: Depreciation and Disposal of Operating Assets, the learning objectives are LO5 Compare depreciation methods and understand the factors affecting the choice of method; LO6 Understand the impact of a change in the estimate of the asset life or residual value; LO7 Determine which expenditures should be capitalized as asset costs and which should be treated as expenses; and LO8 Analyze the effect of the disposal of an asset at a gain or loss. The third column in this row contains two bullet points: •You need to know how a company can record depreciation of operating assets and the factors that affect the choice of depreciation method. (See pp. 373–375.) •You need to know how a company accounts for repairs of the asset and how to analyze the effect of disposal of an asset at a gain or loss. (See pp. 380–382.) For Module 3: Intangible Assets, the learning objectives are LO9 Understand the balance sheet presentation of intangible assets; and LO10 Understand the proper amortization of intangible assets. The third column in this row contains one bullet point: •You need to understand the importance of intangible assets on the balance sheet. (See pp. 384–385.) For Module 4: Cash Flow and Analysis Issues, the learning objectives are LO11 Explain the impact that long-term assets have on the statement of cash flows; and LO12 Understand how investors can analyze a company's operating assets. The third column in this row contains one bullet point: •You need to know what impact operating assets can have on the cash flows of the company and how investors can analyze a company's operating assets. (See pp. 388– 389.)

Making Business Decisions

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A Nike shoe introduces Nike as the largest seller of athletic footwear, apparel, equipment, and accessories in the world. A partial consolidated balance sheet for Nike is also presented to help in understanding the company's reporting for its large investment in property, plant, and equipment, and intangible assets (identifiable intangible assets and goodwill). Positioned under current assets in the balance sheet, these accounts are highlighted in grey on Nike's balance sheet and each lists a corresponding financial footnote in parentheses, where further explanation can be found on these non-current assets.

Nike

Nike is the largest seller of athletic footwear, apparel, equipment, and accessories in the world. Reaching this position of dominance requires a large investment in property, plant, and equipment. At May 31, 2015, the company's balance sheet indicates more than $3.0 billion of property, plant, and equipment. The company's decisions to continually invest in new plant and equipment are vital to its future. Investors and others who read Nike's financial statements must analyze its tangible assets to gauge its ability to generate future profits.

But Nike's intangible assets are equally important. The Nike brand name and company logo are some of the most recognizable in the world. In fact, Nike believes its NIKE and Swoosh Design trademarks are among its most valuable assets and has registered them in over 100 countries. In addition, the company owns many other trademarks, including the Converse , Chuck Taylor , All Star , and One Star lines of athletic footwear. Nike also has valuable licenses and patents on its revolutionary footwear production method known as “Air” technology. A portion of Nike's growth has come from acquiring other sports-related companies. A large portion of the purchase in such Nike acquisitions represents the intangible asset of goodwill. These acquisitions have strengthened Nike's already dominant position in the athletic footwear, apparel, and equipment industry.

Accountants have had to consider carefully the accounting for all long-lived assets, but especially for intangible assets. Investors must be able to read Nike's financial statements and understand how these assets influence the value of the company. The stock price should accurately reflect the value of those assets and the company's ability to use the assets wisely.

® ® ® ®

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The accompanying partial balance sheet presents Nike's property, plant, and equipment and its intangible assets.

Nike

Source: Nike, Inc., Form 10-k for fiscal year ended May 31, 2015.

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LO 2 - Determine the acquisition cost of an operating asset.

LO 3 - Explain how to calculate the acquisition cost of assets purchased for a lump sum.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Acquisition of Property, Plant, and Equipment Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Acquisition of Property, Plant, and Equipment Assets classified as property, plant, and equipment are initially recorded at acquisition cost (also referred to as historical cost or original cost). Acquisition cost (The amount that includes all of the cost normally necessary to acquire an asset and prepare it for its intended use. Alternate term: Historical cost and original cost.) should include all of the costs that are normal and necessary to acquire the asset and prepare it for its intended use, such as

Purchase price

Taxes paid at time of purchase (for example, sales tax)

Transportation charges

Installation costs

An accountant must exercise careful judgment to determine which costs are “normal” and “necessary.” Acquisition cost should not include expenditures unrelated to the acquisition (e.g., repair costs if an asset is damaged during installation) or costs incurred after the asset was installed and use begun.

Group Purchase Quite often, a firm purchases several assets as a group and pays a lump-sum amount. This is most common when a company purchases land and a building situated on it and pays a lump-sum amount for both. It is important to measure the acquisition cost of the land and the building separately, because land is not a depreciable asset. The purchase price should be allocated between land and building on the basis of the proportion of the fair market value of each.

Example 8-1

Determining Cost When a Group of Assets Is Purchased

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LO 4 - Describe the impact of capitalizing interest as part of the acquisition cost of an asset.

Assume that on January 1, ExerCo purchased a building and the land on which it is situated for $100,000. The accountant established the assets' fair market value on January 1 as follows:

Based on the estimated market values, the purchase price should be allocated as follows:

To land

To building

The effect of the transaction can be identified and analyzed as follows:

Market value is best established by an independent appraisal of the property. If such appraisal is not possible, the accountant must rely on the market value of other similar assets, on the value of the assets in tax records, or on other available evidence.

Capitalization of Interest Generally, the interest on borrowed money should be treated as an expense of the period. If a company buys an asset and borrows money to finance the purchase, the interest on the borrowed money is not considered part of the asset's cost. Financial statements generally treat investing and financing as separate decisions. Purchase of an asset, an investing activity, is treated as a business decision that is separate from the decision concerning the financing of the asset. Therefore, interest is treated as a period cost and should appear on the income statement as interest expense in the period incurred.

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Study Tip

Land improvements represent a depreciable asset with a limited life. Land itself is not depreciable.

There is one exception to this general guideline, however. If a company constructs an asset over a period of time and borrows money to finance the construction, the interest incurred during the construction period is not treated as interest expense. Instead, the interest must be included as part of the acquisition cost of the asset. This is referred to as capitalization of interest (Interest on constructed assets is added to the asset account.) . The amount of interest that is capitalized (treated as an asset) is based on the average accumulated expenditures. The average accumulated expenditure is used because this number represents an average amount of money tied up in the project over a year. If it takes $400,000 to construct a building, the interest should not be figured on the full $400,000 because there were times during the year when less than the full amount was being used.

When the cost of building an asset is $400,000 and the amount of interest to be capitalized is $10,000, the acquisition cost of the asset is $410,000. The asset should appear on the balance sheet at that amount. Depreciation of the asset should be based on $410,000 less any residual value.

Land Improvements The acquisition cost of land should be kept in a separate account because land has an unlimited life and is not subject to depreciation. Other costs associated with land should be recorded in an account such as Land Improvements. For example, the costs of paving a parking lot are properly treated as land improvements (Costs that are related to land but that have a limited life.) , which have a limited life. Some landscaping costs also have a limited life. Therefore, the acquisition costs of land improvements should be depreciated over their useful lives.

Module 1

Test Yourself

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Question

1. What are several examples of operating assets? Why are operating assets essential to a company's long-term future?

2. What is the meaning of the term acquisition cost of operating assets? Give some examples of costs that should be included in the acquisition cost.

3. When assets are purchased as a group, how should the acquisition cost of the individual assets be determined?

4. Under what circumstances should interest be capitalized as part of the cost of an asset?

Apply

1. Which of the following would be in the Property, Plant, and Equipment balance sheet category?

Land

Buildings

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Accumulated depreciation

Patent

Leasehold improvements

Construction in process

2. Which of the following would be considered part of the acquisition cost of an asset?

Transportation costs

Installation costs

Repair costs incurred at time of purchase

Repair costs incurred after the asset has been installed and used

Interest on loan to purchase the asset

3. Company X bought from Company Y land and an accompanying warehouse for $800,000. The fair market values of the land and the building at the time of purchase were $700,000 and $300,000, respectively. How much of the purchase price should Company X allocate to land? How much to the building?

4. A company begins construction of an asset on January 1, 2016, and completes construction on December 31, 2016. The company pays the following amounts related to construction:

$1,000,000 January 1

$2,000,000 July 1

$1,000,000 December 1

Calculate the average accumulated expenditures for the purpose of capitalizing interest.

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LO 5 - Compare depreciation methods and understand the factors affecting the choice of method.

Study Tip

Read this. This paragraph is important for students in understanding what depreciation is and isn't.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles: Module 2 Depreciation and Disposal of Operating Assets Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 2 Depreciation and Disposal of Operating Assets All property, plant, and equipment, except land, have a limited life and decline in usefulness over time. The accrual accounting process requires a proper matching of expenses and revenue to measure income accurately. Therefore, the accountant must estimate the decline in usefulness of operating assets and allocate the acquisition cost in a manner consistent with the decline in usefulness. This allocation is the process generally referred to as depreciation (The allocation of the original cost of an asset to the periods benefited by its use.) .

An asset's decline in usefulness is related to:

Physical deterioration from usage or from the passage of time

Obsolescence factors such as changes in technology

The company's repair and maintenance policies

Because the decline in an asset's usefulness is related to a variety of factors, several depreciation methods have been developed. A company should use a depreciation method that allocates the original cost of the asset to the periods benefited and that allows the company to accurately match the expense to the revenue generated by the asset. We will present three methods of depreciation: straight line, units of production, and double declining balance.

All depreciation methods are based on the asset's original acquisition cost. In addition, all methods require an estimate of two additional factors: the asset's life and its residual value. The residual value (also referred to as salvage value) should represent the amount that could be obtained from selling or disposing of the asset at the end of its useful life. Often, this amount may be small or even zero.

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Connect to the Real World 8-1

Nike: Reading the Balance Sheet

What amount did Nike present for operating assets for 2015? Why did the company not show depreciation on the balance sheet?

Straight-Line Method The straight-line method (A method by which the same dollar amount of depreciation is recorded in each year of asset use.) of depreciation allocates the cost of the asset evenly over time. This method calculates the annual depreciation as follows:

Example 8-2

Computing Depreciation Using the Straight-Line Method

Assume that on January 1, 2017, ExerCo, a manufacturer of exercise equipment, purchased a machine for $20,000. The machine's estimated life would be five years, and its residual value at the end of 2020 would be $2,000. The annual depreciation should be calculated as follows:

An asset's book value (The original cost of an asset minus the amount of accumulated depreciation.) is defined as its acquisition cost minus its total amount of accumulated depreciation. Thus, the book value of the machine in this example is $16,400 at the end of 2016.

The book value at the end of 2017 is $12,800.

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The most attractive feature of the straight-line method is its simplicity. It is the most popular method for presenting depreciation in the annual report to stockholders.

Units-of-Production Method In some cases, the decline in an asset's usefulness is directly related to wear and tear as a result of the number of units it produces. In those cases, depreciation should be calculated by the units-of-production method (Depreciation is determined as a function of the number of units the asset produces.) . With this method, the asset's life is expressed in terms of the number of units that the asset can produce. The depreciation per unit can be calculated as follows:

The annual depreciation for a given year can be calculated based on the number of units produced during that year, as follows:

Example 8-3

Computing Depreciation Using the Units-of-Production Method

Assume that ExerCo in Example 8-2 wanted to use the units-of-production method for 2017. ExerCo has estimated that the total number of units that will be produced during the asset's five-year life is 18,000. During 2017, ExerCo produced 4,000 units. The depreciation per unit for ExerCo's machine can be calculated as follows:

The amount of depreciation that should be recorded as an expense for 2017 is $4,000.

In Example 8-2, depreciation will be recorded until the asset produces 18,000 units. The machine cannot be depreciated below its residual value of $2,000.

The units-of-production method is most appropriate when the accountant is able to estimate the total number of units that will be produced over the asset's life. For example, if a factory machine is used to produce a particular item, the life of the asset may be expressed in

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terms of the number of units produced. Further, the units produced must be related to particular time periods so that depreciation expense can be matched accurately with the related revenue. A variation of the units-of-production method can be used when the life of the asset is expensed in other factors, such as miles driven or hours of use.

Accelerated Depreciation Methods In some cases, more cost should be allocated to the early years of an asset's use and less to the later years. For those assets, an accelerated depreciation method is appropriate. The term accelerated depreciation (A higher amount of depreciation is recorded in the early years and a lower amount in the later years.) refers to several depreciation methods by which a higher amount of depreciation is recorded in the early years than in later years.

One form of accelerated depreciation is the double-declining-balance method (Depreciation is recorded at twice the straight-line rate, but the balance is reduced each period.) . Under this method, depreciation is calculated at double the straight-line rate but on a declining amount.

Example 8-4

Computing Depreciation Using the Double-Declining-Balance Method

Assume that ExerCo wants to depreciate its asset using the double-declining- balance method. The first step is to calculate the straight-line rate as a percentage. The straight-line rate for the ExerCo asset with a five-year life is as follows:

The second step is to double the straight-line rate, as follows:

This rate will be applied in all years to the asset's book value at the beginning of each year. As depreciation is recorded, the book value declines. Thus, a constant rate is applied to a declining amount. This constant rate is applied to the full cost or initial book value, not to cost minus residual value as in the other methods. However, the machine cannot be depreciated below its residual value.

The amount of depreciation for 2017 would be calculated as follows:

The amount of depreciation for 2018 would be calculated as follows:

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Study Tip

Residual value is deducted for all depreciation methods except for the declining-balance methods.

The complete depreciation schedule for ExerCo for all five years of the machine's life would be as follows:

The depreciation for 2021 cannot be calculated as $2,592 × 40% because this would result in an accumulated depreciation amount of more than $18,000. The total amount of depreciation recorded in Years 1 through 4 is $17,408. The accountant should record only $592 depreciation ($18,000 − $17,408) in 2021 so that the remaining value of the machine is $2,000 at the end of 2021.

The double-declining-balance method of depreciation is most appropriate for assets subject to a rapid decline in usefulness as a result of technical or obsolescence factors. Double- declining-balance depreciation is not widely used for financial statement purposes but may be appropriate for certain assets. As discussed earlier, most companies use straight-line depreciation for financial statement purposes because it generally produces the highest net income, especially in growing companies that have a stable or expanding base of assets.

Comparison of Depreciation Methods Exhibit 8-1 presents a comparison of the depreciation and book values of the ExerCo asset for 2017–2021 using the straight-line and double- declining-balance methods. (We have excluded the units-of-production method.) Note that both methods result in a depreciation total of $18,000 over the five-year period. The amount of depreciation per year depends, however, on the method of depreciation chosen.

Exhibit 8-1

Comparison of Depreciation and Book Values of Straight-Line and Double- Declining-Balance Methods

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Nonaccountants often misunderstand the accountant's concept of depreciation. Accountants do not consider depreciation to be a process of valuing the asset. That is, depreciation does not describe the increase or decrease in the market value of the asset. Accountants consider depreciation to be a process of cost allocation. The purpose is to allocate the original acquisition cost to the periods benefited by the asset. The depreciation method chosen should be based on the decline in the asset's usefulness. A company can choose a different depreciation method for each individual fixed asset or for each class or category of fixed assets.

Depreciation and Income Taxes Depreciation is deducted for income tax purposes. Sometimes depreciation is referred to as a tax shield because it reduces (as do other expenses) the amount of income tax that would otherwise have to be paid. When depreciating an asset for tax purposes, a company should generally choose a depreciation method that reduces the present value of its tax burden to the lowest possible amount over the life of the asset. Normally, this is best accomplished with an accelerated depreciation method, which allows a company to save more income tax in the early years of the asset. This happens because the higher depreciation charges reduce taxable income more than the straight-line method does. The method allowed for tax purposes is referred to as the Modified Accelerated Cost Recovery System (MACRS). As a form of accelerated depreciation, it results in a larger amount of depreciation in the asset's early years and a smaller amount in later years.

Choice of Depreciation Method The choice of depreciation method can have a significant impact on the bottom line. If two companies are essentially identical in every other respect, a different depreciation method for fixed assets can make one company look more profitable than the other. Or a company that uses accelerated depreciation for one year can find that its otherwise declining earnings are no longer declining if it switches to straight-line depreciation. Investors should pay some attention to depreciation methods when comparing companies. Exhibit 8-2 presents the factors that affect the choice of depreciation method. Usually, the most important factor is whether depreciation is calculated for presentation on the financial statements to stockholders or whether it is calculated for income tax purposes.

Exhibit 8-2

Management's Choice of Depreciation Method

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LO 6 - Understand the impact of a change in the estimate of the asset life or residual value.

When depreciation is calculated for financial statement purposes, a company generally wants to present the most favorable impression (the highest income) possible. More than 90% of large companies use the straight-line method for financial statement purposes.

If management's objective is to minimize the company's income tax liability, the company will generally not choose the straight-line method for tax purposes. As discussed in the preceding section, accelerated depreciation allows the company to save more on income taxes because depreciation is a tax shield.

It is not unusual for a company to use two depreciation methods for the same asset, one for financial reporting purposes and another for tax purposes. This may seem somewhat confusing, but it is the direct result of the differing goals of financial and tax accounting.

Change in Depreciation Estimate An asset's acquisition cost is known at the time it is purchased, but its life and residual value must be estimated. These estimates are then used as the basis for depreciating it. Occasionally, an estimate of the asset's life or residual value must be altered after the depreciation process has begun. This type of accounting change is referred to as a change in estimate (A change in the life of the asset or in its residual value.) .

A change in estimate should be recorded prospectively, meaning that the depreciation recorded in prior years is not corrected or restated. Instead, the new estimate should affect the current year and future years.

Example 8-5

Calculating a Change in Depreciation Estimate

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ExerCo purchased a machine on January 1, 2017, for $20,000. ExerCo estimated that the machine's life would be five years and its residual value at the end of five years would be $2,000. ExerCo has depreciated the machine using the straight-line method for two years. At the beginning of 2019, ExerCo believes that the total machine life will be seven years, or another five years beyond the two years the machine has been used. Thus, depreciation must be adjusted to reflect the new estimate of the asset's life.

ExerCo should depreciate the remaining depreciable amount during 2019 through 2023. The amount to be depreciated over that time period should be calculated as follows:

The remaining depreciable amount should be recorded as depreciation over the remaining life of the machine. The depreciation amount for 2019 and the following four years would be $2,160:

In Example 8-5, the effect of the transaction can be identified and analyzed as follows:

If the change in estimate is a material amount, the company should disclose in the footnotes to the 2019 financial statements that depreciation has changed as a result of a change in estimate. The company's auditors have to be very careful that management's decision to change its estimate of the depreciable life of the asset is not an attempt to manipulate

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earnings. Particularly in capital-intensive manufacturing concerns, lengthening the useful life of equipment can have a material impact on earnings.

A change in estimate of an asset's residual value is treated in a manner that is similar to a change in an asset's life. There should be no attempt to correct or restate the income statements of past periods that were based on the original estimate. Instead, the accountant should use the new estimate of residual value to calculate depreciation for the current and future years.

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LO 7 - Determine which expenditures should be capitalized as asset costs and which should be treated as expenses.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Capital versus Revenue Expenditures Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Capital versus Revenue Expenditures Accountants often must decide whether certain expenditures related to operating assets should be treated as an addition to the cost of the asset or as an expense. One of the most common examples involving this decision concerns repairs to an asset. Should the repairs constitute capital expenditures or revenue expenditures?

A capital expenditure (A cost that improves the asset and is added to the asset account. Alternate term: Item treated as asset.) is a cost that is added to the acquisition cost of an asset.

A revenue expenditure (A cost that keeps an asset in its normal operating condition and is treated as an expense. Alternate term: Item treated as an expense of the period.) is not treated as part of the cost of the asset, but as an expense on the income statement.

Thus, the company must decide whether to treat an item as an asset (balance sheet) and depreciate its cost over its life or to treat it as an expense (income statement) of a single period.

The distinction between capital and revenue expenditures is a matter of judgment. Generally, the following guidelines should be followed:

When an expenditure increases the life of the asset or its productivity, it should be treated as a capital expenditure and added to the asset account.

When an expenditure simply maintains an asset in its normal operating condition, however, it should be treated as an expense.

The materiality of the expenditure must also be considered. Most companies establish a policy of treating an expenditure that is smaller than a specified amount as a revenue expenditure (an expense on the income statement).

A company must not improperly capitalize a material expenditure that should have been written off right away. Analysts trying to assess the value of a company closely monitor its capitalization policies. When a company is capitalizing rather than expensing certain items to artificially boost earnings, that revelation can be very damaging to the stock price.

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Expenditures related to operating assets may be classified in several categories. For each type of expenditure, its treatment as capital or revenue should be as follows:

Category Example Asset or Expense

Normal maintenance Repaint Expense

Minor repair Replace spark plugs Expense

Major repair Replace a vehicle's engine

Asset if life or productivity is enhanced

Addition Add a wing to a building

Asset

An item treated as a capital expenditure affects the amount of depreciation that should be recorded over the asset's remaining life. We will use an example involving ExerCo to illustrate. Assume again that ExerCo purchased a machine on January 1, 2016, for $20,000. ExerCo estimated that its residual value at the end of five years would be $2,000 and has depreciated the machine $3,600 per year for 2016 and 2017, using the straight-line method.

Example 8-6

Capitalizing Costs of a Major Repair

At the beginning of 2019, ExerCo made a $3,000 overhaul to the machine, extending its life by three years. Because the expenditure qualifies as a capital expenditure, the cost of overhauling the machine should be added to the asset account.

Beginning in 2019, the company should record depreciation of $2,300 per year, computed as follows:

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The effect of the transaction for the overhaul in Example 8-6 is as follows:

The effect of the transaction to record depreciation for 2019 can be identified and analyzed as follows:

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Environmental Aspects of Operating Assets Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Environmental Aspects of Operating Assets

As the government's environmental regulations have increased, businesses have been required to expend more money complying with them. A common example involves costs to comply with federal requirements to clean up contaminated soil surrounding plant facilities. In some cases, the costs are high and may exceed the value of the property. Should such costs be considered an expense and recorded entirely in one accounting period, or should they be treated as a capital expenditure and added to the cost of the asset? If there is a legal obligation to clean up the property or restore it to its original condition, companies are required to record the cost of asset retirement obligations as part of the asset's cost. For example, if a company owns a factory and has made a binding promise to restore to its original condition the property used by the factory, the costs of restoring the property must be added to the asset account. Of course, it is sometimes difficult to determine whether a legal obligation exists. However, companies should at least conduct a thorough investigation to determine the potential environmental considerations that may affect the value of operating assets and to ponder carefully the accounting implications of new environmental regulations.

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LO 8 - Analyze the effect of the disposal of an asset at a gain or loss.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Disposal of Property, Plant, and Equipment Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Disposal of Property, Plant, and Equipment An asset may be disposed of in several different ways. One common method is to sell the asset for cash. Sale of an asset involves two important considerations. First, depreciation must be recorded up to the date of sale. If the sale does not occur at the fiscal year-end, usually December 31, depreciation must be recorded for a partial period from the beginning of the year to the date of sale. Second, the gain or loss on the sale must be calculated and recorded.

Gain on Sale of Assets Assume that ExerCo purchased a machine on January 1, 2017, for $20,000, estimating its life to be five years and the residual value to be $2,000. ExerCo used the straight-line method of depreciation. ExerCo sold the machine on July 1, 2019. Depreciation for the six-month period from January 1 to July 1, 2019, is $1,800

. The effect of the transaction can be identified and analyzed follows:

Example 8-7

Calculating the Gain on Sale of an Asset

ExerCo sold the asset on July 1, 2019, for $12,400. The gain can be calculated as follows:

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After the July 1 entry, the balance of the Accumulated Depreciation—Machine account is $9,000, which reflects depreciation for the 2½ years from the date of purchase to the date of sale. The effect of the transaction for the sale can be identified and analyzed as follows:

When an asset is sold, all accounts related to it must be removed. In the preceding entry, the Machine account is reduced (credited) to eliminate the account and the Accumulated Depreciation—Machine account is reduced (debited) to eliminate it. The Gain on Sale of Asset (The excess of the selling price over the asset's book value.) indicates the amount by which the sales price of the machine exceeds the book value. The Gain on Sale of Asset account is an income statement account. Therefore, it should appear in the Other Income/Expense category of the statement because it does not result from the company's ongoing or central activity.

Loss on Sale of Assets The calculation of a loss on the sale of an asset is similar to that of a gain. Depreciation must be recorded to the date of sale, July1.

The effect of the transaction for the sale can be identified and analyzed as follows:

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Example 8-8

Calculating the Loss on Sale of an Asset

Assume that ExerCo sold the asset on July 1, 2019, for $10,000. The loss could be calculated as follows:

The Loss on Sale of Asset (The amount by which selling price is less than book value.) indicates the amount by which the asset's sales price is less than its book value. The Loss on Sale of Asset account is an income statement account and should appear in the Other Income/Expense category of the income statement.

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles IFRS and Property, Plant, and Equipment Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

IFRS and Property, Plant, and Equipment

Generally, the Financial Accounting Standards Board's (FASB) standards concerning property, plant, and equipment are similar to the international accounting standards, and conversion to those standards should not impose great difficulties for U.S. companies. There are important differences, however. First, when depreciation is calculated, the international standards require that estimates of residual value and the life of the asset be reviewed at least annually and revised if necessary. If the estimate is revised, it should be treated as a change in estimate as we have described in this chapter. The FASB standards do not have a specific rule that requires residual value and asset life to be reviewed annually, so this is an instance where the international standards are more explicit than U.S. standards. The international standards also indicate that companies should determine the components of an asset and depreciate each component separately. For example, if a company buys a building, some parts of the building may be depreciated using one estimate of useful life and other parts may use a different estimate of useful life.

Another difference involves the valuation of property, plant, and equipment. The FASB generally requires operating assets to be recorded at acquisition cost, less depreciation, and the assets' values are not changed to reflect their fair market values, or selling prices. International accounting standards allow but do not require companies to revalue their property, plant, and equipment to reflect fair market values. This gives firms additional flexibility in portraying their assets, but may also cause difficulties in comparing one company with another.

Module 2

Test Yourself

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Question

1. What factors should influence the choice of depreciation method? Must a company choose just one method of depreciation for all assets?

2. Why do many companies use one method to calculate depreciation for the income statement developed for stockholders and another method for income tax purposes?

3. What should a company do if it finds that the original estimate of the life of an asset or the residual value of the asset must be changed?

4. How is the gain or loss on the sale of an operating asset calculated? Where would the Gain on Sale of Asset account appear on the financial statements?

Apply

1. A company uses the double-declining-balance method of depreciation. The company purchases an asset for $40,000, which is expected to have a ten- year life and a $4,000 residual value.

a. What depreciation rate will be applied each year?

b. What amount will be charged for depreciation in the first and second years?

c. What amount will be treated as depreciation over the ten-year life?

2. A company purchased an asset on January 1, 2015, for $10,000. The asset was expected to have a ten- year life and a $1,000 salvage value. The company uses the straight-line method of depreciation. On January 1, 2017, the company determines that the asset will last only five more years.

Calculate the amount of depreciation for 2017.

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3. A company purchased an asset on January 1, 2015, for $10,000. The asset was expected to have a ten-year life and a $1,000 salvage value. The company uses the straight-line method of depreciation. On January 1, 2017, the company made a major repair to the asset of $5,000, extending its life. The asset is expected to last ten years from January 1, 2017.

Calculate the amount of depreciation for 2016.

4. A machine with a cost of $100,000 and accumulated depreciation of $80,000 was sold at a loss of $6,000. What amount of cash was received from the sale?

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LO 9 - Understand the balance sheet presentation of intangible assets.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles: Module 3 Intangible Assets Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 3 Intangible Assets Intangible assets (Assets with no physical properties.) are long-term assets with no physical properties. Intangibles are recorded as assets, because they provide future economic benefits to the company. For example, a pharmaceutical company's most important asset may be its patent for a particular drug or process. Likewise, the company that publishes this textbook may consider the copyrights to textbooks to be among its most important revenue-producing assets.

The balance sheet does not include all of the items that may produce future benefit to the company. A company's employees, its management team, its location, or the intellectual capital of a few key researchers may well provide important future benefits and value. They are not recorded on the balance sheet, however, because they do not meet the accountant's definition of assets and cannot be easily identified or measured.

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Balance Sheet Presentation Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Balance Sheet Presentation

Intangible assets are long-term assets and should be shown separately from property, plant, and equipment. Exhibit 8-3 lists the most common intangible assets. Nike's balance sheet presents two lines for intangible assets: Identifiable Intangible Assets and Goodwill. Exhibit 8-4 presents the note that indicates that Nike's intangible assets consist primarily of trademarks and goodwill.

Exhibit 8-3

Most Common Intangible Assets

Intangible Asset Description

Patent Right to use, manufacture, or sell a product; granted by the U.S. Patent Office. Patents have a legal life of 20 years.

Trademark A symbol or name that allows a product or service to be identified; provides legal protection for 20 years in addition to an indefinite number of renewal periods.

Goodwill The excess of the purchase price to acquire a business over the value of the individual net assets acquired.

Exhibit 8-4

The Nike, Inc., Consolidated Assets Section and Intangibles Notes

NOTE 4 — Identifiable Intangible Assets and Goodwill

Identifiable intangible assets, net consists of indefinite-lived trademarks, which are not subject to amortization, and acquired trademarks and other intangible assets, which are subject to amortization. At May 31, 2015 and 2014, indefinite-lived trademarks were $281 million and $282 million, respectively. Acquired trademarks and other intangible assets at May 31, 2015 and 2014 were $17 million and $39 million, respectively, and were fully amortized at the end of both periods. Goodwill was $131 million at May 31, 2015 and 2014 of which $65 million and $64 million

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were included in the Converse segment in the respective periods. The remaining amounts were included in Global Brand Divisions for segment reporting purposes. There were no accumulated impairment balances for goodwill as of either period end.

Goodwill (The excess of the purchase price to acquire a business over the value of the individual net assets acquired. Alternate term: Purchase price in excess of the market value of the assets.) represents the amount of the purchase price paid in excess of the market value of the individual net assets when a business is purchased. Goodwill is recorded only when a business is purchased. Customer loyalty or a good management team may represent goodwill, but neither meets the accountants' criteria to be recorded as an asset on a firm's financial statements.

How Will I Use Accounting?

If you are a financial analyst, you will need to analyze all of the company's assets, including goodwill.

A large balance can hint a company's history of overpaying for acquisitions or being highly acquisitive in general. Additionally, a large amount of goodwill can also be an indication that a company may later have to declare that some of these assets are impaired.

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Acquisition Cost of Intangible Assets Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Acquisition Cost of Intangible Assets

As was the case with property, plant, and equipment, the acquisition cost of an intangible asset includes all of the costs to acquire the asset and prepare it for its intended use. This should include all necessary costs, such as legal costs incurred at the time of acquisition. Acquisition cost also should include those costs that are incurred after acquisition and that are necessary to the existence of the asset. For example, if a firm must pay legal fees to protect a patent from infringement, the costs should be considered part of the acquisition cost and should be included in the Patent account.

Research and Development Costs

You should also be aware of one item that is similar to intangible assets but is not on the balance sheet. Research and development costs (Costs incurred in the discovery of new knowledge.) are expenditures incurred in the discovery of new knowledge and the translation of research into a design or plan for a new product or service or in a significant improvement to an existing product or service. Firms that engage in research and development do so because they believe such activities provide future benefit to the company. In fact, many firms have become leaders in an industry by engaging in research and development and the discovery of new products or technology. It is often very difficult, however, to identify the amount of future benefits of research and development and to associate those benefits with specific time periods. Because of the difficulty in predicting future benefits, the FASB has ruled that firms are not allowed to treat research and development costs as assets; all such expenditures must be treated as expenses in the period incurred. Financial statement users need to be aware of those “hidden assets” when analyzing the balance sheets of companies that must expense research and development costs.

It is important to distinguish between patent costs and research and development costs. Patent costs include legal and filing fees necessary to acquire a patent. Such costs are capitalized as an intangible asset, Patent. However, the Patent account should not include the costs of research and development of a new product.

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LO 10 - Understand the proper amortization of intangible assets.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Amortization of Intangibles Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Amortization of Intangibles

Amortization is very similar to depreciation of property, plant, and equipment. Amortization involves allocating the acquisition cost of an intangible asset to the periods benefited by the use of the asset. Most companies use the straight-line method of amortization.

Intangibles with Finite Life

If an intangible asset has a finite life, amortization must be recognized. A finite life exists when an intangible asset is legally valid for only a certain length of time. For example, a patent is granted for a time period of 20 years and gives the patent holder the legal right to exclusive use of the patented design or invention. A copyright is likewise granted for a specified legal life. A finite life also exists when there is no legal life but company management knows for certain that it will be able to use the intangible asset for only a specified period of time. For example, a company may have purchased the right to use a list of names and addresses of customers for a two-year time period.

Amortization should be recorded over the legal life or the useful life, whichever is shorter. For example, patents may have a legal life of 20 years, but many are not useful for that long because new products and technology make the patent obsolete. The patent should be amortized over the number of years in which the firm receives benefits, which may be a period shorter than the legal life.

Example 8-9

Calculating the Amortization of Intangibles

Assume that Nike developed a patent for a new shoe product on January 1, 2017. The costs involved with patent approval were $10,000, and the company wants to record amortization on the straight-line basis over a five-year life with no residual value. In this case, the useful life of the patent is less than the legal life. Nike should record amortization over the useful life as .

The the effect of the amortization for 2017 is as follows:

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Rather than use an accumulated amortization account, some companies decrease the intangible asset account directly. In that case, the effect of the amortization can be identified and analyzed as follows:

No matter which of the two preceding entries is used, the asset should be reported on the balance sheet at acquisition cost ($10,000) less accumulated amortization ($2,000), or $8,000, as of December 31, 2017.

Intangibles with Indefinite Life

If an intangible asset has an indefinite life, amortization should not be recognized. For example, a television or radio station may have paid to acquire a broadcast license. A broadcast license is usually for a certain time period but can be renewed at the end of that time period. In that case, the life of the asset is indefinite and amortization of the intangible asset representing the broadcast rights should not be recognized. A second example would be a trademark. For many companies, such as Nike and The Coca-Cola Company, a trademark is a valuable asset that provides name recognition and enhances sales. A trademark is granted for a certain time period but can be renewed at the end of that period, so the life may be quite indefinite. If the life of an intangible asset represented by trademarks is indefinite, amortization should not be recorded. Note in Exhibit 8-4 that Nike has considered some trademarks to have an indefinite life and has not amortized them. Others have been amortized because they have a limited life.

Goodwill and Impairments

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Goodwill is an important intangible asset on the balance sheet of many companies. At one time, accounting rules had required companies to record amortization of goodwill over a time period not to exceed 40 years. However, the current stance of the FASB is that goodwill should be treated as an intangible asset with an indefinite life and that companies should no longer record amortization expense related to goodwill.

While companies should not record amortization of intangible assets that have an indefinite life, they are required each year to determine whether the asset has been impaired. A discussion of asset impairment is beyond the scope of this text, but generally, it means that a loss should be recorded when the value of the asset has declined. For example, some trademarks, such as Xerox and Polaroid, that were quite powerful in the past have declined in value over time. When an impairment of the asset is recognized, the loss is recorded in the time period that the value declines rather than the date the asset is sold.

Assume that Nike learns on January 1, 2018, when accumulated amortization is $2,000 (or the book value of the patent is $8,000), that a competing company has developed a new product that renders Nike's patent worthless. Nike has a loss of $8,000 and should record an entry to write off the asset. The effect of the transaction can be identified and analyzed as follows:

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles IFRS and Intangible Assets Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

IFRS and Intangible Assets

The international standards are more flexible than the FASB standards in allowing the use of fair market values for intangible assets. However, such values can only be used for those assets where an “active market” exists and it is possible to determine fair value.

The treatment of research and development costs also differs. FASB standards require all research and development costs to be treated as an expense. The international standards make a distinction between research costs and development costs. All research costs must be treated as an expense, but development costs can be capitalized as an asset if certain criteria are met.

These differences between U.S. and international standards will likely be addressed and eliminated as U.S. companies move to adopt the international standards.

Module 3

Test Yourself

Question

1. Give several examples of intangible assets. In what balance sheet category should intangible assets appear?

2. Define the term goodwill. Give an example of a transaction that would result in the recording of goodwill on the balance sheet.

3. When an intangible asset is amortized, should the asset's amortization occur over its legal life or its useful life? Give an example in which the legal life exceeds the useful life.

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4. Suppose that an intangible asset is being amortized over a ten-year time period but a competitor has just introduced a new product that will have a serious negative impact on the asset's value. Should the company continue to amortize the intangible asset over the ten-year life?

Apply

1. Which of the following would be considered intangible assets on the balance sheet? Which intangibles should be amortized?

Patents

Copyrights

Research and development

Goodwill

The company's advantageous location

Broadcast rights

2. A company develops a patent on January 1, 2014, and the costs involved with patent approval are $12,000. The legal life of the patent is 20 years, but the company projects that it will provide useful benefits for only 12 years. At January 1, 2016, the company discovers that a competitor will introduce a new product, making this patent useless in five years. How much amortization should be recorded in 2015, 2016, and 2017?

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LO 11 - Explain the impact that long-term assets have on the statement of cash flows.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles: Module 4 Cash Flow and Analysis Issues Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 4 Cash Flow and Analysis Issues Exhibit 8-5 illustrates the items discussed in this chapter and their effect on the statement of cash flows.

Exhibit 8-5

Long-Term Assets and the Statement of Cash Flows

The acquisition of a long-term asset is an investing activity and should be reflected in the Investing Activities category of the statement of cash flows. The acquisition should appear as a deduction, or negative item, in that section because it requires the use of cash to purchase the asset. This applies whether the long-term asset is property, plant, and equipment or an intangible asset.

The depreciation or amortization of a long-term asset is not a cash item. It was referred to earlier as a noncash charge to earnings. Nevertheless, it must be presented on the statement of cash flows (if the indirect method is used for the statement). The reason is that it was deducted from earnings in calculating the net income figure. Therefore, it must be eliminated or “added back” if the net income amount is used to indicate the amount of cash generated from operations. Thus, depreciation and amortization should be presented in the Operating Activities category of the statement of cash flows as an addition to net income.

The sale or disposition of long-term assets is an investing activity. When an asset is sold, the amount of cash received should be reflected as an addition in the Investing Activities category of the statement of cash flows. If the asset was sold at a gain or loss, however, one additional aspect should be reflected. Because the gain or loss was reflected on the income statement, it should be eliminated from the net income amount presented in the Operating Activities category (if the indirect method is used). A sale of an asset is not an

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activity related to normal ongoing operations, and all amounts involved with the sale should be removed from the Operating Activities category.

Exhibit 8-6 indicates the Operating and Investing categories of the 2015 statement of cash flows of Nike, Inc. The company had a net income of $3,273 million during 2015. Note that the company generated a positive cash flow from operating activities of $4,680 million. One of the reasons was that depreciation of $606 million and amortization of $43 million affected the income statement but did not involve a cash outflow and therefore are added back on the statement of cash flows. Also note that the Investing Activities category indicates major outlays of cash for new property, plant, and equipment of $963 million. These cash outflows are indications of Nike's need for cash that must be generated from its operating activities.

Exhibit 8-6

Nike, Inc.'s Consolidated Partial Statement of Cash Flows

Source: Nike, Inc., Form 10-k for fiscal year ended May 31, 2015.

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LO 12 - Understand how investors can analyze a company's operating assets.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Analyzing Long-Term Assets for Average Life and Asset Turnover Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Analyzing Long-Term Assets for Average Life and Asset Turnover Because long-term assets constitute the major productive assets of most companies, the age and composition of these assets should be analyzed. Analysis of the age of the assets can be accomplished fairly easily for those companies that use the straight-line method of depreciation. A rough measure of the average life of the assets can be calculated as follows:

The average age of the assets can be calculated as follows:

The Assets category of the balance sheet is also important in analyzing a company's profitability. The asset turnover is a measure of the assets' productivity and is measured as follows:

This ratio is a measure of how many dollars of assets are necessary for every dollar of sales. That is, the ratio is a measure of how productive the assets are in generating sales. If a company is using its assets efficiently, each dollar of assets will create a high amount of sales. A company with less productive assets will generate fewer sales from its dollar of assets. Technically, a ratio is based on average total assets, but long-term assets often constitute the largest portion of a company's total assets.

Making Business Decisions

Nike

Analyzing Operating Assets

Investors and lenders who read financial statements must determine the age, composition, and productivity of operating assets.

A.The Ratio Analysis Model

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1. Formulate the Question

What is the average life of the assets?

What is the average age of the assets?

How productive are the assets in producing revenue for the company? This is referred to as asset turnover.

2. Gather the Information from the Financial Statements

To calculate a company's average life of assets and average age of assets, it is essential to know its total operating assets and accumulated depreciation from the balance sheet and depreciation expense from the income statement or statement of cash flows.

To calculate a company's asset turnover, it is essential to know a company's total sales from the income statement and its average total assets from the balance sheet.

3. Calculate the Ratio for Nike, Inc.

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4. Compare the Ratio with Others

Nike's age, composition, and productivity of operating assets should be compared with those of prior years and to those of companies in the same industry.

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5. Interpret the Ratios

The average life and age of Nike's assets have been consistent from year to year and are in line with other companies in the industry. The asset turnover ratio is a measure of how many dollars of assets are necessary for every dollar of sales. If a company uses its assets efficiently, each dollar of assets will create a high amount of sales. Nike's asset turnover ratio indicates that each dollar of assets in 2015 produced $1.50 of sales. It is an indication that the assets are productive and will be able to provide sales in future periods.

B.The Business Decision Model

1. Formulate the Question

If you were a lender, would you be willing to lend money to Nike, Inc., and use the operating assets as collateral for the loan?

2. Gather Information from the Financial Statements and Other Sources

This information will come from a variety of sources, not limited to but including:

The balance sheet provides information about the age and composition of the assets, the income statement regarding profitability and depreciation, and the statement of cash flows on inflows and outflows of cash.

The outlook for the industry, including consumer trends, foreign markets, labor issues, and other factors.

The outlook for the economy in general.

Alternative uses for the money.

3. Analyze the Information Gathered

Compare Nike, Inc.'s ratios in (A) above with Foot Locker's as well as with industry averages.

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Look at trends over time in the age, composition, and productivity of assets.

Review projections for the economy and the industry.

4. Make the Decision

Taking into account all of the various sources of information, decide either to

Lend money to Nike, Inc., or

Find an alternative use for the money

5. Monitor Your Decision

If you decide to lend the money, you will need to monitor your investment periodically. During the time of the loan, you will want to assess the company's operating assets as well as other factors you considered before making the investment.

Module 4

Test Yourself

Apply

1. In which category of the statement of cash flows (indirect method) should the following items appear?

Depreciation of an operating asset

Gain on the sale of an asset

Amortization of an intangible

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Loss on the sale of an asset

Amount paid to purchase an asset

Amount received upon sale of an asset

2. At December 31, 2017, a company has the following amounts on its financial statements:

Calculate the following ratios:

Average life of the assets

Average age of the assets

Asset turnover

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Chapter Review Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Ratio Review

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Accounts Highlighted Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Accounts Highlighted

Account Titles Where It Appears

In What Section Cited on

Land Balance Sheet

Operating Assets

Example 8-1

Buildings Balance Sheet

Operating Assets

Example 8-1

Machinery Balance Sheet

Operating Assets

Capital versus Revenue Expenditures

Accumulated Depreciation (a contra account)

Balance Sheet

Operating Assets

Example 8-6

Depreciation Expense Income Statement

Operating Expenses

Gain on Sale of Assets

Gain on Sale of Asset Income Statement

Other Income Example 8-7

Loss on Sale of Asset Income Statement

Other Expense

Example 8-8

Intangible Assets

Trademark Balance Sheet

Intangible Assets

Goodwill Balance Sheet

Intangible Assets

Amortization Expense Income Statement

Operating Expenses

Example 8-9

Accumulated Amortization (a contra account)

Balance Sheet

Intangible Assets

Example 8-9

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Acquisition cost

Capitalization of interest

Land improvements

Depreciation

Straight-line method

Book value

Units-of-production method

Accelerated depreciation

Double-declining-balance method

Change in estimate

Capital expenditure

Revenue expenditure

Gain on Sale of Asset

Loss on Sale of Asset

Intangible assets

Goodwill

Research and development costs

1. The amount that includes all of the cost normally necessary to acquire an asset and prepare it for its intended use.

2. Costs that are related to land but that have a limited life.

3. A method by which the same dollar amount of depreciation is recorded in each year of asset use.

4. Depreciation is determined as a function of the number of units the asset produces.

5. Interest on constructed assets is added to the asset account.

6. A change in the life of the asset or in its residual value.

7. The allocation of the original cost of an asset to the periods benefited by its use.

8. A cost that improves the asset and is added to the asset account.

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Key Terms Quiz Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Key Terms Quiz

Read each definition below and write the number of the definition in the blank beside the appropriate term. The quiz solutions appear at the end of the chapter.

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9. The original cost of an asset minus the amount of accumulated depreciation.

10. A cost that keeps an asset in its normal operating condition and is treated as an expense.

11. The excess of the selling price over the asset's book value.

12. The amount by which selling price is less than book value.

13. A higher amount of depreciation is recorded in the early years and a lower amount in the later years.

14. Assets with no physical properties.

15. Depreciation is recorded at twice the straight-line rate, but the balance is reduced each period.

16. The excess of the purchase price to acquire a business over the value of the individual net assets acquired.

17. Costs incurred in the discovery of new knowledge.

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Review Problem & Solution Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Review Problem & Solution

The accountant for Becker Company wants to develop a balance sheet as of December 31, 2017. A review of the asset records has revealed the following information:

a. Asset A was purchased on July 1, 2015, for $40,000 and has been depreciated on the straight-line basis using an estimated life of six years and a residual value of $4,000.

b. Asset B was purchased on January 1, 2016, for $66,000. The straight- line method has been used for depreciation purposes. Originally, the estimated life of the asset was projected to be six years with a residual value of $6,000; however, at the beginning of 2017, the accountant learned that the remaining life of the asset was only three years with a residual value of $2,000.

c. Asset C was purchased on January 1, 2016, for $50,000. The double- declining-balance method has been used for depreciation purposes, with a four-year life and a residual value estimate of $5,000.

Required

1. Assume that these assets represent pieces of equipment. Calculate the acquisition cost, accumulated depreciation, and book value of each asset as of December 31, 2017.

2. How would the assets appear on the balance sheet on December 31, 2017?

3. Assume that Becker Company sold Asset B on January 2, 2018, for $25,000. Calculate the amount of the resulting gain or loss and indicate the effect on the accounting equation for the sale. Where would the gain or loss appear on the income statement?

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Exercises Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Exercises

Exercise 8-1

Acquisition Cost

LO2 - Determine the acquisition cost of an operating asset.

On January 1, 2017, Ruby Company purchased a piece of equipment with a list price of $60,000. The following amounts were related to the equipment purchase:

Terms of the purchase were 2/10, net 30. Ruby paid for the purchase on January 8.

Freight costs of $1,000 were incurred.

A state agency required that a pollution control device be installed on the equipment at a cost of $2,500.

During installation, the equipment was damaged and repair costs of $4,000 were incurred.

Architect's fees of $6,000 were paid to redesign the work space to accommodate the new equipment.

Ruby purchased liability insurance to cover possible damage to the asset. The three-year policy cost $8,000.

Ruby financed the purchase with a bank loan. Interest of $3,000 was paid on the loan during 2016.

Required

Determine the acquisition cost of the equipment.

Exercise 8-2

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Lump-Sum Purchase

LO3 - Explain how to calculate the acquisition cost of assets purchased for a lump sum.

Example 8-1

To add to his growing chain of grocery stores, on January 1, 2017, Danny Marks bought a grocery store of a small competitor for $520,000. An appraiser, hired to assess the acquired assets' values, determined that the land, building, and equipment had market values of $200,000, $150,000, and $250,000, respectively.

Required

1. What is the acquisition cost of each asset? Identify and analyze the effect of the acquisition.

2. Danny plans to depreciate the operating assets on a straight-line basis for 20 years. Determine the amount of depreciation expense for 2017 on these newly acquired assets. You can assume zero residual value for all assets.

3. How would the assets appear on the balance sheet as of December 31, 2017?

Exercise 8-3

Straight-Line and Units-of-Production Methods

LO5 - Compare depreciation methods and understand the factors affecting the choice of method.

Example 8-2, 8-3

Assume that Sample Company purchased factory equipment on January 1, 2017, for $60,000. The equipment has an estimated life of five years and an estimated residual value of $6,000. Sample's accountant is considering whether to use the straight-line or the units- of-production method to depreciate the asset. Because the company is beginning a new production process, the equipment will be used to produce 10,000 units in 2017, but production subsequent to 2017 will increase by 10,000 units each year.

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Required

Calculate the depreciation expense, accumulated depreciation, and book value of the equipment under both methods for each of the five years of its life. Would the units-of-production method yield reasonable results in this situation? Explain.

Exercise 8-4

Accelerated Depreciation

LO5 - Compare depreciation methods and understand the factors affecting the choice of method.

Example 8-4

Koffman's Warehouse purchased a forklift on January 1, 2017, for $6,000. The forklift is expected to last for five years and have a residual value of $600. Koffman's uses the double-declining-balance method for depreciation. Round amounts to the nearest dollar.

Required

1. Calculate the depreciation expense, accumulated depreciation, and book value for each year of the forklift's life.

2. Identify and analyze the effect of the depreciation for 2017.

3. Refer to Exhibit 8-2. What factors may have influenced Koffman to use the double-declining-balance method?

Exercise 8-5

Change in Estimate

LO6 - Understand the impact of a change in the estimate of the asset life or residual value.

Example 8-5

Assume that Bloomer Company purchased a new machine on January 1, 2017, for $80,000. The machine has an estimated useful life of nine years and

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a residual value of $8,000. Bloomer has chosen to use the straight-line method of depreciation. On January 1, 2019, Bloomer discovered that the machine would not be useful beyond December 31, 2022, and estimated its value at that time to be $2,000.

Required

1. Calculate the depreciation expense, accumulated depreciation, and book value of the asset for each year 2017 to 2022.

2. Was the depreciation recorded wrong in 2017 and 2018? If so, why was it not corrected?

Exercise 8-6

Asset Disposal

LO8 - Analyze the effect of the disposal of an asset at a gain or loss.

Assume that Gonzalez Company purchased an asset on January 1, 2015, for $60,000. The asset had an estimated life of six years and an estimated residual value of $6,000. The company used the straight-line method to depreciate the asset. On July 1, 2017, the asset was sold for $40,000.

Required

1. Identify and analyze the effect of the transaction for depreciation for 2017. Identify and analyze the effect of the sale of the asset.

2. How should the gain or loss on the sale of the asset be presented on the income statement?

Exercise 8-7

Asset Disposal

LO8 - Analyze the effect of the disposal of an asset at a gain or loss.

Example 8-7, 8-8

Refer to Exercise 8-6. Assume that Gonzalez Company sold the asset on July 1, 2017, and received $15,000 cash and a note for an additional $15,000.

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Required

1. Identify and analyze the effect of the transaction for depreciation for 2017. Identify and analyze the effect of the sale of the asset.

2. How should the gain or loss on the sale of the asset be presented on the income statement?

Exercise 8-8

Amortization of Intangibles

LO10 - Understand the proper amortization of intangible assets.

Example 8-9

For each of the following intangible assets, indicate the amount of amortization expense that should be recorded for the year 2017 and the amount of accumulated amortization on the balance sheet as of December 31, 2017.

Trademark Patent Copyright

Cost $40,000 $50,000 $80,000

Date of purchase

1/1/10 1/1/12 1/1/15

Useful life indefinite 10 yrs. 20 yrs.

Legal life undefined 20 yrs. 50 yrs.

Method SL SL SL

Exercise 8-9

Impact of Transactions Involving Operating Assets on Statement of Cash Flows

LO11 - Explain the impact that long-term assets have on the statement of cash flows.

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From the following list, identify each item as operating (O), investing (I), financing (F), or not separately reported on the statement of cash flows (N).

Purchase of land

Proceeds from sale of land

Gain on sale of land

Purchase of equipment

Depreciation expense

Proceeds from sale of equipment

Loss on sale of equipment

Exercise 8-10

Impact of Transactions Involving Intangible Assets on Statement of Cash Flows

LO11 - Explain the impact that long-term assets have on the statement of cash flows.

From the following list, identify each item as operating (O), investing (I), financing (F), or not separately reported on the statement of cash flows (N).

Cost incurred to acquire copyright

Proceeds from sale of patent

Gain on sale of patent

Research and development costs

Amortization of patent

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Multi-Concept Exercises Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Multi-Concept Exercises

Exercise 8-11

Capital versus Revenue Expenditures

LO1 - Understand balance sheet disclosures for operating assets. • 7 - Determine which expenditures should be capitalized as asset costs and which should be treated as expenses.

Example 8-6

On January 1, 2015, Jose Company purchased a building for $200,000 and a delivery truck for $20,000. The following expenditures have been incurred during 2017:

The building was painted at a cost of $5,000.

To prevent leaking, new windows were installed in the building at a cost of $10,000.

To improve production, a new conveyor system was installed at a cost of $40,000.

The delivery truck was repainted with a new company logo at a cost of $1,000.

To allow better handling of large loads, a hydraulic lift system was installed on the truck at a cost of $5,000.

The truck's engine was overhauled at a cost of $4,000.

Required

1. Determine which of those costs should be capitalized. Also, identify and analyze the effect of the capitalized costs. Assume that all costs were incurred on January 1, 2017.

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2. Determine the amount of depreciation for the year 2017. The company uses the straight-line method and depreciates the building over 25 years and the truck over six years. Assume zero residual value for all assets.

3. How would the assets appear on the balance sheet of December 31, 2017?

Exercise 8-12

Capitalization of Interest and Depreciation

LO4 - Describe the impact of capitalizing interest as part of the acquisition cost of an asset. • 5 - Compare depreciation methods and understand the factors affecting the choice of method.

Example 8-2

During 2017, Mercator Company borrowed $80,000 from a local bank. In addition, Mercator used $120,000 of cash to construct a new corporate office building. Based on average accumulated expenditures, the amount of interest capitalized during 2017 was $8,000. Construction was completed, and the building was occupied on January 1, 2018.

Required

1. Determine the acquisition cost of the new building.

2. The building has an estimated useful life of 20 years and a $5,000 salvage value. Assuming that Mercator uses the straight-line basis to depreciate its operating assets, determine the amount of depreciation expense for 2017 and 2018.

Exercise 8-13

Research and Development and Patents

LO9 - Understand the balance sheet presentation of intangible assets. • 10 - Understand the proper amortization of intangible assets.

Erin Company incurred the following costs during 2017 and 2018:

a. Research and development costing $20,000 was conducted on a new product to sell in future years. A product was successfully developed,

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and a patent for it was granted during 2017. Erin is unsure of the period benefited by the research, but believes the product will result in increased sales over the next five years.

b. Legal costs and application fees of $10,000 for the 20-year patent were incurred on January 1, 2017.

c. A patent infringement suit was successfully defended at a cost of $8,000. Assume that all costs were incurred on January 1, 2018.

Required

Determine how the costs in (a) and (b) should be presented on Erin's financial statements as of December 31, 2017. Also determine the amount of amortization of intangible assets that Erin should record in 2017 and 2018.

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Problems Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Problems

Problem 8-1

Lump-Sum Purchase of Assets and Subsequent Events

LO3 - Explain how to calculate the acquisition cost of assets purchased for a lump sum.

Carter Development Company purchased, for cash, a large tract of land that was immediately platted and deeded into the following smaller sections:

Section 1, retail development with highway frontage

Section 2, multifamily apartment development

Section 3, single-family homes in the largest section

Based on recent sales of similar property, the fair market values of the three sections are as follows:

Section 1, $630,000

Section 2, $378,000

Section 3, $252,000

Required

1. What value is assigned to each section of land if the tract was purchased for (a) $1,260,000, (b) $1,560,000, and (c) $1,000,000?

2. How does the purchase of the tract affect the balance sheet?

3. Why would Carter be concerned with the value assigned to each section? Would Carter be more concerned with the values assigned if instead of purchasing three sections of land, it purchased land with buildings? Explain.

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Problem 8-2

Depreciation as a Tax Shield

LO5 - Compare depreciation methods and understand the factors affecting the choice of method.

The term tax shield refers to the amount of income tax saved by deducting depreciation for income tax purposes. Assume that Supreme Company is considering the purchase of an asset as of January 1, 2017. The cost of the asset with a five- year life and zero residual value is $100,000. The company will use the straight-line method of depreciation.

Supreme's income for tax purposes before recording depreciation on the asset will be $50,000 per year for the next five years. The corporation is currently in the 35% tax bracket.

Required

Calculate the amount of income tax that Supreme must pay each year if the asset is not purchased. Calculate the amount of income tax that Supreme must pay each year if the asset is purchased. What is the amount of the depreciation tax shield?

Problem 8-3

Book versus Tax Depreciation

LO5 - Compare depreciation methods and understand the factors affecting the choice of method.

Griffith Delivery Service purchased a delivery truck for $33,600. The truck has an estimated useful life of six years and no salvage value. For purposes of preparing financial statements, Griffith is planning to use straight-line depreciation. For tax purposes, Griffith follows MACRS. Depreciation expense using MACRS is $6,720 in Year 1, $10,750 in Year 2, $6,450 in Year 3, $3,870 in each of Years 4 and 5, and $1,940 in Year 6.

Required

1. What is the difference between straight-line and MACRS depreciation expense for each of the six years?

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2. Griffith's president has asked why you use one method for the books and another for tax calculations. “Can you do this? Is it legal? Don't we take the same total depreciation either way?” he asked. Write a brief memo answering his questions and explaining the benefits of using two methods for depreciation.

Problem 8-4

Depreciation and Cash Flow

LO11 - Explain the impact that long-term assets have on the statement of cash flows.

O'hare Company's only asset as of January 1, 2017, was a limousine. During 2017, only the following three transactions occurred:

Services of $100,000 were provided on account.

All accounts receivable were collected.

Depreciation on the limousine was $15,000.

Required

1. Develop an income statement for O'hare for 2017.

2. Determine the amount of the net cash inflow for O'hare for 2017.

3. Explain why O'hare's net income does not equal net cash inflow.

4. If O'hare developed a cash flow statement for 2017 using the indirect method, what amount would appear in the category titled Cash Flow from Operating Activities?

Problem 8-5

Reconstruct Net Book Values Using Statement of Cash Flows

LO11 - Explain the impact that long-term assets have on the statement of cash flows.

Centralia Stores Inc. had property, plant, and equipment, net of accumulated depreciation, of $4,459,000 and intangible assets, net of accumulated

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(1)

(2)

(3)

amortization, of $673,000 at December 31, 2017. The company's 2016 statement of cash flows, prepared using the indirect method, included the following items:

a. The Cash Flows from Operating Activities section included three additions to net income:

Depreciation expense of $672,000

Amortization expense of $33,000

Loss on the sale of equipment of $35,000

b. The Cash Flows from Operating Activities section also included a subtraction from net income for the gain on the sale of a copyright of $55,000.

c. The Cash Flows from Investing Activities section included outflows for the purchase of a building of $292,000 and $15,000 for the payment of legal fees to protect a patent from infringement.

d. The Cash Flows from Investing Activities section also included inflows from the sale of equipment of $315,000 and the sale of a copyright of $75,000.

Required

1. Determine the book values of the assets that were sold during 2017.

2. Reconstruct the amount of property, plant, and equipment, net of accumulated depreciation, that was reported on the company's balance sheet at December 31, 2016.

3. Reconstruct the amount of intangibles, net of accumulated amortization, that was reported on the company's balance sheet at December 31, 2016.

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Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Multi-Concept Problems Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Multi-Concept Problems

Problem 8-6

Cost of Assets, Subsequent Book Values, and Balance Sheet Presentation

LO1 - Understand balance sheet disclosures for operating assets. • 3 - Explain how to calculate the acquisition cost of assets purchased for a lump sum. • 5 - Compare depreciation methods and understand the factors affecting the choice of method. • 7 - Determine which expenditures should be capitalized as asset costs and which should be treated as expenses. • 8 - Analyze the effect of the disposal of an asset at a gain or loss.

The following events took place at Pete's Painting Company during 2017:

a. On January 1, Pete bought a used truck for $14,000. He added a tool chest and side racks for ladders for $4,800. The truck is expected to last four years and then be sold for $800. Pete uses straight-line depreciation.

b. On January 1, he purchased several items at an auction for $2,400. These items had fair market values as follows:

Pete will use all of the paint trays and roller covers this year. The storage cabinets are expected to last nine years; the ladders and scaffolding, four years.

c. On February 1, Pete paid the city $1,500 for a three-year license to operate the business.

d. On September 1, Pete sold an old truck for $4,800 that had cost $12,000 when it was purchased on September 1, 2012. It was expected

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to last eight years and have a salvage value of $800.

Required

1. For each situation, explain the value assigned to the asset when it is purchased [or for (d), the book value when sold].

2. Determine the amount of depreciation or other expense to be recorded for each asset for 2017.

3. How would these assets appear on the balance sheet as of December 31, 2017?

Problem 8-7

Cost of Assets and the Effect on Depreciation

LO2 - Determine the acquisition cost of an operating asset. • 5 - Compare depreciation methods and understand the factors affecting the choice of method.

Early in its first year of business, Toner Company, a fitness and training center, purchased new workout equipment. The acquisition included the following costs:

The bookkeeper recorded an asset, Equipment, $165,000 (purchase price and tax). The remaining costs were expensed for the year. Toner used straight-line depreciation. The equipment was expected to last ten years with zero salvage value.

Required

1. How much depreciation did Toner report on its income statement related to this equipment in Year 1? What is the correct amount of depreciation to report in Year 1?

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2. Income is $100,000 before costs related to the equipment are reported. How much income will Toner report in Year 1? What amount of income should it report? You can ignore income tax.

3. Using the equipment as an example, explain the difference between a cost and an expense.

Problem 8-8

Capital Expenditures, Depreciation, and Disposal

LO5 - Compare depreciation methods and understand the factors affecting the choice of method. • 7 - Determine which expenditures should be capitalized as asset costs and which should be treated as expenses. • 8 - Analyze the effect of the disposal of an asset at a gain or loss.

Merton Company purchased a building on January 1, 2016, at a cost of $364,000. Merton estimated that its life would be 25 years and its residual value would be $14,000.

On January 1, 2017, the company made several expenditures related to the building. The entire building was painted and floors were refinished at a cost of $21,000. A federal agency required Merton to install additional pollution control devices in the building at a cost of $42,000. With the new devices, Merton believed it was possible to extend the life of the building by six years.

In 2018, Merton altered its corporate strategy dramatically. The company sold the building on April 1, 2018, for $392,000 in cash and relocated all operations to another state.

Required

1. Determine the depreciation that should be on the income statement for 2016 and 2017.

2. Explain why the cost of the pollution control equipment was not expensed in 2017. What conditions would have allowed Merton to expense the equipment? If Merton has a choice, would it prefer to expense or capitalize the equipment?

3. What amount of gain or loss did Merton record when it sold the building? What amount of gain or loss would have been reported if the pollution control equipment had been expensed in 2017?

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Problem 8-9

Amortization of Intangible, Revision of Rate

LO6 - Understand the impact of a change in the estimate of the asset life or residual value. • 10 - Understand the proper amortization of intangible assets.

During 2012, Reynosa Inc.'s research and development department developed a new manufacturing process. Research and development costs were $85,000. The process was patented on October 1, 2012. Legal costs to acquire the patent were $11,900. Reynosa decided to expense the patent over a 20-year time period. Reynosa's fiscal year ends on September 30.

On October 1, 2017, Reynosa's competition announced that it had obtained a patent on a new process that would make Reynosa's patent completely worthless.

Required

1. How should Reynosa record the $85,000 and $11,900 costs?

2. How much amortization expense should Reynosa report in each year through the year ended September 30, 2017?

3. What amount of loss should Reynosa report in the year ended September 30, 2018?

Problem 8-10

Purchase and Disposal of Operating Asset and Effects on Statement of Cash Flows

LO8 - Analyze the effect of the disposal of an asset at a gain or loss. • 11 - Explain the impact that long-term assets have on the statement of cash flows.

On January 1, 2017, Castlewood Company purchased machinery for its production line for $104,000. Using an estimated useful life of eight years and a residual value of $8,000, the annual straight-line depreciation of the machinery was calculated to be $12,000. Castlewood used the machinery during 2017 and 2018, but then decided to automate its production process. On December 31, 2018, Castlewood sold the machinery at a loss of $5,000 and purchased new, fully automated machinery for $205,000.

Required

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1. How would the previous transactions be presented on Castlewood's statements of cash flows for the years ended December 31, 2017 and 2018?

2. Why would Castlewood sell at a loss machinery that had a remaining useful life of six years and purchase new machinery with a cost almost twice that of the old?

Problem 8-11

Amortization of Intangibles and Effects on Statement of Cash Flows

LO9 - Understand the balance sheet presentation of intangible assets. • 10 - Understand the proper amortization of intangible assets. • 11 - Explain the impact that long-term assets have on the statement of cash flows.

Tableleaf Inc. purchased a patent a number of years ago. The patent is being amortized on a straight-line basis over its estimated useful life. The company's comparative balance sheets as of December 31, 2017 and 2016, included the following line item:

Required

1. How much amortization expense was recorded during 2017?

2. What was the patent's acquisition cost? When was it acquired? What is its estimated useful life? How was the acquisition of the patent reported on that year's statement of cash flows?

3. Assume that Tableleaf uses the indirect method to prepare its statement of cash flows. How is the amortization of the patent reported annually on the statement of cash flows?

4. How would the sale of the patent on January 1, 2017, for $200,000 be reported on the 2017 statement of cash flows?

Chapter 8: Operating Assets: Property, Plant, and Equipment, and Intangibles Multi-Concept Problems Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Chapter Review

Problems

Problem 8-1

Lump-Sum Purchase of Assets and Subsequent Events

LO3 - Explain how to calculate the acquisition cost of assets purchased for a lump sum.

Carter Development Company purchased, for cash, a large tract of land that was immediately platted and deeded into the following smaller sections:

Section 1, retail development with highway frontage

Section 2, multifamily apartment development

Section 3, single-family homes in the largest section

Based on recent sales of similar property, the fair market values of the three sections are as follows:

Section 1, $630,000

Section 2, $378,000

Section 3, $252,000

Required

1. What value is assigned to each section of land if the tract was purchased for (a) $1,260,000, (b) $1,560,000, and (c) $1,000,000?

2. How does the purchase of the tract affect the balance sheet?

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Problem 8-2

Depreciation as a Tax Shield

LO5 - Compare depreciation methods and understand the factors affecting the choice of method.

Supreme's income for tax purposes before recording depreciation on the asset will be $50,000 per year for the next five years. The corporation is currently in the 35% tax bracket.

Required

Problem 8-3

Book versus Tax Depreciation

LO5 - Compare depreciation methods and understand the factors affecting the choice of method.

Required

1. What is the difference between straight-line and MACRS depreciation expense for each of the six years?

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Problem 8-4

Depreciation and Cash Flow

LO11 - Explain the impact that long-term assets have on the statement of cash flows.

O'hare Company's only asset as of January 1, 2017, was a limousine. During 2017, only the following three transactions occurred:

Services of $100,000 were provided on account.

All accounts receivable were collected.

Depreciation on the limousine was $15,000.

Required

1. Develop an income statement for O'hare for 2017.

2. Determine the amount of the net cash inflow for O'hare for 2017.

3. Explain why O'hare's net income does not equal net cash inflow.

4. If O'hare developed a cash flow statement for 2017 using the indirect method, what amount would appear in the category titled Cash Flow from Operating Activities?

Problem 8-5

Reconstruct Net Book Values Using Statement of Cash Flows

LO11 - Explain the impact that long-term assets have on the statement of cash flows.

Centralia Stores Inc. had property, plant, and equipment, net of accumulated depreciation, of $4,459,000 and intangible assets, net of accumulated

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(1)

(2)

(3)

amortization, of $673,000 at December 31, 2017. The company's 2016 statement of cash flows, prepared using the indirect method, included the following items:

a. The Cash Flows from Operating Activities section included three additions to net income:

Depreciation expense of $672,000

Amortization expense of $33,000

Loss on the sale of equipment of $35,000

b. The Cash Flows from Operating Activities section also included a subtraction from net income for the gain on the sale of a copyright of $55,000.

c. The Cash Flows from Investing Activities section included outflows for the purchase of a building of $292,000 and $15,000 for the payment of legal fees to protect a patent from infringement.

d. The Cash Flows from Investing Activities section also included inflows from the sale of equipment of $315,000 and the sale of a copyright of $75,000.

Required

1. Determine the book values of the assets that were sold during 2017.

2. Reconstruct the amount of property, plant, and equipment, net of accumulated depreciation, that was reported on the company's balance sheet at December 31, 2016.

3. Reconstruct the amount of intangibles, net of accumulated amortization, that was reported on the company's balance sheet at December 31, 2016.

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Chapter 9 Current Liabilities, Contingencies, and the Time Value of Money

Chapter Introduction

Module 1 Current Liabilities Accounts Payable

Notes Payable

Current Maturities of Long-Term Debt

Taxes Payable

Other Accrued Liabilities

IFRS and Current Liabilities

Module 2 Cash Flow Effects

Module 3 Contingent Liabilities Contingent Liabilities That Are Recorded

Contingent Liabilities That Are Disclosed

Contingent Liabilities versus Contingent Assets

IFRS and Contingencies

Module 4 Time Value of Money Simple Interest

Compound Interest

Interest Compounding

Present Value and Future Value: Single Amounts Future Value of a Single Amount

Present Value of a Single Amount

Present Value and Future Value of an Annuity Future Value of an Annuity

Present Value of an Annuity

Solving for Unknowns

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Chapter Review Appendix Accounting Tools: Using Excel for Problems Involving Interest

Calculations

Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Multi-Concept Exercises

Problems

Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

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Chapter Introduction

Making Business Decisions

Jonathan Larsen/Diadem Images/Alamy Stock Photo

Starbucks Corporation

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When you think of coffee, Starbucks Corporation may come to mind. The company's objective is to establish itself as one of the most recognized and respected brands in the world. It took only a few years for the company to be well on its way to achieving that goal. The company offers brewed coffees, espresso beverages, cold blended beverages, various complementary food items, coffee-related accessories and equipment, a selection of premium teas, and a line of compact discs through its retail stores.

Starbucks' balance sheet reveals that it must monitor liquidity carefully. A significant portion of the company's assets are current assets because most of its sales involve cash, credit card, and debit card. Starbucks also has a significant amount of current liabilities. The company realizes the importance of maintaining its current liabilities at a level that will allow them to be paid when they are due. In short, the company's long-term profitability goals are directly linked to its ability to effectively manage its current liabilities and liquidity.

The accompanying partial balance sheet presents Starbucks Corporation's current assets and liabilities.

The financial statements of Starbucks, and other companies, will aid in your understanding of the important concepts related to current and contingent liabilities.

Source: Starbucks, Inc., Form 10-K, For the Fiscal Year Ended September 27, 2015.

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LO 1 - Identify the components of the Current Liability category of the balance sheet.

Module 1 Current Liabilities The balance sheet generally presents two categories of liabilities: current and long term. A current liability (Accounts that will be satisfied within one year or the current operating cycle. Alternate term: Short-term liability.) is an obligation that will be satisfied within one year. The face amount is generally used for all current liabilities because the time period involved is short enough that it is not necessary to record or calculate an interest factor.

Some companies list the accounts in the Current Liability category in the order of payment due date. That is, the account that requires payment first is listed first, the account requiring payment next is listed second, etc. This allows users of the statement to assess the cash- flow implications of each account. Starbucks presents the Accounts Payable account as the first current liability and that account likely requires payment first.

The current liability classification is important because it is closely tied to the concept of liquidity. Management of a firm must be prepared to pay current liabilities within a short time period. Therefore, management must have access to liquid assets, cash, or other assets that can be converted to cash in amounts sufficient to pay the current liabilities. Firms that do not have sufficient resources to pay their current liabilities are often said to have a liquidity problem.

Connect to the Real World 9-1

Starbucks: Reading the Balance Sheet

Refer to Starbucks' September 27, 2015, balance sheet in the chapter opener. What accounts are listed as current liabilities? How much did Accounts Payable change from 2014 to 2015?

A handy ratio to help creditors or potential creditors determine a company's liquidity is the current ratio—the ratio of current assets to current liabilities. A current ratio of 2 to 1 is usually a comfortable margin. If the firm has a large amount of inventory, it is sometimes

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useful to exclude inventory (prepayments are also excluded) when computing the ratio. That provides the “quick” ratio. Usually, a quick ratio of at least 1.5 to 1 would be preferred so that the company could pay its bills on time. Of course, the guidelines given for the current ratio 2 to 1 and the quick ratio 1.5 to 1 are only rules of thumb. The actual current and quick ratios of companies vary widely and depend on the company, the management policies, and the type of industry. Exhibit 9-1 presents the current and quick ratios for Starbucks and two of its competitors. The ratios vary from company to company, yet all are solid companies without liquidity problems. Note especially that the current ratio for Starbucks is less than 2 to 1 because of the nature of its business and because of the efficient use of its current assets.

Exhibit 9-1

Current and Quick Ratios of Selected Companies for 2015

Accounting for current liabilities is an area in which U.S. accounting standards are similar to those of most other countries. Nearly all countries encourage firms to provide a breakdown of liabilities into current and long term to allow users to evaluate liquidity.

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Accounts Payable

Accounts payable (Amounts owed for inventory, goods, or services acquired in the normal course of business.) represent amounts owed for the purchase of inventory, goods, or services acquired in the normal course of business. Accounts payable usually do not require the payment of interest, but terms may be given to encourage early payment. For example, terms may be stated as 2/10, n/30, which means that a 2% discount is available if payment occurs within the first ten days and that if payment is not made within ten days, the full amount must be paid within 30 days.

Timely payment of accounts payable is an important aspect of cash-flow management. Generally, it is to the company's benefit to take advantage of available discounts. If your supplier is going to give you a 2% discount for paying on Day 10 instead of Day 30, that means you are earning 2% on your money over 20/360 of a year. If you took the 2% discount throughout the year, you would be getting a 36% annual return on your money, since there are 18 periods of 20 days each in a year. Therefore, the accounts payable system must be established in a manner that alerts management to take advantage of discounts offered.

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Notes Payable

How is a note payable different from an account payable? The most important difference is that an account payable is not a formal contractual arrangement, whereas a note payable (Amounts owed that are represented by a formal contract.) is represented by a formal agreement or note signed by the parties to the transaction. Notes payable may arise from dealing with a supplier or from acquiring a cash loan from a bank or creditor. Those notes that are expected to be paid within one year of the balance sheet date should be classified as current liabilities.

The accounting for notes payable depends on whether the interest is paid on the note's due date or is deducted before the borrower receives the loan proceeds. With the first type of note, the terms stipulate that the borrower receives a short-term loan and agrees to repay the principal and interest at the note's due date.

How Will I Use Accounting?

If you are a broker in a real estate firm, you will need to understand current liabilities.

If your company needs a bank loan, the bank will analyze your liabilities carefully to see if you can pay back the loan.

Example 9-1

Recording the Interest on Notes Payable

Assume that Hot Coffee Inc. receives a one-year loan from First National Bank on January 1. The face amount of the note of $1,000 must be repaid on December 31 along with interest at the rate of 12%. Hot Coffee could identify and analyze the effect of the loan as follows:

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Banks also use another form of note, one in which the interest is deducted in advance. This is sometimes referred to as discounting a note.

Example 9-2

Discounting a Note

Suppose that on January 1, 2017, First National Bank granted to Hot Coffee a $1,000 loan, due on December 31, 2017, but deducted the interest in advance and gave Hot Coffee the remaining amount of $880 ($1,000 face amount of the note less interest of $120). On January 1, Hot Coffee could identify and analyze the effect of the loan as follows:

The Discount on Notes Payable (A contra-liability that represents interest deducted from a loan in advance.) account should be treated as a reduction of Notes Payable. If a balance sheet was developed immediately after the January 1 loan, the note would appear in the Current Liability category as follows:

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Study Tip

Discount on Notes Payable is a contra- liability account and will have a debit balance.

The original balance in the Discount on Notes Payable account represents interest that must be transferred to interest expense over the life of the note. Refer to Example 9-2. Before Hot Coffee presents its year-end financial statements, it must make an adjustment to transfer the discount to interest expense. The effect of the adjustment on December 31 is as follows:

Thus, the balance of the Discount on Notes Payable account is zero and $120 has been transferred to interest expense. When the note is repaid on December 31, 2017, Hot Coffee must repay the full amount of the note. The effect could be identified and analyzed as follows:

In the previous two examples, the stated interest rate on each note was 12%. The dollar amount of interest incurred in each case was $120. However, the interest rate on a discounted note, the second example, is always higher than it appears. Hot Coffee received the use of only $880, yet it was required to repay $1,000. Therefore, the interest rate incurred on the note was actually $120/$880, or approximately 13.6%.

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Current Maturities of Long-Term Debt

Some companies may have an account that is titled Current Portion of Long-Term Debt. On other companies' balance sheets, this item may appear as Current Maturities of Long- Term Debt (The portion of a long-term liability that will be paid within one year. Alternate term: Long-term debt, current portion.) . This account should appear when a firm has a long-term liability and must make periodic payments.

Example 9-3

Recording Current Maturities of Long-Term Debt

Assume that on January 1, 2017, your firm obtained a $10,000 loan from the bank. The terms of the loan require you to make payments in the amount of $1,000 per year for ten years payable each January 1 beginning January 1, 2018. On December 31, 2017, an entry should be made to classify a portion of the balance as a current liability. The effect could be identified and analyzed as follows:

The December 31, 2017, balance sheet should indicate that the liability for the note payable is classified into two portions: a $1,000 current liability that must be repaid within one year and a $9,000 long-term liability.

Refer to the information in Example 9-3. On January 1, 2018, the company must pay $1,000. The effect could be identified and analyzed as follows:

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On December 31, 2018, the company should again record the current portion of the liability. Therefore, the 2018 year-end balance sheet should indicate that the liability is classified into two portions: a $1,000 current liability and an $8,000 long-term liability. The process should be repeated each year until the bank loan has been fully paid. When an investor or a creditor reads a balance sheet, he or she wants to distinguish between debt that is long term and debt that is short term. Therefore, it is important to segregate the portion of the debt that becomes due within one year.

The balance sheet account labeled Current Portion of Long-Term Debt should include only the amount of principal to be paid. The amount of interest that has been incurred but is unpaid should be listed separately in an account such as Interest Payable.

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LO 2 - Examine how accruals affect the Current Liability category.

Taxes Payable

Corporations pay a variety of taxes, including federal and state income taxes, property taxes, and other taxes. Taxes are an expense of the business and should be accrued in the same manner as any other business expense. A company that ends its accounting year on December 31 is not required to calculate the amount of tax owed to the government until the following March 15 or April 15, depending on the type of business. Therefore, the business must make an accounting entry, usually as one of the year-end adjusting entries, to record the amount of tax that has been incurred but is unpaid. Normally, the effect could be identified and analyzed as follows:

The calculation of the amount of tax a business owes is very complex. For now, the important point is that taxes are an expense when incurred (not when paid) and must be recorded as a liability as incurred.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Other Accrued Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

Other Accrued Liabilities

Starbucks' 2015 balance sheet listed an amount of $1,269.3 million as current liability under the category of Accrued Liabilities. What items might be included in this category? Accrued liabilities (A liability that has been incurred but has not yet been paid.) include any amount that has been incurred due to the passage of time but has not been paid as of the balance sheet date. A common example is salary or wages payable.

Example 9-4

Recording Accrued Liabilities

Suppose that your firm has a payroll of $1,000 per day Monday through Friday and that employees are paid at the close of work each Friday. Also, suppose that December 31 is the end of your accounting year and that it falls on a Tuesday. The effect of the adjusting entry for salaries could be identified and analyzed as follows:

The amount of the salary payable would be classified as a current liability and could appear in a category such as Other Accrued Expenses.

Interest is another item that often must be accrued at year-end. Assume that you received a one-year loan of $10,000 on December 1. The loan carries a 12% interest rate. On December 31, an accounting entry must be made to record interest even though the money may not actually be due. The effect could be identified and analyzed as follows:

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The Interest Payable account should be classified as a current liability, assuming that it is to be paid within one year of the December 31 date.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Other Accrued Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money IFRS and Current Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

IFRS and Current Liabilities The accounting for current liabilities in U.S. and international standards is generally similar, but there are a few important differences. In this chapter, we have presented classified balance sheets with liabilities classified as either current or long term. Interestingly, U.S. standards do not require a classified balance sheet, and financial statements of some U.S. companies may list liabilities in order by size or by order of liquidity.

International accounting standards require companies to present classified balance sheets with liabilities classified as either current or long term. An unclassified balance sheet based on the order of liquidity is acceptable only when it provides more reliable information.

Module 1

Test Yourself

Question

1. What is the definition of current liabilities? Why is it important to distinguish between current and long-term liabilities?

2. Is the account Discount on Notes Payable an income statement or a balance sheet account? Does it have a debit or credit balance?

3. A firm's year ends on December 31. Its tax is computed and submitted to the U.S. Treasury on March 15 of the following year. When should the taxes be reported as a liability?

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Apply

1. A company has the following current assets: Cash, $10,000; Accounts Receivable, $70,000; and Inventory, $20,000. The company also has current liabilities of $40,000. Calculate the company's current ratio and quick ratio.

2. You receive an invoice from a supplier for $5,000 on January 1 with terms 3/15, n/30. If you pay between January 1 and January 16, how much must you pay? If you pay after January 16, how much must you pay?

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money IFRS and Current Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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LO 3 - Explain how changes in current liabilities affect the statement of cash flows.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 2 Cash Flow Effects Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

Module 2 Cash Flow Effects It is important to understand the impact that current liabilities have on a company's cash flows. Exhibit 9-2 illustrates the placement of current liabilities on the statement of cash flows (using the indirect method) and their effect. Most current liabilities are directly related to a firm's ongoing operations. Therefore, the change in the balance of each current liability account should be reflected in the Operating Activities category of the statement of cash flows. A decrease in a current liability account indicates that cash has been used to pay the liability and should appear as a deduction on the cash-flow statement. An increase in a current liability account indicates a recognized expense that has not yet been paid.

Exhibit 9-2

Current Liabilities on the Statement of Cash Flows

A partial statement of cash flows of Starbucks Corporation is presented in Exhibit 9-3. In 2015, the company has a positive amount of $137.7 million for Accounts Payable on the statement of cash flows and a positive amount of $87.6 million for Income Taxes Payable and a positive amount of $124.4 for Accrued Liabilities and Insurance Reserves. This is an indication that those accounts increased, resulting in an increase in cash.

Exhibit 9-3

Starbucks Corporation Partial Consolidated Statement of Cash Flows (In millions)

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Source: Starbucks, Inc., Form 10-K, For the Fiscal Year Ended September 27, 2015.

Almost all current liabilities appear in the Operating Activities category of the statement of cash flows, but there are exceptions. If a current liability is not directly related to operating activities, it should not appear in the Operating Activities category. For example, if Starbucks uses some notes payable as a means of financing, distinct from operating activities, those borrowings and repayments are reflected in the Financing Activities rather than the Operating Activities category.

Module 2

Test Yourself

Question

If a company has current liabilities that have increased during the year, how will they appear on the statement of cash flows? In what category?

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Will they appear as positive or negative amounts?

Apply

A company has the following current liabilities at the beginning of the period: Accounts Payable, $30,000; Taxes Payable, $10,000. At the end of the period, the balances of the account are as follows: Accounts Payable, $20,000; Taxes Payable, $15,000. What amounts will appear in the cash-flow statement? In what category of the statement will they appear?

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 2 Cash Flow Effects Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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LO 4 - Determine when contingent liabilities should be presented on the balance sheet or disclosed in notes and how to calculate their amounts.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 3 Contingent Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

Module 3 Contingent Liabilities Accountants must exercise a great deal of expertise and judgment in deciding what to record and in determining the amount to record. This is certainly true regarding contingent liabilities. A contingent liability (An existing condition for which the outcome is not known but depends on some future event. Alternate term: Contingent loss.) is an obligation that involves an existing condition for which the outcome is not known with certainty and depends on some event that will occur in the future. The actual amount of the liability must be estimated because we cannot clearly predict the future. The important accounting issues are whether contingent liabilities should be recorded and, if so, in what amounts.

This judgment call is normally resolved through discussions between a company's management and its outside auditors. Management would rather not disclose contingent liabilities until they come due because investors and creditors judge management based on the company's earnings, and the recording of a contingent liability must be accompanied by a charge to (reduction in) earnings. Auditors, on the other hand, want to see as much information as possible because they essentially represent the interests of investors and creditors who want to know as much as possible.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 3 Contingent Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Study Tip

Contingent liabilities are recorded only if they are probable and if the amount can be reasonably estimated.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Contingent Liabilities That Are Recorded Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

Contingent Liabilities That Are Recorded

A contingent liability should be accrued and presented on the balance sheet if it is probable and if the amount can be reasonably estimated. But when is an event probable, and what does reasonably estimated mean? The terms must be defined based on the facts of each situation. A financial statement user would want the company to err on the side of full disclosure. On the other hand, the company should not be required to disclose every remote possibility.

Product Warranties and Guarantees: Common Contingent Liabilities That Are Recorded

A common contingent liability that firms must present as a liability involves product warranties and guarantees. Many firms sell products for which they provide the customer a warranty against potential defects. If a product becomes defective within the warranty period, the selling firm ensures that it will repair or replace the item.

At the end of each period, the selling firm must estimate how many of the products sold in the current year will become defective in the future and the cost of repair or replacement. This type of contingent liability is often referred to as an estimated liability (A contingent liability that is accrued and reflected on the balance sheet.) to emphasize that the costs are not known at year-end and must be estimated.

Example 9-5

Recording a Liability for Warranties

Assume that Quickkey Computer sells a computer product for $5,000 with a one- year warranty in case the product must be repaired. Assume that in 2017, Quickkey sold 100 computers for a total sales revenue of $500,000. At the end of 2017, Quickkey must record an estimate of the warranty costs that will occur on 2017 sales. Using an analysis of past warranty records, Quickkey estimates that repairs will average 2% of total sales. The effect of the recording of warranty costs at the end of 2017 could be identified and analyzed as follows:

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The amount of warranty costs that a company presents as an expense is of interest to investors and potential creditors. If the expense as a percentage of sales begins to rise, a logical conclusion is that the product is becoming less reliable.

Warranties are an excellent example of the matching principle. In Example 9-5, the warranty costs related to 2017 sales were estimated and recorded in 2017. This was done to match the 2017 sales with the expenses related to those sales. When actual repairs of the computers occur in 2018, they do not result in an expense. The repair costs incurred in 2018 should be treated as a reduction in the liability that had been estimated previously. The ending balance of the Estimated Liability account can be calculated as:

A company must analyze past warranty records carefully and incorporate any changes in customer buying habits, usage, technological changes, and other changes. Still, even with careful analysis, the actual amount of the expense is not likely to equal the estimated amount. Generally, firms do not change the amount of the expense recorded in past periods for such differences. They may adjust the amount recorded in future periods, however.

Premiums or Coupons: Other Contingent Liabilities That Are Recorded

Another example of a contingent liability is premium or coupon offers that accompany many products. Cereal boxes often allow customers to purchase a toy or game at a reduced price if the purchase is accompanied by cereal box tops or proof of purchase. The offer given to cereal customers represents a contingent liability. At the end of each year, the cereal company must estimate the number of premium offers that will be redeemed and the cost involved and must report a contingent liability for that amount.

Some Lawsuits and Legal Claims Are Contingent Liabilities That Must Be Recorded

Legal claims that have been filed against a firm are also examples of contingent liabilities. Lawsuits and legal claims represent a contingent liability because an event has occurred but the outcome of that event, the resolution of the lawsuit, is not known. The defendant must make a judgment about the lawsuit's outcome to decide whether the item should be recorded on the balance sheet or disclosed in the notes. When the legal claim's outcome is likely to be unfavorable, a contingent liability should be recorded on the balance sheet. Exhibit 9-4 contains footnote disclosure of Burger King Corporation. Burger King was

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involved in a lawsuit that began in 2008 and continued through 2011. It appears that the company is facing an unfavorable outcome. In such cases, the company must decide when the liability should be recorded.

Exhibit 9-4

Note Disclosure of Contingencies for Burger King Corporation

On September 10, 2008, a class action lawsuit was filed against the Company in the United States District Court for the Northern District of California. The complaint alleged that all 96 Burger King restaurants in California leased by the Company and operated by franchisees violate accessibility requirements under federal and state law. In September 2009, the court issued a decision on the plaintiffs' motion for class certification. In its decision, the court limited the class action to the 10 restaurants visited by the named plaintiffs, with a separate class of plaintiffs for each of the 10 restaurants and 10 separate trials. In March 2010, the Company agreed to settle the lawsuit with respect to the 10 restaurants and, in July 2010, the court gave final approval to the settlement. In February 2011, a class action lawsuit was filed with respect to the other 86 restaurants. The plaintiffs sought injunctive relief, statutory damages, attorneys' fees and costs. In January 2012, BKC agreed to settle the lawsuit. The parties are finalizing the terms of the proposed settlement which will be submitted to the court for approval.

Source: Burger King Corporation, Form 10-K, For the Fiscal Year Ended December 31, 2011.

As you might imagine, firms are not eager to record contingent lawsuits as liabilities because the amount of loss is often difficult to estimate. Also, some may view the accountant's decision as an admission of guilt when a lawsuit is recorded as a liability before the courts have finalized a decision. Accountants often must consult with lawyers or other legal experts to determine the probability of the loss of a lawsuit. In cases involving contingencies, the accountant must make an independent judgment based on the facts and not be swayed by the desires of other parties.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Contingent Liabilities That Are Disclosed Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

Contingent Liabilities That Are Disclosed

Any contingent liability that is probable and that can be reasonably estimated must be reported as a liability. We now must consider contingent liabilities that do not meet the probable criterion or cannot be reasonably estimated. In either case, a contingent liability must be disclosed in the financial statement notes but not reported on the balance sheet if the contingent liability is at least reasonably possible. Most lawsuits are not recorded as liabilities because the risk of loss is not considered probable or the amount of the loss cannot be reasonably estimated. If a company does not record a lawsuit as a liability, it still must consider whether the lawsuit should be disclosed in the notes to the financial statements. When the risk of loss is at least reasonably possible, the company should provide note disclosure. This is the course of action taken for most contingent liabilities involving lawsuits. Readers of the financial statements and analysts must read the notes carefully to determine the impact of such contingent liabilities.

The amount and the timing of the cash outlays associated with contingent liabilities are especially difficult to determine. Lawsuits, for example, may extend several years into the future, and the dollar amount of possible loss may be subject to great uncertainty.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Contingent Liabilities versus Contingent Assets Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

Contingent Liabilities versus Contingent Assets

Contingent liabilities that are probable and can be reasonably estimated must be presented on the balance sheet before the outcome of the future events is known. This accounting rule applies only to contingent losses or liabilities. It does not apply to contingencies by which the firm may gain. Generally, contingent gains or contingent assets (An existing condition for which the outcome is not known but by which the company stands to gain. Alternate term: Contingent gain.) are not reported until the gain actually occurs. That is, contingent liabilities may be accrued but contingent assets are not accrued. Remember that accounting is a discipline based on a conservative set of principles. It is prudent and conservative to delay the recording of a gain until an asset is actually received but to record contingent liabilities in advance.

Even though the contingent assets are not reported, the information still may be important to investors. Investment analysts try to place a value on contingent assets that they believe will result in future benefits. By buying stock of a company that has unrecorded assets (or advising their clients to do so), analysts hope to make money when those assets become a reality.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money IFRS and Contingencies Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

IFRS and Contingencies There are very important differences between U.S. and international standards regarding contingencies. In international standards, the term contingent liability is used only for those items that are not recorded on the balance sheet but are disclosed in the notes that accompany the statements. International standards use the term provision for those items that must be recorded on the balance sheet. As in U.S. standards, an item should be recorded if the loss or outflow is probable and can be reasonably estimated. But the meaning of the term probable is somewhat different. In international standards, probable means the loss or outflow is “more likely than not” to occur. This is a lower threshold than in U.S. standards and may cause more items to be recorded as liabilities. Also, international standards require the amount recorded as a liability to be “discounted” or recorded as a present value amount, while U.S. standards do not have a similar requirement.

Module 3

Test Yourself

Question

1. What is a contingent liability? Why are contingent liabilities accounted for differently than contingent assets?

2. Assume that a lawsuit has been filed against your firm. Your legal counsel has assured you that a loss is not probable. How should the lawsuit be disclosed on the financial statements?

Apply

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Omega Company is involved in two unrelated lawsuits, one as the plaintiff and one as the defendant. As a result of these two lawsuits, the company has a contingent asset and a contingent liability. How should Omega record these on its balance sheet?

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money IFRS and Contingencies Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By) © 2018 Cengage Learning, Cengage Learning

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LO 5 - Explain the difference between simple and compound interest.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 4 Time Value of Money Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Module 4 Time Value of Money This section will discuss the impact that interest has on decision making because of the time value of money. The time value of money (An immediate amount should be preferred over an amount in the future.) concept means that people prefer a payment at the present time rather than in the future because of the interest factor. If an amount is received at the present time, it can be invested and the resulting accumulation will be larger than if the same amount is received in the future. Thus, there is a time value to cash receipts and payments.

Exhibit 9-5 indicates some of the personal and accounting decisions affected by the time value of money concept. In your personal life, you make decisions based on the time value of money concept nearly every day. When you invest money, you are interested in how much will be accumulated and you must determine the future value based on the amount of interest that will be compounded. When you borrow money, you must determine the amount of the loan payments. The amount of the loan payment is based on the present value of the loan, another time value of money concept.

Exhibit 9-5

Importance of the Time Value of Money

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Time value of money is also important because of its implications for accounting valuations. Chapter 10 explains that the issue price of a bond is based on the present value of the cash flows that the bond will produce. The valuation of the bond and the recording of the bond on the balance sheet are based on this concept. Further, the amount that is considered interest expense on the financial statements is also based on time value of money concepts. The bottom portion of Exhibit 9-5 indicates that the valuations of many other accounts, including Notes Receivable and Leases, are based on compound interest calculations.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Simple Interest Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Simple Interest

Simple interest (Interest is calculated on the principal amount only.) is interest earned on the principal amount. If the amount of principal is unchanged from year to year, the interest per year will remain the same. Interest can be calculated using the following formula:

where

For example, assume that a firm has signed a two-year note payable for $3,000. Interest and principal are to be paid at the due date with simple interest at the rate of 10% per year. The amount of interest on the note would be $600, calculated as $3,000 × 0.10 × 2. The firm would be required to pay $3,600 on the due date: $3,000 principal and $600 interest.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Compound Interest Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Compound Interest

Compound interest (Interest calculated on the principal plus previous amounts of interest. Alternate term: Interest on interest.) means that interest is calculated on the principal plus previous amounts of accumulated interest. Thus, interest is compounded, or there is interest on interest.

A comparison of the note payable with 10% simple interest with the note payable with 10% compound interest in Example 9-6 clearly indicates that the amount accumulated with compound interest is a higher amount because of the interest-on-interest feature.

Example 9-6

Calculating Compound Interest

Assume a $3,000 note payable for which interest and principal are due in two years with interest compounded annually at 10% per year. Interest would be calculated as follows:

We would be required to pay $3,630 at the end of two years, $3,000 principal and $630 interest.

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LO 6 - Calculate amounts using the future value and present value concepts.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Interest Compounding Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Interest Compounding

For most accounting problems, we will assume that interest is compounded annually. In actual business practice, compounding usually occurs over much shorter intervals. This can be confusing because the interest rate is often stated as an annual rate even though it is compounded over a shorter period. If compounding is not done annually, you must adjust the interest rate by dividing the annual rate by the number of compounding periods per year.

Example 9-7 illustrates that compounding more frequently results in a larger amount accumulated. In fact, many banks and financial institutions now compound interest on savings accounts on a daily basis.

Example 9-7

Compounding Interest Semiannually

Assume that the note payable from the previous example carried a 10% interest rate compounded semiannually for two years. The 10% annual rate should be converted to 5% per period for four semiannual periods. The amount of interest would be compounded, as in the previous example, but for four periods instead of two. The compounding process is as follows:

In the remainder of this section, we will assume that compound interest is applicable. The following four compound interest calculations must be understood:

Future value of a single amount

Present value of a single amount

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Future value of an annuity

Present value of an annuity

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Interest Compounding Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: Print By: Me) © 2018 Cengage Learning, Cengage Learning

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value and Future Value: Single Amounts Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Present Value and Future Value: Single Amounts

Future Value of a Single Amount

A future amount or future value is the amount of interest plus principal that will be accumulated at a future time. The future amount is always larger than the principal amount (payment) because of the interest that accumulates. In some cases, we will use time diagrams to illustrate the relationships. A time diagram to illustrate a future value would be of the following form:

The formula to calculate the future value of a single amount (Amount accumulated at a future time from a single payment or investment.) is as follows:

where

Example 9-8

Calculating Future Values with Formula

Your three-year-old son Robert inherits $50,000 in cash and securities from his grandfather. If the funds are left in the bank and in the stock market and receive an annual return of 10%, how much will be available in 15 years when Robert starts college?

Solution:

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Consider a $2,000 note payable that carries interest at the rate of 10% compounded annually. The note is due in two years, and the principal and interest must be paid at that time. The amount that must be paid in two years is the future value. The future value can be calculated in the manner used in the previous examples:

The future value can also be calculated by using the following formula:

Instead of a formula, other methods can be used to calculate future value. Tables can be constructed to assist in the calculations. Table 9-1 indicates the future value of $1 at various interest rates for various time periods. To find the future value of a two-year note at 10% compounded annually, you read across the line for two periods and down the 10% column, which gives you an interest rate factor of 1.21000. Because the table has been constructed for future values of $1, we would determine the future value of $2,000 as follows:

Table 9-1

Future Value of $1

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A second method is to use the built-in functions of a computerized spreadsheet. The appendix to this chapter will illustrate how to use a common spreadsheet, Microsoft Excel , to perform the same calculations. The numbers produced by each method may differ by a few dollars because of rounding differences.

Remember that compounding does not always occur annually. How does this affect the calculation of future value amounts?

Example 9-9

Calculating Future Values with Quarterly Compounding

Suppose we want to find the future value of a $2,000 note payable due in two years. The note payable requires interest to be compounded quarterly at the rate of 12% per year. To calculate the future value, we must adjust the interest rate to a quarterly basis by dividing the 12% rate by the number of compounding periods per year, which in the case of quarterly compounding is four:

Also, the number of compounding periods is eight—four per year times two years.

The future value of the note can be found in two ways. First, we can insert the proper values into the future value formula:

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We can arrive at the same future value amount with the use of Table 9-1. Refer to the interest factor in the table indicated for eight periods and 3%. The future value would be calculated as follows:

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Study Tip

When interest rates increase, present values decrease. This is called an inverse relationship.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value of a Single Amount Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Present Value of a Single Amount

In many situations, we want to determine the present amount that is equivalent to an amount at a future time. This is the present value concept. The present value of a single amount (The amount at a present time that is equivalent to a payment or an investment at a future time.) represents the value today of a single amount to be received or paid at a future time. This can be portrayed in a time diagram as follows:

The time diagram portrays discount rather than interest because we often speak of “discounting” the future payment back to the present time.

Example 9-10

Calculating Present Value of a Single Amount

Suppose you know that you will receive $2,000 in two years. If you had the money now, you could invest it at 10% compounded annually. What is the present value of the $2,000? In other words, what amount must be invested today at 10% compounded annually to have $2,000 accumulated in two years?

The formula used to calculate present value is as follows:

where

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We can use the present value formula to solve for the present value of the $2,000 note as follows:

Tables have also been developed to determine the present value of $1 at various interest rates and number of periods. Table 9-2 presents the present value or discount factors for an amount of $1 to be received at a future time. To use the table for Example 9-10, you must read across the line for two periods and down the 10% column to the discount factor of 0.82645. The present value of $2,000 would be calculated as follows:

Table 9-2

Present Value of $1

The example illustrates that the present value amount is always less than the future payment. This happens because of the discount factor. In other words, if we had a smaller amount at the present (the present value), we could invest it and earn interest that would

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accumulate to an amount equal to the larger amount (the future payment). Also, study of the present value and future value formulas indicates that each is the reciprocal of the other. When we want to calculate a present value amount, we normally use Table 9-2 and multiply a discount factor times the payment. However, we could also use Table 9-1 and divide by the interest factor. Thus, the present value of the $2,000 to be received in the future could also be calculated as follows:

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value and Future Value of an Annuity Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Present Value and Future Value of an Annuity

Future Value of an Annuity

Annuity (A series of payments of equal amounts.) means a series of payments of equal amounts. Suppose you are to receive $3,000 per year at the end of each of the next four years. Also, assume that each payment could be invested at an interest rate of 10% compounded annually. How much would be accumulated in principal and interest by the end of the fourth year? This is an example of an annuity of payments of equal amounts. A time diagram would portray the payments as follows:

Because we are interested in calculating the future value, we could use the future value of $1 concept and calculate the future value of each $3,000 payment using Table 9-1 as follows:

Note that four payments would be received but that only three of them would draw interest because the payments are received at the end of each period.

Fortunately, there is an easier method to calculate the future value of an annuity (The amount accumulated in the future when a series of payments is invested and accrues interest. Alternate term: Amount of an annuity.) . Table 9-3 has been constructed to indicate the future value of a series of payments of $1 per period at various interest rates and number of periods. The table can be used for the previous example by reading across the four-period line and down the 10% column to a table factor of 4.64100. The future value of an annuity of $3,000 per year can be calculated as follows:

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Table 9-3

Future Value of Annuity of $1

Example 9-11

Calculating Future Value of an Annuity

Your cousin had a baby girl two weeks ago and is already thinking about sending her to college. When the girl is 15, how much money would be in her college account if your cousin deposited $2,000 into it on each of her 15 birthdays? The interest rate is 10%. The future value could be calculated as follows.

What if the scenario was modified so that $1,000 was deposited semiannually and the interest rate was 10% compounded semiannually (or 5% per period) for 15 years? Table 9-3 could be used by reading across the line for 30 periods and down the column for 5% to obtain a table factor of 66.43885. The future value would be calculated as follows:

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Comparing the two scenarios illustrates once again that more frequent compounding results in larger accumulated amounts.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value of an Annuity Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Present Value of an Annuity

Many accounting applications of the time value of money concept concern situations for which we want to know the present value of a series of payments that will occur in the future. This involves calculating the present value of an annuity. An annuity is a series of payments of equal amounts.

Suppose you will receive an annuity of $4,000 per year for four years, with the first received one year from today. The amounts received can be invested at a rate of 10% compounded annually. What amount would you need at the present time to have an amount equivalent to the series of payments and interest in the future? To answer that question, you must calculate the present value of an annuity (The amount at a present time that is equivalent to a series of payments and interest in the future.) . A time diagram of the series of payments would appear as follows:

Because you are interested in calculating the present value, you could refer to the present value of $1 concept and discount each of the $4,000 payments individually using table factors from Table 9-2 as follows:

Tables have been constructed to ease the computational burden. Table 9-4 provides table factors to calculate the present value of an annuity of $1 per year at various interest rates and number of periods. The previous example can be solved by reading across the four- year line and down the 10% column to obtain a table factor of 3.16987. The present value would then be calculated as follows:

Table 9-4

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Present Value of Annuity of $1

Example 9-12

Calculating Present Value of an Annuity

You just won the lottery. You can take your $1 million in a lump sum today, or you can receive $100,000 per year over the next 12 years. Assuming a 5% interest rate, which would you prefer, ignoring tax considerations? The present value of the series of payments can be calculated as follows:

Solution:

Because the present value of the payments over 12 years is less than the $1 million immediate payment, you should take the immediate payment.

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LO 7 - Apply the compound interest concepts to some common accounting situations.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Solving for Unknowns Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Solving for Unknowns

In some cases, the present value or future value amounts will be known but the interest rate or the number of payments must be calculated. The formulas presented thus far can be used for such calculations.

Example 9-13

Solving for an Interest Rate

Assume that you have just purchased an automobile for $14,419 and must decide how to pay for it. Your local bank has graciously granted you a five-year loan. Because you are a good credit risk, the bank will allow you to make annual payments on the loan at the end of each year. The amount of the loan payments, which include principal and interest, is $4,000 per year. You are concerned that your total payments will be $20,000 ($4,000 per year for five years) and want to calculate the interest rate that is being charged on the loan.

Because the market or present value of the car, as well as the loan, is $14,419, a time diagram of the example would appear as follows:

The interest rate we must solve for represents the discount rate that was applied to the $4,000 payments to result in a present value of $14,419. Therefore, the applicable formula is the following:

In this case, PV is known, so the formula can be rearranged as follows:

You need to use Table 9-4 to find the interest rate. You must read across the five- year line until you find a table factor that is near the value of 3.605. In this case, that

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table factor of 3.60478 is found in the 12% column. Therefore, the rate of interest being paid on the auto loan is approximately 12%.

Example 9-14

Solving for the Number of Years

Assume that you want to accumulate $12,000 as a down payment on a home. You believe that you can save $1,000 per semiannual period, and your bank will pay interest of 8% per year, or 4% per semiannual period. How long will it take you to accumulate the desired amount?

The accumulated amount of $12,000 represents the future value of an annuity of $1,000 per semiannual period. Therefore, we can use the interest factors of Table 9- 3 to assist in the solution. The applicable formula in this case is the following:

The future value is known to be $12,000, and we must solve for the interest factor or table factor. Therefore, we can rearrange the formula as follows:

You need to use Table 9-3 and the 4% column to find a table value that is near 12.00. The closest table value you find is 12.00611. That table value corresponds to ten periods. Therefore, if $1,000 is deposited per semiannual period and the money is invested at 4% per semiannual period, it will take ten semiannual periods (five years) to accumulate $12,000.

Module 4

Test Yourself

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Question

1. What is the meaning of the terms present value and future value? How can you determine whether to calculate the present value or the future value of an amount?

2. What is the meaning of the word annuity? Can the present value of an annuity be calculated as a series of single amounts? If so, how?

3. Assume that you know the total dollar amount of a loan and the amount of the monthly payments. How can you determine the interest rate as a percentage of the loan?

Apply

1. You invest $1,000 at the beginning of the year. How much will be accumulated in five years if you earn 10% interest compounded annually?

2. You invest $1,000 per year at the end of each year for five years. How much will be accumulated in five years if you earn 10% interest compounded annually?

3. You will receive $1,000 in five years. What is the present value of that amount if you earn 10% interest compounded annually?

4. You will receive $1,000 per year at the end of each year for five years. What is the present value of that amount if you earn 10% interest compounded annually?

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Chapter Review Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: No one ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Appendix Accounting Tools: Using Excel for Problems Involving Interest Calculations

The purpose of this appendix is to illustrate how the functions built in to the Excel spreadsheet can be used to calculate future value and present value amounts. The use of Excel will be illustrated with the same examples that are used in this chapter.

To view the Excel functions, click on the PASTE function of the Excel toolbar (the paste function is on the top of the Excel toolbar and is noted by the symbol fx); then choose the FINANCIAL option. Several different calculations are available. We will illustrate two of them: FV and PV.

Example 9-15

Using Excel for Future Values

Solution: In Excel , use the FV function and enter the values as follows:

® ®

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Note that the future value of $208,862 is slightly different from that given in the body of the text because of rounding when using the table factors.

Example 9-16

Using Excel for Annual Compounding

Consider a $2,000 note payable that carries interest at the rate of 10% compounded annually. The note is due in two years, and the principal and interest must be paid at that time. What amount must be paid in two years?

Solution: In Excel , use the FV function and enter the values as follows:

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The future value is $2,420.

Example 9-17

Using Excel for Quarterly Compounding

Suppose we want to find the future value of a $2,000 note payable due in two years. The note payable requires interest to be compounded quarterly at the rate of 12% per year. What future amount must be paid in two years?

Solution: In Excel , use the FV function and enter the values as follows:

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The future value is $2,534 (rounded to the nearest dollar).

Example 9-18

Using Excel for Present Values

Suppose you know that you will receive $2,000 in two years. If you had the money now, you could invest it at 10% compounded annually. What is the present value of the $2,000?

Solution: Since this problem requires the calculation of a present value, the PV function of Excel should be chosen and used as follows:

The present value is $1,653 (rounded to the nearest dollar).

Example 9-19

Using Excel for Future Value of an Annuity

Suppose you are to receive $3,000 per year at the end of each of the next four years. Also, assume that each payment could be invested at an interest rate of 10% compounded annually. How much would be accumulated in principal and interest by the end of the fourth year?

Solution: This problem involves the calculation of the future value of an annuity; you should use the FV function of Excel as follows:

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The future value of the series of payments is $13,923. Note that the payments are simply entered as the Pmt variable in the spreadsheet.

Example 9-20

Using Excel for Semiannual Compounding Annuities

Solution: Use the Excel FV function as follows:

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The future value amount is $63,545 (rounded to the nearest dollar).

What if the scenario was modified so that $1,000 was deposited semiannually and the interest rate was 10% compounded semiannually (or 5% per period) for 15 years?

Solution Because the compounding is semiannual, use the FV function of Excel as follows:

The future value is $66,439 (rounded to the nearest dollar).

Example 9-21

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Using Excel for Present Value of an Annuity

Solution: Use the PV function of Excel as follows:

Because the present value of the payments over 12 years is $886,325 (rounded to the nearest dollar) and is less than the $1 million available immediately, you should choose the immediate payment.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Ratio Review Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Print By: Me © 2018 Cengage Learning, Cengage Learning

Chapter Review

Ratio Review

*Working capital is defined and discussed in Chapter 2.

**Quick assets are those assets that can be converted into cash quickly. They may be measured differently by different companies but generally are measured as Total Current Assets − Inventory − Prepaid Expenses.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Accounts Highlighted Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: Print By: Me) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Accounts Highlighted

Account Titles Where It Appears In What Section Cited on

Accounts Payable Balance Sheet

Current Liabilities Consolidated Balance Sheets

Notes Payable Balance Sheet

Current Liabilities Consolidated Balance Sheets

Current Maturities of Long- Term Debt

Balance Sheet

Current Liabilities Example 9-3

Taxes Payable Balance Sheet

Current Liabilities Taxes Payable

Accrued Liabilities Balance Sheet

Current Liabilities Other Accrued Liabilities

Contingent Liabilities Balance Sheet

Current Liabilities or Long-Term (depending upon when it will be paid)

Contingent Liabilities

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Current liability

Accounts payable

Notes payable

Discount on notes payable

Current maturities of long-term debt

Accrued liability

Contingent liability

Estimated liability

Contingent asset

Time value of money

Simple interest

Compound interest

Future value of a single amount

Present value of a single amount

Annuity

Future value of an annuity

Present value of an annuity

1. Accounts that will be satisfied within one year or the current operating cycle.

2. The amount at a present time that is equivalent to a series of payments and interest in the future.

3. Amounts owed for inventory, goods, or services acquired in the normal course of business.

4. A contra-liability that represents interest deducted from a loan in advance.

5. A series of payments of equal amounts.

6. The portion of a long-term liability that will be paid within one year of the balance sheet date.

7. A liability that has been incurred but has not yet been paid as of the balance sheet date.

8. Amounts owed that are represented by a formal contract.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Key Terms Quiz Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: Print By: Me) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Key Terms Quiz

Read each definition below and write the number of the definition in the blank beside the appropriate term. The quiz solutions appear at the end of the chapter.

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9. An existing condition for which the outcome is not known but depends on some future event.

10. Interest is calculated on the principal amount only.

11. A contingent liability that is accrued and reflected on the balance sheet.

12. An existing condition for which the outcome is not known but by which the company stands to gain.

13. Interest calculated on the principal plus previous amounts of interest.

14. An immediate amount should be preferred over an amount in the future.

15. Amount accumulated at a future time from a single payment or investment.

16. The amount accumulated in the future when a series of payments is invested and accrues interest.

17. The amount at a present time that is equivalent to a payment or an investment at a future time.

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Chapter 10 Long-Term Liabilities

Chapter Introduction

Module 1 Long-Term Liabilities Including Bonds Payable

Bonds Payable: Characteristics

Issuance of Bonds Factors Affecting Bond Price

Premium or Discount on Bonds

Module 2 Bond Amortization and Bond Retirement Effective Interest Method: Impact on Expense

Redemption of Bonds Retired Early at a Gain or a Loss

Financial Statement Presentation of Gain or Loss

Module 3 Liability for Leases Leases

IFRS and Leasing

Module 4 Analysis of Long-Term Liabilities and Cash Flow Issues

How Long-Term Liabilities Affect the Statement of Cash Flows

Chapter Review Module 5 Appendix: Deferred Tax

Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Multi-Concept Exercises

Problems

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Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

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Chapter Introduction

Making Business Decisions

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iStockphoto.com/asbe

Coca-Cola

Coca-Cola is truly a global corporation with more than 500 brands in almost 200 countries. While it began many years ago in the United States, now more than 70% of The Coca-Cola Company's income comes from business outside the United States.

To meet long-term growth objectives, Coca-Cola must make significant investments to support its products. The process also involves investment to develop new global brands and to acquire local or global brands when appropriate. In addition, the company makes significant marketing investments to encourage consumer loyalty. Coca-Cola has developed relationships with many sports organizations, including the NBA and NASCAR, to enhance consumer awareness and promote sales of its products. Outside the United States, there is a strong push to sell in many other markets, including India, Brazil, Africa, and Europe.

To expand profitably, Coca-Cola requires more money than it generates in profits. Therefore, it uses a common financing tool: long-term debt. The company monitors interest rate conditions carefully and in 2015 retired nearly $38 billion in long-term debt and replaced it with $40 billion in other debt. Because it is a global company, Coca-Cola has access to key financial markets around the world, which allows it to borrow at the lowest possible rates. While most of its loans are in U.S. dollars, management continually adjusts the composition of the debt to accommodate shifting interest rates and currency exchange rates to minimize the overall cost.

The accompanying balance sheet presents the Liabilities and Shareowners' Equity portion of the balance sheet for The Coca-Cola Company and its subsidiaries.

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Source: The Coca-Cola Company, Form 10-K, For the Fiscal Year Ended December 31, 2015.

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LO 1 - Identify the components of the Long- Term Liability category of the balance sheet.

Chapter 10: Long-Term Liabilities: Module 1 Long-Term Liabilities Including Bonds Payable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 1 Long-Term Liabilities Including Bonds Payable In general, long-term liabilities are obligations that will not be satisfied within one year. Essentially, all liabilities that are not classified as current liabilities are classified as long term. We will concentrate on the long-term liabilities of bonds or notes, leases, and deferred taxes. For example, the Noncurrent Liabilities section of PepsiCo, Inc.'s balance sheet is highlighted in Exhibit 10-1. PepsiCo has acquired financing through a combination of long-term debt, stock issuance, and internal growth or retained earnings. Exhibit 10-1 indicates that long-term debt is one portion of the Long-Term Liability (An obligation that will not be satisfied within one year or the current operating cycle.) category of the balance sheet. But the balance sheet also reveals two other items that must be considered part of the Long-Term Liability category: deferred income taxes and other liabilities. We will concentrate on these long-term liabilities:

Bonds or notes

Leases

Deferred taxes

Exhibit 10-1

PepsiCo's Balance Sheet

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Source: PepsiCo, Inc., Form 10-K, For the Fiscal Year Ended December 26, 2015.

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LO 2 - Define the important characteristics of bonds payable.

Bonds Payable: Characteristics A bond is a security or financial instrument that allows firms to borrow money and repay the loan over a long period of time. The bonds are sold, or issued, to investors who want a return on their investment. The borrower (issuing firm) promises to pay interest on specified dates, usually annually or semiannually. The borrower also promises to repay the principal on a specified date, the due date or maturity date.

A bond certificate, illustrated in Exhibit 10-2, is issued at the time of purchase and indicates the terms of the bond. Unlike the bond in the exhibit, bonds are issued usually in denominations of $1,000. The denomination of the bond is usually referred to as the face value (The principal amount of the bond as stated on the bond certificate. Alternate term: Par value.) or par value. This is the amount that the firm must pay at the maturity date of the bond.

Exhibit 10-2

Bond Certificate

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Firms issue bonds in very large amounts, often in millions in a single issue. After bonds are issued, they may be traded on a bond exchange in the same way that stocks are sold on the stock exchanges. Therefore, bonds are not always held until maturity by the initial investor, but may change hands several times before their eventual due date. Because bond maturities are as long as 30 years, the market for bonds already issued is a critical factor in a company's ability to raise money. Investors in bonds may want to sell them if interest rates paid by competing investments become more attractive or if the issuer becomes less creditworthy. Buyers of these bonds may be betting that interest rates will reverse course or that the company will get back on its feet.

How Will I Use Accounting?

If you are a financial advisor or bond fund manager, you will use accounting every day to analyze the creditworthiness, price, and yield of bonds. The most successful managers determine risk on a continual basis using their accounting and finance expertise.

Risk analysis is an art, not a science.

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Following are some important features that often appear in the bond certificate.

Collateral

The bond certificate should indicate the collateral of the loan. Collateral represents the assets that back the bonds in case the issuer cannot make the interest and principal payments and must default on the loan. Debenture bonds (Bonds that are not backed by specific collateral.) are not backed by specific collateral of the issuing company. Rather, the investor must examine the general creditworthiness of the issuer. If a bond is a secured bond, the certificate indicates specific assets that serve as collateral in case of default.

Due Date

The bond certificate specifies the date that the bond principal must be repaid. Normally, bonds are term bonds, meaning that the entire principal amount is due on a single date. Alternatively, bonds may be issued as serial bonds (Bonds that do not all have the same due date; a portion of the bonds comes due each time period.) , meaning that not all of the principal is due on the same date. For example, a firm may issue serial bonds that have a portion of the principal due each year for the next ten years. Issuing firms may prefer serial bonds because a firm does not need to accumulate the entire amount for principal repayment at one time.

Other Features

Some bonds are issued as convertible or callable bonds. Convertible bonds can be converted into common stock at a future time. This feature allows the investor to buy a security that pays a fixed interest rate but that can be converted at a future date into an equity security (stock) if the issuing firm is growing and profitable. The conversion feature is also advantageous to the issuing firm because convertible bonds normally carry a lower rate of interest.

Callable bonds (Bonds that may be redeemed or retired before their specified due date.) may be retired before their specified due date. Callable generally refers to the issuer's right to retire the bonds. If the buyer or investor has the right to retire the bonds, they are referred to as redeemable bonds. Usually, callable bonds stipulate the price to be paid at redemption; this price is referred to as the redemption price or the reacquisition price.

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LO 3 - Determine the issue price of a bond using compound interest techniques.

Study Tip

Issuance of Bonds

Factors Affecting Bond Price

With bonds payable, two interest rates are always involved: the face rate and the market rate.

1. The face rate of interest (The rate of interest on the bond certificate. Alternate term: Stated rate, nominal rate, contract rate, coupon rate.) (also called the stated rate, nominal rate, contract rate, or coupon rate) is the rate specified on the bond certificate. It is the amount of interest that will be paid each interest period.

For example, if $10,000 worth of bonds was issued with an 8% annual face rate of interest, interest of $800 ($10,000 × 8% × 1 year) would be paid at the end of each annual period.

Alternatively, bonds often require the payment of interest semiannually. If the bonds in the example required the 8% annual face rate to be paid semiannually (at 4%), interest of $400 ($10,000 × 8% × 1/2 year) would be paid each semiannual period.

2. The market rate of interest (The rate that investors could obtain by investing in other bonds that are similar to the issuing firm's bonds. Alternate term: Effective rate, bond yield.) (also called the effective rate or bond yield) is the rate that bondholders could obtain by investing in other bonds that are similar to the issuing firm's bonds.

The market rate of interest is determined by the bond market on the basis of many transactions for similar bonds. The market rate incorporates all of the “market's” knowledge about economic conditions and all of its expectations about future conditions. Normally, issuing firms try to set a face rate that is equal to the market rate. However, because the market rate changes daily, small differences usually occur between the face rate and the market rate at the time bonds are issued.

In addition to the number of interest payments and the maturity length of the

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Calculating the issue price of a bond always involves a calculation of the present value of the cash flows.

bond, both the face rate and the market rate of interest must be known to calculate the issue price of a bond. The bond issue price (The present value of the annuity of interest payments plus the present value of the principal.) equals the present value of the two types of cash flows that the bond will produce for the investor:

1. Interest receipts

2. Repayment of principal (face value)

The interest receipts constitute an annuity of payments each interest period over the life of the bonds. The repayment of principal (face value) is a one-time receipt that occurs at the end of the term of the bonds. The present value of the interest receipts (using Table 9-4) plus the present value of the principal amount (using Table 9-2) equals the issue price of the bond.

Example 10-1

Calculating Bond Issuance at a Discount

Suppose that on January 1, 2017, Discount Firm wants to issue bonds with a face value of $10,000. The face, or coupon, rate of interest has been set at 8%. The bonds will pay interest annually, and the principal amount is due in four years. Also, suppose that the market rate of interest for other similar bonds is currently 10%. Because the market rate of interest exceeds the coupon rate, investors will not be willing to pay $10,000. We want to calculate the amount that will be obtained from the issuance of Discount Firm's bonds.

Discount's bond will produce two sets of cash flows for the investor:

1. An annual interest payment of $800 ($10,000 × 8%) per year for four years.

2. Repayment of the principal of $10,000 at the end of the fourth year.

To calculate the issue price, we must calculate the present value of the two sets of cash flows. A time diagram portrays the cash flows as follows:

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We can calculate the issue price by using the compound interest tables found in Chapter 9, as follows:

The factors used to calculate the present value represent four periods and 10% interest.

The issue price of a bond is always calculated using the market rate of interest. The face rate of interest determines the amount of the interest payments, but the market rate determines the present value of the payments and the present value of the principal (and therefore the issue price).

The example of Discount Firm reveals that the bonds with a $10,000 face value amount would be issued for $9,366. The bond markets and the financial press often state the issue price as a percentage of the face amount. The percentage for Discount's bonds can be calculated as ($9,366/$10,000) × 100, or 93.66%.

Exhibit 10-3 illustrates how bonds are actually listed in the reporting of the bond markets. The exhibit lists two types of IBM bonds that were traded on a particular day. The portion immediately after the company name (e.g., 6⅜ 27) indicates that the face rate of interest is 6⅜% and the due date of the bonds is the year 2027. The next column, (e.g., 6.5) indicates that the bond investor who purchased the bonds on that day will receive a yield of 6.5%. The column labeled “Vol” indicates the number of bonds, in thousands that were bought and sold during the day. The column labeled “Close” indicates the market price of the bonds at the end of the day. For example, the first issue of IBM bonds closed at 98¾%, which means that the price was 98¾% of the face value of the bonds. These bonds are trading at a discount because the face rate (6⅜%) is less than the market rate of 6.5%. The bonds in the second issue (7¼%) have a face rate of 7¼%; will become due in the year 2028; and closed at 101½, or at a premium. The Net Chg column indicates the change in the bond price that occurred for the day's trading.

Exhibit 10-3

Listing of Bonds on the Bond Market

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Connect to the Real World 10-1

Coca-Cola: Reading the Balance Sheet

Coca-Cola lists three items as long-term liabilities on its 2015 balance sheet (shown in Coca-Cola's 2015 Consolidated Partial Balance Sheets). What are those items? Did they increase or decrease?

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LO 4 - Show that you understand the effect on the balance sheet of the issuance of bonds.

Premium or Discount on Bonds Premium (The excess of the issue price over the face value of the bonds.) or discount (The excess of the face value of bonds over the issue price.) represents the difference between the face value and the issue price of a bond. The relationship is stated as follows:

In other words, when issue price exceeds face value, the bonds have sold at a premium and when the face value exceeds the issue price, the bonds have sold at a discount.

We will continue with the Discount Firm in Example 10-1 to illustrate the accounting for bonds sold at a discount. Discount Firm's bonds sold at a discount calculated as follows:

Discount Firm would identify and analyze the effect of the issuance of the bonds as follows:

The Discount on Bonds Payable account is shown as a contra liability on the balance sheet as a deduction from Bonds Payable. If Discount Firm prepared a balance sheet immediately after the bond issuance, the following would appear in the Long-Term Liabilities category of the balance sheet:

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Now we will examine the opposite situation, when the face rate exceeds the market rate.

Example 10-2

Calculating Bond Issuance at a Premium

Suppose that on January 1, 2017, Premium Firm wants to issue the same bonds as in Example 10-1: $10,000 face value bonds with an 8% face rate of interest and with interest paid annually each year for four years. Assume, however, that the market rate of interest is 6% for similar bonds. The issue price is calculated as the present value of the annuity of interest payments plus the present value of the principal at the market rate of interest. The calculations are as follows:

We have calculated that the bonds would be issued for $10,693. The amount of the premium is calculated as follows:

Premium Firm could identify and analyze the effect of the issuance of the bonds as follows:

The account Premium on Bonds Payable is an addition to the Bonds Payable account. If Premium Firm presented a balance sheet immediately after the bond issuance, the Long- Term Liabilities category of the balance sheet would appear as follows:

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Study Tip

When interest rates increase, present values decrease. This is called an inverse relationship.

Note two important points from Discount Firm in Example 10-1 and Premium Firm in Example 10-2:

You should be able to determine whether a bond will sell at a premium or a discount by the relationship that exists between the face rate and the market rate of interest. Premium and discount do not mean “good” and “bad,” respectively. Premium or discount arises solely because of the difference that exists between the face rate and the market rate of interest for a bond issue. The same relationship always exists, so the following statements hold true:

The relationship between interest rates and bond prices is always inverse. The bonds of the two firms in Examples 10-1 and 10-2 are identical in all respects except for the market rate of interest. When the market rate was 10%, the bond issue price was $9,366 (Example 10-1). When the market rate was 6%, the bond issue price increased to $10,693 (Example 10-2). These examples illustrate that as interest rates decrease, prices on the bond markets increase and that as interest rates increase, bond prices decrease.

Module 1

Test Yourself

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Question

1. Which interest rate, the face rate or the market rate, should be used when calculating the issue price of a bond? Why?

2. What is the tax advantage that companies experience when bonds are issued instead of stock?

3. Does the issuance of bonds at a premium indicate that the face rate is higher or lower than the market rate of interest?

Apply

1. A bond payable is dated January 1, 2017, and is issued on that date. The face value of the bond is $100,000, and the face rate of interest is 8%. The bond pays interest semiannually. The bond will mature in five years.

a. What will be the issue price of the bond if the market rate of interest is 6% at the time of issuance?

b. What will be the issue price of the bond if the market rate of interest is 8% at the time of issuance?

c. What will be the issue price of the bond if the market rate of interest is 10% at the time of issuance?

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2. A bond with a face value of $10,000 is issued at a discount of $800 on January 1, 2017. The face rate of interest on the bond is 7%.

a. Was the market rate at the time of issuance greater than 7% or less than 7%?

b. If a balance sheet is presented on January 1, 2017, how will the bonds appear on the balance sheet?

c. If a balance sheet is presented on December 31, 2017, will the amount for the bonds be higher or lower than on January 1, 2017?

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LO 5 - Find the amortization of premium or discount using the effective interest method.

Chapter 10: Long-Term Liabilities: Module 2 Bond Amortization and Bond Retirement Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 2 Bond Amortization and Bond Retirement The amount of interest expense that should be reflected on a firm's income statement for bonds payable is the true, or effective, interest. The effective interest should reflect the face rate of interest as well as interest that results from issuing the bond at a premium or discount. To reflect that interest component, the amount initially recorded in the Premium on Bonds Payable or the Discount on Bonds Payable account must be amortized, or spread over the life of the bond.

Amortization refers to the process of transferring an amount from the discount or premium account to interest expense each time period to adjust interest expense. One commonly used method of amortization is the effective interest method.

To illustrate amortization of a discount, the issue price of the bond in Example 10-1 could be calculated as $9,366, resulting in a contra-liability balance of $634 in the Discount on Bonds Payable account. But what does the initial balance of the Discount account really represent? The discount should be thought of as additional interest that Discount Firm must pay over and above the 8% face rate. Remember that Discount received only $9,366 but must repay the full principal of $10,000 at the bond due date. For that reason, the $634 discount is an additional interest cost that must be reflected as interest expense by the process of amortization.

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Chapter 10: Long-Term Liabilities Effective Interest Method: Impact on Expense Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Effective Interest Method: Impact on Expense

The effective interest method of amortization (The process of transferring a portion of the premium or discount to interest expense; this method results in a constant effective interest rate. Alternate term: Interest method.) amortizes discount or premium in a manner that produces a constant effective interest rate from period to period, but the dollar amount of interest expense will vary from period to period. The interest rate is referred to as the effective interest rate and is equal to the market rate of interest at the time the bonds are issued. The effective interest rate is represented by the following:

The carrying value (The face value of a bond plus the amount of unamortized premium or minus the amount of unamortized discount. Alternate term: Book value.) of bonds is represented by the following:

The carrying value of the bonds for Discount Firm in Example 10-1 as of the date of issuance of January 1, 2017, could be calculated as follows:

In those situations in which there is a premium instead of a discount, carrying value is represented by the following:

The carrying value of the bonds for Premium Firm in Example 10-2 as of the date of issuance of January 1, 2017, could be calculated as follows:

As illustrated in Exhibit 10-4, the effective interest method of amortization for Discount Firm in Example 10-1 is based on several important concepts. The relationships can be stated in equation form as follows:

Exhibit 10-4

Discount Amortization: Effective Interest Method of Amortization

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Column 1 indicates that the cash interest to be paid is $800 ($10,000 × 8%). Column 2 indicates the annual interest expense at the effective rate of interest. The interest expense is calculated by multiplying the carrying value as of the beginning of the period by the market rate of interest. In 2017, the interest expense is $937 ($9,366 × 10%). Note that the amount of interest expense changes each year because the carrying value changes as discount is amortized. The amount of discount amortized each year in Column 3 is the difference between the cash interest in Column 1 and the interest expense in Column 2. Also, note that the amount of discount amortized changes in each of the four years. Finally, the carrying value in Column 4 is the previous year's carrying value plus the discount amortized in Column 3. When bonds are issued at a discount, the carrying value starts at an amount less than face value and increases each period until it reaches the face value amount.

Example 10-3

Recording Amortization of Discount

Exhibit 10-4 is the basis for determining the effect of amortization on the firm's financial statements. The effect of the payment of interest and amortization of discount is as follows:

The balance of the Discount on Bonds Payable account as of December 31, 2017, would be calculated as follows:

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Study Tip

Amortization of a discount increases interest expense. Amortization of a premium reduces interest expense.

In Example 10-3, the December 31, 2017, balance represents the amount unamortized, or the amount that will be amortized in future time periods. On the balance sheet presented as of December 31, 2017, the unamortized portion of the discount appears as the balance of the Discount on Bonds Payable account as follows:

The process of amortization would continue for four years, until the balance of the Discount on Bonds Payable account has been reduced to zero. By the end of 2020, all of the balance of the Discount on Bonds Payable account will have been transferred to the Interest Expense account and represents an increase in interest expense each period.

The amortization of a premium has an impact opposite that of the amortization of a discount. In Example 10-2, recall that on January 1, 2017, Premium Firm issued $10,000 face value bonds with a face rate of interest of 8%. At the time the bonds were issued, the market rate was 6%, resulting in an issue price of $10,693 and a balance in the Premium on Bonds Payable account of $693.

The amortization table in Exhibit 10-5 illustrates effective interest amortization of the bond premium for Premium Firm. As the exhibit illustrates, the following relationships still hold true:

Exhibit 10-5

Premium Amortization: Effective Interest Method of Amortization

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Column 1 indicates that the cash interest to be paid is $800 ($10,000 × 8%). Column 2 indicates the annual interest expense at the effective rate. In 2017, the interest expense is $642 ($10,693 × 6%). Note, however, two differences between Exhibits 10-4 and 10-5. In the amortization of a premium, the cash interest in Column 1 exceeds the interest expense in Column 2. Therefore, the premium amortized is defined as follows:

Also, note that the carrying value in Column 4 starts at an amount higher than the face value of $10,000 ($10,693) and is amortized downward until it reaches face value. Therefore, the carrying value at the end of each year is the carrying value at the beginning of the period minus the premium amortized for that year. For example, the carrying value in Exhibit 10-5 at the end of 2017 ($10,535) was calculated by subtracting the premium amortized for 2017 ($158 in Column 3) from the carrying value at the beginning of 2017 ($10,693).

Example 10-4

Recording Amortization of a Premium

Exhibit 10-5 is the basis for determining the effect of amortization of a premium on the firm's financial statements. Premium Firm could identify and analyze the effect of the payment of interest and amortization of premium as follows:

The balance of the Premium on Bonds Payable account as of December 31, 2017, would be calculated as follows:

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In Example 10-4, the December 31, 2017, balance represents the amount unamortized, or the amount that will be amortized in future time periods. On the balance sheet presented as of December 31, 2017, the unamortized portion of the premium appears as the balance of the Premium on Bonds Payable account as follows:

The process of amortization would continue for four years, until the balance of the Premium on Bonds Payable account has been reduced to zero. By the end of 2020, all of the balance of the Premium on Bonds Payable account will have been transferred to the Interest Expense account and represents a reduction of interest expense each period.

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LO 6 - Find the gain or loss on retirement of bonds.

Redemption of Bonds The term redemption refers to retirement of bonds by repayment of the principal. When bonds are retired on their due date, the accounting entry is not difficult. Refer again to Discount Firm from Examples 10-1 and 10-3. If Discount Firm retires its bonds on the due date of December 31, 2020, it must repay the principal of $10,000 and Cash is reduced by $10,000. No gain or loss is incurred because the carrying value of the bond at that point is $10,000.

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Chapter 10: Long-Term Liabilities Retired Early at a Gain or a Loss Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Retired Early at a Gain or a Loss

A firm may want to retire bonds before their due date for several reasons. A firm may simply have excess cash and determine that the best use of those funds is to repay outstanding bond obligations. Bonds also may be retired early because of changing interest rate conditions. If interest rates in the economy decline, firms may find it advantageous to retire bonds that have been issued at higher rates. Of course, what is advantageous to the issuer is not necessarily so for the investor. Early retirement of callable bonds is always a possibility that must be anticipated. Large institutional investors expect such a development and merely reinvest the money elsewhere. Many individual investors are more seriously inconvenienced when a bond issue is called.

Bond terms generally specify that if bonds are retired before their due date, they are not retired at the face value amount, but at a call price or redemption price indicated on the bond certificate. Also, the amount of unamortized premium or discount on the bonds must be considered when bonds are retired early. The retirement results in a gain or loss on redemption (The difference between the carrying value and the redemption price at the time bonds are redeemed.) that must be calculated as follows:

If the carrying value is higher than the redemption price, the issuing firm must record a gain. If the carrying value is lower than the redemption price, the issuing firm must record a loss.

Example 10-5

Calculating a Gain on Bond Redemption

Refer to Premium Firm from Example 10-4. Assume that on December 31, 2017, Premium Firm wants to retire its bonds due in 2020. Assume, as in the previous section, that the bonds were issued at a premium of $692 at the beginning of 2017. Premium Firm has used the effective interest method of amortization and has recorded the interest and amortization entries for the year. This has resulted in a balance of $535 in the Premium on Bonds Payable account as of December 31, 2017. Also, assume that Premium Firm's bond certificates indicate that the bonds may be retired early at a call price of 102 (meaning 102% of face value). Thus, the redemption price is 102% of $10,000, or $10,200.

Premium Firm's retirement of bonds would result in a gain. The gain can be calculated using two steps:

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Step 1.

Calculate the carrying value of the bonds as of the date they are retired. The carrying value of Premium Firm's bonds at that date is calculated as follows:

Note that the carrying value calculated is the same amount indicated for December 31, 2017, in Column 4 of the effective interest amortization table of Exhibit 10-5.

Step 2.

Calculate the gain:

When bonds are retired, the balance of the Bonds Payable account and the remaining balance of the Premium on Bonds Payable account must be eliminated from the balance sheet.

Example 10-6

Calculating a Loss on Bond Redemption

Refer to Premium Firm from Example 10-4. Assume that Premium Firm retires bonds at December 31, 2017, as in the previous section. However, assume that the call price for the bonds is 107 (or 107% of face value).

Again, the calculations can be performed in two steps:

Step 1.

Calculate the carrying value:

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Step 2.

Compare the carrying value with the redemption price to calculate the amount of the loss:

In Example 10-6, a loss of $165 means that Premium Firm paid more to retire the bonds than the amount at which the bonds were recorded on the balance sheet.

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Chapter 10: Long-Term Liabilities Financial Statement Presentation of Gain or Loss Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Financial Statement Presentation of Gain or Loss

The accounts Gain on Bond Redemption and Loss on Bond Redemption are income statement accounts. A gain on bond redemption increases Premium Firm's income; a loss decreases its income. While gains and losses should be treated as part of the company's operating income, some statement users may consider them as “one-time” events and choose to exclude them when predicting a company's future income. For that reason, it is helpful if companies present their gains and losses separately on the income statement so that readers can determine whether such amounts will affect future periods.

Module 2

Test Yourself

Question

1. How does the effective interest method of amortization result in a constant rate of interest?

2. Does amortization of a premium increase or decrease the bond carrying value? Does amortization of a discount increase or decrease the bond carrying value?

3. Is there always a gain or loss when bonds are redeemed? How is the gain or loss calculated?

Apply

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1. Bonds payable are dated January 1, 2017, and are issued on that date. The face value of the bonds is $100,000, and the face rate of interest is 8%. The bonds pay interest semiannually. The bonds will mature in five years. The market rate of interest at the time of issuance was 6%.

a. Using the effective interest amortization method, what amount should be amortized for the first six-month period? What amount of interest expense should be reported for the first six-month period?

b. Using the effective interest amortization method, what amount should be amortized for the period from July 1 to December 31, 2017? What amount of interest expense should be reported for the period from July 1 to December 31, 2017?

2. Refer to the previous exercise. Assume that the bonds are redeemed on December 31, 2017, at 102.

a. Calculate the gain or loss on bond redemption.

b. Identify and analyze the effect of the bond redemption.

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LO 7 - Determine whether a lease agreement must be reported as a liability on the balance sheet.

Module 3 Liability for Leases Leases are a major source of financing for many companies. Another liability, deferred taxes, is introduced in the appendix at the end of this chapter. In some cases, these liabilities are required to be reported on the financial statements and are important components of the Long-Term Liabilities section of the balance sheet. In other cases, the items are not required to be presented in the financial statements and can be discerned only by a careful reading of the notes to the financial statements.

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Leases

A lease, a contractual arrangement between two parties, allows one party, the lessee, the right to use an asset in exchange for making payments to its owner, the lessor. A common example of a lease arrangement is the rental of an apartment. The tenant is the lessee, and the landlord is the lessor.

Lease agreements are a form of financing. In some cases, it is more advantageous to lease an asset than to borrow money to purchase it. The lessee can conserve cash because a lease does not require a large initial cash outlay. Lease arrangements are popular because of their flexibility. The terms of a lease can be structured in many ways to meet the needs of the lessee and lessor. This results in difficult accounting questions:

1. Should the right to use property be reported as an asset by the lessee?

2. Should the obligation to make payments be reported as a liability by the lessee?

3. Should all leases be accounted for in the same manner regardless of the terms of the lease agreement?

The answers are that some leases should be reported as an asset and a liability by the lessee and some should not. The accountant must examine the terms of the lease agreement and compare those terms with an established set of criteria.

Lease Criteria

From the viewpoint of the lessee, there are two types of lease agreements: operating and capital. In an operating lease (A lease that does not meet any of the four criteria and is not recorded as an asset by the lessee.) , the lessee acquires the right to use an asset for a limited period of time. The lessee is not required to record the right to use the property as an asset or to record the obligation for payments as a liability. Therefore, the lessee is able to attain a form of off-balance-sheet financing. That is, the lessee has attained the right to use property but has not recorded that right, or the accompanying obligation, on the balance sheet. By escaping the balance sheet, the lease does not add to debt or impair the debt-to- equity ratio that investors usually calculate. Management has a responsibility to make sure that such off-balance-sheet financing is not, in fact, a long-term obligation.

In the second type of lease agreement, a capital lease (A lease that is recorded as an asset by the lessee.) (also called a finance lease), the lessee has acquired sufficient rights of ownership and control of the property to be considered its owner. The lease is called a capital lease or finance lease because it is capitalized (recorded) on the balance sheet by the lessee.

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A lease should be considered a capital lease or finance lease by the lessee when certain criteria are met.

If the criteria are met, the lease agreement is accounted for as an operating lease. In some cases, firms may take elaborate measures to evade or manipulate the criteria that would require lease capitalization. The accountant should determine what is full and fair disclosure based on an unbiased evaluation of the substance of the transaction.

Operating Leases

You have already accounted for operating leases in previous chapters when recording rent expense and prepaid rent. A rental agreement for a limited time period is also a lease agreement.

Example 10-7

Recording an Operating Lease

Suppose that Lessee Firm wants to lease a car for a new salesperson. A lease agreement is signed with Lessor Dealer on January 1, 2017, to lease a car for the year for $4,000, payable on December 31, 2017. Typically, a car lease does not transfer title at the end of the term, does not include a bargain-purchase price, and does not last for more than 75% of the car's life. In addition, the present value of the lease payments is not 90% of the car's value. Because the lease does not meet any of the specified criteria, it should be presented as an operating lease. Lessee Firm would simply record lease expense (or rent expense) of $4,000 for the year.

Although operating leases are not recorded on the balance sheet by the lessee, the FASB requires note disclosure of the amount of future lease obligations for leases that are considered operating leases. Exhibit 10-6 provides a portion of the note from Target's annual report of January 31, 2016, contained in the Form 10-K. Target has used operating leases as an important source of financing and has significant off-balance-sheet commitments in future periods as a result. An investor might want to add this off-balance- sheet item to the debt on the balance sheet to get a conservative view of the company's obligations.

Exhibit 10-6

Target's Note Disclosure of Leases, January 31, 2015

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Study Tip

It is called a capital lease because the lease is capital or put on the books of the lessee as an asset.

Source: Target, Form 10-K, For the Fiscal Year Ended January 31, 2015.

Capital Leases

Capital leases are presented as assets and liabilities by the lessee because they meet certain lease criteria.

Example 10-8

Calculating the Amount to Capitalize for a Lease

Suppose that Lessee Firm in Example 10-7 wanted to lease a car for a longer period of time. Assume that on January 1, 2017, Lessee signs a lease agreement with Lessor Dealer. The terms of the agreement specify that Lessee will make annual lease payments of $4,000 per year for five years, payable each December 31. Also, assume that the lease specifies that at the end of the lease agreement, the title to the car is transferred to Lessee Firm.

The lease should be treated as a capital lease by Lessee because it meets at least one of the four criteria. (It meets the first criteria concerning transfer of title.) A capital lease must be recorded at its present value by Lessee as an asset and as an obligation. As of January 1, 2017, we must calculate the present value of the annual payments. If we assume an interest rate of 8%, the present value of the payments is $15,972 (rounded) ($4,000 × an annuity factor of 3.99271 from Table 9-7).

The contractual arrangement between Lessee Firm and Lessor Dealer is called a lease agreement, but clearly the agreement is much different than a year-to-year lease arrangement. Essentially, Lessee Firm has acquired

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the right to use the asset for its entire life and does not need to return it to Lessor Dealer. Lessee has actually purchased the asset, with payments made over time.

For Example 10-8, the first entry is made on the basis of the present value. The effect of the lease could be identified and analyzed as follows:

The Leased Asset account is a long-term asset similar to plant and equipment and represents Lessee's right to use and retain the asset. Because the leased asset represents depreciable property, depreciation (or amortization) must be reported for each of the five years of asset use as follows. On December 31, 2017, Lessee records depreciation of $3,194 ($15,972/5 years), assuming that the straight-line method is adopted. The effect of the depreciation is as follows.

On December 31, Lessee Firm also must make a payment of $4,000 to Lessor Dealer. A portion of each payment represents interest on the obligation (loan), and the remainder represents a reduction of the principal amount. An effective interest table can be established using the same concepts used to amortize a premium or discount on bonds payable.

Exhibit 10-7 illustrates the effective interest method applied to Lessee Firm in Example 10-8. Note that the table begins with an obligation amount equal to the present value of the payments of $15,972. Each payment is separated into principal and interest amounts so that the amount of the loan obligation at the end of the lease agreement equals zero. The amortization table is the basis for the amounts that are reflected on the financial statement. Exhibit 10-7 indicates that the $4,000 payment in 2017 should be considered as interest of

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$1,278 (8% of $15,972) and reduction of principal of $2,722. On December 31, 2017, the effect of the annual lease payment is as follows:

Exhibit 10-7

Lease Amortization: Effective Interest Method of Amortization

For a capital lease, Lessee Firm must record both an asset and a liability. The asset is reduced by the process of depreciation. The liability is reduced by reductions of principal using the effective interest method. According to Exhibit 10-7, the total lease obligation as of December 31, 2017, is $13,250. This amount must be separated into Current and Long- Term categories. The portion of the liability that will be paid within one year of the balance sheet should be considered a current liability. Exhibit 10-7 indicates that the liability will be reduced by $2,940 in 2018 and that amount should be considered a current liability. The remaining amount of the liability, $10,310 ($13,250 – $2,940), should be considered long- term. On the balance sheet as of December 31, 2017, Lessee Firm reports the following balances related to the lease obligation:

Notice that the depreciated asset does not equal the present value of the lease obligation. This is not unusual. For example, an automobile may be completely depreciated but still

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have payments due on it.

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IFRS and Leasing

The accounting for leases is an excellent example of the differences in how U.S. and IFRS accounting standards are applied. Earlier in the text, we indicated that U.S. standards are often “rule-based” and international standards are “principles-based.” In the United States, the criteria to determine whether a lease contract should be considered a capital lease are applied in a rather rigid way. If a lease meets certain criteria, it must be accounted for as a capital lease. If it does not meet the criteria, even by a small margin, then it is considered an operating lease. The international accounting standards provide lease criteria that are similar to the U.S. standards. However, the criteria are used as “guidelines” rather than rigid rules. Therefore, there is much more flexibility in applying the lease standards when using the international standards.

Module 3

Test Yourself

Question

What are the reasons that not all leases are accounted for in the same manner? Do you think it would be possible to develop a new accounting rule that would treat all leases in the same manner? Explain.

Apply

You have signed an agreement to lease a car for four years and will make annual payments of $4,000 at the end of each year. (Assume that the lease meets the criteria for a capital lease.)

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a. Calculate the present value of the lease payments assuming an 8% interest rate.

b. Record the journal entry for the signing of the lease.

c. When the first lease payment is made, what portion of the payment will be considered interest?

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LO 8 - Explain how investors use ratios to evaluate long-term liabilities.

Chapter 10: Long-Term Liabilities: Module 4 Analysis of Long-Term Liabilities and Cash Flow Issues Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 4 Analysis of Long-Term Liabilities and Cash Flow Issues Long-term liabilities are a component of the “capital structure” of the company and are included in the calculation of the debt-to-equity ratio:

Most investors would prefer to see equity rather than debt on the balance sheet. Debt and its interest charges make up a fixed obligation that must be repaid in a finite period of time. In contrast, equity never has to be repaid and the dividends that are declared on it are optional. Stock investors view debt as a claim against the company that must be satisfied before they get a return on their money.

Another ratio used to measure the degree of debt obligation is the times interest earned ratio:

Lenders want to be sure that borrowers can pay the interest and repay the principal on a loan. This ratio reflects the degree to which a company can make its debt payment.

Making Business Decisions

PepsiCo

A.The Ratio Analysis Model

1. Formulate the Question

The use of debt is a good management strategy, but sometimes a company may have too much debt. The important questions to ask are:

What is the amount of debt in relation to the total equity of the company?

Will the company be able to meet its obligations related to the debt? That is, when an interest payment comes due, will the company have the ability to make the payment?

2. Gather the Information from the Financial Statements

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For those questions to be addressed, information from the balance sheet and the income statement needs to be collected and analyzed.

Total debt and total equity: From the balance sheet

Income before interest and tax: From the income statement

Interest expense from the income statement

3. Calculate the Ratios for PepsiCo, Inc.

4. Compare the Ratio with Others

PepsiCo's debt-to-equity ratio and times interest earned ratio should be compared to those of prior years and to those of companies in the same industry.

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5. Interpret the Results

PepsiCo and Coca-Cola are strong companies with a very safe balance of debt to equity. Both companies had a debt-to-equity ratio that increased from 2015 to 2014. This is probably the result of the low interest rates that existed during the year. Both companies have a small amount of interest obligations compared to their income available to meet those obligations. PepsiCo has 8.67 times more income than its interest expense for 2015, while Coca-Cola has 12.22. These ratios indicate that the creditors for both companies are confident that each company will be able to meet its interest obligations on its long-term debt.

B.The Business Decision Model

1. Formulate the Question

If you were a lender, would you be willing to lend money to PepsiCo, Inc., based on its use of debt?

2. Gather Information from the Financial Statements and Other Sources

This information will come from a variety of sources, not limited to but including:

The balance sheet provides information about the amount of debt and equity, the income statement regarding interest, and the statement of cash flows on inflows and outflows of cash.

The outlook for the industry, including consumer trends, foreign markets, labor issues, and other factors.

The outlook for the economy in general.

Alternative uses for the money.

3. Analyze the Information Gathered

Compare PepsiCo's ratios in (A) above with Coca-Cola's as well as with industry averages.

Look at trends over time in the use of debt by the companies.

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Review projections for the economy and the industry.

4. Make the Decision

Taking into account all of the various sources of information, decide either to

Lend money to PepsiCo or

Find an alternative use for the money

5. Monitor Your Decision

If you decide to lend money to the company, you will need to monitor your investment periodically. During the time of the investment, you will want to assess the company's debt levels as well as other factors you considered before making the investment.

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LO 9 - Explain the effects that transactions involving long-term liabilities have on the statement of cash flows.

Chapter 10: Long-Term Liabilities How Long-Term Liabilities Affect the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

How Long-Term Liabilities Affect the Statement of Cash Flows Exhibit 10-8 indicates the impact that long-term liabilities have on a company's cash flow and their placement on the cash flow statement. Most long-term liabilities are related to a firm's financing activities. Therefore, the change in the balance of each long-term liability account should be reflected in the Financing Activities category of the statement of cash flows. The decrease in a long-term liability account indicates that cash has been used to pay the liability. Therefore, in the statement of cash flows, a decrease in a long-term liability account should appear as a subtraction, or reduction. The increase in a long-term liability account indicates that the firm has obtained additional cash via a long-term obligation. Therefore, an increase in a long-term liability account should appear on the statement of cash flows as an addition.

Exhibit 10-8

Long-Term Liabilities on the Statement of Cash Flows

The statement of cash flows of The Coca-Cola Company is presented in Exhibit 10-9. Note that the Financing Activities category contains two items related to long-term liabilities. In 2015, long-term debt was issued for $40,434 million and is an addition to cash. This indicates that Coca-Cola increased its cash position by borrowings. Second, the payment of debt is listed as a deduction of $37,738 million. This indicates that Coca-Cola paid long-term liabilities, resulting in a reduction of cash.

Exhibit 10-9

The Coca-Cola Company and Subsidiaries' 2015 Consolidated Statements of Cash Flows

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Source: The Coca-Cola Company, Form 10-K, For the Fiscal Year Ended December 31, 2015.

Although most long-term liabilities are reflected in the Financing Activities category of the statement of cash flows, the Deferred Tax account (discussed in the appendix at the end of this chapter) is reflected in the Operating Activities category. This presentation is necessary because the Deferred Tax account is related to an operating item, income tax expense. For example, in Exhibit 10-9, Coca-Cola listed an addition of $73 million in the Operating Activities category of the 2015 statement of cash flows. This indicates that $73 million more was recorded as expense than was paid out in cash. Therefore, the amount is a positive amount in the Operating Activities category.

Module 4

Test Yourself

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Question

In what category of the statement of cash flows should the following items be shown? Should they appear as a positive or negative amount on the statement of cash flows?

Increase in long-term liabilities

Decrease in long-term liabilities

Interest expense

Depreciation expense on leased assets

Increase in deferred tax

Apply

Will Able Corporation's balance sheet showed the following amounts: Current Liabilities, $10,000; Bonds Payable, $3,000; Lease Obligations, $4,000; and Notes Payable, $600. Total stockholders' equity was $12,000. The debt-to-equity ratio is:

a. 0.63.

b. 0.83.

c. 1.42.

d. 1.47.

Chapter 10: Long-Term Liabilities How Long-Term Liabilities Affect the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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LO 10 - Explain deferred taxes and calculate the deferred tax liability.

Chapter Review

Module 5 Appendix: Deferred Tax

The financial statements of most major firms include an item titled Deferred Income Taxes or Deferred Tax. (See PepsiCo's deferred taxes in Exhibit 10-1 and Coca-Cola's in the chapter opening.) In most cases, the account appears in the Long-Term Liabilities section of the balance sheet, and the dollar amount may be large.

Deferred tax (The account used to reconcile the difference between the amount recorded as income tax expense and the amount that is payable as income tax.) is an amount that reconciles the differences between the accounting done for purposes of financial reporting to stockholders (“book” purposes) and the accounting done for tax purposes. U.S. firms are allowed to use accounting methods for financial reporting that differ from those used for tax calculations. The reason is that the IRS defines income and expense differently than does the FASB. As a result, companies tend to use accounting methods that minimize income for tax purposes but maximize income in the annual report to stockholders. This is not true in some foreign countries where financial accounting and tax accounting are more closely aligned. Firms in those countries do not report deferred tax because the difference between methods is not significant.

When differences between financial and tax reporting do occur, the differences can be classified into two types: permanent and temporary. Permanent differences (A difference that affects the tax records but not the accounting records, or vice versa.) occur when an item is included in the tax calculation and is never included for book purposes—or vice versa, when an item is included for book purposes but not for tax purposes. For example, the tax laws allow taxpayers to exclude interest on certain investments, usually state and municipal bonds, from their income. When a corporation buys these tax-exempt bonds, it does not have to declare the interest as income for tax purposes. When the corporation develops its income statement for stockholders (book purposes), however, the interest is included and appears in the Interest Income account. Therefore, tax-exempt interest represents a permanent difference between tax and book calculations.

Temporary differences (A difference that affects both book and tax records but not in the same time period. Alternate term: Timing difference.) occur when an item affects both book and tax calculations but not in the same time period. A difference caused by depreciation methods is the most common type of temporary difference. In previous chapters, you

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learned that depreciation may be calculated using a straight-line method or an accelerated method such as the double-declining-balance method. Most firms do not use the same depreciation method for book and tax purposes, however. Generally, straight-line depreciation is used for book purposes and an accelerated method is used for tax purposes because accelerated depreciation lowers taxable income—at least in early years—and therefore reduces the tax due. The IRS's Modified Accelerated Cost Recovery System (MACRS) is similar to other accelerated depreciation methods in that it allows the firm to take larger depreciation deductions for tax purposes in the early years of the asset and smaller deductions in the later years. Over the life of the depreciable asset, the total depreciation using straight-line is equal to that using MACRS. Therefore, this difference is an example of a temporary difference between book and tax reporting.

The Deferred Tax account is used to reconcile the differences between the accounting for book purposes and for tax purposes. It is important to distinguish between permanent and temporary differences because the FASB has ruled that not all differences should affect the Deferred Tax account. The Deferred Tax account should reflect temporary differences but not items that are permanent differences between book accounting and tax reporting.

Example 10-9

Calculation and Reporting Deferred Tax

Assume that Startup Firm begins business on January 1, 2017. During 2017, the firm has sales of $6,000 and has no expenses other than depreciation and income tax at the rate of 40%. Startup has depreciation on only one asset. That asset was purchased on January 1, 2017, for $10,000 and has a four-year life. Startup has decided to use the straight-line depreciation method for financial reporting purposes. Startup's accountants have chosen to use MACRS for tax purposes, however, resulting in $4,000 depreciation in 2017 and a decline of $1,000 per year thereafter.

The depreciation amounts for each of the four years for Startup's asset are as follows:

Startup's tax calculation for 2017 is based on the accelerated depreciation of $4,000, as follows:

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For 2017, Startup owes $800 of tax to the IRS. This amount is ordinarily recorded as tax payable until the time it is remitted.

What amount should be shown as tax expense on the income statement? Remember that the tax payable amount was calculated using the depreciation method that Startup chose for tax purposes. The income statement must be calculated using the straight-line method, which Startup uses for book purposes. Therefore, Startup's income statement for 2017 appears as follows:

In Example 10-9, Startup must make an accounting entry to record the amount of tax expense and tax payable for 2017. The effect is as follows:

The Deferred Tax account is a balance sheet account that is used to reconcile the differences between the accounting for book purposes and tax purposes. A balance in it reflects the fact that Startup has received a tax benefit by recording accelerated depreciation, in effect delaying the ultimate obligation to the IRS. The amount of deferred tax still represents a liability of Startup. The Deferred Tax account balance of $600 represents the amount of the 2017 temporary difference of $1,500 times the tax rate of 40%

What can you learn from Startup Firm in Example 10-9?

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First, when you see a firm's income statement, the amount listed as tax expense does not represent the amount of cash paid to the government for taxes. Accrual accounting procedures require that the tax expense amount be calculated using the accounting methods chosen for book purposes.

Second, when you see a firm's balance sheet, the amount in the Deferred Tax account reflects all of the temporary differences between the accounting methods chosen for tax and book purposes. The accounting and financial communities are severely divided on whether the Deferred Tax account represents a “true” liability. The FASB has taken the stance that deferred tax is an amount that results in a future obligation and meets the definition of a liability.

Module 5

Test Yourself

Question

1. Why do firms have a Deferred Tax account? Where should that account be shown on the financial statements?

2. How can you determine whether an item should reflect a permanent or a temporary difference when calculating the deferred tax amount?

Apply

On January 1, 2017, Deng Company purchased an asset for $100,000. For financial accounting purposes, the asset will be depreciated on a straight-line basis over five years with no residual value at the end of that time. For tax purposes, the asset will be depreciated as follows: 2017,

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$40,000; 2018, $30,000; 2019, $20,000; 2020, $10,000; and 2021, $0. Assume that the company is subject to a 40% tax rate.

a. What is the amount of deferred tax at December 31, 2017?

b. Does the deferred tax represent an asset or a liability?

c. What is the amount of deferred tax at December 31, 2021?

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Chapter Review

Ratio Review

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Chapter Review

Accounts Highlighted

Account Titles Where It Appears In What Section Cited on

Bonds Payable Balance Sheet Long-Term Liabilities Bonds Payable

Premium on Bonds Payable

Balance Sheet Long-Term Liabilities Premium on Bonds Payable

Discount on Bonds Payable

Balance Sheet Long-Term Liabilities as a contra account

Example 10-3

Gain on Bond Redemption

Income Statement

Other Income/Expense Example 10-5

Loss on Bond Redemption

Income Statement

Other Income/Expense Example 10-6

Leased Asset Balance Sheet Property, Plant, and Equipment

Leased Asset

Lease Obligation Balance Sheet Long-Term Liabilities Lease Obligation

Deferred Income Tax Balance Sheet May be Asset or Liability Deferred Income Tax

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Chapter 11 Stockholders' Equity

Chapter Introduction

Module 1 Stockholders' Equity, Issuance of Stock, and Treasury Stock Stockholders' Equity on the Balance Sheet

How Income and Dividends Affect Retained Earnings

Identifying Components of the Stockholders' Equity Section of the Balance Sheet

IFRS and Stockholders' Equity

Preferred Stock

Issuance of Stock Stock Issued for Cash

Stock Issued for Noncash Consideration

What Is Treasury Stock? Retirement of Stock

Module 2 Cash Dividends, Stock Dividends, and Stock Splits Cash Dividends

Cash Dividends for Preferred and Common Stock

Stock Dividends

Stock Splits

Module 3 Analysis and Cash Flow Issues What Is Comprehensive Income?

What Analyzing Stockholders' Equity Reveals About a Firm's Value Calculating Book Value When Preferred Stock Is Present

Market Value per Share

How Changes in Stockholders' Equity Affect the Statement of Cash Flows

Chapter Review

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Module 4 Sole Proprietorships and Partnerships

Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Problems

Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

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Chapter Introduction

Making Business Decisions

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E.J. Baumeister Jr./Alamy

Southwest Airlines

The airline industry is very volatile and has certainly experienced difficulties over the past few years. With reduced revenues, weak demand, high fixed costs, high fuel costs, and increasing expenses for security and insurance, the results for many of the airline companies have been grim. United Airlines and several other airlines declared bankruptcy in order to restructure, but throughout all of the bad times, Southwest Airlines has performed fairly well and has become the model for the future of the industry. The other airlines know that they must cut costs and become more efficient in order to compete with Southwest.

How does Southwest do it? Southwest Airlines Company provides short-haul, high- frequency, point-to-point, low-fare air transportation services. The company's operating strategy also permits Southwest to achieve high-asset utilization. Aircraft are scheduled to minimize the amount of time they sit at the gate, pegged at approximately 25 minutes, consequently reducing the number of aircraft and gate facilities that would otherwise be required.

Southwest Airlines has consistently been an innovator in the industry. In January 1995, Southwest introduced a ticketless travel option, eliminating the need to print and then process a paper ticket. Recently, Southwest has resisted the move by other airlines to charge flyers for checking a bag, thereby maintaining its identity for quality, customer- friendly service at a low cost.

All of the company's efforts are consistent with its financial strategy to build shareholder value, which contributes to the Stockholders' Equity portion of the balance sheet shown here.

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The company experienced a loss during the economic downturn of 2008 but has recovered and has been consistently profitable. As a result, the stockholders have benefited, and shareholder value will likely continue to grow.

This chapter, and the accompanying financial statements of Southwest Airlines and other companies, will help you to understand the Stockholders' Equity section of the balance sheet.

Source: Southwest Airlines Co., Form 10-K, For the Fiscal Year Ended December 31, 2015.

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LO 1 - Understand the concept of stockholders' equity and identify the components of the Stockholders' Equity category.

Chapter 11: Stockholders' Equity: Module 1 Stockholders' Equity, Issuance of Stock, and Treasury Stock Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 1 Stockholders' Equity, Issuance of Stock, and Treasury Stock

Financing can be divided into two general categories: debt (borrowing from banks or other creditors) and equity (issuing stock). The company's management must consider the advantages and disadvantages of each alternative. Exhibit 11-1 indicates a few of the factors that must be considered.

Exhibit 11-1

Advantages and Disadvantages of Stock versus Debt Financing

Issuing stock is a popular method of financing because of its flexibility. It provides advantages for the issuing company and the investors (stockholders). Investors are primarily concerned with the return on their investment. With stock, the return might be in the form of dividends paid to the investors but might also be the price appreciation of the stock. Stock is popular because it generally provides a higher rate of return (but also a

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higher degree of risk) than can be obtained by creditors who receive interest from lending money. Stock is popular with issuing companies because higher dividends can be paid when the firm is profitable; lower dividends, when it is not. Interest on debt financing, on the other hand, is generally fixed and is a legal liability that cannot be adjusted when a company experiences lower profitability.

There are several disadvantages in issuing stock. Stock usually has voting rights, and issuing stock allows new investors to vote. Existing investors may not want to share the control of the company with new stockholders. From the issuing company's viewpoint, there is also a serious tax disadvantage to stock versus debt. As indicated in Chapter 10, interest on debt is tax-deductible and results in lower taxes. Dividends on stock, on the other hand, are not tax-deductible and do not result in tax savings to the issuing company. Finally, issuing stock has an impact on the company's financial statements. Issuing stock decreases several important financial ratios, such as earnings per share. Issuing debt does not have a similar effect on the earnings per share ratio.

Management must consider many other factors in deciding between debt and equity financing. The company's goal should be financing the company in a manner that results in the lowest overall cost of capital to the firm. Usually, companies attain that goal by having a reasonable balance of both debt and equity financing.

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Chapter 11: Stockholders' Equity Stockholders' Equity on the Balance Sheet Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Stockholders' Equity on the Balance Sheet

Connect to the Real World 11-1

Southwest Airlines: Reading the Financial Statements

Refer to the Retained Earnings account of Southwest Airlines. Did the account increase or decrease from 2014 to 2015? What factors may cause the account to change?

The basic accounting equation for a corporation is as follows:

Stockholders' equity is viewed as a residual amount. That is, the owners of a corporation have a claim to all assets after the claims represented by liabilities to creditors have been satisfied.

The Stockholders' Equity category of all corporations has two major components or subcategories:

Contributed capital represents the amount the corporation has received from the sale of stock to stockholders. Retained earnings is the amount of net income the corporation has earned but not paid as dividends. Within these two categories, corporations use a variety of accounts that have several different titles.

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Chapter 11: Stockholders' Equity How Income and Dividends Affect Retained Earnings Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

How Income and Dividends Affect Retained Earnings

The Retained Earnings account serves as a link between the income statement and the balance sheet. The term articulated statements refers to the fact that the information on the income statement is related to the information on the balance sheet. The bridge (or link) between the two statements is the Retained Earnings account. Exhibit 11-2 presents this relationship graphically. As the exhibit indicates, the income statement is used to calculate a company's net income for a given period of time. The amount of the net income is transferred to the statement of retained earnings and is added to the beginning balance of retained earnings (with dividends deducted) to calculate the ending balance of retained earnings. The ending balance of retained earnings is portrayed on the balance sheet in the Stockholders' Equity category. That is why you must prepare the income statement before the balance sheet, as you discovered when developing financial statements in previous chapters of the text.

Exhibit 11-2

Retained Earnings Connects the Income Statement and the Balance Sheet

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Chapter 11: Stockholders' Equity Identifying Components of the Stockholders' Equity Section of the Balance Sheet Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Identifying Components of the Stockholders' Equity Section of the Balance Sheet

All corporations begin the Stockholders' Equity category with a list of the firm's contributed capital. In some cases, there are two categories of stock: common stock and preferred stock. (The latter is discussed later in this chapter.) Common stock normally carries voting rights. The common stockholders elect the corporation's officers and establish its bylaws and governing rules. Corporations often have more than one type of common stock, each with different rights or terms.

Number of Shares

It is important to determine the number of shares of stock for each stock account. Corporate balance sheets report the number of shares in three categories: authorized (The maximum number of shares a corporation may issue as indicated in the corporate charter.) , issued (The number of shares sold or distributed to stockholders.) , and outstanding shares (The number of shares issued less the number of shares held as treasury stock.) .

To become incorporated, a business must develop articles of incorporation and apply to the proper state authorities for a corporate charter. The corporation must specify the maximum number of shares that it will be allowed to issue. This maximum number of shares is called the authorized stock. A corporation applies for authorization to issue many more shares than it will issue immediately to allow for future growth and other events that may occur over its long life. For example, as shown, Southwest Airlines has 2,000,000,000 shares of common stock authorized, but only 807,611,634 shares had been issued as of December 31, 2015.

The number of shares issued indicates the number of shares that have been sold or transferred to stockholders. The number of shares issued does not necessarily mean, however, that those shares are currently outstanding. The term outstanding indicates shares actually in the stockholders' hands. Shares that have been issued by the corporation and then repurchased are counted as shares issued but not as shares outstanding. Quite often, corporations repurchase their own stock as treasury stock (explained in more detail later in this chapter). Treasury stock reduces the number of shares outstanding. The number of Southwest Airlines' shares of common stock outstanding at December 31, 2015, could be calculated as follows:

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Study Tip

Treasury stock is included in the number of shares issued. It is not part of the number of shares outstanding.

Par Value: The Firm's “Legal Capital”

The Stockholders' Equity category of many balance sheets refers to an amount as the par value of the stock. For example, Southwest Airlines' common stock has a par value of $1 per share. Par value (An arbitrary amount that represents the legal capital of the firm.) is an arbitrary amount stated on the face of the stock certificate and represents the legal capital of the corporation. Most corporations set the par value of the stock at very low amounts because there are legal difficulties if stock is sold at less than par. Therefore, par value does not indicate the stock's value or the amount that is obtained when the stock is sold on the stock exchange; it is simply an arbitrary amount that exists to fulfill legal requirements. A company's legal requirement depends on its state of incorporation. Some states do not require corporations to indicate a par value; other states require corporations to designate the stated value of the stock. A stated value is accounted for in the same manner as a par value and appears in the Stockholders' Equity category in the same manner as a par value.

The amount of the par value is the amount that is presented in the stock account. That is, the dollar amount in a firm's stock account can be calculated as its par value per share times number of shares issued. For Southwest Airlines, the dollar amount appearing in the Common Stock account can be calculated as follows:

Additional Paid-In Capital

The dollar amounts of the stock accounts in the Stockholders' Equity category do not indicate the amount that was received when the stock was sold to stockholders. The Common Stock and Preferred Stock accounts indicate only the par value of the stock. When stock is issued for an amount higher than the par value, the excess is reported as additional paid-in capital (The amount received for the issuance of stock in excess of the par value of the stock. Alternate term: Paid-in capital in excess of par.) . Several different titles are used for this account, including Capital in Excess of Par Value and Premium on Stock. Regardless of the title, the account represents the amount received in excess of par when stock was issued.

Southwest Airlines' balance sheet indicates paid-in capital of $1,374 million at December 31, 2015. The company, like many other corporations, presents only one amount for additional paid-in capital for all stock transactions. Therefore, we are unable to determine whether the amount resulted from the issuance of common stock or other stock transactions.

Connect to the Real World 11-2

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Chipotle: Reading the Financial Statements

Refer to Chipotle balance sheet for 2015 reproduced at the end of this book. Determine the number of shares of common stock authorized, issued, and outstanding at the balance sheet date.

Retained Earnings: The Amount Not Paid as Dividends

Retained earnings (Net income that has been made by the corporation but not paid out as dividends. Alternate term: Retained income.) represents net income that the firm has earned but has not paid as dividends. Remember that retained earnings is an amount that is accumulated over the entire life of the corporation and does not represent the income or dividends for a specific year. A balance in retained earnings does not indicate that the company had a net income of this amount in the current year; it simply means that over the life of the corporation, the company has retained more net income than it paid out as dividends to stockholders.

It is also important to remember that the balance of the Retained Earnings account does not mean that liquid assets of that amount are available to the stockholders. Corporations decide to retain income because they have needs other than paying dividends to stockholders. The needs may include the purchase of assets, the retirement of debt, or other financial needs. Money spent for those needs usually benefits the stockholders in the long run, but liquid assets equal to the balance of the Retained Earnings account are not necessarily available to stockholders.

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IFRS and Stockholders' Equity

The accounting for stockholders' equity under U.S. accounting rules is similar in most respects to the accounting under international accounting rules. However, there is one important difference regarding items that have characteristics of both debt and equity. For example, a convertible bond (discussed in Chapter 10) is in some ways similar to debt, but because it will become stock if converted, it also has the characteristics of equity. Under international accounting rules, an item such as this must be separated into two parts and one portion shown in the Liability category and another in the Stockholders' Equity category. U.S. accounting standards do not require such an item to be recorded as a separate amount. It is recorded as either a liability or an amount in stockholders' equity.

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LO 2 - Show that you understand the characteristics of common and preferred stock and the differences between the classes of stock.

Preferred Stock Many companies have a class of stock called preferred stock. One of the advantages of preferred stock is the flexibility it provides because its terms and provisions can be tailored to meet the firm's needs. Generally, preferred stock offers holders a preference to dividends declared by the corporation. That is, if dividends are declared, the preferred stockholders must receive dividends first, before the holders of common stock.

The dividend rate on preferred stock may be stated two ways:

1. It may be stated as a percentage of the stock's par value. For example, if a stock is presented on the balance sheet as $100 par, 7% preferred stock, its dividend rate is $7 per share ($100 × 7%).

2. The dividend may be stated as a per-share amount. For example, a stock may appear on the balance sheet as $100 par, $7 preferred stock, meaning that the dividend rate is $7 per share.

Investors in common stock should note the dividend requirements of the preferred shareholder. The greater the obligation to the preferred shareholder, the less desirable the common stock becomes.

In the event that a corporation is liquidated, or dissolved, preferred stockholders have a right to the company's assets before the common stockholders. Following are additional terms and features that may be associated with preferred stock:

Convertible (Allows preferred stock to be exchanged for common stock.) Preferred stock may allow stockholders the right to convert the stock into common stock.

Redeemable (Allows stockholders to sell stock back to the company.) Preferred stock may allow stockholders to redeem their stock at a specified price.

Callable (Allows the firm to eliminate a class of stock by paying the stockholders a specified amount.) Preferred stock may be callable at the option of the company. In this case, the company can choose to pay a specified amount to the stockholders in order to redeem or retire the stock.

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Cumulative (The right to dividends in arrears before the current-year dividend is distributed.) The dividend on preferred stock may be cumulative. When this is the case, dividends that are not paid are considered to be in arrears. Before a dividend on common stock can be declared in a subsequent period, the dividends in arrears as well as the current year's dividend must be paid to the preferred stockholders.

Participating (Allows preferred stockholders to share on a percentage basis in the distribution of an abnormally large dividend.) When preferred stock carries a participating feature, it allows the preferred stockholders to receive a dividend in excess of the regular rate when the firm has been particularly profitable and declares an abnormally large dividend.

Preferred stock is attractive to many investors because it offers a return in the form of a dividend at a level of risk that is lower than that of most common stocks. Usually, the dividend available on preferred stock is more stable from year to year; as a result, the market price of the stock is also more stable. In fact, when preferred stock carries certain provisions, the stock is very similar to bonds and notes payable. Management must evaluate whether such securities represent debt and should be presented in the Liability category of the balance sheet or whether they represent equity and should be presented in the Equity category. Such a decision involves the concept of substance over form. That is, a company must look not only at the legal form but also at the economic substance of the security to decide whether it is debt or equity.

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LO 3 - Determine the financial statement impact when stock is issued for cash or for other consideration.

Issuance of Stock

Stock Issued for Cash

When stock is issued for cash, the amount of its par value should be reported in the Stock account and the amount in excess of par should be reported in the Additional Paid-In Capital account.

As noted earlier, the Common Stock account and the Additional Paid-In Capital account are both presented in the Stockholders' Equity category of the balance sheet and represent the contributed capital component of the corporation.

If no-par stock is issued, the corporation does not distinguish between common stock and additional paid-in capital. If the firm in Example 11-1 had issued no-par stock on July 1 for $15 per share, the entire amount of $15,000 would have been presented in the Common Stock account.

Example 11-1

Recording Stock Issued for Cash

Assume that on July 1, a firm issued 1,000 shares of $10 par common stock for $15 per share. The effect of the issuance could be identified and analyzed as follows:

Chapter 11: Stockholders' Equity Issuance of Stock Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Chapter 11: Stockholders' Equity Stock Issued for Noncash Consideration Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Stock Issued for Noncash Consideration

Occasionally, stock is issued in return for something other than cash. For example, a corporation may issue stock to obtain land or buildings. When such a transaction occurs, the company faces the difficult task of deciding what value to place on the transaction. According to the general guideline, the transaction should be reported at fair market value. Market value may be indicated by the value of the consideration given (stock) or the value of the consideration received (property), whichever can be most readily determined.

Example 11-2

Recording Stock for Noncash Consideration

Assume that on July 1, a firm issued 500 shares of $10 par preferred stock to acquire a building. The stock is not widely traded, and the current market value of the stock is not evident. The building has recently been appraised by an independent firm as having a market value of $12,000. In this case, the issuance of the stock could be identified and analyzed as follows:

In other situations, the market value of the stock might be more readily determined and should be used as the best measure of the value of the transaction. The company should attempt to develop the best estimate of the market value of the noncash transaction and should neither intentionally overstate nor intentionally understate the assets received by the issuance of stock.

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LO 4 - Describe the financial statement impact of stock treated as treasury stock.

What Is Treasury Stock? The Stockholders' Equity category of Southwest Airlines' balance sheet in the chapter opener includes treasury stock (Stock issued by the firm and then repurchased but not retired.) in the amount of $3,182 million. The Treasury Stock account is created when a corporation buys its own stock sometime after issuing it. For an amount to be treated as treasury stock:

1. It must be the corporation's own stock.

2. It must have been issued to the stockholders at some point.

3. It must have been repurchased from the stockholders.

4. It must not be retired, but must be held for some purpose. Treasury stock is not considered outstanding stock and does not have voting rights.

A corporation might repurchase stock as treasury stock for several reasons. The most common reason is to have stock available to distribute to employees for bonuses or to make available as part of an employee benefit plan. Firms also might buy treasury stock to maintain a favorable market price for the stock or to improve the appearance of the firm's financial ratios. More recently, firms have purchased their stock to maintain control of the ownership and to prevent unwanted takeover or buyout attempts. Of course, the lower the stock price, the more likely a company is to buy back its own stock and wait for the shares to rise in value before reissuing them.

The two methods to account for treasury stock transactions are the cost method and the par value method. We will present the more commonly used cost method.

Example 11-3

Recording the Purchase of Treasury Stock

Assume that the Stockholders' Equity section of Rezin Company's balance sheet on December 31, 2017, appears as follows:

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Assume that on February 1, 2018, Rezin buys 100 of its shares as treasury stock at $25 per share. The effect of the purchase of treasury stock is as follows:

The purchase of treasury stock does not directly affect the Common Stock account. The Treasury Stock account is considered a contra account and is subtracted from the total of contributed capital and retained earnings in the Stockholders' Equity section. Treasury Stock is not an asset account. When a company buys its own stock, it is contracting its size and reducing the equity of stockholders. Therefore, Treasury Stock is a contra-equity account, not an asset.

The Stockholders' Equity section of Rezin's balance sheet on February 1, 2018, after the purchase of the treasury stock, appears as follows:

Corporations may choose to reissue stock to investors after it has been held as treasury stock. When treasury stock is resold for more than it cost, the difference between the sales price and the cost appears in the Additional Paid-In Capital—Treasury Stock account. For example, if Rezin resold 100 shares of treasury stock on May 1, 2018, for $30 per share, the

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Treasury Stock account would be reduced by $2,500 (100 shares times $25 per share) and the Additional Paid-In Capital—Treasury Stock account would be increased by $500 (100 shares times the difference between the purchase price of $25 and the reissue price of $30).

When treasury stock is resold for an amount less than its cost, the difference between the sales price and the cost is deducted from the Additional Paid-In Capital—Treasury Stock account. If that account does not exist, the difference should be deducted from the Retained Earnings account. For example, assume that Rezin Company had resold 100 shares of treasury stock on May 1, 2018, for $20 per share instead of $30 as in the previous example. Since Rezin has had no other treasury stock transactions, no balance existed in the Additional Paid-In Capital—Treasury Stock account. Rezin would then reduce the Treasury Stock account by $2,500 (100 shares times $25 per share) and would reduce Retained Earnings by $500 (100 shares times the difference between the purchase price of $25 and the reissue price of $20 per share). Thus, the Additional Paid-In Capital—Treasury Stock account may have a positive balance, but entries that result in a negative balance in the account should not be made.

Note that income statement accounts are never involved in treasury stock transactions. Regardless of whether treasury stock is reissued for more or less than its cost, the effect is reflected in the Stockholders' Equity accounts. It is simply not possible for a firm to engage in transactions involving its own stock and have the result affect the performance of the firm as reflected on the income statement.

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Retirement of Stock

Retirement of stock (When the stock is repurchased with no intention of reissuing at a later date.) occurs when a corporation buys back stock after it has been issued to investors and does not intend to reissue the stock. Retirement often occurs because the corporation wants to eliminate a particular class of stock or a particular group of stockholders. When stock is repurchased and retired, the balances of the Stock account and the Paid-In Capital account that were created when the stock was issued must be eliminated. When the original issue price is higher than the repurchase price of the stock, the difference is reflected in the Paid- In Capital from Stock Retirement account. When the repurchase price of the stock is more than the original issue price, the difference reduces the Retained Earnings account. The general principle for retirement of stock is the same as for treasury stock transactions. No income statement accounts are affected by the retirement. The effect is reflected in the Cash account and the Stockholders' Equity accounts.

Module 1

Test Yourself

Question

1. What are the two major components of stockholders' equity? Which accounts generally appear in each component?

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2. If a firm has a net income for the year, will the balance in the Retained Earnings account equal the net income? What is the meaning of the balance of the account?

3. What is treasury stock? Where does it appear on a corporation's financial statements?

Apply

1. Nash Company has the following accounts among the items on its balance sheet at December 31, 2017:

Develop the Stockholders' Equity section of the balance sheet for Nash Company at December 31, 2017.

2. Morris had the following transactions during 2017:

a. Issued 2,000 shares of $10 par common stock for cash at $17 per share.

b. Issued 1,000 shares of preferred stock to acquire land. The preferred stock has a par value of $5 per share. The land has been appraised at $7,000.

c. Issued 5,000 shares of $10 par common stock as payment to a company that provided advertising for the company. The stock was selling on the stock exchange at $12 per share at the time of issuance.

Record a journal entry for each transaction.

3. Indicate whether the following transactions increase, decrease, or have no effect on (a) total assets and on (b) total stockholders' equity.

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a. Issue 1,000 shares of common stock at $10 per share

b. Purchase 500 shares of common stock as treasury stock at $15 per share

c. Reissue 400 shares of treasury stock at $18 per share

d. Reissue 100 shares of treasury stock at $12 per share

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LO 5 - Compute the amount of cash dividends when a firm has issued both preferred and common stock.

Chapter 11: Stockholders' Equity: Module 2 Cash Dividends, Stock Dividends, and Stock Splits Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 2 Cash Dividends, Stock Dividends, and Stock Splits

Cash Dividends

Corporations may declare and issue several different types of dividends, the most common of which is a cash dividend to stockholders. Cash dividends may be declared quarterly, annually, or at other intervals. Normally, cash dividends are declared on one date, referred to as the date of declaration, and are paid out on a later date, referred to as the payment date. The dividend is paid to the stockholders who own the stock as of a particular date, the date of record.

Generally, two requirements must be met before the board of directors can declare a cash dividend. First, sufficient cash must be available by the payment date to pay to the stockholders. Second, the Retained Earnings account must have a sufficient positive balance, because dividends reduce the balance of the account. Most firms have an established policy concerning the portion of income that will be declared as dividends. The dividend payout ratio (The annual dividend amount divided by the annual net income; the percentage of earnings paid out as dividends.) is calculated as the annual dividend amount divided by the annual net income. The dividend payout ratio for many firms is 50% or 60% and seldom exceeds 70%. Typically, utilities pay a high proportion of their earnings as dividends. In contrast, fast-growing companies in technology often pay nothing to stockholders.

Cash dividends become a liability on the date they are declared. An accounting entry should be recorded on that date to acknowledge the liability and reduce the balance of the Retained Earnings account.

Example 11-4

Recording the Declaration of a Dividend

Assume that on July 1, the board of directors of Grant Company declared a cash dividend of $7,000 to be paid on September 1. The effect of the declaration of the dividend is as follows:

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Study Tip

A dividend is not an expense on the income statement. It is a reduction of retained earnings and appears on the retained earnings statement. If it is a cash dividend, it also reduces the cash balance when paid.

The Cash Dividend Payable account is a liability and is normally shown in the Current Liabilities section of the balance sheet.

Dividends reduce the amount of retained earnings when declared. When dividends are paid, the company reduces the liability to stockholders reflected in the Cash Dividend Payable account.

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Chapter 11: Stockholders' Equity Cash Dividends for Preferred and Common Stock Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Cash Dividends for Preferred and Common Stock

When cash dividends involving more than one class of stock are declared, the corporation must determine the proper amount to allocate to each class of stock. As indicated earlier, the amount of dividends to which preferred stockholders have rights depends on the terms and provisions of the preferred stock. The proper allocation of cash dividends is illustrated with an example of a firm that has two classes of stock: preferred and common.

Example 11-5

Computing Dividend Payments for Noncumulative Preferred Stock

Assume that on December 31, 2017, Stricker Company has outstanding 10,000 shares of $10 par, 8% preferred stock and 40,000 shares of $5 par common stock. Stricker was unable to declare a dividend in 2015 or 2016 but wants to declare a $70,000 dividend for 2017.

If the terms of the stock agreement indicate that the preferred stock is not cumulative, the preferred stockholders do not have a right to dividends in arrears. The dividends that were not declared in 2015 and 2016 are simply lost and do not affect the distribution of the dividend in 2017. Therefore, the cash dividend declared in 2017 is allocated between preferred and common stockholders as follows:

Example 11-6

Computing Dividend Payments for Cumulative Preferred Stock

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If the terms of the stock agreement in Example 11-5 indicate that the preferred stock is cumulative, the preferred stockholders have a right to dividends in arrears before the current year's dividend is distributed. Therefore, Stricker performs the following steps:

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LO 6 - Show that you understand the difference between cash and stock dividends and the effect of stock dividends.

Stock Dividends

Cash dividends are the most popular and widely used form of dividend, but at times, corporations may use stock dividends instead of or in addition to cash dividends. A stock dividend (The issuance of additional shares of stock to existing stockholders.) occurs when a corporation declares and issues additional shares of its own stock to existing stockholders. Firms use stock dividends for several reasons.

1. Stock dividends do not require the use of cash. A corporation may not have sufficient cash available to declare a cash dividend.

2. Stock dividends reduce the market price of the stock. The lower price may make the stock more attractive to a wider range of investors.

3. Stock dividends do not represent taxable income to recipients and may be attractive to some wealthy investors.

Similar to cash dividends, stock dividends are normally declared by the board of directors on a specific date and the stock is distributed to the stockholders at a later date. The corporation recognizes the stock dividend on the date of declaration.

Example 11-7

Recording a Small Stock Dividend

Assume that Shah Company's Stockholders' Equity category of the balance sheet appears as follows as of January 1, 2017:

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Assume that on January 2, 2017, Shah declares a 10% stock dividend to common stockholders to be distributed on April 1, 2017. Small stock dividends (usually those of 20% to 25%) normally are recorded at the market value of the stock as of the date of declaration. Assume that Shah's common stock is selling at $40 per share on that date. Therefore, the total market value of the stock dividend is $20,000 (10% of 5,000 shares outstanding, or 500 shares, times $40 per share). Shah records the transaction on the date of declaration and the effect is as follows:

The Common Stock Dividend Distributable account represents shares of stock to be issued; it is not a liability account because no cash or assets are to be distributed to the stockholders. Thus, it should be treated as an account in the Stockholders' Equity section of the balance sheet and is a part of the contributed capital component of equity.

Note that the declaration of a stock dividend does not affect the total stockholders' equity of the corporation, although the retained earnings are reduced. That is, the Stockholders' Equity section of Shah's balance sheet on January 2, 2017, is as follows after the declaration of the dividend:

The account balances are different, but total stockholders' equity is $150,000 both before and after the declaration of the stock dividend. In effect, retained earnings has been capitalized (transferred permanently to the contributed capital accounts). When a corporation actually issues a stock dividend, an amount from the Stock Dividend Distributable account must be transferred to the appropriate stock account.

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When a large stock dividend is declared (a stock dividend of more than 20% to 25% of the number of shares of stock outstanding), the stock dividend is reported at par value rather than at fair market value. Retained Earnings is decreased in the amount of the par value per share times the number of shares to be distributed.

Example 11-8

Recording the Declaration of a Large Stock Dividend

Refer to the Shah Company in Example 11-7. Assume that instead of a 10% dividend, on January 2, 2017, Shah declares a 100% stock dividend to be distributed on April 1, 2017. The stock dividend results in 5,000 additional shares being issued and certainly meets the definition of a large stock dividend. The effect of the declaration of the large stock dividend is as follows:

The effect when the stock is actually distributed is as follows:

The Stockholders' Equity category of Shah's balance sheet as of April 1 after the stock dividend is as follows:

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Again, note that the stock dividend has not affected total stockholders' equity. Shah has $150,000 of stockholders' equity both before and after the stock dividend. The difference between large and small stock dividends is the amount transferred from retained earnings to the Contributed Capital portion of equity.

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LO 7 - Determine the difference between stock dividends and stock splits.

Stock Splits

A stock split (The creation of additional shares of stock with a reduction of the par value of the stock.) is similar to a stock dividend in that it results in additional shares of stock outstanding and is nontaxable. In fact, firms may use a stock split for nearly the same reasons as a stock dividend: to increase the number of shares, reduce the market price per share, and make the stock more accessible to a wider range of investors. There is an important legal difference, however. Stock dividends do not affect the par value per share of the stock, whereas stock splits reduce the par value per share. There also is an important accounting difference. An accounting transaction is not recorded when a corporation declares and executes a stock split. None of the Stockholders' Equity accounts are affected by the split. Rather, the note information accompanying the balance sheet must disclose the additional shares and the reduction of the par value per share.

Note in Example 11-9 that the par value per share has been reduced from $10 to $5 per share of stock as a result of the split. Like a stock dividend, the split does not affect total stockholders' equity because no assets have been transferred. Therefore, the split simply results in more shares of stock with claims to the same net assets of the firm.

Example 11-9

Reporting a Stock Split

Refer to the Shah Company in Examples 11-7 and 11-8. Assume that on January 2, 2017, Shah issued a 2-for-1 stock split instead of a stock dividend. The split results in an additional 5,000 shares of stock outstanding but is not recorded in a formal accounting transaction. Therefore, the Stockholders' Equity section of Shah Company immediately after the stock split on January 2, 2017, is as follows:

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Module 2

Test Yourself

Question

1. What is a stock dividend? How should it be recorded?

2. Would you rather receive a cash dividend or a stock dividend from a company? Explain.

3. What is the difference between stock dividends and stock splits? How should stock splits be recorded?

Apply

1. At December 31, 2017, White Company has the following:

Common Stock, $10 par, 10,000 shares authorized, 9,000 issued, 8,000 outstanding

Indicate whether the following would increase, decrease, or have no effect on (a) assets, (b) retained earnings, and (c) total stockholders' equity.

a. A company declares and pays a cash dividend of $25,000.

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b. A company declares and issues a 10% stock dividend.

2. At December 31, 2017, Green Company and Blue Company have identical amounts of common stock and retained earnings as follows:

Common Stock, $10 par, 50,000 shares authorized, 9,000 issued, 9,000 outstanding

Retained Earnings, $500,000

At December 31, 2017, Green Company declares and issues a 100% stock dividend, while Blue Company declares and issues a 2-for-1 stock split.

Determine for each company the following amounts as of January 1, 2018:

Number of shares of common stock outstanding

Par value per share of the common stock

Total amount reported in Common Stock account

Retained earnings

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LO 8 - Show that you understand the statement of stockholders' equity and comprehensive income.

Chapter 11: Stockholders' Equity: Module 3 Analysis and Cash Flow Issues Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Module 3 Analysis and Cash Flow Issues In addition to a balance sheet, an income statement, and a cash flow statement, many annual reports contain a statement of stockholders' equity (Reflects the differences between beginning and ending balances for all accounts in the Stockholders' Equity category of the balance sheet.) . This statement explains the reasons for the difference between the beginning and ending balance of each account in the Stockholders' Equity category of the balance sheet. Of course, if the only changes are the result of income and dividends, a statement of retained earnings is sufficient. When other changes have occurred in Stockholders' Equity accounts, this more complete statement is necessary.

The statement of stockholders' equity of Fun Fitness, Inc., is presented in Exhibit 11-3 for the year 2017. The statement starts with the beginning balances of each of the accounts as of December 31, 2017.

Exhibit 11-3

Fun Fitness's Statement of Stockholders' Equity, 2017

The statement of stockholders' equity indicates the items or events that affected stockholders' equity during 2017. The items or events were as follows:

Item or Event Effect on Stockholders' Equity

Net earnings _________ Increased retained earnings by $64.0 million

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Item or Event Effect on Stockholders' Equity

Dividends _________ Decreased retained earnings by $25.0 million

Shares issued _________ Increased common stock by $5.0 million and

Increased paid-in capital by $39.0 million

The last line of the statement of stockholders' equity indicates the ending balances of the stockholders' equity accounts as of the balance sheet date, December 31, 2017. Note that each of the stockholders' equity accounts increased during 2017. The statement of stockholders' equity is useful in explaining the reasons for the changes that occurred.

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What Is Comprehensive Income?

There has always been some question about which items or transactions should be shown on the income statement and included in the calculation of net income. Generally, the accounting rule-making bodies have held that the income statement should reflect an all- inclusive approach. That is, all events and transactions that affect income should be shown on the income statement. This approach prevents manipulation of the income figure by those who would like to show “good news” on the income statement and “bad news” directly on the retained earnings statement or the statement of stockholders' equity. The result of the all-inclusive approach is that the income statement includes items that are not necessarily under management's control, such as losses from natural disasters, meaning that the income statement may not be a true reflection of a company's future potential.

The FASB has accepted certain exceptions to the all-inclusive approach and has allowed items to be recorded directly to the Stockholders' Equity category. This text discussed one such item: unrealized gains and losses on investment securities. Exhibit 11-4 presents several additional items that are beyond the scope of this text. Items such as these have been excluded from the income statement for various reasons. Quite often, the justification is a concern for the volatility of the net income number.

Exhibit 11-4

The Relationship between the Income Statement and the Statement of Comprehensive Income

Comprehensive income (The total change in net assets from all sources except investments by or distributions to the owners.) is the net assets increase resulting from all

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transactions during a time period (except for investments by owners and distributions to owners). Exhibit 11-4 presents the statement of comprehensive income and its relationship to the traditional income statement. It illustrates that comprehensive income encompasses all of the revenues and expenses that are presented on the income statement and includes items that are not presented on the income statement but affect total stockholders' equity.

The comprehensive income measure is truly all-inclusive because it includes transactions such as unrealized gains that affect stockholders' equity. Firms are required to disclose comprehensive income because it provides a more complete measure of performance.

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LO 9 - Understand how investors use ratios to evaluate stockholders' equity.

Chapter 11: Stockholders' Equity What Analyzing Stockholders' Equity Reveals About a Firm's Value Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

What Analyzing Stockholders' Equity Reveals About a Firm's Value Users of financial statements are often interested in computing the value of a corporation's stock. This is a difficult task because value is not a well-defined term and means different things to different users. One measure of value is the book value of the stock. Book value per share (Total stockholders' equity divided by the number of shares of common stock outstanding.) of common stock represents the rights that each share of common stock has to the net assets of the corporation. The term net assets refers to the total assets of the firm minus total liabilities. In other words, net assets equal the total stockholders' equity of the corporation. Therefore, when only common stock is present, book value per share is measured as follows:

The book value per share is the amount per share of net assets to which the company's common stockholders have the rights. Book value per share does not indicate the price that should be paid by those who want to buy or sell the stock on the stock exchange. Book value also is an incomplete measure of value because the corporation's net assets are normally measured on the balance sheet at the original cost, not at the current value of the assets.

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Chapter 11: Stockholders' Equity Calculating Book Value When Preferred Stock Is Present Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

Calculating Book Value When Preferred Stock Is Present

The focus of the computation of book value per share is always on the value per share of the common stock. Therefore, the computation must be adjusted for corporations that have both preferred and common stock. The numerator of the fraction, total stockholders' equity, should be reduced by the rights that preferred stockholders have to the corporation's net assets. Normally, this can be accomplished by deducting the redemption value or liquidation value of the preferred stock along with any dividends in arrears on cumulative preferred stock. The denominator should not include the number of shares of preferred stock.

To illustrate the computation of book value per share when both common and preferred stock are present, we refer to the Stockholders' Equity category of Workout Wonders, presented in Exhibit 11-5. When calculating book value per share, we want to consider only the common stockholders' equity. The company had total stockholders' equity in 2017 of $13,972 million, but preferred stockholders had a right to $500 million in the event of liquidation. Therefore, $500 million must be deducted to calculate the rights of the common stockholders:

Exhibit 11-5

Workout Wonders' Stockholders' Equity Section

The number of shares of common stock outstanding for the company is 1,782 million issued less 103 million of treasury stock. Therefore, the computation of book value per share is as follows:

If the company was liquidated and the assets sold at their recorded values, the common stockholders would receive $8.02 per share. Of course, if the company went bankrupt and had to liquidate assets at distressed values, stockholders would receive something less than book value.

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Study Tip

Transactions affecting the Stockholders' Equity category of the balance sheet will appear in the Financing Activities category of the cash flow statement. Dividends are included in the cash flow statement when they are paid rather than when they are declared.

Market Value per Share

The market value of the stock is a more meaningful measure of the value of the stock to those financial statement users interested in buying or selling shares of stock. The market value per share (The selling price of the stock as indicated by the most recent transactions.) is the price at which stock is currently selling. For example, the listing for Nike Inc. stock on the Internet may indicate the following:

The two left-hand columns indicate the stock price for the last 52-week period. Nike Inc. sold as high as $68.17 and as low as $39.17 during that time period. The right-hand portion indicates the high and low for the previous day's trading and the closing price. Nike sold as high as $43.30 per share and as low as $42.01 per share and closed at $42.93. For the day, the stock increased by 1.13%, or $0.48 per share.

The market value of the stock depends on many factors. Stockholders must evaluate a corporation's earnings and liquidity as indicated in the financial statements. They also must consider a variety of economic factors and project all of the factors into the future to determine the proper market value per share of the stock. Many investors use sophisticated investment techniques, including large databases, to identify factors that affect a company's stock price.

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LO 10 - Explain the effects that transactions involving stockholders' equity have on the statement of cash flows.

Chapter 11: Stockholders' Equity How Changes in Stockholders' Equity Affect the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits ) © 2018 Cengage Learning, Cengage Learning

How Changes in Stockholders' Equity Affect the Statement of Cash Flows

It is important to determine the effect that the issuance of stock, the repurchase of stock, and the payment of dividends have on the statement of cash flows. Exhibit 11-6 indicates how these stockholders' equity transactions affect cash flow and where the items should be placed on the statement of cash flows.

Exhibit 11-6

The Effect of Stockholders' Equity Items on the Statement of Cash Flows

The issuance of stock is a method to finance business. Therefore, the cash inflow from the sale of stock to stockholders should be reflected as an inflow in the Financing Activities section of the statement of cash flows. Generally, companies do not disclose separately the amount received for the par value of the stock and the amount received in excess of par. Rather, one amount is listed to indicate the total inflow of cash.

The repurchase or retirement of stock also represents a financing activity. Therefore, the cash outflow should be reflected as a reduction of cash in the Financing Activities section of the statement of cash flows. Again, companies do not distinguish between the amount paid for the par of the stock and the amount paid in excess of par.

How Will I Use Accounting?

If you are a portfolio manager, you will help clients meet their investing needs.

The income statement and the statement of cash flows are very useful in the analysis of companies because they tell the story of how a company's decisions have affected the value of that company. There is a great deal of information to be

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gleaned from these two statements—they provide a wealth of information to users of financial statements.

Dividends paid to stockholders represent a cost of financing the business with stock. Therefore, dividends paid should be reflected as a cash outflow in the Financing Activities section of the statement of cash flows. It is important to distinguish between the declaration of dividends and the payment of dividends. The cash outflow occurs at the time the dividend is paid and should be reflected on the statement of cash flows in that period.

The 2015 partial statement of cash flows for Southwest Airlines Co. is shown in Exhibit 11-7. During 2015, the company had considerable cash outflows associated with its long-term debt and capital lease obligations of $213 million. The company had additional cash outflows for payments of dividends of $180 million and repurchases of common stock of $1,180 million.

Exhibit 11-7

Southwest Airlines Co.'s Partial Statement of Cash Flows

Source: Southwest Airlines Co., Form 10-K, For the Fiscal Year Ended December 31, 2015.

Module 3

Test Yourself

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Question

1. How is the book value per share calculated? Does the amount calculated as book value per share mean that stockholders will receive a dividend equal to the book value?

2. Can the market value per share of stock be determined by the information on the income statement?

3. What is the difference between a statement of stockholders' equity and a retained earnings statement?

Apply

1. Deer Company has the following amounts in the Stockholders' Equity category of the balance sheet at December 31, 2017:

Determine the book value per share of the Deer Company stock.

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2. For each of the following items, indicate (a) in what category of the statement of cash flows the item will be reported and (b) whether it will appear as a cash inflow, cash outflow, or neither.

Issuance of common stock for cash

Purchase of treasury stock

Issuance of a stock dividend

Reissuance of treasury stock

Issuance of common stock to acquire land

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LO 11 - Describe the important differences between the sole proprietorship and partnership forms of organization versus the corporate form (Appendix).

Chapter Review

Module 4 Sole Proprietorships and Partnerships

The focus of Chapter 11, as with the rest of the text, has been on the corporate form of organization. Most of the large, influential companies in the United States are organized as corporations. They have a legal and economic existence that is separate from that of the owners of the business, the stockholders. Yet many other companies in the economy are organized as sole proprietorships or partnerships. The purpose of this appendix is to show briefly how the characteristics of such organizations affect the accounting, particularly the accounting for the Owners' Equity category of the balance sheet.

Sole Proprietorships

A sole proprietorship (A business with a single owner.) is a business owned by one person. Most sole proprietorships are small in size, with the owner serving as the operator or manager of the company. The primary advantage of the sole proprietorship form of organization is its simplicity. The Owners' Equity category of the balance sheet consists of one account, the owner's capital account. The owner answers to no one but himself or herself. A disadvantage of the sole proprietorship is that all responsibility for the success or failure of the venture attaches to the owner, who often has limited resources.

There are three important points to remember about this form of organization:

1. A sole proprietorship is not a separate entity for legal purposes. This means that the law does not distinguish between the assets of the business and those of its owner. If an owner loses a lawsuit, for example, the law does not limit an owner's liability to the amount of assets of the business, but extends liability to the owner's personal assets. Thus, the owner is said to have unlimited liability.

2. Accountants adhere to the entity principle and maintain a distinction between the owner's personal assets and the assets of the sole proprietorship. The balance sheet of a sole proprietorship should reflect only the “business” assets and liabilities, with the difference reflected as owner's capital.

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3. A sole proprietorship is not treated as a separate entity for federal income tax purposes. That is, the sole proprietorship does not pay tax on its income. Rather, the business income must be declared as income on the owner's personal tax return, and income tax is assessed at the personal tax rate rather than the rate that applies to companies organized as corporations. This may or may not be advantageous depending on the amount of income involved and the owner's tax situation.

Typical Transactions

When the owners of a corporation, the stockholders, invest in the corporation, they normally do so by purchasing stock. When investing in a sole proprietorship, the owner simply contributes cash or other assets to the business.

Example 11-10

Recording Investments in a Sole Proprietorship

Assume that on January 1, 2017, Peter Tom began a new business by investing $10,000 cash. The effect of the investment by the owner is as follows:

The Peter Tom, Capital account is an owner's equity account and reflects the rights of the owner to the business assets.

An owner's withdrawal of assets from the business is recorded as a reduction of owner's equity. Assume that on July 1, 2017, Peter Tom took an auto valued at $6,000 from the business to use as his personal auto. The effect of the withdrawal is as follows:

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The Peter Tom, Drawing account is a contra-equity account. Sometimes a drawing account is referred to as a withdrawals account, as in Peter Tom, Withdrawals. An increase in the account reduces the owner's equity. At the end of the fiscal year, the drawing account should be closed to the capital account and the effect is as follows:

The amount of the net income of the business also should be reflected in the capital account. Assume that all revenue and expense accounts of Peter Tom Company have been closed to the Income Summary account, resulting in a balance of $4,000, the net income for the year. The Income Summary account is closed to capital and the effect is as follows:

The Owner's Equity section of the balance sheet for Peter Tom Company consists of one account, the capital account, calculated as follows:

Partnerships

A partnership (A business owned by two or more individuals that has the characteristic of unlimited liability that has the characteristic of unlimited liability.) is a company owned by two or more people. Like sole proprietorships, most partnerships are fairly small businesses formed when individuals combine their capital and managerial talents for a common

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business purpose. Other partnerships are large, national organizations. For example, the major public accounting firms are very large, national companies but are organized in most states as partnerships.

Partnerships have characteristics similar to those of sole proprietorships. The following are the most important characteristics of partnerships:

1. Unlimited liability

Legally, the assets of the business are not separate from the partners' personal assets.

Each partner is personally liable for the debts of the partnership.

Creditors have a legal claim first to the assets of the partnership and then to the assets of the individual partners.

2. Limited life

Partnerships do not have a separate legal existence and an unlimited life. The life of a partnership exists only so long as the contract between the partners is valid.

The partnership ends when a partner withdraws or a new partner is added. A new partnership must be created for the business to continue.

3. Not taxed as a separate entity

Partnerships are subject to the same tax features as sole proprietorships.

The partnership itself does not pay federal income tax. Rather, the income of the partnership is treated as personal income on each of the partners' individual tax returns and is taxed as personal income.

All partnership income is subject to federal income tax on the individual partners' returns even if it is not distributed to the partners.

A variety of other factors affects the tax consequences of partnerships versus the corporate form of organization. Those aspects are quite complex and beyond the scope of this text.

A partnership is based on a partnership agreement (Specifies how much the owners will invest, what their salaries will be, and how profits will be shared.) . The agreement should be in writing and should detail items such as how much capital each partner is to invest, how much time each partner is expected to devote to the business, what the salary of each partner is, and how income of the partnership is to be divided. If a partnership agreement is not present, the courts may be forced to settle disputes between partners. Therefore, the

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partners should develop a partnership agreement when the firm is first established and review the agreement periodically to determine if changes are necessary.

Investments and Withdrawals

In a partnership, it is important to account separately for the capital of each partner. A capital account should be established in the Owners' Equity section of the balance sheet for each partner. Investments into the company should be credited to the partner making the investment.

Example 11-11

Recording Investments in a Partnership

Assume that on January 1, 2017, Paige Thoms and Amy Rebec begin a partnership named AP Company. Paige contributes $10,000 cash, and Amy contributes equipment valued at $5,000. The effect of the investment is as follows:

A drawing account also should be established for each owner of the company to account for withdrawals of assets. Assume that on April 1, 2017, each owner withdraws $2,000 of cash from AP Company. The effect of the withdrawl is as follows:

Distribution of Income

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The partnership agreement governs the manner in which income should be allocated to partners. The distribution may recognize the partners' relative investment in the business, their time and effort, their expertise and talents, or other factors. Three methods of income allocation will be illustrated, but be aware that partnerships use many other allocation methods.

One way to allocate income is to divide it evenly between the partners. In fact, when a partnership agreement is not present, the courts specify that an equal allocation must be applied regardless of the relative contributions or efforts of the partners. For example, assume that AP Company has $30,000 of net income for the period and has established an agreement that income should be allocated evenly between the two partners, Paige and Amy. Each capital account would be increased by $15,000. The effect of closing the Income Summary account to the capital accounts is as follows:

An equal distribution of income to all partners is easy to apply but is not fair to those partners who have contributed more in money or time to the partnership.

Another way to allocate income is to specify in the partnership agreement that income be allocated according to a stated ratio. For example, Paige and Amy may specify that all income of AP Company should be allocated in a 2-to-1 ratio, with Paige receiving the larger portion. If that allocation method is applied to Example 11-11, Paige Thoms, Capital would be increased by $20,000 and Amy Rebec, Capital would be increased by $10,000. If that allocation method is applied to Example 11-11, the effect is as follows:

Finally, an allocation method that more accurately reflects the partners' input is illustrated. It is based on salaries, interest on invested capital, and a stated ratio. Assume that the

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partnership agreement of AP Company specifies that Paige and Amy be allowed a salary of $6,000 and $4,000, respectively; that each partner receive 10% on her capital balance; and that any remaining income be allocated equally. Assume that AP Company has been in operation for several years and that the capital balances of the owners at the end of 2017, before the income distribution, are as follows:

If AP Company calculated that its 2017 net income (before partner salaries) was $30,000, income would be allocated between the partners as follows:

Paige Thoms, Capital would be increased by $15,500, and Amy Rebec, Capital, by $14,500. The effect of closing the Income Summary account to the capital accounts is as follows:

This indicates that the amounts of $15,500 and $14,500 were allocated to Paige and Amy, respectively. It does not indicate the amount actually paid to (or withdrawn by) the partners. However, for tax purposes, the income of the partnership is treated as personal income on the partners' individual tax returns regardless of whether the income is actually paid in cash to the partners.

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Module 4

Test Yourself

Question

1. What is an advantage of organizing a company as a corporation rather than a partnership? Why don't all companies incorporate? (Appendix)

2. What are some ways that partnerships could share income among the partners? (Appendix)

Apply

Furyk Company opened business as a sole proprietorship on January 1, 2017. The owner contributed $500,000 cash on that date. During the year, the company had a net income of $10,000. The company purchased equipment of $100,000 during the year. The owner also withdrew $60,000 to pay for personal expenses during 2017.

Determine the company's owner's equity at December 31, 2017.

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Chapter Review

Ratio Review

*When preferred stock is outstanding, the redemption value or liquidation value (disclosed on the preferred stock line or in the notes) of the preferred stock must be subtracted from total stockholders' equity.

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Chapter Review

Accounts Highlighted

Account Titles Where It Appears In What Section Cited on

Common Stock Balance Sheet Contributed Capital Example 11-1

Preferred Stock Balance Sheet Contributed Capital Example 11-2

Additional Paid-In Capital Balance Sheet Contributed Capital Example 11-2

Retained Earnings Balance Sheet Retained Earnings Example 11-4

Treasury Stock Balance Sheet (bottom portion of stockholders' equity as a contra account)

Example 11-3

Cash Dividend Payable Balance Sheet Current Liabilities Example 11-4

Stock Dividend Distributable Balance Sheet Contributed Capital Example 11-7

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Chapter 6 - Cash and Internal Control 2

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Chapter 7 Receivables and Investments

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Chapter 8 - Operating Assets - Property, Plant, and Equipment, and Intangibles

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Chapter 9 Current Liabilities, Contingencies, and the Time Value of Money

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Chapter 10 Long-Term Liabilities

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Chapter 11 Stockholders' Equity

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